A GENERAL APPROACH TO HEDGING OPTIONS:

APPLICATIONS TO BARRIER AND PARTIAL BARRIER

OPTIONS
Hans-Peter Bermin
Department of Economics, Lund University
In this paper we consider a Black and Scholes economy and show how the Malliavin calculus
approach can be extended to cover hedging of any square integrable contingent claim. As an
application we derive the replicating portfolios of some barrier and partial barrier options.
KEY WORDS: contingent claims, hedging, barrier options, Malliavin calculus
1. INTRODUCTION
In this paper we consider a Black and Scholes economy and derive a general expression
for the self-nancing portfolio that generates any square integrable contingent claim.
The expression is an extension of the results in Karatzas and Ocone (1991), which says
that the number of units to be held at time t in the stock S (with volatility r) is given by
the formula
e
rTt
r
1
St
1
E
Q
D
t
GjF
t
;
provided that the contingent claim G (maturing at T) is square integrable and that the
Malliavin derivative, D
t
G satises certain conditions. Based on the results in Watanabe
(1984) and U

stu nel (1995), we show that the above formula is valid under the weaker
condition that G only has to be square integrable. However, for this to work the
Malliavin derivative, D
t
G must be interpreted as a generalized stochastic processthat
is, as a composite of a distribution and a stochastic process. Nevertheless, things turn
out to be tractable because the conditional expectation of the Malliavin derivative
E
Q
D
t
GjF
t
is an ordinary stochastic process. For a similar extension in the case of a
white noise driven market, see Aase et al. (2000).
When the contingent claim is a functional of the stock price, we also show that the
required Malliavin derivative can be derived from the classical chain rule. In many
cases the formal expression can be evaluated analytically. However, when this is not the
case, Monte Carlo simulations can be implemented to derive the replicating portfolio.
We summarize the theory behind the extension of the formula and focus on the
applicability of the Malliavin calculus.
The author thanks Arturo Kohatsu-Higa, Ali Su leyman U

stu nel, and the referee for useful and

valuable comments. Financial support from the Wallander foundation is gratefully acknowledged.
Manuscript received September 1998; nal revision received August 2000.
Address correspondence to the author at the Department of Economics, Lund University, P.O. Box 7082,
S-220 07 Lund, Sweden; e-mail: hans-peter.bermin@nek.lu.se.
Mathematical Finance, Vol. 12, No. 3 (July 2002), 199218
2002 Blackwell Publishing Inc., 350 Main St., Malden, MA 02148, USA, and 108 Cowley Road, Oxford,
OX4 1JF, UK.
199
To motivate the study we consider barrier and partial barrier options. It is well-
known that these contingent claims can be replicated by using the traditional
D-hedging approach, while the Malliavin calculus approach as in Karatzas and
Ocone (1991) is not general enough to handle this situation due to the discontinuity
of the payo functions. However, by using the extended Malliavin calculus approach
we show how we can nd the replicating portfolios of barrier and partial barrier
options in such a way that they agree with the results from the traditional D-hedging
approach.
By denition, the payo of a barrier option is equal to the payo of a standard
option provided that the barrier option is alive at maturity and zero otherwise.
Moreover, we say that the barrier option is alive if the stock stays in some
predened region. These options are of course less expensive than standard options
as they can become worthless at any time before expiration. Depending on how the
alive region is dened, a lot of slightly dierent options can be constructed, such as
up-and-out calls/puts, down-and-out calls/puts, up-and-in calls/puts, and down-and-
in calls/puts. A large number of papers have been written on pricing barrier options,
hence we will just mention some well-known works. The rst published papers go
back to Merton (1973) and Goldman, Sosin, and Shepp (1979). Thereafter
contributions have been made by Conze and Viswanathan (1991) and Reiner and
Rubinstein (1991) among others. For an investor, though, a barrier option may in
some cases have some drawbacks because there is a positive probability that the
option will become worthless at any time before expiration. Therefore, so-called
partial barrier options were introduced in Heynen and Kat (1994; see also Carr
1995). The main feature of these options is that the barrier is only active over a part
of the options lifetime.
This paper is organized as follows. Section 2 summarizes the Black and Scholes
framework and states what the replicating strategy looks like in the case of the
D-hedging approach and the Malliavin calculus approach as in Karatzas and
Ocone (1991). In Section 3 we give a short introduction to Malliavin calculus, and
in Section 4 we show why the standard Malliavin calculus approach cannot be
used when the contingent claim is discontinuous. In Section 5 we extend the
Malliavin calculus approach to be valid for any square integrable contingent claim,
and in Section 6 we show how the extended Malliavin calculus approach can be
used to derive the replicating portfolios of some barrier and partial barrier
options. Finally, in Section 7 we present some extensions and summarize the
paper.
2. THE PRELIMINARIES
We x a nite time interval 0; T and we let fV t : t 2 0; Tg be a Wiener process on
the complete probability space X; F; Q. We also denote by F fF
t
: 0 t Tg the
Q-augmentation of the natural ltration generated by V . Now, let us assume that we
are living in a BlackScholes environment, and thus the basic market consists of two
assets: one locally risk-free asset of price B and one stock of price S. The
interpretation of the locally risk-free asset is as usual that of a bank account where
money grows at the short interest rate r. Under the unique equivalent martingale
measure Q the evolution of the asset prices is modeled by the (stochastic) dierential
equations
200 H. P. BERMIN
dBt rBtdt
B0 1;
_
2:1
dSt rStdt rStdV t
S0 S
0
:
_
2:2
From now on we assume that r; r, and S
0
are positive constants. The basic market is free
from arbitrage and complete in the sense that every F
T
-measurable contingent claim
G 2 L
1
X is attainable by a self-nancing portfolio.
1
Inthis paper, however, we will focus
on contingent claims G 2 L
2
X. The discounted value process V
h
=B of the replicating
portfolio h is then a Q-martingale, and the fair price of G can thus be expressed as
V
h
t e
rTt
E
Q
GjF
t
: 2:3
Although it is simple to derive the arbitrage-free price of the contingent claim G,
equation (2.3) does not tell us anything about how we can nd the self-nancing
portfolio h.
In order to derive the replicating portfolio h we can use either the well-known
D-hedging approach or the Malliavin calculus approach as in Karatzas and Ocone
(1991). Suppose that we choose the D-hedging approach. Then if there exists a
deterministic function f 2 C
1;2
such that f t; St e
rTt
E
Q
GjF
t
, we can apply the
Ito formula to f t; St and use the denition of a self-nancing portfolio to obtain the
representation of the replicating portfolio h h
0
; h
1
,
h
0
t e
rt
V
h
t h
1
tSt; 2:4
h
1
t f
s
t; St: 2:5
Here h
0
t denotes the number of units to be held at time t in the locally risk-free asset
B; and h
1
t denotes the number of units to be held in the stock S at time t. In some
applications, such as the Asian and Lookback options, there exists no such function f .
In these cases, however, we can usually introduce a supplementary state variable Zt;
which for instance can be the running average or the running maximum of the stock
price, such that the price of the option can be expressed as f t; St; Zt. Given
dierentiability conditions on the function f , we can again apply the Ito formula to the
price process of the option and identify the replicating portfolio. The more complex the
contingent claim G is though, in the sense that the more state variables we need to use,
the harder it is to verify the necessary dierentiability conditions on the function f .
This becomes a particularly dicult task when we have no analytical solution for the
price of the contingent claim. On the other hand, if we consider the Malliavin calculus
approach, as in Karatzas and Ocone (1991), we get the representation
h
0
t e
rt
V
h
t h
1
tSt; 2:6
h
1
t e
rTt
r
1
St
1
E
Q
D
t
GjF
t
: 2:7
Here D
t
G denotes the Malliavin derivative of the contingent claim G, which we will
come back to later. The usual restriction in order for the Malliavin calculus approach
to work is basically that the payo G is continuous with respect to movements in the
stock price S.
1
A portfolio h h
0
; h
1
is said to be self-nancing if the corresponding value function
V
h
t h
0
tBt h
1
tSt has the stochastic dierential dV
h
t h
0
tdBt h
1
tdSt:
GENERAL APPROACH TO HEDGING OPTIONS 201
By looking at the various price formulas for barrier and partial barrier options we
see that there actually exists a function f such that f t; St e
rTt
E
Q
GjF
t
if the
option is alive at time t. Hence, as long as the option is alive we can use the traditional
D-hedge, whereas if the option is dead there is nothing to hedge. Moreover, since the
payo of a barrier or partial barrier option is discontinuous we cannot use the
Malliavin calculus approach.
In the next sections, however, we will show how the Malliavin calculus approach can
be generalized to cover discontinuous contingent claims as well.
3. THE MALLIAVIN CALCULUS APPROACH
The Malliavin calculus can be introduced in a number of slightly dierent ways; see, for
example, Watanabe (1984), Karatzas and Ocone (1991), Nualart (1995a), U

