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# Stochastic Modelling in Finance - Itˆ o Lemma and Quadratic variation

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

t t

Xt = X 0 +

0

Υs ds +

0

Φs dWs

**where (Υt )t∈[0,T ] and (Φt )t∈[0,T ] are adapted stochastic processes which
**

T T

|Υs | ds < ∞

0

and

0

|Φs |2 ds < ∞

P −a.s.

The ﬁrst condition implies that the ordinary (Riemann-Stieltjes) integral is welldeﬁned while the second ensures that the stochastic integral is well-deﬁned. Theorem 0.2 (Itˆ o formula). Let (Xt )t≥0 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) =

t

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 ﬁnal 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 )t≥0 is a Itˆ o process. Theorem 0.3 (2.3.5). Let (Xt )t≥0 be a Itˆ 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 )Υs ds

t

+

0

1 fx (s, Xs )Φs dWs + 2

fxx (s, Xs )Φ2 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 = Φ2 t dt. The next result is quite useful as well Proposition 0.4 (Integration-by-parts). Suppose that (Xt )t≥0 and (Yt )t≥0 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

X ]t for all t ≥ 0 (ii) ‘Polarisation identity’ 1 [X. The Quadratic variation of a process X is deﬁned as t 2 [X. Example 0. Y ]t (iv) Suppose that X is of ﬁnite variation (contains no Itˆ o integral) and Y is continuous and of inﬁnite variation then [X. Y is deﬁned as t t [X. X ]t := Xt2 − X0 −2 0 Xs dXs Similarly the quadratic covariation between two continuous processes X. 2nd Ed.6 (Properties of Quadratic variation).7 (Abstract example of integration-by-parts). Suppose that (Xt1 )t≥0 and (Xt2 )t≥0 are Itˆ o processes with respect to the same Brownian motion so that t t ∀t ≥ 0 Xt1 = 1 X0 + 0 t Υ1 s ds + 0 t Φ1 s dWs Φ2 s dWs 0 2 Xt2 = X0 + 0 Υ2 s ds + 2 . X + Y ]t − [X. X ]t + β [X. 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. Deﬁnition 0. 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 don’t get lost: Proposition 0. Xt2 and Yt2 and subtracting the latter two quantities from the ﬁrst. Y to be adapted processes the quadratic variation (when it is well-deﬁned) has the following properties (i) ‘Symmetric’ [X. Y ]t = 0 for all t ≥ 0.see Theorem 23 in Chapter II of Protter ‘Stochastic Integration and Diﬀerential Equations. Take X.5. Springer (2005)). Y ]t ) 2 (iii) ‘Linear form’ [αX + βY. X ]t = α[X. You can prove this very simply by applying the Itˆ o formula to (Xt + Yt )2 . In fact the previous result is often used to deﬁne the quadratic variation of any process X (this diﬀers from the mesh based deﬁnition supplied by Goran in Stochastic calculus but the deﬁnitions are equivalent . Y ]t = ([X + Y. X ]t − [Y.Proof. Y ]t = [Y.

10. X ] and [Y. if we take two Brownian motions (Wt )t≥0 and (Bt )t≥0 such that for each t ≥ 0 the random variable COV(Xt . Φt = 1 for all t ≥ 0. A straightforward example Example 0. X 2 ]t = t 0 1 Φ1 s Φs ds and hence t Xt1 Xt2 = X0 Y0 + 0 t 1 1 Xs (Υ1 s ds + Φs dWs ) t 2 Xs (Υ2 s 0 + ds + Φ2 s dWs ) + 0 2 Φ1 s Φs ds. Deﬁnition 0. where [X. In particular. This is the intuitive reason why quadratic variation of behaves similarly to the ‘variance’ of the process. when COV(Xt .8. Suppose that 2 2 1 o processes with Υ1 Xt1 = t and Xt2 = Wt are Itˆ t = 1. because X 1 is ﬁnite variation so [X 1 . X 2 ]t = 0 for all t ≥ 0. W ]t = ρt ∀t ≥ 0. We use this property as the deﬁnition of correlated Brownian motions. Yt ) = 0 for all t ≥ 0 the process (Wt Bt )t≥0 is a martingale and [W. Thus using the previous example: t t tWt = 0 s dWs + 0 Ws ds. Find an expression for tWt where Wt is a Brownian motion. B ]t = 0 for all t ≥ 0.in this case [X 1 . Υt = 0. Φt = 0. Y ]s is the quadratic covariation between X and Y . 3 . Y ] then the process (Zt )t≥0 deﬁned using Zt = Xt Yt − [X.9 (Martingale generated by quadratic variation). Two Brownian motions (Wt )t≥0 and (Bt )t≥0 are correlated with correlation coeﬃcient ρ ∈ [−1. 1] if [B. In particular. B ]t = ρt. Yt ) = E [Wt Bt ] = ρt then for ρ > 0 the process (Wt Bt )t≥0 is a submartingale (and for ρ < 0 the process (Wt Bt )t≥0 is a supermartingale) so according to the previous proposition Zt := Wt Bt − ρt deﬁnes a process (Zt )t≥0 which a martingale and [W. Y ]t is a martingale. Suppose that (Xt )t≥0 and (Yt )t≥0 are continuous local martingales with well-deﬁned quadratic variations [X. Proposition 0.

2nd Ed. Springer (2005) t 4 . Next week with martingale measures we shall use that Nt − λt is a martingale which is a particular case of the following deﬁnition.12. X t = [X. (iii) Let (Nt )t≥0 be a Poisson process with intensity λ > 0 then the quadratic variation of N is [N. Deﬁnition 0. X ]t = 0 Hs dWs . denoted ( X. Whereas. X ]t − X. 0 · Hs dWs t · + 0 Gs ds. (ii) Let (Yt )t≥0 be deﬁned via Yt = then · Gs ds + · Hs dWs for all t ≥ 0 where H ∈ L∗ [0.11. Y ]t = 0 Hs dWs . In the case that (Xt )t≥0 is an Itˆ o processes (and in particular Brownian motion) it follows that X. X ]t for all t ≥ 0. 0 t 0 Hs dWs t t 0 = 0 (Hs )2 ds. The angle-bracket process associated with an adapted process (Xt )t≥0 . T ] then · t [X. Some more useful examples: (i) Let (Xt )t≥0 be deﬁned via Xt = · t 0 Hs dWs for all t ≥ 0 where H ∈ L∗ [0. N ]t = Nt for all t ≥ 0. in the case of the Poisson process (Nt )t≥0 we have N. N t = λt for all t ≥ 0. T ] · · [Y.Example 0. X deﬁnes a process (Zt )t≥0 which is a martingale. Additional facts about Quadratic variation can be found in Chapter II of Protter ‘Stochastic Integration and Diﬀerential Equations. 0 Gs ds t +2 0 t Hs dWs . X t )t≥0 is deﬁned as the predictable process such that Zt := [X. N ]t = (∆Nt )2 0≤s<t and since the jumps of the Poisson process all have size 1 it follows that [N. where properties (ii) and (iv) from the previous proposition have been used. 0 Gs ds t = 0 (Hs )2 ds.