Introduction to Stochastic Finance

Jia-An Yan
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Universitext

Jia-An Yan

Introduction
to Stochastic
Finance
Universitext
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Jia-An Yan

Introduction to Stochastic
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Jia-An Yan
Academy of Mathematics and System Science
Chineses Academy of Sciences
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Preface

The history of financial mathematics can be traced back to the French mathemati-
cian Louis Bachelier’s doctoral dissertation “Théorie de la speculation” in 1900
Bachelier (1900). Bachelier’s work, however, was not known to most economists
until Paul A. Samuelson mentioned it in an article of 1965. In 1969 and 1971,
Robert C. Merton studied the optimal portfolio problem in continuous-time using
the stochastic dynamic programming method. In 1973, Fischer Black and Myron
S. Scholes used stochastic analysis, in particular, Kiyosi Itô’s formula, to derive
the famous Black-Scholes formula for option pricing. Almost at the same time,
Merton (1973a) improved the Black-Scholes model and developed an idea of using
options to evaluate a company’s debt in the so-called contingent claims analysis.
Harrison and Kreps (1979) proposed a martingale method to characterize a no-
arbitrage market and the use of equivalent martingale measure on options pricing
and hedging, which had profound influence on the subsequent development of
financial mathematics. Since 1970s, in order to study the pricing of interest rate
derivatives, many scholars have proposed several interest rate term structure models,
including Vasicek, CIR, HJM, and BGM models, which could reflect the market
trend of the future spot rate.
For more than half a century, many scholars worked research on theory and
applications of financial mathematics (also known as mathematical finance) and
published many books in the area. Financial mathematics not only has a direct
impact on the innovation of financial instruments and on the efficient functioning
of financial markets but also is widely used in investment decisions, valuation of
research and development projects, and in risk management.
This book is intended to give a systematic introduction to the basic theory of
financial mathematics, with an emphasis on applications of martingale methods in
pricing and hedging of contingent claims, interest rate term structure models, and
expected utility maximization problems. The book consists of 14 chapters. Chap-
ter 1 introduces the basic theory of probability and discrete time martingales, which
is specially designed for readers who do not have much knowledge of probability
theory. In Chap. 2, we introduce the theory of discrete time portfolio selection (i.e.,
Harry M. Markowitz’s mean-variance analysis), the capital asset pricing model

v
vi Preface

(CAPM), the arbitrage pricing theory (APT), and the multistage mean-variance
analysis. The basic idea of expected utility theory and the consumption-based
asset pricing model are also sketched in this chapter. In Chap. 3, we introduce
discrete time financial markets and martingale characterization of arbitrage-free
markets and present the martingale method for the expected utility maximization
and the risk-neutral pricing principle for European contingent claims. Chapter 4
systematically presents Itô’s theory of stochastic analysis (including Itô’s integral
and Itô’s formula, Girsanov’s theorem, and the martingale representation theorem)
which is the theoretical basis of the martingale method in financial mathematics.
This chapter can be used separately as a concise text for postgraduates in probability
studying Itô’s theory of stochastic analysis. In Chap. 5, for the Black-Scholes
model, we introduce the martingale method for pricing and hedging European
contingent claims and derive the Black-Scholes formula for pricing European
options. The pricing of American options is also briefly discussed. In addition,
some examples are given to illustrate applications of the martingale method, and
several modifications of the Black-Scholes model are presented. In Chap. 6, we
introduce several commonly used exotic options: barrier options, Asian options,
lookback options, and reset options. The pricing and hedging of these exotic options
are investigated with the martingale method and partial differential equations.
Chapter 7 presents Itô process and diffusion process models. The martingale method
of contingent claim pricing is presented in detail, including an introduction of
time and scale transformation to give some explicit formulas for option pricing.
Chapter 8 introduces the bond market and interest rate term structure models,
including a variety of single-factor short-term interest rate model, HJM model,
and BGM Model, and studies the pricing of interest rate derivatives. Chapter 9
introduces optimal investment portfolios and investment-consumption strategies
for diffusion process models. Within L2 -allowable trading strategies, the risk-
mean portfolio selection problem, expected utility maximization problem, and
the selection of portfolio strategy with consumption are investigated. Chapter 10
introduces the general theory of static risk measures, which includes consistent
risk measures, convex risk measures, comonotonically sub-additive risk measures,
comonotonically convex risk measure, and a variety of distribution invariant risk
measures, as well as their characterizations and representations. In Chap. 11, after
a brief overview of semimartingales and stochastic calculus, we introduce some
basic concepts and results on markets of semimartingale model and give numeraire-
free characterizations of attainable contingent claims. In Chap. 12, we give a
survey on convex duality theory for optimal investment and present a numeraire-
free and original probability-based framework for financial markets. The expected
utility maximization and valuation problems in a general semimartingale setting are
studied in Chap. 13. For a market driven by a Lévy process, the optimal portfolio and
the related martingale measure are worked out explicitly for some particular types of
utility function. Finally, in Chap. 14, we introduce the “optimal growth portfolios”
in markets of semimartingale model and work out their expressions in a geometric
Lévy process model and a jump-diffusion-like process model.
Preface vii

I have taught from the manuscript of this book in an introductory course of

mathematical finance for my former graduate students. Thanks to them for reporting
misprints and errors. I am grateful to Prof. Jianming Xia for contributing to the
writing of Sect. 9.2 of Chap. 9; to Dr. Yongsheng Song for his PhD thesis, which is
the basic material for Chap. 10 of the book; and to Dr. Jun Yan for typographical
and grammatical suggestions.