stu nel
(1995), or ksendal (1996). Here we basically follow Watanabe and U

stu nel. We say

that a stochastic variable F : X !R belongs to the set P if F is in the form
F x f V t
1
; x; . . . ; V t
n
; x; where the deterministic function f : R
n
!R is a
polynomial. We notice that the set P is dense in L
p
X for p ! 1. Next, we dene the
CameronMartin space H according to
H c : 0; T !R : ct
_
t
0
_ ccsds; jcj
2
H

_
T
0
_ cc
2
sds < 1
_ _
;
and identify our probability space X; F; Q with C
0
0; T; BC
0
0; T; l such that
V t; x xt for all t 2 0; T. Here C
0
0; T denotes the Wiener spacethat is, the
space of all continuous real-valued functions x on 0; T such that x0 0, BC
0
0; T
denotes the corresponding Borel r-algebra and l denotes the unique Wiener measure.
With this setup we can dene the directional derivative of a stochastic variable in all the
directions in the CameronMartin space.
2
Definition 3.1. The stochastic variable F 2 P has a directional derivative D
c
F x at
the point x 2 X in all the directions c 2 H dened by
D
c
F x
d
d
F x c

0
:
Moreover, as a consequence of the coordinate mapping process V t; x xt it
follows that V t
i
; x c xt
i
ct
i
for all t
i
2 0; T, and as F 2 P we see that the
directional derivative also can be expressed as
D
c
F x

n
i1
@f
@x
i
V t
1
; x; . . . ; V t
n
; xct
i
:
remark 3.1. Let us x s 2 0; T, then it follows from the above denition that the
directional derivative of the Wiener process is given by D
c
V s; x cs.
2
The fact that we only dene the directional derivative in the directions in the CameronMartin space
is because of the nice property that if the stochastic variables F and G are equal almost surely, then as a
consequence of the Girsanov theorem F c G c for all c 2 H:
202 H. P. BERMIN
From Denition 3.1 we notice that the map c ! D
c
F x is continuous for all x 2 X
and consequently there exists a stochastic variable rF x with values in the Cameron
Martin space H such that D
c
F x rF x; c
H
:
_
T
0
drF
dt
tctdt: Moreover, since
rF x is an H-valued stochastic variable, the map ! rF t; x is absolutely
continuous with respect to the Lebesgue measure on 0; T. Now, we let the Malliavin
derivative D
t
F x denote the RadonNikodym derivative of rF x with respect to the
Lebesgue measure such that
D
c
F x
_
T
0
D
t
F x_ cctdt:
If we identify this expression with Denition 3.1 we have the following result, which in
many cases is taken directly as a denition.
Definition 3.2. The Malliavin derivative of a stochastic variable F 2 P is the
stochastic process fD
t
F : t 2 0; Tg given by
D
t
F x

n
i1
@f
@x
i
V t
1
; x; . . . ; V t
n
; x1
tt
i
:
We note that the Malliavin derivative is well dened almost everywhere dt dQ.
remark 3.2. Let us x s 2 0; T, then it follows from the above denition that the
Malliavin derivative of the Wiener process is given by D
t
V s; x 1
ts
.
More generally we can dene the k-times iterated Malliavin derivative D
k
t
1
;...;t
k
F x
D
t
1
D
t
2
D
t
k
F x such that D
k
t
1
;...;t
k
F is dened almost everywhere dt
k
dQ. It turns out
that it is natural to introduce the norm k k
k;p
on the set P according to
kF k
k;p
E
Q
jF j
p

