Mathematics of Financial Obligations

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Translations of
MATHEMATICAL
MONOGRAPHS
Volume 212
Mathematics of
Financial Obligations
A. V. Mel nikov
S. N. Volkov
M. L. Nechaev
Am erican M athem atical S ociety
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Translations of
M ATHEM ATICAL
M ONOGRAPHS
Volum e 212
Mathematics of
A. V. Mel'nikov
S. N. Volkov
M. L. Nechaev
American Mathematical Society

Providence, Rhode Island
E D IT O R IA L C O M M IT T E E
A M S S u b com m ittee
Robert D. MacPherson
Grigorii A. Margulis
James D. Stasheff (Chair)
A S L S u b com m ittee Steffen Lempp (Chair)
IM S S u b com m ittee Mark I. Freidlin (Chair)
А. В. Мельников, M. Л. Нечаев, С. H. Волков

М А Т Е М А Т И К А Ф И Н АН СО ВЫ Х О Б Я З А Т Е Л Ь С Т В
Г У В Ш Э , М осква, 2001
Translated from the Russian by H. H. McFaden
2000 Mathematics Subject Classification. Primary 91-02, 91B24, 91B28, 91B26;

Secondary 91B30, 91B82, 60H30, 60G40, 60G48, 60G44, 60G42, 60P20.
L ib ra ry o f C on g ress C a ta log in g -in -P u b lica tion D a ta

Mel'nikov, A. V., 1953-
[Matematika finansovykh obiazatel'stv. English]
Mathematics of financial obligations / A.V. Mel'nikov, S.N. Volkov, M.L. Nechaev.
p. cm. — (Translations of mathematical monographs, ISSN 0065-9282 ; v. 212)
Includes bibliographical references and index.
ISBN 0-8218-2945-9 (alk. paper)
1. Investments— Mathematics. 2. Stochastic analysis. 3. Hedging (Finance)— Mathematical
models. 4. Insurance— Mathematics. I. Volkov, S. N. (Sergei Nikolaevich), 1972- II. Nechaev,
M. L. (Mikhail Leonidovich), 1972- III. Title. IV. Series.
HG4515.3 .M4513 2002

332.6'01'51— dc21 2002074395
C o p y in g an d reprin tin g . Individual readers of this publication, and nonprofit libraries

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Printed in the United States of America.
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Contents
Foreword vii
Main Notation ix
Chapter 1. Financial Systems: Innovations and the Risk Calculus 1

§ 1.1. Financial systems and their innovation changes 1
§ 1.2. General statements in the analysis of contingent claims. Models,
methods, facts 3
§ 1.3. Dynamics of financial markets: from incomplete markets to com
plete markets through financial innovations 10
§ 1.4. Financial innovations and insurance risks 13
Chapter 2. Random Processes and the Stochastic Calculus 17

§2.1. Random processes and their distributions. The Wiener process 17
§ 2.2. Diffusion processes. The Kolmogorov-Ito formula, Girsanov’s the
orem, representations of martingales 20
§ 2.3. Semimartingales and the stochastic calculus 25
Chapter 3. Hedging and Investment in Complete Markets 31

§3.1. A martingale characterization of strategies and perfect hedging 31
§ 3.2. A methodology for finding martingale measures and pricing con
tingent claims for different models of a (B, 5)-market 34
§ 3.3. A methodology for optimal investment and its applications 43
Chapter 4. Hedging and Incomplete Markets 49

§4.1. A methodology for superhedging 49
§ 4.2. The Black-Scholes model with stochastic volatility 52
§ 4.3. Estimation of volatility 61
Chapter 5. Markets with Structural Constraints and Transaction Costs 65

§5.1. Calculations in models of markets with structural constraints: A
general methodology and its concrete realization 65
§ 5.2. Hedging and investment with transaction costs 87
§ 5.3. Appendix: Examples of the simulation of hedgingstrategies 92
Chapter 6. Imperfect Forms of Hedging 97

§6.1. Mean-variance hedging 97
§ 6.2. Quantile hedging 104
Chapter 7. Dynamic Contingent Claims and American Options 121
V
vi CONTENTS
§ 7.1. Pricing dynamic contingent claims and the optimal stopping prob
lem 121
§ 7.2. Concretization of option calculations and closed analytic formulas
for prices and strategies 126
§ 7.3. Quantile hedging of dynamic contingent claims 132
Chapter 8. Analysis of “Bond” Contingent Claims 139

§ 8.1. Models of the term structure of interest rates 139
§ 8.2. Hedging on a bond market 144
§ 8.3. Investing in a bond market 153
Chapter 9. Economics of Insurance and Finance: Convergence of Quantita

tive Methods of Calculations 159
§9.1. “Non-life” insurance. Traditional actuarial principles for calculat
ing premiums and the financial no-arbitrage principle in a model
of collective risk 159
§9.2. Life insurance. Mortality tables. Calculation of premiums and
reserves in traditional and innovation insurance schemes 167
§ 9.3. Estimation of the ruin probability 171
§ 9.4. Catastrophe risks and reinsurance of them on financial markets 176
Bibliographical Notes 181
Bibliography 185
Subject Index 191

Foreword
Contemporary financial mathematics and the associated theory of actuarial

calculations in insurance have reached such a level of mathematical complexity
and abstraction that it is impossible to present a maximally rigorous exposition
of them in brief form without detriment to either mathematical correctness or
breadth of illumination of the subject. However, only the general theory gives
rise to a fundamental approach to the problem on which a practically acceptable
methodology for solving it can be based. Contact with practitioners of financial
and insurance businesses has shown that these pragmatists are interested first and
foremost in the practical realization of concrete models.
Thus arose the plan for this book: to present key and mathematically very
complex results in the contemporary theory of hedging and investment at the brink
of mathematical correctness, and to show as rigorously as possible how this general
methodology can be interpreted in concrete models of financial markets.
This approach, which broadens the spectrum of readers beyond the narrow
circle of specialists in stochastic analysis, was the basis for the advanced courses of
lectures on financial and actuarial mathematics which I delivered at the Mechanics
and Mathematics Department of Moscow State University in 1997-2000 and at the
Laboratory of Actuarial Mathematics of Copenhagen University in 1998.
The problems touched upon here are being worked on very intensively, as re
flected by the appearance of a whole spectrum of publications, of which I single out
the 1999 monograph Essentials of stochastic finance: facts, models, theory by my
teacher A. N. Shiryaev. It is a fundamental encyclopedia in this area.
Nevertheless, the monograph literature does not yet adequately reflect incom
plete markets, markets with constraints on the strategy and structure of the model,
“imperfect” forms of hedging (quantile and mean-variance), the “convergence” of
financial and actuarial mathematics, and so on. This whole area, which forms a
methodological basis for modern quantitative calculations in finance and insurance,
is represented in the present book, and as a rule the chosen form of presentation of
the material generally goes “from the general to the particular.” The above as a
whole distinguishes the book from other publications in the area.
After writing the first three chapters, I enlisted the services of my students
and colleagues S. N. Volkov and M. L. Nechaev for work on the book. They had
prepared the first Russian dissertations devoted entirely to contemporary financial
mathematics at the Steklov Institute of Mathematics of the Russian Academy of
Sciences. Chapters 4-8 were written jointly with them. The exposition of the
concluding Chapter 9 follows my paper On the unity of quantitative methods of
calculations in finance and insurance (preprint no. 5, Actuarial-Financial Center,
Moscow, 2000).
Vll
viii FOREWORD
I would like to believe that this book will find an audience among both the
oreticians and practitioners in finance and insurance and that it can serve as a
basis for modern courses in actuarial and financial mathematics and quantitative
risk management for university specializations in the direction of mathematical
economics.
A. V. Mel'nikov
Main Notation
(fly 3ri P ) probability space (My N) mutual quadratic characteris

tic of My N € Mfoc
W = (&t)t> o filtration
[Xy Y] mutual quadratic characteris
(fi, 5, F, P ) stochastic base, or probab tic of X y Y G Mioc
i l i t y space with a filtration
P* P absolute continuity of a
0 optional cr-algebra measure P* with respect to P
y predictable <r-algebra P* ~ P equivalence of measures P*
£, rjy. .. random variables and P
Rd d-dimensional Euclidean space

r, a stopping times, or Markov times
IA indicator function of an event A
cr{ô> •••, í t } the cr-algebra generated
by the variables £o, ■■•>£t 0 empty set
E£ (mathematical) expectation of a $ (x ) standard normal distribution
random variable f
X t — = limsf £ Xs
DÍ variance of a random variable £
AX t = X t - X t-
P(i4) probability of an event A
a A b = min{a, b}
E(£ |A) conditional expectation of a
random variable £ with respect to a a V 6 = max{a, b}
cr-algebra A
a+ = a V 0
M set of uniformly integrable martin
[a] integer part o f a
gales
) number of combinations of N
M2 set of square-integrable martin
things taken n at a time
gales
X* value of a strategy n
Mice set of local martingales
X ^ 'C } value of a strategy 7r with
M2oc set of local square-integrable
comsumption C
martingales
SF set of self-financing strategies
tp*M stochastic integral of a function
y? with respect to a local martin C(T, / ) price of contingent claim /
gale M with exercise time T
ip o A Lebesgue-Stieltjes integral of € * ( / ) , C * (/) ask and bid prices of a
a function ip with respect to a pro claim /
cess A with bounded variation
tPx probability of living to age x + t
£ t(X ) stochastic exponential of a starting from age x
process X
<p(v)y il>(v) ruin probability and non
M (X , P ) set of measures equivalent ruin probability with initial value
to P with respect to which X is a v
local martingale
t Ux premium for a pure endowment
(M) quadratic characteristic o f an contract for living to age x + T
m e ufoc starting from age x
ix
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CHAPTER 1
Financial Systems: Innovations

and the Risk Calculus
We present the concept of a financial system as a collection of firms, intermedi

ary structures, and individuals interacting through financial markets. A characteri
zation of financial markets (complete and incomplete) is realized by identifying sets
of contingent claims and terminal values of self-financing strategies. The dynamic
behavior of a financial system is described as the movement of incomplete markets
toward complete markets as the volume of tradable derivative securities (financial
innovations) grows. Furthermore, the problem of the risk calculus, both financial
and insurance risks, is constantly analyzed.
§ 1.1. Financial systems and their innovation changes
A financial system is formed by a space endowed with financial markets through

which diverse firms, individuals, and intermediary structures interact (Figure 1.1).
I!
/ ----------------------------- ^
People
V___________________ )
F igure 1.1. Schematic representation of a financial system.
The evolution of the international financial system has gone through several ba
sic stages: the gold standard, the Bretton-Woods mechanism, and floating exchange
rates. Especially profound changes have taken place over the past two decades, due
to the introduction of new financial instruments and the process of computer in
formation technology. New scales of financial mediation, expanded boundaries of
credit mechanisms, and internationalization processes in finance and insurance have
l
2 CHAPTER 1. FINANCIAL SYSTEMS: INNOVATIONS AND THE RISK CALCULUS
become intrinsic features of the modern financial system. To safeguard such vitally
important functions of a financial system as control of payment flows and risks,
insurance of savings and loans, and so on, it became absolutely necessary to make
essential changes in the previously established ways of looking at the operation of
financial markets.
Many countries in the West have taken adequate and timely account of this
new situation and have created a complete infrastructure for introducing financial
innovations, an infrastructure that includes both research centers and companies
and a reformed system of actuarial-financial education.
During the Bretton-Woods period (1944-1971) gold prices and exchange rates
were rigidly tied (within 1%) to the US dollar in the system of world finance.
Therefore, in controlling the financial system institutional methods based on the
creation of various regulating structures were quite suitable. For example, the
International Monetary Fund (IMF) was created with this principal goal.
The abolition of fixed gold prices and the “freeing” of exchange rates and
interest rates meant a transition from the Bretton-Woods mechanism to a system
of floating exchange rates. Interest rates “acquired randomness” , and adequate
control of a financial system required functional methods based on the use of new
financial instruments (financial innovations, derivative securities): forward and
futures contracts, options, swaps, and so on. In financial intermediation there was
a shift in the direction of credit mechanisms in which the risks on the capital
market are diversified with the help of derivative securities. Further, the problem
of controlling risk has become more complicated in view of the large risk variability
of derivative instruments in comparison with underlying assets (stocks, bonds).
Practitioners of the financial business responded to this in turn by opening
specialized exchanges for the trading of derivative securities: the Chicago Board
of Options Exchange (CBOE, 1973), the London International Financial Futures
Exchange (LIFFE, 1982). Moreover, other exchanges which had opened earlier—
the Chicago Board of Trade (CBOT), the American Exchange (AMEX), the New
York Stock Exchange (NYSE), and others— were also forced to shift their activities
in the direction of trade in these new financial instruments. As a result, the volume
of worldwide trade in derivative securities has been constantly growing: from 500
billion US dollars in 1985 to 3500 billion in 1991. This tendency continued also in
the 1990s.
Upon considering the innovation processes in finance, which like a diffusion
have absorbed one market after another, we should observe certain features of
these processes in the “manufacturing industry” . In both cases this is a reaction of
firms to the demands of the “surrounding medium” with a long-term goal of making
a profit. As a rule, innovations are promoted by a high degree of competitiveness
of a firm, although a monopoly not particularly disposed toward competition but
having sufficient reserves can also stably support the latest research results and
their introduction. Industrial know-how can at times lead to cardinal changes
in whole branches of the economy. For instance, the development of computer
technology and information technology over the past two decades has led to the
present revolution in the financial sector of the economy and in banking service.
New information-computer technologies have enabled us to receive, remember, and
store huge amounts of information about accounts and transactions, and to use
this information in real-time mode. All this has given traders new opportunities
for finding arbitrage situations, for implementing continuous monitoring, and for
§ 1.2. GENERAL STATEMENTS IN THE ANALYSIS OF CONTINGENT CLAIMS 3
managing a portfolio made up of a complex combination of securities. As a result,

such structures of banks and investment companies as front-office, middle-office,
and back-office have acquired a completely new aspect, and automated risk-control
systems have become technologically feasible.
Progress in computer technology has enabled us to penetrate more deeply into
the behavior of the markets themselves, since intraday information has turned out
to be accessible. This is a truly enormous statistical reserve, which has not yet been
exploited in full scope. For example, the ticks, or moments when prices change, on
the. foreign exchange market (FX-market) happen roughly 20 times per minute,
while the exchange rate between the US dollar and the Deutsche Mark vacillates
18,000 times per day, and this is equivalent to daily information for 72 years. All
this has led to quantitative changes on a global scale: the daily turnover alone
in the FX-market increased by a factor of five during 1986-1995 and constitutes
more than a trillion dollars, substantially exceeding the total gold reserves of all
the industrially developed countries— the members of the IMF.
Various theories of financial markets have been developed in parallel with the
tendencies mentioned. However, it has proved impossible to take into account the
above dynamics of a financial system while remaining in the framework of the
Markowitz “one-step” theory of diversification and the Schwartz-Lintner Capital
Asset Pricing Model (CAPM) created in the period 1950-1960. The foundations
for a theory adequate to modern securities markets were laid by Black, Scholes,
and Merton. Their Options Pricing Theory (OPT) or Contingent Claim Analysis
(CCA) has provided real possibilities for dynamic hedging and investing in connec
tion with a broad spectrum of financial innovation instruments. It is this theory
that one has in view when one speaks of the definitive transition from the arithmetic
of rent payments to the modern stochastic mathematics of finance and insurance.
In the next section we give a general description of some key concepts (arbitrage,
completeness and incompleteness of markets, and so on), facts, and perspectives of
this theory.
In conclusion we mention that an analysis of market information leads to con
clusions about the fractal structure of price variation, about the “heavy tails” of
their distributions, and so on. A whole spectrum of financial models have arisen
as a consequence: Autoregressive Conditional Heteroscedasticity (ARCH), Gener
alized ARCH (GARCH), Fractional Integrated ARCH (FIARCH), FIGARCH, and
so on. Finally, we mention another indisputable effect of computer know-how: the
widespread use of artificial “neuron networks” in financial practice and analysis.
§ 1.2. General statements in the analysis of

contingent claims. Models, methods, facts
We consider a model of a financial market as a pair of assets: a nonrisky asset

(bank account) B and a risky (stock) asset 5, which can be represented by their
prices B t and 5*, t = 0 ,1 ,... or t € M.\. In this case one speaks of a (B ,5 )-
market with discrete or continuous time, respectively. Here the risky component
of the (£ , S)-market can be multidimensional. The assets B and S will be called
underlying assets or underlying securities.
An important question arises at once: how does one describe the riskiness of
the asset 5 ? A natural answer is to regard S as a random process of the evolution
of its prices St. Therefore, it seems fully justifiable to assume that a probability
space is given from the start, and that (St)tô forms a random process
on it. Here the information supplied by the prices of S up to time t is denoted by
Ft = 9f> t e R \ .
We fix a time horizon T and define a contingent claim f = f o to be any function
determined by the information &t (measurable with respect to T t ).
Next, taking the nonrisky asset Bt and the risky asset St in the quantities fit
and 7t, respectively, we form the pair 7r* = (fit) 7 t), called a portfolio or (investment)
strategy. The value of the portfolio it is defined to be the sum
(1.1) X ? ( x ) = & Bt + 7tSu X £ = x.

The definition of a (B, 5)-market must be completed by indicating what kinds
of portfolios can be used. The most important class consists of the self-financing
portfolios 7r, defined by saying that 7r £ SF if
(1.2) X ? - X U = A X ? = fitA B t + TfcASt, t = 1 ,2 ,...

(or d X ? = fit dBt + 7 t dSt in the case of continuous time under the assumption that
the differentials dBt and dSt are well defined).
Arbitrage (at the time T) means the possibility of creating a positive value
(with positive probability) at the time T by means of a self-financing strategy with
zero initial value x = 0.
Any asset given on a (B, S)-market, and hence on the basis of the underlying
assets B and 5, is called a derivative security and is identified with a contingent
claim. For example, a forward contract (with delivery price F and delivery date T)
for delivery of an asset S is equivalent to the claim f r = / t (£ t ) = St — F, and
an option to buy (with exercise price K and exercise date T) is equivalent to the
claim / t = / t (*5t ) = (St —K ) + . Thus, the set of derivative securities induces the
set CCG of graphs of the corresponding contingent claims (Figure 1.2).
F ig u r e 1.2. CCG (Contingent Claims’ Graphs).
On the other hand, the set of self-financing strategies 7r induces the set TVG
of graphs of the terminal values (Figure 1.3).
A market is said to be complete if
TVG = CCG.
Otherwise, it is said to be incomplete. In other words, a (B, 5)-market is complete

if and only if any contingent claim / t can be replicated. Namely, there exist x and
7t e SF such that X ^ (x ) = / t .
Let Vt stand for the price at time t of the contingent claim / r (in other words,
the price of a derivative security with payments for it at time T determined by
F ig u r e 1.3. TVG (Terminal Values’ Graphs).
the function fr )- The most important problem is to describe the random process
V = (Vt)tô in terms of the (S , 5)-market.
The “heuristic” principle for such a description of Vt consists of two ideas. First,
the amount of the contingent claim f x must be discounted with the help of the
nonrisky asset: BtB ^ }fx - Second, consider the averaged quantity E {BtB ^ }fx |T*)
to be a candidate for Vt.
The first idea is absolutely irreproachable, since a measurement of the cost
at different moments of time in the same units is achieved with the help of the
discounting operation.
The second idea can be questioned: for it does not follow at all that the averag
ing should be implemented with respect to the initially given “physical” probabil
ity P. Moreover, any other probability measure P on the space (ii,T ) determines
its own “probability character” of the (B ,S )-market. It is clear that the risk-
neutral, stable character of the chosen probability predetermines the naturalness of
the price of the given contingent claim. Consequently, the above “heuristic” prin
ciple must be corrected by choosing a more suitable probabilistic character of the
market, determined by some measure P. Here in order to avoid losing essential fea
tures of the market ( “degenerations” of the character) it is natural to assume that
the measures P and P are equivalent. These considerations lead to the no-arbitrage
principle in determining the price V*. This principle is realized in the following gen
eral facts, which represent a somewhat coarsened form of the fundamental theorems
of arbitrage and completeness in financial mathematics:
A (B,S)-m arket does not admit arbitrage opportunities there is a prob

ability measure P* equivalent to P (p ~ P*) such that the process of discounted
prices B ^ 1St of the risky asset is a martingale with respect to P*.
Such a measure is called a martingale measure. Since a martingale is constant

in the mean, the measure P* neutralizes, as it were, the riskiness of the asset S.
Therefore, P* is also called a risk-neutral measure of the (B, 5)-market. Further:
On a complete no-arbitrage (B,S)-m arket the price of any contingent claim is

uniquely determined the martingale measure is unique.
Indeed, if there are two such measures P*, i = 1,2, then two prices of the
claim / are determined: V? = E ^ B t B ^ f x 13^). They must coincide, and thus
P i = P£
Conversely, the price Vt is uniquely determined as Vt = E *(BtBT 1f x |T*) with
respect to the unique martingale measure P*.
CHAPTER 1. FINANCIAL SYSTEMS: INNOVATIONS AND THE RISK CALCULUS
As a result we arrive at the following general statement about pricing contingent

claims in complete markets:
Let P* be the unique martingale measure for a complete (B , S)-market, and let
the price Vt of the contingent claim f r be defined as Vt = f x |$t)- Then
(B , S, V) forms the unique system of prices for which the corresponding extended
market does not admit arbitrage opportunities. Moreover, there is a self-financing
strategy 7r* replicating f r such that X f* (Vo) = Vt for all t G [0,T].
This result sums up the possibility of reducing to zero the risk associated with
any contingent claim on a complete market
We now present several classical examples of a complete market.
The binomial m odel/the Cox-Ross-Rubinstein model.
A St
Let pt = - — , t = 1 , 2 ,..., S0 > 0, be the relative yield from the risky asset S.
S t-i
We assume that the pt form a sequence of independent random variables taking the
A i?
two values b > a with probabilities p and 1 — p, p G (0,1). If r = ——- is a
r —a B t- i
nonrisky interest rate such that —1 < a < r < b, then p* = ------- determines a
b —a
unique martingale measure P* on the space (fi, iF,F) with fi = {a, b}T, T =
Jo = { 0 , fi}. The price of an option to buy with contingent claim f r = (St —K )*
is given by the Cox-Ross-Rubinstein formula:
(1.3) Vo = V * ( l + r ) - T(ST - K ) + = S0M(t0,T ,p ) - K ( l + r ) - TM(t0,T ,p*),
where
K 1+6 _ 1 +6
to — 1 + In In P=
So(l + a)T/ l+o 1+ r ‘
rp
M(ju T ,p ) = E Q p‘ (i - P)r - ‘ .
T h e B achelier m od el.
This is a purely continuous model of a (B , S')-market, where Bt = 1 and the
corresponding return from S per unit time is equal to
(1.4) = H + <rwt, S0 > 0,
where wt is a Gaussian “white noise” , a concept widely used in physics and en
gineering to simulate chaotic nonregular motions, and a > 0 parametrizes the
changeability (volatility) of the indicated return (Figure 1.4).
In this model the no-arbitrage principle leads to the following price for the
option to buy / t = (St — AT)+ .
Defining the martingale measure
dPi . = « p { - i r « r - i ( £ ) V } , i P .
and averaging with respect to it, we come to Bachelier’s formula:
(1.5) Vo = E *(ST - K ) + = (So - K ) * ’

§1.2. GENERAL STATEMENTS IN THE ANALYSIS OF CONTINGENT CLAIMS 7
F ig u r e 1.4. Evolution of return in the Bachelier model.
where
1 _i£
$ (x ) = f <t>{y) dy, <j>(y) = e 2 ,
J—OO V2^
In particular, for So = K
T h e B la ck -S ch oles m odel.
We consider the following relative yield per unit of time for B and S :
dBt dSt
(1.6) = r, = n + crwt , So > 0.
Bt dt St dt
dSt
It is clear that the graphical realization of J will be the same1 as in Fig-
St dt
dSt
ure 1.4 for
dt
This model can be rewritten in the form of the stochastic differential equations
(1.7) dBt = rBt dt, dSt = Stii^dt+ adwt), So > 0,

where wt is a standard Wiener process (Brownian motion).
Another, exponential, form of this model was proposed by Samuelson:
( 1. 8 ) Bt = B0ert St = S0e»t- ^ + aWt.
The process St represented in this form is called a geometric Brownian motion.

The unique martingale measure P* in this model is determined by the density
Z? = exp j - ~^ — - ) Î 1}- According to the no-arbitrage principle,
the price of an option to buy is given by the Black-Scholes formula:
(1.9) C s s (5o, T, r, a) = V0 = E *e~r-T K ) +

= S0$(d+(r)) - K e - rT$(d-(r)),
HSo/K) + T(r±<t2/2 )
where d±(r) —
aVT
: The realizations of St given by the formulas (1.4) and (1.6) will be different, of course.
It is interesting that the “heuristic” principle for calculating the price gives
Cheu(M) = e ^ - ^ S o H d + i » ) ) - K e - rT<f>(d-(ri),
which for ¡I = r coincides with the Black-Scholes price:
CheuM = C bs (So, T ,r,a ).
For the model (1.6)—(1.8) of a (£ , 5)-market we can use the differential equa
tions method, which was also used by Black and Scholes to obtain their famous
formula (1.9).
Suppose that the contingent claim has the form f o = p(Sr),-where g is a
nonnegative function. We consider a portfolio n whose value is a smooth function
of St and t < T: X f = v(St, t). It is clear that
v (x ,T )= g (x ), x > 0,
( 1. 10)
v(x, t) ^ 0, x > 0, t < T.
Application of the Kolmogorov-Itô formula to v(St,t)/Bt leads to the relation
( H I) »(St’ *) v(s Qi°) , f dv{Su>u)

dv(Su,u) dj ( S \ f*\dv
+ Lv — rv B u du,
Bt Bo Jo dx \ B ju Jo [ ôî
d 1 o , d2
where L = r x ^ + - ^ V a x ! is the generating operator of the diffusion process St
(see (1.7)).
It follows from (1.11) that
dv
( 1.12) 7T G SF <=> — + Lv - rv = 0.
dt
The equation (1.12) with the boundary conditions (1.10) is called the funda
mental differential equation of Black and Scholes. We remark that v is a harmonic
q
function for the operator — + L —r.
(jt
If the function g (x ) has polynomial growth, then a solution of the problem
(1.10)-(1.12) exists and is given by the formula
poo
(1.13) v (x ,t)= / (3(y,T - t , x ) g { y ) ( - r ( T - t ) dy,
Jo
lny - Inx — ( r —
where (3(y,t,x) = -----\ = e x p { - is the density of the
yaVZnt { 2a2t
lognormal distribution.
In the case of complete markets the no-arbitrage principle has led to exhaustive
answers with regard to the calculation of prices of contingent claims. How is it
realized in incomplete markets, when the set M (S/B) of martingale measures does
not reduce to a single measure?
Let us consider a set of strategies richer than 5F, the so-called strategies with
consumption:
{(7r,C) : 7t = (/?,7), C a nondecreasing process}.

For such strategies (71*, C) the corresponding (discounted) value has the form
(*•,c) y(7T,C)
A 0
(1.14) + Bo, dCu
Bt So
and hence is a positive supermartingale with respect to any measure P G M(S/B).

On the other hand, a positive process that is a supermartingale with respect to
any measure P G M(S/B) can be represented in the form (1.14), called the optional
decomposition.
We now consider the process
^ - = ess sup E (B ^ 1f T \3rt),

*** PeM (S/B)
which is well known in the theory of optimization as the Snell envelope. This is
a positive supermartingale (with respect to any measure P G 3Vt(S/B)) such that
vy = / t (a.s.).
Suppose that the value of a strategy with consumption (7r, C) hedges the con
tingent claim f x in the following sense:
(1.15) VT = v ¥ ' C ) > f T (a.s.).
According to its supermartingale property we have that for any P G M(S/B)
(a.s.).
Hence, Vt* is the minimal value with the property (1.15), and corresponding to
the optional decomposition there is a portfolio with consumption (7r*,C*) called a
minimal hedge.
Thus,
(1.16) ess sup ’E (B T 1fT\3rt)

PeM (s/B)
must be the natural price of a contingent claim f r on an incomplete (¿?, 5 )-market.

The approach leading to the price (1.16) in the calculus of contingent claims is
called superhedging.
We now give an example of an incomplete (B, S')-market whose incompleteness
is due to stochastic volatility.
A market with stochastic volatility.

Let us consider the (S , £)-market
(1.17) dBt = Btr d t} dSt = St(p>dt + T,t dwt),
where r ^ 0, = a2 + ( ~ l ) Nt A a 2, 0 ^ A a 2 < a 2, and Nt is a standard Poisson

process independent of wt.
According to the Kolmogorov-Ito formula, we have
d Z td w l
t
fi —r
where dw% = dwt + dt.
www.Ebook777.com
It is clear that P G M(S/B) w* is a (local) martingale. Further,

according to Girsanov’s theorem,
(M — r ) 2
Ñt = Z tNt ,
I = 5,=expU ’ ( ¥ :<'”’" 2£2
where Nt is a (local) martingale orthogonal to w with respect to the measure P.

By Novikov’s condition
< oo,
the process Z t is a uniformly integrable martingale, and hence the two martingales
(r -M )2
du
2a2 ± A a 1
determine two martingale measures in M (S /B ), which testifies to the incomplete

ness of the market (1.17).
One more method for getting a reasonable price for a contingent claim is based
on mean-variance hedging.
We define the risk associated with hedging a contingent claim fa with the
strategy 7r by the formula
The corresponding strategy n* and initial value x* are chosen to minimize this
risk:
/$*(& *) = in f/$ (& ).
Risk can be defined similarly for both complete and incomplete markets. We
remark that in the case of the Black-Scholes model the price C bs of a contin
gent claim f r and the strategy n hedging this claim coincide respectively with the
value x* and the strategy 7r* minimizing R ^(x).
In the case of a discrete model of a (B, 5)-market, when the physical measure P
is a martingale, x* and n* are given by the formulas
(1.18) z* = E / t ,
7t E[(ASt)2 19t_i]
Accordingly, for incomplete markets the risk associated with a “not too risky”
contingent claim cannot be reduced to zero, but can be minimized.
§ 1.3. D yn a m ics o f financial m arkets: from in com plete

m arkets to co m p le te m arkets th rou gh financial innovations
It is necessary to discuss (and now we are in a position to do this) the relation

ship between complete and incomplete markets.
Let us consider (purely formally) the difference
(1.19) A = sup B oE B ^ V t - _ inf B oE B ^ / t ,

p eM(s/B) p eM(s/B)
§1.3. DYNAMICS OF FINANCIAL MARKETS 11
which can be interpreted as a measure o f the incompleteness of a (B , S')-market,

since A = 0 for a complete market. The quantity A will be called the spread.
We mention also other characteristics associated with incompleteness of a mar
ket: leasing and overhead costs. The leasing of an asset S is usually proportional to
its price: ltSt- And the payment for overhead costs is proportional to its price and
to the magnitude of change of the portfolio: St |A ^ |St- The parameters l and S are
called the leasing and overhead coefficients and serve again as distinctive measures
of the incompleteness of the market.
The introduction of new financial products makes the original market “more
complete” and correspondingly diminishes A, Z, and S. R. Merton, the Nobel
laureate for economics in 1997, first defined the movement of markets as a financial
innovation spiral in a direction toward ideal complete markets to the extent that
the incompleteness parameters A, Z, and S are reduced toward zero. On this Merton
wrote:
“From the perspective of our theory, these same facts about change
are seen as consistent with a real-world dynamic path evolving
toward an idealized target of an efficient financial-market and in
termediation system. On this premise, these changes can be in
terpreted as part of a “financial innovation spiral” . That is, the
proliferation of new trading markets makes feasible the creation of
new financial products; to hedge these products, producers trade in
these new markets and volume expands; increased volume reduces
marginal transaction costs and thereby makes possible further im
plementation of new products and trading strategies, which in turn
leads to still more volume. Success of these trading markets en
courages investment in creating additional markets, and so on it
goes . . . , spiraling toward the theoretically limiting case of zero
marginal transaction costs and dynamically complete markets.”
([118], p. 468)
For this reason we call Figure 1.5 the financial innovation spiral of Merton.
Thus, according to Merton all the events in contemporary financial reality form
a part of a financial innovation spiral leading to an efficient market and an interme
diation system. Furthermore, the intermediation structures, in becoming more and
more open to new financial products and services, will also expand their geogra
phy, thereby leveling out the geopolitical advantages of various financial institutes.
However, it does not follow that this general direction of development of the finan
cial system “spirals” real financial processes in a smooth way. The growth in the
size and complexity of financial transactions and the global interconnectedness of
markets amplify the total credit risk and create real possibilities for financial crises
on a broad scale.
Striking examples of this kind are given by the financial crises of 1987 and
1997-1998. A drop of more than 500 points (22%) in one of the most adequate
indexes2 of the American economy— the Dow Jones Industrial Average index— can
lead to very negative consequences, as shown in Figure 1.6.
The figure reflects the dynamics of this index in 1929 and in 1987. Fairly quickly
after the crash in 1929 there ensued a period of even steeper drop, now called the
2It is made of information about 30 “blue chips” .

F i g u r e 1.5. The financial innovation spiral of Merton: dynamics

of incomplete markets toward complete markets as the volumes of
financial innovations increase (A , Z, S —>0).
F ig u r e 1.6. Dynamics of the DJIA index in 1929 and 1987.
Great Depression of the American economy. On the other hand, after October 19,
1987 it was possible to avoid such negative consequences, and the index stabilized.
We have already put sufficient emphasis on the most important component
in the dynamics of a financial system both in a qualitative and a quantitative
aspect: financial innovation products. They represent the most efficient tools for
investment and risk management. They cost 10-20 times less than underlying
assets. All this has created unprecedented opportunities for financial leverage, when
for investment goals not only one’s own means but also borrowed means are used
(often simply future rights to dispose over means), thereby increasing the sensitivity
of the financial structure to changes in the market. Not taking this circumstance
sufficiently into account can have a “lethal” outcome.
How seriously one should take the functioning of derivative securities can be
beautifully illustrated by the bankruptcy in 1995 of Barings, the oldest commercial
§1.4. FINANCIAL INNOVATIONS AND INSURANCE RISKS 13
bank in Great Britain, “thanks to” the actions on this market of the head of its
Singapore branch, N. Leeson. He used futures to create the following position at a
cost (astronomical for that bank) of 27 billion dollars: 7 billion in Japanese equities
by means of futures on the NIKKEI 225, and 20 billion in Japanese bonds again
through futures on these bonds and “Euroyen” futures. Because of the relative
cheapness of entry on the futures market, Leeson did not need a lot of money, and
at first he stayed within the established limits, even though the capital of the bank
was estimated at only 615 million dollars. However, he was eventually required
to show a substantial amount of money to support the declared position, since
the prices of the underlying assets had begun to fall steadily, and the variation
margin which Leeson was supposed to pay was growing catastrophically. As a
result, Barings collapsed, and Leeson was blamed.
As noted by Merton, financial innovations represent a permanent component
of the basic flow of development of the global financial system and now play a
decisive role in guaranteeing risk management functions, a role which, like classical
Newtonian mechanics, has three dimensions.
The first is the reduction of risk by selling its source. Here innovation products
enable one to decrease the corresponding costs.
The second is the reduction of risk by means of diversification, which can be
implemented more quickly with the help of derivative instruments.
The third is the reduction of risk with the help of insurance (understood in the
broad sense) against loss.
Most of the commonly accepted financial-economic theories, including CAPM,
the Markowitz theory, and others, “fit” risk management into the plane of the first
two dimensions. OPT (CCA) allows risk control to acquire the third (not less
significant) dimension.
The necessity of new approaches to practical risk management was clearly real
ized in the 1980s, and in June 1988 the central banks of the 12 largest industrially
developed countries reached an accord about new requirements, weighted with risk
taken into account, on the capital of financial structures. This was the so-called
Basel accord, finally introduced on December 31, 1992, which requires the differ
entiation of capital with regard to various types of assets, including balance sheet
items, treats bank capital in a more restrictive manner, dividing it into internal and
supplemental components, and introduces a minimal level of capital as a percent
of the weight of risky assets.
§ 1.4. Financial innovations and insurance risks
Any derivative security is characterized by insurance properties. For example,

forwards, futures, and option contracts for the purchase of an asset make it possible
for their holders to avoid substantial losses when the price of the asset increases.
Traditional insurance focuses almost exclusively on the estimation of risks. The
circulation of options and other derivative financial instruments is quite similar
in many aspects to the insurance sector of the financial system. However, while
insurance companies have to hold considerable reserves of capital in relation to
their obligations, “option” insurance reduces these requirements of reserves. The
principal reason for this situation is apparently that traditional insurance involves
selling the risk by the client to a specific insurance company, while insurance on
the basis of derivative securities involves selling the same risk on a financial market
with the possibility of continuous observation of prices and adequate reaction to

changes.
The main object of the classical theory of risk is the value process of an insur
ance company
Nt
(1.20) Rt = u + c t - ^ 2 ^ k,
fc=l
where u is the initial value of the company, c is the rate of receipt of premiums,
the are the payment claims (independent identically distributed variables), and
Nt is a Poisson process indicating the number of these claims up to the time t ^ 0.
A crucial characteristic for any insurance company is its solvency, which can be
characterized as the positivity of the risk process Rt in the course of time. However,
Rt is a random process, and hence a deterministic characteristic is needed that
expresses the property of solvency. This role is traditionally filled by the ruin
probability
<f>(u) = P { u ; : Rt (u) < 0 for some 1 1Ro = ia}.
Under the above classical assumptions about the risk process (1.20), this prob
ability admits the exponential Cramer-Lundberg upper estimates
(1.21) 4Ku) ^ exp{ —R u })
where R is the Lundberg constant.

The typical idea of classical actuarial mathematics is the following: a chosen
level of risk e > 0 is compared with the indicated bounds (1.21) for </>(u)y and the
level of solvency ue is found.
The traditional theory of risk does not take into account the investment activity
of the company, although the insurance companies of many countries are allowed
such activities (on regulated scales). To take-this circumstance into account it is
necessary first of all to specify a model of a financial market. For example, suppose
that the prices of a risky asset S are modeled as a geometric Brownian motion
(1.6)—(1.8), and the company invests its capital only in this asset. Then by the
Kolmogorov-Ito formula, the risk process evolves according to the equation
Nt+dt
(1.22) dRt = (\idt -her dwt)R t- + cdt —
k=Nt
In this case also we can define the ruin probability </>(u), but the upper bounds
for it will not be exponential. Here it is possible to get an integro-differential equa
tion for the ruin probability. Solving this equation either exactly or approximately,
we then compare the solution with the chosen level of risk e > 0 and find the
corresponding value ue of the solvency.
As mentioned earlier, the dynamics of the financial system, with various in
surance institutions forming an important element of it, has changed qualitatively
from the beginning of the 1970s. The insurance system (occupied with traditional
insurance), it seems, did not at once react to these changes and at the beginning
of the 1980s went through a fairly difficult period of instability. It was apparently
then that the significance of the introduction of the new instruments of insurance
“tied to” the basic innovation flow of the financial system was fully realized. Thus,
REFERENCES FOR CHAPTER 1 15
actuarial theory and practice had to be enriched by stochastic financial mathemat

ics. This meant taking into account a new randomness in actuarial calculations,
stemming from the financial randomness of insurance guarantees.
For instance, in life insurance there appeared contracts in which the payment
by the maturity date is connected with the market value of a portfolio of assets.
These are the equity-linked life insurance contracts, that is, insurance linked to
risky assets of the financial market. The appearance in actuarial calculations of the
Black-Scholes formula so crucial for stochastic financial mathematics in the 1980s
and 1990s is therefore not surprising.
Further, the greater part of the insurance industry deals with insurance events
that are vitally important for the client but constitute a relatively small part of
insurance coverage for the insurance company. These are the so-called “high-
frequency, low severity” risks. Nevertheless, at the beginning of the 1990s the
insurance business encountered another type of risk: “low-frequency, high severity”
risks due to various catastrophes. A catastrophe in the insurance sense is regarded
as an event leading to losses exceeding 5 million dollars (25 million since 1997) and
affecting a large number of people. As we know, catastrophes happen quite regu
larly. It suffices to note that in the period 1970-1993 there were 34 catastrophes
in the USA, with average yearly losses of 2.5 billion dollars. Using even more rep
resentative statistics over the period 1949-1993, one can assert that the absolute
majority of such events had losses confined within 250 million dollars. However,
the potential losses can really be catastrophic. For example, hurricane Andrew
in 1992 brought 16 billion dollars in losses, causing the collapse of 6 large insur
ance companies. The Northridge earthquake in 1994 brought 12.5 billion dollars in
losses.
On the other hand, if the famous San Francisco earthquake of 1906 had hap
pened in 1988, then it would have cost 38 billion dollars, and an earthquake of
the same magnitude in Los Angeles would cost 50 billion. For the USA the reality
is such that in the period 1989-1995 the total losses of this kind amounted to 35
billion dollars for the insurance business, which is equivalent to 18% of its capital.
So how can events of this kind be dealt with when the insurance and reinsurance
business in the USA has capital not exceeding 270 billion dollars? A realistic
answer again lies in the plane of the capital market, since the “capacities” of the
insurance and financial sectors are roughly in the ratio of 1:100. Therefore, finding
instruments on the capital market for diversification of insurance risks impossible
to cover by traditional methods is one of the realistic ways to solve this actuarial
problem. Following these ideas, the Chicago Board of Trade (CBOT) has been
trading in “catastrophe” futures and options since 1992. It is clear that calculations
of appropriate prices are impossible in the framework of traditional actuarial science
and must exploit in full scope the modern stochastic theory of contingent claims
analysis.
References for Chapter 1
[2]—[4], [6], [11], [17], [18], [23], [24], [26]-[36], [40], [43], [44], [46], [48], [49],
[51], [54], [64], [68], [72], [73], [79], [86]-[88], [90], [93], [94], [100], [105], [106],
[108]-[112], [118], [121], [122], [126]—[128], [134], [141]-[143], [158], [161].
CHAPTER 2
Random Processes and the Stochastic Calculus
The main goal of this chapter is to present the concepts and facts from the
theory of random processes needed in what follows, with sufficient rigor and logical
veracity. We give facts from the general theory of random processes and information
about Wiener, Poisson, and diffusion processes, together with a brief sketch of the
theory of the stochastic calculus of semimartingales.
§ 2.1. Random processes and their distributions. The Wiener process
In contemporary stochastic analysis the concept of a stochastic base has become

firmly established. This is a complete probability space (iî, T, P ) endowed with a fil
tration F = ( T t ) o w h i c h is a nondecreasing right-continuous family of (complete)
a-algebras This is the framework in which we consider all random processes
( X t W , under the assumption that the random variable X t is Tt-measurable for
each t ^ 0 (is adapted to F).
The measurability of X is understood as the measurability of the mapping
X : ÎÎ x M+ -* R (usually, R = Md, d ^ 1)
with respect to the a-algebras T x ®(M+) and ®(i?), where < B ( •) is the Borel a-
algebra, and the progressive measurability of X is understood as the measurability
of the mapping
X : (iî x [Ojt],^ x £ [0 ,i]) -* (R, *B(R)) for any t ^ 0.
It is assumed that for almost all u the process X t {oj) has a sample path X .(u )
that is right-continuous and has limits X t~(uj) from the left.
Two processes X and Y are said to be modifications of each other if
P { X t = Yt} = 1 for any t ^ 0.
The stronger concept of indistinguishability of X and Y is expressed as
P { uj : X t = Yt for all t ^ 0} = 1.
The “exotic” nature of the continuous case (t G R+ and not Z + ) is illustrated,

for example, by the process
1, ÜJ = t,
Xt
0,
defined on Q, = [0,1], with T = R [0 ,1] and P = meas (Lebesgue measure). It is

clear that Y = 0 is a modification of X , but they are not indistinguishable, because
of the obvious equality
P {w : X t(u) = 0 for all t € [0,1]} = 0.
17
18 CHAPTER 2. RANDOM PROCESSES AND THE STOCHASTIC CALCULUS
Most important for our purposes is a Wiener process W , or Brownian motion,

defined by the following three conditions:
1) W0 = 0 (P-a.s.);
2) Wt — Ws does not depend on Ts, s ^
3) Wt — W s has a normal distribution with zero mean and variance t —s, that
is, iV(0, t — s).
The “discrete” analogue of a Wiener process is obvious: these are sums of
standard independent Gaussian variables £&: Wn = Y^k=i ^n = cr{î, . . . ,£n}.
For what follows we need to understand what the distribution of a random
process (X t(u;))o^t is. Denote by R[°’°°) the set of all possible functions x : R+ —>R.
A subset A of R[°’°°) is called a cylindrical set if there is an n-tuple t\ < ••• ^ tn
and a set Bn G ® (R n) such that
A — { x . (Xti >•••»x tn) G Bn}.
Such sets form an algebra, which generates a corresponding smallest cr-algebra

£ [0,o°) containing them.
The distribution of a random process X is defined to be the measure p on
$ [0,o°) such that
p(C ) = P{u> : X .(u ) G C }, C e iB [0ôo).
A finite-dimensional distribution of X is a measure Pt!,...,tn given by an equality

of the form
‘ ^ , . , t n{A) = P { ^ : •••, * t » ) £ Bn}.
Furthermore, if a cylindrical set A admits another representation
A — \x : (x Sl, •••, x Sin) G Bm} >
then the equality (for any A)
is called the consistency condition.

Clearly, the measure p gives rise to a system of consistent finite-dimensional
distributions. Kolmogorov’s theorem is the converse of this assertion:
For a given system {p t1}...,tn} of consistent finite-dimensional distributions

there exists on (Ri0»00),® !0’00)) a unique distribution p with the measures Ptly...,tn
as its finite-dimensional distributions.
We remark that p is the distribution of the coordinate process X t{u)) = u;(£),

a; G ft = R[°’°°).
Suppose that the measures Pti,...,tn are determined by the Gaussian density
■- , x n) = (2wti) *e ^ ■(2ir{tn - tn -x)) *e 2(‘»-"n-i> .
It can be verified directly that this system is consistent, and hence by Kolmogorov’s
theorem there exists a unique distribution p = p w = P w , called the Wiener
measure, and the coordinate process W t(u) = w(£) is called a Wiener process.
Associated with the distributions p x and p Y of random processes X and Y
are the concepts of their absolute continuity (p Y p x ) and their equivalence
(px ~ p Y pY p x and p x «C p Y)- In this case a density for the corresponding
§2.1. RANDOM PROCESSES AND THEIR DISTRIBUTIONS. THE WIENER PROCESS 19
daY
measures exists (the Radon-Nikodym derivative): h(x.) = — ^r(a;.), x. e Mt0,oo\
and for an arbitrary bounded measurable function f ( x .) it satisfies the relation
(2.1) Ef(Y ) = [ f ( x .) d f = [ f(x .)h (x .) dfix = E f(X )h (X ).

JR(O.oo) JRIO.oo)
Denoting h(x) by Z, we get from (2.1) that E Z = 1, and hence Z determines

another measure P < P o n the original probability space.
How does one establish that ¡iY <C [ix ? The standard way is first of all to
assume that
.....tn
Then one can investigate the question o f the absolute continuity of the distributions
and fix themselves with the help of Z* = limn-.oo Z il)...)tn> where the limit is
understood in the sense of convergence in probability, EZ* ^ 1:
Ijly < jj,x <=> EZ* = 1.
Singularity p Y _L ¡ix can be characterized in the same terms as the equality

EZ* = 0. For example, _L ¡i2W for a Wiener process.
The construction of a Wiener process was realized in the space Ml0»00) . How
ever, its sample paths are continuous functions, as follows from another theorem of
Kolmogorov:
Suppose that for a random process (Xt)tô there exist constants Cê^/3 > 0
such that E\Xt —X 8f ^ C\t — s\1+£ fo r all t ^ s. Then X has a continuous
modification.
In the case X t = Wt we have E \Wt — W s\4 = 3 \t — s|2, and hence the condi
tions of this theorem hold.
The Wiener processes turn out to be invariant under shifts, inversion, and
dilation in time. Namely, the following random processes are also Wiener processes:
{W t+ a - W t)t> 0, a > 0; (tW 1/t)t>0; (A "1^ * ) ^ , A ^ 0.
The last property is called the self-similarity of W .

To conclude our discussion of the “sample path” properties of a Wiener pro
cess W we remark that the sample paths W., though continuous, are extremely
irregular: they are nowhere differentiable and on each finite interval they have un
bounded variation. It is not hard to convince oneself of this on an intuitive level.
Thus, for h > 0 the increment Wt+h—Wt has normal distribution N (0, /1), and hence
h~1^2(W t^-h-Wh) ~ N (0,1). However, the “pre-limit” expression h~1(W t+ h -W h )
for the derivative has variance increasing to infinity:
D h-'iW t+i - Wh) = ft"2D (Wt+h - Wh) = ft"1 t oo (ft J. 0).

