FN6516

Stochastic Calculus in Finance II

Nicolas Privault

January 4, 2025 https://personal.ntu.edu.sg/nprivault/indext.html

 i

This course provides complements in stochastic calculus for the pricing and hedging of financial
derivatives, mainly using the martingale method. This includes optimal stopping for American
options and pricing and hedging in markets with jumps.
Stochastic asset price modeling using Brownian motion is reviewed in Chapter 1, and the
Black-Scholes model is presented from the angle of partial differential equation (PDE) methods in
Chapter 2, with the derivation of the Black-Scholes formula by transforming the Black-Scholes
PDE into the standard heat equation. A review of historical and implied volatility estimation is also
presented.
The martingale approach to pricing and hedging is then covered in Chapter 3, and complements
the PDE approach of Chapter 2 by recovering the Black-Scholes formula via a probabilistic
argument. A presentation of volatility estimation tools including historical and implied volatilities
is given in Section 2.4 with a comparison of the prices obtained by the Black-Scholes formula with
actual option price market data. Optimal stopping and exercise, with application to the pricing of
American options, are considered in Chapter 5, following the presentation of background material
on filtrations and stopping times in Chapter 4.
Stochastic calculus with jumps is dealt with in Chapter 6 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 7, in which we mostly focus on risk
minimizing strategies as markets with jumps are generally incomplete. The text is completed with
an appendix containing the needed probabilistic background.
The pdf file contains internal and external links, and 151 figures, including 17 animated figures,
e.g. Figures 1.9, 2.17, 5.2, 6.14, 6.16, 6.17, and 2 interacting 3D graphs in Figures 2.16 and 2.19,
that may require using Acrobat Reader for viewing on the complete pdf file.
This document also contains 95 exercises and 10 problems with complete solutions, and
includes 16 Python codes, e.g. on pages 45, 151 and 39 codes on pages 12, 12, 45, 48, 75, 166,
170, 181, 182. Supplementary exercises, problems and solutions are available from the textbook
Introduction to Stochastic Finance with Market Examples, Chapman & Hall/CRC Financial
Mathematics Series, 2022.
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.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 Contents

1 Modeling Market Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.1 Random Walks 1
1.2 Geometric Brownian Motion 7
1.3 Distribution of Market Returns 19
1.4 Gram-Charlier Expansions 23
Exercises 25

2 European Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
2.1 Financial Derivatives 27
2.2 Arbitrage and Risk-Neutral Measures 38
2.3 Black-Scholes Analysis 44
2.4 Historical Volatility 49
2.5 Implied Volatility 52
Exercises 59

3 Martingale Approach to Pricing and Hedging . . . . . . . . . . . . . . . . . . 69

3.1 Martingale Property of the Itô Integral 69
3.2 Risk-Neutral Probability Measures 73
3.3 Change of Measure and the Girsanov Theorem 77
3.4 Pricing by the Martingale Method 79
3.5 Hedging by the Martingale Method 85
Exercises 90

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

4 Optimal Stopping Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
4.1 Filtrations and Information Flow 113
4.2 Submartingales and Supermartingales 114
4.3 Optimal Stopping Theorem 117
4.4 Drifted Brownian Motion 122
Exercises 128

5 American Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

5.1 Perpetual American Put Options 131
5.2 PDE Method for Perpetual Put Options 137
5.3 Perpetual American Call Options 140
5.4 Finite Expiration American Options 144
5.5 PDE Method with Finite Expiration 147
Exercises 151

6 Stochastic Calculus for Jump Processes . . . . . . . . . . . . . . . . . . . . . . . 161

6.1 The Poisson Process 161
6.2 Compound Poisson Process 168
6.3 Stochastic Integrals and Itô Formula with Jumps 173
6.4 Stochastic Differential Equations with Jumps 184
6.5 Girsanov Theorem for Jump Processes 188
Exercises 194

7 Pricing and Hedging in Jump Models . . . . . . . . . . . . . . . . . . . . . . . . . 199

7.1 Risk-Neutral Probability Measures 199
7.2 Pricing in Jump Models 200
7.3 Exponential Lévy Models 202
7.4 Black-Scholes PDE with Jumps 204
7.5 Mean-Variance Hedging with Jumps 206
Exercises 210

Exercise Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213

Chapter 1 213
Chapter 2 216
Chapter 3 232
Chapter 4 274
Chapter 5 281
Chapter 6 303
Chapter 7 313
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
Articles 319
Preprints 321
Books 321

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

Author index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331

 List of Figures

1.1 Graph of 120 = (10 7 ) paths with n = 5 and k = 2

* .................. . . . 2
1.2 Two sample paths of one-dimensional Brownian motion . . . . . . . . . . . . . . 3
1.3 Sample paths of a one-dimensional Brownian motion . . . . . . . . . . . . . . . . 4
1.4 Brownian motion as a random walk* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.5 Statistics of one-dimensional Brownian paths vs. Gaussian distribution . . . . 6
1.6 Statistics of S&P 500 yearly return graphs from 1950 to 2022 . . . . . . . . . . . . 7
1.7 Returns vs. cumulative returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.8 “As if a whole new world was laid out before me.”* . . . . . . . . . . . . . . . . . 10
1.9 Geometric Brownian motion started at S0 = 1* . . . . . . . . . . . . . . . . . . . . . 12
1.10 Ten sample paths of geometric Brownian motion . . . . . . . . . . . . . . . . . . 13
1.11 Underlying market prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.12 Simulated geometric Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.13 Graph of the Gaussian Cumulative Distribution Function (CDF) . . . . . . . 16
1.14 Statistics of geometric Brownian paths vs. lognormal distribution . . . . . . 17
1.15 Market returns vs. normalized Gaussian returns . . . . . . . . . . . . . . . . . . . . 19
1.16 Empirical vs. Gaussian CDF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.17 Quantile-Quantile plot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.18 Empirical density vs. normalized Gaussian density . . . . . . . . . . . . . . . . . 21
1.19 Empirical density vs. normalized lognormal density . . . . . . . . . . . . . . . . 22
1.20 Empirical density vs. power density . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
1.21 Gram-Charlier expansions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
1.22 Sample path of a geometric Brownian motion . . . . . . . . . . . . . . . . . . . . 25

2.1 Comparison of WTI vs. Keppel price graphs . . . . . . . . . . . . . . . . . . . . . . . 28

2.2 Hang Seng index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.3 Two put option scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.4 Payoff function of a put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
2.5 Two call option scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
2.6 Payoff function of a call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

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 viii LIST OF FIGURES

2.7 Brent and WTI price graphs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

2.8 Price map of a four-way collar option . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
2.9 Payoff function of a four-way call collar option . . . . . . . . . . . . . . . . . . . . . 33
2.10 Four-way call collar payoff as a combination of call and put options* . . 34
2.11 Implied probabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.12 One hundred sample price paths used for the Monte Carlo method . . 38
2.13 Why apply discounting? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
2.14 Illustration of the self-financing condition (2.2.3) . . . . . . . . . . . . . . . . . . . 42
2.15 Graph of the Gaussian Cumulative Distribution Function (CDF) . . . . . . . 45
2.16 Black-Scholes call price map* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2.17 Time-dependent solution of the Black-Scholes PDE (call option)* . . . . . 46
2.18 Delta of a European call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.19 Black-Scholes put price function* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
2.20 Time-dependent solution of the Black-Scholes PDE (put option)* . . . . . . 48
2.21 Delta of a European put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
2.22 Underlying asset price vs. log-returns . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2.23 Historical volatility graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2.24 The fugazi: it’s a wazy, it’s a woozie. It’s fairy dust* . . . . . . . . . . . . . . . . . 52
2.25 Option price as a function of the volatility σ . . . . . . . . . . . . . . . . . . . . . . 53
2.26 Implied volatility of Asian options on light sweet crude oil futures . . . . . . 55
2.27 S&P500 option prices plotted against strike prices . . . . . . . . . . . . . . . . . 56
2.28 Market stock price of Cheung Kong Holdings . . . . . . . . . . . . . . . . . . . . . 56
2.29 Comparison of market call option prices vs. calibrated Black-Scholes prices
57
2.30 Market stock price of HSBC Holdings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
2.31 Comparison of market call option prices vs. calibrated Black-Scholes prices
58
2.32 Comparison of market put option prices vs. calibrated Black-Scholes prices
58
2.33 Call option price vs. underlying asset price . . . . . . . . . . . . . . . . . . . . . . . 59
2.34 Graphs of call/put payoff functions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
2.35 Statistics of geometric Brownian paths vs. lognormal distribution . . . . . . 63

3.1 Discretized drifted Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

3.2 Drifted Brownian paths under a shifted Girsanov measure . . . . . . . . . . . . 76
3.3 Payoff functions of bull spread and bear spread options . . . . . . . . . . . . . 91
3.4 Graphs of call/put payoff functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
3.5 Long call butterfly payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
3.6 Option price as a function of underlying asset price and time to maturity 108
3.7 Delta as a function of underlying asset price and time to maturity . . . . 108
3.8 Gamma as a function of underlying asset price and time to maturity . . 109
3.9 Option price as a function of underlying asset price and time to maturity 109
3.10 Delta as a function of underlying asset price and time to maturity . . . 110
3.11 Gamma as a function of underlying asset price and time to maturity . 110

4.1 Drifted Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

4.2 Evolution of the fortune of a poker player vs. number of games played 115
4.3 Convex function example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
4.4 Stopped process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
4.5 Sample paths of a gambling process (Mn )n∈N . . . . . . . . . . . . . . . . . . . . 122
4.6 Brownian motion hitting a barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
4.7 Drifted Brownian motion hitting a barrier . . . . . . . . . . . . . . . . . . . . . . . . . 124

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

LIST OF FIGURES ix

4.8 Hitting probabilities of drifted Brownian motion* . . . . . . . . . . . . . . . . . . 125

5.1 American put prices by exercising at τL for different values of L . . . . . . . 134

5.2 Animated graph of American put prices x 7→ fL (x)* . . . . . . . . . . . . . . . . 135
5.3 Option price as a function of L and of the underlying asset price . . . . . 136
5.4 Path of the American put option price on the HSBC stock . . . . . . . . . . . 136
5.5 American call prices by exercising at τL for different values of L . . . . . . 142
5.6 Animated graph of American call prices x 7→ fL (x)* . . . . . . . . . . . . . . . . 143
5.7 American call prices for different values of L . . . . . . . . . . . . . . . . . . . . . 143
5.8 Black-Scholes call option price vs. (x,t ) 7→ (x − K )+ . . . . . . . . . . . . . . . . . 145
5.9 Black-Scholes put option price vs. (x,t ) 7→ (K − x)+ . . . . . . . . . . . . . . . . . 146
5.10 Optimal frontier for the exercise of a put option . . . . . . . . . . . . . . . . . . 146
5.11 PDE estimates of finite expiration American put option prices . . . . . . . 148
5.12 Longstaff-Schwartz estimates of finite expiration American put prices . 149
5.13 Comparison between Longstaff-Schwartz and finite differences . . . . . 149
5.14 Butterfly payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

6.1 Sample path of a counting process (Nt )t∈R+ . . . . . . . . . . . . . . . . . . . . . . 162

6.2 Sample path of the Poisson process (Nt )t∈R+ . . . . . . . . . . . . . . . . . . . . . . 164
6.3 Sample path of the Poisson process (Nt )t∈R+ . . . . . . . . . . . . . . . . . . . . . . 167
6.4 Sample path of the compensated Poisson process (Nt − λt )t∈R+ . . . . . . 168
6.5 Probability density function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
6.6 Sample path of a compound Poisson process (Yt )t∈R+ . . . . . . . . . . . . . . 169
6.7 Sample path of a compensated compound Poisson process . . . . . . . . 173
6.8 Sample trajectories of a gamma process . . . . . . . . . . . . . . . . . . . . . . . . 181
6.9 Sample trajectories of a variance gamma process . . . . . . . . . . . . . . . . 181
6.10 Sample trajectories of an inverse Gaussian process . . . . . . . . . . . . . . . 182
6.11 Sample trajectories of a negative inverse Gaussian process . . . . . . . . 182
6.12 Sample trajectories of a stable process . . . . . . . . . . . . . . . . . . . . . . . . 182
6.13 USD/CNY Exchange rate data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
6.14 Geometric Poisson process* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
6.15 Ranking data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
6.16 Geometric compound Poisson process* . . . . . . . . . . . . . . . . . . . . . . . 186
6.17 Geometric Brownian motion with compound Poisson jumps* . . . . . . . 187
6.18 Share price with jumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188

S.1 Twenty sample paths of geometric Brownian motion . . . . . . . . . . . . . . . 215

S.2 Brownian crossings of level 1* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
S.3 Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
S.4 Risk-neutral pricing of a foreign exchange option . . . . . . . . . . . . . . . . . . 228
S.5 Delta hedging of a foreign exchange option . . . . . . . . . . . . . . . . . . . . . 228
S.6 Bitcoin XBT/USD order book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
S.7 Time spent by Brownian motion within a given range . . . . . . . . . . . . . . . 229
S.8 Lower bound vs. Black-Scholes call price . . . . . . . . . . . . . . . . . . . . . . . . 234
S.9 Lower bound vs. Black-Scholes put option price . . . . . . . . . . . . . . . . . . . 235
S.10 Bull spread option as a combination of call and put options* . . . . . . . 236
S.11 Bear spread option as a combination of call and put options* . . . . . . 236
S.12 Butterfly option as a combination of call options* . . . . . . . . . . . . . . . . . 238
S.13 Delta of a butterfly option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
S.14 Gaussian approximation of spread probability density function . . . . . . 248
S.15 Gaussian approximation of spread option prices . . . . . . . . . . . . . . . . . 248

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 x LIST OF FIGURES

S.16 Price of a binary call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251

S.17 Risky hedging portfolio value for a binary call option . . . . . . . . . . . . . . 252
S.18 Risk-free hedging portfolio value for a binary call option . . . . . . . . . . . 252
S.19 Black-Scholes price of the maximum chooser option . . . . . . . . . . . . . . 254
S.20 Delta of the maximum chooser option . . . . . . . . . . . . . . . . . . . . . . . . . 254
S.21 Black-Scholes price of the minimum chooser option . . . . . . . . . . . . . . . 255
S.22 Delta of the minimum chooser option . . . . . . . . . . . . . . . . . . . . . . . . . . 256
√
S.23 Sample path of dSt = St dBt / 1 − t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
S.24 Sample path of dSt = St2 dBt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
S.25 Sample path of dSt = St2 dBt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
S.26 “Infogrames” stock price curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
S.27 Hitting times of a straight line started at α < 0 . . . . . . . . . . . . . . . . . . . . 278
S.28 Hitting times of a straight line started at α < 0 . . . . . . . . . . . . . . . . . . . . 279
S.30 Sample path of the random walk (Sn )n∈N . . . . . . . . . . . . . . . . . . . . . . . 280
S.31 American butterfly payoff and price functions . . . . . . . . . . . . . . . . . . . 282
S.32 Perpetual vs. finite expiration American put option price . . . . . . . . . . . 283
S.33 American put price approximation. . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
S.34 Perpetual American binary put price map . . . . . . . . . . . . . . . . . . . . . . 294
S.35 Perpetual American binary call price map . . . . . . . . . . . . . . . . . . . . . . 295
S.36 Finite expiration American binary call price map . . . . . . . . . . . . . . . . . 297
S.37 Finite expiration American binary put price map . . . . . . . . . . . . . . . . . 298

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

 List of Tables

2.1 Call and put options on the Hang Seng Index (HSI). . . . . . . . . . . . . . . . . . 62

3.1 Call and put options on the Hang Seng Index (HSI) . . . . . . . . . . . . . . . . . 93
3.2 Contract summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

4.1 Martingales and stopping times . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

4.2 List of martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

5.1 Optimal exercise strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

6.1 Itô multiplication table with jumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

7.1 Market models and their properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

8.2 Call and put options on the Hang Seng Index (HSI) . . . . . . . . . . . . . . . . 237
8.3 Original call/put options on the Hang Seng Index (HSI) . . . . . . . . . . . . . 238

*Animated figures (work in Acrobat reader).

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 1

1. Modeling Market Returns

In an environment subject to risk and randomness, any result or prediction has to rely on a given
statistical model. This chapter reviews basic Gaussian modeling for the returns risky assets using
Brownian motion and geometric Brownian motion. We also include a statistical benchmarking of
such Gaussian-based models to actual market returns.

1.1 Random Walks 1

1.2 Geometric Brownian Motion 7
1.3 Distribution of Market Returns 19
1.4 Gram-Charlier Expansions 23
Exercises 25

1.1 Random Walks

Our approach to the modeling of the price of risky assets is based on the use of random walks
indexed by discrete or continuous time. We consider the random walk (Sn )n⩾0 , also called the
Bernoulli random walk, and defined by letting S0 := 0 and
n
Sn := ∑ Xk = X1 + · · · + Xn , n ⩾ 1,
k =1

where the increments (Xk )k⩾1 form a sequence of independent and identically distributed (i.i.d.)
Bernoulli random variables, with distribution

 P(Xk = +1) = p,


P(Xk = −1) = q, k ⩾ 1,


" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 2 Chapter 1. Modeling Market Returns

with p + q = 1. In other words, the random walk (Sn )n⩾0 can only evolve by going up or down by
one unit within the finite state space {0, 1, . . . , S}. We have

P(Sn+1 = k + 1 | Sn = k) = p and P(Sn+1 = k − 1 | Sn = k) = q,

k ∈ Z.
Proposition 1.1 The mean value of Sn can be expressed as
" #
n n
IE[Sn | S0 = 0] = IE ∑ Xk = ∑ IE [Xk ] = (2p − 1)n = ( p − q)n,
k =1 k =1

and its variance can be computed as

" #
n n
Var [Sn | S0 = 0] = Var ∑ Xk = ∑ Var [Xk ] = 4npq.
k =1 k =1

   
10 10
Figure 1.1 enumerates the 120 = = possible paths corresponding to n = 5 and k = 2,
7 3
which all have the same probability pn+k qn−k = p7 q3 of occurring.

7
Path number 29 out of 120
6
5
4
3
2
1
0
-1
-2
-3
0 1 2 3 4 5 6 7 8 9 10

   
10 10
Figure 1.1: Graph of 120 = = paths with n = 5 and k = 2.*
7 3

Proposition 1.2 The probability distribution of S2n , n ⩾ 1, is given by

 
2n
P(S2n = 2k | S0 = 0) = pn+k qn−k , −n ⩽ k ⩽ n. (1.1.1)
n+k

In addition, we note that in an even number of time steps, (Sn )n∈N can only reach an even state
in Z after starting from 0.

Similarly, in an odd number of time steps, (Sn )n∈N can only reach an odd state in Z after starting
from 0.
*Animated figure (works in Acrobat Reader).

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

1.1 Random Walks 3

Brownian Motion

The modeling of random assets in finance is mainly based on stochastic processes, which are families
(Xt )t∈I of random variables indexed by a time interval I. Brownian motion is a fundamental example
of a stochastic process.

Brown, 1828 observed the movement of pollen particles as described in “A brief account of
microscopical observations made in the months of June, July 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

Figure 1.2: Two sample paths of one-dimensional Brownian motion.

Einstein, 1905 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.

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.

Wiener, 1923 is credited, among other fundamental contributions, for the mathematical 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).

Itô, 1944 constructed the Itô integral with respect to Brownian motion, and the stochastic calculus
with respect to Brownian motion, which laid the foundation for the development of calculus for
random processes, see Itô, 1951 “On stochastic differential equations”, in Memoirs of the American
Mathematical Society.
Definition 1.3 The standard Brownian motion is a stochastic process (Bt )t∈R+ such that
1. B0 = 0 almost surely,
2. The sample paths t 7→ Bt are (almost surely) continuous.
3. For any finite sequence of times t0 < t1 < · · · < tn , the increments

Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btn − Btn−1

are independent.
4. For any times 0 ⩽ s < t, Bt − Bs is normally distributed with mean zero and variance t − s.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 4 Chapter 1. Modeling Market Returns

Bt3
Bt2

Bt1
0 t1 t2 t3

-1
0 0.2 0.4 0.6 0.8 1

Figure 1.3: Sample paths of a one-dimensional Brownian motion.

See e.g. Chapter 1 of Revuz and Yor, 1994 and Theorem 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 1.3.

Approximating Brownian motion as a random walk

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 (1.1.2)

with equal probabilities (1/2, 1/2), hence

1√ 1√
IE[∆Bt ] = ∆t − ∆t = 0,
2 2

and

 1 1
Var[∆Bt ] = IE (∆Bt )2 = ∆t + ∆t = ∆t.

2 2

Figure 1.4 presents a simulation of Brownian motion as a random walk with ∆t = 0.1.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

1.1 Random Walks 5
3

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

Figure 1.4: Construction of Brownian motion as a random walk.*

In order to recover the Gaussian distribution property of the random variable BT , we can split the
time interval [0, T ] into N subintervals
(tk−1 ,tk ], k = 1, 2, . . . , N,
of same length ∆t = T /N, where tk = kT /N, k = 0, 1, . . . N, and N is “large”.

0 T 2T T
N N

Letting √ √
Xk := ± T = ± N∆t, k = 1, 2, . . . N,
√ √
denote a sequence of symmetric Bernoulli random variables taking values in {− T , T }, with
equal probabilities (1/2, 1/2) and
√
r
T X
∆Btk := ± ∆t = ± = √k , k = 1, 2, . . . N,
N N
we can write
N
X1 + X2 + · · · + XN
BT ≃ ∑ ∆Bt k
= √
N
,
k =1
hence by the central limit theorem we recover the fact that BT has the centered Gaussian distribution
N (0, T ) with variance T , cf. point 4 of the above Definition 1.3 of Brownian motion, and the
illustration given in Figure 1.5.
Remark 1.4
i) The choice of the square root in (1.1.2) 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 codea below.
ii) According to this representation, the paths of Brownian motion are not differentiable,

* The animation works in Acrobat Reader on the entire pdf file.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 6 Chapter 1. Modeling Market Returns

although they are continuous by Property 2, as we have

√
∆Bt ± ∆t 1
≃ = ± √ ≃ ±∞, (1.1.3)
∆t ∆t ∆t
see e.g. Theorem 10.3 page 153 of Schilling and Partzsch, 2014.
a Download the corresponding IPython notebook that can be run here or here.

nsim=100; N=1000; t <- 0:N; dt <- 1.0/N; dev.new(width=16,height=7); # Using Bernoulli samples
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

Figure 1.5: Statistics of one-dimensional Brownian paths vs. Gaussian distribution.

The following code* plots the 72 yearly return graphs of the S&P 500 index from 1950 to 2022,
see Figure 1.6. The histogram of year-end returns is then fitted to a normalized Gaussian probability
density function.

* Download the corresponding IPython notebook that can be run here or here.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

 1.2 Geometric Brownian Motion 7

library(quantmod); getSymbols("^GSPC",from="1950-01-01",to="2022-12-31",src="yahoo")
stock<-Cl(`GSPC`); s=0;y=0;j=0;count=0;N=240;nsim=72; X = matrix(0, nsim, N)
for (i in 1:nrow(GSPC)){if (s==0 && grepl('-01-0',index(stock[i]))) {if (count==0 || X[y,N]>0)
{y=y+1;j=1;s=1;count=count+1;}}
if (j<=N) {X[y,j]=as.numeric(stock[i]);};if (grepl('-02-0',index(stock[i]))) {s=0;};j=j+1;}
t <- 0:(N-1); dt <- 1.0/N; 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))
m=mean(X[,N]/X[,1]-1);sigma=sd(X[,N]/X[,1]-1)
plot(t*dt, X[1,]/X[1,1]-1-m*t*dt, xlab = "", ylab = "", type = "l", ylim = c(-0.5, 0.5), col = 0,
xaxs='i',las=1, cex.axis=1.6)
for (i in 1:nsim){lines(t*dt, X[i,]/X[i,1]-1-m*t*dt, type = "l", col = i)}
lines(t*dt,sigma*sqrt(t*dt),lty=1,col="red",lwd=3);lines(t*dt,-sigma*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]/X[i,1]-1-m*N*dt, pch=1, lwd = 5, col = i)}
x <- seq(-0.5,0.5, length=100); px <- dnorm(x,0,sigma);par(mar = c(2,2,2,2))
H<-hist(X[,N]/X[,1]-1-m*N*dt,plot=FALSE);
plot(NULL , xlab="", ylab="", xlim = c(0, max(px,H$density)), ylim = c(-0.5,0.5),axes=F)
rect(0, H$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)

0.4

0.2

0.0

−0.2

−0.4

0.0 0.2 0.4 0.6 0.8

Figure 1.6: Statistics of 72 S&P 500 yearly return graphs from 1950 to 2022.

1.2 Geometric Brownian Motion

The market returns of an asset price process (St )t∈R+ over time can be estimated in various ways.
Definition 1.5 1. Standard returns are defined as
∆St St +∆t − St
:= . (1.2.1)
St St
2. Log-returns are defined as

∆St
 
St +∆t
∆ log St = log St +∆t − log St = log := log 1 + , t ⩾ 0. (1.2.2)
St St

Estimating market returns with

The package quantmod can be used to fetch financial data from various sources such as Yahoo!
Finance or the Federal Reserve Bank of St. Louis (FRED). It can be installed and run via the
following command.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 8 Chapter 1. Modeling Market Returns

install.packages("quantmod")
library(quantmod)
getSymbols("DEXJPUS",src="FRED") # Japan/U.S. Foreign Exchange Rate
getSymbols("CPIAUCNS",src='FRED') # Consumer Price Index
getSymbols("GOOG",src="yahoo") # Google Stock Price

The package yfinance can be similarly used in Python.

import pandas as pd
import yfinance as yf
# Google Stock Price
GOOG = yf.download("GOOG", start="2022-01-01", end="2023-12-31")

The following script allows us to fetch market price data using the quantmod package. Market
returns can be estimated using either the standard returns ∆St /St or the log-returns ∆ log St , t ⩾ 0,
which can be computed by the command diff(log(stock)), here with dt = 1/365.

getSymbols("^DJI",from="2007-01-03",to=Sys.Date(),src="yahoo")
stock=Ad(`DJI`)
chartSeries(stock,up.col="blue",theme="white")
stock.logrtn=diff(log(stock)); # log returns
stock.rtn=(stock-lag(stock))/lag(stock); # standard returns
chartSeries(stock.rtn,up.col="blue",theme="white")
n = length(!is.na(stock.rtn))

The adjusted close price Ad() is the closing price computed after adjustments for applicable splits
and dividend distributions.
stock.rtn [2007−01−04/2022−12−23] stock [2007−01−03/2022−12−23]
Last 0.00531387123927578 Last 33203.929688
0.10

35000

0.05
30000

25000
0.00

20000

−0.05

15000

−0.10

10000

−0.15

Jan 04 Jul 01 Apr 01 Jan 04 Oct 01 Jul 01 Apr 02 Jan 02 Oct 01 Jul 01 Apr 01 Jan 04 Oct 03 Jul 03 Apr 02 Jan 02 Oct 01 Jul 01 Apr 01 Jan 03 Jan 03 Jul 01 Apr 01 Jan 04 Oct 01 Jul 01 Apr 02 Jan 02 Oct 01 Jul 01 Apr 01 Jan 04 Oct 03 Jul 03 Apr 02 Jan 02 Oct 01 Jul 01 Apr 01 Jan 03
2007 2008 2009 2010 2010 2011 2012 2013 2013 2014 2015 2016 2016 2017 2018 2019 2019 2020 2021 2022 2007 2008 2009 2010 2010 2011 2012 2013 2013 2014 2015 2016 2016 2017 2018 2019 2019 2020 2021 2022

(a) Stock returns. (b) Cumulative stock returns.

Figure 1.7: Returns vs. cumulative returns.

The package yfinance can be similarly used in Python.
import numpy as np; import pandas as pd; import yfinance as yf
import matplotlib.pyplot as plt # Get stock data
stock_data = yf.download("^DJI", start="2007-01-03", end=pd.to_datetime("today"))
stock = stock_data["Adj Close"] # Extract adjusted close prices
stock_logrtn = stock.apply(lambda x: np.log(x)).diff() # Calculate log returns
stock_rtn = (stock - stock.shift(1)) / stock.shift(1) # Calculate standard returns
plt.subplot(1, 2, 1); stock_rtn.plot(color="blue");plt.title("Returns Chart");
plt.subplot(1, 2, 2); stock.plot(color="blue"); plt.title("Stock Chart"); # Plot stock chart
plt.tight_layout(); plt.show() # Plot returns chart
n = stock_rtn.count() # Calculate the number of non-NaN returns

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

1.2 Geometric Brownian Motion 9

Proposition 1.6 The sequence (Stk )k=1,...,N of market prices can be recovered from the sequence
of standard returns
∆St0 St − St0 ∆StN−1 St − StN−1
= 1 ,..., = N
St0 St0 StN−1 StN−1
from the telescoping product identity
n n  ∆Stk−1

Stk
Stn = S0 ∏ = S0 ∏ 1 + , 1 ⩽ n ⩽ N. (1.2.3)
k=1 Stk−1 k =1 Stk−1

Using log-returns, we have similarly

!
n n
Stn = S0 exp ∑ ∆ log Stk = S0 ∏ e ∆ log Stk , 1 ⩽ n ⩽ N.
k =1 k =1

The next code recovers cumulative returns from standard market returns, according to (1.2.3).

stock<-stock[!is.na(stock.rtn)];stock.rtn<-stock.rtn[!is.na(stock.rtn)]
times=index(stock);dev.new(width=16,height=7);par(mfrow=c(1,2))
plot(times,stock.rtn,pch=19,xaxs="i",yaxs="i",cex=0.03,col="blue", ylab="", xlab="", main = 'Asset
returns', las=1, cex.lab=1.8, cex.axis=1.8, lwd=3)
segments(x0 = times, x1 = times, y0 = 0, y1 = stock.rtn,col="blue")
plot(times,100 * cumprod(1 + as.numeric(stock.rtn)),type='l',col='black',main = "Asset prices",ylab="",
cex=0.1,cex.axis=1,las=1)

The package yfinance can be similarly used in Python.

# Remove NaN values from stock and stock_rtn

stock = stock[~np.isnan(stock_rtn)]; stock_rtn = stock_rtn[~np.isnan(stock_rtn)]
times = stock.index; plt.subplot(1, 2, 1); plt.plot(times, stock_rtn, color='blue')
plt.xlabel('Time'); plt.ylabel('Asset Returns')
plt.title('Asset Returns'); plt.xticks(rotation=90)
plt.grid(True) # Plot asset returns
plt.subplot(1, 2, 2); cumulative_returns = (1 + stock_rtn.astype(float)).cumprod() * 100
plt.plot(times, cumulative_returns, color='black'); plt.xlabel('Time')
plt.ylabel('Asset Prices'); plt.title('Asset Prices'); plt.xticks(rotation=90); plt.grid(True)
plt.tight_layout(); plt.show(); # Plot asset prices

Geometric Brownian Motion

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 “Rational theory
of warrant pricing” by Paul Samuelson, Industrial Management Review, p. 13-32, 1965.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 10 Chapter 1. Modeling Market Returns

Figure 1.8: Clark, 2000 “As if a whole new world was laid out before me.”*

The evolution of a riskless bank account value (At )t∈R+ is constructed from standard returns,
defined as follows:
At +∆t − At ∆At
= r∆t, i.e = r∆t.
At At
This equation can be regarded as a discretization of the differential equation

dAt
At′ = = rAt , t ⩾ 0,
dt
which has the solution

At = A0 e rt , t ⩾ 0, (1.2.4)

where r > 0 is the risk-free interest rate.†

In what follows, we will model the risky asset price process (St )t∈R+ using standard returns, from
the equation

St +∆t − St ∆St
= = µ∆t + σ ∆Bt , t ⩾ 0, (1.2.5)
St St

which can be solved numerically according to the following and Python codes.

N=2000; t <- 0:N; dt <- 1.0/N;mu=0.5; sigma=0.2; nsim <- 10; S <- matrix(0, nsim, N+1)
Z <- matrix(rnorm(nsim*N,mean=0,sd=sqrt(dt)), nsim, N+1)
for (i in 1:nsim){S[i,1]=1.0;
for (j in 1:N+1){S[i,j]=S[i,j-1]*(1 + mu*dt+sigma*Z[i,j])}}
plot(t*dt, rep(0, N+1), xlab = "Time", ylab = "Geometric Brownian motion", lwd=2, ylim =
c(min(S),max(S)), 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, S[i, ], lwd=2, type = "l", col = i)}

* Click on the figure to play the video (works in Acrobat Reader on the entire pdf file).
†“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.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

1.2 Geometric Brownian Motion 11

import numpy as np; import matplotlib.pyplot as plt

%matplotlib
N = 2000; t = np.arange(0, N+1); dt = 1.0 / N; mu = 0.5; sigma = 0.2; nsim = 10
X = np.zeros((nsim, N+1)); Z = np.random.normal(0, np.sqrt(dt), (nsim, N+1))
for i in range(nsim):
X[i, 0] = 1.0
for j in range(1, N+1):
X[i, j] = X[i, j-1] + mu * X[i, j-1] * dt + sigma * X[i, j-1] * Z[i, j]
plt.plot(t*dt, np.zeros(N+1), color='black', linewidth=2)
plt.xlabel('Time'); plt.ylabel('Geometric Brownian motion'); plt.xlim(0, N*dt)
plt.ylim(np.min(X), np.max(X)); plt.xticks(fontsize=12); plt.yticks(fontsize=12)
for i in range(nsim):
plt.plot(t*dt, X[i, :], linewidth=2)
plt.show()

The following proposition gives the explicit solution to (1.2.5) regarded as a discretization of the
stochastic differential Equation (1.2.6) below.

Proposition 1.7 — Geometric Brownian motion. The solution of the stochastic differential
equation

dSt = µSt dt + σ St dBt (1.2.6)

is given by
   
1 2
St = S0 exp σ Bt + µ − σ t , t ⩾ 0. (1.2.7)
2

Proof. Using (1.2.5), the log-returns (1.2.2) of an asset priced (St )t∈R+ satisfy
dSt S − St
= t +dt = µdt + σ dBt .
St St
Hence, using the second order approximation log(1 + x) ≃ x − x2 /2 as x tends to zero, we have
d log St ≃ log St +dt − log St
S
= log t +dt
S
 t
− St

S
= log 1 + t +dt
St
 
dSt
= log 1 +
St
= log(1 + µdt + σ dBt )
1
= µdt + σ dBt − ( µdt + σ dBt )2
2
µ2 σ2
≃ µdt + σ dBt − (dt )2 − µσ dBt • dt − (dBt )2
2 2
σ2
≃ µdt − dt + σ dBt , t ⩾ 0.
2
By integration over the time interval [0,t ] we find
wt
log St = log S0 + d log Ss
0

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 12 Chapter 1. Modeling Market Returns
wt σ2 w t wt
= µds − ds + σ dBs
0 2 0 0
σ 2t
= µt − + σ Bt ,
2

which yields (1.2.7) after exponentiation. □

The next Figure 1.9 presents an illustration of the geometric Brownian process of Proposition 1.7
according to the following and Python codes.

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

Figure 1.9: 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=0.2; mu=0.5

Z <- rnorm(N,mean=0,sd=sqrt(dt));
plot(t*dt, exp(mu*t*dt), xlab = "time", ylab = "Geometric Brownian motion", type = "l", ylim = c(0.75,
2), col = 1,lwd=3)
lines(t*dt, exp(sigma*c(0,cumsum(Z))+mu*t*dt-sigma*sigma*t*dt/2),xlab = "time",type = "l",ylim = c(0,
4), col = 'blue', xaxs='i', yaxs='i')

import numpy as np; import matplotlib.pyplot as plt

%matplotlib
N = 1000; t = np.arange(0, N+1); dt = 1.0 / N; sigma = 0.2; mu = 0.5
Z = np.random.normal(0, np.sqrt(dt), N)
GBM = np.exp(sigma * np.concatenate(([0], np.cumsum(Z))) + mu * t * dt - (sigma**2) * t * dt / 2)
plt.plot(t*dt, np.exp(mu * t * dt), color='blue', linewidth=3, label='Expected GBM')
plt.plot(t*dt, GBM, color='red', linewidth=1.5, label='Simulated GBM')
plt.xlabel('Time'); plt.ylabel('Geometric Brownian motion')
plt.xlim(0, N*dt); plt.ylim(0.75, 2); plt.legend(); plt.grid(True); plt.show()

Multiple sample paths of the solution (1.2.7) to (1.2.6) can also be simulated by the following
and Python codes.

* The animation works in Acrobat Reader on the entire pdf file.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

1.2 Geometric Brownian Motion 13

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)}

import numpy as np; import matplotlib.pyplot as plt

%matplotlib
N = 2000; t = np.arange(0, N+1); dt = 1.0 / N; mu = 0.5; sigma = 0.2; nsim = 10
X = np.random.normal(0, np.sqrt(dt), (nsim, N))
X = np.concatenate((np.zeros((nsim, 1)), np.cumsum(X, axis=1)), axis=1)
for i in range(nsim): X[i, :] = np.exp(mu * t * dt + sigma * X[i, :] - (sigma**2) * t * dt / 2)
plt.plot(t*dt, np.zeros(N+1), color='black', linewidth=1)
plt.xlabel('Time'); plt.ylabel('Geometric Brownian motion'); plt.xlim(0, N*dt)
plt.ylim(np.min(X), np.max(X)); plt.xticks(fontsize=12); plt.yticks(fontsize=12)
for i in range(nsim): plt.plot(t*dt, X[i, :], linewidth=1)
plt.show()

Figure 1.10 presents sample paths of geometric Brownian motion.

5
Geometric Brownian motion

1
0.0 0.2 0.4 0.6 0.8 1.0
Time

Figure 1.10: Ten sample paths of geometric Brownian motion (St )t∈R+ .

The next and Python codes compare geometric Brownian motion simulations to asset price data.

library(quantmod); getSymbols("0005.HK",from="2016-02-15",to="2017-05-11",src="yahoo")
Marketprices<-Ad(`0005.HK`);
returns = (Marketprices-lag(Marketprices)) / Marketprices
sigma=sd(as.numeric(returns[-1])); r=mean(as.numeric(returns[-1]))
N=length(Marketprices); t <- 0:N; a=(1+r)*(1-sigma)-1;b=(1+r)*(1+sigma)-1
X <- matrix((a+b)/2+(b-a)*rnorm( N-1, 0, 1)/2, 1, N-1)
X <- as.numeric(Marketprices[1])*cbind(0,t(apply((1+X),1,cumprod))); X[,1]=Marketprices[1];
x=seq(100,100+N-1); dates <- index(Marketprices)
GBM<-xts(x =X[1,], order.by = dates); myPars <- chart_pars();myPars$cex<-1.4
myTheme <- chart_theme();myTheme$col$line.col <- "blue"; myTheme$rylab <- FALSE;
chart_Series(Marketprices,pars=myPars, theme = myTheme);
dexp<-as.numeric(Marketprices[1])*exp(r*seq(1,305)); ddexp<-xts(x =dexp, order.by = dates)
dev.new(width=16,height=8); par(mfrow=c(1,2));
add_TA(exp(log(ddexp)), on=1, col="black",layout=NULL, lwd=4 ,legend=NULL)
graph <- chart_Series(GBM,theme=myTheme,pars=myPars); myylim <- graph$get_ylim()
graph <- add_TA(exp(log(ddexp)), on=1, col="black",layout=NULL, lwd=4 ,legend=NULL)
myylim[[2]] <- structure(c(min(Marketprices),max(Marketprices)), fixed=TRUE)
graph$set_ylim(myylim); graph

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 14 Chapter 1. Modeling Market Returns

import numpy as np; import pandas as pd; import yfinance as yf

from matplotlib import pyplot as plt
data = yf.download("0005.HK", start="2016-02-15", end="2017-05-11", progress=False)
Marketprices = data['Adj Close'];
returns = (Marketprices - Marketprices.shift(1)) / Marketprices
sigma = np.std(returns[1:]); r = np.mean(returns[1:]); N = len(Marketprices);
t = np.arange(0, N); a = (1 + r) * (1 - sigma) - 1; b = (1 + r) * (1 + sigma) - 1
X = np.array([(a + b) / 2 + (b - a) * np.random.normal(0, 1, N-1) / 2])
X = np.concatenate(([Marketprices[0]], Marketprices[0]*np.cumprod(1 + X)))
x = np.arange(100, 100 + N); dates = Marketprices.index; GBM = pd.Series(X, index=dates)
Y = Marketprices[0]*pd.Series(np.exp(r * np.arange(1, N+1)), index=dates)
fig = plt.figure(figsize=(16, 8)); ax1 = fig.add_subplot(121)
ax1.plot(Marketprices, color='blue', linewidth=2)
ax1.set_ylabel('Price'); ax1.set_xlabel('Date'); ylim1 = ax1.get_ylim()
ax2 = fig.add_subplot(122); ax2.plot(GBM, color='blue', linewidth=2)
ax2.plot(Y, color='black', linewidth=2)
ax2.set_ylabel('GBM'); ax2.set_xlabel('Date'); ax2.set_ylim(ylim1)
plt.tight_layout(); plt.show()

Figure 1.11 presents a graph of underlying asset price market data, which is compared to the
geometric Brownian motion simulation of Figure 1.10 in Figure 1.12.

2016−02−15 / 2017−05−10 2016−02−15 / 2017−05−10 60

0005.HK 0005.HK
56 58
rt
e
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

Figure 1.11: 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

Figure 1.12: Graph of simulated geometric Brownian motion.

The package Sim.DiffProc can be used to estimate the coefficients of a geometric Brownian
motion fitting observed market data.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

1.2 Geometric Brownian Motion 15

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=0.01,
theta2=0.01),pmle="euler")

In the next proposition, we compute the probability distribution of geometric Brownian motion at
any given time.

Proposition 1.8 At any time T > 0, the random variable

2 /2)T
ST := S0 e σ BT +(µ−σ

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, (1.2.8)
xσ 2πT

with log-variance σ 2 and log-mean ( µ − σ 2 /2)T + log S0 , see Figure 2.35.

Proof. For all x ∈ R, we have

2
P(ST ⩽ x) = P S0 e σ BT +(µ−σ /2)T ⩽ x

σ2
   
x
= P σ BT + µ − T ⩽ log
2 S0
2
    
1 x σ
= P BT ⩽ log − µ − T
σ S0 2
w (log(x/S0 )−(µ−σ 2 /2)T )/σ 2 dy
= e −y /(2T ) √
−∞ 2πT
w (log(x/S0 )−(µ−σ 2 /2)T )/(σ √T ) 2 dz
= e −z /2 √
−∞ 2π
2
    
1 x σ
= Φ √ log − µ − T ,
σ T S0 2

where

wx 2 /2 dy
Φ (x ) : = e −y √ , x ∈ R, (1.2.9)
−∞ 2πT

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.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 16 Chapter 1. Modeling Market Returns
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

Figure 1.13: Graph of the Gaussian Cumulative Distribution Function (CDF).

After differentiation with respect to x, we find the lognormal probability density function

dP(ST ⩽ x)
f (x ) =
dx
∂ w (log(x/S0 )−(µ−σ 2 /2)T )/σ −y2 /(2T ) dy
= e √
∂ x −∞ 2πT
σ2
    
∂ 1 x
= Φ √ log − µ − T
∂x σ T S0 2
σ2
    
1 1 x
= √ ϕ √ log − µ − T
xσ T 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) = Φ′ (y) := √ e −y /2 , y ∈ R,
2π
denotes the standard Gaussian probability density function. □

The next code is generating sample paths of geometric Brownian motion together with the
histogram of terminal values fitted to the lognormal probability density function (1.2.8), see
Figure 2.35.
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="")

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

1.2 Geometric Brownian Motion 17

3.0

2.5

2.0

1.5

1.0

0.0 0.2 0.4 0.6 0.8 1.0

time

Figure 1.14: Statistics of geometric Brownian paths vs. lognormal distribution.

Time-dependent coefficients
The above construction can be extended to time-dependent interest rate, drift and volatility processes
(r (t ))t∈R+ , ( µ (t ))t∈R+ and (σ (t ))t∈R+ . In this case, we let (At )t∈R+ be the risk-free asset with
price given by
dAt
= r (t )dt, A0 = 1, t ⩾ 0,
At
i.e. rt
r (s)ds
At = A0 e 0 , t ⩾ 0,
and the price process (St )t∈[0,T ] is defined by the stochastic differential equation
dSt = µ (t )St dt + σ (t )St dBt , t ⩾ 0,
i.e., in integral form,
wt wt
St = S0 + µ (u)Su du + σ (u)Su dBu , t ⩾ 0,
0 0

with solution
w wt  
t 1 2
St = S0 exp σ (s)dBs + µ (s) − σ (s) ds ,
0 0 2
t ∈ R+ .
Moments and cumulants of random variables
In the sequel we will use the sequence (κn (X ))n⩾1 of cumulants of a random variable X, defined
from its Moment Generating Function (MGF)
tn
MX (t ) := IE e tX = 1 + ∑ IE[X n ],
 
(1.2.10)
n⩾1 n!

for t in a neighborhood of 0, see Thiele, 1899.

Definition 1.9 The cumulants of a random variable X are the coefficients (κn (X ))n⩾1 appearing
in the series expansion
tn
log IE e tX =
 
∑ κn (X ) n! , (1.2.11)
n⩾1

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 18 Chapter 1. Modeling Market Returns

of the logarithmic moment generating function (log-MGF) of X.

The first cumulants of X can be identified as follows.
a) First moment and cumulant. We have κ1 (X ) = IE[X ].
b) Variance and second cumulant. We have

κ2 (X ) = IE X 2 − (IE[X ])2 = IE (X − IE[X ])2 ,

   

p
and κ2 (X ) is the standard deviation of X.
c) The third cumulant of X is given as the third central moment

κ3 (X ) = IE[(X − IE[X ])3 ].

d) Similarly, the fourth cumulant of X satisfies

κ4 (X ) = IE[(X − IE[X ])4 ] − 3(κ2 (X ))2

2
= IE[(X − IE[X ])4 ] − 3 IE (X − IE[X ])2 .


Example: Gaussian moments and cumulants

When X is centered we have κ1X = 0 and κ2X = IE X 2 = Var [X ], and X becomes Gaussian if and
 

only if κnX = 0, n ⩾ 3, i.e.

κnX = 1{n=2} σ 2 , n ⩾ 1,
or
κ1X , κ2X , κ3X , κ4X , . . . = (0, σ 2 , 0, 0, . . .).

Example: Poisson moments and cumulants

In the particular case of a Poisson random variable Z ≃ P (λ ) with intensity λ > 0, we have
IEλ e tZ = ∑ e nt P(Z = n)
 
n⩾0
(λ e t )n
= e −λ ∑ n!
n⩾0
t
= e λ ( e −1) , t ∈ R+ , (1.2.12)
hence κnZ = λ , n ⩾ 1, or

κ1Z , κ2Z , κ3Z , κ4Z , . . . = (λ , λ , λ , λ , . . .),

Definition 1.10 i) The skewness of X is defined as

IE (X − IE[X ])3
 
κ3 (X )
SkX := = .
(κ2 (X ))3/2 (IE[(X − IE[X ])2 ])3/2
ii) The excess kurtosis of X is defined as

κ4 ( X ) IE[(X − IE[X ])4 ]

EKX := = − 3.
(κ2 (X ))2 (IE[(X − IE[X ])2 ])2

The cumulants of X were originally called “semi-invariants” due to the property κn (X + Y ) =

κn (X ) + κn (Y ), n ⩾ 1, when X and Y are independent random variables. Indeed, in this case we
have
tn
∑ κn (X + Y ) n! = log IE et (X +Y )
 

n⩾1

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

 1.3 Distribution of Market Returns 19

= log IE e tX IE e tY
   

= log IE e tX + log IE e tY
   

tn tn
= ∑ κn (X ) + ∑ κn (Y )
n⩾1 n! n⩾1 n!

tn
= ∑ κn (X ) + κn (Y ) ,
n⩾1 n!

showing that κn (X + Y ) = κn (X ) + κn (Y ), n ⩾ 1.

1.3 Distribution of Market Returns

Market returns vs. Gaussian and power tails
Consider for example the market returns data obtained from fetching DJI and STI index data using
the package quantmod and the following scripts.
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)
dev.new(width=16,height=8)
plot(times,returns,pch=19,xaxs="i",yaxs="i",cex=0.03,col="blue", ylab="", xlab="", main = '', las=1,
cex.lab=1.8, cex.axis=1.8, lwd=3)
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))

Figure 1.15 shows 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| ⩽ 3σ ) = 0.9973002.

0.05

0.00

−0.05

1995 2000 2005 2010 2015

Figure 1.15: Market returns (blue) vs. normalized Gaussian returns (red).

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 20 Chapter 1. Modeling Market Returns

stock.ecdf=ecdf(as.vector(stock.rtn));x <- seq(-0.15, 0.15, length=200);px <- pnorm((x-m)/s)

dev.new(width=16,height=8)
plot(stock.ecdf, xlab = '', col="red",ylab = '', ylim=c(-0.002,1.002), main = '', xaxs="i", yaxs="i", las=1,
cex.lab=1.8, cex.axis=1.8, lwd=4)
lines(x, px, type="l", lty=2, col="blue",xlab="",ylab="", main="", lwd=4)
legend("topleft", legend=c("Empirical CDF", "Gaussian CDF"),col=c("red", "blue"), lty=1:2, cex=2, lwd =
4);grid(lwd = 3)

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

Figure 1.16: Empirical vs. Gaussian CDF.

The following Quantile-Quantile plot is plotting the normalized empirical quantiles against the
standard Gaussian quantiles, and is obtained with the qqnorm(returns) command.

dev.new(width=16,height=8)
qqnorm(returns, col = "blue", xaxs="i", yaxs="i", las=1, cex.lab=1.4, cex.axis=1, lwd=3)
grid(lwd = 2)

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

Figure 1.17: Quantile-Quantile plot.

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1.3 Distribution of Market Returns 21

The following Kolmogorov-Smirnov test clearly rejects the null (normality) hypothesis of market
returns.

n = sum(is.na(returns))+sum(!is.na(returns));x=seq(1,n);y=rnorm(n,mean=m,sd=s)
ks.test(y,"pnorm",mean=m,sd=s)
ks.test(returns,"pnorm",mean=m,sd=s)

One-sample Kolmogorov-Smirnov test

data: returns
D = 0.075577, p-value < 2.2e-16
alternative hypothesis: two-sided

The mismatch in distributions observed in Figures 1.15-1.17 can be further illustrated by the
empirical probability density plot in Figure 1.18, which is obtained from the following code.

dev.new(width=16,height=8)
x <- seq(-0.25, 0.25, length=100);qx <- dnorm(x,mean=m,sd=s)
stock.dens=density(stock.rtn,na.rm=TRUE)
plot(stock.dens, xlab = 'x', lwd=4, col="red",ylab = '', main = '', xlim =c(-0.1,0.1), ylim=c(0,65),
xaxs="i", yaxs="i", las=1, cex.lab=1.8, cex.axis=1.8)
lines(x, qx, type="l", lty=2, lwd=4, col="blue",xlab="x value",ylab="Density", main="")
legend("topleft", legend=c("Empirical density", "Gaussian density"),col=c("red", "blue"), lty=1:2,
cex=1.5);grid(lwd = 2)

Empirical density
60 Gaussian density

50

40

30

20

10

0
−0.10 −0.05 0.00 0.05 0.10
x

Figure 1.18: Empirical density vs. normalized Gaussian density.

Form the above figure, we note that market returns have kurtosis higher than that of the normal
distribution, i.e. their distribution is leptokurtic, in addition to showing some negative skewness.

The next code and graph present a comparison of market prices to a calibrated lognormal
distribution.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 22 Chapter 1. Modeling Market Returns

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)

0.00012
Empirical density
Lognormal density
0.00010

0.00008

0.00006

0.00004

0.00002

5000 10000 15000 20000 25000 30000 35000

Figure 1.19: 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 /|x|α , |x| → ∞, can provide a better fit of empirical probability
density functions, as shown in Figure 1.20.

Empirical density
60 Power density

50

40

30

20

10

0
−0.10 −0.05 0.00 0.05 0.10

Figure 1.20: 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 script.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

 1.4 Gram-Charlier Expansions 23

install.packages("pracma")
library(pracma); x <- seq(-0.25, 0.25, length=1000)
stock.dens=density(returns,na.rm=TRUE, from = -0.1, to = 0.1, n = 1000)
a<-rationalfit(stock.dens$x, stock.dens$y, d1=2, d2=2)
dev.new(width=16,height=8)
plot(stock.dens$x,stock.dens$y, lwd=4, type = "l",xlab = '', col="red",ylab = '', main = '', xlim
=c(-0.1,0.1), ylim=c(0,65), xaxs="i", yaxs="i", las=1, cex.lab=1.8, cex.axis=1.8)
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,col="blue",xlab="x value",lwd=4, ylab="Density",main="")
legend("topleft", legend=c("Empirical density", "Power density"),col=c("red", "blue"), lty=1:2,
cex=1.5);grid(lwd = 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 → ±∞.

1.4 Gram-Charlier Expansions

In this section, we search for a better fit of market return distributions using the additional informa-
tion provided by higher order moments. Let now
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,
−∞

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. 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.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 24 Chapter 1. Modeling Market Returns

Proposition 1.11 (Proposition 2.1 in Tanaka, Yamada, and T. Watanabe, 2010) The Gram-
Charlier expansion of the continuous probability density function φX (x) of a random variable X
is given by

φX ( x ) =
! ! !
1 x − κ1 (X ) 1 x − κ1 (X ) ∞
x − κ1 (X )
p ϕ p +p ϕ p ∑ cn Hn p ,
κ2 (X ) κ2 (X ) κ2 ( X ) κ2 (X ) n=3 κ2 (X )

where c0 = 1, c1 = c2 = 0, and the sequence (cn )n⩾3 is given from the cumulants (κn (X ))n⩾1
of X as
[n/3]
1 κl1 (X ) · · · κlm (X )
cn = ∑ ∑ , n ⩾ 3.
(κ2 (X )) m=1 l1 +···+lm =n m!l1 ! · · · lm !
n/2
l1 ,...,lm ⩾3

The coefficients c3 and c4 can be expressed from the skewness κ3 (X )/(κ2 (X ))3/2 and the excess
kurtosis κ4 (X )/(κ2 (X ))2 as
κ3 (X ) κ4 (X )
c3 = and c4 = .
3!(κ2 (X ))3/2 4!(κ2 (X ))2
a) The second-order expansion
!
(1) 1 x − κ1 (X )
φX ( x ) =p ϕ p
κ2 (X ) κ2 ( X )

corresponds to normal moment matching approximation.

b) The third-order expansion is given by
!! !
(3) 1 x − κ1 ( X ) x − κ1 ( X )
φX ( x ) = p 1 + c3 H3 p ϕ p .
κ2 (X ) κ2 (X ) κ2 (X )

c) The fourth-order expansion is given by

(4)
φX ( x )
! !! !
1 x − κ1 (X ) x − κ1 (X ) x − κ1 (X )
=p 1 + c3 H3 p + c4 H4 p ϕ p .
κ2 (X ) κ2 (X ) κ2 (X ) κ2 (X )

install.packages("SimMultiCorrData");install.packages("PDQutils")
library(SimMultiCorrData);library(PDQutils)
dev.new(width=16,height=8);m<-calc_moments(returns[!is.na(returns)]);
x <- stock.dens$x; qx <- dnorm(x,mean=m[1],sd=m[2])
plot(x,stock.dens$y, xlab = 'x', type = 'l', lwd=4, col="red",ylab = '', main = '', xlim =c(-0.1,0.1),
ylim=c(0,65), xaxs="i", yaxs="i", las=1, cex.lab=1.8, cex.axis=1.8)
grid(lwd = 2); lines(x, qx, type="l", lty=2, lwd=4, col="blue")
cumulants<-c(m[1],m[2]**2);d2 <- dapx_edgeworth(x, cumulants)
lines(x, d2, type="l", lty=2, lwd=4, 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=4, 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=4, 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=1.5)

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

1.4 Gram-Charlier Expansions 25

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

Figure 1.21: Gram-Charlier expansions

Exercises
Exercise 1.1 Let c > 0. Using the definition of Brownian motion (Bt )t∈R+ , show that:
a) (Bc+t − Bc )t∈R+ is a Brownian motion.
b) (cBt/c2 )t∈R+ is a Brownian motion.

Exercise 1.2 Solve the stochastic differential equation

dSt = µSt dt + σ St dBt , (1.4.1)

defining geometric Brownian motion (St )t∈R+ , where µ, σ ∈ R.

4
St
ert
3.5

2.5
St
2

1.5

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

Figure 1.22: Sample path of (1.4.1) with r = 1 and σ 2 = 0.5.

Exercise 1.3
a) Using the Gaussian moment generating function (MGF) formula, compute the n-th order
moment IE[Stn ] for all n ⩾ 1.
b) Compute the lognormal mean and variance
2
IE[St ] = S0 e rt and Var[St ] = S02 e 2rt e σ t − 1 , t ⩾ 0.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 26 Chapter 1. Modeling Market Returns
(1) (2)
Exercise 1.4 Consider two assets whose prices St , St at time t ∈ [0, T ] follow the geometric
Brownian dynamics
(1) (1) (1) (1) (2) (2) (2) (2)
dSt = µSt dt + σ1 St dWt and dSt = µSt dt + σ2 St dWt ,
(1)
(2)

t ∈ [0, T ], where Wt t∈[0,T ] , Wt t∈[0,T ] are two Brownian motions with correlation ρ ∈ [−1, 1],
 (1) (2)   (2) (1) 
i.e. we have IE Wt Wt = ρt. Compute Var St − St , t ∈ [0, T ].

Exercise 1.5 We consider an economy in which individual income is modeled over time by a
geometric Brownian motion
2 t/2
St = S0 e σ Bt +µt−σ , t ⩾ 0.

Compute the value

Theilt := log IE[St ] − IE[log St ]
of the Theil, 1967 inequality index at time t ⩾ 0 in this economy.
Hint: You may use the moment generating function of the normal distribution.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

 2. European Options

In this chapter, we measure risk using the prices of financial derivatives such as options, that protect
their holders against various kinds of market events. For this, we review some basic knowledge of
call or put options and related financial derivatives, together with their pricing in the Black-Scholes
framework. As a result, we introduce the superhedging risk measure, which can be defined from
the price of a portfolio that hedges a given financial derivative.

2.1 Financial Derivatives 27

2.2 Arbitrage and Risk-Neutral Measures 38
2.3 Black-Scholes Analysis 44
2.4 Historical Volatility 49
2.5 Implied Volatility 52
Exercises 59

2.1 Financial Derivatives

Early accounts of option contracts can also be found in The Politics Aristotle, 350 BCE by Aristotle
(384-322 BCE). Option credit contracts appear to have been used as early as the 10th century by
traders in the Mediterranean.
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”.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 28 Chapter 2. European Options

More recently, Robert Merton and Myron Scholes shared the 1997 Nobel Prize in economics:
“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.”* See 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 annualized returns of over 40% in its first years, but registered
a loss of US$4.6 billion in less than four months in 1998, which resulted into its closure in early
2000.

As of year 2015, the size of the financial derivatives market is estimated at over one quadrillion
(or one million billions, or 1015 ) USD, which is more than 10 times the size of the total Gross
World Product (GWP).
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

Figure 2.1: Comparison of WTI vs. Keppel price graphs.

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.).
In the above quote by Aristotle, olive oil can be regarded as the underlying asset, while the oil press
stands for the financial derivative.

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 .

* 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” (Wikipedia).

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.1 Financial Derivatives 29

Figure 2.2: Graph of the Hang Seng index - holding a put option might be useful here.

Definition 2.1 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.

Two possible scenarios (ST finishing above K or below K) are illustrated in Figure 2.3.

10
(K-ST)+=0
9
8 ST

7
Strike price
K=6 K

St 5 K-ST>0
4
3 ST

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

Figure 2.3: Two put option scenarios.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 30 Chapter 2. European Options

In general, the payoff of a (so called European) put option contract can be written as

 K − ST if ST ⩽ K,
φ (ST ) = (K − ST )+ :=
0, if ST ⩾ K.


20
Put option payoff (K-x)+

15

(K-x)+

10

0
80 85 90 95 100 105 110 115 120
K

Figure 2.4: Payoff function x 7→ (K − x)+ of a put option with strike price K = 100.

See e.g. https://optioncreator.com/stwwxvz.

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 .
Cash settlement. In the case of a cash settlement, the put option issuer will satisfy the contract by
transferring the amount C = (K − ST )+ to the option contract holder.
Examples of put options: The buy back guarantee* in currency exchange and the price drop protection
in online ticket booking are common examples of European put options.

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).

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 2.2 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.
* Right-click to open or save the attachment.
† One thousand trillion, or one million billion, or 1015 .

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.1 Financial Derivatives 31

Two possible scenarios (ST finishing above K or below K) are illustrated in Figure 2.5.

10
ST-K>0
9
8 ST

7
Strike price
K=6 K

St 5 (ST-K)+=0
4
3 ST

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

Figure 2.5: Two call option scenarios.

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 ⩽ K.


20
Call option payoff (x-K)+

15

(x-K)+

10

0
80 85 90 95 100 105 110 115 120
K

Figure 2.6: Payoff function x 7→ (x − K )+ of a call option with strike price K = 100.

See e.g. https://optioncreator.com/stqhbgn.

Example of a call option: The price lock guarantee* is a common example of a European call
option, see also here.
According to market practice, options are often divided into a certain number n of warrants, the
(possibly fractional) quantity n being called the entitlement ratio.
* Right-click to open or save the attachment.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 32 Chapter 2. European Options

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.
Physical delivery may include physical goods, commodities or assets such as coffee, airline fuel or
live cattle.
Cash settlement. In the case of a cash settlement, the call option issuer will fulfill the contract by
transferring the amount C = (ST − K )+ to the option contract holder.

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, and 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 .

Example: Fuel hedging and the four-way zero-collar option

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)

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

Figure 2.7: Brent and WTI price graphs.

(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.∗
The four-way call collar call option requires its holder to purchase the underlying asset (here,
airline fuel) at a price specified by the blue curve in Figure 2.8, when the underlying asset price is
represented by the red line.
* Right-click to open or save the attachment.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.1 Financial Derivatives 33

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

Figure 2.8: 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 2.9.

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

Figure 2.9: 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. https://optioncreator.com/st5rf51.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 34 Chapter 2. European Options

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

Figure 2.10: 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 hedging technique in a
one-step binary model with two time instants t = 0 and t = 1. Consider:
i) A risky underlying 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.


Exercise: Does C represent the payoff of a put option contract? Of a call option contract? If yes,
with which strike price K?
Quiz: Using this online form, input your own intuitive estimate for the price of the claim C.

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.
* The animation works in Acrobat Reader on the entire pdf file.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.1 Financial Derivatives 35

Here, the amount $β may be positive or negative, depending on whether it 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 or replicating the contract 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 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 or
here. This algorithm is scalable and can be extended to recombining binary trees over multiple
time steps.
Definition 2.3 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 = to the option contract
$0 if S1 = $2.

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,


* Right-click to save as attachment (may not work on .

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 36 Chapter 2. European Options

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 fulfilled, 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. We
will see that this model is scalable 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

IE[C ] = $3 × P(C = $3) + $0 × P(C = $0)

= $3 × P(S1 = $5).
In absence of arbitrage opportunities (“fair market”), this expected payoff IE[C ] should equal the
initial amount $2 invested in the option. In that case we should have

 IE[C ] = $3 × P(S1 = $5) = $2



P(S1 = $5) + P(S1 = $2) = 1.



from which we can infer the probabilities


 P(S1 = $5) = 2

3


(2.1.1)
 1
 P(S1 = $2) = ,


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 (2.1.1) we can also compute the expected value IE[S1 ] of the stock at
time t = 1. We find

IE[S1 ] = $5 × P(S1 = $5) + $2 × P(S1 = $2)

2 1
= $5 × + $2 ×
3 3

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.1 Financial Derivatives 37

= $4
= S0 .
Here this means that, on average, no extra profit or loss can be made from an investment on the
risky stock, hence the term “risk-neutral”. 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.
Market-implied probabilities
By matching the theoretical price IE[C ] to an actual market price data $M as
$M = IE[C ] = $3 × P(C = $3) + $0 × P(C = $0) = $3 × P(S1 = $5)
we can infer the probabilities

$M
 P(S1 = $5) = 3



(2.1.2)

 P(S1 = $2) =
 3 − $M
,

3
which are implied probabilities estimated from market data, as illustrated in Figure 2.11. 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. Figure 2.11 shows the time evolution of probabilities p(t ), q(t ) of two opposite outcomes.

Figure 2.11: Implied probabilities.

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 IE[C ] daily,
or close to a billion such computations for a large bank.
The Mathematician tends to focus on more theoretical features, such as:

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 38 Chapter 2. European Options

• Elegance,
• 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 IE[C ] and hedging strategies.
The methods involved include:
• Monte Carlo (60%),

10

0.0 0.2 0.4 0.6 0.8 1.0

Time

Figure 2.12: One hundred sample price paths used for the Monte Carlo method.

• PDEs and finite differences (30%),

• Other analytic methods and approximations (10%),
+ AI and Machine Learning techniques.

