Finance Stochast.

2, 399–408 (1998)

c Springer-Verlag 1998

Lévy processes in finance: a remedy

to the non-stationarity of continuous martingales
Boris Leblanc1 , Marc Yor2
1 Ingenierie Options G.I.E./Groupe BNP, Université Paris VII, 13, rue La Fayette, F-75009 Paris,
France (e-mail: boris@bnp-eng.remcomp.com)
2 Université Paris VI, Laboratoire de Probabilités, Tour 56, 4 place Jussieu, F-75252 Paris Cedex

05, France (e-mail: secret@proba.jussieu.fr)

Abstract. In thisR note, we prove that under some minor conditions on σ, if a

t
martingale Xt = 0 σu dWu satisfies, for every given pair u ≥ 0, ξ ≥ 0, Xu+ξ −
Xu =(law) Xξ , then necessarily, |σu | is a constant and X is a constant multiple of
a Brownian motion, thus providing a partial analogue of Lévy’s characterisation
of Brownian motion. In the introduction we explain why this theorem is a reason
for considering Lévy processes in finance.

Key words: Levy processes, martingales with stationary increments, forward-

start-options

JEL classification: G13

Mathematics Subject Classification (1991): 90A09, 60J60, 60H30

1 Introduction

Recent developments in mathematical finance have explored several modelisa-

tions of the underlying. One of the main goals of these models is to capture
the so-called Volatility Smile. Indeed, the Black-Scholes framework assumes that
the underlying process follows a geometrical Brownian motion with a constant
volatility and a constant drift. This means in particular that there exists a constant
Σ such that for any given strikes Ki and any maturities Tj ,the market option price
is given by C BS (Σ, Ki , Tj ) where C BS is the well-known Black-Scholes formula:

Manuscript received: May 1997; final version received: November 1997

The first author thanks Stephane Tyc for his useful comments on the financial motivation of this
study.
400 B. Leblanc, M. Yor

!
ln( SK0 ) − rT + 12 Σ 2 T
C BS
(Σ, K , T ) = S0 N √
Σ T
!
−rT ln( SK0 ) − rT − 12 Σ 2 T
−Ke N √
Σ T

where S0 is the actual value of the underlying, r is the risk-free interest rate,
N (x ) is the cumulative density function of a standard normal law.
Now, in the “real world”, the price structure observed in the market leads to
a function Σ of both Ti and Kj . Thus, one of the aims of mathematical finance
research is to obtain a model on the underlying process which will reproduce
this structure.
For the sake of simplicity, we will assume here that under the risk neutral
probability, r = 0. A deterministic rate could be easily added to our arguments.
We can firstly notice that, under the risk neutral probability, if C (K , T ) is the
market call option price,
∂C
P(STi < Kj ) = − (Ki , Tj ).
∂K
This remark shows that it is equivalent to know every market price for every
strike and every maturity or to know the one-dimensional marginals (: laws) of
the underlying for every t. However, many models could still be suggested.
In order to fit a structure of prices, the following stochastic volatility models
were introduced by Hull and White [HW87]:
dSt p
= 1 − ρ2 σt dWt(1) + ρσt dWt(2) ,
St
d σt = a(σt , t) dt + b(σt , t) dWt(2) .

where Wt(1) and Wt(2) , ρ is a correlation factor and a and b are two functions
which ensure the existence of σ.
Another famous and simple model was suggested by Dupire [Dup93]. Indeed,
taking option prices C (K , T ) and a diffusion model

dSt = σ(St , t)dWt

with
∂C (x ,t)
1 2 ∂t
σ (x , t) = ∂ 2 C (x ,t)
,
2
∂x 2
then one will get back (at least if σ(S , t) is bounded by two strictly positive
values),
E [(ST − K )+ ] = C (K , T ).
Thus, knowing all prices for every K and every T , one could easily get a diffusion
model which reproduces those prices. It has to be noticed that those prices could
be either generated by market prices or generated by some stochastic volatility
model. In that last case, all the vanilla option prices will be the same but the
Lévy processes in finance: a remedy to the non-stationarity of continuous martingales 401

dynamics will be different and so will be exotic option prices. For instance, it
has been shown (see [Leb97]) that lookback options will always be different in
the two models unless σ is constant.
Then, which model i.e which dynamics should we choose? One financial
key-argument is based on forward options. A forward option is a standard option
but whose payoff is based on the future values of the underlying. Typically,
ST
C F (K , t, T ) = E [( − K )+ ], t < T
St
is a forward option T − t years in t year (based on the yield). The idea is that
this option should only depend on T − t. Indeed the one-week randomness of the
yield in two years should be the same as the one-week randomness of the yield
in three years and this will be roughly the same as the one-week randomness
now if no known events are expected.
Thus, taking the logarithm of the underlying, Xt = ln( SS0t ), we could guess
that a good dynamic feature will be:
(law)
∀u and ξ fixed, Xu+ξ − Xu = Xξ . (1)

Obviously, Lévy processes follow (1).

