Stochastic Calculus in the 20th Century

Stochastic Calculus is a mathematical model used to simulate financial options and is mainly used to
model investor behaviour and asset pricing. The base of the stochastic calculus theory allows for
stochastic process integrals with respect to stochastic processes. This write-up looks into the
contribution of stochastic calculus in mathematical finance in the 20 th century.

A. Louis Bachelier’s roles and contributions and Paul Samuelson’s improvements.

At the start of the twentieth century, Louis Bachelier was a French mathematician who was
renowned as the spear header in the study of stochastic methods as well as regarded as forefather
of mathematical finance. In his PhD thesis, The Theory of Speculation, he was credited with being
the first to model the stochastic process now known as Brownian motion.

Bachelier's PhD thesis was the first to utilize advanced mathematics in the study of finance,
introducing the first mathematical model of Brownian motion and its application to the valuation of
stock options. In particular, he presented the most important mathematical finding, which was
mostly employed in financial markets for modelling price fluctuations and evaluating contingent
claims. This ground-breaking study of stock and option market analysis provides various ideas that
are extremely valuable in both finance and probability for valuing stock alternatives.

Significant work by Bachelier includes the below:

1. Independent homogenous fluctuations – which are routine continuous procedures in price

variations that are regarded as independent.
2. Symmetric Random walks in continuous time process – The influences that determine the
movements of the market are innumerable: past, current and even anticipated events that
often have no obvious connection with its changes.
3. The forward-looking algorithm - Bachelier constructs the Chapman–Kolmogorov equation
and deduces that the price distribution at a specific time is Gaussian by assuming merely
that the price evolves as a continuous, memoryless process that is homogenous in time and
space.

Bachelier's thesis was founded on prior work by J. Fourier, G. Lamé, and Poincaré, with notions like
development of probabilities and Jules Regnaul's conceptual context for the application of
probability to stock market activities being drawn from their ideas.

Bachelier Model

Bachelier model is a concept that highly regards Brownian Motion as a key model used for forward
prices in a continuous process. It is useful when transitioned with the Black-Scholes model as it can
be used to summarize results from volatility conversions, risk mitigation, stochastic process volatility
and optional pricing barriers. Below is the forward price process:

dFt = σn dWt

Wt is a BM model which is classified under the T-forward measure. “The undiscounted price of a call
option with strike price K and time-to-maturity T under the Bachelier model is:”

F 0−K
C N ( K )= ( F0 −K ) N ( d N )+ σ N √ T n ( d N ) for d N = ,
σN√ T
Where Probability Density Function and Cumulative distribution function are n(z) and N(z)
respectively. In several instances the Bachelier call formula is defined as:

Bachelier put option formula

Bachelier presented the first option pricing model, which was more than 70 years before the BS
model. However, the BS model eventually surpassed it, as academics and practitioners alike
anticipated asset prices to be strictly positive. The Bachelier model has been reintroduced to the
limelight following the CME's negative oil futures contract pricing and the resulting hasty model
switch. In reality, when Euro and CHF rates turned negative in the mid-2010s, the fixed income
market moved to quoting implied Bachelier volatilities.

Paul Samuelson’s significant contribution to Bachelier’s work was on the Brownian model of financial
markets. Samuelson’s valuable contribution was built on the base that in terms of continuous-time
stochastic processes in financial markets, models are concerned with establishing the concepts of
financial assets and markets, portfolios, gains, and wealth. Bachelier's method was improved by Paul
Samuelson, who used geometric Brownian motion to simulate stock prices. Following Samuelson's
contribution, advances in Mathematical Finance have been made in the area of Stochastic
Integration theory. Bachelier's contribution created the groundwork for the Black Scholes and
Merton equations, which were eventually essential in contemporary financial engineering.
Investment firms and hedge funds have used it to generate highly leveraged wagers that have
triggered financial catastrophes.

Paul Samuelson’s Geometric Brownian Motion

The prominent economist Paul Samuelson introduced the Geometric Brownian motion process to
finance, and it is characterized by the stochastic differential equation (SDE):

Instead of employing a no-arbitrage principle, Samuelson introduced the condition that discounted
options payoffs following a martingale, from which the valuation formulae immediately followed,
hence concluding that Samuelson’s work laid a foundation of efficient market hypothesis and option
pricing which is continuously evolving in the modern financial word.

B. The contribution of Kiyosi Ito and other Japanese mathematicians

Kiyosi Itô is credited for developing the theory of stochastic integration and stochastic differential
equations, which is today known as Itô calculus. Its essential notion is the Itô integral, and one of the
most significant conclusions is Itô's lemma, which is a change of variable formula. Itô calculus is a
mathematical tool for studying random occurrences that is utilized in a variety of domains, but is
arguably best recognized for its application in mathematical finance. It has contributed to the field of
stochastic differential geometry, which studies diffusion processes on manifolds. The innovation of
Kiyoshi Ito directly used random motion which is key in today’s financial markets.

Japanese mathematicians contributed significantly to a number of branches of mathematics and

were instrumental in the development of computer mathematics. They not only contributed to the
expansion of conventional mathematical knowledge, but they also contributed to the expansion of
their profession's bounds by utilizing more sophisticated computer technology. This had far-reaching
implications for mathematics and many elements of modern civilization.

Significant Japanese Mathematicians in the 20 th Century

 Kunihiko Kodaira was a Japanese mathematician who founded the Japanese school of
algebraic geometers and is recognized for his work in algebraic geometry and the theory of
complex manifolds.
 Goro Shimura was a mathematician who specialized in number theory, automorphic forms,
and arithmetic geometry. He was best recognized for establishing the idea of abelian and
Shimura varieties' complicated multiplication.
 Heisuke Hironaka’s contributions where mainly in algebraic geometry and was awarded
several awards for his work.
 Satoshi Nakamoto a well-known author of bitcoin white paper who created and deployed
bitcoin models using the blockchain database.
 Mikio Sato, an innovative Japanese Mathematician who excelled in the fields of algebraic
analysis, holonomic quantum and hyperfunctions which were regarded as models that
revolutionised mathematics.
 Shizuo Kakutani is a mathematician who is most known for his work on the eponymous
fixed-point theorem. His other contributions include the Markov-Kakutani fixed point
theorem and the Markov-Kakutani fixed point theorem.