2.2 Arbitrage and Risk-Neutral Measures

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.
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 )

St = St , St , . . . , St

which forms a stochastic process (St )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.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.2 Arbitrage and Risk-Neutral Measures 39
Definition 2.4 Discounting. Let

(0) (1) (d )
X t := Set , Set , . . . , Set ), t ∈ R,

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 St , t ⩾ 0.
The concept of discounting is illustrated in the following figures.

My portfolio St grew by b = 5% this year.

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?
Q: Did I achieve a positive return?
A:
A:

(a) Scenario A. (b) Scenario B.

(a) Without inflation adjustment. (b) With inflation adjustment.

Figure 2.13: Why apply discounting?

(k )
Definition 2.5 A portfolio strategy is a stochastic process (ξ t )t∈R+ ⊂ Rd +1 , 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 )
Vt := ξ t • St = ∑ ξt St , t ⩾ 0.
k =0

The discounted value of the portfolio is defined by

Vet := e −rt Vt
= e −rt ξ t • St
d
(k ) (k )
= e −rt ∑ ξt St
k =0

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 40 Chapter 2. European Options
d
(k) e(k)
= ∑ ξt St
k =0
= ξ t • Xt, 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.
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 what follows we will only consider admissible portfolio strategies whose
total value Vt remains nonnegative for all times t ∈ [0, T ].
(k )

Definition 2.6 A portfolio strategy ξt t∈[0,T ],k=0,1,...,d
with value

d
(k ) (k )
Vt = ξ t • St = ∑ ξt St , t ∈ [0, T ],
k =0

constitutes an arbitrage opportunity if all three following conditions are satisfied:

i) V0 ⩽ 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 ⩽ u ⩽ t.

Recall that the filtration (Ft )t∈R+ is generated by Brownian motion (Bt )t∈R+ , i.e.

Ft = σ (Bu : 0 ⩽ u ⩽ t ), t ⩾ 0.

Definition 2.7 A probability measure P∗ on Ω is called a risk-neutral measure if it satisfies

 (k ) (k )
IE∗ St Fu = e (t−u)r Su ,

0 ⩽ u ⩽ t, k = 1, 2, . . . , d. (2.2.1)

where IE∗ denotes the expectation under P∗ .

As in the discrete-time case, P♯ would be called a risk premium measure if it satisfied

 (k )
IE♯ St Fu > e (t−u)r Su ,

0 ⩽ u ⩽ 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 ⩽ u ⩽ t.
Similarly, a negative risk premium measure P♭ satisfies
 (k ) (k )
IE♭ St Fu < e (t−u)r Su ,

0 ⩽ u ⩽ t, k = 1, 2, . . . , d.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.2 Arbitrage and Risk-Neutral Measures 41

From the relation

(0) (0)
St = e (t−u)r Su , 0 ⩽ u ⩽ t,
(k )
we interpret (2.2.1) by saying that the expected return of the risky asset St under P∗ equals the
(0) (k )
return of the riskless asset St , k = 1, 2, . . . , d. Recall that the discounted (in $ at time 0) price Set
of the risky asset no k is defined by
(k )
(k ) (k ) St
Set := e −rt St = (0) (0)
, t ⩾ 0, k = 0, 1, . . . , d,
St /S0
(0) (0)
i.e. St /S0 plays the role of a numéraire process.
As in the discrete-time case, the martingale property in continuous time, can be used to
characterize risk-neutral probability measures, for the derivation of pricing partial differential
equations (PDEs), and for the computation of conditional expectations.

Proposition 2.8 The probability measure P∗ is risk-neutral if and only if the discounted risky
(k )
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 )
IE∗ Set Fu = IE∗ e −rt St Fu
  
 (k )
= e −rt IE∗ St Fu


(k )
= e −rt e (t−u)r Su
(k )
= e −ru Su
(k )
= Seu , 0 ⩽ u ⩽ t,
(k ) (k )

hence Set t∈R is a martingale under P∗ , k = 1, 2, . . . , d. Conversely, if Set t∈R is a martingale


+ +
under P∗ , then
 (k ) (k )
IE∗ St Fu = IE∗ e rt Set Fu
  
 (k )
= e rt IE∗ Set Fu


(k )
= e rt Seu
(k )
= e (t−u)r Su , 0 ⩽ u ⩽ t, k = 1, 2, . . . , d,
hence the probability measure P∗ is risk-neutral according to Definition 2.7. □
In what follows 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 2.9 A probability measure P∗ on (Ω, F ) is said to be equivalent to another proba-
bility measure P when

P∗ (A) = 0 if and only if P(A) = 0, for all A ∈ F. (2.2.2)

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.

Theorem 2.10 A market is without arbitrage opportunity if and only if it admits at least one
equivalent risk-neutral probability measure P∗ .
Proof. See Harrison and Pliska, 1981 and Chapter VII-4a of Shiryaev, 1999. □

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 42 Chapter 2. European Options

Self-Financing Portfolio Strategies

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 respectively invested at time t over the time
interval [t,t + dt ), into the risky asset St and riskless asset At , and let

ξ t = (ηt , ξt ), St = (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 • St = ηt At + ξt St , t ⩾ 0.

Our description of portfolio strategies proceeds in four equivalent formulations presented below in
Equations (2.2.3), (2.2.4), (2.2.7) and (2.2.8), 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 remains constant after
updating the portfolio from (ηt , ξt ) to (ηt +dt , ξt +dt ), i.e.

ξ t • St +dt = ηt At +dt + ξt St +dt = ηt +dt At +dt + ξt +dt St +dt = ξ t +dt • St +dt . (2.2.3)

Portfolio value ξ t • St ξ t • St +dt = ξ t +dt • St +dt ξ t +dt • St +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
Figure 2.14: Illustration of the self-financing condition (2.2.3).

Equivalently, Condition (2.2.3) can be rewritten as

At +dt dηt + St +dt dξt = 0, (2.2.4)

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 ). (2.2.5)

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.

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2.2 Arbitrage and Risk-Neutral Measures 43

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 (2.2.5) can also be rewritten as

St (ξt +dt − ξt ) + At (ηt +dt − ηt ) + (St +dt − St )(ξt +dt − ξt ) (2.2.6)

+ (At +dt − At ) (ηt +dt − ηt ) = 0,
•

which shows that (2.2.3) and (2.2.4) are equivalent to

St dξt + At dηt + dSt • dξt + dAt • dηt = 0 (2.2.7)

in differential notation, with

dAt • dηt ≃ (At +dt − At ) • (ηt +dt − ηt ) = rAt (dt • dηt ) = 0

in the sense of Itô’s calculus, by the Itô multiplication Table. This yields the following proposi-
tion.
Proposition 2.11 A portfolio allocation (ξt , ηt )t∈R+ with value

Vt = ηt At + ξt St , t ⩾ 0,
is self-financing according to (2.2.3) if and only if the relation

dVt = η dA + ξt dSt (2.2.8)

| t{z t} | {z }
Risk−free P/L Risky P/L

holds.

Proof. By the Itô formula, we have

dVt = [ηt dAt + ξt dSt ] + [St dξt + At dηt + dSt • dξt + dAt • dηt ],

which shows that (2.2.8) is equivalent to (2.2.7). 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
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.
Market Completeness

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 44 Chapter 2. European Options
Definition 2.12 A contingent claim with payoff C is said to be attainable if there exists a (self-
(k )

financing) portfolio strategy ξt t∈[0,T ],k=0,1,...,d
such that at the maturity time T the equality
d
(k ) (k )
VT = ξ T • ST = ∑ 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.
Definition 2.13 A market model is said to be complete if every contingent claim is attainable.

The next result is the continuous-time statement of the second fundamental theorem of asset pricing.

Theorem 2.14 A market model without arbitrage opportunities is complete 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. □

2.3 Black-Scholes Analysis

In this section we consider an asset price process (St )t∈R+ modeled as the geometric Brownian
motion (1.2.7) of Proposition 1.7. Recall that the evolution of the riskless bank account value
(At )t∈R+ is constructed from standard returns, defined from the differential equation

dAt
= rAt , t ⩾ 0,
dt
with solution

At = A0 e rt , t ⩾ 0,

where r > 0 is the risk-free interest rate. The risky asset price process (St )t∈R+ is modeled from
the equation

dSt = rSt dt + σ St dBt

with solution
   
1
St = S0 exp σ Bt + r − σ 2 t , t ⩾ 0.
2

Let αt and βt be the numbers of units invested at time t ⩾ 0, respectively in the assets priced
(St )t∈R+ and (At )t∈R+ .
In the sequel, we will consider a portfolio whose value Vt at time t ⩾ 0 is given by

Vt = βt At + αt St , t ⩾ 0.

Black-Scholes formula for European call options

In the case of European call options with payoff function φ (x) = (x − K )+ we have the following
Black-Scholes formula.

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2.3 Black-Scholes Analysis 45

Proposition 2.15 The price at time t ∈ [0, T ] of the European call option with strike price K and
maturity T is given by

Blc (St , K, r, T − t, σ ) = e −(T −t )r IE[(ST − K )+ | Ft ] (2.3.1)

= St Φ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

0 ⩽ t ⩽ T , with

log(St /K ) + (r + σ 2 /2)(T − t )
− √

 d
 +
 ( T t ) : = , (2.3.2a)
σ T −t
 log(St /K ) + (r − σ 2 /2)(T − t )
d− (T − t ) :=

 √ , 0 ⩽ t < T, (2.3.2b)
σ T −t

where “log” denotes the natural logarithm “ln” and

1 w x −y2 /2
Φ (x ) : = P(N ⩽ x ) = √ e dy, x ∈ R,
2π −∞
is the standard Gaussian Cumulative Distribution Function (CDF).

We note the relation

√
d+ (T − t ) = d− (T − t ) + |σ | T − t, 0 ⩽ t < T. (2.3.3)

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

Figure 2.15: 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

Blc (St , K, r, T − t, σ ) = St Φ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

0 ⩽ t ⩽ T . The following script implements the Black-Scholes formula for European call options
in .*

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}

* Download the corresponding IPython notebook that can be run here or here.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 46 Chapter 2. European Options

In comparison with the discrete-time Cox-Ross-Rubinstein (CRR) model, the interest in the Black-
Scholes formula is to provide an analytical solution that can be evaluated in a single step, which is
computationally much more efficient.

Figure 2.16: Graph of the Black-Scholes call price map with strike price K = 100.*

Figure 2.16 presents an interactive graph of the Black-Scholes call price map, i.e. of the function

(t, x) 7−→ Blc (x, K, r, T − t, σ ) = xΦ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) .

70
60
50
40
30
20
10
0
0 40
80
100 120 Time in days
Underlying asset price 60 160

Figure 2.17: Time-dependent solution of the Black-Scholes PDE (call option).†

The next proposition is proved by a direct differentiation of the Black-Scholes function.

Proposition 2.16 The Black-Scholes Delta of the European call option is given by

∂
Blc (x, K, r, T − t, σ )|x=St = Φ d+ (T − t ) ∈ [0, 1],


αt = αt (St ) = (2.3.4)
∂x
where d+ (T − t ) is defined in (2.3.2a).

* Right-click on the figure for interaction and “Full Screen Multimedia” view.
† The animation works in Acrobat Reader on the entire pdf file.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.3 Black-Scholes Analysis 47

We note that 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:

Blc (St , K, r, T − t, σ ) = St Φ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,

(2.3.5)
| {z } | {z }
Risky investment (held) Risk free investment (borrowed)

0 ⩽ t ⩽ T , i.e. αt = Φ d+ (T − t ) represents the quantity of assets invested in the risky asset

priced at St . The following script implements the Black-Scholes Delta for European call options.

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 2.18 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
Figure 2.18: Delta of a European call option with strike price K = 100, r = 3%, σ = 10%.

Black-Scholes formula for European Put Options

The European put option price is computed in the next proposition.

Proposition 2.17 The price at time t ∈ [0, T ] of the European put option with strike price K and
maturity T is given by

e −(T −t )r IE[(K − ST )+ | Ft ]
Bl p (St , K, r, T − t, σ ) =
= K e −(T −t )r Φ − d− (T − t ) − St Φ − d+ (T − t ) ,

0 ⩽ t ⩽ T , where d+ (T − t ) and d− (T − t ) are defined in (2.3.2a)-(2.3.2b).

The Black-Scholes formula for European Put Options is plotted in illustrated in Figure 2.19.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 48 Chapter 2. European Options

Figure 2.19: 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

Bl p (St , K, r, T − t, σ ) = K e −(T −t )r Φ − d− (T − t ) − St Φ − d+ (T − t ) ,

0 ⩽ t ⩽ T.

40

30

20

10

00 60
40 80 100
120 160 Underlying asset price
Time in days

Figure 2.20: Time-dependent solution of the Black-Scholes PDE (put option).†

The following script implements the Black-Scholes formula for European put options in .
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}

The Black-Scholes Delta of the European put option is computed in the following proposi-
tion.
Proposition 2.18 The Black-Scholes Delta of the European put option is given by

* Right-click on the figure for interaction and “Full Screen Multimedia” view.
† The animation works in Acrobat Reader on the entire pdf file.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

 2.4 Historical Volatility 49

∂
αt = αt (St ) = Bl p (x, K, r, T − t, σ )|x=St
∂x
= −(1 − Φ d+ (T − t ) ) = −Φ − d+ (T − t ) ∈ [−1, 0],



0 ⩽ t ⩽ T,

where d+ (T − t ) is defined in (2.3.2a).

We note that 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:

Bl p (St , K, r, T − t, σ ) = K e −(T −t )r Φ − d− (T − t ) − St Φ − d+ (T − t ) ,



(2.3.6)
| {z } | {z }
Risk−free investment (savings) Risky investment (short)

0 ⩽ t ⩽ T , i.e. −Φ − d+ (T −t ) represents the quantity of assets invested in the risky asset priced
at St .

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 2.21 we plot the Delta of the European put option as a function of the underlying asset
price and of the time remaining until maturity.

-0.5

-1

150
100 0
Underlying 5
50 10
15
0 Time to maturity T-t

Figure 2.21: Delta of a European put option with strike price K = 100, r = 3%, σ = 10%.

2.4 Historical Volatility

We consider the problem of estimating the parameters µ and σ from market data in the stock price
model
dSt
= µdt + σ dBt . (2.4.1)
St

Historical trend estimation

By discretization of (2.4.1) 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, (2.4.2)
Stk

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 50 Chapter 2. European Options

a natural estimator for the trend parameter µ can be constructed as

!
1 N−1 1 StMk+1 − StMk
bN := , (2.4.3)
N k∑
µ
=0 tk+1 − tk StMk

where (StMk+1 − StMk )/StMk , k = 0, 1, . . . , N − 1 denotes market returns observed at discrete times
t0 ,t1 , . . . ,tN .

Historical log-return estimation

Alternatively, observe that, replacing* (2.4.3) by the log-returns
Stk+1
log = log Stk+1 − log Stk
Stk
Stk+1 − Stk
 
= log 1 +
Stk
Stk+1 − Stk
≃ ,
Stk

with tk+1 − tk = T /N, k = 0, 1, . . . , N − 1, one can replace (2.4.3) with the simpler telescoping
estimate
1 N−1 1 1 ST
∑ (log Stk+1 − log Stk ) = log .
N k=0 tk+1 − tk T S0

Historical volatility estimation

The volatility parameter σ can be estimated by writing, from (2.4.2),
2
(Btk+1 − Btk )2 N−1
N−1 Stk+1 − Stk

2 1
σ ∑ = ∑ − (tk+1 − tk ) µ ,
k =0 tk+1 − tk k=0 tk+1 − tk Stk

which yields the (unbiased) realized variance estimator

2
1 N−1 Stk+1 − Stk

1
bN2 := − (tk+1 − tk ) µ .
N − 1 k∑
σ bN
= 0 k + 1 − tk
t Stk

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")

stock=Ad(`0005.HK`);logreturns=diff(log(stock));returns=(stock-lag(stock))/lag(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

* This approximation does not include the correction term (dSt )2 /(2St2 ) in the Itô formula d log St = dSt /St −
(dSt )2 /(2St2 ).

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.4 Historical Volatility 51

0.02
●

stock [2017−02−15/2017−03−31]
Last 63.3

67 ●
●
●

●
●

● ●

0.00
●

● ● ●

● ● ●

66
●
●

●
●

● ●

●
●

returns
●

65

−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.

Figure 2.22: 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)
myPars <- chart_pars();myPars$cex<-1.4
myTheme <- chart_theme(); myTheme$col$line.col <- "blue"
dev.new(width=16,height=7)
chart_Series(stock,name="0005.HK",pars=myPars,theme=myTheme)
add_TA(histvol, name="Historical Volatility")

Figure 2.23 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

Figure 2.23: Historical volatility graph.

Parameter estimation based on historical data usually requires a lot of samples and it can only be
valid on a given time interval, or as a moving average. Moreover, it can only rely on past data,
which may not reflect future data.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 52 Chapter 2. European Options

Figure 2.24: “The fugazi: it’s a wazy, it’s a woozie. It’s fairy dust.”*

2.5 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 w x −y2 /2
Φ (x ) = √ e 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 (2.5.1)

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 2.25.

* Scorsese, 2013 Click on the figure to play the video (works in Acrobat Reader on the entire pdf file).

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.5 Implied Volatility 53
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

Figure 2.25: 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 ). Various
algorithms can be implemented to solve (2.5.1) 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).

library(devtools); install_github("https://github.com/cran/fOptions") # Install RTools as well

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)

* Download the corresponding code or the IPython notebook that can be run here or here.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 54 Chapter 2. European Options

Option chain data in

install.packages("jsonlite"); library(devtools); # Install RTools as well

remotes::install_github("joshuaulrich/quantmod")
library(quantmod);library(jsonlite)
getSymbols("^GSPC",src="yahoo",from=as.Date("2023-01-01"), to = as.Date("2023-03-01"))
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 2025 to /2027 expiries
SPX.OPTS <- getOptionChain("^SPX", "2025/2027")
AAPL.OPTS <- getOptionChain("AAPL", "2025/2027")

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 , maturities T1 , resp. T2 , and prices
C1 , resp. C2 , on the same stock S, this procedure should yield two estimates σimp (K1 , T1 ) and
σimp (K2 , T2 ) of implied volatilities according to the following equations.


Bl(t, St , K1 , σimp (K1 , T1 ), r, T1 ) = M1 ,
 (2.5.2a)


Bl(t, St , K2 , σimp (K2 , T2 ), r, T2 ) = M2 , (2.5.2b)


Clearly, there is no reason a priori for the implied volatilities σimp (K1 , T1 ), σimp (K2 , T2 ) solutions
of (2.5.2a)-(2.5.2b) 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 contradiction between a model and market data is motivating the development of more
sophisticated stochastic volatility models.

Figure 2.26 presents an estimation of 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).

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.5 Implied Volatility 55

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

Figure 2.26: Implied volatility surface of Asian options on light sweet crude oil futures.*

As observed in Figure 2.26, the volatility surface can exhibit a smile phenomenon, in which implied
volatility is higher at a given end (or at both ends) of the range of strike price values.

remotes::install_github("joshuaulrich/quantmod")
install.packages("jsonlite");install.packages("lubridate")
library(jsonlite);library(lubridate);library(quantmod)
# Maturity to be updated as needed
maturity <- as.Date("2025-08-20", 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("2025-12-17", 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)

*© Tan Yu Jia.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 56 Chapter 2. European Options

0.13
0.12
Implied volatility

0.11
0.10
0.09

2800 3000 3200 3400 3600 3800

Strike price

Figure 2.27: 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 that sense, the Black-Scholes formula, which is modeling asset
returns using Gaussian distribution 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.*

Black-Scholes formula vs. market data - Call option example

On July 28, 2009 a call option 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, cf. page 31.

Figure 2.28: 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
* Download the corresponding IPython notebook that can be run here or here (© Qu Mengyuan).

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.5 Implied Volatility 57

https://www.hkex.com.hk/eng/dwrc/search/listsearch.asp.

The next graph in Figure 2.29a 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.

Figure 2.29: Comparison of market call option prices vs. calibrated Black-Scholes prices.

In Figure 2.29b we have fitted the time evolution t 7→ gc (t, St ) of Black-Scholes prices to the data of
Figure 2.29a using the market stock price data of Figure 2.28, by varying the values of the volatility
σ.

Another example

Let us consider the stock price of HSBC Holdings (0005.HK) over one year:

Figure 2.30: 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 31.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 58 Chapter 2. European Options
0.3
Black-Scholes price

0.2

HK$
0.1

0
Nov 08 Jan 09 Mar 09 May 09 Jul 09 Sep 09

(a) Graph of (market) option prices. (b) Graph of Black-Scholes prices.

Figure 2.31: Comparison of market call option prices vs. calibrated Black-Scholes prices.
As above, in Figure 2.31b we have fitted the path t 7−→ gc (t, St ) of the Black-Scholes option price
to the data of Figure 2.31a using the stock price data of Figure 2.30.
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.

Put option example

In Figure 2.32 we 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, cf. page 31.
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

(a) Graph of (market) option prices. (b) Graph of Black-Scholes prices.

Figure 2.32: Comparison of market put option prices vs. calibrated Black-Scholes prices.
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 2.32b is a fit of the Black-Scholes put price graph

t 7−→ gp (t, St )

to Figure 2.32a as a function of the stock price data of Figure 2.31b. Note that the Black-Scholes
price at maturity is strictly equal to 0 while the corresponding market price cannot be lower than
one cent.
The normalized market data graph in Figure 2.33 shows how the option price can track the values of
the underlying asset price. Note that the range of values [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
European call option on the ALSTOM underlying asset with strike price K = €20, maturity March
20, 2015, and entitlement ratio 10, cf. page 31.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

2.5 Implied Volatility 59

Figure 2.33: Call option price vs. underlying asset price.

Exercises

Exercise 2.1 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 2.2 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 2.3 Consider a risky asset valued S0 = $4 at time t = 0, and taking only two possible
values S1 ∈ {$5, $2} at time t = 1, and the claim payoff

 $3 if S1 = $5
C= at time t = 1.
$0 if S1 = $2.


We assume that the issuer charges $1 for the option contract at time t = 0.
a) Compute the portfolio allocation (α, β ) made of α stocks and $β in cash, so that:
i) the full $1 option price is invested into the portfolio at time t = 0,
and
ii) the portfolio reaches the C = $3 target if S1 = $5 at time t = 1.
b) Compute the loss incurred by the option issuer if S1 = $2 at time t = 1.

Exercise 2.4 Recall that an arbitrage opportunity consist of a portfolio allocation with zero or
negative cost that can yield a nonnegative and possibly strictly positive payoff at maturity.

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 60 Chapter 2. European Options

a) Consider the following market model:

b

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

i) Does this model allow for arbitrage opportunities?

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

i) Does this model allow for arbitrage opportunities?

Yes | No |
ii) If this model allows for arbitrage opportunities, how can they be realized?
By shortselling | By borrowing on savings | N.A. |
c) Consider the following market model:
(1)
( 1 + r ) S0
b
(1)
S0 a

i) Does this model allow for arbitrage opportunities?

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

Exercise 2.5 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) (1)
S1 = S0 (1 + b),




 (1)

S0 (1 + c).

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2.5 Implied Volatility 61

In general, is it possible to hedge (or replicate) a claim with three distinct claim payoff values
Ca ,Cb ,Cc in this market?

Exercise 2.6 Superhedging risk measure. Consider a stock valued S0 at time t = 0, and taking
only two possible values S1 = S1 or S1 = S1 at time t = 1, with S1 < S1 .
a) Compute the initial portfolio allocation (α, β ) of a portfolio made of α units of stock and
$β in cash, hedging the call option with strike price K ∈ [S1 , S1 ] and claim payoff


 S1 − K if S1 = S1
C = (S1 − K )+ =
$0 if S1 = S1 , at time t = 1.


b) Show that the risky asset allocation α satisfies the condition α ∈ [0, 1].
c) Compute the Superhedging Risk Measure SRMC * of the claim C = (S1 − K )+ .

Exercise 2.7 Given two strike prices K1 < K2 , we consider a long box spread option, realized as
the combination of four legs with same maturity date:
• 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)+ .

Short put at K1
Long put at K2
Short call at K2
Long call at K1

K1 x K2
Figure 2.34: Graphs of call/put payoff functions.

a) Find the payoff of the long box spread option in terms of K1 and K2 .
b) From Table 3.1, find a choice of strike prices K1 < K2 that can be used to build a long box
spread option on the Hang Seng Index (HSI).
c) Using Table 3.1, price the option built in part (c)) in index points, and then in HK$.

Hints.
i) The closing prices in Table 3.1 are warrant prices quoted in index points.
ii) Warrant prices are converted to option prices by multiplication by the number given in
the “Entitlement Ratio” column.
iii) The conversion rate from index points to HK$ is HK$50 per index point.
d) Would you buy the option priced in part (d)) ?

*“The smallest amount necessary to be paid for a portfolio at time t = 0 so that the value of this portfolio at time
t = 1 is at least as great as C”.

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 62 Chapter 2. European Options

Table 2.1: Call and put options on the Hang Seng Index (HSI).

2 /2)T
Exercise 2.8 Show that at any time T > 0, the random variable ST := S0 e σ BT +(µ−σ 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 Figure 2.35.

N=1000; t <- 0:N; dt <- 1.0/N; nsim <- 100

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) # using Bernoulli samples
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="")

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2.5 Implied Volatility 63

3.0

2.5

2.0

1.5

1.0

0.0 0.2 0.4 0.6 0.8 1.0

time

Figure 2.35: Statistics of geometric Brownian paths vs. lognormal distribution.

Exercise 2.9
a) Consider the stochastic differential equation

dSt = rSt dt + σ St dBt , t ⩾ 0, (2.5.3)

where r, σ ∈ R are constants and (Bt )t∈R+ is a standard Brownian motion. Compute d log St
using the Itô formula.
b) Solve the ordinary differential equation d f (t ) = c f (t )dt for f (t ), and the stochastic differ-
ential equation (2.5.3) for St .
c) Using the Gaussian moment generating function (MGF) formula, compute the n-th order
moment IE[Stn ] for all n > 0.
d) Compute the lognormal mean and variance
2
IE[St ] = S0 e rt Var[St ] = S02 e 2rt e σ t − 1 ,


and t ⩾ 0.

e) Recover the lognormal mean and variance of Question

 2 (d)) by deriving differential equations
for the functions u(t ) := IE[St ] and v(t ) := IE St , t ⩾ 0, using stochastic calculus.

Exercise 2.10 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 d f (St ,Yt ), for f a C 2 function on R2 using the bivariate Itô formula.

Exercise 2.11 Consider the asset price process (St )t∈R+ given by the stochastic differential
equation
dSt = rSt dt + σ St 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
wT
ST = C (S0 , r, T ) + ζt,T dBt . (2.5.4)
0

Hint: Use the fact that the discounted price process (Xt )t∈[0,T ] := ( e −rt St )t∈[0,T ] satisfies the relation
dXt = σ Xt dBt .

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 64 Chapter 2. European Options

Exercise 2.12 Consider (Bt )t∈R+ a standard Brownian motion generating the filtration (Ft )t∈R+
and the process (St )t∈R+ defined by
w t wt 
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 2.13 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 σ Bs −σ dBs , t ⩾ 0. (2.5.5)
0

b) Express d log(St ) using (2.5.5) and the Itô formula.

2
c) Show that St = eσ Bt −σ t/2 for t ⩾ 0.

Exercise 2.14 We consider a leveraged fund with factor β : 1 on an index (St )t∈R+ modeled as the
geometric Brownian motion

dSt = rSt dt + σ St 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 ξt St of the portfolio
should represent β times the invested amount Ft at any time t ⩾ 0.
b) Find the stochastic differential equation satisfied by (Ft )t∈R+ under the self-financing condi-
tion dFt = ξt dSt + ηt dAt .
c) Find the relation between the fund value Ft and the index St by solving the stochastic
β
differential equation obtained for Ft in Question (b)). For simplicity we take F0 := S0 .

(1) (2)
Exercise 2.15 Consider two assets whose prices St , St at time t ∈ [0, T ] follow the geometric
Brownian dynamics
(1) (1) (1) (1) (2) (2) (2) (2)
dSt = µSt dt + σ1 St dWt and dSt = µSt dt + σ2 St dWt ,
(1)
(2)

t ∈ [0, T ], where Wt t∈[0,T ] , Wt t∈[0,T ] are two Brownian motions with correlation ρ ∈ [−1, 1],
 (1) (2) 
i.e. we have IE Wt Wt = ρt.
 (i) 
a) Compute IE St , t ∈ [0, T ], i = 1, 2.
 (i) 
b) Compute Var St , t ∈ [0, T ], i = 1, 2.
 (2) (1) 
c) Compute Var St − St , t ∈ [0, T ].

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2.5 Implied Volatility 65

Exercise 2.16 Solve the stochastic differential equation

dXt = h(t )Xt dt + σ Xt 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 σ Bt −σ , where f (t ) is a function to be deter-
mined, t ⩾ 0.

Exercise 2.17 Let (Bt )t∈R+ denote a standard Brownian motion generating the filtration (Ft )t∈R+ .
a) Letting Xt := σ Bt + νt, σ > 0, ν ∈ R, compute St := e Xt by the Itô formula
wt
∂f wt ∂ f 1 w t 2∂2 f
f (Xt ) = f (X0 ) + (Xs )dBs + vs (Xs )ds +
us u (Xs )ds, (2.5.6)
0 ∂x 0 ∂x 2 0 s ∂ x2
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 differential equation

dSt = rSt dt + σ St dBt ?

c) Given σ > 0, let Xt := (BT − Bt )σ , and compute Var[Xt ], 0 ⩽ t ⩽ T .

d) Let the process (St )t∈R+ be defined by St = S0 e σ Bt +νt , t ⩾ 0. 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 ⩽ t < T,
σ T −t

where Φ(x) denotes the standard Gaussian Cumulative Distribution Function.

Hint: Use the time splitting decomposition

ST
ST = St = St e (BT −Bt )σ +(T −t )ν , 0 ⩽ t ⩽ T.
St

Problem 2.18 Stop-loss/start-gain strategy (Lipton, 2001 § 8.3.3). Let (Bt )t∈R+ be a standard
Brownian motion started at B0 ∈ R.
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 what follows, for simplicity we assume no time value of money (r = 0), i.e. the (riskless)
SGD account is priced At = A0 = 1, 0 ⩽ t ⩽ 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.
*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.

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 66 Chapter 2. European Options

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.
e) Is the portfolio strategy (ηt , ξt )t∈[0,T ] self-financing? How to interpret the answer in practice?

Problem 2.19 Liquidity pools are smart contracts found on decentralized exchanges (DEX) such
as Uniswap, in which liquidity providers (LPs) may earn passive income by depositing two digital
assets. Liquidity pools enable the automatic trading of digital assets using Automated Market
Makers (AMMs), such as the Constant Product Automated Market Maker (CPAMM) introduced by
Vitalik Buterin in a legendary 2016 Reddit post.

In the Geometric Mean Market Maker (G3M) model used in Uniswap v2,* Sushiswap or
Balancer, the quantities Xt > 0, Yt > 0 of the assets X, Y present in the pool are linked at all times
t ⩾ 0 by the relation
C = Xtα Yt1−α , t ⩾ 0, (2.5.7)
where C > 0 and α ∈ (0, 1) are constants. External traders are accessing the liquidity pool to perform
the exchange of a quantity ∆Yt := Yt −Yt − ∈ R of the asset Y into a quantity ∆Xt := Xt − Xt − ∈ R
of the asset X, where Xt − and Yt − are the left limits†
Xt − := lim Xs and Yt − := lim Ys , t > 0.
s↗t s↗t

The exchange rate St at time t ⩾ 0 is defined as the ratio of the number of units of Y vs. number of
units of X exchanged during an “infinitesimal” transaction, i.e.
∓∆Yt ∆Yt
St := lim = − lim ,
∆Xt →0 ±∆Xt ∆Xt →0 ∆Xt

* See the 2020 White Paper.

† ∆X and ∆Y may be positive or negative, depending on the direction of the transaction.
t t

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2.5 Implied Volatility 67

where the limit is assumed to exist at all times t ⩾ 0. In addition, in what follows we will regard Xt
and Yt as continuous processes.
The following 10 questions are interdependent and should be treated in sequence.
a) Express the exchange rate St in terms of Xt , Yt and γ := α/(1 − α ) under the G3M condition
(2.5.7).
b) At time t = 0, the liquidity provider deposits Y0 units of Y in the pool, together with X0 units
of X. Write down the value LP0 of the liquidity pool at time t = 0 in terms of C, α, γ and S0
only, quoted in units of Y .
c) Write down the liquidity pool value LPt at any time t ⩾ 0 in terms of C α, γ and St only,
quoted in units of Y .
d) We consider an investor who builds a long portfolio with Y0 > 0 units of Y and X0 > 0 of X at
time t = 0, and holds those assets at all times. Write down the value Vt of this long portfolio
at any time t ⩾ 0 in terms of C, α, γ, S0 and St only, quoted in units of Y .
e) Show that the difference in value Vt − LPt between the long portfolio and the liquidity pool
can be written as  
St
Vt − LPt = φ ,
S0
where φ (x) is a function to be determined explicitly, and parameterized by C, S0 , α and γ.
f) Show that the value Vt of the investor’s long portfolio always overperforms the liquidity pool
value LPt .
g) Find a lower bound for the expected loss IE[Vt − LPt ] of the liquidity provider in terms of C,
S0 , IE[St ], α and γ.
Hint: Use Jensen’s inequality.
h) In this question only, we consider the CPAMM setting with α = 1/2 and we model the
exchange rate (St )t =0,1 in a one-step model on the probability space Ω = {ω − , ω + }, with

S1 (ω − ) = a, and S1 (ω + ) = b,

and ab = S02 , a < S0 < b. Show that the potential loss V1 − LP1 of the liquidity provider at
time t = 1 can be exactly hedged by holding a quantity ξ of an option with payoff |S1 − S0 |,
and compute ξ in terms of C, S0 and/or a, b.
Hints: Here the payoff is C = V1 − LP1 and the underlying asset value at time t = 1 is
|S1 − S0 |. The portfolio allocation is (ξ , 0), as no riskless asset is used here.
i) In this question only, we model the exchange rate (St )t∈R+ as the geometric Brownian motion
solution of
dSt = µSt dt + σ St dBt ,

where µ ∈ R, σ > 0, and (Bt )t∈R+ is a standard Brownian motion.

Compute the expected loss IE[Vt − LPt ] incurred by the liquidity provider in comparison to
the investor’s long portfolio.
j) In this question, the liquidity provider is rewarded* by a proportional fee payed on deposits at
the rate κ, and stored outside of the liquidity pool. This results into an ask rate from the pool

∓∆Yt ∆Yt
At := lim = − lim
∆Xt ↗0 ±∆Xt ∆Xt ↗0 ∆Xt

* Yield farming: a high-risk, volatile investment strategy where an investor stakes, or lends, crypto assets on a
decentralized (DeFi) platform to earn a higher return. However, liquidity provision need not necessarily be risky, e.g.
when providing liquidity to a stablecoin pool.

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 68 Chapter 2. European Options

when the trader wishes to exchange Y into X, and a bid rate from the pool

∓∆Yt ∆Yt
Bt := lim = − lim
∆Xt ↘0 ±∆Xt ∆Xt ↘0 ∆Xt

when the trader wishes to exchange X into Y , where the limits are assumed to exist at all
times t ⩾ 0.
Express the ask and bid exchange rates At , Bt in terms of Xt , Yt , κ and γ under the G3M
condition (2.5.7).
Hint: Treat the cases ∆Xt > 0 and ∆Yt > 0 separately.
Further reading
See Mohan, 2022 for an overview of different types of automated market makers, and also Briola
et al., 2023: “Specifically, two main events are identified as the fuse for the Terra collapse. First,
private market actors short sold Bitcoin (BTC) with the final aim of spreading panic into the market.
Second, on 07 May 2022, the liquidity pool Curve-3pool suffered a "liquidity pool attack", which
caused the first UST de-pegging, below $0.99. It is worth noting that, on 01 April 2022, Kwon
announced the launch of a new liquidity pool (4pool) together with DeFi majors Frax Finance and
Redacted Cartel”.

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 69

3. Martingale Approach to Pricing and Hedging

In the martingale approach to the pricing and hedging of financial derivatives, 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.

3.1 Martingale Property of the Itô Integral 69

3.2 Risk-Neutral Probability Measures 73
3.3 Change of Measure and the Girsanov Theorem 77
3.4 Pricing by the Martingale Method 79
3.5 Hedging by the Martingale Method 85
Exercises 90

3.1 Martingale Property of the Itô Integral

Recall that an integrable process (Xt )t⩾0 is said to be a martingale with respect to the filtration
(Ft )t⩾0 if
IE[Xt | Fs ] = Xs , 0 ⩽ s ⩽ t.
In what follows,
L2 (Ω) := {F : Ω → R : IE[|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⩾0 a filtration, the process
(Xt )t⩾0 defined by
Xt := IE[F | Ft ], t ⩾ 0,

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 70 N. Privault

is an (Ft )t⩾0 -martingale under P. Indeed, since Fs ⊂ Ft , 0 ⩽ s ⩽ t, it follows from the

tower property of conditional expectations that
IE[Xt | Fs ] = IE[IE[F | Ft ] | Fs ] = IE[F | Fs ] = Xs , 0 ⩽ s ⩽ t. (3.1.1)
2. Any integrable stochastic process (Xt )t⩾0 whose increments (Xt1 − Xt0 , . . . , Xtn − Xtn−1 ) are
mutually independent and centered under P (i.e. IE[Xt ] = 0, t ⩾ 0) is a martingale with
respect to the filtration (Ft )t⩾0 generated by (Xt )t⩾0 , as we have
IE[Xt | Fs ] = IE[Xt − Xs + Xs | Fs ]
= IE[Xt − Xs | Fs ] + IE[Xs | Fs ]
= IE[Xt − Xs ] + Xs
= Xs , 0 ⩽ s ⩽ t. (3.1.2)
In particular, the standard Brownian motion (Bt )t⩾0 is a martingale because it has centered
and independent increments. This fact is also consequence of Proposition 3.1 below as Bt
can be written as wt
Bt = dBs , t ⩾ 0.
0
3. The driftless geometric Brownian motion
2 t/2
Xt := X0 e σ Bt −σ (3.1.3)
is a martingale. Indeed, using the Gaussian moment generating function identity, we have
2
IE[Xt | Fs ] = IE X0 e σ Bt −σ t/2 | Fs
 
2
= X0 e −σ t/2 IE e σ Bt | Fs
 
2
= X0 e −σ t/2 IE e (Bt −Bs )σ +σ Bs | Fs
 
2
= X0 e −σ t/2+σ Bs IE e (Bt −Bs )σ | Fs
 
2
= X0 e −σ t/2+σ Bs IE e (Bt −Bs )σ
 

2
 σ2 
= X0 e −σ t/2+σ Bs exp IE[(Bt − Bs )σ ] + Var[Bt − Bs ]
2
−σ 2 t/2+σ Bs (t−s)σ 2 /2
= X0 e e
2
= X0 e σ Bs −σ s/2
= Xs , 0 ⩽ s ⩽ t.
The following result shows that the Itô integral yields a martingale with respect to the Brownian
filtration (Ft )t⩾0 .
rt

Proposition 3.1 The stochastic integral process 0 us dBs t⩾0 of a square-integrable adapted
process u ∈ Lad 2 ( Ω × R ) is a martingale, i.e.:
+
hw t i ws
IE uτ dBτ Fs = uτ dBτ , 0 ⩽ s ⩽ t. (3.1.4)
0 0
rt
In particular, 0 us dBs is Ft -measurable, t ⩾ 0, and since F0 = {0, / Ω}, Relation (3.1.4) applied
with t = 0 recovers the fact that the Itô integral is a centered random variable:
hw t i hw t i w0
IE us dBs = IE us dBs F0 = us dBs = 0, t ⩾ 0.
0 0 0

Proof. The statement is first proved in case (ut )t⩾0 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

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3.1 Martingale Property of the Itô Integral 71


 F if s ∈ [a, b],
us := F 1[a,b] (s) =
0 if s ∈
/ [a, b],


with F an Fa -measurable random variable and t ∈ [a, b], we have

hw ∞ i hw ∞ i
IE us dBs Ft = IE F 1[a,b] (s)dBs Ft
0 0
= IE[(Bb − Ba )F | Ft ]
= F IE[Bb − Ba | Ft ]
= F (Bt − Ba )
wt
= us dBs
wat
= us dBs , a ⩽ t ⩽ 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
IE us dBs Ft = IE F 1[a,b] (s)dBs Ft
0 0
= IE[F (Bb − Ba ) | Ft ]
= IE[IE[F (Bb − Ba ) | Fa ] | Ft ]
= IE[F IE[Bb − Ba | Fa ] | Ft ]
= 0, 0 ⩽ t ⩽ a,

where we used the tower property of conditional expectations and the fact that Brownian motion
(Bt )t⩾0 is a martingale:

IE[Bb − Ba | Fa ] = IE[Bb | Fa ] − Ba = Ba − Ba = 0.

The extension from simple 2 ( Ω × R ) can be proved

processes to square-integrable processes in Lad +
as follows. 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 S. Watanabe, 1989, pages 22 and 46, by Fatou’s Lemma,
Jensen’s inequality and the Itô isometry, we have:
w i2 
t hw ∞
IE us dBs − IE us dBs Ft
0 0
 w t hw ∞ i2 
(n)
= IE lim us dBs − IE us dBs Ft
n→∞ 0 0
w i2 
t (n) hw ∞
⩽ lim inf IE us dBs − IE us dBs Ft
n→∞ 0 0
 hw
∞ (n) w∞ i2 
= lim inf IE IE us dBs − us dBs Ft
n→∞ 0 0
 w
∞ (n) w ∞ 2 
⩽ lim inf IE IE us dBs − us dBs Ft
n→∞ 0 0
w 2 
∞ (n)
= lim inf IE (us − us )dBs
n→∞ 0

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 72 N. Privault
hw ∞ i
(n)
= lim inf IE |us − us |2 ds
n→∞ 0
(n)
= lim inf ∥u − u∥2L2 (Ω×[0,T ])
n→∞
= 0,
where we used the Itô isometry. We conclude that
hw ∞ i wt
IE us dBs Ft = us dBs , t ⩾ 0,
0 0

for u ∈ Lad2 ( Ω × R ) a square-integrable adapted process, which leads to (3.1.4) after applying
+
this identity to the process (1[0,t ] us )s⩾0 , i.e.,
hw t i hw ∞ i
IE uτ dBτ Fs = IE 1[0,t ] (τ )uτ dBτ Fs
0
ws 0
= 1[0,t ] (τ )uτ dBτ
w0s
= uτ dBτ , 0 ⩽ s ⩽ t.
0

Examples of martingales (ii)

1. The martingale property of the driftless geometric Brownian motion (3.1.3) can also be
recovered from Proposition 3.1, since by Proposition 1.7, (Xt )t⩾0 satisfies the stochastic
differential equation
dXt = σ Xt dBt ,
which shows that Xt can be written using the Brownian stochastic integral
wt
Xt = X0 + σ Xu dBu , t ⩾ 0.
0

2. Consider an asset price process (St )t⩾0 given by the stochastic differential equation

dSt = µSt dt + σ St dBt , t ⩾ 0, (3.1.5)

with µ ∈ R and σ > 0. By the Discounting Lemma, the discounted asset price process
Set := e −rt St , t ⩾ 0, satisfies the stochastic differential equation

d Set = ( µ − r )Set dt + σ Set dBt ,

and the discounted asset price

2
Set = e −rt St = S0 e (µ−r)t +σ Bt −σ t/2 , t ⩾ 0,

is a martingale under P when µ = r. The case µ ̸= r will be treated in Section 3.3 using
risk-neutral probability measures, see Definition 2.7, and the Girsanov Theorem 3.3, see
(3.3.6) below.
3. The discounted value
Vet = e −rt Vt , t ⩾ 0,
of a self-financing portfolio is given by
wt
Vet = Ve0 + ξu d Seu , t ⩾ 0,
0

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

 3.2 Risk-Neutral Probability Measures 73

is a martingale when µ = r by Proposition 3.1 because

wt
Vet = Ve0 + σ ξu Seu dBu , t ⩾ 0, ,
0

since we have
d Set = Set (( µ − r )dt + σ dBt ) = σ Set dBt

by the Discounting Lemma. 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 ̸= r in the sequel.

3.2 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⩾0 := ( e −rt St )t⩾0

is a martingale, see Definition 2.7 and Proposition 2.8.

Consider an asset price process (St )t⩾0 given by the stochastic differential equation (3.1.5). Note
2
that when µ = r, the discounted asset price process Set t⩾0 = (S0 e σ Bt −σ t/2 )t⩾0 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 ̸= r using the Girsanov Theorem 3.3 below. For this, we note that by the Discounting
Lemma, the relation
d Set = ( µ − r )Set dt + σ Set dBt

where µ − r is the risk premium, can be rewritten as

d Set = σ Set d Bbt , (3.2.1)

where Bbt t⩾0
is a drifted Brownian motion given by

µ −r
Bbt := t + Bt , 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, measured in units of volatility σ .
From (3.2.1) and Propositions 2.8 and 3.1 we note that the risk-neutral probability measure can be
constructed as a probability measure P∗ under which (Bbt )t⩾0 is a standard Brownian motion.
Let us come back to the informal approximation of Brownian motion via its infinitesimal increments:
√
∆Bt = ± ∆t,

with
√
√
1
P ∆Bt = + ∆t = P ∆Bt = − ∆t = ,
2
and
1√ 1√
IE[∆Bt ] = ∆t − ∆t = 0.
2 2

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 74 N. Privault
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

Figure 3.1: Discretized drifted Brownian path (Bbt )t⩾0 with ν > 0.

Clearly, given ν ∈ R, the drifted process

Bbt := νt + Bt , t ⩾ 0,

is no longer a standard Brownian motion because it is not centered:

 
IE Bbt = IE[νt + Bt ] = νt + IE[Bt ] = νt ̸= 0,

cf. Figure 3.1. This identity can be formulated in terms of infinitesimal increments as
1 √ 1 √
IE[ν∆t + ∆Bt ] = (ν∆t + ∆t ) + (ν∆t − ∆t ) = ν∆t ̸= 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 ). (3.2.2)
2 2

Definition 3.2 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 IE[F ] = 1, and

dQ
= F, i.e. dQ = FdP. (3.2.3)
dP
In this case, F is called the Radon-Nikodym density of Q with respect to P.

Relation (3.2.3) is equivalent to the relation

w
IEQ [G] = G(ω )dQ(ω )
Ω

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3.2 Risk-Neutral Probability Measures 75
w dQ
= G(ω )
(ω )dP(ω )
Ω
dP
w
= G(ω )F (ω )dP(ω )
Ω
= IE [FG] ,

for any random variable G integrable under Q.

Coming √ back to Brownian motion considered as a discrete random walk with independent incre-
ments ± ∆t, we try to construct a new probability measure denoted P∗ , under which the drifted
process Bbt := νt + Bt will be a standard Brownian motion. This probability measure will be defined
through its Radon-Nikodym density

√ √
dP∗ P∗ (∆Bt1 = ε1 ∆t, . . . , ∆BtN = εN ∆t )
:= √ √
dP P(∆Bt1 = ε1 ∆t, . . . , ∆BtN = εN ∆t )
√ √
P∗ (∆Bt1 = ε1 ∆t ) · · · P∗ (∆BtN = εN ∆t )
= √ √
P(∆Bt1 = ε1 ∆t ) · · · P(∆BtN = εN ∆t )
1 √ √
= N
P∗ (∆Bt1 = ε1 ∆t ) · · · P∗ (∆BtN = εN ∆t ), (3.2.4)
(1/2)

ε1 , ε2 , . . . , εN ∈ {−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 identi-
fication [0, T ] ≃ {0 = t0 ,t1 , . . . ,tN = T }, this Radon-Nikodym density (3.2.4) can be rewritten as

dP∗ 1 1 √
 
1
≃ ∏ ∓ ν ∆t (3.2.5)
dP (1/2)N 0<t<T 2 2

where 2N becomes a normalization factor.

The following code is rescaling probabilities as in (3.2.2) based on the value of the drift µ.

nsim <- 100; N=12; t <- 0:N; T<-1.0; dt <- T/N; nu=3; p=0.5*(1-nu*(dt)^0.5);
dB <- matrix((dt)^0.5*(rbinom( nsim * N, 1, p)-0.5)*2, nsim, N)
X <- cbind(rep(0, nsim), t(apply(dB, 1, cumsum)))
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){if (N<20) {points(t,t*nu*dt+X[i,],pch=20,cex=0.6, col=i+1,lwd=2)}
lines(t,t*nu*dt+X[i,],type="l",col=i+1,lwd=2)}

The discretized illustration in Figure 3.2 displays the drifted Brownian motion Bbt := νt + Bt
under the shifted probability measure P∗ in (3.2.5) using the above code with N = 100. The
code makes big transitions less frequent than small transitions, resulting into a standard, centered
Brownian motion under P∗ .

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 76 N. Privault

1.0

0.5

0.0

−0.5

−1.0
0 20 40 Time 60 80 100

Figure 3.2: Drifted Brownian motion paths under a shifted Girsanov measure.

Next, using the expansion

√
√ 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∗ 1 1 √
 
= 2 ∏ N
∓ ν ∆t
dP 0<t<T 2 2
 √ 
= ∏ 1 ∓ ν ∆t
0<t<T
!
 √ 
= exp log ∏ 1 ∓ ν ∆t
0<t<T
!
 √ 
= exp ∑ log 1 ∓ ν ∆t
0<t<T
!
√ 1 √
≃ exp ν ∑ ∓ ∆t − ∑ (∓ν ∆t )2
0<t<T 2 0<t<T
!
√ ν2
= exp −ν ∑ ± ∆t − ∑ ∆t
0<t<T 2 0<t<T
!
ν2
= exp −ν ∑ ∆Bt − ∑ ∆t
0<t<T 2 0<t<T
ν2
 
= exp −νBT − T ,
2
based on the identifications
√
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

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 3.3 Change of Measure and the Girsanov Theorem 77

the probability measure P∗ defined by its Radon-Nikodym density

dP∗ ν2
 
= exp −νBT − T .
dP 2

3.3 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 6.5. 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 3.3 will be used in Section 3.4 for the construction of a unique risk-neutral probability
measure P∗ , showing absence of arbitrage and completeness in the Black-Scholes market, see
Theorems 2.10 and 2.14.

Theorem 3.3 Let (ψt )t∈[0,T ] be an adapted process satisfying the Novikov integrability condition

  w 
1 T
IE exp |ψt |2 dt < ∞, (3.3.1)
2 0

and let Q denote the probability measure defined by the Radon-Nikodym density
 w
1wT

dQ T
2
= exp − ψs dBs − |ψs | ds .
dP 0 2 0

Then wt
Bbt := Bt + ψs ds, 0 ⩽ t ⩽ T,
0
is a standard Brownian motion under Q.

In the case of the simple shift

Bbt := Bt + νt, 0 ⩽ t ⩽ T,

by a drift νt with constant ψs = ν ∈ R, the process Bbt

t⩾0
is a standard (centered) 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:


IEQ f BbT = IEQ [ f (νT + BT )]
w
= f (νT + BT )dQ
Ω
w 
1 2

= f (νT + BT ) exp −νBT − ν T dP
Ω 2
w∞ 
1

2 dx
= f (νT + x) exp −νx − ν 2 T e −x /(2T ) √
−∞ 2 2πT

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 78 N. Privault
w∞ 2 / (2T ) dx
= f (νT + x) e −(νT +x) √
−∞ 2πT
w∞ 2 / (2T ) dy
= f (y) e −y √
−∞ 2πT
= IEP [ f (BT )],
i.e.
w
IEQ [ f (νT + BT )] = f (νT + BT )dQ (3.3.2)
wΩ
= f (BT )dP
Ω
= IEP [ f (BT )],
showing that, under Q, νT + BT has the centered N (0, T ) Gaussian distribution with variance
T . For example, taking f (x) = x, Relation (3.3.2) recovers the fact that BbT is a centered random
variable under Q, i.e.  
IEQ BbT = IEQ [νT + BT )] = IEP [BT ] = 0.
The Girsanov Theorem 3.3 also allows us to extend (3.3.2) as
  w·   w
T 1wT

2
IEP [F (·)] = IE F B· + ψs ds exp − ψs dBs − |ψs | ds
0 0 2 0
h  w· i
= IEQ F B· + ψs ds , (3.3.3)
0

for all random variables F ∈ L1 (Ω), see also Exercise 3.26.

When applied to the (constant) market price of risk (or Sharpe ratio)
µ −r
ψt := ,
σ
the Girsanov Theorem 3.3 shows that the process
µ −r
Bbt := t + Bt , 0 ⩽ t ⩽ T, (3.3.4)
σ
is a standard Brownian motion under the probability measure P∗ defined by

dP∗ µ −r ( µ − r )2
 
:= exp − BT − T . (3.3.5)
dP σ 2σ 2

Hence by Proposition 3.1 the discounted price process (Set )t⩾0 solution of

d Set = ( µ − r )Set dt + σ Set dBt = σ Set d Bbt , t ⩾ 0, (3.3.6)

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. Precisely, recall that a probability measure Q on (Ω, F )
is said to be equivalent to another probability measure P when

Q(A) = 0 if and only if P(A) = 0, for all A ∈ F.

Note that when Q is defined by (3.2.3), it is equivalent to P if and only if F > 0 with P-probability
one.

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 3.4 Pricing by the Martingale Method 79

3.4 Pricing by the Martingale Method

In this section we give the expression of the Black-Scholes price using expectations of discounted
payoffs.
Recall that according to the first fundamental theorem of asset pricing Theorem 2.10, a contin-
uous 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 measure is unique, the
market is said to be complete.
The equation
dSt
= µdt + σ dBt , t ⩾ 0,
St
satisfied by the price process (St )t⩾0 can be rewritten using (3.3.4) as
dSt
= rdt + σ d Bbt , t ⩾ 0, (3.4.1)
St
with the solution
2 t/2 2 t/2
St = S0 e µt +σ Bt −σ = S0 e rt +σ Bt −σ , t ⩾ 0. (3.4.2)
b

By the discounting Lemma, we have

d Set = ( µ − r )Set dt + σ Set dBt
µ −r
 
= σ St
e dt + dBt
σ
= σ Set d Bbt , t ⩾ 0, (3.4.3)
hence the discounted price process
Set := e −rt St
2 t/2
= S0 e (µ−r)t +σ Bt −σ
2 t/2
= S0 e σ Bt −σ , t ⩾ 0,
b

is a martingale under the probability measure P∗ defined by (3.3.5). We note that P∗ is a risk-
neutral probability measure equivalent to P, also called martingale measure, whose existence and
uniqueness ensure absence of arbitrage and completeness according to Theorems 2.10 and 2.14.
Therefore, the discounted value Vet of a self-financing portfolio can be written as
wt
Vet = Ve0 + ξu d Seu
0
wt
= Ve0 + σ ξu Seu d Bbu , t ⩾ 0,
0

and by Proposition 3.1 it becomes a martingale under P∗ .

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”).

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 80 N. Privault

Theorem 3.4 Let (ξt , ηt )t∈[0,T ] be a portfolio strategy with value

Vt = ηt At + ξt St , 0 ⩽ t ⩽ 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 IE∗ [C | Ft ], 0 ⩽ t ⩽ T, (3.4.4)

where IE∗ denotes expectation under the risk-neutral probability measure P∗ .

Proof. Since the portfolio strategy (ξt , ηt )t⩾0 is self-financing, the discounted portfolio value
Vet = e −rt Vt satisfies
wt wt
Vet = V0 + ξu d Seu = Ve0 + σ ξu Seu d Bbu , t ⩾ 0,
0 0

which is a martingale under P∗ from Proposition 3.1, hence

Vet = IE∗ VeT Ft

 

= IE∗ [ e −rT VT | Ft ]
= IE∗ [ e −rT C | Ft ]
= e −rT IE∗ [C | Ft ],
which implies
Vt = e rt Vet = e −(T −t )r IE∗ [C | Ft ], 0 ⩽ t ⩽ T.
□
The following code shows the matching between the solution of the Black-Scholes PDE and the
discounted expected value (3.4.4) in the case of European call options.

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}
S0=100; r=0.02; T=1; K=100; sigma=0.2; N=10000
BSCall(S0,K,r,T,sigma)
sum(exp(-r*T)*mapply(max, S0*exp(r*T+sigma*sqrt(T)*rnorm(N)-sigma^2*T/2)-K, rep(0,N)))/N

Black-Scholes PDE for vanilla options by the martingale method

The martingale method can be used to recover the Black-Scholes PDE. As the process (St )t⩾0 has
the Markov property, see § V-6 of Protter, 2004 and Definition 3.14 below, the value

Vt = e −(T −t )r IE∗ [φ (ST ) | Ft ]

= e −(T −t )r IE∗ [φ (ST ) | St ], 0 ⩽ t ⩽ T,

of the portfolio at time t ∈ [0, T ] can be written from (3.4.4) as a function

Vt = g(t, St ) = e −(T −t )r IE∗ [φ (ST ) | St ] (3.4.5)

of t and St , 0 ⩽ t ⩽ T .

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

3.4 Pricing by the Martingale Method 81

Proposition 3.5 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 σ Bt +(r−σ
b

t⩾0

where (Bbt )t⩾0 is a standard Brownian motion under P∗ . Then, the function g(t, x) defined in
(3.4.5) 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 IE∗ [φ (ST ) | St ] = e −(T −t )r IE∗ [φ (xST /St )]|x=St
is in C 1,2 ([0, T ) × R+ ) when φ is a Lipschitz function, by differentiation of the lognormal distri-
bution of ST /St . We note that by the application of Itô’s formula to Vt = g(t, St ) and (3.4.1) with
ut = σ St and vt = rSt 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
∂g 1 ∂ 2g
+ e −rt (t, St )dSt + e −rt (dSt )2 2 (t, St )
∂x 2 ∂x
∂ g
= −r e −rt g(t, St )dt + e −rt (t, St )dt
∂t
∂ g ∂g 1 ∂ 2g
+vt e −rt (t, St )dt + ut e −rt (t, St )d Bbt + e −rt |ut |2 2 (t, St )dt
∂x ∂x 2 ∂x
∂ g
= −r e −rt g(t, St )dt + e −rt (t, St )dt (3.4.6)
∂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 )d Bbt .
∂x 2 ∂x ∂x
−rt
By Proposition 3.1, the discounted price Vet = e 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 (3.4.6) in the proof of Proposition 3.5, we also obtain the stochastic integral expression
e −rT φ (ST ) = e −rT g(T , ST )
wT
d e −rt g(t, St )


= g(0, S0 ) +
0
wT ∂g
= g(0, S0 ) + σ e −rt St (t, St )d Bbt . (3.4.7)
0 ∂x

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 82 N. Privault

Forward contracts
The long forward contract with payoff C = ST − K is priced as

Vt = e −(T −t )r IE∗ [ST − K | Ft ]

= e −(T −t )r IE∗ [ST | Ft ] − K e −(T −t )r
= St − K e −(T −t )r , 0 ⩽ t ⩽ T,

which recovers the Black-Scholes PDE solution

g(t, x) = x − K e −(T −t )r , x > 0, 0 ⩽ t ⩽ T.

European call options

In the case of European call options with payoff function φ (x) = (x − K )+ we recover the Black-
Scholes formula by a probabilistic argument.

Proposition 3.6 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 IE∗ [(ST − K )+ | Ft ] (3.4.8)

= St Φ d+ (T − t ) − K e −(T −t )r Φ d− (T − t ) ,



0 ⩽ t ⩽ T,

with
log(St /K ) + (r + σ 2 /2)(T − t )

d ( T − t ) : = √ ,

+

σ T −t




log(St /K ) + (r − σ 2 /2)(T − t )


 d− (T − t ) := √ 0 ⩽ t < T,

 ,
σ T −t
where “log” denotes the natural logarithm “ln” and Φ is the standard Gaussian Cumulative
Distribution Function.
Proof. The proof of Proposition 3.6 is a consequence of (3.4.4) and Lemma 3.7 below. Using the
relation

2 T /2
ST = S0 e rT +σ BT −σ
b

2 /2
= St e (T −t )r+(BT −Bt )σ −(T −t )σ , 0 ⩽ t ⩽ T,
b b

that follows from (3.4.2), by Theorem 3.4 the value at time t ∈ [0, T ] of the portfolio hedging C is
given by

Vt = e −(T −t )r IE∗ [C | Ft ]
e −(T −t )r IE∗ (ST − K )+ Ft
 
=
2
e −(T −t )r IE∗ (St e (T −t )r+(BT −Bt )σ −(T −t )σ /2 − K )+ Ft
 
=
b b

2
e −(T −t )r IE∗ (x e (T −t )r+(BT −Bt )σ −(T −t )σ /2 − K )+ |x=S
 
=
b b
t
−(T −t )r ∗
 m(x)+X +

= e IE ( e − K ) |x=S , 0 ⩽ t ⩽ T,
t

where
σ2
m(x ) : = (T − t )r − (T − t ) + log x
2

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3.4 Pricing by the Martingale Method 83

and
X := BbT − Bbt σ ≃ N (0, (T − t )σ 2 )

is a centered Gaussian random variable with variance

Var [X ] = Var BbT − Bbt σ = σ 2 Var BbT − Bbt = (T − t )σ 2


  

under P∗ . Hence by Lemma 3.7 below we have

g(t, St ) = Vt

+ 
e −(T −t )r IE∗ e m(x)+X − K

= |x=S
t

m(St ) − log K
 
−(T −t )r m(St )+σ 2 (T −t )/2
= e e Φ v+
v
m(St ) − log K
 
−K e −(T −t )r Φ
v
m(St ) − log K m(St ) − log K
   
−(T −t )r
= St Φ v + −K e Φ
v v
−(T −t )r
= St Φ d+ (T − t ) − K e Φ d− ( T − t ) ,

0 ⩽ t ⩽ T. □
Relation (3.4.8) can also be written as

e −(T −t )r IE∗ (ST − K )+ Ft = e −(T −t )r IE∗ (ST − K )+ St

   
(3.4.9)
log(St /K ) + (r + σ 2 /2)(T − t )
 
= St Φ √
σ T −t
log(St /K ) + (r − σ 2 /2)(T − t )
 
−(T −t )r
−K e Φ √ , 0 ⩽ t ⩽ T.
σ T −t

Lemma 3.7 Let X ≃ N (0, v2 ) be a centered Gaussian random variable with variance v2 > 0. We
have
2
IE ( e m+X − K )+ = e m+v /2 Φ(v + (m − log K )/v) − KΦ((m − log K )/v).
 

Proof. We have

1 w ∞ m+x 2 2
IE ( e m+X − K )+ = √ − K )+ e −x /(2v ) dx
 
(e
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
2πv2 −m+log K 2πv2 −m+log K
2 /2 w
e m + v ∞ 2 2 2 K w∞ 2
= √ e −(v −x) /(2v ) dx − √ e −y /2 dy
2πv2 −m+log K 2π (−m+log K )/v
m + v 2 /2 w
e ∞ 2 2
= √ 2
e −y /(2v ) dy − KΦ((m − log K )/v)
2πv2 −v −m+log K
m+v2 /2
= e Φ(v + (m − log K )/v) − KΦ((m − log K )/v).

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 84 N. Privault

Call-put parity
Let
gp (t, St ) := e −(T −t )r IE∗ (K − ST )+ Ft ,
 
0 ⩽ t ⩽ T,
denote the price of the put option with strike price K and maturity T .

Proposition 3.8 Call-put parity. We have the relation

gc (t, St ) − gp (t, St ) = St − e −(T −t )r K (3.4.10)

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 the relation
ST − K = ( ST − K ) + − ( K − ST ) + ,
see https://optioncreator.com/stijwns, and Theorem 3.4, we have

gc (t, St ) − gp (t, St )
= e −(T −t )r IE∗ [(ST − K )+ | Ft ] − e −(T −t )r IE∗ [(K − ST )+ | Ft ]
= e −(T −t )r IE∗ [(ST − K )+ − (K − ST )+ | Ft ]
= e −(T −t )r IE∗ [ST − K | Ft ]
= e −(T −t )r IE∗ [ST | Ft ] − K e −(T −t )r
= St − e −(T −t )r K, 0 ⩽ t ⩽ T,

as we have IE∗ [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 (3.4.10) we can recover the European put option price (3.4.8).

Proposition 3.9 The price at time t ∈ [0, T ] of the European put option with strike price K and
maturity T is given by

gp (t, St ) = e −(T −t )r IE∗ [(K − ST )+ | Ft ]

= K e −(T −t )r Φ − d− (T − t ) − St Φ − d+ (T − t ) ,



0 ⩽ t ⩽ T,

with
log(St /K ) + (r + σ 2 /2)(T − t )

d ( T − t ) : = √ ,

+

σ T −t




log(St /K ) + (r − σ 2 /2)(T − t )


 d− (T − t ) := √ 0 ⩽ t < T,

 ,
σ T −t
where “log” denotes the natural logarithm “ln” and Φ is the standard Gaussian Cumulative
Distribution Function.
Proof. By the call-put parity (3.4.10), we have
gp (t, St ) = gc (t, St ) − St + e −(T −t )r K

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 3.5 Hedging by the Martingale Method 85

= 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 ) .

