Stochastic Finance

Nicolas Privault
Notes on
Stochastic Finance
This version: July 4, 2021

https://personal.ntu.edu.sg/nprivault/indext.html
Notes on Stochastic Finance
Preface
This text is an introduction to pricing and hedging in discrete and

continuous-time financial models without friction (i.e. without transaction
costs), with an emphasis on the complementarity between analytical and
probabilistic methods. Its contents are mostly mathematical, and also aim at
making the reader aware of both the power and limitations of mathematical
models in finance, by taking into account their conditions of applicability.
The book covers a wide range of classical topics including Black-Scholes pric-
ing, exotic and american options, term structure modeling and change of
numéraire, as well as models with jumps. It is targeted at the advanced un-
dergraduate and graduate level in applied mathematics, financial engineering,
and economics. The point of view adopted is that of mainstream mathemat-
ical finance in which the computation of fair prices is based on the absence
of arbitrage hypothesis, therefore excluding riskless profit based on arbitrage
opportunities and basic (buying low/selling high) trading. Similarly, this doc-
ument is not concerned with any “prediction” of stock price behaviors that
belong other domains such as technical analysis, which should not be con-
fused with the statistical modeling of asset prices. The text also about 20
examples based on actual market data.
The descriptions of the asset model, self-financing portfolios, arbitrage and
market completeness, are first given in Chapter 1 in a simple two time-step
setting. These notions are then reformulated in discrete time in Chapter 2.
Here, the impossibility to access future information is formulated using the
notion of adapted processes, which will play a central role in the construction
of stochastic calculus in continuous time.
In order to trade efficiently it would be useful to have a formula to esti-
mate the “fair price” of a given risky asset, helping for example to determine
whether the asset is undervalued or overvalued at a given time. Although
such a formula is not available, we can instead derive formulas for the pric-
ing of options that can act as insurance contracts to protect their holders
against adverse changes in the prices of risky assets. The pricing and hedging
of options in discrete time, particularly in the fundamental example of the
Cox-Ross-Rubinstein model, are considered in Chapter 3, with a description
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of the passage from discrete to continuous time that prepares the transition
to the subsequent chapters.
A simplified presentation of Brownian motion, stochastic integrals and the
associated Itô formula, is given in Chapter 4, with application to stochastic
asset price modeling in Chapter 5. The Black-Scholes model is presented from
the angle of partial differential equation (PDE) methods in Chapter 6, with
the derivation of the Black-Scholes formula by transforming the Black-Scholes
PDE into the standard heat equation, which is then solved by a heat kernel
argument. The martingale approach to pricing and hedging is then presented
in Chapter 7, and complements the PDE approach of Chapter 6 by recover-
ing the Black-Scholes formula via a probabilistic argument. An introduction
to stochastic volatility is given in Chapter 8, followed by a presentation of
volatility estimation tools including historical, local, and implied volatilities,
in Chapter 9. This chapter also contains a comparison of the prices obtained
by the Black-Scholes formula with actual option price market data.
Exotic options such as barrier, lookback, and Asian options are treated in
Chapters 11, 12 and 13 respectively, following an introduction to the prop-
erties of the maximum of Brownian motion given in Chapter 10. Optimal
stopping and exercise, with application to the pricing of American options,
are considered in Chapter 15, following the presentation of background ma-
terial on filtrations and stopping times in Chapter 14. The construction of
forward measures by change of numéraire is given in Chapter 16 and is applied
to the pricing of interest rate derivatives such as caplets, caps and swaptions
in Chapter 19, after an introduction to bond pricing and to the modeling of
forward rates in Chapters 17, and 18.
Stochastic calculus with jumps is dealt with in Chapter 20 and is restricted
to compound Poisson processes, which only have a finite number of jumps on
any bounded interval. Those processes are used for option pricing and hedging
in jump models in Chapter 21, in which we mostly focus on risk minimiz-
ing strategies as markets with jumps are generally incomplete. Chapter 22
contains an elementary introduction to finite difference methods for the nu-
merical solution of PDEs and stochastic differential equations, dealing with
the explicit and implicit finite difference schemes for the heat equations and
the Black-Scholes PDE, as well as the Euler and Milshtein schemes for SDEs.
The text is completed with an appendix containing the needed probabilistic
background.
The material in this book has been used for teaching in the Masters of
Science in Financial Engineering at City University of Hong Kong and at the
Nanyang Technological University in Singapore. The author thanks Nicky
van Foreest, Jinlong Guo, Kazuhiro Kojima, Sijian Lin, Sandu Ursu, and
Ju-Yi Yen for corrections and improvements.
This text contains 241 exercises and 15 problems with complete solutions.
Clicking on an exercise number inside the solution section will send to the
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original problem text inside the file. Conversely, clicking on a problem number
sends the reader to the corresponding solution, however this feature should
not be misused. The cover graph represents the time evolution of the HSBC
stock price from January to September 2009, plotted on the price surface of
a European put option on that asset, expiring on October 05, 2009, cf. § 6.1.
The pdf file contains internal and external links, 26 table and 351 figures,
including 54 animated Figures 3.7, 3.9, 4.6, 4.7, 4.9, 4.10, 4.15, 5.6, 6.5, 10.1,
10.2, 10.3, 10.6, 11.11, 13.1, 12.1, 12.6, 12.14, 15.2, 17.15, 18.6, 18.9, 18.10,
18.17, 20.14, 20.16, 20.17, and S.15, 2 embedded videos in Figures 2 and 9.3,
and 3 interacting 3D graphs in Figures 6.4, 6.11 and 11.1, that may require
using Acrobat Reader for viewing on the complete pdf file. It also includes
15 Python codes on pages 74, 90, 93, 96, 138, 148, 220, 248, 341, 527 and
861, and 69 R codes on pages 147, 148, 150, 153, 205, 201, 220, 223, 235, 228,
245, 248, 264, 341, 342, 357, 322, 397, 406, 624, 671, 695, 699, 713, 714, 789
and 792.
Nicolas Privault
2021
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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1 Assets, Portfolios, and Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . 21

1.1 Definitions and Notation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
1.2 Portfolio Allocation and Short Selling . . . . . . . . . . . . . . . . . . . . . 22
1.3 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
1.4 Risk-Neutral Probability Measures . . . . . . . . . . . . . . . . . . . . . . . . 28
1.5 Hedging of Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
1.6 Market Completeness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
1.7 Example: Binary Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
2 Discrete-Time Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

2.1 Discrete-Time Compounding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2.2 Arbitrage and Self-Financing Portfolios . . . . . . . . . . . . . . . . . . . . 54
2.3 Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
2.4 Martingales and Conditional Expectations . . . . . . . . . . . . . . . . . 65
2.5 Market Completeness and Risk-Neutral Measures . . . . . . . . . . . 71
2.6 The Cox-Ross-Rubinstein (CRR) Market Model . . . . . . . . . . . . 73
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
3 Pricing and Hedging in Discrete Time . . . . . . . . . . . . . . . . . . . . 83

3.1 Pricing Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
3.2 Pricing Vanilla Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3.3 Hedging Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
3.4 Hedging Vanilla Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
3.5 Hedging Exotic Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
3.6 Convergence of the CRR Model . . . . . . . . . . . . . . . . . . . . . . . . . . 112
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
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4 Brownian Motion and Stochastic Calculus . . . . . . . . . . . . . . . . 141

4.1 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
4.2 Three Constructions of Brownian Motion . . . . . . . . . . . . . . . . . . 145
4.3 Wiener Stochastic Integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
4.4 Itô Stochastic Integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
4.5 Stochastic Calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
5 Continuous-Time Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . 191

5.1 Asset Price Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
5.2 Arbitrage and Risk-Neutral Measures . . . . . . . . . . . . . . . . . . . . . 193
5.3 Self-Financing Portfolio Strategies . . . . . . . . . . . . . . . . . . . . . . . . 196
5.4 Two-Asset Portfolio Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
5.5 Geometric Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
6 Black-Scholes Pricing and Hedging . . . . . . . . . . . . . . . . . . . . . . . 213

6.1 The Black-Scholes PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
6.2 European Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
6.3 European Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
6.4 Market Terms and Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
6.5 The Heat Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
6.6 Solution of the Black-Scholes PDE . . . . . . . . . . . . . . . . . . . . . . . . 240
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
7 Martingale Approach to Pricing and Hedging . . . . . . . . . . . . . 255

7.1 Martingale Property of the Itô Integral . . . . . . . . . . . . . . . . . . . . 255
7.2 Risk-neutral Probability Measures . . . . . . . . . . . . . . . . . . . . . . . . 260
7.3 Change of Measure and the Girsanov Theorem . . . . . . . . . . . . . 264
7.4 Pricing by the Martingale Method . . . . . . . . . . . . . . . . . . . . . . . . 266
7.5 Hedging by the Martingale Method . . . . . . . . . . . . . . . . . . . . . . . 274
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
8 Stochastic Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

8.1 Stochastic Volatility Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
8.2 Realized Variance Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
8.3 Realized Variance Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
8.4 European Options - PDE Method . . . . . . . . . . . . . . . . . . . . . . . . 323
8.5 Perturbation Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
9 Volatility Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

9.1 Historical Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
9.2 Implied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
9.3 Local Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
9.4 The VIX® Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
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Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
10 Maximum of Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 363

10.1 Running Maximum of Brownian Motion . . . . . . . . . . . . . . . . . . . 363
10.2 The Reflection Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
10.3 Density of the Maximum of Brownian Motion . . . . . . . . . . . . . . 370
10.4 Average of Geometric Brownian Extrema . . . . . . . . . . . . . . . . . . 381
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
11 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393

11.1 Options on Extrema . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
11.2 Knock-Out Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398
11.3 Knock-In Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410
11.4 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
12 Lookback Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423

12.1 The Lookback Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
12.2 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426
12.3 The Lookback Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
12.4 Delta Hedging for Lookback Options . . . . . . . . . . . . . . . . . . . . . . 440
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
13 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449

13.1 Bounds on Asian Option Prices . . . . . . . . . . . . . . . . . . . . . . . . . . 449
13.2 Pricing by the Hartman-Watson distribution . . . . . . . . . . . . . . . 456
13.3 Laplace Transform Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459
13.4 Moment Matching Approximations . . . . . . . . . . . . . . . . . . . . . . . 460
13.5 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477
14 Optimal Stopping Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483

14.1 Filtrations and Information Flow . . . . . . . . . . . . . . . . . . . . . . . . . 483
14.2 Submartingales and Supermartingales . . . . . . . . . . . . . . . . . . . . . 484
14.3 Optimal Stopping Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487
14.4 Drifted Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
15 American Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503

15.1 Perpetual American Put Options . . . . . . . . . . . . . . . . . . . . . . . . . 503
15.2 PDE Method for Perpetual Put Options . . . . . . . . . . . . . . . . . . . 509
15.3 Perpetual American Call Options . . . . . . . . . . . . . . . . . . . . . . . . . 513
15.4 Finite Expiration American Options . . . . . . . . . . . . . . . . . . . . . . 518
15.5 PDE Method with Finite Expiration . . . . . . . . . . . . . . . . . . . . . . 522
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
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16 Change of Numéraire and Forward Measures . . . . . . . . . . . . . 539

16.1 Notion of Numéraire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539
16.2 Change of Numéraire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542
16.3 Foreign Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552
16.4 Pricing Exchange Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560
16.5 Hedging by Change of Numéraire . . . . . . . . . . . . . . . . . . . . . . . . . 562
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566
17 Short Rates and Bond Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575

17.1 Short-Term Mean-Reverting Models . . . . . . . . . . . . . . . . . . . . . . 575
17.2 Calibration of the Vasicek Model . . . . . . . . . . . . . . . . . . . . . . . . . 581
17.3 Zero-Coupon and Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . . . . 586
17.4 Bond Pricing PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 606
18 Forward Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617

18.1 Construction of Forward Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . 617
18.2 Interest Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 628
18.3 The HJM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631
18.4 Yield Curve Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 637
18.5 Two-Factor Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
18.6 The BGM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 647
19 Pricing of Interest Rate Derivatives . . . . . . . . . . . . . . . . . . . . . . 653

19.1 Forward Measures and Tenor Structure . . . . . . . . . . . . . . . . . . . . 653
19.2 Bond Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 657
19.3 Caplet Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 659
19.4 Forward Swap Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 663
19.5 Swaption Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 665
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 674
20 Stochastic Calculus for Jump Processes . . . . . . . . . . . . . . . . . . . 689

20.1 The Poisson Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 689
20.2 Compound Poisson Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 697
20.3 Stochastic Integrals and Itô Formula with Jumps . . . . . . . . . . . 703
20.4 Stochastic Differential Equations with Jumps . . . . . . . . . . . . . . 716
20.5 Girsanov Theorem for Jump Processes . . . . . . . . . . . . . . . . . . . . 721
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 729
21 Pricing and Hedging in Jump Models . . . . . . . . . . . . . . . . . . . . . 735

21.1 Fitting the Distribution of Market Returns . . . . . . . . . . . . . . . . 735
21.2 Risk-Neutral Probability Measures . . . . . . . . . . . . . . . . . . . . . . . . 744
21.3 Pricing in Jump Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 745
21.4 Exponential Lévy Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 747
21.5 Black-Scholes PDE with Jumps . . . . . . . . . . . . . . . . . . . . . . . . . . 750
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21.6 Mean-Variance Hedging with Jumps . . . . . . . . . . . . . . . . . . . . . . 753

Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 757
22 Basic Numerical Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 761

22.1 Discretized Heat Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 761
22.2 Discretized Black-Scholes PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . 764
22.3 Euler Discretization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 768
22.4 Milshtein Discretization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 769
Appendix: Background on Probability Theory . . . . . . . . . . . . . . . . 771

23.1 Probability Sample Space and Events . . . . . . . . . . . . . . . . . . . . . 771
23.2 Probability Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 775
23.3 Conditional Probabilities and Independence . . . . . . . . . . . . . . . . 777
23.4 Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 779
23.5 Probability Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 781
23.6 Expectation of Random Variables . . . . . . . . . . . . . . . . . . . . . . . . 788
23.7 Conditional Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 805
Exercise Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 809

Chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 809
Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 816
Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 823
Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 862
Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 891
Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 904
Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 921
Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 963
Chapter 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 969
Chapter 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 979
Chapter 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 994
Chapter 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1014
Chapter 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1024
Chapter 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1036
Chapter 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1044
Chapter 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1072
Chapter 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1084
Chapter 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1103
Chapter 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1114
Chapter 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1137
Chapter 21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1149
Background on Probability Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1154
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1159
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1171
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Author index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1181
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List of Figures
1 Two sample paths of one-dimensional Brownian motion . . . . . . . . . . . . 2

2 “As if a whole new world was laid out before me.”∗ . . . . . . . . . . . . . . . . 4
3 Comparison of WTI vs Keppel price graphs . . . . . . . . . . . . . . . . . . . . . . 5
4 Hang Seng index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
5 Payoff function of a put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
6 Sample price processes modeled by a geometric Brownian motion . . . . . 8
7 Payoff function of a call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
8 “Infogrames” stock price curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
9 Brent and WTI price graphs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
10 Price map of a four-way collar option . . . . . . . . . . . . . . . . . . . . . . . . . . 12
11 Payoff function of a four-way call collar option . . . . . . . . . . . . . . . . . . . 12
12 Four-way call collar payoff as a combination of call and put options∗ . . 13
13 Implied probabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
14 Implied probabilities according to bookmakers . . . . . . . . . . . . . . . . . . . 18
15 Implied probabilities according to polling . . . . . . . . . . . . . . . . . . . . . . . 18
16 Sample trajectories used for the Monte Carlo method . . . . . . . . . . . . . . 19
17 Course plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.1 Triangular arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

1.2 Arbitrage: Retail prices around the world . . . . . . . . . . . . . . . . . . . . . . . 26
1.3 Separation of convex sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
2.1 Illustration of the self-financing condition (2.7) . . . . . . . . . . . . . . . . . . . 57

2.2 Why apply discounting? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
2.3 Oil price graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
2.4 Take the quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
2.5 Discrete-time asset price tree in the CRR model . . . . . . . . . . . . . . . . . . 75
2.6 Discrete-time asset price graphs in the CRR model . . . . . . . . . . . . . . . . 76
2.7 Function x 7→ ((1 + x)21 − (1 + x)10 )/x . . . . . . . . . . . . . . . . . . . . . . . . 79
3.1 Discrete-time call option pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
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3.2 Discrete-time call option hedging strategy (risky component) . . . . . . . . 98

3.3 Discrete-time call option hedging strategy (riskless component) . . . . . . . 98
3.4 Tree of asset prices in the CRR model . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3.5 Tree of option prices in the CRR model . . . . . . . . . . . . . . . . . . . . . . . . 104
3.6 Tree of hedging portfolio allocations in the CRR model . . . . . . . . . . . . . 104
3.7 Galton board simulation∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
3.8 A real-life Galton board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
3.9 Multiplicative Galton board simulation∗ . . . . . . . . . . . . . . . . . . . . . . . . 115
3.10 Dividend detachment graph on Z74.SI . . . . . . . . . . . . . . . . . . . . . . . . . . 123
3.11 Put spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
3.12 Call spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
3.13 Tree of market prices with N = 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
3.14 Trees of bid and ask prices with N = 2 . . . . . . . . . . . . . . . . . . . . . . . . . 131
3.15 BTC/USD order book example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
4.1 Sample paths of a one-dimensional Brownian motion . . . . . . . . . . . . . . . 142

4.2 Evolution of the fortune of a poker player vs number of games played . . 143
4.3 Web traffic ranking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
4.4 Two sample paths of a two-dimensional Brownian motion . . . . . . . . . . . 144
4.5 Sample path of a three-dimensional Brownian motion . . . . . . . . . . . . . . 144
4.6 Scaling property of Brownian motion∗ . . . . . . . . . . . . . . . . . . . . . . . . . . 145
4.7 Brownian motion as a random walk∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
4.8 Statistics of one-dimensional Brownian paths vs Gaussian distribution . 147
4.9 Lévy’s construction of Brownian motion∗ . . . . . . . . . . . . . . . . . . . . . . . 148
4.10 Construction of Brownian motion by series expansions∗ . . . . . . . . . . . . 149
4.11 Step function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
4.12 Area under the step function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
4.13 Squared step function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
4.14 Infinite vs finite area under a curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
4.15 Step function approximation∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
4.16 Adapted pair trading portfolio strategy . . . . . . . . . . . . . . . . . . . . . . . . . 160
4.17 Squared simple predictable process . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
4.18 NGram Viewer output for the term "stochastic calculus" . . . . . . . . . . . . 166
4.19 Wrong application of Itô’s formula (sample) . . . . . . . . . . . . . . . . . . . . . 175
4.20 Simulated path of (4.33) with α = 10, σ = 0.2 and X0 = 0.5 . . . . . . . . . 177
4.21 Simulated path of (4.37) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
4.22 Simulated path of (4.38) with α = −5 and σ = 1 . . . . . . . . . . . . . . . . . 179
5.2 Why apply discounting? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

5.5 Ten sample paths of geometric Brownian motion . . . . . . . . . . . . . . . . . . 202
5.6 Geometric Brownian motion started at S0 = 1∗ . . . . . . . . . . . . . . . . . . 205
5.7 Statistics of geometric Brownian paths vs lognormal distribution . . . . . 209
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6.1 Underlying market prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214

6.2 Simulated geometric Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . 214
6.3 Graph of the Gaussian Cumulative Distribution Function (CDF) . . . . . 220
6.4 Black-Scholes call price map∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
6.5 Time-dependent solution of the Black-Scholes PDE (call option)∗ . . . . . 221
6.6 Delta of a European call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
6.7 Gamma of European call and put options . . . . . . . . . . . . . . . . . . . . . . . 224
6.8 HSBC Holdings stock price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
6.9 Path of the Black-Scholes price for a call option on HSBC . . . . . . . . . . 225
6.10 Time evolution of a hedging portfolio for a call option on HSBC . . . . . . 226
6.11 Black-Scholes put price function∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
6.12 Time-dependent solution of the Black-Scholes PDE (put option)∗ . . . . . 228
6.13 Delta of a European put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
6.14 Path of the Black-Scholes price for a put option on HSBC . . . . . . . . . . 230
6.15 Time evolution of the hedging portfolio for a put option on HSBC . . . . 231
6.16 Time-dependent solutions of the Black-Scholes PDE∗ . . . . . . . . . . . . . . 232
6.19 Warrant terms and data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
6.20 Time-dependent solution of the heat equation∗ . . . . . . . . . . . . . . . . . . . 237
6.21 Time-dependent solution of the heat equation∗ . . . . . . . . . . . . . . . . . . . 239
6.22 Short rate t 7→ rt in the CIR model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
6.23 Option price as a function of the volatility σ . . . . . . . . . . . . . . . . . . . . . 247
7.1 Drifted Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

7.2 Drifted Brownian paths under a shifted Girsanov measure . . . . . . . . . . 264
7.3 Payoff functions of bull spread and bear spread options . . . . . . . . . . . . . 282
7.4 Graphs of call/put payoff functions. . . . . . . . . . . . . . . . . . . . . . . . . 282
7.5 Long call butterfly payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
7.6 Option price as a function of underlying asset price and time to maturity 299
7.7 Delta as a function of underlying asset price and time to maturity . . . . 300
7.8 Gamma as a function of underlying asset price and time to maturity . . 300
7.9 Option price as a function of underlying asset price and time to maturity 301
7.10 Delta as a function of underlying asset price and time to maturity . . . . 302
7.11 Gamma as a function of underlying asset price and time to maturity . . 303
8.1 Euro / SGD exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306

8.2 Fitting of a lognormal probability density function . . . . . . . . . . . . . . . . 315
8.3 Fitting of a gamma probability density function . . . . . . . . . . . . . . . . . . 319
8.4 Variance call option prices with b = 0.15 . . . . . . . . . . . . . . . . . . . . . . . . 322
8.5 Variance call option prices with b = −0.05 . . . . . . . . . . . . . . . . . . . . . . . 322
8.6 Option price approximations plotted against v with ρ = −0.5 . . . . . . . . 333
9.1 Underlying asset price vs log-returns . . . . . . . . . . . . . . . . . . . . . . . . . . . 339

9.2 Historical volatility graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
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9.3 The fugazi: it’s a wazy, it’s a woozie. It’s fairy dust∗ . . . . . . . . . . . . . . . 340
9.4 Option price as a function of the volatility σ . . . . . . . . . . . . . . . . . . . . . 341
9.5 S&P500 option prices plotted against strike prices . . . . . . . . . . . . . . . . . 343
9.6 Implied volatility of Asian options on light sweet crude oil futures . . . . 344
9.7 Market stock price of Cheung Kong Holdings . . . . . . . . . . . . . . . . . . . . 345
9.8 Comparison of market option prices vs calibrated Black-Scholes prices . 345
9.9 Market stock price of HSBC Holdings . . . . . . . . . . . . . . . . . . . . . . . . . . 346
9.12 Call option price vs underlying asset price . . . . . . . . . . . . . . . . . . . . . . . 347
9.13 Simulated path of (9.7) with r = 0.5 and σ = 1.2 . . . . . . . . . . . . . . . . . 348
9.14 Local volatility estimated from Boeing Co. option price data . . . . . . . . . 353
9.15 VIX® Index vs the S&P 500 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
9.16 VIX® Index vs historical volatility for the year 2011 . . . . . . . . . . . . . . . 358
9.17 Correlation estimates between GSPC and the VIX® . . . . . . . . . . . . . . . 359
9.18 VIX® Index vs 30 day historical volatility for the S&P 500 . . . . . . . . . . 359
10.1 Brownian motion (Wt )t∈R+ and its running maximum (X0t )t∈R+ ∗ . . . . 364
10.2 Running maximum of Brownian motion∗ . . . . . . . . . . . . . . . . . . . . . . . . 364
10.3 Zeroes of Brownian motion∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
10.4 Graph of the Cantor function∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
10.5 A function with no last point of increase before t = 1 . . . . . . . . . . . . . . 366
10.6 Reflected Brownian motion with a = 1.07∗ . . . . . . . . . . . . . . . . . . . . . . 367
10.7 Probability density of the maximum of Brownian motion . . . . . . . . . . . 368
10.8 Probability density of the maximum of geometric Brownian motion . . . 370
10.9 Probability computed as a volume integral . . . . . . . . . . . . . . . . . . . . . . 371
10.10Reflected Brownian motion with a = 1.07∗ . . . . . . . . . . . . . . . . . . . . . . 372
10.11Joint probability density of Brownian motion and its maximum . . . . . . 373
10.12 Heat map of the joint density of W1 and its maximum . . . . . . . . . . . . . 374
10.13 Probability density of the maximum of drifted Brownian motion . . . . . 377
11.1 Up-and-out barrier call option price with B > K ∗ . . . . . . . . . . . . . . . . . 400

11.2 Up-and-out barrier put option price . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
11.3 Pricing data for an up-and-out barrier put option with K = B = $28 . . 406
11.4 Down-and-out barrier call option price . . . . . . . . . . . . . . . . . . . . . . . . . 407
11.5 Down-and-out barrier call option price as a function of volatility . . . . . . 408
11.6 Down-and-out barrier put option price with K > B . . . . . . . . . . . . . . . 409
11.7 Down-and-in barrier call option price with K > B . . . . . . . . . . . . . . . . 410
11.8 Up-and-in barrier call option price with K > B . . . . . . . . . . . . . . . . . . 411
11.9 Down-and-in barrier put option price with K > B . . . . . . . . . . . . . . . . 412
11.10 Up-and-in barrier put option price . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
11.11 Delta of the up-and-out barrier call option∗ . . . . . . . . . . . . . . . . . . . . . 418
12.1 Lookback put option price (3D)∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425

12.2 Graph of lookback put option prices . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
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12.3 Graph of lookback put option prices (2D) . . . . . . . . . . . . . . . . . . . . . . . 426

12.4 Normalized lookback put option price . . . . . . . . . . . . . . . . . . . . . . . . . . 430
12.5 Normalized Black-Scholes put price and correction term . . . . . . . . . . . . 432
12.6 Lookback call option price∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433
12.7 Graph of lookback call option prices . . . . . . . . . . . . . . . . . . . . . . . . . . . 434
12.8 Graphs of lookback call option prices (2D) . . . . . . . . . . . . . . . . . . . . . . 434
12.9 Normalized lookback call option price . . . . . . . . . . . . . . . . . . . . . . . . . 437
12.10 Underlying asset prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
12.11 Running minimum of the underlying asset price . . . . . . . . . . . . . . . . . . 437
12.12 Lookback call option price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438
12.13 Normalized Black-Scholes call price and correction term . . . . . . . . . . . . 439
12.14 Delta of the lookback call option∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . 442
12.15 Rescaled portfolio strategy for the lookback call option . . . . . . . . . . . . 442
12.16 Delta of the lookback put option∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
13.1 Brownian motion and its moving average∗ . . . . . . . . . . . . . . . . . . . . . . . 450

13.2 Asian option price vs European option price∗ . . . . . . . . . . . . . . . . . . . . 454
13.3 Asian call option prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459
13.4 Lognormal approximation of probability density . . . . . . . . . . . . . . . . . . 462
13.5 Lognormal approximation to the Asian call option price . . . . . . . . . . . . 463
13.6 Dividend detachment graph on Z74.SI . . . . . . . . . . . . . . . . . . . . . . . . . . 481
14.1 Drifted Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485

14.2 Evolution of the fortune of a poker player vs number of games played . . 485
14.3 Stopped process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
14.4 Sample paths of a gambling process (Mn )n∈N . . . . . . . . . . . . . . . . . . . 493
14.5 Brownian motion hitting a barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494
14.6 Drifted Brownian motion hitting a barrier . . . . . . . . . . . . . . . . . . . . . . . 495
14.7 Hitting probabilities of drifted Brownian motion∗ . . . . . . . . . . . . . . . . 497
15.1 American put prices by exercising at τL for different values of L . . . . . . 507

15.2 Animated graph of American put prices x 7→ fL (x)∗ . . . . . . . . . . . . . . 508
15.3 Option price as a function of L and of the underlying asset price . . . . . 508
15.4 Path of the American put option price on the HSBC stock . . . . . . . . . . 509
15.5 American call prices by exercising at τL for different values of L . . . . . . 516
15.6 Animated graph of American call prices x 7→ fL (x)∗ . . . . . . . . . . . . . . 516
15.7 American call prices for different values of L . . . . . . . . . . . . . . . . . . . . . 517
15.8 Black-Scholes call option price vs (x, t) 7→ (x − K )+ . . . . . . . . . . . . . . . 519
15.9 Black-Scholes put option price vs (x, t) 7→ (K − x)+ . . . . . . . . . . . . . . . 520
15.10 Optimal frontier for the exercise of a put option . . . . . . . . . . . . . . . . . . 521
15.11 PDE estimates of finite expiration American put option prices . . . . . . . 523
15.12 Longstaff-Schwartz estimates of finite expiration American put prices . 524
15.13 Comparison between Longstaff-Schwartz and finite differences . . . . . . . 524
15.14 Butterfly payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 527
16.1 Why change of numéraire? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541

" xix
N. Privault
16.2 Overseas investment opportunity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553
17.1 Short rate t 7→ rt in the Vasicek model . . . . . . . . . . . . . . . . . . . . . . . . . 577

17.2 CBOE 10 Year Treasury Note (TNX) yield . . . . . . . . . . . . . . . . . . . . . . 578
17.3 Short rate t 7→ rt in the CIR model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 579
17.4 Calibrated Vasicek simulation vs market data . . . . . . . . . . . . . . . . . . . . 586
17.5 Five-dollar 1875 Louisiana bond with 7.5% biannual coupons . . . . . . . . 586
17.6 Discrete-time coupon bond pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 589
17.7 Continuous-time coupon bond pricing . . . . . . . . . . . . . . . . . . . . . . . . . . 590
17.8 Comparison of Monte Carlo and PDE solutions . . . . . . . . . . . . . . . . . . . 597
17.9 Bond price t 7→ P (t, T ) vs t 7→ e −r0 (T −t) . . . . . . . . . . . . . . . . . . . . . . . 598
17.10 Bond price t 7→ Pc (t, T ) with a 5% coupon rate . . . . . . . . . . . . . . . . . . 598
17.11 Bond price with coupon rate 6.25% . . . . . . . . . . . . . . . . . . . . . . . . . . . 599
17.12 Orange Cnty Calif bond prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
17.13 Orange Cnty Calif bond yields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
17.14 Approximation of Dothan bond prices . . . . . . . . . . . . . . . . . . . . . . . . . 604
17.15 Brownian bridge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 606
18.1 Forward rate S 7→ f (t, t, S ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 618

18.2 Indonesian government securities yield curve . . . . . . . . . . . . . . . . . . . . 618
18.3 Forward rate process t 7→ f (t, T , S ) . . . . . . . . . . . . . . . . . . . . . . . . . . . 623
18.4 Instantaneous forward rate process t 7→ f (t, T ) . . . . . . . . . . . . . . . . . . . 624
18.5 Federal Reserve yield curves from 1982 to 2012 . . . . . . . . . . . . . . . . . . 625
18.6 European Central Bank yield curves∗ . . . . . . . . . . . . . . . . . . . . . . . . . 625
18.7 August 2019 Federal Reserve yield curve inversion∗ . . . . . . . . . . . . . . . 626
18.8 Stochastic process of forward curves . . . . . . . . . . . . . . . . . . . . . . . . . . . 632
18.9 Forward instantaneous curve in the Vasicek model∗ . . . . . . . . . . . . . . 636
18.10 Forward instantaneous curve x 7→ f (0, x) in the Vasicek model∗ . . . . . 636
18.11 Short-term interest rate curve t 7→ rt in the Vasicek model . . . . . . . . . 637
18.12 Nelson-Siegel graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 637
18.13 Svensson model graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 638
18.14 Fitting of a Svensson curve to market data . . . . . . . . . . . . . . . . . . . . . 638
18.15 Graphs of forward rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639
18.16 Forward instantaneous curve in the Vasicek model . . . . . . . . . . . . . . . . 639
18.17 ECB data vs fitted yield curve∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
18.18 Bond prices t 7→ P (t, T2 ), P (t, T2 ), P (t, T3 ) . . . . . . . . . . . . . . . . . . . . . 642
18.19 Forward rates in a two-factor model . . . . . . . . . . . . . . . . . . . . . . . . . . . 644
18.20 Evolution of instantaneous forward rates in a two-factor model . . . . . . 645
18.21 Roadmap of stochastic interest rate modeling . . . . . . . . . . . . . . . . . . . . 646
19.1 Implied swaption volatilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671
20.1 Sample path of a Poisson process (Nt )t∈R+ . . . . . . . . . . . . . . . . . . . . . . 690

20.2 Sample path of the Poisson process (Nt )t∈R+ . . . . . . . . . . . . . . . . . . . . 693
20.3 Sample path of the Poisson process (Nt )t∈R+ . . . . . . . . . . . . . . . . . . . . 696
20.4 Sample path of the compensated Poisson process (Nt − λt)t∈R+ . . . . . . 697
xx "
20.5 Probability density function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 698

20.6 Sample path of a compound Poisson process (Yt )t∈R+ . . . . . . . . . . . . . 699
20.7 Sample path of a compensated compound Poisson process . . . . . . . . . . . 703
20.8 Sample trajectories of a gamma process . . . . . . . . . . . . . . . . . . . . . . . . . 713
20.9 Sample trajectories of a variance gamma process . . . . . . . . . . . . . . . . . . 713
20.10 Sample trajectories of an inverse Gaussian process . . . . . . . . . . . . . . . . 714
20.11 Sample trajectories of a negative inverse Gaussian process . . . . . . . . . . 714
20.12 Sample trajectories of a stable process . . . . . . . . . . . . . . . . . . . . . . . . . 714
20.13 USD/CNY Exchange rate data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 715
20.14 Geometric Poisson process∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718
20.15 Ranking data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718
20.16 Geometric compound Poisson process∗ . . . . . . . . . . . . . . . . . . . . . . . . . 719
20.17 Geometric Brownian motion with compound Poisson jumps∗ . . . . . . . . 720
20.18 Share price with jumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 720
21.1 Market returns vs normalized Gaussian returns . . . . . . . . . . . . . . . . . . . 736

21.2 Empirical vs Gaussian CDF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737
21.3 Quantile-Quantile plot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737
21.4 Empirical density vs normalized Gaussian density . . . . . . . . . . . . . . . . . 738
21.5 Empirical density vs normalized lognormal density . . . . . . . . . . . . . . . . 739
21.6 Empirical density vs power density . . . . . . . . . . . . . . . . . . . . . . . . . . . . 739
21.7 Gram-Charlier expansions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 744
22.1 Divergence of the explicit finite difference method . . . . . . . . . . . . . . . . . 766

22.2 Stability of the implicit finite difference method . . . . . . . . . . . . . . . . . . 768
23.1 Probability computed as a volume integral . . . . . . . . . . . . . . . . . . . . . . 784
S.1 Strike price as a function of risk-free rate . . . . . . . . . . . . . . . . . . . . . . . 816

S.2 Investment graph (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 817
S.3 Investment graph (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 818
S.4 Put spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 837
S.5 Put spread collar payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 837
S.6 Put spread collar payoff as a combination of call and put payoffs∗ . . . . . 838
S.7 Call spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 839
S.8 Call spread collar payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 839
S.9 Call spread collar payoff as a combination of call and put payoffs∗ . . . . 840
S.10 Tree of market prices with N = 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 849
S.11 Put option prices in the trinomial model . . . . . . . . . . . . . . . . . . . . . . . . 862
S.12 Function x 7→ fε (x) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 878
S.13 Derivative x 7→ fε0 (x) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 879
S.14 Samples of linear interpolations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 882
S.15 Brownian crossings of level 1∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900
S.16 Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 902
S.17 Risk-neutral pricing of a foreign exchange option . . . . . . . . . . . . . . . . . . 902
S.18 Delta hedging of a foreign exchange option . . . . . . . . . . . . . . . . . . . . . . 902
" xxi
N. Privault
S.19 Bitcoin XBT/USD order book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 903

S.20 Time spent by Brownian motion within a given range . . . . . . . . . . . . . . 904
S.21 Market data for the warrant #01897 on the MTR Corporation . . . . . . . 911
S.22 Lower bound vs Black-Scholes call price . . . . . . . . . . . . . . . . . . . . . . . . 925
S.23 Lower bound vs Black-Scholes put option price . . . . . . . . . . . . . . . . . . . 925
S.24 Bull spread option as a combination of call and put options∗ . . . . . . . . 926
S.25 Bear spread option as a combination of call and put options∗ . . . . . . . . 927
S.26 Butterfly option as a combination of call options∗ . . . . . . . . . . . . . . . . . 930
S.27 Delta of a butterfly option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 931
S.28 Price of a binary call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 943
S.29 Risky hedging portfolio value for a binary call option . . . . . . . . . . . . . . 944
S.30 Risk-free hedging portfolio value for a binary call option . . . . . . . . . . . . 944
S.31 Black-Scholes price of the maximum chooser option . . . . . . . . . . . . . . . 946
S.32 Delta of the maximum chooser option . . . . . . . . . . . . . . . . . . . . . . . . . . 947
S.33 Black-Scholes price of the minimum chooser option . . . . . . . . . . . . . . . . 948
S.34 Delta of the minimum chooser option . . . . . . . . . . . . . . . . . . . . . . . . . . 949
S.35 Implied vs local volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 972
S.36 Average return by selling at the maximum vs selling at maturity . . . . . . 984
S.37 Ratios of average returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 986
S.38 Black-Scholes call price upper bound. . . . . . . . . . . . . . . . . . . . . . . . . . . 989
S.39 Black-Scholes put price upper bound. . . . . . . . . . . . . . . . . . . . . . . . . . . 990
S.40 “Optimal exercise” put price upper bound. . . . . . . . . . . . . . . . . . . . . . . 992
S.41 Price of the up-and-in long forward contract . . . . . . . . . . . . . . . . . . . . . 999
S.42 Delta of the up-and-in long forward contract . . . . . . . . . . . . . . . . . . . . . 1000
S.43 Price of the up-and-out long forward contract . . . . . . . . . . . . . . . . . . . . 1001
S.44 Delta of up-and-out long forward contract price . . . . . . . . . . . . . . . . . . 1002
S.45 Price of the down-and-in long forward contract . . . . . . . . . . . . . . . . . . . 1003
S.46 Delta of down-and-in long forward contract . . . . . . . . . . . . . . . . . . . . . . 1003
S.47 Price of the down-and-out long forward contract . . . . . . . . . . . . . . . . . . 1004
S.48 Delta of down-and-out long forward contract . . . . . . . . . . . . . . . . . . . . . 1005
S.49 Payoff function of the European knock-out call option . . . . . . . . . . . . . . 1009
S.50 Price map of the European knock-out call option . . . . . . . . . . . . . . . . . 1011
S.51 Payoff function of the European knock-in put option . . . . . . . . . . . . . . . 1011
S.52 Price map of the European knock-in put option . . . . . . . . . . . . . . . . . . 1012
S.53 Payoff function of the European knock-in call option . . . . . . . . . . . . . . . 1012
S.54 Price map of the European knock-in call option . . . . . . . . . . . . . . . . . . 1013
S.55 Payoff function of the European knock-out put option . . . . . . . . . . . . . . 1014
S.56 Price map of the European knock-out put option . . . . . . . . . . . . . . . . . 1014
S.57 Expected minimum of geometric Brownian motion . . . . . . . . . . . . . . . . 1015
S.58 Black-Scholes put price upper bound. . . . . . . . . . . . . . . . . . . . . . . . . . . 1016
S.59 Time derivative of the expected minimum . . . . . . . . . . . . . . . . . . . . . . . 1016
S.60 Expected maximum of geometric Brownian motion . . . . . . . . . . . . . . . . 1018
S.61 Black-Scholes call price upper bound. . . . . . . . . . . . . . . . . . . . . . . . . . . 1019
S.62 Time derivative of the expected maximum . . . . . . . . . . . . . . . . . . . . . . 1019
S.63 Lookback call option price as a function of maturity time T . . . . . . . . . 1022
xxii "
S.64 Lookback put option price (2D) as a function of M0t . . . . . . . . . . . . . . . 1023

S.65 Hitting times of a straight line started at α < 0 . . . . . . . . . . . . . . . . . . . 1042
S.66 Hitting times of a straight line started at α < 0 . . . . . . . . . . . . . . . . . . . 1043
S.67 American butterfly payoff and price functions . . . . . . . . . . . . . . . . . . . . 1046
S.68 Perpetual vs finite expiration American put option price . . . . . . . . . . . . 1047
S.69 American put price approximation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1048
S.70 Perpetual American binary put price map . . . . . . . . . . . . . . . . . . . . . . . 1060
S.71 Perpetual American binary call price map . . . . . . . . . . . . . . . . . . . . . . . 1061
S.72 Finite expiration American binary call price map . . . . . . . . . . . . . . . . . 1063
S.73 Finite expiration American binary put price map . . . . . . . . . . . . . . . . . 1065
S.74 Log bond prices correlation graph in the two-factor model . . . . . . . . . . 1112
∗
Animated figures (work with Acrobat Reader).
" xxiii
List of Tables
1.1 Mark Six “Investment Table” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2.1 Self-financing portfolio value process . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

2.2 NTRC Input investment plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
2.3 Avenda Insurance investment plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
4.1 Itô multiplication table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
6.1 Black-Scholes Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231

6.2 Variations of Black-Scholes prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
7.1 Call and put options on the Hang Seng Index (HSI). . . . . . . . . . 283
7.2 Contract summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
11.1 Barrier option types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397

11.2 Boundary conditions for barrier option prices . . . . . . . . . . . . . . . . . . . . 418
12.1 Extended Itô multiplication table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427
14.1 Martingales and stopping times . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494

14.2 List of martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
15.1 Optimal exercise strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
16.1 Local vs foreign exchange options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559
18.1 Stochastic interest rate models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 646
19.1 Forward rates arranged according to a tenor structure . . . . . . . . . . . . . . 653

19.2 A list of numéraire processes and their applications . . . . . . . . . . . . . . . . 673
20.1 Itô multiplication table with jumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 711
xxv
N. Privault
21.1 Market models and their properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 757
24.1 CRR pricing and hedging table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 825

24.2 CRR pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 827
24.3 CRR pricing and hedging tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 828
24.4 CRR pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 832
24.5 CRR pricing and hedging tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 833
24.6 Call and put options on the Hang Seng Index (HSI) . . . . . . . . . . . . . . . 928
24.7 Original call/put options on the Hang Seng Index (HSI) . . . . . . . . . . . . 929
xxvi "
Introduction
Modern quantitative finance requires a strong background in fields such as

stochastic calculus, optimization, partial differential equations (PDEs) and
numerical methods, or even infinite dimensional analysis. In addition, the
emergence of new complex financial instruments on the markets makes it
necessary to rely on increasingly sophisticated mathematical tools. Not all
readers of this book will eventually work in quantitative financial analysis,
nevertheless they may have to interact with quantitative analysts, and becom-
ing familiar with the tools they employ be an advantage. In addition, despite
the availability of ready made financial calculators it still makes sense to be
able oneself to understand, design and implement such financial algorithms.
This can be particularly useful under different types of conditions, includ-
ing an eventual lack of trust in financial indicators, possible unreliability of
expert advice such as buy/sell recommendations, or other factors such as
market manipulation. Instead of relying on predictions of stock price move-
ments based on various tools (technical analysis, charting, “cup & handle”
figures), we acknowledge that predicting the future is a difficult task and we
rely on the Efficient Market Hypothesis. In this framework, the time evolution
of the prices of risky assets will be modeled by random walks and stochastic
processes.
Historical sketch
We start with a description of some of the main steps, ideas and individuals
that played an important role in the development of the field over the last
century.
Robert Brown, botanist, 1827

Brown (1828) observed the movement of pollen particles as described in “A
brief account of microscopical observations made in the months of June, July
" 1
N. Privault
and August, 1827, on the particles contained in the pollen of plants; and on
the general existence of active molecules in organic and inorganic bodies.”
Phil. Mag. 4, 161-173, 1828.
0.8
0.6
0.4
0.2
-0.2
-0.4
0 0.2 0.4 0.6 0.8 1
Fig. 1: Two sample paths of one-dimensional Brownian motion.
Philosophical Magazine, first published in 1798, is a journal that “publishes

articles in the field of condensed matter describing original results, theories
and concepts relating to the structure and properties of crystalline materials,
ceramics, polymers, glasses, amorphous films, composites and soft matter.”
Louis Bachelier, Mathematician, PhD 1900

Bachelier (1900) used Brownian motion for the modeling of stock prices in
his PhD thesis “Théorie de la spéculation”, Annales Scientifiques de l’Ecole
Normale Supérieure 3 (17): 21-86, 1900.
Albert Einstein, physicist

Einstein received his 1921 Nobel Prize in part for investigations on the theory
of Brownian motion: “... in 1905 Einstein founded a kinetic theory to account
for this movement”, presentation speech by S. Arrhenius, Chairman of the
Nobel Committee, Dec. 10, 1922.
Einstein (1905) “Über die von der molekularkinetischen Theorie der Wärme
geforderte Bewegung von in ruhenden Flüssigkeiten suspendierten Teilchen”,
Annalen der Physik 17.
Norbert Wiener, Mathematician, founder of cybernetics

Wiener is credited, among other fundamental contributions, for the mathe-
matical foundation of Brownian motion, published in 1923. In particular he
constructed the Wiener space and Wiener measure on C0 ([0, 1]) (the space
of continuous functions from [0, 1] to R vanishing at 0).
2 "
Wiener (1923) “Differential space”, Journal of Mathematics and Physics of

the Massachusetts Institute of Technology, 2, 131-174, 1923.
伊藤清 ), Mathematician, C.F. Gauss Prize 2006

Kiyoshi Itô (伊
Itô constructed the Itô integral with respect to Brownian motion, cf. Itô,
Kiyoshi, Stochastic integral. Proc. Imp. Acad. Tokyo 20, (1944). 519-524. He
also constructed the stochastic calculus with respect to Brownian motion,
which laid the foundation for the development of calculus for random pro-
cesses, see Itô (1951) “On stochastic differential equations”, in Memoirs of
the American Mathematical Society.
“Renowned math wiz Itô, 93, dies.” (The Japan Times, Saturday, Nov. 15,
2008)
Kiyoshi Itô, an internationally renowned mathematician and professor

emeritus at Kyoto University died Monday of respiratory failure at a Ky-
oto hospital, the university said Friday. He was 93. Itô was once dubbed
“the most famous Japanese in Wall Street” thanks to his contribution
to the founding of financial derivatives theory. He is known for his work
on stochastic differential equations and the “Itô Formula”, which laid the
foundation for the Black and Scholes (1973) model, a key tool for financial
engineering. His theory is also widely used in fields like physics and biology.
Paul Samuelson, economist, Nobel Prize 1970
Samuelson (1965) rediscovered Bachelier’s ideas and proposed geometric

Brownian motion as a model for stock prices. In an interview he stated “In
the early 1950s I was able to locate by chance this unknown Bachelier (1900)
book, rotting in the library of the University of Paris, and when I opened it
up it was as if a whole new world was laid out before me.” We refer to “Ra-
tional theory of warrant pricing” by Paul Samuelson, Industrial Management
Review, p. 13-32, 1965.
" 3
N. Privault
Fig. 2: Clark (2000) “As if a whole new world was laid out before me.”∗
In recognition of Bachelier’s contribution, the Bachelier Finance Society was

started in 1996 and now holds the World Bachelier Finance Congress every
two years.
Robert Merton, Myron Scholes, economists
Robert Merton and Myron Scholes shared the 1997 Nobel Prize in eco-
nomics: “In collaboration with Fisher Black, developed a pioneering formula
for the valuation of stock options ... paved the way for economic valuations
in many areas ... generated new types of financial instruments and facilitated
more efficient risk management in society.”†
Black and Scholes (1973) “The Pricing of Options and Corporate Liabilities”.
Journal of Political Economy 81 (3): 637-654.
The development of options pricing tools contributed greatly to the expansion

of option markets and led to development several ventures such as the “Long
Term Capital Management” (LTCM), founded in 1994. The fund yielded an-
nualized returns of over 40% in its first years, but registered lost US$ 4.6
billion in less than four months in 1998, which resulted into its closure in
early 2000.
∗
Click on the figure to play the video (works in Acrobat Reader on the entire pdf file).
†
This has to be put in relation with the modern development of risk societies; “societies
increasingly preoccupied with the future (and also with safety), which generates the
notion of risk”.
4 "
Oldřich Vašíček, economist, 1977
Interest rates behave differently from stock prices, notably due to the phe-
nomenon of mean reversion, and for this reason they are difficult to model
using geometric Brownian motion. Vašíček (1977) was the first to suggest a
mean-reverting model for stochastic interest rates, based on the Ornstein-
Uhlenbeck process, in “An equilibrium characterization of the term struc-
ture”, Journal of Financial Economics 5: 177-188.
David Heath, Robert Jarrow, Andrew Morton
These authors proposed in 1987 a general framework to model the evolu-

tion of (forward) interest rates, known as the Heath-Jarrow-Morton (HJM)
model, see Heath et al. (1992) “Bond pricing and the term structure of inter-
est rates: a new methodology for contingent claims valuation”, Econometrica,
(January 1992), Vol. 60, No. 1, pp 77-105.
Alan Brace, Dariusz Gatarek, Marek Musiela (BGM)
The Brace et al. (1997) model is actually based on geometric Brownian

motion, and it is specially useful for the pricing of interest rate derivatives
such as interest rate caps and swaptions on the LIBOR market, see “The
Market Model of Interest Rate Dynamics”. Mathematical Finance Vol. 7,
page 127. Blackwell 1997, by Alan Brace, Dariusz Gatarek, Marek Musiela.
Although LIBOR rates are to be phased out by the end of year 2021, we
will still use this terminology when referring to simple or linear compounded
forward rates.
Financial derivatives
The following graphs exhibit a correlation between commodity (oil) prices

and an oil-related asset price.
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2012 2013 2014 2015 2016 2012 2013 2014 2015 2016
(a) WTI price graph. (b) Graph of Keppel Corp. stock price
Fig. 3: Comparison of WTI vs Keppel price graphs.
" 5
N. Privault
The study of financial derivatives aims at finding functional relationships

between the price of an underlying asset (a company stock price, a commodity
price, etc) and the price of a related financial contract (an option, a financial
derivative, etc.).
Option contracts
Early accounts of option contracts can also be found in The Politics Aristotle
(BCE) by Aristotle (384-322 BCE). Referring to the philosopher Thales of
Miletus (c. 624 - c. 546 BCE), Aristotle writes:
“He (Thales) knew by his skill in the stars while it was yet winter that
there would be a great harvest of olives in the coming year; so, having a
little money, he gave deposits for the use of all the olive-presses in Chios
and Miletus, which he hired at a low price because no one bid against him.
When the harvest-time came, and many were wanted all at once and of a
sudden, he let them out at any rate which he pleased, and made a quantity
of money”.
Option credit contracts appear to have been used as early as the 10th cen-
tury by traders in the Mediterranean. As of year 2015, the size of the financial
derivatives market is estimated at over one quadrillion (or one million bil-
lions, or 1015 ) USD, which is more than 10 times the size of the total Gross
World Product (GWP).
Next, we move to a description of (European) call and put options, which

are at the basis of risk management.
European put option contracts
As previously mentioned, an important concern for the buyer of a stock at

time t is whether its price ST can decline at some future date T . The buyer of
the stock may seek protection from a market crash by purchasing a contract
that allows him to sell his asset at time T at a guaranteed price K fixed at
time t. This contract is called a put option with strike price K and exercise
date T .
6 "
Fig. 4: Graph of the Hang Seng index - holding a put option might be useful here.
Definition 1. A (European) put option is a contract that gives its holder

the right (but not the obligation) to sell a quantity of assets at a predefined
price K called the strike price (or exercise price) and at a predefined date T
called the maturity.
In case the price ST falls down below the level K, exercising the contract will
give the holder of the option a gain equal to K − ST in comparison to those
who did not subscribe the option contract and have to sell the asset at the
market price ST . In turn, the issuer of the option contract will register a loss
also equal to K − ST (in the absence of transaction costs and other fees).
If ST is above K, then the holder of the option contract will not exercise the
option as he may choose to sell at the price ST . In this case the profit derived
from the option contract is 0.
In general, the payoff of a (so called European) put option contract can be
written as
 K − ST if ST 6 K,

+
φ(ST ) = (K − ST ) :=
0, if ST > K.

" 7
N. Privault
20
Put option payoff (K-x)+
15
(K-x)+
10
0
80 85 90 95 100 105 110 115 120
K
Fig. 5: Payoff function of a put option with strike price K = 100.
See e.g. http://optioncreator.com/stwwxvz.
Two possible scenarios (ST finishing above K or below K) are illustrated in

Figure 6.
10
ST-K>0
9
7
Strike price
6
St
5
4
ST-K<0
3
2
S0.1
1
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 T= 1
Fig. 6: Sample price processes modeled by a geometric Brownian motion.
Example of put option: the buy back guarantee∗ in currency exchange is

a common example of European put option.
Cash settlement vs physical delivery
Physical delivery. In the case of physical delivery, the put option contract
issuer will pay the strike price $K to the option contract holder in exchange
for one unit of the risky asset priced ST , which will be returned to the lender.
Cash settlement. In the case of a cash settlement, the put option contract
issuer will satisfy the option contract by purchasing back the risky asset
∗
Right-click to open or save the attachment.
8 "
priced ST to return it to the lender, and by transferring in the remaining

amount C = (K − ST )+ to the option contract holder.
European call option contracts
On the other hand, if the trader aims at buying some stock or commodity,
his interest will be in prices not going up and he might want to purchase a
call option, which is a contract allowing him to buy the considered asset at
time T at a price not higher than a level K fixed at time t.
Definition 2. A (European) call option is a contract that gives its holder the
right (but not the obligation) to purchase a quantity of assets at a predefined
price K called the strike price, and at a predefined date T called the maturity.
Here, in the event that ST goes above K, the buyer of the option contract
will register a potential gain equal to ST − K in comparison to an agent who
did not subscribe to the call option.
In general, the payoff of a (so called European) call option contract can be
written as
 ST − K if ST > K,

+
φ(ST ) = (ST − K ) :=
0, if ST 6 K.

20
Call option payoff (K-x)+
15
(x-K)+
10
0
80 85 90 95 100 105 110 115 120
K
Fig. 7: Payoff function of a call option with strike price K = 100.
See e.g. http://optioncreator.com/stqhbgn.
According to market practice, options are often divided into a certain number
n of warrants, the (possibly fractional) quantity n being called the entitle-
ment ratio.
" 9
N. Privault
Example of call option: the price lock guarantee∗ in online booking is a

common example of European call option.
Cash settlement vs physical delivery
Physical delivery. In the case of physical delivery, the call option contract
issuer will transfer one unit of the risky asset priced ST to the option contract
holder in exchange for the strike price $K, which will be used to refund the
initial loan subscribed by the contract issuer.
Cash settlement. In the case of a cash settlement, the call option contract
issuer will satisfy the option contract by selling one unit of risky asset at
the price ST , by refunding the initial loan, and by transferring the remaining
amount C = (ST − K )+ to the option contract holder.
The derivatives market
As of year 2015, the size of the derivatives market was estimated at more that
$1.2 quadrillion,† or more than 10 times the Gross World Product (GWP).
See here or here for up-to-date data on notional amounts outstanding and
gross market value from the Bank for International Settlements (BIS).
Option pricing
In order for an option contract to be fair, the buyer of the option contract
should pay a fee (similar to an insurance fee) at the signature of the contract.
The computation of this fee is an important issue, which is known as option
pricing.
Option hedging
The second important issue is that of hedging, i.e. how to manage a given
portfolio in such a way that it contains the required random payoff (K − ST )+
(for a put option) or (ST − K )+ (for a call option) at the maturity date T .
The next Figure 8 illustrates a sharp increase and sharp drop in asset price,
making it valuable to hold a call option contract during the first half of the
graph, whereas holding a put option contract would be recommended during
the second half.
∗
†
One thousand trillion, or one million billion, or 1015 .
10 "
Fig. 8: “Infogrames” stock price curve.
Example: Fuel hedging and the four-way zero-collar option
WTI Oil Prices [2010−01−04/2015−11−27] BRENT Oil Prices [2010−01−04/2015−11−30]

25
Last 3.52 Last 43.73
120
20
100
15
80
10
60
40
Jan 04 Jan 03 Jan 03 Jan 02 Jan 02 Jan 02 Jan 04 Jan 03 Jan 03 Jan 02 Jan 02 Jan 02
2010 2011 2012 2013 2014 2015 2010 2011 2012 2013 2014 2015
(a) WTI price graph. (b) Brent price graph
Fig. 9: Brent and WTI price graphs.
install.packages("Quandl")
library(Quandl);library(quantmod)
getSymbols("DCOILBRENTEU", src="FRED")
chartSeries(DCOILBRENTEU,up.col="blue",theme="white",name = "BRENT Oil
Prices",lwd=5)
BRENT = Quandl("FRED/DCOILBRENTEU",start_date="2010-01-01",
end_date="2015-11-30",type="xts")
chartSeries(BRENT,up.col="blue",theme="white",name = "BRENT Oil Prices",lwd=5)
getSymbols("WTI", from="2010-01-01", to="2015-11-30")
WTI <- Ad(`WTI`)
chartSeries(WTI,up.col="blue",theme="white",name = "WTI Oil Prices",lwd=5)
(April 2011)
Fuel hedge promises Kenya Airways smooth ride in volatile oil market.∗
(November 2015)
A close look at the role of fuel hedging in Kenya Airways $259 million loss.∗
∗
" 11
N. Privault
The four-way call collar call option requires its holder to purchase the un-
derlying asset (here, airline fuel) at a price specified by the blue curve in
Figure 10, when the underlying asset price is represented by the red line.
160
four-way collar
150 y=x
140
130
120
110
100
90
80
70
70 80 90 100 110 120 130 140 150
x
Fig. 10: Price map of a four-way collar option.
The four-way call collar option contract will result into a positive or negative
payoff depending on current fuel prices, as illustrated in Figure 11.
20
four-way collar payoff
15
10
-5
-10
-15
-20
70 80 90 100 110 120 130 140 150
K1 K2 ST K3 K4
Fig. 11: Payoff function of a four-way call collar option.
The four-way call collar payoff can be written as a linear combination
φ(ST ) = (K1 − ST )+ − (K2 − ST )+ + (ST − K3 )+ − (ST − K4 )+
of call and put option payoffs with respective strike prices
K1 = 90, K2 = 100, K3 = 120, K4 = 130,
see e.g. http://optioncreator.com/st5rf51.
12 "
20
(K1-x)+-(K2-x)++(x-K3)+
15 -(x-K4)+
10
-5
-10
-15
-20
70 80 90 100 110 120 130 140 150
K1 K2 ST K3 K4
Fig. 12: Four-way call collar payoff as a combination of call and put options.∗
Therefore, the four-way call collar option contract can be synthesized by:
1. purchasing a put option with strike price K1 = $90, and
2. selling (or issuing) a put option with strike price K2 = $100, and
3. purchasing a call option with strike price K3 = $120, and
4. selling (or issuing) a call option with strike price K4 = $130.
Moreover, the call collar option contract can be made costless by adjusting
the boundaries K1 , K2 , K3 , K4 , in which case it becomes a zero-collar option.
Example - The one-step 4-5-2 model
We close this introduction with a simplified example of the pricing and hedg-
ing technique in a binary model. Consider:
i) A risky stock valued S0 = $4 at time t = 0, and taking only two possible
values 
 $5
S1 =
$2

at time t = 1.
ii) An option contract that promises a claim payoff C whose values are
defined contingent to the market data of S1 as:
 $3 if S1 = $5

C :=
$0 if S1 = $2.

∗
The animation works in Acrobat Reader on the entire pdf file.
" 13
N. Privault
Exercise: Does C represent the payoff of a put option contract? Of a call

option contract? If yes, with which strike price K?
At time t = 0 the option contract issuer (or writer) chooses to invest α units
in the risky asset S, while keeping $β on our bank account, meaning that we
invest a total amount
αS0 + $β at time t = 0.
Here, the amount $β may be positive or negative, depending on whether it

is corresponds to savings or to debt, and is interpreted as a liability.
The following issues can be addressed:

a) Hedging: How to choose the portfolio allocation (α, $β ) so that the value
αS1 + $β
of the portfolio matches the future payoff C at time t = 1?
b) Pricing: How to determine the amount αS0 + $β to be invested by the

option contract issuer in such a portfolio at time t = 0?
S1 = 5 and C = 3
S1 = 5 and C = 3
S0 = 4 S0 = 4
S1 = 2 and C = 0
S1 = 2 and C = 0
Hedging means that at time t = 1 the portfolio value matches the future
payoff C, i.e.
αS1 + $β = C.
Hedge, then price. This condition can be rewritten as
 $3 = α × $5 + $β if S1 = $5,

C=
$0 = α × $2 + $β if S1 = $2,

i.e.
 5α + β = 3,  α = 1 stock,
 
which yields
2α + β = 0, $β = −$2.
 
In other words, the option contract issuer purchases 1 (one) unit of the stock
S at the price S0 = $4, and borrows $2 from the bank. The price of the
14 "
option contract is then given by the portfolio value
αS0 + $β = 1 × $4 − $2 = $2.
at time t = 0.
The above computation is implemented in the attached IPython notebook∗

that can be run here. This algorithm is scalable and can be extended to re-
combining binary trees over multiple time steps.
Definition 3. The arbitrage-free price of the option contract is defined as
the initial cost αS0 + $β of the portfolio hedging the claim payoff C.
 $3 if S1 = $5

Conclusion: in order to deliver the random payoff C =

$0 if S1 = $2.

to the option contract holder at time t = 1, the option contract issuer (or
writer) will:
1. charge αS0 + $β = $2 (the option contract price) at time t = 0,
2. borrow −$β = $2 from the bank,
3. invest those $2 + $2 = $4 into the purchase of α = 1 unit of stock valued

at S0 = $4 at time t = 0,
4. wait until time t = 1 to find that the portfolio value has evolved into
 α × $5 + $β = 1 × $5 − $2 = $3 if S1 = $5,

C=
α × $2 + $β = 1 × $2 − $2 = 0 if S1 = $2,

so that the option contract and the equality C = αS1 + $β can be ful-
filled, allowing the option issuer to break even whatever the evolution of
the risky asset price S.
In a cash settlement, the stock is sold at the price S1 = $5 or S1 = $2,

the payoff C = (S1 − K )+ = $3 or $0 is issued to the option contract
holder, and the loan is refunded with the remaining $2.
In the case of physical delivery , α = 1 share of stock is handed in to the

option holder in exchange for the strike price K = $2 which is used to
refund the initial $2 loan subscribed by the issuer.
Here, the option contract price αS0 + $β = $2 is interpreted as the cost of
hedging the option. In Chapters 2 and 3 we will see that this model is scalable

∗
Right-click to save as attachment (may not work on .
" 15
N. Privault
and extends to discrete time.
We note that the initial option contract price of $2 can be turned to C = $3

(%50 profit) ... or into C = $0 (total ruin).
Thinking further
1) The expected claim payoff at time t = 1 is
E[C ] = $3 × P(C = $3) + $0 × P(C = $0)

= $3 × P(S1 = $5).
In absence of arbitrage opportunities (“fair market”), this expected payoff

E[C ] should equal the initial amount $2 invested in the option. In that case
we should have
 E[C ] = $3 × P(S1 = $5) = $2

P(S1 = $5) + P(S1 = $2) = 1.


from which we can infer the probabilities

 2
 P(S1 = $5) = 3


(1)
 P(S = $2) = 1 ,


1
3
which are called risk-neutral probabilities. We see that under the risk-neutral
probabilities, the stock S has twice more chances to go up than to go down
in a “fair” market.
2) Based on the probabilities (1) we can also compute the expected value
E[S1 ] of the stock at time t = 1. We find
E[S1 ] = $5 × P(S1 = $5) + $2 × P(S1 = $2)

2 1
= $5 × + $2 ×
3 3
= $4
= S0 .
Here this means that, on average, no additional profit can be made from an
investment on the risky stock. In a more realistic model we can assume that
the riskless bank account yields an interest rate equal to r, in which case the
above analysis is modified by letting $β become $(1 + r )β at time t = 1,
nevertheless the main conclusions remain unchanged.
16 "
Market-implied probabilities
By matching the theoretical price E[C ] to an actual market price data $M

as
$M = E[C ] = $3 × P(C = $3) + $0 × P(C = $0) = $3 × P(S1 = $5)
we can infer the probabilities


$M
 P(S1 = $5) = 3



(2)
 P(S1 = $2) = 3 − $M ,



3
which are implied probabilities estimated from market data, as illustrated in
Figure 13. We note that the conditions
0 < P(S1 = $5) < 1, 0 < P(S1 = $2) < 1
are equivalent to 0 < $M < 3, which is consistent with financial intuition in

a non-deterministic market.
Fig. 13: Implied probabilities.

Note that implied probabilities should also be used with caution, as shown
in Figures 14-15.
" 17
N. Privault
Fig. 14: Implied probabilities according to bookmakers.
Fig. 15: Implied probabilities according to polling.
Implied probabilities can be estimated using e.g. binary options, see for ex-
ample Exercise 3.10.
The Practitioner expects a good model to be:
• Robust with respect to missing, spurious or noisy data,
• Fast - prices have to be delivered daily in the morning,
• Easy to calibrate - parameter estimation,
• Stable with respect to re-calibration and the use of new data sets.
Typically, a medium size bank manages 5,000 options and 10,000 deals daily
over 1,000 possible scenarios and dozens of time steps. This can mean a
hundred million computations of E[C ] daily, or close to a billion such com-
putations for a large bank.
The Mathematician tends to focus on more theoretical features, such as:

• Elegance,
18 "
• Sophistication,
• Existence of analytical (closed-form) solutions / error bounds,
• Significance to mathematical finance.
This includes:
• Creating new payoff functions and structured products,
• Defining new models for underlying asset prices,
• Finding new ways to compute expectations E[C ] and hedging strategies.
The methods involved include:
• Monte Carlo (60%),
2.5
2.0
1.5
1.0
0 200 400 600 800 1000

Time
Fig. 16: Sample trajectories used for the Monte Carlo method.
• PDEs and finite differences (30%),

• Other analytic methods and approximations (10%),
+ AI and Machine Learning techniques.
Course plan
The course plan from Chapter 1 to Chapter 7 is structured in layers that

repeat the main concepts (arbitrage, pricing, hedging, risk-neutral measures)
in different time scale settings (one-step, discrete-time, continuous-time).
" 19
N. Privault
-n eutral measure
isk model
s
R
ime Multis
t te p
s-
p model
C o n t i n uo u
Arb
m
te
od e
One-s
itrage
4-5-2
l
ing
Example
Pric
H
ed
ing g
Fig. 17: Course plan.
20 "
Chapter 1
Assets, Portfolios, and Arbitrage
In this chapter, the concepts of portfolio, arbitrage, market completeness,

pricing and hedging, are introduced in a simplified single-step financial model
with only two time instants t = 0 and t = 1. A binary asset price model is
considered as an example in Section 1.7.
1.1 Definitions and Notation . . . . . . . . . . . . . . . . . . . . . . . 21

1.2 Portfolio Allocation and Short Selling . . . . . . . . . . . 22
1.3 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
1.4 Risk-Neutral Probability Measures . . . . . . . . . . . . . . 28
1.5 Hedging of Contingent Claims . . . . . . . . . . . . . . . . . . 33
1.6 Market Completeness . . . . . . . . . . . . . . . . . . . . . . . . . . 35
1.7 Example: Binary Market . . . . . . . . . . . . . . . . . . . . . . . 35
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
1.1 Definitions and Notation
We will use the following notation. An element x of Rd+1 is a vector
x = x(0) , x(1) , . . . , x(d)

made of d + 1 components. The scalar product x • y of two vectors x, y ∈ Rd+1

is defined by
x • y : = x(0) y (0) + x(1) y (1) + · · · + x(d) y (d) .
The vector
(0) (1) (d)
S 0 = S0 , S0 , . . . , S0
(i)
denotes the prices at time t = 0 of d + 1 assets. Namely, S0 > 0 is the price
at time t = 0 of asset no i = 0, 1, . . . , d.
" 21
N. Privault
(i)
The asset values S1 > 0 of assets No i = 0, 1, . . . , d at time t = 1 are
represented by the vector
(0) (1) (d)
S 1 = S1 , S1 , . . . , S1 ,
(1) (d)
whose components S1 , . . . , S1 are random variables defined on a proba-
bility space (Ω, F, P).
In addition we will assume that asset no 0 is a riskless asset (of savings

account type) that yields an interest rate r > 0, i.e. we have
(0) (0)
S1 = (1 + r )S0 .
1.2 Portfolio Allocation and Short Selling

A portfolio based on the assets 0, 1, . . . , d is viewed as a vector
ξ = ξ (0) , ξ (1) , . . . , ξ (d) ∈ Rd+1 ,

in which ξ (i) represents the (possibly fractional) quantity of asset no i owned

by an investor, i = 0, 1, . . . , d. The price of such a portfolio, or the cost of
the corresponding investment, is given by
d
(i) (0) (1) (d)
ξ (i) S0 = ξ (0) S0 + ξ (1) S0 + · · · + ξ (d) S0
X
ξ • S0 =
i=0
at time t = 0. At time t = 1 ,the value of the portfolio has evolved into

d
(i) (0) (1) (d)
ξ (i) S1 = ξ (0) S1 + ξ (1) S1 + · · · + ξ (d) S1 .
X
ξ • S1 =
i=0
There are various ways to construct a portfolio allocation ξ (i) .

i=0,1,...,d
(0)
i) If ξ (0) > 0, the investor puts the amount ξ (0) S0 > 0 on a savings ac-
count with interest rate r.
(0)
ii) If ξ (0) < 0, the investor borrows the amount −ξ (0) S0 > 0 with the
same interest rate r.
iii) For i = 1, 2, . . . , d, if ξ (i) > 0 then the investor purchases a (possibly

fractional) quantity ξ (i) > 0 of the asset no i.
22 "
iv) If ξ (i) < 0, the investor borrows a quantity −ξ (i) > 0 of asset i and sells
(i)
it to obtain the amount −ξ (i) S0 > 0.
In the latter case one says that the investor short sells a quantity −ξ (i) > 0
of the asset no i, which lowers the cost of the portfolio.
Definition 1.1. The short selling ratio, or percentage of daily turnover ac-
tivity related to short selling, is defined as as the ratio of the number of daily
short sold shares divided by daily volume.
Profits are usually made by first buying at a low price and then selling at a
high price. Short sellers apply the same rule but in the reverse time order: first
sell high, and then buy low if possible, by applying the following procedure.
1. Borrow the asset no i.
(i)
2. At time t = 0, sell the asset no i on the market at the price S0 and
(i)
invest the amount S0 at the interest rate r > 0.
(i)
3. Buy back the asset no i at time t = 1 at the price S1 , with hopefully
(i) (i)
S1 < ( 1 + r ) S0 .
4. Return the asset to its owner, with possibly a (small) fee p > 0.∗
At the end of the operation the profit made on share no i equals

(i) (i)
(1 + r )S0 − S1 − p > 0,
(i) (i)
which is positive provided that S1 < (1 + r )S0 and p > 0 is sufficiently
small.
1.3 Arbitrage
Arbitrage can be described as:

“the purchase of currencies, securities, or commodities in one market for
immediate resale in others in order to profit from unequal prices”.†
In other words, an arbitrage opportunity is the possibility to make a strictly
positive amount of money starting from zero, or even from a negative amount.
In a sense, the existence of an arbitrage opportunity can be seen as a way to
“beat” the market.
∗
The cost p of short selling will not be taken into account in later calculations.
†
https://www.collinsdictionary.com/dictionary/english/arbitrage
" 23
.
N. Privault eur to usd
For example, triangular arbitrage is a way to realize arbitrage opportuni-

All News Shopping Maps Books More Settings
ties based on discrepancies in the cross exchange rates of foreign currencies,
as seen in Figure 1.1.∗
About 18,900,000 results (1.32 seconds)
XE Live Exchange Rates
USD EUR GBP
1.00000 0.89347 0.76988
1.11923 1.00000 0.86167

1 day ago
1.29891 1.16054 1.00000
0.01548 0.01384 0.01192
(a) (Wikipedia). 1 more(b)

row Cross exchange rates.
Fig. 1.1: Examples of triangular arbitrage.
XE: Convert EUR/USD. Euro Member Countries to United States Dollar
www.xe.com/currencyconverter/convert/?From=EUR&To=USD
As an attempt to realize triangular arbitrage based on the data of Figure 1.1b,
one could:
About this result F
1. Change US$1.00 into €0.89347,
2. Change €0.89347 into £0.89347 × 0.86167
XE:= £0.769876295,
Convert EUR/USD. Euro Member Countries to United States Dollar
3. Change back £0.769876295 into US$0.769876295
www.xe.com › × 1.2981
XE Currency = US$0.999376418,
Converter - Live Rates
which would actually result into a small loss.EURAlternatively,
to USD currency converter.one
Get live could:
exchange rates for Euro Member Countries to United Sta
Dollar. Use XE's free calculator to convert foreign ...
1. Change US$1.00 into £0.76988,
2. Change £0.76988 into €1.16054 × 0.76988 =€0.893476535,
XE: EUR / USD
3. Change back €0.893476535 into US$0.893476535 Currency Chart.
× 1.11923 Euro to US Dollar Rates
= US$1.000005742,
www.xe.com › XE Currency Charts
which would result into a small gain, assuming
EUR to USDthe absence
currency chart. XE's freeof transaction
live currency conversion chart for Euro to US Dollar allows y
costs. pair exchange rate history for up to 10 years.
Next, we state a mathematical formulation of

EURthe concept
to USD ExchangeofRate
arbitrage.
- Bloomberg Markets
Definition 1.2. A portfolio allocation ξ ∈https://www.bloomberg.com/quote/EURUSD:CUR
Rd+1 constitutes an arbitrage
opportunity if the three following conditions Current exchange rate EURO (EUR) to US DOLLAR (USD) including currency converter, buying & s
are satisfied:
rate and historical conversion chart.
i) ξ • S 0 6 0 at time t = 0, [Start from a zero-cost portfolio, or with a debt.]
ii) ξ • S 1 > 0 at time t = 1, [Finish with a nonnegative amount.]

Top stories
iii) P ξ • S 1 > 0 > 0 at time t = 1. [Profit is made with nonzero

probability.]
∗
https://en.wikipedia.org/wiki/Triangular_arbitrage
24 "
Pound Sterling on Monday: EUR/USD - Euro Edges Up EUR/USD Forecast:
https://personal.ntu.edu.sg/nprivault/indext.htmlHow Will the Conservative on German In ation Report on Trump
Slide in the Polls Impact
Note that there exist multiple ways to break the assumptions of Defini-
tion 1.2 in order to achieve absence of arbitrage. For example, under ab-
sence of arbitrage, satisfying Condition (i) means that either ξ • S 1 cannot
be almost surely ∗ nonnegative (i.e., potential losses cannot be avoided), or
P ξ • S 1 > 0 = 0, (i.e., no strictly positive profit can be made).

Realizing arbitrage
In the example below we realize arbitrage by buying and holding an asset.

(0)
1. Borrow the amount −ξ (0) S0 > 0 on the riskless asset no 0.
(0) (0) (i)
2. Use the amount −ξ (0) S0 > 0 to purchase a quantity ξ (i) = −ξ (0) S0 /S0 ,
(i)
of the risky asset no i > 1 at time t = 0 and price S0 so that the initial
portfolio cost is
(0) (i)
ξ (0) S0 + ξ (i) S0 = 0.
(i)
3. At time t = 1, sell the risky asset no i at the price S1 , with hopefully
(i) (i)
S1 > (1 + r )S0 .
(0)
4. Refund the amount −(1 + r )ξ (0) S0 > 0 with interest rate r > 0.
At the end of the operation the profit made is

(i) (0) (i) (0)
ξ (i) S1 − − (1 + r )ξ (0) S0 = ξ (i) S1 + (1 + r )ξ (0) S0
(0)
S0 (i) (0)
= −ξ (0) (i)
S1 + (1 + r )ξ (0) S0
S0
(0)
S0 (i) (i)
= −ξ (0) (i)
S1 − (1 + r )S0
S0
(i) (i) (i)
= ξ S1 − (1 + r )S0
> 0,
(i) (i)
or S1 − (1 + r )S0 per unit of stock invested, which is positive provided
(i) (i)
that S1 > S0 and r is sufficiently small.
Arbitrage opportunities can be similarly realized using the short selling pro-
cedure described in Section 1.2.
∗
“Almost surely”, or “a.s.”, means “with probability one”.
" 25
N. Privault
City Currency US$

Tokyo 38,800 yen $346
Hong Kong HK$2,956.67 $381
Seoul 378,533 won $400
Taipei NT$12,980 $404
New York $433
Sydney A$633.28 $483
Frankfurt €399 $513
Paris €399 $513
Rome €399 $513
Brussels €399.66 $514
London £279.99 $527
Manila 29,500 pesos $563
Jakarta 5,754,1676 rupiah $627
Fig. 1.2: Arbitrage: Retail prices around the world for the Xbox 360 in 2006.
There are many real-life examples of situations where arbitrage opportunities

can occur, such as:
- assets with different returns (finance),
- servers with different speeds (queueing, networking, computing),
- highway lanes with different speeds (driving).
In the latter two examples, the absence of arbitrage is consequence of the

fact that switching to a faster lane or server may result into congestion, thus
annihilating the potential benefit of the shift.
Table 1.1: Absence of arbitrage - the Mark Six “Investment Table”.
26 "
In the table of Figure 1.1 the absence of arbitrage opportunities is material-

ized by the fact that the price of each combination is found to be proportional
to its probability, thus making the game fair and disallowing any opportunity
or arbitrage that would result of betting on a more profitable combination.
In the sequel, we will work under the assumption that arbitrage opportunities
do not occur and we will rely on this hypothesis for the pricing of financial
instruments.
Example: share rights
Let us give a market example of pricing by absence of arbitrage.
From March 24 to 31, 2009, HSBC issued rights to buy shares at the price of
$28. This right behaves similarly to an option in the sense that it gives the
right (with no obligation) to buy the stock at the discount price K = $28.
On March 24, the HSBC stock price closed at $41.70.
The question is: how to value the price $R of the right to buy one share? This
question can be answered by looking for arbitrage opportunities. Indeed, the
underlying stock can be purchased in two different ways:
1. Buy the stock directly on the market at the price of $41.70. Cost: $41.70,
or:
2. First, purchase the right at price $R, and then the stock at price $28.
Total cost: $R+$28.
a) In case
$R + $28 < $41.70, (1.1)
arbitrage would be possible for an investor who owns no stock and no
rights, by
i) Buying the right at a price $R, and then
ii) Buying the stock at price $28, and
iii) Reselling the stock at the market price of $41.70.
The profit made by this investor would equal
$41.70 − ($R + $28) > 0.
b) On the other hand, in case
$R + $28 > $41.70, (1.2)
arbitrage would be possible for an investor who owns the rights, by:
" 27
N. Privault
i) Buying the stock on the market at $41.70,

ii) Selling the right by contract at the price $R, and then
iii) Selling the stock at $28 to that other investor.
In this case, the profit made would equal
$R + $28 − $41.70 > 0.
In the absence of arbitrage opportunities, the combination of (1.1) and

(1.2) implies that $R should satisfy
$R + $28 − $41.70 = 0,
i.e. the arbitrage-free price of the right is given by the equation
$R = $41.70 − $28 = $13.70. (1.3)
Interestingly, the market price of the right was $13.20 at the close of the
session on March 24. The difference of $0.50 can be explained by the presence
of various market factors such as transaction costs, the time value of money,
or simply by the fact that asset prices are constantly fluctuating over time.
It may also represent a small arbitrage opportunity, which cannot be at all
excluded. Nevertheless, the absence of arbitrage argument (1.3) prices the
right at $13.70, which is quite close to its market value. Thus the absence of
arbitrage hypothesis appears as an accurate tool for pricing.
1.4 Risk-Neutral Probability Measures

In order to use absence of arbitrage in the general context of pricing financial
derivatives, we will need the notion of risk-neutral probability measure.
The next definition says that under a risk-neutral probability measure,

the risky assets no 1, 2, . . . , d have same average rate of return as the riskless
asset no 0.
Definition 1.3. A probability measure P∗ on Ω is called a risk-neutral mea-
sure if
(i) (i)
E∗ S1 = (1 + r )S0 , i = 1, 2, . . . , d. (1.4)
Here, E∗ denotes the expectation under the probability measure P∗ . Note
(0) (0) (0)
that for i = 0, we have E∗ S1 = S1 = (1 + r )S0 by definition.
In other words, P∗ is called “risk neutral” because taking risks under P∗

(i)
by buying a stock S1 has a neutral effect: on average the expected yield of
the risky asset equals the risk-free interest rate obtained by investing on the
savings account with interest rate r, i.e., we have
28 "
(i) (i)
" #
S1 − S0
E∗ (i)
= r.
S0
On the other hand, under a “risk premium” probability measure P# , the

(i)
expected return (or net discounted gain) of the risky asset S1 would be
higher than r, i.e., we would have
" (i) (i)
#
S1 − S0
E# (i)
> r,
S0
or (i) (i)
E# S1 > (1 + r )S0 , i = 1, 2, . . . , d,
whereas under a “negative premium” measure P[ , the expected return of the

(i)
risky asset S1 would be lower than r, i.e., we would have
(i) (i)
" #
S1 − S0
E [
(i)
< r,
S0
or (i) (i)
E[ S1 < (1 + r )S0 , i = 1, 2, . . . , d.
In the sequel we will only consider probability measures P∗ that are equivalent
to P, in the sense that they share the same events of zero probability.
Definition 1.4. A probability measure P∗ on (Ω, F ) is said to be equivalent
to another probability measure P when
P∗ (A) = 0 if and only if P(A) = 0, for all A ∈ F. (1.5)
The following Theorem 1.5 can be used to check for the existence of arbitrage
opportunities, and is known as the first fundamental theorem of asset pricing.
Theorem 1.5. A market is without arbitrage opportunity if and only if it
admits at least one equivalent risk-neutral probability measure P∗ .
Proof. (i) Sufficiency. Assume that there exists a risk-neutral probability
measure P∗ equivalent to P. Since P∗ is risk neutral, we have
d d
(i) 1 X (i) ∗ (i) 1
ξ ( i ) S0 =
X
ξ E S1 = E∗ ξ • S 1 . (1.6)

ξ • S0 =
1+r 1+r
i=0 i=0
We proceed by contradiction, and suppose that the market admits an arbi-

trage opportunity according to Definition 1.2. In this case, Definition 1.2-
(ii)
shows that ξ • S 1 > 0, and Definition 1.2-(iii) implies P ξ • S 1 > 0 > 0,
" 29
N. Privault
hence P∗ ξ • S 1 > 0 > 0 because P is equivalent to P∗ . Since by Rela-

tion (23.13) we have
0 < P∗ ξ • S 1 > 0

[
= P∗ ξ • S 1 > 1/n
n>1
= lim P∗ ξ • S 1 > 1/n

n→∞
= lim P∗ ξ • S 1 > ε ,

ε&0
there exists ε > 0 such that P∗ ξ • S 1 > ε > 0, hence

E∗ ξ • S 1 > E∗ ξ • S 1 1{ξ S >ε}

•
1
> εE∗ 1{ξ S 1 >ε}

•
= εP∗ ξ • S 1 > ε

> 0,
and by (1.6) we conclude that

1
E∗ ξ • S 1 > 0,

ξ • S0 =
1+r
which contradicts Definition 1.2-(i). We conclude that the market is without
arbitrage opportunities.
(ii) The proof of necessity relies on the theorem of separation of convex sets
by hyperplanes Proposition 1.6 below, see Theorem 1.6 in Föllmer and Schied
(2004). It can be briefly sketched as follows. Given two financial assets with
returns X, Y and a portfolio made of one unit of X and c unit(s) of Y , the
absence of arbitrage opportunity property of Definition 1.2 implies that for
any portfolio allocation (1, c) determined by c ∈ R, we have
X + cY > 0 =⇒ X + cY = 0, P − a.s., (1.7)
i.e. a risk-free portfolio with no loss cannot entail a strictly positive gain. In
other words, if one wishes to make a strictly positive gain on the market, one
has to accept the possibility of a loss.
To show that this implies the existence of a risk-neutral probability measure

P∗ under which the risky investments have zero discounted return, i.e.
EP∗ [X ] = EP∗ [Y ] = 0, (1.8)
the convex separation Proposition 1.6 below is applied to the convex subset
30 "
C = (EQ [X ], EQ [Y ]) : Q ∈ P ⊂ R2

of R2 , where P is the family of probability measures Q on Ω equivalent to

P. If (1.8) does not hold under any P∗ ∈ P then (0, 0) ∈
/ C, and the convex
separation Proposition 1.6 below applied to the convex sets C and {(0, 0)}
shows the existence of c ∈ R such that
EQ [X + cY ] = EQ [X ] + c EQ [Y ] > 0 for all Q ∈ P, (1.9)
and
EP∗ [X + cY ] = EP∗ [X ] + c EP∗ [Y ] > 0 for some P∗ ∈ P. (1.10)
The inequality (1.9) shows that X + cY > 0 P∗ -almost surely∗ while (1.10)
implies P∗ (X + cY > 0) > 0, showing that (1.7) is not satisfied, together
with the absence of arbitrage opportunities. Should the directions of the
inequalities in (1.9) and (1.10) be reversed, we can reach the same conclusion
by replacing the allocation (1, c) with (−1, −c).
Next is a version of the separation theorem for convex sets, which relies on
the more general Theorem 1.7 below.
Proposition 1.6. Let C be a convex set in R2 such that (0, 0) ∈
/ C. Then
there exists c ∈ R such that, e.g.,
x + cy > 0,
for all (x, y ) ∈ C, and there exists (x∗ , y ∗ ) ∈ C such that
x∗ + cy ∗ > 0,
up to a change of direction in both inequalities “>” and “>”.

Proof. Theorem 1.7 below applied to C1 := {(0, 0)} and to C2 := C shows
that for some numbers a, c we have, e.g.,
0 + 0 × c = 0 6 a 6 x + cy
for all (x, y ) ∈ C.

∗
“Almost surely”, or “a.s.”, means “with probability one”.
" 31
N. Privault
x + cy = a y
x + cy > a
x + cy 6 a
C
x
(0, 0)
This allows us to conclude when a > 0. When a = 0, if x + cy = 0 for all

(x, y ) ∈ C then the convex set C is an interval part of a straight line crossing
(0, 0), for which there exists c̃ ∈ R such that x + c̃y > 0 for all (x, y ) ∈ C
and x∗ + c̃y ∗ > 0 for some (x∗ , y ∗ ) ∈ C, because (0, 0) ∈
/ C.
x + cy = 0 y
x + c̃y = 0 C
x
(0, 0)

The proof of Proposition 1.6 relies on the following result, see e.g. Theo-
rem 4.14 in Hiriart-Urruty and Lemaréchal (2001).
Theorem 1.7. Let C1 and C2 be two disjoint convex sets in R2 . Then there
exists a, c ∈ R such that
x + cy 6 a (x, y ) ∈ C1 ,
and
a 6 x + cy, (x, y ) ∈ C2 ,
up to exchange of C1 and C2 .
32 "
x + cy = a
x + cy 6 a
x + cy > a
C1
C2
Fig. 1.3: Separation of convex sets by the linear equation x + cy = a.
1.5 Hedging of Contingent Claims
In this section we consider the notion of contingent claim. The adjective

“contingent” means:
1. Subject to chance.
2. Occurring or existing only if (certain circumstances) are the case; depen-
dent on.
More generally, we will work according to the following broad definition which
covers contingent claims such as options, forward contracts etc.
Definition 1.8. A contingent claim is a financial derivative whose payoff
C : Ω −→ R is a random variable depending on the realization(s) of uncertain
event(s).
In practice, the random variable C will represent the payoff of an (option)
contract at time t = 1.
Referring to Definition 2, the European call option with maturity t = 1

on the asset no i is a contingent claim whose payoff C is given by

(i) (i)
+  S1 − K if S1 > K,

(i)
C = S1 − K :=
(i)
0 if S1 < K,


where K is called the strike price. The claim payoff C is called “contingent”
(i)
because its value may depend on various market conditions, such as S1 > K.
A contingent claim is also called a financial “derivative” for the same reason.
" 33
N. Privault
Similarly, referring to Definition 1, the European put option with maturity

t = 1 on the asset no i is a contingent claim with payoff

(i) (i)
 K − S1
 if S1 6 K,
(i) +

C = K − S1 :=
(i)
0 if S1 > K,


Definition 1.9. A contingent claim with payoff C is said to be attainable if

there exists a portfolio allocation ξ = ξ (0) , ξ (1) , . . . , ξ (d) such that
d
(i) (0) (1) (d)
ξ (i) S1 = ξ (0) S1 + ξ (1) S1 + · · · + ξ (d) S1 ,
X
C = ξ • S1 =
i=0
with P-probability one.

When a contingent claim with payoff C is attainable, a trader will be able
to:
1. at time t = 0, build a portfolio allocation ξ = ξ (0) , ξ (1) , . . . , ξ (d)

∈
Rd + 1 ,
2. invest the amount

d
(i)
ξ (i) S0
X
ξ • S0 =
i=0
in this portfolio at time t = 0,
3. at time t = 1, obtain the equality

d
(i)
ξ (i) S1
X
C=
i=0
and pay the claim amount C using the portfolio value

d
(i) (0) (1) (d)
ξ (i) S1 = ξ (0) S1 + ξ (1) S1 + · · · + ξ (d) S1 .
X
ξ • S1 =
i=0
We note that in order to attain the claim payoff C, an initial investment

ξ • S 0 is needed at time t = 0. This amount, to be paid by the buyer to the
issuer of the option (the option writer), is also called the arbitrage-free price,
or option premium, of the contingent claim, and is denoted by
d
(i)
ξ (i) S0 .
X
π0 ( C ) : = ξ • S 0 = (1.11)
i=0
34 "
The action of allocating a portfolio allocation ξ such that

d
(i)
ξ (i) S1
X
C = ξ • S1 = (1.12)
i=0
is called hedging, or replication, of the contingent claim with payoff C.

Definition 1.10. In case the portfolio value ξ • S 1 at time t = 1 exceeds the
amount of the claim, i.e. when
ξ • S 1 > C,
we say that the portfolio allocation ξ = ξ (0) , ξ (1) , . . . , ξ (d) is super-hedging

the claim C.
In this document we only focus on hedging, i.e. on replication of the contin-
gent claim with payoff C, and we will not consider super-hedging.
As a simplified illustration of the principle of hedging, one may an buy

oil-related asset in order to hedge oneself against a potential price rise of
gasoline. In this case, any increase in the price of gasoline that would result
in a higher value of the financial derivative C would be correlated to an
increase in the underlying asset value, so that the equality (1.12) would be
maintained.
1.6 Market Completeness

Market completeness is a strong property, stating that any contingent claim
available on the market can be perfectly hedged.
Definition 1.11. A market model is said to be complete if every contingent
claim is attainable.
The next result is the second fundamental theorem of asset pricing.
Theorem 1.12. A market model without arbitrage opportunities is complete
if and only if it admits only one equivalent risk-neutral probability measure
P∗ .
Proof. See the proof of Theorem 1.40 in Föllmer and Schied (2004).
Theorem 1.12 will give us a concrete way to verify market completeness by
searching for a unique solution P∗ to Equation (1.4).
1.7 Example: Binary Market

In this section we work out a simple example that allows us to apply Theo-
rem 1.5 and Theorem 1.12. We take d = 1, i.e. the portfolio is made of
" 35
N. Privault
(0)
- a riskless asset with interest rate r and priced (1 + r )S0 at time t = 1,
(1)
- and a risky asset priced S1 at time t = 1.
We use the probability space
Ω = {ω − , ω + },
which is the simplest possible nontrivial choice of probability space, made of

only two possible outcomes with
P({ω − }) > 0 and P({ω + }) > 0,
in order for the setting to be nontrivial. In other words the behavior of the
market is subject to only two possible outcomes, for example, one is expect-
ing an important binary decision of “yes/no” type, which can lead to two
distinct scenarios called ω − and ω + .
(1)
In this context, the asset price S1 is given by a random variable
(1)
S1 : Ω −→ R
whose value depends on whether the scenario ω − , resp. ω + , occurs.
Precisely, we set
(1) (1)
S1 (ω − ) = a, and S1 (ω + ) = b,
(1)
i.e., the value of S1 becomes equal a under the scenario ω − , and equal to b
under the scenario ω + , where 0 < a < b. ∗
Arbitrage
The first natural question is:

- Arbitrage: Does the market allow for arbitrage opportunities?
We will answer this question using Theorem 1.5, by searching for a risk-
neutral probability measure P∗ satisfying the relation
(1) (1)
E∗ S1 = (1 + r )S0 , (1.13)
where r > 0 denotes the risk-free interest rate, cf. Definition 1.3.
In this simple framework, any measure P∗ on Ω = {ω − , ω + } is characterized

by the data of two numbers P∗ ({ω − }) ∈ [0, 1] and P∗ ({ω + }) ∈ [0, 1], such
∗
The case a = b leads to a trivial, constant market.
36 "
that
P∗ (Ω) = P∗ ({ω − }) + P∗ ({ω + }) = 1. (1.14)
Here, saying that P∗ is equivalent to P simply means that
P∗ ({ω − }) > 0 and P∗ ({ω + }) > 0.
Although we should solve (1.13) for P∗ , at this stage it is not yet clear how
P∗ is involved in the equation. In order to make (1.13) more explicit we write
the expected value as
(1) (1) (1)
E∗ S1 = aP∗ S1 = a + bP∗ S1 = b ,

hence Condition (1.13) for the existence of a risk-neutral probability measure

P∗ reads
(1) (1) (1)
aP∗ S1 = a + bP∗ S1 = b = (1 + r )S0 .

Using the Condition (1.14) we obtain the system of two equations
 aP∗ ({ω − }) + bP∗ ({ω + }) = (1 + r )S0(1)


(1.15)
P∗ ({ω − }) + P∗ ({ω + }) = 1,

with unique risk-neutral solution
 (1)
∗ ∗ + ∗ (1) (1 + r )S0 − a
 p := P ({ω }) = P S1 = b =



b−a
(1.16)
(1)
b − ( 1 + r )S0

 q ∗ := P∗ ({ω − }) = P∗ S (1) = a =

.

1
b−a
In order for a solution P∗ to exist as a probability measure, the numbers

P∗ ({ω − }) and P∗ ({ω + }) must be nonnegative. In addition, for P∗ to be
equivalent to P they should be strictly positive from (1.5).
We deduce that if a, b and r satisfy the condition

(1)
a < (1 + r )S0 < b, (1.17)
then there exists a risk-neutral equivalent probability measure P∗ which is

unique, hence by Theorems 1.5 and 1.12 the market is without arbitrage and
complete.
(1) (1)
Remark 1.13. i) If a = (1 + r )S0 , resp. b = (1 + r )S0 , then P∗ ({ω + }) =
0, resp. P∗ ({ω − }) = 0, and P∗ is not equivalent to P in the sense of
Definition 1.4.
" 37
N. Privault
Therefore, we check from (1.16) that the condition

(1) (1)
a < b 6 (1 + r )S0 or (1 + r )S0 6 a < b, (1.18)
do not imply existence of an equivalent risk-neutral probability measure

and absence of arbitrage opportunities in general.
(1)
ii) If a = b = (1 + r )S0 then (1.4) admits an infinity of solutions, hence
the market is without arbitrage but it is not complete. More precisely, in
this case both the riskless and risky assets yield a deterministic return
rate r and the portfolio value becomes
ξ • S 1 = (1 + r )ξ • S 0 ,
at time t = 1, hence the terminal value ξ • S 1 is deterministic and this

single value can not always match the value of a contingent claim with
(random) payoff C, that could be allowed to take two distinct values
C (ω − ) and C (ω + ). Therefore, market completeness does not hold when
(1)
a = b = (1 + r )S0 .
Let us give a financial interpretation of Condition (1.18).
(1)
1. If (1 + r )S0 6 a < b, let ξ (1) := 1 and choose ξ (0) such that
(0) (1)
ξ (0) S0 + ξ (1) S0 =0
according to Definition 1.2-(i), i.e.

(1)
S0
ξ (0) = −ξ (1) (0)
< 0.
S0
a
(1)
(1) (1 + r )S0
S0
In particular, Condition (i) of Definition 1.2 is satisfied, and the investor

(0)
borrows the amount −ξ (0) S0 > 0 on the riskless asset and uses it to
buy one unit ξ ( 1 ) = 1 of the risky asset. At time t = 1 he sells the
(1)
risky asset S1 at a price at least equal to a and refunds the amount
(0)
−(1 + r )ξ (0) S0 > 0 that he borrowed, with interest. The profit of the
operation is
(0) (1)
ξ • S 1 = (1 + r )ξ (0) S0 + ξ (1) S1
38 "
(0)
> (1 + r )ξ (0) S0 + ξ (1) a
(1)
= −(1 + r )ξ (1) S0 + ξ (1) a
(1)
= ξ (1) − (1 + r )S0 + a

> 0,
which satisfies Condition (ii) of Definition 1.2. In addition, Condition (iii)

of Definition 1.2 is also satisfied because
(1)
P ξ • S 1 > 0 = P S1 = b = P({ω + }) > 0.

(1)
2. If a 0 and choose ξ (1) such that
(0) (1)
ξ (0) S0 + ξ (1) S0 = 0,
according to Definition 1.2-(i), i.e.

(0)
S0
ξ (1) = −ξ (0) (1)
< 0.
S0
(1)
(1 + r )S0
b
(1)
S0 a
This means that the investor borrows a (possibly fractional) quantity

(1)
−ξ (1) > 0 of the risky asset, sells it for the amount −ξ (1) S0 , and in-
(0)
vests this money on the riskless account for the amount ξ (0) S0 > 0. As
mentioned in Section 1.2, in this case one says that the investor shortsells
(0)
the risky asset. At time t = 1 she obtains (1 + r )ξ (0) S0 > 0 from the
riskless asset, spends at most b to buy back the risky asset, and returns it
to its original owner. The profit of the operation is
(0) (1)
ξ • S 1 = (1 + r )ξ (0) S0 + ξ (1) S1
(0)
> (1 + r )ξ (0) S0 + ξ (1) b
(1)
= −(1 + r )ξ (1) S0 + ξ (1) b
(1)
= ξ (1) − (1 + r )S0 + b

> 0,
(1)
since ξ (1) < 0. Note that here, a 6 S1 6 b became
" 39
N. Privault
(1)
ξ (1) b 6 ξ (1) S1 6 ξ (1) a
because ξ (1) < 0. We can check as in Part 1 above that Conditions (i)-(iii)
of Definition 1.2 are satisfied.
(1)
3. Finally if a = b 6= (1 + r )S0 then (1.4) admits no solution as a probability
measure P∗ hence arbitrage opportunities exist and can be constructed by
the same method as above.
Under Condition (1.17) there is absence of arbitrage and Theorem 1.5 shows
that no portfolio strategy can yield both ξ • S 1 > 0 and P ξ • S 1 > 0 > 0

(0) (1)
starting from ξ (0) S0 + ξ (1) S0 6 0, however this is less simple to show
directly.
Market completeness
The second natural question is:

- Completeness: Is the market complete, i.e., are all contingent claims
attainable?
In the sequel we work under the condition
(1)
a < (1 + r )S0 < b,
under which Theorems 1.5 and 1.12 show that the market is without arbitrage
and complete since the risk-neutral probability measure P∗ exists and is
unique.
(1)
(1) (1 + r )S0
S0
a
Let us recover this fact by elementary calculations. For any contingent claim
with payoff C we need to show that there exists a portfolio allocation ξ =
ξ (0) , ξ (1) such that C = ξ • S 1 , i.e.

(0)
 (1 + r )ξ (0) S0 + ξ (1) b = C (ω + )

(1.19)
(0)
(1 + r )ξ (0) S0 + ξ (1) a = C (ω − ).


These equations can be solved as
40 "
bC (ω − ) − aC (ω + ) C (ω + ) − C (ω − )
ξ (0) = (0)
and ξ (1) = . (1.20)
S0 (1 + r )(b − a) b−a
In this case we say that the portfolio allocation ξ (0) , ξ (1) hedges the contin-

gent claim with payoff C. In other words, any contingent claim is attainable
and the market is indeed complete. Here, the quantity
(0) bC (ω − ) − aC (ω + )
ξ (0) S0 =
(1 + r )(b − a)
represents the amount invested on the riskless asset.
Note that if C (ω + ) > C (ω − ) then ξ (1) > 0 and there is not short selling.
(1)
This occurs in particular if C has the form C = h S1 with x 7−→ h(x) a
non-decreasing function, since
C (ω + ) − C (ω − )
ξ (1) =
b−a
(1) (1)
h S1 (ω + ) − h S1 (ω − )

=
b−a
h(b) − h(a)
=
b−a
> 0,
thus there is no short selling. This applies in particular to European call

options with strike price K, for which the function h(x) = (x − K )+ is non-
decreasing.
In case h is a non-increasing function, which is the case in particular for

European put options with payoff function h(x) = (K − x)+ we will similarly
find that ξ (1) 6 0, i.e. short selling always occurs in this case.
Arbitrage-free price
Definition 1.14. The arbitrage-free price π0 (C ) of the contingent claim with

payoff C is defined in (1.11) as the initial value at time t = 0 of the portfolio
hedging C, i.e.
d
(i)
ξ (i) S0 ,
X
π0 ( C ) = ξ • S 0 = (1.21)
i=0
where ξ (0) , ξ (1) are given by (1.20).

" 41
N. Privault
Arbitrage-free prices can be used to ensure that financial derivatives are

“marked” at their fair value (mark to market).∗ Note that π0 (C ) cannot
be 0 since this would entail the existence of an arbitrage opportunity accord-
ing to Definition 1.2.
The next proposition shows that the arbitrage-free price π0 (C ) of the claim
can be computed as the expected value of its payoff C under the risk-neutral
probability measure, after discounting by the factor 1 + r in order to account
for the time value of money.
Proposition 1.15. The arbitrage-free price π0 (C ) = ξ • S 0 of the contingent
claim with payoff C is given by
1
π0 ( C ) = E∗ [ C ] . (1.22)
1+r
Proof. Using the expressions (1.16) of the risk-neutral probabilities P∗ ({ω − }),
P∗ ({ω + }), and (1.20) of the portfolio allocation ξ (0) , ξ (1) , we have

π0 ( C ) = ξ • S 0
(0) (1)
= ξ (0) S0 + ξ (1) S0
bC (ω − ) − aC (ω + ) + −
(1) C ( ω ) − C ( ω )
= + S0
(1 + r )(b − a) b−a
(1) (1)
!
1 b − S0 (1 + r ) ( 1 + r ) S0 − a
= −
C (ω ) + C (ω + )
1+r b−a b−a
1
( 1 ) ( 1 )
C (ω − )P∗ S1 = a + C (ω + )P∗ S1 = b

=
1+r
1
= E∗ [ C ] .
1+r

In the case of a European call option with strike price K ∈ [a, b] we have
(1) +
C = S1 − K and
(1) + 1 (1) +
π0 S1 − K = E∗ S1 − K
1+r
1 (1)
(b − K )P∗ S1 = b

=
1+r
(1)
1 (1 + r )S0 − a
= (b − K ) .
1+r b−a
∗
Not to be confused with “market making”.
42 "

b−K (1) a
= S0 − .
b−a 1+r
(1) +
In the case of a European put option we have C = K − S1 and
(1) + 1 (1) +
E∗ K − S1

π0 K − S1 =
1+r
1 (1)
(K − a)P∗ S1 = a

=
1+r
(1)
1 b − (1 + r )S0
= (K − a) .
1+r b−a

K −a b (1)
= − S0 .
b−a 1+r
(1) + (1) +
Here, S0 − K , resp. K − S0 is called the intrinsic value at time 0
of the call, resp. put option.
The simple setting described in this chapter raises several questions and re-
marks.
Remarks
1. The fact that π0 (C ) can be obtained by two different methods, i.e. an

algebraic method via (1.20) and (1.21) and a probabilistic method from
(1.22) is not a simple coincidence. It is actually a simple example of the
deep connection that exists between probability and analysis.
In a continuous-time setting, (1.20) will be replaced with a partial differ-

ential equation (PDE) and (1.22) will be computed via the Monte Carlo
method. In practice, the quantitative analysis departments of major fi-
nancial institutions can be split into a “PDE team” and a “Monte Carlo
team”, often trying to determine the same option prices by two different
methods.
2. What if we have three possible scenarios, i.e. Ω = {ω − , ω o , ω + } and the

(1) (1)
random asset S1 is allowed to take more than two values, e.g. S1 ∈
{a, b, c} according to each scenario? In this case the system (1.15) would
be rewritten as
 aP∗ ({ω − }) + bP∗ ({ω o }) + cP∗ ({ω + }) = (1 + r )S0(1)


P∗ ({ω − }) + P∗ ({ω o }) + P∗ ({ω + }) = 1,


" 43
N. Privault
and this system of two equations with three unknowns does not admit a
unique solution, hence the market can be without arbitrage but it cannot
be complete, cf. Exercise 1.4.
Market completeness can be reached by adding a second risky asset, i.e.

taking d = 2, in which case we will get three equations and three un-
knowns. More generally, when Ω contains n > 2 market scenarios, com-
pleteness of the market can be reached provided that we consider d risky
assets with d + 1 > n. This is related to the Meta-Theorem 8.3.1 of
Björk (2004a) in which the number d of traded risky underlying assets
is linked to the number of random sources through arbitrage and market
completeness.
Exercises
Exercise 1.1 Consider a risky asset valued S0 = $3 at time t = 0 and taking

only two possible values S1 ∈ {$1, $5} at time t = 1, and a financial claim
given at time t = 1 by
 $0 if S1 = $5

C :=
$2 if S1 = $1.

Is C the payoff of a call option or of a put option? Give the strike price of
the option.
Exercise 1.2 Consider a risky asset valued S0 = $4 at time t = 0, and taking

only two possible values S1 ∈ {$2, $5} at time t = 1. Compute the initial
value V0 = αS0 + $β of the portfolio hedging the claim payoff
 $0 if S1 = $5

C=
$6 if S1 = $2

at time t = 1, and find the corresponding risk-neutral probability measure

P∗ .
Exercise 1.3
a) Consider the following market model:
44 "
a
(1)
(1) (1 + r )S0
S0
i) Does this model allow for arbitrage?

Yes | No |
ii) If this model allows for arbitrage opportunities, how can they be
realized?
By shortselling | By borrowing on savings | N.A. |
b) Consider the following market model:

b
(1)
(1 + r )S0
(1)
S0 a

Yes | No |
realized?
c) Consider the following market model:

(1)
(1 + r )S0
b
(1)
S0 a

Yes | No |
realized?
" 45
N. Privault
Exercise 1.4 In a market model with two time instants t = 0 and t = 1 and
risk-free interest rate r, consider
(0) (0) (0)
- a riskless asset valued S0 at time t = 0, and value S1 = (1 + r )S0
at time t = 1.
(1)
- a risky asset with price S0 at time t = 0, and three possible values at
time t = 1, with a < b < c, i.e.:
 (1)

 S0 (1 + a),




(1)
S1 = S0(1) (1 + b),




 (1)

S0 (1 + c).
a) Show that this market is without arbitrage but not complete.

b) In general, is it possible to hedge (or replicate) a claim with three distinct
claim payoff values Ca , Cb , Cc in this market?
(0) (0)
Exercise 1.5 We consider a riskless asset valued S1 = S0 , at times k = 0, 1,
with risk-free interest rate is r = 0, and a risky asset S (1) whose return
(1) (1) (1)
R1 := S1 − S0 /S0 can take three values (−b, 0, b) at each time step,
with b > 0 and
p∗ := P∗ (R1 = b) > 0, θ∗ := P∗ (R1 = 0) > 0, q ∗ := P∗ (R1 = −b) > 0,
a) Determine all possible risk-neutral probability measures P∗ equivalent to

P in the sense of Definition 1.4 in terms of the parameter θ∗ ∈ (0, 1), from
the condition E∗ [R1 ] = 0. " (1) (1)
#
S1 − S0
b) We assume that the variance Var∗ (1)
= σ 2 > 0 of the asset
S0
return is known to be equal to σ 2 . Show that this condition provides a
way to select a unique risk-neutral probability measure P∗σ under a certain
condition on b and σ.
Exercise 1.6
a) Consider the following binary one-step model (St )t=0,1,2 with interest rate
r = 0 and P(S1 = 2) = 1/3.
S1 = 2
S0 = 1 S1 = 1
46 "
i) Is the model without arbitrage?

Yes | No |
ii) Does there exist a risk-neutral measure P∗ equivalent to P in the

sense of Definition 1.4?
Yes | No |
b) Consider the following ternary one-step model with r = 0, P(S1 = 2) =

1/4 and P(S1 = 1) = 1/9.
S1 = 2
S0 = 1 S1 = 1
S1 = 0
i) Does there exist a risk-neutral measure P∗ equivalent to P in the

sense of Definition 1.4?
Yes | No |
ii) Is the model without arbitrage?

Yes | No |
iii) Is the market complete?

Yes | No |
iv) Does there exist a unique risk-neutral measure P∗ equivalent to P in

the sense of Definition 1.4?
Yes | No |
Exercise 1.7 Consider a one-step market model with two time instants t = 0
and t = 1 and two assets:
- a riskless asset π with price π0 at time t = 0 and value π1 = π0 (1 + r )
at time t = 1,
- a risky asset S with price S0 at time t = 0 and random value S1 at time
t = 1.
We assume that S1 can take only the values S0 (1 + a) and S0 (1 + b), where
−1 < a < r < b. The return of the risky asset is defined as
S1 − S0
R= .
S0
a) What are the possible values of R?
" 47
N. Privault
b) Show that under the probability measure P∗ defined by
b−r r−a
P∗ (R = a) = , P∗ (R = b) = ,
b−a b−a
the expected return E∗ [R] of S is equal to the return r of the riskless
asset.
c) Does there exist arbitrage opportunities in this model? Explain why.
d) Is this market model complete? Explain why.
e) Consider a contingent claim with payoff C given by
 α if R = a,

C=
β if R = b.

Show that the portfolio allocation (η, ξ ) defined∗ by
α (1 + b) − β (1 + a) β−α
η= and ξ = ,
π0 (1 + r )(b − a) S0 (b − a)
hedges the contingent claim with payoff C, i.e. show that at time t = 1
we have
ηπ1 + ξS1 = C.
Hint: Distinguish two cases R = a and R = b.
f) Compute the arbitrage-free price π0 (C ) of the contingent claim payoff C
using η, π0 , ξ, and S0 .
g) Compute E∗ [C ] in terms of a, b, r, α, β.
h) Show that the arbitrage-free price π0 (C ) of the contingent claim with
payoff C satisfies
1
π0 ( C ) = E∗ [ C ] . (1.23)
1+r
i) What is the interpretation of Relation (1.23) above?
j) Let C denote the payoff at time t = 1 of a put option with strike price
K=$11 on the risky asset. Give the expression of C as a function of S1
and K.
k) Letting π0 = S0 = 1, r = 5% and a = 8, b = 11, α = 2, β = 0, compute
the portfolio allocation (ξ, η ) hedging the contingent claim with payoff C.
l) Compute the arbitrage-free price π0 (C ) of the claim payoff C.
Exercise 1.8 A company issues share rights, so that ten rights allow one to
purchase three shares at the price of €6.35. Knowing that the stock is cur-
rently valued at €8, estimate the price of the right by absence of arbitrage.
∗
Here, η is the (possibly fractional) quantity of asset π and ξ is the quantity held of
asset S.
48 "
Exercise 1.9 Consider a stock valued S0 = $180 at the beginning of the

year. At the end of the year, its value S1 can be either $152 or $203 and
the risk-free interest rate is r = 3% per year. Given a put option with strike
price K on this underlying asset, find the value of K for which the price of
the option at the beginning of the year is equal to the intrinsic option payoff.
This value of K is called the break-even strike price. In other words, the
break-even price is the value of K for which immediate exercise of the option
is equivalent to holding the option until maturity.
How would a decrease in the interest rate r affect this break-even strike price?
" 49
Chapter 2
Discrete-Time Market Model
The single-step model considered in Chapter 1 is extended to a discrete-time

model with N + 1 time instants t = 0, 1, . . . , N . A basic limitation of the
one-step model is that it does not allow for trading until the end of the
first time period is reached, while the multistep model allows for multiple
portfolio re-allocations over time. The Cox-Ross-Rubinstein (CRR) model,
or binomial model, is considered as an example whose importance also lies
with its computer implementability.
2.1 Discrete-Time Compounding . . . . . . . . . . . . . . . . . . . . 51

2.2 Arbitrage and Self-Financing Portfolios . . . . . . . . . . 54
2.3 Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
2.4 Martingales and Conditional Expectations . . . . . . . 65
2.5 Market Completeness and Risk-Neutral Measures 71
2.6 The Cox-Ross-Rubinstein (CRR) Market Model . . 73
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
2.1 Discrete-Time Compounding
Investment plan
We invest an amount m each year in an investment plan that carries a

constant interest rate r. At the end of the N -th year, the value of the
amount m invested at the beginning of year k = 1, 2, . . . , N has turned
into (1 + r )N −k+1 m and the value of the plan at the end of the N -th year
becomes
N
(1 + r )N −k+1
X
AN : = m (2.1)
k =1
" 51
N. Privault
N
X
=m (1 + r )k
k =1
(1 + r )N − 1
= m(1 + r ) ,
r
hence the duration N of the plan satisfies
1

rAN
N +1 = log 1 + r + .
log(1 + r ) m
Loan repayment
At time t = 0 one borrows an amount A1 := A over a period of N years at

the constant interest rate r per year.
Proposition 2.1. Constant repayment. Assuming that the loan is completely
repaid at the beginning of year N + 1, the amount m refunded every year is
given by
r (1 + r )N A r
m= = A. (2.2)
(1 + r )N − 1 1 − (1 + r )−N
Proof. Denoting by Ak the amount owed by the borrower at the beginning

of year no k = 1, 2, . . . , N with A1 = A, the amount m refunded at the end
of the first year can be decomposed as
m = rA1 + (m − rA1 ),
into rA1 paid in interest and m − rA1 in principal repayment, i.e. there
remains
A2 = A1 − (m − rA1 )
= (1 + r )A1 − m,
to be refunded. Similarly, the amount m refunded at the end of the second

year can be decomposed as
m = rA2 + (m − rA2 ),
into rA2 paid in interest and m − rA2 in principal repayment, i.e. there
remains
A3 = A2 − (m − rA2 )
= ( 1 + r ) A2 − m
52 "
= (1 + r )((1 + r )A1 − m) − m
= ( 1 + r ) 2 A1 − m − ( 1 + r ) m
to be refunded. After repeating the argument we find that at the beginning

of year k there remains
Ak = (1 + r )k−1 A1 − m − (1 + r )m − · · · − (1 + r )k−2 m
k−2
X
= (1 + r )k−1 A1 − m (1 + r )i
i=0
1 − (1 + r )k−1
= (1 + r )k−1 A1 + m
r
to be refunded, i.e.
m − (1 + r )k−1 (m − rA)
Ak = , k = 1, 2, . . . , N . (2.3)
r
We also note that the repayment at the end of year k can be decomposed as
m = rAk + (m − rAk ),
with
rAk = m + (1 + r )k−1 (rA1 − m)
in interest repayment, and
m − rAk = (1 + r )k−1 (m − rA1 )
in principal repayment. At the beginning of year N + 1, the loan should be

completely repaid, hence AN +1 = 0, which reads
1 − (1 + r )N
(1 + r )N A + m = 0,
r
and yields (2.2).
We also have
A 1 − (1 + r )−N
= . (2.4)
m r
and
1 m log(1 − rA/m)
N= log =− .
log(1 + r ) m − rA log(1 + r )
" 53
N. Privault
Remark: One needs m > rA in order for N to be finite.
The next proposition is a direct consequence of (2.2) and (2.3).

Proposition 2.2. The k-th interest repayment can be written as
−k +1
NX
1

rAk = m 1 − = mr (1 + r )−l ,
(1 + r )N −k+1
l =1
and the k-th principal repayment is
m
m − rAk = , k = 1, 2, . . . , N .
(1 + r )N −k+1
Note that the sum of discounted payments at the rate r is

N
X m 1 − (1 + r )−N
=m = A.
(1 + r )l r
l =1
In particular, the first interest repayment satisfies

N
X 1
rA = rA1 = mr = m 1 − (1 + r )−N ,
(1 + r ) l
l =1
and the first principal repayment is

m
m − rA = .
(1 + r )N
2.2 Arbitrage and Self-Financing Portfolios
Stochastic processes
A stochastic process on a probability space (Ω, F, P) is a family (Xt )t∈T of

random variables Xt : Ω −→ R indexed by a set T . Examples include:
• the one-step (or two-instant) model: T = {0, 1},
• the discrete-time model with finite horizon: T = {0, 1, . . . , N },
• the discrete-time model with infinite horizon: T = N,
• the continuous-time model: T = R+ .
54 "
For real-world examples of stochastic processes one can mention:

• the time evolution of a risky asset, e.g. Xt represents the price of the asset
at time t ∈ T .
• the time evolution of a physical parameter - for example, Xt represents a

temperature observed at time t ∈ T .
In this chapter, we focus on the finite horizon discrete-time model with T =
{0, 1, . . . , N }.
0 1 2 3 N
Asset price modeling
The prices at time t = 0 of d + 1 assets numbered 0, 1, . . . , d are denoted by

the random vector
(0) (1) (d)
S 0 = S0 , S0 , . . . , S0
in Rd+1 . Similarly, the values at time t = 1, 2, . . . , N of assets no 0, 1, . . . , d
are denoted by the random vector
(0) (1) (d)
S t = St , St , . . . , St
on Ω, which forms a stochastic process S t .

t=0,1,...,N
In the sequel we assume that asset no 0 is a riskless asset (of savings account
type) yielding an interest rate r, i.e. we have
(0) (0)
St = (1 + r )t S0 , t = 0, 1, . . . , N .
Portfolio strategies

Definition 2.3. A portfolio strategy is a stochastic process ξ t ⊂
t=1,2,...,N
(k )
Rd + 1where ξt denotes the (possibly fractional) quantity of asset no k held
in the portfolio over the time interval (t − 1, t], t = 1, 2, . . . , N .
Note that the portfolio allocation
(0) (1) (d)
ξ t = ξt , ξt , . . . , ξt
is decided at time t − 1 and remains constant over the interval (t − 1, t] while

(k ) (k )
the stock price changes from St−1 to St over this time interval.
" 55
N. Privault
ξ1 ξ2 ξ3 ξN
0 1 2 3 N
In other words, the quantity

(k ) (k )
ξt St−1
represents the amount invested in asset no k at the beginning of the time
interval (t − 1, t], and
(k ) (k )
ξt St
represents the value of this investment at the end of the time interval (t − 1, t],
t = 1, 2, . . . , N .
Self-financing portfolio strategies
The opening price of the portfolio at the beginning of the time interval (t −
1, t] is
d
(k ) (k )
X
ξ t • S t−1 = ξt St−1 ,
k =0
when the market “opens” at time t − 1. When the market “closes”at the end
of the time interval (t − 1, t], it takes the closing value
d
(k ) (k )
X
ξt • St = ξt St , (2.5)
k =0
t = 1, 2, . . . , N . After the new portfolio allocation ξ t+1 is designed we get the

new portfolio opening price
d
(k ) (k )
X
ξ t+1 • S t = ξt+1 St , (2.6)
k =0
at the beginning of the next trading session (t, t + 1], t = 0, 1, . . . , N − 1.
Note that here, the stock price S t is assumed to remain constant “overnight”,
i.e. from the end of (t − 1, t] to the beginning of (t, t + 1], t = 1, 2, . . . , N − 1.
In case (2.5) coincides

with (2.6) for t = 0, 1, . . . , N − 1 we say that the
portfolio strategy ξ t t=1,2,...,N is self-financing. A non self-financing portfolio
could be either bleeding money, or burning cash, for no good reason.
Definition 2.4. A portfolio strategy ξ t t=1,2,...,N is said to be self-financing

if
56 "
ξ t • S t = ξ t+1 • S t , t = 1, 2, . . . , N − 1, (2.7)
i.e.
d d
(k ) (k ) (k ) (k )
X X
ξt St = ξt+1 St , t = 1, 2, . . . , N − 1.
k =0 k =0
| {z } | {z }
Closing value Opening price
The meaning of the self-financing condition (2.7) is simply that one cannot
take any money in or out of the portfolio during the “overnight” transition
period at time t. In other words, at the beginning of the new trading session
(t, t + 1] one should re-invest the totality of the portfolio value obtained at
the end of the interval (t − 1, t].
The next figure is an illustration of the self-financing condition.
Portfolio value ξ t S t−1 ξ t S t = ξ t+1 S t ξ t+1 S t+1

Asset value St−1 St St St+1
Time scale t−1 t t t+1

Portfolio allocation ξt ξt ξt + 1 ξt + 1
“Morning” “Evening” “Next morning” “Next evening”

(Opening) (Closing) (Opening) (Closing)
Fig. 2.1: Illustration of the self-financing condition (2.7).
By (2.5) and (2.6) the self-financing condition (2.7) can be rewritten as

d d
(k ) (k ) (k ) (k )
X X
ξt St = ξt+1 St , t = 0, 1, . . . , N − 1,
k =0 k =0
or
d
(k ) (k ) (k )
X
ξt+1 − ξt St = 0, t = 0, 1, . . . , N − 1.
k =0
Note that any portfolio strategy ξ t which is constant over time,

t=1,2,...,N
i.e. ξ t = ξ t+1 , t = 1, 2, . . . , N − 1, is self-financing by construction.
Here, portfolio re-allocation happens “overnight”, during which time the

global portfolio value remains the same due to the self-financing condition.
The portfolio allocation ξt remains the same throughout the day, however
the portfolio value changes from morning to evening due to a change in the
stock price. Also, ξ 0 is not defined and its value is actually not needed in this
" 57
N. Privault
framework.
(0) (1)
In case d = 1 we are only trading d + 1 = 2 assets S t = St , St and
(0) (1)
the portfolio allocation reads ξ t = ξt , ξt . In this case, the self-financing
condition means that:
(1)
• In the event of an increase in the stock position ξt , the corresponding
(1) (1) (1)
cost of purchase ξt+1 − ξt St > 0 has to be deducted from the savings
(0) (0)
account value ξt St , which becomes updated as
(0) (0) (0) (0) (1) (1) (1)
ξt+1 St = ξt St − ξt + 1 − ξt St ,
recovering (2.7).
(1)
• In the event of a decrease in the stock position ξt , the corresponding sale
(1) (1) (1)
profit ξt − ξt+1 St > 0 has to be added to the savings account value
(0) (0)
ξt St , which becomes updated as
(0) (0) (0) (0) (1) (1) (1)
ξt+1 St = ξt St + ξt − ξt+1 St ,
recovering (2.7).
Clearly, the chosen unit of time may not be the day and it can be replaced
by weeks, hours, minutes, or fractions of seconds in high-frequency trading.
Portfolio value
Definition 2.5. The portfolio opening prices at times t = 0, 1, . . . , N − 1 are

defined as
d
(k ) (k )
X
Vt : = ξ t + 1 • S t = ξt+1 St , t = 0, 1, . . . , N − 1.
k =0
Under the self-financing condition (2.7), the portfolio closing values Vt at

time t = 1, 2, . . . , N rewrite as
d
(k ) (k )
X
Vt = ξ t • S t = ξt St , t = 1, 2, . . . , N , (2.8)
k =0
as summarized in the following table.
58 "
V0 V1 V2 ······ VN −1 VN
Opening price ξ 1 • S 0 ξ2 • S 1 ξ3 • S 2 · · · · · · ξ N • S N −1 N.A.
Closing value N.A. ξ1 • S 1 ξ 2 • S 2 · · · · · · ξ N −1 • S N −1 ξN • S N
Table 2.1: Self-financing portfolio value process.
Discounting
My portfolio St grew by b = 5% this year.

The risk-free or inflation rate is r = 10%.
Q: Did I achieve a positive return?
A:
A:
(a) Scenario A. (b) Scenario B.
Fig. 2.2: Why apply discounting?
Definition 2.6. Let

(0) (1) (d)
X t := Set , Set , . . . , Set )
denote the vector of discounted asset prices, defined as:
(i) 1 (i)
Set = S , i = 0, 1, . . . , d, t = 0, 1, . . . , N .
(1 + r )t t
(a) Without inflation adjustment. (b) With inflation adjustment.
Fig. 2.3: Are oil prices higher in 2019 compared to 2005?
We can also write
" 59
N. Privault
1
X t := St, t = 0, 1, . . . , N .
(1 + r )t
The discounted value at time 0 of the portfolio is defined by
1
Vet = Vt , t = 0, 1, . . . , N .
(1 + r )t
For t = 1, 2, . . . , N we have
1
Vet = ξt • St
(1 + r )t
d
1 X (k ) (k )
= ξt St
(1 + r ) t
k =0
d
(k ) (k )
X
= ξt Set
k =0
= ξt • X t,
while for t = 0 we get

Ve0 = ξ 1 • X 0 = ξ 1 • S 0 .
The effect of discounting from time t to time 0 is to divide prices by (1 + r )t ,
making all prices comparable at time 0.
Arbitrage
The definition of arbitrage in discrete time follows the lines of its analog in
the one-step model.

Definition 2.7. A portfolio strategy ξ t t=1,2,...,N constitutes an arbitrage
opportunity if all three following conditions are satisfied:
i) V0 6 0 at time t = 0, [Start from a zero-cost portfolio, or with a debt.]
ii) VN > 0 at time t = N , [Finish with a nonnegative amount.]
iii) P(VN > 0) > 0 at time t = N .[Profit is made with nonzero probability.]
2.3 Contingent Claims
Recall that from Definition 1.8, a contingent claim is given by the nonneg-
ative random payoff C of an option contract at maturity time t = N . For
example, in the case of the European call option of Definition 2, the payoff C
(i) +
is given by C = SN − K where K is called the strike (or exercise) price
of the option, while in the case of the European put option of Definition 1
60 "
(i) +
we have C = K − SN .
The list given below is somewhat restrictive and there exists many more
option types, with new ones appearing constantly on the markets.
Physical delivery vs cash settlement
(i) +
The cash settlement realized through the payoff C = SN − K can be
replaced by the physical delivery of the underlying asset in exchange for the
(i)
strike price K. Physical delivery occurs only when SN > K, in which case
(i)
the underlying asset can be sold at the price SN by the option holder, for a
(i) (i)
payoff SN − K. When SN > K, no delivery occurs and the payoff is 0, which
(i) +
is consistent with the expression C = SN − K . A similar procedure can
be applied to other option contracts.
Vanilla options (examples)
Vanilla options are options whose claim payoff depends only on the terminal
value ST of the underlying risky asset price at maturity time T .
i) European options.
The payoff of the European call option on the underlying asset no i with
maturity N and strike price K is

(i) (i)
 SN − K if SN > K,

(i) +
C = SN − K =
(i)
0 if SN < K.


The moneyness at time t = 0, 1, . . . , N of the European call option with

strike price K on the asset no i is the ratio
(i)
(i) St − K
Mt : = (i)
, t = 0, 1, . . . , N .
St
(i)
The option is said to be “out of the money” (OTM) when Mt < 0, “in
(i)
the money” (ITM) when Mt > 0, and “at the money” (ATM) when
(i)
Mt = 0.
The payoff of the European put option on the underlying asset no i with
exercise date N and strike price K is
" 61
N. Privault

(i) (i)
 K − SN if SN 6 K,

(i) +
C= K − SN =
(i)
0 if SN > K.


The moneyness at time t = 0, 1, . . . , N of the European put option with

strike price K on the asset no i is the ratio
(i)
(i) K − St
Mt : = (i)
, t = 0, 1, . . . , N .
St
ii) Binary options.

Binary (or digital) options, also called cash-or-nothing options, are op-
tions whose payoffs are of the form

(i)
 $1 if SN > K,

C = 1[K,∞) SN =
(i)
(i)
0 if SN < K,


for binary call options, and


(i)
 $1 if SN 6 K,

1(−∞,K ] SN(i)

C= =
(i)
0 if SN > K,


for binary put options.
iii) Collar and spread options.

Collar and spread options provide other examples of vanilla options,
whose payoffs can be constructed using call and put option payoffs, see,
e.g., Exercises 3.11 and 3.12.
Exotic options (examples)
i) Asian options.
The payoff of an Asian call option (also called option on average) on the
underlying asset no i with exercise date N and strike price K is
N
!+
1 X (i)
C= St − K .
N +1
t=0
The payoff of an Asian put option on the underlying asset no i with

exercise date N and strike price K is
62 "
N
!+
1 X (i)
C= K− St .
N +1
t=0
We refer to Section 13.1 for the pricing of Asian options in continuous

time. It can be shown, cf. Exercise 3.13 that Asian call option prices can
be upper bounded by European call option prices.
Other examples of such options include weather derivatives (based on

averaged temperatures) and volatility derivatives (based on averaged
volatilities).
ii) Barrier options.

The payoff of a down-an-out (or knock-out) barrier call option on the
underlying asset no i with exercise date N , strike price K and barrier
level B is
+
C = SN − K 1n
(i) o
(i)
min St > B
t=0,1,...,N
 +
(i) (i)

 N
 S − K if min St > B,
 t=0,1,...,N
=
(i)
0 if min St 6 B.



t=0,1,...,N
This option is also called a Callable Bull Contract with no residual

value, or turbo warrant with no rebate, in which B denotes the call
price B > K.
The payoff of an up-and-out barrier put option on the underlying asset

no i with exercise date N , strike price K and barrier level B is
(i) +
C = K − SN 1n (i)
o
Max St B.


t=0,1,...,N
This option is also called a Callable Bear Contract with no residual

value, in which the call price B usually satisfies B 6 K. See Eriksson
and Persson (2006) and Wong and Chan (2008) for the pricing of type
R Callable Bull/Bear Contracts, or CBBCs, also called turbo warrants,
which involve a rebate or residual value computed as the payoff of a
down-and-in lookback option. We refer the reader to Chapters 11, 12
" 63
N. Privault
and 13 for the pricing and hedging of related options in continuous time.
iii) Lookback options.

The payoff of a floating strike lookback call option on the underlying
asset no i with exercise date N is
(i) (i)
C = SN − min St .
t=0,1,...,N
The payoff of a floating strike lookback put option on the underlying

asset no i with exercise date N is

(i) (i)
C= Max St − SN .
t=0,1,...,N
We refer to Section 10.4 for the pricing of lookback options in continuous

time.
Options in insurance and investment
Such options are involved in the statements of Exercises 2.1 and 2.2.
Vanilla vs exotic options
(i)
Vanilla options such as European or binary options, have a payoff φ(SN )
(i)
that depends only on the terminal value of the underlying asset at ma-
SN
turity, as opposed to exotic or path-dependent options such as Asian, barrier,
or lookback options, whose payoff may depend on the whole path of the un-
derlying asset price until expiration time.
64 "
Exotic vs Vanilla Options

Vanilla options are called that way because:
(A) They were first used for the trading of vanilla by the
Maya beginning around the 14th century.
(B) “Plain vanilla” is the most standard and common of all

ice cream flavors.
(C) To meet FDA standards, pure vanilla extract must

contain 13.35 ounces of vanilla beans per gallon.
(D) Sir Charles C. Vanilla, FLS, was the early discoverer of

the properties of Brownian motion in asset pricing.
Fig. 2.4: Take the Quiz.
2.4 Martingales and Conditional Expectations

Before proceeding to the definition of risk-neutral probability measures in dis-
crete time we need to introduce more mathematical tools such as conditional
expectations, filtrations, and martingales.
Conditional expectations
Clearly, the expected value of any risky asset or random variable is dependent
on the amount of available information. For example, the expected return on
a real estate investment typically depends on the location of this investment.
In the probabilistic framework the available information is formalized as a

collection G of events, which may be smaller than the collection F of all avail-
able events, i.e. G ⊂ F.∗
The notation E[F | G ] represents the expected value of a random variable F

given (or conditionally to) the information contained in G, and it is read “the
conditional expectation of F given G”. In a certain sense, E[F | G ] represents
the best possible estimate of F in the mean-square sense, given the informa-
tion contained in G.
The conditional expectation satisfies the following five properties, cf. Sec-
tion 23.7 for details and proofs.
∗
The collection G is also called a σ-algebra, cf. Section 23.1.
" 65
N. Privault
i) E[F G | G ] = GE[F | G ] if G depends only on the information contained

in G.
ii) E[G | G ] = G when G depends only on the information contained in G.
iii) E[E[F | H] | G ] = E[F | G ] if G ⊂ H, called the tower property, cf. also

Relation (23.38).
iv) E[F | G ] = E[F ] when F “does not depend” on the information con-
tained in G or, more precisely stated, when the random variable F is
independent of the σ-algebra G.
v) If G depends only on G and F is independent of G, then
E[h(F , G) | G ] = E[h(F , x)]x=G .
When H = {∅, Ω} is the trivial σ-algebra we have
E[F | H ] = E[F ], F ∈ L1 (Ω).
See (23.38) and (23.44) for illustrations of the tower property by conditioning
with respect to discrete and continuous random variables.
Filtrations
The total amount of “information” available on the market at times t =

0, 1, . . . , N is denoted by Ft . We assume that
Ft ⊂ Ft+1 , t = 0, 1, . . . , N − 1,
which means that the amount of information available on the market in-
creases over time.
(i) (i) (i)
Usually, Ft corresponds to the knowledge of the values S0 , S1 , . . . , St ,
i = 1, 2, . . . , d, of the risky assets up to time t. In mathematical notation we
(i) (i) (i)
say that Ft is generated by S0 , S1 , . . . , St , i = 1, 2, . . . , d, and we usually
write
(i) (i) (i)
Ft = σ S0 , S1 , . . . , St , i = 1, 2, . . . , d , t = 1, 2, . . . , N ,

with F0 = {∅, Ω}.
Example: Consider the simple random walk
Zt := X1 + X2 + · · · + Xt , t > 0,
66 "
where (Xt )t>1 is a sequence of independent, identically distributed {−1, 1}

valued random variables. The filtration
(or information
flow) (Ft )t>0 gen-
erated by (Zt )t>0 is given by F0 = ∅, Ω , F1 = ∅, {X1 = 1}, {X1 =
−1}, Ω , and

∅, {X1 = 1, X2 = 1}, {X1 = 1, X2 = −1}, {X1 = −1, X2 = 1},

F2 = σ
{X1 = −1, X2 = −1}, Ω .

The notation Ft is useful to represent a quantity of information available at

time t. Note that different agents or traders may work with different filtra-
tions. For example, an insider may have access to a filtration (Gt )t=0,1,...,N
which is larger than the ordinary filtration (Ft )t=0,1,...,N available to an or-
dinary agent, in the sense that
Ft ⊂ Gt , t = 0, 1, . . . , N .
The notation E[F | Ft ] represents the expected value of a random variable F

given (or conditionally to) the information contained in Ft . Again, E[F | Ft ]
denotes the best possible estimate of F in mean-square sense, given the in-
formation known up to time t.
We will assume that no information is available at time t = 0, which

translates as
E[F | F0 ] = E[F ]
for any integrable random variable F . As above, the conditional expectation
with respect to Ft satisfies the following five properties:
i) E[F G | Ft ] = F E[G | Ft ] if F depends only on the information con-

tained in Ft .
ii) E[F | Ft ] = F when F depends only on the information known at time

t and contained in Ft .
iii) E[E[F | Ft+1 ] | Ft ] = E[F | Ft ] if Ft ⊂ Ft+1 (by the tower property, cf.
also Relation (7.1) below).
iv) E[F | Ft ] = E[F ] when F does not depend on the information contained
in Ft .
v) If F depends only on Ft and G is independent of Ft , then
E[h(F , G) | Ft ] = E[h(x, G)]x=F .
" 67
N. Privault
Note that by the tower property (iii) the process t 7→ E[F | Ft ] is a martin-
gale, cf. e.g. Relation (7.1) for details.
Martingales
A martingale is a stochastic process whose value at time t + 1 can be esti-

mated using conditional expectation given its value at time t. Recall that a
stochastic process (Mt )t=0,1,...,N is said to be (Ft )t=0,1,...,N -adapted if the
value of Mt depends only on the information available at time t in Ft ,
t = 0, 1, . . . , N .
Definition 2.8. A stochastic process (Mt )t=0,1,...,N is called a discrete-time
martingale with respect to the filtration (Ft )t=0,1,...,N if (Mt )t=0,1,...,N is
(Ft )t=0,1,...,N -adapted and satisfies the property
E[Mt+1 | Ft ] = Mt , t = 0, 1, . . . , N − 1.
Note that the above definition implies that Mt ∈ Ft , t = 0, 1, . . . , N . In other

words, a random process (Mt )t=0,1,...,N is a martingale if the best possible
prediction of Mt+1 in the mean-square sense given Ft is simply Mt .
In discrete-time finance, the martingale property can be used to character-

ize risk-neutral probability measures, and for the computation of conditional
expectations.
Exercise. Using the tower property (23.38) of conditional expectation, show

that Definition 2.8 can be equivalently stated by saying that
E[Mn | Fk ] = Mk , 0 6 k < n.
A particular property of martingales is that their expectation is constant over

time.
Proposition 2.9. Let (Zn )n∈N be a martingale. We have
E [ Zn ] = E [ Z0 ] , n > 0.
Proof. From the tower property (23.38) of conditional expectation, we have:
E[Zn+1 ] = E[E[Zn+1 | Fn ]] = E[Zn ], n > 0,
hence by induction on n > 0 we have
E[Zn+1 ] = E[Zn ] = E[Zn−1 ] = · · · = E[Z1 ] = E[Z0 ], n > 0.

Weather forecasting can be seen as an example of application of martingales.
If Mt denotes the random temperature observed at time t, this process is a
68 "
martingale when the best possible forecast of tomorrow’s temperature Mt+1

given the information known up to time t is simply today’s temperature Mt ,
t = 0, 1, . . . , N − 1.
Definition 2.10. A stochastic process (ξk )k>1 is said to be predictable if ξk
depends only on the information in Fk−1 , k > 1.
When F0 simply takes the form F0 = {∅, Ω} we find that ξ1 is a constant
when (ξt )t=1,2,...,N is a predictable process. Recall that on the other hand,
(i) (i)
the process St t=0,1,...,N is adapted as St depends only on the information
in Ft , t = 0, 1, . . . , N , i = 1, 2, . . . , d.
The discrete-time stochastic integral (2.9) will be interpreted as the sum of

(1) (1)
discounted profits and losses ξk Sek − Sek−1 , k = 1, 2, . . . , t, in a portfolio
(1) (1)
holding a quantity ξk of a risky asset whose price variation is Sek − Sek−1 at
time k = 1, 2, . . . , t.
An important property of martingales is that the discrete-time stochastic

integral (2.9) of a predictable process is itself a martingale, see also Propo-
sition 7.1 for the continuous-time analog of the following proposition, which
will be used in the proof of Theorem 3.5 below.∗
In the sequel, the martingale (2.9) will be interpreted as a discounted portfolio

(1) (1)
value, in which Sek − Sek−1 represents the increment in the discounted asset
price and ξk is the amount invested in that asset, k = 1, 2 . . . , N .
Theorem 2.11. Martingale transform. Given (Xk )k=0,1,...,N a martingale
and (ξk )k=1,2,...,N a (bounded) predictable process, the discrete-time process
(Mt )t=0,1,...,N defined by
t
X
Mt = ξk (Xk − Xk−1 ), t = 0, 1, . . . , N , (2.9)
| {z }
k =1 Profit/loss
is a martingale.
Proof. Given n > t > 0 we have
" n #
X
E[Mn | Ft ] = E ξk (Xk − Xk−1 ) Ft

k =1
n
X
E ξk (Xk − Xk−1 ) Ft

=
k =1
∗
See here for a related discussion of martingale strategies in a particular case.
" 69
N. Privault
t
X n
X
= E [ξk (Xk − Xk−1 ) | Ft ] + E [ξk (Xk − Xk−1 ) | Ft ]
k =1 k =t+1
X t n
X
= ξk (Xk − Xk−1 ) + E [ξk (Xk − Xk−1 ) | Ft ]
k =1 k =t+1
n
X
= Mt + E [ξk (Xk − Xk−1 ) | Ft ] .
k =t+1
In order to conclude to E [Mn | Ft ] = Mt it suffices to show that
E [ξk (Xk − Xk−1 ) | Ft ] = 0, t + 1 6 k 6 n.
First we note that when 0 6 t 6 k − 1 we have Ft ⊂ Fk−1 , hence by the

tower property (23.38) of conditional expectations we get
E [ξk (Xk − Xk−1 ) | Ft ] = E [E [ξk (Xk − Xk−1 ) | Fk−1 ] | Ft ] .
Next, since the process (ξk )k>1 is predictable, ξk depends only on the infor-
mation in Fk−1 , and using Property (ii) of conditional expectations we may
pull out ξk out of the expectation since it behaves as a constant parameter
given Fk−1 , k = 1, 2, . . . , n. This yields
E [ξk (Xk − Xk−1 ) | Fk−1 ] = ξk E [Xk − Xk−1 | Fk−1 ] = 0 (2.10)
since
E [Xk − Xk−1 | Fk−1 ] = E [Xk | Fk−1 ] − E [Xk−1 | Fk−1 ]

= E [Xk | Fk−1 ] − Xk−1
= 0, k = 1, 2, . . . , N ,
because (Xk )k=0,1,...,N is a martingale. By (2.10), it follows that
E [ξk (Xk − Xk−1 ) | Ft ] = E [E [ξk (Xk − Xk−1 ) | Fk−1 ] | Ft ]

= E [ξk E [Xk − Xk−1 | Fk−1 ] | Ft ]
= 0,
for k = t + 1, . . . , n.
70 "
2.5 Market Completeness and Risk-Neutral Measures

As in the two time step model, the concept of risk-neutral probability mea-
sure (or martingale measure) will be used to price financial claims under the
absence of arbitrage hypothesis.∗
Definition 2.12. A probability measure P∗ on Ω is called a risk-neutral
probability measure if under P∗ , the expected return of each risky asset equals
the return r of the riskless asset, that is
(i) (i)
E∗ St+1 Ft = (1 + r )St , t = 0, 1, . . . , N − 1, (2.11)
i = 0, 1, . . . , d. Here, E∗ denotes the expectation under P∗ .

(i)
Since St ∈ Ft , denoting by
(i) (i)
(i) St+1 − St
Rt + 1 : = (i)
St
the return of asset no i over the time interval (t, t + 1], t = 0, 1, . . . , N − 1,

Relation (2.11) can be rewritten as
" (i) (i)
#
(i) St+1 − St
E∗ Rt+1 Ft = E∗ (i)
Ft

St
" (i) #
S
= E∗ t(+i)1 Ft − 1

St
= r, t = 0, 1, . . . , N − 1,
(i) (i) (i)
which means that the average of the return (St+1 − St )/St of asset no i
under the risk-neutral probability measure P∗ is equal to the risk-free interest
rate r.
In other words, taking risks under P∗ by buying the risky asset no i has a
neutral effect, as the expected return is that of the riskless asset. The measure
P] would yield a positive risk premium if we had
(i) (i)
E] St+1 Ft = (1 + r̃ )St , t = 0, 1, . . . , N − 1,
with r̃ > r, and a negative risk premium if r̃ < r.
In the next proposition we reformulate the definition of risk-neutral prob-

ability measure using the notion of martingale.
∗
See also the Efficient Market Hypothesis.
" 71
N. Privault
Proposition 2.13. A probability measure P∗ on Ω is a risk-neutral measure

if and only if the discounted price process
(i)
(i) St
Set := , t = 0, 1, . . . , N ,
(1 + r )t
is a martingale under P∗ , i.e.
(i) (i)
E∗ Set+1 Ft = Set , t = 0, 1, . . . , N − 1, (2.12)
i = 0, 1, . . . , d.
(i) (i)
Proof. It suffices to check that by the relation St = (1 + r )t Set , Condi-
tion (2.11) can be rewritten as
(i) (i)
(1 + r )t+1 E∗ Set+1 Ft = (1 + r )(1 + r )t Set ,
i = 1, 2, . . . , d, which is clearly equivalent to (2.12) after division by (1 + r )t ,

t = 0, 1, . . . , N − 1.
Note that, as a consequence of Propositions 2.9 and 2.13, the discounted price
(i) (i)
process Set := St /(1 + r )t , t = 0, 1, . . . , n, has constant expectation under
the risk-neutral probability measure P∗ , i.e.
(i) (i)
E∗ Set = Se0 , t = 1, 2, . . . , N ,
for i = 0, 1, . . . , d.
Next, we restate in discrete time the first fundamental theorem of asset pric-
ing, which can be used to check for the existence of arbitrage opportunities.
admits at least one equivalent risk-neutral probability measure.
Proof. See Harrison and Kreps (1979) and Theorem 5.17 of Föllmer and
Schied (2004).
Next, we turn to the notion of market completeness, starting with the defi-
nition of attainability for a contingent claim.
72 "
Definition 2.16. A contingent claim with payoff C is said to be attainable

(at time N ) if there exists a (predictable) self-financing portfolio strategy
ξ t t=1,2,...,N such that
d
(k ) (k )
X
C = ξN • SN = ξN SN , P − a.s. (2.14)
k =0
In case ξ t is a portfolio that attains the claim payoff C at time

t=1,2,...,N
N , i.e. if (2.14) is satisfied, we also say that ξ t t=1,2,...,N hedges the claim

payoff C. In case (2.14) is replaced by the condition
ξ N • S N > C,
we talk of super-hedging.
When a self-financing portfolio ξ t t=1,2,...,N hedges a claim payoff C, the

arbitrage-free price πt (C ) of the claim at time t is given by the value
πt ( C ) = ξ t • S t
of the portfolio at time t = 0, 1, . . . , N . Recall that arbitrage-free prices can

be used to ensure that financial derivatives are “marked” at their fair value
(mark to market). Note that at time t = N we have
πN (C ) = ξ N • S N = C,
i.e. since exercise of the claim occurs at time N , the price πN (C ) of the claim
equals the value C of the payoff.
The next result can be viewed as the second fundamental theorem of asset
pricing in discrete time.
if and only if it admits only one equivalent risk-neutral probability measure.
Proof. See Harrison and Kreps (1979) and Theorem 5.38 of Föllmer and
Schied (2004).
2.6 The Cox-Ross-Rubinstein (CRR) Market Model

We consider the discrete-time Cox-Ross-Rubinstein (Cox et al. (1979)) model,
also called the binomial model, with N + 1 time instants t = 0, 1, . . . , N and
" 73
N. Privault
(0)
d = 1 risky asset, see Sharpe (1978). In this setting, the price St of the
riskless asset evolves as
(0) (0)
St = S0 (1 + r )t , t = 0, 1, . . . , N .
Let the return of the risky asset S (1) be defined as

(1) (1)
St − St−1
Rt : = (1)
, t = 1, 2, . . . , N .
St−1
In the CRR model the return Rt is random and allowed to take only two
values a and b at each time step, i.e.
Rt ∈ {a, b}, t = 1, 2, . . . , N ,
with −1 < a 0, P(Rt = b) > 0, t = 1, 2, . . . , N .

(1) (1)
That means, the evolution of St−1 to St is random and given by
 
(1)
 (1 + b)St−1
 if Rt = b 

(1) (1)
St = = (1 + Rt )St−1 , t = 1, . . . , N ,
(1)
(1 + a)St−1 if Rt = a

 

and
t
(1) (1)
Y
St = S0 ( 1 + Rk ) , t = 0, 1, . . . , N .
k =1
(1)
Note that the price process St t=0,1,...,N evolves on a binary recombining
(or binomial) tree of the following type:∗
∗
Download the corresponding IPython notebook1 and IPython notebook2 that
can be run here.
74 "
S2 = S0 (1 + b)2
S1 = S0 (1 + b)
S0 S2 = S0 (1 + a)(1 + b)
S1 = S0 (1 + a)
S2 = S0 (1 + a)2 .
The discounted asset price is

(1)
(1) St
Set = , t = 0, 1, . . . , N ,
(1 + r )t
with
1 + b e(1)
 
 1 + r St−1

 if Rt = b 

1 + Rt e(1)
 

(1)
Set = = S , t = 1, 2, . . . , N ,
 1 + a e(1)  1 + r t−1
if Rt = a 
 
 S
1 + r t−1
 
and
(1) t t
(1) S0 Y
e(1)
Y 1 + Rk
Set = ( 1 + R k ) = S .
(1 + r )t 0
1+r
k =1 k =1
23.84
19.07
15.26 9.54
12.21 7.63
9.77 6.1 3.81
7.81 4.88 3.05
6.25 3.91 2.44 1.53
5.0 3.12 1.95 1.22
4.0 2.5 1.56 0.98 0.61
2.0 1.25 0.78 0.49
1.0 0.62 0.39 0.24
0.5 0.31 0.2
0.25 0.16 0.1
0.12 0.08
0.06 0.04
0.03
0.02
Fig. 2.5: Discrete-time asset price tree in the CRR model.
In this model, the discounted value at time t of the portfolio is given by
" 75
N. Privault
(0) (0) (1) (1)

ξ t • X t = ξt Se0 + ξt Set , t = 1, 2, . . . , N .
The information Ft known in the market up to time t is given by the

(1) (1) (1)
knowledge of S1 , S2 , . . . , St , which is equivalent to the knowledge of
(1) e(1) (1)
S , S , . . . , S or R1 , R2 , . . . , Rt , i.e. we write
e
1 2
e
t
(1) (1) (1) (1) (1) (1)

Ft = σ S1 , S2 , . . . , St = σ Se1 , Se2 , . . . , Set = σ (R1 , R2 , . . . , Rt ),
t = 0, 1, . . . , N , where, as a convention, S0 is a constant and F0 = {∅, Ω}

contains no information.
Fig. 2.6: Discrete-time asset price graphs in the CRR model.
Theorem 2.19. The CRR model is without arbitrage opportunities if and

only if a < r < b. In this case the market is complete and the equivalent
risk-neutral probability measure P∗ is given by
r−a b−r
P∗ (Rt+1 = b | Ft ) = and P∗ (Rt+1 = a | Ft ) = , (2.15)
b−a b−a
t = 0, 1, . . . , N − 1. In particular, (R1 , R2 , . . . , RN ) forms a sequence of inde-
pendent and identically distributed (i.i.d.) random variables under P∗ , with
r−a b−r
p∗ := P∗ (Rt = b) = and q ∗ := P∗ (Rt = a) = , (2.16)
b−a b−a
t = 1, 2, . . . , N .
Proof. In order to check for arbitrage opportunities we may use Theorem 2.15
and look for a risk-neutral probability measure P∗ . According to the definition
of a risk-neutral measure this probability P∗ should satisfy Condition (2.11),
i.e. (1) (1)
E∗ St+1 Ft = (1 + r )St , t = 0, 1, . . . , N − 1.
76 "
(1)
Rewriting E∗ St+1 Ft as
(1) (1) (1)
E∗ St+1 Ft = E∗ St+1 St
(1) (1)
= (1 + a)St P∗ (Rt+1 = a | Ft ) + (1 + b)St P∗ (Rt+1 = b | Ft ),
it follows that any risk-neutral probability measure P∗ should satisfy the

equations
 (1 + b)St(1) P∗ (Rt+1 = b | Ft ) + (1 + a)St(1) P∗ (Rt+1 = a | Ft ) = (1 + r )St(1)


P∗ (Rt+1 = b | Ft ) + P∗ (Rt+1 = a | Ft ) = 1,

i.e.  ∗
 bP (Rt+1 = b | Ft ) + aP∗ (Rt+1 = a | Ft ) = r
P∗ (Rt+1 = b | Ft ) + P∗ (Rt+1 = a | Ft ) = 1,

with solution
r−a b−r
P∗ (Rt+1 = b | Ft ) = and P∗ (Rt+1 = a | Ft ) = ,
b−a b−a
t = 0, 1, . . . , N − 1. Since the values of P∗ (Rt+1 = b | Ft ) and P∗ (Rt+1 =
a | Ft ) computed in (2.15) are non random, they are independent∗ of the
information contained in Ft up to time t. As a consequence, under P∗ , the
random variable Rt+1 is independent of R1 , R2 , . . . , Rt , hence the sequence
of random variables (Rt )t=0,1,...,N is made of mutually independent random
variables under P∗ , and by (2.15) we have
r−a b−r
P∗ (Rt+1 = b) = and P∗ (Rt+1 = a) = .
b−a b−a
Clearly, P∗ can be equivalent to P only if r − a > 0 and b − r > 0. In this case
the solution P∗ of the problem is unique by construction, hence the market
is complete by Theorem 2.18.
As a consequence of Proposition 2.13, letting p∗ := (r − a)/(b − a), when
(1 , 2 , . . . , n ) ∈ {a, b}N we have
P∗ (R1 = 1 , R2 = 2 , . . . , RN = n ) = (p∗ )l (1 − p∗ )N −l ,
where l, resp. N − l, denotes the number of times the term “b”, resp. “a”,
appears in the sequence (1 , 2 , . . . , N ) ∈ {a, b}N .
∗
The relation P(A | B ) = P(A) is equivalent to the independence relation P(A ∩ B ) =
P(A)P(B ) of the events A and B.
" 77
N. Privault
Exercises
Exercise 2.1 Today I went to the Furong Peak mall. After exiting the
Poon Way MTR station, I was met by a friendly investment consultant from
NTRC Input, who recommended that I subscribe to the following investment
plan. The plan requires to invest $ 2,550 per year over the first 10 years. No
contribution is required from year 11 until year 20, and the total projected
surrender value is $30,835 at maturity N = 20. The plan also includes a
death benefit which is not considered here.
Surrender Value
Year Total Premiums Guaranteed ($S) Projected at 3.25%
Paid To-date ($S) Non-Guaranteed ($S) Total ($S)
1 2,550 0 0 0
2 5,100 2,460 140 2,600
3 7,650 4,240 240 4,480
4 10,200 6,040 366 6,406
5 12,750 8,500 518 9,018
10 25,499 19,440 1,735 21,175
15 25,499 22,240 3,787 26,027
20 25,499 24,000 6,835 30,835
Table 2.2: NTRC Input investment plan.
a) Compute the constant interest rate over 20 years corresponding to this

investment plan.
b) Compute the projected value of the plan at the end of year 20, if the
annual interest rate is r = 3.25% over 20 years.
c) Compute the projected value of the plan at the end of year 20, if the
annual interest rate r = 3.25% is paid only over the first 10 years. Does
this recover the total projected value $30, 835?
Exercise 2.2 Today I went to the East mall. After exiting the Bukit Kecil
MTR station, I was approached by a friendly investment consultant from
Avenda Insurance, who recommended me to subscribe to the following in-
vestment plan. The plan requires me to invest $ 3,581 per year over the first
10 years. No contribution is required from year 11 until year 20, and the
total projected surrender value is $50,862 at maturity N = 20. The plan also
includes a death benefit which is not considered here.
78 "
Surrender Value
Year Total Premiums Guaranteed ($S) Projected at 3.25%
Paid To-date ($S) Non-Guaranteed ($S) Total ($S)
1 3,581 0 0 0
2 7,161 1,562 132 1,694
3 10,741 3,427 271 3,698
4 14,321 5,406 417 5,823
5 17,901 6,992 535 7,527
10 35,801 19,111 1,482 20,593
15 35,801 29,046 3,444 32,490
20 35,801 43,500 7,362 50,862
Table 2.3: Avenda Insurance investment plan.
a) Using the following graph, compute the constant interest rate over 20
years corresponding to this investment.
16
15.5
15
14.5
14
13.5
13
12.5
12
11.5
1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3
x in %
Fig. 2.7: Graph of the function x 7→ ((1 + x)21 − (1 + x)11 )/x.
b) Compute the projected value of the plan at the end of year 20, if the
annual interest rate is r = 3.25% over 20 years.
c) Compute the projected value of the plan at the end of year 20, if the
annual interest rate r = 3.25% is paid only over the first 10 years. Does
this recover the total projected value $50, 862?
Exercise 2.3 A lump sum of $100,000 is to be paid through constant yearly

payments m at the end of each year over 10 years.
a) Find the value of m.
b) Assume that the amount remaining at the beginning of every year is in-
vested at the interest rate r = 2%. How does this affect the value of the
constant yearly payment m?
Exercise 2.4 Consider a two-step trinomial (or ternary) market model

(St )t=0,1,2 with r = 0 and three possible return rates Rt ∈ {−1, 0, 1}. Show
that the probability measure P∗ given by
1 1 1
P∗ (Rt = −1) := , P∗ (Rt = 0) := , P∗ (Rt = 1) :=
4 2 4
" 79
N. Privault
is risk-neutral.
(0) (0)
Exercise 2.5 We consider a riskless asset valued Sk = S0 , k = 0, 1, . . . , N ,
where the risk-free interest rate is r = 0, and a risky asset S (1) whose returns
(1) (1)
S −S
Rk := k (1) k−1 , k = 1, 2, . . . , N , form a sequence of independent identi-
Sk−1
cally distributed random variables taking three values {−b < 0 < b} at each
time step, with
p∗ := P∗ (Rk = b) > 0, θ∗ := P∗ (Rk = 0) > 0, q ∗ := P∗ (Rk = −b) > 0,
k = 1, 2, . . . , N . The information known to the market up to time k is denoted

by Fk .

P in terms of the parameter θ∗ ∈ (0, 1).
b) Assume that the conditional variance
 
(1) (1)
S + − S
Var∗  k 1 k
Fk = σ 2 > 0, k = 0, 1, . . . , N − 1, (2.17)

(1)
S k

of the asset return is constant and equal to σ 2 . Show that this condi-
tion defines a unique risk-neutral probability measure P∗σ under a certain
condition on b and σ, and determine P∗σ explicitly.
Exercise 2.6 We consider the discrete-time Cox-Ross-Rubinstein model with

N + 1 time instants t = 0, 1, . . . , N , with a riskless asset whose price πt
evolves as πt = π0 (1 + r )t , t = 0, 1, . . . , N . The evolution of St−1 to St is
given by
 (1 + b)St−1

St =
(1 + a)St−1

with −1 < a < r < b. The return of the risky asset S is defined as
St − St−1
Rt : = , t = 1, 2, . . . , N ,
St−1
and Ft is generated by R1 , R2 , . . . , Rt , t = 1, 2, . . . , N .
a) What are the possible values of Rt ?
b) Show that, under the probability measure P∗ defined by
r−a b−r
p∗ = P∗ (Rt+1 = b | Ft ) = , q ∗ = P∗ (Rt+1 = a | Ft ) = ,
b−a b−a
80 "
t = 0, 1, . . . , N − 1, the expected return E∗ [Rt+1 | Ft ] of S is equal to the

return r of the riskless asset.
c) Show that under P∗ the process (St )t=0,1,...,N satisfies
E∗ [St+k | Ft ] = (1 + r )k St , t = 0, 1, . . . , N − k, k = 0, 1, . . . , N .
Exercise 2.7 We consider the discrete-time Cox-Ross-Rubinstein model with

N + 1 time instants t = 0, 1, . . . , N , with a riskless asset whose price πt
evolves as πt = π0 (1 + r )t with r > 0, and a risky asset whose price St is
given by
Yt
St = S0 (1 + Rk ), t = 0, 1, . . . , N ,
k =1
where the market return Rk are independent random variables taking two
possible values a and b with −1 < a < r < b, and P∗ is the probability
measure defined by
r−a b−r
p∗ = P∗ (Rt+1 = b | Ft ) = , q ∗ = P∗ (Rt+1 = a | Ft ) = ,
b−a b−a
t = 0, 1, . . . , N − 1, where (Ft )t=0,1,...,N is the filtration generated by (Rt )t=1,2,...,N .
a) Compute the conditional expected return E∗ [Rt+1 | Ft ] under P∗ , t =
0, 1, . . . , N − 1.
b) Show that the discounted asset price process

St
Set t=0,1,...,N :=
πt t=0,1,...,N
is a (nonnegative) (Ft )-martingale under P∗ .

Hint: Use the independence of market returns (Rt )t=1,2,...,N under P∗ .
c) Compute the moment E∗ [(SN )β ] for all β > 0.
Hint: Use the independence of market returns (Rt )t=1,2,...,N under P∗ .
d) For any α > 0, find an upper bound for the probability
P∗ St > απt for some t ∈ {0, 1, . . . , N } .

Hint: Use the fact that when (Mt )t=0,1,...,N is a nonnegative martingale
we have
E[(M )β ]
N
P Max Mt > x 6 , x > 0, β > 1. (2.18)
t=0,1,...,N xβ
e) For any x > 0, find an upper bound for the probability

P∗ Max St > x .
t=0,1,...,N
" 81
N. Privault
Hint: Note that (2.18) remains valid for any nonnegative submartingale.
82 "
Chapter 3
Pricing and Hedging in Discrete Time
We consider the pricing and hedging of financial derivatives in the N -step

Cox-Ross-Rubinstein (CRR) model with N + 1 time instants t = 0, 1, . . . , N .
Vanilla options are priced and hedged using backward induction, and exotic
options with arbitrary claim payoffs are dealt with using the Clark-Ocone
formula in discrete time.
3.1 Pricing Contingent Claims . . . . . . . . . . . . . . . . . . . . . . 83

3.2 Pricing Vanilla Options . . . . . . . . . . . . . . . . . . . . . . . . . 89
3.3 Hedging Contingent Claims . . . . . . . . . . . . . . . . . . . . . 94
3.4 Hedging Vanilla Options . . . . . . . . . . . . . . . . . . . . . . . . 96
3.5 Hedging Exotic Options . . . . . . . . . . . . . . . . . . . . . . . . 104
3.6 Convergence of the CRR Model . . . . . . . . . . . . . . . . . 112
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
3.1 Pricing Contingent Claims

Let us consider an attainable contingent claim with (random) claim payoff
C > 0 and maturity N . Recall that by the Definition 2.16 of attainability
there exists a (predictable) self-financing portfolio strategy (ξt )t=1,2,...,N that
hedges the claim with payoff C, in the sense that
d
(k ) (k )
X
ξN • SN = ξN SN = C (3.1)
k =0
at time N . If (3.1) holds at time N , then investing the amount

d
(k ) (k )
X
V0 = ξ 1 • S 0 = ξ1 S0 (3.2)
k =0
at time t = 0, resp.
" 83
N. Privault
d
(k ) (k )
X
Vt = ξ t • S t = ξt St (3.3)
k =0
at times t = 1, 2, . . . , N into a self-financing hedging portfolio ξ t t=1,2,...,N

will allow one to hedge the option and to reach the perfect replication equality
(3.1) at time t = N .
Definition 3.1. The value (3.2)-(3.3) at time t of a (predictable) self-
financing portfolio strategy (ξt )t=1,2,...,N hedging an attainable claim payoff
C will be called an arbitrage-free price of the claim payoff C at time t and
denoted by πt (C ), t = 0, 1, . . . , N .
Recall that arbitrage-free prices can be used to ensure that financial deriva-
tives are “marked” at their fair value (mark to market).
Next we develop a second approach to the pricing of contingent claims, based

on conditional expectations and martingale arguments. We will need the fol-
lowing lemma, in which Vet := Vt /(1 + r )t denotes the discounted portfolio
value, t = 0, 1, . . . , N .
Relation (3.4) in the following lemma has a natural interpretation by saying

that when a portfolio is self-financing the value Vet of the (discounted) portfolio
at time t is given by summing up the (discounted) trading profits and losses
registered over all trading time periods from time 0 to time t. Note that in
(3.4), the use of the vector of discounted asset prices
(0) (1) (d)
X t := Set , Set , . . . , Set ), t = 0, 1, . . . , N ,
allows us to add up the discounted trading profits and losses ξ t • X t − X t−1

since they are expressed in units of currency “at time 0”. Indeed, in general,
$1 at time t = 0 cannot be added to $1 at time t = 1 without proper
discounting.
Lemma 3.2. The following statements are equivalent:

(i) The portfolio strategy ξ t t=1,2,...,N is self-financing, i.e.
ξ t • S t = ξ t+1 • S t , t = 1, 2, . . . , N − 1.
(ii) We have ξ t • X t = ξ t+1 • X t for all t = 1, 2, . . . , N − 1.
(iii) The discounted portfolio value Vet can be written as the stochastic sum-
mation
t
X
ξ k • X k − X k−1 , t = 0, 1, . . . , N , (3.4)

Vet = Ve0 +
k =1
| {z }
Sum of profits and losses
84 "
of discounted trading profits and losses.

Proof. First, the self-financing condition (i), i.e.
ξ t • S t = ξ t+1 • S t , t = 1, 2, . . . , N − 1,
is clearly equivalent to (ii) by division of both sides by (1 + r )t−1 .
Assuming now that (ii) holds, by (2.8) we have

d
(k ) (k )
X
V0 = ξ 1 • S 0 and Vt = ξ t • S t = ξt St , t = 1, 2, . . . , N .
k =0
which shows that (3.4) is satisfied for t = 1, in addition to being satisfied for
t = 0. Next, for t = 2, 3, . . . , N we have the telescoping identity
t
X
Vet = Ve1 + Vek − Vek−1
k =2
X t

= Ve1 + ξ k • X k − ξ k−1 • X k−1
k =2
X t

= Ve1 + ξ k • X k − ξ k • X k−1
k =2
X t
ξ k • X k − X k−1 , t = 2, 3, . . . , N .

= Ve1 +
k =2
Finally, assuming that (iii) holds, we get
Vet − Vet−1 = ξ t • X t − X t−1 , t = 1, 2, . . . , N , ,

which rewrites as
ξ t • X t − ξ t−1 • X t−1 = ξ t • X t − X t−1 , t = 2, 3, . . . , N , ,

or
ξ t−1 • X t−1 = ξ t • X t−1 , t = 2, 3, . . . , N ,
which implies (ii).
In Relation (3.4), the term ξ t • X t − X t−1 represents the (discounted) trad-

ing profit and loss

Vet − Vet−1 = ξ t • X t − X t−1 ,

" 85
N. Privault
of the self-financing portfolio strategy ξ j over the time interval

j =1,2,...,N
(t − 1, t], computed by multiplication of the portfolio allocation ξ t with the
change of price X t − X t−1 , t = 1, 2, . . . , N .
Remark 3.3. As a consequence of Lemma 3.2, if a contingent claim with
C is attainable by a (predictable) self-financing portfolio strategy
payoff
ξ t t=1,2,...,N , then the discounted claim payoff
e := C
C
(1 + r )N
rewrites as the sum of discounted trading profits and losses
N
X
ξ t • X t − X t−1 . (3.5)

e = VeN = ξ N • X N = Ve0 +
C
t=1
The sum (3.4) is also referred to as a discrete-time stochastic integral of

the portfolio strategy ξ t t=1,2,...,N with respect to the random process

X t t=0,1,...,N .

Remark 3.4. By Proposition 2.13, the process X t t=0,1,...,N is a martingale
under the risk-neutral probability measure P , hence by the martingale trans-
∗
form Theorem 2.11 and Lemma 3.2, (Vet )t=0,1,...,N in (3.4) is also martingale
under P∗ , provided that ξ t t=1,2,...,N is a self-financing and predictable pro-

cess.
The above remarks will be used in the proof of the next Theorem 3.5.
Theorem 3.5. The arbitrage-free price πt (C ) of any (integrable) attainable
contingent with claim payoff C is given by
1
πt ( C ) = E∗ [C | Ft ], t = 0, 1, . . . , N , (3.6)
(1 + r )N −t
where P∗ denotes any risk-neutral probability measure.
Proof. a) Short proof. Since the claim payoff C is attainable, there exists
a self-financing portfolio strategy (ξt )t=1,2,...,N such that C = VN , i.e. Ce=
VN . In addition, by Theorem 2.11 Lemma 3.2 the process (Vt )t=0,1,...,N is a
e e
martingale under P∗ , hence we have
Vet = E∗ VeN Ft = E∗ C e Ft , t = 0, 1, . . . , N , (3.7)

which shows (3.8). To conclude, we note that by Definition 3.1 the arbitrage-
free price πt (C ) of the claim at time t is equal to the value Vt of the self-
financing hedging C.
86 "
b) Long proof. For completeness, we include a self-contained, step-by-step

derivation of (3.7) by following the argument of Theorem 2.11, as follows. By
Remark 3.3 we have
E∗ Ce Ft = E∗ VeN Ft

N
" #
X
∗ e
= E V0 +

ξ k X k − X k−1 Ft
•
k =1
N
∗
X
= E Ve0 Ft + E∗ ξ k • X k − X k−1 Ft

k =1
t
X N
X
E∗ ξ k • X k − X k−1 Ft + E∗ ξ k • X k − X k−1 Ft

= Ve0 +
k =1 k =t+1
t
X N
X
E∗ ξ k • X k − X k−1 Ft

= Ve0 + ξ k • X k − X k−1 +
k =1 k =t+1
N
X
E∗ ξ k • X k − X k−1 Ft ,

= Vet +
k =t+1
where we used Relation (3.4) of Lemma 3.2. In order to obtain (3.8) we need
to show that
N
X
E∗ ξ k • X k − X k−1 Ft = 0,

k =t+1
or
E∗ ξ j • X j − X j−1 Ft = 0,

for all j = t + 1, . . . , N . Since 0 6 t 6 j − 1 we have Ft ⊂ Fj−1 , hence by

the tower property (23.38) of conditional expectations we get
E∗ ξ j • X j − X j−1 Ft = E∗ E∗ ξ j • X j − X j−1 Fj−1 | Ft ,

therefore it suffices to show that
E∗ ξ j • X j − X j−1 Fj−1 = 0, j = 1, 2, . . . , N .

We note that the portfolio allocation ξ j over the time period [j − 1, j ] is

predictable, i.e. it is decided at time j − 1, and it thus depends only on the
information Fj−1 known up to time j − 1, hence
E∗ ξ j • X j − X j−1 Fj−1 = ξ j • E∗ X j − X j−1 Fj−1 .

Finally we note that
E∗ X j − X j−1 Fj−1 = E∗ X j Fj−1 − E∗ X j−1 Fj−1

" 87
N. Privault
= E∗ X j Fj−1 − X j−1

= 0, j = 1, 2, . . . , N ,
because X t t=0,1,...,N is a martingale under the risk-neutral probability mea-

sure P∗ , and this concludes the proof of (3.7). Let
e= C
C
(1 + r )N
denote the discounted payoff of the claim C. We will show that under any
risk-neutral probability measure P∗ the discounted value of any self-financing
portfolio hedging C is given by
Vet = E∗ Ce Ft , t = 0, 1, . . . , N , (3.8)

which shows that

1
Vt = E∗ [C | Ft ]
(1 + r )N −t
after multiplication of both sides by (1 + r )t . Next, we note that (3.8) follows
from the martingale transform result of Theorem 2.11.
Note that (3.6) admits an interpretation in an insurance framework, in which
πt (C ) represents an insurance premium and C represents the random value
of an insurance claim made by a subscriber. In this context, the premium of
the insurance contract reads as the average of the values (3.6) of the random
claims after discounting for the time value of money.
Remark 3.6. By Remark 3.4 the self-financing discounted portfolio value
process
Vet t=0,1,...,N = ((1 + r )−t πt (C ))t=0,1,...,N

hedging the claim C is a martingale under the risk-neutral probability measure

P∗ . This fact can be recovered from Theorem 3.5 as in Remark 3.3, since from
the tower property (23.38) of conditional expectation we have
Vet = E∗ C

e Ft
= E E∗ Ce Ft+1 Ft
∗

= E∗ Vet+1 Ft , t = 0, 1, . . . , N − 1. (3.9)

This will also allow us to compute Vt by backward induction on t = 0, 1, . . . , N −

1, starting from VN = C, see (3.13) below.
In particular, for t = 0 we obtain the price at time 0 of the contingent claim
with payoff C, i.e.
88 "
1
π 0 ( C ) = E∗ C
e F0 = E∗ C E∗ [ C ] .

e =
(1 + r )N
3.2 Pricing Vanilla Options

In this section we consider the pricing of contingent claims in the discrete-time
Cox-Ross-Rubinstein (Cox et al. (1979)) model of Section 2.6, with d = 1 and
(0) (0)
St = S0 (1 + r )t , t = 0, 1, . . . , N ,
and
 
(1)
t  (1 + b)St−1
 if Rt = b 

(1) (1) (1)
Y
St = S0 ( 1 + Rk ) = = (1 + Rt )St−1 ,
(1)
(1 + a)St−1 if Rt = a
 
k =1  
t = 1, . . . , N . More precisely we are concerned with vanilla options whose

payoffs depend on the terminal value of the underlying asset, as opposed to
exotic options whose payoffs may depend on the whole path of the underlying
asset price until expiration time.
Recall that the portfolio value process (Vt )t=0,1,...N and the discounted port-
folio value process (Vet )t=0,1,...N respectively satisfy
1 1
Vt = ξ t • S t and Vet = Vt = ξt • St = ξt • X t, t = 0, 1, . . . , N .
(1 + r )t (1 + r )t
Here we will be concerned with the pricing of vanilla options with payoffs of
the form
(1)
C = h SN ,
e.g. h(x) = (x − K )+ in the case of a European call option. Equivalently, the
discounted claim payoff
e= C
C
(1 + r )N
e = fe S (1) with e
satisfies C h(x) = h(x)/(1 + r )N . For example in the case

N
of the European call option with strike price K we have
1
fe(x) = (x − K ) + .
(1 + r )N
From Theorem 3.5, the discounted value of a portfolio hedging the attainable
(discounted) claim payoff C
e is given by
" 89
N. Privault
(1)
Vet = E∗ fe SN Ft , t = 0, 1, . . . , N ,

under the risk-neutral probability measure P∗ . As a consequence of Theo-

rem 3.5, we have the following proposition.
Proposition 3.7. The arbitrage-free price πt (C ) at time t = 0, 1, . . . , N of
(1)
the contingent claim with payoff C = h SN is given by
1 (1)
E∗ h SN Ft , t = 0, 1, . . . , N . (3.10)

πt ( C ) =
(1 + r )N −t
In the next proposition we implement the calculation of (3.10) in the CRR

model.∗
Proposition 3.8. The price πt (C ) of the contingent claim with payoff C =
(1)
h SN satisfies
(1)
πt (C ) = v t, St , t = 0, 1, . . . , N ,
where the function v (t, x) is given by

N
" !#
1 ∗
Y
v (t, x) = E f x ( 1 + R j ) (3.11)
(1 + r )N −t j =t+1
N −t
1

X N −t
(p∗ )k (q ∗ )N −t−k f x(1 + b)k (1 + a)N −t−k ,

=
(1 + r ) N −t k
k =0
where the risk-neutral probabilities p∗ , q ∗ are defined as

r−a b−r
p∗ : = and q ∗ : = 1 − p∗ = . (3.12)
b−a b−a
Proof. From the relations
N
(1) (1)
Y
SN = St (1 + Rj ),
j =t+1
and (3.10) we have, using Property (v) of the conditional expectation, see
page 66, and the independence of the market returns {R1 , . . . , Rt } and
{Rt+1 , . . . , RN },
1 (1)
E∗ f SN Ft

πt ( C ) =
(1 + r ) N −t
∗
Download the corresponding (non-recursive) IPython notebook that can be run
here.
90 "
N
" ! #
1

(1) (1)
Y
∗
= E f S ( 1 + Rj ) S
(1 + r )N −t t
j =t+1
t
N
" !#
1 Y
= E∗ f x ( 1 + Rj ) ,
(1 + r ) N −t
j =t+1 (1)
x = St
where we used Property (v) of the conditional expectation, see page 66, and
the independence of the market returns. Next, we note that the number of
times Rj is equal to b for j ∈ {t + 1, . . . , N }, has a binomial distribution
with parameter (N − t, p∗ ) since the set of paths
from
time t + 1 to time N
N −t
containing j times “(1 + b)” has cardinality and each such path has
j
probability
(p∗ )j (q ∗ )N −t−j , j = 0, . . . , N − t.
Hence we have
1 (1)
E∗ f SN Ft

πt ( C ) =
(1 + r )N −t
N −t
1

X N −t (1)
(p∗ )k (q ∗ )N −t−k f St (1 + b)k (1 + a)N −t−k .

=
(1 + r )N −t k
k =0

In the above proof we have also shown that πt (C ) is given by the conditional
expected value
1 (1) 1 (1) (1)
E∗ h SN Ft = E∗ h SN St

πt ( C ) =
(1 + r )N −t (1 + r )N −t
(1)
given the value of St at time t = 0, 1, . . . , N , due to the Markov property of
(1)
St t=0,1,...,N . In particular, the price of the claim with payoff C is written
as the average (path integral) of the values of the contingent claim over all
(1)
possible paths starting from St .
Market terms and data
Intrinsic value. The intrinsic value at time t = 0, 1, . . . , N of the option

(1) (1)
with payoff C = h SN is given by the immediate exercise payoff h St .
The extrinsic value at time t = 0, 1, . . . , N of the option is the remaining
(1)
difference πt (C ) − h St between the option price πt (C ) and the immedi-
(1)
ate exercise payoff h St . In general, the option price πt (C ) decomposes
as
" 91
N. Privault
(1) (1)
πt ( C ) = h St + πt (C ) − h St , t = 0, 1, . . . , N .
| {z } | {z }
Intrinsic value Extrinsic value
Gearing. The gearing at time t = 0, 1, . . . , N of the option with payoff

(1)
C = h SN is defined as the ratio
(1) (1)
St St
Gt : = = (1)
,
πt ( C ) v t, St
(1)
telling how many time the option price v t, St is “contained” in the
(1)
stock price St at time t = 0, 1, . . . , N .
Break-even price. The break-even price BEPt of the underlying asset at
time t = 0, 1, . . . , N , see also Exercises 1.9, is the value of S for which
(1)
the intrinsic option value h St equals the option price πt (C ). In other
words, BEPt represents the price of the underlying asset for which we
would break even if the option was exercised immediately. For European
call options it is given by
(1)
BEPt := K + πt (C ) = K + v t, St , t = 0, 1, . . . , N .
whereas for European put options it is given by

(1)
BEPt := K − πt (C ) = K − v t, St , t = 0, 1, . . . , N .
Premium. The option premium OPt can be defined as the variation required
from the underlying asset price in order to reach the break-even price for
which the intrinsic option payoff equals the current option price, i.e. we
have
(1) (1) (1)
BEPt − St K + v t, St ) − St
OPt := (1)
= (1)
, t = 0, 1, . . . , N ,
St St
for European call options, and

(1) (1) (1)
St − BEPt St + v t, St −K
OPt := (1)
= (1)
, t = 0, 1, . . . , N ,
St St
for European put options. The term “premium” is sometimes also used to
(1)
denote the arbitrage-free price v t, St of the option.
92 "
Pricing by backward induction
In the CRR model, the discounted portfolio value Vet can be computed by
solving the backward induction relation (3.9), using the martingale property
of the discounted portfolio value process (Vet )t=0,1,...,N under the risk-neutral
probability measure P∗ .
Proposition 3.9. The function v (t, x) defined from the arbitrage-free at time
(1)
t = 0, 1, . . . , N of the contingent claim with payoff C = h SN by
(1) (1)
= Vt = E∗ h SN Ft

v t, St
satisfies the backward recursion∗
q∗ p∗
v t + 1, x(1 + a) + v t + 1, x(1 + b) , (3.13)

v (t, x) =
1+r 1+r
with the terminal condition
v (N , x) = h(x), x > 0.
Proof. Namely, by the tower property of conditional expectations, letting
(1) 1 (1)
ve t, St := v t, St , t = 0, 1, . . . , N ,
(1 + r )t
we have
(1)
ve t, St = Vet
∗ e (1)
= E f SN

Ft
∗
∗ (1)
= E E f SN

e Ft+1 Ft
= E∗ Vet+1 Ft

(1)
= E∗ ve t + 1, St+1 St

(1) (1)
= ve t + 1, (1 + a)St P∗ (Rt+1 = a) + ve t + 1, (1 + b)St P∗ (Rt+1 = b)
(1) (1)
= q ∗ ve t + 1, (1 + a)St + p∗ ve t + 1, (1 + b)St ,
which shows that ve(t, x) satisfies
ve(t, x) = q ∗ ve t + 1, x(1 + a) + p∗ ve t + 1, x(1 + b) , (3.14)

(1)
while the terminal condition VeN = fe SN implies
∗
Download the corresponding (backward recursive) IPython notebook that can be
run here.
" 93
N. Privault
ve(N , x) = fe(x), x > 0.

The next Figure 3.1 presents a tree-based implementation of the pricing re-
cursion (3.13).
1.14
1.04
0.95 0.75
0.86 0.69
0.78 0.62 0.43
0.71 0.57 0.4
0.65 0.51 0.36 0.17
0.59 0.47 0.33 0.16
0.53 0.43 0.3 0.14 0.0
0.39 0.27 0.13 0.0
0.25 0.12 0.0 0.0
0.11 0.0 0.0
0.0 0.0 0.0
0.0 0.0
0.0 0.0
0.0
0.0
Fig. 3.1: Discrete-time call option pricing tree.
Note that the discrete-time recursion (3.13) can be connected to the continuous-
time Black-Scholes PDE (6.2), cf. Exercises 6.14.
3.3 Hedging Contingent Claims

The basic idea of hedging is to allocate assets in a portfolio in order to pro-
tect oneself from a given risk. For example, a risk of increasing oil prices
can be hedged by buying oil-related stocks, whose value should be positively
correlated with the oil price. In this way, a loss connected to increasing oil
prices could be compensated by an increase in the value of the corresponding
portfolio.
In the setting of this chapter, hedging an attainable contingent claim with

payoff C means computing a self-financing portfolio strategy ξ t t=1,2,...,N

such that
ξ N • S N = C, i.e. ξ N • X N = C.
e (3.15)
Price, then hedge.
The portfolio allocation ξ N can be computed by first solving (3.15) for ξ N

from the payoff values C, based on the fact that the allocation ξ N depends
only on information up to time N − 1, by the predictability of ξ k 16k6N .
If the self-financing portfolio value Vt is known, for example from (3.6), i.e.
94 "
1
Vt = E∗ [C | Ft ], t = 0, 1, . . . , N , (3.16)
(1 + r )N −t
we may similarly compute ξ t by solving ξ t • S t = Vt for all t = 1, 2, . . . , N − 1.
Hedge, then price.
If Vt = πt (C ) has not been computed, we can use backward induction to

compute a self-financing portfolio strategy. Starting from the values of ξ N
obtained by solving
ξ N • S N = C,
we use the self-financing condition to solve for ξ N −1 , ξ N −2 , . . ., ξ 4 , down to
ξ 3 , ξ 2 , and finally ξ 1 .
In order to implement this algorithm we can use the N − 1 self-financing

equations
ξ t • X t = ξ t+1 • X t , t = 1, 2, . . . , N − 1, (3.17)
allowing us in principle to compute the portfolio strategy ξ t t=1,2,...,N .

Based on the values of ξ N we can solve
ξ N −1 • S N −1 = ξ N • S N −1
for ξ N −1 , then
ξ N −2 • S N −2 = ξ N −1 • S N −2
for ξ N −2 , and successively ξ 2 down to ξ 1 . In Section 3.3 the backward induc-
tion (3.17) will be implemented in the CRR model, see the proof of Propo-
sition 3.10, and Exercises 3.16 and 3.4 for an application in a two-step model.
The discounted value Vet at time t of the portfolio claim can then be obtained
from
Ve0 = ξ 1 • X 0 and Vet = ξ t • X t , t = 1, 2, . . . , N . (3.18)
In addition we have shown in the proof of Theorem 3.5 that the price πt (C ) of
the claim payoff C at time t coincides with the value Vt of any self-financing
portfolio hedging the claim payoff C, i.e.
πt (C ) = Vt , t = 0, 1, . . . , N ,
as given by (3.18). Hence the price of the claim can be computed either al-
gebraically by solving (3.15) and (3.17) using backward induction and then
using (3.18), or by a probabilistic method by a direct evaluation of the dis-
" 95
N. Privault
counted expected value (3.16).
The development of hedging algorithms has increased credit exposure and

counterparty risk when one party is unable to deliver the option payoff stated
in the contract.
3.4 Hedging Vanilla Options

In this section we implement the backward induction (3.17) of Section 3.3
for the hedging of contingent claims in the discrete-time Cox-Ross-Rubinstein
model. Our aim is to compute a (predictable) self-financing portfolio strategy
hedging a vanilla option with payoff of the form
(1)
C = h SN .
(0)
Since the discounted price Set of the riskless asset satisfies
(0) (0) (0)
Set = (1 + r )−t St = S0 ,
(0) (0)
we may sometimes write S0 in place of Set . In Propositions 3.10 and 3.12
we present two different approaches to hedging and to the computation of
(1)
the predictable process ξt t=1,2,...,N , which is also called the Delta.
Proposition 3.10. Price, then hedge.∗ The self-financing replicating port-
folio strategy
(0) (1) (0) (1) (1) (1)
ξt , ξt t=1,2,...,N
= ξt St−1 , ξt St−1 t=1,2,...,N
(1)
hedging the contingent claim with payoff C = h SN is given by
(1) (1)
(1) (1) v t, (1 + b)St−1 − v t, (1 + a)St−1
ξt St−1 = (1)
(b − a)St−1
(1) (1)
ve t, (1 + b)St−1 − ve t, (1 + a)St−1

= (1)
, (3.19)
(b − a)Set−1 /(1 + r )
where the function v (t, x) is given by (3.11), and

(1) (1)
(0) (1) (1 + b)v t, (1 + a)St−1 − (1 + a)v t, (1 + b)St−1
ξt St−1 = (0)
(b − a)St
∗
Download the corresponding “price, then hedge” IPython notebook that can be run
here.
96 "
(1) (1)
(1 + b)ve t, (1 + a)St−1 − (1 + a)ve t, (1 + b)St−1
= (0)
, (3.20)
(b − a)S0
t = 1, 2, . . . , N , where the function ve(t, x) = (1 + r )−t v (t, x) is given by

(3.11).
Proof. We first compute the self-financing hedging strategy ξ t t=1,2,...,N by

solving
ξ t • X t = Vet , t = 1, 2, . . . , N ,
from which we deduce the two equations
(1) 1 + a e(1)

 (1) (0)
 ξt(0) St−1 (1)
S0 + ξt St−1 S
(1)
= ve t, (1 + a)St−1

 1 + r t−1
(1) 1 + b e(1)
(1) (0)
 ξt(0) St−1 (1) (1)

S0 + ξt St−1 = ve t, (1 + b)St−1 ,

 S
1 + r t−1
which can be solved as

(1) (1)
 (0) (1) (1 + b)ve t, (1 + a)St−1 − (1 + a)ve t, (1 + b)St−1
=



 ξ t St−1 (0)
(b − a)S0



(1) (1)
ve t, (1 + b)St−1 − ve t, (1 + a)St−1


(1) (1)

= ,

 ξ S
 t t−1

(1)
(b − a)Se /(1 + r )

t−1
(1)
t = 1, 2, . . . , N , which only depends on St−1 , as expected. This is consistent
(1)
with the fact that represents the (possibly fractional) quantity of the
ξt
risky asset to be present in the portfolio over the time period [t − 1, t] in
order to hedge the claim payoff C at time N , and is decided at time t − 1.

By applying (3.19) to the function v (t, x) in (3.11) we find
N −t
1

(1) (1)
X N −t
ξt St−1 = (p∗ )k (q ∗ )N −t−k
(1 + r )N −t k
k =0
(1) (1)
f St−1 (1 + b)k+1 (1 + a)N −t−k − f St−1 (1 + b)k (1 + a)N −t−k+1

× (1)
,
(b − a)St
t = 0, 1, . . . , N .
The next Figure 3.2 presents a tree-based implementation of the risky hedging
component (3.19).
" 97
N. Privault
1.0
1.0
1.0 1.0
0.99 1.0
0.96 0.98 1.0
0.91 0.91 0.93
0.84 0.81 0.79 0.82
0.75 0.7 0.63 0.53
0.58 0.49 0.34 0.0
0.37 0.22 0.0
0.14 0.0 0.0
0.0 0.0
0.0 0.0
0.0
0.0
Fig. 3.2: Discrete-time call option hedging strategy (risky component).
The next Figure 3.3 presents a tree-based implementation of the riskless

hedging component (3.20).
-0.85
-0.85
-0.85 -0.85
-0.84 -0.85
-0.8 -0.82 -0.85
-0.74 -0.75 -0.78
-0.65 -0.64 -0.63 -0.67
-0.55 -0.52 -0.47 -0.4
-0.41 -0.34 -0.24 0.0
-0.24 -0.14 0.0
-0.09 0.0 0.0
0.0 0.0
0.0 0.0
0.0
0.0
Fig. 3.3: Discrete-time call option hedging strategy (riskless component).
We can also check that the portfolio strategy

(0) (1) (0) (1) (1) (1)
= ξt , ξt St−1 , ξt St−1 t=1,2,...,N

ξt t=1,2,...,N t=1,2,...,N
= ξt
given by (3.19)-(3.20) is self-financing, as follows:

(0) (1) (0) (1) (1) (1)
ξ t+1 • X t = ξt+1 St S0+ ξt+1 St Set
(1) (1)
(0) ( 1 + b ) v
e t + 1, (1 + a)St − (1 + a)ve t + 1, (1 + b)St
= S0 (0)
(b − a)S0
(1) (1)
e t + 1, (1 + b)St
(1) v − ve t + 1, (1 + a)St
+Set (1)
(b − a)Set /(1 + r )
(1) (1)
(1 + b)ve t + 1, (1 + a)St − (1 + a)ve t + 1, (1 + b)St
=
b−a
98 "
(1) (1)
ve t + 1, (1 + b)St − ve t + 1, (1 + a)St
+
(b − a) / (1 + r )
r−a (1) b−r (1)
= ve t + 1, (1 + b)St + ve t + 1, (1 + a)St
b−a b−a
(1) (1)
= p∗ ve t + 1, (1 + b)St + q ∗ ve t + 1, (1 + a)St
(1)
= ve t, St
(0) (1) (0) (1) (1) (1)
= ξt St S0 + ξt St Set
= ξt • X t, t = 0, 1, . . . , N − 1,
where we used (3.14) or the martingale property of the discounted portfolio

(1)
value process ṽ t, St t=0,1,...,N
, see Lemma 3.2.
Market terms and data
(1)
Delta. The Delta represents the quantity of underlying risky asset St held
in the portfolio over the time interval [t − 1, t]. Here, it is denoted by
(1) (1)
ξt St−1 for t = 1, 2, . . . , N .
Effective gearing. The effective gearing at time t = 1, 2, . . . , N of the option

(1)
with payoff C = h SN is defined as the ratio
(1)
EGt := Gt ξt
(1)
St (1)
= ξ
πt ( C ) t
(1) (1) (1)
St v t, (1 + b)St−1 − v t, (1 + a)St−1
= (1) (1)
St−1 v t, St (b − a)
(1) (1) (1)
v t, (1 + b)St−1 − v t, (1 + a)St−1 /v t, St

= (1) (1)
, t = 1, 2, . . . , N .
St−1 (b − a)/St
(1)
The effective gearing EGt = ξt St /πt (C ) can be interpreted as the hedge
ratio, i.e. the percentage of the portfolio which is invested on the risky
asset. It also allows one to represent the percentage change in the option
(1) (1)
price in terms of the potential percentage change St−1 (b − a)/St in the
underlying asset price when the market return switches from a to b, as
(1) (1) (1)
v t, (1 + b)St−1 − v t, (1 + a)St−1 St−1 (b − a)
(1) = EGt × (1)
.
v t, St St
" 99
N. Privault
By Proposition 3.8 we have the following remark.

Remark 3.11. i) If the function x 7→ h(x) is non-decreasing, e.g. in the
case of European call options, then the function x 7→ ve(t, x) is also
non-decreasing for all fixed t = 0, 1, . . . , N , hence the portfolio strategy
(0) (1) (1)
ξt , ξt t=1,2,...,N defined by (3.11) or (3.19) satisfies ξt > 0, t =
1, 2, . . . , N and there is not short selling.
ii) Similarly, we can show that when x 7→ h(x) is a non-increasing function,
(1)
e.g in the case of European put options, the portfolio allocation ξt 6 0
is negative, t = 1, 2, . . . , N , i.e. short selling always occurs.
(0) (0) (1) (1)
As a consequence of (3.20), the discounted amounts ξt S0 and ξt Set
respectively invested on the riskless and risky assets are given by
(1) (1)
(0) (0) (1) (1 + b)ve t, (1 + a)St−1 − (1 + a)ve t, (1 + b)St−1
S0 ξt St−1 =
b−a
(3.21)
and
(1) (1)
(1) (1) (1) ve t, (1 + b)St−1 − ve t, (1 + a)St−1
Set ξt St−1 = (1 + Rt ) ,
b−a
t = 1, 2, . . . , N .
(0)
Regarding the quantity ξt of the riskless asset in the portfolio at time t,
from the relation
(0) (0) (1) (1)
Vet = ξ t • X t = ξt Set + ξt Set , t = 1, 2, . . . , N ,
we also obtain
(1) (1)
(0) Vet − ξt Set
ξt = (0)
S
e
t
(1) (1)
Vet − ξt Set
= (0)
S0
(1) (1) (1)
ve t, St − ξt Set
= (0)
, t = 1, 2, . . . , N .
S0
In the next proposition we compute the hedging strategy by backward induc-

tion, starting from the relation
(1) (1)
(1) (1) h (1 + b)SN −1 − h (1 + a)SN −1
ξN SN −1 = (1)
,
(b − a)SN −1
100 "
and
(1) (1)
(0) (1) (1 + b)h (1 + a)SN −1 − (1 + a)h (1 + b)SN −1
ξN SN −1 = (0)
,
(b − a)S0 (1 + r )N
that follow from (3.19)-(3.20) applied to the claim payoff function h(·).
Proposition 3.12. Hedge, then price.∗ The self-financing replicating port-
folio strategy
(0) (1) (0) (1) (1) (1)
ξt , ξt t=1,2,...,N
= ξt St−1 , ξt St−1 t=1,2,...,N
(1)
hedging the contingent claim with payoff C = h SN is given from (3.19) at
time t = N by
(1) (1)
(1) (1) h (1 + b)SN −1 − h (1 + a)SN −1
ξN SN −1 = (1)
, (3.22)
(b − a)SN −1
and
(1) (1)
(0) (1) (1 + b)h (1 + a)SN −1 − (1 + a)h (1 + b)SN −1
ξN SN −1 = (0)
, (3.23)
(b − a)SN
and then inductively by

(1) (1) (1) (1)
(1) (1) (1 + b)ξt+1 ((1 + b)St−1 ) − (1 + a)ξt+1 ((1 + a)St−1 )
ξt St−1 =
b−a
(0) (1) (0) (1)
(0) ξt+1 ((1 + b)St−1 ) − ξt+1 ((1 + a)St−1 )
+S0 (1)
, (3.24)
(b − a)Set−1 /(1 + r )
and
(1) (1) (1) (1) (1)
(0) (1) (1 + a)(1 + b)Set−1 ξt+1 (1 + a)St−1 − ξt+1 (1 + b)St−1
ξt St−1 = (0)
(b − a)(1 + r )S0
(0) (1) (0) (1)
(1 + b)ξt+1 (1 + a)St−1 − (1 + a)ξt+1 (1 + b)St−1
+ , (3.25)
b−a
t = 1, 2, . . . , N − 1.
The pricing function ve(t, x) = (1 + r )−t v (t, x) is then given by

∗
Download the corresponding “hedge, then price” IPython notebook that can be run
here.
" 101
N. Privault
(1) (0) (0) (1) (1) (1) (1)

ve t, St = S0 ξt St−1 + Set ξt St−1 , t = 1, 2, . . . , N .
Proof. Relations (3.22)-(3.23) follow from (3.19)-(3.20) stated at time t = N .
Next, by the self-financing condition (3.17) we have
ξ t • X t = ξ t+1 • X t , t = 0, 1, . . . , N − 1,
i.e.
(1) 1 + b

(0) (0) (1) (1) (1)
 S0 ξt St−1 + Set−1 ξt St−1
1+r



(1) e(1) 1 + b

(0) (1) (0) (1)

1 t+1 (1 + b)St−1 St−1

 = ξ t+1 ( + b ) S S + ξ
1+r

 t−1 0

(0) (0) (1) (1) (1) (1) 1 + a



 S0 ξt St−1 + Set−1 ξt St−1
1+r



 = ξ (0) (1 + a)S (1) S (0) + ξ (1) (1 + a)S (1) Se(1) 1 + a ,



t+1 t+1
t−1 0 t−1 t−1
1+r

which can be solved as

(1) (1) (1) (1)
(1) (1) (1 + b)ξt+1 (1 + b)St−1 − (1 + a)ξt+1 (1 + a)St−1
ξt St−1 =
b−a
(0) (1) (0) (1)
(0) ξt+1 (1 + b)St−1 − ξt+1 (1 + a)St−1
+(1 + r )S0 (1)
,
(b − a)Se t−1
and
(1) (1) (1) (1) (1)
(0) (1) (1 + a)(1 + b)Set−1 ξt+1 (1 + a)St−1 − ξt+1 (1 + b)St−1
ξt St−1 = (0)
(b − a)(1 + r )S0
(0) (1) (0) (1)
(1 + b)ξt+1 (1 + a)St−1 − (1 + a)ξt+1 (1 + b)St−1
+ ,
b−a
t = 1, 2, . . . , N − 1.
By (3.24)-(3.25) we can check that the corresponding discounted portfolio
value process

(Vet )t=1,2,...,N = ξ t • X t t=1,2,...,N
is a martingale under P∗ :
Vet = ξ t • X t
(0) (0) (1) (1) (1) (1)
= S0 ξt St−1 + Set ξt St−1
(1) (1) (1) (1) (1)
(1 + a)(1 + b)Set−1 ξt+1 (1 + a)St−1 − ξt+1 (1 + b)St−1
=
(b − a)(1 + r )
102 "
(0) (1) (0) (1)

(0) (1 + b)ξt+1 (1 + a)St−1 − (1 + a)ξt+1 (1 + b)St−1
+S0
(b − a)
(1) (1) (1) (1)
(1) ( 1 + b ) ξt+1 ( 1 + b ) St−1 − (1 + a)ξt+1 (1 + a)St−1
+Set
b−a
(0) (1) (0) (1)
(1) (0) ξ ( 1 + b ) S t−1 − ξt+1 (1 + a)St−1
+(1 + r )Set S0 t+1 (1)
(b − a)Set−1
r − a (0) (0) (1) b − r (0) (0) (1)
= S ξ S + S ξ S
b − a 0 t+1 t b − a 0 t+1 t
(r − a)(1 + b) e(1) (1) (1) (b − r )(1 + a) e(1) (1) (1)
+ S ξ S + S ξ S
(b − a)(1 + r ) t t+1 t (b − a)(1 + r ) t t+1 t
(0) (0) (1) (0) (0) (1)
p∗ S0 ξt+1 St + q ∗ S0 ξt+1 St

=
1 + b e(1) (1) (1) 1 + a e(1) (1) (1)
+ p∗ + q∗

S ξ S S ξ S
1 + r t t+1 t 1 + r t t+1 t
( 0 ) ( 0 ) ( 1 ) ( 1 ) ( 1 ) ( 1 )
E∗ S0 ξt+1 St

= + Set+1 ξt+1 St Ft
∗ e
E Vt + 1 Ft ,

=
t = 1, 2, . . . , N − 1, as in Remark 3.4.
The next Figure 3.4 presents a tree-based implementation of the riskless

hedging component (3.20).∗
Fig. 3.4: Tree of asset prices in the CRR model.
The next Figure 3.5 presents a tree-based implementation of call option prices
in the CRR model.
∗
Download the corresponding pricing and hedging IPython notebook that can be
run here.
" 103
N. Privault
Fig. 3.5: Tree of option prices in the CRR model.
The next Figure 3.6 presents a tree-based implementation of risky hedging

portfolio allocation in the CRR model.
Fig. 3.6: Tree of hedging portfolio allocations in the CRR model.
3.5 Hedging Exotic Options

In this section we take p = p∗ given by (3.12) and we consider the hedging of
path-dependent options. Here we choose to use the finite difference gradient
and the discrete Clark-Ocone formula of stochastic analysis, see also Föllmer
and Schied (2004), Lamberton and Lapeyre (1996), Privault (2008), Chap-
ter 1 of Privault (2009), Ruiz de Chávez (2001), or §15-1 of Williams (1991).
See Di Nunno et al. (2009) and Section 8.2 of Privault (2009) for a similar
approach in continuous time. Given
ω = (ω1 , ω2 , . . . , ωN ) ∈ Ω = {−1, 1}N ,
and r = 1, 2, . . . , N , let
104 "
t
ω+ := (ω1 , ω2 , . . . , ωt−1 , +1, ωt+1 , . . . , ωN )
and
t
ω− := (ω1 , ω2 , . . . , ωt−1 , −1, ωt+1 , . . . , ωN ).
We also assume that the return Rt (ω ) takes only two possible values
t
Rt ( ω + ) = b and Rt (ω−
t
) = a, t = 1, 2, . . . , N , ω ∈ Ω.
Definition 3.13. The operator Dt is defined on any random variable F by

t
Dt F (ω ) = F (ω+ t
) − F (ω− ), t = 1, 2, . . . , N . (3.26)
We define the centered and normalized return Yt by


 b − r = q∗ ,
 ωt = +1,
Rt − r  b−a

Yt := = t = 1, 2, . . . , N .
b−a  a−r


 = −p∗ , ωt = −1,
b−a
Note that under the risk-neutral probability measure P∗ we have

Rt − r
E∗ [Yt ] = E∗
b−a
a−r ∗ b−r ∗
= P ( Rt = a ) + P (Rt = b)
b−a b−a
a−r b−r b−r r−a
= × + ×
b−a b−a b−a b−a
= 0,
and
Var [Yt ] = p∗ (q ∗ )2 + q ∗ (p∗ )2 = p∗ q ∗ , t = 1, 2, . . . , N .
In addition, the discounted asset price increment reads
(1) (1) ( 1 ) 1 + Rt (1)

Set − Set−1 = Set−1 − Set−1
1+r
Rt − r e(1)
= S
1 + r t−1
b − a e(1)
= Yt St−1 , t = 1, 2, . . . , N .
1+r
We also have

b−r a−r
Dt Yt = − = 1, t = 1, 2, . . . , N ,
b−a b−a
and
" 105
N. Privault
N N
(1) (1) (1)
Y Y
Dt SN = S0 (1 + b) (1 + Rk ) − S0 (1 + a) ( 1 + Rk )
k =1 k =1
k6=t k6=t
N
(1)
Y
= (b − a)S0 (1 + Rk )
k =1
k6=t
N
(1) b−a Y
= S0 ( 1 + Rk )
1 + Rt
k =1
b − a (1)
= S , t = 1, 2, . . . , N .
1 + Rt N
The following stochastic integral decomposition formula for the functionals
of the binomial process is known as the Clark-Ocone formula in discrete time,
cf. e.g. Privault (2009), Proposition 1.7.1.
Proposition 3.14. For any square-integrable random variables F on Ω we
have X
F = E∗ [ F ] + Yk E∗ [Dk F | Fk−1 ]. (3.27)
k>1
The Clark-Ocone formula (3.27) has the following consequence.

Corollary 3.15. Assume that (Mk )k∈N is a square-integrable (Fk )k∈N -
martingale. Then we have
N
X
M N = E∗ [ M N ] + Yk Dk Mk , N > 0.
k =1
Proof. We have
X
M N = E∗ [ M N ] + Yk E∗ [Dk MN | Fk−1 ]
k >1
X
= E∗ [ M N ] + Yk Dk E∗ [MN | Fk ]
k >1
X
= E∗ [ M N ] + Yk Dk Mk
k>1
N
X
= E∗ [ M N ] + Yk Dk Mk .
k =1

In addition to the Clark-Ocone formula we also state a discrete-time analog
of Itô’s change of variable formula, which can be useful for option hedging.
The next result extends Proposition 1.13.1 of Privault (2009) by removing
the unnecessary martingale requirement on (Mt )n∈N .
106 "
Proposition 3.16. Let (Zn )n∈N be an (Fn )n∈N -adapted process and let
f : R × N −→ R be a given function. We have
t
X
f ( Zt , t ) = f ( Z0 , 0 ) + Dk f (Zk , k )Yk
k =1
t
X
E∗ [f (Zk , k ) | Fk−1 ] − f (Zk−1 , k − 1) , t > 0.
(3.28)

+
k =1
Proof. First, we note that the process
t
X
Mt : = f ( Z t , t ) − E∗ [f (Zk , k ) | Fk−1 ] − f (Zk−1 , k − 1) ,

k =1
t = 0, 1, . . . , N , is a martingale under P∗ . Indeed, we have

t
" #
X
E∗ f ( Z t , t ) − E∗ [f (Zk , k ) | Fk−1 ] − f (Zk−1 , k − 1) Ft−1
k =1
= E∗ [f (Zt , t) | Ft−1 ]
X t
E∗ [E∗ [f (Zk , k ) | Fk−1 ] | Ft−1 ] − E∗ [E∗ [f (Zk−1 , k − 1) | Fk−1 ] | Ft−1 ]

−
k =1
t
X
∗
= E [f (Zt , t) | Ft−1 ] − E∗ [f (Zk , k ) | Fk−1 ] − f (Zk−1 , k − 1)

k =1
t−1
X
= f (Zt−1 , t − 1) − E∗ [f (Zk , k ) | Fk−1 ] − f (Zk−1 , k − 1) , t > 1.

k =1
Next, applying Corollary 3.15 to the martingale (Mt )t=0,1,...,N , we have

t
X
f ( Z t , t ) = Mt + E∗ [f (Zk , k ) | Fk−1 ] − f (Zk−1 , k − 1)

k =1
t
X t
X
= E∗ [ M t ] + E∗ [f (Zk , k ) | Fk−1 ] − f (Zk−1 , k − 1)

Yk Dk Mk +
k =1 k =1
X t t
X
= f ( Z0 , 0 ) + Yk Dk f (Zk , k ) + E∗ [f (Zk , k ) | Fk−1 ] − f (Zk−1 , k − 1) ,

k =1 k =1
t > 0, as
Dk E∗ [f (Zk , k ) | Fk−1 ] − f (Zk−1 , k − 1) = 0, k > 1.

" 107
N. Privault
Note that if (Zt )t∈N is a discrete-time (Ft )t∈N -martingale in L2 (Ω) written
as
X t
Zt = Z0 + uk Yk , t > 0,
k =1
where (ut )t∈N is an (Ft )t∈N -predictable process locally∗ in L2 (Ω × N), then
we have
Dt f (Zt , t) = f Zt−1 + qut , t − f Zt−1 − put , t , (3.29)

t = 1, 2, . . . , N . On the other hand, the term
E[f (Zt , t) − f (Zt−1 , t − 1) | Ft−1 ]
is analog to the finite variation part in the continuous-time Itô formula, and
can be written as
pf Zt−1 + qut , t + qf Zt−1 − put , t − f Zt−1 , t − 1 .

When (f (Zt , t))t∈N is a martingale, Proposition 3.16 naturally recovers the

decomposition
f ( Zt , t ) = f ( Z0 , 0 )
t
X
f Zk−1 + quk , k − f Zk−1 − puk , k Yk

+
k =1
t
X
= f ( Z0 , 0 ) + Yk Dk f (Zk , k ), (3.30)
k =1
that follows from Corollary 3.15 as well as from Proposition 3.14. In this
case, the Clark-Ocone formula (3.27) and the change of variable formula
(3.30) both coincide and we have in particular
Dk f (Zk , k ) = E[Dk f (ZN , N ) | Fk−1 ],
k = 1, 2, . . . , N . For example, this recovers the martingale representation

t
(1) (1) (1)
X
Set = S0 + Yk Dk Sek
k =1
t
(1) b − a X e(1)
= S0 + Sk−1 Yk
1+r
k =1
t
(1) (1) R − r
Sek−1 k
X
= S0 +
1+r
k =1
∗
i.e. u(·)1[0,N ] (·) ∈ L (Ω × N) for all N > 0.
2
108 "
t
(1) (1) (1)
X
= S0 + Sek − Sek−1 ,
k =1
of the discounted asset price.
Our goal is to hedge an arbitrary claim payoff C on Ω, i.e. given

an FN -measurable random variable C we search for a portfolio strategy
(0) (1)
ξt , ξt t=1,2,...,N such that the equality
(0) (0) (1) (1)

C = VN = ξN SN + ξN SN (3.31)
(0) (0)
holds, where SN = S0 ( 1 + r ) N denotes the value of the riskless asset at
time N > 0.
The next proposition is the main result of this section, and provides a
solution to the hedging problem under the constraint (3.31).
Proposition 3.17. Hedge, then price. Given a contingent claim with payoff
(1)
C, let ξ0 = 0,
(1) (1 + r )−(N −t)

ξt = (1)
E∗ [Dt C | Ft−1 ], t = 1, 2, . . . , N , (3.32)
(b − a)St−1
and
(0) 1 (1) (1)
ξt = (0)
(1 + r )−(N −t) E∗ [C | Ft ] − ξt St , (3.33)
St
(0) (1)
t = 0, 1, . . . , N . Then the portfolio strategy ξt , ξt t=1,2,...,N
is self financ-
ing and we have
(0) (0) (1) (1)
Vt = ξt St + ξt St = (1 + r )−(N −t) E∗ [C | Ft ], t = 0, 1, . . . , N .
(0) (1)
In particular we have VN = C, hence ξt , ξt t=1,2,...,N is a hedging strategy
leading to C.
(1)
Proof. Let ξt t=1,2,...,N be defined by (3.32), and consider the process
(0)
ξt t=0,1,...,N recursively defined by
(1) (1) (1)

(0) E∗ [ C ] (0) (0) ξt+1 − ξt St
ξ0 = (1 + r )−N (1)
and ξt+1 = ξt − (0)
,
S0 St
(0) (1)
t = 0, 1, . . . , N − 1. Then ξt , ξt t=1,2,...,N
satisfies the self-financing con-
dition
" 109
N. Privault
(0) (0) (0) (1) (1) (1)

St ξt+1 − ξt + St ξt + 1 − ξt = 0, t = 1, 2, . . . , N − 1.
Let now
1 (0) (0) (1) (1)
V0 : = E∗ [ C ] , Vt := ξt St + ξt St , t = 1, 2, . . . , N ,
(1 + r )N
and
Vt
Vet = t = 0, 1, . . . , N .
(1 + r )t
(0) (1)
Since ξt , ξt t=1,2,...,N
is self-financing, by Lemma 3.2 we have
t
X 1 (1) (1)
Vet = Ve0 + (b − a) Yk ξk Sk−1 , (3.34)
(1 + r )k
k =1
t = 1, 2, . . . , N . On the other hand, from the Clark-Ocone formula (3.27) and

(1)
the definition of ξt t=1,2,...,N we have
1
E∗ [C | Ft ]
(1 + r )N
N
" #
1 ∗ ∗
X
∗
E E E

= [ C ] + Yk [ Dk C | Fk−1 ] Ft
(1 + r )N
k =0
t
1 1 X
= E∗ [ C ] + E∗ [Dk C | Fk−1 ]Yk
(1 + r ) N (1 + r ) N
k =0
t
1 X 1 (1) (1)
= E∗ [ C ] + ( b − a ) ξ S Yk
(1 + r ) N (1 + r )k k k−1
k =0
= Vet
from (3.34). Hence

1
Vet = E∗ [C | Ft ], t = 0, 1, . . . , N ,
(1 + r )N
and
Vt = (1 + r )−(N −t) E∗ [C | Ft ], t = 0, 1, . . . , N . (3.35)
In particular, (3.35) shows that we have VN = C. To conclude the proof
(0) (0) (1) (1)
we note that from the relation Vt = ξt St + ξt St , t = 1, 2, . . . , N , the
(0) (0)
process ξt t=1,2,...,N coincides with ξt t=1,2,...,N defined by (3.33).
110 "
Example - Vanilla options
From Proposition 3.8, the price πt (C ) of the contingent claim with payoff
(1)
C = h SN is given by
(1)
πt (C ) = v t, St ,
where the function v (t, x) is given by
(1) 1
v t, St = E∗ [C | Ft ]
(1 + r )N −t
  
N
1 ∗ 
Y
= E f x (1 + Rj ) .
(1 + r )N −t j =t+1 (1)
x = St
(1)
Note that in this case we have C = v N , SN , E[C ] = v (0, M0 ), and the
e = C/(1 + r )N = ve N , S (1) satisfies
discounted claim payoff C

N
N
X
e=E C (1)
Yt E Dt ve N , SN Ft−1

C e +
t=1
N
X (1)
= E Ce + Yt Dt ve t, St
t=1
N
X 1 (1)
= E Ce + Yt Dt v t, St
t=1
(1 + r )t
N
(1)
X
= E Ce + Yt Dt E ve N , SN Ft

t=1
N
1 X
= E Ce + Yt Dt E[C | Ft ],

(1 + r )N t=1
hence we have
(1) (1)
E Dt v N , SN Ft−1 = (1 + r )N −t Dt v t, St , t = 1, 2, . . . , N ,

(1)
and by Proposition 3.17 the hedging strategy for C = h SN is given by
(1) (1 + r )−(N −t) (1)

E Dt h SN Ft−1

ξt = (1)
(b − a)St−1
(1 + r )−(N −t) (1)
E Dt v N , SN Ft−1

= (1)
(b − a)St−1
" 111
N. Privault
1 (1)
= (1)
Dt v t, St
(b − a)St−1
1 (1) (1)
v t, St−1 (1 + b) − v t, St−1 (1 + a)

= (1)
(b − a)St−1
1 (1) (1)
ve t, St−1 (1 + b) − ve t, St−1 (1 + a) ,

= (1)
(b − a)Se /(1 + r )
t−1
t = 1, 2, . . . , N , which recovers Proposition 3.10 as a particular case. Note

(1)
that ξt is nonnegative (i.e. there is no short selling) when f is a non-
decreasing function, because a < b. This is in particular true in the case of
the European call option, for which we have f (x) = (x − K )+ .
3.6 Convergence of the CRR Model

As the pricing formulas (3.11) in the CRR model can be difficult to implement
for large values on N , in this section we consider the convergence of the
discrete-time model to the continuous-time Black Scholes model.
Continuous compounding - riskless asset
Consider the discretization

T 2T (N − 1)T

0, , ,..., ,T
N N N
of the time interval [0, T ] into N time steps.
0 T 2T T
N N
Note that
lim (1 + r )N = ∞,
N →∞
when r > 0, thus we need to renormalize r so that the interest rate on each
time interval becomes rN , with limN →∞ rN = 0. It turns out that the correct
renormalization is
T
rN := r , (3.36)
N
so that for T > 0,
T N

lim (1 + rN )N = lim 1+r
N →∞ N →∞ N

T
= lim exp N log 1 + r
N →∞ N
112 "
= e rT . (3.37)
(0)
Hence the price St of the riskless asset is given by
(0) (0)
St = S0 e rt , t > 0, (3.38)
which solves the differential equation

(0)
dSt (0) (0)
= rSt , S0 = 1, t > 0. (3.39)
dt
We can also write
(0)
(0) (0) dSt
dSt = rSt dt, or (0)
= rdt, (3.40)
St
(0) (0) (0)
and using dSt ' St+dt − St we can discretize this equation by saying that
(0) (0) (0)
the infinitesimal return (St+dt − St )/St of the riskless asset equals rdt on
the small time interval [t, t + dt], i.e.
(0) (0)
St+dt − St
(0)
= rdt.
St
In this sense, the rate r is the instantaneous interest rate per unit of time.
The same equation rewrites in integral form as

wT wT
(0) (0) (0) (0)
ST − S0 = dSt =r St dt.
0 0
Continuous compounding - risky asset
The Galton board simulation of Figure 3.7 shows the convergence of the
binomial random walk to a Gaussian distribution in large time.
" 113
N. Privault
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Fig. 3.7: Galton board simulation.∗

Figure 3.8 pictures a real-life Galton board.
Fig. 3.8: A real-life Galton board at Jurong Point # 03-01.
In the CRR model we need to replace the standard Galton board by its mul-
tiplicative version, which shows that as N tends to infinity the distribution of
(1)
SN converges to the lognormal distribution with probability density function
of the form
(1) 2
 
 − r − σ /2 T + log x/S0
2

1
x 7−→ f (x) = √ exp − ,

xσ 2πT 2σ 2 T
∗
114 "
(1)
x√> 0, with location parameter (r − σ 2 /2)T + log S0 and scale parameter
σ T , or log-variance σ 2 T , as illustrated in the modified Galton board of
Figure 3.9 below, see also Figure 5.7 and Exercises 5.1.
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Fig. 3.9: Multiplicative Galton board simulation.∗

2
Exercise: Check that f is the probability density function of e σX +(r−σ /2)T
where X ' N (0, T ) is a centered Gaussian random variable with variance
T > 0.
In addition to the renormalization (3.36) for the interest rate rN := rT /N ,

we need to apply a similar renormalization to the coefficients a and b of the
CRR model. Let σ > 0 denote a positive parameter called the volatility,
which quantifies the range of random fluctuations, and let aN , bN be defined
from r r
1 + aN T 1 + bN T
= 1−σ and = 1+σ
1 + rN N 1 + rN N
i.e.
r ! r !
T T
aN = (1 + rN ) 1 − σ −1 and bN = (1 + rN ) 1 + σ − 1.
N N
(3.41)
(N )
Consider the random return Rk ∈ {aN , bN } and the price process defined
as
t
(1) (1) (N )
Y
St,N = S0 ( 1 + Rk ) , t = 1, 2, . . . , N .
k =1
Note that the risk-neutral probabilities are given by
∗
" 115
N. Privault
(N ) b − rN
P∗ Rt = aN = N (3.42)

bN − aN
√
(1 + rN ) 1 + σ T /N − 1 − rN

= √ √
(1 + rN ) 1 + σ T /N − (1 + rN ) 1 − σ T /N

1
= , t = 1, 2, . . . , N ,
2
and
(N ) r − aN
P∗ Rt = bN = N (3.43)

bN − aN
√
rN − (1 + rN ) 1 − σ T /N + 1

= √ √
(1 + rN ) 1 + σ T /N − (1 + rN ) 1 − σ T /N

1
= , t = 1, 2, . . . , N .
2
Continuous-time limit in distribution
We have the following convergence result.

Proposition 3.18. Let h be a continuous and bounded function on R. The
(1)
price at time t = 0 of a contingent claim with payoff C = h SN ,N converges
as follows:
1 (1) (1) 2
lim E∗ h SN ,N = e −rT E h S0 e σX +rT −σ T /2

(1 + rT /N )N
N →∞
(3.44)
where X ' N (0, T ) is a centered Gaussian random variable with variance
T > 0.
Proof. This result is consequence of the weak convergence in distribution of
(1)
the sequence SN ,N N >1 to a lognormal distribution, see e.g. Theorem 5.53
page 261 of Föllmer and Schied (2004). Informally, using the Taylor expansion
of the log function and (3.41), we have
N
(1) (1) (N )
X
log SN ,N = log S0,N + log 1 + Rk
k =1
N N (N )
(1)
X X 1 + Rk
= log S0,N + log(1 + rN ) + log
1 + rN
k =1 k =1
N N
r !
(1)
X rT X T
= log S0,N + log 1 + + log 1 ± σ
N N
k =1 k =1
116 "
N N r !
(1)
X rT X T σ2 T T
= log S0,N + + ±σ − +o
N N 2N N
k =1 k =1
N
(1) σ2 T 1 X √ 2
= log S0,N + rT − +√ ± σ T + o(1).
2 N k =1
Next, we note that by the Central Limit Theorem (CLT), the normalized
sum
N
1 X √ 2
√ ± σ T
N k =1
of independent Bernoulli random variables, with variance obtained from
(3.42)-(3.43) as
N N
" #
1 X √ 2 σ2 T X (N ) (N )
Var √ =4 1 − P∗ Rt = bN P∗ Rt = aN

± σ T
N k =1 N
k =1
' σ2 T ,
converges in distribution to a centered N (0, σ 2 T ) Gaussian random vari-

able with variance σ 2 T . Finally, the convergence of the discount factor
(1 + rT /N )N to e −rT follows from (3.37).
Note that the expectation (3.44) can be written as the Gaussian integral
w∞ √ e −x2 /2
(1) 2 (1) 2
e −rT E f S0 e σX +rT −σ T /2 = e −rT f S0 e σ T x+rT −σ T /2 √

dx,
−∞ 2π
see also Lemma 7.8 in Chapter 7, hence we have
1 w∞ √ e −x2 /2
(1) (1) 2
lim E∗ h SN ,N = e −rT f S0 e σx T +rT −σ T /2 √

dx.
N →∞ (1 + rT /N ) N −∞ 2π
It is a remarkable fact that in case h(x) = (x − K )+ , i.e. when

(1) +
C = ST − K
is the payoff of the European call option with strike price K, the above
integral can be computed according to the Black-Scholes formula, as
(1) 2 + (1)
e −rT E S0 e σX +rT −σ T /2 − K = S0 Φ(d+ ) − K e −rT Φ(d− ),
where
(1)
(r − σ 2 /2)T + log S0 /K √

d− = √ , d+ = d− + σ T ,
σ T
" 117
N. Privault
and
1 wx 2
Φ (x) : = √ e −y /2 dy, x ∈ R,
2π −∞
is the Gaussian cumulative distribution function.
The Black-Scholes formula will be derived explicitly in the subsequent

chapters using both PDE and probabilistic methods, cf. Propositions 6.11
and 7.7. It can be regarded as a building block for the pricing of financial
derivatives, and its importance is not restricted to the pricing of options on
stocks. Indeed, the complexity of the interest rate models makes it in general
difficult to obtain closed-form expressions, and in many situations one has
to rely on the Black-Scholes framework in order to find pricing formulas, for
example in the case of interest rate derivatives as in the Black caplet formula
of the BGM model, see Proposition 19.5 in Section 19.3.
Our aim later on will be to price and hedge options directly in continuous-
time using stochastic calculus, instead of applying the limit procedure de-
scribed in the previous section. In addition to the construction of the riskless
asset price (At )t∈R+ via (3.38) and (3.39) we now need to construct a math-
ematical model for the price of the risky asset in continuous time.
(0)
In addition to modeling the return of the riskless asset St as in (3.40),
(1)
the return of the risky asset St over the time interval [t, d + dt] will be
modeled as
(1)
dSt
(1)
= µdt + σdBt ,
St
where in comparison with (3.40), we add a “small” Gaussian random fluctua-
tion σdBt which accounts for market volatility. Here, the Brownian increment
dBt is multiplied by the volatility parameter σ > 0. In the next Chapter 4
we will turn to the formal definition of the stochastic process (Bt )t∈R+ which
will be used for the modeling of risky assets in continuous time.
Exercises
Exercise 3.1 (Exercise 2.4 continued). Consider a two-step trinomial market

(1)
model St t=0,1,2 with r = 0 and three return rates Rt = −1, 0, 1. Taking
(1)
S0 = 1, price the European put option with strike price K = 1 and maturity
N = 2 at times t = 0 and t = 1.
Exercise 3.2 Consider a two-step binomial market model (St )t=0,1,2 with
S0 = 1 and stock return rates a = 0, b = 1, and a riskless account priced
118 "
At = (1 + r )t at times t = 0, 1, 2, where r = 0.5. Price and hedge the tunnel

option whose payoff C at time t = 2 is given by
 3 if S2 = 4,





C = 1 if S2 = 2,



3 if S2 = 1.


Exercise 3.3 In a two-step trinomial market model (St )t=0,1,2 with interest
rate r = 0 and three return rates Rt = −0.5, 0, 1, we consider a down-an-out
barrier call option with exercise date N = 2, strike price K and barrier level
B, whose payoff C is given by
 +
S −K if min St > B,
 N

t=1,2,...,N

+ 
C = SN − K 1 =




 
 0
 if min St 6 B.
t=1,2,...,N
min St > B 
 t=1,2,...,N

 

a) Show that P∗ given by r∗ = P∗ (Rt = −0.5) := 1/2, q ∗ = P∗ (Rt = 0) :=

1/4, p∗ = P∗ (Rt = 1) := 1/4 is a risk-neutral probability measure.
b) Taking S0 = 1, compute the possible values of the down-an-out barrier
call option payoff C with strike price K = 1.5 and barrier level B = 1, at
maturity N = 2.
c) Price the down-an-out barrier call option with exercise date N = 2, strike
price K = 1.5 and barrier level B = 1, at time t = 0 and t = 1.
Hint: Use the formula

1
πt ( C ) = E∗ [C | St ], t = 0, 1, . . . , N ,
(1 + r )N −t
where N denotes maturity time and C is the option payoff.
d) Is this market complete? Is every contingent claim attainable?
Exercise 3.4 Consider a two-step binomial random asset model (Sk )k=0,1,2
with possible returns a = 0 and b = 200%, and a riskless asset Ak = A0 (1 +
r )k , k = 0, 1, 2 with interest rate r = 100%, and S0 = A0 = 1, under the risk-
neutral probabilities p∗ = (r − a)/(b − a) = 1/2 and q ∗ = (b − r )/(b − a) =
1/2.
a) Draw a binomial tree for the possible values of (Sk )k=0,1,2 and compute
the values Vk of the hedging portfolio at times k = 0, 1, 2 of the European
" 119
N. Privault
call option on SN with strike price K = 8 and maturity N = 2.
Hint: Consider three cases when k = 2, and two cases when k = 1.

b) Price, then hedge. Compute the self-financing hedging portfolio strategy
(ξk , ηk )k=1,2 with values
V0 = ξ1 S0 + η1 A0 , V1 = ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1 , and V2 = ξ2 S2 + η2 A2 ,
hedging the European call option with strike price K = 8 and maturity
N = 2.
Hint: Consider two separate cases for k = 2 and one case for k = 1.
c) Hedge, then price. Compute the hedging portfolio strategy (ξk , ηk )k=1,2
from the self-financing condition, and use it to recover the result of
part (a).
Exercise 3.5 We consider a two-step binomial market model (St )t=0,1,2 with
S0 = 1 and return rates Rt = (St − St−1 )/St−1 , t = 1, 2, taking the values
a = 0, b = 1, and assume that
p := P(Rt = 1) > 0, q := P(Rt = 0) > 0, t = 1, 2.
S2 = 4, C = 0
S1 = 2
S0 = 1 S2 = 2, C = 1
S1 = 1
S2 = 1, C = 0.
The riskless account is At = $1 and the risk-free interest rate is r = 0. We

consider the tunnel option whose payoff C at time t = 2 is given by
0 if S2 = 4,






C = $1 if S2 = 2,



0 if S2 = 1.


a) Build a hedging portfolio for the claim C at time t = 1 depending on the

value of S1 .
120 "
b) Price the claim C at time t = 1 depending on the value of S1 .

c) Build a hedging portfolio for the claim C at time t = 0.
d) Price the claim C at time t = 0.
e) Does this model admit an equivalent risk-neutral measure in the sense of
Definitions 2.12-2.14?
f) Is the model without arbitrage according to Theorem 2.15?
Exercise 3.6 Consider a discrete-time market model made of a riskless asset

priced Ak = (1 + r )k and a risky asset with price Sk , k > 0. Compute
the arbitrage-free price πk (C ) at time k = 0, 1, . . . , N of the claim C with
maturity time N and affine payoff function
C = h(SN ) = α + βSN
where α, β ∈ R are constants, in a discrete-time market with risk free rate r.
Exercise 3.7 Call-put parity.

a) Show that the relation (x − K )+ = x − K + (K − x)+ holds for any
K, x ∈ R.
b) From part (a), find a relation between the prices of call and put options
with strike price K > 0 and maturity N > 1 in a market with risk-free
rate r > 0.
Hints:
i) Recall that an option with payoff φ(SN ) and maturity N > 1 is priced
at times k = 0, 1, . . . , N as (1 + r )−(N −k) E∗ φ(SN ) Fk under the

risk-neutral measure P . ∗
ii) The payoff at maturity of a European call (resp. put) option with
strike price K is (SN − K )+ , resp. (K − SN )+ .
Exercise 3.8 Consider a two-step binomial random asset model (Sk )k=0,1,2
with possible returns a = −50% and b = 150%, and a riskless asset Ak =
A0 (1 + r )k , k = 0, 1, 2 with interest rate r = 100%, and S0 = A0 = 1,
under the risk-neutral probabilities p∗ = (r − a)/(b − a) = 3/4 and q ∗ =
(b − r )/(b − a) = 1/4.
a) Draw a binomial tree for the values of (Sk )k=0,1,2 .
b) Compute the values Vk at times k = 0, 1, 2 of the hedging portfolio of the
European put option with strike price K = 5/4 and maturity N = 2 on
SN .
c) Compute the self-financing hedging portfolio strategy (ξk , ηk )k=1,2 with
values
V0 = ξ1 S0 + η1 A0 , V1 = ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1 , and V2 = ξ2 S2 + η2 A2 ,
" 121
N. Privault
hedging the European put option with strike price K = 5/4 and maturity
N = 2.
Problem 3.9 Consider a two-step binomial model for a stock paying a

dividend at the rate α ∈ (0, 1) at times k = 1 and k = 2, and the following
recombining tree represents the ex-dividend∗ prices Sk at times k = 1, 2,
starting from S0 = $1.
S2 = 9
p∗
S1 = 3
p∗
q∗
S0 = 1 S2 = 3
p∗
q∗
S1 = 1
q∗
S2 = 1
install.packages("quantmod");library(quantmod)
getDividends("Z74.SI",from="2018-01-01",to="2018-12-31",src="yahoo")
getSymbols("Z74.SI",from="2018-11-16",to="2018-12-19",src="yahoo")
dev.new(width=16,height=7)
myPars <- chart_pars();myPars$cex<-1.8
myTheme <- chart_theme();myTheme$col$line.col <- "purple"
myTheme$rylab <- FALSE
chart_Series(Op(`Z74.SI`),name="Opening prices (purple) - Closing prices
(blue)",lty=4,lwd=6,pars=myPars,theme=myTheme)
add_TA(Cl(`Z74.SI`),lwd=3,lty=5,legend='Difference',col="blue",on = 1)
Z74.SI.div
2018-07-26 0.107
2018-12-17 0.068
2018-12-18 0.068
∗
“Ex-dividend” means after dividend payment.
122 "
Opening prices (purple) − Closing prices (blue) 2018−11−16 / 2018−12−18

3.12
3.10 3.10
3.08
3.06
3.05
3.04
3.02
3.00 3.00
2.98
Nov 16 Nov 20 Nov 22 Nov 26 Nov 28 Nov 30 Dec 04 Dec 06 Dec 10 Dec 12 Dec 14 Dec 18
2018 2018 2018 2018 2018 2018 2018 2018 2018 2018 2018 2018
Fig. 3.10: SGD0.068 dividend detached on 18 Dec 2018 on Z74.SI.
The difference between the closing price on Dec 17 ($3.06) and the opening
price on Dec 18 ($2.99) is $3.06 − $2.99 = $0.07. The adjusted price on Dec
17 ($2.992) is the closing price ($3.06) minus the dividend ($0.068).
Z74.SI Open High Low Close Volume Adjusted (ex-dividend)

2018-12-17 3.05 3.08 3.05 3.06 17441000 2.992
2018-12-18 2.99 2.99 2.96 2.96 28456400 2.960
The dividend rate α is given by α = 0.068/3.06 = 2.22%.
We consider a riskless asset Ak = A0 (1 + r )k , k = 0, 1, 2 with interest rate

r = 100% and A0 = 1, and two portfolio allocations (ξ1 , η1 ) at time k = 0
and (ξ2 , η2 ) at time k = 1, with the values
V1 = ξ2 S1 + η2 A1 (3.45)
and
V0 = ξ1 S0 + η1 A0 . (3.46)
We make the following three assumptions:
[A] All dividends are reinvested.
[B] The portfolio strategies are self-financing.
[C] The portfolio value V2 at time k = 2 hedges the European call option
with payoff C = (ST − K )+ , strike price K = 8, and maturity T = 2.
a) Using (3.45) and [A], express V2 in terms of ξ2 , η2 , S2 , A2 and α.
b) Using (3.46) and [A]-[B], express V1 in terms of ξ1 , η1 , S1 , A1 and α.
c) Using Assumption [C] and the result of Question (a), compute the port-
folio allocation (ξ2 , η2 ) in cases S1 = 1 and S1 = 3.
d) Using (3.45) and the portfolio allocation (ξ2 , η2 ) obtained in Question (c),
compute the portfolio value V1 in cases S1 = 1 and S1 = 3.
e) From the results of Questions (b) and (d), compute the initial portfolio
allocation (ξ1 , η1 ).
" 123
N. Privault
f) Compute the initial portfolio value V0 from the result of Question (e).
g) Knowing that the dividend rate is α = 25%, draw the tree of asset prices
(S k )k=1,2 before (i.e. without) dividend payments.
∗
S 2 =?
p
S 1 =?
p∗
q∗
S 0 = S0 = 1 ∗
S 2 =?
p
q∗
S 1 =?
q∗
S 2 =?
h) Compute the risk-neutral probabilities p∗ and q ∗ under which the con-

ditional expected return of (S k )k=0,1,2 is the risk-free interest rate r =
100%.
i) X Check that the portfolio value V1 found in Question (d) satisfies
1
E∗ (S2 − K )+ | S1 ].

V1 =
1+r
j) X Check that the portfolio value V0 found in Question (f) satisfies
1 1
E∗ (S2 − K )+ ] and V0 = E∗ V1 ].

V0 =
(1 + r )2 1+r
Exercise 3.10 Analysis of a binary option trading website.

a) In a one-step model with risky asset prices S0 , S1 at times t = 0 and
t = 1, compute the price at time t = 0 of the binary call option with
payoff
 $1 if S1 > K,

C = 1[K,∞) S1 =
0 if S1 < K,

in terms of the probability p∗ = P∗ (S1 > K ) and of the risk-free interest

rate r.
b) Compute the two potential net returns obtained by purchasing one binary
call option.
c) Compute the corresponding expected (net) return.
124 "
d) A website proposes to pay a return of 86% in case the binary call option
matures “in the money”, i.e. when S1 > K. Compute the corresponding
expected (net) return. What do you conclude?
Exercise 3.11 A put spread collar option requires its holder to sell an asset
at the price f (S ) when its market price is at the level S, where f (S ) is the
function plotted in Figure 3.11, with K1 := 80, K2 := 90, and K3 := 110.
130
Put spread collar price map f(S)
y=S
120
110
100
90
80
70
60 70 80 90 100 110 120 130
SN
K1 K2 K3
Fig. 3.11: Put spread collar price map.
a) Draw the payoff function of the put spread collar as a function of the
underlying asset price at maturity. See e.g. http://optioncreator.com/.
b) Show that this put spread collar option can be realized by purchasing
and/or issuing standard European call and put options with strike prices
to be specified.
Hints: Recall that an option with payoff φ(SN ) is priced (1 + r )−N E∗ φ(SN )

at time 0. The payoff of the European call (resp. put) option with strike
price K is (SN − K )+ , resp. (K − SN )+ .
Exercise 3.12 A call spread collar option requires its holder to buy an asset
at the price f (S ) when its market price is at the level S, where f (S ) is the
function plotted in Figure 3.11, with K1 := 80, K2 := 100, and K3 := 110.
" 125
N. Privault
140
Call spread collar price map f(S)
130 y=S
120
110
100
90
80
70
60
60 70 80 90 100 110 120 130
SN
K1 K2 K3
Fig. 3.12: Call spread collar price map.
a) Draw the payoff function of the call spread collar as a function of the
underlying asset price at maturity. See e.g. http://optioncreator.com/.
b) Show that this call spread collar option can be realized by purchasing
and/or issuing standard European call and put options with strike prices
to be specified.
Hints: Recall that an option with payoff φ(SN ) is priced (1 + r )−N E∗ φ(SN )

at time 0. The payoff of the European call (resp. put) option with strike
price K is (SN − K )+ , resp. (K − SN )+ .
Exercise 3.13 Consider an asset price (Sn )n=0,1,...,N which is a martingale

under the risk-neutral probability measure P∗ , with respect to the filtration
(Fn )n=0,1,...,N . Given the (convex) function φ(x) := (x − K )+ , show that
the price of an Asian option with payoff
S1 + · · · + SN

φ
N
and maturity N > 1 is always lower than the price of the corresponding
European call option, i.e. show that
S1 + S2 + · · · + SN

E∗ φ 6 E∗ [φ(SN )].
N
Hint: Use in the following order:

(i) the convexity inequality φ(x1 /N + · · · + xN /N ) 6 φ(x1 )/N + · · · +
φ(xN )/N ,
(ii) the martingale property Sk = E∗ [SN | Fk ], k = 1, 2, . . . , N .
(iii) Jensen’s inequality
φ(E∗ [SN | Fk ]) 6 E∗ [φ(SN ) | Fk ], k = 1, 2, . . . , N ,
126 "
(iv) the tower property E∗ [E∗ [φ(SN ) | Fk ]] = E∗ [φ(SN )] of conditional

expectations, k = 1, 2, . . . , N .
Exercise 3.14 (Exercise 2.6 continued).

a) We consider a forward contract on SN with strike price K and payoff
C := SN − K.
Find a portfolio allocation (ηN , ξN ) with value
VN = ηN πN + ξN SN
at time N , such that

VN = C, (3.47)
by writing Condition (3.47) as a 2 × 2 system of equations.
b) Find a portfolio allocation (ηN −1 , ξN −1 ) with value
VN −1 = ηN −1 πN −1 + ξN −1 SN −1
at time N − 1, and verifying the self-financing condition
VN −1 = ηN πN −1 + ξN SN −1 .
Next, at all times t = 1, 2, . . . , N − 1, find a portfolio allocation (ηt , ξt )

with value Vt = ηt πt + ξt St verifying (3.47) and the self-financing condi-
tion
Vt = ηt+1 πt + ξt+1 St ,
where ηt , resp. ξt , represents the quantity of the riskless, resp. risky, asset
in the portfolio over the time period [t − 1, t], t = 1, 2, . . . , N − 1.
c) Compute the arbitrage-free price πt (C ) = Vt of the forward contract C,
at time t = 0, 1, . . . , N .
d) Check that the arbitrage-free price πt (C ) satisfies the relation
1
πt ( C ) = E∗ [C | Ft ], t = 0, 1, . . . , N .
(1 + r )N −t
Exercise 3.15 Power option. Let (Sn )n∈N denote a binomial price process
with returns −50% and +50%, and let the riskless asset be valued Ak = $1,
k ∈ N. We consider a power option with payoff C := (SN )2 , and a predictable
self-financing portfolio strategy (ξk , ηk )k=1,2,...,N with value
Vk = ξk Sk + ηk A0 , k = 1, 2, . . . , N .
" 127
N. Privault
a) Find the portfolio allocation (ξN , ηN ) that matches the payoff C = (SN )2
at time N , i.e. that satisfies
VN = (SN )2 .
Hint: We have ηN = −3(SN −1 )2 /4.

b) In the following questions we use the risk-neutral probability measure
p∗ = 1/2.
i) Compute the portfolio value
VN −1 = E∗ [C | FN −1 ].
ii) Find the portfolio allocation (ηN −1 , ξN −1 ) at time N − 1 from the

relation
VN −1 = ξN −1 SN −1 + ηN −1 A0 .
Hint: We have ηN −1 = −15(SN −2 )2 /16.
iii) Check that the portfolio satisfies the self-financing condition
VN −1 = ξN −1 SN −1 + ηN −1 A0 = ξN SN −1 + ηN A0 .
Exercise 3.16 Consider the discrete-time Cox-Ross-Rubinstein model with

N + 1 time instants t = 0, 1, . . . , N . The price St0 of the riskless asset evolves
as St0 = π 0 (1 + r )t , t = 0, 1, . . . , N . The return of the risky asset, defined as
St − St−1
Rt : = , t = 1, 2, . . . , N ,
St−1
is random and allowed to take only two values a and b, with −1 < a < r < b.
The discounted asset price is given by Set := St /(1 + r )t , t = 0, 1, . . . , N .

a) Show that this model admits a unique risk-neutral probability measure P∗
and explicitly compute P∗ (Rt = a) and P(Rt = b) for all t = 1, 2, . . . , N ,
with a = 2%, b = 7%, r = 5%.
b) Does there exist arbitrage opportunities in this model? Explain why.
c) Is this market model complete? Explain why.
d) Consider a contingent claim with payoff∗
C = (SN )2 .
Compute the discounted arbitrage-free price Vet , t = 0, 1, . . . , N , of a self-

financing portfolio hedging the claim payoff C, i.e. such that
∗
This is the payoff of a power call option with strike price K = 0.
128 "
2
VN = C = (SN )2 , e = (SN ) .
or VeN = C
(1 + r )N
e) Compute the portfolio strategy
ξ t t=1,2,...,N = ξt0 , ξt1 t=1,2,...,N

associated to Vet , i.e. such that
Vet = ξ t • X t = ξt0 Xt0 + ξt1 Xt1 , t = 1, 2, . . . , N .
f) Check that the above portfolio strategy is self-financing, i.e.
ξ t • S t = ξ t+1 • S t , t = 1, 2, . . . , N − 1.
Exercise 3.17 We consider the discrete-time Cox-Ross-Rubinstein model

with N + 1 time instants t = 0, 1, . . . , N .
The price πt of the riskless asset evolves as πt = π0 (1 + r )t , t = 0, 1, . . . , N .

