ELEMENTARY STOCHASTIC CACULUS ‘with Finance in ViewAdvanced Series on Statistical Science & ‘pPLieD Prosi Applied Probability Eston: Ole EB ELEMENTARY STOCHASTIC CALCULUS with Finance in View World Scientific ‘Singapore Now Jrsey*London+ HongKongUshi: So so se Rw ay Care Cong sein Date ecm homed io il aie ped eg Stsvazeo pee) qantas to oti nel rte natant ae Ba Le ‘Ale ed Par rr myth reed amy bya mea ‘iar i hp oro oo apy of ma ae, ne aig he Cr a Preface Ten years ago I would not have dared o wie book ike hits non-grous ‘weaot of mathemati theory I admit tat Toul have bu aoe, and Tam aad that most. of ay cllasgucsin mathemati lik ie i However, my experience with stds and peactioners convinved ie that there i szong demand for popular mate, started weit thi ton a eta notes 1092 when I prepared course on sochasic calls forthe students ofthe Commerce Faculty st Vicon Univesity Welington (New Zealand). Since | ba fae in ing ttl on boctflothory and investment analy T was expected to tach sorehing Tinow batwor” At that tne, aff members of eeonomis sod rathemate departs aleady discased the us of the Dlack and Scholes option pig formal courses on stochastic ance were offered a ong nstatons wach SS ETH Zavch,Cslumbia sod Stanford, andthe was general agree {at ot only aden and salf members of esas ad nathan partments, but abo peacionr in fan! intiatonsthould know more owt tis ne top ‘Soon Irae that ere wat not very mc iterate which could be nd oF tating stodastic calculus at rather ementry Tee am filly tare ofthe fact hat a eombiaton of elementary and stocasticalets™ Ine cntadction nate. Sorat ale rogues advance talented techlqucs; thi theory cant be fll understood soe des ot kao about the bass of measure hry, fanctoal pales and he theory of enchistle Pocwses, However, I stongly believe that an ited person who om shout demestary probblty thoy and who can handle the rues of inte ‘gation snd dieentation ahi to wnderzand the rai Mes of occ Sleuus. This i supported by my experience which I glaed i coe fr ‘conomics, statistics snd amas students at VUW Weligton and the Degarneae of Matbamatics in Groningen, T got the same ipesion es 6 lecturer of crash cures on stochartc calcu st the Summ Schoo ofthe“ PREPICE Swiss Assocation of Actuaries in Lewsune 1094, the Workshop om Financia Matiematis i Groningen 1997 and a he Ualvtity of Leuven in May 198 "athous colleagues and atets ad read my lecture no and suggest tat Texted them to 4 snl book. Among those are Claudia Kivppelberg and Paul Embrekts, my costor from book abou extemal vente and David Vero-Jonen, my forme college tthe lstiute of Sai {Us und Operations Rccrch in Welington. Clad alo pepo to gt in toneare with Ole Bando Nielsen hai the ete of the pcb sres ff World Seem. T am indebted to him for encouraging me troaghout the ling procs of wing ths boo. Many collages ad students helped in proofreading pats ofthe tok vat stags In particular, [would lke to thank Leigh Roberts fem ‘Walingon, Bojan Basak and Dione Salome fos Groniagen: Tek etiam vas vey pl. am mr pratt to Carle Provost Susten Univesity. She wat a cootans sure of ieprtion, hot on style and anata Issue Ilo tae plese in hankng the Department of Matematica the ‘University of Groningen, my callaguc and students for hr mich appreciated ‘Thomas Mics Groningen, Jane 1, 1908 Contents Reader Guidalin 1 Preliminaries EET Random Variables 112 Random Vectors TLS Independence and Depa 12 Stocbate Process LAT Decing Properties 132 Provente Devine! an Boas Moti 13.3. Simulation of Brovaian Supe Patt 14 Gondsonal Expectation TUL Conditnal Experaton ander Diver Coton TAZ About o-Fadde TAS The General Contin Bape TA Ral for the Calculation of Condon Expectations LAS. The Pioedon Proper of Conditional Expestations 151 Deng Properties 132 Exanples 153 The lepecaion ofa Marigae s 8 Flr Gare 2 Tho Stochastic Integral 21 The Riana Rian Stes Tera ZED The Onnay Niemann Ie 212. ‘The Retann Stk ntl ! 