The financial motivation of this note is to show that none of the processes
described above follow the identity (1). In fact, even very general processes such
as dSt = σt dWt where σ is an adapted process with 0 < σmin ≤ σt ≤ σmax (see
for instance [ALP95]) will not follow (1).
This is the consequence of our Theorem 1 below; thus our present results
seem to indicate the opportunity of using Lévy processes in the modelisation of
the underlying.

2 The only continuous martingales with stationary increments are

Brownian motions

Theorem 1. Let Ft be a filtration in which W is a Brownian motion R t and F0+ is

trivial.
R∞ Let σ t be predictable with respect to Ft and a.s., for every t, 0 u
σ 2
du <∞
and, 0 σu2 du = ∞.
If the process Z t
Xt = σu dWu
0

where |σ| is continuous a.s. at time t = 0 follows (1), then necessarily du dP a.s.,
(|σu | , u ≥ 0) is equal to a constant c; hence,
(law)
(Xt , t ≥ 0) = (cβt , t ≥ 0)

where β is a standard Brownian motion.

In order to prove the theorem, we need the following lemma:

402 B. Leblanc, M. Yor

Lemma 1. Let Gt be a filtration and Mt a local Gt continuous martingale satis-

fying M0 = 0, and hM i∞ = ∞ a.s. This implies
Mt = γhM it
and more generally,
1
√ Mt = γ (ξ) ,
ξ ξ hM it
1

where γ.(ξ) ≡ √1 γξ. is a standard Brownian motion. Then, γ (ξ) and G∞ are
ξ
asymptotically independent when ξ converges to zero.
More precisely, for any Borel bounded functional Φ: C (R+ , R) → R, and any
bounded G∞ -measurable H ,
 
lim E Φ(γ (ξ) )H = E [Φ(γ)] E [H ]. (2)
ξ→0

Proof. For each deterministic Borel function f , bounded and with compact sup-
port, and H ∈ L 2 (G∞ ), we define:
R∞ R∞ 2
i f (u)d γu(ξ) + 12 f (u)du
Iξ = E [e 0 0 H ].
The change of variable u = ξ1 hM is , in the integrals yields

Iξ = E [εif∞ H ],
where R∞ R∞ d hM is
i f ( ξ1 hM is ) √
dMs 1
+2 f ( ξ1 hM is )2 ξ
εif∞ =e 0 ξ 0
.
Let Z t
Ht = E [H /Gt ] = hs dMs + Rt ,
0
where Rt is a martingale which is orthogonal to M (note that R0 = E [H /G0 ] =
H0 ). Thus, we get,
Z ∞ 
hM iu hu d hM iu
Iξ = E [H0 ] + iE εifu f ( ) √
ξ ξ
Z0 ∞ 
hM iu hu d hM iu
= E [H ] + iE εifu f ( ) √
0 ξ ξ
We may assume, from a density
R ∞ argument,
that h is bounded (say by 1) and we
obtain, letting cf = exp 12 0 f 2 (u)du :
Z ∞ 
hM iu d hM iu
|Iξ − E (H )| ≤ cf E |f ( )| √
0 ξ ξ
Z ∞ p Z ∞
t dt
≤ cf |f ( )| √ = cf ξ |f (u)|du
0 ξ ξ 0

which is going to zero as ξ is going to zero.

The convergence in (2) is then easily deduced, using the fact that, for each
ξ, γ (ξ) has a constant law, i.e it is a Brownian motion.
Lévy processes in finance: a remedy to the non-stationarity of continuous martingales 403

Proof of Theorem 1. Assume first that σ is continuous. If u > 0 is fixed, let

Z u+t Z t
(u)
Mt = σs dWs = σu+h dWu+h = γR u+t σ2 ds .
s
u 0 u

The lemma applies with Gt = Ft+u and it follows that γ (ξ) and F∞ are asymp-
totically independent.
R u+ξ
Consequently, √1 u σs dWs = γ (ξ) R u+ξ converge in distribution to
ξ 1 2
ξ σs ds
u
|σu |N , where N is a standard centered gaussian variable independent of |σu |.
(Here we used the measurability of σ with respect to F∞ and the continuity in
u of |σ|).
Under the hypothesis (1), the last result applies with u = 0, and we get:
(law)
|σu | = |σ0 |.

