Girsanov Theorem - Application To Finance

Application To Finance

In finance, Girsanov theorem is used each time one needs to derive an asset's or rate's dynamics under a new probability measure. The most well known case is moving from historic measure P to risk neutral measure Q which is done - in Black Scholes framework - via Radon–Nikodym derivative:

 \frac{d Q}{d P} = \mathcal{E}\left ( \int_0^\cdot \frac{r - \mu }{\sigma}\,
d W_s \right )

where r denotes the instanteaneous risk free rate, the asset's drift and its volatility.

Other classical applications of Girsanov theorem are quanto adjustments and the calculation of forwards' drifts under LIBOR market model.

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