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LECTURE 10: CHANGE OF MEASURE AND THE GIRSANOV …

LECTURE 10: CHANGE OF MEASURE AND THE GIRSANOV Cameron-Martin theorem, which has figured prominently in the developments of the lastseveral lectures, is the most important special case of the far more generalGirsanov theorem, whichis our next topic of discussion. Like the Cameron-Martin theorem, the GIRSANOV theorem relates theWiener measurePto different probability measuresQon the space of continuous paths by giving anexplicit formula for the likelihood ratios between them. But whereas the Cameron-Martin theoremdeals only with very special probability measures, namely those under which paths are distributedas Brownian motion with (constant) drift, the GIRSANOV theorem applies to nearly all probabilitymeasuresQsuch thatPandQare mutually absolutely MartingalesLet{Wt}0 t< be a standard Brownian motion under the probability measureP, and let(Ft)0 t< be the associated Brownian filtration.

By Ito’s formula, the solution2 to the stochastic differential equation (7) is (10) Y t = Y 0 exp ˆ Z t 0 (µ s −σ2 s/2)ds+ t 0 σ s dW s ˙. Proposition 1. Let Q B be a risk-neutral probability measure for the pound-sterling investor. If the dollar/pound sterling exchange rate obeys a stochastic differential equation of the form (7), and

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