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D-MATH Coordinator

Prof. Dr. Martin Schweizer Sebastian Herrmann

Brownian Motion and Stochastic Calculus

Exercise Sheet 11

Please hand in until Monday, May 21, 12:00, in HG G 53-54.

Exercise 11-1

Let W = (W

t

)

t0

be a Brownian motion dened on some ltered probability space (, T, F, P)

satisfying the usual conditions. Moreover, let , > 0.

a) Find a strong solution to the Langevin equation

dX

t

= X

t

dt + dW

t

.

Remark: This SDE describes exponential convergence to zero with noise.

Hint: Consider U

t

= e

t

X

t

.

b) Show that there is a Brownian motion B such that Y := X

2

satises the SDE

dY

t

= (2Y

t

+

2

) dt + 2

Y

t

dB

t

. ()

In other words, show that X

2

is a weak solution of the SDE ().

Exercise 11-2

Let W = (W

t

)

t0

be a Brownian motion dened on some ltered probability space (, T, F, P)

satisfying the usual conditions. Moreover, let > 0 and S = (S

t

)

t0

be the unique strong

solution of the SDE

dS

t

= S

t

dW

t

, S

0

= 1.

The process M = (M

t

)

t0

given by M

t

= sup

0st

S

s

is called running supremum of S. Note

that M is an increasing process whose associated LebesgueStieltjes measure dM() on [0, )

is concentrated on the set D() := t 0 : S

t

() = M

t

(). It can be shown that D() has

Lebesgue measure 0 for P-a.e. . In other words, dM() is singular to the Lebesgue measure

dt for P-a.e. .

Next, for some xed T > 0, we consider the random variable H := M

T

S

T

and dene a

process (V

t

)

t0

by

V

t

= E[H[T

t

].

Using the fact that the pair (S

t

, M

t

)

t0

is a Markov process, one can show that

V

t

= v(t, S

t

, M

t

)

for a suciently smooth function v : R

3

R. The goal of this exercise is to nd a PDE for v,

including domain, terminal and boundary conditions.

a) Apply Its formula to v(t, S

t

, M

t

). Use the dt-term to deduce a PDE for v and argue why

D := (0, T) (x, m) (0, ) (1, ) : x < m is its natural domain.

b) What is the terminal condition for v, i.e., what can you say about v(T, x, m) if x m?

c) What is the boundary condition for v, i.e., what can you say about v(t, x, m) if t (0, T)

and x = m?

Remark: In the language of mathematical nance, S models the discounted price process of some

stock (under a risk-neutral measure), H is the payo of a oating strike lookback put option, and

V is the value process associated to H, i.e., V

t

describes the fair price of the option at time t.

Having deduced a PDE for v with appropriate terminal and boundary conditions, one can use

numerical methods to nd v and thus the fair price V

0

= v(0, 1, 1) of the option at time 0.

Exercise 11-3

Recall that C

0

(R) denotes the space of continuous functions f : R R that vanish at innity.

We call C

2

0

(R) the space of twice continuously dierentiable functions f on R such that f, f

and

f

all belong to C

0

(R). For a, b : R R Lipschitz-continuous, we dene the partial dierential

operator / : C

2

0

(R) C

0

(R) by

/f(x) = a(x)

f

x

(x) +

1

2

b

2

(x)

2

f

x

2

(x), x R.

The goal of this exercise is to link weak solutions of the SDE

dX

t

= a(X

t

) dt +b(X

t

) dW

t

()

to solutions of the martingale problem for (/, C

2

K

(R)) where C

2

K

(R) denotes the subspace of

compactly supported functions in C

2

0

(R).

a) Let X be weak solution to () with initial distribution

{x}

. Show that X is a solution to

the martingale problem for (/, C

2

K

(R)). In other words, show that if (, T, F, Q, W, X)

is a weak solution to () with initial distribution

{x}

, then the process M

f

given by

M

f

t

:= f(X

t

)

t

0

/f(X

s

) ds, t 0, is a (Q, F

X

)-martingale for each f C

2

K

(R).

b) Fix x R and let X, dened on some probability space (, T, P), be a continuous process

which is a solution to the martingale problem for (/, C

2

K

(R)) with X

0

= x. Show that the

process M := X

0

a(X

s

) ds is a continuous local martingale with M =

0

b

2

(X

s

) ds.

Hint: For the rst assertion, use the fact that X is a solution to the martingale problem

for (/, C

2

K

(R)) for sequence of functions in C

2

K

(R) that approximates the identity on R,

and construct a compatible localising sequence (

n

)

nN

for M.

For the second assertion, rst follow the same strategy for the function y y

2

, y R.

Then show that M

2

0

b

2

(X

s

) ds is a continuous local martingale by expressing it as the

sum of continuous local martingales.

c) In the setting of b), assume that b(x) ,= 0 for all x R and construct from X a weak

solution of () with initial distribution

{x}

.

Hint: Consider B :=

0

1

b(X

s

)

dM

s

.

Exercise sheets and further information are also available on:

http://www.math.ethz.ch/education/bachelor/lectures/fs2012/math/bmsc/

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