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Chapter 4

Brownian Motion and Stochastic Calculus


The modeling of random assets in nance is based on stochastic processes,
which are families (X
t
)
tI
of random variables indexed by a time interval I. In
this chapter we present a description of Brownian motion and a construction
of the associated Ito stochastic integral.
4.1 Brownian Motion
First of all we recall the denition of Brownian motion, which is a funda-
mental example of a stochastic process. Here we work on a probability space
(, T, P), where = (
0
(R
+
) is the space of continuous real-valued functions
on R
+
started at 0.
Denition 4.1. The standard Brownian motion is a stochastic process (B
t
)
tR+
such that
(i) B
0
= 0 almost surely,
(ii) The sample trajectories t B
t
are continuous, with probability 1.
(iii) For any nite sequence of times t
0
< t
1
< < t
n
, the increments
B
t1
B
t0
, B
t2
B
t1
, . . . , B
tn
B
tn1
are independent.
(iv) For any times 0 s < t, B
t
B
s
is normally distributed with mean
zero and variance t s.
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In particular, Condition (iv) above implies
IE[B
t
B
s
] = 0 and Var[B
t
B
s
] = t s, 0 s t.
In the sequel the ltration (T
t
)
tR+
will be generated by the Brownian paths
up to time t, i.e.
T
t
= (B
s
: 0 s t), t 0. (4.1)
A random variable F is said to be T
t
-measurable if the knowledge of F
depends only on the information known up to time t. As an example, if
t =today,
- the date of the previous MA5182 exam is T
t
-measurable, because it be-
longs to the past.
- the date of the next Chinese new year, although it refers to a future
event, is also T
t
-measurable because it is known at time t.
- the date of the next typhoon is not T
t
-measurable since it is not known
at time t.
- the maturity date T of a European option is T
t
-measurable for all t R
+
,
because it has been determined at time 0.
- the exercise date of an American option after time t (see Section 9.2)
is not T
t
-measurable because it refers to a future random event.
Property (iii) above shows that B
t
B
s
is independent of all Brownian in-
crements taken before time s, i.e.
(B
t
B
s
) (B
t1
B
t0
, B
t2
B
t1
, . . . , B
tn
B
tn1
),
0 t
0
t
1
t
n
s t, hence B
t
B
s
is also independent of the
whole Brownian history up to time s, hence B
t
B
s
is in fact independent
of T
s
, s 0.
We refer to Theorem 10.28 of [22] and to Chapter 1 of [55] for the proof of
the existence of Brownian motion as a stochastic process (B
t
)
tR+
satisfying
the above properties (i)-(iv).
For convenience we will informally regard Brownian motion as a random walk
over innitesimal time intervals of length t, with increments B
t
over the
time interval [t, t +t] given by
B
t
=

t (4.2)
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Notes on Stochastic Finance
with equal probabilities (1/2, 1/2).
Note that the choice of the square root in (4.2) is not fortuitous. Indeed, any
choice of (t)

with a power > 1/2 would lead to explosion of the process


as dt tends to zero, whereas a power (0, 1/2) would lead to a vanishing
process.
Note that we have
IE[B
t
] =
1
2

t
1
2

t = 0,
and
Var[B
t
] = IE[(B
t
)
2
] =
1
2
t +
1
2
t = t.
According to this representation, the paths of Brownian motion are not dif-
ferentiable, although they are continuous by Property (ii), as we have
dB
t
dt

dt
dt
=
1

dt
. (4.3)
Recall that from the central limit theorem, given any sequence (X
k
)
k1
of
independent identically distributed centered random variables with variance

2
, the normalized sum
X
1
+ +X
n

n
converges (in distribution) to a centered Gaussian random variable A(0,
2
)
with variance
2
as n goes to innity.
After splitting the interval [0, T] into N intervals
_
k 1
N
T,
k
N
T
_
, k = 1, . . . , N,
of length t = T/N with N large and letting
X
k
=

T =

t =

NB
t
with probabilities (1/2, 1/2), i.e.
2
= V ar(X
k
) = T and
B
t
=
X
k

N
=

t
is the increment of B
t
over ((k 1)t, kt], and we get
B
T

0<t<T
B
t

X
1
+ +X
N

N
.
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N. Privault
Hence by the central limit theorem we recover the fact that B
T
has a centered
Gaussian distribution with variance T, cf. point (iv) of the above denition
of Brownian motion. Note that in the above description, B
t
could in fact
be replaced by any centered random variable with variance t.
Note that there is no point in computing the value of B
t
as it is a random
variable for all t > 0, however we can generate samples of B
t
, which are
distributed according to the centered Gaussian distribution with variance t.
Below we draw three sample paths of a standard Brownian motion obtained
by computer simulation using (4.2).
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
0 0.2 0.4 0.6 0.8 1
B
t
Fig. 4.1: Sample paths of one-dimensional Brownian motion.
The n-dimensional Brownian motion can be constructed as (B
1
t
, . . . , B
n
t
)
tR+
where (B
1
t
)
tR+
, . . .,(B
n
t
)
tR+
are independent copies of (B
t
)
tR+
.
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5
Fig. 4.2: Two sample paths of a two-dimensional Brownian motion.
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Notes on Stochastic Finance
Next we turn to simulations of 2 dimensional and 3 dimensional Brownian
motions. Recall that the movement of pollen particles originally observed by
R. Brown in 1827 was indeed 2-dimensional.
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
Fig. 4.3: Sample paths of a three-dimensional Brownian motion.
4.2 Wiener Stochastic Integral
In this section we construct the Ito stochastic integral of square-integrable
deterministic function with respect to Brownian motion.
Recall that Bachelier originally modeled the price S
t
of a risky asset by
S
t
= B
t
where is a volatility parameter. The stochastic integral
_
T
0
f(t)dS
t
=
_
T
0
f(t)dB
t
can be used to represent the value of a portfolio as a sum of prots and
losses f(t)dS
t
where dS
t
represents the stock price variation and f(t) is the
quantity invested in the asset S
t
over the short time interval [t, t +dt].
A naive denition of the stochastic integral with respect to Brownian motion
would consist in writing
_

