5.

It o Calculus
Types of derivatives
Consider a function F(S
t
, t) depending on two
variables S
t
(say, price) and time t, where
variable S
t
itself varies with time t.
In standard calculus there are three types of
derivatives:
Partial derivative:
F
s
=
F(S
t
, t)
S
t
, F
t
=
F(S
t
, t)
t
. (1)
Total derivative:
dF = F
s
dS
t
+F
t
dt. (2)
Chain rule:
dF(S
t
, t)
dt
= F
s
dS
t
dt
+F
t
. (3)
1
Partial derivative are abstractions. Usually
they are called multipliers or marginal eects
(cf. the Greeks in option theory).
Total derivative describes the total change or
response in F as time t and S
t
change
The chain rule indicates the chain eects in
the change of the price S
t
and F as time
changes.
We will consider in this section stochastic
counterparts for the total dierential and chain
rule. Essentially as we will see the major dif-
ferences are that we have to interpret the dif-
ferential in stochastic processes via the stochas-
tic integral and that the second order term
(dS
t
)
2
is not negligible as in standard calcu-
lus.
2
Itos stochastic dierential equation
Itos lemma gives the stochastic version for
the chain rule.
Let
dS
t
= a(S
t
, t) dt +(S
t
, t) dW
t
. (4)
where a(S
t
, t) and (S
t
, t) are nonanticipating
and W
t
is the standard Brownian motion.
3
We interpret dS
t
via the stochastic integral
such that
_
t
0
dS
u
= S
t
S
0
, (5)
so that
S
t
= S
0
+
_
t
0
dS
u
=
_
t
0
a(S
u
, u) du +
_
t
0
(S
u
, u) dW
u
, (6)
where the rst integral is the usual Riemann
integral and the second one is the Ito inte-
gral.
4
Consider a function F(S
t
, t) (e.g. derivative
of a stock)
As time t changes by dt what is the total
eect on F(S
t
, t). The change is
t W
t
S
t
F(S
t
, t). (7)
The interest is dF(S
t
, t).
5
Suppose the observation interval of S
t
is [0, T].
Let 0 = t
0
< t
1
< < t
n
= T be a partition
with
h = t
k
t
k1
=
T
n
k = 1, . . . , n, (8)
so that T = nh.
Consider the nite dierence representation
of dS
t
S
k
= a
k
h +
k
W
k
, k = 1, . . . , n, (9)
with S
k
= S
t
k
S
t
k1
, a
k
= a(S
t
k1
, t
k
),
k
=
(S
k1
, t
k
), and W
k
= W
t
k
W
t
k1
.
6
Ito formula is derived using the Taylor expan-
sion of a smooth function.
If f(x) is such a function the Taylor expansion
around x
0
becomes
f(x) = f(x
0
) +f

(x
0
)(x x
0
) +
1
2
f

(x
0
)(x x
0
)
2
+R,
(10)
where R is the remainder.
7
For a function with two variables the Taylor
expansion is
F(S
t
k
, t
k
) = F(S
t
k1
, t
k
) +F
s
S
k
+F
t
h +
1
2
F
ss
(S
k
)
2
+
1
2
F
tt
h
2
+F
st
hS
k
+R.
(11)
Arranging terms
F
k
= F
s
S
k
+F
t
h +
1
2
F
ss
(S
k
)
2
+
1
2
F
tt
h
2
+F
st
hS
k
+R,
(12)
where
F
k
= F(S
t
k
, t
k
) F(S
t
k1
, t
k1
). (13)
8
As n , h = t
k
t
k1
dt, S
k
dS, and
F
k
dF, and R 0 because it consists of
terms (t
k
)
m
and (W
k
)
m
with m 3.
So we get
dF(S
t
, t) = F
s
dS
t
+F
t
dt +
1
2
F
ss
(dS
t
)
2
+
1
2
F
tt
(dt)
2
+F
st
dt dS
t
.
(14)
Using the calculation rules for the dieren-
tials, we obtain
dt dS
t
= dt (a(S
t
, t)dt +(S
t
, t) dW
t
)
= a(S
t
, t)(dt)
2
+(S
t
, t) dt dW
t
= 0,
(15)
because (dt)
2
= 0 and dt dW
t
= 0.
So we get
dF(S
t
, t) = F
s
dS
t
+F
t
dt +
1
2
F
ss
(dS
t
)
2
(16)
9
Remark 5.1: If S
t
is non-stochastic then (dS
t
)
2
= 0
and the above formula is just the total derivative dF =
F
s
dS +F
t
dt.
Replacing dS
t
with its Ito representation, we
have
dF(S
t
, t) = F
s
[a(S
t
, t) dt +(S
t
, t) dW
t
] +F
t
dt
+
1
2
F
ss
[a(S
t
, t) dt +(S
t
, t) dW
t
]
2
.
(17)
Using the innitesimal calculation rules again
yields
(dS
t
)
2
=
2
(S
t
, t) dt. (18)
Arranging terms, we obtain nally the fa-
mous Itos dierential formula
dF =
_
F
t
+a(S
t
, t)F
t
+
1
2