We mention that although for any interval [0, t] the first variation
sup £ l
o=t0<---<tn ' k=l
is infinite (P-a.s.), the second variation has the following remarkable property:
(2-2) ¿ IWtk - Wt |2 -------->t (P-a.s.).

k= 1 n_>0°
Heuristic arguments for (2.2) stem from the following relations. From the
independence of the increments Wtk — Wtk_x and the properties of the variance we
have, first,
E ¿ \Wtk - W V J 2 = ¿ D ( W tfc - = £ > - = t,

k= 1 k= 1 k= 1
and second,
D - W V J 2 = ¿ D ( W i fc - W V J 2
fc=l /c=l
= 2 ¿ ( í fe- í fe_1)2
/c=l
n
< 2 max(ifc - tk -i) ^ ( i f c - i fc_ i)
fc=l
= 2t •max(tfc - t k - i ) --------►0.
k n—mx)
Another beautiful but implicit construction of a Wiener process W and the

Wiener measure is based on the Prokhorov-Donsker invariance principle:
Let £ = (£n)nî be a sequence o f independent identically distributed random

variables with E£n = 0 and D£n = 1. Prom the sums Sn = Ylk=i ^ define a
sequence o f continuous random processes by
x ? = n ~1/2{ s [nt] + (nt - M ) £ [nt]+i } , t e [0, 1 ].
Then there exists a measure ¡jlw concentrated on C[0,1] such that the distributions
of the processes X n converge weakly to fiw . Furthermore, the coordinate process
Wt(u>) = u t is a Wiener process.
Thus, on the space ÍÍ of continuous functions there exists a measure P with

respect to which the coordinate process Wt = to(t) is a Wiener process. For each
t ^ 0 we define SF* as the a-algebra generated by the coordinate process cj ( s), s < t,
and completed by the sets of P-measure zero. The stochastic base constructed will
be called the coordinate or canonical base.
§ 2.2. D iffusion processes. T h e K o lm o g o r o v -Ito form ula,

G irsa n ov’ s th eorem , representations o f m artingales
An important place in what follows is occupied by diffusion processes, which

we consider at first starting from the general theory of Markov processes.
A random process X is called a Markov process if
P { X t e A \ X uy u ^ s } = P { X t e A \ X $)
for any t ^ s and A e $(M ).

•§ 2.2. DIFFUSION PROCESSES 21
For X s = x the last probability is denoted by P (s, x, t, A) and interpreted

as the transition probability of the process X from the state x (at the time s) to
the set A (at the time t). A Markov process is homogeneous if P(s,a?,t, A) =
P (t —s, a;, A). The transition probability is a measurable function with respect to x
and a probability measure with respect to A, and P (s, x, s, A) = I a {%)-
Further, P(t,#, A) determines a semigroup of operators
P70*0 = / p (t,*,<fo)/(v)
Jr
on some supply of functions / : M —> R. This semigroup has a right-hand derivative

at zero on a certain set of functions:
d+
Af
dt
p 7 ¿->0+ 1. J1
t=o
This is called the infinitesimal operator of the semigroup (P £).
A Markov process X is called a diffusion process if A is a differential operator
on the smooth functions. More precisely, we denote by U£(x) and Ve (x) the neigh
borhood of radius e > 0 about a point x G ( O 1) and its complement in the
whole space.
Suppose that a Markov process X is such that there are continuous functions
atj(x) and bl(x) satisfying
P (t, x, Ve(x)) = o(t),
(;yl - Z*)P(t, x , dy) = W{x)t + o(t),

L )
L Uc (x)
for i , j = 1, . . . , d .
(;yl - Xt)(yj - x j )P(t, x, dy) = atj(x)t + o(t)
Such a process is called a (homogeneous) diffusion process with drift vector b

and diffusion matrix a. On the class of twice continuously differentiable functions
/ we have
A f = L f = - V ' aij ^ I V y d/
* * 2 .4 ^ dxldxi + ^ ° dxi ’
1,3=1 1=1
and this differential operator L is called the generating operator of the diffusion
process.
If the measure P (t,x,dy) admits a smooth transition density p(t, x,c!y), then
it satisfies the forward and backward Kolmogorov equations:
dp r* dp
m =Lp and m =Lp'
where
dx%dx 3 - E&Sr-
l*p = 2- J 2' dx%
i,j= 1 i= 1
A Wiener process W is a diffusion process with transition density
Furthermore, its drift is zero, and its diffusion is the identity, and there are
reasons to hope that all diffusion processes can be obtained from W .
The appropriate construction can be realized with the help of stochastic inte
gration.
Let W = o be a Wiener process. For “simple” functions
n
/(* ) = 2
*:=i
where 0 = t0 < t i < ■•• < t n = T, f k - i ml, and t ^ T, we define the stochastic
integral (with respect to W ) by the sum
f f(s)d W s = - Wtk_lAt).
Jo fc=i
The integral has the following properties:
(2.3) f\af + 0 g )d W . = a [ * f d W . + 0 f g d W s ,
Jo Jo Jo
(2.4)
E( I fdWs I9"*)= L fdWs’
(2.5) E QT / dWs f* g dWs^J = E J* 9f ds.
This integral can be extended as a linear operator to the set of progressively

measurable functions / such that E / Q T f 2 ds < oo with preservation of the proper
ties (2.3)-(2.5), and is then denoted by the same symbol (here T can be oo).
If 6(t,x) and cr{t,x) are continuous functions with respect to (t,x ) £ E+ x E
and satisfy a Lipschitz condition with respect to #, that is,
\b(t,x) -b (t,y )\ + \a(t,x) -<j(t,y)\ ^ L \ x -y \ for all t > 0, x ,y £ E
(L is a positive constant), then there is a unique continuous process X such that
( 2.6) X* = X 0 + s ,X s)d W s
for all t > 0 (P-a.s.).

The equality (2.6) defines a stochastic differential equation, and the process X
is called a (strong) solution of it. It turns out that in this case X is a diffusion
process with generating operator
T2 dj_
2 dx2 dx '
Moreover, with the help of a smooth function F (t, x) £ C 1'2 and X we form the
new random process Yt = F (t>X t), which is also a diffusion process (Figure 2 . 1 )
and satisfies the relation (for all t > 0, P-a.s.)
(2.7) F (t, X l) = F(0, X .) + l ‘ [ f + f 6+ \ g « ’] * + jf ‘ <№.■

§2.2. DIFFUSION PROCESSES 23
F i g u r e 2 . 1 . Closedness of the class of diffusion processes with

respect to smooth transformations F.
This formula is called the Kolmogorov-Ito formula. Thus, according to (2.7)

we have that the square of a Wiener process is equal to
Wt2 = 2 f w s d W s + t .
Jo
In what follows we shall need the concept of a controlled diffusion process X f
as a solution of a stochastic differential equation
( 2.8) Xt = x + / 6(s, a S) X s) ds + S, Qig, -AT^) dW$y

Jo
where the control process a s is determined according to the current information
about the state of X u, u ^ s ) and takes values in some parametric set A of “con
trols” .
The quality of control of the process X t is determined by the loss functional
/o°° f Qt(X t) f a (x ) being a certain function, and by the payoff function
v(x) = sup E dt.

aGA
A control is found from the Bellman differential equation
(2.9) sup{Lau + / “ } = 0,
a GA
where the operator
!.« (* ) = 5 + » (« ,* )£
is the generating operator for the diffusion process X a .

Transformations of probability measures can lead to random processes with
“nice” properties of distributions with respect to the new measures. The first
theorem of this kind is Girsanov’s theorem:
Consider a progressively measurable process (3t for which the process (called the
Girsanov exponential)
Zt = exp f3s dWs - ^ t^ T ,

is well defined, where W is a Wiener process. Let E Zt = 1, dP = ZrdP, and

Wt = Wt —f 0 (3Sds. Then the process W is a Wiener process with respect to P.
In particular, a diffusion process X t = f* b(Xs) ds + Wt with bounded mea

surable drift coefficient is a Wiener process (see Figure 2.2) with respect to the
measure ^
dP = e x p { - j f b(Xs)dWs - ^ J ^ dsj
F i g u r e 2.2. Transformation of diffusion processes into a Wiener

process by a change of measure with the help of the “Girsanov
exponential” .
Just as the class of diffusion processes is exhausted by the solutions of stochastic

differential equations, the class of random processes M adapted to the filtration
F = Fw generated by a Wiener process W , and such that
(2.10) E \Mt \< oo and E (Mt |Ts) = Ms (P-a.s.)
is exhausted by the stochastic integrals of the form f* 0SdWs. A process M satisfy

ing (2.10) is called a martingale. The following martingale representation theorem
will play a key role in what follows.
Any martingale M = o can be represented in the form
( 2. 11) Mt — M0 + f (j)s dWs,

Jo
where <f> is a progressively measurable random process.
We remark that the properties (2.4)-(2.5) of stochastic integrals have the mar
tingale property built in from the start, and the representation theorem says that
there are simply no other martingales (with respect to F = Fw ).
Returning to the example of the process Wt2, we note that the process X t =
W ? - E W ? = W ? - t is adapted to the filtration F and is a martingale with respect
to P. Hence, it can be represented in the form
Xt = X0+ dWs.
www.Ebook777.com
§ 2.3. SEMIMARGINGALES AND THE STOCHASTIC CALCULUS 25
An explicit formula for X t was obtained earlier with the help of the Kolmogorov-Ito
formula.
Another basic process is a Poisson process X = ( X t ^ t ) ^ o with intensity
A > 0, which is defined as follows:
1 ) X 0 = 0 (P-a.s.);
2 ) X t —X s does not depend on 3\s, s ^ t\
3) X t — X s has a Poisson distribution with parameter A(t — s).
It is clear that Nt = Xt — At is a martingale (a Poisson martingale). It turns
out that any other martingale M = {M u 7^)t^ o can be represented in the form of
an integral with respect to a Poisson martingale:
( 2. 12) Mt — M q + (f)s dN§i
where 0 is a progressively measurable process, and the integral f* (ps dNs can be
understood as the difference
nt nt nt
I (j^s dNs = / (f)s dXs / (f)s d\s
Jo Jo Jo
of two Lebesgue-Stieltjes integrals, since X t and \t are increasing processes.
In conclusion we give vector forms of the equation (2.6) and the Kolmogorov-
Ito formula (2.7). Namely, (2.6) can be understood as a vector equation with
b = ( b \ ..., bd)', a = ( c ijY f J c :d
dl, and W = ( W \ . . . , W d')'.
In this case the generating operator of a d-dimensional diffusion process X has
the form
r f 1 ^2/ ik jk
2=1 2 dxidxj -—
i,3 = l J k=1
and the formula (2.7) for F : M+ x Rdl —5 IS
(2.7') F ( t ,X t) = F { 0 ,X 0) + f X S) + L F (X S)
Joo L
t d d\
dW l
Jo h h dXi
The structure of diffusion processes is determined by their drift and diffusion.
The next section shows how the idea of singling out in the structure a low-frequency
component (a process of bounded variation) and a high-frequency component (a
martingale) leads to far-reaching and definitive generalizations in the form of pro
cesses called semimartingales.
§ 2.3. Semimartingales and the stochastic calculus
In correspondence with the general theory of random processes we introduce in

addition to the stochastic base (ii, 5F, F, P ) the following two cr-algebras on M+ x ii:
the cr-algebra 7 generated by all the F-adapted continuous processes;
the cr-algebra 0 generated by all the F-adapted right-continuous processes.
These are the so-called predictable and optional a-algebras. The T-measurable
and O-measurable processes are called predictable processes and optional processes,
respectively.
A stopping time (with respect to F) is defined to be a random variable r : ÍÍ -*

M+ U { + 00} such that for all t ^ 0
{ a ;: t (cj) ^ t} £ 3V
A martingale satisfying (2.10) is said to be uniformly integrable if there is an

integrable random variable M 00 such that (P-a.s.)
M t = E(Moo IiF*).
The martingale M is said to be square integrable if E |Moo|2 < 00.

These classes of martingales are denoted by M and M 2, respectively.
The set of processes having finite (integrable) variation on each finite interval
will be denoted by V (A), and the subset of nondecreasing processes by V+ (A + ).
A process M = 0 is a, local martingale (M £ Mioc) if there is a sequence
of stopping times rn | 00 (n t 00) such that M Tn = (M tATn)t^0 belongs to M for
each n £ N. The classes M 2oc, *A£c, and A\oc are defined similarly according to the
indicated localization procedure, and the corresponding processes are called locally
square-integrable martingales, and so on.
For a process A £ V+ = Vj£c we have a decomposition into the purely continuous
component A c and the purely discontinuous component A d:
A t = A ct + A f,
where A d = a n/ { Tn^ } , and the sequence {r n} of stopping times “exhausts” the

jumps of the process A.
If in the definition (2.10) the equality is replaced by the inequality
E (M t |Ts) ^ M s (^ A f,),
then the process Mt is called a submartingale (supermartingale).

It turns out that the indicated processes are structurally formed from local mar
tingales (or even from martingales) and increasing predictable processes. For ex
ample, an arbitrary nonnegative supermartingale M admits the following (unique)
Doob-Meyer decomposition:
(2.13) Mt = m t - A u
where m £ Mioc and A £ A*oc D T. In particular, for A £ A+oc there exists a unique
predictable process (the compensator) A £ Aôc fl V such that the difference A —A
is in Mioc-
The Doob-Meyer decomposition implies that any M, N £ M 2oc have a mutual
quadratic characteristic (M , AT), which is a predictable process in yLioc with the
property that it compensates M N to form a local martingale: M N - ( M ) N ) £ Mioc-
In particular, M 2 - (M, M ) £ Mioc for M = N £ M 2oc.
An arbitrary local martingale M does not have such a characterization. Never
theless, we have the following decomposition into a continuous component M c and
a purely discontinuous component M d:
Mt = M ct + M f ,
where M c is a continuous local martingale (M c £ Mfoc), and M d belongs to the

class M doc of purely discontinuous local martingales, which is characterized by the
condition that K L £ Mioc for any K £ Mfoc and L £ Mfoc.
For M ,N e Mioc we define their mutual (nonpredictable in general) quadratic

characteristic
[M ,N ]t = (M c,N c)t + 5 3 A M SA N S.
0<s^t
In particular, for M = N e 3Vtioc
ioc.
Suppose that M e Mfoc and the predictable process 0 are such that (for almost
all a;) the Lebesgue-Stieltjes integral
[* d (M ), = 4>2 o (m , M )t
JO
is defined and is in A*oc. Then the stochastic integral
= ffa d M s
Jo
is defined as a process in Môc such that
A (4> * M )t = & AM*, (<(>* M, <!>* M )t = <l>2 o (M, M )t.
In the class Mfoc all possible stochastic integrals with respect to a given mar
tingale M e Mfoc form a subspace. Consequently, any other N e Mfoc must have
a decomposition into a sum of two projections (on the indicated subspace and on
its complement). The realization of this idea is the following (unique) Kunita-
Watanabe decomposition:
Nt = f (f>s dMs + M ly
Jo
where </>is a predictable process (the integrand), and M ' € 3Vtfoc is orthogonal to M
in the sense that (M, M ') = 0.
A semimartingale is defined to be a process representable in the form
(2.14) X* = X 0 + A t + M u
where A G V, M e Mioc, and X q € To-

If in this decomposition A E (P, then X is a special semimartingale.
Now let Ro = Rd \ { 0} and let !B(Ro) be the Borel a-algebra. From the
jumps A X t of a ¿-dimensional semimartingale X we define the integer-valued ran
dom measure
where B € B(R+) and T e B(Ro).

The integer-valued random measure v = z/( cj, B, T) is said to be predictable if
for any 7 x B(Mo)-measurable nonnegative function 0 the process
(j) o v t = / (¡>{S)X)v(ds,dx)
J0 JMo
is predictable. If in this case = E ^ o /x )^ then v is called the com p en sa tor
of the measure ji.
Let a !P x 3 (R0)-measurable function <\> be such that (\(/>\ o v)t e Aôc. Then
the stochastic integral
(2.15) (j) * (fj, - v)t =
with respect to the difference (p — v) of measures is defined, and it is a purely

discontinuous local martingale whose jumps are determined from the relation
A </>* (/x - v )t = A X t)lAXtô ~ / x) i/({t}, dx).

Jmo
Using the original representation (2.14) and (2.15), we can now write the fol
lowing canonical decomposition of X :
(2.16) X t = Xo + B t + M tC+ x /{* :|*Kl} * (M - v)t + Xl{x:\x\>l} OfJLU
where B e V fl 7 and M c € Mfoc.

The triple (£ , (M c, M c), v) is called the triplet o f predictable characteristics of
the semimartingale X .
It is now easy to define the stochastic integral with respect to a semimartin
gale X as the sum of the corresponding integrals with respect to the components
of the decompositions (2.13) or (2.16).
It turns out that the class of semimartingales, like the class of diffusion pro
cesses, is invariant with respect to smooth changes of variables. This is what is
said by the corresponding generalization of the Kolmogorov-Ito formula given by
Doleans and Meyer:
Let X be a semimartingale (2.14) with values in Rd, d ^ 1, and let F : R d —>R 1

be a twice continuously differentiable function. Then
rt u psp
(2.17) F {X t) = F (X o) + / o E w S X - ydX°
1 /** _ d fP TP
+ £ \F(Xs) - F ( X a- ) - Y , ^ . ( X s - ) ( X i - X i - )
dxi
0< s^t i=1
where X c is the continuous component of a local martingale M .
The existence of stochastic integrals with respect to semimartingales enables

us to consider corresponding stochastic equations. Of crucial significance are linear
stochastic equations
( 2. 18) Yt = Y0 + / / : Ys-dX t
where X is a given semimartingale (2.14).

A solution Y is determined with the help of the stochastic exponential
It is clear that £ t(X ) is a solution of (2.18) with Yq = 1 .

We list some important properties of Et (X ):
1) £t(X ) is a process of bounded variation or a local martingale if X is;
2 ) fir 1* * ) = where X * = X t - { X e, X % -
3) = £t(JSC-I- Jt' -H [Jt, s<t
The last property (the multiplication rule for stochastic exponentials) is called
Yor’s formula.
Suppose that besides the original measure on the stochastic base (ii, T, F, P )
we are given a measure P locally equivalent to it and with local density Zt. The
equivalence implies strict positiveness of Zt for almost all t (P-a.s.). Hence, we can
define a local martingale N (with respect to P : N G Mioc(P )) as the stochastic
integral Nt = f* Z~} dZ3, which leads to a representation of Z in the form of the
stochastic exponential
( 2.20) Zt = e t(N).
Just as a diffusion process acquires the properties of a Wiener process under

a transformation of measure with the help of the “Girsanov exponential” , a given
semimartingale R here acquires the properties of a local martingale with respect to
a measure P with density that is a stochastic exponential (2.20):
( 2. 21) R e Mioc(P) <=i> ZR s Mioc(P).
For what follows, facts such as the representation of a martingale in the form
of a stochastic integral with respect to a Wiener process and the Doob-Meyer
decomposition with respect to some family of measures will be important.
Let X be a given process. We denote by M (X , P ) the set formed by all mea
sures P equivalent to P such that X is a local martingale with respect to P.
Correspondingly, this set will be called the family of martingale measures.
The first fact in this direction concerns the structure of nonnegative processes
that are local martingales with respect to all P G M (X ,P ).
M a r t in g a l e R e p r e s e n t a t io n T h e o r e m . I fM (X , P ) ^ 0 , then a nonneg
ative process M belongs to the class Mioc(P ) (is a local martingale) for any measure
P G M (X , P ) there exists a predictable process </> such that
(2.22)
for any t ^ 0.
The next fact gives a description of the structure of nonnegative processes that
are supermartingales with respect to all P e M (X , P ).
www.Ebook777.com
O p t i o n a l D e c o m p o s i t i o n T h e o r e m . Suppose that M (J f,P ) ^ 0 and V is
a nonnegative process. Then V is a supermartingale for any measure P G M (X , P )

<£=>• there exist a predictable process <j> and a nondecreasing optional process C
( often called a consumption process in financial mathematics) such that
(2.23) Vt = V0 + dXs - Ct
for any t ^ 0.
Finally, we give the last assertion connected with the family M (X , P ), which in
this or that capacity is an indispensable attribute of the theory of optimal stopping
rules:
T h e o r e m . Let M f be the set of stopping times taking values in the interval

[t>T\, and let f = (ft)tô be a positive optional process such that
sup E f T < oo.
Then there exists a random process
(2.24) ess sup E [/r |Tt]

P € M (X ,P ) } r £ M f
that is a supermartingale with respect to each measure in M (X ,P ).
In particular, if a positive random variable / is such that suppGM^ EfT <

oo, then there exists a random process
(2.25) ess sup E [ /1 9^1

PeM (x,p),r 6M r
that is a supermartingale with respect to each measure in 3VC(X,P).
R eferen ces for C h apter 2
[49], [55], [81], [82], [90], [94], [98], [103], [104], [106]-[108], [141], [149],
[154], [158].
CHAPTER 3
Hedging and Investment in Complete Markets
We consider a general model of a (B, 5 )-market, and for it we give a martingale

characterization of strategies and develop methods of perfect and quantile hedging
under the assumption that there is a unique martingale measure. A method is
presented for finding the martingale measure, with applications to some well-known
models. Investment problems are looked at on the basis of utility functions and
the associated apparatus. The optimal value and optimal investment strategies are
calculated in some concrete models.
§3.1. A martingale characterization of strategies and perfect hedging

For a given standard stochastic base (ft, iF,F,P), we define on it a (B, S)-
market as a collection of two positive semimartingales B and 5. The values of Bt
and St are interpreted as the prices of a nonrisky asset B and a risky asset S.
A portfolio or investment strategy is defined to be a pair nt = (fit, It) of random
processes, with predictable second component, that determines a nonnegative value
for the investor according to the balance equation
(3 1 ) X ? = X ? { x ) = (3tBt + l t Su
X q = fioBo + 7 o5 o = x.
We remark that the process S', like B , will be assumed to be one-dimensional
in what follows, although all the results remain true also for d-dimensional 5 if
7 1 •St is understood as the inner product of two vectors: a d-dimensional asset
5 = (5 1, . . . , Sd) and a d-dimensional strategy 7 = (7 1, . . . , 7 d).
We write X t = St/Bt and call it the discounted price process (of the risky
asset, or stock). Correspondingly, the quotient X */ B t will be called the discounted
value of the portfolio n.
Assuming that /J, 7 € V, we now consider the discounted value of the portfolio
7r = (/?, 7 ). Using the Kolmogorov-Ito formula and (3.1), we get that
(3.2)
'(I).
7u <
The economic meaning of the last term in this formula is clear: it describes the
dynamics of the discounted value as the discounted prices of the stocks change. It
is therefore quite reasonable to distinguish those portfolios n such that
Xl = Xl
(3.3)
Bt Bo u
31
32 CHAPTER 3. HEDGING AND INVESTMENT IN COMPLETE MARKETS
We call them self-financing and denote the corresponding set by SF.

With the discounted stock price process we associate the set M (X , P ) of mar
tingale measures (see §2.3).
We say that a (B, S')-market admits an arbitrage opportunity (admits arbitrage)
at a time T > 0 if there exists a 7t e SF such that (P-a.s.) Xfi = 0, Xlf ^ 0, and
P { X $ > 0 } > 0.
We remark that if M (X ,P ) ^ 0 , then the (B^S)-market does not admit such
an arbitrage opportunity.
Indeed, let P* G 3Vt(X, P ) and let 7r* be an arbitrage strategy. Then (3.3)
implies that Xf*/Bt G 3Vtioc(P*), and hence E *[Xf*/Bt] = X q */B0 = 0. It is clear
that P *(X rf > 0) = 0, and since the measures P* and P are equivalent, we get
that P(X £* > 0) = 0, which contradicts the assumption that n* is an arbitrage
strategy.
In forming a portfolio diverse payments are possible, called consumption. It
is therefore natural to consider the class of strategies n with consumption C a s a
nonnegative nondecreasing process for which
(3.4)
or, equivalently,
(3.40
where D t = /„* B ^ 1 dCu.

Returning to the formulas (3.2), we see the meaning that can now be given to
the sum of the second and third terms: the cumulative discounted consumption D t.
The classes of strategies introduced admit a very useful martingale characteri
zation.
THEOREM 3.1. Suppose that M (X , P ) consists of a single measure P*, and let
Y be a nonnegative random process. Then:
1 ) Y is the discounted value of a self-financing strategy <=> Y is a local
martingale with respect to P*;
2) Y is the discounted value o f a strategy with consumption Y is a
supermartingale with respect to P*.
In the first case the proof follows directly from the martingale representation
theorem and (3.3), and in the second from the optional decomposition of super
martingales and (3.4)-(3.4;).
Investor activity on a (B, S)-market leads to the conclusion of agreements “de
layed” over a time T into the future, based on contingent claims of the parties.
By a contingent claim (with exercise date T) we understand any nonnegative
measurable random variable / . We remark that if such an agreement is an option
and / represents the corresponding payments, then it is called a European option.
After concluding a financial transaction and accepting a contingent claim / ,
an economic agent tries to choose an attainable investment strategy ir with the
goal that by the expiration date of the claim the value X ^ of his chosen strategy
hedges f in the sense that
(3.5) (P-a.s.).
§3.1. MARTINGALE CHARACTERIZATION OF STRATEGIES 33
In this case 7r is called a hedging strategy (portfolio), or a hedge. If in some class

of hedging strategies ir there is a strategy nr* such that X£*' < X ? (P-a.8.) for all
t G [0,T], then 7r* is called a minimal (in this class) hedge. The theorem below says
that such hedges really do exist in the set SF.
In what follows let g denote the discounted value of the contingent claim / .
T h e o r e m 3.2. Suppose that M (X , P ) consists of a single measure P*, and let

g be a discounted contingent claim such that
(3.6) E *g < oo.
Then in the class of self-financing strategies there is a minimal hedge n*, and its
discounted value X f /Bt and “risky” component 7 * are determined by the formulas
x?
(3.7) = E*fo|3’t), teM,
x f V-7r* ft
(3.8) = -J T + ridX u , *€[0,21.
Bt &0 Jo
P r o o f . In view of the condition (3.6) a (local) martingale (Yt*)tô> Yt* =

E *(g |3^), is defined such that
(3.9) Yf = g (P*-a.s.).
On the one hand, there then exists by the martingale representation theorem a
predictable process 7 * such that
yt* = Y f + 7 *u dXUi
and on the other hand, Y* is the discounted value of some self-financing strategy 7r*
in view of Theorem 3.1. It has thereby been established by virtue of (3.9) that 7r* is
a hedge satisfying the relations (3.7)-(3.8). To prove it is minimal we consider any
other hedge n e SF. By the martingale characterization, X f /Bt is a nonnegative
local martingale, and hence a supermartingale (with respect to P*). Therefore, we
get from (3.5) that for all t G [0,T] (a.s.)
x i
> E * (fl| y t) Y*
Bt
We call a (£ , 5)-market complete if for any bounded discounted claim g there

exists a self-financing hedge n* such that X£*/Bt = g (a.s.). In this case one also
says that n* replicates the claim, and it is said to be attainable.
T h e o r e m 3 .3. Let M (X ,P ) 7^ 0 . Then the {B , S)-market is complete

M (X , P ) consists of a single measure P*.
P r o o f . The sufficiency follows from the preceding theorem. To prove necessity

we assume that there exist two distinct martingale measures P i , P 2 € M (X , P ).
Let A G be a set where they do not coincide, and consider the claim g = I a
(that is, / = I A' Bt). The definition of completeness of a (£ , S)-market implies the
existence of a self-financing strategy 7r* that replicates g: Y f = X ^/B t = g = I a
(P-a.s.).
Hence, P 1{A) = E \IA = E \YT = E \Y = E \IA = P£(A), and therefore

P i(A ) = P ^ A ). This contradiction concludes the proof.
Summing up these theorems, we can say that in a complete (B ,S )-market

perfect hedging of any contingent claim is possible, in the sense that there exists a
self-financing hedge with minimal value that replicates this claim. Perfect hedging
enables us for any t E [0,T] to uniquely determine the (no-arbitrage, fair) price
of a contingent claim as the value of a minimal hedge (at the indicated moment
of time). This price is fair also because it is convenient both for the buyer of the
option (in view of the absence of a cheaper strategy) and for the seller of the option
(since at the given price he can “pay off” according to the accepted claim).
All the foregoing speaks of the necessity not only of establishing the nonempti
ness itself of the class M (A , P ), but also of being able to find martingale measures.
In the next section we present a general method of looking for a (H, 5)-market
whose prices B t and St satisfy linear stochastic equations in semimartingales. Most
financial markets are modeled in just this way.
§ 3.2. A m e th o d o lo g y for finding m artingale m easures and

pricin g con tin gen t claim s for different m odels o f a (B, 5 )-m arket
Suppose that a (B, S)-market is determined by the two linear stochastic equa-
tions
Bt — B q + Aht > - 1 ,
1
f
(3.10)
^0
s t = S0 + [ Su- d H u> A Hu > - 1

10
where h and H are given semimartingales. Then by § 2.3,
Bt = Bo £*(/&),
(3.11)
St = So
Our problem here is to find conditions (in terms of the original semimartingales
h and H ) under which a measure P* equivalent to P takes the process X = S/B
into a local martingale
(3.12) P * e M (X ,P ) ^ X = e Mioc(P*).
Let us first determine when the original measure P is a martingale measure on

the market (3.10)-(3.11).
According to the properties of stochastic exponentials (see §2.3), we have
(3.13)
X t = Xo Zt{H )ZT\h) = Xo £t(H)Et (-h * )
AH Ah\
= X 0 i t ( H - h + (hc, hc) + ^ - (H c,h c) - £
1 + Ah )
= X , e, ( g - H+ < y . y - H ‘ ) + £ M (f * - J H) ) .
www.Ebook777.com
§3.2. A METHODOLOGY FOR FINDING MARTINGALE MEASURES 35
We use the notation
V t (h, H ) = Ht - h t + (hc, hc - H c) + 2 A hs(A hs - A H s)

ssgt 1+
and rewrite (3.13) in the form of the stochastic equation
X t = X 0 + ^ X s-< № s(h ,H ).
Jo
Consequently, to verify that X G Mioc(P ), we must establish that this class
contains the process
It is now clear how to find conditions under which the relation (3.12) we need is
true. To this end let Z£ = dP^/dPt be the local density of the equivalent measures
P* and P. Then by the generalization ( 2 .2 1 ) of Girsanov’s theorem,
(3.14) l G M loc( F ) <=> Z X e M ioc(P).
Next, by (2.20),
(3.15) Z* = Et (N ),
where Nt = / q Z~'} dZs G Mioc(P ). Therefore, we get from (3.14)-(3.15) that
(3.16) X G M loc(P*) «=► X £(AT) G Mioc(P).
In view of (3.13)
X t Z(N) = X 0 Z (* (h yH ))Z t(N )y
and by the rules for multiplying stochastic exponents,
(3.17) X t Et (N ) = X 0 £ * № , H , N )),
where
* t(h yH yN ) = Ht - h t + Nt + ((h - N )cy(h - H )c)t

^ (A h$ - A N s)(A h s - A H $)
^ 1 + A hs
It follows from (3.17) that to verify (3.16) we must determine when
(3.18) V (h yH yN ) e M ioc(P).
Let us apply this method to some well-known models of a (B y5)-market.
dBt — rB t dty B0 = l y
dSt = St(fJidt + crdwt), So > 0,
where r,/z G M+, 0 < a (the volatility), and w = (wt)tô is a standard Wiener
process generating the filtration F.
In the model (3.19), ht = rt and Ht = fit + awty and since wt is the sole
source of randomness in the prices Sty it is perfectly natural to look for the local
martingale Nt in the form Nt = <pwt. Using this, we get from (3.17) that
®t(ft, H yN ) = fit + awt - rt + ipwt + (pert = (fjb - r + (pa)t + (cr + (p)wt.

Hence, the condition (3.18) will be satisfied (and \l?t(ft,if, N ) will even be a
martingale) if (p satisfies the equation
(3.20) fi — r + (pa = 0, or ip = —- — - .
<T
As a result we get from (3.15) and (3.20) the density of the corresponding
martingale measure P*:
fJb —r
(3.21) = £t(iV) = exp
{ <J
and, as we already know from Girsanov’s theorem, the process w% = wt + t

will be a Wiener process with respect to the new measure P*. It is also clear in
view of the uniqueness of the solution of (3.20) that P* is the unique martingale
measure, and the resulting ( 5 , 5 ) - market (3.19) is complete.
We consider the contingent claim / = {St —K ) + corresponding to an option to
buy (the asset S at the price K ). According to Theorem 3.3, there exists a minimal
hedge 7r* = (/?*,7 *) determined by the formulas (3.7) and (3.8), which in this case
we should specify more concretely.
Let us first calculate the initial value of the indicated hedge. To this end
we let (p{x) = —= ex p {—x 2/2} denote the density of the normal distribution
V27T
$ (x ) = (p{y) dy, let a = ^ 0 L and calculate E*e rT(S r —K ) + >making
the obvious transformations (x = z — a and so on):
(3.22)
E * e -rT(ST - K )+ = e - rTEZ£(So •e ^ ~ ^ )T^ WT - AT) +
= e - rTE e - ^ ^ - ^ ) 2T(S0 • - K )+
= e~rT r e- ( ^ ) y T - Ç ( ^ ) 2
J—oo
(So •e ( ^ ) r W f - K ) + <p(x) dx
/ oo e -(a = r)y/ f^ T (M=j:y
= e
■oo
(So • - K ) +ip(x)dx
^2 . _ *2 , _ a2
= e \2n) - ï T e- 4 - z^ - 4 ^ - 4
J—oo
x { S o - e ^ )T+^ z ~ K ) + dz
= e (27T) ~ i f
J{z:(r-s£-)T+ 0 y/Tz>In ^ j
x (So •e< r - £ )T+a'/Tg ~ K ) dz
= e~rT(2ir)~%f fPo e 2 erl dz

J{z:z>z0=(ln £ +T (g-r))/cV T }
- K e - TT( l - $ ( z o ) )
= So(27r) 2 f e* dz — K e rT$ ( —zo)

J{z:z>zo}
= S o(i - $(*o - <ry/T)) - K e - rT$ ( - z 0).
Introducing the new notation
we rewrite (3.22) in the form of the formula
(3.23) C BS(T, S0, K, r, <j ) = S0$ (d + (T)) - K e ~ rT$ (d -(T )),
which is commonly called the Black-Scholes formula.

Using the independence and the Gaussian property of the increments of a
Wiener process, we can repeat the very same procedure for the conditional expec
tation E *(e_rT(Sr — K )+ |Jt), which represents the value of the minimal hedge
at an arbitrary time t ^ T, and obtain
(3.24)
CBS(T - t , S t, К, r, a) = E* (e~rT(ST - K)+ \? t)
= St$(d+(T - 1)) - Ke~r^T~t^ (d -(T - 1)).
It is clear that C BS is a smooth function of S and t, and therefore application
of the Kolmogorov-Ito formula to C BS(T — t, St)/Bt leads to the relation
(3.25)
CBS(St) _ CBS(S0) f* ЭСBS(SU) ( S u\
Bt Bo + Jo dx d\B u)
f rdC BS dCBS <j 2 2 d2C BS
- r C BS du.
+ Jo Bu [ du + Su dx + 2 Su dx2
On the other hand, (3.8) holds for the discounted value C BS of the minimal
hedge, and hence we get from (3.25) that
dCBS,
(3.26) Ъ = <S t)
dx
and
dCBS dCBS d2C BS,
<3'27> « (*, *) + rS»~Q^~(X'
- ..........- a . *) + У dx2 ^ ~ rCBS(æ>f) = °-
The equation (3.27) is called the Black-Scholes equation.
To find the second component n* it is necessary to use the balance equation
X f = f t B t + 7 ¡S t and get
(3.28) ft = - YtSt .
Thus, in the framework of the Black-Scholes model (3.19) the components of

the minimal hedge 7r* = (/?*,7*) can be found from the formulas (3.26) and (3.28),
and its value is determined by the formula (3.24) and satisfies the equation (3.27).
In particular, the initial value (3.22) of this hedge is called the fair price (Black-
Scholes price) for a European option to buy (call option).
As for the dual option, the option to sell (put option) with contingent claim
(K — 5 t )+ , its price PB5(T) and C BS(T) are connected by the following useful
“parity” relation:
(3.29) PBS{T) = C BS(T) - S 0 + K e ~ rT.
The Black-Scholes formula enables us to price contingent claims / that are

smooth functions of St ' f = /( S r ) -
To do this we use integration by parts and write the following Taylor expansion
of the function / : for x > 0
f ( x ) = /( 0 ) + x f ( 0) + f ( x - y )+ f " ( y ) dy.
Jo
We now substitute in this formula x = St from (3.19), divide both sides by erT,
and average with respect to P*. As a result we get the following elegant formula
for the initial price C f s (T) of such a contingent claim:
/»OO
(3.30) C f s (T) = e~rT + S o f(0 ) + / C BS(T, y )f" (y ) dy.
Jo
We remark that it is possible to arrive at a similar formula also for other models
of a financial market. For example, in the Merton model below just replace C BS
in (3.30) by C M.
The Merton model.

dBt = rB t dt, B0 = 1,
] dSt = St- ( p d t - u d U t),
where /x, r € R+, v < 1, and II = (II*)tô is a Poisson process with intensity A > 0
generating the filtration F.
In the model (3.31), ht = rt and Ht = ¡it —ulit, and the martingale Nt will be
found in the form Nt = ^(U t — At). Further,
\Pt(h, H, N ) = p t - ullt - rt + 'ipfn.t - At) - ipvllt

= (p — r — v\ — 'ipv\)t — 1/(11* — At) + V>(n* — At) —^z/(II * — At),
and hence the condition (3.18) is satisfied for \i —r — v\ —ipvX = 0, or
(3.32)
We note at once the uniqueness of the solution of (3.32), and hence the unique
ness of the martingale measure P* and the completeness of the (B ) 5)-market (3.31).
Using (3.15) and (3.32), we get that
(3.33) z ; = - f - = Et{N ) = exp{(A - A*)t + (In A* - lnA)nt},

U/IT *
where A* = (p —r ) jv is the intensity of II* with respect to the new measure P*.
We use the formula (3.33) found for the density to calculate the initial value of
the minimal hedge for the contingent claim / = (St — K )+ .
According to Theorem 3.3, this initial value is
(3.34) C M(T) = E * e -rT(ST - K )+ .

It is clear that
(3.35) (| )^ = e x p {-u U T + v\*T} J J (1 - ^ A n t)e"An‘
= ( J r ) ex p {n T ln(l - v) + v\*T}.
It follows from (3.34)-(3.35) (and the Poisson property of lit with respect to P*)
that
(3.36) C M(T) = B oE *B t \ S t - K ) + = BoE* ( J^- - J ^ -) +
= B 0 £ e - A*T ^ ^ _ B-iK V
rt.=Ci * \ 0 /
Using the notation
r ln f-M T ]
no = infill : H-'-n'i- ÿ
l Ml-*') J’
* (* .» ) = n!
we get from (3.36) that
(3.37) CM(T) = So £ e- A*r+ A V renlp(1- ,/) Â* ^ W - K e - rT9(n o,\ *T )

n\
72=77,0
So T c ^ - ^ ( ^ - ^ ) T ) n - K e - rTV (n0i\*T)
" n!
= 50^ (n 0, A*(l - v)T ) - K e ~ rT^ {n 0, A T ).
The formula (3.37) is called Merton's formula for a fair price of an option to
buy in the market model (3.31).
The jump-diffusion model of a market.
dBt = r B t dt, B0 = 1 ,
(3.38)
dSl = Sî_(f/ dt + a1dwt - i / dût), Sq > 0, i = 1,2,
where \x%,r e M+, a 1 > 0, v%< 1, w = (wt)tô is a Wiener process, II = (Ilt)tô is

a Poisson process (with intensity A), and w and II are mutually independent and
generate the filtration F.
As in the models (3.19) and (3.31), we calculate the function \l>t( f c ,if ,# ), and
then we look for the martingale Nt in the form Nt = cpwt + ^(11* - At): for ¿ = 1,2
\I>t(h, 1?, N ) = fizt + alwt — uzUt — rt + <paH — t

= ([j,1 —r — v%\ + <pa%— û/A)t + a martingale.
Hence, (p and satisfy the two equations (¿ = 1,2):
(3.39) fjf —r — v%\ + (pa%— tyv%\ = 0,
www.Ebook777.com
or, with the notation A* = A(1 + ^),
(3.39') ¡i1 —r + —v%

\* = 0.
Assuming that a 2v 1 — g xv 2 ^ 0, we write out the (unique) solution of (3.39')

(and hence of (3.39)):
(fj? —r)vx — (fl1 —r)v2

<P = a 2v l — cr1!/2
_ Qu1 - r)<72 - (H2 - r)<Jl
^ O l i o
a2v1 —oxv2
The density of the original martingale measure P* can be uniquely determined

from this:
It is clear that with respect to P* the process lujf = w t —ipt is a Wiener process,
while II is a Poisson process with intensity A*.
We remark that the consideration of a (B , S)-market with a single risky asset
leads (in the search for a martingale measure) only to the single equation (3.39)
with two unknowns, and hence to the possibility of finding a whole set of martingale
measures, and together with this to a very clear example of an incomplete market.
We now show how to price the contingent claim / = (S? —K ) + on a complete
market (3.38) with two risky assets. To this end we first rewrite the discounted
price S 1 in the exponential form
(3.41)
By Theorem 3.3, the (initial) price C of this claim is in view of (3.41) equal to
(3.42)
§ 3.2. A METHODOLOGY FOR FINDING MARTINGALE MEASURES 41
Further, using the independence of the Wiener process w* and the Poisson
process II with respect to P*, we get from (3.42) that
(3.43)
c = E*(E*[(S(Je(^lA* - ^ ) T+fflw*+nTln(1_t'1) - B^K)+|nT])
= £ E* ‘"i1- " 1) - B ^ K ) + |HT = n]
n=0
x e -A *T (A*7)”
n!
= E* ¿ ( £ ¿ ( 1 - I/i ) " e (l,lA*- i ^ ) T+<Tl,"î- - B ^ 1K ) + e - y T ^X* ^ n

71=0
= e ~X' T £ ^ p WE * (5 g (l - t'1 )ne (l/lA*_i£^ “ ) T+<rl,u^ - B ^ K ) +

71=0
oo
= e - x tT ' £ ^ ^ C BS(T ,S 1
0 ( i - u 1)ne‘' l y T , r , c 1,K ) ,
71=0
where we recall that C BS is the price determined by the Black-Scholes formula

(3.23).
Thus, the price of the contingent claim (S^—K ) + on this jump-diffusion market
is the Poisson weighting (3.43) of the Black-Scholes formula.
The Cox-Ross-Rubinstein model.

This is a model of a purely discrete market, often called the binomial model
because the prices of the risky asset ( 5 n)n=o,i,... represent a binomial random walk:
(3 44) A B n = Bn — Bn—\ = rB n—i , B q > 0,

Aii?n = Sn —Sn—i = pnSn~ij So > 0,
where (p n )n = i,... is a sequence of independent random variables taking the two
values a r > a > —1.
Setting B t = Bn on [n, n + 1) (and doing the same with S*, Tt, •••)> we “imbed”
the discrete model (3.44) in the standard way in a general semimartingale model of
a (B, S)-market, and hence we can use all the results we need.
In this case A hn = r, A Hn = pn, and A Nn = ^ n{pn - m), m = E pn.
Hence,
(1 + r )A * n(/i, B , N ) = SHn - A hn + A Nn + A B nA B n,
and thus by the martingale property of \I>n(h, B , N )
E (pn —r 'finiPn m) + (Pn(pn m)pn |Tn_ l) = 0.
From this, 'ipn = ------- 2— , where a 2 = Ep2 — m 2 = D pn. As a result, the corre
sponding density of the martingale measure P* is
We find the initial (fair) price of the claim / = (St — K ) + - By Theorem 3.3,
it is
(3.46) C%RR = E *(l + r)~ N(SN - K ) + = (1 + r)~ NE*(SN - K ) + .
By (3.45),
(3.47) E*(S n - K ) + = EZ*n (S n - K ) +
= EEN - m ) ) (Sit - K ) ■I {Sn > k }•
Let k0 - min{fc ^ N : Sq(1 + b)k(l + a)N~k > K } . We observe that ko ln(l + b) +
(N — ko) ln(l + a) > In — , and hence

So
K 1 +5
ko = In In + 1.
So(l + a)N / 1 + a_
r -a
We let p* and use the binomial property and the relations m =
b —a
p (6 — a) + o and a2 = (b — a)2p(l —p) to find that in (3.47)
(3.48)
E £* - m )^ K - I {Sn>k}
N-k
-k0
N
= K p ( f ) ( p * ) k( i - p * ) N- k-
Using the representation Sn = SqEm (Y1 Pfc)> we get an expression for the first
term in (3.47) from the rules for multiplying stochastic exponentials:
(3.49)
E £ jv ^ - mg2 r $ > * ~ m)^ S N ■I{SN>K}
= S0EE n Y^(pk - rn) - Y j(p k ~ m)pk + 'E ,P k )I {s s >K}
-■So £ (l) (l- - rn) + ,i > -^ ( 6 - m » ) 'V

k—fcg '
x ^1 — ^ - _ ~ ( a - m) + a - —m )a j (1 - p ) N~k
= s° I. (?)(p(1 +^ w (1 +*>) 1 -
§ 3.3. A METHODOLOGY FOR OPTIMAL INVESTMENT AND ITS APPLICATIONS 43
= (^ )(p *(l + t))fc((l-P *)(l + «))W_fe
k—k0 x ' N ' N '

Introducing the additional notation
N s \
P= P* and B (j, N ,p) = £ Ç f j p k{l - p)
we get the following expression for C^RR from (3.46)-(3.49):
(3.50) C%RR = S0M(k0,N ,p ) - K ( 1 + r ) - NB {ko,N )P*).
This is called the Cox-Ross-Rubinstein formula for the fair price of a European
option to buy in the binomial model (3.44) of a (B, 5)-market.
§ 3.3. A methodology for optimal investment and its applications
In essence, all activity of economic agents on a financial market is directed

toward optimal investment of the capital they have at their disposal. One natural
criterion for such optimality can be the strategy of “minimal” hedging. In this
section, optimality of an investment is connected with the concept of utility.
A utility function is defined to be a concave nondecreasing continuously differ
entiable function U : >M1 such that
U'( 0+) = lim Uf(x) = oo,

xj.0
(3.51)
U'(oo) = lim Uf(x) = 0.
We introduce the conjugate function
V (y) = sup[[7(x) - xy], y > 0,

æ>0
of £/, which is the Legendre transform of the function —U (—x). Under the above
conditions on U, the function V is strictly decreasing, convex, and continuously
differentiable, and it satisfies the conditions
F '(0) = - o o , V'(oo) = 0,
F ( 0) = C/(oo), F (oo) = C/(0),

U(x) = inf [V(y) + xy], x > 0.
Furthermore,
I(x ) = (U’ ( x ) ) - 1 = - V \ x ) .
On the (B, ^-m arket introduced in §3.1 we must find a self-financing strat
egy 7r* such that for the given utility function U
(3.52) E U (X £ *(x)) = sup E U (X £ (x )) = u{x).

7c£SF
The function u(x) will be called the price function of the optimization problem
(3.52) .
We established earlier a one-to-one correspondence between the class of self

financing strategies and the class of positive processes of the form
(3.53) Yt (x) = x + [ % s dXs

Jo
that are the discounted values of the strategies in SF.
Let X (x) denote the class of all such processes.
In view of the above remarks, the original problem (3.52) has been transformed
into the problem of finding in the class X (x) a process Y *(x) such that
(3.52') E t /( y ? ( x ) ) = sup E U (Y T(x)).

vex
Denoting by P* the unique martingale measure, we let Z£ = dP^/dPt and

define the differentiable function
v(v) = EV(yZ*T).
We also introduce the notation yo = inf{y : v(y) < oo} and xq = lim ^ -^
T h e o r e m 3 .4 . Suppose that a ( B,S)-m arket is complete. Then the following

assertions hold.
1) The function u(x) < oo is continuously differentiable for all x > 0 and is
strictly concave on (0, #o). The function v{y) < oo is continuously differ
entiable and is strictly convex on (y, oo) for sufficiently large y. Further, u
and v are conjugate in the sense that
v(y) = sup(ti(x) - xy), y > 0,

x>0
u(x) = inf (v(y) + a?y), x > 0,

y> o
and uf(0) = oo, u'(oo) = 0.
2) If y = uf{x) in the domain x < xo and y < yo, then the optimal terminal
value for (3.527) is an integrable -measurable random variable and is
determined by the equality
(3.54) Y f(x ) = I(yZ }.).
We avoid the technical complexity of the proof of this theorem and prove only
the optimality of Y f ( x ) i which is what is most important for us. Let Y ( x ) G
X ( x ) be an arbitrary process. This is a positive local martingale and hence a
supermartingale with respect to P*. Therefore, E *Yt { x ) < E *Y o (x ) = x.
Next, in view of the properties of the function U and (3.54) we have
E U(YT(x)) = E [U (Y f(x )) + (U(YT(x)) - U (Y j(x )))]

< E U (Y f(x )) + E U '(Y £ (x))(Y T(x) - Y f(x ))
= E U (Y f(x )) + E*(Z t )~ 1U '(Y£( x ))(Y t {x ) - Y j(x ))
= E U (Y f(x )) + yE *(Y T(x) - Y f{x ))
= E U (Y f(x )) + y(E*YT(x) - x ) < E U (Y f(x )).
§3.3. A METHODOLOGY FOR OPTIMAL INVESTMENT AND ITS APPLICATIONS 45
We now apply this method to the solution of the investment problem (3.52)
for the classical Black-Scholes, Merton, and Cox-Ross-Rubinstein models with the
utility function U(x) = \nx.
In this case I(x ) = and hence the numbers x > 0 and y > 0 in Theorem 3.4
x
are connected by the relation
(3.55) y = U '(x) = - .
X
Since -^ -(\ nx - x y ) = 0 for x = - , * / > 0, it follows that

ox y
(3.56) V (y) = sup(ln x — x y ) = ln - — 1 = —ln y — 1 .

