Solution

ID: past-exam-of-the-mathematics-course-of-the-university-of-cambridge/2016/iii/paper-211/1/b/solution

Write . Conditional on , independent increments of the Brownian motion give
where has the standard normal distribution and is independent of . Factoring out of the positive part identifies the normalized Black-Scholes call function:
The European call option payoff is integrable, because and . The tower property of conditional expectation therefore proves that is a true martingale. At , the boundary value gives . The answer is the conditional payoff martingale

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