22 The Ko Inogeal | Beroon m n Py * st a 2 SOvi conreNts 222 The lt Stochastic nt fo Simple Prooses tot 224. The Genera ho Suerte Ive i 23 The ka Lemma it 2411 The Clasical Chain fae of Diereiation nb 232. A Simple Verson of the hd Lama ut 223 Extended Verso of eho Te Lamina uF 24, The Stratonrth sod Other Integrals 13 {8 Stochatic Differential Equations at "h1 Deermiisie Difeential Equsions 132 412 Ro Stochartic Df Eqoations ibe 321. What wa Sochastle Difeenal Egat a 4322 Solving Io Stoshaste ier! Equations Uy the Hi Tenma. Iss 525 Soleng lo Dern! Bguaions ia Stratonovih Cal ale 16 88. The General Liner Dien Equation 130 451 Linear Egatons with Adstve Nice 160 352 Homogentoas Equations with Malupinaive Nee | 153 333. The Conaal Ca ie ‘334 The Expectation and Valance Puntos ofthe Seaton 136 4 Nomar! Solution 1st SA The Esler Approximation 158 4 Applications of Stochastic Calculus in Finance er AUT The Blak Scholes Option Pring Fore 168 ALL A'Short Exelon ito Finance 18 {U2 What isan Option? 1 413) A Mathematiea Fornlation of ke Option Pricing Pros ther 146 The Black and Soles Fora 1 42 A Useful Teeigue Change of Meare 1 121 What a Change of te Underlying ews? 1% 422 Anlinerpretaton ofthe Black Seboes Fray Cha Appendix 186 TAT” Modes of Convergence 185 2 neues it CONTENTS Al Nom iferentatity and Unbounded Variation of Brownian Sas At Prot ofthe Extn of the Geral id Sacre Hye ANS The Radon Nikon Theorem AS. Proof ofthe Exstance ad Uniques of the Conditional Be Bibliography of Abbreviations and Syibols 1 93 vo 195 200Reader Guidelines ‘The book grew ou flee notes fra couse on achat aul for sor nomics sues, When I prepare the at letes {elie that thee mas no adouat oxtbook tetment for nonsnathematican Othe es handy there was and indo! isan lncteaog demand to ara abot stcharte ea ‘ul, in parla in economies, surance, aan, cennomteies The al ‘ssn for shi interot originate om he fr at his mathemati oy Ise bs fr peng Banca drvtines such a pane ad fares. The fundamental da of Blac, Scholes and Mcton fem 1073 ta we id soca tic clels for pricing an badging of derivative instruments bas curd ‘he real world of fine the Blac Sette ormala ha bon Kwa o thay ‘ope in mathenaies and economics lng before Marton and Soles were ‘Sarde the Nobel pie freeones in 18 For who i this book written? Tn conta tothe increasing popularity of nancial mathematics, etic basis is by no meas teal Who eer teed to road the Set fw page of book on stochastie aus wil eartatalyagrx. Tole from measure theory sud fanciona anaes ae wally requir. [this book {hae tried to Kop he mathematical vel low, The sender wil act be burdened with mani thor, it canoe be ached ager ‘Thon we wl have to ely om brartie argent, sessing the undeg ‘ea ater that tao dtl. Notas suchas measurable faction at ‘measrable stare not ietoduer, and there the formulation and pool of various statements and seule are nossa incomplete or nego, ‘This may sometine dseoarage the maematicaly ered teaser, bt fe ‘howe excl mathematcl textbooks on Mocha cali ext. In dncosions with economists and peacionas rom banks and isu ance companies | fequety listened tothe argument "Ie clelus ea bea READER GUIDELINES derstand on oy ntbnnaiiane” 1 che main objetive ofthis book to tence thi supersion ‘Prey meatal tory has its roots neal Me. Theteoe the notions of Mo integral ma and stochastic deretal equation ean be explained {G aigbody wo ever attended eoures on lamentary elena robabiey thor nyt chests, binges, rears, agices ccna Ta th cunts book the ear wil iar abo the bast rus of stochastic leis, Pally, 9 wil be able to sone some simple ochstie derail ‘Sntons, co siulte thee solitons on computer and to uoderstand the fouthenattalwelogy bend the dees theory of option peng ‘You should be faniiar with tele ofinegration and dierenision. Mealy Jou alo know abot idee equations, bt i x 0¢ cnet. You must now about clecaary probly theory. Chapter 1 wil lp 904 0 reall wre facts about probly, exprtaton, stebutlon et, tat this will ot ‘ie proper bass for the sat ofthe back You wold ave to read one ue roemmnened books oa probably thon thin er to You, bene Som attempt to read ths book 1 depends on your Knowledge of probably theory. 