The Mathematics of Arbitrage

(Tina Meador) #1

246 12 Absolutely Continuous Local Martingale Measures


F={LT> 0 }.

Note that the no-arbitrage condition implies thatP[F]>0. Indeed, sup-
pose thatP[F]=0andlet


U=inf

{


t


∣Lt≤^1
2

}


.


We than have thatP[U<∞]=1,LU≡^12 and thereforeXU≡1. Hence

H=L^1 h′ (^1) [[ 0,U]] is a 1-admissible integrand such that (H·S)∞≡XU ≡1,
a contradiction to(NA).
So we will look at the processSunder the conditional probability mea-
surePF.
Our strategy will be to verify thatSsatisfies the property(NFLVR)with
respect toPF which will imply the existence of a local martingale measure
QforSwhich is equivalent toPF and therefore absolutely continuous with
respect toP. However, there are difficulties: under the measurePFthe Doob-
Meyer decomposition will change, there will be more admissible integrands
and the verification of the no free lunch with vanishing risk property for
general admissible integrands (underPF) is by no means trivial.
We are now ready to reformulate the main theorem stated in the Intro-
duction 12.1 in a more precise way and to commence the proof:
Main Theorem 12.4.2.If the continuous semi-martingaleS satisfies the
no-arbitrage property with respect to general admissible integrands, then with
the notation introduced above, it satisfies the no free lunch with vanishing risk
property with respect toPF.
As a consequence there is an absolutely continuous local martingale mea-
sure that is equivalent toPF, i.e. it is precisely supported by the setF.
The proof of the theorem still needs some auxiliary steps which will be
stated below.
We first deal with the problem of the usual hypotheses under the measure
PF.Theσ-algebrasF ̃tof thePF-augmented filtration are obtained fromFt
by adding allPFnull sets. It is easily seen that the new filtration is still right
continuous and satisfies the usual hypotheses for the new measurePF.The
following technical results are proved in [DS 95c].
Proposition 12.4.3.If ̃τ is a stopping time with respect to the filtration
(F ̃t)t≥ 0 then there is a stopping timeτ with respect to the filtration(Ft)t≥ 0
such thatPF-a.s. we have ̃τ=τ.If ̃τis finite or bounded, thenτ may be
chosen to be finite or bounded.
Proposition 12.4.4.IfH ̃is a predictable process with respect to the filtration
(F ̃t)t≥ 0 then there is a predictable processH with respect to the filtration
(Ft)t≥ 0 , such thatPF-a.s. we haveH ̃=H.

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