Continuous Time Finance

Lecture 5
The Martingale Approach
II: Pricing and Hedging
(Ch 10-12)
Tomas Bjork
Tomas Bjork, 2010
Financial Markets
Price Processes:
S
t
=
_
S
0
t
, ..., S
N
t

Example: (Black-Scholes, S
0
:= B, S
1
:= S)
dS
t
= S
t
dt +S
t
dW
t
,
dB
t
= rB
t
dt.
Portfolio:
h
t
=
_
h
0
t
, ..., h
N
t

h
i
t
= number of units of asset i at time t.
Value Process:
V
h
t
=
N

i=0
h
i
t
S
i
t
= h
t
S
t
Tomas Bjork, 2010 1
Self Financing Portfolios
Denition: (intuitive)
A portfolio is self-nancing if there is no exogenous
infusion or withdrawal of money. The purchase of a
new asset must be nanced by the sale of an old one.
Denition: (mathematical)
A portfolio is self-nancing if the value process
satises
dV
t
=
N

i=0
h
i
t
dS
i
t
Major insight:
If the price process S is a martingale, and if h is
self-nancing, then V is a martingale.
NB! This simple observation is in fact the basis of the
following theory.
Tomas Bjork, 2010 2
Arbitrage
The portfolio u is an arbitrage portfolio if
The portfolio strategy is self nancing.
V
0
= 0.
V
T
0, P a.s.
P (V
T
> 0) > 0
Main Question: When is the market free of arbitrage?
Tomas Bjork, 2010 3
First Attempt
Proposition: If S
0
t
, , S
N
t
are P-martingales, then
the market is free of arbitrage.
Proof:
Assume that V is an arbitrage strategy. Since
dV
t
=
N

i=0
h
i
t
dS
i
t
,
V is a P-martingale, so
V
0
= E
P
[V
T
] > 0.
This contradicts V
0
= 0.
True, but useless.
Tomas Bjork, 2010 4
Example: (Black-Scholes)
dS
t
= S
t
dt +S
t
dW
t
,
dB
t
= rB
t
dt.
(We would have to assume that = r = 0)
We now try to improve on this result.
Tomas Bjork, 2010 5
Choose S
0
as numeraire
Denition:
The normalized price vector Z is given by
Z
t
=
S
t
S
0
t
=
_
1, Z
1
t
, ..., Z
N
t

The normalized value process V

0
h
i
t
Z
i
t
.
Idea:
The arbitrage and self nancing concepts should be
independent of the accounting unit.
Tomas Bjork, 2010 6
Invariance of numeraire
Proposition: One can show (see the book) that
S-arbitrage Z-arbitrage.
S-self-nancing Z-self-nancing.
Insight:
If h self-nancing then
dV
Z
t
=
N

1
h
i
t
dZ
i
t
Thus, if the normalized price process Z is a P-
martingale, then V
Z
is a martingale.
Tomas Bjork, 2010 7
Second Attempt
Proposition: If Z
0
t
, , Z
N
t
are P-martingales, then
the market is free of arbitrage.
True, but still fairly useless.
Example: (Black-Scholes)
dS
t
= S
t
dt +S
t
dW
t
,
dB
t
= rB
t
dt.
dZ
1
t
= ( r)Z
1
t
dt +Z
1
t
dW
t
,
dZ
0
t
= 0dt.
We would have to assume risk-neutrality, i.e. that
= r.
Tomas Bjork, 2010 8
Arbitrage
Recall that h is an arbitrage if
h is self nancing
V
0
= 0.
V
T
0, P a.s.
P (V
T
> 0) > 0
Major insight
This concept is invariant under an equivalent change
of measure!
Tomas Bjork, 2010 9
Martingale Measures
Denition: A probability measure Q is called an
equivalent martingale measure (EMM) if and only
if it has the following properties.
Q and P are equivalent, i.e.
Q P
The normalized price processes
Z
i
t
=
S
i
t
S
0
t
, i = 0, . . . , N
are Q-martingales.
Wan now state the main result of arbitrage theory.
Tomas Bjork, 2010 10
First Fundamental Theorem
Theorem: The market is arbitrage free
i
there exists an equivalent martingale measure.
Tomas Bjork, 2010 11
Comments
It is very easy to prove that existence of EMM
imples no arbitrage (see below).
The other imnplication is technically very hard.
For discrete time and nite sample space the hard
part follows easily from the separation theorem for
convex sets.
For discrete time and more general sample space we
need the Hahn-Banach Theorem.
For continuous time the proof becomes technically
very hard, mainly due to topological problems. See
the textbook.
Tomas Bjork, 2010 12
Proof that EMM implies no arbitrage
Assume that there exists an EMM denoted by Q.
Assume that P(V
T
0) = 1 and P(V
T
> 0) > 0.
Then, since P Q we also have Q(V
T
0) = 1 and
Q(V
T
> 0) > 0.
Recall:
dV
Z
t
=
N

