Paper 2, Section II, I

Stochastic Financial Models
Part II, 2010

What is a martingale? What is a supermartingale? What is a stopping time?

Let M=(Mn)n0M=\left(M_{n}\right)_{n \geqslant 0} be a martingale and M^=(M^n)n0\hat{M}=\left(\hat{M}_{n}\right)_{n \geqslant 0} a supermartingale with respect to a common filtration. If M0=M^0M_{0}=\hat{M}_{0}, show that EMTEM^T\mathbb{E} M_{T} \geqslant \mathbb{E} \hat{M}_{T} for any bounded stopping time TT.

[If you use a general result about supermartingales, you must prove it.]

Consider a market with one stock with prices S=(Sn)n0S=\left(S_{n}\right)_{n \geqslant 0} and constant interest rate rr. Explain why an investor's wealth XX satisfies

Xn=(1+r)Xn1+πn[Sn(1+r)Sn1]X_{n}=(1+r) X_{n-1}+\pi_{n}\left[S_{n}-(1+r) S_{n-1}\right]

where πn\pi_{n} is the number of shares of the stock held during the nnth period.

Given an initial wealth X0X_{0}, an investor seeks to maximize EU(XN)\mathbb{E} U\left(X_{N}\right) where UU is a given utility function. Suppose the stock price is such that Sn=Sn1ξnS_{n}=S_{n-1} \xi_{n} where (ξn)n1\left(\xi_{n}\right)_{n} \geqslant 1 is a sequence of independent and identically distributed random variables. Let VV be defined inductively by

V(n,x,s)=suppREV[n+1,(1+r)xps(1+rξ1),sξ1]V(n, x, s)=\sup _{p \in \mathbb{R}} \mathbb{E} V\left[n+1,(1+r) x-p s\left(1+r-\xi_{1}\right), s \xi_{1}\right]

with terminal condition V(N,x,s)=U(x)V(N, x, s)=U(x) for all x,sRx, s \in \mathbb{R}.

Show that the process (V(n,Xn,Sn))0nN\left(V\left(n, X_{n}, S_{n}\right)\right)_{0 \leqslant n \leqslant N} is a supermartingale for any trading strategy π\pi.

Suppose π\pi^{*} is a trading strategy such that the corresponding wealth process XX^{*} makes (V(n,Xn,Sn))0nN\left(V\left(n, X_{n}^{*}, S_{n}\right)\right)_{0} \leqslant n \leqslant N a martingale. Show that π\pi^{*} is optimal.