Chapter 14

The Itô Integral

The following chapters deal with Stochastic Differential Equations in Finance. References:

1. B. Oksendal, Stochastic Differential Equations, Springer-Verlag,1995

2. J. Hull, Options, Futures and other Derivative Securities, Prentice Hall, 1993.

14.1 Brownian Motion


 

(See Fig. 13.3.) is given, always

 



in the background, even when not explicitly mentioned.
! "
Brownian motion,  , has the following properties:
#
$%'& ! (*)+,& -'./
$%102$43
1.  Technically,  ,
 .

2.  is a continuous function of ,
5$6 87,9 :;9=<><><19 8?
3. If , then the increments
 :
@ A 87B
C<B<C<D  E?
@ A 8?#F :

are independent,normal, and

! GH A JILK :
M@ A JIN
-OP$='
 
! G A EILK :
Q@ A EIN
EOAR$S .IK : @ .IT<
 

14.2 First Variation

WP

QuadraticWvariation
 .

is a measure of volatility. First we will consider first variation, U,V , of a

function .

153
154

f(t)

t2
t
t1 T

W .

Figure 14.1: Example function .


O
For the function pictured in Fig. 14.1, the first variation over the interval is given by:
7  WD
$4 W/A :
@ W#
EO @  W/A
@ W :
EO
 W 
/@ W
EO
U,V R R

 
  
$ WA .
  J@ W-A E

  W J
# L<
7
 


$ WAA J
 <
7 

Thus, first variation measures the total amount of up and down motion of the path.
The general definition of first variation is as follows:
$ )B 7  : C<B<C< ? 0 O
Definition 14.1 (First Variation) Let  be a partition of , i.e.,
$S 7 9 : 9=<><><19 ? $2<

The mesh of the partition is defined to be

$ "!$#  I K : @ I
+<
 I&% 7(' ' ' ?#F :
 

We then define ? F :

7)  WD

$ *,+ 0 W/A EI K :
M@ W/A JIN
<
 7
U,V -(- ./-(-  I1% 7  

W  JI  JI K : O
Suppose is differentiable.
3I2
Then the Mean Value Theorem implies that in each subinterval ,
there is a point such that
W .I K :+
@ W JI
$=W   2I
C .I K :@ .IN
<
CHAPTER 14. The Itô Integral 155

Then ?#F : ? F :
0 W/A JILK :
M@ W/A EIN
$ 0 W   2I
 .IK : @ EIN
+
I&% 7   I&% 7  

and
?#F :

7)  WD

$ * + 0 W   2I
 JILK : @ JIN

 7
U,V - - ./- -  I&% 7  


$ W-A J
 <
7  

14.3 Quadratic Variation

W  O
Definition 14.2 (Quadratic Variation) The quadratic variation of a function on an interval
is ? F :

W
$ *+
7
0 W A EI K :+
@ W  JIN
R <
-(- . -(-  I1% 7  

W
EWB 
Q$
Remark 14.1 (Quadratic Variation of Differentiable Functions) If is differentiable, then

, because
? F : ? F :
0 W  JI K :
@ W  JIN
R $ 0 W A 2I
R A EI K :@ JIN
R
I1% 7   I&% 7  
? F :

9 < 0  A 2I
R A EI K :@ JIN

W
 I1% 7
   

and
? F :

8W> 
9 * +
7
< * +
7
0 W   2I
R  JI K :@ JIN

- - ./- -   
  - - ./- - I&% 7  


$ * + W   J
R 
7 
- - ./- -    7  
$='<

Theorem 3.44

>2
$ 


or more precisely, !( )  
&
.< /

C;
$  50;$43 <


In particular, the paths of Brownian motion are not differentiable.

