Integration Theory in Financial Mathematics

P. Muldowney, W. Wojdowski

1 Introduction
For a majority of people, the use of mathematics is limited to counting and
simple arithmetic, mostly in the handling of money. But since the work of
Black, Scholes [2] and Merton [7] in 1973, sophisticated mathematics has
been required in order to conduct transactions in financial instruments such
as stock options and other kinds of derivative assets.
A financial asset or security is a claim to some payment. It may take
the physical form of a piece of paper on which a legal contract specifying
the claim is written. Assets are frequently traded — bought and sold. We
are concerned with establishing the monetary value, here and now, of such
entities. Because if their correct monetary value is unknown, they cannot be
traded fairly.
A forward contract is a simple kind of derivative asset. It is an agreement
to trade a security at a future time T for a price K called the delivery price.
The party who is going to buy is said to hold the long position in the forward
contract, and the party who is going to sell holds the short position.
At the time of writing the forward contract, no money changes hands
between the two parties, so the initial value of the forward is zero. But at
some time t between the time of writing the contract and its time of expiry,
the underlying security value may increase or decrease. So the value of the
long position will become positive or negative, and the value of the short
position will, respectively, become negative or positive.
Suppose that you hold the long position in the contract. At any time
between the initial writing of the contract and its expiry date, you can go to a
third party and negotiate a transaction — either selling off your long position
if its value is now positive, or buying your way out of it if its value is negative.
Likewise if you are the holder of the short position. Our problem here is to
determine the correct monetary values involved in such a transaction.

1
 So we have an underlying security, concerning which the forward contract
is written, but now both the long and short positions in the forward have
values (the one is the negative of the other) and are themselves negotiable
instruments. In other words, the forward contract is a derivative security.
If the forward contract is written at time 0, and its expiry date is time
T , let t denote any intermediate time. Let x(t) denote the price at time t of
the underlying security, and let f (t) denote the corresponding value of the
forward contract. It is not difficult to express f (t) in terms of other known
quantities, such as the risk-free interest rate r. It is shown in Hull [3] that

f (t) = x(t) − Ke−r(T −t) . (1)

But it is not so easy to establish the values of other kinds of derivative assets.
However, Black, Scholes [2], and Merton [7] opened up the subject of option
pricing.
The holder of the long position in a forward contract is obliged to purchase
the underlying asset at time T for the contracted price K. In contrast, the
holder of the long position in a European call option on the asset has the
right, but not the obligation to purchase the underlying asset at time T for
the price K.
The Black-Scholes formula for the value at time t of a European call
option is
x(t)Φ(d1 ) − Ke−r(T −t) Φ(d2 ) (2)
where 0 ≤ Φ(dj ) ≤ 1, j = 1, 2, and Φ(d) is a value of a cumulative normal
probability distribution which depends, through d, on the behaviour of the
underlying asset price.
Our purpose now is to examine in more detail the Black-Scholes-Merton
analysis, and how it may be improved by using the non-absolute, generalised
Riemann integration of Henstock.

2 The Black-Scholes Model

The basic model is Brownian motion. If a process y(t) is a Brownian motion
(or, in alternative terminology, a Wiener process) it satisfies:

1. For any t1 < t2 the increments y(t2 ) − y(t1 ) are normally distributed;

2. The sample paths {y(t) : 0 ≤ t ≤ T } are continuous functions of t.

2
A normally distributed random variable with mean value µ and variance σ 2
is said to be
N (µ, σ 2 ).
The increments y(t2 )−y(t1 ) of a generalised Brownian motion will have mean
value and variance each proportional to t2 − t1 , so the increments are

N (µ(t2 − t1 ), σ 2 (t2 − t1 )).

We then say that the process y has a drift rate µ and variance rate σ 2 . The
Itô calculus [5] can be used to represent y. This approach uses stochastic dif-
ferential equations (in reality, equations involving stochastic integrals). The
SDE used to represent a generalised Brownian motion y is

dy(t) = σdw(t) + µdt

where w(t) is a standard Brownian motion with zero drift and constant unit
variance rate; so w(t2 ) − w(t1 ) is N (0, t2 − t1 ) for all t1 < t2 .
Our model for a security price x(t) is geometric Brownian motion (or
exponential Wiener process): x(t) is a geometric Brownian motion if ln x(t) =
y(t) is a Brownian motion.
If the Brownian motion y(t) has drift rate µ and variance rate σ 2 , then,
using the Itô calculus [1], we find the following SDE for x(t):

