Gisanov theorem

Gisanov theorem represents measure change techique. This is similar to change variable x on
g(x) in an integral in the case when x is from a functional space. When the BSE was
developed and all people suddenly felt that "no free lunch" in option pricing someone
probably noted that underlying iin BS pricing actually differs from one which actually should
be underlying. The difference is the drift. We calculate price for the option on ( mu , signa )
while BS option formula has underlying on ( r , sigma ) security. Because BS formula is
thinking as magical no arbitrage someone decided to apply Girsanov theorem as a tool that
can replace real mu on r.
In probability Girsanov theorem is used differently than in Finance. In probability we have
original probability space with a measure P. In Finance it is refferred as to 'real'world. On the
real world we introduce given stochastic process=real stock price equation with mu drift.
Then one can make the measure change and state that there exists risk-neutral measure Q such
that mu-GBM would get r drift. This is standard math way. This way actually fails to present
underlying with r drift because integrals with respect to measure Q along the risk-neutral
process with r drift are equal to these integrals with respect to measure P along GBM with mu
drift. In other words Kolmogorov equation will have mu coefficients in front of the derivative
of the first order. Then mathematical experts improved risk neutral concept. The settle original
mu-stock equation on risk neutral probability space with measure Q. The Q is chosen such
that its image on real space with measure P has drift r. This is the same to consider that the
given GBM process has drift r and state that there exists probability space with measer Q that
given r-GBM will have mu drift.
This is nonsense because given mu GBM which govern the stock prices is defined and existed
on the real world (original probability space) regardless whether or not options exist along
with the risk free bond.
The correct initial question to professors who understand mathematics before we beging to
talk about option pricing is that they need to defiene original probability space with pr.
measure P and the stock equation. If the define stock with respect to P we could not arrive at r
in BSE. It is first case in above. If they try to settle it risk-neutral world then we can ask what
is the expected return for our stock? They should answr'r' but you can argue that our stock
should have expected return mu not r and therefore this is not our stock. We do not step here
to derivatives.
This risk-neutral confuse does not eliminate our lovely BS pricing. It is a confusion in
undrstanding mathematics.

What is the risk-neutral measure?

Here is a short list of the most common big-concept questions that I was asked throughout
my years as a quant (whether coming from people on the trading floor, in control functions, or
from newcomers to the team), in no particular order:
What is the risk-neutral measure?
What is arbitrage-free pricing?
What is a change of numeraire?
What is the market price of risk?

I dont know of a single book on financial mathematics that attempts to give answers to these
questions for a reader that is not familiar with stochastic calculus (which most traders are not,
of course). Over a series of posts I will put down my own user-friendly answers to these
questions, and well end up with a grand Guide to Financial Derivatives Pricing for a NonTechnical User!
This post covers the first: what is the risk-neutral measure?

A simple example with a coin-tossing game

Without even getting mixed up with stock and bond prices and suchlike, we can get a good
sense of the risk-premium concept at work in a simple betting game.
The classic example, a game of coin tossing:
1.
2.
3.
4.

a player hands over some money, say X, to play,

the host tosses an unbiased coin,
if it comes up heads then the player is given 2,
but if it comes up tails then nothing is given back.

A textbook on probability will tell you that the price of 1 per go is fair for this game because
the concept of fair is defined in probability textbooks to mean that the price paid should equal
the value of the expected winnings. Clearly it does for this example.
But lets get savvy, step back from the theory, and ask how much would different players be
prepared to pay for this game. Consider two different players:

person A that has 1.50 in their pocket but is under pressure from a traffic warden to
pay 2 for a parking ticket (and nothing less than 2 will do),
person B that has 10 in their pocket and doesnt really need anything more than that.

Dont you think you could convince person A to pay up to their whole 1.50 for this game?
Person B might be a harder sell, but perhaps theyd come around if we charged something like
50p a go and advertised the game as potential 4 times returns on your investment?
The important point is that the theoretical fair price may well be 1 for this game, but the
actual price at which we sell the game may be something different since it will depend on the
circumstances of the players we are selling it to.
The difference between the actual and theoretical price is called the risk premium for this
game. Throwing in a bit of look-ahead market language, lets write that:
the risk premium is the amount of premium (or discount) that needs to be added to the
theoretical fair price in order to match the actual price of the trade in the market.
If you do a google search on risk premium you will see these concepts (amongst others):

equity risk premium,

inflation risk premium,

and these are just the theoretical musings of how much premium or discount there is in stock
prices (to compensate for the volatility) or in bond prices (to compensate for the risk that
inflation eats into your bond coupons and capital).

The risk neutral measure the flipside of the risk premium

The above examples showed that the price paid for a game is very likely to not be equal to the
fair price for that game, ie. the value of the expected winnings.
In fact, it looks as though person A would buy the game for 1.50, which is a full 50p
premium over the fair price of 1.
According to naive probability theory, person A would be paying the fair price only if the coin
actually had a 75% probability of coming up heads, since the expected value would then be
equal to the price paid:
expected winnings = 0.75 * 2 + 0.25 * 0 = 1.50.
This is the definition of the risk-neutral measure:
The risk neutral measure is the set of probabilities for which the given market prices of a
collection of trades would be equal to the expectations of the winnings or losses of each trade.
Remark: It is risk-neutral because in this alternative reality the price paid by player A for the
game contains no risk premium the price is exactly equal to the value of the expected
winnings of the game.

Why is this so useful?

