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Ito Calculus
Ito Calculus
Ito Calculus
Classical to Ito
based on
Stochastic models, Nottingham University
and
Financial Mathematics II, Leicester University
Ito Lemma
Classical. Consider a ”smooth” function x(t) (differentiable or twice differentiable, that is what-
ever we need we can assume). And let us derive the formula
(x2 )0 = 2xx0
Start with
x(t + ∆t) = x + ∆x
= x(t) + ∆x(t)
(∆x(t))2 = o(∆t)
and so
1
In particular,
∆x2 = [x + ∆x]2 − x2
= 2x∆x + o(∆t)
Proof 1: via derivative from which by SDL
dx2
= (x2 )0
dt
∆x2 (t)
= defn = lim
∆t→0 ∆t
2x(t)∆x(t)
= lim
∆t→0 ∆t
∆x(t)
= 2x(t) lim
∆t→0 ∆t
= defn = 2x(t)x0 (t)
Now, write it again
dx2 dx
= 2x
dt dt
by deleting dt
dx2 = 2xdx
and we (re)derive the chain rule for the example in the differential form
dx2 = 2xdx (∗)
Proof 2 of the differential form (*) without the derivative. Simply replace ∆· by d· and let
o(∆t) = 0, so
∆x2 = 2x∆x + o(∆t) =⇒
dx2 = 2xdx
Ito. Imagine that there exists a function Bt = B(t) such that
[∆B]2 = [∆Bt ]2 = ∆t + o(∆t)
Then, derivative B 0 does NOT make sense since roughly
√
∆Bt ∆t
∼ →∞
∆t ∆t
The argument of Proof 1 will not work, since derivative is not defined everywhere.
However, by applying argument of Proof 2 as before
2
Bt+∆t = [B + ∆B]2
= B 2 + 2B∆B + (∆B)2
as before
= B 2 (t) + 2Bt ∆Bt + ∆t + o(∆t)
with a NEW term
2
and so
∆B 2 = [B + ∆B]2 − B 2
= 2B∆B + ∆t + o(∆t)
resulting in
dB 2 = [B + dB]2 − B 2
= 2BdB + dt
Overall, we have shown that the the strange function B satisfies the chain rule with an extra
(so-called Ito) term
dB 2 = 2BdB + dt
Ito lemma
Ito Lemma. Consider a twice continuously differentiable function f (x, t). Then,
df (t, Bt ) = fB (t, Bt )dB + ft (t, Bt )dt + (1/2)fBB (t, Bt )dt or
∂f ∂f ∂ 2f
df (t, Bt ) = dB + dt + (1/2) 2 dt
∂B ∂t ∂ B
∂f (t, Bt ) ∂f (t, Bt ) ∂ 2 f (t, Bt )
= dB + dt + (1/2) dt
∂B ∂t ∂ 2B
The two first terms are usual terms in the differential form of the Chain rule. The last one
(1/2)fBB (t, Bt )dt is the Ito term.
Proof. Start with the Taylor formula (B = Bt )
f (t + ∆t, Bt+∆t ) = f (t + ∆t, B + ∆B)
= f (t, B) + fB (t, B)∆B + ft (t, B)∆t
+(1/2)fBB (t, B)(∆B)2
+(1/2)ftt (t, B)(∆t)2 + fBt (t, B)∆B∆t + o([∆t]2 + [∆B]2 )
3
Now,
√
∆B∆t = O( ∆t)∆t = o(∆t),
|∆B|2 = ∆t, ∆t2 = o(∆t)
and we derive
implying
and so
and so
Example. Let f (x, t) = exp(ax + bt) and let X = X(t) = f (t, Bt ). Then,
4
So,
fB (t, B) = af = aX,
ft (t, B) = bf = bX,
fB,B (t, B) = a2 f = a2 X .
and thus
5
Ito Process and Ito Martingale
Ito process
Defn 1 We say that {St ; t ≥ 0} is an Ito process if its Ito differential is written in the form
dSt = µt dt + σt dBt
where µt , σt are adapted processes, i.e. measurable with respect to the Brownian motion filtration,
Ft , or roughly aT is adapted if at = H(Bs , s ≤ t); µt is referred to as a drift, σt - volatility.
(iv)Ito process is identified by S0 , µt and σt . (i.e. two processes with same characteristics are
equal almost surely).
(v)(Defn 2) Stochastic integral representation. The equivalent form for the Ito process is
Z t Z t Z t
St = S0 + dSu = S0 + µu du + σu dBu .
