Dividends in the Theory of Derivative

Securities Pricing
1
Lars Tyge Nielsen
2
First Draft: January 1995. This Version: February 2006
1
The rst version of the paper was entitled Dividends in the Theory of Deriv-
ative Securities Pricing and Hedging and was presented at ESSEC in 1995. The
initial research was carried out during a visit to the University of Tilburg in the
Fall of 1994. The author would like to thank Knut Aase and Darrel Due for
comments on an earlier version.
2
Copenhagen Business School, Department of Finance, DK-2000 Frederiksberg,
Denmark; e-mail: ltnielsen@post.harvard.com
1 Introduction
This paper develops the fundamental aspects of the theory of martingale pric-
ing of derivative securities in a setting where the cumulative gains processes
are Ito processes, while the cumulative dividend processes of both the under-
liers and the derivative securities are general enough to cover all the ways in
which dividends are modeled in practical applications.
The most general cumulative dividend processes that arise in practice are It o
processes and nite-variation processes. It o processes arise as cumulative div-
idend processes of continuously resettled futures contracts. Finite-variation
processes include the cumulative dividend processes arising from continuous
ows of dividends and random or deterministic lump-sum dividends paid at
random or deterministic discrete dates. Continuous ows are used to model
stocks and stock indexes, currencies, and commodities (where the dividend
ow is called convenience yield). Lump sum dividends at discrete dates are
used to model stocks, bonds and swaps (where the dividends are interest
payments), and American options (which pay a random payo at a random
date).
A key operation that needs to be covered in the theory is changing the
unit of account. The simplest case consists in discounting at the rolled-
over instantaneous interest rate, which is equivalent to changing to units of a
money market account. In this case, the price of the new unit is an absolutely
continuous process. Some authors, including Karatzas and Shreve [25, 1998,
Chapter 2], change to new units whose price processes have nite variation,
but this case will not be considered in the present paper because it does not
seem to be needed in applications.
The more complicated case is where the price of the new unit is an Ito process.
Examples include real as opposed to nomial units, units of a foreign currency
or a foreign money market account, units of a commodity, or units of a stock
with reinvested dividends, as in Schroder [30, 1999]. Margrabe [26, 1978] may
have been the rst to make substantive use of this type of change of unit.
He derived his exchange option formula by changing to units of one of the
risky assets, thereby reducing the problem to that of pricing a standard call
option (Margrabe attributed the idea to Stephen Ross). Since then, the idea
has been further developed and stressed by Geman, El Karoui, and Rochet
1
[15, 1995] and Schroder [30, 1999] and used in numerous applications.
Thus the theory needs to cover cumulative dividend processes that may be
either Ito processes or nite-variation processes, and it needs to prescribe
how to change the unit of account of these processes when the price of the
new unit is an It o process.
In fact, the theory developed here covers virtually all possible cumulative
dividend processes, both for the underliers and for the derivative securities.
They generally only need to need to be measurable and adapted. When
their unit is being changed, they also need to satisfy a minimal integrability
condition which allows them to be integrated with respect to the price of
the new unit. This level of generality comes essentially for free, since it is
simpler to develop a general theory than to develop a theory that is narrowly
designed for Ito processes and nite-variation processes.
Since nite-variation processes and It o processes are covered as special cases,
the pricing of American options and of continuously resettled futures con-
tracts ts seamlessly into the theory.
Our prescription for how to change the unit of account is based on rst prin-
ciples. We rst calculate how the cumulative dividend process of a trading
strategy is transformed under a change of unit in a securities market model
where there are no dividends on the basic securities. This leads to a formula
which is reminiscent of integration by parts. It turns out that virtually every
cumulative dividend process is in fact the cumulative dividend process of a
trading strategy in some very simple securities market model. Therefore, we
use the same formula for changing the unit of account of cumulative dividend
processes in general, including the cumulative dividend processes of the basic
securities when these are non-zero.
The general use of the formula is justied by four of its properties: it obeys
unit-invariance for trading strategies, it satises a consistency property when
the unit is changed twice in a row, it gives the correct results in well-known
and uncontroversial special cases, and it ts perfectly into a generalization
of martingale valuation theory to general dividend processes.
Unit-invariance means the following. Given the formula for changing the
units of a cumulative dividend process, there are two ways of changing the
units of a trading strategys cumulative dividend process. One is to calculate
2
it in old units and then re-measure it in new units. The other is to re-measure
the basic securities prices and dividends in new units and then calculate the
trading strategys dividend process with respect to these re-measured prices
and dividends. The unit-invariance result, which is stated in Theorem 1, says
that these two are equivalent. The result extends a similar result by Huang
[21, 1985] to general dividend processes and modies a related statement by
Due [9, 1991, Section 5].
The consistency property, which is stated in Theorem 2, says that changing
from one unit to a second and then from the second unit to a third is the
same as changing from the rst unit to the third in one go.
Special cases include cumulative dividend processes that are semi-martingales,
and in particular It o processes or processes with nite variation. Our formula
for changing the unit of account is consistent with the literature in the case
of nite-variation processes but not in the general case of semi-martingales.
It is consistent with the current literature but not the earlier literature in
the case of It o processes.
Specically, Due and Zame [13, 1989] and Due [9, 1991] change the unit
of account by integrating the price of the old unit in terms of the new unit
with respect to the cumulative dividend process. This is appropriate if the
cumulative dividend process has nite variation, but it is not appropriate
if it is an It o process, as assumed by Due and Zame [13, 1989], or more
generally if it is a semi-martingale, as assumed by Due [9, 1991].
We nally demonstrate how the theory of martingale valuation of derivatives
extends to general dividend processes for both the basic and the derivative
securities. The third and nal main result, Theorem 3, states that the value of
a dividend process equals the value of a claim to dividends to be accumulated
