Changes of Numraire, Changes of Probability Measure and Option Pricing

Author(s): Hlyette Geman, Nicole El Karoui and Jean-Charles Rochet

Source: Journal of Applied Probability, Vol. 32, No. 2 (Jun., 1995), pp. 443-458
Published by: Applied Probability Trust
Stable URL: http://www.jstor.org/stable/3215299 .
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J. Appl. Prob. 32, 443-458 (1995)

Printedin Israel
c AppliedProbabilityTrust 1995

CHANGESOF NUMERAIRE,CHANGESOF PROBABILITYMEASURE

AND OPTION PRICING
HILYETTE GEMAN,*ESSEC, Cergy-Pontoise
NICOLEEL KAROUI,**UniversittParis VI
ToulouseI
JEAN-CHARLESROCHET,***GREMAQ,UniversitO

Abstract
The use of the risk-neutralprobabilitymeasurehas provedto be very powerfulfor
computingthe pricesof contingentclaims in the context of completemarkets,or the
prices of redundantsecuritieswhen the assumptionof complete marketsis relaxed.
We show here that many other probabilitymeasurescan be definedin the same way
to solve different asset-pricingproblems, in particularoption pricing. Moreover,
these probabilitymeasurechangesarein fact associatedwith numerairechanges;this
feature,besides providinga financialinterpretation,permitsefficientselectionof the
numeraireappropriatefor the pricingof a given contingentclaim and also permits
exhibition of the hedgingportfolio, which is in many respectsmore importantthan
the valuation itself.
The key theorem of general numerairechange is illustratedby many examples,
among which the extension to a stochasticinterestratesframeworkof the Margrabe
formula,Geske formula,etc.
PROBABILITYMEASURECHANGES; MARTINGALES;PRICESRELATIVETO A NUMtRAIRE;
HEDGING PORTFOLIO;FORWARD VOLATILITY
AMS 1991 SUBJECT CLASSIFICATION:PRIMARY 90A09
SECONDARY 60G35

1. Introduction
One of the most populartechnicaltools for computingasset prices is the so-called
'risk-adjustedprobabilitymeasure'.Elaboratingon an initialidea of Arrow,Ross (1978)
and Harrisonand Kreps(1979) have shownthat the absenceof arbitrageopportunities
impliesthe existenceof a probabilitymeasureQ, suchthatthe currentpriceof anybasic
securityis equal to the Q-expectationof its discountedfuturepayments.In particular,
between two payment dates, the discountedprice of any securityis a Q-martingale.
When markets are complete, i.e. when enough non-redundantsecurities are being
traded,Q is unique.
Received 20 July 1993; revision received 4 January1994.
* Postal address: Finance Department, ESSEC, Avenue Bernard Hirsch, BP105, 95021 CergyPontoise Cedex, France.
** Postal address:GREMAQ,IDEI, Universite Toulouse 1, Plane Anatole France, 31042 Toulouse,
France.
*** Postal address:Laboratoirede Probabilit6s,Universit6 Paris VI, 4 Place Jussieu, Tour 56-66,
75252 Paris Cedex 05, France.

443

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H. GEMAN, N. EL KAROUI AND J.-C. ROCHET

