Spring 2006

MGT 6081: Derivative Securities: Homework 10

Instructor: Minqiang Li ( Email: minqiang.li@mgt.gatech.edu)
(Do NOT turn in your solutions.)
1. (Forward measure and the expectation hypothesis) Under the risk-neutral
measure Q, a bond maturing at time T is priced at time t as
P(t, T) = E
Q
t

T
t
r(s)ds

, (1)
where r(s) is the stochastic short-rate process. The (continuously-compounded
instantaneous) forward rate for time T at time t is dened as
f(t, T) =
log P(t, T)
T
. (2)
Let the current time t be 0. The expectation hypothesis states that the forward
rate is peoples expectation of future spot interest rate: f(0, T) = E[r(T)]. How-
ever, we have to specify a measure to take the expectation. One common proposal
is that the expectation should be taken under the physical measure P. Another
proposal is that it should be taken under the risk-neutral measure Q. It turns
out that both proposals are wrong.
(a) By dierentiating the bond price formula under the expectation sign, show
that
f(0, T) = E
Q

r(T)
e

T
0
r(s) ds
P(0, T)

. (3)
(b) Without loss of generality, assume that under Q,
dP(u, T) = r(u)P(u, T)du +
P
(u, T)P(u, T)dW(u), (4)
where
P
(u, T) might be stochastic. Dene a process
u
by

u

e

u
0
r(s) ds
P(u, T)
P(0, T)
. (5)
Show that
u
is an exponential martingale and E
Q
[
T
] = 1.
(c) The forward measure Q
T
is dened as dQ
T
/dQ =
T
. Find out a Brownian
motion in Q
T
.
(d) Show that under this forward measure Q
T
, f(0, T) = E
Q
T
[r(T)].
(e) Let T

= T. Is it in general true that f(0, T

) = E
Q
T
[r(T

)]?
(f) Show that for any T

, P(u, T

)/P(u, T) is a martingale under Q

T
.
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2. (Change of numeraire using a traded security) Suppose we have an econ-
omy with many traded assets {S

}
I
, where I is an index set. For example, if
there are only m assets, then I = {1, 2, , m}. In general, I might be innite.
Under the risk-neutral measure Q, the security prices follow
dS

t
= r
t
S

t
dt +

t
S

t
dW

t
, (6)
where we assume that r
t
and

t
are possibly stochastic and W

s are Brownian
motions. We assume that the correlation between W

and W

is

. Now choose
one particular traded asset N among {S

}
I
. We will call N
t
the numeraire
process. Assume that dN
t
= r
t
N
t
dt +
N
t
N
t
dW
N
t
. Let T > 0.
(a) Dene

N
t

e

t
0
rsds
N
t
N
0
. (7)
Show that
N
t
is an exponential martingale under Q and E
Q
[
N
T
] = 1. In
particular, show that d
N
t
=
N
t
dL
N
t
, where dL
N
t
=
N
t
dW
N
t
.
(b) For any I, dene Y

t
S

t
/N
t
. We will call Y

t
the N-deated price
process for asset . Show that
dY

t
=

(
N
t
)
2

t

N
t

t
dt +Y

t
(

t
dW

t

N
t
dW
N
t
). (8)
(c) Dene a new measure Q
N
by dQ
N
/dQ|
T
=
N
T
. Show that

W
N
t
dened by
d

W
N
t
= dW
N
t

N
t
dt (9)
is a Brownian motion under Q
N
. Furthermore, show that for any I,

t
dened by
d

t
= dW

t

N

N
t
dt (10)
is a Brownian motion under Q
N
.
(d) Show that under measure Q
N
, for any asset , the N-deated price process
is a martingale
dY

t
= Y

t
(

t
d

t

N
t
d

W
N
t
). (11)
Hence conclude
S

0
/N
0
= E
Q
N
[S

T
/N
T
] . (12)
Remark: Thus we showed that if we use a particular traded asset as the nu-
meraire, then all asset prices become martingales under the measure induced by
the change to this numeraire. Also, you do not need to calculate d
t
at all. The
L
t
is a Brownian martingale related to N
t
.
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3. (Self-nancing portfolios under change of numeraire) Fixing two assets
and . Consider a portfolio strategy {, } which holds
u
and
u
shares of
assets and at any time u, respectively. Denote the portfolio value
u
. Show
that
d
u
=
u
dS

u
+
u
dS

u
(13)
if and only if
d(
u
/N
u
) =
u
d(S

u
/N
u
) +
u
d(S

u
/N
u
). (14)
Notice the result does not require N
t
to be the price of a traded asset.
4. (A not so obvious change of numeraire) This problem is under the usual
Black-Sholes setup. Consider a European option that pays S
2
T
to the holder at
time T if S
T
K and zero otherwise. According to risk-neutral valuation, we
know the price of this option at time 0 is given by
c
0
= E
Q

e
rT
S
2
T
1
S
T
K

. (15)
Since we know the distribution of S
T
, we can compute the above expectation
using integration. However, we will take a change of numeraire approach.
(a) What is the dynamics of S
2
T
?
(b) Dene a process
t
by

t

e
(2r+
2
)t
S
2
t
S
2
0
. (16)
Show that
T
can be used as the Radon-Nykodym derivative for a measure
change.
(c) Dene a new measure

Q by d

Q/dQ|
T
=
T
. What is the dynamics of S
T
under

Q?
(d) Compute the option price c to get
c
0
= S
2
0
e
(r+
2
)T
N(d
2
), (17)
where
d
2
=
log

S
0
e
(r+2
2
)T
/K

1
2

T. (18)
Remark: In this problem we are actually using N
t
e
(r+
2
)t
S
2
t
as the numeraire
process. Check the Black-Scholes PDE to conrm that N
t
is the price of a traded
security. Thus the measure

Q is just Q
N
and c
0
/N
0
= E
Q
N
[c
T
/N
T
].
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