The evolution of St−1 to St is given by
 (1 + b)St−1 if Rt = b,

St =
(1 + a)St−1 if Rt = a,

with −1 < a < r < b. The return of the risky asset is defined as
St − St−1
Rt : = , t = 1, 2, . . . , N .
St−1
Let ξt , resp. ηt , denote the (possibly fractional) quantities of the risky, resp.
riskless, asset held over the time period [t − 1, t] in the portfolio with value
Vt = ξt St + ηt πt , t = 0, 1, . . . , N . (3.48)
a) Show that
Vt = (1 + Rt )ξt St−1 + (1 + r )ηt πt−1 , t = 1, 2, . . . , N . (3.49)
b) Show that under the probability P∗ defined by
b−r r−a
P∗ (Rt = a | Ft−1 ) = , P∗ (Rt = b | Ft−1 ) = ,
b−a b−a
where Ft−1 represents the information generated by {R1 , R2 , . . . , Rt−1 },
we have
E∗ [Rt | Ft−1 ] = r.
" 129
N. Privault
c) Under the self-financing condition
Vt−1 = ξt St−1 + ηt πt−1 , t = 1, 2, . . . , N , (3.50)
recover the martingale property

1
Vt−1 = E∗ [Vt | Ft−1 ],
1+r
using the result of Question (a).
d) Let a = 5%, b = 25% and r = 15%. Assume that the value Vt at time t
of the portfolio is $3 if Rt = a and $8 if Rt = b, and compute the value
Vt−1 of the portfolio at time t − 1.
Problem 3.18 CRR model with transaction costs. Stock broker income is
generated by commissions or transaction costs representing the difference
between ask prices (at which they are willing to sell an asset to their client),
and bid prices (at which they are willing to buy an asset from their client).
We consider a discrete-time Cox-Ross-Rubinstein model with one risky
asset priced St at time t = 0, 1, . . . , N . The price At of the riskless asset
evolves as
At = ρ t , t = 0, 1, . . . , N ,
with A0 := 1 and ρ > 0, and the random evolution of St−1 to St is given by
two possible returns α, β as

 βSt−1
St =
αSt−1

t = 1, . . . , N , with 0 < α < β.
S2 = β 2 S0
S1 = βS0
S0 S2 = αβS0
S1 = αS0
S2 = α2 S0 .
Fig. 3.13: Tree of market prices with N = 2.
The ask and bid prices of the risky asset quoted St on the market are respec-
tively given by (1 + λ)St , and (1 − λ)St for some λ ∈ [0, 1), such that
130 "

 α : = α ( 1 + λ ) < β ( 1 − λ ) = : β↓ ,
↑

α↓ := α(1 − λ) < β (1 − λ) := β↓ ,
α : = α (1 + λ) < β (1 + λ) = : β ↑ ,

 ↑
i.e., transaction costs are charged at the rate λ ∈ [0, 1), proportionally to the
traded amount.
β ↑ βS0 = β ↑ S1 β↓ βS0 = β↓ S1
↑
β S0 β↓ S0
↑
α βS0 = α S1↑
α↓ βS0 = α↓ S1
S0 S0
↑
β αS0 = β S1↑ β↓ αS0 = β↓ S1
↑
α S0 α↓ S0
α↑ αS0 = α↑ S1 . α↓ αS0 = α↓ S1 .
(a) Tree of ask prices. (b) Tree of bid prices.
Fig. 3.14: Trees of bid and ask prices with N = 2.
The riskless asset is not subject to transaction costs or bid/ask prices, and
is priced At at time t = 0, 1, . . . , N . We consider a predictable, self-financing
replicating portfolio strategy
(ηt (St−1 ), ξt (St−1 ))t=1,2,...,N .
made of ηt (St−1 ) of the riskless asset At and of ξt (St−1 ) units of the risky
asset St at time t = 1, 2, . . . , N .
Our goal is to derive a backward recursion giving ξt (St−1 ), ηt (St−1 ) from

ξt+1 (St ), ηt+1 (St ) for t = N − 1, N − 2 . . . , 1. The following questions are
interdependent and should be treated in sequence.
a) We consider a portfolio reallocation (ηt (St−1 ), ξt (St−1 )) → (ηt+1 (St ), ξt+1 (St ))
at time t ∈ {1, . . . , N − 1}. Write down the self-financing condition in the
event of:
i) an increase in the stock position from ξt (St−1 ) to ξt+1 (St ),
ii) a decrease in the stock position from ξt (St−1 ) to ξt+1 (St ).
The conditions are written using ηt (St−1 ), ηt+1 (St ), ξt (St−1 ), ξt+1 (St ),
At , St and λ.
b) From Questions ai)-aii), deduce two self-financing equations in case St =
αSt−1 , and two self-financing equations in case St = βSt−1 .
c) Using the functions
" 131
N. Privault
if x 6 y, if x 6 y,
 ↑  ↑
α β
gα (x, y ) := and gβ (x, y ) :=
α↓ if x > y, β↓ if x > y,
 
rewrite the equations of Question (b) into a single equation in case St =

αSt−1 , and a single equation in case St = βSt−1 .
d) From the result of Question (c), derive an equation satisfied by ξt (St−1 ),
and show that it admits a unique solution ξt (St−1 ).
Hint: Show that the piecewise affine function

x 7→ f (x, St−1 ) := gβ (x, ξt+1 (βSt−1 )) x − ξt+1 (βSt−1 )
ηt+1 (βSt−1 ) − ηt+1 (αSt−1 )
−gα (x, ξt+1 (αSt−1 ) x − ξt+1 (αSt−1 ) − ρ
Set−1
is strictly increasing in x ∈ R.
e) Find the expressions of ξt (St−1 ) and ηt (St−1 ) by solving the 2 × 2 system
of equations of Question (c).
Hint: The expressions have to use the quantities
gα (ξt (St−1 ), ξt+1 (αSt−1 )), gβ (ξt (St−1 ), ξt+1 (βSt−1 )),
and they should be consistent with Proposition 4.11 in the course docu-
ment when λ = 0, i.e. when α↑ = α↓ = 1 + a and β ↑ = β↓ = 1 + b, with
ρ = 1 + r.
f) Find the value of gα (ξt (St−1 ), ξt+1 (αSt−1 )) in the following two cases:
i) f (ξt+1 (αSt−1 ), St−1 ) > 0,
ii) f (ξt+1 (αSt−1 ), St−1 ) < 0,
and the value of gβ (ξt (St−1 ), ξt+1 (βSt−1 )) in the following two cases:
i) f (ξt+1 (βSt−1 ), St−1 ) > 0,
ii) f (ξt+1 (βSt−1 ), St−1 ) < 0.
g) Hedge and price the call option with strike price K = $2 and N = 2 when
S0 = 8, ρ = 1, α = 0.5, β = 2, and the transaction cost rate is λ = 12.5%.
Provide sufficient details of hand calculations.
Remark: The evaluation of the terminal payoff uses the value of S2 only,
and is not affected by bid/ask prices.
h) Modify the attached IPython notebook in order to include the treatment
of transaction costs.
132 "
Fig. 3.15: BTC/USD order book example.∗
In the above figure, ask prices are marked in red and bid prices are marked
in green. The center column gives the quantity of the asset available at that
row’s bid or ask price, and the right column represents the cumulative volume
of orders from the last-traded price until the current bid/ask price level. The
large number in the center shows the last-traded price.
Problem 3.19 CRR model with dividends. We consider a riskless asset priced
as
(0) (0)
Sk = S0 (1 + r )k , k = 0, 1, . . . , N ,
with r > −1, and a risky asset S (1) whose return is given by
(1) (1)
Sk − Sk−1
Rk := (1)
, k = 1, 2, . . . , N ,
Sk−1
∗
" 133
N. Privault
with N + 1 time instants k = 0, 1, . . . , N and d = 1. In the CRR model the

return Rk is random and allowed to take two values a and b at each time
step, i.e.
Rk ∈ {a, b}, k = 1, 2, . . . , N ,
(1) (1)
with −1 < a < 0 < b, and the random evolution of Sk−1 to Sk is given by
(1)
 
 (1 + b)Sk−1 if Rk = b 
 
(1) (1)
Sk = = (1 + Rk )Sk−1 , k = 1, 2, . . . , N ,
(1)
(1 + a)Sk−1 if Rk = a

 

(3.51)
according to the tree
(1)
(1 + b)Sk−1
(1)
Sk−1
(1)
(1 + a)Sk−1
and we have
k
(1) (1)
Y
Sk = S0 (1 + Ri ), k = 0, 1, . . . , N .
i=1
The information Fk known to the market up to time k is given by the knowl-

(1) (1) (1)
edge of S1 , S2 , . . . , Sk , i.e. we write
(1) (1) (1)

Fk = σ S1 , S2 , . . . , Sk = σ (R1 , R2 , . . . , Rk ),
(1)
k = 0, 1, . . . , N , where S0 is a constant and F0 = {∅, Ω} contains no infor-
mation.
Under the risk-neutral probability measure P∗ defined by

r−a b−r
p∗ := P∗ (Rk = b) = > 0, q ∗ := P∗ (Rk = a) = > 0,
b−a b−a
k = 1, 2, . . . , N , the market returns (Rk )k=1,2,...,N form a sequence of inde-
pendent identically distributed random variables.
In the sequel we assume that the stock Sk pays a dividend rate α > 0 at
times k = 1, 2, . . . , N . At the beginning of every time step k = 1, 2, . . . , N ,
the price Sk is immediately adjusted to its ex-dividend level by losing α%
134 "
of its value. The following ten questions are interdependent and should be
treated in sequence.
(1) (1)
a) Rewrite the evolution (3.51) of Sk−1 to Sk in the presence of a daily
dividend rate α > 0.
b) Express the dividend amount as a percentage of the ex-dividend price
(1)
Sk , and show that under the risk-neutral probability measure the return
of the risky asset satisfies
 
(1)
S
∗  k +1 (1)
E Fk  = (1 + r )Sk , k = 0, 1, . . . , N − 1.
1−α
c) We consider a (predictable) portfolio strategy (ξk , ηk )k=1,2,...,N with value

process
(1) (0)
Vk = ξk+1 Sk + ηk+1 Sk
at time k = 0, 1, . . . , N − 1. Write down the self-financing condition for the
portfolio value process (Vk )k=0,1,...,N by taking into account the reinvested
dividends, and give the expression of VN .
d) Show that under the self-financing condition, the discounted portfolio
value process
V
Vek := (k0) , k = 0, 1, . . . , N ,
Sk
is a martingale under the risk-neutral probability measure P∗ .
e) Show that the price at time k = 0, 1, . . . , N of a claim with random payoff
C can be written as
1
Vk = E∗ [C | Fk ], k = 0, 1, . . . , N ,
(1 + r )N −k
assuming that the claim C is attained at time N by the portfolio strategy
(ξk , ηk )k=1,2,...,N .
f) Compute the price at time t = 0, 1, . . . , N of a vanilla option with payoff
(1)
h SN using the pricing function
C0 k, x, N , a, b, r

N −k
1

X N −k
(p∗ )l (q ∗ )N −k−l h x(1 + b)l (1 + a)N −k−l

:=
(1 + r ) N −k l
l =0
(1)
of a vanilla claim with payoff h SN .
g) Show that the price at time t = 0, 1, . . . , N of a vanilla option with payoff
(1)
function h SN can be rewritten as
" 135
N. Privault
(1) (1)
Vk = Cα k, Sk , N , aα , bα , rα := (1 − α)N −k C0 k, Sk , N , aα , bα , rα ,

k = 0, 1, . . . , N , where the coefficients aα , bα , rα will be determined ex-

plicitly.
h) Find a recurrence relation between the functions Cα k, x, N , aα , bα , rα

and Cα k + 1, x, N , aα , bα , rα using the martingale property of the dis-

counted portfolio value process (Vek )k=0,1,...,N under the risk-neutral prob-
ability measure P∗ .
i) Using the function C0 k, x, N , aα , bα , rα , compute the quantity ξk of risky

(1)
asset Sk allocated on the time interval [k − 1, k ) in a self-financing port-
(1)
folio hedging the claim C = h SN .
j) How are the dividends reinvested in the self-financing hedging portfolio?
Problem 3.20 We consider a ternary tree (or trinomial) model with N + 1

(0)
time instants k = 0, 1, . . . , N and d = 1 risky asset. The price Sk of the
riskless asset evolves as
(0) (0)
Sk = S0 (1 + r )k , k = 0, 1, . . . , N ,
with r > −1. Let the return of the risky asset S (1) be defined as
(1) (1)
Sk − Sk−1
Rk := (1)
, k = 1, 2, . . . , N .
Sk−1
In this ternary tree model, the return Rk is random and allowed to take only
three values a, 0 and b at each time step, i.e.
Rk ∈ {a, 0, b}, k = 1, 2, . . . , N ,
(1) (1)
with −1 < a < 0 < b. That means, the evolution of Sk−1 to Sk is random
and given by
(1)
(1 + b)Sk−1 if Rk = b 
 

 

 


 

(1) (1) (1)
Sk = Sk−1 if Rk = 0 = (1 + Rk )Sk−1 , k = 1, 2, . . . , N ,

 


 

(1)
 
(1 + a)Sk−1 if Rk = a
 
and
k
(1) (1)
Y
Sk = S0 (1 + Ri ), k = 0, 1, . . . , N .
i=1
136 "
(1)
The price process Sk k =0,1,...,N
evolves on a ternary tree of the form:
(1)
(1 + b)S0
(1) (1)
S0 S0
(1)
(1 + a)S0
The information Fk known to the market up to time k is given by the knowl-

(1) (1) (1)
edge of S1 , S2 , . . . , Sk , i.e. we write
(1) (1) (1)

Fk = σ S1 , S2 , . . . , Sk = σ (R1 , R2 , . . . , Rk ),
(1)
k = 0, 1, . . . , N , where, as a convention, S0 is a constant and F0 = {∅, Ω}
contains no information. In the sequel we will consider that (Rk )k=1,2,...,N
is a sequence of independent identically distributed random variables under
any risk-neutral probability measure P∗ , and we denote
 ∗

 p := P∗ (Rk = b) > 0,



θ∗ := P∗ (Rk = 0) > 0,



 ∗
q := P∗ (Rk = a) > 0, k = 1, 2, . . . , N .


P in terms of the parameter θ∗ ∈ (0, 1).
b) Give a necessary and sufficient condition for absence of arbitrage in this
ternary tree model.
Hint: Use your intuition of the market to find what the condition should
be, and then prove that it is necessary and sufficient. Note that we have
a < 0 and b > 0, and the condition should only depend on the model
parameters a, b and r.
c) When the model parameters allow for arbitrage opportunities, explain
how you would exploit them if you joined the market with zero money to
invest.
d) Is this ternary tree market model complete?
e) In this question we assume that the conditional variance
 
(1) (1)
S
∗  k +1
− Sk
Var (1)
Fk  = σ 2 > 0
S k

" 137
N. Privault
(1) (1) (1)

of the asset return (Sk+1 − Sk )/Sk given Fk is constant and equal
to σ 2 , k = 0, 1, . . . , N − 1. Show that this condition determines a unique
value of θ∗ and a unique risk-neutral probability measure P∗σ to be written
explicitly, under a certain condition on a, b, r and σ.
f) In this question and in the following we impose the condition (1 + a)(1 +
b) = 1, i.e. we let a := −b/(b + 1). What does this imply on this ternary
tree model and on the risk-neutral probability measure P∗ ?
g) We consider a vanilla financial claim with payoff C = h(SN ) and maturity
N , priced as time k as
(1) 1
E∗ h(SN ) Fk

f k, Sk =
(1 + r )N −k θ
1 (1)
E∗ h(SN ) Sk ,

=
(1 + r )N −k θ
k = 0, 1, . . . , N , under the risk-neutral probability measure P∗θ . Find a
recurrence equation between the functions f (k, ·) and f (k + 1, ·), k =
0, . . . , N − 1.
Hint: Use the tower property of conditional expectations.
h) Assuming that C is the payoff of the European put option with strike price
K, give the expression of f (N , x).
i) Modify the attached binomial Python code in order to make it deal with
the trinomial model (attach a printout of your modified code).
(1)
j) Taking S0 = 1, r = 0.1, b = 1, (1 + a)(1 + b) = 1, compute the price
at time k = 0 of the European put option with strike price K = 1 and
maturity N = 2 using the code of Question (i) with θ = 0.5.
Download∗ and install the Anaconda distribution from https://www.
anaconda.com/distribution/ or try it online at https://jupyter.org/try.
∗
Download the corresponding IPython notebook that can be run here.
138 "
%matplotlib inline
import networkx as nx
import numpy as np
import matplotlib
import matplotlib.pyplot as plt
N=2;S0=1
r = 0.1;a=-0.5;b=1; # change
# add definition of theta
p = (r-a)/(b-a) # change
q = (b-r)/(b-a) # change
def plot_tree(g):
plt.figure(figsize=(20,10))
pos={};lab={}
for n in g.nodes():
pos[n]=(n[0],n[1])
if g.node[n]['value'] is not None: lab[n]=float("{0:.2f}".format(g.node[n]['value']))
elarge=g.edges(data=True)
nx.draw_networkx_labels(g,pos,lab,font_size=15)
nx.draw_networkx_nodes(g,pos,node_color='lightblue',alpha=0.4,node_size=1000)
nx.draw_networkx_edges(g,pos,edge_color='blue',alpha=0.7,width=3,edgelist=elarge)
plt.ylim(-N-0.5,N+0.5)
plt.xlim(-0.5,N+0.5)
plt.show()
def graph_stock():
S=nx.Graph()
for k in range(0,N):
for l in range(-k,k+2,2): # change range and step size
S.add_edge((k,l),(k+1,l+1)) # add edge
S.add_edge((k,l),(k+1,l-1))
for n in S.nodes():
k=n[0]
l=n[1]
S.node[n]['value']=S0*((1.0+b)**((k+l)/2))*((1.0+a)**((k-l)/2))
return S
plot_tree(graph_stock())
def European_call_price(K):
price = nx.Graph()
hedge = nx.Graph()
S = graph_stock()
for k in range(0,N):
price.add_edge((k,l),(k+1,l+1)) # add edge
price.add_edge((k,l),(k+1,l-1))
for l in range(-N,N+2,2): # change range and step size
price.node[(N,l)]['value'] = np.maximum(S.node[(N,l)]['value']-K,0)
for k in reversed(range(0,N)):
price.node[(k,l)]['value'] =
(price.node[(k+1,l+1)]['value']*p+price.node[(k+1,l-1)]['value']*q)/(1+r)
# add theta
return price
" 139
N. Privault
K = input("Strike K=")
call_price = European_call_price(float(K))
print('Underlying asset prices:')
plot_tree(graph_stock())
print('European call option prices:')
plot_tree(call_price)
print('Price at time 0 of the European call
option:',float("{0:.4f}".format(call_price.node[(0,0)]['value'])))
140 "
Chapter 4
Brownian Motion and Stochastic Calculus
Brownian motion is a continuous-time stochastic process having stationary

and independent Gaussian distributed increments, and continuous paths.
This chapter presents the constructions of Brownian motion and its asso-
ciated Itô stochastic integral, which will be used for the random modeling of
asset and portfolio prices in continuous time.
4.1 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

4.2 Three Constructions of Brownian Motion . . . . . . . . 145
4.3 Wiener Stochastic Integral . . . . . . . . . . . . . . . . . . . . . . 149
4.4 Itô Stochastic Integral . . . . . . . . . . . . . . . . . . . . . . . . . . 158
4.5 Stochastic Calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
4.1 Brownian Motion
We start by recalling the definition of Brownian motion, which is a funda-

mental example of a stochastic process. The underlying probability space
(Ω, F, P) of Brownian motion can be constructed on the space Ω = C0 (R+ )
of continuous real-valued functions on R+ started at 0.
Definition 4.1. The standard Brownian motion is a stochastic process
(Bt )t∈R+ such that
1. B0 = 0,
2. The sample trajectories t 7→ Bt are continuous, with probability one.
3. For any finite sequence of times t0 < t1 < · · · < tn , the increments
Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btn − Btn−1
" 141
N. Privault
are mutually independent random variables.
4. For any given times 0 6 s < t, Bt − Bs has the Gaussian distribution

N (0, t − s) with mean zero and variance t − s.
In particular, for t ∈ R+ , the random variable Bt ' N (0, t) has a Gaussian

distribution with mean zero and variance t > 0. Existence of a stochastic pro-
cess satisfying the conditions of Definition 4.1 will be covered in Section 4.2.
In Figure 4.1 we draw three sample paths of a standard Brownian motion

obtained by computer simulation using (4.3). Note that there is no point
in “computing” the value of Bt as it is a random variable for all t > 0.
However, we can generate samples of Bt , which are distributed according to
the centered Gaussian distribution with variance t > 0.
Bt3
Bt2
Bt1
0 t1 t2 t3
-1
0 0.2 0.4 0.6 0.8 1
Fig. 4.1: Sample paths of a one-dimensional Brownian motion.
In particular, Property 4 in Definition 4.1 implies
E[Bt − Bs ] = 0 and Var[Bt − Bs ] = t − s, 0 6 s 6 t,
and we have
Cov(Bs , Bt ) = E[Bs Bt ]
= E[Bs (Bt − Bs + Bs )]
= E Bs ( Bt − Bs ) + ( Bs ) 2

= E[Bs (Bt − Bs )] + E (Bs )2

= E[Bs ]E[Bt − Bs ] + E (Bs )2

= Var[Bs ]
= s, 0 6 s 6 t,
hence
142 "
Cov(Bs , Bt ) = E[Bs Bt ] = min(s, t), s, t > 0, (4.1)

cf. also Exercise 4.2-(4.1). The following graphs present two examples of
possible modeling of random data using Brownian motion.
Fig. 4.2: Evolution of the fortune of a poker player vs number of games played.
Fig. 4.3: Web traffic ranking.
In the sequel, we denote by (Ft )t∈R+ the filtration generated by the Brownian
paths up to time t, defined as
F t : = σ ( Bs : 0 6 s 6 t ) , t > 0. (4.2)
Property 3 in Definition 4.1 shows that Bt − Bs is independent of all Brownian

increments taken before time s, i.e.
⊥ (Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btn − Btn−1 ),

( Bt − Bs ) ⊥
0 6 t0 6 t1 6 · · · 6 tn 6 s 6 t, hence Bt − Bs is also independent of the

whole Brownian history up to time s, hence Bt − Bs is in fact independent
of Fs , s > 0. As in Example 2 on page 2 we have the following result.
" 143
N. Privault
Proposition 4.2. Brownian motion (Bt )t∈R+ is a continuous-time martin-

gale.
Proof. We have
E[Bt | Fs ] = E[Bt − Bs + Bs | Fs ]
= E[Bt − Bs | Fs ] + E[Bs | Fs ]
= E [ Bt − Bs ] + Bs
= Bs , 0 6 s 6 t,
because it has centered and independent increments, cf. Section 7.1.

The n-dimensional Brownian motion can be constructed as (Bt1 , Bt2 , . . . , Btn )t∈R+
where (Bt1 )t∈R+ , (Bt2 )t∈R+ , . . .,(Btn )t∈R+ are independent copies of (Bt )t∈R+ .
Next, we turn to simulations of 2 dimensional and 3 dimensional Brownian
motions in Figures 4.4 and 4.5. Recall that the movement of pollen particles
originally observed by Brown (1828) was indeed 2-dimensional.
2
1.5
0.5
-0.5
-1
-1.5
-2
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5
Fig. 4.4: Two sample paths of a two-dimensional Brownian motion.
-1
-2
-1
0
1 2
1
0
2 -1
-2
Fig. 4.5: Sample path of a three-dimensional Brownian motion.
144 "
Figure 4.6 presents an illustration of the scaling property of Brownian motion.
Fig. 4.6: Scaling property of Brownian motion.∗
4.2 Three Constructions of Brownian Motion
We refer the reader to Chapter 1 of Revuz and Yor (1994) and to Theo-
rem 10.28 in Folland (1999) for proofs of existence of Brownian motion as a
stochastic process (Bt )t∈R+ satisfying the Conditions 1-4 of Definition 4.1.
Brownian motion as a random walk
For convenience we will informally regard Brownian motion as a random walk

over infinitesimal time intervals of length ∆t, whose increments
∆Bt := Bt+∆t − Bt ' N (0, ∆t)
over the time interval [t, t + ∆t] will be approximated by the Bernoulli random
variable √
∆Bt = ± ∆t (4.3)
with equal probabilities (1/2, 1/2). Figure 4.7 presents a simulation of Brow-
nian motion as a random walk with ∆t = 0.1.
∗
" 145
N. Privault
2.5
1.5
Bt
1
0.5
-0.5
-1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
t
Fig. 4.7: Construction of Brownian motion as a random walk.∗
Note that we have

1√ 1√
E[∆Bt ] = ∆t − ∆t = 0,
2 2
and
1 1
Var[∆Bt ] = E (∆Bt )2 = ∆t + ∆t = ∆t.

2 2
According to this representation, the paths of Brownian motion are not dif-
ferentiable, although they are continuous by Property 2, as we have
√
dBt ± dt 1
' = ± √ ' ±∞. (4.4)
dt dt dt
In order to recover the Gaussian distribution property of the random variable
BT , we can split the time interval [0, T ] into N subintervals
k−1

k
T, T , k = 1, 2, . . . , N ,
N N
of same length ∆t = T /N , with N “large”.
0 T 2T T
N N
Defining the Bernoulli random variable Xk as

√
Xk := ± T
with equal probabilities (1/2, 1/2), we have Var(Xk ) = T and

∗
146 "
X √
∆Bt := √ k = ± ∆t
N
is the increment of Bt over ((k − 1)∆t, k∆t], and we get
X X1 + X2 + · · · + XN
BT ' ∆Bt ' √ .
0<t<T
N
Hence by the central limit theorem we recover the fact that BT has the cen-
tered Gaussian distribution N (0, T ) with variance T , cf. point 4 of the above
Definition 4.1 of Brownian motion, and the illustration given in Figure 4.8.
Remark 4.3. The choice of the square root in (4.3) is in fact not fortuitous.
Indeed, any choice of ±(∆t)α with a power α > 1/2 would lead to explosion
of the process as dt tends to zero, whereas a power α ∈ (0, 1/2) would lead
to a vanishing process, as can be checked from the following R code.
N=1000; t <- 0:N; dt <- 1.0/N; dev.new(width=16,height=7); # Using Bernoulli samples

nsim=100;X <- matrix((dt)^0.5*(rbinom( nsim * N, 1, 0.5)-0.5)*2, nsim, N)
X <- cbind(rep(0, nsim), t(apply(X, 1, cumsum))); H<-hist(X[,N],plot=FALSE);
layout(matrix(c(1,2), nrow =1, byrow = TRUE));par(mar=c(2,2,2,0), oma = c(2, 2, 2, 2))
plot(t*dt, X[1, ], xlab = "", ylab = "", type = "l", ylim = c(-2, 2), col = 0,xaxs='i',las=1,
cex.axis=1.6)
for (i in 1:nsim){lines(t*dt, X[i, ], type = "l", ylim = c(-2, 2), col = i)}
lines(t*dt,sqrt(t*dt),lty=1,col="red",lwd=3);lines(t*dt,-sqrt(t*dt), lty=1, col="red",lwd=3)
lines(t*dt,0*t, lty=1, col="black",lwd=2)
for (i in 1:nsim){points(0.999, X[i,N], pch=1, lwd = 5, col = i)}
x <- seq(-2,2, length=100); px <- dnorm(x);par(mar = c(2,2,2,2))
plot(NULL , xlab="", ylab="", xlim = c(0, max(px,H$density)), ylim = c(-2,2),axes=F)
rect(0, H$breaks[1:(length(H$breaks) - 1)], col=rainbow(20,start=0.08,end=0.6), H$density,
H$breaks[2:length(H$breaks)]); lines(px,x, lty=1, col="black",lwd=2)
−1
−2
0.0 0.2 0.4 0.6 0.8 1.0
Fig. 4.8: Statistics of one-dimensional Brownian paths vs Gaussian distribution.
Indeed, the central limit theorem states that given any sequence (Xk )k>1 of
independent identically distributed centered random variables with variance
σ 2 = Var[Xk ] = T , the normalized sum
" 147
N. Privault
X1 + X2 + · · · + XN
√
N
converges (in distribution) to the centered Gaussian random variable N (0, σ 2 )

with variance σ 2 as N goes to infinity. As a consequence, ∆Bt could in fact
be replaced by any centered random variable with variance ∆t in the above
description.
Lévy’s construction of Brownian motion
Figure 4.9 represents the construction of Brownian motion by successive lin-

ear interpolations, see Problem 4.19 for a proof of existence of Brownian
motion based on this construction.
0.4
0.2
0.0
−0.2
−0.4
−0.6
0.0 0.2 0.4 0.6 0.8 1.0
Fig. 4.9: Lévy’s construction of Brownian motion.∗
The following R code is used to generate Figure 4.9.†
dev.new(width=16,height=7); alpha=1/2;t <- 0:1;dt <- 1; z=rnorm(1,mean=0,sd=dtâlpha)

plot(t*dt,c(0,z),xlab = "t",ylab = "",col = "blue",main = "",type = "l", xaxs="i", las = 1)
k=0;while (k<12) {readline("Press <return> to continue")
k=k+1;m <- (z+c(0,head(z,-1)))/2;y <- rnorm(length(t)-1,mean=0,sd=(dt/4)âlpha)
x <- m+y;x <- c(matrix(c(x,z), 2, byrow = T));n=2*length(t)-2;t <- 0:n
plot(t*dt/2, c(0, x), xlab = "t", ylab = "", col = "blue", main = "", type = "l", xaxs="i", las
= 1);z=x;dt=dt/2}
∗
†
Download the corresponding R code or the IPython notebook that can be run
here.
148 "
Construction by series expansions
Brownian motion on [0, T ] can also be constructed by Fourier synthesis via

the Paley-Wiener series expansion
√
X 2T X sin((n − 1/2)πt/T )
Bt = Xn fn (t) = Xn , 0 6 t 6 T,
π n − 1/2
n>1 n>1
where (Xn )n>1 is a sequence of independent N (0, 1) standard Gaussian ran-

dom variables, as illustrated in Figure 4.10.∗
2
2
n=35
4
10
0 200 400 600 800
Fig. 4.10: Construction of Brownian motion by series expansions.†
4.3 Wiener Stochastic Integral

In this section, we construct the Wiener stochastic integral of square-
integrable deterministic functions of time with respect to Brownian motion.
Recall that the price St of risky assets was originally modeled in Bachelier
(1900) as St := σBt , where σ is a volatility parameter. The stochastic integral
wT wT
f (t)dSt = σ f (t)dBt
0 0
can be used to represent the value of a portfolio as a sum of profits and
losses f (t)dSt where dSt represents the stock price variation and f (t) is the
quantity invested in the asset St over the short time interval [t, t + dt].
A naive definition of the stochastic integral with respect to Brownian mo-

tion would consist in letting
∗
†
" 149
N. Privault
wT wT dBt
f (t)dBt := f (t) dt,
0 0 dt
and evaluating the above integral with respect to dt. However this definition
fails because the paths of Brownian motion are not differentiable, cf. (4.4).
Next we present Itô’s construction of the stochastic integral with respect to
Brownian motion. Stochastic integrals will be first constructed as integrals
of simple step functions of the form
n
ai 1(ti−1 ,ti ] (t),
X
f (t) = 0 6 t 6 T, (4.5)
i=1
i.e. the function f takes the value ai on the interval (ti−1 , ti ], i = 1, 2, . . . , n,

with 0 6 t0 < · · · < tn 6 T , as illustrated in Figure 4.11.
f (t)
a2
a1
a4
t0 t1 t2 t3 t4 t
Fig. 4.11: Step function t 7→ f (t).
ti<-c(0,2,4.5,7,9)
ai<-c(0,3,1,2,1,0)
plot(stepfun(ti,ai),xlim = c(0,10),do.points = F,main="", col = "blue")
Recall that the classical integral of f given in (4.5) is interpreted as the area
under the curve f , and computed as
wT n
X
f (t)dt = ai (ti − ti−1 ).
0
i=1
f (t)
6
a2 b r
b r b r
a1
a4 b r
-
t0 t1 t2 t3 t4 t
Fig. 4.12: Area under the step function t 7→ f (t).
150 "
In the next Definition 4.4 we use such step functions for the construction
of the stochastic integral with respect to Brownian motion. The stochastic
integral (4.6) for step functions will be interpreted as the sum of profits and
losses ai (Bti − Bti−1 ), i = 1, 2, . . . , n, in a portfolio holding a quantity ai of
a risky asset whose price variation is Bti − Bti−1 at time i = 1, 2, . . . , n.
Definition 4.4. The stochastic integral with respect to Brownian motion
(Bt )t∈[0,T ] of the simple step function f of the form (4.5) is defined by
wT n
X
f (t)dBt := ai (Bti − Bti−1 ). (4.6)
0
i=1
wT
In the next Lemma 4.5 we determine the probability distribution of f (t)dBt
0
and we show that it is independent of the particular representation (4.5) cho-
sen for f (t).
Lemma 4.5. Let f be a simple step function f of the form (4.5). The stochas-
wT
tic integral f (t)dBt defined in (4.6) has the centered Gaussian distribution
0
wT wT
f (t)dBt ' N 0, |f (t)|2 dt
0 0
hw T i
with mean E f (t)dBt = 0 and variance given by the Itô isometry
0
hw T i h w T 2 i w T
Var f (t)dBt = E f (t)dBt = |f (t)|2 dt. (4.7)
0 0 0
Proof. Recall that if X1 , X2 , . . . , Xn are independent Gaussian random vari-
ables with probability distributions N (m1 , σ12 ),. . .,N (mn , σn2 ), then the sum
X1 + · · · + Xn is a Gaussian random variable with distribution
N m1 + · · · + mn , σ12 + · · · + σn2 .

As a consequence, the stochastic integral

wT n
X
f (t)dBt = ak (Btk − Btk−1 )
0
k =1
of the step function

n
ak 1(tk−1 ,tk ] (t),
X
f (t) = 0 6 t 6 T,
k =1
has the centered Gaussian distribution with mean 0 and variance
" 151
N. Privault
hw T
" n #
i X
Var f (t)dBt = Var ak (Btk − Btk−1 )
0
k =1
n
X
= Var[ak (Btk − Btk−1 )]
k =1
X n
= |ak |2 Var[Btk − Btk−1 ]
k =1
X n
= (tk − tk−1 )|ak |2
k =1
X n w tk
= |ak |2 dt
tk−1
k =1
wT X
n
= |ak |2 1(tk−1 ,tk ] (t)dt
0
k =1
wT
= |f (t)|2 dt,
0
since the simple function

n
a2i 1(ti−1 ,ti ] (t),
X
f 2 (t) = 0 6 t 6 T,
i=1
takes the value a2i on the interval (ti−1 , ti ], i = 1, 2, . . . , n, as can be checked

from the following Figure 4.13.
f2
6
a22 b r
b r b r
a21
a24 b r
-
t0 t1 t2 t3 t4 t
Fig. 4.13: Squared step function t 7→ f 2 (t).

In the sequel, we will make a repeated use of the space L2 ([0, T ]) of square-
integrable functions.
Definition 4.6. Let L2 ([0, T ]) denote the space of (measurable) functions
f : [0, T ] −→ R such that
152 "
wT
r
kf kL2 ([0,T ]) := |f (t)|2 dt < ∞, f ∈ L2 ([0, T ]). (4.8)
0
For example, the function f (t) := tα , t ∈ (0, T ], belongs to L2 ([0, T ]) if and

only if α > −1/2, as we have
+∞ if α 6 −1/2,

wT wT



2 2α
f (t)dt = t dt = t=T
t1+2α T 1+2α

0 0
= < ∞ if α > −1/2,


1 + 2α t=0 1 + 2α

see Figure 4.14 for an illustration.

20 20
15 15
10 10
5 5
0 0
0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0
(a) Infinite area, α = −1 < −1/2. (b) Finite area, α = −1/4 > −1/2.
Fig. 4.14: Infinite vs finite area under a curve.
The norm k · kL2 ([0,T ]) on L2 ([0, T ]) induces a distance between any two
functions f and g in L2 ([0, T ]), defined as
wT
r
kf − gkL2 ([0,T ]) := |f (t) − g (t)|2 dt < ∞,
0
cf. e.g. Chapter 3 of Rudin (1974) for details.

Definition 4.7. Convergence in L2 ([0, T ]). We say that a sequence (fn )n∈N
of functions in L2 ([0, T ]) converges in L2 ([0, T ]) to another function f ∈
L2 ([0, T ]) if
wT
r
lim kf − fn kL2 ([0,T ]) = lim |f (t) − fn (t)|2 dt = 0.
n→∞ n→∞ 0
" 153
N. Privault
f = function(x){exp(sin(x*1.8*pi))}
for (i in 3:9){n=2î;x<-cumsum(c(0,rep(1,n)))/n;
z<-c(NA,head(x,-1))
y<-c(f(x)-pmax(f(x)-f(z),0),f(1))
t=seq(0,1,0.01);
plot(f,from=0,to=1,ylim=c(0.3,2.9),type="l",lwd=3,col="red",main="",xaxs="i",yaxs="i",
las=1)
lines(stepfun(x,y),do.points=F,lwd=2,col="blue",main="");
readline("Press <return> to continue");}
2.5
2.0
f
1.5
1.0
0.5
0.0 0.2 0.4 0.6 0.8 1.0
Fig. 4.15: Step function approximation.∗
By e.g. Theorem 3.13 in Rudin (1974) or Proposition 2.4 page 63 of Hirsch

and Lacombe (1999), we have the following result which states that the set
of simple step functions f of the form (4.5) is a linear space which is dense
in L2 ([0, T ]) for the norm (4.8), as stated in the next proposition.
Proposition 4.8. For any function f ∈ L2 ([0, T ]) satisfying (4.8) there ex-
ists a sequence (fn )n∈N of simple step functions of the form (4.5), converging
to f in L2 ([0, T ]) in the sense that
wT
r
lim kf − fn kL2 ([0,T ]) = lim |f (t) − fn (t)|2 dt = 0.
n→∞ n→∞ 0
wT
In order to extend the definition (4.6) of the stochastic integral f (t)dBt
0
to any function f ∈ L2 ([0, T ]), i.e. to f : [0, T ] −→ R measurable such that
wT
|f (t)|2 dt < ∞, (4.9)
0
we will make use of the space L2 (Ω) of square-integrable random variables.

∗
154 "
Definition 4.9. Let L2 (Ω) denote the space of random variables F : Ω −→

R such that q
kF kL2 (Ω) := E F 2 < ∞.
The norm k · kL2 (Ω) on L2 (Ω) induces the distance

q
E (F − G)2 < ∞,

kF − GkL2 (Ω) :=
between the square-integrable random variables F and G in L2 (Ω).

Definition 4.10. Convergence in L2 (Ω). We say that a sequence (Fn )n∈N
of random variables in L2 (Ω) converges in L2 (Ω) to another random variable
F ∈ L2 (Ω) if
q
lim kF − Fn kL2 (Ω) = lim E (F − Fn )2 = 0.

n→∞ n→∞
The next proposition allows us to extend Lemma 4.5 from simple step func-
tions to square-integrable functions in L2 ([0, T ]).
wT
Proposition 4.11. The definition (4.6) of the stochastic integral f (t)dBt
wT 0
can be extended to any function f ∈ L ([0, T ]). In this case,
2 f (t)dBt has
0
the centered Gaussian distribution
wT w
T

f (t)dBt ' N 0, |f (t)|2 dt
0 0
w
T
with mean E f (t)dBt = 0 and variance given by the Itô isometry
0
w "
wT 2 # w
T T
Var f (t)dBt = E f (t)dBt = |f (t)|2 dt. (4.10)
0 0 0
Proof. The extension of the stochastic integral to all functions satisfying

(4.9) is obtained by a denseness and Cauchy∗ sequence argument, based on
the isometry relation (4.10).
i) Given f a function satisfying (4.9), consider a sequence (fn )n∈N of sim-
ple functions converging to f in L2 ([0, T ]), i.e.
wT
r
lim kf − fn kL2 ([0,T ]) = lim |f (t) − fn (t)|2 dt = 0
n→∞ n→∞ 0
as in Proposition 4.8.
∗
See MH3100 Real Analysis I.
" 155
N. Privault
ii) By the isometry (4.10) and the triangle inequality∗ we have

w wT
T
f k ( t ) dBt − fn ( t ) dBt

0 0
L2 (Ω)
v "
u w wT 2 #
u T
= tE fk (t)dBt − fn (t)dBt
0 0
v "
u w 2 #
u T
= tE (fk (t) − fn (t))dBt
0
= kfk − fn kL2 ([0,T ])

6 kfk − f kL2 ([0,T ]) + kf − fn kL2 ([0,T ]) ,
r
T
which tends to 0 as k and n tend to infinity, hence 0 fn (t)dBt
n∈N
is a Cauchy sequence
r in L (Ω) by
2
for the L (Ω)-norm.
2
T
iii) Since the sequence 0 fn (t)dBt is Cauchy and the space L2 (Ω) is
n∈N
complete, cf. e.g. Theorem 3.11 in Rudin (1974) or Chapter 4 of Dudley
wT
(2002), we conclude that fn (t)dBt converges for the L2 -norm
0 n∈N
to a limit in L2 (Ω). In this case we let
wT wT
f (t)dBt := lim fn (t)dBt ,
0 n→∞ 0
which also satisfies (4.10) from (4.7) From (4.10) we can check that the
limit is independent of the approximating sequence (fn )n∈N .
iv) Finally, from the convergence of Gaussian characteristic functions
w w
T T
E exp iα f (t)dBt = E lim exp iα fn (t)dBt
0 n→∞ 0
w
T
= lim E exp iα fn (t)dBt
n→∞ 0
α2 w T

= lim exp − |fn (t)|2 dt
n→∞ 2 0
α2 w T

= exp − |f (t)|2 dt ,
2 0
wT
f ∈ L2 ([0, T ]), α ∈ R, we check that f (t)dBt has the centered Gaus-
0
sian distribution
∗
The triangle inequality kfk − fn kL2 ([0,T ]) 6 kfk − f kL2 ([0,T ]) + kf − fn kL2 ([0,T ])
follows from the Minkowski inequality.
156 "
wT w
T

f (t)dBt ' N 0, |f (t)|2 dt ,
0 0
see Theorem 23.11.

The next corollary is obtained by bilinearity from the Itô isometry (4.10).
Corollary 4.12. The stochastic integral with respect to Brownian motion
(Bt )t∈R+ satisfies the isometry
w wT w
T T
E f (t)dBt g (t)dBt = f (t)g (t)dt,
0 0 0
for all square-integrable deterministic functions f , g ∈ L2 ([0, T ]).

Proof. Applying the Itô isometry (4.10) to the processes f + g and f − g and
the relation xy = (x + y )2 /4 − (x − y )2 /4, we have
w wT
T
E f (t)dBt g (t)dBt
0 0
wT wT 2 w wT
" 2 #
1 T
= E f (t)dBt + g (t)dBt − f (t)dBt − g (t)dBt
4 0 0 0 0
wT wT
" # " 2 #
2
1 1

= E (f (t) + g (t))dBt − E (f (t) − g (t))dBt
4 0 4 0
1 w T 1 w T
= (f (t) + g (t))2 dt − (f (t) − g (t))2 dt
4 0 4 0
w
1 T
(f (t) + g (t))2 − (f (t) − g (t))2 dt

=
4 0
wT
= f (t)g (t)dt.
0

wT
−t
For example, the Wiener stochastic integral e dBt is a random variable
0
having centered Gaussian distribution with variance
wT 2 # w
"
T −2t
E e −t dBt = e dt
0 0
t=T
1

= − e −2t
2 t=0
1
= 1 − e −2T .

2
" 157
N. Privault
wT
Remark 4.13. The Wiener stochastic integral f (s)dBs is a Gaussian
0
random variable which cannot be “computed” in the way standard integral
are computed via the use of primitives. However, when f ∈ L2 ([0, T ]) is in
C 1 ([0, T ]),∗ we have the integration by parts relation
wT wT
f (t)dBt = f (T )BT − Bt f 0 (t)dt. (4.11)
0 0
When f ∈ L2 (R+ ) is in C 1 (R+ ) we also have following formula

w∞ w∞
f (t)dBt = − Bt f 0 (t)dt, (4.12)
0 0
provided that limt→∞ t|f (t)|2 = 0 and f ∈ L2 (R+ ), cf. e.g. Exercise 4.5 and
Remark 2.5.9 in Privault (2009).
4.4 Itô Stochastic Integral

In this section we extend the Wiener stochastic integral from deterministic
functions in L2 ([0, T ]) to random square-integrable (random) adapted pro-
cesses. For this, we will need the notion of measurability.
The extension of the stochastic integral to adapted random processes is

actually necessary in order to compute a portfolio value when the portfolio
process is no longer deterministic. This happens in particular when one needs
to update the portfolio allocation based on random events occurring on the
market.
A random variable F is said to be Ft -measurable if the knowledge of F

depends only on the information known up to time t. As an example, if
t =today,
• the date of the past course exam is Ft -measurable, because it belongs to
the past.
• the date of the next Chinese new year, although it refers to a future event,
is also Ft -measurable because it is known at time t.
• the date of the next typhoon is not Ft -measurable since it is not known
at time t.
• the maturity date T of the European option is Ft -measurable for all

t ∈ [0, T ], because it has been determined at time 0.
∗
This means that f is continuously differentiable on [0, T ].
158 "
• the exercise date τ of an American option after time t (see Section 15.1)
is not Ft -measurable because it refers to a future random event.
In the next definition, (Ft )t∈[0,T ] denotes the information flow defined in
(4.2), i.e.
F t : = σ ( Bs : 0 6 s 6 t ) , t > 0.
Definition 4.14. A stochastic process (Xt )t∈[0,T ] is said to be (Ft )t∈[0,T ] -
adapted if Xt is Ft -measurable for all t ∈ [0, T ].
For example,
- (Bt )t∈R+ is an (Ft )t∈R+ -adapted process,
- (Bt+1 )t∈R+ is not an (Ft )t∈R+ -adapted process,
- (Bt/2 )t∈R+ is an (Ft )t∈R+ -adapted process,
- B √t is not an (Ft )t∈R+ -adapted process,

t∈R+
- Maxs∈[0,t] Bs )t∈R+ is an (Ft )t∈R+ -adapted process,

w
t
- Bs ds is an (Ft )t∈R+ -adapted process,
0 t∈R
w +
t
- f (s)dBs is an (Ft )t∈[0,T ] -adapted process when f ∈ L2 ([0, T ]).
0 t∈[0,T ]
In other words, a stochastic process (Xt )t∈R+ is (Ft )t∈[0,T ] -adapted if the
value of Xt at time t depends only on information known up to time t. Note
that the value of Xt may still depend on “known” future data, for example
a fixed future date in the calendar, such as a maturity time T > t, as long as
its value is known at time t.
The next Figure 4.16 shows an adapted portfolio strategy on two assets,
constructed from a sign-switching signal based on spread data, see § 1.5 in
Privault (2020) and this R code.
" 159
N. Privault
350
Pair trading
0.2
300
0.1
250
Performance
Spread
0.0
200
−0.1
150
−0.2
100
−0.3
2017 2018 2019 2020 2017 2018 2019 2020
Fig. 4.16: Adapted pair trading portfolio strategy.
The stochastic integral of adapted processes is first constructed as integrals

of simple predictable processes.
Definition 4.15. A simple predictable processes is a stochastic process
(ut )t∈R+ of the form
n
Fi 1(ti−1 ,ti ] (t),
X
ut := t > 0, (4.13)
i=1
where Fi is an Fti−1 -measurable random variable for i = 1, 2, . . . , n, and

0 = t0 < t1 < · · · < tn−1 < tn = T .
For example, a natural approximation of (Bt )t∈R+ by a simple predictable
process can be constructed as
n n
Fi 1(ti−1 ,ti ] (t) := Bti−1 1(ti−1 ,ti ] (t),
X X
ut = t > 0, (4.14)
i=1 i=1
since Fi := Bti−1 is Fti−1 -measurable for i = 1, 2, . . . , n. The notion of simple

predictable process makes full sense in the context of portfolio investment,
in which Fi will represent an investment allocation decided at time ti−1 and
to remain unchanged over the time interval (ti−1 , ti ].
By convention, u : Ω × R+ −→ R is denoted in the sequel by ut (ω ), t ∈ R+ ,

ω ∈ Ω, and the random outcome ω is often dropped for convenience of
notation.
Definition 4.16. The stochastic integral with respect to Brownian motion
(Bt )t∈R+ of any simple predictable process (ut )t∈R+ of the form (4.13) is
defined by
wT Xn
ut dBt := Fi (Bti − Bti−1 ), (4.15)
0
i=1
with 0 = t0 < t1 < · · · < tn−1 < tn = T .
160 "
The use of predictability in the definition (4.15) is essential from a financial

point of view, as Fi will represent a portfolio allocation made at time ti−1 and
kept constant over the trading interval [ti−1 , ti ], while Bti − Bti−1 represents
a change in the underlying asset price over [ti−1 , ti ]. See also the related
discussion on self-financing portfolios in Section 5.3 and Lemma 5.15 on the
use of stochastic integrals to represent the value of a portfolio.
Definition 4.17. Let L2 (Ω × [0, T ]) denote the space of stochastic processes
u : Ω × [0, T ] −→ R
(ω, t) 7−→ ut (ω )
such that
s
wT
kukL2 (Ω×[0,T ]) := E |ut |2 dt < ∞, u ∈ L2 (Ω × [0, T ]).
0
The norm k · kL2 (Ω×[0,T ]) on L2 (Ω × [0, T ]) induces a distance between two

stochastic processes u and v in L2 (Ω × [0, T ]), defined as
s
wT
ku − vkL2 (Ω×[0,T ]) = E |ut − vt |2 dt .
0
Definition 4.18. Convergence in L2 (Ω × [0, T ]). We say that a sequence

u(n) n∈N of processes in L2 (Ω × [0, T ]) converges in L2 (Ω × [0, T ]) to an-

other process u ∈ L2 (Ω × [0, T ]) if

s
wT
(n)
lim u − u(n) L2 (Ω×[0,T ]) = lim E |ut − ut |2 dt = 0.

n→∞ n→∞ 0
By Lemma 1.1 of Ikeda and Watanabe (1989), pages 22 and 46, or Propo-
sition 2.5.3 in Privault (2009), the set of simple predictable processes forms
a linear space which is dense in the subspace L2ad (Ω × R+ ) made of square-
integrable adapted processes in L2 (Ω × R+ ), as stated in the next proposi-
tion.
Proposition 4.19. Given u a square-integrable adapted process there exists a
sequence (u(n) )n∈N of simple predictable processes converging to u in L2 (Ω ×
R+ ), i.e.
s
wT
lim u − u (n)
lim E ut − u(n) 2 dt = 0.

L (Ω×[0,T ])
2 = t
n→∞ n→∞ 0
The next Proposition 4.20 extends the construction of the stochastic integral
from simple predictable processes to square-integrable (Ft )t∈[0,T ] -adapted
" 161
N. Privault
processes (ut )t∈R+ for which the value of ut at time t can only depend on
information contained in the Brownian path up to time t.
This restriction means that the Itô integrand ut cannot depend on future
information, for example a portfolio strategy that would allow the trader
to “buy at the lowest” and “sell at the highest” is excluded as it would
require knowledge of future market data. Note that the difference between
Relation (4.16) below and Relation (4.10) is the presence of an expectation
on the right-hand side.
Proposition 4.20. The stochastic integral with respect to Brownian motion
(Bt )t∈R+ extends to all adapted processes (ut )t∈R+ such that
w
T
kuk2L2 (Ω×[0,T ]) := E |ut |2 dt < ∞,
0
with the Itô isometry

w 2 "
wT 2 # w
T T
:= E =E |ut |2 dt . (4.16)

0 ut dBt
ut dBt
2
L (Ω) 0 0
In addition, the Itô integral of an adapted process (ut )t∈R+ is always a cen-
tered random variable: w
T
E ut dBt = 0. (4.17)
0
Proof. We start by showing that the Itô isometry (4.16) holds for the simple
predictable process u of the form (4.13). We have
 !2 
wT n
" 2 # X
E ut dBt = E Fi (Bti − Bti−1 ) 
0
i=1
 ! n 
n
X X
= E Fi (Bti − Bti−1 )  Fj (Btj − Btj−1 )
i=1 j =1
 
n
X
= E Fi Fj (Bti − Bti−1 )(Btj − Btj−1 )
i,j =1
n
" #
X
=E 2
|Fi | (Bti − Bti−1 ) 2
i=1
 
X
+2E  Fi Fj (Bti − Bti−1 )(Btj − Btj−1 )
16i<j 6n
162 "
n
X
E |Fi |2 (Bti − Bti−1 )2

=
i=1
X
+2 E Fi Fj (Bti − Bti−1 )(Btj − Btj−1 )

16i<j 6n
n
X
= E[E[|Fi |2 (Bti − Bti−1 )2 |Fti−1 ]]
i=1
X
+2 E[E[Fi Fj (Bti − Bti−1 )(Btj − Btj−1 )|Ftj−1 ]]
16i<j 6n
n
X
= E[|Fi |2 E[(Bti − Bti−1 )2 |Fti−1 ]]
i=1
X
+2 E Fi Fj (Bti − Bti−1 ) E[(Btj − Btj−1 )|Ftj−1 ]

16i<j 6n
| {z }
=0
n
X
E |Fi |2 E (Bti − Bti−1 )2

=
i=1
X
+2 E[Fi Fj (Bti − Bti−1 ) E[Btj − Btj−1 ]]
16i<j 6n
| {z }
=0
n
X
= E[|Fi | (ti − ti−1 )]
2
i=1
" n #
X
=E |Fi |2 (ti − ti−1 )
i=1
hw T i
=E |ut |2 dt ,
0
where we applied the tower property (23.38) of conditional expectations and

the facts that Bti − Bti−1 is independent of Fti−1 , with
E[Bti − Bti−1 ] = 0, E (Bti − Bti−1 )2 = ti − ti−1 , i = 1, 2, . . . , n.

u2
6
F22 b r
b r b r
F12
F42 b r
-
t0 t1 t2 t3 t4 t
Fig. 4.17: Squared simple predictable process t 7→ u2 (t).
" 163
N. Privault
The extension of the stochastic integral to square-integrable adapted pro-

cesses (ut )t∈R+ is obtained by a denseness and Cauchy sequence argument
using the isometry (4.16), in the same way as in the proof of Proposition 4.11.
i) By Proposition 4.19 given u ∈ L2 (Ω × [0, T ]) a square-integrable adapted
process there exists a sequence (u(n) )n∈N of simple predictable processes
such that
r hw
T i
lim ku − u(n) k 2 = lim E ut − u(n) 2 dt = 0.
n→∞ L (Ω×[0,T ]) n→∞ 0 t
ii) Since the sequence (u(n) )n∈N converges it is a Cauchy sequence in
r T (n)
L2 (Ω × R+ ), hence by the Itô isometry (4.16), the sequence 0 ut dBt
n∈N
is a Cauchy sequence in L2 (Ω), therefore it admits a limit in the com-
plete space L2 (Ω). In this case we let
wT wT
(n)
ut dBt := lim ut dBt
0 n→∞ 0
and the limit is unique from (4.16) and satisfies (4.16).

wT
iii) The fact that the random variable ut dBt is centered can be proved
0
first on simple predictable process u of the form (4.13) as
w " n #
T X
E ut dBt = E Fi (Bti − Bti−1 )
0
i=1
n
X
= E[E[Fi (Bti − Bti−1 ) | Fti−1 ]]
i=1
Xn
= E[Fi E[Bti − Bti−1 | Fti−1 ]]
i=1
Xn
= E[Fi E[Bti − Bti−1 ]]
i=1
= 0,
and this identity extends as above from simple predictable processes to

adapted processes (ut )t∈R+ in L2 (Ω × R+ ).

As an application of the Itô isometry (4.16), we note in particular the identity
wT w w wT
" 2 #
T T T2
E =E |Bt |2 dt = E |Bt |2 dt = ,

Bt dBt tdt =
0 0 0 0 2
164 "
with
wT L2 (Ω)
n
X
lim

Bt dBt = Bti−1 Bti − Bti−1
0 n→∞
i=1
from (4.14).
The next corollary is obtained by bilinearity from the Itô isometry (4.16) by
the same argument as in Corollary 4.12.
Corollary 4.21. The stochastic integral with respect to Brownian motion
(Bt )t∈R+ satisfies the isometry
w wT w
T T
E ut dBt vt dBt = E ut vt dt ,
0 0 0
for all square-integrable adapted processes (ut )t∈R+ , (vt )t∈R+ .

Proof. Applying the Itô isometry (4.16) to the processes u + v and u − v, we
have
w wT
T
E ut dBt vt dBt
0 0
w wT 2 w wT
" 2 #!
1 T T
= E ut dBt + vt dBt − ut dBt − vt dBt
4 0 0 0 0
wT wT
" # " 2 #!
2
1

= E (ut + vt )dBt −E (ut − vt )dBt
4 0 0
w w
1

T T
= E (ut + vt )2 dt − E (ut − vt )2 dt
4 0 0
w
1

T
= E (ut + vt ) − (ut − vt )2 dt
2

4 0
w
T
=E ut vt dt .
0

In addition, when the integrand (ut )t∈R+ is not a deterministic function of
wT
time, the random variable ut dBt no longer has a Gaussian distribution,
0
except in some exceptional cases.
Definite stochastic integral
The definite stochastic integral of an adapted process u ∈ L2ad (Ω × R+ ) over

an interval [a, b] ⊂ [0, T ] is defined as
" 165
N. Privault
wb wT
ut dBt := 1[a,b] (t)ut dBt ,
a 0
with in particular
wb wT
dBt = 1[a,b] (t)dBt = Bb − Ba , 0 6 a 6 b,
a 0
We also have the Chasles relation

wc wb wc
ut dBt = ut dBt + ut dBt , 0 6 a 6 b 6 c,
a a b
and the stochastic integral has the following linearity property:

wT wT wT
(ut + vt )dBt = ut dBt + vt dBt , u, v ∈ L2 (R+ ).
0 0 0
4.5 Stochastic Calculus
Fig. 4.18: NGram Viewer output for the term "stochastic calculus".
Stochastic modeling of asset returns
In the sequel we will construct the return at time t ∈ R+ of the risky asset
(St )t∈R+ as
dSt
= µdt + σdBt , or dSt = µSt dt + σSt dBt . (4.18)
St
with µ ∈ R and σ > 0. Using the relation
wT
XT = X0 + dXt , T > 0,
0
which holds for any process (Xt )t∈R+ , Equation (4.18) can be rewritten in
integral form as
166 "
wT wT wT
ST = S0 + dSt = S0 + µ St dt + σ St dBt , (4.19)
0 0 0
hence the need to define an integral with respect to dBt , in addition to the
usual integral with respect to dt. Note that in view of the definition (4.15),
this is a continuous-time extension of the notion portfolio value based on a
predictable portfolio strategy.
In Proposition 4.20 we have defined the stochastic integral of square-

integrable processes with respect to Brownian motion, thus we have made
sense of the equation (4.19) where (St )t∈R+ is an (Ft )t∈[0,T ] -adapted pro-
cess, which can be rewritten in differential notation as in (4.18).
This model will be used to represent the random price St of a risky asset
at time t. Here the return dSt /St of the asset is made of two components: a
constant return µdt and a random return σdBt parametrized by the coeffi-
cient σ, called the volatility.
Our goal is now to solve Equation (4.18), and for this we will need to introduce
Itô’s calculus in Section 4.5 after a review of classical deterministic calculus.
Deterministic calculus
The fundamental theorem of calculus states that for any continuously differ-
entiable (deterministic) function f we have the integral relation
wx
f (x) = f (0) + f 0 (y )dy.
0
In differential notation this relation is written as the first order expansion
df (x) = f 0 (x)dx, (4.20)
where dx is “infinitesimally small”. Higher-order expansions can be obtained

from Taylor’s formula, which, letting
∆f (x) := f (x + ∆x) − f (x),
states that
1 1 1
∆f (x) = f 0 (x)∆x + f 00 (x)(∆x)2 + f 000 (x)(∆x)3 + f (4) (x)(∆x)4 + · · · .
2 3! 4!
Note that Relation (4.20), i.e. df (x) = f 0 (x)dx, can be obtained by neglecting
all terms of order higher than one in Taylor’s formula, since (∆x)n << ∆x,
n > 2, as ∆x becomes “infinitesimally small”.
" 167
N. Privault
Stochastic calculus
Let us now apply Taylor’s formula to Brownian motion, taking

√
∆Bt = Bt+∆t − Bt ' ± ∆t,
and letting
∆f (Bt ) := f (Bt+∆t ) − f (Bt ),
we have
∆f (Bt )
1 1 1
= f 0 (Bt )∆Bt + f 00 (Bt )(∆Bt )2 + f 000 (Bt )(∆Bt )3 + f (4) (Bt )(∆Bt )4 + · · · .
2 3! 4!
From
√ the construction of Brownian motion by its small increments ∆Bt =
± ∆t, it turns out that the terms in (∆t)2 and ∆t∆Bt ' ±(∆t)3/2 can
be neglected in Taylor’s formula at the first order of approximation in ∆t.
However, the term of order two
√
(∆Bt )2 = (± ∆t)2 = ∆t
can no longer be neglected in front of ∆t itself.
Basic Itô formula
For f ∈ C 2 (R), Taylor’s formula written at the second order for Brownian
motion reads
1
df (Bt ) = f 0 (Bt )dBt + f 00 (Bt )dt, (4.21)
2
for “infinitesimally small” dt. Note that writing this formula as
df (Bt ) dBt 1
= f 0 ( Bt ) + f 00 (Bt )
dt dt 2
does not make sense because the pathwise derivative
√
dBt dt 1
'± ' ± √ ' ±∞
dt dt dt
of Bt with respect to t does not exist. Integrating (4.21) on both sides and
using the relation wt
f (Bt ) − f (B0 ) = df (Bs )
0
we get the integral form of Itô’s formula for Brownian motion, i.e.
168 "
wt 1 w t 00
f (Bt ) = f (B0 ) + f 0 (Bs )dBs + f (Bs )ds.
0 2 0
Itô processes
We now turn to the general expression of Itô’s formula, which is stated for
Itô processes.
Definition 4.22. An Itô process is a stochastic process (Xt )t∈R+ that can
be written as
wt wt
Xt = X0 + vs ds + us dBs , t > 0, (4.22)
0 0
or in differential notation
dXt = vt dt + ut dBt ,
where (ut )t∈R+ and (vt )t∈R+ are square-integrable adapted processes.
Given (t, x) 7→ f (t, x) a smooth function of two variables on R+ × R, from
∂f
now on we let denote partial differentiation with respect to the first (time)
∂t
∂f
variable in f (t, x), while denotes partial differentiation with respect to
∂x
the second (price) variable in f (t, x).
Theorem 4.23. (Itô formula for Itô processes). For any Itô process (Xt )t∈R+
of the form (4.22) and any f ∈ C 1,2 (R+ × R) we have
f (t, Xt )
w t ∂f w t ∂f w t ∂f
= f (0, X0 ) + (s, Xs )ds + vs (s, Xs )ds + us (s, Xs )dBs
0 ∂s 0 ∂x 0 ∂x
1wt 2
2∂ f
+ |us | (s, Xs )ds. (4.23)
2 0 ∂x2
Proof. The proof of the Itô formula can be outlined as follows in the case
where (Xt )t∈R+ = (Bt )t∈R+ is a standard Brownian motion and f (x) does
not depend on time t. We refer to Theorem II-32, page 79 of Protter (2004)
for the general case.
Let {0 = tn0 6 tn1 6 · · · 6 tnn = t}, n > 1, be a refining sequence of

partitions of [0, t] tending to the identity. We have the telescoping identity
n
X
f (Btni ) − f (Btni−1 ) ,

f ( Bt ) − f ( B0 ) =
k =1
" 169
N. Privault
and from Taylor’s formula
∂f 1 ∂2f
f (y ) − f (x) = (y − x) (x) + (y − x)2 2 (x) + R(x, y ),
∂x 2 ∂x
where the remainder R(x, y ) satisfies R(x, y ) 6 o(|y − x|2 ), we get
n
X ∂f 1 ∂2f
f ( Bt ) − f ( B0 ) = (Btni − Btni−1 ) (Btni−1 ) + |Btni − Btni−1 |2 2 (Btni−1 )
∂x 2 ∂x
k =1
n
X
+ R(Btni , Btni−1 ).
k =1
It remains to show that as n tends to infinity the above converges to

w t ∂f 1 w t ∂2f
f ( Bt ) − f ( B0 ) = (Bs )dBs + (Bs )ds.
0 ∂x 2 0 ∂x2

From the relation
wt
df (s, Xs ) = f (t, Xt ) − f (0, X0 ),
0
we can rewrite (4.23) as

wt wt ∂f w t ∂f
df (s, Xs ) = vs (s, Xs )ds + us (s, Xs )dBs
0 0 ∂x 0 ∂x
w t ∂f 1wt ∂2f
+ (s, Xs )ds + |us |2 2 (s, Xs )ds,
0 ∂s 2 0 ∂x
which allows us to rewrite (4.23) in differential notation, as
df (t, Xt ) (4.24)
∂f ∂f ∂f 1 ∂2f
= (t, Xt )dt + vt (t, Xt )dt + ut (t, Xt )dBt + |ut |2 2 (t, Xt )dt.
∂t ∂x ∂x 2 ∂x
In case the function x 7→ f (x) does not depend on the time variable t we get
∂f ∂f 1 ∂2f
df (Xt ) = ut (Xt )dBt + vt (Xt )dt + |ut |2 2 (Xt )dt.
∂x ∂x 2 ∂x
Taking ut = 1, vt = 0 and X0 = 0 in (4.22) yields Xt = Bt , in which case

the Itô formula (4.23) reads
170 "
w t ∂f w t ∂f 1 w t ∂2f
f (t, Bt ) = f (0, B0 ) + (s, Bs )ds + (s, Bs )dBs + (s, Bs )ds,
0 ∂s 0 ∂x 2 0 ∂x2
i.e. in differential notation:
∂f ∂f 1 ∂2f
df (t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt. (4.25)
∂t ∂x 2 ∂x2
Bivariate Itô formula
Next, consider two Itô processes (Xt )t∈R+ and (Yt )t∈R+ written in integral
form as wt wt
Xt = X0 + vs ds + us dBs , t > 0,
0 0
and wt wt
Yt = Y0 + bs ds + as dBs , t > 0,
0 0
or in differential notation as
dXt = vt dt + ut dBt , and dYt = bt dt + at dBt , t > 0.
The Itô formula can also be written for functions f ∈ C 1,2,2 (R+ × R2 ) of two
state variables as
∂f ∂f 1 ∂2f
df (t, Xt , Yt ) = (t, Xt , Yt )dt + (t, Xt , Yt )dXt + |ut |2 2 (t, Xt , Yt )dt
∂t ∂x 2 ∂x
∂f 1 ∂2f ∂2f
+ (t, Xt , Yt )dYt + |at |2 2 (t, Xt , Yt )dt + ut at (t, Xt , Yt )dt.
∂y 2 ∂y ∂x∂y
(4.26)
Itô multiplication table
Applying the bivariate Itô formula (4.26) to be function f (x, y ) = xy shows

that
d(Xt Yt ) = Xt dYt + Yt dXt + dXt • dYt (4.27)
where the product dXt • dYt is computed according to the Itô rule
dt • dt = 0, dt • dBt = 0, dBt • dBt = dt, (4.28)
which can be encoded in the following Itô multiplication table:
" 171
N. Privault
• dt dBt
dt 0 0
dBt 0 dt
Table 4.1: Itô multiplication table.
It follows from the Itô Table 4.1 that
dXt • dYt = (vt dt + ut dBt ) • (bt dt + at dBt )

= bt vt (dt)2 + bt ut dtdBt + at vt dtdBt + at ut (dBt )2
= at ut dt.
Hence we also have
(dXt )2 = (vt dt + ut dBt )2

= (vt )2 (dt)2 + (ut )2 (dBt )2 + 2ut vt (dt • dBt )
= (ut )2 dt,
according to the Itô Table 4.1. Consequently, (4.24) can be rewritten as
∂f ∂f 1 ∂2f
df (t, Xt ) = (t, Xt )dt + (t, Xt )dXt + (t, Xt )dXt • dXt ,
∂t ∂x 2 ∂x2
(4.29)
and the Itô formula for functions f ∈ C 1,2,2 (R+ × R2 ) of two state variables
can be rewritten as
∂f ∂f 1 ∂2f
df (t, Xt , Yt ) = (t, Xt , Yt )dt + (t, Xt , Yt )dXt + (t, Xt , Yt )(dXt )2
∂t ∂x 2 ∂x2
∂f 1 ∂2f ∂2f
+ (t, Xt , Yt )dYt + (t, Xt , Yt )(dYt )2 + (t, Xt , Yt )(dXt • dYt ).
∂y 2 ∂y 2 ∂x∂y
Examples
Applying Itô’s formula (4.25) to Bt2 with
Bt2 = f (t, Bt ) and f (t, x) = x2 ,
and
∂f ∂f 1 ∂2f
(t, x) = 0, (t, x) = 2x, (t, x) = 1,
∂t ∂x 2 ∂x2
172 "
we find
d(Bt2 ) = df (Bt )
∂f ∂f 1 ∂2f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂x2
= 2Bt dBt + dt.
Note that from the Itô Table 4.1 we could also write directly
d(Bt2 ) = Bt dBt + Bt dBt + (dBt )2 = 2Bt dBt + dt.
Next, by integration in t ∈ [0, T ] we find

wT wT wT
BT2 = B0 + 2 Bs dBs + dt = 2 Bs dBs + T , (4.30)
0 0 0
hence the relation

wT 1
BT2 − T , (4.31)

Bs dBs =
0 2
wT
see Exercise 4.12 for the probability distribution of Bs dBs .
0
Similarly, we have
i) d Bt3 = 3(Bt )2 dBt + 3Bt dt.

Letting f (x) := x3 with f 0 (x) = 3x2 and f 00 (x) = 6x, we have

1
d(Bt3 ) = df (Bt ) = f 0 (Bt )dBt + f 00 (Bt )dt = 3(Bt )2 dBt + 3Bt dt.
2
1
ii) d(sin Bt ) = cos(Bt )dBt − sin(Bt )dt.
2
Letting f (x) := sin(x) with f 0 (x) = cos(x), f 00 (x) = − sin(x), we have
d sin(Bt ) = df (Bt )
1
= f 0 (Bt )dBt + f 00 (Bt )dt
2
1
= cos(Bt )dBt − sin(Bt )dt.
2
1 Bt
iii) d e Bt = e Bt dBt + e dt.
2
Letting f (x) := e x with f 0 (x) = e x , f 00 (x) = e x , we have
d e Bt = df (Bt )
" 173
N. Privault
1
= f 0 (Bt )dBt + f 00 (Bt )dt
2
1
= e tBt dBt + e tBt dt.
2
1 1
iv) d log Bt = dBt − dt.
Bt 2 ( Bt ) 2
Letting f (x) := log x with f 0 (x) = 1/x and f 00 (x) = −1/x2 , we have
1 dBt dt
d log Bt = df (Bt ) = f 0 (Bt )dBt + f 00 (Bt )dt = − .
2 Bt 2 ( Bt ) 2
t2 tBt
v) d e tBt = Bt e tBt dt + e dt + t e tBt dBt .
2
Letting f (t, x) := e xt with
∂f ∂f ∂2f
(t, x) = x e xt , (t, x) = t e xt , (t, x) = t2 e xt ,
∂t ∂x ∂x2
we have
d e tBt = df (t, Bt )
∂f ∂f 1 ∂2f
∂t ∂x 2 ∂x2
t2
= Bt e tBt dt + t e tBt dBt + e tBt dt.
2
1
vi) d cos(2t + Bt ) = 2 sin(2t + Bt )dt + sin(2t + Bt )dBt − cos(2t + Bt )dt.
2
Letting f (t, x) := cos(2t + x) with
∂f ∂f ∂2f
(t, x) = 2 sin(2t + x), (t, x) = sin(2t + x), (t, x) = − cos(2t + x),
∂t ∂x ∂x2
we have
d cos(2t + Bt ) = df (t, Bt )
∂f ∂f 1 ∂2f
∂t ∂x 2 ∂x2
1
= 2 sin(2t + Bt )dt + sin(2t + Bt )dBt − cos(2t + Bt )dt.
2
174 "
Notation
We close this section with some comments on the practice of Itô’s calculus. In
certain finance textbooks, Itô’s formula for e.g. geometric Brownian motion
(St )t∈R+ given by
dSt = µSt dt + σSt dBt
can be found written in the notation
wT ∂f wT ∂f
f (T , ST ) = f (0, X0 ) + σ St (t, St )dBt + µ St (t, St )dt
0 ∂St 0 ∂St
w T ∂f 1 w T 2
∂ f
+ (t, St )dt + σ 2 St2 2 (t, St )dt,
0 ∂t 2 0 ∂St
or
∂f ∂f 1 ∂2f
df (St ) = σSt (St )dBt + µSt (St )dt + σ 2 St2 2 (St )dt.
∂St ∂St 2 ∂St
∂f
The notation (St ) can in fact be easily misused in combination with the
∂St
fundamental theorem of classical calculus, and potentially leads to the wrong
identity
∂f

df (S = (St )dSt ,
t)
∂St
as in the following actual example:
Fig. 4.19: Wrong application of Itô’s formula (sample).
Similarly, writing
∂f 1 ∂2f
df (Bt ) = (Bt )dBt + (Bt )dt
∂x 2 ∂x2
is consistent, while writing
∂f (Bt ) 1 ∂ 2 f ( Bt )
df (Bt ) = dBt + dt
∂Bt 2 ∂Bt2
" 175
N. Privault
is potentially a source of confusion. Note also that the right-hand side of the
Itô formula uses partial derivatives while its left-hand side is a total derivative.
Stochastic differential equations
In addition to geometric Brownian motion there exists a large family of

stochastic differential equations that can be studied, although most of the
time they cannot be explicitly solved. Let now
σ : R+ × Rn −→ Rd ⊗ Rn
where Rd ⊗ Rn denotes the space of d × n matrices, and
b : R+ × Rn −→ R
satisfy the global Lipschitz condition
kσ (t, x) − σ (t, y )k2 + kb(t, x) − b(t, y )k2 6 K 2 kx − yk2 ,
t ∈ R+ , x, y ∈ Rn . Then there exists a unique strong solution to the stochastic

differential equation
wt wt
Xt = X0 + b(s, Xs )ds + σ (s, Xs )dBs , t > 0, (4.32)
0 0
i.e., in differential notation
dXt = b(t, Xt )dt + σ (t, Xt )dBt , t > 0,
where (Bt )t∈R+ is a d-dimensional Brownian motion, see e.g. Protter (2004),
Theorem V-7. In addition, the solution process (Xt )t∈R+ of (4.32) has the
Markov property, see § V-6 of Protter (2004).
The term σ (s, Xs ) in (4.32) will be interpreted later on in Chapters 8-9 as a

local volatility component.
Stochastic differential equations can be used to model the behaviour of a

variety of quantities, such as
• stock prices,
• interest rates,
• exchange rates,
• weather factors,
• electricity/energy demand,
• commodity (e.g. oil) prices, etc.
Next, we consider several examples of stochastic differential equations that
can be solved explicitly using Itô’s calculus, in addition to geometric Brown-
176 "
ian motion. See e.g. § II-4.4 of Kloeden and Platen (1999) for more examples
of explicitly solvable stochastic differential equations.
Examples of stochastic differential equations
1. Consider the mean-reverting stochastic differential equation
dXt = −αXt dt + σdBt , X0 = x0 , (4.33)
with α > 0 and σ > 0.

N=10000; t <- 0:(N-1); dt <- 1.0/N;alpha=5; sigma=0.4;
Z <- rnorm(N,mean=0,sd=sqrt(dt));X <- rep(0,N);X[1]=0.5
for (j in 2:N){X[j]=X[j-1]-alpha*X[j-1]*dt+sigma*Z[j]}
plot(t, X, xlab = "t", ylab = "", type = "l", ylim = c(-0.5,1), col = "blue")
abline(h=0)
0.6
0.5
0.4
0.3
Xt
0.2
0.1
-0.1
-0.2
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Fig. 4.20: Simulated path of (4.33) with α = 10, σ = 0.2 and X0 = 0.5.
We look for a solution of the form

wt
Xt = a(t)Yt = a(t) x0 + b(s)dBs
0
where a(·) and b(·) are deterministic functions of time. After applying
rt
Theorem 4.23 to the Itô process x0 + 0 b(s)dBs of the form (4.22) with
ut = b(t) and v (t) = 0, and to the function f (t, x) = a(t)x, we find
dXt = d(a(t)Yt )
= Yt a0 (t)dt + a(t)dYt
= Yt a0 (t)dt + a(t)b(t)dBt . (4.34)
By identification of (4.33) with (4.34), we get
" 177
N. Privault
 0
 a (t) = −αa(t)
a(t)b(t) = σ,

hence a(t) = a(0) e −αt = e −αt and b(t) = σ/a(t) = σ e αt , which shows
that wt
Xt = x0 e −αt + σ e −(t−s)α dBs , t > 0, (4.35)
0
Using integration by parts, we can also write
wt
Xt = x0 e −αt + σBt − σα e −(t−s)α Bs ds, t > 0, (4.36)
0
Remark: the solution of the equation (4.33) cannot be written as a func-

tion f (t, Bt ) of t and Bt as in the proof of Proposition 5.16.
2. Consider the stochastic differential equation
2 /2
dXt = tXt dt + e t dBt , X0 = x0 . (4.37)
N=10000; T<-2.0; t <- 0:(N-1); dt <- T/N;

Z <- rnorm(N,mean=0,sd= sqrt(dt));X <- rep(0,N);X[1]=0.5
for (j in 2:N){X[j]=X[j-1]+j*X[j-1]*dt*dt+exp(j*dt*j*dt/2)*Z[j]}
plot(t, X, xlab = "t", ylab = "", type = "l", ylim = c(-0.5,10), col = "blue")
abline(h=0)
rt
Looking for a solution of the form Xt = a(t) X0 + 0 b(s)dBs , where
a(·) and b(·) are deterministic functions of time, we get a0 (t)/a(t) = t
2 2
and a(t)b(t) = e t /2 , hence a(t) = e t /2 and b(t) = 1, which yields
2 /2
Xt = e t (X0 + Bt ), t > 0.
7
4
Xt
3
-1
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
t
Fig. 4.21: Simulated path of (4.37).
3. Consider the stochastic differential equation

p
dYt = (−2αYt + σ 2 )dt + 2σ Yt dBt , (4.38)
178 "
where α ∈ R and σ > 0.
N=10000; t <- 0:(N-1); dt <- 1.0/N;mu=-5;sigma=1;

Z <- rnorm(N,mean=0,sd=sqrt(dt));Y <- rep(0,N);Y[1]=0.5
for (j in 2:N){
Y[j]=max(0,Y[j-1]+(2*mu*Y[j-1]+sigma*sigma)*dt+2*sigma*sqrt(Y[j-1])*Z[j])}
plot(t, Y, xlab = "t", ylab = "", type = "l", ylim = c(-0.1,1), col = "blue")
abline(h=0)
√
Letting Xt = Yt , we find that dXt = −αXt dt + σdBt , hence by (4.35)
we obtain
wt 2
e −αt e −(t−s)α dBs
p
Yt = (Xt )2 = Y0 + σ .
0
0.7
0.6
0.5
0.4
Yt
0.3
0.2
0.1
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Fig. 4.22: Simulated path of (4.38) with α = −5 and σ = 1.
Exercises
Exercise 4.1 Compute E[Bt Bs ] in terms of s, t > 0.
Exercise 4.2 Let (Bt )t∈R+ denote a standard Brownian motion. Let c > 0.
Among the following processes, tell which is a standard Brownian motion
and which is not. Justify your answer.
a) (Xt )t∈R+ := Bc+t − Bc t∈R ,

+
b) (Xt )t∈R+ := Bct2 t∈R ,

+
c) (Xt )t∈R+ := cBt/c2 t∈R ,
+
d) (Xt )t∈R+ := Bt + Bt/2 t∈R .
+
Exercise 4.3 Let (Bt )t∈R+ denote a standard Brownian motion. Compute
the stochastic integrals
wT wT
2dBt and 2 × 1[0,T /2] (t) + 1(T /2,T ] (t) dBt

0 0
" 179
N. Privault
and determine their probability distributions (including mean and variance).
Exercise 4.4 Determine the probability distribution (including mean and

w 2π
variance) of the stochastic integral sin(t) dBt .
0
Exercise 4.5 Let T > 0. Show that for f : [0, T ] 7→ R a differentiable function
such that f (T ) = 0, we have
wT wT
f (t)dBt = − f 0 (t)Bt dt.
0 0
Hint: Apply Itô’s calculus to t 7→ f (t)Bt .
Exercise 4.6 Let (Bt )t∈R+ denote a standard Brownian motion.

r1
a) Find the probability distribution of the stochastic integral 0 t2 dBt .
r1
b) Find the probability distribution of the stochastic integral 0 t−1/2 dBt .
Exercise 4.7 Given (Bt )t∈R+ a standard Brownian motion and n > 1, let
the random variable Xn be defined as
w 2π
Xn := sin(nt)dBt , n > 1.
0
a) Give the probability distribution of Xn for all n > 1.

b) Show that (Xn )n>1 is a sequence of identically distributed and pairwise
independent random variables.
1
Hint: We have sin a sin b = cos(a − b) − cos(a + b) , a, b ∈ R.

2
Exercise 4.8 Apply the Itô formula to the process Xt := sin2 (Bt ), t > 0.

a) Using the Itô isometry and the known relations
wT wT
BT = dBt and BT2 = T + 2 Bt dBt ,
0 0
compute the third and fourth moments E[BT3 ] and E[BT4 ].

b) Give the third and fourth moments of the centered normal distribution
with variance σ 2 .
Exercise 4.10 Given T > 0, find the stochastic integral decomposition of

(BT )3 as
180 "
wT
( BT ) 3 = C + ζt,T dBt (4.39)
0
where C ∈ R is a constant and (ζt,T )t∈[0,T ] is an adapted process to be de-
termined.
Exercise 4.11 Let f ∈ L2 ([0, T ]), and consider a standard Brownian motion
(Bt )t∈[0,T ] .
a) Compute the conditional expectation
h rT i
E e 0 f (s)dBs Ft , 0 6 t 6 T,
where (Ft )t∈[0,T ] denotes the filtration generated by (Bt )t∈[0,T ] .

b) Using the result of Question (a), show that the process
w
1wt 2

t
t 7−→ exp f (s)dBs − f (s)ds , 0 6 t 6 T,
0 2 0
is an (Ft )t∈[0,T ] -martingale, where (Ft )t∈[0,T ] denotes the filtration gen-
erated by (Bt )t∈[0,T ] .
c) By applying the result of Question (b) to the function f (t) := σ 1[0,T ] (t),
2
show that the process e σBt −σt /2 t∈[0,T ] is an (Ft )t∈[0,T ] -martingale for

any σ ∈ R.
Exercise 4.12
a) Compute the moment generating function
w
T
E exp β Bt dBt
0
for all β < 1/T .

Hint: Expand (BT )2 using the Itô formula as in (4.30).
wT
b) Find the probability distribution of the stochastic integral β Bt dBt .
0
Exercise 4.13
a) Solve the stochastic differential equation
dXt = −bXt dt + σ e −bt dBt , t > 0, (4.40)
where (Bt )t∈R+ is a standard Brownian motion and σ, b ∈ R.
" 181
N. Privault
b) Solve the stochastic differential equation
dXt = −bXt dt + σ e −at dBt , t > 0, (4.41)
where (Bt )t∈R+ is a standard Brownian motion and a, b, σ > 0 are posi-
tive constants.
Exercise 4.14 Given T > 0, let (Xt )t∈[0,T ) denote the solving the stochastic
Xt
dXt = σdBt − dt, t ∈ [0, T ), (4.42)
T −t
under the initial condition X0 = 0 and σ > 0.
a) Show that
wt σ
Xt = (T − t) dBs , 0 6 t < T.
0 T −s
Hint: Start by computing d(Xt /(T − t)) using the Itô formula.
b) Show that E[Xt ] = 0 for all t ∈ [0, T ).
c) Show that Var[Xt ] = σ 2 t(T − t)/T for all t ∈ [0, T ).
d) Show that limt→T Xt = 0 in L2 (Ω). The process (Xt )t∈[0,T ] is called a
Brownian bridge.
Exercise 4.15 Exponential Vašíček (1977) model (1). Consider a Vasicek

process (rt )t∈R+ solving of the stochastic differential equation
drt = (a − brt )dt + σdBt , t > 0,
where (Bt )t∈R+ is a standard Brownian motion and σ, a, b > 0 are positive
constants. Show that the exponential Xt := e rt satisfies a stochastic differ-
ential equation of the form
a − ebf (Xt ) dt + σg (Xt )dBt ,

dXt = Xt e
where the coefficients e

a and eb and the functions f (x) and g (x) are to be
determined.
Exercise 4.16 Exponential Vasicek model (2). Consider a short-term rate

interest rate process (rt )t∈R+ in the exponential Vasicek model:
drt = (η − a log rt )rt dt + σrt dBt , (4.43)
where η, a, σ are positive parameters and (Bt )t∈R+ is a standard Brownian

motion.
182 "
a) Find the solution (Zt )t∈R+ of the stochastic differential equation
dZt = −aZt dt + σdBt
as a function of the initial condition Z0 , where a and σ are positive pa-

rameters.
b) Find the solution (Yt )t∈R+ of the stochastic differential equation
dYt = (θ − aYt )dt + σdBt (4.44)
as a function of the initial condition Y0 . Hint: Let Zt := Yt − θ/a.

c) Let Xt = e Yt , t ∈ R+ . Determine the stochastic differential equation
satisfied by (Xt )t∈R+ .
d) Find the solution (rt )t∈R+ of (4.43) in terms of the initial condition r0 .
e) Compute the conditional mean∗ E[rt |Fu ].
f) Compute the conditional variance
Var[rt |Fu ] := E[rt2 |Fu ] − (E[rt |Fu ])2
of rt , 0 6 u 6 t, where (Fu )u∈R+ denotes the filtration generated by the

Brownian motion (Bt )t∈R+ .
g) Compute the asymptotic mean and variance limt→∞ E[rt ] and limt→∞ Var[rt ].
Exercise 4.17 Cox-Ingersoll-Ross (CIR) model. Consider the equation

√
drt = (α − βrt )dt + σ rt dBt (4.45)
modeling the variations of a short-term interest rate process rt , where α, β, σ

and r0 are positive parameters and (Bt )t∈R+ is a standard Brownian motion.
a) Write down the equation (4.45) in integral form.
b) Let u(t) = E[rt ]. Show, using the integral form of (4.45), that u(t) satisfies
the differential equation
u0 (t) = α − βu(t),
and compute E[rt ] for all t > 0.

c) By an application of Itô’s formula to rt2 , show that
drt2 = rt (2α + σ 2 − 2βrt )dt + 2σrt3/2 dBt . (4.46)
d) Using the integral form of (4.46), find a differential equation satisfied by

v (t) := E[rt2 ] and compute E[rt2 ] for all t > 0.
2
/2
∗
One may use the Gaussian moment generating function E[ e X ] = e α for X '
N (0, α2 ).
" 183
N. Privault
e) Show that
σ 2 −βt ασ 2 2
Var[rt ] = r0 e − e −2βt + 1 − e −βt , t > 0.
β 2β 2
Problem 4.18 Itô-Tanaka formula. Let (Bt )t∈R+ be a standard Brownian

motion started at B0 ∈ R.
a) Does the Itô formula apply to the European call option payoff function
f (x) := (x − K )+ ? Why?
b) For every ε > 0, consider the approximation fε (x) of f (x) := (x − K )+
defined by
if x > K + ε,

x−K



1


fε (x) := (x − K + ε)2 if K − ε < x < K + ε,

 4ε



0 if x < K − ε.

Plot the graph of the function x 7→ fε (x) for ε = 1 and K = 10.

c) Using the Itô formula, show that
wT
fε (BT ) = fε (B0 ) + fε0 (Bt )dBt (4.47)
0
1
+ ` t ∈ [0, T ] : K − ε < Bt < K + ε ,

4ε
where ` denotes the measure of time length (Lebesgue measure) in R.
d) Show that limε→0 k1[K,∞) (·) − fε0 (·)kL2 (R+ ) = 0.
e) Show, using the Itô isometry,∗ that the limit
1
[0,T ] : = lim
LK
ε→0 2ε
`({t ∈ [0, T ] : K − ε < Bt < K + ε})
exists in L2 (Ω), and prove the Itô-Tanaka formula

wT 1
(BT − K )+ = (B0 − K )+ + 1[K,∞) (Bt )dBt + LK
[0,T ] . (4.48)
0 2
[0,T ] is called the local time spent by Brownian motion at

The quantity LK
the level K.
hwT 2 i
∗
Hint: Show that lim E 1[K,∞) (Bt ) − fε0 (Bt ) dt = 0.
ε→0 0
184 "
Problem 4.19 Lévy’s construction of Brownian motion. The goal of this

problem is to prove the existence of standard Brownian motion (Bt )t∈[0,1] as
a stochastic process satisfying the four properties of Definition 4.1, i.e.:
1. B0 = 0 almost surely,
2. The sample trajectories t 7→ Bt are continuous, with probability 1.
3. For any finite sequence of times t0 < t1 < · · · < tn , the increments
Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btn − Btn−1
are independent.
4. For any given times 0 6 s < t, Bt − Bs has the Gaussian distribution

N (0, t − s) with mean zero and variance t − s.
The construction will proceed by the linear interpolation scheme illustrated
in Figure 4.9. We work on the space C0 ([0, 1]) of continuous functions on
[0, 1] started at 0, with the norm
kf k∞ := Max |f (t)|
t∈[0,1]
and the distance

kf − gk∞ := Max |f (t) − g (t)|.
t∈[0,1]
The following ten questions are interdependent.

a) Show that for any Gaussian random variable X ' N (0, σ 2 ) we have
σ 2 2
P(|X| > ε) 6 √ e −ε /(2σ ) , ε > 0.
ε π/2
Hint: Start from the inequality E[(X − ε)+ ] > 0 and compute the left-
hand side.
b) Let X and Y be two independent centered Gaussian random variables

with variances α2 and β 2 . Show that the conditional distribution
P(X ∈ dx | X + Y = z )
of X given X + Y = z is Gaussian with mean α2 z/(α2 + β 2 ) and variance

α2 β 2 / ( α2 + β 2 ) .
Hint: Use the definition

P(X ∈ dx and X + Y ∈ dz )
P(X ∈ dx | X + Y = z ) :=
P(X + Y ∈ dz )
" 185
N. Privault
and the formulas

1 2 / (2α2 ) 1 2 2
dP(X 6 x) := √ e −x dx, dP(Y 6 x) := p e −x /(2β ) dx,
2πα2 2πβ 2
where dx (resp. dy) represents a “small” interval [x, x + dx] (resp. [y, y +
dy ]).
c) Let (Bt )t∈R+ denote a standard Brownian motion and let 0 < u < v. Give
the distribution of B(u+v )/2 given that Bu = x and Bv = y.
Hint: Note that given that Bu = x, the random variable Bv can be written
as
Bv = (Bv − B(u+v )/2 ) + (B(u+v )/2 − Bu ) + x, (4.49)
and apply the result of Question (b) after identifying X and Y in the
above decomposition (4.49).
d) Consider the random sequences

(0)
 Z (0) = 0, Z1






(1) (0)
Z (1) = 0, Z1/2 , Z1









(2) (1) (2) (0)
Z (2) = 0, Z1/4 , Z1/2 , Z3/4 , Z1









(3) (2) (3) (1) (3) (2) (3) (0)

Z (3) = 0, Z1/8 , Z1/4 , Z3/8 , Z1/2 , Z5/8 , Z3/4 , Z7/8 , Z1



.. ..


. .









(n) (n) (n) (n) (n)
Z (n) = 0, Z1/2n , Z2/2n , Z3/2n , Z4/2n , . . . , Z1









 Z (n+1)= 0, Z (n+1) , Z (n) , Z (n+1) , Z (n+1) , Z (n+1) , Z (n+1) , . . . , Z (n+1)


1/2n+1 1/2n 3/2n+1 2/2n 5/2n+1 3/2n 1
(n)
with Z0 = 0, n > 0, defined recursively as
(0)
i) Z1 ' N (0, 1),
(0) (0)
(1)Z0 + Z1
ii) Z1/2 ' + N (0, 1/4),
2
(1) (1) (1) (0)
(2) Z0 + Z1/2 (2) Z + Z1
iii) Z1/4 ' + N (0, 1/8), Z3/4 ' 1/2 + N (0, 1/8),
2 2
and more generally
(n) (n)
(n+1)
Zk/2n + Z(k+1)/2n
Z(2k+1)/2n+1 = + N (0, 1/2n+2 ), k = 0, 1, . . . , 2n − 1,
2
186 "
where N (0, 1/2n+2 ) is an independent centered Gaussian sample with

(n+1) (n)
variance 1/2n+2 , and Zk/2n := Zk/2n , k = 0, 1, . . . , 2n .
(n)
In the sequel we denote by Zt the continuous-time random path
t∈[0,1]
(n)
obtained by linear interpolation of the sequence points in Zk/2n k=0,1,...,2n .
(0) (1)
Draw a sample of the first four linear interpolations Zt t∈[0,1] , Zt t∈[0,1] ,
(2) (3) (n)
Zt t∈[0,1] , Zt t∈[0,1] , and label the values of Zk/2n on the graphs for

k = 0, 1, . . . , 2 and n = 0, 1, 2, 3.
n
e) Using an induction argument, explain why for all n > 0 the sequence
(n) (n) (n) (n) (n)
Z (n) = 0, Z1/2n , Z2/2n , Z3/2n , Z4/2n , . . . , Z1
has same distribution as the sequence
B (n) := B0 , B1/2n , B2/2n , B3/2n , B4/2n , . . . , B1 .

Hint: Compare the constructions of Questions (c) and (d) and note that
under the above linear interpolation, we have
(n) (n)
(n)
Zk/2n + Z(k+1)/2n
Z(2k+1)/2n+1 = , k = 0, 1, . . . , 2n − 1.
2
f) Show that for any εn > 0 we have
(n+1) (n)
P Z (n+1) − Z (n) ∞ > εn 6 2n P |Z1/2n+1 − Z1/2n+1 | > εn .

Hint: Use the inequality

2n −1 n −1
2X
!
[
P Ak 6 P ( Ak )
k =0 k =0
for a suitable choice of events (Ak )k=0,1,...,2n −1 .

g) Use the results of Questions (a) and (f) to show that for any εn > 0 we
have
2n/2 2 n+1
P Z (n+1) − Z (n) ∞ > εn 6 √ e −εn 2 .

εn 2π
h) Taking εn = 2−n/4 , show that
 
( + ) ( )
X
P n 1 n
< ∞ = 1.

Z −Z
∞
n>0
" 187
N. Privault
Hint: Show first that

X
P Z (n+1) − Z (n) ∞ > 2−n/4 < ∞,

n>0
and apply the Borel-Cantelli lemma. n o

(n)
i) Show that with probability one, the sequence Zt t∈[0,1] , n > 1 con-
verges uniformly on [0, 1] to a continuous (random) function (Zt )t∈[0,1] .
Hint: Use the fact that C0 ([0, 1]) is a complete space for the k · k∞ norm.
j) Argue that the limit (Zt )t∈[0,1] is a standard Brownian motion on [0, 1]
by checking the four relevant properties.
Problem 4.20 Consider (Bt )t∈R+ a standard Brownian motion, and for any
n > 1 and T > 0, define the discretized quadratic variation
n
(n)
X
QT := (BkT /n − B(k−1)T /n )2 , n > 1.
k =1
h i
(n)
a) Compute E QT , n > 1.
(n)
b) Compute Var[QT ], n > 1.
c) Show that
(n)
lim QT = T,
n→∞
where the limit is taken in L2 (Ω), that is, show that

(n)
lim kQT − T kL2 (Ω) = 0,
n→∞
where q
(n) (n) 2
:= E QT − T , n > 1.

Q − T 2
T L (Ω)
d) By the result of Question (c), show that the limit

wT n
X
Bt dBt := lim (BkT /n − B(k−1)T /n )B(k−1)T /n
0 n→∞
k =1
exists in L2 (Ω), and compute it.
Hint: Use the identity

1 2
(x − y )y = (x − y 2 − (x − y )2 ), x, y ∈ R.
2
188 "
e) Consider the modified quadratic variation defined by

n
e (n) : =
X
Q T (B(k−1/2)T /n − B(k−1)T /n )2 , n > 1.
k =1
(n)
Compute the limit limn→∞ Q e
T in L ( Ω ) by repeating the steps of Ques-
2
tions (a)-(c).
f) By the result of Question (e), show that the limit
wT n
X
Bt ◦ dBt := lim (BkT /n − B(k−1)T /n )B(k−1/2)T /n
0 n→∞
k =1
Hint: Use the identities

1 2
(x − y )y = (x − y 2 − (x − y )2 ),
2
and
1 2
(x − y )x =(x − y 2 + (x − y )2 ), x, y ∈ R.
2
g) More generally, by repeating the steps of Questions (e) and (f), show that
for any α ∈ [0, 1] the limit
wT n
X
Bt ◦ dα Bt := lim (BkT /n − B(k−1)T /n )B(k−α)T /n
0 n→∞
k =1

h) Comparison with deterministic calculus. Compute the limit
n
X T T T
lim (k − α ) k − (k − 1)
n→∞ n n n
k =1
for all values of α in [0, 1].
Exercise 4.21 Let (Bt )t∈R+ be a standard Brownian motion generating the
information flow (Ft )t∈R+ .
a) Let 0 6 t 6 T . What is the probability distribution of BT − Bt ?
b) From the answer to Exercise S.4-(c), show that
r
T − t −B 2 /(2(T −t)) Bt
E[(BT )+ | Ft ] = e t + Bt Φ √ ,
2π T −t
" 189
N. Privault
0 6 t 6 T . Hint: Use the time splitting decomposition BT = BT − Bt +

Bt .
c) Let σ > 0, ν ∈ R, and Xt := σBt + νt, t > 0. Compute e Xt by applying
the Itô formula
wt ∂f w t ∂f 1 w t 2 ∂2f
f (Xt ) = f (X0 ) + us(Xs )dBs + vs (Xs )ds + u (Xs )ds
0 ∂x 0 ∂x 2 0 s ∂x2
wt wt
to f (x) = e x , where Xt is written as Xt = X0 + us dBs + vs ds,
0 0
t > 0.
d) Let St = e Xt , t > 0, and r > 0. For which value of ν does (St )t∈R+ satisfy
the stochastic differential equation
dSt = rSt dt + σSt dBt ?
Exercise 4.22 From the answer to Exercise S.4-(c), show that for any β ∈ R
we have
r
+ T − t −(β−Bt )2 /(2(T −t)) β − Bt
E[(β − BT ) | Ft ] = e + ( β − Bt ) Φ √ ,
2π T −t
0 6 t 6 T.
Hint: Use the time splitting decomposition BT = BT − Bt + Bt .
190 "
Chapter 5
Continuous-Time Market Model
The continuous-time market model allows for the incorporation of portfolio

re-allocation algorithms in a stochastic dynamic programming setting. This
chapter starts with a review of the concepts of assets, self-financing portfolios,
risk-neutral probability measures, and arbitrage in continuous time. We also
state and solve the equation satisfied by geometric Brownian motion, which
will be used for the modeling of continuous asset price processes.
5.1 Asset Price Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . 191

5.2 Arbitrage and Risk-Neutral Measures . . . . . . . . . . . 193
5.3 Self-Financing Portfolio Strategies . . . . . . . . . . . . . . . 196
5.4 Two-Asset Portfolio Model . . . . . . . . . . . . . . . . . . . . . 198
5.5 Geometric Brownian Motion . . . . . . . . . . . . . . . . . . . . 204
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
5.1 Asset Price Modeling

The prices at time t > 0 of d + 1 assets numbered no 0, 1, . . . , d is denoted
by the random vector
(0) (1) (d)
S t = St , St , . . . , St
which forms a stochastic process (S t )t∈R+ . As in discrete time, the asset no

0 is a riskless asset (of savings account type) yielding an interest rate r, i.e.
we have
(0) (0)
St = S0 e rt , t > 0.
Definition 5.1. Discounting. Let

(0) (1) (d)
X t := Set , Set , . . . , Set ), t ∈ R,
" 191
N. Privault
denote the vector of discounted asset prices, defined as:

(k ) (k )
Set = e −rt St , t > 0, k = 0, 1, . . . , d.
We can also write

X t := e −rt S t , t > 0.
The concept of discounting is illustrated in the following figures.

The risk-free or inflation rate is r = 10%.
A:
A:
(a) Without inflation adjustment. (b) With inflation adjustment.
Fig. 5.2: Why apply discounting?
Definition 5.2. A portfolio strategy is a stochastic process (ξ t )t∈R+ ⊂ Rd+1 ,

(k )
where ξt denotes the (possibly fractional) quantity of asset no k held at time
t > 0.
The value at time t > 0 of the portfolio strategy (ξ t )t∈R+ ⊂ Rd+1 is defined
by
d
(k ) (k )
X
Vt : = ξ t • S t = ξt St , t > 0.
k =0
The discounted value of the portfolio is defined by
Vet := e −rt Vt
= e −rt ξ t • S t
192 "
d
(k ) (k )
X
= e −rt ξt St
k =0
d
(k ) (k )
X
= ξt Set
k =0
= ξt • X t, t > 0.
The effect of discounting from time t to time 0 is to divide prices by e rt ,

making all prices comparable at time 0.
5.2 Arbitrage and Risk-Neutral Measures

In continuous-time, the definition of arbitrage follows the lines of its analogs
in the one-step and discrete-time models. In the sequel we will only consider
admissible portfolio strategies whose total value Vt remains nonnegative for
all times t ∈ [0, T ].
(k )
Definition 5.3. A portfolio strategy ξt t∈[0,T ],k=0,1,...,d with value
d
(k ) (k )
X
Vt = ξ t • S t = ξt St , t > 0,
k =0
constitutes an arbitrage opportunity if all three following conditions are sat-

isfied:
i) V0 6 0 at time t = 0, [Start from a zero-cost portfolio, or with a debt.]

ii) VT > 0 at time t = T , [Finish with a nonnegative amount.]
iii) P(VT > 0) > 0 at time t = T . [Profit is made with nonzero probability.]
Roughly speaking, (ii) means that the investor wants no loss, (iii) means
that he wishes to sometimes make a strictly positive gain, and (i) means
that he starts with zero capital or even with a debt.
Next, we turn to the definition of risk-neutral probability measures (or

martingale measures) in continuous time, which states that under a risk-
neutral probability measure P∗ , the return of the risky asset over the time
interval [u, t] equals the return of the riskless asset given by
(0) (0)
St = e (t−u)r Su , 0 6 u 6 t.
Recall that the filtration (Ft )t∈R+ is generated by Brownian motion (Bt )t∈R+ ,
i.e.
Ft = σ (Bu : 0 6 u 6 t), t > 0.
" 193
N. Privault
Definition 5.4. A probability measure P∗ on Ω is called a risk-neutral mea-

sure if it satisfies
(k ) (k )
E∗ St Fu = e (t−u)r Su , 0 6 u 6 t, k = 1, 2, . . . , d. (5.1)
where E∗ denotes the expectation under P∗ .

As in the discrete-time case, P] would be called a risk premium measure if it
satisfied
(k )
E] St Fu > e (t−u)r Su , 0 6 u 6 t, k = 1, 2, . . . , d,
(i)
meaning that by taking risks in buying St , one could make an expected
return higher than that of the riskless asset
(0) (0)
St = e (t−u)r Su , 0 6 u 6 t.
Similarly, a negative risk premium measure P[ satisfies

(k ) (k )
E[ St Fu < e (t−u)r Su , 0 6 u 6 t, k = 1, 2, . . . , d.
From the relation

(0) (0)
St = e (t−u)r Su , 0 6 u 6 t,
(k )
we interpret (5.1) by saying that the expected return of the risky asset St
(0)
under P∗ equals the return of the riskless asset St ,
k = 1, 2, . . . , d. Recall
(k )
that the discounted (in $ at time 0) price Set of the risky asset no k is defined
by
(k )
(k ) (k ) S
Set := e −rt St = (0) t (0) , t > 0, k = 0, 1, . . . , d,
St /S0
(0) (0)
i.e. St /S0 plays the role of a numéraire in the sense of Chapter 16.
Definition 5.5. A continuous-time process (Zt )t∈R+ of integrable random
variables is a martingale under P and with respect to the filtration (Ft )t∈R+
if
E[Zt | Fs ] = Zs , 0 6 s 6 t.
Note that when (Zt )t∈R+ is a martingale, Zt is in particular Ft -measurable
at all times t > 0.
In continuous-time finance, the martingale property can be used to charac-

terize risk-neutral probability measures, for the derivation of pricing partial
differential equations (PDEs), and for the computation of conditional expec-
194 "
tations.
As in the discrete-time case, see Proposition 2.13, the notion of martingale

can be used to characterize risk-neutral probability measures.
Proposition 5.6. The probability measure P∗ is risk-neutral if and only if
(k )
the discounted risky asset price process (Set )t∈R+ is a martingale under P∗ ,
k = 1, 2, . . . , d.
Proof. If P∗ is a risk-neutral probability measure, we have
(k ) (k )
E∗ Set Fu = E∗ e −rt St Fu

(k )
= e −rt E∗ St Fu
(k )
= e −rt e (t−u)r Su
(k )
= e −ru Su
(k )
= Seu , 0 6 u 6 t,
(k )
hence is a martingale under P∗ , k = 1, 2, . . . , d. Conversely, if
Set t∈R
+
(k )
St t∈R is a martingale under P∗ then
e
+
(k ) (k )
E∗ St Fu = E∗ e rt Set Fu

(k )
= e rt E∗ Set Fu
(k )
= e rt Seu
(k )
= e (t−u)r Su , 0 6 u 6 t, k = 1, 2, . . . , d,
hence the probability measure P∗ is risk-neutral according to Definition 5.4.

Next, we note that the first fundamental theorem of asset pricing also holds
in continuous time, and can be used to check for the existence of arbitrage
opportunities.
admits at least one equivalent risk-neutral probability measure P∗ .
Proof. See Harrison and Pliska (1981) and Chapter VII-4a of Shiryaev (1999).

" 195
N. Privault
5.3 Self-Financing Portfolio Strategies

(i)
Let ξt denote the (possibly fractional) quantity invested at time t over the
(k )
time interval [t, t + dt), in the asset St , k = 0, 1, . . . , d, and let
(k ) (k )
ξ t = ξt k =0,1,...,d
, S t = St k =0,1,...,d
, t > 0,
denote the associated portfolio value and asset price processes. The portfolio
value Vt at time t > 0 is given by
d
(k ) (k )
X
Vt = ξ t • S t = ξt St , t > 0. (5.3)
k =0
Our description of portfolio strategies proceeds in four equivalent formula-

tions (5.4), (5.5) (5.7) and (5.8), which correspond to different interpretations
of the self-financing condition.
Self-financing portfolio update
The portfolio strategy (ξ t )t∈R+ is self-financing if the portfolio value remains

constant after updating the portfolio from ξ t to ξ t+dt , i.e.
d d
(k ) (k ) (k ) (k )
X X
ξ t • S t+dt = ξt St+dt = ξt+dt St+dt = ξ t+dt • S t+dt , (5.4)
k =0 k =0
which is the continuous-time analog of the self-financing condition already

encountered in the discrete setting of Chapter 2, see Definition 2.4. A ma-
jor difference with the discrete-time case of Definition 2.4, however, is that
the continuous-time differentials dSt and dξt do not make pathwise sense
as continuous-time stochastic integrals are defined by L2 limits, cf. Proposi-
tion 4.20, or by convergence in probability.
Portfolio value ξt • S t ξ t • S t+dt = ξ t+dt • S t+dt ξ t+dt • S t+2dt

Asset value St St+dt St+dt St+2dt
Time scale t t + dt t + dt t + 2dt

Portfolio allocation ξt ξt ξt+dt ξt+dt
Equivalently, Condition (5.4) can be rewritten as
196 "
d
(k ) (k )
X
St+dt dξt = 0, (5.5)
k =0
where
(k ) (k ) (k )
dξt := ξt+dt − ξt , k = 0, 1, . . . , d,
denote the respective changes in portfolio allocations. In other words, Equa-
tion (5.5) rewrites as
d
(k ) (k ) (k )
X
St+dt (ξt+dt − ξt ) = 0. (5.6)
k =0
Condition (5.6) can be rewritten as

d d
(k ) (k ) (k ) (k ) (k ) (k ) (k )
X X
St ξt+dt − ξt + St+dt − St ξt+dt − ξt = 0,
k =0 k =0
which shows that (5.4) and (5.5) are equivalent to

d d
(k ) (k ) (k ) (k )
X X
S t • dξ t + dS t • dξ t = St dξt + dSt • dξt =0 (5.7)
k =0 k =0
in differential notation.
Self-financing portfolio differential
In practice, the self-financing portfolio property will be characterized by the

following proposition, which states that the value of a self-financing portfolio
can be written as the sum of its trading Profits and Losses (P/L).
(k )
Proposition 5.9. A portfolio strategy ξt t∈[0,T ],k=0,1,...,d with value
d
(k ) (k )
X
Vt = ξ t • S t = ξt St , t > 0,
k =0
is self-financing according to (5.4) if and only if the relation

d
(k ) (k )
X
dVt = ξ dS (5.8)
| t {z t }
k =0
P/L for asset no k
holds.
Proof. By Itô’s calculus we have
" 197
N. Privault
d d d
(k ) (k ) (k ) (k ) (k ) (k )
X X X
dVt = ξt dSt + St dξt + dSt • dξt ,
k =0 k =0 k =0
which shows that (5.7) is equivalent to (5.8).
Market Completeness
We refer to Definition 1.8 for the definition of contingent claim.

Definition 5.10. A contingent claim with payoff C is said to be attainable
(k )
if there exists a (self-financing) portfolio strategy ξt t∈[0,T ],k=0,1,...,d such
that at the maturity time T the equality
d
(k ) (k )
X
VT = ξ T • S T = ξT ST =C
k =0
holds (almost surely) between random variables.

When a claim with payoff C is attainable, its price at time t will be given by
the value Vt of a self-financing portfolio hedging C.
The next result is the continuous-time statement of the second fundamental
theorem of asset pricing.
if and only if it admits only one equivalent risk-neutral probability measure
P∗ .
Proof. See Harrison and Pliska (1981) and Chapter VII-4a of Shiryaev (1999).

5.4 Two-Asset Portfolio Model
In the Black and Scholes (1973) model, one can show the existence of a unique
risk-neutral probability measure, hence the model is without arbitrage and
complete. From now on we work with d = 1, i.e. with a market based on a
riskless asset with price (At )t∈R+ and a risky asset with price (St )t∈R+ .
Self-financing portfolio strategies
Let ξt and ηt denote the (possibly fractional) quantities invested at time t

over the time interval [t, t + dt), respectively in the assets St and At , and let
198 "
ξ t = ( η t , ξt ) , S t = (At , St ), t > 0,
denote the associated portfolio value and asset price processes. The portfolio
value Vt at time t is given by
Vt = ξ t • S t = ηt At + ξt St , t > 0.
Our description of portfolio strategies proceeds in four equivalent formula-

tions presented below in Equations (5.9), (5.10), (5.12) and (5.13), which
correspond to different interpretations of the self-financing condition.
Self-financing portfolio update
The portfolio strategy (ηt , ξt )t∈R+ is self-financing if the portfolio value re-
mains constant after updating the portfolio from (ηt , ξt ) to (ηt+dt , ξt+dt ),
i.e.
ξ t • S t+dt = ηt At+dt + ξt St+dt = ηt+dt At+dt + ξt+dt St+dt = ξ t+dt • S t+dt .

(5.9)
Portfolio value ξt • S t ξ t • S t+dt = ξ t+dt • S t+dt ξ t+dt • S t+2dt

Asset value St St+dt St+dt St+2dt
Time scale t t + dt t + dt t + 2dt

Portfolio allocation ξt ξt ξt+dt ξt+dt
Equivalently, Condition (5.9) can be rewritten as
At+dt dηt + St+dt dξt = 0, (5.10)
where
dηt := ηt+dt − ηt and dξt := ξt+dt − ξt
denote the respective changes in portfolio allocations, hence we have
At+dt (ηt − ηt+dt ) = St+dt (ξt+dt − ξt ). (5.11)
In other words, when one sells a (possibly fractional) quantity ηt − ηt+dt > 0
of the riskless asset valued At+dt at the end of the time interval [t, t + dt] for
the total amount At+dt (ηt − ηt+dt ), one should entirely spend this income to
buy the corresponding quantity ξt+dt − ξt > 0 of the risky asset for the same
amount St+dt (ξt+dt − ξt ) > 0.
" 199
N. Privault
Similarly, if one sells a quantity −dξt > 0 of the risky asset St+dt between
the time intervals [t, t + dt] and [t + dt, t + 2dt] for a total amount −St+dt dξt ,
one should entirely use this income to buy a quantity dηt > 0 of the riskless
asset for an amount At+dt dηt > 0, i.e.
At+dt dηt = −St+dt dξt .
Condition (5.11) can also be rewritten as
St (ξt+dt − ξt ) + At (ηt+dt − ηt ) + (St+dt − St )(ξt+dt − ξt )

+ (At+dt − At ) • (ηt+dt − ηt ) = 0,
which shows that (5.9) and (5.10) are equivalent to
St dξt + At dηt + dSt • dξt + dAt • dηt = 0 (5.12)
in differential notation, with
dAt • dηt ' (At+dt − At ) • (ηt+dt − ηt ) = rAt (dt • dηt ) = 0
in the sense of Itô’ calculus, by the Itô Table 4.1. This yields the following
proposition, which is also consequence of Proposition 5.9.
Proposition 5.13. A portfolio allocation (ξt , ηt )t∈R+ with value
Vt = ηt At + ξt St , t > 0,
is self-financing according to (5.9) if and only if the relation
dVt = η dA + ξt dSt (5.13)

| t{z t} | {z }
Risk−free P/L Risky P/L
holds.
Proof. By Itô’s calculus we have
dVt = [ηt dAt + ξt dSt ] + [St dξt + At dηt + dSt • dξt + dAt • dηt ],
which shows that (5.12) is equivalent to (5.13). Equivalently, we can also

check the equality
dVt = Vt+dt − Vt
= ηt+dt At+dt + ξt+dt St+dt − (ηt At + ξt St )
= ηt (At+dt − At ) + ξt (St+dt − St ) + St (ξt+dt − ξt ) + At (ηt+dt − ηt )
+(St+dt − St )(ξt+dt − ξt ) + (At+dt − At )(ηt+dt − ηt ).

Let
200 "
Vet := e −rt Vt and Set := e −rt St , t > 0,

respectively denote the discounted portfolio value and discounted risky asset
price at time t > 0.
Geometric Brownian motion
Recall that the riskless asset price process (At )t∈R+ admits the following
equivalent constructions:
At+dt − At dAt
= rdt, = rdt, A0t = rAt , t > 0,
At At
with the solution
At = A0 e rt , t > 0, (5.14)
where r > 0 is the risk-free interest rate.∗
The risky asset price process
(St )t∈R+ will be modeled using a geometric Brownian motion defined from
the equation
dSt
= µdt + σdBt , t > 0, (5.15)
St
see Section 5.5, which can be solved numerically according to the following
R code.
N=2000; t <- 0:N; dt <- 1.0/N;mu=0.5; sigma=0.2; nsim <- 10; X <- matrix(0, nsim, N+1)
Z <- matrix(rnorm(nsim*N,mean=0,sd=sqrt(dt)), nsim, N+1)
for (i in 1:nsim){X[i,1]=1.0;
for (j in 1:N+1){X[i,j]=X[i,j-1]+mu*X[i,j-1]*dt+sigma*X[i,j-1]*Z[i,j]}}
plot(t*dt, rep(0, N+1), xlab = "Time", ylab = "Geometric Brownian motion", lwd=2, ylim
= c(min(X),max(X)), type = "l", col = 0,las=1, cex.axis=1.5,cex.lab=1.5, xaxs='i',
yaxs='i')
for (i in 1:nsim){lines(t*dt, X[i, ], lwd=2, type = "l", col = i)}
Note that by Proposition 5.16 below, we also have
1

St = S0 exp σBt + µ − σ 2 t , t > 0,
2
which can be simulated by the following R code.
N=2000; t <- 0:N; dt <- 1.0/N; mu=0.5;sigma=0.2; nsim <- 10; par(oma=c(0,1,0,0))
X <- matrix(rnorm(nsim*N,mean=0,sd=sqrt(dt)), nsim, N)
X <- cbind(rep(0, nsim), t(apply(X, 1, cumsum)))
for (i in 1:nsim){X[i,] <- exp(mu*t*dt+sigma*X[i,]-sigma*sigma*t*dt/2)}
plot(t*dt, rep(0, N+1), xlab = "Time", ylab = "Geometric Brownian motion", lwd=2, ylim
= c(min(X),max(X)), type = "l", col = 0,las=1,cex.axis=1.5,cex.lab=1.6, xaxs='i',
yaxs='i')
for (i in 1:nsim){lines(t*dt, X[i, ], lwd=2, type = "l", col = i)}
∗
“Anyone who believes exponential growth can go on forever in a finite world is either
a madman or an economist”, K. E. Boulding (1973), page 248.
" 201
N. Privault
The next Figure 5.5 presents sample paths of geometric Brownian motion.
2.0
Geometric Brownian motion
1.8
1.6
1.4
1.2
1.0
0.0 0.2 0.4 0.6 0.8 1.0

Time
Fig. 5.5: Ten sample paths of geometric Brownian motion (St )t∈R+ .
Lemma 5.14. Discounting lemma. Consider an asset price process (St )t∈R+
be as in (5.15), i.e.
dSt = µSt dt + σSt dBt , t > 0.
Then, the discounted asset price process Set t∈R = e −rt St t∈R satisfies

+ +
the equation
dSet = (µ − r )Set dt + σ Set dBt .
Proof. By (4.27) and the Itô multiplication table 4.1, we have
dSet = d( e −rt St )
= St d( e −rt ) + e −rt dSt + (d e −rt ) • dSt
= −r e −rt St dt + e −rt dSt + (−r e −rt St dt) • dSt
= −r e −rt St dt + µ e −rt St dt + σ e −rt St dBt
= (µ − r )Set dt + σ Set dBt .

In the next Lemma 5.15, which is the continuous-time analog of Lemma 3.2,
we show that when a portfolio is self-financing, its discounted value is a gain
process given by the sum over time of discounted trading profits and losses
(number of risky assets ξt times discounted price variation dSet ).
Note that in Equation (5.16) below, no profit or loss arises from trading
the discounted riskless asset A
et := e −rt At = A0 , because its price remains
constant over time.
Lemma 5.15. Let (ηt , ξt )t∈R+ be a portfolio strategy with value
Vt = ηt At + ξt St , t > 0.
202 "
The following statements are equivalent:

(i) the portfolio strategy (ηt , ξt )t∈R+ is self-financing,
(ii) the discounted portfolio value Vet can be written as the stochastic integral
sum wt
Vet = Ve0 + ξu dSeu , t > 0, (5.16)
0 | {z }
Discounted P/L
of discounted profits and losses.

Proof. Assuming that (i) holds, the self-financing condition and (5.14)-(5.15)
show that
dVt = ηt dAt + ξt dSt

= rηt At dt + µξt St dt + σξt St dBt
= rVt dt + (µ − r )ξt St dt + σξt St dBt , t > 0,
where we used Vt = ηt At + ξt St , hence
e −rt dVt = r e −rt Vt dt + (µ − r ) e −rt ξt St dt + σ e −rt ξt St dBt , t > 0,
and
dVet = d e −rt Vt

= −r e −rt Vt dt + e −rt dVt

= (µ − r )ξt e −rt St dt + σξt e −rt St dBt
= (µ − r )ξt Set dt + σξt Set dBt
= ξt dSet , t > 0,
i.e. (5.16) holds by integrating on both sides as

wt wt
Vet − Ve0 = dVeu = ξu dSeu , t > 0.
0 0
(ii) Conversely, if (5.16) is satisfied we have
dVt = d( e rt Vet )
= r e rt Vet dt + e rt dVet
= r e rt Vet dt + e rt ξt dSet
= rVt dt + e rt ξt dSet
= rVt dt + e rt ξt Set ((µ − r )dt + σdBt )
= rVt dt + ξt St ((µ − r )dt + σdBt )
" 203
N. Privault
= ηt dAt + ξt dSt ,
hence the portfolio is self-financing according to Definition 5.9.

As a consequence of Relation (5.16), the problem of hedging a claim payoff
C with maturity T also reduces to that of finding the process (ξt )t∈[0,T ]
appearing in the decomposition of the discounted claim payoff C
e = e −rT C
as a stochastic integral:
wT
e = VeT = Ve0 +
C ξt dSet ,
0
see Section 7.5 on hedging by the martingale method.
Example. Power options in the Bachelier model.

In the Bachelier (1900) model with interest rate r = 0, the underlying asset
price can be modeled by Brownian motion (Bt )t∈R+ , and may therefore
become negative.∗ The claim payoff C = (BT )2 of a power option with at
maturity T > 0 admits the stochastic integral decomposition
wT
( BT ) 2 = T + 2 Bt dBt
0
which shows that the claim can be hedged using ξt = 2Bt units of the
underlying asset at time t ∈ [0, T ], see Exercise 6.1.
Similarly, in the case of power claim payoff C = (BT )3 we have

wT
( BT ) 3 = 3 T − t + (Bt )2 dBt ,

0
cf. Exercise 4.10.

Note that according to (5.16), the (non-discounted) self-financing portfolio
value Vt can be written as
wt wt
Vt = e rt V0 + (µ − r ) e (t−u)r ξu Su du + σ e (t−u)r ξu Su dBu , t > 0.
0 0
(5.17)
5.5 Geometric Brownian Motion
In this section we solve the stochastic differential equation
dSt = µSt dt + σSt dBt

∗
Negative oil prices have been observed in May 2020 when the prices of oil futures
contracts fell below zero.
204 "
which is used to model the St the risky asset price at time t, where µ ∈ R
and σ > 0. This equation is rewritten in integral form as
wt wt
St = S0 + µ Ss ds + σ Ss dBs , t > 0. (5.18)
0 0
The next Figure 5.6 presents an illustration of the geometric Brownian pro-
cess of Proposition 5.16.
4
St
3.5
ert
3
St 2.5
2
1.5
S0=1
0.5
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
t
Fig. 5.6: Geometric Brownian motion started at S0 = 1, with µ = r = 1 and σ 2 = 0.5.∗
N=1000; t <- 0:N; dt <- 1.0/N; sigma=0.6; mu=0.001

Z <- rnorm(N,mean=0,sd=sqrt(dt));
plot(t*dt, exp(mu*t), xlab = "time", ylab = "Geometric Brownian motion", type = "l", ylim
= c(0, 4), col = 1,lwd=3)
lines(t*dt, exp(sigma*c(0,cumsum(Z))+mu*t-sigma*sigma*t*dt/2),xlab = "time",type =
"l",ylim = c(0, 4), col = 4)
Proposition 5.16. The solution of the stochastic differential equation
dSt = µSt dt + σSt dBt (5.19)
is given by
1

St = S0 exp σBt + µ − σ 2 t , t > 0. (5.20)
2
Proof. a) Using log-returns. We apply Itô’s formula to the Itô process
(St )t∈R+ with vt = µSt and ut = σSt , by taking
f (St ) = log St , with f (x) := log x.
This yields the log-return dynamics

∗
" 205
N. Privault
1
d log St = f 0 (St )dSt + f 00 (St )dSt • dSt
2
σ 2 2 00
= µSt f 0 (St )dt + σSt f 0 (St )dBt + S f (St )dt
2 t
σ2
= µdt + σdBt − dt,
2
hence
wt
log St − log S0 = d log Ss
0
σ2 w t wt

= µ− ds + σ dBs
2 0 0
σ2

= µ− t + σBt ,
2
and
σ2

St = S0 exp µ− t + σBt , t > 0.
2
b) Let us provide an alternative proof by searching for a solution of the form
St = f (t, Bt )
where f (t, x) is a function to be determined. By Itô’s formula (4.25) we have
∂f ∂f 1 ∂2f
dSt = df (t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt.
∂t ∂x 2 ∂x2
Comparing this expression to (5.19) and identifying the terms in dBt we get

∂f
(t, Bt ) = σSt ,



 ∂x


 ∂f (t, B ) + 1 ∂ f (t, B ) = µS .


 2

t t t
2 ∂x2

∂t
Using the relation St = f (t, Bt ), these two equations rewrite as


 ∂f (t, Bt ) = σf (t, Bt ),


 ∂x


 ∂f (t, Bt ) + 1 ∂ f (t, Bt ) = µf (t, Bt ).



 2

2 ∂x2

∂t
Since Bt is a Gaussian random variable taking all possible values in R, the
equations should hold for all x ∈ R, as follows:
206 "

∂f
 (t, x) = σf (t, x), (5.23a)


 ∂x


1 ∂2f

∂f


 (t, x) + (t, x) = µf (t, x). (5.23b)


∂t 2 ∂x2
To find the solution f (t, x) = f (t, 0) e σx of (5.23a) we let g (t, x) = log f (t, x)
and rewrite (5.23a) as
∂g ∂ 1 ∂f
(t, x) = log f (t, x) = (t, x) = σ,
∂x ∂x f (t, x) ∂x
i.e.
∂g
(t, x) = σ,
∂x
which is solved as
g (t, x) = g (t, 0) + σx,
hence
f (t, x) = e g (t,0) e σx = f (t, 0) e σx .
Plugging back this expression into the second equation (5.23b) yields
∂f 1
e σx (t, 0) + σ 2 e σx f (t, 0) = µf (t, 0) e σx ,
∂t 2
i.e.
σ2

∂f
(t, 0) = µ− f (t, 0).
∂t 2
∂g
In other words, we have (t, 0) = µ − σ 2 /2, which yields
∂t
σ2

g (t, 0) = g (0, 0) + µ − t,
2
i.e.
f (t, x) = e g (t,x) = e g (t,0)+σx

= e g (0,0)+σx+(µ−σ /2)t
2
= f (0, 0) e σx+(µ−σ )t ,
2 /2
t > 0.
We conclude that
St = f (t, Bt ) = f (0, 0) e σBt +(µ−σ )t ,

2 /2
and the solution to (5.19) is given by
" 207
N. Privault
2 /2)t
St = S0 e σBt +(µ−σ , t > 0.

2
Conversely, taking St = f (t, Bt ) with f (t, x) = S0 e µt+σx−σ t/2 , we may
apply Itô’s formula to check that
dSt = df (t, Bt )
∂f ∂f 1 ∂2f
∂t ∂x 2 ∂x2
2 2
= µ − σ 2 /2 S0 e µt+σBt −σ t/2 dt + σS0 e µt+σBt −σ t/2 dBt

1 2
+ σ 2 S0 e µt+σBt −σ t/2 dt
2
2 2
= µS0 e µt+σBt −σ t/2 dt + σS0 e µt+σBt −σ t/2 dBt
= µSt dt + σSt dBt .
Exercises
Exercise 5.1 Show that at any time T > 0, the random variable ST :=
2
S0 e σBT +(µ−σ /2)T has the lognormal distribution with probability density
function
1 2 2 2
x 7−→ f (x) = √ e −(−(µ−σ /2)T +log(x/S0 )) /(2σ T ) , x > 0,
xσ 2πT
with log-variance σ 2 and log-mean (µ − σ 2 /2)T + log S0 , see Figures 3.9 and
5.7.
N=1000; t <- 0:N; dt <- 1.0/N; nsim <- 100 # using Bernoulli samples
sigma=0.2;r=0.5;a=(1+r*dt)*(1-sigma*sqrt(dt))-1;b=(1+r*dt)*(1+sigma*sqrt(dt))-1
X <- matrix(a+(b-a)*rbinom( nsim * N, 1, 0.5), nsim, N)
X<-cbind(rep(0,nsim),t(apply((1+X),1,cumprod))); X[,1]=1;H<-hist(X[,N],plot=FALSE);
dev.new(width=16,height=7);
layout(matrix(c(1,2), nrow =1, byrow = TRUE)); par(mar=c(2,2,2,0), oma = c(2, 2, 2, 2))
plot(t*dt,X[1,],xlab="time",ylab="",type="l",ylim=c(0.8,3), col = 0,xaxs='i',las=1,
cex.axis=1.6)
for (i in 1:nsim){lines(t*dt, X[i, ], xlab = "time", type = "l", col = i)}
lines((1+r*dt)^t, type="l", lty=1, col="black",lwd=3,xlab="",ylab="", main="")
for (i in 1:nsim){points(0.999, X[i,N], pch=1, lwd = 5, col = i)}; x <- seq(0.01,3,
length=100);
px <- exp(-(-(r-sigma^2/2)+log(x))^2/2/sigma^2)/x/sigma/sqrt(2*pi); par(mar = c(2,2,2,2))
plot(NULL , xlab="", ylab="", xlim = c(0, max(px,H$density)),ylim=c(0.8,3),axes=F, las=1)
rect(0, H$breaks[1:(length(H$breaks) - 1)], col=rainbow(20,start=0.08,end=0.6), H$density,
H$breaks[2:length(H$breaks)])
lines(px,x, type="l", lty=1, col="black",lwd=3,xlab="",ylab="", main="")
208 "
3.0
2.5
2.0
1.5
1.0
0.0 0.2 0.4 0.6 0.8 1.0

time
Fig. 5.7: Statistics of geometric Brownian paths vs lognormal distribution.
Exercise 5.2
a) Consider the stochastic differential equation
dSt = rSt dt + σSt dBt , t > 0, (5.24)
where r, σ ∈ R are constants and (Bt )t∈R+ is a standard Brownian mo-

tion. Compute d log St using the Itô formula.
b) Solve the ordinary differential equation df (t) = cf (t)dt and the stochastic
differential equation (5.24).
c) Compute the lognormal mean and variance
2
E[St ] = S0 e rt and Var[St ] = S02 e 2rt e σ t − 1 , t > 0,

using the Gaussian moment generating function (MGF) formula (23.46).

d) Recover the lognormal mean and variance of Question (c) by deriving
differential equations for the functions u(t) := E[St ] and v (t) := E St2 ,

t > 0, using stochastic calculus.
Exercise 5.3 Assume that (Bt )t∈R+ and (Wt )t∈R+ are standard Brownian
motions, correlated according to the Itô rule dWt • dBt = ρdt for ρ ∈ [−1, 1],
and consider the solution (Yt )t∈R+ of the stochastic differential equation
dYt = µYt dt + ηYt dWt , t > 0, where µ, η ∈ R are constants. Compute
df (St , Yt ), for f a C 2 function on R2 using the bivariate Itô formula (4.26).
Exercise 5.4 Consider the asset price process (St )t∈R+ given by the stochastic
dSt = rSt dt + σSt dBt .
Find the stochastic integral decomposition of the random variable ST , i.e.,
find the constant C (S0 , r, T ) and the process (ζt,T )t∈[0,T ] such that
" 209
N. Privault
wT
ST = C (S0 , r, T ) + ζt,T dBt . (5.25)
0
Hint: Use the fact that the discounted price process (Xt )t∈[0,T ] := ( e rt St )t∈[0,T ]
satisfies the relation dXt = σXt dBt .
Exercise 5.5 Consider (Bt )t∈R+ a standard Brownian motion generating the
filtration (Ft )t∈R+ and the process (St )t∈R+ defined by
w wt
t
St = S0 exp σs dBs + us ds , t > 0,
0 0
where (σt )t∈R+ and (ut )t∈R+ are (Ft )t∈[0,T ] -adapted processes.
a) Compute dSt using Itô calculus.
b) Show that St satisfies a stochastic differential equation to be determined.
Exercise 5.6 Consider (Bt )t∈R+ a standard Brownian motion generating the
filtration (Ft )t∈R+ , and let σ > 0.
a) Compute the mean and variance of the random variable St defined as
wt 2 s/2
St := 1 + σ e σBs −σ dBs , t > 0. (5.26)
0
b) Express d log(St ) using (5.26) and the Itô formula.

2
c) Show that St = eσBt −σ t/2 for t > 0.
Exercise 5.7 We consider a leveraged fund with factor β : 1 on an index

(St )t∈R+ modeled as the geometric Brownian motion
dSt = rSt dt + σSt dBt , t > 0,
under the risk-neutral probability measure P∗ .

Examples of leveraged funds
include ProShares Ultra S&P500 and ProShares UltraShort S&P500.
a) Find the portfolio allocation (ξt , ηt ) of the leveraged fund value
Ft = ξt St + ηt At , t > 0,
where At := A0 e rt represents the risk-free money market account price.

Hint: Leveraging with a factor β : 1 means that the risky component of
the portfolio should represent β times the invested amount βFt at any
time t > 0.
b) Find the stochastic differential equation satisfied by (Ft )t∈R+ under the
self-financing condition dFt = ξt dSt + ηt dAt .
210 "
c) Find the relation between the fund value Ft and the index St by solving
the stochastic differential equation obtained for Ft in Question (b). For
simplicity we take F0 := S0β .
Exercise 5.8 Solve the stochastic differential equation
dXt = h(t)Xt dt + σXt dBt ,
where σ > 0 and h(t) is a deterministic, integrable function of t > 0.

2 t/2
Hint: Look for a solution of the form Xt = f (t) e σBt −σ , where f (t) is a
function to be determined, t > 0.
Exercise 5.9 Let (Bt )t∈R+ denote a standard Brownian motion generating
the filtration (Ft )t∈R+ .
a) Letting Xt := σBt + νt, σ > 0, ν ∈ R, compute St := e Xt by the Itô
formula
wt ∂f w t ∂f 1 w t 2 ∂2f
f (Xt ) = f (X0 ) + us(Xs )dBs + vs (Xs )ds + u (Xs )ds,
0 ∂x 0 ∂x 2 0 s ∂x2
(5.27)
wt wt
applied to f (x) = e x , by writing Xt as Xt = X0 + us dBs + vs ds.
0 0
b) Let r > 0. For which value of ν does (St )t∈R+ satisfy the stochastic
dSt = rSt dt + σSt dBt ?
c) Given σ > 0, let Xt := (BT − Bt )σ, and compute Var[Xt ], 0 6 t 6 T .

d) Let the process (St )t∈R+ be defined by St = S0 e σBt +νt , t > 0. Using the
result of Exercise S.2, show that the conditional probability that ST > K
given St = x can be computed as
log(x/K ) + (T − t)ν

P(ST > K | St = x) = Φ √ , 0 6 t < T.
σ T −t
Hint: Use the time splitting decomposition
ST
ST = St = St e (BT −Bt )σ +(T −t)ν , 0 6 t 6 T.
St
Problem 5.10 Stop-loss/start-gain strategy (Lipton (2001) § 8.3.3., Exer-

cise 4.18 continued). Let (Bt )t∈R+ be a standard Brownian motion started
at B0 ∈ R.
" 211
N. Privault
a) We consider a simplified foreign exchange model in which the AUD is a

risky asset and the AUD/SGD exchange rate at time t is modeled by Bt ,
i.e. AU$1 equals SG$Bt at time t. A foreign exchange (FX) European
call option gives to its holder the right (but not the obligation) to receive
AU$1 in exchange for K = SG$1 at maturity T . Give the option payoff
at maturity, quoted in SGD.
In the sequel, for simplicity we assume no time value of money (r = 0),

i.e. the (riskless) SGD account is priced At = A0 = 1, 0 6 t 6 T .
b) Consider the following hedging strategy for the European call option of
Question (a):
i) If B0 > 1, charge the premium B0 − 1 at time 0, and borrow SG$1
to purchase AU$1.
ii) If B0 < 1, issue the option for free.
iii) From time 0 to time T , purchase∗ AU$1 every time Bt crosses K = 1
from below, and sell† AU$1 each time Bt crosses K = 1 from above.
Show that this strategy effectively hedges the foreign exchange European
call option at maturity T .
Hint: Note that it suffices to consider four scenarios based on B0 < 1 vs

B0 < 1 and BT > 1 vs BT < 1.
c) Determine the quantities ηt of SGD cash and ξt of (risky) AUDs to be
held in the portfolio and express the portfolio value
Vt = ηt + ξt Bt
at all times t ∈ [0, T ].

d) Compute the integral summation
wt wt
ηs dAs + ξs dBs
0 0
of portfolio profits and losses at any time t ∈ [0, T ].
Hint: Apply the Itô-Tanaka formula (4.48), see Question (e) in Exer-
cise 4.18.
e) Is the portfolio strategy (ηt , ξt )t∈[0,T ] self-financing? How to interpret the
answer in practice?
∗
We need to borrow SG$1 if this is the first AUD purchase.
†
We use the SG$1 product of the sale to refund the loan.
212 "
Chapter 6
Black-Scholes Pricing and Hedging
The Black and Scholes (1973) PDE is a Partial Differential Equation which
is used for the pricing of vanilla options under absence of arbitrage and self-
financing portfolio assumptions. In this chapter we derive the Black-Scholes
PDE and present its solution by the the heat kernel method, with application
to the pricing and hedging of European call and put options.
6.1 The Black-Scholes PDE . . . . . . . . . . . . . . . . . . . . . . . . 213

6.2 European Call Options . . . . . . . . . . . . . . . . . . . . . . . . . 219
6.3 European Put Options . . . . . . . . . . . . . . . . . . . . . . . . . 226
6.4 Market Terms and Data . . . . . . . . . . . . . . . . . . . . . . . . 231
6.5 The Heat Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
6.6 Solution of the Black-Scholes PDE . . . . . . . . . . . . . . 240
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
6.1 The Black-Scholes PDE

In this chapter we work in a market based on a riskless asset with price
(At )t∈R+ given by
At+dt − At dAt dAt

= rdt, = rdt, = rAt , t > 0,
At At dt
with
At = A0 e rt , t > 0,
and a risky asset with price (St )t∈R+ modeled using a geometric Brownian
motion defined from the equation
dSt
= µdt + σdBt , t > 0, (6.1)
St
which admits the solution
" 213
N. Privault
1

St = S0 exp σBt + µt − σ 2 t , t > 0,
2
see Proposition 5.16.
library(quantmod)
getSymbols("0005.HK",from="2016-02-15",to="2017-05-11",src="yahoo")
Marketprices<-Ad(`0005.HK`); myPars <- chart_pars();myPars$cex<-1.2
myTheme <- chart_theme();myTheme$col$line.col <- "blue"
chart_Series(Marketprices,pars=myPars, theme = myTheme)
The adjusted close price Ad() is the closing price after adjustments for ap-
plicable splits and dividend distributions.
The next Figure 6.1 presents a graph of underlying asset price market data,
which is compared to the geometric Brownian motion simulations of Fig-
ures 5.5 and 5.6.
2016−02−15 / 2017−05−10 2016−02−15 / 2017−05−10 60
0005.HK 0005.HK
56 58
ert
56
54 55
54
52
52
50
50 50
48
48
46
46
44 45
44
42 42
40 40 40
38 38
35
Feb 15 May 03 Aug 01 Nov 01 Feb 01 May 02 Feb 15 May 03 Aug 01 Nov 01 Feb 01 May 02
2016 2016 2016 2016 2017 2017 2016 2016 2016 2016 2017 2017
Fig. 6.1: Graph of underlying market prices.
2016−02−15 / 2017−05−10 2016−02−15 / 2017−05−10

Geometric Brownian Motion Geometric Brownian Motion
60 60 60
ert
58 58
56 56
55
54 54
52 52
50 50 50
48 48
46
46 45
44
44
42
42
40 40
40
38
Feb 15 May 03 Aug 01 Nov 01 Feb 01 May 02 Feb 15 May 03 Aug 01 Nov 01 Feb 01 May 35
02
2016 2016 2016 2016 2017 2017 2016 2016 2016 2016 2017 2017
Fig. 6.2: Graph of simulated geometric Brownian motion.
The R package Sim.DiffProc can be used to estimate the coefficients of a

geometric Brownian motion fitting observed market data.
214 "
library("Sim.DiffProc")
fx <- expression( theta[1]*x ); gx <- expression( theta[2]*x )
fitsde(data = as.ts(Marketprices), drift = fx, diffusion = gx, start = list(theta1=1,
theta2=1),pmle="euler")
In the sequel, we start by deriving the Black and Scholes (1973) Partial
Differential Equation (PDE) for the value of a self-financing portfolio. Note
that the drift parameter µ in (6.1) is absent in the PDE (6.2), and it does
not appear as well in the Black and Scholes (1973) formula (6.11).
Proposition 6.1. Let (ηt , ξt )t∈R+ be a portfolio strategy such that
(i) the portfolio strategy (ηt , ξt )t∈R+ is self-financing,
(ii) the portfolio value Vt := ηt At + ξt St , takes the form
Vt = g (t, St ), t > 0,
for some function g ∈ C 1,2 (R+ × R+ ) of t and St .

Then, the function g (t, x) satisfies the Black and Scholes (1973) PDE
∂g ∂g 1 ∂2g
rg (t, x) = (t, x) + rx (t, x) + σ 2 x2 2 (t, x), x > 0, (6.2)
∂t ∂x 2 ∂x
and ξt = ξt (St ) is given by the partial derivative
∂g
ξt = ξt (St ) = (t, St ), t > 0. (6.3)
∂x
Proof. (i) First, we note that the self-financing condition (5.8) in Proposi-
tion 5.9 implies

= rVt dt + (µ − r )ξt St dt + σξt St dBt
= rg (t, St )dt + (µ − r )ξt St dt + σξt St dBt , (6.4)
t > 0. We now rewrite (5.18) under the form of an Itô process

wt wt
St = S0 + vs ds + us dBs , t > 0,
0 0
as in (4.22), by taking
ut = σSt , and vt = µSt , t > 0.
" 215
N. Privault
(ii) By (4.24), the application of Itô’s formula Theorem 4.23 to Vt = g (t, St )

leads to
dVt = dg (t, St )
∂g ∂g 1 ∂2g
= (t, St )dt + (t, St )dSt + (dSt )2 2 (t, St )
∂t ∂x 2 ∂x
∂g ∂g ∂g 1 ∂2g
= (t, St )dt + vt (t, St )dt + ut (t, St )dBt + |ut |2 2 (t, St )dt
∂t ∂x ∂x 2 ∂x
∂g ∂g 1 ∂2g ∂g
= (t, St )dt + µSt (t, St )dt + σ 2 St2 2 (t, St )dt + σSt (t, St )dBt .
∂t ∂x 2 ∂x ∂x
(6.5)
By respective identification of components in dBt and dt in (6.4) and (6.5),

we get
 rg (t, St )dt + (µ − r )ξt St dt = ∂g (t, St )dt + µSt ∂g (t, St )dt + 1 σ 2 S 2 ∂ g (t, St )dt,
2


t
2 ∂x2

 ∂t ∂x
 ξt St σdBt = St σ ∂g (t, St )dBt ,




∂x
hence
1 ∂2g

∂g ∂g
 rg (t, St ) = (t, St ) + rSt (t, St ) + σ 2 St2 2 (t, St ),


 ∂t ∂x 2 ∂x
(6.6)
 ξt = ∂g (t, St ),

0 6 t 6 T,


∂x
which yields (6.2) after substituting St with x > 0.
The derivative giving ξt in (6.3) is called the Delta of the option price, see
Proposition 6.4 below. The amount invested on the riskless asset is
∂g
ηt At = Vt − ξt St = g (t, St ) − St (t, St ),
∂x
and ηt is given by
Vt − ξt St
ηt =
At
1

∂g
= g (t, St ) − St (t, St )
At ∂x
1

∂g
= g ( t, St ) − St ( t, St ) .
A0 e rt ∂x
In the next Proposition 6.2 we add a terminal condition g (T , x) = f (x) to

the Black-Scholes PDE (6.2) in order to price a claim payoff C of the form
216 "
C = h(ST ). As in the discrete-time case, the arbitrage-free price πt (C ) at

time t ∈ [0, T ] of the claim payoff C is defined to be the value Vt of the
self-financing portfolio hedging C.
Proposition 6.2. Under the assumptions of Proposition 6.1, the arbitrage-
free price πt (C ) at time t ∈ [0, T ] of the (vanilla) option with claim payoff
C = h(ST ) is given by πt (C ) = g (t, St ) and the hedging allocation ξt is given
by the partial derivative (6.3), where the function g (t, x) is solution of the
following Black-Scholes PDE:
∂g ∂g 1 ∂2g

 rg (t, x) =
 (t, x) + rx (t, x) + σ 2 x2 2 (t, x),
∂t ∂x 2 ∂x (6.7)

g (T , x) = h(x), x > 0.

Proof. Proposition 6.1 shows that the solution g (t, x) of (6.2), g ∈ C 1,2 (R+ ×
R+ ), represents the value Vt = ηt At + ξt St = g (t, St ), t ∈ R+ , of a self-
financing portfolio strategy (ηt , ξt )t∈R+ . By Definition 3.1, πt (C ) := Vt =
g (t, St ) is the arbitrage-free price at time t ∈ [0, T ] of the vanilla option with
claim payoff C = h(ST ).
The absence of the drift parameter µ from the PDE (6.7) can be understood
in the next forward contract example, in which the claim payoff can be hedged
by leveraging on the value St of the underlying asset, independently of the
trend parameter µ.
Example - Forward contracts
The holder of a long forward contract is committed to purchasing an asset at

the price K at maturity time T , while the contract issuer has the obligation
to hand in the asset priced ST in exchange for the amount K at maturity
time T .
Clearly, the contract has the claim payoff C = ST − K, and it can be hedged
by simply holding ξt = 1 asset in the portfolio at all times t ∈ [0, T ]. Denoting
by Vt the option price at time t ∈ [0, T ], the amount St − Vt has to be
borrowed at time t in order to purchase the asset. As the amount K received
at maturity T should be used to refund the loan at time T , we should have
(St − Vt ) e (T −t)r = K, hence
Vt = St − K e −(T −t)r , 0 6 t 6 T. (6.8)
We note that the riskless allocation ηt = −K e −rT is also constant over time
t ∈ [0, T ] due to self-financing.
" 217
N. Privault
More precisely, the forward contract can be realized by the option issuer via
the following steps:
a) At time t, receive the option premium Vt := St − e −(T −t)r K from the
option buyer.
b) Borrow e −(T −t)r K from the bank, to be refunded at maturity.
c) Buy the risky asset using the amount St − e −(T −t)r K + e −(T −t)r K = St .
d) Hold the risky asset until maturity (do nothing, constant portfolio strat-
egy).
e) At maturity T , hand in the asset to the option holder, who will pay the
amount K in return.
f) Use the amount K = e (T −t)r e −(T −t)r K to refund the lender of e −(T −t)r K
borrowed at time t.
On the other hand, the payoff C of the long forward contract can be written
as C = ST − K = h(ST ) where h is the (affine) payoff function h(x) = x − K,
and the Black-Scholes PDE (6.7) admits the easy solution
g (t, x) = x − K e −(T −t)r , x > 0, 0 6 t 6 T, (6.9)
showing that the price at time t ∈ [0, T ] of the long forward contract is
St − K e −(T −t)r , 0 6 t 6 T.
In addition, the Delta of the option price is given by

∂g
ξt = (t, St ) = 1, 0 6 t 6 T,
∂x
which recovers the static, “hedge and forget” strategy, cf. Exercise 6.7.
Forward contracts can be used for physical delivery, e.g. for live cattle. In
the case of European options, the basic “hedge and forget” constant strategy
ξt = 1, ηt = η0 , 0 6 t 6 T,
will hedge the option only if
ST + η0 AT > (ST − K )+ ,
i.e. if −η0 AT 6 K 6 ST .
Future contracts
For a future contract expiring at time T , we take K = S0 e rT and the contract

is usually quoted at time t in terms of the forward price
e (T −t)r St − K e −(T −t)r = e (T −t)r St − K = e (T −t)r St − S0 e rT ,

218 "
discounted at time T , or simply using e (T −t)r St . Future contracts are non-

deliverable forward contracts which are “marked to market” at each time
step via a cash flow exchange between the two parties, ensuring that the
absolute difference | e (T −t)r St − K| is being credited to the buyer’s account
if e (T −t)r St > K, or to the seller’s account if e (T −t)r St < K.
6.2 European Call Options

Recall that in the case of the European call option with strike price K the
payoff function is given by h(x) = (x − K )+ and the Black-Scholes PDE (6.7)
reads
∂g ∂g 1 ∂ 2 gc

 rgc (t, x) = c (t, x) + rx c (t, x) + σ 2 x2
 (t, x)
∂t ∂x 2 ∂x2 (6.10)

+
gc (T , x) = (x − K ) .

The next proposition will be proved in Sections 6.5-6.6, see Proposition 6.11.
Proposition 6.3. The solution of the PDE (6.10) is given by the Black-
Scholes formula for call options
gc (t, x) = Bl(K, x, σ, r, T − t) = xΦ d+ (T − t) − K e −(T −t)r Φ d− (T − t) ,

(6.11)
with
log(x/K ) + (r + σ 2 /2)(T − t)
d+ (T − t ) : = √ (6.12)
|σ| T − t
and
log(x/K ) + (r − σ 2 /2)(T − t)
d− (T − t) := √ , (6.13)
|σ| T − t
0 6 t < T.
We note the relation

√
d+ (T − t) = d− (T − t) + |σ| T − t, 0 6 t < T. (6.14)
Here, “log” denotes the natural logarithm “ln”, and

1 wx 2
Φ (x) : = P(X 6 x) = √ e −y /2 dy, x ∈ R,
2π −∞
denotes the standard Gaussian Cumulative Distribution Function (CDF) of
a standard normal random variable X ' N (0, 1), with the relation
Φ(−x) = 1 − Φ(x), x ∈ R. (6.15)

" 219
N. Privault
1.2
1
Gaussian CDF Φ(x)
1
0.8
Φ(x)
0.6
0.4
0.2
0
-4 -3 -2 -1 0 1 2 3 4
x
Fig. 6.3: Graph of the Gaussian Cumulative Distribution Function (CDF).
In other words, the European call option with strike price K and maturity
T is priced at time t ∈ [0, T ] as
gc (t, St ) = Bl(K, St , σ, r, T − t)
= St Φ d+ (T − t) − K e −(T −t)r Φ d− (T − t) , 0 6 t 6 T.

The following R script is an implementation of the Black-Scholes formula for

European call options in R.∗
BSCall <- function(S, K, r, T, sigma)
{d1 <- (log(S/K)+(r+sigma^2/2)*T)/(sigma*sqrt(T));d2 <- d1 - sigma * sqrt(T)
BSCall = S*pnorm(d1) - K*exp(-r*T)*pnorm(d2)
BSCall}
In comparison with the discrete-time Cox-Ross-Rubinstein (CRR) model of

Section 2.6, the interest in the formula (6.11) is to provide an analytical so-
lution that can be evaluated in a single step, which is computationally much
more efficient.
∗
220 "
Fig. 6.4: Graph of the Black-Scholes call price map with strike price K = 100.∗
Figure 6.4 presents an interactive graph of the Black-Scholes call price map,
i.e. the solution
(t, x) 7−→ gc (t, x) = xΦ d+ (T − t) − K e −(T −t)r Φ d− (T − t)

of the Black-Scholes PDE (6.7) for a call option.
70
60
50
40
30
20
10
0
0 40
80
100 120 Time in days
Underlying asset price 60 160
Fig. 6.5: Time-dependent solution of the Black-Scholes PDE (call option).†
The next proposition is proved by a direct differentiation of the Black-Scholes

function, and will be recovered later using a probabilistic argument in Propo-
sition 7.14 below.
Proposition 6.4. The Black-Scholes Delta of the European call option is
given by
∂gc
(t, St ) = Φ d+ (T − t) ∈ [0, 1], (6.16)

ξt = ξt (St ) =
∂x
where d+ (T − t) is given by (6.12).
∗
Right-click on the figure for interaction and “Full Screen Multimedia” view.
†
" 221
N. Privault
Proof. From Relation (6.14), we note that the standard normal probability
density function
1 2
ϕ(x) = Φ0 (x) = √ e −x /2 , x ∈ R,
2π
satisfies
log(x/K ) + (r + σ 2 /2)(T − t)

ϕ(d+ (T − t)) = ϕ √
|σ| T − t
2 !
1 1 log(x/K ) + (r + σ 2 /2)(T − t)

= √ exp − √
2π 2 |σ| T − t
2 !
1 1 log(x/K ) + (r − σ 2 /2)(T − t) √

= √ exp − √ + |σ| T − t
2π 2 |σ| T − t
1 1

x
= √ exp − (d− (T − t)) − (T − t)r − log
2
2π 2 K
1

K −(T −t)r
= √ e exp − (d− (T − t)) 2
x 2π 2
K −(T −t)r
= e ϕ(d− (T − t)),
x
hence by (6.11) we have
log(x/K ) + (r + σ 2 /2)(T − t)

∂gc ∂
(t, x) = xΦ √ (6.17)
∂x ∂x |σ| T − t
log(x/K ) + (r − σ 2 /2)(T − t)

−(T −t)r ∂
−K e Φ √
∂x |σ| T − t
log(x/K ) + (r + σ 2 /2)(T − t)

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

∂
+x Φ √
∂x |σ| T − t
log (x/K ) + (r − σ 2 /2)(T − t)

∂
−K e −(T −t)r Φ √
∂x |σ| T − t
log(x/K ) + (r + σ 2 /2)(T − t)

=Φ √
|σ| T − t
1 log(x/K ) + (r + σ 2 /2)(T − t)

+ √ ϕ √
|σ| T − t |σ| T − t
K e −(T −t)r log(x/K ) + (r − σ 2 /2)(T − t)

− √ ϕ √
x|σ| T − t |σ| T − t
222 "
1 K e −(T −t)r
= Φ(d+ (T − t)) + √ ϕ(d+ (T − t)) − √ ϕ(d− (T − t))
|σ| T − t x|σ| T − t
= Φ(d+ (T − t)).

As a consequence of Proposition 6.4, the Black-Scholes call price splits into a
risky component St Φ d+ (T − t) and a riskless component −K e −(T −t)r Φ d− (T −
t) , as follows:

gc (t, St ) = St Φ d+ (T − t) − K e −(T −t)r Φ d− (T − t) , 0 6 t 6 T.

| {z } | {z }
Risky investment (held) Risk free investment (borrowed)
(6.18)
See Exercise 6.4 for a computation of the boundary values of gc (t, x), t ∈
[0, T ), x > 0. The following R code is an implementation of the Black-Scholes
Delta for European call options in R.
DeltaCall <- function(S, K, r, T, sigma)

{d1 <- (log(S/K)+(r+sigma^2/2)*T)/(sigma*sqrt(T))
DeltaCall = pnorm(d1);DeltaCall}
In Figure 6.6 we plot the Delta of the European call option as a function of
the underlying asset price and of the time remaining until maturity.
0.5
150
100 0
Underlying 5
50 10
15
0 Time to maturity T-t
Fig. 6.6: Delta of a European call option with strike price K = 100, r = 3%, σ = 10%.
The Gamma of the European call option is defined as the first derivative or
sensitivity of Delta with respect to the underlying asset price. It also repre-
sents the second derivative of the option price with respect to the underlying
asset price. This gives
1
Φ 0 d+ (T − t )

γt = √
St |σ| T − t
2 !
1 1 log(St /K ) + (r + σ 2 /2)(T − t)

= exp − √
St |σ| 2(T − t)π 2
p
|σ| T − t
" 223
N. Privault
> 0.
In particular, a positive value of γt implies that the Delta ξt = ξt (St ) should

increase when the underlying asset price St increases. In other words, the po-
sition ξt in the underlying asset should be increased by additional purchases
if the underlying asset price St increases.
In Figure 6.7 we plot the (truncated) value of the Gamma of a European call
option as a function of the underlying asset price and of time to maturity.
Fig. 6.7: Gamma of European call and put options with strike price K = 100.
As Gamma is always nonnegative, the Black-Scholes hedging strategy is to

keep buying the risky underlying asset when its price increases, and to sell it
when its price decreases, as can be checked from Figure 6.7.
Numerical example - Hedging a call option
In Figure 6.8 we consider the historical stock price of HSBC Holdings

(0005.HK) over one year:
Consider the call option issued by Societe Generale on 31 December 2008 with
strike price K=$63.704, maturity T = October 05, 2009, and an entitlement
ratio of 100, meaning that one option contract is divided into 100 warrants, cf.
page 9. The next graph gives the time evolution of the Black-Scholes portfolio
value
t 7−→ gc (t, St )
driven by the market price t 7−→ St of the risky underlying asset as given in
Figure 6.8, in which the number of days is counted from the origin and not
from maturity.
224 "
Fig. 6.8: Graph of the stock price of HSBC Holdings.
40
35
30
25
20
15
10
5
0 0
90 80 100 50
70 60 150 Time
Underlying (HK$) 50 40 200 in days
Fig. 6.9: Path of the Black-Scholes price for a call option on HSBC.
As a consequence of (6.18), in the Black-Scholes call option hedging model,

the amount invested in the risky asset is
St ξt = St Φ d+ (T − t)

log(St /K ) + (r + σ 2 /2)(T − t)

= St Φ √
|σ| T − t
> 0,
which is always nonnegative, i.e. there is no short selling, and the amount
invested on the riskless asset is
ηt At = −K e −(T −t)r Φ d− (T − t)

log(St /K ) + (r − σ 2 /2)(T − t)

= −K e −(T −t)r Φ √
|σ| T − t
6 0,
which is always nonpositive, i.e. we are constantly borrowing money on the

riskless asset, as noted in Figure 6.10.
" 225
N. Privault
Black-Scholes price
Risky investment ξtSt
100 Riskless investment ηtAt
Underlying asset price
80
K
60
40
HK$
20
-20
-40
-60
0 50 100 150 200
Fig. 6.10: Time evolution of a hedging portfolio for a call option on HSBC.
A comparison of Figure 6.10 with market data can be found in Figures 9.10a
and 9.10b below.
Cash settlement. In the case of a cash settlement, the option issuer will sat-
isfy the option contract by selling ξT = 1 stock at the price ST = $83,
refund the K = $63 risk-free investment, and hand in the remaining amount
C = (ST − K )+ = 83 − 63 = $20 to the option holder.
Physical delivery. In the case of physical delivery of the underlying asset, the
option issuer will deliver ξT = 1 stock to the option holder in exchange for
K = $63, which will be used together with the portfolio value to refund the
risk-free loan.
6.3 European Put Options

Similarly, in the case of the European put option with strike price K the
payoff function is given by h(x) = (K − x)+ and the Black-Scholes PDE (6.7)
reads
∂g ∂g 1 ∂ 2 gp

 rgp (t, x) = p (t, x) + rx p (t, x) + σ 2 x2
 (t, x),
∂t ∂x 2 ∂x2 (6.19)

gp (T , x) = (K − x)+ ,

The next proposition can be proved from the call-put parity Proposition 6.6
and Proposition 6.11, see Sections 6.5-6.6.
Proposition 6.5. The solution of the PDE (6.19) is given by the Black-
Scholes formula for put options
226 "
gp (t, x) = K e −(T −t)r Φ − d− (T − t) − xΦ − d+ (T − t) , (6.20)

with
log(x/K ) + (r + σ 2 /2)(T − t)
d+ (T − t ) = √ (6.21)
|σ| T − t
and
log(x/K ) + (r − σ 2 /2)(T − t)
d− (T − t) = √ , (6.22)
|σ| T − t
0 6 t < T,
as illustrated in Figure 6.11.
Fig. 6.11: Graph of the Black-Scholes put price function with strike price K = 100.∗
In other words, the European put option with strike price K and maturity
T is priced at time t ∈ [0, T ] as
gp (t, St ) = K e −(T −t)r Φ − d− (T − t) − St Φ − d+ (T − t) , 0 6 t 6 T.

∗
" 227
N. Privault
40
30
20
10
00 60
40 80 100
120 160 Underlying asset price
Time in days
Fig. 6.12: Time-dependent solution of the Black-Scholes PDE (put option).∗
The following R script is an implementation of the Black-Scholes formula for

European put options in R.
BSPut <- function(S, K, r, T, sigma)
{d1 = (log(S/K)+(r+sigma^2/2)*T)/(sigma*sqrt(T));d2 = d1 - sigma * sqrt(T);
BSPut = K*exp(-r*T) * pnorm(-d2) - S*pnorm(-d1);BSPut}
Call-put parity
Proposition 6.6. Call-put parity. We have the relation
St − K e −(T −t)r = gc (t, St ) − gp (t, St ), 0 6 t 6 T, (6.23)
between the Black-Scholes prices of call and put options, in terms of the
forward contract price St − K e −(T −t)r .
Proof. The call-put parity (6.23) is a consequence of the relation
x − K = (x − K ) + − (K − x) +
satisfied by the terminal call and put payoff functions in the linear Black-
Scholes PDE (6.7), which is solved as
x − K e −(T −t)r = gc (t, x) − gp (t, x)
for t ∈ [0, T ], since x − K e −(T −t)r is the pricing function of the long forward
contract with payoff ST − K, see (6.8). It can also be verified directly from
(6.11) and (6.20) as
gc (t, x) − gp (t, x) = xΦ d+ (T − t) − K e −(T −t)r Φ d− (T − t)

∗
228 "
− K e −(T −t)r Φ − d− (T − t) − xΦ − d+ (T − t)

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

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

= x − K e −(T −t)r .

The Delta of the Black-Scholes put option can be obtained by differentiation
of the call-put parity relation (6.23) and Proposition 6.4.
Proposition 6.7. The Delta of the Black-Scholes put option is given by
ξt = −(1 − Φ d+ (T − t) ) = −Φ − d+ (T − t) ∈ [−1, 0], 0 6 t 6 T.

Proof. By the call-put parity relation (6.23) and Proposition 6.4, we have
∂gp ∂gc
(t, St ) = (t, St ) − 1
∂x ∂x
= Φ(d+ (T − t)) − 1
= −Φ(−d+ (T − t)), 0 6 t 6 T,
where we applied (6.15).

As a consequence of Proposition 6.7, the Black-Scholes put price splits
into a risky component −St Φ − d+ (T − t) and a riskless component

K e −(T −t)r Φ − d− (T − t) , as follows:

gp (t, St ) = K e −(T −t)r Φ − d− (T − t) − St Φ − d+ (T − t) , 0 6 t 6 T.

| {z } | {z }
Risk−free investment (savings) Risky investment (short)
(6.24)
DeltaPut <- function(S, K, r, T, sigma)

{d1 <- (log(S/K)+(r+sigma^2/2)*T)/(sigma*sqrt(T)); DeltaPut = -pnorm(-d1);DeltaPut}
In Figure 6.13 we plot the Delta of the European put option as a function of
the underlying asset price and of the time remaining until maturity.
" 229
N. Privault
-0.5
-1
150
100 0
Underlying 5
50 10
15
Fig. 6.13: Delta of a European put option with strike price K = 100, r = 3%, σ = 10%.
Numerical example - Hedging a put option
For one more example, we consider a put option issued by BNP Paribas on
04 November 2008 with strike price K=$77.667, maturity T = October 05,
2009, and entitlement ratio 92.593, cf. page 9. In the next Figure 6.14, the
number of days is counted from the origin, not from maturity.
45
40
35
30
25
20
15
10
5
0
40
0 50 60 50
100 150 80 70
Time in days 200 100 90 Underlying (HK$)
Fig. 6.14: Path of the Black-Scholes price for a put option on HSBC.
As a consequence of (6.24), the amount invested on the risky asset for the
hedging of a put option is
log(St /K ) + (r + σ 2 /2)(T − t)

−St Φ − d+ (T − t) = −St Φ −

√
|σ| T − t
6 0,
i.e. there is always short selling, and the amount invested on the riskless asset
priced At = e rt , t ∈ [0, T ], is
ηt At = K e −(T −t)r Φ − d− (T − t)

230 "
log(St /K ) + (r − σ 2 /2)(T − t)

= K e −(T −t)r Φ − √
|σ| T − t
> 0,
which is always nonnegative, i.e. we are constantly saving money on the

riskless asset, as noted in Figure 6.15.
Black-Scholes price
Risky investment ξtSt
100 Riskless investment ηtAt
80 K
60
40
HK$
20
-20
-40
-60
0 50 100 150 200
Fig. 6.15: Time evolution of the hedging portfolio for a put option on HSBC.
In the above example the put option finished out of the money (OTM), so that
no cash settlement or physical delivery occurs. A comparison of Figure 6.10
with market data can be found in Figures 9.11a and 9.11b below.
6.4 Market Terms and Data

The following Table 6.1 provides a summary of formulas for the computation
of Black-Scholes sensitivities, also called Greeks.∗
Call option Put option
Option price g (t, St ) St Φ(d+ (T − t)) − K e −(T −t)r Φ(d− (T − t)) K e −(T −t)r Φ(−d− (T − t)) − St Φ(−d+ (T − t))
∂g
Delta (∆) (t, St ) Φ(d+ (T − t)) > 0 −Φ(−d+ (T − t)) 6 0
∂x
∂2g Φ0 (d+ (T − t))

Gamma (Γ) (t, St ) √ >0
∂x2 St |σ| T − t
∂g √
Vega (t, St ) St T − tΦ0 (d+ (T − t)) > 0
∂σ
0
∂g St |σ|Φ (d+ (T − t)) St |σ|Φ0 (d+ (T − t))
Theta (Θ) (t, St ) − √ − rK e −(T −t)r Φ(d− (T − t)) 6 0 − √ + rK e −(T −t)r Φ(d− (T − t))
∂t 2 T −t 2 T −t
∂g
Rho (ρ) (t, St ) (T − t)K e −(T −t)r Φ(d− (T − t)) −(T − t)K e −(T −t)r Φ(−d− (T − t))
∂r
Table 6.1: Black-Scholes Greeks (Wikipedia).

∗
“Every class feels like attending a Greek lesson” (AY2018-2019 student feedback).
" 231
N. Privault
From Table 6.1 we can conclude that call option prices are increasing func-
tions of the underlying asset price St , of the interest rate r, and of the volatil-
ity parameter σ. Similarly, put option prices are decreasing functions of the
underlying asset price St , of the interest rate r, and increasing functions of
the volatility parameter σ, see also Exercise 6.13.
Parameter Variation of call option prices Variation of put option prices
Underlying St Increasing % Decreasing &
Volatility σ Increasing % Increasing %
Decreasing & if r > 0 Depends on the underlying price level if r > 0

Time t
Depends on the underlying price level if r < 0 Decreasing & if r 6 0
Interest rate r Increasing % Increasing &
Table 6.2: Variations of Black-Scholes prices.
The change of sign in the sensitivity Theta (Θ) with respect to time t can be
verified in the following Figure 6.16 when r > 0.
10 10
T-t=0.00 T-t=0.00
8 8
6 6
gp(x,t)
gc(x,t)
4 4
2 2
0 0
90 95 100 105 110 90 95 100 105 110
x x
(a) Black-Scholes call price maps. (b) Black-Scholes put price maps
Fig. 6.16: Time-dependent solutions of the Black-Scholes PDE with r = +3% > 0.∗
The next two figures show the variations of call and put option prices as
functions of time when r < 0.
∗
232 "
10 10
T-t=0.00 T-t=0.00
8 8
6 6
gp(x,t)
gc(x,t)
4 4
2 2
0 0
90 95 100 105 110 90 95 100 105 110
x x
Fig. 6.17: Time-dependent solutions of the Black-Scholes PDE with r = −3% < 0.∗
The next two figures show the variations of call and put option prices as
functions of time when r = 0.
10 10
T-t=0.00 T-t=0.00
8 8
6 6
gp(x,t)
gc(x,t)
4 4
2 2
0 0
90 95 100 105 110 90 95 100 105 110
x x
Fig. 6.18: Time-dependent solutions of the Black-Scholes PDE with r = 0.†
Intrinsic value. The intrinsic value at time t ∈ [0, T ] of the option with
(1)
claim payoff C = h ST is given by the immediate exercise payoff
(1)
h St . The extrinsic value at time t ∈ [0, T ] of the option is the re-
(1)
maining difference πt (C ) − h St between the option price πt (C ) and
(1)
the immediate exercise payoff h St . In general, the option price πt (C )
decomposes as
(1) (1)
πt ( C ) = h St + πt (C ) − h St , 0 6 t 6 T ].
| {z } | {z }
Intrinsic value Extrinsic value
†
" 233
N. Privault
Gearing. The gearing at time t ∈ [0, T ] of the option with claim payoff
C = h(ST ) is defined as the ratio
St St
Gt : = = , 0 6 t 6 T.
πt ( C ) g (t, St )
Effective gearing. The effective gearing at time t ∈ [0, T ] of the option with
claim payoff C = h(ST ) is defined as the ratio
EGt := Gt ξt
ξt St
=
πt ( C )
St ∂g
= (t, St )
πt (C ) ∂x
St ∂g
= (t, St )
g (t, St ) ∂x
∂
= St log g (t, St ), 0 6 t 6 T.
∂x
The effective gearing
ξt St
EGt =
πt ( C )
can be interpreted as the hedge ratio, i.e. the percentage of the portfolio
which is invested on the risky asset. When written as
∆g (t, St ) ∆St
= EGt × ,
g (t, St ) St
the effective gearing gives the relative variation, or percentage change,

∆g (t, St )/g (t, St ) of the option price g (t, St ) from the relative variation
∆St /St in the underlying asset price.
The ratio EGt = St ∂ log g (t, St )/∂x can also be interpreted as an elasticity
coefficient.
Break-even price. The break-even price BEPt of the underlying asset is the
value of S for which the intrinsic option value h(S ) equals the option price
πt (C ) at time t ∈ [0, T ]. For European call options it is given by
BEPt := K + πt (C ) = K + g (t, St ), t = 0, 1, . . . , N .
whereas for European put options it is given by
BEPt := K − πt (C ) = K − g (t, St ), 0 6 t 6 T.
234 "
Premium. The option premium OPt can be defined as the variation required
from the underlying asset price in order to reach the break-even price, i.e.
we have
BEPt − St K + g (t, St ) − St
OPt := = , 0 6 t 6 T,
St St
for European call options, and
St − BEPt St + g (t, St ) − K
OPt := = , 0 6 t 6 T,
St St
for European put options, see Figure 6.19 below. The term “premium”
is sometimes also used to denote the arbitrage-free price g (t, St ) of the
option.
f (t,x,σ)
100
=
+ x2 2
σ2 ∂ 2f
2 ∂x
K= =(x−K )/x
log f ∂f
x ∂ ∂x = ∆= = ∂x (t,x,σ)
∂x
∂f
σ= ∂f
= ∂σ (t,x,σ)
+ rx
∂f K +f (t,x,σ)−x
(t,x,σ)= = x
∂t
T= =K +f (t,x,σ)
∂t
∂f
rf =
x=
Fig. 6.19: Warrant terms and data.
The R package bizdays (requires to install QuantLib) can be used to compute

calendar time vs business time to maturity
install.packages("bizdays")
library(bizdays)
load_quantlib_calendars('HongKong', from='2018-01-01', to='2018-12-31')
" 235
N. Privault
load_quantlib_calendars('Singapore', from='2018-01-01', to='2018-12-31')

bizdays('2018-03-10', '2018-04-03', 'QuantLib/HongKong')
bizdays('2018-03-10', '2018-04-03', 'QuantLib/Singapore')
6.5 The Heat Equation
In the next proposition we notice that the solution f (t, x) of the Black-
Scholes PDE (6.7) can be transformed into a solution g (t, y ) of the simpler
heat equation by a change of variable and a time inversion t 7−→ T − t on
the interval [0, T ], so that the terminal condition at time T in the Black-
Scholes equation (6.25) becomes an initial condition at time t = 0 in the
heat equation (6.28). See also here for a related discussion on changes of
variables for the Black-Scholes PDE.
Proposition 6.8. Assume that f (t, x) solves the Black-Scholes PDE
∂f ∂f 1 ∂2f

 rf (t, x) =
 (t, x) + rx (t, x) + σ 2 x2 2 (t, x),
∂t ∂x 2 ∂x (6.25)

 +
f (T , x) = (x − K ) ,
with terminal condition h(x) = (x − K )+ , x > 0. Then the function g (t, y )

defined by
2
g (t, y ) = e rt f T − t, e |σ|y +(σ /2−r )t (6.26)

solves the heat equation (6.28) with initial condition
ψ (y ) := h e |σ|y , y ∈ R, (6.27)

i.e. we have
1 ∂2g

∂g
(t, y ) = (t, y )


2 ∂y 2

∂t (6.28)

g (0, y ) = h e |σ|y .


Proposition 6.8 will be proved in Section 6.6. It will allow us to solve the
Black-Scholes PDE (6.25) based on the solution of the heat equation (6.28)
with initial condition ψ (y ) = h e |σ|y , y ∈ R, by inversion of Relation (6.26)
2
with s = T − t, x = e |σ|y +(σ /2−r )t , i.e.
−(σ 2 /2 − r )(T − s) + log x

f (s, x) = e −(T −s)r g T − s, .
|σ|
Next, we focus on the heat equation
236 "
∂ϕ 1 ∂2ϕ
(t, y ) = (t, y ) (6.29)
∂t 2 ∂y 2
which is used to model the diffusion of heat over time through solids. Here,
the data of g (x, t) represents the temperature measured at time t and point
x. We refer the reader to Widder (1975) for a complete treatment of this
topic.
4
t=0.0256
3.5
2.5
φ(y,t)
1.5
0.5
0
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2
y
Fig. 6.20: Time-dependent solution of the heat equation.∗
Proposition 6.9. The fundamental solution of the heat equation (6.29) is

given by the Gaussian probability density function
1 2
ϕ(t, y ) := √ e −y /(2t) , y ∈ R,
2πt
with variance t > 0.
Proof. The proof is done by a direct calculation, as follows:
2
!
∂ϕ ∂ e −y /(2t)
(t, y ) = √
∂t ∂t 2πt
2 2
e −y /(2t) y 2 e −y /(2t)
= − 3/2 √ + 2 √
2t 2π 2t 2πt
1 y2

= − + 2 ϕ(t, y ),
2t 2t
and
2
!
1 ∂2ϕ 1 ∂ y e −y /(2t)
(t, y ) = − √
2 ∂y 2 2 ∂y t 2πt
∗
" 237
N. Privault
2 2
e −y /(2t) y 2 e −y /(2t)
=− √ + 2 √
2t 2πt 2t 2πt
1 y2

= − + 2 ϕ(t, y ), t > 0, y ∈ R.
2t 2t

In Section 6.6 the heat equation (6.29) will be shown to be equivalent to the
Black-Scholes PDE after a change of variables. In particular this will lead to
the explicit solution of the Black-Scholes PDE.
Proposition 6.10. The heat equation
1 ∂2g

∂g
(t, y ) = (t, y )


2 ∂y 2

∂t (6.30)

g (0, y ) = ψ (y )


with continuous initial condition
g (0, y ) = ψ (y )
has the solution

w∞ 2 dz
g (t, y ) = ψ (z ) e −(y−z ) /(2t) √ , y ∈ R, t > 0. (6.31)
−∞ 2πt
Proof. We have
∂g ∂ w∞ 2 dz
(t, y ) = ψ (z ) e −(y−z ) /(2t) √
∂t ∂t −∞ 2πt
w∞ 2
!
∂ e −(y−z ) /(2t)
= ψ (z ) √ dz
−∞ ∂t 2πt
1w∞ (y − z )2 1

2 dz
= ψ (z ) − e −(y−z ) /(2t) √
2 −∞ t 2 t 2πt
1w∞ ∂ 2 −(y−z )2 /(2t) dz
= ψ (z ) 2 e √
2 −∞ ∂z 2πt
1w∞ ∂ 2 −(y−z )2 /(2t) dz
= ψ (z ) 2 e √
2 −∞ ∂y 2πt
1 ∂ 2 w ∞ −(y−z )2 /(2t) dz
= ψ (z ) e √
2 ∂y 2 −∞ 2πt
1 ∂2g
= (t, y ).
2 ∂y 2
On the other hand, it can be checked that at time t = 0 we have
238 "
w∞ 2 / (2t) dz w∞ 2 dz
lim ψ (z ) e −(y−z ) √ = lim ψ (y + z ) e −z /(2t) √
t→0 −∞ 2πt t→0 −∞ 2πt
= ψ (y ), y ∈ R.

The next Figure 6.21 shows the evolution of g (t, x) with initial condition
based on the European call payoff function h(x) = (x − K )+ , i.e.
+
g (0, y ) = ψ (y ) = h e |σ|y = e |σ|y − K , y ∈ R.

10
t= 0
6
g(x,t)
0
0 50 100 150 200
x
Fig. 6.21: Time-dependent solution of the heat equation.∗
Let us provide a second proof of Proposition 6.10, this time using Brownian
motion and stochastic calculus.
Proof of Proposition 6.10. First, note that under the change of variable x =
z − y we have
w∞ dz 2 / (2t)
g (t, y ) = ψ (z ) e −(y−z )
√
−∞ 2πt
w∞
−x2 /(2t) dx
= ψ (y + x) e √
−∞ 2πt
= E[ψ (y + Bt )]
= E[ψ (y − Bt )],
where (Bt )t∈R+ is a standard Brownian motion and Bt ' N (0, t), t > 0.
Applying Itô’s formula to ψ (y − Bt ) and using the fact that the expecta-
tion of the stochastic integral with respect to Brownian motion is zero, see
Relation (4.17) in Proposition 4.20, we find
g (t, y ) = E[ψ (y − Bt )]
∗
" 239
N. Privault
wt 1 w t 00

= E ψ (y ) − ψ 0 (y − Bs )dBs + ψ (y − Bs )ds
0 2 0
w w
1

t 0 t 00
= ψ (y ) − E ψ (y − Bs )dBs + E ψ (y − Bs )ds
0 2 0
1wt
2
∂ ψ
= ψ (y ) + E (y − Bs ) ds
2 0 ∂y 2
w
1 t ∂ 2
= ψ (y ) + E [ψ (y − Bs )] ds
2 0 ∂y 2
w
1 t ∂2g
= ψ (y ) + (s, y )ds.
2 0 ∂y 2
Hence we have
∂g ∂
(t, y ) = E[ψ (y − Bt )]
∂t ∂t
1 ∂2
= E [ψ (y − Bt )]
2 ∂y 2
1∂ g
2
= (t, y ).
2 ∂y 2
Regarding the initial condition, we check that
g (0, y ) = E[ψ (y − B0 )] = E[ψ (y )] = ψ (y ).

The expression g (t, y ) = E[ψ (y − Bt )] provides a probabilistic interpreta-
tion of the heat diffusion phenomenon based on Brownian motion. Namely,
when ψε (y ) := 1[−ε,ε] (y ), we find that
gε (t, y ) = E[ψε (y − Bt )]
= E[1[−ε,ε] (y − Bt )]
= P y − Bt ∈ [−ε, ε]

= P y − ε 6 Bt 6 y + ε

represents the probability of finding Bt within a neighborhood [y − ε, y + ε]

of the point y ∈ R.
6.6 Solution of the Black-Scholes PDE

In this section we solve the Black-Scholes PDE by the kernel method of
Section 6.5 and a change of variables. This solution method uses the change
of variables (6.26) of Proposition 6.8 and a time inversion from which the
240 "
terminal condition at time T in the Black-Scholes equation becomes an initial

condition at time t = 0 in the heat equation.
Next, we provide the proof Proposition 6.8.
2 /2−r )t
Proof of Proposition 6.8. Letting s = T − t and x = e |σ|y +(σ and using
Relation (6.26), i.e.
2 /2−r )t
g (t, y ) = e rt f T − t, e |σ|y +(σ ,

we have
∂g 2 ∂f 2
(t, y ) = r e rt f T − t, e |σ|y +(σ /2−r )t − e rt T − t, e |σ|y +(σ /2−r )t

∂t ∂s
2
σ 2 ∂f 2
− r e rt e |σ|y +(σ /2−r )t T − t, e |σ|y +(σ /2−r )t

+
2 ∂x
2
∂f σ ∂f
= r e rt f (T − t, x) − e rt (T − t, x) + − r e rt x (T − t, x)
∂s 2 ∂x
1 rt 2 2 ∂ 2 f σ 2 rt ∂f
= e x σ (T − t, x) + e x (T − t, x), (6.32)
2 ∂x2 2 ∂x
where on the last step we used the Black-Scholes PDE. On the other hand
we have
∂g 2 ∂f 2
(t, y ) = |σ| e rt e |σ|y +(σ /2−r )t T − t, e |σ|y +(σ /2−r )t

∂y ∂x
and
1 ∂g 2 σ 2 rt |σ|y +(σ2 /2−r )t ∂f 2
e e T − t, e |σ|y +(σ /2−r )t

(t, y ) =
2 ∂y 2 2 ∂x
σ2 2 ∂2f 2
+ e rt e 2|σ|y +2(σ /2−r )t 2 T − t, e |σ|y +(σ /2−r )t

2 ∂x
σ 2 rt ∂f σ 2 rt 2 ∂ 2 f
= e x (T − t, x) + e x (T − t, x). (6.33)
2 ∂x 2 ∂x2
We conclude by comparing (6.32) with (6.33), which shows that g (t, x) solves
the heat equation (6.30) with initial condition
g (0, y ) = f T , e |σ|y = h e |σ|y .

In the next proposition we provide a proof of Proposition 6.3 by deriving
the Black-Scholes formula (6.11) from the solution of the PDE (6.25). The
Black-Scholes formula will also be recovered by a probabilistic argument via
the computation of an expected value in Proposition 7.7.
" 241
N. Privault
Proposition 6.11. When h(x) = (x − K )+ , the solution of the Black-

Scholes PDE (6.25) is given by
f (t, x) = xΦ d+ (T − t) − K e −(T −t)r Φ d− (T − t) , x > 0,

where
1 wx 2
Φ (x) = √ e −y /2 dy, x ∈ R,
2π −∞
and
log(x/K ) + (r + σ 2 /2)(T − t)


 d+ (T − t ) : = √ ,
|σ| T − t



log(x/K ) + (r − σ 2 /2)(T − t)


 d− ( T − t ) : = √ ,


|σ| T − t
x > 0, t ∈ [0, T ).
2 /2−r )t
Proof. By inversion of Relation (6.26) with s = T − t and x = e |σ|y +(σ ,
we get
−(σ 2 /2 − r )(T − s) + log x

f (s, x) = e −(T −s)r g T − s,
|σ|
and
log x

, x > 0, or ψ (y ) = h e |σ|y , y ∈ R.

h(x) = ψ
|σ|
Hence, using the solution (6.31) and Relation (6.27), we get
−(σ 2 /2 − r )(T − t) + log x

f (t, x) = e −(T −t)r g T − t,
|σ|
w
−(σ 2 /2 − r )(T − t) + log x

dz
−(T −t)r ∞ 2
= e ψ + z e −z /(2(T −t)) p
−∞ |σ| 2(T − t)π
w∞ 2 2 dz
= e −(T −t)r h x e |σ|z−(σ /2−r )(T −t) e −z /(2(T −t)) p

−∞ 2(T − t)π
w∞ 2 + 2 dz
= e −(T −t)r x e |σ|z−(σ /2−r )(T −t) − K e −z /(2(T −t)) p
−∞ 2(T − t)π
= e −(T −t)r
w∞ 2 2 dz
× (−r+σ2 /2)(T −t)+log(K/x) x e |σ|z−(σ /2−r )(T −t) − K e −z /(2(T −t)) p

|σ| 2(T − t)π
w∞ 2 /2−r )(T −t) 2 / (2(T −t)) dz
= x e −(T −t)r √ e |σ|z−(σ e −z
2(T − t)π
p
−d− (T −t) T −t
242 "
w∞ 2 / (2(T −t)) dz
−K e −(T −t)r √ e −z
2(T − t)π
p
−d− (T −t) T −t
w∞ dz
|σ|z−(T −t)σ 2 /2−z 2 /(2(T −t))
= x √ e
2(T − t)π
p
−d− (T −t) T −t
w∞ 2 dz
−K e −(T −t)r √ e −z /(2(T −t)) p
−d− (T −t) T −t 2(T − t)π
w∞ 2 dz
= x √ e −(z−(T −t)|σ|) /(2(T −t)) p
−d− (T −t) T −t 2(T − t)π
w∞ 2 dz
−K e −(T −t)r √ e −z /(2(T −t)) p
−d− (T −t) T −t 2(T − t)π
w∞ 2 dz
= x √ e −z /(2(T −t)) p
−d− (T −t) T −t−(T −t)|σ| 2(T − t)π
w∞ 2 dz
−K e −(T −t)r √ e −z /(2(T −t)) p
−d− (T −t) T −t 2(T − t)π
w∞ 2 dz w∞ 2 dz
= x √ e −z /2 √ − K e −(T −t)r e −z /2 √
−d− (T −t)−|σ| T −t 2π −d− (T −t) 2π
x 1 − Φ − d+ (T − t) − K e −(T −t)r 1 − Φ − d− (T − t)

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

=
where we used the relation (6.15), i.e.
1 − Φ(a) = Φ(−a), a ∈ R.
Exercises
Exercise 6.1 Bachelier (1900) model. Consider a market made of a riskless

asset valued At = A0 with zero interest rate, t > 0, and a risky asset whose
price St is modeled by a standard Brownian motion as St = Bt , t > 0.
a) Show that the price g (t, Bt ) of the option with claim payoff C = (BT )2
satisfies the heat equation
∂g 1 ∂2g
− (t, y ) = (t, y )
∂t 2 ∂y 2
with terminal condition g (T , x) = x2 .

b) Find the function g (t, x) by solving the PDE of Question (a).
Hint: Try a solution of the form g (t, x) = x2 + f (t).
" 243
N. Privault
c) Find the risky asset allocation ξt hedging the claim payoff C = (BT )2 .
See Exercises 6.11 and 7.16-7.17 for extensions to nonzero interest rates.
Exercise 6.2 Consider a risky asset price (St )t∈R modeled in the Cox et al.
(1985) (CIR) model as
p
dSt = β (α − St )dt + σ St dBt , α, β, σ > 0, (6.34)
and let (ηt , ξt )t∈R+ be a portfolio strategy whose value Vt := ηt At + ξt St ,

takes the form Vt = g (t, St ), t > 0. Figure 6.22 presents a random simulation
of the solution to (6.34) with α = 0.025, β = 1, and σ = 1.3.
5
St
4
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Fig. 6.22: Graph of the CIR short rate t 7→ rt with α = 2.5%, β = 1, and σ = 1.3.
N=10000; t <- 0:(N-1); dt <- 1.0/N;a=0.025; b=2; sigma=0.05;

X <- rnorm(N,mean=0,sd=sqrt(dt));R <- rep(0,N);R[1]=0.01
for (j in 2:N){R[j]=max(0,R[j-1]+(a-b*R[j-1])*dt+sigma*sqrt(R[j-1])*X[j])}
plot(t, R, xlab = "t", ylab = "", type = "l", ylim = c(0,0.02), col = "blue")
Based on the self-financing condition written as
dVt = rVt dt − rξt St dt + ξt dSt

p
= rVt dt − rξt St dt + β (α − St )ξt dt + σξt St dBt , t > 0, (6.35)
derive the PDE satisfied by the function g (t, x) using the Itô formula.
Exercise 6.3 Black-Scholes PDE with dividends. Consider a riskless asset

with price At = A0 e rt , t > 0, and an underlying asset price process (St )t∈R+
modeled as
dSt = (µ − δ )St dt + σSt dBt ,
where (Bt )t∈R+ is a standard Brownian motion and δ > 0 is a continuous-
time dividend rate. By absence of arbitrage, the payment of a dividend entails
a drop in the stock price by the same amount occurring generally on the ex-
dividend date, on which the purchase of the security no longer entitles the
244 "
investor to the dividend amount. The list of investors entitled to dividend

payment is consolidated on the date of record, and payment is made on the
payable date.
library(quantmod)
getSymbols("0005.HK",from="2010-01-01",to=Sys.Date(),src="yahoo")
getDividends("0005.HK",from="2010-01-01",to=Sys.Date(),src="yahoo")
a) Assuming that the portfolio with value Vt = ξt St + ηt At at time t is self-

financing and that dividends are continuously reinvested, write down the
portfolio variation dVt .
b) Assuming that the portfolio value Vt takes the form Vt = g (t, St ) at time
t, derive the Black-Scholes PDE for the function g (t, x) with its terminal
condition.
c) Compute the price at time t ∈ [0, T ] of the European call option with
strike price K by solving the corresponding Black-Scholes PDE.
d) Compute the Delta of the option.
Exercise 6.4
a) Check that the Black-Scholes formula (6.11) for European call options
gc (t, x) = xΦ d+ (T − t) − K e −(T −t)r Φ d− (T − t) ,

satisfies the following boundary conditions:

i) at x = 0, gc (t, 0) = 0,
ii) at maturity t = T ,

 x − K, x>K
gc (T , x) = (x − K )+ =
0, x 6 K,

and
 1,

 x>K


1


lim Φ(d+ (T − t)) = , x=K
t%T 
 2



0, x < K,

iii) as time to maturity tends to infinity,
lim Bl(K, x, σ, r, T − t) = x, t > 0.

T →∞
b) Check that the Black-Scholes formula (6.20) for European put options
" 245
N. Privault
gp (t, x) = K e −(T −t)r Φ − d− (T − t) − xΦ − d+ (T − t)

satisfies the following boundary conditions:

i) at x = 0, gp (t, 0) = K e −(T −t)r ,
ii) as x tends to infinity, gp (t, ∞) = 0 for all t ∈ [0, T ),
iii) at maturity t = T ,
 0,

x>K
+
gp (T , x) = (K − x) =
K − x, x 6 K,

and
 0,

 x>K


1


− lim Φ(−d+ (T − t)) = − , x=K
t%T 
 2



−1, x < K,

iv) as time to maturity tends to infinity,
lim Blp (K, St , σ, r, T − t) = 0, t > 0.

T →∞
Exercise 6.5 Power option (Exercise 3.15 continued). Power options can be
used for the pricing of realized variance and volatility swaps, see § 8.2.
a) Solve the Black-Scholes PDE
∂g ∂g σ2 ∂ 2 g
rg (x, t) = (x, t) + rx (x, t) + x2 2 (x, t) (6.36)
∂t ∂x 2 ∂x
with terminal condition g (x, T ) = x2 , x > 0, t ∈ [0, T ].
Hint: Try a solution of the form g (x, t) = x2 f (t), and find f (t).
b) Find the respective quantities ξt and ηt of the risky asset St and riskless
asset At = A0 e rt in the portfolio with value
Vt = g (St , t) = ξt St + ηt At , 0 6 t 6 T,
hedging the contract with claim payoff C = (ST )2 at maturity.
Exercise 6.6 On December 18, 2007, a call warrant has been issued by
Fortis Bank on the stock price S of the MTR Corporation with maturity
T = 23/12/2008, strike price K = HK$ 36.08 and entitlement ratio=10.
Recall that in the Black-Scholes model, the price at time t of the European
246 "
claim on the underlying asset priced St with strike price K, maturity T ,

interest rate r and volatility σ > 0 is given by the Black-Scholes formula as
f (t, St ) = St Φ d+ (T − t) − K e −(T −t)r Φ d− (T − t) ,

where
(r − σ 2 /2)(T − t) + log(St /K )


 d− (T − t) = √ ,
|σ| T − t



√ (r + σ 2 /2)(T − t) + log(St /K )


 d+ (T − t) = d− (T − t) + |σ| T − t = √ .


|σ| T − t
Recall that by Proposition 6.4 we have

∂f
(t, St ) = Φ d+ (T − t) , 0 6 t 6 T.

∂x
a) Using the values of the Gaussian cumulative distribution function, com-
pute the Black-Scholes price of the corresponding call option at time
t =November 07, 2008 with St = HK$ 17.200, assuming a volatility σ =
90% = 0.90 and an annual risk-free interest rate r = 4.377% = 0.04377,
b) Still using the Gaussian cumulative distribution function, compute the
quantity of the risky asset required in your portfolio at time t =November
07, 2008 in order to hedge one such option at maturity T = 23/12/2008.
c) Figure 1 represents the Black-Scholes price of the call option as a function
of σ ∈ [0.5, 1.5] = [50%, 150%].
0.6
Market price
0.5
0.4
Option price
0.3
0.2
0.1
0 σ
0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 imp 1.4 1.5
σ
Fig. 6.23: Option price as a function of the volatility σ > 0.
" 247
N. Privault
BSCall <- function(S, K, r, T, sigma)

{d1 <- (log(S/K)+(r+sigma^2/2)*T)/(sigma*sqrt(T));d2 <- d1 - sigma * sqrt(T)
BSCall = S*pnorm(d1) - K*exp(-r*T)*pnorm(d2);BSCall}
sigma <- seq(0.5,1.5, length=100);
plot(sigma,BSCall(17.2,36.08,0.04377,46/365,sigma) , type="l",lty=1, xlab="Sigma",
ylab="Black-Scholes Call Price", ylim = c(0,0.6),col="blue",lwd=3);grid()
abline(h=0.23,col="red",lwd=3)
Knowing that the closing price of the warrant on November 07, 2008 was
HK$ 0.023, which value can you infer for the implied volatility σ at this
date?∗
Exercise 6.7 Forward contracts. Recall that the price πt (C ) of a claim

payoff C = h(ST ) of maturity T can be written as πt (C ) = g (t, St ), where
the function g (t, x) satisfies the Black-Scholes PDE
∂g ∂g 1 ∂2g

 rg (t, x) =
 (t, x) + rx (t, x) + σ 2 x2 2 (t, x),
∂t ∂x 2 ∂x

g (T , x) = h(x), (1)

with terminal condition g (T , x) = h(x), x > 0.

a) Assume that C is a forward contract with payoff
C = ST − K,
at time T . Find the function h(x) in (1).

b) Find the solution g (t, x) of the above PDE and compute the price πt (C )
at time t ∈ [0, T ].
Hint: search for a solution of the form g (t, x) = x − α(t) where α(t) is a
function of t to be determined.
c) Compute the quantities
∂g
ξt = (t, St )
∂x
and ηt of risky and riskless assets in a self-financing portfolio hedging C,
assuming A0 = $1.
d) Repeat the above questions with the terminal condition g (T , x) = x.
Exercise 6.8
a) Solve the Black-Scholes PDE
∂g ∂g σ2 ∂ 2 g
rg (t, x) = (t, x) + rx (t, x) + x2 2 (t, x) (6.37)
∂t ∂x 2 ∂x
∗
here.
248 "
with terminal condition g (T , x) = 1, x > 0.

Hint: Try a solution of the form g (t, x) = f (t) and find f (t).
b) Find the respective quantities ξt and ηt of the risky asset St and riskless
Vt = g (t, St ) = ξt St + ηt At
hedging the contract with claim payoff C = $1 at maturity.
Exercise 6.9 Log contracts can be used for the pricing and hedging of realized
variance swaps, see § 8.2 and Exercise 8.6.
a) Solve the PDE
∂g ∂g σ2 ∂ 2 g
0= (x, t) + rx (x, t) + x2 2 (x, t) (6.38)
∂t ∂x 2 ∂x
with the terminal condition g (x, T ) := log x, x > 0.
Hint: Try a solution of the form g (x, t) = f (t) + log x, and find f (t).
b) Solve the Black-Scholes PDE
∂h ∂h σ2 ∂ 2 h
rh(x, t) = (x, t) + rx (x, t) + x2 2 (x, t) (6.39)
∂t ∂x 2 ∂x
with the terminal condition h(x, T ) := log x, x > 0.
Hint: Try a solution of the form h(x, t) = u(t)g (x, t), and find u(t).
c) Find the respective quantities ξt and ηt of the risky asset St and riskless
Vt = g (St , t) = ξt St + ηt At
hedging a log contract with claim payoff C = log ST at maturity.
Exercise 6.10 Binary options. Consider a price process (St )t∈R+ given by
dSt
= rdt + σdBt , S0 = 1,
St
under the risk-neutral probability measure P∗ . The binary (or digital) call
option is a contract with maturity T , strike price K, and payoff
 $1 if ST > K,

Cd := 1[K,∞) (ST ) =
0 if ST < K.

" 249
N. Privault
a) Derive the Black-Scholes PDE satisfied by the pricing function Cd (t, St )

of the binary call option, together with its terminal condition.
b) Show that the solution Cd (t, x) of the Black-Scholes PDE of Question (a)
is given by
(r − σ 2 /2)(T − t) + log(x/K )

Cd (t, x) = e −(T −t)r Φ √
|σ| T − t
= e −(T −t)r Φ(d− (T − t)),
where
(r − σ 2 /2)(T − t) + log(St /K )
d− ( T − t ) : = √ , 0 6 t < T.
|σ| T − t
Exercise 6.11
a) Bachelier (1900) model. Solve the stochastic differential equation
dSt = αSt dt + σdBt (6.40)
in terms of α, σ ∈ R, and the initial condition S0 .

b) Write down the Bachelier PDE satisfied by the function C (t, x), where
C (t, St ) is the price at time t ∈ [0, T ] of the contingent claim with claim
payoff C = φ(ST ) = exp(ST ), and identify the process Delta (ξt )t∈[0,T ]
that hedges this claim.
c) Solve the Black-Scholes PDE of Question (b) with the terminal condition
φ(x) = e x , x ∈ R.
Hint: Search for a solution of the form

σ2 2

C (t, x) = exp −(T − t)r + xh(t) + (h (t) − 1) , (6.41)
4r
where h(t) is a function to be determined, with h(T ) = 1.

d) Compute the portfolio strategy (ξt , ηt )t∈[0,T ] that hedges the contingent
claim with claim payoff C = exp(ST ).
Exercise 6.12
a) Show that for every fixed value of S, the function
√
d 7−→ h(S, d) := SΦ d + |σ| T − K e −rT Φ(d),
log(S/K ) + (r − σ 2 /2)T
reaches its maximum at d∗ (S ) := √ .
|σ| T
250 "
∂h
Hint: The maximum is reached when the partial derivative vanishes.
∂d
b) By the differentiation rule
d ∂h ∂h
h(S, d∗ (S )) = (S, d∗ (S )) + d0∗ (S ) (S, d∗ (S )),
dS ∂S ∂d
recover the value of the Black-Scholes Delta.
Exercise 6.13
a) Compute the Black-Scholes call and put Vega by differentiation of the
Black-Scholes function
gc (t, x) = Bl(K, x, σ, r, T − t) = xΦ d+ (T − t) − K e −(T −t)r Φ d− (T − t) ,

with respect to the volatility parameter σ > 0, knowing that

2
1 1 log(x/K ) + (r − σ 2 /2)(T − t)

2
− d− (T − t) = − √
2 2 |σ| T − t
1 2 x
= − d+ (T − t) + (T − t)r + log . (6.42)
2 K
How do the Black-Scholes call and put prices behave when subjected an
increase in the volatility parameter σ?
b) Compute the Black-Scholes Rho by differentiation of the Black-Scholes
function gc (t, x). How do the Black-Scholes call and put prices behave
when subjected an increase in the interest rate parameter r?
Exercise 6.14 Consider the backward induction relation (3.14), i.e.
ve(t, x) = (1 − p∗N )ve (t + 1, x(1 + aN )) + p∗N ve (t + 1, x(1 + bN )) ,
using the renormalizations rN := rT /N and

p p
aN := (1 + rN )(1 − |σ| T /N ) − 1, bN := (1 + rN )(1 + |σ| T /N ) − 1,
of Section 3.6, N > 1, with

rN − aN bN − rN
p∗N = and p∗N = .
bN − a N bN − aN
a) Show that the Black-Scholes PDE (6.2) of Proposition 6.1 can be recovered
from the induction relation (3.14) when the number N of time steps tends
to infinity.
∂gc
b) Show that the expression of the Delta ξt = (t, St ) can be similarly
∂x
recovered from the finite difference relation (3.19), i.e.
" 251
N. Privault
(1) v (t, (1 + bN )St−1 ) − v (t, (1 + aN )St−1 )

ξt (St−1 ) =
St−1 (bN − aN )
as N tends to infinity.
Problem 6.15 (Leung and Sircar (2015)) ProShares Ultra S&P500 and
ProShares UltraShort S&P500 are leveraged investment funds that seek daily
investment results, before fees and expenses, that correspond to β times (βx)
the daily performance of the S&P500,® with respectively β = 2 for ProShares
Ultra and β = −2 for ProShares UltraShort. Here, leveraging with a factor
β : 1 aims at multiplying the potential return of an investment by a factor
β. The following ten questions are interdependent and should be treated in
sequence.
a) Consider a risky asset priced S0 := $4 at time t = 0 and taking two
possible values S1 = $5 and S1 = $2 at time t = 1. Compute the two
possible returns (in %) achieved when investing $4 in one share of the asset
S, and the expected return under the risk-neutral probability measure,
assuming that the risk-free interest rate is zero.
b) Leveraging. Still based on an initial $4 investment, we decide to leverage
by a factor β = 3 by borrowing another (β − 1) × $4 = 2 × $4 at rate
zero to purchase a total of β = 3 shares of the asset S. Compute the
two returns (in %) possibly achieved in this case, and the expected return
under the risk-neutral probability measure, assuming that the risk-free
interest rate is zero.
c) Denoting by Ft the ProShares value at time t, how much should the fund
invest in the underlying asset priced St , and how much $ should it borrow
or save on the risk-free market at any time t in order to leverage with a
factor β : 1?
d) Find the portfolio allocation (ξt , ηt ) for the fund value
Ft = ξt St + ηt At , t > 0,
according to Question (c), where At := A0 e rt

is the riskless money market
account.
e) We choose to model the S&P500 index St as the geometric Brownian
motion
dSt = rSt dt + σSt dBt , t > 0,
under the risk-neutral probability measure P∗ . Find the stochastic dif-
ferential equation satisfied by (Ft )t∈R+ under the self-financing condition
dFt = ξt dSt + ηt dAt .
f) Is the discounted fund value ( e −rt Ft )t∈R+ a martingale under the risk-
neutral probability measure P∗ ?
252 "
g) Find the relation between the fund value Ft and the index St by solving
the stochastic differential equation obtained for Ft in Question (e). For
simplicity we normalize F0 := S0β .
h) Write the price at time t = 0 of the call option with claim payoff C =
(FT − K )+ on the ProShares index using the Black-Scholes formula.
i) Show that when β > 0, the Delta at time t ∈ [0, T ) of the call option with
claim payoff C = (FT − K )+ on ProShares Ultra is equal to the Delta of
the call option with claim payoff C = (ST − Kβ (t))+ on the S&P500, for
a certain strike price Kβ (t) to be determined explicitly.
j) When β < 0, find the relation between the Delta at time t ∈ [0, T ) of the
call option with claim payoff C = (FT − K )+ on ProShares UltraShort
and the Delta of the put option with claim payoff C = (Kβ (t) − ST )+ on
the S&P500.
" 253
Chapter 7
Martingale Approach to Pricing and
Hedging
In the martingale approach to the pricing and hedging of financial deriva-

tives, option prices are expressed as the expected values of discounted option
payoffs. This approach relies on the construction of risk-neutral probability
measures by the Girsanov theorem, and the associated hedging portfolios are
obtained via stochastic integral representations.
7.1 Martingale Property of the Itô Integral . . . . . . . . . . 255

7.2 Risk-neutral Probability Measures . . . . . . . . . . . . . . 260
7.3 Change of Measure and the Girsanov Theorem . . . 264
7.4 Pricing by the Martingale Method . . . . . . . . . . . . . . 266
7.5 Hedging by the Martingale Method . . . . . . . . . . . . . 274
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
7.1 Martingale Property of the Itô Integral
Recall (Definition 5.5) that an integrable process (Xt )t∈R+ is said to be a

martingale with respect to the filtration (Ft )t∈R+ if
E[Xt | Fs ] = Xs , 0 6 s 6 t.
In the sequel,
L2 (Ω) := {F : Ω → R : E[|F |2 ] < ∞}
denotes the space of square-integrable random variables.
Examples of martingales (i)
1. Given F ∈ L2 (Ω) a square-integrable random variable and (Ft )t∈R+ a

filtration, the process (Xt )t∈R+ defined by
Xt := E[F | Ft ], t > 0,
" 255
N. Privault
is an (Ft )t∈R+ -martingale under P. Indeed, since Fs ⊂ Ft , 0 6 s 6 t, it

follows from the tower property (23.38) of conditional expectations that
E[Xt | Fs ] = E[E[F | Ft ] | Fs ] = E[F | Fs ] = Xs , 0 6 s 6 t. (7.1)
2. Any integrable stochastic process (Xt )t∈R+ whose increments (Xt1 −

Xt0 , . . . , Xtn − Xtn−1 ) are mutually independent and centered under P
(i.e. E[Xt ] = 0, t ∈ R+ ) is a martingale with respect to the filtration
(Ft )t∈R+ generated by (Xt )t∈R+ , as we have
E[Xt | Fs ] = E[Xt − Xs + Xs | Fs ]
= E[Xt − Xs | Fs ] + E[Xs | Fs ]
= E[Xt − Xs ] + Xs
= Xs , 0 6 s 6 t. (7.2)
In particular, the standard Brownian motion (Bt )t∈R+ is a martingale

because it has centered and independent increments. This fact is also
consequence of Proposition 7.1 below as Bt can be written as
wt
Bt = dBs , t > 0.
0
The following result shows that the Itô integral yields a martingale with
respect to the Brownian filtration (Ft )t∈R+ . It is the continuous-time analog
of the discrete-time Theorem 2.11.
r
t
Proposition 7.1. The stochastic integral process 0 us dBs of a square-
t∈R+
integrable adapted process u ∈ L2ad (Ω × R+ ) is a martingale, i.e.:
w w
t s
E uτ dBτ Fs = uτ dBτ , 0 6 s 6 t. (7.3)

0 0
rt
In particular, 0 us dBs is Ft -measurable, t > 0, and since F0 = {∅, Ω},
Relation (7.3) applied with t = 0 recovers the fact that the Itô integral is a
centered random variable:
w w w
t t 0
E us dBs = E us dBs F0 = us dBs = 0, t > 0.

0 0 0
Proof. The statement is first proved in case (ut )t∈R+ is a simple predictable
process, and then extended to the general case, cf. e.g. Proposition 2.5.7 in
Privault (2009). For example, for u a predictable step process of the form
 F if s ∈ [a, b],

us := F 1[a,b] (s) =
0 if s ∈
/ [a, b],

256 "
with F an Fa -measurable random variable and t ∈ [a, b], by Definition 4.16

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

0 0
= E[F (Bb − Ba ) | Ft ]
= F E[Bb − Ba | Ft ]
= F (Bt − Ba )
wt
= us dBs
a
wt
= us dBs , a 6 t 6 b.
0
On the other hand, when t ∈ [0, a] we have

wt
us dBs = 0,
0
and we check that

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

0 0
= E[F (Bb − Ba ) | Ft ]
= E[E[F (Bb − Ba ) | Fa ] | Ft ]
= E[F E[Bb − Ba | Fa ] | Ft ]
= 0, 0 6 t 6 a,
where we used the tower property (23.38) of conditional expectations and the
fact that Brownian motion (Bt )t∈R+ is a martingale:
E[Bb − Ba | Fa ] = E[Bb | Fa ] − Ba = Ba − Ba = 0.
The extension from simple processes to square-integrable processes in L2ad (Ω ×

R+ ) can be proved as in Proposition 4.20. Indeed, given u(n) n∈N be a

sequence of simple predictable processes converging to u in L2 (Ω × [0, T ])

cf. Lemma 1.1 of Ikeda and Watanabe (1989), pages 22 and 46, by Fatou’s
Lemma 23.4 and Jensen’s inequality we have:
wt
" #
hw ∞ i2
E us dBs − E us dBs Ft

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

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

n→∞ 0 0
" 257
N. Privault
w
∞ (n) w∞ 2
6 lim inf E E us dBs − us dBs Ft

n→∞ 0 0
w 2
∞ (n)
= lim inf E (us − us )dBs
n→∞ 0
hw ∞ i
(n)
= lim inf E |us − us |2 ds
n→∞ 0
= lim inf ku(n) − uk2L2 (Ω×[0,T ])
n→∞
= 0,
where we used the Itô isometry (4.16). We conclude that

hw ∞ i wt
E us dBs Ft = us dBs , t > 0,

0 0
for u ∈ L2ad (Ω
× R+ ) a square-integrable adapted process, which leads to
(7.3) after applying this identity to the process (1[0,t] us )s∈R+ , i.e.,
w hw ∞
t i
E uτ dBτ Fs = E

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

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

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

2
= X0 e −σ t/2 E e σBt | Fs

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

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

2
= X0 e −σ t/2+σBs E e (Bt −Bs )σ

2
1
= X0 e −σ t/2+σBs exp E[(Bt − Bs )σ ] + Var[(Bt − Bs )σ ]
2
2 2
= X0 e −σ t/2+σBs e (t−s)σ /2
258 "
2
= X0 e σBs −σ s/2
= Xs , 0 6 s 6 t.
This fact can also be recovered from Proposition 7.1, since by Proposi-
tion 5.16, (Xt )t∈R+ satisfies the stochastic differential equation
dXt = σXt dBt ,
which shows that Xt can be written using the Brownian stochastic inte-
gral wt
Xt = X0 + σ Xu dBu , t > 0.
0
2. Consider an asset price process (St )t∈R+ given by the stochastic differ-
ential equation
dSt = µSt dt + σSt dBt , t > 0. (7.4)
By the Discounting Lemma 5.14, the discounted asset price process Set :=
e −rt St , t > 0, satisfies the stochastic differential equation
dSet = (µ − r )Set dt + σ Set dBt ,
and the discounted asset price

2
Set = e −rt St = S0 e (µ−r )t+σBt −σ t/2 , t > 0,
is a martingale under P when µ = r. The case µ 6= r will be treated

in Section 7.3 using risk-neutral probability measures, see Definition 5.4,
and the Girsanov Theorem 7.3, see (7.15) below.
3. The discounted value
Vet = e −rt Vt , t > 0,
of a self-financing portfolio is given by

wt
Vet = Ve0 + ξu dSeu , t > 0,
0
cf. Lemma 5.15 is a martingale when µ = r by Proposition 7.1 because

wt
Vet = Ve0 + σ ξu Seu dBu , t > 0, ,
0
since we have
dSet = Set ((µ − r )dt + σdBt ) = σ Set dBt
" 259
N. Privault
by the Discounting Lemma 5.14. Since the Black-Scholes theory is in fact

valid for any value of the parameter µ we will look forward to including
the case µ 6= r in the sequel.
7.2 Risk-neutral Probability Measures

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

+
is a martingale, see Definition 5.4 and Proposition 5.6.
Consider an asset price process (St )t∈R+ given by the stochastic differential
equation (7.4). Note that when µ = r, the discounted asset price process
2
Set t∈R = (S0 e σBt −σ t/2 )t∈R+ is a martingale under P∗ = P, which is a

+
risk-neutral probability measure.
In this section, we address the construction of a risk-neutral probability

measure P∗ in the general case µ 6= r using the Girsanov Theorem 7.3 below.
For this, we note that by the Discounting Lemma 5.14, the relation
dSet = (µ − r )Set dt + σ Set dBt
where µ − r is the risk premium, can be rewritten as

bt ,
dSet = σ Set dB (7.5)
where (B
bt )t∈R is a drifted Brownian motion given by
+
bt := µ − r t + Bt ,
B t > 0,
σ
where the drift coefficient ν := (µ − r )/σ is the “Market Price of Risk”
(MPoR). The MPoR represents the difference between the return µ expected
when investing in the risky asset St , and the risk-free interest rate r, mea-
sured in units of volatility σ.
From (7.5) and Propositions 5.6 and 7.1 we note that the risk-neutral prob-
ability measure can be constructed as a probability measure P∗ under which
bt )t∈R is a standard Brownian motion.
(B +
Let us come back to the informal interpretation of Brownian motion via its
infinitesimal increments: √
∆Bt = ± ∆t,
260 "
with
√ √ 1
P ∆Bt = + ∆t = P ∆Bt = − ∆t = .
2
14
^
12 Drifted Brownian path Bt
Drift νt
10
8
^ 6
Bt
4
2
0
-2
-4
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 7.1: Drifted Brownian path (B

bt )t∈R+ .
Clearly, given ν ∈ R, the drifted process

bt := νt + Bt ,
B t > 0,
is no longer a standard Brownian motion because it is not centered:
E Bbt = E[νt + Bt ] = νt + E[Bt ] = νt 6= 0,

cf. Figure 7.1. This identity can be formulated in terms of infinitesimal in-
crements as
1 √ 1 √
E[ν∆t + ∆Bt ] = (ν∆t + ∆t) + (ν∆t − ∆t) = ν∆t 6= 0.
2 2
In order to make νt + Bt a centered process (i.e. a standard Brownian motion,
since νt + Bt conserves all the other properties (i)-(iii) in the definition of
Brownian motion, one may change the probabilities of ups and downs, which
have been fixed so far equal to 1/2.
That is, the problem is now to find two numbers p∗ , q ∗ ∈ [0, 1] such that
√ √
 p∗ (ν∆t + ∆t) + q ∗ (ν∆t − ∆t) = 0

p∗ + q ∗ = 1.

The solution to this problem is given by

1 √ 1 √
p∗ : = (1 − ν ∆t) and q ∗ := (1 + ν ∆t). (7.6)
2 2
" 261
N. Privault
Definition 7.2. We say that a probability measure Q is absolutely continuous

with respect to another probability measure P if there exists a nonnegative
random variable F : Ω −→ R such that E[F ] = 1, and
dQ
= F, i.e. dQ = F dP. (7.7)
dP
In this case, F is called the Radon-Nikodym density of Q with respect to P.
Relation (7.7) is equivalent to the relation
w
EQ [G] = G(ω )dQ(ω )
Ω
w dQ
= G(ω ) (ω )dP(ω )
w Ω dP
= G(ω )F (ω )dP(ω )
Ω
= E [F G] ,
for any random variable G integrable under Q.
Coming back to Brownian√motion considered as a discrete random walk with

independent increments ± ∆t, we try to construct a new probability measure
denoted P∗ , under which the drifted process B bt := νt + Bt will be a stan-
dard Brownian motion. This probability measure will be defined through its
Radon-Nikodym density
√ √
dP∗ P∗ (∆Bt1 = 1 ∆t, . . . , ∆BtN = N ∆t)
:= √ √
dP P(∆Bt1 = 1 ∆t, . . . , ∆BtN = N ∆t)
√ √
P∗ (∆Bt1 = 1 ∆t) · · · P∗ (∆BtN = N ∆t)
= √ √
P(∆Bt1 = 1 ∆t) · · · P(∆BtN = N ∆t)
1 √ √
= P∗ (∆Bt1 = 1 ∆t) · · · P∗ (∆BtN = N ∆t), (7.8)
(1/2)N
1 , 2 , . . . , N ∈ {−1, 1}, with respect to the historical probability measure

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

and under the identification [0, T ] ' {0 = t0 , t1 , . . . , tN = T }, this Radon-
Nikodym density (7.8) can be rewritten as
dP∗ 1 Y 1 1 √
' ∓ ν ∆t (7.9)
dP (1/2) N 2 2
0<t<T
where 2N becomes a normalization factor. Using the expansion

262 "
√ √ 1 √
log 1 ± ν ∆t = ±ν ∆t − (±ν ∆t)2 + o(∆t)
2
√ ν2
= ±ν ∆t − ∆t + o(∆t),
2
for small values of ∆t, this Radon-Nikodym density can be informally shown
to converge as follows as N tends to infinity, i.e. as the time step ∆t = T /N
tends to zero:
dP∗ Y 1 1 √
= 2N ∓ ν ∆t
dP 2 2
0<t<T
Y √
= 1 ∓ ν ∆t
0<t<T
!
Y √
= exp log 1 ∓ ν ∆t
0<t<T
!
X √
= exp log 1 ∓ ν ∆t
0<t<T
!
X √ 1 X √
' exp ν ∓ ∆t − (∓ν ∆t)2
2
0<t<T 0<t<T
!
X √ ν2 X
= exp −ν ± ∆t − ∆t
2
0<t<T 0<t<T
!
X ν2 X
= exp −ν ∆Bt − ∆t
2
0<t<T 0<t<T
ν2

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

X √ X
BT ' ± ∆t and T ' ∆t.
0<t<T 0<t<T
Informally, the drifted process Bbt )

t∈[0,T ] = (νt + Bt )t∈[0,T ] is a standard
Brownian motion under the probability measure P∗ defined by its Radon-
Nikodym density
dP∗ ν2

= exp −νBT − T .
dP 2
The following R code is rescaling probabilities as in (7.6) based on the value
of the drift µ.
" 263
N. Privault
N=2000; t <- 0:N; dt <- 1.0/N; nu=3; p=0.5*(1-nu*(dt)^0.5); nsim <- 100
X <- matrix((dt)^0.5*(rbinom( nsim * N, 1, p)-0.5)*2, nsim, N)
plot(t, X[1, ], xlab = "Time", ylab = "", type = "l", ylim = c(-2*N*dt,2*N*dt), col =
0,cex.axis=1.4,cex.lab=1.4,xaxs="i", mgp = c(1, 2, 0), las=1)
for (i in 1:nsim){lines(t,t*nu*dt+X[i,],type="l",col=i+1,lwd=2)}
The discretized illustration in Figure 7.2 displays the drifted Brownian motion
Bbt := νt + Bt under the shifted probability measure P∗ in (7.9) using the
above R code with N = 100. The code makes big transitions less frequent
than small transitions, resulting into a standard, centered Brownian motion
under P∗ .
1.0
0.5
0.0
−0.5
−1.0
0 20 40 Time 60 80 100
Fig. 7.2: Drifted Brownian motion paths under a shifted Girsanov measure.
7.3 Change of Measure and the Girsanov Theorem

In this section we restate the Girsanov Theorem in a more rigorous way,
using changes of probability measures. The Girsanov Theorem can actually
be extended to shifts by adapted processes (ψt )t∈[0,T ] as follows, cf. e.g.
Theorem III-42, page 141 of Protter (2004). An extension of the Girsanov
Theorem to jump processes will be covered in Section 20.5. Recall also that
here, Ω = C0 ([0, T ]) is the Wiener space and ω ∈ Ω is a continuous function
on [0, T ] starting at 0 in t = 0. The Girsanov Theorem 7.3 will be used in Sec-
tion 7.4 for the construction of a unique risk-neutral probability measure P∗ ,
showing absence of arbitrage and completeness in the Black-Scholes market,
see Theorems 5.8 and 5.12.
Theorem 7.3. Let (ψt )t∈[0,T ] be an adapted process satisfying the Novikov
integrability condition
w
1 T

E exp |ψt |2 dt < ∞, (7.10)
2 0
and let Q denote the probability measure defined by the Radon-Nikodym den-
sity
264 "
w
dQ 1wT

T
= exp − ψs dBs − |ψs |2 ds .
dP 0 2 0
Then wt
bt := Bt +
B ψs ds, 0 6 t 6 T,
0
is a standard Brownian motion under Q.
In the case of the simple shift
bt := Bt + νt,
B 0 6 t 6 T,
by a drift νt with constant ν ∈ R, the process B is a standard (cen-

bt
t∈R+
tered) Brownian motion under the probability measure Q defined by
ν2

dQ(ω ) = exp −νBT − T dP(ω ).
2
For example, the fact that BbT has a centered Gaussian distribution under Q
can be recovered as follows:
EQ f B bT = EQ [f (νT + BT )]

w
= f (νT + BT )dQ
Ω
w
1

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

2 dy
= f (νT + y ) exp −νy − ν T e −y /(2T ) √
−∞ 2 2πT
w∞
−(νT +x)2 /(2T ) dx
= f (νT + x) e √
−∞ 2πT
w∞
−y 2 /(2T ) dy
= f (y ) e √
−∞ 2πT
= EP [f (BT )],
i.e.
w
EQ [f (νT + BT )] = f (νT + BT )dQ (7.11)
wΩ
= f (BT )dP
Ω
= EP [f (BT )],
showing that, under Q, νT + BT has the centered N (0, T ) Gaussian distribu-

tion with variance T . For example, taking f (x) = x, Relation (7.11) recovers
the fact that B
bT is a centered random variable under Q, i.e.
EQ B bT = EQ [νT + BT )] = EP [BT ] = 0.

" 265
N. Privault
The Girsanov Theorem 7.3 also allows us to extend (7.11) as

w· w
T 1wT

EP [F (·)] = E F B· + ψs ds exp − ψs dBs − |ψs |2 ds
0 0 2 0
h w· i
= EQ F B· + ψs ds , (7.12)
0
for all random variables F ∈ L1 (Ω), see also Exercise 7.24.
When applied to the (constant) market price of risk (or Sharpe ratio)
µ−r
ψt := ,
σ
the Girsanov Theorem 7.3 shows that the process
bt := µ − r t + Bt ,
B 0 6 t 6 T, (7.13)
σ
is a standard Brownian motion under the probability measure P∗ defined by
dP∗ (µ − r )2

µ−r
= exp − BT − T . (7.14)
dP σ 2σ 2
Hence by Proposition 7.1 the discounted price process (Set )t∈R+ solution of
bt ,
dSet = (µ − r )Set dt + σ Set dBt = σ Set dB t > 0, (7.15)
is a martingale under P∗ , therefore P∗ is a risk-neutral probability measure.

We also check that P∗ = P when µ = r.
In the sequel, we consider probability measures Q that are equivalent to P in

the sense that they share the same events of zero probability.
Definition 7.4. A probability measure Q on (Ω, F ) is said to be equivalent
Q(A) = 0 if and only if P(A) = 0, for all A ∈ F.
Note that when Q is defined by (7.7), it is equivalent to P if and only if F > 0

with P-probability one.
7.4 Pricing by the Martingale Method

In this section we give the expression of the Black-Scholes price using expec-
tations of discounted payoffs.
266 "
Recall that according to the first fundamental theorem of asset pricing

Theorem 5.8, a continuous market is without arbitrage opportunities if and
only if there exists (at least) an equivalent risk-neutral probability measure
P∗ under which the discounted price process
Set := e −rt St , t > 0,
is a martingale under P∗ .
In addition, when the risk-neutral probability mea-
sure is unique, the market is said to be complete.
The equation
dSt
= µdt + σdBt , t > 0,
St
satisfied by the price process (St )t∈R+ can be rewritten using (7.13) as
dSt bt ,
= rdt + σdB t > 0, (7.16)
St
with the solution
2 t/2 2 t/2
St = S0 e µt+σBt −σ = S0 e rt+σBbt −σ , t > 0.
By the discounting Lemma 5.14, we have
dSet = (µ − r )Set dt + σ Set dBt

µ−r
= σ Set dt + dBt
σ
bt ,
= σ Set dB t > 0, (7.17)
hence the discounted price process
Set := e −rt St
2
= S0 e (µ−r )t+σBt −σ t/2
2
= S0 e σBbt −σ t/2 , t > 0,
is a martingale under the probability measure P∗ defined by (7.14). We note

that P∗ is a risk-neutral probability measure equivalent to P, also called mar-
tingale measure, whose existence and uniqueness ensure absence of arbitrage
and completeness according to Theorems 5.8 and 5.12.
Therefore, by Lemma 5.15 the discounted value Vet of a self-financing port-

folio can be written as
wt
Vet = Ve0 + ξu dSeu
0
" 267
N. Privault
wt
= Ve0 + σ bu ,
ξu Seu dB t > 0,
0
and by Proposition 7.1 it becomes a martingale under P∗ .
As in Chapter 3, the value Vt at time t of a self-financing portfolio strategy

(ξt )t∈[0,T ] hedging an attainable claim payoff C will be called an arbitrage-
free price of the claim payoff C at time t and denoted by πt (C ), t ∈ [0, T ].
Arbitrage-free prices can be used to ensure that financial derivatives are
“marked” at their fair value (“mark to market”).
Theorem 7.5. Let (ξt , ηt )t∈[0,T ] be a portfolio strategy with value
Vt = ηt At + ξt St , 0 6 t 6 T,
and let C be a contingent claim payoff, such that

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

Then, the arbitrage-free price of the claim payoff C is given by the portfolio
value
πt (C ) = Vt = e −(T −t)r E∗ [C | Ft ], 0 6 t 6 T, (7.18)
where E∗ denotes expectation under the risk-neutral probability measure P∗ .
Proof. Since the portfolio strategy (ξt , ηt )t∈R+ is self-financing, by Lemma 5.15
and (7.17) the discounted portfolio value Vet = e −rt Vt satisfies
wt wt
Vet = V0 + ξu dSeu = Ve0 + σ bu ,
ξu Seu dB t > 0,
0 0
which is a martingale under P∗ from Proposition 7.1, hence
Vet = E∗ VeT Ft

= E∗ [ e −rT VT | Ft ]
= E∗ [ e −rT C | Ft ]
= e −rT E∗ [C | Ft ],
which implies
Vt = e rt Vet = e −(T −t)r E∗ [C | Ft ], 0 6 t 6 T.
268 "
Black-Scholes PDE for vanilla options by the martingale method
The martingale method can be used to recover the Black-Scholes PDE of

Proposition 6.1. As the process (St )t∈R+ has the Markov property, see Sec-
tion 4.5, § V-6 of Protter (2004) and Definition 7.15 below, the value
Vt = e −(T −t)r E∗ [φ(ST ) | Ft ]

= e −(T −t)r E∗ [φ(ST ) | St ], 0 6 t 6 T,
of the portfolio at time t ∈ [0, T ] can be written from (7.18) as a function
Vt = g (t, St ) = e −(T −t)r E∗ [φ(ST ) | St ] (7.19)
of t and St , 0 6 t 6 T .
Proposition 7.6. Assume that φ is a Lipschitz payoff function, and that
(St )t∈R+ is the geometric Brownian motion
2 /2)t
(St )t∈R+ = S0 e σBbt +(r−σ

t∈R+
where (B bt )t∈R is a standard Brownian motion under P∗ . Then, the function

+
g (t, x) defined in (7.19) is in C 1,2 ([0, T ) × R+ ) and solves the Black-Scholes
PDE
∂g ∂g 1 ∂2g

 rg (t, x) =
 (t, x) + rx (t, x) + x2 σ 2 2 (t, x)
∂t ∂x 2 ∂x

g (T , x) = φ(x), x > 0.

Proof. It can be checked by integrations by parts that the function g (t, x)

defined by
g (t, St ) = e −(T −t)r E∗ [φ(ST ) | St ] = e −(T −t)r E∗ [φ(xST /St )]|x=St ,
0 6 t 6 T , is in C 1,2 ([0, T ) × R+ ) when φ is a Lipschitz function, from the

properties of the lognormal distribution of ST . We note that by (4.24), the
application of Itô’s formula Theorem 4.23 to Vt = g (t, St ) and (7.16) leads
to
d e −rt g (t, St ) = −r e −rt g (t, St )dt + e −rt dg (t, St )

∂g
= −r e −rt g (t, St )dt + e −rt (t, St )dt
∂t
−rt ∂g 1 −rt ∂2g
+e (t, St )dSt + e (dSt )2 2 (t, St )
∂x 2 ∂x
∂g
∂t
" 269
N. Privault
bt + 1 e −rt |ut |2 ∂ g (t, St )dt

∂g ∂g 2
+vt e −rt (t, St )dt + ut e −rt (t, St )dB
∂x ∂x 2 ∂x2
∂g
∂t
∂g 1 ∂2g ∂g
+rSt e −rt (t, St )dt + e −rt σ 2 St2 2 (t, St )dt + σ e −rt St (t, St )dB bt .
∂x 2 ∂x ∂x
By Lemma 5.15 and Proposition 7.1, the discounted price Vet = e −rt g (t, St )
of a self-financing hedging portfolio is a martingale under the risk-neutral
probability measure P∗ , therefore from e.g. Corollary II-6-1, page 72 of
Protter (2004), all terms in dt should vanish in the above expression of
d e −rt g (t, St ) , showing that
∂g ∂g 1 ∂2g
−rg (t, St ) + (t, St ) + rSt (t, St ) + σ 2 St2 2 (t, St ) = 0,
∂t ∂x 2 ∂x
and leads to the Black-Scholes PDE
∂g ∂g 1 ∂2g
rg (t, x) = (t, x) + rx (t, x) + σ 2 x2 2 (t, x), x > 0.
∂t ∂x 2 ∂x

From the proof of Proposition 7.6, we also obtain the stochastic integral
expression
wT
e −rT g (T , ST ) = g (0, S0 ) + d e −rt g (t, St )

0
wT ∂g
= g (0, S0 ) + σ e −rt St bt ,
(t, St )dB
0 ∂x
see also Proposition 7.12 below.
Forward contracts
The long forward contract with payoff C = ST − K is priced as
Vt = e −(T −t)r E∗ [ST − K | Ft ]

= e −(T −t)r E∗ [ST | Ft ] − K e −(T −t)r
= St − K e −(T −t)r , 0 6 t 6 T,
which recovers the Black-Scholes PDE solution (6.9), i.e.
g (t, x) = x − K e −(T −t)r , x > 0, 0 6 t 6 T.
270 "
European call options
In the case of European call options with payoff function φ(x) = (x − K )+

we recover the Black-Scholes formula (6.11), cf. Proposition 6.11, by a prob-
abilistic argument.
Proposition 7.7. The price at time t ∈ [0, T ] of the European call option
with strike price K and maturity T is given by
g (t, St ) = e −(T −t)r E∗ [(ST − K )+ | Ft ] (7.20)

= St Φ d+ (T − t) − K e −(T −t)r Φ d− (T − t) , 0 6 t 6 T,

with
log(x/K ) + (r + σ 2 /2)(T − t)

d (T − t) : = √ ,

 +


 σ T −t
log(x/K ) + (r − σ 2 /2)(T − t)


 d− (T − t) := √ , 0 6 t < T,


σ T −t
where “log” denotes the natural logarithm “ln” and Φ is the standard Gaus-
sian Cumulative Distribution Function.
Proof. The proof of Proposition 7.7 is a consequence of (7.18) and Lemma 7.8
below. Using the relation
2
ST = St e (T −t)r +(BT −Bt )σ−(T −t)σ /2 , 0 6 t 6 T,
b b
by Theorem 7.5 the value at time t ∈ [0, T ] of the portfolio hedging C is

given by
Vt = e −(T −t)r E∗ [C | Ft ]
= e −(T −t)r E∗ (ST − K )+ Ft

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

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

t
= e −(T −t)r E∗ ( e m(x)+X − K )+ |x=S , 0 6 t 6 T,

t
where
σ2
m(x) : = (T − t)r − (T − t) + log x
2
and
X : = (B bt )σ ' N (0, (T − t)σ 2 )
bT − B
is a centered Gaussian random variable with variance
" 271
N. Privault
Var [X ] = Var (B bt )σ = σ 2 Var B bt = (T − t)σ 2

bT − B bT − B
under P∗ . Hence by Lemma 7.8 below we have
g (t, St ) = Vt
+
= e −(T −t)r E∗ e m(x)+X − K

|x=St
m(St ) − log K

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

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

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

0 6 t 6 T.
Relation (7.20) can also be written as
e −(T −t)r E∗ (ST − K )+ Ft = e −(T −t)r E∗ (ST − K )+ St (7.21)

log(x/K ) + (r + σ 2 /2)(T − t)

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

−K e −(T −t)r Φ √ , 0 6 t 6 T.
σ T −t
Lemma 7.8. Let X ' N (0, v 2 ) be a centered Gaussian random variable with
variance v 2 > 0. We have
2
E ( e m+X − K )+ = e m+v /2 Φ(v + (m − log K )/v ) − KΦ((m − log K )/v ).

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

2πv 2 −∞
1 w∞ 2 2
= √ ( e m+x − K ) e −x /(2v ) dx
2πv 2 −m+log K
em w ∞ 2 2 K w∞ 2 2
= √ e x−x /(2v ) dx − √ e −x /(2v ) dx
2πv 2 −m+log K 2πv 2 −m+log K
e m+v /2 w ∞ K w∞
2
2 2 2 2
= √ e −(v −x) /(2v ) dx − √ e −x /2 dx
2πv 2 −m+log K 2π (−m+log K )/v
e m+v /2 w ∞
2
2 2
= √ e −y /(2v ) dy − KΦ((m − log K )/v )
2πv 2 −v2 −m+log K
2 /2
= e m+v Φ(v + (m − log K )/v ) − KΦ((m − log K )/v ),
272 "
where we used Relation (6.15).
Call-put parity
Let
P (t, St ) := e −(T −t)r E∗ (K − ST )+ Ft , 0 6 t 6 T,

denote the price of the put option with strike price K and maturity T .
Proposition 7.9. Call-put parity. We have the relation
C (t, St ) − P (t, St ) = St − e −(T −t)r K (7.22)
between the Black-Scholes prices of call and put options, in terms of the
forward contract price St − K e −(T −t)r .
Proof. From Theorem 7.5, we have
C (t, St ) − P (t, St )
= e −(T −t)r E∗ [(ST − K )+ | Ft ] − e −(T −t)r E∗ [(K − ST )+ | Ft ]
= e −(T −t)r E∗ [(ST − K )+ − (K − ST )+ | Ft ]
= e −(T −t)r E∗ [ST − K | Ft ]
= e −(T −t)r E∗ [ST | Ft ] − K e −(T −t)r
= St − e −(T −t)r K, 0 6 t 6 T,
as we have E∗ [ST | Ft ] = e −(T −t)r St , t ∈ [0, T ], under the risk-neutral

probability measure P∗ .
European put options
Using the call-put parity Relation (7.22) we can recover the European put
option price (6.11) from the European call option price (6.11)-(7.20).
Proposition 7.10. The price at time t ∈ [0, T ] of the European put option
with strike price K and maturity T is given by
P (t, St ) = e −(T −t)r E∗ [(K − ST )+ | Ft ]

= K e −(T −t)r Φ − d− (T − t) − St Φ − d+ (T − t) , 0 6 t 6 T,

with
" 273
N. Privault
log(x/K ) + (r + σ 2 /2)(T − t)

 d+ (T − t ) : = √ ,



 σ T −t
log(x/K ) + (r − σ 2 /2)(T − t)


 d− (T − t) := √ , 0 6 t < T,


σ T −t
where “log” denotes the natural logarithm “ln” and Φ is the standard Gaus-
sian Cumulative Distribution Function.
Proof. By the call-put parity (7.22), we have
P (t, St ) = C (t, St ) − St + e −(T −t)r K

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

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

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

7.5 Hedging by the Martingale Method
Hedging exotic options
In the next Proposition 7.11 we compute a self-financing hedging strategy

leading to an arbitrary square-integrable random claim payoff C ∈ L2 (Ω) of
an exotic option admitting a stochastic integral decomposition of the form
wT
C = E∗ [ C ] + bt ,
ζt dB (7.23)
0
where (ζt )t∈[0,t] is a square-integrable adapted process. Consequently, the

mathematical problem of finding the stochastic integral decomposition (7.23)
of a given random variable has important applications in finance. The process
(ζt )t∈[0,T ] can be computed using the Malliavin gradient on the Wiener space,
see, e.g., Di Nunno et al. (2009) or § 8.2 of Privault (2009).
Simple examples of stochastic integral decompositions include the relations
wT
( BT ) 2 = T + 2 Bt dBt ,
0
cf. Exercises 6.1 and 7.1, and

wT
( BT ) 3 = 3 T − t + Bt2 dBt ,

0
see Exercise 4.10. In the sequel, recall that the risky asset follows the equation
274 "
dSt
= µdt + σdBt , t > 0, S0 > 0,
St
and by (7.15), the discounted asset price Set := e −rt St
bt ,
dSet = σ Set dB t > 0, Se0 = S0 > 0, (7.24)
where (B bt )t∈R is a standard Brownian motion under the risk-neutral prob-

+
ability measure P∗ . The following proposition applies to arbitrary square-
integrable payoff functions, in particular it covers exotic and path-dependent
options.
Proposition 7.11. Consider a random claim payoff C ∈ L2 (Ω) and the
process (ζt )t∈[0,T ] given by (7.23), and let
e −(T −t)r
ξt = ζt , (7.25)
σSt
e −(T −t)r E∗ [C | Ft ] − ξt St
ηt = , 0 6 t 6 T. (7.26)
At
Then the portfolio allocation (ξt , ηt )t∈[0,T ] is self-financing, and letting
Vt = ηt At + ξt St , 0 6 t 6 T, (7.27)
we have
Vt = e −(T −t)r E∗ [C | Ft ], 0 6 t 6 T. (7.28)
In particular we have
VT = C, (7.29)
i.e. the portfolio allocation (ξt , ηt )t∈[0,T ] yields a hedging strategy leading to
the claim payoff C at maturity, after starting from the initial value
V0 = e −rT E∗ [C ].
Proof. Relation (7.28) follows from (7.26) and (7.27), and it implies
V0 = e −rT E∗ [C ] = η0 A0 + ξ0 S0
at t = 0, and (7.29) at t = T . It remains to show that the portfolio strategy
(ξt , ηt )t∈[0,T ] is self-financing. By (7.23) and Proposition 7.1 we have
Vt = ηt At + ξt St
= e −(T −t)r E∗ [C | Ft ]
wT
= e −(T −t)r E∗ E∗ [C ] + bu Ft
ζu dB
0
wt
−(T −t)r ∗
= e E [C ] + ζu dB bu
0
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N. Privault
wt
= e rt V0 + e −(T −t)r ζu dB bu
0
wt
= e rt V0 + σ ξu Su e (t−u)r dB bu
0
wt
= e rt V0 + σ e rt ξu Seu dB
bu .
0
By (7.24) this shows that the portfolio strategy (ξt , ηt )t∈[0,T ] given by (7.25)-
(7.26) and its discounted portfolio value Vet := e −rt Vt satisfy
wt
Vet = V0 + ξu dSeu , 0 6 t 6 T,
0
which implies that (ξt , ηt )t∈[0,T ] is self-financing by Lemma 5.15.

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

and initial value

Ve0 = E∗ VeT = e −rT E∗ [C ].

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

the process (ζt )t∈[0,T ] appearing in (7.23). This computation, called Delta
hedging, can be performed by the application of the Itô formula and the
Markov property, see e.g. Protter (2001). The next lemma allows us to com-
pute the process (ζt )t∈[0,T ] in case the payoff C is of the form C = φ(ST ) for
some function φ.
Proposition 7.12. Assume that φ is a Lipschitz payoff function. Then, the
function C (t, x) defined by
C (t, St ) := E∗ [φ(ST ) | St ]
is in C 1,2 ([0, T ) × R), and the stochastic integral decomposition

wT
φ(ST ) = E∗ φ(ST ) + (7.30)

ζt dB
bt
0
276 "
is given by
∂C
ζt = σSt (t, St ), 0 6 t 6 T. (7.31)
∂x
In addition, the hedging strategy (ξt )t∈[0,T ] satisfies
∂C
ξt = e −(T −t)r (t, St ), 0 6 t 6 T. (7.32)
∂x
Proof. It can be checked as in the proof of Proposition 7.6 the function
C (t, x) is in C 1,2 ([0, T ) × R). Therefore, we can apply the Itô formula to the
process
t 7−→ C (t, St ) = E∗ [φ(ST ) | Ft ],
which is a martingale from the tower property (23.38) of conditional expec-
tations as in (7.39). From the fact that the finite variation term in the Itô
formula vanishes when (C (t, St ))t∈[0,T ] is a martingale, (see e.g. Corollary II-
6-1 page 72 of Protter (2004)), we obtain:
wt ∂C
C (t, St ) = C (0, S0 ) + σ Su bu ,
(u, Su )dB 0 6 t 6 T, (7.33)
0 ∂x
with C (0, S0 ) = E∗ φ(ST ) . Letting t = T , we obtain (7.31) by uniqueness

of the stochastic integral decomposition (7.30) of C = φ(ST ). Finally, (7.32)

follows from (7.25) and (7.31).
By (7.31), we also have

∂ ∗
ζt = σSt E [φ(ST ) | St = x]
∂x x=St

∂ ∗ ST
= σSt E φ x , 0 6 t 6 T,
∂x St x=St
hence
1 −(T −t)r
ξt = e ζt (7.34)
σSt

∂ ∗ ST
= e −(T −t)r E φ x
∂x St x = St

−(T −t)r ∗ ST 0 ST
= e E φ x , 0 6 t 6 T,
St St x = St
which recovers the formula (6.3) for the Delta of a vanilla option. As a conse-
quence we have ξt > 0 and there is no short selling when the payoff function
φ is non-decreasing.
In the case of European options, the process ζ can be computed via the next
proposition which follows from Proposition 7.12 and the relation
" 277
N. Privault
C (t, x) = E∗ f (St,T
x
) , 0 6 t 6 T , x > 0.

Corollary 7.13. Assume that C = (ST − K )+ . Then, for 0 6 t 6 T we

have

ST S
ζt = σSt E∗ 1[K,∞) x T , 0 6 t 6 T, (7.35)
St St |x=St
and

ST S
ξt = e −(T −t)r E∗ 1[K,∞) x T , 0 6 t 6 T. (7.36)
St St |x=St
By evaluating the expectation (7.35) in Corollary 7.13 we can recover the

formula (6.16) in Proposition 6.4 for the Delta of the European call option in
the Black-Scholes model. In that sense, the next proposition provides another
proof of the result of Proposition 6.4.
Proposition 7.14. The Delta of the European call option with payoff func-
tion f (x) = (x − K )+ is given by
log(St /K ) + (r + σ 2 /2)(T − t)

ξt = Φ d + ( T − t ) = Φ , 0 6 t 6 T.

√
σ T −t
Proof. By Proposition 7.11 and Corollary 7.13, we have
1 −(T −t)r
ξt = e ζt
σSt

S S
= e −(T −t)r E∗ T 1[K,∞) x T
St St |x=St
= e −(T −t)r
h i
× E∗ e (BT −Bt )σ−(T −t)σ /2+(T −t)r 1
2 bT −Bbt )σ−(T −t)σ2 /2+(T −t)r
(B
[K,∞) (x e )
b b
|x=St
1 w∞ 2 2
=p e σy−(T −t)σ /2−y /(2(T −t)) dy
2(T − t)π (T −t)σ/2−(T −t)r/σ +σ−1 log(K/St )
1 w∞ 2
=p √ e −(y−(T −t)σ ) /(2(T −t)) dy
2(T − t)π −d− (T −t)/ T −t
1 w∞ 2
=√ e −(y−(T −t)σ ) /2 dy
2π −d− (T −t)
1 w∞ 2
=√ e −y /2 dy
2π −d+ (T −t)
1 w d+ (T −t) −y2 /2
=√ e dy
2π −∞
= Φ d+ (T − t ) .

278 "

Proposition 7.14, combined with Proposition 7.7, shows that the Black-
Scholes self-financing hedging strategy is to hold a (possibly fractional) quan-
tity
log(St /K ) + (r + σ 2 /2)(T − t)

ξt = Φ d + ( T − t ) = Φ > 0 (7.37)

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

− ηt = K e −rT Φ √ >0 (7.38)
σ T −t
of the riskless (savings) account, see also Corollary 16.18 in Chapter 16.
As noted above, the result of Proposition 7.14 recovers (6.17) which is ob-
tained by a direct differentiation of the Black-Scholes function as in (6.3) or
(7.34).
Markovian semi-groups
For completeness, we provide the definition of Markovian semi-groups which

can be used to reformulate the proofs of this section.
Definition 7.15. The Markov semi-group (Pt )06t6T associated to (St )t∈[0,T ]
is the mapping Pt defined on functions f ∈ Cb2 (R) as
Pt f (x) := E∗ [f (St ) | S0 = x], t > 0.
By the Markov property and time homogeneity of (St )t∈[0,T ] we also have
Pt f (Su ) := E∗ [f (St+u ) | Fu ] = E∗ [f (St+u ) | Su ], t, u > 0,
and the semi-group (Pt )06t6T satisfies the composition property
Ps P t = Pt Ps = Ps + t = P t + s , s, t > 0,
as we have, using the Markov property and the tower property (23.38) of
conditional expectations as in (7.39),
Ps Pt f (x) = E∗ [Pt f (Ss ) | S0 = x]

= E∗ E∗ [f (St ) | S0 = y ]y =Ss S0 = x

= E∗ E∗ [f (St+s ) | Ss = y ]y =Ss S0 = x

= E∗ E∗ [f (St+s ) | Fs ] S0 = x

= E∗ [f (St+s ) | S0 = x]
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N. Privault
= Pt + s f ( x ) , s, t > 0.
Similarly, we can show that the process (PT −t f (St ))t∈[0,T ] is an Ft -martingale
as in Example (i) above, see (7.1), i.e.:
E∗ [PT −t f (St ) | Fu ] = E∗ E∗ [f (ST ) | Ft ] Fu

= E∗ [f (ST ) | Fu ]
= PT −u f (Su ), 0 6 u 6 t 6 T, (7.39)
and we have

St
Pt−u f (x) = E∗ [f (St ) | Su = x] = E∗ f x , 0 6 u 6 t. (7.40)
Su
Exercises
Exercise 7.1 (Exercise 6.1 continued). Consider a market made of a riskless

asset priced At = A0 with zero interest rate, t > 0, and a risky asset whose
price modeled by a standard Brownian motion as St = Bt , t > 0. Price
the vanilla option with payoff C = (BT )2 , and recover the solution of the
Black-Scholes PDE of Exercise 6.1.
Exercise 7.2 Given the price process (St )t∈R+ defined as

2 /2)t
St := S0 e σBt +(r−σ , t > 0,
price the option with payoff function φ(ST ) by writing e −rT E∗ φ(ST ) as

an integral.
Exercise 7.3 Consider an asset price (St )t∈R+ given by the stochastic dif-
ferential equation
dSt = rSt dt + σSt dBt , (7.41)
where (Bt )t∈R+ is a standard Brownian motion, with r ∈ R and σ > 0.
a) Find the stochastic differential equation satisfied by the power Stp t∈R

+
of order p ∈ R of (St )t∈R+ .
b) Using the Girsanov Theorem 7.3, Construct a probability measure under
which the discounted process e −rt Stp t∈R is a martingale.

+
Exercise 7.4 Consider an asset price process (St )t∈R+ which is a martingale
under the risk-neutral probability measure P∗ in a market with interest rate
280 "
r = 0, and let φ be a (convex) European call payoff function. Show that, for
any two maturities T1 < T2 and p, q ∈ [0, 1] such that p + q = 1, the price of
the option on average with payoff φ(pST1 + qST2 ) is upper bounded by the
price of the European call option with maturity T2 , i.e. show that
E∗ φ(pST1 + qST2 ) 6 E∗ φ(ST2 ) .

Hints:
i) For φ a convex function we have φ(px + qy ) 6 pφ(x) + qφ(y ) for any
x, y ∈ R and p, q ∈ [0, 1] such that p + q = 1.
ii) Any convex function φ(St ) of a martingale St is a submartingale.
Exercise 7.5 Consider an underlying asset price process (St )t∈R+ under a
risk-neutral measure P∗ with risk-free interest rate r.
a) Does the European call option price C (K ) := e −rT E∗ [(ST − K )+ ] in-
crease or decrease with the strike price K? Justify your answer.
b) Does the European put option price C (K ) := e −rT E∗ [(K − ST )+ ] in-
crease or decrease with the strike price K? Justify your answer.
Exercise 7.6 Consider an underlying asset price process (St )t∈R+ under a
risk-neutral measure P∗ with risk-free interest rate r.
a) Show that the price at time t of the European call option with strike
price K and maturity T is lower bounded by the positive part St −
+
K e −(T −t)r of the corresponding forward contract price, i.e. we have
the model-free bound
+
e −(T −t)r E∗ [(ST − K )+ | Ft ] > St − K e −(T −t)r , 0 6 t 6 T .
b) Show that the price at time t of the European put option with strike price
K and maturity T is lower bounded by K e −(T −t)r − St , i.e. we have the
model-free bound
+
e −(T −t)r E∗ [(K − ST )+ | Ft ] > K e −(T −t)r − St , 0 6 t 6 T .
Exercise 7.7 The following two graphs describe the payoff functions φ of
bull spread and bear spread options with payoff φ(SN ) on an underlying asset
priced SN at maturity time N .
" 281
N. Privault
100 100
80 80
60 60
40 40
20 20
0 0
0 50 100 150 200 0 50 100 150 200
K1 x K2 K1 x K2
(i) Bull spread payoff. (ii) Bear spread payoff.

Fig. 7.3: Payoff functions of bull spread and bear spread options.
a) Show that in each case (i) and (ii) the corresponding option can be real-
ized by purchasing and/or short selling standard European call and put
options with strike prices to be specified.
b) Price the bull spread option in cases (i) and (ii) using the Black-Scholes
formula.
Hint: An option with payoff φ(ST ) is priced e −rT E∗ φ(ST ) at time 0. The

payoff of the European call (resp. put) option with strike price K is (ST −
K )+ , resp. (K − ST )+ .
Exercise 7.8 Given two strike prices 0 < K1 < K2 , we consider a long box
spread option with maturity N > 1, realized as the combination of four legs:
• One long call with strike price K1 and payoff function (x − K1 )+ ,
• One short put with strike price K1 and payoff function −(K1 − x)+ ,
• One short call with strike price K2 and payoff function −(x − K2 )+ ,
• One long put with strike price K2 and payoff function (K2 − x)+ .
The risk-free interest rate is denoted by r > 0.
Short put at K1
Long put at K2
Short call at K2
Long call at K1
K1 x K2
Fig. 7.4: Graphs of call/put payoff functions.
a) Find the payoff of the long box spread option in terms of K1 and K2 .
b) Price the long box spread option at times k = 0, 1, . . . , N .
282 "
c) From Table 7.1 below, find a choice of strike prices K1 and K2 suitable
for a long box spread option on the Hang Seng Index (HSI).
d) Price the option built in part (c) in index points and then in HK$.
e) Would you buy the option priced in part (d) ?
Hints.
i) In Table 7.1, every option is split into a number of warrants given in
the “Entitlement Ratio” column. The prices given in the “Closing price”
column are warrant prices.
ii) Option prices (called option premiums) and strike prices are quoted ac-
cording to Table 7.2.
iii) In part (e) you may take r = 0 for simplicity.
iv) It can be useful to treat Question 3 before Question 4.
Table 7.1: Call and put options on the Hang Seng Index (HSI).
" 283
N. Privault
Table 7.2: Contract summary.
Exercise 7.9 Butterfly options. A long call butterfly option is designed to

deliver a limited payoff when the future volatility of the underlying asset is
expected to be low. The payoff function of a long call butterfly option is
plotted in Figure 7.5, with K1 := 50 and K2 := 150.
60
50
40
30
20
10
0
0 50 100 150 200
K1 SN K2
Fig. 7.5: Long call butterfly payoff function.
a) Show that the long call butterfly option can be realized by purchasing
and/or issuing standard European call or put options with strike prices
to be specified.
b) Price the long call butterfly option using the Black-Scholes formula.
c) Does the hedging strategy of the long call butterfly option involve holding
or shorting the underlying stock?
Hints: Recallthat an option with payoff φ(SN ) is priced in discrete time as
(1 + r )−N E∗ φ(SN ) at time 0. The payoff of the European call (resp. put)
option with strike price K is (SN − K )+ , resp. (K − SN )+ .
Exercise 7.10 Forward contracts revisited. Consider a risky asset whose price
2
St is given by St = S0 e σBt +rt−σ t/2 , t > 0, where (Bt )t∈R+ is a standard
284 "
Brownian motion. Consider a forward contract with maturity T and payoff

ST − κ.
a) Compute the price Ct of this claim at any time t ∈ [0, T ].
b) Compute a hedging strategy for the option with payoff ST − κ.
Exercise 7.11 Option pricing with dividends (Exercise 6.3 continued). Con-
sider an underlying asset price process (St )t∈R+ paying dividends at the
continuous-time rate δ > 0, and modeled as
dSt = (µ − δ )St dt + σSt dBt ,
where (Bt )t∈R+ is a standard Brownian motion.

a) Show that as in Lemma 5.15, if (ηt , ξt )t∈R+ is a portfolio strategy with
value
Vt = ηt At + ξt St , t > 0,
where the dividend yield δSt per share is continuously reinvested in the
portfolio, then the discounted portfolio value Vet can be written as the
stochastic integral
wt
Vet = Ve0 + ξu dSeu , t > 0,
0
b) Show that, as in Theorem 7.5, if (ξt , ηt )t∈[0,T ] hedges the claim payoff C,
i.e. if VT = C, then the arbitrage-free price of the claim payoff C is given
by
πt (C ) = Vt = e −(T −t)r E
b [C | Ft ], 0 6 t 6 T,
where Eb denotes expectation under a suitably chosen risk-neutral proba-
bility measure P.
b
c) Compute the price at time t ∈ [0, T ] of a European call option in a market
with dividend rate δ by the martingale method.
d) Compute the Delta of the option.
Exercise 7.12 Forward start options (Rubinstein (1991)). A forward start

European call option is an option whose holder receives at time T1 (e.g. your
birthday) the value of a standard European call option at the money and
with maturity T2 > T1 . Price this birthday present at any time t ∈ [0, T1 ],
i.e. compute the price
e −(T1 −t)r E∗ e −(T2 −T1 )r E∗ (ST2 − ST1 )+ FT1 Ft

at time t ∈ [0, T1 ], of the forward start European call option using the Black-
Scholes formula
" 285
N. Privault
log(x/K ) + (r + σ 2 /2)(T − t)

Bl(K, x, σ, r, T − t) = xΦ √
|σ| T − t
log(x/K ) + (r − σ 2 /2)(T − t)

−K e −(T −t)r Φ √ ,
|σ| T − t
0 6 t < T.
Exercise 7.13 Cliquet options. Let 0 = T0 < T1 < · · · < Tn denote a

sequence of financial settlement dates, and consider a risky asset priced as the
2
geometric Brownian motion St = S0 e σBt +rt−σ t/2 , t > 0, where (Bt )t∈R+
is a standard Brownian motion under the risk-neutral measure P∗ . Compute
the price at time t = 0 of the cliquet option with payoff
n
!+
X STk
−K
STk−1
k =1
using the Black-Scholes formula
log(S0 /κ) + (r + σ 2 /2)T

e −rT E∗ [(ST − κ)+ ] = S0 Φ √
|σ| T
log(S0 /κ) + (r − σ 2 /2)T

−rT
−κ e Φ √ , T > 0.
|σ| T
Exercise 7.14 Log contracts. (Exercise 6.9 continued), see also Exercise 8.6.
Consider the price process (St )t∈[0,T ] given by
dSt
= rdt + σdBt
St
and a riskless asset valued At = A0 e rt , t ∈ [0, T ], with r > 0. Compute the

arbitrage-free price
C (t, St ) = e −(T −t)r E∗ [log ST | Ft ],
at time t ∈ [0, T ], of the log contract with payoff log ST .
Exercise 7.15 Power option. (Exercise 6.5 continued). Consider the price
process (St )t∈[0,T ] given by
dSt
= rdt + σdBt
St
286 "
and a riskless asset valued At = A0 e rt , t ∈ [0, T ], with r > 0. In this problem,

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

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

b) Compute a self-financing hedging strategy (ηt , ξt )t∈[0,T ] hedging the claim
payoff |ST |2 .
Exercise 7.16 Bachelier (1900) model (Exercise 6.11 continued).

a) Consider the solution (St )t∈R+ of the stochastic differential equation
dSt = αSt dt + σdBt .
For which value αM of α is the discounted price process Set = e −rt St ,

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

at time t ∈ [0, T ] of the contingent claim with payoff exp(ST ), and recover
the result of Exercise 6.11.
d) Explicitly compute the portfolio strategy (ηt , ξt )t∈[0,T ] that hedges the
contingent claim with payoff exp(ST ).
e) Check that this strategy is self-financing.
Exercise 7.17 Compute the arbitrage-free price
C (t, St ) = e −(T −t)r Eα (ST )2 Ft

at time t ∈ [0, T ] of the power option with payoff (ST )2 in the framework of
the Bachelier (1900) model of Exercise 7.16.
Exercise 7.18 (Exercise 6.2 continued). Price the option with vanilla payoff
C = φ(ST ) using the noncentral Chi square probability density function
(17.5) of the Cox et al. (1985) (CIR) model.
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N. Privault
Exercise 7.19 Let (Bt )t∈R+ be a standard Brownian motion generating

a filtration (Ft )t∈R+ . Recall that for f ∈ C 2 (R+ × R), Itô’s formula for
(Bt )t∈R+ reads
w t ∂f
f (t, Bt ) = f (0, B0 ) + (s, Bs )ds
0 ∂s
w t ∂f 1 w t ∂2f
+ (s, Bs )dBs + (s, Bs )ds.
0 ∂x 2 0 ∂x2
2
a) Let r ∈ R, σ > 0, f (x, t) = e rt+σx−σ t/2 , and St = f (t, Bt ). Compute
df (t, Bt ) by Itô’s formula, and show that St solves the stochastic differen-
tial equation
dSt = rSt dt + σSt dBt ,
where r > 0 and σ > 0.
b) Show that
2
E e σBT Ft = e σBt +(T −t)σ /2 , 0 6 t 6 T.