from today on plus the value of a ow of interest on the cumulative dividends
at each point in time.
The rest of this introduction consists in an overview of how the literature
has modeled dividends and an overview of the organization of the paper.
We distinguish between dividends on the underlying securities and the div-
idends on the derivative security. In the literature on optimal consumption
and investment choice, the derivative security corresponds to the cumulative
consumption process.
3
underlying securities (or basic securities in the literature on optimal consump-
tion and investment choice) and derivative security (or optimal consumption
process in the
Apart from Due [9, 1991, Section 5], the abstract literature on martingale
pricing of derivatives has so far considered only underlying securities without
dividends or with continuous dividend ows. Due [9, 1991, Section 5] allows
for cumulative dividend processes that are semi-martingales.
The applied literature on pricing of equity derivatives considers continuous
proportional dividend ows and, in addition, various forms of discrete div-
idends. For example, Roll [29, 1977], Geske [16, 1979], and Whaley [32,
1979] introduced non-random discrete dividends, and Wilmott, Dewynne,
and Howison [33, 1993] explored a model with discrete dividends that are
functions of stock price and time.
The literature on optimal portfolio and consumption choice and dynamic
equilibrium, like the literature on derivatives pricing, usually assumes that
the basic securities pay no dividends or else pay continuous proportional
dividend ows. When it relaxes this assumption, it requires the cumulative
dividend processes on the basic securities to be semi-martingales, or at least
to be right-continuous with left limits.
Due and Zame [13, 1989], Dana and Jeablanc-Picque [6, 1994], Dana,
Jeanblanc-Picque, and Koch [7, 2003], Due [10, 1992] and [11, 1996], Chap-
ter 6, Sections K and L, Due [12, 2001], Chapter 6, Sections L and M, and
Aase [1, 2002] assume that the cumulative dividend processes on the basic
securities are Ito processes.
Huang [21, 1985], Dybvig and Huang [14, 1988], Cox and Huang [4, 1991],
Huang and Pag`es [22, 1992], and Hindy [19, 1995] make assumptions which
imply that the cumulative dividend processes on the basic securities have
nite variation.
Back [2, 1991] assumes that the cumulative dividend processes on the basic
securities are semi-martingales, but he changes the unit of account only into
units of security zero, which is assumed to have nite variation.
Cuoco [5, 1997] makes no explicit assumptions about the cumulative dividend
processes on the basic securities but must implicitly be assuming that they
4
are semi-martingales, because he uses them as integrators. He changes to
units of a money market account by integrating, which is unproblematic
because the money market account has nite variation (in fact, it is absolutely
continuous).
Exceptions to the semi-martingale requirement include Due [8, 1986] and
Schweizer [31, 1992]. They assume the basic cumulative dividend processes
to be right-continuous with left limits, but they do not assume them to be
semi-martingales. In Due [8, 1986], there is no need to change the unit of
account. Schweizer [31, 1992] changes to units of the locally riskless asset by
integrating with respect to the cumulative dividend processes. He observes
that when the new numeraire is the locally riskless asset and the cumulative
dividend processes are right-continuous with left limits, this integral is de-
ned by integration by parts even if the cumulative dividend processes are
not semi-martingales.
The theoretical literature on martingale pricing of derivatives mostly consid-
ers only derivatives that pay a random payout at one future point in time.
This is true of Harrison and Kreps [17, 1979], Harrison and Pliska [18, 1981],
Karatzas [24, 1997], and Nielsen [27, 1999], except that Karatzas separately
considers also the case of American contingent claims. Bensoussan [3, 1984]
initially assumes that the derivative pays a ow of dividends and a ran-
dom payout at maturity and then considers American options separately.
Due [9, 1991, Section 5] assumes that the cumulative dividend process of
the derivative security has nite variation. Dana and Jeanblanc-Picque [6,
1994], Aase [1, 2002] and Dana, Jeanblanc-Picque, and Koch [7, 2003] al-
low the cumulative dividend process of the derivative security to be an It o
process. The most general setting available in this literature appears to be
that of Karatzas and Shreve [25, 1998, Chapter 2], who assume that the
cumulative dividend process is a semimartingale.
In models of optimal consumption and portfolio selection or of dynamic equi-
librium, the cumulative consumption process is analogous to the cumulative
dividend process on a derivative security. Most such models assume that
consumption is represented by a continuous ow. Those that go beyond
consumption ows make assumptions which imply that the cumulative con-
sumption process has nite variation. This is true, for example, of Huang
[21, 1985], Dybvig and Huang [14, 1988], Hindy and Huang [20, 1993], Jin
and Deng [23, 1997], and Karatzas [24, 1997].
5
The paper is organized as follows. Section 2 sets up the model and the
basic notation, which is as close as possible to that of Nielsen [27, 1999].
Section 3 lays out how to change the unit of account and proves the gener-
alized unit-invariance result. Section 4 shows what changing to a new unit
does to cumulative dividend processes that are semi-martingales, including
Ito processes and processes with nite variation, and what changing to units
of the money market account does to a general dividend process. It also
reviews an alternative way of changing units that has been proposed in the
literature. Section 5 states and proves the consistency property: changing
the unit twice in a row is the same as changing it in one go. Sections 6 and 7
generalize the standard concepts and results of derivatives pricing to general
dividends and demonstrates a general formula for valuing a dividend process
as a sum of a claim to the total accumulated nominal dividends and a claim
to a stream of interest payment.
2 Securities and Trading Strategies
We consider a securities market where the uncertainty is represented by a
complete probability space (, F, P) with a ltration F = {F
t
}
tT
and a
K-dimensional process W, which is a Wiener process relative to F.
A cumulative dividend process D measures the cumulative value of distribu-
tions, dividends, interest payments or other cash ows, positive or negative,
of a security or trading strategy.
Formally, a cumulative dividend process is a measurable adapted process D
with D(0) = 0.
Suppose a security has cumulative dividend process D and price process S.
Dene the cumulative gains process G of this security as the sum of the price
process and the cumulative dividend process:
G = S +D
Assume that G is an It o process. It follows that G will be continuous,
adapted, and measurable. Since D is adapted and measurable, so is S. Since
D(0) = 0, G(0) = S(0).
6
An (N + 1)-dimensional securities market model (based on F and W) will
be a pair (