3.5 Hedging by the Martingale Method

Hedging exotic options
In the next Proposition 3.10 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 = IE∗ [C ] + ζt d Bbt , (3.5.1)
0

where (ζt )t∈[0,t ] is a square-integrable adapted process, see for example and (3.4.7). Consequently,
the mathematical problem of finding the stochastic integral decomposition (3.5.1) 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, Øksendal, and Proske, 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. Exercise 3.1, and wT

( BT ) 3 = 3 T − t + Bt2 dBt .


0
In the sequel, recall that the risky asset follows the equation
dSt
= µdt + σ dBt , t ⩾ 0, S0 > 0,
St

and by (3.3.6), the discounted asset price Set := e −rt St

d Set = σ Set d Bbt , t ⩾ 0, Se0 = S0 > 0, (3.5.2)

where (Bbt )t⩾0 is a standard Brownian motion under the risk-neutral probability measure P∗ . The
following proposition applies to arbitrary square-integrable payoff functions, in particular it covers
exotic and path-dependent options.

Proposition 3.10 Consider a random claim payoff C ∈ L2 (Ω) and the process (ζt )t∈[0,T ] given
by (3.5.1), and let

e −(T −t )r
ξt = ζt , (3.5.3)
σ St
e −(T −t )r IE∗ [C | Ft ] − ξt St
ηt = , 0 ⩽ t ⩽ T. (3.5.4)
At

Then the portfolio allocation (ξt , ηt )t∈[0,T ] is self-financing, and letting

Vt = ηt At + ξt St , 0 ⩽ t ⩽ T, (3.5.5)

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 86 N. Privault

we have

Vt = e −(T −t )r IE∗ [C | Ft ], 0 ⩽ t ⩽ T. (3.5.6)

In particular we have

VT = C, (3.5.7)

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 IE∗ [C ].

Proof. Relation (3.5.6) follows from (3.5.4) and (3.5.5), and it implies

V0 = e −rT IE∗ [C ] = η0 A0 + ξ0 S0
at t = 0, and (3.5.7) at t = T . It remains to show that the portfolio strategy (ξt , ηt )t∈[0,T ] is
self-financing. By (3.5.1) and Proposition 3.1 we have

Vt = ηt At + ξt St
= e −(T −t )r IE∗ [C | Ft ]
 wT 
−(T −t )r ∗ ∗
= e IE IE [C ] + ζu d Bu Ft
b
0
 wt 
= e −(T −t )r IE∗ [C ] + ζu d Bbu
0
wt
rt −(T −t )r
= e V0 + e ζu d Bbu
0
wt
= e rt V0 + σ ξu Su e (t−u)r d Bbu
0
wt
rt rt
= e V0 + σ e ξu Seu d Bbu .
0

By (3.5.2) this shows that the portfolio strategy (ξt , ηt )t∈[0,T ] given by (3.5.3)-(3.5.4) and its
discounted portfolio value Vet := e −rt Vt satisfy
wt
Vet = V0 + ξu d Seu , 0 ⩽ t ⩽ T,
0

which implies that (ξt , ηt )t∈[0,T ] is self-financing. □

The above proposition shows that there always exists a hedging strategy starting from

V0 = IE∗ [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 = IE∗ VeT Ft = e −rT IE∗ [C | Ft ],

 
0 ⩽ t ⩽ T,

and initial value

Ve0 = IE∗ VeT = e −rT IE∗ [C ].
 

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3.5 Hedging by the Martingale Method 87

Hedging vanilla options

In practice, the hedging problem can now be reduced to the computation of the process (ζt )t∈[0,T ]
appearing in (3.5.1). 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
compute the process (ζt )t∈[0,T ] in case the payoff C is of the form C = φ (ST ) for some function φ .

Proposition 3.11 Assume that φ is a Lipschitz payoff function. Then, the function C (t, x)
defined from the Markov property of (St )t∈[0,T ] by

C (t, St ) := IE∗ [φ (ST ) | Ft ] = IE∗ [φ (ST ) | St ] (3.5.8)

is in C 1,2 ([0, T ) × R), and the stochastic integral decomposition

 wT
φ (ST ) = IE∗ φ (ST ) +

ζt d Bbt (3.5.9)
0

is given by

∂C
ζt = σ St (t, St ), 0 ⩽ t ⩽ T. (3.5.10)
∂x
In addition, the self-financing hedging strategy (ξt )t∈[0,T ] satisfies

∂C
ξt = e −(T −t )r (t, St ), 0 ⩽ t ⩽ T. (3.5.11)
∂x
Proof. It can be checked as in the proof of Proposition 3.5 that 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 ) = IE∗ [φ (ST ) | Ft ],

which is a martingale from the tower property of conditional expectations as in (3.5.18) or Ex-
ample (1) page 69. 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 (u, Su )d Bbu , 0 ⩽ t ⩽ T, (3.5.12)
0 ∂x
with C (0, S0 ) = IE∗ [φ (ST )]. Letting t := T , we have
wT ∂C
φ (ST ) = C (T , ST ) = C (0, S0 ) + σ St (t, St )d Bbt
0 ∂x
see also (3.4.7), which yields (3.5.10) by uniqueness of the stochastic integral decomposition (3.5.9)
of C = φ (ST ). Finally, (3.5.11) follows from (3.5.3) and (3.5.10) by applying Proposition 3.10.
□
In the case of European options, the process ζ can be computed via the next proposition which
recovers the formula for the Delta of a vanilla option, and follows from Proposition 3.11 and the
relation
C (t, x) = IE∗ f (St,T
x
 
) , 0 ⩽ t ⩽ T , x > 0.
In particular, we have ξt ⩾ 0 and there is no short selling when the payoff function φ is non-
decreasing.

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 88 N. Privault

Corollary 3.12 Assume that C = (ST − K )+ . Then, for 0 ⩽ t ⩽ T we have

  
ST ST
ζt = σ St IE ∗
1 x , 0 ⩽ t ⩽ T, (3.5.13)
St [K,∞) St |x=St

and
  
ST ST
ξt = e −(T −t )r
IE∗
1 x , 0 ⩽ t ⩽ T. (3.5.14)
St [K,∞) St |x=St

Proof. By (3.5.8), (3.5.10) and the relation

2 T /2 2 /2
ST = S0 e σ BT +µT −σ = St e (BT −Bt )σ +(T −t )µ−(T −t )σ ,

we have
∂C
ζt = σ St (t, St )
∂x
 
∂ ∗
= σ St IE [φ (ST ) | St = x]
∂x x=St
   
∂ ∗ ST
= σ St IE φ x , 0 ⩽ t ⩽ T,
∂x St x=St

hence by (3.5.3) we have

1 −(T −t )r
ξt = e ζt (3.5.15)
σ St
   
−(T −t )r ∂ ∗ ST
= e IE φ x
∂x St x=St
  
ST ′ ST
= e −(T −t )r IE∗ φ x , 0 ⩽ t ⩽ T.
St St x=St

The above derivation can be checked for φ (x) = (x − K )+ and φ ′ (x) = 1[K,∞) (x) e.g. by writing
expected values as integrals. □
By evaluating the expectation (3.5.13) in Corollary 3.12 we can recover the formula (2.3.4) in
Proposition 2.16 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 2.16.

Proposition 3.13 The Delta of the European call option with payoff function φ (x) = (x − K )+
is given by

log(St /K ) + (r + σ 2 /2)(T − t )
 
ξt = Φ d+ (T − t ) = Φ


√ , 0 ⩽ t ⩽ T.
σ T −t
Proof. By Proposition 3.10 and Corollary 3.12, we have

1 −(T −t )r
ξt = e ζt
σ St
  
−(T −t )r ∗ ST ST
=e IE 1 x
St [K,∞) St |x=St

= e −(T −t )r

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3.5 Hedging by the Martingale Method 89
h i
× IE∗ e (BT −Bt )σ −(T −t )σ /2+(T −t )r 1[K,∞) (x e (BT −Bt )σ −(T −t )σ /2+(T −t )r )
b b 2 b b 2

|x=St
1 w∞ 2 2
=p e σ y−(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 ) .

□
The Delta of the Black-Scholes put option can be obtained as in Proposition 2.18, by differentiation
of the call-put parity relation (3.8), and application of Proposition 3.13.
Proposition 3.13, combined with Proposition 3.6, shows that the Black-Scholes self-financing
hedging strategy is to hold a (possibly fractional) quantity

log(St /K ) + (r + σ 2 /2)(T − t )
 
ξt = Φ d+ (T − t ) = Φ


√ ⩾0 (3.5.16)
σ T −t
of the risky asset, and to borrow a quantity

log(St /K ) + (r − σt2 /2)(T − t )

 
−rT
−ηt = K e Φ √ ⩾0 (3.5.17)
σ T −t
of the riskless (savings) account.

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 3.14 The Markov semi-group (Pt )0⩽t⩽T associated to (St )t∈[0,T ] is the mapping Pt
defined on functions f ∈ Cb2 (R) as

Pt f (x) := IE∗ [ f (St ) | S0 = x], t ⩾ 0.

By the Markov property and time homogeneity of (St )t∈[0,T ] we also have

Pt f (Su ) := IE∗ [ f (St +u ) | Fu ] = IE∗ [ f (St +u ) | Su ], t, u ⩾ 0,

and the semi-group (Pt )0⩽t⩽T satisfies the composition property

Ps Pt = Pt Ps = Ps+t = Pt +s , s,t ⩾ 0,

as we have, using the Markov property and the tower property of conditional expectations as in
(3.5.18),

Ps Pt f (x) = IE∗ [Pt f (Ss ) | S0 = x]

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 90 N. Privault

= IE∗ IE∗ [ f (St ) | S0 = y]y=Ss S0 = x

 

= IE∗ IE∗ [ f (St +s ) | Ss = y]y=Ss S0 = x

 

= IE∗ IE∗ [ f (St +s ) | Fs ] S0 = x

 

= IE∗ [ f (St +s ) | S0 = x]
= 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 (3.1.1), i.e.:
IE∗ [PT −t f (St ) | Fu ] = IE∗ IE∗ [ f (ST ) | Ft ] Fu
 

= IE∗ [ f (ST ) | Fu ]
= PT −u f (Su ), 0 ⩽ u ⩽ t ⩽ T, (3.5.18)
and we have

  
∗ ∗ St
Pt−u f (x) = IE [ f (St ) | Su = x] = IE f x , 0 ⩽ u ⩽ t. (3.5.19)
Su

Exercises
Exercise 3.1 (Bachelier, 1900 model). Consider a market made of a riskless asset priced At = A0 ,
t ⩾ 0, with vanishing risk-free interest rate r = 0, and a risky asset whose price modeled by a
standard Brownian motion as St = Bt , t ⩾ 0. Using Theorem 3.4, price the vanilla option with
payoff C = (BT )2 and recover the solution of the Black-Scholes PDE.

Exercise 3.2 Given the price process (St )t⩾0 defined as the geometric Brownian motion
2 /2)t
St := S0 e σ Bt +(r−σ , t ⩾ 0,

price the option with payoff function φ (ST ) by writing e −rT IE∗ [φ (ST )] as an integral with respect
to the lognormal probability density function, see Exercise 2.8.

Exercise 3.3 (See Exercise 3.30). Consider an asset price (St )t⩾0 given by the stochastic differential
equation

dSt = rSt dt + σ St dBt , (3.5.20)

where (Bt )t⩾0 is a standard Brownian motion, with r ∈ R and σ > 0.

a) Find the stochastic differential equation satisfied by the power Stp t⩾0 of order p ∈ R of

(St )t⩾0 .
b) Using the Girsanov Theorem 3.3 and the discounting Lemma, construct a probability measure
−rt p

under which the discounted process e St t⩾0 is a martingale.

Exercise 3.4 Consider an asset price process (St )t⩾0 which is a martingale under the risk-neutral
probability measure P∗ in a market with interest rate r = 0, and let φ be a convex payoff function.
Show that, for any two maturities T1 < T2 and p, q ∈ [0, 1] such that p + q = 1 we have

IE∗ [φ ( pST1 + qST2 )] ⩽ IE∗ [φ (ST2 )],

i.e. the price of the basket option with payoff φ ( pST1 + qST2 ) is upper bounded by the price of the
option with payoff φ (ST2 ).
Hints:

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3.5 Hedging by the Martingale Method 91

i) For φ a convex function we have φ ( px + qy) ⩽ 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 ))t⩾0 of a martingale (St )t⩾0 is a submartingale.

Exercise 3.5 Consider an underlying asset price process (St )t⩾0 under a risk-neutral measure P∗
with risk-free interest rate r.
a) Does the European call option price C (K ) := e −rT IE∗ [(ST − K )+ ] increase or decrease with
the strike price K? Justify your answer.
b) Does the European put option price C (K ) := e −rT IE∗ [(K − ST )+ ] increase or decrease with
the strike price K? Justify your answer.

Exercise 3.6 Consider an underlying asset price process (St )t⩾0 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 IE∗ [(ST − K )+ | Ft ] ⩾ St − K e −(T −t )r , 0 ⩽ t ⩽ 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 IE∗ [(K − ST )+ | Ft ] ⩾ K e −(T −t )r − St , 0 ⩽ t ⩽ T.

Exercise 3.7 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.

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.
Figure 3.3: Payoff functions of bull spread and bear spread options.

a) Show that in each case (i) and (ii) the corresponding option can be realized 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 IE∗ [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 3.8 Given two strike prices K1 < K2 , we consider a long box spread option realized as
the combination of four legs having the same maturity time N ⩾ 1:

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 92 N. Privault

• 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
Figure 3.4: 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 using K1 , K2 and the interest rate r.
c) From Table 3.1 below, find a choice of strike prices K1 < K2 that can be used to build 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$.

Hints.
i) The closing prices in Table 3.1 are warrant prices quoted in index points.
ii) Warrant prices are converted to option prices by multiplication by the number given in
the “Entitlement Ratio” column.
iii) The conversion from index points to HK$ is given in Table 3.2.
e) Would you buy the option priced in part (d)) ? Here we can take r = 0 for simplicity.

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3.5 Hedging by the Martingale Method 93

Table 3.1: Call and put options on the Hang Seng Index (HSI).

Table 3.2: Contract summary.

Exercise 3.9 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 3.5, with K1 := 50 and K2 := 150.

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 94 N. Privault

60
50
40
30
20
10
0
0 50 100 150 200
K1 SN K2
Figure 3.5: 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: Recall that an option with payoff φ (SN ) is priced in discrete time as (1 + r )−N IE∗ [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 3.10 Forward contracts revisited. Consider a risky asset whose price St is given by
2
St = S0 e σ Bt +rt−σ t/2 , t ⩾ 0, where (Bt )t⩾0 is a standard 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 3.11 Option pricing with dividends reinvested. Consider an underlying asset price process
(St )t⩾0 paying dividends at the continuous-time rate δ > 0, and modeled as

dSt = ( µ − δ )St dt + σ St dBt ,

where (Bt )t⩾0 is a standard Brownian motion.

a) Show that if (ηt , ξt )t⩾0 is a portfolio strategy with value

Vt = ηt At + ξt St , t ⩾ 0,

where the dividend yield δ St 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 d Seu , t ⩾ 0,
0

b) Show that, as in Theorem 3.4, 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 IE∗ [C | Ft ], 0 ⩽ t ⩽ T,

where IE∗ denotes expectation under a risk-neutral probability measure P∗ .

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.

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3.5 Hedging by the Martingale Method 95

Exercise 3.12 Consider the Asian forward contract with payoff

1 wT
Su du − K, (3.5.21)
T 0
2
where Su = S0 e σ Bu +ru−σ u/2 , u ⩾ 0, and (Bu )u⩾0 is a standard Brownian motion under the risk-
neutral measure P∗ .
a) Price the Asian forward contract at any time t ∈ [0, T ].
b) Find the self-financing portfolio strategy (ξt )t∈[0,T ] hedging the Asian forward contract with
payoff (3.5.21), where ξt denotes the quantity invested at time t ∈ [0, T ] in the risky asset St .
Exercise 3.13 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 IE∗ e −(T2 −T1 )r IE∗ (ST2 − ST1 )+ FT1 Ft

   

at time t ∈ [0, T1 ], of the forward start European call option using the Black-Scholes formula

log(x/K ) + (r + σ 2 /2)(T − t )
 
Bl(x, K, σ , r, T − t ) = xΦ √
|σ | T − t
log(x/K ) + (r − σ 2 /2)(T − t )
 
−(T −t )r
−K e Φ √ ,
|σ | T − t
0 ⩽ t < T.

Exercise 3.14 Cliquet (or ratchet) option. Let 0 = T0 < T1 < · · · < Tn denote a sequence of
financial settlement dates, and consider a risky asset priced as the geometric Brownian motion
2
St = S0 e σ Bt +rt−σ t/2 , t ⩾ 0, where (Bt )t⩾0 is a standard Brownian motion under the risk-neutral
measure P∗ . Compute the price at time t = 0 of the cliquet option which consists of the sum of
n at-the-money call option contracts signed at time Tk−1 and maturing at time Tk , with payoffs
(STk /STk−1 − K )+ , k = 1, . . . , n. For this, use the Black-Scholes formula

log(S0 /κ ) + (r + σ 2 /2)T
 
−rT ∗
e IE [(ST − κ ) ] = S0 Φ
+
√
|σ | T
log(S0 /κ ) + (r − σ 2 /2)T
 
−rT
−κ e Φ √ , T > 0.
|σ | T

Exercise 3.15 Log contracts. Consider the price process (St )t∈[0,T ] given by

dSt
= rdt + σ dBt
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 IE∗ [log ST | Ft ],

at time t ∈ [0, T ], of the log contract with payoff log ST .

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 96 N. Privault

Exercise 3.16 Power option. Consider the price process (St )t∈[0,T ] given by

dSt
= rdt + σ dBt
St
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 ⩽ t ⩽ T.

a) Compute the arbitrage-free price

C (t, St ) = e −(T −t )r IE∗ |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 3.17 (Bachelier, 1900 model).

a) Consider the solution (St )t⩾0 of the stochastic differential equation

dSt = αSt dt + σ dBt .

For which value αM of α is the discounted price process Set = e −rt St , 0 ⩽ t ⩽ 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 ⩽ t ⩽ T , is a martingale.
c) Compute the arbitrage-free price

C (t, St ) = e −(T −t )r IEα e ST Ft

 

at time t ∈ [0, T ] of the contingent claim with payoff exp(ST ).

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 3.18 Compute the arbitrage-free price

C (t, St ) = e −(T −t )r IEα (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 3.17.

Exercise 3.19 (Exercise 2.15 continued, see Proposition 4.1 in Carmona and Durrleman, 2003).
(1) (2)
Consider two assets whose prices St , St at time t ∈ [0, T ] follow the geometric Brownian
dynamics
(1) (1) (1) (1) (2) (2) (2) (2)
dSt= rSt dt + σ1 St dWt dSt = rSt dt + σ2 St dWt t ∈ [0, T ],
(1)
(2)

where Wt t∈[0,T ] , Wt t∈[0,T ] are two standard Brownian motions with correlation ρ ∈ [−1, 1]
(1) (2)
under a risk-neutral probability measure P∗ , with dWt • dWt = ρdt.
(2) (1)
Estimate the price e −rT IE∗ [(ST − K )+ ] of the spread option on ST := ST − ST with maturity
T > 0 and strike price K > 0 by matching the first two moments of ST to those of a Gaussian
random variable.

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3.5 Hedging by the Martingale Method 97

Exercise 3.20 Price the option with vanilla payoff C = φ (ST ) using the noncentral Chi square
probability density function of the J. Cox, Ingersoll, and Ross, 1985 (CIR) model.

Exercise 3.21 Let (Bt )t⩾0 be a standard Brownian motion generating a filtration (Ft )t⩾0 . Recall
that for f ∈ C 2 (R+ × R), Itô’s formula for (Bt )t⩾0 reads
wt ∂ f
f (t, Bt ) = f (0, B0 ) + (s, Bs )ds
0 ∂s
wt ∂ f 1 w t ∂2 f
+ (s, Bs )dBs + (s, Bs )ds.
0 ∂x 2 0 ∂ x2
2
a) Let r ∈ R, σ > 0, f (x,t ) = e rt +σ x−σ t/2 , and St = f (t, Bt ). Compute d f (t, Bt ) by Itô’s
formula, and show that St solves the stochastic differential equation
dSt = rSt dt + σ St dBt ,
where r > 0 and σ > 0.
b) Show that
2
IE e σ BT Ft = e σ Bt +(T −t )σ /2 ,
 
0 ⩽ t ⩽ T.
Hint: Use the independence of increments of (Bt )t∈[0,T ] in the time splitting decomposition
BT = (Bt − B0 ) + (BT − Bt ),
2 2
and the Gaussian moment generating function IE e αX = e α η /2 when X ≃ N (0, η 2 ).
 

c) Show that the process (St )t⩾0 satisfies

IE[ST | Ft ] = e (T −t )r St , 0 ⩽ t ⩽ 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 IE[C | Ft ].
e) Find a self-financing portfolio strategy (ξt , ηt )t⩾0 such that
Vt = ξt St + ηt At , 0 ⩽ t ⩽ T,
where At = A0 e rt is the price of a riskless asset with fixed interest rate r > 0.
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 3.22 Binary options. Consider a price process (St )t⩾0 given by
dSt
= rdt + σ dBt , 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 ⩽ 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 IE[Cd | Ft ] and πt (Pd ) = e −(T −t )r IE[Pd | Ft ]. (3.5.22)

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 98 N. Privault

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 (3.5.22), Question (a)), and the relation

1[K,∞) (ST ) St = x = P∗ (ST ⩾ K | St = x),

 
IE

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 2.17-(d)) and of Question (b)), show that the price πt (Cd ) =
Cd (t, St ) of the binary call option is given by the function
− 2 /2)(T − t ) + log(x/K )

−(T −t )r ( r σ
Cd (t, x) = e 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 (3.5.22) and Question (a)), prove the call-put parity relation

πt (Cd ) + πt (Pd ) = e −(T −t )r , 0 ⩽ t ⩽ T. (3.5.23)

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?

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3.5 Hedging by the Martingale Method 99

Exercise 3.23 Computation of Greeks. Consider an underlying asset whose price (St )t⩾0 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 IE[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
∂
e −rT IE[φ (ST ) | S0 = x]


ThetaT =
∂T
of the option price with respect to maturity T can be expressed as
ThetaT = −r e −rT IE[φ (ST ) | S0 = x] + r e −rT IE St φ ′ (ST ) S0 = x
 

1
+ e −rT IE φ ′′ (ST )σ 2 (ST ) S0 = x .
 
2

Problem 3.24 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
2
underlying asset priced St = S0 e σ Bt +rt−σ t/2 , t ⩾ 0, where (Bt )t⩾0 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 ⩽ t ⩽ T. (3.5.24)

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 European 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 (3.5.24).

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 strategy (ξt , ηt )t∈[0,T ]
with portfolio value
Vt = ξt St + ηt e rt , 0 ⩽ t ⩽ 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 .

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 100 N. Privault

g) Price the contract of Question (f)) at any time t ∈ [0, T ].

h) Using the Black-Scholes formula, compute the self-financing hedging strategy (ξt , ηt )t∈[0,T ]
with portfolio value
Vt = ξt St + ηt e rt , 0 ⩽ t ⩽ T,
for the option contract of Question (f)).
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 Questions (c)), (f)) and (i)).
Problem 3.25 (Peng, 2010). Consider a risky asset priced
2 t/2
St = S0 e σ Bt +µt−σ , i.e. dSt = µSt dt + σ St dBt , t ⩾ 0,
a riskless asset valued At = A0 e rt , and a self-financing portfolio allocation (ηt , ξt )t⩾0 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 − πs d Bbs , (3.5.25)
t t

where πt := σ ξt St is the risky amount invested on the asset St , multiplied by σ , and (Bbt )t⩾0
is a standard Brownian motion under P∗ .
Hint: the Girsanov Theorem 3.3 states that
( µ − r )t
Bbt := Bt + , 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 d Bbs . (3.5.26)
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 , (3.5.27)
t t
with terminal condition VT = g(ST ). By matching (3.5.27) to the Itô formula 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 condition
σ
2 /2)T
VT = (S0 e σ BT +(µ−σ − K )+ ,
give the process (πt )t∈[0,T ] appearing in the stochastic integral representation (3.5.26) of the
2 /2)T
discounted claim payoff e −rT (S0 e σ BT +(µ−σ − K )+ .*
* General Black-Scholes knowledge can be used for this question.

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3.5 Hedging by the Martingale Method 101

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 (3.5.27) satisfied by (Vt )t⩾0 , and the corresponding 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⩾0 is a non-decreasing process. Show that the corresponding portfolio strategy
(ξt )t⩾0 is superhedging the claim payoff VT = C.

Exercise 3.26 Girsanov Theorem. Assume that the Novikov integrability condition (3.3.1) is not
satisfied. How does this modify the statement (3.3.3) of the Girsanov Theorem 3.3?

Problem 3.27 The Capital Asset Pricing Model (CAPM) of W.F. Sharpe‡ 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 interest 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 relative volatility of dSt /St with respect to dMt /Mt ,
and it measures the risk of (St )t⩾0 in comparison to the market index (Mt )t⩾0 .
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.
* 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.
‡1990 Nobel Prize in Economics.
§ The risk-free interest rate r is typically the yield of the 10-year Treasury bond.

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 102 N. Privault

In what follows, we assume that the benchmark market is represented by an index fund (Mt )t⩾0
whose value is modeled according to
dMt
= µdt + σM dBt , (3.5.28)
Mt
where (Bt )t⩾0 is a standard Brownian motion. The asset price (St )t⩾0 is modeled in a stochastic
version of the CAPM as
 
dSt dMt
= rdt + αdt + β − rdt + σS dWt , (3.5.29)
St Mt
with an additional stock volatility term σS dWt , where (Wt )t⩾0 is a standard Brownian motion
independent of (Bt )t⩾0 , with

Cov(Bt ,Wt ) = 0 and dBt • dWt = 0, t ⩾ 0.

The following 10 questions are interdependent and should be treated in sequence.

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⩾0 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⩾0 is a standard Brownian motion.

Hint: The standard Brownian motion (Zt )t⩾0 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 (3.5.28)-(3.5.29) into the system
dMt


 = rdt + σM dBt∗ ,
 Mt


 dSt = rdt + σM β (Mt )dBt∗ + σS dWt∗ ,




St
where (Bt∗ )t⩾0 and (Wt∗ )t⩾0 have to be determined explicitly.
d) Using the Girsanov Theorem 3.3, construct a probability measure P∗ under which (Bt∗ )t⩾0
and (Wt∗ )t⩾0 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 ],
where (At )t⩾0 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 ] .

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3.5 Hedging by the Martingale Method 103

g) Consider an option with payoff C = h(ST , MT ), priced as

f (t, St , Mt ) = e −(T −t )r IE∗ [h(ST , MT ) | Ft ], 0 ⩽ t ⩽ T.

Assuming that the portfolio (Vt )t∈[0,T ] replicates the option price process ( 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):

∂f ∂f 1 ∂2 f
d f (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 ] replicating 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 3.28 Market bubbles occur when a financial asset becomes overvalued for various reasons,
for example in the Dutch tulip bubble (1636-1637), Japan’s stock market bubble (1986), dotcom
bubble (2000), or US housing bubble (2009). Local martingales are used for the modeling of market
bubbles and market crashes, see A. Cox and Hobson, 2005, Heston, Loewenstein, and Willard,
2007, Jarrow, Protter, and Shimbo, 2007, in which case the option call-put parity does not hold
in general. In what follows we let T > 0 and we consider a filtration (Ft )t∈[0,T ] on [0, T ] with
F0 = {0,/ Ω} and a probability measure P on (Ω, FT ).
1. An (Ft )t∈[0,T ] -adapted process (Mt )t∈[0,T ] is called a (true) martingale on [0, T ] if
i) IE[|Mt |] < ∞ for all t ∈ [0, T ],
ii) IE[Mt | Fs ] = Ms , for all 0 ⩽ s ⩽ t.
2. An (Ft )t∈[0,T ] -adapted process (Mt )t∈[0,T ] is called a supermartingale on [0, T ] if
i) IE[|Mt |] < ∞ for all t ∈ [0, T ],
ii) IE[Mt | Fs ] ⩽ Ms , for all 0 ⩽ s ⩽ t.
3. An (Ft )t∈[0,T ] -adapted process (Mt )t∈[0,T ] is called a local martingale on [0, T ] if there exists
a nondecreasing sequence (τn )n⩾1 of [0, T ]-valued stopping times such that
i) limn→∞ τn = T almost surely,
ii) for all n ⩾ 1 the stopped process (Mτn ∧t )t∈[0,T ] is a (true) martingale under P.
4. A local martingale on [0, T ] which is not a true martingale is called a strict local martingale.
1) a) Show that any martingale (Mt )t∈[0,T ] on [0, T ] is a local martingale in [0, T ].
b) Show that any nonnegative local martingale (Mt )t∈[0,T ] is a supermartingale.
Hint: Use Fatou’s lemma.
c) Show that if (Mt )t∈[0,T ] is a nonnegative and strict local martingale on [0, T ] we have
IE[MT ] < M0 .
Hint: Do the proof by contradiction using the tower property, the answer to Ques-
tion (b)), and the fact that if a random variable X satisfies X ⩽ 0 a.s. and IE[X ] = 0,
then X = 0 a.s..

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 104 N. Privault

d) Show that the call-put parity

C (0, M0 ) − P(0, M0 ) = IE[M0 ] − e −rT K
between C (0, M0 ) and P(0, M0 ) fails when the discounted asset price process (Mt )t∈[0,T ]
is a strict local martingale.
Hint: See Relation (3.8) in Proposition 3.4.10.
2) Let (St )t∈[0,T ] be the solution of the stochastic differential equation
St
dSt = √ dBt (3.5.30)
T −t
with S0 > 0.
a) Show that (St )t∈[0,T −ε ] is a martingale on [0, T − ε ] for every ε ∈ (0, T ).
Hint: Solve the stochastic differential equation (3.5.30) by the method of Proposi-
tion 6.16-a), and use Exercise 5.11-b).
b) Find the value of ST by a simple argument.
c) Show that (St )t∈[0,T ] is a strict local martingale on [0, T ].
Hint: Consider the stopping times
  
1
τn := 1− T ∧ inf{t ∈ [0, T ] : |St | ⩾ n}, n ⩾ 1,
n
and use Proposition 8.1.
d) Plot a sample graph of (St )t∈[0,T ] with T = 1, and attach or upload it with your submis-
sion.
3) CEV model. Consider the positive strict local martingale (St )t∈[0,T ] solution of dSt = St2 dBt
with S0 > 0, where St has the probability density function
(1/x − 1/S0 )2 (1/x + 1/S0 )2
    
S0
ϕt (x) = √ exp − − exp − ,
x3 2πt 2t 2t
x > 0, t ∈ (0, T ], see § 2.1.2 in Jacquier, 2017.
a) Plot a sample graph of (St )t∈[0,T ] with T = 1, and attach or upload it with your submis-
sion.
b) Compute IE[ST ] and check that the condition of Question (c)) is satisfied.
Hint: Use the change of variable y = 1/x and the standard normal CDF Φ.
c) Compute the limit of IE[ST ] as S0 tends to infinity.
d) Compute the price IE[(ST − K )+ ] of a European call option with strike price K > 0 in
this model, assuming a risk-free interest rate r = 0.
Hint: The final answer should be written in terms of the standard normal CDF Φ and of
the normal PDF ϕ.
e) Show that IE[(ST − K )+ ] is bounded uniformly in S0 > 0 and K > 0 by a constant
depending on T > 0.

Problem 3.29 Quantile hedging (Föllmer and Leukert, 1999, §6.2 of Mel′ nikov, Volkov, and
Nechaev, 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
IEQ [F ] = F (ω )dQ(ω )
Ω
w dQ
= F (ω ) (ω )dP(ω )
Ω dP
 
dQ
= IEP F .
dP

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3.5 Hedging by the Martingale Method 105

a) Neyman-Pearson Lemma. Given P and Q two probability measures, consider the event
 
dP
Aα := >α , α ⩾ 0.
dQ

Show that for A any event, Q(A) ⩽ Q(Aα ) implies P(A) ⩽ P(Aα ).
Hint: Start by proving that we always have
   
dP dP
− α (21Aα − 1) ⩾ − α (21A − 1). (3.5.31)
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
:= (3.5.32)
dP∗ IEP∗ [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 IEP∗ [C ] at time 0 under the risk-neutral measure P∗ .
Budget constraint. In what follows we will assume that no more than a certain fraction β ∈ (0, 1]
of the claim price e −rT IEP∗ [C ] is available to construct the initial hedging portfolio V0 at time 0.
Since a self-financing portfolio process (Vt )t⩾0 started at V0 := β e −rT IEP∗ [C ] may fall short of
hedging the claim C when β < 1, we will attempt to maximize 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 C1A , priced V0A = e −rT IEP∗ [C1A ] at time 0, and such that VTA = C1A 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∗ IEP∗ [C ]

maximizes P(A) over all possible events A, under the condition

e −rT IEP∗ VTA = e −rT IEP∗ [C1A ] ⩽ β e −rT IEP∗ [C ].

 
(3.5.33)

Hint: Rewrite Condition (3.5.33) 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(C1Aα ⩾ C ),

i.e. show that

P(Aα ) = P VTAα ⩾ C = P(C1Aα ⩾ C ).

Hint: To prove an equality x = y we can show first that x ⩽ 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
C1Aα uses only the initial budget β e −rT IEP∗ [C ], and that P VTAα ⩾ C maximizes the

successful hedging probability.

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 106 N. Privault

In the next Questions (f))-(j)) we assume that C = (ST − K )+ is the payoff of a European option in
the Black-Scholes model

dSt = rSt dt + σ St dBt , (3.5.34)

with P = P∗ , dP/dP∗ = 1, and

σ2 1
S0 : = 1 and r= := . (3.5.35)
2 2
f) Solve the stochastic differential equation (3.5.34) with the parameters (3.5.35).
g) Compute the successful hedging probability

P VTAα ⩾ C = P(C1Aα ⩾ C ) = P(Aα )

for the claim C =: (ST − K )+ in terms of K, T , IEP∗ [C ] and the parameter α > 0.
h) From the result of Question (g)), express
the parameter α using K, T , IEP∗ [C ], and the
successful hedging probability P VTAα ⩾ C for the claim C =: (ST − K )+ .
i) Compute the minimal initial budget e −rT IEP∗ [C1Aα ] required to hedge the claim C = (ST −
K )+ in terms of α > 0, K, T and IEP∗ [C ].
j) Taking K := 1, T := 1 and assuming a successful hedging probability of 90%, compute
numerically:
i) The European call price e −rT IEP∗ [(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 successfully hedge the
claim C =: (ST − K )+ with 90% probability.

Problem 3.30 (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 (β x) 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.

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3.5 Hedging by the Martingale Method 107

e) We choose to model the S&P500 index St as the geometric Brownian motion

dSt = rSt dt + σ St dBt , t ⩾ 0,

under the risk-neutral probability measure P∗ . Find the stochastic differential equation
satisfied by (Ft )t⩾0 under the self-financing condition dFt = ξt dSt + ηt dAt , and show that
the discounted fund value is a martingale.
f) Is the discounted fund value ( e −rt Ft )t⩾0 a martingale under the risk-neutral probability
measure P∗ ?
g) Find the relation between the fund value Ft and the index St by solving the stochastic
β
differential equation obtained for Ft in Question (e)). For simplicity we normalize F0 := S0 .
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.

Problem 3.31 Log options. Log options can be used for the pricing of realized variance swaps.
a) Consider a market model made of a risky asset with price (St )t⩾0 and a riskless asset with
price At = $1 × e rt and risk-free interest rate r = σ 2 /2. Show that the arbitrage-free price

Vt = e −(T −t )r IE (log ST )+ Ft
 

at time t ∈ [0, T ] of a log call option with payoff (log ST )+ is equal to

r
T − t −Bt2 /(2(T −t ))
 
−(T −t )r Bt
Vt = σ e e + 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 /(2σ 2 τ ) y
f (τ, y) = σ e + yΦ √ .
2π σ τ

c) Figure 3.6 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?

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 108 N. Privault

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

Figure 3.6: 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 time t in a portfolio
∂x
hedging the payoff (log ST )+ is equal to
 
−(T −t )r 1 log St
ξt = e Φ √ , 0 ⩽ t ⩽ T.
St σ T −t

e) Figure 3.7 represents the graph of (τ, x) 7→ ∂∂ gx (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

Figure 3.7: 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 = 2 (T − t, St ), equals
∂x
 !
−(T −t )r 1 1 −(log St )2 /(2(T −t )σ 2 ) log St
Γt = e e −Φ √ ,
St2 σ 2(T − t )π
p
σ T −t

0 ⩽ t < T.
h) Figure 3.8 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?

∂ 1∂f
* Recall the chain rule of derivation f (τ, log x) = (τ, y)|y=log x .
∂x x ∂y

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3.5 Hedging by the Martingale Method 109

0.8

0.6

0.4

0.2

0
180 200
-0.2 140 160
0.2 0.4 0.6 0.8 1 80 100 120 T-t
1.2 1.4 1.6 1.8 60
St

Figure 3.8: 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
1 ∂2 f

∂f
(τ, y) = (τ, y)


2 ∂ y2

∂τ


f (0, y) = (y)+ .


Problem 3.32 Log put options with a given strike price.

a) Consider a market model made of a risky asset with price (St )t⩾0 as in Exercise 2.17, a
riskless asset valued At = $1 × e rt , risk-free interest rate r = σ 2 /2 and S0 = 1. Show that
the arbitrage-free price
Vt = e −(T −t )r IE∗ (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
 
−(T −t )r
Vt = σ e e + e −(T −t )r (K − σ 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
K −y
 
τ −(K−y)2 /(2σ 2 τ )
f (τ, y) = σ e + (K − y) Φ √ .
2π σ τ
c) Figure 3.9 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

Figure 3.9: Option price as a function of underlying asset price and time to maturity.

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 110 N. Privault

∂g
d) Show* that the quantity ξt = (T − t, St ) of St at time t in a portfolio hedging the payoff
∂x
(K − log ST )+ is equal to

K − log St
 
−(T −t )r 1
ξt = − e Φ √ , 0 ⩽ t ⩽ T.
St σ T −t

e) Figure 3.10 represents the graph of (τ, x) 7→ ∂∂ gx (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

Figure 3.10: 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 = 2 (T − t, St ), equals
∂x
!
−

1 1 2 2 K log St
Γt = e −(T −t )r 2 p e −(K−log St ) /(2(T −t )σ ) + Φ √ ,
St σ 2(T − t )π σ T −t

0 ⩽ t ⩽ T.
h) Figure 3.11 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?

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

Figure 3.11: Gamma as a function of underlying asset price and time to maturity.

∂ 1∂f
* Recall the chain rule of derivation f (τ, log x) = (τ, y)|y=log x .
∂x x ∂y

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3.5 Hedging by the Martingale Method 111

i) Show that the function f (τ, y) of Question (b)) solves the heat equation
2 2

 ∂ f (τ, y) = σ ∂ f (τ, y)

2 ∂ y2

∂τ


f (0, y) = (K − y)+ .


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 113

4. Optimal Stopping Theorem

Stopping times are random times whose value can be determined by the historical 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 5. Applications are given to hitting probabilities for Brownian motion.

4.1 Filtrations and Information Flow 113

4.2 Submartingales and Supermartingales 114
4.3 Optimal Stopping Theorem 117
4.4 Drifted Brownian Motion 122
Exercises 128

4.1 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 ⩽ s ⩽ t} up to time t. Examples
of such events include the event

{Xt0 ⩽ a0 , Xt1 ⩽ a1 , . . . , Xtn ⩽ an }

for a0 , a1 , . . . , an a given fixed sequence of real numbers and 0 ⩽ 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 information generated by
(Xt )t∈R+ .

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 114 N. Privault

4.2 Submartingales and Supermartingales

Let us recall the definition of martingale and introduce in addition the definitions of supermartingale
and submartingale.*
Definition 4.1 An integrablea 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 = IE[Zt | Fs ], 0 ⩽ s ⩽ t, (martingale)

resp.

Zs ⩾ IE[Zt | Fs ], 0 ⩽ s ⩽ t, (supermartingale)

resp.

Zs ⩽ IE[Zt | Fs ], 0 ⩽ s ⩽ t. (submartingale)
a This condition means that IE[|Zt |] < ∞ for all t ⩾ 0.

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 4.2 Let (Zt )t∈R+ denote an adapted integrable process.

a) If (Zt )t∈R+ is a supermartingale, we have

IE[Zs ] ⩾ IE[Zt ], 0 ⩽ s ⩽ t. (supermartingale)

b) If (Zt )t∈R+ is a submartingale, we have

IE[Zs ] ⩽ IE[Zt ], 0 ⩽ s ⩽ t. (submartingale)

c) If (Zt )t∈R+ be a martingale, we have

IE[Zs ] = IE[Zt ], 0 ⩽ s ⩽ t. (martingale)

Proof. The case where (Zt )t∈R+ is a martingale follows from the tower property of conditional
expectations, which shows that
IE[Zt ] = IE[IE[Zt | Fs ]] = IE[Zs ], 0 ⩽ s ⩽ t. (4.2.1)
Regarding supermartingales, similarly to (4.2.1) we have
IE[Zt ] = IE[IE[Zt | Fs ]] ⩽ IE[Zs ], 0 ⩽ s ⩽ t.
The proof is similar in the submartingale case. □
Independent increments processes whose increments have negative expectation give examples of
supermartingales. Indeed, if (Zt )t∈R+ is such a stochastic process, then we have
IE[Zt | Fs ] = IE[Zs | Fs ] + IE Zt − Zs Fs
 

*“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.

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4.2 Submartingales and Supermartingales 115

= IE[Zs | Fs ] + IE[Zt − Zs ]
| {z }
⩽0
⩽ IE[Zs | Fs ]
= Zs , 0 ⩽ s ⩽ t.

Similarly, a stochastic process with independent increments which have positive expectation will
be a submartingale. Brownian motion Bt + µt with positive drift µ > 0 is such an example, as in
Figure 4.1 below.
14
Drifted 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

Figure 4.1: Drifted Brownian path.

The following example comes from gambling.

Figure 4.2: Evolution of the fortune of a poker player vs. number of games played.

Definition 4.3 A function φ : R → R is said to be convex if

φ ( px + qy) ⩽ pφ (x) + qφ (y)

for any p, q ∈ [0, 1] such that p + q = 1 and x, y ∈ R.

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 116 N. Privault

ϕ(px + qy)
pϕ(x) + qϕ(y)

ϕ(x)

x px + qy y

Figure 4.3: Example of convex function φ .

Proposition 4.4 Jensen, 1906 inequality. Jensen’s inequality states that for any sufficiently
integrable random variable X, σ -algebra G , and convex function φ : R → R, we have

φ (IE[X | G ]) ⩽ IE[φ (X ) | G ].

In particular, taking G = {0,

/ Ω}, Jensen’s inequality reads

φ (IE[X ]) ⩽ IE[φ (X )].

Proof. See e.g. (3.7.1) in Hardy, Littlewood, and Pólya, 1988. 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 ) ⩽ p1 φ (x1 ) + p2 φ (x2 ) + · · · + pn φ (xn ), (4.2.2)

x1 , . . . , xn ∈ R, for any sequence of coefficients p1 , p2 , . . . , pn ⩾ 0 such that p1 + p2 + · · · + pn = 1.

The inequality (4.2.2) clearly holds for n = 1, and for n = 2 it coincides with the convexity property
of φ , i.e.
φ ( p1 x1 + p2 x2 ) ⩽ p1 φ (x1 ) + p2 φ (x2 ), x1 , x2 ∈ R.
Assuming that (4.2.2) 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 (4.2.2) 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 ) + pn+1 xn+1
1 − pn+1
p1 x1 + p2 x2 + · · · + pn xn
 
⩽ (1 − pn+1 )φ + pn + 1 φ ( xn + 1 )
1 − pn+1
p1 φ (x1 ) + p2 φ (x2 ) + · · · + pn φ (xn )
 
⩽ (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 4.4.

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 4.3 Optimal Stopping Theorem 117

Proposition 4.5 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 convex function, the
process (φ (Mt ))t∈R+ is a submartingale.

Proof. a) By Jensen’s inequality Proposition 4.4 we have

φ (IE[Mt | Fs ]) ⩽ IE[φ (Mt ) | Fs ], 0 ⩽ s ⩽ t, (4.2.3)

which shows that

φ (Ms ) = φ (IE[Mt | Fs ]) ⩽ IE[φ (Mt ) | Fs ], 0 ⩽ s ⩽ t.

b) If φ is convex non-decreasing and (Mt )∈R+ is a submartingale, the above rewrites as

φ (Ms ) ⩽ φ (IE[Mt | Fs ]) ⩽ IE[φ (Mt ) | Fs ], 0 ⩽ s ⩽ t,

showing that (φ (Mt ))t∈R+ is a submartingale. □

Similarly, (φ (Mt ))t∈R+ will be a supermartingale when (Mt )∈R+ is a martingale and the function
φ is concave.
As a direct application of Proposition 4.5, 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
St = S0 e rt +σ Bt −σ t/2 , t ⩾ 0,
which is a martingale for r = 0, a supermartingale for r ⩽ 0, and a submartingale for r ⩾ 0.

4.3 Optimal Stopping Theorem

Next, we turn to the definition of stopping time, which is based on a probability space (Ω, F , P)
and a filtration (Ft )t∈R+ ⊂ F .
Definition 4.6 An (Ft )t∈R+ -stopping time is a random variable τ : Ω −→ R+ ∪ {+∞} such
that

{τ > t} ∈ Ft , t ⩾ 0. (4.3.1)

The meaning of Relation (4.3.1) 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 knowledge of (Xs )0⩽s⩽t .
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 ⩽ 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 4.7 Every constant time is a stopping time. In addition, if τ and θ are stopping
times, then
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.

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 118 N. Privault

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 ⩽ t} = {τ ⩽ t and θ ⩽ t} = {τ > t}c ∩ {θ > t}c ∈ Ft , t ⩾ 0,

which implies
{τ ∨ θ > t} = {τ ∨ θ ⩽ 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 ̸= x for all s ∈ [0,t ]}

= {X0 ̸= x} ∩ {X1 ̸= x} ∩ · · · ∩ {Xt ̸= 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} (4.3.2)

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 ]

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 := Zmin(t,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 4.4 is an illustration of the path of a stopped process.

*As a convention we let τ = +∞ in case there exists no t ⩾ 0 such that Xt = x.

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4.3 Optimal Stopping Theorem 119

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

Figure 4.4: Stopped process.

Theorem 4.8 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 4.6
below.
Theorem 4.8 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 a martingale transform argument. Writing the
telescoping sum
n
Mn = M0 + ∑ (Ml − Ml−1 ),
l =1

we have
τ∧n n
Mτ∧n = M0 + ∑ (Ml − Ml−1 ) = M0 + ∑ 1{l⩽τ} (Ml − Ml−1 ),
l =1 l =1

and for k ⩽ n,
" #
n
IE[Mτ∧n | Fk ] = IE M0 + ∑ 1{l⩽τ} (Ml − Ml−1 ) Fk
l =1
n
= M0 + ∑ IE[1{l⩽τ} (Ml − Ml−1 ) | Fk ]
l =1
k
= M0 + ∑ IE[1{l⩽τ} (Ml − Ml−1 ) | Fk ]
l =1
n
+ ∑ IE[1{l⩽τ} (Ml − Ml−1 ) | Fk ]
l =k +1
k
= M0 + ∑ (Ml − Ml−1 ) IE[1{l⩽τ} | Fk ]
l =1
n
+ ∑ IE[IE[(Ml − Ml−1 )1{l⩽τ} | Fl−1 ] | Fk ]
l =k +1
k
= M0 + ∑ (Ml − Ml−1 )1{l⩽τ}
l =1

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 120 N. Privault
n
+ ∑ IE[1{l⩽τ} IE[(Ml − Ml−1 ) | Fl−1 ] | Fk ]
l =k +1 | {z }
=0
k
= M0 + ∑ (Ml − Ml−1 )1{l⩽τ}
l =1
τ∧k
= M0 + ∑ (Ml − Ml−1 )
l =1
= Mτ∧k , k = 0, 1, . . . , n,
as by the martingale property of (Ml )l∈N , we have
IE[(Ml − Ml−1 ) | Fl−1 ] = IE[Ml | Fl−1 ] − IE[Ml−1 | Fl−1 ]
= IE[Ml | Fl−1 ] − Ml−1
= 0, l ⩾ 1.
□
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 4.6 below for the case of submartingales in discrete time.
b) Since by Theorem 4.8 the stopped process (Mτ∧t )t∈R+ is a martingale, we find that its
expected value IE[Mτ∧t ] is constant over time t ∈ R+ by Proposition 4.2-c).
As a consequence, if (Mt )t∈R+ is an (Ft )t∈R+ -martingale and τ is a stopping time bounded
by a constant T > 0, i.e. τ ⩽ T almost surely,* we have

IE[Mτ ] = IE[Mτ∧T ] = IE[Mτ∧0 ] = IE[M0 ] = IE[MT ]. (4.3.3)

c) From (4.3.3), if τ, ν are two stopping times a.s. bounded by a constant T > 0 and (Mt )t∈R+
is a martingale, we have

IE[M0 ] = IE[Mτ ] = IE[Mν ] = IE[MT ]. (4.3.4)

d) If τ, ν are two stopping times a.s. bounded by a constant T > 0 and such that τ ⩽ ν a.s.,
then, by Theorem 4.8,
(i) when (Mt )t∈R+ is a supermartingale, we have

IE[M0 ] ⩾ IE[Mτ ] ⩾ IE[Mν ] ⩾ IE[MT ], (4.3.5)

(ii) when (Mt )t∈R+ is a submartingale, we have

IE[M0 ] ⩽ IE[Mτ ] ⩽ IE[Mν ] ⩽ IE[MT ], (4.3.6)

see Exercise 4.6 below for a proof in discrete time.

e) In case τ is finite with probability one (but not bounded by a constant), we may also write
 
IE[Mτ ] = IE lim Mτ∧t = lim IE[Mτ∧t ] = IE[M0 ], (4.3.7)
t→∞ t→∞

provided that

|Mτ∧t | ⩽ C, a.s., t ⩾ 0. (4.3.8)

*“τ ⩽ T almost surely” means P(τ ⩽ T ) = 1, i.e. P(τ > T ) = 0.

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4.3 Optimal Stopping Theorem 121

More generally, (4.3.7) holds provided that the limit and expectation signs can be exchanged,
and this can be done using e.g. the Dominated Convergence Theorem. In some situations the
exchange of limit and expectation signs may not be valid.*
In case P(τ = +∞) > 0, (4.3.7) holds under the above conditions, provided that

M∞ := lim Mt (4.3.9)
t→∞

exists with probability one.

Relations (4.3.5), (4.3.6) and (4.3.4) can be extended to unbounded stopping times along the
same lines and conditions as (4.3.7), such as (4.3.8) 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
   
IE[Mτ ] = IE lim Mτ∧t ⩽ lim IE Mτ∧t ⩽ lim IE[M0 ] = IE[M0 ], (4.3.10)
t→∞ t→∞ t→∞

provided that (Mt )t∈R+ is a nonnegative supermartingale, where we used Fatou’s Lemma. †
As in (4.3.7), the limit (4.3.9) is required to exist with probability one if P(τ = +∞) > 0.

g) As a counterexample to (4.3.4), the random time

n o
τ := inf t ∈ [0, T ] : Mt = Sup Ms ,
s∈[0,T ]

which is not a stopping time, will satisfy

IE[Mτ ] > IE[MT ],

although τ ⩽ T almost surely. Similarly,

n o
τ := inf t ∈ [0, T ] : Mt = inf Ms ,
s∈[0,T ]

is not a stopping time and satisfies

IE[Mτ ] < IE[MT ].

Martingales and stopping times as gambling strategies

When (Mt )t∈[0,T ] is a martingale, e.g. a centered random walk with independent increments, the
message of the Stopping Time Theorem 4.8 is that the expected gain of the exit strategy τx,y of
(4.3.2) remains zero on average since
 
IE Mτx,y = IE[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 = IE[Mτx,y ] = xP(Mτx,y = x) + yP(Mτx,y = y)

* 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].
† IE[lim
n→∞ Fn ] ⩽ limn→∞ IE[Fn ] for any sequence (Fn )n∈N of nonnegative random variables, provided that the limits
exist.

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 122 N. Privault

= −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 appli-
cations 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

Figure 4.5: Sample paths of a gambling process (Mn )n∈N .

In Table 4.1 we summarize some of the results obtained in this section for bounded stopping times.

Bounded stopping times τ, ν







 supermartingale IE[Mτ ] ⩾ IE[Mν ] if τ ⩽ ν.

(Mt )t∈R+

 martingale IE[Mτ ] = IE[Mν ].




IE[Mτ ] ⩽ IE[Mν ] if τ ⩽ ν.

submartingale

Table 4.1: Martingales and stopping times.

In the sequel we note that, as an application of the Stopping Time Theorem 4.8, a number of
expectations can be computed in a simple and elegant way.

4.4 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.
* Hitting times are stopping times.

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4.4 Drifted Brownian Motion 123

x
a

0
0 0.5 1
t

Figure 4.6: Brownian motion hitting a barrier.

Recall that Brownian motion (Bt )t∈R+ is a martingale since it has independent increments, and
those increments are centered:

IE[Bt − Bs ] = 0, 0 ⩽ s ⩽ t.

Consequently, (Bτa,b ∧t )t∈R+ is still a martingale, and by (4.3.7) we have

IE[Bτa,b | B0 = x] = IE[B0 | B0 = x] = x,

as the exchange between limit and expectation in (4.3.7) can be justified since

|Bt∧τa,b | ⩽ Max(|a|, |b|), t ⩾ 0.

Hence we have

 x = IE[Bτa,b | B0 = x] = a × P(Bτa,b = a | B0 = x) + b × P(Bτa,b = b | B0 = x),



P(Bτa,b = a | B0 = x) + P(Bτa,b = b | B0 = x) = 1,


which yields
x−a
P(Bτa,b = b | B0 = x) = , a ⩽ x ⩽ b,
b−a
and also shows that
b−x
P(Bτa,b = a | B0 = x) = , a ⩽ x ⩽ 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.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 124 N. Privault

x
a

0
0 0.5 1
t

Figure 4.7: 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 4.8 we
need to construct a martingale of a different type. Here we note that the process
2 t/2
Mt := e σ Bt −σ , t ⩾ 0,

is a martingale with respect to (Ft )t∈R+ . Indeed, we have

2 2
IE[Mt | Fs ] = IE e σ Bt −σ t/2 Fs = e σ Bs −σ s/2 ,
 
0 ⩽ s ⩽ t,

cf. e.g. Example 3 page 70.

By Theorem 4.8, we know that the stopped process (Mτa,b ∧t )t∈R+ is a martingale, hence its expected
value is constant over time t ∈ R+ Proposition 4.2-c), and (4.3.7) yields

1 = IE[M0 ] = IE[Mτa,b ],

as the exchange between limit and expectation in (4.3.7) can be justified since

|Mt∧τa,b | ⩽ 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 −σ x e σ Xt , and

2 t/2
e σ Xt = e σ x+σ Bt +σ µt = e σ x+σ Bt −σ = e σ x Mt ,

hence

1 = IE[Mτa,b ]
= e −σ x IE[ e σ Xτa,b ]
= e (a−x)σ P(Xτa,b = a | X0 = x) + e (b−x)σ P(Xτa,b = b | X0 = x)
= e −2(a−x)µ P(Xτa,b = a | X0 = x) + e −2(b−x)µ P(Xτa,b = b | X0 = x),

under the additional condition

P(Xτa,b = a | X0 = x) + P(Xτa,b = b | X0 = x) = 1.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

4.4 Drifted Brownian Motion 125

Finally, this gives

e −2µx − e −2µb

eσ x − eσ b
P ( = | = ) = =

 Xτa,b a X0 x (4.4.1a)
e −2µa − e −2µb



 eσ a − eσ b

e −2µa − e −2µx


P(Xτa,b = b | X0 = x) =

 , (4.4.1b)
e −2µa − e −2µb

a ⩽ x ⩽ b, see Figure 4.8 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.

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;
dev.new(width=16,height=8); 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

Figure 4.8: Hitting probabilities of drifted Brownian motion.*

* The animation works in Acrobat Reader on the entire pdf file.

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 126 N. Privault

Escape to infinity
Letting b tend to +∞ in the above equalities shows by (4.4.1a)-(4.4.1b) 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 −2(x−a)µ > 0, µ > 0,



P(τa = +∞) =
0, µ ⩽ 0,


i.e.
 P(Xτa,∞ = a | X0 = x) = e −2(x−a)µ < 1,

µ > 0,
P(τa < +∞) = (4.4.2)
1, µ ⩽ 0.


(4.4.3)

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 −2(x−b)µ > 0, µ < 0,



P(τb = +∞) =
0, µ ⩾ 0,


i.e.
 P(Xτ−∞,b = b | X0 = x) = e −2(x−b)µ < 1,

µ < 0,
P(τb < +∞) = (4.4.4)
1, µ ⩾ 0.


Mean hitting times for standard Brownian motion

The martingale method also allows us to compute the expected time IE[τa,b ], after rechecking that
wt
Bt2 − t = 2 Bs dBS , t ⩾ 0,
0

is also a martingale. Indeed, we have

IE[Bt2 − t | Fs ] = IE[(Bs + (Bt − Bs ))2 − t | Fs ]

= IE[B2s + (Bt − Bs )2 + 2Bs (Bt − Bs ) − t | Fs ]
= IE[B2s − s | Fs ] − (t − s) + IE[(Bt − Bs )2 | Fs ] + 2 IE[Bs (Bt − Bs ) | Fs ]
= B2s − s − (t − s) + IE[(Bt − Bs )2 | Fs ] + 2Bs IE[Bt − Bs | Fs ]
= B2s − s − (t − s) + IE[(Bt − Bs )2 ] + 2Bs IE[Bt − Bs ]
= B2s − s, 0 ⩽ s ⩽ t.

Consequently the stopped process (B2τa,b ∧t − τa,b ∧t )t∈R+ is still a martingale by Theorem 4.8 hence
the expectation IE[B2τa,b ∧t − τa,b ∧ t ] is constant over time t ∈ R+ , hence by (4.3.7) we get*

x2 = IE[B20 − 0 | B0 = x]
= IE[B2τa,b − τa,b | B0 = x]
= IE[B2τa,b | B0 = x] − IE[τa,b | B0 = x]
= b2 P(Bτa,b = b | B0 = x) + a2 P(Bτa,b = a | B0 = x) − IE[τa,b | B0 = x],
* Here we note that it can be showed that IE[τa,b ] < ∞ in order to apply (4.3.7).

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

4.4 Drifted Brownian Motion 127

i.e.

IE[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 ⩽ x ⩽ b.

Mean hitting times for drifted Brownian motion

Finally we show how to recover the value of the mean hitting time IE[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 − (τa,b ∧ t ) µ )t∈R+ is still a martingale by Theorem 4.8. Hence the expectation
IE[Xτa,b ∧t − (τa,b ∧ t ) µ ] is constant over time t ⩾ 0.


Since the stopped process Xτa,b ∧t − (τa,b ∧ t ) µ t∈R is a martingale, we have
+

x = IE[Xτa,b − µτa,b | X0 = x],

which gives

x = IE[Xτa,b − µτa,b | X0 = x]
= IE[Xτa,b | X0 = x] − µ IE[τa,b | X0 = x]
= bP(Xτa,b = b | X0 = x) + aP(Xτa,b = a | X0 = x) − µ IE[τa,b | X0 = x],

i.e. by (4.4.1a),

µ IE[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 −2µa −2µb
+ a −2µa −x
e −e 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 )
IE[τa,b | X0 = x] = ,
( e −2µa − e −2µb ) µ
a ⩽ x ⩽ b, see the code of page 125 for an illustration.
Table 4.2 presents a summary of the families of martingales used in this chapter.

Probabilities
Non drifted Drifted
Problem

2 t/2
Hitting probability P(Xτa,b = a, b) Bt e σ Bt −σ

Mean hitting time IE[τa,b ] Bt2 − t Xt − µt

Table 4.2: List of martingales.

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 128 N. Privault

Exercises
Exercise 4.1 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 supermartingale?
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 IE[τ ] by the Doob Stopping Time Theorem 4.8 in each of the
following two cases:
i) α > 1 and β < 0,
ii) α < 1 and β > 0.

Exercise 4.2 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 IE[ e −τ ] by applying the Stopping Time
Theorem 4.8.
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 IE[τ ] by the Doob Stopping Time
Theorem 4.8.

Exercise 4.3 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+ .

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

4.4 Drifted Brownian Motion 129

a) Compute the Laplace transform IE[ e −rτL ] of τL for all r ⩾ 0.

√
Hint: Use the Stopping Time Theorem 4.8 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 IE e −rτL BτL .
 
L>0

Exercise 4.4 Consider (Bt )t∈R+ a Brownian motion started at B0 = x ∈ [a, b] with a < b, and let

τ := inf t ∈ R+ : Bt = a

or Bt = b

denote the first exit time of (Bt )t∈R+ from the interval [a, b].
1 w t ′′
a) Let f be a C 2 function on R. Show that the process Xt := f (Bt ) − f (Bs )ds is a
2 0
martingale.
b) Assume that f (x) solves the differential equation f ′′ (x) = −2 with boundary conditions
f (a) = f (b) = 0. Using the Doob Stopping Time Theorem, show that f (x) = IE[τ | B0 = x],
x ∈ [a, b].
c) Find the solution f (x) of the equation f ′′ (x) = −2 with f (a) = f (b) = 0.
d) Find the value of IE[τ | B0 = x].
Exercise 4.5 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+ , where α, β ∈ R.
a) Compute the Laplace transform IE[ e −rτ ] of τ for all r > 0 and α ⩾ 0.
b) Compute the Laplace transform IE[ e −rτ ] of τ for all r > 0 and α ⩽ 0.
2
Hint. Use the stopping time theorem and the fact that e σ Bt −σ t/2 t∈R is a martingale for all


+
σ ∈ R.

Exercise 4.6 (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 = {0,
/ 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 ⩽ 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 + IE[Mn+1 − Mn | Fn ], n ⩾ 0,
and define (Nn )n∈N in such a way that it satisfies the four required properties.
b) Show that for all bounded stopping times σ and τ such that σ ⩽ τ a.s., we have

IE[Mσ ] ⩽ IE[Mτ ].

Hint: Use the Stopping Time Theorem 4.8 for martingales and (4.3.4).

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 130 N. Privault

Exercise 4.7 Let (Sn )n⩾0 be the random walk defined by S0 := 0 and
n
Sn := ∑ Xk = X1 + · · · + Xn , n ⩾ 1,
k =1

where (Xn )n⩾1 is an i.i.d. Bernoulli sequence of {−1, 1}-valued random variables with P(Xn =
1) = P(Xn = −1) = 1/2, n ⩾ 1. We consider the random time

τ := inf{n ⩾ 1 : Sn − Sn−1 = −1}

at which (Sn )n⩾0 drops for the first time, and decide to use τ as an exit strategy.
a) Show that τ is a stopping time.
b) Find the range of possible values of Sτ .
c) Give the value of IE[Sτ ] according to the stopping time theorem.
d) Find the probability distribution of Sτ , i.e. find P(Sτ = k) for all k ∈ Z.
e) Compute
IE[Sτ ] = ∑ kP(Sτ = k),
k∈Z

and recover the conclusion of part (c)).

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

 131

5. 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.

5.1 Perpetual American Put Options 131

5.2 PDE Method for Perpetual Put Options 137
5.3 Perpetual American Call Options 140
5.4 Finite Expiration American Options 144
5.5 PDE Method with Finite Expiration 147
Exercises 151

5.1 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:

f (t, St ) = Sup IE∗ e −(τ−t )r (K − Sτ )+ St ,

 
t⩽τ⩽T
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

f (t, St ) = Sup IE∗ e −(τ−t )r (Sτ − K )+ St .

 
t⩽τ⩽T
τ Stopping time

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 132 N. Privault

Finite expiration American options can be found for example on the SPDR S&P 500 ETF Trust
(SPY) exchange-traded fund. 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

f (t, St ) = Sup IE∗ e −(τ−t )r (K − Sτ )+ St ,

 
τ⩾t
τ Stopping time

and
IE∗ e −(τ−t )r (Sτ − K )+ St .
 
f (t, St ) = Sup
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 ⩽ L, then exercise at time t.
2. Otherwise if St > L, wait until the first hitting time

τL := inf{u ⩾ t : Su ⩽ L} (5.1.1)

of the level L > 0, and exercise the option at time τL if τL < ∞.

Note that by definition of (5.1.1) we have τL = t if St ⩽ L.
In case St ⩽ 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 ) = IE∗ e −(τL −t )r (K − SτL )+ St

 

= IE∗ e −(τL −t )r (K − SτL )+ 1{τL <∞} St

 

= IE∗ e −(τL −t )r (K − L)+ 1{τL <∞} St

 

= (K − L) IE∗ e −(τL −t )r St .
 