444

By usinga verysimpletechnicalargument(Theorem1, Section2) we provethatmany

otherprobabilitymeasurescan be definedin a similarway, and proveequallyusefulin
variouskindsof optionpricingproblems.Morespecifically,if X(t) is the priceprocessof
a non-dividend-paying
security(at least in the relevanttime period),our main theorem
states the existenceof a probabilitymeasureQx such that the price of any securityS
relative to the num raire X is a Qx-martingale.A very general numerairechange
formulais then providedand differentapplicationsto exchangeoptionsand optionson
options in a stochasticinterestratesenvironment,options on bonds, etc. illustratethe
efficiencyof the rightchoiceof numeraire.Someof the resultsin the papermaybe found
more or less explicitlyin the existingliterature.Ourgoal is to emphasizethe generality
and the efficiencyof the numerairechangemethodology.
2. The modelandthe crucialtheorem
We considera stochasticintertemporaleconomy,whereuncertaintyis representedby
a probabilityspace(0, F, P). The only role of the probabilityP is in fact to definethe
negligiblesets. Most of our applicationswill be takenin a continuous-timeframework,
withina boundedtime interval[0, T] but ourbasicargumentis also valid for a discretetime economy.
We will not completelyspecifythe underlyingassumptionson the economy.The flow
of informationaccruingto all the agentsin the economyis representedby a filtration
(f)t E[0, T], satisfying 'the usual hypotheses',i.e. the filtration(F)0o1., is right
continuousand 70 containsall the P-null sets of ?F.
In the following, the word 'asset' representsa general financial instrument.We
distinguishtwo classes of assets. One class consists of the basic securities,which are
tradedon the marketsand arethe componentsof the portfoliodefinedbelow.The other
class of assetsto be consideredis the classof derivativesecurities,also calledcontingent
claims, for whichthe key issuesare the valuationand hedging.All assetpriceprocesses
arecontinuousF- semimartingales.The pricesS,(t), --.- , S,(t) of the basicsecuritiesare
observed on the financialmarketsand almost surely strictlypositive for all t; more
generally,unlessotherwisespecified,the price of any asset is almostsurelypositive.
The fundamentalconcept in the pricingor hedgingof contingentclaims is the selffinancingreplicatingportfolio,and these self-financingportfoliosconsequentlydeserve
particularattention(buy and hold portfoliosare the simplestexampleof self-financing
portfolios since there is no trade). More generally,these portfolios track the target
changesover time with no additionof money.
The financialvalue V(t)of a portfoliowhichincludesthe quantitiesw,(t), . , w,(t) of
the assets 1, 2,. - -, n is given by
(1)

V(t)=

X wk(t)Sk(t)
kl1

and

V(t)?O

forallt

are adapted, i.e. the quantities

where the processes (w,(t))r
_o,...,(w,(t))to>
to the informationavailableat time t. The vector
w1(t), . , w,(t) are chosenaccording
?
is calledthe portfoliostrategy.
process(w,(t)), ... ,
(w,(t))to

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measureandoptionpricing
Changesof numraire,changesofprobability

445

Definition 1. The portfolio is called self-financingif the vector stochasticintegral

ST
Wk(t)dSk(t)exists and
Z._l

dV(t)=

(2)

E wk(t)dSk(t).

k-I

Remark. To understandthe intuitionbehindEquation(2), let us takethe exampleof

< t, and
a simplestrategy,i.e. a strategyrebalancedonly at fixeddates0 = to< t <
?
that we supposeleft continuous.The self-financingequationcan then be written
as

V(t) Vct1)
-V(t)

k-I

g)[Sk(t) Sk(tjl)].
Wk(tj+

By definition,

v(t)= k-IE Wk(tj)Sk(ti).

The self-financingconditionis V(tj)= V(t+) for allj or in otherterms,
(3)

=
E Wk(tj)Sk(ty)
E Wk(tj+)Sk(ti).
k-I

k-1

Using (3) at time tj_, and rememberingthat Wk(tj)= Wk(tjiI), the self-financingcondition can also be writtenas
V(tJi)- V(ti-)=

k(u)dSk(U).
i,
More generally,the changeof the portfoliovalue betweenany dates t < t' is

V(t')- V(t)= kf

wk(U)dSk(U).

For non-elementarystrategies,this will be the definitionof self-financingstrategies.

We have not emphasizedso farthe factthat therewas an implicitnumerairebehindthe
pricesSI, S2,... , S,; it is the numbrairerelevantfor domestictransactionsat time t and
obviouslyplays a particularrole. Ourobjectiveis to show that otherquantitiesmay be
chosen as numbrairesand that, for a given problem,there is a 'best'numeraire.
Definition 2. A numeraireis a price processX(t) almost surelystrictlypositive for
each tE [0, T].
Proposition1. Self-financingportfolios remain self-financingafter a numbraire
change.
froma financialviewpoint.Mathematically,
Proof. This propertyis straightforward
it is also clear that Equation(3) still holds after a numbrairechange.Let X be a new
numbraire.From It6's lemma,we derive

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H. GEMAN,N. EL KAROUIAND J.-C. ROCHET

446

(t)=Sk(t)d
X(t))

-d

dSk(t) + d(Sk, 1/X),

X(t) + X(t)

whered(Sk, 1/X) denotesthe instantaneouscovariancebetweenthe semimartingales

Sk
and 1/X. In the same manner
= V(t)d (
dd(W
X(t)
) (X

X(t)

dV(t)1 + d( , 1/X),

The self-financingcondition
n

dV(t)=

and

E wk(t)dSk(t)

V(t)=

wk(t)Sk(t)
k=1

k-1

implies that

X(t) kj

k-1
=-Wk(t)

i wk(t)d

Sk(t)d

+
X(t)

X(t)

dSk(1)+

d(Sk, 1/X),

(t)

and the portfolioexpressedin the new numeraireremainsself-financing.