Since the σ-field F0+ is trivial, |σ0 | and thus the process |σu | are constant a.s
and equal to c ∈ R+ .
In the general case where σ is not necessarily continuous, we get from
Lebesgue’s theorem,
Z
1 u+ξ 2
P (d ω) du a.s, lim σs ds = σu2 (ω)
ξ→0 ξ u

and from Fubini’s theorem, we deduce that for every continuous and bounded f ,
1
du a.s, lim EP [f ( √ (Xu+ξ − Xu ))] = EP [f (|σu |N )], (3)
ξ→0 ξ
and this last expression does not depend on u from the hypothesis (1). If, more-
over, |σ| is continuous a.s at 0, then,

du a.s, EP [f (|σu |N )] = EP [f (|σ0 |N )].

Now, |σ0 | is constant and thus |σu | is equal to the same constant du dP a.s.

Remark. As carefully discussed in Chung-Williams [CW89] paragraph 3.3, fol-
lowing partially Itô [Ito44], [Ito61], the Itô stochastic integral may be defined
for any Ft -adapted, B[0,∞] ⊗ F∞ measurable process σ, which satisfies the
integrability condition in Theorem 1. Our proof of Theorem 1 extends without
any change to this more general class of integrands provided |σ| is continuous
at time 0. Note that (see [CW89]) for any “general” integrand σ, there exists a
predictable generalized process σ̃ such that σu (ω) = σ̃u (ω) du dP a.s.
Moreover, the example given by M. Barlow on page 71 of [CW89] shows
that stochastic integration with respect to a general continuous martingale cannot
be defined for such general measurable integrands.
404 B. Leblanc, M. Yor

3 Complements and related studies

3.1

A slightly unsatisfying aspect of our Theorem 1 is that we needed the continuity

a.s of |σ| at time 0. This may be remedied if we start from the stronger hypothesis:
(law)
∀u fixed, (Xu+ξ − Xu , ξ ≥ 0) = (Xξ , ξ ≥ 0) (4)

Thus, we get the following Theorem:

Theorem 2. Let Ft be a filtration w.r.t. which W is a Brownian motion R t and F0+ is
trivial.
R∞ Let σ t be predictable with respect to Ft and a.s, for every t, σ
0 u
2
du <∞
and, 0 σu2 du = ∞.
If the process
Z t
Xt = σu dWu
0

follows (4), then necessarily du dP a.s, (|σu | , u ≥ 0) is equal to a constant c and,

(law)
(Xt , t ≥ 0) = (cβt , t ≥ 0)

where β is a standard Brownian motion.

Proof. Every argument in the proof of Theorem 1 applies except the last one
which necessitates the continuity of |σ| at time 0. To finish the proof, we imme-
diately deduce from (4) the reinforced identity:
Z u+ξ Z ξ
(law)
∀u fixed, ( σs2 ds, Xu+ξ − Xu ; ξ ≥ 0) = ( σs2 ds, Xξ ; ξ ≥ 0) (5)
u 0

We then use again Lebesgue’s and Fubini’s theorems to get

Z u+ξ
1
du a.s P (lim σs2 ds exists ) = 1.
ξ→0 ξ u

As a consequence of (5), we obtain:

Z ξ
1
P (lim σs2 ds exists ) = 1.
ξ→0 ξ 0

Now, from the triviality of F0+ and (5), there exists a real c ≥ 0 such that,
Z u+ξ
1
for every u ≥ 0, P (lim σs2 ds = c) = 1,
ξ→0 ξ u

and the proof ends as in Theorem 1.


Lévy processes in finance: a remedy to the non-stationarity of continuous martingales 405

3.2

The importance of the continuity of |σ| at time 0 shows up clearly in the following
statement about Brownian martingales having the scaling property.
Theorem 3. Let Ft be a filtration in which W is a Brownian Rmotion and F0+ is
t
trivial. Let (σRt ) be predictable with respect to Ft and satisfy: 0 σu2 du < ∞, for
∞ 2
every t, and 0 σu du = ∞. We assume moreover that (|σu |, u ≥ 0) is continuous
a.s at time 0. Rt
If the local martingale Xt = 0 σu dWu satisfies

(law) √
for each λ > 0, (Xλt , t ≥ 0) = ( λXt , t ≥ 0), (6)

then necessarily, du dP a.s., (|σu |, u ≥ 0) is equal to a constant c, and:

(law)
(Xt , t ≥ 0) = (cβt , t ≥ 0),

where β is a standard Brownian motion.