0
f(t)dB
t
=
_

0
f(t)
dB
t
dt
dt,
and evaluating the above integral with respect to dt. However this denition
fails because the paths of Brownian motion are not dierentiable, cf. (4.3).
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N. Privault
Next we present Itos construction of the stochastic integral with respect to
Brownian motion. Stochastic integrals will be rst constructed as integrals
of simple step functions of the form
f(t) =
n

i=1
a
i
1
(ti1,ti]
(t), t R
+
, (4.4)
i.e. the function f takes the value a
i
on the interval (t
i1
, t
i
], i = 1, . . . , n,
with 0 t
0
< < t
n
, as illustrated in Figure 4.1.
T
f
E
t
0
a
1
t
1
a
2
t
2
t
3
t
4
a
4
t
Fig. 4.1: Step function.
Note that the set of simple step functions f of the form (4.4) is a linear space
which is dense in L
2
(R
+
) for the norm | |
L
2
(R+)
.
Recall also that the classical integral of f given in (4.4) is interpreted as the
area under the curve f and computed as
_

0
f(t)dt =
n

i=1
a
i
(t
i
t
i1
).
In the next denition we adapt this construction to the setting of integration
with respect to Brownian motion.
Denition 4.2. The stochastic integral with respect to Brownian motion
(B
t
)
tR+
of the simple step functions f of the form (4.4) is dened by
_

0
f(t)dB
t
:=
n

i=1
a
i
(B
ti
B
ti1
). (4.5)
In the next proposition we determine the probability distribution of
_

0
f(t)dB
t
and we show that it is independent of the particular representation (4.4) cho-
sen for f(t).
In the sequel we will make use of the space L
2
(R
+
) of functions f : R
+
R
such that
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Notes on Stochastic Finance
|f|
2
L
2
(R+)
:=
_

0
[f(t)[
2
dt < ,
called square-integrable functions.
Proposition 4.1. The denition of the stochastic integral
_

0
f(t)dB
t
can
be extended to any measurable function f L
2
(R
+
), i.e. to f such that
_

0
[f(t)[
2
dt < . (4.6)
In this case,
_

0
f(t)dB
t
has a centered Gaussian distribution
_

0
f(t)dB
t
A
_
0,
_

0
[f(t)[
2
dt
_
with variance
_

0
[f(t)[
2
dt and we have the Ito isometry
IE
_
__

0
f(t)dB
t
_
2
_
=
_

0
[f(t)[
2
dt. (4.7)
Proof. Recall that if X
1
, . . . , X
n
are independent Gaussian random variables
with probability laws A(m
1
,
2
1
), . . . , A(m
n
,
2
n
) then then sum X
1
+ +X
n
is a Gaussian random variable with probability law A(m
1
+ + m
n
,
2
1
+
+
2
n
).
As a consequence, when f is the simple function
f(t) =
n

i=1
a
i
1
(ti1,ti]
(t), t R
+
,
the sum
_

0
f(t)dB
t
=
n

k=1
a
k
(B
t
k
B
t
k1
)
has a centered Gaussian distribution with variance
n

k=1
[a
k
[
2
(t
k
t
k1
),
since
var [a
k
(B
t
k
B
t
k1
)] = a
2
k
var [B
t
k
B
t
k1
] = a
2
k
(t
k
t
k1
),
hence the stochastic integral
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N. Privault
_

0
f(t)dB
t
=
n

k=1
a
k
(B
t
k
B
t
k1
)
of the step function
f(t) =
n

k=1
a
k
1
(t
k1
,t
k
]
(t)
has a centered Gaussian distribution with variance
var
__

0
f(t)dB
t
_
=
n

k=1
[a
k
[
2
(t
k
t
k1
)
=
n

k=1
[a
k
[
2
_
t
k
t
k1
dt
=
_

0
n

k=1
[a
k
[
2
1
(t
k1
,t
k
]
(t)dt
=
_

0
[f(t)[
2
dt.
Finally we note that
var
__

0
f(t)dB
t
_
= IE
_
__

0
f(t)dB
t
_
2
_

_
IE
__

0
f(t)dB
t
__
2
= IE
_
__

0
f(t)dB
t
_
2
_
.
The extension of the stochastic integral to all functions satisfying (4.6) is
obtained by density and a Cauchy sequence argument, applying the isometry
(4.7). Namely, given f a function satisfying (4.6) and (f
n
)
nN
a sequence of
simple functions converging to f for the norm
|f f
n
|
L
2
(R+)
:=
__

0
[f(t) f
n
(t)[
2
dt
_
1/2
i.e. in L
2
(R
+
), the isometry (4.7) shows that
__

0
f
n
(t)dB
t
_
nN
is a Cauchy
sequence in the space L
2
() of square-integrable random variables F : R
such that
|F|
2
L
2
(R+)
:= IE[F
2
] < .
Indeed, we have
_
_
_
_
_

0
f
k
(t)dB
t

_

0
f
n
(t)dB
t
_
_
_
_
L
2
()
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Notes on Stochastic Finance
=
_
IE
_
__

