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Change of drift in one-dimensional diffusions

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  • Sascha Desmettre
  • Gunther Leobacher
  • L. C. G. Rogers

Abstract

It is generally understood that a given one-dimensional diffusion may be transformed by Cameron-Martin-Girsanov measure change into another one-dimensional diffusion with the same volatility but a different drift. But to achieve this we have to know that the change-of-measure local martingale that we write down is a true martingale; we provide a complete characterization of when this happens. This is then used to discuss absence of arbitrage in a generalized Heston model including the case where the Feller condition for the volatility process is violated.

Suggested Citation

  • Sascha Desmettre & Gunther Leobacher & L. C. G. Rogers, 2019. "Change of drift in one-dimensional diffusions," Papers 1910.11904, arXiv.org, revised Dec 2020.
  • Handle: RePEc:arx:papers:1910.11904
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    References listed on IDEAS

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    1. Hardy Hulley & Eckhard Platen, 2008. "A Visual Classification of Local Martingales," Research Paper Series 238, Quantitative Finance Research Centre, University of Technology, Sydney.
    2. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," The Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    3. Cetin, Umut, 2018. "Diffusion transformations, Black-Scholes equation and optimal stopping," LSE Research Online Documents on Economics 87261, London School of Economics and Political Science, LSE Library.
    4. Aleksandar Mijatović & Mikhail Urusov, 2012. "Deterministic criteria for the absence of arbitrage in one-dimensional diffusion models," Finance and Stochastics, Springer, vol. 16(2), pages 225-247, April.
    5. Guo, Zhi Jun, 2008. "A note on the CIR process and the existence of equivalent martingale measures," Statistics & Probability Letters, Elsevier, vol. 78(5), pages 481-487, April.
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