dx(t) = x(t)(σdw(t) + µdt), (3)

which can be solved using the Itô calculus to give

1
 
x(t) = exp σw(t) + (µ − σ 2 )t .
2
Writing µ − 21 σ 2 = ν, we say that the security price process x(t) has growth
rate ν and volatility σ.
Implicit in this model of the security price process as a geometric Brow-
nian motion is a probability measure on the process sample space which
governs the actual changes in time of the security price x(t). But we must
impose a new and different set of probabilities (in place of the “real-world”
or actual probabilities which allow for a risk-premium) on the sample space
in order to accomplish the so-called risk-neutral valuation which is used to
establish the present value of the derivative price.

3
 Let P denote the natural or real-world probability measure, as implied
in the SDE (3) above. Our next step is to impose a different probability
measure Q on the sample space of paths {x(t) : 0 ≤ t ≤ T }. This Q will be
the risk-neutral probability measure that we require.
To see the connection between two probability measures P and Q, we use
the Radon-Nikodym Theorem. First, we suppose that P and Q are equivalent
measures; that is, for any event A of the sample space, P (A) is positive if
and only if Q is positive.
Let dQ
dP
be the Radon-Nikodym derivative. The Radon-Nikodym Theorem
tells us that !
Q P dQ
E (x(T )|x(0)) = E x(T )|x(0) .
dP
dQ
This specifies dP
at time T . Let ζ(t) := E P ( dQ
dP
|x(t)). For t > s it can be
shown that
1
E Q (x(t)|x(s)) = E P (ζ(t)x(t)|x(s)) .
ζ(s)
(The notation · · · |x(s)) indicates that x(t) is determined (or known) for all
times less than or equal to s, but is unknown or random for all times t greater
than s.) This establishes the relationship between the “natural” probability
measure P of the security price process x(t) and any equivalent probability
measure Q on the spaces determined by selecting values for s and t:

{x(τ ) : s ≤ τ ≤ t}, 0 ≤ s < t ≤ T.

We will require to determine such a measure Q which will change a geomet-

ric Brownian motion with a given, non-zero drift, to a geometric Brownian
motion with zero drift.
This is the fundamental step in the valuation of derivatives (and it applies
equally to the classical theory which we are discussing at present, and to the
theory based on Henstock integration which we will discuss later).
In the classical Itô calculus version of derivative pricing the Girsanov
Theorem is the key to determining Q. (But when we use the Henstock
integral, a much simpler approach does the trick.) Loosely, the Girsanov
Theorem says: If w(t) is a P -Brownian motion and γ(t) is a pre-visible
process satisfying the boundedness condition
" #!
P 1Z T
E exp γ(t)2 dt < ∞,
2 0

4
then there exists a probability measure Q such that Q is equivalent to P ,
 
dQ
= exp − 0T γ(t)dw(t) − 12 0T γ(t)2 dt , and
R R
dP
w̄(t) = w(t) + 0t γ(s)ds is a Q- Brownian motion.
R

In other words, given the sample space {y} we can impose a probability
measure on it so that the resulting Brownian motion y(t) has whatever drift
rate we want.
As a consequence of this, if x(t) is a geometric Brownian motion with
SDE
dx(t) = x(t)(σdw(t) + µdt)
where w(t) is a P -Brownian motion, then we can use the Girsanov Theorem
with γ(t) = (µ − ν)/σ to obtain a measure Q so that

dx(t) = x(t)(σdw̄(t) + νdt)

where w̄(t) is a Q-Brownian motion.

We can now formulate the classical Black-Scholes model. For 0 ≤ t ≤
T , let f (t) denote the price process of a derivative security, the underlying
security price process being x(t). We need an amount of cash which grows
at the risk-free rate – a cash bond – so we represent this by the bond price

b(t) = exp[rt].

Let σ be the volatility of the security and let µ be its growth rate. Define
the discounted claim process D as follows:
 
D(t) := E Q b(T )−1 f (T )|x(t) = E Q (exp [−rT ] f (T )|x(t)) ,

where Q has been chosen so that the discounted stock process S,

S(t) := b(t)−1 x(t) = exp (−rt) x(t),

is a Q-martingale. The construction of D implies D(t) is also a martingale

under Q. (It should be noted that, where we have used x, in many books S is
used to represent the stock price process.)
In effect, we use the Radon-Nikodym and Girsanov Theorems to select Q
so that S(t) has zero growth rate. The existence of such a Q is guaranteed,
in the absence of arbitrage, by the Fundamental Theorem of Asset Pricing
[4].

