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n
t=0
|S
t
| is called the length of trajectory.
n
t=0
(S
t
)
2
is known as quadratic variation [very important!!].
n
t=0
|(S
t
)|
3
and
n
t=0
(S
t
)
4
exist and they important too.
4
1) SOME BASICS DEFINITIONS AND CONCEPTS
(continous)
4. [Example on Martingale]
Let S
t
be the price of an asset observed at time t and if in a small
innitesimal period t, one receives a new information on S
t
, denoted by
dS
t
. This change can be expressed as
dS
t
= dW(t), where W(t) is Wiener process and is the volatility of
the asset.
The expectation, EdS
t
= 0, this demonstrates how Wiener process and
martingale are related.
5
1) SOME BASICS DEFINITIONS AND CONCEPTS
(continous)
5. [Stochastic Dierential Equations (SDE)]
A dierrential equation of the form
dX
t
= (X
t
, t)dt +(X
t
, t)dW
t
(1)
is an SDE if dW(t) is a wiener process (sometimes called innovation
term). (X
t
, t) and (X
t
, t) is drift and volatility (diusion) coecients
respectively. The integral of Equation (1) is not trivial!!!
6
2) ITOs INTEGRAL
continous
The Ito isometry
E
_
_
T
0
f(t, w)dW
_
2
= E
_
_
T
0
f
2
(t, w)dt
_
(2)
The consequence of this can be used to show that
_
T
0
WdW =
1
2
W
2
T
2
.
Which is an Ito integral of
_
T
0
WdW, where W is Bromnian process (Wiener
process)
7
2) ITOs INTEGRAL
continous
The Ito formula
Let X
t
be an Ito process given by dX
t
= dt +dW
t
. Let Y be a function
of t and X
t
, dened as Y = y(t, X
t
). Suppose its twice dierentiable on
[0, ), then
dY
t
=
y
t
dt +
y
x
dX
t
+
1
2
2
y
x
2
dt (3)
Example: Given y =
1
2
x
2
, then
y
t
= 0,
y
x
= x and
2
y
x
2
= 1. Yields a new
Ito DE
dY = (x +
1
2
)dt +dW.
Suppose = 0 and = W, then dY =
1
2
dt +WdW.
8
2) ITOs INTEGRAL
continous
Integration by parts in Ito integral
Suppose f only depend on s [0, t] and that f is continuous and of
bounded variation in [0, t]. Then
_
t
0
f(s)dW = f(t)W
t
_
t
0
Wdf (4)
Example: Let X
t
, Y
t
be Ito processes in R. Prove that
d(X
t
Y
t
) = X
t
dY
t
+Y
t
dX
t
+dX
t
dY
t
. (5)
9
2) ITOs INTEGRAL
continous
Deduce the following general integration by parts formula
_
t
0
X
s
dY
s
= X
t
Y
t
X
0
Y
0
_
t
0
Y
s
dX
s
_
t
0
dX
s
dY
s
. (6)
This can be done using Ito formula, i.e, Let f = XY , then
df =
f
t
dt+
f
X
dX
t
+
f
Y
dY
t
+
1
2
2
f
X
2
(dX
t
)
2
+
1
2
2
f
Y
2
(dY
t
)
2
+
2
f
XY
dX
t
dY
t
but the 1
st
, 4
th
and 5
th
right terms equal to zero, and
f
Y
= X
t
,
f
X
= Y
t
,
2
f
XY
= 1 and df = d(X
t
Y
t
). Substituting in Ito formula end the proof.
The last part is rearrangement and integrating.
10
2) STRATONOVICH INTEGRAL
Suppose f is continuous in [0, T], the stratnonvich integral of f is
dened as
_
T
0
f(t, w)dW = lim
t
j
0
j
f(t
, w)W
j
, (7)
where t
=
1
2
(t
j+1
+ t
j
) and W
j
= W
j+1
W
j
. However, Ito integral
takes t
= t
j
.
Stratonovich:
_
t
0
WdW =
1
2
W
2
t
(8)
Ito:
_
t
0
WdW =
1
2
W
2
t
1
2
t (9)
11
0 0.2 0.4 0.6 0.8 1
0.5
0.4
0.3
0.2
0.1
0
0.1
0.2
0.3
Comparing ito and Stratonovich integral
Time
Ito
Stratonovich
Figure 1: At all time point Stratonovich integral (equation (10))is greater
than Ito integral (equation (11)) valve by half that time.
12
Is stratnonvich integral better Ito integral?
Some scholars noted that Stratonovich interpretation in some situations
may be most appropriate. This means that it depends on situation(s) at
hand.
If white noise is approximation to continuously uctuating noise with
nite memory (much shorter than dynamical timescales), appropriate
representation is Stratonovich (Wong and Zakai, 1969)
If white noise approximates set of discrete pulses with nite separation
to which system responds, or SDE continuous approximation to discrete
system, then Ito representation appropriate.
NB: In Stratonovich DE classical dierential calculus can be applied but
not in Ito DE.
13
Transformation from Ito to stratnonvich DE .
Let a physicsl system be dened by Ito SDEs
dX
t
= (X
t
, t)dt +(X
t
, t)dW
t
, (10)
then the same process can be described also with Stratonovich equation
dX
t
=
_
(X
t
, t)
1
2
(X
t
, t)(X
t
, t)
_
dt +(X
t
, t)dW
t
(11)
where
(X
t
, t) =
(X
t
,t)
x
. But if Equation (10) dene Stratonovich SDE,
then, Ito SDE becomes
dX
t
=
_
(X
t
, t) +
1
2
(X
t
, t)(X
t
, t)
_
dt +(X
t
, t)dW
t
(12)
14
Example: Geometric SDE
Let Ito DE be dened by
dX
t
= rX
t
dt +X
t
dW
t
, (13)
Then, we can nd Stratonovich DE using Equation (11). Let = rX
t
and
= X
t
, this implies that
2
)dt +rdW
t
.
Now the solution to the SDE can be found easily by classical DE, i.e,
separating the variables and integrating normally.
We get
X
t
= X
0
exp
_
(r
1
2
2
)t +rW
t
_
.
15
0 0.5 1 1.5 2 2.5 3
98
99
100
101
102
103
104
105
106
Time, t
S
t
o
c
k
p
r
i
c
e
Figure 2: Geometric Brownian motion. Where X
0
= 100, r=0.025 = 0.05
and W is random white noise, N(0,
1
50
)
16
Conclusion
This presentation have not tackle the multivariate aspect of Ito process
in SDE.
THANKYOU FOR
ATTENTION
17