156

$ )B 87# : ><><>< -? 0  O I*$

Proof: (Outline)
A ILK :
@ A I

Let  be a partition of . To simplify notation, set

  . Define the sample quadratic variation
?#F :

. $ 0 IR <
I1% 7

Then ? F :

. @ S$ 0  IR @  .IK : @ .I
EOJ<
I1% 7

We want to show that *,+

-(- ./-(-  7

. @
$6<

Consider an individual summand

IR @  JI K :@ JIN
$   .I K :L
Q@  .IB
JO R @S JI K :@ .IB
C<
 

This has expectation 0, so

? F :

!G
. @
$%! G 0  IR @  .IK : @ .I>
EO $%'<
I&% 7


  , the terms
$

 

For
R @  K : @
IR @  I K : @ I

and
are independent, so
? F :

 !


>
. @ 2
$ 0
I1%7
 !
+ IR @ A EI K :@ .I>
EO

? F :

$ 0
I1%7
! G
  I @  JI K :@ .IB
IR 6 .I K :@ JIN
R O

? F :

$ 0 
 A I K : @ I
R @   I K : @ I
R A I K : @ I
R O
I1%7

(if
? F :
 is normal with mean 0 and variance  R
, then
!G
   )

$

$  0  I K : @ I
R
I1%7
? F :

9  
0  JI K : @ JIC

  I
% 7

$ 
;<
 

Thus we have
! GH
. @ 2
$%'

 !
C
. @ 2
9  
<(;<
 
CHAPTER 14. The Itô Integral 157

As   
 
,  !


B
. @ 2

, so
*,+
-(- ./-(-  7

. @ 2
$6<

Remark 14.2 (Differential Representation) We know that

! G  .I K :
@  JIN

R @  JI K : @ JI
EO $%<
 

We showed above that

 !
C

A JI K :
M@

 .I
.
R @  JI K : @ .IB
JOD$   .I K : @ .I>
R <

 IK : @ I
A ILK : @ I
R
When is small, is very small, and we have the approximate equation
 JI K :
Q@  JI

R
EI K : @ JIT
 

which we can write informally as   .

  .
$ # L<
 

14.4 Quadratic Variation as Absolute Volatility

 : 
O
On any time interval R , we can sample the Brownian motion at times
: $ E7*9 : 96<><B< 9 8? $
R

and compute the squared sample absolute volatility

? F :
3
0 A JILK :
@ A JIN

R <
@ : I&% 7  
R

This is approximately equal to

3 @ :

> R

M@
C :
JO$ R $ 3 <
@ :   @ :
R R

As we increase the number of sample points, this approximation becomes exact. In other words,
Brownian motion has absolute volatility 1.
Furthermore, consider the equation


> 
$ $

3  L  <

7

This says that quadratic variation for Brownian motion accumulates at rate 1 at all times along
almost every path.
158

14.5 Construction of the Itô Integral

 .
    A J
+  
The integrator is Brownian motion  , with associated filtration , and the
following properties:

1.


is also in 
9 .$  A J

every set in ,
 .
  J

2.  is -measurable, ,
9 : 9=<><><19 8? A :
M@ A E
+ 
@  :
+C<B<C<  8?1
@  8? F :

3. For , the increments    R   

  .

are independent of .
 A J
  
The integrand is , where
 A J
  .
 
1. is -measurable (i.e., is adapted)

2. is square-integrable: 
!G

 R  .
  S 2<
7

We want to define the Itô Integral:


!D .
$

 
 

 '<

7

W .

Remark 14.3 (Integral w.r.t. a differentiable function) If is a differentiable function, then

we can define 
  
 
8W 
$   
WA 
  <
7
7

This won’t work when the integrator is Brownian motion, because the paths of Brownian motion
are not differentiable.

14.6 Itô integral of an elementary integrand

$ )C 7  : ><><><' ? 0 '
O
Let  be a partition of , i.e.,
$S E7*9 :29=<><><19 E? $2<

  .
 .I1 JILK : O 
Assume that is constant on each subinterval (see Fig. 14.2). We call such a an
elementary process.
 J
 A I

The functions  and can be interpreted as follows:

Think of   J

as the price per unit share of an asset at time .