0 0 0
Lemma/defn 3 An Ito process {Mt ; t ≥ 0} is a martingale with respect to the Brownian motion
filtration Ft if and only if
dMt = σdBt
6
Main properties of Ito martingales:
Z T Z t
E σu dBu |Ft ] = σu dBu
0 0
(ii)E[Ito] = 0 or
Z T
E σu dBu ] = 0
0
To find an integral E[f (Bt )] use Ito formula to reduce it to simpler calculations since the E[Ito] = 0
and that the second moment of Ito integral can be found via Ito isometry (to be applied in fm2).
To show that the Ito process St (e.g. f (t, Bt )) is a martingale check that there is no the drift, i.e.
µt ≡ 0.
7
SDE=Stochastic differential equations.
Now the Ito process is defined via the equation (SDE):
and X0 = S0 , then the strong solutions are same, i.e. Xt = St almost surely.
Examples
Solution. By the Ito formula applied to the Ito process St = Bt and f (t, Bt ) = Bt2 − t, i.e.
f (t, x) = x2 − t
Solution. By the Ito formula applied to f (t, Bt ) = Bt2 , i.e. f (t, x) = x2 (so ft0 = 0)
Hence
Z t Z t
E[Bt2 ]
= E 2Bu du] + E du
0 0
= 0 + t since E[Ito] = 0
8
Ito integral
Defn. Assume that the process {X(t) ; t ≥ 0} is defined via the differential/sde type representa-
tion
In particular,
Z t Z t
X(t) = X(0) + a(s, Bs )dBs + µ(s, Bs )ds
0 0
(ii) (Fubini)
Z t Z t
E a(s, Bs )ds = E[a(s, Bs )]ds
t0 t0
9
applied to f (x, t) = x3 . So (with x = B = Bt )
And so,
Thus,
Z t Z t
Bt3 3
= B (0) + 3B (s)dBs + 2
6Bs ds
0 0
Z t Z t
Bt3 = 2
3B (s)dBs + 6Bs ds
0 0
because B(0) = 0.
By taking expectation,
Z t Z t
E[Bt3 ] = E 2
3B (s)dBs + E 6Bs ds
0 0
Z t
= E 6Bs ds
0
since E[Ito] = 0
Z t
= E[6Bs ]ds
0
Fubini
Z t
= 6 E[Bs ]ds
0
fB (t, B) = fx (x, t) = 1 ,
ft (t, B) = ft (x, t) = 0 ,
00
fBB (t, B) = fxx (x, t) = 0 .
dBt = dBt
10
Thus,
Z t
Bt = B(0) + 1dBs
0
Z t
Bt = dBs
0
because B(0) = 0.
By taking expectation,
Z t
E[Bt ] = E dBs
0
= 0
since E[Ito] = 0.
Going back,
Z t
E[Bt3 ] = 6 E[Bs ]ds
0
Z t
= 6 0ds
0
= 0
Calculating the integral via modified Fundamental theorem of calculus. Assume that
u(s) is a good differentiable function. The Newton (Newton-Leibniz) formula (refered to as the
Fundamental theorem of calculus) states
Z b
u0 (x)dx = u(b) − u(a)
a
This form is actually MUCH more powerful and holds basically regardless WHAT is the differential.
Classical calculus. Take u(x) = g(x)2 where again g differentiable and so by (either chain or
product rule)
[g(x)2 ]0 = 2g(x)[g(x)]0 or
dg(x)2 = 2g(x)dg(x) (more interesting!)
Then, we can write
Z b Z b
2g(x)dg(x) = dg 2 (x)
a a
= g (b) − g 2 (a)
2
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In particular, if a = 0, b = t, g(0) = 0,
Z t
2g(x)dg(x) = g 2 (t) − g 2 (0) = g 2 (t)
0
Ito calculus. Now, take u(x) = B(x)2 . Then, by the Ito lemma
and so,
Z t
Bt2 = Bt2 − B(0) =2
dBt2
Z t Z 0t
= 2Bs dBs + ds
0 0
Z t
= 2Bs dBs + t
0
12
Some Justification
For a given partition t0 = s0 < s1 < . . . < sK+1 = t1 , let
X
X({sj }) = X = a(B(sj ), sj )[B(sj+1 ) − B(sj )] ,
j
X
Y ({sj }) = Y = c(B(sj ), sj )[B(sj+1 ) − B(sj )] .
j
P PK
where j = j=0 .
Fact. Then,
X
X = aj Z j ,
j
X
Y = cj Zj
j
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