0
f
k
(t)dB
t

_

0
f
n
(t)dB
t
_
2
__
1/2
= |f
k
f
n
|
L
2
(R+)
|f f
k
|
L
2
(R+)
+|f f
n
|
L
2
(R+)
,
which tends to 0 as k, n tend to innity, hence
__

0
f
n
(t)dB
t
_
nN
is it con-
verges for the L
2
-norm as L
2
() is a complete space, cf. e.g. Chapter 4 of
[17]. In this case we let
_

0
f(t)dB
t
:= lim
n
_

0
f
n
(t)dB
t
and the limit is unique from (4.7).
For example,
_

0
e
t
dB
t
has a centered Gaussian distribution with variance
_

0
e
2t
dt =
_

1
2
e
2t
_

0
=
1
2
.
Again, the Wiener stochastic integral
_

0
f(s)dB
s
is nothing but a Gaussian
random variable and it can not be computed in the way standard integral
are computed via the use of primitives.
However we have the following formula
_

0
f(t)dB
t
=
_

0
f

(t)B
t
dt,
provided f L
2
(R
+
) is (
1
on R
+
, such that lim
t
t[f(t)[
2
= 0 and
lim
t
f(t)
_
t
0
f(s)ds = 0,
cf. Remark 2.5.9 in [48].
4.3 It o Stochastic Integral
In this section we extend the Wiener stochastic integral to square-integrable
adapted processes. More precisely, a process (X
t
)
tR+
is said to be T
t
-adapted
if X
t
is T
t
-measurable for all t R
+
, where the information ow (T
t
)
tR+
has been dened in (4.1).
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N. Privault
In other words, a process (X
t
)
tR+
is T
t
-adapted if the value of X
t
at time
t depends only on information known up to time t. Note that the value of
X
t
may still depend on to future data, for example a xed future date in the
calendar, such as a maturity time T > t, since its value is known at time t.
The extension of the stochastic integral to adapted random processes is actu-
ally necessary in order to compute a portfolio value when the portfolio process
is no longer deterministic. This happens in particular when one needs to up-
date the portfolio allocation based on random events occurring on the market.
Stochastic integrals will be rst constructed as integrals of simple predictable
processes (u
t
)
tR+
of the form
u
t
=
n

i=1
F
i
1
(ti1,ti]
(t), t R
+
, (4.8)
where F
i
is an T
t
n
i1
-measurable random variable for i = 1, . . . , n. The notion
of simple predictable process is natural in the context of portfolio investment,
in which F
i
will represent an investment allocation decided at time t
i1
and
to remain unchanged over the time period [t
i1
, t
i
].
By convention, u : R
+
R is denoted by u
t
(), t R
+
, , and the
random outcome is often dropped for convenience of notation.
Denition 4.3. The stochastic integral with respect to Brownian motion
(B
t
)
tR+
of any simple predictable process (u
t
)
tR+
of the form (4.8) is de-
ned by
_

0
u
t
dB
t
:=
n

i=1
F
i
(B
ti
B
ti1
). (4.9)
The next proposition gives the extension of the stochastic integral from sim-
ple predictable processes to square-integrable adapted processes.
In other words, (X
t
)
tR+
is T
t
-adapted when the value of X
t
at time t only
depends on information contained in the Brownian path up to time t. This
also means that knowing the future is not permitted in the denition of the
Ito integral, for example a portfolio strategy that would allow the trader to
buy at the lowest and sell at the highest is not possible.
Note that the dierence between Relation (4.10) below and Relation (4.7) is
the expectation on the right hand side.
Proposition 4.2. The stochastic integral with respect to Brownian motion
(B
t
)
tR+
extends to all adapted processes (u
t
)
tR+
such that
IE
__

0
[u
t
[
2
dt
_
< ,
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Notes on Stochastic Finance
with the Ito isometry
IE
_
__

0
u
t
dB
t
_
2
_
= IE
__

0
[u
t
[
2
dt
_
. (4.10)
Proof. We start by showing that the Ito isometry (4.10) holds for the simple
predictable process u of the form (4.8). We have
IE
_
__

0
u
t
dB
t
_
2
_
= IE
_
_
_
n

i=1
F
i
(B
ti
B
ti1
)
_
2
_
_
= IE
_
_
n

i,j=1
F
i
F
j
(B
ti
B
ti1
)(B
tj
B
tj1
)
_
_
= IE
_
n

i=1
[F
i
[
2
(B
ti
B
ti1
)
2
_
+2 IE
_
_

1i<jn
F
i
F
j
(B
ti
B
ti1
)(B
tj
B
tj1
)
_
_
=
n

i=1
IE[IE[[F
i
[
2
(B
ti
B
ti1
)
2
[T
ti1
]]
+2

1i<jn
IE[IE[F
i
F
j
(B
ti
B
ti1
)(B
tj
B
tj1
)[T
tj1
]]
=
n

i=1
IE[[F
i
[
2
IE[(B
ti
B
ti1
)
2
[T
ti
]]
+2

1i<jn
IE[F
i
F
j
(B
ti
B
ti1
) IE[(B
tj
B
tj1
)[T
tj1
]]
=
n

i=1
IE[[F
i
[
2
IE[(B
ti
B
ti1
)
2
]]
+2

1i<jn
IE[F
i
F
j
(B
ti
B
ti1
) IE[(B
tj
B
tj1
)]]
=
n

i=1
IE[[F
i
[
2
(t
i
t
i1
)]
= IE
_
n

i=1
[F
i
[
2
(t
i
t
i1
)
_
= IE
__

0
[u
t
[
2
dt
_
,
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N. Privault
where we used the tower property of conditional expectations and the facts
that B
ti
B
ti1
is independent of T
ti1
and
IE[B
ti
B
ti1
] = 0, IE
_
(B
ti
B
ti1
)
2