CHAPTER 14. The Itô Integral 159

δ( t ) = δ( t 1 )
δ( t )= δ( t 3 )
δ( t ) = δ( t )
0

0=t0 t1 t2 t3 t4 = T

δ( t ) = δ( t 2 )

Figure 14.2: An elementary function .

Think of E7# :+C<B<><  8?
as the trading dates for the asset.

 A JI>
JI
Think of as the number of shares of the asset acquired at trading date
.I K :
and held until
trading date .
!  .

Then the Itô integral can be interpreted as the gain from trading at time ; this gain is given by:






  87>
  .
@  87>
OJ  9 9 :
 
 %
  7 %  7
! A J
$





   87>
  :
@  E7>
EO   :
+ A J
@  :
EOJ : 9 9
R
   
  7
  :
@  7
EO   :
 A
R

@  :
EO  A
R

 A E
M@ A
R

EO 
R
9 9  <
     

EI 9 9 JI K :
In general, if ,
I+F :

!  .
$ 0  

C 
 K :
M@ 

EO  A JIC
C  .
@  JIN
EOJ<

 % 7    

14.7 Properties of the Itô integral of an elementary process

N!  .
 .

Adaptedness For each is -measurable.

Linearity If
 
 
!D J
$  
 
+ A E
$ 
/ 

 
7 7

then  
! A J
 J
$  
 

/ 

7 

160

s t
t t l+1 ..... t t
l k k+1

Figure 14.3: Showing
and in different partitions.

and
 
!D J
$  
 
<
7 

!D J

Martingale is a martingale.

We prove the martingale property for the elementary process case.

Theorem 7.45 (Martingale Property)

I F :

!D J
$ 0  

+ 
 K :
@ 

EO   .IB
C  .
@ A JIN
EOE JI 9 9 EILK :

 % 7    

is a martingale.

Proof: Let

S9
be given. We treat the more difficult case that:
and areI inI different
9
 
+ 
-K O 
subintervals, i.e., there are partition points and such that


I   K : O
and (See
Fig. 14.3).
Write

JF :

!P .
$ 0  

+ 
 K :
@ 

JO   

  
8K :
@ A 

EO

 % 7
I+F :
   

0  

+ 
 K :
@ A

8O  A EIN
+  .
@  .I
EO

 %
K :    

We compute conditional expectations:


JF :
JF :
!G 0  

B 
 K :
Q@ 


 


 $ 0  

> 
 K :
@ A


<

 %7   

  % 7  

! G  

C 
K :
@ 

E
 


5$  A

! GH 
K :


-O @ 



   
 

$  A



@ 

EO
 
CHAPTER 14. The Itô Integral 161

These first two terms add up to

!

. We show that the third and fourth terms are zero.
 I+F : I+F :

!G 0  A

> 
 K :
@ 

.
 


$ 0 !G  !G   

B 
 K :
Q@ 


  



 %
K :   

  %
K :   





I F : 

$ 0 !G  A

Q ! G  
 K :
 

EO @ 


 



%
8K :  
 %
 7 
 




!G    .I
>  .
@ A JIN

 


$=! G   .IC
! G  J
  JIB
8O @ A JIN

 




   
    7
%  
 

Theorem 7.46 (Itô Isometry)

 
!G !TR A J
$=! G  R 
  <
7

$S JI
Proof: To simplify notation, assume , so
I

! A J
$ 0  

C 
 K :
@ 

O

% 7   



Each  has expectation 0, and different  are independent.

 I R
! R A J
$ 0  A
 

%


7
I

  0
 

$ 0  R 
R    
 


 <

% 7

Since the cross terms have expectation zero,
I

!G !1RBA J
$ 0 ! G  R 
 
R O

 % 7
I

$ 0 !G   R 

! G  
 K :
@ 

.
R   


 % 7
I
  



$ 0 !G  RN
 

> K : @


 % 7
I  

$=! G 0  R 
 
% 7
 

 
$=! G  R#
 
7
162

path of δ
path of δ
4

t1 t2 t3 t4 = T
0=t0

 
O
Figure 14.4: Approximating a general process by an elementary process
 , over .

