Stochastic Modelling in Finance - It o Lemma and Quadratic variation

In the background reading the focus is placed on a small class of processes as things are easier here: Denition 0.1 (2.3.3). A stochastic process (Xt )t[0,T ] is a It o process if it is of the form
t t

Xt = X 0 +
0

s ds +
0

s dWs

where (t )t[0,T ] and (t )t[0,T ] are adapted stochastic processes which

T T

|s | ds <
0

and
0

|s |2 ds <

P a.s.

The rst condition implies that the ordinary (Riemann-Stieltjes) integral is welldened while the second ensures that the stochastic integral is well-dened. Theorem 0.2 (It o formula). Let (Xt )t0 be a continuous process and f : [0, T ] R R 1,2 be a C function. Then for t [0, T ]
t t

f (t, Xt ) = f (0, X0 ) +
0

ft (s, Xs ) ds +
0 f (t, x) x

1 fx (s, Xs ) dXs + 2 and ft (t, x) =

fxx (s, Xs ) d[X, X ]s

0

where ft (t, x) =

f (t, x), t

ft (t, x) =

2 f (t, x). x2

The nal term contains the quadratic variation term d[X, X ]s . Before giving some more facts about quadratic variation for those who did not take Stochastic calculus, lets see how the previous theorem works when (Xt )t0 is a It o process. Theorem 0.3 (2.3.5). Let (Xt )t0 be a It o process and f : [0, T ] R R be a C 1,2 function. Then for t [0, T ]
t t

f (t, Xt ) = f (0, X0 ) +
0 t

ft (s, Xs ) ds +
0

fx (s, Xs )s ds
t

+
0

1 fx (s, Xs )s dWs + 2

fxx (s, Xs )2 s ds
0 2 f (t, x). x2

where ft (t, x) =

f (t, x), t

fx (t, x) =

f (t, x) x

and fxx (t, x) =

So in this case d[X, X ]t = 2 t dt. The next result is quite useful as well Proposition 0.4 (Integration-by-parts). Suppose that (Xt )t0 and (Yt )t0 are continuous processes then
t t

Xt Yt = X0 Y0 +
0

Xs dYs +
0

Ys dXs + [Y, X ]s .

where [X, Y ]s is the quadratic covariation between X and Y . 1

Proof. You can prove this very simply by applying the It o formula to (Xt + Yt )2 , Xt2 and Yt2 and subtracting the latter two quantities from the rst. The extra term in the integration by parts formula is due to the presence of stochastic integrals which do not quite behave like ordinary (Riemann-Stieltjes) integrals. In fact the previous result is often used to dene the quadratic variation of any process X (this diers from the mesh based denition supplied by Goran in Stochastic calculus but the denitions are equivalent - see Theorem 23 in Chapter II of Protter Stochastic Integration and Dierential Equations, 2nd Ed. Springer (2005)). Denition 0.5. The Quadratic variation of a process X is dened as
t 2 [X, X ]t := Xt2 X0 2 0

Xs dXs

Similarly the quadratic covariation between two continuous processes X, Y is dened as t t [X, Y ]t := Xt Yt X0 Y0
0

Ys dXs
0

Xs dYs

The next result collects up a few properties of quadratic variation so that they dont get lost: Proposition 0.6 (Properties of Quadratic variation). Take X, Y to be adapted processes the quadratic variation (when it is well-dened) has the following properties (i) Symmetric [X, Y ]t = [Y, X ]t for all t 0 (ii) Polarisation identity 1 [X, Y ]t = ([X + Y, X + Y ]t [X, X ]t [Y, Y ]t ) 2 (iii) Linear form [X + Y, X ]t = [X, X ]t + [X, Y ]t (iv) Suppose that X is of nite variation (contains no It o integral) and Y is continuous and of innite variation then [X, Y ]t = 0 for all t 0. Example 0.7 (Abstract example of integration-by-parts). Suppose that (Xt1 )t0 and (Xt2 )t0 are It o processes with respect to the same Brownian motion so that
t t

t 0

Xt1

1 X0

+
0 t

1 s

ds +
0 t

1 s dWs 2 s dWs
0

2 Xt2 = X0 + 0

2 s ds +

in this case [X 1 , X 2 ]t =

t 0

1 1 s s ds and hence t

Xt1 Xt2 = X0 Y0 +
0 t

1 1 Xs (1 s ds + s dWs ) t 2 Xs (2 s 0

ds +

2 s

dWs ) +
0

2 1 s s ds.