Corollaryand Definition3
(a) A contingentclaim(i.e. a randomcash-flowH paidat time T) is calledattainableif
there exists a self-financingportfoliowhose terminalvalue equalsH(T).
(b) If a contingentclaimis attainablein a given numeraire,it is also attainablein any
other numbraireand the replicatingstrategyis the same.
This propertyis immediatelyderivedfrom Proposition1.
The pricingmethodologydevelopedin the paperfollowsHarrisonand Kreps(1979)
and Harrisonand Pliska(1981) in the no arbitrageassumption:for everyself-financing
portfolio V belongingto a particularclass of portfolios, V(O)= 0 and V(T) > 0 almost
surelyimply V(T) = 0.
If Q is finiteas well as the set of transactiondates,thereis no restrictionon the classof
portfolios and the no arbitrageassumptionis equivalentto the existence of a 'riskneutral probabilitymeasure'(see Harrisonand Kreps (1979), Harrisonand Pliska
(1981)). In our setting,as observedby Duffie and Huang(1985), this equivalenceno
longerholds and some requirementshave to be put on the portfolios:the naturalone
involves square integrability conditions of the weights of the portfolio with respect to the
instantaneous variance-covariance matrix of the basic assets. Delbaen and Schachermayer (1992) introduce a weaker formulation of the no arbitrageassumption, the no free
lunch with vanishing risk (NFLVR), which only requires portfolios bounded below. The
NFLVR condition is necessary and sufficient to exhibit a (local) martingale measure.
The former condition is clearly not invariant in a numeraire change. The latter one is
if the lower bound is zero, hence the condition V(t) 0 for all t that we introduced
-

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measureandoptionpricing
changesofprobability
Changesof numdraire,

447

earlierand which will remain valid throughoutthe paper unless otherwisespecified.

Moreprecisely,our no arbitrageassumptionwill be expressedin the followingmanner.
Assumption1. There exists a non-dividend-payingasset n(t) and a probability7r
equivalent to the initial probabilityP such that for any basic security Sk without
intermediatepayments,the priceof Skrelativeto n, i.e. Sk(t)/n(t)is a local martingale
with respectto 7r.
By convention,we will take n(0) = 1.
Observations
* Portfoliosthemselvesexpressedin this numbrairewill be, by definition,
gr-local
martingales.
* Moreover,if they are positive for all t, portfoliosare supermartingales,
i.e.
V(t)

V(T)

S(t)>E[(T)
n(t)
Ln(T)

almostsurely.

* If the terminalvalue V(T)/n(T) is squareintegrable,i.e. E,[(V(T)/n(T))2]is finite,

then the portfoliovalue is a n-martingaleand
V(t)W
n(t)[

V(T)
n(T)

* The consequenceis that if a contingentclaimH is attainableand its terminalvalue

in the numbrairen is r-squareintegrable,then all replicatingportfolioshave the same
value at anyintermediarydate t. This valueis the priceat time t of the contingentclaim.
* In the generalcase (relaxingthe assumptionof squareintegrability),all replicating
(positive) portfoliosdo not necessarilyhave the same value at any date t (see Dudley
(1977), developedin Karatzasand Shreve(1988))for the non-unicityof theseportfolios
but all these values are boundedbelow by E,[H(T)/n(T) I t].
Moreover,if thereexistsone replicatingportfoliowhosevalueat anytime t is equalto
this expectation,this value will be calledthe price(orfair price)of the contingentclaim
(with respectto (n, 7r))and the correspondingportfolio called the hedgingportfolio.
Keepingthe samenumbrairen, if thereexists anotherprobabilityn' satisfyingthe same
replicabilityproperty,then

E[HH(T) .1
n(T)
_

[H(T) F

n(T)

Hence, the fair price does not depend on the choice of the 'risk-neutral'probability
measure7r(as long as this price exists); this remarkis very importantfor the main
purpose of this paper, namely the choice of the optimal numbraire when pricing and
hedging a given contingent claim.
We now give an example of a situation where all contingent claims have a fair price.
Suppose that the prices S,(t), S2(t),..., Sn(t) of the basic securities expressed in the
numbraire n are stochastic integrals with respect to q Brownian motions W,, . , Wqand
that the filtration .G is generated by these Brownian motions. Since S,, S2,..., Sn are

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H. GEMAN, N. EL KAROUI AND J.-C. ROCHET

448

local martingales,their dynamics under 7r are driven by the stochastic differential

equations
q

dS,

=Z
dC=

Si

j-1

idWj,

i= 1

...,

n.

