a) Show that a convex function of a martingale is a submartingale. In other words, let M0, M1, ..., MN be a martingale and let f be a convex function. Show that M0 ≤ M1 ≤ ... ≤ MN is a submartingale. Hint: Use Jensen's inequality.
b) Prove that if x = x - Kx0, then x ≤ x0 ≤ X ≤ 1.
Consider now an American call option in a non-dividend paying stock. Consider an N-period multiplicative binomial with initial stock price S0 and with u as the up factor, and d as the down factor, so that for SH = uSo and ST = dSo, SHH = uSoSo and SHT = STH = udsO, STT = dSo. Assume also a constant positive annual continuously compounded interest rate r > 0, and let the time step T = 1.
c) Use the fact that o = (x - K)+ is a convex function and part b, to conclude that it is never optimal to exercise an American option before maturity. That is, show that E[c - f(N - nSN)] ≤ oSn0 ≤ n ≤ N.