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

X ' N (0, η ).
2
c) Show that the process (St )t∈R+ satisfies
E[ST | Ft ] = e (T −t)r St , 0 6 t 6 T.
d) Let C = ST − K denote the payoff of a forward contract with exercise

price K and maturity T . Compute the discounted expected payoff
Vt := e −(T −t)r E[C | Ft ].
e) Find a self-financing portfolio strategy (ξt , ηt )t∈R+ such that
Vt = ξt St + ηt At , 0 6 t 6 T,
where At = A0 e rt
is the price of a riskless asset with fixed interest rate
r > 0. Show that it recovers the result of Exercise 6.7-(c).
f) Show that the portfolio allocation (ξt , ηt )t∈[0,T ] found in Question (e)
hedges the payoff C = ST − K at time T , i.e. show that VT = C.
Exercise 7.20 Binary options. Consider a price process (St )t∈R+ given by
288 "
dSt
= rdt + σdBt , S0 = 1,
St
under the risk-neutral probability measure P∗ . A binary (or digital) call, resp.
put, option is a contract with maturity T , strike price K, and payoff
 $1 if ST > K,  $1 if ST 6 K,
 
Cd : = resp. Pd :=
0 if ST < K, 0 if ST > K.
 
Recall that the prices πt (Cd ) and πt (Pd ) at time t of the binary call and put
options are given by the discounted expected payoffs
πt (Cd ) = e −(T −t)r E[Cd | Ft ] and πt (Pd ) = e −(T −t)r E[Pd | Ft ]. (7.42)
a) Show that the payoffs Cd and Pd can be rewritten as
Cd = 1[K,∞) (ST ) and Pd = 1[0,K ] (ST ).
b) Using Relation (7.42), Question (a), and the relation
E 1[K,∞) (ST ) St = x = P∗ (ST > K | St = x),

show that the price πt (Cd ) is given by
πt (Cd ) = Cd (t, St ),
where Cd (t, x) is the function defined by
Cd (t, x) := e −(T −t)r P∗ (ST > K | St = x).
c) Using the results of Exercise 5.9-(d) and of Question (b), show that the
price πt (Cd ) = Cd (t, St ) of the binary call option is given by the function
(r − σ 2 /2)(T − t) + log(x/K )

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

where
(r − σ 2 /2)(T − t) + log(St /K )
d− (T − t) = √ .
σ T −t
d) Assume that the binary option holder is entitled to receive a “return
amount” α ∈ [0, 1] in case the underlying asset price ends out of the
money at maturity. Compute the price at time t ∈ [0, T ] of this modified
contract.
e) Using Relation (7.42) and Question (a), prove the call-put parity relation
" 289
N. Privault
πt (Cd ) + πt (Pd ) = e −(T −t)r , 0 6 t 6 T. (7.43)
If needed, you may use the fact that P∗ (ST

= K ) = 0.
f) Using the results of Questions (e) and (c), show that the price πt (Pd ) of
the binary put option is given as
πt (Pd ) = e −(T −t)r Φ − d− (T − t) .

g) Using the result of Question (c), compute the Delta
∂Cd
ξt : = (t, St )
∂x
of the binary call option. Does the Black-Scholes hedging strategy of such
a call option involve short selling? Why?
h) Using the result of Question (f), compute the Delta
∂Pd
ξt : = (t, St )
∂x
of the binary put option. Does the Black-Scholes hedging strategy of such
a put option involve short selling? Why?
Exercise 7.21 Computation of Greeks. Consider an underlying asset whose

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

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

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

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

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

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

2
Problem 7.22 Chooser options. In this problem we denote by C (t, St , K, T ),

resp. P (t, St , K, T ), the price at time t of the European call, resp. put, option
with strike price K and maturity T , on an underlying asset priced St =
290 "
2
S0 e σBt +rt−σ t/2 , t > 0, where (Bt )t∈R+ is a standard Brownian motion
under the risk-neutral probability measure
a) Prove the call-put parity formula
C (t, St , K, T ) − P (t, St , K, T ) = St − K e −(T −t)r , 0 6 t 6 T . (7.44)
b) Consider an option contract with maturity T , which entitles its holder to

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

P (T , ST , K, U ) + Max 0, ST − K e −(U −T )r .
Hint: Use the call-put parity formula (7.44).

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

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

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

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

" 291
N. Privault
i) Give the price and hedging strategy of the contract that yields the sum
of the payoffs of Questions (c) and (f).
j) What happens when U = T ? Give the payoffs of the contracts of Ques-
tions (c), (f) and (i).
Problem 7.23 (Peng (2010)). Consider a risky asset priced

2 t/2
St = S0 e σBt +µt−σ , i.e. dSt = µSt dt + σSt dBt , t > 0,
a riskless asset valued At = A0 e rt , and a self-financing portfolio allocation

(ηt , ξt )t∈R+ with value
Vt := ηt At + ξt St , t > 0.
a) Using the portfolio self-financing condition dVt = ηt dAt + ξt dSt , show

that we have
wT wT
VT = Vt + (rVs + (µ − r )ξs Ss )ds + σ ξs Ss dBs .
t t
b) Show that under the risk-neutral probability measure P∗ the portfolio

value Vt satisfies the Backward Stochastic Differential Equation (BSDE)
wT wT
Vt = VT − rVs ds − bs ,
πs dB (7.45)
t t
where πt := σξt St is the risky amount invested on the asset St , multiplied

by σ, and (B
bt )t∈R is a standard Brownian motion under P∗ .
+
Hint: the Girsanov Theorem 7.3 states that
bt := Bt + (µ − r )t ,
B t > 0,
σ
is a standard Brownian motion under P∗ .
c) Show that under the risk-neutral probability measure P∗ , the discounted
portfolio value Vet := e −rt Vt can be rewritten as
wT
VeT = Ve0 + e −rs πs dB
bs . (7.46)
0
d) Express dv (t, St ) by the Itô formula, where v (t, x) is a C 2 function of t

and x.
e) Consider now a more general BSDE of the form
wT wT
Vt = VT − f (s, Ss , Vs , πs )ds − πs dBs , (7.47)
t t
292 "
with terminal condition VT = g (ST ). By matching (7.47) to the Itô for-

mula of Question (d), find the PDE satisfied by the function v (t, x) defined
as Vt = v (t, St ).
f) Show that when
µ−r
f (t, x, v, z ) = rv + z,
σ
the PDE of Question (e) recovers the standard Black-Scholes PDE.
µ−r
g) Assuming again f (t, x, v, z ) = rv + z and taking the terminal con-
σ
dition
2
VT = (S0 e σBT +(µ−σ /2)T − K )+ ,
give the process (πt )t∈[0,T ] appearing in the stochastic integral represen-
2
tation (7.46) of the discounted claim payoff e −rT (S0 e σBT +(µ−σ /2)T −
K ) + .∗
h) From now on we assume that short selling is penalized† at a rate γ > 0,
i.e. γSt |ξt |dt is subtracted from the portfolio value change dVt whenever
ξt < 0 over the time interval [t, t + dt]. Rewrite the self-financing condition
using (ξt )− := − min(ξt , 0).
i) Find the BSDE of the form (7.47) satisfied by (Vt )t∈R+ , and the corre-
sponding function f (t, x, v, z ).
j) Under the above penalty on short selling, find the PDE satisfied by the
function u(t, x) when the portfolio value Vt is given as Vt = u(t, St ).
k) Differential interest rate. Assume that one can borrow only at a rate R
which is higher‡ than the risk-free interest rate r > 0, i.e. we have
dVt = Rηt At dt + ξt dSt
when ηt < 0, and

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

portfolio strategy (ξt )t∈R+ is superhedging the claim payoff VT = C.
Exercise 7.24 Girsanov Theorem. Assume that the Novikov integrability

condition (7.10) is not satisfied. How does this modify the statement (7.12)
∗
General Black-Scholes knowledge can be used for this question.
†
SGX started to penalize naked short sales with an interim measure in September 2008.
‡
Regular savings account usually pays r=0.05% per year. Effective Interest Rates (EIR)
for borrowing could be as high as R=20.61% per year.
" 293
N. Privault
of the Girsanov Theorem 7.3?
Problem 7.25 The Capital Asset Pricing Model (CAPM) of W.F. Sharpe
(1990 Nobel Prize in Economics) is based on a linear decomposition

dSt dMt
= (r + α)dt + β × − rdt
St Mt
of stock returns dSt /St into:

• a risk-free interest rate∗ r,
• an excess return α,
• a risk premium given by the difference between a benchmark market index
return dMt /Mt and the risk free rate r.
The coefficient β measures the sensitivity of the stock return dSt /St with
respect to the market index returns dMt /Mt . In other words, β is the rela-
tive volatility of dSt /St with respect to dMt /Mt , and it measures the risk of
(St )t∈R+ in comparison to the market index (Mt )t∈R+ .
If β > 1, resp. β < 1, then the stock price St is more volatile (i.e. more
risky), resp. less volatile (i.e. less risky), than the benchmark market index
Mt . For example, if β = 2 then St goes up (or down) twice as much as the
index Mt . Inverse Exchange-Traded Funds (IETFs) have a negative value of
β. On the other hand, a fund which has a β = 1 can track the index Mt .
Vanguard 500 Index Fund (VFINX) has a β = 1 and can be considered

as replicating the variations of the S&P 500 index Mt , while Invesco S&P
500 (SPHB) has a β = 1.42, and Xtrackers Low Beta High Yield Bond ETF
(HYDW) has a β close to 0.36 and α = 6.36.
In the sequel we assume that the benchmark market is represented by an

index fund (Mt )t∈R+ whose value is modeled according to
dMt
= µdt + σM dBt , (7.48)
Mt
where (Bt )t∈R+ is a standard Brownian motion. The asset price (St )t∈R+ is
modeled in a stochastic version of the CAPM as

dSt dMt
= rdt + αdt + β − rdt + σS dWt , (7.49)
St Mt
with an additional stock volatility term σS dWt , where (Wt )t∈R+ is a standard
Brownian motion independent of (Bt )t∈R+ , with
∗
The risk-free interest rate r is typically the yield of the 10-year Treasury bond.
294 "
Cov(Bt , Wt ) = 0 and dBt • dWt = 0, t > 0.
The following 10 questions are interdependent and should be treated in se-

quence.
a) Show that β coincides with the regression coefficient
Cov(dSt /St , dMt /Mt )

β= .
Var[dMt /Mt ]
Hint: We have
Cov(dWt , dWt ) = dt, Cov(dBt , dBt ) = dt, and Cov(dWt , dBt ) = 0.
b) Show that the evolution of (St )t∈R+ can be written as

q
dSt = (r + α + β (µ − r ))St dt + St 2 + σ 2 dZ
β 2 σM S t
where (Zt )t∈R+ is a standard Brownian motion.
Hint: The standard Brownian motion (Zt )t∈R+ can be characterized as

the only continuous (local) martingale such that (dZt )2 = dt, see e.g.
Theorem 7.36 page 203 of Klebaner (2005).
From now on, we assume that β is allowed to depend locally on the state
of the benchmark market index Mt , as β (Mt ), t > 0.
c) Rewrite the equations (7.48)-(7.49) into the system
dMt


 = rdt + σM dBt∗ ,
 Mt

 dS
 t = rdt + σM β (Mt )dBt∗ + σS dWt∗ ,


St
where (Bt∗ )t∈R+ and (Wt∗ )t∈R+ have to be determined explicitly.

d) Using the Girsanov Theorem 7.3, construct a probability measure P∗ un-
der which (Bt∗ )t∈R+ and (Wt∗ )t∈R+ are independent standard Brownian
motions.
Hint: Only the expression of the Radon-Nikodym density dP∗ /dP is

needed here.
e) Show that the market based on the assets St and Mt is without arbitrage
opportunities.
f) Consider a portfolio strategy (ξt , ζt , ηt )t∈[0,T ] based on the three assets
(St , Mt , At )t∈[0,T ] , with value
Vt = ξt St + ζt Mt + ηt At , t ∈ [0, T ],
" 295
N. Privault
where (At )t∈R+ is a riskless asset given by At = A0 e rt . Write down the

self-financing condition for the portfolio strategy (ξt , ζt , ηt )t∈[0,T ] .
g) Consider an option with payoff C = h(ST , MT ), priced as
f (t, St , Mt ) = e −(T −t)r E∗ [h(ST , MT ) | Ft ], 0 6 t 6 T.
Assuming that the portfolio (Vt )t∈[0,T ] replicates the option price pro-
cess (f (t, St , Mt ))t∈[0,T ] , derive the pricing PDE satisfied by the function
f (t, x, y ) and its terminal condition.
Hint: The following version of the Itô formula with two variables can be
used for the function f (t, x, y ), see (4.26):
∂f ∂f 1 ∂2f
df (t, St , Mt ) = (t, St , Mt )dt + (t, St , Mt )dSt + (dSt )2 2 (t, St , Mt )
∂t ∂x 2 ∂x
∂f 1 ∂2f ∂2f
+ (t, St , Mt )dMt + (dMt )2 2 (t, St , Mt ) + dSt • dMt (t, St , Mt ).
∂y 2 ∂y ∂x∂y
h) Find the self-financing hedging portfolio strategy (ξt , ζt , ηt )t∈[0,T ] repli-

cating the vanilla payoff h(ST , MT ).
i) Solve the PDE of Question (g) and compute the replicating portfolio of
Question (h) when β (Mt ) = β is a constant and C is the European call
option payoff on ST with strike price K.
j) Solve the PDE of Question (g) and compute the replicating portfolio of
Question (h) when β (Mt ) = β is a constant and C is the European put
option payoff on ST with strike price K.
Problem 7.26 Quantile hedging (Föllmer and Leukert (1999), §6.2 of Mel0 nikov
et al. (2002)). Recall that given two probability measures P and Q, the
Radon-Nikodym density dP/dQ links the expectations of random variables
F under P and under Q via the relation
w
EQ [ F ] = F (ω )dQ(ω )
Ω
w dQ
= F (ω ) (ω )dP(ω )
Ω dP

dQ
= EP F .
dP
a) Neyman-Pearson Lemma. Given P and Q two probability measures, con-

sider the event
dP
Aα : = >α , α > 0.
dQ
296 "
Show that for A any event, Q(A) 6 Q(Aα ) implies P(A) 6 P(Aα ).
Hint: Start by proving that we always have

dP dP
− α (21Aα − 1) > − α (21A − 1). (7.50)
dQ dQ
b) Let C > 0 denote a nonnegative claim payoff on a financial market with

risk-neutral measure P∗ . Show that the Radon-Nikodym density
dQ∗ C
:= (7.51)
dP∗ EP∗ [C ]
defines a probability measure Q∗ .

Hint: Check first that dQ∗ /dP∗ > 0, and then that Q∗ (Ω) = 1. In the
following questions we consider a nonnegative contingent claim with payoff
C > 0 and maturity T > 0, priced e −rT EP∗ [C ] at time 0 under the risk-
neutral measure P∗ .
Budget constraint. In the sequel we will assume that no more than a certain
fraction β ∈ (0, 1] of the claim price e −rT EP∗ [C ] is available to construct
the initial hedging portfolio V0 at time 0.
Since a self-financing portfolio process (Vt )t∈R+ started at V0 := β e −rT EP∗ [C ]
may fall short of hedging the claim C when β < 1, we will attempt to max-
imize the probability P(VT > C ) of successful hedging, or, equivalently, to
minimize the shortfall probability P(VT < C ).
For this, given A an event we consider the self-financing portfolio process
(VtA )t∈[0,T ] hedging the claim C 1A , priced V0A = e −rT EP∗ [C 1A ] at time 0,
and such that VTA = C 1A at maturity T .
c) Show that if α satisfies Q∗ (Aα ) = β, the event
dQ∗

dP dP dP αC
Aα = >α = >α ∗ = >
dQ ∗ dP ∗ dP dP∗ EP∗ [C ]
maximizes P(A) over all possible events A, under the condition
e −rT EP∗ VTA = e −rT EP∗ [C 1A ] 6 β e −rT EP∗ [C ]. (7.52)

Hint: Rewrite Condition (7.52) using the probability measure Q∗ , and

apply the Neyman-Pearson Lemma of Question (a) to P and Q∗ .
d) Show that P(Aα ) coincides with the successful hedging probability P VTAα >
C = P(C 1Aα > C ), i.e. show that

P(Aα ) = P VTAα > C = P(C 1Aα > C ).

" 297
N. Privault
Hint: To prove an equality x = y we can show first that x 6 y, and then

that x > y. One inequality is obvious, and the other one follows from
Question (c).
e) Check that the self-financing portfolio process VtAα t∈[0,T ] hedging the

claim with payoff C 1Aα uses only the initial budget β e −rT EP∗ [C ], and
that P VTAα > C maximizes the successful hedging probability.

In the next Questions (f)-(j) we assume that C = (ST − K )+ is the payoff of

a European option in the Black-Scholes model
with P = P∗ , dP/dP∗ = 1, and
σ2 1
S0 := 1 and r = := . (7.54)
2 2
f) Solve the stochastic differential equation (7.53) with the parameters
(7.54).
g) Compute the successful hedging probability
P VTAα > C = P(C 1Aα > C ) = P(Aα )

for the claim C =: (ST − K )+ in terms of K, T , EP∗ [C ] and the parameter

α > 0.
h) From the result of Question (g), express the parameter α using K, T ,
EP∗ [C ], and the successful hedging probability P VTAα > C for the claim
C =: (ST − K )+ .
i) Compute the minimal initial budget e −rT EP∗ [C 1Aα ] required to hedge
the claim C = (ST − K )+ in terms of α > 0, K, T and EP∗ [C ].
j) Taking K := 1, T := 1 and assuming a successful hedging probability of
90%, compute numerically:
i) The European call price e −rT EP∗ [(ST − K )+ ] from the Black-Scholes
formula.
ii) The value of α > 0 obtained from Question (h).
iii) The minimal initial budget needed to successfully hedge the European
claim C = (ST − K )+ with probability 90% from Question (i).
iv) The value of β, i.e. the budget reduction ratio which suffices to suc-
cessfully hedge the claim C =: (ST − K )+ with 90% probability.
Problem 7.27 Log options. Log options can be used for the pricing of realized
variance swaps, see § 8.2.
298 "
a) Consider a market model made of a risky asset with price (St )t∈R+ as in
Exercise 4.21-(d) and a riskless asset with price At = $1 × e rt and risk-
free interest rate r = σ 2 /2. From the answer to Exercise 4.21-(b), show
that the arbitrage-free price
Vt = e −(T −t)r E (log ST )+ Ft

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

r
T − t −B 2 /(2(T −t)) Bt
Vt = σ e −(T −t)r e t + σ e −(T −t)r Bt Φ √ .
2π T −t
b) Show that Vt can be written as
Vt = g (T − t, St ),
where g (τ , x) = e −rτ f (τ , log x), and

r
τ −y2 /(2σ2 τ ) y
f (τ , y ) = σ e + yΦ √ .
2π σ τ
c) Figure 7.6 represents the graph of (τ , x) 7→ g (τ , x), with r = 0.05 = 5%

per year and σ = 0.1. Assume that the current underlying asset price is $1
and there remains 700 days to maturity. What is the price of the option?
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
600
T-t 400
300
0 1.5 2
0.5 1 St
Fig. 7.6: Option price as a function of underlying asset price and time to maturity.
∂g
d) Show∗ that the (possibly fractional) quantity ξt = (T − t, St ) of St at
∂x
time t in a portfolio hedging the payoff (log ST )+ is equal to
1 log S

ξt = e −(T −t)r Φ √ t , 0 6 t 6 T.
St σ T −t
∂ 1 ∂f
∗
Recall the chain rule of derivation f (τ , log x) = (τ , y )|y =log x .
∂x x ∂y
" 299
N. Privault
∂g
e) Figure 7.7 represents the graph of (τ , x) 7→ ∂x (τ , x). Assuming that the
current underlying asset price is $1 and that there remains 700 days to
maturity, how much of the risky asset should you hold in your portfolio
in order to hedge one log option?
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0 0
2 300 200 100
1.8 1.6 1.4 400
1.2 1 0.8 600 500 T-t
0.6 0.4 0.2 700
St
Fig. 7.7: Delta as a function of underlying asset price and time to maturity.
f) Based on the framework and answers of Questions (c) and (e), should you
borrow or lend the riskless asset At = $1 × e rt , and for what amount?
∂2g
g) Show that the Gamma of the portfolio, defined as Γt = (T − t, St ),
∂x2
equals
!
1 1 log S

2 2
Γt = e −(T −t)r 2 e −(log St ) /(2(T −t)σ ) − Φ √ t ,
St σ 2(T − t)π
p
σ T −t
0 6 t < T.
h) Figure 7.8 represents the graph of Gamma. Assume that there remains
60 days to maturity and that St , currently at $1, is expected to increase.
Should you buy or (short) sell the underlying asset in order to hedge the
option?
0.8
0.6
0.4
0.2
0
180 200
-0.2 140 160
0.2 0.4 0.6 0.8 100 120 T-t
1 1.2 1.4 1.6 1.8 60 80
St
Fig. 7.8: Gamma as a function of underlying asset price and time to maturity.
i) Let now σ = 1. Show that the function f (τ , y ) of Question (b) solves the
heat equation
300 "
1 ∂2f

∂f
(τ , y ) = (τ , y )


2 ∂y 2

∂τ

f (0, y ) = (y )+ .


Problem 7.28 Log put options with a given strike price.

a) Consider a market model made of a risky asset with price (St )t∈R+ as in
Exercise 5.9, a riskless asset valued At = $1 × e rt , risk-free interest rate
r = σ 2 /2 and S0 = 1. From the answer to Exercise S.4-(c), show that the
arbitrage-free price
Vt = e −(T −t)r E∗ (K − log ST )+ Ft

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

r
τ −(K−y )2 /(2σ2 τ ) K −y
f (τ , y ) = σ e + (K − y ) Φ √ .
2π σ τ
c) Figure 7.9 represents the graph of (τ , x) 7→ g (τ , x), with r = 0.125 per

year and σ = 0.5. Assume that the current underlying asset price is $3,
that K = 1, and that there remains 700 days to maturity. What is the
price of the option?
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0 600 700
2.2 400 500
2.4 2.6 2.8 200 300
3 3.2 3.4 100 T-t
3.6 3.8 0
St
Fig. 7.9: Option price as a function of underlying asset price and time to maturity.
" 301
N. Privault
∂g
d) Show∗ that the quantity ξt = (T − t, St ) of St at time t in a portfolio
∂x
hedging the payoff (K − log ST )+ is equal to
1 K − log St

ξt = − e −(T −t)r Φ √ , 0 6 t 6 T.
St σ T −t
∂g
e) Figure 7.10 represents the graph of (τ , x) 7→ ∂x (τ , x). Assuming that the
current underlying asset price is $3 and that there remains 700 days to
maturity, how much of the risky asset should you hold in your portfolio
in order to hedge one log option?
-0.1
-0.2
-0.3
-0.4
-0.5 0
4 300 200 100
3.8 3.6 3.4 400
3.2 3 2.8 600 500 T-t
2.6 2.4 2.2 700
St
Fig. 7.10: Delta as a function of underlying asset price and time to maturity.
f) Based on the framework and answers of Questions (c) and (e), should you
borrow or lend the riskless asset At = $1 × e rt , and for what amount?
∂2g
g) Show that the Gamma of the portfolio, defined as Γt = (T − t, St ),
∂x2
equals
!
1 1 K − log St

2 / (2(T −t)σ 2 )
Γt = e −(T −t)r e −(K−log St ) +Φ √ ,
St2 2(T − t)π
p
σ σ T −t
0 6 t 6 T.
h) Figure 7.11 represents the graph of Gamma. Assume that there remains
10 days to maturity and that St , currently at $3, is expected to increase.
Should you buy or (short) sell the underlying asset in order to hedge the
option?
∗ ∂ 1 ∂f
Recall the chain rule of derivation f (τ , log x) = (τ , y )|y =log x .
∂x x ∂y
302 "
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
10 20
30 40 50 60 2.4 2.2
70 3 2.8 2.6
T-t 80 90 100 3.4 3.2
3.8 3.6
St
Fig. 7.11: Gamma as a function of underlying asset price and time to maturity.
i) Show that the function f (τ , y ) of Question (b) solves the heat equation

∂f σ2 ∂ 2 f
(τ , y ) = (τ , y )


2 ∂y 2

∂τ

f (0, y ) = (K − y )+ .


" 303
Chapter 8
Stochastic Volatility
Stochastic volatility refers to the modeling of volatility using time-dependent

stochastic processes, in contrast to the constant volatility assumption made
in the standard Black-Scholes model. In this setting, we consider the pricing
of realized variance swaps and options using moment matching approxima-
tions. We also cover the pricing of vanilla options by PDE arguments in the
Heston model, and by perturbation analysis approximations in more general
stochastic volatility models.
8.1 Stochastic Volatility Models . . . . . . . . . . . . . . . . . . . . 305

8.2 Realized Variance Swaps . . . . . . . . . . . . . . . . . . . . . . . 309
8.3 Realized Variance Options . . . . . . . . . . . . . . . . . . . . . . 314
8.4 European Options - PDE Method . . . . . . . . . . . . . . . 323
8.5 Perturbation Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 329
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
8.1 Stochastic Volatility Models
Time-dependent stochastic volatility
The next Figure 8.1 refers to the EURO/SGD exchange rate, and shows some
spikes that cannot be generated by Gaussian returns with constant variance.
" 305
N. Privault
Fig. 8.1: Euro / SGD exchange rate.
This type data shows that, in addition to jump models that are commonly
used to take into account the slow decrease of probability tails observed in
market data, other tools should be implemented in order to model a possibly
random and time-varying volatility.
We consider an asset price driven by the stochastic differential equation

√
dSt = rSt dt + St vt dBt (8.1)
under the risk-neutral probability measure P∗ ,

with solution
wT √ 1wT

ST = St exp (T − t)r + vs dBs − vs ds (8.2)
t 2 t
where (vt )t∈R+ is a (possibly random) squared volatility (or variance) process
(1)
adapted to the filtration Ft t∈R generated by (Bt )t∈R+ .
+
Time-dependent deterministic volatility
When the variance process (v (t))t∈R+ is a deterministic function of time,

the solution (8.2) of (8.1) is a lognormal random variable at time T with
conditional log-variance
wT
v (s)ds
t
given Ft . In particular, the European call option on ST can be priced by the
Black-Scholes formula as
√
e −(T −t)r E∗ [(ST − K )+ | Ft ] = Bl St , K, r, T − t, vb(t) ,

with integrated squared volatility parameter
306 "
rT
v (s)ds
vb(t) := t
, t ∈ [0, T ).
T −t
Independent (stochastic) volatility
When the volatility (vt )t∈R+ is a random process generating a filtration

(2) (1)
Ft t∈R , independent of the filtration Ft t∈R generated by the driv-
+ +
(1)
ing Brownian motion Bt t∈R under P∗ , the equation (8.1) can still be
+
solved as
wT √ 1wT

(1)
ST = St exp (T − t)r + vs dBs − vs ds ,
t 2 t
(2)
and, given FT , the asset price ST is a lognormal random variable with
random variance wT
vs ds.
t
In this case, taking
(1) (2)
Ft := Ft ∨ Ft , 0 6 t 6 T,
(1) (1)
where Ft t∈R is the filtration generated by Bt t∈R , we can still price
+ +
an option with payoff φ(ST ) on the underlying asset price ST using the tower
property
(1) (2) (1) (2)
E∗ [φ(ST ) | Ft ] = E∗ E∗ φ(ST ) Ft ∨ FT Ft ∨ Ft .

As an example, the European call option on ST can be priced by averaging

the Black-Scholes formula as follows:
e −(T −t)r E∗ [(ST − K )+ | Ft ]

(1) (2) (1) (2)
= e −(T −t)r E∗ E∗ (ST − K )+ Ft ∨ FT Ft ∨ Ft .

rT
  s  

t vs ds 
= e −(T −t)r E∗ Bl St , K, r, T − t,

Ft

T −t
√ (2)
= e −(T −t)r E∗ Bl x, K, r, T − t, vb(t, T ) Ft |x=S ,

t
which represents an averaged version of Black-Scholes prices, with the random

integrated volatility
1 wT
vb(t, T ) := vs ds, 0 6 t 6 T.
T −t t
" 307
N. Privault
wT
On the other hand, the probability distribution of the time integral vs ds
t
(2)
given Ft can be computed using integral expressions, see Yor (1992)
and Proposition 13.4 when (vt )t∈R)+ is a geometric Brownian motion, and
Lemma 9 in Feller (1951), Corollary 24 in Albanese and Lawi (2005) and
(17.5) when (vt )t∈R)+ is the CIR process.
Two-factor Stochastic Volatility Models
Evidence based on financial market data, see Figure 9.16, Figure 1 of Papan-
icolaou and Sircar (2014) or § 2.3.1 in Fouque et al. (2011), shows that the
variations in volatility tend to be negatively correlated with the variations
of underlying asset prices. For this reason we need to consider an asset price
process (St )t∈R+ and a stochastic volatility process (vt )t∈R+ driven by
 √ (1)
 dSt = rSt + vt St dBt

(2)
dvt = µ(t, vt )dt + β (t, vt )dBt ,


(1) (2)
Here, Bt t∈R+
and Bt t∈R+
are standard Brownian motions such that
(1) (2) (1) (2)

Cov Bt , Bt = ρt and dBt • dBt = ρdt,
where the correlation parameter ρ satisfies −1 6 ρ 6 1, and the coefficients

µ(t, x) and β (t, x) can be chosen e.g. from mean-reverting models (CIR) or
geometric Brownian models, as follows. Note that the observed correlation
coefficient ρ is usually negative, cf. e.g. § 2.1 in Papanicolaou and Sircar
(2014) and Figures 9.16 and 9.17.
The Heston model
In the Heston (1993) model, the stochastic volatility (vt )t∈R+ is chosen to be
a Cox et al. (1985) (CIR) process, i.e. we have
 √ (1)
 dSt = rSt dt + St vt dBt

√ (2)
dvt = −λ(vt − m)dt + η vt dBt ,


√
and µ(t, v ) = −λ(vt − v ), β (t, v ) = η v, where λ, m, η > 0.
Option pricing formulas can be derived in the Heston model using Fourier
inversion and complex integrals, cf. (8.29) below.
308 "
The SABR model
In the Sigma-Alpha-Beta-Rho (σ − α − β − ρ-SABR) model Hagan et al.

(2002), based on the parameters (α, β, ρ), the stochastic volatility process
(σt )t∈R+ is modeled as a geometric Brownian motion with

β (1)
 dFt = σt Ft dBt

(2)
dσt = ασt dBt ,


where (Ft )t∈R+ typically models a forward interest rate. Here, we have α > 0
(1) (2)
and β ∈ (0, 1], and Bt t∈R
, Bt t∈R are standard Brownian motions
+ +
with the correlation
(1) (2)
dBt • dBt = ρdt.
This model is typically used for the modeling of LIBOR rates and is not mean-
reverting, hence it is preferably used with a short time horizon. It allows in
particular for short time asymptotics of Black implied volatilities that can be
used for pricing by inputting them into the Black pricing formula, cf. § 3.3
in Rebonato (2009).
8.2 Realized Variance Swaps
Another look at historical volatility
When tk = kT /N , k = 0, 1, . . . , N , a natural estimator for the trend param-

eter µ can be written in terms of actual returns as
N
1 X 1 Stk − Stk−1
bN :=
µ ,
N tk − tk−1 Stk−1
k =1
or in terms of log-returns as
N
1 X 1 Stk
bN :=
µ log
N tk − tk−1 Stk−1
k =1
N
1 X
log(Stk ) − log(Stk−1 )

=
T
k =1
1 ST
= log .
T S0
Similarly, one can use the squared volatility (or realized variance) estimator
" 309
N. Privault
N −1 2
1 X 1 Stk+1 − Stk

2
σ := − ( tk + 1 − tk ) µ
bN
N −1
bN
tk + 1 − tk Stk
k =0
N
1 X 1 Stk − Stk−1 2

T
= − bN )2
(µ
N −1 tk − tk−1 Stk−1 N −1
k =1
using actual returns, or, using log-returns,∗

N 2
1 X 1

Stk
σ 2
:= log − (tk − tk−1 )µ
bN
N −1
bN
tk − tk−1 Stk−1
k =1
N
1 X 1 Stk 2

T
= log − bN )2 .
(µ (8.3)
N −1 tk − tk−1 Stk−1 N −1
k =1
Realized variance swaps
Realized variance swaps are forward contracts that allow for the exchange of
the estimated volatility (8.3) against a fixed value κσ . They are priced using
the expected value
"N #
1 Stk 2 1 ST 2
X
E σbN = E log log
2
− − κ2σ
T Stk−1 N −1 S0
k =1
of their payoff
N
!
1 Stk 2 1 ST 2
X
log − log − κσ ,
T Stk−1 N −1 S0
k =1
where κσ is the volatility level. Note that the above payoff has to be multiplied
by the vega notional, which is part of the contract, in order to convert it into
currency units.
Heston model
Consider the Heston (1993) model driven by the stochastic differential equa-
tion
√
dvt = (a − bvt )dt + σ vt dWt ,
where a, b, σ > 0. We have
Pn Pn 2 Pn Pn 2
∗
We apply the identity k =1
ak − l=1
al = k =1
a2k − l=1
al .
310 "
a
E[vT ] = v0 e−bT + 1 − e −bT ,
b
see Exercise 4.17-(b), and Exercise 8.2-(a), from which it follows that the
wT
realized variance R0,T
2
:= vt dt can be averaged as
0
w
T
E R0,T =E (8.4)
2
vt dt
0
wT
= E[vt ]dt
0
1 − e −bT e−bT + bT − 1
= v0 +a .
b b2
We can also express the variances
σ 2 −bT aσ 2 2
Var[vT ] = v0 e − e −2bT + 2 1 − e −bT ,
b 2b
cf. Exercise 4.17-(e), and
1 − 2bT e−bT − e −2bT

Var R0,T (8.5)
2
= v0 σ 2
b3
e −2bT + 2bT + 4(bT + 1) e −bT − 5
+aσ 2 ,
2b4
see e.g. Relation (3.3) in Prayoga and Privault (2017).
Stochastic volatility
In the sequel, we assume that the risky asset price process is given by
dSt
= rdt + σt dBt , (8.6)
St
under the risk-neutral probability measure P∗ , i.e.
wt 1wt 2

St = S0 exp rt + σs dBs − σs ds , t > 0, (8.7)
0 2 0
where (σt )t∈R+ is a stochastic volatility process. In this setting, we have the
following proposition.
Proposition 8.1. Denoting by F0 := e rT S0 the future price on ST , we have
the relation w
T 2 F0
E∗ σt dt = 2E∗ log . (8.8)
0 ST
Proof. From (8.7), we have
" 311
N. Privault

ST S
E∗ log = E∗ log T − rT
F0 S0
w
1wT 2

∗ T
=E σt dBt − σt dt
0 2 0
1 ∗ wT 2

=− E σt dt .
2 0
Independent stochastic volatility
In this subsection, we assume that the stochastic volatility process (σt )t∈R+
in (8.6) is independent of the Brownian motion (Bt )t∈R+ .
Lemma 8.2. (Carr and Lee (2008), Proposition 5.1) Assume that (σt )t∈R+
is independent of (Bt )t∈R+ . Then, for every λ > 0 we have
w " ± #
ST pλ

T 2 ±
E∗ exp λ σt dt = e −rpλ T E∗ , (8.9)
0 S0
1 1
r
where p±
λ := ± + 2λ.
2 4
Proof. Letting (Ftσ )t∈R+ denote the filtration generated by the process
(σt )t∈R+ , we have
w
p wT 2
pλ
ST T
e −rpλ T E∗ F = E∗ exp pλ σt dBt − λ
σ
σt dt FTσ

S0 T 0 2 0
pλ w T 2
w
∗ T
= exp − σt dt E exp pλ σt dBt FTσ

2 0 0

p w T
2 w
pλ T

= exp − λ σt2 dt exp σt2 dt
2 0 2 0

pλ wT
= exp (pλ − 1) σt2 dt
2 0
w
T 2
= exp λ σt dt ,
0
provided that λ = pλ (pλ − 1)/2, and in this case we have

pλ pλ
ST ST
e −rpλ T E∗ = e −rpλ T E∗ E∗
σ
F
T
S0 S0
w
T
= E∗ exp λ σt2 dt .
0
312 "
It remains to note that the equation λ = pλ (pλ − 1)/2, i.e. p2λ − pλ − 2λ = 0,

has for solutions
1 1
r
p± = ± + 2λ,
λ 2 4
+
with p−
λ < 0 < pλ when λ > 0.
By differentiating the moment generating function computed in Lemma 8.2
with respect to λ > 0, we can compute the first moment of the realized
wT
variance R0,T
2
= σt2 dt in the following corollary.
0
Corollary 8.3. Assume that (σt )t∈R+ is independent of (Bt )t∈R+ . Denoting
by F0 := e rT S0 the future price on ST , we have
w
T 2 ST ST
E∗ σt dt = 2E∗ log .
0 F0 F0
Proof. Rewriting (8.9) as
w
T 2 ST
E∗ exp λ σt dt = E∗ exp −rp±
λ T + p±
λ log
0 S0
and differentiating this relation with respect to λ, we get

w w
T 2 T 2 ST
E∗ σt dt exp λ σt dt = −rp0λ T E∗ exp −rp± λ T + p±λ log
0 0 S0

0 ∗ ± ± ST ST
+pλ E exp −rpλ T + pλ log log
S0 S0
" p± #
rT ST λ
= ∓√ E∗ exp −rp± λT
2λ + 1/4 S0
1

ST ST
±√ E∗ exp −rp± ±
λ T + pλ log S log ,
2λ + 1/4 0 S0
which, when λ = 0, recovers (8.8) in Lemma 8.1 as

w w
1wT 2

T 2 ST T
E∗ σt dt = 2rT − 2E∗ log = −2E∗ σt dBt − σt dt
0 S0 0 2 0
if p−
0 = 0, and yields
w
e −rT ST

T ST
E∗ σt2 dt = 2 e −rT E∗ log
0 S0 S0
for p0+ = 1.
" 313
N. Privault
8.3 Realized Variance Options

In this section, we consider the realized variance call option with payoff
w +
T
σt2 dt − κ2σ .
0
wt
Proposition 8.4. In case σu2 du > κ2σ , the price of the realized variance
0
call option in the money is given by
w +
T
e −(T −t)r E∗ σu2 du − κ2σ

Ft
0
wt w
T

= e −(T −t)r σu2 du − e −(T −t)r κ2σ + e −(T −t)r E∗ σu2 du Ft .

0 t
wt
Proof. In case σu2 du > κ2σ , we have
0
w +
T

Ft
0
wT
+
= e −(T −t)r E∗ σu2 du − κ2σ

x+ Ft
rt 2
t
x = 0 σu du
wT
−(T −t)r ∗
= e E x+ 2 2

σu du − κσ Ft r
t t 2 du
x= 0
σu
wt w
T

= e −(T −t)r σu2 du − e −(T −t)r κ2σ + e −(T −t)r E∗ σu2 du Ft .

0 t
Lognormal approximation
wt
When R0,t
2
:= σu2 du < κ2σ , in order to estimate the price
0
wT +
e −(T −t)r E∗ σu2 du − κ2σ , (8.10)

x+ Ft
rt
t 2 du
x= 0
σu
of the realized
qr variance call option out of the money, we can approximate
T 2
Rt,T := t σ u du by a lognormal random variable
wT
r
Rt,T = σu2 du ' e µ̃t,T +e
σt,T X
t
314 "
with mean µ̃t,T and variance ηt,T

2 , where X ' N (0, T − t) is a centered
Gaussian random variable with variance T − t.

4
Exact expression
3.5 Lognormal approximation
Probability density
3
2.5
2
1.5
1
0.5
0
0 0.2 0.4 0.6 0.8 1 1.2 1.4
Fig. 8.2: Fitting of a lognormal probability density function.
Proposition 8.5. (Lognormal approximation by volatility q swap moment

rT
matching). The probability density function ϕRt,T of Rt,T := 2
t σu du can
be approximated as
1 (µ̃t,T − log x)2

ϕRt,T (x) ≈ exp − , x > 0, (8.11)
σt,T 2(T − t)π 2(T − t)σ 2
p
xe et,T
where
 2  q 
E[Rt,T ] 2 E Rt,T
2
µ̃t,T := log  q  and σ
2
et,T := log   . (8.12)
E Rt,T
2 T −t E[Rt,T ]
Proof. The parameters µ̃t,T and σ 2are estimated by matching the first
et,T
and second moments E Rt,T and E Rt,T of Rt,T to those of the lognormal
distribution with mean µ̃t,T and variance (T − t)σ 2 , which yields
et,T
µ̃t,T +(T −t)e2 (y ) /2

σt,T 2(µ̃ +(T −t)e2 )
σt,T
E[Rt,T ] = e and E Rt,T = e t,T ,
2
and (8.12).
By (8.12), the parameters µ̃t,T and σ 2
et,T can be estimated from the realized
volatility swap price
rw
T
e −(T −t)r E∗ Rt,T | Ft = e −(T −t)r E∗ σu2 du Ft ,

t
and from the realized variance swap price
" 315
N. Privault
w
T 2
e −(T −t)r E∗ Rt,T | Ft = e −(T −t)r E∗ σu du Ft .
2
t
By Proposition 8.7, we can estimate the price (8.10) of the realized variance
r
2 = T σ 2 du by a lognormal random vari-
call option by approximating Rt,T t u
able. We refer to § 8.4 in Friz and Gatheral (2005) or to Relation (11.15)
page 152 of Gatheral (2006) for the following result.
Proposition 8.6. Under the lognormal approximation (8.11), the price
+
VCt,T (κσ ) = e −(T −t)r E x + Rt,T
2
− κ2σ

x = R2 0,t
of the realized variance call option can be approximated as
VCt,T (κσ ) ≈ e −(T −t)r E Rt,T Φ(d+ ) − e −(T −t)r κ2σ − R0,t Φ(d− ), (8.13)
2 2

where
log (E[Rt,T ])2 / κ2σ − R0,t
2

√
d+ : = √ + 2e
σt,T T − t
2eσt,T T − t
− log κ2σ − R0,t
2 + 2µ̃t,T + 4(T − t)σ 2

et,T
= √ ,
2eσt,T T − t
and
2µ̃t,T − log κ2σ − R0,t
2

√
d− := d+ − 2e
σt,T T − t = √ ,
2e
σt,T T − t
and Φ denotes the standard Gaussian cumulative distribution function.
Proof. The lognormal approximation (8.15) by realized variance moment
matching states that
1 −(−µ̃t,T +log x)2 /(2(T −t)e2 )
σt,T
ϕRt,T (x) ≈ e , x > 0,
2(T − t)π
p
xe
σt,T
or equivalently
1 √
ϕR2 (x) = √ ϕRt,T ( x)
t,T 2 x
1 2 σt,T )2 )
≈ e −(−2µ̃t,T +log x) /(2(T −t)(2e , x > 0.
2xe
σt,T 2(T − t)π
p
2 is approximately that of e 2µ̃t,T +2e

In other words, the distribution of Rt,T σt,T X
where X ' N (0, 1), hence

+
2
− κ2σ

x = R2 0,t
316 "
w∞ +
= e −(T −t)r y − κ2σ − R0,t
2
ϕR2 (y )dy
κσ t,T
−(T −t)r
µ̃ +2e +
≈ e E e t,T σt,T X 2
− (κσ − x) x = R2 0,t
2µ̃ +2(T −t)e2

σt,T
= e −(T −t)r e t,T Φ(d+ ) − κ2σ − R0,t
2
Φ(d− )

= e −(T −t)r E Rt,T Φ(d+ ) − e −(T −t)r κ2σ − R0,t Φ(d− ).(8.14)
2 2

In order to estimate the price
wT +
e −(T −t)r E∗ σu2 du − κ2σ ,

x+ Ft
rt
t 2 du
x= 0
σu
rw
t
of the realized variance call option when R0,t := σu2 du < κσ , we can
0
r
2 : = T σ 2 du by a lognormal random variable
also approximate Rt,T t u
wT
2
Rt,T = σu2 du ' e µ̃t,T +e
σt,T X
t
with mean µ̃t,T and variance σt,T

2 , where X ' N (0, 1) is a standard normal
random variable.
Proposition 8.7. (Lognormal approximation by realized variance moment
matching). Under the lognormal approximation, the probability density func-
r
2 : = T σ 2 du can be approximated as
tion ϕR2 of Rt,T t u
t,T
1 (µ̃t,T − log x)2

ϕR2 (x) ≈ exp − , x > 0, (8.15)
2(T − t)π 2(T − t)σ 2
p
t,T xe
σt,T et,T
where
σ 2
et,T
µ̃t,T := −(T − t) + log E[Rt,T
2
], (8.16)
2
and
Var[Rt,T
2 ]
!
1
σ 2
et,T = log 1 + . (8.17)
T −t (E[Rt,T ])2
2
Proof. The parameters µ̃t,T and σ 4are estimated

et,T by matching the first
and second moments E Rt,T 2 and E Rt,T of Rt,T
4 to those of the lognormal
distribution with mean µ̃t,T and variance (T − t)σ 2 , which yields

et,T
µ̃ +(T −t)e2 /2
σt,T 2(µ̃ +(T −t)e2 )
σt,T
E Rt,T = e t,T , E Rt,T = e t,T ,
2 4
and
" 317
N. Privault
 4 
σ 2
et,T 1 E Rt,T
+ log E Rt,T and σ log 2 2  .
2 2
µ̃t,T = −(T − t) :=
2
et,T 
T −t E Rt,T

By (8.16)-(8.17), the parameters µ̃t,T and σ 2
et,T can be estimated from the
realized variance swap price
w
T 2
e −(T −t)r E∗ Rt,T | Ft = e −(T −t)r E∗ σu du Ft ,
2
t
and from the realized variance power option price

w 2
T
e −(T −t)r E∗ Rt,T | Ft = e −(T −t)r E∗ σu2 du Ft .
4
t
The next proposition is obtained by the same argument as in the proof of

Proposition 8.6.
Proposition 8.8. Under the lognormal approximation (8.15), the price
+
2
− κ2σ

x=R 0,t
VCt,T (κσ ) ≈ e −(T −t)r E Rt,T Φ(d+ ) − e −(T −t)r κ2σ − R0,t Φ(d− ), (8.18)
2 2

where
√
log E Rt,T
2
/ κ2σ − R0,t2

T −t
d+ : = √ +σet,T
et,T T − t
σ 2
− log κ2σ − R0,t
2 2

+ µ̃t,T + (T − t)σet,T
= √ ,
et,T T − t
σ
and
µ̃t,T − log κ2σ − R0,t
2

√
et,T T − t =
d− : = d + − σ √ ,
et,T T − t
σ
and Φ denotes the standard Gaussian cumulative distribution function.
Note that, using the integral identity
√ 1 w∞ dλ
x= (1 − e −λx ) 3/2 ,
2π 0 λ
see e.g. Relation 3.434.1 in Gradshteyn and Ryzhik (2007) and Exercise 9.6-
(a), the realized volatility swap price E[Rt,T ] can be expressed as
318 "
1 w∞ −λR2 dλ
E[Rt,T ] = √ 1−E e t,T , (8.19)
2 π 0 λ3/2
−λR2
see § 3.1 in Friz and Gatheral (2005), where E e t,T can be expressed
from Lemma 8.2. In particular, by e.g. Relation (3.25) in Brigo and Mercurio
(2006), in the Cox et al. (1985) (CIR)
√
dvt = (a − bvt )dt + η vt dWt
variance model with vt = σt2 , we have

−λR2
E e 0,T
!
2v0 λ(1 − e−bT ) a 2a b + b + (b − b)e−bT
= exp − − 2 (b − b)T − 2 log ,
b + b + (b − b) e −bT η η 2b
where b := b2 + 2λη 2 .
p
Gamma approximation
wt
In case R0,t
2
= σu2 du < κ2σ , the realized variance call option price
0
wT +

x+ Ft
rt
t 2 du
x= 0
σu
rT
can be estimated by approximating Rt,T
2 = t σu2 du by a gamma random
variable.
4
Exact expression
3.5 Gamma approximation
Probability density
3
2.5
2
1.5
1
0.5
0
0 0.2 0.4 0.6 0.8 1 1.2 1.4
Fig. 8.3: Fitting of a gamma probability density function.
Proposition 8.9. (Gamma approximation). Under the gamma approxima-

r
2 : = T σ 2 du can be approx-
tion the probability density function ϕR2 of Rt,T t u t,T
imated as
" 319
N. Privault
(x/θt,T )−1+νt,T −x/θt,T

ϕR2 (x) ≈ e , x > 0, (8.20)
t,T θt,T Γ (νt,T )
where
2 2
Var Rt,T E Rt,T E Rt,T
2 2
θt,T = and νt,T = = 2 . (8.21)
E Rt,T Var Rt,T
2
θt,T
Proof. The parameters θt,T , νt,T are estimated by matching the first and
2 to those of the gamma distribution with scale and
second moments of Rt,T
shape parameters θt,T and νt,T , which yields
E Rt,T and Var Rt,T ,

2 2 2
= νt,T θt,T = νt,T θt,T
and (8.21).
Proposition 8.10. Under the gamma approximation (8.20), the price

+
EA(κσ , T ) = e −(T −t)r E x + Rt,T
2
− κ2σ

x = R2 0,t
κ2 κ2

EA(κσ , T ) = e −(T −t)r E Rt,T Q 1 + νt,T , σ − κ2σ Q νt,T , σ ,
2
θt,T θt,T
(8.22)
where
1 w ∞ λ−1 −t
Q(λ, z ) := t e dt, z > 0,
Γ (λ) z
is the (normalized) upper incomplete gamma function.
Proof. Using the gamma approximation
e −x/θt,T x−1+νt,T
ϕR2 (x) ≈ , (8.23)
t,T Γ(νt,T ) (θt,T )νt,T
where θt,T and νt,T are given by (8.21), we have

+ w ∞
E Rt,T = 2 (x − κ2σ )+ ϕR2 (x)dx
2
− κ2σ
κσ t,T
1 w∞ x−1+νt,T −x/θt,T
≈ (x − κ2σ ) e dx
Γ(νt,T ) κ2σ (θt,T )νt,T
1 w∞ κ2σ w ∞ x−1+νt,T −x/θt,T
= (x/θt,T )νt,T e −x/θt,T dx − e dx
Γ(νt,T ) κ2σ Γ(νt,T ) κ2σ (θt,T )νt,T
θt,T w ∞ 2
κσ w ∞
= xνt,T e −x dx − x−1+νt,T e −x dx
Γ(νt,T ) κ2σ /θt,T Γ(νt,T ) κ2σ /θt,T
320 "
κ2 κ2

= θt,T νt,T Q 1 + νt,T , σ − κ2σ Q νt,T , σ ,
θt,T θt,T
where
1 w ∞ λ−1 −t
Q(λ, z ) := t e dt, z > 0,
Γ (λ) z
is the (normalized) upper incomplete gamma function, which yields
+
EA(κσ , T ) = e −(T −t)r E x + Rt,T
2
− κ2σ

κ2 κ2

≈ e −(T −t)r νt,T θt,T Q 1 + νt,T , σ − κ2σ Q νt,T , σ (8.24)
θt,T θt,T

κ 2
κ 2
= e −(T −t)r E Rt,T Q 1 + νt,T , σ − κ2σ Q νt,T , σ .
2
θt,T θt,T
Realized variance options in the Heston model
Taking r = 0, t = 0 and R0,0 = 0, and using the parameters
σ = 0.39, b = 1.15, a = 0.04 × b, v0 = 0.04, T = 1
in the Heston stochastic differential equation

√
dvt = (a − bvt )dt + σ vt dWt ,
in Figures 8.4-8.5 we plot the graphs of the lognormal volatility swap and
realized variance moment matching approximations (8.13), (8.18), and of the
gamma approximation (8.22) for realized variance call 2 option prices
2with
κ2σ ∈ [0, 0.2], based on the expressions (8.4)-(8.5) of E R0,T and Var R0,T .

" 321
N. Privault
0.04
Lognormal variance swap moment matching
Lognormal volatility swap moment matching
Gamma variance swap moment matching
Variance Call Option Price
0.03
0.02
0.01
0.00 Monte Carlo
0.00 0.05 0.10 0.15 0.20
Strike Price K
Fig. 8.4: One-year variance call option prices with b = 0.15.
The graphs of Figures 8.4-8.5 are obtained using this R code.

0.04
Lognormal volatility swap moment matching

Lognormal variance swap moment matching
Gamma variance swap moment matching
Variance Call Option Price
0.03
Monte Carlo
0.02
0.01
0.00
0.00 0.05 0.10 0.15 0.20
Strike Price K
Fig. 8.5: One-year variance call option prices with b = −0.05.
As can be checked from in Figure 8.5 with
σ = 0.39, b = 1.15, a = 0.04 × b, v0 = 0.04, T = 1,
the gamma approximation (8.22) appears to be more accurate than the log-
normal approximations for large values of κ2σ , which can be consistent with
the fact that the long run distribution of the CIR-Heston process has the
gamma probability density function
2a/σ2
1 2b

2 2
f (x) = x−1+2a/σ e −2bx/σ , x > 0.
Γ(2a/σ 2 ) σ2
322 "
with shape parameter 2a/σ 2 and scale parameter σ 2 /(2b), which is also the
invariant distribution of vt .
8.4 European Options - PDE Method
In the sequel we consider an asset price process (St )t∈R+ in the stochastic
volatility model
√ (1)
dSt = rSt dt + St vt dBt
under the risk-neutral probability measure P∗ , where (vt )t∈R+ is a squared
volatility (or variance) process satisfying a stochastic differential equation of
the form
(2)
dvt = µ(t, vt )dt + β (t, vt )dBt ,
(1)
where Bt t∈R is a standard Brownian motion under P∗ , i.e. the dis-
+
counted price process ( e −rt St )t∈R+ is a martingale under P∗ . For simplicity
(2)
of exposition, we also assume that Bt t∈R is a standard Brownian motion
+
under P .
∗
(2)
Proposition 8.11. Assume that Bt t∈R is also a standard Brownian
+
motion under the risk-neutral probability measure∗ P∗ . Consider a vanilla
option with payoff h(ST ) priced as
Vt = f (t, vt , St ) = e −(T −t)r E∗ [h(ST ) | Ft ], 0 6 t 6 T.
The function f (t, y, x) satisfies the PDE
∂f ∂f 1 ∂2f
(t, v, x) + rx (t, v, x) + vx2 2 (t, v, x) (8.25)
∂t ∂x 2 ∂x
∂f 1 2
∂ f √ ∂ f2
+ µ(t, v ) (t, v, x) + β 2 (t, v ) 2 (t, v, x) + ρβ (t, v )x v (t, v, x)
∂v 2 ∂v ∂v∂x
= rf (t, v, x),
under the terminal condition f (T , v, x) = h(x).

Proof. By Itô calculus with respect to the correlated Brownian motions
(1) (2)
Bt t∈R and Bt t∈R , the portfolio value f (t, vt , St ) can be differenti-
+ +
ated as follows:
df (t, vt , St ) (8.26)
∂f ∂f √ ∂f (1)
= (t, vt , St )dt + rSt (t, vt , St )dt + vt St (t, vt , St )dBt
∂t ∂x ∂x
∗
When this condition is not satisfied, we need to introduce a drift that will yield a
market price of volatility.
" 323
N. Privault
1 ∂2f ∂f
+ vt St2 2 (t, vt , St )dt + µ(t, vt ) (t, vt , St )dt
2 ∂x ∂v
∂f (2) 1 2 ∂2f
+β (t, vt ) (t, vt , St )dBt + β (t, vt ) 2 (t, vt , St )dt
∂v 2 ∂v
√ ∂2f (1) (2)
+β (t, vt ) vt St (t, vt , St )dBt • dBt
∂v∂x
∂f ∂f √ ∂f (1)
= (t, vt , St )dt + rSt (t, vt , St )dt + vt St (t, vt , St )dBt
∂t ∂x ∂x
1 ∂2f ∂f
+ vt St2 2 (t, vt , St )dt + µ(t, vt ) (t, vt , St )dt
2 ∂x ∂v
∂f (2) 1 2 ∂2f
+β (t, vt ) (t, vt , St )dBt + β (t, vt ) 2 (t, vt , St )dt
∂v 2 ∂v
√ ∂2f
+ρβ (t, vt ) vt St (t, vt , St )dt.
∂v∂x
Knowing that the discounted portfolio value process ( e −rt f (t, vt , St ))t∈R+ is
also a martingale under P∗ , from the relation
d( e −rt f (t, vt , St )) = −r e −rt f (t, vt , St )dt + e −rt df (t, vt , St ),
we obtain
∂f ∂f 1 ∂2f
− rf (t, vt , St )dt + (t, vt , St )dt + rSt (t, vt , St )dt + vt St2 2 (t, vt , St )dt
∂t ∂x 2 ∂x
∂f 1 2 ∂2f
+ µ(t, vt ) (t, vt , St )dt + β (t, vt ) 2 (t, vt , St )dt
∂v 2 ∂v
√ ∂2f
+ ρβ (t, vt )St vt (t, vt , St )dt
∂v∂x
= 0,
and the pricing PDE (8.25).
Heston model
√
In the Heston model with µ(t, v ) = −λ(vt − v ) and β (t, v ) = η v, from
(8.25) we find the Heston PDE
∂f ∂f 1 ∂2f
(t, v, x) + rx (t, v, x) + vx2 2 (t, v, x) (8.27)
∂t ∂x 2 ∂x
∂f 1 2
∂ f 2
∂ f
− λ(v − m) (t, v, x) + η 2 v 2 (t, v, x) + ρηxv (t, v, x) = rf (t, v, x).
∂v 2 ∂v ∂v∂x
324 "
The solution of this PDE has been expressed in Heston (1993) as a complex
integral by inversion of a characteristic function.
Using the change of variable y = log x where with g (t, v, y ) = f (t, v, ey ), the
PDE (8.27) is transformed into
∂g 1 ∂2g v ∂g
(t, v, y ) + v 2 (t, v, y ) + r − (t, v, x)
∂t 2 ∂y 2 ∂y
∂g 2 2
η ∂ g ∂2g
+ λ(m − v ) (t, v, y ) + v (t, v, y ) + ρηv (t, v, y ) = rg (t, v, y ).
∂v 2 ∂v 2 ∂v∂y
The following proposition shows that the Fourier transform of g (t, v, y ) sat-
isfies an affine PDE with respect to the variable v, when z is regarded as a
constant parameter.
Proposition 8.12. Assume that ρ = 0. The Fourier transform
w∞
gb(t, v, z ) := e −iyz g (t, v, y )dy
−∞
satisfies the partial differential equation
1 1

∂b
g
(t, v, z ) + irz − vz 2 gb(t, v, z ) − iz vb
g (t, v, z ) (8.28)
∂t 2 2
∂b
g η2 ∂ 2 gb
+ (λ(m − v ) + iρηzv ) (t, v, z ) + v g (t, v, z ).
(t, v, z ) = rb
∂v 2 ∂v 2
Proof. We apply the relations i2 = −1 and

w∞ ∂g
g (t, v, z ) =
izb e −iyz (t, v, y )dy.
−∞ ∂y

The equation (8.28) can be solved in closed form, and the final solution
g (t, v, y ) can then be obtained by the Fourier inversion relation
1 w ∞ izy
g (t, v, y ) = e gb(t, v, z )dz, (8.29)
2π −∞
see Heston (1993), Attari (2004), Albrecher et al. (2007), and Rouah (2013)
for details.
Delta hedging in the Heston model
Consider a portfolio of the form

" 325
N. Privault
Vt = ηt e rt + ξt St
based on the riskless asset At = e rt and on the risky asset St . When this
portfolio is self-financing we have
dVt = df (t, vt , St )
= rηt e rt dt + ξt dSt
√ (1)
= rηt e rt dt + ξt rSt dt + St vt dBt
√ (1)
= rVt dt + ξt St vt dBt
√ (1)
= rf (t, vt , St )dt + ξt St vt dBt . (8.30)
However, trying to match (8.26) to (8.30) yields
√ ∂f (1) ∂f (2) √ (1)

(t, vt , St )dBt + β (t, vt ) (t, vt , St )dBt = ξt St vt dBt ,
vt St
∂x ∂v
(8.31)
which admits no solution unless β (t, v ) = 0, i.e. when volatility is determin-
istic. A solution to that problem is to consider instead a portfolio
Vt = f (t, vt , St ) = ηt e rt + ξt St + ζt P (t, vt , St )
that includes an additional asset with price P (t, vt , St ), which can be an

option depending on the volatility vt .
Proposition 8.13. Assume that ρ = 0. The self-financing portfolio alloca-
tion (ξt , ζt )t∈[0,T ] in the assets ( e rt , St , P (t, vt , St ))t∈[0,T ] with portfolio value
Vt = f (t, vt , St ) = ηt e rt + ξt St + ζt P (t, vt , St ) (8.32)
is given by
∂f
(t, vt , St )
ζt = ∂v , (8.33)
∂P
(t, vt , St )
∂v
and
∂P
∂f ∂f (t, vt , St )
ξt = (t, vt , St ) − (t, vt , St ) ∂x . (8.34)
∂x ∂v ∂P
(t, vt , St )
∂v
Proof. Using (8.32), we replace (8.30) with
dVt = df (t, vt , St )
= rηt e rt dt + ξt dSt + ζt dP (t, vt , St )
326 "
√ (1) ∂P
= rηt e rt dt + ξt (rSt dt + St vt dBt ) + rζt St (t, vt , St )dt
∂x
∂P ∂P 1 ∂2P
+ζt µ(t, vt ) (t, vt , St )dt + ζt (t, vt , St )dt + ζt St2 vt 2 (t, vt , St )dt
∂v ∂t 2 ∂x
1 ∂2P √ ∂2P
+ ζt β 2 (t, vt ) 2 (t, vt , St )dt + ρζt β (t, vt )St vt (t, vt , St )dt
2 ∂v ∂x∂v
√ ∂P (1) ∂P (2)
+ζt St vt (t, vt , St )dBt + ζt β (t, vt ) (t, vt , St )dBt ,
∂x ∂v
√ (1) ∂P
= (Vt − ζt P (t, vt , St ))rdt + ξt St vt dBt + rζt St (t, vt , St )dt
∂x
∂P ∂P 1 ∂2P
∂v ∂t 2 ∂x
1 ∂2P √ ∂2P
+ ζt β (t, vt ) 2 (t, vt , St )dt + ρζt β (t, vt )St vt
2
(t, vt , St )dt
2 ∂v ∂x∂v
√ ∂P (1) ∂P (2)
+ζt St vt (t, vt , St )dBt + ζt β (t, vt ) (t, vt , St )dBt
∂x ∂v
√ (1) ∂P
= rf (t, vt , St )dt + ξt St vt dBt + rζt St (t, vt , St )dt
∂x
∂P ∂P 1 ∂2P
∂v ∂t 2 ∂x
1 ∂2P √ ∂2P
+ ζt β (t, vt ) 2 (t, vt , St )dt + ρζt β (t, vt )St vt
2
(t, vt , St )dt
2 ∂v ∂x∂v
√ ∂P (1) ∂P (2)
+ζt St vt (t, vt , St )dBt + ζt β (t, vt ) (t, vt , St )dBt , (8.35)
∂x ∂v
and by matching (8.35) to (8.26), the equation (8.31) now becomes
√ ∂f (1) ∂f (2)
vt St(t, vt , St )dBt + β (t, vt ) (t, vt , St )dBt
∂x ∂v
√ (1) √ ∂P (1) ∂P (2)
= ξt St vt dBt + ζt St vt (t, vt , St )dBt + ζt β (t, vt ) (t, vt , St )dBt .
∂x ∂v
This leads to the equations

√ ∂f √ √ ∂P
 vt St (t, vt , St ) = ξt St vt + ζt St vt (t, vt , St ),


 ∂x ∂x
 ∂f ∂P
 β (t, vt ) (t, vt , St ) = ζt β (t, vt ) (t, vt , St ),


∂v ∂v
which show that
∂f
(t, vt , St )
ζt = ∂v ,
∂P
(t, vt , St )
∂v
and
" 327
N. Privault
1

√ ∂f √ ∂P
ξt = √ (t, vt , St ) − ζt St vt
vt St (t, vt , St ),
St vt ∂x ∂x
∂f ∂P
= (t, vt , St ) − ζt (t, vt , St )
∂x ∂x
∂P
∂f ∂f (t, vt , St )
= (t, vt , St ) − (t, vt , St ) ∂x .
∂x ∂v ∂P
(t, vt , St )
∂v

We note in addition that identifying the “dt” terms when equating (8.35) to
(8.26) would now lead to the more complicated PDE
∂P ∂P
(f (t, vt , St ) − ζt P (t, vt , St ))r + rζt St(t, vt , St ) + ζt µ(t, vt ) (t, vt , St )
∂x ∂v
∂P 1 2
∂ P 1 2
∂ P
+ ζt (t, vt , St ) + ζt St2 vt 2 (t, vt , St ) + ζt β 2 (t, vt ) 2 (t, vt , St )
∂t 2 ∂x 2 ∂v
√ ∂2P
+ρζt β (t, vt )St vt (t, vt , St )
∂x∂v
∂f ∂f 1 ∂2f ∂f
= (t, vt , St ) + rSt (t, vt , St ) + vt St2 2 (t, vt , St ) + µ(t, vt ) (t, vt , St )
∂t ∂x 2 ∂x ∂v
1 ∂2f √ ∂2f
+ β 2 (t, vt ) 2 (t, vt , St ) + ρβ (t, vt )St vt (t, vt , St ),
2 ∂v ∂v∂x
which can be rewritten using (8.33) as

∂f ∂P ∂P ∂P
(t, v, x) −rP (t, v, x) + (t, v, x) + rx (t, v, x) + µ(t, v ) (t, v, x)
∂v ∂t ∂x ∂v
1 2
2 2
∂2P √ ∂2P

∂f x v∂ P
+ (t, v, x) (t, v, x) + β (t, v ) 2 (t, v, x) + ρβ (t, v )x v (t, v, x)
∂v 2 ∂x 2 2 ∂v ∂x∂v
vx2 ∂ 2 f

∂P ∂f ∂f
= (t, v, x) −rf (t, v, x) + (t, v, x) + rx (t, v, x) + ( t, v, x )
∂v ∂t ∂x 2 ∂x2
1 2 ∂2f √ ∂2f

∂P ∂f
+ (t, v, x) µ(t, v ) (t, v, x) + β (t, v ) 2 (t, v, x) + ρβ (t, v )x v (t, v, x) .
∂v ∂v 2 ∂v ∂v∂x
∂P
Therefore, dividing both sides by (t, v, x) and letting
∂v
λ(t, v, x) (8.36)
1

∂P ∂P
:= ∂P −rP (t, v, x) + rx (t, v, x) + (t, v, x)
∂v (t, v, x)
∂x ∂t
1 1
2 2
∂2P √ ∂2P

x v∂ P
+ ∂P (t, v, x) + β 2 (t, v ) 2 (t, v, x) + ρβ (t, v )x v (t, v, x)
∂v (t, v, x)
2 ∂x 2 2 ∂v ∂x∂v
328 "
1 vx2 ∂ 2 f

∂f ∂f
= −rf (t, v, x) + (t, v, x) + rx (t, v, x) + (t, v, x)
∂f ∂t ∂x 2 ∂x 2
∂v (t, v, x)
(8.37)
1 1 2 ∂2f √ ∂2f

+ ∂f β (t, v ) 2 (t, v, x) + ρβ (t, v )x v (t, v, x) (8.38)
(t, v, x) 2
∂v
∂v ∂v∂x
defines a function λ(t, v, x) that depends only on the parameters (t, v, x) and
(2)
not on P , without requiring Bt t∈R to be a standard Brownian motion
+
under P . The function λ(t, v, x) is linked to the market price of volatility
∗
risk, cf. Chapter 1 of Gatheral (2006) § 2.4.1 in Fouque et al. (2000; 2011)
for details.
Combining (8.36)-(8.38) allows us to rewrite the pricing PDE as
∂f ∂f vx2 ∂ 2 f 1 ∂2f
(t, v, x) + rx (t, v, x) + (t, v, x) + β 2 (t, v ) 2 (t, v, x)
∂t ∂x 2 ∂x2 2 ∂v
√ ∂2f ∂f
+ρβ (t, v )x v (t, v, x) = rf (t, v, x) + λ(t, v, x) (t, v, x),
∂v∂x ∂v
and (8.25) corresponds to the choice λ(t, v, x) = −µ(t, v ), which corresponds
to a vanishing “market price of volatility risk”.
8.5 Perturbation Analysis

We refer to Chapter 4 of Fouque et al. (2011) for the contents of this section.
Consider the time-rescaled model
√

(1)
 dSt = rSt dt + St vt/ε dBt

(8.39)
(2)
dvt = µ(vt )dt + β (vt )dBt .


(ε)
We note that vt := vt/ε satisfies the SDE
(ε)
dvt = dvt/ε
' v(t+dt)/ε − vt/ε
= vt/ε+dt/ε − vt/ε
1 (2)
= µ(vt/ε )dt + β (vt/ε )dBt/ε ,
ε
with 2
1 1

( 2 ) 2 dt ( 2 ) 2 (2)
dBt/ε ' ' dBt ' √ dBt ,
ε ε ε
" 329
N. Privault
(ε)
hence the SDE for vt can be rewritten as the slow-fast system
(ε) 1 (ε) 1 (ε) (2)

dvt = µ(vt )dt + √ β (vt )dBt .
ε ε
In other words, ε → 0 corresponds to fast mean-reversion and (8.39) can be

rewritten as
 q
(ε) (1)
 dSt = rSt dt + vt St dBt


 dvt(ε) = 1 µ vt(ε) dt + √1 β vt(ε) dBt(2) , ε > 0.



ε ε
The perturbed PDE
∂fε ∂fε vx2 ∂ 2 fε 1 ∂fε

(t, v, x) + rx (t, v, x) + (t, v, x) + µ(v ) (t, v, x)
∂t ∂x 2 ∂x2 ε ∂v
1 2
∂ fε ρ √ ∂ fε 2
+ β 2 (v ) 2 (t, v, x) + √ β (v )x v (t, v, x) = rfε (t, v, x)
2ε ∂v ε ∂v∂x
with terminal condition fε (T , v, x) = (x − K )+ rewrites as

1 1
L0 fε (t, v, x) + √ L1 fε (t, v, x) + L2 fε (t, v, x) = rfε (t, v, x), (8.40)
ε ε
where
1 ∂ 2 fε

∂fε
L0 fε (t, v, x) := β 2 (v ) 2 (t, v, x) + µ(v ) (t, v, x),


2



 ∂v ∂v



√ ∂ 2 fε

L1 fε (t, v, x) := ρxβ (v ) v (t, v, x),


 ∂v∂x


2 2

 L2 fε (t, v, x) := ∂fε (t, v, x) + rx ∂fε (t, v, x) + vx ∂ fε (t, v, x).



∂t ∂x 2 ∂x2
Note that
• L0 is the infinitesimal generator of the process vs1 , see (8.44) below,

s∈R+
and
• L2 is the Black-Scholes operator, i.e. L2 f = rf is the Black-Scholes PDE.
The solution fε (t, v, x) will be expanded as

√
fε (t, v, x) = f (0) (t, v, x) + εf (1) (t, v, x) + εf (2) (t, v, x) + · · · (8.41)
330 "
with f (T , v, x) = (x − K )+ , f (1) (T , v, x) = 0, and f (2) (T , v, x) = 0. Since

L0 contains only differentials with respect to v, we will choose f (0) (t, v, x) of
the form
f (0) (t, v, x) = f (0) (t, x),
cf. § 4.2.1 of Fouque et al. (2011) for details, with
L0 f (0) (t, x) = L1 f (0) (t, x) = 0. (8.42)
Proposition 8.14. (Fouque et al. (2011), § 3.2). The first order term
f0 (t, v ) in (8.41) satisfies the Black-Scholes PDE
∂f (0) ∂f (0) η2 w ∞ ∂ 2 f (0)

rf (0) (t, x) = (t, x) + rx (t, x) + vφ(v )dv (t, x)
∂t ∂x 2 0 ∂x2
with the terminal condition f (0) (T , x) = (x − K )+ , where φ(v ) is the sta-

tionary (or invariant) probability density function of the process vt1 t∈R .
+
√
Proof. By identifying the terms of order 1/ ε when plugging (8.41) in (8.40)
we have
L0 f (1) (t, v, x) + L1 f (0) (t, x) = 0,
hence L0 f (1) (t, v, x) = 0. Similarly, by identifying the terms that do not
depend on ε in (8.40) and taking f (1) (t, v, x) = f (1) (t, x), we have L1 f (1) = 0
and
L0 f (2) (t, v, x) + L2 f (0) (t, x) = 0. (8.43)
Using the Itô formula, we have
h w s ∂f (2) (2) i
E f (2) t, vs1 , x = f (2) t, v01 , x + E t, vτ1 , x dBτ

0 ∂x
hw s ∂f (2) 1 ∂ 2 f (2) i
+E µ vτ1 t, vτ1 , x + β 2 vτ1 t, vτ1 , x dτ
0 ∂vw 2 ∂v 2
s
= E f (2) t, v01 , x + E L0 f (2) t, vτ1 , x dτ . (8.44)

0
When the process vt1 t∈R is started under its stationary (or invariant)

+
probability distribution with probability density function φ(v ), we have
w ∞ (2)
E f (2) t, vτ1 , x = τ > 0,

f (t, v, x)φ(v )dv,
0
hence (8.44) rewrites as

w∞ w∞ wsw∞
f (2) (t, v, x)φ(v )dv = f (2) (t, v, x)φ(v )dv + L0 f (2) (t, v, x)φ(v )dvdτ .
0 0 0 0
By differentiation with respect to s > 0 this yields
" 331
N. Privault
w∞
L0 f (2) (t, v, x)φ(v )dv = 0,
0
hence by (8.43) we find

w∞
L2 f (0) (t, x)φ(v )dv = 0,
0
cf. § 3.2 of Fouque et al. (2011), i.e. we find
∂f (0) ∂f (0) η2 w ∞ ∂ 2 f (0)

(t, x) + rx (t, x) + vφ(v )dv (t, x) = rf (0) (t, x),
∂t ∂x 2 0 ∂x2
with the terminal condition f (0) (T , x) = (x − K )+ .

As a consequence of Proposition 8.14, the first order term f (0) (t, x) in the
expansion (8.41) is the Black-Scholes function
rw
∞
f (0) (t, x) = Bl St , K, r, T − t, vφ(v )dv ,
0
with the averaged squared volatility

w∞
vφ(v )dv = E vτ1 , τ > 0, (8.45)

0
under the stationary distribution of the process with infinitesimal generator

L0 , i.e. the stationary distribution of the solution to
(2)
dvt1 = µ(vt1 )dt + β (vt1 )dBt .
Perturbation analysis in the Heston model
We have  q
(ε) (1)
 dSt = rSt dt + St vt dBt




s
(ε)
λ (ε) vt

 (ε)
 (2)
dBt ,

 dvt = − vt − m dt + η

ε ε
under the modified short mean-reversion time scale, and the SDE can be
rewritten as s
(ε)
(ε) λ (ε) vt (2)
dBt .

dvt = − vt − m dt + η
ε ε
(ε)
In other words, ε → 0 corresponds to fast mean reversion, in which vt be-
comes close to its mean (8.45).
332 "
Recall, cf. (17.6), that the CIR process vt1 has a gamma invariant

t∈R+
(or stationary) distribution with shape parameter 2λm/η 2 , scale parameter
η 2 /(2λ), and probability density function φ given by
1
φ(v ) = 2v
−1+2λm/η 2 −2vλ/η 2
e 1[0,∞) (v ), v ∈ R,
Γ(2λm/η 2 )(η 2 /(2λ))2λm/η
and mean w∞
vφ(v )dv = m.
0
Hence the first order term f (0) (t, x) in the expansion (8.41) reads
√
f (0) (t, x) = Bl St , K, r, T − t, m ,
with the averaged squared volatility

w∞
vφ(v )dv = m = E vτ1 , τ > 0,

0
under the stationary distribution of the process with infinitesimal generator

L0 , i.e. the stationary distribution of the solution to
(2)
dvt1 = µ(vt1 )dt + β (vt1 )dBt .
In Figure 8.6, cf. Privault and She (2016), related approximations of put
option prices are plotted against the value of v with correlation ρ = −0.5
and ε = 0.01 in the α-hypergeometric stochastic volatility model of Fonseca
and Martini (2016), based on the series expansion of Han et al. (2013), and
compared to a Monte Carlo curve requiring 300, 000 samples and 30, 000 time
steps.
0.8
Monte Carlo
0.7 f
~0
f +εf
Option prices
0.6 ~ 0 2 ~1
f0+εf1+ε f2
0.5
0.4
0.3
0.2
0.1
0 1 2 3 4 5 6 7
v
Fig. 8.6: Option price approximations plotted against v with ρ = −0.5.
" 333
N. Privault
Exercises
Exercise 8.1 (Gatheral (2006), Chapter 11). Compute the expected realized
variance on the time interval [0, T ] in the Heston model, with
√
dvt = −λ(vt − m)dt + η vt dBt , 0 6 t 6 T.
Exercise 8.2
Compute the variance swap rate
 !2 
n w
1  SkT /n − S(k−1)T /n
= 1E
T 1
X
VST := E lim ( dSt ) 2
T n→∞ S(k−1)T /n T 0 St2
k =1
on the index whose level St is given in the following two models.

a) Heston (1993) model. Here, (St )t∈R+ is given by the system of stochastic
differential equations
 p (1)
 dSt = (r − αvt )St dt + St β + vt dBt

√ (2)
dvt = −λ(vt − m)dt + γ vt dBt ,


(1) (2)
where Bt t∈R and Bt t∈R are standard Brownian motions with
+ +
correlation ρ ∈ [−1, 1] and α > 0, β > 0, λ > 0, m > 0, r > 0, γ > 0.
b) SABR model with β = 1. The index level St is given by the system of
stochastic differential equations

(1)
 dSt = σt St dBt

(2)
dσt = ασt dBt ,


(1) (2)
where α > 0 and Bt t∈R and Bt t∈R are standard Brownian
+ +
motions with correlation ρ ∈ [−1, 1].
Exercise 8.3 Convexity adjustment (§ 2.3 of Broadie and Jain (2008)).

a) Using Taylor’s formula
√ √ x − x0 (x − x0 )2
x= x0 +
√ − + o((x − x0 )2 ),
2 x0 8x3/2
0
q q
find an approximation of R0,T = R0,T
2 using E R0,T 2 and correction

terms.
334 "
b) Find an (approximate) relation between the variance swap price E∗ R0,T

2
and the volatility swap price E∗ [R0,T ] up to a correction term.
Exercise 8.4 Consider an asset price (St )t∈R+ with log-return dynamics
d log St = µdt + ZNt− dNt , t > 0,
i.e. St := S0 e µt+Yt in a pure jump Merton model, where (Nt )t∈R+ is a

Poisson process with intensity λ > 0 and (Zk )k>0 is a family of independent
identically distributed Gaussian N (δ, η 2 ) random variables. Compute the
price of the log-return variance swap
w w
T T
E (d log St )2 dNt = E (µdt + ZNt− dNt )2 dNt
0 0
w
T
=E (ZNt− dNt )2 dNt
0
wT
" #
St 2

=E log dNt
0 St−
 !2 
NT
X STk
= E log 
STk−1
n=1
using the smoothing lemma Proposition 20.10.
Exercise 8.5 Consider an asset price (St )t∈R+ given by the stochastic dif-
ferential equation
where (Bt )t∈R+ is a standard Brownian motion, with r ∈ R and σ > 0.
a) Write down the solution (St )t∈R+ of Equation (8.46) in explicit form.
b) Show by a direct calculation that Corollary 8.3 is satisfied by (St )t∈R+ .
Exercise 8.6 (Carr and Lee (2008)) Consider an underlying asset price
(St )t∈R+ given by dSt = rSt dt + σt St dBt , where (Bt )t∈R+ is a standard
Brownian motion and (σt )t∈R+ is an (adapted) stochastic volatility process.
The riskless asset is priced At := e rt , t ∈ [0, T ]. We consider a realized
wT
variance swap with payoff R0,T
2
= σt2 dt.
0
wT
a) Show that the payoff σt2 dt of the realized variance swap satisfies
0
wT w T dS ST
t
σt2 dt = 2 − 2 log . (8.47)
0 0 St S0
" 335
N. Privault
w
T
b) Show that the price Vt := e −(T −t)r E∗ σt2 dt Ft of the variance swap

0
at time t ∈ [0, T ] satisfies
w t dS
u
Vt = Lt + 2(T − t)r e −(T −t)r + 2 e −(T −t)r , (8.48)
0 Su
where
ST
Lt := −2 e −(T −t)r E∗ log

Ft
S0
is the price at time t of the log contract (see Neuberger (1994), Demeterfi
et al. (1999)) with payoff −2 log(ST /S0 ), see also Exercises 6.9 and 7.14.
c) Show that the portfolio made at time t ∈ [0, T ] of:

• one log contract priced Lt ,
• 2 e −(T −t)r /St in shares priced St ,
w
t dSu
• 2 e −rT + (T − t)r − 1 in the riskless asset At = e rt ,
0 Su
hedges the realized variance swap.

d) Show that the above portfolio is self-financing.
Exercise 8.7 Compute the moment E∗ R0,T from Lemma 8.2.

4
336 "
Chapter 9
Volatility Estimation
Volatility estimation methods include historical, implied and local volatility,

and the VIX® volatility index. This chapter presents such estimation meth-
ods, together with examples of how the Black-Scholes formula can be fitted
to market data. While the market parameters r, t, St , T , and K used in
Black-Scholes option pricing can be easily obtained from market terms and
data, the estimation of volatility parameters can be a more complex task.
9.1 Historical Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

9.2 Implied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
9.3 Local Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
9.4 The VIX® Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
9.1 Historical Volatility

We consider the problem of estimating the parameters µ and σ from market
data in the stock price model
dSt
= µdt + σdBt . (9.1)
St
Historical trend estimation
By discretization of (9.1) along a family t0 , t1 , . . . , tN of observation times as
Stk+1 − Stk
= (tk+1 − tk )µ + (Btk+1 − Btk )σ, k = 0, 1, . . . , N − 1, (9.2)
Stk
a natural estimator for the trend parameter µ can be constructed as
" 337
N. Privault
N −1
StM − StM
!
1 X 1
bN :=
µ k +1 k
, (9.3)
N
k =0
tk+1 − tk StM
k
where (StMk +1
− StM
k
)/StM
k
, k = 0, 1, . . . , N − 1 denotes market returns ob-
served at discrete times t0 , t1 , . . . , tN on the market.
Historical log-return estimation
Alternatively, observe that, replacing∗ (9.3) by the log-returns
Stk+1
log = log Stk+1 − log Stk
Stk
− Stk

St
= log 1 + k+1
Stk
Stk+1 − Stk
' ,
Stk
with tk+1 − tk = T /N , k = 0, 1, . . . , N − 1, one can replace (9.3) with the

simpler telescoping estimate
N −1
1 X 1 1 ST
log Stk+1 − log Stk = log .

N tk + 1 − tk T S0
k =0
Historical volatility estimation
The volatility parameter σ can be estimated by writing, from (9.2),

N −1 N −1 2
X X Stk+1 − Stk
σ2 (Btk+1 − Btk )2 = − (tk+1 − tk )µ ,
Stk
k =0 k =0
which yields the (unbiased) realized variance estimator

N −1 2
1 X 1 Stk+1 − Stk

σ 2
:= bN .
− (tk+1 − tk )µ
N −1
bN
tk + 1 − tk Stk
k =0
library(quantmod)
getSymbols("0005.HK",from="2017-02-15",to=Sys.Date(),src="yahoo")
stock=Ad(`0005.HK`)
chartSeries(stock,up.col="blue",theme="white")
∗
This approximation does not include the correction term (dSt )2 /(2St2 ) in the Itô
formula d log St = dSt /St − (dSt )2 /(2St2 ).
338 "
stock=Ad(`0005.HK`);returns=(stock-lag(stock))/stock
returns=diff(log(stock));times=index(returns);returns <- as.vector(returns)
n = sum(is.na(returns))+sum(!is.na(returns))
plot(times,returns,pch=19,cex=0.05,col="blue", ylab="returns", xlab="n", main = '')
segments(x0 = times, x1 = times, cex=0.05,y0 = 0, y1 = returns,col="blue")
abline(seq(1,n),0,FALSE);dt=1.0/365;mu=mean(returns,na.rm=TRUE)/dt
sigma=sd(returns,na.rm=TRUE)/sqrt(dt);mu;sigma
stock [2017−02−15/2017−03−31]
0.02
●
Last 63.3
67
●
●
●
●
●
● ●
0.00
●
66 ● ● ●
● ● ●
●
●
●
●
● ●
●
●
65
returns
●
−0.02
64
−0.04
63
Feb 15 Feb 27 Mar 06 Mar 13 Mar 20 Mar 27 Mar 31 ●
2017 2017 2017 2017 2017 2017 2017
Feb 15 Mar 01 Mar 15 Apr 01
(a) Underlying asset price. (b) Log-returns.
Fig. 9.1: Graph of underlying asset price vs log-returns.
library(PerformanceAnalytics);
returns <- exp(CalculateReturns(stock,method="compound")) - 1; returns[1,] <- 0
histvol <- rollapply(returns, width = 30, FUN=sd.annualized)
myTheme <- chart_theme(); myTheme$col$line.col <- "blue"
chart_Series(stock,name="0005.HK",pars=myPars,theme=myTheme)
add_TA(histvol, name="Historical Volatility")
The next Figure 9.2 presents a historical volatility graph with a 30 days
rolling window.
0005.HK 2017−02−15 / 2021−05−28
70 70
65 65
60 60
55 55
50 50
45 45
40 40
35 35
30 30
0.5 Historical Volatility 0.2402 0.5
0.4 0.4
0.3 0.3
0.2 0.2
0.1 0.1
2017 2018 2019 2020 2021
0.0 0.0
Feb 15 Aug 01 Feb 01 Aug 01 Feb 01 Aug 01 Feb 03 Aug 03 Jan 29
2017 2017 2018 2018 2019 2019 2020 2020 2021
Fig. 9.2: Historical volatility graph.

Parameter estimation based on historical data usually requires a lot of sam-
ples and it can only be valid on a given time interval, or as a moving average.
" 339
N. Privault
Moreover, it can only rely on past data, which may not reflect future data.
Fig. 9.3: “The fugazi: it’s a wazy, it’s a woozie. It’s fairy dust.”∗
9.2 Implied Volatility
Recall that when h(x) = (x − K )+ , the solution of the Black-Scholes PDE

is given by
Bl(t, x, K, σ, r, T ) = xΦ d+ (T − t) − K e −(T −t)r Φ d− (T − t) ,

where
1 wx 2
Φ (x) = √ e −y /2 dy, x ∈ R,
2π −∞
and
log(x/K ) + (r + σ 2 /2)(T − t)

d (T − t) = √ ,

 +


 σ T −t
log(x/K ) + (r − σ 2 /2)(T − t)


 d− ( T − t ) = √ .


σ T −t
In contrast with the historical volatility, the computation of the implied
volatility can be done at a fixed time and requires much less data. Equating
the Black-Scholes formula
Bl(t, St , K, σ, r, T ) = M (9.4)
to the observed value M of a given market price allows one to infer a value
of σ when t, St , r, T are known, as in e.g. Figure 6.23.
∗
Scorsese (2013) Click on the figure to play the video (works in Acrobat Reader on the
entire pdf file).
340 "
0.6
Market price
0.5
0.4
Option price
0.3
0.2
0.1
0 σ
0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 imp 1.4 1.5
σ
Fig. 9.4: Option price as a function of the volatility σ.
This value of σ is called the implied volatility, and it is denoted here by

σimp (K, T ), cf. e.g. Exercise 6.6. Various algorithms can be implemented to
solve (9.4) numerically for σimp (K, T ), such as the bisection method and the
Newton-Raphson method.∗
BS <- function(S, K, T, r, sig){d1 <- (log(S/K) + (r + sig^2/2)*T) / (sig*sqrt(T))

d2 <- d1 - sig*sqrt(T);return(S*pnorm(d1) - K*exp(-r*T)*pnorm(d2))}
implied.vol <- function(S, K, T, r, market){
sig <- 0.20;sig.up <- 10;sig.down <- 0.0001;count <- 0;err <- BS(S, K, T, r, sig) - market
while(abs(err) > 0.00001 && count<1000){
if(err < 0){sig.down <- sig;sig <- (sig.up + sig)/2} else{sig.up <- sig;sig <- (sig.down + sig)/2}
err <- BS(S, K, T, r, sig) - market;count <- count +
1};if(count==1000){return(NA)}else{return(sig)}}
market = 0.83;K = 62.8;T = 7 / 365.0;S = 63.4;r = 0.02; implied.vol(S, K, T, r, market)
BS(S, K, T, r, implied.vol(S, K, T, r, market))
The implied volatility value can be used as an alternative way to quote the
option price, based on the knowledge of the remaining parameters (such as
underlying asset price, time to maturity, interest rate, and strike price). For
example, market option price data provided by the Hong Kong stock exchange
includes implied volatility computed by inverting the Black-Scholes formula,
cf. Figure S.21.
library(fOptions)
market = 0.83;K = 62.8;T = 7 / 365.0;S = 63.4;r = 0.02
sig=GBSVolatility(market,"c",S,K,T,r,r,1e-4,maxiter = 10000)
BS(S, K, T, r, sig)
∗
here.
" 341
N. Privault
Option chain data in R
install.packages("quantmod")
library(quantmod)
getSymbols("^GSPC", src = "yahoo", from = as.Date("2018-01-01"), to =
as.Date("2018-03-01"))
head(GSPC)
# Only the front-month expiry
SPX.OPT <- getOptionChain("^SPX")
AAPL.OPT <- getOptionChain("AAPL")
# All expiries
SPX.OPTS <- getOptionChain("^SPX", NULL)
AAPL.OPTS <- getOptionChain("AAPL", NULL)
# All 2021 to 2023 expiries
SPX.OPTS <- getOptionChain("^SPX", "2021/2023")
AAPL.OPTS <- getOptionChain("AAPL", "2021/2023")
Exporting option price data
write.table(AAPL.OPT$puts, file = "AAPLputs")

write.csv(AAPL.OPT$puts, file = "AAPLputs.csv")
install.packages("xlsx")
library(xlsx)
write.xlsx(AAPL.OPTS$Jun.19.2020$puts, file = "AAPL.OPTS$Jun.19.2020$puts.xlsx")
Volatility smiles
Given two European call options with strike prices K1 , resp. K2 , maturi-
ties T1 , resp. T2 , and prices C1 , resp. C2 , on the same stock S, this proce-
dure should yield two estimates σimp (K1 , T1 ) and σimp (K2 , T2 ) of implied
volatilites according to the following equations.
Bl(t, St , K1 , σimp (K1 , T1 ), r, T1 ) = M1 , (9.5a)



Bl(t, St , K2 , σimp (K2 , T2 ), r, T2 ) = M2 , (9.5b)



Clearly, there is no reason a priori for the implied volatilites σimp (K1 , T1 ),
σimp (K2 , T2 ) solutions of (9.5a)-(9.5b) to coincide across different strike
prices and different maturities. However, in the standard Black-Scholes model
the value of the parameter σ should be unique for a given stock S. This con-
tradiction between a model and market data is motivating the development
of more sophisticated stochastic volatility models.
342 "
install.packages("jsonlite")
install.packages("lubridate")
library(jsonlite);library(lubridate);library(quantmod)
# Maturity to be updated as needed
maturity <- as.Date("2021-08-20", format="%Y-%m-%d")
CHAIN <- getOptionChain("GOOG",maturity)
today <- as.Date(Sys.Date(), format="%Y-%m-%d")
getSymbols("GOOG", src = "yahoo")
lastBusDay=last(row.names(as.data.frame(Ad(GOOG))))
T <- as.numeric(difftime(maturity, lastBusDay, units = "days")/365);r = 0.02;ImpVol<-1:1;
S=as.vector(tail(Ad(GOOG),1))
for (i in 1:length(CHAIN$calls$Strike)){ImpVol[i]<-implied.vol(S,CHAIN$calls$Strike[i],T,r,
CHAIN$calls$Last[i])}
plot(CHAIN$calls$Strike[!is.na(ImpVol)], ImpVol[!is.na(ImpVol)], xlab = "Strike price", ylab
= "Implied volatility", lwd =3, type = "l", col = "blue")
fit4 <- lm(ImpVol[!is.na(ImpVol)]~poly(CHAIN$calls$Strike[!is.na(ImpVol)],4,raw=TRUE))
lines(CHAIN$calls$Strike[!is.na(ImpVol)], predict(fit4,
data.frame(x=CHAIN$calls$Strike[!is.na(ImpVol)])), col="red",lwd=2)
currentyear<-format(Sys.Date(), "%Y")
# Maturity to be updated as needed
maturity <- as.Date("2021-12-17", format="%Y-%m-%d")
CHAIN <- getOptionChain("^SPX",maturity)
# Last trading day (may require update)
today <- as.Date(Sys.Date(), format="%Y-%m-%d")
getSymbols("^SPX", src = "yahoo")
lastBusDay=last(row.names(as.data.frame(Ad(SPX))))
T <- as.numeric(difftime(maturity, lastBusDay, units = "days")/365);r = 0.02;ImpVol<-1:1;
S=as.vector(tail(Ad(SPX),1))
for (i in 1:length(CHAIN$calls$Strike)){ImpVol[i]<-implied.vol(S, CHAIN$calls$Strike[i], T,
r, CHAIN$calls$Last[i])}
plot(CHAIN$calls$Strike[!is.na(ImpVol)], ImpVol[!is.na(ImpVol)], xlab = "Strike price", ylab
= "Implied volatility", lwd =3, type = "l", col = "blue")
fit4 <- lm(ImpVol[!is.na(ImpVol)]~poly(CHAIN$calls$Strike[!is.na(ImpVol)],4,raw=TRUE))
lines(CHAIN$calls$Strike[!is.na(ImpVol)], predict(fit4,
data.frame(x=CHAIN$calls$Strike[!is.na(ImpVol)])), col="red",lwd=3)
0.13
0.12
Implied volatility
0.11
0.10
0.09
2800 3000 3200 3400 3600 3800
Strike price
Fig. 9.5: S&P500 option prices plotted against strike prices.
When reading option prices on the volatility scale, the smile phenomenon
shows that the Black-Scholes formula tends to underprice extreme events for
which the underlying asset price ST is far away from the strike price K. In
" 343
N. Privault
that sense, the Black-Scholes model, which is based on the Gaussian distri-
bution tails, tends to underestimate the probability of extreme events.
Plotting the different values of the implied volatility σ as a function of K and

T will yield a three-dimensional plot called the volatility surface.∗
Figure 9.6 presents an estimated implied volatility surface for Asian options
on light sweet crude oil futures traded on the New York Mercantile Exchange
(NYMEX), based on contract specifications and market data obtained from
the Chicago Mercantile Exchange (CME).
0.6
0.55
Implied volatility
0.5
0.45
0.4
0.35
0.3
0.25
8000
9000
Strike price 10000 10
20
11000 Time to maturity
30
Fig. 9.6: Implied volatility surface of Asian options on light sweet crude oil futures.§
As observed in Figure 9.6, the volatility surface can exhibit a smile phe-
nomenon, in which implied volatility is higher at a given end (or at both
ends) of the range of strike price values.
Black-Scholes Formula vs Market Data
On July 28, 2009 a call warrant has been issued by Merrill Lynch on the stock
price S of Cheung Kong Holdings (0001.HK) with strike price K=$109.99,
Maturity T = December 13, 2010, and entitlement ratio 100.
∗
Download the corresponding IPython notebook that can be run here (© Qu
Mengyuan).
§
© Tan Yu Jia.
344 "
Fig. 9.7: Graph of the (market) stock price of Cheung Kong Holdings.
The market price of the option (17838.HK) on September 28 was $12.30, as

obtained from https://www.hkex.com.hk/eng/dwrc/search/listsearch.asp.
The next graph in Figure 9.8a shows the evolution of the market price of the
option over time. One sees that the option price is much more volatile than
the underlying asset price.
0.2
Black-Scholes price
0.18
0.16
HK$
0.14
0.12
0.1
Jul17 Aug06 Aug26 Sep15
(a) Graph of (market) option prices. (b) Graph of Black-Scholes prices.

Fig. 9.8: Comparison of market option prices vs calibrated Black-Scholes prices.
In Figure 9.8b we have fitted the time evolution t 7→ gc (t, St ) of Black-
Scholes prices to the data of Figure 9.8a using the market stock price data
of Figure 9.7, by varying the values of the volatility σ.
Another example
Let us consider the stock price of HSBC Holdings (0005.HK) over one year:
" 345
N. Privault
Fig. 9.9: Graph of the (market) stock price of HSBC Holdings.

Next, we consider the graph of the price of the call option issued by Societe
Generale on 31 December 2008 with strike price K=$63.704, maturity T =
October 05, 2009, and entitlement ratio 100, cf. page 9.
0.3
Black-Scholes price
0.2
HK$
0.1
0
Nov 08 Jan 09 Mar 09 May 09 Jul 09 Sep 09

As above, in Figure 9.10b we have fitted the path t 7−→ gc (t, St ) of the Black-
Scholes option price to the data of Figure 9.10a using the stock price data of
Figure 9.9.
In this case the option is in the money at maturity. We can also check that
the option is worth 100 × 0.2650 = $26.650 at that time, which, according
to absence of arbitrage, is quite close to the actual value $90 - $63.703 =
$26.296 of its payoff.
For one more example, consider the graph of the price of a put option issued
by BNP Paribas on 04 November 2008 on the underlying asset HSBC, with
strike price K=$77.667, maturity T = October 05, 2009, and entitlement
ratio 92.593.
346 "
0.5
Black-Scholes price
0.4
0.3
HK$
0.2
0.1
0
Nov 08 Jan 09 Mar 09 May 09 Jul 09 Sep 09

One checks easily that at maturity, the price of the put option is worth $0.01
(a market price cannot be lower), which almost equals the option payoff $0, by
absence of arbitrage opportunities. Figure 9.11b is a fit of the Black-Scholes
put price graph
t 7−→ gp (t, St )
to Figure 9.11a as a function of the stock price data of Figure 9.10b. Note
that the Black-Scholes price at maturity is strictly equal to 0 while the cor-
responding market price cannot be lower than one cent.
The normalized market data graph in Figure 9.12 shows how the option price
can track the values of the underlying asset price. Note that the range of val-
ues [26.55, 26.90] for the underlying asset price corresponds to [0.675, 0.715]
for the option price, meaning 1.36% vs 5.9% in percentage. This is a Euro-
pean call option on the ALSTOM underlying asset with strike price K = €20,
maturity March 20, 2015, and entitlement ratio 10.
Fig. 9.12: Call option price vs underlying asset price.
" 347
N. Privault
9.3 Local Volatility

As the constant volatility assumption in the Black-Scholes model does not
appear to be satisfactory due to the existence of volatility smiles, it can make
more sense to consider models of the form
dSt
= rdt + σt dBt
St
where σt is a random process. Such models are called stochastic volatility
models.
A particular class of stochastic volatility models can be written as

dSt
= rdt + σ (t, St )dBt (9.6)
St
where σ (t, x) is a deterministic function of time t and of the underlying asset

price x. Such models are called local volatility models.
As an example, consider the stochastic differential equation with local

volatility
dYt = rdt + σYt2 dBt , (9.7)
where σ > 0.
N=10000; t <- 0:(N-1); dt <- 1.0/N;r=0.5;sigma=1.2;
Z <- rnorm(N,mean=0,sd=sqrt(dt));Y <- rep(0,N);Y[1]=1
for (j in 2:N){ Y[j]=max(0,Y[j-1]+r*Y[j-1]*dt+sigma*Y[j-1]**2*Z[j])}
plot(t*dt, Y, xlab = "t", ylab = "", type = "l", col = "blue", xaxs='i', yaxs='i', cex.lab=1,
cex.axis=1)
abline(h=0)
2.0
1.5
1.0
0.0 0.2 0.4 0.6 0.8
Fig. 9.13: Simulated path of (9.7) with r = 0.5 and σ = 1.2.
In the general case, the corresponding Black-Scholes PDE for the option
prices
348 "
g (t, x, K ) := e −(T −t)r E (ST − K )+ St = x , (9.8)

where (St )t∈R+ is defined by (9.6), can be written as
∂g ∂g 1 ∂2g

 rg (t, x, K ) =
 (t, x, K ) + rx (t, x, K ) + x2 σ 2 (t, x) 2 (t, x, K ),
∂t ∂x 2 ∂x

g (T , x, K ) = (x − K )+ ,

(9.9)
with terminal condition g (T , x, K ) = (x − K )+ , i.e. we consider European
call options.
Lemma 9.1. (Relation (1) in Breeden and Litzenberger (1978)). Consider a
family (C M (T , K ))T ,K>0 of market call option prices with maturities T and
strike prices K given at time 0. Then the probability density function ϕt (y )
of St , t ∈ [0, T ], is given by
∂2C M
ϕT (K ) = e rT (T , K ), K > 0. (9.10)
∂K 2
Proof. Assume that the market option prices C M (T , K ) match the Black-
Scholes prices e −rT E[(ST − K )+ ], K > 0. Letting ϕT (y ) denote the proba-
bility density function of ST , Condition (9.13) can be written at time t = 0
as
C M (T , K ) = e −rT E[(ST − K )+ ]
w∞
= e −rT (y − K )+ ϕT (y )dy
w0∞
= e −rT (y − K )ϕT (y )dy
wK w∞
−rT ∞
= e yϕT (y )dy − K e −rT ϕT (y )dy (9.11)
K K
w
−rT ∞ −rT
= e yϕT (y )dy − K e P(ST > K ).
K
By differentiation of (9.11) with respect to K, one gets
∂C M w∞
(T , K ) = − e −rT KϕT (K ) − e −rT ϕT (y )dy + e −rT KϕT (K )
∂K w K
∞
= − e −rT ϕT (y )dy,
K
which yields (9.10) by twice differentiation of C M (T , K ) with respect to K.

In order to implement a stochastic volatility model such as (9.6), it is impor-
tant to first calibrate the local volatility function σ (t, x) to market data.
" 349
N. Privault
In principle, the Black-Scholes PDE could allow one to recover the value
of σ (t, x) as a function of the option price g (t, x, K ), as
v
u 2rg (t, x, K ) − 2 ∂g (t, x, K ) − 2rx ∂g (t, x, K )
u
σ (t, x) = u
u ∂t ∂x , x, t > 0,
2
2∂ g
t
x 2
(t, x, K )
∂x
however, this formula requires the knowledge of the option price for different
values of the underlying asset price x, in addition to the knowledge of the
strike price K.
The Dupire (1994) formula brings a solution to the local volatility calibra-
tion problem by providing an estimator of σ (t, x) as a function σ (t, K ) based
on the values of the strike price K.
Proposition 9.2. (Dupire (1994), Derman and Kani (1994)) Consider a
family (C M (T , K ))T ,K>0 of market call option prices with maturities T and
strike prices K given at time 0 with S0 = x, and define the volatility function
σ (t, y ) by
v s
u ∂C M ∂C M ∂C M ∂C M
u2
u
(t, y ) + 2ry (t, y ) (t, y ) + ry (t, y )
u ∂t ∂y ∂t ∂y
σ (t, y ) := u = ,
∂2C M
q
y2 y e −rT /2 ϕt (y )/2
t
2
(t, y )
∂y
(9.12)
where ϕt (y ) denotes the probability density function of St , t ∈ [0, T ]. Then

the prices generated from the Black-Scholes PDE (9.9) will be compatible with
the market option prices C M (T , K ) in the sense that
C M (T , K ) = e −rT E[(ST − K )+ ], K > 0. (9.13)

Proof. For any sufficiently smooth function f ∈ C0∞ (R), with limx→−∞ f (x) =
limx→+∞ f (x) = 0, using the Itô formula we have
wT wT
E[f (ST )] = E f (S0 ) + r St f 0 (St )dt + St f 0 (St )σ (t, St )dBt
0 0
1 w T 2 00

+ S f (St )σ 2 (t, St )dt
2 0 t
w
1 w T 2 00

T
= f (S0 ) + E r St f 0 (St )dt + St f (St )σ 2 (t, St )dt
0 2 0
wT 1wT
0
= f (S0 ) + r E[St f (St )]dt + E[St2 f 00 (St )σ 2 (t, St )]dt
0 2 0
350 "
w∞ wT
= f (S0 ) + r yf 0 (y ) ϕt (y )dtdy
−∞ 0
1 w ∞ w T
+ y 2 f 00 (y ) σ 2 (t, y )ϕt (y )dtdy,
2 −∞ 0
hence, after differentiating both sides of the equality with respect to T ,

w∞ ∂ϕT w∞ 1 w ∞ 2 00
f (y ) (y )dy = r yf 0 (y )ϕT (y )dy + y f (y )σ 2 (T , y )ϕT (y )dy.
−∞ ∂T −∞ 2 −∞
Integrating by parts in the above relation yields
w ∞ ∂ϕ
T
(y )f (y )dy
−∞ ∂T
w∞ ∂ 1w∞ ∂2
f (y ) 2 y 2 σ 2 (T , y )ϕT (y ) dy,

= −r f (y ) (yϕT (y ))dy +
−∞ ∂y 2 −∞ ∂y
for all smooth functions f (y ) with compact support in R, hence
∂ϕT ∂ 1 ∂2 2 2
y σ (T , y )ϕT (y ) , y ∈ R.

(y ) = −r (yϕT (y )) +
∂T ∂y 2 ∂y 2
From Relation (9.10) in Lemma 9.1, we have
∂ϕT ∂2C M ∂3C M

(K ) = r e rT (T , K ) + e rT (T , K ),
∂T ∂K 2 ∂T ∂K 2
hence we get
∂2C M ∂3C M
−r 2
(T , y ) − (T , y )
∂y ∂T ∂y 2
1 ∂2
2 M
∂2C M

∂ ∂ C
=r y (T , y ) − y 2 σ 2 (T , y ) (T , y ) , y ∈ R.
∂y ∂y 2 2 ∂y 2 ∂y 2
After a first integration with respect to y under the boundary condition

limy→+∞ C M (T , y ) = 0, we obtain
∂C M ∂ ∂C M
−r (T , y ) − (T , y )
∂y ∂T ∂y
∂2C M 1 ∂ ∂2C M

= ry (T , y ) − y 2 σ 2 (T , y ) (T , y ) ,
∂y 2 2 ∂y ∂y 2
i.e.
∂C M ∂ ∂C M
−r (T , y ) − (T , y )
∂y ∂T ∂y
" 351
N. Privault
∂C M ∂C M 1 ∂ ∂2C M

∂
=r y (T , y ) − r (T , y ) − y 2 σ 2 (T , y ) (T , y ) ,
∂y ∂y ∂y 2 ∂y ∂y 2
or
∂ ∂C M ∂C M 1 ∂ ∂2C M

∂
− (T , y ) = r y (T , y ) − y 2 σ 2 (T , y ) (T , y ) .
∂y ∂T ∂y ∂y 2 ∂y ∂y 2
Integrating one more time with respect to y yields
∂C M ∂C M 1 ∂2C M
− (T , y ) = ry (T , y ) − y 2 σ 2 (T , y ) (T , y ), y ∈ R,
∂T ∂y 2 ∂y 2
which conducts to (9.12) and is called the Dupire (1994) PDE.

Partial derivatives in time can be approximated using forward finite difference
approximations as
∂C C (ti+1 , yj ) − C (ti , yj )
( ti , y ) ' , (9.14)
∂t ∆t
or, using backward finite difference approximations, as
∂C C (ti , yj ) − C (ti−1 , yj )
(ti , y ) ' . (9.15)
∂t ∆t
First order spatial derivatives can be approximated as
∂C C (t, yj ) − C (ti , yj−1 ) ∂C C (t, yj +1 ) − C (ti , yj )

(t, yj ) ' , (t, yj +1 ) ' .
∂y ∆y ∂y ∆y
(9.16)
Reusing (9.16), second order spatial derivatives can be similarly approxi-
mated as
∂2C 1

∂C ∂C
(t, yj ) ' (t, yj +1 ) − (t, yj ) (9.17)
∂y 2 ∆y ∂y ∂y
C (ti , yj +1 ) + C (ti , yj−1 ) − 2C (ti , yj )
' .
(∆y )2
Figure 9.14∗ presents an estimation of local volatility by the finite differences

(9.14)-(9.17), based on Boeing (NYSE:BA) option price data.
∗
© Yu Zhi Yu.
352 "
0.5
0.4
0.3
0.2
0.1
0
0.08
0.07
0.06
Time 0.05
0.04 124 122
128 126
0.03 132 130
136 134
Underlying S or Strike price K
Fig. 9.14: Local volatility estimated from Boeing Co. option price data.
See Achdou and Pironneau (2005) and in particular Figure 8.1 therein for
numerical methods applied to local volatility estimation using spline functions
instead of the discretization (9.14)-(9.17).
The attached R code∗ plots a local volatility estimate for a given stock.
Based on (9.12), the local volatility σ (t, y ) can also be estimated by comput-
ing C M (T , y ) from the Black-Scholes formula, based on a value of the implied
volatility σ.
Local volatility from put option prices
Note that by the call-put parity relation
C M (T , y ) = P M (T , y ) + x − y e −rT , y, T > 0,
where S0 =, cf. (6.23), we have
∂C M ∂P M

−rT
 ∂T (T , y ) = ry e + (T , y ),


∂T

M M
 ∂P (t, y ) = e −rT + ∂C (t, y ),



∂y ∂y
and
∂C M ∂C M ∂P M ∂P M
(T , y ) + ry (T , y ) = (T , y ) + ry (T , y ).
∂T ∂y ∂T ∂y
Consequently, the local volatility in Proposition 9.2 can be rewritten in terms
of market put option prices as
∗
© Abhishek Vijaykumar
" 353
N. Privault
v s
u ∂P M ∂P M ∂P M ∂P M
u2
u
(t, y ) + 2ry (t, y ) (t, y ) + ry (t, y )
u ∂t ∂y ∂t ∂y
σ (t, y ) := u = ,
∂2P M
q
y2 y e −rT /2 ϕt (y )/2
t
( t, y )
∂y 2
which is formally identical to (9.12) after replacing market call option prices
C M (T , K ) with market put option prices P M (T , K ). In addition, we have
the relation
∂2C M ∂2P M
ϕT (K ) = e rT 2
(T , y ) = e rT (T , y ) (9.18)
∂y ∂y 2
between the probability density function ϕT of ST and the call/put option

pricing functions C M (T , y ), P M (T , y ).
9.4 The VIX® Index
Other ways to estimate market volatility include the CBOE Volatility Index®
(VIX® ) for the S&P 500 stock index. Let the asset price process (St )t∈R+
satisfy
dSt = rSt dt + σt St dBt ,
i.e. w
1wt 2

t
St = S0 exp σs dBs + rt − σs ds , t > 0,
0 2 0
where, as in Section 8.2, (σt )t∈R+ is a stochastic volatility process independent
of the Brownian motion (Bt )t∈R+ .
Lemma 9.3. Let φ ∈ C 2 ((0, ∞)). For all y > 0, we have
wy w∞
φ(x) = φ(y ) + (x − y )φ0 (y ) + (z − x)+ φ00 (z )dz + (x − z )+ φ00 (z )dz, x > 0.
0 y
Proof. We use the Taylor formula with integral remainder:
w1
φ(x) = φ(y ) + (x − y )φ0 (y ) + |x − y|2 (1 − τ )φ00 (τ x + (1 − τ )y )dτ , x, y ∈ R.
0
Letting z = τ x + (1 − τ )y = y + τ (x − y ), if x 6 y we have
w1 wx z−y

|x − y|2 (1 − τ )φ00 (τ x + (1 − τ )y )dτ = |x − y| 1− φ00 (z )dz
0 y x−y
wx
= (x − z )φ00 (z )dz
y
w∞
= (x − z )+ φ00 (z )dz.
y
If x > y, we have
354 "
w1 wy y−z

|x − y|2 (1 − τ )φ00 (τ x + (1 − τ )y )dτ = |y − x| 1− φ00 (z )dz
0 x y−x
wy
= (z − x)φ00 (z )dz
wxy
= (z − x)+ φ00 (z )dz.
0

The next Proposition 9.4, cf. Remark 5 in Friz and Gatheral (2005), shows
that the VIX® Volatility Index defined as
s
2 e rτ w Ft,t+τ P (t, t + τ , K ) w∞ C (t, t + τ , K )

VIXt := dK + dK
τ 0 K2 Ft,t+τ K2
(9.19)
at time t > 0 can be interpreted as an average of future volatility values, see
also § 3.1.1 of Papanicolaou and Sircar (2014). Here, τ =30 days,
Ft,t+τ := E∗ [St+τ | Ft ] = e rτ St
represents the future price on St+τ , and P (t, t + τ , K ), C (t, t + τ , K ) are

OTM (Out-Of-the-Money) call and put option prices with respect to Ft,t+τ ,
with strike price K and maturity t + τ .
Proposition 9.4. The value of the VIX® Volatility Index at time t > 0 is
given from the averaged realized variance swap price as
s
1 ∗ w t+τ 2

VIXt := E σu du Ft .
τ t
Proof. We take t = 0 for simplicity. Applying Lemma 9.3 to the function

x x
φ(x) = − 1 − log
y y
with φ0 (x) = 1/y − 1/x and φ00 (x) = 1/x2 shows that
x x wy 1 w∞ 1
− 1 − log = (z − x)+ 2 dz + (x − z )+ 2 dz, x, y > 0.
y y 0 z y z
Equivalently, using integration by parts, we note the relationships
wy dz wy dz
(z − x) + = 1{x6y} (z − x) 2
0 z2 w x z
y dz w y dz
= 1{x6y} −x
x z x z2

x y
= 1{x6y} − 1 + log ,
y x
" 355
N. Privault
and
w∞ dz wx dz
(x − z ) + = 1{x>y}(x − z ) 2
y z2 y z
w w x dz
x dz
= 1{x>y} x 2
−
y z y z

x y
= 1{x>y} − 1 + log .
y x
Hence, taking y := F0,τ = e rτ S0 and x := Sτ , we have
Sτ F0,τ w F0,τ dK w ∞ dK
− 1 + log = ( K − Sτ ) + 2 + (Sτ − K )+ 2 . (9.20)
F0,τ Sτ 0 K F0,τ K
Next, taking expectations under P∗ on both sides of (9.20), we find
2 e rτ w F0,τ P (0, τ , K ) w ∞ C (0, τ , K )

VIX20 = 2
dK + 2
dK
τ 0 K F0,τ K
2 w F0,τ ∗ + dK 2 w∞ ∗ dK
= E [(K − Sτ ) ] 2 + E [(Sτ − K )+ ] 2
τ 0 K τ F0,τ K
w w∞
2 ∗

F0,τ + dK + dK
= E (K − Sτ ) + (Sτ − K )
τ 0 K2 F0,τ K2
2 ∗ Sτ

F0,τ
= E − 1 + log
τ F0,τ Sτ
2 ∗

F0,τ
= E log
τ Sτ
1 ∗ hw τ 2 i
= E σt dt ,
τ 0
where we applied Proposition 8.1.

The following R code allows us to estimate the VIX®
index based on the dis-
cretization of (9.19) and market option prices on the S&P 500 Index (SPX).
Here, the OTM put strike prices and call strike prices are listed as
(p) (p) (p) (c) (c) (c)
K1 < · · · < Knp −1 < Knp := Ft,t+τ =: K0 < K1 < · · · < Knc ,
and (9.19) may for example be discretized as
2 e rτ w Ft,t+τ P (t, t + τ , K ) w∞ C (t, t + τ , K )

VIX2t = dK + dK
τ 0 K2 Ft,t+τ K2
 
n −1
2 e rτ  X w Ki+1 P (t, t + τ , K ) X w Ki C (t, t + τ , K )
p ( p ) n c ( c )
= (p) dK + (c) dK 
τ Ki K2 Ki−1 K2
i=1 i=1
356 "
 
np −1 (p) (c)
2 e rτ  X w Ki+1 P t, t + τ , Ki
nc w (c)
Ki C t, t + τ , Ki
(p) X
' (p) dK + (c) dK 
τ Ki K2 Ki−1 K2
i=1 i=1

np −1 !
2 e rτ  X (p) 1 1
= P t, t + τ , Ki (p)
− (p)
τ Ki Ki+1
i=1
nc w ( c )
!
X Ki (c) 1 1
+ (c) C t, t + τ , Ki (c)
− (c)  ,
Ki−1
i=1 Ki−1 Ki
see page 158 of Gatheral (2006) for the implementation of the discretization
of the CBOE white paper.
library(quantmod)
today <- as.Date(Sys.Date(), format="%Y-%m-%d"); getSymbols("^SPX", src = "yahoo")
S0 = as.vector(tail(Ad(SPX),1)); T = 30/365;r=0.02;F0 = S0*exp(r*T)
maturity <- as.Date("2021-07-07", format="%Y-%m-%d") # Choose a maturity in 30 days
SPX.OPTS <- getOptionChain("^SPX", maturity)
Call <- as.data.frame(SPX.OPTS$calls);Put <- as.data.frame(SPX.OPTS$puts)
Call_OTM <- Call[Call$Strike>F0,];Put_OTM <-Put[Put$Strike<F0,];
Call_OTM$dif = c(1/F0-1/min(Call_OTM$Strike),-diff(1/Call_OTM$Strike))
Put_OTM$dif = c(-diff(1/Put_OTM$Strike),1/max(Put_OTM$Strike)-1/F0)
VIX_imp = 100*sqrt((2*exp(r*T)/T)*(sum(Put_OTM$Last*Put_OTM$dif)
+sum(Call_OTM$Last*Call_OTM$dif)))
getSymbols("^VIX", src = "yahoo", from = lastBusDay);VIX_market =
as.vector(Ad(VIX)[1])
c("Estimated VIX"= VIX_imp, "CBOE VIX"=VIX_market)
VIX.OPTS <- getOptionChain("^VIX")
The following R code is fetching VIX® index data using the quantmod R
package.
library(quantmod)
getSymbols("^GSPC",from="2000-01-01",to=Sys.Date(),src="yahoo")
getSymbols("^VIX",from="2000-01-01",to=Sys.Date(),src="yahoo")
dev.new(width=16,height=7); myPars <- chart_pars();myPars$cex<-1.4
chart_Series(Ad(`GSPC`),name="S&P500",pars=myPars,theme=myTheme)
add_TA(Ad(`VIX`))
The impact of various world events can be identified on the VIX® index in
Figure 9.15.
" 357
N. Privault
S&P500 2000−01−03 / 2021−04−30

4000 4000
3500 3500
3000 3000
2500 2500
2000 2000
1500 1500
1000 1000
100 100
VIX 18.61
80 80
60 60
40 40
20 20
0 0
Jan 03 Jul 02 Jan 02 Jul 01 Jan 03 Jul 02 Jan 02 Jul 01 Jan 03 Jul 01 Jan 02 Jul 01 Jan 02 Jul 01 Dec 31
2000 2001 2003 2004 2006 2007 2009 2010 2012 2013 2015 2016 2018 2019 2020
Fig. 9.15: VIX® Index vs the S&P 500.
library(quantmod);library(PerformanceAnalytics)
getSymbols("^GSPC",from="2000-01-01",to=Sys.Date(),src="yahoo")
getSymbols("^VIX",from="2000-01-01",to=Sys.Date(),src="yahoo");SP500=Ad(`GSPC`)
SP500.rtn <- exp(CalculateReturns(SP500,method="compound")) - 1;SP500.rtn[1,] <- 0
histvol <- rollapply(SP500.rtn, width = 30, FUN=sd.annualized)
chart_Series(SP500,name="SP500",theme=myTheme,pars=myPars)
add_TA(histvol, name="Historical Volatility");add_TA(Ad(`VIX`), name="VIX")
Figure 9.16 compares the VIX® index estimate to the historical volatility of
Section 9.1.
SP500 2000−01−03 / 2021−04−30
4000 4000
3500 3500
3000 3000
2500 2500
2000 2000
1500 1500
1000 1000
1.0 1.0
Historical Volatility 0.10943
0.8 0.8
0.6 0.6
0.4 0.4
0.2 0.2
100 100
0.0 0.0
80 VIX 18.61 80
60 60
40 40
20 20
0 0
Jan 03 Jul 02 Jan 02 Jul 01 Jan 03 Jul 02 Jan 02 Jul 01 Jan 03 Jul 01 Jan 02 Jul 01 Jan 02 Jul 01 Dec 31
2000 2001 2003 2004 2006 2007 2009 2010 2012 2013 2015 2016 2018 2019 2020
Fig. 9.16: VIX® Index vs historical volatility for the year 2011.
We note that the variations of the stock index are negatively correlated to
the variations of the VIX® index, however the same cannot be said of the
correlation to the variations of historical volatility.
358 "
−10 0 10 20 −0.05 0.00 0.05 0.10
100
100
GSPC.Adjusted GSPC.Adjusted
*** **
50
50
−0.80
Density
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−100 −50 0 50 100 −100 −50 0 50 100
x x
(a) Underlying vs the VIX® index. (b) Underlying vs hist. volatility.
Fig. 9.17: Correlation estimates between GSPC and the VIX® .
chart.Correlation(cbind(Ad(`GSPC`)-lag(Ad(`GSPC`)),Ad(`VIX`)-lag(Ad(`VIX`))),
histogram=TRUE, pch="+")
colnames(histvol) <- "HistVol"
chart.Correlation(cbind(Ad(`GSPC`)-lag(Ad(`GSPC`)),histvol-lag(histvol)),
histogram=TRUE, pch="+")
The next Figure 9.18 shortens the time range to year 2011 and shows the
increased reactivity of the VIX® index to volatility spikes, in comparison
with the moving average of historical volatility.
SP500 2011−01−03 / 2011−12−30

1360 1360
1340 1340
1320 1320
1300 1300
1280 1280
1260 1260
1240 1240
1220 1220
1200 1200
1180 1180
1160 1160
1140 1140
1120 1120
1100 1100
0.45 Historical Volatility 0.24002 0.45
0.40 0.40
0.35 0.35
0.30 0.30
0.25 0.25
0.20 0.20
0.15 0.15
0.10 0.10
50 VIX 23.4
0.05 50
0.05
45 45
40 40
35 35
30 30
25 25
20 20
15 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 15
10 10
Jan 03 Feb 01 Mar 01 Apr 01 May 02 Jun 01 Jul 01 Aug 01 Sep 01 Oct 03 Nov 01 Dec 01 Dec 30
2011 2011 2011 2011 2011 2011 2011 2011 2011 2011 2011 2011 2011
Fig. 9.18: VIX® Index vs 30 day historical volatility for the S&P 500.
Exercises
Exercise 9.1 Consider the Black-Scholes call pricing formula

x
C (T − t, x, K ) = Kf T − t,
K
" 359
N. Privault
written using the function
(r + σ 2 /2)τ + log z (r − σ 2 /2)τ + log z

f (τ , z ) := zΦ √ − e −rτ Φ √ .
|σ| τ |σ| τ
∂C ∂C
a) Compute and using the function f , and find the relation between
∂x ∂K
∂C ∂C
(T − t, x, K ) and (T − t, x, K ).
∂K ∂x
∂2C ∂2C
b) Compute and using the function f , and find the relation be-
∂x2 ∂K 2
∂C 2 ∂C 2
tween (T − t, x, K ) and (T − t, x, K ).
∂K 2 ∂x2
c) From the Black-Scholes PDE
∂C ∂C
rC (T − t, x, K ) = (T − t, x, K ) + rx (T − t, x, K )
∂t ∂x
2 2 2
σ x ∂ C
+ (T − t, x, K ),
2 ∂x2
recover the Dupire (1994) PDE for the constant volatility σ.
Exercise 9.2 Let σimp (K ) denote the implied volatility of a call option with
strike price K, defined from the relation
MC (K, S, r, τ ) = C (K, S, σimp (K ), r, τ ),
where MC is the market price of the call option, C (K, S, σimp (K ), r, τ ) is

the Black-Scholes call pricing function, S is the underlying asset price, τ is
the time remaining until maturity, and r is the risk-free interest rate.
a) Compute the partial derivative
∂MC
(K, S, r, τ ).
∂K
using the functions C and σimp .
b) Knowing that market call option prices MC (K, S, r, τ ) are decreasing in
the strike prices K, find an upper bound for the slope σimp 0 (K ) of the
implied volatility curve.
c) Similarly, knowing that the market put option prices MP (K, S, r, τ ) are
increasing in the strike prices K, find a lower bound for the slope σimp
0 (K )
of the implied volatility curve.
Exercise 9.3 (Hagan et al. (2002)) Consider the European option priced
as e−rT E∗ [(ST − K )+ ] in a local volatility model dSt = σloc (St )St dBt . The
implied volatility σimp (K, S0 ), computed from the equation
360 "
Bl S0 , K, T , σimp (K, S0 ), r = e −rT E∗ [(ST − K )+ ],

is known to admit the approximation
K + S0

σimp (K, S0 ) ' σloc .
2
a) Taking a local volatility of the form σloc (x) := σ0 + β (x − S0 )2 , estimate

the implied volatility σimp (K, S ) when the underlying asset price is at the
level S.
b) Express the Delta of the Black Scholes call option price given by
Bl S, K, T , σimp (K, S ), r ,

using the standard Black-Scholes Delta and the Black-Scholes Vega.
Exercise 9.4 Show that the result of Proposition 9.4 can be recovered from
Lemma 8.2 and Relation (9.18).
Exercise 9.5 (Exercise 8.7 continued). Find an expression for E∗ R0,T using
4
call and put pricing functions.
Exercise 9.6 (Henry-Labordère (2009), § 3.5).

a) Using the gamma probability density function and integration by parts or
Laplace transform inversion, prove the formula
w ∞ e −νx − e −µx µρ − ν ρ
dx = Γ (1 − ρ)
0 xρ + 1 ρ
for all ρ ∈ (0, 1) and µ, ν > 0, see Relation 3.434.1 in Gradshteyn and
Ryzhik (2007).
b) By the result of Question (a), generalize the volatility swap pricing ex-
pression (8.19).
c) By Lemma 8.2 and the result of Question (b), find an expression of the
volatility swap price using call and put functions.
" 361
Chapter 10
Maximum of Brownian motion
The probability distribution of the maximum of Brownian motion on a given

interval can be computed in closed form using the reflection principle. As
a consequence, the expected value of the running maximum of Brownian
motion can also be computed explicitly. Those properties with be applied in
the next Chapters 11 and 12 to the pricing of barrier and lookback options,
whose payoffs may depend on extrema of the underlying asset price process
(St )t∈[0,T ] , as well as on its terminal value ST .
10.1 Running Maximum of Brownian Motion . . . . . . . . . 363

10.2 The Reflection Principle . . . . . . . . . . . . . . . . . . . . . . . . 366
10.3 Density of the Maximum of Brownian Motion . . . . 370
10.4 Average of Geometric Brownian Extrema . . . . . . . . 381
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
10.1 Running Maximum of Brownian Motion

Figure 10.1 represents the running maximum process
X0t := Max Ws , t > 0,

s∈[0,t]
of Brownian motion (Wt )t∈R+ .
" 363
N. Privault
3
Mt0
2.5 Bt
Mt0 2
1.5
Bt
1
0.5
-0.5
-1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 10.1: Brownian motion (Wt )t∈R+ and its running maximum (X0t )t∈R+ .∗
Note that Brownian motion admits (almost surely) no “point of increase”.

More precisely, there does not exist t > 0 and ε > 0 such that
Max Ws 6 Wt 6 min Ws ,
s∈(t−ε,t) s∈(t,t+ε)
see Dvoretzky et al. (1961) and Burdzy (1990). This property is illustrated
in Figure 10.2, cf. also (10.4)-(10.5) below.
Fig. 10.2: Running maximum of Brownian motion.∗
Related properties can be observed with the zeroes of Brownian motion which
form an uncountable set (see e.g. Theorem 2.28 page 48 of Mörters and Peres
(2010)) which has zero measure P-almost surely, as we have
∗
364 "
hw ∞ i w∞ w∞
E 1{Wt =0} dt = E 1{Wt =0} dt = P(Wt = 0)dt = 0,

0 0 0
see Figure 10.3.
Fig. 10.3: Zeroes of Brownian motion.∗
See also the Cantor function presented in the next Figure 10.4, which is
continuous on [0, 1] and flat (with a vanishing derivative) everywhere except
on the Cantor set, which is an uncountable set of zero measure in [0, 1].
1.0
0.8
0.6
0.4
0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0
Fig. 10.4: Graph of the Cantor function.†
Examples of deterministic functions having no “last point of increase” can be

built for some ε ∈ (0, 1) as
εn−1 1[1−εn ,1) (t) + 1[1,∞) (t),

X
f (t) : = (1 − ε) t > 0,
n>1
∗
†
" 365
N. Privault
which admits no “last” point of increase before t = 1, as illustrated in Fig-

ure 10.5 with ε = 3/4.
1.2
f(t) 0.8
0.6
0.4
0.2
0
0 0.2 0.4 0.6 0.8 1 1.2
t
Fig. 10.5: A function with no last point of increase before t = 1.
10.2 The Reflection Principle
Let (Wt )t∈R+ denote the standard Brownian motion started at W0 = 0.

While it is well-known that WT ' N (0, T ), computing the distribution of
the maximum
X0T := Max Wt
t∈[0,T ]
might seem a difficult problem. However this is not the case, due to the re-
flection principle.
Note that since W0 = 0 we have
X0T = Max Wt > 0,

t∈[0,T ]
almost surely, i.e. with probability one. Given a > W0 = 0, let
τa = inf{t > 0 : Wt = a}
denote the first time (Wt )t∈R+ hits the level a > 0. Due to the spatial sym-
metry of Brownian motion we note the identity
1
P(WT > a | τa < T ) = P(WT < a | τa < T ) = .
2
In addition, due to the relation
(10.1)
T
X0 > a = {τa < T },
we have
366 "
P(τa < T ) = P(τa < T and WT > a) + P(τa < T and WT < a)
= 2P(τa < T and WT > a)
= 2P X0T > a and WT > a

= 2P(WT > a)
= P(WT > a) + P(WT < −a)
= P(|WT | > a),
where we used the fact that
{WT > a} ⊂ X0T > a and WT > a ⊂ {WT > a}.

Figure 10.6 shows a graph of Brownian motion and its reflected path, with
0 a), a > 0, (10.2)
the maximum X0T of Brownian motion has same distribution as the absolute
value |WT | of WT . In other words, X0T is a nonnegative random variable with
distribution function
P X0T 6 a = P(|WT | 6 a)

1 w a −x2 /(2T )
= √ e dx
2πT −a
∗
" 367
N. Privault
2 w a −x2 /(2T )
= √ e dx, a > 0,
2πT 0
and probability density function
dP X0T 6 a 2 −a2 /(2T )

r
ϕX T (a) = = e 1[0,∞) (a), a ∈ R, (10.3)
0 da πT
which vanishes over a ∈ (−∞, 0] because X0T > 0 almost surely.
1
Density function of XT0
0.8
Gaussian density function
Density
0.6
0.4
0.2
0
-4 -3 -2 -1 0 1 2 3 4
x
Fig. 10.7: Probability density of the maximum X01 of Brownian motion over [0,1].
We note that, as a consequence of the existence of the probability density

function (10.3), we have
w0
P(Wt 6 0, ∀t ∈ [0, ε]) = P(X0ε = 0) = ϕX0ε (a)ds = 0, (10.4)
0
for all ε > 0. Similarly, by a symmetry argument, for all ε > 0 we find
P(Wt > 0, ∀t ∈ [0, ε]) = 0 (10.5)
Using the probability density function of X0T , we can price an option with
payoff φ X0T , as

w∞
e −rT E∗ φ X0T = e −rT φ(x)dP X0T 6 x

−∞
2 w∞
r
2
= e −rT φ(x) e −x /(2T ) dx.
πT 0
Proposition 10.1. Let σ > 0 and (St )t∈[0,T ] := S0 e σWt t∈[0,T ] . The prob-

ability density function of the maximum
368 "
M0T := Max St
t∈[0,T ]
of (St )t∈[0,T ] over the time interval [0, T ] is given by the truncated lognormal
probability density function
1 2 1
r
ϕM T (y ) = 1[S0 ,∞) (y ) exp − 2 (log (y/S0 ))2 , y > 0,
0 σy πT 2σ T
see Figure 10.8.

Proof. Since σ > 0, we have
M0T = Max St
t∈[0,T ]
= S0 Max e σWt
t∈[0,T ]
= S0 e σ Maxt∈[0,T ] Wt
T
= S0 e σX0 .
Hence M0T = h X0T with h(x) = S0 e σx , and

1

y
h0 (x) = σS0 e σx , x ∈ R, and h−1 (y ) = log , y > 0,
σ S0
hence
1
ϕM T (y ) = ϕ T (h−1 (y ))
0 |h0 (h−1 (y ))| X0
√
2
= 1[0,∞) (h−1 (y ))
−1 2
√ e −(h (y )) /(2T )
|h0 (h−1 (y ))| πT
1 2 1
r
= 1[S0 ,∞) (y ) exp − 2 (log (y/S0 ))2 , y > 0.
σy πT 2σ T
" 369
N. Privault
0.8
0.7
Density of MT0
Lognormal density function
0.6
Density
0.5
0.4
0.3
0.2
0.1
0
0 0.5 1 1.5 2 2.5 3 3.5 4
x
Fig. 10.8: Density of the maximum M0T = Maxt∈[0,T ] St of geometric Brownian motion
with S0 = 1.
When the claim payoff takes the form C = φ M0T , where ST = S0 e σWT ,

we have
T
C = φ M0T = φ S0 e σX0 ,

hence
T
e −rT E∗ [C ] = e −rT E∗ φ S0 e σX0

w∞
= e −rT φ(S0 e σx )dP(X0T 6 x)
−∞
2 −rT w ∞
r
2
= e φ(S0 e σx ) e −x /(2T ) dx
πT 0
r
2 w∞
1

dy
= e −rT φ(y ) exp − 2 (log (y/S0 ))2 ,
2
πσ T 1 2σ T y
after the change of variable y = S0 e σx with dx = dy/(σy ).
The above computation is however not sufficient for practical applications as

it imposes the condition r = σ 2 /2. In order to do away with this condition
we need to consider the maximum of drifted Brownian motion, and for this
we have to compute the joint probability density function of X0T and WT .
10.3 Density of the Maximum of Brownian Motion

The reflection principle also allows us to compute the joint probability density
function of Brownian motion WT and its maximum X0T = Max Wt . Recall
t∈[0,T ]
that the probability density function ϕX T ,WT can be recovered from the joint
0
cumulative distribution function
(x, y ) 7−→ FX T ,WT (x, y ) := P X0T 6 x and WT 6 y

0
370 "
wx wy
= ϕX T ,WT (s, t)dsdt,
−∞ −∞ 0
and
w∞w∞
(x, y ) 7−→ P X0T > x and WT > y = ϕX T ,WT (s, t)dsdt,
x y 0
as
∂2
ϕX T ,WT (x, y ) = F T (x, y ) (10.6)
0 ∂x∂y X0 ,WT
∂ 2 w x w y
= ϕ T (s, t)dsdt (10.7)
∂x∂y −∞ −∞ X0 ,WT
∂ 2 w w
∞ ∞
= ϕX T ,WT (s, t)dsdt, x, y ∈ R.
∂x∂y x y 0
The probability densities ϕX T : R −→ R+ and ϕWT : R −→ R+ of X0T and

0
WT are called the marginal densities of X0T , WT , and are given by

w∞
ϕX T (x) = ϕX T ,WT (x, y )dy, x ∈ R,
0 −∞ 0
and w∞
ϕ WT ( y ) = ϕX T ,WT (x, y )dx, y ∈ R.
−∞ 0
0.1
0
-1
0
x
1 1 1.5
-0.5 0 0.5
-1 y
Fig. 10.9: Probability P((X, Y ) ∈ [−0.5, 1] × [−0.5, 1]) computed as a volume integral.
In order to compute the joint probability density function of Brownian motion

WT and its maximum X0T = Max Wt by the reflection principle, we note
t∈[0,T ]
that for any b 6 a we have
P(WT a + (a − b) | τa < T )
as shown in Figure 10.10, i.e.
" 371
N. Privault
P(WT 2a − b and τa < T ),
or, by (10.1),
P X0T > a and WT a and WT > 2a − b .

Bt 2.5
1.5 2a-b
1 a
b
0.5
-0.5
-1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
τa
t
Fig. 10.10: Reflected Brownian motion with a = 1.07.∗
Hence, since 2a − b > a we have
P X0T > a and WT a and WT > 2a − b = P(WT > 2a − b),

(10.8)
{WT > 2a − b} ⊂ X0T > 2a − b and WT > 2a − b

⊂ X0T > a and WT > 2a − b ⊂ {WT > 2a − b},

which shows that
{WT > 2a − b} = X0T > a and WT > 2a − b .

Consequently, by (10.8) we find
P X0T > a and WT 6 b = P X0T > a and WT 2a − b)
∗
372 "
1 w∞ 2
= √ e −x /(2T ) dx, (10.9)
2πT 2a−b
0 6 b 6 a, which yields the joint probability density function
∂2
P X0T 6 a and WT 6 b

ϕX T ,WT (a, b) =
0 ∂a∂b
∂2
P WT 6 b − P X0T > a and WT 6 b

=
∂a∂b
dP X0T > a and WT 6 b

=− , a, b ∈ R.
dadb
By (10.9), we obtain the following proposition.
Proposition 10.2. The joint probability density function of Brownian mo-
tion WT and its maximum X0T = Max Wt is given by
t∈[0,T ]
2 (2a − b) −(2a−b)2 /(2T )

r
ϕX T ,WT (a, b) = e 1{a>Max(b,0)} (10.10)
0 π T 3/2
r
2 (2a − b) −(2a−b)2 /(2T )
e , a > Max(b, 0),



= π T 3/2

0, a < Max(b, 0).


0.5
0.4
0.3
0.2
0.1
0
-0.5
0
0.5 -0.5 -1
1 0
b 1.5 1 0.5
2 1.5
2.5 2.5 2 a
3 3
Fig. 10.11: Joint probability density of W1 and the maximum X

b01 over [0,1].
Figure 10.12 presents the corresponding heat map of the same graph as seen
from above.
" 373
N. Privault
-1
-0.5
0.5
b 1
1.5
2.5
3
3 2.5 2 1.5 1 0.5 0 -0.5 -1
a
Fig. 10.12: Heat map of the joint density of W1 and its maximum X
b01 over [0,1].
Maximum of drifted Brownian motion
Using the Girsanov Theorem, it is even possible to compute the probability

density function of the maximum
b0T := Max W
X ft = Max (Wt + µt)
t∈[0,T ] t∈[0,T ]
of drifted Brownian motion W

ft = Wt + µt over t ∈ [0, T ], for any µ ∈ R.
Proposition 10.3. The joint probability density function ϕX bT

e T of X0
b0T ,W
fT := WT + µT is given by
and W
1 2
r
e (a, b) = 1{a>Max(b,0)}
2 2
ϕX
b T ,W (2a − b) e µb−(2a−b) /(2T )−µ T /2
0 T T πT
(10.11)
 r
1 2 2 2
(2a − b) e −µ T /2+µb−(2a−b) /(2T ) , a > Max(b, 0),



= T πT

0, a < Max(b, 0).


Proof. The arguments previously applied to the standard Brownian motion

(Wt )t∈[0,T ] cannot be directly applied to W ft
t∈[0,T ]
because drifted Brow-
nian motion is no longer symmetric in space when µ 6= 0. On the other
hand, the drifted process W is a standard Brownian motion under

ft
t∈R+
the probability measure P defined from the Radon-Nikodym density
e
374 "
dP 2
:= e −µWT −µ T /2 ,
e
(10.12)
dP
and the joint probability density function of X bT , WfT under P e is given by

0
(10.10). Now, using the probability density function (10.12) we get

P X b T 6 a and W fT 6 b = E 1 T

0 b0 6a and W
{X e T 6b}
w
= 1 bT 6a and We 6b} dP
Ω {X 0 T
w dP
= 1 bT 6a and We 6b} dP e
Ω dP e {X 0 T
e dP 1 T

=E b0 6a and W
e {X
dP e T 6b}

=E e e µWT +µ T /2 1 T
2
{Xb0 6a and W e T 6b}

=E e e µW e T −µ2 T /2
1{XbT 6a and We 6b}
0 T
2 wawb (2x − y ) −(2x−y )2 /(2T )

r
1
2
= (y ) e µy−µ T /2 e dydx,
πT 0 −∞ (−∞,x] T
0 6 b 6 a, which yields the joint probability density function (10.11) from
the differentiation
dP X
b T 6 a and W

fT 6 b
0
ϕX e T (a, b) =
b0T ,W .
dadb

The following proposition is consistent with (10.3) in case µ = 0.
Proposition 10.4. The cumulative distribution function of the maximum
b T := Max W
X ft = Max (Wt + µt)
0
t∈[0,T ] t∈[0,T ]
ft = Wt + µt over t ∈ [0, T ] is given by


P X b0T 6 a = Φ a − µT
− e 2µa Φ
−a − µT
, a > 0, (10.13)

√ √
T T
and the probability density function ϕX bT

b0T of X0 satisfies
2 −(a−µT )2 /(2T )
r
−a − µT
b T (a) =
ϕX e − 2µ e 2µa Φ √ , a > 0. (10.14)
0 πT T
" 375
N. Privault
Proof. Letting a ∨ b := Max(a, b), a, b ∈ R, since the condition (y 6 x and

0 6 x 6 a) is equivalent to the condition (y ∨ 0 6 x 6 a), we have
2 waw∞ (2x − y ) −(2x−y )2 /(2T )

r
1
2
P X
b0T 6 a = (y ) e µy−µ T /2 e

dydx
πT 0 −∞ (−∞,x] T
r w w
2 a x 2 (2x − y ) −(2x−y )2 /(2T )
= e µy−µ T /2 e dydx
πT 0 −∞ T
2 −µ2 T /2 w a w a (2x − y )
r
2
= e e µy e −(2x−y ) /(2T ) dxdy.
πT −∞ y∨0 T
Next, since
 2 × 0 − y = −y, y 6 0,

2(y ∨ 0) − y =
2
2y − y = y, y > 0,

and using the “completion of the square” identity
(2a − y )2 µ2 T 1
µy − − = 2aµ − (y − (µT + 2a))2
2T 2 2T
and a standard changes of variables, we have
2 waw∞ (2x − y ) −(2x−y )2 /(2T )

r
1
2
P Xb0T 6 a = (y ) e µy−µ T /2 e

dydx
πT 0 −∞ (−∞,x] T
1 2
wa 2 2
e −µ T /2 e µy−(2(y∨0)−y ) /(2T ) − e µy−(2a−y ) /(2T ) dy

= √
2πT −∞
1 wa 2 2 2 2
e µy−y /(2T )−µ T /2 − e µy−(2a−y ) /(2T )−µ T /2 dy

= √
2πT −∞
1 wa 2 2
e −(y−µT ) /(2T ) − e −(y−(µT +2a)) /(2T )+2aµ dy

= √
2πT −∞
1 wa 2 1 wa 2
= √ e −(y−µT ) /(2T ) dy − e 2aµ √ e −(y−(µT +2a)) /(2T ) dy
2πT −∞ 2πT −∞
1 w a−µT −y2 /(2T ) 1 w −a−µT −y2 /(2T )
= √ e dy − e 2aµ √ e dy
2πT −∞ 2πT −∞

a − µT −a − µT
=Φ √ − e 2µa Φ √ , a > 0,
T T
cf. Corollary 7.2.2 and pages 297-299 of Shreve (2004) for another derivation.

See Profeta et al. (2010) for interpretations of (10.13) and (10.15) in terms
of the Black-Scholes formula.
376 "
1.4 µ=0
µ=-0.5
1.2 µ=0.5
1
Density
0.8
0.6
0.4
0.2
0
-1 0 1 2 3 4
x
Fig. 10.13: Probability density of the maximum X

b0T of drifted Brownian motion.
We note from Figure 10.13 that small values of the maximum are more likely
to occur when µ takes large negative values. As T tends to infinity, Propo-
sition 10.4 also
shows that when µ < 0, the maximum of drifted Brownian
motion W ft
t∈R+
= (Wt + µt)t∈R+ over all time has an exponential distri-
bution with parameter 2|µ|, i.e.
bT (a) = 2µ e , a > 0.
2µa
ϕX
0
Relation (10.13), resp. Relation (10.16) below, will be used for the pricing of
lookback call, resp. put options in Section 10.4
Corollary 10.5. The cumulative distribution function of the maximum
2 /2)t
M0T := Max St = S0 Max e σWt +(r−σ
t∈[0,T ] t∈[0,T ]
of geometric Brownian motion over t ∈ [0, T ] is given by
−(r − σ 2 /2)T + log(x/S0 )

P M0T 6 x = Φ (10.15)

√
σ T
1−2r/σ2
−(r − σ 2 /2)T − log(x/S0 )

S0
− Φ √ , x > S0 ,
x σ T
and the probability density function ϕM T of M0T satisfies

0
1 (−(r − σ 2 /2)T + log(x/S0 ))2

ϕM T (x) = √ exp −
0 σx 2πT 2σ 2 T
1−2r/σ2
1 ((r − σ 2 /2)T + log(x/S0 ))2

S0
+ √ exp −
σx 2πT x 2σ 2 T
1−2r/σ2
1 2r −(r − σ /2)T − log(x/S0 )
2

S0
+ 1− 2 Φ √ , x > S0 .
x σ x σ T
" 377
N. Privault
Proof. Taking
ft := Wt + µt = Wt + 1 σ2

W r− t
σ 2
with µ := r/σ − σ/2, by (10.13) we find

bT x
P M0T 6 x = P e σX0 6

S0
1

x
= P X0 6 log
b T
σ S0
−µT + σ −1 log(x/S0 ) −µT − σ −1 log(x/S0 )

−1
=Φ √ − e 2µσ log(x/S0 ) Φ √
T T
2µ/σ
−µT + σ −1 log(x/S0 ) −µT − σ −1 log(x/S0 )

x
=Φ √ − Φ √
T S0 T
−(r − σ 2 /2)T + log(x/S0 )

=Φ √
σ T
1−2r/σ2
−(r − σ 2 /2)T − log(x/S0 )

S0
− Φ √ .
x σ T

Minimum of drifted Brownian motion

b
Proposition 10.6. The joint probability density function ϕ of the
XT
0 ,WT
e
ft := Wt + µt and its value W
minimum of the drifted Brownian motion W fT
at time T is given by
1 2
r
e (a, b) = 1{a6min(b,0)} T
2 2
(b − 2a) e µb−(2a−b) /(2T )−µ T /2
b
ϕ
XT
0 , WT πT
 r
1 2 2 2
(b − 2a) e −µ T /2+µb−(2a−b) /(2T ) , a < min(b, 0),



= T πT

0, a > min(b, 0).


Proof. We use the relations
min W
ft = − Max ft ,

−W
t∈[0,T ] t∈[0,T ]
378 "
and
b
X T0 := min W
ft
t∈[0,T ]
= min (Wt + µt)
t∈[0,T ]
= − Max

−W
ft
t∈[0,T ]
= − Max (−Wt − µt)
t∈[0,T ]
' − Max (Wt − µt),
t∈[0,T ]
where the last equality “'” follows from the identity in distribution of
(Wt )t∈R+ and (−Wt )t∈R+ , and we conclude by applying the change of vari-
ables (a, b, µ) 7→ (−a, −b, −µ) to (10.11).
Similarly to the above, the following proposition holds for the minimum
drifted Brownian motion, and Relation (10.17) below can be obtained by
changing the signs of both a and µ in Proposition 10.4.
Proposition 10.7. The cumulative distribution function and probability den-
sity function of the minimum
b
X T := min W
0
ft = min (Wt + µt)
t∈[0,T ] t∈[0,T ]
ft = Wt + µt over t ∈ [0, T ] are given by

of the drifted Brownian motion W
b
a + µT

a − µT
P X T0 6 a = Φ + e 2µa Φ , a 6 0, (10.16)

√ √
T T
and
2 −(a−µT )2 /(2T )
r
a + µT

e + 2µ e 2µa Φ , a 6 0. (10.17)
b
ϕ (a) = √
XT
0 πT T
Proof. From (10.13), the cumulative distribution function of the minimum
of drifted Brownian motion can be expressed as
b
P X T0 6 a = P min W

ft 6 a
t∈[0,T ]

= P min (Wt + µt) 6 a
t∈[0,T ]

= P − Max (−Wt − µt) 6 a
t∈[0,T ]

= P − Max (Wt − µt) 6 a
t∈[0,T ]
" 379
N. Privault

=P Max (Wt − µt) > −a
t∈[0,T ]

= 1 − P Max (Wt − µt) 6 −a
t∈[0,T ]
−a + µT a + µT

= 1−Φ √ + e 2µa Φ √
T T
a + µT

a − µT
=Φ √ +e Φ
2µa
√ , a 6 0,
T T
where we used the identity in distribution of (Wt )t∈R+ and (−Wt )t∈R+ , hence
the probability density function of the minimum of drifted Brownian motion
is given by (10.17).
Similarly, we have
b
µT + a

µT − a
P X T0 > a = Φ − e 2aµ Φ , a 6 0,

√ √
T T
and, if µ > 0, the minimum of the positively drifted Brownian motion
W
ft
t∈R+
= (Wt + µt)t∈R+ over all time has an exponential distribution
with parameter 2µ on R− , i.e.
ϕ T (a) = 2µ e 2µa , a 6 0.
b
X0
In addition, as in Corollary 10.5, we have the following result.

Corollary 10.8. The cumulative distribution function of the minimum
2 /2)t
mT0 := min St = S0 min e σWt +(r−σ
t∈[0,T ] t∈[0,T ]
of geometric Brownian motion over t ∈ [0, T ] is given by
−(r − σ 2 /2)T + log(x/S0 )

P mT0 6 x = Φ (10.18)

√
σ T
1−2r/σ2
(r − σ 2 /2)T + log(x/S0 )

S0
+ Φ √ , 0 < x 6 S0 ,
x σ T
and the probability density function ϕmT of mT0 satisfies

0
1 + log(x/S0 ))2
(−(r − σ 2 /2)T

ϕmT (x) = √ exp −
0 σx 2πT 2σ T2
1−2r/σ2
1 ((r − σ 2 /2)T + log(x/S0 ))2

S0
+ √ exp −
σx 2πT x 2σ T
2
380 "
1−2r/σ2
1 2r (r − σ 2 /2)T + log(x/S0 )

S0
+ − 1 Φ √ , 0 < x 6 S0 .
x σ2 x σ T
Proof. From (10.16) we have
P mT0 6 x

−µT + σ −1 log(x/S0 ) µT + σ −1 log(x/S0 )

−1
=Φ √ + e 2µσ log(x/S0 ) Φ √
T T
2µ/σ
−µT + σ −1 log(x/S0 ) µT + σ −1 log(x/S0 )

x
=Φ √ + Φ √
T S0 T
−(r − σ 2 /2)T + log(x/S0 )

=Φ √
σ T
1−2r/σ 2
(r − σ 2 /2)T + log(x/S0 )

S0
+ Φ √ , 0 < x 6 S0 ,
x σ T
with µ := r/σ − σ/2. The probability density function ϕmT is computed
0
from
∂
P m0 6 x ,
T
0 < x 6 S0 .

ϕ mT ( x ) =
0 ∂x

10.4 Average of Geometric Brownian Extrema
Let
mts = min Su and Mst = Max Su ,
u∈[s,t] u∈[s,t]
0 6 s 6 t 6 T , and let
Ms be either ms or Ms . In the lookback option case
t t t
the payoff φ ST , MT0 depends not only on the price of the underlying asset
at maturity but it also depends on all price values of the underlying asset
over the period which starts from the initial time and ends at maturity.
The payoff of such of an option is of the form φ ST , MT0 with φ(x, y ) =

x − y in the case of lookback call options, and φ(x, y ) = y − x in the case of

lookback put options. We let
e −(T −t)r E∗ φ ST , MT0 |Ft

denote the price at time t ∈ [0, T ] of such an option.
" 381
N. Privault
Maximum selling price over [0, T ]
In the next proposition we start by computing the average of the maximum

selling price M0T := Max St of (St )t∈[0,T ] over the time interval [0, T ]. We
t∈[0,T ]
denote
1 1

τ
δ± (s) : = √ log s + r ± σ 2 τ , s > 0. (10.19)
σ τ 2
Proposition 10.9. The average maximum value of (St )t∈[0,T ] over [0, T ] is
given by
E∗ M0T Ft (10.20)

σ2

T −t St (T −t)r T −t St
= M0 Φ −δ−
t
+ St e 1 + Φ δ +
M0t 2r M0t
2 t 2r/σ2 t
σ M0 T −t M0
−St Φ −δ− ,
2r St St
T −t
where δ± is defined in (10.19).
When t = 0 we have S0 = M00 , and given that
r ± σ 2 /2 √
T
δ± (1) = T, (10.21)
σ
the formula (10.20) simplifies to
E∗ M0T

σ2 σ /2 − r √ σ /2 + r √
2
σ2
2
= S0 1 − Φ T + S0 e rT 1 + Φ T ,
2r σ 2r σ
with
√ !! r
σ2 T T T −σ2 T /8
E∗ M0T = 2S0 1+ Φ σ e

+ σS0
4 2 2π
when r = 0, cf. Exercise 12.2.
In general, when T tends to infinity we find that
σ2

E∗ M0T Ft
1 +
 if r > 0,
lim = 2r
T →∞ E∗ [ST | Ft ] 
if r = 0,

∞
382 "
see Exercise 10.3-(d) in the case r = σ 2 /2.
Proof of Proposition 10.9. We have
E∗ M0T Ft = E∗ Max M0t , MtT Ft

= E∗ M0t 1{M t >M T } Ft + E∗ MtT 1{M T >M t } Ft

0 t t 0
= M0t E∗ 1{M t >M T } Ft + E∗ MtT 1{M T >M t } Ft

0 t t 0
= M0t P M0t > MtT Ft + E∗ MtT 1{M T >M t } Ft .

t 0
Next, we have
M0t MT

P M0t > MtT Ft = P > t Ft

St St
MtT

=P x> Ft
St x=M0t /St
!
T −t
M0
=P <x .
S0 t
x=M0 /St
On the other hand, letting µ := r/σ − σ/2, from (10.13) or (10.15) in Corol-
lary 10.5 we have
T
M0 2
P < x = P Max e σWt +rt−σ t/2 < x
S0 t∈[0,T ]

= P Max e (Wt +µt)σ < x
t∈[0,T ]

= P Max e σW et
<x
t∈[0,T ]
T

= P e σXb0 < x
bT < 1 log x

=P X
σ
−µT + σ −1 log x −µT − σ −1 log x

−1
=Φ √ − e 2µσ log x Φ √
T T
1

−1+2r/σ 2
= Φ −δ− T
−x Φ −δ− (x) .
T
x
Hence, we have
!
M0T −t
P M0t > MtT Ft = P

<x
S0
x=M0t /St
" 383
N. Privault
t −1+2r/σ2 t
T −t St M0 T −t M0
= Φ −δ− t − Φ −δ− .
M0 St St
Next, we have
T
h i Mt
E∗ MtT 1{M T >M t } Ft = St E∗ 1

T t
Ft
t 0 St {Mt /St >M0 /St }

Su
= St E∗ 1{Maxu∈[t,T ] Su /St >x} Max Ft
u∈[t,T ] St x=M0t /St

Su
= St E 1{Maxu∈[0,T −t] Su /S0 >x} Max
∗
,
u∈[0,T −t] S0 x=M t /S
0 t
and by Proposition 10.4 we have

Su
E∗ 1{Maxu∈[0,T ] Su /S0 >x} Max (10.22)
u∈[0,T ] S0

= E∗ 1 Max e σWu
b
{Maxu∈[0,T ] e σWbu >x} u∈ [0,T ]

= E∗ e σ Maxu∈[0,T ] Wu 1{Max
b
u∈[0,T ] Wb u >σ−1 log x}
h i
=E e∗ σXbT
1{Xb >σ−1 log x}
T
w∞
= −1 e σz fXbT (z )dz
σ log x
w∞ r
2 −(z−µT )2 /(2T )

−z − µT
!
= −1 e σz e − 2µ e 2µz Φ √ dz
σ log x πT T
2 w∞ w∞
r
2 −z − µT
= −1
e σz−(z−µT ) /(2T ) dz − 2µ −1 e z (σ +2µ) Φ √ dz.
πT σ log x σ log x T
By a standard “completion of the square” argument, we find
1 w∞ 2
√ e σz−(z−µT ) /(2T ) dz
2πT σ−1 log x
1 w∞ 2 2 2
= √ e −(z +µ T −2(µ+σ )T z )/(2T ) dz
2πT σ−1 log x
1 2
w∞ 2
= √ e σ T /2+µσT −1 e −(z−(µ+σ )T ) /(2T ) dz
2πT σ log x
1 w∞ 2
= √ e rT e −z /(2T ) dz
2πT −(µ+σ )T +σ −1 log x
1

= e rT Φ δ+ T
,
x
384 "
since µσ + σ 2 /2 = r. The second integral

w∞
−z − µT

z (σ +2µ)
e Φ √ dz
σ −1 log x T
can be computed by integration by parts using the identity
w∞ w∞
v 0 (z )u(z )dz = u(+∞)v (+∞) − u(a)v (a) − v (z )u0 (z )dz,
a a
with a := σ −1 log x. We let

−z − µT
u(z ) = Φ √ and v 0 (z ) = e z (σ +2µ)
T
which satisfy
1 2 1
u0 (z ) = − √ e −(z +µT ) /(2T ) and v (z ) = e z (σ +2µ) ,
2πT σ + 2µ
and using the completion of square identity
1 w b γy−y2 /(2T ) −c + γT −b + γT

2
√ e dy = e γ T /2 Φ √ −Φ √
2πT c T T
(10.23)
for b = +∞, we find
w∞
−z − µT
w∞
e z (σ +2µ) Φ √ dz = v 0 (z )u(z )dz
a T a
w∞
= u(+∞)v (+∞) − u(a)v (a) − v (z )u0 (z )dz
a
1

−a − µT
=− e a(σ +2µ) Φ √
σ + 2µ T
1 w ∞ z (σ +2µ) −(z +µT )2 /(2T )
+ √ e e dz
(σ + 2µ) 2πT a
1

−a − µT
=− e a(σ +2µ) Φ √
σ + 2µ T
1 w
( T (σ +µ)2 −µ2 T )/2 ∞ −(z−T (σ +µ))2 /(2T )
+ √ e e dz
(σ + µ) 2πT a
1

−a − µT
=− e a(σ +2µ) Φ √
σ + 2µ T
1 w
( T (σ +µ)2 −µ2 T )/2 ∞ −z 2 /2
+ √ e √ e dz
(σ + 2µ) 2π (a−T (σ +µ))/ T
1

−a − µT
=− e a(σ +2µ) Φ √
σ + 2µ T
" 385
N. Privault
1 −a + T (σ + µ)

2 2
+ e (T (σ +µ) −µ T )/2 Φ √
σ + 2µ T
2r −(r/σ − σ/2)T − σ −1 log x

2r/σ 2
= − (x) Φ √
σ T
2r σT (σ +2µ)/2 T (r/σ + σ/2) − σ −1 log x

+ e Φ √
σ T
1

σ rT σ 2r/σ2 T
= e Φ δ+ T
− x Φ −δ− (x) ,
2r x 2r
cf. pages 317-319 of Shreve (2004) for a different derivation using double
integrals. Hence we have

Su
E∗ MtT 1{M T >M t } Ft = St E∗ 1{Maxu∈[0,T −t] Su /S0 >x} Max

t 0 u∈[0,T −t] S0 x=M t /S
0 t

(T −t)r T −t St µσ (T −t)r T −t St
= 2St e Φ δ+ − St e Φ δ+
M0t r M0t
t 2r/σ2 t
µσ M0 T −t M0
+St Φ −δ− ,
r St St
and consequently this yields, since µσ/r = 1 − σ 2 /(2r ),
E∗ M0T Ft = E∗ M0T M0t

= M0t P M0t > MtT M0t + E∗ MtT 1 T

t
t
M0
{Mt >M0 }
t 2r/σ2 t
T −t St M0 T −t M0
= M0t Φ −δ− t − St Φ −δ−
M St St
0
S t
+2St e (T −t)r Φ δ+ T −t
M0t

σ 2
St

−St 1 − e (T −t)r Φ δ+ T −t
2r M0t
2 t 2r/σ2 t
σ M0 T −t M0
+St 1 − Φ −δ−
2r St St
σ2

T −t St (T −t)r T −t St
= M0 Φ −δ−
t
+ S t e 1 + Φ δ +
M0t 2r M0t
2 t 2r/σ2 t
σ M0 T −t M0
−St Φ −δ− .
2r St St
This concludes the proof of Proposition 10.9. 2
386 "
See Exercise 10.5-(a) for a computation of the average minimum E∗ mT0 =

h i
E∗ mint∈[0,T ] St .
Minimum buying price over [0, T ]
In the next proposition we compute the average of the minimum buying price
mT0 := Max St of (St )t∈[0,T ] over the time interval [0, T ].
t∈[0,T ]
Proposition 10.10. The average minimum value of (St )t∈[0,T ] over [0, T ]
is given by
E∗ mT0 Ft (10.24)

2 t 2r/σ2 t
T −t St σ m0 T −t m0
= mt0 Φ δ− − St Φ δ−
mt0 2r St St
σ2

(T −t)r T −t St
+St e 1+ Φ −δ+ ,
2r mt0
T −t
where δ± is defined in (10.19).
We note a certain symmetry between the expressions (10.20) and (10.24).
When t = 0 we have S0 = m00 , and given (10.21) the formula (10.24) simplifies
to
2r/σ2
r − σ 2 /2 √ σ 2 mt0 r − σ 2 /2 √

E∗ mT0 = S0 Φ Φ

T − S0 T
σ 2r St σ

σ 2
σ 2 /2 + r √
+S0 e rT 1 + Φ − T ,
2r σ
with
r
σ2 T σ 2 T /2

T −σ2 T /8
E∗ mT0 = 2S0 1 + Φ − √ e .

− σS0
4 σ T 2π
when r = 0, cf. Exercise 12.1.
In general, when T tends to infinity we find that
E∗ mT0 Ft

lim = 0, r > 0,
T →∞ E∗ [ST | Ft ]
see Exercise 10.3-(f) in the case r = σ 2 /2.
" 387
N. Privault
Proof of Proposition 10.10. We have
E∗ mT0 Ft = E∗ min mt0 , mTt Ft

= E∗ mt0 1{mt <mT } Ft + E∗ mTt 1{mt >mT } Ft

0 t 0 t
= mt0 E∗ 1{mt <mT } Ft + E∗ mTt 1{mt >mT } Ft

0 t 0 t
= mt0 P mt0 < mTt Ft + E∗ mTt 1{mt >mT } Ft .

0 t
By (10.17) we find the cumulative distribution function

! t −1+2r/σ2
mT0 −t
t
T −t St m0 T −t m0
P >x = Φ δ− t − Φ δ− ,
S0 m0 St St
x=mt0 /St
of the minimum mT0 −t of (St )t∈R+ over the time interval [0, T − t], hence
mt0 mT

P mt0 < mTt Ft = P < t Ft

St St
mTt

=P x< Ft
St x=mt0 /St
!
T −t
m0
=P >x
S0 t x=m0 /St
−1+2r/σ2
mt0
t
T −t St T −t m0
= Φ δ− − Φ δ− .
mt0 St St
Next, by integration with respect to the probability density function (10.16)

as in (10.22) in the proof of Proposition 10.9, we find

Su
E∗ mTt 1{mt >mT } Ft = St E∗ 1{mt /St >mT /St } min

0 t 0 t u∈[t,T ] St x=mt ,y =S
0 t

Su
= St E 1{minu∈[t,T ] Su /St <x} min
∗
u∈[t,T ] St x=mt /S
t
0
Su
= St E 1{minu∈[0,T −t] Su /S0 <x} min
∗
u∈[0,T −t] S0 x=mt /S
0 t

(T −t)r T −t St µσ (T −t)r T −t St
= 2St e Φ −δ+ − S t e Φ −δ +
mt0 r mt0
t 2r/σ2 t
µσ m0 T −t m0
+St Φ δ− .
r St St
Given the relation µσ/r = 1 − σ 2 /(2r ), this yields

388 "
!
mT0 −t
E∗ mT0 Ft = mt0 P

>x
S0
x=mt0 /St

Su
+St E∗ 1{minu∈[0,T −t] Su /S0 <x} min
u∈[0,T −t] S0 x=mt0 /St
t −1+2r/σ2 t
T −t St t m0 T −t m0
= mt0 Φ δ− − m 0 Φ δ −
mt0 St St

St µσ St
+2St e (T −t)r Φ −δ+ T −t
t − St e (T −t)r Φ −δ+ T −t
t
m0 r m0
2r/σ2
µσ mt0
t
T −t m
+St Φ δ− 0
r St St
σ2

St St
= mt0 Φ δ− T −t
+ St e (T −t)r 1 + Φ −δ+ T −t
m0t 2r m0t
2r/σ2
σ 2 mt0
t
T −t m
−St Φ δ− 0
.
2r St St
2
Exercises
Exercise 10.1 Let (Wt )t∈R+ be standard Brownian motion, and let a >
W0 = 0.
a) Using the equality (10.2), find the probability density function ϕτa of the
first time
τa := inf{t > 0 : Wt = a}
that (Wt )t∈R+ hits the level a > 0.
b) Let µ ∈ R. By Proposition 10.4, find the probability density function ϕτa
of the first time
τ̃a := inf{t > 0 : Wft = a}
that the drifted Brownian motion W := (Wt + µt)t∈R+ hits the

ft
t∈R+
level a > 0.
c) Let σ > 0 and r ∈ R. By Corollary 10.5, find the probability density
function ϕτa of the first time
τ̂x := inf{t > 0 : St = x}

2 t/2
that the geometric Brownian motion (St )t∈R+ := e σWt +rt−σ

t∈R+
hits the level x > 0.
Exercise 10.2
" 389
N. Privault
a) Compute the mean value

E Max W ft = E Max (σWt + µt)
t∈[0,T ] t∈[0,T ]
of the maximum of drifted Brownian motion W

ft = Wt + µt over t ∈ [0, T ],
for σ > 0 and µ ∈ R. The probability density function of the maximum
is given in (10.14). h i h i
b) Compute the mean value E mint∈[0,T ] W
ft = E min
t∈[0,T ] (σWt + µt) of
the minimum of drifted Brownian motion W ft = σWt + µt over t ∈ [0, T ],
for σ > 0 and µ ∈ R. The probability density function of the minimum is
given in (10.17).
Exercise 10.3 Consider a risky asset whose price St is given by
σ2
dSt = σSt dWt + St dt, (10.25)
2
where (Wt )t∈R+ is a standard Brownian motion.
a) Solve the stochastic differential equation (10.25).
b) Compute the expected stock price value E∗ [ST ] at time T .
c) What is the probability distribution of the maximum Max Wt over the
t∈[0,T ]
interval [0, T ]?
d) Compute the expected value E∗ M0T ] of the maximum

M0T := Max St = S0 Max e σWt = S0 exp σ Max Wt .
t∈[0,T ] t∈[0,T ] t∈[0,T ]
of the stock price over the interval [0, T ].

e) What is the probability distribution of the minimum min Wt over the
t∈[0,T ]
interval [0, T ]?
f) Compute the expected value E∗ mT0 of the minimum

mT0 := min St = S0 min e σWt = S0 exp σ min Wt .
t∈[0,T ] t∈[0,T ] t∈[0,T ]
of the stock price over the interval [0, T ].

+
a) Compute the “optimal call option” prices E M0T − K estimated by

optimally exercising at the maximum value M0T of (St )t∈[0,T ] before ma-
turity T .
390 "
+
b) Compute the “optimal put option” prices E K − mT0 estimated by

optimally exercising at the minimum value mT0 of (St )t∈[0,T ] before ma-
turity T .
Exercise 10.5 (Exercise 10.4 continued). Consider an asset price St given

2
by St = S0 e rt+σBt −σ t/2 , t > 0, where (Bt )t∈R+ is a standard Brownian
motion, with r > 0 and σ > 0.
a) Compute the average E∗ mT0 of the minimum mT0 := mint∈[0,T ] St of

(St )t∈[0,T ] over [0, T ].

h + i
b) Compute the expected payoff E K − min St for r > 0. Using a
t∈[0,T ]
finite expiration American put option pricer, compare the American put
option price to the above expected payoff.
h + i
c) Compute the expected payoff E K − min St for r = 0.
t∈[0,T ]
Exercise 10.6 Recall that the maximum X0t := Maxs∈[0,t] Ws over [0, t] of
standard Brownian motion (Ws )s∈[0,t] has the probability density function
2 −x2 /(2t)
r
ϕX t (x) = e , x > 0.
0 πt
a) Let τa = inf{s > 0 : Ws = a} denote the first hitting time of a > 0
by (Ws )s∈R+ . Using the relation between {τa 6 t} and X0t > a , write
down the probability P(τa 6 t) as an integral from a to ∞.
b) Using integration by parts on [a, ∞), compute the probability density
function of τa .
2 2 / (2t)
Hint: the derivative of e −x /(2t) with respect to x is −x e −x /t.
c) Compute the mean value E∗ [(τa )−2 ] of 1/τa2 .
" 391
Chapter 11
Barrier Options
Barrier options are financial derivatives whose payoffs depend on the crossing
of a certain predefined barrier level by the underlying asset price (St )t∈[0,T ] .
In this chapter we consider barrier options whose payoffs depend on an ex-
tremum of (St )t∈[0,T ] , in addition to the terminal value ST . Barrier options
are priced by computing the discounted expected values of their claim payoffs,
or by PDE arguments.
11.1 Options on Extrema . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393

11.2 Knock-Out Barrier Options . . . . . . . . . . . . . . . . . . . . . 398
11.3 Knock-In Barrier Options . . . . . . . . . . . . . . . . . . . . . . 410
11.4 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
11.1 Options on Extrema
Vanilla options with payoff C = φ(ST ) can be priced as

w∞
e −rT E∗ [φ(ST )] = e −rT φ(y )ϕST (y )dy
0
where ϕST (y ) is the (one parameter) probability density function of ST , which

satisfies wy
P(ST 6 y ) = ϕST (v )dv, y ∈ R.
0
Recall that typically we have
if x > K,

x−K
φ(x) = (x − K ) + =
0 if x < K,

for the European call option with strike price K, and
" 393
N. Privault
 $1 if x > K,

φ(x) = 1[K,∞) (x) =

0 if x < K,

for the binary call option with strike price K. On the other hand, exotic
options, also called path-dependent options, are options whose payoff C may
depend on the whole path
{St : 0 6 t 6 T }
of the underlying asset price process via a “complex” operation such as aver-
aging or computing a maximum. They are opposed to vanilla options whose
payoff
C = φ(ST ),
depend only using the terminal value ST of the price process via a payoff
function φ, and can be priced by the computation of path integrals, see Sec-
tion 17.2.
For example, the payoff of an option on extrema may take the form
C := φ M0T , ST ,

where
M0T = Max St
t∈[0,T ]
is the maximum of (St )t∈R+ over the time interval [0, T ]. In such situations
the option price at time t = 0 can be expressed as
w∞w∞
e −rT E∗ φ M0T , ST = e −rT

φ(x, y )ϕM T ,ST (x, y )dxdy
0 0 0
where ϕM T ,ST is the joint probability density function of (M0T , ST ), which

0
satisfies
wxwy
P(M0T 6 x and ST 6 y ) = ϕM T ,ST (u, v )dudv, x, y > 0.
0 0 0
General case
Using the joint probability density function of W

fT = WT + µT and
b T = Max W
X f = Max (Wt + µt),
0
t∈[0,T ] t∈[0,T ]
we are able to price any exotic option with payoff φ(W

fT , X
b T ), as
0
e −(T −t)r E∗ φ X
b0T , W
fT Ft ,

394 "
with in particular, letting a ∨ b := Max(a, b),

w∞ w∞
e −rT E∗ φ X fT = e −rT
b0T , W φ(x, y )dP∗ X fT 6 y .
b0T 6 x, W

−∞ y∨0
In this chapter we work in a (continuous) geometric Brownian model in which

the asset price (St )t∈[0,T ] has the dynamics
dSt = rSt dt + σSt dWt , t > 0,
where (Wt )t∈R+ is a standard Brownian motion under the risk-neutral prob-
ability measure P∗ . In particular, by Lemma 5.15 the value Vt of a self-
financing portfolio satisfies
wT
VT e −rT = V0 + σ ξt St e −rt dWt , t ∈ [0, T ].
0
In order to price barrier∗ options by the above probabilistic method, we will

use the probability density function of the maximum
M0T = Max St
t∈[0,T ]
of geometric Brownian motion (St )t∈R+ over a given time interval [0, T ] and
the joint probability density function ϕM T ,ST (u, v ) derived in Chapter 10 by
0
the reflection principle.
Proposition 11.1. An exotic option with integrable claim payoff of the form

C = φ M0T , ST = φ Max St , ST

t∈[0,T ]
can be priced at time 0 as
e −rT E∗ [C ]
e −rT 2 w ∞ w ∞
r
2 2
φ S0 e σy , S0 e σx (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy

= 3/2
T π 0 y
e −rT 2 w 0 w ∞
r
2 2
φ S0 e σy , S0 e σx (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy.

+ 3/2
T π −∞ 0
Proof. We have
2 T /2+rT
ST = S0 e σWT −σ = S0 e (WT +µT )σ = S0 e σW
eT
,
with
∗
“A former MBA student in finance told me on March 26, 2004, that she did not
understand why I covered barrier options until she started working in a bank” Lyuu
(2021).
" 395
N. Privault
σ r
µ := − + and W
fT = WT + µT ,
2 σ
and
2 t/2+rt
M0T = Max St = S0 Max e σWt −σ
t∈[0,T ] t∈[0,T ]
= S0 Max e σW
et
= S0 e σ Maxt∈[0,T ] Wt
e
t∈[0,T ]
T
= S0 e σXb0 ,
we have
2 bT
C = φ ST , M0T = φ S0 e σWT −σ T /2+rT , M0T = φ S0 e σWT , S0 e σX0 ,
e
hence
bT
e −rT E∗ [C ] = e −rT E∗ φ S0 e σWT , S0 e σX0
e
w∞ w∞
= e −rT φ S0 e σy , S0 e σx dP X b T 6 x, W

fT 6 y
0
−∞ y∨0
e −rT 2 w ∞ w ∞
r
2 2

= 3/2
T π −∞ y∨0
e −rT 2 w ∞ w ∞
r
2 2

= 3/2
T π 0 y
e −rT 1 2 w 0 w ∞
r
2 2
φ S0 e σy , S0 e σx (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy.

+ 3/2
T π −∞ 0

Pricing barrier options
The payoff of an up-and-out barrier put option on the underlying asset price
St with exercise date T , strike price K and barrier level (or call level) B is
(K − ST )+ if Max St < B,


06t6T


C = (K − ST ) 1+ n o =
Max St B.
06t6T 06t6T
This option is also called a Callable Bear Contract, or Bear CBBC with no
residual value, or turbo warrant with no rebate, in which the call level B
usually satisfies B 6 K.
396 "
The payoff of a down-and-out barrier call option on the underlying asset price
St with exercise date T , strike price K and barrier level B is
+ if min S > B,

 ( ST − K )

 06t6T
t
C = (ST − K ) 1+ n o =
min St > B 0

 if min St 6 B.
06t6T 06t6T
This option is also called a Callable Bull Contract, or Bull CBBC with no
residual value, or turbo warrant with no rebate, in which B denotes the call
level. ∗
Category ’R’ Callable Bull/Bear Contracts, or CBBCs, also called turbo

warrants, involve a rebate or residual value computed as the payoff of a
down-and-in lookback option. Category ’N’ Callable Bull/Bear Contracts do
not involve a residual value or rebate, and they usually satisfy B = K. See
Eriksson and Persson (2006), Wong and Chan (2008) and Exercise 11.2 for
the pricing of Category ’R’ CBBCs with rebate.
Option type CBBC Behavior Payoff Price Figure

down-and-out (ST − K )+ 1n o B 6 K (11.10) 11.4a
Bull min St > B
(knock-out) 06t6T B > K (11.11) 11.4b
down-and-in (ST − K ) 1n
+ o B 6 K (11.13) 11.7a
min St K (11.14) 11.7b
Barrier call
up-and-out (ST − K ) 1n
+ o B6K 0 N.A.
Max St K (11.5) 11.1
up-and-in (ST − K )+ 1n o B 6 K BSCall 6.4
Max St > B
(knock-in) 06t6T B > K (11.15) 11.8
down-and-out (K − ST )+ 1n o B 6 K (11.12) 11.6
min St > B
(knock-out) 06t6T B>K 0 N.A.
down-and-in (K − ST )+ 1n o B 6 K (11.16) 11.9
min St K BSPut 6.11
Barrier put
up-and-out (K − ST ) 1n
+ o B 6 K (11.8) 11.2a
Bear Max St K (11.9) 11.2b
up-and-in (K − ST ) 1n
+ o B 6 K (11.17) 11.10a
Max St > B
(knock-in) 06t6T B > K (11.18) 11.10b
Table 11.1: Barrier option types.
∗
Download the corresponding R code for the pricing of Bull CBBCs (down-and-out
barrier call options) with B > K.
" 397
N. Privault
We can distinguish between eight different variations on barrier options, ac-

cording to Table 11.1.
In-out parity
We have the following parity relations between the prices of barrier options
and vanilla call and put options:


 Cup-in (t) + Cup-out (t) = e −(T −t)r E∗ [(ST − K )+ | Ft ], (11.1)






−(T −t)r ∗
 down-in (t) + Cdown-out (t) = e E [(ST − K )+ | Ft ], (11.2)

C


−(T −t)r ∗
 Pup-in (t) + Pup-out (t) = e E [(K − ST )+ | Ft ], (11.3)









Pdown-in (t) + Pdown-out (t) = e −(T −t)r E∗ [(K − ST )+ | Ft ], (11.4)

where the price of the European call, resp. put option with strike price K
are obtained from the Black-Scholes formula. Consequently, in the sequel we
will only compute the prices of the up-and-out barrier call and put options
and of the down-and-out barrier call and put options.
Note that all knock-out barrier option prices vanish when M0t > B or mt0 < B,
while the barrier up-and-out call, resp. the down-and-out barrier put option
prices require B > K, resp. B < K, in order not to vanish.
11.2 Knock-Out Barrier Options
Up-and-out barrier call option
Let us consider an up-and-out barrier call option with maturity T , strike

price K, barrier (or call level) B, and payoff
S − K if Max St 6 B,

 T

06t6T

C = (ST − K ) 1+ n o =
Max St B,
06t6T 06t6T
with B > K.
Proposition 11.2. When K 6 B, the price
 
+
 ST −t
e −(T −t)r 1 t E∗  x −K 1n Su o
M0 <B S0

x Max <B
06u6T −t S0 x = St
398 "
of the up-and-out barrier call option with maturity T , strike price K and
barrier level B is given by
h i
e −(T −t)r E∗ (ST − K )+ 1 T Ft (11.5)

M0 <B
(
T −t St T −t St
= St 1 t Φ δ+ − Φ δ+
M0 <B K B
1+2r/σ2 2 )
B T −t B T −t B
− Φ δ+ − Φ δ+
St KSt St
(
T −t St T −t St
− e −(T −t)r K 1 t Φ δ− − Φ δ−
M0 <B K B
1−2r/σ2 2 )
St T −t B T −t B
− Φ δ− − Φ δ−
B KSt St

T −t St
= 1 t Bl(St , r, T − t, σ, K ) − St 1 t Φ δ+
M0 <B M0 <B B
2r/σ2 2 !
B T −t B T −t B
−B Φ δ+ − Φ δ+
St KSt St

S
+ e −(T −t)r K 1 t Φ δ− T −t t
M0 0. (11.6)
σ τ 2
The price of the up-and-out barrier call option is zero when B 6 K.
The following R code implements the up and out pricing formula (11.5).
" 399
N. Privault
dp <- function( T , r, v, s ) { ( log(s) + ( r + v*v/2.0)*T )/v/sqrt(T) }

dm <- function( T , r , v, s ) { ( log(s) + ( r - v*v/2.0)*T )/v/sqrt(T) }
ind<-function(condition) ifelse(condition,1,0)
CBBC <- function(S,K,B,T,r,sig){ S*ind(S<B)*(pnorm(dp(T,r,sig,S/K))
-pnorm(dp(T,r,sig,S/B)) -(B/S)**(1+2*r/sig**2)*(pnorm(dp(T,r,sig,B**2/K/S))
-pnorm(dp(T,r,sig,B/S)))) -K*exp(-r*T)*ind(S<B)*((pnorm(dm(T,r,sig,S/K))
-pnorm(dm(T,r,sig,S/B))) -(S/B)**(1-2*r/sig**2)*(pnorm(dm(T,r,sig,B**2/K/S))
-pnorm(dm(T,r,sig,B/S))))}
CBBC(S=90,K=100,B=120,T=1,r=0.01,sig=0.1)
library(fExoticOptions);StandardBarrierOption("cuo",90,100,120,0,1,0.01,0.01,0.1)
Note that taking B = +∞ in the above identity (11.5) recovers the Black-
Scholes formula

T −t St T −t St
i
e −(T −t)r E∗ [(ST − K )+ | Ft = St Φ δ+ − e −(T −t)r KΦ δ−
K K
for the price of European call options.
The graph of Figure 11.1 represents the up-and-out barrier call option
price given the value St of the underlying asset and the time t ∈ [0, T ] with
T = 220 days.
16
14
12
10
8
6
4
200
2
160 Time in days
0
50 60 120
70 80
Underlying
90
Fig. 11.1: Graph of the up-and-out call option price with B = 80 > K = 65.∗
Proof of Proposition 11.2. We have C = φ ST , M0T with

 (x − K )+ if y < B,

φ(x, y ) = (x − K ) 1{y<B} =
+
0 if y > B,

hence
h i
e −(T −t)r E∗ (ST − K )+ 1 Ft
M0T B x=St
t6r6T St
" + #
ST −t
= e 1 M t <B E
−(T −t)r ∗
x −K 1n Sr o
0 S0 x Max < B x = St
06r6T −t S0
" #
+
= e 1 M t K 1S e σXb0T K} 1{S0 e σx <B} dP X
σy b0T 6 x, W

= fT 6 y
−∞ −∞
w∞ w∞
S0 e σy − K 1{σy>log(K/S0 )} 1{σx<log(B/S0 )} ϕX

= e T (x, y )dxdy
bT ,W
−∞ −∞
w∞ w∞
S0 e σy − K 1{σy>log(K/S0 )} 1{σx<log(B/S0 )} 1{y∨0<x} ϕX

= bT ,We T (x, y )dxdy
−∞ −∞
r w
1 2 σ −1 log (B/S )
0
= 3/2
T π σ−1 log(K/S0 )
w σ−1 log(B/S0 ) 2 2
S0 e σy − K (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy

y∨0
e −µ T /2 2 w σ−1 log(B/S0 )
2 r
2
= (S0 e σy − K ) e µy−y /(2T )
T 3/2 π σ−1 log(K/S0 )
w σ−1 log(B/S0 )
× (2x − y ) e 2x(y−x)/T dxdy,
y∨0
if B > K and B > S0 (otherwise the option price is 0), with µ := r/σ − σ/2
and y ∨ 0 = Max(y, 0). Letting a = y ∨ 0 and b = σ −1 log(B/S0 ), we have
wb wb
(2x − y ) e 2x(y−x)/T dx = (2x − y ) e 2x(y−x)/T dx
a a
T h 2x(y−x)/T ix=b
=− e
2 x=a
" 401
N. Privault
T 2a(y−a)/T
= (e − e 2b(y−b)/T )
2
T
= ( e 2(y∨0)(y−y∨0)/T − e 2b(y−b)/T )
2
T
= (1 − e 2b(y−b)/T ),
2
hence, letting c = σ −1 log(K/S0 ), we have
h i
E∗ (ST − K )+ 1 T
M0 <B
e −µ T /2 w b
2
2
= √ (S0 e σy − K ) e µy−y /(2T ) (1 − e 2b(y−b)/T )dy
2πT c
2 1 w b y (σ +µ)−y2 /(2T )
= S0 e −µ T /2 √ e (1 − e 2b(y−b)/T )dy
2πT c
2 1 w b µy−y2 /(2T )
−K e −µ T /2 √ e (1 − e 2b(y−b)/T )dy
2πT c
2 1 w b y (σ +µ)−y2 /(2T )
= S0 e −µ T /2 √ e dy
2πT c
2 2 1 w b y (σ +µ+2b/T )−y 2 /(2T )
−S0 e −µ T /2−2b /T √ e dy
2πT c
2 1 w b µy−y 2 /(2T )
−K e −µ T /2 √ e dy
2πT c
2 2 1 w b y (µ+2b/T )−y 2 /(2T )
+K e −µ T /2−2b /T √ e dy.
2πT c
Using Relation (10.23), we find
h i
e −rT E∗ (ST − K )+ 1 T
M0 <B
−c + (σ + µ)T −b + (σ + µ)T

2 2
= S0 e −(r +µ /2)T +(σ +µ) T /2 Φ √ −Φ √
T T
2 2 2
−S0 e −(r +µ /2)T −2b /T +(σ +µ+2b/T ) T /2
−c + (σ + µ + 2b/T )T −b + (σ + µ + 2b/T )T

× Φ √ −Φ √
T T
−c + µT −b + µT

−rT
−K e Φ √ −Φ √
T T
2 2 2
+K e −(r +µ /2)T −2b /T +(µ+2b/T ) T /2
−c + (µ + 2b/T )T −b + (µ + 2b/T )T

× Φ √ −Φ √
T T

S0 S0
= S0 Φ δ+ T
− Φ δ+ T
K B
402 "
2
2 2 2 B B
−S0 e −(r +µ /2)T −2b /T +(σ +µ+2b/T ) T /2 Φ δ+
T
− Φ δ+
T
KS0 S0

S0 S0
−K e −rT Φ δ− T
− Φ δ− T
K B
2
2 2 2 B B
+K e −(r +µ /2)T −2b T +(µ+2b/T ) T /2 Φ δ− − Φ δ− ,
KS0 S0
0 6 x 6 B, where δ±
T (s) is defined in (11.6). Given the relations
µ2 b2 T 2b 2 2r
r
σ B
−T r+ −2 + σ+µ+ = 2b + = 1 + 2 log ,
2 T 2 T σ 2 σ S0
and
µ2 b2 T 2b 2 2r

B
−T r+ −2 + µ+ = −rT + 2µb = −rT + −1 + 2 log ,
2 T 2 T σ S0
this yields
h i
e −rT E∗ (ST − K )+ 1 T (11.7)
M0 <B

S0 S0
= S0 Φ δ+ T
− Φ δ+ T
K B

−rT S0 S0
−e K Φ δ− T
− Φ δ−T
K B
2r/σ2 2
B B B
−B Φ δ+ T
− Φ δ+
T
S0 KS0 S0
1−2r/σ2 2
S0 B B
+ e −rT K Φ δ− T
− Φ δ− T
B KS0 S0

S0 S0
= S0 Φ δ+ T
− Φ δ+ T
K B
1+2r/σ2 2
B B B
−S0 Φ δ+ T
− Φ δ+T
S0 KS0 S0

S0 S0
− e −rT K Φ δ− T
− Φ δ−T
K B
1−2r/σ2 2
S0 B B
+ e −rT K Φ δ− T
− Φ δ− T
,
B KS0 S0
and this yields the result of Proposition 11.2, cf. § 7.3.3 pages 304-307 of
Shreve (2004) for a different calculation. This concludes the proof of Propo-
sition 11.2.
" 403
N. Privault
Up-and-out barrier put option
This option is also called a Callable Bear Contract, or Bear CBBC with no
residual value, or turbo warrant with no rebate, in which B denotes the call
level∗ . The price
 
ST −t +

e 1 M t <B E  K − x
−(T −t)r ∗
1n Sr o
S0

0 x Max <B
06r6T −t S0 x=St
of the up-and-out barrier put option with maturity T , strike price K and
barrier level B is given, if B 6 K, by
h i
e −(T −t)r E∗ (K − ST )+ 1 T Ft

M0 <B
1+2r/σ2 !
St B B
= St 1 Φ T −t
δ+ −1− T −t
Φ δ+ −1
M0t <B B St St
1−2r/σ2 !
T −t St St B
− e −(T −t)r K 1 t Φ δ− −1− Φ δ− T −t
−1
M0 K, by
h i
e −(T −t)r E∗ (K − ST )+ 1 Ft
M0T <B
1+2r/σ2 2 !
T −t St B B
= St 1 Φ δ+ −1− T −t
Φ δ+ −1
M0t <B K St KSt
− e −(T −t)r K
1−2r/σ2 2 !
T −t St St B
× 1 Φ δ− −1− T −t
Φ δ− −1
M0t <B K B KSt
∗
Download the corresponding R code for the pricing of Bear CBBCs (up-and-out
barrier put options) with B 6 K.
404 "
1+2r/σ2 2 !
T −t St B B
= St 1 −Φ −δ+ + T −t
Φ −δ+
M0t <B K St KSt
− K e −(T −t)r
1−2r/σ2 2 !
T −t St St B
× 1 −Φ −δ − + Φ −δ T −t
− ,
M0t <B K B KSt
" + #
S
= e −(T −t)r E∗ K − x T −t 1n Sr o
S0 x Max < B x = St
06r6T −t S0
1+2r/σ2 2
T −t St B B
= −St 1 t Φ −δ+ + St 1 t Φ −δ+T −t
M0 <B K M0 <B St KSt
1−2r/σ2 2
T −t St St B
+ K 1 t e −(T −t)r Φ −δ− − K e −(T −t)r Φ −δ− T −t
M0 <B K B KSt
1+2r/σ2 2
B B
= 1 t Blput (St , r, T − t, σ, K ) + St 1 t Φ −δ+ T −t
M0 <B M0 <B St KSt
1−2r/σ2 2
St B
− K 1 t e −(T −t)r Φ −δ− T −t
. (11.9)
M0 B = 80. (b) Case B = 80 > K = 60.
Fig. 11.2: Graphs of the up-and-out put option prices (11.8)-(11.9).
The following Figure 11.3 shows the market pricing data of an up-and-out
barrier put option on BHP Billiton Limited ASX:BHP with B = K = $28
for half a share, priced at 1.79.
" 405
N. Privault
Fig. 11.3: Pricing data for an up-and-out put option with K = B = $28.
The attached R code performs an implied volatility calculation for up-and-

out barrier put option (or Bear CBBC) prices with B < K, based on this
market data set.
Down-and-out barrier call option
Let us now consider a down-and-out barrier call option on the underlying

asset price St with exercise date T , strike price K, barrier level B, and payoff
 ST − K if 06 min St > B,


 t6T
C = (ST − K )+ 1n o=
min St > B 0

 if min St 6 B,
06t6T 06t6T
with 0 6 B 6 K. The down-and-out barrier call option is also called a

Callable Bull Contract, or Bull CBBC with no residual value, or turbo war-
rant with no rebate, in which B denotes the call level.∗ When B 6 K, we
have
 

e E (ST − K ) 1
−(T −t)r ∗  + n
(11.10)

o Ft 
min S > B t
06t6T

St Φ δ T −t St
= St 1 Φ δ T −t
+ − e −(T −t)r K 1 −
mt0 >B K mt0 >B K
∗
Download the corresponding R code for Bull CBBC pricing with B > K.
406 "
2r/σ2
2
B B
−B 1 Φ δ T −t
+
mt0 >B St KSt
1−2r/σ2 2
St B
+ e −(T −t)r K 1 t Φ δ−T −t
m0 >B B KSt
= 1 t Bl(St , r, T − t, σ, K )
m0 >B
2r/σ2
2
B B
−B 1 Φ δ+ T −t
mt0 >B St KSt
1−2r/σ2 2
St B
+ e −(T −t)r K 1 t Φ δ−T −t
m0 >B B KSt
= 1 t Bl(St , r, T − t, σ, K )
m0 >B
2r/σ2
B B K
−St 1 Bl , r, T − t, σ, ,
mt0 >B St St B
0 6 t 6 T . When B > K, we find

 

e−(T −t)r
E ∗
(ST − K ) 1n +
Ft (11.11)
o 
min St > B
06t6T

T −t St T −t St
= St 1 t Φ δ+ − e −(T −t)r K 1 t Φ δ−
m0 >B B m0 >B B
2r/σ2
B B
−B 1 t Φ δ+ T −t
m0 >B St St
1−2r/σ2
St B
+ e −(T −t)r K 1 t Φ δ− T −t
,
m0 >B B St
St > B, 0 6 t 6 T , see Exercise 11.1 below.
60
50
16 40
14 30
12
10 20
8 10
6
4 0
2 200
0 120
90 Time in days 160
80 160
70 Time in days 120
200 70 80 90
Underlying 60 50 60
50 Underlying
(a) Case B = 60 < K = 80. (b) Case K = 40 < B = 60.
Fig. 11.4: Graphs of the down-and-out call option price (11.10)-(11.11).
" 407
N. Privault
In the next Figure 11.5 we plot∗ the down-and-out barrier call option price
(11.11) as a function of volatility with B = 349.2 > K = 346.4, r = 0.03,
T = 99/365, and S0 = 360.
0.20
Bull CBBC Market Price

Bull CBBC Pricing Formula
S0 − Ke−rT
0.18
S0 − B
Bull CBBC Price
0.16
0.14
0.12
0.10
0.0 0.2 0.4 0.6 0.8 1.0

σ
Fig. 11.5: Down-and-out call option price as a function of σ.
We note that with such parameters, the down-and-out barrier call option
price (11.11) is upper bounded by the forward contract price S0 − K e −rT in
the limit as σ tends to zero, and that it decreases to S0 − B in the limit as σ
tends to infinity.
Down-and-out barrier put option
When K > B, the price

 
ST −t + n

e 1 mt >B E
−(T −t)r ∗
K −x 1 o
0 S0 x min Sr /S0 > B
06r6T −t x=St
of the down-and-out barrier put option with maturity T , strike price K and
barrier level B is given by

e −(T −t)r E∗ (K − ST )+ 1 T Ft

m0 >B

T −t St T −t St
= St 1 t Φ δ+ − Φ δ+
m0 >B K B
1+2r/σ2 2 )
B T −t B T −t B
− Φ δ+ − Φ δ+
St KSt St
(
T −t St T −t St
− e −(T −t)r K 1 t Φ δ− − Φ δ−
m0 >B K B
∗
Download the corresponding R code.
408 "
1−2r/σ2 2 )
− Φ δ− − Φ δ−
B KSt St

T −t St T −t St
= St 1 t Φ −δ+ − Φ −δ+
m0 >B B K
1+2r/σ2 2 )
B T −t B T −t B
− Φ δ+ − Φ δ+
St KSt St
(
T −t St T −t St
−e −(T −t)r
K1 t
Φ −δ− − Φ −δ−
m0 >B B K
1−2r/σ2 2 )
− Φ δ− − Φ δ−
B KSt St

T −t St
= 1 t Blput (St , r, T − t, σ, K ) + St 1 t Φ −δ+ (11.12)
m0 >B m0 >B B
2r/σ2 2
B B B
−B 1 t Φ δ+ T −t
− Φ δ+ T −t
m0 >B St KSt St

T −t St
− e −(T −t)r K 1 t Φ −δ−
m0 >B B
1−2r/σ2 2
St B B
+ e −(T −t)r K 1 t Φ δ− T −t
− Φ δ−T −t
,
m0 >B B KSt St
while the corresponding price vanishes when K 6 B.
14
12
10
8
6
4
200
2
160 Time in days
0
50 60 120
70 80
Underlying 90
Fig. 11.6: Graph of the down-and-out put option price (11.12) with K = 80 > B = 65.
Note that although Figures 11.2b and 11.4a, resp. 11.2a and 11.4b, appear
to share some symmetry property, the functions themselves are not exactly
symmetric. Regarding Figures 11.1 and 11.6, the pricing function is actually
the same, but the conditions B < K and B > K play opposite roles.
" 409
N. Privault
11.3 Knock-In Barrier Options
Down-and-in barrier call option
When B 6 K, the price of the down-and-in barrier call option is given from
the down-and-out barrier call option price (11.10) and the down-in-out call
parity relation (11.2) as

e −(T −t)r E∗ (ST − K )+ 1 T Ft (11.13)

m0 B St KSt
1−2r/σ2 2
St B
− e −(T −t)r K 1 t Φ δ−T −t
.
m0 >B B KSt
20
15
1
10
0.8
0.6 5
0.4
0
0.2 160180
0
180 200
90
Time in days
80 200
70 220
Underlying
50 40 30
60 220Time in days 80 70 60
90
50 Underlying
(a) Case K = 80 > B = 65. (b) Case K = 40 K, the price of the down-and-in barrier call option is given from
the down-and-out barrier call option price (11.11) and the down-in-out call
parity relation (11.2) as
h i
e −(T −t)r E∗ (ST − K )+ 1 T Ft (11.14)

mt B B m0 >B B
1+2r/σ2
B B
+1 t St T −t
Φ δ+
m0 >B St St
410 "
1−2r/σ2
St B
− e −(T −t)r K 1 T −t
Φ δ− , 0 6 t 6 T.
mt0 >B B St
Up-and-in barrier call option
When B > K, the price of the up-and-in barrier call option is given from
(11.5) and the up-in-out call parity relation (11.1) as

e −(T −t)r E∗ (ST − K )+ 1 T Ft (11.15)

M0 >B

T −t St
= 1 t Bl(St , r, T − t, σ, K ) + St 1 t Φ δ+
M0 >B M0 <B B
2r/σ2 2 !
B B B
+ B 1 t Φ δ+ T −t
− Φ δ+ T −t
M0 <B St KSt St

T −t St
− e −(T −t)r K 1 t Φ δ−
M0 <B B
1−2r/σ2 2 !
St B B
− e −(T −t)r K Φ δ− T −t
− Φ δ− T −t
.
B KSt St
25
20
15
10
5 180
200
0 Time in days
90
80 70 220
60 50
Underlying
Fig. 11.8: Graph of the up-and-in call option price (11.15) with B = 80 > K = 65.
When B 6 K, the price of the up-and-in barrier call option is given from the
Black-Scholes formula and the up-in-out call parity relation (11.1) as
h i
e −(T −t)r E∗ (ST − K )+ 1 T Ft = Bl(St , r, T − t, σ, K ).

M0 >B
" 411
N. Privault
Down-and-in barrier put option
When B 6 K, the price of the down-and-in barrier put option is given from
(11.12) and the down-in-out put parity relation (11.4) as

e −(T −t)r E∗ (K − ST )+ 1 T Ft (11.16)

mt B B
2r/σ2 2
B B B
+ B 1 t Φ δ+ T −t
− Φ δ+ T −t
m0 >B St KSt St

T −t St
+ e −(T −t)r K 1 t Φ −δ−
m0 >B B
1−2r/σ2 2
S B B
− e −(T −t)r K 1 t
t T −t T −t
Φ δ− − Φ δ− ,
m0 >B B KSt St
0 6 t 6 T.
30
25
20
15
10
5
0
160
50
200 60
Time in days 70
80 Underlying
90
Fig. 11.9: Graph of the down-and-in put option price (11.16) with K = 80 > B = 65.
When B > K, the price of the down-and-in barrier put option is given from
the Black-Scholes put function and the down-in-out put parity relation (11.4)
as

e −(T −t)r E∗ (K − ST )+ 1 T Ft = Blput (St , r, T − t, σ, K ),

mt <B
0 6 t 6 T.
412 "
Up-and-in barrier put option
When B 6 K, the price of the down-and-in barrier put option is given from
(11.8) and the up-in-out put parity relation (11.3) as

e −(T −t)r E∗ (K − ST )+ 1 T Ft (11.17)

M0 >B
= Blput (St , r, T − t, σ, K )
1+2r/σ2 !
B B T −t St
−St 1 t T −t
Φ −δ+ − Φ −δ+
M0 <B St St B
+K e −(T −t)r
1−2r/σ2 !
St B T −t St
×1 T −t
Φ −δ− − Φ −δ− .
M0t B = 70. (b) Case K = 70 K by
h i
e −(T −t)r E∗ (K − ST )+ 1 T Ft (11.18)

M0 >B
= 1 Blput (St , r, T − t, σ, K )
M0t >B
1+2r/σ2
2
B B
−St 1 T −t
Φ −δ+

M0t <B StKSt
1−2r/σ2 2
St B
+K 1 t e −(T −t)r Φ −δ−T −t
.
M0 <B B KSt
" 413
N. Privault
11.4 PDE Method

The up-and-out barrier call option price has been evaluated by probabilistic
arguments in the previous sections. In this section we complement this ap-
proach with the derivation of a Partial Differential Equation (PDE) for this
option price function.
The up-and-out barrier call option price can be written as

h i
e −(T −t)r E∗ (ST − K )+ 1 T Ft

M0 <B
 

= e −(T −t)r
1n oE ∗
(ST − K ) 1n +
o Ft 
Max Sr < B Max Sr < B
06r6t t6r6T
= 1 g (t, St ),
M0t <B
where the function g (t, x) of t and St is given by

 

g (t, x) = e −(T −t)r
E ∗
( ST − K ) 1 n
+ o St = x . (11.19)

Max Sr < B
t6r6T
Next, by the same argument as in the proof of Proposition 6.1 we derive

the Black-Scholes partial differential equation (PDE) satisfied by g (t, x), and
written for the value of a self-financing portfolio.
Proposition 11.3. Let (ηt , ξt )t∈R+ be a portfolio strategy such that
(i) (ηt , ξt )t∈R+ is self-financing,
(ii) the portfolio value Vt := ηt At + ξt St , t > 0, is given as in (11.19) by
Vt = 1 g (t, St ), t > 0.
M0t 0, 0 < x < B, under the boundary condition
g (t, B ) = 0, 0 6 t 6 T,
and ξt is given by
∂g
ξt = (t, St ), t ∈ [0, T ], (11.21)
∂x
414 "
provided that M0t < B.

Proof. By (11.19) the price at time t of the down-and-out barrier call option
discounted to time 0 is given by
e −rt 1 g (t, St )
M0t <B
 

= e −rT
1M t <B E (ST − K ) 1n
∗ +
o Ft 
0 Max Sr 0. Next, applying the Itô formula to

t 7−→ e −rt g (t, St ) “on {M0t 6 B, 0 6 t 6 T }”, we have
d( e −rt g (t, St )) = − r e −rt g (t, St )dt + e −rt dg (t, St )

∂g
∂t
−rt ∂g 1 −rt 2 2 ∂ 2 g
+ r e St (t, St )dt + e σ St 2 (t, St )dt
∂x 2 ∂x
∂g
+ e −rt σSt (t, St )dWt . (11.22)
∂x
In order to derive (11.21) we note that, as in the proof of Proposition 6.1,
the self-financing condition (5.8) implies
d( e −rt Vt ) = −r e −rt Vt dt + e −rt dVt

= −r e −rt Vt dt + ηt e −rt dAt + ξt e −rt dSt
= −r (ηt At + ξt St ) e −rt dt + rηt At e −rt dt + rξt St e −rt dt + σξt St e −rt dWt
= σξt St e −rt dWt , t > 0, (11.23)
and (11.21) follows by identification of (11.22) with (11.23) which shows that
the sum of components in factor of dt have to vanish, hence
∂g ∂g σ2 ∂ 2 g
−rg (t, St ) + (t, St ) + rSt (t, St ) + St2 2 (t, St ) = 0.
∂t ∂x 2 ∂x

" 415
N. Privault
In the next proposition we add a boundary condition to the Black-Scholes

PDE (11.20) in order to hedge the up-and-out barrier call option with ma-
turity T , strike price K, barrier (or call level) B, and payoff
S − K if Max St 6 B,

 T

06t6T

C = (ST − K )+ 1n o=
Max St B,
06t6T 
06t6T
with B > K.
Proposition 11.4. The value Vt = 1M t <B g (t, St ) of the self-financing
0
portfolio hedging the up-and-out barrier call option satisfies the Black-Scholes
PDE

∂g ∂g 1 ∂2g
(t, x) + rx (t, x) + x2 σ 2 2 (t, x), (11.24a)

rg (t, x) =


2



 ∂t ∂x ∂x



g (t, x) = 0,
 x > B, t ∈ [0, T ], (11.24b)





g (T , x) = (x − K )+ 1{x<B} , (11.24c)


on the time-space domain [0, T ] × [0, B ] with terminal condition
g (T , x) = (x − K )+ 1{x<B}
and additional boundary condition
g (t, x) = 0, x > B. (11.25)
Condition (11.25) holds since the price of the claim at time t is 0 whenever
St = B. When K 6 B, the closed-form solution of the PDE (11.24a) under
the boundary conditions (11.24b)-(11.24c) is given from (11.5) in Proposi-
tion 11.2 as
416 "
T −t x T −t x

g (t, x) = x Φ δ+ − Φ δ+ (11.26)
K B
x −1−2r/σ2 2
T −t B T −t B
−x Φ δ+ − Φ δ+
B Kx x
T −t x T −t x

−(T −t)r
−K e Φ δ− − Φ δ−
K B
x 1−2r/σ2 2
−(T −t)r T −t B T −t B
+K e Φ δ− − Φ δ− ,
B Kx x
0 < x 6 B, 0 6 t 6 T ,
see Figure 11.1. We note that the expression (11.26) can be rewritten using
the standard Black-Scholes formula

S S
Bl(S, r, T , σ, K ) = SΦ δ+
T
− K e −rT Φ δ− T
K K
for the price of the European call option, as
T −t x T −t x

g (t, x) = Bl(x, r, T − t, σ, K ) − xΦ δ+ + e −(T −t)r KΦ δ−
B B
2r/σ2 2
B T −t B T −t B
−B Φ δ+ − Φ δ+
x Kx x
x 1−2r/σ2 2
−(T −t)r T −t B T −t B
+e K Φ δ− − Φ δ− ,
B Kx x
0 < x 6 B, 0 6 t 6 T .
Table 11.2 summarizes the boundary conditions satisfied for barrier option
pricing in the Black-Scholes PDE.
" 417
N. Privault
Boundary conditions
Option type CBBC Behavior
Maturity T Barrier B
down-and-out B 6 K (x − K ) + 0
Bull
(knock-out) B>K (x − K )+ 1{x>B} 0
down-and-in B6K 0 Bl(B, r, T − t, σ, K )
(knock-in) B>K (x − K )+ 1{x<B} Bl(B, r, T − t, σ, K )
Barrier call
up-and-out B6K 0 0
(knock-out) B>K (x − K )+ 1{x<B} 0
up-and-in B6K (x − K ) + 0
(knock-in) B>K (x − K )+ 1{x>B} Bl(B, r, T − t, σ, K )
down-and-out B 6 K (K − x)+ 1{x>B} 0
(knock-out) B>K 0 0
down-and-in B6K (K − x)+ 1{x<B} Blp (B, r, T − t, σ, K )
(knock-in) B>K (K − x)+ 0
Barrier put
up-and-out B6K (K − x)+ 1{x<B} 0
Bear
(knock-out) B>K (K − x) + 0
up-and-in B6K (K − x)+ 1{x>B} Blp (B, r, T − t, σ, K )
(knock-in) B>K 0 Blp (B, r, T − t, σ, K )
Table 11.2: Boundary conditions for barrier option prices.
Hedging barrier options
Figure 11.11 represents the value of Delta obtained from (11.21) for the up-
and-out barrier call option in Exercise 11.1-(a).
220
200 90
180 85
80
160 75
t 140 70
65
120 60 St
55
100 50
Fig. 11.11: Delta of the up-and-out barrier call with B = 80 > K = 55.∗
418 "
Down-and-out barrier call option
Similarly, the price g (t, St ) at time t of the down-and-out barrier call option
satisfies the Black-Scholes PDE
1

∂g ∂g ∂2g
 rg (t, x) = (t, x) + rx (t, x) + x2 σ 2 2 (t, x),





 ∂t ∂x 2 ∂x

 g (t, B ) = 0, t ∈ [0, T ],


 g (T , x) = (x − K ) + 1

{x>B} ,

on the time-space domain [0, T ] × [0, B ] with terminal condition g (T , x) =

(x − K )+ 1{x>B} and the additional boundary condition
g (t, x) = 0, x 6 B,
since the price of the claim at time t is 0 whenever St 6 B, see (11.10) and
Figure 11.4a when B 6 K, and (11.11) and Figure 11.4b when B > K.
Exercises
Exercise 11.1 Barrier options.

a) Compute the hedging strategy of the up-and-out barrier call option on the
underlying asset price St with exercise date T , strike price K and barrier
level B, with B > K.
b) Compute the joint probability density function
dP(YT 6 a and WT 6 b)
ϕYT ,WT (a, b) = , a, b ∈ R,
dadb
of standard Brownian motion WT and its minimum
YT = min Wt .
t∈[0,T ]
c) Compute the joint probability density function

b
dP(Y T 6 a and W
fT 6 b)
, a, b ∈ R,
b
ϕ e T (a, b) =
Y T ,W dadb

fT = WT + µT and its minimum
b
Y T = min Wft = min (Wt + µt).
t∈[0,T ] t∈[0,T ]
∗
" 419
N. Privault
d) Compute the price at time t ∈ [0, T ] of the down-and-out barrier call

option on the underlying asset price St with exercise date T , strike price
K, barrier level B, and payoff
S − K if min St > B,

 T

06t6T

C = (ST − K )+ 1n o=
min St > B 0

if min St 6 B,
06t6T 
06t6T
in cases 0 K.
Exercise 11.2 Pricing Category ’R’ CBBC rebates. Given τ > 0, consider
an asset price (St )t∈[τ ,∞) , given by
2 t/2
Sτ +t = Sτ e rt+σWt −σ , t > 0,
where (Wt )t∈R+ is a standard Brownian motion, with r > 0 and σ > 0. In the
sequel, ∆τ is the deterministic length of the Mandatory Call Event (MCE)
valuation period which commences from the time upon which a MCE occurs
up to the end of the following trading session.
h + i
a) Compute the expected rebate (or residual) E min Sτ +s − K Fτ

s∈[0,∆τ ]
of a Category ’R’ CBBC Bull Contract having expired at a given time
τ < T , knowing that Sτ = B > K > 0, with r > 0.
h + i
b) Compute the expected rebate E min Sτ +s − K Fτ of a Cat-

s∈[0,∆τ ]
egory ’R’ CBBC Bull Contract having expired at a given time τ < T ,
knowing that Sτ = B > 0, with r = 0.
c) Find the expression of the probability density function of the first hitting
time
τB = inf{t > 0 : St = B}
of the level B > 0 by the process (St )t∈R+ .
d) Price the CBBC rebate
h + i
e −∆τ E e −τ 1[0,T ] (τ ) min St − K
t∈[τ ,τ +∆τ ]
h h + ii
= e −∆τ
E e −rτ
1[0,T ] (τ )E min St − K Fτ .

t∈[τ ,τ +∆τ ]
Exercise 11.3 Barrier forward contracts. Compute the price at time t of

the following barrier forward contracts on the underlying asset price St with
exercise date T , strike price K, barrier level B, and the following payoffs. In
addition, compute the corresponding hedging strategies.
420 "
a) Up-and-in barrier long forward contract. Take
 ST − K if 0Max

 St > B,
 6t6T
C = (ST − K ) 1n o=
Max St > B 0

 if Max St 6 B.
06t6T 06t6T
b) Up-and-out barrier long forward contract. Take
S − K if Max St < B,

 T

06t6T

C = (ST − K ) 1n o=
Max St B.
06t6T 06t6T
c) Down-and-in barrier long forward contract. Take
 ST − K if 06
min St < B,


 t6T
C = (ST − K ) 1 n o =
min St B.
06t6T 06t6T
d) Down-and-out barrier long forward contract. Take
 ST − K if 06
min St > B,


 t6T
C = (ST − K ) 1n o=
min St > B 0

 if min St 6 B.
06t6T 06t6T
e) Up-and-in barrier short forward contract. Take
K − ST if Max St > B,


06t6T


C = (K − ST ) 1n o=
Max St > B 0

if Max St 6 B.
06t6T 
06t6T
f) Up-and-out barrier short forward contract. Take
 K − ST if 0Max

 St < B,
 6t6T
C = (K − ST ) 1 n o =
Max St B.
06t6T 06t6T
g) Down-and-in barrier short forward contract. Take
" 421
N. Privault
K − ST if min St < B,


06t6T


C = (K − ST ) 1n o=
min St B.
06t6T 06t6T
h) Down-and-out barrier short forward contract. Take
 K − ST if 06min St > B,


 t6T
C = (K − ST ) 1n o=
min St > B 0

 if min St 6 B.
06t6T 06t6T
Exercise 11.4 Compute the Vega of the down-and-out and down-and-in

barrier call option prices, i.e. compute the sensitivity of down-and-out and
down-and-in barrier option prices with respect to the volatility parameter σ.
Exercise 11.5 Stability warrants. Price the up-and-out binary barrier option
with payoff
C := 1{ST >K} 1 = 1
and

M0T K M0T 6B
at time t = 0, with K 6 B.
Exercise 11.6 Check that the function g (t, x) in (11.26) satisfies the bound-
ary conditions
g (t, B ) = 0, t ∈ [0, T ],








 g (T , x) = 0, x 6 K < B,



 g (T , x) = x − K, K 6 x < B,









g (T , x) = 0, x > B.

Exercise 11.7 European knock-in/knock-out barrier options. Price the fol-

lowing vanilla options by computing their conditional discounted expected
payoffs:
a) European knock-out barrier call option with payoff (ST − K )+ 1{ST 6B} ,
b) European knock-in barrier put option with payoff (K − ST )+ 1{ST 6B} ,
c) European knock-in barrier call option with payoff (ST − K )+ 1{ST >B} ,
d) European knock-out barrier put option with payoff (K − ST )+ 1{ST >B} ,
422 "
Chapter 12
Lookback Options
Lookback call (resp. put) options are financial derivatives that allow their
holders to exercise the option by setting the strike price at the minimum
(resp. maximum) of the underlying asset price (St )t∈[0,T ] over the time in-
terval [0, T ]. Lookback options are priced by PDE arguments or by com-
puting the discounted expected values of their claim payoffs C, namely
C = ST − min St in the case of call options, and C = Max St − ST in
06t6T 06t6T
the case of put options.
12.1 The Lookback Put Option . . . . . . . . . . . . . . . . . . . . . . 423

12.2 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426
12.3 The Lookback Call Option . . . . . . . . . . . . . . . . . . . . . . 432
12.4 Delta Hedging for Lookback Options . . . . . . . . . . . . 440
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
12.1 The Lookback Put Option

The standard lookback put option gives its holder the right to sell the un-
derlying asset at its historically highest price. In this case, the floating strike
price is M0T and the payoff is given by the terminal value
C = M0T − ST
of the drawdown process (M0t − St )t∈[0,T ] . The following pricing formula for
lookback put options is a direct consequence of Proposition 10.9.
Proposition 12.1. The price at time t ∈ [0, T ] of the lookback put option
with payoff M0T − ST is given by
" 423
N. Privault
e −(T −t)r E∗ M0T − ST Ft

σ2

St St
= M0t e −(T −t)r Φ −δ− T −t
+ St 1 + Φ δ T −t
+
M0t 2r M0t
2 t 2r/σ2 t
σ M0 T −t M0
−St e −(T −t)r Φ −δ− − St ,
2r St St
T (s) is defined in (11.6).

where δ±
Proof. We have
E∗ M0T − ST Ft = E∗ M0T Ft − E∗ [ST | Ft ]

= E∗ M0T Ft − e (T −t)r St ,

hence Proposition 10.9 shows that

= e −(T −t)r E∗ M0T Ft − e −(T −t)r E∗ [ST | Ft ]

= e −(T −t)r E∗ M0T M0t − St

St St
= M0t e −(T −t)r Φ −δ− T −t
t
T −t
− St Φ −δ+ t
M0 M0
2 2 t 2r/σ2 t
σ T −t St σ −(T −t)r M0 T −t M0
+ St Φ δ+ − St e Φ −δ − .
2r M0t 2r St St

Figure 12.1 represents the lookback put option price as a function of St and
M0t , for different values of the time to maturity T − t.
424 "
T-t = 7.0
100
80
60
40
20
0
80
60
Mt0 40
20
0 40 60 80
0 20 St
Fig. 12.1: Graph of the lookback put option price (3D).∗
From Figures 12.1 and 12.2, we note the following.

i) When the underlying asset price St is close to M0t , an increase in the
value St results into a higher put option price, since in this case the
variation of St can increase the value of M0t .
ii) When the underlying asset price St is far from M0t , an increase in St is
less likely to affect the value of M0t when time t is close to maturity T ,
and this results into a lower option price.
T-t = 7.0 T-t = 7.0

100 100
80 80
60 60
40 40
20 20
0 0
80 80
60 60
Mt0 40 Mt0 40
20 20
0 0 40 St 60 80 0 0 40 St 60 80
20 20
(a) Put prices as functions of S. (b) Put prices as functions of M .

Fig. 12.2: Graph of lookback put option prices.
Figures 12.2 and 12.3 show accordingly that, from the Delta hedging strategy
for lookback put options, see Proposition 12.2 below, one should short the
underlying asset when St is far from M0t , and long this asset when St becomes
closer to M0t .
∗
" 425
N. Privault
80 100
80
60
Lookback put price
Lookback put price

60
40
40
20
20
0 0
0 Mt0 = 20 Mt0 = 40 Mt0 = 60 Mt0 = 80 0 St = 20 St = 40 St = 60 St = 80
x=St y=M0t
(a) Lookback put prices for fixed M0t . (b) Lookback put prices for fixed St .
Fig. 12.3: Graph of lookback put option prices (2D).
12.2 PDE Method
Since the couple (St , M0t ) is a Markov process, the price of the lookback put
option at time t ∈ [0, T ] can be written as a function
f t, St , M0t = e −(T −t)r E∗ φ ST , M0T Ft (12.1)

= e −(T −t)r E∗ φ ST , M0T St , M0t

of St and M0t , 0 6 t 6 T .
Black-Scholes PDE for lookback put option prices
In the next proposition we derive the partial differential equation (PDE) for
the pricing function f (t, x, y ) of a self-financing portfolio hedging a lookback
put option. See Exercise 12.5 for the verification of the boundary conditions
(12.3a)-(12.3c).
Proposition 12.2. The function f (t, x, y ) defined by
f (t, x, y ) = e −(T −t)r E∗ M0T − ST St = x, M0T = y , t ∈ [0, T ], x, y > 0,

is C 2 ((0, T ) × (0, ∞)2 ) and satisfies the Black-Scholes PDE
∂f ∂f 1 ∂2f
rf (t, x, y ) = (t, x, y ) + rx (t, x, y ) + x2 σ 2 2 (t, x, y ), (12.2)
∂t ∂x 2 ∂x
0 6 t 6 T , x, y > 0, under the boundary conditions
426 "



f (t, 0, y ) = e −(T −t)r y, 0 6 t 6 T , y > 0, (12.3a)






∂f

(t, x, y )|y =x = 0, 0 6 t 6 T , y > 0, (12.3b)


 ∂y





f (T , x, y ) = y − x,

0 6 x 6 y. (12.3c)
The replicating portfolio of the lookback put option is given by

∂f
t, St , M0t , t ∈ [0, T ]. (12.4)

ξt =
∂x
Proof. The existence of f (t, x, y ) follows from the Markov property, more
precisely, from the time homogeneity of the asset price process (St )t∈R+ the
function f (t, x, y ) satisfies
f (t, x, y ) = e −(T −t)r E∗ φ ST , M0T St = x, M0t = y

S
= e −(T −t)r E∗ φ x T , Max y, MtT

St

S
= e −(T −t)r E∗ φ x T −t , Max y, M0T −t , t ∈ [0, T ].

S0
Applying the change of variable formula to the discounted portfolio value
fe(t, x, y ) := e −rt f (t, x, y ) = e −rT E∗ φ(ST , M0T ) St = x, M0t = y

which is a martingale indexed by t ∈ [0, T ], we have
dfe t, St , M0t = −r e −rt f t, St , M0t dt + e −rt df t, St , M0t

∂f ∂f
= −r e −rt f t, St , M0t dt + e −rt t, St , M0t dt + r e −rt St t, St , M0t dt

∂t ∂x
∂f 1 ∂2f
+ e −rt σSt t, St , M0t dBt + e −rt σ 2 St2 2 t, St , M0t dt

∂x 2 ∂x
∂f
+ e −rt t, St , M0t dM0t , (12.5)

∂y
according to the following extension of the Itô multiplication table 12.1.
• dt dBt dM0t
dt 0 0 0
dBt 0 dt 0
dM0t 0 0 0
Table 12.1: Extended Itô multiplication table.
" 427
N. Privault
Since fe t, St , M0t = e −rT E∗ φ(ST , M0T ) Ft t∈[0,T ] is a martingale

t∈[0,T ]
under P and M0 t∈[0,T ] has finite variation (it is in fact a non-decreasing
t
process), (12.5) yields:
∂ fe
dfe t, St , M0t = σSt t, St , M0t dBt , t ∈ [0, T ], (12.6)

∂x
and the function f (t, x, y ) satisfies the equation
∂f ∂f
t, St , M0t dt + rSt f t, St , M0t dt

∂t ∂x
1 ∂2f ∂f
+ σ 2 St2 2 t, St , M0t dt + t, St , M0t dM0t = rf t, St , M0t dt,(12.7)

2 ∂x ∂y
which implies
∂f ∂f 1 ∂2f
t, St , M0t + rSt t, St , M0t + σ 2 St2 2 t, St , M0t = rf t, St , M0t ,

∂t ∂x 2 ∂x
which is (12.2), and
∂f
t, St , M0t dM0t = 0.

∂y
Indeed, M0t increases only on a set of zero Lebesgue measure (which has no
isolated points), therefore the Lebesgue measure dt and the measure dM0t
are mutually singular, hence by the Lebesgue decomposition theorem, both
components in dt and dM0t should vanish in (12.7) if the sum vanishes, see
also the Cantor function. This implies
∂f
t, St , M0t = 0,

∂y
when dM0t > 0, hence since
{St = M0t } ⇐⇒ dM0t > 0
and
{St < M0t } ⇐⇒ dM0t = 0,
we have
∂f ∂f
(t, St , St ) = (t, x, y )x=St , y =St = 0,
∂y ∂y
since M0t hits St , i.e. M0t = St , only when M0t increases at time t, and this
shows the boundary condition (12.3b).
On the other hand, (12.6) shows that
428 "
wT ∂f
φ(ST , M0T ) = E∗ [φ(ST , M0T )] + σ t, x, M0t |x=S dBt ,

St
0 ∂x t
0 6 t 6 T , which implies (12.4) as in the proof of Propositions 6.1 or 11.3.

In other words, the price of the lookback put option takes the form
f t, St , M0t = e −(T −t)r E∗ M0T − ST Ft ,

where the function f (t, x, y ) is given from Proposition 12.1 as
σ2

f (t, x, y ) = y e −(T −t)r Φ −δ−T −t
(x/y ) + x 1 + T −t
Φ δ+ (x/y )
2r
σ 2 −(T −t)r y 2r/σ2 T −t
−x e Φ −δ− (y/x) − x.
2r x
(12.8)
Remark 12.3. We have
f (t, x, x) = xC (T − t),
with
σ2 σ 2 −rτ

C (τ ) = e −rτ Φ (−δ−
τ
(1)) + 1 + Φ (δ+
τ
(1)) − e Φ (−δ−τ
(1)) − 1
2r 2r
2
r − σ /2 √

σ 2 2
r + σ /2 √

= e −rτ Φ − τ + 1+ Φ τ
σ 2r σ
σ2 r − σ 2 /2 √

− e −rτ Φ − τ − 1, τ > 0,
2r σ
hence
∂f
(t, x, x) = C (T − t), t ∈ [0, T ].
∂x
Scaling property of lookback put option prices
From (12.8) and the following argument we note the scaling property
f (t, x, y ) = e −(T −t)r E∗ M0T − ST St = x, M0t = y

= e −(T −t)r E∗ Max M0t , MtT − ST St = x, M0t = y

t
M0 MtT

ST
= e −(T −t)r xE∗ Max , − S t = x, M t
0 = y
St St St
" 429
N. Privault
y MtT

ST
= e −(T −t)r xE∗ Max , − St = x, M0t = y
x x x

y
= e −(T −t)r xE∗ Max M0t , MtT − ST St = 1, M0t =

x

−(T −t)r ∗ y
= e xE M0 − ST St = 1, M0 =
T t

x
= xf (t, 1, y/x)
= xg (T − t, x/y ),
where we let
g (τ , z ) : =
2
1 −rτ σ2 σ 2 −rτ 1 2r/σ 1

e Φ (−δ−
τ
(z )) + 1 + Φ (δ+
τ
(z )) − e Φ −δ− τ
− 1,
z 2r 2r z z
with the boundary condition


∂g

 (τ , 1) = 0, τ > 0, (12.9a)
 ∂z


g (0, z ) = 1 − 1,


z ∈ (0, 1]. (12.9b)


z
The next Figure 12.4 shows a graph of the function g (τ , z ).
0.8
0.6
0.4
0.2
0
1
0.6 0.8
0.7 0.6
z 0.8 0.4 τ
0.9 0.2
1 0
Fig. 12.4: Graph of the normalized lookback put option price.
Black-Scholes approximation of lookback put option prices
Letting
x x
Blp (x, K, r, σ, τ ) := K e −rτ Φ −δ−
τ τ
− xΦ −δ+
K K
430 "
denote the standard Black-Scholes formula for the price of the European put
option.
Proposition 12.4. The lookback put option price can be rewritten as
e −(T −t)r E∗ M0T − ST Ft = Blp (St , M0t , r, σ, T − t) (12.10)

2 t 2r/σ2 t !
σ St M0 T −t M0
+St Φ δ+ T −t
− e −(T −t)r Φ −δ− .
2r M0t St St
In other words, we have

St
e −(T −t)r E∗ M0T − ST Ft = Blp (St , M0t , r, σ, T − t) + St hp T − t, t

M0
where the function

σ2 σ 2 −rτ −2r/σ2 1

hp (τ , z ) = Φ (δ+
τ
(z )) − e z Φ −δ−
τ
, (12.11)
2r 2r z
depends only on time τ and z = St /M0t . In other words, due to the relation

x x
Blp (x, y, r, σ, τ ) = y e −rτ Φ −δ− τ τ
− xΦ −δ+
y y
= xBlp (1, y/x, r, σ, τ )
for the standard Black-Scholes put option price formula, we observe that
f (t, x, y ) satisfies
y
x
f (t, x, y ) = xBlp 1, , r, σ, T − t + xh T − t, ,
x y
i.e.
x
f (t, x, y ) = xg T − t, ,
y
with
1

g (τ , z ) = Blp 1, , r, σ, τ + hp (τ , z ), (12.12)
z
where the function hp (τ , z ) is a correction term given by (12.11) which is
small when z = x/y or τ become small.
Note that (x, y ) 7−→ xhp (T − t, x/y ) also satisfies the Black-Scholes PDE
(12.2), in particular (τ , z ) 7−→ Blp (1, 1/z, r, σ, τ ) and hp (τ , z ) both satisfy
the PDE
∂hp ∂hp 1 ∂ 2 hp
(τ , z ) = z r + σ 2 (τ , z ) + σ 2 z 2 2 (τ , z ), (12.13)
∂τ ∂z 2 ∂z
" 431
N. Privault
τ ∈ [0, T ], z ∈ [0, 1], under the boundary condition
hp (0, z ) = 0, 0 6 z 6 1.
The next Figure 12.5b illustrates the decomposition (12.12) of the normalized
lookback put option price g (τ , z ) in Figure 12.4 into the Black-Scholes put
price function Blp (1, 1/z, r, σ, τ ) and hp (τ , z ).
1 1
0.8 0.8
0.6 0.6
0.4 0.4
0.2 0.2
0 0
1 1
0.6 0.8 0.6 0.8
0.7 0.6 0.7 0.6
z 0.8 0.4 τ z 0.8 0.4 τ
0.9 0.2 0.9 0.2
1 0 1 0
(a) Black-Scholes put price. (b) Correction term hp (τ , z ).
Fig. 12.5: Normalized Black-Scholes put price and correction term in (12.12).
Note that in Figure 12.5b the condition hp (0, z ) = 0 is not fully respected
as z tends to 1, due to numerical instabilities in the approximation of the
function Φ.
12.3 The Lookback Call Option

The standard Lookback call option gives the right to buy the underlying asset
at its historically lowest price. In this case, the floating strike price is mT0 and
the payoff is
C = ST − mT0 .
The following result gives the price of the lookback call option, cf. e.g. Propo-
sition 9.5.1, page 270 of Dana and Jeanblanc (2007).
Proposition 12.5. The price at time t ∈ [0, T ] of the lookback call option
with payoff ST − mT0 is given by
e −(T −t)r E∗ ST − mT0 Ft

St St
= St Φ δ+ T −t
t − mt0 e −(T −t)r Φ δ−T −t
t
m0 m0
2 t 2r/σ2 t
σ2

σ m0 T −t m0 St
+ e −(T −t)r St Φ δ− − St Φ −δ+T −t
.
2r St St 2r mt0
432 "
Proof. By Proposition 10.10 we have
e −(T −t)r E∗ ST − mT0 Ft = St − e −(T −t)r E∗ mT0 Ft

St St
= St Φ δ+ T −t
t − e −(T −t)r mt0 Φ δ−T −t
t
m0 m0
2 !
S σ 2 mt 2r/σ t
m

St
−(T −t)r t T −t (T −t)r T −t
+e 0
Φ δ− 0
−e Φ −δ+ .
2r St St mt0

Figure 12.6 represents the price of the lookback call option as a function of
mt0 and St for different values of the time to maturity T − t.
T-t = 7.0
80
60
40
20
80
0 60
80 40 St
60 20
40
20 0
mt0 0
Fig. 12.6: Graph of the lookback call option price.∗
From Figures 12.6 and 12.7, we note the following.

i) When the underlying asset price St is far from mt0 , an increase in the
value St clearly results into a higher call option price.
ii) When the underlying asset price St is close to mt0 , a decrease in St could
lead to a decrease in the value of mt0 , however on average this appears
insufficient to increase the average option payoff.
∗
" 433
N. Privault
80 80
60 60
40 40
20 80 20 80
0 60 0 60
St St
80 40 80 40
60 20 60 20
40 40
20 20
mt0 0 0 mt0 0 0
(a) Call prices as functions of S. (b) Call prices as functions of m.

Fig. 12.7: Graph of lookback call option prices.
Figures 12.7 and 12.8 show accordingly that, from the Delta hedging strategy
for lookback call options, see Propositions 12.6 and 12.8, one should long the
underlying asset in order to hedge a lookback call option.
80 80
60 60
Lookback call price
Lookback call price
40 40
20 20
0 0
0 mt0 = 20 mt0 = 40 mt0 = 60 mt0 = 80 0 St = 20 St = 40 St = 60 St = 80
x=St y=m0t
(a) Lookback call prices for fixed mt0 . (b) Lookback call prices for fixed St .
Fig. 12.8: Graphs of lookback call option prices (2D).
Black-Scholes PDE for lookback call option prices
Since the couple (St , mt0 ) is also a Markov process, the price of the lookback
call option at time t ∈ [0, T ] can be written as a function
f t, St , mt0 = e −(T −t)r E∗ φ ST , mT0 Ft

= e −(T −t)r E∗ φ ST , mT0 St , mt0

of St and mt0 , 0 6 t 6 T . By the same argument as in the proof of Proposi-

tion 12.2, we obtain the following result.
Proposition 12.6. The function f (t, x, y ) defined by
f (t, x, y ) = e −(T −t)r E∗ ST − mT0 St = x, mt0 = y , t ∈ [0, T ], x, y > 0,

434 "
is C 2 ((0, T ) × (0, ∞)2 ) and satisfies the Black-Scholes PDE
∂f ∂f 1 ∂2f
rf (t, x, y ) = (t, x, y ) + rx (t, x, y ) + x2 σ 2 2 (t, x, y ),
∂t ∂x 2 ∂x
0 6 t 6 T , x > 0, under the boundary conditions
lim f (t, x, y ) = x, 0 6 t 6 T, x > 0, (12.14a)



 y&0








∂f
(t, x, y )y =x = 0, 0 6 t 6 T, y > 0, (12.14b)


 ∂y






f (T , x, y ) = x − y, 0 < y 6 x, (12.14c)

and the corresponding self-financing hedging strategy is given by

∂f
t, St , mt0 , t ∈ [0, T ], (12.15)

ξt =
∂x
which represents the quantity of the risky asset St to be held at time t in the
hedging portfolio.
In other words, the price of the lookback call option takes the form
f (t, St , mt ) = e −(T −t)r E∗ ST − mT0 Ft ,

where the function f (t, x, y ) is given by

T −t x T −t x
f (t, x, y ) = xΦ δ+ − e −(T −t)r yΦ δ− (12.16)
y y
σ 2
y 2r/σ 2
T −t y T −t x

+ e −(T −t)r x Φ δ− − e (T −t)r Φ −δ+
2r x x y
σ2

−(T −t)r T −t x T −t x
= x−ye Φ δ− −x 1+ Φ −δ+
y 2r y
σ 2 y 2r/σ 2 y
+x e −(T −t)r Φ δ− T −t
.
2r x x
Scaling property of lookback call option prices
We note the scaling property
f (t, x, y ) = e −(T −t)r E∗ ST − mT0 St = x, mt0 = y

" 435
N. Privault
= e −(T −t)r E∗ ST − min mt0 , mTt St = x, mt0 = y

t
m0 mTt

S
= e −(T −t)r xE∗ T − min , St = x, mt0 = y

St St St

S

y mt T
= e −(T −t)r xE∗ T − min , St = x, mt0 = y

x x x

y
= e −(T −t)r xE∗ ST − min mt0 , mTt St = 1, mt0 =

x

−(T −t)r ∗ y
= e xE ST − m0 St = 1, m0 =
T t

x
= xf (t, 1, y/x)
1

= xg T − t, ,
z
where
g (τ , z ) : =
1 −rτ σ2 σ 2 −rτ −2r/σ2 1

1− e Φ ( δ−
τ
(z )) − 1 + Φ (−δ+
τ
(z )) + e z Φ δ−
τ
,
z 2r 2r z
with g (τ , 1) = C (T − t), and

x
f (t, x, y ) = xg T − t,
y
and the boundary condition


∂g

 (τ , 1) = 0, τ > 0, (12.17a)
 ∂z


g (0, z ) = 1 − 1 ,


z > 1. (12.17b)


z
The next Figure 12.9 shows a graph of the function g (τ , z ).
436 "
0.6
0.4
0.2
0
0 50
3 100
2.5 150
t
z 2
1.5 200
1
Fig. 12.9: Normalized lookback call option price.
The next Figure 12.10 represents the path of the underlying asset price used
in Figure 12.9.
Fig. 12.10: Graph of underlying asset prices.
The next Figure 12.11 represents the corresponding underlying asset price
and its running minimum.
100
St
m0 t
90
80
70
60
50
40
30
20
0 50 100 150 200
t
Fig. 12.11: Running minimum of the underlying asset price.
" 437
N. Privault
Next, we represent
the option price as a function of time, together with the
process St − mt0 t∈R .
+
option price path

60 St-m0t
50
40
30
20
10
0
0 50 100 150 200
t
Fig. 12.12: Graph of the lookback call option price.
Black-Scholes approximation of lookback call option prices
Let
S S
Blc (S, K, r, σ, τ ) = SΦ δ+
τ
− K e −rτ Φ δ−
τ
K K
denote the standard Black-Scholes formula for the price of the European call
option.
Proposition 12.7. The lookback call option price can be rewritten as
e −(T −t)r E∗ ST − mT0 Ft = Blc (St , mt0 , r, σ, T − t) (12.18)

2 t 2r/σ2 t !
σ St m0 T −t m0
−St Φ −δ+ T −t
− e −(T −t)r Φ δ− .
2r mt0 St St

St
e −(T −t)r E∗ ST − mT0 Ft := Blc (St , mt0 , r, σ, T − t) + St hc T − t, t

m0
where the correction term

σ2 1

2
hc (τ , z ) = − Φ (−δ+
τ
(z )) − e −rτ z −2r/σ Φ δ−
τ
, (12.19)
2r z
is small when z = St /mt0 becomes large or τ becomes small. In addition,

hp (τ , z ) is linked to hc (τ , z ) by the relation
σ2 2

hc (τ , z ) = hp (τ , z ) − 1 − e −rτ z −2r/σ , τ > 0, z > 0,
2r
438 "
2
where (z, τ ) 7−→ e −rτ z −2r/σ also solves the PDE (12.13). Due to the relation

x x
Blc (x, y, r, σ, τ ) = xΦ δ+τ
− y e −rτ Φ δ−
τ
y y
y
= xBlc 1, , r, σ, τ
x
for the standard Black-Scholes call price formula, recall that from Proposi-
tion 12.7, f (t, x, y ) can be decomposed as
y
x
f (t, x, y ) = xBlc 1, , r, σ, T − t + xhc T − t, ,
x y
where hc (τ , z ) is the function given by (12.19), i.e.

x
f (t, x, y ) = xg T − t, ,
y
with
1

g (τ , z ) = Blc 1, , r, σ, τ + hc (τ , z ), (12.20)
z
where (x, y ) 7−→ xhc (T − t, x/y ) also satisfies the Black-Scholes PDE (12.2),
i.e. (τ , z ) 7−→ Blc (1, 1/z, r, σ, τ ) and hc (τ , z ) both satisfy the PDE (12.13)
under the boundary condition
hc (0, z ) = 0, z > 1.
The next Figures 12.13a and 12.13b show the decomposition of g (t, z ) in
(12.20) and Figures 12.9-12.10 into the sum of the Black-Scholes call price
function Blc (1, 1/z, r, σ, τ ) and h(t, z ).
0.6 0.6
0.4 0.4
0.2 0.2
0 0
0 50 0 50
3 100 3 100
2.5 150
t 2.5 150
t
z 2 z 2
1.5 200 1.5 200
1 1
(a) Black-Scholes call price g (τ , z ). (b) Correction term hc (τ , z ).
Fig. 12.13: Normalized Black-Scholes call price and correction term in (12.20).
We also note that
E∗ M0T − mT0 S0 = x = x − x e −(T −t)r Φ δ−

T −t
(1)

" 439
N. Privault
σ2 σ2

−x 1 + Φ − δ+ T −t
(1) + x e −(T −t)r Φ δ− T −t
(1)

2r 2r
σ2

+x e −(T −t)r Φ − δ−T −t
(1) + x 1 + T −t
Φ δ+ (1)

2r
σ2
−x e −(T −t)r Φ − δ− T −t
(1) − x

2r
σ2

T −t T −t

= x 1+ Φ δ+ (1 ) − Φ − δ+ (1)

2r
2
σ
+x e −(T −t)r −1 Φ δ−T −t
( 1 ) − Φ − δ− T −t
(1) .

2r
12.4 Delta Hedging for Lookback Options

In this section we compute hedging strategies for lookback call and put op-
tions by application of the Delta hedging formula (12.15). See Bermin (1998),
§ 2.6.1, page 29, for another approach to the following result using the Clark-
Ocone formula. Here we use (12.15) instead, cf. Proposition 4.6 of El Khatib
and Privault (2003).
Proposition 12.8. The Delta hedging strategy of the lookback call option is
given by
σ2

T −t St
ξt = 1 − 1 + Φ −δ+ (12.21)
2r t
m0
t 2r/σ2 2 t
m0 σ T −t m0
+ e −(T −t)r − 1 Φ δ− , 0 6 t 6 T.
St 2r St
Proof. By (12.15) and (12.18), we need to differentiate

x
f (t, x, y ) = Blc (x, y, r, σ, T − t) + xhc T − t,
y
with respect to the variable x, where
σ2 1

2
hc (τ , z ) = − Φ (−δ+
τ
(z )) − e −rτ z −2r/σ Φ δ−
τ
2r z
is given by (12.19) First, we note that the relation

∂ x
Blc (x, y, r, σ, τ ) = Φ δ+
τ
∂x y
is known, cf. Propositions 6.4 and 7.14. Next, we have
440 "

∂ x x x ∂hc x
xhc τ , = hc τ , + τ, ,
∂x y y y ∂z y
and
σ2 ∂ 1

∂hc 2 ∂
(τ , z ) = − (Φ (−δ+τ
(z ))) − e −rτ z −2r/σ Φ δ−τ
∂z 2r ∂z ∂z z
σ 2 2r −rτ −1−2r/σ2 1

− e z Φ δ− τ
2r σ 2 z
1 τ

σ
= √ exp − (δ+ (z ))2
2rz 2πτ 2
2 !
1 1 2r 1

2 σ 2
− e −rτ z −2r/σ √ exp − τ
δ− − 2 e −rτ z −1−2r/σ Φ δ−
τ
.
2rz 2πτ 2 z σ z
Next, we note that
1 τ 1 4r2 4r τ √

τ 2 /2
e −(δ− (1/z )) = exp − (δ+ (z ))2 − τ − δ+ (z ) τ
2 2 σ 2 σ
1 4r2 4r 1 2

τ (z ) 2 /2
− ( δ+
= e ) exp − τ − log z + r + σ τ
2 σ2 σ2 2
−2r2 2r 2r2

2
= e −(δ+ (z )) /2 exp
τ
τ + 2 log z + 2 τ + rτ
σ2 σ σ
2 τ 2 /2
= e rτ z 2r/σ e −(δ+ (z )) (12.22)
as in the proof of Proposition 6.4, hence
1

∂hc x 2
τ, = − e −rτ z −1−2r/σ Φ δ−
τ
,
∂z y z
and
∂

x

x
y 2r/σ2 y
xhc τ , = hc τ , − e −rτ Φ δ−
τ
,
∂x y y x x
which concludes the proof.

We note that ξt = 1 > 0 as T tends to infinity, and that at maturity t = T ,
the hedging strategy satisfies
1 if mT0 < ST ,




ξT =
1 σ2 1 σ2

1− 1+ + − 1 = 0 if mT0 = ST .


2 2r 2 2r
" 441
N. Privault
In Figure 12.14 we represent the Delta of the lookback call option, as given
by (12.21).
T-t = 1.56
1
0.8
0.6
0.4
0.2
0
20
40 30 20 10
mt0 60 60 50 40
80 90 80 70 St
Fig. 12.14: Delta of the lookback call option with r = 2% and σ = 0.41.∗
The above scaling procedure can be applied to the Delta of lookback call
options by noting that ξt can be written as

St
ξt = ζ t, t ,
m0
where the function ζ (t, z ) is given by

σ2
T −t T −t
ζ (t, z ) = Φ δ+ (z ) − Φ −δ+ (z ) (12.23)
2r
T −t 1
2
2 σ
+ e −(T −t)r z −2r/σ − 1 Φ δ− ,
2r z
t ∈ [0, T ], z ∈ [0, 1]. The graph of the function ζ (t, x) is given in Figure 12.15.
0.8
0.6
0.4
0.2
0
z
2
1.5 20 10 0
1 60 50 40 30
70 Time to maturity
Fig. 12.15: Rescaled portfolio strategy for the lookback call option.
∗
442 "
Similar calculations using (12.4) can be carried out for other types of look-
back options, such as options on extrema and partial lookback options, cf.
El Khatib (2003). As a consequence of Propositions 12.5 and 12.8, we have
e −(T −t)r E∗ ST − mT0 Ft

T −t St t −(T −t)r T −t St
= St Φ δ+ − m 0 e Φ δ −
mt0 mt0
2r/σ 2
σ 2 mt0 t σ2

T −t m0 St
+ e −(T −t)r St Φ δ− − St Φ −δ+ T −t
2r St St 2r m0t
1−2r/σ2 t !
t −(T −t)r S t T −t m T −t St
= ξt St + m0 e Φ δ− 0
− Φ δ− ,
mt0 St mt0
and the quantity of the riskless asset e rt in the portfolio is given by

1−2r/σ2 t !
St T −t m0 T −t St
ηt = mt0 e −rT Φ δ− − Φ δ− ,
mt0 St mt0
so that the portfolio value Vt at time t satisfies
Vt = ξt St + ηt e rt , t > 0.
Proposition 12.9. The Delta hedging strategy of the lookback put option is
given by
σ2

T −t St
ξt = 1 + Φ δ+ (12.24)
2r M0t
t 2r/σ2 t
σ2

M0 T −t M0
+ e −(T −t)r 1− Φ −δ− − 1, 0 6 t 6 T .
St 2r St
Proof. By (12.15) and (12.10), we need to differentiate

x
f (t, x, y ) = Blp (x, y, r, σ, T − t) + xhp T − t,
y
where
σ2 σ2 2
hp (τ , z ) = Φ (δ+
τ
(z )) − e −rτ z −2r/σ Φ − δ−
τ
(1/z ) ,

2r 2r
and
1 1

τ
δ± (z ) : = √log z + r ± σ 2 τ , z > 0.
σ τ 2
We have
" 443
N. Privault
σ2 0 τ 1

∂hp 2
(τ , z ) = τ
δ+ (z ) ϕ (δ+ (z )) + e −rτ z −1−2r/σ Φ −δ−τ
∂z 2r z
σ2 0 τ 1 1

−rτ −2r/σ 2
+ δ e z ϕ τ
δ−
2rz 2 − z z
1

2
= e −rτ z −1−2r/σ Φ −δ− τ
z
1

σ 2
τ
(z ) − e −rτ z −2r/σ ϕ δ−τ
.