2
(S
t
, t)F
ss
_
dt +(S
t
, t) dW
t
.
(19)
10
The result is summarized as Itos Lemma:
Lemma 5.1: (Itos Lemma) Let F(S
t
, t) be a twice-
dierentiable function of t and of the random process
S
t
with Ito dierential equation
dS
t
= a
t
dt +
t
dW
t
, t 0,
with a
t
= a(S
t
, t) and
t
= (S
t
, t) continuously twice-
dierentiable (real valued) functions. Then
dF = F
s
dS
t
+F
t
dt +
1
2
F
ss

2
t
dt, (20)
or, after substituting for the right hand side of dS
t
above
dF =
_
F
s
a
t
+F
t
+
1
2
F
ss

2
_
dt +F
s

t
dW
t
, (21)
where
F
s
=
F
S
t
, F
t
=
F
t
, and F
ss
=

2
F
S
2
t
. (22)
11
The major usage of the Ito formula in -
nance is to nd the (Ito) stochastic dieren-
tial equation (SDE) for the nancial deriva-
tive once the (Ito) SDE of the underlying
asset is given.
12
Itos formula can be used also in some cases
to nd the stochastic integral itself.
Example 5.1: Let
F(W
t
, t) = W
2
t
. (23)
Using formula (16) with S
t
= W
t
we obtain
F
w
= W
2
/W = 2W, (24)
and
F
ww
=
2
F/W
2
= 2. (25)
Then because F
t
= 0,
dF(W
t
, t) = F
w
dW
t
+
1
2
F
ww
(dW
t
)
2
= dt +2W
t
dW
t
.
(26)
Thus the drift of F is a(F, t) = 1 and diusion param-
eter is (F, t) = 2W
t
.
13
Example 5.2:
F(W
t
, t) = 3 +t +e
W
t
. (27)
Using again Itos formula (16) with S
t
= W
t
dF(W
t
, t) = F
t
dt +F
w
dW
t
+
1
2
F
ww
(dW
t
)
2
= dt +e
W
t
dW
t
+
1
2
e
W
t
dt
=
_
1 +
1
2
e
W
t
_
dt +e
W
t
dW
t
.
(28)
14
Example 5.3: Consider the geometric Brownian mo-
tion
S
t
= S
0
e
{(
1
2

2
)t+ W
t
}
, (29)
where S
0
is a constant. Then using again Ito with
formula (20), and noting that (W
t
, t) = 1, we get
dS
t
=
S
t
W
t
dW
t
+
S
t
t
dt +
1
2

2
S
t
W
2
t
dt
= S
0
e
{(
1
2

2
)t+ W
t
}
dW
t
+(
1
2

2
)S
0
e
(
1
2

2
)t+ W
t
dt
+
1
2

2
S
0
e
(
1
2

2
)t+ W
t
dt
= S
t
dW
t
+(
1
2

2
)S
t
dt +
1
2

2
S
t
dt
= S
t
(dt + dW
t
),
(30)
or
dS
t
S
t
= dt +dW
t
, (31)
or
dS
t
= S
t
dt +S
t
dW
t
. (32)
Remark 5.2: Comparing to the general formula dS
t
=
a(S
t
, t)dt + (S
t
, t)dW
t
we nd that in (32) a(S
t
, t) =
S
t
, and (S
t
, t) = S
t
.
15
Itos formula as an integration tool
Suppose our task is to evaluate
_
t
0
W
s
dW
s
. (33)
Make a guess
F(W
t
, t) =
1
2
W
2
t
. (34)
Then using Ito
dF(W
t
, t) = W
t
dW
t
+
1
2
dt. (35)
The integral form is
1
2
W
2
t
= F(W
t
, t) =
_
t
0
dF(W
s
, s) =
_
t
0
W
s
dW
s
+
1
2
_
t
0
ds.
(36)
So
_
t
0
W
s
dW
s
=
1
2
W
2
t

1
2
t. (37)
The start o point here is to make a good
guess.
16
Example 5.4: Consider Ito integral
_
t
0
s dW
s
. (38)
Make a start o guess
F(W
t
, t) = tW
t
. (39)
Then
dF(W
t
, t) = W
t
dt +t dW
t
. (40)
and
tW
t
=
_
t
0
dF(W
s
, s) =
_
t
0
W
s
ds +
_
t
0
s dW
s
. (41)
So
_
t
0
s dW
s
= tW
t

_
t
0
W
s
ds. (42)
17
Example 5.5: Consider
dS
t
S
t
= dt + dW
t
. (43)
Let
F(S
t
, t) = logS
t
. (44)
Then
dF(S
t
, t) = F
t
dt +F
s
dS
t
+
1
2
F
ss
(dS
t
)
2
=
1
S
t
dS
t