5
 The next step is to use the Martingale Representation Theorem. As a
process whose increments are governed by the probability measure Q, S(t) is
a martingale because of the way Q is selected. D(t) is also a Q-martingale.
The Martingale Representation Theorem then implies that, if the values of
S(t) and D(t) are known at time t, there exists a function ∆(t) so that the
increments in S(t) and D(t) satisfy the stochastic differential equation

dD(t) = ∆(t)dS(t). (4)

When the value x(t) is known, and hence S(t) and D(t)) are known, the
function ∆(t) is deterministic in terms of the SDE just given. But since x
is stochastic, ∆(t) is globally stochastic. The term pre-visible is sometimes
used to describe this property of ∆. We can think of ∆ as being continuous
from the left.
The implication of (4) is that, under the probability measure Q, the value
of the derivative is growing (“on average”, in terms of expectations relative
to Q) at the risk-free rate, just as the value of the stock is.
The basic Black-Scholes result is the following. Suppose r, µ and σ are
constant. Suppose the derivative claim f is determined at time T . At time
t, x(s) is taken to be known for 0 ≤ s ≤ t, so x(s) is not a random variable
for any such s. Since f (t) is determined by x(s) (0 ≤ s ≤ t), neither f (t)
nor D(t) are random variables. (Randomness only occurs for times greater
than t. This is the conditionality implied by the notation · · · |x(t).) Then
the arbitrage price f (t) of such a claim is given by

b(t)−1 f (t) = E Q (b(T )−1 f (T )|x(t)) or

f (t) = b(t)E Q (b(T )−1 f (T )|x(t))

This gives us the valuation we need. The derivative value at time t is

f (t) = e−r(T −t) E Q (f (T )|x(t)) . (5)

¿From this we can deduce the values of various kinds of derivative instru-
ments, whose values at maturity are given by appropriate functions f (T ).
This is the outline of the classical Black-Scholes model. The above is,
for the most part, a summary of an account of the classical continuous-time-
continuous-values model given in the book [1] of Baxter and Rennie, which
is a good place to start reading this theory, before attempting the deeper
mathematical treatments of the subject.

6
3 Pricing a European Call Option
A European call option gives the holder the right, but not the obligation,
to buy a unit of stock for a pre-determined amount K on a particular date
in the future, say T . If the stock price x(T ) at time T is less than K, the
option is not exercised and its value is zero. If x(T ) is greater than K, the
option is exercised, and a profit of x(T ) − K can be realised if the stock is
immediately sold.
The value of the claim at expiry time T is therefore

f (T ) = max(x(T ) − K, 0). (6)

The Black-Scholes theory then gives the present value of the derivative as
f (t) = e−r(T −t) E Q (f (T )|x(t)). Letting t = 0 represent the present, for a
European call option this reduces to

f (0) = e−rT E Q (max(x(T ) − K, 0)) ,

where Q is the martingale measure for the discounted stock price process
S(t). To evaluate f (0) we need an explicit expression for the probability
distribution of x(T ) under Q. If we look at the process for x(t) in terms
of the standard (drift rate zero, variance rate 1) Brownian motion w̄(t), we
have
d(ln x(t)) = σdw̄(t) + (r − 21 σ 2 )dt,
ln x(t) = ln x(0) + σ w̄(t) + (r − 12 σ 2 )t,
x(t) = x(0) exp[σ w̄(t) + (r − 12 σ 2 )t]
Thus, if we let z denote a normally distributed random variable with param-
eters
1 2
 
2
N − σ T, σ T ,
2
we can write
x(T ) = x(0)ez+rT
 
K
so, letting b = ln x(0)
− rT ,
 
f (0) = e−rT E max(x(0)ez+rT − K, 0)
 
R∞ (s+ 12 σ 2 T )2

= √ 1
2πσ 2 T b x(0)es − Ke−rT exp − 2σ 2 T
ds.

