Past exam of the mathematics course of the University of Cambridge / 2015 / iii / Paper 40 / 1 / a / Solution

Put ${\mathcal{L}}_{r}V(s)=\frac{1}{2}{\sigma }^2{s}^2{V}^{\prime \prime }(s)+rs{V}^{\prime }(s)$ and define the nonnegative reserve rate $a(s)=rV(s)-{\mathcal{L}}_{r}V(s)$. The obstacle problem gives $V\ge g$ and $a\ge 0$. The American-option superhedge with a funded reserve invests the local surplus in the bond rather than consuming it.

For initial wealth $x\ge V(S_0)$, setand choose the stock and bond holdingsThus $D_t\ge 0$ and $F_t\ge V(S_t)\ge g(S_t)$, pathwise at every time. The Itô formula under the original drift givesAdding these equations yieldsThis is a self-financing strategy, and its nonnegative wealth makes it an admissible trading strategy. Continuity of the stock and local regularity of $V$ ensure local integrability of the holdings. The construction does not require $\mu =r$.

For a classical solution, the usual Itô formula applies directly. The smooth fit solution below is $C^1$ and piecewise $C^2$, with locally absolutely continuous first derivative. The generalized Itô formula applies with its almost-everywhere second derivative; the absence of a derivative jump means no boundary local time of a semimartingale term. This is the usual regularity interpretation of the perpetual American option obstacle equation.