(5.1.2)

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
2 t/2
St = S0 e rt +σ Bt −σ , t ⩾ 0, (5.1.3)
b

where (Bbt )t∈R+ is a standard Brownian motion under the risk-neutral probability measure P∗ , r is
the risk-free interest rate, and σ > 0 is the volatility coefficient.
Lemma 5.1 Assume that r > 0. We have

  x −2r/σ 2
IE∗ e −(τL −t )r St = x =

, x ⩾ L. (5.1.4)
L

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

5.1 Perpetual American Put Options 133

Proof. We take t = 0 in (5.1.4) without loss of generality. We note that from (5.1.3), for all λ ∈ R
we have
2
(St )λ = e λ rt +λ σ Bt −λ σ t/2 , t ⩾ 0,
b

(λ )

and the process Zt t⩾0 defined as
(λ ) 2 σ 2 t/2 2 /2)t
Zt := (S0 )λ e λ σ Bt −λ = (St )λ e −(λ r−λ (1−λ )σ , t ⩾ 0, (5.1.5)
b

is a martingale under the risk-neutral probability measure P∗ . Choosing λ ∈ R such that

σ2
r = rλ − λ (1 − λ ) , (5.1.6)
2
we have
(λ )
Zt = (St )λ e −rt , t ⩾ 0. (5.1.7)
The equation (5.1.6) rewrites as
2 σ2 σ2
   
2σ 2r
0=λ +λ r− −r = λ + 2 (λ − 1), (5.1.8)
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 ⩽ Zt = e −rt (St )λ− ⩽ e −rt Lλ− ⩽ Lλ− , 0 ⩽ t ⩽ τL , (5.1.9)
(λ ) (λ ) (λ )
since r > 0. Therefore we have limt→∞ Zt − = 0, and since limt→∞ ZτL ∧t
−
= ZτL − on {τL < ∞},
using (5.1.7), we find
h i
Lλ− IE∗ e −rτL = IE∗ e −rτL Lλ− 1{τL <∞}
 
h i
= IE∗ e −rτL SτL − 1{τL <∞}

λ
h i
= IE∗ ZτL − 1{τL <∞}
(λ )

= IE∗ 1{τL <∞} lim ZτL ∧t

 (λ− ) 
t→∞
∗
 ( λ− ) 
= IE lim ZτL ∧t (5.1.10)
t→∞
 ( λ− ) 
= lim IE∗ ZτL ∧t (5.1.11)
t→∞
 (λ ) 
= lim IE∗ Z0 −
t→∞
= ( S0 ) λ− ,
where by (5.1.9) we applied the dominated convergence theorem from (5.1.10) to (5.1.11). Hence,
we find
  x −2r/σ 2
IE∗ e −rτL S0 = x =

, x ⩾ L.
L
Note also that by (4.4.2) we have P(τL < ∞) = 1 if r − σ 2 /2 ⩽ 0, and P(τL = +∞) > 0 if
r − σ 2 /2 > 0. □
* The bound (5.1.9) does not hold for the positive solution λ+ = 1.

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 134 N. Privault
Next, we apply Lemma 5.1 in order to price the perpetual American put option.

Proposition 5.2 Assume that r > 0. We have

fL (x) = IE∗ e −(τL −t )r (K − SτL )+ St = x

 


 K − x, 0 < x ⩽ L,

=  x −2r/σ 2

 (K − L )
 , x ⩾ L.
L

Proof. We take t = 0 without loss of generality.

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

IE∗ e −rτL (K − SτL )+ S0 = x = IE∗ 1{τL <∞} e −rτL (K − SτL )+ S0 = x

   

= IE∗ 1{τL <∞} e −rτL (K − L) S0 = x

 

= (K − L) IE∗ e −rτL S0 = x ,
 

and we conclude by the expression of IE∗ e −rτL S0 = x given in Lemma 5.1.

 
□
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 (5.1.2). Therefore there
should be an optimal value L∗ , which should be strictly comprised between 0 and K.
Figure 5.1 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

Figure 5.1: 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/σ −1
2r ∗ (L )
fL′ ∗ (L∗ ) = − ( K − L ) = −1, (5.1.12)
σ2 (L∗ )−2r/σ 2

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

5.1 Perpetual American Put Options 135

i.e.

2r
( K − L∗ ) = L∗ ,
σ2

or

2r
L∗ = K < K. (5.1.13)
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):

∂ f L (x )  x −2r/σ 2 2r K − L  x −2r/σ 2
=− + 2 = 0,
∂L L σ L L

cf. page 351 of Shreve, 2004. The next Figure 5.2 is a 2-dimensional animation 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

Figure 5.2: Animated graph of American put prices depending on L with K = 100.*

The next Figure 5.3 gives another view of the put option prices according to different values of L,
with the optimal value L∗ = 85.71.

* The animation works in Acrobat Reader on the entire pdf file.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 136 N. Privault

(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

Figure 5.3: Option price as a function of L and of the underlying asset price.

In Figure 5.4, which is based on the stock price of HSBC Holdings (0005.HK) over year 2009, 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 approximately 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 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

Figure 5.4: Path of the American put option price on the HSBC stock.

See Exercise 5.6 for the pricing of perpetual American put options with dividends.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

 5.2 PDE Method for Perpetual Put Options 137

5.2 PDE Method for Perpetual Put Options

Exercise. Check by hand calculations that the function fL∗ defined as
2r

 K − x, 0 < x ⩽ L∗ = K,
2r + σ 2




f L∗ ( x ) : = −2r/σ 2 (5.2.1)
Kσ 2 2r + σ 2 x

2r


, x ⩾ L∗ =


2
K,
2r + σ 2

2r + σ 2r K
satisfies the Partial Differential Equation (PDE)

1
−r fL∗ (x) + rx fL′ ∗ (x) + σ 2 x2 fL′′∗ (x) = −rK1{x⩽L∗ }
2(
−rK < 0, 0 < x ⩽ L∗ < K, [Exercise now]
=
0, x > L∗ . [Wait]
(5.2.2)

in addition to the conditions

0 < x ⩽ L∗ < K,

 fL∗ (x) = K − x, [Exercise now]

f L∗ ( x ) > ( K − x ) + , x > L ∗ , [Wait]



see (5.2.1).
The above statements can be summarized in the following proposition.

Proposition 5.3 The function fL∗ satisfies the following set of differential inequalities, or
variational differential equation:


 f L∗ ( x ) ⩾ ( K − x ) + , (5.2.3a)

σ2


 ′
rx fL∗ (x) + x2 fL′′∗ (x) ⩽ r fL∗ (x), (5.2.3b)
 2
σ2

 
 r fL∗ (x) − rx fL′ ∗ (x) − x2 fL′′∗ (x) ( fL∗ (x) − (K − x)+ ) = 0.

 (5.2.3c)
2
The equation (5.2.3c) admits an interpretation in terms of absence of arbitrage, as shown below. By
(5.2.2) and Itô’s formula applied under the smooth fit relation (5.1.12) to

dSt = rSt dt + σ St d Bbt ,

the discounted portfolio value process

feL∗ (St ) = e −rt fL∗ (St ), t ⩾ 0,

satisfies


d feL∗ (St )
 
1
= −r fL∗ (St ) + rSt fL′ ∗ (St ) + σ 2 St2 fL′′∗ (St ) e −rt dt + e −rt σ St fL′ ∗ (St )d Bbt
2

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 138 N. Privault

= −1{St ⩽L∗ } rK e −rt dt + e −rt σ St fL′ ∗ (St )d Bbt

= −1{ fL∗ (St )=(K−St )+ } rK e −rt dt + e −rt σ St fL′ ∗ (St )d Bbt , (5.2.4)

hence we have the relation

feL∗ (ST ) − feL∗ (St )

wT wT
= −rK 1{ fL∗ (Su )⩽(K−Su )+ } e −ru du + e −ru σ Su fL′ ∗ (Su )d Bbu ,
t t

for some maturity time T > 0, which implies

IE∗ feL∗ (ST ) − feL∗ (St ) | Ft = IE∗ feL∗ (ST ) | Ft − feL∗ (St )
   
 wT wT 
= IE −rK∗
1{ fL∗ (Su )⩽(K−Su )+ } e du + e σ Su fL∗ (Su )d Bbu Ft
−ru −ru ′
t t
 w 
T
= − IE rK ∗
1{ fL∗ (Su )⩽(K−Su )+ } e du Ft ,
−ru
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∗
= IE fL (ST ) | Ft + rK IE ∗
1{ fL∗ (Su )⩽(K−Su )+ } e du Ft
−ru
 
t
w 
T
−rT ∗
IE (K − ST ) | Ft + rK IE
+ ∗
1{Su ⩽L∗ } e du Ft ,
−ru
 
⩾ e (5.2.5)
| {z } t
European put price | {z }
Early exercise premium

0 ⩽ t ⩽ T , see also Theorem 8.4.1 in § 8.4 in Elliott and Kopp, 2005 on early exercise premiums.
From (5.2.4) we also make the following observations.
a) From Equation (5.2.3c), 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 σ St fL′ ∗ (St )d Bbt ,

or
d fL∗ (St ) = d e rt feL∗ (St ) = r fL∗ (St )dt + σ St fL′ ∗ (St )d Bbt ,

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 σ St fL′ ∗ (St )d
Bbt and

d fL∗ (St ) = d e rt feL∗ (St )

= r fL∗ (St )dt − rKdt + e −rt σ St fL′ ∗ (St )d Bbt .

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

5.2 PDE Method for Perpetual Put Options 139

In this case it is not worth waiting as (5.2.3b)-(5.2.3c) show that the return of the hedging
portfolio is lower than that of the riskless asset, i.e.:
1
−r fL∗ (St ) + rSt fL′ ∗ (St ) + σ 2 St2 fL′′∗ (St ) = −rK < 0,
2
exercise becomes immediate since the process feL∗ (St ) becomes a (strict) supermartingale,
and (5.2.3c) 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 5.4 Assume that r > 0. The price of the perpetual American put option is given for
all t ⩾ 0 by

IE∗ e −(τ−t )r (K − Sτ )+ St
 
fL∗ (St ) = Sup
τ⩾t
τ Stopping time

= IE∗ e −(τL∗ −t )r (K − SτL∗ )+ St

 


 K − St , 0 < St ⩽ L∗ ,


=  −2r/σ 2 2
 2S
−2r/σ 2
∗ St Kσ 2r + σ t
, St ⩾ L∗ .

 (K − L ) =


L∗ 2r + σ 2 2r K

Proof. i) Since the drift

1
−r fL∗ (St ) + rSt fL′ ∗ (St ) + σ 2 St2 fL′′∗ (St )
2
in Itô’s formula (5.2.4) is nonpositive by the inequality (5.2.3b), the discounted 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
(4.3.10),
e −rt fL∗ (St ) ⩾ IE∗ e −rτ fL∗ (Sτ ) St ⩾ IE∗ e −rτ (K − Sτ )+ St ,
   

from (5.2.3a), which implies

e −rt fL∗ (St ) ⩾ IE∗ e −rτ (K − Sτ )+ St .

 
Sup (5.2.6)
τ⩾t
τ Stopping time

ii) The converse inequality is obvious from Proposition 5.2, as

fL∗ (St ) = IE∗ e −(τL∗ −t )r (K − SτL∗ )+ St
 

Sup IE∗ e −(τ−t )r (K − Sτ )+ St ,

 
⩽ (5.2.7)
τ⩾t
τ Stopping time

since τL∗ is a stopping time larger than t ∈ R+ . The inequalities (5.2.6) and (5.2.7) allow us to
derive the equality
fL∗ (St ) = Sup IE∗ e −(τ−t )r (K − Sτ )+ St .
 
τ⩾t
τ Stopping time

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 140 N. Privault

Remark. We note that the converse inequality (5.2.7) can also be obtained from the variational PDE
(5.2.3a)-(5.2.3c) itself, without relying on Proposition 5.2. 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 (5.2.2) since
Su∧τL∗ ⩾ L∗ , hence we have

e −rt fL∗ (St ) = IE∗ e −(u∧τL∗ )r fL∗ (Su∧τL∗ ) St ,

 
u ⩾ t,

hence after letting u tend to infinity we obtain

e −rt fL∗ (St ) = IE∗ e −rτL∗ fL∗ (SτL∗ ) St
 

= IE∗ e −rτL∗ fL∗ (L∗ ) St

 

= IE∗ e −rτL∗ (K − SτL∗ )+ St

 

Sup IE∗ e −rτL∗ (K − SτL∗ )+ St ,

 
⩽
τ⩾t
τ Stopping time

which recovers (5.2.7) as

e −rt fL∗ (St ) ⩽ IE∗ e −rτ (K − Sτ )+ St ,

 
Sup t ⩾ 0.
τ⩾t
τ Stopping time

5.3 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:
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 ⩽ St .
In case St < L, as r > 0 the price of the option will be given by
fL (St ) = IE∗ e −(τL −t )r (SτL − K )+ St
 

= IE∗ e −(τL −t )r (SτL − K )+ 1{τL <∞} St

 

= IE∗ e −(τL −t )r (L − K )+ St
 

= (L − K ) IE∗ e −(τL −t )r St .
 

Lemma 5.5 Assume that r > 0. We have

 S0
IE∗ e −rτL = .

L

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

5.3 Perpetual American Call Options 141

Proof. We only need to consider the case S0 = x < L. Note that for all λ ∈ R, the process
(λ )

Zt t∈R defined as
+

(λ ) 2 t/2−λ 2 σ 2 t/2 2 σ 2 t/2

Zt := (St )λ e −rλt +λ σ = (S0 )λ e λ σ Bt −λ , t ⩾ 0,
b

defined in (5.1.5) is a martingale under the risk-neutral probability measure P.

e Hence the stopped
(λ )

process Zt∧τL t∈R is a martingale and it has constant expectation, i.e., we have
+

 (λ )   (λ ) 
IE∗ Zt∧τL = IE∗ Z0 = (S0 )λ , t ⩾ 0. (5.3.1)

Choosing λ such that

σ2 σ2
r = rλ − λ +λ2 ,
2 2
i.e.
σ2
2 σ2
   
2σ 2r
0=λ +λ r− −r = λ + 2 (λ − 1),
2 2 2 σ
Relation (5.3.1) rewrites as

IE∗ (St∧τL )λ e −(t∧τL )r = (S0 )λ ,

 
t ⩾ 0. (5.3.2)

Choosing the positive solution* λ+ = 1 yields the bound

(λ+ )
0 ⩽ Zt = e −rt St ⩽ St ⩽ L, 0 ⩽ t ⩽ τL , (5.3.3)
+ (λ+ ) (λ )
since r > 0 and St ⩽ L for all t ∈ [0, τL ]. Hence we have limt→∞ Zt
= 0, and since limt→∞ ZτL ∧t =
(λ+ )
ZτL on {τL < ∞}, by (5.3.2)-(5.3.3) and the dominated convergence theorem, we get

L IE∗ e −rτL = IE∗ e −rτL SτL 1{τL <∞}

   

= IE∗ lim e −(τL ∧t )r SτL ∧t

 
t→∞
(λ+ ) 
= IE∗ lim ZτL ∧t

t→∞
 (λ+ ) 
= lim IE∗ ZτL ∧t
t→∞
 (λ ) 
= lim IE∗ Z0 +
t→∞
= S0 ,
which yields
 S0
IE∗ e −rτL = .

(5.3.4)
L
Note also that by (4.4.4) 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 5.5 in order to price the perpetual American call option.

Proposition 5.6 Assume that r > 0. The price of the perpetual American call option is given by
fL (St ) when St < L, where

* The bound (5.3.3) does not hold for the negative solution λ− = −2r/σ 2 .

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 142 N. Privault


 x − K,
 x ⩾ L ⩾ K,
f L (x ) = (5.3.5)
 (L − K ) x ,

0 < x ⩽ 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

IE∗ e −rτL (SτL − K )+ S0 = x = IE∗ 1{τL <∞} e −rτL (SτL − K )+ S0 = x

   

= IE∗ 1{τL <∞} e −rτL (L − K ) S0 = x

 

= (L − K ) IE∗ e −rτL S0 = x ,
 

and we conclude by the expression of IE∗ e −rτL S0 = x given in Lemma 5.1.

 
□

One can check from Figures 5.5 and 5.6 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

Figure 5.5: American call prices by exercising at τL for different values of L and K = 100.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

5.3 Perpetual American Call Options 143

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

Figure 5.6: 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 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

Figure 5.7: American call prices for different values of L.

We check from (5.3.5) that

x
lim fL (x) = x − lim K = x, x > 0. (5.3.6)
L→∞ L→∞ L
As a consequence we have the following proposition.

Proposition 5.7 Assume that r ⩾ 0. The price of the perpetual American call option is given by

* The animation works in Acrobat Reader on the entire pdf file.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 144 N. Privault

IE∗ e −(τ−t )r (Sτ − K )+ St = St ,

 
Sup t ⩾ 0. (5.3.7)
τ⩾t
τ Stopping time

Proof. For all L > K we have

fL (St ) = IE∗ e −(τL −t )r (SτL − K )+ St
 

Sup IE∗ e −(τ−t )r (Sτ − K )+ St ,

 
⩽ t ⩾ 0,
τ⩾t
τ Stopping time

hence from (5.3.6), taking the limit as L → ∞ yields

St ⩽ Sup IE∗ e −(τ−t )r (Sτ − K )+ St .
 
(5.3.8)
τ⩾t
τ Stopping time

On the other hand, since u 7→ e −(u−t )r Su is a martingale under P∗ , by (4.3.10) and Fatou’s Lemma*
we have, for all stopping times τ ∈ [t, ∞),
IE∗ e −(τ−t )r (Sτ − K )+ St ⩽ IE∗ e −(τ−t )r Sτ St
   

= IE∗ lim e −(τ∧n−t )r Sτ∧n St

 
n→∞
⩽ lim IE∗ e −(τ∧n−t )r Sτ∧n St
 
n→∞
= lim St
s→∞
= St , t ⩾ 0,
see also (4.3.10), hence
IE∗ e −(τ−t )r (Sτ − K )+ St ⩽ St ,
 
Sup t ⩾ 0,
τ⩾t
τ Stopping time

which shows (5.3.7) by (5.3.8). □

We may also check that since ( e −rt St )t∈R+
is a martingale, the process t 7→ is a ( e −rt St − K )+
+
submartingale since the function x 7→ (x − K ) is convex, hence for all bounded stopping times τ
such that t ⩽ τ we have
(St − K )+ ⩽ IE∗ ( e −(τ−t )r Sτ − K )+ St ⩽ IE∗ 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 5.8 for the pricing of perpetual American call options with dividends.

5.4 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
f (t, St ) = Sup IE∗ e −(τ−t )r (K − Sτ )+ St ,
 
t⩽τ⩽T
τ Stopping time

and
IE∗ e −(τ−t )r (Sτ − K )+ St .
 
f (t, St ) = Sup
t⩽τ⩽T
τ Stopping time
* IE[limn→∞ Fn ] ⩽ limn→∞ IE[Fn ] for any sequence (Fn )n∈N of nonnegative random variables, provided that the limits
exist.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

5.4 Finite Expiration American Options 145

Two-choice optimal stopping at fixed times with finite expiration

We start by considering the optimal stopping problem in a simplified setting 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 5.8 Assume that r ⩾ 0. For any stopping time τ ∈ [t, T ], the price of the European
call option exercised at time τ satisfies the bound

(x − K )+ ⩽ IE∗ [ e −(τ−t )r (Sτ − K )+ | St = x], x,t > 0. (5.4.1)

Proof. Since the function x 7→ x+ = Max(x, 0) is convex non-decreasing and the process ( e −rt St −
e −rt K )t⩾0 is a submartingale under P∗ since r ⩾ 0, Proposition 4.5-(b)) shows that that t 7→
( e −rt St − e −rt K )+ is a submartingale by the Jensen, 1906 inequality (4.2.3). Hence, by (4.3.6)
applied to submartingales, for any stopping time τ ∈ [t, T ] we have

(St − K )+ = e rt ( e −rt St − e −rt K )+

⩽ e rt IE∗ [( e −rτ Sτ − e −rτ K )+ | Ft ]
= IE∗ [ e −(τ−t )r (Sτ − K )+ | Ft ],

which yields (5.4.1). □

In particular, for the deterministic time τ := T ⩾ t we get

(x − K )+ ⩽ e −(T −t )r IE∗ [(ST − K )+ | St = x], x,t > 0.

as illustrated in Figure 5.8 using the Black-Scholes formula for European call options. 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 IE∗ [(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.

Black-Scholes European call price

Payoff (x-K)+

80
70
60
50
40
30
20
10
0
0 2 1
5 4 3
140 6
120 100 8 7
80 60 109 Time to maturity T-t
Underlying (HK$)

Figure 5.8: 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 IE∗ (ST − K )+ St ,

 

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 146 N. Privault

i.e. T is the optimal exercise date, see Proposition 5.10 below or §14.4 of Steele, 2001 for a proof.
Put options
For put options the situation is entirely different. The Black-Scholes formula for European put
options shows that the inequality

(K − x)+ ⩽ e −(T −t )r IE∗ [(K − ST )+ | St = x],

does not always hold, as illustrated in Figure 5.9.

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
4 5 3
6 110 Underlying (HK$)
Time to maturity T-t 7 8 9 10 120

Figure 5.9: 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 )+ ⩽
e −(T −t )r IE∗ [(K − ST )+ | St ] (in which case one chooses to exercise at time T ) or (K − St )+ >
e −(T −t )r IE∗ [(K − ST )+ | St ] (in which case one chooses to exercise at time t).
A view from above of the graph of Figure 5.9 shows the existence of an optimal 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 5.1, see Figure 5.10.
0
1

5 T-t
6

10
120 115 110 105 100 95 90
Underlying HK$

Figure 5.10: Optimal frontier for the exercise of a put option.

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 5.5 PDE Method with Finite Expiration 147

At a given time t, one will choose to exercise immediately if (St , T − t ) belongs 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
an finite expiration American put option at maturity T , see also Exercise 5.10.

Proposition 5.9 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:

f (t, St ) = Sup IE∗ φ (Sτ ) St = IE∗ φ (ST ) St ,

   
t⩽τ⩽T
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 mea-
sure P∗ , we know from Proposition 4.5-(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

IE∗ [φ (Sτ ) | Ft ] ⩽ IE∗ [φ (ST ) | Ft ],

hence it is always better to wait until time T than to exercise at time τ ∈ [t, T ], and this yields

IE∗ φ (Sτ ) St ⩽ IE∗ φ (ST ) St .

   
Sup
t⩽τ⩽T
τ Stopping time

Since the constant T is a stopping time, it attains the above supremum. □

5.5 PDE Method with Finite Expiration

Let us describe the PDE associated to American put options. After discretization {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 the return r of the
riskless asset. In this case, as in Proposition 5.3, f (t, St ) follows the Black-Scholes PDE

∂f ∂f 1 ∂2 f
r f (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 ∂2 f
r f (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, Lamberton, and
Lapeyre, 1990, Theorem 8.5.9 in Elliott and Kopp, 2005 and Theorem 5 in Üstünel, 2009:

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 148 N. Privault

f (t, x) ⩾ f (T , x) = (K − x)+ ,


 (5.5.1a)






σ2 2 ∂2 f

∂ f
 ∂f

 ( t, x ) + rx (t, x ) + x (t, x) ⩽ r f (t, x), (5.5.1b)
∂x 2 ∂ x2

 ∂t



σ2 2 ∂2 f
  

 ∂f ∂f

 (t, x) + rx (t, x) + x (t, x) − r f (t, x)
∂x 2 ∂ x2



 ∂t
× ( f (t, x) − (K − x)+ ) = 0,

(5.5.1c)






x > 0, 0 ⩽ t ⩽ T , subject to the terminal condition f (T , x) = (K − x)+ . In other words, equality

holds either in (5.5.1a) or in (5.5.1b) due to the presence of the term ( f (t, x) − (K − x)+ ) in
(5.5.1c).
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

τ ∗ = T ∧ 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 , x j ) := Max( f (ti , x j ), (K − x j )+ )
right after the computation of f (ti , x j ).
The next Figure 5.11 shows a numerical resolution of the variational PDE (5.5.1a)-(5.5.1c)
using the above simplified (implicit) finite difference scheme, see also Jacka, 1991 for properties of
the optimal boundary function. In comparison with Figure 5.4, 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

Figure 5.11: 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 )+ ,

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5.5 PDE Method with Finite Expiration 149

i.e. within the blue area in Figure (5.11). We check that the optimal threshold L∗ = 90.64 of the
corresponding perpetual put option is within the exercise 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

f (t, St ) = Sup IE∗ e −(τ−t )r (K − Sτ )+ St

 
t⩽τ⩽T
τ Stopping time

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 5.12.

Immediate payoff (K-x)+

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

Figure 5.12: Longstaff-Schwartz estimates of finite expiration American put option prices.

In Figure 5.12 above and Figure 5.13 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 5.13 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
Immediate payoff (K-x)+
8
Option price

0
90 100 110 120
Underlying

Figure 5.13: 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,

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 150 N. Privault

a small error in the values of the solution translates into a large error on the value of the optimal
exercise threshold.
The fOptions package in contains a finite expiration American put option pricer based on the
Barone-Adesi and Whaley, 1987 approximation, see Exercise 5.4, however, the approximation is
valid only for certain parameter ranges. See also Allegretto, Barone-Adesi, and Elliott, 1995 for a
related approximation of the early exercise premium (5.2.5).
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 5.10 Assume that r ⩾ 0 and let φ : R −→ R be a nonnegative 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

IE∗ e −(τ−t )r φ (Sτ ) St = e −(T −t )r IE∗ φ (ST ) St ,

   
f (t, St ) = Sup
t⩽τ⩽T
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) ⩽ (1 − p) × φ (0) + pφ (x) = pφ (x), (5.5.2)

for all p ∈ [0, 1] and x ⩾ 0. Next, taking p := e −rs in (5.5.2) we note that

e −rs IE∗ φ St +s Ft ⩾ e −rs φ IE∗ St +s Ft


  

⩾ φ e −rs IE∗ St +s Ft
 

= φ (St ),
where we used Jensen’s inequality Proposition 4.4 applied to the convex function φ . Hence the pro-
cess s 7→ e −rs φ (St +s ) is a submartingale, and by the optional stopping theorem for submartingales,
see (4.3.6), for all (bounded) stopping times τ comprised between t and T we have

IE∗ [ e −(τ−t )r φ (Sτ ) | Ft ] ⩽ e −(T −t )r IE∗ [φ (ST ) | Ft ].

In other words, it is always better to wait until time T than to exercise at time τ ∈ [t, T ], and this
yields
Sup IE∗ e −(τ−t )r φ (Sτ ) St ⩽ e −(T −t )r IE∗ φ (ST ) St .
   
t⩽τ⩽T
τ Stopping time

The converse inequality

e −(T −t )r IE∗ φ (ST ) St ⩽ IE∗ e −(τ−t )r φ (Sτ ) St ,

   
Sup
t⩽τ⩽T
τ Stopping time

is obvious because T is a stopping time. □

As a consequence of Proposition 5.10 applied to the convex function φ (x) = (x − K )+ , the price of
the finite expiration American call option is given by

Sup IE∗ e −(τ−t )r (Sτ − K )+ St

 
f (t, St ) =
t⩽τ⩽T
τ Stopping time

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5.5 PDE Method with Finite Expiration 151

= e −(T −t )r IE∗ (ST − K )+ St ,

 

i.e. the optimal strategy is to wait until the maturity time T to exercise the option. In the following
Table 5.1 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 ⩽ L∗ ,

Solve the PDE (5.5.1a)-


Put

−2r/σ 2 τ ∗ = τL∗ (5.5.1c) for f (t, x) or use τ ∗ = T ∧ inf{u ⩾ t : f (u, Su ) = (K − Su )+ }
option

St
 ( K − L∗ ) , St ⩾ L∗ . Longstaff and Schwartz, 2001


L∗

Call
St τ ∗ = +∞ e −(T −t )r IE∗ [(ST − K )+ | St ] τ∗ = T
option

Table 5.1: Optimal exercise strategies.

Exercises
Exercise 5.1 Consider a two-step binomial model (Sk )k=0,1,2 with interest rate r = 0% and
risk-neutral probabilities ( p∗ , q∗ ):

S2 = 1.44
3
p ∗ = 2/
S1 = 1.2
3
p∗ = 2/ q∗ =
1/3
S0 = 1 S2 = 1.08
3
q∗ = 1/ p∗ = 2/
3
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 5.2 Let r > 0 and σ > 0.

2
a) Show that for every C > 0, the function f (x) := Cx−2r/σ solves the differential equation

′ 1 2 2 ′′
 r f (x) = rx f (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 ′ (L∗ ) = −1.
* Download the corresponding discrete-time IPython notebook that can be run here or here.

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 152 N. Privault

Exercise 5.3 Consider an American butterfly option with the following payoff function in the
geometric Brownian model (5.1.3), i.e.
2 t/2
St = S0 e rt +σ Bt −σ , t ⩾ 0.
b

60
Payoff function
50
40
30
20
10
0
0 ^-K
2K ^
K L* K 200

Figure 5.14: Butterfly payoff function.

Price the perpetual American butterfly option with r > 0 in the following cases.
a) Kb ⩽ L ∗ ⩽ S0 .
b) Kb ⩽ S0 ⩽ L∗ .
c) 0 ⩽ S0 ⩽ K.
b

Exercise 5.4 (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∗ , (5.5.3)
f (x,T ) ≃

x ⩽ S∗ ,

K − x, (5.5.4)

where α > 0 is a parameter, S∗ > 0 is called the critical price, and BS p (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
(5.5.3) and (5.5.4) at x = S∗ .
b) Derive the equation satisfied by the critical price S∗ .

Exercise 5.5 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 ε ⩾ 0, let the random time
τε be defined as
τε := inf{t > 0 : Xt > ε},

with inf 0/ = +∞, and let (Ft )t∈R+ denote the filtration generated by (Xt )t∈R+ .
a) Give the possible values of τε in [0, ∞] depending on the value of Z.
b) Take ε = 0. Is τ0 := inf{t > 0 : Xt > 0} an (Ft )t∈R+ -stopping time? Hint: Consider the
event {τ0 > 0}.
c) Take ε > 0. Is τε := inf{t > 0 : Xt > ε} an (Ft )t∈R+ -stopping time? Hint: Consider the
event {τε > t} for t ⩾ 0.

Exercise 5.6 American put options with dividends, cf. Exercise 8.5 in Shreve, 2004. Consider a
dividend-paying asset priced as
2 t/2
St = S0 e (r−δ )t +σ Bt −σ , t ⩾ 0,
b

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5.5 PDE Method with Finite Expiration 153

where r > 0 is the risk-free interest rate, δ ⩾ 0 is a continuous dividend rate, (Bbt )t∈R+ is a
standard Brownian motion under the risk-neutral probability measure P∗ , and σ > 0 is the volatility
coefficient. Consider the American put option with payoff

 κ − Sτ if Sτ ⩽ 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 ⩽ 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 ⩽ L.
In what follows 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− ⩽ 0 ⩽ λ+ of λ that can be computed explicitly.
d) Choosing the negative solution λ− , show that
 λ−
(λ ) L
0 ⩽ Zt − ⩽ , 0 ⩽ t ⩽ τL .
S0
e) Let τL denote the hitting time

τL = inf{u ∈ R+ : Su ⩽ L}.

By application of the Stopping Time Theorem 4.8 to the martingale (Zt )t∈R+ , show that
 λ−
∗
 −rτL
 S0
IE e = , (5.5.5)
L
with
p
−(r − δ − σ 2 /2) − (r − δ − σ 2 /2)2 + 4rσ 2 /2
λ− := . (5.5.6)
σ2
f) Show that for all L ∈ (0, K ) we have
IE∗ e −rτL (K − SτL )+ S0 = x


 K − x, 0 < x ⩽ L,

= √
 x  −(r−δ −σ 2 /2)− (r−δ −σ 2 /2)2 +4rσ 2 /2
σ2

 (K − L )

, x ⩾ L.
L

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 154 N. Privault

g) Show that the value L∗ of L that maximizes

fL (x) := IE∗ 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 ⩽ L∗ = K,


 λ− − 1
f L∗ ( x ) =
1 − λ− λ− −1
   λ−
x

 λ−
x ⩾ L∗ =


 , K,
K −λ− λ− − 1

i) Show by hand computation that fL∗ (x) satisfies the variational differential equation



 f L∗ ( x ) ⩾ ( K − x ) + , (5.5.7a)







 ′ 1 2 2 ′′
 ( r − δ ) x f L∗ ( x ) + σ x f L∗ ( x ) ⩽ r f L∗ ( x ) , (5.5.7b)


2


  
1 2 2 ′′


′
r f L∗ ( x ) − ( r − δ ) x f L∗ ( x ) − σ x f L∗ ( x )


 (5.5.7c)



 2
× ( fL∗ (x) − (K − x)+ ) = 0.



j) Using Itô’s formula, check that the discounted portfolio value process

t 7→ e −rt fL∗ (St )

is a supermartingale.
k) Show that we have

IE∗ e −rτ (K − Sτ )+ S0 .
 
f L ∗ ( S0 ) ⩾ Sup
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

IE∗ e −rτ (K − Sτ )+ .
 
f L ∗ ( S0 ) ⩽ Sup
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 dividend is given for all
t ∈ R+ by
fL∗ (St ) = IE∗ e −(τL∗ −t )r (K − SτL∗ )+ St
 

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5.5 PDE Method with Finite Expiration 155

λ−

 K − St , 0 < St ⩽ K,


 λ− − 1
=
1 − λ− λ− −1
   λ−
St


 λ−

 , St ⩾ K,
K −λ− λ− − 1
where λ− < 0 is given by (5.5.6), and

τL∗ = inf{u ⩾ t : Su ⩽ L}.

Exercise 5.7 (Broadie and Detemple, 1996) Given an asset price process (St )t∈[0,T ] and K > 0,
find a ranking of the form “(x) ⩽ (y) ⩽ (z)” between the three listed quantities in the following
two cases L ⩾ K and L ⩽ K, and provide a short justification for each inequality, if available.
a) Case L ⩾ K.
i) the immediate exercise payoff (St − K )+ ,
ii) the finite exercise American call price with maturity T and strike K,
iii) the supremum over L ⩾ K of the capped call option prices with payoff (min(ST , L) −
K )+ and maturity T .
b) Case L ⩽ K.
i) the finite exercise American put price with maturity T and strike K,
ii) the supremum over L ⩽ K of the capped put option prices payoff (K − Max(ST , L))+
and maturity T ,
iii) the immediate exercise payoff (K − St )+ .

Exercise 5.8 American call options with dividends, see § 9.3 of Wilmott, 2006. Consider a
2
dividend-paying asset priced as St = S0 e (r−δ )t +σ Bt −σ t/2 , t ⩾ 0, where r > 0 is the risk-free
b

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 is a martingale
under P∗ .
(λ )
b) Show that we have Zt = (St )λ e −rt for two values λ− ⩽ 0, 1 ⩽ λ+ of λ satisfying a certain
equation.
(λ )
c) Show that 0 ⩽ Zt + ⩽ Lλ+ for 0 ⩽ t ⩽ τL := inf{u ⩾ t : Su = L}, and compute IE∗ e −rτL (SτL −


K )+ S0 = x when S0 = x < L and K < L.



Exercise 5.9 Optimal stopping for exchange options (Gerber and Shiu, 1996). We consider two
risky assets S1 and S2 modeled by
2 2
S1 (t ) = S1 (0) e σ1Wt +rt−σ2 t/2 and S2 (t ) = S2 (0) e σ2Wt +rt−σ2 t/2 , (5.5.8)

t ⩾ 0, with σ2 > σ1 ⩾ 0 and r > 0, and the perpetual optimal stopping problem

Sup IE[ 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, (5.5.9)

is a martingale.

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 156 N. Privault

b) For some fixed L ⩾ 1, consider the hitting time

τL = inf t ∈ R+ : S1 (t ) ⩾ LS2 (t ) ,


and show that

IE[ e −rτL (S1 (τL ) − S2 (τL ))+ ] = (L − 1) IE[ e −rτL S2 (τL )].

c) By an application of the Stopping Time Theorem 4.8 to the martingale (5.5.9), show that we
have
L−1
IE[ e −rτL (S1 (τL ) − S2 (τL ))+ ] = α S1 (0)α S2 (0)1−α .
L
d) Show that the price of the perpetual exchange option is given by
L∗ − 1
Sup IE[ 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 IE[ e −rτ (κ − S2 (τ ))+ ]

τ Stopping time

when r = σ22 /2.

Exercise 5.10 Consider an underlying asset whose price is written as

2 t/2
St = S0 e rt +σ Bt −σ , t ⩾ 0,

where (Bt )t∈R+ is a standard Brownian motion under the risk-neutral probability measure P∗ ,
σ > 0 denotes the volatility coefficient, and r ∈ R is the risk-free interest rate. For any λ ∈ R we
(λ )

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 λ σ Bt −λ , t ⩾ 0. (5.5.10)
(λ )

a) Assume that r ⩾ −σ 2 /2. Show that, under P∗ , the process Zt t∈R+
is a supermartingale
when −2r/σ 2
⩽ λ ⩽ 1, and that it is a submartingale when λ ∈ (−∞, −2r/σ 2 ] ∪ [1, ∞).
(λ )

b) Assume that r ⩽ −σ 2 /2. Show that, under P∗ , the process Zt t∈R is a supermartingale
+
when 1 ⩽ λ ⩽ −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 4.8 to Zt t∈R to suitable values of λ ,
+
show that
x Max(1,−2r/σ 2 )
  

 , x ⩾ L,
  L

∗
1{τL <∞} | S0 = x ⩽
 −rτ
IE e L
2
  x min(1,−2r/σ )


 , 0 < x ⩽ L.
L

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5.5 PDE Method with Finite Expiration 157

d) Deduce an upper bound on the price

IE∗ 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 ⩽ −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

IE∗ 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 ⩽ L.
g) Show that when −σ 2 /2 ⩽ r < 0, the upper bound of Question (f)) increases in L ⩾ K, and
tends to S0 as L increases to +∞.

Exercise 5.11 Perpetual American binary options.

a) Compute the price

CbAm (t, St ) = IE∗ e −(τ−t )r 1{Sτ ⩾K} St

 
Sup
τ⩾t
τ Stopping time

of the perpetual American binary call option.

b) Compute the price

PbAm (t, St ) = IE∗ e −(τ−t )r 1{Sτ ⩽K} St

 
Sup
τ⩾t
τ Stopping time

of the perpetual American binary put option.

Exercise 5.12 Finite expiration American binary options. An American binary (or dig-
ital) call (resp. put) option with maturity T > 0 on an underlying asset process (St )t∈R+ =
2
( e rt +σ Bt −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 immedi-
ately, or to wait.
b) 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 put option immedi-
ately, 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 ∂CAm 1 ∂ 2CdAm
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 ⩽ t < T , and CdAm (T , T , x), 0 ⩽ x < K?

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 158 N. Privault

d) The price PdAm (t, T , St ) of an American binary put option is known to satisfy the same
Black-Scholes PDE
∂ PdAm ∂ PAm 1 ∂ 2 PdAm
rPdAm (t, T , x) = (t, T , x) + rx d (t, T , x) + σ 2 x2 (t, T , x). (5.5.11)
∂t ∂x 2 ∂ x2
Based on your answers to Question (b)), how would you set the boundary conditions
PdAm (t, T , K ), 0 ⩽ t < T , and PdAm (T , T , x), x > K?
e) Show that the optimal exercise strategy for the American binary call option 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 CdAm (t, T , St ) of the American binary call
option is given by
CdAm (t, x) = IE 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
Cd (t, T , x) = Φ
Am
√
K σ T −t
 x −2r/σ 2  −(r + σ 2 /2)(T − t ) + log(x/K ) 
+ Φ √ , 0 ⩽ x ⩽ 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 5.11 as T tends to infinity.
g) Show that the optimal exercise strategy for the American binary put option 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) = IE[ 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
Pd (t, T , x) = Φ
Am
√
K σ T −t
 x −2r/σ 2  (r + σ 2 /2)(T − t ) − log(x/K ) 
+ Φ √ , x ⩾ K,
K σ T −t
that this formula is consistent with the answer to Question (d)), and that it recovers the answer
to Question (b)) of Exercise 5.11 as T tends to infinity.
i) Does the standard call-put parity relation hold for American binary options?
Exercise 5.13 American forward contracts. Consider (St )t∈R+ an asset price process given by
dSt
= rdt + σ dBt ,
St
where r > 0 and (Bt )t∈R+ is a standard Brownian motion under P∗ .
a) Compute the price
f (t, St ) = Sup IE∗ e −(τ−t )r (K − Sτ ) St ,
 
t⩽τ⩽T
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 ].

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5.5 PDE Method with Finite Expiration 159

b) Compute the price

IE∗ e −(τ−t )r (Sτ − K ) St ,

 
f (t, St ) = Sup
t⩽τ⩽T
τ Stopping time

and optimal exercise strategy of a finite expiration American-type long forward 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 5.14 Consider an underlying asset price process written as
2 t/2
St = S0 e rt +σ Bt −σ , t ⩾ 0,
b

where (Bbt )t∈R+ is a standard Brownian motion under the risk-neutral probability 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}.

By application of the Stopping Time Theorem 4.8 to the martingales (Yt )t∈R+ and (Zt )t∈R+ ,
show that  x
 , 0 < x ⩽ L,
 L

IE∗ e −rτL S0 = x =
 
2
 x −2r/σ ,

  
x ⩾ L.
L
∗ −rτL
c) Compute the price IE [ e (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 Lx∗ of L that maximizes
L 7→ IE[ e −rτL (K − SτL )].
e) Would you use the stopping strategy

τLx∗ = inf{u ∈ R+ : Su = Lx∗ }

as an optimal exercise strategy for the short forward contract with payoff K − Sτ ?

Exercise 5.15 Let p ⩾ 1 and consider a power put option with payoff
(
+ p
(κ − Sτ ) p if Sτ ⩽ κ,
((κ − Sτ ) ) = 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 +σ Bt −σ , t ⩾ 0,

where (Bt )t∈R+ is a standard Brownian motion under the risk-neutral probability 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:

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 160 N. Privault

i) If St ⩽ 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 ⩽ L ?
b) Show that in case St > L, the price of the option is equal to

fL (St ) = (κ − L) p IE∗ e −(τL −t )r St .

 

c) Compute the price fL (St ) of the option at time t.

2
Hint: Recall that by (5.1.4) we have IE∗ [ 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

f (t, St ) = Sup IE∗ e −(τ−t )r ((κ − Sτ )+ ) p St ?

 
τ⩾t
τ Stopping time

Exercise 5.16 Same questions as in Exercise 5.15, this time for the option with payoff κ − (Sτ ) p
exercised at time τ, with p > 0.

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 161

6. Stochastic Calculus for Jump Processes

Jump processes are stochastic processes whose trajectories have discontinuities 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 construction of risk-neutral probability
measures in Chapter 7 for option pricing and hedging in markets with jumps, in relation with market
incompleteness.

6.1 The Poisson Process 161

6.2 Compound Poisson Process 168
6.3 Stochastic Integrals and Itô Formula with Jumps 173
6.4 Stochastic Differential Equations with Jumps 184
6.5 Girsanov Theorem for Jump Processes 188
Exercises 194

6.1 The Poisson Process

The most elementary and useful jump process is the stan-
dard 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, with N0 := 0.

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 162 N. Privault

The counting process (Nt )t∈R+ that can be used to model discrete arrival times such as claim dates
in insurance, or connection logs.

Nt
6
5
4
3
2
1
0
T1 T2 T3 T4 T5 T6 t

Figure 6.1: Sample path of a counting process (Nt )t∈R+ .

Using the indicator functions

(
1 if t ⩾ Tk ,
1[Tk ,∞) (t ) =
0 if 0 ⩽ t < Tk , k ⩾ 1,

the value of Nt at time t can be written as

Nt = ∑ 1[T ,∞) (t ),
k
t ⩾ 0, (6.1.1)
k⩾1

where and (Tk )k⩾1 is the increasing family of jump times of (Nt )t∈R+ such that

lim Tk = +∞.
k→∞

The operation defined in (6.1.1) can be implemented in using the following code.

T=10; Tn=c(1,3,4,7,9); dev.new(width=T, height=5)

plot(stepfun(Tn,c(0,1,2,3,4,5)),xlim =c(0,T),xlab="t",ylab=expression('N'[t]),pch=1, cex=0.8, col='blue',
lwd=2, main="", cex.axis=1.2, cex.lab=1.4,xaxs='i'); grid()

In order for the counting process (Nt )t∈R+ to be a Poisson process, it has to satisfy the following
conditions:
1. Independence of increments: for all 0 ⩽ t0 < t1 < · · · < tn and n ⩾ 1 the increments

Nt1 − Nt0 , . . . , Ntn − Ntn−1 ,

are mutually independent random variables.

2. Stationarity of increments: Nt +h − Ns+h has the same distribution as Nt − Ns for all h > 0 and
0 ⩽ s ⩽ t.
The meaning of the above stationarity condition is that for all fixed k ⩾ 0 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)

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6.1 The Poisson Process 163

does not depend on h > 0, for all fixed 0 ⩽ s ⩽ t and k ⩾ 0.

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 6.1 Assume that the counting process (Nt )t∈R+ satisfies the above independence and
stationarity Conditions 1 and 2 on page 162. Then, for all fixed 0 ⩽ s ⩽ 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, (6.1.2)
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). (6.1.3)
h→0 h

The proof of the above Theorem 6.1 is technical and not included here, cf. e.g. Bosq and Nguyen,
1996 for details, and we could in fact take this distribution property (6.1.2) 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 (6.1.1), which is assumed to have independent
increments distributed according to the Poisson distribution, in the sense that for all 0 ⩽ t0 ⩽ t1 <
· · · < tn ,
(Nt1 − Nt0 , . . . , Ntn − Ntn−1 )
is a vector of independent Poisson random variables with respective parameters

((t1 − t0 )λ , . . . , (tn − tn−1 )λ ).

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 IE[Nt ] and the variance of Nt can be computed as

IE[Nt ] = Var[Nt ] = λt. (6.1.4)

As a consequence, the dispersion index of the Poisson process is

Var[Nt ]
= 1, t ⩾ 0. (6.1.5)
IE[Nt ]

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 164 N. Privault

Short time behaviour

From (6.1.3) above we deduce the short time asymptotics*

P(Nh = 0) = e −λ h = 1 − λ h + o(h),
(
h → 0,
P(Nh = 1) = λ h e −λ h ≃ λ h, h → 0.

By stationarity of the Poisson process we also find more generally that

P(Nt +h − Nt = 0) = e −λ h = 1 − λ h + o(h),


 h → 0,

−λ h
P(Nt +h − Nt = 1) = λ h e

≃ λ h, h → 0, (6.1.6)
 2
 P ( N − N = 2 ) ≃ h2 λ = o ( h ) ,

h → 0,

t +h t t > 0,
2

for all t > 0. This means that within a “short” time interval [t,t + h] of length h, the increment
Nt +h − Nt behaves like a Bernoulli random variable with parameter λ h. This fact can be used for
the random simulation of Poisson process paths.

The next code and Figure 6.2 present a simulation of the standard Poisson process (Nt )t∈R+
according to its short time behavior (6.1.6).

lambda = 0.6;T=10;N=1000*lambda;h=T*1.0/N
t=0;s=c();for (k in 1:N) {if (runif(1)<lambda*h) {s=c(s,t)};t=t+h}
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="", cex.axis=1.2, cex.lab=1.4,xaxs='i'); grid()
5
4
3
Nt
2
1
0

0 2 4 6 8 10

Figure 6.2: Sample path of the Poisson process (Nt )t∈R+ .

More generally, for k ⩾ 1 we have

λk
P(Nt +h − Nt = k) ≃ hk , h → 0, t > 0.
k!
* The notation f (h) = o(hk ) means limh→0 f (h)/hk = 0, and f (h) ≃ hk means limh→0 f (h)/hk = 1.

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6.1 The Poisson Process 165

Time-dependent intensity
The intensity of the Poisson process can in fact be made time-dependent (e.g. by a time change), in
which case we have
r k
 wt  st λ (u)du
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,

  r r
= t +h t +h
 exp − t λ (u)du t λ (u)du = λ (t )h + o(h), k = 1,



 o(h), k ⩾ 2.
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

{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 ⩽ 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 6.2 For all n ⩾ 1, the probability distribution of Tn has the gamma probability
density function
t n−1
t 7−→ λ n e −λt
(n − 1) !
with shape parameter n ⩾ 1 and scaling parameter λ > 0 on R+ , i.e., for all t > 0 the probability
P(Tn ⩾ t ) is given by
w∞ sn−1
P(Tn ⩾ t ) = λ n e −λ s ds.
t (n − 1) !

Proof. We have

P(T1 > t ) = P(Nt = 0) = e −λt , t ⩾ 0,

and by induction, assuming that
w∞ (λ s)n−2
P(Tn−1 > t ) = λ e −λ s ds, n ⩾ 2,
t (n − 2) !

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 166 N. Privault

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∞ (λ s)n−2
= e −λt +λ e −λ s ds
(n − 1) ! t (n − 2) !
w∞ (λ s)n−1
= λ e −λ s ds, t ⩾ 0,
t (n − 1) !

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 random jump time Tn .
In addition to Proposition 6.2 we could show the following proposition which relies on the strong
Markov property, see e.g. Theorem 6.5.4 of Norris, 1998.

Proposition 6.3 The (random) interjump times

τk := Tk+1 − Tk

spent at state k ⩾ 0, with T0 = 0, form a sequence of independent identically 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
IE[τk ] = λ x e −λ x dx = ,
0 λ
we can check that the nth jump time Tn = τ0 + · · · + τn−1 has the mean
n
IE[Tn ] = , n ⩾ 1.
λ
Consequently, the higher the intensity λ > 0 is (i.e., the higher the probability of having a jump
within a small interval), the smaller the time spent in each state k ⩾ 0 is on average.
As a consequence of Proposition 6.2, random samples of Poisson process jump times can be
generated from Poisson jump times using the following code according to Proposition 6.3.

lambda = 0.6;T=10;Tn=c();n=0;
S=0; while (S<T) {S=S+rexp(1,rate=lambda); Tn=c(Tn,S); n=n+1}
Z<-cumsum(c(0,rep(1,n))); dev.new(width=T, height=5)
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,xaxs='i',yaxs='i'); grid()

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6.1 The Poisson Process 167

6
Nt

0
0 2 4 6 8 10

Figure 6.3: Sample path of the Poisson process (Nt )t∈R+ .

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. § 11.1 in Privault, 2018.
This fact can also be useful for the random simulation of Poisson process paths.

lambda = 0.6;T=10;n = rpois(1,lambda*T);Tn <- sort(runif(n,0,T)); Z<-cumsum(c(0,rep(1,n)));

dev.new(width=T, height=5)
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,xaxs='i',tick.ratio = 0.5); grid()

The Poisson process belong to the family of renewal processes, which are counting processes
of the form
Nt = ∑ 1[Tn ,∞) (t ), t ⩾ 0,
n⩾1

for which τk := Tk+1 − Tk , k ⩾ 0, is a sequence of independent identically distributed random

variables.

Compensated Poisson martingale

From (6.1.4) above we deduce that

IE[Nt − λt ] = 0, (6.1.7)

i.e., the compensated Poisson process (Nt − λt )t∈R+ has centered increments.

lambda = 0.6;T=10;Tn=c();S=0;n=0;
while (S<T) {S=S+rexp(1,rate=lambda); Tn=c(Tn,S); n=n+1}
Z<-cumsum(c(0,rep(1,n)));
N <- function(t) {return(stepfun(Tn,Z)(t))};t <- seq(0,10,0.01)
dev.new(width=T, height=5)
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)

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 168 N. Privault

1
Nt−t

−1

−2
0 2 4 6 8 10

Figure 6.4: 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.
We let
Ft := σ Ns : s ∈ [0,t ]), t ⩾ 0,

denote the filtration generated by the Poisson process (Nt )t∈R+ .

Proposition 6.4 The compensated Poisson process

(Nt − λt )t∈R+

is a martingale with respect (Ft )t∈R+ .

6.2 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 random 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 ⩽ 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
P(Z ∈ [a, b]) = ϕ (y)dy, −∞ < a ⩽ b < ∞, k ⩾ 1.
a
Figure 6.5 shows an example of Gaussian jump size distribution.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

6.2 Compound Poisson Process 169

0.4
Probability density
0.3

0.2

0.1

0
−4 −3 −2 −1 a 0 1 b 2 3 4

Figure 6.5: Probability density function ϕ.

Definition 6.5 The process (Yt )t∈R+ given by the random sum

Nt
Yt := Z1 + Z2 + · · · + ZNt = ∑ Zk , t ⩾ 0, (6.2.1)
k =1

is called a compound Poisson process.a

n
aWe use the convention ∑ Zk = 0 if n = 0, so that Y0 = 0.
k =1

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, (6.2.2)
where
∆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

Figure 6.6 represents a sample path of a compound Poisson process, with here Z1 = 0.9, Z2 = −0.7,
Z3 = 1.4, Z4 = 0.6, Z5 = −2.5, Z6 = 1.5, Z7 = −0.5, and
YTk = YTk- + Zk , k ⩾ 1.

Yt
3

0
t
T1 T2 T3 T4 T5 T6 T7
-1

Figure 6.6: Sample path of a compound Poisson process (Yt )t∈R+ .

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 170 N. Privault

Example. Assume that the jump sizes Z are Gaussian distributed with mean δ and variance η 2 ,
with
1 2 2
ν (dy) = p e −(y−δ ) /(2η ) dy.
2πη 2

N<-50;Tk<-cumsum(rexp(N,rate=0.5)); Zk<-rexp(N,rate=0.5); Yk<-cumsum(c(0,Zk))

plot(stepfun(Tk,Yk),xlim = c(0,10),lwd=2,do.points = F,main="L=0.5",col="blue")

Zk<-rnorm(N,mean=0,sd=1); Yk<-cumsum(c(0,Zk))
plot(stepfun(Tk,Yk),xlim = c(0,10),lwd=2,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 6.6 For any t ∈ [0, T ] and α ∈ R we have

IE e (YT −Yt )α = exp (T − t )λ IE e αZ − 1 .

   


(6.2.3)

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,

" !# " !#
NT NT −Nt
(YT −Yt )α
 
IE e = IE exp α ∑ Zk = IE exp α ∑ Zk+Nt
k=Nt +1 k =1
" !#
NT −Nt
= IE exp α ∑ Zk
k =1
" ! #
NT −Nt
= ∑ IE exp α ∑ Zk NT − Nt = n P(NT − Nt = n)
n⩾0 k =1
" !#
n
= ∑ IE exp α ∑ Zk P(NT − Nt = n)
n⩾0 k =1
" !#
n n
λ
= e −(T −t )λ ∑ (T − t )n IE exp α ∑ Zk
n⩾0 n! k =1
n
λn
e −(T −t )λ n
 
= ∑ n! ( T − t ) ∏ IE e αZk
n⩾0 k =1
λn 
n
e −(T −t )λ(T − t )n IE e αZ

= ∑
n⩾0 n!
 


= exp (T − t )λ IE e αZ − 1 .

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6.2 Compound Poisson Process 171

As a consequence of Proposition 6.6, we can derive the following version of the Lévy-Khintchine
formula, after approximating f : [0, T ] −→ R a bounded deterministic function of time by indicator
functions:
 w   w w 
T T ∞
y f (t )


IE exp f (t )dYt = exp λ e − 1 ν (dy)dt . (6.2.4)
0 0 −∞

We note that we can also write

 w∞ 
IE e (YT −Yt )α = exp (T − t )λ
 
( e αy − 1)ν (dy)
 w−∞
∞ w∞ 
= exp (T − t )λ e αy ν (dy) − (T − t )λ ν (dy) ,
−∞ −∞

since the probability distribution ν (dy) of Z satisfies

  w ∞ αy w∞
IE e αZ = e ν (dy) and ν (dy) = 1.
−∞ −∞

From the moment generating function (6.2.3) we can compute the expectation and variance of
Yt for fixed t. Note that the proofs of those identities require to exchange the differentiation and
expectation operators, which is possible when the moment generating function (6.2.3) takes finite
values for all α in a certain neighborhood (−ε, ε ) of 0.

Proposition 6.7 i) The expectation of Yt is given as the product of the mean number of jump
times IE[Nt ] = λt and the mean jump size IE[Z ], i.e.,

IE[Yt ] = IE[Nt ] IE[Z ] = λt IE[Z ]. (6.2.5)

ii) Regarding the variance, we have

Var [Yt ] = IE[Nt ] IE |Z|2 = λt IE |Z|2 .

   
(6.2.6)

Proof. (i) We use the relation

∂ w∞
IE[Yt ] = IE[ e αYt ]|α =0 = λt yν (dy) = λt IE[Z ].
∂α −∞

(ii) By (6.2.3), we have

∂2
IE Yt2 =
 
IE[ e αYt ]|α =0
∂ α2
∂2  


= 2
exp λt IE e αZ − 1 |α =0
∂α
∂    



= λt IE Z e αZ exp λt IE e αZ − 1 |α =0
∂α  
= λt IE Z 2 + (λt IE[Z ])2
w∞ w ∞ 2
= λt y2 ν (dy) + (λt )2 yν (dy)
−∞ −∞
= λt IE[Z 2 ] + (λt IE[Z ])2 .
□

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 172 N. Privault

Relation (6.2.5) can be directly recovered using series summations, as

" #
Nt
IE[Yt ] = IE ∑ Zk
k =1
" #
Nt
= ∑ IE ∑ Zk Nt = n P(Nt = n)
n⩾1 k =1
" #
n
λ nt n
= e −λt ∑ IE ∑ Zk Nt = n
n⩾1 n! k =1
" #
n
λ nt n
= e −λt ∑ IE ∑ Zk
n⩾1 n! k =1
(λt )n−1
= λt e −λt IE[Z ] ∑
n⩾1 (n − 1) !
= λt IE[Z ]
= IE[Nt ] IE[Z ].
As a consequence, the dispersion index of the compound Poisson process
IE |Z|2
 
Var [Yt ]
= , t ⩾ 0.
IE[Yt ] IE[Z ]
coincides with the dispersion index of the random jump size Z. Proposition 6.6 can be used to show
the next result.
Proposition 6.8 (i) The compound Poisson process

Nt
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

are mutually independent random variables.

(ii) In addition, the increment Yt −Ys is stationary, 0 ⩽ s ⩽ t, i.e. the distribution of Yt +h −Ys+h
does not depend of h ⩾ 0.
Proof. This result relies on the fact that the result of Proposition 6.6 can be extended to sequences
0 ⩽ t0 ⩽ t1 ⩽ · · · ⩽ tn and α1 , α2 , . . . , αn ∈ R, as
" # " !#
n n
IE ∏ e iαk (Ytk −Ytk−1 ) = IE exp i ∑ αk (Ytk −Ytk−1 )
k =1 k =1
w∞
!
n
iαk y
= exp λ ∑ (tk − tk−1 ) −∞
(e − 1)ν (dy) (6.2.7)
k =1
n  w∞ 
iαk y
= ∏ exp (tk − t k−1 ) λ ( e − 1 ) ν ( dy )
−∞
k =1
n
e iαk (Ytk −Ytk−1 ) ,
 
= ∏ IE
k =1
which also shows the stationarity in distribution of Yt +h −Ys+h in h ⩾ 0, for 0 ⩽ s ⩽ t. □

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

 6.3 Stochastic Integrals and Itô Formula with Jumps 173

Since the compensated compound Poisson process also has independent and centered increments
by (6.1.7) we have the following counterpart of Proposition 6.4.

Proposition 6.9 The compensated compound Poisson process

Mt := Yt − λt IE[Z ], t ⩾ 0,

is a martingale.

lambda = 0.6;T=10;Tn=c();S=0;n=0;
while (S<T) {S=S+rexp(1,rate=lambda); Tn=c(Tn,S); n=n+1}
Z<-cumsum(c(0,rep(1,n))); Zn<-cumsum(c(0,rexp(n,rate=2)));
Y <- function(t) {return(stepfun(Tn,Zn)(t))};t <- seq(0,10,0.01)
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

Figure 6.7: Sample path of a compensated compound Poisson process (Yt − λt IE[Z ])t∈R+ .

6.3 Stochastic Integrals and Itô Formula with Jumps

Definition 6.10 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
φt dYt = φt ZNt dNt := ∑ φT Zk . k
(6.3.1)
0 0
k =1

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 174 N. Privault

In particular, the compound Poisson process (Yt )t∈R+ in Definition 6.5 admits the stochastic integral
representation
Nt wt
Yt = Y0 + ∑ Zk = Y0 + ZNs dNs .
0
k =1
wT
Note that the expression (6.3.1) of φt dYt has a natural financial interpretation as the value at
0
time T of a portfolio containing a (possibly fractional) quantity φt of a risky asset at time t, whose
price evolves according to random returns Zk , generating profits/losses φTk Zk at random times Tk .
The next result is also called the smoothing lemma, cf. Theorem 9.2.1 in Brémaud, 1999.

Proposition 6.11 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
IE |φt |dt < ∞, T > 0.
0

The expected value of the compound Poisson stochastic integral can be expressed as

w  w  w 
T T T
IE φt - dYt = IE φt - ZNt dNt = λ IE[Z ] IE φt - dt , (6.3.2)
0 0 0

where φt - denotes the left limit

φt - := lim φs , t > 0.
s↗t

Proof. By Proposition 6.9 the compensated compound Poisson process (Yt − λt IE[Z ])t∈R+ is a
martingale, and the adaptedness of (φt )t∈R+ with respect 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.

Hence, by an argument similar to the first part of the proof of Proposition 3.1 and concluded by
dominated convergence as in the proof of Theorem 9.2.1 in Brémaud, 1999, the stochastic integral
process wt
wt

t 7−→ φs- d Ys − λ IE[Z ]ds = φs- ZNs dNs − λ IE[Z ]ds
0 0
is also a martingale. We can then use the fact that the expectation of a martingale remains constant
over time, i.e.,
w 
T

0 = IE φt - dYt − λ IE[Z ]dt
0
w  w 
T T
= IE φt dYt − λ IE[Z ] IE
- φt dt .
-
0 0

□
For example, taking φt = Yt := Nt we have
wT NT
1
0
Nt - dNt = ∑ (k − 1) = 2 NT (NT − 1),
k =1

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

6.3 Stochastic Integrals and Itô Formula with Jumps 175

hence
w 
T 1
IE NT2 − IE[NT ]
 

IE Nt - dNt =
0 2
(λ T )2
=
2
wT
= λ λtdt
0
wT
= λ IE[Nt ]dt,
0

as in (6.3.2). Note however that while the identity in expectations (6.3.2) holds for the left limit φt - ,
it need not hold for φt itself. Indeed, taking φt = Yt := Nt we have
wT NT
1
Nt dNt = ∑ k = 2 NT (NT + 1),
0
k =1

hence
w 
T 1
IE NT2 + IE[NT ]
 

IE Nt dNt =
0 2
1
(λ T )2 + 2λ T


=
2
(λ T )2
= +λT
2
wT 
̸= λ IE Nt dt .
0

Under similar conditions, the compound Poisson compensated stochastic integral can be shown to
satisfy the Itô isometry (6.3.3) in the next proposition.

Proposition 6.12 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
2
IE |φt | dt < ∞, T > 0.
0

The expected value of the squared compound Poisson compensated stochastic integral can be
computed as

wT  wT
" 2 #  
= λ IE |Z|2 IE |φt - |2 dt ,

IE φt - (dYt − λ IE[Z ]dt ) (6.3.3)
0 0

Note that in (6.3.3), 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 − λ IE[Z ]dt ) (6.3.4)
0
wT w t-
= 2 φt - φs- (dYs − λ IE[Z ]ds)(dYt − λ IE[Z ]dt ) (6.3.5)
0 0

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 176 N. Privault
wT
+ |φt - |2 |ZNt |2 dNt , (6.3.6)
0

where integration over the diagonal {s = t} has been excluded in (6.3.5) as the inner integral has
an upper limit t - rather than t. Next, taking expectation on both sides of (6.3.4)-(6.3.6), we find
 w 2  w 
T T
2 2
IE φt - (dYt − λ IE[Z ]dt ) = IE |φt - | |ZNt | dNt
0 0
w 
 2 T
2
= λ IE |Z| IE |φt - | dt ,
0

where we used the vanishing of the expectation of the double stochastic integral:
w w t- 
T
IE φt - φs- (dYs − λ IE[Z ]ds)(dYt − λ IE[Z ]dt ) = 0,
0 0

and the martingale property of the compensated compound Poisson process

!
Nt
t 7−→ ∑ |Zk |2 − λt IE Z 2 ,
 
t ⩾ 0,
k =1

as in the proof of Proposition 6.11. The isometry relation (6.3.3) can also be proved using simple
predictable processes. □
Extensions
a) 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
IE |φt |2 |ut |2 dt < ∞ and IE |φt vt |dt < ∞, T > 0.
0 0

In this case, the stochastic integral of (φt )t∈R+ with respect to (Xt )t∈R+ can be defined by
wT wT wT wT
φt dXt := φt ut dBt + φt vt dt + φt dYt
0 0 0 0
wT wT NT
= φt ut dBt + φt vt dt + ∑ φTk Zk , T > 0.
0 0
k =1
For the mixed continuous-jump martingale
wt
Xt := us dBs + Yt − λt IE[Z ], t ⩾ 0,
0

we then have the isometry:

 w 2  w  w 
T T T
2 2
 2 2
IE φt - dXt = IE |φt - | |ut | dt + λ IE |Z| IE |φt - | dt . (6.3.7)
0 0 0

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 (6.3.7) will be used in Section 7.5 for mean-variance
hedging in jump-diffusion models.