The risk-netural measure has a massively important property which is worth making very
clear:
The price of any trade is equal to the expectation of the trades winnings and losses under the
risk-neutral measure.
This property gives us a scheme for pricing derivatives:
1. take a collection of prices of trades that exist in the market (eg swap rates, bond prices,
swaption prices, cap/floor prices),
2. back out the set of risk-neutral probabilities that these prices imply,
3. calculate the expectation of the derivative trades payoff under these risk-neutral
proabilities,
4. that is the price of the derivative.
Wonderful! This is the reason why the risk-neutral measure is so important it lies at the
heart of the scheme for pricing derivatives (and therefore derivatives pricing is a sort of
interpolation/extrapolation if you think about it).

Am I telling you the whole truth?

This result as stated above in simple terms is not very far away from the real version that we
use in derivatives pricing:
The Fundamental Theorem of Asset Pricing: There are no arbitrage opportunities in the
market if, and only if, there is a unique equivalent martingale measure (read risk-neutral
measure) under which all discounted asset prices are martingales.
So you see, even the simple coin tossing example above has been enough to take us quite far
towards understanding this deep theorem, and without any substantially important lies too!
(But dont misunderstand me the proof of the Fundamental Theorem requires some quite
technical mathematics).
Thats it for now. In following posts I will give simple intuition to other big concept
questions, and well make further progress towards understanding all the key elements in
derivatives pricing.

A footnote: how exactly do my quants derive the risk neutral probabilities

from prices?
Step 2 in the scheme above might seem to be rather magical: deduce the risk-neutral
probabilities from the market prices. Wow!
Well the truth is that it sounds more mystical than it actually is in practice, just because this
way of describing it is really putting the cart before the horse. Here is how it works:
1. Start with a collection of prices of market traded products, from which we will deduce
the risk-neutral probabilities.
2. Do your best to think up a realistic probabilistic mathematical model for the key
elements that determine the payoffs of these traded products (e.g. lets hypothesise a
normal distribution for the 5y5y swap rate).
3. Use your model to calculate the expectations of the winnings/losses for each trade.
4. If this expectation is exactly equal to the market-traded prices then youve done it.
5. Otherwise, fiddle with the parameters of your model (e.g. mean & standard deviations)
until the calculated expectations of each trades winnings/losses in your model are
equal to the prices in the market.
Once (if) you can do this you can then say that you have built a consistent model to explain
the market prices, and can then ask this model to calculate any probabilities you like: e.g.
what is the proability that the 5y5y rate is above 10%?
Note that the process of adjusting your models parameters until you hit the market prices is
called calibration.
Quants love to come up with clever mathematical routines that make calibration automatic
and very quick. Thats a large part of their raison dtre.
Remark: if you only have a small collection of market prices to calibrate to then you may
actually have a few different models that can be well calibrated to the prices. In fact, you
might be surprised to find that there are some quite different models which can be well
calibrated to lots of different market prices.

This is not really a problem until you find that you get quite quite different prices for the
derivative you are pricing. More on this later.
The true probabilities underlying the B-S equation are actually postulated. The pricing process
is assumed to follow the stochastic process dSt=Stdt+StdWt, where Wt is the
Wiener process.
It means that (for simplicity, let's talk about European call) lnST is distributed as

N(ln(S0)+(122)T,2T)
Correct me if I'm wrong, you'd like to find EP(C)=erTEP[max(STK,0)], where
P is a "physical" probability measure. Just to make sure, this expected value won't represent
the fair price of the option.
If my calculations are correct, this expected value is equal to

S0N(d1())e(r)TKN(d2())erT
the terms d1 d2 are from the B-S formula, with the adjustment to replace risk-free rate r
there with "risky"

Now, I write down some derivation steps, please check them.

Let's rewrite expectation as follows, EP[...]=EP[I(STK)(STK)], where I(.) is
the indicator function.
Notice that the inequality STK is equivalent to lnSTlnK
Then, ...=EP[STI(lnSTlnK)]EP[KI(lnSTlnK)]

=EP[elnSTI(lnST)lnK)]KN(d2())
To calculate the first term, use the following lemma: if X distributed as N(a,s2) then

E(eXI(l<X))=es+12s2N(+s2ls)

Take lnST as X and l as lnK, obtain EP[STI(lnSTlnK)]=elnS0+

(122)T+122TN(lnS0+(122)T+2TlnKT)=S0eN(d1())

Finally, discount it with the risk-free rate r and we get the result.
You cannot get "true probabilities" (empirical distribution) from the BS model. Option price is
required initial investment, which is risk neutral expectation of payout. True probabilities
are irrelevant in Black
ou cannot deduce the real-world probabilities from the option prices.
It may seem strange, but here is a simple example which might help you to understand.
Suppose that everyone in the market agrees on the real-world probabilities, and that they are
not changing for any external reason.
Then suppose that the investment board of a large pension fund decides that they need to
increase the amount of options they have bought because they get a feeling that they would
like to hold more protection against an adverse move (and since most pension funds are net
long equities, this is likely to mean that they want to buy out-of-the-money equity put options
to protect against a sell off in the equity market).
The pension fund will come to the dealers (investment banks probably) and will buy a whole
load of put options, say. Naturally the price in the market will go up (simple law of
supply/demand, and demand has increased), which implies that the implied vols will go up.
In summary: no change in the real-world probabilities, but a big change in the implied
volatilities which will in turn lead to a change in the implied underlying probability
distribution.