medium · Quantitative Finance
Girsanov's Theorem identifies the 'market price of risk' as θ = (μ - r)/(σ).
What is the effect of applying the Girsanov transformation to the drift of a stock process?
- It converts a mean-reverting process into a pure random walk with no drift.
- It defines the 'volatility drag' that must be subtracted from the geometric mean return.
- It removes the risk premium from the drift, shifting it from the physical μ to the risk-neutral r.
- It increases the volatility of the process to account for the investor's risk aversion.
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