®>o y
The Black—Scholes model.
Using the form of the density in (3.21), we find from (3.55)-(3.56) that
v{y) = E V {yZ £) = —E in {yZ^) - 1 = - l n y - E l n Z £ - 1
= - In 2/ - 1 +
d 1
Since —~{v(y) + xy) = 0 for y = - , it is easy to calculate the price function u(x)
oy x
of the problem (3.52)—(3.527):
(3.57) u(x) = inf (v(y) + xy) = \nx - l + \ ( + 1

2/>0 ¿\ O* J
=i"i+K^)T'
Further, by (3.53) and (3.21), the discounted optimal terminal value X ^ ( x )/B t
is equal to
(3.58)
By* yZ?p Zj>
; —r
= x expi ;—-— wt +
We introduce the concept of the proportion a£ of risky part in the value X£ (x):
(3.59) 7t*St
a, =
1 x ;(x ) ’
where 7 * is the number of stocks in an optimal portfolio 7r* = (ß*, 7 *). We shall
find = a*.
Using the fact that n* is self-financing, we get that
dx*(x) = ß*dBt + 1;dSt

= ßt rB t dt + 7 t* St((Adt - r dt + r dt + adw t)
= { R B t + 7 t 5t)r dt + 7 ¡St (( a* - r ) d t + o dwt)
= x ; r dt + a*tx ;( ( /i -r ) d t + odwt) .
This leads to the following expression for the discounted value:
= xexpi^croi*WT + Oi*(fJb —r)T — - a 2(a*)2T
Comparison of the last relation with (3.58) leads to a corresponding formula for a *:
¡ji —r
(3.60) a =
We note that from (3.59)-(3.60) and the balance equation X £ (x) ■--R B t+ U S t
we can uniquely reconstruct the portfolio 7r*:
* ? ( * ) - 7 tSt
(3.61) ß*t =
7i ~ st
Thus, in the problem of maximizing the mean logarithmic utility the price func
tion, the optimal value, and the strategy are given by the formulas (3.57), (3.58),
and (3.60)-(3.61) in the Black-Scholes model.
The Merton model.

For the Merton model (3.31) we use (3.55)-(3.56) and the form of the density
Z* in (3.33) to get that
(3.62) v ( y ) = E V r(y2J) = - l n y - l - E l n 2 i
= - l n y - 1 - (A - A*)T - E(ln A* - In A)nT
= - Iny - 1 - (A - A*)T - (In A* - In A)AT,
where A* = - — - .
v
Further, from (3.62) we find the price function of the optimization problem as
in the case of (3.57):
(3.63) u { x ) = inf (v ( y ) + x y )
= - In y - 1 - (A - A*)T - (In A* - In A)AT + x y

= ln x - (A - A* )T - (In A* - In A)AT
= In® + f t z l T - AT In .
V v\
Prom (3.54) we get that the discounted optimal value is given by
(3.64)
= = ® e x p { - (A - A*)T — (In A* - lnA)nT }
= i e x p { ( £ ^ : - A) T . n TlI 1 i f _ i r } .
• /v^
As in the Black-Scholes model, we see using the proportion a\ = that
d X *(x ) = rX l_ dt + a*t X ;_ ( ( p - r ) d t - v dllt) .
We are looking for a* = a*, and thus from the preceding equation we get that
X t(x)
(3.65) ~ ~ = x e x p { a * ( f j . - r ) T + ( l - a * u ) U T}.
§3.3. A METHODOLOGY FOR OPTIMAL INVESTMENT AND ITS APPLICATIONS 47
Equating (3.64) and (3.65), we arrive at the following expression for the optimal
proportion:
fjb — r — A
(3.66) a =
u (fl-r ) '
Thus, in the Merton model the investment problem (3.52)-(3.52') with logarith
mic utility function admits an optimal solution with price function (3.63), optimal
value (3.64), and optimal proportion (3.66).
The Cox-Ross-Rubinstein model.

In the framework of the Cox-Ross-Rubinstein model (3.44) the same ideas lead
to the following results.
Using the form of the martingale density Z*N in (3.45), we find the function
v(y) = E V(yZ*N) = - E l n ( y ^ ) - 1
N / _ \
= —lny —1 —^ E l n f l - m 2 r ( p k - m ) j
k= i ' '
= -ln y - 1 - ^ pln(l -
+ (1 - p) ln(l - ~ m ))]
V* 1- n*
= —In 2/ — 1 — N pln « + ( 1 _ P )l n l ---- --
P 1 ~P
and hence the price function is
V* 1 — n*
(3.67) u(x) = l n x - E l n Z ^ = l n x - N pin — + (1 - p) In --------
p 1 -p
Prom (3.53) we get the discounted optimal value
<“ 8>
Again we introduce the proportion of risky value in the portfolio ir* = (/?*,7 *):
YnSn-l
Oil
n= A"*
n—1
Since it is self-financing,
and hence
(3.69) = X eN ('£ l ^ ( P k - r ) \
Bff
'fc= 1 '
Equating (3.68) and (3.69) gives an equation for finding a* :
(3.70) £„ ( - ^ X > - "•>)£ " ( E ~ ’•>) “ '•
We show that here, as in the preceding two models, the proportion is a con
stant a* = a*. The method used is mathematical induction. For N = 1 the
equation (3.70) can be taken to the form
( „ o ') (l - - » > ) ( l + i f ; ( « - -o ) = 1.
Rewriting (3.70') on the set {p\ = 6}, we get that
or
— ( i + T ^ f-ift-r)) =1-
p \ 1+ r )
... . m —a , .
Since p = —------ , this gives us that
b —a
(l + r ) ( m - r )
(3.71)
(r - a)(b - r)
Consideration of the set {p\ = a} leads to the same formula for a\.
By the induction hypothesis, all the factors in (3.70) satisfy
(* ~ - m) ) ( l + (Pk - r)j = 1,
/c = l , . . . , i V — 1 . Hence,
(* - - TO) ) ( X + (1 + r ) " (pN - r )) = h
and we arrive again at the solved equation (3.70').

As a result, the investment problem (3.52)-(3.52') for the Cox-Ross-Rubinstein
model with logarithmic utility function admits a solution with price function (3.67),
terminal value (3.68), and optimal proportion (3.71).
R eferen ces for C h apter 3
[1], [13], [15], [16], [21], [22], [27], [33], [34], [44], [46], [51], [72], [73], [79], [83],
[86], [87], [90], [93], [95], [100], [106], [108], [113], [115]-[120], [126], [141]-
[143], [152], [158].
CHAPTER 4
Hedging and Incomplete Markets
A general description is given of incomplete markets, when calculations must

be carried out working in a whole class of martingale measures. Here the theory
of minimal hedging “overflows” into the theory of minimal superhedging, when a
minimal hedge turns out in general to be a strategy with consumption. The Black-
Scholes model with stochastic volatility is studied at length as a very representative
model of an incomplete market. It is shown that controlled diffusion processes
and Bellman equations make up a suitable and efficient technique for financial
calculations in such models. Methods for estimating volatility are presented.
§ 4.1. A methodology for super hedging
While keeping to the description of a (B, 5 )-market with the class of strategies
and contingent claims given in §3.1, we assume that the set M (X , P ) of martin
gale measures consists of more than one measure. Such markets are said to be
incomplete. But how are the statements about the martingale characterization of
self-financing strategies and strategies with consumption transformed in this more
complicated situation, and also the theory of hedging contingent claims on the
whole? The following two theorems are devoted to a reflection of exactly these
changes.
T h e o r e m 4.1 (Martingale characterization of strategies). Assume that a (B, S)-

market is incomplete and Y is a positive random process. Then:
1 ) Y is the discounted value of a strategy n e SF Y is a local martingale
with respect to any measure P G M (A , P).
2) Y is the discounted value of a strategy with consumption <=> Y is a super
martingale with respect to any measure P G M (A ’, P ).
To prove this we first observe that (3.3), (3.4), and (3.47) do not depend at all
on the number of martingale measures. Hence, using these relations in the first and
second cases in Theorem 4.1, respectively, we must use the martingale and optional
decompositions with respect to the family M (X , P ), and this concludes the proof.
T h e o r e m 4.2 (Existence and structure of a minimal hedge). Suppose that a

(B,S)-market is incomplete, and let g be a discounted contingent claim (for f with
exercise date T) such that
(4.1) sup E gT < oo.

P e M (x ,p )
49
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50 CHAPTER 4. HEDGING AND INCOMPLETE MARKETS
Then in the class o f strategies with consumption there is a minimal hedge ir* with
discounted value Y*, risky component 7 *, and discounted consumption D* deter
mined by the formulas
x?
(4.2) = Yt* = ess sup E(<7t I£Ft),
P €M (X ,P )
x f x f
(4.3)
Bt Bo
+ /% : dXu - D*t .
Jo
P r o o f . By (2.25), the condition (4.1) ensures the existence and the super
martingale property of the process on the right-hand side of (4.2). The optional
decomposition (2.23) makes it possible to write the equality (4.3) for this process,
and Theorem 4.1 makes it possible to characterize this as the value of the strat
egy 7r* with consumption D*. It remains to prove its minimality in the class of
strategies with consumption hedging g. For any such strategy (tt, D) its discounted
value is a nonnegative supermartingale with respect to each measure P e M (X , P ),
and hence
^ e ( | £ | 3 * ) > E f o | y t) (a.s.)
for t < T and any P 6 3Vt(X,P). Therefore,
Xn ~ X n*
~ET > esssup E (g\ % ) = - ± - (a.s.),
PG M (X,P) Dt
which concludes the proof.
A number of conclusions can be drawn from Theorem 4.2

In incomplete markets it is natural to replace perfect hedging of a claim / by
superhedging, which is based on strategies with consumption. Then the natural
initial price of / is the “upper” price
(4.4) Csup(T) = Bt ess sup

PG M (X,P)
It should be noted that in the case of incomplete markets certain contingent

claims (but not all) can have a replicating strategy that reproduces this claim at
the terminal moment of time.
As an example we consider the (n + l)-dimensional Black-Scholes model con
sisting of
• a nonrisky asset growing in time according to an interest rate r > 0:
d,S? = rSt° dt,
• n risky assets whose evolution is described by the stochastic differential

equations
§4.1. A METHODOLOGY FOR SUPERHEDGING 51
Here W = {W })tô, l^j^d is a ¿-dimensional Wiener process on the probability

space (ii,F, £Ft,P). It is assumed that det(cr# ) ^ 0.
In the case n = d Girsanov’s theorem gives us the existence of a unique martin
gale measure with respect to which the processes (e” rtSJ)tô, i of discounted
prices of risky assets are martingales, and hence the market is complete. In the
case d > n a martingale measure is not unique, and the market is correspondingly
incomplete.
Let / be an J^-measurable random variable corresponding to a payment ac
cording to a contingent claim at a fixed time T > 0. We point out a certain general
fact of separate interest.
Let X = (X t)tô be a continuous semimartingale with respect to the filtration
{&t}t^ 0) and let {3T^}tô be the canonical filtration for X . Suppose that there is
at least one measure P = P such that with respect to P we have:
1) X is a special semimartingale admitting the decomposition
X t = X 0 + M t + A ty
where M t is a local martingale and A t a predictable process of bounded

variation;
2) X is a Markov process with respect to o (and hence also with respect
to { & ? }t>o)-
Let us consider the P-martingale Nt = E [ f ( X r ) |9 ^ ]. Then by the Markov
property 2 ),
Nt = E [ f ( X T) \ ? ? ] = E [ / ( X r ) | * t ] = v ( t yx ) y x = X t.
Suppose that v (tyx) e Cfl,2([0,oo),R+). Then the process N admits the decompo
sition
Nt = E [ f ( X T) |Xo] + f * dv{a f - dMs.
To prove this we must apply the Kolmogorov-Ito formula to v (tyX t) and use the
properties l)-2 ) of the process X .
In particular,
f ( X T) = E [ f ( X T) IXo] + £ dV(Q ^ dMa
for t = T. _ _ _
We now consider the discounted contingent claim / = e~rTf (St ), where St =
e~rTSt - Then with respect to the measure P we have the representation
f(S T) = E [ttS T)\ S o ]+ f T e - ru9vil ^ - d S u,

Jo uo
where v(u ,S u) = eruE [f{S T) |S’«] and | | = ( J i , . . . , .

dv dv
Since — = eru— , we have
OS dS
E [ / ( 5 T) |y«] = E [ / ( 5 T) |So] + J * e - ruSu) dSu,
www.Ebook777.com
and hence
v (t,S t) = er tE [f(S T) \ ? t]
= E [ /( S T) 1S0] + £ eru^ ( u , e~ruSu) dSu
+ r [ v(u ,e~ ruSu) du

Jo
= v(0,S 0) + Jo ^ ( u , e - ruSu)dSu
dv
+ r e~ruSu) - ^ ( u , e ~ ruSu)
?u))) du.
I X v{u’
It follows from this representation that a strategy containing
dv
• jt = shares of stock,
Uu
• f3t = e_ri û(t, e~rtSt) - e " rt5t)5f^ in the nonrisky asset
at each moment of time t with 0 ^ t ^ T will be a hedging strategy for v (t ,X t).
The cost of the contingent claim / ( 5 t ) is uniquely determined and is equal to
E [ /( 5 t ) |So] » and the value of the hedging portfolio at a time t with 0 < t ^ T is
e « E [f{S T )\ ? t].
The Black-Scholes model with stochastic volatility, a comprehensive and mean
ingful model of an incomplete market, is considered in the next section.
§4.2. The Black-Scholes model with stochastic volatility
In the Black-Scholes model it was assumed that the stock price is subject to
the stochastic differential equation
4 p - = n d t + trdWt,
that is, the relative change in the stock price is a Gaussian process with stationary
independent increments. It follows from the form of the Black-Scholes formula that
the basic (unknown) parameter for calculating the price of an option is the vari
ability parameter cr: the volatility of the stock, which was assumed to be constant.
However, numerous investigations have shown that the volatility is not a con
stant quantity. Moreover, the assumption of constant volatility dissipates with the
so-called “smile” effect of volatility, which amounts to the volatility determined
from the prices of the options being traded having a tendency to grow as the exer
cise price of the option increases or decreases from a definite value (for which one
says that the option is an “in-the-money option” ).
In this connection it is natural to consider generalizations of the Black-Scholes
model when the volatility is random.
E x a m p l e 4.1: Volatility depending on the price o f a stock. One such model
for describing the evolution of a stock price is the following:
^ = f i d t + <r(St)d W t,
where the volatility is a function of the stock price, o = a(St)-

§ 4.2. THE BLACK-SCHOLES MODEL WITH STOCHASTIC VOLATILITY 53
It is interesting to note that the model a (x) = a x~ ^ ~ a^ (constant elasticity

of variance model, CEV) turns out to be complete, and the price of a contingent
claim is uniquely determined in it.
E x a m p l e 4 .2 : Volatility as a solution o f a stochastic differential equation. Let

the price o f the stock S = (St)tô and the volatility o = (<Tt)tô b e determ ined by
the system o f stochastic differential equations
dSt = St(iJ, dt + o t d W t),

dvt = vti'ydt + 5 dW 2),
where vt = o f, and W 1 = (W t)tô and W 2 = (W 2)tô are two Wiener processes

with covariance dW^dW2 = pd t, \p\ < 1 .
If there is an asset on the market (for example, an option to buy) for which the
only source of randomness is the volatility (one says that volatility is a tradable
asset), then the model with two risky assets (that is, the stock and the option) is
complete.
In the general case, because of the presence on the market of two sources of
randomness (W 1 and W 2), the model is incomplete, and the price of a contingent
claim is not uniquely determined.
E x a m p l e 4 .3 : Volatility as an autoregression process o f conditional inhomo

geneity. Autoregression models with conditional inhomogeneity (ARCH, GARCH,
HARCH, . . . ) serve for constructing time series with nonconstant volatility in dis
crete time. In the case of the simplest G ARCH (1, 1 ) model, the logarithm In St of
the stock price and the conditional variance o t satisfy the equations
In St = ln S t-i + pt +
(T? =UJ + /3crtL jl + a e t- io f - i,
where £*, t G Z+, are independent identically distributed random variables with
Eet = 0 and Eef = 1 . In the general case of GARCH models, o t is a certain
function of the “past” values of the conditional variance and et.
Models of GARCH type are more adequate than the lognormal Black-Scholes
model in describing the distribution of stock prices observed in practice, and they
enable one to “grasp” the so-called “heavy tail effect” of these distributions. Their
basic deficiencies include the difficulty of constructing hedging portfolios for con
tingent claims.
We proceed to a consideration of the pricing of contingent claims on an incom

plete market representing the following generalization of the Black-Scholes model.
Suppose that the evolution of capital in a bank account B and the dynamics of a
stock price S are described by the stochastic differential equations
dBt = BtRt dt, B q > 0,

1 ’ ] dSt = St{pdt + dWt), S0 > 0.
Here, as before, W = {W t)o^t^T is a Wiener process, but unlike the classical model
the processes R = (Rô^t^T and E = (E ^ o^ t describing the behavior of the
interest rate and the volatility are assumed to be random. In the special case
Rt = r = const and E* = a = const we arrive at the classical Black-Scholes model.
We show below that the model (4.5) is not complete as a rule.
For a random process X defined on the stochastic base (ii, J t , F, P ) we denote

by M ^ P ) the family of martingale measures of X . The method of constructing
a minimal hedge for arbitrary incomplete models of financial markets is based on
Theorems 4.1 and 4.2.
Let M = M ( 5 / £ , P ) denote the family of martingale measures of the pro
cess S/B. We write
(4.6) Wt* = Wt + f 0
JO
By (4.5), the equation for the price of the stock can be written in the form
(4.7) dSt = StRt dt + St £ t dWt*,
and hence
Thus, an equivalent measure Q belongs to M if and only if W* is a local martingale

with respect to Q (moreover, W* is a Wiener process with respect to Q).
In view of Girsanov’s theorem the density process of an arbitrary Q g M with
respect to P has the form
(4.8) Z ? = e x p j^ ( ^ ^ dWu - du) JjVtQ, 0 < t < T,
where N Q is a local martingale orthogonal to W with respect to P , that is, the

quadratic covariance (N ^^W ) is zero.
Suppose that the family of martingale measures of the process S/B is not
empty, which is equivalent to the absence of arbitrage opportunities in the model.
This assumption holds if, for example, the local martingale
(4.9) Z*t = e x p ( :^ ^ dWu - < * « )}, 0 < t < T,
is a uniformly integrable martingale, and hence is the density process for some
martingale measure. A sufficient condition for the uniform integrability of Z* is
the Novikov condition
(4.10) EM U
We consider a European option with exercise time T and payment function

f r ^ 0 that is an T^-measurable random variable. The structure of a minimal hedge
for a model with random volatility and random interest rate is given by the theorem
below, which is convenient for the subsequent consideration of concretizations of
Theorem 4.2.
T h e o r e m 4.3. Assume that M (5 /B ,P ) ^ 0 . The set of hedging strategies is

nonempty if and only if
sup E Qf Te ~ ^ Rudu < + 00.

QGM
§4.2. THE BLACK-SCHOLES MODEL WITH STOCHASTIC VOLATILITY 55
In this case a minimal hedging strategy exists, and its value at the time t is
(4.11) Vt = ess s u p E ^ lf t 6~ ^ Rudu l^t).

QtM
Here the structure of a minimal hedge (the number 7 of shares and the consump
tion C) is determined from the optional decomposition
(4.12) Vte~ JSR“ du = V0 + f 7 « d(Sue~ K R*du) - f e~ % R“ du dCu.

Jo Jo
Let us consider a contingent claim of the classical form
f r = g(ST),
where g ^ 0 is a Borel function of polynomial growth “at infinity” . We study the

structure of an optimal hedge described by the formulas (4.11) and (4.12) by using
the example of a model in which the interest rate is constant,
Rt = r = const,
while the volatility satisfies an equation of “telegraph signal” type:
(4.13) £2 = (j2 + ( - l ) ntAc72,
where 0 ^ A a 2 < a2 is a positive constant describing the upper and lower limits of
the volatility, and II is a Poisson process with intensity A.
Setting
Cmin = y/o2 - A a 2, <rmax = y/cr2 A ct2,
we can write the equation (4.13) in the form
dEt = ( c r m a x — < T m in ) (•^r{ S t _ = < 7 m i „ } _ ^ {E t-= < 7 m a x }) =
From Theorem 4.3 it is clear that the value of a minimal hedge should be sought
in the form
(4.14) Vt = v(Su t)
with the number of shares in an optimal hedge equal to
(4-15) % =
where the function v is the price in the optimal control problem
(4.16) v(x, t) = e " r^T“ ^ su p E g (S ^ }t).

a
Here is a controlled diffusion process described by the stochastic differential

equation
dSia) = rS£«> du + S {ua)a u dWu, S ^ ] = x,
where the controlling process a = {&t)o^t^T takes its values in the two-point set
{^ m in j 0 m a x }*
As follows from the general theory of controlled diffusion processes, the price
function v (x ,t) belongs to C 2,1(E+, [0,T)), and among the functions v = v (x ,t) G
Cf2,1(R+, [0,T )) satisfying a polynomial growth condition there is a unique solution

of the Bellman equation
(4.17)
where the differential operator £ ° is
We note that for A r = A<j 2 = 0 the equation (4.17) reduces to the classical
Black-Scholes partial differential equation for finding a fair price of a contingent
claim of European type.
Let us clarify the origin of the equation (4.17). In the case when the volatility
of the stock price is not constant, the fundamental Black-Scholes equation for the
value of a hedging strategy passes into the nonlinear Bellman equation
For the value of a hedging portfolio we can write the approximation
where
As A ct 0,
V, VXi Vxx * Vxi Vxx'
Therefore.
which leads to (4.17).

In connection with problems of hedging contingent claims in markets with sto
chastic volatility, the concept of the tracking error of hedging turns out to be useful.
We denote by v (t, St) = C (t, St, crmax, K , T ) the value of a self-financing strat
egy in the classical Black-Scholes model with constant volatility crmax, and by Vt
the cost of a self-financing portfolio with initial value Vq = u(0, So) containing
(d/dS)v(t, St) shares at any time 0 ^ t ^ T. Thus, the evolution of the value of
the portfolio is described by the stochastic differential equation
The tracking error et at the time 0 ^ t < T of a hedging strategy is defined to

be the difference between the actual and theoretical values of the hedging strategies:
et =f Vt -v (t,S t).
Since u(T, St ) = (St — /¡0 + > it follows that e r indicates the deviation between
the actual terminal value and the payment according to the option. In particular,
if the tracking error is positive, e r > 0, then the terminal value for the investor
completely covers the contingent claim.
Assume that the stock price evolves according to (4.5), and
(4.18) £ t < <jmax, Vi, 0 < t < T.
Then the tracking error is subject to the stochastic differential equation
1 d2v
det = ret dt + - ( ct^ x - Su) du, 6 q = 0.
To prove this we use the Kolmogorov-Ito formula to get that
rt dv(u, Su)
(4.19) Vi = «(0, So) + j f dv^ s Su) dSu
ds
dv(u^ Su) + —E2 g 2 ^ v (u’ &u) dv(u, Su)
+ rSu du.
a dt ' 2 ~ u~u d2S ' ’ ~u dS
It follows from the fundamental Black-Scholes partial differential equation that
dv(u, Su) 1 2 o2d2v(u ,S u) dv(u,Su)

(4.20) 7*uu ~
dt —2 <Tmax*^“ d s2 dS
Substituting (4.20) in (4.19), we get the above equation for the tracking error.
It is easy to see that the nonnegativeness of the second derivative ^

dSz
(for example, in the case of a standard option to buy) leads to the coincidence of
the sign of the tracking error with the sign of <râx “ • The superhedging strategy
found is universal in the sense that it works for all models with stochastic volatility
that satisfy the condition (4.18).
For an approximate solution of the equation (4.17) we use the small parameter
method. Let Vt* (a2, A ct2) be the value of a minimal hedge in the model with random
volatility, and let V^(a2} 0) be the value of a minimal hedge in the classical Black-
Scholes model with constant volatility a. Then up to small quantities of order
greater than A a2 we have
Vt* = Vt*(a2, A ct2) v tV , o ) A a 2 = V (0) + V (1)A ct2.

(<r2.0)
It is natural to look for hedging portfolios in the class of strategies with value
of the form Vt = v(S t,t), where v is a sufficiently smooth function. Then v =
v1'0'1 + v*-1) A ct2 in our notation. After substituting this expression in (4.17), we get
that
d2u<°) d2v l1)
Lu<0> + L u^ A ct2 + \ + A ct2 A ct2 = 0.
¿t ~ds2~ ~dS2~
Under the assumption that A a 2 is sufficiently small, the second derivatives of the
functions and with respect to S will have the same sign, and therefore we
can write
L«(°) + L v^ A cr2 + i
a2s<°) . 2 1 a2^1) (A ct2)2 = 0.
as2 A°- +2 dS2
Taking into account that ttf0) is the value of a minimal hedge in the classical Black-
Scholes model with constant volatility, and considering only terms of order at most
A ct2, we arrive at the following equation for
a2u(°)
L ^ A cr2+ lz as2 A (j2 = 0
or
d2t f v
“ “ - i ~dsr '
Thus, the problem (4.17) reduces to the solution of the boundary-value problem
L v ^ { x ,u ) = h(x, u),
(4.21)
t f 1)(x )T) = 0,
where h (x , u) = - ^ ^ V
2 1 d x2
Using the Kolmogorov-Ito formula, we get that
e - rtvil\ S u t) - f h { S u,u )d u
Jo
= ^ ( S o , 0) + J * U) d(e-™ Su)
+ f { L r t l\ u ySu) - h(Su,u )) du.

Jo
From this, using (4.21), we find that
u(1)(a;,0) = E - tT^ \ S t , T ) - [ T h(Su,u)du

Jo
-fJo
d tf1')
~ds~(Su,u )d (e~ ruSu)
= -E f h(Su, u) du.
Jo
Thus, we get expressions for the ask and bid prices of the option:
f rrTi |i ida 2u<0>

2v(°>|| 1 ,
r rT i\d2vW\ l
2 I- s s ^ r H ’
where Jo (a) is the fair price in the standard Black-Scholes model with constant
volatility a.
As noted above, introduction in a model of a stochastic volatility can lead to

the model of a financial market becoming incomplete. However, there are models of
markets with stochastic volatility for which the market is complete, and hence the
cost of a contingent claim is uniquely determined. We give an example of such a
market.
Denote the process of the logarithm of the discounted stock price by X , X =
(* t)t> 0:
X t = ln(e-r t 5 t).
We define the function
poo
(4.22) Zlm )= Xe~Xu(X t - X t. u)m du, m € Z+,
Jo
where the parameter A corresponds to the rate of discounting of the “latest” infor
mation about the increments of the process X .
L e m m a 4.1. The process defined in (4.22) satisfies the stochastic differ

ential equation
(4.23) dZ\m) = m Z[m~1] dXt + m (m ~ ^ z t(m~2) d(X )t - XZ[m) dt.
For the proof we note that in view of (4.22)
z\m) = f* XeXu(Xt - X u)mdu

J —oo
m / \ pt
= E ( D №)* J_ *eXu(-X u )m- k du,
and hence
Xextz [ m) dt + ext dZ[m) = d(extz [ m))
XeXu( - X u)m~k du k X t 1 dXt + " v" 2~ !) V k- 2

~ 'X « ~ 2 d (X )t
-P M L
+ (X t)kXext( - X t)m~k d t j
= m J 2 ( ” ” j ) |f XeKu( - X u)<m- i>-ik- r>d u - j x f - 1 dXt
+ m {m ~ 1} E ( 7 l 22) { f XeXu( - X u)(m- V - ( k~V d u ^ X t 2 d (X )t
= ext{m Z\m- l) dXt + m(m2~ l ) z i m- 2) d {X )J j.
We assume that the process X = (X t)tô is controlled by the stochastic differ

ential equation
(4.24) dXt = » (Z ™ , •••, Z\n)) dt + <J{Z[1\ . . . . Z[n)) dWt,
where the functions /¿( •) and a( •) satisfy a Lipschitz condition, and a( •) > 0,
n E Z_|_.
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The only source of randomness in this model is the Wiener process, and hence
the model is complete. Nevertheless, as is clear from (4.24), the volatility in the
model changes after a change in the stock price.
We show how to calculate the cost of a contingent claim of European type in
this model. For simplicity we assume that n = 1 and denote Z W by Z. Then the
equation (4.23) is transformed to
dZf — dXt — AZt dt.
By (4.24),
(4.25) dZt = (n(Zt) - XZt) dt + a (Z t) dWt.
Note that in this case the logarithm of the discounted stock price process is
X t = In(e~rtSt) = X 0 + (Zt - Z0) + A /* du.

Jo
From (4.25) it follows that Zt is ^-measurable, where = a(u ^ t\ Wu).
On the original probability space we define a new measure P as follows:
l2
dP
dP I+r< z j ] dw * - U W ê )+^>] *}■
We remark that with respect to P the process
W t = Wt + / M(Û) . ^ / ry \
-¡m + r ™
du
is a Wiener process. Hence, (4.25) can be rewritten as
dZt = a(Z t) dWt - ( \ a2{Zt) + \Zt ) dt.
Thus,
dXt = dZt + XZt dt = <j{Zt) dWt - ~(T2(Zt) dt

z
and the process (ln(e rtS t))t>0 of the logarithm of the discounted stock price is a
martingale with respect to the measure P.
According to Theorem 3.2, the cost of a contingent claim of European type
with payment function /(S t ) in this model is
Vt = e - r(-T-» E [f(S T)\?t].

Further, as follows from the Feynman-Kac formula, the price of the contingent
claim is a solution of the partial differential equation
/ a dv dv dv\ ( Id v l o 2 d2u 1 d2v _ d2v \ 9/ x

\r S d S ~ r V ~ Xzd z ~ d t ) + \ 2 d z + 2 S dS^ + 2 d ^ + S dzdSJ°' ^ = 0
with the boundary condition

vt = f(S x)-
§4.3. ESTIMATION OF VOLATILITY 61
function for the contingent claim satisfies the fundamental Black-Scholes equation
§ 4.3. Estimation of volatility
We present some methods for estimating the unknown parameters used in fi
nancial mathematics.
The method of moments.

The method of moments is based on the intuitive notion that the sample mo
ments calculated on the basis of the postulated model are approximately equal to
the empirical moments calculated on the basis of observations of the random vari
able. Let ( # i , . . . , x n) be a sample of observations of a random variable X whose
distribution function depends on k unknown parameters 0*, i = 1 , . . . , k, and let
E X r = hr(0 1 , . . . , 0fc), r = 1 ,2 ,..., be the moments of X , where hr ( •) are known
functions of the unknown parameters.
The corresponding empirical sample moments are
Then the moment estimators 0r , r = 1 ,2 ,..., k, are found by solving the system of
equations
hr( ß i , . . . , e k) = m r, r = l,2,...,k.
1. Estimation o f the parameters o f a normal distribution.
In the case of a normal distribution iV(^, cr),
E X = 11 ,
E X 2 = a2 + ß 2.
Consequently, the equations of the moments take the form
From this we find the moment estimators:
2. Estimation o f the parameters o f a gamma-distribution.

The density of the gamma-distribution depends on a shape parameter a and a
scale parameter ¡3: f(x;a,/3) = x a l e /¡3aT(a), x > 0.
The first two moments are equal to
For the moment estimators we get the system of equations

Xj_
n
s (a + i# = x ! = j :^ ,
n
whose solution is
(* )2 x 2 — (x)2
a ■ /3 =
x 2 — (x )2 ’
Estimation of the parameters in some models of markets.
1. In the framework of the classical Black-Scholes model the stock price is
described by a geometric Brownian motion
St = So exp | j> So = so > 0.
The quantities Xj = In Sj/Sj-i are thus independent N(fj,—a2/2, cr2)-distributed

random variables. A moment estimator of the volatility is given by
= ~ * ) 2- * = \ H xi-
j =i j =i
2. Let us consider the following discrete model of a market:
f In St - InSi_i = fjL+ at-iUt,
\ In a* = a + (¡)[lnat- i - a] + 07]t,
where (Ut,rjt) are independent identically distributed random variables with corre
lation 5, and the parameter t takes integer values t G Z+. The given autoregression
model of a market with random volatility is stationary if and only if \<j>\ < 1. Under
this condition the random variable In at has mean a and variance f32 = 02/ ( l —4>2)-
Estimators of the unknown parameters are found by solving the system of equations
' ^ ¿ 0 + 0 1 2 _ Y ^ \X j ~ X\,
2a+2f3Â Oj ~ xf
-E n
3 e 4/32 = ( X3 ~ X ) 3
“ ^ n
Method of estimation from the price statistics of derivative instru
ments, and the “smile” effect.
The volatility, which enters as a parameter in various models, is not an observ
able random variable. Stock prices and prices of derivative instruments “written” on
these stocks are observable variables. The following method of estimation is based
on the observation that if the volatility enters explicitly (for example, through the
Black-Scholes formula) in the formation of the prices of derivative instruments,
then it is necessary to “extract” an estimator of the volatility from the prices of
these derivative instruments.
For example, c market(t, is the price of some tradable option at the
time t, 0 < t < T. Here St is the price of the stock at this time, K is the exercise
price, and T is the exercise time for the option. Let Ctheor(t, St, K , T, a) be the price
www.Ebook777.com
§4.3. ESTIMATION OF VOLATILITY 63
of an option with the same characteristics and volatility a, calculated theoretically

by starting from the assumptions of the model.1 Then an estimator of the volatility,
also called the intrinsic volatility, can be determined from the relation
Ctheor(f, St,K , T, a) = C market(f,
It should be noted that this estimator of the volatility is a function a = a(t, St, K, T)
of the parameters of the option contract. Thus, for different K and T the estimators
of volatility do not coincide in general. For example, in the case of a standard option
to buy, the estimators of volatility, as functions &(K) of the exercise price, form a
curve resembling a smile for fixed £, St>and T. Furthermore, the less the time before
the exercise time of the option, the sharper the smile. Thus, the volatility has, so
to speak, a “time structure” , and this should be taken into account in constructing
models of volatility.
F ig u r e 4 .1 . T h e “volatility smile” .
C onfiden ce estim ation o f op tion s in th e B la ck -S ch oles m odel.

Let us now look at the Black-Scholes formula (3.23) from a statistical point
of view, considering that the randomness arises from errors in estimating the un
known volatility. We shall study the statistical properties of the Black-Scholes price
<C{t,Su K, T, o) = C(cr).
Let So, •••, Sn, n = 1, 2, . . . , be a sequence of stock prices (for example, the
sequence of closing prices of the stock over n + 1 days). As mentioned earlier,
because the variables Xj = \nSj/Sj-i are independent A f(/i-cr2/2, ^ -distribu ted
random variables, an unbiased moment estimator of a2 is given by
j=i
where x = £ £ " = o Xj.

Further, the variable is distributed like a2 ■X n - i/( n - 1), where Xm is the
chi-square distribution with m degrees of freedom and with density function
j 1 m / 2 —1 x/2
f(x) = x > 0.
2™/2 r (m /2 )
1If it does not seem possible to get an analytic expression for the cost of the option, then
(t,St,K,T)
(0theor can be taken to be an estimator of the cost obtained as a result of some
simulation.
Thus,
P (?n < <?o) = p ( x l - 1 < (n - ! ) ) •

Since the Black-Scholes price is an increasing function of the parameter cr, it follows
that
* ~ .r2
(4.26) P►(C(an)
( < C(<r0)) = p ( x L i < (n - 1)) •
Thus, (4.26) gives the distribution function of the Black-Scholes price and can be
used for constructing a confidence interval for the price C(cr) of the option. Namely,
we select a number 1 — a (the confidence level (0 < a < 1)) and choose constants
X* and x* such that
P(x* Xn -1 < X*) = 1- «•
Then for these constants
' (x* < - 1) < X*^ = 1 - oc,

and hence
p(r(n-1Ka2<^(n_1))=1-a'
Again using the monotonicity of the Black-Scholes price, we get that
(4.27) P \C ^ V x * ( n - l ) ) ) J = i - a-
Consequently, the (1 — a) ■100% confidence interval for C(cr) has the form
dl, „1 l<r?
(ci
Letting cr0 —> 0 and cro —> oo in (4.26), we get as a consequence the following
bounds for the price of an option defined on the interval [n, n 4- T\ and having
exercise price K :
Sn - K e~ rT < C(tr) < Sn.
R e m a r k . Since the price of the option depends in a nonlinear way on the
volatility, an unbiased estimator of the volatility does not lead to an unbiased
estimator of the option price. This may be one of the possible explanations for the
“volatility smile” effect observed in practice.
[5], [8]—[10], [15], [20], [38], [40], [42], [43], [45], [49], [50], [51], [59], [60],
[62], [76], [77], [80], [81], [90], [91], [94], [95], [98], [99], [107], [127], [152],
[153], [158].
CHAPTER 5
Markets with Structural

Constraints and Transaction Costs
In this chapter we study the general theory of hedging (and investment) for
financial markets subjected to various constraints (for example, different credit and
deposit interest rates, prohibition on “short” selling, and so on). Applications of
general theoretical statements in concrete models are given. A study is made of
hedging and investment with transaction costs taken into account in the formation
of hedging and investment strategies (Leland’s approach and maximization of mean
yield).
§5.1. Calculations in models of markets with structural

constraints: A general methodology and its concrete realization
We consider contingent claims in markets with initially imposed constraints on
the class of strategies that can be used, constraints having a structural character,
for example, prohibition on “short” selling, distinction between deposit accounts
and credit accounts, and so on.
Optional decompositions in markets with constraints.

We present a model of a securities market consisting of d assets. Let X =
denote the process of prices of these assets. We determine a portfolio
(strategy) 7r = (iJ, C), where H = ( i P ) i ^ d is a predictable X-integrable process
specifying the quantity of each asset contained in the portfolio, and C = (Ct)tô
is an increasing process of total consumption in the portfolio up to and including
the time t. The change in the value V = (Vt)tô of this portfolio n is given by the
equation
(5.1) Ft = u + / * Hs dXs - C u t > 0,

Jo
where v is the initial value of n.

As earlier, such a portfolio will be called a strategy with consumption. The
equality C = 0 means that 7r is a self-financing portfolio.
All processes are defined on a standard stochastic base (ii, F = (T*)*ô> P ) and,
with the exception of integrands of stochastic integrals, are real-valued and right-
continuous, have limits from the left, and are measurable with respect to the given
filtration F. For processes X and Y the relation X -< Y means that Y — X is an
increasing process.
To present a unified methodology for hedging in markets with constraints we
need some results in the theory of stochastic integration in addition to what was
given in Chapter 2.
65
CHAPTER 5. MARKETS WITH STRUCTURAL CONSTRAINTS
The stochastic integral of a predictable process H with respect to a semimartin

gale X will be denoted by H * X = f H d X , and L ( X ) will denote the space of
predictable processes integrable with respect to X.
A process H G L ( X ) is said to be (locally) admissible if H * X is (locally)
bounded below, that is, there exists a sequence of stopping times rn | oo such that
(H * X ) Tn are bounded below.
The corresponding classes of admissible (locally admissible) integrands are de-
noted by L* {X) (Lfoc(X)).
The Emery distance between semimartingales X and Y is defined to be
D ( X , Y ) = sup ( V E [ m i n ( | t f * ( X - Y ) n|, 1)]V
where the sup is taken over all predictable processes H bounded in modulus by 1.
The quantity D ( X , Y ) defines a metric in the space of semimartingales. The
corresponding topology is called the semimartingale topology or the Emery topology.
If X is a semimartingale, then the space L ( X ) is complete with respect to the metric
(5.2) dx ( H, G) = D ( H * X , G * X) .
Suppose that N Ç L?oc(X ) is a family of locally admissible integrands for X .

We assume that N D H = 0, N is closed in Lfoc( X ) with respect to the metric dx
defined by (5.2), and N is convex in the sense that the process ft * i f + (1 — h) * G
is in N for any H, G € N and every predictable process 0 < h ^ 1.
If H G N, then a portfolio n = ( H, C) satisfying (5.1) is called a strategy with
N-constraints.
Such a securities market in which strategies with constraints satisfying (5.1)
operate is called a market with constraints.
Let us look at some examples of markets with constraints, differing from each
other in the choice of the class N. We consider the following variants of N.
1) N = L¡oc(X): no constraints.
2) N = { H e Lioc( X ) : H %^ 0, 1 0, 1 < i < d}, where G\
G e L*oc(X ): the number of assets in the portfolio is bounded above and
below.
4) A market with a deposit account, a credit account, and stocks in which the
interest rates for borrowing capital and allocating capital are different is also
a market with constraints. In this case the set N has the following form:
N = { H e Lfoc( X ) : H 1 ^ 0, H 2 < 0, H 3 e R }, where H 1 and H 2 are the
numbers of units in the deposit account and the credit account, and H 3 is
the number of stocks in the portfolio.
A portfolio 7r with N-constraints is said to be admissible if Vt ^ 0 for all t ^ 0.
Assume that 3 is a family of special semimartingales Y that are locally bounded
below with initial value Yo = 0, and let Y = 0 G 9?.
We introduce the class of measures P (9 ) = {Q : Q ~ P : 3 an increasing
predictable process A depending only on Q and 9 such that Y — A is a local
supermartingale with respect to Q for any Y € 9 , that is,
(5.3) A y (Q) -< A for any

§5.1. CALCULATIONS IN MODELS OF MARKETS WITH CONSTRAINTS 67
where A Y (Q) is the compensator of Y with respect to Q }.

An increasing predictable process A ^ Q ) is called an upper variation of the
family 3 with respect to the measure Q if A Y (Q) -< A ^(Q ) for any 7 6 3 , and
the process A ^(Q ) is minimal in the sense that A ^(Q ) -< A for any increasing
predictable process A satisfying the condition (5.3).
The family 9 is said to be predictably convex if
/i * y 1 + (1 —ft) * y 2 G 9
for any y \ y 2 G 3 and any predictable process 0 ^ h ^ 1.

In what follows we are considering a predictably convex family 9 .
L e m m a 5.1. A measure Q equivalent to P is in P (9?) <=> any Y G 9? is a

special semimartingale with respect to Q and
(5.4) ess sup A y (Q )t < + oo for all t ^ 0.

Yes
In this case the upper variation of the family O' with respect to the measure Q
exists, is unique, and is determined from the equations
A ^ (Q ) t = ess sup A y (Q )r ,
Yes
E[i4®(Q)T] = sup E [ ^ ( Q ) T]
yes
for any stopping time r.

Moreover, there exists a sequence Y n G 5 such that the compensators A n =
A yn(Q ) satisfy the conditions A n -< A n+1 and limn_,oo sup0^t^T(A9f(Q )t—AJ1) = 0
( a.s.) for any stopping time r such that A ^ (Q )T < + oo (a.s.).
E x a m p l e 5 .1. Suppose that X is a semimartingale, G ^ 0, and G < 0, where

G and G are locally admissible integrands for X , that is, G * X and G * X are defined
and locally bounded below. Let N = {H a predictable process |G ^ H ^ G } .
All the stochastic integrals H * X for H G N are locally bounded below, and
9? = {H * X : H G N} is predictably convex.
Let a measure Q ~ P be such that AT is a special semimartingale with respect
to Q. Then X has a canonical decomposition X = M + A , where M G Mioc(Q ) and
A is a predictable process of bounded variation. The compensator of an arbitrary
process y = H * X G 9 has the form H o A with H G N. Further, H o A =
H o A + —H o A ~ < G o A + —G o A “ , with equality for H = hG + (1 —h)G, where
h = dA+/dA. By Lemma 5.1,
¿ ® ( Q ) t = f c s d A t - f a , dAZ for t ^ 0.
Jo Jo
In particular, P (9 ) contains all probability measures Q ~ P with respect to

which X is a special semimartingale.
We can now formulate an equivalent definition of the family P (9 ) of measures:
P (9 ) = { Q : Q ~ P for which A a (Q )t = ess sup A y (Q)t < oo

Yes
68 CHAPTER 5. MARKETS WITH STRUCTURAL CONSTRAINTS
The next theorem gives a (super) martingale, or dual, characterization of strate

gies with ^-constraints and represents a criterion for the existence of an optional
decomposition in such markets.
We consider the family
(5.5) % = { H * X :H eK}
of semimartingales.
T heorem 5.1. Suppose that P (9 ) ^ 0 and the process V is locally bounded

below. Then the following assertions are equivalent:
1) V is the value o f an admissible portfolio with N-constraints, and it satisfies
the relation
(5.6) V = Vo + H * X - C ,
where H G N and C is an increasing process',

2) fo r all measures Q G P(Q ) the process V —A ^(Q ) is a local supermartingale
with respect to Q.
Constraints are often imposed on the portions of a portfolio’s value invested

in various assets. Assume that the components X %, i ^ d, of the process X are
strictly positive. Let
(5.7) t > 0,
be the relative growth process of the price of the zth asset, let
(5.8) K\ = H iX}_/Vt- I {Vt_ >0}
be the fraction of the portfolio’s value in the zth asset at time t , and let
(5.9) A = 0,
be the fraction of the total consumption up to and including the time t.

Then by (5.7)-(5.9), the additive representation (5.6) can be written in the
multiplicative form
(5.10) V = V0 £ ( K * R - D ) .
Let SR be a family of integrands for R such that K A R ^ - 1 for all K G SR.

We assume that SR 2 K = 0, 5R is closed in Lfoc(R) with respect to the metric dR
defined by (5.2), and SR is convex in the sense that /i*AT + (l — /i) * L g SRfor any
K, L G SR and every predictable process 0 ^ h < 1.
The next theorem gives a dual characterization of an admissible portfolio whose
fractions of the value belong to the class SR. It establishes a multiplicative form of
the optional decomposition for markets with SR-constraints.
We consider the family
(5.11) 9 = { K * R : K € 5R}
of semimartingales.
T h e o r e m 5.2. Suppose that P(3?) ^ 0 and let the process V be nonnegative.

Then the following assertions are equivalent:
1) V is the value of an admissible portfolio with proportions in the class 3?, and
it satisfies the relation
(5.12) V = V oZ (K *R -D ),
where K G 3? and D is an increasing process;

2) for all measures Q G P(3?) the process V /£ (A ^ (Q )) is a supermartingale
with respect to Q.
Thus, to get the optional decomposition of the value Vt of a portfolio of securi

ties in a market with constraints we must calculate the upper variation A ^(Q ) for
the family 5 with respect to Q G P(Q ) as the essential supremum of the family of
compensators with respect to Q and then use Theorem 5.1 or Theorem 5.2.
The structure of an optimal hedge in markets with constraints.

As an application of the above theory we consider the problem of hedging a
contingent claim in markets with constraints.
Let / t , T ^ 0, a nonnegative random variable on (ii, P ), be a contingent
claim (a European option with such a payment function).
A strategy 7r with ^-constraints and value V is a hedging strategy for the
contingent claim f r if tt is admissible and Vt ^ / t -
A strategy 7r with ^-constraints and value V is called a minimal hedging strategy
with N-constraints if Vt ^ Vt ^ / t , t ^ T, for any hedging strategy 7r with N-
constraints whose value is given by the process V.
T h e o r e m 5.3. Suppose that 3 satisfies (5.5). The set of hedging strategies is

sup E q ( / t - A ^ (Q ) t ) < +oo.

QeP(S)
In this case a minimal hedging strategy n = ( H , C) with N-constraints exists, and

its value at a time t < T is
(5.13) Vt = v + { H * X ) t - C t = ess sup (E q [fT - >10 (Q )T |St] + ^ ( Q ) t) + ,

QGP(3)
where a+ = max(a,0).
Theorem 5.3 follows from Theorem 5.4 below, which characterizes the value
process of a minimal hedging strategy with ^-constraints for a dynamic contingent
claim.
A nonnegative process / = (ft)tô will bo called a dynamic contingent claim.1
Since ft = we get that the contingent claim fa introduced earlier is a
special case of dynamic contingent claims.
A strategy n with ^-constraints and value V = (Vt)tô is called a hedging
strategy with N-constraints for / if V* ^ ft for all t ^ 0.
A strategy 7r with ^-constraints and value V = {Vt)tô is called a minimal
hedging strategy with N-constraints for / if Vt ^ Vt ^ /*, t ^ 0, for any hedging
strategy 7r with K-constraints whose value is given by the process V.
1See also Chapter 7, which is devoted to a study o f such contingent claims.
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For Q G P(9?) and t ^ 0 we introduce the set
(5.14) Mt( Q ) = { r a stopping tim e : r G [ty+ o o ) and the process
0 4 u A t (Q ) - ¿ ? ( Q ) ) „ > 0 iS boU nded ° n [ ° . D I
LEMMA 5.2. Let (/i)ij>o be a nonnegative process such that

sup sup E q ( / t — -A9 ( Q ) t ) < + o o .
Q € P (9 ) t €M o(Q)
Then there exists a process (Ut)tô such that
Ut = esssup (Eq [fT - j4a ( Q )r |?t] + ^ ° ( Q ) t ) for all t ^ O (a.s.).

QeP(S3f),r6Mt(Q)
Moreover, for any measure Q € P(3f) the process U —A^( Q) is a local supermartin
gale uiith respect to Q .
T h e o r e m 5 .4 . Suppose that Of satisfies (5.5 ). The set of hedging strategies is

sup sup E q ( / t — A ° ( Q ) T) < + o o .
Q 6P(9) T€M0(Q)
In this case a minimal hedging strategy if = ( H , C ) with N-constraints exists, and

its value at a time t ^ 0 is
(5.15) Vt = v + { H * X ) t - C t
= esssu p (E q [ / t - i 4 ° ( Q ) T |Tt] + -4a ( Q ) t).
Q €P (a),r6M t(Q)
P roof. Let
Vt = esssup (E q [fT - v4°(Q)T 13^] + ^ 9 (Q)t)-

Q € P (0 ),r € A /,(Q )
Let Q € P (S ) and let V = (Vt)tô be the value process of a hedging strategy with K-
constraints. Let (Tn)n>1 be a sequence of stopping times such that E Qj4g (Q )t„ <
n. Since V > / ^ 0 and since V has the representation (5.1), it follows from
Theorem 5.1 that the process V - A ° ( Q ) is a local supermartingale with respect
to Q on [0,rn]. Therefore,
^tArn ^ E q [V t ATn — ^ ( Q ) r A r „ |îATn] + ^ ( Q ) t A r n
^ f r nI{t> T n} + E q [(/r A r n — ^ ( Q ) r A T n + A ^ ( Q ) t ) I { t ^ Tn} I $t\
for a llt ^ 0 and for every stopping time r G Mt ( Q ). It follows from the definition
of Mt (Q) that the sequence
[(/r A rn ” ^ ( Q ) r A r n + - ^ ( Q ) t ) J { i < T n} ] n^ i
is bounded below for each n. Then we conclude from Fatou’s Lemma that Vt ^
E q [fT - A ° (Q )T 13Tt] + i49 (Q)t, and hence Vt ^ Vt for t ^ 0.
We remark that Vt ^ ft for t ^ 0. Therefore, we need only show that V is the
value process corresponding to a portfolio with ^-constraints. This follows from
Theorem 5.1 and Lemma 5.2. The proof is complete.
An analogous description applies to the value process of a minimal hedging

strategy in the case of the set 5ft of constraints.
T h e o r e m 5 .5. Let f o ^ 0 be a contingent claim, and suppose that 9 satis

fies (5.11). The set of hedging strategies is nonempty if and only if
sup E Q [ /r /8 ( j4 s*(Q ))T] < +oo.