1 reummend that you Tromso through the “bows” of Chapter 1 IF you know everthing that ‘ue theres yon tan start with Chapter 2 I stocaste cleat and ‘Sn with Chapter 3 on stochastic dere eqatos. You cane rove inthis way if om ate nota with te allowing ‘asic won static proces Browsian motion colina expectation ‘au martingale ‘There is mo doubt that you wil uggs withthe noon a ‘ondtonal expectation, uatas you ave sme Bakyround on mesure the fy. Condtional expectation sone ofthe hey notion uderving stochastic Theol reader can handle simulations ona computer. Computes grap of Broweian motion ad soln to stochaste difereta equations il help Soto expeienoe the thor. The tone toes for thew slain will fe prod i Socios 13.3 and 4 T have not includ te of execs, ut 1 wl ask ou various questions ln the couse of ths boks Ty to answer then. They are oe dit, but they i attesting the evel of our tndestanding READER GUIDELINES 2 asides Sections 19-15, the cre materi is cotained in Chapter 2 and tho fist sesons of Chaper3. Chapter 2 povides the construction ofthe IO Integral ads heute etion ofthe I amma the cha eof sortie falls In Chapter 3 you wil learn ow to sive some simple stochastic ‘iran equations. Section 13m linear stochastic diferent equa = ‘aay inl n order to excise the ao ofthe to asama. Seton 3.4 il eins thee who want to visual auton a achat ere (Chapter 4 for those rouers who want to so how stochate eau ‘stra farce applications, Pree Koowlage af sconce they Woot ‘le, bt we wl nsuce amit ofeconoml eticlegy which can te understood by everbody. If you can feed though Seti 41 an option pricing without major difaties a ere sochase ales, you will have ed the exarinaion on this cours lercaary secu cleus. "AL the end of Dis book you may want to know more about sochastc cates and ite applications. Reteores to met advance erate are ven inthe Note and Comments atte ond of ech ston Thaw refeene® ate ot exhanstive, they do aot lle the thereially tot advanced tertbook "Wetmets,Du they can be fl forthe cntouation of ours, ‘You are now rendy to start. Good luck! TM,i Preliminaries ln this haper we calc sone bs fats need for fining stochastic nt als. Ava ft reading, mare prt ofthis chapter ean be skied, provided {ou have some bsi knowedg of probably theory and schaaie proces You may then want to sat with Chapter 2 on ho morse cles ad recall some fat rom this chap fest To Seton 1.1 we real elenonsay ntios lm probably theory sch 235 random sriht, random vector, dition, tiation incon, den big expectation, moment, arian and covariance. Thi sal ev can replace ale courve opal, and so you are well ommended to fonsult your ld lertre notes ora stnard textbok. Sect 12 is aout Sochaste proceses A stocuatic proces 6 & natural tel fr Ses the elution of tele process eects and sytem in te and space. (One partir stochastic pros plays coral sen is taoks Bowron ‘maton We ietedaee sim Soton 13 andes sone of is seeatary Proper, arias the adrenalin andthe unbounded vara ‘fits sampl path, These properties india that Browoian save path re ‘ecy iogulr ad therfore anew, stochastic cleo hart be ieadven! Ie integrals ith respet to Browaian motion Tn Section A we shorty review wondtonal expectations, The previo einiton i based on deep sithemtical hoy, and therefore we aly give Some ination on ths eeepe The same eark appli to Section 1, where ‘we imoduce a important els of stochastic proces: the maringaen Inelaer Brownian medon and indefinite Ie tegale atptcar eae ee O. corapre 1 1.1 Basie Concepts from Probability Theory La... Random Variables “The outcome of an experi gaie i random. A spl example is cin toning the pss otcomes “brad” o tall” ae oot predictable the vse thar they appear acordingtoa andor chan whic etrauoed bythe Dinsleal properties ofthe ci. A more compiated expert sche sock Fraret, Te the random ostcomer of the broker aetiities (which acualy present semomi tendenc,polical intrest and thi own isint) ace for example share piesa exchange atx Anotber gate scaled om ttt” and in be natshed where products ae on slo tho pie of 1 anc, sys the cutee of gant between the shop emerson te one ‘and, sd tween she sop owner nd the eastomes, Ue other ad Tnetetife etnent an experinent request wo sig a umber to each random outcome. When tossing a en, we cap wtte "I for “head” {tad “for “ai Ths we goa atom varable X= X{4) © (0,1) where Pelongs to the xtcome spas 81 (bead. The valu of share eee of Stork sey random number, and ws the banana peice in reegroees Thee numbers Xo) provi a with infratin sbow the experiment, sen ie do nt know who plas the gune or whet deve “athe make 2 eur cit beeen fealty and a mathematical node they deine no sbratt spaces ellatng al posi outcames of the Ceryngexpernet, It ean abtrart space. Tt does ot evally mater thar