If we assumethatthe matrixI = [oai] is invertible(whichobviouslyimpliesq = n), then

the martingalerepresentationallows us to express any conditionalexpectationas a
stochasticintegralwith respectto the basic asset prices,henceas a portfolio.
The samepropertyholdsif the numbern of basicsecuritiesis greaterthanthe number
of Brownianmotions(and rankI = q).
Theorem1. Let X(t) be a non-dividendpaying numerairesuch that X(t) is a
n-martingale.Then there exists a probabilitymeasure Qx defined by its RadonNikodymderivativewith respectto 7r
dQx
d7r

X(T)
X(O)n(T)

such that
(i) the basic securitiespricesare Qx-localmartingales,
(ii) if a contingentclaimH has a fairpriceunder(n, 7), then it has a fairpriceunder
(X, Qx) and the hedgingportfoliois the same.
Proof
(i) If we denoteby S = (S(t)/X(t)) the relativepriceof a securityS with respectto the
numeraireX, the conditionalexpectationsformulagives

(dQx-ddQx (I==ir
E,,1 dr S(T) -FtdI

'

By Assumption1, we have
S(t)
E [dQx(T)
n(t)X(O)
Ld
and similarly

X(t)
n(t)X(o) =

[dQx
d

dEThis gives the martingalepropertyS(t) underQx, and]"

consequentlyfor any portfolio.
H
If
has
under
a
fair
price
(n, 7r),E,[H(T)/n(T) I is a self-financingportfolio.
(ii)
tt]
Since
T)
X(t)
T) iH(
T)
n(t)
e[H(
X(
n(T)
and we observedearlierthat the propertyof beinga self-financingportfoliois invariant
througha numbrairechange,EeX[H(T)/n(T) 4] is also a self-financingtheoremand
Theorem1 holds.

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measureandoptionpricing
changesofprobability
Changesof numeraire,

449

From now on, we will concentrateon the changesof numbrairetechniques.

Corollary2. If X and Y are two arbitrarysecurities,the generalnumerairechange
formulacan be writtenat any time t < T as

IF1
IF] = Y(O)EQ,[X(T)(
X(O)EQx[Y(T)
where(Dis any randomcash flow 3F-measurable.
Proof. The formulacan be immediatelyderivedfrom Theorem1, which entails
dQx
dQ[, r

dQx

dir dQ,/dir

X(T)

X(T)/Y(T)

X(O)n(T)

Y(T)/Y(O)n(T)

X(O)/Y(O)

We will show lateron in the paperhow the choice of an appropriatenumerairepermits

us to simplifypricingand hedgingproblems.
We startby givingtwo examplesof suchnumerairechangesalreadyencounteredin the
literature.We wantto emphasizethe factthatin both cases,the importantmessageis the
financialsuitabilityof the chosennumbraireto a given problem;the probabilitychanges
that follow are usefultechnicallybut also convey an economicinterpretation.
Example 1: Themoneymarketaccountas a numeraire. It is naturalto takeas a first
exampleof numbrairethe risklessasset (assumingit exists). More precisely,we define
fi(t) (also called the accumulationfactor)as the value at date t of a fund createdby
investingone dollarat time 0 on the money marketand continuouslyreinvestedat the
(instantaneouslyriskless)instantaneousinterest rate r(t). The interestrate processis
denotedby (rt),o. At this point we need a technicalassumption.
Assumption2. Foralmostall o, t - r,(o) is strictlypositiveandcontinuousand r,is
an 5' -measurableprocesson (0, 'F, P). Under this assumption,it is clearthat
f(t) = exp

r(s)ds.

Then the relativeprice S(t) of a securitywith respectto the numbraireP is simply its
discountedprice
S(t) = [exp - fo r(s)ds] S(t).

The probabilitymeasureQgis the usual'risk-neutral'probabilitymeasureQdefinedby

dQ
dr

1 exp

n(T)

o r(s)ds.