Q € P (9 )
In this case there exists a minimal hedging strategy if with fractions of the assets in
the class 5ft and such that the value of the portfolio at time t is
(5.16) Vt = esssup(£(J4a (Q ))tE Q [ / r /£ ( A 9 (Q ))T |5't]).

QeP(O)
We consider a dynamic contingent claim. Let M t°° denote the set of stopping
times r with values in the interval [t , + oo).
T h e o r e m 5.6. Suppose that (ft)tô is a nonnegative process and 9 satis

fies (5.11). Then the set of hedging strategies is nonempty if and only if
sup sup Eq ( / T/£ (,4 a (Q ))r) < + 00.

Q € P (0 ) T£M§°
In this case there exists a minimal hedging strategy if with fractions of assets
in the class 5ft and such that the value of the portfolio at time t is
(5.17) Vt = esssup ( £ ( ^ ( Q ) ) tE Q [ /T/£ ( A 9 (Q ))r |J t]).

QeP(90,T€M£°
The proofs of Theorems 5.5 and 5.6 are analogous to the proof of Theorem 5.4
above.
T h e binom ial m od el w ith different interest rates.
Description of the model and formulation o f the hedging problem for this model
Let us consider a model of a discrete financial market with three assets: a deposit
account, a credit account, and a stock. Suppose that the evolution of the deposit
account value B 1 and the credit account value B 2 and the dynamics of the stock
price S correspond to the recursion equations
£¿> 0,
(5.18) A B l = r 2B 2
n_ ly B l > 0,
ASn = pn(of)Sn—i, So > 0.
Here r 1 and r2 are the constant interest rates for the deposit and credit accounts, re
spectively, r 1 ^ r 2, and p = {pn{u))o<^n^N is a sequence of independent identically
distributed random variables with respect to any measure P in a family { P } of prob
ability measures defined on some measurable space (ii,iF), where il = {+ 1 , —1}N.
Furthermore, the random variables pn(u;) can take two values a < b:
P {pn = b) = p > 0,
P(pn = a) = l - p > 0 .
We introduce on the space (fi, T) the discrete filtration (3rn)o<n^N adapted to the
stock prices:
% = {0, T}; 7n = <t(S0, Si , . . . , 5n), n > 0.
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Thus, we have a discrete model of a securities market with three assets, and
the sequence of prices of these assets has the form
X = { X n)o = (^n>^n>^n)(Kn^JV = (Bn,Bn,Sn)o^n^N-
In this model an investor strategy is a stochastic sequence
H = { H l H l H l ) = ( / 3 £ X 7n),
where /3^, /3^, and are the numbers of units in the deposit and credit accounts
and the number of shares in the investor’s portfolio at the time n.
Since the portfolio is put together solely on the basis of information about
previous prices, the stochastic sequence determining the strategy is predictable.
The investor’s value at time n corresponding to the strategy H has the form
(5.19) v : = f o B l + P lB l + 7«S „.
A portfolio 7r = (H, C) is a strategy with consumption if its value at a time n

satisfies the equation
n
(5.20) Vn = V0 + ^ ( $ A B\ + f t A B l + 7fcASfe) - Cn,
k=1
where the additional parameter C = (Cn)o^n^N of the portfolio is an increasing

stochastic sequence that is interpreted as the total consumption up to the time n.
Auxiliary results. Dual characterization of the model. We consider stochastic

sequences V which have a representation
n
(5-21) Vn = V0 + ' £ H l A X i - Cn,
k=1
where H k = ( H i H i H i ) = ( / M , 7fc), X k = (X fc\ X fc2, X fc3) = ( B ^ B 2,5 fe), and

Cn is an increasing stochastic sequence. The problem is to find a criterion for
the existence of an optional decomposition for the sequence V = {Vn)o^n^N given
by (5.21) in the model (5.18) of a discrete financial market. For this it is necessary to
determine the family 9 , find the upper variation A ^(Q ) for all measures Q G P (S ),
and use Theorem 5.1 or Theorem 5.2.
The representation (5.21) is a discrete analogue of the representation (5.1). In
view of (5.5), the family 9? has the form
(5.22) Q = % ( H , X ) = { y : Y = J 2 H A X > H e **}>
where the constraints N are determined by the inequalities (3l ^ 0 and /?2 ^ 0.
L e m m a 5 .3. Any Y G S has a Doob decomposition
(5.23) Y = M Y + Ay ,
where M Y is a martingale and A Y a predictable sequence.

Furthermore, the decomposition is unique, and A Y is called the compensator of
the stochastic sequence Y .
PROOF. Let M Y = y0) A Y = 0) and
Mn = < + ± ( Y k - E (Yk 1Tfc_ i)),

k= 1
n
An = ^ E ( A F fc|yfc_ 1).
fc = l
It is clear that the so-defined M Y and A Y do have the required properties. Suppose
now that Y = M ,Y + A , y , where M ,Y is a martingale and A ,Y a predictable
sequence. Then
- A X ) + (M - MX) - (JH£, - MZ).

Taking the conditional expectation o f both sides, we get that
A'y,
n+1, _ Aan
,y -— AAn+1
y - An
Ay >
from which, since A'QY = A]f = 0, it follows that A Y = A ,Y and M Y = M ,Y for all
n ^ 0, that is, the decomposition is unique.
Let TJ — (Un)nô be a stochastic sequence with Uq = 0. Then the discrete

stochastic exponential £n(U) is the solution of the difference equation
(5-24) A X n = XnÂU n, X 0 = 1.
By (5.24),
(5.25) £n(U) = I F + AUk), £0(U) = 1.

k= 1
Corresponding to (5.7)-(5.9), we define the sequences ( i i j j, (iQ ), and D n for
0 < n < N and 1 0}> A n = — ------- -«{Vn-Ô},
(5.27) vn—\ Yn—1
K3= - L {Vn_i>0}.
X
n Vn-
A A Ck T
(5.28) Dn = !>»}'
fe=1
Let 5ft be the family of all predictable sequences K = ( K„, K%, K%)0(in^N
taking values in the set
(5.29) A = j a € K3 : t a,i ^ 1 , ai ^ 0, a,2 ^ 0 , as 6 R ^.
By analogy with (5.11) we consider the family
(5.30) 9 = 9f(«,Jl) = { Y : Y = ^ K A R , K € 3ft}.

Then the family P (9 ) of probability measures has the form

(5.31)
P (5 ) = { q : Q ~ P , A 9 (Q )n = esssu p4y (Q ) < +oo,
0 < n ^ IV, A y (Q ) the compensator of Y with respect to Q j.
We can now state the following result for the model (5.18).
P r o p o s i t i o n 5.1. The positive stochastic sequence V = (Vn) o i s the

value of a strategy with consumption if and only if for every Q G P(5$)
(5.32)
and the sequence Kiy/rifc=i (l + E q (pk |S ^ -i)), 0 < n < N , is a supermartingale

with respect to Q.
P r o o f . We reduce the proof to Theorem 5.2. For this it is necessary to find the
class of measures Q G P (9 ) and compute the value of the upper variation -A^(Q)
for such measures.
Suppose that dt and 9? satisfy (5.29) and (5.30), respectively. Then by (5.26)-
(5.28) we can assert that V is the value of a strategy with consumption, that is, it
satisfies the relation (5.19), if and only if
n
(5.33) Vn = V0 + Y J V k-tiK kAR k - A D k).
k= 1
In view of the definition of the stochastic exponential, (5.33) is equivalent to
71
(5.34) Vn = V0 n o + K kA R k - D k).
k= i
Further, according to Lemma 5.3,
n
An (Q) = X ! eq (“ irl + ° 2r2 + azpkIy * - i )

k=1
n
= 5 3 ( a irl + a2r 2 + a3^Q(Pfc |^fc-i)).

k=1
Let x k = E Q(pk |Tfc- 1 ). To find the class P (9 ) of measures defined in (5.31) we
need to investigate the boundedness of the function
Gk(a) = a ir 1 + a2r 2 + a3£fc, 1 < k < N.
Suppose that the measure Q is such that there is a k with x k > r 2, that is,
x k = r2 + a, a > 0. Then
Gk(a) = a ir 1 + a2r 2 + a3(r2 + a) = a ir 1 + (a2 + a3)r2 + a3a.
For ai = 1 and a3 = —a2 the function Gk(a) is = r 1 + a3a, and as a3 —►+ oo we

get that Gk(a) -> +oo, that is, Q P (9 ).
Suppose now that Q is such that there is a k with x k < r 1, that is, x k = r 1 —a,
a > 0. Then Gk{a) = (ai + a ^ r 1 + a2r 2 - aa3, and Gk(a) -> +oo a sa 3 -> -o o .
Hence, Q £ P (9 ).
It remains to examine the case
r 1 ^ Xk < r 2 for all fc = 1 , . . . , N,
so that r 1 + a 1 = Xk = r2 - a 2, where a i, «2 ^ 0. Consequently,
Gfc(a) = ai(xfc - ai) + a2(#fc + a2) + a3Xk
— ^ ) a ia i + a2a 2
M=1 '
^ JS’k—l)'
' 2—1 '
Hence, a measure Q ~ P belongs to P (9 ) the condition (5.32) holds for it.
The upper variation sequence for the family 9? with respect to a Q G P (9 ) is
■An(Q) = E E Q ^ fel Jfe- 1)-

k=l
In view of (5.25) the proof follows immediately from Theorem 5.2.
T h e stru ctu re o f an optim a l hedge in th e binom ial m od el w ith dif

ferent interest rates.
We consider a European option with exercise time N and payment function
fN > 0. Let 9 and P (9 ) satisfy the relations (5.30) and (5.31), respectively, and
assume the condition (5.32). Then Theorem 5.5 takes the following form for the
model of a financial market under discussion.
P r o p o s it io n 5.2. The set of hedging strategies is nonempty if and only if

,N
su p E q fN / T [0 - + EQ(pk\3rk-i)) < 00.
QeP(3) ' k= 1
In this case a minimal hedging strategy exists, and its value at the time n is
N
(5.35) Vn = ess su p E q fN n + 0 < n ^ N.
QeP(3) k= n + 1
The proof is analogous to that of Theorem 5.5.

If the price of a European option is now defined as the initial value of a minimal
hedging strategy, then for the binomial model of a financial market with different
interest rates the price C of a European option is
(5.36) C = Vo = su p
Q e P (3 )
E q
["/HP + E q (Pk I&k-i))
To conclude our investigation of the model (5.18) we present difference equa

tions for the value of a minimal hedging strategy for a contingent claim of the
form
(5.37) fN = 0 (S W ).
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P r o p o s i t i o n 5.3. If a contingent claim satisfies (5.37), then the value of a

minimal hedging strategy can be expressed in the form
(5.38) Vn = v ( S n)n),
where the function v(Sn,n) is a solution of the difference equation
f r 2—a b —r2
v(Sn- i , n - 1) = max< v{Sn- ! (1 + 6),n ) ------- b v{Sn- i (1 + a ),n ) ------ ,
( o —a b —a
v(Sn- i ( l + 5),n) ------- h <

y (5n_ i ( l + a),n ) —------ 1
o —a o —aJ
v (Sn , N ) = p(SW)-
To prove this we use the method of backward induction. Indeed, the validity
of the equality
(5.39) Vk = v(Sk,k)
for k = N follows from the definition of the function v(Sn,ri).

Suppose now that (5.39) is true for all k ^ n. Then it suffices to show that this
equality remains valid for k = n — 1. To this end we use the fact that
(5.40) ess sup E q (Vn - K *-i |Tn- i ) = 0.

Q eP(0)
Let Q G P(30 be arbitrary. Since
EqPn = P q & + ( 1 - P q K
where pq = P Q(pn = b) and 1—pq = P Q(pn = a)> it follows that pq = ^ a

Prom the condition (5.32) we get that
r 1 —a r 2 —a
: PQ
b —a ' * ' b —a
Using the induction hypothesis, we now calculate the conditional expectation:
E q (V„ - Vn-1 I
= E q (v(Sn> n) - Vn- 1 1y „ _ i)
= E q (v(jSn_ i ( l + Pn)>n) —Vn-1 |^n—l)
= v (5 n_ i ( l + a), n )(l - Pq ) + t? (5 „_ i(l + b),n)pQ - Vn- i
= h(J>q ).
Consequently, (5.40) is equivalent to the equality
sup H pq) = 0.
Since the function h(x) is linear, its maximum is attained at an endpoint of the
•Y1 — a r 2 — a
interval and hence
b —a ’ b —a
2 L
Vn- i = max { ^ (S n _i(l + b), n)—— — + v (5 n_ i ( l + a),ri)
b —a b-a'
r 1 —a
v(Sn- i ( l + 6),n) + v(5n_ i(l +
b —a a ),n )6 - a } ’
from which
Vn-l — v{Sn—1)71 !)•
We now treat the case of a payment function of the form
(5.41) / tv = sup Sn — Sn .
n<N
P r o p o s i t i o n 5.4. If a contingent claim satisfies (5.41), then the value of a
minimal hedging strategy can be expressed in the form
(5.42) Vn —
where
suPfc<n Sk
(5.43) Xn =
Sn
and the function v(Sn,ri) is a solution of the difference equation
(1 + a ) ( 6 - r 2)
v ( X n- i , n - 1) = m a x | u ^ m a x | ^ -^ ,l| ,n ^
b —a
(1 + b)(r2 — a)
-‘- ' ( “ " “ { t S ’ 1} ’ " ) b -a
J IXn \ \ ( l + « )(!> -r ‘ )
b —a
v( Xn , N ) = X n -1.
P roof. We proceed by analogy with the proof of Proposition 5.3. The relation
(5.44) Vk = Skv ( X k,k)
for k = N follows from the definition of the function v ( X n, n).

Suppose now that (5.44) is true for all k ^ n. We prove that it remains true
for k = n — 1.
Since
Y Sfc mox.{Sn—i X n—i, Sn}
Sk Sn- i ( l + pn)
Sn—i m ax{X n_ i , 1 -|- Pn} f X n—i -1
5 n- i ( l + Pn) \ l + Pn /
the conditional expectation is
= E q ( Snv ( X n> n) - Vn- i I ? n- i )
= E Q ^ 5 n_ i ( l + pn) u ^ m a x | ^ ^ - )l | ,n ^ - V n- i n—1
- Sn- 1 ((1 + a) v (m ax j , 1j , n ) (1 - pQ)
+ (1 + 6 ) v ( m a x j ^ y p l ) ,n ) p Q ) - V n- i .
Using arguments analogous to those in the proof of Proposition 5.3, we get that
i W 0 J V iXn-1 A \(l + a)(b-r2)

V ( X n- i , n — 1) = Sn- i max< ul max< y - y y , l j-,n I---------------------
f-X »-i A \ ( l + b)(r2 - a )

+ " im aXl T T 6 ’ 1/ )nJ -------— a-------’
i — r 1)
U
ræ C\TT^,1/’nJ-- --
A „ V 1 + <*)(&-
b=~a
r l)
i i r L J 1 " - 1 \ \ (1 + 6)(r1 - q ) l
+ 1, J
U + b’l / ’
i
b —a J’
from which
Vn—i —Sn-iv (X n- i yn 1).
The Black-Scholes model with different interest rates.
Description of the model. We consider a financial market with three assets: a

deposit account, a credit account, and a stock. The changes in the value B 1 of the
deposit account, the value B 2 of the credit account, and the dynamics of the stock
price S have the forms
dB\ = B y dt, B l = 1,
(5.45) dB2 = B 2r 2 dt, B 2 = 1,
dSt = St- (/Ji dt + a dWt), So > 0.
Here r 1 and r 2 are the interest rates received and paid for the deposit and credit
accounts, respectively, r l < r 2; is the mean rate of return on the stock, ¡i > r 1;
a is the volatility, a > 0; W = (Wt)o^t^T is a Wiener process.
We assume that all processes are defined on a standard stochastic base (ii,
F = ( Tt) o P ) , where T < + oo is a time in the future interpreted as the exercise
time for the contingent claim. We assume that F = ¥ s = F ^ .
An investor strategy in the market model (5.45) is defined to be an adapted
process H = ( i f t ) o ^ T = (A1*/?? where A1* A2> and yt are the numbers
of units in the deposit and credit accounts and the number of shares in the portfolio
at the time t. Here it is assumed that (31 ^ 0 and 0 2 < 0. Then the value of the
strategy at time t is
(5.46) Vt = 01 B\ + 02B2 + 'YtSt.

A portfolio 7r = ( # , C) = {/3\(32^ C ) is called a strategy with consumption if

its value at time t satisfies the equation
(5.47) dB\ + dB2

u + 7„ dSu) - Ct,
Jo
where C = (Ct)o^t^T is an increasing adapted process interpreted as the total
consumption process in the portfolio up to and including the time t.
The equality Ct = 0 corresponds to the definition of a self-financing strategy.
Auxiliary results. Dual characterization of the model. We consider processes V

satisfying (5.1) with Hs = (/?£,/?£, 7 s) and X 8 = ( B l , B g , S s). Suppose that the
value (5.47) of the strategy with consumption is positive at each moment of time.
Then the following representation is valid:
(5.48) V = V0 e ( f K d R - D ) ,
where, by (5.7)—(5.9),
(5.49) R = (Bl,R2
t , R3
t ) = (rH, r \ Aa + aWt)
is the process of relative growth of the stock prices,
(5.50) K = {KlK2
t , K 3)
P}B}_ T P fB l v s ,-
y I {vt- > 0} J~ y ~ — ^ {^ -> 0}» - ÿ ^ 1{Vt-> 0}
is the process of the fractions of the portfolio’s value invested at the time t in the
deposit account, the credit account, and the stock, and
(5.51) D = { Dt) = f ^ I (Vu_ >0}

Jo vil
ls the process of relative consumption in the portfolio up to the time t.
The process K = defined in (5.50) belongs to a set 5ft which
satisfies the conditions of convexity and closedness and contains the process K = 0.
Let
(5.52) 3 = { Y : Y = K * R, K G 5ft}.
The problem is to find the class P (S ) of measures and calculate the value of the
upper variation A ^(Q ) for this class. We present some theoretical facts to be used
in arguments below.
A variant of Girsanov’s theorem for semimartingales was mentioned in Chap
ter 2. Here we need a concretization of it.
Girsanov’s theorem for local martingales.

loc
T heorem 5.7. Assume that Q P and Z is the density process. Let M be
a P -local martingale with Mo = 0 such that the P -quadratic covariance [M, Z] has
P -locally integrable variation. Let (M , Z) be its P -compensator. Then the process
(5.53) m ' =m — L . o ( m , z)
Z—
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is defined Q -a.s. and is a Q -local martingale. Moreover, the P -quadratic charac

teristic (M c, M c) of the continuous component M c (with respect to P ) of the local
martingale M is also a version of the Q -quadratic characteristic of the continuous
part (with respect to Q ) of the local martingale M '.
We consider a d-dimensional semimartingale X = ( X 1, ... , X d) defined on the
stochastic base (ii,? T ,F = (^ o ^ t^ r s P )*
Denote by C d the class of all bounded functions h: Rd —> Rd with compact
support such that h(x) = x in a neighborhood of zero.
Let h e C d. Then A X S — h ( A X s) ± 0 only if \AXS\ > b for some b > 0.
Therefore, the formulas
' X(h)t = ' £ /{ ^ s - h ( A X s) ) >

< S^t
kX( h) = X - X( h)
define a process X( h) £ V and a d-dimensional semimartingale X(h). Since the pro

cess A X ( h ) = h ( A X ) is bounded, it follows that X (h) is a special semimartingale.
We consider its canonical decomposition:
X (h ) = Xo + M(h) + B(h), M(h) £ M loc, B ( h ) e V and is predictable.

Let h be a fixed function in C d. The characteristics of the semimartingale X
associated with the cutoff function h are defined to be the triplet (B , C, u), where:
(i) B = (Bait'd is a predictable process in Vd, namely, the B(h) appearing in
the canonical decomposition for X{h)\
(ii) C = {C^)ij^d is a continuous process in Vdxd, namely, C^ = { X^C, X ^ C)\
(iii) v is a predictable random measure on R + x E , namely, the compensator of
the jump measure ¡ix of the process X , where E = Rd \ {0}.
Girsanov’s theorem for semimartingales. Let X = ( X l)i^d be a semimartingale
with characteristics (B , C, v) with respect to a given cutoff function ft, let X c be
the continuous component of X with respect to P , and let A be an increasing
predictable process such that C 2*-7 = cÂ.
loc
T heorem Assume that Q < P with local density Zt, and let X be the
5 .8 .
semimartingale introduced above. Then there exist a B®E-measurable nonnegative
function Y and a predictable process /3 = satisfying the conditions
|ft(x)(y— 1)|*vt < oo (Q -a.s.) for any t e M+,
^ cu /?2 o A t < oo (Q-a.s.) for any t e R+,

j^d
i ^ (3j cjk/3k j o A t < o o (Q -a.s.) for any t £ R+,

'j,k^d '
and such that the predictable characteristics of X with respect to Q are
B H = B i + ( ^ 2 c ij/3j O A + h*(x)(Y
(5.54) C' = c,
u' = Y * v.
Moreover,
(5.55) (.Zc, X l’c) cijj3j Z _

) o A.
To get a representation of the Wiener process Wt with respect to a measure Q G

P(3?), we can use both Theorem 5.1 and Theorem 5.2. It follows from Girsanov’s
theorem for local martingales that with respect to Q ~ P the process Wt can be
represented in the form W = M + — o (W, Z ), where M is a local martingale with
ir
respect to Q.
We now consider Girsanov’s theorem for semimartingales when the process X
is a standard Wiener process Wt. This Wt has characteristics (£ , C, v) = (0, £, 0)
with respect to P. By Theorem 5.8, Wt is a semimartingale with characteristics
(B /,C ,,z//) = (/o bs ds, t, 0^ with respect to Q ~ P , where bs(u>) is a predictable
process satisfying the conditions
/ |bs|ds < oo,

Jo
(5.56)
{ ZC, W ) = f bgZg—ds (Q-a.s. for all t G R+).
Jo
Then with respect to Q ~ P the process Wt can be represented in the form
Wt = M t + /о bs ds, where M t is a local martingale with respect to Q and ь м
satisfies (5.56).
There is a process, unique up to a negligible set and called the compensator
Ap = A of A, which is a predictable process in the class A\oc and such that A —Ap
is a local martingale.
By Theorem 5.7, [W, Z] is in A\oc with respect to P and is continuous. Its com
pensator satisfies the condition [W, Z]p = (W, Z) = [W, Z] G Л ^ с and is predictable
by virtue of continuity.
In this case
(5,57) - ± - o ( W , Z ) = j - o \ W ,Z \
with respect to P. Let us prove that there is a process bs(oj) satisfying (5.56) such
that
1
— o [W, Z ] = bs ds (Q-a.s. for t G M+).
Z- Jo
Indeed, by Theorem 5.8 and the condition (5.57),
o [W, Z]t = [ ~~~—bsZs—ds = f bs ds (Q-a.s. for all t G M+).

Z- Jo Zs~ J0
Thus, the two Girsanov’s theorems above give the same representation for the
Wiener process Wt with respect to a measure Q ~ P with Q G P (9 ):
(5.58) Wt = Mt + [ bs ds,
Jo
where M t is a local martingale with respect to Q and bs(u>) satisfies (5.56).
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We consider the family 9 of semimartingales defined in (5.52). Then by (5.58)

a process has the following form with respect to Q:
(5.59) + * y + + a bu o K l d M u.
By properties of stochastic integrals, the second term in (5.59) is a local martin

gale with respect to Q. We then conclude from the definition of the canonical
decomposition of a special semimartingale that the compensator A Y ( Q )t has the
form
(5.60) AY(Q)i =AJo

+ K i r 2 + K l ( n + abu)) du, 0 < t < T.
We remark that the predictable process K t takes values in the set
A —| û G M3 i ^ ^Cbi ^ 1, cl\ ^ 0, o>2 ^ 0, U3 G M

^ i= 1
Then to find the upper variation of the family 5 with respect to Q we must in
vestigate the boundedness of the function Gu(a) = r l a\ + r 2a 2 + x uaz> where
x u = + abu. By arguments analogous to the preceding model, we conclude that
a measure Q ~ P belongs to the set P (9 ) if and only if
(5.61) r 1 < fi + abu ^ r*2, 0 ^ u < T.
Further, the upper variation process of the family 9? with respect to a measure
Q G P(Q) is
(5.62) A ^ (Q )t = [ (p + abu) du.

Jo
Then by the definition of the stochastic exponential,
(5.63) £ (A 9 (Q ))t = e x p j ^ (p + abu) du
As a result, we arrive at the following criterion for the existence of an optional

decomposition in the Black-Scholes model with different interest rates.
T heorem 5 .9 . The positive process V = (Vt)o^t^T satisfies the relation
V = V0 8 , ( K * R - D ) y
where the processes K , R , and D are defined according to (5.49)-(5.51), if and

only if for all measures Q G P (9 ) the condition (5.61) holds and the process
Vt exp|—J*(p + abs) is a supermartingale with respect to Q.
Structure of an optimal hedge in the Black-Scholes model with different interest

rates. Let us consider a European option with exercise time T < +00 and payment
function / t ^ 0.
T h e o r e m 5 .1 0 . The set of hedging strategies is nonempty if and only if
(5.64) sup E q ( / Te-/or (H-*M‘fc) < +00.

QeP(O)
In this case there is a minimal hedging strategy, and its value at time t is
(5.65) Vt = ess sup Eg [fTe~ K ^ +CTbs)ds 13t] .

Q6P(s>)
Hence, the price of a European option in the market (5.45) as the initial value
of a minimal hedge is equal to
(5.66) C = Vo = sup E q /y e x p | — f (p + crbs)ds

Q € P (9 p) L l Jo
where r 1 < p + <rbs ^ r 2 for all 0 < s < T.
Merton’s model with different interest rates.
Description of the model We consider a financial market with three assets: a

deposit account, a credit account, and a stock. The changes in the value B 1 of the
deposit account and the value B 2 of the credit account and the dynamics of the
stock price S have the form
dB\ = B\_rl dt, B q = 1,

(5.67) dB2 = B 2
t_ r 2 dt, B q = 1,
dSt = St- ( p d t - vdHt), So > 0.
Here r 1 and r 2 are the interest rates of the deposit account and the credit account,
r 1 < r2; fi is the average rate of return from the stock, p > r 1; v < 1 is a constant;
n = (n t) o ^ T is a standard Poisson process with jump intensity A > 0 and with
the representation
(5.68) n t = n$ + At,
where EH* = At and Ut is a martingale with respect to P.

All the processes are bounded on the standard stochastic base (fi, J t »
F = ( 9 ^ ) 0 P)> where T < +00 is a moment of time in the future that is inter
preted as the exercise time for a contingent claim. It is assumed that F = F5 = Fn .
The earlier definitions of a strategy and of a strategy with consumption will be
preserved also in this model.
Auxiliary results. Dual characterization of the model As in the above Black-

Scholes model, we characterize the processes V satisfying the equation (5.1), in
which Hs = (/?s ,/?5 , 7 s) and X s = (J3*, B 2, Ss). Assume that the value (5.47)
of the strategy with consumption is positive at each moment of time. Then the
following representation is valid:
(5.69) Vt = V0i ( J K d R - £>),
where, by (5.7)-(5.9),
(5.70) R = ( R j , Rt , R$) = (rH, r2t, ut - v llt)

is the process of relative growth of the asset prices,
(5.71) K = (K },K lK ?)
r $ B l_ JtSt-
= I y t_ * {V t- > 0 } , y t_
is the process o f fractions of the portfolio value invested at the time t in the deposit
account, the credit account, and the stock, and
(5-72) D = (Dt) = j * ^ - I {Vu_ >0}
is the process of relative consumption in the portfolio up to the time t.

The process K = defined in (5.71) belongs to a set 3? which is
convex and closed and contains K = 0. Suppose that the family 9? of semimartin
gales has the form
(5.73) 9? = { Y : Y = K * R , K e & } .
The problem is to find a criterion for the existence of an optional decomposition

in Merton’s model with different interest rates. For this we must find the upper
variation of the family 9? with respect to a measure Q G P(9?) and then use Theo
rem 5.2.
Let us consider a cutoff function h(x) = with h G C£. Since a
standard Poisson process lit with respect to P has a representation in the form (5.2),
lit is a one-dimensional semimartingale with characteristics
Bt (h) = h(l)\t,
(5.74) Ct = 0,
u(uj\dt, dx) = A d t x £i(dx).
Taking a measure Q ~ P with Q G P(9=), we see from Girsanov’s theorem for
semimartingales that with respect to Q the process lit is a semimartingale with
characteristics
B't (h) = B t(h) + f f h( x) (Y( w, s, x) - l) u( oj -, ds ,d x)

JO J R
= B t(h) + f h(l)(Y(w,s, 1) - 1)Ads

Jo
(5.75) = h( 1)A / Y (u > ;s ,l)d s = [ \ ?(w )d s,
Jo Jo
c't = 0,
v’ — / / Y{(jj\s>x)£i(dx) x Ads.
Jo Jr
Since Y is a nonnegative function and A > 0, it follows that A^(cj) ^ 0.
Thus, with respect to a measure Q ~ P with Q G P (9 ) the Poisson process Ut
admits a representation of the form
(5.76) lit = M t + ds,
where Mt is a local martingale with respect to Q.

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Since S satisfies (5.73) and the predictable process K t takes values in the set
A = /a G ^ ^<2j ^ 1, d\ ^ 0, <22 ^ 0, <23 G m \,

^ ¿= 1 J
a process 7 e 9 has the following form with respect to Q:
(5.77) Y = f { K y + K2
ur2 + K l n ) d u - f v K l d l l v
Jo Jo
= f y y ur2 + Kl (f i - j/A?)) du -
+ K2 f u K l d M u.
Jo Jo
By properties of stochastic integrals, the last term is a martingale with respect
to Q - P. Using the definition of the canonical decomposition of a special semi
martingale, we conclude from (5.77) that the compensator of a process Y G 9? with
respect to Q G P (3 ) has the form
(5.78) + K%r2 + - v\%)) du for all t, 0 < t < T.
To find the upper variation of the family 9 with respect to Q we need to

investigate the boundedness of the function Gu{p) = r xa\ + r 2a,2 + x uas^ where
x u = M~ is an arbitrary number. By arguments analogous to the preceding,
we conclude that a measure Q ~ P belongs to P (Q ) if and only if
(5.79) r 1 < \x - < r2, 0 < u < T.
Further, the process of the upper variation of the family 5 with respect to Q G P (3 )
is
(5.80) 0 ^ t < T.
According to the definition of the stochastic exponential,
(5.81) £(îa (Q ))t = e x p j j f {n - i/A j)d « | .
The next theorem gives a criterion for the existence of an optional decomposi
tion in Merton’s model with different interest rates.
T heorem 5.11. A positive process V = (Vt)o^t<T satisfies the relation
V = V0 £ ( K * R - D ) ,
where the processes K , R, and D are defined in (5.70)-(5.72), if and only if the con
dition (5.79) holds and the process Vt exp|—J*(fi — z/A^) ds| is a supermartingale
with respect to Q for every measure Q G P (3 ).
Structure of an optimal hedge in Mertonys model with different interest rates.

Let us consider a European option with exercise time T < +00 and payment func
tion / r ^ 0.
T heorem 5.12. The set of hedging strategies is nonempty if and only if
(5.82) sup E g [ / r e " & O * -'* ?)* ] < +oo.

Q€P(S*)
In this case a minimal hedging strategy exists, and its value at the time t is
(5.83) Vt = ess sup E q [fTe~ £ |y t] .

Q e P (O )
The proof follows from the proofs of Theorems 5.4-5.6.

As the initial value of a minimal hedge, the price of a European option in the
market (5.67) is equal to
(5.84) C = V0 = sup E q f/T exp( - f (p - vXf) ds

Q € P (3 ) L l JO
where r 1 ^ ¡x — v < r 2 for all 0 ^ s ^ T.

In conclusion we present brief calculations in the models (binomial, Black-
Scholes, Merton) under an additional constraint known as “prohibition of short
selling” .
In the presence of this constraint the set A of values of the process K =
(ATt)o<t^T has the form
A = < a G R3 : < 1, ai ^ 0, a2 < 0, as ^ 0 >.

^ i=l ^
To find the upper variation of a process Y G 3 with respect to a measure Q G
we must investigate the boundedness of the function Gkip) = ai rl + a2^2 + a3Xk
for all fc, 1 ^ k < iV. Here Xk is an arbitrary number.
Suppose that Q is such that there exists a k with Xk > r2>that is, Xk = r 2 + a,
a > 0. In this case
Gk{a) = air 1 + a2r 2 + a3 (r2 + a) = air 1 + (^2 + a3)r2 + a3<*.

Prom this with ai = 1 and a3 = —a2 it is clear that G k{°) = rl + a3a —5►+ ° ° as
a3 —> -foo, that is, Q £ P (5 ).
We now consider the case when there exists a k with Xk < t , that is, Xk =
r1 — a, a > 0. Then, since r 1 ^ r2, we have
Gk(a) = (ai + a3 )rx + a2r 2 - a3a ^ r 2 a3a ^ r2>

\=i '
that is, Q G P (S ).
It remains to check the case when r 1 ^ Xk ^ r 2 for all 1 ^ k ^ iV. We have
r 1 + a i = Xk = r 2 —a 2, where a i, a 2 ^ 0. By the definition of the set A , this gives
us that
Gfc(a) = a i(x k - a i) + a2 (xfc + a 2) + a3Xk
= x fc( j - i aiai + a2a 2 < Xk ^ ^ 3 ai) ^

'¿= i '
that is, Q G P (9 ).
§5.2. HEDGING AND INVESTMENT WITH TRANSACTION COSTS 87
Thus,
if Xk < r 1,
sup Gk(a) =
aeA Xk if r 1 < Xk < r2.
Hence, Q G P (S ) if and only if x k ^ r 2. Further, s u p a eA Gk(a) = r2.
1. Let us consider the binomial model with different interest rates when there
is a prohibition on short selling. In this case, x k = E (pk l ^ - i ) = Ep^. Then
Q G P (S ) if and only if Ep^ ^ r 2. Furthermore,
¿ ° ( Q ) = r 2n , 8 (A ® (Q ))„ = I P 1 + r2) = i 1 + r2)n-

k=l
and the price of a European option is equal to
c = Vo = sup E q [ / jv(1 + r 2)~ N] .

Q € P (9 )
2. In the case of the Black-Scholes model we have k = t G [0, T], x t = /x + a b t ,

and Q G P(9?) if and only if p + c r 6 t < r 2, where b = (& t)o<t<T is a process satisfying
(5.61). Furthermore,
■A°(Q)t = r r 2 ds = r 2i, £(i4®(Q))t = er2f,

Jo
c = Vo = sup E Q [/Te~r2T].
Q 6 P (9 )
3. In the case of the Merton model x t = ¡x — v\^, and Q € -P(3) if and only if
H - v \ ? ^ r 2, where — (A^)oî^T is a process satisfying (5.79). Furthermore,
A * (Q )t = f r2 ds = r % £ (A * (Q ))* = e"2t,
Jo
C = y0 = sup E Q [/Te_r2T].
Q €P(9)
§ 5.2. H edging and investm ent w ith tran saction costs
In this section we consider the Black-Scholes model (3.19) in which the forma
tion of dynamic strategies is implemented with tra n s a ctio n c o sts taken into account.
Under these constraints we solve two fundamental financial problems:
• hedging contingent claims / = / ( S r ) on a time interval [0,T];
• in v e s tm en t when the search for an optimal strategy is implemented by the
criterion of maximizing the mean yield.
In the solution of the first problem the possibilities of re-structuring the port
folio are limited to discrete times U = T, A = t<+1 - tiy and to the taking of a
certain “payment” for re-balancing the portfolio. It is clear that this assumption
brings us closer to a more adequate description of financial realities. We present
Leland’s approach (on a physical level of rigor) to the pricing of options in this
situation, assuming for simplicity that B t = B q = 1 .
As before, suppose that the value X f of a strategy 71-t = (A> 7 t) is determined

by the balance relation
* r = A + 7 iS t.
Here its change over a time A t = £¿+1 — U is realized according to the equation
(5.85) A X £ = j t&St - ^ St|A7t|,
where A; is a nonnegative quantity that can depend in general on N.

The last term \ S,£|A7 *| on the right-hand side of (5.85) is called the transaction
costs ( operational costs, overhead costs, commission fees) borne by the investor
managing the portfolio 7r. The form of the size of these costs, called proportional
costs in this case, can be completely explained and constitutes 1 100% of the size
of the change in the risky part of the portfolio.
One additional assumption about re-balancing the portfolio 7r is that for each
time ti
(5.86) xz = x*(ti,sti) = cBS(ti,sti),

that is, the value of the selected portfolio at the re-hedging time t* is equal to the
price of the contingent claim / , calculated in the framework of the ideal Black-
Scholes model (3.19).
According to the Kolmogorov-Ito formula, we get the following stochastic equa
tion for C BS (see, for example, (3.25)):
dCBS dCBS d2C BS

(5.87) dCBS(t, St) (f, St) dSt + (t, St) + 0t,St) dt.
dS dt ~dSr
Comparing (5.85) and (5.87) and using (5.86), we arrive at the following equal
ities, valid up to small quantities of order A = A t —> 0:
dCBS,
It =
(5.88)
ds
dCBS d2C BS
- 2 $ l A 7t|
dt
(t, St) + ~2~St
~ds2~ At.
Further, by the properties E|AWt| Ât and E|AWt|2 = A i of a Wiener
process, we have with the same order of smallness A t —> 0 that
d2C BS
Ayt (t, St)ASt,
dS2
d2C BS
^ 5 t|A7t|= \kSt ( t , s t) |ASt
d s2
d2C BS
|AWt|
- 2 kSt<r2
as2 (t,St)
a2cBSAt.
^ ( w s ) s> es2
On the other hand,
8C BS
Pt = X ? - TtSt = x; - -^-(t, St)St,
and hence the value X n(t, St) of the selected strategy 7r with transaction costs taken
into account must satisfy the equation
d X "(t,S t) &<£) q2 d2X * (t,S t)

(5.89)
dt 2 * as2
with the boundary condition X n(T ,S r ) = /(«St )> where
d2c BS{ t ,s t)
ïî(r)=<’ï(i+yi(^î))5g“(r)' r =
as2
In the case of an option to buy with payment function / = (St —K ) + we have
r > 0, and the value of the hedging strategy satisfies the Black-Scholes equation
(3.27) with the increased volatility
Thus, our attempt to replicate the contingent claim / in this situation is accompa
nied by an increase in volatility, which is a kind of “payment” for the presence of
the transaction costs.
However, Kabanov and Safaryan have shown that the asymptotic behavior as
A —> 0 of the convergence of the contingent claim price, determined with the help
of the above discrete strategy (Leland strategy), is not unique. For example, for
k = koN~a) a G [0,1/2], and T = 1 the indicated strategy ensures perfect hedging,
while for k = ko a hedging error J\ — J2 < 0 arises in the “limit” , where
J\ = m in {it',5 i},
, ha f ° ° Si / v fin S t/ K ^ 1 \ 2\ .
G (S .v) = ‘ f L - + -^ 1 « -* -/^ .
V 2 ^ j -o o l V zH v V 2^\
In solving the second investment problem we start out from the assumption
that the strategies nt = (Pu7t) satisfy the “balance relation”
(5.90) dßt + St d'yt = —SSt \djt\, ô > 0,
which can be interpreted in a natural way as the taking of 5 •100% in commission

fees, equal to ¿St|A7 t|, when stocks are bought (sold). Of course, it is assumed
here that the corresponding differentials d/3t and d'yt exist.
We define the (random) yield on [0, T] of a portfolio 7r satisfying (5.90) by the
relation
(5.91) = - l), (3 € [0,1).
The parameter /3in (5.91) “is responsible for” compound interest, and in particular,
we get for /3 = 0 that
ir w ) = !in fj,
which corresponds to a rate of growth with continuous compounding of interest.
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The selection of an optimal portfolio n* can be realized by solving the extremal

problem
(5.92) R*(/3, S) = E RT*(P,5) = su p E iT O M ),
where the “sup” is taken over the class of strategies n satisfying (5.90).
Getting the exact theoretical result in the problem (5.92) is obviously impos
sible. However, the assumption that the operational expenses are “small” (5 —» 0)
leads to the following important result in this direction.
T h e o r e m 5 .1 3 . R* has an asymptotic representation
R*(0, S) = R * (0 ,0) - exp^/3 ^ t ) u*<S2/ 3 + o(62' 3),
where
(5.93) R*(0,O) = ± ( e x p ( / 3 ^ T ) - l ) ,
(5.94) 1 M
1 -/ 3 a2 ’
1/3
(5.95) v* = ° 2 ( — 32 ^ ) ( « * ( l - a * ) ) 4/3-
Further, a strategy 7r* for which a change in the structure of the portfolio is im
plemented at the times the process a = (a*)tô> &t — ItS t/ X ?, first leaves the
interval
/ q \ l./3
[a* - x * « 1/ » , a * + x * * 1/ 8], x* = ( ^ j ^ y ) ( « * ( 1 - <**))2 /3 .
in an amount minimally necessary for returning to the boundary of this interval, is

asymptotically optimal.
PROOF. Prom (5.90) we get the equation
dVt = Vt (a tptdt + CLtodWt - 5\at\ \dKt \)
for the evolution of the value of the portfolio, where dK = ¿ 7 /7 is the process of
relative change of the stocks in the portfolio. Using the Kolmogorov-Ito formula,
we arrive at the relation
= £ P atadW t^ji^P J a tpdt - dt — S\at \\dKt \
Let a * be the constant defined in (5.94). We denote by £ = a —a* the deviation

from this quantity of the process that is the proportion of the risky part of the
value of the portfolio. It is clear that a & a* for “small” operational expenses, and
therefore in the first approximation with respect to S

^ / rT
(*)-«a ~ )
xe{ßjo S2idt~^2^**°*dt~ m) 5|a*1
« s (jf /?aVdWt)
x exp( / ? ^ t ) ( x “ Z3Jo dt+ % * l \dKt\J.

We define a new probability measure P as follows:
dP / 'T
ßa*a d W t .
dP - n
Note that the process Wt = Wt — (3a*adt is a Wiener process with respect to P.
Then the extremal problem (5.92) is equivalent to the problem
E ji dt + 8\a*\\dKt \'j -> m in .
Making the change of variables
t = s<52/ 3, T = S52/ 3, & = CsS1/z,

Wt = BsS1' 3, \a*\Kt = L s8l>3,
we arrive at the problem
(5.96) ^ J ( ^ C V 2 ds + |d£s|) - f nun (= u*).
According to the Tauberian theorem, under very general conditions the as
ymptotic behavior of a function at infinity is uniquely determined by the behavior
of the Laplace transform of the function near zero. Hence, the problem (5.96) is
equivalent to the problem
v* = lim Av(A,0),
A —>0 V n
where
f c a-\t 1 “ ß J1/-2
v(XjX) = inf E / cr2Ç2 dt + \dLt\ Co = x.
Jo
Thus, we come to the following Bellman equation for the function v(\ ,x):
d v{\,x)
(5.97) m in ( y (a*(l—q *))2^ ^ 2’ ^ -X v (X ,x)+ ^ ^ -< r2x2, - l ) =0.
Let us consider formally the following decomposition of v(A, x) with respect to

powers of A:
u(A, x) = + w (x ) + o(A).
Passing to the limit as A —» 0 in the Bellman equation (5.97), we get that
id2w (x) dw(x)

mm -i)= o .
dx
According to the general theory of optimal stopping rules, the solution of the last
equation must have the structure
>d2w(x)
y (a * (l-a * )): —v* + ^ a2x 2 = 0, \x\ < x *,
dx 2 z
dw(x) _
— -L \x\ > X *.
dx
Three additional conditions are needed to find the unknown parameters. Two are
the so-called conditions o f “smooth pasting” on the boundary separating the regions
of “continuing and stopping the observations” :
The third condition

dw. x
arises because by the sense of the problem the solution w (x) is a symmetric function.
Solving the system of equations with the indicated boundary conditions, we find
the desired expressions for x* and v*y and this completes the proof of the theorem.
We remark that the quantity R* (/3,0) is the solution of the problem (5.92) in
the absence of operational expenses (S = 0). Further, the value of a* given in (5.94)
determines the optimal proportion of stocks in the portfolio.
§ 5.3. Appendix: Examples of the simulation of hedging strategies
In this section we give an example of the hedging of a “life” option contract,

taken from Russian financial practice. It is known that a characteristic feature of
option contracts is the lack of symmetry between profits and losses for the parties
in the contract. As a rule, the maximal profit of the buyer of an option is unlimited,
while the amount of his maximal loss is limited to the premium paid for the option.
On the other hand, the maximal profit of the seller of the option is equal to the
premium received from emission of the option, while his losses are without limit.
As an illustration of the fact that buying an option can turn out to be an
extremely profitable financial operation, we present an example taken from the
history of a financial market. Table 5.1 contains prices for the sale of options to
buy on domestic currency loan (DCL) bonds of the 2nd tranche with exercise times
30, 60, and 90 days from 04/19/95, and with exercise price equal to the weighted
mean price over transactions with this bond on 04/19/95. Table 5.2 shows the
yields from the operation of buying these options, computed with respect to the
weighted mean prices of the DCL bonds at the exercise times of the options.
§ 5.3. APPENDIX: EXAMPLES OF THE SIMULATION OF HEDGING STRATEGIES 93
T a b l e 5.1. Q uotations o f options to bu y (4/19/95).
Premium
Exercise time Exercise price
(percent of face value)
05/19/95 79.60 1.80
06/18/95 79.60 2.60
07/18/95 79.60 3.10
T a b l e 5.2. R eturn to buyers o f

options (5/19/95, 6/18/95, 7/18/95).
Price of purchase at Yield of operation

Exercise time
exercise time (annual %)
05/19/95 83.90 1667%
06/18/95 85.80 831%
07/18/95 88.40 735%
As is clear from Table 5.2, the buyers of the options garnered a fairly nice yield
for themselves.2 Correspondingly, a seller of the options would incur sizable losses
with his “passive” strategy of waiting for the exercise time of the option.
In this connection the seller of the option must solve the following problems for
himself:
• how to protect himself against possible losses connected with fulfilling obli
gations according to the option;
• how to minimize costs by constructing a strategy ensuring fulfillment of the
obligation according to the option.
Of course, it is necessary to take into account factors connected with the im
perfectness of a real financial market, namely, the presence of stochastic volatility,
structural constraints on the hedging portfolio, transaction costs, and so on.
Below we give the results of a simulation (with operational expenses and the
leasing of stocks taken into account) of hedging processes on the basis of real data.
Assume that on September 20, 1994 we wanted to purchase an option to buy
on a DCL bond of the 2nd tranche with exercise price 77.00 (% of face value) and
exercise time October 20, 1994. An approximate value in estimating the historical
volatility over this time period is a « 16%, and the interest rate with respect to US
dollars is r « 14%. If we worked in the market of the ideal Black-Scholes model,
then hedging with the given parameters a and r would lead to a zero value of the
minimal hedge at the terminal time.
Table 5.3 represents a process of hedging an option to buy in the Black-Scholes
model “in real time mode” , that is, with respect to calendar days on which there
are records of the weighted mean prices of DCL bonds of the 2nd tranche. For each
such date the table shows the structure of the hedging portfolio:
• the value of a minimal hedging portfolio;
• the amount of DCL bonds in a minimal hedging portfolio;
2DCL bonds are traded in US dollars.

T a b l e 5.3. Simulation of a hedging procedure for a

purchased call option in the classical Black-Scholes model.
Closing price Value of a Amount Amount

Date Disbalance
DCL bonds min. hedge DCL bonds US dollars
09/20/94 77.13 1.60 - 0.66 49.34
09/21/94 76.94 1.44 -0 .6 3 47.04 - 0.01
09/22/94 77.82 2.01 -0 .7 5 56.48 0.03
09/23/94 77.83 1.98 -0 .7 5 56.59 0.01
09/26/94 77.85 1.89 -0 .7 6 56.99 -0.03
09/27/94 77.99 1.96 -0 .7 8 58.51 -0.05
09/28/94 78.50 2.33 -0 .8 4 63.48 -0 .0 5
09/29/94 78.88 2.62 - 0.88 66.71 -0 .0 5
09/30/94 79.31 2.98 -0 .9 2 69.79 -0 .0 5
10/03/94 80.24 3.76 -0 .9 7 74.28 -0 .0 4
10/04/94 80.87 4.34 -0 .9 9 75.62 -0 .0 4
10/05/94 80.61 4.05 -0 .9 9 75.44 -0 .0 4
10/06/94 80.97 4.39 -0 .9 9 76.03 -0 .0 4
10/07/94 81.11 4.50 - 1.00 76.26 -0 .0 4
10/10/94 81.57 4.86 - 1.00 76.65 -0 .0 4
10/11/94 81.96 5.22 - 1.00 76.72 -0 .0 4
10/12/94 81.47 4.71 - 1.00 76.74 -0 .0 4
10/13/94 80.28 3.49 - 1.00 76.57 -0 .0 4
10/14/94 79.17 2.36 -0 .9 8 75.16 -0.04
10/17/94 78.42 1.51 -0 .9 7 74.38 -0.06
10/18/94 78.03 1.11 -0 .9 5 73.07 -0.06
10/19/94 79.23 2.26 - 1.00 76.97 - 0.02
10/20/94 79.51 2.51 - 1.00 77.00 - 0.02
• the amount o f US dollars in a minimal hedging portfolio;

• the disbalance of the hedging portfolio, that is, the sum of the differences
between the values of a real portfolio and a minimal hedging portfolio from
the initial date to the current date.
The disparity between theory and practice is, of course, a consequence of the
fact that the parameters of a minimal hedging portfolio are calculated in a con
tinuous model, while hedging “in practice” is implemented at discrete moments of
time. If the value of the portfolio is greater than the theoretical value of the mini
mal hedge, then we put a certain amount of US dollars into our portfolio, in order
to bring it into correspondence with the theoretical value. And if the value of the
portfolio is less than the theoretical value of the minimal hedge, then we withdraw
a certain amount of US dollars from our portfolio (for example, by consumption).
In this example the size of the “disbalance” at the exercise time of the option
turned out to be less than zero, and the buyer of the option (the hedger) “earned”
0.02% of the face value of the bond, or 200 dollars. This quantity is comparable with
the usual broker’s commission (constituting « 100 dollars) on the purchase/sale of
DCL bonds.
§ 5.3. APPENDIX: EXAMPLES OF THE SIMULATION OF HEDGING STRATEGIES 95
T able 5.4. Simulation of a classical Black-Scholes hedge for a

purchased call option in a market with operational expenses.