k
j1
E
Q
D
j
t
1
;...;t
j
F
_
_
_
_
_
_
p
L
2
0;T
j

_ _
_ _
1=p
; 3:1
for p > 1 and k 2 N[ f0g. Here we set kF k
p
0;p
E
Q
jF j
p
. Now, as the Malliavin
derivative is a closable operator (see Nualart 1995a), we dene by D
k;p
the Banach
space which is the closure of P under k k
k;p
. For future applications we also dene the
complete, countably normed, vector space D
1
as the intersection D
1
\
k!1
\
p>1
D
k;p
.
3
Hence, we have the inclusions D
1
& D
k;p
& D
j;q
whenever k ! j and p ! q.
remark 3.3. Let us x s 2 0; T. The solution Ss s
0
expr
1
2
r
2
s rV s to
the stochastic dierential equation (2.2) belongs to the Banach space D
1;2
and
D
t
Ss rSs1
ts
. In order to prove this standard result, we approximate the solution
Ss by a sequence in P and use Denition 3:2. together with the closability of the
Malliavin derivative. Moreover, we deduce for future applications that Ss 2 D
1
since
Ss 2 L
p
X for all p:
What makes Malliavin calculus interesting in mathematical nance is the Clark
Ocone formula. We present the formula as a theorem and refer to Nualart (1995a) for a
complete proof.
3
Although D
1
is not a normed space it is a countably normed spacethat is, a metric space where the
metric is constructed from the countably many norms k k
k;p
.
GENERAL APPROACH TO HEDGING OPTIONS 203
Theorem 3.1 (The ClarkOcone formula). Let the F
T
-measurable stochastic variable
G belong to the space D
1;2
. Then
G E
Q
G
_
T
0
E
Q
D
t
GjF
t
dV t:
This theorem is a generalization of the Ito representation theorem, see ksendal
(1998), in the sense that it gives an explicit expression for the integrand. Moreover,
since the discounted value process V
h
=B of a self-nancing portfolio h is a
Q-martingale, the Ito formula tells us that
V
h
T e
rT
V
h
0
_
T
0
e
rTt
h
1
trStdV t: 3:2
Hence, in order to nd the replicating portfolio (i.e., the self-nancing portfolio h such
that V
h
T G a.s.) we can identify the coecients in the ClarkOcone formula and
(3.2):
V
h
0 e
rT
E
Q
G;
h
1
t e
rTt
r
1
St
1
E
Q
D
t
GjF
t
:
_
Note that the initial amount V
h
0 required to replicate the stochastic variable
(contingent claim) G is just our previously dened unique price according to (2.3).
This explains equations (2.6) and (2.7) since V
h
t h
0
tBt h
1
tSt by deni-
tion.
In order to explicitly derive the replicating portfolio h of a contingent claim G 2 D
1;2
,
we need to calculate the Malliavin derivative of G. This is fairly simple if the contingent
claim G is a Lipschitz function of a stochastic vector process belonging to D
1;2
as
proved in Nualart (1995a).
Proposition 3.1. Let u : R
n
!R be a function such that
jux uyj Kjx yj;
for any x; y 2 R
n
and some constant K. Suppose that F F
1
; . . . ; F
n
is a stochastic
vector whose components belong to the space D
1;2
and suppose that the law of F is
absolutely continuous with respect to the Lebesgue measure on R
n
. Then uF 2 D
1;2
and
D
t
uF

n
i1
@u
@x
i
F D
t
F
i
:
In order to see the implications of this proposition, we derive the replicating
portfolio of a standard call option.
example 3.1. Let Pt denote the time t price of a standard call optionthat is, a
contingent claim with payo function ST K

for some strike price K. Since

x K

is a Lipschitz function for all x and ST has a density function, it follows

from Remark 3.3 and Proposition 3.1 that ST K

2 D
1;2
with
D
t
ST K

1fST > KgrST:

Consequently, the replicating portfolio is given by
204 H. P. BERMIN
h
1
t e
rTt
r
1
S
1
tE
Q
1fST > KgrSTjF
t

e
rTt
S
1
tE
Q
ST K

1fST > KgKjF

t

S
1
tPt S
1
te
rTt
KQST > KjF
t
:
The Malliavin calculus approach is both elegant and straightforward to use for
contingent claims in the space D
1;2
.
4. LIMITATIONS OF THE MALLIAVIN CALCULUS APPROACH
In Section 2 we stated that any contingent claim G 2 L
2
X could be replicated by
a self-nancing portfolio. However, the ClarkOcone formula works only for those
contingent claims that belong to the space D
1;2
& D
0;2
L
2
X: Hence the
Malliavin calculus approach is indeed more restrictive than the D-hedging
approach in some cases. In order to see this, let us start with the following
simple example.
example 4.1. Let us x the F
T
-measurable contingent claim G 1fST Kg.
Then
V
h
t e
rTt
E
Q
GjF
t
e
rTt
QST KjF
t
e
rTt
F
ST
K;
where F
ST
denotes the F
t
-conditional cumulative distribution function of ST. From
Appendix A it follows that F
ST
K is in the form /ln
K
St
; t for some deterministic
function /: Hence /
s
ln
K
St
; t S
1
tK/
K
ln
K
St
; t S
1
tKf
ST
K; where
f
ST
denotes the corresponding F
t
-conditional density function of ST. It is easily
veried that the deterministic function f t; s e
rTt
/ln
K
s
; t is of class C
1;2
; and
consequently we can use the D-hedging approach to identify the replicating portfolio
h
1
t according to 2:5 as
h
1
t f
s
t; St e
rTt
/
s
ln
K
St
_ _
; t
_ _
e
rTt
S
1
tKf
ST
K:
Now let us see what happens if we use the Malliavin calculus approach in a
similar way. If we assume that A is any F
T
-measurable set such that 1fAg 2 D
1;2
,
then from Proposition 3.1 with ux x
2
on 0; 1; it follows that
D
t
1fAg 21fAgD
t
1fAg: Hence D
t
1fAg 0 on the complement to A, and
D
t
1fAg 2D
t
1fAg on the set A. Thus, the only solution on the set A is given
by D
t
1fAg 0, and thereby we get that D
t
1fAg 0 almost everywhere. By using
the ClarkOcone formula we see that in this case 1fAg E
Q
1fAg QA;
consequently it follows that
QA 6 1fAg ! 1fAg j 2D
1;2
:
If we return to Example 4.1 and put A fST Kg we see that
1fST Kg j 2D
1;2
, although 1fST Kg 2 L
2
X. As a consequence we cannot
use the Malliavin calculus approach to identify the replicating portfolio h. This is
rather disturbing because the Ito representation theorem (see ksendal 1998) tells us
that there exists a unique F-adapted process fwt : t 2 0; Tg such that
G E
Q
G
_
T
0
wtdV t; with
GENERAL APPROACH TO HEDGING OPTIONS 205
E
Q
_
T
0
w
2
tdt
_ _
< 1; 4:1
for any F
T
-measurable stochastic variable G 2 L
2
X.
In the next section, however, we will see that the problem of calculating the process w
may be solved by regarding the Malliavin derivative in the sense of distributions.
5. EXTENSIONS OF THE CLARKOCONE FORMULA
In this section we show that the ClarkOcone formula is valid for any F
T
-measurable
stochastic variable in L
2
X, and thereafter we show that the Malliavin calculus
approach to derive the replicating portfolio of a contingent claim as in Karatzas and
Ocone (1991) can be extended in a similar way. At rst glance, the extension of the
ClarkOcone formula seems rather innocent since the space D
1;2
is a dense subspace of
L
2
X. This is nevertheless not the case. The problem we are facing is that the Malliavin
derivative cannot be dened in the usual way for stochastic variables in L
2
X. Hence,
what rst needs to be done is to extend this denition and thereafter characterize the
new space for which the ClarkOcone formula is valid. U