'Historically' (see Harrison and Pliska (1981)), Q = i was the first 'risk-neutral'
probability measure (associated with the numbraire f) expressing that discounted asset
prices are Q-martingales.
Example 2: Zero-coupon bonds as numdraires. A zero-coupon bond imposes itself
as the numbraire when one looks at the price at time t of an asset giving right to a single

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H. GEMAN,
N. ELKAROUI
ANDJ.-C.ROCHET

450

cash-flowat a well-definedfuture time T. Keeping in mind the generalmartingale

propertyof Theorem 1, the right numbraireto introduce,whetherinterest rates are
stochasticor not, is the zero-couponbond maturingat time T. Let us makeexplicitthe
correspondingprobabilitymeasurechange.
The priceprocessof the bond will be denotedeitherby B(t, T) or by Br(t),
Br(t)

= EQ[exp-

tr(s)ds
whereQ is the probabilitydefinedin Example1.
Corollary2 of Theorem1 gives
dQT

f(O)

dQ P(T)r
B(0,T) B(0,
T)---

or(

TherelativepriceS(t)/B(t,T) is preciselytheforwardpriceFs(t)of thesecurityS and

fromTheorem1 we get
FS(t)=

[S(T)
EQT[B(T

T)jT)

In otherwords,theforward
price,relativeto timeT, of a securitywhichpaysnodividend
up to timeT is equalto theexpectation
of thevalueat timeT of thissecurityunderthe
probability.
forwardneutral'
Thefinancialintuitionof thisresultcanbe foundin Bick(1988)andMerton(1973);
themathematical
treatment
wasdevelopedin thegeneralcaseof stochastic
interestrates
byJamshidian
byGeman(1989)andin a Gaussianinterestrateframework
(1989).Even
if thischangeof numeraire
T
on
time
and
is
not
as
universal
as
the
'accumulatdepends
in
it
to
factor'
turns
out
be
the
when
numbraire
presented Example1,
evaluating
right
ing
a futurerandomcash-flowin a stochasticinterestrates environment.Besidesits
in thenextsection,thisnumeraire
to optionpricingpresented
applications
changegives
resultsin the pricingof floating-rate
remarkable
notesand of interestrateswaps,as
shownin ElKarouiandGeman(1991),(1994).
3. Applicationsto options
In this sectionwe focuson findinginterestingexpressionsfor optionpricesratherthan
discussingtheirexistence.Consequently,we will supposethat all optionsconsideredin
the followingare attainableassets.We gave earlieran exampleof a situationwherethis
propertyholds;we must observe,though,that in many situationsweakerassumptions
suffice. The best example is the classical Black and Scholes frameworkwhere no
assumption of completeness is necessary since it is easy to replicate the conditional
expectation of the terminal pay-off by a portfolio of the riskless asset and the risky asset,
hence to derive a fair price for the European call.
3.1. A general formula. Let us consider a call written on a security whose price
dynamics S(t) does not require any other specification than the fact of being a positive
semimartingale.

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measureandoptionpricing
changesofprobability
Changesof numdraire,

451

Theorem2. Under Assumptions1 and 2, and denotingby T and K respectivelyits

maturityand exerciseprice,the price at time 0 of the call can be writtenas
S(T)

C(0)
B(0, T)

K+

B(T, T)

or
C(O)= S(O)Qs(A) - KB(O, T)QT(A)

whereA = ({ IS(T, o) > KB(T, T)}.

The first expressionof C(0) is immediatelyderived from Theorem 1 used in the
context of Example2. We will prove the second one:
- K)]=+ E
T) 1A- KQ(A)
\B(
B( T,T)
Egr[(S(T)
From the generalnumbrairechangeformula(Corollary2 of Theorem1), we get
B(0, T)

S(O)

ET(S(T)
\B(T, T))

Es(1A).

B(0, T)

We thus obtainthe secondexpressionof C(0).

Corollary3. In the same way, the option of exchangingasset 2 againstasset 1 at
time T gives right to the cash-flow[SI(T) - KS2(T)] + with K = 1 and its price C(0)
at time 0 is such that
CS(O)= E
S(T)

or
C(O)= S,(O)Qs (A) - KS2(0)Qs,(A)

whereA - to ED ISI(T, co)2 KS2(T, o)}.