S,

D) of measurable and adapted processes

S and

D of dimension
N + 1, interpreted as a vector of price processes and a vector of cumulative
dividends processes, such that

D(0) = 0 and such that

G =

S +

D is an It o
process with respect to F and W. The process

G =

S +

G is the cumulative
gains processes corresponding to (

S,

D).
Write

G(t) =

G(0) +
_
t
0
ds +
_
t
0
dW
where is an N+1 dimensional vector process in L
1
and is an (N+1)K
dimensional matrix valued process in L
2
.
Here, L
1
is the set of adapted, measurable, and pathwise integrable processes,
and L
2
is the set of adapted, measurable, and pathwise square integrable
processes.
A trading strategy is an adapted, measurable (N+1)-dimensional row-vector-
valued process

.
The value process of a trading strategy

in securities model (

S,

D) is the
process

S.
The set of trading strategies

such that

L
1
and

L
2
, will be
denoted L(

G).
Generally, if X is an n-dimensional It o process,
X(t) = X(0) +
_
t
0
a ds +
_
t
0
b dW
then L(X) is the set of adapted, measurable, (n K)-dimensional processes
such that L
1
and L
2
.
If

is a trading strategy in L(

G), then the cumulative gains process of

, measured relative to the securities market model (

S,

D), is the process
G(

;

G) dened by
G(

;

G)(t) =

(0)

G(0) +
_
t
0

G
for all t T .
7
A trading strategy

in L(

G) is self-nancing with respect to (

S,

D) if

S = G(

;

G)
or

(t)

S(t) =

(0)

S(0) +
_
t
0

G
Generally, if

is a trading strategy in L(

G) which may not be self-nancing,
then the cumulative dividend process of

with respect to (

S,

D) is the
process D(

;

S,

D) dened by

S +D(

;

S,

D) = G(

;

G)
The process D(

;

S,

D) is adapted and measurable and has initial value
D(

;

S,

D)(0) = 0.
3 Changing the Unit of Account
Let be a one-dimensional Ito process:
(t) = (0) +
_
t
0

ds +
_
t
0

dW
where

is a one-dimensional process in L
1
and

is a K dimensional row
vector process in L
2
.
If D is a cumulative dividend process such that D L(), dene a process
D

by
D

(t) = (t)D(t)
_
t
0
Dd
The process D

is adapted and measurable, and, hence, it is a cumulative

dividend process. The purpose of assuming that D L() is to make sure
that the integral in this expression is well dened.
The following proposition shows how the cumulative dividend process of a
trading strategy is re-measured in a new unit of account in the case where
there are no dividends on the basic securities. The original securities market
model is (

S, 0), and the new one is (

S, 0). The original dividend process D

of the trading strategy is replaced by D

.
8
Proposition 1 Suppose

D = 0. Let

L(

S), and set D = D(

;

S, 0).
Then

L(

S) if and only if D L(), in which case D(

S, 0) = D

.
Proposition 1 will follow from Theorem 1 below.
In the expression for D

, the term (t)D(t) is the dividends cumulated in the

old units and expressed in the new unit. This ignores the fact that at each
point in time, already accumulated dividends change value. The integral
term corrects for that. The term D(s) d(s) represents the change during
instant s in the value of the dividends D(s) that have been accumulated up
to that time. The integral represents the cumulative value of these changes.
If, for example, the process tends to increase over time, it means that
the value of the old unit of account increases. The term (t)D(t) overstates
the cumulative dividends in the new unit of account, because most of the
dividends have been accumulated at times when they were worth less than
(t) per old unit.
Proposition 1 tells us how to change the unit of account of a cumulative
dividend process that arises as the cumulative dividend process of a trading
strategy. But as we shall now see, every cumulative dividend process is in fact
the cumulative dividend process of a trading strategy in some very simple
securities market model.
Let D be a cumulative dividend process. Consider a securities market model
where there is a money market account, and assume for simplicity that the
money market account has zero interest rate and value process M = 1.
Consider the trading strategy which consists in holding, at every point in
time t, D(t) units of the money market account. The value process is
D. Since the trading strategy only invests in the money market account,
which has zero interest rate, its cumulative gains process is zero. Hence, the
cumulative dividend process is D.
This observation, taken together with Proposition 1, suggests that in general,
for any cumulative dividend process D, the process D

can be interpreted as
D re-measured in the new unit of account. Therefore, we will use the same
procedure to change the unit of account on the basic securities in the case
where the basic securities pay dividends.
If (

S,

D) is a securities market model such that

D L(), then we dene
9
the transformed cumulative dividend process

D

in the new unit of account

entry by entry by

N
.
.
.

or

(t) = (t)

D(t)
_
t
0

Dd
The transformed securities price process is

S, and the transformed securities

market model is (

S,

D

). The corresponding cumulative gains process

G

is given by

S +

D

N
.
.
.

or

(t) = (t)

G(t)
_
t
0

Dd
The next proposition exhibits the It o dierential of

G

.
Proposition 2 Let be an It o process, and assume that

D L(). Then

is an It o process with
d

=
_
+

S

_
dt +
_
+

S

_
dW
Proof: Since

(t) = (t)

G(t)
_
t
0

Dd

is obviously an It o process, and

d

= d

G+

Gd +

dt

Dd
= d

G+

S d +

dt
=
_
+ (

G

D)

_
dt +
_
+ (

G

D)

_
dW
=
_
+

S

_
dt +
_
+

S

_
dW
2
10
We now need to show that even when there are dividends on the basic secu-
rities, the cumulative dividend process of a trading strategy will undergo the
transformation
D D

In other words, if D is the cumulative dividend process of a trading strategy

measured in the old prices, then D

is the cumulative dividend process of

the same trading strategy measured in the new prices. This general unit-
invariance result is the content of Theorem 1 below.
Theorem 1 Let be an It o process, assume that

D L(), and let


L(

G). Then

L(

G

) if and only if

S L(), and if and only if

D(

;

S,

D) L(). If so, then
D(

S,

D

) = D

and
G(

;

G

) = G

In particular, if

is self-nancing with respect to (

S,

D), then

L(

G

)
and

is self-nancing with respect to (

S,

D

).
Proof: Set S =

S, D = D(

;

S,

D), and G = G(

;

G). Since G is a
continuous process, it is in L(); and since G = S +D, one of the processes
S and D is in L() if and only if the other one is.
Observe that

_
+

S

_
=

+S

and

[ +

S

] =

+S

Now

L
1
because is continuous and

L
1
;

L
1
because

and

are in L
2
; and

L
2
because is continuous and

L
2
.
Hence,

_
+

S

_
L
1
if and only if S

L
1
, and

[ +

S

] L
2
11
if and only if S

L
2
. It follows that

L(

G

) if and only if S L().

Assume that this is so. Then
dG(

;

G

) =

G+S d +

dt
and
d (G) = d
_
G(

;

G)
_
= dG(

;

G) +G(

;

G) d +

dt
=

G+Gd +

dt
Hence,
d (G) dG(

;

G

) = [GS] d = Dd
This implies that
G(

;

G

)(t) = (t)G(t)
_
t
0
Dd = G

(t)
and
D(

S,

D

)(t) = G(

;

G

)(t) (t)

(t)

S(t)
= G

(t) (t)S(t)
= D

(t)
2
It is remarkable that and D are all we need in order to calculate D

. Once
we know and D = D(

;

S,

D), we do not need

or

S or

G in order to
calculate D

= D(

S,

D

).
Theorem 1 extends Proposition 4.2 of Huang [21, 1985] to general cumu-
lative dividend processes (in the case where is an It o process). Huangs
proposition assumes that the cumulative dividend processes on both the basic
securities and the trading strategy have nite variation. It involves changing
the unit of account by integrating with respect to the cumulative dividend
process. It will be shown in Proposition 4 below that our procedure for
changing the unit coincides with Huangs in the case of nite variation.
Theorem 1 modies Proposition 9 of Due [9, 1991, Section 5] (in the case
where, as here, is an It o process). Dues proposition changes the unit by
12
integrating with respect to the cumulative dividend processes. This is ne
in the case of the cumulative dividend process of the trading strategy, which
is assumed to have nite variation, but it is not suitable in the case of the
cumulative dividend processes of the basic securities, which are assumed to be
semi-martingales. Proposition 5 is a counterexample to Dues proposition.
4 Examples and Counterexamples
In this section, we shall rst calculate D
1/M
for a general cumulative dividend
process D when M is the value process of a money market account.
Next, we shall calculate the process D

for two types of cumulative dividend

processes: It o processes and processes of nite variation. The cumulative
dividend process of a continuously resettled futures contract would be an
example of the former, and random discrete dividends at random times are
a special case of the latter.
Finally, we shall show that if the cumulative dividend processes of the basic
securities are Ito processes, and if they are re-measured in a new unit by
simple integration, then the unit-invariance result of Theorem 1 generally
does not hold.
A money market account for (

S,

D) is a self-nancing trading strategy

b
(or a security that pays no dividends) whose value process is positive and
instantaneously riskless (has zero dispersion). We denote its value process
by M: M =

b

S.
If M is the value process of a money market account, then it must have the
form
M(t) = M(0)[r, 0](t) = M(0) exp
__
t
0
r ds
_
for some r L
1
(the interest rate process) and some M(0) > 0.
We use the general notation [, ] for the stochastic exponential, which is
the process dened by
[, ](t) = exp
__
t
0
_
(s)
1
2
(s)(s)

_
ds +
_
t
0
(s)dW(s)
_
13
Here, and are processes in L
1
and L
2
, of dimension one and K, respec-
tively.
Let us now change the unit of account by = 1/M.
Let D be a cumulative dividend process. Then Dr L
1
if and only if
D L(1/M) = L(M). If so, then
D
1/M
(t) = D(t)/M(t) +
_
t
0
D
r
M
ds
Schweizer [31, 1992, Equation 2.2] is similar to this equation except that we
assume D(0) = 0, while he assumes D to be right-continuous with left limits
and allows M to have nite variation rather than be absolutely continuous.
When M is not absolutely continuous, it is necessary to replace D by D

(the limit from the left) in the integral on the right, which of course can only
be done if this limit exists.
The term D(t)/M(t) in the formula is the nominal cumulative dividends
expressed as a number of units of the money market account, ignoring the
interest earned at each point in time on already accumulated dividends in the
form of appreciation of the money market account. The integral represents
the cumulative value of this interest, expressed in units of the money market
account.
Next, we consider cumulative dividend processes that are semi-martingales,
including It o processes and processes with nite variation.
Proposition 3 If D is a semi-martingale, then
D

(t) =
_
t
0
dD + [D, ](t)
Proof: By the formula for integration by parts for semi-martingales (Protter
[28, 1990, Chapter 2, Corollary 6.2]),
D(t)(t) =
_
t
0
Dd +
_
t
0
dD + [D, ](t)
Hence,
D

(t) = D(t)(t)
_
t
0
Dd =
_
t
0
dD + [D, ](t)
2
14
Corollary 1 If D is a cumulative dividend process which is and It o process
with
dD = f ds +g dW
then D L() and
D

(t) =
_
t
0
dD +
_
t
0
g

ds
Proof: Since D is continuous, it is in L(). The formula follows from
Proposition 3 and the fact that
[D, ](t) =
_
t
0
g

ds
2
Notice in particular from Corollary 1 that when D is an It o process, D

in
general is not equal to the integral of with respect to dD:
D

(t) =
_
t
0
dD
However, if and D have zero instantaneous covariance (g

= 0), then D

is indeed equal to the integral of with respect to dD:

D

(t) =
_
t
0
dD
This includes the special case where has zero dispersion (

= 0). It also
includes the case where D simply involves a continuous dividend ow:
D(t) =
_
t
0
f ds
In this case,
D

(t) =
_
t
0
dD =
_
t
0
f ds
In other words, D

has continuous dividend ow f. This is exactly what

we would expect.
15
Proposition 4 If D is right-continuous and has nite variation, then
D

(t) =
_
t
0
dD
Proof: Referring to Proposition 3, we just need to verify that the quadratic
covariation [D, ] is zero. The quadratic variation of the Wiener process W
is time: [W, W](t) = t, and the quadratic variation of D is zero. By the
Kunita-Watanabe inequality (Protter [28, 1990, Chapter 2, Theorem 6.25]),
for each k = 1, . . . , K,
_
t
0
|d[D, W
k
]|
__
t
0
d[D, D]
_
1/2
__
t
0
d[W
k
, W
k
]
_
1/2
= 0

t
= 0
Hence, [D, W
k
] = 0 for each k, and so [D, W] = 0. Letting I be the stochastic
integral process
I(t) =
_
t
0

dW
it follows from Protter [28, 1990, Chapter 2, Theorem 6.29] that
[D, I](t) =
_
t
0

d[D, W] = 0
Hence [D, ] = 0. 2
Consider an alternative way of changing the unit of account, which has been
used by Due and Zame [13, 1989] for cumulative dividend processes that
are Ito processes and by Due [9, 1991] for the more general case of semi-
martingales.
If D is a cumulative dividend process which is a semi-martingale, dene the
process D
()
by simple integration:
D
()
(t) =
_
t
0
dD
Similarly, suppose (

S,

D) is a securities market model such that

D is a semi-
martingale, dene the process

D
()
by

D
()
(t) =
_
t
0
d

D
16
Proposition 5 Suppose (

S,

D) is a securities market model such that

D is
an It o process with
d

D =

f dt + g dW
Suppose

L(

G) is a trading strategy such that D(

;

S,

D) has nite vari-
ation. Then the following are equivalent:
1. For every t,
D(

;

S,

D
()
)(t) = D(

;

S,

D)
()
(t)
with probability one
2.

g

= 0 almost everywhere (the trading strategy has zero instanta-

neous covariance with )
Proof: It follows from Corollary 1 that

D
()
(t) =
_
t
0
d

D =

D

(t)
_
t
0
g

ds
The transformed securities market model is (

S,

D
()
), and the corresponding
cumulative gains process

G
()
is given by

G
()
(t) = (t)

S(t) +

D
()
(t) =

D

(t)
_
t
0
g

ds
In the transformed securities market model, the cumulative gains process of

is
G(

;