stu nel (1995) shows that a

ClarkOcone formula can be derived for elements in the dual space of D
1
, which is a
much larger space than L
2
X. However, this extension is made in a distributional sense
and therefore we have no guarantee a priori that the formula actually make sense in the
usual way when restricted to L
2
X. We show that this is indeed the case. In order to
prove our statement, we briey summarize the results of U

stu nel and also refer to

Watanabe (1984).
The preceding arguments will be based on the Wiener chaos expansion, which we
state as a theorem and refer to, for example, ksendal (1996) for a complete proof.
Theorem 5.1 (Wiener chaos expansion). Let F be an F
T
-measurable stochastic
variable such that F 2 L
2
X. Then there exists a sequence ff
n
g
1
n0
of deterministic
functions f
n
2
^
LL
2
R
n
such that
F

1
n0
I
n
f
n
E
Q
F

1
n1
I
n
f
n
:
Here
^
LL
2
R
n
denotes the space of symmetric square integrable functions on 0; T
n
and
I
n
f
n
is the iterated Ito integral I
n
f
n

_
T
0

_
T
0
f
n
t
1
; . . . ; t
n
dV t
1
dV t
n
:
Moreover, for future simplicity we also denote by J
n
F the orthogonal projection of
the stochastic variable F on the nth Wiener chaos; that is, J
n
F I
n
f
n
.
We see that the Wiener chaos expansion is closely related to the Ito representation
theorem and the ClarkOcone formula. Motivated by this observation we follow
Watanabe (1984) and introduce, similar to (3.1), the norm jk kj
k;p
on the set P
according to
jkF kj
k;p

1
n0
1 n
k
2
J
n
F
_
_
_
_
_
_
_
_
_
_
L
p
X
; F 2 P;
for p > 1 and k 2 R. From the Wiener chaos expansion we see directly that
jkF kj
0;p
kF k
L
2
X
kF k
0;p
: Hence, the norms jk kj
k;p
and k k
k;p
are equivalent for
206 H. P. BERMIN
p > 1 and k 0. However, more surprisingly, it can be shown by means of the Meyer
inequalities and the multiplier theorem (see, e.g., U

stu nel 1995) that the norms jk kj

k;p
and k k
k;p
are equivalent whenever p > 1 and k 2 N. Moreover, the couple
P; jk kj
k;p
is a Banach space, and consequently we extend our previous denition
of D
k;p
to be the closure of P under jk kj
k;p
such that the following inclusions are valid
D
b;p
& D
a;p
& D
0;p
L
p
X & D
a;p
& D
b;p
[ [ [ [ [
D
b;q
& D
a;q
& D
0;q
L
q
X & D
a;q
& D
b;q
whenever 1 < p < q and 0 < a < b. Watanabe (1984) shows that the dual of the space
D
b;p
, denoted D
0
b;p
, is given by D
b;q
with
1
q

1
p
1, where the elements of D
b;q
are to
be interpreted as generalized stochastic variablesthat is, as composites of distribu-
tions and stochastic processes. We set D
1
: \
k2R
\
p>1
D
k;p
such that this space is
dened just as before. The dual of the complete countably normed vector space D
1
is
now given by
D
0
1

_
k2R
_
p>1
D
0
k;p

_
k2R
_
q>1
D
k;q
: D
1
: 5:1
The dual space D
1
is large enough to contain every composition of Schwartz
distributions and nondegenerate stochastic variables in D
1
such as d
x
ST, where d
x
denotes the Dirac delta function
4
with point mass at x 2 R. Recall that the stock
ST 2 D
1
according to Remark 3.3. We let the term d
x
ST serve as our main
example of a generalized stochastic variable: note that by itself it has no meaning and
that all the moments of order two and higher are not dened. Still, the (conditional)
expectation of d
x
ST exists with
E
Q
d
x
STjF
t
:
_
1
0
d
x
sf
ST
sds f
ST
x; x 2 0; 1;
where as usual f
ST
denotes the F
t
-conditional density function of ST.
Now we return to the ClarkOcone formula and consider the implications of the
previous denitions. We know that D
1
& D
1;2
, hence the ClarkOcone formula is
obviously valid for any element of D
1
. Moreover, U

stu nel (1995) shows that the map

G !
_
T
0
E
Q
D
t
GjF
t
dV t from D
1
!D
1
extends as a continuous mapping to
D
1
!D
1
, which results in the following proposition.
Proposition 5.1. Let G be an element of D
1
. Then we have the representation
formula
G E
Q
G
_
T
0
E
Q
D
t
GjF
t
dV t:
For the proof see U

stu nel (1995). The above formula is written in a somewhat sloppy

way since G is a generalized stochastic variable. Hence the interpretation must be taken
in the sense of distributions, meaning that what looks like an ordinary expectation and
an Ito integral need not be so. However, an explanation for expressing Proposition 5.1
as above is that we are only interested in stochastic variables G that belong to
4
Note that the Dirac delta function is not an ordinary function but a distribution dened such that
_
b
a
d
x
yhydy hx 1fa x bg for any suciently smooth function h. Moreover, d
x
is the formal
derivative of the indicator function 1f > xg.
GENERAL APPROACH TO HEDGING OPTIONS 207
L
2
X & D
1
; and in this case all the terms in Proposition 5.1 make sense in the usual
way. This is proved in the following lemma.
Lemma 5.1. The map G ! E
Q
D
t
GjF
t
is continuous from L
2
X ! L
2
0; T X,
and
_

0
E
Q
D
t
GjF
t
dV t is an ordinary Ito integral.
Proof. It is clearly sucient to show that the map is continuous from a dense subset
of L
2
X to L
2
0; T X, and here we choose our dense subset to be the linear span of
the Wick exponentials, or, as they are also called, the martingale exponentials,
exp
_
T
0
hsdV s
1
2
_
T
0
h
2
sds
_ _
; h 2 L
2
0; T
_ _
:
If we denote by u
i
exp
_