Thisformulaholdseven whenriskyasset volatilitiesand interestratesare stochastic.
Corollary4. Moregenerally,an optionwhichgivesrightto the paymentat time Tof

the quantity (Zn..1 4kXk(T))+, where A, - - , A, are any real numbers, X, - - , X, are
risky assets and possibly X,(T) = K (the usual strike price of the option), has a value at
time 0 which can be written as
C(O)=

3k
k-I

Xk(O)Q(A).

Obviously,this is the situationencounteredwith options on bonds.

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H. GEMAN, N. EL KAROUI AND J.-C. ROCHET

452

3.2. Applicationsof Theorem2

(a) A reexaminationof the Black and Scholes'formula. We will make the usual
assumptionsof the Blackand Scholes'model,exceptthatwe will allowinterestratesand
riskyassetvolatilityto be stochastic.Theorem2 entailsthe followingcall price:
C(O) = S(O)Qs(A) - KB(O, T)QT(A).

The asset involved in the secondterm is in fact the forwardpriceof S,

Fs(t) =

S(t)

B(t, T) '

which is a positive martingaleunder QT and can thereforebe writtenas a stochastic

integralof a Brownianprocess:
dFs(t)

Fs(t)

F(t)dWv

where (f,,)2 = (1/dt)Var(dFS/FS).

Assumingthat aFs is deterministic,QT(A)is equalto Pr(u 0), whereu is a Gaussian
variable with mean In(S(O)/KB(O,T)) - qFT and variance
OFsT. Consequently,
QT(A) = N(d2) with

S(0)

1
I
d2=
SaFs

InKB(O,

T}

T)-?FsT

The firstterm in the Theorem2 formulainvolves the asset

B(t, T)
S(t)

1
Fs(t)

z'(t).

Whetherstochasticor not, the volatility of ZT under Qs is the same as the volatility

of Fs underQT(withpossiblydifferentBrownianprocesses).Assumingthesevolatilities
deterministic,
Qs(A)= Qs Z(T)

Qs(A)= Qs arsWT- uT

= Qs Z(0)exp aW

5
--

T-

< InKZ(O)

(
S(O)
KZ1
1
A
Tar S(0)In
KB((O,T)) + 2 ars /

= N(d,).

In fact we obtain the Merton formula, and, if we define r by B(O, T) = e-rT, it becomes
the Black and Scholes' formula.
We have thus shown that these two formulae hold under the sole hypothesis of a
volatility for the forward contract S(t)/B(t, T), without any necessary specification on
the asset price or interest rates.

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measure
andoption
pricing
ofprobability
changes
ofnumdraire,
Changes

453

Obviously,in the Blackand Scholes'framework,interestratesare assumedconstant

and the hypothesisof a deterministicvolatilityof the forwardcontractis equivalentto
the hypothesisof a deterministicvolatilityof the stock price.
(b) Applicationto the exchangeoption. In this case,thereis no 'forwardcontract'of
S, with respectto S2. Consequentlywe need to specifythe movementof the two asset
prices underthe risk neutralprobability:
dX1
S=rdt + aidW,,

X,

dX
X2

X2

rdt + q2dW2

wherea, and q2 are not supposeddeterministicand (dW,, dW2)= rdt.

q2 and, for the same
Consequently,the volatilityof X,/X2is equalto /ru,2+ u22 2p
reasonsas earlier,we see thatMargrabe'sformula(1978)holdsunderthe sole hypothesis
withoutsummingnon-stochasticinterestrates.
of a deterministicvolatilityfor X,A/X2,
We observe that the same methodologycould be applied to the pricingof equitylinked foreignexchangeoptions also calledquantooptions (see Reiner(1992)).
(c) Applicationto hedging. Fromthe calculationsconductedin (a), we see thatin the
generalsituationof stochasticinterestrates,the rightway of hedgingshouldnot be read
in the Blackand Scholes'formulabut in the Mertonformula
C(0) = S(O)N(d,)- KB(O,T)N(d2).
From this, we can derive very symmetricallythe quantityN(d1)to invest in the risky
asset and the quantityN(d2)to invest in K zero-couponbonds maturingat time T.
Practitionerswho use these weightsto hedgethe optionwith the underlyingassetand
moneymarketinstrumentsimplicitlyassumenon-stochasticinterestrates.Moreover,it
is clearthat if interestratesare stochastic,what is usuallydenominatedas the 'implied
volatility'of the asset is in fact the impliedvolatilityof the forwardcontract.
If interestratesarestochasticandif one wantsto hedgethe optionwiththe underlying
asset and short-termbills, it is necessaryto assume that the same Brownianmotion
perturbatesthe movement of the risky asset and the one of the zero-couponbond
maturing at time T, namely that under the risk neutral probability,we have the
followingdynamics:
dS
= rdtacdW,
+
S

dBT
= rdt + a2dW
BT

from whichwe derive

dB T r i 1

dt + a dS

Consequently,we see that the quantityto hold shortin the riskyasset in orderto hedge
the option is not N(d1)but in fact