Beijing, China Jia-An Yan

May, 2018
Contents

1 Foundation of Probability Theory and Discrete-Time

Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Basic Concepts of Probability Theory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1.1 Events and Probability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1.2 Independence, 0-1 Law, and Borel-Cantelli Lemma . . . . . . 3
1.1.3 Integrals, (Mathematical) Expectations of Random
Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.1.4 Convergence Theorems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2 Conditional Mathematical Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.2.1 Definition and Basic Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.2.2 Convergence Theorems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.2.3 Two Theorems About Conditional Expectation . . . . . . . . . . . 15
1.3 Duals of Spaces L∞ (, F) and L∞ (, F, m) . . . . . . . . . . . . . . . . . . . . 17
1.4 Family of Uniformly Integrable Random Variables . . . . . . . . . . . . . . . . 18
1.5 Discrete Time Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
1.5.1 Basic Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
1.5.2 Basic Theorems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
1.5.3 Martingale Transforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
1.5.4 Snell Envelop . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
1.6 Markov Sequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
2 Portfolio Selection Theory in Discrete-Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
2.1 Mean-Variance Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
2.1.1 Mean-Variance Frontier Portfolios Without
Risk-Free Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.1.2 Revised Formulations of Mean-Variance Analysis
Without Risk-Free Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
2.1.3 Mean-Variance Frontier Portfolios with Risk-Free
Asset. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
2.1.4 Mean-Variance Utility Functions . . . . . . . . . . . . . . . . . . . . . . . . . . 45

ix
x Contents

2.2 Capital Asset Pricing Model (CAPM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

2.2.1 Market Competitive Equilibrium and Market Portfolio . . 47
2.2.2 CAPM with Risk-Free Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
2.2.3 CAPM Without Risk-Free Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.2.4 Equilibrium Pricing Using CAPM . . . . . . . . . . . . . . . . . . . . . . . . 53
2.3 Arbitrage Pricing Theory (APT). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
2.4 Mean-Semivariance Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
2.5 Multistage Mean-Variance Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
2.6 Expected Utility Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
2.6.1 Utility Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
2.6.2 Arrow-Pratt’s Risk Aversion Functions. . . . . . . . . . . . . . . . . . . . 64
2.6.3 Comparison of Risk Aversion Functions . . . . . . . . . . . . . . . . . . 66
2.6.4 Preference Defined by Stochastic Orders. . . . . . . . . . . . . . . . . . 66
2.6.5 Maximization of Expected Utility and Initial Price
of Risky Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
2.7 Consumption-Based Asset Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . 72
3 Financial Markets in Discrete Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
3.1 Basic Concepts of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
3.1.1 Numeraire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
3.1.2 Pricing and Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
3.1.3 Put-Call Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
3.1.4 Intrinsic Value and Time Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
3.1.5 Bid-Ask Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
3.1.6 Efficient Market Hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
3.2 Binomial Tree Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
3.2.1 The One-Period Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
3.2.2 The Multistage Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
3.2.3 The Approximately Continuous Trading Case . . . . . . . . . . . . 82
3.3 The General Discrete-Time Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
3.3.1 The Basic Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
3.3.2 Arbitrage, Admissible, and Allowable Strategies . . . . . . . . . 85
3.4 Martingale Characterization of No-Arbitrage Markets . . . . . . . . . . . . . 86
3.4.1 The Finite Market Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
3.4.2 The General Case: Dalang-Morton-Willinger Theorem . . 87
3.5 Pricing of European Contingent Claims. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
3.6 Maximization of Expected Utility and Option Pricing . . . . . . . . . . . . . 92
3.6.1 General Utility Function Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
3.6.2 HARA Utility Functions and Their Duality Case . . . . . . . . . 94
3.6.3 Utility Function-Based Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
3.6.4 Market Equilibrium Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
3.7 American Contingent Claims Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3.7.1 Super-Hedging Strategies in Complete Markets . . . . . . . . . . 103
3.7.2 Arbitrage-Free Pricing in Complete Markets . . . . . . . . . . . . . 104
3.7.3 Arbitrage-Free Pricing in Non-complete Markets . . . . . . . . 105
Contents xi

4 Martingale Theory and Itô Stochastic Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 107

4.1 Continuous Time Stochastic Processes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
4.1.1 Basic Concepts of Stochastic Processes . . . . . . . . . . . . . . . . . . . 107
4.1.2 Poisson and Compound Poisson Processes. . . . . . . . . . . . . . . . 108
4.1.3 Markov Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
4.1.4 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
4.1.5 Stopping Times, Martingales, Local Martingales . . . . . . . . . 114
4.1.6 Finite Variation Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.1.7 Doob-Meyer Decomposition of Local Submartingales . . . 116
4.1.8 Quadratic Variation Processes of Semimartingales . . . . . . . 119
4.2 Stochastic Integrals w.t.t. Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . 124
4.2.1 Wiener Integrals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
4.2.2 Itô Stochastic Integrals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
4.3 Itô’s Formula and Girsanov’s Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
4.3.1 Itô’s Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
4.3.2 Lévy’s Martingale Characterization of Brownian
Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
4.3.3 Reflection Principle of Brownian Motion . . . . . . . . . . . . . . . . . 134
4.3.4 Stochastic Exponentials and Novikov Theorem . . . . . . . . . . 134
4.3.5 Girsanov’s Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
4.4 Martingale Representation Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
4.5 Itô Stochastic Differential Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
4.5.1 Existence and Uniqueness of Solutions . . . . . . . . . . . . . . . . . . . 140
4.5.2 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
4.6 Itô Diffusion Processes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
4.7 Feynman-Kac Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
4.8 Snell Envelop (Continuous Time Case) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
5 The Black-Scholes Model and Its Modifications . . . . . . . . . . . . . . . . . . . . . . . . 153
5.1 Martingale Method for Option Pricing and Hedging . . . . . . . . . . . . . . . 154
5.1.1 The Black-Scholes Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
5.1.2 Equivalent Martingale Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
5.1.3 Pricing and Hedging of European Contingent Claims . . . . 157
5.1.4 Pricing of American Contingent Claims. . . . . . . . . . . . . . . . . . . 160
5.2 Some Examples of Option Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
5.2.1 Options on a Stock with Proportional Dividends . . . . . . . . . 162
5.2.2 Foreign Currency Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
5.2.3 Compound Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
5.2.4 Chooser Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
5.3 Practical Uses of the Black-Scholes Formulas . . . . . . . . . . . . . . . . . . . . . . 166
5.3.1 Historical and Implied Volatilities . . . . . . . . . . . . . . . . . . . . . . . . . 166
5.3.2 Delta Hedging and Analyses of Option Price
Sensitivities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
xii Contents