0
h
i
sdV s
1
2
_

0
h
2
i
sds a Wick exponential, then the
following three properties hold: (a) E
Q
u
i
Tu
j
T exp
_
T
0
h
i
sh
j
sds, (b)
E
Q
u
i
TjF
t
u
i
t, and (c) u
i
T 2 D
1;2
with D
t
u
i
T h
i
tu
i
T; see, for example,
U

stu nel (1995). All that remains is to consider a real-valued linear combination of
Wick exponentials U
n
T

n
i1
c
i
u
i
T and to show that
kE
Q
D
s
U
n
TjF
s
k
L
2
0;TX
KkU
n
Tk
L
2
X
for some constant K. By using property (a) we see that
kU
n
Tk
2
L
2
X
E
Q

n
i1
c
i
u
i
T
_ _
2
_
_
_
_

n
i1

n
j1
c
i
c
j
exp
_
T
0
h
i
sh
j
sds
_ _
:
Moreover, from properties (b) and (c) we get that
E
Q
D
s
U
n
TjF
s
E
Q

n
i1
c
i
h
i
su
i
TjF
s
_ _

n
i1
c
i
h
i
su
i
s:
Hence, inserting the results and using the Fubini theorem together with property (a)
yield
kE
Q
D
s
U
n
TjF
s
k
2
L
2
0;TX

_
T
0

n
i1

n
j1
c
i
c
j
h
i
sh
j
s exp
_
s
0
h
i
th
j
tdt
_ _
ds

n
i1

n
j1
c
i
c
j
exp
_
s
0
h
i
th
j
tdt
_ _ _ _
T
s0

n
i1

n
j1
c
i
c
j
exp
_
T
0
h
i
th
j
tdt
_ _
1
_ _
kU
n
Tk
2
L
2
X

n
i1
c
i
_ _
2
;
which completes the rst part of the proof. Finally, by a careful analysis of
Proposition 5.1 in U

stu nel (1995) it follows that

_

0
E
Q
D
t
GjF
t
:dV t is an ordinary Ito
integral. h
Although the Malliavin derivative D
t
G of a square integrable stochastic variable
must be interpreted as a generalized stochastic process (i.e., as a composite of a
208 H. P. BERMIN
distribution and a stochastic process), the conditional expectation of the Malliavin
derivative is an ordinary stochastic process. Thanks to this smoothing eect we have
the following important result.
Theorem 5.2. Any contingent claim G 2 L
2
X can be replicated by the self-nancing
portfolio h h
0
; h
1
dened by
h
0
t e
rt
V
h
t h
1
tSt;
h
1
t e
rTt
r
1
St
1
E
Q
D
t
GjF
t
:
_
Proof. The result is a direct consequence of (3.2), Proposition 5.1, Lemma 5.1, and
the uniqueness of the Ito integral. h
In order to derive the replicating portfolio using the above theorem, we must
establish how to calculate the Malliavin derivative. If we denote the space of R
n
-valued
Schwartz distributions by S
0
R
n
, we have the following extension of Proposition 3.1.
Corollary 5.1. Let T 2 S
0
R
n
. Suppose that F F
1
; . . . ; F
n
is a stochastic vector
whose components belong to the space D
1
and suppose that the law of F is absolutely
continuous with respect to the Lebesgue measure on R
n
. Then the composite TF 2 D
1
and
D
t
TF

n
i1
@T
@x
i
F D
t
F
i
:
Here
@T
@x
i
F shall be interpreted as an element of D
1
for each i 1; . . . ; n.
For the proof we refer toWatanabe (1984) or U

stu nel (1995). Tosee the implications of

the previous extensionof the ClarkOcone formula let us consider the following example.
example 5.1. Let us x the F
T
-measurable contingent claim G 1fST Kg 2
L
2
X as in Example 4.1. Then by using Corollary 5.1 we can formally calculate the
replicating portfolio according to Theorem 5.2 as
h
1
t e
rTt
r
1
S
1
tE
Q
D
t
1fST KgjF
t

e
rTt
r
1
S
1
tE
Q
d
K
STrSTjF
t

e
rTt
S
1
t
_
1
0
d
K
ssf
ST
sds
e
rTt
S
1
tKf
ST
K;
which is precisely the result we obtained in Example 4.1.
In order to continue with barrier contracts we must be able to control the whole
trajectory of the stock. This motivates the introduction of the following stochastic
variables:
M
S
t
1
;t
2
sup
t2t
1
;t
2

St and m
S
t
1
;t
2
inf
t2t
1
;t
2

St;
for 0 t
1
t
2
T. Now, let us consider the following example of the simplest existing
barrier contract.
GENERAL APPROACH TO HEDGING OPTIONS 209
example 5.2. Let us x the F
T
-measurable contingent claim G 1fM
S
0;T
Hg.
Then from 2:3 we get that
V
h
t e
rTt
E
Q
1fM
S
0;T
HgjF
t

e
rTt
1fM
S
0;t
HgQM
S
t;T
HjF
t

e
rTt
1fM
S
0;t
HgF
M
S
t;T
H;
where F
M
S
t;T
denotes the F
t
-conditional cumulative distribution function of M
S
t;T
. Just
as in Example 4.1 it follows from Appendix A that there exists a deterministic function
/ such that F
M
S
t;T
H /ln
H
St
; t, with /
s
ln
H
St
; t S
1
tH/
H
ln
H
St
; t
S
1
tHf
M
S
t;T
H: Here f
M
S
t;T
denotes the corresponding F
t
-conditional density
function of M
S
t;T
. Suppose that the barrier contract is alive at time t (i.e., M
S
0;t
H),
then we can dene the deterministic function f t; s by f t; s e
rTt
/ln
H
s
; t. A
simple calculation shows that f 2 C
1;2
and therefore we can use the D-hedging
approach to identify the replicating portfolio h
1
t according to 2:5:
h
1
t f
s
t; St e
rTt
/
s
ln
H
St
_ _
; t
_ _
e
rTt
S
1
tHf
M
S
t;T
H;
whenever M
S
0;t
H. If on the other hand M
S
0;t
> H, then h
1
t 0, which implies that
h
1
t e
rTt
S
1
tHf
M
S
t;T
H1fM
S
0;t
Hg:
Let us try to repeat the above example by using the Malliavin calculus approach.
Thus, we want to derive the Malliavin derivative of 1fM
S
0;T
Hg. The natural way of
proceeding would be to use Corollary 5.1 according to
D
t
1fM
S
0;T
Hg d
H
M
S
0;T
D
t
M
S
0;T
: 5:2
However, for this to work it is essential that M
S
0;T
2 D
1
. Unfortunately, as shown in
Nualart and Vives (1988; see also Bermin 2000), this is not the case. In fact we only
have the following weaker result.
Corollary 5.2. Let 0 t
1
t
2
T: Then M
S
t
1
;t
2
and m
S
t
1
;t
2
belong to D
1;2
with
D
t
M
S
t
1
;t
2
M
S
t
1
;t
2
r1
t<t
1
M
S
t
1
;t
2
1fM
S
t
1
;t
M
S
t;t
2
gr1
t
1
tt
2
;
D
t
m
S
t
1
;t
2
m
S
t
1
;t
2
r1
t<t
1
m
S
t
1
;t
2
1fm
S
t
1
;t
m
S
t;t
2
gr1
t
1
tt
2
:
Consequently we cannot use Corollary 5.1 to obtain (5.2) since M
S
0;T
j 2D
1
. On the
other hand, Nualart (1995b) and U