= t
i
t
i1
, i = 1, . . . , n.
The extension of the stochastic integral to square-integrable adapted pro-
cesses (u
t
)
tR+
is obtained as in Proposition 4.1 by density and a Cauchy se-
quence argument using the isometry (4.10), in the same way as in the proof
of Proposition 4.1. Let L
2
( R
+
) denote the space of square-integrable
stochastic processes u : R
+
R such that
|u|
2
L
2
(R+)
:= IE
__

0
[u
t
[
2
dt
_
< .
By Lemma 1.1 of Ikeda and Watanabe [30], p. 22 and p. 46, or Proposi-
tion 2.5.3 of [48], the set of simple predictable processes forms a linear space
which is dense in the subspace L
2
ad
( R
+
) of square-integrable adapted
processes. In other words, given u a square-integrable adapted process there
exists a sequence (u
n
)
nN
of simple predictable processes converging to u in
L
2
( R
+
), and the isometry (4.10) shows that
__
u
n
t
dB
t
_
nN
is a Cauchy
sequence in L
2
(), hence it converges in the complete space L
2
(). In this
case we let
_

0
u
t
dB
t
:= lim
n
_

0
u
n
t
dB
t
and the limit is unique from (4.10).
In addition, the Ito integral of an adapted process (u
t
)
tR+
is always a cen-
tered random variable:
IE
__

0
u
s
dB
s
_
= 0. (4.11)
Note also that the Ito isometry (4.10) can also be written as
IE
__

0
u
t
dB
t
_

0
v
t
dB
t
_
= IE
__

0
u
t
v
t
dt
_
,
for all square-integrable adapted processes u, v.
In addition, when the integrand (u
t
)
tR+
is not a deterministic function, the
random variable
_

0
u
s
dB
s
no longer has a Gaussian distribution, except in
some exceptional cases.
The stochastic integral of u over the interval [a, b] is dened as
_
b
a
u
t
dB
t
:=
_

0
1
[a,b]
(t)u
t
dB
t
.
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In particular we have
_

0
1
[a,b]
(t)dB
t
= B
b
B
a
, 0 a b,
and
_
b
a
dB
t
= B
b
B
a
, 0 a b.
We also have the Chasles relation
_
c
a
u
t
dB
t
=
_
b
a
u
t
dB
t
+
_
c
b
u
t
dB
t
, 0 a b c,
and the stochastic integral has the following linearity property:
_

0
(u
t
+v
t
)dB
t
=
_

0
u
t
dB
t
+
_

0
v
t
dB
t
, u, v L
2
(R
+
).
In the sequel we wish to dene the return at time t R
+
of the risky asset
(S
t
)
tR+
as
dS
t
S
t
= dt +dB
t
.
This equation can be formally rewritten in integral form as
S
T
= S
0
+
_
T
0
S
t
dt +
_
T
0
S
t
dB
t
,
hence the need to dene an integral with respect to dB
t
, in addition to the
usual integral with respect to dt.
In the previous chapter we have dened the stochastic integral of square-
integrable processes with respect to Brownian motion, thus we have made
sense of the equation
S
T
= S
0
+
_
T
0
S
t
dt +
_
T
0
S
t
dB
t
,
which can be rewritten in dierential form as
dS
t
= S
t
dt +S
t
dB
t
,
or
dS
t
S
t
= dt +dB
t
. (4.12)
This model will be used to represent the random price S
t
of a risky asset at
time t. Here the return dS
t
/S
t
of the asset is made of two components: a con-
stant return dt and a random return dB
t
parametrized by the coecient
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N. Privault
, called the volatility.
Our goal is now to solve Equation (4.12) and for this we need to introduce
Itos calculus.
4.4 Deterministic Calculus
The fundamental theorem of calculus states that for any continuously dier-
entiable (deterministic) function f we have
f(x) = f(0) +
_
x
0
f

(y)dy.
In dierential form this relation is written as the rst order expansion
df(x) = f

(x)dx, (4.13)
where dx is small. Higher order expansions can be obtained from Taylors
formula, which, letting
df(x) = f(x +dx) f(x),
states that
df(x) = f

(x)dx +
1
2
f

(x)(dx)
2
+
1
3!
f

(x)(dx)
3
+
1
4!
f
(4)
(x)(dx)
4
+ .
Note that Relation (4.13) can be obtained by neglecting the terms of order
larger than one in Taylors formula, since (dx)
n
<< dx when n 2 and dx
is small.
4.5 Stochastic Calculus
Let us apply Taylors formula to Brownian motion, taking
dB
t
= B
t+dt
B
t
,
and letting
df(B
t
) = f(B
t+dt
) f(B
t
),
we have
df(B
t
) = f

(B
t
)dB
t
+
1
2
f

(B
t
)(dB
t
)
2
+
1
3!
f

(B
t
)(dB
t
)
3
+
1
4!
f
(4)
(B
t
)(dB
t
)
4
+ .
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From the construction of Brownian motion by its small increments dB
t
=

dt, it turns out that the terms in (dt)


2
and dtdB
t
= (dt)
3/2
can be ne-
glected in Taylors formula at the rst order of approximation in dt. However,
the term of order two
(dB
t
)
2
= (

dt)
2
= dt
can no longer be neglected in front of dt.
Hence Taylors formula written at the second order for Brownian motion
reads
df(B
t
) = f