5.4 Capturing Biases in Black-Scholes Formulas . . . . . . . . . . . . . . . . . . . . . . . 168

5.4.1 CEV Model and Level-Dependent Volatility Model . . . . . . 168
5.4.2 Stochastic Volatility Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
5.4.3 SABR Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
5.4.4 Variance-Gamma (VG) Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
5.4.5 GARCH Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
6 Pricing and Hedging of Exotic Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
6.1 Running Extremum of Brownian Motion with Drift . . . . . . . . . . . . . . . 175
6.2 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
6.2.1 Single-Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
6.2.2 Double-Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
6.3 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
6.3.1 Geometric Average Asian Options. . . . . . . . . . . . . . . . . . . . . . . . . 181
6.3.2 Arithmetic Average Asian Options . . . . . . . . . . . . . . . . . . . . . . . . 183
6.4 Lookback Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
6.4.1 Lookback Strike Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
6.4.2 Lookback Rate Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
6.5 Reset Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
7 Itô Process and Diffusion Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
7.1 Itô Process Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
7.1.1 Self-Financing Trading Strategies . . . . . . . . . . . . . . . . . . . . . . . . . 195
7.1.2 Equivalent Martingale Measures and No Arbitrage. . . . . . . 197
7.1.3 Pricing and Hedging of European Contingent Claims . . . . 201
7.1.4 Change of Numeraire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
7.1.5 Arbitrage Pricing Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
7.2 PDE Approach to Option Pricing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
7.3 Probabilistic Methods for Option Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
7.3.1 Time and Scale Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
7.3.2 Option Pricing in Merton’s Model . . . . . . . . . . . . . . . . . . . . . . . . . 210
7.3.3 General Nonlinear Reduction Method . . . . . . . . . . . . . . . . . . . . . 211
7.3.4 Option Pricing Under the CEV Model . . . . . . . . . . . . . . . . . . . . 212
7.4 Pricing American Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
8 Term Structure Models for Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
8.1 The Bond Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
8.1.1 Basic Concepts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
8.1.2 Bond Price Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
8.2 Short Rate Models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
8.2.1 One-Factor Models and Affine Term Structures . . . . . . . . . . 221
8.2.2 Functional Approach to One-Factor Models . . . . . . . . . . . . . . 225
8.2.3 Multifactor Short Rate Models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
8.2.4 Forward Rate Models: The HJM Model . . . . . . . . . . . . . . . . . . . 231
8.3 Forward Price and Futures Price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
8.3.1 Forward Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
8.3.2 Futures Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
Contents xiii

8.4 Pricing Interest Rate Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236

8.4.1 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
8.4.2 Forward Measure Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
8.4.3 Changing Numeraire Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
8.5 The Flesaker-Hughston Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
8.6 BGM Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
9 Optimal Investment-Consumption Strategies in Diffusion Models . . . 247
9.1 Market Models and Investment-Consumption Strategies . . . . . . . . . . 247
9.2 Expected Utility Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
9.3 Mean-Risk Portfolio Selection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
9.3.1 General Framework for Mean-Risk Models. . . . . . . . . . . . . . . 258
9.3.2 Weighted Mean-Variance Model. . . . . . . . . . . . . . . . . . . . . . . . . . . 259
10 Static Risk Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
10.1 Coherent Risk Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
10.1.1 Monetary Risk Measures and Coherent Risk Measures . . 264
10.1.2 Representation of Coherent Risk Measures . . . . . . . . . . . . . . . 266
10.2 Co-monotonic Subadditive Risk Measures . . . . . . . . . . . . . . . . . . . . . . . . . 268
10.2.1 Representation: The Model-Free Case . . . . . . . . . . . . . . . . . . . . 269
10.2.2 Representation: The Model-Dependent Case . . . . . . . . . . . . . 272
10.3 Convex Risk Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
10.3.1 Representation: The Model-Free Case . . . . . . . . . . . . . . . . . . . . 274
10.3.2 Representation: The Model-Dependent Case . . . . . . . . . . . . . 275
10.4 Co-monotonic Convex Risk Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
10.4.1 The Model-Free Case. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
10.4.2 The Model-Dependent Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
10.5 Law-Invariant Risk Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
10.5.1 Law-Invariant Coherent Risk Measures . . . . . . . . . . . . . . . . . . 280
10.5.2 Law-Invariant Convex Risk Measures . . . . . . . . . . . . . . . . . . . . 285
10.5.3 Some Results About Stochastic Orders and Quantiles. . . . 286
10.5.4 Law-Invariant Co-monotonic Subadditive Risk
Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
10.5.5 Law-Invariant Co-monotonic Convex Risk Measures . . . . 298
11 Stochastic Calculus and Semimartingale Model . . . . . . . . . . . . . . . . . . . . . . . . 307
11.1 Semimartingales and Stochastic Calculus. . . . . . . . . . . . . . . . . . . . . . . . . . . 308
11.1.1 Doob-Meyer’s Decomposition of Supermartingales . . . . . . 308
11.1.2 Local Martingales and Semimartingales . . . . . . . . . . . . . . . . . . 310
11.1.3 Stochastic Integrals w.r.t. Local Martingales . . . . . . . . . . . . . . 311
11.1.4 Stochastic Integrals w.r.t. Semimartingales . . . . . . . . . . . . . . . 313
11.1.5 Itô’s Formula and Doléans Exponential Formula . . . . . . . . . 314
11.2 Semimartingale Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
11.2.1 Basic Concepts and Notations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
11.2.2 Vector Stochastic Integrals w.r.t. Semimartingales. . . . . . . . 318
11.2.3 Optional Decomposition Theorem . . . . . . . . . . . . . . . . . . . . . . . . . 319
xiv Contents

