Paper 2, Section II, J

Stochastic Financial Models
Part II, 2009

What is a martingale? What is a stopping time? State and prove the optional sampling theorem.

Suppose that ξi\xi_{i} are independent random variables with values in {1,1}\{-1,1\} and common distribution P(ξ=1)=p=1q\mathbb{P}(\xi=1)=p=1-q. Assume that p>qp>q. Let SnS_{n} be the random walk such that S0=0,Sn=Sn1+ξnS_{0}=0, S_{n}=S_{n-1}+\xi_{n} for n1n \geqslant 1. For z(0,1)z \in(0,1), determine the set of values of θ\theta for which the process Mn=θSnznM_{n}=\theta^{S_{n}} z^{n} is a martingale. Hence derive the probability generating function of the random time

τk=inf{t:St=k}\tau_{k}=\inf \left\{t: S_{t}=k\right\}

where kk is a positive integer. Hence find the mean of τk\tau_{k}.

Let τk=inf{t>τk:St=k}\tau_{k}^{\prime}=\inf \left\{t>\tau_{k}: S_{t}=k\right\}. Clearly the mean of τk\tau_{k}^{\prime} is greater than the mean of τk\tau_{k}; identify the point in your derivation of the mean of τk\tau_{k} where the argument fails if τk\tau_{k} is replaced by τk\tau_{k}^{\prime}.