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H. GEMAN, N. EL KAROUI AND J.-C. ROCHET

454

dC
-

B(t, T)OC
+, a2
S a, S(t) OB

i.e.

a2B(t, T)
TN(d2).
N(d,)- K a, B(t,
S(t)
The number of risky stocks involved in the self-financingportfolio replicatingthe
but the partialderivativeof the Blackand Scholespricewith
Europeancall is not
N(dl),
to
the
stock
and well-knownas the delta of the call.
respect
underlying
The classical 'A hedging'is correctunderstochasticinterestratesonly if the hedging
portfolioinvolves,besidesthe riskystock, the zero-couponbondmaturingat time T.
(d) Applicationto compoundoptions. We now extendthe pricingformulagiven by
Geske(1979) for a compoundoptionbut withoutassumingdeterministicinterestrates.
This involves,besidesthe riskystock,the zero-coupon.Let
S) be the priceat date t
Cl(t,
of a Europeancall optionon the stock,with strikepriceK, and
exercisedata T,; C2(t, S)
be the priceat date t of a Europeancall option on C,, with strikepriceK2and T2< TI;
E I
A, = ({oE9S(T, ow)- K,)} be the exercise set of option C,; and A2= {wEo
S(T2,w) 2 S*} be the exercise set of option C2, where S* is defined implicitly by
C,(T2, S*) = K2.
In the same spiritas earlier,we write
C2(0)= B(O, T2)EQT,
{([C,(T2, S(T2)) - K2]+
+ B(O, T2)EQT,[C,(T2,
C2(0)= - K2B(O,T2)QT2(A2)
S(T2))

1A2].

Makingexplicit CI(T2,S(T2)),we get

S(T2) 1A2]
B(O, T2)EQT,[CI(T2,
= B(O, T2)EQ,[1A2B(T2, TI)EQT,{(S(T)

KI)+} I , ].

Takingin Corollary1 the assetX as the zero-couponbond maturingat time T,, Yas the
zero-couponbond maturingat time T2and T = T2,we rewritethis expressionas
B(O,

{(S(T,)
TI)E~QT[1A2EQT,

KI)+ I?,)

or
n
TI)Eo,,[ 1AS(T,)1 A,] KIB(O,TI)Q,,(A, A2).
Using again the change of numbraire formula, we obtain
B(O,

B(O, T,)EQp,,[S(T,)1,AnA2]= S(O)Qg(A,n A2).

Regrouping the different terms, we write the price of the compound option as
C2(0)= S(O)Qs(A, n A2) - KB(O, T,)Q, (A, n A2) - K2B(0, T2)QT2(A2).

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measureandoptionpricing
Changesof numdraire,
changesof probability

455

This formula does not assume interest rates and stock price volatility to be nonstochastic.
If we makethe assumptionof a deterministicstock price volatility,we can prove by
the same argumentsas in Section 2.2 that
S

S*B(O,T2) 2
In S*B(O0T2) 21

QT2(A2)=^N(52) = (a

/T

QTr,(A,n A2)= N(61, 2)

where
6,

1
11

I-n---IL

S(O)

1
2 ofJ

KIB(0,TI)
and N(.,. ) is the cumulativefunctionof a centredbivariateGaussiandistributionwith
covariancematrix
1

nA2)= N(6+ 2Y/, + O ft).

Qs(A,
l52

Regroupingthe differentterms,we obtain Geske'sformulafor stochasticinterestrates

= S(0)N(51
+ aJ, 6,2+ /)
C2(O)
- KIB(O,
T2)N(62).
T,)N(6,,62)- K2B(O,
4. Optionson bonds
This section concernsEuropeancalls on default-freebonds.
4.1. Optionson zero-couponbonds. Theorem2 entailsthe followingformulafor the
price of a call maturingat date Towrittenon zero-couponbonds maturingat date T,
C(O) = B(O, T,)QT,(A) - KB(O, To)Qro(A)

whereK is the exerciseprice and A the exerciseset.

