Solution: Reweighting a Two-State Model

Exercise: Reweighting a Two-State Model

Solution

The density is $Z(u)=0.4/0.7=4/7$ and $Z(d)=0.6/0.3=2$ . Then

\mathbb{E}^{\mathbb{P}}[Z]=0.7(4/7)+0.3(2)=0.4+0.6=1.

Takeaways

A density is a likelihood ratio.
It must have expectation one under the original measure.
State weights can rise or fall after the measure change.

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Solution - Reweighting a Two-State Model | q4quant.studio