Date Disbalance
09/20/94 77.13 1.39 -0.61 45.64
09/21/94 76.94 1.25 -0 .5 8 43.31 0.02
09/22/94 77.82 1.79 -0.71 53.33 0.01
09/23/94 77.83 1.77 -0.71 53.51 0.03
09/26/94 77.85 1.70 -0 .7 2 54.11 0.08
09/27/94 77.99 1.77 -0 .7 4 55.81 0.10
09/28/94 78.50 2.14 -0.81 61.30 0.11
09/29/94 78.88 2.42 -0 .8 5 64.94 0.13
09/30/94 79.31 2.78 -0 .9 0 68.46 0.14
10/03/94 80.24 3.58 -0 .9 6 73.76 0.14
10/04/94 80.87 4.17 -0 .9 8 75.37 0.14
10/05/94 80.61 3.89 -0 .9 8 75.16 0.15
10/06/94 80.97 4.24 -0 .9 9 75.88 0.15
10/07/94 81.11 4.35 -0 .9 9 76.15 0.15
10/10/94 81.57 4.75 - 1.00 76.63 0.15
10/11/94 81.96 5.12 - 1.00 76.71 0.15
10/12/94 81.47 4.62 - 1.00 76.73 0.15
10/13/94 80.28 3.41 - 1.00 76.52 0.15
10/14/94 79.17 2.29 -0 .9 8 74.92 0.15
10/17/94 78.42 1.48 -0 .9 6 74.15 0.18
10/18/94 78.03 1.09 -0 .9 5 72.80 0.19
10/19/94 79.23 2.25 - 1.00 76.97 0.16
10/20/94 79.51 2.51 - 1.00 77.00 0.16
Introduction into the hedging process of the spread between the purchase/sale
prices of DCL bonds (it usually constitutes 0.50% of face value) leads to a depressing
result (see Table 5.4.).
In this case the disbalance at the exercise time of the option is 0.16 or 1600 dol
lars for a single DCL bond. Thus, a trader who used the classical Black-Scholes
hedge in the real market would suffer fairly appreciable material losses.
We give an example of hedging a purchased call option with use of the technique
developed in Chapter 4. There we noted that the presence of a spread between the
purchase and sale price can be reduced to the case of stochastic volatility “squeezed”
in the interval [amin, 0-max]. The results of simulation of the hedging process in this
situation are shown in Table 5.5.
The disbalance of the hedging portfolio is now equal to zero. We mention also
that in this case the (purchase) price of the option at the initial moment of time is
1.89% (or 18900 dollars), while this quantity was 1.60% (or 16000 dollars) in the
Black-Scholes model.
T a b l e 5 .5. Sim ulation o f a minimal hedge for a purchased call

op tion w ith leasing fee and operational costs taken into account.

Date Disbalance
09/20/94 77.13 1.89 -0.63 46.52
09/21/94 76.94 1.73 -0.60 46.55 - 0.02
09/22/94 77.82 2.27 -0 .7 0 46.57 - 0.02
09/23/94 77.83 2.23 -0 .7 0 46.61 -0 .0 4
09/26/94 77.85 2.13 -0.71 52.77 -0.09
09/27/94 77.99 2.18 -0.72 52.81 - 0.11
09/28/94 78.50 2.52 -0 .7 8 52.83 - 0.11
09/29/94 78.88 2.78 -0.82 61.61 -0 .0 7
09/30/94 79.31 3.11 - 0.86 61.64 -0.08
10/03/94 80.24 3.82 -0.93 70.79 - 0.02
10/04/94 80.87 4.38 -0.96 70.81 - 0.02
10/05/94 80.61 4.09 -0.95 70.86 -0 .0 4
10/06/94 80.97 4.41 -0 .9 7 74.18 - 0.02
10/07/94 81.11 4.51 -0 .9 8 74.21 -0 .0 3
10/10/94 81.57 4.87 -0 .9 9 74.30 -0.03
10/11/94 81.96 5.22 - 1.00 76.51 - 0.02
10/12/94 81.47 4.71 - 1.00 76.54 - 0.02
10/13/94 80.28 3.50 -0 .9 8 75.44 - 0.01
10/14/94 79.17 2.39 -0 .9 4 72.07 - 0.01
10/17/94 78.42 1.54 -0 .9 2 70.73 -0 .0 4
10/18/94 78.03 1.14 -0 .9 0 70.79 -0 .0 6
10/19/94 79.23 2.26 - 1.00 76.96 0.00
10/20/94 79.51 2.51 - 1.00 76.99 0.00
Bibliography for Chapter 5
[7], [14], [37], [55], [69], [70], [82], [85], [90], [92], [102], [125], [144], [145], [157],
[158].
CHAPTER 6
Imperfect Forms of Hedging
In this chapter we consider two approaches for solving the problem of imperfect
hedging: mean-variance hedging and quantile hedging. The first approach is char
acterized by the “quality” of the hedging strategy being measured by averaging the
square of the difference between the terminal value and the contingent claim. In the
second approach the probability of the “set of trajectories of asset prices admissible
for hedging” is maximized. In both cases the possibility of loss is preserved, which
makes these forms of hedging “imperfect” .
§6 .1 . Mean-variance hedging
Suppose that an investor with some initial capital (value) x accepts a contingent
claim f r presentable at the exercise time T.
Perfect hedging ensures the possibility of choosing a strategy ir with terminal
value greater (P-a.s.) than the contingent claim / t -
At the same time, this hedging of contingent claims can be so expensive that
the initial value x is insufficient for implementing the strategy n.
In this case one natural solution yields a strategy 7r* with terminal value Xlf
such that
(6.1) E[(/T - X f ) 2] < E[(/T - A?)2]

for any strategy 7r attainable by the investor, with terminal value Xlf.
Of course, the investor prefers to measure his returns in real and not nominal
terms, and therefore the criterion for optimality should be taken to be the condition
and not (6.1), where B t is the discounting factor. If the value of B t is a constant,
then the inequalities ( 6.1 ) and (6.2 ) are equivalent, but this is not true in the general
case.
Such a strategy n* is naturally said to be mean-variance optimal, since the
contingent claim fa is approximated as well as possible in the sense of the distance
in the space L2. We proceed to a precise exposition of this approach.
Let processes B = {B t}tô and S = representing respectively the price
of a nonrisky asset (bank account) and the price of a risky asset (a stock) be given
on a probability base ( f i ,? , F ,P ) with filtration F = o> where t e [0,T] or
t e { 0, 1 ,2 , . . . }. It is assumed that they form a complete (Z?, S)-market, and that
the density process Z t* of the unique martingale measure P* with respect to P is
square integrable.
97
98 CHAPTER 6. IMPERFECT FORMS OF HEDGING
The hedging of a contingent claim fp £ 7p such that
^ € l 2 (J T,P )
Dp
is implemented by means of self-financing strategies 7r with discounted terminal
value Y f = X p/B p belonging to the space L2(9rT ,P ). The set of such strategies
is denoted by SF2 (P ).
We consider the terminal value X p of an arbitrary strategy 7r £ SF2(P ). In
view of the martingale characterization of self-financing strategies (see Chapter 3)
any 7r £ SF2(P ) has a discounted value Y* that is a square-integrable martingale.
Consequently,
(6.3) E P* [Yf] = E p [ Z j r f ] = Y0\
Setting G f = Y ? - y 07r, we get from (6.3) that for any strategy n £ SF2(P)
Ep*[GJ] = E P [ZJGJ] = 0.
Note that for any strategy n £ SF2(P ) the result Gp of using it (gain or loss)
is represented as a random variable orthogonal (in the sense of the inner product
in L2(P )) to the variable Zp.
Further, for any random variable V £ L2( P ,3 t ) orthogonal to Zp we define
X p = Bp(x/Bo + V ). Since the market is complete, there is a strategy 7r £ SF
such that X p = X p (P-a.s.). The discounted value Y * of 7r is a square-integrable
martingale with respect to P*. Then
Xn Xt x
-^ - = ycf = Ep.[r#]=Ep
Bp
and hence Xfi = x.

It follows from the definition of X p that Xp/Bp £ L2(P ), that is, 7r £ SF2(P ).
Thus, for any strategy ir £ SF2(P ) the result Gp of using it belongs to the
subspace Lo(Zp) o f vectors in L2(P ) orthogonal to Z p , and conversely, for any
vector V £ Lo(Zp) there is a strategy n £ SF2(P ) with initial value x such that
G\ = V.
In other words, the space Lo(Zp) represents the set of all results Gp = Yp —Yq
of using the strategies 7r in the family SF2(P ).
We rewrite the condition (6.2) in the form
Considering only the strategies with initial value x and writing
(6.5) h = ÈL~ —
BT Bo
we use (6.4) to reduce the problem (6.2) to the determination of a strategy 7r* £
SF%(P ) corresponding to the condition
(6.6) E [(£ - GJ* )2] < E [(h - G%)2] ,
where h € L 2(P ), and Gj- G L q{Z j) C L 2 (P ).

§6.1. MEAN-VARIANCE HEDGING 99
In a Euclidean space the element of a subspace closest to a given vector is the

projection of this vector on the given subspace, and therefore the strategy n* should
be chosen so that
(6.7) Gt = h -
Z r E P [ ( ^ ) 2] '
Since Gji* G Lq(Z^), it follows from the foregoing that there is a strategy
7r* GSF2(P ) such that
EP [Z*h]
Xn = x and G t = h — Zn e L2( P ).
E p[(^)2]
If we call the quantity
the risk of the strategy 7r, then it is natural for us to choose ir so that this risk is
minimized. It is clear that R depends also on the initial value x.
Therefore, it is natural to consider the problem of finding a pair (x *, 7r*) such
that for any strategy n G SF2(P ) and for some initial value x G R
7r(*) \ 2-
R (x\ n * ) = E P = i?(x,7T),
= «*, X £ = x.
As was shown, for any initial value x there is a strategy tt*(x ) G SF2(P ) such
that for any other strategy 7r G SF2(P ) with the same initial value
R (x )n*(x)) ^ i?(a:, 7r(x)).
Consequently, to find an optimal initial value it suffices to minimize the quantity

r(x) = R (x i7r*(x)).
We remark that
r(x) = Ep
[(/T
[/ E p [Z*Th\ \ 21 _ (E p [^ K ])2
= Ep
IV ^T E p [{Z})*]J \ EP [(Z tf] '
Using the definition of h in ( 6.6) and (6.7), we get that
2
( 6. 8) r(x) = 1 1( e p h 7 *
E p [(^ )2 ] 1 T T^t
DJ'
2
.._ .1 1( e p . f r
E p [ ( ^ ) 2] 1 Bt
It is clear that the minimum of ( 6.8) is equal to zero and is attained for
h
(6.9) B0 Ep*
BTy
which coincides with the price of the contingent claim for perfect hedging, and in
particular, if dBt = B tr d t, then x* = e“ rTEp *[/ t ]-
dBt = rB t dt, B0 = 1,
dSt = dt + adwt), So > 0,
where r ,// G R+, 0 < <r (the volatility), and w = (wt)tô is a standard Wiener
process generating the filtration F (see (3.19)).
As was shown, this (B, 5 )-market is a complete no-arbitrage market, and the
density of the martingale measure P* with respect to the initial measure P is
represented by the process
,* _ d P t fJL—r fJL —r
■Wt
dPt a
Suppose that an investor is faced with the problem of hedging a contingent

claim at the time T with payment function f r € L 2 (P ); since Bt is deterministic,
this is equivalent to the requirement that E L 2(P ).
If we assume that fa is a constant, then the solution of the problem posed
follows immediately from (6.7) and the Kolmogorov-Ito formula. Indeed,
. Î ^ Ep [Z^h] Z*T \
( 6. 10)
T TE
EPp [(
[ (^^ ) )22]
] ^
'V E P [{Z^Y\,) '
E P m y }
from which, using the Kolmogorov-Ito formula, we get that

2
dGl = h
E№ )*
p {^~~dWt + ) dt)
Z*t I* ~ r Bt d S±
= h
Ep [{ZD*} <t2 St "Bt
Since
G f = Y f - Y 0 = i \ f d § -,
Jo Bt
we have
z; at-rBt
( 6. 11) 7Î = h :
Ep[(^t*)2] St
Further, it follows from (6.11) and (6.10) that
„,JT* _ /"or* \ T Bt
% = { n - G t ) — 5- 7T .
Let / t = (St — K ) + be a standard European option to buy. Then we get

from (6.7) that
. ( (ST - K ) + Zf. ( ST - K ) +
(6.12) G*T Ep. -x .
\ Bt E p [ ( ^ ) 2] Bt
Since Co = Ep* [Bt 1{St — K )+ ] is the cost of the option in the Black-Scholes
model, we get by adding and subtracting Co on the right-hand side of ( 6.12 ) that
(6.13)
bt ~ 7 ' v~u Ep [(^t )2L
Note that the first term of the sum in (6.13) is the stochastic integral
[ T c-. jSt (ST

((S t - KK))+
+ \
Jo ltdB r { — ih ------Co>
where 7 is the investment strategy in the Black-Scholes model.
As in the case of (6.10), the second term of the sum in (6.13) can be represented
in the form
L ^ dWt = (C° ~ x) ( 2 _ E p [(Z f )2] ) ’

where (analogous to ( 6. 1 1 ))
l i - T Bt
It = (C0 - x)
E p [ ( ^ ) a] St '
Setting 7 ^* = 7 * + 7 i, we get that
Gf = Jo
f tit
[ 7td§ -= Jo
Jo
[
and hence the optimality of the strategy 7 ^ .
It is not hard to interpret the result obtained. The strategy 7 ^* has two
components: one operates according to the Black-Scholes strategy and replicates
the contingent claim P-a.s.; the other minimizes the (possible) deficiency of the
initial value x.
The formula (6.9) representing the optimal initial value shows that the value
x = Co is optimal, and in this case 7 1 = 0, that is, the perfect hedging strategy is
optimal.
The example given enables us to draw a conclusion about the structure of the
mean-variance optimal hedging strategy for an arbitrary contingent claim f r in the
case of a complete market.
Indeed, as follows from Chapter 3, the optimal value (rational cost) of a con
tingent claim f r is
Co = Bo Ep* [B? 1/ t ]-
Correspondingly, we get from (6.7) that
(6.14)
We denote by 7 * the integrand in the representation
(6.15)
which exists and determines a component of the strategy hedging f T (P-a.s.). Next,
defining 7 t by
~ _ C0 - x Zf i i - r Bt
7 t_ B0 E P [(Zt*)2] a 2 St '
we get from (6.14) and (6.15) that
which confirms the optimality of the choice 7 f* = 7 * H- 7 *.

The second component f f f of the optimal strategy 7r* can be obtained from
the balance equation
Xf = B tY f = B t(x + G f ) = Bt ($f J*Ju'dSuj

+ •
It follows immediately from (6.14) that for an initial value x the risk is deter
mined by the formula
( x - C 0)2
Kx) = «(»,*•(*)) = Ep [ ( ^ Ë J (k n ) . S02 Ep[(ZT)2] *
T h e M e rto n m od el.
dBt = r B t dt, Bo = 1,
dSt = St- (/i d t - v dUt ),
where /¿, r E M+, v < 1 , and II = (Ut)tô is a, Poisson process with intensity A > 0
that generates the filtration F.
This (B, 5 )-market is a complete no-arbitrage market, and the density of the
martingale measure P* has the form
jp *
Zï = t f T t = ZtiN) = exp {(A - A*)t + (In A* - In A)II*},
where A* = (fj, —r ) jv is the intensity of 11* with respect to the new measure P*.
We consider a deterministic contingent claim / r . Then it follows from (6.7)
that
<616>
Applying the Kolmogorov-Ito formula to (6.16), we have
and then by (6.16),

Thus, for a deterministic contingent claim fa the optimal strategy n* has the
form
C
ft* _ yn* _ ^ * z l
Pt — xt it g t »
where h is determined by the formula (6.5).

Suppose now that fa = (St — AT)+• Then it follows from (6.7) that
(6.17) G f = IlZ L -± -]- (B p . [ ¿ I -

KBT BqJ EP[(^)2] V p [ b t \ B o)
=(s"c')+(c""i,)(1" Ep [ ( ^ ) 2 )■
As in the case of the preceding model, the first term of the sum in (6.17) is
represented by a stochastic integral
[T* i st ( (St - K )+ \
Jo ---- c“>
where 7 is the investment strategy in the Merton model, and the second term in
(6.17) can be represented in the form
f a i * . L ) ,
where
~ nn x z t- f y - X \ B t
7 t_( ° x ) E p [(2 ? ) 2] ( \v ) S t-
Letting 7 ^ = 7 t + 7 i, we have
rT
G f= / 7 td f + / 7 td§-= l
Jo Jo Jo Mt
from which it follows that the strategy 7 ^* is optimal.

As in the Black-Scholes model, the risk r(x ) of the strategy 7r* for the initial
value x is equal to
2n
(x — C 0)2
f l ( * .,• (* )) = E P [ ( ( * - C 0) j i J ^ )
E P [(Z * )2] *
T h e C o x -R o s s -R u b in s te in m odel.
We consider a model of a discrete market with the price of a nonrisky asset
(Bn)n=ox... and the price of a risky asset (Sn)n=o,i,... determined by the formulas
A R n = Bn — Bn—1 = vBn—1 , B q = 1,
A Sn = Sn — Sn—i = pnSn—\, So > 0,
where (pn)n=i,... is a sequence of independent random variables taking two values

a < b with probabilities p and q = 1 - p.
Setting B t = B n and St = Sn for t G [n,n + 1), we get a standard semi

martingale model for a complete ( jB, S)-market, where the density Z£ of the unique
martingale measure P* is
' k^n '

For a deterministic contingent claim f r we get from (6.7) and the Kolmogorov-
Ito formula that
Z t-i m —r Pk~r \
Gt = / t E
k^T E p l ( Z U ) 2}
Z fe -i (m — r ) ( l + r ) g fc- 1 Sk
= EP[(^_!)2] a2 + m —r Sk-i Bk
k<T
r §** x(” » - T ) ( l + r) B k~i . Sk
= ¿ ^ ( / t - Gk_ i) 2 - o— A -5",
cr2 + m - r 5 fc _i ’
fc<T
and hence
(m — r ) ( l + r ) B fe_ i
<j2 + m - r 5 jt_i ’
For a standard European option to buy and for fx = (St — K )+, we have
(~m* ( fT ______________ %T ( Ep f r ] _ _x_\

T \BT B o) E p [ ( ^ ) 2]V Bt . B q)
= ( ^ - Co)+ (Co -* ) ( l- E p[(Zf)2] ) '

As earlier, GJ* can be represented in the form
G i- = E % A | + E % i f = E 7; A f ,
Bk Bk
k^T k<T k^T
where 7 is the investment strategy in the Cox-Ross-Rubinstein model, and 7 is the
strategy determined by the formula
z k -1 ~ 0 ( 1 + r) B k_ 1
7 k = (C 0 - x)
E P [ ( ^ _ x ) 2] a2 + m —r 5 fc_ r
Thus, the optimal strategy 7 t* can be represented in the form 7 * = 7 t + 7 t» and
the risk of the strategy 7r* for initial value x is equal to
(x - Co )2
E p [ ( ^ ) 2] '
§ 6 . 2 . Q uantile hedging
Together with mean-variance hedging we consider one more form of imperfect

hedging in which the hedging is implemented with probability less than 1. In this
case there are two forms of problems when either the hedging probability is given
and it is necessary to minimize the value of a minimal hedge, or a constraint on
the initial value of a minimal hedge is given and it is necessary to maximize the
hedging probability.
§ 6.2. QUANTILE HEDGING 105
Thus, the problem of'hedging in this formulation is methodologically connected

with problems of statistical confidence estimation. One of the main concepts in the
general theory of estimation is the concept of quantile, that is, the boundary of
the domain of estimation with a specific probability. The method of hedging with
probability less than 1 has thus come to be called “quantile” hedging.
Let us consider the Black-Scholes model (3.19). We recall that an admissible
strategy is defined to be a self-financing strategy ixt = (Pu7t) with value
%t —ptBt + 7 tSt
such that X f ^ 0 for all t ^ 0.

We denote the discounted value of a portfolio by Yt = Y * = X */ B t. Then the
Kolmogorov-Ito formula gives us that (see Chapter 3 for details)
(6.18) dYt = <t>t d W f, Y0 = X £ ,
where <j>t = a^tSt/Bt and W f = Wt + is a standard Wiener process with

respect to the measure P*.
As earlier, by a contingent claim with exercise time T we mean a nonnegative
T^-measurable random variable / .
The successful hedging set of a claim / for a strategy n with initial value x is
defined to be
(6.19) A = A {x, 7r, f ) = { uj : X f ( x ) > f } = {u>: YT(x) ^ f/ B T}-
The theory of perfect hedging enables one to find a hedging strategy with initial
value X q = W f /Bt and P (A ) = 1. What if an investor responsible according to
the claim / is not in a position to invest the initial value X q necessary for perfect
hedging? The following problem arises naturally for him:
• among all admissible strategies, choose a strategy minimizing the risk of losses
associated with exercising the claim / ,
• or, among all admissible strategies, choose a strategy maximizing the probabil
ity that the value X j, of the portfolio at the time of exercising the contingent
claim is not less than the payment according to this contingent claim, that is,
(6.20) P (A (x , 7r, / ) ) —►max
under the budget constraint
(6.21) x ^ x0 < E *f/ B T = X q,
where x q is the initial capital the investor has at his disposition.

The relations (6.20)-(6.21) represent a mathematical formulation of the prob
lem of quantile hedging, which is our object of study in this section.
Lemma 6.1. Let A € ¿Ft be a solution of the problem
( 6 .22) P (A ) —> max,

(6.23) E *f/ B T - I a ^ x .
Then a perfect hedge n with initial value x for the contingent claim f = f •IA is a
solution of the problem ( 6.20) - ( 6.2 1 ), and the successful hedging set A = A ( x , tt, f )
coincides with A.
P r o o f . 1 . We consider an arbitrary admissible strategy n with initial value

x < E *f /Bt = X q. It follows from (6.18) that its discounted value
(6.24) = x + f <t>s d w :
Jo
is a nonnegative (local) martingale with respect to P*, and hence is a supermartin
gale. For the successful hedging set A = A (x, 7r, / ) we get that
Yt ^ / /Bt *I a (P-a.s.),
therefore,
x = E*YT > E * (f/ B T - I A\
and thus the condition (6.23) holds.
Moreover, in view of ( 6.22 ) we have for A that P(-A) ^ P (A).
2 . Suppose now that the strategy n is a perfect hedge for the contingent claim
/ •I a with initial value satisfying the inequality
E *(f/ B T - I A) ^ x ,
where x is determined from (6.2 1 ). We show that the strategy n is optimal for the
problem (6.20)-(6.21). To do this we note first of all that, since
* i s dw ; > E '{ f / B r •IA) + f is dw : = E * (f/ B r •Ix \Jt) > 0,

Jo
the strategy n is admissible.
Let
A = {x+l *adW* > f/BT

be the successful hedging set for 7r in the problem (6.20)-(6.21). Because n is
“perfect” for the contingent claim f •I £, we get that
A 'D {f.I À > f}D A ,
and hence P (A ') ^ P (A ).

3. Using the definition of the sets A! = A, we have from items 1 and 2 that
A — A (P-a.s.). But A is the successful hedging set for the strategy 7?, and therefore
7r is an optimal strategy for the problem ( 6.20) - ( 6.2 1 ).
Thus, if the equivalence (6.20)-(6.21)<=>(6.22)-(6.23) has been proved, then

for constructing the maximal success set it is natural to turn to the Neyman-
Pearson fundamental lemma, which allows us to devise a most powerful test for the
problem of distinguishing between two simple hypotheses under restriction to an
error of the first kind.
Below it will be assumed that the distribution Q* corresponds to the hypothesis
H0 and the distribution P corresponds to the hypothesis H\. Moreover, let a =
E q *</> be the probability of an error of the first kind, and /3 = Ep</> the power of
the test corresponding to the critical function <f. The Neyman-Pearson test having
the structure
dP
> c,
dQ*
(6.25)
dP
< c,
dQ*
is most powerful, that is, maximizes (3 under the condition that the probability of
an error of the first kind does not exceed the given level a. Here c is a constant,
and the value of the critical function (j> (1 or 0) shows which of the hypotheses Hi
or Ho should be accepted.
Let us return to the problem (6.22)-(6.23). We introduce a probability measure
Q* by the relation
dQ* = f f
(6.26)
dP* BT •E *f/B T E* / ‘
Then the restriction (6.23) takes the form
( 6.27) = a.
E *f/ B T
L emma 6.2. The solution of the problem (6.22)-(6.23) is the set
( dP \ ( dP f \
(6.28)
\ dQ* / \ dP* E* / J ’
where c = inf|a : Q* < aj.
The proof follows from the Neyman-Pearson fundamental lemma in view of the
equalities a = E q *</> = Q*(A) and /3 = E p 0 = P (A ) = max.
We get the following theorem from Lemmas 6.1 and 6.2.
T h e o r e m 6.1. An optimal strategy it for the problem (6.20)-(6.21) coincides

with a perfect hedge for the contingent claim f •J j, where the maximal success set
A is defined in (6.28).
R e m a r k 6.1. If Q *(dP/dQ * = c) ± 0, then for the equality a = E q *<f> to

hold for an error of the first kind, it is necessary to use the randomized critical
function 0 , 0 ^ <f) ^ 1 , of the form
. r r ol — Q*(dP/dQ* > c)
<t> = -i{dP /dQ »>c} + 7 ^ {d P /d Q *= c }, 7 = Q * ( d p / d Q * = C) '
In this case the optimal strategy n coincides with a perfect hedge for the contingent
claim / •4 •
R e m a r k 6.2. Q *(dP/dQ * = c) = 0 in the Black-Scholes model by the conti

nuity of the distribution.
T h e dual p rob lem .

Let a number e G (0,1) be fixed. We consider a situation in which the investor
agrees to undertake a certain risk in exercising a contingent claim. Namely, we
shall solve the problem of finding the smallest initial value necessary for exercising
a contingent claim with probability at least 1 —e.
This problem is dual to (6.20) - ( 6.21 ) and can be expressed mathematically in
the form
(6.29) x —> min,

(6.30) P ( A ( x ,i r ,f) ) > 1 - e ,
or, equivalently,
(6.31) E * [ //B T • /* ]-> min,

(6.32) P (A ) ^ 1 - e .
We denote by A = Q, \ A the complement of the set A:
A = { uj : YT(x) < f/ B T}.
Then we can write the problem dual to (6.31)-(6.32) as follows:
(6.33) E *[f/B T - I À\-»m a x ,

(6.34) P (À) ^ e.
By (6.26), we can rewrite (6.33) in the form
E *f/ B T •Q*(A) - max,
and hence the problem (6.33)-(6.34) is equivalent to the relations
(6.35) Q*(A) - max,

(6.36) P (A ) < e.
Thus, the problem (6.29)-(6.30) reduces to finding the critical set A, and this
problem has already been solved. Using the Neyman-Pearson fundamental lemma,
we can show that the solution in this case is (cf. Lemma 6.2 )
, r dQ* 1
A = < uj : — — > a >,
\ dP y
where a = inf js : > ^ e |* ^ ere an strategy in the problem

(6.35)-(6.36) is a perfect hedge for the contingent claim / •/ 4.
We remark also that a perfect hedge for the contingent claim / •I a , where
A = ft \ A, is an optimal strategy in the problem (6.29)-(6.30), which in turn is
dual to the problem (6.35)-(6.36).
Let us now consider the problem of quantile hedging of a standard option to
buy with payment function / = (St —K )+ in the classical Black-Scholes model.
As shown in Chapter 3, the initial value of a perfect hedge in this case is
(6.37) X q = S 0$ ( d + ) - K e ~ rT$ ( d - ) ,
H S o/ K ) + T (r ± a2/2)
where d± = , and $ (x ) is the normal distribution function
ay/T
$ (x ) = — f e x*/2 dx.
V 2 ÏJ -0 0
Assume that the investor has initial capital x with x < X$. By Theorem 6.1, an
optimal strategy in the problem of quantile hedging coincides with a perfect hedge
of the contingent claim / •I a , where the set A has the form
(6.38) = { “ '■S F > const- / } -
Using the fact that the process equal to the density of the martingale measure P*
with respect to P is
dPl
(6'39) M r
we can rewrite (6.38) in the form
(6.40)
A = je x p ^ ^ ^ W J - 1 r ) > con st' (St ~ * 0 + }
={exp(^ (ln5°+(r- y )t + ctW

?))
x- p ( - ^ ( ^ + ( , - ^ ) ) r - i ( i ^ ) V )
> const •(S t — AT)+ |
= { # = e x p ( - i ^ (l»S„ + i t ± l z ^ ) r ) > con,. . (ST - K)+ }.
Here two cases have to be considered separately.

n _ y
1 . Assume that ^ 0 ^ 1 .
a 2.
In Figure 6.1 the shaded region is the solution domain of the inequality in (6.40).
Thus, in this case the set A can be written as follows:
r —a
(6.41) A = {ST < d} = { W,J < b } = \ST < S 0 exp(^
~{l
T + ba
)}
under the restriction
(6.42) E* ( j - . i ^ j = Xo.
We have from (6.41) that
ß -r r
P(i4) = $
VT
F ig u r e 6 .1 . Structure o f the hedging set.
and to find the constant b we have the condition
(6.43) x 0 = E *(e~rTf - I A) = e - rTF Ï(S T),
where >
(N
CM
1
m s r ) = -4 = L ' ( « ■ “ » f ' ' 5' » * 2 T},
V27t
1
J (« ,« * {„ /? „ + 2 t } - K j e - y2/2
x/2^
ln(K/S0) - r- ^ - T
do =
<7s/T
Consequently,
(6.44)
x 0 = Sq * ( * V T - d o ) - $ ( o ^ - ^ j - K e ~ rT
■So $(d+) - $ (<tV f - - ^ ) ] - Ke~rT [$(d- ) - $ ( - -^=) .
We remark that in the case of the dual problem with the constraint P (A) =
1 — £, 0 < e < 1 , we have the equation
fJL — T t
(6.45) b = V r $ - 1( i - e ) +
for finding the constant 6, and the corresponding value of a minimal hedge can be
computed from (6.44).
2 . Assume that ^ 0 > 1 . In this case the set A has the structure
a2
A = { W i b 2}.
The solution of the problem of quantile hedging is given by
'h -
P (A ) = $ + $
. vf ,
F ig u r e 6.2. Structure o f the hedging set.
and for determining the constants b\ and 62 we have the condition
x 0 = E *[e~rTf ■IA] = e - rTF }(S T),
where
I t (St ) = ^ f ( s 0exp{<rVTy+ -r ^ - T ^ e - y 2/ 2dy
+ ^ £ ^ K s° M " V T v + r - ^ l T } ) e~’ ‘/ *dv-
By analogy with the case < 1, we get that
x 0 = 5o ^ d + ) - $ ( c V T - ^ + * ( * V T - ^
-K e
®(d->- * ( - ; ! ) +* (-M
T h e M e rto n m odel.
In the Merton model (3.31) there are two assets:
dBt = rB t dt, Bo = 1,
dSt = St-(/j,dt — I'dllt), So > 0,
where r e R+ , V < 1 , and II = (Ilt)tô is a Poisson process with intensity A > 0.

As shown in Chapter 3, there is a unique martingale measure P* for the dis
counted stock price process St/Bt in this model, and its density with respect to the
initial measure P is
jp *
Z; = = exp((A - A*)f + (In A* - In A)nt),
where A* = is the intensity of lit with respect to P*.

By the Kolmogorov-Ito formula,
St = So e x p ( n t ln(l - v) + f.it).
Using this equality, we can rewrite the density dP^/dPr as

jp *
= ex p (n T(lnA* - In A) + (A - A*)T)
= exp ( ~ n^ l - u ) X ln^ ~ l/) + lnSo + » T )^J
x exp ((A - X*)T + ^ ; : y (- I n So - pT)^j
= exp^(A - A * )T + in (1 _ ° V inSo - /¿ T )).
We consider the situation when the initial value xo of the investor’s capital
is < E *//Bt = X q. By analogy with the case of the Black-Scholes model, the
maximal successful hedging set for a contingent claim / has the structure
A = { § - - >co“ t ! \
where const is chosen so that E * f/ B r ■I a = xo- In our case the set A has the form
(6.46)
In A * - I n A
-{
ST ln<1“ ,/) exp ( - ( A - A*)T + i„ T i
ln(l - v)
+ pT)
) .
> const (St — K ) + j
= {S £ > const •(ST - AT)+ },
In A* - In A
where a = — — ------ * .
ln(l — v)
We consider the following variants for the value of the quantity a.
1. Let a < 1. In this case we have a situation analogous to that in Figure 6.1,
that is, there is a constant b such that the set A can be written as
A = {ST < b) = { n T < d } = {S T < S0 exp(dln(l - v) + pT ) }.
For finding b we have the condition
xo = E*(e-r T / •IA) = E *(e~rT(ST - K ) + •I{S t<b}).
Note that
(ST - K ) + ■I {sT<b} = (S t - K ) + - (ST - b)+ - ( b - K ) - I {ST>b}.
Consequently,
E *(e - rTf •I A) = E *e~rT(ST - K ) + - E * e -rT(5T - b)+

- E * e - rT( b - K ) - I {STz b}
= E*e~rT(ST - K ) + - E * e -rT(ST - b)+

- e~rT(b - K )P * (S T > b).
§6.2. QUANTILE HEDGING 113
Here the first two terms are the costs of standard options to buy with exercise prices
K and fc, respectively, and with exercise time T. According to (3.37),
E * e -rT(5 T - K )+ = S o ^ n o , A*(l - v)T ) - K e~ rT^ {n 0, X*T),

E *e~rT(ST - b)+ = A*(l - v)T ) - be~rT'S>(ni,\*T),
where the constants no and ni are determined from the relations
InK/So —¡iT ln6/5o - /¿T"

no = , ni =
ln(l - v) ln(l - u)
and the function ’¡'(x, y) is Y ^ = x e y Cf •

For the third term we have
p *(ST > b ) = P * (n T ^ d) = £ e " A*T .
2 . Suppose that a > 1 . We have a situation analogous to that in Figure 6.2 .

Thus, the set A has the structure
A = {S t < bi} U {S t > £>2 } = {H r < d\} U {H r > ¿ 2 },
where bi = So exp(di ln(l — v) + /xT) ,¿ = 1,2.

The constants b\ and b2 are found as in the preceding case, with use of the
relation
/ •I a = (St - AT)+ *I{ST<bi}u{sT>b2}

= (S t — AT)+ — (S t — î)+ + (S t — b2) *
- (61 - K ) •I{ST>bx} + (&2 - K ) •I{ST^b2}-
T h e ju m p -diffu sion m odel.

In this model we consider three assets
dBt = rB t dt) B0 = 1 ,
dS} = S\_(^ dt + <t* dWt - cfllt), So > 0. i = 1>2-
Here r 6 M+ are constants, a1 > 0, i/* < 1, W = (W t)t>o is a Wiener process,

and n = (n t)^ o is a Poisson process with intensity A > 0 and is independent of W .
In the case o 2v 1 - a l v2 ^ 0 there is a unique martingale measure P* for the
discounted stock price processes (S}/Bt)t ^0 and (St/Bt)tô> and its density has
the form
(6.47) Z*t = ^ = e x p jW t ~ Y t + (X ~ y ) t + n ‘ (lnA* " lnA )} ’
where
^ (m2 - r )v 1 - (n1 - r )v 2 1, _ (m1 - r)a 2 - (n2 - r )a l
<t>~ a V i - a 1!/2 ’ “ aW -vW
Furthermore, W * = Wt - <t>t is a Wiener process with respect to the measure P*,
and n t is a Poisson process with intensity A*.
We next consider a European contingent claim on one of the assets, say S 1:
/ = (S1 - K ) + .
Using the Kolmogorov-Ito formula, we have
Sj. = So e x p ( ( V - + o 1W t + n T ln(l - x/1) ) .
Let 'ip = X*/\ — 1. Then for the density process in (6.47),
® = exp|^W r - ( y + A^ ) T + Ut ln( ! + 4>)}
= exp| £ (in Si + a 1W T + (/x 1 - T + n T In(l - v 1) ) )
x e x p j - ^ l n 5 i - ± ( m1 - (i- + A
+n^ o ^ w }
= ■Ci ■C ? T,
where C\ and C 2 denote the corresponding expressions.

In our case the critical set A has the form
A = {(S ^ . ) - ^ 1 > const •Ci ■C ? T •/ } .
Since W* and II are independent with respect to P*,
E *(e~rTf - I A) = j t E *(e_r27 • r=n) •P * (n T = » ).

71=0 .
As in the case of the previous model we must treat separately two cases.
1 . Let —(p/cr1 ^ 1. For a fixed n € N,
/ •IA\nT=n = (s$. - K ) + - № - b(n))+ - (b(n) - K ) . I{3 1 ^ (w)},
where b(n) is a constant depending only on n.

Consequently,
E *(e~rTf ■IA\nT=n) = E *e~rT{S\ - K ) + - E *e~rT(S^ - b(n))+

- e~rT(b(n) - K )P *(S ^ > b(n)).
Moreover,
P * ( « r > b(n)) = P *(W T > d(n)) = * ( - — y T).
where b(n) = Sq exp^crld(n) + ^/j,1 — + n ln (l — .

Introducing the notation
T+
U (x ,y ) = E*e-rT (£ T
) t + x ln (l
2
§ 6.2 . QUANTILE HEDGING 115
we have
oo
(6.48) E *(e~rTf - I a ) = Y 1 E *(e~rTf ■IA,nT=n) •P*(IIT = n)
n=0
= g e- A * T ( A j r _ u {n b{n))
n—0
- e~rT(b(n) - K ) •P *(5 t- ^ b(n ))}.
The constants b(n) are found by solving the equation
x -M * 1 = Cl •C2
n •const •(x - K )+
for x. We then sum over n in (6.48), and to find the unknown const we have the
condition E*(e-rT / •I a ) = x q .
2 . Suppose that —0 / a 1 > 1. In this case the critical set has the structure
A\nT=n = {S t < h ( n ) } U {S t > b2(n )}.
Thus,
/ •l a |nx=n = (S i - K ) + - (S i - 6i(n ))+ + (S i - b2(n))+

- (&l(n) - K) ■ + (&2(n) - K) ■I{S^b2(n)}-
The unknown constants &i(n) and b2 (n) are then found as in the first case.
T h e ju m p -diffu sion m od el o f an in com p lete m arket.

Let us consider the following model of an incomplete market with two assets:
dBt = rB t dt, B 0 = 1,
dSt = S t-ifid t + ad W t - v d n t), So > 0.
Here, as before, fi, r e E+, v < 1, W — (W t)tô is a Wiener process, and n =

(n t)tô is a Poisson process with intensity A.
In this case there is a set 7 = {p*> of martingale measures, whose densities
with respect to the initial measure P are determined by
(6.49) ^ = expj#Vt- ( y + ^ ) i + ntln(l + V0},
where <f) and V> are connected by the relation
H- r + - z/A(l + ^ ) = 0.
With respect to each such measure, W f = Wt — <l>t is a Wiener process, and n is a

Poisson process with intensity A* = A(1 + VO-
By the Kolmogorov-Ito formula,
St = S0 exp f (fi — —■'j T + <tW t + IIt ln(l - v) J .

Then for the density dP^/dPr we can write
= exp| ^ ^ln So + o W t + “ ~2^)T + n T ln (l - i/)^j |
x exp|-^ InSo - (p - Y + y + A ^)r + nT In
= s p * ■Ci •C2n r .
Thus, the critical set in this case has the form
A = {S t H ° > Ci ■C ? T •const •/ }
and by analogy with the preceding model we must consider two cases.
1. Suppose that —<f>/cr ^ 1. For a fixed n € N the critical set has the form
A\nT=n = {St < b{n)},

where b(n) is a constant depending only on n.
Consequently,
E *(e-r T / •JX|nT=n) = E *e~rT(ST - K ) + - E *e~rT(ST - b(n))+

- e~rT{b{n) - K ) •P *{ST ^ b{n)).
We have
p *{ST > 6(n)) = P *(W T > d(n)) = $ ( - d(n^ / r ),
where the constants b(n) and d(n) are connected by the relation
b(n) = So exp âd(n) + T + n ln(l — .
Let
U (x ,y ) = E*e rT 5 0 exp^ crW r+ y ^ T + x ln (l - -y
Then
E*(e-rT/ •IA) = £ E*(e~rTf •I{A\nT=n}) •P*(nT = n)

n=0
—\*T (A*T)n
= D n!
71=0
x .{U (n ,K ) - U (n,b(n)) - e~rT(b(n) — K ) ■P *(St > b(n))}.
The constants b(n) are found by solving the equation
x - 4>/a = C\ ■C% ■const •(x — K ) +
for x. Then the unknown const is found by maximizing the probability of the suc
cessful hedging set over the family T = {P * } of all martingale measures determined
in (6.49):
P (A ) = P
W l^ > C
°nSt'/) max
P*€T
§6.2. QUANTILE HEDGING 117
under the constraint
E *(f/ B T ■I a ) < xo for a11 p * € 9.
2. Let —<j>/a > 1. By analogy with the preceding model we have
A|nT=n = {S t < h ( n ) } U {ST > b2(n )},
and hence
/ •/A|nr =n = (S t - K ) + - (S t - h ( n ) ) + + (ST - 62(n))+

- (b\{n) - K ) •IiSrZbxin)} + (h (n ) - K ) •I{s T>b2(n)}-
The constants &i(n) and b2(n) are found by a procedure analogous to the first case.
The C ox-R oss-R ubinstein model.

Let us consider the discrete-market model (3.44):
A B n = rB n- i ) B0 = 1 ,
ASn = pnSn—1 >
where (pn)i^n^N is a sequence of independent random variables taking two values
a < b with probabilities p and q = 1 —p.
As noted in Chapter 3, this model of a market is complete. The density of the
initial measure with respect to the martingale measure can be represented in the
form
dPN _ ( p \ ^ ( i - p \ n ~A n
d,p*N \p*j \ i - p *J
where p* = ------, A n = Si H------- h 5n , and (Sn)i^ n^N is a sequence of independent

b CL
identically distributed random variables such that
Pi = a + (b — a)5i for all 1 ^ i ^ N.
Of course, here
Pn
“ {« ^ ■S” ” { o
and 7 n = a(p1, . . . , p n) =
We note that the stock price can be represented with the help of A n in the
form
N / 1 h\ AN
SN = S0 j [ ( l + pk) = So(l + a)N \ ^ f i-J .
Thus, the critical set A can be written as
■Hf w >~•WKir-'H.
where C\ and C2 are positive constants.
Consequently, two cases must be distinguished.

1+6
1. Suppose that p < In this case A can be represented in the form
l + r?
(Figure 6.3)
A = {S N < h} = { A N < d } = {S 0(l + a)N~d( 1 + b)d < h}.
The condition
(6.50) E * (f/ B N - I A) = x0
can be used for finding the constant h.

We have the relation
(S n - K ) + ■I {s N<h} = (SN - K ) + - (SN - h)+ - (h - K )■ I{SN>h}.
Thus, (6.50) can be rewritten in the form
£ (N
k ) (P* )*(! - P*)N~k [(*5o(l + a)w" fc(l + b)k - K ) +
- (S0(l + a)N- k(l + b)k - h ) +
-(h -K )- /{s0(i+o)w-«'(i+6)fc^fe}] ~ *<>(1 + r)N•
2. Let p > zr— P*- In this case A has the form (Figure 6.4):
1+ r
A = { S n < h\} U { S n > ^2} = { A n < d i } U { A n > ¿ 2})
where hi = S0(l + a)N di (1 + b)di,< = 1,2.

Since
/ • / a = (SN - * 0 + " {S n - + (SN - /i2)+

- (/li - K ) •I{SN^h!} + (6-2 - K ) •I{SN^h2}i
F ig u r e 6 .4. Structure o f the hedging set.
we get the following expression for determ ining the constants hi, i — 1 , 2:
N
E ( fc) - P*)N~k [(S°(l + + b)k ~ K )+
— (So(l + cl)n fc(l + b)k —/ii)+ + (jSo(1 + o,)N fc(l + b)k —/12)
- (hi - K ) •/{S o(l+ a )"-fc(l+&)fc>/ii}
+ ( h2 - K ) •i { 5 o ( l + a ) ^ - fc(l+ 6 )fc^ /i2}] “ Xo ( l + r ) N .
Quantile hedging and value at risk (VaR).

Quantile hedging can be regarded as a dynamic version of the well-known con
cept of risk management VaR. Just as in the dual problem of quantile hedging, a
certain given constant e with 0 < e < 1 is assumed in it, and the quantity VaR
is defined as the maximum possible size of decrease of the value of the portfolio
(in percent of the initial value) on the time interval [0, T] for the given probability
1 —e:
VaR = in f{s : P (ln (X J /X0) < - s ) = 1 - e }.
We remark that in view of the fact that the VaR strategy is static, that is, does
not change in correspondence with movements of the stock price, the initial value
of the VaR strategy turns out to be greater than the initial value necessary for
constructing the corresponding quantile hedging strategy.
[25], [46], [47], [51], [56]-[58], [71], [84], [93], [97], [101], [108], [114], [126],
[139], [141], [148].
CHAPTER 7
Dynamic Contingent Claims

and American Options
We study contingent claims that are random processes adapted to the price dy
namics of the underlying assets of a financial market. This dynamic character of the
contingent claims under consideration “changes the dimension” of the correspond
ing calculations, since along with the value of a hedging portfolio it presupposes
the determination of a (random) moment of time for presenting the claim for pay
ment. It is shown that an adequate solution of these problems can be attained in
the framework of a study of the class of problems on optimal stopping of random
processes.
§7.1. Pricing dynamic contingent claims

and the optimal stopping problem
As in § 3.1 and § 4.1, we consider a semimartingale (15,5)-market given on some

stochastic base (ii,5F, F ,P ).
A dynamic contingent claim with last exercise date T < oo is defined to be any
nonnegative optional random process f = (/t)o<t^T-
A strategy with consumption (7r, C) is called a hedging strategy for / (or a
hedge for / ) on [0, T] if
(7.1) X ? ’c > f t
for any t ^ T (P-a.s.). We remark that the inequality (7.1) is preserved if a stopping
time r £ M q is taken instead of t.
A minimal hedge is defined to be a hedging strategy (7r*, C*) such that
x f ' c ' < X ? ’c
for any other hedge (tt, C) and any t ^ T (P-a.s.). The initial value of a minimal
hedge, if there is a minimal hedge, is denoted by C J.(/) and called the (upper) price
of the contingent claim / .
The mathematical problem of the calculations under consideration here consists
in finding the price C£,(/) and a minimal hedging strategy (7r*, C*).
A somewhat different terminology is usually used in finance in the solution
of this problem. We introduce the concept of an American option as a derivative
security with term of validity [0,T] giving the holder the right to present it at
any moment of time r ^ T and receive a payment in the amount f T. The time
r is unknown beforehand. It is determined on the basis of the current market
information F, and hence is a stopping time with respect to F. In view of the obvious
dualism between dynamic contingent claims and American options, this problem
121
122 CHAPTER 7. DYNAMIC CONTINGENT CLAIMS
admits the equivalent formulation of finding the price C ^ (/) and a minimal hedge
(n*,C*) for an American option with payment function f = (ft)t^T-
The general methodology for solving this problem consists essentially in the
following.
On a ( B ,5 )-market we consider a dynamic contingent claim / such that
(7.2) sup E B ~ l f T < oo.

PeM(s/£,P)
Under the condition (7.2) the nonnegative process
Yt = esssup E ( B ^ f T |J t)
reMT,P€M(s/B,p)
is well defined and is a nonnegative supermartingale according to (2.24).

The optional decomposition (2.23) gives us the possibility of representing Y in
the form
(7.3) Yt = Yo + f o < d { ^ ) u ~ D t
with a predictable process 7 U and with an optional nondecreasing process D*.