(a) In the same manneras Heathet al. (1987), we will assumethe followingdynamics
of the term structure of interest rates
dB(t, T) =
r(t)dt + a(t, T)dW,
B(t, T)
where a(t, T) is decreasing in t and a(T, T) = 0.
Assuming a(t, T) deterministic, the same arguments as in Example 1 of Section 3
provide a formula of the Black-Scholes type

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456

H. GEMAN, N. EL KAROUI AND J.-C. ROCHET

C(0)= B(O, T,)N(d,) - KB(O, To)N(d2)

where
1

oJT0

B(O, T,)
KB(O,

d,= d2-oT,

To)

and a is the volatilityof the forwardpriceB(t, T1)/B(t, To)of the zero-couponbond.

(b) Another explicit formula was obtained by Cox et al. (1985) in the context of
stochasticvolatilities,but with a one-statevariabledescriptionof the termstructureof
interestrates.The (risk-adjusted)dynamicsof the shortrate is definedby
dr(t) = a(b - r(t))dt + adW, wherea, b and a are positive constants.
From that dynamics,it follows that the shortrate is distributedunderQ (respectively
as a non-centralX 2 processwith parameterof non-centralityq (respectivelyq0,
QT0, QT,)
q1).Coxet al. showthatthe call is exercisedif and only if r(To)is less thana criticallevel
do;theyobtainan explicitformulafora callon a zero-couponbond,whichcanbe written
in our notationas
C(0) = B(0, T)X 2(dl, n, q,) - KB(O,T0o)2(do,n, qo)
where X2(., n, q) is the non-centredx2 distributionwith n degrees of freedom and
parameterof non-centralityq; n, q0,q,, doand d, are parametersdependingon a, b, a
and the characteristicsof the call. It is interestingto notice that the assumptionof a
deterministicvolatilityof interestratesis not necessaryto obtain a formulaa la Black
and Scholes.The resultholds becausethe spot rate drivenby the dynamics
dr = a(b - r)dt + a

rdW

follows a X2distributionand that underthe 'forwardneutral'probabilityassociatedto

any date T, this is still true (with a change in the drift of dr); consequently,the
probabilitiesof exerciseunderthe differentprobabilitiesare expressedin termsof noncentredX2distributions.
4.2. Optionson couponbonds. Let us supposethat the underlyingasset is a general
default-freebond, characterizedby the sequenceF1,F2,- - -, F of fixed paymentsit
generatesat times T,,.-- , T,. Underthe assumptionsandnotationof Section3, its price
at date t (t < T, < ... < T,) is given by P(t) =
FiB(t, Ti), where
IL1

B(t,T)=

EQexp-

r(s)ds/F,.

We consider a call written on the bond, with exercise price K and maturity To< TI.
The probability of exercise will involve the distribution of n variables, namely the
prices of the n zero-coupon bonds B(0, T,), .. , B(0, T,). To obtain a formula of the
Black and Scholes type, it is necessary that these n prices depend on only one statevariable, for instance the spot rate.

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measureandoptionpricing
changesofprobability
Changesof numdraire,

457

In the Gaussiancase with one source of randomness(as in Section 3, 1(a)),this is

equivalent to assuming a Markovianspot rate, or in other words, a deterministic
volatility a(t, T) whichhas the form
a(t, T) = [h(T) - h(t)]g(t).

Jamshidian(1989) and El Karouiand Rochet (1989) obtain underthese hypothesesa

quasi-explicitformulafor the call price
C(O)=

- KB(O,

FB(O,
i-I

T.)N(d,)

To)N(do)

where d, = do + pi,

S=

[a(s,T,)- a(s, T ds

and dois definedimplicitlyby

i-I

- f + } = KB(0,
F,B(O,
T,)exp{
To).
dou

5. Conclusion
The paperhas shown that a changeof numerairedoes not changethe self-financing
portfolios,and hence does not changethe hedgingor replicatingportfolioseither.An
immediate consequencein option pricing is that, dependingon whetherthe option
under analysisis writtenon a stock, on a bond, is an exchangeoption or a compound
option, the choiceof the appropriatenumbrairewill providethe easiestcalculationsand
the relevanthedgingportfolio.
Acknowledgements
HelpfulcommentsfromRobertGeskeon an earlierversionof this paperaregratefully
acknowledged.All remainingerrorsare ours.
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STRICKER,

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