Explicit construction of a dynamic Bessel bridge of dimension 3

TL;DR

This paper explicitly constructs a dynamic Bessel bridge process of dimension 3, which is a Brownian motion in its own filtration ending at zero at a random time, with applications to insider trading models with default risk.

Contribution

It provides an explicit construction and semimartingale decomposition of a dynamic Bessel bridge using enlargement and filtering techniques, extending classical Bessel bridge theory.

Findings

Constructs a process hitting zero at a random time V(τ)

Provides semimartingale decomposition under combined filtration

Models a dynamic Bessel bridge with applications to insider trading

Abstract

Given a deterministically time-changed Brownian motion $Z$ starting from 1, whose time-change $V(t)$ satisfies $V(t) > t$ for all $t > 0$, we perform an explicit construction of a process $X$ which is Brownian motion in its own filtration and that hits zero for the first time at $V(\tau)$, where $\tau := \inf\{t>0: Z_t =0\}$. We also provide the semimartingale decomposition of $X$ under the filtration jointly generated by $X$ and $Z$. Our construction relies on a combination of enlargement of filtration and filtering techniques. The resulting process $X$ may be viewed as the analogue of a 3-dimensional Bessel bridge starting from 1 at time 0 and ending at 0 at the random time $V(\tau)$. We call this {\em a dynamic Bessel bridge} since $V(\tau)$ is not known in advance. Our study is motivated by insider trading models with default risk, where the insider observes the firm's value continuously on time.