By Theorem 4.1, the supermartingale Y is the discounted value of some strategy
with consumption whose structure is determined from the relation (7.3). Denoting
by (7T*, C*) the strategy with consumption found, we can see at once (see the proof
of Theorem 4.2) that this is also a minimal hedge, and
(7.4) C*T( f ) = sup E B ~ xf T,

P€M(S/B,P),t€M%
(7.5) x f'c'= x ;= esssup E (B ~ 1f T \^t),
P€M(S/B,P),t€MT
(7.6) B^Xt = C*T( f ) + j f 7: d ( § ) - j f B - 1 dC*.
The formulas (7.4)-(7.6) obtained determine a general methodology for (su

per) hedging American options.
We reproduce the above in greater detail for the Black-Scholes model (3.19).
In this case M (S/B, P ) consists of a unique martingale measure P* with density Z*
(see (3.21)).
It was noted above that in calculating an American option it is necessary to
find both its price and its exercise time. Here the following remark is appropriate.
R e m a r k . Assume that an American option with payment function / = ( f t ) t ^ r

was purchased at the price C ^ (/), and is exercised at a time r G M q when the
value of the hedging strategy X * 'c strictly exceeds f r with positive probability.
The irrationality of this behavior on the market is clear, because for the initial
value C J ( /) one should use the strategy (7r, C) at once. This yields (with the same
positive probability) a net gain equal to X * 'c —f T in comparison with the purchase
of the option.
§7.1. PRICING DYNAMIC CONTINGENT CLAIMS 123
F ig u r e 7.1. A rational (r * ) and an irrational ( r ) exercise tim e.
The foregoing justifies the following definition (Figure 7.1).

An exercise time r* is called rational if for any admissible strategy (7r, C) with
initial value X q ,c = C ^ (/) the inequality X *lc ^ f T* (P-a.s.) implies the equality
X *lc = f T, (P-a.s.).
T h e o r e m 7.1. Suppose that on the (B , S)-market (3.19) a dynamic contingent

claim f = (ft)t^T is given such that
(7.7) sup E *e~rTf T < oo.

tem 'S
Then there exists a minimal hedging strategy (7r*, C*) = (/?*,7 *, C*) with consump
tion■, determined by the relations
(7.8) C*T( f ) = sup E*e_rr/ r ,
(7.9) X; = x f'c*= esssu pE *(e-r<T-*>/T |* t),
(7.10) e~rtX ; = C*T( f ) + f < d(e~ruSu) - f e~ru dC*u,

Jo Jo
x t-Y tS t
P i- ¡rt •
The stopping time t * € M q is rational if and only if
(7.11) Q . ( / ) = E * e -rT7 r * .
Farther,
(7.12) t* = inf{t < T : X*t > f t }
if A ft ^ 0 for all t ^ T and the family |e f tgivIq1 ^ uniformly integrable.
P r o o f . T he relations (7.8)-(7.10) follow from (7.4)-(7.6), since the con d ition

(7.7) ensures that (7.2) holds.
Further, if r* is a rational exercise time, then the difference c = C ^ (/) —
E *e~rT*f T* is nonnegative. We define the nonnegative supermartingale
F* = c + E* (e~rr*f T* |T f).
By Theorem 3.1, Yt = e~rtX ^ ,c for some strategy ( 7r,C ) with consumption, and
X q ,c = Yo = C ^ (/). Further, the “rationality” of r* implies that
X\r;c = erT*YT* = f T* + cer r * = X ^ c + cer r * .
Hence, c = 0 and (7.11) holds.

Using (7.11), we now prove that r* is a rational stopping time. Let us consider a
strategy (71, C) with consumption such that X q 'c = C ^ (/) and X *lc ^ f T*. Then
in view of the supermartingale property of the discounted value of this strategy we
get that
C*T( f ) = X * ’c > E*e~rT'X ? :c > E*e-rT* /r. = C*T( f ) ,
and hence X * i° = f T*.
To prove (7.12) we establish first that for e > 0
(7.13) E *e~tT' f Te > C W ) - e ,
where t £ = inf{t : f t > X t* — e}.

The inequality (7.13) can be proved using the following arguments. By the
definition of the least upper bound, there is a sequence of stopping times an € M q
such that E *e~rCnf an f ( / ) as n Î oo. Further, from the chain of obvious
relations
E*e ranfan — E*e r<TnfanI{on<Tc} + E e °nfanI{<Tn^T€}

< E*e~r<rn(X *n - e ) + W e - ™ » X * J {un>Tc}
< E*e~ranX * n — eP*{crn < re}
< C r (/) - eP*{(Tn < t£}
and the definition of (<rn)nî it follows that P*{trn < Tn} —»■0 as n f oo.
We define r„ = an A t£ and note that for any n > 1
(7.14) E*e~rTnf Tn = E * e -r° " f aJ {an^ } + E*e~rT‘ f TJ {„ n>Te}

> E*e~r^ f c + E *e-rT'X*T'I {an>Te) - e
> + E * e - r^ X ; j {an>Ti} - e
^ E*e Tr*nfanI{an^Tc} + E e nf<rnI{crn>Te} —£
= E * e - Ta" f o n - e .
From (7.14),
(7.15)
E*e-rT‘ fT'= E * e - rT’'fTnI{re<*n} + V * e- rT‘ freI{re><,n}
= E*e~TTnfTn - E * e - " n/ TnJ{T. ><rn} + E * e -" '/rt/ {Tl>M
> E*e— " / CTn- £ - E * e - ^ f TnI{Tt><rn}.
We get (7.13) from (7.15) by passing to the limit as n | oo and using the
uniform integrability of {err/ r}Tgjv[J ■
Assume now that en | 0 (n f oo) and r„ = re„ f r, where f is some stopping
time with f < r*. Since A / t ^ 0, it follows that fc > limn_oo /?„• Then
sup E *e~rTf T = C*T(f) < limsupE*e_rfn/ ?ri < E*e“ rf/r

§7.1. PRICING DYNAMIC CONTINGENT CLAIMS 125
by Fatou’s lemma and the condition of uniform integrability in Theorem 7.1. Hence,
C y ( /) = E *e~rTfry and the equality X~ = / ? follows from the fact that X~ ^ /V.
Then the definition of the stopping time r* implies that r = r*, so X** = f r* and
r* is rational.
Theorem 7.1 is proved.
It should be noted that the assertion in the theorem about the existence of
a rational stopping time is untrue in general without the indicated conditions of
uniform integrability and nonnegativity of the jumps A f t .
Theorem 7.1 reduces the problem of finding the price C ^ (/) and exercise time
r* of an American option with payment function / to the extremal problem (7.8),
(7.12), which is called an optimal stopping problem.
The essence of this problem is to find, for the nonnegative random process
(X t)tô on (ii,3 r,F ,P ), the supremum supr EATr and an optimal stopping time r*
at which this supremum is attained.
One of the interesting and effective approaches to the solution is to find another
random process (Yt)tô such that
(7.16) X t = g {Y t)M u
where g is a function with a unique maximum, and (M t)tô is a nonnegative mar

tingale with Mo = 1.
If a representation (7.16) has been found, then X t = g(Yt)M t < g(y*)M ti where
y* = Argmax y g (y )i and for any stopping time r
(7.17) E X T ^ g(y*)-
The representation (7.16) and the inequality (7.17) lead to a natural determination
of the stopping time,
r* = i n f { t : Yt ^ y*}.
The optimality of r* for continuous processes in this problem follows from the
equalities
E X T* — Eg(YT*)M T*I{T*< 00} — g(y )E.MT*.Z{T*<00j — g(y ).
Let us use this approach in the framework of the Black-Scholes model (3.19) to
calculate the price of an American option (to buy), regarded on the infinite time
interval [0,oo).
To simplify the computations we assume that the rate of yield fi and the interest
rate r coincide. Consequently, the martingale measure P* coincides with the orig
inal probability P , and the dynamic behavior of the stock prices St is determined
by the formula
(7.18) St = e x p j ( r - + <rWtj , 5 0 = 1.
Let the payment function of the option be ft = e~6t(St —AT)+ , where the constants
AT, S are > 0. According to Theorem 7.1,
C to( / ) = sup E e~XT( S r - K ) + ,

re m §°
where A = r + 5.
The martingale M t in the decomposition (7.16) will be found in the form

e~xtS*, a > 0. Applying the Kolmogorov-Ito formula to e~xtS* and using (7.18)
and the martingale property of this product, we get that
{«a ?
(7.19)
'“ ( r " £ ) " * ’
and thus
Further,
Pit = exp jacrW t -
■I
t!
e - xt(St - K ) + = (St - K ) + S t aPIt = g(St)PIt,

where g(y) = ( y - K ) +y a .
OL
Direct calculations show that g(y) has a unique maximum point y* = —— -K>
and g(y*) = ( a - l ) “ 1 K l' a.

To prove the optimality of the stopping time r* = inf{t : St = y*} it suffices
to show that
EMT*/{T*<oo}
dQ
Denote by Q the measure with local density — = M t. With respect to this
measure, Wt = Wt — aat is a Wiener process.

We get from (7.18) that with respect to the measure Q the drift log5 t is equal
to
<72 2 2( 2A (r 1 \ 2 \ 1/2
r - - + c a = v + j >0,
and Q (r* < oo) = 1 and P (r* < oo) = 1 because logy* > 0.
As a result we arrive at the following formulas for the price and exercise time
of this option:
C « ( e - 5t(5 t - K ) + ) = (a - l ) -1 ( ^ ) ^ 1_° .
where a is defined by (7.19).
§ 7.2. Concretization of option calculations and

closed analytic formulas for prices and strategies
The concept of a dual martingale measure turns out to be useful for many prac
tical calculations of options. Namely, let P be a probability measure on (fi, J, F, P )
such that: ^
1) P and P are mutually equivalent;
2) the process (B t/St)o<^t^T is a local martingale with respect to P.
§7.2. CONCRETIZATION OF OPTION CALCULATIONS 127
It can be shown that the local density of the measure P with respect to P is
r —¡i + a2 {r —n + a2)2
Zt = exp Wt -
2^2“
and
r —fi + a2
Wt = W t -
is a Wiener process with respect to P. We remark also that the local density of P
with respect to the martingale measure P* defined in (3.21) is
-rt
(7.20) ( ,- ,,+ £ )< ) = | ,
Making a change of probability measures, we arrive at the following analogue of

Theorem 4.1. This analogue gives a dual representation for a minimal hedging
portfolio and the exercise time of the option.
T heorem 7.2. Suppose that on a (B, S)-market (3.19) a dynamic contingent

claim f = is given such that
- fT
(7.21) sup E < oo.
re Mg’
Then there exists a minimal hedging strategy (5?, C) = (/3,7 , C ) with consumption,
given by
(7.22) C t ( / ) = S0 sup E F ,
(7.23) x t = X ? ’d = St ess sup E ( A I Y

reM f 1 /
(7.24) f = C t ( / ) + f p u d i |^) -
Jo \ / Jo
~ X t - ptert
(7.25) 11 = Q
The stopping time r £ M q is rational if and only if
(7.26) Cr ( / ) = S o E j j . .
Furthermore,
(7.27) f = i n f { t ^ T : X t > f t}
if A ft ^ 0 for all t ^ T and the family {fr/ S T} Te^T is uniformly integrable.
Using (7.20), we find that
Cr(/) = S0 sup E ^ = sup E*e_rr/ T = C^(/).

reMg1 reM j
We present some concrete examples of calculating American options in which
it is possible to get an exact analytic solution.
Let 7 i < 72 be the roots of the equation
T 72“ ( T +r) 1_A = 0'

T h e o r e m 7.3. The fair (rational) price C ^ ( f ) of an American option with
payment function f t = e~xt(St —K ) * and exercise times with values in the interval
[0, oo) is given by the formula
(7.28) № J Gf)V w ' * > r ’

{ l-K x p , V» < “0*.
where
7i
r =
K {7 1 -1 )'
The rational exercise time of the option is
t* = inf { i ^ 0 : < v»*}>
where 'fit =
St
T h e o r e m 7 .4. The fair ( rational) price C^c ( / ) of an American option with
payment function ft = e ^ ( K —St)* and exercise times with values in the interval
[0, oo) is given by the formula
(7.29) C ^ (/) = 5 0( ( t ) { K r ~V ’
{ K i > - 1, x/j ^ if)*,
where
= ___ 2 * _ r
K { 72 - 1) '
The rational exercise time o f the option is
T* = in f{i > 0 : xpt >
where xpt =
St
p a y Z T ^ t i l n 5 ' Tke fair {rati° nal) PHCe
ft = e _At (aSt -
l e i t e n b y t L 'f o m v L * > ° ' ^ eXerctSe Umes with values in the interval [0,oo)
{
a —'fioi
, _ a
(7i V>72 - 72^71) -------- ~ ^ , ,»
V’o>V’ ,
where the boundary value xp* is the solution o f the equation
xjP2( l - — - = x l> ^ (j _ J _
V 72 W ^ ^ <a-
t* = in f{i ^ 0 : ipt ^ </>*},
where ^
^ t = s~t ' e ~Xt { aSt - min Su, s 0V>o]) •
T heorem 7 .6. The fair (rational) price C £<>(/) of an American option with
payment function
ft = e“ At(m ax[m axS,tl)soV>o] - aSt) + ,
a > 0, 1 ^ ipo < oo, r + A > 0, and exercise times with values in the interval [0, oo)
is given by the formula
{
i >o tb0 > xb**,
( /72 /*y. \ r*-a
M » --ft* ^ < r .,
where the boundary value is the solution o f the equation
t* = in f{i > 0 :xpt ^ -0**},

where ^
= -gt ■e~At (max [max Su, so-0o] - aStJ .
T heorem 7 .7. The fair (rational) price C £q( / ) of an American option with
payment function
(7.32) ft = c At du + (s 0V>o)T\ i/n
•)
r + A > 0, and exercise times with values in the interval [0, oo) is given by the
formula
i’o, V’o ^
(7.33) < £ ,( /) = 4
u(xp)
where the function u(ip) admits an integral representation
u{i>) = y e x p ^ - J ^ ^ j / - ^ - i ( i + yxl>n)y* dy
with 7 i < 72 the roots of the equation
<J2 2 2 ( 0-2 \
T n 7 _ \ 2 + r ) n j ~ A = 0*
and xp is determined from the relation
u(ip) = tpu'iip).
t * = inf{i > 0 : ^ V’}.

where
1/n
(7.34)
T h e o r e m 7.8. The fair (rational) price CI d f ) of an American option with

payment function
—l / n
(7.35) ft = e~xt ( / 4 r du +
r + A > 0, and exercise times with values in the interval [0, +oo) is given by the
following formulas.
I. If one of the conditions
1) A < 0,
2 ) A = 0, r ^ a 2/2,
3) 0 < A < ^ ( i + ^ , r > ^ / 2
holds, then C ^ / ) = 0.
II. If r < ct2/2 , then
V’o, tpo < ip,

CU(f) = So-{ fj)
m(ip0), V’o ^ V ’,
. m(V>)
where the function m(ip) admits an integral representation depending on the value
of the parameter A:
!) i f ^ < 7 f ( 1 + “ l ) ’ then
m(ip) = a;”72 J e x p ^ ^ 2 ^ f72_1(l - t )-7 1 dt,
where 71 and 72 are the roots of the equation
(7.36) Y »V - ( y + + A = 0;
2) t f A = y ( 1 + “ l ) ’ then
m(ip) = x n72 J e x p ^ ^ 2 ^ i " (^ + ^)_1( l - f ) _ n(? f + 5) dt;
3) f / A > y ( l + ^ ) , ifcen
»»W = Jo exp ( ^ 2 ) i7_1(1 “
where 7 and 7 are i/ie complex roots o f the equation (7.36).

Here the constant 0 is determined from the relation
ra(0) = 0
The rational exercise time o f the option is
r* = inf{t ^ 0 : 0t ^ 0 } ,
where
—l/n
R e m a r k . We remark that
(7.37) max j^max Su> soV’oj i
(7.38) min[mm,Su,soV’o]
as n —►oo, where the “limit” payment functions define a Russian option to sell and
buy, respectively. In the case n = 1 we get from (7.19) an integral option.
We present the basic ideas of the proofs o f these theorems by using^Theorem 7.7
as an example. First of all, note that with respect to the measure P the process
ip = (V>t)t>o defined in (7.34) is a Markov diffusion process satisfying the following
stochastic differential equation:
dipt = dt + a dWt) H----- dt.

nipt
Using Theorem 7.2 on a characterization of a minimal hedging portfolio, we arrive
at the standard problem on optimal stopping of the diffusion process ip = (ipt)tô-
€ £ , ( / ) = -So sup E e XripT.

TÔO
According to the general theory for solving such problems, an optimal time r* has
the structure _
t * = inf{t ^ 0 : 0t ^ 0 } ,
where 0 is a constant. _
We let F (0 ) = supr E e -Ar0 r and assume that the function V (0 ) is sufficiently
smooth (for example, in the class C 2(M+)). According to the general theory, the
equation
(7.39) L F (0 ) = XV W
must hold in the region C = { 0 : 0* < 0 } of “continuing the observations” , where
r ( 1 \ J <J2 /2 d2
L~\ r + mpny dip + 2 ^ dip2
is the generating operator of the process 0.
The general solution of (7.22) will be found in the form
V(ip) = x n71 (Cl Af (a, b, z) + C2U(a, b, z) ) ,

where a = —71, b = 1 - 71 + 72, 2 = —¿—z— , 7i < 72 are the roots of the equation
nza zx n
yn 27 2 - ^ y + r)rvy - X = 0,
Ci, C 2 are unknown constants, and M (a ,b ,z) and U(a, 6, z) are so-called Kummer
functions of confluent type. They have the integral representations
M(aM = n a n b - a ) l » P W i l - « ) 4—
1 r°°
U (a,b,z) = — - / e x p ( - 2 i)ta -1 (l + t)b~a~1 dt.
M a) Jo
In this case the constant Ci is 0, since otherwise V (0 ) —> 00 as 0 —* 0, which

can be excluded, because according to the meaning of the problem the solution of
interest to us must be bounded. _
Thus, we have, two unknown parameters C 2 = C and 0 , and the following
conditions jire used to determine them:
1) U (0) = 0 , which means that on the boundary separating the regions of
“continuing” and “stopping” the observations the gain from continuing the
observations coincides with the gain from stopping them;
2) V 'fy ) = 1, or the “smooth pasting” condition on the boundary separating
the regions.
Under these two additional conditions the solution of the above problem is given
by the formula (7.23) in Theorem 7.2. Of course, we must still prove that the
solution found coincides with C £o(/). To this end it suffices to prove the following
two properties:
A l) for any finite (P-a.s.) Markov time r
E e-ATe-ArVv <
(that is, CJo < V(ip));

A2) the time r* = inf{f ^ 0 : tpt ^ is finite P-a.s., and
E e - AT> r. = V(ip).
These assertions can be proved by applying the Kolmogorov-Ito formula to the

process ( e - xtV (i)t))tô-
§ 7.3. Quantile hedging of dynamic contingent claims
In this section we show how quantile hedging is realized in its dynamic variant
for American options in the framework of the Black-Scholes model (3.19).
Let S F (xo) denote the set of self-financing admissible strategies 7r = (/?, 7) with
initial value xo > 0. According to (3.2), (3.20)-(3.21), for any such strategy we
have
(7.40) Yt« = ^ - = x 0 + J % u d ( ^ ) = x 0 + J * a u d W :, 0,
S ( ^
where a t = and
= Wt + ---------- t is a Wiener process with respect to
■LJt &
the unique martingale measure P* with density
(, 41)
It is necessary to find the function
(7.42) U (xo) = sup P {Y ? > 1},

r€M(T),7rG5F(æ0)
where M (T) = { r G Mg0 : E r < T } , 0 < x o < 1, and to find a stopping time
r* G M (T) and a strategy ir* G S F (x o) for which the supremum in (7.42) is
attained.
The financial interpretation of this problem amounts to obtaining a discounted
value exceeding a given level at the exercise time r* of the option.
We remark that the “unitness” of the contingent claim in (7.42) does not involve
a loss of generality, in view of the following considerations.
If g is a (discounted) contingent claim (go = 1 for simplicity), then in the
framework of the “coordinate” Black-Scholes model (3.19) (see Chapter 2 ) it can
be represented in the form
Hence, {Y * ^ gT} = {# 0+ Sl(<t>u—(t>u) dW* ^ 1}, and the problem reduces to (7.42)
with (j)u replaced by (¡>u —
The basic result with regard to the problem (7.42) is the following.
T heorem 7 .9. There exist constants a and b such that xo < a < 1 < b ,
(7.43) u (* o) = o — a ,
(7.44) T * = i n i { t :Z ;< £ ( a ,b ) } ,
where
S t\ ~ ^ / M -r , 2
* - G a,) H 5 r
The optimal portfolio n* = (/?*, 7 *) has the structure
= ab(p - r)B t V 7T
(7.45)
7t (b — a )e 2Z%St ’
The constants a and b can be expressed in terms o f the original parameters of the
model:
x0 _ 1 -X o
(7.46)
I -/? ’ ß
where /3 is the unique solution o f the equation
(7.47) U E lZ Ï \ 2T = { 1 - /?) In ^ + /3 In - f —
2 y O J Xq 1 Xq
P roof A predictable function (¡>t{^) will be called an xo-admissible strategy if

x0 + /0 a s dW* > 0 (a.s.) for all t ^ 0. We denote the corresponding set by A (x 0),
and by the definition of S F (x 0) we get from (7.42) that
(7.48) U (x o )= sup p ( x0 + f as dW *^ 1
TeM(T),4>eA(x0) l Jo
Further, we introduce for a stopping time r £ M (T ) the following class of sets:
A ( x 0, t ) = ^ A & 9 t - . A = £ : v + J^ <ps dW*s > 1
for some v £ [0, xo] and some </>£ A (v)
For a set A £ 9> we have the equivalence
(7.49) A £ A (x ,t) P *(A ) ^ xq.
The implication (=>) follows from the Chebyshev inequality in view of the super
martingale property of the process v + Jjj <f>s dW
p*(A) = p *jt; +£ <t>sdw; > i } < E*{t, + jf
To verify the converse implication (<=) in (7.49) we consider the nonnegative mar
tingale mt = P *(A |ST*) and observe that
mt (¡>sdW:
for some predictable </> (martingale representation).

Further, mT = I a = v + f j </>s dW* with v = P*(A) ^ Xo, and hence A £
A(xo, t ) .
It is clear that the relation (7.49) enables us to give the problem (7.42) the
form
(7.50) U (x0) = sup P (A ), P*(A ) ^ x0.

r€ M (T ), AeA(xo,r)
It is natural to approach (7.50) like the Wald problem of sequential distinction
between two simple hypotheses about the mean value of a Wiener process:
H0 : dCt = ^— 1 dt + dWt, Co = 0,
a
H x : dQ = dWu Co = 0,
in which A is the critical set for the hypothesis Ho, Xo is the probability of an error
of the first kind, and P (A ) is the power of the sequential test.
def
Let A = InZ. According to the general theory of sequential analysis, the
“region of continuing the observations” in the problem (7.50) has the following
structure.
There are numbers a and b with a < 0 O : \ t i (a, 6 ) }
for “stopping the observations” and with critical set A has the form
_ i I» A<r* ^
(7.52) Ia
t 0) A«y* ^ a,
and the probability of an error of the first kind is equal to x. The indicated rule is
optimal in the sense that for any other rule with time r
Er* ^ E f .
We turn to the problem of finding the thresholds a, b and the mathematical

expectation Er* of the duration of the observations. For this we need some auxiliary
assertions.
L e m m a 7.1. For the decision rule (7.51)-(7.52)
P (r* < oo) = P*(r* < oo) = 1.
P r o o f . W e define the stopping times
cn = i » f { t > 0 ; J f ■n.
r )!
Then
At*Aan =
Jo ° 2 Jo <T2
and
CL ^ \T*Aan ^ 6.
Consequently,
i"r*A<Tn fit - r l2 ~
^ 2 } d t ^ 2 (b d ) < OO,
■ /
and by passing to the limit as n —►oo, we get that
rr * ( M - r ) 2
E dt < 2(6 — a) < oo.
Jo
Since
f T (n - r )2 /,°° { f X - r f (m - r )2
E l 2 ’ d t > E I{T dt and f ° ° it— dt = oo,
0 <** Jo °
we conclude that P ( r * < o o) = 1.
n -- ff in _ r')^
Similarly, noting that Xt = ---------- W f + v ; we prove the equality
o 2crd
P * (r * < oo) = 1.
R e m a r k . A s a consequence o f the above argum ents we get that the random

variable Ar * takes only the tw o values a and b.
ea(eb — 1) .
L e m m a 7 .2 . P*CA) = zr- is the probability of an error of the first kind,
1 — ed e e
and 1 — P(^4) = —----- - is the probability of an error of the second kind.
eb _ ea
P r o o f . Let a (x ) and (3(x) b e the solutions o f the differential equations
a " (x ) + a '(x) = 0, (3” (x) + (3'(x) = 0
satisfying the bou n d ary con ditions
a(a) = 1, a(b) = 0, (3(a) = 0, (3(b) = 1.
We show that
P*(A) = a(0), P (A ) = U(x) = (3(0).
We have
ea(eb- x - 1) e" - eu
a (x ) = ß {x ) =
eb _ ea
On the other hand, by the Kolmogorov-Ito formula,

t * A<rn
p/»T A Cn i , — tp
(7.53) a (\ T*A<rn) = a(0) + j a'(A t) dWt*
+ \ f AanK (A t) + a"(At) ] ^ ^ dt
pT A<7n _
= a (0 )+ / Oif(Xt) - ----- dWt*.
Jo G
Consequently, since
E* f (a '(\ t) —— dt < n sup [a'(x)]2 < oo,

Jo \ G ) a<x<b
we have
pr A<rn it — r
E* /
«'(A t) —— d w ; = o.
jo ^
Taking the expectation with respect to P* of both sides of (7.53), we get that
E*(a(AT*ACTn)) = a(0). By the dominated convergence theorem, E*(a(AT*)) = u(0)
results when we pass to the limit as n —> oo. On the other hand, by the remark
after Lemma 7.1,
E*a(AT*) = 1 •P*(Ar* = a) + 0 •P*(Ar* = b ) = P *(A).
It can be proved similarly that
1 - P (A) = 1 - P(AT* = a) = P(Ar* = b ) = /3(0).
L e m m a 7 .3 . The expectation of the duration of observations is
F . _ 2er2 _ 2a2 ((eb-

(V - l ) l( f)(b-d)
e -S )
(7.54)
(p -r )2 (m - î’)2 1 ee b&_ -ee a
5 J‘
P r o o f . Denote by g(x) the solution of the differential equation
/ ( * ) - £ '( * ) = - 2
with boundary condition

g(b) = g (a) = 0.
Direct computations show that
(eb — ex)(b — a)
9(x) -b + x
= 2{-
Applying the Kolmogorov-Ito formula to the process g(\T*AcXii), we see that
rr*A"» ( / x - r ) 2
Eg(\T*Aan) — g(0) + E f dt.
Jo
Consequently, passing to the limit as n —►oo, we get that
R e m a r k . According to Lemma 7.2, xo — — ----- zr~ • Let ¡3 = —----- r • Then

p6 _ pO>
we can rewrite (7.54) in the form
I t z l l Er- = * ? -- ‘ >+ Sj1 - et>_ ( i - g ) h i ^ + № *

Xo 1 — Xq
Let us proceed to the search for an optimal strategy in the problem (7.50). We
have shown that the critical set A on which the hypothesis Ho is rejected has the
structure
A = {u :Z ;*{u > ) = a}
with optimal time
r* = inf{t ^ 0 : ^ (a, 6)}
for stopping the observations, where a = ea and b = eb. Since the terminal value of
the optimal strategy is YT*(u) = /¿(u ;), the value of the strategy at a time t with
0 ^ t < r* is
y; = E*[iA \?t) = p * (z ;* = a \ ?t).
It follows from the properties of the filtration and the Markov property of the
process Zt that the conditional probability in the last equality must be found in
the form
(7.55) P * ( z ;. = a \ ? t ) = <Kz;AT.).
According to the “telescope” property of conditional expectations, 4>(ZtAT*) is a

martingale with respect to the measure P*; therefore, use of the Kolmogorov-Ito
formula necessarily leads to the differential equation
^(¡>"{z)z + 4>'(z) = 0
in the function <f)(z) with boundary conditions 0(a) = 1 and 0(6) = 0. Solving this,
we get
On the other hand, it follows from the definition of self-financing strategies that
(7.56)
Applying the Kolmogorov-Ito formula to the process 0, we get from (7.55)-(7.56)

that
and we arrive at the expression (7.45) for the number of shares and the number of
units in the bank account in an optimal portfolio.
R e m a r k . We compare the mean time Er* defined in (7.44) for stopping the
observations with the mean time E f corresponding to the optimal decision rule with
fixed observation time t(xo,(3) needed for distinguishing between the hypotheses
about the mean value of a Wiener process with the use of the Neyman-Pearson
most powerful classical rule. Suppose that the probabilities of errors of the first
and second kinds do not exceed xo and /3, respectively. The Neyman-Pearson
optimal test proposes an answer on the finite time interval t(x o,/3) in the form of
the critical set
where h(xo,P) is determined from the equality P *(A) = xq. It can be shown that
where C7 is the root of the equation
Thus, for given xq and /3 we get from (7.47) that

Er* _ u (x 0,ß )
t(x 0,ß
t(XQ, ß) (CX0+ C ß) 2 ’
1 —y y
where u)(x, y) = (1 — y ) In ----- - + j/ln -------. Moreover, if Xq = B, then
x 1 —x
Er* _ 1 U>(Xq, Xq) __ 1
soJ.0 t(x 0, x 0) 2 *o.lo C lQ 4'
[19], [46], [51], [87], [90], [96], [98], [126], [132], [142], [143], [155], [156],
[158], [162].
CHAPTER 8
Analysis of “Bond” Contingent Claims
Bonds are a significant part of the financial market. This chapter is devoted to
an analysis of the structure of bond prices, or the term structure of interest rates,
and to the pricing of contingent claims on these markets.
§ 8.1. Models of the term structure of interest rates
A bond is a security issued by a government of other issuer, with an obligation to

pay a certain sum (the face value) to the owner at the expiration of the established
time T until maturity.
During the period before a bond matures, intermediate payments can be made,
called coupon payments or simply coupons. Correspondingly, bonds are divided
into zero-coupon (discount) bonds and bonds with coupon payments.
Let us consider a (£ , P ) -market consisting of a bank account B and zero-coupon
bonds P (T ) with different redemption dates T. The value at time t of a unit of the
bank account and the value of a bond with redemption date T ^ t are denoted by
B t and P t(T )y respectively. We assume that the face value Pt {T ) of the bond is
equal to 1 and the prices of the zero-coupon (discount) bonds satisfy the relation
0 < Pt(T) ^ 1 in view of the no-arbitrage requirement.
Since the bonds have to be redeemed by the issuer at a fixed price, the investor
receives a deterministic return at the time of redemption of a bond, the amount
being determined by the price Pt(T) for acquiring the bond. Prom this viewpoint,
bonds can be regarded as nonrisky assets.
At the same time, the price Pt(T) of the bond can vary on the time interval
(£, T), and an investor selling it on this time interval does not know the amount of
return (or loss). This feature makes investing in bonds and the associated contin
gent claims risky, and gives rise to problems of hedging and investment on a bond
market.
The interest rate structure or evolution of bond prices can often be represented
in the form
exP (/o a (s , T) dMa)

( 8. 1) Pt (T) = P0(T )B (t)
E P. [ex p (/0* cr(s, T) dMs)] ’
where M t is a random process with independent increments, and B (t) describes the
dynamics of the spot market,1 that is, it characterizes the movement of the bank
1The spot market, in this case, is the market of very “short” funds, when resources are
made available for a period of at most 24 hours, like overnight credit, when funds of European
financial instruments are made available in credit to far-Asian banks for playing the stock markets
of Singapore and Tokyo in the course of a night while the European markets are closed.
139
www.Ebook777.com
140 CHAPTER 8. ANALYSIS OF “BOND” CONTINGENT CLAIMS
account and (or) other nonrisky assets. The exact form of B (t) is determined by
the boundary condition Pt(t) = 1.
From the practical point of view, the formula (8.1) asserts that the dynamic
behavior of the bond market is determined by the movement of the spot market
B (t)y and “on the average” the resources invested in bonds must bring a return
according to how the price of the nonrisky assets has changed. At the same time,
if the resources are put into bonds whose redemption period has not yet expired,
then the bond prices (and hence also the return) can deviate from the movement
of the spot market, which is taken into account in the second factor
ex P (/o ff(s>T) dMs)

( 8. 2)
E P. [exp(/0* o {s, T) dMa)]
of the formula (8.1).

The structure (8.2) is determined by the following: the factor cannot be neg
ative or zero, the bond prices must “remember” the past, and deviations from
the movement of the spot market must not allow arbitrage opportunities. Con
sequently, the factor must be represented in the form exp (X t(T ))C (t,T )) where
C (tyT) = Ep* [exp(Xt(T ))]_1, and P* is a certain measure equivalent to the orig
inal measure. Among the different processes X t(T) an integral form seems conve
nient that gives the possibility of constructing processes “remembering” the past
but having independent increments.
The amount of possible deviation of bond prices from the movement of the
spot market is determined both by the properties of the process M and by the
“volatility” cr(s,£). In each concrete case we must impose on the process M , the
function a, and the process B (t) restrictions of a technical nature that render the
model noncontradictory and make it possible to use stochastic integrals and other
methods of stochastic analysis.
The H o-Lee model.

The Ho-Lee model has both a discrete and a continuous form which is a special
case of a more general model of Heath, Jarrow, and Morton. In both cases the
main distinguishing feature of the model is the form of the function cr, which is
represented as a linear function a (s yt) = 8(t — s) of the time left before the bond
is redeemed. In the discrete case t = 0 ,1 ,... we should set
where £ = (£*)* is a sequence of independent identically distributed random vari

ables taking the values 0 and 1 with probabilities p and 1 - p, respectively.
Specifying a measure P* equivalent to the original one and substituting in the
formula (8.1) the explicit expressions for M t and cr(s,T), we get that
§8.1. MODELS OF THE TERM STRUCTURE OF INTEREST RATES 141
Note that
Pt (T) _ P t.^ T ) exp(<J(T - t)6 )
(8.3)
B (t) B (t-1 ) p*+ (l-p * )e x p (ô (T -t))
_ Pt-i(T)
h(t,T,Çt),
B ( t - 1)
where h(t, T , £t) = exp(<5(T —f)£t) (p* + (1 —p*) exp(<5(T —t))) 1 is often called the
perturbation function.
In view of the condition Pt (t) = 1 and the property h (t,t,£ ) = 1, we get from
(8.3) that
B i t r ^ P t ^ B i t - 1 ) - 1,
and hence
(8.4) B (t) - B ( t - l ) P t - i ( i ) - 1, B (t) =

2=1
The expression (8.4) reflects the essence of the spot market, when money is
invested for a short time with a fixed return. Indeed, investing a sum V at time
t — 1 in a bond with redemption date £, the investor receives a deterministic return
in the amount
Pt(t)
V
Investing the sum V in this way at time 0 and continuing the process by investing
resources at each moment of time t only in bonds with redemption date t + 1 , which
yield a fixed (nonrisky) return at the next moment of time, the investor will have
the capital
T
X T = V ' [ [ P i- 1( i ) - 1 = V B (T )
2=1
at the time T. This allows us to interpret the factor B (t) as the value of a unit of
the nonrisky asset (bank account) at the time t.
Thus, we get an explicit formula for the price of the bond P (T ) at the time t :
n e v -w *
2=1
(8.5) Pt(T) = P o ( T ) n ^ - i W _1-
2=1
n ( p * + ( i - p * ) * (r - <))
2=1
which depends on the structure of the bond prices {P o(t)}t^ i at the initial moment
of time and the dynamics of the stochastic sequence £ = {£t}tî* where 0 = exp(i).
The deficiencies of the Ho-Lee model stem from the unnecessary simplicity of
the function cr(s,t). For large values of £, when the central limit theorem begins
to “operate” in view of the linearity of <r(s, T ), there is a “disappearance” of ran
domness. This property is clearly evident in Figure 8.1, which is constructed on
the basis of selecting random numbers. Formally, we get by using the formula (8.5)
that
Po(T) p* + ( 1 - p * ) ^ - *
Pt{T) = exp ( ¿ ( T - i ) 5 ^ Î i ) J J
Po(t) p* + (1 - p*)dT~i ‘
\ 2=1 ' 2=1
F ig u r e 8 .1. Example of the interest rate structure for the Ho-Lee

model.
Hence, for sufficiently large t the value Pt(T) will be determined by a random factor
of the order 0\Ap*(1_p*), which decreases as t increases.
On the basis of the above arguments we can construct a very broad spectrum of
discrete models using the structure of the formula (8.1). For example, employing a
simple autoregression scheme with cr(s, t) = S(T—t)I[T -t^ K } along with a sequence
£ — {& }t> i ° f independent standard normal variables, we get a model lacking the
deficiency indicated above.
Moreover, we can construct not only single-factor but also multifactor discrete
models of the. interest rate structure, when the price dynamics is determined by
formulas of the kind
expCEtiQ^.IT)# + •••+ <r"(t,T)ff))

Pt(T) = Po(T)B (t)
Ep* [e x p (£ j=1(ffl(*»r )$i1 + •••+ an(i,T )t f))} '
The independence of the elements of the sequence £ = {£t}t^l actually ensures

the absence of arbitrage in these models, because with respect to the measure P*
the discounted price
Pt{T) p m exp(E *=ig (z ,T )& )

Pt(T) =
B (t) ° E P. [exp(X)-=i <r(i, T)& )]
of the bond is a martingale.
T h e H e a th -J a r r o w -M o r to n m odel.
This model is constructed on the basis of the forward interest rates /t(T ), when
under the assumption that Pt(T) is continuously differentiable with respect to T
the structure of the function is given by the expression
(8-6) Pt(T) = e x p ( - £ f t (s)d s
The quantity /t(T ) is the interest rate at the time t for loans over the “future”
infinitesimal interval from T to T + d T . In other words, this is the rate with respect
§ 8 .1. MODELS OF THE TERM STRUCTURE OF INTEREST RATES 143
to which a forward agreement can be concluded at the time t concerning a loan on

the interval [T,T + dT].2
We define ft(T ) by the structural formula
(8.7) f t(T) = fo (T ) + f Vs(T) ds + f Ss(T) dws,

Jo Jo
where w = {wt)tô is a standard Brownian motion. Under certain additional as
sumptions about the processes a and <j , assumptions ensuring the existence of
iterated integrals and the validity of Fubini’s theorem for random processes, it can
be shown that Pt(T) is a solution of the stochastic differential equation
dPt(T) = Pt(T) [(r(t) + bt (T)) dt + at (T) dwt],

where
= at{T) = - £ 5t (s)d s, bt(T) = - j \ t ( s ) d s + ^ a t (T )2.
Assuming the existence of a solution 7 t(T) of the equation
at(T)Ct(T) = - b t(T),
we get that
dPt (T) = Pt(T) [r(i) dt + at (T) dwt] .
Here Wt = Wt — Ct(T) is a Wiener process with respect to the measure P* with
density
dZt(T) = e x p j ^ Cs(T)dws Cs(U2 d«|-
Setting B (t) = e x p r(t) d t), we arrive at a multiplicative representation of

Pt(T) in terms of the stochastic exponential £:
(8.8) Pt(T) = P o(T )B (t) e t (^J as(T ) dw .'j.
The process B (t) can be interpreted as the value of a unit of the bank account
at the moment of time t. The discounted value of the price Pt(T) has the form
P t(T ) = ^ = Po(T) £ as(T) dws^j,
and hence is a martingale with respect to the measure P*. If the values of the
process 7 t(T) do not depend on the value of T, then the discounted price of an
arbitrary bond is a martingale with respect to P*, and this (B, P)-market is a
no-arbitrage market.
On the other hand, defining by
exp(/o* as(T) dws)

(8.9) Pt(T) = P0(T )B (t)
E P. [exp(/0* as(T) dws)]
the price process Pt(T) from the start with the help of (8.1) for a bond with
redemption date T, where w is a Wiener process with respect to a measure P*
2That is, a contract can be concluded at the time t, where a rate R t = /t (T ) is stipulated
for which one of the parties agrees to extend credit to the other party on the interval [T, T + dT).
equivalent to the initial measure P , we get a model of the interest rate structure.
In view of the martingale property and the positivity of the factor
exp(Jp* as(T) dws)

E P. [exp(/0* as(T) cftus)]
the equality (8.9) can be written in the form
Pt(T) = P0(T )B (t) e x p ( —^ as{T )2 ds + j f as(T) dws^J
= P0(T )B (t) ¿ t ( y as(T) dw^J,
which coincides with (8.8). The boundary condition Pt(t) = 1 makes it possible to
define B (t) by the formula
B (t) = P0( r l e x p Q J ° S(t)2 ds - J <rs(t) dw ^j.
Various special cases of the Heath-Jarrow-Morton model are obtained in de

pendence on the specific form of the function at(T ) in (8.9) or 5t(T) in (8.7). For
example, for
at(T) = d (T — t) or, equivalently, St (T) = d
we get a diffusion analogue of the Ho-Lee model, while for
at (T) = - (1 - e - ^ T~t)) or 8t{T) = a e - a(T- t)

a
we get a diffusion analogue of the Bachelier model
Just as in the discrete case, the Heath-Jarrow-Morton model can be made
a multifactor model. For example, in place of the equality (8.7) we can give the
dynamics of the forward rates by the expression
f t(T) = f 0( T ) + / % s(T )d s + £ f 6 l(T )d w l

Jo ¡ r j Jo
where w = (w\, . . . , w™)t^>o is a multidimensional Wiener process with respect to P.

In the subsequent exposition we use the one-dimensional case of the Heath-Jarrow-
Morton model in order to facilitate the reading of the text, although most of the
results can be formulated also in the multidimensional case with the appropriate
refinements.
§ 8.2. H edgin g on a b o n d m arket
One can consider various forms of derivative securities on a bond market, and
this leads to the problem of hedging the corresponding contingent claims.
We show how contingent claims should be calculated on a bond market. If on
a given (H,P)-market there is a unique martingale measure P*, then the cost Co
of a contingent claim f c presented for exercise at the time T must be equal to
Co = Ep*[P(£) 1/ t ] •
§8.2. HEDGING ON A BOND MARKET 145
But if there is a family Q = M (P ) of martingale measures, then we should calculate

the ask and bid prices for a contingent claim /y :
C* = sup e q [ B ( i ) - 7 r ] , c„ = inf E q [ B ( i ) - 7 r ] •
QeQ
At the same time, we must determine not only the price of an arbitrary con
tingent claim on the given market, but also a corresponding hedging strategy which
enables us to hedge or even replicate fa-
A basic feature of this market is the presence of a large (often infinite) number
of bonds, including bonds with a redemption date less than T. Correspondingly,
resources can be invested in these bonds only on the interval up to the moment of
redemption.
The general theory of bond markets assumes the possibility of investing re
sources simultaneously in all bonds existing at the given time on the market. This
circumstance requires a definition of an integral for processes taking values in some
function space when the investment strategy forms a pair (/?, 7 ) = (/?*, where
fit is the number of units in the bank account in the portfolio, and 7 t(ds) is a mea
sure on [t, T ] determining the number of bonds with redemption dates S G [£, T] in
which resources are invested at the time t.
In the present exposition we deal with a situation in which the portfolio can
contain only a finite number of bonds at one time. This means that for any t the
distribution of 7 t(ds) is concentrated at a finite number of points.
A portfolio at time t is defined to be a pair (/?t,7 t), where fit is the number
of units of a bank account at time t, and 7 t = (7 t( 5 't1) , .. . , 7 t( 5 ^ ) ) is a vector
determining the number of bonds with redemption dates S'*1, . . . , SJ1* contained in
the portfolio at the time t.
An investment strategy n is defined to be a pair (/?, 7 ) = {(/?t, 7 t)}tô of pro
cesses representing a portfolio at each moment of time t.
The value X * of a strategy 7r at the time t is defined to be the quantity
x ^ = ptB (t) + ^ t( s i ) p t(si).

2=1
An investment strategy n is said to be self-financing if:

a) (in the case of discrete time)
nt
A X ? = 0tA B (t) + A Pt(Sl),
i= 1
where A P t(Si) = Pt(S|) - P t-i(5|);

b) (in the case of continuous time)
nt
d x ? = A dB(t) + 7t(s i) dPt(si),
2=1
where it is convenient to understand the differential dPt (Si) as if the pa

rameter SI were fixed.3
3Such a definition is due to our trying to avoid complexities connected with an exposition
of the theory of integration with respect to a measure-valued process. Anyone wishing to master
this technique can turn to the paper [22].
H edgin g in th e H o -L e e m odel.
Let us consider the problem of hedging a contingent claim in a model of a
discrete bond market when the price dynamics is determined by the equations
(8.3)—(8-5):
B (t) = n Pt(T) = P0( r ) B ( t ) - e^p ^ ^ l(r ~ ^ ^ ,

*=i Ep*[exp((S£‘=i(r -i)& )]
where & is a sequence of independent identically distributed random variables tak
ing the values 0 and 1 with probabilities p and 1 —p, respectively.
Suppose that an investor takes as investment objects only a bank account B
and a bond P (T X) with (fixed) redemption date T 1. Then at each moment of time
t E [0, T 1] his portfolio is determined by the pair (P tm iT 1)) indicating the number
of units in the bank account and the number of bonds with redemption date T 1
contained in the portfolio on the interval (t - 1,£]. The capital V n of the investor
at the time t is given by
V ? = ptB {t) + l t {T l )Pt{T l ).
A strategy ir = is said to be self-financing if
A X ? = V ? - V fh = Pt A B (t) + 7t(T1) A P t(T l ).
The ( P ,P ( T 1))-market obtained in this way consists of two assets in all, and
in this sense does not differ from a (B, 5)-market. Obviously, P* is a martingale
measure for this market. By using the methodology for finding martingale measures
it is not hard to show that P* is the unique martingale measure equivalent to P.
Consequently, the (B, P (T 1))-market is a complete and no-arbitrage market.
For an arbitrary contingent claim f r exercised at a time T < T 1 and measurable
with respect to the cr-algebra f r = &(&, i ^ T ) there exists a self-financing strategy
7r* such that
X f = fr (P-a.s.), C = X f = E P* [B(t)~ V T].
It is clear that f r can be taken to be any other bond with redemption date
T 2 > T. The random variable P t (T 2) is fr-measurable, and the rational price of
a contingent claim with payment function Pt {T 2) is equal to
C = X f = E p . [ B ( T ) - V t ] = E p . [ B i T r 'P r i T 2)].
In view of the martingale property of discounted bond prices, the rational price
of such a contingent claim is
C = E p .f B C T ^ i H T 2)] = P0(T 2).
Since the discounted value of a self-financing strategy ir is a martingale with respect

to the measure P*, we can write
Y** = P t o - 'x f = EP. [B(T)-V t |? t]

= E P. [ B i T ^ P r i T 2) |i t] = B {t)~ l Pt{T2).
Thus, the hedging of a contingent claim with payment function Pt {T 2) reduces

to the equality X f* = Pt(T2) for any time t e [0,T].
§ 8 .2 . HEDGING ON A BOND MARKET 147
Further, the equality
A 17* = ^ ( T 1) A (B (t)~ 1Pt(T 1))
holds for a self-financing strategy n*. Therefore, using the formula (8.5), we get
that
P t-i(T 2) p* + ( l - p * ) 6 Tl- t 6MT2- t ) - p * - ( i - p*)0T*-t
7t 1 ’ Pt-iiT1) ' p* + (l-p*)0T2-t ' QMT'-t) - p* - ( 1 - p*)0T'-t >
where the last factor, aside from dependence on the value of £t, is equal to
0T2- ‘ - 1
ffr '-t _ 1 '
Consequently, 7 t(T 1) is an Tt^-measurable function and takes the value
x _ P t - !( T 2) p* + ( l - p * ) 0 Tl~t
nK ' P t-iiT 1) p* + (1 - p*)0T2- t ' 0(r1—t) _ ! •
The quantity P* can be obtained from the balance equation
x t - i = P t-i(T 2) = $ B { t - 1) + 7 ?(T 1)Pt(T 1).
The strategy 7r* constructed is such that for any t € [0,T] its value X f coin
cides with Pt (T 2). The following useful device is based on this result.
Let 7r = (/3,7(T2)) be a self-financing strategy using a bank account B (t) and
a bond with redemption date T 2. Such a strategy must be implemented with the
help of a bond P (T 1) with redemption date T 1. Then it is natural to propose
substituting in place of the bond P (T 2) the value V ** of a portfolio replicating this
bond:
X I = ptB {t) + l t (T 2)Pt(T 2) = ¡3tB {t) + l t {T 2) X f

= (Pt + l t{T 2)P l)B {t) + 7t(T2)7t*(T 1)Pt(T 1).
We let P't = P t+ lt{T 2)Pl and t £(Tx) = 7t(3"'2)7t*(T1) and rewrite the value X ?
in the form X ? = P'tB ( t ) + i tPt {T l ). Let us show that the strategy n' = ( p '^ '{ T 1))
is self-financing.
Indeed, it follows from the self-financing property of the strategies 7r and 7r*
that
A X ? = A X ? = 0t A B (t) + 7t(T 2) A Pt (T 2) = pt A B (t) + 7t(T 2) A X ? '

= pt A B (t) + 7t(T2) (pt A B (t) + 7«(r 1) APtCT1))
= (A + 7t(T 2)p*) A B (t) + 7t(T2)7 *(T 1) A P tiT 1)
= Pt A B (t) + 7 J A P tiT 1).
Thus, the self-financing strategy using the bank account B and the bond P (T 2)
can be replaced by a self-financing strategy constructed using the bank account B
and another bond P (T ). This makes it possible to construct a hedging strategy
when there are restrictions on the bonds used in the portfolio.
As another example we consider the pricing o f an option to buy for a bond
with some redemption date T 2 > T and payment function (PT(T 2) - K ) + . Since
the dynamics of the price of P (T 2) is also determined by the sequence { & } t < T ,
the function ( P t ( T 2) — K )+ is Ty-measurable, and hence the rational price of the

option is equal to
c = x f =Ep. [BCT)-7x] = Ep. [B (T )-\ P t (T 2) - #)+].

