5.

Itô Calculus

Types of derivatives

Consider a function F (St, t) depending on two

variables St (say, price) and time t, where
variable St itself varies with time t.

In standard calculus there are three types of

derivatives:

Partial derivative:
∂F (St, t) ∂F (St, t)
(1) Fs = , Ft = .
∂St ∂t
Total derivative:

(2) dF = Fs dSt + Ft dt.

Chain rule:
dF (St, t) dSt
(3) = Fs + Ft.
dt dt

1
Partial derivative are abstractions. Usually
they are called multipliers or marginal effects
(cf. the Greeks in option theory).

Total derivative describes the total change or

response in F as time t and St change

The chain rule indicates the chain effects in

the change of the price St and F as time
changes.

We will consider in this section stochastic

counterparts for the total differential and chain
rule. Essentially as we will see the major dif-
ferences are that we have to interpret the dif-
ferential in stochastic processes via the stochas-
tic integral and that the second order term
(dSt)2 is not negligible as in standard calcu-
lus.

2
Itô’s stochastic differential equation

Itô’s lemma gives the stochastic version for

the chain rule.

Let

(4) dSt = a(St, t) dt + σ(St, t) dWt.

where a(St, t) and σ(St, t) are nonanticipating
and Wt is the standard Brownian motion.

3
We interpret dSt via the stochastic integral
such that
Z t
(5) dSu = St − S0,
0
so that

Z t Z t Z t
(6) St = S0 + dSu = a(Su , u) du + σ(Su , u) dWu ,
0 0 0

where the first integral is the usual Riemann

integral and the second one is the Itô inte-
gral.

4
Consider a function F (St, t) (e.g. derivative
of a stock)

As time t changes by dt what is the total

effect on F (St, t). The change is

(7) t → Wt → St → F (St, t).

The interest is dF (St, t).

5
Suppose the observation interval of St is [0, T ].
Let 0 = t0 < t1 < · · · < tn = T be a partition
with
T
(8) h = tk − tk−1 = k = 1, . . . , n,
n
so that T = nh.

Consider the finite difference representation

of dSt

(9) ∆Sk = ak h + σk ∆Wk , k = 1, . . . , n,

with ∆Sk = Stk −Stk−1 , ak = a(Stk−1 , tk ), σk =
σ(Sk−1, tk ), and ∆Wk = Wtk − Wtk−1 .

6
Itô formula is derived using the Taylor expan-
sion of a ”smooth” function.

If f (x) is such a function the Taylor expansion

around x0 becomes

1 00
f (x) = f (x0) + f 0 (x0)(x − x0 ) + f (x0 )(x − x0 )2 + R,
2
(10)

where R is the remainder.

7
For a function with two variables the Taylor
expansion is
F (Stk , tk ) = F (Stk−1 , tk ) + Fs ∆Sk + Fth + 12 Fss (∆Sk )2

+ 12 Ftt h2 + Fst h ∆Sk + R.

(11)

Arranging terms
∆Fk = Fs∆Sk + Fth + 2 1 F (∆S )2
ss k
(12)
+12 F tt h2 + F h ∆S + R,
st k
where

(13) ∆Fk = F (Stk , tk ) − F (Stk−1 , tk−1).

8
As n → ∞, h = tk −tk−1 → dt, ∆Sk → dS, and
∆Fk → dF , and R → 0 because it consists of
terms (∆tk )m and (∆Wk )m with m ≥ 3.

So we get
dF (St, t) = Fs dSt + Ft dt + 12 Fss (dSt )2
(14)
+ 12 Ftt (dt)2 + Fst dt dSt.

Using the calculation rules for the differen-

tials, we obtain
dt dSt = dt (a(St, t)dt + σ(St, t) dWt)

(15) = a(St, t)(dt)2 + σ(St, t) dt dWt

= 0,
because (dt)2 = 0 and dt dWt = 0.

So we get
1
(16) dF (St, t) = Fs dSt + Ft dt + Fss (dSt)2
2

9
Remark 5.1: If St is non-stochastic then (dSt )2 = 0
and the above formula is just the total derivative dF =
Fs dS + Ft dt.