11.3 Superhedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321

11.4 Fair Prices and Attainable Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
12 Optimal Investment in Incomplete Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
12.1 Convex Duality on Utility Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
12.1.1 The Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
12.1.2 Complete Market Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
12.1.3 Incomplete Market Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
12.1.4 Results of Kramkov and Schachermayer . . . . . . . . . . . . . . . . . . 332
12.2 A Numeraire-Free Framework. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
12.2.1 Martingale Deflators and Superhedging . . . . . . . . . . . . . . . . . . . 335
12.2.2 Reformulation of Theorem 12.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
12.3 Utility-Based Approaches to Option Pricing. . . . . . . . . . . . . . . . . . . . . . . . 338
12.3.1 Minimax Martingale Deflator Approach . . . . . . . . . . . . . . . . . . 338
12.3.2 Marginal Utility-Based Approach . . . . . . . . . . . . . . . . . . . . . . . . . 340
13 Martingale Method for Utility Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
13.1 Expected Utility Maximization and Valuation . . . . . . . . . . . . . . . . . . . . . . 344
13.1.1 Expected Utility Maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
13.1.2 Utility-Based Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346
13.2 Minimum Relative Entropy and Maximum Hellinger Integral. . . . . 348
13.2.1 HARA Utility Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
13.2.2 Another Type of Utility Function . . . . . . . . . . . . . . . . . . . . . . . . . . 350
13.2.3 Utility Function W0 (x) = −e−x . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
13.3 Market Driven by a Lévy Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
13.3.1 The Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
13.3.2 Results for HARA Utility Functions . . . . . . . . . . . . . . . . . . . . . . 354
13.3.3 Results for Utility Functions of the Form Wγ (γ < 0) . . . 359
13.3.4 Results for Utility Function W0 (x) = −e−x . . . . . . . . . . . . . . 359
14 Optimal Growth Portfolios and Option Pricing . . . . . . . . . . . . . . . . . . . . . . . . . 365
14.1 Optimal Growth Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
14.1.1 Optimal Growth Strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
14.1.2 A Geometric Lévy Process Model . . . . . . . . . . . . . . . . . . . . . . . . . 367
14.1.3 A Jump-Diffusion-Like Process Model . . . . . . . . . . . . . . . . . . . 373
14.2 Pricing in a Geometric Lévy Process Model . . . . . . . . . . . . . . . . . . . . . . . . 377
14.3 Other Approaches to Option Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
14.3.1 The Föllmer-Schwarzer Approach . . . . . . . . . . . . . . . . . . . . . . . . . 383
14.3.2 The Davis’ Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383
14.3.3 Esscher Transform Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
Chapter 1
Foundation of Probability Theory
and Discrete-Time Martingales

Gambling with dice was very popular in medieval Europe. The study of problems
involving probability associated with gambling led to the development of proba-
bility theory. However, it was not until the early twentieth century that probability
theory was considered as a branch of mathematics. The mathematical foundation
of modern probability theory was laid by Andrei N. Kolmogorov in 1933. He
adopted Lebesgue’s framework of measure theory and created an axiomatic system
for probability theory. This chapter introduces some basic concepts and results
of modern probability theory, highlights the results related to the conditional
mathematical expectation, and then introduces discrete-time martingale theory,
including the martingale transform and the Snell envelope. We assume that the
reader has basic knowledge of measure theory.

1.1 Basic Concepts of Probability Theory

1.1.1 Events and Probability

Consider a trial or random experiment. Let  be the collection of all possible

outcomes of the trial, called sample space. If the number of outcomes of the trial is
finite or countable, we can use combinatorial mathematics to study issues related to
probability. However, if the number of outcomes of the trial is uncountably infinite,
we may not be able to consider a single outcome of the trial because the probability
of its appearance may be zero. Hence, we need to study issues related to probability
under the framework of measure theory.
In measure theory, we use  to represent a space, i.e., a predefined biggest set
for a study. Its elements are denoted by ω; ω ∈ A or ω ∈
/ A stands for the fact that ω
belongs to A or does not belong to A, respectively. The set which does not contain
any element is called an empty set and is denoted by ∅. We use A ⊃ B or B ⊂ A to

© Springer Nature Singapore Pte Ltd. and Science Press 2018 1

J.-A. Yan, Introduction to Stochastic Finance, Universitext,
https://doi.org/10.1007/978-981-13-1657-9_1
2 1 Foundation of Probability Theory and Discrete-Time Martingales

express that B is a subset of A and use

A∩B, A∪B, A\B, A B

to express the intersection, union, difference, and symmetric difference of A and B,

respectively. That is:
A ∩ B = {ω : ω ∈ A and ω ∈ B}, A ∪ B = {ω : ω ∈ A or ω ∈ B},
A \ B = {ω : ω ∈ A and ω ∈
/ B}, A B = (A \ B) ∪ (B \ A).