stu nel (1995) show that the Malliavin derivative

D
t
is a continuous operator from D
s;p
to D
s1;p
L
2
0; T for every p > 1 and
s 2 R, where D
s1;p
L
2
0; T denotes the space of all L
2
0; T-valued stochastic
variables in D
s1;p
. With this result in mind, we return to the stochastic variable
1fM
S
0;T
Hg. Obviously 1fM
S
0;T
Hg 2 L
2
X D
0;2
and thereby we also know
that D
t
1fM
S
0;T
Hg 2 D
1;2
L
2
0; T: Hence, in order to dierentiate 1fM
S
0;T
Hg
in the sense of distributions as in (5.2), we need to show that the space D
1;2
is
large enough to contain generalized stochastic variables such as d
H
M
S
0;T
. However,
since D
1;2
is the dual of D
1;2
(i.e., D
1;2
fall continuous linear functionals
on D
1;2
g, this follows directly and therefore (5.2) is actually valid. Let us explicitly
210 H. P. BERMIN
write down this generalization of Proposition 3.1 for square integrable stochastic
variables.
Corollary 5.3. Suppose that F F
1
; . . . ; F
n
is a stochastic vector whose
components belong to the space D
1;2
and suppose that the law of F is absolutely
continuous with respect to the Lebesgue measure on R
n
. Let u : R
n
!R be a piecewise
Lipschitz function such that uF 2 L
2
X then D
t
uF 2 D
1;2
L
2
0; T and
D
t
uF

n
i1
@u
@x
i
F D
t
F
i
:
Here
@u
@x
i
F shall be interpreted as an element of D
1;2
for each i 1; . . . ; n:
Proof. Since u is a piecewise Lipschitz function and D
1;2
is large enough to
contain variables such as dF , F 2 D
1;2
, we can dierentiate u in the sense of
distributions. h
example 5.3. Let us x the F
T
-measurable contingent claim G 1fM
S
0;T
Hg as in
Example 5.2. Then by using corollaries 5.2 and 5.3 we can formally calculate the
replicating portfolio according to Theorem 5.2 as
h
1
t e
rTt
r
1
S
1
tE
Q
D
t
f1fM
S
0;T
HggjF
t

e
rTt
r
1
S
1
tE
Q
d
H
M
S
0;T
M
S
0;T
1fM
S
0;t
M
S
t;T
gjF
t

e
rTt
r
1
S
1
tE
Q
d
H
M
S
t;T
M
S
t;T
1fM
S
0;t
M
S
t;T
gjF
t

e
rTt
r
1
S
1
t
_
1
0
d
H
mm1fM
S
0;t
mgf
M
S
t;T
mdm
e
rTt
r
1
S
1
tHf
M
S
t;T
H1fM
S
0;t
Hg;
which again is the same result as in the D-hedging approach according to Example 5.2.
Now we are ready to use the extended Malliavin calculus approach to nd the
replicating portfolios of some barrier contracts.
6. HEDGING BARRIER AND PARTIAL BARRIER OPTIONS
In this section, we derive the self-nancing portfolios that generate the square
integrable payo functions of barrier and partial barrier options by using the
extended Malliavin calculus approach. Actually we will only consider partial barrier
options since these contingent claims might be seen as generalizations of standard
barrier options. Though not presented the results can thereafter easily be veried to
equal the replicating portfolios obtained by using the D-hedging approach. The
prices of the options have already been derived in the paper by Heynen and Kat
(1994), so according to (2.3) we already know the initial amount of money needed
to replicate these contingent claims. In fact we will only derive the number of units
to be held in the stock S, since we know from Theorem 5.2 that the number of
units to be held in the bank account B will then be implicitly determined.
Henceforth, we consider the times 0 s T and interpret time 0 as today, time s
as the monitoring time, and time T as the maturity of the options. Moreover, we
GENERAL APPROACH TO HEDGING OPTIONS 211
will denote by Nx the cumulative distribution function of a standard normal
stochastic variable and by Nx; y; q the cumulative distribution function of a
bivariate standard normal stochastic variable with correlation q. Let us also
introduce the variables
d
1

lnS
0
=K llT
r

T
p
; d
2
d
1
r

T
p
; d
0
1
d
1

2 lnH=S
0

T
p
; d
0
2
d
2

2 lnH=S
0

T
p
e
1

lnH=S
0
lls
r

s
p
; e
2
e
1
r

s
p
; e
0
1
e
1

2 lnH=S
0

r

s
p
; e
0
2
e
2

2 lnH=S
0

r

s
p
;
where l r
1
2
r
2
and ll r
1
2
r
2
:
For both standard and partial barrier options it is possible to distinguish between
knock-out and knock-in options. However, since the sum of a knock-out option and a
knock-in option by denition is equal to a standard option, we will only consider the
knock-out options. In order to facilitate the reading, though, we will just call them out
options. Finally we introduce the variables
g
1 if call option
1 if put option
_
; m
1 if up-and-out option
1 if down-and-out option
_
in order to keep track of all the relevant combinations.
There are four possible combinations of out barrier options, namely the up-and-out
call (UOC), the up-and-out put (UOP), the down-and-out call (DOC), and the down-
and-out put (DOP). According to (2.3) the time t prices of the partial out barrier
options, P
PO
t, may formally be written as
P
PO
t e
rTt
E
Q
ST K