where [X, Y ]s is the quadratic covariation between X and Y . A straightforward example Example 0.8. Find an expression for tWt where Wt is a Brownian motion. Suppose that 2 2 1 o processes with 1 Xt1 = t and Xt2 = Wt are It t = 1, t = 0, t = 0, t = 1 for all t 0. Thus using the previous example:
t t

tWt =
0

s dWs +
0

Ws ds.

because X 1 is nite variation so [X 1 , X 2 ]t = 0 for all t 0. Proposition 0.9 (Martingale generated by quadratic variation). Suppose that (Xt )t0 and (Yt )t0 are continuous local martingales with well-dened quadratic variations [X, X ] and [Y, Y ] then the process (Zt )t0 dened using Zt = Xt Yt [X, Y ]t is a martingale. In particular, if we take two Brownian motions (Wt )t0 and (Bt )t0 such that for each t 0 the random variable COV(Xt , Yt ) = E [Wt Bt ] = t then for > 0 the process (Wt Bt )t0 is a submartingale (and for < 0 the process (Wt Bt )t0 is a supermartingale) so according to the previous proposition Zt := Wt Bt t denes a process (Zt )t0 which a martingale and [W, B ]t = t. We use this property as the denition of correlated Brownian motions. Denition 0.10. Two Brownian motions (Wt )t0 and (Bt )t0 are correlated with correlation coecient [1, 1] if [B, W ]t = t t 0.

In particular, when COV(Xt , Yt ) = 0 for all t 0 the process (Wt Bt )t0 is a martingale and [W, B ]t = 0 for all t 0. This is the intuitive reason why quadratic variation of behaves similarly to the variance of the process. 3

Example 0.11. Some more useful examples: (i) Let (Xt )t0 be dened via Xt =
t 0

Hs dWs for all t 0 where H L [0, T ] then

t

[X, X ]t =
0

Hs dWs ,
0 t 0

Hs dWs
t t 0

=
0

(Hs )2 ds.

(ii) Let (Yt )t0 be dened via Yt = then

Gs ds +

Hs dWs for all t 0 where H L [0, T ]

[Y, Y ]t =
0

Hs dWs ,
0

Hs dWs
t

+
0

Gs ds,
0

Gs ds
t

+2
0 t

Hs dWs ,
0

Gs ds
t

=
0

(Hs )2 ds.

where properties (ii) and (iv) from the previous proposition have been used. (iii) Let (Nt )t0 be a Poisson process with intensity > 0 then the quadratic variation of N is [N, N ]t = (Nt )2
0s<t

and since the jumps of the Poisson process all have size 1 it follows that [N, N ]t = Nt for all t 0. Next week with martingale measures we shall use that Nt t is a martingale which is a particular case of the following denition. Denition 0.12. The angle-bracket process associated with an adapted process (Xt )t0 , denoted ( X, X t )t0 is dened as the predictable process such that Zt := [X, X ]t X, X denes a process (Zt )t0 which is a martingale. In the case that (Xt )t0 is an It o processes (and in particular Brownian motion) it follows that X, X t = [X, X ]t for all t 0. Whereas, in the case of the Poisson process (Nt )t0 we have N, N t = t for all t 0. Additional facts about Quadratic variation can be found in Chapter II of Protter Stochastic Integration and Dierential Equations, 2nd Ed. Springer (2005)
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