7
Now let
s + 12 σ 2 T
v=− √ ,
σ T
so √
1 Za  1 2
 1 2
f (0) = √ x(0)e−σ T v− 2 σ T − Ke−rT e− 2 v dv
2π −∞
where
ln x(0)
K
+ (r − 12 σ 2 )T
a= √ .
σ T
Since √ √
T v− 12 σ 2 T − 12 v 2 1
T )2
e−σ = e− 2 (v+σ ,
we get
√ ! !
1 Z a+σ T − 1 v2 1 Z a − 1 v2
f (0) = x(0) √ e 2 dv − Ke−rT √ e 2 dv , (7)
2π −∞ 2π −∞

and this is the celebrated Black-Scholes formula for the price of a European
call option. Compare its form to the form of the expression for the value of a
forward contract (1) above. If the present value x(0) of the underlying asset
is substantially larger than the exercise price K in the option, then the option
is very likely to be exercised, and, to some extent, performs financially like
a forward contract. In that case a will be large, and the bracketed factors in
(7) above will approach 1. In another notation,
√
f (0) = x(0)Φ(a + σ T ) − Ke−rT Φ(a) (8)

where Φ(a) is the probability that a standard normal variable v (with mean
zero and variance 1) is less than or equal to a.

4 Derivative Pricing and Henstock Integrals

The classical Black-Scholes-Merton method for pricing European call options
uses the Itô calculus to model the processes involved. But it is possible to
model stochastic process using Henstock integrands instead of Itô differentials
(or stochastic integrals), and to derive the Black-Scholes partial differential
equation and pricing formulae using elementary methods. This is done in [8].
We outline some of the basic ideas here.

8
 The Black-Scholes model [2] assumes that the price of an economic asset,
as a random function of time, is a geometric Brownian motion. This implies
that if the value xj−1 occurs at time tj−1 , the probability of the outcome
that, at time tj the process takes a value xj between uj and vj , is related to
(ln xj − ln xj−1 )2
" #
Z vj 1 1
exp − dxj
uj Aj x j 2σ 2 (tj − tj−1 )
1
where Aj is a normalising factor (2πσ 2 (tj − tj−1 )) 2 .
When pricing a derivative asset, such as a European call option whose
value depends on the movements in the value of an underlying asset, the
probabilities involved turn out to have the form
Z vj
gj (µ)dxj (9)
uj

where gj (µ) is
 !2 
1 1 1 ln xj − ln xj−1 − (µ − 12 σ 2 )(tj − tj−1 )
exp − 2 (tj − tj−1 )
Aj x j 2σ tj − tj−1
(10)
with µ being the actual growth rate of the underlying asset values.
¿From this, the probability of the outcome that, at times tj , the under-
lying asset price process x takes values xj in the range [uj , vj [ for 1 ≤ j ≤ n
will be given by integrating from uj to vj , j = 1, 2, . . . , n, giving an integral
of the form  
Z v1 Z vn n
Y 
··· gj (µ) dx1 · · · dxn . (11)
u1 un 
j=1

In order to accomplish the risk-neutral valuation described in Section 2 above,

we construct probability functions which give the underlying asset values x(t)
a growth rate equal to the risk-free interest rate r. This is done simply by
replacing the parameter µ by r in (10) above, giving
 !2 
1 1 1 ln xj − ln xj−1 − (r − 12 σ 2 )(tj − tj−1 )
exp − 2 (tj − tj−1 )
Aj x j 2σ tj − tj−1
(12)
which is gj (r), and then forming the density functions
 