+ √ ϕ δ+
2rz τ z
From the relation

2
T −t 1 T −t 1 T −t 1

T −t
2 T −t T −t
δ+ ( z ) − δ− = δ+ ( z ) + δ− δ+ ( z ) − δ−
z z z
2r
= 2 log z + 2r (T − t),
σ
we have
T −t 1

2
T −t
(z ) = z −2r/σ e −r (T −t) ϕ δ− ,

ϕ δ+
z
hence
1

∂hp 2
(τ , z ) = e −rτ z −1−2r/σ Φ −δ−
τ
.
∂z z
Therefore, knowing that the Black-Scholes put Delta is

T −t x T −t x
−Φ −δ+ = −1 + Φ δ+ ,
y y
see e.g. Proposition 6.7, we have

∂f T −t x x x ∂hp x
(t, x, y ) = −Φ −δ+ + hp T − t, + T − t,
∂x y y y ∂z y

x σ 2
x
T −t T −t
= −Φ −δ+ + Φ δ+
y 2r y
2r/σ2 σ2

−(T −t)r y T −t y

+e 1− Φ −δ− ,
x 2r x
which yields (12.24).

Note that we have ξt = σ 2 /(2r )
> 0 as T tends to infinity. At maturity
t = T , the hedging strategy satisfies
if M0T > ST ,


 −1

ξT =
1 σ2 1 σ2

 + + 1− − 1 = 0 if M0T = ST .


2 4r 2 2r
444 "
In Figure 12.16 we represent the Delta of the lookback put option, as given
by (12.24).
T-t = 200.0000
-1
0
20
Mt0 40 20 10
60 50 40 30
80 80 70 60 St
90
Fig. 12.16: Delta of the lookback put option with r = 2% and σ = 0.25.∗
As a consequence of Propositions 12.1 and 12.9, we have

σ2

St St
= M0t e −(T −t)r Φ −δ− T −t
+ St 1 + Φ δ+ T −t
M0t 2r M0t
2
σ 2 M t 2r/σ t
M
−St e −(T −t)r 0
Φ −δ− T −t 0
− St
2r St St
1−2r/σ2 t !
St St T −t M0
= ξt St + M0t e −(T −t)r Φ −δ− T −t
− Φ −δ − ,
M0t M0t St
and the quantity of the riskless asset e rt in the portfolio is given by

2 t !
St 1−2r/σ

T −t St T −t M0
ηt = M0t e −rT Φ −δ− − Φ −δ −
M0t M0t St
so that the portfolio value Vt at time t satisfies
Vt = ξt St + ηt e rt , t > 0.
Exercises
Exercise 12.1
∗
" 445
N. Privault
a) Give the probability density function of the maximum of drifted Brownian

motion Max (Bt + σt/2).
t∈[0,1]
2 t/2
b) Taking St := e σBt −σ , compute the expected value
h i
2
E min St = E min e σBt −σ t/2
t∈[0,1] t∈[0,1]
h i
= E e −σ Maxt∈[0,1] (Bt +σt/2) .
" + #
2 t/2
c) Compute the “optimal exercise” price E K − S0 min e σBt −σ
t∈[0,1]
of a finite expiration American put option with S0 6 K.

a) Compute the expected value
h i h i
E Max St = E e σ Maxt∈[0,1] (Bt −σt/2) .
t∈[0,1]
" + #
2 t/2
b) Compute the “optimal exercise” price E S0 Max e σBt −σ −K
t∈[0,1]
of a finite expiration American call option with S0 > K.
Exercise 12.3 Consider a risky asset whose price St is given by
dSt = σSt dBt + σ 2 St dt/2,
where (Bt )t∈R+ is a standard Brownian motion.

a) Compute the cumulative distribution function and the probability density
function of the minimum min Bt over the interval [0, T ]?
t∈[0,T ]
b) Compute the price value

2 T /2
e −σ E∗ ST − min St
t∈[0,T ]
of a lookback call option on ST with maturity T .
Exercise 12.4 (Dassios and Lim (2019)) The digital drawdown call option
with qualifying period pays a unit amount when the drawdown period reaches
one unit of time, if this happens before fixed maturity T , but only if the size of
drawdown at this stopping time is larger than a prespecified K. This provides
446 "
an insurance against a prolonged drawdown, if the drawdown amount is large.

Specifically, the digital drawdown call option is priced as
E∗ e −rτ 1{τ 6T } 1{M τ −Sτ >K} ,

0
where M0t := Maxu∈[0,t] Su , Ut := t − Sup{0 6 u 6 t : M0t = Su }, and

τ := inf{t ∈ R+ : Ut = 1}. Write the price of the drawdown option as a
triple integral using the joint probability density function f(τ ,Sτ ,Mτ ) (t, x, y )
of (τ , Sτ , Mτ ) under the risk-neutral probability measure P∗ .
Exercise 12.5
a) Check explicitly that the boundary conditions (12.3a)-(12.3c) are satisfied.
b) Check explicitly that the boundary conditions (12.14a)-(12.14b) are sat-
isfied.
" 447
Chapter 13
Asian Options
Asian options are special cases of average value options, whose claim payoffs
are determined by the difference between the average underlying asset price
over a certain time interval and a strike price K. This chapter covers several
probabilistic and PDE techniques for the pricing and hedging of Asian op-
tions. Due to their dependence on averaged asset prices. Asian options are
less volatile than plain vanilla options whose claim payoffs depend only on
the terminal value of the underlying asset.
13.1 Bounds on Asian Option Prices . . . . . . . . . . . . . . . . . 449

13.2 Pricing by the Hartman-Watson distribution . . . . . 456
13.3 Laplace Transform Method . . . . . . . . . . . . . . . . . . . . . 459
13.4 Moment Matching Approximations . . . . . . . . . . . . . . 460
13.5 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477
13.1 Bounds on Asian Option Prices

Asian options were first traded in Tokyo in 1987, and have become particu-
larly popular in commodities trading.
Arithmetic Asian options
Given an underlying asset price process (St )t∈[0,T ] , the payoff of the Asian
call option on (St )t∈[0,T ] with exercise date T and strike price K is given by
1 wT
+
C= St dt − K .
T 0
Similarly, the payoff of the Asian put option on (St )t∈[0,T ] with exercise date
T and strike price K is
" 449
N. Privault
1 wT
+
C= K− St dt .
T 0
Due to their dependence on averaged asset prices, Asian options are less
volatile than plain vanilla options whose payoffs depend only on the terminal
value of the underlying asset.
As an example, Figure 13.1 presents a graph of Brownian motion and its

moving average process
1wt
Xt := Bs ds, t > 0.
t 0
3
Xt
Bt
2.5
1.5
Bt , X t
1
K
0.5
-0.5
-1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 13.1: Brownian motion Bt and its moving average Xt .∗
Related exotic options include the Asian-American options, or Hawaiian op-

tions, that combine an Asian claim payoff with American style exercise, and
can be priced by variational PDEs, cf. § 8.6.3.2 of Crépey (2013).
An option on average is an option whose payoff has the form
C = φ(ΛT , ST ),
where wT wT
2 u/2
ΛT = S0 e σBu +ru−σ du = Su du, T > 0.
0 0
• For example when φ(y, x) = (y/T − K )+

this yields the Asian call option
with payoff w + +
1 T ΛT
Su du − K = −K , (13.1)
T 0 T
∗
450 "
which is a path-dependent option whose price at time t ∈ [0, T ] is given

by
1 wT
" + #
e −(T −t)r E∗ Ft . (13.2)

Su du − K
T 0
• As another example, when φ(y, x) := e −y this yields the price

h rT i
P (0, T ) = E∗ e − 0 Su du = E∗ e −ΛT

at time 0 of a bond with underlying short-term rate process St .

Using the time homogeneity of the process (St )t∈R+ , the option with payoff
C = φ(ΛT , ST ) can be priced as
wT
e −(T −t)r E∗ [φ(ΛT , ST ) | Ft ] = e −(T −t)r E∗ φ Λt +

Su du, ST Ft
t
wT S ST

u
= e −(T −t)r E∗ φ y + x du, x
t St St y =Λt ,x=St
w T −t S ST −t

−(T −t)r ∗ u
= e E φ y+x du, x . (13.3)
0 S0 S0 y =Λt ,x=St
Using the Markov property of the process (St , Λt )t∈R+ , we can write down
the option price as a function
f (t, St , Λt ) = e −(T −t)r E∗ [φ(ΛT , ST ) | Ft ]

= e −(T −t)r E∗ [φ(ΛT , ST ) | St , Λt ]
of (t, St , Λt ), where the function f (t, x, y ) is given by

w T −t S ST −t

u
f (t, x, y ) = e −(T −t)r E∗ φ y + x du, x .
0 S0 S0
As we will see below there exists no easily tractable closed-form solution for
the price of an arithmetically averaged Asian option.
Geometric Asian options
On the other hand, replacing the arithmetic average
1 wT
n
1 X
Stk (tk − tk−1 ) ' Su du
T T 0
k =1
with the geometric average
" 451
N. Privault
n n
!
Y (t −tk−1 )/T Y (t −tk−1 )/T
Stkk = exp log Stkk
k =1 k =1
n
!
1 X t −t
= exp log Stkk k−1
T
k =1
n
!
1 X
= exp (tk − tk−1 ) log Stk
T
k =1
w
1 T

' exp log Su du
T 0
leads to closed-form solutions using the Black Scholes formula, see Exer-
cise 13.5.
Pricing by probability density functions
We note that the prices of option on averages can be estimated numerically

using the joint probability density function ψΛT −t ,BT −t of (ΛT −t , BT −t ), as
follows:
w T −t S ST −t

u
f (t, x, y ) = e −(T −t)r E∗ φ y + x du, x
0 S0 S0
w w
−(T −t)r ∞ ∞

σu+(T −t)r−(T −t)σ 2 /2
e φ y + xz, x e ψΛT −t ,BT −t (z, u)dzdu,
0 −∞
see Section 13.2 for details.
Bounds on Asian option prices
We note (see Lemma 1 of Kemna and Vorst (1990) and Exercise 13.7 below
for the discrete-time version of that result), that the Asian call option price
can be upper bounded by the corresponding European call option price using
convexity arguments.
Proposition 13.1. Assume that r > 0, and let φ be a convex and non-
decreasing payoff function. We have the bound
w
1 T

e −rT E∗ φ Su du − K 6 e −rT E∗ [φ(ST − K )].
T 0
Proof. By Jensen’s inequality for the uniform measure with probability den-
sity function (1/T )1[0,T ] on [0, T ] and for the probability measure P∗ , we
have
w w
T du T du
e −rT E∗ φ Su −K = e −rT E∗ φ (Su − K )
0 T 0 T
452 "
w
T du
6 e −rT E∗ φ(Su − K )
0 T
w
T du
= e −rT
E ∗
φ e −(T −u)r E∗ [ST | Fu ] − K
0 T
w
T du
e −rT E∗ φ E∗ [ e −(T −u)r ST − K | Fu ]

=
0 T
w
−rT ∗ T ∗ −(T −u)r
du
6 e E E φ e ST − K Fu (13.4)
0 T
w du
−rT T ∗
∗
6 e E E φ(ST − K ) Fu (13.5)
0 T
wT du
−rT ∗
= e E [φ(ST − K )]
0 T
−rT ∗
= e E [φ(ST − K )],
where from (13.4) to (13.5) we used the facts that r > 0 and φ is non-
decreasing.
In particular, taking φ(x) : (x − K )+ , Proposition 13.1 shows that Asian
option prices are upper bounded by European call option prices, as
1 wT
" + #
e −rT E∗ Su du − K 6 e −rT E∗ [(ST − K )+ ],
T 0
see Figure 13.2 for an illustration, as the averaging feature of Asian options
reduces their underlying volatility.
nSim=99999;N=1000; t <- 1:N; dt <- 1.0/N; sigma=2;r=0.5; european=0;asian=0;K=1.5

dev.new(width=16,height=7); par(oma=c(0,5,0,0))
for (j in 1:nSim){S<-exp(sigma*cumsum(rnorm( N,
0,sqrt(dt)))+r*t/N-sigma**2*t/2/N);color="blue"
A<-sum(c(1,S))/(N+1);if (S[N]>=K) {european=european+S[N]-K}
if (A>=K) {asian=asian+A-K};if (S[N]>A) {color="darkred"} else {color="darkgreen"}
plot(c(0,t/N),c(1,S), xlab = "Time", type='l', lwd = 3, ylab = "", ylim = c(0,exp(4*r)), col =
color,main=paste("Asian Price=",format(round(asian,2)),"/",
j,"=",format(round(asian/j,2)),"European Price=",format(round(european,2)),
"/",j,"=",format(round(european/j,2))), xaxs='i',xaxt='n',yaxt='n', yaxs='i', yaxp =
c(0,10,10), cex.lab=2, cex.main=2)
text(0.3,6,paste("A-Payoff=",format(round(max(A-K,0),2)),", E-Payoff=",
format(round(max(S[N]-K,0),2))), col=color,cex=2)
axis(1, las=1, cex.axis=2)
axis(2, at=c(0,K,A,1,2,3,4,5,6,7,8,9,10), labels=c(0,"K","Average",1,2,3,4,5,6,7,8,9,10), las=2,
cex.axis=2)
lines(c(0,t/N),rep(K,N+1),col = "red",lty = 1, lwd = 4);
lines(c(0,t/N),rep(A,N+1),col = "darkgreen",lty = 2, lwd = 4); Sys.sleep(0.1)
if (S[N]>K || A>K) {readline(prompt = "Pause. Press <Enter> to continue...")}}
" 453
N. Privault
Asian Price= 0.16 / 8 = 0.02 European Price= 0 / 8 = 0
6 A−Payoff= 0 , E−Payoff= 0
2
K
1
0
0.0 0.2 0.4 0.6 0.8 1.0
Time
Fig. 13.2: Asian option price vs European option price.∗
In the case of Asian call options we have the following result.

Proposition 13.2. We have the conditional bound
1 wT
" + #
e −(T −t)r E∗ (13.6)

Su du − K Ft
T 0
1 wt
" + #
T −t
6 e −(T −t)r E∗

Su du + ST − K Ft
T 0 T
on Asian option prices, t ∈ [0, T ].

Proof. Let the function f (t, x, y ) be defined as
1 wT
" + #
∗
f (t, St , Λt ) = E Ft ,

Su du − K
T 0
i.e., from Proposition 13.1,

w T −t S
" + #
1

u
f (t, x, y ) = E∗ y+x du − K
T 0 S0
" + #
1

x
= E∗ y+ ΛT −t − K
T S0
" + #
∗ y x
=E −K + ΛT −t
T T S0
∗
454 "
" + #
(T − t)x ∗ yS0 KT S0 Λ
= E − + T −t
T S0 (T − t)x (T − t)x T − t
" + #
(T − t)x ∗ yS0 KT S0
6 E − + ST −t
T S0 (T − t)x (T − t)x
(T − t)xST −t +
" #
y
= E∗ −K + , x, y > 0,
T T S0

See also Proposition 3.2-(ii) of Geman and Yor (1993) for lower bounds when
r takes negative values. We also have the following bound which yields the
behavior of Asian call option prices in large time.
Proposition 13.3. The Asian call option price satisfies the bound
1 wT −(T −t)r w t
" + #
Ft 6 e 1 − e −(T −t)r
e −(T −t)r E∗ ,

Su du − K Su du + St
T 0 T 0 rT
t ∈ [0, T ], and tends to zero (almost surely) as time to maturity T tends to

infinity:
1 wT
" + #!
lim e −(T −t)r E∗ = 0, t > 0.

Su du − K Ft
T →∞ T 0
Proof. We have the bound
1 wT
" + #
0 6 e −(T −t)r E∗

Su du − K Ft
T 0
w
1 T
6 e −(T −t)r E∗ Su du Ft

T 0
w w
1 t 1 T
= e −(T −t)r E∗ Su du Ft + e −(T −t)r E∗ Su du Ft

T 0 T t
1 w t ∗ 1 wT
e −(T −t)r E Su | Ft du + e −(T −t)r E∗ Su | Ft du

=
T 0 T t
1 wt 1 wT
= e −(T −t)r Su du + e −(T −t)r e (u−t)r St du
T 0 T t
1 −(T −t)r t w w
St T −(T −u)r
= e Su du + e du
T 0 T t
1 −(T −t)r t w 1− e − ( T −t ) r
= e Su du + St .
T 0 rT

" 455
N. Privault
Note that as T tends to infinity the Black-Scholes European call price tends
to St , i.e., we have
lim e −(T −t)r E∗ [(ST − K )+ | Ft ] = St , t > 0,

T →∞
see Exercise 6.4-aiii).
13.2 Pricing by the Hartman-Watson distribution

First, we note that the numerical computation of Asian call option prices can
be done using the probability density function of
wT
ΛT = St dt.
0
In Yor (1992), Proposition 2, the joint probability density function of

w
t σB −pσ 2 s/2
( Λ t , Bt ) = e s ds, Bt − pσt/2 , t > 0,
0
has been computed in the case σ = 2, cf. also Dufresne (2001) and Matsumoto
and Yor (2005). In the next proposition, we restate this result for an arbitrary
variance parameter σ after rescaling. Let θ (v, τ ) denote the function defined
as
v e π /(2τ ) w ∞ −ξ2 /(2τ ) −v cosh ξ

2
θ (v, τ ) = √ e e sinh(ξ ) sin (πξ/τ ) dξ, v, τ > 0.

2π 3 τ 0
(13.7)
Proposition 13.4. For all t > 0 we have
w
t σB −pσ 2 s/2 σt
P e s ds ∈ dy, Bt − p ∈ dz
0 2
!
1 + e σz 4 e σz/2 σ 2 t

σ −pσz/2−p2 σ2 t/8 dy
= e exp −2 θ , dz,
2 σ2 y σ2 y 4 y
y > 0, z ∈ R.
The expression of this probability density function can then be used for the
pricing of options on average such as (13.3), as
w T −t S ST −t

v
f (t, x, y ) = e −(T −t)r E∗ φ y + x dv, x
0 S0 S0
= e −(T −t)r
w∞ 2
w T −t S
v
× φ y + xz, x e σu+(T −t)r−(T −t)σ /2 P dv ∈ dz, BT −t ∈ du
0 0 S0
456 "
σ −(T −t)r +(T −t)p2 σ2 /8 w ∞ w ∞ 2

= e φ y + xz, x e σu+(T −t)r−(T −t)(1+p)σ /2
2 0 −∞
! !
2 2
1 + e σu−(T −t)pσ /2 p 4 e σu/2−(T −t)pσ /4 (T − t)σ 2 dz
× exp −2 − σu θ , du
σ2 z 2 σ2 z 4 z
w w
−(T −t)r−(T −t)p2 σ 2 /8 ∞ ∞

2 (T −t)r−(T −t)σ 2 /2
= e φ y + x/z, xv e
0 0
1+v 2 4vz (T − t)σ 2

dz
×v −1−p exp −2z θ , dv ,
σ2 σ2 4 z
which actually stands as a triple integral due to the definition (13.7) of θ (v, τ ).
Note that here the order of integration between du and dz cannot be ex-
changed without particular precautions, at the risk of wrong computations.
By repeating the argument of (13.3) for φ(x, y ) := (x − K )+ , the Asian call

option can be priced as
1 wT
" + #
e −(T −t)r E∗

Su du − K Ft
T 0
w
" + #
1

−(T −t)r ∗ T
= e E Λt +

Su du − K Ft
T t
wT S
" #
+
1

u
= e −(T −t)r E∗ y+x du − K Ft
T t St
x = St , y = Λ t
w T −t S
" #
+
1

−(T −t)r ∗ u
= e E y+x du − K .
T 0 S0
x=St , y =Λt
Hence the Asian call option can be priced as
1 wT
" + #
f (t, St , Λt ) = e −(T −t)r E∗ Ft ,

Su du − K
T 0
where the function f (t, x, y ) is given by
w T −t S
" + #
1

−(T −t)r ∗ u
f (t, x, y ) = e E y+x du − K
T 0 S0
" + #
1

x
= e −(T −t)r E∗ y+ ΛT −t − K , x, y > 0. (13.8)
T S0
From Proposition 13.4, we deduce the marginal probability density function

of ΛT , also called the Hartman-Watson distribution see e.g. Barrieu et al.
(2004).
" 457
N. Privault
Proposition 13.5. The probability density function of

wT 2 t/2
ΛT : = e σBt −pσ dt,
0
is given by
w
T σB −pσ 2 t/2
P e t dt ∈ du
0
σ p2 σ2 T /8 w ∞
2
! 2
!
1 + e σv−pσ T /2 p 4 e σv/2−pσ T /4 σ 2 T
= e exp −2 − σv θ , dvdu
2u −∞ σ2 u 2 σ2 u 4
2 2
w∞
1 + v2

4v σ 2 T

du
= e −p σ T /8 v −1−p exp −2 2 θ , dv ,
0 σ u σ2 u 4 u
u > 0.
From Proposition 13.5, we get
w
T
P(ΛT /S0 ∈ du) = P St dt ∈ du (13.9)
0
2 2
w ∞ −1−p

1+v 2
4v σ T
2
du
= e −p σ T /8 v exp −2 2 θ , dv ,
0 σ u σ2 u 4 u
2
where St = S0 e σBt −pσ t/2 and p = 1 − 2r/σ 2 . By (13.8), this probability
density function can then be used for the pricing of Asian options, as
" + #
1

−(T −t)r ∗ x
f (t, x, y ) = e E y+ ΛT −t − K (13.10)
T S0
w ∞ y + xz
+
= e −(T −t)r −K P(ΛT −t /S0 ∈ dz )
0 T
σ 2 2
w ∞ w ∞ y + xz +
= e −(T −t)r e −(T −t)p σ /8 −K
2 0 0 T
1 + 2 4v σ2

v dz
×v −1−p exp −2 2 θ , (T − t) dv
σ z 2
σ z 4 z
1 −(T −t)r−(T −t)p2 σ2 /8 w ∞ w∞
= e (xz + y − KT )
T 0∨(KT −y )/x 0
1+v 2 4v 2

σ dz
× exp −2 2 θ , (T − t) dv
σ z σ2 z 4 z
4x 2 2
w ∞ w ∞

1 (KT − y )σ 2
+
= 2 e −(T −t)r−(T −t)p σ /8 −
σ T 0 0 z 4x
1 + 2 2

v σ dz
×v −1−p exp −z θ vz, (T − t) dv ,
2 4 z
458 "
cf. Theorem in § 5 of Carr and Schröder (2004), which is actually a triple

integral due to the definition (13.7) of θ (v, t). Note that since the integrals
are not absolutely convergent, here the order of integration between dv and
dz cannot be exchanged without particular precautions, at the risk of wrong
computations.
13.3 Laplace Transform Method

The time Laplace transform of the rescaled option price
1wt
" + #
C ( t ) : = E∗ Su du − K , t > 0,
t 0
as
r K/2 √ √
w∞ e −x x−2+(p+ 2λ+p2 )/2 (1 − 2Kx)2+( 2λ+p2 −p)/2 dx
−λt
e C (t)dt = 0
,
λ(λ − 2 + 2p)Γ − 1 + p + 2λ + p2 /2
p
0
with here σ := 2, and Γ(z ) denotes the gamma function, see Relation (3.10) in
Geman and Yor (1993). This expression can be used for pricing by numerical
inversion of the Laplace transform using e.g. the Widder method, the Gaver-
Stehfest method, the Durbin-Crump method, or the Papoulis method. The
following Figure 13.3 represents Asian call option prices computed by the
Geman and Yor (1993) method.
30
25
20
15
10
5
0
95
Underlying 90
85 350
250 300
150 200
80 50 100
0 Time in months
Fig. 13.3: Graph of Asian call option prices with σ = 1, r = 0.1 and K = 90.
We refer to e.g. Carr and Schröder (2004), Dufresne (2000), and references
therein for more results on Asian option pricing using the probability density
function of the averaged geometric Brownian motion.
" 459
N. Privault
Figure 9.6 presents a graph of implied volatility surface for Asian options on
light sweet crude oil futures.
13.4 Moment Matching Approximations
Other numerical approaches to the pricing of Asian options include Levy

(1992), Turnbull and Wakeman (1992) which rely on approximations of the
average price distribution based on the lognormal distribution. The lognormal
distribution has the probability density function
1 2 2 dx
g (x) = √ e −(µ−log x) /(2η ) , x > 0,
η 2π x
where µ ∈ R, η > 0, with moments

2 /2 2
E [ X ] = e µ+η and E X 2 = e 2µ+2η . (13.11)

The approximation is implemented by matching the above first two moments

to those of time integral
wT
ΛT : = St dt
0
of geometric Brownian motion
2 /2)t
St = S0 e σBt +(r−σ , 0 6 t 6 T,
as computed in the next proposition, cf. also (7) and (8) page 480 of Levy
(1992).
Proposition 13.6. We have
e rT − 1
E∗ [ΛT ] = S0 ,
r
and 2
r e (σ +2r )T − (σ 2 + 2r ) e rT + (σ 2 + r )
E∗ (ΛT )2 = 2S02 .

(σ 2 + r )(σ 2 + 2r )r
Proof. The computation of the first moment is straightforward: we have
hw T i
E∗ Λ T = E∗

Su du
0
wT
= E∗ [Su ]du
0
wT
= S0 e ru du
0
460 "
e rT − 1
= S0 .
r
For the second moment we have, letting p := 1 − 2r/σ 2 ,
2 wT wT 2 2
E∗ Λ T = S02 e −pσ a/2−pσ b/2 E∗ e σBa e σBb dbda

0 0
wT wa 2 2 2 2
= 2S02 e −pσ a/2−pσ b/2 e (a+b)σ /2 e bσ dbda
0 0
wT 2
wa 2
= 2S02 e −(p−1)σ a/2 e −(p−3)σ b/2 dbda
0 0
4S02 wT 2 2
= e −(p−1)σ a/2 (1 − e −(p−3)σ a/2 )da
(p − 3)σ 2 0
4S02 wT 2 4S02 wT 2 2
= e −(p−1)σ a/2 da − e −(p−1)σ a/2 e −(p−3)σ a/2 da
(p − 3)σ 02 (p − 3)σ 0 2
8S02 2 4S02 wT 2
= (1 − e −(p−1)σ T /2 ) − e −(2p−4)σ a/2 da
(p − 3)(p − 1)σ 4 (p − 3)σ 2 0
8S02 2 4S02 2
= (1 − e −(p−1)σ T /2 ) − (1 − e −(p−2)σ T )
(p − 3)(p − 1)σ 4 (p − 3)(p − 2)σ 4
2 +2r )T
r e (σ − (σ 2 + 2r ) e rT + (σ 2 + r )
= 2S02 ,
(σ 2 + r )(σ 2 + 2r )r
since r − σ 2 /2 = −pσ 2 /2.

By matching the first and second moments
2 2
E[ΛT ] ' e µ̂T +η̂T T /2 and E Λ2T ' e 2(µ̂T +η̂T T )

of the lognormal distribution with the moments of Proposition 13.6 we esti-

mate µbT and ηbT as
!
1 E Λ2T 1 1
ηbT = log
2
and µbT = log E∗ [ΛT ] − ηbT2 .
T (E∗ [ΛT ])2 T 2
Under this approximation, the probability density function ϕΛT of ΛT =

rT
0 St dt is approximated by the lognormal probability density function
1 bT − log x)2
(µ

ϕΛT (x ) ≈ exp − , x > 0.
xσt,T 2(T − t)π 2(T − t)ηbT
2
p
" 461
N. Privault
2.5
Exact expression
2
Probability density
1.5
0.5
0
0 0.5 1 1.5 2 2.5 3
x
Fig. 13.4: Lognormal approximation for the probability density function of ΛT .

As a consequence of Lemma 7.8 we find the approximation
1 wT w∞x
" + # +
−rT ∗
e E St dt − K = e −rT −K ϕΛT (x)dx
T 0 0 T
e −rT w∞x +
bT − log x)2 dx
(µ

' −K exp −
σt,T 2(T − t)π 0 2(T − t)ηbT2
p
T x
1 (b η 2 /2)T
= e µ+b Φ(d1 ) − KΦ(d2 ), (13.12)
T
where
√
log(E∗ [ΛT ]/(KT )) T bT + ηb2 T − log(KT )
µ
d1 = √ + ηb = √
ηb T 2 ηb T
and √
√ log(E∗ [ΛT ]/(KT )) T
d2 = d1 − ηb T = √ − ηb .
ηb T 2
The next Figure 13.5 compares the lognormal approximation to a Monte
Carlo estimate of Asian call option prices with σ = 0.5, r = 0.05 and K/St =
1.1.
462 "
1
0.9 Monte Carlo estimate
Stratified lognormal approximation
Asian option price 0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
2 4 6 8 10
Time t
Fig. 13.5: Lognormal approximation to the Asian call option price.
Figure 13.5 also includes the stratified approximation
1 wT
" + #
e −rT E St dt − K (13.13)
T 0
w ∞ hx + i
= e −rT E −K ST = y ϕΛT |ST =y (x)dP(ST 6 y )dx

0 T
e −rT w ∞ −p(y/x)σ2 (y/x)T /2+σ2 (y/x)T /2
e Φ(d+ (K, y, x)) − KT Φ(d− (K, y, x))

'
T 0
× dP(ST 6 y )dx,
cf. Privault and Yu (2016), where

√
1 2x(bT (y/x) − (1 + y/x)aT (y/x)) σ (y/x) T

d± (K, y, x) := √ log ±
2σ (y/x) T σ2 K 2 T 2 2
and
1 2

bT (z )

σ 2
( z ) : = log − 1 − z ,


T σ 2 aT (z ) aT (z )







1 log z 1√ 2 log z 1√ 2


aT (z ) := 2 Φ √ + σ T −Φ √ − σ T ,

 σ p(z ) σ2 T 2 σ2 T 2



1 log z √ log z √


Φ √ + σ2 T − Φ √ ,

 bT ( z ) : = 2 − σ2 T


σ q (z ) σ2 T σ2 T
and
1 2 T /2+log z )2 / (2σ 2 T ) 1 2 T +log z )2 / (2σ 2 T )
p(z ) : = √ e −(σ , q (z ) : = √ e −(σ .
2πσ 2 T 2πσ 2 T
" 463
N. Privault
Conditioning on the geometric mean price
Asian options on the arithmetic average

1 wT
St dt
T 0
have been priced by conditioning on the geometric mean price
w w
1 T 1 T 1 wT

G := exp log St dt 6 exp log St dt = St dt
T 0 T 0 T 0
in Curran (1994), as
1 wT
" + #
e −rT E∗ Su du − K
T 0
w 1 wT
" + #
−rT ∞ ∗
= e E G = x dP(G 6 x)

Su du − K
0 T 0
wK 1 wT
" #
+
= e −rT E∗ Su du − K G = x dP(G 6 x)
0 T 0
w 1 wT
" #
+
−rT ∞ ∗
+e E Su du − K G = x dP(G 6 x)

K T 0
= C1 + C2 ,
where
wK 1 wT
" + #
C1 := e −rT E∗ G = x dP(G 6 x),

Su du − K
0 T 0
and
w∞ 1 wT
" + #
−rT ∗
:= e E G = x dP(G 6 x)

C2 Su du − K
K T 0
w∞ w
1 T
= e −rT E∗ Su du − K G = x dP(G 6 x)

K T 0
e −rT w ∞ ∗ w T w∞

= E Su du G = x dP(G 6 x) − K e −rT dP(G 6 x)

T K 0 K
e −rT ∗ w T

= E Su du1{G>K} − K e −rT P(G > K ).
T 0
The term C1 can be estimated by a lognormal approximation given that

G = x. As for C2 , we note that
464 "
1 wT

G = exp log St dt
T 0
w
1 T σ2 t

= exp µt + σBt − dt
T 0 2
σ2 σ wT

T
= exp µ− + Bt dt ,
2 2 T 0
hence
T σ wT
log G = (µ − σ 2 /2) + Bt dt
2 T 0
has the Gaussian distribution N (µ − σ 2 /2)T /2, σ 2 T /3 with mean (µ −

σ /2)T /2, and variance

2
wT w w
" 2 #
T T
E Bt dt =E Bs Bt dsdt
0 0 0
wT wT
= E[Bs Bt ]dsdt
00
wT wt
=2 sdsdt
0 0
wT
= t2 dt
0
T3
= .
3
Hence, we have
P(G > K ) = P(log G > log K )

σ2 σ wT

T
=P µ− + Bt dt > log K
2 2 T 0
w
σ2

T T T
=P Bt dt > − µ− + log K
0 σ 2 2
√
3 σ2

T
=Φ √ µ− − log K .
σ T 2 2
Basket options
Basket options on the portfolio

N
(k )
X
AT : = αk ST
k =1
" 465
N. Privault
have also been priced in Milevsky (1998) by approximating AT by a lognormal

or a reciprocal gamma random variable, see also Deelstra et al. (2004) for
additional conditioning on the geometric average of asset prices.
Asian basket options
Moment matching techniques combined with conditioning have been applied

to Asian basket options in Deelstra et al. (2010). See also Dahl and Benth
(2002) for the pricing of Asian basket options using quasi Monte Carlo sim-
ulation.
13.5 PDE Method
Two variables
The price at time t of the Asian call option with payoff (13.1) can be written
as
1 wT
" + #
f (t, St , Λt ) = e −(T −t)r E∗ Ft , 0 6 t 6 T .

Su du − K
T 0
(13.14)
Next, we derive the Black-Scholes partial differential equation (PDE) for the
value of a self-financing portfolio. Until the end of this chapter we model the
asset price (St )t∈[0,T ] as
dSt = µSt dt + σSt dBt , t > 0, (13.15)
where (Bt )t∈R+ is a standard Brownian motion under the historical proba-
bility measure P.
Proposition 13.7. Let (ηt , ξt )t∈R+ be a self-financing portfolio strategy
whose value Vt := ηt At + ξt St , t > 0, takes the form
Vt = f (t, St , Λt ), t > 0,
where f ∈ C 1,2,1 ((0, T ) × (0, ∞)2 ) is given by (13.14). Then, the function
f (t, x, y ) satisfies the PDE
466 "
∂f ∂f ∂f 1 ∂2f
rf (t, x, y ) = (t, x, y ) + x (t, x, y ) + rx (t, x, y ) + x2 σ 2 2 (t, x, y ),
∂t ∂y ∂x 2 ∂x
(13.16)
0 6 t 6 T , x > 0, under the boundary conditions
 y +
f (t, 0+ , y ) = lim f (t, x, y ) = e −(T −t)r −K , (13.17a)





 x&0 T

+
f (t, x, 0 ) = lim f (t, x, y ) = 0, (13.17b)
 y&0

y +


f (T , x, y ) = −K , (13.17c)


T
0 6 t 6 T , x > 0, y > 0,
and ξt is given by
∂f
(t, St , Λt ),
ξt = 0 6 t 6 T. (13.18)
∂x
Proof. We note that the self-financing condition (5.8) implies

= rηt At dt + µξt St dt + σξt St dBt (13.19)
= rVt dt + (µ − r )ξt St dt + σξt St dBt , t > 0.
Since dΛt = St dt, an application of Itô’s formula to f (t, x, y ) leads to
∂f ∂f
dVt = f (t, St , Λt ) = (t, St , Λt )dt + (t, St , Λt )dΛt
∂t ∂y
∂f 1 2
∂ f ∂f
+µSt (t, St , Λt )dt + St2 σ 2 2 (t, St , Λt )dt + σSt (t, St , Λt )dBt
∂x 2 ∂x ∂x
∂f ∂f
= (t, St , Λt )dt + St (t, St , Λt )dt
∂t ∂y
∂f 1 ∂2f ∂f
+µSt (t, St , Λt )dt + St2 σ 2 2 (t, St , Λt )dt + σSt (t, St , Λt )dBt .
∂x 2 ∂x ∂x
(13.20)
By respective identification of components in dBt and dt in (13.19) and

(13.20), we get
" 467
N. Privault

∂f ∂f ∂f
 rηt At dt + µξt St dt =

 (t, St , Λt )dt + St (t, St , Λt )dt + µSt (t, St , Λt )dt

 ∂t ∂y ∂x
1 ∂2f


+ St2 σ 2 2 (t, St , Λt )dt,

 2 ∂x



 ∂f
 ξt St σdBt = St σ (t, St , Λt )dBt ,


∂x
hence
1 2 2 ∂2f

∂f ∂f
 rVt − rξt St = ∂t (t, St , Λt ) + St ∂y (t, St , Λt )dt + 2 St σ ∂x2 (t, St , Λt ),



 ξt = ∂f (t, St , Λt ),



∂x
i.e.

∂f ∂f ∂f
 rf (t, St , Λt ) = (t, St , Λt ) + St (t, St , Λt ) + rSt (t, St , Λt )



 ∂t ∂y ∂x
1 ∂2f


+ St2 σ 2 2 (t, St , Λt ),

 2 ∂x



 ∂f
(t, St , Λt ).

 ξt =

∂x

Remarks.
i) We have ξT = 0 at maturity from (13.17c) and (13.18), which is consis-
tent with the fact that the Asian option is cash-settled at maturity and,
close to maturity, its payoff (ΛT /T − K )+ becomes less dependent on
the underlying asset price ST .
ii) If Λt /T > K, by Exercise 13.8 we have
1 wT
" + #
f (t, St , Λt ) = e −(T −t)r E∗

Su du − K Ft
T 0
Λt 1 − e −(T −t)r

= e −(T −t)r −K + St , (13.21)
T rT
0 6 t 6 T . In particular, the function

y 1 − e −(T −t)r
f (t, x, y ) = e −(T −t)r −K +x ,
T rT
0 6 t 6 T , x > 0, y > 0, solves the PDE (13.16).
iii) When Λt /T > K, the Delta ξt is given by
468 "
∂f 1 − e −(T −t)r
ξt = (t, St , Λt ) = , 0 6 t 6 T. (13.22)
∂x rT
Next, we examine two methods which allow one to reduce the Asian option
pricing PDE from three variables (t, x, y ) to two variables (t, z ). Reduction
of dimensionality can be of crucial importance when applying discretization
scheme whose complexity are of the form N d where N is the number of
discretization steps and d is the dimension of the problem (curse of dimen-
sionality).
(1) One variable with time-independent coefficients
Following Lamberton and Lapeyre (1996), page 91, we define the auxiliary
process
1 1 wt 1 Λt

Zt : = Su du − K = −K , 0 6 t 6 T.
St T 0 St T
With this notation, the price of the Asian call option at time t becomes
h 1 w T + i
e −(T −t)r E∗ Ft = e −(T −t)r E∗ ST (ZT )+ Ft .

Su du − K

T 0
Lemma 13.8. The price (13.2) at time t of the Asian call option with payoff
(13.1) can be written as
f (t, St , Λt ) = St g (t, Zt ) (13.23)

1 wT
" + #
= e −(T −t)r E∗ Ft , t ∈ [0, T ],

Su du − K
T 0
with the relation

1 y

f (t, x, y ) = xg t, −K , x > 0, y > 0, 0 6 t 6 T,
x T
where
1 w T −t Su
" + #
g (t, z ) = e −(T −t)r E∗ z+ du (13.24)
T 0 S0
" + #
Λ
= e −(T −t)r E∗ z + T −t ,
S0 T
with the boundary condition
g (T , z ) = z + , z ∈ R.
" 469
N. Privault
Proof. For 0 6 s 6 t 6 T , we have

w
1

t St
d(St Zt ) = d Su du − K = dt,
T 0 T
hence wt wt S
u
St Zt = Ss Zs + d(Su Zu ) = Ss Zs + du,
s s T
and therefore
St Zt 1 w t Su
= Zs + du, 0 6 s 6 t 6 T.
Ss T s Ss
Since for any t ∈ [0, T ], St is positive and Ft -measurable, and Su /St is

independent of Ft , u > t, we have:
" + #
ST
e −(T −t)r E∗ ST (ZT )+ Ft = e −(T −t)r St E∗

ZT Ft
St
1 w T Su
" #
+
= e −(T −t)r St E∗ Zt + du Ft
T t St
1 w T Su
" #
+
= e −(T −t)r St E∗ z + du
T t St
z =Zt
w T −t S
" + #
1 u
= e −(T −t)r St E∗ z + du
T 0 S0
z = Zt
" + #
Λ T −t
= e −(T −t)r St E∗ z +
S0 T
z =Zt
= St g (t, Zt ),
which proves (13.24).

When Λt /T > K we have Zt > 0, hence in this case by (13.21) and (13.23)
we find
1 − e −(T −t)r
g (t, Zt ) = e −(T −t)r Zt + , 0 6 t 6 T. (13.25)
rT
Note that as in (13.10), g (t, z ) can be computed from the probability density
function (13.9) of ΛT −t , as
" #
ΛT −t +
g (t, z ) = E∗ z+
S0 T
w∞ u +

Λt

= z+ dP 6u
0 T S0
470 "
2 2
= e −p σ t/8
w∞ u + w ∞ −1−p

1 + v2

4v σ2

du
× z+ v exp −2 θ , (T − t) dv
0 T 0 σ 2 2
σ u 4 u
2 2 t/8
= e −p σ
w∞ u w ∞ −1−p

1 + v2

4v σ2

du
× z+ v exp −2 θ , ( T − t ) dv
(−zT )∨0 T 0 σ2 σ2 u 4 u
2 2
w∞ w∞
1 + v 2 4v σ 2 du
= z e −p σ t/8 v −1−p exp −2 θ , (T − t) dv
(−zT )∨0 0 σ2 σ2 u 4 u
1 −p2 σ2 t/8 ∞w w ∞ −1−p

1+v 2
4v σ 2
+ e v exp −2 θ , (T − t) dvdu.
T (−zT )∨0 0 σ2 σ2 u 4
The next proposition gives a replicating hedging strategy for Asian options.
Proposition 13.9. (Rogers and Shi (1995)). Let (ηt , ξt )t∈R+ be a self-
financing portfolio strategy whose value Vt := ηt At + ξt St , t ∈ [0, T ], is given
by
1 Λt

Vt = St g (t, Zt ) = St g t, −K , 0 6 t 6 T,
St T
where g ∈ C 1,2 ((0, T ) × (0, ∞)) is given by (13.24). Then, the function g (t, z )
satisfies the PDE
1 1 ∂2g

∂g ∂g
(t, z ) + − rz (t, z ) + σ 2 z 2 2 (t, z ) = 0, (13.26)
∂t T ∂z 2 ∂z
0 6 t 6 T , under the terminal condition
g (T , z ) = z + , z ∈ R, (13.27)
and the corresponding replicating portfolio Delta is given by

∂g
(t, Zt ),
ξt = g (t, Zt ) − Zt 0 6 t 6 T. (13.28)
∂z
Proof. By (13.15) and the Itô formula applied to 1/St , we have
1 2 (dSt )2

dSt
d =− +
St (St )2 2 (St )3
1
−µ + σ 2 dt − σdBt ,

=
St
hence
1 Λt

dZt = d −K
St T
" 471
N. Privault
Λt

K
=d −
T St St
1 Λt 1

= d − Kd
T St St
1 dΛt Λt 1

= + −K d
T St T St
1

dt
= + St Zt d
T St
dt
+ Zt −µ + σ 2 dt − Zt σdBt .

=
T
By the self-financing condition (5.8) we have

= rηt At dt + µξt St dt + σξt St dBt , t > 0. (13.29)
Another application of Itô’s formula to f (t, St , Zt ) = St g (t, Zt ) leads to
d(St g (t, Zt )) = g (t, Zt )dSt + St dg (t, Zt ) + dSt • dg (t, Zt )

∂g ∂g
= g (t, Zt )dSt + St (t, Zt )dt + St (t, Zt )dZt
∂t ∂z
1 ∂2g 2
+ St 2 (t, Zt )(dZt ) + dSt • dg (t, Zt )
2 ∂z
∂g
= µSt g (t, Zt )dt + σSt g (t, Zt )dBt + St (t, Zt )dt
∂t
∂g 1 ∂g ∂g
+St Zt −µ + σ 2 (t, Zt )dt + St (t, Zt )dt − σSt Zt (t, Zt )dBt
∂z T ∂z ∂z
1 ∂2g ∂g
+ σ 2 Zt2 St 2 (t, Zt )dt − σ 2 St Zt (t, Zt )dt
2 ∂z ∂z
∂g ∂g 1 ∂g
= µSt g (t, Zt )dt + St (t, Zt )dt + St Zt −µ + σ 2 (t, Zt )dt + St (t, Zt )dt
∂t ∂z T ∂z
1 ∂2g ∂g
+ σ 2 Zt2 St 2 (t, Zt )dt − σ 2 St Zt (t, Zt )dt
2 ∂z ∂z
∂g
+σSt g (t, Zt )dBt − σSt Zt (t, Zt )dBt . (13.30)
∂z
(13.30), we get
472 "
∂g ∂g

 rηt At + µξt St = µSt g (t, Zt ) + St ∂t (t, Zt ) − µSt Zt ∂z (t, Zt )



1 ∂g 1 ∂2g


+ St (t, Zt ) + σ 2 Zt2 St 2 (t, Zt ),


2

T ∂z ∂z





 ξ S σ = σS g (t, Z ) − σS Z ∂g (t, Z ),



t t t t t t t
∂z
hence
1 ∂g 1 2 2 ∂2g

∂g
 rVt − rξt St = St ∂t (t, Zt ) + T St ∂z (t, Zt ) + 2 σ Zt St ∂z 2 (t, Zt ),



 ξt = g (t, Zt ) − Zt ∂g (t, Zt ),



∂z
i.e.
1 1 2 2 ∂2g

∂g ∂g
 ∂t (t, z ) + T − rz ∂z (t, z ) + 2 σ z ∂z 2 (t, z ) = 0,



 ξ = g (t, Z ) − Z ∂g (t, Z ),



t t t t
∂z
under the terminal condition g (T , z ) = z + , z ∈ R, which follows from (13.24).

When Λt /T > K we have Zt > 0 and (13.25) and (13.28) show that
∂g
ξt = g (t, Zt ) − Zt (t, Zt )
∂z
1 − e −(T −t)r
= e −(T −t)r Zt + − e −(T −t)r Zt
rT
1 − e −(T −t)r
= , 0 6 t 6 T,
rT
which recovers (13.22). Similarly, from (13.27) we recover
∂g
ξT = g ( T , Z T ) − Z T (T , ZT ) = ZT 1{ZT >0} − ZT 1{ZT >0} = 0
∂z
at maturity.
We also check that

∂f ∂f
ξt = e −(T −t)r σSt f (t, St , Zt ) − σZt f (t, St , Zt )
∂x ∂z
−(T −t)r ∂g
= e −Zt (t, Zt ) + g (t, Zt )
∂z
" 473
N. Privault
1 wt
!
1

∂g
= e −(T −t)r St t, Su du − K + g (t, Zt )
∂x T 0 x |x=St
w
1 1 t

∂ −(T −t)r
= xe g t, Su du − K , 0 6 t 6 T.
∂x x T 0 |x=St
We also find that the amount invested on the riskless asset is given by
∂g
ηt At = Zt St (t, Zt ).
∂z
Next we note that a PDE with no first order derivative term can be obtained
using time-dependent coefficients.
(2) One variable with time-dependent coefficients
Define now the auxiliary process
1 − e −(T −t)r 1 1 wt

Ut := + e −(T −t)r Su du − K
rT St T 0
1 −(T −t)r −(T −t)r
1− e +e Zt , 0 6 t 6 T ,

=
rT
i.e.
e (T −t)r − 1
Zt = e (T −t)r Ut + , 0 6 t 6 T.
rT
We have
1 −(T −t)r
dUt = − e dt + r e −(T −t)r Zt dt + e −(T −t)r dZt
T
= e −(T −t)r σ 2 Zt dt − e −(T −t)r σZt dBt − (µ − r ) e −(T −t)r Zt dt
= − e −(T −t)r σZt dB bt , t > 0,
where
bt = dBt − σdt + µ−r
dB dt = dB
et − σdt
σ
is a standard Brownian motion under
b = e σBT −σ 2 t/2 ST
dP dP∗ = e −rT dP∗ .
S0
Lemma 13.10. The Asian call option price can be written as
1 wT
" + #
−(T −t)r ∗
St h(t, Ut ) = e E Ft ,

Su du − K
T 0
where the function h(t, y ) is given by

474 "
b (UT )+ Ut = y ,
h(t, y ) = E 0 6 t 6 T. (13.31)

Proof. We have
1 1 wT

UT = Su du − K = ZT ,
ST T 0
and
dP
b |F 2 e −rT S
t
= e (BT −Bt )σ−(T −t)σ /2 = −rt T ,
dP|Ft
∗ e St
hence the price of the Asian call option is
e −(T −t)r E∗ [ST (ZT )+ | Ft ] = e −(T −t)r E∗ [ST (UT )+ | Ft ]

e
−rT
ST
= St E∗ (UT )+ Ft

e St
−rt
dP
" #
b |F
∗ +
= St E t

( UT ) F t
dP∗|Ft
b [(UT )+ | Ft ].
= St E

The next proposition gives a replicating hedging strategy for Asian options.
See § 7.5.3 of Shreve (2004) and references therein for a different derivation
of the PDE (13.32).
Proposition 13.11. (Večeř (2001)). Let (ηt , ξt )t∈R+ be a self-financing port-
folio strategy whose value Vt := ηt At + ξt St , t > 0, is given by
Vt = St h(t, Ut ), t > 0,
where h ∈ C 1,2 ((0, T ) × (0, ∞)) is given by (13.31). Then, the function h(t, z )
satisfies the PDE
!2
∂h σ2 1 − e −(T −t)r ∂2h
(t, y ) + −y (t, y ) = 0, (13.32)
∂t 2 rT ∂y 2
under the terminal condition
h(T , z ) = z + ,
and the corresponding replicating portfolio is given by

∂h
ξt = h(t, Ut ) − Zt (t, Ut ), 0 6 t 6 T.
∂y
" 475
N. Privault
Proof. By the self-financing condition (13.19) we have
dVt = rηt At dt + µξt St dt + σξt St dBt (13.33)

= rVt dt + (µ − r )ξt St dt + σξt St dBt ,
t > 0. By Itô’s formula we get
d(St h(t, Ut )) = h(t, Ut )dSt + St dh(t, Ut ) + dSt • dh(t, Ut )

= µSt h(t, Ut )dt + σSt h(t, Ut )dBt
1 ∂2h

∂h ∂h
+St (t, Ut )dt + (t, Ut )dUt + (t, Ut )(dUt )2
∂t ∂y 2 ∂y 2
∂h
+ (t, Ut )dSt • dUt
∂y
∂h
= µSt h(t, Ut )dt + σSt h(t, Ut )dBt − St (µ − r ) (t, Ut )Zt dt
∂y

∂h ∂h σ 2 ∂2h

+St (t, Ut )dt − σ (t, Ut )Zt dB et + Zt2 2 (t, Ut )dt
∂t ∂y 2 ∂y
2 ∂h
−σ St (t, Ut )Zt dt
∂y
∂h
= µSt h(t, Ut )dt + σSt h(t, Ut )dBt − St (µ − r ) (t, Ut )Zt dt
∂y
σ2 ∂ 2 h

∂h ∂h
+St (t, Ut )dt − σ (t, Ut )Zt (dBt − σdt) + Zt2 2 (t, Ut )dt
∂t ∂y 2 ∂y
2 ∂h
−σ St (t, Ut )Zt dt. (13.34)
∂y

(13.34), we get
∂h ∂h


 rηt At + µξt St = µSt h(t, Ut ) − (µ − r )St Zt (t, Ut )dt + St (t, Ut )


 ∂y ∂t
σ2 ∂2h


+ St Zt2 2 (t, Ut ),


2

∂y






 ∂h
 ξt = h(t, Ut ) − Zt (t, Ut ),


∂y
hence
476 "
∂h σ2 ∂2h

 rη A = −rSt (ξt − h(t, Ut )) + St (t, Ut ) + St Zt2 2 (t, Ut ),
 t t 2

 ∂t ∂y
 ξt = h(t, Ut ) − Zt ∂h (t, Ut ),



∂y
and  !2
 ∂h σ2 1 − e −(T −t)r ∂2h
(t, y ) + −y (t, y ) = 0,


2 ∂y 2

 ∂t

 rT
!
1 − e −(T −t)r

∂h


 ξt = h(t, Ut ) + − Ut (t, Ut ),


 rT ∂y
under the terminal condition
h(T , z ) = z + .

We also find the riskless portfolio allocation
!
(T −t)r 1 − e −(T −t)r ∂h ∂h
η t At = e St Ut − (t, Ut ) = St Zt (t, Ut ).
rT ∂y ∂y
Exercises
Exercise 13.1 Compute the first and second moments of the time integral
wT
St dt for τ ∈ [0, T ), where (St )t∈R+ is the geometric Brownian motion
τ
2 t/2
St := S0 e σBt +rt−σ , t > 0.
Exercise 13.2 Consider the short rate process rt = σBt , where (Bt )t∈R+ is
a standard Brownian motion.
rT
a) Find the probability distribution of the time integral 0 rs ds.
b) Compute the price
wT
" + #
e −rT E∗ ru du − K
0
rT
of a caplet on the forward rate 0 rs ds.
Exercise 13.3 Asian call option with negative strike price. Consider the asset
price process
" 477
N. Privault
2 t/2
St = S0 e rt+σBt −σ , t > 0,
where (Bt )t∈R+ is a standard Brownian motion. Assuming that K 6 0,
compute the price
1 wT
" + #
e −(T −t)r E∗

Su du − K Ft
T 0
of the Asian option at time t ∈ [0, T ].
Exercise 13.4 Consider the Asian forward contract with payoff

wT
Su du − K, (13.35)
0
2
where Su = S0 e σBu +ru−σ u/2 , u > 0, and (Bu )u∈R+ is a standard Brownian
motion under the risk-neutral measure P∗ .
a) Price the Asian forward contract at any time t ∈ [0, T ]. (10 marks)
b) Find the self-financing portfolio strategy (ξt )t∈[0,T ] hedging the Asian for-
ward contract with payoff (13.35), where ξt denotes the quantity invested
at time t ∈ [0, T ] in the risky asset St . (10 marks)
Exercise 13.5 Compute the price

" w + #
1 T

−(T −t)r ∗
e E exp log Su du − K Ft , 0 6 t 6 T.

T 0
at time t of the geometric Asian option with maturity T , where St =

2
S0 e rt+σBt −σ t/2 , t ∈ [0, T ].
Hint: When X ' N (0, v 2 ) we have

2 /2
E∗ [( e m+X − K )+ ] = e m+v Φ(v + (m − log K )/v ) − KΦ((m − log K )/v ).
Exercise 13.6 Consider a CIR process (rt )t∈R+ given by

√
drt = −λ(rt − m)dt + σ rt dBt , (13.36)
where (Bt )t∈R+ is a standard Brownian motion under the risk-neutral prob-
ability measure P∗ , and let
1 wt
Λt : = rs ds, t ∈ [τ , T ].
T −τ τ
478 "
Compute the price at time t ∈ [τ , T ] of the Asian option with payoff

(ΛT − K )+ , under the condition Λt > K.
Exercise 13.7 Consider an asset price (St )t∈R+ which is a submartingale

under the risk-neutral probability measure P∗ , in a market with risk-free in-
terest rate r > 0, and let φ(x) = (x − K )+ be the (convex) payoff function
of the European call option.
Show that, for any sequence 0 < T1 < · · · < Tn , the price of the option on
average with payoff
ST1 + · · · + STn

φ
n
can be upper bounded by the price of the European call option with maturity
Tn , i.e. show that
ST1 + · · · + STn

E∗ φ 6 E∗ [φ(STn )].
n
Exercise 13.8 Let (St )t∈R+ denote a risky asset whose price St is given by
dSt = µSt dt + σSt dBt ,
ability measure P∗ . Compute the price at time t ∈ [τ , T ] of the Asian option
with payoff
1 wT
+
Su du − K ,
T −τ τ
under the condition that
1 wt
At : = Su du > K.
T −τ τ
Exercise 13.9 Pricing Asian options by PDEs. Show that the functions g (t, z )
and h(t, y ) are linked by the relation
!
1 − e −(T −t)r −(T −t)r
g (t, z ) = h t, +e z , 0 6 t 6 T , z > 0,
rT
and that the PDE (1.35) for h(t, y ) can be derived from the PDE (1.33) for
g (t, z ) and the above relation.
2 t/2
Exercise 13.10 (Brown et al. (2016)) Given St := S0 e σBt +rt−σ a geo-
metric Brownian motion and letting
" 479
N. Privault
e −(T −t)r 1 wt e −(T −t)r Λt

Zet := Su du − K = −K , 0 6 t 6 T,
St T 0 St T
find the PDE satisfied by the pricing function ge(t, z ) such that
1 wT
" + #
−(T −t)r ∗
St ge t, Zt = e E Ft .

Su du − K
e
T 0
Exercise 13.11 Hedging Asian options (Yang et al. (2011)).

a) Compute the Asian option price f (t, St , Λt ) when Λt /T > K.
b) Compute the hedging portfolio allocation (ξt , ηt ) when Λt /T > K.
c) At maturity we have f (T , ST , ΛT ) = (ΛT /T − K )+ , hence ξT = 0 and
+
e −rT ΛT ΛT

ηT AT = AT −K 1{ΛT >KT } = −K .
A0 T T
d) Show that the Asian option with payoff (ΛT − K )+ can be hedged by the
self-financing portfolio
1 Λt 1 Λt

ξt = f (t, St , Λt ) − e −(T −t)r − K h t, −K
St T St T
in the asset St and
e −rT Λt 1 Λt

ηt = − K h t, −K , 0 6 t 6 T,
A0 T St T
in the riskless asset At = A0 e rt , where h(t, z ) is solution to a partial

differential equation to be written explicitly.
Exercise 13.12 Asian options with dividends. Consider an underlying as-

set price process (St )t∈R+ modeled as dSt = (µ − δ )St dt + σSt dBt , where
(Bt )t∈R+ is a standard Brownian motion and δ > 0 is a continuous-time
dividend rate.
a) Write down the self-financing condition for the portfolio value Vt = ξt St +
ηt At with At = A0 e rt , assuming that all dividends are reinvested.
b) Derive the Black-Scholes PDE for the function gδ (t, x, y ) such that Vt =
gδ (t, St , Λt ) at time t ∈ [0, T ].
480 "
library(quantmod)
getDividends("Z74.SI",from="2018-01-01",to="2018-12-31",src="yahoo")
getSymbols("Z74.SI",from="2018-11-16",to="2018-12-19",src="yahoo")
T <- chart_theme(); T$col$line.col <- "black"
chart_Series(Op(`Z74.SI`),name="Opening prices (black) - Closing prices
(blue)",lty=4,theme=T)
add_TA(Cl(`Z74.SI`),lwd=2,lty=5,legend='Difference',col="blue",on = 1)
Z74.SI.div
2018-07-26 0.107
2018-12-17 0.068
2018-12-18 0.068
Opening prices (purple) − Closing prices (blue) 2018−11−16 / 2018−12−18

3.12
3.10 3.10
3.08
3.06
3.05
3.04
3.02
3.00 3.00
2.98
Nov 16 Nov 20 Nov 22 Nov 26 Nov 28 Nov 30 Dec 04 Dec 06 Dec 10 Dec 12 Dec 14 Dec 18
2018 2018 2018 2018 2018 2018 2018 2018 2018 2018 2018 2018
Fig. 13.6: SGD0.068 dividend detached on 18 Dec 2018 on Z74.SI.
The difference between the closing price on Dec 17 ($3.06) and the opening
price on Dec 18 ($2.99) is $3.06 − $2.99 = $0.07. The adjusted price on Dec
17 ($2.992) is the closing price ($3.06) minus the dividend ($0.068).
Z74.SI Open High Low Close Volume Adjusted (ex-dividend)

2018-12-17 3.05 3.08 3.05 3.06 17441000 2.992
2018-12-18 2.99 2.99 2.96 2.96 28456400 2.960
The dividend rate α is given by α = 0.068/3.06 = 2.22%.
" 481
Chapter 14
Optimal Stopping Theorem
Stopping times are random times whose value can be determined by the his-
torical behavior of a stochastic process modeling market data. This chapter
presents additional material on optimal stopping and martingales, for use in
the pricing and optimal exercise of American options in Chapter 15. Appli-
cations are given to hitting probabilities for Brownian motion.
14.1 Filtrations and Information Flow . . . . . . . . . . . . . . . . 483

14.2 Submartingales and Supermartingales . . . . . . . . . . . 484
14.3 Optimal Stopping Theorem . . . . . . . . . . . . . . . . . . . . . 487
14.4 Drifted Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . 494
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
14.1 Filtrations and Information Flow
Let (Ft )t∈R+ denote the filtration generated by a stochastic process (Xt )t∈R+ .
In other words, Ft denotes the collection of all events possibly generated by
{Xs : 0 6 s 6 t} up to time t. Examples of such events include the event
{Xt0 6 a0 , Xt1 6 a1 , . . . , Xtn 6 an }
for a0 , a1 , . . . , an a given fixed sequence of real numbers and 0 6 t1 < · · · <

tn < t, and Ft is said to represent the information generated by (Xs )s∈[0,t]
up to time t > 0.
By construction, (Ft )t∈R+ is a non-decreasing family of σ-algebras in the

sense that we have Fs ⊂ Ft (information known at time s is contained in the
information known at time t) when 0 < s < t.
One refers sometimes to (Ft )t∈R+ as the non-decreasing flow of informa-

tion generated by (Xt )t∈R+ .
" 483
N. Privault
14.2 Submartingales and Supermartingales

Let us recall the definition of martingale (cf. Definition 5.5), and introduce
in addition the definitions of supermartingale and submartingale.∗
Definition 14.1. An integrable† stochastic process (Zt )t∈R+ is a martingale
(resp. a supermartingale, resp. a submartingale) with respect to (Ft )t∈R+ if
it satisfies the property
Zs = E[Zt | Fs ], 0 6 s 6 t, (martingale)
resp.
Zs > E[Zt | Fs ], 0 6 s 6 t, (supermartingale)
resp.
Zs 6 E[Zt | Fs ], 0 6 s 6 t. (submartingale)
Clearly, a stochastic process (Zt )t∈R+ is a martingale if and only if it is both
a supermartingale and a submartingale.
A particular property of martingales is that their expectation is constant over

time t ∈ R+ . In the next proposition we also check that supermartingales
have non-increasing expectation over time, while submartingales have a non-
decreasing expectation.
Proposition 14.2. Let (Zt )t∈R+ denote an adapted integrable process.
a) If (Zt )t∈R+ is a supermartingale, we have
E [ Zs ] > E [ Zt ] , 0 6 s 6 t. (supermartingale)
b) If (Zt )t∈R+ is a submartingale, we have
E [ Zs ] 6 E [ Zt ] , 0 6 s 6 t. (submartingale)
c) If (Zt )t∈R+ be a martingale, we have
E [ Zs ] = E [ Zt ] , 0 6 s 6 t. (martingale)
Proof. The case where (Zt )t∈R+ is a martingale follows from the tower prop-
erty (23.38) of conditional expectations, which shows that
E[Zt ] = E[E[Zt | Fs ]] = E[Zs ], 0 6 s 6 t. (14.1)
Regarding supermartingales, similarly to (14.1) we have

∗
“This obviously inappropriate nomenclature was chosen under the malign influence of
the noise level of radio’s SUPERman program, a favorite supper-time program of Doob’s
son during the writing of Doob (1953)”, cf. Doob (1984), historical notes, page 808.
†
This condition means that E[|Zt |] < ∞ for all t > 0.
484 "
E[Zt ] = E[E[Zt | Fs ]] 6 E[Zs ], 0 6 s 6 t.
The proof is similar in the submartingale case.

Independent increments processes whose increments have negative expecta-
tion give examples of supermartingales. For example, if (Zt )t∈R+ is such a
stochastic process then we have
E[Zt | Fs ] = E[Zs | Fs ] + E Zt − Zs Fs

= E[Zs | Fs ] + E[Zt − Zs ]
6 E[Zs | Fs ]
= Zs , 0 6 s 6 t.
Similarly, a stochastic process with independent increments which have pos-

itive expectation will be a submartingale. Brownian motion Bt + µt with
positive drift µ > 0 is such an example, as in Figure 14.1 below.
14
Drifted Brownian Brownian motion
12 Drift µt
10
-2
-4
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 14.1: Drifted Brownian path.
The following example comes from gambling.
Fig. 14.2: Evolution of the fortune of a poker player vs number of games played.
" 485
N. Privault
Proposition 14.3. Jensen’s inequality. Let ϕ : R → R be a convex function,

i.e.
ϕ(px + qy ) 6 pϕ(x) + qϕ(y )
for any p, q ∈ [0, 1] such that p + q = 1 and x, y ∈ R. Jensen’s inequal-
ity states that for X any sufficiently integrable random variable and convex
function ϕ : R → R we have
ϕ(E[X ]) 6 E[ϕ(X )].

Proof. We only consider the case where X is a discrete random variable
taking values in a finite set {x1 , . . . , xn }, with P(X = xi ) = pi , i = 1, . . . , n,
and show by induction on n > 1 that
φ(p1 x1 + p2 x2 + · · · + pn xn ) 6 p1 φ(x1 ) + p2 φ(x2 ) + · · · + pn φ(xn ), (14.2)
x1 , . . . , xn ∈ R, for any sequence of coefficients p1 , p2 , . . . , pn > 0 such that

p1 + p2 + · · · + pn = 1. The inequality (14.2) clearly holds for n = 1, and for
n = 2 it coincides with the convexity property of φ, i.e.
φ(p1 x1 + p2 x2 ) 6 p1 φ(x1 ) + p2 φ(x2 ), x1 , x2 ∈ R.
Assuming that (14.2) holds for some n > 1 and taking p1 , p2 , . . . , pn+1 > 0
such that p1 + p2 + · · · + pn+1 = 1 and 0 < pn+1 < 1 and applying (14.2) at
the second order, we have
φ(p1 x1 + p2 x2 + · · · + pn+1 xn+1 )

p1 x1 + p2 x2 + · · · + pn xn

= φ (1 − pn+1 ) + p n + 1 xn + 1
1 − pn+1
p1 x1 + p2 x2 + · · · + pn xn

6 (1 − pn+1 )φ + pn+1 φ(xn+1 )
1 − pn+1
p1 φ(x1 ) + p2 φ(x2 ) + · · · + pn φ(xn )

6 (1 − pn+1 ) + pn+1 φ(xn+1 )
1 − pn+1
= p1 φ(x1 ) + p2 φ(x2 ) + · · · + pn+1 φ(xn+1 ),
and we conclude by induction.

A natural way to construct submartingales is to take convex functions of
martingales and to apply Jensen’s inequality.
Proposition 14.4. a) Given (Mt )t∈R+ a martingale and φ : R −→ R a
convex function, the process (φ(Mt ))t∈R+ is a submartingale.
b) Given (Mt )t∈R+ a submartingale and φ : R −→ R a non-decreasing con-
vex function, the process (φ(Mt ))t∈R+ is a submartingale.
Proof. By Jensen’s inequality we have
φ(E[Mt | Fs ]) 6 E[φ(Mt ) | Fs ], 0 6 s 6 t, (14.3)

486 "
which shows that
φ(Ms ) = φ(E[Mt | Fs ]) 6 E[φ(Mt ) | Fs ], 0 6 s 6 t.
If φ is convex non-decreasing and (Mt )∈R+ is a submartingale, the above

rewrites as
φ(Ms ) 6 φ(E[Mt | Fs ]) 6 E[φ(Mt ) | Fs ], 0 6 s 6 t,
showing that (φ(Mt ))t∈R+ is a submartingale.

Similarly, (φ(Mt ))t∈R+ will be a supermartingale when (Mt )∈R+ is a mar-
tingale and the function φ is concave.
As a direct application of Proposition 14.4, the process (Bt2 )t∈R+ is a

submartingale as ϕ(x) = x2 is a convex function. Other examples of (super,
sub)-martingales include geometric Brownian motion
2 t/2
St = S0 e rt+σBt −σ , t > 0,
which is a martingale for r = 0, a supermartingale for r 6 0, and a

submartingale for r > 0.
14.3 Optimal Stopping Theorem
Next, we turn to the definition of stopping time, which is based on a proba-

bility space (Ω, F, P) and a filtration (Ft )t∈R+ ⊂ F.
Definition 14.5. An (Ft )t∈R+ -stopping time is a random variable τ : Ω −→
R+ ∪ {+∞} such that
{τ > t} ∈ Ft , t > 0. (14.4)
The meaning of Relation (14.4) is that the knowledge of the event {τ > t}
depends only on the information present in Ft up to time t, i.e. on the knowl-
edge of (Xs )06s6t .
In other words, an event occurs at a stopping time τ if at any time t it

can be decided whether the event has already occurred (τ 6 t) or not (τ > t)
based on the information Ft generated by (Xs )s∈R+ up to time t.
For example, the day you bought your first car is a stopping time (one
can always answer the question “did I ever buy a car”), whereas the day you
will buy your last car may not be a stopping time (one may not be able to
answer the question “will I ever buy another car”).
Proposition 14.6. Every constant time is a stopping time. In addition, if
τ and θ are stopping times, then
" 487
N. Privault
i) the minimum τ ∧ θ := min(τ , θ ) of τ and θ is also a stopping time,

ii) the maximum τ ∨ θ := Max(τ , θ ) of τ and θ is also a stopping time.
Proof. Point (i) is easily checked. Regarding (ii), we have
{τ ∧ θ > t} = {τ > t and θ > t} = {τ > t} ∩ {θ > t} ∈ Ft , t > 0.
On the other hand, we have
{τ ∨ θ 6 t} = {τ 6 t and θ 6 t} = {τ > t}c ∩ {θ > t}c ∈ Ft , t > 0,
which implies
{τ ∨ θ > t} = {τ ∨ θ 6 t}c ∈ Ft , t > 0.
Hitting times
Hitting times provide natural examples of stopping times. The hitting time
of level x by the process (Xt )t∈R+ , defined as
τx = inf{t ∈ R+ : Xt = x},
is a stopping time,∗ as we have (here in discrete time)
{τx > t} = {Xs 6= x for all s ∈ [0, t]}

= {X0 6= x} ∩ {X1 6= x} ∩ · · · ∩ {Xt 6= x} ∈ Ft , t ∈ N.
In gambling, a hitting time can be used as an exit strategy from the game.
For example, letting
τx,y := inf{t ∈ R+ : Xt = x or Xt = y} (14.5)
defines a hitting time (hence a stopping time) which allows a gambler to exit
the game as soon as losses become equal to x = −10, or gains become equal
to y = +100, whichever comes first. Hitting times can be used to trigger for
“buy limit” or “sell stop” orders in finance.
However, not every R+ -valued random variable is a stopping time. For

example the random time
( )
τ = inf t ∈ [0, T ] : Xt = Sup Xs ,
s∈[0,T ]
∗
As a convention we let τ = +∞ in case there exists no t > 0 such that Xt = x.
488 "
which represents the first time the process (Xt )t∈[0,T ] reaches its maximum
over [0, T ], is not a stopping time with respect to the filtration generated by
(Xt )t∈[0,T ] . Indeed, the information known at time t ∈ (0, T ) is not sufficient
to determine whether {τ > t}.
Stopped process
Given (Zt )t∈R+ a stochastic process and τ : Ω −→ R+ ∪ {+∞} a stopping

time, the stopped process (Zt∧τ )t∈R+ is defined as
 Zt if t < τ ,

Zt∧τ :=
Zτ if t > τ ,

Using indicator functions, we may also write
Zt∧τ = Zt 1{t<τ } + Zτ 1{t>τ } , t > 0.
The following Figure 14.3 is an illustration of the path of a stopped process.
0.065
0.06
0.055
0.05
0.045
0.04
0.035
0.03
0.025
0 2 4 6 τ8 10 12 14 16 18 20
t
Fig. 14.3: Stopped process.
Theorem 14.7 below is called the Stopping Time (or Optional Sampling, or
Optional Stopping) Theorem, it is due to the mathematician J.L. Doob (1910-
2004). It is also used in Exercise 14.6 below.
Theorem 14.7. Assume that (Mt )t∈R+ is a martingale with respect to
(Ft )t∈R+ , and that τ is an (Ft )t∈R+ -stopping time. Then the stopped process
(Mt∧τ )t∈R+ is also a martingale with respect to (Ft )t∈R+ .
Proof. We only give the proof in discrete time by applying the martingale
transform argument of Theorem 2.11. Writing the telescoping sum
n
X
Mn = M0 + (Ml − Ml−1 ),
l =1
" 489
N. Privault
we have
∧n
τX n
1{l6τ } (Ml − Ml−1 ),
X
Mτ ∧n = M0 + (Ml − Ml−1 ) = M0 +
l =1 l =1
and for k 6 n,
n
" #

1{l6τ } (Ml − Ml−1 ) Fk
X
E[Mτ ∧n | Fk ] = E M0 +
l =1
n
E[1{l6τ } (Ml − Ml−1 ) | Fk ]
X
= M0 +
l =1
k
E[1{l6τ } (Ml − Ml−1 ) | Fk ]
X
= M0 +
l =1
n
E[1{l6τ } (Ml − Ml−1 ) | Fk ]
X
+
l =k +1
k
(Ml − Ml−1 )E[1{l6τ } | Fk ]
X
= M0 +
l =1
n
E[E[(Ml − Ml−1 )1{l6τ } | Fl−1 ] | Fk ]
X
+
l =k +1
k
(Ml − Ml−1 )1{l6τ }
X
= M0 +
l =1
n
E[1{l6τ } E[(Ml − Ml−1 ) | Fl−1 ] | Fk ]
X
+
| {z }
l =k +1 =0
k
(Ml − Ml−1 )1{l6τ }
X
= M0 +
l =1
τ ∧k
X
= M0 + (Ml − Ml−1 )
l =1
= Mτ ∧k , k = 0, 1, . . . , n,
as by the martingale property of (Ml )l∈N , we have
E[(Ml − Ml−1 ) | Fl−1 ] = E[Ml | Fl−1 ] − E[Ml−1 | Fl−1 ]

= E[Ml | Fl−1 ] − Ml−1
= 0, l > 1.
490 "

Remarks.
a) More generally, if (Mt )t∈R+ is a super (resp. sub)-martingale with respect
to (Ft )t∈R+ , then the stopped process (Mt∧τ )t∈R+ remains a super (resp.
sub)-martingale with respect to (Ft )t∈R+ , see e.g. Exercise 14.6 below for
the case of submartingales in discrete time.
b) Since by Theorem 14.7 the stopped process (Mτ ∧t )t∈R+ is a martingale,

we find that its expected value E[Mτ ∧t ] is constant over time t ∈ R+ by
Proposition 14.2-c).
As a consequence, if (Mt )t∈R+ is an (Ft )t∈R+ -martingale and τ is a stop-

ping time bounded by a constant T > 0, i.e. τ 6 T almost surely,∗ we
have
E[Mτ ] = E[Mτ ∧T ] = E[Mτ ∧0 ] = E[M0 ] = E[MT ]. (14.6)
c) From (14.6), if τ , ν are two stopping times a.s. bounded by a constant

T > 0 and (Mt )t∈R+ is a martingale, we have
E [ M0 ] = E [ Mτ ] = E [ Mν ] = E [ MT ] . (14.7)
d) If τ , ν are two stopping times a.s. bounded by a constant T > 0 and such
that τ 6 ν a.s., then
(i) when (Mt )t∈R+ is a supermartingale, we have
E [ M0 ] > E [ Mτ ] > E [ Mν ] > E [ MT ] , (14.8)
(ii) when (Mt )t∈R+ is a submartingale, we have
E [ M0 ] 6 E [ Mτ ] 6 E [ Mν ] 6 E [ MT ] , (14.9)
see Exercise 14.6 below for a proof in discrete time.
e) In case τ is finite with probability one (but not bounded) we may also
write
E[Mτ ] = E lim Mτ ∧t = lim E[Mτ ∧t ] = E[M0 ], (14.10)

t→∞ t→∞
provided that
|Mτ ∧t | 6 C, a.s., t > 0+. (14.11)
∗
“τ 6 T almost surely” means P(τ 6 T ) = 1, i.e. P(τ > T ) = 0.
" 491
N. Privault
More generally, (14.10) holds provided that the limit and expectation signs
can be exchanged, and this can be done using e.g. the Dominated Conver-
gence Theorem. In some situations the exchange of limit and expectation
signs may not be valid.∗
In case P(τ = +∞) > 0, (14.10) holds under the above conditions, pro-
vided that
M∞ := lim Mt (14.12)
t→∞
exists with probability one.
Relations (14.8), (14.9) and (14.7) can be extended to unbounded stop-

ping times along the same lines and conditions as (14.10), such as (14.11)
applied to both τ and ν. Dealing with unbounded stopping times can be
necessary in the case of hitting times.
f) In general, for all a.s. finite (bounded or unbounded) stopping times τ it

remains true that
E[Mτ ] = E lim Mτ ∧t 6 lim E Mτ ∧t 6 lim E[M0 ] = E[M0 ],

t→∞ t→∞ t→∞
(14.13)
provided that (Mt )t∈R+ is a nonnegative supermartingale, where we used
Fatou’s Lemma 23.4.† As in (14.10), the limit (14.12) is required to exist
with probability one if P(τ = +∞) > 0.
g) As a counterexample to (14.7), the random time

n o
τ := inf t ∈ [0, T ] : Mt = Sup Ms ,
s∈[0,T ]
which is not a stopping time, will satisfy
E [ Mτ ] > E [ MT ] ,
although τ 6 T almost surely. Similarly,

n o
τ := inf t ∈ [0, T ] : Mt = inf Ms ,
s∈[0,T ]
is not a stopping time and satisfies
E [ Mτ ] < E [ MT ] .
∗
Consider for example the sequence Mn = n1{X<1/n} , n > 1, where X ' U (0, 1] is a
uniformly distributed random variable on (0, 1].
†
E[limn→∞ Fn ] 6 limn→∞ E[Fn ] for any sequence (Fn )n∈N of nonnegative random
variables, provided that the limits exist.
492 "
Martingales and stopping times as gambling strategies
When (Mt )t∈[0,T ] is a martingale, e.g. a centered random walk with indepen-
dent increments, the message of the Stopping Time Theorem 14.7 is that the
expected gain of the exit strategy τx,y of (14.5) remains zero on average since
E Mτx,y = E[M0 ] = 0,

if M0 = 0. Therefore, on average, this exit strategy does not increase the

average gain of the player. More precisely we have
0 = M0 = E[Mτx,y ] = xP(Mτx,y = x) + yP(Mτx,y = y )

= −10 × P(Mτx,y = −10) + 100 × P(Mτx,y = 100),
which shows that

10 1
P(Mτx,y = −10) = and P(Mτx,y = 100) = ,
11 11
provided that the relation P(Mτx,y = x) + P(Mτx,y = y ) = 1 is satisfied, see
below for further applications to Brownian motion.
Mn
10
9
8
7
6
5
4
3
2
1
T−10,100
M0 = 0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 n
-1
T−10,100
Fig. 14.4: Sample paths of a gambling process (Mn )n∈N .
In the next Table 14.1 we summarize some of the results obtained in this
section for bounded stopping times.
In the sequel we note that, as an application of the Stopping Time Theo-
rem 14.7, a number of expectations can be computed in a simple and elegant
way.
" 493
N. Privault
bounded stopping times τ , ν



supermartingale E[Mτ ] > E[Mν ] if τ 6 ν.






(Mt )t∈R+

 martingale E [ Mτ ] = E [ Mν ] .



E[Mτ ] 6 E[Mν ] if τ 6 ν.

submartingale

Table 14.1: Martingales and stopping times.
14.4 Drifted Brownian Motion
Brownian motion hitting a barrier
Given a, b ∈ R, a < b, let the hitting∗ time τa,b : Ω −→ R+ be defined by
τa,b = inf{t > 0 : Bt = a or Bt = b},
which is the hitting time of the boundary {a, b} of Brownian motion (Bt )t∈R+ ,
a < b ∈ R.
x
a
0
0 0.5 1
t
Fig. 14.5: Brownian motion hitting a barrier.
Recall that Brownian motion (Bt )t∈R+ is a martingale since it has indepen-
dent increments, and those increments are centered:
E[Bt − Bs ] = 0, 0 6 s 6 t.
Consequently, (Bτa,b ∧t )t∈R+ is still a martingale, and by (14.10) we have

∗
Hitting times are stopping times.
494 "
E[Bτa,b | B0 = x] = E[B0 | B0 = x] = x,
as the exchange between limit and expectation in (14.10) can be justified

since
|Bt∧τa,b | 6 Max(|a|, |b|), t > 0.
Hence we have
 x = E[Bτa,b | B0 = x] = a × P(Bτa,b = a | B0 = x) + b × P(Bτa,b = b | B0 = x),


P(Xτa,b = a | X0 = x) + P(Xτa,b = b | X0 = x) = 1,

which yields
x−a
P(Bτa,b = b | B0 = x) = , a 6 x 6 b,
b−a
and also shows that
b−x
P(Bτa,b = a | B0 = x) = , a 6 x 6 b.
b−a
Note that the above result and its proof actually apply to any continuous
martingale, and not only to Brownian motion.
Drifted Brownian motion hitting a barrier
Next, let us turn to the case of drifted Brownian motion
Xt = x + Bt + µt, t > 0.
x
a
0
0 0.5 1
t
Fig. 14.6: Drifted Brownian motion hitting a barrier.

In this case, the process (Xt )t∈R+ is no longer a martingale and in order to
use Theorem 14.7 we need to construct a martingale of a different type. Here
we note that the process
" 495
N. Privault
2 t/2
Mt := e σBt −σ , t > 0,
is a martingale with respect to (Ft )t∈R+ . Indeed, we have

2 2
E[Mt | Fs ] = E e σBt −σ t/2 Fs = e σBs −σ s/2 , 0 6 s 6 t,

cf. e.g. Example 1 page 258.
By Theorem 14.7 we know that the stopped process (Mτa,b ∧t )t∈R+ is a

martingale, hence its expected value is constant over time t ∈ R+ Propo-
sition 14.2-c), and (14.10) yields
1 = E[M0 ] = E[Mτa,b ],
as the exchange between limit and expectation in (14.10) can be justified

since
|Mt∧τa,b | 6 Max e σ|a| , e σ|b| , t > 0.

Next, we note that taking µ = −σ/2, i.e. σ = −2µ, we have Mt = e −σx e σXt ,
and
2
e σXt = e σx+σBt +σµt = e σx+σBt −σ t/2 = e σx Mt ,
hence
1 = E[Mτa,b ]
σXτa,b
= e −σx E[ e ]
(a−x)σ
= e P(Xτa,b = a | X0 = x) + e (b−x)σ P(Xτa,b = b | X0 = x),
under the additional condition
P(Xτa,b = a | X0 = x) + P(Xτa,b = b | X0 = x) = 1.
Finally, this gives
e σx − e σb e −2µx − e −2µb

P(Xτa,b = a | X0 = x) = σa = −2µa (14.14a)


e −e σb e − e −2µb





e −2µa − e −2µx


P ( X , (14.14b)


τa,b = b | X0 = x) =
e −2µa − e −2µb
a 6 x 6 b, see Figure 14.7 for an illustration with a = 1, b = 2, x = 1.3,
µ = 2.0, and ( e −2µa − e −2µx )/( e −2µa − e −2µb ) = 0.7118437.
496 "
nsim <- 1000;a=1;b=2;x=1.3;mu=2.0;N=10001; T<-2.0; t <- 0:(N-1); dt <- T/N; prob=0;

time=0;
for (i in 1:nsim){signal=0;colour="blue";Z <- rnorm(N,mean=0,sd= sqrt(dt));
X <- c(1,N);X[1]=x;for (j in 2:N){X[j]=X[j-1]+Z[j]+mu*dt
if (X[j]<=a && signal==0) {signal=-1;colour="purple";time=time+j}
if (X[j]>=b && signal==0) {signal=1;colour="blue";prob=prob+1;time=time+j}}
plot(t, X, xlab = "t", ylab = "", type = "l", ylim = c(-0,3), col =
"blue",main=paste("Prob=",prob,"/",i,"=",round(prob/i, digits=5),"
Time=",round(time*dt, digits=3),"/",i,"=",round(time*dt/i, digits=5)), xaxs="i",
yaxs="i", xaxt="n", yaxt="n",cex.axis=1.8,cex.lab=1.8,cex.main=2)
lines(t, x+mu*t*dt, type = "l", col = "orange",lwd=3);yticks<-c(0,a,x,b);
axis(side=2, at=yticks,labels = c(0,"a","x","b"), las = 2,cex.axis=1.8)
xticks<-c(0,5000,10000)
axis(side=1, at=xticks,labels = c(0,"0.5","1"), las = 1,cex.axis=1.8)
abline(h=x,lw=2); abline(h=a,col="purple",lwd=3);
abline(h=b,col="blue",lwd=3)# Sys.sleep(0.5)
readline(prompt = "Pause. Press <Enter> to continue...")}
(exp(-2*mu*a)-exp(-2*mu*x))/(exp(-2*mu*a)-exp(-2*mu*b))
(b*(exp(-2*mu*a)-exp(-2*mu*x))+a*(exp(-2*mu*x)-exp(-2*mu*b))
-x*(exp(-2*mu*a)-exp(-2*mu*b)))/mu/(exp(-2*mu*a)-exp(-2*mu*b))
Prob= 34 / 44 = 0.77273
0
0 0.5 1
t
Fig. 14.7: Hitting probabilities of drifted Brownian motion.∗
Escape to infinity
Letting b tend to +∞ in the above equalities shows that the probability

P(τa = +∞) of escape to +∞ of Brownian motion started from x ∈ (a, ∞)
is equal to
 1 − P(Xτa,∞ = a | X0 = x) = 1 − e −2µ(x−a) > 0, µ > 0,


P(τa = +∞) =
0, µ 6 0,

∗
" 497
N. Privault
i.e.
 P(Xτa,∞ = a | X0 = x) = e −2µ(x−a) < 1, µ > 0,


P(τa < +∞) = (14.15)

1, µ 6 0.

(14.16)
Similarly, letting a tend to −∞ shows that the probability P(τb = +∞) of

escape to −∞ of Brownian motion started from x ∈ (−∞, b) is equal to
 1 − P(Xτ−∞,b = b | X0 = x) = 1 − e −2µ(x−b) > 0, µ < 0,


P(τb = +∞) =
0, µ > 0,

i.e.
 P(Xτ−∞,b = b | X0 = x) = e −2µ(x−b) < 1, µ < 0,


P(τb < +∞) = (14.17)

1, µ > 0.

Mean hitting times for Brownian motion
The martingale method also allows us to compute the expectation E[Bτa,b ],

after rechecking that
wt
Bt2 − t = 2 Bs dBS , t > 0,
0
is also a martingale. Indeed, we have
E[Bt2 − t | Fs ] = E[(Bs + (Bt − Bs ))2 − t | Fs ]

= E[Bs2 + (Bt − Bs )2 + 2Bs (Bt − Bs ) − t | Fs ]
= E[Bs2 − s | Fs ] − (t − s) + E[(Bt − Bs )2 | Fs ] + 2E[Bs (Bt − Bs ) | Fs ]
= Bs2 − s − (t − s) + E[(Bt − Bs )2 | Fs ] + 2Bs E[Bt − Bs | Fs ]
= Bs2 − s − (t − s) + E[(Bt − Bs )2 ] + 2Bs E[Bt − Bs ]
= Bs2 − s, 0 6 s 6 t.
Consequently the stopped process (Bτ2a,b ∧t − τa,b ∧ t)t∈R+ is still a martingale

by Theorem 14.7 hence the expectation E[Bτ2a,b ∧t − τa,b ∧ t] is constant over
time t ∈ R+ , hence by (14.10) we get∗
x2 = E[B02 − 0 | B0 = x]
= E[Bτ2a,b − τa,b | B0 = x]
∗
Here we note that it can be showed that E[τa,b ] < ∞ in order to apply (14.10).
498 "
= E[Bτ2a,b | B0 = x] − E[τa,b | B0 = x]
= b2 P(Bτa,b = b | B0 = x) + a2 P(Bτa,b = a | B0 = x) − E[τa,b | B0 = x],
i.e.
E[τa,b | B0 = x] = b2 P(Bτa,b = b | B0 = x) + a2 P(Bτa,b = a | B0 = x) − x2

x−a b−x
= b2 + a2 − x2
b−a b−a
= (x − a)(b − x), a 6 x 6 b.
Mean hitting time for drifted Brownian motion
Finally we show how to recover the value of the mean hitting time E[τa,b |
X0 = x] of drifted Brownian motion Xt = x + Bt + µt. As above, the process
Xt − µt is a martingale the stopped process (Xτa,b ∧t − µ(τa,b ∧ t))t∈R+ is still
a martingale by Theorem 14.7. Hence the expectation E[Xτa,b ∧t − µ(τa,b ∧ t)]
is constant over time t > 0.
Since the stopped process Xτa,b ∧t − µ(τa,b ∧ t) t∈R is a martingale, we

+
have
x = E[Xτa,b − µτa,b | X0 = x],
which gives
x = E[Xτa,b − µτa,b | X0 = x]
= E[Xτa,b | X0 = x] − µE[τa,b | X0 = x]
= bP(Xτa,b = b | X0 = x) + aP(Xτa,b = a | X0 = x) − µE[τa,b | X0 = x],
i.e. by (14.14a),
µE[τa,b | X0 = x] = bP(Xτa,b = b | X0 = x) + aP(Xτa,b = a | X0 = x) − x

e −2µa − e −2µx e −2µx − e −2µb
=b + a −2µa −x
e −2µa − e −2µb e − e −2µb
b( e −2µa −e −2µx ) + a( e −2µx −e −2µb ) − x( e −2µa − e −2µb )
= ,
e −2µa −e −2µb
hence
b( e −2µa − e −2µx ) + a( e −2µx − e −2µb ) − x( e −2µa − e −2µb )
E[τa,b | X0 = x] = ,
µ( e −2µa − e −2µb )
a 6 x 6 b, see the code of page 496 for an illustration.
" 499
N. Privault
Table 14.2 presents a summary of the families of martingales used in this

chapter.
Probabilities
Non drifted Drifted
Problem
2
Hitting probability P(Xτa,b = a, b) Bt e σBt −σ t/2
Mean hitting time E[τa,b ] Bt2 − t Xt − µt
Table 14.2: List of martingales.
Exercises
Exercise 14.1 Let (Bt )t∈R+ be a standard Brownian motion started at 0,

i.e. B0 = 0.
a) Is the process t 7−→ (2 − Bt )+ a submartingale, a martingale or a su-
permartingale?
b) Is the process ( e Bt )t∈R+ a submartingale, a martingale, or a supermartingale?
c) Consider the random time ν defined by
ν := inf{t ∈ R+ : Bt = B2t },
which represents the first intersection time of the curves (Bt )t∈R+ and
(B2t )t∈R+ .
Is ν a stopping time?
d) Consider the random time τ defined by
τ := inf t ∈ R+ : e Bt −t/2 = α + βt ,

which represents the first time geometric Brownian motion e Bt −t/2 crosses
the straight line t 7−→ α + βt. Is τ a stopping time?
e) If τ is a stopping time, compute E[τ ] by the Doob Stopping Time Theo-
rem 14.7 in each of the following two cases:
i) α > 1 and β < 0,
ii) α < 1 and β > 0.
500 "
Exercise 14.2 Stopping times. Let (Bt )t∈R+ be a standard Brownian motion
started at 0.
a) Consider the random time ν defined by
ν := inf{t ∈ R+ : Bt = B1 },
which represents the first time Brownian motion Bt hits the level B1 . Is
ν a stopping time?
b) Consider the random time τ defined by
τ := inf t ∈ R+ : e Bt = α e −t/2 ,

which represents the first time the exponential of Brownian motion Bt

crosses the path of t 7−→ α e −t/2 , where α > 1.
Is τ a stopping time? If τ is a stopping time, compute E[ e −τ ] by applying

the Stopping Time Theorem 14.7.
c) Consider the random time τ defined by
τ := inf t ∈ R+ : Bt2 = 1 + αt ,

which represents the first time the process (Bt2 )t∈R+ crosses the straight
line t 7−→ 1 + αt, with α < 1.
Is τ a stopping time? If τ is a stopping time, compute E[τ ] by the Doob

Stopping Time Theorem 14.7.
Exercise 14.3 Consider a standard Brownian motion (Bt )t∈R+ started at

B0 = 0, and let
τL = inf{t ∈ R+ : Bt = L}
denote the first hitting time of the level L > 0 by (Bt )t∈R+ .
a) Compute the Laplace transform E[ e −rτL ] of τL for all r > 0.
√
Hint: Use the Stopping Time Theorem 14.7 and the fact that e 2rBt −rt t∈R

+
is a martingale when r > 0.
b) Find the optimal level stopping strategy depending on the value of r > 0
for the maximization problem
Sup E e −rτL BτL .

L>0
Exercise 14.4 Consider (Bt )t∈R+ a Brownian motion started at B0 = x ∈

[a, b] with a < b, and let
" 501
N. Privault
τ := inf t ∈ R+ : Bt = a or Bt = b

denote the first exit time of the interval [a, b]. Show that the solution f (x)
of the differential equation f 00 (x) = −2 with f (a) = f (b) = 0 satisfies
f ( x ) = E [ τ | B0 = x ] .
1 w t 00
Hint: Consider the process Xt := f (Bt ) − f (Bs )ds, and apply the Doob
2 0
Stopping Time Theorem 14.7.
Exercise 14.5 Consider a standard Brownian motion (Bt )t∈R+ started at

B0 = 0, and let
τ := inf{t ∈ R+ : Bt = α + βt}
denote the first hitting time of the straight line t 7−→ α + βt by (Bt )t∈R+ .
a) Compute the Laplace transform E[ e −rτ ] of τ for all r > 0 and α > 0.
b) Compute the Laplace transform E[ e −rτ ] of τ for all r > 0 and α 6 0.
2
Hint. Use the stopping time theorem and the fact that e σBt −σ t/2 t∈R is

+
a martingale for all σ ∈ R.
Exercise 14.6 (Doob-Meyer decomposition in discrete time). Let (Mn )n∈N

be a discrete-time submartingale with respect to a filtration (Fn )n∈N , with
F−1 = {∅, Ω}.
a) Show that there exists two processes (Nn )n∈N and (An )n∈N such that
i) (Nn )n∈N is a martingale with respect to (Fn )n∈N ,
ii) (An )n∈N is non-decreasing, i.e. An 6 An+1 a.s., n ∈ N,
iii) (An )n∈N is predictable in the sense that An is Fn−1 -measurable,

n ∈ N, and
iv) Mn = Nn + An , n ∈ N.
Hint: Let A0 := 0,
An+1 := An + E[Mn+1 − Mn | Fn ], n > 0,
and define (Nn )n∈N in such a way that it satisfies the four required prop-
erties.
b) Show that for all bounded stopping times σ and τ such that σ 6 τ a.s.,
we have
E [ Mσ ] 6 E [ M τ ] .
Hint: Use the Stopping Time Theorem 14.7 for martingales and (14.7).
502 "
Chapter 15
American Options
American options are financial derivatives that can be exercised at any time
before maturity, in contrast to European options which have fixed maturities.
The prices of American options are evaluated as an optimization problem in
which one has to find the optimal time to exercise in order to maximize the
claim option payoff.
15.1 Perpetual American Put Options . . . . . . . . . . . . . . . . 503

15.2 PDE Method for Perpetual Put Options . . . . . . . . . 509
15.3 Perpetual American Call Options . . . . . . . . . . . . . . . 513
15.4 Finite Expiration American Options . . . . . . . . . . . . . 518
15.5 PDE Method with Finite Expiration . . . . . . . . . . . . 522
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526
15.1 Perpetual American Put Options

The price of an American put option with finite expiration time T > 0 and
strike price K can be expressed as the expected value of its discounted payoff:
Sup E∗ e −(τ −t)r (K − Sτ )+ St ,

f (t, St ) =
t6τ 6T
τ Stopping time
under the risk-neutral probability measure P∗ , where the supremum is taken

over stopping times between t and a fixed maturity T . Similarly, the price of
a finite expiration American call option with strike price K is expressed as
Sup E∗ e −(τ −t)r (Sτ − K )+ St .

f (t, St ) =
t6τ 6T
τ Stopping time
In this section we take T = +∞, in which case we refer to these options as

perpetual options, and the corresponding put and call options are respectively
priced as
" 503
N. Privault
Sup E∗ e −(τ −t)r (K − Sτ )+ St ,

f (t, St ) =
τ >t
τ Stopping time
and
Sup E∗ e −(τ −t)r (Sτ − K )+ St .

f (t, St ) =
τ >t
τ Stopping time
Two-choice optimal stopping at a fixed price level for perpetual

put options
In this section we consider the pricing of perpetual put options. Given L ∈

(0, K ) a fixed price, consider the following choices for the exercise of a put
option with strike price K:
1. If St 6 L, then exercise at time t.
2. Otherwise if St > L, wait until the first hitting time
τL := inf{u > t : Su 6 L} (15.1)
of the level L > 0, and exercise the option at time τL if τL < ∞.

Note that by definition of (15.1) we have τL = t if St 6 L.
In case St 6 L, the payoff will be
(K − St )+ = K − St
since K > L > St , however in this case one would buy the option at price
K − St only to exercise it immediately for the same amount.
In case St > L, as r > 0 the price of the option is given by
fL (t, St ) = E∗ e −(τL −t)r (K − SτL )+ St

= E∗ e −(τL −t)r (K − SτL )+ 1{τL <∞} St

= E∗ e −(τL −t)r (K − L)+ 1{τL <∞} St

= (K − L)E∗ e −(τL −t)r St . (15.2)

We note that the starting date t does not matter when pricing perpetual
options, which have an infinite time horizon. Hence, fL (t, x) = fL (x), x > 0,
does not depend on t ∈ R+ , and the pricing of the perpetual put option can
be performed at t = 0. Recall that the underlying asset price is written as
b 2
St = S0 e rt+σBt −σ t/2 , t > 0, (15.3)
504 "
where (B bt )t∈R is a standard Brownian motion under the risk-neutral prob-

+
ability measure P∗ , r is the risk-free interest rate, and σ > 0 is the volatility
coefficient.
Lemma 15.1. Assume that r > 0. We have
x −2r/σ2
E∗ e −(τL −t)r St = x = , (15.4)

x > L.
L
Proof. We take t = 0 in (15.4) without loss of generality. We note that from

(15.3), for all λ ∈ R we have
2 t/2
(St )λ = e λrt+λσBbt −λσ , t > 0,
(λ)
and the process Zt t∈R defined as
+
(λ) b 2 2 2
Zt := (S0 )λ e λσBt −λ σ t/2 = (St )λ e −(λr−λ(1−λ)σ /2)t , t > 0, (15.5)
is a martingale under the risk-neutral probability measure P∗ . Choosing λ ∈

R such that
σ2
r = rλ − λ(1 − λ) , (15.6)
2
we have
(λ)
Zt = (St )λ e −rt , t > 0. (15.7)
The equation (15.6) rewrites as
σ2 σ2 σ2 2r

0 = λ2 +λ r− −r = λ + 2 (λ − 1), (15.8)
2 2 2 σ
with solutions
2r
λ+ = 1 and λ− = − .
σ2
Choosing the negative solution∗ λ− = −2r/σ 2 < 0 and noting that St > L
for all t ∈ [0, τL ], we obtain
( λ− )
0 6 Zt = e −rt (St )λ− 6 e −rt Lλ− 6 Lλ− , 0 6 t 6 τL , (15.9)
( λ− ) (λ )
since r > 0. Therefore we have limt→∞ Zt = 0, and since limt→∞ ZτL−
∧t =
(λ )
ZτL− on {τL < ∞}, using (15.7), we find
h i
Lλ− E∗ e −rτL = E∗ e −rτL Lλ− 1{τL <∞}

∗
The bound (15.9) does not hold for the positive solution λ+ = 1.
" 505
N. Privault
h i
= E∗ e −rτL SτL − 1{τL <∞}
λ
h i
= E∗ ZτL− 1{τL <∞}
(λ )
= E∗ 1{τL <∞} lim ZτL−

(λ )
t→∞ ∧t
∗ ( λ− )
= E lim ZτL ∧t (15.10)

t→∞
(λ )
= lim E∗ ZτL− ∧t (15.11)
t→∞
∗
(λ− )
= lim E Z0
t→∞
= (S0 )λ− ,
where by (15.9) we applied the dominated convergence theorem from (15.10)

to (15.11). Hence, we find
x −2r/σ2
E∗ e −rτL S0 = x = ,

x > L.
L
Note also that by (14.15) we have P(τL < ∞) = 1 if r − σ 2 /2 6 0, and
P(τL = +∞) > 0 if r − σ 2 /2 > 0.
Next, we apply Lemma 15.1 in order to price the perpetual American put
option.
Proposition 15.2. Assume that r > 0. We have
fL (x) = E∗ e −(τL −t)r (K − SτL )+ St = x

K − x, 0 < x 6 L,



= 2
 (K − L) x −2r/σ , x > L.

L
Proof. We take t = 0 without loss of generality.

i) The result is obvious for S0 = x 6 L since in this case we have τL = t = 0
and SτL = S0 = x, so that we only focus on the case x > L.
ii) Next, we consider the case S0 = x > L. We have
E∗ e −rτL (K − SτL )+ S0 = x = E∗ 1{τL <∞} e −rτL (K − SτL )+ S0 = x

= E∗ 1{τL <∞} e −rτL (K − L) S0 = x

= (K − L)E∗ e −rτL S0 = x ,

and we conclude by the expression of E∗ e −rτL S0 = x given in Lemma 15.1.

506 "
We note that taking L = K would yield a payoff always equal to 0 for the
option holder, hence the value of L should be strictly lower than K. On the
other hand, if L = 0 the value of τL will be infinite almost surely, hence
the option price will be 0 when r > 0 from (15.2). Therefore there should
be an optimal value L∗ , which should be strictly comprised between 0 and K.
Figure 15.1 shows for K = 100 that there exists an optimal value L∗ =
85.71 which maximizes the option price for all values of the underlying asset
price.
35
L=75
30
L=L*=85.71
25 L=98
Option price
(K-x)+
20
15
10
0
70 80 90 K= 100 110 120
Underlying x
Fig. 15.1: American put by exercising at τL for different values of L and K = 100.
Smooth pasting In order to compute L∗ we observe that, geometrically, the

slope of fL (x) at x = L∗ is equal to −1, i.e.
2
2r (L∗ )−2r/σ −1
fL0 ∗ (L∗ ) = − (K − L∗ ) = −1,
σ2 (L∗ )−2r/σ2
i.e.
2r
(K − L∗ ) = L∗ ,
σ2
or
2r
L∗ = K < K. (15.12)
2r + σ 2
We note that L∗ tends to zero as σ becomes large or r becomes small, and

that L∗ tends to K when σ becomes small.
The same conclusion can be reached from the vanishing of the derivative of
L 7→ fL (x):
∂fL (x) x −2r/σ2 2r K − L x −2r/σ2

=− + 2 = 0,
∂L L σ L L
" 507
N. Privault
cf. page 351 of Shreve (2004). The next Figure 15.2 is a 2-dimensional ani-
mation that also shows the optimal value L∗ of L.
35
Perpetual American put price
30 Immediate exercise payoff (K-x)+
25
Option price
20
15
10
0
70 80 90 K= 100 110 120
L = 85.0
Underlying x
Fig. 15.2: Animated graph of American put prices depending on L with K = 100.∗
The next Figure 15.3 gives another view of the put option prices according
to different values of L, with the optimal value L∗ = 85.71.
(K-x)+
fL(x)
fL*(x)
K-L
30
25
20
15
10
5 100
0 90
70 80
80 70 L
90
Underlying x 100 60
110
Fig. 15.3: Option price as a function of L and of the underlying asset price.
In Figure 15.4, which is based on the stock price of HSBC Holdings (0005.HK)
over year 2009 as in Figures 6.8-6.15, the optimal exercise strategy for an
American put option with strike price K=$77.67 would have been to exercise
whenever the underlying asset price goes above L∗ = $62, i.e. at approxi-
mately 54 days, for a payoff of $25.67. Exercising after a longer time, e.g. 85
days, could yield an even higher payoff of over $65, however this choice is not
∗
508 "
made because decisions are taken based on existing (past) information, and
optimization is in expected value (or average) over all possible future paths.
Payoff (K-x)+
American put price
Option price path
80 L*
70
60
50
40
30
20
10
0
50 40
100 60
Time in days 150 80
200 100 Underlying (HK$)
120
Fig. 15.4: Path of the American put option price on the HSBC stock.
See Exercise 15.6 for the pricing of perpetual American put options with
dividends.
15.2 PDE Method for Perpetual Put Options
Exercise. Check by hand calculations that the function fL∗ defined as

2r

 K − x, 0 < x 6 L∗ = K,
2r + σ 2




fL∗ (x) := −2r/σ2
Kσ 2 2r + σ 2 x 2r

, x > L∗ =

K,


2r + σ 2 2r K 2r + σ 2

(15.13)
satisfies the Partial Differential Equation (PDE)
1
−rfL∗ (x) + rxfL0 ∗ (x) + σ 2 x2 fL00∗ (x) = 1{x6L∗ }
2(
−rK < 0, 0 < x 6 L∗ < K, [Exercise now]
=
0, x > L∗ . [Wait]
(15.14)
in addition to the conditions
" 509
N. Privault
0 < x 6 L∗ < K, [Exercise now]


 fL∗ (x) = K − x,
fL∗ (x) > (K − x)+ , x > L∗ , [Wait]


see (15.13).
The above statements can be summarized in the following proposition.

Proposition 15.3. The function fL∗ satisfies the following set of differential
inequalities, or variational differential equation:
fL∗ (x) > (K − x)+ ,



 (15.15a)

σ 2 2 00


0
x fL∗ (x) 6 rfL∗ (x), (15.15b)

rxfL∗ (x) +
 2

 σ 2
 rfL∗ (x) − rxfL0 ∗ (x) − x2 fL00∗ (x) (fL∗ (x) − (K − x)+ ) = 0. (15.15c)


2
The equation (15.15c) admits an interpretation in terms of absence of arbi-
trage, as shown below. By (15.14) and Itô’s formula applied to
bt ,
dSt = rSt dt + σSt dB
the discounted portfolio value process
feL∗ (St ) = e −rt fL∗ (St ), t > 0,
satisfies

d feL∗ (St )
1

= −rfL∗ (St ) + rSt fL0 ∗ (St ) + σ 2 St2 fL00∗ (St ) e −rt dt + e −rt σSt fL0 ∗ (St )dB
bt
2
= −1{S 6L∗ } rK e −rt dt + e −rt σSt f 0 ∗ (St )dB
t L
bt
= −1{fL∗ (St )=(K−St )+ } rK e −rt dt + e −rt σSt fL0 ∗ (St )dB

bt , (15.16)
hence we have the relation
feL∗ (ST ) − feL∗ (St )

wT wT
= −rK 1{fL∗ (Su )6(K−Su )+ } e −ru du + e −ru σSu fL0 ∗ (Su )dB
bu ,
t t
which implies
E∗ feL∗ (ST ) − feL∗ (St ) | Ft = E∗ feL∗ (ST ) | Ft − feL∗ (St )

wT wT
= E∗ −rK 1{fL∗ (Su )6(K−Su )+ } e −ru du + e −ru σSu fL0 ∗ (Su )dB
bu Ft
t t
510 "
wT
= −E∗ rK 1{fL∗ (Su )6(K−Su )+ } e −ru du Ft ,

t
hence the following decomposition of the perpetual American put price into
the sum of a European put price and an early exercise premium:
feL∗ (St )
w
T
= E∗ feL∗ (ST ) | Ft + rKE∗ 1{fL∗ (Su )6(K−Su )+ } e −ru du Ft

t
w
T
> e −rT +
E (K − ST ) | Ft + rKE∗
∗
1{Su 6L∗ } e −ru du Ft ,

| {z } t
European put price | {z }
Early exercise premium
(15.17)
0 6 t 6 T , see also Theorem 8.4.1 in § 8.4 in Elliott and Kopp (2005) on early
exercise premiums. From (15.16) we also make the following observations.
a) From Equation (15.15c), feL∗ (St ) is a martingale when
fL∗ (St ) > (K − St )+ , i.e. St > L∗ , [Wait]
and in this case the expected rate of return of the hedging portfolio value
fL∗ (St ) equals the rate r of the riskless asset, as
d feL∗ (St ) = e −rt σSt fL0 ∗ (St )dB

bt ,

or
d fL∗ (St ) = d e rt feL∗ (St ) = rfL∗ (St )dt + σSt fL0 ∗ (St )dB
bt ,

and the investor prefers to wait.
b) On the other hand, if
fL∗ (St ) = (K − St )+ , i.e. 0 < St < L∗ , [Exercise now]
the return of the hedging portfolio becomes lower than r as d feL∗ (St ) =

−rK e −rt dt + e −rt σSt fL0 ∗ (St )dB

bt and
d fL∗ (St ) = d e rt feL∗ (St )

= rfL∗ (St )dt − rKdt + e −rt σSt fL0 ∗ (St )dB

bt .
In this case it is not worth waiting as (15.15b)-(15.15c) show that the

return of the hedging portfolio is lower than that of the riskless asset, i.e.:
" 511
N. Privault
1
−rfL∗ (St ) + rSt fL0 ∗ (St ) + σ 2 St2 fL00∗ (St ) = −rK < 0,
2
exercise becomes immediate since the process feL∗ (St ) becomes a (strict)
supermartingale, and (15.15c) implies fL∗ (x) = (K − x)+ .
In view of the above derivation, it should make sense to assert that fL∗ (St ) is
the price at time t of the perpetual American put option. The next proposition
confirms that this is indeed the case, and that the optimal exercise time is
τ ∗ = τL∗ .
Proposition 15.4. The price of the perpetual American put option is given
for all t > 0 by
fL∗ (St ) = Sup E∗ e −(τ −t)r (K − Sτ )+ St

τ >t
τ Stopping time
−(τL∗ −t)r
=E e ∗
(K − SτL∗ )+ St

K − St , 0 < St 6 L∗ ,




= −2r/σ2 −2r/σ2
Kσ 2 2r + σ 2 St

St
 (K − L∗ ) , St > L∗ .

 =
L∗ 2r + σ 2 2r K
Proof. i) Since the drift

1
−rfL∗ (St ) + rSt fL0 ∗ (St ) + σ 2 St2 fL00∗ (St )
2
in Itô’s formula (15.16) is nonpositive by the inequality (15.15b), the dis-
counted portfolio value process
u 7→ e −ru fL∗ (Su ), u ∈ [t, ∞),
is a supermartingale. As a consequence, for all (a.s. finite) stopping times

τ ∈ [t, ∞) we have, by (14.13),
e −rt fL∗ (St ) > E∗ e −rτ fL∗ (Sτ ) St > E∗ e −rτ (K − Sτ )+ St ,

from (15.15a), which implies
e −rt fL∗ (St ) > Sup E∗ e −rτ (K − Sτ )+ St . (15.18)

τ >t
τ Stopping time
ii) The converse inequality is obvious by Proposition 15.2, as
fL∗ (St ) = E∗ e −(τL∗ −t)r (K − SτL∗ )+ St

512 "
Sup E∗ e −(τ −t)r (K − Sτ )+ St , (15.19)

6
τ >t
τ Stopping time
since τL∗ is a stopping time larger than t ∈ R+ . The inequalities (15.18) and
(15.19) allow us to conclude to the equality
Sup E∗ e −(τ −t)r (K − Sτ )+ St .

fL∗ (St ) =
τ >t
τ Stopping time

Remark. We note that the converse inequality (15.19) can also be obtained
from the variational PDE (15.15a)-(15.15c) itself, without relying on Propo-
sition 15.2. For this, taking τ = τL∗ we note that the process
u 7→ e −(u∧τL∗ )r fL∗ (Su∧τL∗ ), u > t,
is not only a supermartingale, it is also a martingale until exercise at time

τL∗ by (15.14) since Su∧τL∗ > L∗ , hence we have
e −rt fL∗ (St ) = E∗ e −(u∧τL∗ )r fL∗ (Su∧τL∗ ) St ,

u > t,
hence after letting u tend to infinity we obtain
e −rt fL∗ (St ) = E∗ e −rτL∗ fL∗ (SτL∗ ) St

= E∗ e −rτL∗ fL∗ (L∗ ) St

= E∗ e −rτL∗ (K − SτL∗ )+ St

Sup E∗ e −rτL∗ (K − SτL∗ )+ St ,

6
τ >t
τ Stopping time
which recovers (15.19) as
e −rt fL∗ (St ) 6 Sup E∗ e −rτ (K − Sτ )+ St , t > 0.

τ >t
τ Stopping time
15.3 Perpetual American Call Options

In this section we consider the pricing of perpetual call options.
Two-choice optimal stopping at a fixed price level for perpetual

call options
Given L > K a fixed price, consider the following choices for the exercise of
a call option with strike price K:
" 513
N. Privault
1. If St > L, then exercise at time t.
2. Otherwise, wait until the first hitting time
τL = inf{u > t : Su = L}
and exercise the option and time τL .

In case St > L, the immediate exercise (or intrinsic) payoff will be
(St − K )+ = St − K,
since K < L 6 St .
In case St < L, as r > 0 the price of the option will be given by
fL (St ) = E∗ e −(τL −t)r (SτL − K )+ St

= E∗ e −(τL −t)r (SτL − K )+ 1{τL <∞} St

= E∗ e −(τL −t)r (L − K )+ St

= (L − K )E∗ e −(τL −t)r St .

Lemma 15.5. Assume that r > 0. We have
S0
E∗ e −rτL = .

L
Proof. We only need to consider the case S0 = x < L. Note that for all
(λ)
λ ∈ R, the process Zt t∈R defined as
+
(λ) 2 t/2−λ2 σ 2 t/2 2 σ 2 t/2

Zt := (St )λ e −rλt+λσ = (S0 )λ e λσBbt −λ , t > 0,
defined in (15.5) is a martingale under the risk-neutral probability measure

e Hence the stopped process Z (λ)
P. t∧τL t∈R+ is a martingale and it has constant

expectation, i.e., we have

(λ) (λ)
E∗ Zt∧τL = E∗ Z0 = (S0 )λ , t > 0. (15.20)
Choosing λ such that

σ2 σ2
r = rλ − λ + λ2 ,
2 2
i.e.
σ2 σ2 σ2 2r

0 = λ2 +λ r− −r = λ + 2 (λ − 1),
2 2 2 σ
Relation (15.20) rewrites as
514 "
E∗ (St∧τL )λ e −(t∧τL )r = (S0 )λ , t > 0. (15.21)

Choosing the positive solution∗ λ+ = 1 yields the bound

(λ+ )
0 6 Zt = e −rt St 6 St 6 L, 0 6 t 6 τL , (15.22)
(λ+ )
since r > 0 and St 6 L for all t ∈ [0, τL ]. Hence we have limt→∞ Zt = 0,
(λ ) (λ )
and since limt→∞ ZτL+∧t
= on {τL < ∞}, by (15.21)-(15.22) and the
ZτL+
dominated convergence theorem, we get
LE∗ e −rτL = E∗ e −rτL SτL 1{τL <∞}

= E∗ lim e −(τL ∧t)r SτL ∧t

t→∞
(λ )
= E∗ lim ZτL+∧t

t→∞
(λ )
= lim E∗ ZτL+∧t
t→∞
(λ )
= lim E∗ Z0 +
t→∞
= S0 ,
which yields
S0
E∗ e −rτL = . (15.23)

L
Note also that by (14.17) we have P(τL < ∞) = 1 if r − σ 2 /2 > 0, and
P(τL = +∞) > 0 if r − σ 2 /2 < 0.
Next, we apply Lemma 15.5 in order to price the perpetual American call
option.
Proposition 15.6. Assume that r > 0. The price of the perpetual American
call option is given by fL (St ) when St < L, where

 x − K,
 x > L > K,
fL (x) = (15.24)
 (L − K ) x ,

0 < x 6 L.
L
Proof. i) The result is obvious for S0 = x > L since in this case we have
τL = t = 0 and SτL = S0 = x, so that we only focus on the case x < L.
ii) Next, we consider the case S0 = x < L. We have
E∗ e −rτL (K − SτL )+ S0 = x = E∗ 1{τL <∞} e −rτL (K − SτL )+ S0 = x

∗
The bound (15.22) does not hold for the negative solution λ− = −2r/σ 2 .
" 515
N. Privault
= E∗ 1{τL <∞} e −rτL (K − L) S0 = x

= (K − L)E∗ e −rτL S0 = x ,

and we conclude by the expression of E∗ e −rτL S0 = x given in Lemma 15.1.

One can check from Figures 15.5 and 15.6 that the situation completely differs
from the perpetual put option case, as there does not exist an optimal value
L∗ that would maximize the option price for all values of the underlying asset
price.
450
400
L=150
L=250
350
L=400
Option price
300 (x-K)+
250 x
200
150
100
50
0
K=
0 50 100 150 200 250 300 350 400 450
Underlying
Fig. 15.5: American call prices by exercising at τL for different values of L and K = 100.
400
Perpetrual American call price
350 Immediate exercise payoff (x-K)+
300
Option price
250
200
150
100
50
0
0 50 K= 100 150 200 250 300 350 400
L = 315
Underlying x
Fig. 15.6: Animated graph of American option prices depending on L with K = 100.∗
The intuition behind this picture is that there is no upper limit above which
one should exercise the option, and in order to price the American perpetual
∗
516 "
call option we have to let L go to infinity, i.e. the “optimal” exercise strategy
is to wait indefinitely.
(x-K)+
fL(x)
K-L
180
160
140
120
100
80
60
40
250
20 200
0 150
100 Underlying x
300 250
L 200 150 100
Fig. 15.7: American call prices for different values of L.
We check from (15.24) that

x
lim fL (x) = x − lim K = x, x > 0. (15.25)
L→∞ L→∞ L
As a consequence we have the following proposition.
Proposition 15.7. Assume that r > 0. The price of the perpetual American
call option is given by
Sup E∗ e −(τ −t)r (Sτ − K )+ St = St , t > 0. (15.26)

τ >t
τ Stopping time
Proof. For all L > K we have
fL (St ) = E∗ e −(τL −t)r (SτL − K )+ St

Sup E∗ e −(τ −t)r (Sτ − K )+ St , t > 0,

6
τ >t
τ Stopping time
hence from (15.25), taking the limit as L → ∞ yields
Sup E∗ e −(τ −t)r (Sτ − K )+ St . (15.27)

St 6
τ >t
τ Stopping time
On the other hand, since u 7→ e −(u−t)r Su is a martingale, by (14.13) we have,

for all stopping times τ ∈ [t, ∞),
" 517
N. Privault
E∗ e −(τ −t)r (Sτ − K )+ St 6 E∗ e −(τ −t)r Sτ St 6 St , t > 0,

hence
Sup E∗ e −(τ −t)r (Sτ − K )+ St 6 St , t > 0,

τ >t
τ Stopping time
which shows (15.26) by (15.27).

We may also check that since ( e −rt St )t∈R+ is a martingale, the process t 7→
( e −rt St − K )+ is a submartingale since the function x 7→ (x − K )+ is convex,
hence for all bounded stopping times τ such that t 6 τ we have
(St − K )+ 6 E∗ ( e −(τ −t)r Sτ − K )+ St 6 E∗ e −(τ −t)r (Sτ − K )+ St ,

t > 0, showing that it is always better to wait than to exercise at time t,

and the optimal exercise time is τ ∗ = +∞. This argument does not apply to
American put options.
See Exercise 15.7 for the pricing of perpetual American call options with
dividends.
15.4 Finite Expiration American Options

In this section we consider finite expiration American put and call options
with strike price K. The prices of such options can be expressed as
Sup E∗ e −(τ −t)r (K − Sτ )+ St ,

f (t, St ) =
t6τ 6T
τ Stopping time
and
Sup E∗ e −(τ −t)r (Sτ − K )+ St .

f (t, St ) =
t6τ 6T
τ Stopping time
Two-choice optimal stopping at fixed times with finite expiration
We start by considering the optimal stopping problem in a simplified set-

ting where τ ∈ {t, T } is allowed at time t to take only two values t (which
corresponds to immediate exercise) and T (wait until maturity).
Proposition 15.8. Assume that r > 0. For any stopping time τ > t, the
price of the European call option exercised at time τ satisfies the bound
(x − K )+ 6 E∗ [ e −(τ −t)r (Sτ − K )+ | St = x], x, t > 0. (15.28)

Proof. Since the function x 7→ x+ = Max(x, 0) is convex non-decreasing
and the process ( e −rt St − e −rt K )t∈R+ is a submartingale under P∗ since
518 "
r > 0, Proposition 14.4-(b) shows that that t 7→ ( e −rt St − e −rt K )+ is a

submartingale by the Jensen inequality (14.3). Hence, by (14.13) applied to
submartingales, for any stopping time τ bounded by t > 0 we have
(St − K )+ = e rt ( e −rt St − e −rt K )+

6 e rt E∗ [( e −rτ Sτ − e −rτ K )+ | Ft ]
= E∗ [ e −(τ −t)r (Sτ − K )+ | Ft ],

In particular, for the deterministic time τ := T > t we get
(x − K )+ 6 e −(T −t)r E∗ [(ST − K )+ | St = x], x, t > 0.
as illustrated in Figure 15.8 using the Black-Scholes formula for European

call options, see also Figure 6.16a. In other words, taking x = St , the payoff
(St − K )+ of immediate exercise at time t is always lower than the expected
payoff e −(T −t)r E∗ [(ST − K )+ | St = x] given by exercise at maturity T . As
a consequence, the optimal strategy for the investor is to wait until time T
to exercise an American call option, rather than exercising earlier at time t.
Note that the situation is completely different when r < 0, see Figure 6.17a.
Black-Scholes European call price

Payoff (x-K)+
80
70
60
50
40
30
20
10
0
0 2 1
4 3
140 120 7 6 5
100 8
80 60 109 Time to maturity T-t
Underlying (HK$)
Fig. 15.8: Black-Scholes call option price with r = 3% > 0 vs (x, t) 7→ (x − K )+ .

More generally, it can be shown that the price of the American call option
equals the price of the corresponding European call option with maturity T ,
i.e.
f (t, St ) = e −(T −t)r E∗ (ST − K )+ St ,

i.e. T is the optimal exercise date, see Proposition 15.10 below or §14.4 of
Steele (2001) for a proof.
" 519
N. Privault
Put options
For put options the situation is entirely different. The Black-Scholes formula
for European put options shows that the inequality
(K − x)+ 6 e −(T −t)r E∗ [(K − ST )+ | St = x],
does not always hold, as illustrated in Figure 15.9, see also Figure 6.16b.
Payoff (K-x)+
Black-Scholes European put price
Option price path
16
14
12
10
8
6
4
2
0
0 90
1 2 100
3
4 5
6 110 Underlying (HK$)
Time to maturity T-t 7 8 9 10 120
Fig. 15.9: Black-Scholes put option price with r = 3% > 0 vs (x, t) 7→ (K − x)+ .
As a consequence, the optimal exercise decision for a put option depends

on whether (K − St )+ 6 e −(T −t)r E∗ [(K − ST )+ | St ] (in which case one
chooses to exercise at time T ) or (K − St )+ > e −(T −t)r E∗ [(K − ST )+ | St ]
(in which case one chooses to exercise at time t).
A view from above of the graph of Figure 15.9 shows the existence of an opti-
mal frontier depending on time to maturity and on the price of the underlying
asset, instead of being given by a constant level L∗ as in Section 15.1, see
Figure 15.10.
520 "
2
3
5 T-t
6
9
10
120 115 110 105 100 95 90
Underlying HK$
Fig. 15.10: Optimal frontier for the exercise of a put option.
At a given time t, one will choose to exercise immediately if (St , T − t) be-

longs to the blue area on the right, and to wait until maturity if (St , T − t)
belongs to the red area on the left.
When r = 0 we have L∗ = 0, and the next remark shows that in this case
it is always better to exercise the finite expiration American put option at
maturity T , see also Exercise 15.9.
Proposition 15.9. Assume that r = 0 and let φ : R −→ R be a nonnegative
convex function. Then the price of the finite expiration American option with
payoff function φ on the underlying asset price (St )t∈R+ coincides with the
corresponding vanilla option price:
Sup E∗ φ(Sτ ) St = E∗ φ(ST ) St ,

f (t, St ) =
t6τ 6T
τ Stopping time
i.e. the optimal strategy is to wait until the maturity time T to exercise the
option, and τ ∗ = T .
Proof. Since the function φ is convex and (St+s )s∈[0,T −t] is a martingale
under the risk-neutral measure P∗ , we know from Proposition 14.4-(a) that
the process (φ(St+s ))s∈[0,T −t] is a submartingale. Therefore, for all (bounded)
stopping times τ comprised between t and T we have,
E∗ [φ(Sτ ) | Ft ] 6 E∗ [φ(ST ) | Ft ],
i.e. it is always better to wait until time T than to exercise at time τ ∈ [t, T ],
and this yields
Sup E∗ φ(Sτ ) St 6 E∗ φ(ST ) St .

t6τ 6T
τ Stopping time
Since the constant T is a stopping time, it attains the above supremum.
" 521
N. Privault
15.5 PDE Method with Finite Expiration

Let us describe the PDE associated to American put options. After discretiza-
tion {0 = t0 < t1 < . . . < tN = T } of the time interval [0, T ], the optimal
exercise strategy for the American put option can be described as follow at
each time step:
If f (t, St ) > (K − St )+ , wait.
If f (t, St ) = (K − St )+ , exercise the option at time t.
Note that we cannot have f (t, St ) < (K − St )+ .
If f (t, St ) > (K − St )+ the expected return of the hedging portfolio equals

that of the riskless asset. This means that f (t, St ) follows the Black-Scholes
PDE
∂f ∂f 1 ∂2f
rf (t, St ) = (t, St ) + rSt (t, St ) + σ 2 St2 2 (t, St ),
∂t ∂x 2 ∂x
whereas if f (t, St ) = (K − St )+ it is not worth waiting as the return of the
hedging portfolio is lower than that of the riskless asset:
∂f ∂f 1 ∂2f
rf (t, St ) > (t, St ) + rSt (t, St ) + σ 2 St2 2 (t, St ).
∂t ∂x 2 ∂x
As a consequence, f (t, x) should solve the following variational PDE, see
Jaillet et al. (1990), Theorem 8.5.9 in Elliott and Kopp (2005) and Theorem 5
in Üstünel (2009):
+
f (t, x) > f (T , x) = (K − x) , (15.29a)








σ2 2 ∂ 2 f

 ∂f ∂f
(t, x) 6 rf (t, x), (15.29b)

 (t, x) + rx (t, x) + x

2

 ∂t
 ∂x ∂x2

 2 2
 ∂f (t, x) + rx ∂f (t, x) + σ x2 ∂ f (t, x) − rf (t, x)


2



 ∂t ∂x ∂x 2

× (f (t, x) − (K − x)+ ) = 0, (15.29c)






x > 0, 0 6 t 6 T , subject to the terminal condition f (T , x) = (K − x)+ .

In other words, equality holds either in (15.29a) or in (15.29b) due to the
presence of the term (f (t, x) − (K − x)+ ) in (15.29c).
The optimal exercise strategy consists in exercising the put option as soon
as the equality f (u, Su ) = (K − Su )+ holds, i.e. at the time
522 "
τ ∗ = inf{u > t : f (u, Su ) = (K − Su )+ },
after which the process feL∗ (St ) ceases to be a martingale and becomes a
(strict) supermartingale.
A simple procedure to compute numerically the price of an American put

option is to use a finite difference scheme while simply enforcing the condition
f (t, x) > (K − x)+ at every iteration by adding the condition
f (ti , xj ) := Max(f (ti , xj ), (K − xj )+ )
right after the computation of f (ti , xj ).
The next Figure 15.11 shows a numerical resolution of the variational

PDE (15.29a)-(15.29c) using the above simplified (implicit) finite difference
scheme, see also Jacka (1991) for properties of the optimal boundary function.
In comparison with Figure 15.4, one can check that the PDE solution becomes
time-dependent in the finite expiration case.
Finite expiration American put price
Immediate payoff (K-x)+
L*=2r/(2r+sigma2)
16
14
12
10
8
6
4
2
0 90
0 2 100
4 6 110 Underlying
Time to maturity T-t 8 10 120
Fig. 15.11: PDE estimates of finite expiration American put option prices.
In general, one will choose to exercise the put option when
f (t, St ) = (K − St )+ ,
i.e. within the blue area in Figure (15.11). We check that the optimal thresh-
old L∗ = 90.64 of the corresponding perpetual put option is within the ex-
ercise region, which is consistent since the perpetual optimal strategy should
allow one to wait longer than in the finite expiration case.
The numerical computation of the American put option price
Sup E∗ e −(τ −t)r (K − Sτ )+ St

f (t, St ) =
t6τ 6T
τ Stopping time
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N. Privault
can also be done by dynamic programming and backward optimization using

the Longstaff and Schwartz (2001) (or Least Square Monte Carlo, LSM)
algorithm as in Figure 15.12.

Longstaff-Schwartz algorithm
L*=2r/(2r+sigma2)
16
14
12
10
8
6
4
2
0 90
0 2 100
4 6 110
8 120 Underlying
Time to maturity T-t 10
Fig. 15.12: Longstaff-Schwartz estimates of finite expiration American put option

prices.
In Figure 15.12 above and Figure 15.13 below the optimal threshold of the
corresponding perpetual put option is again L∗ = 90.64 and falls within the
exercise region. Also, the optimal threshold is closer to L∗ for large time to
maturities, which shows that the perpetual option approximates the finite
expiration option in that situation. In the next Figure 15.13 we compare
the numerical computation of the American put option price by the finite
difference and Longstaff-Schwartz methods.
10
Longstaff-Schwartz algorithm
Implicit finite differences
8
Option price
0
90 100 110 120
Underlying
Fig. 15.13: Comparison between Longstaff-Schwartz and finite differences.
It turns out that, although both results are very close, the Longstaff-Schwartz
method performs better in the critical area close to exercise at it yields the
expected continuously differentiable solution, and the simple numerical PDE
solution tends to underestimate the optimal threshold. Also, a small error
in the values of the solution translates into a large error on the value of the
524 "
optimal exercise threshold.
The fOptions package in R contains a finite expiration American put option

pricer based on the Barone-Adesi and Whaley (1987) approximation, see
Exercise 15.4, however the approximation is valid only for certain parameter
ranges. See also Allegretto et al. (1995) for a related approximation of the
early exercise premium (15.17).
The finite expiration American call option
In the next proposition we compute the price of a finite expiration American

call option with an arbitrary convex payoff function φ.
Proposition 15.10. Assume that r > 0 and let φ : R −→ R be a nonneg-
ative convex function such that φ(0) = 0. The price of the finite expiration
American call option with payoff function φ on the underlying asset price
(St )t∈R+ is given by
Sup E∗ e −(τ −t)r φ(Sτ ) St = e −(T −t)r E∗ φ(ST ) St ,

f (t, St ) =
t6τ 6T
τ Stopping time
i.e. the optimal strategy is to wait until the maturity time T to exercise the
option, and τ ∗ = T .
Proof. Since the function φ is convex and φ(0) = 0, we have
φ(px) = φ((1 − p) × 0 + px) 6 (1 − p) × φ(0) + pφ(x) = pφ(x), (15.30)
for all p ∈ [0, 1] and x > 0. Next, taking p := e −rs

in (15.30) we note that
−rs ∗ −rs ∗
e E φ St+s Ft > e φ E St+s Ft

> φ e −rs E∗ St+s Ft

= φ(St ),
where we used Jensen’s inequality (14.3) applied to the convex function φ,

hence the process s 7→ e −rs φ(St+s ) is a submartingale. Hence by the optional
stopping theorem for submartingales, cf (14.9), for all (bounded) stopping
times τ comprised between t and T we have,
E∗ [ e −(τ −t)r φ(Sτ ) | Ft ] 6 e −(T −t)r E∗ [φ(ST ) | Ft ],
i.e. it is always better to wait until time T than to exercise at time τ ∈ [t, T ],
and this yields
Sup E∗ e −(τ −t)r φ(Sτ ) St 6 e −(T −t)r E∗ φ(ST ) St .

t6τ 6T
τ Stopping time
" 525
N. Privault
The converse inequality
e −(T −t)r E∗ φ(ST ) St 6 Sup E∗ e −(τ −t)r φ(Sτ ) St ,

t6τ 6T
τ Stopping time
is obvious because T is a stopping time.

As a consequence of Proposition 15.10 applied to the convex function φ(x) =
(x − K )+ , the price of the finite expiration American call option is given by
Sup E∗ e −(τ −t)r (Sτ − K )+ St

f (t, St ) =
t6τ 6T
τ Stopping time
= e −(T −t)r E∗ (ST − K )+ St ,

i.e. the optimal strategy is to wait until the maturity time T to exercise
the option. In the following Table 15.1 we summarize the optimal exercise
strategies for the pricing of American options.
Option Perpetual Finite expiration

type Pricing Optimal time Pricing Optimal time
∗
 K − St , 0 < St 6 L ,

 Solve the PDE (15.29a)-
Put
τ ∗ = τL∗ (15.29c) for f (t, x) or use τ ∗ = T ∧ inf{u > t : f (u, Su ) = (K − Su )+ }
option 
St
−2r/σ2
 (K − L∗ ) , St > L∗ . Longstaff and Schwartz (2001)
L∗
Call
St τ ∗ = +∞ e −(T −t)r E∗ [(ST − K )+ | St ] τ∗ = T
option
Table 15.1: Optimal exercise strategies.
Exercises
Exercise 15.1 Consider a two-step binomial model (Sk )k=0,1,2 with interest
rate r = 0% and risk-neutral probabilities (p∗ , q ∗ ):
526 "
S2 = 1.44
2/ 3
p =
∗
S1 = 1.2
3
p∗ = 2/ q∗ =
1/3
S0 = 1 S2 = 1.08
3
q∗ =
1/3 p∗ = 2/
S1 = 0.9
q∗ =
1/3
S2 = 0.81
a) At time t = 1, would you exercise the American put option with strike
price K = 1.25 if S1 = 1.2? If S1 = 0.9?
b) What would be your investment allocation at time t = 0?∗
Exercise 15.2 Let r > 0 and σ > 0.

2
a) Show that for every C > 0, the function f (x) := Cx−2r/σ solves the
1 2 2 00

0
 rf (x) = rxf (x) + σ x f (x),

2

 lim f (x) = 0.


x→∞
b) Show that for every K > 0 there exists a unique level L∗ ∈ (0, K ) and
constant C > 0 such that f (x) also solves the smooth fit conditions
f (L∗ ) = K − L∗ and f 0 (L∗ ) = −1.
Exercise 15.3 Consider an American butterfly option with the following

payoff function.
60
Payoff function
50
40
30
20
10
0
0 ^-K
2K ^
K L* K 200
Fig. 15.14: Butterfly payoff function.

∗
Download the corresponding discrete-time IPython notebook that can be run here.
" 527
N. Privault
Price the perpetual American butterfly option with r > 0 in the following
cases.
a) K
b 6 L∗ 6 S0 .
b) K
b 6 S0 6 L∗ .
c) 0 6 S0 6 K.
b
Exercise 15.4 (Barone-Adesi and Whaley (1987)) We approximate the

finite expiration American put option price with strike price K as
∗ −2r/σ 2

BSp (x, T ) + α(x/S )
 , x > S∗, (15.31)
f (x,T ) '

x 6 S∗, (15.32)

K − x,
where α > 0 is a parameter, S ∗ > 0 is called the critical price, and

BSp (x, T ) = e −rT KΦ(−d− (x, T )) − xΦ(−d+ (x, T )) is the Black-Scholes put
pricing function.
a) Find the value α∗ of α which achieves a smooth fit (equality of derivatives
in x) between (15.31) and (15.32) at x = S ∗ .
b) Derive the equation satisfied by the critical price S ∗ .
Exercise 15.5 Consider the process (Xt )t∈R+ given by Xt := tZ, t ∈ R+ ,

where Z ∈ {0, 1} is a Bernoulli random variable with P(Z = 1) = P(Z =
0) = 1/2. Given > 0, let the random time τ be defined as
τ := inf{t > 0 : Xt > },
with inf ∅ = +∞, and let (Ft )t∈R+ denote the filtration generated by
(Xt )t∈R+ .
a) Give the possible values of τ in [0, ∞] depending on the value of Z.
b) Take = 0. Is τ0 := inf{t > 0 : Xt > 0} an (Ft )t∈R+ -stopping time?
Hint: Consider the event {τ0 > 0}.
c) Take > 0. Is τ := inf{t > 0 : Xt > } an (Ft )t∈R+ -stopping time?
Hint: Consider the event {τ > t} for t > 0.
Exercise 15.6 American put options with dividends, cf. Exercise 8.5 in Shreve
(2004). Consider a dividend-paying asset priced as
b 2
St = S0 e (r−δ )t+σBt −σ t/2 , t > 0,
where r > 0 is the risk-free interest rate, δ > 0 is a continuous dividend rate,
bt )t∈R is a standard Brownian motion under the risk-neutral probability
(B +
528 "
measure P∗ , and σ > 0 is the volatility coefficient. Consider the American

put option with payoff
 κ − Sτ if Sτ 6 κ,

(κ − Sτ )+ =
0 if Sτ > κ,

when exercised at the stopping time τ > 0. Given L ∈ (0, κ) a fixed level,
consider the following exercise strategy for the above option:
- If St 6 L, then exercise at time t.
- If St > L, wait until the hitting time τL := inf{u > t : Su = L}, and
exercise the option at time τL .
a) Give the intrinsic option value at time t = 0 in case S0 6 L.
In the sequel we work with S0 = x > L.

(λ)
b) Show that for all λ ∈ R the process Zt t∈R defined as
+
λ
(λ) St 2 /2)t
Zt := e −((r−δ )λ−λ(1−λ)σ
S0
is a martingale under the risk-neutral probability measure P∗ .

(λ)
c) Show that Zt t∈R can be rewritten as
+
λ
(λ) St
Zt = e −rt , t > 0,
S0
for two values λ− 6 0 6 λ+ of λ that can be computed explicitly.

d) Choosing the negative solution λ− , show that
λ−
( λ− ) L
0 6 Zt 6 , 0 6 t 6 τL .
S0
e) Let τL denote the hitting time
τL = inf{u ∈ R+ : Su 6 L}.
By application of the Stopping Time Theorem 14.7 to the martingale

(Zt )t∈R+ , show that
λ−
S0
E∗ e −rτL = , (15.33)

L
with
" 529
N. Privault
(r − δ − σ 2 /2)2 + 4rσ 2 /2
p
−(r − δ − σ 2 /2) −
λ− := . (15.34)
σ2
f) Show that for all L ∈ (0, K ) we have
E∗ e −rτL (K − SτL )+ S0 = x

K − x, 0 < x 6 L,




= √
 x −(r−δ−σ2 /2)− (r−δ−σ2 /2)2 +4rσ2 /2
σ2
 (K − L) ,

x > L.
L
g) Show that the value L∗ of L that maximizes
fL (x) := E∗ e −rτL (K − SτL )+ S0 = x

for every x > 0 is given by

λ−
L∗ = K.
λ− − 1
h) Show that
λ−

 K − x, 0 < x 6 L∗ = K,
λ− − 1




fL∗ (x) =
1 − λ− λ− −1
λ−
x λ−

,

x > L∗ = K,


−λ− λ− − 1

K
i) Show by hand computation that fL∗ (x) satisfies the variational differential
equation



 fL∗ (x) > (K − x)+ , (15.35a)





1 2 2 00


0
 (r − δ )xfL∗ (x) + 2 σ x fL∗ (x) 6 rfL∗ (x), (15.35b)





1



rfL∗ (x) − (r − δ )xfL0 ∗ (x) − σ 2 x2 fL00∗ (x) (15.35c)


2





+
× (f ∗ (x) − (K − x) ) = 0.


L
j) Using Itô’s formula, check that the discounted portfolio value process
t 7→ e −rt fL∗ (St )
is a supermartingale.
530 "
k) Show that we have
Sup E∗ e −rτ (K − Sτ )+ S0 .

fL∗ (S0 ) >
τ Stopping time
l) Show that the stopped process
s 7→ e −(s∧τL∗ )r fL∗ (Ss∧τL∗ ), s > 0,
is a martingale, and that
Sup E∗ e −rτ (K − Sτ )+ .

fL∗ (S0 ) 6
τ Stopping time
m) Fix t ∈ R+ and let τL∗ denote the hitting time
τL∗ = inf{u > t : Su = L∗ }.
Conclude that the price of the perpetual American put option with divi-
dend is given for all t ∈ R+ by
fL∗ (St ) = E∗ e −(τL∗ −t)r (K − SτL∗ )+ St

λ−

 K − St , 0 < St 6 K,
λ− − 1




= λ −1
 1 − λ− − St λ−

λ−

, St >

 K,
−λ− λ− − 1

K
where λ− < 0 is given by (15.34), and
τL∗ = inf{u > t : Su 6 L}.
Exercise 15.7 American call options with dividends, see § 9.3 of Wilmott
2
(2006). Consider a dividend-paying asset priced as St = S0 e (r−δ )t+σBbt −σ t/2 ,
t > 0, where r > 0 is the risk-free interest rate, δ > 0 is a continuous dividend
rate, and σ > 0.
(λ) 2
a) Show that for all λ ∈ R the process Zt := (St )λ e −((r−δ )λ−λ(1−λ)σ /2)t
(λ)
b) Show that we have Zt = (St )λ e −rt for two values λ− 6 0, 1 6 λ+ of λ
satisfying a certain equation.
(λ )
c) Show that 06 Zt + 6 Lλ+ for 0 6 t 6 τL := inf{u > t : Su = L}, and
compute E∗ e −rτL (SτL − K )+ S0 = x when S0 = x < L and K < L.
Exercise 15.8 Optimal stopping for exchange options (Gerber and Shiu
(1996)). We consider two risky assets S1 and S2 modeled by
" 531
N. Privault
2 2
S1 (t) = S1 (0) e σ1 Wt +rt−σ2 t/2 S2 (t) = S2 (0) e σ2 Wt +rt−σ2 t/2 ,
and
(15.36)
t > 0, with σ2 > σ1 > 0 and r > 0, and the perpetual optimal stopping
problem
Sup E[ e −rτ (S1 (τ ) − S2 (τ ))+ ],
τ Stopping time
where (Wt )t∈R+ is a standard Brownian motion under P.

a) Find α > 1 such that the process
Zt := e −rt S1 (t)α S2 (t)1−α , t > 0, (15.37)
is a martingale.
b) For some fixed L > 1, consider the hitting time
τL = inf t ∈ R+ : S1 (t) > LS2 (t) ,

and show that
E[ e −rτL (S1 (τL ) − S2 (τL ))+ ] = (L − 1)E[ e −rτL S2 (τL )].
c) By an application of the Stopping Time Theorem 14.7 to the martingale

(15.37), show that we have
L−1
E[ e −rτL (S1 (τL ) − S2 (τL ))+ ] = S1 (0)α S2 (0)1−α .
Lα
d) Show that the price of the perpetual exchange option is given by
L∗ − 1
Sup E[ e −rτ (S1 (τ ) − S2 (τ ))+ ] = S1 (0)α S2 (0)1−α ,
τ Stopping time (L∗ )α
where
α
L∗ = .
α−1
e) As an application of Question (d), compute the perpetual American put
option price
Sup E[ e −rτ (κ − S2 (τ ))+ ]
τ Stopping time
when r = σ22 /2.
Exercise 15.9 Consider an underlying asset whose price is written as

2 t/2
St = S0 e rt+σBt −σ , t > 0,
ability measure P∗ , σ > 0 denotes the volatility coefficient, and r ∈ R is the
532 "
(λ)
risk-free interest rate. For any λ ∈ R we consider the process Zt t∈R+
defined by
(λ)
Zt := e −rt (St )λ
2 σ 2 t/2+(λ−1)(λ+2r/σ 2 )σ 2 t/2
= (S0 )λ e λσBt −λ , t > 0. (15.38)
(λ)
a) Assume that r > −σ 2 /2. Show that, under P∗ , the process Zt t∈R is
+
a supermartingale when −2r/σ 2 6 λ 6 1, and that it is a submartingale
when λ ∈ (−∞, −2r/σ 2 ] ∪ [1, ∞).
(λ)
b) Assume that r 6 −σ 2 /2. Show that, under P∗ , the process Zt t∈R is
+
a supermartingale when 1 6 λ 6 −2r/σ 2 , and that it is a submartingale
when λ ∈ (−∞, 1] ∪ [−2r/σ 2 , ∞).
c) From this question onwards, we assume that r < 0. Given L > 0, let τL
denote the hitting time
τL = inf{u ∈ R+ : Su = L}.
(λ)
By application of the Stopping Time Theorem 14.7 to Zt t∈R to suit-
+
able values of λ, show that
x Max(1,−2r/σ2 )

, x > L,


 L

E∗ e −rτL 1{τL <∞} | S0 = x 6

min(1,−2r/σ2 )
 x

, 0 < x 6 L.


L
d) Deduce an upper bound on the price
E∗ e −rτL (K − SτL )+ S0 = x

of the American put option exercised in finite time under the stopping
strategy τL when L ∈ (0, K ) and x > L.
e) Show that when r 6 −σ 2 /2, the upper bound of Question (d) increases
and tends to +∞ when L decreases to 0.
f) Find an upper bound on the price
E∗ e −rτL (SτL − K )+ 1{τL <∞} | S0 = x

of the American call option exercised in finite time under the stopping
strategy τL when L > K and x 6 L.
g) Show that when −σ 2 /2 6 r < 0, the upper bound of Question (f) increases
in L > K, and tends to S0 as L increases to +∞.
Exercise 15.10 Perpetual American binary options.
" 533
N. Privault
a) Compute the price
CbAm (t, St ) = Sup E∗ e −(τ −t)r 1{Sτ >K} St

τ >t
τ Stopping time
of the perpetual American binary call option.

PbAm (t, St ) = Sup E∗ e −(τ −t)r 1{Sτ 6K} St

τ >t
τ Stopping time
of the perpetual American binary put option.
Exercise 15.11 Finite expiration American binary options. An American

binary (or digital) call (resp. put) option with maturity T > 0 on an under-
2
lying asset process (St )t∈R+ = ( e rt+σBt −σ t/2 )t∈R+ can be exercised at any
time t ∈ [0, T ], at the choice of the option holder.
The call (resp. put) option exercised at time t yields the payoff 1[K,∞) (St )
(resp. 1[0,K ] (St )), and the option holder wants to find an exercise strategy
that will maximize his payoff.
a) Consider the following possible situations at time t:
i) St > K,
ii) St < K.
In each case (i) and (ii), tell whether you would choose to exercise the
call option immediately, or to wait.
b) Consider the following possible situations at time t:
i) St > K,
ii) St 6 K.
In each case (i) and (ii), tell whether you would choose to exercise the
put option immediately, or to wait.
c) The price CdAm (t, T , St ) of an American binary call option is known to
satisfy the Black-Scholes PDE
∂CdAm ∂C Am 1 ∂ 2 CdAm
rCdAm (t, T , x) = (t, T , x) + rx d (t, T , x) + σ 2 x2 (t, T , x).
∂t ∂x 2 ∂x2
Based on your answers to Question (a), how would you set the boundary
conditions CdAm (t, T , K ), 0 6 t < T , and CdAm (T , T , x), 0 6 x < K?
d) The price PdAm (t, T , St ) of an American binary put option is known to
satisfy the same Black-Scholes PDE
534 "
∂PdAm ∂P Am 1 ∂ 2 PdAm
rPdAm (t, T , x) = (t, T , x) + rx d (t, T , x) + σ 2 x2 (t, T , x).
∂t ∂x 2 ∂x2
(15.39)
Based on your answers to Question (b), how would you set the boundary
conditions PdAm (t, T , K ), 0 6 t < T , and PdAm (T , T , x), x > K?
e) Show that the optimal exercise strategy for the American binary call op-
tion with strike price K is to exercise as soon as the price of the underlying
asset reaches the level K, i.e. at time
τK := inf{u > t : Su = K},
starting from any level St 6 K, and that the price CdAm (t, T , St ) of the
American binary call option is given by
CdAm (t, x) = E e −(τK −t)r 1{τK <T } | St = x .

f) Show that the price CdAm (t, T , St ) of the American binary call option is
equal to
(r + σ 2 /2)(T − t) + log(x/K )

x
CdAm (t, T , x) = Φ √
K σ T −t
x −2r/σ2 −(r + σ 2 /2)(T − t) + log(x/K )
+ Φ √ , 0 6 x 6 K,
K σ T −t
that this formula is consistent with the answer to Question (c), and that
it recovers the answer to Question (a) of Exercise 15.10 as T tends to
infinity.
g) Show that the optimal exercise strategy for the American binary put op-
tion with strike price K is to exercise as soon as the price of the underlying
asset reaches the level K, i.e. at time
τK := inf{u > t : Su = K},
starting from any level St > K, and that the price PdAm (t, T , St ) of the
American binary put option is
PdAm (t, T , x) = E[ e −(τK −t)r 1{τK <T } | St = x], x > K.
h) Show that the price PdAm (t, T , St ) of the American binary put option is
equal to
−(r + σ 2 /2)(T − t) − log(x/K )

x
PdAm (t, T , x) = Φ √
K σ T −t
x −2r/σ2 (r + σ 2 /2)(T − t) − log(x/K )
+ Φ √ , x > K,
K σ T −t
" 535
N. Privault
that this formula is consistent with the answer to Question (d), and that
it recovers the answer to Question (b) of Exercise 15.10 as T tends to
infinity.
i) Does the standard call-put parity relation hold for American binary op-
tions?
Exercise 15.12 American forward contracts. Consider (St )t∈R+ an asset

price process given by
dSt
= rdt + σdBt ,
St
where r > 0 and (Bt )t∈R+ is a standard Brownian motion under P∗ .
a) Compute the price
Sup E∗ e −(τ −t)r (K − Sτ ) St ,

f (t, St ) =
t6τ 6T
τ Stopping time
and optimal exercise strategy of a finite expiration American-type short

forward contract with strike price K on the underlying asset priced
(St )t∈R+ , with payoff K − Sτ when exercised at time τ ∈ [0, T ].
Sup E∗ e −(τ −t)r (Sτ − K ) St ,

f (t, St ) =
t6τ 6T
τ Stopping time
and optimal exercise strategy of a finite expiration American-type long for-

ward contract with strike price K on the underlying asset priced (St )t∈R+ ,
with payoff Sτ − K when exercised at time τ ∈ [0, T ].
c) How are the answers to Questions (a) and (b) modified in the case of
perpetual options with T = +∞?
Exercise 15.13 Consider an underlying asset price process written as
b 2
St = S0 e rt+σBt −σ t/2 , t > 0,
where (Bbt )t∈R is a standard Brownian motion under the risk-neutral prob-
+
ability measure P∗ , with σ, r > 0.
a) Show that the processes (Yt )t∈R+ and (Zt )t∈R+ defined as
2
Yt := e −rt St−2r/σ and Zt := e −rt St , t > 0,
are both martingales under P∗ .

b) Let τL denote the hitting time
τL = inf{u ∈ R+ : Su = L}.
536 "
By application of the Stopping Time Theorem 14.7 to the martingales

(Yt )t∈R+ and (Zt )t∈R+ , show that
x
 , 0 < x 6 L,
L

E∗ e −rτL S0 = x =

2
 x −2r/σ ,


x > L.
L
c) Compute the price E∗ [ e −rτL (K − SτL )] of a short forward contract under
the exercise strategy τL .
d) Show that for every value of S0 = x there is an optimal value L∗x of L
that maximizes L 7→ E[ e −rτL (K − SτL )].
e) Would you use the stopping strategy
τL∗x = inf{u ∈ R+ : Su = L∗x }
as an optimal exercise strategy for the short forward contract with payoff
K − Sτ ?
Exercise 15.14 Let p > 1 and consider a power put option with payoff
(κ − Sτ )p if Sτ 6 κ,
(
((κ − Sτ )+ )p = 0 if Sτ > κ,
exercised at time τ , on an underlying asset whose price St is written as

2 t/2
St = S0 e rt+σBt −σ , t > 0,
ability measure P∗ , r > 0 is the risk-free interest rate, and σ > 0 is the
volatility coefficient.
Given L ∈ (0, κ) a fixed price, consider the following choices for the exercise
of a put option with strike price κ:
i) If St 6 L, then exercise at time t.
ii) Otherwise, wait until the first hitting time τL := inf{u > t : Su = L},
and exercise the option at time τL .
a) Under the above strategy, what is the option payoff equal to if St 6 L ?
b) Show that in case St > L, the price of the option is equal to
fL (St ) = (κ − L)p E∗ e −(τL −t)r St .

c) Compute the price fL (St ) of the option at time t.
" 537
N. Privault
2
Hint: Recall that by (15.4) we have E∗ [ e −(τL −t)r | St = x] = (x/L)−2r/σ
for x > L.
d) Compute the optimal value L∗ that maximizes L 7→ fL (x) for all fixed
x > 0.
Hint: Observe that, geometrically, the slope of x 7→ fL (x) at x = L∗ is

equal to −p(κ − L∗ )p−1 .
e) How would you compute the American put option price
Sup E∗ e −(τ −t)r ((κ − Sτ )+ )p St ?

f (t, St ) =
τ >t
τ Stopping time
Exercise 15.15 Same questions as in Exercise 15.14, this time for the option
with payoff κ − (Sτ )p exercised at time τ , with p > 0.
538 "
Chapter 16
Change of Numéraire and Forward
Measures
Change of numéraire is a powerful technique for the pricing of options under

random discount factors by the use of forward measures. It has applications
to the pricing of interest rate derivatives and other types of options, including
exchange options (Margrabe formula) and foreign exchange options (Garman-
Kohlagen formula). The computation of self-financing hedging strategies by
change of numéraire is treated in Section 16.5, and the change of numéraire
technique will be applied to the pricing of interest rate derivatives such as
bond options and swaptions in Chapter 19.
16.1 Notion of Numéraire . . . . . . . . . . . . . . . . . . . . . . . . . . . 539

16.2 Change of Numéraire . . . . . . . . . . . . . . . . . . . . . . . . . . . 542
16.3 Foreign Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552
16.4 Pricing Exchange Options . . . . . . . . . . . . . . . . . . . . . . 560
16.5 Hedging by Change of Numéraire . . . . . . . . . . . . . . . 562
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566
16.1 Notion of Numéraire
A numéraire is any strictly positive (Ft )t∈R+ -adapted stochastic process

(Nt )t∈R+ that can be taken as a unit of reference when pricing an asset
or a claim.
In general, the price St of an asset, when quoted in terms of the numéraire

Nt , is given by
St
Sbt := , t > 0.
Nt
Deterministic numéraires transformations are easy to handle, as change of
numéraire by a constant factor is a formal algebraic transformation that
does not involve any risk. This can be the case for example when a currency
" 539
N. Privault
is pegged to another currency,∗ for example the exchange rate of the French
franc to the Euro was locked at €1 = FRF 6.55957 on 31 December 1998.
On the other hand, a random numéraire may involve new risks, and can
allow for arbitrage opportunities.
Examples of numéraire processes (Nt )t∈R+ include:

- Money market account.
Given (rt )t∈R+ a possibly random, time-dependent and (Ft )t∈R+ -adapted
risk-free interest rate process, let†
w
t
Nt := exp rs ds .
0
In this case,
St rt
Sbt = = e − 0 rs ds St , t > 0,
Nt
represents the discounted price of the asset at time 0.
- Currency exchange rates
In this case, Nt := Rt denotes e.g. the EUR/SGD (EURSGD=X) exchange

rate from a foreign currency (e.g. EUR) to a domestic currency (e.g. SGD),
i.e. one unit of foreign currency (EUR) corresponds to Rt units of local
currency (SGD). Let
St
Sbt := , t > 0,
Rt
denote the price of a local (SG) asset quoted in units of the foreign currency
(EUR). For example, if Rt = 1.63 and St = S$1, then
St 1
Sbt = = × $1 ' €0.61,
Rt 1.63
and 1/Rt is the domestic SGD/EUR exchange rate. A question of interest

is whether a local asset $St , discounted according to a foreign risk-free
rate rf and priced in foreign currency as
ft St f
e −r = e −r t Sbt ,
Rt
∗
Major currencies have started floating against each other since 1973, following the end
of the system of fixed exchanged rates agreed upon at the Bretton Woods Conference,
July 1-22, 1944.
†
“Anyone who believes exponential growth can go on forever in a finite world is either
a madman or an economist”, K.E. Boulding (1973), page 248.
540 "
can be a martingale on the foreign market.
My foreign currency account St grew by 5%

My foreign currency account St grew by 5%
this year.
this year.
The foreign exchange rate dropped by 10%.
A:
A:
Fig. 16.1: Why change of numéraire?
- Forward numéraire.
The price P (t, T ) of a bond paying P (T , T ) = $1 at maturity T can be

taken as numéraire. In this case, we have
h rT i
Nt := P (t, T ) = E∗ e − t rs ds Ft , 0 6 t 6 T.

Recall that
rt h rT i
t 7→ e − rs ds
P (t, T ) = E∗ e − 0 rs ds Ft , 0 6 t 6 T,
0

is an Ft - martingale.
- Annuity numéraire.
Processes of the form

n
X
Nt := (Tk − Tk−1 )P (t, Tk ), 0 6 t 6 T1 ,
k =1
where P (t, T1 ), P (t, T2 ), . . . , P (t, Tn ) are bond prices with maturities T1 <
T2 < · · · < Tn arranged according to a tenor structure.
- Combinations
rt f
of the above: for example a foreign money market ac-
count e 0 s Rt , expressed in local (or domestic) units of currency, where
r ds
rtf t∈R represents a short-term interest rate on the foreign market.

+
When the numéraire is a random process, the pricing of a claim whose value
has been transformed under change of numéraire, e.g. under a change of cur-
rency, has to take into account the risks existing on the foreign market.
" 541
N. Privault
In particular, in order to perform a fair pricing, one has to determine a proba-

bility measure under which the transformed (or forward, or deflated) process
Sbt = St /Nt will be a martingale, see Section 16.3 for details.
rt
For example in case Nt := e 0 rs ds is the money market account, the risk-
neutral probability measure P∗ is a measure under which the discounted price
process
St rt
Sbt = = e − 0 rs ds St , t > 0,
Nt
is a martingale. In the next section, we will see that this property can be
extended to any type of numéraire.
See Exercises 16.5 and 16.6 for other examples of numéraires.
16.2 Change of Numéraire
In this section we review the pricing of options by a change of measure asso-

ciated to a numéraire Nt , cf. e.g. Geman et al. (1995) and references therein.
Most of the results of this chapter rely on the following assumption, which
expresses absence of arbitrage. In the foreign exchange setting where Nt =
Rt , this condition states that the price of one unit of foreign currency is a
martingale when quoted and discounted in the domestic currency.
Assumption (A). The discounted numéraire
rt
t 7→ Mt := e − 0
rs ds
Nt
is an Ft -martingale under the risk-neutral probability measure P∗ .

Definition 16.1. Given (Nt )t∈[0,T ] a numéraire process, the associated for-
ward measure P
b is defined by the Radon-Nikodym density
dP MT rT N
= e − 0 rs ds T .
b
:= (16.1)
dP∗ M0 N0
Recall that from Section 7.3 the above Relation (16.1) rewrites as
MT rT NT
dP
b= dP∗ = e − 0 rs ds dP∗ ,
M0 N0
which is equivalent to stating that
w
Eb [F ] = F (ω )dP b (ω )
Ω
w rT NT
= F (ω ) e − 0 rs ds dP∗ (ω )
Ω N0
542 "
rT N

= E∗ F e − 0 rs ds T ,
N0
for all integrable FT -measurable random variables F . More generally, by

(16.1) and the fact that the process
rt
t 7→ Mt := e − 0
rs ds
Nt
is an Ft -martingale under P∗ under Assumption (A), we find that

" #
dP rT

E∗ Ft = E∗ NT e − 0 rs ds Ft
b
dP∗ N0

MT
= E∗ Ft
M0
Mt
=
M0
Nt − r t rs ds
= e 0 , 0 6 t 6 T. (16.2)
N0
In Proposition 16.5 we will show, as a consequence of next Lemma 16.2 below,
that for any integrable random claim payoff C we have
h rT i
E∗ C e − t rs ds NT Ft = Nt Eb [C | Ft ], 0 6 t 6 T.
Similarly to the above, the Radon-Nikodym density dP

b |F /dP∗ of P
t |Ft
b |F with
t
respect to P∗|Ft satisfies the relation
w
E
b [F | Ft ] = F (ω )dP
b |F (ω )
Ω t
w rT dP
b |F
= F (ω ) e − 0
rs ds t
dP∗|Ft (ω )
Ω dP∗|Ft
dP
" #
b |F
∗
=E F t
Ft ,
dP∗|Ft
for all integrable FT -measurable random variables F , 0 6 t 6 T . Note that

(16.2), which is Ft -measurable, should not be confused with (16.3), which is
FT -measurable.
Lemma 16.2. We have
dP
b |F M rT N
t
= T = e − t rs ds T , 0 6 t 6 T. (16.3)
dP|Ft
∗ Mt Nt
" 543
N. Privault
Proof. The proof of (16.3) relies on an abstract version of the Bayes formula.
For all bounded Ft -measurable random variable G, by (16.2), the tower prop-
erty (23.38) of conditional expectations and the characterization (23.49) in
Proposition 23.19, we have
rT
E b = E∗ GX b e − 0 rs ds NT

b GX
N0

N rt rT
= E∗ G
t
e − 0 rs ds E∗ X b e − t rs ds NT Ft
N0 Nt
" " # #
dP
rT
∗ b − t rs ds NT
b
= E∗ GE∗ F t E X e F t
dP∗ Nt

" #
dP
rT
b e − t rs ds NT Ft

= E∗ G ∗ E∗ X
b
dP Nt
rT
=Eb GE∗ X b e − t rs ds NT Ft ,
Nt
for all bounded random variables X,

b which shows that
rT
E b | Ft = E∗ Xb e − t rs ds NT Ft ,

b X
Nt
i.e. (16.3) holds.

rt
We note that in case the numéraire Nt = e 0
rs ds
is equal to the money
market account we simply have P
b = P∗ .
Definition 16.3. Given (Xt )t∈R+ an asset price process, we define the pro-
cess of forward (or deflated) prices
bt := Xt ,
X 0 6 t 6 T. (16.4)
Nt
The process X epresents the values at times t of Xt , expressed in

bt
t∈R+
units of the numéraire Nt . In the sequel, it will be useful to determine the
dynamics of X under the forward measure P. b The next proposition

bt
t∈R+ rt
shows in particular that the process e 0 rs ds /Nt is an Ft -martingale
t∈R+
under P.
b
Proposition 16.4. Let (Xt )t∈R+ denote a continuous (Ft )t∈R+ -adapted as-
set price process such that
rt
t 7→ e − 0
rs ds
Xt , t > 0,
is a martingale under P∗ . Then, under change of numéraire,

544 "

the deflated process X
bt
t∈[0,T ]
= (Xt /Nt )t∈[0,T ] of forward prices is an
Ft -martingale under P,
b
is integrable under P.

provided that X
bt
t∈[0,T ]
b
Proof. We show that

b Xt Fs = Xs ,
E 0 6 s 6 t, (16.5)

Nt Ns
using the characterization (23.49) of conditional expectation in Proposi-

tion 23.19. Namely, for all bounded Fs -measurable random variables G we
note that using (16.2) under Assumption (A) we have
" #
b G Xt = E∗ G Xt dP
b
E
Nt Nt dP∗
" " ##
∗ ∗ Xt dP b
=E E G Ft
Nt dP∗
" " ##
Xt dP
= E∗ G E∗
b
Ft
Nt dP∗
rt Xt

= E∗ G e − 0 ru du (16.6)
N0
rs Xs

= E∗ G e − 0 ru du (16.7)
N0
" " ##
Xs dP
= E∗ G E∗
b
Fs
Ns dP∗
" " ##
Xs dP
= E∗ E∗ G
b
Fs
Ns dP∗
" #
Xs dP
= E∗ G
b
Ns dP∗

=Eb G Xs , 0 6 s 6 t,
Ns
where from (16.6) to (16.7)we used the fact that

rt
t 7→ e − 0
rs ds
Xt
is an Ft -martingale under P∗ . Finally, the identity
" 545
N. Privault

E b G Xt = E
ct = E b G Xs = E cs , 0 6 s 6 t,

b GX b GX
Nt Ns
for all bounded Fs -measurable G, implies (16.5).
Pricing using change of numéraire
The change of numéraire technique is specially useful for pricing under ran-
dom interest rates, in which case an expectation of the form
h rT i
E∗ e − t rs ds C Ft

becomes a path integral, see e.g. Dash (2004) for a recent account of path
integral methods in quantitative finance. The next proposition is the basic
result of this section, it provides a way to price
r
an option with arbitrary
T
payoff C under a random discount factor e − t rs ds by use of the forward
measure. It will be applied in Chapter 19 to the pricing of bond options and
caplets, cf. Propositions 19.1, 19.3 and 19.5 below.
Proposition 16.5. An option with integrable claim payoff C ∈ L1 (Ω, P∗ , FT )
is priced at time t as
h rT
b C Ft ,
i
E∗ e − t rs ds C Ft = Nt E 0 6 t 6 T, (16.8)

NT
provided that C/NT ∈ L1 Ω, P,

b FT .
Proof. By Relation (16.3) in Lemma 16.2 we have
dP
" #
h rT i b |F N
t
E∗ e − t rs ds C Ft = E∗ t

C Ft
dP∗|Ft NT
dP
" #
b |F C
∗
= Nt E t Ft
dP∗|Ft NT
w dP b |F C
= Nt t
dP∗|Ft
Ω dP∗ NT
|Ft
w C
= Nt dPb |F
Ω NT t

C
= Nt E Ft , 0 6 t 6 T.
b
NT
Equivalently, we can write
546 "
C dP
" #

C
b |F
Nt E Ft = Nt E∗
t
b Ft
NT NT dP∗|Ft
h rT i
= E∗ e − t rs ds C Ft , 0 6 t 6 T.

Each application of the change of numéraire formula (16.8) will require to:
a) pick a suitable numéraire (Nt )t∈R+ satisfying Assumption (A),
b) make sure that the ratio C/NT takes a sufficiently simple form,
c) use the Girsanov theorem in order to determine the dynamics of asset
prices under the new probability measure P,b
so as to compute the expectation under P

b on the right-hand side of (16.8).
Next, we consider further examples of numéraires and associated examples

of option prices.
Examples:
a) Money market account.
rt
Take Nt := e 0 rs ds , where (rt )t∈R+ is a possibly random and time-
dependent risk-free interest rate. In this case, Assumption (A) is clearly
satisfied, we have P
b = P∗ and dP∗ /dP, b and (16.8) simply reads
h rT i rt h rT i
E∗ e − t rs ds C Ft = e 0 rs ds E∗ e − 0 rs ds C Ft , 0 6 t 6 T,

which yields no particular information.
b) Forward numéraire.
Here, Nt := P (t, T ) is the price P (t, T ) of a bondmaturing

r
at timeT , 0 6
t
t 6 T , and the discounted bond price process e− r ds
0 s P (t, T )
t∈[0,T ]
is an Ft -martingale under P∗ , i.e. Assumption (A) is satisfied and Nt =
P (t, T ) can be taken as numéraire. In this case, (16.8) shows that a random
claim payoff C can be priced as
h rT i
E∗ e − t rs ds C Ft = P (t, T )Eb [C | Ft ], 0 6 t 6 T, (16.9)

since NT = P (T , T ) = 1, where the forward measure P

b satisfies
rT
dP rT P (T , T ) e − 0 rs ds
= e − 0 rs ds
b
= (16.10)
dP∗ P (0, T ) P (0, T )
" 547
N. Privault
by (16.1).
c) Annuity numéraires.
We take
n
X
Nt : = (Tk − Tk−1 )P (t, Tk )
k =1
where P (t, T1 ), . . . , P (t, Tn ) are bond prices with maturities T1 < T2 <
· · · < Tn . Here, (16.8) shows that a swaption on the cash flow P (T , Tn ) −
P (T , T1 ) − κNT can be priced as
h rT i
E∗ e − t rs ds (P (T , Tn ) − P (T , T1 ) − κNT )+ Ft
" + #
P (T , Tn ) − P (T , T1 )
= Nt E −κ Ft ,
b
NT
0 6 t 6 T < T1 , where (P (T , Tn ) − P (T , T1 ))/NT becomes a swap rate,

cf. (18.18) in Proposition 18.8 and Section 19.5.
Girsanov theorem
We refer to e.g. Theorem III-35 page 132 of Protter (2004) for the following
version of the Girsanov Theorem.
Theorem 16.6. Assume that P b is equivalent∗ to P∗ with Radon-Nikodym
density dP/dP
b ∗ , and let (W )
t t∈[0,T ] be a standard Brownian motion under
P∗ . Then, letting
dP
b
Φ t : = E∗ Ft , 0 6 t 6 T, (16.11)

dP∗

the process W
ct
t∈[0,T ]
defined by
1
ct := dWt −
dW dΦt • dWt , 0 6 t 6 T, (16.12)
Φt
is a standard Brownian motion under P.

b
In case the martingale (Φt )t∈[0,T ] takes the form

w
1wt

t
Φt = exp − ψs dWs − |ψs |2 ds , 0 6 t 6 T,
0 2 0
∗
This means that the Radon-Nikodym densities dP b /dP∗ and dP∗ /dP
b exist and are
strictly positive with P∗ and P
b -probability one, respectively.
548 "
i.e.
dΦt = −ψt Φt dWt , 0 6 t 6 T,
the Itô multiplication Table 4.1 shows that Relation (16.12) reads
1
ct = dWt −
dW dΦt • dWt
Φt
1
= dWt − (−ψt Φt dWt ) • dWt
Φt
= dWt + ψt dt, 0 6 t 6 T,
r
and shows that the shifted process W = Wt + 0t ψs ds t∈[0,T ] is a

ct
t∈[0,T ]
standard Brownian motion under P, b which is consistent with the Girsanov
Theorem 7.3. The next result is another application of the Girsanov Theorem.

Proposition 16.7. The process W ct
t∈[0,T ]
defined by
1
ct := dWt −
dW dNt • dWt , 0 6 t 6 T, (16.13)
Nt
b
Proof. Relation (16.2) shows that Φt defined in (16.11) satisfies
dP
b
Φ t = E∗ Ft
dP∗
NT − r T rs ds

= E∗ e 0 Ft
N0
Nt − r t rs ds
= e 0 , 0 6 t 6 T,
N0
hence
Nt − r t rs ds

dΦt = d e 0
N0
rt
Nt

= −Φt rt dt + e − 0
rs ds
d
N0
Φt
= −Φt rt dt + dNt ,
Nt
which, by (16.12), yields
1
ct = dWt −
dW dΦt • dWt
Φt
1 Φt

= dWt − −Φt rt dt + dNt • dWt
Φt Nt
" 549
N. Privault
1
= dWt − dNt • dWt ,
Nt
which is (16.13), from Relation (16.12) and the Itô multiplication Table 4.1.

The next Proposition 16.8 is consistent with the statement of Proposi-
tion 16.4, and in addition it specifies the dynamics of X bt
t∈R+
under P
b
using the Girsanov Theorem 16.7. As a consequence, we have the next propo-
sition, see Exercise 16.1 for another calculation based on geometric Brownian
motion, and Exercise 16.10 for an extension to correlated Brownian motions.
Proposition 16.8. Assume that (Xt )t∈R+ and (Nt )t∈R+ satisfy the stochas-
tic differential equations
dXt = rt Xt dt + σtX Xt dWt , and dNt = rt Nt dt + σtN Nt dWt , (16.14)
where (σtX )t∈R+ and (σtN )t∈R+ are (Ft )t∈R+ -adapted volatility processes and
(Wt )t∈R+ is a standard Brownian motion under P∗ . Then we have
bt = σtX − σtN X ct , (16.15)

dX bt dW
hence (X
bt )
t∈[0,T ] is given by the driftless geometric Brownian motion
w
1wt X

t
b0 exp
bt = X
X (σsX − σsN )dW
cs − (σs − σsN )2 ds , 0 6 t 6 T.
0 2 0
Proof. First we note that by (16.13) and (16.14),
1
ct = dWt −
dW dNt • dWt = dWt − σtN dt, t > 0,
Nt
is a standard Brownian motion under P. b Next, by Itô’s calculus and the Itô
multiplication Table 4.1 and (16.14) we have
1 1 1

d = − 2 dNt + 3 dNt • dNt
Nt Nt Nt
1 |σ N |2
= − 2 rt Nt dt + σtN Nt dWt + t dt
Nt Nt
1 N 2
ct + σtN dt + |σt | dt
= − 2 rt Nt dt + σtN Nt dW

Nt Nt
1 ct ,
rt dt + σtN dW (16.16)

=−
Nt
hence

bt = d Xt
dX
Nt
550 "
1 1

dXt
= + Xt d + dXt • d
Nt Nt Nt
1 Xt
rt Xt dt + σtX Xt dWt − rt dt + σtN dWt − |σtN |2 dt

=
Nt Nt
1
rt Xt dt + σtX Xt dWt · rt dt + σtN dWt − |σtN |2 dt

−
Nt
1 Xt
rt Xt dt + σtX Xt dWt − rt dt + σtN dWt

=
Nt Nt
Xt Xt X N
+ |σtN |2 dt − σ σ dt
Nt Nt t t
Xt X Xt N Xt X N |σ N |2
= σt dWt − σt dWt − σt σt dt + Xt t dt
Nt Nt Nt Nt
Xt X
σt dWt − σtN dWt − σtX σtN dt + |σtN |2 dt

=
Nt
ct σtX − σtN dWt − X ct σtX − σtN σtN dt

= X
ct σtX − σtN dW ct ,

= X
ct = dWt − σ N dt, 0 6 t 6 T .
since dW t
We end this section with some comments on inverse changes of measure.
Inverse changes of measure
In the next proposition we compute the conditional inverse Radon-Nikodym

density dP∗ /dP,
b see also (16.2).
Proposition 16.9. We have

w
b dP Ft = N0 exp
∗
t
E rs ds , 0 6 t 6 T, (16.17)
dP
b Nt 0
and the process

w
M0 N0 t
t 7→ = exp rs ds , 0 6 t 6 T,
Mt Nt 0
is an Ft -martingale under P.
b
Proof. For all bounded and Ft -measurable random variables F we have,
b F dP = E∗ [F ]
∗
E
dP
b

Nt
= E∗ F
Nt
" 551
N. Privault
w
N T
= E∗ F T exp − rs ds
Nt t
w
N0 t
=E F
b exp rs ds .
Nt 0

By (16.16) we also have
w w
1 1

t t
d exp rs ds = − exp ct ,
rs ds σtN dW
Nt 0 Nt 0
which recovers the second part of Proposition 16.9, i.e. the martingale prop-
erty of w
1

M0 t
t 7→ = exp rs ds
Mt Nt 0
under P.
b
16.3 Foreign Exchange

Currency exchange is a typical application of change of numéraire, that illus-
trates the absence of arbitrage principle.
Let Rt denote the foreign exchange rate, i.e. Rt is the (possibly fractional)
quantity of local currency that correspond to one unit of foreign currency,
while 1/Rt represents the quantity of foreign currency that correspond to a
unit of local currency.
Rt trf Discount Rt ( rf −rl )t

Local $1 e e
R0 R0
f
1 e tr
Foreign
R0 R0
Consider an investor that intends to exploit an “overseas investment oppor-

tunity” by
a) at time 0, changing one unit of local currency into 1/R0 units of foreign
currency,
b) investing 1/R0 on the foreign market at the rate rf , which will yield the
f
amount e tr /R0 at time t > 0,
f f
c) changing back e tr /R0 into a quantity e tr Rt /R0 = Nt /R0 of local cur-
rency.
552 "
Fig. 16.2: Overseas investment opportunity.∗
f f
In other words, the foreign money market account e tr is valued e tr Rt on
the local (or domestic) market, and its discounted value on the local market
is
l f
e −tr +tr Rt , t > 0.
The outcome of this investment will be obtained by a martingale comparison
f l
of e tr Rt /R0 to the amount e tr that could have been obtained by investing
on the local market.
Taking
f
Nt := e tr Rt , t > 0, (16.18)
as numéraire, absence of arbitrage is expressed by Assumption (A), which

states that the discounted numéraire process
l l −r f )
t 7→ e −r t Nt = e −t(r Rt
is an Ft -martingale under P∗ .
Next, we find a characterization of this arbitrage condition using the model

parameters r, rf , µ, by modeling the foreign exchange rates Rt according to
a geometric Brownian motion (16.19).
Proposition 16.10. Assume that the foreign exchange rate Rt satisfies a
stochastic differential equation of the form
dRt = µRt dt + σRt dWt , (16.19)
where (Wt )t∈R+ is a standard Brownian motion under P∗ .

Under the absence
of arbitrage Assumption (A) for the numéraire (16.18), we have
µ = rl − rf , (16.20)
hence the exchange rate process satisfies
dRt = rl − rf Rt dt + σRt dWt . (16.21)

under P∗ .
∗
For illustration purposes only. Not an advertisement.
" 553
N. Privault
Proof. The equation (16.19) has solution

2 t/2
Rt = R0 e µt+σWt −σ , t > 0,
f
hence the discounted value of the foreign money market account e tr on the
local market is
l l +tr f f −r l +µ)t+σW −σ 2 t/2
e −tr Nt = e −tr Rt = R0 e ( r t
, t > 0.
l f
Under the absence of arbitrage Assumption (A), the process e −(r −r )t Rt =
l
e −tr Nt should be an Ft -martingale under P∗ , and this holds provided that
r − r + µ = 0, which yields (16.20) and (16.21).
f
As a consequence of Proposition 16.10, under absence of arbitrage a local
investor who buys a unit of foreign currency in the hope of a higher return
rf >> r will have to face a lower (or even more negative) drift
µ = rl − rf << 0
in his exchange rate Rt . The drift µ = rl − rf is also called the cost of carry-
ing the foreign currency.
l l
The local money market account Xt := e tr is valued e tr /Rt on the
foreign market, and its discounted value at time t > 0 on the foreign market
is
l f )t
e (r −r Xt
= (16.22)
Rt Nt
1 (rl −rf )t−µt−σWt +σ2 t/2
= e
R0
1 (rl −rf )t−µt−σW
b t −σ2 t/2
= e ,
R0
where
ct = dWt − 1
dW dNt • dWt
Nt
1
= dWt − dRt • dWt
Rt
= dWt − σdt, t > 0,
is a standard Brownian motion under P b by (16.13). Under absence of arbi-

l f
trage, the process e −(r −r )t Rt is an Ft -martingale under P∗ and (16.22) is
an Ft -martingale under P b by Proposition 16.4, which recovers (16.20).
Proposition 16.11. Under the absence of arbitrage condition (16.20), the

inverse exchange rate 1/Rt satisfies
554 "
1 rf − rl

σ c
d = dt − dWt , (16.23)
Rt Rt Rt
under P
b , where (Rt )t∈R is given by (16.21).
+
Proof. By (16.20), the exchange rate 1/Rt is written using Itô’s calculus as
1 1 1

d = − 2 (µRt dt + σRt dWt ) + 3 σ 2 Rt2 dt
Rt Rt Rt
µ − σ2 σ
=− dt − dWt
Rt Rt
µ σ c
= − dt − dWt
Rt Rt
rf − rl σ c
= dt − dWt ,
Rt Rt
where (W
ct )t∈R is a standard Brownian motion under P.
+
b
Consequently, under absence of arbitrage, a foreign investor who buys a unit
of the local currency in the hope of a higher return r >> rf will have to face
a lower (or even more negative) drift −µ = rf − r in his exchange rate 1/Rt
as written in (16.23) under P.
b
Foreign exchange options
We now price a foreign exchange call option with payoff (RT − κ)+ under
P∗ on the exchange rate RT by the Black-Scholes formula as in the next
proposition, also known as the Garman and Kohlhagen (1983) formula. The
foreign exchange call option is designed for a local buyer of foreign currency.
Proposition 16.12. (Garman and Kohlhagen (1983) formula for call op-
tions). Consider the exchange rate process (Rt )t∈R+ given by (16.21). The
price of the foreign exchange call option on RT with maturity T and strike
price κ > 0 is given in local currency units as
l f l
e −(T −t) r E∗ (RT − κ)+ Ft = e −(T −t) r Rt Φ+ (t, Rt ) − κ e −(T −t) r Φ− (t, Rt ),

(16.24)
0 6 t 6 T , where
!
log(x/κ) + (T − t) rl − rf + σ 2 /2
Φ+ (t, x) = Φ √ ,
σ T −t
and
" 555
N. Privault
!
log(x/κ) + (T − t) rl − rf − σ 2 /2
Φ− (t, x) = Φ √ .
σ T −t
Proof. As a consequence of (16.21), we find the numéraire dynamics
f
dNt = d e tr Rt

f f
= rf e tr Rt dt + e tr dRt
f f
= r e tr Rt dt + σ e tr Rt dWt
= rNt dt + σNt dWt .
Hence, a standard application of the Black-Scholes formula yields

l l f +
e −(T −t) r E∗ (RT − κ)+ Ft = e −(T −t) r E∗ e −T r NT − κ Ft

l f f +
= e −(T −t) r e −T r E∗ NT − κ e T r

| Ft
f
!
f log(Nt e −T r /κ) + (r + σ 2 /2)(T − t)
= e −T r Nt Φ √
σ T −t
f
!!
log(Nt e r /κ) + rl − σ 2 /2 (T − t)
−T

f l
−κ e T r −(T −t) r Φ √
σ T −t
!
−T r f log ( R t /κ ) + ( T − t ) rl − rf + σ 2 /2
= e Nt Φ √
σ T −t
!!
f l log(Rt /κ) + (T − t) rl − rf − σ 2 /2
−κ e T r −(T −t) r Φ √
σ T −t
f l
= e −(T −t) r Rt Φ+ (t, Rt ) − κ e −(T −t) r Φ− (t, Rt ).
A similar conclusion can be reached by directly applying (16.21).

Similarly, from (16.23) rewritten as
l
! l l
e tr e tr e tr c
d = rf dt − σ dWt ,
Rt Rt Rt
a foreign exchange put option with payoff (1/κ − 1/RT )+ can be priced under
b in a Black-Scholes model by taking e trl /Rt as underlying asset price, rf as
P
risk-free interest rate, and −σ as volatility parameter. The foreign exchange
put option is designed for the foreign seller of local currency, see for example
the buy back guarantee∗ which is a typical example of a foreign exchange
put option.
∗
556 "
Proposition 16.13. (Garman and Kohlhagen (1983) formula for put op-
tions). Consider the exchange rate process (Rt )t∈R+ given by (16.21). The
price of the foreign exchange call option on RT with maturity T and strike
price 1/κ > 0 is given in foreign currency units as
1 1 +

f
e −(T −t) r E (16.25)

b − Ft
κ RT
f l
e −(T −t) r 1 e −(T −t) r 1

= Φ− t, − Φ+ t, ,
κ Rt Rt Rt
0 6 t 6 T , where
!
log(κx) + (T − t) rf − rl + σ 2 /2
Φ+ (t, x) := Φ − √ ,
σ T −t
and !
log(κx) + (T − t) rf − rl − σ 2 /2
Φ− (t, x) := Φ − √ .
σ T −t
Proof. The Black-Scholes formula (6.11) yields
" + # " l l
!+ #
−(T −t) rf 1 1 Ft = e −(T −t) rf e −T rl E eT r eT r
e E

b − b − Ft
κ RT κ RT
( ) l
1 1 e − T −t r 1

f
= e −(T −t) r Φ− t, − Φ+ t, ,
κ Rt Rt Rt
which is the symmetric of (16.24) by exchanging Rt with 1/Rt , and r with

rf .
Call/put duality for foreign exchange options
f
Let Nt = e tr Rt , where Rt is an exchange rate with respect to a foreign
currency and rf is the foreign market interest rate.
Proposition 16.14. The foreign exchange call and put options on the local
and foreign markets are linked by the call/put duality relation
" #
1 1 +

l f
e −(T −t) r E∗ (RT − κ)+ Ft = κRt e −(T −t) r E Ft ,

b −
κ RT
(16.26)
" 557
N. Privault
between a put option with strike price 1/κ and a (possibly fractional) quantity
1/(κRt ) of call option(s) with strike price κ.
Proof. By application of change of numéraire from Proposition 16.5 and
(16.8) we have
1 1 −(T −t) rl ∗

+
E e E (RT − κ)+ Ft ,

b ( R T − κ ) Ft =
e T r RT
f
Nt
hence
" + #
1 1 1

f f
e −(T −t) r E − Ft = e −(T −t) r E (RT − κ)+ Ft
b b
κ RT κRT
1 1

f +
= e tr Eb ( R T − κ ) Ft
e T r RT
f
κ
1 trf −(T −t) rl ∗
e E ( RT − κ ) + F t

=
κNt
1 −(T −t) rl ∗
e E ( RT − κ ) + F t .

=
κRt

In the Black-Scholes case, the duality (16.26) can be directly checked by
verifying that (16.25) coincides with
1 −(T −t) rl ∗
e E ( RT − κ ) + F t

κRt
1 −(T −t) rl −T rf ∗ T rf f +
e e E e RT − κ e T r

= Ft
κRt
1 −(T −t) rl −T rf ∗ f +
e e E NT − κ e T r

= Ft
κRt
1 f l
e −(T −t) r Rt Φc+ (t, Rt ) − κ e −(T −t) r Φc− (t, Rt )

=
κRt
l
1 −(T −t) rf c e −(T −t) r c
= e Φ+ (t, Rt ) − Φ− (t, Rt )
κ Rt
l
1 1 e −(T −t) r 1

f
= e −(T −t) r Φ− t, − Φ+ t, ,
κ Rt Rt Rt
where !
log(x/κ) + (T − t) rl − rf + σ 2 /2
Φc+ (t, x) := Φ √ ,
σ T −t
and !
log(x/κ) + (T − t) rl − rf − σ 2 /2
Φc− (t, x) := Φ √ .
σ T −t
558 "
Local market Foreign market
Measure P∗ P
b
l f
Discount factor t 7→ e −r t
t 7→ e −r t
l f
l l
−r f ) Xt e (r −r )t
Martingale t 7→ e −tr Nt = e −t(r Rt t 7→ =
Nt Rt
+
l f 1 1
e −(T −t)r E∗ (RT − κ)+ Ft e −(T −t)r E

Option − Ft
b
κ RT
Application Local purchase of foreign currency Foreign selling of local currency
Table 16.1: Local vs foreign exchange options.
Example - Buy back guarantee
The put option priced
1 1 +

f
e −(T −t) r Eb − Ft
κ RT
l
1 1 e −(T −t) r 1

f
= e −(T −t) r Φ− t, − Φ+ t,
κ Rt Rt Rt
on the foreign market corresponds to a buy back guarantee∗ in currency

exchange. In the case of an option “at the money” with κ = Rt and r = rf '
0, we find
" # √ √
1 1 + 1

σ T −t σ T −t
Eb − Ft = × Φ −Φ −
Rt RT Rt 2 2
√
1

σ T −t
= × 2Φ −1 .
Rt 2
For example, let Rt denote the USD/EUR (USDEUR=X) exchange rate from
a foreign currency (USD) to a local currency (EUR), i.e. one unit of the
foreign currency (USD) corresponds to Rt = 1/1.23 units of local currency
(EUR). Taking T − t = 30 days and σ = 10%, we find that the foreign
currency put option allowing the foreign sale of one EURO back into USDs
∗
" 559
N. Privault
is priced at the money in USD as

" #
1 1 +
p
E Ft = 1.23 2Φ 0.05 × 31/365 − 1

b −
Rt RT
= 1.23(2 × 0.505813 − 1)
= $0.01429998
per USD, or €0.011626 per exchanged unit of EURO. Based on a displayed

option price of €4.5 and in order to make the contract fair, this would trans-
late into an average amount of 4.5/0.011626 ' €387 exchanged at the counter
by customers subscribing to the buy back guarantee.
16.4 Pricing Exchange Options
Based on Proposition 16.4, we model the process X

bt of forward prices as a
continuous martingale under P,
b written as
bt = σ
dX ct ,
bt dW t > 0, (16.27)
where W is a standard Brownian motion under P b and (σ bt )t∈R+ is

ct
t∈R+
an (Ft )t∈R+ -adapted stochastic volatility process. More precisely, we assume
that X has the dynamics

bt
t∈R+
ct , (16.28)

bt = σ
dX bt X
bt dW
where x 7→ σbt (x) is a local volatility function which is Lipschitz in x, uni-

formly in t > 0. The Markov property of the diffusion process X ,

bt
t∈R+
cf. Theorem V-6-32 of Protter (2004), shows that when gb is a deterministic
payoff function, the conditional expectation E bT Ft can be written

b gb X
using a (measurable) function C b (t, x) of t and X
bt , as
E bt , 0 6 t 6 T.

bT Ft = C
b gb X b t, X
Consequently, a vanilla option with claim payoff C := NT gb X can be

bT
priced from Proposition 16.5 as
h rT i
E∗ e − t rs ds NT gb X
bT Ft = Nt E

b gb XbT Ft
bt , 0 6 t 6 T . (16.29)

= Nt Cb t, X
In the next Proposition 16.15 we state the Margrabe (1978) formula for the
pricing of exchange options by the zero interest rate Black-Scholes formula.
It will be applied in particular in Proposition 19.3 below for the pricing
560 "
of bond options. Here, (Nt )t∈R+ denotes any numéraire process satisfying
Assumption (A).

Proposition 16.15. (Margrabe (1978) formula). Assume that σ bt =
bt X

b (t)X
σ bt , i.e. the martingale X
bt
t∈[0,T ]
is a (driftless) geometric Brownian
motion under P with deterministic volatility (σ
b b (t)) . Then we havet∈[0,T ]
h rT i
E∗ e − t rs ds (XT − κNT )+ Ft = Xt Φ0+ t, X
bt − κNt Φ0 t, X
bt ,

−
(16.30)
t ∈ [0, T ], where
log(x/κ) v (t, T ) log(x/κ) v (t, T )

Φ0+ (t, x) = Φ + , Φ0− (t, x) = Φ − ,
v (t, T ) 2 v (t, T ) 2
(16.31)
wT
and v 2 (t, T ) = b2 (s)ds.
σ
t
Proof. Taking g (x) := (x − κ)+ in (16.29), the call option with payoff
(XT − κNT )+ = NT XbT − κ +

w wT +
ct − 1

T
= NT X bt exp b (t)dW
σ σ (t)|2 dt − κ
|b ,
t 2 t
and floating strike price κNT is priced by (16.29) as
h rT h rT
b T − κ + Ft
i i
E∗ e − t rs ds (XT − κNT )+ Ft = E∗ e − t rs ds NT X
= Nt E bT − κ + Ft

b X
bt ,

= Nt Cb t, X
where the function C bt is given by the Black-Scholes formula

b t, X
b (t, x) = xΦ0 (t, x) − κΦ0 (t, x),

C + −
with zero interest rate, since X is a driftless geometric Brownian

bt
t∈[0,T ]
motion which is an Ft -martingale under P, b and X bT is a lognormal random
wT
variable with variance coefficient v (t, T ) =
2
b (s)ds. Hence we have
σ 2
t
h rT i
∗ − +
E e rs ds

t (XT − κNT ) Ft = Nt C
b t, X
bt
" 561
N. Privault
bt Φ0+ t, X
bt − κNt Φ0− t, X
bt ,

= Nt X
t > 0.
In particular, from Proposition 16.8 and (16.15), we can take σ
b (t) = σtX − σtN
when (σtX )t∈R+ and (σtN )t∈R+ are deterministic.
Examples:
a) When the short rate process (r (t))t∈[0,T ] is a deterministic function of time
rT
and Nt = e t r (s)ds , 0 6 t 6 T , we have P b = P∗ and Proposition 16.15
yields the Merton (1973) “zero interest rate” version of the Black-Scholes
formula
rT
e − t r (s)ds E∗ (XT − κ)+ Ft

rT rT rT
= Xt Φ0+ t, e t r (s)ds Xt − κ e − t r (s)ds Φ0− t, e t r (s)ds Xt ,
where Φ0+ and Φ0− are defined in (16.31) and (Xt )t∈R+ satisfies the equa-
tion
dXt dX
bt
b (t)dWt ,
= r (t)dt + σ i.e. b (t)dWt ,
=σ 0 6 t 6 T.
Xt Xt
b
b) In the case of pricing under a forward numéraire, i.e. when Nt = P (t, T ),

t ∈ [0, T ], we get
h rT i
E∗ e − t rs ds (XT − κ)+ Ft = Xt Φ0+ t, X
bt − κP (t, T )Φ0 t, Xbt ,

−
0 6 t 6 T , since NT = P (T , T ) = 1. In particular, when Xt = P (t, S )

the above formula allows us to price a bond call option on P (T , S ) as
h rT i
E∗ e − t rs ds (P (T , S ) − κ)+ Ft = P (t, S )Φ0+ t, X
bt − κP (t, T )Φ0 t, X
bt ,

−
0 6 t 6 T , provided that the martingale X

bt = P (t, S )/P (t, T ) under P
b
is given by a geometric Brownian motion, cf. Section 19.2.
16.5 Hedging by Change of Numéraire

In this section we reconsider and extend the Black-Scholes self-financing hedg-
ing strategies found in (7.37)-(7.38) and Proposition 7.14 of Chapter 7. For
this, we use the stochastic integral representation of the forward claim pay-
offs and change of numéraire in order to compute self-financing portfolio
strategies. Our hedging portfolios will be built ron the assets (Xt , Nt ), not
t
on Xt and the money market account Bt = e r ds
0 s , extending the classi-
562 "
cal hedging portfolios that are available in from the Black-Scholes formula,
using a technique from Jamshidian (1996), cf. also Privault and Teng (2012).
Consider a claim with random payoff C, typically an interest rate deriva-

tive, cf. Chapter 19. Assume that the forward claim payoff C/NT ∈ L2 (Ω)
has the stochastic integral representation
w
b := C = E b C +
T
C bt ,
φbt dX (16.32)
NT NT 0
where X is given by (16.27) and φbt t∈[0,T ] is a square-integrable

bt
t∈[0,T ]
adapted process under P,
b from which it follows that the forward claim price
1 ∗ h − r T rs ds i b C

Vt
Vbt := = E e t C Ft = E Ft , 0 6 t 6 T ,
Nt Nt NT
is an Ft -martingale under P,
b that can be decomposed as
w
b C + φbs dX
t
Vbt = E b | Ft = E bs , 0 6 t 6 T. (16.33)

b C
NT 0
The next Proposition 16.16 extends the argument of Jamshidian (1996) to

the general framework of pricing using change of numéraire. Note that this
result differs
rt
from the standard formula that uses the money market account
Bt = e 0 rs ds for hedging instead of Nt , cf. e.g. Geman et al. (1995) pages 453-
454. The notion of self-financing portfolio is similar to that of Definition 5.9.
Proposition 16.16. Letting ηbt := Vbt − X bt φbt , with φbt defined in (16.33),
0 6 t 6 T , the portfolio allocation
φbt , ηbt t∈[0,T ]

with value
Vt = φbt Xt + ηbt Nt , 0 6 t 6 T,
is self-financing in the sense that
dVt = φbt dXt + ηbt dNt ,
and it hedges the claim payoff C, i.e.

h rT i
Vt = φbt Xt + ηbt Nt = E∗ e − t rs ds C Ft , 0 6 t 6 T. (16.34)

Proof. In order to check that the portfolio allocation φbt , ηbt t∈[0,T ] hedges

the claim payoff C it suffices to check that (16.34) holds since by (16.8) the
price Vt at time t ∈ [0, T ] of the hedging portfolio satisfies
" 563
N. Privault
h rT i
Vt = Nt Vbt = E∗ e − t rs ds C Ft , 0 6 t 6 T.

Next, we show that the portfolio allocation φbt , ηbt t∈[0,T ] is self-financing. By

numéraire invariance, cf. e.g. page 184 of Protter (2001), we have, using the
relation dVbt = φbt dX
bt from (16.33),

dVt = d Nt Vbt
= Vbt dNt + Nt dVbt + dNt • dVbt
= Vbt dNt + Nt φbt dX
bt + φbt dNt • dX
bt

= φbt X
bt dNt + Nt φbt dX bt + Vbt − φbt X
bt + φbt dNt • dX bt dNt

= φbt d Nt X
bt + ηbt dNt
= φbt dXt + ηbt dNt .

We now consider an application to the forward Delta hedging of European-
type options with payoff C = NT gb X bT where gb : R −→ R and X

bt
t∈R+
has the Markov property as in (16.28), where σ b : R+ × R is a deterministic
function. Assuming that the function Cb (t, x) defined by
Vbt := E

b T Ft = C
b gb X b t, X
bt
is C 2 on R+ , we have the following corollary of Proposition 16.16, which

extends the Black-Scholes Delta hedging technique to the general change of
numéraire setup.
bt ∂ C t, X
b
bt , 0 6 t 6 T , the

Corollary 16.17. Letting ηbt = Cb t, Xbt − X
∂x
portfolio allocation
∂C b
bt , ηbt
t, X
∂x t∈[0,T ]
with value
∂C
b
bt , t > 0,

Vt = ηbt Nt + Xt t, X
∂x

is self-financing and hedges the claim payoff C = NT gb X
bT .
Proof. This result follows directly from Proposition 16.16 by noting that
by Itô’s formula, and the martingale property of Vbt under P
b the stochastic
integral representation (16.33) is given by
VbT = C
b

= gb X
bT
564 "
w T ∂C b w T ∂C
b
= Cb (0, X

b0 ) + t, Xbt dt + t, X
bt dX
bt
0 ∂t 0 ∂x
1 w T ∂2C b 2
+ t, Xbt |bσt | dt
2 0 ∂x2
w T ∂C b
= Cb (0, X

b0 ) + t, Xbt dXbt
0 ∂x
w
b C +
T
=E φbt dXbt , 0 6 t 6 T,
NT 0
hence
∂C
b
bt , 0 6 t 6 T.

φbt = t, X
∂x

In the case of an exchange option with payoff function
bT − κ +
C = (XT − κNT )+ = NT X

on the geometric Brownian motion X under P

b with

bt
t∈[0,T ]
bt , (16.35)

σ bt = σ
bt X b (t)X
where σ b (t) t∈[0,T ] is a deterministic volatility function of time, we have the

following corollary on the hedging of exchange options based on the Margrabe

(1978) formula (16.30).
Corollary 16.18. The decomposition
h rT i
E∗ e − t rs ds (XT − κNT )+ Ft = Xt Φ0+ t, X
bt − κNt Φ0− t, X

bt
yields a self-financing portfolio allocation Φ0+ t, X

bt , −κΦ0 t, X

−
bt
t∈[0,T ]
in
the assets (Xt , Nt ), that hedges the claim payoff C = (XT − κNT )+ .
Proof. We apply Corollary 16.17 and the relation
∂C
b
(t, x) = Φ0+ (t, x), x ∈ R,
∂x
for the function C

b (t, x) = xΦ0 (t, x) − κΦ0 (t, x), cf. Relation (6.16) in
+ −
Proposition 6.4.
Note that the Delta hedging method requires the computation of the function
b (t, x) and that of the associated finite differences, and may not apply to
C
path-dependent claims.
" 565
N. Privault
Examples:
a) When the short rate process (r (t))t∈[0,T ] is a deterministic function of

rT
time and Nt = e t r (s)ds , Corollary 16.18 yields the usual Black-Scholes
hedging strategy
rT
bt , −κ e 0 r (s)ds Φ− (t, Xt )
Φ+ t, X

t∈[0,T ]
rT rT rT
r (s)ds bt , −κ e 0 r (s)ds Φ0 t, e t r (s)ds Xt
= Φ0+ t, e ,

t X − t∈[0,T ]
rt
in the assets Xt , e r (s)ds
, that hedges the claim payoff C = (XT − κ)+ ,

0
with
rT !
log(x/κ) + r (s)ds + (T − t)σ 2 /2
Φ+ (t, x) := Φ t √ ,
σ T −t
and rT !
log(x/κ) + r (s)ds − (T − t)σ 2 /2
Φ− (t, x) := Φ t √ .
σ T −t
b) In case Nt = P (t, T ) and Xt = P (t, S ), 0 6 t 6 T < S, Corollary 16.18
shows that when X is modeled as the geometric Brownian motion

bt
t∈[0,T ]
(16.35) under P, the bond call option with payoff (P (T , S ) − κ)+ can be
b
hedged as
h rT i
E∗ e − t rs ds (P (T , S ) − κ)+ Ft = P (t, S )Φ+ t, X bt − κP (t, T )Φ− t, X

bt
by the self-financing portfolio allocation
Φ+ t, X bt , −κΦ− t, X

bt
t∈[0,T ]
in the assets (P (t, S ), P (t, T )), i.e. one needs to hold the quantity Φ+ t, X

t
b
of the bond maturing at time S, and to short a quantity κΦ− t, X bt of
the bond maturing at time T .
Exercises
Exercise 16.1 Let (Bt )t∈R+ be a standard Brownian motion started at 0 un-
der the risk-neutral probability measure P∗ . Consider a numéraire (Nt )t∈R+
given by
2
Nt := N0 e ηBt −η t/2 , t > 0,
566 "
and a risky asset (Xt )t∈R+ given by

2 t/2
Xt := X0 e σBt −σ , t > 0,
in a market with risk-free interest rate r = 0. Let P b denote the forward

measure relative to the numéraire (Nt )t∈R+ , under which the process X
bt : =
Xt /Nt of forward prices is known to be a martingale.
a) Using the Itô formula, compute

dXbt = d Xt
Nt
X0 2 2
d e (σ−η )Bt −(σ −η )t/2 .

=
N0
b) Explain why the exchange option price E∗ [(XT − λNT )+ ] at time 0 has
the Black-Scholes form
E∗ [(XT − λNT )+ ] (16.36)

√ ! √ !
log X log X

b0 /λ σ
b T b0 /λ σ
b T
= X0 Φ √ + − λN0 Φ √ − .
σ
b T 2 σ
b T 2
Hints:
(i) Use the change of numéraire identity
E∗ [(XT − λNT )+ ] = N0 E bT − λ + .

b X
(ii) The forward price Xbt is a martingale under the forward measure P
b
relative to the numéraire (Nt )t∈R+ .
c) Give the value of σ
b in terms of σ and η.
(1) (2)
Exercise 16.2 Let Bt t∈R and Bt t∈R be correlated standard Brow-
+ +
nian motions started at 0 under the risk-neutral probability measure P∗ , with
(1) (2) (1) (2)
correlation Corr Bs , Bt = ρ min(s, t), i.e. dBt • dBt = ρdt. Consider

(1) (2)
two asset prices St t∈R and St t∈R given by the geometric Brownian
+ +
motions
(1) (1) (1) (2) (2) (2)
−σ 2 t/2 −η 2 t/2
St := S0 e rt+σBt , and St := S0 e rt+ηBt , t > 0.
(2)
Let P
b 2 denote the forward measure with numéraire (Nt )t∈R := S
+ t t∈R+
and Radon-Nikodym density
" 567
N. Privault
(2)
dP
b2 S (2) 2
= e −rT T(2) = e ηBT −η T /2 .
dP∗ S 0
b (1)
a) Using the Girsanov Theorem 16.7, determine the shifts B and

t t∈R+
(2) (1) (2)
Bt t∈R of Bt t∈R and Bt t∈R which are standard Brownian

b
+ + +
motions under P b 2.
b) Using the Itô formula, compute
(1)
!
(1) St
dSbt = d (2)
St
(1)
S0 (1) (2)
−ηBt −(σ 2 −η 2 )t/2
d e σBt ,

= (2)
S0
b (1) and dB
and write the answer in terms of the martingales dB b (2) .
t t
c) Using change of numéraire, explain why the exchange option price
(1) (2) +
e −rT E∗ ST − λST
at time 0 has the Black-Scholes form

(1) √ !
log Sb0 /λ

−rT ∗ (1) (2) + (1) σ
b T
e E S0 Φ

ST − λST = √ +
σ
b T 2
(1) √ !
log S0 /λ

(2)
b σ
b T
−λS0 Φ √ − ,
σ
b T 2
where the value of σ

b can be expressed in terms of σ and η.
Exercise 16.3 Consider two zero-coupon bond prices of the form P (t, T ) =
F (t, rt ) and P (t, S ) = G(t, rt ), where (rt )t∈R+ is a short-term interest rate
process. Taking Nt := P (t, T ) as a numéraire defining the forward measure
P,
b compute the dynamics of (P (t, S ))
t∈[0,T ] under P using a standard Brow-
b
nian motion Wt under P.

c b
t∈[0,T ]
Exercise 16.4 Forward contracts. Using a change of numéraire argument for

the numéraire Nt := P (t, T ), t ∈ [0, T ], compute the price at time t ∈ [0, T ]
of a forward (or future) contract with payoff P (T , S ) − K in a bond market
with short-term interest rate (rt )t∈R+ . How would you hedge this forward
contract?
568 "
Exercise 16.5 (Question 2.7 page 17 of Downes et al. (2008)). Consider a

price process (St )t∈R+ given by dSt = rSt dt + σSt dBt under the risk-neutral
probability measure P∗ , where r ∈ R and σ > 0, and the option with payoff
ST (ST − K )+ = Max(ST (ST − K ), 0)

at maturity T .
a) Show that the option payoff can be rewritten as
(ST (ST − K ))+ = NT (ST − K )+
for a suitable choice of numéraire process (Nt )t∈[0,T ] .

b) Rewrite the option price e −(T −t)r E∗ (ST (ST − K ))+ | Ft using a for-

ward measure P b and a change of numéraire argument.

c) Find the dynamics of (St )t∈R+ under the forward measure P.b
d) Price the option with payoff
ST (ST − K )+ = Max(ST (ST − K ), 0)
at time t ∈ [0, T ] using the Black-Scholes formula.
Exercise 16.6 Consider the risk asset with dynamics dSt = rSt dt + σSt dWt
with constant r ∈ R and σ > 0 under the risk-neutral measure P∗ . The power
call option with payoff (STn − K n )+ , n > 1, is priced at time t ∈ [0, T ] as
+
e −(T −t)r E∗ STn − K n Ft

= e −(T −t)r E∗ STn 1{ST >K} Ft − K n e −(T −t)r E∗ 1{ST >K} Ft

under the risk-neutral measure P∗ .

dPb
a) Write down the density using the numéraire process
dP∗
2 t/2−(n−1)rt
Nt := Stn e −(n−1)nσ , t ∈ [0, T ].
b) Construct a standard Brownian motion Wt under

c
P.
b
c) Compute the term e −(T −t)r E∗ STn 1{ST >K} Ft using change of numéraire.
Hint: We have
P∗ (ST > K | Ft ) = E∗ 1{ST >K} Ft

log(St /K ) + (rl − σ 2 /2)(T − t)

=Φ √ .
σ T −t
" 569
N. Privault
Exercise 16.7 Bond options. Consider two bonds with maturities T and S,
with prices P (t, T ) and P (t, S ) given by
dP (t, T )
= rt dt + ζtT dWt ,
P (t, T )
and
dP (t, S )
= rt dt + ζtS dWt ,
P (t, S )
where (ζ T (s))s∈[0,T ] and (ζ S (s))s∈[0,S ] are deterministic volatility functions
of time.
a) Show, using Itô’s formula, that
P (t, S ) P (t, S ) S

d = ct ,
(ζ (t) − ζ T (t))dW
P (t, T ) P (t, T )
where W is a standard Brownian motion under P.

ct b
t∈R+
b) Show that
w wT
P (t, S ) cs − 1

T S
P (T , S ) = exp (ζ (s) − ζ T (s))dW |ζ S (s) − ζ T (s)|2 ds .
P (t, T ) t 2 t
Let P
b denote the forward measure associated to the numéraire
Nt := P (t, T ), 0 6 t 6 T.
c) Show that for all S, T > 0 the price at time t

h rT i
E∗ e − t rs ds (P (T , S ) − κ)+ Ft
of a bond call option on P (T , S ) with payoff (P (T , S ) − κ)+ is equal to

h rT i
E∗ e − t rs ds (P (T , S ) − κ)+ Ft (16.37)
1 P (t, S ) 1 P (t, S )

v v
= P (t, S )Φ + log − κP (t, T )Φ − + log ,
2 v κP (t, T ) 2 v κP (t, T )
where wT
v2 = |ζ S (s) − ζ T (s)|2 ds.
t
d) Compute the self-financing hedging strategy that hedges the bond option
using a portfolio based on the assets P (t, T ) and P (t, S ).
Exercise 16.8 Consider two risky assets S1 and S2 modeled by the geometric
Brownian motions
570 "
S1 (t) = e σ1 Wt +µt and S2 (t) = e σ2 Wt +µt , t > 0, (16.38)
where (Wt )t∈R+ is a standard Brownian motion under P.

a) Find a condition on r, µ and σ2 so that the discounted price process
e −rt S2 (t) is a martingale under P.
b) Assume that r − µ = σ22 /2, and let
2 2
Xt = e (σ2 −σ1 )t/2 S1 (t), t > 0.
Show that the discounted process e −rt Xt

is a martingale under P.
c) Taking Nt = S2 (t) as numéraire, show that the forward process X b (t) =
Xt /Nt is a martingale under the forward measure P
b defined by the Radon-
Nikodym density
dP N
= e −rT T .
b
dP N0
Recall that
ct := Wt − σ2 t
W
b
d) Using the relation
(S1 (T ) − S2 (T ))+

e −rT E∗ [(S1 (T ) − S2 (T ))+ ] = N0 E
b ,
NT
compute the price
e −rT E∗ [(S1 (T ) − S2 (T ))+ ]
of the exchange option on the assets S1 and S2 .
Exercise 16.9 Compute the price e −(T −t)r E∗ 1{RT >κ} Ft at time t ∈ [0, T ]

of a cash-or-nothing “binary” foreign exchange call option with maturity T

and strike price κ on the foreign exchange rate process (Rt )t∈R+ given by
dRt = (rl − rf )Rt dt + σRt dWt ,
where (Wt )t∈R+ is a standard Brownian motion under P∗ .

Hint: We have the relation
!
µ − log(κ/x)
P∗ x e X +µ > κ = Φ

Var[X ]
p
for X ' N (0, Var[X ]) a centered Gaussian random variable.
" 571
N. Privault
Exercise 16.10 Extension of Proposition 16.8 to correlated Brownian mo-

tions. Assume that (St )t∈R+ and (Nt )t∈R+ satisfy the stochastic differential
equations
dSt = rt St dt + σtS St dWtS , and dNt = ηt Nt dt + σtN Nt dWtN ,
where (WtS )t∈R+ and (WtN )t∈R+ have the correlation
dWtS • dWtN = ρdt,
where ρ ∈ [−1, 1].

a) Show that (WtN )t∈R+ can be written as
p
WtN = ρWtS + 1 − ρ2 Wt , t > 0,
where (Wt )t∈R+ is a standard Brownian motion under P∗ , independent

of (WtS )t∈R+ .
b) Letting Xt = St /Nt , show that dXt can be written as
bt Xt dWtX ,
dXt = (rt − ηt + (σtN )2 − ρσtN σtS )Xt dt + σ
where (WtX )t∈R+ is a standard Brownian motion under P∗ and σ

bt is to
be computed.
Exercise 16.11 Quanto options (Exercise 9.5 in Shreve (2004)). Consider an

asset priced St at time t, with
dSt = rSt dt + σ S St dWtS ,
and an exchange rate (Rt )t∈R+ given by
dRt = (r − rf )Rt dt + σ R Rt dWtR ,
from (16.20) in Proposition 16.10, where (WtR )t∈R+ is written as

p
WtR = ρWtS + 1 − ρ2 Wt , t > 0,
where (Wt )t∈R+ is a standard Brownian motion under P∗ , independent of

(WtS )t∈R+ , i.e., we have
dWtR • dWtS = ρdt,
where ρ is a correlation coefficient.

a) Let
a = rl − rf + ρσ R σ S − (σ R )2
572 "
and Xt = e at St /Rt , t > 0, and show by Exercise 16.10 that dXt can be
written as
bXt dWtX ,
dXt = rXt dt + σ
where (WtX )t∈R+ is a standard Brownian motion under P∗ and σ
b is to be
determined.
+
ST
e −(T −t)r E∗

−κ Ft
RT
of the quanto option at time t ∈ [0, T ].
" 573
Chapter 17
Short Rates and Bond Pricing
Short-term rates, typically daily rates, are the interest rates applied to short-
term lending between financial institutions. The stochastic modeling of short-
term interest rate processes is based on the mean reversion property, as in the
Vasicek, CIR, CEV, and affine-type models studied in this chapter. The pric-
ing of fixed income products, such as bonds, is considered in this framework
using probabilistic and PDE arguments.
17.1 Short-Term Mean-Reverting Models . . . . . . . . . . . . . 575

17.2 Calibration of the Vasicek Model . . . . . . . . . . . . . . . . 581
17.3 Zero-Coupon and Coupon Bonds . . . . . . . . . . . . . . . . 586
17.4 Bond Pricing PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 606
17.1 Short-Term Mean-Reverting Models
Money market accounts with price (At )t∈R+ can be defined from a short-term
interest rate process (rt )t∈R+ as
At+dt − At dAt dAt

= rt dt, = rt dt, = rt At , t > 0,
At At dt
with w
t
At = A0 exp rs ds , t > 0.
0
As short-term interest rates behave differently from stock prices, they require
the development of specific models to account for properties such as positivity,
boundedness, and return to equilibrium.
" 575
N. Privault
Vašíček (1977) model
The first model to capture the mean reversion property of interest rates, a
property not possessed by geometric Brownian motion, is the Vašíček (1977)
model, which is based on the Ornstein-Uhlenbeck process. Here, the short-
term interest rate process (rt )t∈R+ solves the equation
drt = (a − brt )dt + σdBt , (17.1)
where a, σ ∈ R, b > 0, and (Bt )t∈R+ is a standard Brownian motion, with

solution
a wt
rt = r0 e −bt + 1 − e −bt + σ e −(t−s)b dBs , t > 0, (17.2)

b 0
see Exercise 17.1. The probability distribution of rt is Gaussian at all times

t, with mean
a
E[rt ] = r0 e −bt + 1 − e −bt ,

b
and variance
w
t −(t−s)b
Var[rt ] = Var σ e dBs
0
wt 2
=σ 2
e −(t−s)b ds
0
w
2 t
=σ e −2bs ds
0
σ2
1 − e −2bt , t > 0,

=
2b
i.e.
σ2

a
r0 e −bt + 1 − e −bt , 1 − e −2bt , t > 0.

rt ' N
b 2b
In particular, the probability density function ft (x) of rt at time t > 0 is
given by
√ 2 !
r0 e −bt + a 1 − e −bt /b − x

b/π
ft (x) = √ exp − , x ∈ R.
σ 1 − e −2bt σ 2 1 − e −2bt /b

In the long run,∗ i.e. as time t becomes large we have, assuming b > 0,
a σ2
lim E[rt ] = and lim Var[rt ] = , (17.3)
t→∞ b t→∞ 2b
∗
“But this long run is a misleading guide to current affairs. In the long run we are all
dead.” J. M. Keynes, A Tract on Monetary Reform (1923), Ch. 3, p. 80.
576 "
and this distribution converges to the Gaussian N (a/b, σ 2 /(2b)) distribu-

tion, which is also the invariant (or stationary) distribution of (rt )t∈R+ , see
Exercise 17.1. In addition, the process tends to revert to its long term mean
a/b = limt→∞ E[rt ] which makes the average drift vanish, i.e.:
lim E[a − brt ] = a − b lim E[rt ] = 0.

t→∞ t→∞
Figure 17.1 presents a random simulation of t 7→ rt in the Vasicek model

with r0 = 3%, and shows the mean-reverting property of the process with
respect to a/b = 2.5%.
8
7
rt (%)
6
5
4
3
a/b
2
1
0
-1
-2
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Fig. 17.1: Graph of the Vasicek short rate t 7→ rt with a = 0.025, b = 1, and σ = 0.1.
As can be checked from the simulation of Figure 17.1 the value of rt in the Va-
sicek model may become negative due to its Gaussian distribution. Although
real interest rates may sometimes fall below zero,∗ this can be regarded as
a potential drawback of the Vasicek model. The next R code provides a nu-
merical solution of the stochastic differential equation (17.1) using the Euler
method, see Figure 17.1.
N=10000;t<-0:(N-1);dt<-1.0/N;nsim<-2; a=0.025;b=1;sigma=0.1;
R <- matrix(0,nsim,N);R[,1]=0.03
for (i in 1:nsim){for (j in 2:N){R[i,j]=R[i,j-1]+(a-b*R[i,j-1])*dt+sigma*X[i,j]}}
par(mar=c(0,1,1,1));par(oma=c(0,1,1,1));par(mgp=c(-5,1,1))
plot(t,R[1,],xlab = "Time",ylab = "",type = "l",ylim = c(R[1,1]-0.2,R[1,1]+0.2),col =
0,axes=FALSE)
axis(2, pos=0,las=1);for (i in 1:nsim){lines(t, R[i, ], xlab = "time", type = "l", col = i+0)}
abline(h=a/b,col="blue",lwd=3);abline(h=0)
∗
Eurozone interest rates turned negative in 2014.
" 577
N. Privault
Example - TNX yield
We consider the yield of the 10 Year Treasury Note on the Chicago Board
Options Exchange (CBOE), for later use in the calibration of the Vasicek
model. Treasury notes usually have a maturity between one and 10 years,
whereas treasury bonds have maturities beyond 10 years)
library(quantmod)
getSymbols("^TNX",from="2012-01-01",to="2016-01-01",src="yahoo")
rate=Ad(`TNX`);rate<-rate[!is.na(rate)]
dev.new(width=10,height=7);chartSeries(rate,up.col="blue",theme="white")
n = sum(!is.na(rate))
The next Figure 17.2 displays the yield of the 10 Year Treasury Note.
rate [2012−01−03/2015−12−31]
Last 2.269 3.0
2.5
2.0
1.5
Jan 03 Jul 02 Jan 02 Jul 01 Jan 02 Jul 01 Jan 02 Jul 01 Dec 31

2012 2012 2013 2013 2014 2014 2015 2015 2015
Fig. 17.2: CBOE 10 Year Treasury Note (TNX) yield.
Cox-Ingersoll-Ross (CIR) model
The Cox et al. (1985) (CIR) model brings a solution to the positivity problem
encountered with the Vasicek model, by the use the nonlinear stochastic
√
drt = β (α − rt )dt + σ rt dBt , (17.4)
with α > 0, β > 0, σ > 0. The probability distribution of rt at time t > 0

admits the noncentral Chi square probability density function given by
ft ( x ) (17.5)
! αβ/σ2 −1/2 !
2β x + r0 e −βt
p
2β x 4β r0 x e −βt
= 2 exp − I2αβ/σ2 −1 ,
σ 1 − e −βt σ 2 1 − e −βt r0 e −βt σ 2 1 − e −βt

x > 0, where
578 "
z λ X (z 2 /4)k
Iλ ( z ) : = , z ∈ R,
2 k!Γ(λ + k + 1)
k>0
is the modified Bessel function of the first kind, see Lemma 9 in Feller (1951)
and Corollary 24 in Albanese and Lawi (2005). Note that ft (x) is not defined
at x = 0 if αβ/σ 2 − 1/2 < 0, i.e. σ 2 > 2αβ, in which case the probability
distribution of rt admits a point mass at x = 0. On the other hand, rt remains
almost surely strictly positive under the Feller condition 2αβ > σ 2 , cf. the
study of the associated probability density function in Lemma 4 of Feller
(1951) for α, β ∈ R.
Figure 17.3 presents a random simulation of t 7→ rt in the Cox et al. (1985)

(CIR) model in the case σ 2 > 2αβ, in which the process is mean reverting
with respect to α = 2.5% and has a nonzero probability of hitting 0.
7
rt (%)
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Fig. 17.3: Graph of the CIR short rate t 7→ rt with α = 2.5%, β = 1, and σ = 1.3.
The next R code provides a numerical solution of the stochastic differential

equation (17.4) using the Euler method, see Figure 17.3.
N=10000; t <- 0:(N-1); dt <- 1.0/N; nsim <- 2

a=0.025; b=1; sigma=0.1; sd=sqrt(sigma^2/2/b)
R <- matrix(0,nsim,N);R[,1]=0.03
for (i in 1:nsim){for (j in
2:N){R[i,j]=max(0,R[i,j-1]+(a-b*R[i,j-1])*dt+sigma*sqrt(R[i,j-1])*X[i,j])}}
plot(t,R[1,],xlab="time",ylab="",type="l",ylim=c(0,R[1,1]+sd/5),col=0,axes=FALSE)
axis(2, pos=0)
for (i in 1:nsim){lines(t, R[i, ], xlab = "time", type = "l", col = i+8)}
abline(h=a/b,col="blue",lwd=3);abline(h=0)
In large time t → ∞, using the asymptotics

1 z λ
Iλ (z ) 'z→0 ,
Γ (λ + 1) 2
the probability density function (17.5) becomes the gamma density function
" 579
N. Privault
2αβ/σ2
1 2β

2 2
f (x) = lim ft (x) = x−1+2αβ/σ e −2βx/σ , x > 0.
t→∞ Γ(2αβ/σ 2 ) σ2
(17.6)
with shape parameter 2αβ/σ 2 and scale parameter σ 2 /(2β ), which is also
the invariant distribution of rt .
The family of classical mean-reverting models also includes the Courtadon

(1982) model
drt = β (α − rt )dt + σrt dBt ,
where α, β, σ are nonnegative, cf. Exercise 17.5, and the exponential Vasicek
model
drt = rt (η − a log rt )dt + σrt dBt ,
where a, η, σ > 0, cf. Exercises 4.15 and 4.16.
Constant Elasticity of Variance (CEV) model
Constant Elasticity of Variance models are designed to take into account

nonconstant volatilities that can vary as a power of the underlying asset
price. The Marsh and Rosenfeld (1983) short-term interest rate model
drt = (βrtγ−1 + αrt )dt + σrtγ/2 dBt , (17.7)
where α ∈ R, β, σ > 0 are constants and γ > 0 is the variance (or diffusion)
elasticity coefficient, covers most of the CEV models. Here, the elasticity
coefficient is defined as ratio
dv 2 (r )/v 2 (r )
dr/r
between the relative change dv (r )/v (r ) in the variance v (r ) and the relative
change dr/r in r. Denoting by v 2 (r ) := σ 2 rγ the variance coefficient in (17.7),
constant elasticity refers to the constant ratio
dv 2 (r )/v 2 (r ) r dv (r ) d log v (r ) d log rγ/2

=2 =2 =2 = γ.
dr/r v (r ) dr d log r d log r
For γ = 1, (17.7) yields the Cox et al. (1985) (CIR) equation

√
drt = (β + αrt )dt + σ rt dBt .
For β = 0 we get the standard CEV model
drt = αrt dt + σrtγ/2 dBt ,
and for γ = 2 and β = 0 this yields the Dothan (1978) model
580 "
drt = αrt dt + σrt dBt ,
which is a version of geometric Brownian motion used for short-term interest

rate modeling.
Time-dependent affine models
The class of short rate interest rate models admits a number of generalizations
(see the references quoted in the introduction of this chapter), including the
class of affine models of the form
q
drt = (η (t) + λ(t)rt )dt + δ (t) + γ (t)rt dBt . (17.8)
Such models are called affine because the associated bonds can be priced
using an affine PDE of the type (17.25) below with solution of the form
(17.28), as will be seen after Proposition 17.2.
The family of affine models also includes:

i) the Ho and Lee (1986) model
drt = θ (t)dt + σdBt ,
where θ (t) is a deterministic function of time, as an extension of the

Merton model drt = θdt + σdBt ,
ii) the Hull and White (1990) model
drt = (θ (t) − α(t)rt )dt + σ (t)dBt
which is a time-dependent extension of the Vasicek model (17.1), with

the explicit solution
rt wt rt wt rt
rt = r0 e − 0 α(τ )dτ + e − u α(τ )dτ θ (u)du + σ (u) e − u α(τ )dτ dBu ,
0 0
t > 0.
17.2 Calibration of the Vasicek Model

The Vasicek equation (17.1), i.e.
drt = (a − brt )dt + σdBt ,
can be discretized according to a discrete-time sequence (tk )k>0 = (t0 , t1 , t2 , . . .)

of time instants, as
rtk+1 − rtk = (a − brtk )∆t + σZk , k > 0,
" 581
N. Privault
where ∆t := tk+1 − tk and (Zk )k>0 is a Gaussian white noise with variance ∆t,
i.e. a sequence of independent, centered and identically distributed N (0, ∆t)
Gaussian random variables, which yields
rtk+1 = rtk + (a − brtk )∆t + σZk = a∆t + (1 − b∆t)rtk + σZk , k > 0.
Based on a set (r̃tk )k=0,1,...,n of market data, we consider the quadratic resid-
ual
n−1
X 2
r̃tk+1 − a∆t − (1 − b∆t)r̃tk (17.9)
k =0
which represents the quadratic distance between the observed data sequence
(r̃tk )k=1,2,...,n and its predictions a∆t + (1 − b∆t)r̃tk k=0,1,...,n−1 .

In order to minimize the residual (17.9) over a and b we use Ordinary

Least Square (OLS) regression, and equate the following derivatives to zero.
Namely, we have
n−1
∂ X 2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl
∂a
l =0
n−1
!
X
r̃tl+1 − (1 − b∆t)r̃tl

= −2∆t −an∆t +
l =0
= 0,
hence
n−1
1X
r̃tl+1 − (1 − b∆t)r̃tl ,

a∆t =
n
l =0
and
n−1
∂ X 2
r̃tk+1 − a∆t − (1 − b∆t)r̃tk
∂b
k =0
n−1
X
= 2∆t r̃tk −a∆t + r̃tk+1 − (1 − b∆t)r̃tk

k =0
n−1 n−1
!
X 1X
= 2∆t r̃tk r̃tk+1 − (1 − b∆t)r̃tk − r̃tl+1 − (1 − b∆t)r̃tl

n
k =0 l =0
 
n−1 n−1 n−1 n−1
X ∆t X X 1 X
= 2∆t r̃tk r̃tk+1 − r̃tk r̃tl+1 − ∆t(1 − b∆t)  2
(r̃tk ) − r̃tk r̃tl 
n n
k =0 k,l=0 k =0 k,l=0
= 0.
582 "
This leads to estimators for the parameters a and b, respectively as the em-
pirical mean and covariance of (r̃tk )k=0,1,...,n , i.e.

n−1
 1 X
a∆t = r̃tk+1 − (1 − bb∆t)r̃tk ,


 b

 n
k =0






 and







n−1 n−1

1 X

 X

r̃tk r̃tk+1 − r̃tk r̃tl+1


n



k = 0 k,l = 0
1 − bb∆t = n−1 (17.10)
n−1

 X
2 1 X
( r̃ ) − r̃ r̃

tk tk tl

n





 k =0 k,l=0 !
n−1 n−1 n−1
!
1X 1X


 X
r̃ − r̃ r̃ − r̃

t t t t

k l k +1 l+1
n n



= k =0 l =0 l =0
.



 n−1 n−1
!2
1X

 X


 r̃tk − r̃tk
n


k =0 k =0
This also yields
σ 2 ∆t = Var[σZk ]
2
' E r̃tk+1 − (1 − b∆t)r̃tk − a∆t , k > 0,

hence σ can be estimated as

n−1
1X 2
b2 ∆t =
σ r̃tk+1 − r̃tk (1 − bb∆t) − b
a∆t . (17.11)
n
k =0
Exercise. Show that (17.11) can be recovered by from minimizing the residual
n−1
X 2 2
η 7→ r̃tk+1 − r̃tk (1 − bb∆t) − b
a∆t − η∆t
k =0
as a function of η > 0, see also Exercise 17.3.
Time series modeling
Defining rbtn := rtn − a/b, n > 0, we have

a
rbtn+1 = rtn+1 −
b
" 583
N. Privault
a
= rtn − + (a − brtn )∆t + σZn
b
a a
= rtn − − b rtn − ∆t + σZn
b b
rtn ∆t + σZn
= rbtn − bb
= (1 − b∆t)rbtn + σZn , n > 0.
In other words, the sequence (rbtn )n>0 is modeled according to an autoregres-

sive AR(1) time series (Xn )n>0 with parameter α = 1 − b∆t, in which the
current state Xn of the system is expressed as the linear combination
Xn := σZn + αXn−1 , n > 1, (17.12)
where (Zn )n>1 another Gaussian white noise sequence with variance ∆t. This
equation can be solved recursively as the causal series
X
Xn = σZn + α(σZn−1 + αXn−2 ) = · · · = σ αk Zn−k ,
k >0
which converges when |α| < 1, i.e. |1 − b∆t| < 1, in which case the time series
(Xn )n>0 is weakly stationary, with
X
E[Xn ] = σ αk E[Zn−k ]
k>0
X
= σE[Z0 ] αk
k>0
σ
= E [ Z0 ]
1−α
= 0, n > 0.
The variance of Xn is given by

 
X
Var[Xn ] = σ Var 
2 k
α Zn−k 
k>0
X
= σ 2 ∆t α2k
k>0
X
= σ 2 ∆t (1 − b∆t)2k
k>0
σ 2 ∆t
=
1 − (1 − b∆t)2
σ 2 ∆t
=
2b∆t − b2 (∆t)2
584 "
σ2
' , [∆t ' 0],
2b
which coincides with the variance (17.3) of the Vasicek process in the sta-
tionary regime.
Example - TNX yield calibration
The next R code is estimating the parameters of the Vasicek model using
the 10 Year Treasury Note yield data of Figure 17.2, by implementing the
formulas (17.10).
ratek=as.vector(rate);ratekplus1 <- c(ratek[-1],0)

b <- (sum(ratek*ratekplus1) - sum(ratek)*sum(ratekplus1)/n)/(sum(ratek*ratek) -
sum(ratek)*sum(ratek)/n)
a <- sum(ratekplus1)/n-b*sum(ratek)/n;sigma <- sqrt(sum((ratekplus1-b*ratek-a)^2)/n)
Parameter estimation can also be implemented using the linear regression

command
lm(c(diff(ratek)) ∼ ratek[1:length(ratek)-1])
in R, which estimates the values of a∆t ' 0.017110 and −b∆t ' −0.007648
in the regression
rtk+1 − rtk = (a − brtk )∆t + σZk , k > 0,
Coefficients:
(Intercept) ratek[1:length(ratek) - 1]
0.017110 -0.007648
for (i in 1:100) {ar.sim<-arima.sim(model=list(ar=c(b)),n.start=100,n)
y=a/b+sigma*ar.sim;y=y+ratek[1]-y[1]
time <- as.POSIXct(time(rate), format = "%Y-%m-%d")
yield <- xts(x = y, order.by = time);
chartSeries(yield,up.col="blue",theme="white",yrange=c(0,max(ratek)))
Sys.sleep(0.5)}
The above R code is generating Vasicek random samples according to the

AR(1) time series (17.12), see Figure 17.4.
" 585
N. Privault
rate [2012−01−03/2015−12−31] yield [2012−01−03 08:00:00/2015−12−31 08:00:00]

Last 2.269 3.0 Last 1.01150069015231 3.0
2.5
2.5 2.0
1.5
2.0
1.0
0.5
1.5
0.0
Jan 03 Jul 02 Jan 02 Jul 01 Jan 02 Jul 01 Jan 02 Jul 01 Dec 31 Jan 03 Jul 02 Jan 02 Jul 01 Jan 02 Jul 01 Jan 02 Jul 01 Dec 31
2012 2012 2013 2013 2014 2014 2015 2015 2015 2012 2012 2013 2013 2014 2014 2015 2015 2015
(a) CBOE TNX market yield. (b) Calibrated Vasicek sample path.
Fig. 17.4: Calibrated Vasicek simulation vs market data.
17.3 Zero-Coupon and Coupon Bonds
A zero-coupon bond is a contract priced P (t, T ) at time t < T to deliver the

face value (or par value) P (T , T ) = $1 at time T . In addition to its value
at maturity, a bond may yield a periodic coupon payment at regular time
intervals until the maturity date.
Fig. 17.5: Five-dollar 1875 Louisiana bond with 7.5% biannual coupons and maturity
T = 01/01/1886.
The computation of the arbitrage-free price P0 (t, T ) of a zero-coupon bond

based on an underlying short-term interest rate process (rt )t∈R+ is a basic
and important issue in interest rate modeling.
Constant short rate
In case the short-term interest rate is a constant rt = r, t > 0, a standard

arbitrage argument shows that the price P (t, T ) of the bond is given by
586 "
P (t, T ) = e −r (T −t) , 0 6 t 6 T.
Indeed, if P (t, T ) > e −r (T −t) we could issue a bond at the price P (t, T ) and
invest this amount at the compounded risk free rate r, which would yield
P (t, T ) e r (T −t) > 1 at time T .
On the other hand, if P (t, T ) < e −r (T −t) we could borrow P (t, T ) at the
rate r to buy a bond priced P (t, T ). At maturity time T we would receive $1
and refund only P (t, T ) e r (T −t) < 1.
The price P (t, T ) = e −r (T −t) of the bond is the value of P (t, T ) that makes
the potential profit P (t, T ) e r (T −t) − 1 vanish for both traders.
Time-dependent deterministic short rates
Similarly to the above, when the short-term interest rate process (r (t))t∈R+
is a deterministic function of time, a similar argument shows that
rT
r (s)ds
P (t, T ) = e − t , 0 6 t 6 T. (17.13)
Stochastic short rates
In case (rt )t∈R+ is an (Ft )t∈R+ -adapted random process the formula (17.13)
is no longer valid as it relies on future information, and we replace it with
the averaged discounted payoff
h rT i
P (t, T ) = E∗ e − t rs ds Ft , 0 6 t 6 T, (17.14)

under a risk-neutral probability measure P∗ . It is natural to write P (t, T ) as a

conditional expectation under a martingale measure, as the use of conditional
expectation helps to “filter out” the (random/unknown) future information
wT
past time t contained in rs ds. The expression (17.14) makes sense as
t rT
the “best possible estimate” of the future quantity e − t
rs ds
in mean-square
sense, given the information known up to time t.
Coupon bonds
Pricing bonds with nonzero coupon is not difficult since in general the amount
and periodicity of coupons are deterministic.∗ In the case of a succession
of coupon payments c1 , c2 , . . . , cn at times T1 , T2 , . . . , Tn ∈ (t, T ], another
application of the above absence of arbitrage argument shows that the price
∗
However, coupon default cannot be excluded.
" 587
N. Privault
Pc (t, T ) of the coupon bond with discounted (deterministic) coupon payments

is given by the linear combination of zero-coupon bond prices
" n #
r Tk r
X T
Pc (t, T ) := E∗ ck e − t rs ds Ft + E∗ e − t rs ds Ft

k =1
n
X r
Tk

ck E∗ e − t rs ds Ft + P0 (t, T )

=
k =1
n
X
= P0 (t, T ) + ck P0 (t, Tk ), 0 6 t 6 T1 , (17.15)
k =1
which represents the present value at time t of future $c1 , $c2 , . . . , $cn receipts
respectively at times T1 , T2 , . . . , Tn , in addition to a terminal $1 principal pay-
ment.
In the case of a constant coupon rate c paid at regular time intervals

τ = Tk+1 − Tk , k = 0, 1, . . . , n − 1, with T0 = t, Tn = T , and a constant
deterministic short rate r, we find
n
e −(Tk −T0 )r
X
Pc (T0 , Tn ) = e −rnτ + c
k =1
X n
= e −rnτ + c e −krτ
k =1
e −rτ − e −r (n+1)τ
= e −rnτ + c .
1 − e −rτ
In terms of the discrete-time interest rate r̃ := e rτ − 1, we also have
c r̃ − c
Pc (T0 , Tn ) = + .
r̃ (1 + r̃ )n r̃
588 "
1.8
c>r
c<r
1.6 ~
c=r
1.4
Bond price
1.2
0.8
0.6
0.4
0.2
0 2 4 6 8 10
t
Fig. 17.6: Discrete-time coupon bond pricing.
In the case of a continuous-time coupon rate c > 0, the above discrete-time

calculation (17.15) can be reinterpreted as follows:
wT
Pc (t, T ) = P0 (t, T ) + c P0 (t, u)du (17.16)
t
wT
−(u−t)r
= P0 (t, T ) + c e du
t
w T −t
= e −(T −t)r + c e −ru du
0
c
= e −(T −t)r + 1 − e −(T −t)r ,

r
c r − c −(T −t)r
= + e , 0 6 t 6 T, (17.17)
r r
where the coupon bond price Pc (t, T ) solves the ordinary differential equation
dPc (t, T ) = (r − c) e −(T −t)r dt = −cdt + rPc (t, T )dt, 0 6 t 6 T,
see also Figures 17.7 and 17.11 below.
" 589
N. Privault
1.8
c>r
c<r
1.6 c=r
1.4
Bond price
1.2
0.8
0.6
0.4
0.2
0 2 4 6 8 10
t
Fig. 17.7: Continuous-time coupon bond pricing.
In the sequel, we will mostly consider zero-coupon bonds priced as P (t, T ) =

P0 (t, T ), 0 6 t 6 T , in the setting of stochastic short rates.
Martingale property of discounted bond prices
The following proposition shows that Assumption (A) of Chapter 16 is sat-

isfied, in other words, the bond price process t 7→ P (t, T ) can be used as a
numéraire.
Proposition 17.1. The discounted bond price process
rt
t 7→ Pe (t, T ) := e − 0
rs ds
P (t, T )
Proof. By (17.14) we have
rt
Pe (t, T ) = e − rs ds
P (t, T )
0
rt h rT i
−
= e E∗ e − t rs ds Ft
rs ds
0

h rt rT i
= E∗ e − 0 rs ds e − t rs ds Ft

h rT i
= E∗ e − 0 rs ds Ft , 0 6 t 6 T,

and this suffices in order to conclude, since by the tower property (23.38) of
conditional expectations, any process (Xt )t∈R+ of the form t 7→ Xt := E∗ [F |
Ft ], F ∈ L1 (Ω), is a martingale, see also Relation (7.1). In other words, we
have
r
T
E∗ Pe (t, T ) Fu = E∗ E∗ e − 0 rs ds Ft Fu

590 "
r
T
= E∗ e − 0 rs ds Fu

= Pe (u, T ), 0 6 u 6 t.
17.4 Bond Pricing PDE

We assume from now on that the underlying short rate process solves the
stochastic differential equation
drt = µ(t, rt )dt + σ (t, rt )dBt (17.18)
where (Bt )t∈R+ is a standard Brownian motion under P∗ .

Note that spec-
ifying the dynamics of (rt )t∈R+ under the historical probability measure P
will also lead to a notion of market price of risk (MPoR) for the modeling of
short rates.
As all solutions of stochastic differential equations such as (17.18) have the

Markov property, cf. e.g. Theorem V-32 of Protter (2004), the arbitrage-free
price P (t, T ) can be rewritten as a function F (t, rt ) of rt , i.e.
h rT i
P (t, T ) = E∗ e − t rs ds Ft

h rT i
= E∗ e − t rs ds rt

= F (t, rt ), (17.19)
and depends on (t, rt ) only, instead of depending on the whole information

available in Ft up to time t, meaning that the pricing problem can now be
formulated as a search for the function F (t, x).
Proposition 17.2. (Bond pricing PDE). Consider a short rate (rt )t∈R+
modeled by a diffusion equation of the form
drt = µ(t, rt )dt + σ (t, rt )dBt .
The bond pricing PDE for P (t, T ) = F (t, rt ) as in (17.19) is written as
∂F ∂F 1 ∂2F
xF (t, x) = (t, x) + µ(t, x) (t, x) + σ 2 (t, x) 2 (t, x), (17.20)
∂t ∂x 2 ∂x
t > 0, x ∈ R, subject to the terminal condition
" 591
N. Privault
F (T , x) = 1, x ∈ R. (17.21)
In addition, the bond price dynamics is given by

∂F
dP (t, T ) = rt P (t, T )dt + σ (t, rt ) (t, rt )dBt . (17.22)
∂x
Proof. By Itô’s formula, we have
rt rt rt
d e − 0 rs ds P (t, T ) = −rt e − 0 rs ds P (t, T )dt + e − 0 rs ds dP (t, T )
rt rt
= −rt e − 0
rs ds
F (t, rt )dt + e − 0
rs ds
dF (t, rt )
rt rt∂F
= −rt e − 0 rs ds F (t, rt )dt + e − 0 rs ds (t, rt )(µ(t, rt )dt + σ (t, rt )dBt )
∂x
rt
1 2 2
∂ F ∂F

+ e − 0 rs ds σ (t, rt ) 2 (t, rt ) + (t, rt ) dt
2 ∂x ∂t
rt rt
− 0 rs ds − 0 rs ds ∂F
= −rt e F (t, rt )dt + e (t, rt )drt
∂x
1 − r t rs ds ∂ 2 F rt ∂F
+ e 0 (t, rt )(drt )2 + e − 0 rs ds (t, rt )dt
2 ∂x2 ∂t
rt ∂F
= e − 0 rs ds σ (t, rt ) (t, rt )dBt
∂x
rt
∂F 1 ∂2F ∂F

+ e − 0 rs ds −rt F (t, rt ) + µ(t, rt ) (t, rt ) + σ 2 (t, rt ) 2 (t, rt ) + (t, rt ) dt.
∂x 2 ∂x ∂t
(17.23)
rt
Given that t 7→ e − 0 rs ds P (t, T ) is a martingale, the above expression (17.23)
should only contain terms in dBt (cf. Corollary II-6-1, page 72 of Protter
(2004)), and all terms in dt should vanish inside (17.23). This leads to the
identities

r F (t, r ) = µ(t, r ) ∂F (t, r ) + 1 σ 2 (t, r ) ∂ F (t, r ) + ∂F (t, r )
 2
t t t t t t t
2

∂x ∂x2 ∂t





 rt rt ∂F
d e − 0 rs ds P (t, T ) = e − 0 rs ds σ (t, rt ) (t, rt )dBt , (17.24a)


∂x
which lead to (17.20) and (17.22). Condition (17.21) is due to the fact that
P (T , T ) = $1.
In the case of an interest rate process modeled by (17.8), we have
q
µ(t, x) = η (t) + λ(t)x, and σ (t, x) = δ (t) + γ (t)x,
hence (17.20) yields the affine PDE
592 "
∂F ∂F 1 ∂2F
xF (t, x) = (t, x) + (η (t) + λ(t)x) (t, x) + (δ (t) + γ (t)x) 2 (t, x)
∂t ∂x 2 ∂x
(17.25)
with time-dependent coefficients, t > 0, x ∈ R. By (17.24a), the proof of

Proposition 17.2 also shows that
dP (t, T ) 1 rt rt
= d e 0 rs ds e − 0 rs ds P (t, T )
P (t, T ) P (t, T )
1 rt rt
= rt P (t, T )dt + e 0 rs ds d e − 0 rs ds P (t, T )
P (t, T )
1 rt rt
= rt dt + e 0 rs ds d e − 0 rs ds P (t, T )
P (t, T )
1 ∂F
= rt dt + (t, rt )σ (t, rt )dBt
F (t, rt ) ∂x
∂
= rt dt + σ (t, rt ) log F (t, rt )dBt . (17.26)
∂x
Vašíček (1977) model
In the Vasicek case

drt = (a − brt )dt + σdBt ,
the bond price takes the form
F (t, rt ) = P (t, T ) = e A(T −t)+rt C (T −t) ,
where A(·) and C (·) are deterministic functions of time, see (17.35) below,
and (17.26) yields
dP (t, T )
= rt dt + σC (T − t)dBt (17.27)
P (t, T )
σ
= rt dt − 1 − e −(T −t)b dBt ,

b
since F (t, x) = e A(T −t)+xC (T −t) .
Note that more generally, all affine short rate models as defined in Rela-
tion (17.8), including the Vasicek model, will yield a bond pricing formula of
the form
P (t, T ) = e A(T −t)+rt C (T −t) , (17.28)
cf. e.g. § 3.2.4. in Brigo and Mercurio (2006).
" 593
N. Privault
Probabilistic solution of the Vasicek PDE
Next, we solve the PDE (17.20), written with µ(t, x) = a − bx and σ (t, x) = σ
in the Vašíček (1977) model
drt = (a − brt )dt + σdBt (17.29)
as
∂F ∂F σ2 ∂ 2 F

 xF (t, x) =
 (t, x) + (a − bx) (t, x) + (t, x),
∂t ∂x 2 ∂x2 (17.30)

F (T , x) = 1.

