Stochastic Calculus II Brandon Lee 15.450 Recitation 4 Brandon Lee Stochastic Calculus II Kolmogorov Backward Equation Consider a stochastic process Xt . Xt is a martingale if for s > t, Et [Xs ] = Xt In other words, conditional expectation of future value is simply the current value (example: fair gamble). The notion of a martingale makes sense for both discrete and continuous time processes. Now let’s look at this concept when Xt is an Ito process. Suppose dXt = µ (t, Xt ) dt + σ (t, Xt ) dZt If Xt were a martingale, then over a small time interval dt, Et [Xt +dt ] = Xt Et [Xt +dt − Xt ] = 0 Et [dXt ] = 0 This is another way of thinking about martingales: expected changes are zero. Brandon Lee Stochastic Calculus II Continued But now recall the dynamics of dXt : Et [dXt ] = Et [µ (t, Xt ) dt + σ (t, Xt ) dZt ] = µ (t, Xt ) dt So Xt is a martingale if and only if µ (t, Xt ) = 0. This is intuitive: the drift term is responsible for expected change whereas the diffusion term is responsible for variance of change. The Kolmogorov Backward Equation simply formalizes this idea. Brandon Lee Stochastic Calculus II Continued Suppose we have an underlying process Xt where dXt = µ (t, Xt ) dt + σ (t, Xt ) dZt Consider Yt = f (t, Xt ). Suppose we know for some reason that Yt is a martingale. We have seen two such examples: 1) conditional expectation, 2) security price discounted at risk-free rate under the risk-neutral measure. Then by the above argument, we know that the drift term of dYt = d (f (t, Xt )) should be zero. By Ito’s Lemma, df (t , Xt ) = ! ∂ f (t, Xt ) ∂ f (t, Xt ) 1 ∂ 2 f (t, Xt ) ∂ f (t, Xt ) + µ (t, Xt ) + (σ (t, Xt ))2 dt + σ (t, Xt ) dZt 2 ∂t ∂ Xt 2 ∂ Xt ∂ Xt So if Yt = f (t, Xt ) is a martingale, then ∂ f (t, Xt ) ∂ f (t, Xt ) 1 ∂ 2 f (t, Xt ) + µ (t, Xt ) + (σ (t, Xt ))2 = 0 ∂t ∂ Xt 2 ∂ Xt2 Brandon Lee Stochastic Calculus II Option Replication How do you dynamically replicate an European option in the Black-Scholes setting? Answer: Match the “delta”. Suppose you have the option price f (t, St ) on the one hand and the value of a replicating portfolio consisting of the stock and the bond, Wt . At time t, this replicating portfolio holds θt number of stocks and the rest is invested in the risk-free bond. This means dWt = θt dSt + r (Wt − θt St ) dt To have perfect replication, we need d (f (t, St )) = dWt In particular we need the coefficient in front of dSt to match: ∂ f (t, St ) = θt ∂ St This argument is exactly as in yesterday’s lecture where we tried to replicate an option in an environment with stochastic volatility using a stock and another option. Brandon Lee Stochastic Calculus II State Price Density and Risk-Neutral Measure We can always move from one to the other very easily in both discrete time and continuous time settings. In discrete time, if the state price density is given by πt 1 2 = exp −rt−1 − ηt−1 εt − ηt−1 πt−1 2 then the change of measure from P to Q is given by dQ 1 2 = exp −ηt−1 εt − ηt−1 2 dP t In continuous time, if the state price density is given by Zt Z t Z 1 t 2 πt = exp − rs ds − ηs dZs − ηs ds 2 0 0 0 then the change of measure from P to Q is given by Zt Z dQ 1 t 2 = exp − ηs dZs − ηs ds dP t 2 0 0 We can always decompose the state price density into time discount and change of measure from P to Q. Brandon Lee Stochastic Calculus II Change of Measure in Continuous Time Similar as in the discrete time case. If Zt Z dQ 1 t 2 η ds = exp − ηs dZs − 2 0 s dP t 0 then the Brownian motion under P, ZtP acquires a drift but its diffusion coefficient does not change. Therefore dZtP = dZtQ − ηt dt Suppose WtP is another Brownian motion under P and it has correlation ρ with ZtP . How does WtP look under the Q-measure? Do the decomposition p WtP = ρZtP + 1 − ρ 2 VtP where VtP is another Brownian motion under P that’s independent of ZtP . Conclude dWtP = dWtQ − ρηt dt Brandon Lee Stochastic Calculus II MIT OpenCourseWare http://ocw.mit.edu 15.450 Analytics of Finance Fall 2010 For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms .