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1
1.1
Introduction
The market model
(1)
B(0) = 1
S(0) = x
where r, are deterministic constants with > 0 and W (t) is a Brownian
motion under P. We refer to r as the interest rate and to as the volatility of
S. We denote by {Ft }t0 the natural augmented filtration of W . It is easy to
verify that (1) under P has the unique strong solution
B(t) = ert
(2)
/2)t
(3)
1.2
Pricing formula
Theorem 1 (Fundamental theorem of asset pricing). Let T > 0 and D be a Pintegrable and FT -measurable random variable, which we interpret as the value
of some derivative security at time T . The arbitrage-free price of D at time
t [0; T ] is given by
D(t) = E[er(T t) D|Ft ]
(4)
Moreover ert D(t) is a {Ft }-martingale under P.
Proof. See [8] Chapter 5.
1.3
Eur
= E[e
rT
(K S(T )) ]
(5)
(6)
(7)
[0,T ]
(8)
[0,T ]
(9)
(10)
2
2.1
Let {W
/2)s
(11)
X(s)() = (t + s, S(s)())
where r, are deterministic constants with , r > 0. Moreover, for s 0,
let Fs = B(E) Fs and Gs = {, E} Fs . Finally define probability mea and
sures {P(t,x) }(t,x)E on {, F } and P on {, G } by P(t,x) := t x P
Remark. Under P(t,x) we interpret S(s) as the value of a stock S with volatility
= x.
in a financial market with interest rate r at time t + s given that S(t)
We fix a strike price K > 0. Define the gain function G : E 7 [0, K] by
G(t, x) := ert (K x)+ . For (t, x) E define the optimal stopping problem
V (t, x) =
sup
E(t,x) [G(X(s))]
[0,T t]
sup
(12)
[0,T t]
sup
Ex [er (K S( ))+ ]
(13)
[0,T t]
(14)
which we call the gain* function. Even though V and G are the formal correct
objects, which in addition carry the economic interpretation of time value of
money, it turns out that v and g are the convenient mathematical objects to
work with.
2.2
Lemma 1.
1. If T = , the function t 7 v(t, x) is constant
2. If T < , the function t 7 v(t, x) is decreasing with v(T, x) = (K x)+ .
Proof. Let 0 t1 t2 T 6 . Then
v(t1 , x) =
sup
Ex [er (K S( ))+ ]
[0,T t1 ]
sup
Ex [er (K S( ))+ ]
(15)
[0,T t2 ]
= v(t2 , x)
Since [0, t1 ] = [0, t2 ] and clearly v(T, x) = (K x)+ by definition for
T < , both assertions follow immediately.
4 In general we allow to be an {F }-stopping time. Note, however, that for fixed
t
(t, x) E for each {Ft }-stopping time F there exists a {Gt }-stopping time G with
F = G P(t,x) -a.s.. If necessary we will work with G rather than with F , which will
always be clear from the context.
5 t := ; moreover we allow = if T =
6 We require t <
/2) +
(16)
sup
E[u(x, )]
(17)
[0,T t]
The assertion follows by the well-know facts that the supremum of convex functions is convex again, and that convex functions are continuous.
Lemma 3. The function (t, x) 7 v(t, x) is lsc.
Proof. For [0, T ] and (t, x) E define
u(t, x, ) := er( (T t)) (K xeW ( (T t))+(r
/2)( (T t)) +
(18)
The assertion follows by the well-know fact that the supremum of lsc functions
is lsc again.
2.3
(20)
(21)
(22)
Lemma 4. All points (t, x) [0, T ) [K, ) belong to the continuation set C.
7 Again
we require t <
{ (T t) : [0, T ]} = { : [0, T t]}
9 This is indeed a stopping time since D is closed and X is continuous.
8 Note
Proof. Let (t, x) [0, T ) [K, ) and 0 < < K. Define the stopping time10
:= inf{s 0 : Ss K } (T t)
(23)
It is not difficult to show that P(t,x) (0 < < T t) =: > 0. Hence we have
V (t, x) erT > 0 = G(t, x), which establishes the claim.
Now define w(t, x) = v(x, t) + x. Lemma 4 implies
C = {(t, x) [0, T ) (0, ) : w(t, x) > K}
(24)
(25)
2.3.1
(26)
(27)
For convenience set v(x) := v(0, x). For 0 < b < K define the stopping time
b = inf{s 0 : S(s) b} and let
vb (x) := Ex [erb (K S(b ))+ ]
(28)
The formula for the Laplace transform for the first passage time of a Brownian
motion with drift11 yields after some simple calculations
(
K x
if 0 < x b
2
(29)
vb (x) =
x 2r/
if x b
(K b) b
Define v (x) = supb(0,K) vb (x). Elementary Calculus yields
(
K x
if 0 < x b
2
v (x) = vb (x) =
2r/
(K b ) bx
if x b
(30)
2r
C 1 ((0, )) and
where b = 2r+
2 K. It is straightforward to check that v
2
v C ((0, b) (b, )) with
(
1
if 0 < x b
vx (x) = 2r
(31)
2 x v (x) if x b
(
0
if 0 < x < b
(33)
Hence V (t, S(t)) is a {Ft }-supermartingale13 with V (t, S(t)) G(t, S(t))14 .
Let [0, ] be a stopping time. Monotonicity of the integral and the optional
sampling theorem yield
Ex [G(, S( ))] Ex [V (, S( ))] V (0, x) = v (x)
(34)
Taking the supremum in (34) over [0, ] yields v (x) v(x). On the other
hand v (x) v(x) by definition. Hence
v (x) = v(x) = Ex [v (b , S(b ))]
(35)
q.e.d.
2.3.2
2.4
(36)
(37)
[0,]
[6] p 74 et seq
rs 1.
S(s)V
x (s, S(s)) dW (s) is a proper martingale since |Vx (s, S(s))| e
0
14 Note that v (x) (K x)+ for x (0, ).
13
Rt
2.5
sup
Ex [er (K S( ))+ ]
[0,T t]
= (K b )
x 2r/2
(38)
/2)(1 2 ) +
r2
) ]
/2)(1 2 ) +
) |G2 ]]
W (1 2 )+(r /2)(1 2 ) +
S(2 )E[(1 e
) ]]
/2)|(t2 t1 ) +
) ]
(39)
2
Hence v is continuous in E.
8
(40)
2 2 2
LX =
(41)
+ rx
+
x
t
x
2
x2
Now fix (t0 , x0 ) C and let r0 > 0 such that B := B r0 (t0 , x0 ) C. Now
consider the following PDE
LX U = 0
U =V
in B
on B
(42)
(43)
(44)
Note that LX = 0 in B by (42). Hence (43) and the Optional Sampling theorem
yield17
U (t, x) = U (t, x) = E(t,x) [U (XBc )] = E(t,x) [U (XBc )]
(45)
On the other hand, since Bc D we get by the Strong Markov property
E(t,x) [V (XBc )] = E(t,x) [EXBc [G(XD )]]
(46)
(47)
Since > 0 was arbitrary, we get V (t, x) = U (t, x). Thus V = U in B, which
in particular implies that V is C 1,2 in (t0 , x0 ). Since (t0 , x0 ) C was chosen
15 See
2
2 x2
2r
v(t, x)
2 x2
(48)
(49)
0
= lim
0
x +
x
2r/2
=1
(50)
This implies that for any sequence {n }n1 in R+ with limn n = 0 we have
limn n = 0 in probability. For t 0 define M (t) := sup0st |W (s)| and
2
2
for convenience set (t) := eW (t)+(r /2)t and (t) := e M (t)|(r /2)|t .
Let > 0 be arbitrary and {n }n1 a sequence in R+ with limn n = 0.
After possibly discarding a subsequence we may assume that limn n = 0
a.s. Then it holds
v(t , x + n ) v(t , x )
+v
(t , x ) = lim sup
x
n
n
lim sup E[er
n
r
(51)
10
(52)
+v
x (t , x )
= 1. Finally we have
v
v(t , x ) v(t , x )
(t , x ) = lim
0
x
g(x ) g(x )
= 1
= lim
0
(53)
+v
(t , x)
x
(55)
2.6
(56)
20 Recall
11
(t, b(t)) D. Seeking a contradiction, suppose that b(t) < b(t). Set
x := (b(t) + b(t))/2 and let t0 < t21 . Then
b(t0 ) b(t) < x < b(t) K
(57)
(58)
vxx (t0 , x)
(59)
v(t , x ) g(x ) =
b(t0 )
=
b(t0 )
b(t0 )
dz dy =
b(t0 )
b(t0 )
(x b(t0 ))2
2
(60)
(x b(t))2
>0
2
(61)
Hence (t, x )
/ D in contradiction to (t, x ) D. Thus b(t) = b(t) and
t 7 b(t) is left-continuous with limtT b(t) = K.
Lemma 13. The function t 7 b(t) is convex and satisfies
log(b(t)/K)
lim p
=1
tT (T t)( log(8r 2 (T t)/ 2 ))
(62)
2.7
The above lemmata imply22 that V C 0,1 (E\{T } {K}) C 1,2 (E\(b(t)))23 .
Moreover, since P(t,x) (X(s) = b(t + s)) = 0 for all (t, x) (0, T ) (0, ) and
that t0 < T .
that clearly V C 1,2 (Int{D}).
23 (b(t)) := {(t, x) [0, T ] (0, ) : x = b(t)}
21 Note
22 Note
12
all 0 < s < T t, we can apply a slightly generalized version of Itos formula24
to V (Xs ) and get
dV (Xs ) = LX V (Xs )1{X(s)6=b(t+s)} ds + Vx (X(s)) dS(t)
= ers rK1{S(s)<b(t+s)} dt + S(t)Vx (Xs ) dW (t)
(63)
(65)
(66)
b(0)
2
s
0
(67)
2.8
Theorem 4. The function t 7 b(t) is the unique solution in the class of continuous increasing functions c : [0, T ] R satisfying 0 < c(t) < K for all
0 < t < of the following free-boundary integral equation
Z K
1
K x
2
K b(t) = er(T t)
log
r
(T t)
dx
b(t)
2
T t
0
Z T t
1
b(t + s)
2
rs
+ rK
e
log
r
s
ds (68)
b(t)
2
s
0
24 confer
25 Note
ert < 1.
[6] p 74 et seq
R
that 0t S(s)Vx (s, S(s)) dW (s) is a proper zero-mean martingale since |Vx (Xs )|
13
Proof.
t 7 b(t) is a solution of (68): Plugging (t, b(t)) in (66) and noting that
v(t, b(t)) = K b(t) yields after some lengthy calculation (68).
t 7 b(t) is the unique solution of (68): See [6] p 386 - 392.
References
[1] Thomas Bj
ork, Arbitrage theory in continuous time, 2nd ed., Oxford University Press, 2004.
[2] Xinfu Chen, John Chadam, Lishang Jiang, and Weian Zheng, Convexity of
the exercise boundary of the american put option on a zero dividend asset,
Mathematical Finance 18 (2008), 185 197.
[3] Laurence Evans, Partial differential equations, Oxford University Press,
1998.
[4] Ioannis Karatzas and Steven Shreve, Brownian motion and stochastic calculus, 2nd ed., Springer-Verlag, 1991.
[5] Achim Klenke, Wahrscheinlichkeitstheorie, Springer-Verlag, 2006.
[6] Goran Peskir and Albert Shiryaev, Optimal stopping and free-boundary problems, Birkh
auser Verlag, 2006.
[7] Daniel Revuz and Mark Yor, Continuous martingales and brownian motion,
3rd ed., Springer-Verlag, 2005.
[8] Steven Shreve, Stochastic calculus for finance 2, 2nd ed., Springer-Verlag,
2004.
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