G
()
)(t) =

(0)

G(0) +
_
t
0

G
()
=

(0)

G(0) +
_
t
0

_
t
0

ds
= G(

;

G

)(t)
_
t
0

ds
and the cumulative dividend process is
D(

;

S,

D
()
)(t) = G(

;

G
()
)(t)

(t)

S(t)
= G(

;

G

)(t)
_
t
0

ds

(t)

S(t)
= D(

S,

D

)(t)
_
t
0

ds
17
Since D(

;

S,

D) has nite variation, it follows from Proposition 4 that
D(

;

S,

D)
()
= D(

;

S,

D)

whereas, as shown above,

D(

;

S,

D
()
)(t) = D(

;

S,

D)

(t)
_
t
0

ds
Hence, for all t,
D(

;

S,

D
()
)(t) = D(

;

S,

D)
()
(t)
with probability one if and only if for all t,
_
t
0

ds = 0
with probability one, which is true if and only if g

= 0 almost everywhere.
2
Proposition 5 contradicts Proposition 9 of Due [9, 1991, Section 5] and
implies that it is not appropriate in general to change the unit of a cumulative
dividend process by simple integration, even if the integral is well dened
because the cumulative dividend process is a semi-martingale. In particular,
this procedure is not appropriate if the cumulative dividend process is an
Ito process, as recognized in Due [10, 1992], [11, 1996], and [12, 2001], and
Aase [1, 2002]
Due and Zame [13, 1989, page 1287] assume that the cumulative dividend
processes of the basic securities are It o process. They re-measure them in
units of a consumption good by simple integration, thus dening the real
cumulative dividend processes. Due [9, 1991, Section 4, page 1640] also
re-measures a cumulative dividend process (which is assumed to be a semi-
martingale) in units of a consumption good by simple integration. One should
be careful with the interpretation of this procedure, because it does not satisfy
unit invariance.
Proposition 6 of Due [9, 1991, Section 4] similarly involves changing the unit
of account by simple integration. Its Equation 16 contradicts Equation 2.3
of Aase [1, 2002]. The source of this discrepancy seems to be the step in
the proof where Fubinis theorem for conditional expectations is applied.
18
This theorem applies to time integrals of conditional expectations but not to
general stochastic integrals.
A similar calculation appears in the proof Proposition 7.3.2 in Dana and
Jeanblanc-Picque [6, 1994] and Dana, Jeanblanc-Picque, and Koch [7, 2003].
The last equation of this proof is essentially an application of Fubinis theo-
rem for conditional expectations to a stochastic integral.
5 Consistency
Suppose we change the unit of account of a cumulative dividend process D
by , calculating D

, and we then further change the unit of account by a

process , calculating (D

. The result should be the same as if we changed

the unit of account by in one step, calculating D

.
This consistency property of changes of the unit of account is veried in the
following theorem.
Theorem 2 Let and be one-dimensional It o processes, and let D be
a cumulative dividend process such that D L() and D

L(). Then
D L() and
(D

= D

Proof: First, observe that D L(). This follows from the fact that
D

L() and D

D belongs to L() because the latter is a continuous

process.
Write
d =

dt +

dW
where

L
1
and

L
2
. Then
d() = d + d +

dt
=
_

_
dt + [

] dW
Since D L() and D L() by assumption, D

L
1
, D

L
2
,
D

L
1
, and D

L
2
. Since is continuous, it follows that D

L
1
, D

L
2
, and consequently, D L().
19
Now,
(D

(t) = (t)D

(t)
_
t
0
D

d
= (t)(t)D(t) (t)
_
t
0
Dd
_
t
0
Dd +
_
t
0
__
s
0
Dd
_
d
and
D

(t) = (t)(t)D(t)
_
t
0
Dd()
= (t)(t)D(t)
_
t
0
D d
_
t
0
D d
_
t
0
D

ds
The dierence between these two processes is
(D

(t) D

(t) = (t)(t)D(t) (t)

_
t
0
Dd
_
t
0
Dd
+
_
t
0
__
s
0
Dd
_
d (t)(t)D(t)
+
_
t
0
D d +
_
t
0
D d +
_
t
0
D

ds
= (t)
_
t
0
Dd +
_
t
0
__
s
0
Dd
_
d
+
_
t
0
D d +
_
t
0
D

ds
It is an It o process with dierential
d ((D

) = Dd
__
t
0
Dd
_
d D

dt
+
__
s
0
Dd
_
d +D d +D

ds
= 0
Since the processes (D

and D

have the same initial value, it follows that

(D

= D

2
20
6 State Prices and Risk Adjustment
This section generalizes some standard concepts and results to general divi-
dends: state price process, prices of risk, the martingale property, and risk-
adjusted probabilities.
Consider a securities market model of the form (

S,

D).
Let be a positive one-dimensional It o process. It must have the form
= (0)[r, ]
for some (0) > 0 and processes r L
1
and L
2
. Given a positive
constant M(0), set
M = M(0)[r, 0]
Then
= (0)M(0)
[0, ]
M
Say that is a state price process for (

S,

D) if

Dr L
1
and the process
[0, ]

G
1/M
has zero drift.
This denition is consistent with the standard denition for the case where

D = 0: is a state price process for (

S, 0) if and only if
[0, ]

G
M
= [0, ]
1
M

S =
1
M(0)(0)