It follows from (8.4) and (8.5) that Pt (T2) ^ K in the case when among
£i , . . . , £ r there are at least fco = k (T ,T 2, Po{T), Po(T2)) variables with value 1,
where
k (n ,N ,P l , P 2)
1
= inf { k : k ^
S(N - n) P* + (1 —p*)0n ~ i ) J
Let
n r~ i 0Xi(N~i> pn-ZXi (J _ p ) E * i
M(k0>n ,N ,p ) = ^2
(®l ,...,Xn) Lnr=i(p* + ( i - p * ) ^ _i))
where (rci,. . . , x n) is a vector with components equal to 0 or 1. Then
Ep. [BtTr^PrCT2) - K ) +] = EP. [(B {T )~ 1Pt {T'2) - K B ( T ) - l )+]
= Ep# n L i oMT2~i}
Po(T2)
n i ^ + a - p * ) ^ 2- 0 )
- K P 0( T ) - ^
n iL 1(p* + ( i - ^ ( r - i)),
= P0(T 2)M (ko,T ,T 2,p*) - K P o(T )B (ko,T ,T ,p *),
and hence
(8.10) C = P0(T 2)M {ko,T ,T 2,p*) - ¿ r P o C O B fo .T .T .p * ).
The dynamic behavior of the value X f of the hedging strategy 7r* is determined
from the self-financing condition, which implies that the discounted value of n* is
a martingale:
B ^ X f = EP. [B (T)-7T |Tt] = EP. [B {T )~ \ P t (T 2) - K ) + \7 t}.
Setting kt = k (T —t, T 2- t , Pt (T ),P t(T 2)), we get the following general formula
for the value X £ * :
X f = B { t ) E p. [B (T )-\ P t (T2) - K ) + ITt]

= B (t)(P t(T 2) » {kt,T —t,T 2 —t,p*) —K P t(T) B{ku T - t , T - t,p *))
= Pt (T 2) B (k t,T - t , T 2 - t,p*) - K P t (T ) B(kt,T - t , T - t,p*).
§ 8 .2 . HEDGING ON A BOND MARKET 149
Hedging in the Heath-Jarrow-M orton model.

Suppose that the bond market given by the equations (8.6)-(8.8) consists solely
of the bank account B (t) and one bond P (T l ). In this case the definition of a self
financing strategy 7T = {fi,^ {T 1)) can be rewritten in the form
dX ? = ^ dB(t) + 7t(T2) dPt {T 2).
The existence of a unique martingale measure P* implies that under the con
dition as(T 2) > 0 such a (B, P (T 2))-market does not differ from a diffusion (B, S)-
market. Therefore, for an arbitrary contingent claim f r with exercise time T < T 1
the rational price is equal to
C = Ep.[P(i)-1/ r ],
We consider a contingent claim with payment function Pt {T2) coinciding with

the price of a bond with redemption date T 2. Clearly, the rational price of such a
contingent claim coincides with the initial bond price:
C = EP. [Bitr'frl = EP. [Bitr'PriT2)]
—Ep* Po(T2) £ ^ J a s(T2) dw^j = Po(T2).
The evolution of the discounted value Ytn* of a hedging strategy 7r*, which
exists by the results in Chapter 3, is determined by the equation
17 * = = Ep. [ B (t )-1/ r ISt]

= EP. [Bitr'PriT2) |St] = Bity'PtiT2).
Since the discounted value of a self-financing strategy satisfies the stochastic
differential equation dYf* = 7 ^( T x) d , we get that
B {t)
Pt(T2) Pt(T2 ) 2 _ * ( r u, Pt ( T1)

d B (t) - B {t) a s {T )d W s ~ l t i 'T ) d ~ B W
and hence
Pt {T 2) as(T 2)
( 8. 11) 1 Ü T 1) =
P tiT 1) o ,(T i)
The value of fit, as usual, is found from the balance equation Pt(T2) = fit B (t)+
1t ( T 1)Pt(T 1):
Pt(T2) f as(T 2)\

( 8. 12)
~ B (t) V1 as(T i)J -
CL (T2)
The ratio , .( in the formula (8.12) represents the portion of the value that
asfT1)
( CL (T2)\
should be invested in the bond P ^ T 1), while ^1 — J rePresents the portion
of the value deposited in the bank account.
www.Ebook777.com
. ^ a se^"financing strategy operating with the bank account

B (t) and a bond with redemption date T 2. As earlier, we get that
P't = Pt+ 7t(T2)/?*, 7i(T l ) = 7t(T2)7t*(T1).

Then
X f = (3'tB (t) + 7 i ( T 1)Pt(T 1)

= (A + 7t(T 2) f t ) B ( t ) + 7t (T 2)7t* (T 1) Pt (T 1)
= A B (t) + -yt(T 2)(ffiB (t) + 7t*(T 1)Pt(T 1))
= A-B (i) + 7t(T 2) X f = /3tB (i) + 7t{T 2)Pt (T 2) = X ? ,
and hence
d * ? ' = # dB(t) + 7 j(T 1) dPt( r x)

= (A + 7t(T2)/?;) dP (i) + 7t(T2)7t*(T'1) dPt(p i)
= a dP(t) + 7t(T 2) ( # dB (i) + 7t*(T 1) d P ^ T 1))
= fit dB(t) + 7t(T 2) dX7* = 0t dB(t) + 7t(T 2) dPt(T2) = d X f.
Thus, on arbitrary self-financing strategy using some bond and a bank account can
(on the interval [0, T ]) be replaced by a self-financing strategy operating with the
bank account and the bond P (T l ).
The indicated property is an immediate consequence of the completeness and
the no-arbitrage property of our market and is satisfied for an arbitrary self
financing strategy. Indeed, let tt = (M O ^ 1) , . . . , 7 (Stn‘ )) be some self-financing
strategy. Then the evolution of its value satisfies the equation
(8.13) d X f = ptdB{t) + 7t(Slt ) dPt(Sl)

¿=1
= fit dB(t) + j r 7 t (Si)Po(Si) £ ( I as(St) dws^j dB(t)
+ E M S i)P 0 (S i)B (t) ¿ ( 1 as(Si) d w A a s(Si) dws
= (.X ? B (t)~ ')d B (t)
+ E ^t(Si)P 0 (S i)B (t) £ ( j as(St) dwA as(Sl) dws.
X*
Denoting by Y * = ^he discounted value of the strategy 7r, we get that
d {Y ?B {t)) = Y ?d B {t) + B (t)d Y *
= ( A 7 P (t )-i)d P (t )
+ E M S i)P o(S i)B (t) £ ( j a s(Si) dwsy s(Si) duis;

§8.2. HEDGING ON A BOND MARKET 151
consequently,
dYt = £ ( / as(S\) d w ^ a s(Si) dws,
that is, the discounted value of the self-financing strategy is a martingale with
respect to the measure P*.
We consider the contingent claim f r = X j, on the ( 5 ,P ( T 1))-market, where
in view of completeness and the no-arbitrage property there exists a self-financing
strategy 7r* such that = X l£ (P-a.s.). By the martingale properties of the
discounted value of a self-financing strategy, we get that
x * = B (t) E p. [ B { t ) - l X ^ \ 3 t] = B (t) E p. [B (t)~ l f T I% ] = X f .
Thus, an arbitrary self-financing strategy can be realized (on the interval [0, T ])
with the use of only a bank account and a single bond with redemption date T 1 ^ T.
There is also a converse result, in a certain sense.
Suppose that on the interval [0, T] we are given a predictable process Tt with
values at each moment of time satisfying the inequality t < T t ^ T 1. We interpret
this process as a rule indicating in which bond we can invest our resources at the
time t.4
We consider a contingent claim f c = Pt (Tx) that should be hedged with the
help of some self-financing strategy n* = (/?*,7*(Ti)), that is, using a bond with
redemption date Tt at each moment of time.
It follows from the equalities (8.11) and (8.12) that a hedging strategy has the
form
P t(T l ) asjT 1) P tjT 1) ( , asjT 1) }
(8.14) 7¡(Tt) A* =
Pt(Tt) as(Tt) ’ B (t) \ as(Tt) J ■
Indeed,
x f-
= + p t(T 1) ^ ® = p t(T l ),
\ as(Ti) / Q's(Ti)
and at the same time we have the equality
d x f = dPt(T l ) = Pt(T 1 )as(T 1) dwt + ( B ^ P t i T 1)) dB{t)

= 1 *t {Tt)Pt{Tt)as(Tt)dwt
± ' 1 *t {Tt){B {t)~ 1 Pt{Tt)) dB{t) + (■B(i)-1 P<(T 1)) dB(t)
= 1 *t {Tt)d P t{Tt)+l3*t dB{t),
which implies that the strategy tt* is self-financing.
4Such an assumption, perhaps seeming artificial at first glance, is of interest because in a real
market there are only a limited number of bonds available at each moment of time. Indeed, if the
government issues four-year bonds every two years, then to hedge a contingent claim with exercise
time in 10 years the investor must exchange the bonds with which he is working at least three
times, because there are no bonds with redemption date T 1 > 10 on the market. In this case one
possible pricing variant is to assume that all bonds are present on the market, but one can invest
only in bonds with redemption date 4 on the interval [0,2], only in bonds with redemption dates
4 and 6 on the interval [2,4], only in bonds with redemption dates 6 and 8 on the interval [4,6],
and so on.
152 CHAPTER 8. ANALYSIS OF “BOND" CONTINGENT CLAIMS
According to arguments similar to those above, we can show that an arbitrary

self-financing strategy 7r = ( / ^ ( T 1)) operating with a bank account B (t) and a
bond with redemption date T 1 can be replaced by a self-financing strategy n' =
(/^»VWO)» where
(8.15) p[ = fit + I t i T ^ P l i t {Tt) =
Thus, on a complete (B > P (T 1))-market any self-financing strategy can be rep

resented by some strategy n = (P ^ (T t)) using only a bank account and a bond with
redemption date Tt at each moment of time t.
We apply the above methodology to a concrete model.
T h e H o -L e e con tin uou s m odel. Let us consider an option to buy with

payment function
h = (P t (T 2) - K B (T ))+ .
According to this option, if the discounted value of the bond Pt {T2) at the time T
exceeds the level AT, then the buyer of the option receives a payment in the amount
PT(T 2) - K B (T ) = B (T )(B (T )~ 1Pt {T 1) - K ).
The rational price C of this option in the case of the Ho-Lee model is equal to
C = E p .[ B ( T ) - 1/ T]
= E ? .[ ( B ( T ) - 1 Pt (T 1) - K ) +]
= E p .^ P o C T 1) £ ( ^ ¿ (T 1 - t) dw^J - k ) ]
= E P.[(P oC T 1) e x p ( - i Jf S2(T 1 - 1)2 dt + jT 8{Tl - 1) dw^j - K
As earlier, let <j>(x) and $ (y ) stand for the density and distribution function, re
spectively, of a standard normal random variable. We get that
(8.16)
C = PoiT1) jf ° e x p j ^ T 1 ~ t ? dt + x ^ J ^ S ^ T 1 - 1)2 dt j <j>{x) dx
poo
-K <p{x) dx
J Xq
= P0(T 1) J ™ 4, ^ ^ £ S ^ T 1 - t ) 2dt ' ' j d x - K j ™ 4>(x) dx,
where xq is determined from the condition
pT pT
PoiT1) e x p ( - i 82{T l - 1)2 dt + j f ô(T l - 1) dw^j > K.
§8.3. INVESTING IN A BOND MARKET 153
Since Jq ¿ (T 1—t) dwt is a normal random variable (with respect to the measure P*)
with parameters 0 and / Q
T ^ ( T 1 - f)2 dt, this condition leads to the inequality
f ^ ¡—^-------------------- ~ x° ’
V/cfs^-tydt
where £ is a standard normal random variable.
Setting
l n ( Z f l ) + % f ? S 2 (T 1 - t ) 2dt
\JJo $2(T l ~ t ) 2 dt
d l n ( ^ f l ) - l f ^ S 2 (T 1 - t ) 2 dt
y / f i 62 { T ' - t ) 2 dt
we rewrite the formula (8.16) in the standard form
(8.17) C = Po(T 1 )$ (d + ) - K 9 ( d - ) .
In the same way it can be shown that at the time t the value of a hedging strategy
7r* can be represented in the form
(8.18) X f = B (t) E P. [ B ( T ) - 7 r |Si]
= Pt(T 1 )^ (d + (t)) - K B ( t ) * (d -{t )),
where
, M $ $ ) + U T i 2C r ' - » ) 2 *
y / f ? 62 ( T ' - s ) 2 ds
, K ® ) - 5 ¡^ (T '-s fis
a-\ tJ — /—=---------------------
j g 82 { T ' - s y d s
The formulas (8.17) and (8.18) are analogous to the Black-Scholes formulas for the
(£ , S)-market.
§ 8.3. Investing in a b o n d m arket
One can also consider optimal investment problems on a bond market. A

methodology for solving such problems was presented in § 3.3.
For some utility function U (see (3.51)) on a given (¿?, P)-market we consider
the problem of maximizing the mean value of this function for the discounted value
Y f = B (t)~ lX?r of a self-financing strategy 7r with initial value v = Xfi.
Using Theorem 3.4 for a complete ( jB, P)-market, we can find a self-financing
strategy 7r* such that
(8.19) E [U (Y f)} = sup E[U{Yf)\.

We set U(a?) = ln(a;) and find a strategy tt* for the Ho-Lee model and the Heath-
Jarrow-Morton model.
The Heath—Jarrow—Morton model.

For the model determined by the equations (8.6) - ( 8.8) we consider the prob
lem (8.19) under the condition that the self-financing strategy 1r uses only a bank
account and a bond with redemption date T.
For the function
V (y) = sup[U(x) - xy\ = - ln(s/) - 1

®>o
conjugate to U we find that
(8.20) v(y) = E [V{yZ*T)\ = It * ] - 1 - ln(V),
where
is the density of the unique martingale measure P*.

Prom (8.20) we find the price function of the problem (8.19):
u(x ) = inf M y ) + xy] = ln(a;) + ^ E Ct dt
By (3.54),
( 8 . 21) § T ) = Y f = I ( y Z * T) = ^
= x e x p j- J Cadws + ^ s j>
C
where
I(x ) = (U 'ix ) ) - 1 = -V'(y).
For a self-financing strategy w = (/?,7 (T )) we let
7t(T)Pt(T)
atCO =
XT
Since the evolution o f the discounted value Y * = X f B (t ) for a self-financing strat

egy ir = (f3, 7 (X')) is determined by the equation
Pt(T)
dY* = 7 t(T)d
B (t) ’
we get that
d Y f = 7 t(T) d *^ ~ j- = 7 t(T ) ^ ) at(T) dm = Y ? a t{T)at{T) dwt.

§8.3. INVESTING IN A BOND MARKET 155
Consequently,
(8.22) Y f = z e x p j j T a t(T)at(T) dwt - ± j \ a t {T)at{ T ) f d i )
= x exp| J a t(T)at(T) dwt
- Jo (<*t (T)at (T )(t d t + l- (a t (T)at (T ))2) di j .
Comparing (8.22) and (8.21), we get
bt(T)
(8.23) <**t(T) = -
at(T) at (T )2 ’
and hence
(8 24) -v -m - H T )x f ( M n \x f
' 1 a,(T)! f>,(T) ’ " l1 a,(T)2 j Bit) '
To clarify the formulas (8.23)-(8.24) obtained we observe that
bt{T ) = - j \ s{ T ) d s + \ at{T )2.
Further, from (8.23),
<8'25)
We now set rjs(T) = 0. This corresponds to the situation when the forward
rates oscillate around some value and do not have a “trend” in any particular
direction. In this case we get from (8.25) that
Thus, in this “indeterminate” situation an optimal strategy consists in investing

half our resources at hand in a bond with redemption date T, and the other half in
a nonrisky asset B. Corresponding to this,
yn yn
ru*(T\ = 1 ft* — 1
It K ) 2 Pt(T) ’ Pt 2B(t) ■
We note further that for the collection of bonds corresponding to a predictable

process Tt specifying at each moment of time t a bond available for investment,
we can use (8.14) and (8.15) to get from (8.24) a strategy tt7 = (/?', T^Tt)) that
represents a solution of the problem (8.19) in this case:
bt( T ) X f ( at(T )\
Pt =
at (T )* B (t)\ at(Tt) J ’
bt{ T ) X f
it{T t) =
at(T)at(Tt)Pt(Tt) '
T h e H o -L e e m odel.
Let us consider the model (8.3)-(8.5). Setting £t = & on the interval [i,i + 1),
we get a model with continuous time and the possibility of using the previous
arguments and results. Our methodology for finding martingale measures (see
Chapter 3) gives us an expression for the density of a martingale measure:
(8.26) ZN =
We consider the problem (8.19) under the condition that the investor uses only
a bank account B (t) and a bond with redemption date T. This (B, P(T))-market
is complete, and hence we can use Theorem 3.4.
In view, of the form of the utility function and (8.26) we find the following
expression for v(y):
v(y) = E [V (yZ T)] = - 1 - E[ln(yZT)]
= - 1 - Into) - f > [ l n ( l - - (‘
rp
= -l-ln (j,)-g p ln ^ l — (! ~ P ))S

j
+ ( 1 - p)ln( 1- £ ^ j ’’).
- 1- I n f o ) + (1
Consequently, the price function for the problem (8.19) is equal to
u(x) = ln(x) - E[ln(Zr )] = ln(x) - + (1 - p) ln^^— .
Using (3.53), we get a formula for the discounted optimal value:
«**>
For an optimal strategy it * = (/?*,7 *(T1)) let
,.m 1 *n{T)Pn-x{T)
“ ” (T )= B (n -l) '
Using the self-financing property of the strategy 7r*, we have
a X’ . P „(T ) _ x z _ m t ) P „(T )
AW ) 7" ( r ) A B M ■ P .-iC n A BW ■
and by (8.5),
_ Xâ^T) f 9^T~ ^ \
B (n) B ( n - 1) VP* + ( l- P * ) Ö T- n )'
Consequently, the discounted terminal value of the strategy it * has the form
(8.28)
B (T )
From the formulas (8.27) and (8.28) we get that
£t = 1.
+ (1 - p * ) 0 T~
By an induction argument analogous to § 3.3 we prove that
*m = p* -p QT w - i
’ p*( 1 - p*) p* + (1 - p*)QT~n '
The arguments given above for the Heath-Jarrow-Morton model enable us
to construct an optimal strategy with a predictable process Tn specifying a bond
available to the investor on the interval [n — l,n ).
[22], [46], [64], [74], [75], [79], [108], [126], [129], [133], [135], [141].
CHAPTER 9
Economics of Insurance and Finance:

Convergence of Quantitative
Methods of Calculations
In this chapter we study problems involved with calculating premiums and

reserves in insurance. It is shown how traditional actuarial methods of calculation
in property insurance can be derived from the financial principle of no arbitrage. A
general method is given for estimating the ruin probability as a risk characteristic
of the solvency of an insurance company.
In life insurance we focus on innovation systems of “flexible” insurance, where
a connection is indicated between calculations of the corresponding premiums and
reserves, and the Black-Scholes formula and equation.
We present a new approach to the insurance and reinsurance of catastrophe
risks by means of diversification of them on financial markets with the help of
insurance derivative instruments.
§9.1. “Non-life” insurance. Traditional actuarial

principles for calculating premiums and the financial
no-arbitrage principle in a model of collective risk
The concept of insurance usually involves a contract whereby one party (the
insurant) pays a certain amount of money (a premium) to buy from a second party
(an insurance company, or insurer) a service consisting in indemnification by the
insurer of possible losses, described in the contract, of the insurant. Here the party
subject to the risk tries to ensure for himself a certain amount of protection, while
the second party provides such protection. An insurance contract against this or
that risk is called a policy. It specifies the conditions of the contract: the time it
is in effect, the method of indemnification against damage, and so on. If during
the indicated periods a corresponding risky situation arose, and the policy was
presented for payment, then the insurer is said to have received a claim. But if no
risky situation arose during the periods indicated in the policy, then the insurant
loses the premium.
Thus, one of the fundamental problems of an insurer is the calculation of the
premium for the risk-coverage service offered. For the investigation of this problem
relating to “the economics of insurance” we introduce the following basic objects:
v is the initial value (capital) of the company;
(rn)nô, T0 = 0, is a nondecreasing sequence of random variables— the times
when claims are received;
Nt = sup{n : rn ^ t} is the total number of claims up to the time t ^ 0;
iXk)k^\ is a sequence of nonnegative random variables determining the size of
the claims at the times 7*1 , 72, . . . .
159
160 CHAPTER 9. ECONOMICS OF INSURANCE AND FINANCE
The cumulative payments of the insurer on the time interval [0, t] are called the
risk process
Nt
x t = j 2 y k>
k= 1
which together with the cumulative premiums c(t) and the initial value v of the
insurance company determines its value V at the time t (Figure 9.1):
(9.1) Vt = v + c ( t ) - X t.
F ig u r e 9.1. Typical form of the value V with linear premiums

C (t) — C ' t .
Risk is understood to mean the possibility of various losses, and often the
word “risk” is identified with the losses themselves. The model (9.1) introduced
for the formation of capital of an insurance company is adapted to the insurance
of collective risks, when several payments are possible according to a single policy.
Therefore, it is called a collective risk model
To solve the problem of “correct” calculation of premiums in insurance it is
common to start from the equivalence principle, which amounts to the requirement
that the cumulative premiums must be equal to the payments on the average:
(9.2) E c(t) = E X t.
It is natural to regard the process c(t) as deterministic, and even linear: c{t) = c-t.
This reduces the problem of calculating a linear premium to finding the density c.
A solution of the equivalence equation (9.2) is the so-called net premium
c = T ~ l E X T,
which balances the claim expenditures on some time interval [0,T].

However, a company also has to have extra resources to ensure its proper
functioning (for example, worker salaries, taxes, and so on). Therefore, a “load” on
the net premium is introduced in the insurance or actuarial calculations, and the
corresponding amount is called a loaded premium or gross premium. There are a
number of traditional actuarial principles for determining such premiums.
§9.1. “NON-LIFE” INSURANCE 161
1. Principles involving the concept of net premium:

(a) the mathematical expectation principle,
c = T - 1 (E X T + a E X T), a > 0;
(b) the variance principle,
c = T ~ 1(E X t + o D X t ), a > 0;
(c) the standard deviation principle,
c = T ~ \ E X T + a V D X T ), a > 0.
2. The Esscher principle,
c = r - 1E X Te“ * T/E e aXT> a > °-

3. The principle o f calculating premiums on the basis of the concept of utility,
U{v - cT) = EU(v - X T),
where U is a convex utility function.

In the third case we get
U(v - cT) = EU{v - X T) ^ U {E(v - X T)) = > c T ^ E X T
by Jensen’s inequality, and hence the loaded premium is correctly determined.

Furthermore, in the first case the choice of load is completely obvious and natural:
the load is determined either as the ath portion of the mean claim, or as the
ath portion of the variance and mean-square deviation, which are often convenient
quantitative measures of risk. In the second case we set
Z = eaXT/ E eaXT
and note that

cT — E X t Z = E q X t*,
where Q is the measure with density Z. Hence, the Esscher principle is also an
equivalence principle, but with respect to a specially chosen probability measure Q.
As is clear from the preceding, there is no unified method for calculating pre
miums in traditional insurance. This is explained by the history and practice of
insurance. Another explanation can be found in the theory of financial markets, in
the interconnection between finance and insurance. Central in financial economics
is the concept of a financial market with a chain of wbought-sold” actions, and so
on. Although initially this concept was really untypical for insurance, in the course
of time many of its forms have been characterized by a large number of assets and
competitions, and this forms a certain model of the insurance market on the basis
of a system of reinsurance with a natural chain of “insured-reinsured” actions, and
so on.
Reinsurance appeared in connection with the insurance of very large risks.
A basic and essentially systematizing form of reinsurance of risks is the so-called
quota-share proportional reinsurance, when the ath portion of risk is assumed by
an “initial” company (the cedent), with the remaining (1 —a)th portion of the risk
passed on to a reinsurer and with the premiums divided in the same proportion.
Another representative of proportional reinsurance is excess of surplus: the insurer
assumes the risk of total losses up to a certain limit A (the responsibility level of
the company), the reinsurer assumes the risk from A up to a certain level B, and
all losses above B revert again to the insurer. In this form of reinsurance the layer
A/B is reinsured. A traditional nonproportional reinsurance contract is an excess
of loss contract, in which one considers not the total of payments according to the
contract as above, but the individual payments according to each insurance event.
Here A is called the priority and B the ceiling of guarantees.
In nonproportional reinsurance the interrelation between the premiums and
the payments is more complicated. We mention also stop loss, when insurance pro
tection is implemented not according to each claim, but according to the results
of activities over, for example, a year. There are also other methods of reinsur
ance, but they all can be derived from those above (and even from quota-share
proportional reinsurance) with the help of various recurrence relations.
Suppose that the sphere of insurance is characterized by the possibility at
any time of concluding a new contract involving insurance and reinsurance, and
cancelling the old contract, which means the existence of a certain price of the risk
and its liquidity.
Let (iî, T, ¥ = 0) P ) be a standard stochastic base on which we are given
a predictable process Ct and an adapted process X t characterizing the premiums
and payments of an insurance company up to a time t < T. The risk connected
with the process (A’î )ÎG[0>t ] is the object of the insurance (the premiums Ct are
paid for this) and reinsurance.
In connection with the latter we take as given a bounded predictable process
characterizing the portion of risk (X u)u€[tiT\- At any time t the insurance company
can decide to buy or sell this portion of the risk. The process (</>t)t^T will be called
a reinsurance policy, which determines the following flow of capital:
It is assumed that the corresponding integrals in (9.3) are defined.

The policy (¡> is called an arbitrage policy if C t () ^ 0 and P (C r($ ) > 0) > 0.
The processes (C ,X , <fi) form a reinsurance market
As in the case of financial markets, we have the following characterization.
On a reinsurance market there do not exist arbitrage policies there exists

a measure P equivalent to P such that the difference X — C is a martingale with
respect to P .
The above analogy between reinsurance markets and financial markets allows
us to use martingale arguments in the calculus of premiums (for risk) in insurance.
We look for a martingale measure P converting the difference X —C into a martin
gale. Then averaging with respect to P leads to the determination of the premium
itself. To implement this approach we assume that in the collective risk model (9.1)
(N t) t>0 is a standard Poisson process with intensity À > 0, the sequence (Yk)kî
of independent nonnegative random variables is independent of the Poisson process
and has distribution function F {x ), and c(t) = c -t. Under these conditions (9.1) is
commonly called the Cramer-Lundberg model In this framework we give a char
acterization of all martingale measures P with respect to which (Nt)tô remains a
Poisson process, perhaps with a different intensity.
Let ¡3: R+ —>R be a measurable function such that E e ^ 1) < oo. We define
r Nt }
M f = exp< 2 (3{Yk) - - 1] [, * < T.
^k= 1 '
L emma 9.1. The positive process A ff is a martingale with respect to the orig
inal measure P , and E A ff = 1, t ^ T .
P r o o f . Let X f = Y^k= 1 P(Yk) and observe that X f is a process with indepen

dent increments. Consequently, for any 0 < s ^ t we get that
E P [M f |J 3] = M f E P e x p { x f - X f } - e x p {-A {t - ^ E p f e ^ - 1]} = M f,
which proves the lemma.
L emma 9 .2 . If Q and P are two equivalent probability measures on ( O ^ F ) ,

then the corresponding probability distributions Q yx and P Yl of the random variable
Y\ are equivalent.
P r o o f . Let A be a Borel set in R + such that P Yl (A) = 0. Then
QyM) =Q{X?(A)) = Jim QiX-HA) n(n < n)),

since ri is finite. Further, X “ 1 (A) fl (ri ^ n) and Q ( X ” 1 (^4) fl (ti ^ n)) = 0,
and hence Q y 1 (A ) = 0.
The next lemma gives a characterization of all martingale measures in the

Cramer-Lundberg model.
L emma 9.3. Let Q be a measure on (ii, T ,F ) such that:

1 ) Q and P are locally equivalent;
2 ) (X t)tô is a Q -compound Poisson process.
Then there is a measurable function /3: R+ —>R such that E e < oo and
(9.4) Q (A ) = [ A /f dP for all A € T5, 0 ^ s < t.

Ja
Conversely, if there exists such a measurable function ¡3: R+ —> R, then there exists
a unique probability measure Q that is defined by (9.4) and has the properties 1 )
and 2 ).
P roof. Consider a measure Q satisfying the conditions 1) and 2 ). It follows

from 2 ) that (Nt)tô is a Poisson process on (ii, T, F, Q) with some intensity A' > 0.
Setting a = log A' —log A, we have
Q (Nt = n) = P (N t = n)ena_A(ea_1)t.
By Lemma 9.2, P Yl and are equivalent. Therefore, there is a strictly positive

density function / such that
Q Vl( A ) = [ f d P Yl for all A g J.

Ja
Let 7 ( 2:) = lo g /(x ).
If s > 0, then for n e No = { 0 ,1 ,... }
Yn n (Ns = n) c cr{Yi, . . . , Yn) n (Ns = n).
For n = 0 the right-hand side of this imbedding is trivial: { 0 , i i } fl (Ns = 0). Let
A e 7 S be arbitrary. Then for each n € No there exist Bn 6 <r(Yi, . . . , Yn) such
that
Q (4 ) = ^ Q(-A n (Ns = n))

nÔ
= ^ Q ( B n n(JVs = n))
nÔ
= £ Q ( B n)Q (Ns = n).
nÔ
Let Bn = y i- 1 (C'i) n ■••fl yn- 1 (Cn), where C \,. . . , Cn are Borel subsets of R+.
Then
Q (Bn) = EQ[/Cl(yi) •--IcAYn)} = EQ[ICl(Yi)} ■•-EQ[/c„(y„)]

= E P [lCl ( y i ) e ^ ) ] •••E P \lCn (y»)e7(y" )]
= E P [/Bnexp{7(yi) + --- + 7(^)}].
The latter can be extended in the standard way to any B n 6 a(Y i, . . . , Yn). Con
sequently,
Q (A) = E p [Is n exp{7 (y i) + •••+ 7 (* n )}] * Q (Ns = n)

nÔ
= l ^ E p [IBn exp{7 (y1) + •••+ 7(^»)}]
x P (Ns = n) exp{an — A(ea — l ) f }
= ^ E P [ /Bnn(jv.=n) exp { 7 (Yi) + •••+ 70'n) + <*n - \(ea - l)f }]

0
Ns
=Y l Ep ^n(;\r.=n) exp j ¿ ( a + 7 (y<)) - A(ea - l)t j
nÔ L M=1
= e x p | ^ ( a + 7 (y<)) - A(eQ - l)f j dP.
With the notation /3(x) = a + 7 (x) we have that E p [e^ yi^] = ea and Q (A ) =
JA M f dP. Using the fact that ( M f )tô is a martingale, we obtain the equality
Q(i4) = J M f dP for 0 < s < t,
which proves the direct implication.

To prove the reverse implication we assume that /3(x) is a real function on M+
with Ep[exp{/?(Yi)}] < oo. Since (M f )tô is a martingale, the equality (9.4) defines
a measure Q on the algebra (Jt>0 Tt, and its restriction to each is a probability
measure.
We show that for any fixed t > 0 the random process (X u)u^t is a stationary
process with independent increments. To prove this we verify that for any r > 0
and 0 ^ u < s ^ t the conditional expectation EQ[e- r ^Xs_Xu^ |Tw] is deterministic
and depends only on the difference s —u.
Let A G 3 U. Then
E q [I a e x p { - r ( X s - X M)}]
= E P [IA e x p { - r ( X s - X u) } M f ]
= Ep [IA e x p { - r ( X s - X u) + X f }] x e x p {-A sE p [e ^ yi) - 1]}
= Ep [IA exp{Xf}]EP [Ia exp{-r(Xs - X u) + (X f - X f )}]

x exp{—AsEp[e^y^ —1]}
= E P [lAM%\E P [I a e x p { - r ( X , - X u) + ( X f - X f )}]
x exp{—A(s —u )E p [e^ y^ — 1]}
= Q 04)E P [e x p {-r X s_ u + X f _ } ] x e x p {-A (s - u )E p [e^ yi) - 1]}.
We consider two probability measures (x and v on 1R+ defined on Borel sets A E R+

by
exp{/3(a:)}
M dPYl,
a E P [exp{/3(Yi)}]
e X x dx,
u {a )= x' L
where A' = AEp[exp{/?(Yi)}].
Let Q = v®N ® as a product measure on iî = R+ x R + . It follows at
once from the structure of Q that (X t)tô is a compound Poisson process with
respect to Q. We show that the measures Q and Q coincide on for all t e R+.
Since (X s)s^t has independent increments on the spaces 3^, Q) and (£2,iFt,Q),
it suffices to establish that for all Borel sets A G R+ and all s < t
Q x M ) = Q x s(A):
To this end we show that for any r > 0
(9.5) E Q[e -rX*] - E ^ [c-r X *].
Prom the equalities
„ r _ ryi] _ E P [exp{—r l j + /?Q 'i)}]

^ J E p le x p i^ x )}] ’
Q (Ns = n) = EP [exp{/3(Fi)}]n
x e x p {-A sE p [exp {/?(Y i)} - 1]} x P (Ns = n)
it follows that
E ^ [c“ rX*] = E p[exp{—rlj. + 0(Y 1)})n

nÔ
x e3qj{-A ,E p [exp {/3 (yi)} - 1]} x P (Ns = n).
We observe now that
E q [e~rX‘ ] = ^ E P [exp { - r i l + m W
nÔ
x e x p {—ASE P [exp{/3(ii)} - 1]} x P (N S = n),
and we get (9.5).

Further, the measures Q and Q coincide on Uiô and hence Q is the unique
extension of Q to the cr-algebra 7.
Lemma 9.3 is proved.
We turn to the calculation of premiums.

T h e o r e m 9.1. The martingale approach to calculating the premium in the
Cramer-Lundberg model leads to the following family of premiums:
c = AEp[Yi exp{/?(Yj)}],
where /3 is the function in Lemma 9.3.

P r o o f . From /?(•) we construct a measure Q with respect to which X t — c - t
is a martingale. Then it is clear that c = E q X±. With respect to Q the process
(X t)t>o is again a composite Poisson process; therefore, the expectation factors into
the product E q X t = E q A/i •E gY i. As is clear from the proof of Lemma 9.3,
EP [Vi exp{/?(Yi )}]
E q ^ i = AEP [exp{/?(Yi)}] and
Q 1 E P [exp{/?(Yj)}] '
Consequently, their product is equal to c = AEp[Yi exp{/?(Yi)}], which concludes
the proof of the theorem.
From the martingale principle we can get all the traditional methods for cal
culating premiums in insurance with the help of the function /3(x).
1. Mathematical expectation principle. We let (3(x) = ln(l + a) and get that
c = AEp[Yie^yi)] = AEp[Yi(l + a)] = EPX i ( l + a),
and hence
c •T = E p X r ( l + of).
2. Variance principle. We consider fi(x) = ln(a + bx), b > 0, and a = 1 —
6EpYi > 0 and get that
c = AEp [Yi (a + 6Yi)] = AEpYia + AEpY^fc = o E p X j + 6DPATi.
Hence,
c *T = oEjpX t + b D p X r,
which for a = 1 and b = a reduces to the variance principle.
3. Esscher principle. For (3{x) = a x — ln E peaVl we have that
YieaYl
c = AEp
E peaYl *
and hence
Yie aYl YxeaYl
c •T = ATEp = EpATÊp
E p eaYl E p eaYl
§ 9.2. LIFE INSURANCE. CALCULATION OF PREMIUMS AND RESERVES 167
On the other hand, the “Esscher” premium has the form
E PX TeaXT y YkeaYk YieaYl

= EpiVÊp
E peaXT P" E p e "1^ E PeaVi '
Comparison of these two formulas leads to the required assertion.

Thus, it is established that in the Cramér-Lundberg model there is a whole
series of martingale measures, which means, on the one hand, the no-arbitrage prop
erty and, on the other hand, incompleteness of the corresponding market, if we may
use the “financial” terminology. This is a theoretical explanation for the nonunique
ness of the methods for determining insurance premiums. The nonuniqueness leads
also to the important practical conclusion that there are risks not suitable for in
surance.
§ 9.2. Life insurance. Mortality tables. Calculation of premiums

and reserves in traditional and innovation insurance schemes
Along with property insurance, or “non-life” insurance, a second very important

component is life insurance, where the corresponding specifics of the calculus of
premiums and reserves stem from the mortality of the company’s insured clients.
All calculations in traditional life insurance are carried out on the basis of the
“demographic history” of the insurance event: sickness, death, and so on. For these
purposes one uses mortality tables giving a general idea about the probabilities of
such events.
Mortality tables are statistical data about the longevity of a population group,
categorized according to different criteria (gender, region, profession, etc.). They
contain a number of variables and indicators characterizing the decrease in numbers
of the group under observation and the mortality level for different periods. Tables
based only on age give an idea of the mortality dynamics as a whole and are thus
called general tables. If other parameters besides age are taken into account, then
the tables are called special (selective) tables.
Key indicators of mortality tables are the probability qx of someone of age x
dying within a year and the probability px of someone of age x living through the
year. They are often determined using the direct method, when qx is taken as the
ratio of the number of members of an observed group who died during a year to
the number who were alive at the beginning of the year. However, the difficulties of
selecting a homogeneous group and compiling data for 100 years as it evolves (and
this is the approximate size of the table) lead to essential distortions of the reality.
In practice, therefore, statistical data are gathered about a group of contemporaries
including people of all ages and giving indicators for a complete age range ( cross-
sectional analysis). The composition of the age groups is very dynamic, while in
a mortality table the number of people must decrease monotonically, and thus the
tables are smoothed and completed to fill out a whole category of ages.
The mortality table obtained accumulates in itself the general probabilistic
reality in which insurance companies operate, and it provides a certain physical
measure of mortality. It is natural to call such “first approximation” tables tables
of the first kind. However, real calculations of premiums and reserves done by
qualified actuaries are carried out according to different, actuarial, tables which will
be called tables of the second kind. The fact of the matter is that each insurance
company, using its own experience, specifics, statistics, and so on, transforms the
original mortality table. It is usually taken into account that not all people are
insured in a given category (an age category, for example) for which the mortality
is well known from tables of the first kind, but only people with a larger “data
base” (security, passing a medical examination, and so on). As a result, a different
more suitable mortality table emerges that provides the corresponding probability
with risk-neutral properties.
In practice one can often pass from one table to another by a linear transforma
tion of the form q W = AqW + B . For example, A = 0.7 for Moscow, and hence the
premium calculated from the probability measure induced by such a table will be
roughly 30% less than that calculated from the original measure. Thus, in both life
insurance and financial economics there is the same process of looking for measures
more “inconvenient” for risk and using them in actuarial calculations.
In the traditional approach the problem of insurance is to determine the pre
mium at the conclusion of the contract (a one-time premium if it is to be paid
immediately upon concluding the contract, and a periodic premium if it is to be
paid according to a chosen scheme over the period when the contract is in effect).
Calculation of a one-time premium uses the equivalence principle, when the pre
miums are equated to the future payments according to the insurance contract, on
the average with respect to the “physical” probability given by the mortality table
of the first kind.
Suppose that the insurance company concludes a “pure endowment” contract
with a group of l x clients of age x for a time T. The corresponding policy gives the
holder the right to receive a payment in the amount X upon living to the date T.
To calculate a one-time individual premium t Ux according to such an agree
ment we denote by T i , . . . , T^x the remaining lifetimes of the members of this group
as independent identically distributed variables. Then for each i = 1 ,... , t x the
payments of the company are X •
By the equivalence principle,
(9.6) t Ux = "EX •I{Ti>T} = X •t Px ,
where Tpx = P № > T ), i = 1 , . . . , i x .

Taking into account the nonzero interest rate r leads to the discounted size of
the payments and to the corresponding formula
(9.7) TUX = e~rTX ■TPx.
For a term insurance agreement, when a payment of amount X is made in case

of the death of the client before the date T, the corresponding formula for the
premium U (x,T ) follows from (9.6)—(9.7):
(9.8) U (x ,T ) = (1 — tPx)X and U (x ,T ) = (1 - Tpx) e - rTX .
The price formulas (9.6)-(9.8) were obtained under the assumption that X is deter-
ministic, and they take into account the unique randomness factor stemming from
the mortality of people in the selected group. We show how they can be trans
formed for contracts with payments depending on the prices St of a risky asset
in a Black-Scholes financial market (3.19) given, as usual, on a coordinate space
(il1, ? 1^ 1, ? 1).
§9.2. LIFE INSURANCE. CALCULATION OF PREMIUMS AND RESERVES 169
Let Nt = Yfi=i be a mortality process on another space (ft2, J 2, F2, P 2)

with F2 = (3^) and — a(N U) u ^ t ) . We assume that
tPx = P (î s* t) = exp | J* px+s ds
with some density p x+s {the mortality rate).

It is reasonable to assume that the two randomness factors are independent of
each other. Then the whole model belongs on the probability space (ft,T ,F ,P ) =
(ft1 x f t 2,3r l0 3r2,F 1 (8)F2, P 1 x P 2).
Let us consider the pure endowment model with payment X = m ax{5r, i f } ,
where i f is a nonnegative constant that is the distinctive guaranteed payment for
the insurant. We find a formula for the premium t Ux starting from the equivalence
principle with respect to the martingale measure P* in the Black-Scholes model.
Such a change of measure in the equivalence principle corresponds completely to
the actuarial practice described above when one goes from general mortality tables
to actuarial tables.
Prom the property of independence we have that
(9.9) TUX = t Px *E*e“ rT m ax{Sr, K }.
Since
(9.10) max{SV, i f } = i f + max {S t — if, 0},
we get from (9.9) and the Black-Scholes formula (3.23) that
(9.11) t Ux = T P x [ K e - r T + So$(d+(0)) - i f e “ rT$ (d _ (0 ))],
Similarly, in the case of a term con-

v' ay/T ^t
tract the individual premium is
(9.12) U (x,T ) = [ T [S0 <Hd+(t)) - K e - rt$(d -(t))\ px/*x+ tdt.

Jo
A periodic premium is characterized by its density p{t). Balancing premiums leads
to the relation
(9.13) t Ux = / p(t)e~ rt ■tPx dt.

Jo
It is clear that at each moment of time t the insurance company must have some
reserve capital to cover claims that arise. We define the reserves V {t) to be the
conditional expectation of the difference between the discounted (up to the time t)
payments and the future premiums. Conditional averaging is necessary because
neither future claims nor future receipts are known.
In the case of a pure endowment contract the payment for a claim is X =
max{ST, X } . By (9.13), taking the average with respect to the risk-neutral measure
P* gives us
(9.14) V (t) = T-tPx+tE * (X 13 ?) - J \ ( u ) e ~ r^ ■u- tPx+t du.
www.Ebook777.com
Next, we let t f ( T ) = E * (X 13 t)e rt and rewrite (9.14) in the form
(9.15) v(t) = T-tPx+tK(T)ert - J \ (u )e ~ r^ • u- tPx+tdu.
Letting if)(t) = e ri/ x —tPx+t and assuming that nf, V (t), and u-tPx+t are suffi
ciently smooth, we get that
du—tPx+t
— px+t ' u—tPx+ti U ^ t ,
dt
d
Oj. 1 >(t) = -{P x + t + r)rp{t),
d2V
ip(t)
ds WK)as ’ as2 dS2 ’
1h = (^F" 0“*+«+ ~ p(())•

Prom (9.15),
(9.16) < ( T ) = i>(t) v (t) + J p(u)e r(u 4) •U-tPx+t du
Using (9.16), the representation
dSt = rSt dt + aSt d ( w t + t j = rSt dt + aSt dWt\
and the Kolmogorov-Ito formula, we get that for any s ^ t
(9.17) < ( T ) = tt*(T) + £ ^ { u ) ^ a S u dW*
dv
+ J' *P(u) B V rS + l . i g > 8d ‘Sv2 ~ (M*+u + r)V (u) + — - p(u) du.
dsri>u+ o<7
Since 7r^(T) is a martingale with respect to the martingale measure P*, we have
that the third term on the right-hand side of (9.17) must be zero, and we arrive at
a generalization of Thiele9$ equation for the reserves V (t), which is well known in
the economics of insurance:
(918) % =p(i)+^ x+t+r)yw ~ ~ rSt% -

When the reserves are independent of Sti (9.18) passes into Thiele9s classical equa
tion:
(9.19) — = p(t) + (px+t + r)V (t),
which describes the dynamics of the reserves of an insurance company in dependence

on the premiums being received, the mortality rate, and the interest rate.
For a long time (and the equation (9.19) was discovered in 1875) this was
sufficient for the problems that arose in life insurance. However, the intensive
development of financial markets has had a strong influence on the structure of
insurance products: among them have appeared a whole spectrum of equity-linked
innovation proposals. Thus, the corresponding reserves have gotten another risk
measurement connected with risky assets of the financial market, and the equation
§9.3. ESTIMATION OF THE RUIN PROBABILITY 171
(9.18) takes this into account. Furthermore, if we formally set the parameters p(t)
and px+t (which are not characteristic for the “financial” theory) equal to zero,
then (9.18) reduces to the Black-Scholes equation (3.27).
Thus, the above results on calculating premiums and reserves clearly attest to
the unity of the methodological foundations of these calculations in finance and
insurance.
§ 9.3. E stim ation o f th e ruin p rob a b ility

In the calculations of premiums and reserves it was noted that they depend
on a parameter that had to be identified starting from various principles. In this
section the ruin probability appears as a criterion for an identification of this kind.
The ruin probability is a traditional characteristic of the solvency of an insurance
company and is the main object of our investigation below.
There are several ways of estimating the ruin probability. Of all the approaches
(the Cramer-Lundberg approach, renewal theory, and so on) the martingale ap
proach, which lies at the basis of the general methodology expounded here for
estimating the ruin probability, is beyond comparison from the viewpoint of the
structural generality of the formation of capital of a company.
On a standard stochastic base (ii, T, F, P ) we consider the following collective
risk model (see Chapter 2 and (9.1)):
(9.20) Vt = v + Bt + M t + X u
where v is the initial value, B is the predictable increasing process of premium
payments, X is the pure jump process of claims, with the jump times unpredictable
and the jumps A X t themselves required to be negative, M is a continuous (local)
martingale describing the influence of the “random” environment surrounding the
company, and Bo = Mo = X q = 0 (a.s.).
It is technically convenient for us to assume (and this is in complete agreement
with the “genealogy” of the process V) that on any time interval (0, t] the series of
its jumps converges (a.s.).
We represent the jump process of the risk X in the form
Xt = / xp(w ,ds,dx),
JO J(—oo,0)
where p is the random jump measure of the semimartingale V, and we assume
that there is a predictable random measure i/(u;, c?t, dx) with i/(u;, {£}, (—oo, 0)) = 0
(a.s.) that compensates p in the sense that
Xt - f f ° xdv
Jo J—oo
is a (local) martingale. It is natural to call such a measure v the intensity of
incoming claims.
We rewrite (9.20) in the form
(9.21) Vt - v = B t + f* f ° x d J )+ M t + ( x t - f f x d v ).
Jo J—oo / V Jo J—oo /
The last two terms on the right-hand side of (9.21) are (local) martingales, and
therefore can be assumed to be zero in the mean. Hence, the insurance company’s
attempt to form an amount of capital Vt exceeding the initial value v leads to the
natural condition that
pt pO
(9.22) Bt > - / x du
JO J —oo
for any t > 0 (P-a.s.). In the framework of the semimartingale model (9.20) under
consideration for the collective risk, (9.22) is an analogue of the net return condition
well known from the classical Cramer-Lundberg theory (see (9.1)), namely, c ^
A •E l i , which means that the ratio of the intensity of accumulation of premiums
to the intensity of the payments must exceed the mean size of a claim. Thus, the
premium strategy of the company must be designed with the intensity of the claims
taken into account.
Suppose that the sizes of the claims have kth exponential conditional moment
for all t > 0 (P-a.s.):
(9.23) f f e~kx du < oo, 0 < k ^ ko < oo.

Jo J —oo
Under the condition (9.23) the following characteristic of the semimartingale V,

called its cumulant, is well defined:
Gt(k) = - k B t + + [* f (e~kx - 1) dv,

* Jo J—oo
where (M ) is the quadratic characteristic of M .
We form (assuming continuity of Bt for simplicity) the process
(9.24) Mt (k) = e - k{yt~v)/eGt(k\ M 0 (k) = 1,
which is a (local) martingale under our conditions.