ches ae. In mathemati! hinguage, te random sorele X= Xo) ‘Ehucng but e-aloed fnction deed oa “The next step in the proces fabtraton em realty ithe probabilistic eserption of he random vaable X Wich are the most Ml ves (a), what ae they encetrated around, Wht th pend? To appotch these problems, ne ft cles good” enbuts f e eee tna las sayin advanced textoks called fe ot olga; we p62 for procn iin, Sora cla ie aupposed wo conta ll ietersing Sonia, Wat cold be for coin toning? Cerny fo: X(e) =O) = (el) She = X(o) = 1) = (head) mst bout, bat also the union, derence, Intesecion of any events heat t= (aad) and its complement, theompty ot 0. This a iva example, but ie hows what F shoul be be Hae 7 cos ls conplomene Hand ABE 7, so a0 ANB, AUB, BOB, BUA AOR, BAe 11. BASIC CONCEPTS FROM PROBABILITY THEORY 7 If we considera share rice X, nt only the events {2 Xa) = should long to F bt bo fora X()SH), (e:be XI, (or Xledsad, sn any more events which cn be rlevat in thio that situation. Asin the ‘hse of cin tssing we wold ke tat olnenary operation such a8 Ue tn the ovens of should nt lon onside the clas FThis tho luv ning fa eld Probab oy Distribution and Distribution Function Now, whe do the probabilities come in? When tipping a in ead” or “eal ocursPrbsbits measure the Histon tat thse events happen the coin i “fr” we aig the probability O§ to both events, Le. PCL Xis) =0)) = P((a" Xa) = 1)) = 05. This mathematal deinton is iced on eapivieal evidon iF we ipa fal orn a large nme of ie, we tape that about 0% ofthe otermes are he a thot SO ae ta. Ta [roallty thor, te fav of lye mumders ives the theoreti anieation {or this empita bservation. “This demeary example explains what a profeity mearre on te lass ‘Froth event to each vet A € ie ati s aurber PCA) € (0,1) This aoe ste expected faci of eceuvenoe ofthe eect in ong eres hexperieats where 4 oe A" ae served ‘Soe clerentty propre of probably assure areal summarized For events AB EF, PUA) = P(A) + PIB) PLAN), snd Aad B ae dion, P(AUB) = P(A) + PB) Moreover, PUA) =1- PIA), PIM) oot PO “The relationship between rand vaabln and potty can be character {aed by cetin muerca quate In what flows, we conser some of the i5 (CHAPTER 1 “Te caletion of the probailtis Fels) = POL $2) =Pllw ls) Se), 26 29,25) isthe dation faction Fy of X eye the probity that Xmas to he ters), Hdd, Pllua< Xu) £89) = Fxl0)~ Fela), 0d Moreover, we alo obtain the probability that X i qua oa mer: Pix=s) = Plle: Xu) =2)) = Pte: X 0 mx z ‘Soo Figure 1.1.2 for a istration a In conto to discrete distributions and random wriabes, the dation function ofa cotinnus rondom variable dvs not have rps, bees PX 2) = Ofer allo oqusaleati, By Fele+ m= Fe) forall, 02) i such «random variable asses any particular sae wih proba 0. A ‘eninss ande varable gun same um the contin propet (1.2) ofthe dition foncuon Fy. ee eein ‘CHAPTER 1 Figure 1.12 Lette plabice PLN = 4). A= 0,12. of the Paton die Tiwi ameter 1. Right th coreaondydrbton fn igure 11. Lele he ety of he andar normelratin (me 0, tance Night the oregon rat oto igure 1.4 Lathe dn of helpers X= Yi — Ios ofthe ds fling pcs Yo the Se dee The Sk? one of he Bae US nba tier Rigi ceponding tration fncon Atari th Page 11 1L1, BASIC CONCEPTS FROM PROBABILITY THEORY ” ‘Most continanas davis of ers ave a deaty Fo 1020 too zetnd J senee=t Example 11.5 (The nema and union diseibotoas) ‘An impoea coutinsoos distribution tthe norma oc Ganson datrbuion (goo! with pramrers 6 Bo? > 0, Ie ba Snsty = show {-Eo), rer . Ine)= ghee GB), os 1.40, aatl ar) stp ee ey ft ae Tae angorm dstbatica Ua) oa (a) he deity npg Hc : say postive cel sumer Clearly, hee are tech nitions computer (or poeks lear i not eapble of saving the vale of an exchange rate ‘wi ately many digs, V2 say; every amen the computer's memory Tercunded of, ‘Tetefore any adm varabe of paris iterest fe araly fleets Homer tk often contniet ty think of mucha arable a 2 fontinous oe There maybe thor! reasons: For example, the neal ‘Anebation appear as nit dstsbtio Wn he cet int heoren oe 5, Many factions of sample ae tee approximately normal, ace ‘ein dstaibaton continous. Dv there are no practi emo Se tt lo ttious to work with «websted contains stabi (ue ‘neem, expanetil, gansta, wif) beau wea tsa standard gen particular, standard setware plage) about