(B
t
)dB
t
+
1
2
f

(B
t
)dt, (4.14)
for small dt. Note that writing this formula as
df(B
t
)
dt
= f

(B
t
)
dB
t
dt
+
1
2
f

(B
t
)
does not make sense because the derivative
dB
t
dt

dt
dt

1

dt

does not exist.
Integrating (4.14) on both sides from the relation
f(B
t
) f(B
0
) =
_
t
0
df(B
s
)
we get the integral form of Itos formula for Brownian motion, i.e.
f(B
t
) = f(B
0
) +
_
t
0
f

(B
s
)dB
s
+
1
2
_
t
0
f

(B
s
)ds.
We now turn to the general expression of Itos formula which applies to Ito
processes of the form
X
t
= X
0
+
_
t
0
v
s
ds +
_
t
0
u
s
dB
s
, t R
+
, (4.15)
or in dierential notation
dX
t
= v
t
dt +u
t
dB
t
,
where (u
t
)
tR+
and (v
t
)
tR+
are square-integrable adapted processes.
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N. Privault
Given f(t, x) a smooth function of two variables, from now on we let
f
x
denote partial dierentiation with respect to the second variable, while
f
s
denote partial dierentiation with respect to the rst (time) variable.
Theorem 4.1. (Ito formula for Ito processes). For any Ito process (X
t
)
tR+
of the form (4.15) and any f (
1,2
(R
+
R) we have
f(t, X
t
) = f(0, X
0
) +
_
t
0
v
s
f
x
(s, X
s
)ds +
_
t
0
u
s
f
x
(s, X
s
)dB
s
+
_
t
0
f
s
(s, X
s
)ds +
1
2
_
t
0
[u
s
[
2

2
f
x
2
(s, X
s
)ds. (4.16)
Proof. cf. [54].
Using the relation
_
t
0
df(s, X
s
) = f(t, X
t
) f(0, X
0
),
we get
_
t
0
df(s, X
s
) =
_
t
0
v
s
f
x
(s, X
s
)ds +
_
t
0
u
s
f
x
(s, X
s
)dB
s
+
_
t
0
f
s
(s, X
s
)ds +
1
2
_
t
0
[u
s
[
2

2
f
x
2
(s, X
s
)ds,
which allows us to rewrite Itos formula (4.16) in dierential notation as
df(t, X
t
) =
f
t
(t, X
t
)dt+u
t
f
x
(t, X
t
)dB
t
+v
t
f
x
(t, X
t
)dt+
1
2
[u
t
[
2

2
f
x
2
(t, X
t
)dt,
(4.17)
or
df(t, X
t
) =
f
t
(t, X
t
)dt +
f
x
(t, X
t
)dX
t
+
1
2
[u
t
[
2

2
f
x
2
(t, X
t
)dt.
Next, given two processes (X
t
)
tR+
and (Y
t
)
tR+
written as
X
t
= X
0
+
_
t
0
v
s
ds +
_
t
0
u
s
dB
s
, t R
+
,
and
Y
t
= Y
0
+
_
t
0
b
s
ds +
_
t
0
a
s
dB
s
, t R
+
,
the Ito formula also shows that
d(X
t
Y
t
) = X
t
dY
t
+Y
t
dX
t
+dX
t
dY
t
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Notes on Stochastic Finance
where the product dX
t
dY
t
is computed according to the Ito rule
(dt)
2
= 0, dtdB
t
= 0, (dB
t
)
2
= dt, (4.18)
i.e.
dX
t
dY
t
= (v
t
dt +u
t
dB
t
)(b
t
dt +a
t
dB
t
)
= b
t
v
t
(dt)
2
+u
t
b
t
dtdB
t
+v
t
a
t
dtdB
t
+u
t
a
t
(dB
t
)
2
= u
t
a
t
dt.
Hence we have
(dX
t
)
2
= (v
t
dt +u
t
dB
t
)
2
= (v
t
)
2
(dt)
2
+ (u
t
)
2
(dB
t
)
2
+ 2u
t
v
t
dt dB
t
= (u
t
)
2
dt,
according to the Ito multiplication table
dt dB
t
dt 0 0
dB
t
0 dt
and (4.17) can also be rewriten as
df(t, X
t
) =
f
t
(t, X
t
)dt +
f
x
(t, X
t
)dX
t
+
1
2

2
f
x
2
(t, X
t
)(dX
t
)
2
.
Taking u
t
= 1 and v
t
= 0 in (4.15) yields X
t
= B
t
, in which case the Ito
formula (4.16) reads
f(t, B
t
) = f(0, B
0
)+
_
t
0
f
s
(s, B
s
)ds+
_
t
0
f
x
(s, B
s
)dB
s
+
1
2
_
t
0

2
f
x
2
(s, B
s
)ds,
i.e. in dierential form:
df(t, B
t
) =
f
t
(t, B
t
)dt +
f
x
(t, B
t
)dB
t
+
1
2

2
f
x
2
(t, B
t
)dt. (4.19)
As another example, applying Itos formula (4.19) to B
2
t
with
B
2
t
= f(t, B
t
) and f(t, x) = x
2
,
we get
dB
2
t
= df(B
t
)
=
f
t
(t, B
t
)dt +
f
x
(t, B
t
)dB
t
+
1
2

2
f
x
2
(t, B
t
)dt
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N. Privault
= 2B
t
dB
t
+dt,
since
f
t
(t, x) = 0,
f
x
(t, x) = 2x, and
1
2

