Past exam of the mathematical models of financial derivatives course of the University of Oxford / 2021 / 1 / b

Set ${\theta }_t=(\mu -r)S_t/\sigma$. The Girsanov theorem uses the densityFor these nonexplosive linear stochastic differential equations, the linear drift change of measure ensures that $Z$ is a true martingale on each finite horizon. This matters: a stochastic exponential being a local martingale alone would not prove that its terminal expectation is one. Its strict positivity gives an equivalent risk-neutral measure $\mathbb{Q}$, under whichThe discounted asset is then a martingale. The Feynman-Kac formula, equivalently risk-neutral valuation of the replicable claim, givesHere the payoff must meet the usual integrability and replication assumptions; the bounded digital payoff below does.