Past exam of the mathematics course of the University of Cambridge / 2008 / iii / Paper 39 / 6 / i

Let $Q$ denote the given unique equivalent martingale measure. A zero-coupon bond paying one at $T$ has risk-neutral pricing valueWrite $h=T-t$. Split the integrated short rate into its known and future parts:By integrating the future Brownian motion increments in the opposite order, the last integral equals ${\int }_t^T(T-u)d{\hat{W}}_u$. It is independent of ${\mathcal{F}}_t$ and is a Gaussian random variable of mean zero and varianceThe Gaussian exponential moment formula $\mathbb{E}[e^{aZ}]=e^{a^2\mathrm{Var}(Z)/2}$ for centered $Z$ therefore gives the bond price in this Gaussian short-rate model with a deterministic shift:The instantaneous forward rate is the negative maturity derivative of the logarithm of the bond price. ConsequentlyIn particular, $P_t(t)=1$ and $f_t(t)=g(t)+\sigma {\hat{W}}_t=r_t$, as required. The derivative formula is pointwise for continuous $g$ and almost everywhere for locally integrable $g$.