2
f
x
2
(t, x) = 1,
hence by integration we nd
B
2
T
= B
0
+ 2
_
T
0
B
s
dB
s
+
_
T
0
dt
= 2
_
T
0
B
s
dB
s
+T,
and
_
T
0
B
s
dB
s
=
B
2
T
2

T
2
.
We close this section with some comments on the practice of Itos calculus.
In many nance textbooks, Itos formula for e.g. geometric Brownian motion
can be found written as
f(T, S
T
) = f(0, X
0
) +
_
T
0
S
t
f
S
t
(t, S
t
)dB
t
+
_
T
0
S
t
f
S
t
(t, S
t
)dt
+
_
T
0
f
t
(t, S
t
)dt +
1
2

2
_
T
0
S
2
t

2
f
S
2
t
(t, S
t
)dt,
or
df(S
t
) = S
t
f
S
t
(S
t
)dB
t
+S
t
f
S
t
(S
t
)dt +
1
2

2
S
2
t

2
f
S
2
t
(S
t
)dt.
This expression can be easily confused with the fundamental theorem of clas-
sical calculus, which reads
df(S
t
) =
f
S
t
(S
t
)dS
t
= S
t
f
S
t
(S
t
)dB
t
+S
t
f
S
t
(S
t
)dt,
and leads here to a wrong expression. In other words, in classical dierential
calculus we have
df(x)
dg(x)
= lim
0
f(x +) f(x)
g(x +) g(x)
,
and in particular
df(x)
dx
= lim
0
f(x +) f(x)
(x +) x
= lim
0
f(x +) f(x)

,
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Notes on Stochastic Finance
whereas stochastic calculus relies on
df(S
t
)
dg(S
t
)
= lim
0
f(S
t+
) f(S
t
)
g(S
t+
) g(S
t
)
and in particular
df(B
t
)
dB
t
= lim
0
f(B
t+
) f(B
t
)
B
t+
B
t
.
To summarize, classical dierential calculus is a calculus in space:
df(x)
dx
= lim
0
f(x +) f(x)
(x +) x
,
and stochastic calculus is a dierential calculus in time:
df(B
t
)
dB
t
= lim
0
f(B
t+
) f(B
t
)
B
t+
B
t
.
Writing
df(B
t
)
dB
t
for
df
dx
(B
t
) = lim
0
f(B
t
+) f(B
t
)
(B
t
+) B
t
is a source of confusion, as
df(B
t
)
dB
t
is not equal to
df
dx
(B
t
):
df(B
t
)
dB
t
,=
df
dx
(B
t
). (4.20)
Writing
df(B
t
) =
df
dx
(B
t
)dB
t
+
1
2
d
2
f
dx
2
(B
t
)dt
is consistent, however, writing
df(B
t
) =
df(B
t
)
dB
t
dB
t
+
1
2
d
2
f(B
t
)
dB
2
t
dt
can be a source of confusion due to (4.20). In conclusion, stochastic calculus
is a dierential calculus df(B
t
)/dB
t
in time that uses classical dierential
calculus df(x)/dx in space.
4.6 Geometric Brownian Motion
Our aim in this section is to solve the stochastic dierential equation
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N. Privault
dS
t
= S
t
dt +S
t
dB
t
, (4.21)
where R and > 0. This equation is rewritten in integral form as
S
t
= S
0
+
_
t
0
S
s
ds +
_
t
0
S
s
dB
s
, t R
+
. (4.22)
It can be solved by applying Itos formula to f(S
t
) = log S
t
with f(x) = log x,
which shows that
d log S
t
= S
t
f

(S
t
)dt +S
t
f

(S
t
)dB
t
+
1
2

2
S
2
t
f

(S
t
)dt
= dt +dB
t

1
2

2
dt,
hence
log S
t
log S
0
=
_
t
0
d log S
r
=
_
t
0
_

1
2

2
_
dr +
_
t
0
dB
r
=
_

1
2

2
_
t +B
t
, t R
+
,
and
S
t
= S
0
exp
__

1
2

2
_
t +B
t
_
, t R
+
,
which proves the next proposition.
Proposition 4.3. The solution of (4.21) is given by
S
t
= S
0
e
t+Bt
2
t/2
, t R
+
.
Proof. Let us provide an alternative proof by searching for a solution of the
form
S
t
= f(t, B
t
)
where f(t, x) is a function to be determined.
By Itos formula (4.19) we have
dS
t
= df(t, B
t
) =
f
t
(t, B
t
)dt +
f
x
(t, B
t
)dB
t
+
1
2

2
f
x
2
(t, B
t
)dt.
Comparing this expression to (4.21) and identifying the terms in dB
t
we get
f
x
(t, B
t
) = S
t
,
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Notes on Stochastic Finance
and
f
t
(t, B
t
) +
1
2

2
f
x
2
(t, B
t
) = S
t
.
Using the relation S
t
= f(t, B
t
) these two equations rewrite as
f
x
(t, B
t
) = f(t, B
t
),
and
f
t
(t, B
t
) +
1
2

2
f
x
2
(t, B
t
) = f(t, B
t
).
Since B
t
is a Gaussian random variable taking all possible values in R, the
equations should hold for all x R, as follows:
f
x
(t, x) = f(t, x), (4.23)
and
f
t
(t, x) +
1
2

2
f
x
2
(t, x) = f(t, x). (4.24)
Letting g(t, x) = log f(t, x), the rst equation (4.23) shows that
g
x
(t, x) =
log f
x
(t, x) =
1
f(t, x)
f
x
(t, x) = ,
i.e.
g
x
(t, x) = ,
which is solved as
g(t, x) = g(t, 0) +x,
hence
f(t, x) = e
g(t,0)
e
x
= f(t, 0)e
x
.
Plugging back this expression into the second equation (4.24) yields
e
x
f
t
(t, 0) +
1
2