14.8 Itô integral of a general integrand

Fix

 
. Let be a process (not necessarily an elementary process) such that

 A J
  .
    O
is -measurable, ,

!G  7

 R  .
  S<

Theorem 8.47 There is a sequence of elementary processes

)  
?0 ? % :
such that


* +
? 
 !G
7

 ? A J
@  A J


R # $=<

Proof: Fig. 14.4 shows the main idea.

In the last section we have defined



!? 2
$  ?P .
 A E


for every . We now define
 
 
7
 A J


 .
$ *,+
? 
 7
 ?  .


 .
<
CHAPTER 14. The Itô Integral 163


The only difficulty with this approach is that we need to make sure the above limit exists. Suppose
and are large positive integers. Then

!
  R
! ?
Q@ !




$=! G   ? A E
M@ 

 .
EO  .

7 


$ !G   ?  J
M@ 

 .
EO R 
(Itô Isometry:) 7


$ !G   ? A E
M@   J
 A E
Q@ 

 J
O R #
7
     
 
R 9    R R 
9  #! G

7
 ?D .
@   J
R    !G

7


 J
@   .
R  
   

which is small. This guarantees that the sequence

) !?
L0 ?  % :
has a limit.

14.9 Properties of the (general) Itô integral

 
!D J
$  
 
+<
7 


Here is any adapted, square-integrable process.
! A J
  .

Adaptedness. For each , is -measurable.

Linearity. If  
 
!D J
$  
 
+ A E
$ 
/ 

 
7 7 

then  
! A J
 J
$  
 

/ 

7 


and  
!D J
$  
 
+<
7 

!D .

Martingale. is a martingale.
!D .


Continuity. is a continuous function of the upper limit of integration .
!G ! R  .
$6! G 7  R 
 
Itô Isometry. .

Example 14.1 () Consider the Itô integral



  

We approximate the integrand as shown in Fig. 14.5

164

T/4 2T/4 3T/4 T


   O
Figure 14.5: Approximating the integrand  with
 , over .

  
 


if



 
 
 
 if

 



 


  


!"




 if  

By definition,

!




)(+* 43   3+: <3
      $#&%&' ,.-  0/21 5/ 17698 5/;1 

To simplify notation, we denote

,>= 3A@
 ?/1

so
!


0

C(+* , ,.E  : ,
     B#&%&' ,D-    

We compute

!
!
! 
!
 0 F  0 F 0  0 F
F ,DE  : , F , E  :
D , , E 
. F ,
, -  
.   , - 
D , - 
D , - 
D

GH
 6

  0 0  0

F I
F
, ,.E  ,
F
F F : F
 IJ-  ,D-  ,D- 
6
!  
!
G 6
 0 0

F , :
F
, ,DE 
F
 ,D-  ,D- 
6
!
 0

F , ,.E  : ,
F :
 ,D-  
  
CHAPTER 14. The Itô Integral 165

Therefore,
G!
G!

0   0
, ,DE  : ,
F ,DE  : ,
F
F : F @
,D-    , -  
. 

or equivalently


!




F
0  F  0


3   34: 3 F : F   3
3
,.-  5/21 ?/ 1 6<8 /1    ,D-  5/ 1 698 / 1 

(
Let

and use the definition of quadratic variation to get


 
F

F : F
        

:
W W#
/$6
Remark 14.4 (Reason for the R term) If is differentiable with , then
 
 
W 
8W 
M$ W/ 
W-  
 
7 7

:
$ W R 

7
R 
: 
$ W R 2
+<
R

In contrast, for Brownian motion, we have


 : :

 
$ R ;
@ <
7   R  R

:
The extra term R comes from the nonzero quadratic variation of Brownian motion. It has to be
there, because 