1
h
i
t
dZ
i
t
Q is a martingale measure

V
Z
is a Q-martingale

V
0
= V
Z
0
= E
Q
_
V
Z
T

> 0

No arbitrage
Tomas Bjork, 2010 13
Choice of Numeraire
The numeraire price S
0
t
can be chosen arbitrarily. The
most common choice is however that we choose S
0
as
the bank account, i.e.
S
0
t
= B
t
where
dB
t
= r
t
B
t
dt
Here r is the (possibly stochastic) short rate and we
have
B
t
= e
R
t
0
r
s
ds
Tomas Bjork, 2010 14
Example: The Black-Scholes Model
dS
t
= S
t
dt +S
t
dW
t
,
dB
t
= rB
t
dt.
Look for martingale measure. We set Z = S/B.
dZ
t
= Z
t
( r)dt +Z
t
dW
t
,
Girsanov transformation on [0, T]:
_
dL
t
= L
t

t
dW
t
,
L
0
= 1.
dQ = L
T
dP, on F
T
Girsanov:
dW
t
=
t
dt +dW
Q
t
,
where W
Q
is a Q-Wiener process.
Tomas Bjork, 2010 15
The Q-dynamics for Z are given by
dZ
t
= Z
t
[ r +
t
] dt +Z
t
dW
Q
t
.
Unique martingale measure Q, with Girsanov kernel
given by

t
=
r

.
Q-dynamics of S:
dS
t
= rS
t
dt +S
t
dW
Q
t
.
Conclusion: The Black-Scholes model is free of
arbitrage.
Tomas Bjork, 2010 16
Pricing
We consider a market B
t
, S
1
t
, . . . , S
N
t
.
Denition:
A contingent claim with delivery time T, is a random
variable
X F
T
.
At t = T the amount X is paid to the holder of the
claim.
Example: (European Call Option)
X = max [S
T
K, 0]
Let X be a contingent T-claim.
Problem: How do we nd an arbitrage free price
process
t
[X] for X?
Tomas Bjork, 2010 17
Solution
The extended market
B
t
, S
1
t
, . . . , S
N
t
,
t
[X]
must be arbitrage free, so there must exist a martingale
measure Q for (S
t
,
t
[X]). In particular

t
[X]
B
t
must be a Q-martingale, i.e.

t
[X]
B
t
= E
Q
_

T
[X]
B
T

F
t
_
Since we obviously (why?) have

T
[X] = X
we have proved the main pricing formula.
Tomas Bjork, 2010 18
Risk Neutral Valuation
Theorem: For a T-claim X, the arbitrage free price is
given by the formula

t
[X] = E
Q
_
e

R
T
t
r
s
ds
X

F
t
_
Tomas Bjork, 2010 19
Example: The Black-Scholes Model
Q-dynamics:
dS
t
= rS
t
dt +S
t
dW
Q
t
.
Simple claim:
X = (S
T
),

t
[X] = e
r(Tt)
E
Q
[(S
T
)| F
t
]
Kolmogorov

t
[X] = F(t, S
t
)
where F(t, s) solves the Black-Scholes equation:
_

_
F
t
+rs
F
s
+
1
2

2
s
2
2
F
s
2
rF = 0,
F(T, s) = (s).
Tomas Bjork, 2010 20
Problem
Recall the valuation formula

t
[X] = E
Q
_
e

R
T
t
r
s
ds
X

F
t
_
What if there are several dierent martingale measures
Q?
This is connected with the completeness of the
market.
Tomas Bjork, 2010 21
Hedging
Def: A portfolio is a hedge against X (replicates
X) if
h is self nancing
V
T
= X, P a.s.
Def: The market is complete if every X can be
hedged.
Pricing Formula:
If h replicates X, then a natural way of pricing X is

t
[X] = V
h
t
When can we hedge?
Tomas Bjork, 2010 22
Existence of hedge

Existence of stochastic integral

1
h
i
t
dZ
i
t
Thus V
Z
is a Q-martingale.
V
Z
t
= E
Q
_
X
B
T

F
t
_
Tomas Bjork, 2010 24
Lemma:
Fix T-claim X. Dene martingale M by
M
t
= E
Q
_
X
B
t