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6.3 Stochastic Integrals and Itô Formula with Jumps 177

b) When (Xt )t∈R+ takes the form

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+ can be defined as
wT wT wT wT
φt dXt := φt ut dBt + φt vt dt + ηt φt dYt
0 0 0 0
wT wT NT
= φt ut dBt + φt vt dt + ∑ φTk ηTk Zk , T > 0.
0 0
k =1

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 6.13 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 + NTk- , k ⩾ 1.

Hence we have the telescoping sum

Nt
f (Nt ) = f (0) + ∑ ( f (k) − f (k − 1))
k =1
Nt
= f (0) + ∑ ( f (NTk ) − f (NTk- ))
k =1
Nt
= f (0) + ∑ ( f (1 + NTk- ) − f (NTk- ))
k =1
wt
= f (0) + ( f (1 + Ns- ) − f (Ns- ))dNs
w0t
= f (0) + ( f (Ns ) − f (Ns − 1))dNs
w0t
= 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 (6.5) via a similar argu-
ment.
Proposition 6.14 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. (6.3.8)
0

Proof. We have
Nt



f (Yt ) = f (0) + ∑ f YTk − f YTk-
k =1

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 178 N. Privault
Nt



= f (0) + ∑ f YTk- + Zk − f YTk-
k =1
wt
= f (0) + ( f (Ys- + ZNs ) − f (Ys- ))dNs
w0t
= f (0) + ( f (Ys ) − f (Ys- ))dNs , t ⩾ 0.
0

□
From the expression
Nt wt
Yt = Y0 + ∑ Zk = Y0 + ZNs dNs ,
0
k =1

the Itô formula (6.3.8) can be decomposed using a compensated Poisson stochastic integral as

d f (Yt ) = ( f (Yt ) − f (Yt - ))dNt − IE[( f (y + Z ) − f (y)]y=Yt - dt (6.3.9)

+ IE[( f (y + Z ) − f (y)]y=Yt - dt,

where
( f (Yt ) − f (Yt - ))dNt − IE[( f (y + ZNt ) − f (y)]y=Yt - dt
is the differential of a martingale by the smoothing lemma Proposition 6.11.
More generally, we have the following result.

Proposition 6.15 For an Itô process of the form

wt wt wt
Xt = X0 + vs ds + us dBs + ηs dYs , t ⩾ 0,
0 0 0

and f a C 2 (R) function, we have the Itô formula

wt wt 1 w t ′′
f (Xt ) = f (X0 ) + vs f ′ (Xs )ds + us f ′ (Xs )dBs + f (Xs )|us |2 ds
wt
0 0 2 0

+ ( f (Xs ) − f (Xs- ))dNs , t ⩾ 0. (6.3.10)

0

Proof. By combining the Itô formula for Brownian motion with the Itô formula for the compound
Poisson process of Proposition 6.14, we find
wt 1 w t ′′ wt
f (Xt ) = f (X0 ) + us f ′ (Xs )dBs + f (Xs )|us |2 ds + vs f ′ (Xs )ds
0 2 0 0
NT



+∑ f XTk- + ηTk Zk − f XTk-
k =1
wt 1 w t ′′ wt
= f (X0 ) + us f ′ (Xs )dBs + f (Xs )|us |2 ds + vs f ′ (Xs )ds
wt
0 2 0 0

+ ( f (Xs- + ηs ZNs ) − f (Xs- ))dNs , t ⩾ 0,

0

which yields (6.3.10). □

The integral Itô formula (6.3.10) can be rewritten in differential notation as

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

6.3 Stochastic Integrals and Itô Formula with Jumps 179

|ut |2 ′′
d f (Xt ) = vt f ′ (Xt )dt + ut f ′ (Xt )dBt + f (Xt )dt + ( f (Xt ) − f (Xt - ))dNt , (6.3.11)
2

t ⩾ 0. 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 ′ (Xs )dBs + |us |2 f ′′ (Xs )dBs
wt
0
wt 2 0

+ vs f ′ (Xs )ds + ( f (Xs- + ηs ) − f (Xs- ))dNs

0 0
wt 1wt
= f (0) + us f ′ (Xs )dBs + |us |2 f ′′ (Xs )dBs
wt
0
wt 2 0

+ vs f ′ (Xs )ds + ( f (Xs ) − f (Xs- ))dNs .

0 0

Itô multiplication table with jumps

Given two Itô processes (Xt )t∈R+ and (Yt )t∈R+ written in differential notation 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. The relation dBt • dNt = 0 is due to the fact that (Nt )t∈R+ has finite variation on any finite
interval.
• dt dBt dNt
dt 0 0 0
dBt 0 dt 0
dNt 0 0 dNt

Table 6.1: Itô multiplication table with jumps.

In other words, we have

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 ,

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 180 N. Privault

since
dNt • dNt = (dNt )2 = dNt ,
as ∆Nt ∈ {0, 1}. In particular, we have

(dXt )2 = (vt dt + ut dBt + ηt dNt )2 = ut2 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 (6.3.10) can be rewritten as

wt wt 1 w t ′′
f (Xt ) = f (X0 ) + vs f ′ (Xs )ds + us f ′ (Xs )dBs + f (Xs )|us |2 ds
wt
0 0
wt  2 0

+ ( f (Xs- + η (s)∆Ys ) − f (Xs- )) dNs − λ IE 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 IE f (x + η (s)Z ) − f (x) |x=Xs- ds
0 0
wt
= ( f (Xs- + η (s)∆Ys ) − f (Xs- )) dNs
0
wtw∞
−λ ( f (Xs- + η (s)y) − f (Xs )) ν (dy)ds, (6.3.12)
0 −∞

with the relation dXs = ηs ∆Ys . We note that from the relation
w∞
IE[Z ] = yν (dy),
−∞

the above compensator term (6.3.12) rewrites as

wtw∞
λ ( f (Xs- + η (s)y) − f (Xs- )) ν (dy)ds
0 −∞
wtw∞
= λ ( f (Xs- + η (s)y) − f (Xs- ) − η (s)y f ′ (Xs- )) ν (dy)ds (6.3.13)
0 −∞
wt
+λ IE[Z ] η (s) f ′ (Xs- )ds.
0

The expression (6.3.13) 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
y2 ν (dy) < ∞ and ν ([−1, 1]c ) < ∞,
|y|⩽1

using the bound

| f (x + y) − f (x) − y f ′ (x)| ⩽ Cy2 , y ∈ [−1, 1],
that follows from Taylor’s theorem for f a C 2 (R) function. This yields
wt wt 1 w t ′′
f (Xt ) = f (X0 ) + vs f ′ (Xs )ds + us f ′ (Xs )dBs + f (Xs )|us |2 ds
wt
0 0
wt  2 0

+ ( f (Xs- + η (s)∆Ys ) − f (Xs- )) dNs − λ IE f (x + η (s)Z ) − f (x) |x=X - ds


0 0 s

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

6.3 Stochastic Integrals and Itô Formula with Jumps 181
wtw∞
+λ ( f (Xs- + η (s)y) − f (Xs- ) − η (s)y f ′ (Xs- )) ν (dy)ds
0 −∞
wt
+ λ IE[Z ] η (s) f ′ (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.

1. Gamma process.

Figure 6.8: Sample trajectories of a gamma process.

The next code can be used to generate the gamma process paths of Figure 6.8.

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);}
X <- cbind(rep(0, nsim), t(apply(X, 1, cumsum)))
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.

Figure 6.9: Sample trajectories of a variance gamma process.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 182 N. Privault
3. Inverse Gaussian process.

Figure 6.10: Sample trajectories of an inverse Gaussian process.

4. Negative Inverse Gaussian process.

Figure 6.11: Sample trajectories of a negative inverse Gaussian process.

5. Stable process.

Figure 6.12: Sample trajectories of a stable process.

The above sample paths of a stable process can be compared to the USD/CNY exchange rate over
the year 2015, according to the date retrieved using the following code.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

6.3 Stochastic Integrals and Itô Formula with Jumps 183

library(quantmod);myPars <- chart_pars();myPars$cex<-1.5

getSymbols("USDCNY=X",from="2015-01-01",to="2015-12-06",src="yahoo")
rate=Ad(`USDCNY=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(`EURCHF=X`);chart_Series(rate, pars=myPars, theme = myTheme)

The adjusted close price Ad() is the closing price after adjustments for applicable 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

Figure 6.13: USD/CNY Exchange rate data.

Cumulants of stochastic integrals with jumps

Using the stochastic integral of a deterministic function f (t ) with respect to (Yt )t∈R+ defined as

wT NT
f (t )dYt = ∑ Zk f (Tk ),
0
k =1

Relation
rT (6.2.4) can be used to show that, more generally, the moment generating function of
0 f (t ) dY t is given by
 w   w w 
T T ∞
y f (t )


IE exp f (t )dYt = exp λ e − 1 ν (dy)dt
0 0 −∞
 w 
T
IE e f (t )Z − 1 dt .
 

= exp λ
0

We also have
 w  wTw
T
e y f (t ) − 1 ν (dy)dt


log IE exp f (t )dYt = λ
0 0 R
∞
1 wTw
= λ ∑ n! yn f n (t )ν (dy)dt
0 R
n=1
∞
1 wT
n
= λ ∑ n! I
E [ Z ] f n (t )dt,
0
n=1
wT
hence the cumulant of order n ⩾ 1 of f (t )dYt is given by
0
wT
κn = λ IE[Z n ] f n (t )dt,
0

which recovers (6.2.5) and (6.2.6) by taking f (t ) := 1[0,T ] (t ) when n = 1, 2.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 184 N. Privault

6.4 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 + σ dBt .
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 := , (6.4.1)
St -
assuming the presence of a jump at time t > 0, i.e., ∆Nt = 1. Using the identity ∆St = St − St - ,
Relation (6.4.1) rewrites as
St − St - ∆St
η∆Nt = = , (6.4.2)
St - St -
or

dSt = ηSt - dNt , (6.4.3)

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 (6.4.3) occurs naturally from the
definition (6.4.2) of market returns when dividing by the previous index value St - .
In the presence of a jump at time t, i.e. when dNt = 1, the equation (6.4.2) 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,
of (6.4.3).
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 > −1, t ⩾ 0.
Next, consider the case where ηt is time-dependent, i.e.,

dSt = ηt St - dNt . (6.4.4)

At each jump time Tk , Relation (6.4.4) reads

dSTk = STk − STk- = ηTk STk- ,

i.e.,
STk = (1 + ηTk )STk- ,

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

6.4 Stochastic Differential Equations with Jumps 185

and repeating this argument for all k = 1, 2, . . . , Nt yields the product solution
Nt
St = S0 ∏ (1 + ηTk )
k =1
= S0 ∏ (1 + ηs )
∆Ns =1
0⩽s⩽t

= S0 ∏ (1 + ηs ∆Ns ), t ⩾ 0.
0⩽s⩽t
By a similar argument, we obtain the following proposition.

Proposition 6.16 The stochastic differential equation with jumps

dSt = µt St dt + ηt St - (dNt − λ dt ), (6.4.5)

admits the solution

w t wt  Nt
St = S0 exp µs ds − λ ηs ds ∏ (1 + ηTk ), t ⩾ 0.
0 0
k =1

Note that the equations

dSt = µt St - dt + ηt St - (dNt − λ dt )

and
dSt = µt St dt + ηt St - (dNt − λ dt )

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 (6.4.5) is given in Figure 6.14
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

Figure 6.14: Geometric Poisson process.*

The above simulation can be compared to the real sales ranking data of Figure 6.15.

* The animation works in Acrobat Reader on the entire pdf file.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 186 N. Privault

Figure 6.15: Ranking data.

Next, consider the equation

dSt = µt St dt + ηt St - (dYt − λ IE[Z ]dt )

driven by the compensated compound Poisson process (Yt − λ IE[Z ]t )t∈R+ , also written as

dSt = µt St dt + ηt St - (ZNt dNt − λ IE[Z ]dt ),

with solution
w t wt  Nt
St = S0 exp µs ds − λ IE[Z ] ηs ds ∏ (1 + ηTk Zk ) t ⩾ 0. (6.4.6)
0 0
k =1

A random simulation of the geometric compound Poisson process (6.4.6) is given in Figure 6.16.

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

Figure 6.16: Geometric compound Poisson process.*

In the case of a jump-diffusion stochastic differential equation of the form

dSt = µt St dt + ηt St - (dYt − λ IE[Z ]dt ) + σt St dBt ,

* The animation works in Acrobat Reader on the entire pdf file.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

6.4 Stochastic Differential Equations with Jumps 187

we get

w wt wt 1wt

t
St = S0 exp µs ds − λ IE[Z ] ηs ds + σs dBs − |σs |2 ds
0 0 0 2 0
Nt
× ∏ (1 + ηTk Zk ), t ⩾ 0.
k =1

A random simulation of the geometric Brownian motion with compound Poisson jumps is given in
Figure 6.17.

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

Figure 6.17: Geometric Brownian motion with compound Poisson jumps.*

By rewriting St as

w wt wt
1wt

t
2
St = S0 exp µs ds + ηs (dYs − λ IE[Z ]ds) + σs dBs − |σs | ds
0 0 0 2 0
Nt
× ∏ (1 + ηTk Zk ) e −ηTk Zk ,


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 6.18 shows a number of downward
and upward jumps occurring in the SMRT historical share price data, with a typical geometric
Brownian behavior in between jumps.

* The animation works in Acrobat Reader on the entire pdf file.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 188 N. Privault

Figure 6.18: SMRT Share price.

6.5 Girsanov Theorem for Jump Processes

Recall that in its simplest form, cf. Section 3.2, the Girsanov Theorem 3.3 for Brownian motion
states the following.

Let µ ∈ R. Under the probability measure P

e −µ defined by the Radon-Nikodym density

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

2
E−µ [ f (BT + µT )] = IE[ f (BT + µT ) e −µBT −µ T /2 ]
Ie
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 −∞
= IE[ f (BT )], (6.5.1)
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 standard 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, whatever 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.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

6.5 Girsanov Theorem for Jump Processes 189

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.

Proposition 6.17 Consider a random variable NT having the Poisson distribution P (λ T ) with
parameter λ T under Pλ . Under the probability measure P e defined by the Radon-Nikodym
λ̃
density
!NT
dPe λ
e
λ̃
:= e −(λ̃ −λ )T ,
dPλ λ

the random variable NT has a Poisson distribution with intensity e

λ T . As a consequence, the
compensated process Nt − λt t∈[0,T ] is a martingale under Pλ̃ .
e

e

Proof. This follows from the relation

!k
λ
e
P
e (NT = k) =
λ̃ e −(λ̃ −λ )T Pλ (NT = k)
λ
!k
λ
e (λ T )k
= e −(λ̃ −λ )T e −λ T
λ k!
λ T )k
(e
= e −λ̃ T , 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 (6.5.1) 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
λ = (1 + c)λ . We note that
or e
(λ (1 + c)T )k −λ (1+c)T
Pλ N(1+c)T = k


= e
k!
= (1 + c)k e −λ cT Pλ (NT = k)
= P
e (NT = k),
λ̃ k ⩾ 0,
hence
dP
e
λ̃
:= (1 + c)NT e −λ cT ,
dPλ
and by analogy with (6.5.1) we have
IEλ f (N(1+c)T ) = ∑ f (k)Pλ N(1+c)T = k
 

(6.5.2)
k⩾0

= e −λ cT ∑ f (k)(1 + c)k Pλ (NT = k)

k⩾0
−λ cT
IEλ f (NT )(1 + c)NT
 
= e
" #
dPe
= IEλ f (NT ) λ̃
dPλ

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 190 N. Privault

= IE
e [ f (NT )],
λ̃

for any bounded function f on N. In other words, taking f (x) := 1{x⩽n} , we have

Pλ N(1+c)T ⩽ n = P


e (NT ⩽ n), n ⩾ 0,
λ̃

or
P
e (NT /(1+c) ⩽ n) = Pλ NT ⩽ n ,


λ̃ n ⩾ 0.
As a consequence, we have the following proposition.

λ > 0, and set

Proposition 6.18 Let λ , e

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
e λ
e
λ̃
:= e −(λ̃ −λ )T = e −cλ T (1 + c)NT .
dPλ λ

In particular, the compensated Poisson processes

Nt/(1+c) − λt and Nt − e
λt, 0 ⩽ t ⩽ T,

are martingales under P

e .
λ̃

Proof. As in (6.5.2), we have



IEλ [ f (NT )] = Ie
Eλ̃ f NT /(1+c) ,

i.e., under P
e the distribution of NT /(1+c) is that of a standard Poisson random variable with
λ̃


parameter λ T . 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 (Nt/(1+c) − λt )t∈[0,T ] is a
λ̃
martingale under Pe by (3.1.2). Similarly, the compensated process
λ̃


(Nt − (1 + c)λt )t∈[0,T ] = Nt − e
λt t∈[0,T ]

has independent increments and is a martingale under P

e .
λ̃ □
We also have  
t
Nt/(1+c) = ∑ 1[T ,∞)
n
1+c
= ∑ 1[(1+c)T ,∞) (t ),
n
t ⩾ 0,
n⩾1 n⩾1

are distributed under P

which shows that the jump times ((1 + c)Tn )n⩾1 of Nt/(1+c) t∈[0,T ]
e as
λ̃
the jump times of a Poisson process with intensity λ .
The next 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 parameter e λ > 0.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

6.5 Girsanov Theorem for Jump Processes 191

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 ̸= r, the discounted price process (Set )t∈R+ = ( e −rt St )t∈R+ written as

d Set
= ( µ − r )dt + σ (dNt − λ dt ) (6.5.3)
Set -
is not a martingale under Pλ . However, we can rewrite (6.5.3) as

µ −r
   
d Set
= σ dNt − λ − dt
Set - σ
and letting
µ −r
λ := λ −
e = (1 + c)λ
σ
with
µ −r
c := − ,
σλ
we have
d Set

= σ dNt − e
λ dt
Set -
hence the discounted price process (Set )t∈R+ is martingale under the probability measure P
e defined
λ̃
by the Radon-Nikodym density

dP µ − r NT
e  
−λ cT NT ( µ−r )/σ
λ̃
:= e (1 + c) = e 1− .
dPλ σλ
We note that if
µ −r ⩽ σλ
then the risk-neutral probability measure P e exists and is unique, therefore by Theorems 2.10
λ̃
and 2.14 the market is without arbitrage and complete. If µ − r > σ λ 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 vari-
ations in jump sizes in addition to time variations, and we have the following more general
result.
Theorem 6.19 Let (Yt )t⩾0 be a compound Poisson process with intensity λ > 0 and jump size
distribution ν (dx). Consider another intensity parameter e
λ > 0 and jump size distribution νe (dx),
and let

λ νe (dx)
e
ψ (x ) : = − 1, x ∈ R. (6.5.4)
λ ν (dx)

Then,

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 192 N. Privault

under the probability measure P

e
λ̃ ,ν̃ defined by the Radon-Nikodym density

dP
e
λ̃ ,ν̃
NT
:= e −(λ̃ −λ )T ∏ (1 + ψ (Zk )),
dP
e λ ,ν k =1

the process
Nt
Yt := ∑ Zk , t ⩾ 0,
k =1

is a compound Poisson process with

λ > 0, and
- modified intensity e
- modified jump size distribution νe (dx).

Proof. For any bounded measurable function f on R, we extend (6.5.2) to the following change of
variable
" #
NT
IEλ̃ ,ν̃ [ f (YT )] = e −(λ̃ −λ )T IEλ ,ν f (YT ) ∏(1 + ψ (Zi ))
i=1
" ! #
k k
= e −(λ̃ −λ )T ∑ IEλ ,ν f ∑ Zi ∏(1 + ψ (Zi )) NT = k Pλ (NT = k)
k⩾0 i=1 i=1
" ! #
k k k
( λ T )
= e −λ̃ T ∑ IEλ ,ν f ∑ Zi ∏(1 + ψ (Zi ))
k⩾0 k! i=1 i=1

(λ T ) ∞k w w ∞ k
= e −λ̃ T ∑ ··· f (z1 + · · · + zk ) ∏(1 + ψ (zi ))ν (dz1 ) · · · ν (dzk )
k⩾0 k! −∞ −∞
i=1

kw w k e
!
−λ̃ T λT
e ∞ ∞ ν (dzi )
= e ∑ k! −∞ · · · −∞ f (z1 + · · · + zk ) ∏ ν (dzi ) ν (dz1 ) · · · ν (dzk )
k⩾0 i=1
k
λT w ∞ w∞
e

= e −λ̃ T ∑ ··· f (z1 + · · · + zk )νe (dz1 ) · · · νe (dzk ).
k⩾0 k! −∞ −∞

This shows that under Pλ̃ ,ν̃ , YT has the distribution of a compound Poisson process with intensity
λ and jump size distribution νe. We refer to Proposition 9.6 of Cont and Tankov, 2004 for the
e
independence of increments of (Yt )t∈R under P e .
+ λ̃ ,ν̃ □

Example. In case ν ≃ N (α, σ 2 ) and νe ≃ N (β , η 2 ), we have

   
dx 1 2 dx 1 2
ν (dx) = √ exp − 2 (x − α ) , νe (dx) = p exp − 2 (x − β ) ,
2πσ 2 2σ 2πη 2 2η

x ∈ R, hence  
νe (dx) η 1 2 1 2
= exp (x − β ) − 2 (x − α ) ,
ν (dx) σ 2η 2 2σ
and ψ (x) in (6.5.4) is given by
 
λ νe (dx)
e λη
e 1 1
1 + ψ (x ) = = exp ( x − β ) 2
− ( x − α ) 2
, x ∈ R.
λ ν (dx) λσ 2η 2 2σ 2

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6.5 Girsanov Theorem for Jump Processes 193

λ > 0 and jump size distribution νe can be

Note that the compound Poisson process with intensity e
built as
Nλ̃t/λ
Xt := ∑ h(Zk ),
k =1

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 6.19 we have the following
proposition.

Proposition 6.20 The compensated process

Yt − e
λt IEν̃ [Z ]

is a martingale under the probability measure P

e
λ̃ ,ν̃ defined by the Radon-Nikodym density

dP
e
λ̃ ,ν̃
NT
= e −(λ̃ −λ )T ∏ (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 particular case of Theorem 33.2 of Sato, 1999.

Theorem 6.21 Let (Yt )t⩾0 be a compound Poisson process with intensity λ > 0 and jump size
distribution ν (dx). Consider another jump size distribution νe (dx) and intensity parameter e
λ > 0,
and let
λ d νe
e
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 − e
λ IEν̃ [Z ]t
0 t∈R+

is a martingale under the probability measure P

e
u,λ̃ ,ν̃ defined by the Radon-Nikodym density

dPe  wT 1wT
 NT
u,λ̃ ,ν̃
2
= exp − λ − λ T −
e us dBs − |us | ds ∏ (1 + ψ (Zk )). (6.5.5)
dP
e λ ,ν 0 2 0 k =1

As a consequence of Theorem 6.21, if

wt
Bt + vs ds + Yt (6.5.6)
0

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 ν
e
are chosen in such a way that

vs = us − e
λ IEν̃ [Z ], s ∈ R, (6.5.7)

in which case (6.5.6) can be rewritten into the martingale decomposition

dBt + ut dt + dYt − e
λ IEν̃ [Z ]dt,

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 194 N. Privault
 wt   
in which both Bt + us ds and Yt − e
λt IEν̃ [Z ] are martingales under P
e
u,λ̃ ,ν̃
0 t∈R+ t∈R+

The following remarks will be of importance for arbitrage-free pricing in jump models in Chapter 7.
a) When e λ = λ = 0, Theorem 6.21 coincides with the usual Girsanov Theorem for Brownian
motion, in which case (6.5.7) 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 (6.5.7) also admits
λ = v and there is uniqueness of P
only one solution e e
0,λ̃ ,δa .
−rt
When µ ̸= r, the discounted price process (Set )t∈R = ( e St )t∈R defined by
+ +

d Set
= ( µ − r )dt + σ dBt + η (dYt − λt IEν [Z ])
Set -

is not martingale under Pλ ,ν , however we can rewrite the equation as

µ −r
   
d Set uσ
= σ (udt + dBt ) + η dYt − + λ IEν [Z ] − dt
Set - η η

and choosing u, νe, and e

λ such that
uσ µ −r
λ IEν̃ [Z ] =
e + λ IEν [Z ] − , (6.5.8)
η η

we have
d Set

= σ (udt + dBt ) + η dYt − e
λ IEν̃ [Z ]dt .
Set -
Hence the discounted price process (Set )t∈R+ is martingale under the probability measure P e
u,λ̃ ,ν̃ ,
and the market is without arbitrage by Theorem 2.10 and the existence of a risk-neutral probability
measure P e
u,λ̃ ,ν̃ . However, the market is not complete due to the non uniqueness of solutions


u, νe, λ to (6.5.8), and Theorem 2.14 does not apply in this situation.
e

Exercises
Exercise 6.1 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 6.2 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 − ηλ St dt = ηSt - (dNt − λ dt ).

b) Using the first Poisson jump time T1 , solve the stochastic differential equation

dSt = −λ ηSt dt + dNt , t ∈ (0, T2 ).

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6.5 Girsanov Theorem for Jump Processes 195

Exercise 6.3 Consider (Bt )t∈R+ a standard Brownian motion and (Nt )t∈R+ a standard Poisson
process with intensity λ > 0, and the stochastic differential equation

dXt = αXt dt + σ dBt + ηdNt .

a) Write down the Itô formula for d f (Xt ).

b) Write down the Itô formula for d (Xt2 ).

Exercise 6.4 Consider an asset price process (St )t∈R+ given by the stochastic differential equation
dSt = µSt dt + σ St dBt + ηSt - dYt , i.e.
wt wt wt
St = S0 + µ Ss ds + σ Ss dBs + η Ss- dYs , t ⩾ 0, (6.5.9)
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 ) := IE[St ], t ⩾ 0.
Hint: Use the smoothing lemma Proposition 6.9.
b) Find the value of IE[St ], t ⩾ 0, in terms of S0 , µ, η, λ and IE[Z ].

Exercise 6.5 Consider a standard Poisson process (Nt )t∈R+ with intensity λ > 0.
a) Solve the stochastic differential equation dXt = αXt dt + σ dNt over the time intervals [0, T1 ),
[T1 , T2 ), [T2 , T3 ), [T3 , T4 ), where X0 = 1.
b) Write a differential equation for f (t ) := IE[Xt ], and solve it for t ∈ R+ .

Exercise 6.6 Consider a standard Poisson process (Nt )t∈R+ with intensity λ > 0.
a) Solve the stochastic differential equation dXt = σ Xt - 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 + σ St - dNt ,

wt
is given by St = S0 Xt + rXt Xs−1 ds.
0
c) Compute IE[Xt ] and IE[Xt /Xs ], 0 ⩽ s ⩽ t.
d) Compute IE[St ], t ⩾ 0.

Exercise 6.7 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 supermartingale?
b) Let r > 0. Solve the stochastic differential equation

dSt = rSt dt + σ St - (dNt − λ dt ).

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−λ σ )T ,
where σ > 0.

Exercise 6.8 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 + σ Xt - dNt , where σ > 0, and a ∈ R.
b) Compute IE[Xt ] for t ∈ R+ .

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 196 N. Privault
Nt
Exercise 6.9 Consider the compound Poisson process Yt := ∑ Zk , where (Nt )t∈R + is a standard
k =1
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 differential equation

dSt = rSt dt + ηSt - dYt ,

where η, r ∈ R.

Exercise 6.10 Show, by direct computation or using the moment generating function (6.2.3), that
the variance of the compound Poisson process Yt with intensity λ > 0 satisfies
w∞
Var [Yt ] = λt IE |Z|2 = λt x2 ν (dx).
 
−∞

Exercise 6.11 Consider an exponential compound Poisson process of the form

St = S0 e µt +σ Bt +Yt , t ⩾ 0,

where (Yt )t∈R+ is a compound Poisson process of the form (6.2.1).

a) Derive the stochastic differential equation with jumps satisfied by (St )t∈R+ .
b) Let r > 0. Find a family P


u,λ̃ ,νe of probability measures under which the discounted asset
e
price e −rt St is a martingale.

Exercise 6.12 Consider (Nt )t∈R+ a standard Poisson process with intensity λ > 0 under a
probability measure P. Let (St )t∈R+ be defined by the stochastic differential equation

dSt = µSt dt + ZNt St - dNt , (6.5.10)

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 (6.5.10).

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 > 0, using a series expansion of Black-Scholes
functions.

Exercise 6.13 Consider a standard Poisson process (Nt )t∈R+ with intensity 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 − β dt ), (6.5.11)

where S0 > 0 and α, β > 0.

a) Solve the equation (6.5.11) for St .
b) Compute f (t ) := IE[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 IE[φ (ST )] where φ is a
payoff function.

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6.5 Girsanov Theorem for Jump Processes 197

Exercise 6.14 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).
a) Under the probability measure Pλ , the process t 7→ Yt − λt (t + IE[Z ]) is a:

submartingale | martingale | supermartingale |

b) Consider the process (St )t∈[0,T ] given by

dSt = µSt dt + σ St - dYt .

Find eλ such that the discounted process (Set )t∈[0,T ] := (e−rt St )t∈[0,T ] is a martingale under
the probability measure Pλ̃ defined by the Radon-Nikodym density
!NT
dPλ̃ λ
e
:= e −(λ̃ −λ )T .
dPλ λ

with respect to Pλ .
c) Price the forward contract with payoff ST − κ.

Exercise 6.15 Consider (Yt )t∈R+ a compound Poisson process written as

Nt
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 differential equation

dSt = µSt dt + St - dYt . (6.5.12)

a) Solve the equation (6.5.12).

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 > 0, using a series expansion of integrals.

Exercise 6.16 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


dSt = rSt dt + σ St dBt + ηSt - dYt − e
λ IE[Z1 ]dt .

λ > 0.
with r, σ , η, λ , e
a) Assume that e λ = λ . Under the probability measure Pλ , the discounted price process
( e −rt St )t∈[0,T ] is a:

submartingale | martingale | supermartingale |

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 198 N. Privault

λ > λ . Under the probability measure Pλ , the discounted price process ( e −rt St )t∈[0,T ]
b) Assume e
is a:
submartingale | martingale | supermartingale |

λ < λ . Under the probability measure Pλ , the discounted price process ( e −rt St )t∈[0,T ]
c) Assume e
is a:
submartingale | martingale | supermartingale |

d) Consider the probability measure P

e defined by its Radon-Nikodym density
λ̃
!NT
dP
e λ
e
λ̃
:= e −(λ̃ −λ )T .
dPλ λ

with respect to Pλ . Under the probability measure P

e , the discounted price process
λ̃
−rt
( e St )t∈[0,T ] is a:

submartingale | martingale | supermartingale |

Exercise 6.17 Let (Nt )t∈[0,T ] and (Bt )t∈[0,T ] be a standard Poisson process with intensity λ > 0
and an independent standard Brownian motion under a probability measure P. 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 P, and
let µ, σ > 0. Let also P
e denote the probability measure defined by the density
!NT
dP
e 2 2 λ
e
:= e−(λ −λ )T −µBT /σ −µ T /(2σ )
e
dP λ

with respect to P, where e

λ > λ > 0. Which of the following processes are martingales under P?
e
a) Bt ,
b) µt/σ + Bt ,
c) µt/σ − Bt ,
d) −µt/σ + Bt ,
e) Yt − e
λ IE[Z1 ]t,
f) Yt − λ IE[Z1 ]t,
g) µt/σ + Bt + Yt − eλ IE[Z1 ]t,
h) µt/σ + Bt − (Yt − eλ IE[Z1 ]t ),
i) −µt/σ + Bt + Yt − e λ IE[Z1 ]t,
j) µt/σ + Bt + Yt − λ IE[Z1 ]t.

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 199

7. 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. Unlike in the case of continuous asset price
modeling, the 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.

7.1 Risk-Neutral Probability Measures 199

7.2 Pricing in Jump Models 200
7.3 Exponential Lévy Models 202
7.4 Black-Scholes PDE with Jumps 204
7.5 Mean-Variance Hedging with Jumps 206
Exercises 210

7.1 Risk-Neutral Probability Measures

Consider an asset price process modeled by the equation,

dSt = µSt dt + σ St dBt + St - dYt , (7.1.1)

where (Yt )t∈R+ is the compound Poisson process defined in Section 6.2, with jump size distribution
ν (dx) under Pν . The equation (7.1.1) has for solution
 Nt
σ2

St = S0 exp µt + σ Bt − t ∏ (1 + Zk ), (7.1.2)
2 k =1

t ⩾ 0. An important issue for non-arbitrage pricing is to determine a risk-neutral probability

measure (or martingale measure) P∗ under which the discounted asset price process (Set )t∈R+ :=

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 200 N. Privault

( e −rt St )t∈R+ is a martingale, and this goal can be achieved using the Girsanov Theorem for jump
processes, cf. Section 6.5.
Lemma 7.1 Discounting lemma. The discounted asset price process

Set := e −rt St , t ⩾ 0,

satisfies the equation

d Set = ( µ − r )Set dt + σ Set dBt + Set - dYt . (7.1.3)

In addition, Equation 7.1.3 can be rewritten as

d Set = ( µ − r + λ̃ IEν̃ [Z ] − σ u)Set dt + σ Set (dBt + udt ) + Set - (dYt − λ̃ IEν̃ [Z ]dt ),

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 + λ̃ IEν̃ [Z ] − σ u = 0 (7.1.4)

with σ u + r − µ > 0, then

σu + r − µ
λ̃ = > 0,
IEν̃ [Z ]
and the Girsanov Theorem 6.21 for jump processes shows that

dBt + udt + dYt − λ̃ IEν̃ [Z ]dt

is a martingale under the probability measure P e

u,λ̃ ,ν̃ defined in Theorem 6.21. As a consequence,
−rt
the discounted price process (St )t∈R+ = ( e St )t∈R+ becomes a martingale is a martingale under
e
P
e
u,λ̃ ,ν̃ .

In this setting, the non-uniqueness of the risk-neutral probability measure Pe

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 (3.3.4) was unique.

7.2 Pricing in Jump Models

Recall that a market is without arbitrage if and only it admits at least one risk-neutral probability
measure.
Consider the probability measure P e constructed in Theorem 6.21, under which the dis-
u,λ̃ ,ν̃
counted asset price process

d Set = σ Set d Bbt + Set - (dYt − λ̃ IEν [Z ]dt ),

is a martingale, and Bbt = 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 IEu,λ̃ ,ν̃ [C | Ft ] (7.2.1)

under P
e
u,λ̃ ,ν̃ .
Clearly the price (7.2.1) 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 martingale condition (7.1.4), and such a market
is not complete, except if either λ̃ = λ = 0, or (σ = 0 and ν̃ = ν = δ1 ).

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7.2 Pricing in Jump Models 201

Various techniques can be used for the selection of a risk-neutral probability measure, such as
the determination of a minimal entropy risk-neutral probability measure P e
u,λ̃ ,ν̃ that minimizes the
Kullback-Leibler relative entropy
 
dQ dQ
Q 7→ I (Q, P) := IE 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 (7.2.1) as

e −(T −t )r IEu,λ̃ ,ν̃ [φ (ST ) | Ft ], (7.2.2)

where the expectation can be computed as

IEu,λ̃ ,ν̃ φ (ST ) Ft

 
"  NT ! #
σ2

= IEu,λ̃ ,ν̃ φ S0 exp µT + σ BT − T ∏ (1 + Zk ) Ft
2 k =1
"  NT ! #
σ2

= IEu,λ̃ ,ν̃ φ St exp (T − t ) µ + (BT − Bt )σ −
2
(T − t ) ∏ (1 + Zk ) Ft
k=Nt +1
"  NT !#
σ2

= IEu,λ̃ ,ν̃ φ x exp (T − t ) µ + (BT − Bt )σ − (T − t ) ∏ (1 + Zk )
2 k=Nt +1 x=St
= ∑ Pu,λ̃ ,ν̃ (NT − Nt = n)
n⩾0
" ! #
NT
(T −t ) µ +(BT −Bt )σ −(T −t )σ 2 /2
IEu,λ̃ ,ν̃ φ xe ∏ (1 + Zk ) NT − Nt = n
k=Nt +1 x=St
((T − t )λ̃ )n
= e −(T −t )λ̃ ∑
n⩾0 n!
" !#
n
(T −t ) µ +(BT −Bt )σ −(T −t )σ 2 /2
× IEu,λ̃ ,ν̃ φ xe ∏ (1 + Zk )
k =1 x=St
(λ̃ (T − t ))n w ∞ w∞
= e −λ̃ (T −t ) ∑ ···
n⩾0 n! | −∞ {z −∞}
n times
" !#
n
(T −t ) µ +(BT −Bt )σ −(T −t )σ 2 /2
IEu,λ̃ ,ν̃ φ xe ∏ ( 1 + zk ) ν̃ (dz1 ) · · · ν̃ (dzn ),
k =1 x=St

hence the price of the vanilla option with payoff φ (ST ) is given by
e −(T −t )r IEu,λ̃ ,ν̃ [φ (ST ) | Ft ]
1 (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 / (2(T −t ))
φ St e (T −t )µ +σ x−(T −t )σ ∏ (1 + zk ) e −x ν̃ (dz1 ) · · · ν̃ (dzn )dx.
k =1

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 202 N. Privault

7.3 Exponential Lévy Models

Instead of modeling the asset price (St )t∈R+ through a stochastic exponential (7.1.2) solution of
the stochastic differential equation with jumps of the form (7.1.1), we may consider an exponential
price process of the form
St := S0 e µt +σ Bt +Yt
!
Nt
= S0 exp µt + σ Bt + ∑ Zk
k =1
Nt
= S0 e µt +σ Bt ∏ eZ k

k =1
= S0 e µt +σ Bt
∏ e ∆Yt , t ⩾ 0,
0⩽s⩽t

from Relation (6.2.2), i.e. ∆Yt = ZNt ∆Nt . The process (St )t∈R+ is equivalently given by the
log-return dynamics
d log St = µdt + σ dBt + dYt , t ⩾ 0.
In the exponential Lévy model we also have
2 /2)t +σ B −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 + σ St dBt + St - ( e ∆Yt − 1)dNt
2
σ2
 
= µ+ St dt + σ St dBt + St - ( e ZNt − 1)dNt ,
2
hence the process St has jumps of size STk- ( e Zk − 1), k ⩾ 1, and (7.1.4) reads

σ2
µ+ − r = σ u − λ̃ IEν̃ [ e Z − 1].
2
Under this condition we can choose a risk-neutral probability measure P
e
u,λ̃ ,ν̃ under which ( e
−rt S )
t t∈R+
is a martingale, and the expected value
e −(T −t )r IEu,λ̃ ,ν̃ [φ (ST ) | Ft ]
represents a (non-unique) arbitrage-free price at time t ∈ [0, T ] for the contingent claim with payoff
φ (ST ).
This arbitrage-free price can be expressed as
e −(T −t )r IEu,λ̃ ,ν̃ φ (ST ) Ft = e −(T −t )r IEu,λ̃ ,ν̃ φ (S0 e µT +σ BT +YT ) Ft
   

= e −(T −t )r IEu,λ̃ ,ν̃ φ (St e (T −t )µ +(BT −Bt )σ +YT −Yt ) Ft

 

= e −(T −t )r IEu,λ̃ ,ν̃ φ (x e (T −t )µ +(BT −Bt )σ +YT −Yt ) x=S

 
t
" !!#
NT
= e −(T −t )r IEu,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
(λ̃ (T − t ))n
×∑ IEu,λ̃ ,ν̃ φ x e (T −t )µ +(BT −Bt )σ exp ∑ Zk .
n⩾0 n! k =1 x=St

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7.3 Exponential Lévy Models 203

Merton, 1976 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 = σ u − λ̃ IEν̃ [ e Z − 1] = σ u − λ̃ ( e δ +η /2 − 1),
2
as in (7.1.4), hence by the Girsanov Theorem 6.21 for jump processes, Bt + ut + Yt − λ̃ IEν̃ [ e Z − 1]t
is a martingale and Bt + ut is a standard Brownian motion under P e
u,λ̃ ,ν̃ . For simplicity we choose
u = 0, which yields
σ2 2
µ = r− − λ̃ ( e δ +η /2 − 1).
2

Proposition 7.2 The price of the European call option in the Merton model is given by

e −(T −t )r IEλ̃ ,ν̃ [(ST − K )+ | Ft ]

2 /2
−λ̃ e δ +η
2 /2
(T −t ) (λ̃ e δ +nη (T − t ))n
= e ∑
n⩾0 n!
δ + η 2 /2
 
2 2 δ +η 2 /2
×Bl St , K, σ + nη /(T − t ), r + n − λ̃ ( e − 1), T − t ,
T −t
0 ⩽ t ⩽ T.
Proof. We have
e −(T −t )r IEλ̃ ,ν̃ [φ (ST ) | Ft ]
((T − t )λ̃ )n
= e −(T −t )r−(T −t )λ̃ ∑
n⩾0 n!
" !!#
n
× IEλ̃ ,ν̃ φ x e (T −t )µ +(BT −Bt )σ exp ∑ Zk
k =1 x=St
((T − t )λ̃ )n
e −(T −t )r−(T −t )λ̃ IE φ (x e (T −t )µ +nδ +Xn ) x=S
 
= ∑
n⩾0 n! t

((T − t )λ̃ )n w ∞
2 2 2
−(T −t )r−(T −t )λ̃ (T −t ) µ +nδ +y

e −y /(2((T −t )σ +nη ))
= e ∑ φ St e p dy,
n⩾0 n! −∞ 4((T − t )σ 2 + nη 2 )π
where
n
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
v2n := (T − t )σ 2 + ∑ Var Zk = (T − t )σ 2 + nη 2 .
k =1

Hence when φ (x) = (x − K ) + is the payoff function of a European call option, using the relation
2
+ 
Bl x, K, v2n /τ, r, τ = e −rτ IE x e Xn −vn /2+rτ − K



we get

e −(T −t )r−(T −t )λ̃ IEλ̃ ,ν̃ [(ST − K )+ | Ft ]

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 204 N. Privault

((T − t )λ̃ )n  (T −t )µ +nδ +Xn
+ 

= e −(T −t )r−(T −t )λ̃ ∑ IE x e −K x=St
n⩾0 n!
((T − t )λ̃ )n
= e −(T −t )r−(T −t )λ̃ ∑
n⩾0 n!
2 δ +η 2 /2 −1))(T −t )+nδ +X
+ 
× IE x e (r−σ /2−λ̃ ( e

n
−K x=S t

((T − t )λ̃ )n
= e −(T −t )r−(T −t )λ̃ ∑
n⩾0 n!
2 δ +η 2 /2 −1)(T −t )+X −v2 /2+(T −t )r
+ 
× IE x e nδ +nη /2−λ̃ ( e

n n −K x=S t

((T − t )λ̃ )n
= e −(T −t )λ̃ ∑
n⩾0 n!
2 /2−λ̃ ( e δ +η 2 /2 −1)(T −t )
×Bl St e nδ +nη , K, σ 2 + nη 2 /(T − t ), r, T − t .

We may also write

e −(T −t )r−(T −t )λ̃ IEλ̃ ,ν̃ [(ST − K )+ | Ft ]

n
−(T −t )λ̃ (T − t )λ̃ 2 δ +η 2 /2 −1)(T −t )
= e ∑ e nδ +nη /2−λ̃ ( e
n⩾0 n!
δ +η 2 /2 −1)(T −t )
 2

×Bl St , K e −nδ −nη /2+λ̃ ( e , σ 2 + nη 2 /(T − t ), r, T − t
2 /2
−λ̃ e δ +η
2 /2
(T −t ) (λ̃ e δ +nη (T − t ))n
= e ∑
n! n⩾0
δ + η 2 /2
 
2
×Bl St , K, σ 2 + nη 2 /(T − t ), r + n − λ̃ ( e δ +η /2 − 1), T − t .
T −t
□

7.4 Black-Scholes PDE with Jumps

In this section, we consider the asset price process (St )t∈R+ modeled by the equation (7.1.1), i.e.

dSt = µSt dt + σ St dBt + St - dYt , (7.4.1)

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 (7.2.2) 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 IEu,λ̃ ,ν̃ [φ (ST ) | Ft ] = e −(T −t )r IEu,λ̃ ,ν̃ [φ (ST ) | St ], (7.4.2)

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 (3.1.1).

In the next proposition we derive a Partial Integro-Differential Equation (PIDE) for the function
(t, x) 7→ f (t, x).

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7.4 Black-Scholes PDE with Jumps 205

Proposition 7.3 The price f (t, St ) of the vanilla option with payoff function φ in the model
(7.4.1) satisfies the Partial Integro-Differential Equation (PIDE)

∂f ∂f σ2 ∂2 f
r f (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
(7.4.3)

under the terminal condition f (T , x) = φ (x).

Proof. We have
dSt = rSt dt + σ St d Bbt + St - (dYt − λ̃ IEν̃ [Z ]dt ), (7.4.4)

where Bbt = Bt + ut is a standard Brownian motion under P

e
u,λ̃ ,ν̃ . Next, by the Itô formula with
jumps (6.3.10), we have
d f (t, St )
∂f ∂f ∂f σ2 ∂2 f
= (t, St )dt + rSt (t, St )dt + σ St (t, St )d Bbt + St2 2 (t, St )dt
∂t ∂x ∂x 2 ∂x
∂f
− λ̃ IEν̃ [Z ]St (t, St )dt + ( f (t, St - (1 + ZNt )) − f (t, St - ))dNt
∂x
∂f
= σ St (t, St )d Bbt + ( f (t, St - (1 + ZNt )) − f (t, St - ))dNt
∂x
− λ̃ IEν̃ [( f (t, x(1 + Z )) − f (t, x))]x=St dt
σ2 2 ∂2 f
 
∂f ∂f
+ (t, St ) + rSt (t, St ) + St 2 (t, St ) dt
∂t ∂x 2 ∂x
 
∂f
+ λ̃ IEν̃ [( f (t, x(1 + Z )) − f (t, x))]x=St − λ̃ IEν̃ [Z ]St (t, St ) dt.
∂x
Based on the discounted portfolio value differential
d ( e −rt f (t, St ))
∂f
= e −rt σ St (t, St )d Bbt
∂x
−rt


+e f (t, St - (1 + ZNt )) − f (t, St - ))dNt − λ̃ IEν̃ [( f (t, x(1 + Z )) − f (t, x))]x=St dt
σ2 2 ∂2 f
 
−rt ∂f ∂f
+e −r f (t, St ) + (t, St ) + rSt (t, St ) + St 2 (t, St ) dt (7.4.5)
∂t ∂x 2 ∂x
 
−rt ∂f
+e λ̃ IEν̃ [( f (t, x(1 + Z )) − f (t, x))]x=St − λ̃ IEν̃ [Z ]St (t, St ) dt, (7.4.6)
∂x
obtained from the Itô Table 6.1 with jumps, and the facts that
• the Brownian motion (Bbt )t∈R+ is a martingale under Pe
u,λ̃ ,ν̃ ,
• by the smoothing lemma Proposition 6.11, the process given by the differential
( f (t, St - (1 + ZNt )) − f (t, St - ))dNt − λ̃ IEν̃ [( f (t, x(1 + Z )) − f (t, x))]x=St dt,
is a martingale under P
e
u,λ̃ ,ν̃ , see also (6.3.9),

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 206 N. Privault

• the discounted portfolio value process t 7→ e −rt f (t, St ), is also a martingale under the risk-
neutral probability measure P
e
u,λ̃ ,ν̃ ,
we conclude to the vanishing of the terms (7.4.5)-(7.4.6) above, i.e.

∂f ∂f σ2 ∂2 f
−r f (t, St ) + (t, St ) + rSt (t, St ) + St2 2 (t, St )
∂t ∂x 2 ∂x
∂f
+λ̃ IEν̃ [( f (t, x(1 + Z )) − f (t, x))]x=St − λ̃ IEν̃ [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) − λ̃ x (t, x) yν̃ (dy) = r f (t, x),
−∞ ∂x −∞

which leads to the Partial Integro-Differential Equation (7.4.3). □

A major technical difficulty when solving the PIDE (7.4.3) numerically is that the operator
w∞  ∂f

f 7→ f (t, x(1 + y)) − f (t, x) − yx (t, x) ν̃ (dy)
−∞ ∂x

is nonlocal, therefore adding significant difficulties to the application of standard discretization

schemes.
In addition, we have shown that the change d f (t, St ) in the portfolio value (7.4.2) is given by

∂f
d f (t, St ) = σ St (t, St )d Bbt + r f (t, St )dt (7.4.7)
∂x
+( f (t, St - (1 + ZNt )) − f (t, St - ))dNt − λ̃ IEν̃ [( 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
(7.4.3) reads

∂f ∂f σ2 ∂2 f
r f (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
d f (t, St ) = σ St (t, St )d Bbt + r f (t, St )dt
∂x
+( f (t, St - (1 + a)) − f (t, St - ))dNt − λ̃ ( f (t, St (1 + a)) − f (t, St ))dt.

7.5 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

dVt = ηt dAt + ξt dSt = rηt e rt dt + ξt dSt .

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

7.5 Mean-Variance Hedging with Jumps 207

Assuming that the portfolio value takes the form Vt = f (t, St ) at all times t ∈ [0, T ], by (7.4.4) we
have

dVt = d f (t, St )
= rηt e rt dt + ξt dSt
= rηt e rt dt + ξt (rSt dt + σ St d Bbt + St - (dYt − λ̃ IEν̃ [Z ]dt ))
= rVt dt + σ ξt St d Bbt + ξt St - (dYt − λ̃ IEν̃ [Z ]dt )
= r f (t, St )dt + σ ξt St d Bbt + ξt St - (dYt − λ̃ IEν̃ [Z ]dt ), (7.5.1)

has to match
∂f
d f (t, St ) = r f (t, St )dt + σ St (t, St )d Bbt (7.5.2)
∂x
+ ( f (t, St - (1 + ZNt )) − f (t, St - ))dNt − λ̃ IEν̃ [( f (t, x(1 + Z )) − f (t, x))]x=St dt,

which is obtained from (7.4.7).

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 ). (7.5.3)
∂x
(ii) Poisson jump market, σ = 0 and Yt = aNt , ν (dx) = δa (dx). In this case, by matching (7.5.1)
to (7.5.2) we find
1
ξt = ( f (t, St - (1 + a)) − f (t, St - )). (7.5.4)
aSt -
Note that in the limit a → 0 this expression recovers the Black-Scholes Delta formula (7.5.3).
When Conditions (i) or (ii) above are not satisfied, exact replication is not possible, and this results
into an hedging error given from (7.5.1) and (7.5.2) by

VT − φ (ST ) = VT − f (T , ST )
wT wT
= V0 + dVt − f (0, S0 ) − d f (t, St )
0 0
wT 
∂f

= V0 − f (0, S0 ) + σ St ξt − (t, St ) d Bbt
0 ∂x
wT
+ ξt St - (ZNt dNt − λ̃ IEν̃ [Z ]dt )
0
wT
− ( f (t, St - (1 + ZNt )) − f (t, St - ))dNt
0
wT
+λ̃ IEν̃ [( f (t, x(1 + Z )) − f (t, x))]x=St dt.
0

Fixed jump size

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 208 N. Privault

Proposition 7.4 Assume that Yt = aNt , i.e. ν (dx) = δa (dx). The mean-square hedging error is
minimized by
V0 = f (0, S0 ) = e −rT IEu,λ̃ ,ν̃ [φ (ST )],
and

σ2 ∂f a2 λ̃ f (t, St - (1 + a)) − f (t, St - )

ξt = (t, St - ) + × ,
σ + a λ̃ ∂ x
2 2 2
σ + a λ̃ 2 aSt -
(7.5.5)

t ∈ [0, T ].

Proof. We have
wT 
∂f

VT − f (T , ST ) = V0 − f (0, S0 ) + σ St - ξt − (t, St - ) d Bbt
0 ∂x
wT
− ( f (t, St - (1 + a)) − f (t, St - ) − aξt St - )(dNt − λ̃ dt ),
0

hence the mean-square hedging error is given by


2 
IEu,λ̃ VT − f (T , ST )
wT 
"  2 #
∂ f
= (V0 − f (0, S0 ))2 + σ 2 IEu,λ̃ St - ξt − (t, St - ) d Bbt
0 ∂x
wT
" 2 #
+ IEu,λ̃ ( f (t, St - (1 + a)) − f (t, St - ) − aξt St - )(dNt − λ̃ dt )
0

wT
 " 2 #
∂ f
= (V0 − f (0, S0 ))2 + σ 2 IEu,λ̃ St2- ξt − (t, St - ) dt
0 ∂x
w 
T
2
+λ̃ IEu,λ̃ ( f (t, St - (1 + a)) − f (t, St - ) − aξt St - ) dt ,
0

where we applied the Itô isometry (6.3.7). Clearly, the initial portfolio value V0 minimizing the
above quantity is
V0 = f (0, S0 ) = e −rT IEu,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
σ 2 St2- ξt −


IEu,λ̃ (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

 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 - ) − 2aλ̃ St - (( f (t, St - (1 + a)) − f (t, St - ) − aξt St - )) = 0,
∂x

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7.5 Mean-Variance Hedging with Jumps 209

i.e.
σ2 ∂f a2 λ̃ f (t, St - (1 + a)) − f (t, St - )
ξt = (t, St - ) + × ,
σ + a λ̃ ∂ x
2 2 2
σ + a λ̃ 2 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
IEu,λ̃ VT − f (T , ST ) = λ̃ IEu,λ̃ ( f (t, St - (1 + a)) − f (t, St - ) − aξt St - ) dt ,
0

t ∈ (0, T ]. We note that the optimal strategy (7.5.5) is a weighted average of the Brownian and
jump hedging strategies (7.5.3) and (7.5.4) 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 (7.5.4). See § 10.4.2 of Cont and Tankov, 2004 for mean-variance hedging in exponential
Lévy model, and § 12.6 of Di Nunno, Øksendal, and Proske, 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, 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 excluding each other over time.
In Table 7.1 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 ✗ ✓ ✓
Fat tailed market returns ✗ ✓ ✓
Complete market ✓ ✗ ✗
Unique prices and risk-neutral measure ✓ ✗ ✗

Table 7.1: Market models and their properties.

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 210 N. Privault

Exercises
Exercise 7.1 Consider a standard Poisson process (Nt )t∈R+ with intensity λ > 0 under a probability
measure P. Let (St )t∈R+ be defined by the stochastic differential equation

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+ is a martingale under
P.
b) Compute the price at time t ∈ [0, T ] of a power option with payoff |ST |2 at maturity T .

Exercise 7.2 Consider a long forward contract with payoff ST − K on a jump diffusion risky asset
price process (St )t∈R+ given by

dSt = µSt dt + σ St 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
(7.5.5).

Exercise 7.3 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 differential equation

dSt = µSt dt + ηSt - dNt + σ St dBt . (7.5.6)

a) Solve the equation (7.5.6).

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 K and maturity T , using a series expansion of Black-Scholes
functions.

Exercise 7.4 Consider (Nt )t∈R+ a standard Poisson process with intensity λ > 0 under a probability
measure P. Let (St )t∈R+ be defined by the stochastic differential equation

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 K and maturity
T , using a series of multiple integrals.

Exercise 7.5 Consider a standard Poisson process (Nt )t∈R+ with intensity λ > 0 under a probability
measure P. Let (St )t∈R+ be defined by the stochastic differential equation

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].

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 211

a) Find the value of α ∈ R such that the discounted process ( e −rt St )t∈R+ is a martingale under
P.
b) Compute the price at time t ∈ [0, T ] of the long forward contract with maturity T and payoff
ST − K.

Exercise 7.6 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

dSt = rSt dt + αSt - (dNt − λ dt ), (7.5.7)

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 its value can be written as
a function Vt = f (t, St ) of t and St for all times t ∈ [0, T ].
a) Solve the stochastic differential equation (7.5.7).
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 = r f (t, St )dt + αξt St - (dNt − λ dt ). (7.5.8)

d) Show that the claim payoff C = φ (ST ) can be exactly replicated by the delta hedging strategy

1
ξt = ( f (t, St - (1 + α )) − f (t, St - )).
αSt -

Exercise 7.7 Pricing by the Esscher  transform  (Gerber and Shiu, 1994). Consider a compound
Poisson process (Yt )t∈[0,T ] with IE e θ (Yt −Ys ) = e (t−s)m(θ ) , 0 ⩽ s ⩽ 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 ) ,
IE e θYt

and consider the probability measure Pθ defined as

dPθ|Ft NT
:= = e (YT −Yt )θ −(T −t )m(θ ) , 0 ⩽ t ⩽ 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 ] = eYt t∈[0,T ] is

a martingale under Pθ .
c) Price the European call option with payoff (ST − K )+ by taking Pθ as risk-neutral probability
measure.

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FN6516 Stochastic Calculus in Finance II 213

Exercise Solutions

Chapter 1
Exercise 1.1 According to Definition 1.3, we need to check the following five properties of
Brownian motion:
(i) starts at 0 at time 0,
(ii) independence of increments,
(iii) almost sure continuity of trajectories,
(iv) stationarity of the increments,
(v) Gaussianity of increments.
Checking conditions (i) to (iv) does not pose any particular problem since the time changes
t 7→ c + t and t 7→ t/c2 are deterministic and continuous.
a) Let Xt := Bc+t − Bt , t ∈ R+ . For any finite sequence of times t0 < t1 < · · · < tn , the sequence

(Xt1 − Xt0 , Xt2 − Xt1 , . . . , Xtn − Xtn−1 )

= (Bc+t1 − Bc+t0 , Bc+t2 − Bc+t1 , . . . , Bc+tn − Bc+tn−1 )

is made of independent random variables. Concerning (v), Xt − Xs = Bc+t − Bc+s is normally

distributed with mean zero and variance t + c − (c + s) = t − s for any 0 ⩽ s < t.
b) Let Xt := cBt/c2 −, t ∈ R+ . For any finite sequence of times t0 < t1 < · · · < tn , the sequence

(Xt1 − Xt0 , Xt2 − Xt1 , . . . , Xtn − Xtn−1 )

= (cBt1 /c2 − cBt0 /c2 , cBt2 /c2 − cBt1 /c2 , . . . , cBtn /c2 − cBtn−1/c2 )

is made of independent random variables. Concerning (v), Xt − Xs = cBt/c2 − cBs/c2 is

normally distributed with mean zero and variance c2 (t/c2 − s/c2 ) = t − s for any 0 ⩽ s < t,
since
Var [cBt/c2 ] = c2 Var [Bt/c2 ] = c2t/c2 = t, t ⩾ 0.

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 214 Exercise Solutions

Exercise 1.2 The solution to (1.4.1) is given by

2 /2)t
St = S0 e σ Bt +(µ−σ , t ⩾ 0,

see the proof of Proposition 1.7 for details. The next code can be used to generate Figure 1.22.
N=1000; t <- 0:N; dt <- 1.0/N; nsim <- 10; sigma=0.6; mu=0.001
Z <- c(rnorm(n = N, 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)

Exercise 1.3
a) Those quantities can be computed from the expression of Stn as a function of the N (0,t )
random variable Bt for n ⩾ 1. Namely, we have
2
IE[Stn ] = IE S0n e nσ Bt −nσ t/2+nrt
 
2
= S0 e −nσ t/2+nrt IE e nσ Bt
 
2 2 2
= S0 e −nσ t/2+nrt +n σ t/2
2
= S0n e nrt +(n−1)nσ t/2 ,
where we used the Gaussian moment generating function (MGF) formula, i.e.
2 2
IE e nσ Bt = e n σ t/2
 

for the normal random variable Bt ≃ N (0,t ), t > 0.

b) By the result of Question (c)), we have IE[St ] = S0 e rt and
2
IE[St2 ] = IE S02 e 2σ Bt −σ t +2rt
 
2
= S02 e −σ t +2rt IE e 2σ Bt
 
2 t +2rt
= S02 e σ , t ⩾ 0.

Exercise 1.4 From the solution of Exercise 2.9, we have

 (i)  (i)
IE St = S0 e µt , t ∈ [0, T ], i = 1, 2,

and
 (i)   (i)
2   (i) 

Var St = IE St − IE St
(i)
2 2 (i)
2
= S0 e 2µt +σi t − S0 e 2µt
(i)
2 2
= S0 e 2µt e σi t − 1 , t ∈ [0, T ], i = 1, 2.

Hence, we have
 (2) (1)   (1)   (2)  (1) (2)

Var St − St = Var St + Var St − 2 Cov St , St

with
 (1) (2)   (1) (2) (1) 2 (2) 2
= IE S0 S0 e 2µt +σ1Wt −σ1 t/2+σ2Wt −σ2 t/2

IE St St
(1) (2) 2 2 (1) (2) 
= S0 S0 e 2µt−σ1 t/2−σ2 t/2 IE e σ1Wt +σ2Wt

 
(1) (2) 2 2 1  (1) (2)
2 
= S0 S0 e 2µt−σ1 t/2−σ2 t/2 exp IE σ1Wt + σ2Wt ,
2

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FN6516 Stochastic Calculus in Finance II 215

with
 (1) (2)
2   (1)
2   (1) (2)   (2)
2 
IE σ1Wt + σ2Wt = IE σ1Wt + 2 IE σ1Wt σ2Wt + IE σ2Wt
= σ12t + 2ρσ1 σ2t + σ22t,

hence
 (1) (2)  (1) (2)
IE St St = S0 S0 e 2µt +ρσ1 σ2t ,

and
(1) (2)
 (1) (2)   (1)   (2)  (1) (2)
Cov St , St = IE St St − IE St IE St = S0 S0 e 2µt ( e ρσ1 σ2t − 1),

and therefore
 (2) (1) 
Var St − St
(1)
2 2µt 2 (2)
2 2µt 2 (1) (2)
= S0 e ( e σ1 t − 1) + S0 e ( e σ2 t − 1) − 2S0 S0 e 2µt ( e ρσ1 σ2t − 1)
(1)
2 σ12 t (2)
2 σ22 t (1) (2) (2) (1)
2

= e 2µt S0 e + S0 e − 2S0 S0 e ρσ1 σ2t − S0 − S0 .

Exercise 1.5 We have

2 2 2 2
IE S0 e σ Bt +µt−σ t/2 = S0 e µt−σ t/2 IE e σ Bt = S0 e µt−σ t/2 e σ t/2 = S0 e µt
   

and
σ 2t σ 2t
 
IE[log St ] = IE log S0 + σ Bt + µt − = (log S0 ) + µt − ,
2 2
hence

σ 2t σ 2t
 
Theilt = log IE[St ] − IE[log St ] = log S0 + µt − (log S0 ) + µt − = .
2 2

5
Geometric Brownian motion

1
0.0 0.2 0.4 0.6 0.8 1.0
Time

Figure S.1: Twenty sample paths of geometric Brownian motion (St )t∈R+ .

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 216 Exercise Solutions

Chapter 2
Exercise 2.1 The payoff C is that of a put option with strike price K = $3.

Exercise 2.2 Each of the two possible scenarios yields one equation:
 
 5ξ + η = 0  ξ = −2
with solution
2ξ + η = 6, η = +10.
 

The hedging strategy at t = 0 is to shortsell −ξ = +2 units of the asset S priced S0 = 4, and to put
η = $10 on the savings account. The price V0 = ξ S0 + η of the initial portfolio at time t = 0 is
V0 = ξ S0 + η = −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 −ξ = +2 units of the stock priced S0 = 4, which yields $8.
(c) Put η = $8 + $2 = $10 on the savings account.
ii) At time t = 1,
(a) If S1 = $5, spend $10 from savings to buy back −ξ = +2 stocks.
(b) If S1 = $2, spend $4 from savings to buy back −ξ = +2 stocks, and deliver a $10 - $4
= $6 payoff.
Pricing the option by the expected value IE∗ [C ] yields the equality
$2 = IE∗ [C ]
= 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 2.3
a) Each of the stated conditions yields one equation, i.e.
 
 4ξ + η = 1  ξ =2
with solution
5ξ + η = 3, η = −7.
 

Therefore, the portfolio allocation at t = 0 consists to purchase ξ = 2 unit of the asset S

priced S0 = 4, and to borrow −η = $7 in cash.

We can check that the price V0 = ξ S0 + η of the initial portfolio at time t = 0 is

V0 = ξ S0 + η = 2 × 4 − 7 = $1.
b) This loss is expressed as
ξ × $2 + η = 2 × 2 − 7 = −$3.
Note that the $1 received when selling the option is not counted here because it has already
been fully invested into the portfolio.

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FN6516 Stochastic Calculus in Finance II 217

Exercise 2.4
a) 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) 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. | ✓
c) 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. |

Exercise 2.5 Hedging a claim with possible payoff values Ca ,Cb ,Cc would require to solve
(1) (0)


 (1 + a)ξ S0 + (1 + r )ηS0 = Ca




(1) (0)
(1 + b)ξ S0 + (1 + r )ηS0 = Cb




(1) (0)


(1 + c)ξ S0 + (1 + r )ηS0 = Cc ,

for ξ and η, which is not possible in general due to the existence of three conditions with only two
unknowns.