For this, Proposition 17.3 relies on a direct computation of the conditional

expectation h rT i
F (t, rt ) = P (t, T ) = E∗ e − t rs ds Ft . (17.31)

See also Exercise 17.7 for a bond pricing formula in the Cox et al. (1985)
(CIR) model.
Proposition 17.3. The zero-coupon bond price in the Vasicek model (17.29)
can be expressed as
P (t, T ) = e A(T −t)+rt C (T −t) , 0 6 t 6 T, (17.32)
where A(x) and C (x) are functions of time to maturity given by

1
1 − e −bx , (17.33)

C (x) : = −
b
and
4ab − 3σ 2 σ 2 − 2ab σ 2 − ab −bx σ 2 −2bx
A(x) : = + x+ e − 3e (17.34)
4b3 2b2 b3 4b

a σ 2
σ 22
= − − (x + C (x)) − C (x), x > 0.
b 2b2 4b
Proof. Recall that in the Vasicek model (17.29), the short rate process
(rt )t∈R+ solution of (17.29) has the expression
wt a wt
h(t, s)dBs = r0 e −bt + 1 − e −bt + σ e −(t−s)b dBs ,

rt = g (t) +
0 b 0
where g and h are the deterministic functions

a
g (t) := r0 e −bt + 1 − e −bt , t > 0,

b
and
594 "
h(t, s) := σ e −(t−s)b , 0 6 s 6 t.
Using the fact that Wiener integrals are Gaussian random variables and the
Gaussian moment generating function, and exchanging the order of integra-
tion between ds and du over [t, T ] according to the following picture,
u
t T
we have
h rT i
P (t, T ) = E∗ e − t rs ds Ft

h rT rs i
= E∗ e − t (g (s)+ 0 h(s,u)dBu )ds Ft

w h rT rs
T i
= exp − g (s)ds E∗ e − t 0 h(s,u)dBu ds Ft

t
w rT rT
T − h(s,u)dsdBu
= exp − g (s)ds E∗ e 0 Max(u,t) Ft
t
w w w rT rT
T t T − h(s,u)dsdBu
= exp − g (s)ds − h(s, u)dsdBu E∗ e t Max(u,t) Ft
t 0 Max(u,t)
w w w rT rT
T t T h i
= exp − g (s)ds − h(s, u)dsdBu E∗ e − t u h(s,u)dsdBu Ft

t 0 t
w wtwT h rT rT
T i
= exp − g (s)ds − h(s, u)dsdBu E∗ e − t u h(s,u)dsdBu
t 0 t
wT wtwT 1wT wT
2 !
= exp − g (s)ds − h(s, u)dsdBu + h(s, u)ds du
t 0 t 2 t u
w w w
T a t T −(s−u)b
= exp − r0 e −bs + 1 − e −bs ds − σ e

dsdBu
t b 0 t
σ 2 w T
w
T −(s−u)b
2 !
× exp e ds du
2 t u
w
w t −(t−u)b

T a σ
= exp − r0 e −bs + 1 − e −bs ds − 1 − e −(T −t)b e

dBu
t b b 0
" 595
N. Privault
σ 2 w T 2bu e −bu − e −bT

2 !
× exp e du
2 t b
1

rt a
= exp − 1 − e −(T −t)b + 1 − e −(T −t)b r0 e −bt + 1 − e −bt
b b b
wT a σ 2 w T 2bu e
−bu
− e −bT
2 !
× exp − r0 e −bs + 1 − e −bs ds + e

du
t b 2 t b
= e A(T −t)+rt C (T −t) , (17.35)
where A(x) and C (x) are the functions given by (17.33) and (17.34).
Analytical solution of the Vasicek PDE
In order to solve the PDE (17.30) analytically, we may start by looking for a
solution of the form
F (t, x) = e A(T −t)+xC (T −t) , (17.36)
where A(·) and C (·) are functions to be determined under the conditions
A(0) = 0 and C (0) = 0. Substituting (17.36) into the PDE (17.20) with the
Vasicek coefficients µ(t, x) = (a − bx) and σ (t, x) = σ shows that
x e A(T −t)+xC (T −t) = −(A0 (T − t) + xC 0 (T − t)) e A(T −t)+xC (T −t)

+(a − bx)C (T − t) e A(T −t)+xC (T −t)
1
+ σ 2 C 2 (T − t) e A(T −t)+xC (T −t) ,
2
i.e.
1
x = −A0 (T − t) − xC 0 (T − t) + (a − bx)C (T − t) + σ 2 C 2 (T − t).
2
By identification of terms for x = 0 and x 6= 0, this yields the system of
Riccati and linear differential equations
σ2 2

 A0 (s) = aC (s) +
 C (s)
2

 0
C (s) = −1 − bC (s),
which can be solved to recover the above value of P (t, T ) = F (t, rt ) via
1
1 − e −bs

C (s) = −
b
and
596 "
wt
A(t) = A(0) + A0 (s)ds
0
wt σ2 2

= aC (s) + C (s) ds
0 2
w t a σ2 2

1 − e −bs + 2 1 − e −bs

= ds
0 b 2b
a tw σ 2 w t 2
1 − e −bs ds + 2 1 − e −bs ds

=
b 0 2b 0
4ab − 3σ 2 σ 2 − 2ab σ 2 − ab −bt σ 2 −2bt
= + t+ e − 3e , t > 0.
4b 3 2b 2 b3 4b
The next Figure 17.8 shows the output of the attached R code for the Monte
Carlo and analytical estimation of Vasicek bond prices.
r0= 0.1 , n= 1 , Sum / 7 = 0.90261 Bond prices estimates
1.0
0.6
0.4
0.9
0.2
0.8
0.0
0.7
−0.2
Monte Carlo Estimation

Analytical PDE Solution
0.6
Time
−0.4
0.2 0.4 0.6 0.8 1.0
r0
(a) Short rate paths. (b) Comparison with the PDE solution.
Fig. 17.8: Comparison of Monte Carlo and analytical PDE solutions.
Vasicek bond price simulations
In this section we consider again the Vasicek model, in which the short rate
(rt )t∈R+ is solution to (17.1). Figure 17.9 presents a random simulation of
the zero-coupon bond price (17.32) in the Vasicek model with σ = 10%, r0 =
2.96%, b = 0.5, and a = 0.025. The graph of the corresponding deterministic
zero-coupon bond price with r = r0 = 2.96% is also shown in Figure 17.9.
" 597
N. Privault
0.8
P(t,T)
0.6
0.4
0.2
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Fig. 17.9: Graphs of t 7→ F (t, rt ) = P (t, T ) vs t 7→ e −r0 (T −t) .
Figure 17.10 presents a random simulation of the coupon bond price (17.16)
in the Vasicek model with σ = 2%, r0 = 3.5%, b = 0.5, a = 0.025, and
coupon rate c = 5%. The graph of the corresponding deterministic coupon
bond price (17.17) with r = r0 = 3.5% is also shown in Figure 17.10.
1.8
1.7
1.6
1.5
Pc(t,T)
1.4
1.3
1.2
1.1
1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Fig. 17.10: Graph of t 7→ Pc (t, T ) for a bond with a 5% coupon rate.
Figure 17.11 presents market price data for a coupon bond with coupon rate
c = 6.25%.
598 "
Fig. 17.11: Bond price graph with maturity 01/18/08 and coupon rate 6.25%.
Zero-coupon bond price and yield data
The following zero-coupon public bond price data was downloaded from
EMMA at the Municipal Securities Rulemaking Board.
ORANGE CNTY CALIF PENSION OBLIG CAP APPREC-TAXABLE-

REF-SER A (CA)
CUSIP: 68428LBB9
Dated Date: 06/12/1996 (June 12, 1996)
Maturity Date: 09/01/2016 (September 1st, 2016)
Interest Rate: 0.0 %
Principal Amount at Issuance: $26,056,000
Initial Offering Price: 19.465
library(quantmod);getwd()
bondprice <- read.table("bond_data_R.txt",col.names =
c("Date","HighPrice","LowPrice","HighYield","LowYield","Count","Amount"))
head(bondprice)
time <- as.POSIXct(bondprice$Date, format = "%Y-%m-%d")
price <- xts(x = bondprice$HighPrice, order.by = time)
yield <- xts(x = bondprice$HighYield, order.by = time)
pdf("orange_prices.pdf",width=8,height=3.5);
chartSeries(price,up.col="blue",theme="white")
dev.off()
pdf("orange_yield.pdf",width=8,height=3.5);
chartSeries(yield,up.col="blue",theme="white")
dev.off()
" 599
N. Privault
Date HighPrice LowPrice HighYield LowYield Count Amount

1 2016-01-13 99.082 98.982 1.666 1.501 2 20000
2 2015-12-29 99.183 99.183 1.250 1.250 1 10000
3 2015-12-21 97.952 97.952 3.014 3.014 1 10000
4 2015-12-17 99.141 98.550 2.123 1.251 5 610000
5 2015-12-07 98.770 98.770 1.714 1.714 2 10000
6 2015-12-04 98.363 98.118 2.628 2.280 2 10000
price [2005−01−26/2016−01−13]
100
Last 99.082
90
80
70
60
50
Jan 26 Feb 08 Mar 27 Feb 06 Aug 06 Nov 01 Nov 09 May 16 Dec 29

2005 2006 2007 2009 2010 2011 2012 2014 2015
Fig. 17.12: Orange Cnty Calif bond prices.
The next Figure 17.13 plots the bond yield y (t, T ) defined as
log P (t, T )
y (t, T ) = − , or P (t, T ) = e −(T −t)y (t,T ) , 0 6 t 6 T.
T −t
yield [2005−01−26/2016−01−13]
Last 1.666 8
Jan 26 Feb 08 Mar 27 Feb 06 Aug 06 Nov 01 Nov 09 May 16 Dec 29

2005 2006 2007 2009 2010 2011 2012 2014 2015
Fig. 17.13: Orange Cnty Calif bond yields.
600 "
Bond pricing in the Dothan model
In the Dothan (1978) model, the short-term interest rate process (rt )t∈R+ is
modeled according to a geometric Brownian motion
drt = µrt dt + σrt dBt , (17.37)
where the volatility σ > 0 and the drift µ ∈ R are constant parameters and
(Bt )t∈R+ is a standard Brownian motion. In this model the short-term in-
terest rate rt remains always positive, while the proportional volatility term
σrt accounts for the sensitivity of the volatility of interest rate changes to
the level of the rate rt .
On the other hand, the Dothan model is the only lognormal short rate
model that allows for an analytical formula for the zero-coupon bond price
h rT i
P (t, T ) = E∗ e − t rs ds Ft , 0 6 t 6 T.

For convenience of notation we let p = 1 − 2µ/σ 2 and rewrite (17.37) as
σ2
drt = (1 − p) rt dt + σrt dBt ,
2
with solution
2 t/2
rt = r0 e σBt −pσ , t > 0. (17.38)
By the Markov property of (rt )t∈R+ , the bond price P (t, T ) is a function
F (t, rt ) of rt and time t ∈ [0, T ]:
h rT i
P (t, T ) = F (t, rt ) = E∗ e − t rs ds rt , 0 6 t 6 T. (17.39)

By computation of the conditional expectation (17.39) using (13.9) we easily

obtain the following result, cf. Proposition 1.2 of Pintoux and Privault (2011),
where the function θ (v, t) is defined in (13.7).
Proposition 17.4. The zero-coupon bond price P (t, T ) = F (t, rt ) is given
for all p ∈ R by
F (t, x) (17.40)
2 p2 (T −t) /8
w∞w∞ 1 + z2
!
4z (T − t)σ 2
du dz
= e −σ e −ux exp −2 θ , ,
0 0 σ2 u σ2 u 4 u z p+1
x > 0.
" 601
N. Privault
Proof. By Proposition 13.4, cf. Proposition 2 in Yor (1992), the probability

w T −t 2
distribution of the time integral e σBs −pσ s/2 ds is given by
0
w
T −t 2
P e σBs −pσ s/2 ds ∈ dy
0
w∞ w
t σB −pσ 2 s/2

= P e s ds ∈ dy, Bt − pσt/2 ∈ dz
−∞ 0
σ w ∞ −pσz/2−p2 σ2 t/8
!
1 + e σz 4 e σz/2 σ 2 t dy

= e exp −2 θ , dz
2 −∞ σ2 y σ2 y 4 y
2 2
w∞
1 + z2

4z (T − t)σ 2

dz dy
= e −(T −t)p σ /8 exp −2 2 θ , , y > 0,
0 σ y 2
σ y 4 z p+1 y
where the exchange of integrals is justified by the Fubini theorem and the
nonnegativity of integrands. Hence, by (13.9) and (17.38) we find
F (t, rt ) = P (t, T )
w
T
= E∗ exp − rs ds Ft

t
wT 2

= E∗ exp −rt e σ (Bs −Bt )−σ p(s−t)/2 ds Ft

t
wT 2

= E∗ exp −x e σ (Bs −Bt )−σ p(s−t)/2 ds
t x=rt
w T −t 2

∗
= E exp −x e σBs −σ ps/2 ds
0 x=rt
w∞ w
T −t

−rt y σBs −pσ 2 s/2
= e P e ds ∈ dy
0 0
w∞ w∞
1 + z2

4z (T − t)σ 2

dz dy
−(T −t)p2 σ 2 /8
= e e −rt y exp −2 2 θ , .
0 0 σ y 2
σ y 4 z p+1 y

The zero-coupon bond price P (t, T ) = F (t, rt ) in the Dothan model can also
be written for all p ∈ R as
√
(2x)p/2 w ∞ −(p2 +u2 )σ2 t/8 p u 2 8x
F (t, x) = ue sinh(πu) Γ − + i Kiu du

2π σ
2 p 0 2 2 σ
√
(2x)p/2 X 2(p − 2k )+ σ2 k(k−p)t/2 8x

+ e Kp−2k , x > 0, t > 0,
σp k!(p − k )! σ
k>0
cf. Corollary 2.2 of Pintoux and Privault (2010), see also Privault and Uy
(2013) for numerical computations. Zero-coupon bond prices in the Dothan
602 "
model can also be computed by the conditional expression

w w w
T ∞ T
E exp − rt dt = E exp − rt dt rT = z dP(rT 6 z ),

0 0 0
(17.41)
where rT has the lognormal distribution
2 T /2 1 2 2 2
dP(rT 6 z ) = dP(r0 e σBT −pσ 6 z) = √ e −(pσ T /2+log(z/r0 )) /(2σ T ) .
z 2πσ 2 T
In Proposition 17.5 we note that the conditional Laplace transform
w
T
E exp − rt dt rT = z

0
cf. (17.45) above, can be computed by a closed-form integral expression based

on the modified Bessel function of the second kind
zζ w ∞ z2

du
Kζ ( z ) : = ζ + 1 exp −u − , ζ ∈ R, z ∈ C, (17.42)
2 0 4u uζ +1
cf. e.g. Watson (1995) page 183, provided that the real part R(z 2 ) of z 2 ∈ C
is positive.
Proposition 17.5. (Privault and Yu (2016), Proposition 4.1). Taking r0 =
1, for all λ, z > 0 we have
wT 2 r
4 e −σ T /8

λ
E exp −λ rs ds rT = z = 3/2 2 (17.43)

0 π σ p(z ) T
√ p √
w∞ 2 2 2

4πξ

K1 8λ 1 + 2 z cosh ξ + z/σ

× e 2(π −ξ )/(σ T ) sin sinh ( ξ ) √ dξ.
σ2 T 1 + 2 z cosh ξ + z
p
0
Note however that the numerical evaluation of (17.43) fails for small values
of T > 0, and for this reason the integral can be estimated by a gamma
approximation, cf. (17.44) below. Under the gamma approximation we can
approximate the conditional bond price on the Dothan short rate rt as
wT
E exp −λ rt dt rT = z ' (1 + λθ (z ))−ν (z ) ,

0
where the parameters ν (z ) and θ (z ) are determined by conditional moment

fitting to a gamma distribution, as
Var[ΛT | ST = z ] (E[ΛT | ST = z ])2 E[ΛT | ST = z ]

θ (z ) : = , ν (z ) : = = ,
E[ΛT | ST = z ] Var[ΛT | ST = z ] θ
cf. Privault and Yu (2016), which yields
" 603
N. Privault
wT w
∞
E exp −λ rs ds ' (1 + λθ (z ))−ν (z ) dP(rT 6 z ). (17.44)
0 0
Note that θ (z ) is known in physics as the Fano factor or dispersion index

which measures the dispersion of the probability distribution of ΛT given that
ST = z. Figures 17.14 shows that the stratified gamma approximation (17.44)
matches the Monte Carlo estimate, while the use of the integral expressions
(17.41) and (17.43) leads to numerical instabilities.
1
Stratified gamma
Monte Carlo
0.8 Integral expression
0.6
F(x,t)
0.4
0.2
0
0 1 2 3 4 5 6 7 8 9 T=10
t
Fig. 17.14: Approximation of Dothan bond prices t 7→ F (t, x) with σ = 0.3 and T = 10.
Related computations for yield options in the Cox et al. (1985) (CIR) model
can also be found in Prayoga and Privault (2017).
Path integrals in option pricing
Let } denote the Planck constant, and let S (x(·)) denote the action functional
given as
wt w t 1
S (x(·)) = L(x(s), ẋ(s), s)ds = m(ẋ(s))2 − V (x(s)) ds,
0 0 2
where L(x(s), ẋ(s), s) is the Lagrangian

1
L(x(s), ẋ(s), s) := m(ẋ(s))2 − V (x(s)).
2
In physics, the Feynman path integral
w
i

ψ (y, t) := Dx(·) exp S (x(·))
x(0)=x, x(t)=y }
solves the Schrödinger equation
∂ψ }2 ∂ 2 ψ
i} (x, t) = − (x, t) + V (x(t))ψ (x, t).
∂t 2m ∂x2
604 "
After the Wick rotation t 7→ −it, the function

w
1

φ(y, t) := Dx(·) exp − S (x(·))
x(0)=x, x(t)=y }
solves the heat equation
∂φ }2 ∂ 2 φ
} (x, t) = − (x, t) + V (x(t))φ(x, t).
∂t 2m ∂x2
By reformulating the action functional S (x(·)) as
w t 1
S (x(·)) = m(ẋ(s))2 + V (x(s)) ds
0 2
N
X (x(ti ) − x(ti−1 ))2
' + V (x(ti−1 )) ∆ti ,
2(ti − ti−1 ) 2
i=1
we can rewrite the Euclidean path integral as

w
1

φ(y, t) = Dx(·) exp − S (x(·))
x(0)=x, x(t)=y }
w N N
!
1 X (x(ti ) − x(ti−1 ))2 1 X
= Dx(·) exp − − V (x(ti−1 ))
x(0)=x, x(t)=y 2} 2∆ti }
i=1 i=1
w
1 t

∗
= E exp − V (Bs )ds B0 = x, Bt = y .

} 0
This type of path integral computation
w
t
φ(y, t) = E∗ exp − V (Bs )ds B0 = x, Bt = y . (17.45)

0
is particularly useful for bond pricing, as (17.45) can be interpreted as

the price of a bond with short-term interest rate process (rt )t∈R+ :=
(V (Bt )))t∈R+ conditionally to the value of the endpoint Bt = y, cf. (17.43)
below. It can also be useful for exotic option pricing, cf. Chapter 13, and
for risk management, see e.g. Kakushadze (2015). The path integral (17.45)
can be estimated either by closed-form expressions using Partial Differential
Equations (PDEs) or probability densities, by approximations such as (con-
ditional) Moment matching, or by Monte Carlo estimation, from the paths
of a Brownian bridge as shown in Figure 17.15.
" 605
N. Privault
x
0 t
Fig. 17.15: Brownian bridge.
Exercises
Exercise 17.1 We consider the stochastic differential equation
drt = (a − brt )dt + σdBt , (17.46)
where a, σ ∈ R, b > 0.
a) Show that the solution of (17.46) is
a wt
rt = r0 e −bt + 1 − e −bt + σ e −(t−s)b dBs , t > 0. (17.47)

b 0
b) Show that the Gaussian N (a/b, σ 2 /(2b)) distribution is the invariant (or
stationary) distribution of (rt )t∈R+ .
Exercise 17.2 (Brody et al. (2018)) In the mean-reverting Vasicek model

(17.47) with b > 0, compute:
i) The asymptotic bond yield, or exponential long rate of interest
log P (t, T )
r∞ := − lim .
T →∞ T −t
ii) The long-bond return
P (t, T )
Lt := lim .
T →∞ P (0, T )
Hint: Start from log(P (t, T )/P (0, T )).
606 "
Exercise 17.3 Consider the Chan-Karolyi-Longstaff-Sanders (CKLS) in-

terest rate model (Chan et al. (1992)) parametrized as
drt = (a − brt )dt + σrtγ dBt ,
and time-discretized as
rtk+1 = rtk + (a − brtk )∆t + σrtγk Zk

= a∆t + (1 − b∆t)rtk + σrtγk Zk , k > 0,
where ∆t := tk+1 − tk and (Zk )k>0 is an i.i.d. sequence of N (0, ∆t) random
variables. Assuming that a, b, γ > 0 are known, find an unbiased estimator
b2 for the variance coefficient σ 2 , based on a market data set (r̃tk )k=0,1,...,n .
σ
Exercise 17.4 Let (Bt )t∈R+ denote a standard Brownian motion started at
0 under the risk-neutral probability measure P∗ . We consider a short-term
interest rate process (rt )t∈R+ in a Ho-Lee model with constant deterministic
volatility, defined by
drt = adt + σdBt , (17.48)
where a ∈ R and σ > 0. Let P (t, T ) denote the arbitrage-free price of a
zero-coupon bond in this model:
w
T
P (t, T ) = E∗ exp − rs ds Ft , 0 6 t 6 T. (17.49)

t
a) State the bond pricing PDE satisfied by the function F (t, x) defined via
w
T
F (t, x) := E∗ exp − rs ds rt = x , 0 6 t 6 T.

t
b) Compute the arbitrage-free price F (t, rt ) = P (t, T ) from its expression

(17.49) as a conditional expectation.
Hint: One may use the integration by parts relation

wT wT
Bs ds = T BT − tBt − sdBs
t t
wT
= (T − t)Bt + T (BT − Bt ) − sdBs
t
wT
= ( T − t ) Bt + (T − s)dBs ,
t
2 η 2 /2
and the Gaussian moment generating function E[ e λX ] = e λ for X '
N (0, η 2 ).
" 607
N. Privault
c) Check that the function F (t, x) computed in Question (b) does satisfy the
PDE derived in Question (a).
Exercise 17.5 Consider the Courtadon (1982) model
drt = β (α − rt )dt + σrt dBt , (17.50)
where α, β, σ are nonnegative, which is a particular case of the Chan-Karolyi-

Longstaff-Sanders (CKLS) model (Chan et al. (1992)) with γ = 1. Show that
the solution of (17.50) is given by
wt S
t
rt = αβ du + r0 St , t > 0, (17.51)
0 Su
where (St )t∈R+ is the geometric Brownian motion solution of dSt = −βSt dt +
σSt dBt with S0 = 1.
Exercise 17.6 Consider the Marsh and Rosenfeld (1983) short-term interest
rate model
drt = βrtγ−1 + αrt dt + σrtγ/2 dBt

where α ∈ R and β, σ, γ > 0.

a) Letting Rt := rt2−γ , t > 0, find the stochastic differential equation satisfied
by (Rt )t∈R+ .
b) Given that the discounted bond price process is a martingale, derive the
bond pricing PDE satisfied by the function F (t, x) such that
h rT i h rT i
F (t, rt ) = P (t, T ) = E∗ e − t rs ds Ft = E∗ e − t rs ds rt .

Exercise 17.7 Consider the Cox et al. (1985) (CIR) process (rt )t∈R+ solution
of
√
drt = −art dt + σ rt dBt ,
where a, σ > 0 are constants (Bt )t∈R+ is a standard Brownian motion started
at 0.
a) Write down the bond pricing PDE for the function F (t, x) given by
w
T
F (t, x) := E∗ exp − rs ds rt = x , 0 6 t 6 T.

t
Hint: Use Itô calculus and the fact that the discounted bond price is a
martingale.
b) Show that the PDE of Question (a) admits a solution of the form
F (t, x) = e A(T −t)+xC (T −t) where the functions A(s) and C (s) satisfy
608 "
ordinary differential equations to be also written down together with the

values of A(0) and C (0).
Exercise 17.8 Convertible bonds. Consider an underlying asset price process

(St )t∈R+ given by
(1)
and a short-term interest rate process (rt )t∈R+ given by
(2)
drt = γ (t, rt )dt + η (t, rt )dBt ,
(1) (2)
where Bt t∈R+
and Bt t∈R+
are two correlated Brownian motions un-
(1) (2)
der the risk-neutral probability measure P∗ , with dBt • dBt = ρdt. A con-
vertible bond is made of a corporate bond priced P (t, T ) at time t ∈ [0, T ],
that can be exchanged into a quantity α > 0 of the underlying company’s
stock priced Sτ at a future time τ , whichever has a higher value, where α is
a conversion rate.
a) Find the payoff of the convertible bond at time τ .
b) Rewrite the convertible bond payoff at time τ as the linear combination
of P (τ , T ) and a call option payoff on Sτ , whose strike price is to be
determined.
c) Write down the convertible bond price at time t ∈ [0, τ ] as a function
C (t, St , rt ) of the underlying asset price and interest rate, using a dis-
counted conditional expectation, and show that the discounted corporate
bond price rt
e − 0 rs ds C (t, St , rt ), t ∈ [0, τ ],
is a martingale. r
t
d) Write down d e − 0 rs ds C (t, St , rt ) using the Itô formula and derive the

pricing PDE satisfied by the function C (t, x, y ) together with its terminal
condition.
e) Taking the bond price P (t, T ) as a numéraire, price the convertible bond
as a European option with strike price K = 1 on an underlying asset
priced Zt := St /P (t, T ), t ∈ [0, τ ] under the forward measure P b with
maturity T .
f) Assuming the bond price dynamics
dP (t, T ) = rt P (t, T )dt + σB (t)P (t, T )dBt ,
determine the dynamics of the process (Zt )t∈R+ under the forward mea-
sure P.
b
g) Assuming that (Zt )t∈R+ can be modeled as a geometric Brownian motion,
price the convertible bond using the Black-Scholes formula.
" 609
N. Privault
Exercise 17.9 Bond duration. Compute the duration

1+r ∂
Dc (0, n) := − Pc (0, n)
Pc (0, n) ∂r
of a discrete-time coupon bond priced as

n
1 X 1
Pc (0, n) = + c
(1 + r )n (1 + r )k
k =1
c c 1
= + 1− ,
r r (1 + r )n
where r > 0, and c > 0 denotes the coupon rate. What happens when n
becomes large?
Exercise 17.10 Let (rt )t∈R+ denote a short-term interest rate process. For
any T > 0, let P (t, T ) denote the price at time t ∈ [0, T ] of a zero-coupon
bond defined by the stochastic differential equation
dP (t, T )
= rt dt + σtT dBt , 0 6 t 6 T, (17.52)
P (t, T )
under the terminal condition P (T , T ) = 1, where (σtT )t∈[0,T ] is an adapted

process. We define the forward measure P b by
" #
dP
b P (t, T ) − r t rs ds
E∗ F t = e 0 , 0 6 t 6 T.
dP∗ P (0, T )

Recall that wt
BtT := Bt − σsT ds, 0 6 t 6 T,
0

b

b) Derive the stochastic differential equation satisfied by the discounted bond
price process rt
t 7→ e − 0 rs ds P (t, T ), 0 6 t 6 T,
and show that it is a martingale.
c) Show that
h rT i rt
E∗ e − 0 rs ds Ft = e − 0 rs ds P (t, T ), 0 6 t 6 T.

d) Show that
610 "
h rT i
P (t, T ) = E∗ e − t rs ds Ft , 0 6 t 6 T.

e) Compute P (t, S )/P (t, T ), 0 6 t 6 T , show that it is a martingale under

the forward measure P b with maturity T , and that
w
P (t, S ) 1wT S

T
P (T , S ) = exp (σsS − σsT )dBsT − (σs − σsT )2 ds .
P (t, T ) t 2 t
f) Assuming that (σtT )t∈[0,T ] and (σtS )t∈[0,S ] are deterministic functions of
time, compute the price
h rT i h i
E∗ e − t rs ds (P (T , S ) − κ)+ Ft = P (t, T )Eb (P (T , S ) − κ)+ Ft

of a bond option with strike price κ.
Recall that if X is a Gaussian random variable with mean m(t) and vari-
ance v 2 (t) given Ft , we have
+
E eX − K

Ft
v (t) 1

2
= e m(t)+v (t)/2 Φ + (m(t) + v 2 (t)/2 − log K )
2 v (t)
v (t) 1

−KΦ − + (m(t) + v 2 (t)/2 − log K )
2 v (t)
where Φ(x), x ∈ R, denotes the Gaussian cumulative distribution func-

tion.
Exercise 17.11 (Exercise 4.17 continued). Write down the bond pricing PDE
for the function h rT i
F (t, x) = E∗ e − t rs ds rt = x

and show that in case α = 0 the corresponding bond price P (t, T ) equals
P (t, T ) = e −rt B (T −t) , 0 6 t 6 T,
where
2( e γx − 1)
B (x) : = , x ∈ R,
2γ + (β + γ )( e γx − 1)
with γ = β 2 + 2σ 2 .
p
Exercise 17.12 Consider a zero-coupon bond with prices P (1, 2) = 91.74%

and P (0, 2) = 83.40% at times t = 0 and t = 1.
" 611
N. Privault
a) Compute the corresponding yields y0,1 , y0,2 and y1,2 at times t = 0 and
t = 1.
b) Assume that $0.1 coupons are paid at times t = 1 and t = 2. Price the
corresponding coupon bond at times t = 0 and t = 1 using the yields y0
and y1 .
Exercise 17.13 Consider the Vasicek process (rt )t∈R+ solution of the equation
drt = (a − brt )dt + σdBt . (17.53)
a) Consider the discretization

√
rtk+1 := rtk + (a − brtk )∆t ± σ ∆t, k = 0, 1, 2, . . .
of the equation (17.53) with p(rt0 ) = p(rt1 ) = 1/2 and

√ √
E[∆rt1 ] = (a − brt0 )∆t + σp(rt0 ) ∆t − σq (rt0 ) ∆t = (a − brt0 )∆t
and
√ √
E[∆rt2 ] = (a − brt1 )∆t + σp(rt0 ) ∆t − σq (rt0 ) ∆t = (a − brt1 )∆t.
Does this discretization lead to a (recombining) binomial tree?

b) Using the Girsanov Theorem, find a probability measure Q under which
the process (rt /σ )t∈[0,T ] with
drt a − brt
= dt + dBt
σ σ
is a standard Brownian motion.
rt
Hint: By the Girsanov Theorem, the process Xt = X0 + 0 us ds + Bt is a
martingale under the probability measure Q with Radon-Nikodym density
w
1wT

dQ T
= exp − ut dBt − (ut )2 dt
dP 0 2 0
with respect to P.
c) Prove the Radon-Nikodym derivative approximation
Y 1 a − brt √
2T /∆T ± ∆t
2 2σ
0<t<T
w
1 T 1 wT

' exp (a − brt )drt − 2 (a − brt )2 dt . (17.54)
2
σ 0 2σ 0
612 "
d) Using (17.54), show that the Vasicek process can be discretized along the
binomial tree
√ √
rt2 = rt1 + σ ∆t = rt0 + 2σ ∆t
p (r t 1 )
√
rt1 = rt0 + σ ∆t
)
p(r t 0
q (rt
rt0 1 ) rt2 = rt0
)
p(r t 1
q (r
t0 )
√
rt1 = rt0 − σ ∆t
q (r
t1 ) √ √
rt2 = rt1 − σ ∆t = rt0 − 2σ ∆t
with
E[∆rt1 | rt0 ] = (a − brt0 )∆t and E[∆rt2 | rt1 ] = (a − brt1 )∆t,
where ∆rt1 := rt1 − rt0 , ∆rt2 := rt2 − rt1 , and the probabilities p(rt0 ),
q (rt0 ), p(rt1 ), q (rt1 ) will be computed explicitly.
The use of binomial (or recombining) trees can make the implementation
of the Monte Carlo method easier as their size grows linearly instead of
exponentially.
Exercise 17.14 Black-Derman-Toy model (Black et al. (1990)). Consider a

one-step interest rate model in which the short-term
√
interest rate r0 on [0,
√
1]
can turn into two possible values r1u = r0 e µ∆t+σ ∆t and r1d = r0 e µ∆t−σ ∆t
on the time interval [1, 2] with equal probabilities 1/2 at time ∆t = 1 year
and volatility σ = 22% per year, and a zero-coupon bonds with prices P (0, 1)
and P (0, 2) at time t = 0.
a) Write down the value of P (1, 2) using r1u and r1d .
b) Write down the value of P (0, 2) using r1u , r1d and r0 .
c) Estimate the value of r0 from the market price P (0, 1) = 91.74.
d) Estimate the values of r1u and r1d from the market price P (0, 2) = 83.40.
Exercise 17.15 Consider a yield curve (f (t, t, T ))06t6T and a bond paying
coupons c1 , c2 , . . . , cn at times T1 , T2 , . . . , Tn until maturity Tn , and priced as
" 613
N. Privault
n
ck e −(Tk −t)f (t,t,Tk ) ,
X
P (t, Tn ) = 0 6 t 6 T1 ,
k =1
where cn is inclusive of the last coupon payment and the nominal $1 value
of the bond. Let fe(t, t, Tn ) denote the compounded yield to maturity defined
by equating
n
˜
ck e −(Tk −t)f (t,t,Tn ) ,
X
P (t, Tn ) = 0 6 t 6 T1 , (17.55)
k =1
i.e. fe(t, t, Tn ) solves the equation
F t, fe(t, t, Tn ) = P (t, Tn ), 0 6 t 6 T1 ,

with
n
ck e −(Tk −t)x ,
X
F (t, x) := 0 6 t 6 T1 .
k =1
The bond duration D (t, Tn ) is the relative sensitivity of P (t, Tn ) with respect
to fe(t, t, Tn ), defined as
1 ∂F
t, fe(t, t, Tn ) , 0 6 t 6 T1 .

D (t, Tn ) := −
P (t, Tn ) ∂x
The bond convexity C (t, Tn ) is defined as
1 ∂2F
t, fe(t, t, Tn ) , 0 6 t 6 T1 .

C (t, Tn ) :=
P (t, Tn ) ∂x2
a) Compute the bond duration in case n = 1.

b) Show that the bond duration D (t, Tn ) can be interpreted as an average of
times to maturity weighted by the respective discounted bond payoffs.
c) Show that the bond convexity C (t, Tn ) satisfies
C (t, Tn ) = (D (t, Tn ))2 + (S (t, Tn ))2 ,
where
n
X
(S (t, Tn ))2 := wk (Tk − t − D (t, Tn ))2
k =1
measures the dispersion of the duration of the bond payoffs around the
portfolio duration D (t, Tn ).
d) Consider now the zero-coupon yield defined as
P (t, t + α(Tn − t)) = exp − α(Tn − t)fα (t, t, Tn ) ,

614 "
where α ∈ (0, 1), i.e.

1
fα (t, t, Tn ) := − log P (t, t + α(Tn − t)), 0 6 t 6 Tn .
α(Tn − t)
Compute the bond duration associated to the yield fα (t, t, Tn ) in affine

bond pricing models of the form
P (t, T ) = e A(T −t)+rt B (T −t) , 0 6 t 6 T.
e) (Wu (2000)) Compute the bond duration associated to the yield fα (t, t, Tn )
in the Vasicek model, in which
1 − e −(T −t)b
B (T − t) : = , 0 6 t 6 T.
b
" 615
Chapter 18
Forward Rates
Forward rates are interest rates used in Forward Rate Agreements (FRA) for
financial transactions, such as loans, that can take place at a future date.
This chapter deals with the modeling of forward rates and swap rates in the
Heath-Jarrow-Morton (HJM) and Brace-Gatarek-Musiela (BGM) models. It
also includes a presentation of the Nelson and Siegel (1987) and Svensson
(1994) curve parametrizations for yield curve fitting, and an introduction to
two-factor interest rate models.
18.1 Construction of Forward Rates . . . . . . . . . . . . . . . . . . 617

18.2 Interest Rate Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 628
18.3 The HJM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631
18.4 Yield Curve Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . 637
18.5 Two-Factor Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
18.6 The BGM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 647
18.1 Construction of Forward Rates

A forward interest rate contract (or Forward Rate Agreement, FRA) gives
to its holder the possibility to lock an interest rate denoted by f (t, T , S ) at
present time t for a loan to be delivered over a future period of time [T , S ],
with t 6 T 6 S.
0 t T S
The rate f (t, T , S ) is called a forward interest rate. When T = t, the spot
forward rate f (t, t, T ) coincides with the yield, see Relation (18.3) below.
Figure 18.1 presents a typical yield curve on the LIBOR (London Interbank
Offered Rate) market with t =07 May 2003.
" 617
N. Privault
5 TimeSerieNb 505
Forward interest rate AsOfDate 7mai03
2D 2,55
1W 2,53
4.5 1M 2,56
2M 2,52
3M 2,48
4 1Y 2,34
2Y 2,49
3Y 2,79
4Y 3,07
3.5
%
5Y 3,31
6Y 3,52
7Y 3,71
8Y 3,88
3 9Y 4,02
10Y 4,14
11Y 4,23
2.5 12Y 4,33
13Y 4,4
14Y 4,47
15Y 4,54
2 20Y 4,74
0 5 10 15 20 25 30 25Y 4,83
30Y 4,86
Years
Fig. 18.1: Forward rate graph S 7−→ f (t, t, S ).
Maturity transformation, i.e., the ability to transform short-term borrowing

(debt with short maturities, such as deposits) into long term lending (credits
with very long maturities, such as loans), is among the roles of banks. Prof-
itability is then dependent on the difference between long rates and short
rates.
Another example of market data is given in the next Figure 18.2, in which
the red and blue curves refer respectively to July 21 and 22 of year 2011.
Fig. 18.2: Market example of yield curves, cf. (18.3).
Long maturities usually correspond to higher rates as they carry an increased

risk. The dip observed with short maturities can correspond to a lower mo-
tivation to lend/invest in the short-term.
618 "
Forward rates from bond prices
Let us determine the arbitrage or “fair” value of the forward interest rate
f (t, T , S ) by implementing the Forward Rate Agreement using the instru-
ments available in the market, which are bonds priced at P (t, T ) for various
maturity dates T > t.
The loan can be realized using the available instruments (here, bonds) on the
market, by proceeding in two steps:
1) At time t, borrow the amount P (t, S ) by issuing (or short selling) one
bond with maturity S, which means refunding $1 at time S.
2) Since the money is only needed at time T , the rational investor will
invest the amount P (t, S ) over the period [t, T ] by buying a (possibly
fractional) quantity P (t, S )/P (t, T ) of a bond with maturity T priced
P (t, T ) at time t. This will yield the amount
P (t, S )
$1 ×
P (t, T )
at time T > 0.
As a consequence, the investor will actually receive P (t, S )/P (t, T ) at time
T , to refund $1 at time S.
The corresponding forward rate f (t, T , S ) is then given by the relation
P (t, S )
exp ((S − T )f (t, T , S )) = $1, 0 6 t 6 T 6 S, (18.1)
P (t, T )
where we used exponential compounding, which leads to the following defi-

nition (18.2).
Definition 18.1. The forward rate f (t, T , S ) at time t for a loan on [T , S ]
is given by
log P (t, T ) − log P (t, S )

f (t, T , S ) = . (18.2)
S−T
The spot forward rate f (t, t, S ) coincides with the yield y (t, S ), with
log P (t, S )
f (t, t, S ) = y (t, S ) = − , or P (t, S ) = e −(S−t)f (t,t,S ) ,
T −t
(18.3)
0 6 t 6 S.
" 619
N. Privault
Instantaneous forward rates
Proposition 18.2. The instantaneous forward rate f (t, T ) = f (t, T , T ) is

defined by taking the limit of f (t, T , S ) as S & T , and satisfies
1 ∂P
f (t, T ) := lim f (t, T , S ) = − (t, T ). (18.4)
S&T P (t, T ) ∂T
Proof. We have
f (t, T ) : = lim f (t, T , S )

S&T
log P (t, S ) − log P (t, T )
= − lim
S&T S−T
log P (t, T + ε) − log P (t, T )
= − lim
ε&0 ε
∂
=− log P (t, T )
∂T
1 ∂P
=− (t, T ).
P (t, T ) ∂T

The above equation (18.4) can be viewed as a differential equation to be
solved for log P (t, T ) under the initial condition P (T , T ) = 1, which yields
the following proposition.
Proposition 18.3. The bond price P (t, T ) can be recovered from the instan-
taneous forward rate f (t, s) as
w
T
P (t, T ) = exp − f (t, s)ds , 0 6 t 6 T. (18.5)
t
Proof. We check that
log P (t, T ) = log P (t, T ) − log P (t, t)

wT ∂
= log P (t, s)ds
t ∂s
wT
=− f (t, s)ds.
t

Proposition 18.3 also shows that
f (t, t, t) = f (t, t)
∂ wT
= f (t, s)ds|T =t
∂T t
620 "
∂
=− log P (t, T )|T =t
∂T
1 ∂P
=− (t, T )|T =t
P (t, T ) |T =t ∂T
1 ∂ ∗ h − r T rs ds i
=− E e t Ft
P (T , T ) ∂T |T =t
h rT i
∗ − t rs ds
= E rT e Ft
|T =t
= E∗ [rt | Ft ]
= rt , (18.6)
i.e. the short rate rt can be recovered from the instantaneous forward rate
as
rt = f (t, t) = lim f (t, T ).

T &t
As a consequence of (18.1) and (18.5) the forward rate f (t, T , S ) can be

recovered from (18.2) and the instantaneous forward rate f (t, s), as:
log P (t, T ) − log P (t, S )

f (t, T , S ) =
S−T
w wS
1

T
=− f (t, s)ds − f (t, s)ds
S−T t t
1 wS
= f (t, s)ds, 0 6 t 6 T < S. (18.7)
S−T T
Similarly, as a consequence of (18.3) and (18.5) we have the next proposition.
Proposition 18.4. The spot forward rate or yield f (t, t, T ) can be written
in terms of bond prices as
log P (t, T ) 1 wT
f (t, t, T ) = − = f (t, s)ds, 0 6 t < T. (18.8)
T −t T −t t
Differentiation with respect to T of the above relation shows that the yield
f (t, t, T ) and the instantaneous forward rate f (t, s) are linked by the relation
∂f 1 wT 1
(t, t, T ) = − f (t, s)ds + f (t, T ), 0 6 t < T,
∂T (T − t)2 t T −t
from which it follows that
" 621
N. Privault
1 wT ∂f
f (t, T ) = f (t, s)ds + (T − t) (t, t, T )
T −t t ∂T
∂f
= f (t, t, T ) + (T − t) (t, t, T ), 0 6 t < T.
∂T
Forward Vašíček (1977) rates
In this section we consider the Vasicek model, in which the short rate process
is the solution (17.2) of (17.1) as illustrated in Figure 17.1.
In the Vasicek model, the forward rate is given by

f (t, T , S ) = −
S−T
rt (C (S − t) − C (T − t)) + A(S − t) − A(T − t))
=−
S−T
σ 2 − 2ab
=−
2b2
1 σ 2 − ab σ2

rt
e −(S−t)b − e −(T −t)b − 3 e −2(S−t)b − e −2(T −t)b ,

− +
S−T b b 3 4b
and the spot forward rate, or yield, satisfies
log P (t, T ) rt C (T − t) + A(T − t)

f (t, t, T ) = − =−
T −t T −t
σ 2 − 2ab 1 σ 2 − ab σ2

rt
1 − e −(T −t)b − 3 1 − e −2(T −t)b ,

=− + +
2b2 T −t b b 3 4b
with the mean
E[f (t, t, T )]
σ 2 − 2ab 1 E[rt ] σ 2 − ab σ2

1 − e −(T −t)b − 3 1 − e −2(T −t)b

=− + +
2b2 T −t b b3 4b
σ 2 − 2ab 1 σ 2 − ab

r0 −bt a
e 1 e −bt
1 − e −(T −t)b

=− + + − +
2b2 T −t b b2 b3
σ2
1 − e −2(T −t)b .

− 3
4b (T − t)
In this model, the forward rate t 7−→ f (t, T , S ) can be represented as in the
following Figure 18.3, with a = 0.06, b = 0.1, σ = 0.1 and r0 = %1.
622 "
1
E[f(t,T,S)]
f(t,T,S)
0.8
0.6
f(t,T,S)
0.4
0.2
0
0 5 10 15 20 25 30 35 40 45 50
t
Fig. 18.3: Forward rate process t 7−→ f (t, T , S ).
We note that the Vasicek forward rate curve t 7−→ f (t, T , S ) appears flat for
small values of t, i.e. longer rates are more stable, while shorter rates show
higher volatility or risk. Similar features can be observed in Figure 18.4 for
the instantaneous short rate given by
∂
f (t, T ) : = − log P (t, T ) (18.9)
∂T
a σ 2 2
= rt e −(T −t)b + 1 − e −(T −t)b − 2 1 − e −(T −t)b ,
b 2b
from which the relation limT &t f (t, T ) = rt can be easily recovered. We can
also evaluate the mean
a σ2 2
E[f (t, T )] = E[rt ] e −(T −t)b + 1 − e −(T −t)b − 2 1 − e −(T −t)b
b 2b
a σ2 2
= r0 e −bT + 1 − e −bT − 2 1 − e −(T −t)b .
b 2b
The instantaneous forward rate t 7−→ f (t, T ) can be represented as in the
following Figure 18.4, with a = 0.06, b = 0.1, σ = 0.1 and r0 = %1.
" 623
N. Privault
0.7
E[f(t,T)]
0.6 f(t,T)
0.5
0.4
f(t,T)
0.3
0.2
0.1
0
0 5 10 15 20 25 30 35 40 45 50
t
Fig. 18.4: Instantaneous forward rate process t 7−→ f (t, T ).
Yield curve data
We refer to Chapter III-12 of Charpentier (2014) on the R package “Yield-

Curve” Guirreri (2015) for the following R code and further details on yield
curve and interest rate modeling using R.
install.packages("YieldCurve");require(YieldCurve);data(FedYieldCurve)
first(FedYieldCurve,'3 month');last(FedYieldCurve,'3 month')
mat.Fed=c(0.25,0.5,1,2,3,5,7,10);n=50
plot(mat.Fed, FedYieldCurve[n,], type="o",xlab="Maturities structure in years",
ylab="Interest rates values", col = "blue", lwd=3)
title(main=paste("Federal Reserve yield curve observed at",time(FedYieldCurve[n], sep=" ")))
grid()
The next Figure 18.5 is plotted using this code∗ which is adapted from
https://www.quantmod.com/examples/chartSeries3d/chartSeries3d.alpha.R
∗
Click to open or download.
624 "
15%
14%
13%
12%
11%
10%
9%
8%
7%
6%
5%
Jan Jan 4%
1982 1984 Jan Jan 3%
1986 Jan
1988 Jan 2%
1990 Jan
1992 Jan 1%
1994 Jan
1996 Jan 0%
1998 Jan 10Y
7Y
2000 Jan 5Y
3Y
2002 Jan 2Y
2004 Jan 1Y
6M
2006 Jan 3M
2008 Jan
2010 Jan
2012
2012
Fig. 18.5: Federal Reserve yield curves from 1982 to 2012.
European Central Bank (ECB) data can be similarly obtained by the next R
code.
data(ECBYieldCurve);first(ECBYieldCurve,'3 month');last(ECBYieldCurve,'3 month')
mat.ECB<-c(3/12,0.5,1,2,3,4,5,6,7,8,9,10,11,12,13,14,15,16,17,18,19,20,21,22,23,
24,25,26,27,28, 29,30)
for (n in 200:400) {
plot(mat.ECB, ECBYieldCurve[n,], type="o",xlab="Maturity structure in years",
ylab="Interest rates
values",ylim=c(3.1,5.1),col="blue",lwd=2,cex.axis=1.5,cex.lab=1.5)
title(main=paste("European Central Bank yield curve observed at",time(ECBYieldCurve[n],
sep=" ")))
grid();Sys.sleep(0.5)}
The next Figure 18.6 represents the output of the above script.
European Central Bank yield curve observed at 2008−07−21
5.0
4.5
Interest rates values
4.0
3.5
0 5 10 15 20 25 30
Maturity structure in years
Fig. 18.6: European Central Bank yield curves.∗
∗
" 625
N. Privault
Yield curve inversion
Increasing yield curves are typical of economic expansion phases. Decreasing

yield curves can occur when central banks attempt to limit inflation by tight-
ening interest rates, such as in the case of an economic recession. In this case,
uncertainty triggers increased investment in long bonds whose rates tend to
drop as a consequence, while reluctance to lend in the short term can lead to
higher short rates.
August 09, 2019

3.2
3.0
2.8
2.6
2.4
2.2
2.0
1.8
1.6
1.4
r
o
Yr
Yr
Yr
Yr
Yr
.Y
.Y
.Y
M
1.
2.
3.
5.
7.
10
20
30
1.
2.
3.
6.
Fig. 18.7: August 2019 Federal Reserve yield curve inversion.∗

The above Figure 18.7 illustrates a Federal Reserve (FED) yield curve inver-
sions occurring in February and August 2019.
LIBOR (London Interbank Offered) Rates
Recall that the forward rate f (t, T , S ), 0 6 t 6 T 6 S, is defined using

exponential compounding, from the relation

f (t, T , S ) = − . (18.10)
S−T
In order to compute swaption prices one prefers to use forward rates as de-
fined on the London InterBank Offered Rates (LIBOR) market instead of
the standard forward rates given by (18.10). Other types of LIBOR rates in-
clude EURIBOR (European Interbank Offered Rates), HIBOR (Hong Kong
Interbank Offered Rates), SHIBOR (Shanghai Interbank Offered Rates), SI-
BOR (Singapore Interbank Offered Rates), TIBOR (Tokyo Interbank Offered
Rates), etc. LIBOR rates are to be replaced by alternatives, including the
Secured Overnight Financing Rate (SOFR), by the end of year 2021. In the
sequel, the term LIBOR refers to the linear or simple compounding used in
∗
626 "
the next definition.
The forward LIBOR rate L(t, T , S ) for a loan on [T , S ] is defined using

linear compounding, i.e. by replacing (18.10) with the relation
P (t, T )
1 + (S − T )L(t, T , S ) = , 0 6 t 6 T,
P (t, S )
which yields the following definition.

Definition 18.5. The forward LIBOR rate L(t, T , S ) at time t for a loan
on [T , S ] is given by
1 P (t, T )

L(t, T , S ) = −1 , 0 6 t 6 T < S. (18.11)
S−T P (t, S )
Note that (18.11) above yields the same formula for the (LIBOR) instanta-
neous forward rate
L(t, T ) : = lim L(t, T , S )

S&T
P (t, T ) − P (t, S )
= lim
S&T (S − T )P (t, S )
P (t, T ) − P (t, T + ε)
= lim
ε&0 εP (t, T + ε)
1 P (t, T ) − P (t, T + ε)
= lim
P (t, T ) ε&0 ε
1 ∂P
= − (t, T )
P (t, T ) ∂T
∂
= − log P (t, T )
∂T
= f (t, T ),
as in (18.4).
In addition, Relation (18.11) shows that the LIBOR rate can be viewed
as a forward price X bt = Xt /Nt with numéraire Nt = (S − T )P (t, S ) and
Xt = P (t, T ) − P (t, S ), according to Relation (16.4) of Chapter 16. As a
consequence, from Proposition 16.4, the LIBOR rate (L(t, T , S ))t∈[T ,S ] is a
martingale under the forward measure P b defined by
dP 1 rS
e − 0 rt dt .
b
=
dP∗ P (0, S )
" 627
N. Privault
18.2 Interest Rate Swaps

The first interest rate swap occurred in 1981 between the World Bank, which
was interested in borrowing German Marks and Swiss Francs, and IBM, which
already had large amounts of those currencies but needed to borrow U.S. dol-
lars.
The vanilla interest rate swap makes it possible to exchange a sequence of

variable LIBOR rates L(T , Tk , Tk+1 ), k = 1, 2, . . . , n − 1, against a fixed rate
κ over a succession of time intervals [T1 , T2 ), [T2 , T3 ), . . . , [Tn−1 , Tn ] defining
a tenor structure, see Section 19.1 for details.
Making the agreement fair results into an exchange of cashflows
(T − Tk )L(T , Tk , Tk+1 ) − (Tk+1 − Tk )κ,

| k +1 {z } | {z }
floating leg fixed leg
at the dates T2 , T3 , . . . Tn between the two parties, generating a cumulative

discounted cash flow
n−1
X r Tk+1
e− T
rs ds
(Tk+1 − Tk )(L(T , Tk , Tk+1 ) − κ),
k =1
at time T = T0 , in which we used simple (or linear) interest rate compound-

ing. This corresponds to a payer swap in which the swap holder receives the
floating leg and pays the fixed leg κ, whereas the holder of a seller swap re-
ceives the fixed leg κ and pays the floating leg.
The above cash flow is used to make the contract fair, and it can be priced
at time T as
"n−1 #
X r Tk+1
E∗ (Tk+1 − Tk ) e − T rs ds
(L(T , Tk , Tk+1 ) − κ) FT

k =1
n−1 rT
k +1
X
= (Tk+1 − Tk )(L(T , Tk , Tk+1 ) − κ)E∗ e − T rs ds
FT
k =1
n−1
X
(Tk+1 − Tk )P (T , Tk+1 ) L(T , Tk , Tk+1 ) − κ . (18.12)

=
k =1
The swap rate S (T , T1 , Tn ) is by definition the value of the rate κ that makes
the contract fair by making the above cash flow C (T ) vanish.
Definition 18.6. The LIBOR swap rate S (T , T1 , Tn ) is the value of the
break-even rate κ that makes the contract fair by making the cash flow (18.12)
628 "
vanish, i.e.
n−1
X
(Tk+1 − Tk )P (T , Tk+1 ) L(T , Tk , Tk+1 ) − κ = 0. (18.13)

k =1
The next Proposition 18.7 makes use of the annuity numéraire

"n−1 #
X r Tk+1
P (T , T1 , Tn ) := E∗ (Tk+1 − Tk ) e − T rs ds
FT (18.14)
k =1
n−1 rT
X k +1
(Tk+1 − Tk )E∗ e − T rs ds

= FT

k =1
n−1
X
= (Tk+1 − Tk )P (T , Tk+1 ), 0 6 T 6 T2 ,
k =1
which represents the present value at time T of future $1 receipts at times

T1 , T2 , . . . , Tn , weighted by the lengths Tk+1 − Tk of the time intervals
(Tk , Tk+1 ], k = 1, 2, . . . , n − 1.
The time intervals (Tk+1 − Tk )k=1,2,...,n−1 in the definition (18.14) of the

annuity numéraire can be replaced by coupon payments (ck+1 )k=1,2,...,n−1
occurring at times (Tk+1 )k=1,2,...,n−1 , in which case the annuity numéraire
becomes
"n−1 #
X r Tk+1
P (T , T1 , Tn ) := E∗ ck+1 e − T rs ds

F T
k =1
n−1 rT
k +1
X
= ck + 1 E∗ e − T rs ds
FT
k =1
n−1
X
= ck+1 P (T , Tk+1 ), 0 6 T 6 T1 , (18.15)
k =1
which represents the value at time T of the future coupon payments dis-
counted according to the bond prices (P (T , Tk+1 ))k=1,2,...,n−1 . This expres-
sion can also be used to define amortizing swaps in which the value of the
notional decreases over time, or accreting swaps in which the value of the
notional increases over time.
LIBOR swap rates
The LIBOR swap rate S (t, T1 , Tn ) is defined by solving Relation (18.13) for
the forward rate S (t, Tk , Tk+1 ), i.e.
" 629
N. Privault
n−1
X
(Tk+1 − Tk )P (T , Tk+1 ) L(T , Tk , Tk+1 ) − S (T , T1 , Tn ) = 0. (18.16)

k =1
Proposition 18.7. The LIBOR swap rate S (T , T1 , Tn ) is given by
n−1
1 X
S (T , T1 , Tn ) = (Tk+1 − Tk )P (T , Tk+1 )L(T , Tk , Tk+1 ).
P (T , T1 , Tn )
k =1
(18.17)
Proof. By definition, S (T , T1 , Tn ) is the (fixed) break-even rate over [T1 , Tn ]

that will be agreed in exchange for the family of forward rates L(T , Tk , Tk+1 ),
k = 1, 2, . . . , n − 1, and it solves (18.16), i.e. we have
n−1
X
(Tk+1 − Tk )P (T , Tk+1 )L(T , Tk , Tk+1 ) − P (T , T1 , Tn )S (T , T1 , Tn )
k =1
n−1
X
= (Tk+1 − Tk )P (T , Tk+1 )L(T , Tk , Tk+1 )
k =1
n−1
X
−S (T , T1 , Tn ) (Tk+1 − Tk )P (T , Tk+1 )
k =1
n−1
X
= (Tk+1 − Tk )P (T , Tk+1 )L(T , Tk , Tk+1 ) − S (T , T1 , Tn )P (T , T1 , Tn )
k =1
= 0,
which shows (18.17) by solving the above equation for S (T , T1 , Tn ) .

The LIBOR swap rate S (t, T1 , Tn ) is defined by the same relation as
(18.13), with the forward rate L(t, Tk , Tk+1 ) replaced with the LIBOR rate
L(t, Tk , Tk+1 ). In this case, using the Definition 18.11 of LIBOR rates we
obtain the next corollary.
Corollary 18.8. The LIBOR swap rate S (t, T1 , Tn ) is given by
P (t, T1 ) − P (t, Tn )
S (t, T1 , Tn ) = , 0 6 t 6 T1 . (18.18)
P (t, T1 , Tn )
Proof. By (18.17), (18.11) and a telescoping summation argument we have

n−1
1 X
S (t, T1 , Tn ) = (Tk+1 − Tk )P (t, Tk+1 )L(t, Tk , Tk+1 )
P (t, T1 , Tn )
k =1
630 "
n−1
1 P (t, Tk )
X
= P (t, Tk+1 ) −1
P (t, T1 , Tn ) P (t, Tk+1 )
k =1
n−1
1 X
= (P (t, Tk ) − P (t, Tk+1 ))
P (t, T1 , Tn )
k =1
P (t, T1 ) − P (t, Tn )
= . (18.19)
P (t, T1 , Tn )

By (18.18), the bond prices P (t, T1 ) can be recovered from the values of the
forward swap rates S (t, T1 , Tn ).
Clearly, a simple expression for the swap rate such as that of Corollary 18.8
cannot be obtained using the standard (i.e. non-LIBOR) rates defined in
(18.10). Similarly, it will not be available for amortizing or accreting swaps
because the telescoping summation argument does not apply to the expression
(18.15) of the annuity numéraire.
When n = 2, the LIBOR swap rate S (t, T1 , T2 ) coincides with the LIBOR
rate L(t, T1 , T2 ), as from (18.15) we have
P (t, T1 ) − P (t, T2 )
S (t, T1 , T2 ) = (18.20)
P (t, T1 , T2 )
P (t, T1 ) − P (t, T2 )
=
(T2 − T1 )P (t, T2 )
= L(t, T1 , T2 ).
Similarly to the case of LIBOR rates, Relation (18.18) shows that the LIBOR
swap rate can be viewed as a forward price with (annuity) numéraire Nt =
P (t, T1 , Tn ) and Xt = P (t, T1 ) − P (t, Tn ). Consequently the LIBOR swap
rate (S (t, T1 , Tn )t∈[T ,S ] is a martingale under the forward measure P
b defined
from (16.1) by
dPb P (T1 , T1 , Tn ) − r T1 rt dt
= e 0 .
dP ∗ P (0, T1 , Tn )
18.3 The HJM Model

In this section we turn to the modeling of instantaneous forward rate curves.
From the beginning of this chapter we have started with the modeling of
the short rate (rt )t∈R+ , followed by its consequences on the pricing of bonds
P (t, T ) and on the expressions of the forward rates f (t, T , S ) and L(t, T , S ).
" 631
N. Privault
In this section we choose a different starting point and consider the prob-
lem of directly modeling the instantaneous forward rate f (t, T ). The graph
given in Figure 18.8 presents a possible random evolution of a forward interest
rate curve using the Musiela convention, i.e. we will write
g (x) = f (t, t + x) = f (t, T ), (18.21)
under the substitution x = T − t, x > 0, and represent a sample of the

instantaneous forward curve x 7−→ f (t, t + x) for each t > 0.
Forward rate
5
4.5
4
3.5
3 20
2.5
2 15
1.5
1 10
0.5 t
0
5 5
10
15 0
x 20
Fig. 18.8: Stochastic process of forward curves.
Definition 18.9. In the Heath-Jarrow-Morton (HJM) model, the instanta-

neous forward rate f (t, T ) is modeled under P∗ by a stochastic differential
equation of the form
dt f (t, T ) = α(t, T )dt + σ (t, T )dBt , 0 6 t 6 T, (18.22)
where t 7−→ α(t, T ) and t 7−→ σ (t, T ), 0 6 t 6 T , are allowed to be random

(adapted) processes.
In the above equation, the date T is fixed and the differential dt is with
respect to the time variable t.
Under basic Markovianity assumptions, a HJM model with deterministic

coefficients α(t, T ) and σ (t, T ) will yield a short rate process (rt )t∈R+ of the
form
drt = (a(t) − b(t)rt )dt + σ (t)dBt ,
see § 6.6 in Privault (2012), which is the Hull and White (1990) model, with
the explicit solution
rt wt rt wt rt
rt = rs e − s b(τ )dτ + e − u b(τ )dτ a(u)du + σ (u) e − u b(τ )dτ dBu ,
s s
0 6 s 6 t.
632 "
The HJM condition
How to “encode” absence of arbitrage in the defining HJM Equation (18.22)

is an important question. Recall that under absence of arbitrage, the bond
price P (t, T ) has been constructed as
w w
T T
P (t, T ) = E∗ exp − rs ds Ft = exp − f (t, s)ds , (18.23)

t t
cf. Proposition 18.3, hence the discounted bond price process is given by
w w wT
t t
t 7−→ exp − rs ds P (t, T ) = exp − rs ds − f (t, s)ds (18.24)
0 0 t
is a martingale under P∗ by Proposition 17.1 and Relation (18.5) in Propo-

sition 18.3. This shows that P∗ is a risk-neutral probability measure, and by
the first fundamental theorem of asset pricing Theorem 5.8 we conclude that
the market is without arbitrage opportunities.
Proposition 18.10. (HJM Condition Heath et al. (1992)). Under the con-
dition
wT
α(t, T ) = σ (t, T ) σ (t, s)ds, 0 6 t 6 T, (18.25)
t
which is known as the HJM absence of arbitrage condition, the discounted

bond price process (18.24) is a martingale, and the probability measure P∗ is
risk-neutral.
Proof. Using the process (Xt )t∈[0,T ] defined as
wT
Xt := f (t, s)ds = − log P (t, T ), 0 6 t 6 T,
t
such that P (t, T ) = e −Xt , we rewrite the spot forward rate, or yield
1 wT
f (t, t, T ) = f (t, s)ds,
T −t t
see (18.8), as
1 wT Xt
f (t, t, T ) = f (t, s)ds = , 0 6 t 6 T,
T −t t T −t
where the dynamics of t 7−→ f (t, s) is given by (18.22). We also use the
extended Leibniz integral rule
" 633
N. Privault
wT wT wT
dt f (t, s)ds = −f (t, t)dt + dt f (t, s)ds = −rt dt + dt f (t, s)ds,
t t t
see (18.6). This identity can be checked in the particular case where f (t, s) =
g (t)h(s) is a smooth function that satisfies the separation of variables prop-
erty, as
w wT
T
dt g (t)h(s)ds = dt g (t) h(s)ds
t t
wT wT
= h(s)dsdg (t) + g (t)dt h(s)ds
t t
w
T
= g 0 (t) h(s)ds dt − g (t)h(t)dt.
t
We have
wT
dt Xt = dt f (t, s)ds
t
wT
= −f (t, t)dt + dt f (t, s)ds
t
wT wT
= −f (t, t)dt + α(t, s)dsdt + σ (t, s)dsdBt
t t
w w
T T
= −rt dt + α(t, s)ds dt + σ (t, s)ds dBt ,
t t
hence w 2
T
|dt Xt |2 = σ (t, s)ds dt.
t
By Itô’s calculus, we find
dt P (t, T ) = dt e −Xt
1 −Xt
= − e −Xt dt Xt + e (dt Xt )2
2
w 2
1 T
= − e −Xt dt Xt + e −Xt σ (t, s)ds dt
2 t
wT wT
−Xt
= −e −rt dt + α(t, s)dsdt + σ (t, s)dsdBt
t t
w 2
1 T
+ e −Xt σ (t, s)ds dt,
2 t
and the discounted bond price satisfies

w
t
dt exp − rs ds P (t, T )
0
634 "
w w
t t
= −rt exp − rs ds − Xt dt + exp − rs ds dt P (t, T )
0 0
w w
t t
= −rt exp − rs ds − Xt dt − exp − rs ds − Xt dt Xt
0 0
w w 2
1 t T
+ exp − rs ds − Xt σ (t, s)ds dt
2 0 t
w
t
= −rt exp − rs ds − Xt dt
0
w wT wT
t
− exp − rs ds − Xt −rt dt + α(t, s)dsdt + σ (t, s)dsdBt
0 t t
w w 2
1 t T
+ exp − rs ds − Xt σ (t, s)ds dt
2 0 t
w w
t T
= − exp − rs ds − Xt σ (t, s)dsdBt
0 t
w w
1 wT
2 !
t T
− exp − rs ds − Xt α(t, s)ds − σ (t, s)ds dt.
0 t 2 t
Thus, the discounted bond price process

w
t
t 7−→ exp − rs ds P (t, T )
0
will be a martingale provided that

wT 1
w
T
2
α(t, s)ds − σ (t, s)ds = 0, 0 6 t 6 T. (18.26)
t 2 t
Differentiating the above relation with respect to T yields

wT
α(t, T ) = σ (t, T ) σ (t, s)ds,
t
which is in fact equivalent to (18.26).
Forward Vasicek rates in the HJM model
The HJM coefficients in the Vasicek model are in fact deterministic, for ex-
ample, taking a = 0, by (18.9) we have
wT
dt f (t, T ) = σ 2 e −(T −t)b e (t−s)b dsdt + σ e −(T −t)b dBt ,
t
i.e.
" 635
N. Privault
wT 1 − e −(T −t)b
α(t, T ) = σ 2 e −(T −t)b e (t−s)b ds = σ 2 e −(T −t)b ,
t b
and σ (t, T ) = σ e −(T −t)b , and the HJM condition reads

wT wT
α(t, T ) = σ 2 e −(T −t)b e (t−s)b ds = σ (t, T ) σ (t, s)ds. (18.27)
t t
Random simulations of the Vasicek instantaneous forward rates are provided

in Figures 18.9 and 18.10 using the Musiela convention (18.21).
7
6
rate %
5
4
3
2 40
1 30
0
0 20
5 t
10 10
15
20
x 25
30 0
Fig. 18.9: Forward instantaneous curve (t, x) 7−→ f (t, t + x) in the Vasicek model.∗
5
rate (%)
0 5 10 15 20 25 30
x
Fig. 18.10: Forward instantaneous curve x 7−→ f (0, x) in the Vasicek model.†
For x = 0 the first “slice” of this surface is actually the short rate Vasicek
process rt = f (t, t) = f (t, t + 0) which is represented in Figure 18.11 using
another discretization.
†
636 "
6.5
5.5
5
rate (%)
4.5
3.5
3
0 1 2 3 4 5
t
Fig. 18.11: Short-term interest rate curve t 7−→ rt in the Vasicek model.
18.4 Yield Curve Modeling
Nelson-Siegel parametrization of instantaneous forward rates
In the Nelson and Siegel (1987) parametrization the instantaneous forward

rate curves are parametrized by 4 coefficients z1 , z2 , z3 , z4 , as
g (x) = z1 + (z2 + z3 x) e −xz4 , x > 0.
An example of a graph obtained by the Nelson-Siegel parametrization is given

in Figure 18.12, for z1 = 1, z2 = −10, z3 = 100, z4 = 10.
4
z1+(z2+xz3)exp(-xz4)
-2
%
-4
-6
-8
-10
0 0.2 0.4 0.6 0.8 1
x
Fig. 18.12: Graph of x 7−→ g (x) in the Nelson-Siegel model.
Svensson parametrization of instantaneous forward rates
The Svensson (1994) parametrization has the advantage to reproduce two

humps instead of one, the location and height of which can be chosen via 6
parameters z1 , z2 , z3 , z4 , z5 , z6 as
g (x) = z1 + (z2 + z3 x) e −xz4 + z5 x e −xz6 , x > 0.

" 637
N. Privault
A typical graph of a Svensson parametrization is given in Figure 18.13, for

z1 = 6.6, z2 = −5, z3 = −100, z4 = 10, z5 = −1/2, z6 = 1.
7
z1+(z2+z3x)exp(-xz4)+z5xexp(-z6x)
4
%
3
0
0 0.2 0.4 0.6 0.8 1
x
Fig. 18.13: Graph of x 7−→ g (x) in the Svensson model.
Figure 18.14 presents a fit of the market data of Figure 18.1 using a Svensson
curve.
5
4.5
% 3.5
2.5
Market data
Svensson curve
2
0 5 10 15 20 25 30
years
Fig. 18.14: Fitting of a Svensson curve to market data.
The attached IPython notebook that may be run here to fit a Svensson
curve to market data.
Vasicek parametrization
In the Vasicek model, the instantaneous forward rate process is given from
(18.9) and (18.21) as
σ2 a σ2 σ2

a
f (t, T ) = − 2 + rt − + 2 e −bx − 2 e −2bx , (18.28)
b 2b b b 2b
in the Musiela notation (x = T − t), and we have
638 "
σ2

∂f
(t, T ) = a − brt − (1 − e −(T −t)b ) e −(T −t)b .
∂T b
We check that the derivative ∂f /∂T vanishes when a − brt + a − σ 2 (1 −

e −bx )/b = 0, i.e.
b
e −bx = 1 + 2 (brt − a),
σ
which admits at most one solution, provided that a > brt . As a consequence,
the possible forward curves in the Vasicek model are limited to one change
of “regime” per curve, as illustrated in Figure 18.15 for various values of rt ,
and in Figure 18.16.
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
0 5 10 15 20
Time to maturity
Fig. 18.15: Graphs of forward rates with b = 0.16, a/b = 0.04, r0 = 2%, σ = 4.5%.
The next Figure 18.16 is also using the parameters b = 0.16, a/b = 0.04,
r0 = 2%, and σ = 4.5%.
0.08
0.06
0.04
0.02
0
0 20
2 15
4
x 6 10
5 t
8
10 0
Fig. 18.16: Forward instantaneous curve (t, x) 7−→ f (t, t + x) in the Vasicek model.
One may think of constructing an instantaneous forward rate process taking

values in the Svensson space, however this type of modeling is not consistent
with absence of arbitrage, and it can be proved that the HJM curves can-
not live in the Nelson-Siegel or Svensson spaces, see §3.5 of Björk (2004b).
" 639
N. Privault
In other words, it can be shown that the forward yield curves produced by
the Vasicek model are included neither in the Nelson-Siegel space, nor in the
Svensson space. In addition, the Vasicek yield curves do not appear to cor-
rectly model the market forward curves cf. also Figure 18.1 above.
Another way to deal with the curve fitting problem is to use deterministic
shifts for the fitting of one forward curve, such as the initial curve at t = 0,
cf. e.g. § 8.2 in Privault (2012).
Fitting the Nelson-Siegel and Svensson models to yield curve data
Recall that in the Nelson-Siegel parametrization the instantaneous forward

rate curves are parametrized by four coefficients z1 , z2 , z3 , z4 , as
f (t, t + x) = z1 + (z2 + z3 x) e −xz4 , x > 0. (18.29)
Taking x = T − t, the yield f (t, t, T ) is given as

1 wT
f (t, t, T ) = f (t, s)ds
T −t t
1 wx
= f (t, t + y )dy
x 0
z2 w x −yz4 z3 w x −yz4
= z1 + e dy + ye dy
x 0 x 0
1− e −xz 4 1− e −xz 4 + x e −xz4
= z1 + z2 + z3 .
xz4 xz4
The yield f (t, t, T ) can be reparametrized as
β2 −x/λ
f (t, t + x) = z1 + (z2 + z3 x) e −xz4 = β0 + β1 e −x/λ + xe , x > 0,
λ
cf. Charpentier (2014), with β0 = z1 , β1 = z2 , β2 = z3 /z4 , λ = 1/z4 .
require(YieldCurve);data(ECBYieldCurve)
mat.ECB<-c(3/12,0.5,1,2,3,4,5,6,7,8,9,10,11,12,13,14,15,16,17,18,19,20,21,22,23,
24,25,26,27,28,29,30)
first(ECBYieldCurve, '1 month');Nelson.Siegel(first(ECBYieldCurve, '1 month'), mat.ECB)
640 "
for (n in seq(from=70, to=290, by=10)) {

ECB.NS <- Nelson.Siegel(ECBYieldCurve[n,], mat.ECB)
ECB.S <- Svensson(ECBYieldCurve[n,], mat.ECB)
ECB.NS.yield.curve <- NSrates(ECB.NS, mat.ECB)
ECB.S.yield.curve <- Srates(ECB.S, mat.ECB,"Spot")
plot(mat.ECB, as.numeric(ECBYieldCurve[n,]), type="o", lty=1, col=1,ylab="Interest
rates", xlab="Maturity in years", ylim=c(3.2,4.8))
lines(mat.ECB, as.numeric(ECB.NS.yield.curve), type="l", lty=3,col=2,lwd=2)
lines(mat.ECB, as.numeric(ECB.S.yield.curve), type="l", lty=2,col=6,lwd=2)
title(main=paste("ECB yield curve observed at",time(ECBYieldCurve[n], sep=" "),"vs fitted
yield curve"))
legend('bottomright', legend=c("ECB data","Nelson-Siegel","Svensson"),col=c(1,2,6), lty=1,
bg='gray90')
grid();Sys.sleep(2.5)}
ECB yield curve observed at 2008−02−17 vs fitted

yield curve
● ●
● ●
● ●
●
●
●
●
●
●
●
4.5
●
●
●
●
●
●
●
Interest rates
●
4.0
●
●
● ●
●
3.5
●
●
ECB data
●
● Nelson−Siegel
Svensson
0 5 10 15 20 25 30
Maturity in years
Fig. 18.17: ECB data vs fitted yield curve.∗
18.5 Two-Factor Model

The correlation problem is another issue of concern when using the affine
models considered so far, see (17.8) and (17.28). Let us compare three bond
price simulations with maturity T1 = 10, T2 = 20, and T3 = 30 based on the
same Brownian path, as given in Figure 18.18. Clearly, the bond prices
F (rt , Ti ) = P (t, Ti ) = e A(t,Ti )rt C (t,Ti ) , 0 6 t 6 Ti , i = 1, 2,
with maturities T1 and T2 are linked by the relation
P (t, T2 ) = P (t, T1 ) exp A(t, T2 ) − A(t, T1 ) + rt (C (t, T2 ) − C (t, T1 )) ,

(18.30)
meaning that bond prices with different maturities could be deduced from
each other, which is unrealistic.
∗
" 641
N. Privault
0.9
0.8
0.7
0.6
0.5
0.4
P(t,T1)
P(t,T2)
P(t,T3)
0.3
0 5 10 15 20 25 30
t
Fig. 18.18: Graph of t 7−→ P (t, T1 ), P (t, T2 ), P (t, T3 ).
In affine short rate models, by (18.30), log P (t, T1 ) and log P (t, T2 ) are linked
by the affine relationship
log P (t, T2 ) = log P (t, T1 ) + A(t, T2 ) − A(t, T1 ) + rt (C (t, T2 ) − C (t, T1 ))

log P (t, T1 ) − A(t, T1 )
= log P (t, T1 ) + A(t, T2 ) − A(t, T1 ) + (C (t, T2 ) − C (t, T1 ))
C (t, T1 )
C (t, T2 ) − C (t, T1 ) C (t, T2 )

= 1+ log P (t, T1 ) + A(t, T2 ) − A(t, T1 )
A(t, T1 ) C (t, T1 )
with constant coefficients, which yields the perfect correlation or anticorrela-

tion
Cor(log P (t, T1 ), log P (t, T2 )) = ±1,
depending on the sign of the coefficient 1 + (C (t, T2 ) − C (t, T1 ))/A(t, T1 ),
cf. § 8.3 in Privault (2012),
A solution to the correlation problem is to consider a two-factor model

based on two control processes (Xt )t∈R+ , (Yt )t∈R+ which are solution of

(1)
 dXt = µ1 (t, Xt )dt + σ1 (t, Xt )dBt ,

(18.31)
(2)
dYt = µ2 (t, Yt )dt + σ2 (t, Yt )dBt ,


(1) (2)
where Bt t∈R , Bt t∈R are correlated Brownian motion, with
+ +
(1) (2)
Cov Bs , Bt = ρ min(s, t), s, t > 0, (18.32)
and
(1) (2)
dBt • dBt = ρdt, (18.33)
for some correlation parameter ρ ∈ [−1, 1]. In practice, and B (1)

t∈R+
B (2) t∈R can be constructed from two independent Brownian motions

+
642 "
W (1) and W (2) , by letting

t∈R+ t∈R+

(1) (1)
 Bt = Wt ,

(2) (1) (2)

1 − ρ2 Wt , t > 0,
 p
Bt = ρWt +

and Relations (18.32) and (18.33) are easily satisfied from this construction.
In two-factor models one chooses to build the short-term interest rate rt via
rt := Xt + Yt , t > 0.
By the previous standard arbitrage arguments we define the price of a bond

with maturity T as
w
T
P (t, T ) : = E∗ exp − rs ds Ft

t
w
T
= E∗ exp − rs ds Xt , Yt

t
w
T
= E∗ exp − (Xs + Ys )ds Xt , Yt

t
= F (t, Xt , Yt ), (18.34)
since the couple (Xt , Yt )t∈R+ is Markovian. Applying the Itô formula with
two variables to
w
T
t 7−→ F (t, Xt , Yt ) = P (t, T ) = E∗ exp − rs ds Ft ,

t
and using the fact that the discounted process

rt w
T
t 7−→ e − 0 rs ds P (t, T ) = E∗ exp − rs ds Ft

0
is an Ft -martingale under P∗ , we can derive a PDE

∂F ∂F
−(x + y )F (t, x, y ) + µ1 (t, x) (t, x, y ) + µ2 (t, y ) (t, x, y )
∂x ∂y
1 2
∂ F 1 2
∂ F
+ σ12 (t, x) 2 (t, x, y ) + σ22 (t, y ) 2 (t, x, y )
2 ∂x 2 ∂y
∂2F ∂F
+ρσ1 (t, x)σ2 (t, y ) (t, x, y ) + (t, x, y ) = 0, (18.35)
∂x∂y ∂t
on R2 for the bond price P (t, T ). In the Vasicek model
" 643
N. Privault

(1)
 dXt = −aXt dt + σdBt ,

(2)
dYt = −bYt dt + ηdBt ,


this yields the solution F (t, x, y ) of (18.35) as
P (t, T ) = F (t, Xt , Yt ) = F1 (t, Xt )F2 (t, Yt ) exp (ρU (t, T )) , (18.36)
where F1 (t, Xt ) and F2 (t, Yt ) are the bond prices associated to Xt and Yt in
the Vasicek model, and
!
ση e −(T −t)a − 1 e −(T −t)b − 1 e −(a+b)(T −t) − 1
U (t, T ) := T −t+ + −
ab a b a+b
(1) (2)
is a correlation term which vanishes when Bt t∈R and Bt t∈R are
+ +
independent, i.e. when ρ = 0, cf. Ch. 4, Appendix A in Brigo and Mercurio
(2006), § 8.4 of Privault (2012).
Partial differentiation of log P (t, T ) with respect to T leads to the instanta-

neous forward rate
ση
1 − e −(T −t)a 1 − e −(T −t)b , (18.37)

f (t, T ) = f1 (t, T ) + f2 (t, T ) − ρ
ab
where f1 (t, T ), f2 (t, T ) are the instantaneous forward rates corresponding to
Xt and Yt respectively, cf. § 8.4 of Privault (2012).
An example of a forward rate curve obtained in this way is given in Fig-

ure 18.19.
2.4
2.3
2.2
2.1
%
1.9
1.8
0 5 10 15 20 25 30 35 40
T
Fig. 18.19: Graph of forward rates in a two-factor model.
Next, in Figure 18.20 we present a graph of the evolution of forward curves

in a two-factor model.
644 "
0.24
0.235
0.23
0.225
0.22
0.215
1.4
1.2
1
0.8 8
7
t 0.6 6
5
0.4 4
0.2 3
2
1 x
0 0
Fig. 18.20: Random evolution of instantaneous forward rates in a two-factor model.
18.6 The BGM Model

The models (HJM, affine, etc.) considered in the previous chapter suffer from
various drawbacks such as nonpositivity of interest rates in Vasicek model,
and lack of closed-form solutions in more complex models. The Brace et al.
(1997) (BGM) model has the advantage of yielding positive interest rates,
and to permit to derive explicit formulas for the computation of prices for
interest rate derivatives such as interest rate caps and swaptions on the LI-
BOR market.
In the BGM model we consider two bond prices P (t, T1 ), P (t, T2 ) with ma-
turities T1 , T2 , and the forward measure
r T2
dP2 e − 0 rs ds
= ,
dP∗2 P (0, T2 )
with numéraire P (t, T2 ), cf. (16.10). The forward LIBOR rate L(t, T1 , T2 ) is
modeled as a driftless geometric Brownian motion under P2 , i.e.
dL(t, T1 , T2 )
= γ1 (t)dBt , (18.38)
L(t, T1 , T2 )
0 6 t 6 T1 , i = 1, 2, . . . , n − 1, for some deterministic volatility function of

time γ1 (t), with solution
w
1wu

u
L(u, T1 , T2 ) = L(t, T1 , T2 ) exp γ1 (s)dBs − |γ1 |2 (s)ds ,
t 2 t
i.e. for u = T1 ,
w
1 w T1

T1
L(T1 , T1 , T2 ) = L(t, T1 , T2 ) exp γ1 (s)dBs − |γ1 |2 (s)ds .
t 2 t
" 645
N. Privault
Since L(t, T1 , T2 ) is a geometric Brownian motion under P2 , standard caplets

can be priced at time t ∈ [0, T1 ] from the Black-Scholes formula.
In the next Table 18.1 we summarize some stochastic models used for interest
rates.
Model
Short rate rt Mean reverting SDEs
Instantaneous forward rate f (t, s) HJM model
Forward rate f (t, T , S ) BGM model
Table 18.1: Stochastic interest rate models.
The following Graph 18.21 summarizes the notions introduced in this chapter.
Bondh price 2
rT i Bond price
P (t, T ) = IE∗ e − t rs ds | Ft P (t, T ) = e −(T −t)f (t,t,T )
Swap rate
S(t, T1 , Tn ) = P (t,T 1 )−P (t,Tn )
P (t,T1 ,Tn )
Short rate1 rt
LIBOR rate3
L(t, T, S) = P(S−T
(t,T )−P (t,S)
)P (t,S)
Forward rate3
Bond price
rT f (t, T, S) = log P (t,TS−T
)−log P (t,S)
P (t, T ) = e − t f (t,s)ds
Instantaneous forward rate4

f (t, T ) = L(t, T ) = − ∂ log∂T
P (t,T )
Short rate Spot forward rate (yield)

rt = f (t, t) = f (t, t, t) rT
f (t, t, T ) = t f (t, s)ds/(T − t)
Instantaneous forward rate4

f (t, T ) = L(t, T ) = limS&T f (t, T, S)
= limS&T L(t, T, S)
1
Can be modeled by Vasiçek and other short rate models
2
Can be modeled from dP (t, T )/P (t, T ).
3
Can be modeled in the BGM model
4
Can be modeled in the HJM model
Fig. 18.21: Roadmap of stochastic interest rate modeling.
646 "
Exercises
Exercise
h r T 18.1 We i consider a bond with maturity T , priced P (t, T ) =
E∗ e − t rs ds Ft at time t ∈ [0, T ].

a) Using the forward measure P b with numéraire Nt = P (t, T ), apply the

∂P
change of numéraire formula (16.9) to compute the derivative (t, T ).
∂T
b) Using Relation (18.5), find an expression of the instantaneous forward
rate f (t, T ) using the short rate rT and the forward expectation E.
b
c) Show that the instantaneous forward rate (f (t, T ))t∈[0,T ] is a martingale
under the forward measure P. b
Exercise 18.2 Consider a tenor structure {T1 , T2 } and a bond with maturity
T2 and price given at time t ∈ [0, T2 ] by
w
T2
P (t, T2 ) = exp − f (t, s)ds , t ∈ [0, T2 ],
t
where the instantaneous yield curve f (t, s) is parametrized as
f (t, s) = r1 1[0,T1 ] (s) + r2 1[T1 ,T2 ] (s), t 6 s 6 T2 .
Find a formula to estimate the values of r1 and r2 from the data of P (0, T2 )
and P (T1 , T2 ).
Same question when f (t, s) is parametrized as
f (t, s) = r1 s1[0,T1 ] (s) + (r1 T1 + (s − T1 )r2 )1[T1 ,T2 ] (s), t 6 s 6 T2 .
Exercise 18.3 (Exercise 4.14 continued). Bridge model. Assume that the
price P (t, T ) of a zero-coupon bond is modeled as
T
P (t, T ) = e −µ(T −t)+Xt , t ∈ [0, T ],
where µ > 0.
a) Show that the terminal condition P (T , T ) = 1 is satisfied.
b) Compute the forward rate
1
f (t, T , S ) = − (log P (t, S ) − log P (t, T )).
S−T
c) Compute the instantaneous forward rate
" 647
N. Privault
1
f (t, T ) = − lim (log P (t, S ) − log P (t, T )).
S&T S−T
d) Show that the limit lim f (t, T ) does not exist in L2 (Ω).
T &t
e) Show that P (t, T ) satisfies the stochastic differential equation
dP (t, T ) σ2 log P (t, T )

= σdBt + dt − dt, t ∈ [0, T ].
P (t, T ) 2 T −t
f) Rewrite the equation of Question (e) as
dP (t, T )
= σdBt + rtT dt, t ∈ [0, T ],
P (t, T )
where (rtT )t∈[0,T ] is a process to be determined.

g) Show that we have the expression
h rT T i
P (t, T ) = E∗ e − t rs ds Ft , 0 6 t 6 T.

h) Compute the conditional Radon-Nikodym density
dPT P (t, T ) − r t rsT ds

E∗ Ft = e 0
dP ∗ P (0, T )
of the forward measure PT with respect to P∗ .

i) Show that the process
bt := Bt − σt,
B 0 6 t 6 T,
is a standard Brownian motion under PT .

j) Compute the dynamics of XtS and P (t, S ) under PT .
Hint: Show that
wt 1 S−T
−µ(S − T ) + σ (S − T ) dBs = log P (t, S ).
0 S−s S−t
k) Compute the bond option price
h rT T i
E∗ e − t rs ds (P (T , S ) − K )+ Ft = P (t, T )ET (P (T , S ) − K )+ Ft ,

0 6 t < T < S.
Hint: Given X a Gaussian random variable with mean m and variance v 2

given Ft , we have:
648 "
1

+ 2
E e X − κ | Ft = e m+v /2 Φ (m + v 2 − log κ)

v
1

−κΦ (m − log κ) .
v
Exercise 18.4 Consider a short rate process (rt )t∈R+ of the form rt =
h(t) + Xt , where h(t) is a deterministic function of time and (Xt )R+ is a
Vasicek process started at X0 = 0.
a) Compute the price P (0, T ) at time t = 0 of a bond with maturity T , using
h(t) and the function A(T ) defined in (17.34) for the pricing of Vasicek
bonds.
b) Show how the function h(t) can be estimated from the market data of the
initial instantaneous forward rate curve f (0, t).
Exercise 18.5
a) Given two LIBOR spot rates L(t, t, T ) and L(t, t, S ), compute the corre-
sponding LIBOR forward rate L(t, T , S ).
b) Assuming that L(t, t, T ) = 2%, L(t, t, S ) = 2.5% and t = 0, T = 1, S =
2T = 2, would you buy a LIBOR forward contract over [T , 2T ] with rate
L(0, T , 2T ) if L(T , T , 2T ) remained at L(T , T , 2T ) = L(0, 0, T ) = 2%?

a) Compute the forward rate f (t, T , S ) in the Ho-Lee model (17.48) with
constant deterministic volatility.
In the next questions we take a = 0.
b) Compute the instantaneous forward rate f (t, T ) in this model.
c) Derive the stochastic equation satisfied by the instantaneous forward rate
f (t, T ).
d) Check that the HJM absence of arbitrage condition is satisfied in this
equation.
Exercise 18.7 Consider the two-factor Vasicek model


(1)
 dXt = −bXt dt + σdBt ,

(2)
dYt = −bYt dt + σdBt ,


(1) (2)
where Bt t∈R+
, Bt t∈R+
are correlated Brownian motion such that
(1) (2)
dBt • dBt = ρdt, for ρ ∈ [−1, 1].
" 649
N. Privault
a) Write down the expressions of the short rates Xt and Yt .

Hint: They can be found in Section 17.1.
b) Compute the variances Var[Xt ], Var[Yt ], and the covariance Cov(Xt , Yt ).
Hint: The expressions of Var[Xt ] and Var[Yt ] can be found in Section 17.1.
c) Compute the covariance Cov(log P (t, T1 ), log P (t, T2 )) for the two-factor
bond prices
P (t, T1 ) = F1 (t, Xt , T1 )F2 (t, Yt , T1 ) e ρU (t,T1 )
and
P (t, T2 ) = F1 (t, Xt , T2 )F2 (t, Yt , T2 ) e ρU (t,T2 ) ,
where
log F1 (t, x, T ) = C1T + xAT1 and log F2 (t, x) = C2T + xAT2 .
Hint: We have Cov(X + Y , Z ) = Cov(X, Z ) + Cov(Y , Z ) and Cov(c, X ) =

0 when c is a constant.
Exercise 18.8 Stochastic string model (Santa-Clara and Sornette (2001)).

Consider an instantaneous forward rate f (t, x) solution of
dt f (t, x) = αx2 dt + σdt B (t, x), (18.39)
with a flat initial curve f (0, x) = r, where x represents the time to maturity,
and (B (t, x))(t,x)∈R2 is a standard Brownian sheet with covariance
+
E[B (s, x)B (t, y )] = (min(s, t))(min(x, y )), s, t, x, y > 0, (18.40)
and initial conditions B (t, 0) = B (0, x) = 0 for all t, x > 0.

a) Solve the equation (18.39) for f (t, x).
b) Compute the short-term interest rate rt = f (t, 0).
c) Compute the value at time t ∈ [0, T ] of the bond price
w
T −t
P (t, T ) = exp − f (t, x)dx
0
with maturity T .
w 2
T −t
d) Compute the variance E B (t, x)dx of the centered Gaussian
0
r T −t
random variable 0 B (t, x)dx.
e) Compute the expected value E∗ [P (t, T )].
f) Find the value of α such that the discounted bond price
650 "

α w T −t
e −rt P (t, T ) = exp −rT − t(T − t)3 − σ B (t, x)dx , t ∈ [0, T ].
3 0
satisfies E∗ [P (t, T )] = e −(T −t)r .

w
T
g) Compute the bond option price E∗ exp − rs ds (P (T , S ) − K )+
0
by the Black-Scholes formula, knowing that for any centered Gaussian
random variable X ' N (0, v 2 ) with variance v 2 we have
E[(x e m+X − K )+ ]
2 /2
= x e m+v Φ(v + (m + log(x/K ))/v ) − KΦ((m + log(x/K ))/v ).
" 651
Chapter 19
Pricing of Interest Rate Derivatives
Interest rate derivatives are option contracts whose payoffs can be based on
fixed-income securities such as bonds, or on cash flows exchanged in e.g.
interest rate swaps. In this chapter we consider the pricing and hedging of
interest rate and fixed income derivatives such as bond options, caplets, caps
and swaptions, using the change of numéraire technique and forward mea-
sures.
19.1 Forward Measures and Tenor Structure . . . . . . . . . . 653

19.2 Bond Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 657
19.3 Caplet Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 659
19.4 Forward Swap Measures . . . . . . . . . . . . . . . . . . . . . . . . 663
19.5 Swaption Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 665
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 674
19.1 Forward Measures and Tenor Structure
The maturity dates are arranged according to a discrete tenor structure
{0 = T0 < T1 < T2 < · · · < Tn }.
A sample of forward interest rate curve data is given in Table 19.1, which con-
tains the values of (T1 , T2 , . . . , T23 ) and of {f (t, t + Ti , t + Ti + δ )}i=1,2,...,23 ,
with t = 07/05/2003 and δ = six months.
Maturity 2D 1W 1M 2M 3M 1Y 2Y 3Y 4Y 5Y 6Y 7Y
Rate (%) 2.55 2.53 2.56 2.52 2.48 2.34 2.49 2.79 3.07 3.31 3.52 3.71
Maturity 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y 25Y 30Y
Rate (%) 3.88 4.02 4.14 4.23 4.33 4.40 4.47 4.54 4.74 4.83 4.86
Table 19.1: Forward rates arranged according to a tenor structure.
" 653
N. Privault
Recall that by definition of P (t, Ti ) and absence of arbitrage the discounted

bond price process
rt
t 7−→ e − 0
rs ds
P (t, Ti ), 0 6 t 6 Ti ,
is an Ft -martingale under the probability measure P∗ = P, hence it satisfies

the Assumption (A) on page 542 for i = 1, 2, . . . , n. As a consequence the
bond price process can be taken as a numéraire
(i)
Nt := P (t, Ti ), 0 6 t 6 Ti ,
in the definition
dP
bi 1 r Ti
= e − 0 rs ds (19.1)
dP∗ P (0, Ti )
of the forward measure Pb i . The following proposition will allow us to price
contingent claims using the forward measure P b i , it is a direct consequence of
Proposition 16.5, noting that here we have P (Ti , Ti ) = 1.
Proposition 19.1. For all sufficiently integrable random variables F we
have
r Ti
E∗ F e − t rs ds Ft = P (t, Ti )E
b i [F | Ft ], 0 6 t 6 Ti , i = 1, 2, . . . , n.

(19.2)
Recall that by Proposition 16.4, the deflated process
P (t, Tj )
t 7−→ , 0 6 t 6 min(Ti , Tj ),
P (t, Ti )
is an Ft -martingale under P
b i for all Ti , Tj > 0.
In the sequel we assume as in (17.26) that the dynamics of the bond price
P (t, Ti ) is given by
dP (t, Ti )
= rt dt + ζi (t)dWt , (19.3)
P (t, Ti )
for i = 1, 2, . . . , n, where (Wt )t∈R+ is a standard Brownian motion under
P∗ and (rt )t∈R+ and (ζi (t))t∈R+ are adapted processes with respect to the
filtration (Ft )t∈R+ generated by (Wt )t∈R+ , i.e.
w wt 1wt

t
P (t, Ti ) = P (0, Ti ) exp rs ds + ζi (s)dWs − |ζi (s)|2 ds ,
0 0 2 0
0 6 t 6 Ti , i = 1, 2, . . . , n.
654 "
Forward Brownian motions
Proposition 19.2. For all i = 1, 2, . . . , n, the process

wt
cti := Wt − ζi (s)ds,
W 0 6 t 6 Ti , (19.4)
0
is a standard Brownian motion under the forward measure P

b i.
Proof. The Girsanov Proposition 16.7 applied to the numéraire

(i)
Nt := P (t, Ti ), 0 6 t 6 Ti ,
as in (16.13), shows that
cti := dWt − 1 (i)

dW (i)
dNt • dWt
Nt
1
= dWt − dP (t, Ti ) • dWt
P (t, Ti )
1
= dWt − (P (t, Ti )rt dt + ζi (t)P (t, Ti )dWt ) • dWt
P (t, Ti )
= dWt − ζi (t)dt,

b i for all i =
1, 2, . . . , n.
We have
c i = dWt − ζi (t)dt,
dW t i = 1, 2, . . . , n, (19.5)
and
c j = dWt − ζj (t)dt = dW
dW cti + (ζi (t) − ζj (t))dt, i, j = 1, 2, . . . , n,
t
c j )t∈R has drift (ζi (t) − ζj (t))t∈R under P

which shows that (W b i.
t + +
Bond price dynamics under the forward measure
In order to apply Proposition 19.1 and to compute the price

r
Ti
E∗ e − t rs ds C Ft = P (t, Ti )E
b i [C | Ft ],

of a random claim payoff C, it can be useful to determine the dynamics of

the underlying variables rt , f (t, T , S ), and P (t, T ) via their stochastic differ-
ential equations written under the forward measure P b i.
" 655
N. Privault
As a consequence of Proposition 19.2 and (19.3), the dynamics of t 7−→

P (t, Tj ) under P
b i is given by
dP (t, Tj ) cti ,
= rt dt + ζi (t)ζj (t)dt + ζj (t)dW i, j = 1, 2, . . . , n, (19.6)
P (t, Tj )
where (W
c i )t∈R is a standard Brownian motion under P
t +
b i , and we have
P (t, Tj )
w wt 1wt

t
= P (0, Tj ) exp rs ds + |ζj (s)|2 ds
ζj (s)dWs − [under P∗ ]
0 0 2 0
w wt wt
csj + 1

t
= P (0, Tj ) exp rs ds + ζj (s)dW |ζj (s)|2 ds [under P bj]
0 0 2 0
w wt wt wt
c i + ζj (s)ζi (s)ds − 1

t
= P (0, Tj ) exp rs ds + ζj (s)dW s |ζ j ( s ) |2
ds [under Pb i]
0 0 0 2 0
w w w w
csi − 1 1 t

t t t
= P (0, Tj ) exp rs ds + ζj (s)dW |ζj (s) − ζi (s)|2 ds + |ζi (s)|2 ds ,
0 0 2 0 2 0
t ∈ [0, Tj ], i, j = 1, 2, . . . , n. Consequently, the forward price P (t, Tj )/P (t, Ti )

can be written as
P (t, Tj )
P (t, Ti )
w wt
P (0, Tj ) csj + 1

t
= exp (ζj (s) − ζi (s))dW |ζj (s) − ζi (s)|2 ds , [under P
bj]
P (0, Ti ) 0 2 0
w wt
P (0, Tj ) csi − 1

t
= exp (ζj (s) − ζi (s))dW |ζi (s) − ζj (s)|2 ds , [under Pb i]
P (0, Ti ) 0 2 0
(19.7)
t ∈ [0, min(Ti , Tj )], i, j = 1, 2, . . . , n, which also follows from Proposi-

tion 16.8.
Short rate dynamics under the forward measure
In case the short rate process (rt )t∈R+ is given as the (Markovian) solution
to the stochastic differential equation
drt = µ(t, rt )dt + σ (t, rt )dWt ,
by (19.5) its dynamics will be given under P

b i by
ci

drt = µ(t, rt )dt + σ (t, rt ) ζi (t)dt + dW t
cti .
= µ(t, rt )dt + σ (t, rt )ζi (t)dt + σ (t, rt )dW (19.8)
656 "
In the case of the Vašíček (1977) model, by (17.27) we have
drt = (a − brt )dt + σdWt ,
and
σ
1 − e −b(Ti −t) , 0 6 t 6 Ti ,

ζi ( t ) = −
b
hence from (19.8) we have
σ
cti = dWt − ζi (t)dt = dWt + 1 − e −b(Ti −t) dt,

dW
b
and
σ2
1 − e −b(Ti −t) dt + σdW
cti (19.9)

drt = (a − brt )dt −
b
and we obtain
dP (t, Ti ) σ2 2 σ
= rt dt + 2 1 − e −b(Ti −t) dt − 1 − e −b(Ti −t) dW
cti ,

P (t, Ti ) b b
from (17.27).
19.2 Bond Options

The next proposition can be obtained as an application of the Margrabe for-
(i)
mula (16.30) of Proposition 16.15 by taking Xt = P (t, Tj ), Nt = P (t, Ti ),
( i )
and Xbt = Xt /N = P (t, Tj )/P (t, Ti ). In the Vasicek model, this formula
t
has been first obtained in Jamshidian (1989).
We work with a standard Brownian motion (Wt )t∈R+ under P∗ , generating

the filtration (Ft )t∈R+ , and an (Ft )t∈R+ -adapted short rate process (rt )t∈R+ .
Proposition 19.3. Let 0 6 Ti 6 Tj and assume as in (17.26) that the
dynamics of the bond prices P (t, Ti ), P (t, Tj ) under P∗ are given by
dP (t, Ti ) dP (t, Tj )
= rt dt + ζi (t)dWt , = rt dt + ζj (t)dWt ,
P (t, Ti ) P (t, Tj )
where (ζi (t))t∈R+ and (ζj (t))t∈R+ are deterministic volatility functions. Then
the price of a bond call option on P (Ti , Tj ) with payoff
C := (P (Ti , Tj ) − κ)+
can be written as
" 657
N. Privault
r
Ti
E∗ e − t rs ds (P (Ti , Tj ) − κ)+ Ft (19.10)

v (t, Ti ) 1 P (t, Tj )

= P (t, Tj )Φ + log
2 v (t, Ti ) κP (t, Ti )
v (t, Ti ) 1 P (t, Tj )

−κP (t, Ti )Φ − + log ,
2 v (t, Ti ) κP (t, Ti )
w Ti
where v 2 (t, Ti ) := |ζi (s) − ζj (s)|2 ds and
t
1 wx 2
Φ (x) : = √ e −y /2 dy, x ∈ R,
2π −∞
is the Gaussian cumulative distribution function.
(i)
Proof. First, we note that using Nt := P (t, Ti ) as a numéraire the price
of a bond call option on P (Ti , Tj ) with payoff F = (P (Ti , Tj ) − κ)+ can be
written from Proposition 16.5 using the forward measure P b i , or directly by
(16.9), as
r
Ti
E∗ e − t rs ds (P (Ti , Tj ) − κ)+ Ft = P (t, Ti )E
b i (P (Ti , Tj ) − κ)+ Ft .

(19.11)
Next, by (19.7) or by solving (16.15) in Proposition 16.8 we can write
P (Ti , Tj ) as the geometric Brownian motion
P (Ti , Tj )
P (Ti , Tj ) =
P (Ti , Ti )
w w Ti
P (t, Tj ) csi − 1

Ti
= exp (ζj (s) − ζi (s))dW |ζi (s) − ζj (s)|2 ds ,
P (t, Ti ) t 2 t
under the forward measure P b i , and rewrite (19.11) as

r
Ti
E∗ e − t rs ds (P (Ti , Tj ) − κ)+ Ft

" + #
P (t, Tj ) r Ti (ζj (s)−ζi (s))dW r
b si − 21 tTi |ζi (s)−ζj (s)|2 ds
= P (t, Ti )Ei e

b t −κ Ft
P (t, Ti )
" #
r Ti r +

b i 1 Ti 2
=Ebi P (t, Tj ) e t (ζj (s)−ζi (s))dWs − 2 t |ζi (s)−ζj (s)| ds − κP (t, Ti ) Ft .

658 "
Since (ζi (s))s∈[0,Ti ] and (ζj (s))s∈[0,Tj ] in (19.3) are deterministic volatility
functions, P (Ti , Tj ) is a lognormal random variable given Ft under P b i and we
can use Lemma 7.8 to price the bond option by the zero-rate Black-Scholes
formula p
Bl P (t, Tj ), κP (t, Ti ), v (t, Ti )/ Ti − t, 0, Ti − t

with underlying asset price P (t, Tj ), strike level κP (t, Ti ), volatility param-
eter sr
Ti 2
v (t, Ti ) t |ζi (s) − ζj (s)| ds
√ = ,
Ti − t Ti − t
time to maturity Ti − t, and zero interest rate, which yields (19.10).
Note that from Corollary 16.17 the decomposition (19.10) gives the self-
financing portfolio in the assets P (t, Ti ) and P (t, Tj ) for the claim with payoff
(P (Ti , Tj ) − κ)+ .
In the Vasicek case the above bond option price could also be computed
rT
from the joint distribution of rT , t rs ds , which is Gaussian, or from the
dynamics (19.6)-(19.9) of P (t, T ) and rt under P
b i , cf. § 7.3 of Privault (2012),
and Kim (2002) for the CIR and other short rate models with correlated
Brownian motions.
19.3 Caplet Pricing

An interest rate caplet is an option contract that offers protection against
the fluctations of a variable (or floating) rate with respect to a fixed rate κ.
The payoff of a caplet on the yield (or spot forward rate) L(Ti , Ti , Ti+1 ) with
strike level κ can be written as
(L(Ti , Ti , Ti+1 ) − κ)+ ,
and priced at time t ∈ [0, Ti ] from Proposition 16.5 using the forward measure
P
b i+1 as
rT
i+1
E∗ e − t rs ds
(L(Ti , Ti , Ti+1 ) − κ)+ Ft (19.12)

b i+1 (L(Ti , Ti , Ti+1 ) − κ)+ | Ft ,

= P (t, Ti+1 )E

(i+1)
by taking Nt = P (t, Ti+1 ) as a numéraire.
Proposition 19.4. The LIBOR rate
1 P (t, Ti )

L(t, Ti , Ti+1 ) := −1 , 0 6 t 6 Ti < Ti+1 ,
Ti+1 − Ti P (t, Ti+1 )
" 659
N. Privault
is a martingale under the forward measure P

b i+1 defined in (19.1).
Proof. The LIBOR rate L(t, Ti , Ti+1 ) is a deflated process according to
the forward numéraire process (P (t, Ti+1 ))t∈[0,Ti+1 ] . Therefore, by Propo-
sition 16.4 it is a martingale under P
b i+1 .
The caplet on L(Ti , Ti , Ti+1 ) can be priced at time t ∈ [0, Ti ] as
rT
i+1
E∗ e − t rs ds
(L(Ti , Ti , Ti+1 ) − κ)+ Ft (19.13)

+
" #
r Ti+1 1

P (t, Ti )

= E∗ e − t rs ds
−1 −κ Ft ,
Ti+1 − Ti P (t, Ti+1 )
where the discount factor is counted from the settlement date Ti+1 . The
next pricing formula (19.15) allows us to price and hedge a caplet using a
portfolio based on the bonds P (t, Ti ) and P (t, Ti+1 ), cf. (19.19) below, when
L(t, Ti , Ti+1 ) is modeled in the BGM model of Section 18.6.
Proposition 19.5. (Black caplet formula). Assume that L(t, Ti , Ti+1 ) is
modeled in the BGM model as
dL(t, Ti , Ti+1 ) c i+1 ,
= γi ( t ) dW (19.14)
L(t, Ti , Ti+1 ) t
0 6 t 6 Ti , i = 1, 2, . . . , n − 1, where γi (t) is a deterministic volatility

function of time t ∈ [0, Ti ], i = 1, 2, . . . , n − 1. The caplet on L(Ti , Ti , Ti+1 )
with strike level κ is priced at time t ∈ [0, Ti ] as
rT
i+1
(Ti+1 − Ti )E∗ e − t rs ds
(L(Ti , Ti , Ti+1 ) − κ)+ Ft (19.15)

= (P (t, Ti ) − P (t, Ti+1 ))Φ(d+ (t, Ti )) − κ(Ti+1 − Ti )P (t, Ti+1 )Φ(d− (t, Ti )),
0 6 t 6 Ti , where
log(L(t, Ti , Ti+1 )/κ) + (Ti − t)σi2 (t, Ti )/2

d+ (t, Ti ) = √ , (19.16)
σi (t, Ti ) Ti − t
and
log(L(t, Ti , Ti+1 )/κ) − (Ti − t)σi2 (t, Ti )/2
d− (t, Ti ) = √ , (19.17)
σi (t, Ti ) Ti − t
and
1 w Ti
|σi (t, Ti )|2 = |γi |2 (s)ds. (19.18)
Ti − t t
660 "
Proof. Taking P (t, Ti+1 ) as a numéraire, the forward price
bt := P (t, Ti ) = 1 + (Ti+1 − Ti )L(Ti , Ti , Ti+1 )

X
P (t, Ti+1 )
and the forward LIBOR rate process (L(t, Ti , Ti+1 )t∈[0,Ti ] are martingales
under Pb i+1 by Proposition 19.4, i = 1, 2, . . . , n − 1. More precisely, by (19.14)
we have
w w Ti
csi+1 − 1

Ti
L(Ti , Ti , Ti+1 ) = L(t, Ti , Ti+1 ) exp γi (s)dW |γi (s)|2 ds ,
t 2 t
0 6 t 6 Ti , i.e. t 7−→ L(t, Ti , Ti+1 ) is a geometric Brownian motion with time-

dependent volatility γi (t) under P b i+1 . Hence by (19.12), since N (i+1) = 1,
Ti+1
we have
rT
i+1
E∗ e − t rs ds
(L(Ti , Ti , Ti+1 ) − κ)+ Ft

= P (t, Ti+1 )E b i+1 (L(Ti , Ti , Ti+1 ) − κ)+ Ft

= P (t, Ti+1 ) (L(t, Ti , Ti+1 )Φ(d+ (t, Ti )) − κΦ(d− (t, Ti )))

= P (t, Ti+1 )Bl(L(t, Ti , Ti+1 ), κ, σi (t, Ti ), 0, Ti − t),
t ∈ [0, Ti ], where
Bl(x, κ, σ, 0, τ ) = xΦ(d+ (t, Ti )) − κΦ(d− (t, Ti ))
is the zero-interest rate Black-Scholes function, with

1 w Ti
|σi (t, Ti )|2 = |γi |2 (s)ds.
Ti − t t
Therefore, we obtain
rT
i+1
(L(Ti , Ti , Ti+1 ) − κ)+ Ft

= P (t, Ti+1 )L(t, Ti , Ti+1 )Φ(d+ (t, Ti )) − κP (t, Ti+1 )Φ(d− (t, Ti ))
P (t, Ti )

= P (t, Ti+1 ) − 1 Φ(d+ (t, Ti )) − κ(Ti+1 − Ti )P (t, Ti+1 )Φ(d− (t, Ti )),
P (t, Ti+1 )

In addition, by Corollary 16.17 we obtain the self-financing portfolio strategy
(Φ(d+ (t, Ti )), −Φ(d+ (t, Ti )) − κ(Ti+1 − Ti )Φ(d− (t, Ti ))) (19.19)
" 661
N. Privault
in the bonds (P (t, Ti ), P (t, Ti+1 )) with maturities Ti and Ti+1 , cf. Corol-
lary 16.18 and Privault and Teng (2012).
The formula (19.15) can be applied to options on underlying futures or

forward contracts on commodities whose prices are modeled according to
(19.14), as in the next corollary.
Corollary 19.6. (Black (1976) formula). Let L(t, Ti , Ti+1 ) be modeled as in
(19.14) and let the bond price P (t, Ti+1 ) be given as P (t, Ti+1 ) = e −(Ti+1 −t)r .
Then, (19.15) becomes
e −(Ti+1 −t)r L(t, Ti , Ti+1 )Φ(d+ (t, Ti )) − κ e −(Ti+1 −t)r Φ(d− (t, Ti )),
0 6 t 6 Ti .
Floorlet pricing
The floorlet on L(Ti , Ti , Ti+1 ) with strike level κ is a contract with payoff (κ −
L(Ti , Ti , Ti+1 ))+ . Floorlets are analog to put options and can be similarly
priced by the call/put parity in the Black-Scholes formula.
Proposition 19.7. Assume that L(t, Ti , Ti+1 ) is modeled in the BGM model
as in (19.14). The floorlet on L(Ti , Ti , Ti+1 ) with strike level κ is priced at
time t ∈ [0, Ti ] as
rT
i+1
(κ − L(Ti , Ti , Ti+1 ))+ Ft (19.20)

= κ(Ti+1 − Ti )P (t, Ti+1 )Φ − d− (Ti − t) − (P (t, Ti ) − P (t, Ti+1 ))Φ − d+ (Ti − t) ,

0 6 t 6 Ti , where d+ (t, Ti ), d− (t, Ti ) and |σi (t, Ti )|2 are defined in (19.16)-
(19.18).
Proof. We have
rT
i+1
(κ − L(Ti , Ti , Ti+1 ))+ Ft

b i+1 (κ − L(Ti , Ti , Ti+1 ))+ | Ft

= (Ti+1 − Ti )P (t, Ti+1 )E

= (Ti+1 − Ti )P (t, Ti+1 ) κΦ − d− (Ti − t) − (Ti+1 − Ti )L(t, Ti , Ti+1 )Φ − d+ (Ti − t)

= (Ti+1 − Ti )P (t, Ti+1 )κΦ − d− (Ti − t) − (P (t, Ti ) − P (t, Ti+1 ))Φ − d+ (Ti − t) ,

0 6 t 6 Ti .
662 "
Cap pricing
More generally, one can consider interest rate caps that are relative to a given
tenor structure {T1 , T2 , . . . , Tn }, with discounted payoff
n−1 r Tk+1
(L(Tk , Tk , Tk+1 ) − κ)+ .
X
(Tk+1 − Tk ) e − t rs ds
k =1
Pricing formulas for interest rate caps are easily deduced from analog formulas
for caplets, since the payoff of a cap can be decomposed into a sum of caplet
payoffs. Thus, the cap price at time t ∈ [0, T1 ] is given by
"n−1 #
rT
− t k+1 rs ds +
X
∗
E (Tk+1 − Tk ) e (L(Tk , Tk , Tk+1 ) − κ) Ft

k =1
n−1 rT
k +1
(L(Tk , Tk , Tk+1 ) − κ)+ Ft
X
(Tk+1 − Tk )E∗ e − t rs ds

=
k =1
n−1
b k+1 (L(Tk , Tk , Tk+1 ) − κ)+ Ft .
X
(Tk+1 − Tk )P (t, Tk+1 )E

=
k =1
(19.21)
In the BGM model (19.14) the interest rate cap with payoff
n−1
(Tk+1 − Tk )(L(Tk , Tk , Tk+1 ) − κ)+
X
k =1
can be priced at time t ∈ [0, T1 ] by the Black formula

n−1
X
(Tk+1 − Tk )P (t, Tk+1 )Bl(L(t, Tk , Tk+1 ), κ, σk (t, Tk ), 0, Tk − t),
k =1
where
1 w Tk
|σk (t, Tk )|2 = |γk |2 (s)ds.
Tk − t t
19.4 Forward Swap Measures

In this section we introduce the forward swap (or annuity) measures, or an-
nuity measures, to be used for the pricing of swaptions, and we study their
properties. We start with the definition of the annuity numéraire
" 663
N. Privault
j−1
(i,j )
X
Nt := P (t, Ti , Tj ) = (Tk+1 − Tk )P (t, Tk+1 ), 0 6 t 6 Ti , (19.22)
k =i
with in particular, when j = i + 1,
P (t, Ti , Ti+1 ) = (Ti+1 − Ti )P (t, Ti+1 ), 0 6 t 6 Ti .
1 6 i < n. The annuity numéraire can be also used to price a bond lad-
der. It satisfies the following martingale
rt
property, which can be proved by
linearity and the fact that t 7−→ e − 0 rs ds P (t, Tk ) is a martingale for all
k = 1, 2, . . . , n, under Assumption (A).
Remark 19.8. The discounted annuity numéraire
rt rt j−1
X
t 7→ e − 0
rs ds
P (t, Ti , Tj ) = e − 0
rs ds
(Tk+1 − Tk )P (t, Tk+1 ), 0 6 t 6 Ti ,
k =i
The forward swap measure P
b i,j is defined, according to Definition 16.1, by
r Ti r Ti (i,j )
dP
b i,j NT i P (Ti , Ti , Tj )
:= e − 0 rs ds (i,j = e − 0 rs ds , (19.23)
dP ∗
N
) P (0, Ti , Tj )
0
1 6 i < j 6 n.
Remark 19.9. We have
" # r
∗ dPi,j 1
b Ti
E Ft = E∗ e − 0 rs ds P (Ti , Ti , Tj ) Ft

dP∗ P (0, Ti , Tj )
j−1
" #
1 r Ti X
E∗ e − 0 rs ds (Tk+1 − Tk )P (Ti , Tk+1 ) Ft

=
P (0, Ti , Tj )
k =i
j−1 r
1 X Ti
= (Tk+1 − Tk )E∗ e − 0 rs ds P (Ti , Tk+1 ) Ft

P (0, Ti , Tj )
k =i
rt j−1
1 X
= e − 0 rs ds (Tk+1 − Tk )P (t, Tk+1 )
P (0, Ti , Tj )
k =i
rt P (t, Ti , Tj )
−
= e 0
rs ds
,
P (0, Ti , Tj )
0 6 t 6 Ti , by Remark 19.8, and
664 "
dP
b i,j|F r Ti P (Ti , Ti , Tj )
t
= e − t rs ds , 0 6 t 6 Ti+1 , (19.24)
dP∗|Ft P (t, Ti , Tj )
by Relation (16.3) in Lemma 16.2.

Proposition 19.10. The LIBOR swap rate
P (t, Ti ) − P (t, Tj )
S (t, Ti , Tj ) = = vii,j (t) − vji,j (t), 0 6 t 6 Ti ,
P (t, Ti , Tj )
see Corollary 18.8, is a martingale under the forward swap measure P

b i,j .
Proof. We use the fact that the deflated process
P (t, Tk )
t 7−→ vki,j (t) := , i, j, k = 1, 2, . . . , n,
P (t, Ti , Tj )
is an Ft -martingale under P
b i,j by Proposition 16.4.
The following pricing formula is then stated for a given integrable claim with
payoff of the form P (Ti , Ti , Tj )F , using the forward swap measure P b i,j :
dP
r " #
Ti b i,j|F
E∗ e − t rs ds P (Ti , Ti , Tj )F Ft = P (t, Ti , Tj )E∗ F
t
F t
dP∗
|Ft
= P (t, Ti , Tj )E
b i,j [F | Ft ], (19.25)
after applying (19.23) and (19.24) on the last line, or Proposition 16.5.
19.5 Swaption Pricing
A payer (or call) swaption gives the option, but not the obligation, to enter an
interest rate swap as payer of a fixed rate κ and as receiver of floating LIBOR
rates L(Ti , Tk , Tk+1 ) at time Tk+1 , k = i, . . . , j − 1, and has the payoff
j−1 r Tk+1 !+
X − rs ds
(Tk+1 − Tk )E∗ e Ti F
i T ( L ( Ti , Tk , Tk + 1 ) − κ )
k =i
j−1
!+
X
= (Tk+1 − Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) − κ) (19.26)
k =i
at time Ti . This swaption can be priced at time t ∈ [0, Ti ] under the risk-
neutral probability measure P∗ as
" 665
N. Privault

j−1
!+ 
r Ti X
∗ −
E e rs ds
(Tk+1 − Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) − κ) Ft  ,

t

k =i
(19.27)
t ∈ [0, Ti ]. When j = i + 1, the swaption price (19.27) coincides with the
price at time t of a caplet on [Ti , Ti+1 ] up to a factor δi := Ti+1 − Ti , since
r
Ti
E∗ e − t rs ds ((Ti+1 − Ti )P (Ti , Ti+1 )(L(Ti , Ti , Ti+1 ) − κ))+ Ft

r
Ti
= (Ti+1 − Ti )E∗ e − t rs ds P (Ti , Ti+1 ) (L(Ti , Ti , Ti+1 ) − κ)+ Ft

r r Ti + 1
Ti −

rs ds +
= (Ti+1 − Ti )E∗ e − t rs ds E∗ e Ti FTi (L(Ti , Ti , Ti+1 ) − κ) Ft
r rT
Ti − i+1 rs ds

= (Ti+1 − Ti )E∗ E∗ e − t rs ds e Ti (L(Ti , Ti , Ti+1 ) − κ)+ FTi Ft

rT
i+1
= (Ti+1 − Ti )E∗ e − t rs ds
(L(Ti , Ti , Ti+1 ) − κ)+ Ft , (19.28)

0 6 t 6 Ti , which coincides with the caplet price (19.12) up to the factor

Ti+1 − Ti . Unlike in the case of interest rate caps, the sum in (19.27) can not
be taken out of the positive part. Nevertheless, the price of the swaption can
be bounded as in the next proposition.
Proposition 19.11. The payer swaption price (19.27) can be upper bounded
by the interest rate cap price (19.21) as

j−1
!+ 
r Ti X
E∗  e − t rs ds (Tk+1 − Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) − κ)

Ft 

k =i
j−1 rT
k +1
(L(Ti , Tk , Tk+1 ) − κ)+ Ft ,
X
(Tk+1 − Tk )E∗ e − t rs ds

6
k =i
0 6 t 6 Ti .
Proof. Due to the inequality
(x1 + x2 + · · · + xm )+ 6 x1+ + x2+ + · · · + xm

+
, x1 , x2 , . . . , xm ∈ R,
we have

j−1
!+ 
r Ti X
∗ −
E e rs ds
(Tk+1 − Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) − κ)

t Ft 

k =i
666 "
j−1
" #
r Ti
(Tk+1 − Tk )P (Ti , Tk+1 ) (L(Ti , Tk , Tk+1 ) − κ)+ Ft
X
6 E∗ e − rs ds

t
k =i
j−1 r
Ti
(Tk+1 − Tk )E∗ e − t rs ds P (Ti , Tk+1 ) (L(Ti , Tk , Tk+1 ) − κ)+ Ft
X
=

k =i
j−1 r r Tk+1
Ti −

rs ds +
X
= (Tk+1 − Tk )E∗ e − t rs ds E∗ e Ti FTi (L(Ti , Tk , Tk+1 ) − κ) Ft
k =i
j−1 rT
k +1

(L(Ti , Tk , Tk+1 ) − κ)+ FTi
X
(Tk+1 − Tk )E∗ E∗ e − t rs ds

= Ft

k =i
j−1 rT
k +1
(L(Ti , Tk , Tk+1 ) − κ)+ Ft
X
= (Tk+1 − Tk )E∗ e − t rs ds
k =i
"j−1 #
r Tk + 1
(L(Ti , Tk , Tk+1 ) − κ)+ Ft ,
X
= E∗ (Tk+1 − Tk ) e − rs ds

t
k =i
0 6 t 6 Ti .
The payoff of the payer swaption can be rewritten as in the following lemma
which is a direct consequence of the definition of the swap rate S (Ti , Ti , Tj ),
see Proposition 18.7 and Corollary 18.8.
Lemma 19.12. The payer swaption payoff (19.26) at time Ti with swap rate
κ = S (t, Tj , Tj ) can be rewritten as
j−1
!+
X
k =i
= (P (Ti , Ti ) − P (Ti , Tj ) − κP (Ti , Ti , Tj ))+ (19.29)
= P (Ti , Ti , Tj ) (S (Ti , Ti , Tj ) − κ)+ . (19.30)
Proof. The relation
j−1
X
(Tk+1 − Tk )P (t, Tk+1 )(L(t, Tk , Tk+1 ) − S (t, Ti , Tj )) = 0
k =i
that defines the forward swap rate S (t, Ti , Tj ) shows that
j−1
X
(Tk+1 − Tk )P (t, Tk+1 )L(t, Tk , Tk+1 )
k =i
j−1
X
= S (t, Ti , Tj ) (Tk+1 − Tk )P (t, Tk+1 )
k =i
" 667
N. Privault
= P (t, Ti , Tj )S (t, Ti , Tj )
= P (t, Ti ) − P (t, Tj )
as in the proof of Corollary 18.8, hence by the definition (19.22) of P (t, Ti , Tj )

we have
j−1
X
(Tk+1 − Tk )P (t, Tk+1 )(L(t, Tk , Tk+1 ) − κ)
k =i
= P (t, Ti ) − P (t, Tj ) − κP (t, Ti , Tj )
= P (t, Ti , Tj ) (S (t, Ti , Tj ) − κ) ,
and for t = Ti we get
j−1
!+
X
k =i
= P (Ti , Ti , Tj ) (S (Ti , Ti , Tj ) − κ)+ .

The next proposition simply states that a payer swaption on the LIBOR rate
can be priced as a European call option on the swap rate S (Ti , Ti , Tj ) under
the forward swap measure Pb i,j .
Proposition 19.13. The price (19.27) of the payer swaption with payoff
j−1
!+
X
(Tk+1 − Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) − κ) (19.31)
k =i
on the LIBOR market can be written under the forward swap measure P b i,j
as the European call price
b i,j (S (Ti , Ti , Tj ) − κ)+ Ft , 0 6 t 6 Ti ,
P (t, Ti , Tj )E

on the swap rate S (Ti , Ti , Tj ).

Proof. As a consequence of (19.25) and Lemma 19.12, we find

j−1
!+ 
r Ti X
E∗  e − t rs ds (Tk+1 − Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) − κ)

Ft 

k =i
r Ti
=E ∗
e (P (Ti , Ti ) − P (Ti , Tj ) − κP (Ti , Ti , Tj ))+ Ft
− rs ds
(19.32)
t

r
Ti
= E∗ e − t rs ds P (Ti , Ti , Tj ) (S (Ti , Ti , Tj ) − κ)+ Ft

668 "
dP
" #
b i,j|F
= P (t, Ti , Tj )E∗ t
(S (Ti , Ti , Tj ) − κ)+ Ft

dP∗|Ft
b i,j S (Ti , Ti , Tj ) − κ + Ft .
= P (t, Ti , Tj )E (19.33)

In the next Proposition 19.14 we price the payer swaption with payoff (19.31)
or equivalently (19.30), by modeling the swap rate (S (t, Ti , Tj ))06t6Ti using
standard Brownian motion (W c i,j )06t6T under the swap forward measure
t i
Pi,j . See Exercise 19 for swaption pricing without the Black-Scholes formula.
b
Proposition 19.14. (Black swaption formula). Assume that the LIBOR

swap rate (18.18) is modeled as a geometric Brownian motion under Pbi,j ,
i.e.
dS (t, Ti , Tj ) = S (t, Ti , Tj )σ c i,j ,
bi,j (t)dW (19.34)
t

where σbi,j (t) t∈R is a deterministic volatility function of time. Then the
+
payer swaption with payoff
(P (T , Ti ) − P (T , Tj ) − κP (Ti , Ti , Tj ))+ = P (Ti , Ti , Tj ) (S (Ti , Ti , Tj ) − κ)+
can be priced using the Black-Scholes call formula as

r
Ti
E∗ e − t rs ds P (Ti , Ti , Tj ) (S (Ti , Ti , Tj ) − κ)+ Ft

= (P (t, Ti ) − P (t, Tj ))Φ(d+ (Ti − t))

j−1
X
−κΦ(d− (Ti − t)) (Tk+1 − Tk )P (t, Tk+1 ),
k =i
where
log(S (t, Ti , Tj )/κ) + σi,j2 (t, T )(T − t) /2
i i
d+ (Ti − t) = √ , (19.35)
σi,j (t, Ti ) Ti − t
and
log(S (t, Ti , Tj )/κ) − σi,j2 (t, T )(T − t) /2
i i
d− (Ti − t) = √ , (19.36)
σi,j (t, Ti ) Ti − t
and
1 w Ti
|σi,j (t, Ti )|2 = σi,j (s)|2 ds,
|b 0 6 t 6 T. (19.37)
Ti − t t
Proof. Since S (t, Ti , Tj ) is a geometric Brownian motion with volatility func-
tion (σ
b (t))t∈R+ under P b i,j , by (19.29)-(19.30) in Lemma 19.12 or (19.32)-
" 669
N. Privault
(19.33) we have
r
Ti
E∗ e − t rs ds P (Ti , Ti , Tj ) (S (Ti , Ti , Tj ) − κ)+ Ft

h rT i
= E∗ e − t rs ds (P (T , Ti ) − P (T , Tj ) − κP (Ti , Ti , Tj ))+ Ft

b i,j (S (Ti , Ti , Tj ) − κ)+ Ft

= P (t, Ti , Tj )E

= P (t, Ti , Tj )Bl(S (t, Ti , Tj ), κ, σi,j (t, Ti ), 0, Ti − t)

= P (t, Ti , Tj ) (S (t, Ti , Tj )Φ+ (t, S (t, Ti , Tj )) − κΦ− (t, S (t, Ti , Tj )))
= P (t, Ti ) − P (t, Tj ) Φ+ (t, S (t, Ti , Tj )) − κP (t, Ti , Tj )Φ− (t, S (t, Ti , Tj ))

= P (t, Ti ) − P (t, Tj ) Φ+ (t, S (t, Ti , Tj ))

j−1
X
−κΦ− (t, S (t, Ti , Tj )) (Tk+1 − Tk )P (t, Tk+1 ).
k =i

In addition, the hedging strategy
(Φ+ (t, S (t, Ti , Tj )), −κΦ− (t, S (t, Ti , Tj ))(Ti+1 − Ti ), . . .

. . . , −κΦ− (t, S (t, Ti , Tj ))(Tj−1 − Tj−2 ), −Φ+ (t, S (t, Ti , Tj )))
based on the assets (P (t, Ti ), . . . , P (t, Tj )) is self-financing by Corollary 16.18,

see also Privault and Teng (2012). Similarly to the above, a receiver (or put)
swaption gives the option, but not the obligation, to enter an interest rate
swap as receiver of a fixed rate κ and as payer of floating LIBOR rates
L(Ti , Tk , Tk+1 ) at times Ti+1 , . . . , Tj , and can be priced as in the next propo-
sition.
Proposition 19.15. Assume that the LIBOR swap rate (18.18) is modeled
as the geometric Brownian motion (19.34) under the forward swap measure
Pbi,j . Then the receiver swaption with payoff
+
κP (Ti , Ti , Tj ) − P (T , Ti ) − P (T , Tj ) = P (Ti , Ti , Tj ) (κ − S (Ti , Ti , Tj ))+
can be priced using the Black-Scholes put formula as

r
Ti
E∗ e − t rs ds P (Ti , Ti , Tj ) (κ − S (Ti , Ti , Tj ))+ Ft

j−1
X
= κΦ(−d− (Ti − t)) (Tk+1 − Tk )P (t, Tk+1 )
k =i
−(P (t, Ti ) − P (t, Tj ))Φ(−d+ (Ti − t)),
670 "
where d+ (Ti − t), and d− (Ti − t) and |σi,j (t, Ti )|2 are defined in (19.35)-
(19.37).
Swaption prices can also be computed by an approximation formula, from the
exact dynamics of the swap rate S (t, Ti , Tj ) under the forward swap measure
P
b i,j , based on the bond price dynamics of the form (19.3), cf. Schoenmakers
(2005), page 17.
Swaption volatilities can be estimated from swaption prices as implied

volatilities from the Black pricing formula:
0.2
0.18
0.16
0.14
0.12
9
8
0.1 7
6
5
0.08 4 i
0 3
1 2 2
3 4 5 6 1
7 8 0
j 9
Fig. 19.1: Implied swaption volatilities.
Implied swaption volatilities can then be used to calibrate the BGM model,
cf. Schoenmakers (2005), Privault and Wei (2009), § 11.4 of Privault (2012).
Bermudan swaption pricing in Quantlib
The Bermudan swaption on the tenor structure {Ti , . . . , Tj } is priced as the

supremum

j−1
!+ 
rT
∗  − t l rs ds
X
Sup E e δk P (Tl , Tk+1 )(L(Tl , Tk , Tk+1 ) − κ)

Ft 

l∈{i,...,j−1} k =l
r Tl
= Sup E∗ e − rs ds
(P (Tl , Tl ) − P (Tl , Tj ) − κP (Tl , Tl , Tj ))+ Ft
t

l∈{i,...,j−1}
r
Tl
= Sup E∗ e − t rs ds P (Tl , Tl , Tj )(S (Tl , Tl , Tj ) − κ)+ Ft ,

l∈{i,...,j−1}
where the supremum is over all stopping times taking values in {Ti , . . . , Tj }.
" 671
N. Privault
Bermudan swaptions can be priced using this Rcode∗ in (R)quantlib, with

the following output:
Summary of pricing results for Bermudan Swaption
Price (in bp) of Bermudan swaption is 24.92137

Strike is NULL (ATM strike is 0.05 )
Model used is: Hull-White using analytic formulas
Calibrated model parameters are:
a = 0.04641
sigma = 0.005869
This modified code† can be used in particular the pricing of ordinary swap-
tions, with the output:
Summary of pricing results for Bermudan Swaption
Price (in bp) of Bermudan swaption is 22.45436

Strike is NULL (ATM strike is 0.05 )
Model used is: Hull-White using analytic formulas
Calibrated model parameters are:
a = 0.07107
sigma = 0.006018
Table 19.2 summarizes some possible uses of change of numéraire in option
pricing.
∗
†
672 "
"
Application Asset price Numéraire process Option payoff b
Forward measure P Deflated process Option price Change of numéraire formula
b
dP i i
r ds
0 s
r ds
0 s
r ds
0 s

C
rt rt h rT rt h rT
Risk-neutral pricing St Nt = e =1 Set = e − St E∗ e − t rs ds C Ft e E∗ e − 0 rs ds C Ft
dP∗
b
dP N St i
rT

h rT
Exchange option St Nt (ST − κNT )+ = e − 0 rs ds T Xbt = E∗ e − t rs ds (ST − κNT )+ Ft b XbT − κ + Ft
Nt E
dP∗ N0 Nt
2 t/2
b
dP S +
Exotic St = S0 e rt+σWt −σ Nt = St ST (ST − K )+ = e −(T −t)r T Xbt = 1 E∗ e −(T −t)r ST ST − K Ft b [(ST − K )+ | Ft ]
St E
dP∗ S0
" + #
f f
b
dP f R f f κ
Foreign exchange e r t Rt Nt = e r t Rt ( RT − κ ) + = e (r −r)T T Xbt = 1 e r T E∗ e −(T −t)r (RT − κ) | Ft b
e r t Rt E 1− Rt

dP∗ R0 RT
P (t, S ) i
rT
bT
dP e − 0 rs ds
P (t, S ) =
h rT
Bond option Nt = P (t, T ) (P (T , S ) − K ) + Xbt = E∗ e − t rs ds (P (T , S ) − K )+ Ft P (t, T )E
b T [(P (T , S ) − K )+ | Ft ]
dP∗ P (0, T ) P (t, T )
i
P (t, T )
rS
bS
dP e − 0 rs ds 1
P (t, T ) =
h rS
Caplets and caps Nt = P (t, S ) (S − T )(L(T , T , S ) − κ)+ L(t, T , S ) = −1 (S − T )E∗ e − t rs ds (L(T , T , S ) − K )+ Ft (S − T )P (t, S )E
b S [(L(T , T , S ) − K )+ | Ft ]
dP∗ P (0, S ) S−T P (t, S )
b 1,n
dP P (T1 , T1 , Tn )
r T1 P (t, T1 ) − P (t, Tn ) ∗ − r T1 rs ds
Swaption P (t, T1 ), P (t, Tn ) Nt = P (t, T1 , Tn ) (P (T1 , T1 ) − P (T1 , Tn ) − κP (T1 , T1 , Tn ))+ = e − 0 rs ds S (t, T1 , Tn ) = E e t b 1,n (S (T1 , T1 , Tn ) − κ)+ Ft
(P (T1 , T1 ) − P (T1 , Tn ) − κP (T1 , T1 , Tn ))+ Ft P (t, T1 , Tn )E
dP∗ P (0, T1 , Tn ) P (t, T1 , Tn )
2 t/2 2 t/2−(n−1)rt
b
dP 2 2 2
Black-Scholes St = S0 e rt+σWt −σ Nt = Stn e −(n−1)nσ (STn − K n )+ = e nσWT −(nσ) T /2 Xbt = Stn−1 e (n−1)nσ t/2+(n−1)rt e −(T −t)r E∗ STn 1{ST >K} Ft − K n e −(T −t)r E∗ 1{ST >K} Ft e (n−1)nσ T /2+(n−1)rT Nt E T
b 1{S >K} Ft
dP∗
−K n e −(T −t)r E∗ 1{ST >K} Ft
Table 19.2: A list of numéraire processes and their applications.

673
N. Privault
Exercises
Exercise 19.1 Consider a floorlet on a three-month LIBOR rate in nine

month’s time, with a notional principal amount of $10, 000 per interest rate
percentage point. The term structure is flat at 3.95% per year with discrete
compounding, the volatility of the forward LIBOR rate in nine months is
10%, and the floor rate is 4.5%.
a) What are the key assumptions on the LIBOR rate in nine month in order
to apply Black’s formula to price this floorlet?
b) Compute the price of this floorlet using Black’s formula as an application
of Proposition 19.7 and (19.20), using the functions Φ(d+ ) and Φ(d− ).
Exercise 19.2 Consider a payer swaption giving its holder the right, but not
the obligation, to enter into a 3-year annual pay swap in four years, where a
fixed rate of 5% will be paid and the LIBOR rate will be received. Assume
that the yield curve is flat at 5% with continuous annual compounding and
the volatility of the swap rate is 20%. The notional principal is $100,000 per
interest rate percentage point.
a) What are the key assumptions in order to apply Black’s formula to value
this swaption?
b) Compute the price of this swaption using Black’s formula as an application
of Proposition 19.14.
Exercise 19.3 Consider a receiver swaption giving its holder the right, but not
the obligation, to enter into a 2-year annual pay swap in three years, where
a fixed rate of 5% will be received and the LIBOR rate will be paid. Assume
that the yield curve is flat at 2% with continuous annual compounding and
the volatility of the swap rate is 10%. The notional principal is $10,000 per
percentage point, and the swaption price is quoted in basis points. Write
down the expression of the price of this swaption using Black’s formula.
Exercise 19.4 Consider two bonds with maturities T1 and T2 , T1 < T2 , which
follow the stochastic differential equations
dP (t, T1 ) = rt P (t, T1 )dt + ζ1 (t)P (t, T1 )dWt
and
dP (t, T2 ) = rt P (t, T2 )dt + ζ2 (t)P (t, T2 )dWt .
a) Using Itô calculus, show that the forward process P (t, T2 )/P (t, T1 ) is
a driftless geometric Brownian motion driven by dW
ct := dWt − ζ1 (t)dt
under the T1 -forward measure P.
b
674 "
r
T1
b) Compute the price E∗ e − t rs ds (K − P (T1 , T2 ))+ Ft of a bond put

option at time t ∈ [0, T1 ] using change of numéraire and the Black-Scholes

formula.
Hint: Given X a Gaussian random variable with mean m and variance v 2

given Ft , we have:
1

+
E κ − eX | Ft = κΦ − (m − log κ) (19.38)

v
1

2
− e m+v /2 Φ − (m + v 2 − log κ) .
v
Exercise 19.5 Given two bonds with maturities T , S and prices P (t, T ),
P (t, S ), consider the LIBOR rate
P (t, T ) − P (t, S )
L(t, T , S ) :=
(S − T )P (t, S )
at time t ∈ [0, T ], modeled as
dL(t, T , S ) = µt L(t, T , S )dt + σL(t, T , S )dWt , 0 6 t 6 T, (19.39)
where (Wt )t∈[0,T ] is a standard Brownian motion under the risk-neutral prob-
ability measure P∗ , σ > 0 is a constant, and (µt )t∈[0,T ] is an adapted process.
Let h rS i
F (t) := E∗ e − t rs ds (κ − L(T , T , S ))+ Ft

denote the price at time t of a floorlet option with strike level κ, maturity T ,
and payment date S.
a) Rewrite the value of F (t) using the forward measure P b S with maturity S.
b) What is the dynamics of L(t, T , S ) under the forward measure P bS?
c) Write down the value of F (t) using the Black-Scholes formula.
Hint: Given X a centered Gaussian random variable with variance v 2 , we

have
2 /2
E∗ [(κ − e m+X )+ ] = κΦ(−(m − log κ)/v ) − e m+v Φ(−v − (m − log κ)/v ),
where Φ denotes the Gaussian cumulative distribution function.
Exercise 19.6 Jamshidian’s trick (Jamshidian (1989)). Consider a family

(P (t, Tk ))k=i,...,j of bond prices defined from a short rate process (rt )t∈R+ .
We assume that the bond prices are functions P (Ti , Tk+1 ) = Fk+1 (Ti , rTi )
of rTi that are increasing in the variable rTi , for all k = i, i + 1, . . . , j − 1.
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N. Privault
a) Compute the price P (t, Ti , Tj ) of the annuity numeraire paying coupons

ci+1 , . . . , cj at times Ti+1 , . . . , Tj in terms of the bond prices
P (t, Ti+1 ), . . . , P (t, Tj ).
b) Show that the payoff

+
P (Ti , Ti ) − P (Ti , Tj ) − κP (Ti , Ti , Tj )
of a European swaption can be rewrittten as
j−1
!+
X
1−κ c̃k+1 P (Ti , Tk+1 ) ,
k =i
by writing c̃k in terms of ck , k = i + 1, . . . , j.

c) Assuming that the bond prices are functions P (Ti , Tk+1 ) = Fk (Ti , rTi ) of
rTi that are increasing in the variable rTi , for all k = i, . . . , j − 1, show,
choosing γκ such that
j−1
X
κ ck+1 Fk+1 (Ti , γκ ) = 1,
k =i
that the European swaption with payoff
j−1
!+
+ X
P (Ti , Ti ) − P (Ti , Tj ) − κP (Ti , Ti , Tj ) = 1−κ ck+1 P (Ti , Tk+1 ) ,
k =i
where cj contains the final coupon payment, can be priced as a weighted

sum of bond put options under the forward measure P b i with numéraire
(i)
Nt := P (t, Ti ).
Exercise 19.7 Path freezing. Consider n bonds with prices (P (t, Ti ))i=1,...,n
and the bond option with payoff
n
!+
= P (T0 , T1 ) (XT0 − κ)+ ,
X
ci P (T0 , Ti ) − κP (T0 , T1 )
i=2
where Nt := P (t, T1 ) is taken as numeraire and

n n
1 X X
Xt := ci P (t, Ti ) = ci Pb (t, Ti ), 0 6 t 6 T1 .
P (t, T1 )
i=2 i=2
with Pb (t, Ti ) := P (t, Ti )/P (t, T1 ), i = 2, 3, . . . , n.

676 "
a) Assuming that the deflated bond price (Pb (t, Ti ))t∈[0,Ti ] has the (martin-
gale) dynamics dPb (t, Ti ) = σi (t)Pb (t, Ti )dW ct under the forward measure
P
b 1 , where (σi (t))t∈R is a deterministic function, write down the dynam-
+
ics of Xt as dXt = σt Xt dW ct , where σt is to be computed explicitly.
b) Approximating (Pb (t, Ti ))t∈[0,Ti ] by Pb (0, Ti ) and (P (t, T2 , Tn ))t∈[0,T2 ] by
P (0, T2 , Tn ), find a deterministic approximation σ b (t) of σt , and deduce an
expression of the option price
" n
!+ #
rT
− 0 1 rs ds b (XT − κ)+
X
∗
E e ci P (T0 , Ti ) − κP (T0 , T1 ) = P (0, T1 )E

0
i=2
using the Black-Scholes formula.

have:
2 +
E x e X−v /2 − κ = xΦ(v/2 + (log(x/κ))/v ) − κΦ(−v/2 + (log(x/κ))/v ).

Exercise 19.8 (Exercise 17.4 continued). We work in the short rate model
drt = σdBt ,
where (Bt )t∈R+ is a standard Brownian motion under P∗ , and P

b 2 is the
forward measure defined by
dP
b2 1 r T2
= e − 0 rs ds .
dP∗ P (0, T2 )
a) State the expressions of ζ1 (t) and ζ2 (t) in
dP (t, Ti )
= rt dt + ζi (t)dBt , i = 1, 2,
P (t, Ti )
and the dynamics of the P (t, T1 )/P (t, T2 ) under P b 2 , where P (t, T1 ) and
P (t, T2 ) are bond prices with maturities T1 and T2 .
Hint: Use Exercise 17.4 and the relation (17.26).
b) State the expression of the forward rate f (t, T1 , T2 ).
c) Compute the dynamics of f (t, T1 , T2 ) under the forward measure P b 2 with
dP
b2 1 r T2
= e − 0 rs ds .
dP∗ P (0, T2 )
d) Compute the price

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N. Privault
r
T2
(T2 − T1 )E∗ e − t rs ds (f (T1 , T1 , T2 ) − κ)+ Ft

of an interest rate cap at time t ∈ [0, T1 ], using the expectation under the
forward measure P b 2.
e) Compute the dynamics of the swap rate process
P (t, T1 ) − P (t, T2 )
S (t, T1 , T2 ) = , t ∈ [0, T1 ],
(T2 − T1 )P (t, T2 )
under P
b 2.
f) Using (19.28), compute the swaption price
r
T1
(T2 − T1 )E∗ e − t rs ds P (T1 , T2 )(S (T1 , T1 , T2 ) − κ)+ Ft

on the swap rate S (T1 , T1 , T2 ) using the expectation under the forward
swap measure Pb 1,2 .
Exercise 19.9 Consider three zero-coupon bonds P (t, T1 ), P (t, T2 ) and

P (t, T3 ) with maturities T1 = δ, T2 = 2δ and T3 = 3δ respectively, and
the forward LIBOR L(t, T1 , T2 ) and L(t, T2 , T3 ) defined by
1 P (t, Ti )

L(t, Ti , Ti+1 ) = −1 , i = 1, 2.
δ P (t, Ti+1 )
Assume that L(t, T1 , T2 ) and L(t, T2 , T3 ) are modeled in the BGM model by
dL(t, T1 , T2 ) c (2) ,
= e −at dW 0 6 t 6 T1 , (19.40)
L(t, T1 , T2 ) t
c (2) is
and L(t, T2 , T3 ) = b, 0 6 t 6 T2 , for some constants a, b > 0, where W t
a standard Brownian motion under the forward measure P2 defined by
b
r T2
dP
b2 e − 0 rs ds
= .
dP∗ P (0, T2 )
a) Compute L(t, T1 , T2 ), 0 6 t 6 T2 by solving Equation (19.40).

b) Show that the price at time t of the caplet with strike level κ can be
written as
r
T2
E∗ e − t rs ds (L(T1 , T1 , T2 ) − κ)+ Ft = P (t, T2 )E
b 2 (L(T1 , T1 , T2 ) − κ)+ | Ft ,

where E
b 2 denotes the expectation under the forward measure P
b 2.
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c) Using the hint below, compute the price at time t of the caplet with strike
level κ on L(T1 , T1 , T2 ).
d) Compute
P (t, T1 ) P (t, T3 )
, 0 6 t 6 T1 , and , 0 6 t 6 T2 ,
P (t, T1 , T3 ) P (t, T1 , T3 )
in terms of b and L(t, T1 , T2 ), where P (t, T1 , T3 ) is the annuity numéraire
P (t, T1 , T3 ) = δP (t, T2 ) + δP (t, T3 ), 0 6 t 6 T2 .
e) Compute the dynamics of the swap rate
P (t, T1 ) − P (t, T3 )
t 7−→ S (t, T1 , T3 ) = , 0 6 t 6 T1 ,
P (t, T1 , T3 )
i.e. show that we have

c (2) ,
dS (t, T1 , T3 ) = σ1,3 (t)S (t, T1 , T3 )dW t
where σ1,3 (t) is a stochastic process to be determined.

f) Using the Black-Scholes formula, compute an approximation of the swap-
tion price
r
T1
E∗ e − t rs ds P (T1 , T1 , T3 )(S (T1 , T1 , T3 ) − κ)+ Ft

b 2 (S (T1 , T1 , T3 ) − κ)+ | Ft ,
= P (t, T1 , T3 )E

at time t ∈ [0, T1 ]. You will need to approximate σ1,3 (s), s > t, by “freez-
ing” all random terms at time t.

have
2
E∗ ( e m+X − κ)+ = e m+v /2 Φ(v + (m − log κ)/v ) − κΦ((m − log κ)/v ),

Exercise 19.10 Bond option hedging. Consider a portfolio allocation (ξtT , ξtS )t∈[0,T ]
made of two bonds with maturities T , S, and value
Vt = ξtT P (t, T ) + ξtS P (t, S ), 0 6 t 6 T,
at time t. We assume that the portfolio is self-financing, i.e.
dVt = ξtT dP (t, T ) + ξtS dP (t, S ), 0 6 t 6 T, (19.41)
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N. Privault
and that it hedges the claim payoff (P (T , S ) − κ)+ , so that

h rT i
Vt = E∗ e − t rs ds (P (T , S ) − κ)+ Ft
= P (t, T )ET (P (T , S ) − κ)+ Ft , 0 6 t 6 T.

a) Show that we have

h rT i
E∗ e − t rs ds (P (T , S ) − K )+ Ft

wt wt
= P (0, T )ET (P (T , S ) − K )+ + ξsT dP (s, T ) + ξsS dP (s, S ).

0 0
b) Show that underrt

the self-financing condition (19.41), the deflated portfolio
value Vet = e − 0 rs ds Vt satisfies
dVet = ξtT dPe (t, T ) + ξtS dPe (t, S ),
where rt
Pe (t, T ) := e − 0
rs ds
P (t, T ), t ∈ [0, T ],
and rt
Pe (t, S ) := e − 0
rs ds
P (t, S ), t ∈ [0, S ],
denote the discounted bond prices.
c) From now on we work in the framework of Proposition 19.3, and we let
the function C (x, v ) be defined by
C (Xt , v (t, T )) := ET (P (T , S ) − K )+ Ft ,

where Xt is the forward price Xt := P (t, S )/P (t, T ), t ∈ [0, T ], and

wT
v 2 (t, T ) := σsS − σsT 2 ds.

t
Show that
ET (P (T , S ) − K )+ Ft = ET (P (T , S ) − K )+

w t ∂C
+ (Xu , v (u, T ))dXu , t > 0.
0 ∂x
Hint: Use the martingale property and the Itô formula.

d) Show that the deflated portfolio value Vbt = Vt /P (t, T ) satisfies
∂C
dVbt = (Xt , v (t, T ))dXt
∂x
P (t, S ) ∂C
= (Xt , v (t, T ))(σtS − σtT )dB
btT .
P (t, T ) ∂x
680 "
e) Show that
∂C
dVt = P (t, S ) (Xt , v (t, T ))(σtS − σtT )dBt + Vbt dP (t, T ).
∂x
f) Show that
∂C
dVet = Pe (t, S ) (Xt , v (t, T ))(σtS − σtT )dBt + Vbt dPe (t, T ).
∂x
g) Compute the hedging strategy (ξtT , ξtS )t∈[0,T ] of the bond option.
h) Show that
log(x/K ) + τ v 2 /2

∂C
(x, v ) = Φ √ ,
∂x τv
and compute the hedging strategy (ξtT , ξtS )t∈[0,T ] in terms of the normal
cumulative distribution function Φ.
Exercise 19.11 Consider a LIBOR rate L(t, T , S ), t ∈ [0, T ], modeled

as dL(t, T , S ) = µt L(t, T , S )dt + σ (t)L(t, T , S )dWt , 0 6 t 6 T , where
(Wt )t∈[0,T ] is a standard Brownian motion under the risk-neutral probability
measure P∗ , (µt )t∈[0,T ] is an adapted process, and σ (t) > 0 is a deterministic
volatility function of time t.
a) What is the dynamics of L(t, T , S ) under the forward measure P b with
numéraire Nt := P (t, S )?
b) Rewrite the price
h rS i
E∗ e − t rs ds φ(L(T , T , S ))Ft (19.42)
at time t ∈ [0, T ] of an option with payoff function φ using the forward

measure P.
b
c) Write down the above option price (19.42) using an integral.
Exercise 19.12 Given n bonds with maturities T1 , T2 , . . . , Tn , consider the

annuity numéraire
j−1
X
P (t, Ti , Tj ) = (Tk+1 − Tk )P (t, Tk+1 )
k =i
and the swap rate
P (t, Ti ) − P (t, Tj )
S (t, Ti , Tj ) =
P (t, Ti , Tj )
at time t ∈ [0, Ti ], modeled as

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N. Privault
dS (t, Ti , Tj ) = µt S (t, Ti , Tj )dt + σS (t, Ti , Tj )dWt , 0 6 t 6 Ti , (19.43)
where (Wt )t∈[0,Ti ] is a standard Brownian motion under the risk-neutral prob-
ability measure P∗ , (µt )t∈[0,T ] is an adapted process and σ > 0 is a constant.
Let r
Ti
E∗ e − t rs ds P (Ti , Ti , Tj )φ(S (Ti , Ti , Tj )) Ft (19.44)

at time t ∈ [0, Ti ] of an option with payoff function φ.

a) Rewrite the option price (19.44) at time t ∈ [0, Ti ] using the forward swap
measure Pb i,j defined from the annuity numéraire P (t, Ti , Tj ).
b) What is the dynamics of S (t, Ti , Tj ) under the forward swap measure P b i,j ?
c) Write down the above option price (19.42) using a Gaussian integral.
d) Apply the above to the computation at time t ∈ [0, Ti ] of the put swaption
price r
Ti
E∗ e − t rs ds P (Ti , Ti , Tj )(κ − S (Ti , Ti , Tj ))+ Ft

with strike level κ, using the Black-Scholes formula.

have
2 /2
E[(κ − e m+X )+ ] = κΦ(−(m − log κ)/v ) − e m+v Φ(−v − (m − log κ)/v ),
Exercise 19.13 Consider a bond market with two bonds with maturities T1 ,
T2 , whose prices P (t, T1 ), P (t, T2 ) at time t are given by
dP (t, T1 ) dP (t, T2 )
= rt dt + ζ1 (t)dBt , = rt dt + ζ2 (t)dBt ,
P (t, T1 ) P (t, T2 )
where (rt )t∈R+ is a short-term interest rate process, (Bt )t∈R+ is a standard
Brownian motion generating a filtration (Ft )t∈R+ , and ζ1 (t), ζ2 (t) are volatil-
ity processes. The LIBOR rate L(t, T1 , T2 ) is defined by
P (t, T1 ) − P (t, T2 )
L(t, T1 , T2 ) = .
P (t, T2 )
Recall that a caplet on the LIBOR market can be priced at time t ∈ [0, T1 ]
as
r
T2
E e − t rs ds (L(T1 , T1 , T2 ) − κ)+ Ft (19.45)

b L(T1 , T1 , T2 ) − κ + Ft ,
= P (t, T2 )E

682 "
under the forward measure P

b defined by
dP r T1 P (T1 , T2 )
= e − 0 rs ds
b
,
dP∗ P (0, T2 )
under which wt
bt := Bt −
B ζ2 (s)ds, t ∈ R+ , (19.46)
0
is a standard Brownian motion.
In the sequel we let Lt = L(t, T1 , T2 ) for simplicity of notation.

a) Using Itô calculus, show that the LIBOR rate satisfies
bt ,
dLt = Lt σ (t)dB 0 6 t 6 T1 , (19.47)
where the LIBOR rate volatility is given by
P (t, T1 )(ζ1 (t) − ζ2 (t))

σ (t) = .
P (t, T1 ) − P (t, T2 )
b) Solve the equation (19.47) on the interval [t, T1 ], and compute LT1 from
the initial condition Lt .
c) Assuming that σ (t) in (19.47) is a deterministic volatility function of time
t, show that the price
b LT − κ + Ft
P (t, T2 )E

1
of the caplet can be written as P (t, T2 )C (Lt , v (t, T1 )), where v 2 (t, T1 ) =
w T1
|σ (s)|2 ds, and C (t, v (t, T1 )) is a function of Lt and v (t, T1 ).
t
(1) (2)
d) Consider a portfolio allocation (ξt , ξt )t∈[0,T1 ] made of bonds with ma-
turities T1 , T2 and value
(1) (2)
Vt = ξt P (t, T1 ) + ξt P (t, T2 ),
at time t ∈ [0, T1 ]. We assume that the portfolio is self-financing, i.e.

(1) (2)
dVt = ξt dP (t, T1 ) + ξt dP (t, T2 ), 0 6 t 6 T1 , (19.48)
and that it hedges the claim payoff (LT1 − κ)+ , so that

r
T1
Vt = E e − t rs ds (P (T1 , T2 )(LT1 − κ))+ Ft

b (LT − κ)+ Ft ,
= P (t, T2 )E

1
0 6 t 6 T1 . Show that we have

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N. Privault
r
T1 +
E e − t rs ds P (T1 , T2 )(LT1 − κ) Ft
wt wt
b LT − κ + + ξs(1) dP (s, T1 ) + ξs(2) dP (s, T1 ),
= P (0, T2 )E

1
0 0
0 6 t 6 T1 .
e) Show that under ther self-financing condition (19.48), the discounted port-
t
folio value Vet = e − 0 rs ds Vt satisfies
(1) (2)
dVet = ξt dPe (t, T1 ) + ξt dPe (t, T2 ),
rt rt
where Pe (t, T1 ) := e − 0 rs ds P (t, T1 ) and Pe (t, T2 ) := e − 0
rs ds
P (t, T2 )
denote the discounted bond prices.
f) Show that
w t ∂C
b LT − κ + Ft = E
E b LT − κ + + (Lu , v (u, T1 ))dLu ,

1 1
0 ∂x
and that the deflated portfolio value Vbt = Vt /P (t, T2 ) satisfies
∂C ∂C
dVbt = (Lt , v (t, T1 ))dLt = σ (t)Lt (Lt , v (t, T1 ))dB
bt .
∂x ∂x
Hint: use the martingale property and the Itô formula.
g) Show that
∂C
dVt = (P (t, T1 ) − P (t, T2 )) (Lt , v (t, T1 ))σ (t)dBt + Vbt dP (t, T2 ).
∂x
h) Show that
∂C
dVet = (Lt , v (t, T1 ))d(Pe (t, T1 ) − Pe (t, T2 ))
∂x
∂C
+ Vbt − Lt (Lt , v (t, T1 )) dPe (t, T2 ),
∂x
(1) (2)
and deduce the values of the hedging portfolio allocation (ξt , ξt )t∈R+ .
Exercise 19.14 Consider a bond market with tenor structure {Ti , . . . , Tj } and
j − i + 1 bonds with maturities Ti , . . . , Tj , whose prices P (t, Ti ), . . . P (t, Tj )
at time t are given by
dP (t, Tk )
= rt dt + ζk (t)dBt , k = i, . . . , j,
P (t, Tk )
684 "
where (rt )t∈R+ is a short-term interest rate process and (Bt )t∈R+ de-
notes a standard Brownian motion generating a filtration (Ft )t∈R+ , and
ζi (t), . . . , ζj (t) are volatility processes.
The swap rate S (t, Ti , Tj ) is defined by
P (t, Ti ) − P (t, Tj )
S (t, Ti , Tj ) = ,
P (t, Ti , Tj )
where
j−1
X
P (t, Ti , Tj ) = (Tk+1 − Tk )P (t, Tk+1 )
k =i
is the annuity numéraire. Recall that a swaption on the LIBOR market can
be priced at time t ∈ [0, Ti ] as

j−1
!+ 
rT
∗  − t i rs ds
X
E e (Tk+1 − Tk )P (Ti , Tk+1 )(S (Ti , Tk , Tk+1 ) − κ) Ft


k =i
= P (t, Ti , Tj )Ei,j (S (Ti , Ti , Tj ) − κ)+ Ft , (19.49)

under the forward swap measure P

b i,j defined by
dP
b i,j r Ti P (Ti , Ti , Tj )
= e − 0 rs ds , 1 6 i < j 6 n,
dP ∗ P (0, Ti , Tj )
under which
j−1
b i,j := Bt −
X P (t, Tk+1 )
B (Tk+1 − Tk ) ζk+1 (t)dt (19.50)
t
P (t, Ti , Tj )
k =i
is a standard Brownian motion. Recall that the swap rate can be modeled as
b i,j ,
dS (t, Ti , Tj ) = S (t, Ti , Tj )σi,j (t)dB 0 6 t 6 Ti , (19.51)
t
where the swap rate volatilities are given by

j−1
X P (t, Tl+1 )
σi,j (t) = (Tl+1 − Tl ) (ζi (t) − ζl+1 (t)) (19.52)
P (t, Ti , Tj )
l =i
P (t, Tj )
+ (ζi (t) − ζj (t))
P (t, Ti ) − P (t, Tj )
1 6 i, j 6 n, cf. e.g. Proposition 10.8 in Privault (2012). In the sequel we

denote St = S (t, Ti , Tj ) for simplicity of notation.
" 685
N. Privault
a) Solve the equation (19.51) on the interval [t, Ti ], and compute S (Ti , Ti , Tj )
from the initial condition S (t, Ti , Tj ).
b) Assuming that σi,j (t) is a deterministic volatility function of time t for
1 6 i, j 6 n, show that the price (19.33) of the swaption can be written
as
P (t, Ti , Tj )C (St , v (t, Ti )),
where w Ti
v 2 (t, Ti ) = |σi,j (s)|2 ds,
t
and C (x, v ) is a function to be specified using the Black-Scholes formula
Bl(x, K, σ, r, τ ), with the relation
E[(x e m+X − K )+ ] = Φ(v + (m + log(x/K ))/v ) − KΦ((m + log(x/K ))/v ),
where X is a centered Gaussian random variable with variance v 2 .

(i) (j )
c) Consider a portfolio allocation (ξt , . . . , ξt )t∈[0,Ti ] made of bonds with
maturities Ti , . . . , Tj and value
j
(k )
X
Vt = ξt P (t, Tk ),
k =i
at time t ∈ [0, Ti ]. We assume that the portfolio is self-financing, i.e.

j
(k )
X
dVt = ξt dP (t, Tk ), 0 6 t 6 Ti , (19.53)
k =i
and that it hedges the claim payoff (S (Ti , Ti , Tj ) − κ)+ , so that


j−1
!+ 
r Ti X
Vt = E∗  e − t rs ds (Tk+1 − Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) − κ) Ft


k =i
+
= P (t, Ti , Tj )Ei,j (S (Ti , Ti , Tj ) − κ) Ft ,

0 6 t 6 Ti . Show that

j−1
!+ 
rT
X
E e (Tk+1 − Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) − κ) Ft


k =i
j w
t (k )
= P (0, Ti , Tj )Ei,j (S (Ti , Ti , Tj ) − κ)+ +
X
ξs dP (s, Ti ),

0
k =i
0 6 t 6 Ti .
686 "
d) Show that under ther self-financing condition (19.53), the discounted port-
t
folio value Vet = e − 0 rs ds Vt satisfies
j
(k )
X
dVet = ξt dPe (t, Tk ),
k =i
rt
where Pe (t, Tk ) = e − 0 rs ds P (t, Tk ), k = i, i + 1 . . . , j, denote the dis-
counted bond prices.
e) Show that
Ei,j (S (Ti , Ti , Tj ) − κ)+ Ft

w t ∂C
= Ei,j (S (Ti , Ti , Tj ) − κ)+ + (Su , v (u, Ti ))dSu .

0 ∂x
Hint: use the martingale property and the Itô formula.

f) Show that the deflated portfolio value Vbt = Vt /P (t, Ti , Tj ) satisfies
∂C ∂C
dVbt = (St , v (t, Ti ))dSt = St (St , v (t, Ti ))σti,j dB
b i,j .
t
∂x ∂x
g) Show that
∂C
dVt = (P (t, Ti ) − P (t, Tj )) (St , v (t, Ti ))σti,j dBt + Vbt dP (t, Ti , Tj ).
∂x
h) Show that
j−1
∂C X
dVt = St ζi (t) (St , v (t, Ti )) (Tk+1 − Tk )P (t, Tk+1 )dBt
∂x
k =i
j−1
∂C X
+(Vbt − St (St , v (t, Ti ))) (Tk+1 − Tk )P (t, Tk+1 )ζk+1 (t)dBt
∂x
k =i
∂C
+ (St , v (t, Ti ))P (t, Tj )(ζi (t) − ζj (t))dBt .
∂x
i) Show that
∂C
dVet = (St , v (t, Ti ))d(Pe (t, Ti ) − Pe (t, Tj ))
∂x
∂C
+(Vbt − St (St , v (t, Ti )))dPe (t, Ti , Tj ).
∂x
j) Show that
log(x/K ) v (t, Ti )

∂C
(x, v (t, Ti )) = Φ + .
∂x v (t, Ti ) 2
" 687
N. Privault
k) Show that we have
log(St /K ) v (t, Ti )

dVet = Φ + d(Pe (t, Ti ) − Pe (t, Tj ))
v (t, Ti ) 2

−κΦ − dPe (t, Ti , Tj ).
v (t, Ti ) 2
l) Show that the hedging strategy is given by

(i)
ξt = Φ + ,
v (t, Ti ) 2
log(St /K ) v (t, Ti ) log(St /K ) v (t, Ti )

(j )
ξt = −Φ + − κ(Tj − Tj−1 )Φ − ,
v (t, Ti ) 2 v (t, Ti ) 2
and

(k )
ξt = −κ(Tk+1 − Tk )Φ − , i 6 k 6 j − 2.
v (t, Ti ) 2
688 "
Chapter 20
Stochastic Calculus for Jump Processes
Jump processes are stochastic processes whose trajectories have discontinu-

ities called jumps, that can occur at random times. This chapter presents
the construction of jump processes with independent increments, such as
the Poisson and compound Poisson processes, followed by an introduction to
stochastic integrals and stochastic calculus with jumps. We also present the
Girsanov Theorem for jump processes, which will be used for the construc-
tion of risk-neutral probability measures in Chapter 21 for option pricing and
hedging in markets with jumps, in relation with market incompleteness.
20.1 The Poisson Process . . . . . . . . . . . . . . . . . . . . . . . . . . . 689

20.2 Compound Poisson Process . . . . . . . . . . . . . . . . . . . . . 697
20.3 Stochastic Integrals and Itô Formula with Jumps . 703
20.4 Stochastic Differential Equations with Jumps . . . . 716
20.5 Girsanov Theorem for Jump Processes . . . . . . . . . . 721
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 729
20.1 The Poisson Process

The most elementary and useful jump process is
the standard Poisson process (Nt )t∈R+ which is a
counting process, i.e. (Nt )t∈R+ has jumps of size
+1 only, and its paths are constant in between two
jumps. In addition, the standard Poisson process
starts at N0 = 0.
The Poisson process can be used to model discrete arrival times such as claim
dates in insurance, or connection logs.
" 689
N. Privault
Nt
6
5
4
3
2
1
0
T1 T2 T3 T4 T5 T6 t
Fig. 20.1: Sample path of a Poisson process (Nt )t∈R+ .
In other words, the value Nt at time t is given by∗
1[Tk ,∞) (t),

X
Nt = t > 0, (20.1)
k >1
where
 1 if t > Tk ,

1[Tk ,∞) (t) =

0 if 0 6 t < Tk ,

k > 1, and (Tk )k>1 is the increasing family of jump times of (Nt )t∈R+ such
that
lim Tk = +∞.
k→∞
In addition, the Poisson process (Nt )t∈R+ is assumed to satisfy the following
conditions:
1. Independence of increments: for all 0 6 t0 < t1 < · · · < tn and n > 1 the
increments
Nt1 − Nt0 , . . . , Ntn − Ntn−1 ,
2. Stationarity of increments: Nt+h − Ns+h has the same distribution as

Nt − Ns for all h > 0 and 0 6 s 6 t.
The meaning of the above stationarity condition is that for all fixed k ∈ N
we have
P ( Nt + h − Ns + h = k ) = P ( Nt − Ns = k ) ,
for all h > 0, i.e., the value of the probability
P ( Nt + h − Ns + h = k )
does not depend on h > 0, for all fixed 0 6 s 6 t and k ∈ N.
∗
The notation Nt is not to be confused with the same notation used for numéraire
processes in Chapter 16.
690 "
Based on the above assumption, given T > 0 a time value, a natural question
arises:
what is the probability distribution of the random variable NT ?
We already know that Nt takes values in N and therefore it has a discrete

distribution for all t ∈ R+ .
It is a remarkable fact that the distribution of the increments of (Nt )t∈R+ ,

can be completely determined from the above conditions, as shown in the
following theorem.
As seen in the next result, cf. Theorem 4.1 in Bosq and Nguyen (1996),
the Poisson increment Nt − Ns has the Poisson distribution with parameter
(t − s)λ.
Theorem 20.1. Assume that the counting process (Nt )t∈R+ satisfies the
above independence and stationarity Conditions 1 and 2 on page 690. Then
for all fixed 0 6 s 6 t the increment Nt − Ns follows the Poisson distribution
with parameter (t − s)λ, i.e. we have
((t − s)λ)k
P(Nt − Ns = k ) = e −(t−s)λ , k > 0, (20.2)
k!
for some constant λ > 0.

The parameter λ > 0 is called the intensity of the Poisson process (Nt )t∈R+
and it is given by
1
λ := lim P(Nh = 1). (20.3)
h→0 h
The proof of the above Theorem 20.1 is technical and not included here, cf.
e.g. Bosq and Nguyen (1996) for details, and we could in fact take this dis-
tribution property (20.2) as one of the hypotheses that define the Poisson
process.
Precisely, we could restate the definition of the standard Poisson process

(Nt )t∈R+ with intensity λ > 0 as being a stochastic process defined by (20.1),
which is assumed to have independent increments distributed according to
the Poisson distribution, in the sense that for all 0 6 t0 6 t1 < · · · < tn ,
(Nt1 − Nt0 , . . . , Ntn − Ntn−1 )
is a vector of independent Poisson random variables with respective param-

eters
((t1 − t0 )λ, . . . , (tn − tn−1 )λ).
" 691
N. Privault
In particular, Nt has the Poisson distribution with parameter λt, i.e.,
(λt)k −λt
P(Nt = k ) = e , t > 0.
k!
The expected value E[Nt ] and variance of Nt can be computed as
E[Nt ] = Var[Nt ] = λt, (20.4)
see Exercise S.1. As a consequence, the dispersion index of the Poisson

process is
Var[Nt ]
= 1, t > 0. (20.5)
E [ Nt ]
Short time behaviour
From (20.3) above we deduce the short time asymptotics∗
 P(Nh = 0) = e −λh = 1 − λh + o(h), h → 0,


P(Nh = 1) = λh e −λh ' λh, h → 0.


By stationarity of the Poisson process we also find more generally that
P(Nt+h − Nt = 0) = e −λh = 1 − λh + o(h),



 h → 0,




P(Nt+h − Nt = 1) = λh e −λh ' λh, h → 0,

(20.6)


2

 P(Nt+h − Nt = 2) ' h2 λ = o(h),

h → 0, t > 0,


2
for all t > 0. This means that within a “short” interval [t, t + h] of length
h, the increment Nt+h − Nt behaves like a Bernoulli random variable with
parameter λh. This fact can be used for the random simulation of Poisson
process paths.
More generally, for k > 1 we have
λk
P(Nt+h − Nt = k ) ' hk , h → 0, t > 0.
k!
The intensity of the Poisson process can in fact be made time-dependent (e.g.
by a time change), in which case we have
∗
The notation f (h) = o(hk ) means limh→0 f (h)/hk = 0, and f (h) ' hk means
limh→0 f (h)/hk = 1.
692 "
r t λ(u)du k

w
t s
P(Nt − Ns = k ) = exp − λ(u)du , k = 0, 1, 2, . . . .
s k!
Assuming that λ(t) is a continuous function of time t we have in particular,

as h tends to zero,
P(Nt+h − Nt = k )
 r
t+h
 exp − t λ(u)du = 1 − λ(t)h + o(h), k = 0,





= exp − r t+h λ(u)du r t+h λ(u)du = λ(t)h + o(h),

 t t k = 1,




o(h), k > 2.


The next R code and Figure 20.2 present a simulation of the standard Pois-
son process (Nt )t∈R+ according to its short time behavior (20.6).
lambda = 0.6;T=10;N=1000*lambda;dt=T*1.0/N
t=0;s=c();for (k in 1:N) {if (runif(1)<lambda*dt) {s=c(s,t)};t=t+dt}
dev.new(width=T, height=5)
plot(stepfun(s,cumsum(c(0,rep(1,length(s))))),xlim
=c(0,T),xlab="t",ylab=expression('N'[t]),pch=1, cex=0.8, col='blue', lwd=2,
main="", las = 1, cex.axis=1.2, cex.lab=1.4)
6
Nt
0 2 4 6 8 10
t
Fig. 20.2: Sample path of the Poisson process (Nt )t∈R+ .
The intensity process (λ(t))t∈R+ can also be made random, as in the case of
Cox processes.
Poisson process jump times
In order to determine the distribution of the first jump time T1 we note that
we have the equivalence
" 693
N. Privault
{T1 > t} ⇐⇒ {Nt = 0},
which implies
P(T1 > t) = P(Nt = 0) = e −λt , t > 0,
i.e., T1 has an exponential distribution with parameter λ > 0.
In order to prove the next proposition we note that more generally, we

have the equivalence
{Tn > t} ⇐⇒ {Nt 6 n − 1},
for all n > 1. This allows us to compute the distribution of the random
jump time Tn with its probability density function. It coincides with the
gamma distribution with integer parameter n > 1, also known as the Erlang
distribution in queueing theory.
Proposition 20.2. For all n > 1 the probability distribution of Tn has the
gamma probability density function
tn−1
t 7−→ λn e −λt
(n − 1) !
on R+ , i.e., for all t > 0 the probability P(Tn > t) is given by

w∞ sn−1
P(Tn > t) = λn e −λs ds.
t (n − 1) !
Proof. We have
P(T1 > t) = P(Nt = 0) = e −λt , t > 0,

and by induction, assuming that
w∞ (λs)n−2
P(Tn−1 > t) = λ e −λs ds, n > 2,
t (n − 2) !
we obtain
P(Tn > t) = P(Tn > t > Tn−1 ) + P(Tn−1 > t)

= P(Nt = n − 1) + P(Tn−1 > t)
(λt)n−1 w∞ (λs)n−2
= e −λt +λ e −λs ds
(n − 1) ! t (n − 2) !
w∞ (λs) n−1
=λ e −λs ds, t > 0,
t (n − 1) !
694 "
where we applied an integration by parts to derive the last line.

In particular, for all n ∈ Z and t ∈ R+ , we have
(λt)n
P(Nt = n) = pn (t) = e −λt ,
n!
i.e., pn−1 : R+ → R+ , n > 1, is the probability density function of the ran-
dom jump time Tn .
In addition to Proposition 20.2 we could show the following proposition which

relies on the strong Markov property, see e.g. Theorem 6.5.4 of Norris (1998).
Proposition 20.3. The (random) interjump times
τk := Tk+1 − Tk
spent at state k ∈ N, with T0 = 0, form a sequence of independent iden-

tically distributed random variables having the exponential distribution with
parameter λ > 0, i.e.,
P(τ0 > t0 , . . . , τn > tn ) = e −(t0 +t1 +···+tn )λ , t0 , t1 , . . . , tn > 0.
As the expectation of the exponentially distributed random variable τk with

parameter λ > 0 is given by
w∞ 1
E[τk ] = λ x e −λx dx = ,
0 λ
we can check that the nth jump time Tn = τ0 + · · · + τn−1 has the mean
n
E[Tn ] = , n > 1.
λ
Consequently, the higher the intensity λ > 0 is (i.e., the higher the probabil-
ity of having a jump within a small interval), the smaller the time spent in
each state k ∈ N is on average.
In addition, conditionally to {NT = n}, the n jump times on [0, T ] of

the Poisson process (Nt )t∈R+ are independent uniformly distributed random
variables on [0, T ]n , cf. e.g. § 12.1 of Privault (2018). This fact can be useful
for the random simulation of the Poisson process.
As a consequence of Propositions 20.2 and 20.2, random samples of Pois-

son process jump times can be generated using the following R code.
" 695
N. Privault
lambda = 0.6;n = 200*lambda;T=10;Z<-cumsum(c(0,rep(1,n))); tau_n <-

rexp(n,rate=lambda); Tn <- cumsum(tau_n)
plot(stepfun(Tn,Z),xlim =c(0,T),ylim=c(0,8),xlab="t",ylab=expression('N'[t]),pch=1,
cex=1, col="blue", lwd=2, main="", las = 1, cex.axis=1.2, cex.lab=1.4)
6
Nt
0 2 4 6 8 10
Fig. 20.3: Sample path of the Poisson process (Nt )t∈R+ .
Compensated Poisson martingale
From (20.4) above we deduce that
E[Nt − λt] = 0, (20.7)
i.e., the compensated Poisson process (Nt − λt)t∈R+ has centered increments.
lambda = 0.6;n = 20;Z<-cumsum(c(0,rep(1,n)));

tau_n <- rexp(n,rate=lambda); Tn <- cumsum(tau_n)
N <- function(t) {return(stepfun(Tn,Z)(t))};t <- seq(0,10,0.01)
plot(t,N(t)-lambda*t,xlim = c(0,10),ylim =
c(-2,2),xlab="t",ylab=expression(paste('N'[t],'-t')),type="l",lwd=2,col="blue",main="",
xaxs = "i", yaxs = "i", xaxs = "i", yaxs = "i", las = 1, cex.axis=1.2, cex.lab=1.4)
abline(h = 0, col="black", lwd =2)
points(Tn,N(Tn)-lambda*Tn,pch=1,cex=0.8,col="blue",lwd=2)
696 "
1
Nt−t
−1
−2
0 2 4 6 8 10
Fig. 20.4: Sample path of the compensated Poisson process (Nt − λt)t∈R+ .
Since in addition (Nt − λt)t∈R+ also has independent increments, we get the
following proposition, see e.g. Example 2 page 256. We let
Ft := σ Ns : s ∈ [0, t]), t > 0,
denote the filtration generated by the Poisson process (Nt )t∈R+ .

Proposition 20.4. The compensated Poisson process
(Nt − λt)t∈R+
is a martingale with respect (Ft )t∈R+ .

Extensions of the Poisson process include Poisson processes with time-
dependent intensity, and with random time-dependent intensity (Cox pro-
cesses). Poisson processes belong to the family of renewal processes, which
are counting processes of the form
1[Tn ,∞) (t),

X
Nt = t > 0,
n>1
for which τk := Tk+1 − Tk , k > 0, is a sequence of independent identically

distributed random variables.
20.2 Compound Poisson Process
The Poisson process itself appears to be too limited to develop realistic price
models as its jumps are of constant size. Therefore there is some interest in
considering jump processes that can have random jump sizes.
Let (Zk )k>1 denote a sequence of independent, identically distributed

(i.i.d.) square-integrable random variables, distributed as a common ran-
" 697
N. Privault
dom variable Z with probability distribution ν (dy ) on R, independent of the

Poisson process (Nt )t∈R+ . We have
wb
P(Z ∈ [a, b]) = ν ([a, b]) = ν (dy ), −∞ < a 6 b < ∞, k > 1,
a
and when the distribution ν (dy ) admits a probability density ϕ(y ) on R, we

write ν (dy ) = ϕ(y )dy and
wb wb
P(Z ∈ [a, b]) = ν ([a, b]) = ν (dy ) = ϕ(y )dy, −∞ < a 6 b < ∞, k > 1.
a a
0.4
0.3
Probability density
0.2
0.1
0
−4 −3 −2 −1 a 0 1 b 2 3 4
Fig. 20.5: Probability density function ϕ.
Definition 20.5. The process (Yt )t∈R+ given by the random sum
Nt
X
Yt := Z1 + Z2 + · · · + ZNt = Zk , t > 0, (20.8)
k =1
is called a compound Poisson process.∗

Letting Yt− denote the left limit
Yt− := lim Ys , t > 0,

s%t
we note that the jump size
∆Yt := Yt − Yt− , t > 0,
of (Yt )t∈R+ at time t is given by the relation
∆Yt = ZNt ∆Nt , t > 0, (20.9)
where
n
X
∗
We use the convention Zk = 0 if n = 0, so that Y0 = 0.
k =1
698 "
∆Nt := Nt − Nt− ∈ {0, 1}, t > 0,

denotes the jump size of the standard Poisson process (Nt )t∈R+ , and Nt− is
the left limit
Nt− := lim Ns , t > 0,
s%t
Example. Assume that jump sizes are Gaussian distributed with mean δ
and variance η 2 , with
1 2 2
ν (dy ) = p e −(y−δ ) /(2η ) dy.
2πη 2
The next Figure 20.6 represents a sample path of a compound Poisson pro-
cess, with here Z1 = 0.9, Z2 = −0.7, Z3 = 1.4, Z4 = 0.6, Z5 = −2.5,
Z6 = 1.5, Z7 = −0.5, with the relation
YTk = YT − + Zk , k > 1.
k
Yt
3
0
t
T1 T2 T3 T4 T5 T6 T7
-1
Fig. 20.6: Sample path of a compound Poisson process (Yt )t∈R+ .
N<-50;Tk<-cumsum(rexp(N,rate=0.5))
Zk<-cumsum(c(0,rexp(N,rate=0.5)))
plot(stepfun(Tk,Zk),xlim = c(0,10),do.points = F,main="L=0.5",col="blue")
Zk<-cumsum(c(0,rnorm(N,mean=0,sd=1)))
plot(stepfun(Tk,Zk),xlim = c(0,10),do.points = F,main="L=0.5",col="blue")
Given that {NT = n}, the n jump sizes of (Yt )t∈R+ on [0, T ] are independent
random variables which are distributed on R according to ν (dx). Based on
this fact, the next proposition allows us to compute the Moment Generating
Function (MGF) of the increment YT − Yt .
Proposition 20.6. For any t ∈ [0, T ] and α ∈ R we have
E e α(YT −Yt ) = exp (T − t)λ E e αZ − 1 . (20.10)

Proof. Since Nt has a Poisson distribution with parameter t > 0 and is

independent of (Zk )k>1 , for all α ∈ R we have, by conditioning on the value
of NT − Nt = n,
" 699
N. Privault
NT NT −Nt
" !# " !#
E e α(YT −Yt ) = E exp α
X X
= E exp α

Zk Zk + N t
k =Nt +1 k =+1
NT −Nt
" !#
X
= E exp α Zk
k =1
   
X NT
X −Nt
E exp α Zk  NT − Nt = n P(NT − Nt = n)

=
n>0 k =1
n
" !#
X λn
= e −(T −t)λ
X
(T − t)n E exp α Zk
n!
n>0 k =1
X λn n
−(T −t)λ
Y
= e (T − t)n E e αZk

n!
n>0 k =1
X λn n
= e −(T −t)λ (T − t)n E e αZ

n!
n>0

= exp (T − t)λ E e αZ − 1 .

We note that we can also write
w∞
E e α(YT −Yt ) = exp (T − t)λ ( e αy − 1)ν (dy )

−∞
w∞ w∞
= exp (T − t)λ e αy ν (dy ) − (T − t)λ ν (dy )
−∞ −∞
w∞
= exp (T − t)λ ( e αy − 1)ν (dy ) ,
−∞
since the probability distribution ν (dy ) of Z satisfies

w ∞ αy w∞
E e αZ = e ν (dy ) and ν (dy ) = 1.

−∞ −∞
From the moment generating function (20.10) we can compute the expec-
tation of Yt for fixed t as the product of the mean number of jump times
E[Nt ] = λt and the mean jump size E[Z ], i.e.,
∂ w∞
E[Yt ] = E[ e αYt ]|α=0 = λt yν (dy ) = E[Nt ]E[Z ] = λtE[Z ].
∂α −∞
(20.11)
Note that the above identity requires to exchange the differentiation and
expectation operators, which is possible when the moment generating func-
700 "
tion (20.10) takes finite values for all α in a certain neighborhood (−ε, ε) of 0.
Relation (20.11) states that the mean value of Yt is the mean jump size E[Z ]
times the mean number of jumps E[Nt ]. It can be directly recovered using
series summations, as
"N #
X t
E[Yt ] = E Zk
k =1
n
" #
X X
E Zk Nt = n P(Nt = n)

=
n>1 k =1
" n #
X λ n tn X
= e −λt E

Zk Nt = n
n!
n>1 k =1
" n #
X λn tn X
−λt
= e E Zk
n!
n>1 k =1
X (λt)n−1
= λt e −λt E[Z ]
(n − 1) !
n>1
= λtE[Z ]
= E [ Nt ] E [ Z ] .
Regarding the variance, by (20.10) we have
∂2
E Yt2 = E[ e αYt ]|α=0

∂α2
∂2
exp λt E e αZ − 1 |α=0

=
∂α2
∂
λtE Z e αZ exp λt E e αZ − 1

=
∂α |α=0
= λtE Z 2 + (λtE[Z ])2

w∞ w ∞ 2
= λt y 2 ν (dy ) + (λt)2 yν (dy ) ,
−∞ −∞
which yields
w∞
Var [Yt ] = λt y 2 ν (dy ) = λtE |Z|2 = E[Nt ]E |Z|2 . (20.12)

−∞
As a consequence, the dispersion index of the compound Poisson process
Var [Yt ] E |Z|2

= , t > 0.
E[Yt ] E[Z ]
" 701
N. Privault
coincides with the dispersion index of the random jump size Z. By a multi-
variate version of Theorem 23.12, Proposition 20.6 can be used to show the
next result.
Proposition 20.7. The compound Poisson process
Nt
X
Yt = Zk , t > 0,
k =1
has independent increments, i.e. for any finite sequence of times t0 < t1 <
· · · < tn , the increments
Yt1 − Yt0 , Yt2 − Yt1 , . . . , Ytn − Ytn−1

Proof. This result relies on the fact that the result of Proposition 20.6 can
be extended to sequences 0 6 t0 6 t1 6 · · · 6 tn and α1 , α2 , . . . , αn ∈ R, as
" n # " n
!#
Y iα (Y −Y
tk−1 )
X
E e k tk
= E exp i αk (Ytk − Ytk−1 )
k =1 k =1
n w∞
!
X
= exp λ (tk − tk−1 ) ( e iαk y − 1)ν (dy ) (20.13)
−∞
k =1
n
Y w∞
= exp (tk − tk−1 )λ ( e iαk y − 1)ν (dy )
−∞
k =1
n
Y iα (Y −Y )
= E e k tk tk−1 .
k =1

Since the compensated compound Poisson process also has independent and
centered increments by (20.7) we have the following counterpart of Proposi-
tion 20.4, cf. also Example 2 page 256.
Proposition 20.8. The compensated compound Poisson process
Mt := Yt − λtE[Z ], t > 0,
is a martingale.
702 "
lambda = 0.6;n = 20;Zn<-cumsum(c(0,rexp(n,rate=2)));

tau_n <- rexp(n,rate=lambda); Tn <- cumsum(tau_n)
Y <- function(t) {return(stepfun(Tn,Zn)(t))};t <- seq(0,10,0.01)
dev.new(width=T, height=5);
par(oma=c(0,0.1,0,0))
plot(t,Y(t)-0.5*lambda*t,xlim = c(0,10),ylim =
c(-2,2),xlab="t",ylab=expression(paste('Y'[t],'-t')),type="l",lwd=2,col="blue",main="", xaxs
= "i", yaxs = "i", xaxs = "i", yaxs = "i", las = 1, cex.axis=1.2, cex.lab=1.4)
abline(h = 0, col="black", lwd =2)
points(Tn,Y(Tn)-0.5*lambda*Tn,pch=1,cex=0.8,col="blue",lwd=2);grid()
1
Yt−t
−1
−2
0 2 4 6 8 10
Fig. 20.7: Sample path of a compensated compound Poisson process (Yt − λtE[Z ])t∈R+ .
20.3 Stochastic Integrals and Itô Formula with Jumps
Definition 20.9. Based on the relation
∆Yt = ZNt ∆Nt ,
we define the stochastic integral of a stochastic process (φt )t∈[0,T ] with respect
to (Yt )t∈[0,T ] by
wT wT NT
X
φt dYt = φt ZNt dNt := φ Tk Z k . (20.14)
0 0
k =1
As a consequence of Proposition 20.6 we can derive the following version of

the Lévy-Khintchine formula:
w w w
T T ∞
E exp = exp λ e yf (t) − 1 ν (dy )dt

f (t)dYt
0 0 −∞
for f : [0, T ] −→ R a bounded deterministic function of time.
" 703
N. Privault
wT
Note that the expression (20.14) of φt dYt has a natural financial interpre-
0
tation as the value at time T of a portfolio containing a (possibly fractional)
quantity φt of a risky asset at time t, whose price evolves according to ran-
dom returns Zk , generating profits/losses φTk Zk at random times Tk .
In particular, the compound Poisson process (Yt )t∈R+ in (20.5) admits the
stochastic integral representation
Nt
X wt
Yt = Y0 + Zk = Y0 + ZNs dNs .
0
k =1
The next result is also called the smoothing lemma, cf. Theorem 9.2.1 in
Brémaud (1999).
Proposition 20.10. Let (φt )t∈R+ be a stochastic process adapted to the
filtration generated by (Yt )t∈R+ , admitting left limits and such that
w
T
E |φt |dt < ∞, T > 0.
0
The expected value of the compound Poisson stochastic integral can be ex-
pressed as
w w w
T T T
E φt− dYt = E φt− ZNt dNt = λE[Z ]E φt− dt ,
0 0 0
(20.15)
where φt− denotes the left limit
φt− := lim φs , t > 0.

s%t
Proof. By Proposition 20.8 the compensated compound Poisson process (Yt −

λtE[Z ])t∈R+ is a martingale, and as a consequence the stochastic integral
process
wt wt
t 7−→ φs− d Ys − λE[Z ]ds = φs− ZNs dNs − λE[Z ]ds
0 0
is also a martingale, by an argument similar to that in the proof of Propo-

sition 7.1 because the adaptedness of (φt )t∈R+ to the filtration generated
by (Yt )t∈R+ , makes (φt− )t>0 predictable, i.e. adapted with respect to the
filtration
Ft− := σ (Ys : s ∈ [0, t) ), t > 0.
It remains to use the fact that the expectation of a martingale remains con-
stant over time, which shows that
704 "
w
T
0=E

φt− dYt − λE[Z ]dt
0
w w
T T
=E φt− dYt − λE[Z ]E φt− dt .
0 0

For example, taking φt = Yt := Nt we have
wT NT
X 1
Nt− dNt = ( k − 1 ) = NT ( NT − 1 ) ,
0 2
k =1
hence
w
1 2

T
E E NT − E [ NT ]

Nt− dNt =
0 2
(λT )2
=
2
wT
=λ λtdt
0
wT
=λ E[Nt ]dt,
0
as in (20.15). Note however that while the identity in expectations (20.15)

holds for the left limit φt− , it need not hold for φt itself. Indeed, taking
φt = Yt := Nt we have
wT NT
X 1
Nt dNt = k= NT ( NT + 1 ) ,
0 2
k =1
hence
w
1 2

T
E E NT + E [ NT ]

Nt dNt =
0 2
1
(λT )2 + 2λT

=
2
(λT )2
= + λT
2
wT
6= λE Nt dt .
0
Under similar conditions, the compound Poisson compensated stochastic in-

tegral can be shown to satisfy the Itô isometry (20.16) in the next proposition.
Proposition 20.11. Let (φt )t∈R+ be a stochastic process adapted to the
filtration generated by (Yt )t∈R+ , admitting left limits and such that
" 705
N. Privault
w
T
E |φt |2 dt < ∞, T > 0.
0
The expected value of the squared compound Poisson compensated stochastic

integral can be computed as
wT wT
" 2 #
E = λE |Z|2 E |φt− |2 dt ,

φt− (dYt − λE[Z ]dt)
0 0
(20.16)
Note that in (20.16), the generic jump size Z is squared but λ is not.
Proof. From the stochastic Fubini-type theorem, we have
w 2
T
φt− (dYt − λE[Z ]dt) (20.17)
0
wT w t−
=2 φt− φs− (dYs − λE[Z ]ds)(dYt − λE[Z ]dt) (20.18)
0 0
wT
+ |φt− |2 |ZNt |2 dNt , (20.19)
0
where integration over the diagonal {s = t} has been excluded in (20.18) as

the inner integral has an upper limit t− rather than t. Next, taking expecta-
tion on both sides of (20.17)-(20.19), we find
w 2 w
T T
E φt− (dYt − λE[Z ]dt) =E |φt− |2 |ZNt |2 dNt
0 0
2 w T

= λE |Z| E |φt− |2 dt ,
0
where we used the vanishing of the expectation of the double stochastic in-
tegral:
w w t−
T
E φt − φs− (dYs − λE[Z ]ds)(dYt − λE[Z ]dt) = 0,
0 0
and the martingale property of the compensated compound Poisson process

Nt
!
X
|Zk |2 − λtE Z 2 , t > 0,

t 7−→
k =1
as in the proof of Proposition 20.10. The isometry relation (20.16) can also
be proved using simple predictable processes, similarly to the proof of Propo-
sition 4.20.
706 "
Next, take (Bt )t∈R+ a standard Brownian motion independent of (Yt )t∈R+
and (Xt )t∈R+ a jump-diffusion process of the form
wt wt
Xt := us dBs + vs ds + Yt , t > 0,
0 0
where (ut )t∈R+ is a stochastic process which is adapted to the filtration

(Ft )t∈R+ generated by (Bt )t∈R+ and (Yt )t∈R+ , and such that
hw T i hw T i
E |φt |2 |ut |2 dt < ∞ and E |φt vt |dt < ∞, T > 0.
0 0
We define the stochastic integral of (φt )t∈R+ with respect to (Xt )t∈R+ by
wT wT wT wT
φt dXt := φt ut dBt + φt vt dt + φt dYt
0 0 0 0
wT wT NT
X
:= φt ut dBt + φt vt dt + φ Tk Z k , T > 0.
0 0
k =1
For the mixed continuous-jump martingale

wt
Xt := us dBs + Yt − λtE[Z ], t > 0,
0
we then have the isometry:
w w
2 wT

T T
E =E |φt− |2 |ut |2 dt + λE |Z|2 E |φt− |2 dt .

φt− dXt
0 0 0
(20.20)
provided that (φt )t∈R+ is adapted to the filtration (Ft )t∈R+ generated by
(Bt )t∈R+ and (Yt )t∈R+ . The isometry formula (20.20) will be used in Sec-
tion 21.6 for mean-variance hedging in jump-diffusion models.
More generally, when (Xt )t∈R+ contains an additional drift term,

wt wt wt
Xt = X0 + us dBs + vs ds + ηs dYs , t > 0,
0 0 0
the stochastic integral of (φt )t∈R+ with respect to (Xt )t∈R+ is given by
wT wT wT wT
φs dXs := φs us dBs + φs vs ds + ηs φs dYs
0 0 0 0
wT wT NT
X
= φs us dBs + φs vs ds + φTk ηTk Zk , T > 0.
0 0
k =1
" 707
N. Privault
Itô Formula with Jumps
The next proposition gives the simplest instance of the Itô formula with
jumps, in the case of a standard Poisson process (Nt )t∈R+ with intensity λ.
Proposition 20.12. Itô formula for the standard Poisson process. We have
wt
f (Nt ) = f (0) + (f (Ns ) − f (Ns− ))dNs , t > 0,
0
where Ns− denotes the left limit Ns− = limh&0 Ns−h .

Proof. We note that
Ns = Ns− + 1 if dNs = 1 and k = NTk = 1 + NT − , k > 1.

k
Hence we have the telescoping sum

Nt
X
f (Nt ) = f (0) + (f (k ) − f (k − 1))
k =1
XNt
= f (0) + (f (NTk ) − f (NT − ))
k
k =1
XNt
= f (0) + (f (1 + NT − ) − f (NT − ))
k k
k =1
wt
= f (0) + (f (1 + Ns− ) − f (Ns− ))dNs
0
wt
= f (0) + (f (Ns ) − f (Ns − 1))dNs
0
wt
= f (0) + (f (Ns ) − f (Ns− ))dNs ,
0
where Ns− denotes the left limit Ns− = limh&0 Ns−h .

The next result deals with the compound Poisson process (Yt )t∈R+ in (20.5)
via a similar argument.
Proposition 20.13. Itô formula for the compound Poisson process (Yt )t∈R+ .
We have the pathwise Itô formula
wt
f (Yt ) = f (0) + (f (Ys ) − f (Ys− ))dNs , t > 0. (20.21)
0
Proof. We have
Nt
X
f (Yt ) = f (0) +

f YTk − f YT −
k
k =1
708 "
Nt
X
= f (0) +

f YT − + Zk − f YT −
k k
k =1
wt
= f (0) + (f (Ys− + ZNs ) − f (Ys− ))dNs
0
wt
= f (0) + (f (Ys ) − f (Ys− ))dNs , t > 0.
0

From the expression
Nt
X wt
Yt = Y0 + Zk = Y0 + ZNs dNs ,
0
k =1
the Itô formula (20.21) can be decomposed using a compensated Poisson

stochastic integral as
df (Yt ) = (f (Yt ) − f (Yt− ))dNt − E[(f (y + Z ) − f (y )]y =Yt− dt (20.22)

+E[(f (y + Z ) − f (y )]y =Yt− dt,
where
(f (Yt ) − f (Yt− ))dNt − E[(f (y + ZNt ) − f (y )]y =Yt− dt
is the differential of a martingale by the smoothing lemma Proposition 20.10.
More generally, we have the following result.

Proposition 20.14. For an Itô process of the form
wt wt wt
Xt = X0 + vs ds + us dBs + ηs dYs , t > 0,
0 0 0
we have the Itô formula
wt wt 1 w t 00
f (Xt ) = f (X0 ) + vs f 0 (Xs )ds + us f 0 (Xs )dBs + f (Xs )|us |2 ds
0 0 2 0
wt
+ (f (Xs ) − f (Xs− ))dNs , t > 0. (20.23)
0
Proof. By combining the Itô formula for Brownian motion with the above
argument we find
wt 1 w t 00 wt
f (Xt ) = f (X0 ) + us f 0 (Xs )dBs + f (Xs )|us |2 ds + vs f 0 (Xs )ds
0 2 0 0
NT
X
+ f XT − + ηTk Zk − f XT −
k k
k =1
" 709
N. Privault
wt 1 w t 00 wt
= f (X0 ) + us f 0 (Xs )dBs + f (Xs )|us |2 ds + vs f 0 (Xs )ds
0 2 0 0
wt
+ (f (Xs− + ηs ZNs ) − f (Xs− ))dNs , t > 0,
0

The integral Itô formula (20.23) can be rewritten in differential notation as
|ut |2 00
df (Xt ) = vt f 0 (Xt )dt + ut f 0 (Xt )dBt + f (Xt )dt + (f (Xt ) − f (Xt− ))dNt ,
2
(20.24)
t > 0.
Itô multiplication table with jumps
For a stochastic process (Xt )t∈R+ given by

wt wt wt
Xt = us dBs + vs ds + ηs dNs , t > 0,
0 0 0
the Itô formula with jumps reads

wt 1wt
f (Xt ) = f (0) + us f 0 (Xs )dBs + |us |2 f 00 (Xs )dBs
0 2 0
wt wt
+ vs f 0 (Xs )ds + (f (Xs− + ηs ) − f (Xs− ))dNs
0 0
wt 1wt
0
= f (0) + us f (Xs )dBs + |us |2 f 00 (Xs )dBs
0 2 0
wt wt
+ vs f 0 (Xs )ds + (f (Xs ) − f (Xs− ))dNs .
0 0
Given two Itô processes (Xt )t∈R+ and (Yt )t∈R+ written in differential nota-
tion as
dXt = ut dBt + vt dt + ηt dNt , t > 0,
and
dYt = at dBt + bt dt + ct dNt , t > 0,
the Itô formula for jump processes can also be written as
d(Xt Yt ) = Xt dYt + Yt dXt + dXt • dYt
where the product dXt • dYt is computed according to the following extension
of the Itô multiplication Table 4.1. The relation dBt • dNt = 0 is due to the
fact that (Nt )t∈R+ has finite variation on any finite interval.
710 "
• dt dBt dNt
dt 0 0 0
dBt 0 dt 0
dNt 0 0 dNt
Table 20.1: Itô multiplication table with jumps.
dXt • dYt = (vt dt + ut dBt + ηt dNt )(bt dt + at dBt + ct dNt )

= vt bt dt • dt + ut bt dBt • dt + ηt bt dNt • dt
+vt at dt • dBt + ut at dBt • dBt + ηt at dNt • dBt
+vt ct dt • dNt + ut ct dBt • dNt + ηt ct dNt • dNt
= +ut at dBt • dBt + ηt ct dNt • dNt
= ut at dt + ηt ct dNt ,
since
dNt • dNt = (dNt )2 = dNt ,
as ∆Nt ∈ {0, 1}. In particular, we have
(dXt )2 = (vt dt + ut dBt + ηt dNt )2 = u2t dt + ηt2 dNt .
Jump processes with infinite activity
Given η (s), s ∈ R+ , a deterministic function of time and (Xt )t∈R+ an Itô

process of the form
wt wt wt
Xt := X0 + vs ds + us dBs + η (s)dYt , t > 0,
0 0 0
the Itô formula with jumps (20.23) can be rewritten as

wt wt 1 w t 00
0 0 2 0
wt wt
+ (f (Xs− + η (s)∆Ys ) − f (Xs− )) dNs − λ E f (x + η (s)Z ) − f (x) |x=X ds

0 0 s−
wtw∞
+λ (f (Xs− + η (s)y ) − f (Xs− )) ν (dy )ds, t > 0,
0 −∞
using the compensated martingale

wt wt
(f (Xs ) − f (Xs− )) dNs − λ E f (x + η (s)Z ) − f (x) |x=X ds

0 0 s−
wt
= (f (Xs− + η (s)∆Ys ) − f (Xs− )) dNs
0
" 711
N. Privault
wtw∞
−λ (f (Xs− + η (s)y ) − f (Xs )) ν (dy )ds,
0 −∞
with the relation dXs = ηs ∆Ys . We note that from the relation
w∞
E[Z ] = yν (dy ),
−∞
the above compensator can be written as

wtw∞
λ (f (Xs− + η (s)y ) − f (Xs− )) ν (dy )ds
0 −∞
wtw∞
f (Xs− + η (s)y ) − f (Xs− ) − η (s)yf 0 (Xs− ) ν (dy )ds (20.25)

=λ
0 −∞
wt
+λE[Z ] η (s)f 0 (Xs− )ds.
0
The expression (20.25) above is at the basis of the extension of Itô’s formula
to Lévy processes with an infinite number of jumps on any interval under the
conditions w
y 2 ν (dy ) < ∞ and ν ([−1, 1]c ) < ∞,
|y|61
using the bound
|f (x + y ) − f (x) − yf 0 (x)| 6 Cy 2 , y ∈ [−1, 1],
that follows from Taylor’s theorem for f a C 2 (R) function. This yields
wt wt 1 w t 00
0 0 2 0
wt wt
+ (f (Xs− + η (s)∆Ys ) − f (Xs− )) dNs − λ E f (x + η (s)Z ) − f (x) |x=X ds

0 0 s−
wtw∞
0

+λ f (Xs− + η (s)y ) − f (Xs− ) − η (s)yf (Xs− ) ν (dy )ds
0 −∞
wt
+ λE[Z ] η (s)f 0 (Xs− )ds, t > 0,
0
see e.g. Theorem 1.16 in Øksendal and Sulem (2005) and Theorem 4.4.7 in
Applebaum (2009) in the setting of Poisson random measures.
By construction, compound Poisson processes only have a finite number of

jumps on any interval. They belong to the family of Lévy processes which may
have an infinite number of jumps on any finite time interval, see e.g. § 4.4.1
of Cont and Tankov (2004). Such processes, also called “infinite activity Lévy
processes” are also useful in financial modeling, cf. Cont and Tankov (2004),
and include the gamma process, stable processes, variance gamma processes,
inverse Gaussian processes, etc, as in the following illustrations.
712 "
1. Gamma process.
Fig. 20.8: Sample trajectories of a gamma process.
The next R code can be used to generate the gamma process paths of
Figure 20.8.
N=2000; t <- 0:N; dt <- 1.0/N; nsim <- 6; alpha=20.0

X = matrix(0, nsim, N)
for (i in 1:nsim){X[i,]=rgamma(N,alpha*dt);}
plot(t, X[1, ], xlab = "time", type = "l", ylim = c(0, 2*N*alpha*dt), col = 0)
for (i in 1:nsim){points(t, X[i, ], xlab = "time", type = "p", pch=20, cex =0.02, col =
i)}
2. Variance gamma process.
Fig. 20.9: Sample trajectories of a variance gamma process.
" 713
N. Privault
3. Inverse Gaussian process.
Fig. 20.10: Sample trajectories of an inverse Gaussian process.
4. Negative Inverse Gaussian process.
Fig. 20.11: Sample trajectories of a negative inverse Gaussian process.
5. Stable process.
Fig. 20.12: Sample trajectories of a stable process.

The above sample paths of a stable process can be compared to the US-
D/CNY exchange rate over the year 2015, according to the date retrieved
using the following code.
714 "
library(quantmod);myPars <- chart_pars();myPars$cex<-1.5

getSymbols("USDCNY=X",from="2015-01-01",to="2015-12-06",src="yahoo")
rate=Ad(ÙSDCNY=X`);myTheme <- chart_theme();myTheme$col$line.col <- "blue"
myTheme$rylab <- FALSE;chart_Series(rate, pars=myPars, theme = myTheme,
name="USDCNY=X")
getSymbols("EURCHF=X",from="2013-12-30",to="2016-01-01",src="yahoo")
rate=Ad(ÈURCHF=X`);chart_Series(rate, pars=myPars, theme = myTheme)
The adjusted close price Ad() is the closing price after adjustments for ap-
plicable splits and dividend distributions.
USDCNY=X 2015−01−01 / 2015−12−04

6.40
6.38
6.36
6.34
6.32
6.30
6.28
6.26
6.24
6.22
6.20
6.18 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Jan 01 Feb 02 Mar 02 Apr 01 May 01 Jun 01 Jul 01 Aug 03 Sep 01 Oct 01 Nov 02 Dec 01
2015 2015 2015 2015 2015 2015 2015 2015 2015 2015 2015 2015
Fig. 20.13: USD/CNY Exchange rate data.
Using the stochastic integral of a deterministic function f (t) with respect to

(Yt )t∈R+ defined as
wT NT
X
f (t)dYt = Zk f (Tk ),
0
k =1
Relation (20.13) can be used to show that, more generally, the moment gen-
rT
erating function of 0 f (t)dYt is given by
w w w
T T
E exp = exp λ e yf (t) − 1 ν (dy )dt

f (t)dYt
0 0 R
w
T
= exp λ E e f (t)Z − 1 dt .

0
We also have
w wT w
T
log E exp e yf (t) − 1 ν (dy )dt

f (t)dYt =λ
0 0 R
1 wT w n n
∞
X
=λ y f (t)ν (dy )dt
n! 0 R
n=1
X∞
1 wT
=λ E[Z n ] f n (t)dt,
n! 0
n=1
" 715
N. Privault
wT
hence the cumulant of order n > 1 of f (t)dYt , see Definition 21.1, is given
0
by
wT
κn = λE[Z n ] f n (t)dt,
0
which recovers (20.11) and (20.12) by taking f (t) := 1[0,T ] (t) when n = 1, 2.
20.4 Stochastic Differential Equations with Jumps

In the continuous asset price model, the returns of the riskless asset price
process (At )t∈R+ and of the risky asset price process (St )t∈R+ are modeled
as
dAt dSt
= rdt and = µdt + σdBt .
At St
In this section we are interested in using jump processes in order to model
an asset price process (St )t∈R+ .
i) Constant market return η > −1.

In the case of discontinuous asset prices, let us start with the simplest
example of a constant market return η written as
St − St−
η := , (20.26)
St−
assuming the presence of a jump at time t > 0, i.e., dNt = 1. Using the
relation dSt := St − St− , (20.26) rewrites as
St − St− dSt
ηdNt = = , (20.27)
St− St−
or
dSt = ηSt− dNt , (20.28)
which is a stochastic differential equation with respect to the standard
Poisson process, with constant volatility η ∈ R. Note that the left limit
St− in (20.28) occurs naturally from the definition (20.27) of market re-
turns when dividing by the previous index value St− .
In the presence of a jump at time t, the equation (20.26) also reads
St = (1 + η )St− , dNt = 1,
which can be applied by induction at the successive jump times T1 , T2 , . . . , TNt

until time t, to derive the solution
St = S0 (1 + η )Nt , t > 0,
716 "
of (20.28).
The use of the left limit St− turns out to be necessary when computing
pathwise solutions by solving for St from St− .
ii) Time-dependent market returns ηt , t > 0.
Next, consider the case where ηt is time-dependent, i.e.,
dSt = ηt St− dNt . (20.29)
At each jump time Tk , Relation (20.29) reads
dSTk = STk − ST − = ηTk ST − ,

k k
i.e.,
STk = (1 + ηTk )ST − ,
k
and repeating this argument for all k = 1, 2, . . . , Nt yields the product

solution
Nt
Y
St = S0 (1 + ηTk )
k =1
Y
= S0 ( 1 + ηs )
∆Ns =1
06s6t
Y
= S0 (1 + ηs ∆Ns ), t > 0.
06s6t
By a similar argument, we obtain the following proposition.

Proposition 20.15. The stochastic differential equation with jumps
dSt = µt St dt + ηt St− (dNt − λdt), (20.30)
admits the solution
w wt Nt
Y
t
St = S0 exp µs ds − λ ηs ds ( 1 + η Tk ) , t > 0.
0 0
k =1
Note that the equations
dSt = µt St− dt + ηt St− (dNt − λdt)
and
" 717
N. Privault
dSt = µt St dt + ηt St− (dNt − λdt)

are equivalent because St− dt = St dt as the set {Tk }k>1 of jump times has
zero measure of length.
A random simulation of the numerical solution of the above equation (20.30)

is given in Figure 20.14 for η = 1.29 and constant µ = µt , t > 0.
1.5
1
St
0.5
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 20.14: Geometric Poisson process.∗
The above simulation can be compared to the real sales ranking data of
Figure 20.15.
Fig. 20.15: Ranking data.
Next, consider the equation
dSt = µt St dt + ηt St− (dYt − λE[Z ]dt)

∗
718 "
driven by the compensated compound Poisson process (Yt − λE[Z ]t)t∈R+ ,

also written as
dSt = µt St dt + ηt St− (ZNt dNt − λE[Z ]dt),
with solution
w wt Nt
Y
t
St = S0 exp µs ds − λE[Z ] ηs ds ( 1 + η Tk Z k ) t > 0. (20.31)
0 0
k =1
A random simulation of the geometric compound Poisson process (20.31) is

given in Figure 20.16.
1.5
1
St
0.5
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 20.16: Geometric compound Poisson process.∗
In the case of a jump-diffusion stochastic differential equation of the form
dSt = µt St dt + ηt St− (dYt − λE[Z ]dt) + σt St dBt ,
we get
w wt wt 1wt

t
St = S0 exp µs ds − λE[Z ] ηs ds + σs dBs − |σs |2 ds
0 0 0 2 0
Nt
Y
× ( 1 + η Tk Z k ) , t > 0.
k =1
A random simulation of the geometric Brownian motion with compound Pois-

son jumps is given in Figure 20.17.
∗
" 719
N. Privault
20
St
eµt
15
10
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 2.0
t
Fig. 20.17: Geometric Brownian motion with compound Poisson jumps.∗
By rewriting St as
w wt wt 1wt

t
St = S0 exp µs ds + ηs (dYs − λE[Z ]ds) + σs dBs − |σs |2 ds
0 0 0 2 0
Nt
(1 + ηTk Zk ) e −ηTk Zk ,
Y
×
k =1
t > 0, one can extend this jump model to processes with an infinite number
of jumps on any finite time interval, cf. Cont and Tankov (2004). The next
Figure 20.18 shows a number of downward and upward jumps occuring in
the SMRT historical share price data, with a typical geometric Brownian
behavior in between jumps.
Fig. 20.18: SMRT Share price.

∗
720 "
20.5 Girsanov Theorem for Jump Processes

Recall that in its simplest form, cf. Section 7.2, the Girsanov Theorem 7.3
for Brownian motion states the following.
Let µ ∈ R. Under the probability measure P

e −µ defined by the
dP
e −µ 2
:= e −µBT −µ T /2 ,
dP
the random variable BT + µT has the centered Gaussian distribution
N (0, T ).
This fact follows from the calculation

e −µ [f (BT + µT )] = E[f (BT + µT ) e −µBT −µ2 T /2 ]
E
1 w∞ 2 2
= √ f (x + µT ) e −µx−µ T /2 e −x /(2T ) dx
2πT −∞
1 w∞ 2
= √ f (x + µT ) e −(x+µT ) /(2T ) dx
2πT −∞
1 w∞ 2
= √ f (y ) e −y /(2T ) dy
2πT −∞
= E[f (BT )], (20.32)
for any bounded measurable function f on R, which shows that BT + µT is

a centered Gaussian random variable under P
e −µ .
More generally, the Girsanov Theorem states that (Bt + µt)t∈[0,T ] is a stan-
dard Brownian motion under P e −µ .
When Brownian motion is replaced with a standard Poisson process (Nt )t∈[0,T ] ,
a spatial shift of the type
Bt 7−→ Bt + µt
can no longer be used because Nt + µt cannot be a Poisson process, what-
ever the change of probability applied, since by construction, the paths of the
standard Poisson process has jumps of unit size and remain constant between
jump times.
The correct way to extend the Girsanov Theorem to the Poisson case is
to replace the space shift with a shift of the intensity of the Poisson process
as in the following statement.
" 721
N. Privault
Proposition 20.16. Consider a random variable NT having the Poisson dis-

tribution P (λT ) with parameter λT under Pλ . Under the probability measure
P
e defined by the Radon-Nikodym density
λ̃
!NT
dP λ
:= e −(λ̃−λ)T
e e
λ̃
,
dPλ λ
the random variable NT has a Poisson distribution

with intensity λT
e . As a
consequence, the compensated process Nt − λt
e
t∈[0,T ]
is a martingale under
P
e .
λ̃
Proof. This follows from the relation
!k
e (NT = k ) = e −(λ̃−λ)T λ
e
Pλ̃ Pλ (NT = k )
λ
!k
λ λk
= e −(λ̃−λ)T e −λT
e
λ k!
ek
λ
= e −λ̃T , k > 0.
k!

Assume now that (Nt )t∈[0,T ] is a standard Poisson process with intensity λ
under a probability measure Pλ . In order to extend (20.32) to the Poisson
case we can replace the space shift with a time contraction (or dilation)
Nt 7−→ N(1+c)t
by a factor 1 + c, where
λ
e
c := −1 + > −1,
λ
or λ
e = (1 + c)λ. We note that
(λ(1 + c)T )k −λ(1+c)T

Pλ N(1+c)T = k = e

k!
k −λcT
= (1 + c) e Pλ (NT = k )
=Pe (NT = k ),
λ̃ k > 0,
hence
dP
e
λ̃
:= (1 + c)NT e −λcT ,
dPλ
and by analogy with (20.32) we have
722 "
X
Eλ f ( N ( 1 + c ) T ) = f (k )Pλ N(1+c)T = k (20.33)

k>0
X
= e −λcT f (k )(1 + c)k Pλ (NT = k )
k >0
= e −λcT Eλ f (NT )(1 + c)NT

" #
dP
e
= Eλ f (NT ) λ̃
dPλ
=E
e [f (NT )],
λ̃
for any bounded function f on N. In other words, taking f (x) := 1{x6n} ,

we have
Pλ N(1+c)T 6 n = P e ( NT 6 n ) , n > 0,

λ̃
or
P T /(1+c) 6 n) = Pλ NT 6 n , n > 0.

e (N
λ̃
As a consequence, we have the following proposition.
Proposition 20.17. Let λ, λe > 0, and set
λ
e
c := −1 + > −1.
λ

The process Nt/(1+c) t∈[0,T ]
is a standard Poisson process with intensity λ
under the probability measure P e defined by the Radon-Nikodym density
λ̃
!NT
dP λ
:= e −(λ̃−λ)T
e
= e −cλT (1 + c)NT .
e
λ̃
dPλ λ
In particular, the compensated Poisson processes
Nt/(1+c) − λt and Nt − λt,

e 0 6 t 6 T,
are martingales under P

e .
λ̃
Proof. As in (20.33), we have
Eλ [f (NT )] = E T / (1+c) ,

e f N
λ̃
i.e., under P
e the distribution of N
λ̃ T /(1+c) is that of a standard Poisson
random variable with parameter λT . Since Nt/(1+c) t∈[0,T ] has independent
increments, Nt/(1+c) t∈[0,T ] is a standard Poisson process with intensity λ

under Pe , and the compensated process (N

λ̃ − λt)
t/(1+c) is a martingale
t∈[0,T ]
under P
e by (7.2). Similarly, the compensated process
λ̃
" 723
N. Privault
(Nt − (1 + c)λt)t∈[0,T ] = Nt − λt

e
t∈[0,T ]
has independent increments and is a martingale under P

e .
λ̃
We also have

t
1[Tn ,∞) 1[(1+c)Tn ,∞) (t), t > 0,
X X
Nt/(1+c) = =
1+c
n>1 n>1
which shows that the jump times ((1 + c)Tn )n>1 of Nt/(1+c) t∈[0,T ] are dis-

tributed under P
e as the jump times of a Poisson process with intensity λ.
λ̃
The next R code shows that the compensated Poisson process (Nt/(1+c) −
λt)t∈[0,T ] , remains a martingale after the Poisson process interjump times
(τk )k>1 have been generated using exponential random variables with pa-
rameter λ e > 0.
lambda = 0.5;lambdat=2;c=-1+lambdat/lambda;n = 20;Z<-cumsum(c(0,rep(1,n)))

for (k in 1:n){tau_k <- rexp(n,rate=lambdat); Tn <- cumsum(tau_k)}
N <- function(t) {return(stepfun(Tn,Z)(t))};t <- seq(0,10,0.01)
plot(t,N(t/(1+c))-lambda*t,xlim = c(0,10),ylim =
c(-2,2),xlab="t",ylab="Nt-t",type="l",lwd=2,col="blue",main="", xaxs = "i", yaxs =
"i", xaxs = "i", yaxs = "i");abline(h = 0, col="black", lwd =2)
points(Tn*(1+c),N(Tn)-lambda*Tn*(1+c),pch=1,cex=0.8,col="blue",lwd=2)
When µ 6= r, the discounted price process (Set )t∈R+ = ( e −rt St )t∈R+ written
as
dSet
= (µ − r )dt + σ (dNt − λdt) (20.34)
Se − t
is not a martingale under Pλ . However, we can rewrite (20.34) as

dSet µ−r
= σ dNt − λ − dt
Set− σ
and letting
e : = λ − µ − r = (1 + c)λ
λ
σ
with
µ−r
c := − ,
σλ
we have
dSet
= σ dNt − λdt
e
Set−
hence the discounted price process (Set )t∈R+ is martingale under the proba-
bility measure P
e defined by the Radon-Nikodym density
λ̃
724 "
dP µ − r NT

:= e −λcT (1 + c)NT = e (µ−r )/σ 1 −
e
λ̃
.
dPλ σλ
We note that if
µ − r 6 σλ
then the risk-neutral probability measure P
e exists and is unique, therefore
λ̃
by Theorems 5.8 and 5.12 the market is without arbitrage and complete.
If µ − r > σλ then the discounted asset price process (Set )t∈R+ is always
increasing, and arbitrage becomes possible by borrowing from the savings
account and investing on the risky underlying asset.
Girsanov Theorem for compound Poisson processes
In the case of compound Poisson processes, the Girsanov Theorem can be

extended to variations in jump sizes in addition to time variations, and we
have the following more general result.
Theorem 20.18. Let (Yt )t>0 be a compound Poisson process with intensity
λ > 0 and jump size distribution ν (dx). Consider another intensity parameter
e > 0 and jump size distribution νe(dx), and let
λ
e νe(dx)
λ
ψ (x) : = − 1, x ∈ R. (20.35)
λ ν (dx)
Then,
under the probability measure P

e
λ̃,ν̃ defined by the Radon-Nikodym density
NT
dP
e
λ̃,ν̃
:= e −(λ̃−λ)T
Y
(1 + ψ (Zk )),
dP
e λ,ν
k =1
the process
Nt
X
Yt := Zk , t > 0,
k =1
is a compound Poisson process with
e > 0, and
- modified intensity λ
- modified jump size distribution νe(dx).
Proof. For any bounded measurable function f on R, we extend (20.33) to

the following change of variable
" 725
N. Privault
 
NT
−(λ̃−λ)T
Y
Eλ̃,ν̃ [f (YT )] = e Eλ,ν f (YT ) (1 + ψ (Zi ))
i=1
k k
" ! #

= e −(λ̃−λ)T
X X Y
Eλ,ν f Zi (1 + ψ (Zi )) NT = k Pλ (NT = k )

k >0 i=1 i=1
k k
" ! #
X (λT )k X Y
= e −λ̃T Eλ,ν f Zi (1 + ψ (Zi ))
k!
k>0 i=1 i=1
X (λT )k w ∞ w∞ Yk
= e −λ̃T ··· f (z1 + · · · + zk ) (1 + ψ (zi ))ν (dz1 ) · · · ν (dzk )
k! −∞ −∞
k>0 i=1
e )k w ∞ w∞ k
!
X (λT Y νe(dzi )
= e −λ̃T ··· f (z1 + · · · + zk ) ν (dz1 ) · · · ν (dzk )
k! −∞ −∞ ν (dzi )
k>0 i=1
e )k w ∞
X (λT w∞
= e −λ̃T ··· f (z1 + · · · + zk )νe(dz1 ) · · · νe(dzk ).
k! −∞ −∞
k>0
This shows that under Pλ̃,ν̃ , YT has the distribution of a compound Poisson
process with intensity λe and jump size distribution νe. We refer to Propo-
sition 9.6 of Cont and Tankov (2004) for the independence of increments of
(Yt )t∈R+ under Pe .
λ̃,ν̃
Example. In case ν ' N (α, σ 2 ) and νe ' N (β, η 2 ), we have
1 1

dx dx
ν (dx) = √ exp − 2 (x − α)2 , νe(dx) = p exp − 2 (x − β )2 ,
2πσ 2 2σ 2πη 2 2η
x ∈ R, hence
νe(dx) 1 1

η
= exp (x − β )2 − 2 (x − α )2 , x ∈ R,
ν (dx) σ 2η 2 2σ
and ψ (x) in (20.35) is given by
e νe(dx) 1 1

λ λη
e
1 + ψ (x) = = exp (x − β )2 − 2 (x − α )2 , x ∈ R.
λ ν (dx) λσ 2η 2 2σ
Note that the compound Poisson process with intensity λ

e > 0 and jump size
distribution νe can be built as
Nλ̃t/λ
X
Xt := h ( Zk ) ,
k =1
726 "
provided that νe is the pushforward measure of ν by the function h : R → R,

i.e.,
P(h(Zk ) ∈ A) = P(Zk ∈ h−1 (A)) = ν (h−1 (A)) = νe(A),
for all (measurable) subsets A of R. As a consequence of Theorem 20.18 we
have the following proposition.
Proposition 20.19. The compensated process
e ν̃ [Z ]
Yt − λtE
is a martingale under the probability measure P

e
λ̃,ν̃ defined by the Radon-
Nikodym density
NT
dP
e
λ̃,ν̃
= e −(λ̃−λ)T
Y
(1 + ψ (Zk )).
dP
e λ,ν
k =1
Finally, the Girsanov Theorem can be extended to the linear combination

of a standard Brownian motion (Bt )t∈R+ and a compound Poisson process
(Yt )t∈R+ independent of (Bt )t∈R+ , as in the following result which is a par-
ticular case of Theorem 33.2 of Sato (1999).
Theorem 20.20. Let (Yt )t>0 be a compound Poisson process with intensity
λ > 0 and jump size distribution ν (dx). Consider another jump size distri-
e > 0, and let
bution νe(dx) and intensity parameter λ
λ
e de
ν
ψ (x) : = (x) − 1, x ∈ R,
λ dν
and let (ut )t∈R+ be a bounded adapted process. Then the process
wt
Bt + us ds + Yt − λEe ν̃ [Z ]t
0 t∈R+
is a martingale under the probability measure P

e
u,λ̃,ν̃ defined by the Radon-
Nikodym density
wT NT
dP 1wT
e Y
u,λ̃,ν̃
= exp − λ |us |2 ds (1 + ψ (Zk )).

e−λ T − us dBs −
dPe λ,ν 0 2 0
k =1
(20.36)
As a consequence of Theorem 20.20, if
wt
Bt + vs ds + Yt (20.37)
0
" 727
N. Privault
is not a martingale under P e λ,ν , it will become a martingale under P

e
u,λ̃,ν̃
provided that u, λ̃ and νe are chosen in such a way that
e ν̃ [Z ],
vs = us − λE s ∈ R, (20.38)
in which case (20.37) can be rewritten into the martingale decomposition
dBt + ut dt + dYt − λE
e ν̃ [Z ]dt,
wt
in which both Bt + us ds and Yt − λtE
e ν̃ [Z ] are martingales
0 t∈R+ t∈R+
under P
e
u,λ̃,ν̃
The following remarks will be of importance for arbitrage-free pricing in jump

models in Chapter 21.
a) When λ e = λ = 0, Theorem 20.20 coincides with the usual Girsanov
Theorem for Brownian motion, in which case (20.38) admits only one
solution given by u = v and there is uniqueness of P e u,0,0 .
b) Uniqueness also occurs when u = 0 in the absence of Brownian motion,
and with Poisson jumps of fixed size a (i.e., νe(dx) = ν (dx) = δa (dx))
since in this case (20.38) also admits only one solution λe = v and there is
uniqueness of P0,λ̃,δa .
e
When µ 6= r, the discounted price process (Set )t∈R+ = ( e −rt St )t∈R+ defined
by
dSet
= (µ − r )dt + σdBt + η (dYt − λtEν [Z ])
Se −t
is not martingale under Pλ,ν , however we can rewrite the equation as

dSet uσ µ−r
= σ (udt + dBt ) + η dYt − + λEν [Z ] − dt
Set− η η
and choosing u, νe, and λ

e such that
e ν̃ [Z ] = uσ + λEν [Z ] − µ − r ,
λE (20.39)
η η
we have
dSet e ν̃ [Z ]dt .

= σ (udt + dBt ) + η dYt − λE
Set−
Hence the discounted price process (Set )t∈R+ is martingale under the proba-
bility measure P
e
u,λ̃,ν̃ , and the market is without arbitrage by Theorem 5.8
and the existence of a risk-neutral probability measure P e . However, the
u,λ̃,ν̃
728 "
market is not complete due to the non uniqueness of solutions u, νe, λ

e to

(20.39), and Theorem 5.12 does not apply in this situation.
Exercises
Exercise 20.1 Analysis of user login activity to the DBX digibank app showed
that the times elapsed between two logons are independent and exponentially
distributed with mean 1/λ. Find the CDF of the time T − TNT elapsed since
the last logon before time T , given that the user has logged on at least once.
Hint: The number of logins until time t > 0 can be modeled by a standard
Poisson process (Nt )t∈[0,T ] with intensity λ.
Exercise 20.2 Consider a standard Poisson process (Nt )t∈R+ with intensity
λ > 0, started at N0 = 0.
a) Solve the stochastic differential equation
dSt = ηSt− dNt − ηλSt dt = ηSt− (dNt − λdt).
b) Using the first Poisson jump time T1 , solve the stochastic differential equa-
tion
dSt = −ληSt dt + dNt , t ∈ (0, T2 ).
Exercise 20.3 Consider an asset price process (St )t∈R+ given by the stochas-
tic differential equation dSt = µSt dt + σSt dBt + ηSt− dYt , i.e.
wt wt wt
St = S0 + µ Ss ds + σ Ss dBs + η Ss− dYs , t > 0, (20.40)
0 0 0
where S0 > 0, µ ∈ R, σ > 0, η > 0 are constants, and (Yt )t∈R+ is a compound
Poisson process with intensity λ > 0 and i.i.d. jump sizes Zk , k > 1.
a) Write a differential equation satisfied by u(t) := E[St ], t > 0.
Hint: Use the smoothing lemma Proposition 6.9.
b) Find the value of E[St ], t > 0, in terms of S0 , µ, η, λ and E[Z ].
λ > 0.
a) Solve the stochastic differential equation dXt = αXt dt + σdNt over the
time intervals [0, T1 ), [T1 , T2 ), [T2 , T3 ), [T3 , T4 ), where X0 = 1.
b) Write a differential equation for f (t) := E[Xt ], and solve it for t ∈ R+ .
λ > 0.
" 729
N. Privault
a) Solve the stochastic differential equation dXt = σXt− dNt for (Xt )t∈R+ ,
where σ > 0 and X0 = 1.
b) Show that the solution (St )t∈R+ of the stochastic differential equation
dSt = rdt + σSt− dNt ,

wt
is given by St = S0 Xt + rXt Xs−1 ds.
0
c) Compute E[Xt ] and E[Xt /Xs ], 0 6 s 6 t.
d) Compute E[St ], t > 0.
Exercise 20.6 Let (Nt )t∈R+ be a standard Poisson process with intensity
λ > 0, started at N0 = 0.
a) Is the process t 7→ Nt − 2λt a submartingale, a martingale, or a su-
permartingale?
b) Let r > 0. Solve the stochastic differential equation
dSt = rSt dt + σSt− (dNt − λdt).
c) Is the process t 7→ St of Question (b) a submartingale, a martingale, or a

supermartingale?
d) Compute the price at time 0 of the European call option with strike price
K = S0 e (r−λσ )T , where σ > 0.
Exercise 20.7 Affine stochastic differential equation with jumps. Consider a

standard Poisson process (Nt )t∈R+ with intensity λ > 0.
a) Solve the stochastic differential equation dXt = adNt + σXt− dNt , where
σ > 0, and a ∈ R.
b) Compute E[Xt ] for t ∈ R+ .
Nt
X
Exercise 20.8 Consider the compound Poisson process Yt := Zk , where
k =1
(Nt )t∈R+ is a standard Poisson process with intensity λ > 0, and (Zk )k>1 is
an i.i.d. sequence of N (0, 1) Gaussian random variables. Solve the stochastic
dSt = rSt dt + ηSt− dYt ,
where η, r ∈ R.
Exercise 20.9 Show, by direct computation or using the moment generating

function (20.10), that the variance of the compound Poisson process Yt with
intensity λ > 0 satisfies
w∞
Var [Yt ] = λtE |Z|2 = λt x2 ν (dx).

−∞
730 "
Exercise 20.10 Consider an exponential compound Poisson process of the

form
St = S0 e µt+σBt +Yt , t > 0,
where (Yt )t∈R+ is a compound Poisson process of the form (20.8).
a) Derive the stochastic differential equation with jumps satisfied by (St )t∈R+ .
b) Let r > 0. Find a family P ν of probability measures under which the

e
u,λ̃,e
discounted asset price e −rt St is a martingale.
Exercise 20.11 Consider (Nt )t∈R+ a standard Poisson process with inten-
sity λ > 0 under a probability measure P. Let (St )t∈R+ be defined by the
dSt = µSt dt + ZNt St− dNt , (20.41)
where (Zk )k>1 is an i.i.d. sequence of random variables of the form
Zk = e Xk − 1, where Xk ' N (0, σ 2 ), k > 1.
a) Solve the equation (20.41).

b) We assume that µ and the risk-free interest rate r > 0 are chosen such
that the discounted process ( e −rt St )t∈R+ is a martingale under P. What
relation does this impose on µ and r?
c) Under the relation of Question (b), compute the price at time t of the
European call option on ST with strike price κ and maturity T , using a
series expansion of Black-Scholes functions.
λ > 0 under a probability measure P. Let (St )t∈R+ be the mean-reverting
process defined by the stochastic differential equation
dSt = −αSt dt + σ (dNt − βdt), (20.42)
where S0 > 0 and α, β > 0.

a) Solve the equation (20.42) for St .
b) Compute f (t) := E[St ] for all t ∈ R+ .
c) Under which condition on α, β, σ and λ does the process St become a
submartingale?
d) Propose a method for the calculation of expectations of the form E[φ(ST )]
where φ is a payoff function.
Exercise 20.13 Let (Nt )t∈[0,T ] be a standard Poisson process started at

N0 = 0, with intensity λ > 0 under the probability measure Pλ , and consider
the compound Poisson process (Yt )t∈[0,T ] with i.i.d. jump sizes (Zk )k>1 of
distribution ν (dx).
" 731
N. Privault
a) Under the probability measure Pλ , the process t 7→ Yt − λt(t + E[Z ]) is

a:
submartingale | martingale | supermartingale |
b) Consider the process (St )t∈[0,T ] given by
dSt = µSt dt + σSt− dYt .
Find λ
e such that the discounted process (Set )
t∈[0,T ] : = (e t t∈[0,T ] is
−rt S )
a martingale under the probability measure Pλ̃ defined by the Radon-

Nikodym density
!NT
dPλ̃ λ
:= e −(λ̃−λ)T
e
.
dPλ λ
with respect to Pλ .
c) Price the forward contract with payoff ST − κ.
Exercise 20.14 Consider (Yt )t∈R+ a compound Poisson process written as
Nt
X
Yt = Zk , t ∈ R+ ,
k =1
where (Nt )t∈R+ a standard Poisson process with intensity λ > 0 and (Zk )k>1
is an i.i.d family of random variables with probability distribution ν (dx) on
R, under a probability measure P. Let (St )t∈R+ be defined by the stochastic
dSt = µSt dt + St− dYt . (20.43)
b) We assume that µ, ν (dx) and the risk-free interest rate r > 0 are chosen
such that the discounted process ( e −rt St )t∈R+ is a martingale under P.
What relation does this impose on µ, ν (dx) and r?
c) Under the relation of Question (b), compute the price at time t of the
European call option on ST with strike price κ and maturity T , using a
series expansion of integrals.
Exercise 20.15 Consider a standard Poisson process (Nt )t∈[0,T ] with intensity
λ > 0 and a standard Brownian motion (Bt )t∈[0,T ] independent of (Nt )t∈[0,T ]
under the probability measure Pλ . Let also (Yt )t∈[0,T ] be a compound Poisson
process with i.i.d. jump sizes (Zk )k>1 of distribution ν (dx) under Pλ , and
consider the jump process (St )t∈[0,T ] solution of
e [ Z1 ] .

dSt = rSt dt + σSt dBt + ηSt− dYt − λtE
732 "
with r, σ, η, λ, λ
e > 0.
a) Assume that λ e = λ. Under the probability measure Pλ , the discounted

price process ( e −rt St )t∈[0,T ] is a:
b) Assume λ e > λ. Under the probability measure Pλ , the discounted price

process ( e −rt St )t∈[0,T ] is a:
c) Assume λ e < λ. Under the probability measure Pλ , the discounted price

process ( e −rt St )t∈[0,T ] is a:
d) Consider the probability measure P e defined by its Radon-Nikodym den-

λ̃
sity
!NT
dP λ
:= e −(λ̃−λ)T
e e
λ̃
.
dPλ λ
with respect to Pλ . Under the probability measure P

e , the discounted
λ̃
price process ( e −rt St )t∈[0,T ] is a:
" 733
Chapter 21
Pricing and Hedging in Jump Models
This chapter considers the pricing and hedging of financial derivatives using
discontinuous processes that can model sharp movements in asset prices. Un-
like in the case of continuous asset price modeling, uniqueness of risk-neutral
probability measures can be lost and, as a consequence, the computation of
perfect replicating hedging strategies may not be possible in general.
21.1 Fitting the Distribution of Market Returns . . . . . . 735

21.2 Risk-Neutral Probability Measures . . . . . . . . . . . . . . 744
21.3 Pricing in Jump Models . . . . . . . . . . . . . . . . . . . . . . . . 745
21.4 Exponential Lévy Models . . . . . . . . . . . . . . . . . . . . . . . 747
21.5 Black-Scholes PDE with Jumps . . . . . . . . . . . . . . . . . 750
21.6 Mean-Variance Hedging with Jumps . . . . . . . . . . . . . 753
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 757
21.1 Fitting the Distribution of Market Returns

The modeling of risky asset by stochastic processes with continuous paths,
based on Brownian motions, suffers from several defects. First, the path con-
tinuity assumption does not seem reasonable in view of the possibility of
sudden price variations (jumps) resulting of market crashes, gaps or opening
jumps, see e.g. Chapter 1 of Cont and Tankov (2004). Secondly, the modeling
of risky asset prices by Brownian motion relies on the use of the Gaussian
distribution which tends to underestimate the probabilities of extreme events.
The R package Quantmod is installed through the command:
The following scripts allow us to fetch DJI and STI index data using Quant-
mod. The command diff(log(stock)) computes log-returns
" 735
N. Privault
St+dt
d log St ' log St+dt − log St = log , t > 0,
St
with dt = 1/365, which are modeled by the stochastic differential equation
σ2
d log St = σdBt + rdt − dt
2
2 t/2
satisfied by geometric Brownian motion St = S0 e σBt +rt−σ , t > 0.
library(quantmod)
getSymbols("^STI",from="1990-01-03",to="2015-01-03",src="yahoo");stock=Ad(`STI`);
getSymbols("^DJI",from="1990-01-03",to=Sys.Date(),src="yahoo");stock=Ad(`DJI`);
stock.rtn=diff(log(stock));returns <- as.vector(stock.rtn)
m=mean(returns,na.rm=TRUE);s=sd(returns,na.rm=TRUE);times=index(stock.rtn)
n = sum(is.na(returns))+sum(!is.na(returns));x=seq(1,n);y=rnorm(n,mean=m,sd=s)
plot(times,returns,pch=19,xaxs="i",cex=0.03,col="blue", ylab="", xlab="", main = '')
segments(x0 = times, x1 = times, y0 = 0, y1 = returns,col="blue")
points(times,y,pch=19,cex=0.3,col="red")
abline(h = m+3*s, col="black", lwd =1);abline(h = m, col="black", lwd =1);abline(h =
m+-3*s, col="black", lwd =1)
length(returns[abs(returns-m)>3*s])/length(stock.rtn)
length(y[abs(y-m)>3*s])/length(y);2*(1-pnorm(3*s,0,s))
The next Figures 21.1-21.6 illustrate the mismatch between the distributional
properties of market log-returns vs standardized Gaussian returns, which tend
to underestimate the probabilities of extreme events. Note that when X '
N (0, σ 2 ), 99.73% of samples of X are falling within the interval [−3σ, +3σ ],
i.e. P(|X| 6 3σ ) = 0.9973002.
0.05
0.00
−0.05
1995 2000 2005 2010 2015
Fig. 21.1: Market returns vs normalized Gaussian returns.
736 "
stock.ecdf=ecdf(as.vector(stock.rtn));x <- seq(-0.25, 0.25, length=100);px <- pnorm((x-m)/s)

plot(stock.ecdf, xlab = 'Sample Quantiles', col="blue",ylab = '', main = '')
lines(x, px, type="l", lty=2, col="red",xlab="x value",ylab="Probability", main="")
legend("topleft", legend=c("Empirical CDF", "Gaussian CDF"),col=c("blue", "red"), lty=1:2,
cex=0.8)
1.0
Empirical CDF
Gaussian CDF
0.8
0.6
0.4
0.2
0.0
−0.15 −0.10 −0.05 0.00 0.05 0.10
Fig. 21.2: Empirical vs Gaussian CDF.
The following Quantile-Quantile graph is plotting the normalized empirical

quantiles against the standard Gaussian quantiles, and is obtained with the
qqnorm(returns) command.
Normal Q−Q Plot
0.10
0.05
Sample Quantiles
0.00
−0.05
−0.10
−3 −2 −1 0 1 2 3
Theoretical Quantiles
Fig. 21.3: Quantile-Quantile plot.
ks.test(y,"pnorm",mean=m,sd=s)
ks.test(returns,"pnorm",mean=m,sd=s)
The Kolmogorov-Smirnov test clearly rejects the null (normality) hypothesis.

" 737
N. Privault
One-sample Kolmogorov-Smirnov test
data: returns
D = 0.075577, p-value < 2.2e-16
alternative hypothesis: two-sided
This mismatch can be further illustrated by the empirical probability density

plot in Figure 21.4, which is obtained from the following R code.
x <- seq(-0.1, 0.1, length=100);qx <- dnorm(x,mean=m,sd=s)

returns.dens=density(stock.rtn,na.rm=TRUE)
dev.new(width=10, height=5)
plot(returns.dens, xlim=c(-0.1,0.1),xlab = 'x', lwd=3, col="red",ylab = '', main =
'',panel.first = abline(h = 0, col='grey', lwd =0.2), las=1, cex.axis=1.2, cex.lab=1.3)
lines(x, qx, type="l", lty=2, lwd=3, col="blue",xlab="x value",ylab="Density", main="")
legend("topleft", legend=c("Empirical density", "Gaussian density"),col=c("red", "blue"),
lty=1:2, cex=1.2)
Empirical density
60 Gaussian density
50
40
30
20
10
0
−0.10 −0.05 0.00 0.05 0.10
x
Fig. 21.4: Empirical density vs normalized Gaussian density.
The next code and graph present a comparison to a calibrated lognormal

distribution.
x <- seq(0, max(stock), length=100);qx <- dlnorm(x,mean=mean(log(stock)),
sd=sd(log(stock)))
stock.dens=density(stock,na.rm=TRUE);dev.new(width=10, height=5)
plot(stock.dens, xlab = 'x', lwd=3, col="red",ylab = '', main = '',panel.first = abline(h = 0,
col='grey', lwd =0.2), las=1, cex.axis=1, cex.lab=1, xaxs='i', yaxs='i')
lines(x, qx, type="l", lty=2, lwd=3, col="blue",xlab="x value",ylab="Density", main="")
legend("topright", legend=c("Empirical density", "Lognormal density"),col=c("red", "blue"),
lty=1:2, cex=1.2)
738 "
0.00012
Empirical density
Lognormal density
0.00010
0.00008
0.00006
0.00004
0.00002
5000 10000 15000 20000 25000 30000 35000
Fig. 21.5: Empirical density vs normalized lognormal density.
Power tail distributions
We note that the empirical density has significantly higher kurtosis and non
zero skewness in comparison with the Gaussian probability density. On the
other hand, power tail probability densities of the form ϕ(x) ' Cα /xα ,
x → ∞, can provide a better fit of empirical probability density functions,
as shown in Figure 21.6.
Empirical density
60 Power density
50
40
30
20
10
0
−0.10 −0.05 0.00 0.05 0.10
Fig. 21.6: Empirical density vs power density.
The above fitting of empirical probability density function is using a power

probability density function defined by a rational fraction obtained by the
following R script.
" 739
N. Privault
install.packages("pracma")
library(pracma); x <- seq(-0.25, 0.25, length=1000)
returns.dens=density(returns,na.rm=TRUE, from = -0.1, to = 0.1, n = 1000)
a<-rationalfit(returns.dens$x, returns.dens$y, d1=2, d2=2)
dev.new(width=10, height=5)
plot(returns.dens$x, returns.dens$y, lwd=3, type = "l",xlab = 'x', col="red",ylab = '', main
= '', panel.first = abline(h = 0, col='grey', lwd =0.2),las=1, cex.axis=1, cex.lab=1,
xaxs='i', yaxs='i')
lines(x,(a$p1[3]+a$p1[2]*x+a$p1[1]*x^2)/(a$p2[3]+a$p2[2]*x+a$p2[1]*x^2), type="l",
lty=2, lwd=3, col="blue",xlab="x value",ylab="Density", main="")
legend("topright", legend=c("Empirical density", "Power density"),col=c("red", "blue"),
lty=1:2, cex=1.2)
The output of the rationalfit command is

$p1
[1] -0.184717249 -0.001591433 0.001385017
$p2
[1] 1.000000e+00 -6.460948e-04 1.314672e-05
which yields a rational fraction of the form
0.001385017 − 0.001591433 × x − 0.184717249 × x2

x 7−→
1.314672 10−5 − 6.460948 10−4 × x + x2
0.001591433 0.001385017
' −0.184717249 − + ,
x x2
which approximates the empirical probability density function of DJI returns
in the least squares sense.
A solution to this tail problem is to use stochastic processes with jumps, that
will account for sudden variations of the asset prices. On the other hand,
such jump models are generally based on the Poisson distribution which has
a slower tail decay than the Gaussian distribution. This allows one to assign
higher probabilities to extreme events, resulting in a more realistic modeling
of asset prices. Stable distributions with parameter α ∈ (0, 2) provide typical
examples of probability laws with power tails, as their probability density
functions behave asymptotically as x 7→ Cα /|x|1+α when x → ±∞, see
Figure 20.12 for stable processes.
Edgeworth and Gram-Charlier expansions
Let
1 2
ϕ(x) := √ e −x /2 , x ∈ R,
2π
denote the standard normal density function, and let
wx
Φ (x) : = ϕ(y )dy, x ∈ R,
−∞
740 "
denote the standard normal cumulative distribution function. Let also

(−1)n ∂ n ϕ
Hn ( x ) : = (x), x ∈ R,
ϕ(x) ∂xn
denote the Hermite polynomial of degree n, with H0 (x) = 1.
Given X a random variable, the sequence (κX n )n>1 of cumulants of X

has been introduced in Thiele (1899). In the sequel we will use the Moment
Generating Function (MGF) of the random variable X, defined as
X tn
MX (t) := E e tX = 1 + E[X n ], t ∈ R. (21.1)

n!
n>1
Definition 21.1. The cumulants of a random variable X are defined to be

the coefficients (κX
n )n>1 appearing in the series expansion
 
X tn X tn
log E e = log 1 + E[X ] = , t ∈ R, (21.2)
tX n
κX
n
n! n!
n>1 n>1
of the logarithmic moment generating function (log-MGF) of X.