Replacing dSt with its Itô representation, we

have
dF (St, t) = Fs · [a(St , t) dt + σ(St , t) dWt ] + Ft dt
(17)
+ 21 Fss [a(St, t) dt + σ(St, t) dWt]2 .
Using the infinitesimal calculation rules again
yields
(18) (dSt)2 = σ 2(St, t) dt.
Arranging terms, we obtain finally the fa-
mous Itô’s differential formula

· ¸
1 2
dF = Ft + a(St , t)Ft + σ (St , t)Fss dt + σ(St, t) dWt.
2
(19)

10
The result is summarized as Itô’s Lemma:

Lemma 5.1: (Itô’s Lemma) Let F (St , t) be a twice-

differentiable function of t and of the random process
St with Itô differential equation
dSt = at dt + σt dWt , t ≥ 0,
with at = a(St, t) and σt = σ(St , t) continuously twice-
differentiable (real valued) functions. Then
1
(20) dF = Fs dSt + Ft dt + Fss σt2 dt,
2
or, after substituting for the right hand side of dSt
above
µ ¶
1
(21) dF = Fs at + Ft + Fss σ 2 dt + Fs σt dWt ,
2
where
∂F ∂F ∂ 2F
(22) Fs = , Ft = , and Fss = .
∂St ∂t ∂St2

11
The major usage of the Itô formula in fi-
nance is to find the (Itô) stochastic differen-
tial equation (SDE) for the financial deriva-
tive once the (Itô) SDE of the underlying
asset is given.

12
Itô’s formula can be used also in some cases
to find the stochastic integral itself.

Example 5.1: Let

(23) F (Wt, t) = Wt2 .

Using formula (16) with St = Wt we obtain
(24) Fw = ∂W 2 /∂W = 2W ,
and
(25) Fww = ∂ 2F/∂W 2 = 2.
Then because Ft = 0,
dF (Wt , t) = Fw dWt + 12 Fww (dWt )2
(26)
= dt + 2Wt dWt.
Thus the drift of F is a(F, t) = 1 and diffusion param-
eter is σ(F, t) = 2Wt .

13
Example 5.2:

(27) F (Wt , t) = 3 + t + eWt .

Using again Itô’s formula (16) with St = Wt
dF (Wt, t) = Ft dt + Fw dWt + 21 Fww (dWt)2

(28) = dt + eWt dWt + 12 eWt dt

¡ ¢
= 1 + 21 eWt dt + eWt dWt .

14
Example 5.3: Consider the geometric Brownian mo-
tion
1
St = S0e{(µ− 2 σ )t+σ Wt }
2
(29) ,
where S0 is a constant. Then using again Itô with
formula (20), and noting that σ(Wt, t) = 1, we get
∂St ∂St 1 ∂ 2 St
dSt = ∂Wt
dWt + ∂t
dt + 2 ∂Wt2
dt
1 1
= S0 σe{(µ− 2 σ )t+σ Wt }
dWt + (µ − 12 σ 2 )S0 e(µ− 2 σ )t+σ Wt
2 2
dt
1
+ 12 σ 2 S0e(µ− 2 σ )t+σ Wt
2
dt

= Stσ dWt + (µ − 12 σ 2 )St dt + 12 σ 2 St dt

= St(µ dt + σ dWt),
(30)
or
dSt
(31) = µ dt + σdWt ,
St
or
(32) dSt = µStdt + σSt dWt .

Remark 5.2: Comparing to the general formula dSt =

a(St, t)dt + σ(St , t)dWt we find that in (32) a(St, t) =
µ St, and σ(St, t) = σ St.

15
Itô’s formula as an integration tool

Suppose our task is to evaluate

Z t
(33) Ws dWs.
0
Make a guess
1 2
(34) F (Wt, t) = Wt .
2
Then using Itô
1
(35) dF (Wt, t) = Wt dWt + dt.
2
The integral form is
Z t Z t Z t
1 2 1
W = F (Wt , t) = dF (Ws , s) = Ws dWs + ds.
2 t 0 0 2 0
(36)
So
Z t
1 2 1
(37) Ws dWs =Wt − t.
0 2 2
The start off point here is to make a “good
guess”.

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Example 5.4: Consider Itô integral
Z t
(38) s dWs .
0
Make a start off guess
(39) F (Wt, t) = tWt.
Then
(40) dF (Wt, t) = Wt dt + t dWt.
and
Z t Z t Z t
(41) tWt = dF (Ws , s) = Ws ds + s dWs .
0 0 0
So
Z t Z t
(42) s dWs = tWt − Ws ds.
0 0

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Example 5.5: Consider
dSt
(43) = µ dt + σ dWt.
St
Let
(44) F (St , t) = log St.
Then
dF (St, t) = Ft dt + Fs dSt + 21 Fss (dSt)2

1 1 1
= St
dSt − 2 St2
(dSt )2
(45)
1 1 2 2
= µ dt + σ dWt − 2 St2
σ St dt

= (µ − 12 σ 2 ) dt + σ dWt.
We get
Rt
log St = log S0 + 0
dF (Su , u)
Rt 1 2
Rt
(46) = log S0 + 0
(µ − 2
σ )du + 0
σ dWu

= log S0 + (µ − 21 σ 2)t + σWt .