Exercise 2.6
a) Each of two possible scenarios yields one equation:

S1 − K

 
 α=
 αS1 + β = S1 − K S1 − S1



with solution
αS1 + β = 0, S −K
 
 β = −S1 1


 .
S1 − S1

b) We have
S1 − K
0⩽α = ⩽1
S1 − S1
since K ∈ [S1 , S1 ].
c) We find
SRMC = αS0 + β
= α ( S0 − S 1 )
S1 − K
= ( S0 − S 1 ) .
S1 − S1
We note that when S0 < S1 the value of SRMC is negative because in this case, investing in
the zero-cost portfolio (α, −αS0 ) that would yield a payoff at least equal to α (S1 − S0 ) =
−α (S0 − S1 ) > 0, which represents an arbitrage opportunity.

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 218 Exercise Solutions

Exercise 2.7
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) From Table 3.1 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.
c) 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
| {z }
×8, 000 −0.370 ×11, 000 +0.044 ×10, 000 = −92
| {z } | {z }
Long call Short put Short call Long put

index points, or −92 × $50 = −$4, 600.

Note that option prices are quoted in index points (to be multiplied by the relevant
option/warrant entitlement ratio), and every index point is worth $50.
ii) Using the put option issued by HT (Haitong Securities) at 0.061.
In this case, the box spread option represents a long position priced

| {z } ×7, 500 −0.044

0.540
| {z }
×8, 000 −0.370 ×11, 000 +0.061 ×10, 000 = +78
| {z } | {z }
Long call Short put Short call Long put

index points, or 78 × $50 = $3, 900.

d) As the option built in i)) represents a short position paying $4, 600 today with an additional
$50 × (K2 − K1 ) = 200 = $10, 000 payoff at maturity on March 28, I would definitely enter
this position.
As for the option built in ii)), it is less profitable because it costs $3, 900, however it is still
profitable taking into account the $10, 000 payoff at maturity on March 28.

Exercise 2.8 For all x ∈ R, we have

2
P(ST ⩽ x) = P S0 e σ BT +(µ−σ /2)T ⩽ x

σ2
   
x
= P σ BT + µ − T ⩽ log
2 S0
2
    
1 x σ
= P BT ⩽ log − µ − T
σ S0 2
w (log(x/S0 )−(µ−σ 2 /2)T )/σ 2 dy
= e −y /(2T ) √
−∞ 2πT
w (log(x/S0 )−(µ−σ 2 /2)T )/(σ √T ) 2 dz
= e −z /2 √
−∞ 2π
σ2
    
1 x
= Φ √ log − µ − T ,
σ T S0 2
where wx dy 2 /2
Φ (x ) : = √e −y , x ∈ R,
−∞ 2πT
denotes the standard Gaussian cumulative distribution function. After differentiation with respect
to x, we find the lognormal probability density function
dP(ST ⩽ x)
f (x ) =
dx

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FN6516 Stochastic Calculus in Finance II 219

∂ w (log(x/S0 )−(µ−σ 2 /2)T )/σ −y2 /(2T ) dy

= e √
∂ x −∞ 2πT
2
    
∂ 1 x σ
= Φ √ log − µ − T
∂x σ T S 0 2
σ2
    
1 1 x
= √ ϕ √ log − µ − T
xσ T 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) = Φ′ (y) := √ e −y /2 , y ∈ R,
2π
denotes the standard Gaussian probability density function.

Exercise 2.9
a) We have
1 1 σ2
d log St = dSt − 2 (dSt )2 = rdt + σ dBt − dt, t ⩾ 0.
St 2St 2
b) We have f (t ) = f (0) e ct (continuous-time interest rate compounding), and
2 t/2+rt
St = S0 e σ Bt −σ , t ⩾ 0,

which is a geometric Brownian motion.

c) Those quantities can be computed from the expression of Stn as a function of the N (0,t )
random variable Bt for n > 0. Namely, we have
2
IE[Stn ] = IE S0n e nσ Bt −nσ t/2+nrt
 
2
= S0n e −nσ t/2+nrt IE e nσ Bt
 
2 t/2+nrt +n2 σ 2 t/2
= S0n e −nσ
2
= S0n e nrt +(n−1)nσ t/2 ,
where we used the Gaussian moment generating function (MGF) identity, i.e.
2 2
IE e nσ Bt = e n σ t/2
 

for the normal random variable Bt ≃ N (0,t ), t > 0.

d) By the result of Question (c)), we have IE[St ] = S0 e rt and
2
IE[St2 ] = IE S02 e 2σ Bt −σ t +2rt
 
2
= S02 e −σ t +2rt IE e 2σ Bt
 
2
= S02 e σ t +2rt , t ⩾ 0.
e) We note that from the stochastic differential equation
wt wt
St = S0 + r Ss ds + σ Ss dBs ,
0 0

the function u(t ) := IE[St ] satisfies the Ordinary Differential Equation (ODE) u′ (t ) = ru(t )
with u(0) = S0 and solution u(t ) = IE[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 + 2σ St2 dBt ,

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 220 Exercise Solutions

hence letting v(t ) = IE 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 ) = IE St2
 
hw t i hw t i
= S02 + (2r + σ 2 ) IE Su2 du + 2σ IE Su2 dBu
0 0
wt  
2 2 2
= S0 + (2r + σ ) IE Su du
w0t
2 2
= S0 + (2r + σ ) v(u)du,
0
hence v(t ) := IE St2 satisfies the ordinary differential equation
 

v′ (t ) = (σ 2 + 2r )v(t ),

with v(0) = S02 and solution

2
v(t ) = IE St2 = S02 e (σ +2r)t ,
 

which recovers
Var[St ] = IE St2 − (IE[St ])2
 

= v(t ) − u2 (t )
2 +2r )t
= S02 e (σ − S02 e 2rt
2
= S02 e 2rt ( e σ t − 1), t ⩾ 0.

Exercise 2.10 Using the bivariate Itô formula, we find

∂f ∂f
d f (St ,Yt ) = (St ,Yt )dSt + (St ,Yt )dYt
∂x ∂y
1 ∂2 f 2 1 ∂2 f 2 ∂2 f
+ ( S t ,Y t )( dS t ) + ( St ,Y t )( dY t ) + (St ,Yt )dSt • dYt
2 ∂ x2 2 ∂ y2 ∂ x∂ y
∂f ∂f
= (St ,Yt )(rSt dt + σ St dBt ) + (St ,Yt )( µYt dt + ηYt dWt )
∂x ∂y
σ 2 St2 ∂ 2 f η 2Yt2 ∂ 2 f ∂2 f
+ ( S t ,Yt ) dt + ( S t ,Yt ) dt + ρσ ηS t Yt (St ,Yt )dt.
2 ∂ x2 2 ∂ y2 ∂ x∂ y

Exercise 2.11 Taking expectations on both sides of (2.5.4) shows that

w 
T
IE[ST ] = C (S0 , r, T ) + IE ζt,T dBt = C (S0 , r, T ),
0

hence

C (S0 , r, T ) = IE[ST ]
2 T /2
= IE[S0 e rT +σ BT −σ ]
rT −σ 2 T /2
= S0 e IE[ e σ BT ]
2 T /2+σ 2 T /2
= S0 e rT −σ
= S0 e rT ,

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FN6516 Stochastic Calculus in Finance II 221

where we used the moment generating function

2 T /2
IE[ e σ BT ] = 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 = σ Xt 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

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 2.12
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 = d f (Xt )
1 ′′
= f ′ (Xt )dXt + f (Xt )(dXt )2
2
1
= ut f ′ (Xt )dt + σt f ′ (Xt )dBt + σt2 f ′′ (Xt )dt
2
1
= S0 ut e dt + S0 σt e dBt + S0 σt2 e Xt dt
Xt Xt
2
1 2
= ut St dt + σt St dBt + σt St dt.
2
b) The process (St )t∈R+ satisfies the stochastic differential equation
 
1 2
dSt = ut + σt St dt + σt St dBt .
2

Exercise 2.13
a) We have IE[St ] = 1 because the expected value of the Itô stochastic integral is zero. Regarding
the variance, using the Itôisometry, we have 
w t 2
2
Var[St ] = σ 2 IE e σ Bs −σ s/2 dBs
0
w  2 
t
2 σ Bs −σ 2 s/2
= σ IE e ds
0
w t  2
2 
= σ 2 IE e σ Bs −σ s/2 ds
0
wt h 2
i
= σ 2 IE e 2σ Bs −σ s ds
0
wt 2
2
e −σ s IE e 2σ Bs ds
 
= σ
0

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 222 Exercise Solutions
wt 2 2
= σ2 e −σ s e 2σ s ds
w0t 2
2
= σ e σ s ds
0
σ 2t
= e − 1.
b) Taking f (x) = log x, we have
d log(St ) = d f (St )
1 ′′
= f ′ (St )dSt + f (St )(dSt )2
2
2 1 2
= σ f ′ (St ) e σ Bt −σ t/2 dBt + σ 2 f ′′ (St ) e 2σ Bt −σ t dt
2
σ σ Bt −σ 2t/2 σ 2 2σ Bt −σ 2t
= e dBt − 2 e dt. (S.1)
St 2St
2
c) We check that letting Zt := eσ Bt −σ t/2 , t ⩾ 0, we have

σ2
log Zt = σ Bt − σ 2t/2, and d log Zt = σ dBt − dt.
2
On the other hand, we also have

σ2 σ 2 σ2 2
σ dBt − dt = e σ Bt −σ t/2 dBt − 2 e 2σ Bt −σ t dt,
2 Zt 2Zt
showing by (S.1) that the equation

σ σ Bt −σ 2t/2 σ2 2
d log Zt = e dBt − 2 e 2σ Bt −σ t dt
Zt 2Zt
is satisfied. By uniqueness of solutions to (S.1) we obtain

log St = log Zt = σ Bt − σ 2t/2,

2 t/2
and we conclude that St = Zt = eσ Bt −σ , t ⩾ 0.

Exercise 2.14
a) Leveraging with a factor β : 1 means that when the fund value is Ft , the amount ξt St = β Ft
is actually invested 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
with ξt = β Ft /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
= β Ft (rdt + σ dBt ) − (β − 1)rFt dt
= rFt dt + β σ Ft dBt , t ⩾ 0.
The above equation shows that the volatility β σ of the fund is β times the volatility of the
index. On the other hand, the risk-free rate r remains the same.

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FN6516 Stochastic Calculus in Finance II 223

c) By Proposition 1.7 we have

2 2
Ft = F0 e β σ Bt +rt−β σ t/2
2 t/2
= F0 e σ Bt +rt/β −β σ

β

2 t/2−(1−1/β )rt−(β −1)σ 2 t/2
β

= F0 e σ Bt +rt−σ
2 t/2 2 t/2
e −(β −1)rt−(β −1)β σ

β
= F0 e σ Bt +rt−σ
2 t/2 2 t/2
e −(β −1)rt−(β −1)β σ

β
= S0 e σ Bt +rt−σ
2 t/2
= Stβ e −(β −1)rt−(β −1)β σ , t ⩾ 0.

Exercise 2.15
a) For t ∈ [0, T ] and i = 1, 2 we have
 (i)   (i) (i) 2
= IE S0 e µt +σiWt −σi t/2

IE St
(i) 2 (i) 
= S0 e µt−σi t/2 IE e σiWt


(i) 2 2
= S0 e µt−σi t/2+σi t/2
(i)
= S0 e µt .
b) For all t ∈ [0, T ] and i = 1, 2, we have
 (i)
2   (i)
2 (i) 2 
IE St = IE S0 e 2µt +2σiWt −σi t
(i)
2 2 (i) 
= S0 e 2µt−σi t IE e 2σiWt


(i)
2 2 2
= S0 e 2µt−σi t +2σi t
(i)
2 2
= S0 e 2µt +σi t ,
hence  (i)   (i)
2   (i) 

Var St = IE St − IE St
(i)
2 2 (i)
2
= S0 e 2µt +σi t − S0 e 2µt
(i)
2 2
= S0 e 2µt e σi t − 1 , t ∈ [0, T ], i = 1, 2.

c) We have
 (2) (1)   (1)   (2)  (1) (2)

Var St − St = Var St + Var St − 2 Cov St , St
with
 (1) (2)   (1) (2) (1) 2 (2) 2
= IE S0 S0 e 2µt +σ1Wt −σ1 t/2+σ2Wt −σ2 t/2

IE St St
(1) (2) 2 2 (1) (2) 
= S0 S0 e 2µt−σ1 t/2−σ2 t/2 IE e σ1Wt +σ2Wt

 
(1) (2) 2µt−σ12 t/2−σ22 t/2 1  (1) (2)
2 
= S0 S0 e exp IE σ1Wt + σ2Wt ,
2
with 
(1) (2)
2   (1)
2   (1) (2)   (2)
2 
IE σ1Wt + σ2Wt = IE σ1Wt + 2 IE σ1Wt σ2Wt + IE σ2Wt
= σ12t + 2ρσ1 σ2t + σ22t,
hence  (1) (2)  (1) (2)
IE St St = S0 S0 e 2µt +ρσ1 σ2t ,
and
(1) (2)
 (1) (2)   (1)   (2)  (1) (2)
Cov St , St = IE St St − IE St IE St = S0 S0 e 2µt ( e ρσ1 σ2t − 1),

and therefore
 (2) (1) 
Var St − St

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 224 Exercise Solutions
(1)
2 2µt 2 (2)
2 2µt 2 (1) (2)
= S0 e ( e σ1 t − 1) + S0 e ( e σ2 t − 1) − 2S0 S0 e 2µt ( e ρσ1 σ2t − 1)
(1)
2 σ12 t (2)
2 σ22 t (1) (2) (2) (1)
2

= e 2µt S0 e + S0 e − 2S0 S0 e ρσ1 σ2t − S0 − S0 .
2 t/2
Exercise 2.16 Letting Xt := f (t ) e σ Bt −σ and noting the relation
2 t/2 2 t/2
d e σ Bt −σ = σ f (t ) e σ Bt −σ dBt , t ⩾ 0,

that follows from Proposition 1.7 and the Itô formula with µ = 0, we have
2 t/2 2 t/2
dXt = e σ Bt −σ f ′ (t )dt + f (t )d e σ Bt −σ
2 2 t/2
= e σ Bt −σ t/2 f ′ (t )dt + σ f (t ) e σ Bt −σ dBt
f ′ (t )
= Xt dt + σ Xt dBt
f (t )
= h(t )Xt dt + σ Xt dBt ,
hence
d f ′ (t )
log f (t ) = = h(t ),
dt f (t )
which shows that wt
log f (t ) = log f (0) + h(s)ds,
0
and
2
Xt = f (t ) e σ Bt −σ t/2
w
σ2

t
= f (0) exp h(s)ds + σ Bt − t
0 2
w 2

t σ
= X0 exp h(s)ds + σ Bt − t , t ⩾ 0.
0 2

Exercise 2.17
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 w t Xs
= e X0 + σ e Xs dBs + ν e Xs ds + e 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 equation

dSt = rSt dt + σ St 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 σ Bt +νt , t ⩾ 0. Using the time splitting
decomposition
ST
ST = St = St e (BT −Bt )σ +ντ ,
St

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FN6516 Stochastic Calculus in Finance II 225

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)
BT − Bt
 
1 −(T −t )ν
= P √


> √ log K e /x
T −t σ T −t

!
log K e −(T −t )ν /x
= 1−Φ √
σ τ

!
log K e −(T −t )ν /x
= Φ − √
σ τ
 
log(x/K ) + ντ
= Φ √ ,
σ τ
where τ = T − t.
Problem 2.18
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
w a stop-loss/start-gain strategy.
t
d) Noting that ηs dAs = 0 because At = A0 is constant, t ∈ [0, T ], we find by the Itô-Tanaka
0
formula
w tthat wt wT
ηs dAs + ξs dBs = 1[K,∞) (Bt )dBt
0 0 0
1
= (BT − K )+ − (B0 − K )+ − L[K0,T ] .
2
e) Question (d)) shows that
wt wt 1
( BT − K ) + = ( B0 − K ) + + ηs dAs + ξs dBs + L[K0,T ] ,
0 0 2
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
2 L[0,T ] > 0. Therefore the portfolio allocation (ξt , ηt )t∈[0,T ] is not self-financing.
1 K

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 226 Exercise Solutions

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.2.

-1 -0.5 0 0.5 1

Figure S.2: 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 IE∗ [(BT − K )+ | Ft ]

= e −(T −t )r IE∗ [(BT − Bt + x − K )+ | Ft ]x=Bt
= e −(T −t )r IE∗ [(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∞ 2 dy
= e −(T −t )r (y + Bt − K ) e −y /(2(T −t )) p
K−Bt 2π (T − t )
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
w∞ 2 dy
+(Bt − K ) e −(T −t )r √ e −y /2 √
(K−Bt )/ T −t 2π
e − ( T −t ) r h 2
i ∞
= √ − e −y /2 √
2π (K−Bt )/ T −t
Bt − K
 
−(T −t )r
+(Bt − K ) e Φ √
T −t
e − ( T −t ) r 2
= √ e −(K−Bt ) /(2(T −t ))
2π

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FN6516 Stochastic Calculus in Finance II 227

Bt − K
 
−(T −t )r
+(Bt − K ) e Φ √
T −t
=: g(t, Bt ),

where the function

e −(T −t )r −(K−x)2 /(2(T −t )) x−K

 
−(T −t )r
g(t, x) := √ e + (x − K ) e 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 2
= (K − Bt ) √ e −(K−Bt ) /(2(T −t ))
2π (T − t )
e −(T −t )r Bt − K
 
2
+ (Bt − K ) p e −(Bt −K ) /(2(T −t )) + e −(T −t )r Φ √
2π (T − t ) T −t
!
Bt − K
= e −(T −t )r Φ p
(T − t )
=: h(t, Bt ),

with
x−K
 
−(T −t )r
h(t, x) := e Φ √ , t ∈ [0, T ),
T −t

and h(T , x) = 1[K,∞) (x).

Bt

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Figure S.3: Brownian path started at B0 > 1.

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 228 Exercise Solutions

(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

Figure S.4: 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

Figure S.5: 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 because 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 in the sample of Figure S.6 with 383.16964 < 384.07141.

Figure S.6: 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

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FN6516 Stochastic Calculus in Finance II 229

potentially results into a trading loss that can be proportional to the time


ℓ 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

wT 1
(BT − K )+ = (B0 − K )+ + 1[K,∞) (Bt )dBt + L[K0,T ] ,
0 2
precisely shows that the trading loss equals half the local time L[K0,T ] spent by (Bt )t∈[0,T ] at the
level K. When ε is small we have
1 K 1
L[0,T ] ≃ ℓ({t ∈ [0, T ] : K − ε < Bt < K + ε}),
2 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 ).

Bt

K+ε

K-ε

0 0.05 0.1 0.15 0.2

Figure S.7: Time spent by Brownian motion within the range (K − ε, K + ε ).

More generally, one 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.5. This invalidates the stop-loss/start-gain strategy as a
self-financing portfolio strategy.

Problem 2.19
a) We have
0 = d (Xtα Yt1−α )
= (1 − α )Xtα Yt−α dYt + αYt1−α Xtα−1 dXt
= −(1 − α )St Xtα Yt−α dXt + αYt1−α Xtα−1 dXt ,
hence
−(1 − α )St Xt dXt + αYt dXt = 0,
and therefore
αYt Yt
St = =γ , t > 0.
(1 − α )Xt Xt
b) We have
Y0 CS0α CS0α
LP0 = Y0 + X0 S0 = = = ( 1 + γ ) .
1−α (1 − α )γ α γα
We note that when α = 1/2, i.e. in the CPAMM model, the dollar amounts deposited at time
t = 0 in X and Y are equal.

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 230 Exercise Solutions

c) At time t ⩾ 0, the value of the quantity Xt of asset X quoted in units of Y is

αYt
Xt St = = γYt ,
1−α
and we have
Yt CStα CStα
LPt = Yt + Xt St = = = ( 1 + γ ) .
1−α (1 − α )γ α γα
As above, we note that when α = 1/2, i.e. in the CPAMM model, the dollar amounts in X
and Y remaining in the pool at any time t > 0 are equal.
d) We have  
CS0α St
Vt = Y0 + X0 St = α 1 + γ .
γ S0
e) We have
 
CS0α St CStα
Vt − LPt = α 1 + −
γ γS0 (1 − α )γ α
St α
   
CS0α St
= α 1 − (1 + γ ) +γ
γ S0 S0
 
St
=φ ,
S0

where
CS0α
φ (x ) : = (1 − (1 + γ )xα + γx) , x > 0.
γα
f) We have
 
CS0α St CStα
Vt − LPt = α 1 + −
γ γS0 (1 − α )γ α
α   α 
CS St St
= α0 1 − (1 + γ ) +γ
γ S0 S0
α  
CS St
= α0 ψ ,
γ S0

where the function

ψ (x) = 1 − (1 + γ )xα + γx
is nonnegative and reaches its minimum value 0 at x = 1 since ψ ′ (x) = γ − (1 + γ )αxα−1 ,
ψ ′′ (x) = αxα−2 ⩾ 0, x ⩾ 0, and ψ ′ (1) = γ − (1 + γ )α = 0.
g) We note that the function ψ is convex on (0, ∞) since ψ ′′ (x) = αxα−2 ⩾ 0, x ⩾ 0. Hence, by
Jensen’s inequality, we have   
St
IE[Vt − LPt ] = CS0α IE ψ
S0
  
S t
⩾ CS0α ψ IE
S0
= CS0α (1 + γ e µt − (1 + γ ) e α µt ).
h) We need to satisfy the conditions

 V1 − LP1 = ξ |a − S0 | if S1 = a,

V1 − LP1 = ξ |b − S0 | if S1 = b,


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FN6516 Stochastic Calculus in Finance II 231

i.e.   r 2  
C a a
√


 1− = ξ 1− if S1 = a,
 S0 S0 S0




 s !2  

 C b b
 √S 1 − S =ξ −1 if S1 = b,



0 0 S0
hence √ √ √ √
C ( S0 − a)2 C ( S0 − b ) 2
ξ=√ =√ ,
S0 S0 − a S0 b − S0
or √ √ √ √
S0 − a b − S0
ξ =C √ =C √ .
S0 + aS0 S0 + bS0
i) We have
  α 
CS0α St St
IE[Vt − LPt ] = α IE 1 − (1 + γ ) +γ
γ S0 S0
α α  α  α  
CS0 CS0 St CS0 St
= α − α (1 + γ ) IE + γ α IE
γ γ S0 γ S0
CS0α CS0α 2 CS α
2
= α − α (1 + γ ) e α µ IE[ e ασ Bt −ασ t/2 ] + γ α0 e µt IE[ e σ Bt −σ t/2 ]
γ γ γ
CS α CS α
2
= (1 + γ e µt ) α0 − α0 (1 + γ ) e α µt e −ασ t/2 IE[ e ασ Bt ]
γ γ
CS0α 2
= α (1 + γ e µt − (1 + γ ) e α µt−(1−α )ασ t/2 ), t ⩾ 0.
γ
j) The ask rate St refers to how many units of Y the pool is asking in order to deliver one unit of
X. The bid rate St refers to how many units of Y the pool agrees to deliver in order to receive
a deposit of one unit of X. If ∆Xt > 0, we have
0 = d (Xtα Yt1−α )
= (1 − α )Xtα Yt−α dYt + (1 − κ )αYt1−α Xtα−1 dXt
= −(1 − α )St Xtα Yt−α dXt + (1 − κ )αYt1−α Xtα−1 dXt ,
hence
0 = −(1 − α )St Xt dXt + (1 − κ )αYt dXt ,
i.e. the bid rate from the pool when changing Y into X is
Yt
St = (1 − κ )γ , t ⩾ 0.
Xt
On the other hand, if ∆Yt > 0, we have
0 = d (Xtα Yt1−α )
= (1 − κ )(1 − α )Xtα Yt−α dYt + αYt1−α Xtα−1 dXt
= −(1 − κ )(1 − α )St Xtα Yt−α dXt + αYt1−α Xtα−1 dXt ,
hence
0 = −(1 − κ )(1 − α )St Xt dXt + αYt dXt ,
i.e. the ask rate from the pool when changing X into Y is
γ Yt
St = , t ⩾ 0.
1 − κ Xt

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 232 Exercise Solutions

Additional question: Find a way to exactly compensate the liquidity provider at the opening of the
pool in a multistep or continuous-time model. Approximate and exact solutions have been proposed
in Fukasawa, Maire, and Wunsch, 2023a; Fukasawa, Maire, and Wunsch, 2023b using variance and
gamma swaps.

Chapter 3
Exercise 3.1 Since r = 0 we have P = P∗ and

g(t, Bt ) = IE∗ B2T | Ft

 

= IE∗ (BT − Bt + Bt )2 | Ft
 

= IE∗ (BT − Bt + x)2 x=B

 
t
∗
= IE (BT − Bt ) + 2x(BT − Bt ) + x2 x=B
2
 
t
∗ 2 ∗ 2
 
= IE (BT − Bt ) + 2x IE [BT − Bt ] + Bt
= Bt2 + T − t, 0 ⩽ t ⩽ T,

hence ξt is given by the partial derivative

∂g
ξt = (t, Bt ) = 2Bt , 0 ⩽ t ⩽ T,
∂x
with
g(t, Bt ) − ξt Bt
ηt =
A0
Bt + (T − t ) − 2Bt2
2
=
A0
(T − t ) − Bt2
= , 0 ⩽ t ⩽ T.
A0

Exercise 3.2 Since BT ≃ N (0, T ), we have

2
IE[φ (ST )] = IE φ S0 e σ BT +(r−σ /2)T



1 w∞ 2 2
= √ φ (S0 e σ y+(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 )
2 −∞ x
w ∞2πσ T
= φ (x)g(x)dx,
−∞

under the change of variable

2 /2)T 2 /2)T
x = S0 e σ y+(r−σ , with dx = σ S0 e σ y+(r−σ dy = σ xdy,

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 )
2
x 2πσ T

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FN6516 Stochastic Calculus in Finance II 233

is the lognormal probability

√ density function with location parameter (r − σ 2 /2)T + log S0 and
scale parameter σ T .

Exercise 3.3
a) By the Itô formula, we have
p( p − 1) p−2
dStp = pStp−1 dSt + St dSt • dSt
2
p( p − 1) p−2
= pStp−1 (rSt dt + σ St dBt ) + St (rSt dt + σ St dBt ) • (rSt dt + σ St dBt )
2
p( p − 1) p
= prStp dt + σ pStp dBt + σ 2 St dt
2
p( p − 1)
 
= pr + σ 2 Stp dt + σ pStp dBt .
2
b) By the Girsanov Theorem 3.3, letting

p( p − 1)
 
1
ν := ( p − 1)r + σ 2 ,
pσ 2
the drifted process
Bbt := Bt + νt, 0 ⩽ t ⩽ 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 + σ pStp dBt
2
= (r + pσ ν ) Stp dt + σ pStp dBt
= rStp dt + σ pStp (dBt + νdt )
= rStp dt + σ pStp d Bbt ,
hence the discounted process Set := e −rt Stp satisfies d Set = σ pSet d Bbt , and (Set )t∈R+ is a mar-
tingale under the probability measure Q.

Exercise 3.4 We have

IE∗ [φ ( pST1 + qST2 )] ⩽ IE∗ [ pφ (ST1 ) + qφ (ST2 )] since φ is convex,
∗ ∗
= p IE [φ (ST1 )] + q IE [φ (ST2 )]
= p IE∗ [φ (IE∗ [ST2 | FT1 ])] + q IE∗ [φ (ST2 )] because (St )t∈R+ is a martingale,
⩽ p IE∗ [IE∗ [φ (ST2 ) | FT1 ]] + q IE∗ [φ (ST2 )] by Jensen’s inequality,
= p IE∗ [φ (ST2 )] + q IE∗ [φ (ST2 )] by the tower property,
= IE∗ [φ (ST2 )], because p + q = 1.

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

h  2 2
i
IE∗ [φ ( pST1 + qST2 )] = IE∗ φ pS0 e σ BT1 −σ T1 /2 + qS0 e σ BT2 −σ T2 /2

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 234 Exercise Solutions
h  2
 2
i
= IE∗ φ S0 e σ BT1 −σ T1 /2 p + q e (BT2 −BT1 )σ −(T2 −T1 )σ /2
1 w∞ w∞  2
 2

= φ S0 e σ x−σ T1 /2 p + q e σ y−(T2 −T1 )σ /2
2π −∞ −∞
2 2 dxdy
× e −x /(2T1 )−y (2(T2 −T1 )) p
T1 (T2 − T1 )
w
1 ∞ ∞ w 2 2
+
S0 e σ x−σ T1 /2 p + q e σ y−(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 σ x ( p+q e σ y−(T2 −T1 )σ 2 /2 )⩾K e σ 2 T1 /2 }
2 2
(S0 e σ x−σ T1 /2 ( p + q e σ y−(T2 −T1 )σ /2 ) − K )
2 2 dxdy
× e −x /(2T1 )−y (2(T2 −T1 )) p
T1 (T2 − T1 )
= ···

Exercise 3.5
a) The European call option price C (K ) := e −rT IE∗ [(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 IE∗ [(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 3.6
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 measure P∗ , we have

+
e −(T −t )r IE∗ [(ST − K )+ | Ft ] ⩾ e −(T −t )r IE∗ [ST − K | Ft ]

+
= e −(T −t )r e (T −t )r St − K

+
= St − K e −(T −t )r , 0 ⩽ t ⩽ T .

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

Figure S.8: Lower bound vs. Black-Scholes call price.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 235

In terms of the break-even price defined as

BEPt := K + e −(T −t )r IE∗ [(ST − K )+ | Ft ],

we obtain the bound

+
BEPt ⩾ K + St − K e −(T −t )r .

b) Similarly, by Jensen’s inequality and the martingale property, we find

+
e −(T −t )r IE∗ [(K − ST )+ | Ft ] ⩾ e −(T −t )r IE∗ [K − ST | Ft ]

+
= e −(T −t )r K − e (T −t )r St

+
= K e −(T −t )r − St , 0 ⩽ t ⩽ T .
Black-Scholes European put price
Lower bound
30
25
20
15
10
5
0
120

100

Underlying (HK$)
0
80 5
10
15 Time to maturity T-t
20

Figure S.9: 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 IE∗ [( e −rT K − e −rT ST )+ | Ft ] ⩾ e rt ( e −rT K − e −rt St )+

+
= K e −(T −t )r − St , 0 ⩽ t ⩽ T .
In terms of the break-even price defined as

BEPt := K − e −(T −t )r IE∗ [(ST − K )+ | Ft ],

we obtain the bound

+
BEPt ⩽ K − K e −(T −t )r − St .

Exercise 3.7
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 European call option with strike
price K2 , because the bull spread payoff function can be written as

x 7−→ (x − K1 )+ − (x − K2 )+ .

see https://optioncreator.com/st3ce7z.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 236 Exercise Solutions

150
(x-K1)+
-(x-K2)+

100

50

-50
0 50 100 150 200
K1 ST K2

Figure S.10: 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 https://optioncreator.com/stmomsb.

150
-(K1-x)+
(K2-x)+

100

50

-50
0 50 100 150 200
K1 ST K2

Figure S.11: 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 Black-Scholes formula
for call options as
Blc (St , K1 , σ , r, T − t ) − Blc (St , K2 , σ , r, T − t ).
(ii) The bear spread option can be priced at time t ∈ [0, T ) using the Black-Scholes formula
for put options as
Blp (St , K2 , σ , r, T − t ) − Blp (St , K1 , σ , r, T − t ).
* The animation works in Acrobat Reader on the entire pdf file.
† The animation works in Acrobat Reader on the entire pdf file.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 237

Exercise 3.8
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 8.2 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.

Table 8.2: 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
| {z }
×8, 000 −0.370 ×11, 000 +0.044 ×10, 000 = −92
| {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 3.2, option prices are quoted in index points (to be
multiplied by the relevant option/warrant entitlement ratio), and every index point is
worth $50.
ii) Using the put option issued by HT (Haitong Securities) at 0.061.
In this case, the box spread option represents a long position priced

| {z } ×7, 500 −0.044

0.540
| {z }
×8, 000 −0.370 ×11, 000 +0.061 ×10, 000 = +78
| {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 i)) 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 ii)) 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).

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 238 Exercise Solutions

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 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 3.1 was in fact modified market data. The original 02 March 2021 data is displayed in
Table 8.3, 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 8.3: Original call/put options on the Hang Seng Index (HSI) as of 02/03/2021.

Exercise 3.9
a) The payoff function can be written as
(x − K1 )+ + (x − K2 )+ − 2(x − (K1 + K2 )/2)+
= (x − 50)+ + (x − 150)+ − 2(x − 100)+ , (S.2)
see also https://optioncreator.com/stnurzg.

150
(x-K1)++(x-K2)+
-2(x-K1/2-K2/2)+

100

50

-50
0 50 100 150 200
K1 ST K2

Figure S.12: Butterfly option as a combination of call options.*

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 239

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 (S.2), the long call butterfly option can be priced at time t ∈ [0, T ) using the Black-
Scholes call formula as

Bl(St , K1 , σ , r, T − t ) + Bl(St , K2 , σ , r, T − t ) − 2Bl(St , (K1 + K2 )/2, σ , r, T − t ).

c) For example, in the discrete-time Cox-Ross-Rubinstein (J. Cox, Ross, and Rubinstein, 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 by
h    i
IE∗ φ x(1 + b) ∏Nj=t +1 (1 + R j ) − φ x(1 + a) ∏Nj=t +1 (1 + R j )
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.

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

Figure S.13: Delta of a butterfly option with strike prices K1 = 50 and K2 = 150.

Exercise 3.10
a) We have
Ct = e −(T −t )r IE∗ [ST − K | Ft ]
= e −(T −t )r IE∗ [ST | Ft ] − K e −(T −t )r
e rt IE∗ 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 σ 2 ∂ 2g
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.
* The animation works in Acrobat Reader.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 240 Exercise Solutions

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 ⩽ t ⩽ T.

Note again that this hedging strategy is constant over time, and the relation ξt = ∂ g(St ,t )/∂ x
for the option Delta is satisfied.

Exercise 3.11 Option pricing with dividends.

a) Let P∗ denote the probability measure under which the process (Bbt )t∈R+ defined by
µ −r
d Bbt = dt + dBt
σ
is a standard Brownian motion. Under absence of arbitrage the asset price process (St )t∈R+
has the dynamics
dSt = ( µ − δ )St dt + σ St dBt
= (r − δ )St dt + σ St d Bbt ,
and the discounted asset price process (Set )t∈R+ = ( e −rt St )t∈R+ satisfies

d Set = −δ Set dt + σ Set d Bbt .

Assuming that the dividend yield δ St per share is continuously reinvested in the portfolio,
the self-financing portfolio condition
dVt = ηt dAt + ξt dSt + δ ξt St dt
| {z } | {z }
Trading profit and loss Dividend payout

= rηt At dt + ξt ((r − δ )St dt + σ St d Bbt ) + δ ξt St dt

= rηt At dt + ξt (rSt dt + σ St d Bbt )
= rVt dt + σ ξt St d Bbt , 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
= σ ξt e −rt St d Bbt
= σ ξt Set d Bbt
= ξt (d Set + δ Set dt ), t ⩾ 0.
Therefore, we have w
t
Vet − Ve0 = dVeu
0
wt
= σ ξu Seu d Bbu
wt 0 wt
= ξu d Seu + δ Seu du, t ⩾ 0.
0 0
Here, the asset price process ( e δt St )t∈R+ with added dividend yield satisfies the equation


d e δt St = r e δt St dt + σ e δt St d Bbt ,

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) We have wt
Vet = Ve0 + σ ξu Seu d Bbu , t ⩾ 0,
0
which is a martingale under P∗ from Proposition 3.1, hence
Vet = IE∗ VeT Ft


January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 241

= e −rT IE∗ [VT | Ft ]

= e −rT IE∗ [C | Ft ],
which implies
Vt = e rt Vet = e −(T −t )r IE∗ [C | Ft ], 0 ⩽ t ⩽ T.
c) After discounting the payoff (ST − K )+ at the continuously compounded interest rate r, we
obtain
Vt = e −(T −t )r IE∗ (ST − K )+ | Ft
 
2
+
= e −(T −t )r IE∗ S0 e σ BT +(r−δ −σ /2)T − K | Ft
 b 
2
+
= e −(T −t )δ e −(T −t )(r−δ ) IE∗ S0 e σ BT +(r−δ −σ /2)T − K | Ft
 b 

= e −(T −t )δ Bl(x, K, σ , r − δ , T − t )
e −(T −t )δ St Φ d+ (T − t ) − K e −(T −t )(r−δ ) Φ d−δ (T − t )
δ




=
e −(T −t )δ St Φ d+ (T − t ) − K e −(T −t )r Φ d−δ (T − t ) ,
δ



= 0 ⩽ t < T,
where
log(St /K ) + (r − δ + σ 2 /2)(T − t )
δ
d+ (T − t ) : = √
|σ | T − t
and
log(St /K ) + (r − δ − σ 2 /2)(T − t )
δ
d− (T − t ) : = √ .
|σ | T − t
We also have
g(t, x) = Bl x e −(T −t )δ , K, σ , r, T − t

= e −(T −t )δ Bl x, K e (T −t )δ , σ , r, T − t ,


0 ⩽ t ⩽ T.
d) In view of the pricing formula
Vt = e −(T −t )δ St Φ d+ (T − t ) − K e −(T −t )r Φ d−δ (T − t ) ,
δ

the Delta of the option is identified as

ξt = e −(T −t )δ Φ d+
δ


(T − t ) , 0 ⩽ t < T.

Exercise 3.12
a) We have
1 wT
 
−(T −t )r ∗
e IE Su du − K Ft
T 0
 w 
−(T −t )r ∗ 1
T
= e IE Su du Ft − K e −(T −t )r
T 0
e −(T −t )r ∗ w t e −(T −t )r ∗ w T
   
= IE Su du Ft + IE Su du Ft − K e −(T −t )r
T 0 T t

e −(T −t )r w t e −(T −t )r w T ∗
= Su du + IE [Su | Ft ]du − K e −(T −t )r
T 0 T t
e −(T −t )r w t e −(T −t )r w T (u−t )r
= Su du + e St du − K e −(T −t )r
T 0 T t
e −(T −t )r w t e −rT w T ru
= Su du + St e du − K e −(T −t )r
T 0 T t
e −(T −t )r w t St
1 − e −(T −t )r − K e −(T −t )r .


= Su du +
T 0 rT

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 242 Exercise Solutions

b) Any self-financing portfolio strategy (ξt )t∈R+ with price process (Vt )t∈R+ has to satisfy the
equation
dVt = ηt dAt + ξt dSt
= rηt At dt + µξt St dt + σ ξt St dBt
= rVt dt + ( µ − r )ξt St dt + σ ξt St dBt , t ⩾ 0.
On the other hand, by part (a)) we have
e −(T −t )r w t
!
St −(T −t )r −(T −t )r
dVt = d Ss ds + (1 − e )−K e
T 0 rT
r −(T −t )r w t e −(T −t )r St
= e Ss dsdt + St dt − e −(T −t )r dt
T 0 T T
1− e − ( T −t ) r
+ dSt − rK e −(T −t )r dt
rT
r −(T −t )r w t 1 − e −(T −t )r
= e Ss dsdt + dSt − rK e −(T −t )r dt
T 0 rT
1 − e −(T −t )r
= rVt dt + dSt − St (1 − e −(T −t )r )dt
rT
1 − e −(T −t )r
= rVt dt + (( µ − r )St dt + σ St dBt ),
rT
hence
1 − e −(T −t )r
ξt = , t ∈ [0, T ],
rT
which can be recovered by differentiating the pricing function

e −(T −t )r x
1 − e −(T −t )r − K e −(T −t )r


y+
T rT
wt
with respect to x = St , with y = Su du. We also have
0
e −(T −t )r w t
Vt = Ss ds + ξt St − K e −(T −t )r , t ∈ [0, T ].
T 0

Exercise 3.13 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 IE∗ (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 )
 
−ST1 e −(T2 −T1 )r Φ √
σ T2 − T1
r + σ /2 √
2 r − σ 2 /2 √
   
−(T2 −T1 )r
= ST1 Φ T2 − T1 − ST1 e Φ T2 − T1 ,
σ σ
where we applied (3.4.9) with T = T2 , t = T1 , and K = ST1 . As a consequence, the forward start
option can be priced as

e −(T1 −t )r IE∗ e −(T2 −T1 )r IE∗ (ST2 − ST1 )+ | FT1 Ft

   

= e −(T1 −t )r
r + σ 2 /2 √ r − σ 2 /2 √
     
× IE∗ ST1 Φ T2 − T1 − ST1 e −(T2 −T1 )r Φ T2 − T1 Ft
σ σ

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 243

= e −(T1 −t )r
r + σ 2 /2 √ r − σ 2 /2 √
    
−(T2 −T1 )r
× Φ T2 − T1 − e Φ T2 − T1 IE∗ [ST1 | Ft ]
σ σ
r + σ 2 /2 √ r − σ 2 /2 √
    
= St Φ T2 − T1 − e −(T2 −T1 )r Φ T2 − T1 ,
σ σ
0 ⩽ t ⩽ T1 .

Exercise 3.14 From the Black-Scholes formula we have

" + #
(r + σ 2 /2)(Tk − Tk−1 ) − log K
 
−(Tk −Tk−1 )r ∗ STk
e IE −K FTk−1 = Φ √
STk−1 σ Tk − Tk−1
(r − σ 2 /2)(Tk − Tk−1 ) − log K
 
−(Tk −Tk−1 )r
−K e Φ √ .
σ Tk − Tk−1
As a consequence, for t = T0 = 0 we have
" + # " " + ##
S Tk STk
IE∗ −K Ft = IE∗ IE∗ −K FTk−1
STk−1 STk−1
(r + σ 2 /2)(Tk − Tk−1 ) − log K
  
∗ (Tk −Tk−1 )r
= IE e Φ √
σ Tk − Tk−1
(r − σ 2 /2)(Tk − Tk−1 ) − log K
 
−KΦ √
σ Tk − Tk−1
(r + σ 2 /2)(Tk − Tk−1 ) − log K
 
(Tk −Tk−1 )r
=e Φ √
σ Tk − Tk−1
(r − σ 2 /2)(Tk − Tk−1 ) − log K
 
− KΦ √ .
σ Tk − Tk−1
Hence, the cliquet option can be priced at time t = T0 = 0 as
" + #
n
−rTk ∗ STk
∑ e IE ST − K
k =1 k−1

n 
(r + σ 2 /2)(Tk − Tk−1 ) − log K
 
−rTk−1
=∑ e Φ √
k =1 σ Tk − Tk−1
(r − σ 2 /2)(Tk − Tk−1 ) − log K
 
−K e −rTk Φ √ .
σ Tk − Tk−1

Exercise 3.15 We have

e −(T −t )r IE∗ log ST | Ft

 
C (t, St ) =
σ2
   
−(T −t )r ∗
= e IE log St + (BT − Bt )σ + r −
b b (T − t ) | Ft
2
σ2
 
= e −(T −t )r log St + e −(T −t )r r − (T − t ), 0 ⩽ t ⩽ T.
2

Exercise 3.16

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 244 Exercise Solutions

a) By (1.2.7), for all t ∈ [0, T ], we have

C (t, St ) = e −(T −t )r IE[ST2 | Ft ]
2
 
−(T −t )r 2 ST
= e IE St 2 Ft
St
 2 
−(T −t )r 2 ST
= e St IE 2 Ft
St
 2
S
= e −(T −t )r St2 IE T2
St
−(T −t )r 2
 2(B −B )σ −(T −t )σ 2 +2(T −t )r 
= e St IE e T t
2
= e −(T −t )r St2 e −(T −t )σ +2(T −t )r IE e 2(BT −Bt )σ
 
2
= St2 e (r+σ )(T −t ) ,
where we used the Gaussian moment generating function (MGF) identity, i.e.
2
IE e 2(BT −Bt )σ = e 2(T −t )σ
 

for the normal random variable BT − Bt ≃ N (0, T − t ), 0 ⩽ 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+σ 2 )(T −t ) 2
− 2St2 e (r+σ )(T −t )


ηt = = St e
At A0
S2 2
= − t e σ (T −t )+(T −2t )r ,
A0
i.e.
At σ 2 (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
dC (t, St ) = d St2 e (r+σ )(T −t )


2 )(T −t ) 2 )(T −t )
= − ( r + σ 2 ) e (r +σ St2 dt + e (r+σ d St2


2 )(T −t ) 2 )(T −t )
= − ( r + σ 2 ) e (r +σ St2 dt + e (r+σ 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 σ 2 (T −t )+(T −2t )r
ξt dSt + ηt dAt = 2St e (r+σ dSt − r e At dt
A0
2 2
= 2St e (r+σ )(T −t ) dSt − rSt2 e σ (T −t )+(T −t )r dt,
which recovers dC (t, St ) = ξt dSt + ηt dAt , i.e. the portfolio strategy is self-financing.

Exercise 3.17
a) The discounted process Xt := e −rt St satisfies

dXt = (α − r )Xt dt + σ e −rs dBs ,

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FN6516 Stochastic Calculus in Finance II 245

which is a martingale when α = r by Proposition 3.1, as in this case it becomes a stochastic

integral with respect to a standard Brownian motion. This fact can be recovered by directly
computing the conditional expectation IE[Xt | Fs ] and showing it is equal to Xs . 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 
−ru
IE[Xt | Fs ] = IE S0 + σ e dBu Fs
0
w 
t
−ru
= IE[S0 ] + σ IE e dBu Fs
0
w  w 
s t
= S0 + σ IE e −ru dBu Fs + σ IE e −ru dBu Fs
0 s
ws w
t

−ru −ru
= S0 + σ e dBu + σ IE e dBu
0 s
ws
= S0 + σ e −ru dBu
0
= Xs , 0 ⩽ s ⩽ t.
b) We rewrite the stochastic differential equation satisfied by (St )t∈R+ as

dSt = αSt dt + σ dBt = rSt dt + σ d Bbt ,

where
α −r
d Bbt := St dt + dBt ,
σ
which yields
 wt  wt
St = e rt S0 + σ e −rs d Bbs = S0 e rt + σ e (t−s)r d Bbs . (S.3)
0 0

Taking
α −r
ψt := St , 0 ⩽ t ⩽ T,
σ
in the Girsanov Theorem 3.3, the process (Bbt )t∈R+ is a standard Brownian motion under the
probability measure Pαdefined by
dPα wT 1wT 2

:= exp − ψt dBt − ψ dt
dP 0 2 0 t
α −r w T 1 α −r 2w T 2
  !
= exp − St dBt − St dt ,
σ 0 2 σ 0

and (Xt )t∈R+ is a martingale under Pα .

c) Using (S.3) under the risk-neutral probability measure P∗ , we have
C (t, St ) = e −(T −t )r IEα [exp(ST ) | Ft ]
  wT  
= e −(T −t )r IEα exp e rT S0 + σ e (T −u)r d Bbu Ft
0
  wt wT  
−(T −t )r (T −u)r b (T −u)r b
= e rT
IEα exp e S0 + σ e d Bu + σ e d Bu Ft
0 t
    wT  
= exp − (T − t )r + e (T −t )r St IEα exp σ e (T −u)r d Bbu Ft
t

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 246 Exercise Solutions
    wT 
(T −t )r
= exp − (T − t )r + e St IEα exp σ e (T −u)r d Bbu
t
  σ2 w T 
= exp − (T − t )r + e (T −t )r St exp e 2(T −u)r du
2 t
 σ 2 
(T −t )r 2(T −t )r
= exp − (T − t )r + e St + (e − 1) , 0 ⩽ t ⩽ 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 
− exp St e (T −t )r + ( e 2(T −t )r − 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 
−rSt exp St e (T −t )r + ( e 2(T −t )r − 1) dt
4r
σ 2 (T −t )r  σ 2 2(T −t )r 
− e exp St e (T −t )r + (e − 1) dt
2 4r
 σ 2 
+ exp St e (T −t )r + ( e 2(T −t )r − 1) dSt
4r
1 (T −t )r  σ 2 2(T −t )r 
+ e exp St e (T −t )r + (e − 1) σ 2 dt
2 4r
 σ 2 
= r e −(T −t )r exp St e (T −t )r + ( e 2(T −t )r − 1) dt
4r
 σ 2 
−rSt exp St e (T −t )r + ( e 2(T −t )r − 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 
−rSt exp St e (T −t )r + ( e 2(T −t )r − 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 3.18
a) Using (S.3) under the risk-neutral probability measure P∗ , we have
C (t, St ) = e −(T −t )r IEα [ST2 | Ft ]
wT
" 2 #
−(T −t )r (T −u)r b
= e IEα rT
e S0 + σ e d Bu Ft
0

wt wT
" 2 #
= e −(T −t )r IEα e rT S0 + σ e (T −u)r d Bbu + σ e (T −u)r d Bbu Ft
0 t

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FN6516 Stochastic Calculus in Finance II 247
 wt 2 
−(T −t )r (T −u)r b
= e rT
IEα e S0 + σ e d Bu Ft
0
 wt  w
T

−(T −t )r (T −u)r b (T −u)r b
+2σ e rT
e S0 + σ e d Bu IEα e d Bu Ft
0 t
wT
" 2 #
2 −(T −t )r (T −u)r b
+σ e IEα e d Bu Ft
t

wt wT
" 2 #
 2
= e −(T −t )r e rT S0 + σ e (T −u)r d Bbu + σ 2 e −(T −t )r IEα e (T −u)r d Bbu
0 t
 wt 2 wT
= e −(T −t )r e rT S0 + σ e (T −u)r d Bbu + 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 −(T −t )r


= e
2r
sinh((T − t )r )
= e (T −t )r St2 + σ 2 , 0 ⩽ t ⩽ T.
r
b) We find
∂C
ξt = (t, St ) = 2 e (T −t )r St , 0 ⩽ t ⩽ T.
∂x

Exercise 3.19 (Exercise 2.15 continued, see Proposition 4.1 in Carmona and Durrleman, 2003).
(2) (1)

Letting α := IE∗ [ST ] = e rt S0 − S0 and
 (2) (1) 
η 2 := Var∗ St − St
(1)
2 σ12 t (2)
2 σ22 t (1) (2) (2) (1)
2

= e 2rt S0 e + S0 e − 2S0 S0 e ρσ1 σ2t − S0 − S0 ,

we approximate

e −rt w ∞ 2 2
e −rt IE∗ [(ST − K )+ ] ≃ p (x − K )+ e −(x−α ) /(2η ) dx
2πη 2 −∞
e −rt w ∞ 2 2
= p (x − K ) e −(x−α ) /(2η ) dx
2πη 2 K
e −rt w ∞ −(x−α )2 /(2η 2 ) K e −rt w ∞ −(x−α )2 /(2η 2 )
= p xe dx − p e dx
2πη 2 K 2πη 2 K
η e −rt w ∞ 2 K e −rt w ∞ 2
= √ (x + α ) e −x /2 dx − √ e −x /2 dx
2π (K−α )/η 2π (K−α )/η
−rt K −α
 
ηe h
−x2 /2
i∞
−rt
= −√ e − (K − α ) e Φ −
2π (K−α )/η η
η e −rt −(K−α )2 /(2η 2 ) −
 
K α
= √ e − (K − α ) e −rt Φ − .
2π η

Remark: We note that the expected value IE∗ [φ (ST − K )] can be exactly computed from
w ∞w ∞
(2) (1)

IE∗ [φ (ST )] = IE∗ φ ST − ST


= φ x − y ϕ1 (x)ϕ2 (y)dxdy,
0 0

where
(−(r − σi2 /2)T + log(x/S0 ))2
 
1
ϕi (x) = √ exp −
xσi 2πT 2σi2 T

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 248 Exercise Solutions
(i)
is the lognormal probability density function of ST , i = 1, 2. In particular, we have
w∞
(2) (1)

IE∗ [φ (ST )] = IE∗ φ ST − ST


= φ z ϕ (z)dz,
0
where
w∞
ϕ (z) = ϕ1 (z + y)ϕ2 (y)dydy
w ∞0 2 2 2 2 2 2
= e −(−(r−σ1 /2)T +log((z+y)/S0 )) /(2σ1 T )−(−(r−σ2 /2)T +log(y/S0 )) /(2σ2 T )
0
dy
×
2πT σ1 σ2 (z + y)y
is the probability density function of ST .

1.6
1.4
1.2
1
0.8
0.6
0.4
0.2 Gaussian PDF
Integral formula
0
-1 -0.5 0 0.5 1
z

Figure S.14: Gaussian approximation of spread probability density function.

0.12
Integral evaluation
0.1 Monte Carlo estimation
Gaussian approximation
0.08

0.06

0.04

0.02

0
0 0.2 0.4 0.6 0.8 1
K

Figure S.15: Gaussian approximation of spread option prices.

Exercise 3.20 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 ) IE∗ [φ (ST ) | Ft ], 0 ⩽ t ⩽ T,

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FN6516 Stochastic Calculus in Finance II 249

where IE∗ denotes expectation under the risk-neutral measure P∗ . Hence, from the noncentral Chi
square probability density function

fT −t (x)

! αβ /σ 2 −1/2
2β 2β x + rt e −β (T −t ) x
= 2
exp −
σ 1 − e −β (T −t ) σ 2 1 − e −β (T −t ) rt e −β (T −t )


p !
4β rt x e −β (T −t )
× I2αβ /σ 2 −1
,
σ 2 1 − e −β (T −t )

of ST given St , x > 0, we find

g(t, St ) = e −r(T −t ) IE∗ [φ (ST ) | Ft ]

2β e −r(T −t ) w∞ 
x
αβ /σ 2 −1/2 β (x+S e −β (T −t ) )
−2 2 t −β (T −t )
= 2 φ ( x ) e σ (1− e )
σ 1 − e −β (T −t ) 0 St e −β (T −t )


p !
4β xSt e −β (T −t )
× I2αβ /σ 2 −1
dx
σ 2 1 − e −β (T −t )

0 ⩽ t ⩽ T , under the Feller condition 2αβ ⩾ σ 2 .

Exercise 3.21
a) We have
∂f ∂f
(t, x) = (r − σ 2 /2) f (t, x), (t, x) = σ f (t, x),
∂t ∂x
and
∂2 f
(t, x) = σ 2 f (t, x),
∂ x2
hence
dSt = d f (t, Bt )
∂f ∂f 1 ∂2 f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t  ∂x 2 ∂ x2
1 1
= r − σ 2 f (t, Bt )dt + σ f (t, Bt )dBt + σ 2 f (t, Bt )dt
2 2
= r f (t, Bt )dt + σ f (t, Bt )dBt
= rSt dt + σ St dBt .
b) We have
IE e σ BT Ft = IE e (BT −Bt +Bt )σ Ft
  

= e σ Bt IE e (BT −Bt )σ Ft
 

= e σ Bt IE e (BT −Bt )σ
 
2 (T −t ) /2
= e σ Bt +σ
.
c) We have
2
IE[ST | Ft ] = IE e σ BT +rT −σ T /2 Ft
 
2
= e rT −σ T /2 IE e σ BT Ft
 
2 T /2 2 (T −t ) /2
= e rT −σ e σ Bt +σ
2 t/2
= e rT +σ Bt −σ

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 250 Exercise Solutions
2 t/2
= e (T −t )r+σ Bt +rt−σ
= e (T −t )r St , 0 ⩽ t ⩽ T.
d) We have
Vt = e −(T −t )r IE[C | Ft ]
= e −(T −t )r IE[ST − K | Ft ]
= e −(T −t )r IE[ST | Ft ] − e −(T −t )r IE[K | Ft ]
= St − e −(T −t )r K, 0 ⩽ t ⩽ T.
e) We take ξt = 1 and ηt = −K e −rT /A0 , t ∈ [0, T ].
f) We find
VT = IE[C | FT ] = C.

Exercise 3.22 Binary options.

a) By definition of the indicator (or step) functions 1[K,∞) and 1[0,K ] we have
 
 1 if x ⩾ K,  1 if x ⩽ 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 IE[Cb | Ft ]
= e −(T −t )r IE 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 ) + α 1[0,K ) (ST )

is given by
πt (Cα ) = e −(T −t )r IE 1[K,∞) (ST ) + α 1[0,K ) (ST ) St
 

= e −(T −t )r P(ST ⩾ K | St ) + α e −(T −t )r P(ST ⩽ 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

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FN6516 Stochastic Calculus in Finance II 251

1.2
1
0.8
0.6
0.4
0.2
0

15

10 200
150
5 100
Time to maturity T-t 50
0 Underlying (HK$)
0

Figure S.16: 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 IE[Cb | Ft ] + e −(T −t )r IE[Pb | Ft ]
= e −(T −t )r IE[Cb + Pb | Ft ]
e −(T −t )r IE 1[K,∞) (ST ) + 1[0,K ] (ST ) Ft
 
=
e −(T −t )r IE 1[0,∞) (ST ) Ft
 
=
= e −(T −t )r IE[1 | Ft ]
= e −(T −t )r , 0 ⩽ t ⩽ 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 )
 
−(T −t )r ∂
= e Φ √
∂x σ T −t x=St
1 2
= e −(T −t )r p e −(d− (T −t )) /2
σ St 2(T − t )π
> 0.
The Black-Scholes hedging strategy of such a call option does not involve short selling
because ξt > 0 at all times t, cf. Figure S.17 which represents the risky investment in the
hedging portfolio of a binary call option.

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 252 Exercise Solutions

Figure S.17: Risky hedging portfolio value for a binary call option.

Figure S.18 presents the risk-free hedging portfolio value for a binary call option.

Figure S.18: 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 )
 
−(T −t )r ∂
= e Φ − √
∂x σ T −t x=St
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 3.23 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, we have

C (x, T ) = IE e −rT φ (ST ) S0 = x

 
(S.4)
 wT wT
= IE φ (x) − r e −rt φ (St )dt + r e −rt St φ ′ (St )dt
0 0

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FN6516 Stochastic Calculus in Finance II 253
wT 1 w T −rt ′′

−rt ′ 2
+σ e St φ (St )dBt + e φ (St )σ (St )dt S0 = x
0 2 0
w  w 
T T
−rs −rt ′
= φ (x) − r IE e φ (St )dt S0 = x + r IE e St φ (St )dt S0 = x
0 0
w 
1 T
−rt ′′ 2
+ IE e φ (St )σ (St )dt S0 = x
2 0
wT wT
r e −rt IE φ (St ) S0 = x dt + r e −rt IE St φ ′ (St ) S0 = x dt
   
= φ (x ) −
0 0
1 w T −rt  ′′ 2

+ e IE φ (St )σ (St ) S0 = x dt,
2 0
hence, by differentiation with respect to T we find
∂
e −rT IE[φ (ST ) | S0 = x]


ThetaT =
∂T
= −r e −rT IE φ (ST ) S0 = x + r e −rT IE ST φ ′ (ST ) S0 = x
   

1
+ e −rT IE φ ′′ (ST )σ 2 (ST ) S0 = x .
 
2

Problem 3.24 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 IE∗ [(ST − K )+ | Ft ] − e −(T −t )r IE∗ [(K − ST )+ | Ft ]
= e −(T −t )r IE∗ [ST − K | Ft ]
= e −(T −t )r IE∗ [ST | Ft ] − K e −(T −t )r
= St − K e −(T −t )r , 0 ⩽ t ⩽ T.
b) The price this contract at time t ∈ [0, T ] can be written as
e −(T −t )r IE∗ [P(T , ST , K,U ) | Ft ]
h i
= e −(T −t )r IE∗ e −(U−T )r IE∗ (K − SU )+ | FT | Ft
 

= e −(U−t )r IE∗ (K − SU )+ | Ft
 

= P(t, St , K,U ).
c) From the call-put parity (3.5.24) 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 IE∗ [Max(P(T , ST , K,U ),C (T , ST , K,U )) | Ft ]
= e −(T −t )r IE∗ [P(T , ST , K,U ) | Ft ]
h i
+ e −(T −t )r IE∗ Max(ST − K e −(U−T )r , 0) | Ft
= e −(T −t )r IE∗ [ e −(U−T )r IE∗ [(K − SU )+ | FT ] | Ft ]
+ e −(T −t )r IE∗ Max ST − K e −(U−T )r , 0 Ft



= e −(U−t )r IE∗ [(K − SU )+ | Ft ]

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 254 Exercise Solutions

+ e −(T −t )r IE∗ Max ST − K e −(U−T )r , 0 Ft




= P(t, St , K,U ) + C t, St , K e −(U−T )r , T .

(S.5)

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
Figure S.19: Black-Scholes price of the maximum chooser option.

e) By (S.5), 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

Figure S.20: Delta of the maximum chooser option.

f) From the call-put parity (3.5.24) 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)

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 255

= 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 IE∗ min P(T , ST , K,U ),C (T , ST , K,U ) Ft




= e −(T −t )r IE∗ [C (T , ST , K,U ) | Ft ]

− e −(T −t )r IE∗ Max ST − K e −(U−T )r , 0 Ft



= e −(T −t )r IE∗ [ e −(U−T )r IE∗ [(SU − K )+ | FT ] | Ft ]

− e −(T −t )r IE∗ Max ST − K e −(U−T )r , 0 Ft



= e −(U−t )r IE∗ (SU − K )+ | Ft

 

− e −(T −t )r IE∗ Max ST − K e −(U−T )r , 0 Ft




= C (t, St , K,U ) −C t, St , K e −(U−T )r , T .

(S.6)

8
7
6
5
4
3
2
1
0

8
6
4 140
Time to maturity T-t 120
100
2 80
60
40
0 20
0 Underlying

Figure S.21: Black-Scholes price of the minimum chooser option.

h) By (S.6), we have

∂C ∂C
t, St , K e −(U−T )r , T


ξt = (t, St , K,U ) −
∂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

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 256 Exercise Solutions

0.6
0.4
0.2
0
-0.2
-0.4

8
6
140
4 120
Time to maturity T-t 100
2 80
60
40
0 20 Underlying
0

Figure S.22: 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 the 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 3.25
a) The self-financing condition reads
dVt = ηt dAt + ξt dSt
= rηt At dt + µξt St dt + σ ξt St dBt
= rVt dt + ( µ − r )ξt St dt + σ ξt St dBt ,
hence 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 − πs d Bbs .
t t
c) We have wT wT
Vt = VT − r Vs ds − πs d Bbs ,
t t

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 257

hence
dVt = rVt dt + πt d Bbt ,
and after discounting we find
dVet = −r e −rt Vt dt + e −rt dVt
= −r e −rt Vt dt + e −rt (rVt dt + πt d Bbt )
= e −rt πt d Bbt ,
which shows that wT
VeT = V0 + e −rt πt d Bbt ,
0
after integration in t ∈ [0, T ].
d) We have
dVt = du(t, St )
∂u ∂u ∂u
= (t, St )dt + µSt (t, St )dt + σ St (t, St )dBt
∂t ∂x ∂x
1 2 2 ∂ 2u
+ σ St 2 (t, St )dt. (S.7)
2 ∂x
e) By matching the Itô formula (S.7) term by term to the BSDE (3.5.27) we find that Vt = u(t, St )
satisfies the PDE
∂ 2u
 
∂u ∂u 1 ∂u
(t, x) + µ (t, x) + σ 2 x2 2 (t, x) + f t, x, u(t, x), σ x (t, x) = 0.
∂t ∂x 2 ∂x ∂x
f) In this case we have
∂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 = σ ξt St = σ St Φ √ , 0 ⩽ t ⩽ 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 + σ ξt St dBt − γSt (ξt )− dt
= rVt dt + ( µ − r )ξt St dt − γSt (ξt )− dt + σ ξt St dBt ,
we get the BSDE w wT
T
rVs + ( µ − r )πs + γ (πs )− ds −


Vt = VT − πs dBs .
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 + σ ξt St dBt .

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 258 Exercise Solutions

j) We find the nonlinear PDE

−
∂ 2u

∂u ∂u 1 ∂u
(t, x) + rx (t, x) + σ 2 x2 2 (t, x) − γσ x (t, x) = ru(t, x), (S.8)
∂t ∂x 2 ∂x ∂x

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
= 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 + σ ξt St dBt ,
which yields the BSDE
wT wT
rVs + ( µ − r )πs − (R − r )(Vs − ξs Ss )− ds −


Vt = VT − πs dBs ,
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 2 2 ∂ 2u
 
∂u ∂u ∂u
(t, x) + µ (t, x) + σ x (t, x) + f t, x, u(t, x), σ x (t, x) = 0
∂t ∂x 2 ∂ x2 ∂x

rewrites as
−
1 2 2 ∂ 2u

∂u ∂u ∂u
(t, x) + r (t, x) + σ x (t, x) = ru(t, x) + (r − R) u(t, x) − x (t, x) .
∂t ∂x 2 ∂ x2 ∂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 3.26 Girsanov Theorem. For all n ⩾ 1, let

:= 1{ψt ∈[−n,n]} ψt ,
(n)
ψt 0 ⩽ t ⩽ T.