F
t
_
Suppose that there exist predictable processes
h
1
, , h
N
such that
M
t
= x +
N

i=1
_
t
0
h
i
s
dZ
i
s
,
Then X can be replicated.
Tomas Bjork, 2010 25
Proof
We guess that
M
t
= V
Z
t
= h
B
t
1 +
N

i=1
h
i
t
Z
i
t
Dene: h
B
by
h
B
t
= M
t

i=1
h
i
t
Z
i
t
.
We have M
t
= V
Z
t
, and we get
dV
Z
t
= dM
t
=
N

i=1
h
i
t
dZt
i
,
so the portfolio is self nancing. Furthermore:
V
Z
T
= M
T
= E
Q
_
X
B
T

F
T
_
=
X
B
T
.
Tomas Bjork, 2010 26
Second Fundamental Theorem
The second most important result in arbitrage theory
is the following.
Theorem:
The market is complete
i
the martingale measure Q is unique.
Proof: It is obvious (why?) that if the market
is complete, then Q must be unique. The other
implication is very hard to prove. It basically relies on
duality arguments from functional analysis.
Tomas Bjork, 2010 27
Black-Scholes Model
Q-dynamics
dS
t
= rS
t
dt +S
t
dW
Q
t
,
dZ
t
= Z
t
dW
Q
t
M
t
= E
Q
_
e
rT
X

F
t

,
Representation theorem for Wiener processes

there exists g such that

F
t

,
Kolmogorov backward equation M
t
= f(t, S
t
)
_
f
t
+rs
f
s
+
1
2

2
s
2

2
f
s
2
= 0,
f(T, s) = e
rT
(s).
Ito
dM
t
= S
t
f
s
dW
Q
t
,
so
g
t
= S
t

f
s
,
Replicating portfolio h:
h
B
t
= f S
t
f
s
,
h
1
t
= B
t
f
s
.
Interpretation: f(t, S
t
) = V
Z
t
.
Tomas Bjork, 2010 30
Dene F(t, s) by
F(t, s) = e
rt
f(t, s)
so F(t, S
t
) = V
t
. Then
_
_
_
h
B
t
=
F(t,S
t
)S
t
F
s
(t,S
t
)
B
t
,
h
1
t
=
F
s
(t, S
t
)
where F solves the Black-Scholes equation
_
F
t
+rs
F
s
+
1
2

2
s
2
2
F
s
2
rF = 0,
F(T, s) = (s).
Tomas Bjork, 2010 31
Main Results
The market is arbitrage free There exists a
martingale measure Q
The market is complete Q is unique.
Every X must be priced by the formula

t
[X] = E
Q
_
e

R
T
t
r
s
ds
X

F
t
_
for some choice of Q.
In a non-complete market, dierent choices of Q
will produce dierent prices for X.
For a hedgeable claim X, all choices of Q will
produce the same price for X:

t
[X] = V
t
= E
Q
_
e

R
T
t
r
s
ds
X

F
t
_
Tomas Bjork, 2010 32
Completeness vs No Arbitrage
Rule of Thumb
Question:
When is a model arbitrage free and/or complete?
Answer:
Count the number of risky assets, and the number of
random sources.
R = number of random sources
N = number of risky assets
Intuition:
If N is large, compared to R, you have lots of
possibilities of forming clever portfolios. Thus lots
of chances of making arbitrage prots. Also many
chances of replicating a given claim.
Tomas Bjork, 2010 33
Rule of thumb
Generically, the following hold.
The market is arbitrage free if and only if
N R
The market is complete if and only if
N R
Example:
The Black-Scholes model.
dS
t
= S
t
dt +S
t
dW
t
,
dB
t
= rB
t
dt.
For B-S we have N = R = 1. Thus the Black-Scholes
model is arbitrage free and complete.
Tomas Bjork, 2010 34
Stochastic Discount Factors
Given a model under P. For every EMM Q we dene
the corresponding Stochastic Discount Factor, or
SDF, by
D
t
= e

R
t
0
r
s
ds
L
t
,
where
L
t
=
dQ
dP
, on F
t
There is thus a one-to-one correspondence between
EMMs and SDFs.
The risk neutral valuation formula for a T-claim X can
now be expressed under P instead of under Q.
Proposition: With notation as above we have

t
[X] =
1
D
t
E
P
[D
T
X| F
t
]
Proof: Bayes formula.
Tomas Bjork, 2010 35
Martingale Property of S D
Proposition: If S is an arbitrary price process, then
the process
S
t
D
t
is a P-martingale.
Proof: Bayes formula.
Tomas Bjork, 2010 36