Comment on Theorem 3: If we do not assume that (|σu |, u ≥ 0) is continuous at
time 0, then there are many examples of martingales X satisfying (6), different
from multiples
R t Wu of Brownian motion, e.g:
α
Xt = 0 ( √ ) dW u , for any α > 0, and more generally:
Rt u
Xt = 0 θu dWu where the predictable process θ satisfies the joint scaling
property with W :

(law) √
for each λ > 0, (Wλt , θλt ; t ≥ 0) = ( λWt , θt ; t ≥ 0).

Proof of Theorem 3. From the scaling property of X , and the well-known ap-
proximation of hX it by sums of squares of increments, we deduce from (6) that:
R λt Rt
for each λ > 0, ( λ1 0 σu2 du, t ≥ 0)=(law) ( 0 σu2 du, t ≥ 0).
Letting λ → 0 on the left hand side, and using the a.s continuity of (|σu |, u ≥
0) at 0, we obtain:
Z t
(law)
( σu2 du, t ≥ 0) = (c 2 t, t ≥ 0),
0

where c = |σ0 |. (Of course, the equality in law is, in fact, an a.s equality).
Finally, we obtain:

(law)
(Xt , t ≥ 0) = (cβt , t ≥ 0),

as announced.

406 B. Leblanc, M. Yor

3.3

We now come back to our previous stationarity problem, but we consider more
generally, Itô type semimartingales:
Z t Z t
Xt = σu dWu + bu du,
0 0

where (bu , u ≥ 0) is a (Fu ) predictable, locally bounded process.

Then, under the “weak” stationarity assumption (1), but with the continuity
property of (|σu |, u ≥ 0) at 0, we obtain that (Xt , t ≥ 0) is necessarily of the
form: Z t
Xt = cβt + bu du, (7)
0
where c = |σ0 |, and (βt , t ≥ 0) is a 1-dimensional standard Brownian motion.
Indeed, the previous proof applies: since
Z u+ξ
1
lim √ bs ds = 0,
ξ→0 ξ u
we deduce from (3) that |σu | is equal, du dP a.s, to a constant c.

Now, there exist interesting examples of processes (Xt , t ≥ 0) of the form

(7) which satisfy the weak stationarity condition (1): indeed, processes of the
form:
Xt = cβt + tV , (8)
where V is independent of (βt ) obviously satisfy (1).
Moreover, the canonical decomposition of X (i.e: its decomposition as a
semi-martingale in its own filtration Ft X ≡ σ{Xs , s ≤ t}, t ≥ 0, is:
Z t
h0
Xt = c(β̂t + ds x (s, Xs )), (9)
0 h
R 2
where h(s, x ) = ν(dy) exp(yx − y2 s), and ν(dy) is the law of c1 V (see [Y92]).
There are many other interesting examples. Indeed, if the pair (β, b) satisfies:
(law)
∀h > 0, (βh+t − βh , bh+t ; t ≥ 0) = (βt , bt ); t ≥ 0) (10)

then, obviously, the strong stationarity hypothesis (4) holds for (Xu , u ≥ 0),
given by (7).
Here is now a “concrete” example, which indeed plays a fundamental role in
linear filtering theory (see, e.g, Rogers-Williams [RW87], pp. 322–329) of a pair
(β, b) which satisfies (10):
If (bu ≡ Uu , u ≥ 0) is a stationary Ornstein-Uhlenbeck process, driven by a
Brownian motion (γu , u ≥ 0), i.e:
Z
1 u
Uu = U0 + γu − Us ds,
2 0
Lévy processes in finance: a remedy to the non-stationarity of continuous martingales 407

where U0 is a standard centered Gaussian variable, independent of the pair (β, γ),
and β and γ are linearly correlated, i.e, hβ, γit ≡ ρt, (|ρ| ≤ 1), then (10) is
satisfied. For simplicity, we (and the reader) may assume: ρ = 0.
At this point, we underline that, just as in (8), the decomposition:
Z t
Xt = cβt + Uu du (11)
0

