Past exam of the mathematics course of the University of Cambridge / 2016 / iii / Paper 211 / 1 / d / Solution

A martingale with the specified terminal value must equal its conditional expectation. If ${\hat{S}}_t=0$, default has already occurred and the terminal European call option payoff is zero. If ${\hat{S}}_t>0$, put $h=T-t$. Conditional on survival to $T$,where $Y$ has the standard normal distribution; the conditional probability of this survival is $e^{-\lambda h}$. The conditional expectation of the payoff in the enlarged filtration used in part (c) is consequentlyThis expression is already measurable with respect to the natural filtration of $\hat{S}$, so the tower property of conditional expectation gives the same value there. The survival factor cancels the compensating growth factor:The separate zero branch avoids division by zero. At $t=T$ it gives the required payoff, using $F(0,m)=(1-m{)}^{+}$; integrability follows from $({\hat{S}}_T-K{)}^{+}\le {\hat{S}}_T$.