1fM
S
0;s
HgjF
t
if UOC and H ! K;
P
PO
t e
rTt
E
Q
K ST

1fM
S
0;s
HgjF
t
if UOP and H ! K;
P
PO
t e
rTt
E
Q
ST K

1fm
S
0;s
! HgjF
t
if DOC and H K;
P
PO
t e
rTt
E
Q
K ST

1fm
S
0;s
! HgjF
t
if DOP and H K:
Note that by setting the monitoring time s T, we obtain the standard out barrier
options. Hence, if we know how to price and hedge partial out barrier options we also
know how to price and hedge standard out barrier options.
Obviously, the price of a partial out barrier option will depend on whether time t
is less or greater than the monitoring time s. If the option is alive at time s then the
price is equal to the price of a standard option, which we already know how to
price and hedge. Let us therefore assume that t s. From the results in Heynen and
Kat (1994) we know that the time 0 price of the partial out barrier options is given
by
P
PO
0 g S
0
N gd
1
; me
1
; gm

s
T
_ _ _

H
S
0
_ _
2 ll=r
2
N gd
0
1
; me
0
1
; gm

s
T
_ _ _
_ _ _
e
rT
K N gd
2
; me
2
; gm

s
T
_ _ _

H
S
0
_ _
2l=r
2
N gd
0
2
; me
0
2
; gm

s
T
_ _ _
_ __
;
and according to (2.3) this is just the initial amount of money we need to replicate the
options. In order to nd the replicating strategies let us consider the partial up-and-out
call. From Theorem 5.2 it follows that the replicating portfolio must consist of
h
1
t e
rTt
r
1
S
1
tE
Q
D
t
ST K

1fM
S
0;s
HgjF
t

212 H. P. BERMIN
units of the stock S at time t whenever t s. This expression is evaluated in Appendix B.
By repeating the procedure for the other possibilities we get for the general case when
t s that
h
1
t g N g
ln
St
K
_ _
llT t
r

T t
p ; m
ln
St
H
_ _
lls t
r

s t
p ; gmq
_
_
_
_
_
_
_

2r
r
2
H
St
_ _
2 ll=r
2
N g
ln
KSt
H
2
_ _
llT t
r

T t
p ; m
ln
St
H
_ _
lls t
r

s t
p ; gmq
_
_
_
_

2r
r
2
1
_ _
e
rTt
KS
1
t
H
St
_ _
2l=r
2
N g
ln
KSt
H
2
_ _
lT t
r

T t
p ; m
ln
St
H
_ _
ls t
r

s t
p ; gmq
_
_
_
_
mu
ln
St
H
_ _
lls t
r

s t
p
_
_
_
_
2
r

s t
p
N g
ln
H
K
_ _
llT s
r

T s
p
_ _
e
rTs
K
H
N g
ln
H
K
_ _
lT s
r

T s
p
_ _ _ _
_
_
_
;
whenever M
S
0;t
H or m
S
0;t
! H and zero otherwise. In the above formula we have set
q

s t=T t
_
for notational convenience. When t > s we notice from the
denition of the payo functions that the hedging strategy is equal to the hedging
strategy of a standard option provided that the partial out barrier option is alive at
time s. Moreover, setting s T gives the replicating portfolios for the standard out
barrier options.
7. EXTENSIONS AND SUMMARY
In this paper we show how the Malliavin calculus approach to hedging contingent
claims can be extended to any square integrable payo function, or more precisely we
show that the ClarkOcone formula can be extended to square integrable random
variables. From a practical point of view the extension is interesting because there are a
lot of contingent claims, such as barrier options, that do not belong to the subspace
D
1;2
& L
2
X. It is also clear that our results still hold when we consider more general
dynamics of the stock price. For instance, if we dene the stock price S as the solution
to the stochastic dierential equation:
dSt rStdt rStdV t
S0 S
0
;
_
and assume that the functional form of r is such that rx > 0 for x > 0; zero is an
unattainable boundary, and the solution is nonexploding, then Theorem 5.2 still holds
after the obvious modication of the replicating portfolio
h
1
t e
rTt
rSt
1
E
Q
D
t
GjF
t
: 7:1
GENERAL APPROACH TO HEDGING OPTIONS 213
Moreover, under these conditions it is known (see Nualart 1995a) that the stock price has
a density which simplies the calculation of the Malliavin derivative D
t
Gconsiderably. In
the case where the analytical form of the density is known, the replicating portfolio can
usually be calculated in closed form. However, when this is not possible we use equation
(7.1) as a basis for Monte Carlo simulation. If the contingent claim G 2 D
1;2
then (7.1) is
often directly amenable for simulations; however, if G is only in L
2
X the situation is
more complicated because the Malliavin derivative of G will in general include Dirac
delta functions which if approximated with deterministic functions will generate a high
variance for the estimated value of the replicating portfolio. A way to overcome this
problem was presented in Fournie et al. (1999). Their approach, which was based on the
integration by parts formula of Malliavin calculus, was to reexpress (7.1) in the form
h
1
t e
rTt
rSt
1
E
Q
G HjF
t
;
for some stochastic variable H. In that paper explicit forms for the stochastic
variable H were derived for standard and Asian options, after which Monte Carlo
simulations were carried out. Recently, the integration by parts technique has also
been applied to lookback and barrier options in papers by Gobet and Kohatsu-Higa
(2001) and Bernis, Gobet, and Kohatsu-Higa (2002), conrming the eciency of the
method.
If we compare the Malliavin calculus approach with the well-known D-hedging
approach, we nd an interesting dierence. While we only need the contingent claim to
be square integrable in order to derive a formal expression for the replicating portfolio
with the Malliavin calculus approach, the standard D-hedging approach requires
dierentiability conditions at any point in time. For instance, if the time t price of the
contingent claim G can be expressed in the form f t; St; Zt; with Z being some
additional state variable of bounded variation, and f is of class C
1;2;1
, then the
D-hedging approach implies that
h
1
t f
s
t; St; Zt;
f t; s; z e
rTt
E
Q
GjSt s; Zt z:
_
However, by using (7.1) as a starting point it is possible to show that the D-hedging
formula holds under the weaker condition that f t; s; z only is Lipschitz continuous in
s; provided that the pair S; Z has a joint density (see Bermin 2002 for details). This
result is of particular interest when we depart from the standard BlackScholes setup
with a constant volatility and thus are forced to use Monte Carlo simulations, since the
integration by parts technique of Malliavin calculus in general requires a D-hedging
formula to start with.
As an application of our general results we derive the replicating portfolios for some
barrier and partial barrier options. It should be pointed out however that in the
standard BlackScholes model where the joint density of the stock price and its running
maximum (minimum) is analytically known and closed-form solutions for the option
prices are available, it is usually easier to apply the D-hedging formula directly rather
than to use the extended Malliavin calculus approach.
APPENDIX A
In this appendix we present the dierent cumulative distribution functions that we will
use. These joint cumulative (conditional) distribution functions are all consequences of
214 H. P. BERMIN
the reection principle (see, e.g., Karatzas and Shreve 1996), and can be derived from
the results in Heynen and Kat (1994) and Carr (1995).
Lemma A.1. Given that 0 t s T. Let H > St and dene k lnK=St,
h lnH=St. Then QST K; M
S
t;s
HjF
t
: is equal to
N
k lT t
r