in the present example is not the canonical decomposition of (Xt , t ≥ 0) in its

natural filtration, which we shall denote here by (Ft X , t ≥ 0).
The canonical decomposition of (Xt , t ≥ 0) in (Ft X ) is precisely the subject
of the Kalman-Bucy filter and is succinctly although very clearly presented in
Rogers-Williams [RW87], VI-9; moreover, from Theorem 8.4 in VI.8, it follows
that (F0+X ) is trivial, and that all martingales w.r.t (Ft X ) may be written as
stochastic integrals w.r.t the martingale (=Brownian) part of X , in its (Ft X )
decomposition.
In fact, from (11), one deduces
Z t
Xt = c β̂t + Ûu du
0

where (Ût , t ≥ 0) is the predictable projection of (Ut , t ≥ 0) on (Ft X ). This

projection may be written explicitly in terms of β̂ (see equation (9.4) p.328 in
[RW87]), hence (Ft X ) = (Ft β̂ ).
Rt
Remark 1. The equation (7) shows that, in particular, if Xt = 0 σu dWu −
R
1 t 2
2 0 σu du (which is the case in examples from Mathematical Finance where
exp(Xt ) must be a local martingale), then necessarily,
(law) c2t
(Xt , t ≥ 0) = (cβt − , t ≥ 0)
2
with c ∈ R.

3.4

We now make some similar remarks about the class of “weak” stationary
n-dimensional local martingales of the form
Z t
Xt = σu dWu , t ≥ 0,
0

where (σu , u ≥ 0) is a Fu predictable family of n × n matrices, and (Wu , u ≥ 0)

an n-dimensional standard Brownian motion.
We assume again that (Xt , t ≥ 0) satisfies (1), and that (σu∗ σu , u ≥ 0) is
continuous a.s at 0.
Then, using the 1-dimensional result of Theorem 1, it is not difficult to show
that, for each θ ∈ Rn , one has
408 B. Leblanc, M. Yor

(law)
{(θ, Xt ); t ≥ 0} = {(θ, σ0 βt ); t ≥ 0} (12)

where (βt , t ≥ 0) denotes an n-dimensional standard Brownian motion.

However, C. Hardin’s examples of spurious Brownian motions ([Har85] or
see also [RY94] Exercise 1.19, p. 22) show that we cannot a priori infer from
(12) the strong statement:
(law)
(Xt ; t ≥ 0) = (σ0 βt ; t ≥ 0) (13)

3.5

As a conclusion of this note, we have seen that the weak stationarity assumption
(1) leads quickly to strong constraints for continuous martingales, and we have
studied related questions.
We hope to clarify some of the points which eluded us in Sections 3.3 and
3.4, as well as study under which additional conditions would a right-continuous
martingale which satisfies (1) be in fact a Lévy process.
Finally, we would like to say that both the technique and the results in this
note are reminiscent of asymptotic studies on continuous martingales as found
in [Del92] and [RY94], chap. XIII.

References

[ALP95] Avellaneda, M., Lévy, A., Paras, A.: Pricing and hedging derivatives securities in markets
with uncertain volatilities. Appl. Math. Finance 2, 73–88 (1995)
[CW89] Chung, K.L., Williams, R.T.: Introduction to Stochastic Integration, 2nd edn. Boston:
Birkhäuser 1989
[Del92] Delbaen, F.: Infinitesimal Behaviour of a Continuous Local Martingale. In: Azerna, J.,
Meyer, P.A., York, M. (eds.) Séminaire de Probabilités XXVI (Lecture Notes in Mathe-
matics 1526, pp. 388–404) Berlin Heidelberg New York: Springer 1992
[Dup93] Dupire, B.: The Model Art. Risk Magazine 1993
[Har85] Hardin, C.: A spurious Brownian motion. Proc. Amer. Math. Soc. 93, 350 (1985)
[HW87] Hull, J., White, A.: The Pricing of Options on Assets with Stochastic Volatilities. J.
Finance 42, 281–300 (1987)
[Ito44] Itô, K.: Stochastic Integral. Proc. Imperial Acad. Tokyo 20, 519–524 (1944)
[Ito61] Itô, K.: Lectures on Stochastic Processes. Bombay: Tata Institute 1961
[Leb97] Leblanc, B.: Modélisations de la Volatilité d’un Actif Financier et Applications. Thèse de
doctorat. Université Paris 7, 1997
[RY94] Revuz, D., Yor, M.: Continuous Martingales and Brownian Motion, 2nd edn. Berlin Hei-
delberg New York: Springer 1994
[RW87] Rogers, L.C.G., Williams, D.: Diffusion Markov processes and Martingales. New York:
Wiley 1987
[Y92] Yor, M.: Some Aspects of Brownian Motion. Part I: some special functionals. Lectures in
Maths. ETH Zürich. Basel: Birkhäuser 1992