!G 
 
$6
7   (Itô integral is a martingale)

but : :
!G R 2
Q$ ;<
R  R

14.10 Quadratic variation of an Itô integral

Theorem 10.48 (Quadratic variation of Itô integral) Let

 
!D J
$  
 
+<
7 

Then  

! C .
$  RN
  <
7
166


This holds
 even if is not an elementary process.! The quadratic variation formula says that at each
 R 

time , the instantaneous absolute volatility of is

  J.
This is the absolute volatility of the
Brownian motion scaled by the size of the position (i.e. ) in the Brownian motion. Informally,
we can write the quadratic variation formula in differential form as follows:
T!  .
 !D .
$  R  .
# L<

Compare this with   .

  .
$ # L<
 

 $ )> -7  : ><><>< 8?'0    .

$
Proof: process ). Let 
  JIB
(For
JI*9
an elementary
9 .IK : /$6 8?
be the partition for , i.e.,
for . To simplify notation, assume . We have
? F :

8! > E
$ 0

 8! C .I K :
Q@
8! > .I
EO1<
I1%7

8! C JI K :
M@
8! B JI>
$ )
7B
:>><><><'
0
Let us compute . Let
be a partition
JI2$
7*9
: 9=<><>< 9


$ JI K : <

Then



 

!D
K :
M@ !

$   JI>
 





$   .IC



 K :+
@



EO 

so
F :



E! CA JILK :
@
8! B JI
$ 0  !D
 K :
@ !D

EO R

 % 7
F :


$  R  .I>
0 
 K :
@

JO R

 % 7  


@ @@@'@T
 R  JI>
> .IK : @ .I
+<
 

It follows that
? F :

8! B J
$ 0  R A EIN
> .I K : @ EIN

I&% 7

?#F :  

$ 0  R#
 
I&% 7
 
 
 
@8@ @'@'@ @ 
 RB 
   <
7
 
Chapter 15

Itô’s Formula

15.1 Itô’s formula for one Brownian motion

W  J

W/


We want a rule .
to “differentiate” expressions of the form  , where is a differentiable
function. If  were also differentiable, then the ordinary chain rule would give

W  J

M$=W  A J

  J
+
   

which could be written in differential notation as

EW/  .

$=W   J

 A E

  
$=W8  J


  J

 .

However,  is not differentiable, and in particular has nonzero quadratic variation, so the correct
formula has an extra term, namely,
:
8W A J

$6W-  .

 A E
W -
  .


# <
   R  
  

   
  

This is Itô’s formula in differential form. Integrating this, we obtain Itô’s formula in integral form:
  :  
W A J

@ W #

$ W8 

 
W 8
 

  <
  7   R 7 
   7 


Remark 15.1 (Differential vs. Integral Forms) The mathematically meaningful form of Itô’s for-
mula is Itô’s formula in integral form:

  :  
W A J

@ W #

$ W8 

 
W 8
 

  <
  7   R 7 

167
168

This is because we have solid definitions for both integrals appearing on the right-hand side. The
first,
 
W  

 

is an Itô integral, defined in the previous chapter. The second,

 
W 8 

  
7 

is a Riemann integral, the type used in freshman calculus.

For paper and pencil computations, the more convenient form of Itô’s rule is Itô’s formula in differ-
ential form: :
8W  J

$6W   .

  .
W   .

 <
   R 

8W  J

+
  .

There is an intuitive meaning but no solid definition for the terms   and appearing
in this formula. This formula becomes mathematically respectable only after we integrate it.

