What is a martingale? What is a supermartingale? What is a stopping time?
Let M=(Mn)n⩾0 be a martingale and M^=(M^n)n⩾0 a supermartingale with respect to a common filtration. If M0=M^0, show that EMT⩾EM^T for any bounded stopping time T.
[If you use a general result about supermartingales, you must prove it.]
Consider a market with one stock with prices S=(Sn)n⩾0 and constant interest rate r. Explain why an investor's wealth X satisfies
Xn=(1+r)Xn−1+πn[Sn−(1+r)Sn−1]
where πn is the number of shares of the stock held during the nth period.
Given an initial wealth X0, an investor seeks to maximize EU(XN) where U is a given utility function. Suppose the stock price is such that Sn=Sn−1ξn where (ξn)n⩾1 is a sequence of independent and identically distributed random variables. Let V be defined inductively by
V(n,x,s)=p∈RsupEV[n+1,(1+r)x−ps(1+r−ξ1),sξ1]
with terminal condition V(N,x,s)=U(x) for all x,s∈R.
Show that the process (V(n,Xn,Sn))0⩽n⩽N is a supermartingale for any trading strategy π.
Suppose π∗ is a trading strategy such that the corresponding wealth process X∗ makes (V(n,Xn∗,Sn))0⩽n⩽N a martingale. Show that π∗ is optimal.