Sometimes we also use AB to represent A ∩ B. We use Ac to express  \ A and

call Ac the complement of A (in ). Consequently, it holds that A \ B = A ∩ B c . If
A ∩ B = ∅, we say that A and B are disjoint. Clearly, A ∩ Ac= ∅, A ∪ A c = .

Let {Aλ , λ ∈ } be a family of subsets of . We use Aλ and Aλ to

λ∈ λ∈
express their union and intersection, respectively. Assume that {An , n1} (denoted
also as (An )) is a finite or countable sequence of subsets of
. If (An ) are mutually

disjoint (i.e., n = m ⇒ An ∩ Am = ∅), we usually use An to express An . If
 n n
An = , we say that {An , n1} is a partition of .
n
For any sequence (An ) of subsets, set
 ∞
∞  ∞ 
 ∞
lim sup An = Ak , lim inf An = Ak ,
n→∞ n→∞
n=1 k=n n=1 k=n

and call them the upper limit and lower limit of (An ). Obviously,
lim inf An ⊂ lim sup An .
n→∞ n→∞

If lim inf An = lim sup An , we say that the limit of (An ) exists, and we denote its
n→∞ n→∞
same upper and lower limit by lim An and call it the limit of (An ).
n→∞
A family of subsets of  is called a set class. A set class C is called an algebra,
if  ∈ C, ∅ ∈ C, and C is closed under finite intersection and complement (thereby,
C is closed under finite union and under difference). We call C a σ -algebra, if  ∈
C, ∅ ∈ C, and C are closed under countable intersection and complement (thereby,
C is closed under the countable union and the difference). The smallest σ -algebra
containing a set class C is called a σ -algebra generated by C, denoted by σ (C).
Let F be a σ -algebra on . We call ordered couple (, F) a measurable space,
and an element of F an F-measurable set. Let μ be a function defined on F with
values in R+ = [0, ∞]. If μ(∅) = 0 and μ is countably additive or σ -additive,
namely,
∀n1 , An ∈ F ; ∀n = m , An ∩ Am = ∅
∞ ∞
 
⇒μ An = μ(An ),
n=1 n=1
1.1 Basic Concepts of Probability Theory 3

then we call μ a measure on  (or (, F)). If μ() < ∞, we call μ a finite
measure. If there is a countable measurable division (Ai )i1 of , such that for any
Ai , μ(Ai ) < ∞, we call μ a σ -finite measure. If μ() = 1, we call μ a probability
measure and call the ordered triple (, F, μ) a probability space. Usually, we use
P to denote a probability measure.
Let (, F, P) be a probability space. If A ∈ F, and P(A) = 0, we call A a null
set. If all subsets of any P-null set belong to F, F is said to be complete w.r.t. P,
and we call (, F, P) a complete probability space.
Let (, F, P) be a probability space. Set

N = {N ⊂  : there exists A ∈ F, P(A) = 0, such that N ⊂ A},

F = {B ∪ N : B ∈ F, N ∈ N },

P(B ∪ N) = P(B), B ∈ F, N ∈ N .

Then (, F, P) is a complete probability space, which is the smallest complete

probability space containing (, F, P). We call (, F , P) the completion of
(, F, P) and call F the completion of F w.r.t. P.

1.1.2 Independence, 0-1 Law, and Borel-Cantelli Lemma

Let (, F, P) be a probability space. If A ∈ F, we call A an event. The sample

space  itself is called the inevitable event. An event A happens if the outcome ω
of the trial is an element of A. Let A and B be two events. If P(AB) = P(A)P(B),
events A and B are called independent. An event class (At , t ∈ T ) is called an
independent class, if for any finite subset S of T , we have

P As = P(As ).
s∈S s∈S

In this case we say that the events in this event class are mutually independent. This
mutual independence is much stronger than pairwise independence.
Two event classes A and B are called independent if any event A ∈ A and any
event B ∈ B are independent. More generally, let (Ct , t ∈ T ) be a family of event
classes. If for any event At from each event class Ct , event class (At , t ∈ T ) is an
independent event class, then we call this family an independent family and say that
the event classes in this family are mutually independent.
It is easy to prove the following result.
Extension theorem of independent class Let (Ct , t ∈ T ) be an independent class.
If each Ct is a π class (i.e., closed under intersection), then (σ (Ct ), t ∈ T ) is also an
independent class, where σ (Ct ) is the σ -algebra generated by event class Ct .
1.2 Conditional Mathematical Expectation 15

Theorem 1.7 (Monotone convergence theorem) Let (Xn ) be a sequence of ran-

dom variables whose conditional expectations w.r.t. G exist. If Xn ↑ X a.s. and
E[X1 − | G] < ∞ a.s., then the conditional expectation of X w.r.t. G exists and
E[Xn | G] ↑ E[X| G] a.s.
Theorem 1.8 (Fatou’s lemma) Let (Xn ) be a sequence of random variables
whose conditional expectations w.r.t. G exist.
(1) If there exists a random variable Y such that E[Y − | G] < ∞ a.s., and for each
n1, Xn Y a.s., then the conditional expectation of lim inf Xn w.r.t. G exists,
n→∞
and we have:

E[lim inf Xn | G] lim inf E[Xn | G];

n→∞ n→∞

(2) If there exists a random variable Y , such that E[Y + | G] < ∞ a.s., and for each
n1, Xn Y a.s., then the conditional expectation of lim sup Xn w.r.t. G exists,
n→∞
and we have

E[lim sup Xn | G] lim sup E[Xn | G].

n→∞ n→∞

a.s.
Theorem 1.9 (Dominated convergence theorem) Assume Xn −→ X (respec-
p
tively, Xn → X). If there exists a nonnegative random variable Y , such that |Xn |Y
a.s., then X is integrable, and we have lim E[Xn | G] = E[X| G] a.s. (respectively,
n→∞
p
E[Xn | G] −→ E[X| G]).