S
has zero drift.
The following proposition exhibits the standard equation for the prices of
risk and identies r as the interest rate.
Proposition 6 Let (0) > 0, M(0) > 0, r L
1
, and L
2
, and assume
that

Dr L
1
. Then = (0)[r, ] is a state price process for (

S,

D) if
and only if
r

S =

almost everywhere. If so, and if

b is a money market account with initial value

b(0)

S(0) = M(0), then

b has value process

b

S = M(0)[r, 0] and interest rate

r.
21
Proof: The drift of [0, ]

G
1/M
is
[0, ]
M
_
r

_
Hence, = (0)[r, ] is a state price process for (

S,

D) if and only if
r

S =

almost everywhere. If so, and if

b is a money market account with initial
value

b(0)

S(0) = M(0), then

b r

S =

b

= 0
and
d(

S) = dG(

b;

G) =

b d

G =

b dt = r

S dt
Given the initial condition

b(0)

S(0) = M(0), this dierential equation has

the unique solution

b

S = M(0)[r, 0]. 2
The next proposition says that the zero-drift condition that denes the state
price process holds for the discounted cumulative gains processes not only of
the basic securities but of any trading strategies (whether self-nancing or
not).
Proposition 7 If is a state price process for (

S,

D), and if

L(

G
1/M
),
then
[0, ]G
_

,

G
1/M
_
has zero drift.
Proof: By Theorem 1, D L(1/M). Observe that
d
_
[0, ]G
_

,

G
1/M
__
= [0, ] dG
_

,

G
1/M
_
+G
_

,

G
1/M
_
d[0, ] [0, ]

dt
Since [0, ] has zero drift, the coecients to dt in G
_

,

G
1/M
_
d[0, ]
and in (

G
1/M
) d[0, ] are both zero, and the drift of [0, ]G
_

,

G
1/M
_
22
equals the coecient to dt in
[0, ] dG
_

,

G
1/M
_
+ (

G
1/M
) d[0, ] [0, ]

dt
=

_
[0, ] d

G
1/M
+

G
1/M
d[0, ] [0, ] dt
_
=

d
_
[0, ]

G
1/M
_
Since [0, ]

G
1/M
has zero drift, the coecient to dt is zero, and, hence
[0, ]G
_

,

G
1/M
_
has zero drift. 2
Assume that

D L(M).
Let

be a trading strategy in L(

G
1/M
). It was just shown above that
[0, ]G(

;

G
1/M
)
has zero drift. Say that

is admissible for (

S,

D) and if this process is a
martingale.
If

is a self-nancing trading strategy, then
[0, ]G
_

;

G
1/M
_
= [0, ]

S/M =
1
(0)M(0)

S
Hence,

is admissible if and only if

S is a martingale. This is consistent

with the denition of admissibility in Harrison and Pliska [18, 1981], even
though now there may be dividends on the basic securities.
Requiring self-nancing trading strategies to be admissible rules out self-
nancing arbitrage strategies when there are no dividends on the basic se-
curities. The same will be seen to be true of trading strategies that are
not necessarily self-nancing, and even if there are dividends on the basic
securities.
We formally generalize the concept of arbitrage to basic securities with gen-
eral dividends and to trading strategies that are not necessarily self-nancing,
as follows.
An arbitrage trading strategy is a trading strategy

L
_

G
1/M
_
23
such that

(0)

S(0)/M(0) = 0 and for some t,

G
_

;

G
1/M
_
(t) 0
with probability one, and
G
_

;

G
1/M
_
(t) > 0
with positive probability.
Recall that a trading strategy

is self-nancing relative to (

S,

D) if and
only if it self-nancing relative to (

S/M,

D
1/M
), in which case its normalized
cumulative gains process is
G
_

;

G
1/M
_
=

S/M
Therefore, a self-nancing arbitrage trading strategy is a self-nancing trad-
ing strategy

L(

G) such that

(0)

S(0) = 0 and for some t,

(t)

S(t) 0
with probability one, and

(t)

S(t) > 0 with positive probability.

Thus, the denition is consistent with the usual denition in the case where
there are no dividends.
If

is an arbitrage trading strategy, then
E
_
[0, ](t)G
_

;

G
1/M
_
(t)
_
>

(0)

S(0)/M(0)
= [0, ](0)G
_

;

G
1/M
_
(0)
Hence, [0, ]G(

;

G
1/M
) cannot be a martingale, and

cannot be ad-
missible. So, there are no arbitrage trading strategies among the admissible
trading strategies.
Dene the K-dimensional process W

by
W

(t) =
_
t
0

ds +W(t)
We can express the dierential of

G
1/M
in terms of dW

:
d

G
1/M
=
1
M
( r

S) dt +
1
M
dW
=
1
M
( r

) dt +
1
M
dW

=
1
M
dW

24
If

L(

G
1/M
) is a trading strategy, then
dG(

;

G
1/M
) =

d

G
1/M
=
1
M

dW

Dene the risk-adjusted probability measure Q (on the horizon T) correspond-

ing to as the measure on (, F) which has density [0, ](T) with respect
to the original probability measure P.
According to Girsanovs Theorem, if [0, ] is a martingale on [0, T], then
W

is a Wiener processes with respect to F and Q on [0, T].