So
1
St = S0 e(µ− 2 σ )t+σWt
2
(47) .

18
Integral form of Itô’s Lemma

Integrating both sides of (21) yields Itô’s for-

mula in integral form:
Z t· ¸
1
F (St, t) = F (S0 , 0) + F2 (Su , u) + F11(Su , u)σu2 du
0 2
Z t
+ Fs dSu .
0
(48)
where
∂F (x, y) ∂F (x, y)
(49) F1 (x, y) = ,F2(x, y) = ,
∂x ∂y
and
∂ 2F (x, y)
(50) F11(x, y) = ,
∂x2
and we have used
Z t
(51) dF (Su, u) = F (St, t) − F (S0, 0).
0

19
Remark 5.3: Rearranging terms in the Itô’s integral form yields
Z t
Fs dSu = [F (St , t) − F (S0 , 0)]
0
(52) Z th i
1
− F2 (Su , u) + F11 (Su , u)σu2 du,
0
2

which is a representation of the stochastic integral as a function

of integrals with respect to time.

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Multivariate Itô formula

(53)
µ ¶ µ ¶ µ ¶µ ¶
dS1 (t) a1 (t) σ11 (t) σ12 (t) dW1 (t)
= dt+
dS2 (t) a2 (t) σ21 (t) σ22 (t) dW2 (t)
or
(54)
dS1 (t) = a1(t) dt + σ11(t) dW1 (t) + σ12 (t) dW2 (t)
dS2 (t) = a2(t) dt + σ21(t) dW1 (t) + σ22 (t) dW2 (t),
where it is assumed that Wiener processes
W1(t) and W2(t) are independent.

21
Suppose F (S1(t), S2(t), t) is a twice differen-
tiable real valued function.

Use of the Taylor expansion and taking limit

in the same manner as in the univariate case,
yields (with (dt)2 = 0, dt dS1 = 0, and dt dS2 =
0)

(55)
dF = Ft dt + Fs1 dS1 + Fs2 dS2
£ ¤
+ 12 2 2
Fs1 ,s1 (dS1 ) + Fs2 ,s2 (dS2 ) + 2Fs1,s2 dS1 dS2 .

The independence of W1 and W2 implies that

dW1 dW2 = 0 (otherwise if they were cor-
related with correlation ρ, then dW1 dW2 =
ρ dt).

22
Then
(56) (dS1)2 = (σ11
2 + σ 2 ) dt,
12

(57) (dS2)2 = (σ21

2 + σ 2 ) dt,
22
and

(58) dS1 dS2 = (σ11σ21 + σ12σ22)dt.

Using these in the multivariate Itô gives a

formula as a function of dW1 and dW2.

23
Example 5.6: Interest rate derivatives. Assume that
the yield curve depends on two state variables, short
rate rt, and long rate Rt . Denote the price of the
derivative as F (rt, Rt, t). Assume
(59) drt = a1 (t) dt + σ11(t) dW1 (t) + σ12 (t) dW2 (t),
and
(60) dRt = a2 (t) dt + σ21 (t) dW1 (t) + σ22 (t)dW2(t).
Straightforward application of the Itô formula gives
(61)

dF = Ft dt + Fr drt + FR dRt
£ ¤
+ 12 Frr (σ11
2 + σ2 ) + F
12
2 2
RR (σ21 + σ22 ) + 2FrR (σ11 σ21 + σ12 σ22 ) dt,

which indicates how the price of an interest rate deriva-

tive will change during a small interval dt.

Remark 5.4:
(62) Cov(drt , dRt ) = [σ11 (t)σ21 (t) + σ12 (t)σ22 (t)] dt.

24
Example 5.7: Total value of wealth
n
X
(63) Y (t) = Ni (t)Pi (t),
i=1

where Ni (t) is units of the ith asset and Pi (t) the price.
Increment of wealth as time passes
Xn Xn
∂Y ∂Y ∂Y
dY (t) = dt + dNi (t) + dPi (t)
∂t i=1
∂Ni i=1
∂Pi
n n
1 X ∂ 2Y 2 1 X ∂ 2Y 2
+ (dN i (t)) + (dP i (t))
2 i=1 ∂Ni2 2 i=1 ∂Pi2
Xn
∂ 2Y
+ dNi (t) dPi (t)
i=1
∂N i ∂P i

n
X n
X
= Pi (t)dNi (t) + Ni (t)dPi (t)
i=1 i=1
n
X
+ dNi (t) dPi (t).
i=1
(64)
In the standard calculations the last term would not
be present.

25