STRATHMORE UNIVERSITY

SCHOOL OF FINANCE AND APPLED ECONOMICS

Bachelor of Business Science- Actuarial Science, Finance & Financial Economics

BSA 3109/BSF 3224/BSA 3144: STOCHASTIC MODELS FOR ACTUARIAL AND

FINANCE APPLICATIONS & STOCHASTIC ANALYSIS FOR FINANCIAL
APPLICATIONS

Probability measures and Martingale approach- risk-neutral valuation of

derivatives

Syllabus objectives
a. Demonstrate a knowledge and understanding of the mathematics underpinning the pricing of
derivative instruments, including:
 Statement of the Cameron-Martin-Girsanov theorem
 Change of measure
 Statement of the martingale representation theorem
 Self-financing portfolios
 Construction of replicating strategies using the martingale approach
b. Demonstrate an understanding of the role of the market price of risk in the transfer between the
real-world and the risk-neutral probability measures.

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 Introduction
When doing real-world valuation of derivatives there is a problem in knowing exactly the discount
rate that should be applied to the payoff of the derivative. The expected return from the underlying
may be known but not for the derivative. A position in a derivative is, of course, riskier than a
position in the underlying. As a result the discount rate to be applied to the derivative is higher than
the expected return from the underlying, but we do not know how much higher it should be. This is
why we use the risk-neutral valuation, where we assume that all the investors are risk neutral and all
assets have an expected return equal to the risk-free rate.

We can then convert between the risk neutral and real world. To do this conversion, we use Cameron-
Martin-Girsanov theorem (Girsanov theorem) and the market price of risk.

In this chapter we apply the martingales we have studied so far to derivative pricing. We come up
with a formula for derivative pricing using the martingale approach. This formula is for the value of a
portfolio comprising cash account and an underlying asset. We proceed to prove that this portfolio is
self-financing, previsible and replicates the payoff of any derivative and as such can be used to find
the theoretical values of any derivative.

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Key Concepts
Probability measures
This is a set of probabilities associated with the paths of a random variable. There are two probability
measures, the real-world probability measure P and risk-neutral probability measure. The real-
world probability measure assigns actually probability to an upward to the downward
movement of a share. On the other hand risk-neutral probability measure assigns artificially
probability to the upward and to the downward movement of a share.
Risk-neutral probability measure Q

A risk-neutral probability measure Q for an asset is a set of artificial probabilities under which the
discounted value of the asset is a martingale. It is artificial set of probabilities.
Examples:
1. Discounted value of an underlying asset,
[ | ]

[ | ]
2. Discounted value of a cash account ,

[ | ]

[ | ]

Risk-neutral derivative pricing formula/Martingale Approach

[ | ]
This formula suggests that if we want to get the value of any derivative using the risk-neutral
(martingale approach), we do this in three steps:

1. Get the payoff at maturity, at time T.

2. Get the expected payoff, using the risk-neutral probabilities, Q-measure.
3. Discount this to time t using the risk-free rate

Martingale Approach for common derivatives

all option [ | ]
Put Option [ | ]
Forward contract [ | ]
Any derivative(general) [ | ]
K is the exercise price and is the price of the share at maturity

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Value of a forward contract under the risk-neutral (martingale approach)

[ | ]

[ | ] [ | ] ]
[ | ]

[ ( ) ]

[ | ]

[ | ] ] [ ]

Proof that the Risk-neutral formula valuation formula holds

We need to prove that we can form a martingale portfolio (comprising the underlying asset cash).
We then prove further that this portfolio is previsible, self-financing and that it replicates the
derivative payoff at maturity.

Formation of the portfolio

Consider a portfolio, comprising units of the underlying asset and units of cash. Its
value is:

Proof that the portfolio is a martingale

The discounted value of this portfolio is a martingale because it is a linear combination
of two martingales (discounted value of the underlying and discounted cash account) is also a
martingale.

[ | ]

Proof that the portfolio replicates the derivative payoff

For this formula to hold, our final value the portfolio at time T must be equal to the derivative payoff,
i.e. . This means that our portfolio replicates the derivative payoff.

This gives the formula:

[ | ]

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We also need the portfolio to be previsible and self-financing.

A previsible process
A stochastic process is said to be previsible one that is measurable. This means that can be
precisely determined based on the history that we have up to time t-1.

This is necessary because at the start of each time interval we can always determine the correct
adjustment to make without the benefit of hindsight.

Martingale Representation theorem

If and are martingales under the same probability measure, then there exists a previsible process
such that

For instance both the discounted asset value and the discounted portfolio value are both
martingales under probability measure Q. This means, according to the martingale representation
theorem, that

Proof for the previsibilty condition

, and are all previsible processes. This means that must also be

previsible. The portfolio is hence a previsible portfolio.

Self-financing portfolio
The change of the portfolio value

Pure investment gain results purely from changes in asset prices while gain from balancing arises
from rebalancing the number of units.

