Explicit construction of a dynamic Bessel bridge of dimension 3

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.