deny, mre, ‘able, te, and we can ponubly obtain sme sce expel exprestons ft2 onapren 1 Expectation, Variance and Moments Iotrotingcaraceritin of random vrlableX ae the exgetation EX, the team ar(X] ad the moments EU “The capectaion or mean ele fa randn wave X with deny fx ieee by x= [7 sistelde Teer wel [i-esriae ‘The th moment of X or 1 Ns dined as of = aa) (x)= © pete). Fora ral-alod function the expectation of 9X) gen by ss) = [Fase ‘The expectation oF wean value of a discrete random variable X with robin pu = P(X = 24) bs ven by Dan te deine as Sta mntn “Te lth momento X fr 1 € Ne defined a Dam x! LA. BASIC CONCEPTS FROM PROBABILITY THEORY 6 Fr a veavald Fonction 9 Ub expectation of 8) ve by BoX)= Yolen py We can ryard the expectation jy a the “cntr of gat” of Ue random arable Ny La. the rnd voles (a) are concentrated aro the no ‘random number jn. ‘The expectation is ite fen taken at surest for thesia the random variable. Forename ample mene fo proiting the fare value ina tne eis, The stead o dispersion ofthe random valu X(e) around the expats ti ey sere ty the wines O% = wa X) = BU px)? BU = 2p Xe) = BUA) 2 BO) and te standard destin 35 Recall the normal dens fom (13). The parameter the expectation tux al the parameter ois the variance of of «random tatiable ‘ity (1.3). wl now it (and cary to vey example withthe ‘copter tha fran N(j,o) random viable X, Pln~1960 < X< p+ 1969) = 94141980) ~ 84.1986) a4 So der is 405% chance thatthe normal random wauibleX sana dase Jn [a= 1.860, + 1.966}. Anaogosty to (1-4) ane ean fornulate «beste real ee nshing bat this one can consti enteretapee) tha or & fic” vandoa variable X the probity Plax ~2ox SX Spx + 20x) [costo 1. This ules als supported by the Chebysheeinyuaty PUN -yxl> 2] S28, 2>0, Sehich provers with a cel acerate bound of the roby hat he abt deviate rate vara from expectation exceeds tome tealu CHAPTER 1 1.1.2 Random Vectors a what ills we fruently mike we of fiit-dimensiosl aod nite tenia undo stractares, We come with Eite-dipensonal random ‘Neto at at sep toward the detain of «stochastic proces E> (Big) an dimen random wet i componeate yrs Nate onedimeigal ealvalued condom vals. 1 we oterpet € = Bsn a8 equine tata of time, Xy can stand forthe outome of an sxperinent a tne 1. Such a time sores may, for fevampi, const of BMW share pris Xy at wsucreing days Cleary Smatherotcal tn, thus sorhing bot a Index of conning vale, Foe ramp random vector can deeb the state of the weater in Wellington ($2) at geen ines Xy could be the emperature, Xy thea presse and I the windoeed (the ter swallow to init) “Anaogouly to one-dimensional ravdom wales one ean atradace the inition funtion, the expereation, moments and the covariance mathe Pe tandom yvtr in onder to dessa ie dtebution and Ie dependence Ect ‘The later aspect a new one dependonce des not ake sage rhe we ak jst about one random variable Probability, Distribution and Disteibution Function Toes a fir coin ence, We consider the four pes (HH), (7.7), (HT) sin (FH) (Hea, Total ar ootame ofthe experiment “ping a coin {io Thos our pte consti the eto spe fb A Before we aig Teo ff and 0 to 7 Inthe way we obtain two random variables Xy and 8 tod X= (X,Xe) fea two densonal andom sector. Notice Cat (HH) = (48), XUT,7) = (00), XCE,H) = (0,1), KUT) = 0.0) 1 he coins inde ae we a ang the probability 0.25 0 eae ofthe our Pils: Xt) (op 025, Be f0.) As hfe, we considera calleson F of suet of and deve a probity Imesure on ite, we asign a marier P(A) € [yl tearh AF 1L1. BASIC CONCEPTS FROM PROBABILITY THEORY 6 al (sb (01.00) (asa (hoon) a & “The collection of he probabilities - Fe) = PUNY Say. Ma Sta) a) Pal Be} Sys Kul) Sea Gee) em the dation faction Fy of, 1 provides us with the probly of the event Chat X assumes vale nthe rectangle (able beseech For example, if X is two-iensonal, PI € (a) = Fabia) + Belo) ~ Bela) ~ F(a) (Check that chi arma score et also Figur 11.6. At in he cate of ‘ne-dinensional random vrais, te probate approximate PUX € B) for wey goal ate.6 CHAPTER t “Te election of he probbiiis PB) = Kfo2X(W) BD) (Kem) for wae suits BC BY consiates the dation of K Stale subsets of Bare the Borel es which are obtaiod by «countable tmberof operations U © ae u the ltrs sep. 8for a Dre defn. Fer example, pat ss, ball aod etangles are Borel ss Era