1
2
1
S
2
t
(dS
t
)
2
= dt + dW
t

1
2
1
S
2
t

2
S
2
t
dt
= (
1
2

2
) dt + dW
t
.
(45)
We get
logS
t
= logS
0
+
_
t
0
dF(S
u
, u)
= logS
0
+
_
t
0
(
1
2

2
)du +
_
t
0
dW
u
= logS
0
+(
1
2

2
)t +W
t
.
(46)
So
S
t
= S
0
e
(
1
2

2
)t+W
t
. (47)
18
Integral form of Itos Lemma
Integrating both sides of (21) yields Itos for-
mula in integral form:
F(S
t
, t) = F(S
0
, 0) +
_
t
0
_
F
2
(S
u
, u) +
1
2
F
11
(S
u
, u)
2
u
_
du
+
_
t
0
F
s
dS
u
.
(48)
where
F
1
(x, y) =
F(x, y)
x
,F
2
(x, y) =
F(x, y)
y
, (49)
and
F
11
(x, y) =

2
F(x, y)
x
2
, (50)
and we have used
_
t
0
dF(S
u
, u) = F(S
t
, t) F(S
0
, 0). (51)
19
Remark 5.3: Rearranging terms in the Itos integral form yields
_
t
0
F
s
dS
u
= [F(S
t
, t) F(S
0
, 0)]

_
t
0
_
F
2
(S
u
, u) +
1
2
F
11
(S
u
, u)
2
u
_
du,
(52)
which is a representation of the stochastic integral as a function
of integrals with respect to time.
20
Multivariate Ito formula
(53)
_
dS
1
(t)
dS
2
(t)
_
=
_
a
1
(t)
a
2
(t)
_
dt+
_

11
(t)
12
(t)

21
(t)
22
(t)
__
dW
1
(t)
dW
2
(t)
_
or
(54)
dS
1
(t) = a
1
(t) dt +
11
(t) dW
1
(t) +
12
(t) dW
2
(t)
dS
2
(t) = a
2
(t) dt +
21
(t) dW
1
(t) +
22
(t) dW
2
(t),
where it is assumed that Wiener processes
W
1
(t) and W
2
(t) are independent.
21
Suppose F (S
1
(t), S
2
(t), t) is a twice dieren-
tiable real valued function.
Use of the Taylor expansion and taking limit
in the same manner as in the univariate case,
yields (with (dt)
2
= 0, dt dS
1
= 0, and dt dS
2
=
0)
(55)
dF = F
t
dt +F
s
1
dS
1
+F
s
2
dS
2
+
1
2
_
F
s
1
,s
1
(dS
1
)
2
+F
s
2
,s
2
(dS
2
)
2
+2F
s
1
,s
2
dS
1
dS
2

.
The independence of W
1
and W
2
implies that
dW
1
dW
2
= 0 (otherwise if they were cor-
related with correlation , then dW
1
dW
2
=
dt).
22
Then
(dS
1
)
2
= (
2
11
+
2
12
) dt, (56)
(dS
2
)
2
= (
2
21
+
2
22
) dt, (57)
and
dS
1
dS
2
= (
11

21
+
12

22
)dt. (58)
Using these in the multivariate Ito gives a
formula as a function of dW
1
and dW
2
.
23
Example 5.6: Interest rate derivatives. Assume that
the yield curve depends on two state variables, short
rate r
t
, and long rate R
t
. Denote the price of the
derivative as F(r
t
, R
t
, t). Assume
dr
t
= a
1
(t) dt +
11
(t) dW
1
(t) +
12
(t) dW
2
(t), (59)
and
dR
t
= a
2
(t) dt +
21
(t) dW
1
(t) +
22
(t)dW
2
(t). (60)
Straightforward application of the Ito formula gives
(61)
dF = F
t
dt +F
r
dr
t
+F
R
dR
t
+
1
2
_
F
rr
(
2
11
+
2
12
) +F
RR
(
2
21
+
2
22
) +2F
rR
(
11

21
+
12

22
)

dt,
which indicates how the price of an interest rate deriva-
tive will change during a small interval dt.
Remark 5.4:
Cov(dr
t
, dR
t
) = [
11
(t)
21
(t) +
12
(t)
22
(t)] dt. (62)
24
Example 5.7: Total value of wealth
Y (t) =
n

i=1
N
i
(t)P
i
(t), (63)
where N
i
(t) is units of the ith asset and P
i
(t) the price.
Increment of wealth as time passes
dY (t) =
Y
t
dt +
n

i=1
Y
N
i
dN
i
(t) +
n

i=1
Y
P
i
dP
i
(t)
+
1
2
n

i=1

2
Y
N
2
i
(dN
i
(t))
2
+
1
2
n

i=1

2
Y
P
2
i
(dP
i
(t))
2
+
n

i=1

2
Y
N
i
P
i
dN
i
(t) dP
i
(t)
=
n

i=1
P
i
(t)dN
i
(t) +
n

i=1
N
i
(t)dP
i
(t)
+
n

i=1
dN
i
(t) dP
i
(t).
(64)
In the standard calculations the last term would not
be present.
25