The cumulants of X were originally called “semi-invariants” due to the prop-
erty κX +Y = κX + κY , n > 1, when X and Y are independent random
n n n
variables. Indeed, in this case we have
+Y tn
= log E e t(X +Y )
X
κX

n
n!
n>1
= log E e tX E e tY

= log E e tX + log E e tY

X tn X t n
= κX
n + κYn
n! n!
n>1 n>1
X tn
= κX
n + κYn , t ∈ R,
n!
n>1
showing that κX +Y = κX + κY , n > 1.

n n n
a) First moment and cumulant. Taking n = 1 and π = {1}, we find κX
1 =
E[X ].
b) Variance and second cumulant. We have
2 =E X
κX − (E[X ])2 = E (X − E[X ])2 ,
2
q
and 2 is the standard deviation of X.
κX
" 741
N. Privault
c) The third cumulant of X is given as the third central moment
3 = E[(X − E[X ]) ],
κX 3
and the coefficient

E (X − E[X ])3

κX3
=
(κX
2 )
3/2 (E[(X − E[X ])2 ])3/2
is the skewness of X.
d) Similarly, we have
κX4 = E (X − E[X ]) − 3(κ2 )

4 X 2

2
= E (X − E[X ]) − 3 E (X − E[X ])2 ,
4

and the excess kurtosis of X is defined as

κX E[(X − E[X ])4 ]
4
= − 3.
(κX
2 ) 2 ( E [(X − E[X ])2 ])2
The next proposition summarizes the Gram-Charlier expansion method to

obtain series expansion of a probability density function, see Gram (1883),
Charlier (1914) and § 17.6 of Cramér (1946).
Proposition 21.2. (Proposition 2.1 in Tanaka et al. (2010)) The Gram-
Charlier expansion of the continuous probability density function φX (x) of a
random variable X is given by
     
∞
1 x − κX 1 X x − κX x − κX
φX ( x ) = q ϕ  q 1  + q cn Hn  q 1  ϕ  q 1  ,
κX2 κX
2 κX
2 n=3 κX
2 κX
2
where c0 = 1, c1 = c2 = 0, and the sequence (cn )n>3 is given from the

cumulants (κX
n )n>1 of X as
[n/3]
1 X X κX X
l1 · · · κlm
cn = , n > 3.
(κX
2 )
n/2
m=1 l1 +···+lm =n
m!l1 ! · · · lm !
l1 ,...,lm >3
The coefficients c3 and c4 can be expressed from the skweness κX X 3/2

3 / (κ2 )
and the excess kurtosis κX
4 / ( κX )2 as
2
κX κX
c3 = 3
and c4 = 4
.
3!(κX
2 )
3/2 4!(κX
2 )
2
a) The first-order expansion
742 "
 
(1) 1 x − κX
1
φX ( x ) =q ϕ q 
κX2 κX
2
corresponds to normal moment matching approximation.

b) The third-order expansion is given by
   
(3) 1 x − κX x − κX
φX (x) = q ϕ  q 1  1 + c3 H3  q 1 
κX2 κX
2 κX2
c) The fourth-order expansion is given by

     
(4) 1 x − κX
1 x
 1 + c3 H3  q − κX
1 x − κ X
1  .
φX ( x ) = q ϕ  q  + c 4 H4  q
κX2 κX
2 κX
2 κX
2
The next R code presents a fit of first to fourth order Gram-Charlier density
approximations to the empirical distribution of asset returns.
install.packages("SimMultiCorrData");install.packages("PDQutils")
library(SimMultiCorrData);library(PDQutils)
x <- seq(-0.25, 0.25, length=1000);dev.new(width=10, height=5)
plot(returns.dens$x, returns.dens$y, xlim=c(-0.1,0.1), xlab = 'x', type = 'l', lwd=3,
col="red",ylab = '', main = '',panel.first = abline(h = 0, col='grey', lwd =0.2),las=1,
cex.axis=1, cex.lab=1,xaxs='i', yaxs='i')
lines(x, qx, type="l", lty=2, lwd=3, col="blue")
m<-calc_moments(returns[!is.na(returns)])
cumulants<-c(m[1],m[2]**2);d2 <- dapx_edgeworth(x, cumulants)
lines(x, d2, type="l", lty=2, lwd=3, col="blue")
cumulants<-c(m[1],m[2]**2,m[3]*m[2]**3);d3 <- dapx_edgeworth(x, cumulants)
lines(x, d3, type="l", lty=2, lwd=3, col="green")
cumulants<-c(m[1],m[2]**2,0.5*m[3]*m[2]**3,0.2*m[4]*m[2]**4)
d4 <- dapx_edgeworth(x, cumulants);lines(x, d4, type="l", lty=2, lwd=3, col="purple")
legend("topleft", legend=c("Empirical density", "Gaussian density", "Third order
Gram-Charlier", "Fourth order Gram-Charlier"),col=c("red", "blue", "green",
"purple"), lty=1:2,cex=1.2)
grid()
" 743
N. Privault
Empirical density
60 Gaussian density
Third order Gram−Charlier
Fourth order Gram−Charlier
50
40
30
20
10
0
−0.10 −0.05 0.00 0.05 0.10
x
Fig. 21.7: Gram-Charlier expansions
21.2 Risk-Neutral Probability Measures

Consider an asset price process modeled by the equation,
dSt = µSt dt + σSt dBt + St− dYt , (21.3)
where (Yt )t∈R+ is the compound Poisson process defined in Section 20.2, with
jump size distribution ν (dx) under Pν . The equation (21.3) has for solution
Nt
σ2
Y
St = S0 exp µt + σBt − t ( 1 + Zk ) , (21.4)
2
k =1
t > 0. An important issue for non-abitrage pricing is to determine a risk-

neutral probability measure (or martingale measure) P∗ under which the
discounted asset price process (Sbt )t∈R+ := ( e −rt St )t∈R+ is a martingale, and
this goal can be achieved using the Girsanov Theorem for jump processes, cf.
Section 20.5. Similarly to Lemma 5.14, we have the following result.
Lemma 21.3. Discounting lemma. The discounted asset price process
Set := e −rt St , t > 0,
satisfies the equation
dSet = (µ − r )Set dt + σ Set dBt + e −rt Set− dYt . (21.5)
In addition, Equation 21.5 can be rewritten as
dSet = (µ − r + λ̃Eν̃ [Z ] − σu)Set dt + σ Set (dBt + udt) + Set− (dYt − λ̃Eν̃ [Z ]dt),
744 "
for any u ∈ R. When the drift parameter u, the intensity λ̃ > 0 and the jump
size distribution ν̃ are chosen to satisfy the condition
µ − r + λ̃Eν̃ [Z ] − σu = 0 (21.6)
with σu + r − µ > 0, then

σu + r − µ
λ̃ = > 0,
Eν̃ [Z ]
and the Girsanov Theorem 20.20 for jump processes shows that
dBt + udt + dYt − λ̃Eν̃ [Z ]dt
is a martingale under the probability measure P e

u,λ̃,ν̃ defined in Theo-
rem 20.20. As a consequence, the discounted price process (Set )t∈R+ =
( e −rt St )t∈R becomes a martingale is a martingale under P
+
e .u,λ̃,ν̃
In this setting, the non-uniqueness of the risk-neutral probability measure

P
e
u,λ̃,ν̃ is apparent since additional degrees of freedom are involved in the
choices of u, λ and the measure ν̃, whereas in the continuous case the choice
of u = (µ − r )/σ in (7.13) was unique.
21.3 Pricing in Jump Models

Recall that a market is without arbitrage if and only it admits at least one
Consider the probability measure P e

u,λ̃,ν̃ constructed in Theorem 20.20,
under which the discounted asset price process
bt + Sb − (dYt − λ̃Eν [Z ]dt),
dSbt = σ Sbt dB t
is a martingale, and B bt = Bt + ut is a standard Brownian motion under

P
e
u,λ̃,ν̃ . Then, the arbitrage-free price of a claim with payoff C is given by
e −(T −t)r Eu,λ̃,ν̃ [C | Ft ] (21.7)
under P
e
u,λ̃,ν̃ .
Clearly the price (21.7) of C is no longer unique in the presence of jumps

due to an infinity of possible choices of parameters u, λ̃, ν̃ satisfying the mar-
tingale condition (21.6), and such a market is not complete, except if either
λ̃ = λ = 0, or (σ = 0 and ν̃ = ν = δ1 ).
" 745
N. Privault
Various techniques can be used for the selection of a risk-neutral proba-

bility measure, such as the determination of a minimal entropy risk-neutral
probability measure Pe
u,λ̃,ν̃ that minimizes the Kullback-Leibler relative en-
tropy
dQ dQ

Q 7−→ I (Q, P) := E log
dP dP
among the probability measures Q equivalent to P.
Pricing vanilla options
The price of a vanilla option with payoff of the form φ(ST ) on the underlying
asset ST can be written from (21.7) as
e −(T −t)r Eu,λ̃,ν̃ [φ(ST ) | Ft ], (21.8)
where the expectation can be computed as

Eu,λ̃,ν̃ φ(ST ) | Ft
" NT
Y ! #
σ2

= Eu,λ̃,ν̃ φ S0 exp µT + σBT − T ( 1 + Zk ) Ft

2
k =1
" NT
Y ! #
σ2

= Eu,λ̃,ν̃ φ St exp ( T − t ) µ + ( BT − Bt ) σ − (T − t) ( 1 + Zk ) Ft

2
k = Nt + 1
" NT
Y !#
2
σ
= Eu,λ̃,ν̃ φ x exp ( T − t ) µ + ( BT − Bt ) σ − (T − t) ( 1 + Zk )
2
k =Nt +1 x = St
X
= Pu,λ̃,ν̃ (NT − Nt = n)
n>0
" NT
! #

(T −t)µ+(BT −Bt )σ−(T −t)σ 2 /2
Y
Eu,λ̃,ν̃ φ xe ( 1 + Zk ) NT − Nt = n

k =Nt +1 x = St
X ((T − t)λ̃)n
−(T −t)λ̃
= e
n!
n>0
" n
!#
2 Y
×Eu,λ̃,ν̃ φ x e (T −t)µ+(BT −Bt )σ−(T −t)σ /2
( 1 + Zk )
k =1 x = St
X (λ̃(T − t))n w ∞ w∞
−λ̃(T −t)
= e ···
n! |−∞ {z −∞
n>0 }
n times
" n
!#
(T −t)µ+(BT −Bt )σ−(T −t)σ 2 /2
Y
Eu,λ̃,ν̃ φ xe ( 1 + zk ) ν̃ (dz1 ) · · · ν̃ (dzn ),
k =1 x = St
746 "
hence the price of the vanilla option with payoff φ(ST ) is given by
e −(T −t)r Eu,λ̃,ν̃ [φ(ST ) | Ft ]

1 X (λ̃(T − t))n w ∞ w∞
= p e −(r +λ̃)(T −t) ···
2(T − t)π n>0
n! |
−∞
{z
−∞
}
n+1 times
n
!
2 /2 2
φ St e (T −t)µ+σx−(T −t)σ (1 + zk ) e −x /(2(T −t)) ν̃ (dz1 ) · · · ν̃ (dzn )dx.
Y
k =1
21.4 Exponential Lévy Models
Instead of modeling the asset price (St )t∈R+ through a stochastic exponential
(21.4) solution of the stochastic differential equation with jumps of the form
(21.3), we may consider an exponential price process of the form
St := S0 e µt+σBt +Yt
Nt
!
X
= S0 exp µt + σBt + Zk
k =1
Nt
= S0 e µt+σBt
Y
e Zk
k =1
= S0 e µt+σBt e ∆Yt ,
Y
t > 0,
06s6t
from Relation (20.9), i.e. ∆Yt = ZNt ∆Nt . The process (St )t∈R+ is equiva-
lently given by the log-return dynamics
d log St = µdt + σdBt + dYt , t > 0.
In the exponential Lévy model we also have

2 /2)t+σB −σ 2 t/2+Y
St = S0 e (µ+σ t t
and the process St satisfies the stochastic differential equation
σ2

dSt = µ + St dt + σSt dBt + St− ( e ∆Yt − 1)dNt
2
σ2

= µ+ St dt + σSt dBt + St− ( e ZNt − 1)dNt ,
2
hence the process St has jumps of size ST − ( e Zk − 1), k > 1, and (21.6) reads
k
" 747
N. Privault
σ2
µ+ − r = σu − λ̃Eν̃ [ e Z − 1].
2
Under this condition we can choose a risk-neutral probability measure P

e
u,λ̃,ν̃
under which ( e −rt St )t∈R+ is a martingale, and the expected value
e −(T −t)r Eu,λ̃,ν̃ [φ(ST ) | Ft ]
represents a (non-unique) arbitrage-free price at time t ∈ [0, T ] for the con-

tingent claim with payoff φ(ST ).
This arbitrage-free price can be expressed as
e −(T −t)r Eu,λ̃,ν̃ φ(ST ) Ft = e −(T −t)r Eu,λ̃,ν̃ φ(S0 e µT +σBT +YT ) Ft

= e −(T −t)r Eu,λ̃,ν̃ φ(St e (T −t)µ+(BT −Bt )σ +YT −Yt ) Ft

= e −(T −t)r Eu,λ̃,ν̃ φ(x e (T −t)µ+(BT −Bt )σ +YT −Yt ) x=S

t
   
NT
−(T −t)r
X
= e Eu,λ̃,ν̃ φ x exp (T − t)µ + (BT − Bt )σ +
   Zk 
k =Nt +1 x=St
−(T −t)r−(T −t)λ̃
= e
n
" !!#
X (λ̃(T − t))n
Eu,λ̃,ν̃ φ x e (T −t)µ+(BT −Bt )σ exp
X
× Zk .
n!
n>0 k =1 x=St
Merton model
We assume that (Zk )k>1 is a family of independent identically distributed

Gaussian N (δ, η 2 ) random variables under P
e
u,λ̃,ν̃ with
σ2 2
µ+ − r = σu − λ̃Eν̃ [ e Z − 1] = σu − λ̃( e δ +η /2 − 1),
2
as in (21.6), hence by the Girsanov Theorem 20.20 for jump processes, Bt +
ut + Yt − λ̃Eν̃ [ e Z − 1]t is a martingale and Bt + ut is a standard Brownian
motion under P e . For simplicity we choose u = 0, which yields
u,λ̃,ν̃
σ2 2
µ = r− − λ̃( e δ +η /2 − 1).
2
Proposition 21.4. The price of the European call option in the Merton
model is given by
748 "
e −(T −t)r Eλ̃,ν̃ [(ST − K )+ | Ft ]

δ +η 2 /2 (T −t) X (λ̃ e δ +nη2 /2 (T − t))n
= e −λ̃ e
n!
n>0
δ + η 2 /2

2
×Bl St , κ, σ + nη 2 /(T − t), r + n
2
− λ̃( e δ +η /2 − 1), T − t ,
T −t
0 6 t 6 T.
Proof. We have
e −(T −t)r Eλ̃,ν̃ [φ(ST ) | Ft ]

X ((T − t)λ̃)n
= e −(T −t)r−(T −t)λ̃
n!
n>0
n
" !!#
×Eλ̃,ν̃ φ x e (T −t)µ+(BT −Bt )σ exp
X
Zk
k =1 x = St
X ((T − t)λ̃)n
= e −(T −t)r−(T −t)λ̃ E φ(x e (T −t)µ+nδ +Xn ) x=S

n! t
n>0
X ((T − t)λ̃)n w ∞ e −y2 /(2((T −t)σ2 +nη2 ))
= e −(T −t)r−(T −t)λ̃ φ St e (T −t)µ+nδ +y p dy,
n>0
n! −∞ 4((T − t)σ 2 + nη 2 )π
where
n
X
Xn := (BT − Bt )σ + (Zk − δ ) ' N (0, (T − t)σ 2 + nη 2 ), n > 0,
k =1
is a centered Gaussian random variable with variance

n
X
vn2 := (T − t)σ 2 + Var Zk = (T − t)σ 2 + nη 2 .
k =1
Hence when φ(x) = (x − κ)+ is the payoff function of a European call option,
using the relation
2 +
Bl x, κ, vn2 /τ , r, τ = e −rτ E x e Xn −vn /2+rτ − K

we get
e −(T −t)r−(T −t)λ̃ Eλ̃,ν̃ [(ST − κ)+ | Ft ]

X ((T − t)λ̃)n +
= e −(T −t)r−(T −t)λ̃ E x e (T −t)µ+nδ +Xn − κ x = St
n!
n>0
" 749
N. Privault
X ((T − t)λ̃)n
= e −(T −t)r−(T −t)λ̃
n!
n>0
2 δ +η 2 /2 −1))(T −t)+nδ +X +
×E x e (r−σ /2−λ̃( e
n
−κ x=S t
X ((T − t)λ̃)n
−(T −t)r−(T −t)λ̃
= e
n!
n>0
2 δ +η 2 /2 −1)(T −t)+X −v 2 )n/2+(T −t)r +
×E x e nδ +nη /2−λ̃( e
n
−κ x=S t
X ((T − t)λ̃)n
= e −(T −t)λ̃
n!
n>0
2 /2
nδ +nη 2 /2−λ̃( e δ +η −1)(T −t)
×Bl St e , κ, σ 2 + nη 2 /(T − t), r, T − t .

We may also write
e −(T −t)r−(T −t)λ̃ Eλ̃,ν̃ [(ST − κ)+ | Ft ]

X ((T − t)λ̃)n 2 δ +η 2 /2 −1)(T −t)
= e −(T −t)λ̃ e nδ +nη /2−λ̃( e
n!
n>0

2 δ +η 2 /2 −1)(T −t)
×Bl St , κ e −nδ−nη /2+λ̃( e , σ 2 + nη 2 /(T − t), r, T − t
δ +η 2 /2 (T −t) X (λ̃ e δ +nη2 /2 (T − t))n

= e −λ̃ e
n!
n>0
δ + η 2 /2

2
×Bl St , κ, σ + nη 2 /(T − t), r + n
2
− λ̃( e δ +η /2 − 1), T − t .
T −t
21.5 Black-Scholes PDE with Jumps
In this section, we consider the asset price process (St )t∈R+ modeled by the
equation (21.3), i.e.
dSt = µSt dt + σSt dBt + St− dYt , (21.9)
where (Yt )t∈R+ is a compound Poisson process with jump size distribution
ν (dx). Recall that by the Markov property of (St )t∈R+ , the price (21.8) at
time t of the option with payoff φ(ST ) can be written as a function f (t, St )
of t and St , i.e.
f (t, St ) = e −(T −t)r Eu,λ̃,ν̃ [φ(ST ) | Ft ] = e −(T −t)r Eu,λ̃,ν̃ [φ(ST ) | St ],

(21.10)
750 "
with the terminal condition f (T , x) = φ(x). In addition, the process
t 7−→ e (T −t)r f (t, St )
is a martingale under P
e
u,λ̃,ν̃ by the same argument as in (7.1).
In the next proposition we derive a Partial Integro-Differential Equation

(PIDE) for the function (t, x) 7−→ f (t, x).
Proposition 21.5. The price f (t, St ) of the vanilla option with payoff func-
tion φ in the model (21.9) satisfies the Partial Integro-Differential Equation
(PIDE)
∂f ∂f σ2 ∂ 2 f
rf (t, x) = (t, x) + rx (t, x) + x2 2 (t, x)
∂t ∂x 2 ∂x
w∞ ∂f

+λ̃ f (t, x(1 + y )) − f (t, x) − yx (t, x) ν̃ (dy ),
−∞ ∂x
(21.11)
under the terminal condition f (T , x) = φ(x).

Proof. We have
bt + S − (dYt − λ̃Eν̃ [Z ]dt),
dSt = rSt dt + σSt dB (21.12)
t
where B bt = Bt + ut is a standard Brownian motion under P

e
u,λ̃,ν̃ . Next, by
the Itô formula with jumps (20.23), we have
df (t, St )
∂f ∂f ∂f 2 2
= (t, St )dt + rSt (t, St )dt + σSt (t, St )dB bt + σ S 2 ∂ f (t, St )dt
∂t ∂x ∂x 2 t ∂x2
∂f
− λ̃Eν̃ [Z ]St (t, St )dt + (f (t, St− (1 + ZNt )) − f (t, St− ))dNt
∂x
∂f bt + (f (t, S − (1 + ZN )) − f (t, S − ))dNt
= σSt (t, St )dB t t t
∂x
− λ̃Eν̃ [(f (t, x(1 + Z )) − f (t, x))]x=St dt
σ2 ∂ 2 f

∂f ∂f
+ (t, St ) + rSt (t, St ) + St2 2 (t, St ) dt
∂t ∂x 2 ∂x

∂f
+ λ̃Eν̃ [(f (t, x(1 + Z )) − f (t, x))]x=St − λ̃Eν̃ [Z ]St (t, St ) dt.
∂x
Based on the discounted portfolio value differential
d( e −rt f (t, St ))
" 751
N. Privault
∂f
= e −rt σSt (t, St )dB
bt
∂x
−rt
+e f (t, St− (1 + ZNt )) − f (t, St− ))dNt − λ̃Eν̃ [(f (t, x(1 + Z )) − f (t, x))]x=St dt

σ2 ∂ 2 f

∂f ∂f
+ e −rt −rf (t, St ) + (t, St ) + rSt (t, St ) + St2 2 (t, St ) dt
∂t ∂x 2 ∂x
(21.13)

∂f
+ e −rt λ̃Eν̃ [(f (t, x(1 + Z )) − f (t, x))]x=St − λ̃Eν̃ [Z ]St (t, St ) dt,
∂x
(21.14)
obtained from the Itô Table 20.1 with jumps, and the facts that
• the Brownian motion (B
bt )t∈R is a martingale under P
+
e
u,λ̃,ν̃ ,
• by the smoothing lemma Proposition 20.10, the process given by the dif-
ferential
(f (t, St− (1 + ZNt )) − f (t, St− ))dNt − λ̃Eν̃ [(f (t, x(1 + Z )) − f (t, x))]x=St dt,
is a martingale under P
e
u,λ̃,ν̃ , see also (20.22),
• the discounted portfolio value process t 7−→ e −rt f (t, St ), is also a martin-
gale under the risk-neutral probability measure P e
u,λ̃,ν̃ ,
we conclude to the vanishing of the terms (21.13)-(21.14) above, i.e.
∂f ∂f σ2 ∂ 2 f
−rf (t, St ) + (t, St ) + rSt (t, St ) + St2 2 (t, St )
∂t ∂x 2 ∂x
∂f
+λ̃Eν̃ [(f (t, x(1 + Z )) − f (t, x))]x=St − λ̃Eν̃ [Z ]St (t, St ) = 0,
∂x
or
∂f ∂f σ2 ∂ 2 f
(t, x) + rx (t, x) + x2 2 (t, x)
∂t ∂x 2 ∂x
w∞ ∂f w∞
+λ̃ (f (t, x(1 + y )) − f (t, x))ν̃ (dy ) − λ̃x (t, x) y ν̃ (dy ) = rf (t, x),
−∞ ∂x −∞
which leads to the Partial Integro-Differential Equation (21.11).

A major technical difficulty when solving the PIDE (21.11) numerically is
that the operator
w∞ ∂f

f 7−→ f (t, x(1 + y )) − f (t, x) − yx (t, x) ν̃ (dy )
−∞ ∂x
752 "
is nonlocal, therefore adding significant difficulties to the application of stan-

dard discretization schemes, cf. e.g. Section 22.2.
In addition, we have shown that the change df (t, St ) in the portfolio value
(21.10) is given by
∂f
df (t, St ) = σSt (t, St )dB
bt + rf (t, St )dt (21.15)
∂x
+(f (t, St− (1 + ZNt )) − f (t, St− ))dNt − λ̃Eν̃ [(f (t, x(1 + Z )) − f (t, x))]x=St dt.
Fixed jump size
In the case of Poisson jumps with fixed size a, i.e. when Yt = aNt and
ν (dx) = δa (dx), the PIDE (21.11) reads
∂f ∂f σ2 ∂ 2 f
rf (t, x) = (t, x) + rx (t, x) + x2 2 (t, x)
∂t ∂x 2 ∂x
∂f
+λ̃ f (t, x(1 + a)) − f (t, x) − ax (t, x) ,
∂x
and we have
∂f
df (t, St ) = σSt (t, St )dB
bt + rf (t, St )dt
∂x
+(f (t, St− (1 + a)) − f (t, St− ))dNt − λ̃(f (t, St (1 + a)) − f (t, St ))dt.
21.6 Mean-Variance Hedging with Jumps
Consider a portfolio valued
Vt := ηt At + ξt St = ηt e rt + ξt St
at time t ∈ R+ , and satisfying the self-financing condition (5.3), i.e.
dVt = ηt dAt + ξt dSt = rηt e rt dt + ξt dSt .
Assuming that the portfolio value takes the form Vt = f (t, St ) at all times
t ∈ [0, T ], by (21.12) we have
dVt = df (t, St )
= rηt e rt dt + ξt dSt
= rηt e rt dt + ξt (rSt dt + σSt dB
bt + S − (dYt − λ̃Eν̃ [Z ]dt))
t
= rVt dt + σξt St dBt + ξt St− (dYt − λ̃Eν̃ [Z ]dt)
b
bt + ξt S − (dYt − λ̃Eν̃ [Z ]dt),
= rf (t, St )dt + σξt St dB (21.16)
t
" 753
N. Privault
has to match
∂f
df (t, St ) = rf (t, St )dt + σSt (t, St )dB
bt (21.17)
∂x
+ (f (t, St− (1 + ZNt )) − f (t, St− ))dNt − λ̃Eν̃ [(f (t, x(1 + Z )) − f (t, x))]x=St dt,
which is obtained from (21.15).
In such a situation we say that the claim payoff C can be exactly replicated.
Exact replication is possible in essentially only two situations:
(i) Continuous market, λ = λ̃ = 0. In this case we find the usual Black-

Scholes Delta:
∂f
ξt = (t, St ). (21.18)
∂x
(ii) Poisson jump market, σ = 0 and Yt = aNt , ν (dx) = δa (dx). In this
case we find
1
ξt = (f (t, St− (1 + a)) − f (t, St− )). (21.19)
aSt−
Note that in the limit a → 0 this expression recovers the Black-Scholes

Delta formula (21.18).
When Conditions (i) or (ii) above are not satisfied, exact replication is not
possible, and this results into an hedging error given from (21.16) and (21.17)
by
VT − φ(ST ) = VT − f (T , ST )
wT wT
= V0 + dVt − f (0, S0 ) − df (t, St )
0 0
wT ∂f

= V0 − f (0, S0 ) + σ St ξt − (t, St ) dB
bt
0 ∂x
wT
+ ξt St− (ZNt dNt − λ̃Eν̃ [Z ]dt)
0
wT
− (f (t, St− (1 + ZNt )) − f (t, St− ))dNt
0
wT
+λ̃ Eν̃ [(f (t, x(1 + Z )) − f (t, x))]x=St dt.
0
Fixed jump size
Proposition 21.6. Assume that Yt = aNt , i.e. ν (dx) = δa (dx). The mean-
square hedging error is minimized by
754 "
V0 = f (0, S0 ) = e −rT Eu,λ̃,ν̃ [φ(ST )],
and
σ2 ∂f a2 λ̃ f (t, St− (1 + a)) − f (t, St− )

ξt = (t, St− ) + 2 × ,
σ2 2
+ a λ̃ ∂x σ + a2 λ̃ aSt−
(21.20)
t ∈ [0, T ].
Proof. We have
wT
∂f

VT − f (T , ST ) = V0 − f (0, S0 ) + σ St− ξt − (t, St− ) dB
bt
0 ∂x
wT
− (f (t, St− (1 + a)) − f (t, St− ) − aξt St− )(dNt − λ̃dt),
0
hence the mean-square hedging error is given by

2
Eu,λ̃ VT − f (T , ST )

w
" 2 #
T ∂f
= (V0 − f (0, S0 ))2 + σ 2 Eu,λ̃ St− ξt − (t, St− ) dB
bt
0 ∂x
w
" 2 #
T
+Eu,λ̃ (f (t, St− (1 + a)) − f (t, St− ) − aξt St− )(dNt − λ̃dt)
0
wT
" 2 #
∂f
= (V0 − f (0, S0 ))2 + σ 2 Eu,λ̃ St2−
ξt − (t, St− ) dt
0 ∂x
w
T 2
+λ̃Eu,λ̃ (f (t, St− (1 + a)) − f (t, St− ) − aξt St− ) dt ,
0
where we applied the Itô isometry (20.20). Clearly, the initial portfolio value
V0 minimizing the above quantity is
V0 = f (0, S0 ) = e −rT Eu,λ̃,ν̃ [φ(ST )].
Next, let us find the optimal portfolio strategy (ξt )t∈[0,T ] minimizing the
remaining hedging error
wT
" 2 ! #
∂f 2
Eu,λ̃ σ 2 St2− ξt − (t, St− ) + λ̃ (f (t, St− (1 + a)) − f (t, St− ) − aξt St− ) dt .
0 ∂x
For all t ∈ (0, T ], the almost-sure minimum of
" 755
N. Privault
2
∂f 2
ξt 7−→ σ 2 St2− ξt − (t, St− ) + λ̃ (f (t, St− (1 + a)) − f (t, St− ) − aξt St− )
∂x
is given by differentiation with respect to ξt , as the solution of

∂f
2σ 2 St2− ξt − (t, St− ) − 2aλ̃St− ((f (t, St− (1 + a)) − f (t, St− ) − aξt St− )) = 0,
∂x
i.e.
σ2 ∂f a2 λ̃ f (t, St− (1 + a)) − f (t, St− )
ξt = (t, St− ) + 2 × ,
σ 2 + a2 λ̃ ∂x σ + a2 λ̃ aSt−
t ∈ (0, T ].
When hedging only the risk generated by the Brownian part, we let
∂f
ξt = (t, St− )
∂x
as in the Black-Scholes model, and in this case the hedging error due to the
presence of jumps becomes
w
2 T 2
Eu,λ̃ VT − f (T , ST ) (f (t, St− (1 + a)) − f (t, St− ) − aξt St− ) dt ,

= λ̃Eu,λ̃
0
t ∈ (0, T ]. We note that the optimal strategy (21.20) is a weighted average of

the Brownian and jump hedging strategies (21.18) and (21.19) according to
the respective variance parameters σ 2 and a2 λ̃ of the continuous and jump
components.
Clearly, if aλ̃ = 0 we get

∂f
ξt = (t, St− ), t ∈ (0, T ],
∂x
which is the Black-Scholes perfect replication strategy, and when σ = 0 we
recover
f (t, (1 + a)St− ) − f (t, St− )
ξt = , t ∈ (0, T ].
aSt−
which is (21.19). See § 10.4.2 of Cont and Tankov (2004) for mean-variance
hedging in exponential Lévy model, and § 12.6 of Di Nunno et al. (2009) for
mean-variance hedging by the Malliavin calculus.
Note that the fact that perfect replication is not possible in a jump-
diffusion model can be interpreted as a more realistic feature of the model,
756 "
as perfect replication is not possible in the real world.
See Jeanblanc and Privault (2002) for an example of a complete market

model with jumps, in which continuous and jump noise are mutually exclud-
ing each other over time.
In Table 21.1 we summarize the properties of geometric Brownian motion

vs jump-diffusion models in terms of asset price and market behaviors.
Model
Geometric Brownian motion Jump-diffusion model Real world
Properties
Discontinuous asset prices 7 X X
Fat tailed market returns 7 X X
Complete market X 7 7
Unique prices and risk-neutral measure X 7 7
Table 21.1: Market models and their properties.
Exercises
Exercise 21.1 Consider a standard Poisson process (Nt )t∈R+ with inten-
dSt = rSt dt + ηSt− (dNt − αdt),
where η > 0.
a) Find the value of α ∈ R such that the discounted process ( e −rt St )t∈R+
b) Compute the price at time t ∈ [0, T ] of a power option with payoff |ST |2
at maturity T .
Exercise 21.2 Consider a long forward contract with payoff ST − K on a

jump diffusion risky asset (St )t∈R+ given by
dSt = µSt dt + σSt dBt + St− dYt .
a) Show that the forward claim admits a unique arbitrage-free price to be

computed in a market with risk-free rate r > 0.
b) Show that the forward claim admits an exact replicating portfolio strategy
based on the two assets St and e rt .
c) Recover portfolio strategy of Question (b) using the optimal portfolio
strategy formula (21.20).
" 757
N. Privault
Exercise 21.3 Consider (Bt )t∈R+ a standard Brownian motion and (Nt )t∈R+
a standard Poisson process with intensity λ > 0, independent of (Bt )t∈R+ ,
under a probability measure P∗ . Let (St )t∈R+ be defined by the stochastic
dSt = µSt dt + ηSt− dNt + σSt dBt . (21.21)

b) We assume that µ, η and the risk-free rate r > 0 are chosen such that the
discounted process ( e −rt St )t∈R+ is a martingale under P∗ . What relation
does this impose on µ, η, λ and r?
c) Under the relation of Question (b), compute the price at time t ∈ [0, T ]
of a European call option on ST with strike price κ and maturity T , using
a series expansion of Black-Scholes functions.
Exercise 21.4 Consider (Nt )t∈R+ a standard Poisson process with inten-
dSt = rSt dt + YNt St− dNt ,
where (Yk )k>1 is an i.i.d. sequence of uniformly distributed random variables

on [−1, 1].
a) Show that the discounted process ( e −rt St )t∈R+ is a martingale under P.
b) Compute the price at time 0 of a European call option on ST with strike
price κ and maturity T , using a series of multiple integrals.
Exercise 21.5 Consider a standard Poisson process (Nt )t∈R+ with inten-
dSt = rSt dt + YNt St− (dNt − αdt),
where (Yk )k>1 is an i.i.d. sequence of uniformly distributed random variables

on [0, 1].
a) Find the value of α ∈ R such that the discounted process ( e −rt St )t∈R+
b) Compute the price at time t ∈ [0, T ] of the long forward contract with
maturity T and payoff ST − κ.
Exercise 21.6 Consider (Nt )t∈R+ a standard Poisson process with intensity
λ > 0 under a risk-neutral probability measure P∗ . Let (St )t∈R+ be defined
by the stochastic differential equation
758 "
dSt = rSt dt + αSt− (dNt − λdt), (21.22)
where α > 0. Consider a portfolio with value
Vt = ηt e rt + ξt St
at time t ∈ [0, T ], and satisfying the self-financing condition
dVt = rηt e rt dt + ξt dSt .
We assume that the portfolio hedges a claim payoff C = φ(ST ), and that the
portfolio value can be written as a function Vt = f (t, St ) of t and St for all
times t ∈ [0, T ].
b) Price the claim C = φ(ST ) at time t ∈ [0, T ] using a series expansion.
c) Show that under self-financing, the variation dVt of the portfolio value Vt
satisfies
dVt = rf (t, St )dt + αξt St− (dNt − λdt). (21.23)
d) Show that the claim payoff C = φ(ST ) can be exactly replicated by the
hedging strategy
1
ξt = (f (t, St− (1 + α)) − f (t, St− )).
αSt−
Exercise 21.7 Pricing by the Esscher transform (Gerber and Shiu (1994)).
Consider a compound Poisson process (Yt )t∈[0,T ] with E e θ (Yt −Ys ) = e (t−s)m(θ ) ,
0 6 s 6 t, with m(θ ) a function of θ ∈ R, and the asset price process
St := e rt+Yt , t ∈ [0, T ]. Given θ ∈ R, let
e θYt
Nt : = = e θYt −tm(θ ) = Stθ e −rθt−tm(θ ) ,
E e θYt

and consider the probability measure Pθ defined as
dPθ|Ft NT
:= = e (YT −Yt )θ−(T −t)m(θ ) , 0 6 t 6 T.
dP|Ft Nt
a) Check that (Nt )t∈R+ is a martingale under P.

b) Find a condition on θ such that the discounted price process ( e −rt St )t∈[0,T ] =
e Yt t∈[0,T ] is a martingale under Pθ .

c) Price the European call option with payoff (ST − K )+ by taking Pθ as

" 759
Chapter 22
Basic Numerical Methods
Numerical methods in finance include finite difference methods, and statisti-

cal and Monte Carlo methods for computation of option prices and hedging
strategies. This chapter is a basic introduction to finite difference methods
for the resolution of PDEs and stochastic differential equations. We cover the
explicit and implicit finite difference schemes for the heat equations and the
Black-Scholes PDE, as well as the Euler and Milshtein schemes for stochastic
differential equations.
22.1 Discretized Heat Equation . . . . . . . . . . . . . . . . . . . . . . 761

22.2 Discretized Black-Scholes PDE . . . . . . . . . . . . . . . . . . 764
22.3 Euler Discretization . . . . . . . . . . . . . . . . . . . . . . . . . . . . 768
22.4 Milshtein Discretization . . . . . . . . . . . . . . . . . . . . . . . . 769
22.1 Discretized Heat Equation
Consider the heat equation
∂φ ∂2φ
(t, x) = (t, x) (22.1)
∂t ∂x2
with initial condition
φ(0, x) = f (x)
on a compact time-space interval [0, T ] × [0, X ].
The intervals [0, T ] and [0, X ] are respectively discretized according to

{t0 = 0, t1 , . . . , tN = T } and {x0 = 0, x1 , . . . , xM = X} with ∆t = T /N and
∆x = X/M , from which we construct a grid
(ti , xj ) = (i∆t, j∆x), i = 0, . . . , N , j = 0, . . . , M ,
" 761
N. Privault
on [0, T ] × [0, X ].
Our goal is to solve the heat equation (22.1) with initial condition φ(0, x),
x ∈ [0, X ], and lateral boundary conditions φ(t, 0), φ(t, X ), t ∈ [0, T ], via a
discrete approximation
(φ(ti , xj ))06i6N , 06j 6M
of the solution to (22.1), by evaluating derivatives using finite differences.
Explicit scheme
Using the forward time difference approximation
∂φ φ(ti+1 , xj ) − φ(ti , xj )
( ti , x ) '
∂t ∆t
of the time derivative, and the related space difference approximations
∂φ φ(t, xj ) − φ(ti , xj−1 ) ∂φ φ(t, xj +1 ) − φ(ti , xj ))

(t, xj ) ' , (t, xj +1 ) '
∂x ∆x ∂x ∆x
and
∂2φ 1 φ(ti , xj +1 ) + φ(ti , xj−1 ) − 2φ(ti , xj )

∂φ ∂φ
(t, xj ) ' (t, xj +1 ) − (t, xj ) =
∂x2 ∆x ∂x ∂x (∆x)2
of the time and space derivatives, we discretize (22.1) as
φ ( t i + 1 , xj ) − φ ( t i , xj ) φ(ti , xj +1 ) + φ(ti , xj−1 ) − 2φ(ti , xj )

= . (22.2)
∆t (∆x)2
Letting ρ = (∆t)/(∆x)2 , this yields
φ(ti+1 , xj ) = ρφ(ti , xj +1 ) + (1 − 2ρ)φ(ti , xj ) + ρφ(ti , xj−1 ),
1 6 j 6 M − 1, 1 6 i 6 N , i.e.
φ ( t i , x0 )
 
 0 
..
 
Φi+1 = AΦi + ρ  . , i = 0, 1, . . . , N − 1, (22.3)
 
0
 
 
φ ( t i , xM )
with
762 "
φ ( t i , x1 )
 
Φi =  ..
. , i = 0, 1, . . . , N ,
 
φ(ti , xM −1 )
and
1 − 2ρ ρ 0 0 0 0
 
···
 ρ 1 − 2ρ ρ ··· 0 0 0 
0 ρ 1 − 2ρ 0 0 0
 
 ··· 
.. .. .. .. .. .. ..
 
A= . . . . . . . .
 
0 0 0 · · · 1 − 2ρ ρ 0
 
 
0 0 0 · · · ρ 1 − 2ρ ρ
 
 
0 0 0 ··· 0 ρ 1 − 2ρ
The vector
φ(ti , x0 ) φ ( ti , 0 )
   
 0   0 
.. ..
   
. = . , i = 0, 1, . . . , N ,
   

0 0
   
   
φ(ti , xM ) φ ( ti , X )
in (22.3) can be given by the lateral boundary conditions φ(t, 0) and φ(t, X ).
From those boundary conditions and the initial data of
φ(0, x0 )
 
 φ(0, x1 ) 
..
 
Φ0 =  .
 

 φ(0, xM −1 ) 
 
φ(0, xM )
we can apply (22.3) in order to solve (22.2) recursively for Φ1 , Φ2 , Φ3 , . . .
Implicit scheme
Using the backward time difference approximation
∂φ φ(ti , xj ) − φ(ti−1 , xj )
( ti , x ) '
∂t ∆t
of the time derivative, we discretize (22.1) as
φ(ti , xj ) − φ(ti−1 , xj ) φ(ti , xj +1 ) + φ(ti , xj−1 ) − 2φ(ti , xj )

= (22.4)
∆t (∆x)2
and letting ρ = (∆t)/(∆x)2 we get
" 763
N. Privault
φ(ti−1 , xj ) = −ρφ(ti , xj +1 ) + (1 + 2ρ)φ(ti , xj ) − ρφ(ti , xj−1 ),
1 6 j 6 M − 1, 1 6 i 6 N , i.e.
φ ( t i , x0 )
 
 0 
..
 
Φi−1 = BΦi + ρ  . , i = 1, 2, . . . , N ,
 
0
 
 
φ ( t i , xM )
with
1 + 2ρ −ρ 0 ··· 0 0 0
 
 −ρ 1 + 2ρ −ρ · · · 0 0 0 
 0 −ρ 1 + 2ρ · · · 0 0 0 
 
 .. . . .. . . .
 
B= . .. .. . .. .. .. .
 0 0 0 1 2ρ 0
 
· · · + −ρ 
 0 0 0 · · · −ρ 1 + 2ρ −ρ 
 
0 0 0 ··· 0 −ρ 1 + 2ρ
By inversion of the matrix B, Φi is given in terms of Φi−1 as
φ ( t i , x0 )
 
 0 
.
 
−1
Φi = B Φi−1 − ρB  −1  .. ,

i = 1, . . . , N ,
0
 
 
φ(ti , xM )
which also allows for a recursive solution of (22.4).
22.2 Discretized Black-Scholes PDE

Consider the Black-Scholes PDE
∂φ ∂φ 1 ∂2φ
rφ(t, x) = (t, x) + rx (t, x) + x2 σ 2 2 (t, x), (22.5)
∂t ∂x 2 ∂x
under the terminal condition φ(T , x) = (x − K )+ , resp. φ(T , x) = (K − x)+ ,
for a European call, resp. put, option. The constant volatility coefficient σ
may also be replaced with a function σ (t, x) of the underlying asset price, in
the case local volatility models.
Note that in the solution of the Black-Scholes PDE, time is run backwards
as we start from a terminal condition φ(T , x) at time T . Thus here the ex-
plicit scheme uses backward differences while the implicit scheme uses forward
differences.
764 "
Explicit scheme
Using here the backward time difference approximation
∂φ φ(ti , xj ) − φ(ti−1 , xj )
( ti , x ) '
∂t ∆t
φ(ti , xj ) − φ(ti−1 , xj ) φ(ti , xj +1 ) − φ(ti , xj−1 )

rφ(ti , xj ) = + rxj
∆t 2∆x
1 2 2 φ(ti , xj +1 ) + φ(ti , xj−1 ) − 2φ(ti , xj )
+ xj σ , (22.6)
2 (∆x)2
1 6 j 6 M − 1, 0 6 i 6 N − 1, i.e.
1 2 2
φ(ti−1 , xj ) = (σ j − rj )φ(ti , xj−1 )∆t + φ(ti , xj )(1 − (σ 2 j 2 + r )∆t)
2
1
+ (σ 2 j 2 + rj )φ(ti , xj +1 )∆t,
2
1 6 j 6 M − 1, where the lateral boundary conditions φ(ti , 0) and φ(ti , xM )
are (approximately) given as follows.
European call options. We take the lateral boundary conditions

+
φ(ti , x0 ) = 0, and φ(ti , xM ) ' xM − K e −r (T −ti ) = xM − K e −r (T −ti ) ,
i = 0, 1, . . . , N , provided that xM is sufficiently large.
European put options. We take the lateral boundary conditions

+
φ(ti , x0 ) ' K e −(T −ti )r − x0 = K e −(T −ti )r , and φ(ti , xM ) = 0,
i = 0, 1, . . . , N , with here x0 = 0.
Given a terminal condition of the form
φ(T , xj ) = (xj − K )+ , resp. φ(T , xj ) = (K − xj )+ , j = 1, . . . , M − 1,
this allows us to solve (22.6) successively for
φ(tN −1 , xj ), φ(tN −2 , xj ), φ(tN −3 , xj ), . . . , φ(t1 , xj ), φ(t0 , xj ).
The explicit finite difference method is nevertheless known to have a divergent

behaviour as time is run backwards, as illustrated in Figure 22.1.
" 765
N. Privault
100
50
-50
-100
0.1 0.2 180 200
0.3 140 160
0.4 0.5 0.6 80 100 120
0.7 0.8 40 60
Time to maturity 0.9 20 Strike price
10
Fig. 22.1: Divergence of the explicit finite difference method.
Implicit scheme
Using the forward time difference approximation
∂φ φ(ti+1 , xj ) − φ(ti , xj )
( ti , x ) '
∂t ∆t
φ(ti+1 , xj ) − φ(ti , xj ) φ(ti , xj +1 ) − φ(ti , xj−1 )

rφ(ti , xj ) = + rxj (22.7)
∆t ∆x
1 φ ( t , x
i j +1 ) + φ ( t , x
i j−1 ) − 2φ ( t ,
i jx )
+ x2j σ 2 ,
2 (∆x)2
1 6 j 6 M − 1, 0 6 i 6 N − 1, i.e.
1
φ(ti+1 , xj ) = − (σ 2 j 2 − rj )φ(ti , xj−1 )∆t + φ(ti , xj )(1 + (σ 2 j 2 + r )∆t)
2
1
− (σ 2 j 2 + rj )φ(ti , xj +1 )∆t,
2
1 6 j 6 M − 1, i.e.
1
r − σ 2 φ(ti , x0 )∆t
 
2
 0 
..
 
Φi+1 = BΦi +  . ,
 
0
 
 
− 21 r (M − 1) + (M − 1)2 σ 2 φ(ti , xM )∆t

i = 0, 1, . . . , N − 1, with
766 "
1
rj − σ 2 j 2 ∆t, Bj,j = 1 + σ 2 j 2 ∆t + r∆t,

Bj,j−1 =
2
and
1
rj + σ 2 j 2 ∆t,

Bj,j +1 = −
2
for j = 1, 2, . . . , M − 1, and B (i, j ) = 0 otherwise.
By inversion of the matrix B, Φi is given in terms of Φi+1 as
2 r − σ φ(ti , x0 ) ∆t
1 2
 
 0 
..
 
Φi = B −1 Φi+1 − B −1  . ,
 
0
 
 
− 2 r (M − 1) + (M − 1) σ φ(ti , xM )∆t
1 2 2

i = 0, 1, . . . , N − 1, where the lateral boundary conditions φ(ti , x0 ) and

φ(ti , xM ) can be provided as in the case of the explicit scheme, allowing
us to solve (22.7) recursively for φ(tN −1 , xj ), φ(tN −2 , xj ), φ(tN −3 , xj ), . . .
Remark. Note that for all j = 1, 2, . . . , M − 1 we have
Bj,j−1 + Bj,j + Bj,j +1 = 1 + r∆t,
hence when the terminal condition is a constant φ(T , x) = c > 0 we get
T −(N −i)

φ(ti , x) = c(1 + r∆t)−(N −i) = c 1 + r , i = 0, . . . , N .
N
In particular, when the number N of discretization steps tends to infinity,

denoting by [x] the integer part of x ∈ R we find
φ(s, x) = lim φ t[N s/T ] , x

N →∞
T −(N −[N s/T ])

= c lim 1+r
N →∞ N
T −[N (T −s)/T ]

= c lim 1 + r
N →∞ N
T −(T −s)/T

= c lim 1 + r
N →∞ N
= c e −r (T −s) ,
for all s ∈ [0, T ], as expected.
" 767
N. Privault
The implicit finite difference method is known to be more stable than the
explicit scheme, as illustrated in Figure 22.2, in which the discretization pa-
rameters have been taken to be the same as in Figure 22.1.
140
120
100
80
60
40
20
0
0 1 180 200
2 3 140 160
4 5 80 100 120
6 7 60
8 9 20 40
Time to maturity 100 Strike price
Fig. 22.2: Stability of the implicit finite difference method.
22.3 Euler Discretization

In order to apply the Monte Carlo method in option pricing, we need to
generate a sequence (Xb1 , . . . , X
bN ) of sample values of a random variable X,
such that the empirical mean
φ(X
b1 ) + · · · + φ(X
bN )
E[φ(X )] '
N
can be used according to the strong law of large number for the evaluation
of the expected value E[φ(X )]. Despite its apparent simplicity, the Monte
Carlo method can converge slowly. The optimization of Monte Carlo algo-
rithms and of random number generators have been the object of numerous
studies which are outside the scope of this text, see, e.g., Glasserman (2004),
Korn et al. (2010).
Random samples for the solution of a stochastic differential equation of

the form
dXt = b(Xt )dt + a(Xt )dWt (22.8)
where (Wt )t∈R+ is a standard Brownian motion, can be generated by time
discretization on {t0 , t1 , . . . , tN }. This can be applied in particular to option
pricing with local volatility, see § 9.3.
More precisely, the Euler discretization scheme for the stochastic differen-
tial equation (22.8) is given by
768 "
w tk+1 w tk+1
btN = X
X btN + b(Xs )ds + a(Xs )dWs
k +1 k tk tk
' bN
Xtk
b N )(tk+1
+ b(Xtk
b N )(Wt
− tk ) + a(Xtk k +1
− Wtk ),
where Wtk+1 − Wtk ' N (0, tk+1 − Wtk ), k = 0, 1, . . . , N − 1.
In particular, when Xt is the geometric Brownian motion given by
dXt = rXt dt + σXt dWt
we get
btN = X
X k +1
btN + rX
k
btN (tk+1 − tk ) + σ X
k
btN (Wt
k k +1
− Wt k ) ,
which can be computed as

k
Y
btN = X
btN 1 + r (ti − ti−1 ) + (Wti − Wti−1 )σ , k = 0, 1, . . . , N .

X k 0
i=1
22.4 Milshtein Discretization
In the Milshtein scheme we use (22.8) to expand a(Xs ) as
a(Xs ) ' a(Xtk ) + a0 (Xtk )(Xs − Xtk )

' a(Xtk ) + a0 (Xtk ) b(Xtk )(s − tk ) + a(Xtk )(Ws − Wtk ) ,

0 6 tk < s. As a consequence, we get

wt wt
XbtN = X btN + k+1 b(Xs )ds + k+1 a(Xs )dWs
k +1 k tk tk
wt
btN + k+1 b(Xs )ds + a(Xt )(Wt
'X − Wtk )
k k k +1
tk
w tk+1
+a0 (Xtk )b(Xtk ) (s − tk )dWs
tk
w tk+1
+a0 (Xtk )a(Xtk ) (Ws − Wtk )dWs
tk
w tk+1
btN +
'X b(Xs )ds + a(Xtk )(Wtk+1 − Wtk )
k tk
w tk+1
+a0 (Xtk )a(Xtk ) (Ws − Wtk )dWs .
tk
Next, using Itô’s formula we note that

w tk+1 w tk+1
(Wtk+1 − Wtk )2 = 2 (Ws − Wtk )dWs + ds,
tk tk
" 769
N. Privault
hence
w tk+1 1
(Ws − Wtk )dWs = ((Wtk+1 − Wtk )2 − (tk+1 − tk )),
tk 2
and
w tk+1
btN ' X
X btN + b(Xs )ds + a(Xtk )(Wtk+1 − Wtk )
k +1 k tk
1
+ a0 (Xtk )a(Xtk )((Wtk+1 − Wtk )2 − (tk+1 − tk ))
2
btN + b(Xt )(tk+1 − tk ) + a(Xt )(Wt
'X − Wtk )
k k k k +1
1 0
+ a (Xtk )a(Xtk )((Wtk+1 − Wtk ) − (tk+1 − tk )).
2
2
As a consequence the Milshtein scheme is written as
btN ' X
X btN + b(X
btN )(tk+1 − tk ) + a(X
btN )(Wt − Wtk )
k +1 k k k k +1
1 0 bN
+ a (Xtk )a(X N
bt )((Wt − Wtk ) − (tk+1 − tk )),
2
2 k k +1
i.e. in the Milshtein scheme we take into account the “small” difference
(Wtk+1 − Wtk )2 − (tk+1 − tk )
existing between (∆Wt )2 and ∆t. Taking (∆Wt )2 equal to ∆t brings us back
to the Euler scheme.
When Xt is the geometric Brownian motion given by
dXt = rXt dt + σXt dWt
we get
1 bN
tk (Wtk+1 − Wtk ) ,
bN = X
X b N + (r − σ 2 /2)X
b N ( tk + 1 − tk ) + σ X
b N ( Wt − Wtk ) + σ 2 X 2
tk+1 tk tk tk k +1
2
which can be computed as
k
1
Y
btN = X
X btN 1 + (r − σ 2 /2)(ti − ti−1 ) + (Wti − Wti−1 )σ + (Wti − Wti−1 )2 σ 2 .
k 0
2
i=1
770 "
Appendix: Background on Probability
Theory
In this appendix, we review a number of basic probabilistic tools that can

be needed for option pricing and hedging. We refer the reader to Pitman
(1999) Jacod and Protter (2000), Devore (2003), for additional background
on probability theory.
23.1 Probability Sample Space and Events . . . . . . . . . . . . 771

23.2 Probability Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . 775
23.3 Conditional Probabilities and Independence . . . . . . 777
23.4 Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 779
23.5 Probability Distributions . . . . . . . . . . . . . . . . . . . . . . . 781
23.6 Expectation of Random Variables . . . . . . . . . . . . . . . 788
23.7 Conditional Expectation . . . . . . . . . . . . . . . . . . . . . . . . 800
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 805
23.1 Probability Sample Space and Events
We will need the following notation coming from set theory. Given A and
B to abstract sets, “A ⊂ B” means that A is contained in B, and in this
case, B \ A denotes the set of elements of B which do not belong to A. The
property that the element ω belongs to the set A is denoted by “ω ∈ A”,
and given two sets A and Ω such that A ⊂ Ω, we let Ac = Ω \ A denote
the complement of A in Ω. The finite set made of n elements ω1 , . . . , ωn is
denoted by {ω1 , . . . , ωn }, and we will usually distinguish between the element
ω and its associated singleton set {ω}.
A probability sample space is an abstract set Ω that contains the possible

outcomes of a random experiment.
Examples
i) Coin tossing: Ω = {H, T }.
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N. Privault
ii) Rolling one die: Ω = {1, 2, 3, 4, 5, 6}.
iii) Picking one card at random in a pack of 52: Ω = {1, 2, 3, . . . , 52}.
iv) An integer-valued random outcome: Ω = N = {0, 1, 2, . . .}.
In this case the outcome ω ∈ N can be the random number of trials

needed until some event occurs.
v) A nonnegative, real-valued outcome: Ω = R+ .
In this case the outcome ω ∈ R+ may represent the (nonnegative) value

of a continuous random time.
vi) A random continuous parameter (such as time, weather, price or wealth,

temperature, ...): Ω = R.
vii) Random choice of a continuous path in the space Ω = C (R+ ) of all

continuous functions on R+ .
In this case, ω ∈ Ω is a function ω : R+ −→ R and a typical example is

the graph t 7−→ ω (t) of a stock price over time.
Product spaces:
Probability sample spaces can be built as product spaces and used for the
modeling of repeated random experiments.
i) Rolling two dice: Ω = {1, 2, 3, 4, 5, 6} × {1, 2, 3, 4, 5, 6}.
In this case a typical element of Ω is written as ω = (k, l ) with

k, l ∈ {1, 2, 3, 4, 5, 6}.
ii) A finite number n of real-valued samples: Ω = Rn .
In this case the outcome ω is a vector ω = (x1 , . . . , xn ) ∈ Rn with n

components.
Note that to some extent, the more complex Ω is, the better it fits a practical
and useful situation, e.g. Ω = {H, T } corresponds to a simple coin tossing
experiment while Ω = C (R+ ) the space of continuous functions on R+ can
be applied to the modeling of stock markets. On the other hand, in many
cases and especially in the most complex situations, we will not attempt to
specify Ω explicitly.
772 "
Events
An event is a collection of outcomes, which is represented by a subset of

Ω. The collections G of events that we will consider are called σ-algebras,
according to the following definition.
Definition 23.1. A collection G of events is a σ-algebra provided that it
satisfies the following conditions:
(i) ∅ ∈ G,
[ all countable sequences (An )n>1 such that An ∈ G, n > 1, we have
(ii) For
An ∈ G,
n>1
(iii) A ∈ G =⇒ (Ω \ A) ∈ G,
where Ω \ A := {ω ∈ Ω : ω ∈
/ A}.
Note that Properties (ii) and (iii) above also imply
!c
\ [
An = Acn ∈ G, (23.9)
n>1 n>1
for all countable sequences An ∈ G, n > 1.
The collection of all events in Ω will often be denoted by F. The empty set
∅ and the full space Ω are considered as events but they are of less importance
because Ω corresponds to “any outcome may occur” while ∅ corresponds to
an absence of outcome, or no experiment.
In the context of stochastic processes, two σ-algebras F and G such that

F ⊂ G will refer to two different amounts of information, the amount of in-
formation associated to F being here lower than the one associated to G.
The formalism of σ-algebras helps in describing events in a short and precise

way.
Examples
i) Let Ω = {1, 2, 3, 4, 5, 6}.
The event A = {2, 4, 6} corresponds to
“the result of the experiment is an even number”.
ii) Taking again Ω = {1, 2, 3, 4, 5, 6},
F := {Ω, ∅, {2, 4, 6}, {1, 3, 5}}
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N. Privault
defines a σ-algebra on Ω which corresponds to the knowledge of parity

of an integer picked at random from 1 to 6.
Note that in the set-theoretic notation, an event A is a subset of Ω, i.e.

A ⊂ Ω, while it is an element of F, i.e. A ∈ F. For example, we have
Ω ⊃ {2, 4, 6} ∈ F, while {{2, 4, 6}, {1, 3, 5}} ⊂ F.
iii) Taking
G := {Ω, ∅, {2, 4, 6}, {2, 4}, {6}, {1, 2, 3, 4, 5}, {1, 3, 5, 6}, {1, 3, 5}} ⊃ F,
defines a σ-algebra on Ω which is bigger than F, and corresponds to

the parity information contained in F, completed by the knowledge of
whether the outcome is equal to 6 or not.
iv) Take
Ω = {H, T } × {H, T } = {(H, H ), (H, T ), (T , H ), (T , T )}.
In this case, the collection F of all possible events is given by
F = {∅, {(H, H )}, {(T , T )}, {(H, T )}, {(T , H )}, (23.10)
{(T , T ), (H, H )}, {(H, T ), (T , H )}, {(H, T ), (T , T )},
{(T , H ), (T , T )}, {(H, T ), (H, H )}, {(T , H ), (H, H )},
{(H, H ), (T , T ), (T , H )}, {(H, H ), (T , T ), (H, T )},
{(H, T ), (T , H ), (H, H )}, {(H, T ), (T , H ), (T , T )}, Ω} .
Note that the set F of all events considered in (23.10) above has altogether

n
1= event of cardinality 0,
0

n
4= events of cardinality 1,
1

n
2

n
3

n
1= event of cardinality 4,
4
with n = 4, for a total of
4
X 4
16 = 2n = = 1+4+6+4+1
k
k =0
774 "
events. The collection of events
G := {∅, {(T , T ), (H, H )}, {(H, T ), (T , H )}, Ω}
defines a sub σ-algebra of F, associated to the information “the results of

two coin tossings are different”.
Exercise: Write down the set of all events on Ω = {H, T }.
Note also that (H, T ) is different from (T , H ), whereas {(H, T ), (T , H )} is

equal to {(T , H ), (H, T )}.
In addition, we will distinguish between the outcome ω ∈ Ω and its associated

event {ω} ∈ F, which satisfies {ω} ⊂ Ω.
23.2 Probability Measures
Definition 23.2. A probability measure is a mapping P : F −→ [0, 1] that

assigns a probability P(A) ∈ [0, 1] to any event A ∈ F, with the properties
a) P(Ω) = 1, and
 
[ X
b) P  An  = P(An ), whenever Ak ∩ Al = ∅, k 6= l.
n>1 n>1
Property (b) above is named the law of total probability. It states in particular
that we have
P ( A1 ∪ · · · ∪ An ) = P ( A1 ) + · · · + P ( An )
when the subsets A1 , . . . , An of Ω are disjoints, and
P(A ∪ B ) = P(A) + P(B ) (23.11)
if A ∩ B = ∅. We also have the complement rule
P ( Ac ) = P ( Ω \ A ) = P ( Ω ) − P ( A ) = 1 − P ( A ) .
When A and B are not necessarily disjoint we can write
P(A ∪ B ) = P(A) + P(B ) − P(A ∩ B ).
The triple
(Ω, F, P) (23.12)
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N. Privault
is called a probability space, and was introduced by A.N. Kolmogorov (1903-

1987). This setting is generally referred to as the Kolmogorov framework.
A property or event is said to hold P-almost surely (also written P-a.s.) if

it holds with probability equal to one.
Example
Take
Ω = (T , T ), (H, H ), (H, T ), (T , H )

and
F = {∅, {(T , T ), (H, H )}, {(H, T ), (T , H )}, Ω} .
The uniform probability measure P on (Ω, F ) is given by setting
1 1
P({(T , T ), (H, H )}) := and P({(H, T ), (T , H )}) := .
2 2
In addition, we have the following convergence properties.
1. Let (An )n∈N be a non-decreasing sequence of events, i.e. An ⊂ An+1 ,

n > 0. Then we have
!
[
P An = lim P(An ). (23.13)
n→∞
n∈N
2. Let (An )n∈N be a non-increasing sequence of events, i.e. An+1 ⊂ An ,

n > 0. Then we have
!
\
P An = lim P(An ). (23.14)
n→∞
n∈N
Theorem 23.3. Borel-Cantelli Lemma. Let (An )n>1 denote a sequence of

events on (Ω, F, P), such that
X
P(An ) < ∞.
n>1
Then we have \ [
P Ak = 0,
n>1 k>n
i.e. the probability that An occurs infinitely many times occur is zero.
Proposition 23.4. (Fatou’s lemma) Let (Fn )n∈N be a sequence of nonneg-
ative random variable. Then we have
776 "
E lim inf Fn 6 lim inf E[Fn ].

n→∞ n→∞
In particular, Fatou’s lemma shows that if in addition the sequence (Fn )n∈N
converges with probability one and the sequence (E[Fn ])n∈N converges in R
then we have
E lim Fn 6 lim E[Fn ].

n→∞ n→∞
23.3 Conditional Probabilities and Independence
We start with an example.
Consider a population Ω = M ∪ W made of a set M of men and a set W of

women. Here the σ-algebra F = {Ω, ∅, W , M } corresponds to the information
given by gender. After polling the population, e.g. for a market survey, it turns
out that a proportion p ∈ [0, 1] of the population declares to like apples, while
a proportion 1 − p declares to dislike apples. Let A ⊂ Ω denote the subset
of individuals who like apples, while Ac ⊂ Ω denotes the subset individuals
who dislike apples, with
p = P(A) and 1 − p = P ( Ac ) ,
e.g. p = 60% of the population likes apples. It may be interesting to get a

more precise information and to determine
P(A ∩ W )
- the relative proportion of women who like apples, and
P(W )
P(A ∩ M )
- the relative proportion of men who like apples.
P(M )
Here, P(A ∩ W )/P(W ) represents the probability that a randomly chosen
woman in W likes apples, and P(A ∩ M )/P(M ) represents the probability
that a randomly chosen man in M likes apples. Those two ratios are inter-
preted as conditional probabilities, for example P(A ∩ M )/P(M ) denotes
the probability that a given individual likes apples given that he is a man.
For another example, suppose that the population Ω is split as Ω = Y ∪ O

into a set Y of “young” people and another set O of “old” people, and denote
by A ⊂ Ω the set of people who voted for candidate A in an election. Here
it can be of interest to find out the relative proportion
P(Y ∩ A)
P(A | Y ) =
P(Y )
of young people who voted for candidate A.
More generally, given any two events A, B ⊂ Ω with P(B ) 6= 0, we call

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N. Privault
P(A ∩ B )
P(A | B ) : =
P(B )
the probability of A given B, or conditionally to B.

Remark 23.5. We note that if P(B ) = 1 we have P(A ∩ B c ) 6 P(B c ) = 0,
hence P(A ∩ B c ) = 0, which implies
P(A) = P(A ∩ B ) + P(A ∩ B c ) = P(A ∩ B ),
and P(A | B ) = P(A).

We also recall the following property:
!
[ X
P B∩ An = P ( B ∩ An )
n>1 n>1
X
= P ( B | An ) P ( An )
n>1
X
= P ( An | B ) P ( B ) ,
n>1
for any family of disjoint events (An )n>1 with Ai ∩ Aj = ∅, i 6= j, and

P(B ) > 0, n > 1. This also shows that conditional probability measures are
probability measures, in the sense that whenever P(B ) > 0 we have
a) P(Ω | B ) = 1, and
!
[ X
b) P P(An | B ), whenever Ak ∩ Al = ∅, k 6= l.

An B =
n>1 n>1
[
In particular, if An = Ω, (An )n>1 becomes a partition of Ω and we get
n>1
the law of total probability
X X X
P(B ) = P ( B ∩ An ) = P ( An | B ) P ( B ) = P ( B | An ) P ( An ) ,
n>1 n>1 n>1
(23.15)
provided that Ai ∩ Aj = ∅, i 6= j, and P(B ) > 0, n > 1. However, in general
we have [ !
X
P A P ( A | Bn ) ,

Bn 6=
n>1 n>1
even when Bk ∩ Bl = ∅, k 6= l. Indeed, taking for example A = Ω = B1 ∪ B2

with B1 ∩ B2 = ∅ and P(B1 ) = P(B2 ) = 1/2, we have
1 = P(Ω | B1 ∪ B2 ) 6= P(Ω | B1 ) + P(Ω | B2 ) = 2.

778 "
Independent events
Two events A and B such that P(A), P(B ) > 0 are said to be independent if
P(A | B ) = P(A),
which is equivalent to
P(A ∩ B ) = P(A)P(B ).
In this case we find

P(A | B ) = P(A).
23.4 Random Variables

A real-valued random variable is a mapping
X : Ω −→ R
ω 7−→ X (ω )
from a probability sample space Ω into the state space R. Given
X : Ω −→ R
a random variable and A a (measurable)∗ subset of R, we denote by {X ∈ A}

the event
{X ∈ A} := {ω ∈ Ω : X (ω ) ∈ A}.
Examples
i) Let Ω := {1, 2, 3, 4, 5, 6} × {1, 2, 3, 4, 5, 6}, and consider the mapping
X : Ω −→ R
(k, l ) 7−→ k + l.
Then X is a random variable giving the sum of the two numbers appear-
ing on each die.
ii) the time needed everyday to travel from home to work or school is a
random variable, as the precise value of this time may change from day
to day under unexpected circumstances.
iii) the price of a risky asset is modeled using a random variable.
∗
Measurability of subsets of R refers to Borel measurability, a concept which will not
be defined in this text.
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N. Privault
In the sequel we will often use the notion of indicator function 1A of an event
A ⊂ Ω.
Definition 23.6. For any A ⊂ Ω, the indicator function 1A is the random
variable
1A : Ω −→ {0, 1}
ω 7−→ 1A (ω )
defined by
1 if ω ∈ A,

1A (ω ) = 0 if ω ∈/ A.
Indicator functions satisfy the property
1A∩B (ω ) = 1A (ω )1B (ω ), (23.16)
since
ω ∈ A ∩ B ⇐⇒ {ω ∈ A and ω ∈ B}
⇐⇒ {1A (ω ) = 1 and 1B (ω ) = 1}
⇐⇒ 1A (ω )1B (ω ) = 1.
We also have
1A∪B = 1A + 1B − 1A∩B = 1A + 1B − 1A 1B ,
and
1A∪B = 1A + 1B , (23.17)
if A ∩ B = ∅.
For example, if Ω = N and A = {k}, for all l > 0 we have
 1 if k = l,

1{k} (l) =
0 if k 6= l.

Given X a random variable, we also let
 1 if X = n,

1{X =n} =
0 if X 6= n,

and
 1 if X < n,

1{X<n} =
0 if X > n.

780 "
23.5 Probability Distributions

The probability distribution of a random variable X : Ω −→ R is the collection
{P(X ∈ A) : A is a measurable subset of R}.
As the collection of measurable subsets of R coincides with the σ-algebra

generated by the intervals in R, the distribution of X can be reduced to the
knowledge of either
{P(a < X 6 b) = P(X 6 b) − P(X 6 a) : a a) : a ∈ R},
see e.g. Corollary 3.8 in Çınlar (2011).
Two random variables X and Y are said to be independent under the

probability P if their probability distributions satisfy
P(X ∈ A , Y ∈ B ) = P(X ∈ A)P(Y ∈ B )
for all (measurable) subsets A and B of R.
Distributions admitting a density
We say that the distribution of X admits a probability density distribution

function ϕX : R −→ R+ if, for all a 6 b, the probability P(a 6 X 6 b) can
be written as wb
P(a 6 X 6 b) = ϕX (x)dx.
a
We also say that the distribution of X is absolutely continuous, or that X
is an absolutely continuous random variable. This, however, does not imply
that the density function ϕX : R −→ R+ is continuous.
In particular, we always have

w∞
ϕX (x)dx = P(−∞ 6 X 6 ∞) = 1
−∞
for all probability density functions ϕX : R −→ R+ .
Remark 23.7. Note that if the distribution of X admits a probability density

function ϕX , then for all a ∈ R we have
wa
P(X = a) = ϕX (x)dx = 0, (23.18)
a
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N. Privault
and this is not a contradiction.

In particular, Remark 23.7 shows that
P(a 6 X 6 b) = P(X = a) + P(a < X 6 b) = P(a < X 6 b) = P(a < X < b),
for a 6 b. Property (23.18) appears for example in the framework of lottery

games with a large number of participants, in which a given number “a” se-
lected in advance has a very low (almost zero) probability to be chosen.
The probability density function ϕX can be recovered from the cumulative

distribution functions
wx
x 7−→ FX (x) := P(X 6 x) = ϕX (s)ds,
−∞
and w∞
x 7−→ 1 − FX (x) = P(X > x) = ϕX (s)ds,
x
as
∂FX ∂ wx ∂ w∞
ϕX (x) = (x) = ϕX (s)ds = − ϕX (s)ds, x ∈ R.
∂x ∂x −∞ ∂x x
Examples
i) The uniform distribution on an interval.
The probability density function of the uniform distribution on the in-

terval [a, b], a < b, is given by
1
ϕ(x) = 1 (x), x ∈ R.
b − a [a,b]
ii) The Gaussian distribution.
The probability density function of the standard normal distribution is

given by
1 2
ϕ(x) = √ e −x /2 , x ∈ R.
2π
More generally, the probability density function of the Gaussian distri-
bution with mean µ ∈ R and variance σ 2 > 0 is given by
1 2 / (2σ 2 )
ϕ(x) : = √ e −(x−µ) , x ∈ R.
2πσ 2
In this case, we write X ' N (µ, σ 2 ).
782 "
iii) The exponential distribution.
The probability density function of the exponential distribution with

parameter λ > 0 is given by
 λ e −λx , x > 0

ϕ(x) := λ1[0,∞) (x) e −λx

= (23.19)
0, x < 0.

We also have
P(X > t) = e −λt , t > 0. (23.20)
iv) The gamma distribution.
The probability density function of the gamma distribution is given by

 λ
a
xλ−1 e −ax , x > 0

λ

1[0,∞) (x)xλ−1 e −ax = Γ(λ)
a 
ϕ(x) : =
Γ (λ) 
0, x < 0,


where a > 0 and λ > 0 are parameters, and

w∞
Γ (λ) : = xλ−1 e −x dx, λ > 0,
0
is the gamma function.
v) The Cauchy distribution.
The probability density function of the Cauchy distribution is given by

1
ϕ(x) : = , x ∈ R.
π ( 1 + x2 )
vi) The lognormal distribution.
The probability density function of the lognormal distribution is given

by
 1 −(µ−log x)2 /(2σ 2 )
1  √ e
 , x>0
ϕ(x) := 1[0,∞) (x) √ e −(µ−log x)2 /(2σ 2 )
= xσ 2π
xσ 2π 
0, x < 0.

Exercise: For each of the above probability density functions ϕ, check that
the condition
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N. Privault
w∞
ϕ(x)dx = 1
−∞
is satisfied.
Joint densities
Given two absolutely continuous random variables X : Ω −→ R and Y :

Ω −→ R we can form the R2 -valued random variable (X, Y ) defined by
(X, Y ) : Ω −→ R2
ω 7−→ (X (ω ), Y (ω )).
We say that (X, Y ) admits a joint probability density
ϕ(X,Y ) : R2 −→ R+
when w w
P((X, Y ) ∈ A × B ) = ϕ(X,Y ) (x, y )dxdy
B A
for all measurable subsets A, B of R, cf. Figure 23.1.
0.1
0
-1
0
x
1 1 1.5
-0.5 0 0.5
-1 y
Fig. 23.1: Probability P((X, Y ) ∈ [−0.5, 1] × [−0.5, 1]) computed as a volume integral.
The probability density function ϕ(X,Y ) can be recovered from the joint cu-
mulative distribution function
wx wy
(x, y ) 7−→ F(X,Y ) (x, y ) := P(X 6 x and Y 6 y ) = ϕ(X,Y ) (s, t)dsdt,
−∞ −∞
and
w∞w∞
(x, y ) 7−→ P(X > x and Y > y ) = ϕ(X,Y ) (s, t)dsdt,
x y
as
784 "
∂2
ϕ(X,Y ) (x, y ) = F (x, y ) (23.21)
∂x∂y (X,Y )
∂ 2 w x w y
= ϕ (s, t)dsdt (23.22)
∂x∂y −∞ −∞ (X,Y )
∂2 w w
∞ ∞
= ϕ(X,Y ) (s, t)dsdt,
∂x∂y x y
x, y ∈ R.
The probability densities ϕX : R −→ R+ and ϕY : R −→ R+ of X : Ω −→ R

and Y : Ω −→ R are called the marginal densities of (X, Y ), and are given
by w∞
ϕX (x) = ϕ(X,Y ) (x, y )dy, x ∈ R, (23.23)
−∞
and w∞
ϕY ( y ) = ϕ(X,Y ) (x, y )dx, y ∈ R.
−∞
The conditional probability density ϕX|Y =y : R −→ R+ of X given Y = y is
defined by
ϕ(X,Y ) (x, y )
ϕX|Y =y (x) := , x, y ∈ R, (23.24)
ϕY ( y )
provided that ϕY (y ) > 0. In particular, X and Y are independent if and only
if ϕX|Y =y (x) = ϕX (x), x, y ∈ R, i.e.,
ϕ(X,Y ) (x, y ) = ϕX (x)ϕY (y ), x, y ∈ R.
Example
If X1 , . . . , Xn are independent exponentially distributed random variables
with parameters λ1 , . . . , λn we have
P(min(X1 , . . . , Xn ) > t) = P(X1 > t, . . . , Xn > t)

= P(X1 > t) · · · P(Xn > t)
= e −(λ1 +···+λn )t , t > 0, (23.25)
hence min(X1 , . . . , Xn ) is an exponentially distributed random variable with

parameter λ1 + · · · + λn .
From the joint probability density function of (X1 , X2 ) given by
ϕ(X1 ,X2 ) (x, y ) = ϕX1 (x)ϕX2 (y ) = λ1 λ2 e −λ1 x−λ2 y , x, y > 0,
we can write
P(X1 < X2 ) = P(X1 6 X2 )
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N. Privault
w∞wy
= ϕ(X1 ,X2 ) (x, y )dxdy
0
w0 ∞ w y
= λ1 λ2 e −λ1 x−λ2 y dxdy
0 0
λ1
= , (23.26)
λ1 + λ2
and we note that
w
P(X1 = X2 ) = λ1 λ2 e −λ1 x−λ2 y dxdy = 0.
{(x,y )∈R2+ : x=y}
Discrete distributions
We only consider integer-valued random variables, i.e. the distribution of X

is given by the values of P(X = k ), k > 0.
Examples
i) The Bernoulli distribution.
We have
P(X = 1) = p and P(X = 0) = 1 − p, (23.27)
where p ∈ [0, 1] is a parameter.
Note that any Bernoulli random variable X : Ω −→ {0, 1} can be written

as the indicator function
X = 1A
on Ω with A = {X = 1} = {ω ∈ Ω : X (ω ) = 1}.
ii) The binomial distribution.
We have

n k
P(X = k ) = p (1 − p)n−k , k = 0, 1, . . . , n,
k
where n > 1 and p ∈ [0, 1] are parameters.
iii) The geometric distribution.
In this case, we have
P(X = k ) = (1 − p)pk , k > 0, (23.28)
786 "
where p ∈ (0, 1) is a parameter. For example, if (Xk )k∈N is a sequence of

independent Bernoulli random variables with distribution (23.27), then
the random variable,∗
T0 := inf{k > 0 : Xk = 0}
can denote the duration of a game until the time that the wealth Xk of a
player reaches 0. The random variable T0 has the geometric distribution
(23.28) with parameter p ∈ (0, 1).
iv) The negative binomial (or Pascal) distribution.
We have
k+r−1

P(X = k ) = (1 − p)r pk , k > 0, (23.29)
r−1
where p ∈ (0, 1) and r > 1 are parameters. Note that the sum of r > 1
independent geometric random variables with parameter p has a negative
binomial distribution with parameter (r, p). In particular, the negative
binomial distribution recovers the geometric distribution when r = 1.
v) The Poisson distribution.
We have
λk −λ
P(X = k ) = e , k > 0,
k!
where λ > 0 is a parameter.
The probability that a discrete nonnegative random variable X : Ω −→
N ∪ {+∞} is finite is given by
X
P(X < ∞) = P(X = k ), (23.30)
k>0
and we have
X
1 = P(X = ∞) + P(X < ∞) = P(X = ∞) + P(X = k ).
k >0
Remark 23.8. The distribution of a discrete random variable cannot admit

a probability density. If this were the case, by Remark 23.7 we would have
P(X = k ) = 0 for all k > 0 and
∗
The notation “inf” stands for “infimum”, meaning the smallest n > 0 such that
Xn = 0, if such an n exists.
" 787
N. Privault
X
1 = P(X ∈ R) = P(X ∈ N) = P(X = k ) = 0,
k>0
which is a contradiction.
Given two discrete random variables X and Y , the conditional distribution
of X given Y = k is given by
P(X = n and Y = k )
P(X = n | Y = k ) = , n > 0,
P(Y = k )
provided that P(Y = k ) > 0, k > 0.
23.6 Expectation of Random Variables
The expectation, or expected value, of a random variable X is the mean, or

average value, of X. In practice, expectations can be even more useful than
probabilities. For example, knowing that a given equipment (such as a bridge)
has a failure probability of 1.78493 out of a billion can be of less practical
use than knowing the expected lifetime (e.g. 200000 years) of that equipment.
For example, the time T (ω ) to travel from home to work/school can be a

random variable with a new outcome and value every day, however we usually
refer to its expectation E[T ] rather than to its sample values that may change
from day to day.
Expected value of a Bernoulli random variable
Any Bernoulli random variable X : Ω −→ {0, 1} can be written as the

indicator function X := 1A where A is the event A = {X = 1}, and the
parameter p ∈ [0, 1] of X is given by
p = P ( X = 1 ) = P ( A ) = E [ 1A ] = E [ X ] .
The expectation of a Bernoulli random variable with parameter p is defined

as
E [ 1 A ] : = 1 × P ( A ) + 0 × P ( Ac ) = P ( A ) . (23.31)
Expected value of a discrete random variable
Next, let X : Ω −→ N be a discrete random variable. The expectation E[X ]

of X is defined as the sum
788 "
X
E[X ] = kP(X = k ), (23.32)
k>0
in which the possible values k > 0 of X are weighted by their probabilities.

More generally we have
X
E[φ(X )] = φ(k )P(X = k ),
k>0
for all sufficiently summable functions φ : N −→ R.
The expectation of the indicator function X = 1A = 1{X =1} can be recovered

from (23.32) as
E [ X ] = E [ 1A ] = 0 × P ( Ω \ A ) + 1 × P ( A ) = 0 × P ( Ω \ A ) + 1 × P ( A ) = P ( A ) .
Note that the expectation is a linear operation, i.e. we have
E[aX + bY ] = aE[X ] + bE[Y ], a, b ∈ R, (23.33)
provided that
E[|X|] + E[|Y |] < ∞.
Examples
i) Expected value of a Poisson random variable with parameter λ > 0:
X X λk X λk
E[X ] = kP(X = k ) = e −λ k = λ e −λ = λ. (23.34)
k! k!
k>0 k>1 k>0
ii) Estimating the expected value of a Poisson random variable using R:
Taking λ := 2, we can use the following R code:

poisson_samples <- rpois(100000, lambda = 2)
poisson_samples
mean(poisson_samples)
Given X : Ω −→ N ∪ {+∞} a discrete nonnegative random variable X, we

have X
P(X < ∞) = P(X = k ),
k>0
and
X
1 = P(X = ∞) + P(X < ∞) = P(X = ∞) + P(X = k ),
k >0
and in general
" 789
N. Privault
X
E[X ] = +∞ × P(X = ∞) + kP(X = k ).
k>0
In particular, P(X = ∞) > 0 implies E[X ] = ∞, and the finiteness

E[X ] < ∞ condition implies P(X < ∞) = 1, however the converse is not
true.
Examples
a) Assume that X has the geometric distribution
1
P(X = k ) : = , k > 0, (23.35)
2k+1
with parameter p = 1/2, and
X k 1X k 1 1
E[X ] = = = = 1 < ∞.
2k+1 4 2k−1 4 (1 − 1/2)2
k >0 k>1
Letting φ(X ) := 2X , we have

X 1
P(φ(X ) < ∞) = P(X < ∞) = = 1,
2k+1
k >0
and
X X 2k X1
E[φ(X )] = φ(k )P(X = k ) = = = +∞,
2k+1 2
k>0 k >0 k>0
hence the expectation E[φ(X )] is infinite although φ(X ) is finite with

probability one.∗
b) The uniform random variable U on [0, 1] satisfies E[U ] = 1/2 < ∞ and
P(1/U < ∞) = P(U > 0) = P(U ∈ (0, 1]) = 1,
however we have w 1 dx
E[1/U ] =
= +∞,
0 x
and P(1/U = +∞) = P(U = 0) = 0.
c) If the random variable X has an exponential distribution with parameter

µ > 0 we have
∗
This is the St. Petersburg paradox.
790 "
 µ
w∞  µ − λ < ∞ if µ > λ,

E e λX
e λx e −µx dx =

=µ
0 
+∞, if µ 6 λ.

Conditional expectation
The notion of expectation takes its full meaning under conditioning. For ex-
ample, the expected return of a random asset usually depends on information
such as economic data, location, etc. In this case, replacing the expectation by
a conditional expectation will provide a better estimate of the expected value.
For instance, life expectancy is a natural example of a conditional expec-

tation since it typically depends on location, gender, and other parameters.
The conditional expectation of a finite discrete random variable X : Ω −→

N given an event A is defined by
X X P(X = k and A)
E[X | A] = kP(X = k | A) = k .
P(A)
k>0 k>1
Lemma 23.9. Given an event A such that P(A) > 0, we have

1
E[X | A] = E X 1A . (23.36)

P(A)
Proof. The proof is done only for X : Ω −→ N a discrete random vari-
able, however (23.36) is valid for general real-valued random variables. By
Relation (23.16) we have
X
E[X | A] = kP(X = k | A)
k>0
1 X 1 X
kE 1{X =k}∩A

= kP({X = k} ∩ A) =
P(A) P(A)
k>0 k >0
 
1 X 1
kE 1{X =k} 1A = E 1A k 1{X =k} 
X
=
P(A) P(A)
k>0 k>0
1
E 1A X ,

=
P(A)
where we used the relation
k 1{X =k}
X
X=
k >0
" 791
N. Privault
which holds since X takes only integer values.

Example
i) For example, consider Ω = {1, 3, −1, −2, 5, 7} with the non-uniform
probability measure given by
1 2 1
P({−1}) = P({−2}) = P({1}) = P({3}) = , P({5}) = , P({7}) = ,
7 7 7
and the random variable
X : Ω −→ Z
given by
X (k ) = k, k = 1, 3, −1, −2, 5, 7.
Here, E[X | X > 1] denotes the expected value of X given
A = {X > 1} = {3, 5, 7} ⊂ Ω,
i.e. the mean value of X given that X is strictly positive. This conditional
expectation can be computed as
E[X | X > 1]
= 3 × P(X = 3 | X > 1) + 5 × P(X = 5 | X > 1) + 7 × P(X = 7 | X > 1)
3+2×5+7
=
4
3+5+5+7
=
7 × 4/7
1
E X 1{X>1} ,

=
P(X > 1)
where P(X > 1) = 4/7 and the truncated expectation E X 1{X>1} is

given by E X 1{X>1} = (3 + 2 × 5 + 7)/7.

ii) Estimating a conditional expectation using R:

geo_samples <- rgeom(100000, prob = 1/4)
mean(geo_samples)
mean(geo_samples[geo_samples<10])
Taking p := 3/4, we have

X p
E[X ] = (1 − p) kpk = = 3,
1−p
k>1
and
1
E[X | X < 10] = E X 1{X<10}

P(X < 10)
792 "
9
1 X
= kP(X = k )
P(X < 10)
k =0
9
1 X
= 9 kpk
k =1
X
pk
k =0
9
p(1 − p) ∂ X k
= p
1 − p ∂p
10
k =0
p(1 − p) ∂ 1 − p10

=
1 − p10 ∂p 1−p
p(1 − p10 − 10(1 − p)p9 )
=
(1 − p)(1 − p10 )
' 2.4032603455.
If the random variable X : Ω −→ N is independent∗ of the event A, we have
E [ X 1A ] = E [ X ] E [ 1A ] = E [ X ] P ( A ) ,
and we naturally find

E[X | A] = E[X ]. (23.37)
Taking X = 1A with
1A : Ω −→ {0, 1}
1 if ω ∈ A,
ω 7−→ 1A :=
0 if ω ∈
/ A,
shows that, in particular,
E [ 1A | A ] = 0 × P ( X = 0 | A ) + 1 × P ( X = 1 | A )
= P(X = 1 | A)
= P(A | A)
= 1.
One can also define the conditional expectation of X given A = {Y = k}, as

X
E[X | Y = k ] = nP(X = n | Y = k ),
n>0
where Y : Ω −→ N is a discrete random variable.

∗
i.e., P({X = k} ∩ A) = P({X = k})P(A) for all k > 0.
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N. Privault
Proposition 23.10. Given X a discrete random variable such that E[|X|] <
∞, we have the relation
E[X ] = E[E[X | Y ]], (23.38)
which is sometimes referred to as the tower property.

Proof. We have
X
E[E[X | Y ]] = E[X | Y = k ]P(Y = k )
k>0
XX
= nP(X = n | Y = k )P(Y = k )
k>0 n>0
X X
= n P(X = n and Y = k )
n>0 k>0
X
= nP(X = n) = E[X ],
n>0
where we used the marginal distribution

X
P(X = n) = P(X = n and Y = k ), n > 0,
k >0
that follows from the law of total probability (23.15) with Ak = {Y = k},
k > 0.
Taking
k 1A k ,
X
Y =
k >0
with Ak := {Y = k}, k > 0, from (23.38) we also get the law of total
expectation
E[X ] = E[E[X | Y ]] (23.39)

X
= E[X | Y = k ]P(Y = k )
k >0
X
= E [ X | Ak ] P ( Ak ) .
k>0
Example
Life expectancy in Singapore is E[T ] = 80 years overall, where T denotes
the lifetime of a given individual chosen at random. Let G ∈ {m, w} denote
the gender of that individual. The statistics show that
E[T | G = m] = 78 and E[T | G = w ] = 81.9,

794 "
and we have
80 = E[T ]
= E[E[T |G]]
= P(G = w )E[T | G = w ] + P(G = m)E[T | G = m]
= 81.9 × P(G = w ) + 78 × P(G = m)
= 81.9 × (1 − P(G = m)) + 78 × P(G = m),
showing that
80 = 81.9 × (1 − P(G = m)) + 78 × P(G = m),
i.e.
81.9 − 80 1.9
P(G = m) = = = 0.487.
81.9 − 78 3.9
Variance
The variance of a random variable X is defined in general by
Var[X ] := E X 2 − (E[X ])2 ,

provided that E |X|2 < ∞. If (Xk )k∈N is a sequence of independent random

variables we have
" n  !2  #!2
n
# " n
X X X
Var Xk = E  Xk  − E Xk
k =1 k =1 k =1
n n n n
" # " # " #
X X X X
=E Xk Xl − E Xk E Xl
k =1 l =1 k =1 l =1
n Xn n X
n
" #
X X
=E Xk Xl − E[Xk ]E[Xl ]
k =1 l =1 k =1 l =1
n
X X n
X X
E Xk2 + E[Xk Xl ] − (E[Xk ])2 − E[Xk ]E[Xl ]

=
k =1 16k6=l6n k =1 16k6=l6n
X n
E Xk2 − (E[Xk ])2

=
k =1
X n
= Var [Xk ]. (23.40)
k =1
" 795
N. Privault
Random sums
In the sequel we consider Y : Ω −→ N an a.s. finite, integer-valued random

variable, i.e. we have P(Y < ∞) = 1 and P(Y = ∞) = 0. Based on the
tower property of conditional expectations (23.38) or ordinary conditioning,
XY
the expectation of a random sum Xk , where (Xk )k∈N is a sequence of
k =1
random variables, can be computed from the tower property (23.38) or from
the law of total expectation (23.39) as
Y Y
" # " " ##
X X
E Xk = E E Xk Y

k =1 k =1
Y
" #
X X
= E Xk Y = n P(Y = n)

n>0 k =1
n
" #
X X
= E Xk Y = n P(Y = n),

n>0 k =1
and if the sequence (Xk )k∈N is (mutually) independent of Y , this yields

Y n
" # " #
X X X
E Xk = E Xk P(Y = n)
k =1 n>0 k =1
X n
X
= P(Y = n) E[Xk ].
n>0 k =1
Random products
Similarly, for a random product we will have, using the independence of Y

with (Xk )k∈N ,
Y n
" # " #
Y X Y
E Xk = E Xk P(Y = n) (23.41)
k =1 n>0 k =1
X n
Y
= P(Y = n) E[Xk ],
n>0 k =1
where the last equality requires the (mutual) independence of the random
variables in the sequence (Xk )k>1 .
796 "
Distributions admitting a density
Given a random variable X whose distribution admits a probability density

ϕX : R −→ R+ we have
w∞
E[X ] = xϕX (x)dx,
−∞
and more generally,

w∞
E[φ(X )] = φ(x)ϕX (x)dx, (23.42)
−∞
for all sufficiently integrable function φ on R. For example, if X has a standard

normal distribution we have
w∞ 2 dx
E[φ(X )] = φ(x) e −x /2 √ .
−∞ 2π
In case X has a Gaussian distribution with mean µ ∈ R and variance σ 2 > 0

we get
1 w∞ 2 2
E[φ(X )] = √ φ(x) e −(x−µ) /(2σ ) dx. (23.43)
2πσ −∞
2
Exercise: In case X ' N (µ, σ 2 ) has a Gaussian distribution with mean µ ∈ R

and variance σ 2 > 0, check that
µ = E[X ] and σ 2 = E X 2 − (E[X ])2 .

When (X, Y ) : Ω −→ R2 is a R2 -valued couple of random variables whose

distribution admits a probability density ϕX,Y : R2 −→ R+ we have
w∞ w∞
E[φ(X, Y )] = φ(x, y )ϕX,Y (x, y )dxdy,
−∞ −∞
for all sufficiently integrable function φ on R2 .
The expectation of an absolutely continuous random variable satisfies the

same linearity property (23.33) as in the discrete case.
The conditional expectation of an absolutely continuous random variable can

be defined as w∞
E[X | Y = y ] = xϕX|Y =y (x)dx
−∞
where the conditional probability density ϕX|Y =y (x) is defined in (23.24),

with the relation
E[X ] = E[E[X | Y ]] (23.44)
" 797
N. Privault
which is called the tower property and holds as in the discrete case, since
w∞
E[E[X | Y ]] = E[X | Y = y ]ϕY (y )dy
−∞
w∞ w∞
= xϕX|Y =y (x)ϕY (y )dxdy
−∞ −∞
w∞ w∞
= x ϕ(X,Y ) (x, y )dydx
−∞ −∞
w∞
= xϕX (x)dx = E[X ],
−∞
where we used Relation (23.23) between the probability density of (X, Y )

and its marginal X.
For example, an exponentially distributed random variable X with prob-

ability density function (23.19) has the expected value
w∞ 1
E[X ] = λ x e −λx dx = .
0 λ
Moment Generating Functions
Characteristic functions
The characteristic function of a random variable X is the function
ΨX : R −→ C
defined by
ΨX (t) = E e itX , t ∈ R.

The characteristic function ΨX of a random variable X with probability

density function f : R −→ R+ satisfies
w∞
ΨX (t) = e ixt ϕ(x)dx, t ∈ R.
−∞
On the other hand, if X : Ω −→ N is a discrete random variable we have

X
ΨX (t) = e itn P(X = n), t ∈ R.
n>0
One of the main applications of characteristic functions is to provide a char-

acterization of probability distributions, as in the following theorem.
Theorem 23.11. Two random variables X : Ω −→ R and Y : Ω −→ R
have same distribution if and only if
ΨX (t) = ΨY (t), t ∈ R.
798 "
Theorem 23.11 is used to identify or to determine the probability distribution

of a random variable X, by comparison with the characteristic function ΨY
of a random variable Y whose distribution is known.
The characteristic function of a random vector (X, Y ) is the function

ΨX,Y : R2 −→ C defined by
ΨX,Y (s, t) = E e isX +itY , s, t ∈ R.

Theorem 23.12. The random variables X : Ω −→ R and Y : Ω −→ R are

independent if and only if
ΨX,Y (s, t) = ΨX (s)ΨY (t), s, t ∈ R.
A random variable X has a Gaussian distribution with mean µ and variance

σ 2 if and only if its characteristic function satisfies
2 2
E e iαX = e iαµ−α σ /2 , α ∈ R. (23.45)

In terms of moment generating functions (MGF) we have, replacing iα by α,

2 2
E e αX = e αµ+α σ /2 , α ∈ R. (23.46)

From Theorems 23.11 and 23.12 we deduce the following proposition.

Proposition 23.13. Let X ' N (µ, σX2 ) and Y ' N (ν, σ 2 ) be independent
Y
Gaussian random variables. Then X + Y also has a Gaussian distribution
2
X + Y ' N (µ + ν, σX + σY2 ).
Proof. Since X and Y are independent, by Theorem 23.12 the characteristic
function ΨX +Y of X + Y is given by
Φ X +Y (t ) = Φ X (t ) Φ Y (t )
2 2 2 2
= e itµ−t σX /2 e itν−t σY /2
2 2 2
= e it(µ+ν )−t (σX +σY )/2 , t ∈ R,
where we used (23.45). Consequently, the characteristic function of X + Y is

that of a Gaussian random variable with mean µ + ν and variance σX 2 + σ2
Y
and we conclude by Theorem 23.11.
Moment generating functions
The moment generating function of a random variable X is the function

ΦX : R −→ R defined by
" 799
N. Privault
ΦX (t) = E e tX , t ∈ R,

provided that the expectation is finite. In particular, we have

∂n
E[X n ] = ΦX (0), n > 1,
∂t
provided that E[|X|n ] < ∞, and
X tn
ΦX (t) = E e tX = E[X n ],

n!
n>0
provided that E e t|X|

< ∞, t ∈ R, and for this reason the moment generat-

ing function GX characterizes the moments E[X n ] of X : Ω −→ N, n > 0.
The moment generating function ΦX of a random variable X with probability

density function f : R −→ R+ satisfies
w∞
ΦX (t) = e xt ϕ(x)dx, t ∈ R.
−∞
Note that in probability, the moment generating function is written as a

bilateral transform defined using an integral from −∞ to +∞.
23.7 Conditional Expectation
The construction of conditional expectations of the form E[X | Y ] given

above for discrete and absolutely continuous random variables can be gener-
alized to σ-algebras.
Definition 23.14. Given F a σ-algebra on Ω, a random variable F : Ω −→
R is said to be F-measurable if
{F 6 x} := {ω ∈ Ω : F (ω ) 6 x} ∈ F,
for all x ∈ R.
Intuitively, when F is F-measurable, the knowledge of the values of F de-
pends only on the information contained in F. For example, [ when F =
σ (A1 , . . . , An ) where (An )n>1 is a partition of Ω with An = Ω, any
n>1
F-measurable random variable F can be written as
n
ck 1 A k ( ω ) ,
X
F (ω ) = ω ∈ Ω,
k =1
for some c1 , . . . , cn ∈ R.
800 "
Definition 23.15. Given (Ω, F, P) a probability space we let L2 (Ω, F ) de-

note the space of F-measurable and square-integrable random variables, i.e.
L2 (Ω, F ) := F : Ω −→ R : E |F |2 < ∞ .

More generally, for p > 1 one can define the space Lp (Ω, F ) of F-measurable
and p-integrable random variables as
Lp (Ω, F ) := F : Ω −→ R : E[|F |p ] < ∞ .

We define a scalar product h·, ·iL2 (Ω,F ) between elements of L2 (Ω, F ), as
hF , GiL2 (Ω,F ) := E[F G], F , G ∈ L2 (Ω, F ).
This scalar product is associated to the norm k · kL2 (Ω) by the relation
q q
kF kL2 (Ω) = E F 2 = hF , F iL2 (Ω,F ) , F ∈ L2 (Ω, F ).
The norm k · kL2 (Ω) also defines the mean-square distance

q
E (F − G)2

kF − GkL2 (Ω) =
between random variables F , G ∈ L2 (Ω, F ), and it induces a notion of or-

thogonality, namely F is orthogonal to G in L2 (Ω, F ) if and only if
hF , GiL2 (Ω,F ) = 0.
Proposition 23.16. The ordinary expectation E[F ] achieves the minimum

distance
F − E[F ] 2 2 = min kF − ck2L2 (Ω) . (23.47)

L (Ω) c∈R
Proof. It suffices to differentiate

∂
E (F − c)2 = 2E[F − c] = 0,

∂c
showing that the minimum in (23.47) is reached when E[F − c] = 0, i.e.
c = E[F ].
Similarly to Proposition 23.16, the conditional expectation will be defined by
a distance minimizing procedure.
Definition 23.17. Given G ⊂ F a sub σ-algebra of F and F ∈ L2 (Ω, F ),
the conditional expectation of F given G, and denoted
E[F | G ],
" 801
N. Privault
is defined as the orthogonal projection of F onto L2 (Ω, G ).
L2 (Ω, F )
L2 (Ω, G )
0 E[F | G ]
As a consequence of the uniqueness of the orthogonal projection onto the

subspace L2 (Ω, G ) of L2 (Ω, F ), the conditional expectation E[F | G ] is char-
acterized by the relation
hG, F − E[F | G ]iL2 (Ω,F ) = 0,
which rewrites as
E[G(F − E[F | G ])] = 0,
i.e.
E[GF ] = E[GE[F | G ]],
for all bounded and G-measurable random variables G, where h·, ·iL2 (Ω,F )
denotes the inner product in L2 (Ω, F ). The next proposition extends Propo-
sition 23.16 as a consequence of Definition 23.17. See Theorem 5.1.4 page 197
of Stroock (2011) for an extension of the construction of conditional expec-
tation to the space L1 (Ω, F ) of integrable random variable.
Proposition 23.18. The conditional expectation E[F | G ] realizes the min-
imum in mean-square distance between F ∈ L2 (Ω, F ) and L2 (Ω, G ), i.e. we
have
kF − E[F | G ]kL2 (Ω) = inf kF − GkL2 (Ω) . (23.48)
G∈L2 (Ω,G )
The following proposition will often be used as a characterization of E[F | G ].

Proposition 23.19. Given F ∈ L2 (Ω, F ), X := E[F | G ] is the unique
random variable X in L2 (Ω, G ) that satisfies the relation
E[GF ] = E[GX ] (23.49)
for all bounded and G-measurable random variables G.

We note that taking G = 1 in (23.49) yields
E[E[F | G ]] = E[F ]. (23.50)
In particular, when G = {∅, Ω} we have E[F | G ] = E[F | {∅, Ω}] and
802 "
E[F | {∅, Ω}] = E[E[F | {∅, Ω}]] = E[F ]
because E[F | {∅, Ω}] is in L2 (Ω, {∅, Ω}) and is a.s. constant. In addition,
the conditional expectation operator has the following properties.
i) E[F G | G ] = GE[F | G ] if G depends only on the information contained

in G.
Proof. By the characterization (23.49) it suffices to show that
E[H (GF )] = E[H (GE[F |G ])], (23.51)
for all bounded and G-measurable random variables H, which implies

E[F G | G ] = GE[F | G ].
Relation (23.51) holds from (23.49) because the product HG is G-

measurable hence G in (23.49) can be replaced with HG.
ii) E[G|G ] = G when G depends only on the information contained in G.
Proof. This is a consequence of point (i) above by taking F := 1.
iii) E[E[F |G ] | H] = E[F |H] if H ⊂ G, called the tower property.
Proof. First, we note that by (23.50), (iii) holds when H = {∅, Ω}. Next,
by the characterization (23.49) it suffices to show that
E[HE[F |G ]] = E[HE[F |H]], (23.52)
for all bounded and G-measurable random variables H, which will imply
(iii) from (23.49).
In order to prove (23.52) we check that by point (i) above and (23.50)
we have
E[HE[F |G ]] = E[E[HF |G ]] = E[HF ]

= E[E[HF |H]] = E[HE[F |H]],
and we conclude by the characterization (23.49).
iv) E[F |G ] = E[F ] when F “does not depend” on the information contained
in G or, more precisely stated, when the random variable F is indepen-
dent of the σ-algebra G.
Proof. It suffices to note that for all bounded G-measurable G we have
" 803
N. Privault
E[F G] = E[F ]E[G] = E[GE[F ]],
and we conclude again by (23.49).
v) If G depends only on G and F is independent of G, then
E[h(F , G)|G ] = E[h(F , x)]x=G . (23.53)
Proof. This relation can be proved using the tower property, by noting
that for any K ∈ L2 (Ω, G ) we have
E[KE[h(x, F )]x=G ] = E[KE[h(x, F ) | G ]x=G ]

= E[KE[h(G, F ) | G ]]
= E[E[Kh(G, F ) | G ]]
= E[Kh(G, F )],
which yields (23.53) by the characterization (23.49).

The notion of conditional expectation can be extended from square-integrable
random variables in L2 (Ω, F ) to integrable random variables in L1 (Ω, F ),
cf. e.g. Theorem 5.1 in Kallenberg (2002).
Proposition 23.20. When the σ-algebra G := σ (A1 , A2 , . . . , An ) is gener-
ated by n disjoint events A1 , A2 , . . . , An ∈ F, we have
E [ F 1A k ]
n n
1 A k E [ F | Ak ] = 1A k
X X
E[F | G ] = .
P ( Ak )
k =1 k =1
Proof. It suffices to note that the G-measurable random variables can be
generated by indicators of the form 1Al , and that
E [ F 1A k ] E [ F 1A l ]
n
" #
E 1A l 1A k = E 1A l
X
P ( Ak ) P ( Al )
k =1
E[F 1Al ]
E 1A l

=
P ( Al )
= E F 1A l , l = 1, 2, . . . , n,

showing (23.49). The relation
E [ F 1A k ]
E [ F | Ak ] = , k = 1, 2, . . . , n,
P ( Ak )
follows from Lemma 23.9.

For example, in case Ω = {a, b, c, d} and G = ∅, Ω, {a, b}, {c}, {d} , we have

E[F | G ] = 1{a,b} E[F | {a, b}] + 1{c} E[F | {c}] + 1{d} E[F | {d}]
804 "
E F 1{a,b} E F 1{c} E F 1{d}

= 1{a,b} + 1{c} + 1{d} .
P({a, b}) P({c}) P({d})
Regarding conditional probabilities we have similarly, for A ⊂ Ω = {a, b, c, d},
P A ∩ {a, b} P A ∩ {c} P A ∩ {d}

P(A | G ) = 1{a,b} + 1{c} + 1{d}
P({a, b}) P({c}) P({d})
= 1{a,b} P(A | {a, b}) + 1{c} P(A | {c}) + 1{d} P(A | {d}).
In particular, if A = {a} ⊂ Ω = {a, b, c, d} we find
P({a} | G ) = 1{a,b} P({a} | {a, b})

P {a} ∩ {a, b}

= 1{a,b}
P({a, b})
P({a})
= 1{a,b} .
P({a, b})
In other words, the probability of getting the outcome a is P({a})/P({a, b})

knowing that the outcome is either a or b, otherwise it is zero.
Exercises
Exercise S.1 Let X denote a Poisson random variable with parameter λ > 0.
a) Compute the expected value E[X ] of X.
b) Compute the second moment E[X 2 ] and variance Var[X ] of X.
Exercise S.2 Let X denote a centered Gaussian random variable with

variance η 2 , η > 0. Show that the probability P (eX > c) is given by
P eX > c = Φ(−(log c)/η ),

where log = ln denotes the natural logarithm and

1 wx 2
Φ (x) = √ e −y /2 dy, x ∈ R,
2π −∞
denotes the Gaussian cumulative distribution function.
Exercise S.3 Let X ' N (µ, σ 2 ) be a Gaussian random variable with param-
eters µ ∈ R and σ > 0, and probability density function
1 2 / (2σ 2 )
ϕ(x) : = √ e −(x−µ) , x ∈ R.
2πσ 2
" 805
N. Privault
a) Confirm that ϕ > 0 is indeed a probability density function, i.e., show

that w∞
1 2 2
√ e −(x−µ) /(2σ ) dx = 1.
2πσ 2 −∞
b) Write down E[X ] as an integral, and show that
µ = E[X ].
c) Write down E[X 2 ] as an integral, and show that
σ 2 = E[(X − E[X ])2 ].
d) Write down E[ e X ] as an integral and prove (23.46), i.e. show that

2 /2
E [ e X ] = e µ+σ .
Exercise S.4 Let X ' N (0, σ 2 ) be a centered Gaussian random variable

with variance σ 2 > 0 and probability density function
1 2 / (2σ 2 )
ϕ(x) : = √ e −(x−µ) , x ∈ R.
2πσ 2
a) Consider the function x 7→ x+ from R to R+ , defined as
 x if x > 0,

x+ =
0 if x 6 0.

Compute E[X + ] as an integral.

b) Consider the function x 7→ (x − K )+ from R to R+ , defined as
 x − K if x > K,

+
(x − K ) =
0 if x 6 K,

where K ∈ R. Compute E[(X − K )+ ] as an integral using the cumulative

distribution function of the standard normal distribution
wx 2 dy
Φ (x) : = e −y /2 √ , x ∈ R.
−∞ 2π
c) Consider the function x 7→ (K − x)+ from R to R+ , defined as
 K − x if x 6 K,

+
(K − x) =
0 if x > K,

806 "
where K ∈ R. Compute E[(K − X )+ ] using the cumulative distribution

function Φ.
Exercise S.5 Let X ' N (0, v 2 ) be a centered Gaussian random variable

with variance v 2 > 0.
a) Compute
1 w∞
E e σX 1[K,∞) (x e σX ) = √
2 2
e σy−y /(2v ) dy.

2πv 2 σ−1 log(K/x)
Hint. Use the completion of square identity
y2 v 2 σ 2 y vσ 2
σy − = − − .
v 2 4 v 2
b) Compute
1 w∞ 2 / (2v 2 )
E[(em+X − K )+ ] = √ (em+x − K )+ e −x dx.
2πv 2 −∞
" 807
Exercise Solutions
Chapter 1
Exercise 1.1 The payoff C is that of a put option with strike price K = $3.
Exercise 1.2 Each of the two possible scenarios yields one equation:
 5α + β = 0
 
 α = −2
with solution
2α + β = 6, β = +10.
 
The hedging strategy at t = 0 is to shortsell −α = +2 units of the asset

S priced S0 = 4, and to put β = $10 on the savings account. The price
V0 = αS0 + β of the initial portfolio at time t = 0 is
V0 = αS0 + β = −2 × 4 + 10 = $2,
which yields the price of the claim at time t = 0. In order to hedge then
option, one should:
i) At time t = 0,
a. Charge the $2 option price.
b. Shortsell −α = +2 units of the stock priced S0 = 4, which yields $8.
c. Put β = $8 + $2 = $10 on the savings account.
ii) At time t = 1,
a. If S1 = $5, spend $10 from savings to buy back −α = +2 stocks.
b. If S1 = $2, spend $4 from savings to buy back −α = +2 stocks, and
deliver a $10 - $4 = $6 payoff.
Pricing the option by the expected value E∗ [C ] yields the equality
$2 = E∗ [C ]
" 809
N. Privault
= 0 × P∗ (C = 0) + 6 × P∗ (C = 6)
= 0 × P∗ (S1 = 2) + 6 × P∗ (S1 = 5)
= 6 × q∗ ,
hence the risk-neutral probability measure P∗ is given by

2 1
p∗ = P∗ (S1 = 5) = and q ∗ = P∗ (S1 = 2) = .
3 3
Exercise 1.3
a) i) Does this model allow for arbitrage? Yes | X No |
ii) If this model allows for arbitrage opportunities, how can they be real-
ized? By shortselling | By borrowing on savings | X N.A. |
b) i) Does this model allow for arbitrage? Yes | No | X
ized? By shortselling | By borrowing on savings | N.A. | X
c) i) Does this model allow for arbitrage? Yes | X No |
ized? By shortselling | X By borrowing on savings | N.A. |
Exercise 1.4
a) We need to search for possible risk-neutral probability measure(s) P∗ such
(1) (1)
that E∗ S1 = (1 + r )S0 . Letting
(1) (1)
 !
S1 − S0
 p∗ = P∗ S1(1) = S0(1) (1 + a) = P∗ =a ,


 (1)
S0







(1) (1)

 !

(1) (1) S1 − S0
θ∗ = P∗ S1 = S0 (1 + b) = P∗ =b ,

(1)


 S0




(1) (1)
 !
S1 − S0

 q ∗ = P∗ S (1) = (1 + c)S (1) = P∗

=c ,

1 0

 (1)
S0
We have
810 "
 (1 + a)p∗ S0(1) + (1 + b)θ∗ S0(1) + (1 + c)q ∗ S0(1) = (1 + r )S0(1)


p∗ + θ∗ + q ∗ = 1,

from which we obtain

(1 − θ )c + θ ∗ b − r

∗
 ∗
 p a + θ∗ b + q ∗ c = r, p =

 ∈ (0, 1),
c−a

=⇒
 q ∗ = r − (1 − θ )a − θ b ∈ (0, 1),
∗
p∗ + θ∗ + q ∗ = 1.
 


c−a
for any θ∗ ∈ (0, 1) such that
(1 − θ∗ )a + θ∗ b < r < (1 − θ∗ )c + θ∗ b,
i.e.
r−c r−a
< θ∗ < ,
b−c b−a
or
(1 − θ ∗ )a < r < (1 − θ ∗ )c
i.e. < 1 − r/c, in case a < b = 0 < c. Therefore there exists an infinity
θ∗
of risk-neutral probability measures depending on the value of θ∗ ∈ (0, 1),
and the market is without arbitrage but not complete.
b) Hedging a claim with possible payoff values Ca , Cb , Cc would require to
solve
(1) (0)




(1 + a)αS0 + (1 + r )βS0 = Ca



(1) (0)

(1 + b)αS0 + (1 + r )βS0 = Cb



(1) (0)

(1 + c)αS0 + (1 + r )βS0 = Cc ,

for α and β, which is not possible in general due to the existence of three
conditions with only two unknowns.
Exercise 1.5
a) The risk-neutral condition E∗ [R1 ] = 0 reads
bP∗ (R1 = b) + 0 × P∗ (R1 = 0) + (−b) × (R1 = −b) = bp∗ − bq ∗ = 0,
hence
1 − θ∗
p∗ = q ∗ = ,
2
since p∗ + q ∗ + θ∗ = 1.
b) We have
" 811
N. Privault
(1) (1)
" #
S1 − S0
Var∗ = E∗ R12 − (E∗ [R1 ])2

(1)
S0
= E∗ R12

= b2 P∗ (R1 = b) + 02 × P∗ (R1 = 0) + (−b)2 × (R1 = −b)

= b2 ( p ∗ + q ∗ )
= b2 ( 1 − θ ∗ )
= σ2 ,
hence θ∗ = 1 − σ 2 /b2 , and therefore
1 − θ∗ σ2
p∗ = q ∗ = = 2,
2 2b
provided that σ 2 6 2b2 .
Exercise 1.6
a) We denote the risk-neutral measure by p∗ = P∗ (S1 = 2), q ∗ = P∗ (S1 =
1).
i) Yes | No | X Comment: No loss is possible, while a 100%

profit is possible with non-zero probability 1/3.
ii) Yes | No | X Comment: The (unique) risk-neutral measure
(p∗ , q ∗ ) = (0, 1) is given by
$2 × p∗ + $1 × q ∗ = $1 × (1 + r ) = $1 and p∗ + q ∗ = 1,
and is not equivalent to P given by (p, q ) = (1/3, 2/3).

b) We denote the risk-neutral measure by p∗ = P∗ (S1 = 2), θ∗ = P∗ (S1 =
1), q ∗ = P∗ (S1 = 0).
i) Yes | X No | Comment: The risk-neutral measure (p∗ , θ∗ , q ∗ )

is given by the equations
$2 × p∗ + $1 × θ∗ + $0 × q ∗ = $1 × (1 + r ) = $1 and p∗ + θ∗ + q ∗ = 1,
(A.1)
which clearly admit solutions, see (biv) below.
ii) Yes | X No | Comment: Realizing arbitrage would mean
building a portfolio achieving no strictly negative return with prob-
ability one, which is impossible since the probability of 100% loss is
P(S1 = 0) = 1 − 1/4 − 1/9 = 23/36 > 0.
812 "
iii) Yes | No | X Comment: Examples of claims that cannot be

attained can be easily constructed in this market. For example, the
claim 1{S1 >0} cannot be attained since there is no portfolio allocation
(α, β ) satisfying 
 $2 × α + β = $1

$1 × α + β = $1

$0 × α + β = $0.

iv) Yes | No | X Comment: The risk-neutral measure is clearly

not unique, as for example
(p∗ , θ∗ , q ∗ ) = (1/4, 1/2, 1/4) and (p∗ , θ∗ , q ∗ ) = (1/3, 1/3, 1/3)
are both solutions of (A.1).
Exercise 1.7
a) The possible values of R are a and b.
b) We have
E∗ [R] = aP∗ (R = a) + bP∗ (R = b)

b−r r−a
=a +b
b−a b−a
= r.
c) By Theorem 1.5, there do not exist arbitrage opportunities in this market

since from Question (b) there exists a risk-neutral probability measure P∗
whenever a < r < b.
d) The risk-neutral probability measure is unique hence the market model is
complete by Theorem 1.12.
e) Taking
α (1 + b) − β (1 + a) β−α
η= and ξ = ,
π1 ( b − a ) S0 (b − a)
we check that
 ηπ1 + ξS0 (1 + a) = α if R = a,

ηπ1 + ξS0 (1 + b) = β if R = b,

which shows that

ηπ1 + ξS1 = C
in both cases R = a and R = b.
f) We have
π0 (C ) = ηπ0 + ξS0
" 813
N. Privault
α (1 + b) − β (1 + a) β − α
= +
(1 + r )(b − a) b−a
α(1 + b) − β (1 + a) − (1 + r )(α − β )
=
(1 + r )(b − a)
αb − βa − r (α − β )
= . (A.2)
(1 + r )(b − a)
g) We have
E∗ [C ] = αP∗ (R = a) + βP∗ (R = b)
b−r r−a
=α +β . (A.3)
b−a b−a
h) Comparing (A.2) and (A.3) above we do obtain
1
π0 ( C ) = E∗ [ C ]
1+r
i) The initial value π0 (C ) of the portfolio is interpreted as the arbitrage-
free price of the option contract and it equals the expected value of the
discounted payoff.
j) We have
 11 − S1 if K > S1 ,

+ +
C = (K − S1 ) = (11 − S1 ) =
0 if K 6 S1 .

k) We have S0 = 1, a = 8, b = 11, α = 2, β = 0, hence
β−α 0−2 2
ξ= = =− ,
S0 (b − a) 11 − 8 3
and
α (1 + b) − β (1 + a) 24
η= = .
π1 ( b − a ) 3 × 1.05
l) The arbitrage-free price π0 (C ) of the contingent claim with payoff C is
π0 (C ) = ηπ0 + ξS0 = 6.952.
Exercise 1.8 Letting R denote the price of one right, it will require 10R/3
to purchase one stock at €6.35, hence absence of arbitrage tells us that
10
R + 6.35 = 8,
3
from which it follows that
814 "
3
R= (8 − 6.35) = €0.495.
10
Note that the actual share right was quoted at €0.465 according to market
data. See also Exercise 17.8 for the pricing of convertible bonds.
Exercise 1.9 Let a := (152 − 180)/180 = −7/45 and b := (203 − 180)/180 =

23/180 denote the potential market returns, with r = 0.03. From the strike
price K and the risk-neutral probabilities
r−a b−r
p∗r = = 0.6549 and qr∗ = = 0.3451,
b−a b−a
the price of the option at the beginning of the year is given from Proposi-
tion 1.15 as the discounted expected value
1 1
E∗ [(K − S1 )+ ] = p∗ (K − 203)+ + qr∗ (K − 152)+ .

1+r 1+r r
Equating this price with the intrinsic value (K − 180)+ of the put option
yields the equation
1
(K − 180)+ = p∗ (K − 203)+ + qr∗ (K − 152)+

1+r r
which requires K > 180 (the case K 6 152 is not considered because both
the option price and option payoff vanish in this case). Hence we consider the
equation
1
K − 180 = p∗ (K − 203)+ + qr∗ (K − 152)+ ,

1+r r
with the following cases.
i) If K ∈ [180, 203] we get
(1 + r )(K − 180) = qr∗ (K − 152),
hence
(1 + r )180 − qr∗ 152 (1 + r )180 − qr∗ 152
K= = = 194.11.
1 + r − qr∗ p∗r + r
ii) If K > 203 we find
180(1 + r ) − 203p∗r − 152qr∗

K= < 203,
r
which is out of range and leads to a contradiction.
We note that the above formula
" 815
N. Privault
(1 + r )180 − qr∗ 152 28b − 180a + r (180(b − a) + 152)

K= =
p∗r + r (b + 1 − a)r − a
yields a decreasing function K (r ) of r in the interval [0, 100%], although the

function is not monotone over R+ .
150
140
130
120
110
K(r)
100
90
80
70
60
0 0.5 1 1.5 2
r
Fig. S.1: Strike price as a function of risk-free rate r.
Chapter 2
Exercise 2.1 Let m := $2, 550 denote the amount invested each year.
a) By (2.1), the value of the plan after N = 10 years becomes
N
X (1 + r )N − 1
m (1 + r )k = m(1 + r ) ,
r
k =1
which in turns becomes

N
(1 + r )N − 1
(1 + r )k = m (1 + r )N +1
X
(1 + r )N m ,
r
k =1
after N additional years without further contributions to the plan. Equat-

ing
(1 + r )N − 1
A = 30835 = m(1 + r )N +1
r
shows that
(1 + r )2N +1 − (1 + r )N +1 A
= ,
r m
with m = 2550, or
(1 + r )21 − (1 + r )11 30835

= ' 12.09215,
r 2550
816 "
hence r ' 1.23% according to Figure S.2, which is typical of an annual

fixed deposit interest rate.
14
13.5
13
12.5
12
11.5
11
10.5
10
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2
r in %
Fig. S.2: Graph of r 7−→ ((1 + r )21 − (1 + r )11 )/r.
In the hypothesis r = 3.25% we would find
(1 + r )N − 1
A = m (1 + r )N +1 = 42040.42.
r
b) Taking N = 10, m = 2, 550 and r = 0.0325, we find
N
(1 + r )N −k+1
X
A2N : = m(1 + r )N
k =1
XN
= m(1 + r ) N
(1 + r )k
k =1
N +1 (1 + r ) −1
N
= m(1 + r )
r
= $42, 040.42.
c) In this case, with N = 10, m = 2, 550 and r = 0.0325, we find

N
(1 + r )N − 1
(1 + r )N −k+1 = m(1 + r )
X
A2N = AN = m = $30, 532.79.
r
k =1
Exercise 2.2
a) Let m := $3, 581 denote the amount invested each year. After multiplying
(2.1) by (1 + r )N in order to account for the compounded interest from
year 11 until year 20, we get the equality
(1 + r )N − 1
A = m (1 + r )N +1
r
" 817
N. Privault
shows that
50862
(1 + r )21 − (1 + r )11 = r ' 14.2033r,
3581
showing that r ' 2.28% according to Figure S.3.
16
15.5
15
14.5
14
13.5
13
12.5
12
11.5
1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3
r in %
Fig. S.3: Graph of r 7−→ ((1 + r )21 − (1 + r )11 )/r.
b) Taking N = 10, m = 3, 581 and r = 0.0325, we find

N
(1 + r )N −k+1
X
A2N : = m(1 + r )N
k =1
XN
= m(1 + r )N (1 + r )k
k =1
(1 + r )N − 1
= m (1 + r )N +1
r
= $59, 037.94.
c) In this case, we find

N
(1 + r )N − 1
(1 + r )N −k+1 = m(1 + r )
X
A2N = m = $42, 877.61.
r
k =1
Exercise 2.3
a) We find m = $10, 000.
b) Taking N = 10, A = 100, 000 and r = 0.02, Proposition 2.1 shows that
r 0.02 × 100, 000
m= A= = $11, 132.65.
1 − (1 + r )−N 1 − 1.02−10
Exercise 2.4 We check that for any P∗ of the form

818 "
P∗ (Rt = −1) := p∗ , P∗ (Rt = 0) := 1 − 2p∗ , P∗ (Rt = 1) := p∗ ,
we have
E∗ [S1 ] = S0 (2p∗ + 1 − 2p∗ ) = S0 ,
and similarly
E∗ [S2 | S1 ] = S1 (2p∗ + (1 − 2p∗ )) = S1 ,
hence the probability measure P∗ is risk-neutral.
Exercise 2.5
a) In order to check for arbitrage opportunities we look for a risk-neutral
probability measure P∗ which should satisfy
(1) (1)
E∗ Sk+1 | Fk = (1 + r )Sk , k = 0, 1, . . . , N − 1,

(1)
with r = 0. Rewriting E∗ Sk+1 | Fk as

(1)
E∗ Sk+1 | Fk

(1) (1)
= (1 − b)Sk P∗ (Rk+1 = a | Fk ) + Sk P∗ (Rk+1 = 0 | Fk )
(1)
+ (1 + b)Sk P∗ (Rk+1 = b | Fk )
(1) (1) (1)
= (1 − b)Sk P∗ (Rk+1 = a) + Sk P∗ (Rk+1 = 0) + (1 + b)Sk P∗ (Rk+1 = b),
k = 0, 1, . . . , N − 1, it follows that any risk-neutral probability measure

P∗ should satisfy the equations
 (1 + b)Sk(1) P∗ (Rk+1 = b) + Sk(1) P∗ (Rk+1 = 0) + (1 − b)Sk(1) P∗ (Rk+1 = a) = Sk(1)


P∗ (Rk+1 = b) + P∗ (Rk+1 = 0) + P∗ (Rk+1 = −b) = 1,


k = 0, 1, . . . , N − 1, i.e.
 bP (Rk = b) − bP∗ (Rk = −b) = 0,

 ∗
P∗ (Rk = b) + P∗ (Rk = −b) = 1 − P∗ (Rk = 0),


k = 1, 2, . . . , N , with solution
1 − θ∗
P∗ (Rk = b) = P∗ (Rk = −b) = ,
2
k = 1, 2, . . . , N .
b) We have
" 819
N. Privault
 
(1) (1)
S
∗  k +1
− Sk
Var (1)
Fk 

Sk
 2
   2
(1) (1) (1) (1)
S − Sk S − Sk

∗  k +1 ∗  k +1
=E Fk − E

Fk
   
(1) (1)
Sk Sk
 2 
(1) (1)
S − Sk

∗  k +1
=E

 Fk 

(1)
Sk
= b2 P∗σ (Rk+1 = −b | Fk ) + b2 P∗σ (Rk+1 = b | Fk )
1 − P∗σ (Rk+1 = 0) 1 − P∗σ (Rk+1 = 0)
= b2 + b2
2 2
= b2 (1 − θ∗ )
= σ2 ,
k = 0, 1, . . . , N − 1, hence
σ2
P∗σ (Rk = 0) = θ∗ = 1 − ,
b2
and therefore
1 − P∗σ (Rk = 0) σ2
P∗σ (Rk = b) = P∗σ (Rk = −b) = = 2,
2 2b
k = 0, 1, . . . , N − 1, under the condition 0 < σ 2 < b2 .
Exercise 2.6
a) The possible values of Rt are a and b.
b) We have
E∗ [Rt+1 | Ft ] = aP∗ (Rt+1 = a | Ft ) + bP∗ (Rt+1 = b | Ft )

b−r r−a
=a +b = r.
b−a b−a
c) Letting p∗ = (r − a)/(b − a) and q ∗ = (b − r )/(b − a) we have
k
X k
E∗ [St+k | Ft ] = (p∗ )i (q ∗ )k−i (1 + b)i (1 + a)k−i St
i
i=0
k
k
(p∗ (1 + b))i (q ∗ (1 + a))k−i
X
= St
i
i=0
= St (p (1 + b) + q ∗ (1 + a))k
∗
820 "
k
r−a b−r
= St (1 + b) + (1 + a)
b−a b−a
= (1 + r )k St .
Assuming that the formula holds for k = 1, its extension to k > 2 can
also be proved recursively from the tower property (23.38) of conditional
expectations, as follows:
E∗ [St+k | Ft ] = E∗ [E∗ [St+k | Ft+k−1 ] | Ft ]

= (1 + r )E∗ [St+k−1 | Ft ]
= (1 + r )E∗ [E∗ [St+k−1 | Ft+k−2 ] | Ft ]
= (1 + r )2 E∗ [St+k−2 | Ft ]
= (1 + r )2 E∗ [E∗ [St+k−2 | Ft+k−3 ] | Ft ]
= (1 + r )3 E∗ [St+k−3 | Ft ]
= ···
= (1 + r )k−2 E∗ [St+2 | Ft ]
= (1 + r )k−2 E∗ [E∗ [St+2 | Ft+1 ] | Ft ]
= (1 + r )k−1 E∗ [St+1 | Ft ]
= (1 + r )k St .
Exercise 2.7
a) We check that
E∗ [Rt+1 | Ft ] = aP∗ (Rt+1 = a | Ft ) + bP∗ (Rt+1 = b | Ft )

b−r r−a
=a +b = r.
b−a b−a
b) We have
1
E∗ Set+1 Ft = E∗ [St+1 | Ft ]

π0 ( 1 + r ) t + 1
1
(1 + a)St P∗ (Rt+1 = a | Ft ) + (1 + b)St P∗ (Rt+1 = b | Ft )

=
π0 ( 1 + r ) t + 1
1

b−r r−a
= (1 + a)St + (1 + b)St
π0 ( 1 + r ) t + 1 b−a b−a
b − a + (b − a)r
= St
e
(1 + r )(b − a)
= Set , t = 0, 1, . . . , N − 1.
c) We have
" 821
N. Privault

N
!β 
Y
∗ ∗
E (SN ) β
= S0 E ( 1 + Rk )


k =1
N
" #
Y
= S0 E∗ (1 + Rk )β
k =1
N
Y
E∗ (1 + Rk )β ,

= S0
k =1
after using the independence of the returns (Rk )k=1,2,...,N , with
b−r r−a
E∗ (1 + Rk )β = (1 + a)β + (1 + b)β , k = 0, 1, . . . , N ,

b−a b−a
hence we find
N
b−r r−a
E∗ (SN )β = S0β (1 + a)β + (1 + b)β .

b−a b−a
d) We have

St
P∗ St > απt for some t ∈ {0, 1, . . . , N } = P∗ Max

>α
t=0,1,...,n πt
E ( MN ) β

6
αβ
β
r−a N

S0 b−r
= (1 + a)β + (1 + b)β ,
(1 + r ) απ0
N b−a b−a
since the discounted price process

St
(Mt )t=0,1,...,N :=
πt t=0,1,...,N
is a nonnegative martingale by part (b).

e) Since (Mt )t=0,1,...,N is a nonnegative martingale, we have
E[St+1 | Ft ] = E[Mt+1 πt+1 | Ft ]

= πt+1 E[Mt+1 | Ft ]
= πt + 1 Mt
> πt Mt
= St , t = 0, 1, . . . , N − 1,
because r > 0, hence (St )t=0,1,...,N is a nonnegative submartingale. There-

fore, we have
822 "
E ( MN ) β

P∗ Max St > x 6
t=0,1,...,n xβ
β
r−a N

S0 b−r
6 (1 + a)β + (1 + b)β .
x b−a b−a
Chapter 3
Exercise 3.1 (Exercise 2.4 continued). We consider the following trinomial
tree.
S2 = 4, C = 0
p∗
1 − 2p∗
S1 = 2 S2 = 2, C = 0
p∗
∗ S2 = 0, C = 1
p
S2 = 2, C = 0
p∗
1 − 2p∗ 1 − 2p∗
S0 = 1 S1 = 1 S2 = 1, C = 0
p∗
S2 = 0, C = 1
p∗
S2 = 0, C = 1
p∗
1 − 2p∗
S1 = 0 S2 = 0, C = 1
p∗
S2 = 0, C = 1
At time t = 0, we find
1
π0 ( C ) = E∗ [(K − S2 )+ ]
(1 + r )2
= p∗ (p∗ + (1 − 2p∗ ) + p∗ ) + (1 − 2p∗ )p∗ + (p∗ )2
= p∗ + (1 − 2p∗ )p∗ + (p∗ )2
= 2p∗ − (p∗ )2 .
At time t = 1, we find
1
π1 ( C ) = E∗ [(K − S2 )+ | S1 ]
1 +
 ∗r
 p if S1 = 2S0 ,




= p∗ if S1 = S0 ,



1 if S1 = 0.


" 823
N. Privault
Exercise 3.2 We have p∗ = (r − a)/(b − a) = 1/2 and q ∗ = (b − r )/(b − a) =

1/2, and the following underlying asset price tree:
S2 = 4, C = 3
p∗
S1 = 2
p∗
q∗
S0 = 1 S2 = 2, C = 1
p∗
q∗
S1 = 1
q∗
S2 = 1, C = 3.
We first price, and then hedge. At time t = 1, by Theorem 3.5 we have
3p + q ∗ 4
 ∗
 1 + r = 3 if S1 = 2


4 p∗ + q ∗ 8

π1 (C ) = V1 = and π0 (C ) = V0 = = .
 p∗ + 3q ∗ 4 3 1+r 9
if S1 = 1,

 =
1+r 3

This leads to the following option pricing tree:
S2 = 4, V2 = 3
p∗
V1 = 4/3
∗ S1 = 2
p
q∗
V0 = 8/9
S2 = 2 V2 = 1
S0 = 1
p∗
q∗
V1 = 4/3
S1 = 1
q∗
S2 = 1 V2 = 3.
Regarding hedging, if S1 = 2 the condition ξ 2 · S 2 = ξ2 S2 + η2 A2 = V2 reads
 4ξ2 + η2 (1 + r )2 = 3

S1 = 2 =⇒
2ξ2 + η2 (1 + r )2 = 1,

hence (ξ2 , η2 ) = (1, −4/9). On the other hand, if S1 = 1 we have

824 "
 2ξ2 + η2 (1 + r )2 = 1

S1 = 1 =⇒
ξ2 + η2 (1 + r )2 = 3,

hence (ξ2 , η2 ) = (−2, 20/9). Finally, at time t = 0 with S0 = 1 the condition

ξ 1 · S 1 = ξ1 S1 + η1 A1 = V1 yields
 4
 2ξ1 + η1 (1 + r ) = 3


 ξ + η (1 + r ) = 4 ,


1 1
3
hence (ξ1 , η1 ) = (0, 8/9). The results can be summarized in the following
table:
S1 = 2, V1 = 4/3 S2 =4
S0 = 1 ξ2 = 1, η2 = −4/9 V2 =3
V0 = 8/9 S2 =1
ξ1 = 0 V2 =3
η1 = 8/9 S1 = 1, V1 = 4/3 S2 =1
ξ2 = −2, η2 = 20/9 V2 =3
Table 24.1: CRR pricing and hedging table.
In addition, it can be checked that the portfolio strategy (ξk , ηk )k=1,2 is self-
financing as we have
8 3
ξ1 S1 + η1 A1 = ×
9 2
 4 3
2− ×
9 2


=
 −2 + 20 × 3


9 2
= ξ2 S1 + η2 A1 .
Exercise 3.3
a) We have
E∗ [St+1 | Ft ] = E∗ [St+1 | St ]
St
= P∗ (Rt = −0.5) + St P∗ (Rt = 0) + 2St P∗ (Rt = 1)
2 ∗
r
= + q ∗ + 2p∗ St
2
= St , t = 0, 1,
" 825
N. Privault
with r = 0.
b) We have the following graph:
S2 = 4, C = 2.5
4
p∗ = 1/
q ∗ = 1/4
S1 = 2 S2 = 2, C = 0.5
r ∗ = 1/
4 2
1/ S2 = 1, C = 0
∗ =
p
S2 = 2, C = 0
p∗ = 1/4
q ∗ = 1/4 q ∗ = 1/4
S0 = 1 S1 = 1 S2 = 1, C = 0
r ∗ = 1/
2
S2 = 0.5, C = 0
r∗
=
1/
2 S2 = 1, C = 0
4
p∗ = 1/
q ∗ = 1/4
S1 = 0.5 S2 = 0.5, C = 0
r ∗ = 1/
2
S2 = 0.25, C = 0
c) The down-an-out barrier call option is priced at time t = 0 as

3
V0 = E∗ [C ] = 2.5 × (p∗ )2 + 0.5 × p∗ q ∗ = .
16
At time t = 1 we have
1 1 3
V1 = 2.5 × p∗ + 0.5 × q ∗ = 2.5 × + 0.5 × =
4 4 4
if S1 = 2, and V1 = 0 in both cases S1 = 1 and S1 = 0.5.
d) This market is not complete, and not every contingent claim is attainable,
because the risk-neutral probability measure P∗ is not unique, for example
(r∗ , q ∗ , p∗ ) = (1/4, 5/8, 1/8) and (r∗ , q ∗ , p∗ ) = (1/2, 1/4, 1/4) are both
risk-neutral probability measures.
Exercise 3.4 The CRR model can be described by the following binomial tree.
826 "
(1 + b)2 S0
p∗
(1 + b)S0
p∗
q∗
S0 = 1 (1 + a)(1 + b)S0
p∗
q∗
(1 + a)S0
q∗
(1 + a)2 S0
a) By the formulas
1 1
V1 = E∗ [V2 | F1 ] = E∗ [V2 | S1 ]
1+r 1+r
S0 (1 + b)2 − 8 ∗
= P (S2 = S0 (1 + b)2 | S1 )
1+r
(S0 (1 + b)2 − 8)
= p∗ 1{S1 =S0 (1+b)} ,
1+r
and
1
V0 = E∗ [V1 | F0 ]
1+r
1 (S0 (1 + b)2 − 8)

= p∗ × P∗ (S1 = S0 (1 + b)) + 0 × P∗ (S1 = S0 (1 + a))
1+r 1+r
(S0 (1 + b)2 − 8)
= ( p∗ ) 2 ,
(1 + r )2
we find the table
S2 =9
S1 = 3, V1 = 1/4 V2 =1
S0 = 1 S2 =3
V0 = 1/16 V2 =0
S1 = 1, V1 = 0 S2 =1
V2 =0
Table 24.2: CRR pricing tree.
Note that we could also directly compute V0 from
" 827
N. Privault
1
V0 = E∗ [V2 | F0 ].
(1 + r )2
b) When S1 = S0 (1 + b), the equation ξ2 S2 + η2 A2 = V2 reads
 ξ2 S0 (1 + b)2 + η2 A0 (1 + r )2 = S0 (1 + b)2 − 8

ξ2 S0 (1 + b)(1 + a) + η2 A0 (1 + r )2 = 0,

which yields
S0 ( 1 + b ) 2 − 8 (S0 (1 + b)2 − 8)(1 + a)

ξ2 = and η2 = − . (A.4)
S0 (b − a)(1 + b) ( b − a ) A0 ( 1 + r ) 2
c) When S1 = S0 (1 + a), the equation ξ2 S2 + η2 A2 = V2 reads
 ξ2 S0 (1 + a)2 + η2 A0 (1 + r )2 = 0

ξ2 S0 (1 + b)2 + η2 A0 (1 + r )2 = 0,

which has the unique solution (ξ2 , η2 ) = (0, 0). Next, the equation ξ1 S1 +
η1 A1 = V1 reads
p∗ (S0 (1 + b)2 − 8)

 ξ1 S0 (1 + b) + η1 A0 (1 + r ) = ,


1+r

 ξ S (1 + a) + η A (1 + r ) = 0

1 0 1 0
which yields
S0 (1 + b)2 − 8 (1 + a)(S0 (1 + b)2 − 8)

ξ1 = p∗ and η1 = −p∗ .
S0 (b − a)(1 + r ) ( b − a ) A0 ( 1 + r ) 2
(A.5)
This can be summarized in the following table:
S1 = 3, V1 = 1/4 S2 =9
S0 = 1 V2 =1
V0 = 1/16 ξ2 = 1/6, η2 = −1/8 S2 =3
ξ1 = 1/8 S1 = 1, V1 = 0 V2 =0
η1 = −1/16 S2 =1
ξ2 = 0, η2 = 0 V2 =0
Table 24.3: CRR pricing and hedging tree.
When S1 = S0 (1 + a) at time t = 1 the option price is V1 = 0 and the

hedging strategy is to cut all positions: ξ2 = η2 = 0. On the other hand,
828 "
if S1 = S0 (1 + b) then there is a chance of being in the money at ma-

turity and we need to increase our position in the underlying asset from
ξ1 = 1/8 to ξ2 = 1/6.
Note that the self-financing condition
ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1 , (A.6)
is verified. For example when S1 = S0 (1 + a) we have

1 1
× S1 − A1 = 0 × S1 + 0 × A1 = 0,
8 16
while when S1 = S0 (1 + b) we find
1 1 1 1 1
× S1 − A1 = × S1 − × A1 = .
8 16 6 8 4
On the other hand, we can also use the self-financing condition (A.6) to
recover (A.5) by rewriting the system of equations as
 ξ1 S0 (1 + b) + η1 A0 (1 + r ) = ξ2 S0 (1 + b) + η2 A0 (1 + r )

ξ1 S0 (1 + a) + η1 A0 (1 + r ) = 0,

with (ξ2 , η2 ) given by (A.4), which recovers

3 2 1
 − = if S1 = 3,
8 16 4


V1 = ξ1 S1 + η1 A1 =
 1 − 2 = 0 if S = 1.


1
8 16
Exercise 3.5
a) We build a portfolio based at times t = 0, 1 on αt+1 units of stock and
$βt+1 in cash. When S1 = 2, we should have
4α2 + β2 = 0

2α2 + β2 = 1,
hence (α2 , β2 ) = (−1/2, 2). On the other hand, when S1 = 1 we should

have
2α1 + β1 = 1

α1 + β1 = 0,
hence (α2 , β2 ) = (1, −1).
b) When S1 = 2, the price of the claim at t = 1 is
" 829
N. Privault
α2 S1 + β2 = (−1/2) × 2 + 2 × 1 = 1.
When S1 = 1, the price of the claim at t = 1 is α2 S1 + β2 = 1 × 1 − 1 × 1 =

0.
c) At time t = 1 we build a portfolio using α1 units of stock and $β1 in cash.
We should have
2α1 + β1 = 1

α1 + β1 = 0,
hence (α1 , β1 ) = (1, −1).
d) The price of the claim C at time t = 0 is α1 S0 + β1 = 1 × 1 + (−1) × 1 = 0.
e) The probabilities (p∗ , q ∗ ) = ((r − a)/(b − a), (b − r )/(b − a)) = (0, 1) are
clearly risk-neutral in the sense of Definition 2.12, as they yield
E∗ [S2 | S1 ] = S1 and E∗ [S1 | S0 ] = S0 .
with the risk-free rate r = 0. However, this does not form a risk-neutral
probability measure P∗ equivalent to P in the sense of Definition 2.14
when q = P(R1 = 0) = P(R2 = 0) > 0.
In case (p, q ) = (0, 1), the probabilities (p∗ , q ∗ ) = (0, 1) would yield an
equivalent risk-neutral probability measure.
f) According to Theorem 2.15 this model allows for arbitrage opportunities
as the unique available risk-neutral probability measure P∗ are not be
equivalent to the historical probability measure P when q = P(R1 =
0) = P(R2 = 0) > 0. In this case, arbitrage opportunities are easily
implemented by purchasing the option at the price 0 of part (d) while
receiving a strictly positive payoff at maturity. More generally, arbitrage
opportunities exist when the underlying price may increase with nonzero
probability, without a possibility of strict decrease.
In case (p, q ) = (0, 1), no arbitrage is possible as prices remain constant.
Exercise 3.6 We have the model-free answer

1
πk ( C ) = E∗ [h(SN ) | Fk ]
(1 + r )N −k
1
= E∗ [α + βSN | Fk ]
(1 + r )N −k
α β
= + E∗ [SN | Fk ]
(1 + r )N −k (1 + r )N −k
α
= A + βSk , k = 0, 1, . . . , N .
(1 + r )N k
The hedging portfolio strategy is to hold β units of the underlying asset
priced Sk and α/(1 + r )N units of the riskless asset priced Ak = (1 + r )k at
830 "
time k = 0, 1, . . . , N .
Note that in the particular case of the CRR model, this answer is also com-
patible with (3.19)-(3.20).
Exercise 3.7 Call-put parity.

a) The relation (x − K )+ = x − K + (K − x)+ can be verified by successively
checking the cases x 6 K and x > K.
b) Respectively denoting by C (k ) and P (k ) the call and put prices at time
k = 0, 1, . . . , N , by part (a) we have
C (k ) = (1 + r )−(N −k) E∗ (SN − K )+ Fk

= (1 + r )−(N −k) E∗ SN − K − (K − SN )+ Fk

= (1 + r )−(N −k) E∗ [SN | Fk ] − (1 + r )−(N −k) K

−(1 + r )−(N −k) E∗ (K − SN )+ Fk

= Sk − (1 + r )−(N −k) K − (1 + r )−(N −k) E∗ (K − SN )+ Fk

= Sk − (1 + r )−(N −k) K − P (k ).
Exercise 3.8
a) Taking q ∗ = 1 − p∗ = 1/4, we find the binary tree
6.25 = (1 + b)2
p∗
2.5 = 1 + b
p∗
q∗
S0 = 1 1.25 = (1 + a)(1 + b)
p∗
q∗
0.5 = 1 + a
q∗
0.25 = (1 + a)(1 + b)
b) We find the binary tree
" 831
N. Privault
S2 = 6.25 and V2 = 0
p∗
S1 = 2.5 and V1 = 0
p∗
q∗
S0 = 1 and V0 = 1/64 S2 = 1.25 and V2 = 0
p∗
q∗
S1 = 0.5 and V1 = 1/8
q∗
S2 = 0.25 and V2 = 1
and the table
S2 = 6.25
S1 = 2.5, V1 = 0
V2 = 0
S0 = 1 S2 = 1.25
V0 = 1/64 V2 = 0
S1 = 0.5, V1 = 1/8 S2 = 0.25
V2 = 1
Table 24.4: CRR pricing tree.
c) Here, we compute the hedging strategy from the option prices. When
S1 = S0 (1 + b) we clearly have ξ2 = η2 = 0. When S1 = S0 (1 + a), the
equation ξ2 S2 + η2 A2 = V2 reads
 ξ2 S0 (1 + a)2 + η2 (1 + r )2 = (K − S0 (1 + a)2 )

ξ2 S0 (1 + b)(1 + a) + η2 (1 + r )2 = 0

hence
(K − S0 (1 + a)2 ) (K − S0 (1 + a)2 )(1 + b)
ξ2 = − and η2 = .
S0 (b − a)(1 + a) S0 (b − a)(1 + r )2
Next, at time t = 1 the equation ξ1 S1 + η1 A1 = V1 reads
q ∗ (K − (1 + a)(1 + b))

 ξ1 S0 (1 + a) + η1 (1 + r ) = S0
 ,
1+r

ξ1 S0 (1 + b) + η1 (1 + r ) = 0

which yields
832 "
q ∗ (K − S0 (1 + a)(1 + b)) q ∗ (K − S0 (1 + a)(1 + b))(1 + b)

ξ1 = − and η1 = .
S0 (b − a)(1 + r ) S0 (b − a)(1 + r )2
This can be summarized in the following table:
S1 = 2.5, V1 = 0 S2 = 6.25
S0 = 1 V2 = 0
V0 = 1/64 ξ2 = 0, η2 = 0 S2 = 1.25
ξ1 = −1/16 S1 = 0.5, V1 = 1/8 V2 = 0
η1 = 5/64 S2 = 0.25
ξ2 = −1, η2 = 5/16 V2 = 1
Table 24.5: CRR pricing and hedging tree.
If S1 = S0 (1 + a) then there is a chance of being in the money at maturity

and we need to short sell further by decreasing ξ1 from ξ1 = −1/16 to
ξ2 = −1. Note that the self-financing condition
ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1
is satisfied.
Problem 3.9
a) Denoting Sb2 the asset price at time 2 before the dividend is paid at the
rate α, we find that the ex-dividend asset price S2 after dividend payment
is
S2 = Sb2 − αSb2 ,
hence
V2 = ξ2 S2 + η2 A2 + αξ2 Sb2
S2
= ξ2 S2 + η2 A2 + αξ2
1−α
S2
= ξ2 + η 2 A2 .
1−α
b) Denoting Sb1 the asset price at time 1 before the dividend is paid at the
rate α, we find that the ex-dividend asset price S1 after dividend payment
is
S1 = Sb1 − αSb1 ,
hence
V1 = ξ1 S1 + η1 A1 + αξ1 Sb1
S1
= ξ1 S1 + η1 A1 + αξ1
1−α
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N. Privault
S1
= ξ1 + η 1 A1 .
1−α
c) If S1 = 3 we have
9ξ2

 1 − α + η2 2 = $1 if S2 = 9,

 2

S2
V2 = ξ2 + η 2 A2 =
1−α  3ξ2
+ η2 22 = 0 if S2 = 3,


1−α

hence (ξ2 , η2 ) = ((1 − α)/6, −1/8).
If S1 = 1 we have
3ξ2

 1 − α + η2 2 = 0 if S2 = 3,

 2

S2
V2 = ξ2 + η 2 A2 =
1−α  ξ
 2 + η2 22 = 0 if S2 = 1,


1−α
hence (ξ2 , η2 ) = (0, 0).
d) We have
1−α 1 1 − 2α

 V1 = ξ2 S1 + 2η2 = 3 ×
 −2× = if S1 = 3,
6 8 4

V1 = ξ2 S1 + 2η2 = 0 × 1 + 0 × 2 = 0 if S1 = 1.

e) We have
3ξ1 1 − 2α

 1 − α + 2η1 = if S1 = 3,

4


S1
V 1 = ξ1 + η 1 A1 =
1−α  ξ
 1 + 2η1 = 0 if S1 = 1,


1−α
hence (ξ1 , η1 ) = ((α − 1)(2α − 1)/8, (2α − 1)/16).
f) At time k = 0 we have
(α − 1)(2α − 1) 2α − 1 (2α − 1)2

V0 = ξ1 S0 + η1 = + = .
8 16 16
g) Multiplying the prices (Sk )k=1,2 of the original tree by
k k k
1 1 4

= = ,
1−α 1 − 1/4 3
we find the prices (S k )k=1,2 = (Sk /(1 − α)k )k=1,2 as in the following tree:
834 "
S 2 = 16
p∗
S1 = 4
p∗
q∗
S0 = 1 S 2 = 16/3
p∗
q∗
S 1 = 4/3
q∗
S 2 = 16/9
h) The market returns found in Question (g) are a = 1/3 and b = 3, with
r = 1%. Therefore we have
r−a 1 − 1/3 1 3−1 b−r 3
p∗ = = = and q ∗ = = = .
b−a 3 − 1/3 4 3 − 1/3 b−a 4
i) If S1 = 3 we have
1 p∗ 1
E∗ (S2 − K )+ | S 1 = 3] = $1 × = ,

1+r 2 8
which coincides with
3 2 1
V1 = ξ2 S1 + 2η2 = − = .
8 8 8
If S1 = 1 we have
1
E∗ (S2 − K )+ | S 1 = 1] = 0,

1+r
V1 = ξ2 S1 + 2η2 = 0.
j) At time k = 0 we have
1 (p∗ )2 1
E∗ (S2 − K )+ ] = = ,

(1 + r )2 (1 + r )2 64

3 1 1
V0 = ξ1 S0 + η1 = − = .
64 32 64
We also have
" 835
N. Privault
1 p∗ 1 1 1 1
E∗ V1 ] = .

× = × =
1+r 1+r 8 8 8 64
Exercise 3.10
a) The binary call option can be priced under the risk-neutral probability
measure P∗ as
1
π0 ( C ) = E∗ [ C ]
1+r
1
= E∗ [1[K,∞) (SN )]
1+r
1
= P∗ (SN > K )
1+r
p∗
= ,
1+r
with p∗ := P∗ (SN > K ).
b) Investing $p∗ by purchasing one binary call option yields a potential net
return of
$1 − p∗ $1


 p∗
 = ∗ − 1 if SN > K,
 p
∗
 $0 − p = −100% if SN < K.



p∗
c) The corresponding expected return is
1

p∗ × − 1 + (1 − p∗ ) × (−1) = 0.
p∗
d) The corresponding expected return is
p∗ × 0.86 + (1 − p∗ ) × (−1) = p∗ × 1.86 − 1,
which will be negative if

1
p∗ < ' 0.538.
1.86
That means, the expected gain can be negative even if
0.538 > p∗ = P∗ (SN > K ) > 0.5.
Similarly, the expected gain
(1 − p∗ ) × 0.86 + p∗ × (−1) = 0.86 − p∗ × 1.86,
on binary put options will be negative if 1 − p∗ > 1/1.86, i.e. if

836 "
0.86
p∗ > ' 0.462.
1.86
That means, the expected gain can be negative even if 1 − 0.462 >
P∗ (SN < K ) > 0.5. In conclusion, the average gains of both call and
put options will be negative if p∗ ∈ (0.462, 0.538).
Note that the average of call and put option gains will still be negative,
as
p∗ × 1.86 − 1 0.86 − p∗ × 1.86 0.86 − 1
+ = < 0.
2 2 2
Exercise 3.11
a) Based on the price map of the put spread collar option:
130
Put spread collar price map f(S)
y=S
120
110
100
90
80
70
60 70 80 90 100 110 120 130
SN
K1 K2 K3
Fig. S.4: Put spread collar price map.
we deduce the following payoff function graph of the put spread collar
option in the next Figure S.5.
20
Put spread collar payoff function
15
10
-5
-10
-15
-20
60 70 80 90 100 110 120 130
K1 K2 SN K3
Fig. S.5: Put spread collar payoff function.
" 837
N. Privault
b) The payoff function can be written as
−(K1 − x)+ + (K2 − x)+ − (x − K3 )+

= −(80 − x)+ + (90 − x)+ − (x − 110)+ ,
see also http://optioncreator.com/stp7xy2.
20
-(K1-x)++(K2-x)+
15 -(x-K3)+
10
-5
-10
-15
-20
60 70 80 90 100 110 120 130
K1 K2 SN K3
Fig. S.6: Put spread collar payoff as a combination of call and put option payoffs.∗
Hence this collar option payoff can be realized by

1. issuing (or shorting/selling) one put option with strike price K1 = 80,
and
2. purchasing and holding one put option with strike price K2 = 90, and
3. issuing (or shorting/selling) one call option with strike price K3 = 110.
Exercise 3.12
a) Based on the price map of the call spread collar option:
∗
838 "
140
Call spread collar price map f(S)
130 y=S
120
110
100
90
80
70
60
60 70 80 90 100 110 120 130
SN
K1 K2 K3
Fig. S.7: Call spread collar price map.
we deduce the following payoff function graph of the call spread collar
option in the next Figure S.8.
20
Call spread collar payoff function
15
10
-5
-10
-15
-20
60 70 80 90 100 110 120 130
SN
K1 K2 K3
Fig. S.8: Call spread collar payoff function.
b) The payoff function can be written as
−(K1 − x)+ + (x − K2 )+ − (x − K3 )+
= −(80 − x)+ + (x − 100)+ − (x − 110)+ ,
see also http://optioncreator.com/st3e4cz.
" 839
N. Privault
20
-(K1-x)++(x-K2)+
15 -(x-K3)+
10
-5
-10
-15
-20
60 70 80 90 100 110 120 130
K1 SN K2 K3
Fig. S.9: Call spread collar payoff as a combination of call and put option payoffs.∗
Hence this collar option payoff can be realized by

1. issuing (or shorting/selling) one put option with strike price K1 = 80,
and
2. purchasing and holding one call option with strike price K2 = 100, and
3. issuing (or shorting/selling) one call option with strike price K3 = 110.
Exercise 3.13 We have

S1 + · · · + SN φ(S1 ) + · · · + φ(SN )

E∗ φ 6 E∗ since φ is convex,
N N
E∗ [φ(S1 )] + · · · + E∗ [φ(SN )]
=
N
E∗ [φ(E∗ [SN | F1 ])] + · · · + E∗ [φ(E∗ [SN | FN ])]
= because (Sn )n∈N is a martingale,
N
E∗ [E∗ [φ(SN ) | F1 ]] + · · · + E∗ [E∗ [φ(SN ) | FN ]]
6 by Jensen’s inequality,
N
E∗ [φ(SN )] + · · · + E∗ [φ(SN )]
= by the tower property.
N
= E∗ [φ(SN )].
The above argument is implicitly using the fact that a convex function φ(Sn )
of a martingale (Sn )n∈N is itself a submartingale, as
φ(Sk ) = φ(E∗ [SN | Fk ]) 6 E∗ [φ(SN ) | Fk ], k = 1, 2, . . . , N .

∗
840 "
a) The condition VN = C reads
 ηN πN + ξN (1 + a)SN −1 = (1 + a)SN −1 − K

ηN πN + ξN (1 + b)SN −1 = (1 + b)SN −1 − K,

from which we deduce the (static) hedging strategy ξN = 1 and ηN =

−K (1 + r )−N /π0 .
b) We have
 ηN −1 πN −1 + ξN −1 (1 + a)SN −2 = ηN πN −1 + ξN (1 + a)SN −2

ηN −1 πN −1 + ξN −1 (1 + b)SN −2 = ηN πN −1 + ξN (1 + b)SN −2 ,

which yields ξN −1 = ξN = 1 and ηN −1 = ηN = −K (1 + r )−N /π0 .

Similarly, solving the self-financing condition
 ηt πt + ξt (1 + a)St−1 = ηt+1 πt + ξt+1 (1 + a)St−1


ηt πt + ξt (1 + b)St−1 = ηt+1 πt + ξt+1 (1 + b)St−1


at time t yields
K
ξt = 1 and ηt = −(1 + r )−N , t = 1, 2, . . . , N .
π0
c) We have
πt ( C ) = V t
= ηt πt + ξt St
πt
= St − K (1 + r )−N
π0
= St − K (1 + r )−(N −t) .
d) For all t = 0, 1, . . . , N we have
(1 + r )−(N −t) E∗ [C | Ft ] = (1 + r )−(N −t) E∗ [SN − K | Ft ],

= (1 + r )−(N −t) E∗ [SN | Ft ] − (1 + r )−(N −t) E∗ [K | Ft ]
= (1 + r )−(N −t) (1 + r )N −t St − K (1 + r )−(N −t)
= St − K (1 + r )−(N −t)
= V t = πt ( C ) .
For a future contract expiring at time N we take K = S0 (1 + r )N

and the contract is usually quoted at time t using the forward price
(1 + r )N −t (St − K (1 + r )N −t ) = (1 + r )N −t St − K = (1 + r )N −t St −
" 841
N. Privault
S0 (1 + r )N , or simply using (1 + r )N −t St . Future contracts are “marked

to market” at each time step t = 1, 2, . . . , N via a positive or negative
cash flow exchange (1 + r )N −t St − (1 + r )N −t+1 St−1 from the seller to
the buyer, ensuring that the absolute difference |(1 + r )N −t St − K| has
been credited to the buyer’s account if it is positive, or to the seller’s ac-
count if it is negative.
Exercise 3.15
a) We write
 ξN SN −1 (1 + 1/2) + ηN = (SN −1 (1 + 1/2))2


VN =
ξN SN −1 (1 − 1/2) + ηN = (SN −1 (1 − 1/2))2 ,

which yields
 ξN = 2SN −1

ηN = −3(SN −1 )2 /4.

b) i) We have
E∗ [(SN )2 | FN −1 ] = p∗ (SN −1 )2 (1 + 1/2)2 + (1 − p∗ )(SN −1 )2 (1 − 1/2)2

1
= (SN −1 )2 (1 + 1/2)2 + (1 − 1/2)2

2
= 5(SN −1 )2 /4.
ii) We have
 ξN −1 SN −2 (1 + 1/2) + ηN −1

ξN −1 SN −1 + ηN −1 A0 =
ξN −1 SN −2 (1 − 1/2) + ηN −1

= VN −1
= 5(SN −1 )2 /4
 5(SN −2 (1 + 1/2))2 /4

=
5(SN −2 (1 − 1/2))2 /4,

hence
 ξN −1 = 5SN −2 /2

ηN −1 = −15(SN −2 )2 /16.

iii) We have
ξN −1 SN −1 + ηN −1 A0 = 5SN −2 SN −1 /2 − 15(SN −2 )2 /16
842 "
 5(SN −2 )2 (1 + 1/2)/2 − 15(SN −2 )2 /16


=
5(SN −2 )2 (1 − 1/2)/2 − 15(SN −2 )2 /16

 15(SN −2 )2 /4 − 15(SN −2 )2 /16


=
5(SN −2 )2 − 15(SN −2 )2 /16

 45(SN −2 )2 /16

=
5(SN −2 )2 /16,

and on the other hand,
ξN SN −1 + ηN A0 = 2(SN −1 )2 − 3(SN −1 )2 /4
 2(SN −2 )2 (1 + 1/2)2 − 3(SN −2 )2 (1 + 1/2)2 /4

=
2(SN −2 )2 (1 − 1/2)2 − 3(SN −2 )2 (1 − 1/2)2 /4

 45(SN −2 )2 /16

=
5(SN −2 )2 /16.

Remark: We could also determine (ξN −1 , ηN −1 ) as in Proposition 3.12,

from (ξN , ηN ) and the self-financing condition
ξN −1 SN −1 + ηN −1 A0 = ξN SN −1 + ηN AN −1 ,
as
 ξN −1 SN −2 (1 + 1/2) + ηN −1

ξN −1 SN −1 + ηN −1 A0 =
ξN −1 SN −2 (1 − 1/2) + ηN −1

= ξN SN −1 + ηN A0
= 2(SN −1 )2 − 3(SN −1 )2 /4
 2(SN −2 )2 (1 + 1/2)2 − 3(SN −2 )2 (1 + 1/2)2 /4

=
2(SN −2 )2 (1 − 1/2)2 − 3(SN −2 )2 (1 − 1/2)2 /4,

which recovers ξN −1 = 5SN −2 /2 and ηN −1 = −15(SN −2 )2 /16.
Exercise 3.16
a) By Theorem 2.19 this model admits a unique risk-neutral probability mea-
sure P∗ because a < r < b, and from (2.16) we have
b−r 0.07 − 0.05

P∗ (Rt = a) = = ,
b−a 0.07 − 0.02
" 843
N. Privault
and
r−a 0.05 − 0.02
P(Rt = b) = = ,
b−a 0.07 − 0.02
t = 1, 2, . . . , N .
b) There are no arbitrage opportunities in this model, due to the existence
of a risk-neutral probability measure.
c) This market model is complete because the risk-neutral probability mea-
sure is unique.
d) We have
C = (SN )2 ,
hence
2
e = (SN ) = h(XN ),
C
(1 + r )N
with
h ( x ) = x2 ( 1 + r ) N . (A.7)
Now we have
Vet = ṽ (t, Xt ),
where the function v (t, x) is given from Proposition 3.8 as
N −t
!
1 + b k 1 + a N −t−k

X N −t ∗ k ∗ N −t−k
ṽ (t, x) = (p ) (q ) h x .
k 1+r 1+r
k =0
Using (A.7) and the binomial theorem, we find

N −t
X N −t
ṽ (t, x) = x2 (1 + r )N
k
k =0
1 + a 2(N −t−k)
2k
1+b

×(p∗ )k (q ∗ )N −t−k
1+r 1+r
N −t
X N −t
= x2 ( 1 + r ) N
k
k =0
k N −t−k
(r − a)(1 + b)2 (b − r )(1 + a)2

×
(b − a)(1 + r )2 (b − a)(1 + r )2
N −t
(r − a)(1 + b)2 (b − r )(1 + a)2

= x2 ( 1 + r ) N +
(b − a)(1 + r )2 (b − a)(1 + r )2
N −t
x (r − a)(1 + b)2 + (b − r )(1 + a)2
2
=
(1 + r )N −2t (b − a)N −t
N −t
x (r − a)(1 + 2b + b2 ) + (b − r )(1 + 2a + a2 )
2
=
(1 + r )N −2t (b − a)N −t
844 "
N −t
x2 r (1 + 2b + b2 ) − a(1 + 2b + b2 ) + b(1 + 2a + a2 ) − r (1 + 2a + a2 )
=
(1 + r )N −2t (b − a)N −t
(1 + r (a + b + 2) − ab)N −t
= x2 .
(1 + r )N −2t
e) We have

+b X
v t, 11+ 1+a

r t−1 − v t, 1+r Xt−1
ξt1 =
Xt−1 (b − a)/(1 + r )
2
1+b a 2
− 11+

1+r +r (1 + r (a + b + 2) − ab)N −t
= Xt−1
(b − a) / (1 + r ) (1 + r )N −2t
(1 + r (a + b + 2) − ab)N −t
= St−1 (a + b + 2) , t = 1, 2, . . . , N ,
(1 + r )N −t
representing the quantity of the risky asset to be present in the portfolio
at time t. On the other hand we have
Vt − ξt1 Xt
ξt0 =
Xt0
Vt − ξt1 Xt
=
π0
Xt − Xt−1 (a + b + 2)/(1 + r )
= Xt (1 + r (a + b + 2) − ab)N −t
π0 (1 + r )N −2t
N −t St − St−1 (a + b + 2)
= St (1 + r (a + b + 2) − ab)
π0 ( 1 + r ) N
(1 + a)(1 + b)
= −(St−1 )2 (1 + r (a + b + 2) − ab)N −t ,
π0 ( 1 + r ) N
t = 1, 2, . . . , N .
f) Let us check that the portfolio is self-financing. We have
ξ t+1 · S t = ξt0+1 St0 + ξt1+1 St1

(1 + a)(1 + b) 0
= −(St )2 (1 + r (a + b + 2) − ab)N −t−1 S
π0 ( 1 + r ) N t
(1 + r (a + b + 2) − ab)N −t−1
+(St )2 (a + b + 2)
(1 + r )N −t−1
(1 + r (a + b + 2) − ab)N −t−1
= (St )2
(1 + r )N −t
× ((a + b + 2)(1 + r ) − (1 + a)(1 + b))
" 845
N. Privault
1
= (Xt )2 (1 + r (a + b + 2) − ab)N −t
(1 + r )N −3t
= ( 1 + r ) t Vt
= ξt · St, t = 1, 2, . . . , N .
Exercise 3.17
a) We have
Vt = ξt St + ηt πt
= ξt (1 + Rt )St−1 + ηt (1 + r )πt−1 .
b) We have
E∗ [Rt |Ft−1 ] = aP∗ (Rt = a | Ft−1 ) + bP∗ (Rt = b | Ft−1 )

b−r r−a
=a +b
b−a b−a
r r
=b −a
b−a b−a
= r.
c) By the result of Question (a), we have
E∗ [Vt | Ft−1 ] = E∗ [ξt (1 + Rt )St−1 | Ft−1 ] + E∗ [ηt (1 + r )πt−1 | Ft−1 ]

= ξt St−1 E∗ [1 + Rt | Ft−1 ] + (1 + r )E∗ [ηt πt−1 | Ft−1 ]
= (1 + r )ξt St−1 + (1 + r )ηt πt−1
= (1 + r )ξt−1 St−1 + (1 + r )ηt−1 πt−1
= (1 + r )Vt−1 ,
where we used the self-financing condition.

d) We have
1
Vt−1 = E∗ [Vt | Ft−1 ]
1+r
3 8
= P∗ (Rt = a | Ft−1 ) + P∗ (Rt = b | Ft−1 )
1+r 1+r
1 0.25 − 0.15 0.15 − 0.05

= 3 +8
1 + 0.15 0.25 − 0.05 0.25 − 0.05
1 3 8

= +
1.15 2 2
= 4.78.
Problem 3.18 CRR model with transaction costs.
846 "
a) i) In the event of an increase in the stock position ξt , the corresponding

cost of purchase (1 + λ)(ξt+1 − ξt )St > 0 has to be deducted from the
savings account value ηt At , which becomes updated as
ηt+1 At = ηt At − (1 + λ)(ξt+1 − ξt )St ,
hence we have
ηt+1 At + (1 + λ)ξt+1 St = ηt At + (1 + λ)ξt St .
ii) In the event of a decrease in the stock position ξt , the corresponding

sale profit (ξt − ξt+1 )(1 − λ)St > 0 has to be added to from the savings
account value ηt At , which becomes updated as
ηt+1 At = ηt At + (ξt − ξt+1 )(1 − λ)St ,
hence we have
ηt+1 At + ξt+1 (1 − λ)St = ηt At + ξt (1 − λ)St .
b) We have:
i) If ξt+1 (βSt−1 ) > ξt (St−1 ),
(ξt (St−1 ) − ξt+1 (βSt−1 ))β ↑ Set−1 = (ηt+1 (βSt−1 ) − ηt (St−1 ))ρ.
ii) If ξt+1 (βSt−1 ) < ξt (St−1 ),
(ξt (St−1 ) − ξt+1 (βSt−1 )) β↓ Set−1 = (ηt+1 (βSt−1 ) − ηt (St−1 ))ρ,
and
iii) If ξt+1 (αSt−1 ) > ξt (St−1 ),
(ξt (St−1 ) − ξt+1 (αSt−1 )) α↑ Set−1 = ρηt+1 (αSt−1 ) − ρηt (St−1 ).
iv) If ξt+1 (αSt−1 ) < ξt (St−1 ),
(ξt (St−1 ) − ξt+1 (αSt−1 )) α↓ Set−1 = ρηt+1 (αSt−1 ) − ρηt (St−1 ).
c) We find
gβ (ξt (St−1 ), ξt+1 (βSt−1 )) ξt (St−1 ) − ξt+1 (βSt−1 ) Set−1 = ρηt+1 (βSt−1 ) − ρηt (St−1 ).

and
gα (ξt (St−1 ), ξt+1 (αSt−1 )) ξt (St−1 ) − ξt+1 (αSt−1 ) Set−1 = ρηt+1 (αSt−1 ) − ρηt (St−1 ).

d) The equation is
" 847
N. Privault
Set−1 gβ (ξt (St−1 ), ξt+1 (βSt−1 )) ξt (St−1 ) − ξt+1 (βSt−1 )

−Set−1 gα (ξt (St−1 ), ξt+1 (αSt−1 )) ξt (St−1 ) − ξt+1 (αSt−1 )

= ρηt+1 (βSt−1 ) − ρηt+1 (αSt−1 ),
which can be rewritten as
f (x, St−1 ) = 0 (A.8)
at x = ξt (St−1 ). The function
x 7→ f (x, St−1 )
is continuous by construction, and its derivative is the function
x 7→ gβ (x, ξt+1 (βSt−1 )) − gα (x, ξt+1 (αSt−1 )),
which can only take four values β ↑ − α↑ , β ↑ − α↓ , β↓ − α↑ , β↓ − α↓ , which

are all strictly positive due to the conditions

 α : = α ( 1 + λ ) < β ( 1 − λ ) = : β↓ ,
↑

α↓ := α(1 − λ) < β (1 − λ) := β↓ ,
α : = α (1 + λ) < β (1 + λ) = : β ↑ .

 ↑
Hence x 7→ f (x, St−1 ) is stricly increasing and we have
lim f (x, St−1 ) = −∞ and lim f (x, St−1 ) = ∞.

x→−∞ x→∞
Therefore, Equation (A.8) admits a unique solution x = ξt (St−1 ).

e) We have
ηt+1 (βSt−1 ) − ηt+1 (αSt−1 )

ξt (St−1 ) = ρ
Set−1 gβ (ξt (St−1 ), ξt+1 (βSt−1 )) − gα (ξt (St−1 ), ξt+1 (αSt−1 ))

ξt+1 (βSt−1 )gβ (ξt (St−1 ), ξt+1 (βSt−1 )) − ξt+1 (αSt−1 )gα (ξt (St−1 ), ξt+1 (αSt−1 ))
+ ,
gβ (ξt (St−1 ), ξt+1 (βSt−1 )) − gα (ξt (St−1 ), ξt+1 (αSt−1 ))
and
ηt (St−1 )
gα (ξt (St−1 ), ξt+1 (αSt−1 ))gβ (ξt (St−1 ), ξt+1 (βSt−1 ))ξt+1 (βSt−1 )
= Set−1
ρgα (ξt (St−1 ), ξt+1 (αSt−1 )) − ρgβ (ξt (St−1 ), ξt+1 (βSt−1 ))
gβ (ξt (St−1 ), ξt+1 (βSt−1 ))gα (ξt (St−1 ), ξt+1 (αSt−1 ))ξt+1 (αSt−1 )
− Set−1
ρgα (ξt (St−1 ), ξt+1 (αSt−1 )) − ρgβ (ξt (St−1 ), ξt+1 (βSt−1 ))
gα (ξt (St−1 ), ξt+1 (αSt−1 ))ηt+1 (βSt−1 ) − gβ (ξt (St−1 ), ξt+1 (βSt−1 ))ηt+1 (αSt−1 )
+ .
gα (ξt (St−1 ), ξt+1 (αSt−1 )) − gβ (ξt (St−1 ), ξt+1 (βSt−1 ))
848 "
f) i) In case f (ξt+1 (αSt−1 ), St−1 > 0 we have ξt (St−1 ) 6 ξt+1 (αSt−1 )

because f is increasing, hence
gα (ξt (St−1 ), ξt+1 (αSt−1 )) = α↑ (1 + λ)α.
ii) In case f ξt+1 (αSt−1 ), St−1 < 0 we have ξt (St−1 ) > ξt+1 (αSt−1 )

because f is increasing, hence
gα (ξt (St−1 ), ξt+1 (αSt−1 )) = α↓ = (1 − λ)α.
Note that in case f ξt+1 (αSt−1 ), St−1 = 0 we have ξt (St−1 ) = ξt+1 (αSt−1 )

hence there is no transaction from St−1 to αSt−1 . Similarly,

iii) If f ξt+1 (βSt−1 ), St−1 > 0 then ξt (St−1 ) 6 ξt+1 (βSt−1 ), hence

gβ (ξt (St−1 ), ξt+1 (βSt−1 )) = β ↑ (1 + λ)β.
iv) If f ξt+1 (βSt−1 ), St−1 < 0 then ξt (St−1 ) > ξt+1 (βSt−1 ), hence

gβ (ξt (St−1 ), ξt+1 (βSt−1 )) = β↓ = (1 − λ)β.
Note that in case f ξt+1 (βSt−1 ), St−1 = 0 we have ξt (St−1 ) = ξt+1 (βSt−1 )

hence there is no transaction from St−1 to βSt−1 .

g) With the parameters N = 2, K = $2, S0 = 8, ρ = 1, α = 0.5, β = 2, and
the transaction cost rate λ = 12.5%, we find the tree of asset prices
S2 = 32
S1 = 16
S0 = 8 S2 = 8
S1 = 4
S2 = 2.
Fig. S.10: Tree of market prices with N = 2.
At maturity time N we use the equations (4.4.4)-(4.4.5) of Proposi-

tion 4.11, which read here
h(βSN −1 ) − h(αSN −1 )
, (4.4.4)

ξN SN −1 =
(β − α)SN −1
where h(t, x) = (x − K )+ , and
βh(αSN −1 ) − αh(βSN −1 )
ηN (SN −1 ) = , (4.4.5)
( β − α ) AN
" 849
N. Privault
as the evaluation of the terminal payoff is not affected by bid/ask prices.

This yields
(η2 (16), ξ2 (16)) = (−2, 1) and (η2 (4), ξ2 (4)) = (−2, 1).
In this case we check that f (ξ2 (16), S0 ) = f (1, 8) = 0 and f (ξ2 (4), S0 ) =
f (1, 8) = 0, which yields the hedging strategy ξ1 (8) = ξ2 (16) = ξ2 (4) = 1
and η1 (8) = η1 (15) = η1 (4) = −2 as the portfolio is self-financing. This
static hedging involves no transaction costs and gives the initial price
V0 = 8 × 1 − 2 × 1 = $6.
Due to the simplicity of the case K = $2, we now consider the case
K = $4. In this case, (4.4.4) and (4.4.5) give
(η2 (16), ξ2 (16)) = (−4, 1) and (η2 (4), ξ2 (4)) = (−4/3, 2/3),
which yields
f (ξ2 (16), S0 ) = f (1, 8)

−4 − (−4/3)
= gβ (1, 1)(1 − 1) − gα (1, 2/3)(1 − 2/3) −
8
1 1
= − α↓ +
3 3
1 1
= − (1 − λ)α +
3 3
1 1 1
= − × 0.875 × +
3 2 3
> 0,
hence
gβ (ξ1 (S0 ), ξ2 (βS0 )) = β↑ = (1 + λ)β.
We also have
f (ξ2 (4), S0 ) = f (2/3, 8)

−4 − (−4/3)
= gβ (2/3, 1)(2/3 − 1) − gα (2/3, 2/3)(2/3 − 2/3) −
8
1 1
= − β↑ +
3 3
1 1
= − (1 + λ)β +
3 3
2 1
= − × 1.125 +
3 3
< 0,
hence
850 "
gα (ξ1 (S0 ), ξ2 (αS0 )) = α↓ = (1 − λ)α.

Therefore, we find
η2 (βS0 ) − η2 (αS0 )
ξ1 (S0 ) = ρ
Se0 gβ (ξ1 (S0 ), ξ2 (βS0 )) − gα (ξ1 (S0 ), ξ2 (αS0 ))

ξ2 (βS0 )gβ (ξ1 (S0 ), ξ2 (βS0 )) − ξ2 (αS0 )gα (ξ1 (S0 ), ξ2 (αS0 ))
+
gβ (ξ1 (S0 ), ξ2 (βS0 )) − gα (ξ1 (S0 ), ξ2 (αS0 ))
η2 (βS0 ) − η2 (αS0 ) ξ2 (βS0 )(1 + λ)β − ξ2 (αS0 )(1 − λ)α
=ρ +
Se0 (1 + λ)β − (1 − λ)α (1 + λ)β − (1 − λ)α
−4 − (−4/3) 1.125 × 2 − (2/3) × 0.875 × 0.5
= +
8 1.125 × 2 − 0.875 × 0.5 2 × 1.125 − 0.5 × 0.875
= 0.8965,
and
gα (ξ1 (S0 ), ξ2 (αS0 ))gβ (ξ1 (S0 ), ξ2 (βS0 ))ξ2 (βS0 )
η1 (S0 ) = Se0
ρgα (ξ1 (S0 ), ξ2 (αS0 )) − ρgβ (ξ1 (S0 ), ξ2 (βS0 ))
gβ (ξ1 (S0 ), ξ1 (βS0 ))gα (ξ1 (S0 ), ξ2 (αS0 ))ξ2 (αS0 )
−Se0
ρgα (ξ1 (S0 ), ξ2 (αS0 )) − ρgβ (ξ1 (S0 ), ξ2 (βS0 ))
gα (ξ1 (S0 ), ξ2 (αS0 ))η2 (βS0 ) − gβ (ξ1 (S0 ), ξ2 (βS0 ))η2 (αS0 )
+
gα (ξ1 (S0 ), ξ2 (αS0 )) − gβ (ξ1 (S0 ), ξ2 (βS0 ))
(1 − λ)α(1 + λ)βξ2 (βS0 ) e (1 + λ)β (1 − λ)αξ2 (αS0 )
= Se0 − S0
ρ(1 − λ)α − ρ(1 + λ)β (1 − λ)αρ − (1 + λ)βρ
(1 − λ)αη2 (βS0 ) − (1 + λ)βη2 (αS0 )
+
(1 − λ)α − (1 + λ)β
0.875 × 0.5 × 1.125 × 2 − 1.125 × 2 × 0.875 × 0.5 × 2/3
=8
0.875 × 0.5 − 1.125 × 2
0.875 × 0.5 × (−4) − 1.125 × 2 × (−4/3)
+
0.875 × 0.5 − 1.125 × 2
= −2.1379.
This leads to the initial option price
V0 = 0.8965 × 8 − 2.1379 = 5.0345.
Remark: Note that with λ = 0 and K = 4 we would find

8 20 44
ξ1 (S0 ) = = 0.88, η1 (S0 ) = − = −2.22, and V0 = = 4.88.
9 9 9
Therefore, the presence of transaction costs increases the price of the
option, and requires a higher stock position and a higher level of debt.
" 851
N. Privault
h) Please refer to the attached IPython notebook.∗
Remark: Transaction costs in the CRR model were originally introduced in

Boyle and Vorst (1992). The present solution is based on the method of
Mel0 nikov and Petrachenko (2005), which originally also takes into account
different borrowing and lending rates ρ↑ = 1 + r↑ and ρ↓ = 1 + r↓ , which can
be regarded as bid/ask prices for the riskless asset, and can also represent
transaction costs.
Problem 3.19 CRR model with dividends.

a) We have
(1)
 
 (1 + b)(1 − α)Sk−1 if Rk = b 
 
(1)
Sk =
(1)
(1 + a)(1 − α)Sk−1 if Rk = a

 

(1)
= (1 + Rk )(1 − α)Sk−1 , k = 1, 2, . . . , N ,
and
k
(1) (1)
Y
Sk = S0 ( 1 + Ri ) , k = 0, 1, . . . , N ,
i=1
with the binary tree
(1)
(1 + b)(1 − α)S0
(1)
S0
(1)
(1 + a)(1 − α)S0
(1)
b) The asset price before dividend payment is Sk /(1 − α), hence the divi-
dend amount is
(1) (1)
Sk (1) αSk
− Sk = ,
1−α 1−α
therefore, the dividend value represents a percentage α/(1 − α) of the ex-
(1)
dividend price Sk . Moreover, the return of the risky asset satisfies the
following relation
∗

Right-click to save as attachment (may not work on .
852 "
 
(1)
∗
Sk+1 (1)
E Fk  = E∗ (1 + Rk )Sk Fk

1−α
r−a (1) b−r (1)
= (1 + b)Sk + (1 + a)Sk
b−a b−a
(1)
= (1 + r )Sk , k = 0, 1, . . . , N − 1.
α (1)
c) When reinvesting the dividend amount ξk Sk into the new portfolio
1−α
allocation, we have
(1) (0)
Vk = ξk+1 Sk + ηk+1 Sk
(1) (0) α (1)
= ξk Sk + ηk Sk + ξk Sk
1−α
(1)
Sk (0)
= ξk + ηk Sk ,
1−α
at times k = 1, 2, . . . , N − 1. Moreover, at time N we will similarly have
(1)
(1) α (1) (0) S (0)
VN = ξN SN + ξN SN + ηN SN = ξN N + ηN SN ,
1−α 1−α
therefore the self-financing condition reads
(1)
Sk (0)
Vk = ξk + ηk Sk , k = 1, 2, . . . , N . (A.9)
1−α
d) By the self-financing condition (A.9) we have
(1) (1)
S S
Vek − Vek−1 = ξk+1 k(0) + ηk+1 − ξk k−1
(0)
− ηk
Sk Sk−1
(1) (1)
ξk Sk Sk−1
= (0)
+ ηk − ξk (0)
− ηk
Sk ( 1 − α ) Sk−1
 
(1) (1)
Sk Sk−1
= ξk 
(0)
− (0)  , k = 1, 2, . . . , N ,
Sk (1 − α) Sk−1
which allows us to conclude from Question (b) that
E∗ Vek | Fk−1 − Vek−1 = E∗ Vek − Vek−1 | Fk−1

   
(1) (1)
Sk−1

∗ Sk
= E ξk ×  ( 0 ) − (0)  Fk−1 
Sk (1 − α) Sk−1
" 853
N. Privault
 
(1) (1)
∗ Sk Sk−1
= ξk E (0)
− (0) Fk−1 

Sk (1 − α) Sk−1
" (1) # !
ξk Sk Fk−1 − (1 + r )S (1)
E∗

=
Sk
(0) (1 − α ) k−1
= 0, k = 1, 2, . . . , N ,
therefore Vek k=0,1,...,N −1 is a martingale under P∗ .

e) Assuming that the portfolio strategy attains the claim C we have C = VN

and Ce = VeN , hence by the martingale property of Vek under

k =0,1,...,N −1
P , we find
∗
Vek = E∗ VeN Fk = E∗ C e Fk , k = 0, 1, . . . , N ,

which shows that

1
Vk = E∗ [C | Fk ], k = 0, 1, . . . , N ,
(1 + r )N −k
f) By a binomial probability computation, we have

1
Vk = E∗ [h(SN ) | Fk ]
(1 + r )N −k
N
" ! #
1 ∗
Y
E 1 ,

= h x ( + R l ) F
k

(1 + r )N −k (1)
l =t+1 x=Sk
1
=
(1 + r )N −k
N −k
X N −k (1)
(p∗ )l (q ∗ )N −k−l h Sk (1 + b)k (1 + a)N −k−l (1 − α)N −k

×
l
l =0
(1)
= C0 k, Sk (1 − α)N −k , N , a, b, r .

g) We “absorb” the dividend rate α into new market returns by taking

aα , bα , rα such that
1 + aα = (1 + a)(1 − α), 1 + bα = (1 + b)(1 − α), 1 + rα = (1 + r )(1 − α),
i.e.
aα = −α + a(1 − α), bα = −α + b(1 − α), rα = −α + r (1 − α).
As a consequence, we have
854 "
1
Vk =
(1 + r )N −k
N −k
X N −k (1)
(p∗ )l (q ∗ )N −k−l h Sk (1 + b)k (1 + a)N −k−l (1 − α)N −k

×
l
l =0
N −k
(1 − α)N −k X N − k

(1)
(p∗ )k (q ∗ )N −k−l h Sk (1 + bα )k (1 + aα )N −k−l

=
(1 + rα ) N −k l
l =0
(1)
= (1 − α)N −k C0 k, Sk , N , aα , bα , rα ,

where
rα − aα r−a
p∗ := P∗ (Rk = b) = = > 0,
bα − aα b−a
and
bα − rα b−r
q ∗ := P∗ (Rk = a) = = > 0,
bα − aα b−a
k = 1, 2, . . . , N .
h) We have
1 (1)
Cα k, Sk , N , aα , bα , rα , k = 0, 1, . . . , N ,

Vek =
(1 + r )N
hence by the martingale property we have
1 (1)
Cα k, Sk , N , aα , bα , rα

Vek =
(1 + r )k
= E∗ Vek+1 | Fk

1 (1)
E∗ Cα k + 1, Sk+1 , N , aα , bα , rα Fk

=
(1 + r )k +1
1
(1)
p∗ Cα k + 1, Sk (1 + bα ), N , aα , bα , rα

=
(1 + r ) k + 1
(1)
+q ∗ Cα k + 1, Sk (1 + aα ), N , aα , bα , rα .
This yields
(1)
(1 + r )Cα k, Sk , N , aα , bα , rα

(1) (1)
= p∗ Cα k + 1, Sk (1 + bα ), N , aα , bα , rα + q ∗ Cα k + 1, Sk (1 + aα ), N , aα , bα , rα .

i) We find the equations

(0) (1) (1)

 ηk Sk + ξk (1 + aα )Sk−1 = Cα k, (1 + aα )Sk−1 , N , aα , bα , rα


(0) (1) (1)

ηk Sk + ξk (1 + bα )Sk−1 = Cα k, (1 + bα )Sk−1 , N , aα , bα , rα ,


" 855
N. Privault
which imply
(1) (1)
Cα k, (1 + bα )Sk−1 , N , aα , bα , rα − Cα k, (1 + aα )Sk−1 , N , aα , bα , rα

ξk = (1)
(bα − aα )Sk−1
(1)
C k, (1 + bα )Sk−1 , N , aα , bα , rα

N −k 0
= (1 − α ) (1)
(1)
C0 k, (1 + aα )Sk−1 , N , aα , bα , rα

− (1 − α)N −k (1)
,
and
(1)
(1 + bα )Cα k, (1 + bα )Sk−1 , N , aα , bα , rα

ηk = (0)
(1)
(1 + aα )Cα k, (1 + aα )Sk−1 , N , aα , bα , rα

− (0)
(1)
(1 + bα )C0 k, (1 + bα )Sk−1 , N , aα , bα , rα

= (1 − α)N −k (0)
(1)
(1 + aα )C0 k, (1 + aα )Sk−1 , N , aα , bα , rα

− (1 − α)N −k (0)
,
k = 1, 2, . . . , N .
j) A possible answer: We have
N −k
1

X N −k
ξk = (1)
(p∗ )k (q ∗ )N −k−l
(b − a)Sk−1 l=0 l

(1)
× h (1 − α)N −k Sk (1 + b)k+1 (1 + a)N −k−l

(1)
−h (1 − α)N −k Sk (1 + b)k (1 + a)N −k−l+1
and
N −k
1

X N −k
ηk = (1)
(p∗ )k (q ∗ )N −k−l
(b − a)Sk−1 l=0 l

(1)
× (1 + b)h (1 − α)N −k Sk (1 + b)k (1 + a)N −k−l+1

(1)
−(1 + a)h (1 − α)N −k Sk (1 + b)k+1 (1 + a)N −k−l ,
856 "
k = 1, 2, . . . , N . Differentiation with respect to α of the general term inside

the above summations yields respectively
(1 + a)yh0 ((1 + a)y ) − (1 + b)yh0 ((1 + b)y ) (A.10)
for ξk , and
(1 + b)yh0 ((1 + b)y ) − (1 + a)yh0 ((1 + a)y ), (A.11)

(1)
for ηk , with y := (1 − α)N −k Sk (1 + b)k (1 + a)N −k−l and a < b.
We note that the sign of the above quantities (A.10)-(A.11) depends on

whether the function x 7−→ xh0 (x) is non-decreasing, which is the case for
example for the payoff functions h(x) = (x − K )+ and h(x) = (K − x)+
of both European call and put options.
In particular, when the function x 7−→ xh0 (x) is non-decreasing, the

amount invested on the risky (resp. riskless) asset will be lower (resp.
higher) in the presence of a higher dividend.
We also note that the expected return
p∗ (1 + b)(1 − α) + q ∗ (1 + a)(1 − α) = r (1 − α)
and the variance
p∗ (1 + b)2 (1 − α)2 + q ∗ (1 + a)2 (1 − α)2 − r2 (1 − α)2

= (1 − α)2 p∗ (1 + b)2 + q ∗ (1 + a)2 − r2

of returns are lower in the presence of dividends.
Problem 3.20
a) In order to check for arbitrage opportunities we look for a risk-neutral
probability measure P∗ which should satisfy
(1) (1)
E∗ Sk+1 Fk = (1 + r )Sk , k = 0, 1, . . . , N − 1.
(1)
Rewriting E∗ Sk+1 Fk as
(1) (1) (1)
E∗ Sk+1 Fk = (1 + a)Sk P∗ (Rk+1 = a | Fk ) + Sk P∗ (Rk+1 = 0 | Fk )
(1)
+(1 + b)Sk P∗ (Rk+1 = b | Fk )
(1) (1)
= (1 + a)Sk P∗ (Rk+1 = a) + Sk P∗ (Rk+1 = 0)
(1)
+(1 + b)Sk P∗ (Rk+1 = b),
" 857
N. Privault
k = 0, 1, . . . , N − 1, it follows that any risk-neutral probability measure

P∗ should satisfy the equations

(1)
 (1 + r )Sk =





(1) ∗ (1) ∗ (1) ∗
 (1 + b)Sk P (Rk+1 = b) + Sk P (Rk+1 = 0) + (1 + a)Sk P (Rk+1 = a),



P (Rk+1 = b) + P∗ (Rk+1 = 0) + P∗ (Rk+1 = a) = 1,
 ∗

k = 0, 1, . . . , N − 1, i.e.
 ∗
 bP (Rk = b) + aP∗ (Rk = a) = r,
P∗ (Rk = b) + P∗ (Rk = a) = 1 − P∗ (Rk = 0),


k = 1, 2, . . . , N , with solution
r − (1 − P∗ (Rk = 0))a r − (1 − θ ∗ )a
P ∗ ( Rk = b ) = = ,
b−a b−a
and
(1 − P∗ (Rk = 0))b − r (1 − θ ∗ )b − r
P∗ (Rk = a) = = ,
b−a b−a
k = 1, 2, . . . , N . We check that this ternary tree model is without arbitrage
if and only if there exists θ∗ := P∗ (Rk = 0) ∈ (0, 1) such that
(1 − θ∗ )a < r < (1 − θ∗ )b, (A.12)
or  r
 1 − b if r > 0,


r−a b−r
0 < θ∗ < min , =
−a b
 1 − r if r 6 0.


a
Condition (A.12) is necessary in order to have
P∗ (Rk = b) > 0 and P∗ (Rk = a) > 0,
and it is sufficient because it also implies
P∗ (Rk = b) = 1 − θ∗ − P∗ (Rk = a) 6 1
and
P∗ (Rk = a) = 1 − θ∗ − P∗ (Rk = b) 6 1.
b) We will show that this ternary tree model is without arbitrage if and only
if a < r < b.
858 "
(i) Indeed, if the condition a < r < b is satisfied there always exists
θ ∈ (0, 1) such that
a < (1 − θ )a < r < (1 − θ )b < b,
as can be seen by taking

r−a b−r
θ∈ 0, min , ,
−a b
hence there exists a risk-neutral probability measure P∗θ , and the market
model is without arbitrage.
(ii) Conversely, if this ternary tree model is without arbitrage there exists
some θ = P∗ (Rt = 0) ∈ (0, 1) such that
(1 − θ )a < r < (1 − θ )b.
c) When r 6 a < 0 < b the risky asset overperforms the riskless asset,
therefore we can realize arbitrage by borrowing from the riskless asset to
purchase the risky asset. When a < 0 < b 6 r the riskless asset overper-
forms the risky asset, therefore we can realize arbitrage by shortselling
the risky asset and save the profit of the short sale on the riskless asset.
d) Under the absence of arbitrage condition a < r < b, every value of θ ∈
(0, 1) such that
r−a b−r
0 < θ < min ,
−a b
satisfies
(1 − θ )a < r < (1 − θ )b,
and gives rise to a different risk-neutral probability measure, hence the
risk-neutral measure is not unique and by Theorem 5.12 this ternary tree
model is not complete.
In particular, every risk-neutral probability measure P∗θ will give rise to a

different claim price
(θ ) 1
E∗ C F t , t = 0, 1, . . . , N .

πt ( C ) =
(1 + r )N −t θ
e) We have
 
(1) (1)
S − Sk

∗  k +1
Var

Fk 
(1)
Sk
" 859
N. Privault
 2    2
(1) (1) (1) (1)
S − Sk S − Sk

∗  k +1  Fk  − E∗  k+1
=E

Fk 
(1) (1)
Sk Sk
 2 
(1) (1)
S −S

= E∗  k+1 (1) k  Fk  − r2

Sk
= a2 P∗σ (Rk+1 = a | Fk ) + b2 P∗σ (Rk+1 = b | Fk ) − r2
(1 − P∗σ (Rk+1 = 0))b − r r − (1 − P∗σ (Rk+1 = 0))a
= a2 + b2 − r2
b−a b−a
= ab(θ − 1) + r (a + b) − r2
= σ2 ,
k = 0, 1, . . . , N − 1, hence
σ 2 + r 2 − r (a + b)
P∗σ (Rk = 0) = θ = 1 + ,
ab
and therefore
r − (1 − P∗σ (Rk = 0))a σ 2 − r (a − r )
P∗σ (Rk = b) = = ,
b−a b(b − a)
and
(1 − P∗σ (Rk = 0))b − r r (b − r ) − σ 2
P∗σ (Rk = a) = = ,
b−a a(b − a)
k = 1, 2, . . . , N , under the condition
σ 2 > Max(−r (r − a), r (b − r )),
in addition to the condition 0 < θ < 1, i.e.
r (b − r ) + rb < σ 2 < (b − r )(r − a).
Finally, we find
−r (r − a) < σ 2 < (b − r )(r − a),
if r ∈ (a, 0], and
r (b − r ) < σ 2 < (b − r )(r − a),
if r ∈ [0, b).
f) In this case the ternary tree becomes a trinomial recombining tree, and
the expression of the risk-neutral probability measure becomes
r (b + 1) + (1 − θ )b
P∗θ (Rk = b) = ,
b2 + 2b
860 "
and
(1 − θ )b − r
P∗θ (Rk = a) = (b + 1) ,
b2 + 2b
k = 1, 2, . . . , N . The market model is without arbitrage if and only if there
exists θ := P∗θ (Rk = 0) ∈ (0, 1) such that
b
−(1 − θ ) < r < (1 − θ )b,
b+1
or
r
0 < θ < 1− .
b
g) Using the tower property (23.38) of conditional expectations, we have
(1) 1
f k, Sk = E∗ [C | Fk ]
(1 + r )N −k
1
= E∗ [E∗ [C | Fk+1 ] | Fk ]
(1 + r )N −k
1 (1)
E∗ (1 + r )N −(k+1) f k + 1, Sk+1 Fk

=
(1 + r )N −k
1 (1)
E∗ f k + 1, Sk+1 Fk

=
1+r
1 (1) (1)
f k + 1, Sk (1 + a) P∗θ (Rk = a) + f k + 1, Sk P∗θ (Rk = 0)

=
1+r

(1)
+f k + 1, Sk (1 + b) P∗θ (Rk = b) .

h) In this case we have f (N , x) = (K − x)+ .

i) See the attached code.∗†
j) Taking θ = 0.5 we find the following graph:
∗
Download the modified (trinomial) IPython notebook that can be run here.
†
Download the corresponding (binomial) IPython notebook. The Anaconda distri-
bution can be installed from https://www.anaconda.com/distribution/ or tried online
at https://jupyter.org/try.
" 861
N. Privault
4.0 0.0
2.0 2.0 0.24 0.0
1.0 1.0 1.0 0.74 0.82 1.0
0.5 0.5 1.32 1.5
0.25 1.75
(a) Underlying asset prices. (b) Put option prices.
Fig. S.11: Put option prices in the trinomial model.
There also exists extensions of the trinomial model to five states (pentanomial
model), six states (hexanomial model), etc.
Chapter 4
Exercise 4.1 If 0 6 s 6 t, using the facts that E[Bt ] = 0 and E Bt2 = 0,

t > 0, we have
E[Bt Bs ] = E[(Bt − Bs )Bs ] + E Bs2

= E[(Bt − Bs )]E[Bs ] + E Bs2

= 0+s
= s,
and similarly we obtain E[Bt Bs ] = t when 0 6 t 6 s, hence in general we

have
E[Bt Bs ] = min(s, t), s, t > 0.
Exercise 4.2 We need to check whether the four properties of the definition
of Brownian motion are satisfied.
a) Checking Conditions 1-2-3 are easily satisfied using the time shift t 7→
c + t. As for Condition 4, Bc+t − Bc+s clearly has the centered Gaus-
sian distribution with variance c + t − (c − s) = t − s. We conclude that
(Bc+t − Bc )t∈R+ is a standard Brownian motion.
b) We note that Bct2 is a centered Gaussian random variable with variance
ct2 - not t, hence (Bct2 )t∈R+ is not a standard Brownian motion.
c) Similarly, checking Conditions 1-2-3 does not pose any particular problem
using the time change t 7→ t/c2 . As for Condition 4, Bc+t − Bc+s clearly
has a centered Gaussian distribution with
862 "
Var c Bt/c2 − Bs/c2 = c2 Var Bt/c2 − Bs/c2

= (t − s)c2 /c2
= t − s.
As a consequence, Bt/c2 t∈R is a standard Brownian motion.

+
d) This process does not have independent increments, hence it cannot be a
Brownian motion. For example, by (4.1) we have
E Bt + Bt/2 − Bs + Bs/2 Bs + Bs/2

= E Bt Bs + Bt Bs/2 + Bt/2 Bs + Bt/2 Bs/2

−E Bs Bs + Bs Bs/2 + Bs/2 Bs + Bs/2 Bs/2
s s s s s
= s+ +s+ −s− − −
2 2 2 2 2
s
= ,
2
which differs from 0, hence the two increments are not independent. In-
deed, independence of Bt + Bt/2 − Bs + Bs/2 ) and Bs + Bs/2 would yield
E Bt + Bt/2 − Bs + Bs/2 ) Bs + Bs/2 )

= E Bt + Bt/2 − Bs + Bs/2 ) E Bs + Bs/2 )

= 0.

wT
2dBt = 2(BT − B0 ) = 2BT ,
0
which has a Gaussian distribution with mean 0 and variance 4T . On the other
hand,
wT
(2 × 1[0,T /2] (t) + 1(T /2,T ] (t))dBt = 2(BT /2 − B0 ) + (BT − BT /2 )
0
= BT + BT /2 ,
which has a Gaussian distribution with mean 0 and variance
Var[BT + BT /2 ] = Var[(BT − BT /2 ) + 2BT /2 ]

= Var[BT − BT /2 ] + 4 Var[BT /2 ]
T 4T
= +
2 2
5T
= .
2
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N. Privault
Equivalently, using the Itô isometry (4.7), we have

w
T
Var (2 × 1[0,T /2] (t) + 1(T /2,T ] (t))dBt
0
wT
" 2 #
=E (2 × 1[0,T /2] (t) + 1(T /2,T ] (t))dBt
0
wT
2 × 1[0,T /2] (t) + 1(T /2,T ] (t) dt
2
=
0
w T /2 wT
=4 dt + dt
0 T /2
5T
= .
2
w 2π
Exercise 4.4 By Proposition 4.11, the stochastic integral sin(t) dBt has
0
a Gaussian distribution with mean 0 and variance
w 2π 1 w 2π
sin2 (t)dt = (1 − cos(2t))dt = π.
0 2 0
Exercise 4.5 By the Itô formula (4.28), we have
d(f (t)Bt ) = f (t)dBt + Bt df (t) + df (t) • dBt

= f (t)dBt + Bt f 0 (t)dt + f 0 (t)dt • dBt
= f (t)dBt + Bt f 0 (t)dt,
and by integration on both sides we get

wT wT wT
f (t)dBt + Bt f 0 (t)dt = d ( f ( t ) Bt )
0 0 0
= f (T )BT − f (0)B0
= 0,
since f (T ) = 0 and B0 = 0, hence the conclusion. Note that this result can
also be obtained by integration by parts on the interval [0, T ], see (4.11).
Exercise 4.6
r1
a) The stochastic integral 0 t2 dBt is a centered Gaussian random variable
with variance
w1 2 # w
"
1 4 1
E 2
t dBt = t dt = .
0 0 5
r 1 −1/2
b) The stochastic integral 0 t dBt has the variance
864 "
w1 w1 1
" 2 #
E t−1/2 dBt = dt = +∞.
0 0 t
r1
In fact, the stochastic integral 0 t−1/2 dBt does not exist as a random
variable in L2 (Ω) because the function t 7→ t−1/2 is not in L2 ([0, 1]).
Remark. Writing Relation (5.3.7) page 190 with f (t) = t−1/2 gives
w1 BT 1 w 1 −3/2
t−1/2 dBt = √ + t Bt dt,
0 T 2 0
however this is only a formal statement as f is not in C 1 ([0, 1]). Informally,

wT
we can check that the term t−3/2 Bt dt has the infinite variance
0
wT w w
" 2 #
0 T T
E Bt f (t)dt =E Bt f 0 (t)dt Bs f 0 (s)ds
0 0 0
w w
T T
=E Bs Bt f 0 (s)f 0 (t)dsdt
0 0
wT wT
= f 0 (s)f 0 (t)E[Bs Bt ]dsdt
0 0
w w
1 T T −3/2 −3/2
= s t min(s, t)dsdt
4 0 0
w w
1 T −3/2 t −5/2 1 w T −5/2 w T −3/2
= t s dsdt + t s dsdt
4 0 0 4 0 t
1 w T −3/2 w t −5/2 1 w T −5/2 w T −3/2
= t s dsdt + t s dsdt
4 0 0 4 0 t
= +∞,
where we used Relation (4.1) or the result of Exercise 4.1
Exercise 4.7
a) By Proposition 4.11, the probability distribution of Xn is Gaussian with
mean zero and variance
w 2π
" 2 #
Var[Xn ] = E sin(nt)dBt
0
w 2π
= sin2 (nt)dt
0
1 w 2π 1 w 2π
= cos(0)dt − cos(2nt)dt
2 0 2 0
= π, n > 1.
" 865
N. Privault
b) The random variables (Xn )n>1 have same Gaussian distribution, and they
are pairwise independent as from Corollary 4.12 we have
w w 2π
2π
E[Xn Xm ] = E sin(nt)dBt sin(mt)dBt
0 0
w 2π
= sin(nt) sin(mt)dt
0
1 w 2π 1 w 2π
= cos((n − m)t)dt − cos((n + m)t)dt
2 0 2 0
=0
and the vector (Xn , Xm ) is jointly Gaussian, for n, m > 1 such that
n 6= m. Note that this condition implies independence only when the
random variables have a Gaussian distribution.
Exercise 4.8 We have Xt = f (Bt ) with f (x) = sin2 x, f 0 (x) = 2 sin x cos x =
sin(2x), and f 00 (x) = 2 cos(2x), hence
dXt = d sin2 (Bt )

= df (Bt )
1
= f 0 (Bt )dBt + f 00 (Bt )dt
2
= sin(2Bt )dBt + cos(2Bt )dt.
Exercise 4.9
a) Using the Itô isometry (4.16), we have
w wT
T
E BT3 = E dBt T + 2

Bt dBt
0 0
w w wT
T T
= TE dBt + 2E dBt Bt dBt
0 0 0
w
T
= 2E Bt dt
0
wT
=2 E[Bt ]dt
0
= 0.
We also have
wT
" 2 #
E BT4 = E T +2

Bt dBt
0
866 "
wT w
" 2 #
T
= E T 2 + 2T Bt dBt + 4 Bt dBt
0 0
w "
wT 2 #
T
= T + 2T E
2
Bt dBt + 4E Bt dBt
0 0
w
T
= T 2 + 4E |Bt |2 dt
0
wT
= T +4
2
E |Bt |2 dt

0
wT
= T2 + 4 tdt
0
T2
= T2 + 4
2
= 3T 2 .
b) If X ' N (0, σ 2 ), we have X ' BT with σ 2 = T , hence the answer to

Question (a) yields
E X 3 = 0 and E X 4 = 3σ 4 .

We note that those moments can be recovered directly from the Gaussian
probability density function as
1 w∞ 2 2
E X3 = √ x3 e −x /(2σ ) dx = 0

2πσ 2 −∞
and w∞
1 2 2
E X4 = √ x4 e −x /(2σ ) dx = 3σ 4 .

2πσ 2 −∞
Exercise 4.10 Taking expectation on both sides of (4.39) shows that
0 = E ( BT ) 3

wT
=E C+ ζt,T dBt
0
w
T
= C +E ζt,T dBt
0
=0
by (4.17), hence C = 0. Next, applying Itô’s formula to the function f (x) =

x3 shows that
(BT )3 = f (BT )
wT 1 w T 00
= f ( B0 ) + f 0 (Bt )dBt + f (Bt )dt
0 2 0
" 867
N. Privault
wT wT
=3 Bt2 dBt + 3 Bt dt.
0 0
By the integration by parts formula (4.11) applied to f (t) = t, we find

wT wT wT
Bt dt = T BT − tdBt = (T − t)dBt ,
0 0 0
hence
wT wT
( BT ) 3 = 3 Bt2 dBt + 3 T BT − tdBt
0 0
wT
=3 (T − t + Bt2 )dBt ,
0
and we find ζt,T = 3(T − t + Bt2 ), t ∈ [0, T ]. This type of stochastic integral
decomposition can be used for option hedging, cf. Section 7.5.
Exercise 4.11
a) We have
h rT i rt h rT i
E e 0 f (s)dBs Ft = e 0 f (s)dBs E e t f (s)dBs Ft

rt h rT i
= e 0 f (s)dBs E e t f (s)dBs
w
1wT

t
= exp f (s)dBs + |f (s)|2 ds , (A.13)
0 2 t
0 6 t 6 T , where we used the Gaussian moment generating function

2
wT
E e X = e σ /2 for X ' N (0, σ 2 ) and the fact that

f (s)dBs '
w t
T 2
N 0, f (s)ds by Proposition 4.11.
t
b) We have
w
1wt 2

t
E exp f (s)dBs − f (s)ds Fu

0 2 0
1wt 2 wt

= exp − f (s)ds E exp f (s)dBs Fu

2 0 0
1wt 2
w wt
u
= exp − f (s)ds E exp f (s)dBs + f (s)dBs Fu

2 0 0 u
w
1wt 2
w
u t
= exp f (s)dBs − f (s)ds E exp f (s)dBs Fu

0 2 0 u
w
1wt 2
w
u t
= exp f (s)dBs − f (s)ds E exp f (s)dBs
0 2 0 u
868 "
w
1wt 2 1wt 2

u
= exp f (s)dBs −
f (s)ds + f (s)ds
0 2 0 2 u
w
1wu 2

u
= exp f (s)dBs − f (s)ds , 0 6 u 6 t.
0 2 0
This result can also be obtained by directly applying (A.13).

c) We apply the conclusion of Question (b) to the constant function f (t) :=
σ, t > 0.
Exercise 4.12
a) Using (4.31), we have
w
T 2
E exp β = E e β (BT −T )/2

Bt dBt
0
h 2
i
= e −βT /2 E e β (BT ) /2
e −βT /2 w ∞ βx2 /2 −x2 /(2T )
= √ e e dx
2πT −∞
e −βT /2 w ∞ 2
= √ e (β−1/T )x /2 dx
2πT −∞
e −βT /2 w ∞ e −x /(2/(1/T −β ))
2
= √ dx
1 − βT −∞ 2π/(1/T − β )
p
e −βT /2
= √ ,
1 − βT
2
for all β < 1/T , where we applied Relation (23.43) to φ(x) = e βx /2 ,
knowing that BT ' N√(0, T ).
b) The function β 7→ 1/ 1 − βT can be identified as the moment generating
function of the gamma distribution with shape parameter λ = 1/2, scaling
parameter 1/T and probability density function
1
y 7→ (yT )−1/2 e −y/T ,
Γ(1/2)
due to the relation

T −λ w ∞ βy λ−1 −y/T 1
e y e dy = , β < 1/T ,
Γ (λ) 0 (1 − βT )λ
wT
therefore T + Bt dBt = BT2 has a gamma distribution with shape
0
parameter 1/2 and scaling parameter T . In other words, the square
" 869
N. Privault
wT √
1+ Bt dBt /T = BT2 /T of the normal random variable BT / T '
0
N (0, 1) has a χ2 distribution with one degree of freedom.
Exercise 4.13
a) Letting Yt = e bt Xt , we have
dYt = d( e bt Xt )
= b e bt Xt dt + e bt dXt
= b e bt Xt dt + e bt (−bXt dt + σ e −bt dBt )
= σdBt ,
hence wt wt
Yt = Y0 + dYs = Y0 + σ dBs = Y0 + σBt ,
0 0
and
Xt = e −bt Yt = e −bt Y0 + σ e −bt Bt = e −bt X0 + σ e −bt Bt .
Alternatively, we can also search for a solution Xt of the form Xt =
f (t, Bt ), with
∂f ∂f 1 ∂2f
dXt = df (t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂x2
from the Itô formula. Matching this expression to the stochastic differen-
tial equation (4.40) would yield
∂f 1 ∂2f
(t, Bt ) + (t, Bt )dt = −bXt = −bf (t, Bt )
∂t 2 ∂x2
and
∂f
(t, Bt ) = σ e −bt ,
∂x
hence
∂f 1 ∂2f ∂f
(t, x) + (t, x)dt = −bf (t, x) and (t, x) = σ e −bt ,
∂t 2 ∂x2 ∂x
x ∈ R, which can be solved as f (t, x) = f (t, 0) + σx e −bt and
∂f
(0, x) = −bf (t, 0),
∂t
which gives f (t, 0) = f (0, 0) e −bt , and recovers
Xt = f (t, Bt ) = X0 e −bt + σ e −bt Bt , t > 0.
870 "
b) Letting Yt = e bt Xt , we have
dYt = d( e bt Xt )
= b e bt Xt dt + e bt dXt
= b e bt Xt dt + e bt − bXt dt + σ e −at dBt

= σ e (b−a)t dBt ,
hence we can solve for Yt by integrating on both sides as

wt wt
Yt = Y0 + dYs = Y0 + σ e (b−a)s dBs , t > 0.
0 0
This yields the solution

wt
Xt = e −bt Yt = e −bt X0 + σ e −bt e (b−a)s dBs , t > 0.
0
Comments:
(i) This type of computation appears anywhere discounting by the factor
e −bt is involved.
(ii) In part (b) the solution cannot take the form Xt = f (t, Bt ) when
a 6= b. Indeed, solving
∂f
(t, x) = σ e −at
∂x
gives f (t, x) = f (t, 0) + σx e −at , yielding
∂f 1 ∂2f ∂f
(t, x) + (t, x) = (t, 0) − aσx e −at ,
∂t 2 ∂x2 ∂t
which cannot match −bf (t, x) unless a = b.
wt
(iii) The stochastic integral e (b−a)s dBs cannot be computed in closed
0
form. It is a centered Gaussian random variable with variance
wt e 2(b−a)t − 1
e 2(b−a)s ds =
0 2(b − a)
if b 6= a, and variance t if a = b.
Exercise 4.14
a) Note that the stochastic integral
wT 1
dBs
0 T −s
" 871
N. Privault
is not defined in L2 (Ω) as the function s 7→ 1/(T − s) is not in L2 ([0, T ]),

and by the Itô isometry (4.7) we have
wT 1 2 # w
" ∞
1 1

T
E dBs = ds = = +∞.
0 T −s 0 (T − s)2 T −s 0
On the other hand, by (4.27) and (4.42) we have
1 1

Xt dXt
d = + Xt d + dXt • d
T −t T −t T −t T −t
dXt Xt
= + dt
T − t (T − t)2
dBt
=σ ,
T −t
hence, by integration over the time interval [0, t] and using the initial
condition X0 = 0, we find
X0 w t w t dB

Xt Xs s
= + d =σ , 0 6 t < T.
T −t T 0 T −s 0 T −s
b) By (4.17), we have
w
1

t
E[Xt ] = (T − t)σE dBs = 0, 0 6 t < T.
0 T −s
c) By the Itô isometry, we have

w
1

t
Var[Xt ] = (T − t)2 σ 2 Var dBs
0 T −s
wt 1
" 2 #
= (T − t) σ E
2 2
dBs
0 T −s
wt 1
= (T − t)2 σ 2 ds
0 (T − s)2
1 1

= (T − t)2 σ 2 −
T −t T
2 T −t
=σ t , 0 6 t < T.
T
d) We have
t2

lim kXt kL2 (Ω) = lim Var[Xt ] = σ 2 lim t− = 0.
t→T t→T t→T T
872 "
Exercise 4.15 Exponential Vašíček (1977) model (1). Applying the Itô for-
mula (4.29) to Xt = e rt = f (rt ) with f (x) = e x , we have
dXt = d e rt
1
= f 0 (rt )drt + f 00 (rt )drt • drt
2
1
= e rt drt + e rt drt • drt
2
1
= e rt ((a − brt )dt + σdBt ) + e rt ((a − brt )dt + σdBt )2
2
σ 2 rt
= e rt ((a − brt )dt + σdBt ) + e dt
2

σ 2
= Xt a + − b log(Xt ) dt + σXt dBt
2
= Xt (e a − ebf (Xt ))dt + σg (Xt )dBt ,
hence
σ2
a = a+ and eb = b
2
e
the functions f (x) and g (x) are given by f (x) = log x and g (x) = x. Note
that this stochastic differential equation is that of the exponential Vasicek
model.
Exercise 4.16 Exponential Vasicek model (2).

wt
a) We have Zt = e −at Z0 + σ e −(t−s)a dBs .
0
θ wt
b) We have Yt = e −at Y0 + 1 − e −at + σ e −(t−s)a dBs .

a 0

σ 2
c) We have dXt = Xt θ + − a log Xt dt + σXt dBt .
2

θ wt
d) We have rt = exp e −at log r0 + 1 − e −at + σ e −(t−s)a dBs .

a 0
2
e) Using the Gaussian moment generating function identity E[ e X ] = e α /2
for X ' N (0, α ) and the variance formula (4.10), we have
2

θ wt
E[rt | Fu ] = E exp e −at log r0 + 1 − e −at + σ e −(t−s)a dBs Fu

a 0
r w
−at θ −at +σ u e −(t−s)a dB t −(t−s)a
= e e log r0 + a 1− e 0 s
E exp σ e dBs Fu

u
r w
−at θ −at +σ u e −(t−s)a dB t −(t−s)a
= e e log r0 + a 1− e 0 s
E exp σ e dBs
u

θ wu σ 2 w t −2(t−s)a

−at −at −(t−s)a
= exp e log r0 + 1 − e e e

+σ dBs + ds
a 0 2 u
" 873
N. Privault

θ wu σ2

= exp e −at log r0 + 1 − e −at + σ e −(t−s)a dBs + 1 − e −2(t−u)a

a 0 4a

θ wu
−(t−u)a −au −au −(u−s)a
= exp e e log r0 + 1 − e e

+σ dBs
a 0
θ σ 2
+ 1 − e −(t−u)a + 1 − e −2(t−u)a

a 4a
σ2

θ
= exp e −(t−u)a log ru + 1 − e −(t−u)a + 1 − e −2(t−u)a

a 4a
σ2

e −(t−u)a θ −(t−u)a
exp 1− e 1 − e −2(t−u)a .

= ru +
a 4a
In particular, for u = 0 we find
σ2

−at θ
E[rt ] = r0e exp + 1 − e −at + 1 − e −2at .

a 4a
f) Similarly, we have

2θ wt
E[rt2 | Fu ] = E exp 2 e −at log r0 + 1 − e −at + 2σ e −(t−s)a dBs Fu

a 0
r w
−at 2θ −at +2σ u e −(t−s)a dB t −(t−s)a
= e 2 e log r0 + a 1− e 0 s
E exp 2σ e dBs Fu

u
r w
−at 2θ −at +2σ u e −(t−s)a dB t −(t−s)a
= e 2 e log r0 + a 1− e 0 s
E exp 2σ e dBs
u

2θ wu wt
−(t−s)a
= exp 2 e −at
log r0 + 1− e −at
+ 2σ e dBs + 2σ 2 e −2(t−s)a ds

a 0 u

2θ wu σ 2
= exp 2 e −at log r0 + 1 − e −at + 2σ e −(t−s)a dBs + 1 − e −2(t−u)a

a 0 a

2θ wu
−(t−u)a −au −au −(u−s)a
= exp 2 e 2e log r0 + 1− e + 2σ e

dBs
a 0
2θ 2
σ
1 − e −(t−u)a + 1 − e −2(t−u)a

+
a a
2θ σ2

= exp 2 e −(t−u)a log ru + 1 − e −(t−u)a + 1 − e −2(t−u)a

a a
2θ 2

− ( t−u ) a σ
= ru2 e exp 1 − e −(t−u)a + 1 − e −2(t−u)a ,

a a
hence
Var[rt | Fu ] = E[rt2 | Fu ] − (E[rt | Fu ])2
874 "
2θ σ2

−(t−u)a
= ru2 e exp 1 − e −(t−u)a + 1 − e −2(t−u)a

a a
2θ σ2

2 e −(t−u)a −(t−u)a
exp 1− e 1 − e −2(t−u)a

−ru +
a 2a
2θ σ2

2 e −(t−u)a −(t−u)a
exp 1− e 1 − e −2(t−u)a

= ru +
a a
σ2

× 1 − exp − 1 − e −2(t−u)a .

2a
σ2

θ
g) We find lim E[rt ] = r0 exp + and
t→∞ a 4a
2θ σ 2 σ2

lim Var[rt ] = exp + 1 − exp −
t→∞ a a 2a
2θ
2
σ
= exp exp −1 .
a a
Exercise 4.17 Cox-Ingersoll-Ross (CIR) model.

a) We have
wt wt√
rt = r0 + (α − βrs )ds + σ rs dBs , t > 0. (A.14)
0 0
b) Taking expectations on both sides of (A.14) and using the fact that the
expectation of the stochastic integral with respect to Brownian motion is
zero, we find
u(t) = E[rt ]
wt wt√
= E r0 + (α − βrs )ds + σ rs dBs
0 0
wt
= E r0 + (α − βrs )ds
0
w
t
= r0 + E (α − βrs )ds
0
wt
= r0 + (α − βE[rs ])ds
0
wt
= r0 + (α − βu(s))ds,
0
which yields the differential equation u0 (t) = α − βu(t). Letting w (t) :

e βt u(t), we have
w0 (t) = β e βt u(t) + e βt u0 (t) = α e βt ,

" 875
N. Privault
hence
E[rt ] = u(t)
= e −βt w (t)
wt
= e −βt w (0) + α e βs ds
0

α
= e −βt u(0) + ( e βt − 1)
β
α
= e −βt r0 + 1 − e −βt , t > 0. (A.15)

β
c) By applying Itô’s formula (4.29) to

wt wt√
rt2 = f r0 + (α − βrs )ds + σ rs dBs ,
0 0
with f (x) = x2 , we find

1
d(rt )2 = f 0 (rt )drt + f 00 (rt )drt • drt
2
= 2rt drt + drt • drt
= rt (σ 2 + 2α − 2βrt )dt + 2σrt3/2 dBt
or, in integral form,

wt wt
rt2 = r02 + rs (σ 2 + 2α − 2βrs )ds + 2σ rs3/2 dBs , t > 0. (A.16)
0 0
d) Taking again the expectation on both sides of (A.16), we find
v (t) = E[rt2 ]
wt wt
= E r02 + rs (σ 2 + 2α − 2βrs )ds + 2σ rs3/2 dBs
0 0
w
t
= r0 + E
2
rs (σ + 2α − 2βrs )ds
2
0
wt
= r02 (σ 2 E[rs ] + 2αE[rs ] − 2βE[rs2 ])ds
+
0
wt
= v (0) + (σ 2 u(s) + 2αu(s) − 2βv (s))ds,
0
and after differentiation with respect to t this yields the differential equa-
tion
v 0 (t) = (σ 2 + 2α)u(t) − 2βv (t), t > 0.
By (A.15) we find
876 "

α α
v 0 (t) = (σ 2 + 2α) + r0 − e −βt − 2βv (t), t > 0.
β β
Looking for a solution of the form
v (t) = c0 + c1 e −βt + c2 e −2βt , t > 0,
we find
v 0 (t) = −βc1 e −βt − 2βc2 e −2βt

α α
= (σ 2 + 2α) + r0 − e −βt − 2β (c0 + c1 e −βt + c2 e −2βt )
β β

α 2 α
= (σ + 2α) + (σ + 2α) r0 −
2
e −βt − 2βc0 − 2βc1 e −βt − 2βc2 e −βt ,
β β
t > 0, hence
α 2
 0 = β (σ + 2α) − 2βc0 ,





 α
 −βc1 = (σ 2 + 2α) r0 − − 2βc1 ,


β
and
σ 2 + 2α

α α
c0 = (σ 2 + 2α), c1 = r0 − ,
2β 2 β β
with
r02 = v (0) = c0 + c1 + c2 ,
which yields
c2 = r02 − c0 − c1
σ 2 + 2α

α α
= r02 − 2 (σ 2 + 2α) − r0 −
2β β β

r0 α
= r0 − (σ + 2α)
2 2
− 2 ,
β 2β
and
E[rt2 ] = v (t)
= c0 + c1 e −βt + c2 e −2βt
σ 2 + 2α

α α
= 2 (σ 2 + 2α) + r0 − e −βt
2β β β

r0 α
+ r02 − (σ 2 + 2α) − 2 e −2βt , t > 0.
β 2β
" 877
N. Privault
e) We have
Var[rt ] = E[rt2 ] − (E[rt ])2

σ 2 + 2α

α α
= ( σ 2
+ 2α ) + r0 − e −βt
2β 2 β β

r0 α
+ r02 − (σ 2 + 2α) − 2 e −2βt
β 2β
2
α α
− + r0 − e −βt
β β
σ 2 + 2α

α α
= 2 (σ + 2α) +
2
r0 − e −βt
2β β β

r0 α
+ r02 − (σ 2 + 2α) − 2 e −2βt
β 2β
2 2 !
2α

α α α α
− − r0 − e −βt − r02 − 2r0 + e −2βt
β β β β β
σ 2 −βt ασ 2 ασ 2 −βt ασ 2 −2βt
e − e −2βt + − 2 e + 2e

= r0
β 2β 2 β 2β
σ 2 −βt ασ 2
−βt 2
e − e −2βt + 1− e , t > 0.

= r0
β 2β 2
Problem 4.18
a) The Itô formula cannot be applied to the function f (x) := (x − K )+
because it is not (twice) differentiable.
b) The function x 7→ fε (x) can be plotted as follows with K = 1.
1
fε
0
0 K-ε K K+ε
x
Fig. S.12: Graph of the function x 7→ fε (x).
We note that fε converges uniformly on R to the function x 7→ (x − K )+

as we have
ε
0 6 fε ( x ) − ( x − K ) + 6 , x ∈ R. (A.17)
4
878 "
c) Applying the Itô formula to the function fε we find

wT 1 w T 00
fε ( BT ) = fε ( B0 ) + fε0 (Bt )dBt + f (Bt )dt
0 2 0 ε
wT 1 wT
= fε ( B0 ) + fε0 (Bt )dBt + 1 (Bt )dt,
0 4ε 0 (K−ε,K +ε)
and to conclude it suffices to note that
wT
t ∈ [0, T ] : K − ε < Bt < K + ε 1(K−ε,K +ε) (Bt )dt.

` =
0
d) The derivative fε0 (x) of fε (x) is given by
1 if x > K + ε,





1


fε0 (x) := (x − K + ε) if K − ε < x < K + ε,

 2ε



0 if x < K − ε.

1
f'ε
0
0 K-ε K K+ε
x
Fig. S.13: Graph of the derivative x 7→ fε0 (x).
Hence we have
w∞
k1[K,∞) (·) − fε0 (·)k2L2 (R+ ) = 1[K,∞) (x) − fε0 (x) 2 dx

0
w K +ε
1 + |fε0 (x)|2 dx

=
K−ε
1 w K +ε 2
6 2ε + 2 x − K + ε dx
4ε K−ε
1 h 3 iK +ε
= 2ε + x−K +ε
12ε 2 K−ε
2ε
= 2ε + .
3
e) i) We have
" 879
N. Privault
w wT
T h 2 i
E 1[K,∞) (Bt ) − fε0 (Bt ) 2 dt = E 1[K,∞) (Bt ) − fε0 (Bt )

dt
0 0
wT w∞ 1
1[K,∞) (x) − fε0 (x) 2 e −x
2 / (2t)
= dx √ dt
0 −∞ 2πt
w T w K +ε 1
1[K,∞) (x) − fε0 (x) 2 e −(K−ε)
2 / (2t)
6 dx √ dt
0 K−ε 2πt
wT 1
6 k1[K,∞) (·) − fε0 (·)k2L2 (R+ )
2
e −(K−ε) /(2t) √ dt
0 2πt
w
2ε T −(K−ε)2 /(2t) 1

6 2ε + e √ dt,
3 0 2πt
where
wT 1 wT
2 / (2t) 2 1
e −(K−ε) dt < e −K /(8t) √
√ dt < ∞,
0 2πt 0 2πt
w
T
for ε < K/2, hence lim E 1[K,∞) (Bt ) − fε0 (Bt ) 2 dt = 0, and

ε→0 0
by the Itô isometry
w 2
∞ hw ∞ i
E 1[K,∞) (Bt ) − fε (Bt ) dBt =E 1[K,∞) (Bt ) − fε (Bt ) 2 dt

0 0
we find that
w
∞ w∞ 2
lim E 1[K,∞) (Bt )dBt − fε (Bt )dBt = 0,
ε→0 0 0
r∞ w∞
which shows that 0 fε (Bt )dBt converges to 1[K,∞) (Bt )dBt in
0
L2 (Ω) as ε tends to zero.
ii) By (A.17) we have
h 2 i ε
E (BT − K )+ − fε (BT ) 6 ,
4
hence fε (BT ) converges to (BT − K )+ in L2 (Ω).
iii) Similarly, fε (B0 ) converges to (B0 − K )+ for any fixed value of B0 .
As a consequence of (ei), (eii) and (eiii) above, the equation (4.47) shows
that
1
` t ∈ [0, T ] : K − ε < Bt < K + ε

2ε
admits a limit in L2 (Ω) as ε tends to zero, and this limit is denoted by
[0,T ] . The formula (4.48) is known as the Tanaka formula.
LK
Problem 4.19
880 "
a) We have
0 6 E[(X − ε)+ ]
1 w∞ 2 2
= √ (x − ε) e −x /(2σ ) dx
2πσ 2 ε
1 w∞ 2 2 ε w∞ 2 2
= √ x e −x /(2σ ) dx − √ e −x /(2σ ) dx
2πσ 2 ε 2πσ ε
2
σ 2 h −x2 /(2σ2 ) i∞
= −√ e − εP(X > ε)
2πσ 2 ε
σ2 2 2
= √ e −εx /(2σ ) − εP(X > ε),
2πσ 2
which leads to the conclusion.
b) We have
P(X ∈ dx and X + Y ∈ dz )
P(X ∈ dx | X + Y = z ) =
P(X + Y ∈ dz )
P(X ∈ dx and Y ∈ (dz ) − x)
=
P(X + Y ∈ dz )
2 2 2 2
2π (α2 + β 2 ) e −x /(2α )−(z−x) /(2β )
p
= dx
2παβ e −z 2 / (2(α2 +β 2 ))
1/β 2 + 1/α2 −(x2 (1+β 2 /α2 )+(x2 +z 2 −2xz )(1+α2 /β 2 )−z 2 )/(2(α2 +β 2 ))
p
= √ e dx
2π
1/β 2 + 1/α2 −(x2 (2+β 2 /α2 +α2 /β 2 )+z 2 α2 /β 2 −2xz (1+α2 /β 2 ))/(2(α2 +β 2 ))
p
= √ e dx
2π
1/β 2 + 1/α2 −(x(β/α+α/β )−zα/β )2 /(2(α2 +β 2 ))
p
= √ e dx
2π
1/β 2 + 1/α2 −(x((α2 +β 2 )/(αβ ))−zα/β )2 /(2(α2 +β 2 ))
p
= √ e dx
2π
1/β 2 + 1/α2 −(x−zα2 /(α2 +β 2 ))2 /(2/(1/α2 +1/β 2 )))
p
= √ e dx.
2π
c) Given that Bu = x we decompose
Bv = (Bv − B(u+v )/2 ) + (B(u+v )/2 − Bu ) + x,
and apply the result of Question (b) by taking
X = B(u+v )/2 − Bu and Y = Bv − B(u+v )/2 ,
i.e.
v−u
α2 = β 2 = and z = y − x,
2
" 881
N. Privault
which shows that the distribution of B(u+v )/2 = x + X given that Bu = x

x+y v−u

and Bv = y is Gaussian N , with mean
2 4
α2 z y−x x+y α2 β 2 v−u

x+ = x+ = and variance = .
α2 + β2 2 2 α2 + β 2 4
d) Four linear interpolations are displayed in Figure S.14.
n= 0 n= 1 n= 2 n= 3
2.0
2.0
2.0
2.0
1.5
1.5
1.5
1.5
1.0
1.0
1.0
1.0
0.5
0.5
0.5
0.5
0.0
0.0
0.0
0.0
0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0
t t t t
Fig. S.14: Samples of linear interpolations.
(0)
e) Clearly, the statement is true for n = 0 because Z1 and B1 have the
same N (0, 1) distribution. Next, assuming that it holds at the rank n, we
note that the terms appearing in the sequence
(n+1) (n+1) (n+1) (n+1) (n+1)
Z (n+1) = 0, Z1/2n+1 , Z2/2n+1 , Z3/2n+1 , Z4/2n+1 , . . . , Z1 .
can be written for any k = 0, 1, . . . , 2n − 1 as

(n+1) (n+1)
 
( n + 1 )
Z2k/2n+1 + Z(2k+2)/2n+1 (n+1)
. . . , Z +
2k/2n+1
, + N 0, 1/2 n 2
, Z(2k+2)/2n+1 , . . .
2
(n) (n)
 
( n )
Z2k/2n+1 + Z(2k+2)/2n+1 (n)
+
= . . . , Zk/2n , + N 0, 1/2 n 2
, Z(k+1)/2n , . . .
2
  (n) (n)
 
( n )
Z2k/2n+1 + Z(2k+2)/2n+1 1 ( n )
= . . . , Zk/2n , N  , n+2  , Z(k+1)/2n , . . . .
2 2
(A.18)
On the other hand, the result of Question (c) shows that given that
B2k/2n+1 = x and B(2k+2)/2n+1 = y, the distribution of B(2k+1)/2n+1
is
B2k/2n+1 + B(2k+2)/2n+1 (2k + 2)/2n+1 − (2k + 2)/2n+1

N ,
2 4
882 "
B2k/2n+1 + B(2k+2)/2n+1 1

=N , . (A.19)
2 2n+2
Given that Z (n) and B (n) have same distribution, we conclude by compar-
ing (A.18) and (A.19) that Z (n+1) and B (n+1) also have same distribution.
f) We have
!
(n+1) (n)
P Sup |Zt − Zt | > εn
t∈[0,1]

(n+1) (n)
=P Max |Z n+1 − Z(2k +1) /2n+1 | > εn
k =0,1,...,2n −1 (2k +1)/2
 
n o
( n + 1 ) ( n )
[
6 P |Z(2k+1)/2n+1 − Z(2k+1)/2n+1 | > εn 
k =0,1,...,2n −1
n −1
2X
(n+1) (n)
P |Z(2k+1)/2n+1 − Z(2k+1)/2n+1 | > εn

6
k =0
(n+1) (n)
= 2n P |Z1/2n+1 − Z1/2n+1 | > εn

 
(n) (n)
Z0/2n + Z1/2n

n  ( n + 1 )
= 2 P Z1/2n+1 − > εn  .

2

g) Since
(n) (n)
(n+1) Z0 + Z1/2n (n)
Z1/2n+1 = + N (0, 1/2n+2 ) = Z1/2n+1 + N (0, 1/2n+2 ),
2
we have
!
(n+1) (n) (n+1) (n)
P Sup |Zt 6 2n P |Z1/2n+1 − Z1/2n+1 | > εn

− Zt | > εn
t∈[0,1]
 
(n) (n)
Z0/2n + Z1/2n

(n+1)
= 2 P Z1/2n+1 −
n
> εn

2
 

= 2n P N (0, 1/2n+2 ) > εn

2n/2 −ε2n 2n+1

6 √ e ,
εn 2π
where we applied the bound of Question (a) to the Gaussian random

variable
(n) (n)
(n+1) Z n + Z1/2n
Z1/2n+1 − 0/2 ' N (0, 1/2n+2 ).
2
" 883
N. Privault
h) We have
!
(n+1) (n) (n+1) (n)
X X
−n/4
P kZ k∞ > 2 P Sup

−Z = |Zt − Zt | > εn
n>0 n>0 t∈[0,1]
X 2n/2 2 n+1
6 √ e −εn 2
n>0
ε n 2π
1 X 3n/4 −21+n/2
= √ 2 e < ∞,
2π n>0
since
1+(n+1)/2
23(n+1)/4 e −2 1+n/2 (
√
2−1)
lim 1+n/2
= 23/4 lim e −2 = 0.
n→∞ 23n/4 e −2 n→∞
Hence the Borel-Cantelli lemma shows that
P kZ (n+1) − Z (n) k∞ > 2−n/4 for infinitely many n = 0,

therefore we have
P kZ (n+1) − Z (n) k∞ < 2−n/4 except for finitely many n = 1.

i) The result of Question (h) shows that with probability one we have
p−1
X
(p) (q ) (n+1) (n)
lim kZ − Z k∞ = lim Z −Z

p,q→∞ p,q→∞
n=q

∞
p−1
kZ (n+1) − Z (n) k∞
X
6 lim
p,q→∞
n=q
kZ (n+1) − Z (n) k∞
X
6 lim
p→∞
n>q
= 0,
hence the sequence Z (n)

is Cauchy in C0 ([0, 1]) for the k · k∞ norm.

n>0
Since C0 ([0, 1]) is a complete space for the k · k∞ norm, this implies that,
with probability one, the sequence (Z (n) )n>0 admits a limit in C0 ([0, 1]).
(n)
j) 1. By construction we have Z0 = 0 for all n ∈ N, hence Z0 =
(n)
limn→∞ Z0 = 0, almost surely.
2. The sample trajectories t 7→ Zt are continuous, because the limit Z

belongs to C0 ([0, 1]) with probability 1.
884 "
3. The result of Question (e) shows that for any fixed m > 1, the sequences
Zt1 − Zt0 , Zt2 − Zt1 , . . . , Ztm − Ztm−1
and
Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btm − Btm−1
have same distribution when the t0k s are dyadic rationals of the form
tk = in /2n , k = 0, 1, . . . , n. This property extends to any sequence
t0 , t1 , . . . , tm of real numbers by approximation of each tk > 0 by a
sequence (in )n∈N such that tk = limn→∞ in /2n and taking the limit
as n tends to infinity.
4. By a similar argument as in the above point 3, one can show that for
any 0 6 s < t, Zt − Zs has the Gaussian distribution N (0, t − s).
Problem 4.20
a) We have
n
(n) X
E QT = E (BkT /n − B(k−1)T /n )2

k =1
n
X T T
= k − (k − 1)
n n
k =1
= T, n > 1.
b) We have
 !2 
n
(n) X
E (QT )2 = E  (BkT /n − B(k−1)T /n )2 
k =1
 
n
X
= E 2
(BkT /n − B(k−1)T /n ) (BlT /n − B(l−1)T /n ) 2
k,l=1
n
X h i
= E (BkT /n − B(k−1)T /n )4
k =1
X h i h i
+2 E (BkT /n − B(k−1)T /n )2 E (BlT /n − B(l−1)T /n )2
16k<l6n
n
X
=3 (kT /n − (k − 1)T /n)2
k =1
X
+2 (kT /n − (k − 1)T /n)(lT /n − (l − 1)T /n)
16k<l6n
" 885
N. Privault
T2 n(n − 1)T 2
=3 +
n n2
2T 2
= T2 + , n > 1,
n
hence
(n) ( n ) 2 (n) 2 2T 2
Var QT = E QT − E QT = , n > 1.
n
c) We have
(n) (n) (n)
kQT − T k2L2 (Ω) = E (QT − E[QT ])2

(n)
= Var QT
n(n + 2)T 2
= − T2
n2
2T 2
= ,
n
hence
(n) 2T 2
lim kQT − T k2L2 (Ω) = lim = 0,
n→∞ n→∞ n
showing that
(n)
lim QT =T
n→∞
in L2 (Ω).
d) We have
n n
X 1X 2
(BkT /n − B(k−1)T /n )B(k−1)T /n = BkT /n − B(2k−1)T /n
2
k =1 k =1
n
1X
− (BkT /n − B(k−1)T /n )(BkT /n − B(k−1)T /n )
2
k =1
1
= ((BT )2 − (B0 )2 )
2
n
1X
− (BkT /n − B(k−1)T /n )(BkT /n − B(k−1)T /n )
2
k =1
1 (n)
= (BT )2 − QT ,
2
which converges to ((BT )2 − T )/2 in L2 (Ω) as n tends to infinity, hence
wT n
X
Bt dBt = lim (BkT /n − B(k−1)T /n )B(k−1)T /n
0 n→∞
k =1
886 "
( BT ) 2 − T
= .
2
e) We have
n
(n) X
E Q E (B(k−1/2)T /n − B(k−1)T /n )2

e
T =
k =1
X n
= ((k − 1/2)T /n − (k − 1)T /n)
k =1
T
= , n > 1.
2
Next, we have
 !2 
n
( n ) 2 X 2
E Qe
T = E  B (k−1/2)T /n − B (k−1)T /n

k =1
 
n
X
= E 2
(B(k−1/2)T /n − B(k−1)T /n ) (BlT /n − B(l−1)T /n ) 2
k,l=1
n
X
E (B(k−1/2)T /n − B(k−1)T /n )4

=
k =1
X
+2 E (B(k−1/2)T /n − B(k−1)T /n )2 E (B(l−1/2)T /n − B(l−1)T /n )2

16k<l6n
n
X
=3 ((k − 1/2)T /n − (k − 1)T /n)2
k =1
X
+2 ((k − 1/2)T /n − (k − 1)T /n)((l − 1/2)T /n − (l − 1)T /n)
16k<l6n
T2 n(n − 1)T 2
=3 +
4n 4n2
n(n + 2)T 2
= , n > 1.
4n2
Finally, we find
e (n) − T /2k2 2
(n)
e (n) 2
L (Ω) = E (QT − E[QT ])

kQ T
e
(n)
= Var Q
e
T
n(n + 2)T 2 T 2
= −
4n2 4
" 887
N. Privault
T2
= ,
2n
hence
(n) T2
lim kQ L (Ω) = lim
e − T /2k2 2 = 0,
n→∞ T n→∞ 2n
showing that
e (n) = T
lim Q
n→∞ T 2
in L2 (Ω).
f) We have
n
X
BkT /n − B(k−1)T /n B(k−1/2)T /n
k =1
n
X
= BkT /n − B(k−1/2)T /n B(k−1/2)T /n
k =1
n
X
+ B(k−1/2)T /n − B(k−1)T /n B(k−1/2)T /n
k =1
n
1X 2
= BkT /n − B(2k−1/2)T /n
2
k =1
n
1X
− BkT /n − B(k−1/2)T /n BkT /n − B(k−1/2)T /n
2
k =1
n
1X 2
+ B(k−1/2)T /n − B(2k−1)T /n
2
k =1
n
1X
+ B(k−1/2)T /n − B(k−1)T /n B(k−1/2)T /n − B(k−1)T /n
2
k =1
n
1 1X
= ( BT ) 2 −

BkT /n − B(k−1/2)T /n BkT /n − B(k−1/2)T /n
2 2
k =1
n
1X
B(k−1/2)T /n − B(k−1)T /n B(k−1/2)T /n − B(k−1)T /n ,

+
2
k =1
which converges to ((BT )2 − T + T )/2 = (BT )2 /2 in L2 (Ω) as n tends

to infinity, hence
wT n
X ( BT ) 2
Bt ◦ dBt = lim (BkT /n − B(k−1)T /n )B(k−1/2)T /n = ,
0 n→∞ 2
k =1
888 "
see Section 2.4 of Mikosch (1998) for further details on the Stratonovich
integral.
g) We have
n
(n) X 2
E Q E B(k−α)T /n − B(k−1)T /n

e
T =
k =1
X n
= ((k − α)T /n − (k − 1)T /n)
k =1
T
= (1 − α ) , n > 1.
2
Next, we have
 !2 
n
e (n) 2
X
E = E 2

Q T (B(k−α)T /n − B(k−1)T /n ) 
k =1
 
n
X
= E 2
(B(k−α)T /n − B(k−1)T /n ) (BlT /n − B(l−1)T /n ) 2
k,l=1
n
X
E (B(k−α)T /n − B(k−1)T /n )4

=
k =1
X
+2 E (B(k−α)T /n − B(k−1)T /n )2 E (B(l−α)T /n − B(l−1)T /n )2

16k<l6n
n
X
=3 ((k − α)T /n − (k − 1)T /n)2
k =1
X
+2 ((k − α)T /n − (k − 1)T /n)((l − α)T /n − (l − 1)T /n)
16k<l6n
T2 n(n − 1)T 2
= 3(1 − α )2 + (1 − α )2
n n2
n ( n + 2 ) T 2
= (1 − α )2 , n > 1.
n2
Finally we find
e (n) − (1 − α)T /2k2 2

(n) (n) 2
kQ L (Ω) = E QT − E QT
e e
T
(n)
= Var Q
e
T
n(n + 2)T 2
= (1 − α )2 − (1 − α )2 T 2
n2
T 2
= 2(1 − α )2 ,
n
" 889
N. Privault
hence
(n) T2
lim kQ
e − (1 − α)T k2 2
T L (Ω) = (1 − α) lim
2
= 0.
n→∞ n→∞ n
Next, we have
n
X
(BkT /n − B(k−1)T /n )B(k−α)T /n
k =1
n
X n
X
= (BkT /n − B(k−α)T /n )B(k−α)T /n + (B(k−α)T /n − B(k−1)T /n )B(k−α)T /n
k =1 k =1
n n
1 X
2 2 1X
= BkT /n − B(k−α)T /n − (BkT /n − B(k−α)T /n )(BkT /n − B(k−α)T /n )
2 2
k =1 k =1
n
1X 2
+ B(k−α)T /n − B(2k−1)T /n
2
k =1
n
1X
+ (B(k−α)T /n − B(k−1)T /n )(B(k−α)T /n − B(k−1)T /n )
2
k =1
n
1 1X
= ( BT ) 2 − (BkT /n − B(k−α)T /n )(BkT /n − B(k−α)T /n )
2 2
k =1
n
1X
+ (B(k−α)T /n − B(k−1)T /n )(B(k−α)T /n − B(k−1)T /n ),
2
k =1
which converges to
(BT )2 − αT + (1 − α)T (BT )2 + (1 − 2α)T

=
2 2
in L2 (Ω) as n tends to infinity, hence
wT n
X
Bt ◦ dα Bt = lim (BkT /n − B(k−1)T /n )B(k−α)T /n
0 n→∞
k =1
( BT )2 + (1 − 2α)T
= .
2
In particular we find
wT n
X ( BT ) 2 + T
Bt ◦ d0 Bt = lim (BkT /n − B(k−1)T /n )BkT /n = ,
0 n→∞ 2
k =1
and we note that
890 "
wT 1
w
T wT
Bt ◦ dBt = Bt dBt + Bt ◦ d1 Bt .
0 2 0 0
h) We have
n
X T T T
lim (k − α ) k − (k − 1)
n→∞ n n n
k =1
n
T X T
= lim (k − α )
n→∞ n n
k =1
n n
T X T T XT
= lim k − α lim
n→∞ n n n→∞ n n
k =1 k =1
n(n + 1) T2
= T 2 lim − α lim
n→∞ 2n 2 n→∞ n
T2
= ,
2
which does not depend on α ∈ [0, 1]< hence the stochastic phenomenon
of the previous questions does not occur when approximating the deter-
rT
ministic integral 0 tdt = T 2 /2 by Riemann sums.
In quantitative finance we choose to use the Itô integral (which corre-

sponds to the choice α = 1) because it is suitable for the modeling of
market returns as
dSt S − St
' t+∆t = µ∆t + σ∆Bt = µ∆t + (Bt+∆t − Bt )σ
St St
or
dSt ' St+∆t − St = µSt ∆t + σSt ∆Bt , = µSt ∆t + σSt (Bt+∆t − Bt ),
based on the value St at the the left endpoint of the discretized time
interval [t, t + ∆t].
Chapter 5
Exercise 5.1 For all x ∈ R, we have
2
P(ST 6 x) = P S0 e σBT +(µ−σ /2)T 6 x

σ2

x
= P σBT + µ − T 6 log
2 S0
1 σ2

x
= P BT 6 log − µ− T
σ S0 2
" 891
N. Privault
w (log(x/S0 )−(µ−σ2 /2)T )/σ

dy 2 / (2T )
= √ e −y
−∞ 2πT
1 σ2

x
=Φ √ log − µ− T ,
σ T S0 2
where wx 2 /2 dy
Φ (x) : = e −y √ , x ∈ R,
−∞ 2πT
denotes the standard Gaussian cumulative distribution function. After differ-
entiation with respect to x we find the lognormal probability density function
dP(ST 6 x)
f (x) =
dx
∂ w (log(x/S0 )−(µ−σ2 /2)T )/σ −y2 /(2T ) dy
= e √
∂x −∞ 2πT
1 σ2

∂ x
= Φ √ log − µ− T
∂x σ T S0 2
1 1 2

x σ
= ϕ √ log − µ− T
xσ σ T S0 2
1 2 2 2
= √ e −(−(µ−σ /2)T +log(x/S0 )) /(2σ T ) , x > 0,
xσ 2πT
where
1 2
ϕ(y ) = Φ0 (y ) := √ e −y /2 , y ∈ R,
2π
denotes the standard Gaussian probability density function.
Exercise 5.2
a) We have
1 1 σ2
d log St = dSt − 2 (dSt )2 = rdt + σdBt − dt, t > 0.
St 2St 2
b) We have f (t) = f (0) e ct (continuous-time interest rate compounding),

and
2
St = S0 e σBt −σ t/2+rt , t > 0,
(geometric Brownian motion).
c) Those quantities can be directly computed from the expression of St as a
function of the N (0, t) random variable Bt . Namely, we have
2
E[St ] = E S0 e σBt −σ t/2+rt

2
= S0 e −σ t/2+rt E e σBt

892 "
= S0 e rt ,
where we used the Gaussian moment generating function (MGF) formula

(23.46)
2
E e σBt = e σ t/2

for the normal random variable Bt ' N (0, t), t > 0. Similarly, we have
2
E[St2 ] = E S02 e 2σBt −σ t+2rt

2
= S02 e −σ t+2rt E e 2σBt

2 t+2rt
= S02 e σ , t > 0.
d) We note that from the stochastic differential equation

wt wt
St = S0 + r Ss ds + σ Ss dBs ,
0 0
the function u(t) := E[St ] satisfies the Ordinary Differential Equation

(ODE) u0 (t) = ru(t) with u(0) = S0 and solution u(t) = E[St ] = S0 e rt .
On the other hand, by the Itô formula we have
dSt2 = 2St dSt + (dSt )2 = 2rSt2 dt + σ 2 St2 dt + 2σSt2 dBt ,
hence letting v (t) = E St2 and taking expectations on both sides of

wt wt wt
St2 = S02 + 2r Su2 du + σ 2 Su2 du + 2σ Su2 dBu ,
0 0 0
we find
v (t) = E St2

w w
t 2 t 2
= S02 + (2r + σ 2 )E Su du + 2σE Su dBu
0 0
wt
= S02 + (2r + σ 2 ) E Su2 du
0
wt
= S02 + (2r + σ 2 ) v (u)du,
0
hence v (t) := E St2 satisfies the ordinary differential equation

v 0 (t) = (σ 2 + 2r )v (t),
with v (0) = S02 and solution

2
v (t) = E St2 = S02 e (σ +2r )t ,

which recovers
" 893
N. Privault
Var[St ] = E St2 − (E[St ])2

= v (t) − u2 (t)
2 +2r )t
= S02 e (σ − S02 e 2rt
σ2 t
= S02 e 2rt ( e − 1), t > 0.
Exercise 5.3 Using the bivariate Itô formula (4.26), we find
∂f ∂f
df (St , Yt ) = (St , Yt )dSt + (St , Yt )dYt
∂x ∂y
1 ∂2f 1 ∂2f ∂2f
+ (St , Yt )(dSt )2 + (St , Yt )(dYt )2 + (St , Yt )dSt • dYt
2 ∂x2 2 ∂y 2 ∂x∂y
∂f ∂f
= (St , Yt )(rSt dt + σSt dBt ) + (St , Yt )(µYt dt + ηYt dWt )
∂x ∂y
2 2
σ St ∂ f2 2 2
η Yt ∂ f2 ∂2f
+ (St , Yt )dt + (St , Yt )dt + ρσηSt Yt (St , Yt )dt.
2 ∂x 2 2 ∂y 2 ∂x∂y
Exercise 5.4 Taking expectations on both sides of (5.25) shows that

w
T
E[ST ] = C (S0 , r, T ) + E ζt,T dBt = C (S0 , r, T ),
0
hence
C (S0 , r, T ) = E[ST ]
2 T /2
= E[S0 e rT +σBT −σ ]
rT −σ 2 T /2
= S0 e E[ e σBT
]
2 T /2+σ 2 T /2
= S0 e rT −σ
= S0 e rT ,
where we used the moment generating function

2 T /2
E[ e σBT ] = e σ
of the Gaussian random variable BT ' N (0, T ). On the other hand, the
discounted asset price Xt := e −rt St satisfies dXt = σXt dBt , which shows
that wT
XT = X0 + σ Xt dBt .
0
Multiplying both sides by e rT shows that

wT wT
ST = e rT S0 + σ e rT Xt dBt = e rT S0 + σ e (T −t)r St dBt ,
0 0
894 "
which recovers the relation C (S0 , r, T ) = S0 e rT , and shows that ζt,T =

σ e (T −t)r St , t ∈ [0, T ].
Exercise 5.5
a) We have St = f (Xt ), t > 0, where f (x) = S0 e x and (Xt )t∈R+ is the Itô
process given by
wt wt
Xt := σs dBs + us ds, t > 0,
0 0
or in differential form
dXt := σt dBt + ut dt, t > 0,
hence
dSt = df (Xt )
1
= f 0 (Xt )dXt + f 00 (Xt )(dXt )2
2
1
= ut f 0 (Xt )dt + σt f 0 (Xt )dBt + σt2 f 00 (Xt )dt
2
1
= S0 ut e Xt dt + S0 σt e Xt dBt + S0 σt2 e Xt dt
2
1
= ut St dt + σt St dBt + σt2 St dt.
2
b) The process (St )t∈R+ satisfies the stochastic differential equation
1

dSt = ut + σt2 St dt + σt St dBt .
2
Exercise 5.6
a) We have E[St ] = 1 because the expected value of the Itô stochastic in-
tegral is zero. Regarding the variance, using the Itô isometry (4.7) we
have
wt
" 2 #
σBs −σ 2 s/2
Var[St ] = σ E
2
e dBs
0
w 2
t 2 s/2
= σ2 E e σBs −σds
0
w 2
2 t 2
=σ E e σBs −σ s/2 ds
0
wt h 2
i
= σ 2 E e 2σBs −σ s ds
0
" 895
N. Privault
wt 2
h i
= σ2 e −σ s E e 2σBs ds
0
w
2 t 2s 2
=σ e −σ e 2σ s ds
0
w
2 t 2
=σ e σ s ds
0
σ2 t
= e − 1.
b) Taking f (x) = log x, we have
d log(St ) = df (St )
1
= f 0 (St )dSt + f 00 (St )(dSt )2
2
2 1 2
= σf 0 (St ) e σBt −σ t/2 dBt + σ 2 f 00 (St ) e 2σBt −σ t dt
2
σ σBt −σ2 t/2 σ2 2
= e dBt − 2 e 2σBt −σ t dt. (A.20)
St 2St
2 t/2
c) We check that when St = eσBt −σ , t > 0, we have
σ2
log St = σBt − σ 2 t/2, and d log St = σdBt − dt.
2
On the other hand, we also find
σ2 σ σBt −σ2 t/2 σ2 2

σdBt − dt = e dBt − 2 e 2σBt −σ t dt,
2 St 2St
showing by (A.20) that the equation
σ σBt −σ2 t/2 σ2 2

d log St = e dBt − 2 e 2σBt −σ t dt
St 2St
2 t/2
is satisfied. By uniqueness of solutions, we conclude that St := eσBt −σ
solves wt 2
St = 1 + σ e σBs −σ s/2 dBs , t > 0.
0
Exercise 5.7
a) Leveraging with a factor β : 1 means that we invest the amount ξt St = βFt
on the risky asset priced St . In this case, the fund value Ft at time t > 0
decomposes into the portfolio
Ft Ft
Ft = ξt St + ηt At = β St − (β − 1) At , t > 0,
St At
896 "
with ξt = βFt /St and ηt = −(β − 1)Ft /At , t > 0.

b) We have
dFt = ξt dSt + ηt dAt

Ft Ft
= β dSt − (β − 1) dAt
St At
Ft
= β dSt − (β − 1)rFt dt
St
= βFt (rdt + σdBt ) − (β − 1)rFt dt
= rFt dt + βσFt dBt , t > 0.
The above equation shows that the volatility βσ of the fund is β times
the volatility of the index. On the other hand, the risk-free rate r remains
the same.
c) By Proposition 5.16 we have
2 σ 2 t/2
Ft = F0 e βσBt +rt−β
σBt +rt/β−βσ 2 t/2 β
= F0 e

2 t/2−(1−1/β )rt−(β−1)σ 2 t/2 β

= F0 e σBt +rt−σ
2 t/2 β 2 t/2
= F0 e σBt +rt−σ e −(β−1)rt−β (β−1)σ
+rt−σ 2 t/2 β 2 t/2
= S0 e σBt e −(β−1)rt−β (β−1)σ

−(β−1)rt−β (β−1)σ 2 t/2

= Stβ e , t > 0.
2 t/2
Exercise 5.8 Letting Xt := f (t) e σBt −σ and noting the relation
−σ 2 t/2 −σ 2 t/2
d e σBt = σf (t) e σBt dBt , t > 0,
see Proposition 5.16 with µ = 0, we have

2 t/2 2 t/2
dXt = e σBt −σ f 0 (t)dt + f (t)d e σBt −σ
−σ 2 t/2 2 t/2
= e σBt f 0 (t)dt + σf (t) e σBt −σ dBt
f 0 (t)
= Xt dt + σXt dBt
f (t)
= h(t)Xt dt + σXt dBt ,
hence
d f 0 (t)
log f (t) = = h(t),
dt f (t)
which shows that wt
log f (t) = log f (0) + h(s)ds,
0
" 897
N. Privault
and
2
Xt = f (t) e σBt −σ t/2
w
σ2

t
= f (0) exp h(s)ds + σBt − t
0 2
w
σ2

t
= X0 exp h(s)ds + σBt − t , t > 0.
0 2
Exercise 5.9
a) We have
St = e Xt
wt wt 1 w t 2 Xs
= e X0 + us e Xs dBs + vs e Xs ds + u e ds
0 0 2 0 s
wt wt σ 2 wt
= e X0 + σ e Xs dBs + ν e Xs ds + e Xs ds
0 0 2 0
wt wt σ2 w t
= S0 + σ Ss dBs + ν Ss ds + Ss ds.
0 0 2 0
b) Let r > 0. The process (St )t∈R+ satisfies the stochastic differential equa-
tion
dSt = rSt dt + σSt dBt
when r = ν + σ 2 /2.
c) We have
Var[Xt ] = Var[(BT − Bt )σ ] = σ 2 Var[BT − Bt ] = (T − t)σ 2 , t ∈ [0, T ].
d) Let the process (St )t∈R+ be defined by St = S0 e σBt +νt , t > 0. Using the
time splitting decomposition
ST
ST = St = St e (BT −Bt )σ +ντ ,
St
we have
P(ST > K | St = x) = P(St e (BT −Bt )σ +(T −t)ν > K | St = x)

= P(x e (BT −Bt )σ +(T −t)ν > K )
= P( e (BT −Bt )σ > K e −(T −t)ν /x)
1

B − Bt
= P √T log K e −(T −t)ν /x

> √
T −t σ T −t
!
log K e −(T −t)ν /x
= 1−Φ √
σ τ
898 "
!
log K e −(T −t)ν /x
=Φ − √
σ τ
log(x/K ) + ντ

=Φ √ ,
σ τ
where τ = T − t.
Problem 5.10 (Exercise 4.18 continued).

a) The option payoff is (BT − K )+ at maturity.
b) We can ignore what happens between two crossings as every crossing resets
the portfolio to its state right before the previous crossing. Based on this,
It is clear that every of the four possible scenarios will lead to a portfolio
value (BT − K )+ at maturity:
i) If B0 < 1 and BT < 1 we issue the option for free and finish with an
empty portfolio and zero payoff.
ii) If B0 < 1 and BT > 1 we issue the option for free and finish with
one AUD and one SGD to refund, which yields the payoff BT − 1 =
( BT − 1 ) + .
iii) If B0 > 1 and BT < 1 we purchase one AUD and borrow one SGD
at the start, however the AUD will be sold and the SGD refunded
before maturity, resulting into an empty portfolio and zero payoff.
iv) If B0 > 1 and BT > 1 we purchase one AUD and borrow one SGD
right before maturity, which yields the payoff BT − 1 = (BT − 1)+ .
Therefore we are hedging the option in all cases. Note that P(BT = K ) =
0 so the case BT = 1 can be ignored with probability one.
c) Since the portfolio strategy is to hold AU$1 when Bt > K and to and
borrow SG$1 when Bt > K, we let
ξt := 1(K,∞) (Bt ) and ηt := −1(K,∞) (Bt ), t ∈ [0, T ],
which is called a stop-loss/start-gain strategy.

wt
d) Noting that ηs dAs = 0 because At = A0 is constant, t ∈ [0, T ], we find
0
by the Itô-Tanaka formula (4.48) that
wt wt wT
ηs dAs + ξs dBs = 1[K,∞) (Bt )dBt
0 0 0
1
= ( BT − K ) + − ( B0 − K ) + − L K .
2 [0,T ]
e) Question (d) shows that
wt wt 1
(BT − K )+ = (B0 − K )+ + ηs dAs + ξs dBs + LK ,
0 0 2 [0,T ]
" 899
N. Privault
i.e. the initial premium (B0 − K )+ plus the sum of portfolio profits and
losses is not sufficient to cover the terminal payoff (BT − K )+ , and that
we fall short of this by the positive amount 21 LK [0,T ] > 0. Therefore the
portfolio allocation (ξt , ηt )t∈[0,T ] is not self-financing.
Additional comments:
The stop-loss/start-gain strategy described here is difficult to implement in
practice because it would require infinitely many transactions when Brownian
motion crosses the level K, as illustrated in Figure S.15.
-1 -0.5 0 0.5 1
Fig. S.15: Brownian crossings of level 1.∗
The arbitrage-free price of the option can in fact be computed as the expected
discounted option payoff
πt = e −(T −t)r E∗ [(BT − K )+ | Ft ]

= e −(T −t)r E∗ [(BT − Bt + x − K )+ | Ft ]x=Bt
= e −(T −t)r E∗ [(BT − Bt + x − K )+ ]x=Bt
w∞ 2 dy
= e −(T −t)r (y + Bt − K )+ e −y /(2(T −t)) p
−∞ 2π (T − t)
w dy
−(T −t)r ∞ −y 2 /(2(T −t))
= e ( y + Bt − K ) e
2π (T − t)
p
K−Bt
w∞ 2 dy
= e −(T −t)r y e −y /(2(T −t)) p
K−Bt 2π (T − t)
w∞ 2 dy
+(Bt − K ) e −(T −t)r e −y /(2(T −t)) p
K−Bt 2π (T − t)
w∞ 2 dy
= e −(T −t)r √ y e −y /2 √
(K−Bt )/ T −t 2π
900 "
w∞ 2 /2 dy
+(Bt − K ) e −(T −t)r √ e −y √
(K−Bt )/ T −t 2π
e −(T −t)r h −y2 /2 i∞
= √ −e √
2π (K−Bt )/ T −t

Bt − K
+(Bt − K ) e −(T −t)r Φ √
T −t
e −(T −t)r −(K−Bt )2 /(2(T −t))
= √ e
2π

Bt − K
+(Bt − K ) e −(T −t)r Φ √
T −t
=: g (t, Bt ),
where the function
e −(T −t)r −(K−x)2 /(2(T −t))

x−K
g (t, x) := √ e + (x − K ) e −(T −t)r Φ √ , t ∈ [0, T ),
2π T −t
solves the Black-Scholes heat equation
∂g ∂g 1 ∂2g
(t, x) + r (t, x) + (t, x) = 0
∂t ∂x 2 ∂2x
with terminal condition g (T , x) = (x − K )+ . The Delta gives the amount to
be invested in AUD at time t and is given by
∂g
ξt = (t, Bt )
∂x
e −(T −t)r −(K−Bt )2 /(2(T −t))
= ( K − Bt ) √ e
2π (T − t)
e −(T −t)r

2 Bt − K
+ ( Bt − K ) p e −(Bt −K ) /(2(T −t)) + e −(T −t)r Φ √
2π (T − t) T −t
!
B t − K
= e −(T −t)r Φ p
(T − t)
=: h(t, Bt ),
with
x−K
h(t, x) := e −(T −t)r Φ √ , t ∈ [0, T ),
T −t
and h(T , x) = 1[K,∞) (x).
" 901
N. Privault
Bt
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Fig. S.16: Brownian path started at B0 > 1.
(Bt-K)+
g(t,Bt)
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Fig. S.17: Risk-neutral pricing of the FX option by πt (Bt ) = g (t, Bt ) vs stop-loss/start-

gain pricing.
1[K,∞ )(Bt)
h(t,Bt)
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Fig. S.18: Delta hedging of the FX option by ξt = h(t, Bt ) vs the stop-loss/start-gain

strategy.
The “one or nothing” stop-loss/start-gain strategy is not self-financing be-

cause in practice there is an impossibility to buy/sell the AUD at exactly
SGD1.00 to the existence of an order book that generates a gap between
bid/ask prices as the sample of Figure S.19 with 383.16964 < 384.07141.
902 "
Fig. S.19: Bitcoin XBT/USD order book.
The existence of the order book will force buying and selling within a certain
range [K − ε, K + ε], typically resulting into selling lower than K = 1.00 and
buying higher than K = 1.00. This potentially results into a trading loss that
can be proportional to the time
` t ∈ [0, T ] : K − ε < Bt < K + ε

spent by the exchange rate (Bt )t∈[0,T ] within the range [K − ε, K + ε].
The Itô-Tanaka formula (4.48)

wT 1
(BT − K )+ = (B0 − K )+ + 1[K,∞) (Bt )dBt + LK
[0,T ] ,
0 2
precisely shows that the trading loss equals half the local time LK
[0,T ] spent
by (Bt )t∈[0,T ] at the level K. When ε is small we have
1 K 1
L ' `({t ∈ [0, T ] : K − ε < Bt < K + ε}),
2 [0,T ] 4ε
therefore the trading loss is proportional to the time spent by Brownian
motion (Bt )t∈R+ within the interval (K − ε, K + ε), with proportionality
coefficient 1/(4ε).
" 903
N. Privault
Bt
K+ε
K-ε
0 0.05 0.1 0.15 0.2
Fig. S.20: Time spent by Brownian motion within the range (K − ε, K + ε).
More generally, we could show that there is no self-financing (buy and hold)
portfolio that can remain constant over time intervals, and that the self-
financing portfolio has to be constantly re-adjusted in time as illustrated
in Figure S.18. This invalidates the stop-loss/start-gain strategy as a self-
financing portfolio strategy.
Chapter 6
Exercise 6.1
a) By the Itô formula, we have
∂g ∂g 1 ∂2g
dVt = dg (t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt. (A.21)
∂t ∂x 2 ∂x2
Consider a hedging portfolio with value Vt = ηt At + ξt Bt , satisfying the
self-financing condition
dVt = ηt dAt + ξt dBt = ξt dBt , t > 0. (A.22)
By respective identification of the terms in dBt and dt in (A.21) and

(A.22) we get
1 ∂2g

∂g
 0 = ∂t (t, Bt )dt + 2 ∂x2 (t, Bt )dt,



 ξt dBt = ∂g (t, Bt )dBt ,




∂x
hence
 0 = ∂g (t, Bt ) + 1 ∂ g (t, Bt ),
2


2 ∂x2

 ∂t
 ξt = ∂g (t, Bt ),



∂x
and
904 "
1 ∂2g

∂g
0 = (t, Bt ) + (t, Bt ),


 ∂t 2 ∂x2
 ξt = ∂g (t, Bt ),



∂x
hence the function g (t, x) satisfies the heat equation
∂g 1 ∂2g
0= (t, x) + (t, x), x > 0, (A.23)
∂t 2 ∂x2
with terminal condition g (T , x) = x2 , and ξt is given by the partial deriva-
tive
∂g
ξt = (t, Bt ), t > 0.
∂x
b) In order to solve (A.23) we substitute a solution of the form g (t, x) =
x2 + f (t) in to the partial differential equation, which yields 1 + f 0 (t) = 0
with the terminal condition f (T ) = 0. Therefore we have f (T − t) = T − t,
and
g (t, x) = x2 + f (t) = x2 + T − t, t ∈ [0, T ].
c) By (6.3), we have
∂g
ξt = ξt (Bt ) = (t, Bt ) = 2Bt , t ∈ [0, T ],
∂x
which recovers the value of ξt found on page 204 in the power option
example.
Exercise 6.2 By the Itô formula, we have
dVt = dg (t, St ) (A.24)

∂g ∂g 1 ∂2g p ∂g
= (t, St )dt + β (α − St ) (t, St )dt + σ 2 St 2 (t, St )dt + σ St (t, St )dBt .
∂t ∂x 2 ∂x ∂x
By respective identification of the terms in dBt and dt in (6.35) and (A.24)
we get

 rg (t, St )dt + β (α − St )ξt dt − rξt St dt
1 ∂2g

∂g ∂g

(t, St )dt + β (α − St ) (t, St )dt + σ 2 St 2 (t, St )dt,

=


∂t ∂x 2 ∂x


 p p ∂g
 σξt St dBt = σ St (t, St )dBt ,


∂x
hence
" 905
N. Privault
1 ∂2g

∂g ∂g
 rg (t, St ) + β (α − St )ξt − rξt St = (t, St ) + β (α − St ) (t, St ) + σ 2 St 2 (t, St ),


 ∂t ∂x 2 ∂x
 ξt = ∂g (t, St ),



∂x
and
1 ∂2g

∂g
 rg (t, St ) + β (α − St )ξt − rξt St = (t, St ) + σ 2 St 2 (t, St ),


 ∂t 2 ∂x
 ξt = ∂g (t, St ),



∂x
hence the function g (t, x) satisfies the PDE
∂g ∂g 1 ∂2g
rg (t, x) = (t, x) + rx (t, x) + σ 2 x 2 (t, x), x > 0,
∂t ∂x 2 ∂x
and ξt is given by the partial derivative
∂g
ξt = (t, St ), t > 0.
∂x
Exercise 6.3
a) Let Vt := ξt St + ηt At denote the hedging portfolio value at time t ∈ [0, T ].
Since the dividend yield δSt per share is continuously reinvested in the
portfolio, the portfolio change dVt decomposes as
dVt = ηt dAt + ξt dSt + δξt St dt

| {z } | {z }
trading profit and loss dividend payout
= rηt At dt + ξt ((µ − δ )St dt + σSt dBt ) + δξt St dt
= rηt At dt + ξt (µSt dt + σSt dBt )
= rVt dt + (µ − r )ξt St dt + σξt St dBt , t > 0.
b) By Itô’s formula we have
∂g ∂g
dg (t, St ) = (t, St )dt + (µ − δ )St (t, St )dt
∂t ∂x
1 ∂2g ∂g
+ σ 2 St2 2 (t, St )dt + σSt (t, St )dBt ,
2 ∂x ∂x
hence by identification of the terms in dBt and dt in the expressions of
dVt and dg (t, St ), we get
∂g
ξt = (t, St ),
∂x
906 "
and we derive the Black-Scholes PDE with dividend

∂g ∂g 1 ∂2g
rg (t, x) = (t, x) + (r − δ )x (t, x) + σ 2 x2 2 (t, x). (A.25)
∂t ∂x 2 ∂x
c) In order to solve (A.25) we note that, letting f (t, x) := e (T −t)δ g (t, x) and
substituting g (t, x) = e −(T −t)δ f (t, x) into the PDE (A.25), we have
∂f ∂f 1 ∂2f
rf (t, x) = δf (t, x) + (t, x) + (r − δ )x (t, x) + σ 2 x2 2 (t, x),
∂t ∂x 2 ∂x
hence f (t, x) := e (T −t)δ g (t, x), satisfies the standard Black-Scholes PDE
with interest rate r − δ, i.e. we have
∂f ∂f 1 ∂2f
(r − δ )f (t, x) = (t, x) + (r − δ )x (t, x) + σ 2 x2 2 (t, x),
∂t ∂x 2 ∂x
with same terminal condition f (T , x) = g (T , x) = (x − K )+ , hence we
have
f (t, x) = Bl(K, x, σ, r − δ, T − t)
= xΦ dδ+ (T − t) − K e −(r−δ )(T −t) Φ dδ− (T − t) ,

where
log(x/K ) + (r − δ ± σ 2 /2)(T − t)
dδ± (T − t) := √ .
σ T −t
Consequently, the pricing function of the European call option with divi-
dend rate δ is
g (t, x) = e −(T −t)δ f (t, x)

= e −(T −t)δ Bl(K, x, σ, r − δ, T − t)
= x e −(T −t)δ Φ dδ+ (T − t) − K e −(T −t)r Φ dδ− (T − t) , 0 6 t 6 T.