mathenatieal nse, the detbtion and the derbationfancton of & ‘adn vector X are eqialst notions Both, F and Py, ca be used to falealte the probably of any event (X €B) ‘Notice hat th dstibution of X = (Xu. Xa) cots he whole foxntin abou the dntbtion ofthe components X, pais (Xy X), eps (hanXyu), ete Thsisenly son from (13), yom ge the datibutn ne Aiowof Xs by forall nting fy =" ty 2, the dition fonction of (xh) by ating 2) = ss act “Analogue to random arable uw et nrodone decree ad caine ous fandom sectors and dibtione For oar porpoises Fann Cectrs wth a densty willbe revant, nd o ne my restoration Tie dtton oa anda vector Xa dena Fone can eproel te datibatlon fet Fx of X os Pants) = fos ftom dn, rennet ere the deity 3 fnetion satin Jx(a) 20 or evry xR Lo [Linon 16a vector X has densty fx, all components Xj, he vectors of the pats (x, Aah tiles (Xi Xj AG) ey ae deat They ee elle marginal LL. BASIC CONCEPTS FROM PROBABILITY THEORY ” Example 1.1.7 (Margi dents: the case n = 3) We consider the case n= 3. Thon the marginal dense are obtlued at pete = 0 fT addres, tase = fede olen bine yn fu) wh pc 2 ahd FB intsgraing Fate) with rope too ‘ne casos patel simple: he density f(x) ca be written as a proce of non negate funtion 9 Ix) To this case (oe) dy = 1 # = 1. Sethe funetons ee) ase ‘no dimensional protabity dense, and th mesaiy anr)~ gutta) eB Irfoi)= ales Ira le02))=aledakssh, ee Vent wis xanmple 1.1.8 (Gasianstndom eter) 8 Gentian or normal random vector bas x Gaussian o¢ onal dtsibtion The n-dimensional nrmaor Gossin tations ven by dente Jats arta fone}, xe, 0 si rt ed E, le dt wn, dnt de ‘og rg at a Tegan can pane Expectation, Variance and Covariance ‘Te expectation of a randoen vector has sma eo 4 he ea vale ft random variable. The vals X(o) are sonceatrated road “The eapecation or mea wl of «random vecor Xs gven by (ER BX)6 (CHAPTER 1 “Te cmovince mabrirol Xs defied as Bie = fon(Nie Ke = Bona) vere eoeXiA A) = BLM px MX — 05) BRN) ss 2X) = of, Example 1.4.9 (Continuation of Example 1.18) Helton (1.0 edt of iG cad ctr X. The parameter i the expetation jy of Kad iss eavariance matic Sx Thos the density of Gavan ctor (hence ts dition) I empl ‘itr rin es expectation ad coaiane mati In actu, {Su Ei he m-imeninal deat tara fy, me have de Ig = and © Th Ths dey fx then simply the product of standard normal densities Freon) wlan) len) We write Ny) fr the dstibution fon mdimensonal Gausin vector X sith expsttion ad ovine rntix © Sock a yeetor baste appealing [ropety al eine Gain under lneae transformations (rel that J Enda dee the tasepowee of and A respecte) ‘have an Mu) distebation and A be a m x | tet X= (Xs nets Then AX’ bs an NUAWAE A) cstbatin, Inte covariance of Xe and Ny, Notice that ent 11s conseniot to standardise comvancs by viding the csesponding ran thm vrais by ta anda denon The esl qvantty sev. X3) End eon.) isthe corelation of X and Xz. At a ol of titandarlation the core Tato of to ado vara ix always barren and. Chek thi fe yan sean fee Casey Sewary inequality; p18 1.1, BASIC CONCEPTS FROM PROBABILITY THEORY 19 Eigue 1110 Dai of te 2nd mr dt = 0 an 1.1.8 Independence and Dependence Flip flr coln twice ad Wt the ras mers X(a), Xa(o) € (0,1) be the corresponding outa ofthe Best and cond expernene I any to verify tat Px =X (Xi =BPOG =D, EE 101) “This propery is alls independance ofthe rads variables X; and Xa, ‘uit indepodence mec that the fest experiment ds nt ince tha cond on, and vee versa. For example knowledge of Xy doce wot allow one ‘0 prod the al of Np and ie vers ‘Below we real sone of th santa fins and proprio inde een ev and independent atom vara. "Two events Ay and Ay ae tependen Play de) = PLAY) PLA).» cuHaPrER 1 [eo random variables X; and Xp are independent i PES € By Na € Ba) = PIX, EM) PUK € Be) for all stable mbes By and By of R This means cht the evouts (ee Bi) and Xp Be} ae ieee. Alternatively, one can dete lndependene via distribution functions ad den fie ‘The random viable Xy and ae dependent nd ony Pryrlenze) = Fle) Piltehs 4,23 €R ‘Assume a (XX) has dense fc with marl dense fy and fe Seep. 18. Then the raidom variables Xy and are independent i and nly « facaglers) = fos) flea), 1122 OR “The dito f independence can be extended toa pba Balt mtn er feet and random vectors Nolo tat idepandene ofthe componeats fe random vector imps the independence of each pa of ts components, ‘but the converse a general nt tre Th evnts Aly say are inpendet I fr every ke of ids Tesco eiy Sand intense k=, PUA. 10 Aa) = Pll) Pa) “sare idapendon for every ee oF Indes 1 iy Ive expesation ro. Ths co XX2) = BCX) ~ BX BLN) =, bt X and A ae lly dependent: since (X € [-1.1}} = (X* € (0. 