(n)
Since (ψt )t∈[0,T ] is a bounded process it satisfies the Novikov integrability condition (3.3.1),
hence for all n ⩾ 1 and random variable F ∈ L1 (Ω) we have
  w·   w
T (n) 1 w T (n) 2

(n)
IE[F ] = IE 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)
IE[F ] = lim IE F B· + ψs ds exp − ψs dBs − (ψs ) ds
n→∞ 0 0 2 0
  w·   w
T (n) 1 w T (n) 2

(n)
⩾ IE lim inf F B· + ψs ds exp − ψs dBs − (ψs ) ds
n→∞ 0 0 2 0
  w·   w
T 1wT

= IE F B· + ψs ds exp − ψs dBs − (ψs )2 ds ,
0 0 2 0

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 259

where we applied Fatou’s Lemma.*

Problem 3.27
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 β σM dBt + σS dWt , σM dBt
=
Var[σM dBt ]



Cov β σM dBt , σM dBt + Cov σS dWt , σM dBt
=
Var[σM dBt ]


Cov β σM 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 + β St ( µdt + σM dBt − rdt ) + σS St dWt


= (r + α + β ( µ − r ))St dt + St β σM dBt + σS dWt
β σM dBt + σS dWt
q
= (r + α + β ( µ − r ))St dt + St β 2 σM2 + σS2 q .
2 + σ2
β 2 σM S
Now, we
 have 2
2
2
β σ dB + σ dW β σM dBt + β σM σS dBt • dWt + σS dWt
 qM t S t
= 2 + σ2
β 2 σM
2
β 2 σM + σS 2 S

β 2 σM
2 (dB )2 + σ 2 (dW )2
t S t
= 2 + σ2
β 2 σM S
β 2 σM2 dt + σ 2 dt
S
= 2 + σ2
β 2 σM S
= dt.
By the characterization of Brownian motion as the only continuous martingale whose
quadratic variation is dt, it follows that the process (Zt )t∈R+ defined by
β σM 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 Klebaner, 2005. Hence,
we have

dSt = (r + α + β ( µ − r ))St dt + St β σM dBt + σS dWt
* IE[limn→∞ Fn ] ⩽ limn→∞ IE[Fn ] for any sequence (Fn )n∈N of nonnegative random variables, provided that the limits
exist, see MH4100 Real Analysis II.

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 260 Exercise Solutions
q
= (r + α + β ( µ − r ))St dt + St β 2 σM2 + σS2 dZt .
In what follows 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 (S.9)
σM
and
α
dWt∗ = dWt + dt (S.10)
σS
in order to have

dMt

 = µdt + σM dBt = rdt + σM dBt∗ ,
M

t





  
dSt dMt (S.11)
= (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 under the probability
measure P∗B defined by its Radon-Nikodym density

dP∗B µ −r ( µ − r )2
 
= exp − BT − 2
T ,
dP σM 2σM

and (Wt∗ )t∈[0,T ] is a standard Brownian motion under the probability measure PW
∗ defined by

its Radon-Nikodym density

∗ α2
 
dPW 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 dPW ∗ µ −r ( µ − r )2 α2

 
α
= × = exp − BT − WT − 2
T − 2T .
dP dP dP σM σS 2σM 2σS

Indeed, for any sequence t0 = 0 < t1 < · · · < tn−1 < tn = T we have
 ∗ 
∗
 ∗ ∗ ∗ ∗

 dP ∗ ∗ ∗ ∗


IE f Bt1 − Bt0 , . . . , Btn − Btn−1 = IE f Bt1 − Bt0 , . . . , Btn − Btn−1
dP
= IE f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1


µ −r ( µ − r )2 α2
 
α
× exp − BT − 2
T − WT − 2 T
σM 2σM σS 2σS
µ −r ( µ − r )2
  
∗ ∗ ∗ ∗


= IE f Bt1 − Bt0 , . . . , Btn − Btn−1 exp − BT − 2
T
σM 2σM
α2
  
α
× IE exp − WT − 2 T
σS 2σS

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FN6516 Stochastic Calculus in Finance II 261

µ −r ( µ − r )2
  
∗ ∗ ∗ ∗


= IE f Bt1 − Bt0 , . . . , Btn − Btn−1 exp − BT − 2
T
σM 2σM


= IE f Bt1 − Bt0 , . . . , Btn − Btn−1 ,

and similarly for (Wt∗ )t∈[0,T ] .

e) By (S.11), the discounted price processes

(Set )t∈R+ := ( e −rt St )t∈R+ and et )t∈R+ := ( e −rt Mt )t∈R+

(M

satisfy
et dBt∗ ,

et = σM M
 dM

d Set = σM β (Mt )Set dBt∗ + σS Set dWt∗ ,



hence by
the Girsanov theorem of Question (d)) the discounted two-dimensional process
Set , M
et
t∈R+
is a martingale under the probability measure P ∗ , showing that P∗ is a risk-

neutral probability measure. Therefore, 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

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 = d f (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∗ . (S.12)

On the other hand, by the Itô formula for two state variables, we have

∂f ∂f 1 ∂2 f
d f (t, St , Mt ) = (t, St , Mt )dt + (t, St , Mt )dSt + (t, St , Mt )(dSt )2
∂t ∂x 2 ∂ x2
∂f 1 ∂2 f 2 ∂2 f
+ (t, St , Mt )dMt + (t, St , M t )( dM t ) + (t, St , Mt )dSt • dMt
∂y 2 ∂ y2 ∂ x∂ y
∂f ∂f
= (t, St , Mt )dt + (t, St , Mt )(rSt dt + σM β (Mt )St dBt∗ + σS St dWt∗ )
∂t ∂x
1 ∂2 f
+ (t, St , Mt )(σM2 β 2 (Mt )St2 + σS2 St2 )dt
2 ∂ x2

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 262 Exercise Solutions

∂f 1 ∂2 f
+ (t, St , Mt )(rMt dt + σM Mt dBt∗ ) + (t, St , Mt )σM2 Mt2 dt
∂y 2 ∂ y2
∂2 f
+ 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 )(σM2 β 2 (Mt )St2 dt + σS2 St2 dt )
∂x 2 ∂ x2
∂f ∂f
+ rMt (t, St , Mt )dt + σM Mt (t, St , Mt )dBt∗
∂y ∂y
1 ∂2 f 2 2 2 ∂2 f
+ ( t, St , Mt ) σ M
M t dt + σ S M
M t t β ( Mt ) (t, St , Mt )dt
2 ∂ y2 ∂ x∂ y
∂f ∂f ∂f
= (t, St , Mt )dt + rMt (t, St , Mt )dt + rSt (t, St , Mt )dt
∂t ∂y ∂x
1 ∂ f2 1 ∂2 f
+ σM2 Mt2 2 (t, St , Mt )dt + σM2 β 2 (Mt )St2 2 (t, St , Mt )dt
2 ∂y 2 ∂x
1 2
∂ f ∂2 f
+ σS2 St2 2 (t, St , Mt )dt ) + σM2 St Mt β (Mt ) (t, St , Mt )dt
2 ∂x ∂ x∂ y
 
∂f ∂f
+ σM β (Mt )St (t, St , Mt ) + σM Mt (t, St , Mt ) dBt∗ (S.13)
∂x ∂y
∂f
+ σS St (t, St , Mt )dWt∗ .
∂x
By identification of the terms in dt in (S.12) and (S.13), we find

∂f ∂f
r f (t, St , Mt ) =(t, St , Mt ) + rSt (t, St , Mt )
∂t ∂x
1 2
∂ f
+ (σS2 + σM2 β 2 (Mt ))St2 2 (t, St , Mt )
2 ∂x
∂f 1 2 2∂2 f ∂2 f
+ rMt (t, St , Mt ) + σM Mt 2 (t, St , Mt ) + σM2 St Mt β (Mt ) (t, St , Mt )dt,
∂y 2 ∂y ∂ x∂ y
which yields the PDE
r f (t, x, y) (S.14)
∂f ∂f 1 ∂2 f
= (t, x, y) + rx (t, x, y) + x2 (σS2 + σM2 β 2 (y)) 2 (t, x, y)
∂t ∂x 2 ∂x
∂f 1 2 2∂2 f 2 ∂2 f
+ry (t, x, y) + σM y (t, x, y ) + σM xyβ ( y ) (t, x, y),
∂y 2 ∂ y2 ∂ x∂ y
with the terminal condition

f (T , x, y) = h(x, y), x, y > 0.

h) By identification of terms in dBt∗ and dWt∗ in (S.12) and (S.13), 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

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FN6516 Stochastic Calculus in Finance II 263

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 ⩽ t ⩽ T.
A0 e rt
i) When the option payoff depends only on ST we can look for a solution of (S.14) of the form
f (t, x), in which case (S.14) simplifies to

∂f ∂f 1 ∂2 f
r f (t, x, y) = (t, x, y) + rx (t, x, y) + x2 (σS2 + σM2 β 2 (y)) 2 (t, x, y), (S.15)
∂t ∂x 2 ∂x
When β (Mt ) = β is a constant, (S.15) becomes the Black-Scholes PDE with squared volatil-
ity parameter
σ 2 := σS2 + σM
2 2
β .
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(x, K, 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

2 β 2 ) /2)(T − t )
log(x/K ) + (r − (σS2 + σM
d− (T − t ) := √ ,
|σ | T − t

and
∂f
(t, St , Mt ) = Φ d+ (T − t ) ,


ξt =
∂x
with
K −(T −t )r K
Φ d− (T − t ) = − e −Tr Φ d− (T − t ) ,



ηt = − e 0 ⩽ t < T.
At A0
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

ζt = (t, St , Mt ) = −Φ − d+ (T − t ) , 0 ⩽ t < T.
∂y

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 264 Exercise Solutions

and
K −Tr
e Φ − d− (T − t ) ,


ηt = 0 ⩽ t < T.
A0
Remark. By the answer to Question (b)) we have
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, hence the answers to Questions (i)) and j)
can be recovered from the pricing relation

f (t, St ) = e −(T −t )r IE∗ φ (ST ) | Ft ],


0 ⩽ t ⩽ T.

Problem 3.28
1) a) It suffices to let τn := T , n ⩾ 1. Then, the sequence (τn )n⩾1 clearly satisfies Condi-
tions (v) − (vi), and the process (Mτn ∧t )t∈[0,T ] = (Mt )t∈[0,T ] is a (true) martingale under
P.
b) Applying
i) the local martingale property to a suitable sequence (τn )n⩾1 of stopping times, and
ii) Fatou’s Lemma to the nonnegative sequence (Mτn ∧t )n⩾1 ,
we have
IE[Mt | Fs ] = IE lim Mτn ∧t Fs
 
n→∞
⩽ lim inf IE[Mτn ∧t | Fs ]
n→∞
= lim inf Mτn ∧s
n→∞
= lim Mτn ∧s
n→∞
= Ms , 0 ⩽ s ⩽ t ⩽ T,
which shows that (Mt )t∈[0,T ] is a supermartingale.
c) Since (Mt )t∈[0,T ] is a supermartingale by Question (b)), for any t ∈ [0, T ] we have
IE[MT | Ft ] − Mt ⩽ 0 a.s., and there exists t ∈ [0, T ] such that IE[IE[MT | Ft ] − Mt ] < 0,
otherwise we would have IE[MT | Ft ] − Mt = 0 a.s. for all t ∈ [0, T ], and (Mt )t∈[0,T ]
would be a martingale by the tower property.* Therefore, using again the tower property,
we find

IE[MT − M0 ] = IE[IE[MT | Ft ] − M0 ] ⩽ IE[IE[MT | Ft ] − Mt ] < 0.

d) We have
C (0, M0 ) − P(0, M0 ) = e −rT IE[( e rT MT − K )+ − (K − e rT MT )+ ]
= IE[(MT − e −rT K )+ − ( e −rT K − MT )+ ]
= IE[MT − e −rT K ]
< IE[M0 ] − e −rT K,
showing that the call-put parity relation C (0, M0 ) − P(0, M0 ) = IE[M0 ] − e −rT K is not
satisfied.
2) a) The√stochastic differential equation can be rewritten as dSt = σ (t, St )dBt where σ (t, x) =
x/ T − t, t ∈ [0, T − ε ], satisfies the global Lipschitz condition

x−y |x − y|
|σ (t, x) − σ (t, y)| = √ ⩽ , x, y ∈ R.
T −t T −ε
* If Mt = IE[MT | Ft ] for all t ∈ [0,t ] then Ms = IE[MT | Fs ] = IE[IE[MT | Ft ] | Fs ] = IE[MT | Fs ], 0 ⩽ s ⩽ t ⩽ T .

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 265

Hence by e.g. Theorem V-7 in Protter, 2004 this stochastic differential equation admits
unique (strong) solution such that

wt S
s
St = S0 + dBs , 0 ⩽ t ⩽ T − ε.
0 T −s

Next, we have w
1 w t ds

dBst
St = S0 exp √ −
0 T −s 2 0 T −s
w 
t dBs 1 T
= S0 exp √ − log
0 T −s 2 T −t
r w 
t t dBs
= S0 1 − exp √ , 0 ⩽ t ⩽ T − ε.
T 0 T −s
b) We have ST = 0, as can be checked from the graphs of Question (d ) below.
c) Consider the stopping times

  
1
τn := 1− T ∧ inf{t ∈ [0, T ] : |St | ⩾ n}, n ⩾ 1.
n

for all n ⩾ 1 the stopped process (Sτn ∧t )t∈[0,T ] is given by

w τn ∧t S wt S
Sτn ∧t = S0 + √ u dBu = S0 + 1[0,τn ] (u) √ u dBu ,
0 T −u 0 T −u

√
0 ⩽ t ⩽ T , and the process (1[0,τn ] (u)Su / T − u)0⩽u⩽τn ∧t is square integrable as

w w
Su2 n2
 
T (1−1/n)T
IE 1[0,τn ] (u) du ⩽ IE 1[0,τn ] (u) du ,
0 T −u 0 T −u

hence by Proposition 8.1 the stopped process (Sτn ∧t )t∈[0,T ] is a (true) martingale under
P for all n ⩾ 1, and therefore (St )t∈[0,T ] is a local martingale on [0, T ]. Finally, we note
that since 0 = IE[ST ] ̸= S0 , the process (St )t∈[0,T ] is not a martingale.
√
d) The following code solves the stochastic differential equation dSt = St dBt / 1 − t by
the Euler scheme.

N=10000; t <- 0:N; dt <- 1.0/N;

dB <- rnorm(N,mean=0,sd=sqrt(dt));S <- rep(0,N+1);S[1]=1.0
for (k in 2:(N-1)){S[k]=S[k-1]+S[k-1]*dB[k]/sqrt(1-k*dt)}
plot(t*dt, S, xlab = "t", ylab = "", type = "l", ylim = c(0,1.05*max(S)), col = "blue", xaxs =
"i", yaxs = "i",cex.axis=1.6,cex.lab=1.8)

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 266 Exercise Solutions

7
6
5
4
3
2
1
0

0.0 0.2 0.4 0.6 0.8 1.0

t
√
Figure S.23: Sample path of dSt = St dBt / 1 − t.

3) a) The following code solves the stochastic differential equation dSt = St2 dBt by the Euler
scheme.

N=10000; t <- 0:N; dt <- 1.0/N;

dB <- rnorm(N+1,mean=0,sd=sqrt(dt));S <- rep(0,N+1);S[1]=1.0
for (k in 2:(N+1)){S[k]=S[k-1]+S[k-1]^2*dB[k]}
plot(t*dt, S, xlab = "t", ylab = "", type = "l", ylim = c(1.05*min(S),1.05*max(S)), col =
"blue", xaxs = "i", yaxs = "i",cex.axis=1.6,cex.lab=1.8)
6
5
4
3
2
1

0.0 0.2 0.4 0.6 0.8 1.0

t

Figure S.24: Sample path of dSt = St2 dBt .

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 267

3.5
3.0
2.5
2.0
1.5
1.0

0.0 0.2 0.4 0.6 0.8 1.0

t

Figure S.25: Sample path of dSt = St2 dBt .

b) With the change of variable y = 1/x and dy = −dx/x2 , we have

w∞
IE[ST ] = xϕT (x)dx
0
w∞ S0
 
(1/x − 1/S0 )2
 
(1/x + 1/S0 )2

= √ exp − − exp − dx
0 x2 2πT 2T 2T
w∞ S 
(y − 1/S0 )2
 w∞ S 
(y + 1/S0 )2

= √ 0 exp − dy − √ 0 exp − dy
0 2πT 2T 0 2πT 2T
w∞ S0
 2
y w∞ S0
 2
y
= √ exp − dy − √ exp − dy
−1/S0 2πT 2t 1/S0 2πT 2T
w∞ S0
 2
y w∞ S0
 2
y
= √ √ exp − dy − √ √ exp − dy
−1/(S0 T ) 2π 2 1/(S0 T ) 2π 2
√ √
= S0 Φ(1/(S0 T )) − S0 Φ(−1/(S0 T ))
√
= S0 (1 − 2Φ(−1/(S0 T ))).
c) We have
   
1 1
IE[ST ] = 2S0 Φ √ −
S0 T 2
w √ w0 
1/(S0 T ) 2 dx 2 dx
= 2S0 e −x /2 √ − e −x /2 √
−∞ 2π −∞ 2π
w 1/(S0 √T ) 2 dx
= 2S0 e −x /2 √
0 2π
w 1/√T 2 dy
= 2 e −(y/S0 ) /2 √ ,
0 2π
hence by the dominated convergence theorem we have
w 1/√T 2 dy
lim IE[ST ] = lim 2 e −(y/S0 ) /2 √
S0 →∞ S0 →∞ 0 2π
w 1/√T 2 dy
= 2 lim e −(y/S0 ) /2 √
0 S0 →∞ 2π
w 1/√T dy
= 2 1√
0 2π

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 268 Exercise Solutions
r
2
= .
πT
d) With the change of variable y = 1/x and dy = −dx/x2 , we have
w∞
IE[(ST − K )+ ] = (x − K )+ ϕT (x)dx
0
w ∞ x−K  
(1/x − 1/S0 )2
 
(1/x + 1/S0 )2

= S0 √ exp − − exp − dx
K x3 2πT 2T 2T
w 1/K S  
(y − 1/S0 )2
 
(y + 1/S0 )2

0
= √ exp − − exp − dy
0 2πT 2T 2T
w 1/K y  
(y − 1/S0 )2
 
(y + 1/S0 )2

−KS0 √ exp − − exp − dy
0 2πT 2T 2T
w 1/K−1/S0 S 
y2
 w 1/K +1/S0 S 
y2

= √ 0 exp − dy − √ 0 exp − dy
−1/S0 2πT 2T 1/S0 2πT 2T
w 1/K−1/S0 y + 1/S  2
y
0
−KS0 √ exp − dy
−1/S0 2πT 2T
w 1/K +1/S0 y − 1/S  2
y
0
+KS0 √ exp − dy
1/S0 2πT 2T
   
1 1 1
= S0 Φ √ − √ − S0 Φ − √
K T S0 T S T
   0 
1 1 1
−S0 Φ √ + √ + S0 Φ √
K T S0 T S0 T
√ √
   
1 1 1 1
+KS0 T ϕ √ − √ − KS0 T ϕ √ + √
K T S0 T K T S0 T
   
1 1 1
−KΦ √ − √ + KΦ − √
K T S0 T S T
   0 
1 1 1
−KΦ √ + √ + KΦ √
K T S0 T S T
   0 
1 1 1
= S0 Φ √ − √ − S0 Φ − √
K T S0 T S T
   0 
1 1 1
−S0 Φ √ + √ + S0 Φ √
K T S0 T S0 T
√ √
   
1 1 1 1
+KS0 T ϕ √ − √ − KS0 T ϕ √ + √
K T S0 T K T S0 T
   
1 1 1 1
−KΦ √ − √ − KΦ √ + √ +1
K T S0 T K T S0 T
   
1 1 1
= S0 Φ √ − √ − S0 Φ − √
K T S0 T S T
   0 
1 1 1
−S0 Φ √ + √ + S0 Φ √
K T S0 T S0 T
√ √
   
1 1 1 1
+KS0 T ϕ √ − √ − KS0 T ϕ √ + √
K T S0 T K T S0 T
   
1 1 1 1
+KΦ √ − √ − KΦ √ + √ ,
S0 T K T K T S0 T
2 √
where ϕ (z) := e −z / 2π is the standard normal probability density function, see
Relation (2.1.2) in Jacquier, 2017.

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 269

e) We have
IE[(ST − K )+ ] ⩽ IE[ST ]
w 1/√T 2 dy
= 2 e −(y/S0 ) /2 √
0 2π
w 1/√T dy
⩽ 2 √
0 2π
r
2
⩽ .
πT

Figure S.26: “Infogrames” stock price curve.

Problem 3.29
a) Relation (3.5.31) can be checked to hold first on the event Aα , and then on its complement
Acα . Taking the Q-expectation on both sides of (3.5.31) yields
     
dP dP
IEQ − α (21Aα − 1) ⩾ IEQ − α (21A − 1) ,
dQ dQ
i.e.
   
dP dP
IEQ (21Aα − 1) − α IEQ [21Aα − 1] ⩾ IEQ (21A − 1) − α IEQ [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 show that P(Aα ) − P(A) ⩾ 0 since α ⩾ 0.
b) We check that dQ∗ /dP
w
∗ ⩾ 0 since C ⩾ 0, and

Q∗ (Ω) = dQ∗
Ω
w dQ∗
= dP∗
Ω dP∗
w C
= dP∗
Ω IEP∗ [C ]
 
C
= IEP∗
IEP∗ [C ]

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 270 Exercise Solutions

IEP∗ [C ]
=
IEP∗ [C ]
= 1.
In the next questions we consider a nonnegative contingent claim payoff C ⩾ 0 with maturity
T > 0, priced e −rT IEP∗ [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 IEP∗ [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 IEP∗ [C ] may not able
to hedge the claim C when β < 1, we will attempt to maximize 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
C1A , priced V0A = e −rT IEP∗ [C1A ] at time 0, and such that VTA = C1A at maturity T .
c) Using the probability measure Q∗ , we rewrite the condition (3.5.33) as

dQ∗ IEP∗ [C1A ]

 
Q (A) = IEQ∗ [1A ] = IEP∗ 1A ∗ =
∗
⩽ β,
dP IEP∗ [C ]

i.e.
Q∗ (A) ⩽ Q∗ (Aα ) = β .
By the Neyman-Pearson Lemma, for any event A, the inequality Q∗ (A) ⩽ Q∗ (Aα ) = β
implies P(A) ⩽ P(Aα ), which shows that the event A = Aα realizes the maximum under the
required condition.
d) The obvious inequality is

P(Aα ) ⩽ P(C1Aα ⩾ C ) = P VTAα ⩾ C .

In the other direction, we note that the event Bα := {C1Aα ⩾ C} = VTAα ⩾ C satisfies


(3.5.33), as
e −rT IEP∗ VTBα = e −rT IEP∗ C1Bα
   

= e −rT IEP∗ C1{C1Aα ⩾C}

 

= e −rT IEP∗ C1Aα

 

=  β e −rT
 IEP∗ [C ],
where the last equality IEP∗ C1Aα = β IEP∗ [C ] follows from Q∗ (Aα ) = β and the definition
(3.5.32) of Q∗ .

Therefore, by the result of Question (c)) we have

P(C1Aα ⩾ C ) = P VTAα ⩾ C = P(Bα ) ⩽ P(Aα ).

e) This hedging strategy starts from the initial amount

V0Aα = e −rT IEP∗ [C1Aα ] = β e −rT IEP∗ [C ],

and it satisfies
P VTAα ⩾ C = P(C1Aα ⩾ C ) = P(Aα )

which is the maximum hedging probability under the constraint (3.5.33).

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 271

f) We have
2 t/2
St = S0 e σ Bt +rt−σ = S0 e σ Bt = 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∗ IEP∗ [C ]
= P (αC < IEP∗ [C ])
= P (ST − K )+ < IEP∗ [C ]/α

= P ST − K < IEP∗ [C ]/α

= P ST < K + IEP∗ [C ]/α

= P S0 e BT < K + IEP∗ [C ]/α

= P (BT < log(K + IEP∗ [C ]/α ))

 
log(K + IEP∗ [C ]/α )
= Φ √ .
T
h) We have
IEP∗ [C ]
α= √ .
exp T Φ P VTAα ⩾ C
−1




−K
i) We have
IEP∗ [C1Aα ] = IEP∗ [(ST − K )+ 1Aα ]
h i
= IEP∗ (ST − K )+ 1{BT <log(K +IEP∗ [C]/α )}
h i
= IEP∗ e BT − K 1{BT <log(K +IEP∗ [C]/α )}

+

w log(K +IEP∗ [C]/α )/√T 2 dx

e x − K e −x /2 √


= √
(log K )/ T 2π
w log(K +IEP∗ [C]/α )/√T 2 dx
= √ e x e −x /2 √
(log K )/ T 2π
w log(K +IEP∗ [C]/α )/√T 2 dx
−K √ e −x /2 √
(log K )/ T 2π
w log(K +IEP∗ [C]/α )/√T 2 dx
= √ e 1/2−(x−1) /2 √
(log K )/ T 2π
−K Φ(log(K + IEP∗ [C ]/α )) − Φ(log K )


w −1/√T +log(K +IEP∗ [C]/α )/√T 2 dx
= √ e 1/2−x /2 √
(−1+log K )/ T 2π
−K Φ(log(K + IEP∗ [C ]/α )) − Φ(log K )

√ −1 + log(K + IEP∗ [C ]/α ) −1 + log K

    
= e Φ √ −Φ √
T T
    
log(K + IEP∗ [C ]/α ) log K
−K Φ √ −Φ √ ,
T T
hence
e −rT IEP∗ [C1Aα ]

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 272 Exercise Solutions

−1 + log(K + IEP∗ [C ]/α ) −1 + log K

    
−rT +1/2
= e Φ √ −Φ √
T T
    
log ( K + I
E [C ] /α ) log K
√P
∗
−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
+
IEP∗ [(ST − K ) ] = eS0 Φ(d+ (T )) − KΦ(d− (T ))
= 1.64872 × 0.84134 − 1/2
= 0.88713,
and
e −rT IEP∗ [(ST − K )+ ] = S0 Φ(d+ (T )) − K e −Tr Φ(d− (T ))
= 0.84134 − 0.60653/2
= 0.53807.
ii) By the result of Question (h)), we have
IEP∗ [C ]
α =
exp Φ−1 P VTAα ⩾ C




−K
0.88714
=
exp (Φ−1 (0.9)) − 1
0.88714
= = 0.34165.
e 1.28 − 1
iii) By the result of Question (i)), we find
e −rT IEP∗ [C1Aα ] = Φ(−1 + log(K + IEP∗ [C ]/α )) − Φ(−1 + log K )

−K e −1/2 Φ(log(K + IEP∗ [C ]/α )) − Φ(log K )

= Φ(−1 + log(1 + IEP∗ [C ]/α )) − Φ(−1)

− e −1/2 Φ(log(1 + IEP∗ [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 IEP∗ [C1Aα ] 0.20915

β= −rT
= = 37.53%.
e IEP [C ]
∗ 0.53807

Problem 3.30
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 ̸= 0.

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FN6516 Stochastic Calculus in Finance II 273

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

meaning that we invest the amount β Ft in the risky asset St , and borrow/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 = β Ft /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 (S.16)
St
= β Ft (rdt + σ dBt ) − (β − 1)rFt dt
= rFt dt + β σ Ft dBt , t ⩾ 0.
By (S.16), 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. By the Discounting Lemma, the discounted fund value
Fet := e −rt Ft , t ⩾ 0, satisfies the stochastic differential equation

d Fet = β σ Fet dBt ,

hence by Proposition 3.1 it is a martingale.

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 ) = β σ e −rt Ft dBt , t ⩾ 0.

g) We have
2 σ 2 t/2
Ft = F0 e β σ Bt +rt−β
and  β
2 2
St = S0 e σ Bt +rt−σ t/2 = F0 e β σ Bt +β rt−β σ t/2 ,
β

hence
2 t/2
Ft = St e −(β −1)rt−β (β −1)σ
β
, 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 IE∗ (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
−K e Φ √ ,
|β |σ T − t

t ∈ [0, T ).

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 274 Exercise Solutions

i) We have

log(Ft /K ) + (r + β 2 σ 2 /2)(T − t )
 
Φ √
|β |σ T − t
2
!
log(St e −(β −1)rt−β (β −1)σ t/2 /K ) + (r + β 2 σ 2 /2)(T − t )
β
=Φ √
|β |σ T − t
!
β
log(St /K ) − (β − 1)rt − β (β − 1)σ 2t/2 + (r + β 2 σ 2 /2)(T − t )
=Φ √
|β |σ T − t
2
!
log(St /(K e (β −1)rT −(T /2−t )(β −1)β σ )) + (T − t )β r + (T − t )β σ 2 /2
β
=Φ √
|β |σ T − t
!
log(St /Kβ (t )) + (r + σ 2 /2)(T − t )
=Φ √ , 0 ⩽ 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 )β r + (T − t )β σ 2 /2
= Φ √
|β |σ T − t
!
log(St /Kβ (t )) + (r + σ 2 /2)(T − t )
= Φ − √ , 0 ⩽ t < T,
σ T −t
which coincides, up to a negative sign, with the Delta of the put option on ST with strike
2
price Kβ (t ) := K 1/β e (β −1)(rT /β −(T /2−t )σ ) .

Chapter 4
Exercise 4.1
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 Proposition 4.5-(a)).
b) Taking σ := 1 and µ := σ 2 /2 > 0, the process e Bt can be written as
2 t/2+ µt 2 t/2
e Bt = e σ Bt −σ = e µt e σ Bt −σ , t ∈ R+ ,
2
hence it is a submartingale as the driftless geometric Brownian motion e σ Bt −σ t/2 is a
martingale.
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 )0⩽s⩽t and of the (deterministic) curve ( e s/2 + αs e s/2 )0⩽s⩽t 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 4.8


+
shows that e Bt∧τ −(t∧τ )/2 t∈R is also a martingale and, in particular, its expected value*


+

IE e Bt∧τ −(t∧τ )/2 = IE e B0∧τ −(0∧τ )/2 = IE e B0 −0/2 = 1

     

*We let t ∧ τ := min(t, τ ).

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FN6516 Stochastic Calculus in Finance II 275

 B −τ/2  h t ⩾ 0. This shows

is constantly equal to 1 for all i that
B − (t∧τ ) /2
IE e τ = IE lim e t∧τ
t→∞
= lim IE e Bt∧τ −(t∧τ )/2
 
t→∞
= 1.
Next, we note that e Bτ = (α + β τ ) e τ/2 at time τ, hence α + β τ = e Bτ −τ/2 and

α + β IE[τ ] = IE[α + β τ ] = IE e Bτ −τ/2 = 1,

 

i.e. IE[τ ] = (1 − α )/β .

Remark: This argument also recovers IE[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 4.2 Stopping times.

a) When 0 ⩽ 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 )0⩽s⩽t and of the (deterministic) curve α e −s/2 0⩽s⩽t 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 4.8
shows that e Bt∧τ −(t∧τ )/2 t∈R is also a martingale and in particular its expected value


+

IE e Bt∧τ −(t∧τ )/2 = IE e B0∧τ −(0∧τ )/2 = IE e B0 −0/2 = 1

     

is constantly equal to 1 for all t. This shows that

h i
IE e Bτ −τ/2 = IE lim e Bτ∧t −(τ∧t )/2 = lim IE 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

 1
α IE e −τ = IE e Bτ −τ/2 = 1, IE e −τ = ⩽ 1.
    
i.e.
α
Remark: 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 )0⩽s⩽t and of the (deterministic) curve (1 + αs)0⩽s⩽t 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 4.8
2 − (t ∧ τ ))
shows that (Bt∧τ t∈R+ is also a martingale and in particular its expected value

2
IE[Bt∧τ − (t ∧ τ )] = IE[B20∧τ − (0 ∧ τ )] = IE[B20 − 0] = 0

is constantly equal to 0 for all t. This shows that

h i
2 2
 2 
IE[Bτ − τ ] = IE lim (Bt∧τ − (t ∧ τ )) = lim IE (Bt∧τ − (t ∧ τ )) = 0.
t→∞ t→∞

Next, we note that B2τ = 1 + ατ at time τ, hence

1 + α IE[τ ] = IE[1 + ατ ] = IE[B2τ ] − IE[τ ] = 0,

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 276 Exercise Solutions

i.e.
1
IE[τ ] =
.
1−α
Remark: This argument is valid whenever α ⩽ 1 and yields IE[τ ] = +∞ when α = 1, how-
ever it fails when α > 1 because in that case τ is not a.s. finite.

Exercise 4.3
a) By the StoppinghTime√
Theorem 4.8, i for all n ⩾ 0 we have
2rBτL ∧n −r (τL ∧n)
1 = IE e
h √ i h √ i
= IE e 2rBτL ∧n −r(τL ∧n) 1{τL <n} + IE e 2rBτL ∧n −r(τL ∧n) 1{τL ⩾n}
h √ i h √ i
= IE e 2rBτL −rτL 1{τL <n} + IE e 2rBn −rn 1{τL ⩾n}
√ h √ i
= e L 2r IE e −rτL 1{τL <n} + IE e 2rBn −rn 1{τL ⩾n} .
 

The first term above converges to

√ √
e L 2r IE e −rτL 1{τL <∞} = e L 2r IE 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 ⩽ IE e 2rBn −rn 1{τL ⩾n} ⩽ e −rn IE e L 2r 1{τL ⩾n} ⩽ e −rn e L 2r ,

which tends to 0 as n tends to infinity because r > 0. Therefore we have

h √ i √
1 = lim IE e 2rBτL ∧n −r(τL ∧n) = e L 2r IE e −rτL ,
 
n→∞
√
which yields IE e −rτL = e −L 2r for any r ⩾ 0. When r < 0 we could in fact show that
 

IE e −rτL = +∞.
 

b) In order to maximize

 the quantity
IE e −rτL BτL = IE e −rτL BτL 1{τL <∞}
 

= L IE e −rτL 1{τL <∞}

 

= L IE 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 4.4 See e.g. Theorem 6.16 page 161 of Klebaner, 2005.
a) By the Itô formula, we have
1 w t ′′
Xt = f (Bt ) − f (Bs )ds
2 0
wt 1 w t ′′ 1 w t ′′
= f (B0 ) + f ′ (Bs )dBs + f (Bs )ds − f (Bs )ds
w
0 2 0 2 0
t
= f (B0 ) + f ′ (Bs )dBs ,
0
hence the process (Xt )t∈R+ is a martingale by Proposition 3.1.

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FN6516 Stochastic Calculus in Finance II 277

b) By the Doob stopping time Theorem, we have

f (x) = IE[X0 | B0 = x]
= IE[Xτ∧t | B0 = x]
1 hw τ∧t ′′ i
= IE[ f (Bτ∧t ) | B0 = x] − IE f (Bs )ds | B0 = x
2 0
= IE[ f (Bτ∧t ) | B0 = x] + IE[τ ∧ t | B0 = x],
since f ′′ (y) = −2 for all y ∈ R.
h We note that, by idominated convergence,
 
IE τ | B0 = x = IE lim (τ ∧ t ) | B0 = x
t→∞
= lim IE[τ ∧ t | B0 = x]
t→∞
⩽ | f (x)| + Sup | f (y)|
y∈[a,b]
< ∞,
hence IE[τ ] < ∞ and therefore P(τ < ∞) = 1. Next, we have
f (x) = lim IE[ f (Bτ∧t ) | B0 = x] + lim IE[τ ∧ t | B0 = x]
t→∞ t→∞
h i
= IE lim f (Bτ∧t ) | B0 = x + IE[τ | B0 = x]
t→∞
= IE[ f (Bτ ) | B0 = x] + IE[τ | B0 = x]
= IE[τ | B0 = x],
since f ′′ (x) = −2 and f (a) = f (b) = 0 with Bτ ∈ {a, b}.
Remark. The above exchanges between limt→∞ and the expectation operator IE[ · | B0 = x] is
justified by the dominated convergence theorem, since

| f (Bτ∧t )| ⩽ Sup | f (y)|, t ∈ R+ .

y∈[a,b]

c) The function f (x) can be determined by searching for a quadratic solution of the form
f (x) = α + β x + γx2 , which shows that f ′′ (x) = 2γ = −2 hence γ = −1, and
 2
 f (a) = α + β a − a = 0,



f (b) = α + β b − b2 = 0,


hence α = −ab and β = a + b.

d) We find
IE[τ | B0 = x] = f (x) = −ab + (a + b)x − x2 = (x − a)(b − x).

2 t/2
Exercise 4.5 We use the Stopping Time Theorem 4.8 and the fact that e σ Bt −σ


t∈R+
is a
martingale for all σ ∈ R. By the stopping time theorem, for all n ⩾ 0 we have
2
1 = IE e σ Bτ∧n −σ (τ∧n)/2
 

= IE e σ Bτ∧n −σ (τ∧n)/2 1{τ<n} + IE e σ Bτ∧n −σ (τ∧n)/2 1{τ⩾n}

 2   2 

= IE e σ Bτ −σ τ/2 1{τ<n} + IE e σ Bn −σ n/2 1{τ⩾n}

 2   2 

= e σ α IE e σ β τ−σ τ/2 1{τ<n} + IE e σ Bn −σ n/2 1{τ⩾n} .

 2   2 
(S.17)
2
Under the condition σ 2 ⩾ 2σ β we have 0 ⩽ e σ β τ−σ τ/2 ⩽ 1, hence by dominated or monotone
convergence we find

lim IE e σ β τ−σ τ/2 1{τ<n} = IE e σ β τ−σ τ/2 lim 1{τ<n}

 2   2 
n→∞ n→∞

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 278 Exercise Solutions

= IE e σ β τ−σ τ/2 1{τ<∞} ,

 2 

and the first term in (S.17) converges to

e σ α IE e −(σ /2−σ β )τ 1{τ<∞} = e σ α IE e −(σ /2−σ β )τ

 2   2 

p
as n tends to infinity. In what follows we use the solutions σ± = β ± β 2 + 2r of the equation
r = σ 2 /2 − σ β with σ+ ⩾ 0 and σ− ⩽ 0, and we distinguish two cases.
a) If α ⩾ 0, we have Bn ⩽ α + β n, n ⩽ τ, hence the second term above can be bounded as
0 ⩽ IE e σ+ Bn −nσ+ /2 1{τ⩾n}
 2 

⩽ e −nσ+ /2 IE e ασ+ +β σ+ n 1{τ⩾n}

2  
2
⩽ e ασ+ −nσ+ /2+β σ+ n
= e ασ+ −rn ,
which tends to 0 as n tends to infinity. Therefore, we have
2 2
1 = lim IE e σ+ Bτ∧n −σ+ (τ∧n)/2 = e ασ+ IE e −(σ+ /2−β σ+ )τ ,
   
n→∞

which yields
2
IE e −rτ = IE e −(σ+ /2−β σ+ )τ
   

= e −ασ+ √
2
= e −αβ −α √β +2r
β 2 +2r
= e −αβ −|α| ,
with
(
e −2αβ if β ⩾ 0,
P(τ < +∞) = IE[1{τ<∞} ] = lim IE 1{τ<∞} e −rτ
 
=
r→0 1 if β ⩽ 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

Figure S.27: Hitting times of a straight line started at α < 0.

b) If α ⩽ 0, we have Bn ⩾ α + β n, n ⩽ τ, hence the second term above can be bounded as

0 ⩽ IE e σ− Bn −nσ− /2 1{τ⩾n}
 2 

⩽ e −nσ− /2 IE e ασ− +β nσ− 1{τ⩾n} ⩽ e ασ− −nσ− /2+β nσ−

2   2

= e ασ− −rn ,
which tends to 0 as n tends to infinity. Therefore, we have
2 2
1 = lim IE e σ− Bτ∧n −σ− (τ∧n)/2 = e ασ− IE e −(σ− /2−β σ− )τ ,
   
n→∞

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FN6516 Stochastic Calculus in Finance II 279

which yields
2
IE e −rτ = IE e −(σ− /2−β σ− )τ = e −ασ−
   
√ 2
= e −αβ +α √β +2r
β 2 +2r
= e −αβ −|α| ,
with
(
1 if β ⩾ 0,
P(τ < +∞) = IE[1{τ<∞} ] = lim IE 1{τ<∞} e −rτ
 
=
r→0 e −2αβ if β ⩽ 0.

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

Figure S.28: Hitting times of a straight line started at α < 0.

Exercise 4.6
a) Letting A0 := 0,
An+1 := An + IE[Mn+1 − Mn | Fn ], n ⩾ 0,
and

Nn := Mn − An , n ∈ N, (S.18)

we have
(i) for all n ∈ N,
IE[Nn+1 | Fn ] = IE[Mn+1 − An+1 | Fn ]
= IE[Mn+1 − An − IE[Mn+1 − Mn | Fn ] | Fn ]
= IE[Mn+1 − An | Fn ] − IE[IE[Mn+1 − Mn | Fn ] | Fn ]
= IE[Mn+1 − An | Fn ] − IE[Mn+1 − Mn | Fn ]
= − IE[An | Fn ] + IE[Mn | Fn ]
= Mn − An
= Nn ,
hence (Nn )n∈N is a martingale with respect to (Fn )n∈N .
(ii) We have
An+1 − An = IE[Mn+1 − Mn | Fn ]
= IE[Mn+1 | Fn ] − IE[Mn | Fn ]
= IE[Mn+1 | Fn ] − Mn ⩾ 0, n ∈ N,
since (Mn )n∈N is a submartingale.
(iii) By induction we have

An = An−1 + IE[Mn − Mn−1 | Fn−1 ], n ⩾ 1,

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 280 Exercise Solutions

which is Fn−1 -measurable provided that An is Fn−1 -measurable, n ⩾ 1.

(iv) This property is obtained by construction in (S.18).
b) For all bounded stopping times σ and τ such that σ ⩽ τ a.s., we have
IE[Mσ ] = IE[Nσ ] + IE[Aσ ]
⩽ IE[Nσ ] + IE[Aτ ]
= IE[Nτ ] + IE[Aτ ]
= IE[Mτ ],
by (4.3.4), since (Mn )n∈N is a martingale and (An )n∈N is non-decreasing.

Exercise 4.7
a) The random time τ is a stopping time because for every n ⩾ 0, the validity of the event
{τ > n} can be decided
6 by studying the path of the process (Sk )k⩾0 until time n.
b) The range of possible values of Sτ is {−1, 0, 1, 2, 3, 4, . . .}.
5

Sτ = 3

S0 = 0
0 1 2 3 4 5 6 7 n
τ

Figure S.30: Sample path of the random walk (Sn )n∈N .

c) According to the stopping time theorem, the stopped process (Sn∧τ )n⩾0 is a martingale, and
therefore we have
 
IE[Sτ ] = IE lim Sn∧τ = lim IE[Sn∧τ ] = lim IE[S0 ] = 0.
n→∞ n→∞ n→∞

The exchange between between limit and expected value can be justified from the dominated
convergence theorem, see the next question.
d) We have P(Sτ = −1) = 1/2 and P(Sτ = k) = 1/2k+1 , k ⩾ 0. In particular, we have
Sn∧τ ⩽ 1 + Sτ , and Sτ is integrable according to the next question.
e) We have
IE[Sτ ] = ∑ kP(Sτ = k)
k∈Z
1
= − + ∑ kP(Sτ = k)
2 k⩾0
1
= − + ∑ k2k+2
2 k⩾0
1 1 k
= − + ∑ k−1
2 8 k⩾0 2

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FN6516 Stochastic Calculus in Finance II 281
1 1 1
= − +
2 8 (1 − 1/2)2
= 0.

Chapter 5
Exercise 5.1 The option payoffs at immediate exercise are given as follows:
( K − S2 ) + = 0
2/3
p∗ =
(K − S1 )+ = 0.05
2/3 q∗ =
p =
∗
1/3
(K − S0 )+ = 0.3 (K − S2 )+ = 0.17
q∗ = 2/3
1/3 p∗ =
(K − S1 )+ = 0.35
q∗ =
1/3
(K − S2 )+ = 0.44

On the other hand, the expected payoffs are given by:

( K − S2 ) + = 0

IE∗ [(K − S2 )+ | S1 = 1.2] = 0.17/3

(K − S2 )+ = 0.17

IE∗ [(K − S2 )+ | S1 = 0.9] = 0.26

(K − S2 )+ = 0.44

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 immediately as well.

Exercise 5.2
2
a) Taking f (x) := Cx−2r/σ , we have
2r2 −2r/σ 2
 
′ 1 2 2 ′′ 2r 2
rx f (x) + σ x f (x) = −C 2 x + Cr 1 + 2 x−2r/σ
2 σ σ
2
= Crx−2r/σ
= r f (x ),
and the condition limx→∞ f (x) = 0 is satisfied since r > 0.
b) The conditions f (L∗ ) = K − L∗ and f ′ (L∗ ) = −1 read

∗ −2r/σ 2
 C (L )

 = K − L∗ ,

2r 2
 − C (L∗ )−1−2r/σ = −1,


σ 2

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 282 Exercise Solutions

i.e. 
∗ −2r/σ 2
 C (L )

 = K − L∗

2r
( K − L∗ ) = L∗ ,



σ2
hence
2rK


 L∗ =


 2r + σ 2
2r/σ 2 1+2r/σ 2
Kσ 2 σ2
 
2rK 2rK


 C= = .


2r + σ 2 2r + σ 2 2r 2r + σ 2

Exercise 5.3
a) This an American put option with strike price considered at S0 ⩾ L∗ , hence by Propositions 5.2
and 5.4 the price of this option is
 −2r/σ 2
∗ ∗
 −τ ∗  ∗ S0
(K − L ) IE e L = (K − L ) ∗ .
L
b) This an American put option with strike price K and immediately exercised at S0 ⩽ L∗ , hence
by Propositions 5.2 and 5.4 the price of this option is K − S0 .
b − K exercised at the optimal level L∗ = K,
c) This is an American call option with strike price 2K b
hence by Equation (5.3.4) the price of this option is
S0
(L∗ − (2Kb − K )) IE∗ e −τL∗ = (Kb − (2Kb − K )) IE∗ e −τL∗ = (K − Kb) .
   
Kb

In conclusion, the pricing function is obtained by pasting together the pricing functions of
American call and put options, see Figure S.31.

60
Price function
50
Payoff function
40
30
20
10
0
0 ^-K
2K ^
K L* K 200

Figure S.31: American butterfly payoff and price functions.

Exercise 5.4
a) Given the value
∂
BSp (x, T ) = −Φ(−d+ (x, T ))
∂x
of the Delta of the Black-Scholes put option, see Proposition 2.18, the smooth fit condition
states that at x = S∗ , the left derivative of (5.5.3), which is
2
∂ ∂ 2 (S∗ )2r/σ
BSp (x, T ) + α (x/S∗ )−2r/σ = −Φ(−d+ (x, T )) + α 1+2r/σ 2 ,
∂x ∂x x
x > S∗ , should match the right derivative of (5.5.4), which is −1, hence
2rα ∗ −1
−1 = −Φ(−d+ (S∗ , T )) − (S ) ,
σ2

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FN6516 Stochastic Calculus in Finance II 283

which yields

σ 2 S∗ σ 2 S∗
α∗ = (1 − Φ(−d+ (S∗ , T ))) = Φ(d+ (S∗ , T )),
2r 2r

and
2

σ 2 (S∗ )1+2r/σ
Φ(d+ (S∗ , T )), x > S∗ ,

 BSp (x, T ) +

2rx 2r/σ 2
f (x, T ) ≃


K − x, x ⩽ S∗ .


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 (5.5.3) to (5.5.4) 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 corresponding 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

Figure S.32: Perpetual vs. finite expiration American put option price.

The plot in Figure S.32 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.33 we plot the graph of a Barone-Adesi and Whaley, 1987 approximation,
together with the European put option price, using the fOptions package. Note that this
approximation is valid only for certain parameter ranges.

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 284 Exercise Solutions

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

Underlying asset price

Figure S.33: American put price approximation.

Exercise 5.5
a) We have 
 ε if Z = 1,
τε =
+∞ if Z = 0.


b) First, we note that

/ Ω}

 {0, if t = 0,
Ft =
/ Ω, {Z = 0}, {Z = 1}} if t > 0.
{0,


Next, we have
{τε > 0} = {Z = 0},
hence
/ F0 = {0,
{τε > 0} ∈ / Ω},
and therefore τ0 is not an (Ft )t∈R+ -stopping time.

c) i) For t = 0 we have {τε > 0} = {Z = 0} ∪ {Z = 1} = Ω, hence

{τε > 0} ∈ F0 = {0,

/ Ω}.

ii) For 0 < t < ε we have {τε > t} = Ω, hence

{τε > t} ∈ Ft = {0,

/ Ω, {Z = 0}, {Z = 1}}.

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FN6516 Stochastic Calculus in Finance II 285

iii) For t > ε we have {τε > t} = {Z = 0}, hence

{τε > t} ∈ Ft = {0,

/ Ω, {Z = 0}, {Z = 1}}.

Therefore τε is an (Ft )t∈R+ -stopping time when ε > 0.

Note that here the filtration (Ft )t∈R+ is not right-continuous, as

/ Ω} = F0 ̸= F0+ := Ft = {0,
/ Ω, {Z = 0}, {Z = 1}}.
\
{0,
t>0

Exercise 5.6
a) This intrinsic payoff is κ − S0 .
b) We note that the process (Zt )t∈R+ defined as
 λ
St 2 2 2
Zt := e −(r−δ )λt +λ σ t/2−λ σ t/2
S0
2 2 2 2
e (r−δ )t +σ Bt −σ t/2 e −(r−δ )λt +λ σ t/2−λ σ t/2

λ
=
b

2 2
= e λ σ Bt −λ σ t/2 , t ⩾ 0,
b

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.

λ 2 σ 2 /2 + λ (r − δ − σ 2 /2) − r = 0.

This equation admits two solutions

p
−(r − δ − σ 2 /2) ± (r − δ − σ 2 /2)2 + 4rσ 2 /2
λ± = ,
σ2
d) We have
 λ−
(λ ) St
0 ⩽ Zt − = e −rt
S0
 λ−
St
⩽
S0
L λ−

⩽ , 0 ⩽ t < τL ,
S0
since λ− < 0 and St > L for t ∈ [0, τL ).
e) By the Stopping Time Theorem 4.8 we have

IE∗ [ZτL ] = IE∗ [Z0 ] = 1,

which rewrites as
" λ #
S τL −((r−δ )λ −λ σ 2 /2+λ 2 σ 2 /2)τ
IE∗ e L
= 1,
S0

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 286 Exercise Solutions

or, given the relation SτL = L,

 λ
L h 2 2 2
i
IE∗ e −((r−δ )λ −λ σ /2+λ σ /2)τL = 1,
S0
i.e.  λ
S0
IE∗ e −rτL =
 
,
L
provided that we choose λ such that

−((r − δ )λ − λ σ 2 /2 + λ 2 σ 2 /2) = −r, (S.19)

i.e. p
−(r − δ − σ 2 /2) ± (r − δ − σ 2 /2)2 + 4rσ 2 /2
λ= ,
σ2
and we choose the negative solution
p
−(r − δ − σ 2 /2) − (r − δ − σ 2 /2)2 + 4rσ 2 /2
λ :=
σ2
since S0 /L = x/L > 1 and the expectation IE∗ e −rτL < 1 is lower than 1 as r ⩾ 0.
 

f) This follows from (5.1.9) and the fact that r > 0. Using the fact that SτL = L < K when
τL < ∞, we h find i h i
∗
IE e −rτL +
(K − SτL ) S0 = x = IE e ∗ −rτL
(K − SτL ) 1{τL <x} S0 = x
+

h i
= IE∗ e −rτL (K − L)1{τL <x} S0 = x
h i
= (K − L) IE∗ e −rτL 1{τL <x} S0 = x
h i
= (K − L) IE∗ e −rτL S0 = x .
Next, noting
∗
that τL = 0 if S0 ⩽ L, for
 −rτ +
 all L ∈ (0, K ) we have
IE e L
(K − SτL ) S0 = x

 K − x, 0 < x ⩽ L,
=
  −rτL
(K − L)+ S0 = x ,

IE e x ⩾ L.

 K − x, 0 < x ⩽ L,
=
(K − L) IE e −rτL S0 = x ,
 
x ⩾ L.



 K − x, 0 < x ⩽ L,

= √
 x  −(r−a−σ 2 /2)− (r−a−σ 2 /2)2 +4rσ 2 /2
σ2

 (K − L )

, 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
fL′ ∗ (L∗ ) = λ− (K − L∗ ) = −1,
( L ∗ ) λ−
hence
λ−
λ− (K − L∗ ) = L∗ , or L∗ = K < K.
λ− − 1

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FN6516 Stochastic Calculus in Finance II 287

Equivalently we may recover the value of L∗ from the optimality condition

∂ f L (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  1−λ−
1 K
Sup IE∗ e −rτL (K − SτL )+ S0 = x = −
 
x λ− .
L∈(0,K ) λ − 1 − 1/λ−
h) For x ⩾ L we have
 x λ−
f L∗ ( x ) = ( K − L ∗ )
L∗
  !λ−
λ− x
= K− K
λ− − 1 λ−
λ− −1 K
λ
x(λ− − 1) −
 
K
= −
λ− − 1 λ− K
λ− 
λ− − 1 λ−
  
K x
= −
λ− − 1 −λ− −K
λ−  λ− −1
λ− − 1

x
=
−λ− −K
 x λ−  λ − 1 λ− K
−
= . (S.20)
K λ− 1 − λ−
i) Let us check that the relation

f L∗ ( x ) ⩾ ( K − x ) + (S.21)

holds. For all x ⩽ K we have

 x λ−  λ − 1 λ− K
−
f (x ) − (K − x ) =
L∗ +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∗ = ⩽x⩽1
λ− − 1

we have λ−
λ− − 1
λ 
x−
f L∗ ( 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
λ− − 1 λ− 1
 
fL′ ∗ (x) − (1 − x)′ = λ− xλ− −1 +1
λ− 1 − λ−

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 288 Exercise Solutions
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 (S.19) it can be checked by hand that fL∗ given by (S.20) satisfies
the equality
1
(r − δ )x fL′ ∗ (x) + σ 2 x2 fL′′∗ (x) = r fL∗ (x) (S.22)
2
λ−
for x ⩾ L∗ = K. In case
λ− − 1

λ−
0 ⩽ x ⩽ L∗ = K < K,
λ− − 1
we have
f L∗ ( x ) = K − x = ( K − x ) + ,
hence the relation
 
′ 1 2 2 ′′
r f L∗ ( x ) − ( r − δ ) x f L∗ ( x ) − σ x f L∗ ( x ) ( f L∗ ( x ) − ( K − x ) + ) = 0
2
always holds. On the other hand, in that case we also have
1
(r − δ )x fL′ ∗ (x) + σ 2 x2 fL′′∗ (x) = −(r − δ )x,
2
and to conclude we need to show that
1
(r − δ )x fL′ ∗ (x) + σ 2 x2 fL′′∗ (x) ⩽ r fL∗ (x) = r (K − x), (S.23)
2
which is true if
δ x ⩽ rK.
Indeed, by (S.19) we have
(r − δ )λ− = r + λ− (λ− − 1)σ 2 /2
⩾ r,
hence
λ−
δ ⩽ r,
λ− − 1
since λ− < 0, which yields

λ−
δ x ⩽ δ L∗ ⩽ δ K ⩽ rK.
λ− − 1
j) By Itô’s formula and the relation

dSt = (r − δ )St dt + σ St d Bbt

we have
d feL∗ (St ) = −r e −rt fL∗ (St )dt + e −rt d fL∗ (St )

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 289

σ 2 −rt 2 ′′
= −r e −rt fL∗ (St )dt + e −rt fL′ ∗ (St )dSt + e St fL∗ (St )
2
σ 2 2 ′′
 
−rt ′
= e −r fL∗ (St ) + (r − δ )St fL∗ (St ) + St fL∗ (St ) dt
2
−rt ′
+ e σ St fL∗ (St )d Bbt ,
and from Equations (S.22) and (S.23) we have

1
(r − δ )x fL′ ∗ (x) + σ 2 x2 fL′′∗ (x) ⩽ r fL∗ (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 ) ⩾ IE∗ e −rτ fL∗ (Sτ ) S0 ⩾ IE∗ e −rτ (K − Sτ )+ S0 ,

   

by (S.21), hence

IE∗ e −rτ (K − Sτ )+ S0 .
 
fL∗ (S0 ) ⩾ Sup
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 (S.22), and it is constant after
time τL∗ , hence by the Stopping
h Time Theoremi 4.8 we find
∗ −rτ
fL∗ (S0 ) = IE e fL∗ (SτL∗ ) S0
h i
= IE∗ e −rτ fL∗ (L∗ ) S0
h i
= IE∗ e −rτ (K − SτL∗ )+ S0
h i
⩽ Sup IE∗ e −rτ (K − Sτ )+ S0 .
τ stopping time
m) By combining the aboveh results and conditioning ati time t instead of time 0 we deduce that
fL∗ (St ) = IE∗ e −r(τL∗ −t ) (K − SτL∗ )+ St

λ−
 K − St ,
 0 < St ⩽ K,


 λ− − 1
= λ −1 
 λ− − 1 − −St λ−
  
 λ−

 , St ⩾ K,
−K λ− λ− − 1
for all t ∈ R+ , where
τL∗ = inf{u ⩾ t : Su ⩽ L}.
We note that the perpetual put option price does not depend on the value of t ⩾ 0.

Exercise 5.7

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 290 Exercise Solutions

a) Case L ⩾ K. Letting


τL := min T , inf u ∈ [t, T ] : Su = L

denote the first hitting time of the level L by the process (St )t∈[0,T ] before time T , we have

(St − K )+ ⩽ IE∗ [ e −(T −t )r (ST − K )+ | Ft ]

⩽ Sup IE∗ [ e −(T −t )r (min(ST , L) − K )+ | Ft ]
L⩾K

⩽ Sup IE∗ [ e −(T −t )r (SτL − K )+ | Ft ]

L⩾K

IE∗ e −(τ−t )r (Sτ − K )+ St ,

 
⩽ Sup
t⩽τ⩽T
τ Stopping time

hence
(a) ⩽ (c) ⩽ (b).

b) Case L ⩽ K. Letting again



τL := min T , inf u ∈ [t, T ] : Su = L

denote the first hitting time of the level L by the process (St )t∈[0,T ] before time T , we have

IE∗ [ e −(T −t )r (K − ST )+ | Ft ] ⩽ Sup IE∗ [ e −(T −t )r (K − Max(ST , L))+ | Ft ]

L⩽K

⩽ Sup IE∗ [ e −(T −t )r (K − SτL )+ | Ft ]

L⩽K

IE∗ e −(τ−t )r (K − Sτ )+ St ,
 
⩽ Sup
t⩽τ⩽T
τ Stopping time

hence
(b) ⩽ (a).

Note however that in the put option case, the inequality

(K − St )+ ⩽ IE∗ [ e −(T −t )r (K − ST )+ | Ft ]

may not always hold, depending on the value of St .

Exercise 5.8
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 λ σ Bt −λ ,
b

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
p
δ − r + σ 2 /2 − (δ − r + σ 2 /2)2 + 2rσ 2
λ− = ⩽ 0,
σ2
p
δ − r + σ 2 /2 + (δ − r + σ 2 /2)2 + 2rσ 2
λ+ = ⩾ 1.
σ2

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FN6516 Stochastic Calculus in Finance II 291

c) Due to the inequality

(λ+ )
0 ⩽ Zt = (St )λ+ e −rt ⩽ Lλ+ ,
(λ )
which holds because λ+ > 0 and St ⩽ L, 0 ⩽ t < τL , we note that since limt→∞ Zt + = 0, we
have h i h i
Lλ+ IE∗ e −rτL = IE∗ SτL + e −rτL 1{τL <∞} = IE∗ ZτL + 1{τL <∞}
 
λ (λ )

h i
(λ+ )  (λ+ ) 
= IE∗ lim ZτL ∧t = lim IE∗ ZτL ∧t
t→∞ t→∞
∗
 (λ+ )  λ+
= IE Z0 = ( S0 ) .
Therefore, we have
IE∗ e −rτL (SτL − K )+ S0 = x = IE∗ (SτL − K ) e −rτL 1{τL <∞} S0 = x
  

= (L − K ) IE∗ e −rτL 1{τL <∞} S0 = x

 

= (L − K ) IE∗ e −rτL S0 = x
 
 x λ+
= (L − K ) ,
L
when S0 = x > L. In order to maximize

Sup IE∗ 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
Lδ∗ = K= ,
λ+ − 1 1 − 1/λ+
and  1−λ+
∗
 −rτL +
 1 K
Sup IE e (K − SτL ) S0 = x = xλ + .
L∈(0,K ) λ+ 1 − 1/λ+
We note that as δ ↘ 0 we have λ+ ↘ 1 and Lδ∗ ↗ ∞, 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 5.9
 S1 (t )and
a) By the definition (5.5.8) of
α
S2 (t ) we have
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 ,

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 292 Exercise Solutions

which yields either α = 0 or

2σ2 σ1 + σ2
α= = 1+ > 1,
σ2 − σ1 σ2 − σ1
since 0 ⩽ σ1 < σ2 .
b) We have
IE e −rτL (S1 (τL ) − S2 (τL ))+ = IE e −rτL (LS2 (τL ) − S2 (τL ))+
  

= (L − 1)+ IE e −rτL S2 (τL ) .

 
(S.24)
c) Since τL ∧ t is
 a bounded
 stopping time we can write
S1 (0) α S1 (τL ∧ t ) α
   
−r (τL ∧t )
S2 (0) = IE e S2 (τL ∧ t ) (S.25)
S2 (0) S2 (τL ∧ t )
S1 (τL ) α S (t ) α
       
= IE e −rτL S2 (τL ) 1{τL <t} + IE e −rt S2 (t ) 1 1{τL >t}
S2 (τL ) S2 (t )
We have
 α
S1 (t )
−rt
e S2 (t ) 1{τL >t} ⩽ e −rt S2 (t )Lα 1{τL >t} ⩽ e −rt S2 (t )Lα ,
S2 (t )

hence by a uniform integrability argument,

S1 (t ) α
   
−rt
lim IE e S2 (t ) 1{τL >t} = 0,
t→∞ S2 (t )

and letting t go to infinity in (S.25) shows that

 α   α 
S1 ( 0 ) S1 (τL )
= IE e −rτL S2 (τL ) = Lα IE e −rτL S2 (τL ) ,
 
S2 ( 0 )
S2 ( 0 ) S2 (τL )

since S1 (τL )/S2 (τL ) = L/L = 1. The conclusion

 α
 −rτL +
 + −α S1 ( 0 )
IE e (S1 (τL ) − S2 (τL )) = (L − 1) L S2 (0) (S.26)
S2 ( 0 )

then follows by an application of (S.24).

d) In order to maximize (S.26) as a function of L we consider the derivative

∂ L−1
 
1
= α − α (L − 1)L−α−1 = 0,
∂L L α L

which vanishes for

α
L∗ = ,
α −1
and we substitute L in (S.26) 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
IE e −rτ (κ − S2 (τ ))+ =
 
Sup ,
τ stopping time S2 (0) 2

which coincides with the result of Proposition 5.4.

Exercise 5.10

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FN6516 Stochastic Calculus in Finance II 293

a) It suffices to check the sign of the quantity

(λ − 1)(λ + 2r/σ 2 ), (S.27)

in (5.5.10), which is positive when λ ∈ (−∞, −2r/σ 2 ] ∪ [1, ∞), and negative when −2r/σ 2 ⩽
λ ⩽ 1.
b) The sign of (S.27) is positive when λ ∈ (−∞, 1] ∪ [−2r/σ 2 , ∞), and negative when 1 ⩽ λ ⩽
−2r/σ 2 .
c) By the Stopping Timeh Theorem 4.8, for anyi n ⩾ 0 we have
(λ )
x = IE e −r(τL ∧n) ZτL ∧n | S0 = x
λ ∗

h i h i
= IE∗ ZτL 1{τL <n} | S0 = x + e −rn IE∗ Zn 1{τL >n} | S0 = x
(λ ) (λ )

h i
⩾ IE∗ e −rτL (SτL )λ 1{τL <n} | S0 = x
= Lλ IE∗ e −rτL 1{τL <n} | S0 = x .
 
(λ )

By the results of Questions (a))-(b)), the process Zt t∈R is a martingale when λ ∈
+
{1, −2rσ 2 /2}. Next, letting n to infinity, by monotone convergence we find

x Max(1,−2r/σ 2 )
  
 x λ


 L
 , x ⩾ L,
∗ −rτL
1{τL <∞} | S0 = x ⩽
 
IE e ⩽
L  min(1,−2r/σ 2 )
 x


, 0 < x ⩽ L.