2
e
x
f(t, 0) = f(t, 0)e
x
,
i.e. after division by e
x
:
f
t
(t, 0) =
_

2
/2
_
f(t, 0),
or
g
t
(t, 0) =
2
/2,
i.e.
g(t, 0) = g(0, 0) +
_

2
/2
_
t,
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and
f(t, x) = e
g(t,x)
= e
g(t,0)+x
= e
g(0,0)+x+(
2
/2)t
= f(0, 0)e
x+(
2
/2)t
,
hence
S
t
= f(t, B
t
) = f(0, 0)e
Bt+(
2
/2)t
,
and the solution to (4.21) is given by
S
t
= S
0
e
Bt+(
2
/2)t
t R
+
.

Conversely, taking S
t
= f(t, B
t
) with f(t, x) = S
0
e
x
2
t/2+t
we may apply
Itos formula to check that
dS
t
= df(t, B
t
)
=
f
t
(t, B
t
)dt +
f
x
(t, B
t
)dB
t
+
1
2

2
f
x
2
(t, B
t
)dt
=
_

2
/2
_
S
0
e
Bt+(
2
/2)t
dt +S
0
e
Bt+(
2
/2)t
dB
t
+
1
2

2
S
0
e
Bt+(
2
/2)t
dt
= S
0
e
Bt+(
2
/2)t
dt +S
0
e
Bt+(
2
/2)t
dB
t
= S
t
dt +S
t
dB
t
.
4.7 Stochastic Dierential Equations
In addition to geometric Brownian motion there exists a large family of
stochastic dierential equations that can be studied.
Let now
: R
+
R
n
R
d
R
n
where R
d
R
n
denotes the space of d n matrices, and
b : R
+
R
n
R
satisfy the global Lipschitz condition
|(t, x) (t, y)|
2
+|b(t, x) b(t, y)|
2
K
2
|x y|
2
,
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Notes on Stochastic Finance
t R
+
, x, y R
n
.
Then there exists a unique strong solution to the stochastic dierential equa-
tion
X
t
= X
0
+
_
t
0
(s, X
s
)dB
s
+
_
t
0
b(s, X
s
)ds, t R
+
,
where (B
t
)
tR+
is a d-dimensional Brownian motion, cf. [54].
Examples
1. Consider the stochastic dierential equation
dX
t
= X
t
dt +dB
t
, X
0
= x
0
,
with > 0 and > 0.
Looking for a solution of the form
X
t
= a(t)
_
x
0
+
_
t
0
b(s)dB
s
_
where a() and b() are deterministic functions, yields
X
t
= x
0
e
t
+
_
t
0
e
(ts)
dB
s
, t > 0,
after applying Theorem 4.1 to the Ito process x
0
+
_
t
0
b(s)dB
s
of the form
(4.15) with u
t
= b(t) and v(t) = 0, and to the function f(t, x) = a(t)x.
Remark: the solution of this equation cannot be written as a function
f(t, B
t
) of t and B
t
as in the proof of Proposition 4.3.
2. Consider the stochastic dierential equation
dX
t
= tX
t
dt +e
t
2
/2
dB
t
, X
0
= x
0
.
Looking for a solution of the form X
t
= a(t)
_
X
0
+
_
t
0
b(s)dB
s
_
, where
a() and b() are deterministic functions we get a

(t)/a(t) = t and
a(t)b(t) = e
t
2
/2
, hence a(t) = e
t
2
/2
and b(t) = 1, which yields X
t
=
e
t
2
/2
(X
0
+B
t
), t R
+
.
3. Consider the stochastic dierential equation
dY
t
= (2Y
t
+
2
)dt + 2
_
Y
t
dB
t
,
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N. Privault
where , > 0.
Letting X
t
=

Y
t
we have dX
t
= X
t
dt +dB
t
, hence
Y
t
=
_
e
t
_
Y
0
+
_
t
0
e
(ts)
dB
s
_
2
.
4.8 Exercises
Exercise 4.1. Let (B
t
)
tR+
denote a standard Brownian motion.
1. Let c > 0. Among the following processes, tell which is a standard Brow-
nian motion and which is not. Justify your answer.
a. (B
c+t
B
c
)
tR+
.
b. (cB
t/c
2)
tR+
.
c. (B
ct
2)
tR+
.
2. Compute the stochastic integrals
_
T
0
2dB
t
and
_
T
0
(2 1
[0,T/2]
(t) +1
(T/2,T]
(t))dB
t
and determine their probability laws (including mean and variance).
3. Determine the probability law (including mean and variance) of the
stochastic integral
_
2
0
sin(t) dB
t
.
4. Compute IE[B
t
B
s
] in terms of s, t 0.
5. Let T > 0. Show that if f is a dierentiable function with f(0) = f(T) = 0
we have
_
T
0
f(t)dB
t
=
_
T
0
f

(t)B
t
dt.
Hint: Apply Itos calculus to t f(t)B
t
.
Exercise 4.2. Let f L
2
([0, T]). Compute the conditional expectation
E
_
e

T
0
f(s)dBs

T
t
_
, 0 t T,
where (T
t
)
t[0,T]
denotes the ltration generated by (B
t
)
t[0,T]
.
Exercise 4.3. Compute the expectation
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Notes on Stochastic Finance
E
_
exp
_