Z v1 Z vn Yn 
··· gj (r) dx1 · · · dxn . (13)
u1 un 
j=1


9
These are the risk-neutral probabilities for the asset price process x. That
the risk-neutral probabilities are, firstly, so easily established, and, secondly,
specified sufficiently in (13), distinguishes the Henstock integral approach
sharply from the pricing theory that has developed over the past twenty
five years or so, as described in Section 2 above. The latter approach re-
quires that the simple sets of outcomes described above be extended, us-
ing the Kolmogorov Theorem, to a sigma-algebra of measurable sets in an
infinite-dimensional sample space whose representative elements are continu-
ous paths; that the processes involved be represented by appropriate stochas-
tic differential equations; that a suitable probability measure for the sample
space be found by means of the Girsanov and Radon-Nikodym Theorems;
and that the derivative asset valuation be then determined by means of an
expectation using Lebesgue integration.
The binomial model of derivative valuation (see [3]), in which only a finite
number of times tj and a finite number of asset and derivative values are
considered, is much simpler than the continuous time model in which every
possible time t is allowed. The difficulty arises because of the complicated
structures of measurable sets which the continuous-time-continuous-values
model requires in the classical Itô model described in Section 2 above.
However, to calculate expectation using Henstock integration, the ma-
chinery of measurable sets is not required. It is sufficient that the probabil-
ities be defined for uj ≤ x(tj ) < vj , 1 < j ≤ n. And in this situation, it is
remarkably simple to determine the change of measure needed for risk-neutral
valuation. The simple sets we have just described are, of course, measurable
sets in the classical Itô theory of Section 2. But since that theory requires
us to deal with probability measure on general measurable sets, which are
harder to visualise than the simple sets we have just described, the classical
theory uses the very abstract notation and methods of stochastic differential
equations, and tends to lose sight of the basic transition probabilities of (11)
which are fundamental to both the Itô and Henstock approaches.
Let us take, for instance, a European call option, whose claim value de-
pends on the underlying asset value at time T in a very simple way, as we
have seen in (6). If we seek to obtain the claim value by trying to compute
a statistical expectation by integrating the discounted claim value, in n di-
mensions only, with respect to the probabilities defined by the n-dimensional
integrals of (11) above, we get a result similar to that which is obtained by

10
the Lebesgue integral-based continuous-time model. To see this, take

0 = t0 < t1 < · · · < tn = T ; xj := x(tj ) for 0 ≤ j ≤ n,

and, following the reasoning involved in (5), as discussed in Section 2, esti-

mate the expectation of

exp[−rT ] max(x(T ) − K, 0)

with respect to the probabilities in (11) above. We may suspect that this
involves evaluation of an integral of the form
Z ∞ Z ∞
··· φdx1 · · · dxn .
−∞ −∞

(Remember that x0 is the present, known value of the underlying asset, and
is not, therefore, a random variable.) The integrand φ is
n
−rT
Y
e max(xn − K, 0) × gj (r). (14)
j=1

When the integration with respect to xj (1 ≤ j ≤ n) is performed, we get the

very same expression as that found in Section 3 for the value of a European
call option.
Another pointer to a new approach to derivative valuation is obtained
from the Black-Scholes partial differential equation. The problem of option
valuation was originally solved (with r and σ assumed constant) by Black
and Scholes [2], not by the the risk-neutral probability method described in
Sections 2 and 3, but by solving the following partial differential equation,
where x0 , t0 are written as ξ, τ , respectively:

∂f ∂f 1 ∂2f
+ rξ + σ 2 ξ 2 2 = rf, (15)
∂τ ∂ξ 2 ∂ξ
subject to the boundary condition

f (T ) = max(x(T ) − K, 0).

Note that the integrand φ of (14) depends on the parameters ξ = x0 , τ = t0

If we perform on φ the various partial differentiations that appear in (15),

11
we obtain a partial differential equation which is very similar to the Black-
Scholes equation. We might then hope to take expectations (using some
system of integration) involving risk-neutral probabilities, and, switching the
order of integration and differentiation, obtain the Black-Scholes partial dif-
ferential equation (15).
These simplistic observations indicate that there may be a way to avoid
using the Itô calculus and other advanced mathematical theories in formu-
lating a continuous time model for pricing derivatives, and this is further
motivation for examining the problem in terms of Henstock integration in
the manner of [8].

References
[1] M. Baxter and A. Rennie, Financial Calculus: an introduction to deriva-
tive pricing, Cambridge, 1996.

[2] F. Black and M. Scholes, The pricing of options and corporate liabilities,
Journal of Political Economy, 81, 1973, 637-659.

[3] John Hull, Options, Futures and other Derivatives, Prentice Hall, 1999.

[4] J.E. Ingersoll, Theory of Financial Decision Making, Rowman and Lit-
tlefield, Savage, 1987.

[5] I. Karatzas and S.E. Shreve, Brownian Motion and Stochastic Calculus,
Springer-Verlag, 1988.

[6] I. Karatzas and S.E. Shreve, Methods of Mathematical Finance,

Springer, 1998.

[7] R.C. Merton, Theory of rational option pricing, Bell Journal of Eco-
nomics and Management Sciences, 4, 1973, 141-183.

[8] P. Muldowney, The Henstock integral and the Black-Scholes theory of

derivative asset pricing, Real Analysis Exchange, 2000-1, 1-16.

12