L
d) We note that P∗ (τL < ∞) = 1 by (4.4.2), hence 2
 if −σ /2 ⩽ r < 0 we have
∗
(K − SτL ) 1{τL <∞} | S0 = x
 −rτ +
IE e L

  x −2r/σ 2

 ( K − L ) , x ⩾ L,
∗
 −rτ   L
= (K − L) IE e L
| S0 = x ⩽
 (K − L ) x ,


0 < x ⩽ L.
L
2
Similarly, if r ⩽ −σ /2 we have
IE∗ e −rτL (K − SτL )+ 1{τL <∞} | S0 = x = (K − L) IE∗ e −rτL | S0 = x
  
 x
 (K − L ) , x ⩾ L,

 L
⩽
2
 (K − L) x −2r/σ ,

  
0 < x ⩽ 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⩽ r < 0 we have
IE∗ e −rτL (SτL − K )+ 1{τL <∞} | S0 = x


= (L − K ) IE∗ e −rτL 1{τL <∞} | S0 = x

 
  x −2r/σ 2

 ( L − K ) , x ⩾ L,
 L
⩽
 (L − K ) x ,


0 < x ⩽ L.
L
2
If r ⩽ −σ /2 we have
IE∗ e −rτL (SτL − K )+ 1{τL <∞} | S0 = x


= (L − K ) IE∗ e −rτL 1{τL <∞} | S0 = x

 

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 294 Exercise Solutions
 x
 (L − K ) , x ⩾ L,

 L
⩽
2
 (L − K ) x −2r/σ ,

  
0 < x ⩽ L.
L
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 5.11 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 exercise time τK , and by e.g. (4.4.22) page 135 we have
CbAm (t, x) = Sup IE∗ e −(τ−t )r 1{Sτ ⩾K} St = x
 
τ⩾t
τ stopping time

= IE∗ 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

Figure S.34: Perpetual American binary put price map with K = 100.

b) For x ⩽ K, immediate exercise is the optimal strategy and we have PbAm (t, x) = 1. When
x > K the optimal exercise level of the perpetual American binary put option is L∗ = K with
the optimal exercise time τK , and by e.g. (4.4.11) page 125 we have
PbAm (t, x) = Sup IE∗ e −(τ−t )r 1{Sτ ⩽K} St = x
 
τ⩾t
τ stopping time

= IE∗ e −(τK −t )r St = x
 
 x −2r/σ 2
= , x > K.
K

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FN6516 Stochastic Calculus in Finance II 295

1.4

1.2
American binary call price

0.8

0.6

0.4

0.2

0
0 50 100 150 200
Underlying x

Figure S.35: Perpetual American binary call price map with K = 100.

Exercise 5.12 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 ⩽ K, exercise immediately.
c) Based on the answers to Question (a)) we set

CdAm (t, T , K ) = 1, 0 ⩽ t < T,

and
CdAm (T , T , x) = 0, 0 ⩽ x < K.
d) Based on the answers to Question (b)), we set

PdAm (t, T , K ) = 1, 0 ⩽ t < T,

and
PdAm (T , T , x) = 0, x > K.
e) 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 } .
f) 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 ⩽ u) = Φ √ −e Φ
2µa
√ , u > 0,
u u
and by differentiation with respect to u this yields the probability density function

∂ a
e −(a−µu) /(2u) 1[0,∞) (u)
2
f τa ( u ) = P(τa ⩽ u) = √
∂u 2πu 3

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,

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 296 Exercise Solutions

with µ = r/σ − σ /2, we find that (Su )u∈[t,∞) hits the level K at a time τK = t + τa , such that
2τ
SτK = St e σWτa −σ a /2+rτa
= 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
s 7−→ p e −(a−(s−t )µ ) /(2(s−t )) , s > t,
2π (s − t ) 3

with
σ2
 
1 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) = IE 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 2πs 3
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/σ 2 −1/2)±(r/σ 2 +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/σ 2 w
1 K ∞ 2
= √ e dy + √ e −y /2 dy
2π K y− 2π x y+
2
(r + σ /2)(T − t ) + log(x/K )
 
x
= Φ √
K σ T −t
 x −2r/σ 2  −(r + σ 2 /2)(T − t ) + log(x/K ) 
+ Φ √ , 0 < x < K,
K σ T −t
where
σ2
   
1 K
y± = √ ± r+ (T − t ) + log ,
σ T −t 2 x
and we used the decomposition

σ2 σ2
      
K 1 K 1 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/σ 2
CdAm (T , T , x) = Φ (−∞) + Φ (−∞) = 0, x < K,
K K

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 297

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 Cd (t, T , x) = lim Φ
Am
√
T →∞ K T →∞ σ T −t
 x −2r/σ 2 −(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 5.11.

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

Figure S.36: Finite expiration American binary call price map with K = 100.

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 andanswer to Question (f)), for  x > K we find
PdAm (t, T , x) = IE 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
   
  r2 − 21 ± r2 + 21
K σ σ
=
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/σ 2 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/σ 2  (r + σ 2 /2)(T − t ) − log(x/K ) 
+ Φ √ , x > K,
K σ T −t
with
σ2
   
1 x
y± = √ ∓ r+ (T − t ) + log .
σ T −t 2 K

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 298 Exercise Solutions

We check that
PdAm (T , T , K ) = Φ(0) + Φ(0) = 1,
and
x  x −2r/σ 2
Φ (−∞) +
PdAm (T , T , x) = 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 wehave

−(r + σ 2 /2)(T − t ) − log(x/K )

x
lim Pd (t, T , x) = lim Φ
Am
√
T →∞ K T →∞ σ T −t
 x −2r/σ 2 (r + σ 2 /2)(T − t ) − log(x/K )
 
+ lim Φ √
K T →∞ σ T −t
 x −2r/σ 2
= , x > K,
K
which is consistent with the answer to Question (b)) of Exercise 5.11

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

Figure S.37: 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
2
(r + σ /2)(T − t ) + log(x/K )

x
CdAm (t, T , x) + PdAm (t, T , x) = 1 + Φ √
K σ T −t
 x −2r/σ 2  −(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/σ 2  (r + σ 2 /2)(T − t ) − log(x/K ) 
+ Φ √ .
K σ T −t

Exercise 5.13 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 )u∈[t,∞)


u∈[t,∞)
is also a martingale
h by the Stopping
i Time Theorem 4.8, we have
∗ −r (τ−t ) ∗
 −r(τ−t )
(K − Sτ ) Ft = K IE e Ft − IE∗ e −r(τ−t ) Sτ Ft
  
IE e

= K IE∗ e −r(τ−t ) Ft − IE∗ Seτ∧T Ft

   

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FN6516 Stochastic Calculus in Finance II 299

= K IE∗ e −r(τ−t ) Ft − Seτ∧t

 

= K IE∗ e −r(τ−t ) Ft − Set

 

= K IE∗ e −r(τ−t ) Ft − St ,
 

and the above quantity is clearly maximized by taking τ = t. Hence we have

f (t, St ) = Sup IE∗ e −r(τ−t ) (K − Sτ ) Ft = K − St ,

 
t⩽τ⩽T
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 
IE∗ e −r(τ−t ) (Sτ − K ) Ft = IE∗ e −r(τ−t ) Sτ Ft − K IE∗ e −r(τ−t ) Ft
   

= St − K IE∗ 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

f (t, St ) = Sup IE∗ e −r(τ−t ) (Sτ − K ) Ft = St − e −(T −t )r K,

 
t⩽τ⩽T
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 discounted asset price
process Seu u∈[t,∞) := e −(u−t )r Su )u∈[t,∞) is a martingale, by the Stopping Time Theorem 4.8,
for all stopping times τ ⩾ t we have* ,

IE∗ e −r(τ−t ) (Sτ − K ) Ft = IE∗ e −r(τ−t ) Sτ Ft − K IE∗ e −r(τ−t ) Ft

     

= IE∗ Seτ Ft − K IE∗ e −r(τ−t ) Ft

   

= Set − K IE∗ e −r(τ−t ) Ft

 

= St − K IE∗ e −r(τ−t ) Ft
 

⩽ St , t ⩾ 0.

 hand, for all fixed T > 0 we have

On the other
IE∗ e −r(T −t ) (ST − K ) Ft = e −r(T −t ) IE∗ [ST | Ft ] − e −r(T −t ) IE∗ [K | Ft ]
= St − e −r(T −t ) K, t ∈ [0, T ],
hence

(St − e −r(T −t ) K ) ⩽ IE∗ e −r(τ−t ) (Sτ − K ) Ft ⩽ St ,

 
Sup T ⩾ t,
t⩾
τ stopping time

and letting T → ∞ we get

St = lim (St − e −r(T −t ) K )
T →∞
Sup IE∗ e −r(τ−t ) (Sτ − K ) Ft
 
⩽
τ⩾t
τ stopping time

⩽ St ,
hence we have

IE∗ e −r(τ−t ) (Sτ − K ) Ft = St ,

 
f (t, St ) = Sup
τ⩾t
τ stopping time

* Using Fatou’s Lemma.

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 300 Exercise Solutions

and the optimal strategy τ ∗ = +∞ is to wait indefinitely.

Regarding the perpetual American short forward contract, we have

∗ −r (τ−t )
f (t, St ) = Sup IE e (K − Sτ ) Ft
τ⩾t
τ stopping time

IE∗ e −r(τ−t ) (K − Sτ )+ Ft
 
⩽ Sup
τ⩾t
τ stopping time

= fL∗ (St ), (S.28)

with
2r
L∗ = K<K
2r + σ 2
as defined in (5.1.13). 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 ) = IE∗ e −r(τL∗ −t ) (K − SτL∗ )+ Ft
 

= IE∗ e −r(τL∗ −t ) (K − SτL∗ ) Ft

 

Sup IE∗ e −r(τ−t ) (K − Sτ ) Ft

 
⩽
τ⩾t
τ stopping time

= f (t, St ),
which, together with (S.28), shows that

f (t, St ) = fL∗ (St ),

i.e. the perpetual American short forward contract has same price and exercise strategy as
the perpetual American put option.

Exercise 5.14
a) We have
2 t/2 2
Yt = e −rt (S0 e rt +σ Bt −σ )−2r/σ
b

2 2 t/σ 2 +2r B
= S0−2r/σ e −rt−2r
bt /σ +rt

2 2
= S0−2r/σ e 2rBt /σ −(2r/σ ) t/2 , t ⩾ 0,
b

and
2 t/2
Zt = e −rt St = S0 e σ Bt −σ , t ⩾ 0,
b

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 = IE∗ [Y0 ]
= IE∗ [YτL ]
2
= IE∗ e −rτL Sτ−2r/σ

L
2
= IE∗ e −rτL L−2r/σ

2
= L−2r/σ IE∗ e −rτL ,
 

hence
  x −2r/σ 2
IE∗ e −rτL =

L

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FN6516 Stochastic Calculus in Finance II 301
2
if S0 = x ⩾ L (note that in this case YτL ∧t remains bounded by L−2r/σ ), and
S0 = IE∗ [Z0 ] = IE∗ [ZτL ] = IE∗ e −rτL SτL = IE∗ e −rτL L = L IE∗ e −rτL ,
     

hence  x
IE∗ e −rτL =

L
if S0 = x ⩽ L. Note that in this case ZτL ∧t remains bounded by L.
c) We find 
IE e −rτL (K − SτL ) S0 = x = (K − L) IE∗ e −rτL S0 = x
  

K −L

 x L ,


 0 < x ⩽ L,
= (S.29)

  x −2r/σ 2
 (K − L )

, x ⩾ L.
L
d) We check that when L ⩾ x, the maximum value of (S.29) is K − x, and that it is reached at
L∗ := x. On the other hand, when L < x, (S.29) can be maximized using L∗ := 2rK/(2r + σ 2 )
as in the perpetual American put option setting.
e) The stopping strategy τLx∗ would be suboptimal in comparison with the perpetual American
put option stopping strategy, see Exercise 5.13-(c)).

Exercise 5.15
a) The option payoff equals (κ − St ) p if St ⩽ L.
b) We have h i
fL (St ) = IE∗ e −r(τL −t ) ((κ − SτL )+ ) p Ft
h i
= IE∗ e −r(τL −t ) ((κ − L)+ ) p Ft
h i
= (κ − L) p IE∗ e −r(τL −t ) Ft .
c) We have h i
fL (x) = IE∗ e −r(τL −t ) (κ − SτL )+ Ft = x
(κ − x ) p , 0 < x ⩽ L,




=  2r/σ 2 (S.30)
L
 (κ − L ) p

 , x ⩾ L.
x
d
d) By the differentiation (κ − x) p = −p(κ − x) p−1 we find
dx
 2r/σ 2  2r/σ 2
∂ f L (x ) 2r p L p−1 L
= 2 (κ − L ) − p(κ − L ) ,
∂L σ L x x
∂ fL′ ∗ (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 (S.30) the price can be computed as

p
 (κ − St ) ,
 0 < St ⩽ L∗ ,


f (t, St ) = fL∗ (St ) =  2κ
p  2S
−2r/σ 2
pσ 2r + pσ t
St ⩾ L∗ ,

,


2r + pσ 2 2r

κ

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 302 Exercise Solutions

using (4.3.10) as in the proof of Proposition 5.4, since the process

u 7−→ e −ru fL∗ (Su ), u ⩾ t,

is a nonnegative supermartingale.

Exercise 5.16
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 − 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 ) p ) St = x


 κ − xp, 0 < x ⩽ L,

=  x −2r/σ 2
 (κ − L p )

 , x ⩾ L.
L
d) We have
2
2r (L∗ )−2r/σ −1
fL′ ∗ (L∗ ) = − 2 ( κ − ( L∗ ) p ) ∗ −2r/σ 2 = −p(L∗ ) p−1 ,
σ (L )
i.e.
2r
( κ − ( L∗ ) p ) = p ( L∗ ) p ,
σ2
or
 1/p
∗ 2rκ
L = < (κ )1/p . (S.31)
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/σ 2 !
∂ f L (x ) ∂ L
= (κ − L p )
∂L ∂L x
 2r/σ 2  2r/σ 2
p−1 L 2r −1 p L
= −pL + 2 L (κ − L ) ,
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 (S.31).
e) We have
κ − (St ) p , 0 < St ⩽ L∗ ,




fL∗ (St ) = 2
(S )−2r/σ
 ( κ − ( L∗ ) p ) t St ⩾ L∗

 ,
(L∗ )−2r/σ 2

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FN6516 Stochastic Calculus in Finance II 303


 κ − (St ) p , 0 < St ⩽ L∗ ,

=
σ2 2 2
p(St )−2r/σ (L∗ ) p+2r/σ , St ⩾ L∗ ,



 2r

 κ − (St ) p , 0 < St ⩽ L∗ ,


= −2r/( pσ 2 )
pσ 2 κ 2r + pσ 2 Stp

St ⩾ L∗ ,

< κ,


2r + pσ 2 2r

κ
however we cannot conclude as in Exercise 5.15-(e)) since the process

u 7−→ e −ru fL∗ (Su ), u ⩾ t,

does not remain nonnegative when p > 1, so that (4.3.10) cannot be applied as in the proof
of Proposition 5.4.

Chapter 6

Exercise 6.1 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 −λ T
e −(T −(T −x))λ − e −λ T
=
1 − e −λ T
e −λ x − e −λ T
= , 0 ⩽ t ⩽ T.
1 − e −λ T

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 304 Exercise Solutions

Nt
6

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 6.2
a) When t ∈ [0, T1 ), the equation reads
dSt = −ηλ St - dt = −ηλ St dt,
which is solved as St = S0 e −ηλt , 0 ⩽ 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 )ST1- = S0 (1 + η ) e −ηλ T1 . Repeating this
procedure over the Nt jump times contained in the interval [0,t ] we get
St = S0 (1 + η )Nt e −λ ηt , t ⩾ 0.
b) When t ∈ [0, T1 ) the equation reads
dSt = −ηλ St - dt = −ηλ St dt,
which is solved as St = S0 e −ηλt , 0 ⩽ 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 + ST1- = 1 + S0 e −ηλ T1 , and for t ∈ [T1 , T2 ) we will
find
St = (1 + S0 e −ηλ T1 ) e −(t−T1 )ηλ , T1 ⩽ t < T2 .
More generally, the equation can be solved by letting Yt := e ηλt St and noting that (Yt )t∈R+
satisfies dYt = e λ ηt dNt , which has the solution
wt
Yt = Y0 + e ηλ s dNs , t ⩾ 0,
0

hence in general we have

wt
St = e −ηλt S0 + e −(t−s)ηλ dNs , t ⩾ 0,
0

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FN6516 Stochastic Calculus in Finance II 305

Exercise 6.3
a) We have
1
d f (Xt ) = f ′ (Xt )dXt + σ 2 f ′′ (Xt )dt + f (Xt ) − f (Xt - )
2
1
= αXt f ′ (Xt )dt + σ f ′ (Xt )dBt + σ 2 f ′′ (Xt )dt
2
+( f (Xt - + η ) − f (Xt - ))dNt .
b) Taking f (x) := x2 with f ′ (x) = 2x and f ′′ (x) = 2, we have
d (Xt )2 = 2α (Xt )2 dt + 2σ Xt dBt + σ 2 dt + ((Xt - + η )2 − Xt2- )dNt
= 2α (Xt )2 dt + 2σ Xt dBt + σ 2 dt + (2ηXt - + Xt2- )dNt .
This result can also be recovered using the Itô Table 6.1 with jumps, as
d (Xt )2 = 2Xt - dXt + dXt • dXt
= 2α (Xt )2 dt + 2σ Xt dBt + 2ηXt - dNt + σ 2 dt + η 2 dNt .

Exercise 6.4
a) Taking expectations on both sides of (6.5.9), we have
u(t ) = IE[St ]
h wt wt wt i
= IE S0 + µ Ss ds + σ Ss dBs + η Ss- dYs
h0 w t i 0 h wt 0
i h wt i
= IE[S0 ] + IE µ Ss ds + IE σ Ss dBs + IE η Ss- dYs
0 0 0
wt wt
= S0 + µ IE[Ss ]ds + 0 + ηλ IE[Z ] IE[Ss- ]ds
w0t wt 0

= S0 + µ u(s)ds + ηλ IE[Z ] u(s)ds, , t ⩾ 0.

0 0
b) The above equation can be rewritten in differential form as

u′ (t ) = µu(t ) + ηλ IE[Z ]u(t )

with u(0) = S0 , which admits the solution

IE[St ] = u(t ) = u(0) e (µ +ηλ IE[Z ])t = S0 e (µ +ηλ IE[Z ])t , t ⩾ 0.

Exercise 6.5
a) We have
X0 e αt , 0 ⩽ t < T1 ,






 X0 e αT1 + σ e (t−T1 )α = X0 e αt + σ e (t−T1 )α , T1 ⩽ t < T2 ,



Xt =
  
X0 e αT1 + σ e (T2 −T1 )α + σ e (t−T2 )α







= X0 e αt + σ e (t−T1 )α + σ e (t−T2 )α ,

T2 ⩽ t < T3 ,

and more generally the solution (Xt )t∈R+ can be written as

Nt wt
Xt = X0 e αt + σ ∑ e (t−T )α = X0 e αt + σ
k
0
e (t−s)α dNs , t ⩾ 0. (S.32)
k =1

b) Letting f (t ) := IE[Xt ] and taking expectation on both sides of the stochastic differential
equation dXt = αXt dt + σ dNt we find

d f (t ) = α f (t )dt + σ λ dt,

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 306 Exercise Solutions

or
f ′ (t ) = α f (t ) + σ λ .
Letting g(t ) = f (t ) e −αt , we check that
g′ (t ) = σ λ e −αt ,
hence
wt wt λ
g(t ) = g(0) + g′ (s)ds = g(0) + σ λ e −αs ds = f (0) + σ (1 − e −αt ),
0 0 α
and
f (t ) = IE[Xt ]
= g(t ) e αt
λ αt
= f (0) e αt + σ ( e − 1)
α
λ
= X0 e αt + σ ( e αt − 1), t ⩾ 0.
α
We could also take the expectation on both sides of (S.32) and directly find
wt λ
f (t ) = IE[Xt ] = X0 e αt + σ λ e (t−s)α ds = X0 e αt + σ ( e αt − 1), t ⩾ 0.
0 α
Exercise 6.6
Nt
a) We have Xt = X0 ∏ (1 + σ ) = X0 (1 + σ )Nt = (1 + σ )Nt , t ∈ R+ .
k =1
b) By stochastic calculus
 and using
w the relation dXt = σ Xt
- dNt , we have
w
 t  t
dSt = d S0 Xt + rXt Xs−1 ds = S0 dXt + rd Xt Xs−1 ds
0
w t  w t  0 w t 
−1 −1
= S0 dXt + rXt d Xs ds + r Xs ds dXt + rdXt • d Xs−1 ds
0 0 0
w t 
−1 −1 −1
= S0 dXt + rXt Xt dt + r Xs ds dXt + rdXt • (Xt dt )
0
w t   wt 
= S0 dXt + rdt + r Xs−1 ds dXt = rdt + S0 + r Xs−1 ds dXt
0 0
 wt 
−1
= rdt + σ S0 Xt - + rXt - Xs ds dNt = rdt + σ St - dNt .
0
c) We have
IE[Xt /Xs ] = IE[(1 + σ )Nt −Ns ]
= ∑ (1 + σ )k P(Nt − Ns = k)
k⩾0
((t − s)λ )k ((t − s)(1 + σ )λ )k
= e −(t−s)λ ∑ (1 + σ )k = e −(t−s)λ ∑
k⩾0 k! k⩾0 k!
−(t−s)λ
= e e (t−s)(1+σ )λ = e (t−s)λ σ , 0 ⩽ s ⩽ t.
Remarks: We could also let f (t ) = IE[Xt ] and take expectation in the equation dXt = σ Xt - dNt
to get f ′ (t ) = σ λ f (t )dt and f (t ) = IE[Xt ] = f (0) e λ σt = e λ σt . Note that the relation
IE[Xt /Xs ] = IE[Xt ]/ IE[Xs ], which happens to be true here, is wrong in general.
d) We have h wt i wt
IE[St ] = IE S0 Xt + rXt Xs−1 ds = S0 IE[Xt ] + r IE[Xt /Xs ]ds
0 0
wt wt
= S0 e λ σt + r e (t−s)λ σ ds = S0 e λ σt + r e λ σ s ds
0 0
( e λ σt − 1)r
= S0 e λ σt + , t ⩾ 0.
λσ

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FN6516 Stochastic Calculus in Finance II 307

Exercise 6.7
a) Since IE[Nt ] = λt, the expectation IE[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−λ σt (1 + σ )Nt , t ⩾ 0.
c) The stochastic differential equation
dSt = rSt dt + σ St - (dNt − λ dt )
contains a martingale component (dNt − λ dt ) 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 IE∗ [(ST − K )+ ] = e −rT IE∗ [(S0 e (r−σ λ )T (1 + σ )NT − K )+ ]
= e −rT IE∗ [(S0 e (r−σ λ )T (1 + σ )NT − S0 e (r−λ σ )T )+ ]
= S0 e −σ λ T IE∗ [((1 + σ )NT − 1)+ ]
= S0 e −σ λ T ∑ ((1 + σ )k − 1)+ P(NT = k)
k⩾0
−σ λ T
= S0 e ∑ ((1 + σ )k − 1)P(NT = k)
k⩾0
−σ λ T
= S0 e ∑ (1 + σ )k P(NT = k) − S0 e −σ λ T ∑ P(NT = k)
k⩾0 k⩾0
(T (1 + σ )λ )k
= S0 e −σ λ T −λ T ∑ − S0 e −σ λ T
k⩾0 k!
−σ λ T
= S0 ( 1 − e ),
where we applied the exponential identity
xk
ex = ∑ k!
k⩾0

to x := T (1 + σ )λ .

Exercise 6.8
a) For all k = 1, 2, . . . , Nt we have
XTk − XTk- = a + σ XTk- ,
hence
XTk = a + (1 + σ )XTk- ,
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
Nt
 a a
= (1 + σ ) X0 + − , t ⩾ 0.
σ σ
This result can also be obtained by noting that
a  a
XTk + = (1 + σ ) XTk- + , k = 1, 2, . . . , Nt .
σ σ

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b) We have
(λt )k
IE[(1 + σ )Nt ] = e −λt ∑ (1 + σ )k = e σ λt , t ⩾ 0,
n⩾0 k!
hence
λ σt e λ σt − 1 λ σt
 a a
IE[Xt ] = X0 e +a =e X0 + − , t ⩾ 0.
σ σ σ
Nt
Exercise 6.9 We have St = S0 e rt ∏ (1 + ηZk ), t ∈ R+ .
k =1

Exercise 6.10 We have

 !2 
NT
Var [YT ] = IE  ∑ Zk − IE[YT ] 
k =1
 !2 
NT
= ∑ IE  ∑ Zk − λt IE[Z ] NT = k P(NT = k)
n⩾0 k =1
 !2 
n
λ nt n
= e −λt ∑ IE  ∑ Zk − λt IE[Z ] 
n⩾0 n! k =1
 !2 
n n
λ nt n 
= e −λt ∑ IE ∑ Zk − 2λt IE[Z ] ∑ Zk + λ 2t 2 (IE[Z ])2 
n⩾0 n! k =1 k =1

λ nt n
= e −λt ∑
n⩾0 n!
" #
n n
2 2 2 2
× IE 2 ∑ Zk Zl + ∑ |Zk | − 2λt IE[Z ] ∑ Zk + λ t (IE[Z ])
1⩽k<l⩽n k =1 k =1
λ nt n
= e −λt ∑
n⩾0 n!
×(n(n − 1)(IE[Z ])2 + n IE |Z|2 − 2nλt (IE[Z ])2 + λ 2t 2 (IE[Z ])2 )
 

λ nt n λ nt n
= e −λt (IE[Z ])2 ∑ + e −λt IE |Z|2 ∑
 
n⩾2 (n − 2) ! n⩾1 (n − 1) !
λ nt n
−2 e −λt λt (IE[Z ])2 ∑ + λ 2t 2 (IE[Z ])2 )
n⩾1 (n − 1) !

= λt IE |Z|2 ,
 

or, using the moment generating function of Proposition 6.6,

Var [YT ] = IE |YT |2 − (IE[YT ])2

 

∂2
= IE[ e αYT ]|α =0 − λ 2t 2 (IE[Z ])2
∂ αw2
∞
|y|2 µ (dy) = λt IE |Z|2 .
 
= λt
−∞

Exercise 6.11

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FN6516 Stochastic Calculus in Finance II 309

a) Applying the Itô formula (6.3.11) to the function f (x) = e x and to the process Xt = µt +
σWt + Yt , wefind 
1 2
dSt = µ + σ St dt + σ St dWt + (St − St - )dNt
2
 
1 2
= µ + σ St dt + σ St dWt + (S0 e µt +σWt +Yt − S0 e µt +σWt +Yt− )dNt
2
 
1 2
= µ + σ St dt + σ St dWt + (S0 e µt +σWt +Yt - +ZNt − e µt +σWt +Yt− )dNt
2
 
1 2
= µ + σ St dt + σ St 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
 
−rt −rt 1 2
d ( e St ) = e µ − r + σ St dt + σ e −rt St dWt + e −rt St - ( e ZNt − 1)dNt .
2

Hence by the Girsanov Theorem 6.21, choosing u, λ̃ , ν̃ such that

1
µ − r + σ 2 = σ u − λ̃ IEν̃ [ e Z − 1],
2
shows that

d ( e −rt St ) = σ e −rt St (dWt + udt ) + e −rt St - e ZNt − 1 dNt − λ̃ IEν̃ e Z − 1 dt

 

is a martingale under (Pu,λ̃ ,ν̃ ).

Exercise 6.12
a) We have !
Nt Nt
St = S0 e µt ∏ (1 + Zk ) = S0 exp µt + ∑ Xk , t ⩾ 0.
k =1 k =1

b) We have the discounted asset price process

!
Nt
Set := e −rt St = S0 exp ( µ − r )t + ∑ Xk , t ⩾ 0,
k =1

satisfies the stochastic differential equation

d Set = ( µ − r )Set dt + XNt Set - dNt


= ( µ − r + λ IE[Z ])Set dt + XNt − λ IE[Z ] Set - dNt t ⩾ 0,
hence it is a martingale if
2 /2
0 = µ − r + λ IE[Z ] = µ − r + λ IE[ e Xk − 1] = µ − r + ( e σ − 1)λ .

c) We have
e −(T −t )r IE[(ST − κ )+ | St ]
" ! !+ #
NT
= e −(T −t )r IE S0 exp µT + ∑ Xk − κ St
k =1
" ! !+ #
NT
= e −(T −t )r IE St exp (T − t ) µ + ∑ Xk − κ St
k=Nt +1

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 310 Exercise Solutions
" ! !+ #
NT
= e −(T −t )r IE x exp (T − t ) µ + ∑ Xk − κ
k=Nt +1 x=St
" ! !+ #
NT −Nt
= e −(T −t )r IE x exp (T − t ) µ + ∑ Xk − κ
k =1 x=St
 + 
(T −t ) µ +∑nk=1 Xk
= e −(T −t )r ∑ IE x e −κ P(NT − Nt = n)
n⩾0 x=St
((T − t )λ )n
 + 
−(r +λ )(T −t ) (T −t ) µ +∑nk=1 Xk
= e ∑ IE x e −κ
n⩾0 x=St n!
((T − t )λ )n 2 /2
= e −(T −t )λ ∑ Bl(St e (µ−r)(T −t )+nσ , r, nσ 2 /(T − t ), κ, T − t )
n⩾0 n!
 2
 ((T − t )λ )n
= e −(T −t )λ ∑ St e (µ−r)(T −t )+nσ /2 Φ(d+ ) − κ e −(T −t )r Φ(d− ) ,
n⩾0 n!
with 2 /2
log(St e (µ−r)(T −t )+nσ
/κ ) + (T − t )r + nσ 2 /2
d+ = √
σ n
log(St /κ ) + (T − t ) µ + nσ 2
= √ ,
σ n
2
log(St e (µ−r)(T −t )+nσ /2 /κ ) + (T − t )r − nσ 2 /2
d− = √
σ n
log(St /κ ) + (T − t ) µ
= √ ,
σ n
2
and µ = r + (1 − e σ /2 )λ .

Exercise 6.13
a) We have
d ( e αt St ) = σ e αt (dNt − β dt ),
hence wt
e αt St = S0 + σ e αs (dNs − β d ),
0
and
wt
St = S0 e −αt + σ e −(t−s)α (dNs − β ds), t ⩾ 0. (S.33)
0

b) We have
f (t ) = IE[St ]
hw t i wt
= S0 e −αt + σ IE e −(t−s)α dNs − β σ e −(t−s)α ds
0 0
wt wt
= S0 e −αt + λ σ e −(t−s)α ds − β σ e −(t−s)α ds
0 0
1 − e −αt
= S0 e −αt + (λ − β )σ
α
λ −β β −λ

= σ + S0 + σ e −αt , t ⩾ 0.
α α
c) By rewriting (S.33) as w wt
t
St = S0 − αS0 e −(t−s)α ds + σ e −(t−s)α (dNs − β ds)
0 0
wt
= S0 + σ e −(t−s)α (dNs − (β + αS0 /σ )ds)
0

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FN6516 Stochastic Calculus in Finance II 311
wt wt
= S0 + σ e −(t−s)α (λ − β − αS0 /σ )ds) + σ e −(t−s)α (dNs − λ ds),
0 0
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 ⩽ 0. We also check that this condition makes the
expectation f (t ) = IE[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 
−αT −(T −s)α
IE[φ (ST )] = IE φ S0 e +σ e (dNs − β ds),
0

= ∑ P(NT = n)
n⩾0
  wT  
−αT −(T −s)α
× IE φ S0 e +σ e (dNs − β ds) NT = n
0

(λ T )n
= e −λ T ∑
n⩾0 n!
wT
" ! #
n
−αT −(T −Tk )α −(T −s)α
× IE φ S0 e +σ ∑e −σβ e ds NT = n
0
k =1
λn
= e −λ T ∑
n⩾0 n!
wT wT
!
n
1 − e −αT
× ··· φ S0 e −αT + σ ∑ e −(T −sk )α − σ β ds1 · · · dsn ,
0 0 α
k =1

T ⩾ 0.

Exercise 6.14
a) From the decomposition Yt − λt (t + IE[Z ]) = Yt − λ IE[Z ]t − λt 2 as the sum of a martingale
and a decreasing function, we conclude that t 7→ Yt − λt (t + IE[Z ]) is a supermartingale.
b) Writing
dSt = µSt dt + σ St - dYt
r−µ
 
= rSt dt + σ St - dYt − dt
σ


= rSt dt + σ St - dYt − λ̃ IE[Z ]dt , 0 ⩽ t ⩽ T,
we conclude that (St )t∈[0,T ] is a martingale under Pλ̃ provided that

µ −r
= −λ̃ IE[Z ]dt,
σ
i.e.
r−µ
λ̃ = .
σ IE[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 IEλ̃ [ST − κ | Ft ] = e rt IEλ̃ [ 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 .

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Exercise 6.15
a) We have
Nt
St = S0 e µt ∏ (1 + Zk ), t ⩾ 0.
k =1

b) Letting Xk = log(1 + Zk ), k ⩾ 1, we find that

!
Nt
e −rt St = S0 exp ( µ − r )t + ∑ Xk , t ⩾ 0,
k =1

and (6.5.12) can be rewritten for the discounted price process

Set := e −rt St , t ⩾ 0,

as
d Set = ( µ − r + λ IE[Z ])Set dt + Set - (dYt + λ IE[Z ]),

which becomes a martingale if

w∞
0 = µ − r + λ IE[Z ] = µ − r + λ zν (dz).
−∞

c) We have

e −(T −t )r IE[(ST − κ )+ | St ]
" !+ #
NT
−(T −t )r µT
=e IE S0 e ∏ Zk − κ St
k =1
" !+ #
NT
= e −(T −t )r ∑ IE St e (T −t )µ ∏ Zk − κ St P(NT − Nt = n)
n⩾0 k=Nt +1
" !+ #
NT
−(r +λ )(T −t ) (T −t ) µ ((T − t )λ )n
=e ∑ IE St e ∏ Zk − κ St
n⩾0 k=Nt +1 n!
((T − t )λ )n
= e −(r+λ )(T −t ) ∑
n⩾0 n!
!+
w∞ w∞ n
(T −t ) µ
× ··· St e ∏ zk − κ ν (dz1 ) · · · ν (dzn ).
−∞ −∞
k =1

Exercise 6.16
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 Pe , the discounted price process ( e −rt St )t∈[0,T ] is a martingale,
λ̃
hence it is both a submartingale and a supermartingale.

Exercise 6.17

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FN6516 Stochastic Calculus in Finance II 313

No Process Martingale Not Martingale

1 Bt ✓

2 µt/σ + Bt ✓

3 µt/σ − Bt ✓

4 −µt/σ + Bt ✓

5 Yt − e
λ IE[Z1 ]t ✓

6 Yt − λ IE[Z1 ]t ✓

7 µt/σ + Bt + Yt − e
λ IE[Z1 ]t ✓

8 µt/σ + Bt − (Yt − e
λ IE[Z1 ]t ) ✓

9 −µt/σ + Bt + Yt − e
λ IE[Z1 ]t ✓

10 µt/σ + Bt + Yt − λ IE[Z1 ]t ✓

Chapter 7
Exercise 7.1
a) We have IE[Nt − αt ] = IE[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 ⩽ t ⩽ T,

hence the price at time t of the option is

e −(T −t )r IE[|ST |2 | Ft ]
= e −(T −t )r IE[|St |2 e 2(r−ηλ )(T −t ) (1 + η )2(NT −Nt ) | Ft ]
= |St |2 e (r−2ηλ )(T −t ) IE[(1 + η )2(NT −Nt ) | Ft ]

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 314 Exercise Solutions

= |St |2 e (r−2ηλ )(T −t ) IE[(1 + η )2(NT −Nt ) ]

= |St |2 e (r−2ηλ )(T −t ) ∑ (1 + η )2n P(NT − Nt = n)
n⩾0
(λ (T − t ))n
= |St |2 e (r−2ηλ −λ )(T −t ) ∑ (1 + η )2n
n⩾0 n!
2 (r−2ηλ −λ )(T −t )+(1+η )2 λ (T −t )
= |St | e
2 λ )(T −t )
= |St |2 e (r+η , 0 ⩽ t ⩽ T.

Exercise 7.2
a) Regardless of the choice of a particular risk-neutral probability measure Pu,λ̃ ,ν̃ , we have
e −(T −t )r IEu,λ̃ ,ν̃ [ST − K | Ft ] = e rt IEu,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 fractional) 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 ae
λ
σ 2 (t, St - ) + ( f (t, St - (1 + a)) − f (t, St - ))
∂x St -
ξt =
σ 2 + a2e λ
aλ
e
σ2 + (St - (1 + a) − St - )
St -
=
σ 2 + a2eλ
= 1, 0 ⩽ t ⩽ T,
which coincides with the result of Question (b)).

Exercise 7.3
a) We have  
1 2
St = S0 exp µt + σ Bt − σ t (1 + η )Nt .
2
b) We have  
1 2
Set = S0 exp ( µ − r )t + σ Bt − σ t (1 + η )Nt ,
2
and
d Set = ( µ − r + λ η )Set dt + η Set - (dNt − λ dt ) + σ Set dWt ,
hence we need to take
µ − r + λ η = 0,
since the compensated Poisson process (Nt − λt )t∈R+ is a martingale.
c) We have
e −r(T −t ) IE∗ [(ST − K )+ | St ]

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 315
"   + #
−r (T −t ) ∗ 1 2 NT
= e IE S0 exp µT + σ BT − σ T (1 + η ) − K St
2
 + 
−r (T −t ) ∗ µ (T −t )+(BT −Bt )σ −(T −t )σ 2 /2 NT −Nt
= e IE St e (1 + η ) −K St

= e −r(T −t ) ∑ P(NT − Nt = n)
n⩾0
 + 
2
× IE∗ St e µ (T −t )+(BT −Bt )σ −(T −t )σ /2 (1 + η )n − K St

(λ (T − t ))n
= e −(r+λ )(T −t ) ∑
n⩾0 n!
 + 
∗ (r−λ η )(T −t )+(BT −Bt )σ −(T −t )σ 2 /2 n
× IE St e (1 + η ) − K St

(λ (T − t ))n
= e −λ (T −t ) ∑ Bl(St e −λ η (T −t ) (1 + η )n , r, σ 2 , T − t, K )
n⩾0 n!
  (λ (T − t ))n
= e −λ (T −t ) ∑ St e −λ η (T −t ) (1 + η )n Φ(d+ ) − K e −r(T −t ) Φ(d− ) ,
n⩾0 n!
with
log(St e −λ η (T −t ) (1 + η )n /K ) + (r + σ 2 /2)(T − t )
d+ = √
σ T −t
log(St (1 + η )n /K ) + (r − λ η + σ 2 /2)(T − t )
= √ ,
σ T −t
and
log(St e −λ η (T −t ) (1 + η )n /K ) + (r − σ 2 /2)(T − t )
d− = √
σ T −t
log(St (1 + η )n /K ) + (r − λ η − σ 2 /2)(T − t )
= √ .
σ T −t

Exercise 7.4
a) The discounted process Set = e −rt St satisfies the equation

d Set = YNt Set - dNt , ,

and it is a martingale since the compound Poisson process YNt dNt is centered with independent
increments as IE[Y1 ] = 0.
b) We have
NT
ST = S0 e rT ∏ (1 + Yk ),
k =1

hence " !+ #
NT
−rT + −rT rT
 
e IE (ST − K ) =e IE S0 e ∏ (1 + Yk ) − K
k =1
" !+ #
NT
= e −rT ∑ IE S0 e rT ∏ (1 + Yk ) − K NT = n P(NT = n)
n⩾0 k =1
" !+ #
n
(λ T )n
= e −rT −λ T ∑ IE S0 e rT ∏ (1 + Yk ) − K
k⩾0 k =1 n!

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

 316 Exercise Solutions
!+
(λ T )n w 1 w1 n
= e −rT −λ T ∑ n −1 −1 · · · S0 e rT
∏ (1 + yk ) − K dy1 · · · dyn .
k⩾0 2 n! k =1
Exercise 7.5
a) We find α = λ where λ is the intensity of the Poisson process (Nt )t∈R+ .
b) We have
e −(T −t )r IE[ST − K | Ft ] = e rt IE[ e −rT ST | Ft ] − e −(T −t )r IE[K | Ft ]
= e rt IE[ e −rt St | Ft ] − e −(T −t )r K
= St − e −(T −t )r K,
since the process ( e −rt St )t∈R+ is a martingale.

Exercise 7.6
a) We have
St = S0 e (r−λ α )t (1 + α )Nt , t ⩾ 0.

b) We have   
−(T −t )r ∗ −(T −t )r ∗ ST
e IE [φ (ST ) | Ft ] = e IE φ x
St |x=St
−(T −t )r ∗ (r−λ α )(T −t ) NT −Nt
 
= e IE φ (x e (1 + α ) ) |x=S
t
∞
((T − t )λ )k
e −(r+λ )(T −t ) φ St e (r−λ α )(T −t ) (1 + α )k ,


= ∑ 0 ⩽ t ⩽ T.
k =0 k!
c) We have
dVt = rηt e rt dt + ξt dSt
= rηt e rt dt + ξt (rSt dt + αSt - (dNt − λ dt ))
= rVt dt + αξt St - (dNt − λ dt )
= r f (t, St )dt + αξt St - (dNt − λ dt ). (S.34)
d) By the Itô formula with jumps we have
d ( e −rt f (t, St )) = −r e −rt f (t, St )dt + e −rt d f (t, St )
= −r e −rt f (t, St )dt

−rt ∂ f ∂f ∂f
+e (t, St )dt + rSt (t, St )dt − λ St (t, St )dt
∂t ∂x ∂x



+ f (t, (1 + α )St - ) − f (t, St - ) dNt

= −r e −rt f (t, St )dt


−rt ∂ f ∂f ∂f
+e (t, St ) + rSt (t, St ) − λ St (t, St )
∂t ∂x ∂x

+λ e −rt ( f (t, (1 + α )St ) − f (t, St )) dt

+ e −rt f (t, (1 + α )St - ) − f (t, St - ) dNt

−λ e −rt IE[ f (t, (1 + α )x) − f (t, x)]|x=St - dt.

Since the discounted price process ( e −rt f (t, St ))t∈R+ is a martingale under 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 IE[ f (t, (1 + α )x) − f (t, x)]|x=St - dt

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

FN6516 Stochastic Calculus in Finance II 317

= 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


d f (t, St ) = r f (t, St )dt + f (t, (1 + α )St - ) − f (t, St - ) (dNt − λ )dt. (S.35)

Finally, by identification of the terms in the above formula (S.35) with those appearing in
(S.34), we obtain


αξt St - (dNt − λ dt ) = f (t, (1 + α )St - ) − f (t, St - ) (dNt − λ dt ),

which yields the hedging strategy

1

ξt = f (t, (1 + α )St - ) − f (t, St - ) , 0 < t ⩽ T.
αSt -

Exercise 7.7
a) We have
IE[Nt | Fs ] = e θYs −sm(θ ) IE e (Yt −Ys )θ −(t−s)m(θ ) Fs
 

e θYs −sm(θ ) IE e (Yt −Ys )θ −(t−s)m(θ ) = Ns ,

 
= 0 ⩽ s ⩽ t.
b) We have  
NT
IEθ e −rt St | Fs = IE eYt Fs
 
Ns
 
Yt Nt
= IE e Fs
Ns
= eYs IE eYt −Ys e (Yt −Ys )θ −(t−s)m(θ ) | Fs
 

= eYs e −(t−s)m(θ ) IE e (1+θ )(Yt −Ys )

 

= eYs 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  
−(T −t )r θ −(T −t )r + NT
e IE [(ST − K ) | Ft ] = e
+
IE (ST − K ) Ft
Nt
"  θ #
−(T −t )((1+r )θ +m(θ )) + ST
= e IE (ST − K ) Ft .
St

" January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault

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 Index

Symbols price . . . . . . . . . . . . . . . . . . . . . . . . . . . 35, 79

Asian
code . . . . . . . . . . . . . . . . . . . . . . . 6, 7, 10, 12– forward contract . . . . . . . . . . . . . . . . . . . . 95
14, 16, 32, 45, 47–49, 53–55, 62, 75, asset pricing
80, 125, 162, 164, 167, 168, 170, 173, first theorem
181, 182, 191, 214, 265, 266, 284 continuous time, 41
package second theorem
fOptions . . . . . . . . . . . . . . . . . . 53, 150, 284 continuous time, 44
quantmod . . . . . . . . . . . 7, 13, 50, 125, 182 at the money . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
Sim.DiffProc . . . . . . . . . . . . . . . . . . . . . . . 14 ATM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
attainable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
A automated market maker (AMM) . . . . . . . . . 66

adjusted close price . . . . . . . . . . . . . . . . . . 8, 183 B

admissible portfolio strategy . . . . . . . . . . . . . 40
American Bachelier model . . . . . . . . . . . . . . . . . . . . . 90, 96
binary option backward
finite expiration, 157 stochastic differential equation . . . . . . 100
perpetual, 157 Bank for International Settlements . . . . . . . . 30
forward contract . . . . . . . . . . . . . . . . . . . 158 Barone-Adesi & Whaley approximation . 150,
option 152, 284
butterfly, 152 basket option . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
call, 131, 140 bear spread option . . . . . . . . . . . . . . . . . . 91, 235
dividend, 152, 155 Bernoulli
finite expiration, 144 random walk . . . . . . . . . . . . . . . . . . . . . . . . . 1
perpetual, 131, 140 binary option . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
put, 131 American
arbitrage finite expiration, 157
continuous time . . . . . . . . . . . . . . . . . . . . . 40 perpetual, 157
opportunity . . . . . . . . . . . . . . . . . . . . . . . 218 BIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

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 326 INDEX

bisection method . . . . . . . . . . . . . . . . . . . . . . . . 53 attainable . . . . . . . . . . . . . . . . . . . . . . . . . . 44

Black-Scholes costless collar option . . . . . . . . . . . . . . . . . . . . 34
calibration . . . . . . . . . . . . . . . . . . . . . . . . . 56 counting process . . . . . . . . . . . . . . . . . . 161, 163
formula . . . . . . . . . . . . . . . . . . . . . . . . . 44, 82 Cox process . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
put options, 48 Cox-Ross-Rubinstein model . . . . . . . . . . . . . 46
PDE critical price . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
with jumps, 204 CRR model. . . . . . . . . . . . . . . . . . . . . . . . . . . . .46
box spread option . . . . . . . . . . . . . . . . . . . . . . . 93 cumulant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
break-even cumulants
underlying asset price . . . . . . . . . . . . . . 235 Gaussian . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Brent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Poisson . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Brownian
motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 D
geometric, 70
Lévy’s construction, 226 decentralized exchange (DEX) . . . . . . . . . . . 66
series construction, 5 Delta . . . . . . . . . . . . . . . . . . . . . . . 47, 49, 88, 239
BSDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
bubble . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 derivatives
bull spread option . . . . . . . . . . . . . . . . . . 91, 235 market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
butterfly option . . . . . . . . . . . . . . . . . . . . . 94, 239 differential inequalities . . . . . . . . . . . . . . . . . 137
American . . . . . . . . . . . . . . . . . . . . . . . . . 152 differential interest rate . . . . . . . . . . . . . . . . . 101
buy back guarantee . . . . . . . . . . . . . . . . . . . . . . 30 digital option . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
buy limit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
lemma . . . . . . . . . . . . . . . . . . . . . . . . 79, 200
C dispersion index . . . . . . . . . . . . . . . . . . . . . . . 163
distribution
call lognormal . . . . . . . . . . . . . . . . . . 15, 62, 233
option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 stable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
call-put parity . . . . . . . . . . . . . . . . . . . . . . . 84, 99 dividend . . . . . . . . . . . . . . . . . . . . . . 94, 152, 155
Capital Asset Pricing Model (CAPM)101, 259 dominated convergence theorem133, 141, 267
cash settlement . . . . . . . . . . . . . . . . . . . . . . 30, 32 Doob-Meyer decomposition. . . . . . . . . . . . .129
CEV model . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 drift estimation . . . . . . . . . . . . . . . . . . . . . . . . . 49
change of measure . . . . . . . . . . . . . . . . . . . . . . 77 drifted Brownian motion . . . . . . . . . . . . . . . . . 74
Chi square distribution . . . . . . . . . . . . . . 97, 249
chooser option . . . . . . . . . . . . . . . . . . . . . 99, 253 E
CIR model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
cliquet early exercise premium . . . . . . . . . . . . . . . . . 138
option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 efficient market hypothesis . . . . . . . . . . . . . . 238
collar option . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 entitlement ratio . . . . . . . . . . . . . . . . . . 31, 56–58
costless . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 equivalent probability measure . . . . . . . . 41, 78
complete market . . . . . . . . . . . . . . . . . . . . . . . . 79 Esscher transform . . . . . . . . . . . . . . . . . . . . . . 211
completeness ETF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
continuous time . . . . . . . . . . . . . . . . . . . . . 43 excess kurtosis . . . . . . . . . . . . . . . . . . . . . . . . . . 18
compound Poisson exchange option . . . . . . . . . . . . . . . . . . . . . . . 155
martingale . . . . . . . . . . . . . . . . . . . . . . . . 193 exchange-traded fund . . . . . . . . . . . . . . . . . . . 101
process . . . . . . . . . . . . . . . . . . 168, 196, 199 exercise price . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
constant product automated market maker (CPAMM)exotic option . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
66 exponential
Consumer Price Index . . . . . . . . . . . . . . . . . . . . 7 distribution . . . . . . . . . . . . . . . . . . . . . . . . 166
contingent claim Lévy model . . . . . . . . . . . . . . . . . . . . . . . 201

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INDEX 327

F with jumps . . . . . . . . . . . . . . . . . . . . . . . . 206

historical
Fatou’s lemma . . . . . . . . . . . . . . . . . 71, 121, 259 probability measure . . . . . . . . . . . . . . . . . 75
filtration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
first theorem of asset pricing . . . . . . . . . . . . . 41 hitting
fOptions ( package) . . . . . . . . . . 53, 150, 284 time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
foreign exchange option . . . . . . . . . . . . . . . . . 65
formula I
Lévy-Khintchine . . . . . . . . . . . . . . . . . . . 171
smoothing . . . . . . . . . . . . . . . . . . . . . . . . 174 implied
Tanaka . . . . . . . . . . . . . . . . . . . . . . . . 66, 225 probability . . . . . . . . . . . . . . . . . . . . . . . . . 37
forward volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 in the money . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
American, 158, 298 independent increments . . . . . . . . . . . . . 70, 190
Asian, 95 interest rate
start option . . . . . . . . . . . . . . . . . . . . . . . . . 95 differential . . . . . . . . . . . . . . . . . . . . . . . . 101
model
four-way collar option . . . . . . . . . . . . . . . . . . . 32
Cox-Ingersoll-Ross, 97
Fubini theorem . . . . . . . . . . . . . . . . . . . . . . . . 175
inverse Gaussian process . . . . . . . . . . . . . . . 182
fugazi (the) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
IPython notebook5, 6, 8–10, 12–14, 35, 45, 53,
FX option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
56, 151
Itô
G
formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
Gamma pathwise, 177
process . . . . . . . . . . . . . . . . . . . . . . . . . . . 181 with jumps, 178
Gaussian isometry . . . . . . . . . . . . . . . . . . . . . . . . . . 175
distribution . . . . . . . . . . . . . . . . . . . . . . . . . 15 stochastic integral . . . . . . . . . . . . . . . . . . . 69
geometric table
Brownian motion . . . . . . . . . . . . . . . . . 7, 70 with jumps, 179, 305
geometric mean market maker model . . . . . 66 ITM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
Girsanov Theorem . . . . . . . . . . . . . . . . . . 77, 101
J
jump processes . . . . . . . . . . . . . . . .188, 200
Greeks Japan/U.S. Foreign Exchange Rate . . . . . . . . . 7
Delta . . . . . . . . . . . . . . . . . . . 47, 49, 88, 239 Jensen’s inequality . . . . . . . . . . . . . 71, 116, 234
Theta . . . . . . . . . . . . . . . . . . . . . . . . . 99, 252 jump-diffusion process . . . . . . . . . . . . . . . . . 199
gross market value . . . . . . . . . . . . . . . . . . . . . . 30
gross world product . . . . . . . . . . . . . . . . . . 28, 30 K
guarantee
buy back . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Kullback-Leibler entropy . . . . . . . . . . . . . . . 201
price lock . . . . . . . . . . . . . . . . . . . . . . . . . . 31 kurtosis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18, 22
GWP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28, 30
L
H
Lévy
hedge and forget . . . . . . . . . . . . . . . . . . . . . . . 314 construction of Brownian motion . . . . 226
hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 process . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
mean-variance . . . . . . . . . . . . . . . . . . . . . 206 Lévy-Khintchine formula . . . . . . . . . . . . . . . 171
quantile . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Laplace transform . . . . . . . . . . . . . . . . . . . . . . 129
static . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314 least square Monte Carlo . . . . . . . . . . . . . . . 149
strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 lemma

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 328 INDEX

Neyman-Pearson . . . . . . . . . . . . . . . . . . 105 Bachelier . . . . . . . . . . . . . . . . . . . . . . . 90, 96

leptokurtic distribution . . . . . . . . . . . . . . . . . . . 21 Barone-Adesi & Whaley . . . . . . . . . . . 152
leverage. . . . . . . . . . . . . .64, 102, 106, 259, 272 CEV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 exponential Lévy . . . . . . . . . . . . . . . . . . 201
liquidity Merton . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
pool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 moment
provider . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 generating function . . . . . . . . . . . . . . . . 308
local martingale . . . . . . . . . . . . . . . . . . . . . . . 103 moments
log Gaussian . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 Poisson . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
option . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 MPoR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73, 78
return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
dynamics, 202 N
variance . . . . . . . . . . . . . . . . . . . . . . . . 15, 62
log variance . . . . . . . . . . . . . . . . . . . . . . . . . 15, 62 natural logarithm . . . . . . . . . . . . . . . . . . . . . . . . 15
log-returns . . . . . . . . . . . . . . . . . . . . . . . . . . . 7, 11 negative
lognormal inverse Gaussian process . . . . . . . . . . . 182
distribution . . . . . . . . . . . . . . . . . 15, 62, 233 risk premium . . . . . . . . . . . . . . . . . . . . . . . 40
long box spread option . . . . . . 62, 93, 218, 237 Newton-Raphson method . . . . . . . . . . . . . . . . 53
long forward contract . . . . . . . . . . . . . . 210, 211 Neyman-Pearson Lemma . . . . . . . . . . . . . . . 105
LSM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 noncentral Chi square . . . . . . . . . . . . . . . 97, 249
nonlocal operator . . . . . . . . . . . . . . . . . . . . . . 206
M notional amount . . . . . . . . . . . . . . . . . . . . . . . . 30
numéraire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
mark to market . . . . . . . . . . . . . . . . . . . . . . . . . 79
market O
bubble . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
efficiency . . . . . . . . . . . . . . . . . . . . . . . . . 238 optimal stopping . . . . . . . . . . . . . . . . . . . . . . . 145
log-returns . . . . . . . . . . . . . . . . . . . . . . . 7, 11 option
price of risk . . . . . . . . . . . . . . . . . . . . . 73, 78 at the money . . . . . . . . . . . . . . . . . . . . . . . 95
returns . . . . . . . . . . . . . . . . . . . . . . . . . . . 7, 11 basket . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
martingale . . . . . . . . . . . . . . . . . . . . . . . . . 69, 114 bear spread . . . . . . . . . . . . . . . . . . . . 91, 235
compound Poisson . . . . . . . . . . . . . . . . . 193 box spread . . . . . . . . . . . . . . . . . . . . . . . . . 93
continuous time . . . . . . . . . . . . . . . . . . . . . 41 bull spread . . . . . . . . . . . . . . . . . . . . . 91, 235
local . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 butterfly . . . . . . . . . . . . . . . . . . . . . . . 94, 239
measure chooser . . . . . . . . . . . . . . . . . . . . . . . . 99, 253
continuous time, 40, 199 cliquet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
method . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 exotic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Poisson . . . . . . . . . . . . . . . . . . . . . . . . . . . 190 foreign exchange . . . . . . . . . . . . . . . . . . . 65
submartingale . . . . . . . . . . . . . . . . . . . . . 114 forward start. . . . . . . . . . . . . . . . . . . . . . . .95
supermartingale . . . . . . . . . . . . . . . . . . . 114 issuer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
transform . . . . . . . . . . . . . . . . . . . . . . 70, 119 long box spread . . . . . . . . 62, 93, 218, 237
maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 on average . . . . . . . . . . . . . . . . . . . . . . . . . 90
mean out of the money . . . . . . . . . . . . . . . . . . . . 98
hitting time . . . . . . . . . . . . . . . . . . . . . . . . 127 path-dependent . . . . . . . . . . . . . . . . . . . . . 85
Merton model . . . . . . . . . . . . . . . . . . . . . . . . . 202 power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
method ratchet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
bisection . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
Newton-Raphson . . . . . . . . . . . . . . . . . . . 53 writer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
model zero-collar . . . . . . . . . . . . . . . . . . . . . . . . . 34

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "

INDEX 329

optional stable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

sampling . . . . . . . . . . . . . . . . . . . . . . . . . . 119 stopped . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
stopping . . . . . . . . . . . . . . . . . . . . . . . . . . 119 variance gamma . . . . . . . . . . . . . . . . . . . 181
order book . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228 pushforward measure . . . . . . . . . . . . . . . . . . . 193
OTM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 put
out of the money . . . . . . . . . . . . . . . . . . . . . . . . 98 option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Python code 5, 6, 8–10, 12–14, 35, 45, 53, 56,
P 151
Python package
parity yfinance . . . . . . . . . . . . . . . . . . . . . . . 8, 9, 56
call-put . . . . . . . . . . . . . . . . . . . . . . . . . 84, 99
Partial integro-differential equation . . . . . . 205 Q
path-dependent option . . . . . . . . . . . . . . . . . . . 85
pathwise Itô formula . . . . . . . . . . . . . . . . . . . 177 quantile hedging . . . . . . . . . . . . . . . . . . . . . . . 104
payoff function . . . . . . . . . . . . . . . . . . . . . . 30, 31 quantmod ( package) . . . 7, 13, 50, 125, 182
PDE
integro-differential . . . . . . . . . . . . . . . . . 205 R
variational . . . . . . . . . . . . . . . . . . . . . . . . 147
physical delivery . . . . . . . . . . . . . . . . . . . . 30, 32 Radon-Nikodym . . . . . . . . . . . . . . . . . . . . . . . . 74
PIDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204, 205 ratchet
Poisson option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
compound martingale . . . . . . . . . . 168, 199 realized variance . . . . . . . . . . . . . . . . . . . . . . . . 50
process . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 relative entropy . . . . . . . . . . . . . . . . . . . . . . . . 201
compound, 196 renewal processes . . . . . . . . . . . . . . . . . . . . . . 167
portfolio return
strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 log . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
admissible, 40, 44 risk
update . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 market price . . . . . . . . . . . . . . . . . . . . 73, 78
value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 premium . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
power option . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 risk measure
predictable process . . . . . . . . . . . . . . . . . . . . . 174 superhedging . . . . . . . . . . . . . . . . . . . . . . . 61
premium risk premium . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
early exercise . . . . . . . . . . . . . . . . . . . . . . 138 risk-neutral
risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40, 73 measure . . . . . . . . . . . . . . . . . . . . . . . 36, 199
price continuous time, 40, 73
critical . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152 probabilities . . . . . . . . . . . . . . . . . . . . . . . . 37
graph . . . . . . . . . . . . . . . . . . . . . . . . . . . 30–32 riskless asset . . . . . . . . . . . . . . . . . . . . . . . . 10, 17
price lock guarantee . . . . . . . . . . . . . . . . . . . . . 31 Robinhood incident . . . . . . . . . . . . . . . . . . . . 238
pricing
with jumps . . . . . . . . . . . . . . . . . . . . . . . . 200 S
probability
measure second theorem of asset pricing . . . . . . . . . . . 44
equivalent, 41, 78 self-financing portfolio
process continuous time . . . . . . . . . . . . . 42, 43, 206
counting . . . . . . . . . . . . . . . . . . . . . . . . . . 161 sell stop . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
Cox . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Sharpe ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
gamma. . . . . . . . . . . . . . . . . . . . . . . . . . . .181 Sim.DiffProc . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
inverse Gaussian . . . . . . . . . . . . . . . . . . . 181 skewness . . . . . . . . . . . . . . . . . . . . . . . . . . . 18, 22
Lévy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .181 smile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
predictable . . . . . . . . . . . . . . . . . . . . . . . . 174 smooth pasting . . . . . . . . . . . . . . . . . . . . . . . . 134

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 330 INDEX

smoothing formula . . . . . . . . . . . . . . . . . . . . . 174 variational PDE . . . . . . . . . . . . . . . . . . . 137, 147

SRM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 volatility
stable historical . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
distribution . . . . . . . . . . . . . . . . . . . . . . . . . 23 implied . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
process . . . . . . . . . . . . . . . . . . . . . . . . . . . 182 smile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
static hedging . . . . . . . . . . . . . . . . . . . . . . . . . 314 surface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
stochastic
integral W
with jumps, 173
warrant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
integral decomposition . . . . . . . . . . . 85, 87
West Texas Intermediate (WTI) . . . . . . . 28, 32
stop-loss/start-gain strategy . . . . . . . . . . . . . . 65
Wiener space . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
stopped process . . . . . . . . . . . . . . . . . . . . . . . . 118
stopping time . . . . . . . . . . . . . . . . . . . . . . . . . . 117
Y
theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
straddle option . . . . . . . . . . . . . . . . . . . . . . . . . 256 yfinance (Python package) . . . . . . . . . . . 8, 9, 56
strike price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
strong Markov property. . . . . . . . . . . . . . . . .166 Z
submartingale . . . . . . . . . . . . . . . . . . . . . . . . . 114
superhedging risk measure . . . . . . . . . . . . . . . 61 zero-
supermartingale . . . . . . . . . . . . . . . . . . . . . . . . 114 collar option . . . . . . . . . . . . . . . . . . . . . . . . 34

Tanaka formula . . . . . . . . . . . . . . . . . . . . . 66, 225

Theil index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
theorem
asset pricing . . . . . . . . . . . . . . . . . . . . 41, 44
dominated convergence . . . . . . . . 133, 141
Fubini . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Girsanov . . . . . . . . . . . . . 77, 101, 188, 200
stopping time . . . . . . . . . . . . . . . . . . . . . . 119
Theta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99, 252
time
splitting . . . . . . . . . . . . . . . . . . . . 65, 97, 225
tower property . . . . . . . . . . . . . . . . 70, 71, 87, 89
transform
Esscher . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
Laplace . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
martingale . . . . . . . . . . . . . . . . . . . . . . . . 119
trend estimation . . . . . . . . . . . . . . . . . . . . . . . . . 49

Uniswap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

variance
gamma process . . . . . . . . . . . . . . . . . . . . 181
realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

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INDEX 331

Author index

Allegretto, J. 150 Jarrow, R.A. 103

Applebaum, D. 181 Jeanblanc, M. 209
Aristotle 27 Jensen, J. 116, 145
Aste, T. 68
Klebaner, F. 102, 259, 276
Bachelier, L. 3 Kopp, P.E. 138, 147
Barone-Adesi, G. 150, 152
Lamberton, D. 147
Billingsley, R.S. 238
Lapeyre, B. 147
Black, F. 42
Leukert, P. 104
Bosq, D. 163
Leung, T. 106
Boulding, K.E. 10
Lipton, A. 65
Brémaud, P. 174
Littlewood, J.E. 116
Briola, A. 68
Loewenstein, M. 103
Broadie, M. 155
Longstaff, F.A. 149, 151
Brown, R. 3
Buterin, V. 66 Maire†, B. 232
Melnikov, A.V. 104
Carmona, R. 96
Merton, R.C. 202
Chance, D.M. 238 Meyer, P.A. 129
Charlier, C.V.L. 23
Cont, R. 181, 187, 192, 209 Nechaev, M.L. 104
Cox, A.M.G. 103 Nguyen, H.T. 163
Cox, J.C. 97 Nikodym, O.M. 74
Cramér, H. 23 Norris, J.R. 166
Novikov, A. 77
Detemple, J. 155
Di Nunno, G. 85, 209 Øksendal, B. 85, 181, 209
Doob, J.L. 114, 119, 129
Durrleman, V. 96 Partzsch, L. 6
Peng, S. 100
Elliott, R.J. 138, 147, 150 Pliska, S.R. 41, 44
Poisson, S.D. 161
Feller, W. 249 Pólya, G. 116
Folland, G.B. 4 Proske, F. 85, 209
Föllmer, H. 104 Protter, P. 77, 87, 103, 264
Fukasawa, M. 232
Radon, J. 74
Gerber, H.U. 155, 211 Revuz, D. 4
Gram, J.P. 23 Ross, S.A. 97

Hardy, G.H. 116 Sato, K. 193

Harrison, J.M. 41, 44 Schilling, R.L. 6
Heston, S.L. 103 Scholes, M. 42
Hobson, D.G. 103 Schwartz, E.S. 149, 151
Scorsese, M. 52
Ikeda, N. 71 Shimbo, K. 103
Ingersoll, J.E. 97 Shiryaev, A.N. 41, 44
Shiu, E.S.W. 155, 211
Jacka, S.D. 148 Shreve, S. 135, 152
Jacquier, A. 104, 268 Sircar, K.R. 106
Jaillet, P. 147 Steele, J.M. 146

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Sulem, A. 181 Wang, Y. 68
Watanabe, S. 71
Tanaka, K. 23
Watanabe, T. 23
Tankov, P. 181, 187, 192, 209
Whaley, R.E. 150, 152
Thales 27
Theil, H. 26 Willard, G.A. 103
Thiele, T.N. 17 Wilmott, P. 155
Wunsch, M. 232
Üstünel, A.S. 147

Vidal-Tomás, D. 68 Yamada, T. 23
Volkov, S.N. 104 Yor, M. 4

January 4, 2025 FN6516 Stochastic Calculus in Finance II - N. Privault "