MARTINGALES

B.B.Chakrabarti
Professor of Finance
 Martingales
• A martingale is a zero-drift stochastic process.
• A variable θ follows a martingale if its process
has the form
dθ = σ dz
where dz is a Wiener process.
• The expected value of a martingale at any
future time is equal to its value today.
E(θT) = θ0
 Market Price of Risk
• The market price of risk of a variable θ is given
by
λ = (μ – r) / σ
where
μ = expected rate of return
r = risk-free rate
σ = volatility
 Money Market Account
• The money market account is a security that is
worth 1 at time zero and earns the
instantaneous risk-free rate r at any given
time.
• If g is a money market account then
dg = r g dt
Equivalent Martingale Measure Result
• Suppose that f and g are the prices of two
traded securities dependent on a single source
of uncertainty and provide no income during
the time period under consideration.
• Let φ = f/g
• f/g can be considered as a price of f per unit of
g.
• The price of g is referred to as the numeraire.
Equivalent Martingale Measure Result
• The equivalent martingale measure result
shows that, without arbitrage opportunities, if
the market price of risk of f is set equal to the
volatility of g, then the ratio f/g is a martingale
for all security prices of f.
• Then λ of security f = σg
• μ=r+λσ
Equivalent Martingale Measure Result
- Proof
• df = μ f dt + σ f dz
• or, df = (r + λ σ) f dt + σ f dz
• Hence, df = (r + σg σf) f dt + σf f dz
and dg = (r + σg2) g dt + σg g dz
• Using ITO’s lemma,
dlnf = (r + σg σf - σf2/2) dt + σf dz
and dlng = (r + σg2/2) dt + σg dz
• Hence, d(ln f/g) = - (σf – σg)2/2 dt +(σf – σg) dz
• With reverse ITO’s lemma then the process for f/g is
d(f/g) = (σf – σg) f/g dz
• So, f/g is a martingale i.e. E(fT/gT) = f0/g0