3)e¥0 PU e -1t}.X? € (1) > PUY e L-LApPtx? a) Pox e(-ta) IKE. og2 CHAPTER 1 Bxample 1.113 (Avtocsrlations of a ne sere) Fara time seis) Ny. Xi. the autocorrelation at lg hs defined by fortiXan Ne), B= Dyly A eam which cm fequeely he found in the erate hat Bil tine erie (derived fom eck et, share pi, ‘xehange eaten ete) ate pearly uneotlated Thi supported bythe sample ‘itoooratonso the daly lg-otre X, ofthe SEP ade se Faure LL Tn ctr to ths obseraton the ctinated autocorrelation ofthe abate ‘luce [| ae diferent fom neo een for large lags Tie eats hat ‘hte depedeace Ln ths tine sve. ° Figure L114 The esol eutrlation of the SP ent) and of {Holt sls we Boone 111 Ne cmmentsn Pape 1 what floes, ne wil en deal with infin ellactions (Nit € 7) of random variable Xj, eT van nat ade te, I thst up, we ay aso Introduce independence “Te cobection of random vais (Xy1€ 7) is ndepndent io very ce of distinc dies 24 €F and n 2 1 the rom variables Nir ae independent ‘Thr collecion i ndpenden! od sen tay dred (a Sndepndent a al edo aablasXy thre the me date, Notes and Comments In this ection we ead se olementry probably theory which can be {and in evry toxthokom the topic ane fr instance Pitan (199) for an 12, STOCHASTIC PROCESSES 2s slementary eve and Gut (1005) fran intermetiate course. Also many tet tooka onsale often beg mith at itrdcton to probably hry, se rexample Mendenbal, Wacky ad Schaller (1990) 1.2. Stochastic Processes ‘We suppose tha the exchange ate NZS/USS at evry Sed istant ¢ between 9 am aod 10 am. thi moraing is random. "Forte we ca Inerpet ‘ea rcliraton Xia) ofthe random triable Xj, and so me observe Xs), Sices I, vorderto maken guosat am. about thewxchangersteX} (0) {e11 am, (i geaonae to fok a the whole elation of Sa) between Sam. and 10 am. ‘This i alo.a demand ofthe high standard techie eves which provide with sotto ingratin abot te poss idee. A mathenaial model or deetbagsorh a peaomenon called 2 Sochastc procs. [A sacastic proves Xi collection of random waabes (rer) Mie). teT vem, eine on sme pce orourpurpwes,P x ofen a itera fr example = [a8 a8) o fs) fora'c b Then we cll Xa contmuoneme proces in canta to duerete tame proces, Inthe ater case, Ta fe countably fate se For vou roaons, the nde tof the random saree Xt feqinty eferrod tora ime aad me wl fallow thi convention “Aston procs X ea funtion of oo vara, XM), ven For fd andom osteo € 0, 8a fetion of ae x ile). te. “This function eal razon rajectary a smple path ofthe ‘These two aspects of a stohastle eons ate iusto in Figure 12Ey conapre 1 12, STOCHASTIC PROCESSES 2s Figura 1.2.2 The (ald) al alas of the SP ener on pred of 7.422 {pe The rh get tae csr te SEP tone sr as be srg pth oft catnsons time proc If tere a man ae ne err ach ht he “tunis of tne eT are ewe an tra the one ayant oer ie ReotSee poss ove sratvurrtone prt, Te snple pas of rae ovine pce ar grote terete tnt of tone Depending Site mitaton, neha lo ake toon whch modal eee etn To mare serait Example 1.2.3 A tine series Sea dirt time proces ith P= Z-= {0,41,22,..). Tine as constitute sh inperant clus of stachastie proces ‘They ae fleet mods any ‘polation, whore one I interred nthe evolution of rea ie proce | ‘Sus series represent, example diy ody temperature of pet bn i Showpital, the dally returns of pice or tbe moathly umber of a tafe ppsenget in the US. The mot popular there ie sores models are the AFICA (AstoRaqressve Moning Average) prossss. They are given by igure 12:1 5 sample pty of thane pres (Top ney ple ‘tain diferene equation in wich an Bd sequence (2) (sp 2) the 6 torpor € Mi and Eom: vas nthe tert es Called nie, fvoved. Tor example, a moving aveage of erdet@ > 1 Is Wee 08 twa the rondom vrais ote sNesy ty oor ae = 0-40 -990— rojo he empleo othe wre Ma B AB b A ligy 1B:6 mare 1 snd an autorogresve proces of onder 1 i ion by Maem te, te2, ere fy an ar geen ral parameters. ‘Tie svioe mods can be Aidertaod a dicraaions of stocnatie dient equations, We wil we {his or the autoreve proses on . 