We also have
g (t, x) = Bl x e −(T −t)δ , K, σ, r, T − t , 0 6 t 6 T.

d) As in Proposition 6.4, we have
∂g
(t, St ) = e −(T −t)δ Φ dδ+ (T − t) , 0 6 t < T.

ξt =
∂a
Exercise 6.4
a) We check that gc (t, 0) = 0, as when x = 0 we have d+ (T − t) = d− (T −
t) = −∞ for all t ∈ [0, T ). On the other hand, we have
" 907
N. Privault


 +∞, x > K,



lim d+ (T − t) = lim d− (T − t) = 0, x = K,
t%T t%T 



−∞, x < K,

which allows us to recover the boundary condition
gc (T , x) = lim gc (t, x)
t%T
xΦ(+∞) − KΦ(+∞) = x − K,
 

 x>K


 

 
x K
 
= − = 0, x=K = (x − K ) +


 2 2 



 

xΦ(−∞) − KΦ(−∞) = 0,
 
x<K
at t = T . Regarding the Delta of the European call option, we find
Φ(+∞) = 1, x > K 
 

 

 

1

 

lim Φ(d+ (T − t)) = Φ(0) = , x=K
t%T 
 2 


 

 
Φ(−∞) = 0, x < K
 
see Figure 6.6. Similarly, we can check that
σ2

+∞, r> ,


2







σ2

lim d− (T − t) = 0, r= ,
T →∞ 

 2


σ2


,

 −∞,

r<
2
and limT →∞ d+ (T − t) = +∞, hence
lim Bl(K, x, σ, r, T − t)
T →∞
= x lim Φ(d+ (T − t)) − lim e −(T −t)r Φ(d− (T − t))

T →∞ T →∞
= x, t > 0.
b) We check that gp (t, 0) = K e −(T −t)r and gp (t, ∞) = 0 as when x = 0 we

have d+ (T − t) = d− (T − t) = −∞ and as x tends to infinity we have
d+ (T − t) = d− (T − t) = +∞ for all t ∈ [0, T ). On the other hand, we
have
908 "
KΦ(+∞) − xΦ(+∞) = K − x,
 

 x<K


 

 
K x
 
gp (T , x) = − = 0, x=K = (K − x) +


 2 2 



 

KΦ(−∞) − xΦ(−∞) = 0,
 
x>K
at t = T . Regarding the Delta of the European put option, we find
Φ(−∞) = 0,
 

 x>K 

 

1

 

− lim Φ(−d+ (T − t)) = −Φ(0) = − , x = K
t%T 
 2 


 

 
−Φ(+∞) = −1, x < K
 
see Figure 6.13. Similarly, we can check that
σ2

+∞, r > ,


2







σ2

lim d− (T − t) = 0, r= ,
T →∞ 

 2


2

 −∞, r < σ ,



2
and limT →∞ d+ (T − t) = +∞, hence
lim Blp (K, x, σ, r, T − t) = 0, t > 0.

T →∞

a) Substituting g (x, t) = x2 f (t) in (6.36), we find f 0 (t) = −(r + σ 2 )f (t),
hence
2 2
f (t) = f (0) e −(r +σ )t = f (T ) e (r +σ )(T −t) ,
2 2
hence g (x, t) = f (T )x2 e (r +σ )(T −t) = x2 e (r +σ )(T −t) due to the terminal
condition g (x, T ) = x2 .
∂g 2
b) We have ξt = g (St , t) = 2St e (r +σ )(T −t) , and
∂x
1
ηt = (g (St , t) − ξt St )
At
1 2 2
S 2 e (r +σ )(T −t) − 2St2 e (r +σ )(T −t)

=
A0 ert t
S2 2
= − t e (T −2t)r +(T −t)σ , t ∈ [0, T ].
A0
" 909
N. Privault
Exercise 6.6
a) Counting approximately 46 days to maturity, we have
(r − σ 2 /2)(T − t) + log(St /K )
d− ( T − t ) = √
σ T −t
(0.04377 − (0.9)2 /2)(46/365) + log(17.2/36.08)
= √
0.9 46/365
= −2.461179058,
and p
d+ (T − t) = d− (T − t) + 0.9 46/365 = −2.14167602.
From the standard Gaussian cumulative distribution table we get
Φ(d+ (T − t)) = Φ(−2.14) = 0.0161098
and
Φ(d− (T − t)) = Φ(−2.46) = 0.00692406,
hence
f (t, St ) = St Φ(d+ (T − t)) − K e −(T −t)r Φ(d− (T − t))

= 17.2 × 0.0161098 − 36.08 × e −0.04377×46/365 × 0.00692406
= HK$ 0.028642744.
For comparison, running the corresponding Black-Scholes R script of Fig-

ure 6.23 yields
BSCall(17.2, 36.08, 0.04377, 46/365, 0.9) = 0.02864235.
b) We have
∂f
ηt = (t, St ) = Φ(d+ (T − t)) = Φ(−2.14) = 0.0161098, (A.26)
∂x
hence one should only hold a fractional quantity equal to 16.10 units in
the risky asset in order to hedge 1000 such call options when σ = 0.90.
c) From the curve it turns out that when f (t, St ) = 10 × 0.023 = HK$ 0.23,
the volatility σ is approximately equal to σ = 122%.
This approximate value of implied volatility can be found under the col-
umn “Implied Volatility (IV.)” on this set of market data from the Hong
Kong Stock Exchange:
910 "
Derivative Warrant Search
http://www.hkex.com.hk/dwrc/sea
Updated: 6 November 2008
Basic Data
DW Issuer UL Call DW Listing Maturity Strike Entitle- Total O/S D
Code /Put Type (D-M-Y) (D-M-Y) ment Issue (%) (
Ratio^
Link to Relevant Exchange Traded Options Size
01897 FB 00066 Call Standard 18-12-2007 23-12-2008 36.08 10 138,000,000 16.43
04348 BP 00066 Call Standard 18-12-2007 23-02-2009 38.88 10 300,000,000 0.25

Market Data
04984 AA 00066 Call Standard 02-06-2005 22-12-2008 12.88 10 300,000,000 0.36
ty Strike Entitle- Total O/S Delta IV. Day Day Closing T/O UL Base Listing Suppl
Y) ment Issue (%) (%) (%) High Low Price # ('000) Price Document
05931 SB 00066 Call Standard 27-03-2008 29-12-2008 27.868 10 200,000,000 0.04
Ratio^ Size ($) ($) ($) ($) Announ
008 36.08 09133 CT 16.43
10 138,000,000 000660.780
Call125.375
Standard 31-01-2008
0.000 0.000 08-12-2008
0.023 36.88 0 17.200
10 200,000,000 0.15
009 38.88 13436 SG 0.25

10 300,000,000 000660.767
Call 88.656
Standard 14-05-2008
0.000 0.000 30-04-2009 32 0 17.200
10 200,000,000
0.024 Corporation. 0.10
Fig. S.21: Market data for the warrant #01897 on the MTR
008 12.88 13562
10 Remark: BP
300,000,000 000668.075
0.36
a typical Call128.202
value Standard
for 26-05-2008
the0.000 0.000 in 08-12-2008
volatility 0.540
standard 30 0conditions
market 10 150,000,000
17.200 0.00
would
13688
beRB
around 20%.
000662.239
The observed
Call126.132
Standard
volatility
04-06-2008
value σ = 26.6
20-02-2009
1.22 per year is
10 200,000,000 7.17
008 27.868 10 200,000,000 0.04 0.000 0.000 0.086 0 17.200
actually quite high.
008 36.88 13764 SG 0.15
10 200,000,000 000660.416
Call133.443
Standard 13-06-2008
0.000 0.000 26-02-2009
0.010 28 0 17.200
10 300,000,000 0.31
Exercise 6.7
009 32 13785 ML 0.10
10 200,000,000 000661.059
Call 61.785
Standard 17-06-2008
0.000 0.000 19-01-2009
0.031 27.38 0 17.200
10 100,000,000 0.50
a) We find h(x) = x − K.
008 30 b)
10 Letting
13821 g (JPt, x
150,000,000 ),00066
0.00 the0.987
PDE rewrites
Call127.080
Standard as
18-06-2008
0.000 0.000 18-12-2008
0.026 28.8 0 17.200
10 100,000,000 0.81
009 26.6 14111 UB 7.17

10 200,000,000 000660.706
Call Standard
(x49.625
− r 09-07-2008
0.000
α(t)) 16-02-2009
−α0 (t) +
= 0.000 rx, 0.013 23.88 0 17.200
10 500,000,000 0.88
14264
009 28 10 hence α(tBI
300,000,000 α00066
) =0.31 e rtCall
(0) 0.549 Standard
and49.880 ) =16-07-2008
g (t, x0.010 − α(0) 25-02-2009
x0.010 0.010
e rt . The 26.38 6 17.200
final condition10 200,000,000 0.03
009 27.38 14305 DB 0.50

10 100,000,000 000660.714
Call 63.598
Standard 22-07-2008 09-03-2009 27 0 17.200
10 300,000,000 0.00
g (T , x) 0.000
= h(x0.000
) = x − K 0.014
008 28.8 14489 FB 0.81
10 100,000,000 000660.670
Call 91.664
Standard 06-08-2008
0.000 0.000 −29-06-2009 28.08 0 17.200
10 175,000,000 0.15
yields α(0) = K e
−rT and g (t, x) = x − K e(T −t)r 0.014
.
009 23.88 c)
10 We have MB 0.88
14512
500,000,000 000662.288
Call 66.247
Standard 08-08-2008
0.000 0.000 26-02-2009
0.068 26 0 17.200
10 300,000,000 0.86
∂g
14531 UB 0.03
000661.250
Call 58.172
Standard (t, St ) = 1,
ξt = 08-08-2008
009 26.38 10 200,000,000 ∂x 0.000 11-05-2009
0.000 0.030 26.88 0 17.200
10 500,000,000 0.00
009 27 10
hence
14548 CT 0.00
300,000,000 000660.000
Call Standard 12-08-2008
0.000 0.000 25-05-2009 26.88 0 17.200
0.000 99,999,999.000 10 400,000,000 0.03
14571 VCTt −0.15

ξt00066 g (t, SStandard
St 1.681 t ) − S0.000St − K e −(T −t)r0.053
− St
= Put 52.209
t 15-08-2008
009 28.08 10 175,000,000
ηt = = 0.000 22-06-2009 =26−K 10 240,000,000
0 17.200
e −rT . 0.06 (6
At At At
009 26 14925 CT 0.86
10 300,000,000 000661.273
Call 56.527
Standard 18-09-2008
0.000 0.000 12-10-2009
0.030 28.88 0 17.200
10 330,000,000 0.00
Note that we could also have directly used the identification
009 26.88 15159 JP 0.00
10 500,000,000 000663.261
Call 84.055
Standard 29-09-2008
0.000 0.000 12-10-2009
0.162 28.08 0 17.200
10 100,000,000 2.00
Vt = g (St , t) = St − K e −(T −t)r = St − K e −rT At = ξt St + ηt At ,
009 26.88 15257 RB 0.03
10 400,000,000 000662.749
Call 70.622
Standard 15-10-2008
0.000 0.000 30-07-2009
0.117 22 0 17.200
10 100,000,000 0.41
which immediately yields ξt = 1 and ηt = −K e −rT .
009 26 15339
10 240,000,000CT 00066 Call 71.243
Standard 17-10-2008 19-10-2009 20 0 17.200
10 200,000,000 0.07
d) It suffices to 0.06
take (6.751) 0.000
K = 0, which shows 0.000
that g (t, x) =1.020
x, ξt = 1 and ηt = 0.
009 28.88 10 330,000,000 0.00
" 0.000 0.000 0.000 0.000 99,999,999.000 0 17.200911
009 28.08 10 100,000,000 2.00ratio

^ The entitlement 3.270 66.344
in general 0.000 0.000
represents 0.169version:
the number of This
derivative 0July
17.200
warrants 4,required
2021 to be exercis ed in
necessary to reflect any capitalization, rights issue, distribution or the like).
009 22 10 100,000,000
# Closing price0.41 4.158
value = 60.731
99999999 0.280
when 0.201
it is not available. 0.201 234 17.200
N. Privault
Exercise 6.8
a) We develop two approaches.
(i) By financial intuition. We need to replicate a fixed amount of $1 at
maturity T , without risk. For this there is no need to invest in the
stock. Simply invest g (t, St ) := e −(T −t)r at time t ∈ [0, T ] and at
maturity T you will have g (T , ST ) = e (T −t)r g (t, St ) = $1.
(ii) By analysis and the Black-Scholes PDE. Given the hint, we try plug-
ging a solution of the form g (t, x) = f (t), not depending on the
variable x, into the Black-Scholes PDE (6.37). Given that here we
have
∂g ∂2g ∂g
(t, x) = 0, (t, x) = 0, and (t, x) = f 0 (t),
∂x ∂x2 ∂t
we find that the Black-Scholes PDE reduces to rf (t) = f 0 (t) with
the terminal condition f (T ) = g (T , x) = 1. This equation has
for solution f (t) = e −(T −t)r and this is also the unique solution
g (t, x) = f (t) = e −(T −t)r of the Black-Scholes PDE (6.37) with
terminal condition g (T , x) = 1.
b) We develop two approaches.
(i) By financial intuition. Since the terminal payoff $1 is risk-free we do
not need to invest in the risky asset, hence we should keep ξt = 0.
Our portfolio value at time t becomes
Vt = g (t, St ) = e −(T −t)r = ξt St + ηt At = ηt At
with At = e rt , so that we find ηt = e −rT , t ∈ [0, T ]. This portfolio

strategy remains constant over time, hence it is clearly self-financing.
(ii) By analysis. The Black-Scholes theory of Proposition 6.1 tells us that
∂g
ξt = (t, x) = 0,
∂x
and
Vt − ξt St Vt e −(T −t)r
ηt = = = = e −rT .
At At e rt
Exercise 6.9 Log contracts.

a) Substituting the function g (x, t) := f (t) + log x in the PDE (6.38), we
have
σ2
0 = f 0 (t) + r − ,
2
912 "
hence
σ2

f (t) = f (0) − r − t,
2
σ2

with f (0) = r − T in order to match the terminal condition
2
g (x, T ) := log x, hence we have
σ2

g (x, t) = r − (T − t) + log x, x > 0.
2
b) Substituting the function
σ2

h(x, t) := u(t)g (x, t) = u(t) r− (T − t) + log x
2
in the PDE (6.38), we find u0 (t) = ru(t), hence u(t) = u(0) e rt =

e −(T −t)r , with u(T ) = 1, and we conclude to
σ2

h(x, t) = u(t)g (x, t) = e −(T −t)r r− (T − t) + log x ,
2
x > 0, t ∈ [0, T ].
c) We have
∂h e −(T −t)r
ξt = (t, St ) = , 0 6 t 6 T,
∂x St
and
1
ηt = h(t, St ) − ξt St
At
e −rT σ2

= r− (T − t) + log x − 1 ,
A0 2
0 6 t 6 T.
Exercise 6.10 Binary options.

a) From Proposition 6.1, the function Cd (t, x) solves the Black-Scholes PDE
 rC (t, x) = ∂Cd (t, x) + rx ∂Cd (t, x) + 1 σ 2 x2 ∂ Cd (t, x),


 2
d
2 ∂x2

∂t ∂x
 C (T , x) = 1

[K,∞) (x).

d
b) We can check by direct differentiation that the Black-Scholes PDE is

satisfied by the function Cd (t, x), together with the terminal condition
Cd (T , x) = 1[K,∞) (x) as t tends to T .
" 913
N. Privault
Exercise 6.11
a) By (4.35) we have
wt
St = S0 e αt + σ e (t−s)α dBs .
0
b) By the self-financing condition (5.8) we have

= rηt At dt + αξt St dt + σξt dBt
= rVt dt + (α − r )ξt St dt + σξt dBt , (A.27)
t > 0. Rewriting (6.40) under the form of an Itô process

wt wt
St = S0 + vs ds + us dBs , t > 0,
0 0
with
ut = σ, and vt = αSt , t > 0,
the application of Itô’s formula Theorem 4.23 to Vt = C (t, St ) shows that
∂C ∂C
dC (t, St ) = vt (t, St )dt + ut (t, St )dBt
∂x ∂x
∂C 1 2
∂ C
+ (t, St )dt + |ut |2 2 (t, St )dt
∂t 2 ∂x
∂C ∂C 1 ∂2C ∂C
= (t, St )dt + αSt (t, St )dt + σ 2 2 (t, St )dt + σ (t, St )dBt .
∂t ∂x 2 ∂x ∂x
(A.28)
Identifying the terms in dBt and dt in (A.27) and (A.28) above, we get
σ2 ∂ 2 C

∂C ∂C
 rC (t, St ) = (t, St ) + rSt (t, St ) + (t, St ),


∂t ∂x 2 ∂x2
 ξt = ∂C (t, St ),


∂x
hence the function C (t, x) satisfies the usual Black-Scholes PDE
∂C ∂C 1 ∂2C
rC (t, x) = (t, x) + rx (t, x) + σ 2 2 (t, x), x > 0, 0 6 t 6 T,
∂t ∂x 2 ∂x
(A.29)
with the terminal condition C (T , x) = e x , x > 0.
c) Based on (6.41), we compute
914 "
σ2

∂C
(t, x) = r + xh0 (t) + h(t)h0 (t) C (t, x),


∂t 2r






∂C
(t, x) = h(t)C (t, x)


 ∂x
2

 ∂ C (t, x) = (h(t))2 C (t, x),



∂x2
hence the substitution of (6.41) into the Black-Scholes PDE (A.29) yields
the ordinary differential equation
σ2 0 σ2
xh0 (t) + h (t)h(t) + rxh(t) + (h(t))2 = 0, x > 0, 0 6 t 6 T,
2r 2
which reduces to the ordinary differential equation h0 (t) + rh(t) = 0 with
terminal condition h(T ) = 1 and solution h(t) = e (T −t)r , t ∈ [0, T ], which
yields
σ 2 2(T −t)r

C (t, x) = exp −(T − t)r + x e (T −t)r + (e − 1) .
4r
d) We have
σ2

∂C
ξt = (t, St ) = exp St e (T −t)r + ( e 2(T −t)r − 1) .
∂x 4r
Exercise 6.12
2 /2
a) Noting that ϕ(x) = Φ0 (x) = (2π )−1/2 e −x , we have the
∂h √
(S, d) = Sϕ d + σ T − K e −rT ϕ(d)
∂d
√ 2
S K 2
= √ e − d+σ T /2 − √ e −rT e −d /2
2π 2π
√
S 2 2 K 2
= √ e −d /2−σ T d−σ T /2 − √ e −rT e −d /2 ,
2π 2π
∂h
hence the vanishing of (S, d∗ (S )) at d = d∗ (S ) yields
∂d
√
S 2 2 K 2
√ e −d∗ (S )/2−σ T d∗ (S )−σ T /2 − √ e −rT e −d∗ (S )/2 = 0,
2π 2π
log(S/K ) + rT − σ 2 T /2
i.e. d∗ (S ) = √ . We can also check that
σ T
" 915
N. Privault
√ 2
∂2h

∂ S K 2
(S, d∗ (S )) = √ e − d∗ (S )+σ T /2 − √ e −rT e −d∗ (S )/2
∂d2 ∂d 2π 2π
√ S − d (S )+σ√T 2 /2 K 2
= − d∗ ( S ) + σ T √ e ∗
+ √ d∗ (S ) e −rT e −d∗ (S )/2
2π 2π
√ K 2 K 2
= − d∗ (S ) + σ T √ e −rT e −d∗ (S )/2 + √ d∗ (S ) e −rT e −d∗ (S )/2
2π 2π
√ K 2
= −σ T √ e −rT e −d∗ (S )/2 < 0,
2π
√
hence the function d 7−→ h(S, d) := SΦ d + σ T − K e −rT Φ(d) admits
a maximum at d = d∗ (S ), and
√
h(S, d∗ (S )) = SΦ d∗ (S ) + σ T − K e −rT Φ(d∗ (S ))
log(S/K ) + (r + σ 2 /2)T log(S/K ) + (r − σ 2 /2)T

= SΦ √ − K e −rT Φ √
σ T σ T
is the Black-Scholes call option price.
b) Since ∂h
∂d (S, d∗ (S )) = 0, we find
d ∂h ∂h
∆= h(S, d∗ (S )) = (S, d∗ (S )) + d0∗ (S ) (S, d∗ (S ))
dS ∂S ∂d
√ log(S/K ) + rT + σ 2 T /2

= Φ d∗ (S ) + σ T = Φ √ .
σ T
Exercise 6.13
a) When σ > 0 we have
∂gc ∂ ∂
= xΦ0 d+ (T − t) d+ (T − t) − K e −(T −t)r Φ0 d− (T − t) d− (T − t)
∂σ ∂σ ∂σ
∂
= xΦ0 d+ (T − t)

d+ (T − t )
∂σ
∂
−K e −(T −t)r Φ0 d+ (T − t) e (T −t)r +log(x/K ) d− (T − t)

∂σ
∂
= xΦ0 d+ (T − t)

d+ (T − t) − d− (T − t)
∂σ
∂ √
= xΦ0 d+ (T − t)

σ T −t
√ ∂σ
= x T − tΦ0 d+ (T − t) ,


1 2
Φ0 d− (T − t) = √ e −(d− (T −t)) /2

2π
916 "
1 2
= √ e −(d− (T −t)) /2+(T −t)r +log(x/K )
2π
= Φ0 d+ (T − t) e (T −t)r +log(x/K ) .

Relation (6.42) can be obtained from the equalities

2 2
d+ (T − t ) − d− (T − t)

= d+ (T − t) + d− (T − t) d+ (T − t) − d− (T − t)
x
= 2r (T − t) + 2 log .
K
Due to the call-put parity relation (6.23), the Black-Scholes call and put
Vega are identical, i.e.
∂gp ∂gc √
= x T − tΦ0 d+ (T − t) .

=
∂σ ∂σ
The Black-Scholes European call and put prices are increasing functions
of the volatility parameter σ > 0.
b) We have
∂gc ∂ ∂
= xΦ0 (d+ (T − t)) d+ (T − t) − K e −(T −t)r Φ0 (d− (T − t)) d− (T − t)
∂r ∂r ∂r
+(T − t)K e −(T −t)r Φ(d− (T − t))
∂
= xΦ0 (d+ (T − t)) d+ (T − t)
∂r
∂
−K e −(T −t)r Φ0 (d+ (T − t)) e (T −t)r +log(x/K ) d− (T − t)
∂r
+(T − t)K e −(T −t)r Φ(d− (T − t))
∂
= xΦ0 (d+ (T − t)) d+ (T − t) − d− (T − t) + (T − t)K e −(T −t)r Φ(d− (T − t))

∂r
∂ √
= xΦ0 (d+ (T − t)) σ T − t + (T − t)K e −(T −t)r Φ(d− (T − t))

∂r
= (T − t)K e −(T −t)r Φ(d− (T − t)),

1 2
Φ0 (d− (T − t)) = √ e −(d− (T −t)) /2
2π
1 2
= √ e −(d− (T −t)) /2+(T −t)r +log(x/K )
2π
= Φ0 (d+ (T − t)) e (T −t)r +log(x/K ) .
The same relationship is used to simplify the formulas of the Black-Scholes

Delta and Vega. We note that the Black-Scholes European call price is an
" 917
N. Privault
increasing function of the interest rate parameter r.
Regarding put option prices gp (t, x), the call-put parity relation (6.23)
yields
∂gp ∂
gc − (x − K e −r (T −t) )

=
∂r ∂r
= (T − t)K e −(T −t)r Φ(d− (T − t)) − (T − t)K e −r (T −t)
= (T − t)K e −(T −t)r (Φ(d− (T − t)) − 1)
= −(T − t)K e −(T −t)r Φ(−d− (T − t)),
therefore the Black-Scholes European call price is a decreasing function

of the interest rate parameter r.
Exercise 6.14
a) Given that
rN − aN 1 bN − rN 1
p∗ = = and q ∗ = = ,
bN − aN 2 bN − aN 2
Relation (3.14) reads

1 p
ve t + T /N , x(1 + rT /N )(1 − σ T /N )

ve(t, x) =
2
1 p
+ ve t + T /N , x(1 + rT /N )(1 + σ T /N ) .

2
After letting ∆T := T /N and applying Taylor’s formula at the second
order we obtain
1 √
0= ve t + ∆T , x 1 + r∆T − σ ∆T − ve(t, x)

2
1 √
+ ve t + ∆T , x 1 + r∆T + σ ∆T − ve(t, x) + o ∆T

2
1 √ ∂e

∂e
v v
= ∆T (t, x) + x r∆T − σ ∆T (t, x)
2 ∂t ∂x
x2 √ 2 ∂ 2 ve

+ r∆T − σ ∆T (t, x) + o(∆T )
2 ∂x 2
1 √ ∂e

∂e
v v
+ ∆T (t, x) + x r∆T + σ ∆T (t, x)
2 ∂t ∂x
x2 √ 2 ∂ 2 ve

r∆T + σ ∆T ∆T + o ∆T

+ ( t, x ) + o ( )
2 ∂x2
∂e
v ∂e
v x2 √ 2 ∂ 2 ve
= ∆T (t, x) + rx∆T (t, x) + σ ∆T (t, x) + o ∆T ,

∂t ∂x 2 ∂x2
918 "
which shows that

o ∆T

∂e
v ∂e
v σ 2 ∂ 2 ve
(t, x) + rx (t, x) + x2 ( t, x ) = − ,
∂t ∂x 2 ∂x2 ∆T
hence as N tends to infinity (or as ∆T tends to 0) we find∗
∂e
v ∂e
v σ 2 ∂ 2 ve
0= (t, x) + rx (t, x) + x2 2 (t, x),
∂t ∂x 2 ∂x
showing that the function v (t, x) := e (T −t)r ve(t, x) solves the classical
Black-Scholes PDE
∂v ∂v σ2 ∂ 2 v
rv (t, x) = (t, x) + rx (t, x) + x2 2 (t, x).
∂t ∂x 2 ∂x
b) Similarly, we have
(1) v (t, (1 + bN )x) − v (t, (1 + aN )x)

ξt (x) =
x ( bN − a N )
√ √
v t, (1 + r/N )(1 + σ T /N )x − v t, (1 + r/N )(1 − σ T /N )x

= √
2x(1 + r/N )σ T /N
∂v
→ (t, x),
∂x
as N tends to infinity.
Problem 6.15
a) When the risk-free rate is r = 0 the two possible returns are (5 − 4)/4 =
25% and (2 − 4)/4 = −50%. Under the risk-neutral probability measure
given by P∗ (S1 = 5) = (4 − 2)/(5 − 2) = 2/3 and P∗ (S1 = 2) =
(5 − 4)/(5 − 2) = 1/3 the expected return is 2 × 25%/3 − 50%/3 = 0%.
In general the expected return can be shown to be equal to the risk-free
rate r.
b) The two possible returns become (3 × 5 − 4 − 2 × 4)/4 = 75% and (3 ×
2 − 4 − 2 × 4)/4 = −150%. Under the risk-neutral probability measure
given by P∗ (S1 = 5) = (4 − 2)/(5 − 2) = 2/3 and P∗ (S1 = 2) =
(5 − 4)/(5 − 2) = 1/3 the expected return is 2 × 75%/3 − 150%/3 = 0%.
Similarly to Question (a), the expected return can be shown to be equal
to the risk-free rate r when r 6= 0.
c) We decompose the amount Ft invested in one unit of the fund as
Ft = βF − (β − 1)Ft ,
| {z t} | {z }
Purchased/sold Borrowed/saved
∗
The notation o(∆T ) is used to represent any function of ∆T such that
lim∆T →0 o(∆T )/∆T = 0.
" 919
N. Privault
meaning that we invest the amount βFt in the risky asset St , and bor-
row/save the amount −(β − 1)Ft from/on the saving account.
d) We have
Ft Ft
Ft = ξt St + ηt At = β St − (β − 1) At , t > 0,
St At
with ξt = βFt /St and ηt = −(β − 1)Ft /At , t > 0.

e) We have
dFt = ξt dSt + ηt dAt

Ft Ft
= β dSt − (β − 1) dAt
St At
Ft
= β dSt − (β − 1)rFt dt (A.30)
St
= βFt (rdt + σdBt ) − (β − 1)rFt dt
= rFt dt + βσFt dBt , t > 0.
By (A.30), the return of the fund Ft is β times the return of the risky
asset St , up to the cost of borrowing (β − 1)r per unit of time.
f) The discounted fund value ( e −rt Ft )t∈R+ is a martingale under the risk-
neutral probability measure P∗ as we have
d( e −rt Ft ) = βσ e −rt Ft dBt , t > 0.
g) We have
2 σ 2 t/2
Ft = F0 e βσBt +rt−β
and β
2 2
Stβ = S0 e σBt +rt−σ t/2 = F0 e βσBt +βrt−βσ t/2 ,
hence
2 t/2
Ft = Stβ e −(β−1)rt−β (β−1)σ , t > 0.
Note that when β = 0 we have Ft = e rt ,
i.e. in this case the fund Ft
coincides with the money market account.
h) We have
e −(T −t)r E∗ (FT − K )+ | Ft

log(Ft /K ) + (r + β 2 σ 2 /2)(T − t)

= Ft Φ √
|β|σ T − t
log(Ft /K ) + (r − β 2 σ 2 /2)(T − t)

−(T −t)r
−Ke Φ √ ,
|β|σ T − t
t ∈ [0, T ).
920 "
i) We have
log(Ft /K ) + (r + β 2 σ 2 /2)(T − t)

Φ √
|β|σ T − t
2
!
log(Stβ e −(β−1)rt−β (β−1)σ t/2 /K ) + (r + β 2 σ 2 /2)(T − t)
=Φ √
|β|σ T − t
!
log(Stβ /K ) − (β − 1)rt − β (β − 1)σ 2 t/2 + (r + β 2 σ 2 /2)(T − t)
=Φ √
|β|σ T − t
2
!
log(Stβ /(K e (β−1)rT −(T /2−t)(β−1)βσ )) + (T − t)βr + (T − t)βσ 2 /2
=Φ √
|β|σ T − t
log(St /Kβ (t)) + (r + σ 2 /2)(T − t)

=Φ √ , 0 6 t < T,
σ T −t
2
if β > 0, with Kβ (t) := K 1/β e (β−1)(rT /β−(T /2−t)σ ) .
j) When β < 0 we find that the Delta of the call option on FT with strike
price K is
log(Ft /K ) + (r + β 2 σ 2 /2)(T − t)

Φ √
|β|σ T − t
β
!
log(St /Kβ ) + (T − t)βr + (T − t)βσ 2 /2
=Φ √
|β|σ T − t
log(St /Kβ (t)) + (r + σ 2 /2)(T − t)

=Φ − √ , 0 6 t < T,
σ T −t
which coincides, up to a negative sign, with the Delta of the put option
2
on ST with strike price Kβ (t) := K 1/β e (β−1)(rT /β−(T /2−t)σ ) .
Chapter 7
Exercise 7.1 (Exercise 6.1 continued). Since r = 0 we have P = P∗ and
g (t, Bt ) = E∗ BT2 | Ft

= E∗ (BT − Bt + Bt )2 | Ft

= E∗ (BT − Bt + x)2 x=B

t
= E∗ (BT − Bt )2 + 2x(BT − Bt ) + x2 x=B

t
= E∗ (BT − Bt )2 + 2xE∗ [BT − Bt ] + Bt2

= Bt2 + T − t, 0 6 t 6 T,
" 921
N. Privault
hence ξt is given by the partial derivative

∂g
ξt = (t, Bt ) = 2Bt , 0 6 t 6 T,
∂x
with
g (t, Bt ) − ξt Bt
ηt =
A0
Bt2 + (T − t) − 2Bt2
=
A0
(T − t) − Bt2
= , 0 6 t 6 T.
A0
Exercise 7.2 Since BT ' N (0, T ), we have

2
E[φ(ST )] = E φ S0 e σBT +(r−σ /2)T

1 w ∞ 2 2
= √ φ(S0 e σy +(r−σ /2)T ) e −y /(2T ) dy
2πT −∞
1 w∞ 2 2 2 dx
= √ φ(x) e −((σ /2−r )T +log x) /(2σ T )
w∞2πσ 2 T −∞ x
= φ(x)g (x)dx,
−∞
under the change of variable

2 /2)T 2 /2)T
x = S0 e σy +(r−σ , with dx = σS0 e σy +(r−σ dy = σxdy,
i.e.
(σ 2 /2 − r )T + log(x/S0 ) dx
y= and dy = ,
σ σx
where
1 2 2 2
g (x) : = √ e −((σ /2−r )T +log(x/S0 )) /(2σ T )
x 2πσ 2 T
is the lognormal probability density function
√ with location parameter (r −
σ 2 /2)T + log S0 and scale parameter σ T .
Exercise 7.3
p(p − 1) p−2
dStp = pStp−1 dSt + St dSt • dSt
2
p(p − 1) p−2
= pStp−1 (rSt dt + σSt dBt ) + St (rSt dt + σSt dBt ) • (rSt dt + σSt dBt )
2
922 "
p(p − 1) p
= prStp dt + σpStp dBt + σ 2 St dt
2
( 1 )

p p − p p
= pr + σ 2 St dt + σpSt dBt .
2
b) By the Girsanov Theorem 7.3, letting
1 p(p − 1)

ν := (p − 1)r + σ 2 ,
pσ 2
the drifted process

bt := Bt + νt,
B 0 6 t 6 T,
is a standard (centered) Brownian motion under the probability measure

Q defined by
ν2

dQ(ω ) = exp −νBT − T dP(ω ).
2
Therefore, the differential of (Stp )t∈R+ can be written as
p(p − 1)

dStp = pr + σ 2 Stp dt + σpStp dBt
2
= (r + pσν ) Stp dt + σpStp dBt
= rStp dt + σpStp (dBt + νdt)
= rS p dt + σpS p dB
t t
bt ,
hence the discounted process Set := e −rt Stp satisfies dSet = σpSet dB
bt , and
(Set )t∈R+ is a martingale under the probability measure Q.

E∗ [φ(pST1 + qST2 )] 6 E∗ [pφ(ST1 ) + qφ(ST2 )] since φ is convex,
= pE∗ [φ(ST1 )] + qE∗ [φ(ST2 )]
= pE∗ [φ(E∗ [ST2 | FT1 ])] + qE∗ [φ(ST2 )] because (St )t∈R+ is a martingale,
6 pE∗ [E∗ [φ(ST2 ) | FT1 ]] + qE∗ [φ(ST2 )] by Jensen’s inequality,
= pE∗ [φ(ST2 )] + qE∗ [φ(ST2 )] by the tower property,
= E∗ [φ(ST2 )], because p + q = 1,
see Exercise 13.7 for an extension to arbitrary summations.

Remark: This kind of technique can provide an upper price estimate from
Black-Scholes when the actual option price is difficult to compute: here the
closed-form computation would involve a double integration of the form
" 923
N. Privault
h 2 2
i
E∗ [φ(pST1 + qST2 )] = E∗ φ pS0 e σBT1 −σ T1 /2 + qS0 e σBT2 −σ T2 /2
h 2
2
i
= E∗ φ S0 e σBT1 −σ T1 /2 p + q e (BT2 −BT1 )σ−(T2 −T1 )σ /2
1 w∞ w∞ 2
2

= φ S0 e σx−σ T1 /2 p + q e σy−(T2 −T1 )σ /2
2π −∞ −∞
2 2 dxdy
× e −x /(2T1 )−y (2(T2 −T1 )) p
T1 (T2 − T1 )
1 w∞ w∞ 2
2
+
= S0 e σx−σ T1 /2 p + q e σy−(T2 −T1 )σ /2 − K
2π −∞ −∞
2 2 dxdy
× e −x /(2T1 )−y (2(T2 −T1 )) p
T1 (T2 − T1 )
1 w
=
2π {(x,y )∈R2 : S0 e σx (p+q e σy−(T2 −T1 )σ2 /2 )>K e σ2 T1 /2 }
2 T /2 2 /2
(S0 e σx−σ 1 (p + q e σy−(T2 −T1 )σ ) − K)
−x2 /(2T1 )−y 2 (2(T2 −T1 )) dxdy
×e p
T1 (T2 − T1 )
= ···
Exercise 7.5
a) The European call option price C (K ) := e −rT E∗ [(ST − K )+ ] decreases
with the strike price K, because the option payoff (ST − K )+ decreases
and the expectation operator preserves the ordering of random variables.
b) The European put option price C (K ) := e −rT E∗ [(K − ST )+ ] increases
with the strike price K, because the option payoff (K − ST )+ increases
and the expectation operator preserves the ordering of random variables.
Exercise 7.6
a) Using Jensen’s inequality and the martingale property of the discounted
asset price process ( e −rt St )t∈R+ under the risk-neutral probability mea-
sure P∗ , we have
+
e −(T −t)r E∗ [(ST − K )+ | Ft ] > e −(T −t)r E∗ [ST − K | Ft ]
+
= e −(T −t)r e (T −t)r St − K

+
= St − K e −(T −t)r , 0 6 t 6 T .

924 "
Black-Scholes European call price

Lower bound
80
70
60
50
40
30
20
10
0
120
100
80 10 5
Underlying (HK$) 20 15
60
Time to maturity T-t
Fig. S.22: Lower bound vs Black-Scholes call price.
b) Similarly, by Jensen’s inequality and the martingale property, we find

+
e −(T −t)r E∗ [(K − ST )+ | Ft ] > e −(T −t)r E∗ [K − ST | Ft ]
+
= e −(T −t)r K − e (T −t)r St
+
= K e −(T −t)r − St , 0 6 t 6 T .

Black-Scholes European put price

Lower bound
30
25
20
15
10
5
0
120
100
Underlying (HK$)
0
80 5
10
20
Fig. S.23: Lower bound vs Black-Scholes put option price.
We may also use the fact that a convex function of the martingale
( e rt St )t∈R+ under the risk-neutral probability measure P∗ is a submartingale,
showing that
e rt E∗ [( e −rT K − e −rT ST )+ | Ft ] > e rt ( e −rT K − e −rt St )+

+
= K e −(T −t)r − St , 0 6 t 6 T .
Exercise 7.7
a) (i) The bull spread option can be realized by purchasing one European
call option with strike price K1 and by short selling (or issuing) one
" 925
N. Privault
European call option with strike price K2 , because the bull spread
payoff function can be written as
x 7−→ (x − K1 )+ − (x − K2 )+ .
see http://optioncreator.com/st3ce7z.
150
(x-K1)+
-(x-K2)+
100
50
-50
0 50 100 150 200
K1 ST K2
Fig. S.24: Bull spread option as a combination of call and put options.∗
(ii) The bear spread option can be realized by purchasing one European
put option with strike price K2 and by short selling (or issuing) one
European put option with strike price K1 , because the bear spread
payoff function can be written as
x 7−→ −(K1 − x)+ + (K2 − x)+ ,
see http://optioncreator.com/stmomsb.
∗
926 "
150
-(K1-x)+
(K2-x)+
100
50
-50
0 50 100 150 200
K1 ST K2
Fig. S.25: Bear spread option as a combination of call and put options.∗
b) (i) The bull spread option can be priced at time t ∈ [0, T ) using the
Bl(K1 , St , σ, r, T − t) − Bl(K2 , St , σ, r, T − t).
(ii) The bear spread option can be priced at time t ∈ [0, T ) using the
Bl(K2 , St , σ, r, T − t) − Bl(K1 , St , σ, r, T − t).
Exercise 7.8
a) Using (a), the payoff of the long box spread option is given in terms of
K1 and K2 as
(x − K1 )+ − (K1 − x)+ − (x − K2 )+ + (K2 − x)+ = x − K1 − (x − K2 ) = K2 − K1 .
b) By standard absence of arbitrage, the long box spread option payoff is

priced (K2 − K1 )/(1 + r )N −k at times k = 0, 1, . . . , N .
c) From Table 24.6 below we check that the strike prices suitable for a long
box spread option on the Hang Seng Index (HSI) are K1 = 25, 000 and
K2 = 25, 200.
∗
" 927
N. Privault
Table 24.6: Call and put options on the Hang Seng Index (HSI).
d) Based on the data provided, we note that the long box spread can be
realized in two ways.
i) Using the put option issued by BI (BOCI Asia Ltd.) at 0.044.
In this case, the box spread option represents a short position priced
| {z } ×7, 500 −0.064

0.540 ×8, 000 −0.370 ×11, 000 +0.044 ×10, 000 = −92
| {z } | {z } | {z }
Long call Short put Short call Long put
index points, or −92 × $50 = −$4, 600 on 02 March 2021.

Note that according to Table 2 in the test paper, option prices are
quoted in index points (to be multiplied by the relevant option/war-
rant entitlement ratio), and every index point is worth $50.
ii) Using the put option issed by HT (Haitong Securities) at 0.061.
In this case, the box spread option represents a long position priced
0.540
| {z } ×7, 500 −0.044 ×8, 000 −0.370 ×11, 000 +0.061 ×10, 000 = +78
| {z } | {z } | {z }
Long call Short put Short call Long put
index points, or 78 × $50 = $3, 900 on 02 March 2021.

e) As the option built in di) represents a short position paying $4, 600 today
with an additional $50 × (K2 − K1 ) = 200 = $10, 000 payoff at maturity
on June 29, I would definitely enter this position.
As for the option built in dii) it is less profitable because it costs $3, 900,
however it is still profitable taking into account the $10, 000 payoff at
maturity on June 29.
By the way, the put option at 0.061 has zero turnover (T/O).
In the early 2019 Robinhood incident, a member of the Reddit community
/r/WallStreetBets realized a loss of more than $57,000 on $5,000 principal
928 "
by attempting a box spread. This was due to the use of American call and
put options that may be exercised by their holders at any time, instead
of European options with fixed maturity time N . Robinhood subsequently
announced that investors on the platform would no longer be able to open
box spreads, a policy that remains in place as of early 2021
Remark. Searching for arbitrage opportunities via the existence of profitable
long box spreads is a way to test the efficiency of the market (Billingsley and
Chance (1985)). The data used for this test in Table 7.1 was in fact modified
market data. The original 02 March 2021 data is displayed in Table 24.7, and
shows that the call option with strike price K2 = 25, 200 was actually not
available for trading (N/A) at that time, with 0% outstanding quantity and
zero turnover (T/O).
Table 24.7: Original call/put options on the Hang Seng Index (HSI) as of 02 March
2021.
Exercise 7.9
a) The payoff function can be written as
(K1 − x)+ + (K2 − x)+ − 2(x − (K1 + K2 )/2)+

= (50 − x)+ + (150 − x)+ − 2(x − 100)+ , (A.31)
see also https://optioncreator.com/stnurzg.
" 929
N. Privault
150
(x-K1)++(x-K2)+
-2(x-K1/2-K2/2)+
100
50
-50
0 50 100 150 200
K1 ST K2
Fig. S.26: Butterfly option as a combination of call options.∗
Hence the butterfly option can be realized by:

1. purchasing one call option with strike price K1 = 50, and
2. purchasing one call option with strike price K2 = 150, and
3. issuing (or selling) two call options with strike price (K1 + K2 )/2 =
100.
b) From (A.31), the long call butterfly option can be priced at time t ∈ [0, T )
using the Black-Scholes formula as
Blp (K1 , St , σ, r, T − t) + Blp (K2 , St , σ, r, T − t) − 2Bl((K1 + K2 )/2, St , σ, r, T − t).
c) For example, in the discrete-time Cox-Ross-Rubinstein (Cox et al. (1979))

model, denoting by φ(x) the payoff function, the self-financing replicating
portfolio strategy (ξt (St−1 ))t=1,2,...,N hedging the contingent claim with
payoff C = φ(SN ) is given as in Proposition 3.10 by
h i
E∗ φ x(1 + b) N
QN
j = t + 1 ( 1 + Rj ) − φ x ( 1 + a ) j = t + 1 ( 1 + Rj )
Q
ξt ( x ) =
(b − a)(1 + r )N −t St−1
with x = St−1 . Therefore, ξt (x) will be positive (holding) when x = St−1

is sufficiently below (K1 + K2 )/2, and ξt (x) will be negative (short selling)
when x = St−1 is sufficiently above (K1 + K2 )/2.
∗
The animation works in Acrobat Reader.
930 "
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4 15 200
-0.6
-0.8 10 150
-1 Time to maturity T-t 100
5
50
0 0
Underlying price
Fig. S.27: Delta of a butterfly option with strike prices K1 = 50 and K2 = 150.
Exercise 7.10
a) We have
Ct = e −(T −t)r E∗ [ST − K | Ft ]

= e −(T −t)r E∗ [ST | Ft ] − K e −(T −t)r
= e rt E∗ e −rT ST Ft − K e −(T −t)r

= e rt e −rt St − K e −(T −t)r

= St − K e −(T −t)r .
We can check that the function g (x, t) = x − K e −(T −t)r satisfies the
Black-Scholes PDE
∂g ∂g σ2 ∂ 2 g
rg (x, t) = (x, t) + rx (x, t) + x2 2 (x, t)
∂t ∂x 2 ∂x
with terminal condition g (x, T ) = x − K, since ∂g (x, t)/∂t = −rK e −(T −t)r
and ∂g (x, t)/∂x = 1.
b) We simply take ξt = 1 and ηt = −K e −rT in order to have
Ct = ξt St + ηt e rt = St − K e −(T −t)r , 0 6 t 6 T.
Note again that this hedging strategy is constant over time, and the rela-
tion ξt = ∂g (St , t)/∂x for the option Delta, cf. (A.26), is satisfied.
Exercise 7.11 Option pricing with dividends (Exercise 6.3 continued).

a) Let Pb denote the probability measure under which the process (B
bt )t∈R
+
defined by
bt = µ − r
dB dt + dBt
σ
" 931
N. Privault
is a standard Brownian motion. Under absence of arbitrage the asset price

process (St )t∈R+ has the dynamics
dSt = (µ − δ )St dt + σSt dBt

bt ,
= (r − δ )St dt + σSt dB
and the discounted asset price process (Set )t∈R+ = ( e −rt St )t∈R+ satisfies
bt .
dSet = −δ Set dt + σ Set dB
Assuming that the dividend yield δSt per share is continuously reinvested
in the portfolio, the self-financing portfolio condition
dVt = ηt dAt + ξt dSt + δξt St dt

| {z } | {z }
Trading profit and loss Dividend payout
= rηt At dt + ξt ((r − δ )St dt + σSt dB

bt ) + δξt St dt
= rηt At dt + ξt (rSt dt + σSt dBt )
b
bt ,
= rVt dt + σξt St dB t > 0.
In other words, no arbitrage is induced by the dividend payout. This yields
dVet = d e −rt Vt

= −r e −rt Vt dt + e −rt dVt

= σξt e −rt St dBbt
= σξt St dBt
e b
= ξt (dSet + δ Set dt), t > 0.
Therefore, we have
wt
Vet − Ve0 = dVeu
0
wt
= σ ξu Seu dB bu
0
wt wt
= ξu dSeu + δ Seu du, t > 0.
0 0
Here, the asset price process ( e δt St )t∈R+ with added dividend yield sat-
isfies the equation
d e δt St = r e δt St dt + σ e δt St dB
bt ,

and after discount, the process ( e −rt e δt St )t∈R+ = ( e −(r−δ )t St )t∈R+ is a

martingale under P.
b
b) We have
932 "
wt
Vet = Ve0 + σ bu ,
ξu Seu dB t > 0,
0
which is a martingale under Pb from Proposition 7.1, hence
Vet = E

b VeT Ft
= e −rT E
b [VT | Ft ]
= e −rT E
b [C | Ft ],
which implies
Vt = e rt Vet = e −(T −t)r E

b [C | Ft ], 0 6 t 6 T.
c) After discounting the payoff (ST − K )+ at the continuously compounded

interest rate r, we obtain
Vt = e −(T −t)r E
b (ST − K )+ | Ft

b S0 e σBbT +(r−δ−σ2 /2)T − K + | Ft

= e −(T −t)r E

b S0 e σBbT +(r−δ−σ2 /2)T − K + | Ft

= e −(T −t)δ e −(T −t)(r−δ ) E

= e −(T −t)δ Bl(K, x, σ, r − δ, T − t)

= e −(T −t)δ St Φ dδ+ (T − t) − K e −(T −t)(r−δ ) Φ dδ− (T − t)

= e −(T −t)δ St Φ dδ+ (T − t) − K e −(T −t)r Φ dδ− (T − t) , 0 6 t < T,

where
log(St /K ) + (r − δ + σ 2 /2)(T − t)
dδ+ (T − t) := √
|σ| T − t
and
log(St /K ) + (r − δ − σ 2 /2)(T − t)
dδ− (T − t) := √ .
|σ| T − t
We also have
g (t, x) = Bl x e −(T −t)δ , K, σ, r, T − t , 0 6 t 6 T.

d) In view of the pricing formula
Vt = e −(T −t)δ St Φ dδ+ (T − t) − K e −(T −t)r Φ dδ− (T − t) ,

the Delta of the option is given by
ξt = e −(T −t)δ Φ dδ+ (T − t) , , 0 6 t < T,

which recovers the result of Exercise 6.3-(d).
" 933
N. Privault
Exercise 7.12 We start by pricing the “inner” at-the-money option with payoff
(ST2 − ST1 )+ and strike price K = ST1 at time T1 as
e −(T2 −T1 )r E∗ (ST2 − ST1 )+ | FT1

(r + σ 2 /2)(T2 − T1 ) + log(ST1 /ST1 )

= ST1 Φ √
σ T2 − T1
(r − σ 2 /2)(T2 − T1 ) + log(ST1 /ST1 )

−(T2 −T1 )r
−ST1 e Φ √
σ T2 − T1
r + σ 2 /2 p r − σ 2 /2 p

= ST1 Φ T2 − T1 − ST1 e −(T2 −T1 )r Φ T2 − T1 ,
σ σ
where we applied (7.21) with T = T2 , t = T1 , and K = ST1 . As a consequence,

the forward start option can be priced as
e −(T1 −t)r E∗ e −(T2 −T1 )r E∗ (ST2 − ST1 )+ | FT1 Ft

= e −(T1 −t)r
r + σ 2 /2 p r − σ 2 /2 p

× E∗ ST1 Φ T2 − T1 − ST1 e −(T2 −T1 )r Φ T2 − T1 Ft

σ σ
= e −(T1 −t)r
r + σ 2 /2 p r − σ 2 /2 p

× Φ T2 − T1 − e −(T2 −T1 )r Φ T2 − T1 E∗ [ST1 | Ft ]
σ σ
r + σ 2 /2 p r − σ 2 /2 p

= St Φ T2 − T1 − e −(T2 −T1 )r Φ T2 − T1 ,
σ σ
0 6 t 6 T1 .
Exercise 7.13 From the Black-Scholes formula we have

" !+ # !
STk (r + σ 2 /2)(Tk − Tk−1 ) − log K
e −(Tk −Tk−1 )r E∗ Φ

−K FT
k−1 = p
STk−1 σ Tk − Tk−1
!
(r − σ /2)(Tk − Tk−1 ) − log K
2
−K e −(Tk −Tk−1 )r Φ p .
σ Tk − Tk−1
As a consequence, for t = T0 = 0 we have

" !+ # " " !+ ##
STk STk
E∗ F t = E∗ E∗

−K − K FT
k−1
STk−1 STk−1
" !
(r + σ 2 /2)(Tk − Tk−1 ) − log K
= E∗ e (Tk −Tk−1 )r Φ p
σ Tk − Tk−1
934 "
!#
(r − σ 2 /2)(Tk − Tk−1 ) − log K
−KΦ p
σ Tk − Tk−1
!
(Tk −Tk−1 )r (r + σ 2 /2)(Tk − Tk−1 ) − log K
= e Φ p
σ Tk − Tk−1
!
(r − σ 2 /2)(Tk − Tk−1 ) − log K
− KΦ p .
σ Tk − Tk−1
Hence, the cliquet option can be priced at time t = T0 = 0 as

n
" !+ #
X STk
e −rTk E∗ −K
STk−1
k =1
n
!
X (r + σ 2 /2)(Tk − Tk−1 ) − log K
= e −rTk−1 Φ p
k =1
σ Tk − Tk−1
!!
(r − σ /2)(Tk − Tk−1 ) − log K
2
−K e −rTk Φ p .
σ Tk − Tk−1
Exercise 7.14 (Exercise 6.9 continued). We have
C (t, St ) = e −(T −t)r E∗ log ST | Ft

2
= e −(T −t)r E∗ log St + (B bT − B bt )σ + r − σ (T − t) | Ft
2
σ2

−(T −t)r −(T −t)r
= e log St + e r− (T − t), 0 6 t 6 T.
2

a) By (5.20), for all t ∈ [0, T ], we have
C (t, St ) = e −(T −t)r E[ST2 | Ft ]

S2

= e −(T −t)r E St2 T2 Ft
St
2
S
= e −(T −t)r St2 E T2 Ft

St
2
S
= e −(T −t)r St2 E T2
St
2
= e −(T −t)r St2 E e 2(BT −Bt )σ−(T −t)σ +2(T −t)r

2
= e −(T −t)r St2 e −(T −t)σ +2(T −t)r E e 2(BT −Bt )σ

" 935
N. Privault
2 )(T −t)
= St2 e (r +σ ,
where we used the Gaussian moment generating function (MGF) formula

(23.46)
2
E e 2(BT −Bt )σ = e 2(T −t)σ

for the normal random variable BT − Bt ' N (0, T − t), 0 6 t < T .

b) For all t ∈ [0, T ], we have
∂C 2
ξt = (t, x)|x=St = 2St e (r +σ )(T −t) ,
∂x
i.e.
2 )(T −t)
ξt St = 2St2 e (r +σ = 2C (t, St ),
and
C (t, St ) − ξt St e −rt 2 (r +σ2 )(T −t) 2
St e − 2St2 e (r +σ )(T −t)

ηt = =
At A0
S2 2
= − t e σ (T −t)+(T −2t)r ,
A0
i.e.
At σ2 (T −t)+(T −2t)r 2
ηt At = −St2 e = −St2 e σ (T −t)+(T −t)r = −C (t, St ).
A0
As for the self-financing condition, we have
2 )(T −t)
dC (t, St ) = d St2 e (r +σ

2 )(T −t) 2 )(T −t)
= − ( r + σ 2 ) e (r +σ St2 dt + e (r +σ d St2

(r +σ 2 )(T −t) (r +σ 2 )(T −t)

= −(r + σ 2 ) e St2 dt + e 2St dSt + σ 2 St2 dt

2 )(T −t) 2 )(T −t)
= −r e (r +σ St2 dt + 2St e (r +σ dSt ,
and
2 )(T −t) St2 σ2 (T −t)+(T −2t)r
ξt dSt + ηt dAt = 2St e (r +σ dSt − r e At dt
A0
2 )(T −t) 2 (T −t)+(T −t)r
= 2St e (r +σ dSt − rSt2 e σ dt,
which recovers dC (t, St ) = ξt dSt + ηt dAt , i.e. the portfolio strategy is

self-financing.

a) The discounted process Xt := e −rt St satisfies
936 "
dXt = (α − r )Xt dt + σ e −rs dBs ,
which is a martingale when α = r by Proposition 7.1, as in this case it be-

comes a stochastic integral with respect to a standard Brownian motion.
This fact can be recovered by directly computing the conditional expecta-
tion E[Xt | Fs ] and showing it is equal to Xs . By (4.35), see Exercise 6.11,
we have wt
St = S0 e αt + σ e (t−s)α dBs ,
0
hence wt
Xt = S0 + σ e −rs dBs , t > 0,
0
and
wt
E[Xt | Fs ] = E S0 + σ e −ru dBu Fs

0
w
t −ru
= E[S0 ] + σE e dBu Fs

0
w w
s −ru t −ru
= S0 + σE e dBu Fs + σE e dBu Fs

0 s
ws w
t −ru

= S0 + σ e −ru dBu + σE e dBu
0 s
ws
= S0 + σ e −ru dBu
0
= Xs , 0 6 s 6 t.
b) We rewrite the stochastic differential equation satisfied by (St )t∈R+ as
bt ,
dSt = αSt dt + σdBt = rSt dt + σdB
where
α−r
bt :=
dB St dt + dBt ,
σ
which allows us to rewrite (4.35), by taking α := −r therein, as
wt wt
St = e rt S0 + σ e −rs dB
bs = S0 e rt + σ e (t−s)r dB
bs . (A.32)
0 0
Taking
α−r
ψt := St , 0 6 t 6 T,
σ
in the Girsanov Theorem 7.3, the process (B
bt )t∈R is a standard Brownian
+
motion under the probability measure Pα defined by
w
1wT 2

dPα T
:= exp − ψt dBt − ψt dt
dP 0 2 0
" 937
N. Privault
α−r wT 1 α−r 2wT 2

!
= exp − St dBt − St dt ,
σ 0 2 σ 0
and (Xt )t∈R+ is a martingale under Pα .

c) Using (A.32) under the risk-neutral probability measure P∗ , we have
C (t, St ) = e −(T −t)r Eα [exp(ST ) | Ft ]

wT
= e −(T −t)r Eα exp e rT S0 + σ e (T −u)r dBbu Ft
0
wt wT
= e −(T −t)r Eα exp e rT S0 + σ e (T −u)r dBbu + σ e (T −u)r dB
bu Ft
0 t
wT
(T −t)r (T −u)r b
= exp − (T − t)r + e St Eα exp σ e dBu F t

t
wT
= exp − (T − t)r + e (T −t)r St Eα exp σ e (T −u)r dB bu
t
σ2 w T
(T −t)r
= exp − (T − t)r + e St exp e 2(T −u)r du
2 t
σ2
= exp − (T − t)r + e (T −t)r St + ( e 2(T −t)r − 1) , 0 6 t 6 T.
4r
d) We have
∂C σ2
ξt = (t, St ) = exp St e (T −t)r + ( e 2(T −t)r − 1)
∂x 4r
and
C (t, St ) − ξt St
ηt =
At
e −(T −t)r σ 2 2(T −t)r
= exp St e (T −t)r + (e − 1)
At 4r
St σ 2 2(T −t)r
− exp St e (T −t)r + (e − 1) .
At 4r
e) We have
σ 2 2(T −t)r
dC (t, St ) = r e −(T −t)r exp St e (T −t)r + (e − 1) dt
4r
σ 2 2(T −t)r
−rSt exp St e (T −t)r + (e − 1) dt
4r
σ2 σ 2 2(T −t)r
− e (T −t)r exp St e (T −t)r + (e − 1) dt
2 4r
σ2
+ exp St e (T −t)r + ( e 2(T −t)r − 1) dSt
4r
938 "
1 σ2
+ e (T −t)r exp St e (T −t)r + ( e 2(T −t)r − 1) σ 2 dt
2 4r
−(T −t)r

(T −t)r σ 2 2(T −t)r
= re exp St e + (e − 1) dt
4r
σ 2 2(T −t)r
−rSt exp St e (T −t)r + (e − 1) dt + ξt dSt .
4r
On the other hand, we have
ξt dSt + ηt dAt = ξt dSt

σ2
+r e −(T −t)r exp St e (T −t)r + ( e 2(T −t)r − 1) dt
4r
σ 2 2(T −t)r
−rSt exp St e (T −t)r + (e − 1) dt,
4r
showing that
dC (t, St ) = ξt dSt + ηt dAt ,
and confirming that the strategy (ξt , ηt )t∈R+ is self-financing.
Exercise 7.17
a) Using (A.32) under the risk-neutral probability measure P∗ , we have
C (t, St ) = e −(T −t)r Eα [ST2 | Ft ]

wT
" 2 #
= e −(T −t)r Eα e rT S0 + σ e (T −u)r dB Ft
bu
0
wt wT
" 2 #
= e −(T −t)r Eα e rT S0 + σ e (T −u)r dB
bu + σ e (T −u)r dB Ft
bu
0 t
wt
" 2 #
= e −(T −t)r Eα e rT S0 + σ e (T −u)r b
dBu Ft

0
wt w
T (T −u)r
+2σ e −(T −t)r e rT S0 + σ e (T −u)r dB
bu Eα e bu Ft
dB
0 t
wT
" 2 #
+σ 2 e −(T −t)r Eα e (T −u)r dB Ft
bu
t
wt wT
2 " 2 #
= e −(T −t)r e rT S0 + σ e (T −u)r dB
bu + σ 2 e −(T −t)r Eα e (T −u)r dB
bu
0 t
wt 2 wT
= e −(T −t)r e rT S0 + σ e (T −u)r dB
bu + σ 2 e −(T −t)r e 2(T −u)r du
0 t
σ 2 (T −t)r
= e (T −t)r St2 + e − e −(T −t)r

2r
" 939
N. Privault
sinh((T − t)r )
= e (T −t)r St2 + σ 2 , 0 6 t 6 T.
r
b) We find
∂C
ξt = (t, St ) = 2 e (T −t)r St , 0 6 t 6 T.
∂x
Exercise 7.18 (Exercise 6.2 continued). If C is a contingent claim payoff of

the form C = φ(ST ) such that (ξt , ηt )t∈[0,T ] hedges the claim payoff C, the
arbitrage-free price of the claim payoff C at time t ∈ [0, T ] is given by
πt (X ) = Vt = e −r (T −t) E∗ [φ(ST ) | Ft ], 0 6 t 6 T,
where E∗
denotes expectation under the risk-neutral measure P∗ . Hence,
from the noncentral Chi square probability density function
fT −t (x)
! αβ/σ2 −1/2
2β 2β x + rt e −β (T −t) x
= exp −
σ 1− e −β ( −t ) σ 2 1 − e −β (T −t) e −β (T −t)

2 T rt
p !
4β rt x e −β (T −t)
× I2αβ/σ2 −1 ,
σ 2 1 − e −β (T −t)
of ST given St , x > 0, we find
g (t, St ) = e −r (T −t) E∗ [φ(ST ) | Ft ]

w∞ αβ/σ2 −1/2 β (x+St e −β (T −t) )
2β e −r (T −t)

x −2
= 2 φ ( x ) e σ 2 (1− e −β (T −t) )
σ 1 − e −β (T −t) 0 St e −β (T −t)

p !
4β xSt e −β (T −t)
× I2αβ/σ2 −1 dx
σ 2 1 − e −β (T −t)
0 6 t 6 T , under the Feller condition 2αβ > σ 2 .
Exercise 7.19
a) We have
∂f ∂f
(t, x) = (r − σ 2 /2)f (t, x), (t, x) = σf (t, x),
∂t ∂x
and
∂2f
(t, x) = σ 2 f (t, x),
∂x2
940 "
hence
dSt = df (t, Bt )
∂f ∂f 1 ∂2f
∂t ∂x 2 ∂x2
1 1

= r − σ 2 f (t, Bt )dt + σf (t, Bt )dBt + σ 2 f (t, Bt )dt
2 2
= rf (t, Bt )dt + σf (t, Bt )dBt
= rSt dt + σSt dBt .
b) We have
E e σBT Ft = E e (BT −Bt +Bt )σ Ft

= e σBt E e (BT −Bt )σ Ft

= e σBt E e (BT −Bt )σ

2 (T −t) /2
= e σBt +σ .
c) We have
2
E[ST | Ft ] = E e σBT +rT −σ T /2 Ft

2
= e rT −σ T /2 E e σBT Ft

2 T /2 2 (T −t) /2
= e rT −σ e σBt +σ
−σ 2 t/2
= e rT +σBt
2 t/2
= e (T −t)r +σBt +rt−σ
= e (T −t)r St , 0 6 t 6 T.
d) We have
Vt = e −(T −t)r E[C | Ft ]

= e −(T −t)r E[ST − K | Ft ]
= e −(T −t)r E[ST | Ft ] − e −(T −t)r E[K | Ft ]
= St − e −(T −t)r K, 0 6 t 6 T.
e) We take ξt = 1 and ηt = −K e −rT /A0 , t ∈ [0, T ].

f) We find
VT = E[C | FT ] = C.
Exercise 7.20 Binary options. (Exercise 6.10 continued).
" 941
N. Privault
a) By definition of the indicator (or step) functions 1[K,∞) and 1[0,K ] we

have
 1 if x > K,  1 if x 6 K,
 
1[K,∞) (x) = resp. 1[0,K ] (x) =

0 if x < K, 0 if x > K,
 
which shows the claimed result by the definition of Cb and Pb .

b) We have
πt (Cb ) = e −(T −t)r E[Cb | Ft ]

= e −(T −t)r E 1[K,∞) (ST ) St

= e −(T −t)r P(ST > K | St )

= Cb (t, St ).
c) We have πt (Cb ) = Cb (t, St ), where
Cb (t, x) = e −(T −t)r P(ST > K | St = x)

(r − σ 2 /2)(T − t) + log(St /K )

= e −(T −t)r Φ √
σ T −t
= e −(T −t)r Φ (d− (T − t)) ,
with
(r − σ 2 /2)(T − t) + log(St /K )
d− (T − t) = √ .
σ T −t
d) The price of this modified contract with payoff
Cα = 1[K,∞) (ST ) + α1[0,K ) (ST )
is given by
πt (Cα ) = e −(T −t)r E 1[K,∞) (ST ) + α1[0,K ) (ST ) St

= e −(T −t)r P(ST > K | St ) + α e −(T −t)r P(ST 6 K | St )

= e −(T −t)r P(ST > K | St ) + α e −(T −t)r (1 − P(ST > K | St ))
= α e −(T −t)r e −(T −t)r + (1 − α)P(ST > K | St )
(T − t)r − (T − t)σ 2 /2 + log(St /K )

= α e −(T −t)r + (1 − α) e −(T −t)r Φ √ .
σ T −t
942 "
1.2
1
0.8
0.6
0.4
0.2
0
15
10 200
150
5 100
0 Underlying (HK$)
0
Fig. S.28: Price of a binary call option.
e) We note that
1[K,∞) (ST ) + 1[0,K ] (ST ) = 1[0,∞) (ST ),

almost surely since P(ST = K ) = 0, hence
πt (Cb ) + πt (Pb ) = e −(T −t)r E[Cb | Ft ] + e −(T −t)r E[Pb | Ft ]

= e −(T −t)r E[Cb + Pb | Ft ]
= e −(T −t)r E 1[K,∞) (ST ) + 1[0,K ] (ST ) Ft

= e −(T −t)r E 1[0,∞) (ST ) Ft

= e −(T −t)r E[1 | Ft ]

= e −(T −t)r , 0 6 t 6 T.
f) We have
πt (Pb ) = e −(T −t)r − πt (Cb )

(T − t)r − (T − t)σ 2 /2 + log(x/K )

= e −(T −t)r − e −(T −t)r Φ √
σ T −t
= e −(T −t)r (1 − Φ(d− (T − t)))
= e −(T −t)r Φ(−d− (T − t)).
g) We have
∂Cb
ξt = (t, St )
∂x
(T − t)r − (T − t)σ 2 /2 + log(x/K )

∂
= e −(T −t)r Φ √
∂x σ T −t x = St
" 943
N. Privault
1 2 /2
= e −(T −t)r e −(d− (T −t))
2(T − t)π
p
σSt
> 0.
The Black-Scholes hedging strategy of such a call option does not involve
short selling because ξt > 0 for all t, cf. Figure S.29 which represents the
risky investment in the hedging portfolio of a binary call option.
Fig. S.29: Risky hedging portfolio value for a binary call option.
Figure S.30 presents the risk-free hedging portfolio value for a binary call
option.
Fig. S.30: Risk-free hedging portfolio value for a binary call option.
h) Here, we have
∂Pb
ξt = (t, St )
∂x
(T − t)r − (T − t)σ 2 /2 + log(x/K )

∂
= e −(T −t)r Φ − √
∂x σ T −t x=St
944 "
1 2
= − e −(T −t)r p e −(d− (T −t)) /2
σ 2(T − t)πSt
< 0.
The Black-Scholes hedging strategy of such a put option does involve short
selling because ξt < 0 for all t.
Exercise 7.21 Applying Itô’s formula to e −rt φ(St ))t∈R+ and using the fact
that the expectation of the stochastic integral with respect to (Bt )t∈R+ is
zero, cf. Relation (4.17), we have
C (x, T ) = E e −rT φ(ST ) S0 = x (A.33)

wT wT
−rt −rt 0
= E φ(x) − r e φ(St )dt + r e St φ (St )dt
0 0
wT w
1 T −rt 00
+σ e −rt St φ0 (St )dBt + e φ (St )σ 2 (St )dt S0 = x

0 2 0
w w
T −rs T −rt
= φ(x) − rE e φ(St )dt S0 = x + rE e St φ0 (St )dt S0 = x

0 0
w
1

T −rt 00
+ E e φ (St )σ (St )dt S0 = x
2
2 0
wT wT
r e −rt E φ(St ) S0 = x dt + r e −rt E St φ0 (St ) S0 = x dt

= φ(x) −
0 0
1 w T −rt 00
e E φ (St )σ 2 (St ) S0 = x dt,

+
2 0
hence, by differentiation with respect to T we find
∂
ThetaT = e −rT E[φ(ST ) | S0 = x]

∂T
= −r e −rT E φ(ST ) S0 = x + r e −rT E ST φ0 (ST ) S0 = x

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

2
Problem 7.22 Chooser options.

a) We take conditional expectations in the equality
(ST − K )+ − (K − ST )+ = ST − K
to find
C (t, St , K, T ) − P (t, St , K, T )
= e −(T −t)r E∗ [(ST − K )+ | Ft ] − e −(T −t)r E∗ [(K − ST )+ | Ft ]
= e −(T −t)r E∗ [ST − K | Ft ]
" 945
N. Privault
= e −(T −t)r E∗ [ST | Ft ] − K e −(T −t)r

= St − K e −(T −t)r , 0 6 t 6 T.
b) The price this contract at time t ∈ [0, T ] can be written as
e −(T −t)r E∗ [P (T , ST , K, U ) | Ft ]
h i
= e −(T −t)r E∗ e −(U −T )r E∗ (K − SU )+ | FT | Ft

= e −(U −t)r E∗ (K − SU )+ | Ft

= P (t, St , K, U ).
c) From the call-put parity (7.44) the payoff of this contract can be written
as
Max(P (T , ST , K, U ), C (T , ST , K, U ))
= Max(P (T , ST , K, U ), P (T , ST , K, U ) + ST − K e −(U −T )r )
= P (T , ST , K, U ) + Max(ST − K e −(U −T )r , 0).
d) The contract of Question (c) is priced at any time t ∈ [0, T ] as
e −(T −t)r E∗ [Max(P (T , ST , K, U ), C (T , ST , K, U )) | Ft ]

= e −(T −t)r E∗ [P (T , ST , K, U ) | Ft ]
h i
+ e −(T −t)r E∗ Max(ST − K e −(U −T )r , 0) | Ft
= e −(T −t)r E∗ [ e −(U −T )r E∗ [(K − SU )+ | FT ] | Ft ]
+ e −(T −t)r E∗ Max ST − K e −(U −T )r , 0 Ft

= e −(U −t)r E∗ [(K − SU )+ | Ft ]

+ e −(T −t)r E∗ Max ST − K e −(U −T )r , 0 Ft

= P (t, St , K, U ) + C t, St , K e −(U −T )r , T . (A.34)

100
90
80
70
60
50
40
30
20
10
8
6 120 140
4 80 100
Time to maturity T-t 2 40 60
0 0 20
Underlying
Fig. S.31: Black-Scholes price of the maximum chooser option.
946 "
e) By (A.34) and Relation (6.3) in Proposition 6.1 we have
∂C ∂P
ξt = t, St , K e −(U −T )r , T + (t, St , K, U )
∂x ∂x !
log( e ( U −T ) r St /K ) + (r + σ 2 /2)(T − t)
=Φ √
σ T −t
log(St /K ) + (r + σ 2 /2)(U − t)

−Φ − √
σ U −t
log(St /K ) + (U − t)r + (T − t)σ 2 /2

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

−Φ − √ .
σ U −t
0.5
-0.5
-1
2.5
2
1.5 140
Time to maturity T-t 1 120
100
0.5 80
0 60
40 Underlying
Fig. S.32: Delta of the maximum chooser option.
f) From the call-put parity (7.44) the payoff of this contract can be written
as
min(P (T , ST , K, U ), C (T , ST , K, U ))
= min C (T , ST , K, U ) − ST + K e −(U −T )r , C (T , ST , K, U )

= C (T , ST , K, U ) + min(−ST + K e −(U −T )r , 0)
= C (T , ST , K, U ) − Max(ST − K e −(U −T )r , 0).
g) The contract of Question (f) is priced at any time t ∈ [0, T ] as
e −(T −t)r E∗ min P (T , ST , K, U ), C (T , ST , K, U ) Ft

= e −(T −t)r E∗ [C (T , ST , K, U ) | Ft ]
− e −(T −t)r E∗ Max ST − K e −(U −T )r , 0 Ft

= e −(T −t)r E∗ [ e −(U −T )r E∗ [(SU − K )+ | FT ] | Ft ]

" 947
N. Privault

= e −(U −t)r E∗ (SU − K )+ | Ft


= C (t, St , K, U ) − C t, St , K e −(U −T )r , T . (A.35)

8
7
6
5
4
3
2
1
0
8
6
4 140
100
2 80
60
40
0 20
0 Underlying
Fig. S.33: Black-Scholes price of the minimum chooser option.
h) By (A.35) and Relation (6.3) in Proposition 6.1 we have
∂C ∂C
(t, St , K, U ) − t, St , K e −(U −T )r , T

ξt =
∂x ∂x
log(St /K ) + (r + σ 2 /2)(U − t)

=Φ √
σ U −t
!
log( e (U −T )r St /K ) + (r + σ 2 /2)(T − t)
−Φ √
σ T −t
log(St /K ) + (r + σ 2 /2)(U − t)

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

−Φ √ .
σ T −t
948 "
0.6
0.4
0.2
0
-0.2
-0.4
8
6
140
4 120
2 80
60
40
0 20 Underlying
0
Fig. S.34: Delta of the minimum chooser option.
i) Such a contract is priced as the sum of a European call and a European put
option with maturity U , and is priced at time t ∈ [0, T ] as P (t, St , K, U ) +
C (t, St , K, U ). Its hedging strategy is the sum of the hedging strategies of
Questions (e) and (h), i.e.
log(St /K ) + (r + σ 2 /2)(U − t)

ξt = Φ √
σ T −t
log(St /K ) + (r + σ 2 /2)(U − t)

−Φ − √
σ T −t
log(St /K ) + (r + σ 2 /2)(U − t)

= 2Φ √ − 1.
σ T −t
j) When U = T , the contracts of Questions (c), (f) and (i) have respective
payoffs
• Max((ST − K )+ , (K − ST )+ ) = |ST − K|,
• min((ST − K )+ , (K − ST )+ ) = 0, and
• (ST − K )+ + (K − ST )+ = |ST − K|,

where |ST − K| is known as the payoff of a straddle option.
Problem 7.23
a) The self-financing condition reads

hence
" 949
N. Privault
wT wT
VT = V0 + (rVt + (µ − r )ξt St )dt + σ ξt St dBt
0 0
wT wT
= Vt + (rVs + (µ − r )ξs Ss )ds + σ ξs Ss dBs .
t t
b) The portfolio value Vt rewrites as

wT µ−r
wT
Vt = VT − rVs + πs ds − πs dBs
t σ t
wT wT
= VT − r Vs ds − bs .
πs d B
t t
c) We have
wT wT
Vt = VT − r Vs ds − bs ,
πs dB
t t
hence
bt ,
dVt = rVt dt + πt dB
and after discounting we find
dVet = −r e −rt Vt dt + e −rt dVt

= −r e −rt Vt dt + e −rt (rVt dt + πt dB
bt )
−rt
= e πt dBt ,b
which shows that wT

VeT = V0 + e −rt πt dB
bt ,
0
after integration in t ∈ [0, T ].
d) We have
dVt = du(t, St )
∂u ∂u ∂u
= (t, St )dt + µSt (t, St )dt + σSt (t, St )dBt
∂t ∂x ∂x
1 ∂2u
+ σ 2 St2 2 (t, St )dt. (A.36)
2 ∂x
e) By matching the Itô formula (A.36) term by term to the BSDE (7.47) we
find that Vt = u(t, St ) satisfies the PDE
1 ∂2u

∂u ∂u ∂u
(t, x) + µ (t, x) + σ 2 x2 2 (t, x) + f t, x, u(t, x), σx (t, x) = 0.
∂t ∂x 2 ∂x ∂x
f) In this case we have
950 "
∂u ∂u 1 ∂2u ∂u
(t, x) + µx (t, x) + σ 2 x2 2 (t, x) − ru(t, x) − (µ − r )x (t, x) = 0,
∂t ∂x 2 ∂x ∂x
which recovers the Black-Scholes PDE
∂u ∂u 1 ∂2u
ru(t, x) = (t, x) + rx (t, x) + σ 2 x2 2 (t, x).
∂t ∂x 2 ∂x
g) In the Black-Scholes model the Delta of the European call option is given
by
(r + σ 2 /2)(T − t) + log(St /K )

ξt = Φ √ ,
σ T −t
hence
(r + σ 2 /2)(T − t) + log(St /K )

πt = σξt St = σSt Φ √ , 0 6 t 6 T.
σ T −t
h) Replacing the self-financing condition with
dVt = ηt dAt + ξt dSt − γSt (ξt )− dt

= rηt At dt + µξt St dt + σξt St dBt − γSt (ξt )− dt
= rVt dt + (µ − r )ξt St dt − γSt (ξt )− dt + σξt St dBt ,
we get the BSDE

wT wT
rVs + (µ − r )πs + γ (πs )− ds − πs dBs .

Vt = VT −
t t
i) In this case we have

µ−r
f (t, x, u, z ) = −ru − z − γz −
σ
and the BSDE reads
dVt = ru(t, St )dt + (µ − r )ξt St dt − γSt (ξt )− dt + σξt St dBt .
j) We find the nonlinear PDE

−
1 ∂2u

∂u ∂u ∂u
(t, x) + rx (t, x) + σ 2 x2 2 (t, x) − γσx (t, x) = ru(t, x),
∂t ∂x 2 ∂x ∂x
(A.37)
with the terminal condition u(T , x) = g (x).
k) The self-financing condition reads
dVt = r1{ηt >0} At ηt dt + R1{ηt <0} At ηt dt + ξt dSt

= rAt ηt dt + (R − r )1{ηt <0} At ηt dt + ξt dSt
" 951
N. Privault
= rVt dt − rSt ξt dt − (R − r )(ηt At )− dt + ξt dSt

= rVt dt + (µ − r )St ξt dt − (R − r )(Vt − ξt St )− dt + σξt St dBt ,
which yields the BSDE

wT wT
rVs + (µ − r )πs − (R − r )(Vs − ξs Ss )− ds − πs dBs ,

Vt = VT −
t t
hence we have
(µ − r ) z −
f (t, x, u, z ) = −ru − z + (R − r ) u −
σ σ
and the nonlinear PDE
1 ∂2u

∂u ∂u ∂u
(t, x) + µ (t, x) + σ 2 x2 2 (t, x) + f t, x, u(t, x), σx (t, x) =0
∂t ∂x 2 ∂x ∂x
rewrites as
−
1 ∂2u

∂u ∂u ∂u
(t, x) + r (t, x) + σ 2 x2 2 (t, x) = ru(t, x) + (r − R) u(t, x) − x (t, x) .
∂t ∂x 2 ∂x ∂x
l) The sum of profits and losses of the portfolio (ξt , ηt )t∈R+ is

wT wT wT wT
V0 + ηt dAt + ξt dSt = V0 + dVt + dUt
0 0 0 0
= VT + UT − U0
> VT = C,
hence the corresponding portfolio strategy superhedging the claim payoff

VT = C.
Exercise 7.24 Girsanov Theorem. For all n > 1, let
:= 1{ψt ∈[−n,n]} ψt ,
(n)
ψt 0 6 t 6 T.
(n)
Since (ψt )t∈[0,T ] is a bounded process it satisfies the Novikov integrability
condition (7.10), hence for all n > 1 and random variable F ∈ L1 (Ω) we
have
w· w
T (n) 1 w T (n) 2

(n)
E[F ] = E F B· + ψs ds exp − ψs dBs − (ψs ) ds ,
0 0 2 0
which yields
w· w
T (n) 1 w T (n) 2

(n)
E[F ] = lim E F B· + ψs ds exp − ψs dBs − (ψs ) ds
n→∞ 0 0 2 0
952 "
w· w
T (n) 1 w T (n) 2

(n)
> E lim inf F B· + ψs ds exp − ψs dBs − (ψs ) ds
n→∞ 0 0 2 0
w· w
T 1wT

= E F B· + ψs ds exp − ψs dBs − (ψs ) ds ,
2
0 0 2 0
where we applied Fatou’s Lemma 23.4.
Problem 7.25
a) We have
Cov(dSt /St , dMt /Mt )

Var[dMt /Mt ]
Cov((r + α)dt + β (dMt /Mt − rdt) + σS dWt , µdt + σM dBt )
=
Var[µdt + σM dBt ]
Cov (r + α)dt + β (µdt + σM dBt − rdt) + σS dWt , µdt + σM dBt

=
Var[µdt + σM dBt ]
Cov βσM dBt + σS dWt , σM dBt

=
Var[σM dBt ]
Cov βσM dBt , σM dBt + Cov σS dWt , σM dBt

=
Var[σM dBt ]
Cov βσM dBt , σM dBt

=
Var[σM dBt ]
Cov σM dBt , σM dBt

= β
Var[σM dBt ]
= β.
b) We have

dMt
dSt = (r + α)St dt + β − r St dt + σS St dWt
Mt
= (r + α)St dt + βSt (µdt + σM dBt − rdt) + σS St dWt

= (r + α + β (µ − r ))St dt + St βσM dBt + σS dWt
2 + σ 2 βσqM dBt + σS dWt
q
= (r + α + β (µ − r ))St dt + St β 2 σM S .
2 + σ2
β 2 σM S
Now, we have
 2 2 2
βσM dB t + σ S dW t βσM dBt + βσM σS dBt • dWt + σS dWt
 q  =
2 + σ2
β 2 σM
β 2 σM2 + σ2 S
S
" 953
N. Privault
β 2 σM
2 (dB )2 + σ 2 (dW )2
t S t
= 2 + σ2
β 2 σM S
β 2 σM
2 dt + σ 2 dt
S
= 2 2 + σ2
β σM S
= dt.
By the characterization of Brownian motion as the only continuous mar-

tingale whose quadratic variation is dt, it follows that the process (Zt )t∈R+
defined by
βσM dBt + σS dWt
dZt = q
2 + σ2
β 2 σM S
is a standard Brownian motion, see e.g. Theorem 7.36 page 203 of Kle-
baner (2005). Hence, we have

dSt = (r + α + β (µ − r ))St dt + St βσM dBt + σS dWt
q
2 + σ 2 dZ .
= (r + α + β (µ − r ))St dt + St β 2 σM S t
In the sequel we assume that β is allowed to depend locally on the state

of the benchmark market index on Mt , as β (Mt ), t ∈ R+ .
c) We take
µ−r
dBt∗ = dBt + dt (A.38)
σM
and
α
dWt∗ = dWt + dt (A.39)
σS
in order to have
 dM
t

 = µdt + σM dBt = rdt + σM dBt∗ ,


 Mt



(A.40)

dSt dMt
= (r + α)dt + β (Mt ) × − rdt + σS dWt
St Mt



= (r + α)dt + σM β (Mt )dBt∗ + σS dWt




= rdt + σM β (Mt )dBt∗ + σS dWt∗ .

d) By the Girsanov theorem, (Bt∗ )t∈[0,T ] is a standard Brownian motion un-

der the probability measure P∗B defined by its Radon-Nikodym density
dP∗B (µ − r )2

µ−r
= exp − BT − T ,
dP σM 2σM
2
and (Wt∗ )t∈[0,T ] is a standard Brownian motion under the probability

measure P∗W defined by its Radon-Nikodym density
954 "
dP∗W α2

α
= exp − WT − 2 T .
dP σS 2σS
We conclude that (Bt∗ )t∈[0,T ] and (Wt∗ )t∈[0,T ] are independent standard
Brownian motions under the probability measure P∗ defined by its Radon-
Nikodym density
dP∗ dP∗B dP∗W (µ − r )2 α2

µ−r α
= × = exp − BT − WT − T− 2T .
dP dP dP σM σS 2σM
2 2σS
Indeed, for any sequence t0 = 0 < t1 < · · · < tn−1 < tn = T we have
∗
dP
E∗ f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1 = E f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1

dP
h
= E f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1

(µ − r )2 α2

µ−r α
× exp − BT − T− WT − 2 T
σM 2σM 2 σS 2σS
(µ − r )2

∗ ∗ ∗ ∗ µ−r
= E f Bt1 − Bt0 , . . . , Btn − Btn−1 exp −

BT − T
σM 2σM 2

α α 2
× E exp − WT − 2 T
σS 2σS
(µ − r )2

µ−r
= E f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1 exp −

BT − T
σM 2σM 2
= E f Bt1 − Bt0 , . . . , Btn − Btn−1 ,

and similarly for (Wt∗ )t∈[0,T ] .

e) By (A.40), the discounted price processes
(Set )t∈R+ := ( e −rt St )t∈R+ and ft )t∈R := ( e −rt Mt )t∈R

(M + +
satisfy
ft dBt∗ ,

ft = σM M
 dM
dSt = σM β (Mt )Set dBt∗ + σS Set dWt∗ ,

 e
hence by the Girsanov theorem of Question (d) the discounted two-

dimensional process Set , M is a martingale under the probability

ft
t∈R+
measure P , showing that P is a risk-neutral probability measure. There-
∗ ∗
fore, by Theorem 6.8 the market made of St and Mt is without arbitrage

opportunities due to the existence of a risk-neutral probability measure
P∗ .
f) The self-financing condition for the portfolio strategy (ξt , ζt , ηt )t∈[0,T ]
reads
" 955
N. Privault
ηt+dt At+dt + ξt+dt St+dt + ζt+dt Mt+dt , = ηt At+dt + ξt St+dt + ζt Mt+dt
which yields
At+dt dηt + St+dt dξt + Mt+dt ζt = 0,
i.e.
dAt • dηt + dSt • dξt + dMt • dζt + At dηt + St dξt + Mt dζt = 0,
hence
dVt = ηt dAt + ξt dSt + ζt dMt

+At dηt + dηt • dAt + St dξt + dξt • dSt + Mt dζt + dζt • dMt
= ηt dAt + ξt dSt + ζt dMt
= 0.
g) By the self-financing condition we have
dVt = df (t, St , Mt )
= ξt dSt + ζt dMt + ηt dAt
= ξt (rSt dt + σM β (Mt )St dBt∗ + σS St dWt∗ ) + ζt (rMt dt + σM Mt dBt∗ ) + rηt At dt
= rξt St dt + σM β (Mt )ξt St dBt∗ + σS ξt St dWt∗ + rζt Mt dt + σM ζt Mt dBt∗ + rηt At dt
= rξt St dt + rηt At dt + σS ξt St dWt∗ + rζt Mt dt + (σM β (Mt )ξt St + σM ζt Mt )dBt∗
= rVt dt + σS ξt St dWt∗ + (σM β (Mt )ξt St + σM ζt Mt )dBt∗ . (A.41)
On the other hand, by the Itô formula for two state variables, we have
∂f ∂f 1 ∂2f
df (t, St , Mt ) = (t, St , Mt )dt + (t, St , Mt )dSt + (t, St , Mt )(dSt )2
∂t ∂x 2 ∂x2
∂f 1 ∂2f ∂2f
+ (t, St , Mt )dMt + (t, St , Mt )(dMt )2 + (t, St , Mt )dSt • dMt
∂y 2 ∂y 2 ∂x∂y
∂f ∂f
= (t, St , Mt )dt + (t, St , Mt )(rSt dt + σM β (Mt )St dBt∗ + σS St dWt∗ )
∂t ∂x
1∂ f2
+ (t, St , Mt )(σM2 2
β (Mt )St2 + σS2 St2 )dt
2 ∂x2
∂f 1 ∂2f
+ (t, St , Mt )(rMt dt + σM Mt dBt∗ ) + (t, St , Mt )σM2
Mt2 dt
∂y 2 ∂y 2
∂2f
+ σM2
St Mt β (Mt ) (t, St , Mt )dt
∂x∂y
∂f ∂f ∂f
= (t, St , Mt )dt + rSt (t, St , Mt )dt + σM β (Mt )St (t, St , Mt )dBt∗
∂t ∂x ∂x
∂f ∗ 1 ∂2f
+ σS St (t, St , Mt )dWt + (t, St , Mt )(σM β (Mt )St2 dt + σS2 St2 dt)
2 2
∂x 2 ∂x2
956 "
∂f ∂f
+ rMt (t, St , Mt )dt + σM Mt (t, St , Mt )dBt∗
∂y ∂y
1 ∂2f ∂2f
+ (t, St , Mt )σM Mt dt + σM
2 2 2
St Mt β (Mt ) (t, St , Mt )dt
2 ∂y 2 ∂x∂y
∂f ∂f ∂f
= (t, St , Mt )dt + rMt (t, St , Mt )dt + rSt (t, St , Mt )dt
∂t ∂y ∂x
1 2 ∂ 2f 1 ∂2f
+ σM Mt2 2 (t, St , Mt )dt + σM β (Mt )St2 2 (t, St , Mt )dt
2 2
2 ∂y 2 ∂x
1 2 2 ∂2f ∂2f
+ σS St 2 (t, St , Mt )dt) + σM St Mt β (Mt )
2
(t, St , Mt )dt
2 ∂x ∂x∂y

∂f ∂f
+ σM β (Mt )St (t, St , Mt ) + σM Mt (t, St , Mt ) dBt∗ (A.42)
∂x ∂y
∂f
+ σS St (t, St , Mt )dWt∗ .
∂x
By identification of the terms in dt in (A.41) and (A.42), we find
∂f ∂f
rf (t, St , Mt ) =(t, St , Mt ) + rSt (t, St , Mt )
∂t ∂x
1 2 2
2∂ f
+ (σS + σM β (Mt ))St 2 (t, St , Mt )
2 2
2 ∂x
∂f 1 2 ∂2f ∂2f
+ rMt (t, St , Mt ) + σM Mt2 2 (t, St , Mt ) + σM 2
St Mt β (Mt ) (t, St , Mt )dt,
∂y 2 ∂y ∂x∂y
which yields the PDE
rf (t, x, y ) (A.43)
∂f ∂f 1 ∂2f
= (t, x, y ) + rx (t, x, y ) + x2 (σS2 + σM 2 2
β (y )) 2 (t, x, y )
∂t ∂x 2 ∂x
∂f 1 2 2 ∂2f ∂2f
+ry (t, x, y ) + σM y 2
(t, x, y ) + σM xyβ (y ) (t, x, y ),
∂y 2 ∂y 2 ∂x∂y
f (T , x, y ) = h(x, y ), x, y > 0.
h) By identification of terms in dBt∗ and dWt∗ in (A.41) and (A.42), we find
∂f
ξt = (t, St , Mt )
∂x
and
∂f ∂f
σM β (Mt )St (t, St , Mt ) + σM Mt (t, St , Mt ) = σM β (Mt )ξt St + σM ζt Mt ,
∂x ∂y
" 957
N. Privault
hence
∂f
ζt = (t, St , Mt ),
∂y
and by the relation Vt = ξt St + ζt Mt + ηt At we find
Vt − ξt St − ζt Mt
ηt =
At
∂f ∂f
f (t, St , Mt ) − St (t, St , Mt ) − Mt (t, St , Mt )
∂x ∂y
= , 0 6 t 6 T.
A0 e rt
i) When the option payoff depends only on ST we can look for a solution of
(A.43) of the form f (t, x), in which case (A.43) simplifies to
∂f ∂f 1 ∂2f
rf (t, x, y ) = (t, x, y ) + rx (t, x, y ) + x2 (σS2 + σM β (y )) 2 (t, x, y ),
2 2
∂t ∂x 2 ∂x
(A.44)
When β (Mt ) = β is a constant, (A.44) becomes the Black-Scholes PDE
with squared volatility parameter
σ 2 := σS2 + σM β .
2 2
When the option is the European call option with strike price K on ST ,
its solution is given by the Black-Scholes function
f (t, x) = Bl(K, x, σ, r, T − t)
= xΦ d+ (T − t) − K e −(T −t)r Φ d− (T − t) ,

with
log(x/K ) + (r + (σS2 + σM
2 β 2 ) /2)(T − t)
d+ (T − t ) : = √ ,
|σ| T − t
log(x/K ) + (r − (σS2 + σM
2 β 2 ) /2)(T − t)
d− (T − t) := √ ,
|σ| T − t
and
∂f
(t, St , Mt ) = Φ d+ (T − t) ,

ξt =
∂x
with
K −(T −t)r K −T r
e Φ d− ( T − t ) = − e Φ d− (T − t) , 0 6 t < T.

ηt = −
At A0
958 "
j) Similarly to Question (i), when the option is the European put option
with strike price K on ST , its solution is given by the Black-Scholes put
price function
f (t, x) = K e −(T −t)r Φ − d− (T − t) − xΦ − d+ (T − t) ,

with
∂f
(t, St , Mt ) = −Φ − d+ (T − t) , 0 6 t < T.

ζt =
∂y
and
K −T r
e Φ − d− ( T − t ) , 0 6 t < T.

ηt =
A0
Remark. By the answer to Question (b) we have
q
2 + σ 2 dZ
dSt = (r + α + β (µ − r ))St dt + St β 2 σM S t
where (Zt )t∈R+ is a standard Brownian motion, hence the answers to

Questions (i) and j can be recovered from the pricing relation
f (t, St ) = e −(T −t)r E∗ φ(ST ) | Ft ], 0 6 t 6 T.

Problem 7.26
a) Relation (7.50) can be checked to hold first on the event Aα , and then
on its complement Acα . Taking the Q-expectation on both sides of (7.50)
yields

dP dP
EQ − α ( 2 1 A α − 1 ) > EQ − α (21A − 1) ,
dQ dQ
i.e.

dP dP
EQ (21Aα − 1) − αEQ [21Aα − 1] > EQ (21A − 1) − αEQ [21A − 1],
dQ dQ
i.e.
2P(Aα ) − 1 − α(2Q(Aα ) − 1) > 2P(A) − 1 − α(2Q(A) − 1),
which shows that
P(Aα ) − P(A) > α(Q(Aα ) − Q(A)),
allowing us to conclude to P(Aα ) − P(A) > 0 since α > 0.

" 959
N. Privault
b) We check that dQ∗ /dP∗ > 0 since C > 0, and

w
Q∗ ( Ω ) = dQ∗
Ω
w dQ∗
= dP∗
Ω dP∗
w C
= dP∗
Ω EP∗ [C ]

C
= EP∗
EP∗ [C ]
EP∗ [C ]
=
EP∗ [C ]
= 1.
In the next questions we consider a nonnegative contingent claim payoff

C > 0 with maturity T > 0, priced e −rT EP∗ [C ] at time 0 under the
risk-neutral measure P∗ .
Budget constraint. We assume that no more than a certain fraction

β ∈ (0, 1] of the claim price e −rT EP∗ [C ] is available to construct the
initial hedging porftolio V0 at time 0.
Since a self-financing portfolio process (Vt )t∈R+ started at V0 = β e −rT EP∗ [C ]

may not able to hedge the claim C when β < 1, we will attempt to max-
imize the probability P(VT > C ) of successful hedging.
For this, given A an event we consider the portfolio process (VtA )t∈[0,T ]
hedging the claim C 1A , priced V0A = e −rT EP∗ [C 1A ] at time 0, and such
that VTA = C 1A at maturity T .
c) Using the probability measure Q∗ , we rewrite the condition (7.52) as
dQ∗ E ∗ [ C 1A ]

Q∗ (A) = EQ∗ [1A ] = EP∗ 1A ∗ = P 6 β,
dP EP∗ [C ]
i.e.
Q∗ (A) 6 Q∗ (Aα ) = β.
By the Neyman-Pearson Lemma, for any event A, the inequality Q∗ (A) 6
Q∗ (Aα ) = β implies P(A) 6 P(Aα ), which shows that the event A = Aα
realizes the maximum under the required condition.
d) The obvious inequality is
P(Aα ) 6 P(C 1Aα > C ) = P VTAα > C .

960 "
In the other direction, we note that the event Bα := {C 1Aα > C} =

Aα
VT > C satisfies (7.52), as

e −rT EP∗ VTBα = e −rT EP∗ C 1Bα

= e −rT EP∗ C 1{C 1Aα >C}

= e −rT EP∗ C 1Aα

= β e −rT EP∗ [C ],
where the last equality EP∗ C 1Aα = βEP∗ [C ] follows from Q∗ (Aα ) = β

and the definition (7.51) of Q .

∗
Therefore, by the result of Question (c) we have
P(C 1Aα > C ) = P VTAα > C = P(Bα ) 6 P(Aα ).

e) This hedging strategy starts from the initial amount
V0Aα = e −rT EP∗ [C 1Aα ] = β e −rT EP∗ [C ],
and it satisfies
P VTAα > C = P(C 1Aα > C ) = P(Aα )

which is the maximum hedging probability under the constraint (7.52).

f) We have
2 t/2
St = S0 e σBt +rt−σ = S0 e σBt = S0 e Bt , t > 0.
g) We have
P VTAα > C = P(Aα )

dP
=P ∗
>α
dQ
dQ∗

dP
=P > α
dP∗ dP∗

dP C
=P >α
dP∗ EP∗ [C ]
= P (αC < EP∗ [C ])
= P (ST − K )+ < EP∗ [C ]/α

= P ST − K < EP∗ [C ]/α

= P ST < K + EP∗ [C ]/α

= P S0 e BT < K + EP∗ [C ]/α

" 961
N. Privault
= P (BT < log(K + EP∗ [C ]/α))

log(K + EP∗ [C ]/α)

=Φ √ .
T
h) We have
EP∗ [C ]
α= √ .
exp T Φ−1 P VTAα > C

−K
i) We have
EP∗ [C 1Aα ] = EP∗ [(ST − K )+ 1Aα ]

h i
= EP∗ (ST − K )+ 1{BT <log(K +EP∗ [C ]/α)}
h + i
= EP∗ e BT − K 1{BT <log(K +EP∗ [C ]/α)}
w log(K +EP∗ [C ]/α)/√T 2 dx
e x − K e −x /2 √

= √
(log K )/ T 2π
= √ e x e −x /2 √
(log K )/ T 2π
w log(K +EP∗ [C ]/α)/√T
−x2 /2 dx
−K √ e √
(log K )/ T 2π
= √ e 1/2−(x−1) /2 √
(log K )/ T 2π
−K Φ(log(K + EP∗ [C ]/α)) − Φ(log K )

√
w −1/ T +log(K +EP∗ [C ]/α)/ T √
2 dx
= √ e 1/2−x /2 √
(−1+log K )/ T 2π
−K Φ(log(K + EP∗ [C ]/α)) − Φ(log K )

√ −1 + log(K + EP∗ [C ]/α) −1 + log K

= e Φ √ −Φ √
T T
log(K + EP∗ [C ]/α) log K

−K Φ √ −Φ √ ,
T T
hence
e −rT EP∗ [C 1Aα ]

−1 + log(K + EP∗ [C ]/α) −1 + log K

= e −rT +1/2 Φ √ −Φ √
T T
log(K + EP∗ [C ]/α) log K

−K e −rT Φ √ −Φ √ .
T T
j) i) We have d+ (T ) = 1, d− (T ) = 0, hence by the Black-Scholes formula

we find
962 "
√
EP∗ [(ST − K )+ ] = eS0 Φ(d+ (T )) − KΦ(d− (T ))
= 1.64872 × 0.84134 − 1/2
= 0.88713,
and
e −rT EP∗ [(ST − K )+ ] = S0 Φ(d+ (T )) − K e −T r Φ(d− (T ))

= 0.84134 − 0.60653/2
= 0.53807.
ii) By the result of Question (h), we have
EP∗ [C ]
α=
exp Φ−1 P VTAα > C

−K
0.88714
=
exp (Φ−1 (0.9)) − 1
0.88714
= 1.28 = 0.34165.
e −1
iii) By the result of Question (i), we find
e −rT EP∗ [C 1Aα ] = Φ(−1 + log(K + EP∗ [C ]/α)) − Φ(−1 + log K )

−K e −1/2 Φ(log(K + EP∗ [C ]/α)) − Φ(log K )

= Φ(−1 + log(1 + EP∗ [C ]/α)) − Φ(−1)

− e −1/2 Φ(log(1 + EP∗ [C ]/α)) − Φ(0)

= Φ(−1 + log(1 + 0.88713/0.34165)) − Φ(−1)

− e −1/2 Φ(log(3.596604712)) − Φ(0)

= Φ(0.27999) − Φ(−1)

−0.60653 × Φ(1.279990265) − Φ(0)

= (0.61026 − 0.158655) − 0.60653 × (0.899726 − 0.5)

= 0.20915.
In addition, we find
e −rT EP∗ [C 1Aα ] 0.20915

β= = = 37.53%.
e −rT EP∗ [C ] 0.53807
Chapter 8
Exercise 8.1 We need to compute the average
" 963
N. Privault
w
1 1 wT 1 wT

T
E vt dt = E[vt ]dt = u(t)dt,
T 0 T 0 T 0
where u(t) := E[vt ]. Taking expectation on both sides of the equation

wt wt√
vt = v0 − λ (vs − m)ds + η vs dBs ,
0 0
we find
u ( t ) = E [ vt ]
wt wt√
= E v0 − λ (vs − m)ds + η vs dBs
0 0
w
t
= v0 − λE (vs − m)ds
0
wt
= v0 − λ (E[vs ] − m)ds
0
wt
= v0 − λ (u(s) − m)ds, t > 0,
0
hence by differentiation with respect to t ∈ R we find the ordinary differential

equation
u0 (t) = λm − λu(t),
cf. e.g. Exercise 4.17-(b). This equation can be rewritten as
( e λt u(t))0 = λ e λt u(t) + e λt u0 (t) = λm e λt ,
which can be integrated as

wt
e λt u(t) = u(0) + λm e λs ds
0
= E[v0 ] + m( e λt − 1)
= m e λt + E[v0 ] − m t ∈ R+ ,
from which we conclude that
u(t) = m + (E[v0 ] − m) e −λt , t ∈ R+ ,
and
w
1 1 wT

T
E vt dt = u(t)dt
T 0 T 0
w
1 T
m + (E[v0 ] − m) e −λt dt

=
T 0
E[v0 ] − m w T −λt
= m+ e dt
T 0
964 "
1 − e −λT
= m + E [ v0 ] − m .
λT
Exercise 8.2
a) By e.g. Exercise 4.17-(b), we have
E[vt ] = E[v0 ] e −λt + m(1 − e −λt ), t ∈ R+ ,
hence
w
1 T 1

VST = E 2 (dSt )2
T 0 St
w
1 T 1
(1) 2
= E
p
( r − αvt ) St dt + St β + v t dBt
T 0 St2
w
1

T
= E (β + vt )dt
T 0
1 wT
=β+ E[vt ]dt,
T 0
which yields
1 wT
VST = β + (E[v0 ] e −λt + m(1 − e −λt ))dt
T 0
w
1 T
=β+ (E[v0 ] e −λt + m(1 − e −λt ))dt
T 0
1 wT
= β + m + ( E [ v0 ] − m ) e −λt dt
T 0
e λT − 1
= β + m + ( E [ v0 ] − m ) .
λT
Note that if the process (vt )t∈R+ is started in the gamma stationary dis-
tribution then we have E[v0 ] = E[vt ] = m, t ∈ R+ , and the variance swap
rate VST = β + m becomes independent of the time T .
(2)
b) The stochastic differential equation dσt = ασt dBt is solved as
(2)
−α2 t/2
σt = σ0 e αBt , t ∈ R+ ,
hence we have
w
1 1

T
VST = E ( dS t ) 2
T 0 St2
w
1 1

T ( 1 ) 2
= E 2 σt St dBt
T 0 St
w
1

T
= E σt2 dt
T 0
" 965
N. Privault
σ02 w T

(2) 2
= E e 2αBt −α t dt
T 0
σ02 w T −α2 t

(2)
= e E e 2αBt dt
T 0
σ02 w T −α2 t+2α2 t
= e dt
T 0
σ02 w T 2
= e α t dt
T 0
σ02 2
= ( e α T − 1).
α2 T
Exercise 8.3
a) Taking x = R0,T
2 and x0 = E R0,T , we have
2
2 − E R2
2 − E R2
2
q R0,T 0,T R0,T 0,T
R0,T ≈ E R0,T
2 + q − 2 3/2 , (A.45)
2 E R0,T
2 8 E R0,T

provided that R0,T

2 is sufficiently close to E R0,T .
2
b) Taking expectations on both sides of (A.45), we find
2 ] 2
E R0,T − E R0,T E R0,T − E[R0,T
2 2 2
q
E∗ [R0,T ] ≈ E R0,T
2 + q − 2 3/2
2 E R0,T
2 8 E R0,T

2 2
E R0,T − E R0,T
2
q
= E R0,T
2 − 2 3/2
8 E R0,T
Var R0,T
2
q
= E R0,T
2
2 3/2 ,

−
8 E R0,T
provided that R0,T

2 is sufficiently close to E R0,T .
2

 !2 
NT wT
" #
St 2

X STk
E log =E log dNt
STk−1 0 St−
n=1
w
T 2
=E ZNt− dNt
0
wT 2
E ZNt− dt

=λ
0
966 "
wT
=λ (η 2 + δ 2 )dt
0
= λ(η + δ 2 )T .
2
Exercise 8.5
2
a) We have St = S0 e σBt −σ t/2+rt , t ∈ R+ .
2
b) Letting Set := e −rt St , t ∈ R+ , we have SeT = S0 e σBT −σ T /2 and dSet =
σ Set dBt , hence
wT
SeT = S0 + σ Set dBt ,
0
and
" #
e −rT ST e −rT ST

Se Se
2E∗ log = 2E∗ T log T
S0 S0 S0 S0
w T Se
" ! #
2
σ T
t
= 2E∗ 1+σ dBt σBT −
0 S0 2
w w T Se
" # " #

σ T2
T S et t
= 2E∗ σBT − + 2σ 2 E∗ BT dBt − σ 2 T E∗ dBt
2 0 S0 0 S0
wT w T Se
" #
t
= −σ 2 T + 2σ 2 E∗ dBt dBt
0 0 S0
w T Se
" #
t
= −σ 2 T + 2σ 2 E∗ dt
0 S0
wT
" #
Set
= −σ 2 T + 2σ 2 E∗ dt
0 S0
wT
= −σ 2 T + 2σ 2 dt
0
= −σ 2 T + 2σ 2 T
= σ2 T .
Alternatively, we could also write

" #
e −rT ST e −rT ST

Se Se
2E∗ log = 2E∗ T log T
S0 S0 S0 S0
h i
∗ σBT −σ 2 T /2 σBT −σ 2 T /2
= 2E e log e
σ2 T

2
= 2E∗ e σBT −σ T /2 σBT −
2
−σ 2 T /2 ∗ 2
= 2σ e E BT e σBT
− σ T E∗ e σBT −σ T /2
2

" 967
N. Privault
∂ ∗ σBT
2 T /2
= 2σ e −σ E e − σ2 T
∂σ
2 ∂ σ2 T /2
= 2σ e −σ T /2 e − σ2 T
∂σ
2 2
= 2σ 2 T e −σ T /2 e σ T /2 − σ 2 T
= σ2 T .
Exercise 8.6
ST w T dS 1 w T σt2
t
log = log ST − log S0 = − dt.
S0 0 St 2 0 St2
b) By (8.47) we have
w w
T dSt
Ft − 2E∗ log ST Ft
T 2
E∗ σt dt Ft = 2E∗

0 0 St S0
w t dS
S

u
=2 + 2r (T − t) − 2E∗ log T Ft .
0 Su S0
c) At time t ∈ [0, T ] we check that

w
2

t dSu
Lt + e −(T −t)r St + 2 e −rT + ( T − t ) r − 1 At
St 0 Su
w t dS
u
= Lt + 2r (T − t) e −(T −t)r + 2 e −(T −t)r
0 Su
= Vt .
d) By (8.48) we have
w t dS
u
dVt = d Lt + 2r (T − t) e −(T −t)r + 2 e −(T −t)r
0 Su
= dLt − 2r e −(T −t)r dt + 2r2 (T − t) e −(T −t)r dt

w t dS dSt
u
+2r e −(T −t)r dt + 2 e −(T −t)r
0 Su St
w
−(T −t)r 2

−rT t dSu
= dLt + e dSt + 2 e + (T − t)r − 1 dAt ,
St 0 Su
with dAt = r e rt dt, hence the portfolio is self-financing.
Exercise 8.7 By second differentiation of the moment generating function

(8.9), we find the two expressions
968 "
" 2 # " 2 #
ST ST ST
E∗ R0,T = 4E∗ log + 2 log = 4E∗ log − 4E∗ R0,T ,
4 2
F0 F0 F0
and
" !#
ST 2

∗ ∗ ST ST
E R0,T = 4E log − 2 log
4
F0 F0 F0
" 2 #
S S
= 4E∗ T log T − 4E∗ R0,T .
2
F0 F0
Chapter 9
Exercise 9.1
∂C ∂f x
a) We have (T − t, x, K ) = T − t, and
∂x ∂z K
∂C ∂ x
(T − t, x, K ) = Kf T − t,
∂K ∂K K
x x ∂f x
= f T − t, − T − t,
K K ∂z K
1 x ∂C
= C (T − t, x, K ) − (T − t, x, K ),
K K ∂x
hence
∂C 1 K ∂C
(T − t, x, K ) = C (T − t, x, K ) − (T − t, x, K ).
∂x x x ∂K
∂2C 1 ∂2f x
b) We have (T − t, x, K ) = T − t, and
∂x2 K ∂z 2 K
∂2C
(T − t, x, K )
∂K 2
x ∂f x x ∂f x x2 ∂f x
=− 2 T − t, + 2 T − t, + 3 T − t,
K ∂z K K ∂z K K ∂z K
x2 ∂ 2 f x
= 3 2 T − t,
K ∂z K
x2 ∂ 2 C
= 2 2 (T − t, x, K ),
K ∂x
hence
∂2C K 2 ∂2C
(T − t, x, K ) = 2 (T − t, x, K ).
∂x2 x ∂K 2
" 969
N. Privault
c) Noting that
∂C ∂C
(T − t, x, K ) = − (T − t, x, K ),
∂t ∂T
we can rewrite the Black-Scholes PDE as
∂C
rC (T − t, x, K ) = − (T − t, x, K )
∂T
1

K ∂C
+rx C (T − t, x, K ) − (T − t, x, K )
x x ∂K
σ 2 x2 K 2 ∂ 2 C
+ (T − t, x, K ),
2 x2 ∂K 2
i.e.
∂C ∂C σ 2 x2 K 2 ∂ 2 C
(T − t, x, K ) = −rK (T − t, x, K ) + (T − t, x, K ).
∂T ∂K 2 x2 ∂K 2
Remarks:
1. Using the Black-Scholes Greek Gamma expression
∂2C 1
(T − t, x, K ) = √ Φ0 (d+ (T − t))
∂x2 σx T − t
1 2
= e −(d+ (T −t)) /2 ,
σx 2π (T − t)
p
we can recover the lognormal probability density function ϕT (y ) of geo-

metric Brownian motion ST as follows:
∂2C
ϕT (K ) = e (T −t)r (T − t, x, K )
∂K 2
x ∂2C
2
= e (T −t)r 2 2 (T − t, x, K )
K ∂x
e (T −t)r x 2
= e −(d+ (T −t)) /2
2π (T − t)
p
σK 2
1 2
= e −(d− (T −t)) /2
σK 2π (T − t)
p
2 !
1 (r − σ 2 /2)(T − t) + log(x/K )
= exp − ,
σK 2π (T − t) 2(T − t)σ 2
p
knowing that
970 "
2
1 1 log(x/K ) + (r − σ 2 /2)(T − t)

2
− d− ( T − t ) = − √
2 2 |σ| T − t
2
1 log(x/K ) + (r + σ 2 /2)(T − t)

x
=− √ + (T − t)r + log
2 |σ| T − t K
1 2 x
= − d+ (T − t) + (T − t)r + log ,
2 K
which can be obtained from the relation
2 2
d + ( T − t ) − d− ( T − t )

= d+ (T − t) + d− (T − t) d+ (T − t) − d− (T − t)
x
= 2r (T − t) + 2 log .
K
2. Using the expressions of the Black-Scholes Greeks Delta and Theta we can
also recover
∂C ∂C
(T − t, x, K ) + rK (T − t, x, K )
2 ∂T ∂K
∂2C
K2 (T − t, x, K )
∂K 2
1

∂C x ∂C
− (T − t, x, K ) + rKC (T − t, x, K ) − (T − t, x, K )
∂t K K ∂x
=2 2
∂ C
x2 2 (T − t, x, K )
∂x
√
xσΦ0 (d+ (T − t))/(2 T − t) + rK e −(T −t)r Φ(d− (T − t))
=2 √
x2 Φ0 (d+ (T − t))/(xσ T − t)
rC (T − t, x, K ) − rxΦ(d+ (T − t))
+2 √
x2 Φ0 (d+ (T − t))/(xσ T − t)
= σ2 .
Exercise 9.2
a) We have
∂MC ∂C 0 ∂C
(K, S, r, τ ) = (K, S, σimp (K ), r, τ ) + σimp (K ) (K, S, σimp (K ), r, τ ).
∂K ∂K ∂σ
b) We have
∂C 0 ∂C
(K, S, σimp (K ), r, τ ) + σimp (K ) (K, S, σimp (K ), r, τ ) 6 0,
∂K ∂σ
which shows that
" 971
N. Privault
∂C
(K, S, σimp (K ), r, τ )
0
σimp (K ) 6 − ∂K
∂C
(K, S, σimp (K ), r, τ )
∂σ
c) We have
∂P 0 ∂P
(K, S, σimp (K ), r, τ ) + σimp (K ) (K, S, σimp (K ), r, τ ) > 0,
∂K ∂σ
which shows that
∂P
(K, S, σimp (K ), r, τ )
0
σimp (K ) >− ∂K
∂P
(K, S, σimp (K ), r, τ )
∂σ
Exercise 9.3
a) We have
K +S

σimp (K, S ) ' σloc
2
2
K +S

= σ0 + β − S0
2
β
= σ0 + (K − (2S0 − S ))2 .
4
20 20
15 15
σ in %
σ in %
10 10
5 5
σimp in % σimp in %
σloc in % σloc in %
0 0
0 50 100 150 200 0 50 100 150 200
S S
(a) At the money K = S0 . (b) Out of the money K > S0 .
Fig. S.35: Implied vs local volatility.
b) We find
∂ ∂Bl
S, K, T , σimp (K, S ), r x, K, T , σimp (K, S ), r x=S

=
∂S ∂x
972 "
∂σimp ∂Bl
x, K, T , σ, r σ =σ (K,S )

+
∂S ∂σ imp
β
= ∆ + ν (K − (2S0 − S )),
2
where
∂Bl
∆= x, K, T , σimp (K, S ), r x=S

∂x
is the Black-Scholes Delta and
∂Bl
S, K, T , σ, r σ =σ (K,S )

ν=
∂σ imp
is the Black-Scholes Vega, cf. §2.2 of Hagan et al. (2002).
Exercise 9.4 We take t = 0 for simplicity. We start by showing that for every
λ > 0, we have
1 h wτ i 2 e rτ w F0

dK w∞ dK

E exp λ σt2 dt − 1 = pλ P (τ , K ) 2−p + C (τ , K ) 2−p .
λ 0 S0 0 K λ F0 K λ
By Lemma 8.2, we have
1 h wτ i 1
pλ
Sτ

E exp λ σt2 dt − 1 = E −1 , λ > 0.
λ 0 λ F0
Using Relation (9.18), i.e.

M M
∂2C ∂2P
ϕτ (K ) = e rτ 2
(τ , y ) = e rτ 2 (τ , y ),
∂y ∂y
we have
1 h wτ i 1
pλ
Sτ

E exp λ σt2 dt − 1 = E −1
λ 0 λ F0
1 pλ
E Sτ − F0
p
= λ
λF0pλ
1 w ∞ pλ
= K ϕτ (K )dK − F0pλ
λF0pλ 0
w w∞
1

F0
= pλ K pλ ϕτ (K )dK + K pλ ϕτ (K )dK − F0pλ
λF0 0 F0
1
w F0 ∂ 2P w∞ ∂2C

= pλ e rτ K pλ 2
(τ , K )dK + e rτ K pλ 2
(τ , K )dK − S0pλ .
λS0 0 ∂K F0 ∂K
Next, integrating by parts over the intervals [0, F0 ] and [F0 , ∞) and using
the boundary conditions
" 973
N. Privault
∂P ∂C
P (τ , 0) = C (τ , ∞) = 0, (τ , 0) = (τ , ∞) = 0,
∂K ∂K
with the relation
∂P ∂C
(τ , K ) − (τ , K ) − e −rτ = 0
∂K ∂K
and the call-put parity
P (τ , F0 ) − C (τ , F0 ) = S0 − F0 e rτ = 0
as boundary conditions, we find

1 h wτ i
E exp λ σt2 dt − 1
λ 0
1 ∂P w F0 ∂P
= pλ e rτ S0pλ (τ , F0 ) − pλ e rτ K pλ −1 (τ , K )dK
λS0 ∂K 0 ∂K
∂C w∞ ∂C

− e rτ S0pλ (τ , F0 ) − pλ e rτ K pλ −1 (τ , K )dK − S0pλ
∂K F0 ∂K
e rτ w F0 pλ −1 ∂P w∞

∂C
= −pλ pλ K (τ , K )dK + K pλ −1 (τ , K )dK
λS0 0 ∂K F0 ∂K
pλ e rτ
w F0
pλ −1 pλ −2
= S0 P (τ , F0 ) + (pλ − 1) K P (τ , K )dK
λS0pλ 0
w∞
−S0pλ −1 C (τ , F0 ) + (pλ − 1) K pλ −2 C (τ , K )dK
F0
pλ (pλ − 1) rτ w F0 pλ −2 w∞

= pλ e K P (τ , K )dK + K pλ −2 C (τ , K )dK
λS0 0 F0
2 e rτ w F0 w∞

dK dK
= pλ P (τ , K ) 2−p + C (τ , K ) 2−p
S0 0 K λ F0 K λ
2 e rτ w F0 w∞

dK dK
= pλ P (τ , K ) 2−p + C (τ , K ) 2−p .
S0 0 K λ F0 K λ
Finally, taking p
pλ := p−
λ = 1/2 − 1/4 + 2λ
and letting λ tend to zero, we find
hw τ i 1 h wτ i
E σt2 dt = lim E exp λ σt2 dt − 1
0 λ→0 λ 0
2 e rτ w F0 w∞

dK dK
= lim pλ P (τ , K ) 2−p + C (τ , K ) 2−p
λ→0 S0 0 K λ F0 K λ
w w∞
F0 dK dK
= 2 e rτ P (τ , K ) 2 + C (τ , K ) 2 .
0 K F0 K
974 "
Exercise 9.5 (Exercise 8.7 continued). Taking φ(x) = (log(x/F0 ))2 with
y = F0 , we have
2 2

x x
φ0 (x) = log and φ00 (x) = 2 1 − log ,
x F0 x F0
hence
ST 2

log = φ(F0 ) + (ST − F0 )φ0 (F0 )
F0
w F0 w∞
+ (z − ST )+ φ00 (z )dz + (ST − z )+ φ00 (z )dz
0 F0
w F0
K dK
=2 (K − ST )+ 1 − log
0 F0 K 2
w∞
K dK

+2 (ST − K )+ 1 − log .
F0 F0 K 2
Therefore, we have
w F0 w∞
" #
ST 2 dK dK
E ∗
log =2 E∗ [(K − ST )+ ] 2 + 2 E∗ [(ST − K )+ ] 2
F0 0 K F0 K
w F0 K dK w∞ K dK
−2 E∗ [(K − ST )+ ] log −2 E∗ [(ST − K )+ ] log
0 F0 K 2 F0 F0 K 2
w F0 K dK w∞ K dK
= E∗ R0,T 2
− 2 e rT P (T , K ) log − 2 e rT C (T , K ) log ,

0 F0 K 2 F0 F0 K 2
and
w F0
F0 dK w
K dK
rT ∞
E∗ R0,T = 8 e rT P (T , K ) log 8 e , log .
4
− C ( T K )
0 K K2 F0 F0 K 2
(A.46)
Alternatively, taking φ(x) = (x/F0 )(log(x/F0 ))2 with y = F0 , we have
2
1 2

x x
φ0 ( x ) = log + log
F0 F0 F0 F0
and
2 2 2

x x
φ00 (x) = log + = 1 + log ,
xF0 F0 xF0 xF0 F0
hence
ST 2 w F0 2

K
log = (K − ST )+ 1 + log dK
F0 0 KF0 F0
w∞ 2

K

+ (ST − K )+ 1 + log dK.
F0 KF0 F0
" 975
N. Privault
Therefore, we have
" # w
ST 2 2

F0 K
E ∗
log = E[(K − ST )+ ] 1 + log dK
F0 0 KF0 F0
w∞ 2

K

+ E[(ST − K )+ ] 1 + log dK.,
F0 KF0 F0
and
8 rT w F0

K dK
E∗ R0,T e P (T , K ) 1 + log
4
=
F0 0 F0 K
8 rT w ∞

K dK
+ e P (T , K ) 1 + log − 4E∗ R0,T .
2
F0 F 0 F0 K
Exercise 9.6
a) We have
w ∞ e −νx − e −µx w ∞ e −νx − e −µx
dx = dx
0 xρ + 1 0 xρ + 1
1 w ∞ −ν e −νx + µ e −µx
∞
1 e −e
−νx −µx
=− + dx
ρ xρ 0 ρ 0 xρ
ν w ∞ µ w ∞
=− e −νx x−ρ dx + e −µx x−ρ dx
ρ 0 ρ 0
µρ − ν ρ
= Γ (1 − ρ).
ρ
b) Taking ν = 0 and µ = Rt,T , we find

w
ρ ∞ 2 dλ
−λRt,T
E∗ [Rt,T ] = E∗ 1− e
Γ (1 − ρ) 0 λρ+1
ρ w∞ 2 dλ
∗ −λRt,T
1−E e ,

=
Γ (1 − ρ) 0 λρ+1
see § 3.1 in Friz and √

Gatheral (2005) with ρ = 1/2.
c) Letting p±λ : = 1/2 ± 1/4 − 2λ, we have
ρ w∞ −λR2 dλ
E∗ [Rt,T ] = 1 − E∗ e t,T
Γ (1 − ρ) 0 λρ+1
" ± #!
ρ w∞ ± ST pλ dλ
= 1 − e −rpλ T E∗
Γ (1 − ρ) 0 S0 λρ + 1
w∞
" p ± #
ρ ∗ ST λ dλ
= E 1−
Γ (1 − ρ) 0 F0 λρ+1
976 "
w 1/8
" p± #
ρ ST λ dλ
= E∗ 1 −
Γ (1 − ρ) 0 F0 λρ + 1
w∞
" #
i√
r
ρ ST ST dλ
+ E∗ 1 − exp ± 8λ − 1 log
Γ(1 − ρ) 1/8 F0 2 F0 λρ + 1
w 1/8
" p± #
8ρ ρ ∗ ST λ dλ
= + E 1−
ρ + 1 Γ (1 − ρ) 0 F0 λρ + 1
w∞
"r #
1√

ρ ST ST dλ
− E∗ cos 8λ − 1 log
Γ(1 − ρ) 1/8 F0 2 F0 λρ + 1
ρ w 1/8 dλ ρ
= E∗ [φλ (ST )] ρ+1 + E∗ [ψ (ST )] ,
Γ (1 − ρ) 0 λ Γ (1 − ρ)
where
p±
x λ
φλ ( x ) = 1 − ,
F0
we have
± ± ±
xpλ −1 xpλ −2 xpλ −2
φ0λ (x) = −p±
λ and φ00λ (x) = −p± ±
λ (pλ − 1) = 2λ ,
p±
λ
p±
λ
p±
F0 F0 F0 λ
hence with y := F0 we have φλ (y ) = 0 and
E∗ [φλ (ST )]
 
p± w F0 p± −2 w∞ p± −2
∗ +K λ +K λ
= E (ST − F0 ) λ
− 2λ (K − ST ) dK − 2λ (ST − K ) dK 
F0 0 p± F0 p±
F0 λ F0 λ
± ±
w F0 K pλ −2 w∞ K pλ −2
= 2λ E∗ [(K − ST )+ ] ± dK + E∗ [(ST − K )+ ] dK
0 p F0 p±
F0 λ F0 λ
e rT w F0 w∞

± ±
= 2λ ± P (T , K )K pλ −2 dK + C (T , K )K pλ −2 dK .
p 0 F0
F0 λ
Taking now
w∞ r
x

1√ x

dλ
ψ (x) : = 1− cos 8λ − 1 log ,
1/8 F0 2 F0 λρ + 1
we have
1 w∞
1√ x

dλ
ψ 0 (x) = − √ cos 8λ − 1 log
2 F0 x 1/8 2 F0 λρ+1
" 977
N. Privault
1 w∞
1√ x √

dλ
+ √ sin 8λ − 1 log 8λ − 1 ρ+1 ,
2 F0 x 1/8 2 F0 λ
which converges provided that ρ > 1/2, while ψ 00 (x) cannot be written
as a converging integral but can be estimated numericallly from ψ 0 (x).
Hence, we have
E∗ [Rt,T ]
ρ e rT
=
Γ (1 − ρ)
w 1/8 2
w
F0 ±
w∞ ±

dλ
× √ P (T , K )K pλ −2 dK + C (T , K )K pλ −2 dK
0
F0± 1/4−2λ 0 F0 λp
w F0 w∞
+ P (T , K )ψ 00 (K )dK + C (T , K )ψ 00 (K )dK .
0 F0
library(quantmod)
today <- as.Date(Sys.Date(), format="%Y-%m-%d"); getSymbols("^SPX", src = "yahoo")
S0 = as.vector(tail(Ad(SPX),1)); T = 30/365;r=0.02;F0 = S0*exp(r*T)
maturity<- as.Date("2021-07-07", format="%Y-%m-%d") # Choose a maturity in 30 days
SPX.OPTS <- getOptionChain("^SPX", maturity)
Call <- as.data.frame(SPX.OPTS$calls); Put <- as.data.frame(SPX.OPTS$puts)
Call_OTM <- Call[Call$Strike>F0,];Call_OTM$dif = c(min(Call_OTM$Strike)-F0,
diff(Call_OTM$Strike))
Put_OTM <-Put[Put$Strike<F0,];Put_OTM$dif = c(diff(Put_OTM$Strike),
F0-max(Put_OTM$Strike))
pl <- function(lambda){return( 1/2+sqrt(1/4-2*lambda ))}; rho=0.9

g1 <- function(x){ f1 <- function(lambda){ - cos ( 0.5*sqrt(lambda*8-1)*log
(x/F0))/lambda^(rho+1)/sqrt(x*F0)/2}; return(f1)}
g2 <- function(x){ f2 <- function(lambda){ sin ( 0.5*sqrt(lambda*8-1)*log
(x/F0))/lambda^(rho+1)/sqrt(lambda*8-1)/sqrt(x*F0)/2}; return(f2)}
g3 <- function (x) { integrate(g1(x), lower=0.125, upper=Inf,stop.on.error =
FALSE)$value}
g4 <- function (x) { if (x>F0) {integrate(g2(x), lower=0.125,
upper=1000000,stop.on.error = FALSE)$value} else {integrate(g2(x),
lower=0.125, upper=100000,stop.on.error = FALSE)$value}}
eps=1;psi2nd <- function(x){(g3(x+eps)+g4(x+eps)-g3(x)-g4(x))/eps}
f <- function(lambda){ return
(2*(sum(Put_OTM$Last*Put_OTM$Strike**(pl(lambda)-2) *Put_OTM$dif))
+sum(Call_OTM$Last *Call_OTM$Strike**(pl(lambda)-2)
*Call_OTM$dif)/F0**pl(lambda)/lambda**rho)}
(sum(Put_OTM$Last*as.numeric(lapply(Put_OTM$Strike,psi2nd)) *Put_OTM$dif)
+sum(Call_OTM$Last*as.numeric(lapply(Call_OTM$Strike,psi2nd))
*Call_OTM$dif)+integrate(Vectorize(f), lower=0,
upper=0.125)$value)*rho*exp(r*T)/gamma(1-rho)
978 "
Chapter 10
Exercise 10.1
a) By differentiating (10.2) with respect to T , we find
∂
ϕτa (T ) = P(τa < T )
∂T
∂
= 2 P ( WT > a )
∂T
2 ∂ w ∞ −x2 /(2T )
= √ e dx
2πT ∂T a
2 ∂ w ∞ −y 2 /2
= √ √ e dy
2π ∂T a/ T
a 2
= √ e −a /(2T ) , T > 0. (A.47)
2πT 3
b) By differentiating (10.13) with respect to T , we find
∂
ϕτ̃a (T ) = P(τ̃a < T )
∂T
∂
= − P(τ̃a > T )
∂T
∂
P X bT 6 a

= −
∂T 0
∂ a − µT ∂ −a − µT
= − Φ √ + e 2µa Φ √
∂T T ∂T T

a µ −(a−µT )2 /(2T )
= √ +√ e
2 2πT 3 2πT

a µ 2
+ √ −√ e 2µa−(a+µT ) /(2T )
2 2πT 3 2πT
a 2
= √ e −(a−µT ) /(2T ) , T > 0.
2 2πT 3
c) By differentiating (10.15) with respect to T , for x > S0 we find
∂
ϕτ̂x (T ) = P(τ̂a < T )
∂T
∂
= − P(τ̂x > T )
∂T
∂
= − P M0T 6 x

∂T
−(r − σ 2 /2)T + log(x/S0 )

∂
=− Φ √
∂T σ T
" 979
N. Privault
2
S0 1−2r/σ ∂ −(r − σ 2 /2)T − log(x/S0 )

+ Φ √
x ∂T σ T
log(x/S0 ) 1

= √ exp − 2 ((r − σ /2)T − log(x/S0 ))2 ,
2
T > 0,
σ 2πT 3 2σ T
which can also be recovered from (A.47) by taking a := log(S0 /x)/σ and
µ := r/σ − σ/2. Similarly, when 0 < x < S0 we can differentiate (10.18)
in Corollary 10.8 to find
∂
ϕτ̂x (T ) = P(τ̂x < T )
∂T
∂
P mT0 6 x

=
∂T
−(r − σ 2 /2)T + log(x/S0 )

∂
= Φ √
∂T σ T
1−2r/σ2
(r − σ 2 /2)T + log(x/S0 )

S0 ∂
+ Φ √
x ∂T σ T
log(S0 /x) 1

= √ exp − 2 ((r − σ 2 /2)T − log(x/S0 ))2 , T > 0,
σ 2πT 3 2σ T
which yields
| log(S0 /x)| 1

ϕτ̂x (T ) = √ exp − 2 ((r − σ 2 /2)T − log(x/S0 ))2 , T > 0,
σ 2πT 3 2σ T
for all x > 0.
Exercise 10.2
a) We use Relation (10.14) and the integration by parts identity
w∞ w∞
v 0 (z )u(z )dz = u(+∞)v (+∞) − u(0)v (0) − v (z )u0 (z )dz
0 0
with
2µ 2µy/σ

−y − µT /σ
u(y ) = Φ √ and v 0 (y ) = ye
T σ
which satisfy
1 2 σ 2µy/σ
u0 (y ) = − √ e −(y +µT /σ ) /(2T ) and v (y ) = y e 2µy/σ − e ,
2πT 2µ
we have

E Max W ft = σE Max (Wt + µt/σ )
t∈[0,T ] t∈[0,T ]
980 "
2 w ∞ −(y−µT /σ )2 /(2T ) w∞
r
−y − µT /σ
=σ ye dy − 2µ y e 2µy/σ Φ √ dy
πT 0 0 T
2 w ∞ −(y−µT /σ )2 /(2T ) w∞
r
= σ ye dy − σ v 0 (y )u(y )dy
πT 0 0
2 w ∞ −(y−µT /σ )2 /(2T ) w∞
r
= σ ye dy − σu(+∞)v (+∞) + σu(0)v (0) + σ u0 (y )v (y )dy
πT 0 0
√ !
2 w ∞ −(y−µT /σ )2 /(2T )
r
σ2 µ T
= σ ye dy − Φ −
πT 0 2µ σ
σ w ∞ 2 σ2 w∞ 2
−√ y e 2µy/σ−(y +µT /σ ) /(2T ) dy + √ e 2µy/σ−(y +µT /σ ) /(2T ) dy
2πT 0 2µ 2πT 0
2 w ∞ −(y−µT /σ )2 /(2T ) σ w ∞ −(y−µT /σ )2 /(2T )
r
= σ ye dy − √ ye dy
πT 0 2πT 0
√ !
w∞
σ2 µ T σ2 2
− Φ − + √ e −(y−µT /σ ) /(2T ) dy
2µ σ 2µ 2πT 0
√ !
σ w ∞ −(y−µT /σ )2 /(2T ) σ2 µ T
= √ ye dy − Φ −
2πT 0 2µ σ
σ2 w∞ 2
+ √ e −(y−µT /σ ) /(2T ) dy
2µ 2πT 0
√ !
σ w∞ σ2

µT 2 µ T
= √ y+ e −y /(2T ) dy − Φ −
2πT −µT /σ σ 2µ σ
σ 2 w ∞ 2
+ √ e −y /(2T ) dy
2µ 2πT −µT /σ
√ !
σ w∞ 2 µT + σ 2 /(2µ) w ∞ 2 σ2 µ T
= √ y e −y /(2T ) dy + √ e −y /(2T ) dy − Φ −
2πT −µT /σ 2πT −µT /σ 2µ σ
√ !
2
√ ! 2
√ !
σ h 2
i ∞ µ T σ µ T σ µ T
= √ −T e −y /(2T ) + µT Φ + Φ − Φ −
2πT −µT /σ σ 2µ σ 2µ σ
r 2 √ ! 2
√ !
T −µ2 T /2 σ µ T σ µ T
= σ e + µT + Φ − Φ − .
2π 2µ σ 2µ σ
As σ tends to zero, we find

 µT Φ(+∞) = µT if µ > 0,


E Max Wt = f
t∈[0,T ]
µT Φ(−∞) = 0 if µ 6 0.

We also have
" 981
N. Privault
r √ ! √ ! √ !!
σ2

E Max W ft = σ T e −µ2 T /2 + µT Φ µ T
+ Φ
µ T
−Φ −
µ T
t∈[0,T ] 2π σ 2µ σ σ
√ ! √
σ 2 w µ T /σ −y2 /2
r
T −µ2 T /2 µ T
=σ e + µT Φ + √ √ e dy.
2π σ 2µ 2π −µ T /σ
Hence, as µ tends to zero we find

r √ ! r
E Max W ft = σ T e −µ2 T /2 + µT Φ µ T
+σ
T
+ o(µ), [µ → 0],
t∈[0,T ] 2π σ 2π
and for µ = 0 and σ = 1 we recover the average maximum of standard

Brownian motion r
2T

E Max Wt = ,
t∈[0,T ] π
which represents two times the expected maximum
1 w∞ 2 / (2T )
E[Max(WT , 0)] = √ Max(y, 0) e −y dy
2πT −∞
1 w∞ 2 / (2T )
= √ y e −y dy
2πT 0
1 h 2
i∞
= √ −T e −y /(2T )
2πT 0
r
T
= .
2π
b) By part (a) the identity in distribution (−Wt )t∈R+ ≈ (Wt )t∈R+ , we have

E min W ft = σE min (Wt + µt/σ )
t∈[0,T ] t∈[0,T ]

= −σE Max (−Wt − µt/σ )
t∈[0,T ]

= −σE Max (Wt − µt/σ )
t∈[0,T ]
r √ ! √ !
σ2 σ2

T −µ2 T /2 −µ T µ T
= −σ e + µT + Φ − Φ .
2π 2µ σ 2µ σ
In particular, as σ tends to zero, we find

 µT Φ(+∞) = µT if µ 6 0,


E min Wt = f
t∈[0,T ]
µT Φ(−∞) = 0 if µ > 0.

982 "
Exercise 10.3
a) We have St = S0 e σWt , t ∈ R+ .
b) We have
2
E[ST ] = S0 E e σWT = S0 e σ T /2 .

c) We have
w∞ 2 dx
P Max Wt > a = 2 e −x /(2T ) √ , a > 0,
t∈[0,T ] a 2πT
and wa 2 dx
P Max Wt 6 a = 2 e −x /(2T ) √ , a > 0,
t∈[0,T ] 0 2πT
hence the probability density function ϕ of Max Wt is given by
t∈[0,T ]
2 −a2 /(2T )
r
ϕ(a) = e 1[0,∞) (a), a ∈ R.
πT
d) We have
w∞
E M0T = S0 E exp σ Max Wt e σx ϕ(x)dx

= S0
t∈[0,T ] 0
2S0 w ∞ σx−x2 /(2T ) 2S0 w ∞ −(x−σT )2 /(2T )+σ2 T /2
= √ e dx = √ e dx
2πT 0 2πσ 2 T 0
2S0 σ2 T /2 ∞ w 2 2S0 2 w ∞ −x2 /2
= √ e e −x /(2T ) dx = √ e σ T /2 √ e dx
2πT −σT 2π −σ T
w √
2 σ T −x2 /2
= 2S0 e σ T /2 e dx
−∞
σ 2 T /2
√
= 2S0 e Φ σ T
√
= 2E[ST ]Φ σ T .
Remarks:
(i) From the inequality
0 6 E[(WT − σT )+ ]
1 w∞ 2
= √ (x − σT )+ e −x /(2T ) dx
2πT −∞
1 w∞ 2
= −√ (x − σT ) e −x /(2T ) dx
2πT σT
1 w ∞ −x2 /(2T ) σT w ∞ −x2 /(2T )
= √ xe dx − √ e dx
2πT σT 2πT σT
" 983
N. Privault
T w∞ σT w ∞
r
−x2 /2 −x2 /2
= √ xe dx − √ √ e dx
2π σ T 2π σ T
√
r
T h −x2 /2 i∞
= e √ − σT Φ − σ T
2π σ T
√
r
T −σ2 T /2
= e − σT 1 − Φ σ T ,
2π
we get
2
√ e −σ T /2
Φ σ T > 1− √ ,
σ 2πT
hence
2 √
E M0T = 2S0 e σ T /2 Φ σ T

2
!
σ 2 T /2 e −σ T /2
> 2S0 e 1− √
σ 2πT
2 T /2
!
e −σ
= 2E[ST ] 1 − √
σ 2πT
1

2
= 2S0 e σ T /2 − √ .
σ 2πT
(ii) We observe that the ratio between the expected gains by
√ selling at
the maximum and selling at time T is given by 2Φ σ T , which

cannot be greater than 2.

2
2 Φ(σT1/2)
1.5
ratio
0.5
0
0 0.5 1 1.5 2 2.5 3 3.5 4
time T
Fig. S.36: Average return by selling at the maximum vs selling at maturity.
e) By a symmetry argument, we have

P min Wt 6 a = P − Max (−Wt ) 6 a
t∈[0,T ] t∈[0,T ]
984 "

= P − Max Wt 6 a
t∈[0,T ]

= P Max Wt > −a
t∈[0,T ]
w∞ 2 / (2T ) dx
=2 e −x √ , a < 0,
−a 2πT
i.e. the probability density function ϕ of min Wt is given by
t∈[0,T ]
2 −a2 /(2T )
r
ϕ(a) = e 1(−∞,0] (a), a ∈ R.
πT
f) We have

E mT0 = S0 E exp σ min Wt

t∈[0,T ]
w0
= S0 e ϕ(x)dx
σx
−∞
2S0 w0 2
= √ e σx−x /(2T ) dx
2πT −∞
2S0 w 0 2 2
= √ e −(x−σT ) /(2T )+σ T /2 dx
2πT −∞
2S0 σ2 T /2 w −σT −x2 /(2T )
= √ e e dx
2πT −∞
√
w −σ T
2S0 2 2
= √ e σ T /2 e −x /2 dx
2π −∞
2 √
= 2S0 e σ T /2 Φ − σ T
√
= 2E[ST ]Φ − σ T .
Remarks:
(i) From the inequality
0 6 E[(−σT − WT )+ ]
1 w∞ 2
= √ (−σT − x)+ e −x /(2T ) dx
2πT −∞
1 w −σT 2
= −√ (σT + x) e −x /(2T ) dx
2πT −∞
σT w −σT −x2 /(2T ) 1 w −σT 2
= −√ e dx − √ x e −x /(2T ) dx
2πT −∞ 2πT −∞
√ √
σT w −σ T −x2 /2 T w −σ T
r
2
= −√ e dx − x e −x /2 dx
2π −∞ 2π −∞
" 985
N. Privault
√
√
r
T h −x2 /2 i−σ T
= −σT Φ − σ T + e
2π −∞
√
r
T −σ2 T /2
= −σT Φ − σ T + e ,
2π
we get
2 T /2 √ 1 2S
eσ Φ −σ T 6 , hence E mT0 6 √ 0 .

√
σ 2πT σ 2πT
(ii) The ratio between the expected √ gains
by maturity T vs selling at the
minimum is given by 2Φ − σ T , which is at most 1 and tends to
0 as σ and T tend to infinity.
2
2 Φ(-σT1/2)
2 Φ(σT1/2)
1.5
ratio
0.5
0
0 0.5 1 1.5 2 2.5 3 3.5 4
time T
Fig. S.37: Average returns by selling at the minimum vs selling at maturity.

√
(iii) Given that E M0T = 2E[ST ]Φ σ T , we find the bound

√ √
2E[ST ]Φ − σ T 6 E[ST ] 6 2E[ST ]Φ σ T ,
with equality if σ = 0 or T = 0. We also have

2 √
2E[ST ] − E M0T = 2 e σ T /2 1 − Φ σ T

2 √
= 2 e σ T /2 Φ − σ T
= E m0 ,
T
hence we have
E mT0 + E M0T = 2E[ST ], or E[ST ] − E mT0 = E M0T − E[ST ],

and
2S0
2E[ST ] − √ 6 E M0T 6 2E[ST ].

σ 2πT
986 "

a) Regarding call option prices we have, assuming K > S0 ,
" + #
+
E M0T − K = S0 E exp σ Max Wt − K

t∈[0,T ]
w∞
= (S0 e σx − K )+ ϕ(x)dx
0
2 w∞ + 2
= √ S0 e σx − K e −x /(2T ) dx
2πT 0
2 w∞ 2
S0 e σx − K e −x /(2T ) dx

= √
2πT σ−1 log(K/S0 )
2S0 w ∞ 2
= √ e σx−x /(2T ) dx
2K w ∞ 2
−√ e −x /(2T ) dx
2S0 w ∞ 2 2
= √ e −(x−σT ) /(2T )+σ T /2 dx
2K w ∞ 2
−√ e −x /(2T ) dx
2S0 σ2 T /2 w ∞ 2
= √ e e −x /(2T ) dx
2πT −σT +σ −1 log(K/S0 )
2K w ∞ 2
−√ e −x /(2T ) dx
2 √ √
= 2S0 e σ T /2 Φ σ T + σ −1 log(S0 /K )/ T
√
−2KΦ σ −1 log(S0 /K )/ T .
When K 6 S0 , by “completion of the square” and use of the Gaussian

cumulative distribution function Φ(·), we find
h + i h i
E Max St − K = E Max St − K
t∈[0,T ] t∈[0,T ]
h i
= E Max St − E[K ]
t∈[0,T ]
h i
= E Max St − K
t∈[0,T ]

= S0 E exp σ Max Wt − K
t∈[0,T ]
w∞
= S0 e σx ϕ(x)dx − K
0
2S0 w ∞ σx−x2 /(2T )
= √ e dx
2πT 0
" 987
N. Privault
2S0 w ∞ −(x−σT )2 /(2T )+σ2 T /2

= √ e dx − K
2πT 0
2S0 σ2 T /2 ∞ w 2
= √ e e −x /(2T ) dx − K
2πT −σT
2 √
= 2S0 e σ T /2 Φ σ T − K
2
√
= 2S0 e σ T /2 1 − Φ − σ T − K
√
= 2E[ST ]Φ σ T − K,
hence
2 T /2 + √ 2
e −σ E M0T − K = 2S0 Φ σ T − K e −σ T /2 .

Recall that when r = σ 2 /2 the price of the finite expiration American call
option price is the Black-Scholes price with maturity T , with
BlCall (S0 , K, σ, r, T )
√ √ 2 √
= S0 Φ σ T + σ −1 log(S0 /K )/ T − K e −σ T /2 Φ σ −1 log(S0 /K )/ T
√ √ 2 √
2S0 Φ σ T + σ −1 log(S0 /K )/ T − 2K e −σ T /2 Φ σ −1 log(S0 /K )/ T


if K > S0 ,




6
√ −σ 2 T /2
 2S0 Φ σ T − K e




if K 6 S0 .
 2 × BlCall (S0 , K, σ, r, T ) if K > S0 ,


= √ 2
2S0 Φ σ T − K e −σ T /2 if K 6 S0 ,

√ 2

= Max 2 × BlCall (S0 , K, σ, r, T ), 2S0 Φ σ T − K e −σ T /2 .
988 "
2.0
Upper bound
Black−Scholes call price
1.5
price
1.0
0.5
0.0
0.0 0.5 1.0 1.5 2.0
Fig. S.38: Black-Scholes call price upper bound with S0 = 1.
b) Regarding put option prices we have, assuming S0 > K,

" + #
+
E K − mT0 = S0 E K − exp σ min Wt

t∈[0,T ]
w∞
σx +
= (K − S0 e ) ϕ(x)dx
0
2 w0 + 2
= √ K − S0 e σx e −x /(2T ) dx
2πT −∞
2 w σ−1 log(K/S0 ) 2
K − S0 e σx e −x /(2T ) dx

= √
2πT −∞
2K w σ−1 log(K/S0 ) −x2 /(2T )
= √ e dx
2πT −∞
2S0 w σ −1 log(K/S0 ) σx−x2 /(2T )
−√ e dx
2πT −∞
2K w σ−1 log(K/S0 ) −x2 /(2T )
= √ e dx
2πT −∞
2S0 w σ −1 log(K/S0 ) −(x−σT )2 /(2T )+σ 2 T /2
−√ e dx
2πT −∞
2K w σ −1 log(K/S0 ) −x2 /(2T )
= √ e dx
2πT −∞
2S0 σ2 T /2 w −σT +σ−1 log(K/S0 ) −x2 /(2T )
−√ e e dx
2πT −∞
√
2KΦ(−σ −1 log S0 /K )/ T

=
2 √ √
−2S0 e σ T /2 Φ − σ T − σ −1 log(S0 /K )/ T ,
with
" 989
N. Privault
2 T /2 + 2 √
e −σ E K − mT0 = K e −σ T /2 − 2S0 Φ − σ T

if S0 6 K. Therefore we deduce the bounds
BlPut (S0 , K, σ, r, T )
2 T /2 √ √ √
= K e −σ Φ − σ −1 log(S0 /K )/ T − S0 Φ − σ T − σ −1 log(S0 /K )/ T
6 American put option price

√ √ √
−σ 2 T /2 Φ − σ −1 log (S /K ) / T − 2S Φ − σ T − σ −1 log (S /K ) / T
 2K e

 0 0 0
if S0 > K,

6

 2 √
K e −σ T /2 − 2S0 Φ − σ T if S0 6 K,

 2 × BlPut (S0 , K, σ, r, T ) if S0 > K,


= √
2
K e −σ T /2 − 2S0 Φ − σ T if S0 6 K,

2 √
= Max 2 × BlPut (S0 , K, σ, r, T ), K e −σ T /2 − 2S0 Φ − σ T
for the finite expiration American put option price when r = σ 2 /2.
1.0
Upper bound
Black−Scholes put price
0.8
0.6
price
0.4
0.2
0.0
0.0 0.5 1.0 1.5 2.0
Fig. S.39: Black-Scholes put price upper bound with S0 = 1.

a) Using the expression
2 −(x−µT )2 /(2T )
r
x + µT

ϕ T (x) = e + 2µ e 2µx Φ √ , x 6 0.
b
X0 πT T
of the probability density function of the minimum
990 "
b
T
X 0 := min W
ft = min (Wt + µt)
t∈[0,T ] t∈[0,T ]

ft = Wt + µt over t ∈ [0, T ] given in Propo-
sition 10.7, we find
h i w0
E min St = S0 e σx ϕ T (x)dx
b
t∈[0,T ] −∞ X0
w0 2 −(x−µT )2 /(2T )
r
= S0 e σx
e dx
−∞ πT
w0
x + µT

+2µS0 e σx e 2µx Φ √ dx
−∞ T
2 √ 2µS0 √
= 2S0 e σ T /2−µσT Φ (µ − σ ) T + Φ −µ T

2µ − σ
2µS0 σ2 T /2−µσT √
− e Φ (µ − σ ) T ,
2µ − σ
with µ := r/σ − σ/2, which yields
σ2 r − σ 2 /2 √
h i
E min St = S0 1 − Φ T
t∈[0,T ] 2r σ
σ2 r + σ 2 /2 √

+S0 1 + Φ − T .
2r σ
h i
See Exercise 12.1-(b) for the computation of E mint∈[0,1] St when r = 0.
b) When S0 6 K, we have
h + i h i
E K − min St = E K − min St
t∈[0,T ] t∈[0,T ]
h i
= K − E min St
t∈[0,T ]
σ2 r − σ 2 /2 √

= K − S0 1 − Φ T
2r σ
σ2 r + σ 2 /2 √

−S0 e rT
1+ Φ − T .
2r σ
Next, when S0 > K we have, using the probability density function

ϕ T (x),
b
X0
b
h + i h T + i
E K − min St =E K − S0 min e σX 0
t∈[0,T ] t∈[0,T ]
" 991
N. Privault
w0 + b
= K − S0 e σx ϕ T (x)dx
−∞ X0
2 w0
r
+ 2
= S0 K − S0 e σx e −(x−µT ) /(2T ) dx
πT −∞
w0 +

x + µT

+2µS0 K − S0 e σx e 2µx Φ √ dx
−∞ T
(r − σ 2 /2)T + log(S0 /K )

= KΦ − √
σ T
1−2r/σ2
(r − σ 2 /2)T + log(K/S0 )

S0
+K Φ √
K σ T
−2r/σ2
2 (r − σ 2 /2)T + log(K/S0 )

σ S0
−S0 1 − Φ √
2r K σ T

σ 2
( r + σ 2 /2)T + log (S /K )
0
−S0 e rT 1 + Φ − √ .
2r σ T
In Figure S.40, using a finite expiration American put option pricer from
the R fOptions package, we plot the graph of American put option price
vs (A.48)-(A.49), together with the European put option price, according
to the following R code.
1.0
Upper bound
American put price
0.8
0.6
Price
0.4
0.2
0.0
0.0
0.0 0.5
0.5 1.0
1.0 1.5 2.0
Fig. S.40: “Optimal exercise” put price upper bound with S0 = 1.
992 "
d1 <- function(S,K,r,T,sig) {return((log(S/K)+(r+sig^2/2)*T)/(sig*sqrt(T)))}

d2 <- function(S,K,r,T,sig) {return(d1(S, K, r, T, sig) - sig * sqrt(T))}
BSPut <- function(S, K, r, T, sig){return(K*exp(-r*T) * pnorm(-d2(S, K, r, T, sig)) -
S*pnorm(-d1(S, K, r, T, sig)))}
Optimal_Put_Option <- function(S,K,r,T,sig){
if (r==0) {if (S>=K) {return(K*pnorm(d1(K,S,0,T,sig))-S*(1+sig*sig*T/2
+log(S/K))*pnorm(-d1(S,K,0,T,sig))
+S*sig*sqrt(T/(2*pi))*exp(-d1(S,K,0,T,sig)*d1(S,K,0,T,sig)/(2*sig*sig*T)))}
else {return(K-2*S*(1+sig*sig*T/4)*pnorm(-sig*sqrt(T)/2)
+S*sig*sqrt(T/(2*pi))*exp(-sig*sig*T/8))}}
else {if (S>=K) {return(K*pnorm(-d2(S,K,r,T,sig))
+K*(S/K)**(1-2*r/sig/sig)*pnorm(d2(K,S,r,T,sig))
-2*S*exp(r*T)*pnorm(-d1(S,K,r,T,sig))
-S*(1-sig*sig/2/r)*(S/K)**(-2*r/sig/sig)*pnorm(d1(K,S,r,T,sig))
+S*exp(r*T)*(1-sig*sig/2/r)*pnorm(-d1(S,K,r,T,sig)))}
else {return(K-S*(1-sig*sig/2/r)*pnorm((r-sig*sig/2)*sqrt(T)/sig)
-S*(1+sig*sig/2/r)*pnorm(-(r+sig*sig/2)*sqrt(T)/sig))}}}
r=0.5;sig=1;S=1;T=1
library(fOptions)
curve(BAWAmericanApproxOption("p",S,x,T,r,b=0,sig,title = NULL, description =
NULL)@price, from=0.01, to=2 , xlab="K", lwd = 3,
ylim=c(0,1),ylab="",col="orange")
par(new=TRUE)
curve(BSPut(S,x,r,T,sig), from=0, to=2 , xlab="K", lwd = 3, ylim=c(0,1),
ylab="Price",col="blue")
par(new=TRUE)
curve(Optimal_Put_Option(S,x,r,T,sig), from=0, to=2 , xlab="K", lwd = 3,
ylim=c(0,1),ylab="",col="red")
grid (lty = 5)
legend(.0,1.0,legend=c("Upper bound","American put price","Black-Scholes put
price"),col=c("red","orange", "blue"), lty=1:1, cex=1.)
c) When r = 0 and S0 6 K, we find

√ ! r
+ i σ2 T

h σ T T −σ2 T /8
E K − min St = K − 2S0 1 + Φ − + σS0 e .
t∈[0,T ] 4 2 2π
(A.48)
Next, when r = 0 and S0 > K, we find
σ T /2 + log(K/S0 )
h + i 2
E K − min St = KΦ √ (A.49)
t∈[0,T ] σ T
σ2 T σ 2 T /2 + log(S0 /K )

S0
−S0 1 + log + Φ − √
K 2 σ T
r
T −(σ2 T /2+log(S0 /K ))2 /(2σ2 T )
+S0 σ e .
2π
From the above R code we can check that when r ' 0 the price of the finite
expiration American put option coincides with the price of the standard
European put option, as noted in Proposition 15.9.
Exercise 10.6
a) We have
P (τa > t) = P (Xt > a)
" 993
N. Privault
w∞
= ϕXt (x)dx
ra
2 w ∞ −x2 /(2t)
= e dx, y > 0.
πt y
b) We have
d
ϕτa (t) = P (τa 6 t)
dt
d w∞
= ϕXt (x)dx
dt r a
1 2 −3/2 w ∞ −x2 /(2t) 1 2 −3/2 w ∞ x2 −x2 /(2t)
r
= − t e dx + t e dx
2 π a 2 π a t
1 2 −3/2
r w ∞ −x2 /(2t) 2
w ∞ −x2 /(2t)
= t − e dx + a e −a /(2t) + e dx
2 π a a
a 2
= √ e −a /(2t) , t > 0.
2πt3
c) We have
w ∞ −2
E (τa )−2 =

t ϕτa (t)dt
0
a w ∞ −7/2 −a2 /(2t)
= √ t e dt
2π 0
2a w ∞ 2 2
= √ x4 e −a x /2 dx
2π 0
3
= 4,
a
by the change of variable x = t−1/2 , i.e. x2 = 1/t, t = x−2 , and

dt = −2x−3 dx.
Remark: We have
a w ∞ −1/2 −a2 /(2t)
E [ τa ] = √ t e dt = +∞.
2π 0
Chapter 11
Exercise 11.1 Barrier options.
a) By (11.26) and (12.15) we find

∂g T −t St T −t St
ξt = (t, St ) = Φ δ+ − Φ δ+
∂y K B
994 "
−2r/σ2
2r
2
K −(T −t)r St T −t B T −t B
+ e 1− 2 Φ δ− − Φ δ−
B σ B KSt St
2
2r St −1−2r/σ
2
T −t B T −t B
+ 2 Φ δ+ − Φ δ+
σ B KSt St
2 !
2 1

K T −t St
− p 1− exp − δ+ ,
σ 2π (T − t) B 2 B
0 < St 6 B, 0 6 t 6 T , cf. also Exercise 7.1-(ix) of Shreve (2004) and

Figure 11.11 above. At maturity for t = T we find ξT = 1[K,B ] (ST ).
b) We find
P(YT 6 a and WT > b) = P(WT 6 2a − b), a b)
fYT ,WT (a, b) = =− ,
dadb dadb
a, b ∈ R, satisfies
2 (b − 2a) −(2a−b)2 /(2T )

r
fYT ,WT (a, b) = 1 (a) e
πT (−∞,min(0,b)] T
r
2 (b − 2a) −(2a−b)2 /(2T )
e , a < min(0, b),



= πT T

0, a > min(0, b).


c) We find
1 2
r
b T (a, b) = 1(−∞,min(0,b)] (a) T

2 2
(b − 2a) e −µ T /2+µb−(2a−b) /(2T )
b
f
Y T ,W πT
 r
1 2 2 2
(b − 2a) e −µ T /2+µb−(2a−b) /(2T ) , a < min(0, b),



= T πT

0, a > min(0, b).


d) The function g (t, x) is given by the Relations (11.10) and (11.11) above.
Exercise 11.2
" 995
N. Privault
a) By Corollary 10.8, the probability density function of the minimum
m0∆τ = min Sτ +s
s∈[0,∆τ ]
with Sτ = B is given by
1 (−(r − σ 2 /2)∆τ + log(x/B ))2

ϕm∆τ (x) = √ exp −
0 σx 2π∆τ 2σ 2 ∆τ
1−2r/σ2
1 ((r − σ 2 /2)∆τ + log(x/B ))2

B
+ √ exp −
σx 2π∆τ x 2σ 2 ∆τ
1−2r/σ2
1 2r (r − σ /2)∆τ + log(x/B )
2

B
+ − 1 Φ √ ,
x σ2 x σ ∆τ
0 < x 6 B, see also Proposition 10.7 for the probability density function of
the minimum of the drifted Brownian motion W ft = Wt + µt over t ∈ [0, T ].
Hence, we have
h + i wB
E min Sτ +s − K Fτ = (x − K )+ ϕm∆τ (x)dx

s∈[0,∆τ ] 0 0
σ2 σ√ log(B/K ) + (r − σ 2 /2)∆τ

r
= B 1+ e r∆τ Φ − + ∆τ + KΦ − √
2r σ 2 σ ∆τ
σ2 log ( ) + (r + σ 2 /2)∆τ

B/K
−B 1 + e Φ −
r∆τ
√
2r σ ∆τ
2 r σ √

σ
+B 1 − Φ − ∆τ
2r σ 2
2
σ 2 K 2r/σ log(B/K ) − (r − σ 2 /2)∆τ

+B Φ − √ − K,
2r B σ ∆τ
with r > 0.
b) When r = 0, we find
+ σ2 σ√
h i
E min Sτ +s − K Fτ = B 2 + ∆τ Φ − ∆τ

s∈[0,∆τ ] 2 2
2 σ2
! !
σ2 log(B/K ) + σ2 ∆τ log(B/K ) − 2 ∆τ

B
−B 1 + ∆τ + log Φ − √ + KΦ − √ .
2 K σ ∆τ σ ∆τ
1 √
− √ σB ∆τ e −σ ∆τ /8 − e −d+ /2 − K.
2 2
2π
c) By the solution of Exercise 10.1-(c), the probability density function of
τB is given by
996 "
| log(S0 /B )| 1

ϕτB (x) = √ exp − 2 ((r − σ 2 /2)x − log(B/S0 ))2 , x > 0.
σ 2πx3 2σ x
d) We have
h + i
e −∆τ E e −τ 1[0,T ] (τ ) min St − K
t∈[τ ,τ +∆τ ]
h h + ii
= e −∆τ
E e −rτ
1[0,T ] (τ )E min St − K Fτ

t∈[τ ,τ +∆τ ]
h + i
= e −∆τ
E e −rτ
1[0,T ] (τ ) E min Fτ ,

St − K

t∈[τ ,τ +∆τ ]
h + i
where E mint∈[τ ,τ +∆τ ] St − K Fτ is given by Questions (a)-(b),

and
w T −rx
E e −rτ 1[0,T ] (τ ) = e

ϕτB (x)dx
0
wT 1

1

= | log(S0 /B )| e −rxτ √ exp − 2 ((r − σ 2 /2)x − log(B/S0 ))2 dx
0 σ 2πx 3 2σ x
!
log(B/S0 ) r − σ 2 /2 − (r − σ 2 /2)2 + 2rσ 2
p
= | log(S0 /B )| exp
σ2
wT 1

1
q 2

× √ exp − 2 x (r − σ 2 /2)2 + 2rσ 2 − log(B/S0 ) dx
0 σ 2πx 3 2σ x
!
log(B/S0 ) r − σ 2 /2 − (r − σ 2 /2)2 + 2rσ 2
p
= exp
σ2
wT 1

1
q 2

× √ exp − 2 x (r − σ 2 /2)2 + 2rσ 2 − log(B/S0 ) dx
0 σ 2πx 3 2σ x
√
r−σ2 /2− (r−σ2 /2)2 +2rσ2 /σ2
!
log(B/S0 ) − T (r − σ 2 /2)2 + 2rσ 2
p
B
= Φ √
S0 σ T
r−σ2 /2+√(r−σ2 /2)2 +2rσ2 /σ2
!
log(B/S0 ) + T (r − σ 2 /2)2 + 2rσ 2
p
B
+ Φ √ ,
S0 σ T
where the last identity follows from Proposition 10.4 and the relation

a − µT −a − µT
Φ − e 2µa Φ =P X bT 6 a

√ √ 0
T T
= P(τ̃a 6 T )
wT
= ϕτ̃a (x)dx
0
" 997
N. Privault
1wT a 2
= √ e −(a−µx) /(2x) dx, T > 0.
2 0 2πx3
with a := log(B/S0 )/σ, for a Brownian motion with drift µ = (r − σ 2 /2)2 + 2rσ 2 /σ,
p
see Exercise 10.1-(b).
Exercise 11.3 Barrier forward contracts.

a) Up-and-in barrier long forward contract. We have
 
 
 
 
 
e −(T −t)r
E[C | Ft ] = e E (ST − K ) 1
−(T −t)r   Ft 

 
 
 
   
Max Su > B 
 
 
 06u6T

 

= 1  (St − K e −(T −t)r ) + 1  φ(t, St ),


 
 
 

   
Max Su > B  Max Su 6 B 
 06u6t  06u6t

  
 
 
(A.50)
where the function

φ(t, x) := xΦ δ+T −t
(x/B ) − K e −(T −t)r Φ δ−
T −t
(x/B )
2

T −t
+B (B/x)2r/σ Φ −δ+ (B/x)
2

−K e −(T −t)r (B/x)−1+2r/σ Φ −δ− T −t
(B/x)
solves the Black-Scholes PDE with the terminal condition

2r/σ2 !
B K
φ(T , x) = x − K + B−x 1[B,∞) (x),
x B
as in the proof of Proposition 11.3. Note that only the values of φ(t, x)
with x ∈ [0, B ] are used for pricing.
998 "
20
15
10
0
75
70 100
120
Underlying 65 140
60 160
180
55 200 Time in days
220
Fig. S.41: Price of the up-and-in long forward contract with K = 60 < B = 80.
As for the hedging strategy, we find

∂φ 1 T −t 2
ξt = (t, St ) = Φ δ+T −t
(x/B ) + √ e −(δ+ (x/B )) /2
∂x 2π
1 T −t 2 2r 2

− √ K e −(T −t)r−(δ− (x/B )) /2 − 2 (B/x)1+2r/σ Φ −δ+ T −t
(B/x)
x 2π σ
1 2 T −t 2
+ √ (B/x)1+2r/σ e −(δ+ (B/x)) /2
2π
K (1 − 2r/σ 2 ) −(T −t)r 2

T −t

− e (B/x)2r/σ Φ −δ− (B/x)
B
K 2 T −t 2
− √ (B/x)2r/σ e −(T −t)r−(δ− (B/x)) /2
B 2π
2r 2

= Φ δ+ T −t
(x/B ) − 2 (B/x)1+2r/σ Φ −δ+ T −t
(B/x)
σ
1

T −t 2 B T −t 2
+ √ (1 − K/B ) e −(δ+ (x/B )) /2 + e −(T −t)r−(δ− (x/B )) /2
2π x
K 2 −(T −t)r 2r/σ 2

T −t

− (1 − 2r/σ ) e (B/x) Φ −δ− (B/x) ,
B
since by (12.22) we have
T −t T −t
(B/x))2 /2 2 (x/B ))2 /2
e − ( δ− = e r (T −t) (x/B )2r/σ e −(δ+
and
T −t T −t
(x/B ))2 /2 2 (B/x))2 /2
e − ( δ− = e r (T −t) (B/x)2r/σ e −(δ+ .
" 999
N. Privault
0.3
0.25
0.2
0.15
0.1
0.05
0
75
70 100
120
Underlying 65 140
60 160
180
55 200 Time in days
220
Fig. S.42: Delta of the up-and-in long forward contract with K = 60 < B = 80.
b) Up-and-out barrier long forward contract. We have

 
 
 
 
 
e −(T −t)r
E[C | Ft ] = e E (ST − K ) 1
−(T −t)r   Ft 

 
 
 
   
Max
 
 Su < B 
 06u6T

 


= 1  φ(t, St ), (A.51)

 

 
Max Su 6 B 
 06u6t

 

where the function

φ(t, x) := xΦ −δ+ T −t
(x/B ) − K e −(T −t)r Φ −δ− T −t
(x/B )
2

T −t
−B (B/x)2r/σ Φ −δ+ (B/x)
2

+K e −(T −t)r (B/x)−1+2r/σ Φ −δ− T −t
(B/x)

2r/σ2
B K
φ(T , x) = (x − K )1[0,B ] (x) − B−x 1[B,∞) (x).
x B
Note that only the values of φ(t, x) with x ∈ [B, ∞) are used for pricing.
1000 "
20
15
10
200
Time in days 150 80
100 70 75
60 65
Underlying
Fig. S.43: Price of the up-and-out long forward contract with K = 60 < B = 80.
∂φ 1 T −t 2
ξt = (t, St ) = Φ −δ+ T −t
(x/B ) − √ e −(δ+ (x/B )) /2
∂x 2π
1 T −t 2 2r 2

+ √ K e −(T −t)r−(δ− (x/B )) /2 + 2 (B/x)1+2r/σ Φ −δ+ T −t
(B/x)
x 2π σ
1 1+2r/σ 2 −(δ+ T −t
( B/x))2 /2
− √ (B/x) e
2π
K (1 − 2r/σ ) −(T −t)r
2 2

T −t

+ e (B/x)2r/σ Φ −δ− (B/x)
B
K 2 T −t 2
+ √ (B/x)2r/σ e −(T −t)r−(δ− (B/x)) /2
B 2π
2r 2

= Φ −δ+ T −t
(x/B ) + 2 (B/x)1+2r/σ Φ −δ+ T −t
(B/x)
σ
1 T −t 2 1 B −(T −t)r−(δ− T −t
(x/B ))2 /2
− √ e −(δ+ (x/B )) /2 − √ e
2π 2π x
K T −t 2 1 K −(T −t)r−(δ− T −t
(x/B ))2 /2
+ √ e −(δ+ (x/B )) /2 + √ e
B 2π 2π x
K 2

+ (1 − 2r/σ 2 ) e −(T −t)r (B/x)2r/σ Φ −δ− T −t
(B/x)
B
2r 2

= Φ −δ+ T −t
(x/B ) + 2 (B/x)1+2r/σ Φ −δ+ T −t
(B/x)
σ
1

T −t 2 B T −t 2
− √ (1 − K/B ) e −(δ+ (x/B )) /2 + e −(T −t)r−(δ− (x/B )) /2
2π x
2r/σ2
2r

K B T −t B
+ 1 − 2 e −(T −t)r Φ −δ− ,
B σ x x
by (12.22).
" 1001
N. Privault
1
0.95
0.9
0.85
0.8
0.75
0.7
0.65
0.6
0.55
60
65
70
Underlying 75 200
80 100 150
Time in days
Fig. S.44: Delta of the up-and-out long forward contract price with K = 60 < B = 80.
c) Down-and-in barrier long forward contract. We have

 
 
 
 
 
e −(T −t)r
E[C | Ft ] = e E (ST − K ) 1
−(T −t)r   Ft 

 
 
 
   
min
 
 Su B 
 06u6t  06u6t

  
 
 
(A.52)
where the function

φ(t, x) := xΦ −δ+ T −t
(x/B ) − K e −(T −t)r Φ −δ− T −t
(x/B )
2

T −t
+B (B/x)2r/σ Φ δ+ (B/x)
2

−K e −(T −t)r (B/x)−1+2r/σ Φ δ− T −t
(B/x)

2r/σ2 !
B K
φ(T , x) = x − K + B−x 1[0,B ] (x).
x B
1002 "
18
16
14
12
10
8
6
4
2
0
120 80
140 85
160 90
180 Underlying
200 95
Time in days 220
100
Fig. S.45: Price of the down-and-in long forward contract with K = 60 < B = 80.
∂φ
ξt = (t, St )
∂x
2r 2

= Φ −δ+ T −t
(x/B ) + 2 (B/x)1+2r/σ Φ δ+ T −t
(B/x)
σ
1

T −t 2 B T −t 2
− √ (1 − K/B ) e −(δ+ (x/B )) /2 + e −(T −t)r−(δ− (x/B )) /2
2π x
K 2

+ (1 − 2r/σ 2 ) e −(T −t)r (B/x)2r/σ Φ δ− T −t
(B/x) .
B
0.6
0.5
0.4
0.3
0.2
0.1
0
120 80
140 85
160 90
180 Underlying
200 95
Time in days 220
100
Fig. S.46: Delta of the down-and-in long forward contract with K = 60 B 
 06u6T

 


" 1003
N. Privault
= 1  φ(t, St ) (A.53)

 

 
min Su > B 
 06u6t

 

where the function

T −t x T −t x

φ(t, x) := xΦ δ+ − K e −(T −t)r Φ δ−
B B
2r/σ 2 T −t B
−B (B/x) Φ δ+
x
!
2 T −t B
+K e −(T −t)r (B/x)−1+2r/σ Φ δ−
x

2r/σ2
K B
φ(T , x) = (x − K )1[B,∞) (x) − B − x 1[0,B ] (x).
B x
Note that φ(t, x) above coincides with the price of (11.11) of the standard
down-and-out barrier call option in the case K < B, cf. Exercise 11.1-(d).
40
35
30
25
20
15
10
5
0 100
220 200 95
180 160 90 Underlying
140 120 85
Time in days 100 80
Fig. S.47: Price of the down-and-out long forward contract with K = 60 < B = 80.
∂φ
ξt = (t, St )
∂x
2r
T −t x
2

= Φ δ+ − 2 (B/x)1+2r/σ Φ δ+ T −t
(B/x)
B σ
1

K T −t 2 B T −t 2
+√ 1− e −(δ+ (x/B )) /2 + e −(T −t)r−(δ− (x/B )) /2
2π B x
2r/σ2
2r

K B T −t B
− 1 − 2 e −(T −t)r Φ δ− .
B σ x x
1004 "
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2 100
220 200 95
180 160 90 Underlying
140 120 85
Time in days 100 80
Fig. S.48: Delta of the down-and-out long forward contract with K = 60 < B = 80.
e) Up-and-in barrier short forward contract. The price of the up-and-in bar-
rier short forward contract is identical to (A.50) with a negative sign.
f) Up-and-out barrier short forward contract. The price of the up-and-out

barrier short forward contract is identical to (A.51) with a negative sign.
Note that φ(t, x) coincides with the price of (11.8) of the standard up-
and-out barrier put option in the case B < K.
g) Down-and-in barrier short forward contract. The price of the down-and-

in barrier short forward contract is identical to (A.52) with a negative sign.
h) Down-and-out barrier short forward contract. The price of the down-and-

out barrier short forward contract is identical to (A.53) with a negative
sign.
Exercise 11.4 When B < K, we find
Vegadown-and-out-call
r
T − t −(δT −t (St /K ))2 /2
= St e +
2π
1−2r/σ2 2
4r St
2 2
B B B St
− 3 Φ δ+ T −t
− K e −(T −t)r Φ δ−
T −t
log
σ B St KSt KSt B
r
2 1−2r/σ2
T −tB St T −t 2 2
− e −(δ+ (B /K/St )) /2 .
2π St B
When B > K, we find
Vegadown-and-out-call
! !
T −t
(St /B ) √ √

St T −t 2 K δ−
= √ e −(δ+ (St /K )) /2 −1 + T −t + T −t
2π B σ
" 1005
N. Privault
1−2r/σ2
4r B2

St B B St
− Φ δ+ T −t
− K e −(T −t)r Φ δ−
T −t
log
σ3 B St St St B
! !
T −t
1 B 2 −(δT −t (St /B ))2 /2 (B/St ) √ √

K δ−
−√ e + −1 + T −t + T −t .
2π St B σ
The corresponding formulas for the down-and-in call

q option Tcan be obtained
−t −(δ+ −t (St /K ))2 /2
from the parity relation (11.2) and the value St T2π e of
the Black-Scholes Vega, see Table 6.1.

h i
E∗ [C ] = E∗ 1{ST >K} 1{M T 6B}
0

= E∗ 1 σ W
1 σ X T
{S0 e b T >K} {S e
0
b 0 6B}
w∞ w∞
= 1{S0 e σy >K} 1{S0 e σx 6B} dP(Xb0T 6 x, W cT 6 y )
−∞ y∨0
w∞ w∞
= 1{S0 e σy >K} 1{S0 e σx 6B} fXb ,Wb (x, y )dxdy
−∞ y∨0 T T
1
r w
2 σ−1 log(B/S0 )
=
T πT −∞
w∞
1{S0 e σy >K} 1{S0 e σx 6B} (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy
2 2
y∨0
1 2 w σ−1 log(B/S0 ) w σ−1 log(B/S0 )
r
2 2
= (2x − y ) e −µ T /2+µy−(2x−y ) /(2T ) dxdy,
T πT σ−1 log(K/S0 ) y∨0
if B > S0 (otherwise the option price is 0), with µ = r/σ − σ/2 and y ∨ 0 =
Max(y, 0). Next, letting a = y ∨ 0 and b = σ −1 log(B/S0 ), we have
wb T
(2x − y ) e 2x(y−x)/T dx = (1 − e 2b(y−b)/T ),
a 2
hence, letting c = σ −1 log(K/S0 ), we have
2 T /2 1 w b µy−y2 /(2T )
E∗ [C ] = e −µ √ e (1 − e 2b(y−b)/T )dy
2πT c
2 T /2 1 wb 2
= e −µ √ e µy−y /(2T ) dy
2πT c
−µ2 T /2−2b2 /T 1 w b y (µ+2b/T )−y2 /(2T )

−e √ e dy.
2πT c
Using the relation
1006 "
1 w b γy−y2 /(2T ) −c + γT −b + γT

2
√ e dy = e γ T /2 Φ √ −Φ √ ,
2πT c T T
we find
h i
E∗ [C ] = E∗ (ST − K )+ 1{M T 6B}
0
−c + µT −b + µT

=Φ √ −Φ √
T T
−c + (µ + 2b/T )T −b + (µ + 2b/T )T

2 2 2
− e −µ T /2−2b /T +(µ+2b/T ) T /2 Φ √ −Φ √
T T

S0 S0
= Φ δ− T
− Φ δ− T
K B
2
2 2 2 B B
− e −µ T /2−2b T +(µ+2b/T ) T /2 Φ δ− − Φ δ− ,
KS0 S0
0 6 x 6 B. Given the relation

2
µ2 T b2 2b 2r

T B
− −2 + µ+ = −1 + 2 log ,
2 T 2 T σ S0
we get
h i
e −rT E∗ [C ] = e −rT E∗ 1{ST >K} 1{M T 6B}
0

S0 S0
= e −rT Φ δ− T
− Φ δ− T
K B
1−2r/σ2 2 !
S0 B B
− Φ δ−
T
− Φ δ− T
.
B KS0 S0
Exercise 11.6
a) For x = B and t ∈ [0, T ] we check that

T −t B

T −t
g (t, B ) = B Φ δ+ − Φ δ+ (1)
K

T −t B

− e −(T −t)r K Φ δ− − Φ δ− T −t
(1)
K

T −t B

T −t
−B Φ δ+ − Φ δ+ (1)
K

T −t B

+ e −(T −t)r K Φ δ− − Φ δ− T −t
(1)
K
= 0,
" 1007
N. Privault
and the function g (t, x) is extended to x > B by letting
g (t, x) = 0, x > B.
b) For x = K and t = T , we find
+∞ if s > 1,






0
δ± (s) = −∞ × 1{s<1} + ∞ × 1{s>1} = 0 if s = 1,



−∞ if s < 1,


hence when x < K < B we have
g (T , x) = x (Φ (−∞) − Φ (−∞))
−K (Φ (−∞) − Φ (−∞))
2r/σ2
B
−B (Φ (+∞) − Φ (+∞))
x
2r/σ2
B
+K (Φ (+∞) − Φ (+∞))
K
= 0,
c) when K < x < B, we get
g (T , x) = x (Φ (+∞) − Φ (−∞))
−K (Φ (+∞) − Φ (−∞))
2r/σ2
B
−B (Φ (+∞) − Φ (+∞))
x
2r/σ2
B
+K (Φ (+∞) − Φ (+∞))
K
= x − K.
Finally, for x > B we obtain
g (T , K ) = x (Φ (+∞) − Φ (+∞))
−K (Φ (+∞) − Φ (+∞))
2r/σ2
B
−B (Φ (−∞) − Φ (−∞))
x
2r/σ2
B
+K (Φ (−∞) − Φ (−∞))
K
= 0.
1008 "
Exercise 11.7
a) The price at time t ∈ [0, T ] of the European knock-out call option is given
by
EKOCt = e −(T −t)r E∗ (ST − K )+ 1{ST 6B} Ft , 0 6 t 6 T.

100
90
80
70
60
50
40
30
20
10
0
0 50 100 150 200
K x B
Fig. S.49: Payoff function of the European knock-out call option.
Using the relation

2
ST = St e (T −t)r +(BT −Bt )σ−(T −t)σ /2 , 0 6 t 6 T,
b b
we have
e −(T −t)r E∗ (ST − K )+ 1{ST 6B} Ft

2
= e −(T −t)r E∗ (x e (T −t)r + BT −Bt σ−(T −t)σ /2 − K )+
b b
i
×1 (T −t)r+(Bb −Bb )σ−(T −t)σ2 /2
{x e T t 6B} x=St
−(T −t)r ∗
− K ) 1{ e m(x)+X 6B} x=S ,
m(x)+X +
= e E (e 0 6 t 6 T,

t
where
σ2
m(x) : = (T − t)r − (T − t) + log x
2
and
bt σ ' N (0, (T − t)σ 2 )

X := B
bT − B
under P∗ . Next, as in Lemma 7.8 we note that if X is a centered Gaussian

random variable with variance v 2 > 0 and B > K, for any m ∈ R we have
E ( e m+X − K )+ 1{ e m+X 6B}

1 w∞
( e m+x − K )+ 1{ e m+x 6B} e −x /(2v ) dx
2 2
= √
2πv 2 −∞
" 1009
N. Privault
1 w −m+log B 2 / (2v 2 )
= √ ( e m+x − K ) e −x dx
2πv 2 −m+log K
em w −m+log B 2 / (2v 2 ) K w −m+log B 2 / (2v 2 )
= √ e x−x dx − √ e −x dx
e m+v /2 w −m+log B −(v2 −x)2 /(2v2 ) K w (−m+log B )/v −x2 /2

2
= √ e dx − √ e dx
2πv 2 −m+log K 2π (−m+log K )/v
e m+v /2 w −v2 −m+log B −y2 /(2v2 )
2
= √ e dy
2πv 2 −v2 −m+log K
−K Φ((m − log K )/v ) − Φ((m − log B )/v )

2
= e m+v /2 Φ(v + (m − log K )/v ) − Φ(v + (m − log B )/v )

−K Φ((m − log K )/v ) − Φ((m − log B )/v ) .

Hence, the price of the European knock-out call option is given, if B > K,
by
EKOCt = e −(T −t)r E∗ (ST − K )+ 1{ST 6B} Ft

m(St ) − log K m(St ) − log K

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

−(T −t)r
−Ke Φ −Φ
v v
(T − t)r + (T − t)σ 2 /2 + log(St /K )

= St Φ √
σ T −t
(T − t)r + (T − t)σ 2 /2 + log(St /B )

− St Φ √
σ T −t
(T − t)r − (T − t)σ 2 /2 + log(St /K )

−(T −t)r
−Ke Φ √
σ T −t
(T − t)r − (T − t)σ 2 /2 + log(St /B )

−(T −t)r
+Ke Φ √ ,
σ T −t
0 6 t 6 T , with EKOCt = 0 if B 6 K.
1010 "
16
14
12
10
8
6
4
2
0
120
90
80 80
Time to maturity (days) 40 70
60 Underlying
0 50
Fig. S.50: Price map of the European knock-out call option.
b) By computations similar to part (a) we find that, if B 6 K,
(T − t)r − (T − t)σ 2 /2 + log(St /B )

EKIPt = K e −(T −t)r Φ − √
σ T −t
(T − t)r + (T − t)σ 2 /2 + log(St /B )

−St Φ − √ .
σ T −t
160
140
120
100
80
60
40
20
0
0 50 100 150 200
B x K
Fig. S.51: Payoff function of the European knock-in put option.
When B > K, we find the Black-Scholes put option price
EKIPt = e −(T −t)r E∗ (K − ST )+ 1{ST 6B} Ft

= e −(T −t)r E∗ (K − ST )+ Ft

(T − t)r − (T − t)σ 2 /2 + log(St /K )

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

− St Φ − √ ,
σ T −t
0 6 t 6 T.
" 1011
N. Privault
35
30
25
20
15
10
5
500
60
70 80 120
Underlying 80 40
90 0 Time to maturity (days)
Fig. S.52: Price map of the European knock-in put option.
c) Using the in-out parity relation
EKOCt + EKICt = e −(T −t)r E∗ [(ST − K )+ | Ft ]

(T − t)r + (T − t)σ 2 /2 + log(St /K )

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

T −
−K e −(T −t)r Φ √ ,
σ T −t
which is the price of the European call put option with strike price K,
the price at time t ∈ [0, T ] of the European knock-in call option is given,
if B > K, as
EKICt = e −(T −t)r E∗ (ST − K )+ 1{ST >B} Ft

(T − t)r + (T − t)σ 2 /2 + log(St /B )

= St Φ √
σ T −t
(T − t)r − (T − t)σ 2 /2 + log(St /B )

−(T −t)r
−K e Φ √ ,
σ T −t
0 6 t 6 T.
160
140
120
100
80
60
40
20
0
0 50 100 150 200
K x B
Fig. S.53: Payoff function of the European knock-in call option.
When B 6 K, we find the Black-Scholes call option price

1012 "
EKICt = e −(T −t)r E∗ (ST − K )+ 1{ST >B} Ft

= e −(T −t)r E∗ (ST − K )+ Ft

(T − t)r + (T − t)σ 2 /2 + log(St /K )

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

−(T −t)r
−K e Φ √ .
σ T −t
30
25
20
15
10
5 90
0 80
120 70
80 60
Underlying
40
Time to maturity (days)
0 50
Fig. S.54: Price map of the European knock-in call option.
d) Using the in-out parity relation
EKOPt + EKIPt = e −(T −t)r E∗ [(K − ST )+ | Ft ],
which is the price of the European put option with strike price K, we find
that the price at time t ∈ [0, T ] of the European knock-in put option is
given, if B 6 K, as
EKOPt = e −(T −t)r E∗ (K − ST )+ 1{ST >B} Ft

= e −(T −t)r E∗ [(K − ST )+ | Ft ] − EKIPt

(T − t)r − (T − t)σ 2 /2 + log(St /K )

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

−St Φ − √
σ T −t
(T − t)r + (T − t)σ 2 /2 + log(St /B )

+St Φ − √
σ T −t
(T − t)r − (T − t)σ 2 /2 + log(St /B )

−(T −t)r
−K e Φ − √ .
σ T −t
" 1013
N. Privault
100
90
80
70
60
50
40
30
20
10
0
0 50 100 150 200
B x K
Fig. S.55: Payoff function of the European knock-out put option.
When B > K, we have
EKIPt = e −(T −t)r E∗ (K − ST )+ 1{ST >B} Ft = 0.

14
12
10
8
6
4
90
2
0 80
120 70
Underlying
80 60
40
Time to maturity (days)
0 50
Fig. S.56: Price map of the European knock-out put option.
In addition, by the results of Questions (d) and (c) we can verify the call-put
parity relation
EKICt − EKIPt = e −(T −t)r E∗ (ST − K )1{ST >B} Ft

(T − t)r + (T − t)σ 2 /2 + log(St /B )

= St Φ √
σ T −t
(T − t)r − (T − t)σ 2 /2 + log(St /B )

−(T −t)r
−K e Φ √ .
σ T −t
Chapter 12
Exercise 12.1
1014 "
a) This probability density function is given by
2 −(x−σT /2)2 /(2T )

r
−x − σT /2
x 7−→ e − σ e σx Φ √ , x > 0.
πT T
b) We have

2
E min St = S0 E min e σBt −σ t/2
t∈[0,T ] t∈[0,T ]
h i
= S0 E e −σ Maxt∈[0,T ] (Bt +σt/2)
w∞ r
2 −(x−σT /2)2 /(2T )

−x − σT /2
!
−σx
= S0 e e −σe Φ σx
√ dx
0 πT T
2S0 w ∞ −(x+σT /2)2 /(2T ) w∞
−x − σT /2
= √ e dx − S0 σ Φ √ dx
2πT 0 0 T
2S0 w ∞ 2 σS0 w ∞ 2
= √ e −x /(2T ) dx − √ x e −(x+σT /2) /(2T ) dx
2πT σT /2 2πT 0
2S0 w ∞ 2 σS0 w ∞ 2
= √ e −x /(2T ) dx − √ (x − σT /2) e −x /(2T ) dx
2πT σT /2 2πT σT /2
√
r
T −σ2 T /8
= 2S0 (1 + σ 2 T /4)Φ(−σ T /2) − S0 σ e . (A.54)
2π
0.9
0.8
0.7
0.6
price
0.5
0.4
0.3
0.2
0.1
0
0 10 20 30 40 50
time T
Fig. S.57: Expected minimum of geometric Brownian motion over [0, T ].
c) We have
" + #
E K − min St = E K − min St
t∈[0,T ] t∈[0,T ]
√ ! r !
σ2 T

σ T T −σ2 T /8
= K − S0 2 1 + Φ − −σ e .
4 2 2π
" 1015
N. Privault
2.0
Upper bound
1.5
Price
1.0 0.5
0.0
1.0 1.2 1.4 1.6 1.8 2.0

K
Fig. S.58: Black-Scholes put price upper bound with S0 = 1.
The derivative with respect to time is given by
σ2 √ σ2 T

∂ σ 2
E min St = S0 Φ − σ T /2 − 2S0 1 + e −σ T /8

√
∂T t∈[0,T ] 2 4 4 2πT
r
σS0 −σ2 T /8 S0 σ 3 T −σ2 T /8
−√ e + e
8πT 8 2π
√ !
S0 σ 2 3σ 2 T

T S0 σ −σ2 T /8
= Φ −σ −√ e 1+ .
2 2 2πT 4
-0.2
-0.4
derivative
-0.6
-0.8
-1
0 5 10 15 20 25 30 35 40 45 50
time T
Fig. S.59: Time derivative of the expected minimum of geometric Brownian motion.
On the other hand, when r > 0 we have

2r/σ2
σ 2 mt0
t
T −t St T −t m0
E∗ mT0 | Ft = mt0 Φ δ− Φ

− St δ −
mt0 2r St St

σ 2
St

(T −t)r T −t
+St e 1+ Φ −δ+ .
2r mt0
1016 "
When r tends to 0, this minimum tends to
log(St /mt0 ) − σ 2 T /2 log(St /mt0 ) + σ 2 T /2

mt0 Φ √ + St Φ − √
σ T σ T
t 2r/σ2 t !
1

S t m T −t m0
+σ 2 St lim e (T −t)r Φ −δ+ T −t
− 0
Φ δ − ,
r→0 2r mt0 St St
where
t 2r/σ2 t !
1

St m0 T −t m0
lim e (T −t)r Φ −δ+ T −t
− Φ δ −
r→0 2r mt0 St St
1 log(St /m0 ) + σ T /2 + rT
t 2

= lim (1 + (T − t)r ) Φ − √
r→0 2r σ T
2r mt log(mt0 /St ) − σ 2 T /2 + rT

− 1 + 2 log 0 Φ √
σ St σ T
1 2 mt0 log(St /mt0 ) + σ 2 T /2

= T − t + 2 log Φ − √
2 σ St σ T
w √
1 −(log(St /mt0 )+σ 2 T /2+rT )/(σ T ) −y 2 /2
+ lim √ e dy
r→0 r 8π −∞
w (− log(St /mt )−σ2 T /2+rT )/(σ√T ) 2

e −y /2 dy
0
−
−∞
1 2 mt log(St /mt0 ) + σ 2 T /2

= T − t + 2 log 0 Φ − √
2 σ St σ T
√
1 w (− log(St /mt0 )−σ2 T /2+rT )/(σ T ) −y2 /2
− lim √ √ e dy
r→0 r 8π (− log(St /m0 )−σ T /2−rT )/(σ T )
t 2
1 2 t log(St /m0 ) + σ T /2
t 2

m
= T − t + 2 log 0 Φ − √
2 σ St σ T
√ √
T t 2 2
− √ e −((log(St /m0 )+σ T /2)/(σ T )) /2 ,
σ 2π
hence
log(St /mt0 ) − σ 2 T /2 log(St /mt0 ) + σ 2 T /2

E∗ mT0 | Ft = mt0 Φ + St Φ −

√ √
σ T σ T
mt0 log(St /mt0 ) + σ 2 T /2

St
+ (T − t)σ + 2 log
2
Φ − √
2 St σ T
r
T −((log(St /mt )+σ2 T /2)/(σ√T ))2 /2
−σSt e 0 .
2π
In particular, when T tends to infinity we find that
" 1017
N. Privault
E∗ mT0 | Ft

lim = 0, r > 0.
T →∞ E∗ [ST | Ft ]
When t = 0 we have S0 = m00 , and we recover

√ ! r
σ2 T

∗ T T −σ2 T /8
E m0 = 2 S0 + Φ −σ e .
T
− σS0
4 2 2π
Exercise 12.2
a) By (A.54), we have
h i
E Max St = E e σ Maxt∈[0,T ] (Bt −σt/2)
t∈[0,T ]
h i
= S0 E e −(−σ ) Maxt∈[0,T ] (Bt −(−σ )t/2)
√
r
T −σ2 T /8
= 2S0 (1 + σ 2 T /4)Φ(σ T /2) + S0 σ e .
2π
1.9
1.8
1.7
1.6
1.5
price
1.4
1.3
1.2
1.1
1
0 0.1 0.2 0.3 0.4 0.5
time T
Fig. S.60: Expected maximum of geometric Brownian motion over [0, T ].
b) We have
" + #
2 t/2 2
E S0 Max e σBt −σ −K = E S0 Max e σBt −σ t/2 − K
t∈[0,T ] t∈[0,T ]
√ ! r
σ2 T

T T −σ2 T /8
= 2S0 1+ Φ σ + S0 σ e − K.
4 2 2π
1018 "
2.0
Upper bound
Black−Scholes call price
1.5
Price
1.0 0.5
0.0
0.0 0.2 0.4 0.6 0.8 1.0

K
Fig. S.61: Black-Scholes call price upper bound with S0 = 1.
The derivative with respect to time is given by

√ !
S0 σ 2 3σ 2 T

∂ T S0 σ −σ2 T /8
E Max St = Φ σ +√ e 1+ .
∂T t∈[0,T ] 2 2 2πT 4
10
6
derivative
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
time T
Fig. S.62: Time derivative of the expected maximum of geometric Brownian motion.
Note that when r > 0 we have

σ2

St St
E∗ M0T | Ft = M0t Φ −δ− T −t
+ St e (T −t)r 1 + T −t
Φ δ+

M0t 2r M0t
2 t 2r/σ2 t
σ M0 T −t M0
−St Φ −δ− .
2r St St
When r tends to 0, this maximum tends to
log(St /M0t ) − σ 2 T /2 log(St /M0t ) + σ 2 T /2

M0t Φ − √ + St Φ √
σ T σ T
" 1019
N. Privault
t 2r/σ2 t !
1

St M0 T −t M0
+σ 2 St lim e (T −t)r Φ δ+
T −t
− Φ −δ − ,
r→0 2r M0t St St
where
t 2r/σ2 t !
1

St M0 T −t M0
lim e (T −t)r Φ δ+
T −t
− Φ −δ −
r→0 2r M0t St St
  
2
1  log MSt
t + σ2 T + rT
= lim (1 + (T − t)r ) Φ  0
√
 
r→0 2r

σ T
2r Mt log(St /M0t ) + σ 2 T /2 − rT

− 1+ log 0 Φ √
σ2 St σ T
1 2 M0t log(St /M0t ) + σ 2 T /2

= T − t + 2 log Φ √
2 σ St σ T
w √
1 (log(St /M0t )+σ 2 T /2+rT )/(σ T ) −y 2 /2
+ lim √ e dy
r→0 r 8π −∞
√
w (log(St /M t )+σ2 T /2−rT )/(σ T )
2
e −y /2 dy
0
−
−∞
1 2 Mt log(St /M0t ) + σ 2 T /2

= T − t + 2 log 0 Φ √
2 σ St σ T
√
1 w (log(St /M0t )+σ2 T /2+rT )/(σ T ) −y2 /2
+ lim √ √ e dy
r→0 r 8π (log(St /M0t )+σ 2 T /2−rT )/(σ T )
1 2 t log(St /M0 ) + σ T /2
t 2

M
= T − t + 2 log 0 Φ √
2 σ St σ T
√ √
T t 2 2
+ √ e −((log(St /M0 )+σ T /2)/(σ T )) /2 ,
σ 2π
hence
log(St /M0t ) − σ 2 T /2 log(St /M0t ) + σ 2 T /2

E∗ M0T | Ft = M0t Φ − + St Φ

√ √
σ T σ T
M0t log(St /M0t ) + σ 2 T /2

St
+ (T − t)σ + 2 log
2
Φ √
2 St σ T
r
T −((log(St /M t )+σ2 T /2)/(σ√T ))2 /2
+σSt e 0 .
2π
In particular, when T tends to infinity we find that
1020 "
σ2

E∗ M0T | Ft
1 +
 if r > 0,
lim = 2r
T →∞ E∗ [ST | Ft ] 
if r = 0.

+∞
When t = 0 we have S0 = M00 , and we recover

√ ! r
σ2 T

∗ T T −σ2 T /8
E M0 = 2 S0 + Φ σ e .
T
+ σS0
4 2 2π
Exercise 12.3
a) We have
wa 2 / (2T ) dx
P min Bt 6 a = 2 e −x √ , a < 0,
t∈[0,T ] −∞ 2πT
i.e. the probability density function ϕ of Sup Bt is given by

t∈[0,T ]
2 −a2 /(2T )
r
ϕ(a) = e 1(−∞,0] (a), a ∈ R.
πT
b) We have

E min St = S0 E exp σ min Bt
t∈[0,T ] t∈[0,T ]
2S0 w 0 2 2S0 w 0 2 2
= √ e σx−x /(2T ) dx = √ e −(x−σT ) /(2T )+σ T /2 dx
2πT −∞ 2πσ 2 T −∞
2S0 σ2 T /2 w −σT −x2 /(2T ) 2S0 2 w −σ√T 2
= √ e e dx = √ e σ T /2 e −x /2 dx
2πT −∞ 2π −∞
2 √ √
= 2S0 e σ T /2 Φ − σ T = 2E[ST ] 1 − Φ σ T ,
hence
√
E ST − min St = E[ST ] − E min St = E[ST ] − 2E[ST ] 1 − Φ σ T
t∈[0,T ] t∈[0,T ]
√
2
√ 1
= E[ST ] 2Φ σ T − 1 = 2S0 e σ T /2 Φ σ T − ,
2
and
2 T /2
√ √
e −σ E ST − min St = S0 2Φ σ T − 1 = S0 1 − 2Φ − σ T .
t∈[0,T ]
" 1021
N. Privault
Remark: We note that the price of the lookback option converges to S0

as T goes to infinity.
1
2 (Φ(σT1/2)-1)
0.8
0.6
Price
0.4
0.2
0
0 1 2 3 4 5
Time T
Fig. S.63: Lookback call option price as a function of T with S0 = 1.

h i
E∗ e −rτ 1{τ 6T } 1{M τ −Sτ >K}
0
wT w∞w∞
= e −rt f(τ ,Sτ ,Mτ ) (t, x, y )dydxdt
1 0 K +x
w T w ∞ w y−K
= e −rt f(τ ,Sτ ,Mτ ) (t, x, y )dxdydt
1 K 0
h i
for T > 1, and E∗ e −rτ 1{τ 6T } 1{M τ −Sτ >K} = 0 if T ∈ [0, 1].
0
Exercise 12.5
a) i) The boundary condition (12.3a) is explained by the fact that
f (t, 0, y ) = e −(T −t)r E∗ M0T − ST St = 0, M0t = y

= e −(T −t)r E∗ M0t − ST St = 0, M0t = y

= e −(T −t)r E∗ M0t M0t = y − e −(T −t)r E∗ [ST | St = 0]

= y e −(T −t)r ,
since E∗ [ST | St = 0] = 0 as St = 0 implies ST = 0 from the relation

2 /2)(T −t)
ST = St e σ (BT −Bt )+(µ−σ , 0 6 t 6 T.
ii) The boundary condition (12.3b), i.e.
∂f
(t, x, y )y =x = 0, 0 6 x 6 y,
∂y
1022 "
is illustrated in the following Figure S.64, see also Figure 12.3.
80
Lookback put price
60
40
20
0
40 St= 60 80
t
y=M0
Fig. S.64: Graph of the lookback put option price (2D) with St = 60.
iii) Condition (12.3c) follows from the fact that
f (T , x, y ) = E∗ M0T − ST ST = x, M0T = y = y − x.

b) i) The boundary condition (12.14a) is explained by the fact that
f (t, x, 0) = e −(T −t)r E∗ ST − mT0 St = x, mt0 = 0

= e −(T −t)r E∗ ST St = x, mt0 = 0

= e −(T −t)r E∗ [ST | St = x]

= e −(T −t)r x, x > 0.
ii) Condition (12.14b) follows from the fact that
f (T , x, y ) = E∗ ST − mT0 ST = x, mT0 = y = x − y.

We have
f (t, x, x) = xC (T − t),
with
C (τ ) = 1 − e −rτ Φ δ−τ
(1)

σ2 σ2

− 1+ Φ − δ+ τ
(1) + e −rτ Φ δ−
τ
(1) , τ > 0,

2r 2r
hence
∂f
(t, x, x) = C (T − t), 0 6 t 6 T,
∂x
while we also have
" 1023
N. Privault
∂f
(t, x, y )y =x = 0, 0 6 x 6 y,
∂y
see also Figure 12.8.
Chapter 13
w w
T T
E St dt = E[St ]dt
τ τ
wT 2 t/2
= S0 E[ e σBt +rt−σ ]dt
τ
wT
rt−σ 2 t/2
= S0 e E[ e σBt ]dt
τ
wT
= S0 e rt dt
τ
e rT − e rτ
= S0 , 0 6 τ 6 T,
r
and
wT w wT
" 2 #
T
E St dt =E St dt Su du
τ τ τ
w wT
T
=E Su St dtdu
τ τ
wT wu
=2 E[Su St ]dtdu
τ τ
wT wu 2 2
= 2S02 E[ e σBu +ru−σ u/2 e σBt +rt−σ t/2 ]dtdu
τ τ
wT wu 2 2
= 2S02 e ru−σ u/2+rt−σ t/2 E[ e σBu +σBt ]dtdu
τ τ
wT 2
w u (r−σ 2 /2)t
= 2S02 e (r−σ /2)u e E[ e σBu +σBt ]dtdu
τ τ
wT 2
w u 2
= 2S02 e (r−σ /2)u e (r−σ /2)t E[ e 2σBt +σ (Bu −Bt ) ]dtdu
τ τ
wT 2
w u (r−σ 2 /2)t
= 2S02 e (r−σ /2)u e E[ e 2σBt ]E[ e σ (Bu −Bt ) ]dtdu
τ τ
wT 2
w u 2 2 2
= 2S02 e (r−σ /2)u e (r−σ /2)t e 2σ t e σ (u−t)/2 dtdu
τ τ
wT wu 2
= 2S02 e ru e rt+σ t dtdu
τ τ
2S02 w T (2r +σ2 )u 2
= e − e ru e (r +σ )τ du
σ2 + r τ
1024 "
2 +2r )T 2 2 +2r )τ
r e (σ − (σ 2 + 2r ) e rT +(σ +r )τ + (σ 2 + r ) e (σ
= 2S02 , 0 6 τ 6 T.
(σ 2 + r )(σ 2 + 2r )r
Exercise 13.2
rT
a) The integral 0 rs ds has a centered Gaussian distribution with variance
wT w w
" 2 #
T T
E rs ds = σ2 E Bs Bt dsdt
0 0 0
wT wT
=σ 2
E[Bs Bt ]dsdt
0 0
wT wT
= σ2 min(s, t)dsdt
0 0
wT wt
= 2σ 2
sdsdt
0 0
wT
= σ2 t2 dt
0
σ2
= T3 .
3
rT
b) Since the integral 0 rs ds is a random variable with probability density
1 2 3
ϕ(x) = √ e −3x /(2πT ) ,
2πT 3 /3
we have
wT w∞
" + #
e −rT E ru du − κ = e −rT (x − κ)+ ϕ(x)dx
0 −∞
e −rT w∞ 2 2 3
= √ (x − κ) e −3x /(2σ T ) dx
2πσ 2 T 3 /3 κ
e −rT w ∞ p 2
= √ √ (x σ 2 T 3 /3 − κ) e −x /2 dx
2π κ/ σ 2 T 3 /3
√
e −rT σ 2 T 3 /3 w ∞ 2 e −rT w ∞ 2
= √ √ x e −x /2 dx − κ √ √ e −x /2 dx
2π κ/ σ 2 T 3 /3 2π κ/ σ2 T 3 /3
√
e −rT σ 2 T 3 /3 h −x2 /2 i∞ e −rT p
= − √ e √ − κ √ (1 − Φ(κ/ σ 2 T 3 /3))
2π 2
κ/ σ T /3 3
2π
√
e −rT σ 2 T 3 /3 −3κ2 /(2σ2 T 3 ) e −rT p
= √ e − κ √ (1 − Φ(κ/ σ 2 T 3 /3))
2π 2π
r !
e −rT 3
r
−rT σ 2 T 3 −3κ2 /(2σ2 T 3 )
= e e − κ √ Φ −κ .
6π 2π σ2 T 3
" 1025
N. Privault
1 wT
" + # w
1 T
e −(T −t)r E Su du − κ Ft = e −(T −t)r E Su du − κ Ft

T 0 T 0
w
1 T
= e −(T −t)r E Su du Ft − κ e −(T −t)r

T 0
w w
1 t 1 T
= e −(T −t)r E Su du Ft + e −(T −t)r E Su du Ft − κ e −(T −t)r

T 0 T t
1 wt 1 wT

= e −(T −t)r Su du + e −(T −t)r E Su du Ft − κ e −(T −t)r

T 0 T t
1 wt 1 wT
= e −(T −t)r Su du + e −(T −t)r E[Su | Ft ]du − κ e −(T −t)r
T 0 T t
1 wt 1 wT
= e −(T −t)r Su du + e −(T −t)r St e (u−t)r du − κ e −(T −t)r
T 0 T t
1 wt St w T −t ru
= e −(T −t)r Su du + e −(T −t)r e du − κ e −(T −t)r
T 0 T 0
w
1 t St (T −t)r
= e −(T −t)r Su du + e −(T −t)r (e − 1) − κ e −(T −t)r
T 0 rT
1 wt 1 − e −(T −t)r
= e −(T −t)r Su du + St − κ e −(T −t)r ,
T 0 rT
t ∈ [0, T ], cf. Geman and Yor (1993) page 361. We check that the function
f (t, x, y ) = e −(T −t)r (y/T − κ) + x(1 − e −(T −t)r )/(rT ) satisfies the PDE
∂f ∂f ∂f 1 ∂2f
rf (t, x, y ) = (t, x, y ) + x (t, x, y ) + rx (t, x, y ) + x2 σ 2 2 (t, x, y ),
∂t ∂y ∂x 2 ∂x
t, x > 0, and the boundary conditions f (t, 0, y ) = e −(T −t)r (y/T − κ),
0 6 t 6 T , y ∈ R+ , and f (T , x, y ) = y/T − κ, x, y ∈ R+ . However, the
condition limy→−∞ f (t, x, y ) = 0 is not satisfied because we need to take
y > 0 in the above calculation.
Exercise 13.4
a) We have
w wT
T
e −(T −t)r E∗ Ss ds − K Ft = e −(T −t)r E∗ [Ss | Ft ]ds − K e −(T −t)r

0 0
wt wT
−(T −t)r −(T −t)r
= e ∗
E [Ss | Ft ]ds + e E∗ [Ss | Ft ]ds − K e −(T −t)r
0 t
wt wT
= e −(T −t)r Ss ds + e −(T −t)r e (t−s)r St ds − K e −(T −t)r
0 t
wt wT
= e −(T −t)r Ss ds + St e −rT e rs ds − K e −(T −t)r
0 t
1026 "
wt 1 − e −(T −t)r
= e −(T −t)r Ss ds + St − K e −(T −t)r .
0 r
b) Any self-financing portfolio strategy (ξt )t∈R+ with price process (Vt )t∈R+
has to satisfy the equation

t ∈ R+ . On the other hand, by part (a) we have
wt
!
−(T −t)r 1 − e −(T −t)r
dVt = d e Ss ds + St − K e −(T −t)r
0 r
wt
−(T −t)r
= re Ss dsdt + e −(T −t)r St dt − St e −(T −t)r dt
0
1− e − ( T −t ) r
+ dSt − rK e −(T −t)r dt
r
wt 1 − e −(T −t)r
= r e −(T −t)r Ss dsdt + dSt − rK e −(T −t)r dt
0 r
1 − e −(T −t)r
= rVt dt + dSt − St (1 − e −(T −t)r )dt
r
1 − e −(T −t)r
= rVt dt + ((µ − r )St dt + σSt dBt ),
r
hence
1 − e −(T −t)r
ξt = , t ∈ [0, T ],
r
and
wt
Vt = e −(T −t)r Ss ds + ξt St − K e −(T −t)r , t ∈ [0, T ].
0
Exercise 13.5 The geometric mean price G satisfies

w w
1 T 1 t 1 wT

G = exp log Su du = exp log Su du + log Su du
T 0 T 0 T t
w
1 t 1 wT

T −t Su
= exp log Su du + log St + log du
T 0 T T t St
w
1 t T −t
= exp log Su du + log St
T 0 T
1 wT

+ (r (u − t) + (Bu − Bt )σ − (u − t)σ 2 /2)du
T t
" 1027
N. Privault
1 wt

T −t
= exp log Su du + log St
T 0 T
1 w T −t σ wT

+ (ru − σ 2 u/2)du + (Bu − Bt )du
T 0 T t
w
1 (T − t)2 σ wT

t
= (St )(T −t)/T exp log Su du + (r − σ 2 /2) + (Bu − Bt )du
T 0 2T T t
wT
where Bu du is centered Gaussian with conditional variance
t
wT wT
" 2 # " 2 #
E Ft = E

Bu du (Bu − Bt )du Ft
t t
wT
" # 2
=E (Bu − Bt )du
t
w T −t 2 # w
T −t w T −t
"
=E (Bu − Bt )du = E [Bs Bu ] dsdu
0 0 0
w T −t w u w T −t (T − t)3
=2 sdsdu = u2 du = .
0 0 0 3
Hence, letting
1 wt T −t (T − t)2 σ wT
m := log Su du + log St + (r − σ 2 /2), X := Bu du,
T 0 T 2T T t
and v 2 = (T − t)σ 2 /3, we find
" w + #
1 T

−(T −t)r ∗
e E exp log Su du − K Ft

T 0
w
1 t (T − t)2 σ2

= (St )(T −t)/T e −(T −t)r exp log Su du + (2r − σ 2 ) + (T − t)
T 0 4T 6
 r t S
(T −t)/T
( T −t ) 2

(T − t)σ 2 /3 + T1 0 log Su du + log t K + 2T (r − σ 2 /2)
×Φ  p 
σ (T − t)/3
 r (T −t)/T 
St −t)2
1 t
−(T −t)r  T 0 log Su du + log + (T2T (r − σ 2 /2)
−K e Φ p K ,
σ (T − t)/3
0 6 t 6 T . In case t = 0, we get
" w + #
1 T

e −rT E∗ exp log Su du − K
T 0
1028 "
! !
2 /6) /2 log SK0 + T
(r + σ 2 /6) log SK0 + T
(r − σ 2 /2)
= S0 e −T (r +σ Φ √2 − K e −rT Φ √2 .
σ T /3 σ T /3
Exercise 13.6 Under the above condition we have, taking t ∈ [τ , T ],
1 wT
" + #
−(T −t)r ∗
e E

rs ds − K Ft
T −τ τ
1 wT
" + #
= e −(T −t)r E∗ Λt +

rs ds − K Ft
T −τ t

1 w T

= e −(T −t)r E∗ Λt +

rs ds − K Ft
T −τ t
e −(T −t)r ∗ w T

= e −(T −t)r (Λt − K ) + E

rs ds Ft
T −τ t
e −(T −t)r w T ∗
= e −(T −t)r (Λt − K ) + E [rs | Ft ]ds, t ∈ [τ , T ],
T −τ t
where
E∗ [rs | Ft ] = vt e −(s−t)λ + m(1 − e −(s−t)λ ), 0 6 s 6 t,
hence
1 wT 1 wT
" + # " + #
E∗ Ft = E∗ Λ

rs ds − K t + rs ds − K Ft
T −τ τ T −τ t
1 w T
= Λt − K + E∗ [rs | Ft ]ds
T −τ t
1 wT
= Λt − K + rt e −(s−t)λ + m(1 − e −(s−t)λ ) ds

T −τ t
1 w T −t e −(T −t)r
= Λt − K + (rt − m) e −λs ds + m(T − t)
T −τ 0 T −τ
1 w T −t −λs T −t
= Λt − K + (rt − m) e ds + m
T −τ 0 T −τ
1− e − ( T −t ) λ T −t
= Λt − K + (rt − m) + m .
(T − τ )λ T −τ
Exercise 13.7 This question extends Exercise 7.4 to n > 3. If (St )t∈R+ is a
martingale then for any convex payoff function φ we can write
h S + · · · + S i
T1 Tn φ(S ) + · · · + φ(S )
T1 Tn
E∗ φ 6 E∗ since φ is convex,
n n
" 1029
N. Privault
E∗ [φ(ST1 )] + · · · + E∗ [φ(STn )]
=
n
E∗ [φ(E∗ [STn | FT1 ])] + · · · + E∗ [φ(E∗ [STn | FTn ])]
= because (St )t∈R+ is a martingale,
n
E∗ [E∗ [φ(STn ) | FT1 ]] + · · · + E∗ [E∗ [φ(STn ) | FTn ]]
6 by Jensen’s inequality,
n
E∗ [φ(STn )] + · · · + E∗ [φ(STn )]
= by the tower property,
n
= E∗ [φ(STn )].
On the other hand, if (St )t∈R+ is only a submartingale then the above ar-
gument still applies to a convex non-decreasing payoff function φ such as
φ(x) = (x − K ) + .
Exercise 13.8 Taking t ∈ [τ , T ], under the condition

1 wt
Λt : = Ss ds > K,
T −τ τ
we have
1 wT
" + #
e −(T −t)r E∗

Ss ds − K Ft
T −τ τ
1 wT
" + #
= e −(T −t)r E∗ Λt +

Ss ds − K Ft
T −τ t

1 w T

= e −(T −t)r E∗ Λt +

Ss ds − K Ft
T −τ t
e −(T −t)r ∗ w T

= e −(T −t)r (Λt − K ) + E

Ss ds Ft
T −τ t
e −(T −t)r w T ∗
= e −(T −t)r (Λt − K ) + E [Ss | Ft ]ds
T −τ t
e − ( T −t ) r w T (s−t)r
= e −(T −t)r (Λt − K ) + St e ds
T −τ t
e −(T −t)r w T −t rs
= e −(T −t)r (Λt − K ) + St e ds
T −τ 0
e − ( T −t ) r
= e −(T −t)r (Λt − K ) + St ( e (T −t)r − 1)
(T − τ )r
1 − e −(T −t)r
= e −(T −t)r (Λt − K ) + St , t ∈ [τ , T ].
(T − τ )r
Exercise 13.9 The Asian option price can be written as
1030 "
1 wT
" + #
e −r (T −t) E∗ b (UT )+ | Ut
Ft = St E

Su du − K
T 0
= St h(t, Ut ) = St g (t, Zt ),
which shows that

g (t, Zt ) = h(t, Ut ),
and it remains to use the relation
1 − e −(T −t)r
Ut = + e −(T −t)r Zt , t ∈ [0, T ].
rT
Exercise 13.10
i) By change of variable. We note that Zet = e −(T −t)r Zt , where
1 1 wt 1 Λt

Zt : = Su du − K = −K , 0 6 t 6 T,
St T 0 St T
and the pricing function g (t, Zt ) satisfies the Rogers-Shi PDE
1 1 ∂2g

∂g ∂g
(t, z ) + − rz (t, z ) + σ 2 z 2 2 (t, z ) = 0.
∂t T ∂z 2 ∂z
Letting ze := e −(T −t)r z and ge(t, ze) := g t, e (T −t)r ze = g (t, z ) =

ge t, e − ( T −t ) r z , we note that

∂g ∂

(t, z ) = ge t, e −(T −t)r z





 ∂t ∂t



∂eg ∂e
g

t, e −(T −t)r z + r e −(T −t)r z t, e −(T −t)r z

=





 ∂t ∂x



∂eg ∂eg

= z (t, ze),
(t, ze) + re

 ∂t ∂x



 ∂g ∂e
g ∂eg
(t, z ) = e −(T −t)r t, e −(T −t)r z = e −(T −t)r (t, ze),



∂z ∂e
z ∂ez







 2 2 2
 ∂ g (t, z ) = e −2(T −t)r ∂ ge t, e −(T −t)r z = e −2(T −t)r ∂ ge (t, ze),


∂z 2 ∂e
z 2 z2
∂e
hence
1 1 ∂2g

∂g ∂g
0= (t, z ) + − rz (t, z ) + σ 2 z 2 2 (t, z )
∂t T ∂z 2 ∂z
" 1031
N. Privault
1

∂e
g ∂e
g ∂e
g
= (t, ze) + re
z (t, ze) + − rz e −(T −t)r (t, ze)
∂t ∂x T ∂e
z
1 ∂ 2 ge
+ σ 2 z 2 e −2(T −t)r 2 (t, ze)
2 ∂ez
∂e
g 1 −(T −t)r ∂e g 1 ∂ 2 ge
= (t, ze) + e (t, ze) + σ 2 ze2 2 (t, ze),
∂t T ∂e
z 2 ∂ez
and the (simpler) PDE
∂e
g 1 ∂e
g 1 ∂ 2 ge
(t, ze) + e −(T −t)r (t, ze) + σ 2 ze2 2 (t, ze) = 0.
∂t T ∂e
z 2 ∂ez
ii) Using the Itô formula. Given that
et = d( e −(T −t)r Zt )
dZ
= r e −(T −t)r Zt dt + e −(T −t)r dZt
= rZet dt + e −(T −t)r dZt ,
and
under the risk-neutral probability measure P∗ , an application of Itô’s
formula to the discounted portfolio price leads to
d e −rt St ge t, Zet

= e −rt − re

g t, Zet dt + ge t, Z et dSt + St de g t, Zet + dSt • de g t, Z
et

∂e
g ∂eg
= e −rt −rSt ge t, Zet dt + ge t, Zet dSt + St

t, Zet dt + St t, Z
et dZet
∂t ∂z
1 −rt ∂ 2 ge

2
+ e

St 2 t, Zet dZet + dSt • de g t, Zet
2 ∂z

∂e
g
= e −rt −rSt ge t, Zet dt + ge t, Zet dSt + St

t, Zet dt
∂t

∂eg et dt + St e −(T −t)r ∂e
g
+rZet St t, Z t, Zet dZt
∂z ∂z
1 −rt ∂ 2 ge

+ e

St 2 t, Zt dZt + dSt • de
e e g t, Zet
2 ∂z

= e −rt et dBt + rZet St ∂e g

−rSt ge t, Zet dt + rSt ge t, Zet dt + σSt ge t, Z t, Zet dt
∂z

2 ∂e
−rt −(T −t)r
g
+e e

St Zt −r + σ t, Zt dt
e
∂z
1

∂e g ∂eg
+ e −(T −t)r St t, Zet dt − σ e −(T −t)r St Zt

t, Zet dBt
T ∂z ∂z
1032 "
1 2 e2 ∂ 2 ge

+ e −rt et dt − σ 2 St Zet ∂eg

σ Zt St 2 t, Z t, Zet dt
2 ∂z ∂z
1 −(T −t)r ∂e 1 2

−rt ∂eg g et2 ∂ ge t, Zet dt
= e St et + e t, Zet + σ 2 Z

t, Z
∂t T ∂z 2 ∂z 2

∂eg
+St e −rt σe t, Zet dBt .

g t, Zet − σ Zet
∂z
Since the discounted portfolio price process is a martingale under the

risk-neutral probability measure P∗ , the sum of components in dt should
vanish in the above expression, which yields
∂e
g 1 ∂e
g 1 2
t, Zet + e −(T −t)r et2 ∂ ge t, Zet = 0,
t, Zet + σ 2 Z

∂t T ∂z 2 ∂z 2
and the PDE
∂e
g 1 ∂e
g 1 ∂ 2 ge
(t, ze) + e −(T −t)r (t, ze) + σ 2 ze2 2 (t, ze) = 0,
∂t T ∂e
z 2 ∂ez
under the terminal condition ge(T , ze) = ze+ , ze ∈ R.
Exercise 13.11
a) When Λt /T > K we have
Λt 1 − e −(T −t)r

f (t, St , Λt ) = e −(T −t)r −K + St ,
T rT
see Exercise 13.8.

b) When Λt /T > K we have
1 − e −(T −t)r Λt

ξt = and ηt At = e (T −t)r −K , 0 6 t 6 T.
rT T
c) At maturity we have f (T , ST , ΛT ) = (ΛT /T − K )+ , hence ξT = 0 and

+
e −rT ΛT ΛT

ηT AT = AT −K 1{ΛT >KT } = −K .
A0 T T
d) By Proposition 13.11 we have
1 Λt 1 Λt

∂g
ξt = f (t, St , Λt ) − −K t, −K
St T ∂z St T
where the function g (t, z ) satisfies f (t, x, y ) = xg (t, (y/T − K )/x)) and
" 1033
N. Privault
1 − e −(T −t)r
g (t, z ) = z e −(T −t)r + , z > 0,
rT
and solves the PDE
1 1 ∂2g

∂g ∂g
(t, z ) + − rz (t, z ) + σ 2 z 2 2 (t, z ) = 0,
∂t T ∂z 2 ∂z
under the terminal condition g (T , z ) = z + , hence letting
∂g
h(t, z ) := e (T −t)r (t, z ),
∂z
we have
1 1 ∂2g

∂g ∂g
e (T −t)r (t, z ) + e (T −t)r − rz (t, z ) + σ 2 z 2 2 (t, z ) = 0,
∂t T ∂z 2 ∂z
with h(t, z ) = 1, z > 0, hence
∂2g 1 ∂2g

∂g
e (T −t)r (t, z ) − r e (T −t)r (t, z ) + e (T −t)r − rz (t, z )
∂t∂z ∂z T ∂z 2
∂2g 1 ∂3g
+σ 2 z e (T −t)r (t, z ) + e (T −t)r σ 2 z 2 3 (t, z ) = 0,
∂z 2 2 ∂z
or
1 1 ∂2h

∂h ∂h
(t, z ) + + (σ 2 − r )z (t, z ) + σ 2 z 2 2 (t, z ) = 0,
∂t T ∂z 2 ∂z
with the terminal condition h(T , z ) = 1{z>0} . On the other hand, we have
1
ηt = (f (t, St , Λt ) − ξt St )
At
1 Λt 1 Λt

∂g
= −K t, −K
At T ∂z St T
e −(T −t)r Λt 1 Λt

= − K h t, −K .
At T St T
Exercise 13.12 Asian options with dividends. When reinvesting dividends,

the portfolio self-financing condition reads
dVt = ηt dAt + ξt dSt + δξ S dt

| {z } | t{zt }
Trading profit and loss Dividend payout
= rηt At dt + ξt ((µ − δ )St dt + σSt dBt ) + δξt St dt
= rηt At dt + ξt (µSt dt + σSt dBt )
1034 "
= rVt dt + (µ − r )ξt St dt + σξt St dBt , t ∈ R+ .
On the other hand, by Itô’s formula we have
dgδ (t, St , Λt )
∂g ∂g ∂g
= δ (t, St , Λt )dt + δ (t, St , Λt )dΛt + (µ − δ )St δ (t, St , Λt )dt
∂t ∂y ∂x
1 2 2 ∂ 2 gδ ∂gδ
+ σ St (t, St , Λt )dt + σSt (t, St , Λt )dBt
2 ∂x2 ∂x
∂gδ ∂gδ ∂g
= (t, St , Λt )dt + St (t, St , Λt )dt + (µ − δ )St δ (t, St , Λt )dt
∂t ∂y ∂x
1 2 2 ∂ 2 gδ ∂gδ
+ σ St (t, St , Λt )dt + σSt (t, St , Λt )dBt ,
2 ∂x2 ∂x
hence by identification of the terms in dBt and dt in the expressions of dVt
and dgδ (t, St ), we get
∂g
ξt = δ (t, St , Λt ),
∂x
and we derive the Black-Scholes PDE with dividend
∂gδ ∂g
rgδ (t, x, y ) = (t, x, y ) + y δ (t, x, y ) (A.55)
∂t ∂y
∂gδ 1 ∂2g
+(r − δ )x (t, x, y ) + σ 2 x2 2δ (t, x, y ).
∂x 2 ∂x
Defining f (t, x, y ) := e (T −t)δ gδ (t, x, y ) and substituting
gδ (t, x, y ) = e (T −t)δ f (t, x, y )
in (A.55) yields the equation
∂f ∂f
rf (t, x, y ) = δf (t, x, y ) + y(t, x, y ) + (t, x, y )
∂y ∂t
∂f 1 ∂2f
+(r − δ )x (t, x, y ) + σ 2 x2 2 (t, x, y ),
∂x 2 ∂x
i.e.
∂f ∂f
(r − δ )f (t, x, y ) = (t, x, y ) + y (t, x, y )
∂t ∂y
∂f 1 ∂2f
+(r − δ )x (t, x, y ) + σ 2 x2 2 (t, x, y ),
∂x 2 ∂x
whose solution f (t, x, y ) is the Asian option pricing function with modified
interest rate r − δ and no dividends, under the terminal condition
" 1035
N. Privault
y +
f (T , x, y ) = gδ (T , x, y ) = −K .
T
Therefore the Asian option price gδ (t, St , Λt ) with dividend rate δ can be
recovered from the relation
gδ (t, x, y ) = e (T −t)δ f (t, x, y ), t ∈ [0, T ], x, y > 0.
Note that we can also define
h(t, x, y ) := gδ t, x e −δ (T −t) , y

and substituting
gδ (t, x, y ) = h t, x e δ (T −t) , y

in (A.55) yields the equation
∂h ∂h
rh(t, x, y ) = y (t, x, y ) + (t, x, y )
∂y ∂t
∂h 1 ∂2h
+rx (t, x, y ) + σ 2 x2 2 (t, x, y ),
∂x 2 ∂x
whose solution h(t, x, y ) is the Asian option pricing function with interest
rate r and no dividends, under the terminal condition
y +
h(T , x, y ) = gδ (T , x, y ) = −K .
T
Finally, the Asian option price gδ (t, St , Λt ) with dividend rate δ can be also
recovered from the relation
gδ (t, x, y ) = h t, x e −(T −t)δ , y , t ∈ [0, T ], x, y > 0.

Chapter 14
Exercise 14.1
a) The process ((2 − Bt )+ )t∈R+ is a convex function x 7−→ (2 − x)+ of the
Brownian martingale (Bt )t∈R+ , hence it is a submartingale by Proposi-
tion 14.4-(a).
b) The process e Bt can be written as
2 t/2+µt 2 t/2
e σBt −σ = e µt e σBt −σ , t ∈ R+ ,
with σ = 1 and µ = σ 2 /2 > 0, hence it is a submartingale as the geometric

2
Brownian motion e σBt −σ t/2 is a martingale.
1036 "
c) When t > 0, the question “is ν > t?” cannot be answered at time t
without waiting to know the value of B2t at time 2t > t. Therefore ν is
not a stopping time.
d) For any t ∈ R+ , the question “is τ > t?” can be answered based on the
observation of the paths of (Bs )06s6t and of the (deterministic) curve
( e s/2 + αs e s/2 )06s6t up to the time t. Therefore τ is a stopping time.
e) Since τ is a stopping time and e Bt −t/2 t∈R is a martingale, the Stopping
+
Time Theorem 14.7 shows that e Bt∧τ −(t∧τ )/2 t∈R is also a martingale

+
and, in particular, its expected value∗
E e Bt∧τ −(t∧τ )/2 = E e B0∧τ −(0∧τ )/2 = E e B0 −0/2 = 1

is constantly equal to 1 for all t > 0. This shows that

h i
E e Bτ −τ /2 = E lim e Bt∧τ −(t∧τ )/2

t→∞
= lim E e Bt∧τ −(t∧τ )/2

t→∞
= 1.
Next, we note that e Bτ = (α + βτ ) e τ /2 at time τ , hence α + βτ =

e Bτ −τ /2 and
α + βE[τ ] = E[α + βτ ] = E e Bτ −τ /2 = 1,

i.e. E[τ ] = (1 − α)/β.

Remark: This argument also recovers E[τ ] = 0 when α = 1, however it
fails when (α > 1 and β > 0) and when (α < 1 and β < 0), because τ is
not a.s. finite (P(τ < ∞) < 1) in those cases.
Exercise 14.2 Stopping times.

a) When 0 6 t < 1 the question “is ν > t?” cannot be answered at time t
without waiting to know the value of B1 at time 1. Therefore ν is not a
stopping time.
b) For any t ∈ R+ , the question “is τ > t?” can be answered based on the
observation
of the paths of (Bs )06s6t and of the (deterministic) curve
α e −s/2 06s6t up to the time t. Therefore τ is a stopping time.
Since τ is a stopping time and (Bt )t∈R+ is a martingale, the Stopping
Time Theorem 14.7 shows that e Bt∧τ −(t∧τ )/2 t∈R is also a martingale

+
and in particular its expected value
E e Bt∧τ −(t∧τ )/2 = E e B0∧τ −(0∧τ )/2 = E e B0 −0/2 = 1

∗
We let t ∧ τ := min(t, τ ).
" 1037
N. Privault
is constantly equal to 1 for all t. This shows that

h i
E e Bτ −τ /2 = E lim e Bτ ∧t −(τ ∧t)/2 = lim E e Bτ ∧t −(τ ∧t)/2 = 1.

t→∞ t→∞
Next, we note that we have e Bτ = α e −τ /2 at time τ , hence
−τ 1
αE e = E e Bτ −τ /2 = 1, i.e. E e −τ = 6 1.

α
Remark: note that this argument fails when α < 1 because in that case τ
is not a.s. finite.
c) For any t ∈ R+ , the question “is τ > t?” can be answered based on the
observation of the paths of (Bs )06s6t and of the (deterministic) curve
(1 + αs)06s6t up to the time t. Therefore τ is a stopping time.
Since τ is a stopping time and (Bt )t∈R+ is a martingale, the Stopping

Time Theorem 14.7 shows that (Bt∧τ 2 − (t ∧ τ ))
t∈R+ is also a martingale
and in particular its expected value
E[Bt∧τ
2
− (t ∧ τ )] = E[B0∧τ
2
− (0 ∧ τ )] = E[B02 − 0] = 0
is constantly equal to 0 for all t. This shows that

h i
E[Bτ2 − τ ] = E lim (Bt∧τ
2
− (t ∧ τ )) = lim E (Bt∧τ − (t ∧ τ )) = 0.
2
t→∞ t→∞
Next, we note that Bτ2 = 1 + ατ at time τ , hence
1 + αE[τ ] = E[1 + ατ ] = E[Bτ2 ] − E[τ ] = 0,
i.e.
1
E[τ ] =
.
1−α
Remark: Note that this argument is valid whenever α 6 1 and yields
E[τ ] = +∞ when α = 1, however it fails when α > 1 because in that case
τ is not a.s. finite.
Exercise 14.3
a) By the Stopping Time Theorem 14.7, for all n > 0 we have
h √ i
1 = E e 2rBτL ∧n −r (τL ∧n)
h √ i h √ i
= E e 2rBτL ∧n −r (τL ∧n) 1{τL <n} + E e 2rBτL ∧n −r (τL ∧n) 1{τL >n}
h √ i h √ i
= E e 2rBτL −rτL 1{τL <n} + E e 2rBn −rn 1{τL >n}
1038 "
√ h √ i
= eL 2r
E e −rτL 1{τL <n} + E e 2rBn −rn 1{τL >n} .

The first term above converges to

√ √
eL 2r
E e −rτL 1{τL <∞} = e L 2r E e −rτL

as n tends to infinity, by dominated or monotone convergence and the fact

that r > 0. The second term can be bounded as
h √ i h √ i √
0 6 E e 2rBn −rn 1{τL >n} 6 e −rn E e L 2r 1{τL >n} 6 e −rn e L 2r ,
which tends to 0 as n tends to infinity because r > 0. Therefore we have

h √ i √
1 = lim E e 2rBτL ∧n −r (τL ∧n) = e L 2r E e −rτL ,

n→∞
√
which yields E e −rτL = e −L 2r for any r > 0. When r < 0 we could in

fact show that E e L = +∞.

−rτ
b) In order to maximize the quantity
E e −rτL BτL = E e −rτL BτL 1{τL <∞}

= LE e L 1{τL <∞}
−rτ
= LE e −rτL

√
= L e −L 2r
,
we differentiate
∂ √ √ √ √
(L e −L 2r ) = e −L 2r − L 2r e −L 2r = 0,
∂L
√
which yields the optimal level L∗ = 1/ 2r.
This shows that when the value of r is “large”

√ the better strategy is to
opt for a “small gain” at the level L∗ = 1/ 2r rather than to wait for a
longer time.
Exercise 14.4 See e.g. Theorem 6.16 page 161 of Klebaner (2005). By the Itô
formula, we have
1 w t 00
Xt = f (Bt ) − f (Bs )ds
2 0
wt 1 w t 00 1 w t 00
= f (B0 ) + f 0 (Bs )dBs + f (Bs )ds − f (Bs )ds
0 2 0 2 0
wt
= f (B0 ) + f 0 (Bs )dBs ,
0
" 1039
N. Privault
hence the process (Xt )t∈R+ is a martingale. By the Stopping Time Theo-
rem 14.7 we have
f (x) = E[X0 | B0 = x]
= E[Xτ ∧t | B0 = x]
w
1

τ ∧t 00
= E[f (Bτ ∧t ) | B0 = x] − E f (Bs )ds | B0 = x
2 0
= E[f (Bτ ∧t ) | B0 = x] + E[τ ∧ t | B0 = x],
since f 00 (y ) = −2 for all y ∈ R. We note that, by dominated convergence,

h i
E τ | B0 = x = E lim (τ ∧ t) | B0 = x

t→∞
= lim E[τ ∧ t | B0 = x]
t→∞
6 |f (x)| + Max |f (y )|
y∈[a,b]
< ∞,
hence E[τ ] < ∞ and therefore P(τ < ∞) = 1, allowing us to write

limt→∞ (τ ∧ t) = τ < ∞ with probability P(τ < ∞) = 1. Next, we have
f (x) = lim E[f (Bτ ∧t ) | B0 = x] + lim E[τ ∧ t | B0 = x]

t→∞ t→∞
h i h i
= E lim f (Bτ ∧t ) | B0 = x + E lim (τ ∧ t) | B0 = x
t→∞ t→∞
= E [ f ( Bτ ) | B0 = x ] + E [ τ | B0 = x ]
= E [ τ | B0 = x ] ,
since f 00 (x) = −2 and f (a) = f (b) = 0 with Bτ ∈ {a, b}.
Remarks.
i) The above exchanges between limt→∞ and the expectation operator
E[ · | B0 = x] is justified by the dominated convergence theorem, since
|f (Bτ ∧t )| 6 Max |f (y )|, t ∈ R+ .

y∈[a,b]
ii) The function f (x) can be determined by searching for a quadratic solu-
tion of the form f (x) = α + βx + γx2 , which shows that f 00 (x) = 2γ =
−2 hence γ = −1, and

 f (a) = α + βa − a = 0,
 2
f (b) = α + βb − b2 = 0,


1040 "
hence α = −ab and β = a + b. Therefore, we have
E[τ | B0 = x] = f (x) = −ab + (a + b)x − x2 = (x − a)(b − x).
Exercise 14.5 We use the Stopping Time Theorem 14.7 and the fact that
2
e σBt −σ t/2 t∈R is a martingale for all σ ∈ R. By the stopping time theo-

+
rem, for all n > 0 we have
2
1 = E e σBτ ∧n −σ (τ ∧n)/2

1{τ <n} + E e σBτ ∧n −σ (τ ∧n)/2 1{τ >n}

σBτ ∧n −σ2 (τ ∧n)/2 2
=E e

= E e σBτ −σ τ /2 1{τ <n} + E e σBn −σ n/2 1{τ >n}

2 2
= e σα E e σβτ −σ τ /2 1{τ <n} + E e σBn −σ n/2 1{τ >n} .

