0
$\begingroup$

I have a question to prove martingale under risk-neutral measure:

Question

Consider a discrete time process $S$, which at time $n \in \mathbb{N}$ has value $S_n = S_{0}\prod_{j=1}^{n}Z_j$, $S_0>0$ and $Z_j$ a sequence of independent and identically distributed random variables to either 1.15 or 0.85. Assume a zero risk free rate of rate.

Show that under the risk neutral martingale measure $\mathbb{\hat{P}}$ the process $S_n$ is a martingale.

My thoughts

  1. I do understand that under the risk neutral measure $\mathbb{\hat{P}}$, which is that $e^{-rt}C_t = \mathbb{\hat{E}}[e^{-rt}C_T|\mathbb{F}_t]$.
  2. I understand that 1 - period $\mathbb{\hat{P}}$ is that:
    • $\mathbb{\hat{P}}_u = \frac{1-0.85}{1.15-0.85}=0.5$, and so is $\mathbb{\hat{P}}_d$ = 0.5.
  3. I think I seek to prove the martingale property of $S_n$,but I am not sure how is that related to the $\mathbb{\hat{P}}$ if I just want to prove that:
    • $\mathbb{E}|S_n|< \infty$
    • $\mathbb{E}[S_{n+1}|\mathbb{F}_t]=S_n$
$\endgroup$

1 Answer 1

1
$\begingroup$

You already have it. Risk neutral measure is one where tosses are still independent but each individual toss has probability of 0.5 up or down.

Say you're at step n, with $S_{n}$ known.

$E(S_{n+1}|F_{n})=S_{n}*(0.5*1.15+0.5*0.85)=S_{n}$

and unconditional expectation is also finite using tower law as it equals $S0$.

$\endgroup$
1
  • 1
    $\begingroup$ Oh that is super helpful! I didn't even realise how close I was ! $\endgroup$
    – joshdalton
    Aug 21, 2023 at 21:16

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.