RMS 4005 Tutorial 10

26-27/Nov/2013
Part 1: Ito Integral
The stochastic integral of

T
0
W
t
()dW
t
() is dened as
lim
n
n1

j=0
W(t
j
)(W(t
j+1
) W(t
j
)).
By choosing dierent points within each subinterval of the partition with
which to approximate the integrand over the subinterval we obtain the same
limit in the classical theory. However, in the stochastic theory this is no
longer the case, as you can see in the following exercise.
[Exercise 6.1]
Let 0 = t
n
0
< t
n
1
< . . . < t
n
n
= T be a partition of the interval [0, T] into
n equal parts. Find the limit
(a) lim
n

n1
j=0
W(t
n
j
)(W(t
n
j+1
) W(t
n
j
));
(b) lim
n

n1
j=0
W(t
n
j+1
)(W(t
n
j+1
) W(t
n
j
));
(c) lim
n

n1
j=0
W((1 p)t
n
j
+ pt
n
j+1
)(W(t
n
j+1
) W(t
n
j
)), for p (0, 1).
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Part 2: Itos Lemma
[Exercise 6.8]
Show that the exponential martingale X
t
= exp{W
t
t/2} satises
dX
t
= X
t
dW
t
.
[Exercise 6.9]
Show that the initial value problem dX
t
= aX
t
dt + bX
t
dW
t
and X
0
= x
0
has a solution given by
X
t
= x
0
exp{(a
b
2
2
)t + bW
t
}.
2
[Exercise 6.12]
Use Itos Lemma to compute E(W
6
t
).
3
[An old exam question]
Suppose the Sterling price of an asset follows the stochastic dierential equa-
tion
dS
t
=
1
S
t
dt +
1
S
t
dW
t
and the dollar cost of 1 Sterling at time t is E
t
where
dE
t
=
2
E
t
dt +
2
E
t
d

W
t
.
Here {W
t
}
t0
and {

W
t
}
t0
are Brownian motions with
E[(W
t
W
s
)(

W
t


W
s
)] =

t
s
(u)du
for some deterministic function (u) > 0.
(a) If the riskless interest rate is in the UK market, nd the stochas-
tic dierential equation for the discounted asset price in the Sterling
market.
(b) What is the covariation process [S, E]
t
?
(c) If the riskless interest rate is s in the dollar market, nd the stochastic
dierential equation for the discounted asset price in the dollar market.
(d) For what values of the parameters are the discounted asset prices mar-
tingales in each market?
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