15.2 Derivation of Itô’s formula

:
W 
$ R
Consider R , so that
W8
$  W 8 
$ 3#<

I  I K :
Let be numbers. Taylor’s formula implies
:
W ILK :
@ W IN
$
ILK : @ IN
WA IC

ILK : @ IB
RW(8 IC
+<
R

W
In this case, Taylor’s formula to second order is exact because is a quadratic function.
ILK : @
 general case, the above equation is only approximate, and the error is of the order of
InI
the

Fix

. The total error will have limit zero in the last step of the following argument.

and let 
$ )> E7# : ><><C<  E?0
be a partition of
 'O
. Using Taylor’s formula, we write:
W

@ W 


 : :
$ R
@ R 

R  R 
? F :

$ 0 W  JI K :

/@ W/  .IB

EO
I&% 7  
?#F : ? F :
:
$ 0   JILK :
@  JIN
EOBW8  JI

 0   JILK :
@  JIN
EO R W(A  .IB


I&% 7    R I
% 7   
?#F : ?#F :
:
$ 0  JIN
  JILK :
@  .I
JO 0   .IK :
M@  .I
JO R <
I % 7 
&   R I&% 7  
CHAPTER 15. Itô’s Formula 169

 
We let    to obtain

 :
W 2

@ W #

$ 
 
/
C 2

  7   R     
 
 : 
$ W8 

 
 W(A 

  <
7   R 7 
  : 

This is Itô’s formula in integral form for the special case

:
W 
$ R <
R

15.3 Geometric Brownian motion

Definition 15.1 (Geometric Brownian Motion) Geometric Brownian motion is


)#  :



 J
$ 

 
 .
/ @
R  R

*

where and  
are constant.

Define

)#   :

W/A 
$ -

 @
R  R



so
 .
$=W   .

+<


Then
  :
 *$
W

$ @
R  R

W W ,$
 W W
 R W<

According to Itô’s formula,

  J
Q$ -W L  J

 :
$=W

# W   W   
 R     
 
 : :
$

@
R
R
W  
 W 
 R  R W #
$  .
 
  J


 .

Thus, Geometric Brownian motion in differential form is


  J
Q$  .
 
  J


 .
+

and Geometric Brownian motion in integral form is

    

   

 .
$ -

7

7 
/

<
170

15.4 Quadratic variation of geometric Brownian motion

In the integral form of Geometric Brownian motion,

    
  
 
 J
$ 

7


7  



the Riemann integral 

 .
$
  
 
U 7

 A J
M$   J

is differentiable with U . This term has zero quadratic variation. The Itô integral
 
 

 .
$
7 
/


is not differentiable. It has quadratic variation

 

 
 
A J
$
7  R R <

Thus the quadratic variation of is given by the quadratic variation of . In differential notation,
we write 
  .
  J
$ A J
 
  J



 J

R $
 R R A J


15.5 Volatility of Geometric Brownian motion

9 : 9 $ )> 87#B<C<B< E?'0 ( :  O
Fix R . Let  be a partition of R . The squared absolute sample
 :  O
volatility of on R is
? F : 

3 3 

 
R
@ Q: &
0
I % 7
  JI K :
@  .I>
EO R
R
@ Q:

 R R

 R R :

As R 
:
, the above approximation becomes exact. In other words, the instantaneous relative
R

volatility of is . This is usually called simply the volatility of .

15.6 First derivation of the Black-Scholes formula

Wealth  of an investor. An investor begins with nonrandom initial wealth and at each time ,  7

holds  .

shares of stock. Stock is modelled by a geometric Brownian motion:


  J
Q$ A J
 
  J



 J
<
CHAPTER 15. Itô’s Formula 171

  .

can be random, but must be adapted. The investor finances his investing by borrowing or
lending at interest rate .
Let   J

denote the wealth of the investor at time . Then


  J
Q$
 A J



 .

   .
@
  .
 .
EO #

$
 A J
 .
 
  J



A E
EO

  J
@
  J
 J
JO)

$
  J

  J
 J

 
@



 A E
 J

 

 J
+<

Risk premium

Value of an option. Consider an European option which pays

 .
$

at time . Let
2

denote   

the value of this option at time

   O
if the stock price is . In other words, the value of the


option at each time is    .