1.2.3 Two Theorems About Conditional Expectation

In this book we will often utilize the following two theorems about conditional
expectations.
Theorem 1.10 Let (, F, P) be a probability space, G be a sub-σ -algebra of F,
X be a Rm -valued G-measurable random variable, and Y be a Rn -valued random
variable. If Y and G are independent (i.e., σ (Y ) and G are independent), then for
any nonnegative Borel function g(x, y) on Rm × Rn , it holds

E[g(X, Y ) | G] = E[g(x, Y )]|x=X . (1.5)

Proof In order to prove (1.5), we need only to prove that for any nonnegative G-
measurable random variable Z,

E[g(X, Y )Z] = E[f (X)Z],

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 *****

Päivällisen jälkeen loiottiin kalliolla ja luettiin Kiven Veljeksistä

parhaita paikkoja. Julistettiin tarinakilpailu, johon kaikki saisivat ottaa
osaa, ja yhdessä arvosteltaisiin tulokset.

Jallun tarina julistettiin voittaneeksi kilpailun ja tästä hyvästynyt

Jallu lupasi laittaa oikein suussa sulavan illallisen.

Illalla saivat Jaakko ja Mikko laskea pitkän siiman ja pohtia

uudelleen suunnitelmaansa kepposta.

— Mitäs, jos vene menisi niin kauaksi, etteivät sitä pojat tavoita ja
jäädään niin neuvoin kaikki saareen, sanoi Jaakko.

— No ei se mitään. Kylläpähän tulevat hakemaan, kun ei kotiin

kuulu ja ahvenia ongitaan muonaksi, sanoi Mikko.

— Niinpä sitten olkoon päätetty, julisti Jaakko. — Ennen uintia

jätetään venhe hyvin vähän kiinni kallion laitaan, ja toinen käy sitten
sopivassa tilaisuudessa irroittamassa sen ja antamassa sille
alkuvauhtia.

Yöksi rakensivat pojat kalliolle hongan pölkyistä nuotion, ja tyveniä

vesiä katsellen ja käen kukuntaa kuunnellen nukuttiin.

Aamupäivä meni pitkäsiimaa kokiessa, ja kun se antoi runsaan

saaliin, suoritettiin intiaanitanssi kalliolla kalastuksen kunniaksi.
Sopisi ylpeillä äideille ja siskoille hyvin onnistuneesta kalaretkestä.

Eilen toimittamatta jäänyt tervaaminen suoritettiin nyt hehkuvassa

auringon paahteessa, kun terva oli ensin padassa lämmitetty.
 — Hii, miten se kutittaa ihoa, sanoi Mikko.

— Kas, miten hyvin se menee nahkaan, ihaili Jaakko ja Jallu.

Olisipa nyt kelvannut näyttää ihoaan kotijoukoille.

— Nyt on parasta hiukan liotella ihoaan, koskapa sitä niin hirveästi

kuumottaa, sanoi Jallu. — Murjaanit järveen!

Jaakon ja Mikon sydän takoi kiivaammin, mutta koetettiin olla

huolettoman näköisiä kaikesta. Tuuli oli hyvä ja mantereeseen päin
lähtisi vene viilettämään, ja kun se oli toisella puolella saarta, kuin
poikien majapaikka, eivät Lassi ja Jallu tietäisi mitään, ennenkuin
venhe olisi jo kaukana.

Kevyt venhe jo viiletti kaukana, kun Lassi sen huomasi.

— Voi turkkilainen, kun venhe on karannut! huudahti hän, — Kuka

peikkolainen sen kytki niin huonosti.

— No voi sun saksan sakilainen! kivahti Jallukin, ja pojat hokivat

sitä samaa kuin toisetkin.

— Lähtään uimaan ja otetaan se kiinni, sanoi Jallu ja alkoi jo

vedellä voimakkain ottein selälle.

— Ei sitä tavoita enää minkäänlainen uimari, julisti Lassi. — Nyt

on vain otettava selvää, kuka venheen on kytkenyt niin huonosti, että
se pääsi karkaamaan. Ja sen minä sanon, että sen ilkimyksen korvat
kuumenevat.

Tutkittiin asiata ja tulos oli Lassille masentava. Hän oli viimeksi

käynyt veneellä viemässä rantarisuun lisää männynhavuja.
 — No koska minä olen joutunut syylliseksi, niin jokainen teistä saa
livauttaa minua korvalle, mutta tehkää se kepeällä kädellä, koskapa
teitä on niin kovin monta rankaisijaa.

— Täysi satsi Lassille, ei siinä auta puolustelu, huusi Jallu.

— Mikä mies se semmoinen on, joka pyrkii syntejään pakoon.

Korvat tänne!

— Ei muuta kuin pieni livaus vain, oli Mikon ja Jaakon

mielipiteenä. —
Onhan tässä otettava huomioon lieventävät asianhaarat.

Ja sen sijaan kuin Jallu antoi navakan tillikan Lassille, hipaisivat

toiset pojat Lassin korvalehteä hieman vain sormen päillään.

Lassilla oli kiivas luonto, jota hän ei osannut vielä kylliksi hillitä, ja
nyt se kuohahti siitä, että Jallu tahtoi kovempaa rangaistusta hänelle
kuin toiset.

— Sinä olet sakin jukuripää ja sinua on pehmitettävä, sanoi hän, ja

pian kieriskelivät pojat kalliolla ja kanervikossa ankarassa
sylirysyssä.

— Tämän piti nyt tulla meidän tähtemme, sanoi Jaakko.