T t
p ;
h ls t
r

s t
p ;

s t
T t
_
_ _
e
2hl
r
2
N
k 2h lT t
r

T t
p ;
h ls t
r

s t
p ;

s t
T t
_
_ _
:
Lemma A.2. Given that 0 t s T. Let H > St and dene k lnK=St,
h lnH=St. Then QST > K; M
S
t;s
HjF
t
is equal to
N
k lT t
r

T t
p ;
h ls t
r

s t
p ;

s t
T t
_
_ _
e
2hl
r
2
N
k 2h lT t
r

T t
p ;
h ls t
r

s t
p ;

s t
T t
_
_ _
:
Lemma A.3. Given that 0 t s T. Let H < St and dene k lnK=St,
h lnH=St. Then QST K; m
S
t;s
> HjF
t
is equal to
N
k lT t
r

T t
p ;
h ls t
r

s t
p ;

s t
T t
_
_ _
e
2hl
r
2
N
k 2h lT t
r

T t
p ;
h ls t
r

s t
p ;

s t
T t
_
_ _
:
Lemma A.4. Given that 0 t s T. Let H < St and dene k lnK=St,
h lnH=St. Then QST > K; m
S
t;s
> HjF
t
is equal to
N
k lT t
r

T t
p ;
h ls t
r

s t
p ;

s t
T t
_
_ _
e
2hl
r
2
N
k 2h lT t
r

T t
p ;
h ls t
r

s t
p ;

s t
T t
_
_ _
:
In order to obtain the corresponding density functions, we need to know how to
dierentiate the bivariate normal cumulative distribution function. If we dene the
variable WK; H by
WK; H NAK; H; BK; H; q
_
AK;H
1
_
BK;H
1
uu; v; qdudv;
where A; and B; are some continuously dierentiable functions with respect to
both arguments and u; ; q being the density function of a standard bivariate normal
stochastic variable with correlation q, it then follows that
GENERAL APPROACH TO HEDGING OPTIONS 215
@WK; H
@H
uAK; HN
BK; H qAK; H

1 q
2
_
_ _
@AK; H
@H
uBK; HN
AK; H qBK; H

1 q
2
_
_ _
@BK; H
@H
:
Here, u denotes the density function of a standard normal stochastic variable.
APPENDIX B
In this appendix we derive the conditional expectation of the Malliavin derivative for
the partial up-and-out call in Section 6. We use the notation d
H
for the Dirac delta
function with point mass at H, which is the formal derivative of the indicator function
1f > Hg. Moreover, we dene the RadonNikodym derivative
dQ
S
dQ

ST
E
Q
ST
on F
T
;
such that Q
S
is a probability measure absolutely continuous with respect to Q. It is easy
to show that the Girsanov kernel for this transformation is just equal to r, and
consequently the distribution functions in Appendix A taken with respect to Q
S
are
obtained by simply replacing l with ll l r
2
. For a complete and detailed study of
these aspects, see Geman, El Karoui, and Rochet (1995). Moreover, for every
stochastic variable X such that E
Q
S jXj < 1 it follows that
E
Q
STXjF
t
E
Q
STjF
t
E
Q
S XjF
t
; B:1
see, for example, ksendal (1998) for details.
Proposition B.1. Let the payo G be dened by G ST K

1fM
S
0;s
Hg: Then,
for t s,
D
t
G rST1fST > K; M
S
t;s
Hg1fM
S
0;t
Hg
rST K

Hd
H
M
S
t;s
1fM
S
0;t
Hg:
Proof. By using the fact that the joint law of ST; M
S
0;s
is absolutely continuous
with respect to the Lebesgue measure on R
2
and Corollary 5:3 we get that
D
t
G 1fST > KgrST1fM
S
0;s
Hg
ST K

d
H
M
S
0;s
rM
S
0;s
1fM
S
0;t
M
S
t;s
g
rST1fST > K; M
S
0;s
Hg
rST K

d
H
M
S
t;s
M
S
t;s
1fM
S
0;t
M
S
t;s
g
rST1fST > K; M
S
t;s
Hg1fM
S
0;t
Hg
rST K

Hd
H
M
S
t;s
1fM
S
0;t
Hg;
which completes the proof. h
216 H. P. BERMIN
Our next step is to derive the conditional expectation
E
Q
D
t
ST K

1fM
S
0;s
HgjF
t
; for t s < T:
Given that M
S
0;t
H, these formal calculations follow from (B.1):
E
Q
D
t
GjF
t
rE
Q
STjF
t
Q
S
ST > K; M
S
t;s
HjF
t

rHE
Q
STjF
t
E
Q
S 1fST > Kgd
H
M
S
t;s
jF
t

rHKE
Q
1fST > Kgd
H
M
S
t;s
jF
t
:
We let F
l
ST;M
S
t;s
and F
ll
ST;M
S
t;s
, denote the joint cumulative F
t
-conditional distribution
functions of the pair ST; M
S
t;s
with respect to the probability measures Q and Q
S
,
respectively, and introduce the notations
f
i
ST;M
S
t;s
s; m
@
2
@s@m
F
i
ST;M
S
t;s
s; m
F
i
STjM
S
t;s
H
s
@
@m
F
i
ST;M
S
t;s
s; m

mH
_

_
; i l; ll
Note that the upper index indicates the relevant probability measure (i.e., if we are to
use l or ll in the formulas that are presented in Appendix A). Now, since
E
Q
1fST > Kgd
H
M
S
t;s
jF
t

_
1
0
_
m
0
1fs > Kgd
H
mf
l
ST;M
S
t;s
s; mds dm

_
H
0
1fs > Kgf
l
ST;M
S
t;s
s; Hds

_
H
K
f
l
ST;M
S
t;s
s; Hds
F
l
STjM
S
t;s
H
H F
l
STjM
S
t;s
H
K;
and similar for the term E
Q
S 1fST > Kgd
H
M
S
t;s
jF
t
, we nally get that
E
Q
D
t
GjF
t
re
rTt
StQ
S
ST > K; M
S
t;s
HjF
t

rHe
rTt
St
_
F
ll
STjM
S
t;s
H
H F
ll
STjM
S
t;s
H
K
_
rHK F
l
STjM
S
t;s
H
H F
l
STjM
S
t;s
H
K
_ _
;
if M
S
0;t
H and zero otherwise. Inserting the formulas from Appendix A yields the
desired results presented in Section 6.
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