+<

The differential of this value is

     
:
  L A J

$   $  


       
R
 :
$    
  O R R 

 
  R

  
:
$


R  R R # 


 7
 A E


A hedging portfolio
A   J


starts with some initial wealth and invests so that the wealth at each
time tracks . We saw above that


  J
Q$4

 @
O  
  

<

To ensure that   J
$
  L A J


for all , we equate coefficients in their differentials. Equating the

 coefficients, we obtain the  -hedging rule:

#
  J
$
    .

<

Equating the coefficients, we obtain:

 
   
:


R  R R $

 @
<

But we have set   , and we are seeking to cause  to agree with  . Making these substitutions,
 $

          
we obtain :
R R $ @



(where  
R
$ A   E

$  .

and ) which simplifies to

      
:
R R $ <
 R

In conclusion, we should let  be the solution to the Black-Scholes partial differential equation
     
:
A 
 A 
R R   
$   



satisfying the terminal condition 2
$
+<

If an investor starts with   and uses the hedge   7 $ - #

 .
$    .


.
, then he will have
  J
$
for all , and in particular, 
 L  J

2
Q$ 


172

15.7 Mean and variance of the Cox-Ingersoll-Ross process

The Cox-Ingersoll-Ross model for interest rates is

  .
$  @ A J

 

 J


A E
+

where
   
 and


are positive constants. In integral form, this equation is

   
  
 
 E
$ -#
 
7
 @


 7 

<

 R  .
 W  J

W

$ R
We apply Itô’s formula to compute . This is , where . We obtain
 R A J
$EW/ A J


:
$6W8  J

  .
 W  A E

  .
  .

$  .
   @ 
 .

#
 A J


 .
  @  .

#
  J


 .

R

    
$  J
@ R  J
   
 J
  .

 R  .
#

    

R  J
#  J


$ R
 .
# Q@ A E

A J

The mean of . The integral form of the CIR equation is

   
  
 
 E
$ -#
 
7
 @


 7 

<

Taking expectations and remembering that the expectation of an Itô integral is zero, we obtain
 
!G  .
$ 
   @ !G 

  <
7

Differentiation yields 
!G  J
$ P@ !G  .

$ @  !G  J
+


which implies that



 
 !G  .
  
$   !G A J



!G  .

 
$ <

Integration yields   
 
 ! G  J
Q@ 
$   
   $  
 @ 3>
+<
7

!G  J

We solve for :  
!G  J
$  F 
 #
/@ <
3
/
  
If

Q$

, then
!G  J
Q$

for every . If

$

, then
 .

exhibits mean reversion:




* +
 !G  J
$ <
CHAPTER 15. Itô’s Formula 173

 .
 R  .

Variance of . The integral form of the equation derived earlier for is

R  .
$ R 
=  /
 R


7


  @   
7

R 
    
7







<

Taking expectations, we obtain

!G R  .
$ R 
%   R


7

!G 
  @   
7

!G R 
  <

Differentiation yields



!G R  J
$ /  R
! G  J
@  !G R  J
+

which implies that



 R 
 ! G R  J
$  R 
   !G R A J



!G R  J

 R 

$ /  R
! G  .
+<

!G  J

Using the formula already derived for and integrating the last equation, after considerable


algebra we obtain

  
  R  
!G R A J
$
R

Q@
R
 F 

R R 3
/


@

3
R
 R
 F
R 
  R


@ #

3
 F
R 
 <
/ /
! A J
$=! G R  J
@S ! G  J

R

  
  
R R
 F 
 R
 F


$
R

/

Q@
3

/
@ #

3
R <

15.8 Multidimensional Brownian Motion

 
Definition 15.2 ( -dimensional Brownian Motion) A -dimensional Brownian Motion is a pro-
cess :  .
$  .
><B<C<'  .

with the following properties:

Each  I E


is a one-dimensional Brownian motion;

If

$
  , then the processes 
A J

and    J

are independent.
 )  A E
0
Associated with a -dimensional Brownian motion, we have a filtration such that

For each , the random vector 
 J

is
 A E

-measurable;

