Past exam of the mathematics course of the University of Cambridge / 2017 / ii / Paper 1 / 29J (Stochastic Financial Models)

A martingale with respect to a filtration $({\mathcal{F}}_n)$ is an adapted process: $X_n$ is ${\mathcal{F}}_n$-measurable for every $n$. It must satisfy $\mathbb{E}|X_n|<\infty$ andBy the tower property this is equivalent to $\mathbb{E}[X_m\mid {\mathcal{F}}_n]=X_n$ for all $m\ge n$. Integrability and adaptation are part of the definition, not consequences of writing a formal conditional-mean identity.

Inductively, $X_0,\dots ,X_n$ are functions of ${\Delta }_0,\dots ,{\Delta }_n$, so ${\mathcal{F}}_n\subseteq \sigma ({\Delta }_0,\dots ,{\Delta }_n)$. The average $f_n(X_0,\dots ,X_n)$ is therefore ${\mathcal{F}}_n$-measurable and independent of ${\Delta }_{n+1}$. If $X_0,\dots ,X_n$ are integrable, thenStarting with $X_0={\Delta }_0$, induction proves integrability of every $X_n$. Adaptation holds by definition of the natural filtration. Independence and zero mean now legitimately giveHence the process is a martingale. Only first moments are used; no second-moment or boundedness assumption on the increments is needed.

The bounded-time optional stopping theorem states that if $X$ is an integrable discrete-time martingale and $\tau$ is a stopping time bounded by a deterministic integer $N$, then $X_{\tau }$ is integrable and $\mathbb{E}{X}_{\tau }=\mathbb{E}{X}_0$. Indeed $|X_{\tau }|\le {\sum }_{j=0}^N|X_j|$ proves integrability, andThe event $\{\tau \ge j\}=\{\tau >j-1\}$ belongs to ${\mathcal{F}}_{j-1}$. Conditional expectation of each summand given ${\mathcal{F}}_{j-1}$ is zero, soMore generally, if $\sigma \le \tau \le N$ are stopping times, $\mathbb{E}[X_{\tau }\mid {\mathcal{F}}_{\sigma }]=X_{\sigma }$. To prove this, test against $A\in {\mathcal{F}}_{\sigma }$ and apply the same argument to $1_A{1}_{\{\sigma <j\le \tau \}}(X_j-X_{j-1})$; its coefficient is ${\mathcal{F}}_{j-1}$-measurable. Boundedness of the stopping times makes the sums finite, so no limiting optional-stopping hypothesis is being omitted.