— Ei se pahaa tee Jallulle pieni kuranssaus, sanoi Mikko. — Mitäs

ei tyytynyt toisten päätökseen.

Kun nujellus lakkasi, katseltiin mustelmia ja naarmuja, joita oli

saatu kanervikossa.

— Tunnustatko saaneesi hassausta ansiosta? kysyi Lassi Jallulta.

 — Kyl-lä. Samallahan sitä sait sinäkin, mutta sinun kauemmin
tervassa ollut pintasi kesti risujen raapaisuja paremmin kuin minun,
sanoi Jallu.

— Mutta mitäs tästä. Pääasia on se, että nyt olemme kuin hiiret
loukussa. Sinne meni vielä meidän riitatoverien vaatteet. Kuka
käskikin meidän niitä venheeseen riisumaan. Se oli noloa, se…

— Nyt on jo vene rannalla, sanoi Jaakko, joka oli sen kulkua

seurannut.

— Ja pysyy siellä. Saamme odottaa, kunnes tulevat sydän

kurkussa meitä katselemaan, arveli Mikko.

— Katsotaanpa, mitä meille jäi, sanoi Lassi.

— Pata jäi ja onget, kahvipannu ja sokerit meni veneen mukana,

ilmoitti
Jaakko, joka oli jo tehnyt tutkimuksen.

— Jäiköhän lierotuohinen edes?

— On jäänyt varmasti. Pistin sen kallion koloon, sanoi Jallu. —

Mitäs muuta kuin onkimaan ja ahvenia pataan.

— Tulikin pahuuksenmoinen nälkä siinä tappeluksessa, sanoi

Lassi.

— Eihän vain liene siinä nujakassa aapeluksemme, Seitsemät

Veljekset, hävinnyt? kysyi Jallu.

— Minä nostin kirjan puuhun, sanoi Jaakko.

 Päivä paistoi ja kallio poltteli jalkapohjia. Veneen menetys ei
surettanut liioin. Ainahan keinoja löytyi, kunhan vain aurinko paistoi
ja ruoka riitti. Ja sitä taas sai, kun vain heitti siiman kalliolta veteen.
Ahvenet hyppivät ihan maan ja veden rajassa.

*****

Jallu oli mennyt veljensä kanssa puita noutamaan nuotioon ja

Lassi kyykötti kallion reunalla odotellen ahventa onkeen. Jaakko oli
onkineen vähän matkan päässä. Hän nauroi.

— Mitä hörötät? kysyi Lassi.

— Sitä, kun sinulla ei ole vaatteita ja saat yöllä paahtaa itseäsi

kuin neekeri nuotiossa.

— Täälläpä ei ensi yötä ollakaan, sanoi Lassi.

— Mikäs auttaa?

— Sepähän nähdään.

Lassi oli löytänyt saaresta muutamia kuivia hirsiä, joista saisi

lautan, kun olisi millä se sitoa kokoon. Sitä hän nyt mietti siinä
seuratessaan kylläistä ahventa, joka repi syöttiä, mutta ei haukannut
sitä rohkeammin.

Olisipa vain köyttä, jolla solmiaisi puut yhteen ja sitten vielä purje.
Poikien paidoista ja housuista ei sitä taitaisi saada kokoon.

— Mustikoita, hei pojat! kuului toisten huuto metsästä.

Pojat jättivät onkensa ja juoksivat viidakkoon. Mustikat olivat

kesän ensimmäisiä heille ja halulla käytiin niihin käsiksi. Siinä
vierähtivät tunnit huomaamatta ja päivä alkoi olla illoillaan, kun pojat
palasivat kalliolle. Koetettiin onkia, mutta ahven ei syönyt enää.

— Oikeastaan me emme mitään päivällistä tarvitsekaan, kun

jokaisen maaru on mustikoita täysi, arveli Jallu.

— Mutta kotiin paluuta meidän olisi pohdittava ankarasti, sanoi

Lassi.
— Minulla olisi hyvä keino, mutta siinä on yksi niksi.

— Mikä, sanohan?

— Ei ole köyttä. Saaren rannalla on ainakin kahdeksan vankkaa

hirttä, ja niistä me voisimme laittaa lautan, kun olisi vain nuoraa.

— Sitä me saamme Koivunvesoista vaikka kuinka… voimme niillä

kyllä sitoa lautan kokoon, sanoi Mikko ja kimpaisi metsään vitsaksia
noutamaan.

— No nyt ei siis puutu muuta kuin kiireesti lautan tekoon, sanoi

Lassi. — Sattui vielä niin mainiosti, että puut ovat mantereen
puoleisella rannalla. Ei muuta kuin heti purjetta laskemaan.

Puut olivat raskaita ja vaivoin saatiin ne vieritetyksi veteen. Kun

lautta oli valmis, aleni jo aurinkokin kaukaisen rannan taakse ja tuuli
laimeni.

— Näyttää siltä, että yöksi tulee aivan tyyni, mutta voimmehan

soutaa lauttaa maihin, sanoi Jallu.

— Tahi odottaa aamua, jolloin tuuli kantaa meitä soutamattakin,

arveli
Lassi.
 — Millä me soudamme, kun ei ole airoja. Ja sitäpaitsi me
palellumme lautalle, kun ei ole vaatteita, sanoi Jallu. Parasta, kun
viritämme nuotion ja odotamme aamua.

— Mutta minulla on niin turkkilaisen nälkä, eikä ole enää

leipääkään, sanoi Lassi. — Kyllä me lämmintä saamme, kun
melomme oikein vahvasti seipäillä.