To see this, we apply integration by parts to the ratio (9.24) (see Chapter 2)
and get
(9.25)
Mt (k) = 1 + f* c - W - - t O d e -G°W + f e - G s (k) d e - k ( v s - v )
Jo Jo
= 1 + e-k(Vs--v)-Gs(k)
Jo
X
[ k2
Ik dBs - — d (M )s - Jpo
(e~kx - 1) du
1
+ j* e-G.(k)-k(V,.-v)
° r k2 r° 1
x I-JfedBs - k d M s + -^ {M )s + J (e~kx - 1 )d/j,
= l - k f* dMs
Jo
+ f f° e-HV,--v)-G.(k)(e-kx _ ^
Jo J—oo
+ / / M . - ( k ) ( e - k* - l ) d U i - v ) .
JO J-oo
The equality (9.25) shows that M t(k) satisfies a linear stochastic equation with
respect to (local) martingales and, according to the properties of stochastic expo
nentials (Chapter 2), is a (local) martingale.
We define next the stopping time
r = inf{t > 0 : Vt < 0}
and call it (by actuarial tradition) the ruin time of the company.
Like every nonnegative (local) martingale, M t(k) is a supermartingale, and
hence its expectations decrease as a function of time. Therefore,
1 = EAfo(fc) ^ EM iAr(fc) ^ E (M T(k) |r < t) •P (r < t)
for t > 0 and k ^ ko- Further, we get from (9.24) and Jensen’s inequality that
r»—kv
(9.26) P ( t < t) ^
E (ex p {—<7T(fc)} |r ^ t) ‘
Note that GT(0) = 0, and in view o f (9.22)
/*r /*0
(9.27) —G'T(0) = B T + í Í x d v > 0.
Jo J—oo
The strict convexity of the function E (ex p {—kv + GT(k )} \r ^ t) with respect to k
and the property (9.27) imply the existence of a unique minimum point k* < ko
such that
(9.28) P (r < t) < E (ex p {_ GT(fc*) } |r < f ) •
Then the following exponential estimate holds if there is a K t for which the denom
inator on the right-hand side of (9.28) is equal to 1:
(9.29) P ( r < t) < e~ K(V.
Prom the estimate (9.29) of the ruin probability on a finite time interval (0, t) we
get an exponential estimate of the ruin probability on the infinite interval when
there is a finite limit K = lim ôo K t:
(9.30) P (r < oo) < e~ Kv.
We now consider a substantive example of the model (9.20) that is the classical
Cramer-Lundberg model “perturbed” by a Wiener process W :
Nt
(9.31) Vt = v + c - t + aW t - J 2 Y i ,
2=1
where c is the intensity of the premiums, TV is a Poisson process with intensity of

claims A > 0, and the 1* are independent identically distributed random variables
determining the size of the claims and having distribution F(dx). It is assumed
that W, iV, and Y are independent.
It is clear that B t = c •t, M t = aW t, (M )t = a 2 •£, z/(u;, dt, cte) = AF*(cte) dt,

F*(rr) = 1 — F ( —#), and the cumulant Gt in the model (9.31) takes the form
Gt {k) = g(k) ■t = ( - k c + ^ + A[Eefcy* - l ] ) i .
The process M t (k) constructed in the framework of the model (9.31) is a martingale,
as follows from the independence of W', iV, 1*, the independence of the increments
of W and iV, and the chain of equalities (where we set v = 0 for simplicity)
E (M t(fc) | = E ( e - fcvr‘ - ff(fe)t | = E (e _fe(v‘ - vi)“ fcv» - 9(fc)t |? s)

= e - kVs ~ 9 ( k ) s -g (k )(t-s) E (e “ fc(Vt_V«^ |Ts)
= M s(k) e~ 9 ^ t~sÊ(e~kc^t~^~ka^Wt~Ws^+k^ ts+lYi I% )

— M s(k) e- 9 (k) ( t - s ) e - k c ( t - s ) + * ¥ - ( t - s ) + \ [ E e kYi - l ] ( t - s )
= M 8 (k)
for s ^ t.
The general methodology for estimating the ruin probability, which led to the
estimates (9.29)-(9.30), admits a concretization for the model (9.31) such that the
so-called Lundberg constant K is found as the positive solution of the equation
9(k) = 0.
The indicated estimates can be derived immediately. For example, using the
stopping theorem for martingales, we get that for t > 0
1 = E M 0 (K ) = E M tAT(K ) = E e~K(Vt^ - v\
and hence
E e~KVtAT = e ~Kv.
Further, since Vr is negative,
(9.32) e~ Kv = Ee-ifV ‘ AT ^ E e~KVt^ I {T<t}

= E e~ KVr • > P ( r < f).
Passing to the limit as t —> oo in (9.32) leads to the desired exponential Cramer-
Lundberg estimate:
<j)(v) = P (r < oo) ^ e~Kv.
We turn now to a study of the ruin probability (f>(vy of an insurance com
pany whose capital evolves according to the Cramer-Lundberg model (9.1). In
this case it turns out to be possible to get an integro-differential and even a
differential equation for </>(v) or, what is equivalent, for the non-ruin probability
-0(v) = 1 — </)(v) under the assumption that the density f (y ) of the distribution
function F (y) of the claims is sufficiently smooth. Moreover, for exponential pay
ments with F (y) = 1 —ex p {—a -1 y}, y > 0, we find exact exponential formulas for
<t>(v) and i)(v) as functions of the initial value v.
By the formula for the total probability and by the properties of a Poisson
process, we have that (as A t —> 0)
(9.33) = ?/>('v + cA t) ( l - AAt + o(A t))

pv+cAt
+ AA t ip(v + cA.t —y)d,F(y) + o(A t).
Jo
Using Taylor’s formula, we can rewrite (9.33) in the form
ip(v) = (V>(v) + apf(v)A t) ( l — AAt + o(A t))

/*v+cAt
+ AAt / ip(v + cA t - y) dF(y) + o(A t),
Jo
and hence
(9.34) ip(v) (AAt + o(A t)) = c ^ v ) A i ( 1 — AAt + o(A t))

/»u + c A i
+ AA t / + cAt - y) dF(y) + o(At).
Jo
Next, we divide both sides of (9.34) by At and, passing to the limit as At —» 0,
we get the integro-differential equation •
(9.35) ^(v)A = a¡)\v) + A f ^ (v - y) dF(y).

Jo
For the exponential distribution F (y ) we differentiate the equation (9.35) and in
tegrate by parts:
» A = al>"{v) + \il){Q>)a~l e~vla + X T <(t> - y J a - V « '/ “ dy

Jo
= aj)n{v) + A ^ (0 )a "1e“ t,â - A f o T ^ e ^ 0, dip(v - y)
Jo
= c^N(v) + —'ipiv) + A [ i>(v - y )o T l de~y/a
Oi Jo
= al)"(v) + - M v ) - a -1 [a f xp(v - y)e~ y/a dy
Oi I Jo
= C\j)n (v ) + —^ ( v ) + —^ f (v ) — —ll>(v)
a a a
= c^ "{v ) + —Ip 'iv ) .
a
As a result we arrive at the differential equation
(9.36) $ \ v) + ^ '(v) ^ce” 1 ” = 0*
The general form of the solution of (9.36) is exponential:
il>(v) = B + A evt t - a~l),
where - — a “ 1 < 0 in view of the net return condition. The constants A and B
c
are found from the relations 'ip(oo) = 1 and ^(0)A = c^'(0). Consequently,
rl>(v) = 1 - ^ exp| ^ - a j,
(9.37)
^ exp| ^
are the exact exponential values of ^ (v) and <j>{v).

If we assume now that the company invests its capital in a bank account with
interest rate r ^ 0, then analogous considerations lead to the integro-differential
equation
ipiv)A = t/>(v)(rv + c) + A / %!){v - y) d F (y))
Jo
which for exponential payments “turns into” the purely differential equation
(9.38) ^)N{v){rv + c) + ^'{v) + r - A^ = 0 .
The form of a solution of (9.38) is easy to find:
^ (v) = A f (rx + c)(x/r~ ^ e~ x/a dx + B,

Jo
where A and B are determined from the same conditions as earlier for (9.36).
An uncomplicated analysis of the asymptotics of V>(v) and 4>{v) as r —> 0 leads
to the “natural” limits (9.37).
It is a more complicated matter to study the case when the company’s capital
is invested in stocks whose prices are governed by the stochastic equation
dSt = St {/x dt + or dWt)
(see the Black-Scholes model (3.19)).

Nonetheless, the non-ruin probability ^ (v) again satisfies an integro-differential
equation
^ rv 2/
tp"(v) + {/xv + c)^ '(v) - A-0(u) + A [ i){v - y) dF{y) = 0
^ Jo
and for exponential payments admits the asymptotic representation (as v —» oo):
2
V>(u) = -0(oo) + const •v 1“ 2^ 2 + o(v1_2/i^ 2) for /x > ,
z
POO
/ip(v) = xj){oo) + const • / x ~ 2 e~x/a dx
+ °^ J x ~ 2 e~x/a dx^j for /x < .
Thus, investing capital in a risky asset of the financial market violates the
exponential asymptotics (9.37), making it power asymptotics.
§ 9.4. Catastrophe risks and reinsurance of them on financial markets
Traditional insurance works well for insurance of events significant for the client
but relatively minor for the company. However, more and more frequently in insur
ance practice there are cases which absolutely do not fit in the given scheme because
of their significance for the solvency of the insurance companies themselves. There
are catastrophes, or events affecting many people and causing damages exceeding
25 million dollars (5 million before 1997). The corresponding risks are difficult for
an insurance business to accept, since the losses exceed ordinary losses by orders of
magnitude, and hence the insurance claims are practically impossible to correlate
with the premiums. For example, hurricane Andrew in the USA swallowed up | of
the whole sum of premiums during 1992. Nevertheless, catastrophic events are a
§ 9.4. CATASTROPHE RISKS AND REINSURANCE OF THEM 177
reality which insurance encounters. There are several approaches to the insurance
of risks of a catastrophic nature {CAT-insurance).
The first is traditional reinsurance with coverage of a percent of losses fixed
in the contract, and so on. CAT-insurance has historically been the domain of
reinsurance associations like the syndicate Lloyd’s. However, the cost of CAT-
reinsurance has substantially increased in recent times. For example, from 1989
to 1995 it increased twofold (from 8 to 15%) for “Guy Carpenter” , the largest
reinsurance brokerage firm in the USA. The scales of natural disasters can reach
sizes comparable with the whole of the insurance and reinsurance business. For
instance, as already mentioned, insurance and reinsurance in the USA is exhausted
by roughly 270 billion dollars (230 and 40, respectively), while a computer simu
lation of possible California earthquakes led to damage estimates in the range of
50-100 billion dollars. Moreover, the statistics of expenditures on CAT-insurance
also point to a clear “exhaustibility” of the resources of traditional insurance. For
example, in 1992 it guaranteed 10 billion dollars for these purposes in the USA,
while the international potential of reinsurance held fairly stable on a level of 15
billion dollars.
The second approach consists in the creation of opportunities to exchange such
risks “inside” the insurance and reinsurance businesses themselves. This institu
tional approach was realized, for example, by the creation in 1996 of a specialized
exchange in the USA: the CATEX, or Catastrophe Risk Exchange. Its activities,
which are formally separate from the stock market, involve insurance companies,
reinsurance companies, and insurance brokers.
The third approach has to do with the creation of a complex of insurance
securities and diversification through them of catastrophe risks on the stock market.
In principle such a possibility really does exist in view of the huge US “funds
capacity” of 19 trillion dollars with its daily fluctuations of 130-140 billion. In
essence, “risk securitization” is a new form of reinsurance. Here we distinguish two
directions which have definitely been realized in practice:
• catastrophe bonds;
• catastrophe futures and options.
The best known example of a bond of this kind is the three-year Winterthur In
surance convertible bond with face value 4700 Swiss francs and 2.25% coupons.
This convertible bond was issued at the beginning of 1997 by the Swiss insurance
company “Winterthur Insurance” . According to the provisions, it is convertible
into five stock shares of the issuer, and the total amount of this bonded debt con
stitutes 300 million Swiss francs. The “catastrophe” qualities of the Winterthur
Insurance convertible bond are determined as follows. The coupons for the bond
are not paid off if there is a “catastrophe” : more than 6000 motor vehicles insured
by Winterthur Insurance being damaged by strong winds (more than 75 km/hr)
or hail. The main question in pricing these bonds is the adequate valuation of the
corresponding coupon payments. The number of such events is simulated with the
help of a Poisson process with varying intensity, and the amount of the damage is
simulated with the help of the Pareto distribution.
Let us dwell on an interesting aspect of the second of the indicated direc
tions: catastrophe derivative securities— the futures and options introduced into
the reinsurance business by the Chicago Board of Trade (CBOT) in 1992 and 1995,
respectively.
The use of CAT-futures and CAT-options has the purpose of diversifying the
scaled risks of events like natural disasters on the capital market. Here the problem
unavoidably arises of what to take as the underlying asset for “writing” these de
rivative securities. In 1992 the ISO-index was taken in this capacity (named after
the “Insurance Services Office” , a statistical agency that accumulates data about
losses of the most significant US insurance companies), and then the PCS-index
in 1995 (named after the “Property Claims Service” , a specialized noncommercial
organization that has compiled losses in this special index since 1949).
CAT-futures based on the ISO-index were traded up to 1995 quarterly: March,
June, September, December. Contracts were based on losses suffered in the current
quarter and added by the participant companies to the end of the next quarter. The
so-called reported period was composed in this way over six months. Moreover, an
additional three month period was set aside for refinements, which is fairly typical
for the practice of insurance compensations. The contract was fulfilled on the fifth
day of the fourth month after the reported period.
Let T\ < T2 be the terminal times for the period of losses and reports, respec
tively. The cost of the contract was computed with the help of the ISO-index of
losses, which was formed as follows.
The ISO agency gathered data from 100 insurance companies about quarterly
losses. A representative pool was then singled out (from no fewer than 10 compa
nies). On the basis of “weighted” data about losses and premiums of the members
of this pool, the agency made up its index
losses
I = ISO-index =
premiums *
The CBOT made public the list of companies and the number of premiums they
earned before the start of trading, and the established cost of the contract was
determined by the formula
(9.39) Ft2 = 25000 •m in {/T2, 2},
where I t2 is the value of the index at TV

It is clear from (9.39) that the exchange established a limit of 50 thousand
dollars on losses per contract, and that one point of the index cost 250 dollars.
The determination of a futures price Ft in the contract period is based on the
following considerations. The quantity Ft = Ft2 is a contingent claim, and Ft is
its price at time t ^ T. Hence, according to the general “financial” approach, this
price should be taken to be
Ft — E*(F t l^t)
(let the interest rate be zero, and let T* be the market information up to time
t ^ T), where E* is the expectation with respect to a certain martingale measure
to be determined, for example, with the help of the Esscher transform.
We will not spend any more time on this no longer traded instrument of CAT-
reinsurance. Let us pass to instruments that are more interesting, from both a
theoretical and practical point of view: PCS-futures and PCS-options.
A key deficiency of the statistics of the ISO agency is the truth of the declared
losses and premiums supplied for ISO by its own insurance companies. This was
clearly demonstrated in 1994 by the Northridge earthquake, when the ISO-index
turned out to be essentially lower, and the corresponding payments were far from
covering the actual losses. In 1995 the ISO-index was replaced by the PCS-index,
which is based on the size of the actual losses from a catastrophic event during a
definite period. It is usual to distinguish two periods: the risk-period (as a rule, the
quarter when the PCS agency estimates the losses as catastrophic) and the period
of development of the losses (usually half a year, when there is a refinement of the
information from the risk-period).
At the beginning of the risk-period the index is set equal to zero, and then
each point of it is equivalent to losses of 100 million dollars in the period being
observed. The size of possible losses is limited to 50 billion dollars, and to get
a monetary expression for options and futures, a monetary equivalent of each of
its points, namely, 200 dollars, is introduced on the PCS-index. Accordingly, the
PCS-index is defined by
where X t is the loss process, and C = 100 million dollars.

Naturally, concretization of the process X t is necessary in order to get calcula
tion formulas for futures and options on this index as the underlying asset.
We consider X t = where Nt is a Poisson process with intensity Л > 0,
and (Yi) is a sequence of independent (and independent of Nt) random variables
having a gamma-distribution with density
9 (n ,iJ,)(x )= Y (n )X 6 ** 1 X ^0 ,
where p )n > 0 and Г( •) is the gamma-function.
Clearly, the price of a futures contract at time t is equal to the sum of two
quantities: the losses up to the time £, divided by C (this is the value L*), and
the premium for the remaining risk, which is computed by the martingale method
presented in § 9.1:
(9.40) Д - Г . + АЧ W E z fl,
where the function /?( •) determines the “insurance” martingale measure. In par
ticular, by finding this measure from the exponential utility principle with U(ж) =
1 — а ~ 1 е ~ах, we arrive at (3(x) = сеж, and (9.40) can be calculated exactly:
Xnpn(T - 1 )
Ft — Lt + 0 ^ a < p.
(p - a )n+ l C ’
As for options on the PCS-index, an analogous simulation of the process X t for the
risk-period and the period of development, together with the Esscher technique for
finding martingale measures, leads to the determination of an appropriate price.
[2]-[4], [12], [17], [24], [26]—[32], [35], [36], [39], [48], [52]-[54], [61], [63]-[68],
[104]-[106], [109]-[112], [123], [124], [130], [131], [133], [136]-[138], [141],
[146], [147], [150], [151], [159]—[161].
Bibliographical Notes
C h a pter 1
The descriptive nature of the survey in Chapter 1 reflects an attempt to give an

idea about financial systems (§ 1.1), tendencies in their development (§1.3), models
of financial markets, and pricing of financial instruments (§1.2). Here attention
is focused on the classical Bachelier [H i. Black-Scholes [23], Merton [118], and
Cox-Ross-Rubinstein ([33], [34]) models, as well as a very enlightening example
of an incomplete market with stochastic volatility in the form of a “telegraph sig
nal” ([43], [127], [158]). The essentials of complete and incomplete markets are
explained along with the main principles for hedging of contingent claims (deriv
ative securities) and calculating the corresponding strategies and premiums, and
sketches are given for the basic methodological approaches and mathematical tech
niques (methods of the theory of martingales and differential equations) ([27], [40],
[46], [49], [72], [73], [79], [81], [87], [90], [93], [94], [100], [106], [108], [126],
[134], [141]—[143], [158]). In the description of innovation tendencies in the evolu
tion of a financial system ([29], [122]) attention is given to the extremely attractive
idea of the “financial-innovation spiral” ([118], [121]). Also called the “Merton spi
ral” in this book, it acquires for the first time an intuitive graphical interpretation
in terms of incompleteness parameters of financial markets ([111], [112]).
With regard to insurance (§ 1.4), which is intentionally treated in the general
context of a financial system, we use the references [17], [26], [35], [64], [68].
Here we give the first facts about the connection observed between finance and
insurance in terms of investment on financial markets ([54], [106]), calculating
flexible insurance schemes, and catastrophe insurance ([2]-[4], [28], [31], [32], [36],
[112], [158], [161]).
C h a pter 2
The description of the necessary elements of the theory of random processes

in §2.1 uses mainly [149], [154], and that in §2.2 uses [98], [103], [154]. The
exposition in §2.3 is based on [106], [107]. A more complete picture of the semi
martingale calculus can be obtained from [82], [104]. Theorems on representation
of martingales, on optional decomposition of semimartingales, and on Snell en
velopes in the theory of controlled random processes can be found in [49], [55],
[81], [90], [94], [98], [141], [158].
C h a pter 3
The theory of hedging in complete markets presented in §3.1 is given in semi

martingale (and hence most general) form, and follows [106], [107], [115], [158]
(see also [27], [72], [73], [152]). The methodology for finding martingale measures
181
182 BIBLIOGRAPHICAL NOTES
in §3.2 is based on [107], [115]. This methodology is used to derive from general
results in §3.1 a spectrum of classical formulas for hedging strategies and call op
tion prices for the Black-Scholes model ([15], [16], [21], [44], [46], [51], [79], [83],
[86], [87], [90], [100], [117], [118], [126], [141], [143]), the Merton model [118],
the Cox-Ross-Rubinstein binomial model ([21], [33], [34], [44], [46], [51], [79],
[100], [108], [113], [126], [141], [142], [158]), and the complete jump-diffusion
model ([1], [13], [22], [100], [115], [116], [158]). In the study in §3.3 of optimal
investment in the sense of maximalizing the mean utility function, the basic result is
taken from [95], and from it formulas are obtained for optimal (with a logarithmic
utility function) investment strategies in the case of the above (complete) models
of a (£ , S)-market ([46], [51], [87], [90], [100], [113], [118]-[120]).
Chapter 4
In §4.1 a description is given (in semimartingale form) of financial markets

in which there is more than one martingale measure, and this is identified with
incompleteness of the market. To characterize a hedging methodology adequate for
these conditions, we invoke the concept of superhedging with the use of theorems on
optional decomposition and on Snell envelopes in the theory of controlled random
processes (see Chapter 2) ([38], [40], [49], [81], [90], [91], [94], [95], [107], [152],
[158]).
A fully representative example of an incomplete market is given [20] in which
perfect hedging of a series of contingent claims is nevertheless possible.
In §4.2 a systematic study is made of the Black-Scholes model with stochastic
volatility ([77], [80], [81]). The stress is on the case when the volatility is a bounded
process ([8]—[10], [15], [50], [59], [60], [127]). For the model with volatility in the
form of a “telegraph signal” a corresponding methodology for hedging contingent
claims is worked out that leads to an optimal control problem for diffusion processes
and to the Bellman equation ([98], [99]). In this way the ask and bid prices of
options are calculated by the small parameter method ([43], [127], [158]). An
example is also given [76] of a complete diffusion market with stochastic volatility.
In § 4.3 a survey is given of methods for estimating volatility: point and interval
estimation ([5], [62], [153]), along with estimation from the statistic of option prices
with indication of the so-called smile effect [77].
Chapter 5
The basic theoretical propositions in §5.1 on the topic of markets with con
straints were taken from [55] and [158], with [82] as the main source on stochastic
analysis. Concrete calculations for particular models with constraints like prohibi
tion of short sales and with different credit and deposit interest rates are derived
from general theoretical propositions, and this correlates with earlier particular
results ([14], [37], [90], [92], [144], [145]).
In § 5.2 Leland’s approach to hedging in the Black-Scholes model with trans
action costs is presented ([69], [102], [85]). With regard to investment problems
with small transaction costs the exposition follows [157], which in its formulation
is related to [7], [125].
Concrete applications of the theory to the Russian financial market are pre
sented in § 5.3.
BIBLIOGRAPHICAL NOTES 183
Chapter 6
Chapter 6 concentrates on two types of imperfect hedging: mean-variance hedg
ing in §6.1, and quantile hedging in §6.2.
For mean-variance hedging a general methodology is given ([56], [101], [139]),
which is then interpreted in the concrete classical models: Black-Scholes, Merton,
and Cox-Ross-Rubinstein ([46], [47], [51], [93], [126], [141]).
As for quantile hedging, which is to a certain degree a dynamic variant of the
now popular VaR method in financial risk management ([71], [84]), this topic is
scarcely represented at all in the monograph literature. The methodology used in
treating this type of hedging is based on the papers [57] and [58], whose authors
associate the origin of the approach first and foremost with the names D. Heath and
M. Kulldorff. Concrete calculations, representing independent problems in them
selves, are given as earlier for the Black-Scholes, Merton, Cox-Ross-Rubinstein,
and jump-diffusion models ([25], [97], [108], [148]).
Chapter 7
The exposition in § 7.1 of problems involving American options and the general
method of pricing them is based on optional decomposition (see Chapter 2) [158].
A complete solution of the problem is given there in the framework of the Black-
Scholes model, by reducing it to the solution of the corresponding optimal stopping
problem, based mainly on [143] (see also [46], [51], [87], [90], [98]). The method
presented at the end of § 7.1 for solving the indicated problem is taken from [19].
In § 7.2 a whole spectrum of analytic formulas is given for various American
options ([96], [155], [156]).
In § 7.3 a complete solution of the quantile hedging problem is given for Amer
ican options in the Black-Scholes model, mostly following [162]. An analogous
problem, in more general form but with less complete results, is treated in [132].
Chapter 8
The general idea of the term structure of bond prices is presented in §8.1.
This structure is made specific for the classical Ho-Lee and Heath-Jarrow-Morton
models ([22], [46], [74], [75], [79], [108], [126], [133], [135], [141]).
In § 8.2 the problem is solved of hedging options on a bond in the framework of
the Ho-Lee model and the Heath-Jarrow-Morton model ([74], [75], [108], [126],
[129], [135], [141]).
In § 8.3 investment problems on a bond market are treated for the Ho-Lee and
Heath-Jarrow-Morton models when an optimal strategy is found from the condition
that the mean logarithmic utility function be maximized ([46], [64], [108], [135]).
Chapter 9
In §9.1 a model of collective risk is studied, and a set of commonly accepted

actuarial principles for calculating insurance premiums is presented ([17], [26],
[35], [53], [64], [131], [136], [151]). It is shown in the framework of the Cramer-
Lundberg model how the “financial” no-arbitrage principle works in insurance cal
culations, and from this the above actuarial principles for calculating insurance
premiums are deduced ([39], [146]).
184 BIBLIOGRAPHICAL NOTES
§9.2 is devoted to problems in life insurance ([26], [65], [68]). It is shown that
the Black-Scholes formula arises in the structure of premiums when working out
“flexible” insurance schemes (insurance payments are'connected with the price of a
stock in the Black-Scholes model), and a component of the Black-Scholes equation
arises in Thiele’s equation for reserves ([3], [12], [24], [124], [130], [131], [133],
[136], [150]).
In § 9.3 questions are investigated concerning an insurance company’s solvency.
The ruin probability provides an adequate description of this. A study is made of
the ruin probability in the framework of a semimartingale model for the capital
of the insurance company [147], and then the results obtained are connected with
more specific models ([48], [137]). In the case of the Cramér-Lundberg model,
corresponding integro-differential equations and differential equations are obtained
for the ruin probability as a function of the initial capital, equations leading to the
Cramér-Lundberg exponential estimates. Further, it is indicated that the exponen
tial asymptotics can be violated if the company invests capital on a Black-Scholes
market ([35], [61], [106], [136]).
In § 9.4 questions involving the insurance of catastrophe risks are considered,
and possible approaches are described in terms of traditional reinsurance, in terms
of the creation of specialized exchanges, and in terms of the creation of new instru
ments: “catastrophe” bonds and “catastrophe” forwards, futures, and options ([2],
[4], [28]—[32], [36], [52], [105], [109]-[112], [123], [124], [138], [159]-[161]).
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Subject Index
absolute continuity of distributions 18 conversion period 139

account, credit 66 coordinate base 27r
— , deposit 66 — process 18, 20
actuarial calculations 160 coupon 139
— mathematics 14 Cramer-Lundberg estimate 14, 174
— principles 160 critical function 107
arbitrage 4, 32 — set 114, 134
— opportunity 32 cumulant 172
ask (upper) price 50 cumulative payments 160
of an option 58 — premiums 160
balance equation 37, 149 decomposition, D oob 72

— relation 89 . — , Doob-M eyer 26
Basel accord 13 — , Kunita-Watanabe 27
binomial random walk 41 density 18
bond 139 — of a martingale measure 156
Brownian motion 7, 18 derivative security 4
--------, geometric 7 difference equation 76, 77
differential equation 176
canonical base 20
, Bellman 23
— decomposition 28, 67
— operator 21
catastrophe 15, 176
diffusion 22, 25
— bonds 177
— process 20, 21
— derivative securities 177
discounted value 31
— futures and options 15, 177
discounting 5
— risks 176
distinction between deposit and credit
cedent 161
accounts 65
claim 159
distribution 18
closed analytic formulas for prices and
— , lognormal 8
strategies 126
diversification 13, 15
commission fees 88
drift 21, 25
compensator 26
— vector 21
— of a measure 27
dual characterization 68, 79
condition, consistency 18
--------of a model 83
— , net return 172
— martingale measure 126
— , Novikov 10, 54
— problem 108
— , “smooth pasting” 92
— representation 127
confidence estimation of options 63
— level 64 effect, “smile” 62
consumption 32, 50 — , — , o f volatility 64
contingent claim 4, 32 34, 51, 77, 101, Emery distance 66
105 equation, balance 46
--------, attainable 33 — , Bellman’s 56, 91
--------, “bond” 139 — , Kolmogorov’s backward 21
--------, dynamic 69, 121, 123, 127 — , — forward 21
controlled diffusion process 23, 55 — , Thiele’s 170
controlling process 55 — , — classical 170
191
192 SUBJECT INDEX
equivalence o f distributions 18 — properties 13

excess o f surplus 161 — securities 177
— of loss 162 insurant 159
insurer 159
face value 139 integer-valued random measure 27
fair (rational) price 128-130 integro-differential equation 14, 175
family of martingale measures 29 investment 31, 87
— , predictably convex 67 — activity 14
filtration 17, 35 — on a bond market 153
financial system 1
— innovation spiral 11 jump diffusion model 113
formula, Black-Scholes 7, 15, 37, 41
leasing 11
— , Cox-Ross-Rubinstein 6, 43
Leland’s approach 87
— , Feynman-Kac 60
linear stochastic equation 28, 34, 173
— , Kolmogorov-Ito 8, 9, 14, 20, 23,
Lundberg constant 174
25, 31, 37, 51, 58, 88, 90, 100, 102,
111, 114, 132, 136, 137, 170 market, (B, P )- 139
— , Merton’s 39 — , complete 4
— , Yor’s 29 — , — ( £ ,S )- 33, 34, 102
forward contract 4 — , financial 4
— interest rates 142 — , incomplete 4, 8, 40
fractal structure 3 — , no-arbitrage (B, S)- 102
functional, loss 23 — , reinsurance 162
function, Kummer 132 — , semimartingale ( B, S) - 121
— , payment 122 — with stochastic volatility 9
— , payoff 23 markets with structural constraints 65
— , price 43, 48, 154 transaction costs 65
— , utility 43, 48, 153 Markov diffusion process 21
fundamental equation of Black and — process 20, 51
Scholes 8, 37, 56, 57, 61, 89 , homogeneous 21
— lemma of Neyman and Pearson — property 51
106-108 martingale 24, 26
— approach to calculating premiums
generating operator 21 166
Girsanov exponential 29 — characterization 32
gross premium 160 of strategies 31, 49
hedge 33, 121 — , local 10, 26, 28, 51, 84, 126
— , minimal 9, 33, 34, 37, 50, 55, 121 — , Poisson 25
— , optimal 69, 75 — , square-integrable 26
hedging 9, 31, 33, 87 — , — , locally 26
— error 89 — , uniformly integrable 26
— in the Heath-Jarrow-Morton model matrix, diffusion 21
149 maximal success set 107
— , mean-variance 10, 97 measurability 17
— on a bond market 144 — , progressive 17
— , perfect 31, 97 measure 5
— , quantile 97 — , martingale 5, 6, 34, 36, 127, 162,
— strategy 33, 69, 121 163
--------with ^-constraints 69 — of incompleteness 11
heuristic principle 5, 8 — , risk-neutral 5
— , Wiener 18
indistinguishability 17 method, differential equations 8
inequality, Jensen’s 161 — of moments 61
infinitesimal operator 21 — , small parameter 57
initial value 121 minimal hedging strategy 55, 71, 75,
insurance 159 83
— , life 167 ------------ with N-constraints 69, 70
— , “nonlife” 159 -------------with consumption 123, 127
— , property 159 minimality 50
SUBJECT INDEX 193
— of risk 99 — , arbitrage 162

minimization of risk 10 portfolio 4, 145
model, Bachelier 6 — , self-financing 4, 32, 65
— , binomial 6, 41 power of a sequential test 134
— , — , with different interest rates predictable measure 27
71, 87 — process 25, 51
— , Black-Scholes 35, 45, 52, 53, 88, — <r-algebra 25
100, 105, 108 premium 159
— , — , with different interest rates 78 — , one-time 168
— , Cox-Ross-Rubinstein 6, 41, 47, — , periodic 168
103, 117 — with a load 160
— , Cramer-Lundberg 162, 163, 166, price, bid, o f an option 58
167 — , Black-Scholes 63
— , Heath-Jarrow-Morton 140, 142, principle, equivalence 160, 168
154 — , Esscher 161
— , Ho-Lee 146, 156 — , martingale 166
— , — , continuous 152 — , mathematical expectation 161
— , jump-diffusion, of a market 39, — , net-premium 160
113 — , no-arbitrage 5, 6, 7, 8
— , Merton 38, 46, 111 — o f calculating premiums based on
— , — , with different interest rates 83 the concept o f utility 161
— of a financial market 3 — , Prokhorov-Donsker invariance 20
— of collective risk 160 — , standard-deviation 161
models of markets with stochastic — , variance 161
volatility 59 probability o f an error of the first kind
modifications 17 134
mortality rate 169 — space 4
multiplicative form 68 procedure, localization 26
mutual quadratic characteristic 27 process, admissible 66
— , autoregression 53
net premium 160
— , mortality 169
nonrisky asset 3, 31
— , Poisson 9, 25, 38, 83, 102, 111,
nonruin probability 174
113, 162, 173
operating costs, 88 — , risk 160
optimal investment 43 — , square-integrable 98
— portfolio 90, 133 — , upper variation 85
— proportion 47, 48 — , Wiener 7, 18, 21, 24, 35, 51, 100,
— stopping problem 125 113, 143, 173
time 125 prohibition on short sales 65
— value 47 proportion 45, 47, 48
option, American 121 proportional costs 88
— , call (to buy) 4, 37, 43 pure endowment 168
— , European 32 purely continuous component 26
— , — call 37, 100 — discontinuous component 26
— , integral 131 local martingales 26
— , put (to sell) 38
— , Russian 131 quantile 105
optional decomposition 9, 65 — hedging 104, 119, 132
— process 25
random process 3, 17
— cr-algebra 25
-------- , progressively measurable 24
overhead costs 11, 88
rational cost 101
parity relation 38 — exercise time 123, 128-131
payment function 77 reinsurance 161
PCS-futures 178 — , nonproportional 162
PCS-options 178 — o f catastrophe risks 159
perfect hedge 107, 108 — , proportional 161
Poisson weighting 41 — , traditional 177
policy 162 relative yield 7
194 SUBJECT INDEX
replicated contingent claim 4 supermartingale 9, 26, 74

replication 33 — characterization 68
representation o f martingales 20, 24 system, reinsurance 161
reserve 169 systems, “flexible” insurance 159
— capital 169 — , risk-control 2
responsibility level of a company 161
risk 10, 103, 159, 160 tables, general 167
— management 13 — , mortality 167
— of a strategy 99 — , special (selective) 167
risk-free asset 10, 31 term structure o f interest rates 139
riskiness of an asset 3 theorem, Girsanov’s 10, 20, 23, 35, 36,
risk-neutral character 5 51, 54, 84
risks, calculation of 13 — , — , for local martingales 79
risky asset 3, 31 — , — , for semimartingales 80
ruin probability 14, 171 — , Kolmogorov’s 18, 19
— , martingale representation 29
sample path 17
— , optimal decomposition 30
self-similarity 19
time, rational 123
semimartingale 25, 27, 31, 34, 51
— , ruin 173
set o f martingale measures 8, 115
— , stopping 26
singularity 19
— , — , rational 123, 127
Snell envelope 9
topology, Emery 66
solvency 14
tracking error 57
spot market 139 traditional insurance 13
spread 11
transaction costs 87, 88
stochastic base 17
transform, Esscher 178
— differential equation 22
— , Legendre 43
— exponential 34, 42, 73, 74, 82, 85
transition probability 21
— financial mathematics 15
triplet of predictable characteristics of
— integral 22
a semimartingale 28
— integration 22
— volatility 9 underlying asset 3
stop loss 162 — securities 3
strategy, admissible 105, 134 upper variation of a family 67
— , investment 4, 145 utility 43
— , investor 72, 78
— , Leland’s 89 value 145
— , mean-variance optimal 97 — at risk (VaR) 119
— , self-financing 79 — for the investor 31
— with consumption 8, 32, 65, 72, 74, — o f portfolio 4
79 volatility 6, 35, 52, 61, 140
structure, interest rate 139 — , intrinsic 63
— , optimal hedge 85 — , stochastic 52
submartingale 26
successful hedging set 105 Wald problem 134
superhedging 9, 49, 50 white noise 6
T itles in This Series
212 A . V . M el'n ik ov , S. N . V olk ov , an d M . L. N ech a ev , Mathematics of financial

obligations, 2002
211 T akeo O hsaw a, Analysis of several complex variables, 2002
210 Toshitake K o h n o , Conformal field theory and topology, 2002
209 Y asu m asa N ishiura, Far-from-equilibrium dynamics, 2002
208 Y u k io M a ts u m o to , An introduction to Morse theory, 2002
207 K e n ’ ichi O hshika, Discrete groups, 2002
206 Y u ji Shim izu an d K e n ji U en o, Advances in moduli theory, 2002
205 Seiki Nishikawa, Variational problems in geometry, 2001
204 A . M . V in o g ra d o v , Cohomological analysis o f partial differential equations and
Secondary Calculus, 2001
203 T e Sun H an an d K in g o K oba ya sh i, Mathematics o f information and coding, 2002
202 V . P. M a slov and G . A . O m el'y a n ov , Geometric asymptotics for nonlinear PDE. I,
2001
201 Sh igeyu ki M o rita , Geometry of differential forms, 2001
200 V . V . P ra solov and V . M . T ik h o m iro v , Geometry, 2001
199 Shigeyuki M orita , Geometry of characteristic classes, 2001
198 V . A . S m irn ov, Simplicial and operad methods in algebraic topology, 2001
197 K en ji U en o, Algebraic geometry 2: Sheaves and cohomology, 2001
196 Y u. N . L in 'kov, Asymptotic statistical methods for stochastic processes, 2001
195 M in oru W a k im oto, Infinite-dimensional Lie algebras, 2001
194 V a lery B . N e v zo ro v , Records: Mathematical theory, 2001
193 T osh io N ish ino, Function theory in several complex variables, 2001
192 Y u. P. S olov y ov and E. V . T roitsk y, C*-algebras and elliptic operators in differential
topology, 2001
191 Shun-ichi A m a ri and H irosh i N agaoka, Methods o f information geometry, 2000
190 A lex a n d er N . Starkov, Dynamical systems on homogeneous spaces, 2000
189 M itsu ru Ikawa, Hyperbolic partial differential equations and wave phenomena, 2000
188 V . V . B u ld y gin and Y u. V . K oza ch en k o, Metric characterization o f random variables
and random processes, 2000
187 A . V . Fursikov, Optimal control of distributed systems. Theory and applications, 2000
186 K azu ya K a to , N ob u sh ige K urokaw a, an d Takeshi Saito, Number theory 1:
Fermat’s dream, 2000
185 K en ji U en o, Algebraic Geometry 1: From algebraic varieties to schemes, 1999
184 A . V . M el'n ik ov , Financial markets, 1999
183 H a jim e Sato, Algebraic topology: an intuitive approach, 1999
182 I. S. K rasil'shchik and A . M . V in o g ra d o v , E d itors, Symmetries and conservation
laws for differential equations of mathematical physics, 1999
181 Y a. G . B erk ovich and E. M . Z h m u d ', Characters of finite groups. Part 2, 1999
180 A . A . M ily u tin and N . P. O sm olovsk ii, Calculus of variations and optimal control,
1998
179 V . E. V oskresenskii, Algebraic groups and their birational invariants, 1998
178 M itsu o M o rim o to , Analytic functionals on the sphere, 1998
177 Sat or u Igari, Real analysis— with an introduction to wavelet theory, 1998
176 L. M . L erm an and Y a. L. U m an skiy, Four-dimensional integrable Hamiltonian
systems with simple singular points (topological aspects), 1998
175 S. K . G o d u n o v , Modern aspects of linear algebra, 1998
TITLES IN THIS SERIES
174 Y a -Z h e C h en an d L a n -C h en g W u , Second order elliptic equations and elliptic

systems, 1998
173 Y u . A . D a v y d o v , M . A . Lifshits, an d N . V . S m orod in a , Local properties of
distributions of stochastic functionals, 1998
172 Y a. G . B erk ovich an d E. M . Z h m u d ', Characters of finite groups. Part 1, 1998
171 E. M . Lan dis, Second order equations of elliptic and parabolic type, 1998
170 V ik to r P ra so lo v an d Y u ri S olov y ev , Elliptic functions and elliptic integrals, 1997
169 S. K . G o d u n o v , Ordinary differential equations with constant coefficient, 1997
168 J u n jiro N og u ch i, Introduction to complex analysis, 1998
167 M asa ya Y a m a gu ti, M a sa yosh i H ata, an d J u n K iga m i, Mathematics of fractals, 1997
166 K e n ji U en o, An introduction to algebraic geometry, 1997
165 V . V . Ishkh an ov, B . B . L u r'e, an d D . K . F ad deev, The embedding problem in
Galois theory, 1997
164 E. I. G o rd o n , Nonstandard methods in commutative harmonic analysis, 1997
163 A . Y a. D o ro g o v ts e v , D . S. S ilvestrov, A . V . S k orok h od , an d M . I. Y ad ren k o,
Probability theory: Collection of problems, 1997
162 M . V . B old in , G . I. S im on ova, an d Y u . N . T y u rin , Sign-based methods in linear
statistical models, 1997
161 M ich a el B lan k, Discreteness and continuity in problems of chaotic dynamics, 1997
160 V . G . O sm olovsk ii, Linear and nonlinear perturbations of the operator div, 1997
159 S. Y a. K h a vin son , Best approximation by linear superpositions (approximate
nomography), 1997
158 H idek i O m ori, Infinite-dimensional Lie groups, 1997
157 V . B . K olm a n ov sk ii an d L. E. Shatkhet, Control of systems with aftereffect, 1996
156 V . N . S h evch en ko, Qualitative topics in integer linear programming, 1997
155 Y u. S afarov and D . V assiliev, The asymptotic distribution o f eigenvalues of partial
differential operators, 1997
154 V . V . P ra so lo v and A . B . Sossinsky, Knots, links, braids and 3-manifolds. An
introduction to the new invariants in low-dimensional topology, 1997
153 S. K h . A ra n son , G . R . B elitsk y, and E. V . Z h u zh om a, Introduction to the
qualitative theory of dynamical systems on surfaces, 1996
152 R . S. Ism agilov, Representations of infinite-dimensional groups, 1996
151 S. Y u. Slavyanov, Asymptotic solutions of the one-dimensional Schrodinger equation,
1996
150 B . Y a. L evin , Lectures on entire functions, 1996
149 Takashi Sakai, Riemannian geometry, 1996
148 V la d im ir I. P ite rb a rg , Asymptotic methods in the theory of Gaussian processes and
fields, 1996
147 S. G . G in dik in and L. R . V olevich , Mixed problem for partial differential equations
with quasihomogeneous principal part, 1996
146 L. Y a. A d ria n ov a , Introduction to linear systems of differential equations, 1995
145 A . N . A n d ria n ov and V . G . Z h u ravlev, Modular forms and Hecke operators, 1995
144 O. V . T rosh kin, Nontraditional methods in mathematical hydrodynamics, 1995
143 V . A . M a ly sh ev an d R . A . M in los, Linear infinite-particle operators, 1995
142 N . V . K ry lo v , Introduction to the theory of diffusion processes, 1995
141 A . A . D a v y d o v , Qualitative theory of control systems, 1994
140 A izik I. V o lp e rt, V ita ly A . V o lp e rt, and V la d im ir A . V o lp e rt, Traveling wave
solutions of parabolic systems, 1994
TITLES IN THIS SERIES
139 I. V . Skrypnik, Methods for analysis of nonlinear elliptic boundary value problems, 1994
138 Y u. P. R a zm y slov, Identities of algebras and their representations, 1994
137 F. I. K a rp elev ich and A . Y a. K rein in , Heavy traffic limits for multiphase queues, 1994
136 M asayoshi M iyanishi, Algebraic geometry, 1994
135 M asaru Takeuchi, Modern spherical functions, 1994
134 V . V . P rasolov, Problems and theorems in linear algebra, 1994
133 P. I. N aum kin and I. A . S h ishm arev, Nonlinear nonlocal equations in the theory of
waves, 1994
132 H a jim e Urakawa, Calculus o f variations and harmonic maps, 1993
131 V . V . Sharko, Functions on manifolds: Algebraic and topological aspects, 1993
130 V . V . V ershinin, Cobordisms and spectral sequences, 1993
129 M itsu o M o rim o to , An introduction to Sato’s hyperfunctions, 1993
128 V . P. O rev k ov, Complexity of proofs and their transformations in axiomatic theories,
1993
127 F. L. Zak, Tangents and secants o f algebraic varieties, 1993
126 M . L. AgranovskiY, Invariant function spaces on homogeneous manifolds of Lie groups
and applications, 1993
125 M asayoshi N agata, Theory of commutative fields, 1993
124 M asahisa A d a ch i, Embeddings and immersions, 1993
123 M . A . A k iv is and B . A . R o se n fe ld , Elie Cartan (1869-1951), 1993
122 Z hang G u a n -H ou , Theory o f entire and meromorphic functions: deficient and
asymptotic values and singular directions* 1993
121 I. B . Fesenko and S. V . V ostok ov , Local fields and their extensions: A constructive
approach, 1993
120 Takeyuki H ida and M asu yu k i H itsu da, Gaussian processes, 1993
119 M . V . K arasev and V . P. M a slov, Nonlinear Poisson brackets. Geometry and
quantization, 1993
118 K en kich i Iwasawa, Algebraic functions, 1993
117 B oris Z ilb er, Uncountably categorical theories, 1993
116 G . M . F el'dm an, Arithmetic of probability distributions, and characterization problems
on abelian groups, 1993
115 N ikolai V . Ivanov, Subgroups of Teichmuller modular groups, 1992
114 Seizo Ito , Diffusion equations, 1992
113 M ich ail Zhitom irskit, Typical singularities of differential 1-forms and Pfaffian equations,
1992
112 S. A . L om ov , Introduction to the general theory of singular perturbations, 1992
111 S im on G in dikin , Tube domains and the Cauchy problem, 1992
110 B . V . Shabat, Introduction to complex analysis Part II. Functions of several variables,
1992
109 Isao M iya dera, Nonlinear semigroups, 1992
108 Takeo Y okon u m a, Tensor spaces and exterior algebra, 1992
107 B . M . M akarov, M . G . G olu zin a, A . A . L od k in , and A . N . P o d k o r y to v , Selected
problems in real analysis, 1992
106 G .-C . W en , Conformal mappings and boundary value problems, 1992
105 D . R . Y afaev, Mathematical scattering theory: General theory, 1992
For a complete list of titles in this series, visit the

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Am erican M athem atical S ociety

American Mathematical Society

А. В. Мельников, M. Л. Нечаев, С. H. Волков

Translated from the Russian by H. H. McFaden

2000 Mathematics Subject Classification. Primary 91-02, 91B24, 91B28, 91B26;

L ib ra ry o f C on g ress C a ta log in g -in -P u b lica tion D a ta

HG4515.3 .M4513 2002

C o p y in g an d reprin tin g . Individual readers of this publication, and nonprofit libraries

© 2002 by the American Mathematical Society. All rights reserved.

Chapter 1. Financial Systems: Innovations and the Risk Calculus 1

Chapter 2. Random Processes and the Stochastic Calculus 17

Chapter 3. Hedging and Investment in Complete Markets 31

Chapter 4. Hedging and Incomplete Markets 49

Chapter 5. Markets with Structural Constraints and Transaction Costs 65

Chapter 6. Imperfect Forms of Hedging 97

Chapter 7. Dynamic Contingent Claims and American Options 121

Chapter 8. Analysis of “Bond” Contingent Claims 139

Chapter 9. Economics of Insurance and Finance: Convergence of Quantita­

Bibliographical Notes 181

Subject Index 191

Contemporary financial mathematics and the associated theory of actuarial

(fly 3ri P ) probability space (My N) mutual quadratic characteris­

Rd d-dimensional Euclidean space

Financial Systems: Innovations

We present the concept of a financial system as a collection of firms, intermedi­

§ 1.1. Financial systems and their innovation changes

A financial system is formed by a space endowed with financial markets through

F igure 1.1. Schematic representation of a financial system.

managing a portfolio made up of a complex combination of securities. As a result,

§ 1.2. General statements in the analysis of

We consider a model of a financial market as a pair of assets: a nonrisky asset

(1.1) X ? ( x ) = & Bt + 7tSu X £ = x.

(1.2) X ? - X U = A X ? = fitA B t + TfcASt, t = 1 ,2 ,...

F ig u r e 1.2. CCG (Contingent Claims’ Graphs).

Otherwise, it is said to be incomplete. In other words, a (B, 5)-market is complete

F ig u r e 1.3. TVG (Terminal Values’ Graphs).

A (B,S)-m arket does not admit arbitrage opportunities there is a prob­

Such a measure is called a martingale measure. Since a martingale is constant

On a complete no-arbitrage (B,S)-m arket the price of any contingent claim is

As a result we arrive at the following general statement about pricing contingent

(1.3) Vo = V * ( l + r ) - T(ST - K ) + = S0M(t0,T ,p ) - K ( l + r ) - TM(t0,T ,p*),

(1.4) = H + <rwt, S0 > 0,

and averaging with respect to it, we come to Bachelier’s formula:

(1.5) Vo = E *(ST - K ) + = (So - K ) * ’

F ig u r e 1.4. Evolution of return in the Bachelier model.

(1.7) dBt = rBt dt, dSt = Stii^dt+ adwt), So > 0,

( 1. 8 ) Bt = B0ert St = S0e»t- ^ + aWt.

The process St represented in this form is called a geometric Brownian motion.

(1.9) C s s (5o, T, r, a) = V0 = E *e~r-T K ) +

which for ¡I = r coincides with the Black-Scholes price:

CheuM = C bs (So, T ,r,a ).

Application of the Kolmogorov-Itô formula to v(St,t)/Bt leads to the relation

( H I) »(St’ *) v(s Qi°) , f dv{Su>u)

{(7r,C) : 7t = (/?,7), C a nondecreasing process}.

and hence is a positive supermartingale with respect to any measure P G M(S/B).

^ - = ess sup E (B ^ 1f T \3rt),

(1.15) VT = v ¥ ' C ) > f T (a.s.).

According to its supermartingale property we have that for any P G M(S/B)

(1.16) ess sup ’E (B T 1fT\3rt)

must be the natural price of a contingent claim f r on an incomplete (¿?, 5 )-market.

A market with stochastic volatility.

(1.17) dBt = Btr d t} dSt = St(p>dt + T,t dwt),

where r ^ 0, = a2 + ( ~ l ) Nt A a 2, 0 ^ A a 2 < a 2, and Nt is a standard Poisson

Chapter 9. Economics of Insurance and Finance: Convergence of Quantita

(fly 3ri P ) probability space (My N) mutual quadratic characteris

We present the concept of a financial system as a collection of firms, intermedi

A (B,S)-m arket does not admit arbitrage opportunities there is a prob

(1.5) Vo = E (ST - K ) + = (So - K ) ’

determine two martingale measures in M (S /B ), which testifies to the incomplete

It is necessary to discuss (and now we are in a position to do this) the relation

actuarial theory and practice had to be enriched by stochastic financial mathemat

■- , x n) = (2wti) e ^ ■(2ir{tn - tn -x)) e 2(‘»-"n-i> .