For each 9 : 96<B<><19 ?
, the vector increments
 :
Q@  J
+B<C<B<  8?T
@  8? F :

   
  .

are independent of .
174

15.9 Cross-variations of Brownian motions



Because each component  is a one-dimensional

 
Brownian motion, we have the informal equation
  .
  J
$ # L<
 

However, we have:
$
 , 



Theorem 9.49 If
  .
  J
$=
 

Proof: Let 



$ )B 87#><B<C<  8?0
 '
O
be a partition of
'
O
. For


$
  , define the sample cross variation
of  and  on to be
? F :  

. $ 0 
I1% 7 
 JI K :
@

 JIB
8O1

  .I K :
@

  JIN
EO#<

The increments appearing on the right-hand side of the above equation are all independent of one
another and all have mean zero. Therefore,
!G $6<
.

We compute  !
.
. First note that
? F :  

 
R R
R $ 0   .IK :
Q@  JI
  JILK :
@  .IN

.
I&% 7    
? F :

   

0 

I


A
K :
@



JON

 
K :
@

 

JO <>

 .IK :
M@

 .IC
EO1

 A JILK :
@

  .I>
8O

All the increments appearing in the sum of cross terms are independent of one another and have
mean zero. Therefore,
! C
.
$%! G
? F :
.
R

$%! G 0 
I1% 7 
 JI K :
@

 JIN
EO R 

 A EI K :
@

  JIB
EO R <

But 
  .I K :
Q@
 .IK :

@ .I

 EIN
EO R
and 

  .I K :L
M@

  JI>
EO R
are independent of one another, and each has
expectation . It follows that
? F : ? F :

 !
>
.
$
0
I1% 7
A JI K :@ JI
R 9

0
I1% 7
 JI K :@ .IB
$

< ;<
   

As   
 
, we have  !
B
.
 , so . converges to the constant
!G
. $=
.
CHAPTER 15. Itô’s Formula 175

15.10 Multi-dimensional Itô formula

To keep the notation as simple as possible, we write the Itô formula for two processes driven by a
two-dimensional Brownian motion. The formula generalizes to any number of processes driven by
a Brownian motion of any number (not necessarily the same number) of dimensions.
Let  and be processes of the form
  
  
   
 
  
+
  J
$
 


7


7
::

:
7
:
R


 R

     

       
 .
$ -#

 7

7 R
:


:

7 R R


 R

+<


Such processes, consisting of a nonrandom initial condition, plus
more Itô integrals, are called semimartingales. The integrands
a
Riemann
 
 integral,
and
 
plus one or
can be any
 
adapted processes. The adaptedness of the integrands guarantees that and are also adapted. In 
differential notation, we write
 

 $

  :: 

:/ :
R

 R


 
 $
 # 
R
: 

:
RR

 R
<

Given these two semimartingales  and , the quadratic and cross variations are:

 

  $

  : :  : : 
R 


 R  R
$ N:R :  :  : : :  :
R
 :  N:R  
        7   R R   R   R
   
$  :R :
  :R
R  
R
 
  $
  
R
: 

:
R R

 R

R

$  R :  R
R  
R R R
   

  $

   : : 

: :
R

 R

>
 
R
: 

:
R R

 R

$ ::  R
:  :
R
 R R



Let
W L 
 1

be a function of three variables, and let  A E

and
 .

be semimartingales. Then we
have the corresponding Itô formula:
8W L 
 1

:
$ W

 W  
 W  
R
W  
    W  W 
   O <

In integral form, with  and as decribed earlier and with all the variables filled in, this equation
is
W 
  J
+ A J

Q@ W
 #
+ 

   
 : :
           
$
7
W



W W
R
R :
: :R
R

W : :
R
: :
R R R

W
R R
R : R
W
R R
O 


7

  : : W   R
: W  O 

:

7

  :
R
W   R R
W  O 
 R


where
W $=W  
 
+ 

, for



  ) 3# T0
,
  $   

, and 
$