_
T
0
B
t
dB
t
__
for all < 1/T. Hint: expand (B
T
)
2
using Itos formula.
Exercise 4.4. Given T > 0, let (X
T
t
)
t[0,T]
denote the solution of the stochastic
dierential equation
dX
T
t
= dB
t

X
T
t
T t
dt, t [0, T],
under the initial condition X
T
0
= 0 and > 0.
1. Show that
X
T
t
= (T t)
_
t
0
1
T s
dB
s
, t [0, T].
Hint: Start by computing d(X
T
t
/(T t)) using Itos calculus.
2. Show that IE[X
T
t
] = 0 for all t [0, T].
3. Show that Var[X
T
t
] =
2
t(T t)/T for all t [0, T].
4. Show that X
T
T
= 0. The process (X
T
t
)
t[0,T]
is called a Brownian bridge.
Exercise 4.5. Exponential Vasicek model. Consider a short term rate interest
rate proces (r
t
)
tR+
in the exponential Vasicek model:
dr
t
= r
t
( a log r
t
)dt +r
t
dB
t
, (4.25)
where , a, are positive parameters.
1. Find the solution (z
t
)
tR+
of the stochastic dierential equation
dz
t
= az
t
dt +dB
t
as a function of the initial condition z
0
, where a and are positive pa-
rameters.
2. Find the solution (y
t
)
tR+
of the stochastic dierential equation
dy
t
= ( ay
t
)dt +dB
t
(4.26)
as a function of the initial condition y
0
. Hint: let z
t
= y
t
/a.
3. Let x
t
= e
yt
, t R
+
. Determine the stochastic dierential equation
satised by (x
t
)
tR+
.
4. Find the solution (r
t
)
tR+
of (4.25) in terms of the initial condition r
0
.
5. Compute the mean
1
E[r
t
] of r
t
, t 0.
6. Compute the asymptotic mean lim
t
E[r
t
].
1
You will need to use the formula E[e
X
] = e

2
/2
for X N(0,
2
).
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N. Privault
Exercise 4.6. Cox-Ingerson-Ross model. Consider the equation
dr
t
= ( r
t
)dt +

r
t
dB
t
(4.27)
modeling the variations of a short term interest rate process r
t
, where , ,
and r
0
are positive parameters.
1. Write down the equation (4.27) in integral form.
2. Let u(t) = E[r
t
]. Show, using the integral form of (4.27), that u(t) satises
the dierential equation
u

(t) = u(t).
3. By an application of Itos formula to r
2
t
, show that
dr
2
t
= r
t
(2 +
2
2r
t
)dt + 2r
3/2
t
dB
t
. (4.28)
4. Using the integral form of (4.28), nd a dierential equation satised by
v(t) = E[r
2
t
].
Exercise 4.7. Let (B
t
)
tR+
denote a standard Brownian motion generating
the ltration (T
t
)
tR+
.
1. Consider the Ito formula
f(X
t
) = f(X
0
)+
_
t
0
u
s
f
x
(X
s
)dB
s
+
_
t
0
v
s
f
x
(X
s
)ds+
1
2
_
t
0
u
2
s

2
f
x
2
(X
s
)ds,
(4.29)
where X
t
= X
0
+
_
t
0
u
s
dB
s
+
_
t
0
v
s
ds.
Compute S
t
:= e
Xt
by the Ito formula (4.29) applied to f(x) = e
x
and
X
t
= B
t
+t, > 0, R.
2. Let r > 0. For which value of does (S
t
)
tR+
satisfy the stochastic
dierential equation
dS
t
= rS
t
dt +S
t
dB
t
?
3. Let the process (S
t
)
tR+
be dened by S
t
= S
0
e
Bt+t
, t R
+
. Using
the result of Exercise 16.1, show that the conditional probability P(S
T
>
K [ S
t
= x) is given by
P(S
T
> K [ S
t
= x) =
_
log(x/K) +

_
,
where = T t. Hint: use the decomposition S
T
= S
t
e
(B
T
Bt)+
.
4. Given 0 t T and > 0, let
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Notes on Stochastic Finance
X = (B
T
B
t
) and
2
= Var[X], > 0.
What is equal to ?
Exercise 4.8. Let (B
t
)
tR+
be a standard Brownian motion generating the
information (T
t
)
tR+
.
1. Let 0 t T. What is the probability law of B
T
B
t
?
2. From the answer to Exercise 16.16-(2), show that
IE[(B
T
)
+
[T
t
] =
_

2
e

B
2
t
2
+B
t

_
B
t

_
, 0 t T,
where = T t. Hint: write B
T
= B
T
B
t
+B
t
.
3. Let > 0, R, and X
t
= B
t
+t. Compute e
Xt
using the Ito formula
f(X
t
) = f(X
0
)+
_
t
0
u
s
f
x
(X
s
)dB
s
+
_
t
0
v
s
f
x
(X
s
)ds+
1
2
_
t
0
u
2
s

2
f
x
2
(X
s
)ds
stated here for a process X
t
= X
0
+
_
t
0
u
s
dB
s
+
_
t
0
v
s
ds, t R
+
, and
applied to f(x) = e
x
.
4. Let S
t
= e
Xt
, t R
+
, and r > 0. For which value of does (S
t
)
tR+
satisfy the stochastic dierential equation
dS
t
= rS
t
dt +S
t
dB
t
?
Exercise 4.9. From the answer to Exercise 16.2-(2), show that
IE[( B
T
)
+
[T
t
] =
_

2
e

(B
t
)
2
2
+ ( B
t
)
_
B
t

_
, 0 t T,
where = T t. Hint: write B
T
= B
T
B
t
+B
t
.
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