In terms of the risk-adjusted probabilities, a trading strategy

in L(

G
1/M
) is
admissible if and only if the discounted cumulative gains process G(

;

G
1/M
)
is a martingale under Q.
7 Replication and Valuation
A trading strategy

is said to replicate a contingent claim Y (a random
variable) at time T with respect to (

S,

D) if it is self-nancing with respect
to (

S,

D) and

(T)

S(T) = Y .
If

is a self-nancing trading strategy which replicates a contingent claim
Y at time T with respect to (

S,

D), and which is admissible for (

S,

D) and
on [0, T], then for t T, because of the martingale property,

(t)

S(t) =
1
(t)
E [(T)Y | F
t
]
If is any positive It o process and Y is any claim such that (T)Y is
integrable, dene the value process or, for emphasis, its martingale value
process of Y with respect to as the process V (Y ; ; T) given by
V (Y ; ; T)(t) =
1
(t)
E [(T)Y | F
t
]
for 0 t T.
25
If is a state price process for (

S,

D) and if Y happens to be replicated
at time T with respect to (

S,

D) by a self-nancing strategy

, then

is
admissible for (

S,

D) and if and only if

S = V (Y ; ; T)
A trading strategy

will be said to replicate a cumulative dividend process
D up to time T with respect to (

S,

D) if

L(

G), D(

;

S,

D) = D and

(T)

S(T) = 0.
Proposition 8 Let (

S,

D) be a securities market model such that

D L(M),
and let D be a cumulative dividend process. If D is replicated with respect to
(

S,

D) up to time T by a trading strategy

L(

G) which is admissible for
(

S,

D) and , then D L(M), and for every t [0, T],
G
_

;

G
1/M
_
(t) = V (D
1/M
(T); [0, ]; T)(t)

(t)

S(t)/M(t) = V (D
1/M
(T); [0, ]; T)(t) D
1/M
(t)
and

(t)

S(t) = V (D
1/M
(T)M(T); ; T)(t) D
1/M
(t)M(t)
with probability one.
Proof: Since

is admissible,

L(

G
1/M
). By Theorem 1, Dr L
1
, and

replicates D
1/M
with respect to

S/M and

D
1/M
. Furthermore,
[0, ]G
_

;

G
1/M
_
= [0, ]

S/M +[0, ]D
1/M
is a martingale. Hence,
[0, ](T)G
_

;

G
1/M
_
(T) = [0, ](T)D
1/M
(T)
is integrable, and for 0 t T,
[0, ](t)G
_

;

G
1/M
_
(t) = E
_
[0, ](T)D
1/M
(T) | F
t
_
This implies that
G
_

;

G
1/M
_
(t) =
1
[0, ](t)
E
_
[0, ](T)D
1/M
(T) | F
t
_
= V (D
1/M
(T); [0, ]; T)(t)
26
Hence,

(t)

S(t)/M(t) = G
_

;

G
1/M
_
(t) D
1/M
(t)
= V (D
1/M
(T); [0, ]; T)(t) D
1/M
(t)
and

(t)

S(t) = V (D
1/M
(T); [0, ]; T)(t)M(t) D
1/M
(t)M(t)
= V (D
1/M
(T)M(T); ; T)(t) D
1/M
(t)M(t)
with probability one. 2
We may want to use the formulas from Proposition 8 to value a cumulative
dividend process even if it is not replicated by an admissible trading strategy.
Let D be a cumulative dividend process such that Dr L
1
and such that
[0, ](T)D
1/M
(T)
is integrable. Dene the value process or, for emphasis, the martingale value
process V [D; ; T] of D with respect to , on [0, T], by
V [D; ; T] = V (D
1/M
(T)M(T); ; T) D
1/M
M
= V (D
1/M
(T); [0, ]; T)M D
1/M
M
It may be interpreted as the present value of the dividends yet to be paid up
to time T.
We refer to this valuation procedure as the martingale method.
The nal theorem says that the value of a dividend process equals the value
of a claim to the cumulative dividends from today on plus the value of a ow
of interest on the cumulative dividends at each point in time.
Theorem 3 Let D be a cumulative dividend process in L(M) and let

D be
the cumulative dividend process with continuous dividend ow Dr:

D(t) =
_
t
0
Dr ds
Assume that [0, ] is a martingale. If two of the variables (T)D(T),
[0, ](T)D
1/M
(T), and [0, ](T)

D
1/M
(T) are integrable, then so is the
third, and
V [D; ; T](t) = V (D(T); ; T)(t) D(t) +V [

D; ; T](t)
27
Proof: The statement about integrability follows directly from the equation
(0)M(0)[0, ](T)D
1/M
(T)
= (T)D(T) + (0)M(0)[0, ](T)
_
T
0
D
r
M
ds
= (T)D(T) + (0)M(0)[0, ](T)

D
1/M
(T)
If the relevant variables are indeed integrable, then
V [D; ; T](t)/M(t)
= E
Q
_
D
1/M
(T) | F
t
_
D
1/M
(t)
= E
Q
[D(T)/M(T) | F
t
] D(t)/M(t) +E
Q
_
_
T
t
D
r
M
ds

F
t
_
= V (D(T); ; T)(t)/M(t) D(t)/M(t) +V [

D; ; T](t)/M(t)
which implies that
V [D; ; T](t) = V (D(T); ; T)(t) D(t) +V [

D; ; T](t)
2
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