A portfolio strategy is said to be self-financing if the change in the portfolio value over time
interval always satisfies the equation:
This means that at time there is no inflow or outflow of money necessary to make the value of
the portfolio back up to

Proof for the self-financing condition

The task here is to prove that the change in portfolio value over the interval arises purely
from the pure investment, i.e. we need to show that

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But

But from the martingale representation theorem

Hence the proof that our portfolio is self-financing

Proof for that the strategy replicates the final derivative payoff
The value of our portfolio at time t=T is:
[ | ]
The final value of the portfolio always matches the derivative payoff i.e. it is a replicating strategy

Conclusion
Since we have proved that our portfolio is previsible, self-financing and that it replicates the
derivative payoff, if the market is arbitrage-free, the portfolio must have the same value same as the
derivative, i.e. [ | ]. The martingale approach for derivative pricing is hence valid.

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Equivalent probability measures
Two measures P and Q which apply to the same sigma-algebra F are said to be equivalent if
for any event E in F:
If and only if

Alternatively:
Any event E that is possible (impossible) under probability measure P is also possible
(impossible) under probability measure Q.

Girsanov theorem
Suppose that is a standard Brownian motion under P. Furthermore suppose that is a
previsible process. Then there exists a measure Q equivalent to P and where:

̃ ∫

Where ̃ is a standard Brownian motion under

For our case . This is the market price of risk (Sharpe ratio).

Applications in Finance

Girsanov’s theorem enables us to remove the drift from a process that is a Brownian motion with a
drift by changing to different probability measure. The process will therefore be a martingale under
the new measure.

We can also apply the Girsanov result to interest rate models to convert between real-world and risk-
neutral world probability measures.

Summary of the Girsanov’s Result

Framework Probability Standard Brownian Relationship

measure Brownian increment
motion
Real-World P ̃
Risk-neutral Q ̃ ̃
̃

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 Practice Questions
1. Define the term risk-neutral valuation
2. Distinguish between a filtration and a previsible process
3. Distinguish between the real-world probability measure P and the risk-neutral measure Q
4. When are the probability measure P and Q said to be equivalent?
5. State the Cameron-Martin-Girsirnov’s(Girsirnov’s) Theorem
6. The standard Brownian motion under real-world probability measure P is denoted by
while under the risk-neutral probability Q is denoted by ̃ . The SDE of the share price
under P is also .Given further the risk-premium . Show

that:
i. The SDE of the share price under Q is given by ̃
( ) ̃
ii. The solution of the share price is given by
7. State the Martingale Representation theorem
8. Show ,using the risk neutral valuation, that the value of a forward contract is given by

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 Exam-style Question (20 marks)
a)
i. Explain the term “probability measure”. [2]
ii. Explain what is meant by saying that two probability measures P and Q are
equivalent [2]
iii. State the Cameron-Martin-Girsanov theorem and give its role in the valuation of
derivatives [3]
iv. State Martingale representation theorem and explain its role in valuation of
derivatives
b) Let be a P Brownian motion where satisfying the following stochastic differential
equation:

Show that:
̌ ∫
Where is the process that satisfies the stochastic differential equation under
the Q Brownian motion ̌ . [6]

* +
c) Asset price is given by the solution , where is the standard
Brownian motion under probability measure P. Show that the discounted asset price
is a martingale under the probability measure Q. [5]

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 Suggested solution for the Exam style Question
i. It is a function that assigns a real number in the interval [0, 1] to each of the
possible payoffs of a derivative.

ii. Two measures P and Q which apply to the same sigma-algebra F are said to be
equivalent if for any event E in F:

If and only if
Alternatively:
Any event E that is possible/impossible under probability measure P is also
possible/impossible under probability measure Q.

iii. Suppose that is a standard Brownian motion under P. Furthermore suppose that
is a previsible process. Then there exists a measure Q equivalent to P and
where:

̃ ∫

Where ̃ is a standard Brownian motion under

Role in derivative valuation
It tells how to convert from the physical measure which describes the probability that an
underlying instrument (such as a share price or interest rate) will take a particular value or
values to the risk-neutral measure which is a very useful tool for pricing derivatives on the
underlying.
iv. Suppose that and are martingale with respect to the same probability
measure (Q or P). Then there exists a previsible process such that:

Alternatively:

Role in derivative valuation

It allows us to construct a self-financing portfolio

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b.

Applying the Girsanov theorem

̌ ( )

[ ( ) ]

̌ ∫

̌ ∫

* +

c. Using Girsanov theorem

̃ is the standard Brownian motion under probability measure P

* + ̃
* + *̃ +
* + *̃ +

* + ̃
[ ] [ ]

For

* + ̃ ̃
[ | ] [ ]

Hence the proof that [ ]

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 References
1. Institute and Faculty of Actuaries examination materials; CT 8 ActED materials
2. Baxter, Martin & Andrew Rennie, Financial calculus; An introduction to derivative pricing,
Cambridge University Press, 1996. (233 pages) ISBN: 978-0521552899.
3. Hull, John C, Options, futures and other derivatives (7th edition), Prentice Hall, 2008 (822
pages) ISBN: 978-0136015864.
4. Elton, Edwin J, Martin J Gruber, Stephen J Brown et al, Modern portfolio theory and
investment analysis (8th edition), John Wiley, 2010 (727 pages) ISBN: 978-0470505847.

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