Mikko oli taas kähminyt verkkomökille ja toi nyt sieltä vanhan

sarkapalton, joka kai oli Lassin ja Jaakon isältä joskus sinne jäänyt
kalamatkoilla oltaessa. Toinenkin, vielä kuluneempi vanha takki löytyi
ja Mikko palasi meluten saaliineen.

— Nyt ei ole enää muusta puutetta kuin tuulesta, riemuittiin.

Sitä odotellen tehtiin nuotio ja jokainen sai nyt koettaa parastaan

tärinäin kertomisessa, että aika paremmin kuluisi.

Lassi oli huomannut eteläisellä ilmanrannalla pilven kasvavan ja

piti sitä silmällä. Kohta alkoikin haapa kalliolla hiljaa humista ja
veden pintaan syntyi tummia juovia. Pilvikin etelän taivaalla kasvoi
kasvamistaan ja siellä välähti joskus salama.

— Tuliko lautta hyvin kiinni? kysyi Lassi pojilta.

— Tuli varmasti.

Pian alkoivat laineet lipattaa kallion laitaan ja pojat tunsivat

selvästi tuulen kiihtyvän.

Nyt lautta irti ja mars matkalle! komensi Lassi. — Tulee pian sade
ja silloin ei ole täällä kovinkaan hauskat olot.
 Lautta kannatti hyvin. Melottiin tuulen avuksi sauvoimilla, ja lautta
eteni rannasta paremmin kuin olisi osattu odottaakaan.

— Tämäpä on suurenmoista! kehasivat pojat. Sarkaviitasta

laitettiin vielä purje, ja se lisäsi vauhtia. Jallu sai väliin lainata Lassille
takkiressuaan ja onneksi oli tuulikin lämmintä ja se kiihtyi joka hetki.
Laineet keinuttelivat jo lauttaa, niin että oli varottava siltä syvyyteen
suistumasta.

Ukkonenkin jyrähteli jo ja salamat valaisivat tummentuvaa

taivasta. Vakavina katselivat pojat mantereen rantaa ja vuoroin
taakseen, jossa taivas yhä synkkeni. Ulappa kuohui jo
valkopäälaineissa ja poikien täytyi laskeutua polvilleen lautalle
pysyäkseen sillä. Sitäpaitsi täytyi Lassin ja Jallun meloa voimiensa
takaa estääkseen kylmää, joka tahtoi väkisinkin puistatella ruumista.

Jyrisi yhä ankarammin, ja Mikko alkoi vetistellä, mutta ei sanonut

mitään. Häntä vaivasi se, että oli näin aiheuttanut Jaakon kanssa
heille kaikille yhteisen kärsimyksen. Olisi jo pitänyt tunnustaa, mutta
Mikko pelkäsi, että hänet heitettäisiin Jaakon kanssa uimaan.

Jaakko oli kovin kalpea. Hän ei miettinyt muuta, kuin että rannalle
päästyä on heti tunnustettava asia pojille, vaikkakin he kuinkakin
peittoaisivat. Ei mitenkään voisi jättää tunnustamatta. Ja nyt kun sen
tekisi, olisi kuranssauskin ehkä lievempi, kun pojat olivat väsyneitä.

Ranta oli enää vain noin puolen kilometrin päässä, kun jyrähti
entisiä ankarammin ja sadepilvi puhkesi. Vettä tuli, niin että romisi.

Pojat luulivat nyt jo voivansa loppumatkan uidakin hätätilassa ja se

antoi jälleen varmuuden tunnetta.
 — Jopa nyt aivan kaatamalla sataa, sanoi Jallu ja vilu tärisytti
pojan leukoja.

— Antaa tulla vain!

— No kyllä minun puolesta vaikka seipäitä. Siinä tämä poika

kestää, missä toinenkin, kehaisi Jallu.

Lautta alkoi kolista rantakivillä ja odottamatta sen kokonaan

rannalle ajautumista pojat kahlasivat maalle. Ei siitä ollutkaan pitkä
matka veneelle, joka oli heiltä karannut. Se vedettiin kiireesti maalle
ja sitten hurjaa juoksua kotiin. Vaahtopäälaineissa ei viitsitty enää
lähteä venhettä, soutamaan.

Vasta puolitiessä kotimatkaa huomasivat pojat, että heidän

vaatteensa olivat unohtuneet venheeseen.

— Jääkööt!

Peräkkäin paineltiin rantaa pitkin ja pellon poikki oikaistiin suoraan

saunaan.

Se oli illalla lämminnyt ja kiuas pohisi vielä, kun sitä vesitti.

— Hei pojat! Nyt otetaan oikein mustalaisen löylyt sen retken

kunniaksi!

Jaakko ja Mikko tekivät tunnustusta. Kovin heitä vapisutti.

— Sitä jo ajattelinkin, sanoi Lassi. — Kylläpä siitä vielä nahkanne

kuumenee.

— Mutta rankaisu pitää toimittaa ihmisiksi, tokaisi Mikko. — Mitäs

kiusasitte minua saaressa.
 Lassi mietti, että vähällä taitavat pojat siitä päästä, kun kerran
hyvin oli seikkailusta selvitty. Ja olihan ollut oikeastaan hauskakin se
lauttakyyti. Seikkailua!

Saunan ovi avattiin ja äidin pää pisti oviaukosta esiin.

— Ovatpahan toki vielä hengissä, sanoi hän. — Minä olen jo ollut

niin levoton teidän tähtenne. Tulkaa sitten lapsikullat syömään, kun
joudutte.

Lassin olisi tehnyt mieli selvittää matkansa seikkailu äidille, mutta

se jäi seuraavaan päivään. Nyt nautittiin löylystä, joka teki kovin
hyvää tervaiselle iholle.
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