2 2
(A.56)

2 τ /2
Under the condition σ 2 > 2σβ we have 0 6 e σβτ −σ 6 1, hence by
dominated or monotone convergence we find
lim E e σβτ −σ τ /2 1{τ <n} = E e σβτ −σ τ /2 lim 1{τ <n} = E e σβτ −σ 1{τ <∞} ,
2 2 2 τ /2
n→∞ n→∞
and the first term in (A.56) converges to
e σα E e −(σ /2−σβ )τ 1{τ <∞} = e σα E e −(σ /2−σβ )τ

2 2
as n tends to infinity. In the sequel we use the solutions σ± = β ± β 2 + 2r

p
of the equation r = σ 2 /2 − σβ, and we distinguish two cases.

a) If α > 0, we have Bn 6 α + βn, n 6 τ , hence the second term above can
be bounded as
0 6 E e σ+ Bn −nσ+ /2 1{τ >n}

2
6 e −nσ+ /2 E e ασ+ +βσ+ n 1{τ >n}

2
2
6 e ασ+ −nσ+ /2+βσ+ n
= e ασ+ −rn ,
which tends to 0 as n tends to infinity. Therefore, we have

2 2
1 = lim E e σ+ Bτ ∧n −σ+ (τ ∧n)/2 = e ασ+ E e −(σ+ /2−βσ+ )τ ,

n→∞
which yields
2
E e −rτ = E e −(σ+ /2−βσ+ )τ

= e −ασ+
" 1041
N. Privault
√
2
= e −αβ−α √β +2r
−αβ−|α| β 2 +2r
= e ,
with
e −2αβ if β > 0,

P(τ < +∞) = E[1{τ <∞} ] = lim E 1{τ <∞} e −rτ =

r→0 1 if β 6 0.
2 2
α α
0 0
−1 −1
−2 −2
0 0.1 0.2 0.3 τ 0.4 0.5 0.6 0.7 0.8 0.9 1 0 0.1 0.2 τ 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
(a) α = 1, β = 0.5 (b) α = 1, β = −0.5
Fig. S.65: Hitting times of a straight line started at α < 0.
b) If α 6 0, we have Bn > α + βn, n 6 τ , hence the second term above can

be bounded as
2
0 6 E e σ− Bn −nσ− /2 1{τ >n}

2 2
6 e −nσ− /2 E e ασ− +βnσ− 1{τ >n} 6 e ασ− −nσ− /2+βnσ−

= e ασ− −rn ,
which tends to 0 as n tends to infinity. Therefore, we have

2 2
1 = lim E e σ− Bτ ∧n −σ− (τ ∧n)/2 = e ασ− E e −(σ− /2−βσ− )τ ,

n→∞
which yields
2
E e −rτ = E e −(σ− /2−βσ− )τ = e −ασ−

√
2
= e −αβ +α √β +2r
β 2 +2r
= e −αβ−|α| ,
with
1 if β > 0,

P(τ < +∞) = E[1{τ <∞} ] = lim E 1{τ <∞} e −rτ =

r→0 e −2αβ if β 6 0.
1042 "
2 2
1 1
0 0
α α
−2 −2
0 0.1 τ 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0 0.1 0.2 0.3 τ 0.4 0.5 0.6 0.7 0.8 0.9 1
(a) α = −1, β = 0.5 (b) α = −1, β = −0.5
Fig. S.66: Hitting times of a straight line started at α < 0.
Exercise 14.6
a) Letting A0 := 0,
An+1 := An + E[Mn+1 − Mn | Fn ], n > 0,
and
Nn : = M n − An , n ∈ N, (A.57)
we have
(i) for all n ∈ N,
E[Nn+1 | Fn ] = E[Mn+1 − An+1 | Fn ]

= E[Mn+1 − An − E[Mn+1 − Mn | Fn ] | Fn ]
= E[Mn+1 − An | Fn ] − E[E[Mn+1 − Mn | Fn ] | Fn ]
= E[Mn+1 − An | Fn ] − E[Mn+1 − Mn | Fn ]
= −E[An | Fn ] + E[Mn | Fn ]
= M n − An
= Nn ,
hence (Nn )n∈N is a martingale with respect to (Fn )n∈N .

(ii) We have
An+1 − An = E[Mn+1 − Mn | Fn ]
= E[Mn+1 | Fn ] − E[Mn | Fn ]
= E[Mn+1 | Fn ] − Mn > 0, n ∈ N,
since (Mn )n∈N is a submartingale.

(iii) By induction we have
An = An−1 + E[Mn − Mn−1 | Fn−1 ], n > 1,
" 1043
N. Privault
which is Fn−1 -measurable provided that An is Fn−1 -measurable,

n > 1.
(iv) This property is obtained by construction in (A.57).
b) For all bounded stopping times σ and τ such that σ 6 τ a.s., we have
E[Mσ ] = E[Nσ ] + E[Aσ ]

6 E[Nσ ] + E[Aτ ]
= E[Nτ ] + E[Aτ ]
= E [ Mτ ] ,
by (14.7), since (Mn )n∈N is a martingale and (An )n∈N is non-decreasing.
Chapter 15
Exercise 15.1 The option payoffs at immediate exercise are given as follows:
(K − S2 )+ = 0
3
p
∗ = 2/
(K − S1 )+ = 0.05
3
p
∗ = 2/ q∗ =
1/3
(K − S0 )+ = 0.3 (K − S2 )+ = 0.17
3
q∗ =
1/3 p
∗ = 2/
(K − S1 )+ = 0.35
q∗ =
1/3
(K − S2 )+ = 0.44
On the other hand, the expected payoffs are given by:
(K − S2 )+ = 0
E∗ [(K − S2 )+ | S1 = 1.2] = 0.17/3
(K − S2 )+ = 0.17
E∗ [(K − S2 )+ | S1 = 0.9] = 0.26
(K − S2 )+ = 0.44
1044 "
Consequently, at time t = 1 we would exercise immediately if S1 = 0.9, and

wait if S1 = 1.2. At time t = 0 with S0 = 1 the initial value of the option
is (0.34/3 + 0.35)/3 = 1.39/9 ' 0.154 < 0.25 so we would exercise immedi-
ately as well.
Exercise 15.2
2
a) Taking f (x) := Cx−2r/σ , we have
1 2r2 2r

2 2
rxf 0 (x) + σ 2 x2 f 00 (x) = −C 2 x−2r/σ + Cr 1 + 2 x−2r/σ
2 σ σ
2
= Crx−2r/σ
= rf (x),
and the condition limx→∞ f (x) = 0 is satisfied since r > 0.

b) The conditions f (L∗ ) = K − L∗ and f 0 (L∗ ) = −1 read
∗ −2r/σ 2
= K − L∗ ,

 C (L )

 − 2r C (L∗ )−1−2r/σ2 = −1,


σ2
i.e.
∗ −2r/σ 2
= K − L∗

 C (L )

 2r (K − L∗ ) = L∗ ,

σ2
hence
2rK

 L∗ =
2r + σ 2




2r/σ2 1+2r/σ2
Kσ 2 2rK σ2 2rK

.

C = =


2r + σ 2 2r + σ 2 2r 2r + σ 2
Exercise 15.3
a) This an American put option with strike price considered at S0 > L∗ ,
hence by Propositions 15.2 and 15.4 the price of this option is
−2r/σ2
S0
(K − L∗ )E∗ e −τL∗ = (K − L∗ ) .

L∗
b) This an American put option with strike price K and immediately exer-
cised at S0 6 L∗ , hence by Propositions 15.2 and 15.4 the price of this
option is K − S0 .
" 1045
N. Privault
c) This is an American call option with strike price 2K

b − K exercised at the
optimal level L∗ = K,
b hence by Equation (15.23) the price of this option
is
(L∗ − (2K
b − K ))E∗ e −τL∗ = (K b ) S0 .
b − K ))E∗ e −τL∗ = (K − K
b − (2K

Kb
In conclusion, the pricing function is obtained by pasting together the

pricing functions of American call and put options.
60
Price function
50
Payoff function
40
30
20
10
0
0 ^-K
2K ^
K L* K 200
Fig. S.67: American butterfly payoff and price functions.
Exercise 15.4
a) Given the value
∂
BSp (x, T ) = −Φ(−d+ (x, T ))
∂x
of the Delta of the Black-Scholes put option see Proposition 6.7, the
smooth fit condition states that at x = S ∗ , the left derivative of (15.31),
which is
2
∂ ∂ 2 (S ∗ )2r/σ
BSp (x, T ) + α (x/S ∗ )−2r/σ = −Φ(−d+ (x, T )) + α 1+2r/σ2 ,
∂x ∂x x
x > S ∗ , should match the right derivative of (15.32), which is −1, hence
2rα ∗ −1
−1 = −Φ(−d+ (S ∗ , T )) − (S ) ,
σ2
which yields
σ2 S ∗ σ2 S ∗
α∗ = (1 − Φ(−d+ (S ∗ , T ))) = Φ(d+ (S ∗ , T )),
2r 2r
and
1046 "
2

σ 2 (S ∗ )1+2r/σ
 BSp (x, T ) + Φ(d+ (S ∗ , T )), x > S∗,


2rx2r/σ
2
f (x, T ) '

x 6 S∗.

K − x,

Note that at maturity (T = 0 here) we have d+ (S ∗ , 0) = −∞ since

S ∗ < K, hence Φ(d+ (S ∗ , 0)) = 0 and f (x, 0) = K − x as expected.
b) Equating (15.31) to (15.32) at x = S ∗ yields the equation
K − S ∗ = BSp (x, T ) + α∗ ,
i.e.
S∗ σ2

1 = e −rT Φ(−d− (S ∗ , T )) + 1+ Φ(d+ (S ∗ , T )),
K 2r
which can be used to determine the value of S ∗ , and then the correspond-
ing value of α. The proposed strategy is to exercise the put option as soon
as the underlying asset price reaches the critical level S ∗ .
16
S*=87.8
L*=85.71
14
(K-x)+
12
10
Option price
0
85 90 95 100 105
L* = 85.7 S* = 87.3
Underlying x
Fig. S.68: Perpetual vs finite expiration American put option price.
The plot in Figure S.68 yields a finite expiration critical price S ∗ = 87.3
which is expectedly higher than the perpetual critical price L∗ = 85.71,
with K = 100, σ = 10%, and r = 3%. The perpetual price, however,
appears higher than the finite expiration price.
In Figure S.69 we plot the graph of a Barone-Adesi and Whaley (1987)

approximation, together with the European put option price, using the R
fOptions package. Note that this approximation is valid only for certain
parameter ranges.
" 1047
N. Privault
r=0.1;sig=0.15;T=0.5;K=100;library(ragtop)
library(fOptions);payoff <- function(x){return(max(K-x,0))};vpayoff <- Vectorize(payoff)
par(new=TRUE)
curve(vpayoff, from=85, to=120, xlab="", lwd = 3, ylim=c(0,10),ylab="",col="red")
par(new=TRUE)
curve(blackscholes(callput=-1, x, K, r, T, sig, 0)$Price, from=85, to=120, xlab="", lwd = 3,
ylim=c(0,10),ylab="",col="orange")
par(new=TRUE)
curve(BAWAmericanApproxOption("p",x,K,T,r,b=0,sig,title = NULL, description =
NULL)@price, from=85, to=120 , xlab="Underlying asset price", lwd =
3,ylim=c(0,10),ylab="",col="blue")
grid (lty = 5);legend(105,9.5,legend=c("Approximation","European payoff","Black-Scholes
put"),col=c("blue","red","orange"),lty=1:1, cex=1.)
10
Approximation
European payoff
8
Black−Scholes
put
6
4
2
0
85 90 95 100 105 110 115 120
Fig. S.69: American put price approximation.
Exercise 15.5
a) We have
if Z = 1,


τ =
+∞ if Z = 0.

b) First, we note that
 {∅, Ω} if t = 0,

Ft =
{∅, Ω, {Z = 0}, {Z = 1}} if t > 0.

Next, we have
{τ > 0} = {Z = 0},
hence
{τ > 0} ∈
/ F0 = {∅, Ω},
and therefore τ0 is not an (Ft )t∈R+ -stopping time.
1048 "
c) i) For t = 0 we have {τ > 0} = {Z = 0} ∪ {Z = 1} = Ω, hence
{τ > 0} ∈ F0 = {∅, Ω}.
ii) For 0 < t < we have {τ > t} = Ω, hence
{τ > t} ∈ Ft = {∅, Ω, {Z = 0}, {Z = 1}}.
iii) For t > we have {τ > t} = {Z = 0}, hence
{τ > t} ∈ Ft = {∅, Ω, {Z = 0}, {Z = 1}}.
Therefore τ is an (Ft )t∈R+ -stopping time when > 0.
Note that here the filtration (Ft )t∈R+ is not right-continuous, as

\
{∅, Ω} = F0 6= F0+ := Ft = {∅, Ω, {Z = 0}, {Z = 1}}.
t>0
Exercise 15.6
a) This intrinsic payoff is κ − S0 .
b) We note that the process (Zt )t∈R+ defined as
λ
St 2 t/2−λ2 σ 2 t/2
Zt : = e −(r−δ )λt+λσ
S0
b 2 λ 2 2 2
= e (r−δ )t+σBt −σ t/2 e −(r−δ )λt+λσ t/2−λ σ t/2
2 2
= e λσBbt −λ σ t/2 , t > 0,
is a geometric Brownian motion without drift, hence a martingale, under

the risk-neutral probability measure P∗ .
c) The parameter λ should satisfy the equation
σ2
r = (r − δ )λ − λ(1 − λ),
2
i.e.
λ2 σ 2 /2 + λ(r − δ − σ 2 /2) − r = 0.
This equation admits two solutions
−(r − δ − σ 2 /2) ± (r − δ − σ 2 /2)2 + 4rσ 2 /2

p
λ± = ,
σ2
d) We have
" 1049
N. Privault
λ−
(λ− ) St
0 6 Zt = e −rt
S0
λ−
St
6
S0
λ−
L
6 , 0 6 t < τL ,
S0
since λ− < 0 and St > L for t ∈ [0, τL ).

e) By the Stopping Time Theorem 14.7 we have
E∗ [ZτL ] = E∗ [Z0 ] = 1,
which rewrites as
" λ #
∗ SτL −((r−δ )λ−λσ 2 /2+λ2 σ 2 /2)τL
E e = 1,
S0
or, given the relation SτL = L,

λ
L h 2 2 2
i
E∗ e −((r−δ )λ−λσ /2+λ σ /2)τL = 1,
S0
i.e. λ
S0
E∗ e −rτL = ,

L
provided that we choose λ such that
− ((r − δ )λ − λσ 2 /2 + λ2 σ 2 /2) = −r, (A.58)
i.e.
(r − δ − σ 2 /2)2 + 4rσ 2 /2
p
−(r − δ − σ 2 /2) ±
λ= ,
σ2
and we choose the negative solution
−(r − δ − σ 2 /2) − (r − δ − σ 2 /2)2 + 4rσ 2 /2

p
λ :=
σ2
since S0 /L = x/L > 1 and the expectation E∗ e −rτL < 1 is lower than

1 as r > 0.
f) This follows from (15.9) and the fact that r > 0. Using the fact that
SτL = L < K when τL < ∞, we find
h i h i
E∗ e −rτL (K − SτL )+ S0 = x = E∗ e −rτL (K − SτL )+ 1{τL <x} S0 = x

1050 "
h i
= E∗ e −rτL (K − L)1{τL <x} S0 = x

h i
= (K − L)E∗ e −rτL 1{τL <x} S0 = x

h i
= (K − L)E∗ e −rτL S0 = x .

Next, noting that τL = 0 if S0 6 L, for all L ∈ (0, K ) we have
E∗ e −rτL (K − SτL )+ S0 = x

0 < x 6 L,

 K − x,
=
E e −rτL (K − L)+ S0 = x , x > L.

0 < x 6 L,

 K − x,
=
(K − L)E e −rτL S0 = x , x > L.

K − x, 0 < x 6 L,




= √
−(r−a−σ2 /2)− (r−a−σ2 /2)2 +4rσ2 /2
 (K − L) x

σ2
, x > L.

L
g) In order to compute L∗ we observe that, geometrically, the slope of x 7−→
fL (x) = (K − L)(x/L)λ− at x = L∗ is equal to −1, i.e.
(L∗ )λ− −1
fL0 ∗ (L∗ ) = λ− (K − L∗ ) = −1,
(L∗ )λ−
hence
λ−
λ− (K − L∗ ) = L∗ , or L∗ = K < K.
λ− − 1
Equivalently we may recover the value of L∗ from the optimality condition
∂fL (x) x λ− x λ− + 1

=− − λ− x(K − L) = 0,
∂L L L
at L = L∗ , hence
x λ−
− − λ− (K − L)xλ− L−λ− −1 = 0,
L
hence
λ− 1
L∗ = K= K,
1 − λ− 1 − 1/λ−
and
" 1051
N. Privault
1−λ−
1

K
Sup E∗ e −rτL (K − SτL )+ S0 = x = − xλ− .

L∈(0,K ) λ− 1 − 1/λ−
h) For x > L we have

x λ−
fL∗ (x) = (K − L∗ )
L∗
  λ−

λ− x
= K− K 
λ− − 1

λ−
λ− −1 K
x(λ− − 1) λ−

K
= −
λ− − 1 λ− K
λ−
λ − − 1 λ−

K x
= −
λ− − 1 −λ− −K
λ− − 1 λ− −1
λ−
x
=
−λ− −K
x λ− λ − 1 λ− K
−
= . (A.59)
K λ− 1 − λ−
i) Let us check that the relation
fL∗ (x) > (K − x)+ (A.60)
holds. For all x 6 K we have

x λ− λ − 1 λ− K
−
fL∗ (x) − (K − x) = +x−K
K λ− 1 − λ−
!
x λ− λ − 1 λ−

1 x
−
=K + −1 .
K λ− 1 − λ− K
Hence it suffices to take K = 1 and to show that for all

λ−
L∗ = 6x61
λ− − 1
we have
λ−
xλ− λ− − 1

fL∗ (x) − (1 − x) = + x − 1 > 0.
1 − λ− λ−
Equality to 0 holds for x = λ− /(λ− − 1). By differentiation of this relation

we get
1052 "
λ − − 1 λ− 1

fL0 ∗ (x) − (1 − x)0 = λ− xλ− −1 +1
λ− 1 − λ−
λ− −1
λ− − 1

= xλ− −1 +1
λ−
> 0,
hence the function fL∗ (x) − (1 − x) is non-decreasing and the inequality

holds throughout the interval [λ− /(λ− − 1), K ].
On the other hand, using (A.58) it can be checked by hand that fL∗ given
by (A.59) satisfies the equality
1
(r − δ )xfL0 ∗ (x) + σ 2 x2 fL00∗ (x) = rfL∗ (x) (A.61)
2
λ−
for x > L∗ = K. In case
λ− − 1
λ−
0 6 x 6 L∗ = K < K,
λ− − 1
we have
fL∗ (x) = K − x = (K − x)+ ,
hence the relation
1

rfL∗ (x) − (r − δ )xfL0 ∗ (x) − σ 2 x2 fL00∗ (x) (fL∗ (x) − (K − x)+ ) = 0
2
always holds. On the other hand, in that case we also have

1
(r − δ )xfL0 ∗ (x) + σ 2 x2 fL00∗ (x) = −(r − δ )x,
2
and to conclude we need to show that
1
(r − δ )xfL0 ∗ (x) + σ 2 x2 fL00∗ (x) 6 rfL∗ (x) = r (K − x), (A.62)
2
which is true if
δx 6 rK.
Indeed, by (A.58) we have
(r − δ )λ− = r + λ− (λ− − 1)σ 2 /2

> r,
hence
" 1053
N. Privault
λ−
δ 6 r,
λ− − 1
since λ− < 0, which yields
λ−
δx 6 δL∗ 6 δ K 6 rK.
λ− − 1
j) By Itô’s formula and the relation
dSt = (r − δ )St dt + σSt dB

bt
we have
d feL∗ (St ) = −r e −rt fL∗ (St )dt + e −rt dfL∗ (St )

σ 2 −rt 2 00
= −r e −rt fL∗ (St )dt + e −rt fL0 ∗ (St )dSt + e St fL∗ (St )
2

σ 2
= e −rt −rfL∗ (St ) + (r − δ )St fL0 ∗ (St ) + St2 fL00∗ (St ) dt
2
−rt 0
+ e σSt fL∗ (St )dBt ,b
and from Equations (A.61) and (A.62) we have

1
(r − δ )xfL0 ∗ (x) + σ 2 x2 fL00∗ (x) 6 rfL∗ (x),
2
hence
t 7−→ e −rt fL∗ (St )
is a supermartingale.
k) By the supermartingale property of
t 7−→ e −rt fL∗ (St ),
for all stopping times τ we have
fL∗ (S0 ) > E∗ e −rτ fL∗ (Sτ ) S0 > E∗ e −rτ (K − Sτ )+ S0 ,

by (A.60), hence
Sup E∗ e −rτ (K − Sτ )+ S0 .

fL∗ (S0 ) >
τ stopping time
l) The stopped process
t 7−→ e −rt∧τL∗ fL∗ (St∧τL∗ )
is a martingale since it has vanishing drift up to time τL∗ by (A.61), and

it is constant after time τL∗ , hence by the Stopping Time Theorem 14.7
1054 "
we find
h i
fL∗ (S0 ) = E∗ e −rτ fL∗ (SτL∗ ) S0

h i
= E∗ e −rτ fL∗ (L∗ ) S0

h i
= E∗ e −rτ (K − SτL∗ )+ S0

h i
6 Sup E∗ e −rτ (K − Sτ )+ S0 .

τ stopping time
m) By combining the above results and conditioning at time t instead of time

0 we deduce that
h i
fL∗ (St ) = E∗ e −r (τL∗ −t) (K − SτL∗ )+ St

λ−

 K − St ,
 0 < St 6 K,
λ− − 1



=
λ− − 1 λ− −1 −St λ−

λ−

, St >

K,


−K λ− − 1

λ−
for all t ∈ R+ , where
τL∗ = inf{u > t : Su 6 L}.
We note that the perpetual put option price does not depend on the value
of t > 0.
Exercise 15.7
a) We have
(λ) 2 /2) 2 σ 2 t/2

Zt = (St )λ e −t((r−δ )λ−λ(1−λ)σ = (S0 )λ e λσBbt −λ ,
which is a driftless geometric Brownian motion, and therefore a martingale

under P∗ .
b) The condition is r = (r − δ )λ − λ(1 − λ)σ 2 /2, with solutions
δ − r + σ 2 /2 − (δ − r + σ 2 /2)2 + 2rσ 2
p
λ− = 6 0,
σ2
δ − r + σ 2 /2 + (δ − r + σ 2 /2)2 + 2rσ 2
p
λ+ = > 1.
σ2
c) Due to the inequality
(λ+ )
0 6 Zt = (St )λ+ e −rt 6 Lλ+ ,
" 1055
N. Privault
which holds because λ+ > 0 and St 6 L, 0 6 t < τL , we note that since

(λ )
limt→∞ Zt + = 0, we have
h i h i
Lλ+ E∗ e −rτL = E∗ SτL + e −rτL 1{τL <∞} = E∗ ZτL+ 1{τL <∞}
λ (λ )
h i
(λ ) (λ )
= E∗ lim ZτL+∧t = lim E∗ ZτL+∧t
t→∞ t→∞
(λ )
= E∗ Z0 + = (S0 )λ+ .
Therefore, we have
E∗ e −rτL (SτL − K )+ S0 = x = E∗ (SτL − K ) e −rτL 1{τL <∞} S0 = x

= (L − K )E∗ e −rτL 1{τL <∞} S0 = x

= (L − K )E∗ e −rτL S0 = x

x λ +
= (L − K ) ,
L
when S0 = x > L. In order to maximize
Sup E∗ e −rτL (K − SτL )+ S0 = x ,

L∈(0,K )
we differentiate L 7−→ (L − K ) (x/L)λ+ with respect to L, to find

x λ +
− λ+ (L − K )xλ+ L−λ+ −1 = 0,
L
hence
λ+ K
L∗δ = K= ,
λ+ − 1 1 − 1/λ+
and
1−λ+
1

K
Sup E∗ e −rτL (K − SτL )+ S0 = x = xλ + .

L∈(0,K ) λ+ 1 − 1/λ+
We note that as δ & 0 we have λ+ & 1 and L∗δ % ∞, and since

1−λ+
λ+ − 1

K
= exp (λ+ − 1) log → 1,
1 − 1/λ+ λ+ K
we find that the perpetual American call option price without dividend
(δ = 0) is S0 = x.
Exercise 15.8
a) By the definition (15.36) of S1 (t) and S2 (t) we have
1056 "
α
S1 (t)

Zt = e −rt S2 (t)
S2 (t)
= e −rt S1 (t)α S2 (t)1−α
2
= S1 (0)α S2 (0)1−α e (ασ1 +(1−α)σ2 )Wt −σ2 t/2 ,
which is a martingale when
σ22 = (ασ1 + (1 − α)σ2 )2 ,
i.e.
ασ1 + (1 − α)σ2 = ±σ2 ,
which yields either α = 0 or
2σ2 σ1 + σ2
α= = 1+ > 1,
σ2 − σ1 σ2 − σ1
since 0 6 σ1 < σ2 .
b) We have
E e −rτL (S1 (τL ) − S2 (τL ))+ = E e −rτL (LS2 (τL ) − S2 (τL ))+

= (L − 1)+ E e −rτL S2 (τL ) . (A.63)

c) Since τL ∧ t is a bounded stopping time we can write
S1 (0) α S1 (τL ∧ t) α

S2 (0) = E e −r (τL ∧t) S2 (τL ∧ t) (A.64)
S2 ( 0 ) S2 (τL ∧ t)
α α
S1 (τL ) S (t)

= E e −rτL S2 (τL ) 1{τL <t} + E e −rt S2 (t) 1 1{τL >t}
S2 (τL ) S2 (t)
We have
α
S1 (t)

e −rt S2 (t) 1{τL >t} 6 e −rt S2 (t)Lα 1{τL >t} 6 e −rt S2 (t)Lα ,
S2 (t)
hence by a uniform integrability argument,
S1 (t) α

lim E e −rt S2 (t) 1{τL >t} = 0,
t→∞ S2 (t)
and letting t go to infinity in (A.64) shows that
S1 (0) α S1 (τL ) α

S2 (0) = E e −rτL S2 (τL ) = Lα E e −rτL S2 (τL ) ,

S2 ( 0 ) S2 (τL )
since S1 (τL )/S2 (τL ) = L/L = 1. The conclusion
" 1057
N. Privault
α
S1 (0)

E e −rτL (S1 (τL ) − S2 (τL ))+ = (L − 1)+ L−α S2 (0) (A.65)

S2 (0)
then follows by an application of (A.63).

d) In order to maximize (A.65) as a function of L we consider the derivative
L−1 1

∂
= α − α(L − 1)L−α−1 = 0,
∂L Lα L
which vanishes for

α
L∗ = ,
α−1
and we substitute L in (A.65) with the value of L∗ .
e) In addition to r = σ22 /2 it is sufficient to let S1 (0) = κ and σ1 = 0 which
yields α = 2, L∗ = 2, and we find
1 κ 2
Sup E e −rτ (κ − S2 (τ ))+ = ,

τ stopping time S2 (0) 2
which coincides with the result of Proposition 15.4.
Exercise 15.9
a) It suffices to check the sign of the quantity
(λ − 1)(λ + 2r/σ 2 ), (A.66)
in (15.38), which is positive when λ ∈ (−∞, −2r/σ 2 ] ∪ [1, ∞),

and nega-
tive when −2r/σ 2 6 λ 6 1.
b) The sign of (A.66) is positive when λ ∈ (−∞, 1] ∪ [−2r/σ 2 , ∞), and
negative when 1 6 λ 6 −2r/σ 2 .
c) By the Stopping Time Theorem 14.7, for any n > 0 we have
h i
(λ)
xλ = E∗ e −r (τL ∧n) ZτL ∧n | S0 = x
h i h i
= E∗ ZτL 1{τL <n} | S0 = x + e −rn E∗ Zn 1{τL >n} | S0 = x
(λ) (λ)
h i
> E∗ e −rτL (SτL )λ 1{τL <n} | S0 = x
= Lλ E∗ e −rτL 1{τL <n} | S0 = x .

(λ)
By the results of Questions (a)-(b), the process Zt t∈R+
is a martin-
gale when λ ∈ {1, −2rσ 2 /2}. Next, letting n to infinity, by monotone
convergence we find
1058 "
x Max(1,−2r/σ2 )

, x > L,


x λ  L

E∗ e −rτL 1{τL <∞} | S0 = x 6

6
L min(1,−2r/σ2 )
 x

, 0 < x 6 L.


L
d) We note that P∗ (τL < ∞) = 1 by (14.15), hence if −σ 2 /2 6 r < 0 we
have
E∗ e −rτL (K − SτL )+ 1{τL <∞} | S0 = x

 x −2r/σ2
 (K − L) L

 , x > L,
= (K − L)E∗ e −rτL | S0 = x 6

 (K − L) x ,

0 < x 6 L.

L
Similarly, if r 6 −σ 2 /2 we have
E∗ e −rτL (K − SτL )+ 1{τL <∞} | S0 = x = (K − L)E∗ e −rτL | S0 = x

 x
 (K − L) , x > L,

 L
6
2
 (K − L) x −2r/σ , 0 < x 6 L.


L
e) This follows by noting that (K − L)(x/L) = (K/L − 1)x increases to ∞
when L tends to zero.
f) If −σ 2 /2 6 r < 0 we have
E∗ e −rτL (SτL − K )+ 1{τL <∞} | S0 = x

= (L − K )E∗ e −rτL 1{τL <∞} | S0 = x

 x −2r/σ 2
 (L − K ) L

 , x > L,
6
 (L − K ) x ,

0 < x 6 L.

L
If r 6 −σ 2 /2 we have
E∗ e −rτL (SτL − K )+ 1{τL <∞} | S0 = x

= (L − K )E∗ e −rτL 1{τL <∞} | S0 = x

 x
 (L − K ) , x > L,

 L
6
2
 (L − K ) x −2r/σ , 0 < x 6 L.


L
" 1059
N. Privault
g) This follows by noting that for fixed x > 0, the quantity (L − K )x/L =
(1 − K/L)x increases to x when L tends to infinity.
Exercise 15.10 Perpetual American binary options.

a) Similarly, for x > K, immediate exercise is the optimal strategy and
we have CbAm (t, x) = 1. When x < K the optimal exercise level of the
perpetual American binary call option is L∗ = K with the optimal exercice
time τK , and by e.g. (4.4.22) page 135 we have
CbAm (t, x) = Sup E∗ e −(τ −t)r 1{Sτ >K} St = x

τ >t
τ stopping time
= E∗ e −(τK −t)r St = x

x
= , x < K.
K
1.4
1.2
American binary put price
0.8
0.6
0.4
0.2
0
0 50 100 150 200 250
Underlying x
Fig. S.70: Perpetual American binary put price map with K = 100.
b) For x 6 K, immediate exercise is the optimal strategy and we have

PbAm (t, x) = 1. When x > K the optimal exercise level of the perpet-
ual American binary put option is L∗ = K with the optimal exercice time
τK , and by e.g. (4.4.11) page 125 we have
PbAm (t, x) = Sup E∗ e −(τ −t)r 1{Sτ 6K} St = x

τ >t
τ stopping time
= E∗ e −(τK −t)r St = x

x −2r/σ2
= , x > K.
K
1060 "
1.4
American binary call price 1.2
0.8
0.6
0.4
0.2
0
0 50 100 150 200
Underlying x
Fig. S.71: Perpetual American binary call price map with K = 100.
Exercise 15.11 Finite expiration American binary options.

a) The optimal strategy is as follows:
(i) if St > K, then exercise immediately.
(ii) if St < K, then wait.
b) The optimal strategy is as follows:
(i) if St > K, then wait.
(ii) if St 6 K, exercise immediately.
c) Based on the answers to Question (a) we set
CdAm (t, T , K ) = 1, 0 6 t < T,
and
CdAm (T , T , x) = 0, 0 6 x < K.
d) Based on the answers to Question (b), we set
PdAm (t, T , K ) = 1, 0 6 t < T,
and
PdAm (T , T , x) = 0, x > K.
e) Starting from St 6 K, the maximum possible payoff is clearly reached
as soon as St hits the level K before the expiration date T , hence the
discounted optimal payoff of the option is e −r (τK −t) 1{τK <T } .
f) From Relation (10.13), we find that the first hitting time τa of the level a
by a µ-drifted Brownian motion (Wu + µu)u∈R+ satisfies

a − µu −a − µu
P(τa 6 u) = Φ √ − e 2µa Φ √ , u > 0,
u u
" 1061
N. Privault
and by differentiation with respect to u this yields the probability density

function
∂ a
e −(a−µu) /(2u) 1[0,∞) (u)
2
fτa (u) = P(τa 6 u) = √
∂u 2πu3
of the first hitting time of level a by Brownian motion with drift µ. Given
the relation
2 /2+(u−t)r
Su = St e σWu−t −(u−t)σ = St e (Wu−t +(u−t)µ)σ , u > t,
with µ = r/σ − σ/2, we find that (Su )u∈[t,∞) hits the level K at a time
τK = t + τa , such that
2 τ /2+rτ
SτK = St e σWτa −σ a a
= St e (Wτa +µτa )σ = K,
i.e.
1 K
a = Wτa + µτa = log .
σ St
Therefore, the probability density function of the first hitting time τK of
level K after time t by (Su )u∈[t,∞) is given by
a 2 / (2(s−t))
s 7−→ p e −(a−(s−t)µ) , s > t,
2π (s − t)3
with
1 σ2 1

K
µ := r− and a := log ,
σ 2 σ x
given that St = x. Hence, for x ∈ (0, K ) we have
CdAm (t, T , x) = E e −r (τK −t) 1{τK <T } | St = x

wT a 2
= e −(s−t)r p e −(a−(s−t)µ) /(2(s−t)) ds
t 2π (s − t)3
w T −t a 2
= e −rs √ e −(a−µs) /(2s) ds
0 2πs3
w T −t log(K/x) 1

σ2

K
2 !
= √ exp −rs − 2 − r− s + log ds
0 σ 2πs3 2σ s 2 x
(r/σ2 −1/2)±(r/σ2 +1/2)
K
=
x
w T −t log(K/x) 1

σ2

K
2 !
× √ exp − 2 ± r+ s + log ds
0 σ 2πs3 2σ s 2 x
1 x w ∞ −y2 /2
2r/σ2 w
1 K ∞ −y 2 /2
= √ e dy + √ e dy
2π K y− 2π x y+
1062 "
(r + σ 2 /2)(T − t) + log(x/K )

x
= Φ √
K σ T −t
x −2r/σ2 −(r + σ 2 /2)(T − t) + log(x/K )
+ Φ √ , 0 < x < K,
K σ T −t
where
1 σ2

K
y± = √ ± r+ (T − t) + log ,
σ T −t 2 x
and we used the decomposition
1 σ2 1 σ2

K K K
log = r+ s + log + − r+ s + log .
x 2 2 x 2 2 x
We check that
CdAm (T , T , K ) = Φ(0) + Φ(0) = 1,
and
x x −2r/σ2
CdAm (T , T , x) = Φ (−∞) + Φ (−∞) = 0, x < K,
K K
since t = T , which is consistent with the answers to Question (c).
In addition, as T tends to infinity we have
(r + σ 2 /2)(T − t) + log(x/K )

x
lim CdAm (t, T , x) = lim Φ √
T →∞ K T →∞ σ T −t
x −2r/σ2 −(r + σ 2 /2)(T − t) + log(x/K )

+ lim Φ √
K T →∞ σ T −t
x
= , 0 < x < K,
K
which is consistent with the answer to Question (a) of Exercise 15.10.
1.4 T=5
T=20
1.2
American binary call price
0.8
0.6
0.4
0.2
0
0 50 100 150 200
Underlying x
Fig. S.72: Finite expiration American binary call price map with K = 100.
" 1063
N. Privault
g) Starting from St > K, the maximum possible payoff is clearly reached

as soon as St hits the level K before the expiration date T , hence the
discounted optimal payoff of the option is e −r (τK −t) 1{τK <T } .
h) Using the notation and answer to Question (f), for x > K we find
PdAm (t, T , x) = E e −r (τK −t) 1{τK <T } | St = x

w T −t a 2
= e −rs √ e −(a−µs) /2s) ds
0 2πs3
w T −t log(x/K ) 1

σ2

x
2 !
= √ exp −rs − 2 r− s + log ds
0 σ 2πs3 2σ s 2 K
r − 1 ± r + 1
K σ2 2 σ2 2
=
x
w T −t log(x/K ) 1

σ2

x
2 !
× √ exp − 2 ∓ r+ s + log ds
0 σ 2πs3 2σ s 2 K
1 x w ∞ −y2 /2 1 x 2r/σ2 w ∞ −y2 /2
= √ e dy + √ e dy
2π K y− 2π K y+
−(r + σ 2 /2)(T − t) − log(x/K )

x
= Φ √
K σ T −t
x −2r/σ2 (r + σ 2 /2)(T − t) − log(x/K )
+ Φ √ , x > K,
K σ T −t
with
1 σ2

x
y± = √ ∓ r+ (T − t) + log .
σ T −t 2 K
We check that
PdAm (T , T , K ) = Φ(0) + Φ(0) = 1,
and
x x −2r/σ2
PdAm (T , T , x) = Φ (−∞) + Φ (−∞) = 0, 0 < x < K,
K K
since t = T , which is consistent with the answers to Question (c).
In addition, as T tends to infinity we have
−(r + σ 2 /2)(T − t) − log(x/K )

x
lim PdAm (t, T , x) = lim Φ √
T →∞ K T →∞ σ T −t
x −2r/σ2 (r + σ 2 /2)(T − t) − log(x/K )

+ lim Φ √
K T →∞ σ T −t
x −2r/σ2
= , x > K,
K
1064 "
which is consistent with the answer to Question (b) of Exercise 15.10
1.4 T=5
T=20
1.2
American binary put price
0.8
0.6
0.4
0.2
0
0 50 100 150 200 250
Underlying x
Fig. S.73: Finite expiration American binary put price map with K = 100.
i) The call-put parity does not hold for American binary options since for
x ∈ (0, K ) we have
(r + σ 2 /2)(T − t) + log(x/K )

x
CdAm (t, T , x) + PdAm (t, T , x) = 1 + Φ √
K σ T −t
x −2r/σ2 −(r + σ 2 /2)(T − t) + log(x/K )
+ Φ √ ,
K σ T −t
while for x > K we find
−(r + σ 2 /2)(T − t) − log(x/K )

x
CdAm (t, T , x) + PdAm (t, T , x) = 1 + Φ √
K σ T −t
x −2r/σ2 (r + σ 2 /2)(T − t) − log(x/K )
+ Φ √ .
K σ T −t
Exercise 15.12 American forward Contracts.

a) For all (bounded) stopping times τ ∈ [t, T ], since the discounted asset
price process Seu u∈[t,∞) := e −(u−t)r Su )u∈[t,∞) is a martingale and the

stopped process Seτ ∧u = e −(τ ∧u−t)r Sτ ∧u ) is also a mar-

u∈[t,∞) u∈[t,∞)
tingale by the Stopping Time Theorem 14.7, we have
h i
E∗ e −r (τ −t) (K − Sτ ) Ft = KE∗ e −r (τ −t) Ft − E∗ e −r (τ −t) Sτ Ft

= KE∗ e −r (τ −t) Ft − E∗ Seτ ∧T Ft

= KE∗ e −r (τ −t) Ft − Seτ ∧t

= KE∗ e −r (τ −t) Ft − Set

= KE∗ e −r (τ −t) Ft − St ,

" 1065
N. Privault
and the above quantity is clearly maximized by taking τ = t. Hence we

have
Sup E∗ e −r (τ −t) (K − Sτ ) Ft = K − St ,

f (t, St ) =
t6τ 6T
τ stopping time
and the optimal strategy is to exercise immediately (or to avoid purchasing

the option) at time t and price K due to the effect of time value of money
when r > 0.
b) Similarly to the above, we have
E∗ e −r (τ −t) (Sτ − K ) Ft = E∗ e −r (τ −t) Sτ Ft − KE∗ e −r (τ −t) Ft

= St − KE∗ e −r (τ −t) Ft ,

since τ ∈ [t, T ] is bounded and ( e −rt St )t∈R+ is a martingale. As the above

quantity is clearly maximized by taking τ = T , we have
Sup E∗ e −r (τ −t) (Sτ − K ) Ft = St − e −(T −t)r K,

f (t, St ) =
t6τ 6T
τ stopping time
and the optimal strategy is to wait until the maturity time T in order to
exercise at price K, due to the effect of time value of money when r > 0.
c) Regarding the perpetual American long forward contract, since the dis-
counted asset price process Seu := e −(u−t)r Su ) is a mar-

u∈[t,∞) u∈[t,∞)
tingale, by the Stopping Time Theorem 14.7, for all stopping times τ > t
we have∗ ,
E∗ e −r (τ −t) (Sτ − K ) Ft = E∗ e −r (τ −t) Sτ Ft − KE∗ e −r (τ −t) Ft

= E∗ Seτ Ft − KE∗ e −r (τ −t) Ft

= Set − KE∗ e −r (τ −t) Ft

= St − KE∗ e −r (τ −t) Ft

6 St , t > 0.
On the other hand, for all fixed T > 0 we have
E∗ e −r (T −t) (ST − K ) Ft = e −r (T −t) E∗ [ST | Ft ] − e −r (T −t) E∗ [K | Ft ]

= St − e −r (T −t) K, t ∈ [0, T ],
hence
(St − e −r (T −t) K ) 6 Sup E∗ e −r (τ −t) (Sτ − K ) Ft 6 St ,

T > t,
t6τ 6T
τ stopping time
∗
using Fatou’s Lemma 23.4.
1066 "
and letting T → ∞ we get
St = lim (St − e −r (T −t) K )

T →∞
Sup E∗ e −r (τ −t) (Sτ − K ) Ft

6
τ >t
τ stopping time
6 St ,
hence we have
Sup E∗ e −r (τ −t) (Sτ − K ) Ft = St ,

f (t, St ) =
τ >t
τ stopping time
and the optimal strategy τ ∗ = +∞ is to wait indefinitely.
Regarding the perpetual American short forward contract, we have
Sup E∗ e −r (τ −t) (K − Sτ ) Ft

f (t, St ) =
τ >t
τ stopping time
Sup E∗ e −r (τ −t) (K − Sτ )+ Ft

6
τ >t
τ stopping time
= fL∗ (St ), (A.67)
with
2r
L∗ = K<K
2r + σ 2
as defined in (15.12). On the other hand, for τ = τL∗ we have
(K − SτL∗ ) = (K − L∗ ) = (K − L∗ )∗
since 0 < L∗ = 2Kr/(2r + σ 2 ) < K, hence
fL∗ (St ) = E∗ e −r (τL∗ −t) (K − SτL∗ )+ Ft

= E∗ e −r (τL∗ −t) (K − SτL∗ ) Ft

Sup E∗ e −r (τ −t) (K − Sτ ) Ft

6
τ >t
τ stopping time
= f (t, St ),
which, together with (A.67), shows that
f (t, St ) = fL∗ (St ),
" 1067
N. Privault
i.e. the perpetual American short forward contract has same price and
exercise strategy as the perpetual American put option.
Exercise 15.13
a) We have
b 2 2
Yt = e −rt (S0 e rt+σBt −σ t/2 )−2r/σ
2 2 2
= S0−2r/σ e −rt−2r t/σ +2rBbt /σ +rt
2 2
= S0−2r/σ e 2rBbt /σ−(2r/σ ) t/2 , t > 0,
and
b 2
Zt = e −rt St = S0 e σBt −σ t/2 , t > 0,
which are both martingales under P∗ because they are standard geometric
Brownian motions with respective volatilities σ and 2r/σ.
b) Since (Yt )t∈R+ and (Zt )t∈R+ are both martingales and τL is a stopping
time, we have
2
S0−2r/σ = E∗ [Y0 ]
= E∗ [YτL ]
2
= E∗ e −rτL Sτ−2r/σ

L
2
= E∗ e −rτL L−2r/σ

2
= L−2r/σ E∗ e −rτL ,

hence
x −2r/σ2
E∗ e −rτL =

L
2
if S0 = x > L (note that in this case YτL ∧t remains bounded by L−2r/σ ),
and
S0 = E∗ [Z0 ] = E∗ [ZτL ] = E∗ e −rτL SτL = E∗ e −rτL L = LE∗ e −rτL ,

hence
x
E∗ e −rτL =

L
if S0 = x 6 L. Note that in this case ZτL ∧t remains bounded by L.
c) We find
E e −rτL (K − SτL ) S0 = x = (K − L)E∗ e −rτL S0 = x

1068 "
K −L

x L , 0 < x 6 L,



= (A.68)
−2r/σ2
 (K − L) x

,

x > L.

L
d) By differentiating
∂ −rτL
E e

(K − SτL ) S0 = x
∂L
x −2r/σ2 2r K


 − 1 − 1 , 0 < L < x,
 L σ2 L

=
 Kx


 − 2, L > x,
L
and check that the minimum occurs for L∗ = x.
e) The value L∗ = x shows that the optimal strategy for the American finite
expiration short forward contract is to exercize immediately starting from
S0 = x, which is consistent with the result of Exercise 15.12-(a), since
given any stopping time τ upper bounded by T we have
E e −rτ (K − Sτ ) = KE e −rτ − E e −rτ Sτ = KE e −rτ − S0 6 K − S0 .

Exercise 15.14
a) The option payoff equals (κ − St )p if St 6 L.
b) We have
h i
fL (St ) = E∗ e −r (τL −t) ((κ − SτL )+ )p Ft
h i
= E∗ e −r (τL −t) ((κ − L)+ )p Ft
h i
= (κ − L)p E∗ e −r (τL −t) Ft .
c) We have
h i
fL (x) = E∗ e −r (τL −t) (κ − SτL )+ Ft = x

(κ − x)p , 0 < x 6 L,




= 2r/σ2 (A.69)
L
 (κ − L)p , x > L.


x
d
d) By the differentiation (κ − x)p = −p(κ − x)p−1 we find
dx
" 1069
N. Privault
2r/σ2 2r/σ2
∂fL (x) 2r L L
= 2 (κ − L)p − p(κ − L)p−1 ,
∂L σ L x x
∂fL0 ∗ (x)
hence the condition = 0 reads
∂L |x=L∗
2r 2r
(κ − L∗ ) − p = 0, or L∗ = κ < κ.
σ 2 L∗ 2r + pσ 2
e) By (A.69) the price can be computed as
(κ − St )p , 0 < St 6 L∗ ,




f (t, St ) = fL∗ (St ) = p −2r/σ2
pσ 2 κ 2r + pσ 2 St
, St > L∗ ,


2r + pσ 2 2r

κ
using (14.13) as in the proof of Proposition 15.4, since the process
u 7−→ e −ru fL∗ (Su ), u > t,
is a nonnegative supermartingale.
Exercise 15.15
a) The option payoff is κ − (St )p .
b) We have
h i
fL (St ) = E∗ e −r (τL −t) (κ − (SτL )p ) Ft

h i
= E∗ e −r (τL −t) (κ − Lp ) Ft

h i
= (κ − Lp )E∗ e −r (τL −t) Ft .

c) We have
h i
fL (x) = E∗ e −r (τL −t) (κ − (SτL )p ) St = x

κ − xp , 0 < x 6 L,



= 2
 (κ − Lp ) x −2r/σ , x > L.

L
d) We have
2
2r (L∗ )−2r/σ −1
fL0 ∗ (L∗ ) = − ( κ − ( L∗ ) p ) = −p(L∗ )p−1 ,
σ2 (L∗ )−2r/σ2
1070 "
i.e.
2r
(κ − (L∗ )p ) = p(L∗ )p ,
σ2
or 1/p
2rκ

L∗ = < (κ)1/p . (A.70)
2r + pσ 2
Remark: We may also compute L∗ by maximizing L 7−→ fL (x) for all
fixed x. The derivative ∂fL (x)/∂L can be computed as
2r/σ2 !
∂fL (x) ∂ p L
= (κ − L )
∂L ∂L x
2r/σ2 2r/σ2
L 2r L
= −pLp−1 + 2 L−1 (κ − Lp ) ,
x σ x
and equating ∂fL (x)/∂L to 0 at L = L∗ yields

2r ∗ −1
−p(L∗ )p−1 + (L ) (κ − (L∗ )p ) = 0,
σ2
which recovers (A.70).
e) We have
κ − (St )p , 0 < St 6 L∗ ,




fL∗ (St ) = 2
(St )−2r/σ
 (κ − (L∗ )p ) , St > L∗


(L∗ )−2r/σ2
κ − (St )p , 0 < St 6 L∗ ,



= 2
 σ p(S )−2r/σ2 (L∗ )p+2r/σ2 , S > L∗ ,

t t
2r
κ − (St )p , 0 < St 6 L∗ ,




= −2r/(pσ2 )
pσ 2 κ 2r + pσ 2 Stp

St > L∗ ,

 < κ,
2r + pσ 2r

2 κ
however we cannot conclude as in Exercise 15.14-(e) since the process
u 7−→ e −ru fL∗ (Su ), u > t,
does not remain nonnegative when p > 1, so that (14.13) cannot be applied
as in the proof of Proposition 15.4.
" 1071
N. Privault
Chapter 16
Exercise 16.1
a) We have

bt = d Xt
dX
Nt
X0 (σ−η )Bt −(σ2 −η2 )t/2
= d e
N0
X0 2 2
= (σ − η ) e (σ−η )Bt −(σ −η )t/2 dBt
N0
X0 2 2
+ (σ − η )2 e (σ−η )Bt −(σ −η )t/2 dt
2N0
X0 2 2 2
− (σ − η 2 ) e (σ−η )Bt −(σ −η )t/2 dt
2N0
Xt 2 Xt Xt
= − (σ − η 2 )dt + (σ − η )dBt + (σ − η )2 dt
2Nt Nt 2Nt
Xt Xt
= − η (σ − η )dt + (σ − η )dBt
Nt Nt
Xt
= (σ − η )(dBt − ηdt)
Nt
Xt b
= (σ − η ) dB t = (σ − η )Xt dBt ,
b b
Nt
where dB
bt = dBt − ηdt is a standard Brownian motion under P.
b
b) By change of numéraire, we have

E[(XT − λNT )+ ] = Eb N0 (XT − λNT )+ = N0 E bT − λ) + .

b (X
NT
Next, by the result of Question (a), X

bt is a driftless geometric Brownian
motion with volatility σ − η under P,
b hence we have
√ ! √ !
b0 Φ log(X log(X
b /λ) σ b T b /λ) σ b T
E bT − λ) + ] = X
b [(X √0 + − λΦ √0 − ,
σ
b T 2 σ
b T 2
by the Black-Scholes formula with zero interest rate and volatility param-
eter σ
b = σ − η. By multiplication by N0 and the relation X0 = N0 X b0 we
conclude to (16.36), i.e.
E (XT − λNT )+ = N0 E bT − λ) +

b (X
b0 Φ(d+ ) − λN0 Φ(d− )
= N0 X
= X0 Φ(d+ ) − λN0 Φ(d− ).
1072 "
c) We have σ
b = σ − η.
Exercise 16.2
a) By the Girsanov Theorem 16.7, the processes
(1) (1) 1 (1) (1) 1 (2) (1) (1)

dB
b
t = dBt − dNt • dBt = dBt − (2) dSt • dBt = dBt − ηρdt,
Nt S t
and
(2) (2) 1 (2) (2) 1 (2) (2) (2)
dB
b
t = dBt − dNt • dBt = dBt − (2) dSt • dBt = dBt − ηdt
Nt S t
are both standard Brownian motions (and martingales) under P

b 2.
b) We have
(1)
!
(1) St
dSbt = d (2)
St
(1)
S0 (1) (2)
−ηBt −(σ 2 −η 2 )t/2
d e σBt

= (2)
S0
(1)
S0 (1) (2)
−ηBt −(σ 2 −η 2 )t/2
= (2)
e σBt
S0
σ2 η2 σ2 − η2

(1) (2)
× σdBt + dt − ηdBt + dt − dt − σηρdt
2 2 2
(1) (1) (2)
= St σdBt − ηdBt .
b b b
(1)
c) We note that the driftless geometric Brownian motion (Sbt )t∈R can be
written as
(1) (1) c
dSbt = σbSbt dW t,
where (W
ct )t∈R is a standard Brownian motion under P
b 2 . In order to
determine σ
b we note that
b2 dt = σ
σ b2 dWct • dW ct
(1) (1)
dSbt dSbt
= (1) • (1)
Sb Sbt
t
(1) b (2) · σdB (1) − ηdB
b (2)
= σdB − ηdB t t t t
= (σ 2 + η 2 − 2σηρ)dt,
" 1073
N. Privault
hence σ
b2 = σ 2 + η 2 − 2σηρ. We conclude by applying the change of
numéraire formula
(1) (2) + (2) b b(1) +
e −rT E∗ ST − λST = S0 E ST − λ
and the Black-Scholes formula to the the driftless geometric Brownian

(1)
motion (Sbt )t∈R .
Exercise 16.3 We have Nt = P (t, T ) and from (17.26) and the relations
P (t, T ) = F (t, rt ) and P (t, S ) = G(t, rt ) we find

dP (t, S ) ∂
= rt dt + σ (t, rt ) log G(t, rt )dWt ,


 P (t, S ) ∂x


 dNt dP (t, T ) ∂
log F (t, rt )dWt .

= = rt dt + σ (t, rt )


Nt P (t, T ) ∂x

By the Girsanov Theorem (16.12) we also have
dNt ∂
ct = dWt −
dW • dW = dW − σ (t, r )
t t t log F (t, rt )dt,
Nt ∂x
hence
dP (t, S ) ∂ ∂ ∂
= rt dt + σ 2 (t, rt ) log F (t, rt ) log G(t, rt )dt + σ (t, rt ) log G(t, rt )dW
ct .
P (t, S ) ∂x ∂x ∂x
Using the relation P (t, S ) = G(t, rt ) we can also write
∂ ∂ ∂
dP (t, S ) = rt P (t, S )dt + σ 2 (t, rt ) log F (t, rt ) G(t, rt )dt + σ (t, rt ) G(t, rt )dW
ct .
∂x ∂x ∂x
Exercise 16.4 Forward contract. Taking Nt := P (t, T ), t ∈ [0, T ], we have

w
b (P (T , S ) − K ) Ft

T
E∗ exp − rs ds (P (T , S ) − K ) Ft = Nt E

t NT
(P (T , S ) − K )

= P (t, T )E
b Ft
P (T , T )
= P (t, T )E
b [P (T , S ) − K | Ft ]
= P (t, T )Eb [P (T , S ) | Ft ] − KP (t, T )
b P (T , S ) | Ft − KP (t, T )

= P (t, T )E
P (T , T )
P (t, S )
= P (t, T ) − KP (t, T )
P (t, T )
1074 "
= P (t, S ) − KP (t, T ),
since
P (t, T ) P (t, S )
t 7−→ =
Nt P (t, T )
is a martingale under the forward measure P. b The corresponding (static)
hedging strategy is given by buying one bond with maturity S and by short
selling K units of the bond with maturity T .
Remark: The above result can also be obtained by a direct argument using
the tower property of conditional expectations:
w
T
E∗ exp − rs ds (P (T , S ) − K ) Ft

t
w w
T S
= E∗ exp − rs ds E∗ exp − rs ds FT − K Ft

t T
w w
T S
= E∗ exp − rs ds E∗ exp − rs ds − K FT Ft

t T
w w
S T
= E∗ E∗ exp − rs ds − K exp − rs ds FT Ft

t t
w w
S T
= E∗ exp − rs ds − K exp − rs ds Ft

t t
= P (t, S ) − KP (t, T ), t ∈ [0, T ].
Exercise 16.5
a) We choose Nt := St as numéraire because this allows us to write the option
payoff as (ST (ST − K ))+ = NT (ST − K )+ . In this case, the forward
measure Pb satisfies
dP N S
= e −rT T = e −rT T ,
b
dP N0 S0
or
dP
b |F N S
t
= e −(T −t)r T = e −(T −t)r T , 0 6 t 6 T.
dP|Ft Nt St
b) By the change of numéraire formula of Proposition 16.5, the option price
becomes
e −(T −t)r E∗ (ST (ST − K ))+ Ft = E∗ e −(T −t)r NT (ST − K )+ Ft

b (ST − K )+ Ft
= Nt E

= St E (ST − K )+ Ft . (A.71)

b
" 1075
N. Privault
c) In order to compute (A.71) it remains to determine the dynamics of

b Since St = S0 e σBt +rt−σ2 t/2 , we have
(St )t∈R+ under P.
dP S 2
= e −rT T = e σBT −σ T /2 ,
b
dP S0
hence by the Girsanov Theorem 7.3 B

bt := Bt − σt is a standard Brownian
motion under P,
b with
2 T /2
ST = S0 e rT +σBT −σ
(r +σ 2 )T +σ BT −σ 2 T /2
= S0 e b
2 )(T −t)+(BbT −Bbt )σ−(T −t)σ2 /2
= St e (r +σ , 0 6 t 6 T.
d) According to the above, (A.71) becomes

+
e −(T −t)r E∗ ST (ST − K ) Ft = St E b ST − K + Ft

b S0 e rT +σ2 T +σBbT −σ2 T /2 − K + Ft

= St E

b St e (r +σ2 )(T −t)+(BbT −Bbt )σ−(T −t)σ2 /2 − K + Ft

= St E

2
= St e (T −t)(r +σ ) Bl(St , r + σ 2 , σ, K, T − t), 0 6 t 6 T,
since the Black-Scholes formula with interest rate r + σ 2 reads

2
b St e (r +σ2 )(T −t)+(BbT −Bbt )σ−(T −t)σ2 /2 − K + Ft
e −(T −t)(r +σ ) E

= Bl(St , r + σ 2 , σ, K, T − t), 0 6 t 6 T.
Remarks:
i) The option price can be rewritten using other Black-Scholes parametriza-
tions, such as for example
2
St Bl St e (T −t)(r +σ ) , 0, σ, K, T − t ,

or
2 2
St e (T −t)(r +σ ) Bl St , 0, σ, K e −(T −t)(r +σ ) , T − t ,

however we prefer to choose the simplest possibility.

ii) Deflated (or forward) processes such as St /N1 = 1 or
e −(T −t)r ∗ b (ST − K )+ Ft ,

E (ST (ST − K ))+ Ft = E 0 6 t 6 T,

Nt
are martingales under the forward measure P.

b
1076 "
iii) This option can also be priced via an integral calculation instead of using
change of numéraire, as follows:
e −(T −t)r E∗ [ST (ST − K )+ | Ft ]

2
= e −(T −t)r E∗ St e (T −t)r +(BT −Bt )σ−(T −t)σ /2

2
×(St e (T −t)r +(BT −Bt )σ−(T −t)σ /2 − K )+ Ft

2 2
= St e −(T −t)σ /2 E∗ (St e (T −t)r +2(BT −Bt )σ−(T −t)σ /2 − K e (BT −Bt )σ )+ Ft

2 2
= St e −(T −t)σ /2 E∗ (x e (T −t)r +2(BT −Bt )σ−(T −t)σ /2 − K e (BT −Bt )σ )+ x=S

t
2
= St e −(T −t)σ /2 E∗ ( e m(x)+2X − K e X )+ x=S , 0 6 t 6 T,

t
where X ' N (0, v 2 ) with v 2 = (T − t)σ 2 and m(x) = (T − t)r − (T −

t)σ 2 /2 + log x. Next, we note that
+ 1 w∞ + 2 / (2v 2 )
E e m+2X − K e X e m+2x − K e x e −x

=√ dx
2πv 2 −∞
1 w∞ 2 / (2v 2 )
=√ ( e m+2x − K e x ) e −x dx
2πv 2 −m+log K
em w ∞ 2 / (2v 2 ) K w∞ 2 2
=√ e 2x−x dx − √ e x−x /(2v ) dx
e m+2v w ∞ K e v /2 w ∞
2 2
2 2 2 2 2 2
= √ e −(2v −x) /(2v ) dx − √ e −(v −x) /(2v ) dx
2πv 2 −m+log K 2π −m+log K
e m+2v w ∞ K e v /2 w ∞
2 2
−x2 /(2v 2 ) 2 2
= √ e dx − √ e −x /(2v ) dx
2πv 2 −2v2 −m+log K 2πv 2 −v2 −m+log K
e m+2v w ∞ K e v /2 w ∞
2 2
−x2 /2 2
= √ e dx − √ e −x /2 dx
2π (−2v 2 −m+log K )/v 2π (−v 2 −m+log K )/v
m − log K m − log K

2 2
= e m+2v Φ 2v + − K e v /2 Φ v + ,
v v
hence
+
e −(T −t)r E∗ ST ST − K Ft

2 +
= St e −(T −t)σ /2 E∗ e m(x)+2X − K e X

x = St
(T − t)(r + σ 2 ) + (T − t)σ 2 /2 + log(St /K )

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

−KSt Φ √
σ T −t
2
= St e (T −t)(r +σ ) Bl(St , r + σ 2 , σ, K, T − t), 0 6 t 6 T.
" 1077
N. Privault
Exercise 16.6
2 t/2
a) Knowing that St = S0 e σWt +rt−σ , we check that the discounted nu-
meraire process
2 t/2−nrt
e −rt Nt := Stn e −(n−1)nσ
2 t/2 2 t/2−nrt
= S0n e nσWt +nrt−nσ e −(n−1)nσ
−(nσ )2 t/2
= S0 e nσWt , 0 6 t 6 T,
is a martingale under P∗ , and
dP N Sn 2 2
= e −rT T = Tn e −nσ T −nrT = e nσWT −(nσ ) T /2 .
b
(A.72)
dP∗ N0 S0
b) From Equation (A.72) and the Girsanov theorem, the process W

ct := Wt −
σnt is a standard Brownian motion under P,
b and we have
2
St = S0 e rt+σWt −σ t/2
b t +nσt)−σ2 t/2
= S0 e rt+σ (W
2 b t +σ2 t/2
= S0 e (r +nσ )t+σW , t > 0.
c) We have
e −(T −t)r E∗ STn 1{ST >K} Ft = E∗ e −(T −t)r STn 1{ST >K} Ft

= e (n−1)nσ T /2+(n−1)rT E∗ NT 1{ST >K} Ft

2
2
= e (n−1)nσ T /2+(n−1)rT Nt E b 1{S >K} Ft

T
2 T /2+(n−1)rT
= e (n−1)nσ Nt P
b (ST > K | Ft )
log(St /K ) + (r + (n − 1/2)σ 2 )(T − t)

2
= e (n−1)nσ T /2+(n−1)rT Nt Φ √
σ T −t
log ( ) + (r + (n − 1/2)σ 2 )(T − t)

2 S t /K
= Stn e (n−1)nσ (T −t)/2+(n−1)r (T −t) Φ √ ,
σ T −t
0 6 t 6 T , n > 0. Hence the power call option with payoff (STn − K n )+

is priced at time t ∈ [0, T ] as
+
e −(T −t)r E∗ STn − K n Ft

log(St /K ) + (r + (n − 1/2)σ 2 )(T − t)

2 (T −t) /2+(n−1)r (T −t)
= Stn e (n−1)nσ Φ √
σ T −t
log(St /K ) + (r − σ 2 /2)(T − t)

−K n e −(T −t)r Φ √ , n > 1.
σ T −t
1078 "
Exercise 16.7 Bond options.

a) Itô’s formula yields
P (t, S ) P (t, S ) S

ζ (t) − ζ T (t) (dWt − ζ T (t)dt)

d =
P (t, T ) P (t, T )
P (t, S ) S ct ,
ζ ( t ) − ζ T ( t ) dW (A.73)

=
P (t, T )
where (W ct )t∈R is a standard Brownian motion under P

+
b by the Girsanov
Theorem 7.3.
b) From (A.73) or (19.7) we have
w wt
P (t, S ) P (0, S ) cs − 1

t
exp ζ S (s) − ζ T (s) dW ζ S (s) − ζ T (s)2 ds ,

=
P (t, T ) P (0, T ) 0 2 0
hence
w wu
P (u, S ) P (t, S ) cs − 1

u
exp ζ S ( s ) − ζ T ( s ) dW ζ S (s) − ζ T (s)2 ds ,

=
P (u, T ) P (t, T ) t 2 t
t ∈ [0, u], and for u = T this yields

w wT
P (t, S ) cs − 1

T
P (T , S ) = exp ζ S ( s ) − ζ T ( s ) dW ζ S (s) − ζ T (s)2 ds ,

P (t, T ) t 2 t
since P (T , T ) = 1. Let P
b denote the forward measure associated to the
numéraire
Nt := P (t, T ), 0 6 t 6 T.
c) For all S > T > 0 we have
h rT i
E e − t rs ds (P (T , S ) − K )+ Ft

1 w T S
" + #
P (t, S )

2
= P (t, T )E exp X − ζ (s) − ζ T (s) ds − K Ft
b
P (t, T ) 2 t
b e X +m(t,T ,S ) − K + Ft ,
= P (t, T )E

where X is a centered Gaussian random variable with variance

wT
v 2 (t, T , S ) = ζ S (s) − ζ T (s)2 ds

t
given Ft , and
1 P (t, S )
m(t, T , S ) = − v 2 (t, T , S ) + log .
2 P (t, T )
" 1079
N. Privault
Recall that when X is a centered Gaussian random variable with variance

v 2 , the expectation of ( e m+X − K )+ is given, as in the standard Black-
Scholes formula, by
2 /2
E[( e m+X − K )+ ] = e m+v Φ(v + (m − log K )/v ) − KΦ((m − log K )/v ),
where wz 2 /2 dy
Φ (z ) = e −y √ , z ∈ R,
−∞ 2π
denotes the Gaussian cumulative distribution function and for simplicity
of notation we dropped the indices t, T , S in m(t, T , S ) and v 2 (t, T , S ).
Consequently we have
h rT i
E e − t rs ds (P (T , S ) − K )+ Ft

1 P (t, S ) 1 P (t, S )

v v
= P (t, S )Φ + log − KP (t, T )Φ − + log .
2 v KP (t, T ) 2 v KP (t, T )
d) The self-financing hedging strategy that hedges the bond option is ob-
tained by holding a (possibly fractional) quantity
1 P (t, S )

v
Φ + log
2 v KP (t, T )
of the bond with maturity S, and by shorting a quantity
1 P (t, S )

v
KΦ − + log
2 v KP (t, T )
of the bond with maturity T .
Exercise 16.8
a) The process
e −rt S2 (t) = S2 (0) e σ2 Wt +(µ−r )t
is a martingale if
1 2
r−µ = σ .
2 2
b) We note that
2
e −rt Xt = e −rt e (r−µ)t−σ1 t/2 S1 (t)
−rt (σ22 −σ12 )t/2
= e e S1 (t)
−µt−σ12 t/2
= e S1 (t)
1080 "
2
= S1 (0) e µt−σ1 t/2 e σ1 Wt +µt
2
= S1 (0) e σ1 Wt −σ1 t/2
is a martingale, where
2 2 2
Xt = e (r−µ)t−σ1 t/2 S1 (t) = e (σ2 −σ1 )t/2 S1 (t).
c) By (16.38) we have
b (t) = Xt
X
Nt
2 2 S1 (t)
= e (σ2 −σ1 )t/2
S2 (t)
S1 (0) (σ2 −σ2 )t/2+(σ1 −σ2 )Wt
= e 2 1
S2 (0)
S1 (0) (σ2 −σ2 )t/2+(σ1 −σ2 )W b t +σ2 (σ1 −σ2 )t
= e 2 1
S2 (0)
S1 (0) (σ1 −σ2 )W
b t +σ2 σ1 t−(σ22 +σ12 )t/2
= e
S2 (0)
S1 (0) (σ1 −σ2 )W
b t −(σ1 −σ2 )2 t/2
= e ,
S2 (0)
where
ct := Wt − σ2 t
W
b defined by
dP rT N
= e − 0 rs ds T
b
dP N0
−rT S2 (T )
= e
S2 (0)
= e −rT e σ2 WT +µT
= e σ2 WT +(µ−r )T
2
= e σ2 WT −σ2 t/2 .
2 2
d) Given that Xt = e (σ2 −σ1 )t/2 S1 (t) and X
b (t) = Xt /Nt = Xt /S2 (t), we
have
2 2
e −rT E[(S1 (T ) − κS2 (T ))+ ] = e −rT E[( e −(σ2 −σ1 )T /2 XT − κS2 (T ))+ ]
2 2 2 2
= e −rT e −(σ2 −σ1 )T /2 E[(XT − κ e (σ2 −σ1 )T /2 S2 (T ))+ ]
2 2
= S2 (0) e −(σ2 −σ1 )T /2 E bT − κ e (σ22 −σ12 )T /2 )+ ]
b [(X
2 2 2 T /2 2 2
= S2 (0) e −(σ2 −σ1 )T /2 E b0 e (σ1 −σ2 )W
b [(X b T −(σ1 −σ2 )
− κ e (σ2 −σ1 )T /2 )+ ]
" 1081
N. Privault
2 2
= S2 (0) e −(σ2 −σ1 )T /2 X b0 ) − κ e (σ22 −σ12 )T /2 Φ0− (T , X
b0 Φ0+ (T , X

b0 )
2 2
= S2 (0) e −(σ2 −σ1 )T /2 X
b0 Φ0+ (T , X
b0 )
−(σ22 −σ12 )T /2 2 2
−κS2 (0) e e (σ2 −σ1 )T /2 Φ0− (T , X
b0 )
2 2
= X0 e −(σ2 −σ1 )T /2 Φ0+ (T , X
b0 ) − κS2 (0)Φ0− (T , X
b0 )
2 2
−(σ2 −σ1 )T /2 0
= S1 (0) e Φ+ (T , X0 ) − κS2 (0)Φ− (T , X
b 0 b0 ),
where
log(x/κ) (σ − σ2 )2 − (σ22 − σ12 ) √

Φ0+ (T , x) = Φ √ + 1 T
|σ1 − σ2 | T 2|σ1 − σ2 |

log(x/κ) √


 Φ √ + σ1 T , σ1 > σ2 ,
|σ1 − σ2 | T



=
log(x/κ) √

Φ √ − σ1 T , σ1 < σ2 ,



|σ1 − σ2 | T
and
log(x/κ) (σ − σ2 )2 + (σ22 − σ12 ) √

Φ0− (T , x) = Φ √ − 1 T
|σ1 − σ2 | T 2|σ1 − σ2 |

log(x/κ) √


 Φ √ + σ2 T , σ1 > σ2 ,
|σ1 − σ2 | T



=
log(x/κ) √

Φ √ − σ2 T , σ1 < σ2 ,



|σ1 − σ2 | T
if σ1 6= σ2 . In case σ1 = σ2 , we find
e −rT E[(S1 (T ) − κS2 (T ))+ ] = e −rT E[S1 (T )(1 − κS2 (0)/S1 (0))+ ]
= (1 − κS2 (0)/S1 (0))+ e −rT E[S1 (T )]
= (S1 (0) − κS2 (0))1{S1 (0)>κS2 (0)} .
e −(T −t)r E∗ 1{RT >κ} Rt = e −(T −t)r P∗ RT > κ Rt

f )(T −t)−(T −t)σ 2 /2

= e −(T −t)r P∗ Rt e (WT −Wt )σ +(r−r

> κ Rt
)σ +(r−rf )(T −t)−(T −t)σ 2 /2
= e −(T −t)r P∗ x e (WT −Wt

> κ x=R
t

( r − r f )(T − t) − (T − t)σ 2 /2 − log (κ/R )
−(T −t)r t
= e Φ √ ,
σ T −t
after applying the hint provided, with
1082 "
η 2 : = (T − t)σ 2 and µ := (r − rf )(T − t) − (T − t)σ 2 /2.
Remark: Binary options are often proposed at the money, i.e. κ = Rt , with
a short time to maturity, for example the small value
T − t ' 30 seconds = 0.000000951 = 9.51 × 10−7 year−1 ,
in which case we have

r − rf √

σ
e −(T −t)r E∗ 1{RT >κ} Rt = e −(T −t)r Φ

− T −t
σ 2
' Φ (0)
1
= .
2
Taking for example r − rf = 0.02 = 2% and σ = 0.3 = 30%, we have
r − rf σ √ 0.02 0.3 p

− T −t = − 9.51 × 10−7 = −0.000081279
σ 2 0.3 2
and
e −(T −t)r E∗ 1{RT >κ} Rt = e −(T −t)r Φ(−0.000081279)

= e −r×0.000000951 × 0.499968
= 0.49996801
1
' ,
2
with r = 0.02 = 2%.
Exercise 16.10
a) It suffices to check that the definition of (WtN )t∈R+ implies the correlation
identity dWtS • dWtN = ρdt by Itô’s calculus.
b) We let q
bt =
σ (σtS )2 − 2ρσtR σtS + (σtR )2
and
σtS − ρσtN p σN
dWtX = dWtS − 1 − ρ2 t dWt , t > 0,
σ
bt σ
bt
which defines a standard Brownian motion under P∗ due to the definition
of σ
bt .
Exercise 16.11
a) We have σ (σ S )2 − 2ρσ R σ S + (σ R )2 .
p
b=
" 1083
N. Privault
et = e −rt Xt = e (a−r )t St /Rt , t > 0, we have

b) Letting X
" + #
ST +
∗
E −κ Ft = e −aT E∗ XT − e aT κ Ft

RT
+
= e −(a−r )T E∗ X eT − e (a−r )T κ Ft
et Φ (r − a +√ b2 /2)(T − t) 1

σ St
= e −(a−r )T X + √ log
b T −t
σ b T −t
σ κRt
(r − a − σb2 /2)(T − t) 1

(a−r )T St
−κ e Φ √ + √ log
b T −t
σ σb T −t κRt
(r − a + σb2 /2)(T − t) 1

St (r−a)(T −t) St
= e Φ √ + √ log
Rt b T −t
σ σb T −t κRt
(r − a − σ b2 /2)(T − t) 1

St
−κΦ √ + √ log ,
b T −t
σ b T −t
σ κRt
hence the price of the quanto option is

" + #
ST
e −(T −t)r E∗ −κ Ft

RT
b2 /2)(T − t)
(r − a + σ 1

St −a(T −t) St
= e Φ √ + √ log
Rt b T −t
σ b T −t
σ κRt
b2 /2)(T − t)
(r − a − σ 1

−r (T −t) St
−κ e Φ √ + √ log .
b T −t
σ b T −t
σ κRt
Chapter 17
Exercise 17.1
a) We have
a
wt
drt = r0 d e −bt + d 1 − e −bt + σd e −bt e bs dBs

b 0
wt wt
−bt −bt −bt
= −br0 e dt + a e dt + σ e e dBs + σ
d bs
e bs dBs d e −bt
0 0
wt
= −br0 e −bt dt + a e −bt dt + σ e −bt e bt dBt − σb e bs dBs e −bt dt
0
wt
= −br0 e −bt dt + a e −bt dt + σdBt − σb e bs dBs e −bt dt
0 a
= −br0 e −bt dt + a e −bt dt + σdBt − b rt − r0 e −bt − 1 − e −bt dt
b
= (a − brt )dt + σdBt ,
1084 "
which shows that rt solves (17.46).

b) We note that
a wt
rt = r0 e −bt + 1 − e −bt + σ e −(t−u)b dBu

b 0
a
= r0 e −bs e −(t−s)b + e −(t−s)b 1 − e −bs

b
a ws wt
+ 1 − e (t−s)b + σ e −(t−s)b e −(s−u)b dBu + σ e −(t−u)b dBu

b 0 s
a w t −(t−u)b
= rs e −(t−s)b + 1 − e (t−s)b + σ e dBu , 0 6 s 6 t.

b s
Hence, assuming that rs has the N (a/b, σ 2 /(2b)) distribution, the distri-
bution of rt is Gaussian with mean
a
E[rt ] = e −(t−s)b E[rs ] +
1 − e (t−s)b

b
a a
= e −(t−s)b + 1 − e (t−s)b

b b
a
= ,
b
and variance

a wt
Var[rt ] = Var rs e −(t−s)b + 1 − e (t−s)b + σ e −(t−u)b dBu

b s
wt
−(t−s)b −(t−u)b
= Var rs e +σ e dBu
s
w
t −(t−u)b
= Var rs e −(t−s)b + Var σ e

dBu
s
w
−2(t−s)b t −(t−u)b
= e Var rs + σ Var
2
e

dBu
s
σ2 wt
= e −2(t−s)b + σ 2 e −2(t−u)b du
2b s
σ2 w t−s
= e −2(t−s)b + σ 2 e −2bu du
2b 0
σ2
= , t > 0.
2b
Exercise 17.2
i) The zero-coupon bond price P (t, T ) in the Vasicek model is given by
log P (t, T ) = A(T − t) + rt C (T − t), 0 6 t 6 T,
where
" 1085
N. Privault
1
1 − e −(T −t)b ,

C (T − t) : = −
b
and
4ab − 3σ 2 σ 2 − 2ab
A(T − t) : = + (T − t)
4b 3 2b2
2
σ − ab −(T −t)b σ 2 −2(T −t)b
+ e − 3e 0 6 t 6 T .(A.74)
b3 4b
Since limT →∞ C (T − t)/(T − t) = 0 and
lim A(T − t)/(T − t) = (σ 2 − 2ab)/(2b2 ),

T →∞
we find
log P (t, T ) σ 2 − 2ab a σ2
r∞ = − lim =− = − 2 = lim (E[rt ] − Var[rt ]).
T →∞ T −t 2b2 b 2b t→∞
ii) We have
P (t, T )
log = log P (t, T ) − log P (0, T )
P (0, T )
= A(T − t) − A(T ) + rt (C (T − t) − C (T ))
σ 2 − 2ab σ 2 − ab −bT bt σ2
= −t + e ( e − 1) − 3 e −2bT ( e 2bt − 1),
2b2 b3 4b
hence
P (t, T ) σ 2 − 2ab σ2

a
lim log = −t = − t = r∞ t,
T →∞ P (0, T ) 2b2 b 2b2
and∗
P (t, T ) 2 2
lim log = e t(a/b−σ /(2b )) = e r∞ t ,
T →∞ P (0, T )
which shows that the yield of the long-bond return is the asymptotic
bond yield r∞ .
Remark: By (1.4.15) of the course notes, the Vasicek bond price P (t, T )
can be rewritten in terms of the asymptotic bond yield r∞ as
2 C 2 (T −t) / (4b)
P (t, T ) = e −(T −t)r∞ +(rt −r∞ )C (T −t)−σ , 0 6 t 6 T,
see e.g. Relation (3.12) in Brody et al. (2018).

∗
The log function is continuous on (0, ∞).
1086 "
Exercise 17.3 An estimator of σ can be obtained from the orthogonality

relation
n−1 n−1
X 2 X
r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ = σ 2 (r̃tl )2γ (Zl )2 − ∆t

l =0 l =0
' 0,
which is due to the independence of ttl and Zl , l = 0, . . . , n − 1, and yields

n−1
X 2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl
l =0
b2 =
σ n−1
.
X
∆t (r̃tl ) 2γ
l =0
Regarding the estimation of γ, we can combine the above relation with the
second orthogonality relation
n−1
X 2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ r̃tl

l =0
n−1
(r̃tl )2γ +1 (Zl )2 − ∆t
X
= σ2

l =0
' 0,
cf. § 2.2 of Faff and Gray (2006). One may also attempt to minimize the
residual
n−1
X 2
2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ
l =0
by equating the following derivatives to zero, as
n−1 2
∂ X 2
∂σ
l =0
n−1
X 2
(r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ

= −4σ
l =0
= 0,
hence
n−1 n−1
X 2 X
(r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t (r̃tl )4γ = 0,
l =0 l =0
" 1087
N. Privault
which yields
n−1
X 2
(r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl
l =0
b2 =
σ n−1
. (A.75)
X
∆t (r̃tl )4γ
l =0
We also have
n−1 2
∂ X 2
∂γ
l =0
n−1
X 2
= −4σ 2 ∆t (r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ log r̃tl

l =0
= 0,
which yields
n−1
X 2
(r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl log r̃tl
l =0
2
b =
σ n−1
, (A.76)
X
∆t (r̃tl )4γ log r̃tl
l =0
and shows that γ can be estimated by matching Relations (A.75) and (A.76),
i.e.
n−1
X 2
(r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl
l =0
n−1
X
(r̃tl )4γ
l =0
n−1
X 2
(r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl log r̃tl
l =0
= n−1
.
X
(r̃tl ) 4γ
log r̃tl
l =0
Remarks.
i) Estimators of a and b can be obtained by minimizing the residual
1088 "
n−1
X 2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl
l =0
as in the Vašíček (1977) model, i.e. from the equations

n−1
X
r̃tl+1 − a∆t − (1 − b∆t)r̃tl = 0

l =0
and
n−1
X
r̃tl+1 − a∆t − (1 − b∆t)r̃tl r̃tl = 0.

l =0
ii) Instead of using the (generalised) method of moments, parameter esti-

mation for stochastic differential equations can be achieved by maximum
likelihood estimation, see e.g. Lindström (2007) and references therein.
Exercise 17.4
a) We have rt = r0 + at + σBt , and
F (t, rt ) = F (t, r0 + at + σBt ),
hence by Proposition 17.2 the PDE satisfied by F (t, x) is
∂F ∂F 1 ∂2F
− xF (t, x) + (t, x) + a (t, x) + σ 2 2 (t, x) = 0, (A.77)
∂t ∂x 2 ∂x
with terminal condition F (T , x) = 1.
b) We have rt = r0 + at + σBt and
w
T
F (t, rt ) = E∗ exp − rs ds Ft

t
wT wT
= E∗ exp −r0 (T − t) − a sds − σ Bs ds Ft

t t

2 2
wT
= E∗ e −r0 (T −t)−a(T −t )/2 exp −(T − t)Bt − σ (T − s)dBs Ft

t
2 2
wT
= e −r0 (T −t)−a(T −t )/2−(T −t)σBt E∗ exp −σ (T − s)dBs Ft

t
wT
= e −r0 (T −t)−a(T −t)(T +t)/2−(T −t)σBt E∗ exp −σ (T − s)dBs
t
σ2 w T

= exp −(T − t)rt − a(T − t) /2 + 2 2
(T − s) ds
2 t
= exp −(T − t)rt − a(T − t) /2 + (T − t)3 σ 2 /6 ,
2

" 1089
N. Privault
hence F (t, x) = exp −(T − t)x − a(T − t)2 /2 + (T − t)3 σ 2 /6 .

Note that the PDE (A.77) can also be solved by looking for a solution
of the form F (t, x) = e A(T −t)+xC (T −t) , in which case one would find
A(s) = −as2 /2 + σ 2 s3 /6 and C (s) = −s.
c) We check that the function F (t, x) of Question (b) satisfies the PDE
(A.77) of Question (a), since F (T , x) = 1 and
σ2

−xF (t, x) + x + a(T − t) − (T − t)2 F (t, x) − a(T − t)F (t, x)
2
σ2
+ (T − t)2 F (t, x) = 0.
2
wt
Exercise 17.5 We check from (17.51) and the differentiation rule d f (u)du =
0
f (t)dt that
w
t 1

drt = αβd St du + r0 dtSt
0 Su
wt 1 wt 1
= αβSt d du + αβ dudSt + r0 dtSt
0 Su 0 Su
St w t St dSt
= αβ dt + αβ du + r0 dSt
St 0 Su St
dSt
= αβdt + (rt − r0 St ) + r0 dSt
St
dSt
= αβdt + rt
St
= αβdt + rt (−βdt + σdBt )
= β (α − rt )dt + σdBt , t > 0.
Exercise 17.6
a) Applying the Itô formula
1
df (rt ) = f 0 (rt )drt + f 00 (rt )(drt )2
2
to the function f (x) = x2−γ with
f 0 (x) = (2 − γ )x1−γ and f 00 (x) = (2 − γ )(1 − γ )x−γ ,
we have
dRt = drt2−γ
1090 "
= df (rt )
1
= f 0 (rt )drt + f 00 (rt )(drt )2
2
= f 0 (rt ) (βrtγ−1 + αrt )dt + σrtγ/2 dBt drt +

1 00 2
f (rt ) (βrtγ−1 + αrt )dt + σrtγ/2 dBt
2
σ2
= f 0 (rt ) (βrtγ−1 + αrt )dt + σrtγ/2 dBt drt + f 00 (rt )rtγ dt

2
σ2
= (2 − γ )rt 1−γ
(βrt + αrt )dt + σrt dBt + (2 − γ )(1 − γ )rtγ rt−γ dt
γ−1 γ/2
2
σ2
= (2 − γ )(β + αrt )dt + (2 − γ )(1 − γ )dt + σ (2 − γ )rt1−γ/2 dBt
2−γ
2
σ2 p
= (2 − γ ) β + (1 − γ ) + αRt dt + (2 − γ )σ Rt dBt .
2
We conclude that the process Rt = rt2−γ follows the CIR equation

p
dRt = b(a − Rt )dt + η Rt dBt
with initial condition R0 = r02−γ and coefficients
1 σ2

b = (2 − γ )α, a= β + (1 − γ ) , and η = (2 − γ )σ.
α 2
b) By Itô’s formula and the relation P (t, T ) = F (t, rt ), t ∈ [0, T ], we have

rt rt rt
d e − 0 rs ds P (t, T ) = −rt e − 0 rs ds P (t, T )dt + e − 0 rs ds dP (t, T )
rt rt
= −rt e − 0
rs ds
F (t, rt )dt + e − 0
rs ds
dF (t, rt )
rt rt rt
− − rs ds ∂F rs ds ∂F
= −rt e 0
rs ds
F (t, rt )dt + e 0 (t, rt )dt + e − 0 (t, rt )drt
∂t ∂x
rt
rs ds 1 ∂2F
+ e− 0 (t, rt )(drt )2
2 ∂x2
rt rt ∂F −(1−γ )
= −rt e − F (t, rt )dt + e − 0 rs ds
0
rs ds
(t, rt )((βrt + αrt )dt + σrtγ/2 dBt )
∂x
rt
∂F 1 ∂2F

+ e − 0 rs ds (t, rt ) + σ 2 rtγ 2 (t, rt ) dt
∂t 2 ∂x
rt
− 0 rs ds γ/2 ∂F
= e σrt (t, rt )dBt
rt ∂x
−(1−γ ) ∂F
+ e − 0 rs ds −rt F (t, rt ) + (βrt + αrt ) (t, rt )
∂x
1 ∂2F

∂F
+ σ 2 rtγ 2 (t, rt ) + (t, rt ) dt. (A.78)
2 ∂x ∂t
" 1091
N. Privault
rt
Given that t 7−→ e − 0 rs ds P (t, T ) is a martingale, the above expression
(A.78) should only contain terms in dBt and all terms in dt should vanish
inside (A.78). This leads to the identities

 r F (t, r ) = (βr−(1−γ ) + αr ) ∂F (t, r ) + 1 σ 2 rγ ∂ F (t, r ) + ∂F (t, r )
 2
t t t t t t
t
2 t

∂x ∂x2 ∂t




 rt rt ∂F
 d e − 0 rs ds P (t, T ) = σ e − 0 rs ds rtγ/2

(t, rt )dBt ,


∂x
and to the PDE
∂F ∂F σ2 ∂ 2 F
xF (t, x) = (t, x) + (βx−(1−γ ) + αx) (t, x) + xγ 2 (t, x).
∂t ∂x 2 ∂x
Exercise 17.7
rt
a) The discounted bond prices process e − 0 rs ds F (t, rt ) is a martingale, and
we have
rt
d e − 0 rs ds F (t, rt )
rt
∂F ∂F σ2 ∂ 2 F

= e − 0 rs ds −rt F (t, rt )dt + (t, rt )dt + (t, rt )drt + ( t, rt )( drt ) 2
∂t ∂x 2 ∂x2
rt
∂F ∂F √

= e − 0 rs ds −rt F (t, rt )dt + (t, rt )dt + (t, rt )(−art dt + σ rt dBt )
∂t ∂x
rt 2 ∂2F
rs ds σ
+rt e − 0 (t, rt )dt,
2 ∂x2
hence F (t, x) satisfies the affine PDE
∂F ∂F σ2 ∂ 2 F
− xF (t, x) + (t, x) − ax (t, x) + x (t, x) = 0. (A.80)
∂t ∂x 2 ∂x2
b) Plugging F (t, x) = e A(T −t)+xC (T −t) into the PDE (A.80) shows that
2

σ x 2
e A(T −t)+xC (T −t) −x − A0 (T − t) − xC 0 (T − t) − axC (T − t) + C (T − t)
2
= 0.
Taking successively x = 0 and x = 1 in the above relation then yields the

two equations
 0
 A (T − t) = 0,

2
 −1 − C 0 (T − t) − aC (T − t) + σ C 2 (T − t) = 0.

2
1092 "
Remark: The initial condition A(0) = 0 shows that A(s) = 1, and it can
be shown from the condition C (0) = 0 that
2(1 − e γ (T −t) )
C (T − t) = , t ∈ [0, T ],
2γ + (a + γ )( e γ (T −t) − 1)
√
with γ = a2 + 2σ 2 , see e.g. Eq. (3.25) page 66 of Brigo and Mercurio
(2006).
Exercise 17.8
a) The payoff of the convertible bond is given by Max(αSτ , P (τ , T )).
b) We have
Max(αSτ , P (τ , T )) = P (τ , T )1{αSτ 6P (τ ,T ))} + αSτ 1{αSτ >P (τ ,T ))}

= P (τ , T ) + (αSτ − P (τ , T ))1{αSτ >P (τ ,T ))}
= P (τ , T ) + (αSτ − P (τ , T ))+
= P (τ , T ) + α(Sτ − P (τ , T )/α)+ ,
where the latter European call option payoff has the strike price K :=
P (τ , T )/α.
c) From the Markov property applied at time t ∈ [0, τ ], we will write the
corporate bond price as a function C (t, St , rt ) of the underlying asset price
and interest rate, hence we have
h rτ i
C (t, St , rt ) = E∗ e − t rs ds Max(αSτ , P (τ , T )) Ft .

The martingale property follows from the equalities

rt rt h rτ i
e − 0 rs ds C (t, St , rt ) = e − 0 rs ds E∗ e − t rs ds Max(αSτ , P (τ , T )) Ft

h rτ i
= E∗ e − 0 rs ds Max(αSτ , P (τ , T )) Ft .

d) We have
rt
d e − 0 rs ds C (t, St , rt )
rt rt
rs ds ∂C
= −rt e − 0
rs ds
C (t, St , rt )dt + e − 0 (t, St , rt )dt
∂t
rt
rs ds ∂C (1)
+ e− 0 (t, St , rt )(rSt dt + σSt dBt )
∂x
rt ∂C (2)
+ e − 0 rs ds (t, St , rt )(γ (t, rt )dt + η (t, St )dBt )
∂y
" 1093
N. Privault
rt 2
∂2C rt 1 ∂2C
rs ds σ
+ e− 0 (t, St , rt )dt + e − 0 rs ds η 2 (t, rt )
St2 (t, St , rt )dt
2 ∂x2 2 ∂y 2
rt 2
∂ C
+ρσSt η (t, rt ) e − 0 rs ds (t, St , rt )dt. (A.81)
∂x∂y
rt
The martingale property of e − 0 rs ds C (t, St , rt ) t∈R shows that the sum

+
of terms in factor of dt vanishes in the above Relation (A.81), which yields
the PDE
∂C ∂C ∂C
0 = − yC (t, x, y ) +(t, x, y )dt + ry (t, x, y ) + γ (t, y ) (t, x, y )
∂t ∂x ∂y
σ2 ∂ 2 C 1 ∂2C ∂2C
+ x2 2 (t, x, y ) + η 2 (t, y ) (t, x, y ) + ρσxη (t, y ) (t, x, y ),
2 ∂x 2 ∂y 2 ∂x∂y
C (τ , x, y ) = Max(αx, F (τ , y )), where F (τ , rτ ) = P (τ , T )
is the bond pricing function.

e) The convertible bond can be priced as
h rτ i
E∗ e − t rs ds Max(αSτ , P (τ , T )) Ft

h rτ i h rτ i
= E∗ e − t rs ds P (τ , T ) Ft + αE∗ e − t rs ds (Sτ − P (τ , T )/α)+ Ft

b (Sτ /P (τ , T ) − 1/α)+ Ft .
= P (t, T ) + αP (t, T )E (A.82)

f) By Proposition 16.8 we find
ct ,
dZt = (σ − σB (t))Zt dW
where (W ct )t∈R is a standard Brownian motion under the forward mea-

+
sure Pb.
g) By modeling (Zt )t∈R+ as the geometric Brownian motion
ct ,
dZt = σ (t)Zt dW
(A.82) shows that the convertible bond is priced as
P (t, T ) + αSt Φ(d+ ) − P (t, T )Φ(d− ),
where
1094 "
1 v 2 (t, τ )

St
d+ = log + ,
v (t, T ) P (t, T ) 2
1 v 2 (t, τ )

St
d− = log − ,
v (t, T ) P (t, T ) 2
rT
and v 2 (t, T ) = t σ 2 (s, T )ds, 0 < t < T .

1 1

∂ ∂ c
Pc (0, n) = + 1 −
∂r ∂r (1 + r )n r (1 + r )n
1

n c nc
=− − 1 − + ,
(1 + r )n+1 r 2 (1 + r )n r (1 + r )n+1
hence
1+r ∂
Dc (0, n) = − Pc (0, n)
Pc (0, n) ∂r
(1 + r )c 1

n nc
− − 1 − +
(1 + r )n r2 (1 + r )n r (1 + r )n
= −
1 1

c
+ 1 −
(1 + r )n r (1 + r )n
1+r
−nr − (c((1 + r ) − 1)) + nc
n
= − r
r + c ((1 + r )n − 1)
1+r
1 + r − nr − (r + c((1 + r )n − 1)) + nc
= − r
r + c ((1 + r )n − 1)
1+r 1 + r + n(c − r )
= −
r r + c ((1 + r )n − 1)
(1 − c/r )n 1+r c ((1 + r )n − 1)

= + ,
1 + c ((1 + r ) − 1) /r
n r r + c ((1 + r ) − 1)
n
with D0 (0, n) = n. We note that
1+r 1 + r + n(c − r ) 1

lim Dc (0, n) = lim − = 1+ .
n→∞ n→∞ r r + c ((1 + r ) − 1)
n r
When n becomes large, the duration (or relative sensitivity) of the bond price
converges to 1 + 1/r whenever the (nonnegative) coupon amount c is nonzero,
otherwise the bond duration of Pc (0, n) is n. In particular, the presence of a
nonzero coupon makes the duration (or relative sensitivity) of the bond price
bounded as n increases, whereas the duration n of P0 (0, n) goes to infinity
" 1095
N. Privault
as n increases.
As a consequence, the presence of the coupon tends to put an upper limit

the risk and sensitivity of bond prices with respect to the market interest
rate r as n becomes large, which can be used for bond immunization. Note
that the duration Dc (0, n) can also be written as the relative average
n
!
1 n X k
Dc (0, n) = + c
Pc (0, n) (1 + r )n (1 + r )k
k =1
of zero coupon bond durations, weighted by their respective zero-coupon

prices.
Exercise 17.10
a) We have
w wt 1wt T 2

t
P (t, T ) = P (s, T ) exp ru du + σuT dBu − |σu | du ,
s s 2 s
0 6 s 6 t 6 T.
b) We have
rt rt
d e − 0 rs ds P (t, T ) = e − 0 rs ds σtT P (t, T )dBt ,
which gives a martingale after integration, from the properties of the Itô
integral.
c) By the martingale property of the previous question we have
h rT i h rT i
E e − 0 rs ds Ft = E P (T , T ) e − 0 rs ds Ft

rt
= P (t, T ) e − 0
rs ds
, 0 6 t 6 T.
d) By the previous question we have

rt h rT i
P (t, T ) = e E e − 0 rs ds Ft
rs ds
0

h rt rT i
= E e 0 rs ds e − 0 rs ds Ft

h rT i
= E e − t rs ds Ft , 0 6 t 6 T,

rt
since e − 0
rs ds
is an Ft -measurable random variable.
e) We have
w
P (t, S ) P (s, S ) 1wt S 2

t S
= exp (σu − σuT )dBu − (|σu | − |σuT |2 )du
P (t, T ) P (s, T ) s 2 s
1096 "
w
P (s, S ) 1wt S

t S
= exp (σu − σuT )dBuT − (σu − σuT )2 du ,
P (s, T ) s 2 s
0 6 t 6 T , hence letting s = t and t = T in the above expression, we find

w
P (t, S ) 1wT S

T 2
P (T , S ) = exp σsS − σsT dBsT − σs − σsT ds .

P (t, T ) t 2 t
f) We have
b (P (T , S ) − κ) +
P (t, T )E

" + #
P (t, S ) r T (σsS −σsT )dBsT −r T (σsS −σsT )2 ds/2
= P (t, T )Eb e t t −κ
P (t, T )
∗
+
= P (t, T )E e − κ Ft
X
v (t) 1

2
= P (t, T ) e m(t)+v (t)/2 Φ + (m(t) + v 2 (t)/2 − log κ)
2 v (t)
v (t) 1

−κP (t, T )Φ − + (m(t) + v 2 (t)/2 − log κ) ,
2 v (t)
where
P (t, S ) 1 w T S 2
m(t) := log − σs − σsT ds,
P (t, T ) 2 t
and X is a centered Gaussian random variable with variance
wT 2
v 2 (t) : = σsS − σsT ds,
t
given Ft . This yields

b (P (T , S ) − κ) +
P (t, T )E

v (t) 1 P (t, S ) v (t) 1 P (t, S )

= P (t, S )Φ + log − κP (t, T )Φ − + log .
2 v (t) κP (t, T ) 2 v (t) κP (t, T )
Exercise 17.11 (Exercise 4.17 continued). From Proposition 17.2, the bond
pricing PDE is
∂F ∂F 1 ∂2F

 (t, x) = xF (t, x) − (α − βx) (t, x) − σ 2 x2 2 (t, x)
2

∂t ∂x ∂x

F (T , x) = 1.

We search for a solution of the form
F (t, x) = e A(T −t)−xB (T −t) ,
" 1097
N. Privault
with A(0) = B (0) = 0, which implies

 0
 A (s) = 0

 B 0 (s) + βB (s) + 1 σ 2 B 2 (s) = 1,


2
hence in particular A(s) = 0, s ∈ R, and B (s) solves a Riccati equation,
whose solution can be checked to be
2( e γs − 1)
B (s) = ,
2γ + (β + γ )( e γs − 1)
with γ = β 2 + 2σ 2 .
p
Exercise 17.12
a) We have
1


 y0,1 = − log P (0, T1 ) = 9.53%,

 T1
1


y0,2 = − log P (0, T2 ) = 9.1%,
T2
1 P (0, T2 )


log = 8.6%,

 y1,2 = −


T2 − T1 P (T1 , T2 )
with T1 = 1 and T2 = 2.
b) We have
Pc (1, 2) = ($1 + $0.1) × P0 (1, 2) = ($1 + $0.1) × e −(T2 −T2 )y1,2 = $1.00914,
and
Pc (0, 2) = ($1 + $0.1) × P0 (0, 2) + $0.1 × P0 (0, 1)

= ($1 + $0.1) × e −(T2 −T2 )y0,2 + $0.1 × e −(T2 −T2 )y0,1
= $1.00831.
Exercise 17.13
√
a) The discretization rtk+1 := rtk + (a − brtk )∆t ± σ ∆t, does not lead to a
binomial tree as rt2 could be obtained in four different ways from rt0 as
√
rt2 = rt1 (1 − b∆t) + a∆t ± σ ∆t
1098 "
 √ √



(rt0 (1 − b∆t) + a∆t + σ ∆t)(1 − b∆t) + a∆t + σ ∆t

√ √


 (rt0 (1 − b∆t) + a∆t + σ ∆t)(1 − b∆t) + a∆t − σ ∆t



= √ √
(rt0 (1 − b∆t) + a∆t − σ ∆t)(1 − b∆t) + a∆t + σ ∆t






√ √


(rt0 (1 − b∆t) + a∆t − σ ∆t)(1 − b∆t) + a∆t − σ ∆t.


b) By the Girsanov Theorem, the process (rt /σ )t∈[0,T ] with
drt a − brt
= dt + dBt
σ σ
is a standard Brownian motion under the probability measure Q with
dQ 1 wT 1 wT

= exp − (a − brt )dBt − 2 (a − brt )2 dt
dP σ 0 2σ 0
1 wT 1 wT

' exp − 2 (a − brt )(drt − (a − brt )dt) − 2 (a − brt )2 dt
σ 0 2σ 0
1 wT 1 wT

= exp − 2 (a − brt )drt + 2 (a − brt )2 dt .
σ 0 2σ 0
In other words, if we generate (rt /σ )t∈[0,T ] and the increments σ −1 drt '
√
± ∆t as a standard Brownian motion under Q, then, under the proba-
bility measure P such that
w
dP 1 T 1 wT

= exp ( a − brt ) drt − ( a − brt ) 2
dt ,
dQ σ2 0 2σ 2 0
the process
drt a − brt
dBt =− dt
σ σ
will be a standard Brownian motion under P, and the samples
drt = (a − brt )dt + σdBt
of (rt )t∈[0,T ] will be distributed as a Vasicek process under P.

c) Approximating
√ the standard Brownian increment σ −1 drt under Q by
± ∆t, we have
Y 1 a − brt √ Y a − brt √

2T /∆T ± ∆t = 1± ∆t
2 2σ σ
0<t<T 0<t<T
" 1099
N. Privault
!
Y a − brt √
= exp log 1± ∆t
σ
0<t<T
!
a − brt √
X
= exp log 1 ± ∆t
σ
0<t<T
!
X a − brt √ 1 X (a − brt )2
' exp ± ∆t − ∆t
σ 2 σ2
0<t<T 0<t<T
w
1 T 1 wT

' exp (a − brt )drt − 2 (a − brt )2 dt
σ2 0 2σ 0
dP
= .
dQ
d) We check that
E[∆rt1 | rt0 ] = (a − brt0 )∆t

√ √
= p(rt0 )σ ∆t − (1 − p(rt0 ))σ ∆t
√ √
= σp(rt0 ) ∆t − σq (rt0 ) ∆t,
with
1 a − brt0 √ 1 a − brt0 √
p(rt0 ) = + ∆t and q (rt0 ) = − ∆t.
2 2σ 2 2σ
Similarly, we have
E[∆rt2 | rt1 ] = (a − brt1 )∆t

√ √
= p(rt1 )σ ∆t − (1 − p(rt1 ))σ ∆t
√ √
= σp(rt1 ) ∆t − σq (rt1 ) ∆t,
with
1 a − brt1 √ 1 a − brt1 √
p(rt1 ) = + ∆t, q (rt1 ) = − ∆t.
2 2σ 2 2σ
Exercise 17.14
a) We have
100 100 100

P (1, 2) = E∗ = + .
1 + r1 2(1 + r1u ) 2(1 + r1d )
b) We have
100 100
P (0, 2) = + .
2(1 + r0 )(1 + r1u ) 2(1 + r0 )(1 + r1d )
1100 "
c) We have P (0, 1) = 91.74 = 100/(1 + r0 ), hence
100 − P (0, 1)
r0 = = 100/91.74 − 1 = 0.090037061 ' 9%.
P (0, 1)
d) We have
P (0, 1) P (0, 1)
83.40 = P (0, 2) = +
2(1 + r1u ) 2(1 + r1d )
√
and r1u /r1d = e 2σ ∆t , hence
P (0, 1) P (0, 1)
83.40 = P (0, 2) = √ +
2(1 + r1d e 2σ ∆t ) 2(1 + r1d )
or
√ √ √ P (0, 1) P (0, 1)

∆t ∆t
e 2σ (r1d )2 + 2r1d e σ cosh σ ∆t 1 − +1− = 0,
2P (0, 2) P (0, 2)
and
√ √ P (0, 1)

r1d = e −σ ∆t cosh σ ∆t −1
2P (0, 2)
s 
2
P (0, 1) √ P (0, 1)
± − 1 cosh2 σ ∆t + − 1
2P (0, 2) P (0, 2)
= 0.078684844 ' 7.87%,
and
√
∆t
r1u = r1d e 2σ
√ √ P (0, 1)

= e σ ∆t cosh σ ∆t −1
2P (0, 2)
s 
2
P (0, 1) √ P (0, 1)
± − 1 cosh σ ∆t +
2
− 1
2P (0, 2) P (0, 2)
= 0.122174525 ' 12.22%.
We also find
1 √ rd 1 √ ru

µ= σ ∆t + log 1 = −σ ∆t + log 1 = 0.085229181 ' 8.52%.
∆t r0 ∆t r0
Exercise 17.15
" 1101
N. Privault
a) When n = 1 the relation (17.55) shows that fe(t, t, T1 ) = f (t, t, T1 ) with

F (t, x) = c1 e −(T1 −1)x and P (t, T1 ) = c1 e f (t,t,T1 ) , hence
1 ∂F
D (t, T1 ) := − (t, f (t, t, T1 )) = T1 − t, 0 6 t 6 T1 .
P (t, T1 ) ∂x
b) In general, we have
1 ∂F
D (t, Tn ) = − t, fe(t, t, Tn )
P (t, Tn ) ∂x
n
1 ˜
(Tk − t)ck e −(Tk −t)f (t,t,Tn )
X
=
P (t, Tn )
k =1
n
X
= (Tk − t)wk ,
k =1
where
ck ˜
wk : = e −(Tk −t)f (t,t,Tn )
P (t, Tn )
˜
ck e −(Tk −t)f (t,t,Tn )
= n
cl e −(Tl −t)f (t,t,Tl )
X
l =1
ck e −(Tk −t)f˜(t,t,Tn )
= n , k = 1, 2, . . . , n,
˜
cl e −(Tl −t)f (t,t,Tn )
X
l =1
and the weights w1 , w2 , . . . , wn satisfy

n
X
wk = 1.
k =1
c) We have
1 ∂2F
C (t, Tn ) = t, fe(t, t, Tn )
P (t, Tn ) ∂x2
n
X
= (Tk − t)2 wk
k =1
X n n
X
= (Tk − t − D (t, Tn ))2 wk + 2D (t, Tn ) (Tk − t)wk − (D (t, Tn ))2
k =1 k =1
1102 "
n
X
= (D (t, Tn ))2 + (Tk − t − D (t, Tn ))2 wk
k =1
= (D (t, Tn ))2 + (S (t, Tn ))2 ,
where
n
X
(S (t, Tn ))2 := (Tk − t − D (t, Tn ))2 wk .
k =1
d) We have
n
1
ck B (Tk − t) e A(Tk −t)+B (Tk −t)fα (t,t,Tn )
X
D (t, Tn ) =
P (t, Tn )
k =1
n
1
ck B (Tk − t) e A(Tk −t)+B (Tk −t)fα (t,t,Tn )
X
=
e A(Tn −t)+B (Tn −t)fα (t,t,Tn ) k =1
n
ck B (Tk − t) e A(Tk −t)−A(Tn −t)+(B (Tk −t)−B (Tn −t))fα (t,t,Tn ) .
X
=
k =1
e) We have
n
1X

e −(Tn −t)b − e −(Tk −t)b fα (t,t,Tn )/b
1 − e −(Tk −t)b ck e A(Tk −t)−A(Tn −t)+

D (t, Tn ) =
b
k =1
n ( e −(Tn −t)b − e −(Tk −t)b )
1X
1 − e −(Tk −t)b ck e A(Tk −t)−A(Tn −t) (P (t, t + α(Tn − t)) .

= (Tn −t)αb
b
k =1
Chapter 18
Exercise 18.1
a) By partial differentiation with respect to T under the expectation E,
b we
have
∂P ∂ ∗ h − r T rs ds i
(t, T ) = E e t Ft
∂T ∂T
h rT i
= E∗ − rT e − t rs ds Ft

= −P (t, T )E
b [rT | Ft ].
b) As a consequence of Question (a), we find
1 ∂P
f (t, T ) = − (t, T ) = E
b [rT | Ft ], 0 6 t 6 T, (A.83)
P (t, T ) ∂T
" 1103
N. Privault
see Relation (22) page 10 of Mamon (2004).

c) The martingale property of (f (t, T ))t∈[0,T ] is a under the forward measure
E
b follows from Relation (A.83) and the from the tower property (23.38)
of conditional expectations as in e.g. (7.1) or (7.39).
Remark. In the Vasicek model, by (17.2) we have

a wT
rT = r0 e −bT + (1 − e −bT ) + σ e −(T −s)b dWs
b 0
a wT
= r0 e −bT + (1 − e −bT ) + σ e −(T −s)b dW
cs
b 0
σ 2 w T −(T −s)b
− e (1 − e −(T −s)b )ds
b 0
a wT
= r0 e −bT + (1 − e −bT ) + σ e −(T −s)b dW
cs
b 0
σ 2 w T −(T −s)b σ 2 w T −2(T −s)b
− e ds + e ds,
b 0 b 0
hence
wt
b [rT | Ft ] = r0 e −bT + a 1 − e −bT + σ
E e −(T −s)b dW

cs
b 0
σ 2 w T −(T −s)b σ 2 w T −2(T −s)b
− e ds + e ds
b 0 b 0
a wt
= r0 e −bT + 1 − e −bT + σ e −(T −s)b dWs

b 0
w
σ 2 t −(T −s)b
e 1 − e −(T −s)b ds

+
b 0
σ 2 w T −(T −s)b σ 2 w T −2(T −s)b
− e ds + e ds
b 0 b 0
−bT a −bT −(T −t)b
a
= r0 e + 1− e +e rt − r0 e −bt − 1 − e −bt

b b
σ 2 w t −(T −s)b σ 2 w t −2(T −s)b
+ e ds − e ds
b 0 b 0
σ 2 w T −(T −s)b σ 2 w T −2(T −s)b
− e ds + e ds
b 0 b 0
a a σ 2 w T −(T −s)b σ 2 w T −2(T −s)b
= + e −(T −t)b rt − − e ds + e ds
b b b t b t
a a σ 2 w T −t −bs σ 2 w T −t −2bs
= + e −(T −t)b rt − − e ds + e ds
b b b 0 b 0
a a σ 2 σ 2
= + e −(T −t)b rt − − 2 1 − e −(T −t)b + 2 1 − e −2(T −t)b

b b b b
σ2 a σ2 σ2

a
= − 2 + e −(T −t)b rt − + 2 − 2 e −2(T −t)b ,
b 2b b b b
1104 "
which recovers (18.28).

w
T2
P (0, T2 ) = exp − f (t, s)ds = e −r1 T1 −r2 (T2 −T1 ) , t ∈ [0, T2 ],
0
and
w
T2
P (T1 , T2 ) = exp − f (t, s)ds = e −r2 (T2 −T1 ) , t ∈ [0, T2 ],
T1
from which we deduce

1
r2 = − log P (T1 , T2 ),
T2 − T1
and
T2 − T1 1
r1 = −r2 − log P (0, T2 )
T1 T1
1 1
= log P (T1 , T2 ) − log P (0, T2 )
T1 T1
1 P (0, T2 )
= − log .
T1 P (T1 , T2 )

T
a) We check that P (T , T ) = e XT = 1.
b) We have
1 S
f (t, T , S ) = − Xt − XtT − µ(S − T )
S−T
1
wt 1 wt 1
= µ−σ (S − t) dBs − (T − t) dBs
S−T 0 S−s 0 T −s
1 wt S−t

T −t
= µ−σ − dBs
S−T 0 S−s T −s
1 w t (T − s)(S − t) − (T − t)(S − s)
= µ−σ dBs
S−T 0 (S − s)(T − s)
σ w t (s − t)(S − T )
= µ+ dBs .
S − T 0 (S − s)(T − s)
c) We have
" 1105
N. Privault
wt t−s
f (t, T ) = µ − σ dBs .
0 (T − s)2
d) We note that
wt 1
lim f (t, T ) = µ − σ dBs
T &t 0 t−s
does not exist in L2 (Ω).
e) By Itô’s calculus we have
dP (t, T ) 1 XT
= σdBt + σ 2 dt + µdt − t dt
P (t, T ) 2 T −t
1 log P (t, T )
= σdBt + σ 2 dt − dt, t ∈ [0, T ].
2 T −t
f) Letting
1 XT
rtT := µ + σ 2 − t
2 T −t
1 w t dB
s
= µ + σ2 − σ ,
2 0 T −s
by Question (e) we find that
dP (t, T )
= σdBt + rtT dt, 0 6 t 6 T.
P (t, T )
g) The equation of Question (f) can be solved as
σ2 t w t T

P (t, T ) = P (0, T ) exp σBt − + rs ds , 0 6 t 6 T,
2 0
hence the process

w
σ2

t
P (t, T ) exp − rsT ds = P (0, T ) exp σBt − t , 0 6 t 6 T,
0 2
is a martingale under P∗ , with the relation

w w
t T T
P (t, T ) exp − rsT ds = E∗ P (T , T ) exp −

rs ds Ft
0 0
w
T T
= E∗ exp − rs ds Ft , 0 6 t 6 T,

0
showing that
1106 "
w w
t T T T
P (t, T ) = exp rs ds E∗ exp −

rs ds Ft
0 0
w w
t T T T
= E∗ exp rs ds exp −

rs ds Ft
0 0
w
T T
= E∗ exp − rs ds Ft , 0 6 t 6 T.

t
h) By Question (g) we have
P (t, T ) − r t rsT ds

dPT 2
E Ft = e 0 = e σBt −σ t/2 , 0 6 t 6 T.
dP P (0, T )
i) By the Girsanov Theorem, the process B

bt := Bt − σt is a standard Brow-
nian motion under PT .
j) We have
wT S−T
log P (T , S ) = −µ(S − T ) + σ dBs
0 S−s
wt S−T wT S−T
= −µ(S − T ) + σ dBs + σ dBs
0 S−s t S−s
S−T wT S−T
= log P (t, S ) + σ dBs
S−t t S−s
S−T w T S−T wT S−T
= log P (t, S ) + σ dBbs + σ 2 ds
S−t t S−s t S−s
S−T w T S−T
= log P (t, S ) + σ dBbs + (S − T )σ 2 log S − t ,
S−t t S−s S−T
0 < T < S.
k) We have
P (t, T )ET (P (T , S ) − K )+ Ft

+
= P (t, T )E e X − K | Ft

1

2 vt
= P (t, T ) e mt +vt /2 Φ + (mt + vt2 /2 − log κ)
2 vt
1

vt
−κP (t, T )Φ − + (mt + vt2 /2 − log κ)
2 vt
1 1

mt +vt2 /2
= P (t, T ) e Φ vt + (mt − log κ) − κP (t, T )Φ (mt − log κ) ,
vt vt
with
S−T S−t
mt = log P (t, S ) + (S − T )σ 2 log
S−t S−T
and
" 1107
N. Privault
w T (S − T )2
vt2 = σ 2 ds
t (S − s)2
1 1

= (S − T )2 σ 2 −
S−T S−t
( T − t )
= (S − T )σ 2 ,
(S − t)
hence
P (t, T )ET (P (T , S ) − K )+ Ft

2
S − t (S−T )σ v2 /2

= P (t, T )(P (t, S ))(S−T )(S−t) e t
S−T
2 !!
1 (P (t, S ))(S−T )(S−t) S − t (S−T )σ

×Φ vt + log
vt κ S−T
2 !!
1 (P (t, S )) ( S−T )( S−t ) S − t (S−T )σ

−κP (t, T )Φ log .
vt κ S−T
Exercise 18.4
a) In the Vašíček (1977) model, we have
w
T
P (t, T ) = E exp − rs ds
t
w wT
T
= E exp − h(s)ds − Xs ds
t t
w w
T T
= exp − h(s)ds E exp − Xs ds
t t
w
T
= exp − h(s)ds + A(T − t) + Xt C (T − t) , 0 6 t 6 T,
t
w
T
hence, since X0 = 0 we find P (0, T ) = exp − h(s)ds + A(T ) .
0
b) By the identification
w
T
P (t, T ) = exp − h(s)ds + A(T − t) + Xt C (T − t)
t
w
T
= exp − f (t, s)ds ,
t
we find
wT wT
h(s)ds = f (t, s)ds + A(T − t) + Xt C (T − t),
t t
1108 "
and by differentiation with respect ot T this yields
h(T ) = f (t, T ) + A0 (T − t) + Xt C 0 (T − t), 0 6 t 6 T,
where
4ab − 3σ 2 σ 2 − 2ab σ 2 − ab −b(T −t) σ 2 −2b(T −t)
A(T − t) = + (T − t) + e − 3e .
4b 3 2b 2 b3 4b
Given an initial market data curve f M (0, T ), the matching f M (0, T ) =
f (0, T ) can be achieved at time t = 0 by letting
σ 2 − 2ab σ 2 − ab −bT σ2
h(T ) := f M (0, T ) + A0 (T ) = f M (0, T ) + − e + 2 e −2bT ,
2b 2 b2 2b
T > 0. Note however that in general, at time t ∈ (0, T ] we will have
h(T ) = f (t, T ) + A0 (T − t) + Xt C 0 (T − t) = f M (0, T ) + A0 (T ),
and the relation
f (t, T ) = f M (0, T ) + A0 (T ) − A0 (T − t) − Xt C 0 (T − t), t ∈ [0, T ],
will allow us to match market data at time t = 0 only, i.e. for the initial
curve. In any case, model calibration is to be done at time t = 0.
Exercise 18.5 From the definition

1 1

L(t, t, T ) = −1 ,
T −t P (t, T )
we have
1
P (t, T ) = ,
1 + (T − t)L(t, t, T )
and similarly
1
P (t, S ) = .
1 + (S − t)L(t, t, S )
Hence we get
1 P (t, T )

L(t, T , S ) = −1
S − T P (t, S )
1 1 + (S − t)L(t, t, S )

= −1
S − T 1 + (T − t)L(t, t, T )
1 (S − t)L(t, t, S ) − (T − t)L(t, t, T )

= .
S−T 1 + (T − t)L(t, t, T )
When T = one year and L(0, 0, T ) = 2%, L(0, 0, 2T ) = 2.5% we find

" 1109
N. Privault
1 2T L(0, 0, 2T ) − T L(0, 0, T ) 2 × 0.025 − 0.02

L(t, T , S ) = = = 2.94%,
T 1 + T L(0, 0, T ) 1 + 0.02
so we would not prefer a spot rate at L(T , T , 2T ) = 2% over a forward con-

tract with rate L(0, T , 2T ) = 2.94%.

a) By Definition 18.1, we have
1
f (t, T , S ) = (log P (t, T ) − log P (t, S ))
S−T
1 σ2 σ2

= −(T − t)rt + (T − t)3 − −(S − t)rt + (S − t)3
S−T 6 6
1 σ2
(T − t)3 − (S − t)3 .

= rt +
S−T 6
b) We have
∂ σ2
f (t, T ) = − log P (t, T ) = rt − (T − t)2 .
∂T 2
c) We have
dt f (t, T ) = (T − t)σ 2 dt + σdBt .
d) The HJM condition (18.25) is satisfied since the drift of dt f (t, T ) equals
rT
σ t σds.
Exercise 18.7
a) We have
wt
(1)
Xt = X0 e −bt + σ e −(t−s)b dBs
0
and wt
(2)
Yt = Y0 e −bt + σ e −(t−s)b dBs , t ∈ R+ ,
0
see (17.2).
b) We have
σ2
Var[Xt ] = Var[Yt ] = (1 − e −2bt ), t ∈ R+ ,
2b
see page 576, and therefore
wt wt
(1) (2)
Cov(Xt , Yt ) = Cov X0 e −bt + σ e −(t−s)b dBs , Y0 e −bt + σ e −(t−s)b dBs
0 0
w wt
t −(t−s)b (1) −(t−s)b (2)
= σ Cov
2
e dBs , e dBs
0 0
1110 "
w w
t −(t−s)b (1) t −(t−s)b (2)
= σ2 E e dBs e dBs
0 0
w
2 t −2(t−s)b
= ρσ e ds
0
σ2
1 − e −2bt , t ∈ R+ .

=ρ
2b
c) We have
Cov(log P (t, T1 ), log P (t, T2 ))

= Cov log F1 (t, Xt , T1 )F2 (t, Yt , T2 ) e ρU (t,T1 ) , log F1 (t, Xt , T1 )F2 (t, Yt , T2 ) e ρU (t,T2 )

= Cov C1T1 + Xt AT1 1 + C2T1 + Yt AT2 1 , C1T2 + Xt AT1 2 + C2T2 + Yt AT2 2

= Cov Xt AT1 1 + Yt AT2 1 , Xt AT1 2 + Yt AT2 2

= AT1 1 AT1 2 Var[Xt ] + AT2 1 AT2 2 Var[Yt ] + AT1 1 AT2 2 + AT1 2 AT2 1 Cov(Xt , Yt )

= AT1 1 AT1 2 + AT2 1 AT2 2 + ρ AT1 1 AT2 2 + AT1 2 AT2 1 Var[Xt ].

When Cov(Xt , Yt ) = ρ Var[Xt ] = ρ Var[Yt ], we find the correlation

Cov(log P (t, T1 ), log P (t, T2 )) = p
Var[log P (t, T1 )] Var[log P (t, T2 )]
T1 T2 T1 T2
A A + A2 A2 + ρ AT1 1 AT2 2 + AT1 2 AT2 1

= q1 1
2 2
AT1 1 + AT2 1 + ρ AT1 1 AT2 1 + AT1 1 AT2 1

1
×q 2 2 .
AT1 2 + AT2 2 + ρ AT1 2 AT2 2 + AT1 2 AT2 2
When ρ = 1, we find

AT1 1 AT1 2 + AT2 1 AT2 2 + AT1 1 AT2 2 + AT1 2 AT2 1
= q q
T1 2 T1 2 2 2
A1 + A2 + AT1 1 AT2 1 + AT1 1 AT2 1 AT1 2 + AT2 2 + AT1 2 AT2 2 + AT1 2 AT2 2
AT1 + AT2 1 AT1 2 + AT2 2

= 1T
A 1 + AT1 AT2 + AT2

1 2 1 2
= ±1.
For example, if AT1 1 = 4, AT1 2 = 1, AT2 1 = 1 and AT2 2 = 4, we find
8 + 17ρ
Cov(log P (t, T1 ), log P (t, T2 )) = .
17 + 8ρ
" 1111
N. Privault
0.5
Correlation
-0.5
-1
-1 -0.5 0 0.5 1
ρ
Fig. S.74: Log bond prices correlation graph in the two-factor model.
Exercise 18.8
a) We have
wt wt
f (t, x) = f (0, x) + α s2 ds + σ ds B (s, x) = r + αtx2 + σB (t, x).
0 0
b) We have
rt = f (t, 0) = r + B (t, 0) = r.
c) We have
w
T
P (t, T ) = exp − f (t, s)ds
t
w T −t w T −t
= exp −(T − t)r − αt s2 ds − σ B (t, x)dx
0 0

α w T −t
= exp −(T − t)r − t(T − t)3 − σ B (t, x)dx , t ∈ [0, T ].
3 0
d) Using (18.40), we have
w T −t 2 # w
T −t w T −t
"
E B (t, x)dx = E[B (t, x)B (t, y )]dxdy
0 0 0
w T −t w T −t
=t min(x, y )dxdy
0 0
w T −t w y 1
= 2t xdxdy = t(T − t)3 .
0 0 3
e) By Question (d) we have

α w T −t
E[P (t, T )] = E exp −(T − t)r − t(T − t)3 − σ B (t, x)dx
3 0
1112 "
α w T −t
= exp −(T − t)r − t(T − t)3 E exp −σ B (t, x)dx
3 0
2 w
α σ T −t
= exp −(T − t)r − t(T − t) exp
3
Var B (t, x)dx
3 2 0

α σ 2
= exp −(T − t)r − t(T − t)3 + t(T − t)3 , 0 6 t 6 T.
3 6
f) By Question (e) we check that the required relation is satisfied if
α σ2
− t(T − t)3 + t(T − t)3 = 0,
3 6
i.e. α = σ 2 /2.
Remark: In order to derive an analog of the HJM absence of arbitrage con-

dition in this stochastic string model, one would have to check whether the
discounted bond price e −rt P (t, T ) can be a martingale by doing stochastic
calculus with respect to the Brownian sheet B (t, x).
g) We have
w
T
E exp − rs ds (P (T , S ) − K )+
0
w S−T
" + #
α
= e −rT E exp −(S − T )r − T (S − T )3 + σ B (T , x)dx − K
3 0
h i
−rT m+X +
= e E (x e − K) ,
where x = e −(S−T )r , m = −αT (S − T )3 /3, and

w S−T
X=σ B (T , x)dx ' N (0, σ 2 t(T − t)3 /3).
0
Given the relation α = σ 2 /2, this yields

w
T
E exp − rs ds (P (T , S ) − K )+
0
!
log( e −(S−T )r /K )
q
−rS
= e Φ σ T (S − T )3 /12 + p
σ T (S − T )3 /3
!
q
−K e −rT Φ −σ T (S − T )3 /12 +
p
σ T (S − T )3 /3
!
q
= P (0, S )Φ σ T (S − T ) /12 + p
3
σ T (S − T )3 /3
" 1113
N. Privault
!
q
−KP (0, T )Φ −σ T (S − T )3 /12 + p .
σ T (S − T )3 /3
Chapter 19
Exercise 19.1
a) We price the floorlet at t = 0, with T1 = 9 months, T2 = 1 year, κ = 4.5%.
The LIBOR rate (L(t, T1 , T2 ))t∈[0,T1 ] is modeled as a driftless geometric
Brownian motion with volatility coefficient σ b = σ1,2 (t) = 0.1 under the
forward measure P2 . The discount factors are given by
P (0, T1 ) = e −9r/12 ' 0.970809519
and
P (0, T2 ) = e −r ' 0.961269954,
with r = 3.95%.
b) By (19.20), the price of the floorlet is
r
T2
E∗ e − 0 rs ds (κ − L(T1 , T1 , T2 ))+
= P (0, T2 ) κΦ − d− (T1 ) − L(0, T1 , T2 )Φ − d+ (T1 ) , (A.84)

where
log(L(0, T1 , T2 )/κ) + σ 2 T1 /2
d+ (T1 ) = √ ,
σ1 T1
and
log(L(0, T1 , T2 )/κ) − σ 2 T1 /2
d− (T1 ) = √ ,
σ T1
are given in Proposition 19.5, and the LIBOR rate L(0, T1 , T2 ) is given by
P (0, T1 ) − P (0, T2 )
L(0, T1 , T2 ) =
(T2 − T1 )P (0, T2 )
e −3r/4 − e −r
=
0.25 e −r
= 4( e r/4 − 1)
' 3.9695675%.
Hence, we have
log(0.039695675/0.045) + (0.1)2 × 0.75/2

d+ (T1 ) = √ ' −1.404927033,
0.1 × 0.75
1114 "
and
log(0.039695675/0.045) − (0.1)2 × 0.75/2
d− (T1 ) = √ ' −1.491529573,
0.1 × 0.75
hence
r
T2
E∗ e − 0 rs ds (κ − L(T1 , T1 , T2 ))+
= 0.961269954 × (κΦ(1.491529573) − L(0, T1 , T2 ) × Φ(1.404927033))

= 0.961269954 × (0.045 × 0.932089 − 0.039695675 × 0.919979)
' 0.52147141%.
Finally, we need to multiply (A.84) by the notional principal amount of

$1 million per interest rate percentage point, i.e. $10, 000 per percentage
point or $100 per basis point, which yields $5214.71.
Exercise 19.2
a) We price the swaption at t = 0, with T1 = 4 years, T2 = 5 years, T3 = 6
years, T4 = 7 years, κ = 5%, and the swap rate (S (t, T1 , T4 ))t∈[0,T1 ]
is modeled as a driftless geometric Brownian motion with volatility co-
efficient σb = σ1,4 (t) = 0.2 under the forward swap measure P1.4 .
The discount factors are given by P (0, T1 ) = e −4r , P (0, T2 ) = e −5r ,
P (0, T3 ) = e −6r , P (0, T4 ) = e −7r , where r = 5%.
b) By Proposition 19.14 the price of the swaption is
(P (0, T1 ) − P (0, T4 ))Φ(d+ (T1 − t))

−κΦ(d− (T1 ))(P (0, T2 ) + P (0, T3 ) + P (0, T4 )),
where d+ (T1 ) and d− (T1 ) are given in Proposition 19.14, and the LIBOR
swap rate S (0, T1 , T4 ) is given by
P (0, T1 ) − P (0, T4 )
S (0, T1 , T4 ) =
P (0, T1 , T4 )
P (0, T1 ) − P (0, T4 )
=
P (0, T2 ) + P (0, T3 ) + P (0, T4 )
e −4r − e −7r
=
e −5r
+ e −6r + e −7r
e 3r − 1
= 2r
e + er + 1
e 0.15 − 1
= 0.1
e + e 0.05 + 1
= 0.051271096.
" 1115
N. Privault
By Proposition 19.14 we also have
log(0.051271096/0.05) + (0.2)2 × 4/2

d+ (T1 ) = √ = 0.526161682,
0.2 4
and
log(0.051271096/0.05) − (0.2)2 2 × 4/2
d− (T1 ) = √ = 0.005214714,
0.2 4
Hence, the price of the swaption is given by
( e −4r − e −7r )Φ(0.526161682) (A.85)

−κΦ(0.005214714)( e −5r + e −6r + e −7r )
= (0.818730753 − 0.70468809) × 0.700612
−0.05 × 0.50208 × (0.818730753 + 0.740818221 + 0.70468809)
= 2.3058251%.
Finally, we need to multiply (A.85) by the notional principal amount of

$10 million, i.e. $100, 000 by interest percentage point, or $1, 000 by basis
point, which yields $230, 582.51.
Exercise 19.3 Taking t = 0, we have T1 = 3, T2 = 4 and T3 = 5. The LIBOR

swap rate S (t, T1 , T3 ) is modeled as a driftless geometric Brownian motion
with volatility σ = 0.1 under the forward swap measure Pbi,j . The receiver
swaption is priced using the Black-Scholes formula as
r
T1
E∗ e − t rs ds P (T1 , T1 , T3 ) (κ − S (T1 , T1 , T3 ))+ Ft

2
X
= κΦ(−d− (T1 − t)) (Tk+1 − Tk )P (t, Tk+1 )
k =1
−(P (t, T1 ) − P (t, T3 ))Φ(−d+ (T1 − t)),
where κ = 5%, r = 2% and P (t, T1 ) = e −3r = 0.9417, P (t, T2 ) = e −4r =

0.9231, P (t, T3 ) = e −5r = 0.9048. Hence,
P (t, T1 , T3 ) = P (t, T2 ) + P (t, T3 ) = 0.92311 + 0.90483 = 1.82794
and
P (t, T1 ) − P (t, T3 ) 0.9417 − 0.9048
S (t, T1 , T3 ) = = = 0.02018.
P (t, T1 , T3 ) 1.82794
We also have
1116 "
log(S (t, T1 , T3 )/κ) + σ 2 (T1 − t)/2

d+ (T1 − t) = √
σ T1 − t
log(2.018/5) + 0.12 × 3/2
= √ = −5.1518
0.1 3
and p
d− (T1 − t) = d+ (T1 − t) − σ T1 − t = −5.3250,
hence
r
T1
E∗ e − t rs ds P (T1 , T1 , T3 ) (κ − S (T1 , T1 , T3 ))+ Ft

= 0.05 × 1.82794 × Φ(5.3250) − (0.9417 − 0.9048) × Φ(5.1518)

= 0.05 × 1.82794 × 0.9999999 − (0.9417 − 0.9048) × 0.9999999
= 0.054496
= 5.4496%
= 544.96 bp,
which yields $54, 496 after multiplication by the $10, 000 notional principal.
Exercise 19.4
a) We have
P (t, T2 ) dP (t, T2 ) 1 1

d = + P (t, T2 )d + dP (t, T2 ) • d
P (t, T1 ) P (t, T1 ) P (t, T1 ) P (t, T1 )
dP (t, T2 ) dP (t, T1 ) dP (t, T1 ) • dP (t, T1 )

= + P (t, T2 ) − +
P (t, T1 ) (P (t, T1 ))2 (P (t, T1 ))3
dP (t, T1 ) dP (t, T2 )
•
−
(P (t, T1 ))2
1
= rt P (t, T2 )dt + ζ2 (t)P (t, T2 )dWt
P (t, T1 )
P (t, T2 )
− rt P (t, T1 )dt + ζ1 (t)P (t, T1 )dWt
(P (t, T1 ))2
P (t, T2 )
(rt P (t, T1 )dt + ζ1 (t)P (t, T1 )dWt )2

+
(P (t, T1 ))3
1
− (rt P (t, T1 )dt + ζ1 (t)P (t, T1 )dWt ) • (rt P (t, T2 )dt + ζ2 (t)P (t, T2 )dWt )
(P (t, T1 ))2
P (t, T2 ) P (t, T2 )
= ζ2 ( t ) dWt − ζ1 (t) dWt
P (t, T1 ) P (t, T1 )
P (t, T2 ) P (t, T2 )
+ (ζ1 (t))2 dt − ζ1 (t)ζ2 (t) dt
P (t, T1 ) P (t, T1 )
" 1117
N. Privault
P (t, T2 ) P (t, T2 )
=− ζ1 (t)(ζ2 (t) − ζ1 (t))dt + (ζ2 (t) − ζ1 (t))dWt
P (t, T1 ) P (t, T1 )
P (t, T2 )
= (ζ2 (t) − ζ1 (t))(dWt − ζ1 (t)dt)
P (t, T1 )
P (t, T2 ) c P (t, T2 ) c
= (ζ2 (t) − ζ1 (t)) dWt = (ζ2 (t) − ζ1 (t)) dWt ,
P (t, T1 ) P (t, T1 )
where dW ct = dWt − ζ1 (t)dt is a standard Brownian motion under the

T1 -forward measure P.
b
b) From Question (a) or (19.7) we have
P (T1 , T2 )
P (T1 , T2 ) =
P (T1 , T1 )
w w T1
P (t, T2 ) cs − 1

T1
= exp (ζ2 (s) − ζ1 (s))dW (ζ2 (s) − ζ1 (s))2 ds
P (t, T1 ) t 2 t
P (t, T2 ) X−v2 /2
= e ,
P (t, T1 )
where X is a centered Gaussian random variable with variance v 2 =

w T1
(ζ2 (s) − ζ1 (s))2 ds, independent of Ft under P.
b Hence by the hint
t
(19.38) with x := P (t, T2 )/P (t, T1 ) and κ := K/x, we find
r
T1
E∗ e − 0 rs ds (K − P (T1 , T2 ))+ Ft = P (t, T1 )E b (K − P (T1 , T2 ))+ | Ft

1 P (t, T2 ) 1

v K v K
= P (t, T1 ) KΦ + log − Φ − + log
2 v x P (t, T1 ) 2 v x
1 1

v K v K
= KP (t, T1 )Φ + log − P (t, T2 )Φ − + log .
2 v x 2 v x
Exercise 19.5
a) The forward measure P
b S is defined from the numéraire Nt := P (t, S ) and
this gives
b [(κ − L(T , T , S ))+ | Ft ].
Ft = P (t, S )E
b) The LIBOR rate L(t, T , S ) is a driftless geometric Brownian motion with
volatility σ under the forward measure P b S . Indeed, the LIBOR rate
L(t, T , S ) can be written as the forward price L(t, T , S ) = Xbt = Xt /Nt
where Xt = (P (t, T ) − P (rt, S ))/(S − T ) and Nr t = P (t, S ). Since both
t t
discounted bond prices e − 0 rs ds P (t, T ) and e − 0 rs ds P (t, S ) are martin-
gales under P∗ , the same is true of Xt . Hence L(t, T , S ) = Xt /Nt becomes
a martingale under the forward measure P b S by Proposition 2.1, and com-
puting its dynamics under P b S amounts to removing any “dt” term in
1118 "
(19.39), i.e.
dL(t, T , S ) = σL(t, T , S )dW

ct , 0 6 t 6 T,
2 t/2
hence L(t, T , S ) = L(0, T , S ) e σW
b t −σ , where (W
ct )t∈R is a standard
+
Brownian motion under PS .b
c) We find
b [(κ − L(T , T , S ))+ | Ft ]

Ft = P (t, S )E
b [(κ − L(t, T , S ) e −(T −t)σ2 /2+(W
= P (t, S )E b t )σ +
b T −W
) | Ft ]
= P (t, S )(κΦ(−d− (T − t)) − Xt Φ(−d+ (T − t)))
b
= κP (t, S )Φ(−d− (T − t)) − P (t, S )L(t, T , S )Φ(−d+ (T − t))
= κP (t, S )Φ(−d− (T − t)) − (P (t, T ) − P (t, S ))Φ(−d+ (T − t))/(S − T ),
2 /2
where e m = L(t, T , S ) e −(T −t)σ , v 2 = (T − t)σ 2 , and
√
log(L(t, T , S )/κ) σ T − t
d+ (T − t ) = √ + ,
σ T −t 2
and √
log(L(t, T , S )/κ) σ T − t
d− (T − t) = √ − ,
σ T −t 2
because L(t, T , S ) is a driftless geometric Brownian motion with volatility
σ under the forward measure P bS.
Exercise 19.6
a) We have
j−1
X
P (Ti , Ti , Tj ) = ck+1 P (Ti , Tk+1 ).
k =i
b) It suffices to let c̃k = 1, k = i + 1, . . . , j − 1. and c̃j = cj + 1/κ.

c) The swaption can be priced as
r
Ti +
E∗ e − t rs ds P (Ti , Ti ) − P (Ti , Tj ) − κP (Ti , Ti , Tj ) Ft

j−1
!+ 
rT
X
=E e 1−κ ck+1 P (Ti , Tk+1 ) Ft

k =i

j−1 j−1
!+ 
r Ti X X
∗ −
= κE e rs ds
ck+1 Fk+1 (Ti , γκ ) − ck+1 Fk+1 (Ti , rTi ) Ft
t

k =i k =i
" 1119
N. Privault

j−1
!+ 
r Ti X
∗ −
= κE e rs ds
ck+1 (Fk+1 (Ti , γκ ) − Fk+1 (Ti , rTi )) Ft
t

k =i
j−1
" #
r Ti
ck+1 1{rT
X
= κE∗ e − rs ds
6γk } (Fk +1 (Ti , γκ ) − Fk +1 (Ti , rTi )) Ft
t

i
k =i
j−1
" #
r Ti
ck+1 (Fk+1 (Ti , γκ ) − Fk+1 (Ti , rTi ))+ Ft
X
∗ −
= κE e rs ds
t

k =i
j−1 r Ti
(Fk+1 (Ti , γκ ) − P (Ti , Tk+1 ))+ Ft
X
=κ ck+1 E∗ e − rs ds
t

k =i
j−1
b i (Fk+1 (Ti , γκ ) − P (Ti , Tk+1 ))+ Ft ,
X
ck+1 P (t, Ti )E

=κ
k =i
which is a weighted sum of bond put option prices with strike prices
Fk+1 (Ti , γκ ), k = i, i + 1, . . . , j − 1.
Exercise 19.7
a) We have
n
X n
X
dXt = ci dPb (t, Ti ) = ci σi (t)Pb (t, Ti )dW ct ,
ct = σt Xt dW
i=2 i=2
from which we obtain

n
X n
X
n
ci σi (t)Pb (t, Ti ) ci σi (t)P (t, Ti )
1 X i=2 i=2
σt = ci σi (t)Pb (t, Ti ) = n = n .
Xt X X
i=2 ci Pb (t, Ti ) ci P (t, Ti )
i=2 i=2
b) Approximating the random process (σt )t∈R+ by the deterministic function

of time
n
X n
X
n
ci σi (t)Pb (0, Ti ) ci σi (t)P (0, Ti )
1 X i=2 i=2
b (t) : =
σ ci σi (t)Pb (0, Ti ) = n = n ,
X0 X X
i=2 ci Pb (0, Ti ) ci P (0, Ti )
i=2 i=2
we find
b (XT − κ)+
P (0, T1 )E

0
1120 "
r T0 rT +
(1)
σ (t)|2 dWt − 21 0 0 |b σ (t)|2 dt
' P (0, T1 )E
b X0 e 0 |b −κ
r w
1 T0

= P (0, T1 )Blcall X0 , κ, σ (t)|2 dt, 0, T
|b
T0 0
= P (0, T1 ) X0 Φ(v/2 + (log(X0 /κ))/v ) − κΦ(−v/2 + (log(X0 /κ))/v )

n n
!!
X v 1 X ci P (0, Ti )
= ci P (0, Ti )Φ − log
2 v κP (0, T1 )
i=2 i=2
n
!!
v 1 X ci P (0, Ti )
−κP (0, T1 )Φ − − log ,
2 v κP (0, T1 )
i=2
w T0
r
with v := σ (t)|2 dt.
|b
0
Exercise 19.8
a) We have
dP (t, Ti )
= rt dt + ζ (i) (t)dBt , i = 1, 2,
P (t, Ti )
and
w wT 1 w T (i)

T
P (T , Ti ) = P (t, Ti ) exp rs ds + ζ (i) (s)dBs − |ζ (s)|2 ds ,
t t 2 t
0 6 t 6 T 6 Ti , i = 1, 2, hence
wT wT 1 w T (i)
log P (T , Ti ) = log P (t, Ti ) + rs ds + ζ (i) (s)dBs − |ζ (s)|2 ds,
t t 2 t
0 6 t 6 T 6 Ti , i = 1, 2, and
1
d log P (t, Ti ) = rt dt + ζ (i) (t)dBt − |ζ (i) (t)|2 dt, i = 1, 2.
2
In the present model, we have
drt = σdBt ,
where (Bt )t∈R+ is a standard Brownian motion under P, by the solution

of Exercise 17.4 and (17.26) we have
ζ (i) (t) = −(Ti − t)σ, 0 6 t 6 Ti , i = 1, 2.
Letting
(i)
dBt = dBt − ζ (i) (t)dt,
" 1121
N. Privault
defines a standard Brownian motion under Pi , i = 1, 2, and we have

w
P (T , T1 ) P (t, T1 ) 1 w T (1)

T (1)
= exp (ζ (s) − ζ (2) (s))dBs − (|ζ (s)|2 − |ζ (2) (s)|2 )ds
P (T , T2 ) P (t, T2 ) t 2 t
w
P (t, T1 ) 1 w T (1)

T (1) ( 2 )
= exp (ζ (s) − ζ (2) (s))dBs − (ζ (s) − ζ (2) (s))2 ds ,
P (t, T2 ) t 2 t
which is an Ft -martingale under P2 and under P1,2 , and

w
P (T , T2 ) P (t, T2 ) 1 w T (1)

T (1) (1)
= exp − (ζ (s) − ζ (2) (s))dBs − (ζ (s) − ζ (2) (s))2 ds ,
P (T , T1 ) P (t, T1 ) t 2 t
which is an Ft -martingale under P1 .

b) We have
1
f (t, T1 , T2 ) = − (log P (t, T2 ) − log P (t, T1 ))
T2 − T1
1 σ2
= rt + ((T1 − t)3 − (T2 − t)3 ).
T2 − T1 6
c) We have
1 P (t, T2 )
df (t, T1 , T2 ) = − d log
T2 − T1 P (t, T1 )
1 1

=− (ζ (2) (t) − ζ (1) (t))dBt − (|ζ (2) (t)|2 − |ζ (1) (t)|2 )dt
T2 − T1 2
1 1

(2)
=− (ζ (t) − ζ (t))(dBt + ζ (2) (t)dt) − (|ζ (2) (t)|2 − |ζ (1) (t)|2 )dt
(2) (1)
T2 − T1 2
1 1

( 2 )
=− (ζ (2) (t) − ζ (1) (t))dBt − (ζ (2) (t) − ζ (1) (t))2 dt .
T2 − T1 2
d) We have
1 P (T , T2 )
f (T , T1 , T2 ) = − log
T2 − T1 P (T , T1 )
w
1 1

T (2)
= f (t, T1 , T2 ) − (ζ (s) − ζ (1) (s))dBs − (|ζ (2) (s)|2 − |ζ (1) (s)|2 )ds
T2 − T1 t 2
w
1 1 w T (2)

T (2) (1) (2)
= f (t, T1 , T2 ) − (ζ (s) − ζ (s))dBs − (ζ (s) − ζ (1) (s))2 ds
T2 − T1 t 2 t
w
1 1 w T (2)

T (2) (1) (1)
= f (t, T1 , T2 ) − (ζ (s) − ζ (s))dBs + (ζ (s) − ζ (1) (s))2 ds .
T2 − T1 t 2 t
Hence f (T , T1 , T2 ) has a Gaussian distribution given Ft with conditional

mean
1122 "
1 w T (2)
m1 := f (t, T1 , T2 ) − (ζ (s) − ζ (1) (s))2 ds
2 t
under P1 , resp.
1 w T (2)
m2 := f (t, T1 , T2 ) + (ζ (s) − ζ (1) (s))2 ds
2 t
under P2 , and variance
1 wT
v2 = (ζ (2) (s) − ζ (1) (s))2 ds.
(T2 − T1 )2 t
Hence
r
T2
(T2 − T1 )E∗ e − t rs ds (f (T1 , T1 , T2 ) − κ)+ Ft

= (T2 − T1 )P (t, T2 )E2 (f (T1 , T1 , T2 ) − κ)+ Ft

= (T2 − T1 )P (t, T2 )E2 (m2 + X − κ)+ Ft

v 2 2
= (T2 − T1 )P (t, T2 ) √ e −(κ−m2 ) /(2v ) + (m2 − κ)Φ((m2 − κ)/v ) ,
2π
see Exercise S.4.
e) We have
L(T , T1 , T2 ) = S (T , T1 , T2 )
1 P (T , T1 )

= −1
T2 − T1 P (T , T2 )
w
1 P (t, T1 ) 1 w T (1)

T (1)
= exp (ζ (s) − ζ (2) (s))dBs − (|ζ (s)|2 − |ζ (2) (s)|2 )ds −
T2 − T1 P (t, T2 ) t 2 t
w
1 P (t, T1 ) 1 w T (1)

T (1) (2) (2)
= exp (ζ (s) − ζ (s))dBs − (ζ (s) − ζ (2) (s))2 ds − 1
T2 − T1 P (t, T2 ) t 2 t
w
1 P (t, T1 ) 1 w T (1)

T (1) (2) (1)
= exp (ζ (s) − ζ (s))dBs + (ζ (s) − ζ (2) (s))2 ds − 1
T2 − T1 P (t, T2 ) t 2 t
and, by Itô calculus,
1 P (t, T1 )

dS (t, T1 , T2 ) = d
T2 − T1 P (t, T2 )
1 P (t, T1 ) 1

= (ζ (t) − ζ (2) (t))dBt + (ζ (1) (t) − ζ (2) (t))2 dt
(1)
T2 − T1 P (t, T2 ) 2
1

− (|ζ (1) (t)|2 − |ζ (2) (t)|2 )dt
2
1

= + S (t, T1 , T2 ) (ζ (1) (t) − ζ (2) (t))dBt + ζ (2) (t)(ζ (2) (t) − ζ (1) (t))dt)dt
T2 − T1
" 1123
N. Privault
1

(1)
= + S (t, T1 , T2 ) (ζ (1) (t) − ζ (2) (t))dBt + (|ζ (2) (t)|2 − |ζ (1) (t)|2 )dt
T2 − T1
1

(2)
= + S (t, T1 , T2 ) (ζ (1) (t) − ζ (2) (t))dBt , t ∈ [0, T1 ],
T2 − T1
hence t 7−→ 1
T2 −T1 + S (t, T1 , T2 ) is a geometric Brownian motion, with
1
+ S (T , T1 , T2 )
T2 − T1
w
1 1 w T (1)

T (1) (2)
= + S (t, T1 , T2 ) exp (ζ (s) − ζ (2) (s))dBs − (ζ (s) − ζ (2) (s))2 d
T2 − T1 t 2 t
0 6 t 6 T 6 T1 .
f) We have
r
T2
(T2 − T1 )E∗ e − t rs ds (L(T1 , T1 , T2 ) − κ)+ Ft

r
T1
= (T2 − T1 )E∗ e − t rs ds P (T1 , T2 )(L(T1 , T1 , T2 ) − κ)+ Ft

= P (t, T1 , T2 )E1,2 (S (T1 , T1 , T2 ) − κ)+ Ft .

The forward measure P2 is defined by
P (t, T2 ) − r t rs ds

dP2
E∗ Ft = e 0 , 0 6 t 6 T2 ,
dP P (0, T2 )
and the forward swap measure is defined by
P (t, T2 ) − r t rs ds

dP1,2
E∗ Ft = e 0 , 0 6 t 6 T1 ,
dP P (0, T2 )
(2)
hence P2 and P1,2 coincide up to time T1 and Bt t∈[0,T ] is a standard
1
Brownian motion until time T1 under P2 and under P1,2 , consequently
under P1,2 we have
L(T , T1 , T2 ) = S (T , T1 , T2 )
r
1 1 (2) 1 r T (1)

T (1) (2) (2) 2
=− + + S (t, T1 , T2 ) e t (ζ (s)−ζ (s))dBs − 2 t (ζ (s)−ζ (s)) ds ,
T2 − T1 T2 − T1
has same distribution as

1 P (t, T1 ) X−Var [X ]/2

e −1 ,
T2 − T1 P (t, T2 )
where X is a centered Gaussian random variable with variance
1124 "
w T1
(ζ (1) (s) − ζ (2) (s))2 ds
t
given Ft . Hence, we have

h r T2 i
(T2 − T1 )E∗ e − t rs ds (L(T1 , T1 , T2 ) − κ)+ Ft

= P (t, T1 , T2 )
r T1 ( 1 )
1 (ζ (s) − ζ (2) (s))2 ds 1

×Bl + S (t, T1 , T2 ), t ,κ+ , T1 − t .
T2 − T1 T1 − t T2 − T1
Exercise 19.9
a) We have
rt (2) rt
γ1 (s)dWs − |γ1 (s)|2 ds/2
L(t, T1 , T2 ) = L(0, T1 , T2 ) e 0 0 , 0 6 t 6 T1 ,
and L(t, T2 , T3 ) = b. Note that we also have P (t, T2 )/P (t, T3 ) = 1 + δb,
hence Pb2 = Pb3 = Pb1,2 up to time T1 .
b) We use change of numéraire under the forward measure P2 .
c) We have
h r T2 i
E∗ e − t rs ds (L(T1 , T1 , T2 ) − κ)+ Ft

b 2 (L(T1 , T1 , T2 ) − κ)+ Ft
= P (t, T2 )E

h r T1 (2) r T
i
b 2 (L(t, T1 , T2 ) e t γ1 (s)dWs − t 1 |γ1 (s)|2 ds/2 − κ)+ Ft
= P (t, T2 )E
= P (t, T2 )Bl(κ, L(t, T1 , T2 ), σ1 (t), 0, T1 − t),
where
1 w T1
σ12 (t) = |γ1 (s)|2 ds.
T1 − t t
d) We have
P (t, T1 ) P (t, T1 )
=
P (t, T1 , T3 ) δP (t, T2 ) + δP (t, T3 )
P (t, T1 ) 1
=
δP (t, T2 ) 1 + P (t, T3 )/P (t, T2 )
1 + δb
= (1 + δL(t, T1 , T2 )), 0 6 t 6 T1 ,
δ (δb + 2)
and
P (t, T3 ) P (t, T3 )
=
P (t, T1 , T3 ) P (t, T2 ) + P (t, T3 )
" 1125
N. Privault
1
=
1 + P (t, T2 )/P (t, T3 )
1 1
= , 0 6 t 6 T2 .
δ 2 + δb
e) We have
P (t, T1 ) P (t, T3 )
S (t, T1 , T3 ) = −
P (t, T1 , T3 ) P (t, T1 , T3 )
1 + δb 1
= (1 + δL(t, T1 , T2 )) −
δ (2 + δb) δ (2 + δb)
1
= (b + (1 + δb)L(t, T1 , T2 )), 0 6 t 6 T2 .
2 + δb
We have
1 + δb (2)
dS (t, T1 , T3 ) = L(t, T1 , T2 )γ1 (t)dWt
2 + δb

b (2)
= S (t, T1 , T3 ) − γ1 (t)dWt
2 + δb
(2)
= S (t, T1 , T3 )σ1,3 (t)dWt , 0 6 t 6 T2 ,
with

b
σ1,3 (t) = 1− γ1 ( t )
S (t, T1 , T3 )(2 + δb)

b
= 1− γ1 ( t )
b + (1 + δb)L(t, T1 , T2 )
(1 + δb)L(t, T1 , T2 )
= γ1 ( t )
b + (1 + δb)L(t, T1 , T2 )
(1 + δb)L(t, T1 , T2 )
= γ1 ( t ) .
(2 + δb)S (t, T1 , T3 )
f) The process W (2) is a standard Brownian motion under Pb2 = Pb1,3

t∈R+
and
b 1,3 (S (T1 , T1 , T3 ) − κ)+ | Ft
P (t, T1 , T3 )E

= P (t, T2 )Bl(κ, S (t, T1 , T2 ), σ

e1,3 (t), 0, T1 − t),
where |e
σ1,3 (t)|2 is the approximation of the volatility
1 w T1 1 w T1
2
(1 + δb)L(s, T1 , T2 )

|σ1,3 (s)|2 ds = γ1 (s)ds
T1 − t t T1 − t t (2 + δb)S (s, T1 , T3 )
1126 "
obtained by freezing the random component of σ1,3 (s) at time t, i.e.

2 w
1 (1 + δb)L(t, T1 , T2 )

2 T1
σ
e1,3 (t) = |γ1 (s)|2 ds.
T1 − t (2 + δb)S (t, T1 , T3 ) t
Exercise 19.10 Bond option hedging.

a) We have
h rT i wT
E∗ e − t rs ds (P (T , S ) − κ)+ Ft = VT = V0 + dVt

0
wt wt
= P (0, T )ET (P (T , S ) − κ)+ + ξsT dP (s, T ) + ξsS dP (s, S ).

0 0
b) We have
rt
dVet = d e − 0 rs ds Vt
rt rt
= −rt e − 0
rs ds
Vt dt + e − 0
rs ds
dVt
rt
−
= −rt e 0
rs ds
(ξtT P (t, T )
rt rt
+ξtS P (t, S ))dt + e − 0 rs ds ξtT dP (t, T ) + e − 0
rs ds S
ξt dP (t, S )
= ξtT dPe (t, T ) + ξtS dPe (t, S ).
c) By Itô’s formula we have
ET (P (T , S ) − κ)+ Ft = C (Xt , v (t, T ))

w t ∂C
= C (X0 , v (0, T )) + (Xs , v (s, T ))dXs
0 ∂x
w t ∂C
= ET (P (T , S ) − κ)+ + (Xs , v (s, T ))dXs ,

0 ∂x
since the process

t 7−→ ET (P (T , S ) − κ)+ Ft

e
d) We have

Vt
dVbt = d
P (t, T )
= dET (P (T , S ) − κ)+ Ft

∂C
= (Xt , v (t, T ))dXt
∂x
P (t, S ) ∂C
= (Xt , v (t, T ))(σtS − σtT )dBtT .
P (t, T ) ∂x
" 1127
N. Privault
e) We have
P (t, T )

dVt = d
Vbt
= P (t, T )dVbt + Vbt dP (t, T ) + dVbt • dP (t, T )
∂C
= P (t, S ) (Xt , v (t, T ))(σtS − σtT )dBtT + Vbt dP (t, T )
∂x
∂C
+P (t, S ) (Xt , v (t, T ))(σtS − σtT )σtT dt
∂x
∂C
= P (t, S ) (Xt , v (t, T ))(σtS − σtT )dBt + Vbt dP (t, T ).
∂x
f) We have
rt
dVet = d( e − rs ds
0 Vt )
rt rt
− 0 rs ds
= −rt e Vt dt + e− r ds
0 s dVt
∂C
= Pe (t, S ) (Xt , v (t, T ))(σtS − σtT )dBt + Vbt dPe (t, T ).
∂x
g) We have
∂C
dVet = Pe (t, S ) (Xt , v (t, T ))(σtS − σtT )dBt + Vbt dPe (t, T )
∂x
∂C
= (Xt , v (t, T ))dPe (t, S )
∂x
P (t, S ) ∂C
− (Xt , v (t, T ))dPe (t, T ) + Vbt dPe (t, T )
P (t, T ) ∂x
P (t, S ) ∂C

= Vbt − (Xt , v (t, T )) dPe (t, T )
P (t, T ) ∂x
∂C
+ (Xt , v (t, T ))dPe (t, S ),
∂x
hence the hedging strategy (ξtT , ξtS )t∈[0,T ] of the bond option is given by
P (t, S ) ∂C
ξtT = Vbt − (Xt , v (t, T ))
P (t, T ) ∂x
P (t, S ) ∂C
= C (Xt , v (t, T )) − (Xt , v (t, T )),
P (t, T ) ∂x
and
∂C
ξtS = (Xt , v (t, T )), 0 6 t 6 T.
∂x
h) We have
1128 "
1 1

∂C ∂ v x v x
(x, v ) = xΦ + log − κΦ − + log
∂x ∂x 2 v κ 2 v κ
1 1 1

∂ v x ∂ v x v x
=x Φ + log − κ Φ − + log +Φ + log
∂x 2 v κ ∂x 2 v κ 2 v κ
x 2 x 2
− 21 ( v2 + v1 log κ ) − 21 (− v2 + v1 log κ )
e e 1

v x
=x √ −κ √ +Φ + log
2πvx 2πvx 2 v κ
log(x/κ) + v 2 /2

=Φ .
v
As a consequence, we get
P (t, S ) ∂C
ξtT = C (Xt , v (t, T )) − (Xt , v (t, T ))
P (t, T ) ∂x
v (t, T )/2 + log Xt
2
P (t, S )

= Φ
P (t, T ) v (t, T )
v (t, T ) 1 P (t, S )

−κΦ − + log
2 v (t, T ) κP (t, T )
P (t, S ) log(Xt /κ) + v 2 (t, T )/2

− Φ √
P (t, T ) T −t
log(Xt /κ) − v 2 (t, T )/2

= −κΦ ,
v (t, T )
and
log(Xt /κ) + v 2 (t, T )/2

∂C
ξtS = (Xt , v (t, T )) = Φ ,
∂x v (t, T )
t ∈ [0, T ], and the hedging strategy is given by
h rT i
VT = E∗ e − t rs ds (P (T , S ) − κ)+ Ft

wt wt
= V0 + ξsT dP (s, T ) + ξsS dP (s, S )
0 0
w t log(X /κ) − v 2 (t, T )/2
t
= V0 − κ Φ dP (s, T )
0 v (t, T )
w t log(X /κ) + v 2 (t, T )/2
t
+ Φ dP (s, S ).
0 v (t, T )
Consequently, the bond option can be hedged by shortselling a bond with

maturity T for the amount
log(Xt /κ) − v 2 (t, T )/2

κΦ ,
v (t, T )
and by holding a bond with maturity S for the amount

" 1129
N. Privault
log(Xt /κ) + v 2 (t, T )/2

Φ .
v (t, T )
Exercise 19.11
a) The LIBOR rate L(t, T , S ) is a driftless geometric Brownian motion with
deterministic volatility function σ (t) under the forward measure P
bS.
Explanation: The LIBOR rate L(t, T , S ) can be written as the forward

price L(t, T , S ) = X
bt = Xt /Nt where Xt = (P (t, T ) − P (t, S ))/(S − T )
r t
andr Nt = P (t, S ). Since both discounted bond prices e − r ds
0 s P (t, T ) and
t
e− r ds
0 s P (t, S ) are martingales under P∗ , the same is true of Xt . Hence
L(t, T , S ) = Xt /Nt becomes a martingale under the forward measure P bS
by Proposition 2.1, and computing its dynamics under PS amounts to
b
removing any “dt” term in the original SDE defining L(t, T , S ), i.e. we
find
dL(t, T , S ) = σ (t)L(t, T , S )dW
ct , 0 6 t 6 T,
hence
w wt
t
L(t, T , S ) = L(0, T , S ) exp σ ( s ) dW
cs − σ 2 (s)ds/2 ,
0 0
where (W
ct )t∈R is a standard Brownian motion under P
+
bS.
b) Choosing the annuity numéraire Nt = P (t, S ), we have
h rS i h rS i
E∗ e − t rs ds φ(L(T , T , S ))Ft = E∗ e − t rs ds NS φ(L(T , T , S ))Ft
= Nt E
b φ(L(T , T , S ))Ft

= P (t, S )E
b [φ(L(T , T , S )) | Ft ].
c) Given the solution

w wT
T
L(T , T , S ) = L(0, T , S ) exp σ ( s ) dW
cs − σ 2 (s)ds/2
0 0
w wT
T
= L(t, T , S ) exp σ (s)dW
cs − σ 2 (s)ds/2 ,
t t
we find
P (t, S )E
b [φ(L(T , T , S )) | Ft ]
rT r
b s − tT σ2 (s)ds/2
h i
= P (t, S )Eb φ L(t, T , S ) e t σ (s)dW Ft
w∞ 2 2 2 dx
φ L(t, T , S ) e x−η /2 e −x /(2η ) p ,

= P (t, S )
−∞ 2πη 2
1130 "
wT
because cs is a centered Gaussian variable with variance η 2 :=
σ (s)dW
wT t
σ 2 (s)ds, independent of Ft under the forward measure P.b
t
Exercise 19.12
a) Choosing the annuity numéraire Nt = P (t, Ti , Tj ), we have
r
Ti
E∗ e − t rs ds P (Ti , Ti , Tj )φ(S (Ti , Ti , Tj ))Ft

b i,j P (Ti , Ti , Tj ) φ(S (Ti , Ti , Tj ))Ft

= Nt E
NT i
= P (t, Ti , Tj )E
b i,j [φ(S (Ti , Ti , Tj )) | Ft ].
b) Since S (t, Ti , Tj ) is a forward price for the numéraire P (t, Ti , Tj ), it is a

martingale under the forward swap measure P b i,j and we have
c i,j ,
S (t, Ti , Tj ) = σS (t, Ti , Tj )dW 0 6 t 6 Ti ,
t
c i,j )t∈R is a standard Brownian motion under the forward swap

where (W t +
measure P
b i,j .
c) Given the solution
2 2
S (Ti , Ti , Tj ) = S (0, Ti , Tj ) e σWTi −σ Ti /2 = S (t, Ti , Tj ) e (WTi −Wt )σ−(Ti −t)σ /2
b b b
of (19.43), we find
P (t, Ti , Tj )E
b i,j [φ(S (Ti , Ti , Tj )) | Ft ]

b i,j φ S (t, Ti , Tj ) e (W b t )σ−(Ti −t)σ2 /2
b Ti −W
= P (t, Ti , Tj )E Ft
w∞ 2
2 dx
= P (t, Ti , Tj ) φ S (t, Ti , Tj ) e σx−(Ti −t)σ /2 e −x /(2(Ti −t)) p ,
−∞ 2π (Ti − t)
because W
cT − W
i
ct is a centered Gaussian variable with variance Ti − t,
independent of Ft under the forward measure P
b i,j .
d) We find
b i,j (κ − S (Ti , Ti , Tj ))+ | Ft

P (t, Ti , Tj )E

= P (t, Ti , Tj )E b i,j (κ − S (t, Ti , Tj ) e −(Ti −t)σ2 /2+(W b t )σ +

b Ti −W

) | Ft
= P (t, Ti , Tj )(κΦ(−d− (Ti − t)) − X bt Φ(−d+ (Ti − t)))
= P (t, Ti , Tj )κΦ(−d− (Ti − t)) − P (t, Ti , Tj )S (t, Ti , Tj )Φ(−d+ (Ti − t))
= P (t, Ti , Tj )κΦ(−d− (Ti − t)) − (P (t, Ti ) − P (t, Tj ))Φ(−d+ (Ti − t)),
" 1131
N. Privault
2 /2
where e m = S (t, Ti , Tj ) e −(T −t)σ , v 2 = (T − t)σ 2 , and
√
log(S (t, Ti , Tj )/κ) σ Ti − t
d+ (Ti − t) = √ + ,
σ Ti − t 2
and √
log(S (t, Ti , Tj )/κ) σ Ti − t
d− (Ti − t) = √ − ,
σ Ti − t 2
because S (t, Ti , Tj ) is a driftless geometric Brownian motion with volatil-
ity σ under the forward measure P b i,j .
Exercise 19.13
a) Apply the Itô formula to d(P (t, T1 )/P (t, T2 ).
b) We have
w w T1
bs − 1

T1
LT1 = Lt exp σ ( s ) dB |σ (s)|2 ds .
t 2 t
c) We have
b (LT − κ)+ Ft
P (t, T2 )E

1
" + #
r T1 r
b 1 T1 2
= P (t, T2 )E Lt e t σ (s)dBs − 2 t |σ (s)| ds − κ

b Ft
p
= P (t, T2 )Bl κ, v (t, T1 )/ T1 − t, 0, T1 − t
log(x/K ) v (t, T1 ) log(x/K ) v (t, T1 )

= P (t, T2 ) Lt Φ + − κΦ − .
v (t, T1 ) 2 v (t, T1 ) 2
d) Integrate the self-financing condition (19.48) between 0 and t.

e) We have
rt
rt rt
= −rt e − 0
rs dsVt
dt + e −
r ds
0 s dVt
rt rt
− (1) (2)
= −rt e 0 r s ds
ξt P (t, T1 ) − rt e − 0 rs ds ξt P (t, T2 )dt
rt rt
( 1 ) ( 2 )
+ e − 0 rs ds ξt dP (t, T1 ) + e − 0 rs ds ξt dP (t, T2 )
(1) (2)
= ξt dPe (t, T1 ) + ξt dPe (t, T2 ), 0 6 t 6 T1 .
since
dPe (t, T1 ) dPe (t, T2 )
= ζ1 (t)dt, = ζ2 (t)dt.
Pe (t, T1 ) Pe (t, T2 )
1132 "
f) We apply the Itô formula and the fact that
b (LT − κ)+ Ft
t 7→ E

1
and (Lt )t∈R+ are both martingales under P.

b Next we use the fact that
b (LT − κ)+ Ft ,
Vbt = E

1
and apply the result of Question (f).

g) Apply the Itô rule to Vt = P (t, T2 )Vbt using Relation (19.46) and the result
of Question (f).
h) We have
∂C
dVt = (Lt , v (t, T1 ))P (t, T1 )(ζ1 (t) − ζ2 (t))dBt + Vbt dP (t, T2 )
∂x
∂C
= (Lt , v (t, T1 ))P (t, T1 )(ζ1 (t) − ζ2 (t))dBt + Vbt ζ2 (t)P (t, T2 )dBt
∂x
∂C
= (1 + Lt ) (Lt , v (t, T1 ))P (t, T2 )(ζ1 (t) − ζ2 (t))dBt + Vbt ζ2 (t)P (t, T2 )dBt
∂x
∂C ∂C
= Lt ζ1 (t) (Lt , v (t, T1 ))P (t, T2 )dBt − Lt (Lt , v (t, T1 ))P (t, T2 )ζ2 (t)dBt
∂x ∂x
∂C
+ (Lt , v (t, T1 ))P (t, T2 )(ζ1 (t) − ζ2 (t))dBt + Vbt ζ2 (t)P (t, T2 )dBt
∂x
∂C ∂C
= Lt (Lt , v (t, T1 ))P (t, T2 )ζ1 (t)dBt + Vbt − Lt (Lt , v (t, T1 )) P (t, T2 )ζ2 (t)dBt
∂x ∂x
∂C
+ (Lt , v (t, T1 ))P (t, T2 )(ζ1 (t) − ζ2 (t))dBt ,
∂x
hence
∂C
dVet = Lt ζ1 (t) (Lt , v (t, T1 ))Pe (t, T2 )dBt
∂x
∂C
+ Vbt − Lt (Lt , v (t, T1 )) Pe (t, T2 )ζ2 (t)dBt
∂x
∂C
+ (Lt , v (t, T1 ))Pe (t, T2 )(ζ1 (t) − ζ2 (t))dBt
∂x
∂C
= (Pe (t, T1 ) − Pe (t, T2 ))ζ1 (t) (Lt , v (t, T1 ))dBt
∂x
∂C
+ Vbt − Lt (Lt , v (t, T1 )) dPe (t, T2 )
∂x
∂C
+ (Lt , v (t, T1 ))Pe (t, T2 )(ζ1 (t) − ζ2 (t))dBt
∂x
∂C
= (ζ1 (t)Pe (t, T1 ) − ζ2 (t)Pe (t, T2 )) (Lt , v (t, T1 ))dBt
∂x
" 1133
N. Privault

∂C
+ Vbt − Lt (Lt , v (t, T1 )) dPe (t, T2 )
∂x

∂C ∂C
= (Lt , v (t, T1 ))d(Pe (t, T1 ) − Pe (t, T2 )) + Vbt − Lt (Lt , v (t, T1 )) dPe (t, T2 ).
∂x ∂x
Exercise 19.14
a) We have
w
1 w Ti

Ti
S (Ti , Ti , Tj ) = S (t, Ti , Tj ) exp σi,j (s)dBsi,j − |σi,j |2 (s)ds .
t 2 t
b) We have
P (t, Ti , Tj )Ei,j (S (Ti , Ti , Tj ) − κ)+ Ft

" + #
r Ti rT
σi,j (s)dBsi,j − 21 t i |σi,j |2 (s)ds
= P (t, Ti , Tj )Ei,j S (t, Ti , Tj ) e −κ
t

Ft
p
= P (t, Ti , Tj )Bl κ, v (t, Ti )/ Ti − t, 0, Ti − t
= P (t, Ti , Tj )
log(x/K ) v (t, Ti ) log(x/K ) v (t, Ti )

× S (t, Ti , Tj )Φ + − κΦ − ,
v (t, Ti ) 2 v (t, Ti ) 2
where w Ti
v 2 (t, Ti ) = |σi,j |2 (s)ds.
t
c) Integrate the self-financing condition (19.53) between 0 and t.
d) We have
rt
rt rt
= −rt e − 0
rs dsVt
dt + e − 0
rs ds
dVt
rt j rt j
(k ) (k )
X X
= −rt e − 0
rs ds
ξt P (t, Tk )dt + e − 0
rs ds
ξt dP (t, Tk )
k =i k =i
j
(k )
X
= ξt dPe (t, Tk ), 0 6 t 6 Ti .
k =i
since
dPe (t, Tk )
= ζk (t)dt, k = i, . . . , j.
Pe (t, Tk )
e) We apply the Itô formula and the fact that
1134 "
t 7−→ Ei,j (S (Ti , Ti , Tj ) − κ)+ Ft

and (St )t∈R+ are both martingales under Pi,j .

f) Use the fact that
Vbt = Ei,j (S (Ti , Ti , Tj ) − κ)+ Ft ,

and apply the result of Question (e).

g) Apply the Itô rule to Vt = P (t, Ti , Tj )Vbt using Relation (19.50) and the
result of Question (f).
h) From the expression (19.52) of the swap rate volatilities we have
∂C
dVt = St (St , v (t, Ti ))
∂x
j−1
!
X
× (Tk+1 − Tk )P (t, Tk+1 )(ζi (t) − ζk+1 (t)) + P (t, Tj )(ζi (t) − ζj (t)) dBt
k =i
+Vbt dP (t, Ti , Tj )
∂C
= St (St , v (t, Ti ))
∂x
j−1
!
X
× (Tk+1 − Tk )P (t, Tk+1 )(ζi (t) − ζk+1 (t)) + P (t, Tj )(ζi (t) − ζj (t)) dBt
k =i
j−1
X
+Vbt (Tk+1 − Tk )ζk+1 (t)P (t, Tk+1 )dBt
k =i
j−1
∂C X
= St (St , v (t, Ti )) (Tk+1 − Tk )P (t, Tk+1 )(ζi (t) − ζk+1 (t))dBt
∂x
k =i
∂C
+ (St , v (t, Ti ))P (t, Tj )(ζi (t) − ζj (t))dBt
∂x
j−1
X
k =i
j−1
∂C X
= St ζi (t) (St , v (t, Ti )) (Tk+1 − Tk )P (t, Tk+1 )dBt
∂x
k =i
j−1
∂C X
−St (St , v (t, Ti )) (Tk+1 − Tk )P (t, Tk+1 )ζk+1 (t)dBt
∂x
k =i
∂C
+ (St , v (t, Ti ))P (t, Tj )(ζi (t) − ζj (t))dBt
∂x
j−1
X
k =i
" 1135
N. Privault
j−1
∂C X
= St ζi (t) (St , v (t, Ti )) (Tk+1 − Tk )P (t, Tk+1 )dBt
∂x
k =i
j−1
X
∂C
+ Vbt − St (St , v (t, Ti )) (Tk+1 − Tk )P (t, Tk+1 )ζk+1 (t)dBt
∂x
k =i
∂C
+ (St , v (t, Ti ))P (t, Tj )(ζi (t) − ζj (t))dBt .
∂x
i) We have
j−1
∂C X
dVet = St ζi (t) (St , v (t, Ti )) (Tk+1 − Tk )Pe (t, Tk+1 )dBt
∂x
k =i
Xj−1
∂C
+ Vbt − St (St , v (t, Ti )) (Tk+1 − Tk )Pe (t, Tk+1 )ζk+1 (t)dBt
∂x
k =i
∂C
+ (St , v (t, Ti ))Pe (t, Tj )(ζi (t) − ζj (t))dBt
∂x
∂C
= (Pe (t, Ti ) − Pe (t, Tj ))ζi (t) (St , v (t, Ti ))dBt
∂x
∂C
+ Vbt − St (St , v (t, Ti )) dPe (t, Ti , Tj )
∂x
∂C
+ (St , v (t, Ti ))Pe (t, Tj )(ζi (t) − ζj (t))dBt
∂x
∂C
= (ζi (t)Pe (t, Ti ) − ζj (t)Pe (t, Tj )) (St , v (t, Ti ))dBt
∂x
∂C
∂x
∂C
= (St , v (t, Ti ))d(Pe (t, Ti ) − Pe (t, Tj ))
∂x
∂C
+ Vbt − St (St , v (t, Ti )) dPe (t, Ti , Tj ).
∂x
j) We have
1 1

∂C ∂ v x v x
(x, τ , v ) = xΦ + log − κΦ − + log
∂x ∂x 2 v κ 2 v κ
1 1 1

∂ v x ∂ v x v x
=x Φ + log − κ Φ − + log +Φ + log
∂x 2 v κ ∂x 2 v κ 2 v κ
1 −1 2 κ −1 2
= √ e −(v/2+v log(x/κ)) /2 − √ e −(−v/2+v log(x/κ)) /2
v 2π vx 2π
log(x/κ) v log(x/κ) v

+Φ + =Φ + .
v 2 v 2
1136 "
k) We have
∂C
dVet = (St , v (t, Ti ))d(Pe (t, Ti ) − Pe (t, Tj ))
∂x
∂C
∂x

=Φ + d(Pe (t, Ti ) − Pe (t, Tj ))
v (t, Ti ) 2

−κΦ − dPe (t, Ti , Tj ).
v (t, Ti ) 2
l) We compare the results of Questions (d) and (k).
Chapter 20
Exercise 20.1 For any x ∈ [0, T ], we have
P(T − TNT > x and NT > 1)

P(T − TNT > x | NT > 1) =
P ( NT > 1 )
P(NT − NT −x = 0 and NT > 1)
=
P ( NT > 1 )
P(NT − NT −x = 0 and NT −x > 1)
=
P ( NT > 1 )
P(NT − NT −x = 0)P(NT −x > 1)
=
P ( NT > 1 )
e −(T −(T −x))λ (1 − e −(T −x)λ )
=
1 − e −λT
e −(T −(T −x))λ − e −λT
=
1 − e −λT
e −λx − e −λT
= , 0 6 t 6 T.
1 − e −λT
" 1137
N. Privault
Nt
0
T1 T2 T3 T4 T5 TNT T −x T t
We note that
P(T − TNT > 0 | NT > 1) = 1 and P(T − TNT > T | NT > 1) = 0.
Exercise 20.2
a) When t ∈ [0, T1 ), the equation reads
dSt = −ηλSt− dt = −ηλSt dt,
which is solved as St = S0 e −ηλt , 0 6 t < T1 . Next, at the first jump time

t = T1 we have
∆St := St − St− = ηSt− dNt = ηSt− ,
which yields St = (1 + η )St− , hence ST1 = (1 + η )ST − = S0 (1 +

1
η ) e −ηλT1 . Repeating this procedure over the Nt jump times contained
in the interval [0, t] we get
St = S0 (1 + η )Nt e −ληt , t ∈ R+ .
b) When t ∈ [0, T1 ) the equation reads
dSt = −ηλSt− dt = −ηλSt dt,
which is solved as St = S0 e −ηλt , 0 6 t < T1 . Next, at the first jump time

t = T1 we have
dSt = St − St− = dNt = 1,
which yields St = 1 + St− , hence ST1 = 1 + ST − = 1 + S0 e −ηλT1 , and for
1
t ∈ [T1 , T2 ) we will find
St = (1 + S0 e −ηλT1 ) e −(t−T1 )ηλ , t ∈ [T1 , T2 ).
More generally, the equation can be solved by letting Yt := e ηλt St and

noting that (Yt )t∈R+ satisfies dYt = e ληt dNt , which has the solution
1138 "
wt
Yt = Y0 + e ηλs dNs , t ∈ R+ ,
0
hence in general we have

wt
St = e −ηλt S0 + e −(t−s)ηλ dNs , t ∈ R+ ,
0
Exercise 20.3
a) Taking expectations on both sides of (20.40), we have
u(t) = E[St ]
wt wt wt
= E S0 + µ Ss ds + σ Ss dBs + η Ss− dYs
0 0 0
w w w
t t t
= E[S0 ] + E µ Ss ds + E σ Ss dBs + E η Ss− dYs
0 0 0
wt wt
= S0 + µ E[Ss ]ds + 0 + ηλE[Z ] E[Ss− ]ds
0 0
wt wt
= S0 + µ u(s)ds + ηλE[Z ] u(s)ds, , t > 0.
0 0
b) The above equation can be rewritten in differential form as
u0 (t) = µu(t) + ηλE[Z ]u(t)
with u(0) = S0 , which admits the solution
E[St ] = u(t) = u(0) e (µ+λE[Z ])t = S0 e (µ+λE[Z ])t , t > 0.
Exercise 20.4
a) We have
X0 e αt , 0 6 t < T1 ,







 X0 e αT1 + σ e (t−T1 )α = X0 e αt + σ e (t−T1 )α , T1 6 t < T2 ,


Xt =


 X e αT1 + σ e (T2 −T1 )α + σ e (t−T2 )α



 0
= X0 e αt + σ e (t−T1 )α + σ e (t−T2 )α , T2 6 t < T3 ,


and more generally the solution (Xt )t∈R+ can be written as
Nt wt
e (t−Tk )α = X0 e αt + σ e (t−s)α dNs ,
X
Xt = X0 e αt + σ t ∈ R+ .
0
k =1
(A.86)
" 1139
N. Privault
b) Letting f (t) := E[Xt ] and taking expectation on both sides of the stochas-
tic differential equation dXt = αXt dt + σdNt we find
df (t) = αf (t)dt + σλdt,
or
f 0 (t) = αf (t) + σλ.
Letting g (t) = f (t) e −αt , we check that
g 0 (t) = σλ e −αt ,
hence
wt wt λ
g (t) = g (0) + g 0 (s)ds = g (0) + σλ e −αs ds = f (0) + σ (1 − e −αt ),
0 0 α
and
f (t) = E[Xt ]
= g (t) e αt
λ
= f (0) e αt + σ ( e αt − 1)
α
λ
= X0 e αt + σ ( e αt − 1), t ∈ R+ .
α
We could also take the expectation on both sides of (A.86) and directly
find
wt λ
f (t) = E[Xt ] = X0 e αt + σλ e (t−s)α ds = X0 e αt + σ ( e αt − 1), t ∈ R+ .
0 α
Exercise 20.5
Nt
Y
a) We have Xt = X0 (1 + σ ) = X0 (1 + σ )Nt = (1 + σ )Nt , t ∈ R+ .
k =1
b) By stochastic calculus and using the relation dXt = σXt− dNt , we have
wt w
t −1

dSt = d S0 Xt + rXt Xs−1 ds = S0 dXt + rd Xt Xs ds
0 0
w w w
t −1 t −1 t −1
= S0 dXt + rXt d Xs ds + r Xs ds dXt + rdXt • d Xs ds
0 0 0
w
−1 t −1 −1
= S0 dXt + rXt Xt dt + r Xs ds dXt + rdXt • (Xt dt)
0
w wt
t −1
= S0 dXt + rdt + r Xs ds dXt = rdt + S0 + r Xs−1 ds dXt
0 0
1140 "
wt
= rdt + σ S0 Xt− + rXt− Xs−1 ds dNt = rdt + σSt− dNt .
0
c) We have
E[Xt /Xs ] = E[(1 + σ )Nt −Ns ]

X
= ( 1 + σ ) k P ( Nt − Ns = k )
k >0
((t − s)λ)k X ((t − s)(1 + σ )λ)k
= e −(t−s)λ = e −(t−s)λ
X
(1 + σ )k
k! k!
k >0 k>0
= e −(t−s)λ e (t−s)(1+σ )λ = e (t−s)λσ , 0 6 s 6 t.
Remarks: We could also let f (t) = E[Xt ] and take expectation in the
equation dXt = σXt− dNt to get f 0 (t) = σλf (t)dt and f (t) = E[Xt ] =
f (0) e λσt = e λσt . Note that the relation E[Xt /Xs ] = E[Xt ]/E[Xs ],
which happens to be true here, is wrong in general.
d) We have
wt wt
E[St ] = E S0 Xt + rXt Xs−1 ds = S0 E[Xt ] + r E[Xt /Xs ]ds
0 0
wt wt
(t−s)λσ
= S0 e λσt
+r e ds = S0 e λσt
+r e λσs ds
0 0
( e λσt − 1)r
= S0 e λσt + , t ∈ R+ .
λσ
Exercise 20.6
a) Since E[Nt ] = λt, the expectation E[Nt − 2λt] = −λt is a decreasing
function of t ∈ R+ , and (Nt − 2λt)t∈R+ is a supermartingale.
b) We have
St = S0 e rt−λσt (1 + σ )Nt , t ∈ R+ .
c) The stochastic differential equation
dSt = rSt dt + σSt− (dNt − λdt)
contains a martingale component (dNt − λdt) and a positive drift rSt dt,
therefore (St )t∈R+ is a submartingale.
d) Given that σ > 0 we have ((1 + σ )k − 1)+ = (1 + σ )k − 1, hence
e −rT E∗ [(ST − K )+ ] = e −rT E∗ [(S0 e (r−σλ)T (1 + σ )NT − K )+ ]

= e −rT E∗ [(S0 e (r−σλ)T (1 + σ )NT − S0 e (r−λσ )T )+ ]
= S0 e −σλT E∗ [((1 + σ )NT − 1)+ ]
" 1141
N. Privault
((1 + σ )k − 1)+ P(NT = k )

X
= S0 e −σλT
k>0
X
= S0 e −σλT ((1 + σ )k − 1)P(NT = k )
k>0
X X
= S0 e −σλT (1 + σ )k P(NT = k ) − S0 e −σλT P(NT = k )
k>0 k >0
X (T (1 + σ )λ)k
= S0 e −σλT −λT − S0 e −σλT
k!
k >0
= S0 (1 − e −σλT ),
where we applied the exponential identity

X xk
ex =
k!
k >0
to x := T (1 + σ )λ.
Exercise 20.7
a) For all k = 1, 2, . . . , Nt we have
XTk − XT − = a + σXT − ,
k k
hence
XTk = a + (1 + σ )XT − ,
k
and continuing by induction, we obtain
XTk = a + (1 + σ )a + · · · + (1 + σ )k−1 a + X0 (1 + σ )k
(1 + σ )k − 1
=a + X0 (1 + σ )k ,
σ
which shows that
Xt = XTNt
(1 + σ )Nt − 1
= X0 (1 + σ )Nt + a
σ
a a
= (1 + σ )Nt X0 + − , t ∈ R+ .
σ σ
This result can also be obtained by noting that
a a
XTk + = (1 + σ ) XT − + , k = 1, 2, . . . , Nt .
σ k σ
1142 "
b) We have
X (λt)k
E[(1 + σ )Nt ] = e −λt (1 + σ )k = e σλt , t ∈ R+ ,
k!
n>0
hence
e λσt − 1 a a
E[Xt ] = X0 e λσt + a = e λσt X0 + − , t ∈ R+ .
σ σ σ
Nt
Y
Exercise 20.8 We have St = S0 e rt (1 + ηZk ), t ∈ R+ .
k =1
 2 
NT
X
Var [YT ] = E  Zk − E[YT ] 
k =1
 2 
X NT
X
= E  Zk − λtE[Z ] NT = k  P(NT = k )

n>0 k =1
 !2 
X λ n tn X n
= e −λt E Zk − λtE[Z ] 
n!
n>0 k =1
 !2 
X λ n tn X n n
X
−λt
= e E Zk − 2λtE[Z ] Zk + λ t (E[Z ]) 
2 2 2
n!
n>0 k =1 k =1
X λ n tn
−λt
= e
n!
n>0
 
X n
X n
X
×E 2 Zk Zl + |Zk | − 2λtE[Z ]
2
Zk + λ t (E[Z ]) 
2 2 2
16k<l6n k =1 k =1
X λ n tn
−λt
= e
n!
n>0
×(n(n − 1)(E[Z ])2 + nE |Z|2 − 2nλt(E[Z ])2 + λ2 t2 (E[Z ])2 )

X λn tn X λ n tn
= e −λt (E[Z ])2 + e −λt E |Z|2

(n − 2) ! (n − 1) !
n>2 n>1
−λt
X λ n tn
−2 e λt(E[Z ]) 2
+ λ2 t2 (E[Z ])2 )
(n − 1) !
n>1
= λtE |Z|2 ,

" 1143
N. Privault
or, using the moment generating function of Proposition 20.6,
Var [YT ] = E |YT |2 − (E[YT ])2

∂2
= E[ e αYT ]|α=0 − λ2 t2 (E[Z ])2
∂αw2
∞
|y|2 µ(dy ) = λtE |Z|2 .

= λt
−∞
Exercise 20.10
a) Applying the Itô formula (20.24) to the function f (x) = e x and to the
process Xt = µt + σWt + Yt , we find
1

dSt = µ + σ 2 St dt + σSt dWt + (St − St− )dNt
2
1 2

= µ + σ St dt + σSt dWt + (S0 e µt+σWt +Yt − S0 e µt+σWt +Yt− )dNt
2
1 2

= µ + σ St dt + σSt dWt + (S0 e µt+σWt +Yt− +ZNt − e µt+σWt +Yt− )dNt
2
1

= µ + σ 2 St dt + σSt dWt + St− ( e ZNt − 1)dNt ,
2
hence the jumps of St are given by the sequence ( e Zk − 1)k>1 .

b) The discounted process e −rt St satisfies
1

d( e −rt St ) = e −rt µ − r + σ 2 St dt + σ e −rt St dWt + e −rt St− ( e ZNt − 1)dNt .
2
Hence by the Girsanov Theorem 20.20, choosing u, λ̃, ν̃ such that

1
µ − r + σ 2 = σu − λ̃Eν̃ [ e Z − 1],
2
shows that
d( e −rt St ) = σ e −rt St (dWt + udt) + e −rt St− (( e ZNt − 1)dNt − λ̃Eν̃ [ e Z − 1]dt)
is a martingale under (Pu,λ̃,ν̃ ).
Exercise 20.11
a) We have
Nt Nt
!
Y X
St = S0 e µt
(1 + Zk ) = S0 exp µt + Xk , t ∈ R+ .
k =1 k =1
b) We have the discounted asset price process

1144 "
Nt
!
X
Set := e −rt St = S0 exp (µ − r )t + Xk , t ∈ R+ ,
k =1
satisfies the stochastic differential equation
dSet = (µ − r )Set dt + XNt Set− dNt

t ∈ R+ ,

= (µ − r + λE[Z ])Set dt + XNt − λE[Z ] Set− dNt
hence it is a martingale if
2 /2
0 = µ − r + λE[Z ] = µ − r + λE[ e Xk − 1] = µ − r + ( e σ − 1)λ.
c) We have
e −(T −t)r E[(ST − κ)+ | St ]

   + 
NT
−(T −t)r
X
= e E S0 exp µT + Xk  − κ St

k =1
   + 
NT
−(T −t)r
X
= e E St exp µ(T − t) + Xk  − κ St

k =Nt +1
   + 
NT
= e −(T −t)r E x exp µ(T − t) +
X
Xk  − κ 
k =Nt +1 x=St
   + 
NT −Nt
= e −(T −t)r E x exp µ(T − t) +
X
Xk  − κ 
k =1 x = St
Pn +
−(T −t)r µ(T −t)+ Xk
X
= e E xe k =1 −κ P(NT − Nt = n)
n>0 x = St
+ ((T − t)λ)n
Pn
= e −(r +λ)(T −t) x e µ(T −t)+ Xk
X
E k =1 −κ
x=St n!
n>0
X ((T − t)λ)n 2
= e −(T −t)λ Bl(St e (µ−r )(T −t)+nσ /2 , r, nσ 2 /(T − t), κ, T − t)
n!
n>0
X 2
((T − t)λ)n
−(T −t)λ
= e St e (µ−r )(T −t)+nσ /2 Φ(d+ ) − κ e −(T −t)r Φ(d− ) ,
n!
n>0
with
2 /2
log(St e (µ−r )(T −t)+nσ /κ) + (T − t)r + nσ 2 /2
d+ = √
σ n
" 1145
N. Privault
log(St /κ) + µ(T − t) + nσ 2

= √ ,
σ n
2 /2
log(St e (µ−r )(T −t)+nσ /κ) + (T − t)r − nσ 2 /2
d− = √
σ n
log(St /κ) + µ(T − t)
= √ ,
σ n
2 /2
and µ = r + (1 − e σ )λ.
Exercise 20.12
a) We have
d( e αt St ) = σ e αt (dNt − βdt),
hence wt
e αt St = S0 + σ e αs (dNs − βd),
0
and
wt
St = S0 e −αt + σ e −(t−s)α (dNs − βds), t ∈ R+ . (A.87)
0
b) We have
f (t) = E[St ]
w wt
t −(t−s)α
= S0 e −αt + σE e dNs − βσ e −(t−s)α ds
0 0
wt wt
= S0 e −αt + λσ e −(t−s)α ds − βσ e −(t−s)α ds
0 0
−αt 1 − e −αt
= S0 e + (λ − β )σ
α
λ−β β−λ
=σ + S0 + σ e −αt , t > 0.
α α
c) By rewriting (A.87) as
wt wt
St = S0 − αS0 e −(t−s)α ds + σ e −(t−s)α (dNs − βds)
0 0
wt
= S0 + σ e −(t−s)α (dNs − (β + αS0 /σ )ds)
0
wt wt
= S0 + σ e −(t−s)α (λ − β − αS0 /σ )ds) + σ e −(t−s)α (dNs − λds),
0 0
1146 "
t ∈ R+ , we check that the process (St )t∈R+ is a submartingale, provided

that λ − β − αS0 /σ > 0, i.e. S0 + (β − λ)σ/α 6 0. We also check that this
condition makes the expectation f (t) = E[St ] decreasing in Question (b).
d) Since, given that NT = n the jump times (T1 , T2 , . . . , Tn ) of the Poisson
process (Nt )t∈R+ are independent uniformly distributed random variables
over [0, T ], hence we can write
wT
E[φ(ST )] = E φ S0 e −αT + σ e −(T −s)α (dNs − βds),
0
X
= P ( NT = n )
n>0
wT
× E φ S0 e −αT + σ e −(T −s)α (dNs − βds) NT = n

0
X (λT )n
−λT
= e
n!
n>0
n wT
" ! #

e −(T −Tk )α − σβ e −(T −s)α ds
X
× E φ S0 e −αT + σ NT = n

0
k =1
X λn
= e −λT
n!
n>0
wT wT n
!
1 − e −αT
e −(T −sk )α − σβ
X
× ··· φ S0 e −αT + σ ds1 · · · dsn ,
0 0 α
k =1
T > 0.
Exercise 20.13
a) From the decomposition Yt − λt(t + E[Z ]) = Yt − λE[Z ]t − λt2 as the
sum of a martingale and a decreasing function, we conclude that t 7→
Yt − λt(t + E[Z ]) is a supermartingale.
b) Writing
dSt = µSt dt + σSt− dYt

r−µ
= rSt dt + σSt− dYt − dt
σ
= rSt dt + σSt− dYt − λ̃E[Z ]dt , 0 6 t 6 T,

we conclude that (St )t∈[0,T ] is a martingale under Pλ̃ provided that
µ−r
= −λ̃E[Z ]dt,
σ
i.e.
" 1147
N. Privault
r−µ
λ̃ = .
σE[Z ]
We note that λ̃ < 0 if µ < r, hence in this case there is no risk-neutral
probability measure and the market admits arbitrage opportunities as the
risky asset always overperforms the risk-free interest rate r.
c) We have
e −(T −t)r Eλ̃ [ST − κ | Ft ] = e rt Eλ̃ [ e −rT ST | Ft ] − K e −(T −t)r

= St − K e −(T −t)r ,
since (St )t∈[0,T ] is a martingale under Pλ̃ .
Exercise 20.14
a) We have
Nt
Y
St = S0 e µt ( 1 + Zk ) , t ∈ R+ .
k =1
b) Letting Xk = log(1 + Zk ), k > 1, we find that

Nt
!
X
−rt
e St = S0 exp (µ − r )t + Xk , t ∈ R+ ,
k =1
and (20.43) can be rewritten for the discounted price process
Set := e −rt St , t ∈ R+ ,
as
dSet = (µ − r + λE[Z ])Set dt + Set− (dYt + λE[Z ]),
which becomes a martingale if
w∞
0 = µ − r + λE[Z ] = µ − r + λ zν (dz ).
−∞
c) We have
e −(T −t)r E[(ST − κ)+ | St ]

 + 
NT
= e −(T −t)r E S0 e µT
Y
Zk − κ S

t
k =1
 + 
NT
−(T −t)r
E St e µ(T −t)
X Y
= e Zk − κ St P(NT − Nt = n)

n>0 k = Nt + 1
1148 "
 + 
NT
 ((T − t)λ)n

−(r +λ)(T −t) µ(T −t)
X Y
= e E St e Zk − κ St
n!
n>0 k =Nt +1
X ((T − t)λ)n
= e −(r +λ)(T −t)
n!
n>0
!+
w∞ w∞ n
St e µ(T −t)
Y
× ··· zk − κ ν (dz1 ) · · · ν (dzn ).
−∞ −∞
k =1
Exercise 20.15
a) The discounted price process ( e −rt St )t∈[0,T ] is a martingale, hence it is
both a submartingale and a supermartingale.
b) The discounted price process ( e −rt St )t∈[0,T ] is a supermartingale.
c) The discounted price process ( e −rt St )t∈[0,T ] is a submartingale.
d) Under the probability measure P e , the discounted price process ( e −rt St )
λ̃ t∈[0,T ]
is a martingale, hence it is both a submartingale and a supermartingale.
Chapter 21
Exercise 21.1
a) We have E[Nt − αt] = E[Nt ] − αt = λt − αt, hence Nt − αt is a martingale
if and only if α = λ. Given that
d( e −rt St ) = η e −rt St− (dNt − αdt),
we conclude that the discounted price process e −rt St is a martingale if

and only if α = λ.
b) Since we are pricing under the risk-neutral probability measure we take
α = λ. Next, we note that
ST = S0 e (r−ηλ)T (1 + η )NT = St e (r−ηλ)(T −t) (1 + η )NT −Nt , 0 6 t 6 T,
hence the price at time t of the option is
e −(T −t)r E[|ST |2 | Ft ]

= e −(T −t)r E[|St |2 e 2(r−ηλ)(T −t) (1 + η )2(NT −Nt ) | Ft ]
= |St |2 e (r−2ηλ)(T −t) E[(1 + η )2(NT −Nt ) | Ft ]
= |St |2 e (r−2ηλ)(T −t) E[(1 + η )2(NT −Nt ) ]
= |St |2 e (r−2ηλ)(T −t)
X
(1 + η )2n P(NT − Nt = n)
n>0
" 1149
N. Privault
(λ(T − t))n
= |St |2 e (r−2ηλ−λ)(T −t)
X
(1 + η )2n
n!
n>0
2 λ(T −t)
= |St |2 e (r−2ηλ−λ)(T −t)+(1+η )
(r +η 2 λ)(T −t)
= |St |2 e , 0 6 t 6 T.
Exercise 21.2
a) Regardless of the choice of a particular risk-neutral probability measure
Pu,λ̃,ν̃ , we have
e −(T −t)r Eu,λ̃,ν̃ [ST − K | Ft ] = e rt Eu,λ̃,ν̃ [ e −rT ST | Ft ] − K e −(T −t)r

= e rt e −rt St − K e −(T −t)r
= St − K e −(T −t)r
= f (t, St ),
for
f (t, x) = x − K e −(T −t)r , t, x > 0.
b) Clearly, holding one unit of the risky asset and shorting a (possibly frac-
tional) quantity K e −rT of the riskless asset will hedge the payoff ST − K,
and this (static) hedging strategy is self-financing because it is constant
in time.
∂f
c) Since (t, x) = 1 we have
∂x
∂f aλe
σ2 (t, St− ) + (f (t, St− (1 + a)) − f (t, St− ))
∂x St−
ξt =
σ 2 + a2 λ
e
a λ
e
σ2 + (S − (1 + a) − St− )
St− t
=
σ 2 + a2 λ
e
= 1, 0 6 t 6 T,
which coincides with the result of Question (b).
Exercise 21.3
a) We have
1

St = S0 exp µt + σBt − σ 2 t (1 + η )Nt .
2
b) We have
1150 "
1

Set = S0 exp (µ − r )t + σBt − σ 2 t (1 + η )Nt ,
2
and
dSet = (µ − r + λη )Set dt + η Set− (dNt − λdt) + σ Set dWt ,
hence we need to take
µ − r + λη = 0,
since the compensated Poisson process (Nt − λt)t∈R+ is a martingale.
c) We have
e −r (T −t) E∗ [(ST − κ)+ | St ]

" + #
1

= e −r (T −t) E∗ S0 exp µT + σBT − σ 2 T (1 + η )NT − κ St

2
+
2
= e −r (T −t) E∗ St e µ(T −t)+(BT −Bt )σ−(T −t)σ /2 (1 + η )NT −Nt − κ St

= e −r (T −t)
X
P(NT − Nt = n)
n>0
+
2 /2
×E ∗
St e µ(T −t)+(BT −Bt )σ−(T −t)σ (1 + η )n − κ St

X (λ(T − t))n
= e −(r +λ)(T −t)
n!
n>0
+
∗ (r−λη )(T −t)+(BT −Bt )σ−(T −t)σ 2 /2
×E St e (1 + η )n − κ St

(λ(T − t))n
= e −λ(T −t) Bl(St e −λη (T −t) (1 + η )n , r, σ 2 , T − t, κ)
X
n!
n>0
X (λ(T − t))n
= e −λ(T −t) St e −λη (T −t) (1 + η )n Φ(d+ ) − κ e −r (T −t) Φ(d− ) ,
n!
n>0
with
log(St e −λη (T −t) (1 + η )n /κ) + (r + σ 2 /2)(T − t)

d+ = √
σ T −t
log(St (1 + η )n /κ) + (r − λη + σ 2 /2)(T − t)
= √ ,
σ T −t
and
log(St e −λη (T −t) (1 + η )n /κ) + (r − σ 2 /2)(T − t)

d− = √
σ T −t
" 1151
N. Privault
log(St (1 + η )n /κ) + (r − λη − σ 2 /2)(T − t)

= √ .
σ T −t
Exercise 21.4
a) The discounted process Set = e −rt St satisfies the equation
dSet = YNt Set− dNt , ,
and it is a martingale since the compound Poisson process YNt dNt is

centered with independent increments as E[Y1 ] = 0.
b) We have
NT
Y
ST = S0 e rT (1 + Yk ),
k =1
hence
 + 
NT
+
Y
−rT −rT 
e E ( ST − κ ) = e E S0 e rT
(1 + Yk ) − κ 

k =1
 + 
X NT
Y
−rT
= e E S0 e rT
(1 + Yk ) − κ NT = n P(NT = n)

n>0 k =1
" n
!+ #
−rT −λT
X Y (λT )n
= e E S0 e rT
(1 + Yk ) − κ
n!
k>0 k =1
!+
X (λT )n w 1 w1 n
Y
= e −rT −λT ··· S0 e rT (1 + yk ) − κ dy1 · · · dyn .
2n n! −1 −1
k>0 k =1
Exercise 21.5
a) We find α = λ where λ is the intensity of the Poisson process (Nt )t∈R+ .
b) We have
e −(T −t)r E[ST − κ | Ft ] = e rt E[ e −rT ST | Ft ] − e −(T −t)r E[κ | Ft ]

= e rt E[ e −rt St | Ft ] − e −(T −t)r κ
= St − e −(T −t)r κ,
since the process ( e −rt St )t∈R+ is a martingale.
Exercise 21.6
a) We have
St = S0 e (r−λ)t (1 + α)Nt , t > 0.
1152 "
b) We have

ST
e −(T −t)r E∗ [φ(ST ) | Ft ] = e −(T −t)r E∗ φ x
St |x=St
−(T −t)r ∗ (r−λ)(T −t) NT −Nt
= e E φ(x e (1 + α )

) |x=S
t
∞
((T − t)λ)k
= e −(r +λ)(T −t) φ St e (r−λ)(T −t) (1 + α)k ,
X
0 6 t 6 T.

k!
k =0
c) We have
dVt = rηt e rt dt + ξt dSt

= rηt e rt dt + ξt (rSt dt + αSt− (dNt − λdt))
= rVt dt + αξt St− (dNt − λdt)
= rf (t, St )dt + αξt St− (dNt − λdt). (A.88)
d) By the Itô formula with jumps we have
d( e −rt f (t, St )) = −r e −rt f (t, St )dt + e −rt df (t, St )

= −r e −rt f (t, St )dt

∂f ∂f ∂f
+ e −rt (t, St )dt + rSt (t, St )dt − λSt (t, St )dt
∂t ∂x ∂x

+ f (t, (1 + α)St− ) − f (t, St− ) dNt

= −r e −rt f (t, St )dt

∂f ∂f ∂f
+ e −rt (t, St ) + rSt (t, St ) − λSt (t, St )
∂t ∂x ∂x

−rt
+λ e (f (t, (1 + α)St ) − f (t, St )) dt
+ e −rt f (t, (1 + α)St− ) − f (t, St− ) dNt

−λ e −rt E[f (t, (1 + α)x) − f (t, x)]|x=S − dt.

t
Since the discounted price process ( e −rt f (t, St ))t∈R+ is a martingale un-
der the risk-neutral measure, d( e −rt f (t, St )) must reduce to its martingale
component, i.e. the sum of “dt” terms vanishes, and we get
d( e −rt f (t, St ))
= e −rt f (t, (1 + α)St− ) − f (t, St− ) dNt − λ e −rt E[f (t, (1 + α)x) − f (t, x)]|x=St− dt

= e −rt f (t, (1 + α)St− ) − f (t, St− ) dNt − λ e −rt f (t, (1 + α)St− ) − f (t, St− ) dt,

or equivalently
" 1153
N. Privault
df (t, St ) = rf (t, St )dt + f (t, (1 + α)St− ) − f (t, St− ) (dNt − λ)dt.

(A.89)
Finally, by identification of the terms in the above formula (A.89) with
those appearing in (A.88), we obtain
αξt St− (dNt − λdt) = f (t, (1 + α)St− ) − f (t, St− ) (dNt − λdt),

which yields the hedging strategy

1
f (t, (1 + α)St− ) − f (t, St− ) , 0 < t 6 T.

ξt =
αSt−
Exercise 21.7
a) We have
E[Nt | Fs ] = e θYs −sm(θ ) E e (Yt −Ys )θ−(t−s)m(θ ) Fs

= e θYs −sm(θ ) E e (Yt −Ys )θ−(t−s)m(θ ) = Ns , 0 6 s 6 t.

b) We have

NT
Eθ e −rt St | Fs = E e Yt

Fs
Ns

Yt Nt
=E e Fs
Ns
= e Ys E e Yt −Ys e (Yt −Ys )θ−(t−s)m(θ ) | Fs

= e Ys e −(t−s)m(θ ) E e (1+θ )(Yt −Ys )

= e Ys e −(t−s)m(θ ) e (t−s)m(θ +1) ,
hence we should have m(θ ) = m(θ + 1). For example, when (Yt )t∈R+ =
(Nt − t)t∈R+ is a compensated Poisson process we have m(θ ) = e θ − θ − 1
and the condition reads e θ + 1 = e θ +1 , i.e. θ = − log( e − 1).
c) We have

NT
e −(T −t)r Eθ [(ST − K )+ | Ft ] = e −(T −t)r E (ST − K )+ Ft
Nt
" θ #
ST
= e −(T −t)((1+r )θ +m(θ )) E (ST − K )+ Ft .

St
Background on Probability Theory

Exercise S.1
1154 "
a) We have
X X λk
E[X ] = kP(X = k ) = e −λ k
k!
k>0 k >0
−λ
X λk X λk
= e = λ e −λ = λ.
(k − 1) ! k!
k>1 k>0
b) We have
X
E[X 2 ] = k 2 P(X = k )
k>0
X λk
= e −λ k2
k!
k>1
−λ
X λk
= e k
(k − 1) !
k>1
−λ
X λk X λk
= e + e −λ
(k − 2) ! (k − 1) !
k>2 k>1
X λk X λk
= λ2 e −λ + λ e −λ
k! k!
k>0 k >0
2
= λ + λ,
and
Var[X ] = E[X 2 ] − (E[X ])2 = λ = E[X ].
Exercise S.2 We have

w∞ 2 / (2η 2 ) dy
P( e X > c) = P(X > log c) = e −y
2πη 2
p
log c
w∞ 2 /2 dy
= e −y √ = 1 − Φ((log c)/η ) = Φ(−(log c)/η ).
(log c)/η 2π
Exercise S.3
a) Using the change of variable z = (x − µ)/σ, we have
w∞ 1 w∞ 2 / (2σ 2 )
ϕ(x)dx = √ e −(x−µ) dx
−∞ 2πσ 2 −∞
1 w∞ 2 / (2σ 2 )
= √ e −y dy
2πσ 2 −∞
" 1155
N. Privault
1 w ∞ −z 2 /2
= √ e dz.
2π −∞
Next, using the polar change of coordinates dxdy = rdrdθ, we find∗
1 w ∞ −z 2 /2 1 w ∞ −y2 /2 w ∞ −z 2 /2
2
√ e dz = e dy e dz
2π −∞ 2π −∞ −∞
w w
1 ∞ ∞ −(y2 +z 2 )/2
= e dydz
2π −∞ −∞
w w
1 2π ∞ −r2 /2
= re drdθ
w2π 0 0 ∞ 2
= r e −r /2 dr
0
wR 2
= lim r e −r /2 dy
R→+∞ 0
h 2 /2
iR
= − lim e −r
R→+∞ 0
−R2 /2
= lim (1 − e )
R→+∞
= 1,
or w∞ √
2 /2
e −z dz = 2π.
−∞
b) We have
w∞
E[X ] = xϕ(x)dx
−∞
1 w∞ 2 2
= √ x e −(x−µ) /(2σ ) dx
2πσ 2 −∞
1 w∞ 2 2
= √ (µ + y ) e −y /(2σ ) dx
2πσw2 −∞
µ ∞ 2 σ w∞ 2
= √ e −y /2 dy + √ y e −y /2 dy
2π −∞ 2π −∞
µ w ∞ −y2 /2 σ wA 2
= √ e dy + √ lim y e −y /2 dy
2π −∞ 2π A→+∞ −A
µ w ∞ −y2 /2
= √ e dy
2π −∞
w∞
= µ ϕ(y )dy
−∞
= µP(X ∈ R)
∗
“In a discussion with Grothendieck, Messing mentioned the formula expressing the
2
integral of e −x in terms of π, which is proved in every calculus course. Not only did
Grothendieck not know the formula, but he thought that he had never seen it in his
life”. Milne (2005).
1156 "
= µ,
2
by symmetry of the function y 7−→ y e −y /2 on R.
c) Similarly, by integration by parts twice on R, we find
w∞
E[(X − E[X ])2 ] = (x − µ)2 ϕ(x)dx
−∞
1 w∞ 2 2
= √ y 2 e −(y−µ) /(2σ ) dy
2πσ −∞
2
σ2 w ∞ 2
= √ y × y e −y /2 dy
2π −∞
σ 2 w ∞ −y2 /2
= √ e dy
2π −∞
= σ2 .
d) By a completion of squares argument, we have

w∞
E[ e X ] = e x ϕ(x)dx
−∞
1 w∞ 2 2
= √ e x−(x−µ) /(2σ ) dx
2πσ −∞
2
e µ w ∞ y−y2 /(2σ2 )
= √ e dy
2πσ 2 −∞
eµ w ∞ 2 2 2 2
= √ e σ /2+(y−σ ) /(2σ ) dy
2πσ 2 −∞
e µ + σ 2 /2 w ∞ x2 /(2σ2 )
= √ e dy
2πσ 2 −∞
σ2
= eµ + .
2
Exercise S.4
a) We have
1 w∞ 2 2
E[X + ] = √ x+ e −x /(2/σ ) dx
2πσw2 −∞
σ ∞ 2
= √ x e −x /2 dx
2π 0
σ h −x2 /2 ix=∞
= √ −e
2π x=0
σ
= √ .
2π
b) We have
" 1157
N. Privault
1 w∞ 2 / (2σ 2 )
E[(X − K )+ ] = √ (x − K )+ e −x dx
2πσ 2 −∞
1 w∞ 2 / (2σ 2 )
= √ (x − K ) e −x dx
2πσ 2 K
1 w∞ 2 / (2σ 2 ) K w∞ 2 2
= √ x e −x e −x /(2σ ) dx
dx − √
2πσ 2 K 2πσ 2 K
σ h −x2 /(2σ2 ) i∞ K w −K/σ −x2 /2
= √ −e dx −√ e dx
2π x=K 2π −∞

σ 2 2 K
= √ e −K /(2σ ) − KΦ − .
2π σ
c) Similarly, we have
1 w∞ 2 / (2σ 2 )
E[(K − X )+ ] = √ (K − x)+ e −x dx
2πσ 2 −∞
1 wK 2 / (2σ 2 )
= √ (K − x) e −x dx
2πσ 2 −∞
K wK 2 / (2σ 2 ) 1 wK 2 / (2σ 2 )
= √ e −x dx − √ x e −x dx
2πσ 2 −∞ 2πσ 2 −∞
K w K/σ −x2 /2 σ h −x2 /(2σ2 ) ix=K
= √ e dx − √ −e dx
2π −∞ 2π −∞

σ −K 2 /(2σ )2 K
= √ e + KΦ .
2π σ
1158 "
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Index
σ-algebra, 773 discrete time, 60

Markov property, 176 opportunity, 24
price, 15, 41, 73, 84, 268
absence of arbitrage, 27, 587 triangular, 23
abstract Bayes formula, 544 arithmetic average, 449
accreting swap, 629 Asian
adapted process, 159 forward contract, 478
adjusted close price, 214, 715 Asian option, 449, 451
adjustment basket, 466
convexity, 334 call, 449
admissible portfolio strategy, 193 dividends, 480
affine model, 581 hedging, 480
affine PDE, 325, 581, 1092 asset pricing
American first theorem, 29
binary option continuous time, 195, 633
finite expiration, 534 discrete time, 72
perpetual, 533 second theorem, 35
forward contract, 536 continuous time, 198
option discrete time, 73
butterfly, 527 at the money, 61, 285
call, 503, 513 ATM, 61, 285
dividend, 528, 531 attainable, 34, 40, 83, 198
finite expiration, 518
perpetual, 503, 513 Bachelier model, 204, 244, 250, 287
put, 503 backward
amortizing swap, 629 induction, 93, 95
annuity stochastic differential equation, 292
measure, 664, 683, 685 Bank for International Settlements, 10
numéraire, 663, 681 Barone-Adesi & Whaley approximation,
annuity numéraire, 629 525, 528, 1048
approximation barrier
gamma, 603 level, 396
lognormal, 460 barrier forward contract, 420
arbitrage, 23 down-and-in
arbitrage-free long, 421, 1002
absence of, 27 down-and-out
continuous time, 193 long, 421, 1003
1171
N. Privault
up-and-in convertible, 609, 815

long, 421, 998 convexity, 614
up-and-out corporate, 609
long, 421, 1000 duration, 610, 614
barrier option, 63, 393, 396 immunization, 1096
down-and-in ladder, 664
call, 398, 410 option, 570, 657, 1079
put, 398, 412 pricing
down-and-out PDE, 591, 643
call, 398, 406, 419 yield, 600
put, 398, 408 zero-coupon, 586
in-out parity, 398 Borel-Cantelli Lemma, 187, 776
up-and-in boundary condition, 765
call, 398, 411 box spread option, 283
put, 398, 413 break-even
up-and-out rate, 628, 630
call, 398 strike price, 49
put, 398, 404 underlying asset price, 92, 234
basis point, 674 Brent, 11
basket option, 465 Bretton Woods, 540
BDT model, 613 bridge model, 647
bear spread option, 282, 925 Brownian
Bermudan swaption, 671 bridge, 182, 605
Bernoulli distribution, 786 extrema, 381
Bessel function, 579, 603 motion, 141
BGM model, 645, 660 geometric, 258
binary Lévy’s construction, 148, 185, 900
tree, 74, 130 series construction, 146, 149
binary option, 62, 124, 249, 288, 571, 836 BSDE, 292
American bull spread option, 282, 925
finite expiration, 534 business time, 236
perpetual, 533 butterfly option, 284, 930
barrier, 422 American, 527
binomial buy back guarantee, 8, 559
distribution, 786 buy limit, 488
model, 74
dividends, 122 calendar time, 236
transaction costs, 130 call
BIS, 10 level, 396
bisection method, 248, 341 option, 8
bizdays (R package), 236 price, 397, 404
Black spread collar option, 126
(1976) formula, 662 swaption, 668
caplet formula, 660 call-put parity, 121, 228, 273, 291, 353,
swaption formula, 669 557, 1009
Black-Derman-Toy model, 613 callable
Black-Scholes bear contract, 63, 396–398
calibration, 344 bull contract, 397, 404
formula, 241, 247, 271, 557, 646 Cantor function, 365
call options, 219, 661 cap pricing, 663
put options, 226, 227, 662 Capital Asset Pricing Model (CAPM),
PDE, 217, 240, 248, 416, 419, 764 294, 953
with jumps, 750 caplet pricing, 659
bond cash settlement, 9, 10, 61, 226
1172 "
cash-or-nothing option, 62, 571 conversion rate, 609

Category ’N’ CBBC, 397 convertible bond, 609, 815
Category ’R’ CBBC, 397, 420 convexity, 614
cattle futures, 218 convexity adjustment, 334
Cauchy corporate bond, 609
distribution, 783 correction
sequence, 884 convexity, 334
CBBC, 63, 396–398, 404 correlation
Category ’N’, 397 perfect, 642, 650
Category ’R’, 397, 420 problem, 641
rebate, 397, 420 cost of carry, 554
residual, 397, 420 costless collar option, 13
CBOE, 578 counterparty risk, 96
Volatility Index® , 354 counting process, 689, 691
CEV model, 580 coupon
change of measure, 264 bond, 587
change of numéraire, 542, 557 rate, 598
characteristic Courtadon model, 580, 608
function, 798 Cox process, 692
Chasles relation, 166 Cox-Ingersoll-Ross model, 183
Chi square distribution, 287, 578, 940 Cox-Ross-Rubinstein model, 74, 220
Chicago Board Options Exchange, 578 dividends, 122
chooser option, 290, 945 transaction costs, 130
CIR model, 183, 244, 287, 578, 608 credit exposure, 96
CKLS model, 607 critical price, 528
Clark-Ocone formula, 106, 440 CRR model, 74, 220
cliquet dividends, 122
option, 286 transaction costs, 130
closing portfolio value, 56 cumulant, 716
collar option, 11 cumulative distribution function, 782
call spread, 126 joint, 370, 784
costless, 13 cup & handle, 1
put spread, 125
complement rule, 775 date
complete market, 35, 40, 267 of payment, 245
complete space, 156, 164 of record, 245
completeness deflated price, 542
continuous time, 198 Delta, 96, 99, 216, 222–224, 229, 232,
discrete time, 72 247, 250, 278, 930
compound Poisson hedging, 276, 564, 565
martingale, 727 density
process, 697, 730, 744 function, 781
compounded yield to maturity, 614 marginal, 371, 785
compounding derivatives
linear, 627 fixed income, 653
conditional interest rate, 653
expectation, 65, 791, 800 market, 10
probability, 777 differential inequalities, 510
conditioning, 777 differential interest rate, 293
constant repayment, 52 diffusion
contingent claim, 33, 60, 72, 83 elasticicity, 580, 608
attainable, 34, 40, 198 digital option, 62, 124, 249, 288, 571, 836
continuous-time discounting, 59, 191
limit, 116 lemma, 202, 267, 744
" 1173
N. Privault
discrete distribution, 786 knock-out, 422

dispersion index, 604, 692 event, 773
distribution ex-dividend, 245, 480
Bernoulli, 786 excess kurtosis, 742
binomial, 786 exchange option, 531, 560
Cauchy, 783 exchange-traded fund, 294, 356
discrete, 786 exercise price, 7
exponential, 782 exotic option, 63, 89, 275, 393
gamma, 783 Asian, 449
Gaussian, 782 continuous time, 393, 423, 449
geometric, 786 discrete time, 104
Hartman-Watson, 457 lookback option, 423
invariant, 323, 331, 577, 580 expectation, 788
lognormal, 115, 208, 460, 603, 783, 922 conditional, 791, 800
marginal, 794 exponential
negative binomial, 787 Vasicek model, 580
Pascal, 787 exponential distribution, 695, 782
Poisson, 787 exponential Lévy model, 747
stable, 740 exponential Vasicek model, 182, 873
stationary, 323, 331, 577, 580 extrinsic value, 91, 233
uniform, 782
dividend, 122, 133, 244, 285, 480, 528, face value, 586, 614
531 Fano factor, 604
date of payment, 245 Fatou’s lemma, 257, 492, 776
date of record, 245 FED, 626
ex-date, 245 Feller condition, 579
payable date, 245 filtration, 66, 143, 483
dollar value, 614 finite differences
dominated convergence theorem, 506, 515 explicit scheme, 762, 765
Doob-Meyer decomposition, 502 implicit scheme, 763, 766
Dothan model, 580, 600 first theorem of asset pricing, 29, 72, 195,
drawdown option, 447 633
drawdown process, 423 fixed
drift estimation, 337 income, 575
drifted Brownian motion, 261 derivatives, 653
Dupire PDE, 350 leg, 628
duration, 610, 614 rate, 659
floating
early exercise premium, 511 leg, 628
ECB, 625 rate, 659
effective gearing, 99, 234 strike, 64
efficient market hypothesis, 1, 71, 929 floorlet, 662, 675
elasticicity of diffusion, 580, 608 fOptions (R package), 525, 992, 1048
elasticity, 234 foreign exchange, 552
entitlement ratio, 9, 224, 230, 346, 347 option, 555
equivalent probability measure, 29, 37, 72, foreign exchange option, 211
195, 266 formula
Esscher transform, 759 Lévy-Khintchine, 703
ETF, 294, 356 smoothing, 704
Euclidean path integral, 605 Tanaka, 184, 212, 880, 899
Euler discretization, 768 Taylor, 918
EURIBOR, 626 forward
European option contract, 127, 218, 248, 270, 568, 617,
knock-in, 422 911, 1074
1174 "
American, 536, 1065 Gamma, 223, 232

Asian, 478 Rho, 232
non-deliverable, 219 Rhod, 251
measure, 610, 654 Theta, 232, 290, 945
price, 542 Vega, 232, 251, 422, 1006
rate, 617 gross market value, 10
agreement, 617 gross world product, 6, 10
spot, 617–619, 659 guarantee
swap, 628 buy back, 8, 559
start option, 285 price lock, 10
swap rate, 628 GWP, 6
forward measure, 542
forward swap Hartman-Watson distribution, 457
measure, 664, 683, 685 Hawaiian option, 450
four-way collar option, 11 heat
Fourier equation, 236, 761
synthesis, 149 map, 373
transform, 325 hedge and forget, 218, 841, 1075, 1150
inversion, 325 hedge ratio, 100, 234
FRA, 617 hedging, 35, 94, 96, 104, 274
Fubini theorem, 706 change of numéraire, 562
fugazi (the), 340 mean-variance, 753
future contract, 218, 841 quantile, 296
FX option, 211 static, 218, 841, 1075, 1150
strategy, 275
gains process, 88 with jumps, 753
Galton board, 113 Heston model, 308, 334
Gamma hexanomial model, 862
Greek, 223, 232 HIBOR, 626
gamma historical
approximation, 603 probability measure, 262
distribution, 783 volatility, 309, 337
function, 783 hitting
process, 713 time, 488
gap, 735 HJM
Garman-Kohlagen formula, 555 condition, 633
Gaussian model, 631
cumulative distribution function, 118, Ho-Lee model, 581
658 Hull-White model, 581, 632
distribution, 220, 782
random variable, 799 immunization, 1096
gearing, 92, 234 implied
effective, 99, 234 probability, 17
Geman-Yor method, 459 volatility, 340
generating function, 183, 798 in the money, 61, 346, 829
geometric in-out parity, 398, 1009
average, 451, 478 independence, 777, 779, 781, 785, 787,
Brownian motion, 204, 258 792, 799, 803
distribution, 786 independent increments, 256, 724
Girsanov Theorem, 264, 293, 548 indicator function, 779
jump processes, 721, 744 infimum, 787
Greeks, 232 infinitesimal, 167
Delta, 216, 222–224, 229, 232, 247, information flow, 67
250, 278, 930 instantaneous forward rate, 620
" 1175
N. Privault
interest rate of total probability, 775, 778, 794

derivatives, 653 least square Monte Carlo, 524
differential, 293 least square regression, 582
model leg
affine, 581 fixed, 628
Constant Elasticity of Variance, 580 floating, 628
Courtadon, 580, 608 Leibniz integral rule, 633
Cox-Ingersoll-Ross, 244, 287, 578 lemma
Dothan, 580, 600 Neyman-Pearson, 297
exponential Vasicek, 182, 580, 873 leverage, 210, 252, 295, 919, 953
Ho-Lee, 581 liability, 14
Hull-White, 581, 632 LIBOR
Marsh-Rosenfeld, 580, 608 model, 626
Vasicek, 576, 581 rate, 626
intrinsic value, 43, 91, 233 swap rate, 628, 666, 669
invariant distribution, 323, 331, 577, 580 Lipschitz function, 560
inverse Gaussian process, 714 local
IPython notebook, 15, 74, 90, 93, 96, 101, time, 184
103, 132, 138, 148, 149, 220, 248, volatility, 347, 764
341, 527, 638, 861 log
Itô contract, 249, 286, 336
formula, 169, 288 option, 298
pathwise, 708 return, 338
with jumps, 709 dynamics, 205, 335, 747
isometry, 151, 155, 162, 705 variance, 115, 208, 306
process, 169, 171, 215, 914 log variance, 208
stochastic integral, 151, 160, 162, 255 lognormal
table, 172, 427 approximation, 460
with jumps, 710 distribution, 115, 208, 603, 783, 922
ITM, 61, 346, 829 long box spread option, 283, 928
long forward contract, 757, 758
Jamshidian’s trick, 675 lookback option
Jensen’s inequality, 127, 257, 452, 486, call, 432
840, 924, 1030 put, 423, 426
joint LSM, 524
cumulative distribution function, 370,
784 Macaulay duration, 614
probability density function, 784 Mandatory Call Event, 420
jump-diffusion process, 735 marginal
density, 371, 785
knock-in option, 422 distribution, 794
knock-out option, 63, 398, 422 Margrabe formula, 560
Kullback-Leibler entropy, 746 mark to market, 42, 73, 84, 219, 268, 842
kurtosis, 739, 742 market
completeness, 35, 40, 72
Lévy efficiency, 929
construction of Brownian motion, 148, making, 42
185, 900 price of risk, 260, 266, 329, 591
process, 712 volatility, 329
Lévy-Khintchine formula, 703 market terms and data, 91, 231
Lagrangian, 604 Markov property, 560, 564
Laplace transform, 459, 501 Marsh-Rosenfeld model, 580, 608
law martingale, 65, 144, 255, 484
of total expectation, 794 compound Poisson, 727
1176 "
continuous time, 194 moving average, 450

discrete time, 68 MPoR, 260, 266, 329, 591
measure Musiela notation, 632
continuous time, 193, 744
discrete time, 71 natural logarithm, 220
method, 266 negative
Poisson, 723, 724 binomial distribution, 787
submartingale, 484 inverse Gaussian process, 714
supermartingale, 484 premium, 29
transform, 69, 88, 256, 489 risk premium, 194
maturity, 7 Nelson-Siegel, 637, 640
transformation, 618 Newton-Raphson method, 341
maximum of Brownian motion, 363 Neyman-Pearson Lemma, 297
MCE, 420 nominal value, 614
mean non-deliverable forward contract, 219
hitting time, 499 noncentral Chi square, 287, 578, 940
reversion, 575 nonlocal operator, 753
mean-square distance, 802 notional, 629
measurability, 158 principal, 674, 1115, 1116
Merton model, 748 notional amount, 10
method numéraire, 194, 539
bisection, 341 annuity, 629, 663
Newton-Raphson, 341 invariance, 562
Milshtein discretization, 769 numéraire invariance, 564
Minkowski inequality, 156
model OLS, 582
affine, 581 opening jump, 735
Bachelier, 204, 244, 250, 287 opening portfolio price, 56
Barone-Adesi & Whaley, 528 optimal stopping, 518
BDT, 613 option
binomial, 74 Asian, 449
dividends, 122 basket, 466
transaction costs, 130 call, 449
CEV, 580 at the money, 285
CIR, 578, 608 barrier, 63, 393
CKLS, 607 basket, 465
Courtadon, 580, 608 bear spread, 282, 925
Dothan, 580, 600 binary, 62, 124, 571, 836
exponential Lévy, 747 box spread, 283
exponential Vasicek, 580 bull spread, 282, 925
hexanomial, 862 butterfly, 284, 930
Ho-Lee, 581 cash-or-nothing, 62, 571
Hull-White, 581, 632 chooser, 290, 945
Marsh-Rosenfeld, 580, 608 cliquet, 286
Merton, 748 digital, 62, 124, 571, 836
pentanomial, 862 drawdown, 447
trinomial, 79, 118, 136 effective gearing, 99, 234
Vasicek, 576, 581 exotic, 63, 89, 104, 275, 393, 423, 449
modified extrinsic value, 91, 233
Bessel function, 579, 603 foreign exchange, 211
duration, 614 forward start, 285
moment gearing, 92, 234
generating function, 798, 1144 Hawaiian, 450
moneyness, 62 intrinsic value, 91, 233
" 1177
N. Privault
issuer, 15, 34 physical delivery, 8, 10, 61, 226

knock-out, 63, 398 PIDE, 751
long box spread, 283, 928 Planck constant, 604
lookback, 423 Poisson
on average, 62, 281, 449, 479 compound martingale, 697, 744
on extrema, 394 distribution, 787
out of the money, 289 process, 689
path-dependent, 104, 275 compound, 730
power, 127, 204, 246, 286, 287, 842 portfolio, 22
premium, 34, 92, 235 process, 88
straddle, 949 replicating, 96, 101
tunnel, 119, 120 strategy, 34, 54, 83, 196, 199
vanilla, 217 admissible, 193, 198
variance call, 313 update, 196, 199
variance swap, 310 value, 58, 84
volatility swap, 318, 361, 976 power option, 127, 204, 246, 286, 287,
writer, 15, 34 569, 842
zero-collar, 13 predictable process, 69, 87, 704
optional premium
sampling, 489 early exercise, 511
stopping, 489 negative, 29
order book, 902 option, 92, 235
Ornstein-Uhlenbeck process, 576 risk, 29, 194, 260
OTM, 61, 289 price
out of the money, 61, 289 critical, 528
graph, 7, 9, 12, 125, 126, 837, 839
Paley-Wiener series, 149 price lock guarantee, 10
par value, 586, 614 pricing, 83, 89
parity with jumps, 745
call-put, 121, 228, 273, 291, 353, 557, principal amount, 674
1009 probability
in-out, 398, 1009 conditional, 777
Partial integro-differential equation, 751 density function, 781
partition, 778, 800 joint, 784
Pascal distribution, 787 distribution, 781
path measure, 775
freezing, 676 equivalent, 29, 37, 72, 195, 266
integral, 91, 394, 546, 604 sample space, 771
Euclidean, 605 space, 776
path-dependent option, 104, 275 process
pathwise Itô formula, 708 counting, 689
payable date, 245 Cox, 692
payer drawdown, 423
swap, 628 gamma, 712
swaption, 665 inverse Gaussian, 712
payoff function, 7, 9, 393 Lévy, 712
PDE predictable, 69, 87, 704
affine, 325, 581, 1092 stable, 712
Black-Scholes, 217, 240 stopped, 489
Heston, 323 variance gamma, 712
integro-differential, 751 pushforward measure, 727
variational, 522 put
pentanomial model, 862 option, 6
perfect correlation, 642, 650 spread collar option, 125
1178 "
swaption, 670 risk

Python code, 15, 74, 90, 93, 96, 101, 103, counterparty, 96
132, 138, 148, 149, 220, 248, 341, market price, 260, 266, 329, 591
527, 638, 861 premium, 29, 194
Python package risk premium, 260
yfinance, 344 risk-neutral measure, 16, 28, 744
continuous time, 193, 260
quantile hedging, 296 discrete time, 71
Quantlib, 671 riskless asset, 118, 201
quantmod, 214, 338, 399, 496, 585, 624, Robinhood incident, 929
714, 735 RQuantLib, 672
running maximum, 363, 364
R code, 11, 147, 148, 150, 153, 159,
177–179, 201, 205, 208, 214, 220, SABR model, 334
223, 228, 229, 235, 244, 245, 247, second theorem of asset pricing, 35, 73,
248, 264, 322, 341, 342, 348, 353, 198
357–359, 397, 399, 404, 406, 408, self-financing portfolio
496, 577, 579, 597, 624, 672, 693, change of numéraire, 564
696, 699, 703, 713, 714, 724, 789, continuous time, 196–198, 200, 753
792, 978, 993, 1048 discrete time, 56, 84
R package sell stop, 488
bizdays, 236 seller swap, 628
fOptions, 525, 992, 1048 share right, 28
quantmod, 214, 338, 399, 496, 585, Sharpe ratio, 266
624, 714, 735 SHIBOR, 626
RQuantLib, 672 short selling, 39, 100, 225
Sim.DiffProc, 214 ratio, 23
YieldCurve, 624 SIBOR, 626
Radon-Nikodym, 262 Sim.DiffProc, 214
Radon-Nikodym density, 542 singular measure, 428
random skewness, 739, 742
product, 796 slow-fast system, 330
sum, 796 smile, 342
variable, 779 smooth pasting, 507
rate smoothing formula, 704
forward, 617 spline function, 353
forward swap, 628 spot forward rate, 617–619, 659
instantaneous forward, 620 square-integrable
LIBOR, 626, 629 functions, 152
swap, 628 random variables, 154
LIBOR swap, 666, 669 St. Petersburg paradox, 790
swap, 628 stability warrant, 422
realized variance, 309, 338 stable
swap, 310 distribution, 740
receiver swaption, 670 process, 714
reflection principle, 393 static hedging, 218, 841, 1075, 1150
relative entropy, 746 stationary distribution, 323, 331, 577, 580
renewal processes, 697 stochastic
replicating portfolio, 96, 101 calculus, 166
replication, 35 differential equations, 176
return integral, 86, 149, 158
log, 338 with jumps, 703
Rho, 232, 251 integral decomposition, 106, 180, 274,
Riccati equation, 596, 1098 276
" 1179
N. Privault
process, 54 ternary, 79, 118, 136

stop-loss/start-gain strategy, 211 trend estimation, 337
stopped process, 489 triangle inequality, 156
stopping time, 487 triangular arbitrage, 23
theorem, 489 trinomial model, 79, 118, 136
straddle option, 949 tunnel option, 119, 120
Stratonovich integral, 889 turbo warrant, 63, 396–398, 404
strike price, 7, 33 two-factor model, 643
floating, 64
string model, 650 uniform distribution, 782
strong Markov property, 695
submartingale, 484 valuation period, 420
super-hedging, 35, 73 vanilla option, 61, 89, 217
supermartingale, 484 variable rate, 659
Svensson parametrization, 637 variance, 795
swap, 628 call option, 313
amortizing, 629 gamma process, 713
forward measure, 664, 683, 685 realized, 309, 338
payer, 628 swap, 310
rate, 628, 629 variational PDE, 510, 522
seller, 628 Vasicek model, 576, 581
variance, 310 Vega, 232, 251, 422, 1006
swaption, 665 notional, 310
Bermudan , 671 VIX® , 354
volatility
Tanaka formula, 184, 212, 880, 899 historical, 309, 337
Taylor’s formula, 167, 918 implied, 340
telescoping sum, 630 level, 310
tenor structure, 541, 628, 653 local, 347, 764
terms and data, 91, 231 smile, 342
ternary tree, 79, 118, 136 surface, 344
theorem swap, 318, 361, 976
asset pricing, 29, 35, 72, 73, 195, 198, variance swap, 310
633
dominated convergence, 506, 515 warrant, 9, 224
Fubini, 706
stability, 422
Girsanov, 264, 293, 548, 721, 744
terms and data, 235
stopping time, 489
turbo, 63, 396–398, 404
Theta, 232, 290, 945
West Texas Intermediate (WTI), 5, 11
TIBOR, 626
Wiener space, 3
time
business, 236
yfinance (Python package), 344
splitting, 211, 288, 898
yield, 617, 619, 659
tower property, 68, 70, 87, 93, 163, 256,
bond, 600
257, 277, 279, 544, 590, 794, 798,
compounded to maturity, 614
803, 821, 861, 1104
curve, 618
transaction cost, 130
data, 624
transform
inversion, 626
Esscher, 759
YieldCurve (R package), 624
Fourier, 325
Laplace, 459, 501
zero measure, 365
martingale, 69, 88, 489
zero-
treasury note, 578
collar option, 13
tree
coupon bond, 586
binary, 74, 130
1180 "
Author index
Achdou, Y. 353 Dana, R.A. 432

Albanese, C. 308, 579 Dash, J. 546
Albrecher, H. 325 Dassios, A. 446
Allegretto, J. 525 Deelstra, G. 466
Applebaum, D. 712 Demeterfi, K. 336
Aristotle 6 Denson, N. 569
Attari, M. 325 Derman, E. 336, 350, 613
Devore, J.L. 771
Bachelier, L. 2, 149 Di Nunno, G. 104, 274, 756
Barone-Adesi, G. 525, 528 Diallo, I. 466
Barrieu, P. 457 Doob, J.L. 484, 489, 502
Benth, F.E. 466 Dothan, L.U. 580, 601
Bermin, H. 440 Downes, A. 569
Billingsley, R.S. 929 Dudley, R.M. 156
Björk, T. 44, 640 Dufresne, D. 456, 459
Black, F. 3, 198, 213, 613, 660, 662, 669 Dupire, B. 350
Bosq, D. 691 Dvoretzky, A. 364
Boulding, K.E. 201, 540
Boyle, P.P. 852 Einstein, A. 2
Brace, A. 5, 645 El Karoui, N. 542, 563
Breeden, D.T. 349 El Khatib, Y. 440, 443
Brémaud, P. 704 Elliott, R.J. 511, 522, 525
Brigo, D. 319, 593, 644, 1093 Erdos, P. 364
Broadie, M. 334 Eriksson, J. 63, 397
Brody, D.C. 606 Ewald, C.-O. 480
Brown, C. 479
Brown, R. 2, 144 Faff, R. 1087
Burdzy, K. 364 Feller, W. 308, 579, 940
Folland, G.B. 145
Carr, P. 312, 335, 459 Föllmer, H. 104, 296
Chan, C.M. 63, 397 Fouque, J.-P. 308, 329
Chan, K.C. 607 Friz, P. 316, 355
Chance, D.M. 929
Charlier, C.V.L. 742 Galton, F. 114
Charpentier, A. 624 Gao, M. 333
Çınlar, E. 781 Garman, M.B. 555
Cont, R. 712, 720, 726, 735, 756 Gatarek, D. 5, 645
Courtadon, G. 580, 608 Gatheral, J. 316, 329, 334, 355, 357
Cox, J.C. 74, 244, 287, 578 Geman, H. 455, 459, 542, 563, 1026
Cramér, H. 742 Gerber, H.U. 531, 759
Crépey, S. 450 Glasserman, P. 768
Curran, M. 464 Gradshteyn, I.S. 318, 976
Gram, J.P. 742
Da Fonseca, J. 333 Gray, P. 1087
Dahl, L. O. 466 Guirreri, S. 624
" 1181
N. Privault
Hagan, P.S. 309, 360, 973 Leung, T. 252

Han, J. 333 Levy, E. 460
Handley, J.C. 479 Li, Y. 333
Harrison, J.M. 72, 73, 195, 198 Liinev, J. 466
Heath, D. 5, 633 Lim, J.W. 446
Henry-Labordère, P. 361 Lindström, E. 1089
Heston, S.L. 308, 325 Ling, C.-T. 479
Hiriart-Urruty, J.-B. 32 Lipton, A. 211
Hirsch, F. 154 Litzenberger, R.h. 349
Ho, S.Y. 581 Longstaff, F.A. 524, 526, 607
Hughston, L.P. 606 Lyuu, Y.-D. 395
Hull, J. 581
Mamon, R.S. 1104
Ikeda, N. 161, 257 Margrabe, W. 560
Ingersoll, J.E. 244, 287, 578 Marsh, T.A. 580, 608
Itô, K. 3 Martini, C. 333
Matsumoto, H. 456
Jacka, S.D. 523 Mayer, P. A. 325
Jacod, J. 771 Meier, D.M. 606
Jaillet, P. 522 Mel~nikov, A.V. 296, 852
Jain, A. 334 Menkens, O. 480
Jamshidian, F. 563, 657, 675 Mercurio, F. 319, 593, 644, 1093
Jarrow, R. 5, 633 Merton, R.C. 4, 562
Jeanblanc, M. 432, 757 Meyer, P.A. 502
Joshi, M.S. 569 Mikosch, T. 889
Milevsky, M.A. 466
Kakushadze, Z. 605 Milne, J.S. 1156
Kakutani, S. 364 Mörters, P. 365
Kallenberg, O. 804 Morton, A. 5, 633
Kamal, M. 336 Musiela, M. 5, 632, 645
Kani, I. 350
Karolyi, G.A. 607 Nechaev, M.L. 296
Kemna, A.G.Z. 452 Nelson, C.R. 637
Kim, Y.-J. 659 Neuberger, A. 336
Klebaner, F. 295, 954 Nguyen, H.T. 691
Klebaner, F.C 1039 Nikodym, O.M. 262
Kloeden, P.E. 177 Norris, J.R. 695
Kohlhagen, S.W. 555 Novikov, A. 264
Kopp, P.E. 511, 522
Korn, E. 768 Øksendal, B. 104, 274, 712, 756
Korn, R. 768
Kreps, D.M. 72, 73 Paley, R. 149
Kroisandt, G. 768 Palmer, K.J. 479
Kumar, D. 309, 360, 973 Papanicolaou, A. 308, 355
Papanicolaou, G. 308, 329
Lacombe, G. 154 Peng, S. 292
Lamberton, D. 104, 469, 522 Peres, Y. 365
Lapeyre, B. 469, 522 Persson, J. 63, 397
Lawi, S. 308, 579 Petrachenko, Y.G. 852
Lee, R. 312, 335 Pintoux, C. 601, 602
Lee, S.B. 581 Pironneau, O. 353
Lemaréchal, C. 32 Pitman, J. 771
Lesniewski, A.S. 309, 360, 973 Platen, E. 177
Leukert, P. 296 Pliska, S.R. 195, 198
1182 "
Poisson, S.D. 689 Stroock, D.W. 802

Prayoga, A. 311, 604 Sulem, A. 712
Profeta, C. 376 Svensson, L.E.O. 637
Proske, F. 104, 274, 756
Protter, P. 169, 176, 264, 276, 277, 548, Tanaka, K. 742
560, 564, 591, 592, 771 Tankov, P. 712, 720, 726, 735, 756
Teng, T.-R. 563, 662, 670
Radon, J. 262 Thales 6
Rebonato, R. 309 Thiele, T.N. 741
Revuz, D. 145 Tistaert, J. 325
Rochet, J.-C. 542, 563 Toy, B. 613
Rogers, C. 471 Turnbull, S.M. 460
Rosenfeld, E.R. 580, 608
Ross, S.A. 74, 244, 287, 578 Üstünel, A.S. 522
Rouah, F.D. 325 Uy, W.I. 602
Rouault, A. 457
Roynette, B. 376 Vanmaele, M. 466
Rubinstein, M. 74 Vašíček, O. 5, 576, 594
Rudin, W. 153, 154 Večeř, J. 475
Ruiz de Chávez, J. 104 Volkov, S.N. 296
Ryzhik, I.M. 318, 976 Vorst, A.C.F. 452
Vorst, T. 852
Samuelson, P.A. 3
Sanders, A.B. 607 Wakeman, L. 460
Santa-Clara, P. 650 Watanabe, S. 161, 257
Sato, K. 727 Watanabe, T. 742
Schied, A. 30, 35, 72, 73, 104, 116 Wei, X. 671
Schoenmakers, J. 671 Whaley, R.E. 525, 528
Scholes, M. 3, 4, 198, 213 White, A. 581
Schoutens, W. 325 Widder, D.V. 237
Schröder, M. 459 Wiener, N. 2, 149
Schwartz, E.S. 524, 526 Williams, D. 104
Scorsese, M. 340 Wilmott, P. 531
Sharpe, W.F. 74 Wong, H.Y. 63, 397
She, Q.H. 333 Woodward, D.E. 309, 360, 973
Shi, Z. 471 Wu, X. 615
Shiryaev, A.N. 195, 198
Shiu, E.S.W. 531, 759 Yamada, T. 742
Shreve, S. 376, 386, 403, 475, 508, 528, Yang, Z. 480
572, 995 Yor, M. 145, 308, 376, 455–457, 459, 602,
Siegel, A.F. 637 1026
Sircar, K.R. 252, 308, 329, 355 Yu, J.D. 463, 603
Sølna, K. 308, 329
Sornette, D. 650 Zhang, Q. 333
Steele, J.M. 519 Zou, J. 336
" 1183
This text is an introduction to the pricing and hedging of financial deriva-

tives, including vanilla and exotic options, by stochastic calculus and partial
differential equation methods. The presentation is done both in discrete and
continuous-time financial models, with an emphasis on the complementarity
between algebraic and probabilistic methods. In particular it covers the pric-
ing of some interest rate derivatives, of American options, of exotic options
such as barrier, lookback and Asian options, and stochastic models with com-
pound Poisson jumps. The text is accompanied with a number of figures and
simulations, and includes numerous examples based on actual market data.
The concepts presented are also illustrated by 241 exercises and 15 problems
with complete solutions.
1184 "

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Stochastic Finance

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Nicolas Privault

This version: July 4, 2021

This text is an introduction to pricing and hedging in discrete and

1 Assets, Portfolios, and Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . 21

2 Discrete-Time Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

3 Pricing and Hedging in Discrete Time . . . . . . . . . . . . . . . . . . . . 83

4 Brownian Motion and Stochastic Calculus . . . . . . . . . . . . . . . . 141

5 Continuous-Time Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . 191

6 Black-Scholes Pricing and Hedging . . . . . . . . . . . . . . . . . . . . . . . 213

7 Martingale Approach to Pricing and Hedging . . . . . . . . . . . . . 255

8 Stochastic Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

9 Volatility Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

10 Maximum of Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 363

11 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393

12 Lookback Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423

13 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449

14 Optimal Stopping Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483

15 American Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503

16 Change of Numéraire and Forward Measures . . . . . . . . . . . . . 539

17 Short Rates and Bond Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575

18 Forward Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617

19 Pricing of Interest Rate Derivatives . . . . . . . . . . . . . . . . . . . . . . 653

20 Stochastic Calculus for Jump Processes . . . . . . . . . . . . . . . . . . . 689

21 Pricing and Hedging in Jump Models . . . . . . . . . . . . . . . . . . . . . 735

21.6 Mean-Variance Hedging with Jumps . . . . . . . . . . . . . . . . . . . . . . 753

22 Basic Numerical Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 761

Appendix: Background on Probability Theory . . . . . . . . . . . . . . . . 771

Exercise Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 809

Author index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1181

1 Two sample paths of one-dimensional Brownian motion . . . . . . . . . . . . 2

1.1 Triangular arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

2.1 Illustration of the self-financing condition (2.7) . . . . . . . . . . . . . . . . . . . 57

3.1 Discrete-time call option pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

3.2 Discrete-time call option hedging strategy (risky component) . . . . . . . . 98

4.1 Sample paths of a one-dimensional Brownian motion . . . . . . . . . . . . . . . 142

5.2 Why apply discounting? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

6.1 Underlying market prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214

7.1 Drifted Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

8.1 Euro / SGD exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306

9.1 Underlying asset price vs log-returns . . . . . . . . . . . . . . . . . . . . . . . . . . . 339

11.1 Up-and-out barrier call option price with B > K ∗ . . . . . . . . . . . . . . . . . 400

12.1 Lookback put option price (3D)∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425

12.3 Graph of lookback put option prices (2D) . . . . . . . . . . . . . . . . . . . . . . . 426

13.1 Brownian motion and its moving average∗ . . . . . . . . . . . . . . . . . . . . . . . 450

14.1 Drifted Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485

15.1 American put prices by exercising at τL for different values of L . . . . . . 507

16.1 Why change of numéraire? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541

16.2 Overseas investment opportunity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553

17.1 Short rate t 7→ rt in the Vasicek model . . . . . . . . . . . . . . . . . . . . . . . . . 577

18.1 Forward rate S 7→ f (t, t, S ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 618

19.1 Implied swaption volatilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671

20.1 Sample path of a Poisson process (Nt )t∈R+ . . . . . . . . . . . . . . . . . . . . . . 690

20.5 Probability density function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 698

21.1 Market returns vs normalized Gaussian returns . . . . . . . . . . . . . . . . . . . 736

22.1 Divergence of the explicit finite difference method . . . . . . . . . . . . . . . . . 766

23.1 Probability computed as a volume integral . . . . . . . . . . . . . . . . . . . . . . 784

S.1 Strike price as a function of risk-free rate . . . . . . . . . . . . . . . . . . . . . . . 816

S.19 Bitcoin XBT/USD order book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 903

S.64 Lookback put option price (2D) as a function of M0t . . . . . . . . . . . . . . . 1023