1 Figure 124 shows two examples. ° ! \ ri } sh i ll 4 4) he i! \ Figure 1.2.4 Two tine sees Xi €= 10 Uae 100 uci day Lp Fer of he SP index se Fayre £1 gh: a simalatl sample oh of Be eorgree pce Xe OSX Za 2, aed Nl) random sre Wo we thatthe conopts of andor arabe and of «stochastic process (Xipt 27) see me sn much diferent oak have dam elation, bt tbe Felistion X(a) of «random varale bs @ number, wheres te realization Kee).teT, of a tchasbe proces i function of. $0 we ae completly ‘ores If we understand a stohaste procs to be a raiom met” tak ‘ing fonctions a aie Moreover, we ca interpret random vara at random vetor ar special stochastic proces wil afte Index st. Distribution Tr analogy to random variables and random vectors we want to Introduce son-rapom sharactrnics of wocastie proset nich am its datribtion, epetation, cc. and dori i dependence tuctre. This «tsk och 1.2, STOCHASTIC PROCESSES 2 smote compliato than the dcrigtion of a anda vector. Inde aon: Irv stochastic promos X= (At € 7) wilh insite index set Tie a Jntnitedimensonal cit ean be understood athe infite elleton of the random varalesXy, € 7. Siar the vlaes of Xaze function on 7, the dtrbtion of ® shoud be dfn on suboets of ertain “facie space PIXEA), ACF, as) whee 7 i 8 callection of stale subsets of this space of functions. This {oprah i pose, bat rogues atanend mathematen nd 30 me tr tO fn somes means ‘The key dsuvation tha a stochastic proces cane nerpeeted a | selon of ado vector. ‘Te fte-dimensiona dtribtions (fs) ofthe stochastic process tie tedious ofthe fate dimensional vectors (Kio Xde Boot eh for al pose doles fest ny €T ad every n> ‘We an imagine the fis mich ener han the cmplcated dasibuon (1) of ssotaie proces. Ica be show that the fs decrine the dstbution EX. In ths seme, we tle to the alaeton ofthe fs as te dstrauton of he tchate proce Stohastle proses can be cso seording to diferent extra, One of ham i the Kind of Example 1.2.5 (Ganssian process) Recal fom (1.6) the dfniton of az dimensional Gausian density. A ochstie proce i called Gaason alt sar multivariate Gatsan ‘We ear in Example 1.9 shat the parameters and 3 of « Gaasian wetoe se ts expectation and covaance matt, rapes. Hence the distribution fa Gaussian stochastic process determined only by the ceetion ofthe ‘apectations and cvaiance maties ofthe 6s ‘A simple Gresan process c= [0,1 consi of il (0,1) andor va ‘Tachi cau the fis re craton Wy he dstebtion Eaeons PU, Sticky Sa) PUM, $2) PU S40) = M2) en) a eeei eC ey (CHAPTER 1 OSHS SST, (rer “Te sample paths of thi proces are very Ugur, Soo Figure 1.26 for an igure 4.2.6 A sample pth of the Gaston pre (Xf [sate he Xia SEN Be 228, eran i ae) ~ 0 el Be Expectation and Covariance Punetion ora random sector X= (Xy,--%y) we defied the expectation x (EX), Ey) andthe evarancemaes Dx = (coe(Xy Xj)ofj Bent) WN stckaie aces X= (kit T) ean be coded a the ealection af the andotn vectors (Xiyg-vy Xt) 8 thmste €T abd m > 1 Por each of "hem we can determine te expectation and coraraace mated. Alternatively tne am cons thew unis se functions of px) =a, = EX, C67: “The exertion fnrtion of i gow By The eovrince fection of X is ven by x(a) = OMX X = FI — nel) ene), GET 412, STOCHASTIC PROCESSES 2 “The variance faction of 8 ven by — ake) =erltt = val), te | ——— ‘We learnt in Example 1.25 that Gavasian procomee ae dteraied oly via theie expectation at coerance fantions "This isnot eotet Tor & bon Gasein proce hr lors randm veto, the expetaionfnction iy) deterministe quay around wis the sample pata X are concentated. The covariance ftineson et) Sr mesure of dpcadeace i tho process X. The tartans fursion 946) can be cnsered at mee of spend of Che ape pals GEN aroun px [In contrat tothe one-dimensional ease, a saree The “8% of al smple par he tren the graph of x8) - Bae) and lex(t)+ 2ay(0) se sery eel 10 show (oven for Gans process) and {ein gewral not covet. We wil sometines conde cmpoter graph wit pe of etisalat pocsae ant als india the curves px) at Inalt) Bry (t), £6. The ater ave to be interpre or every Bef Le for every india random vaisble Xn i «brute sons, do they [Bro bounds forthe ptf the oon. Se Ege 26 for a teaton Example 1.2.7 Continuation of Example 1.25) Consider the Gausan proces (Xo (02) random vais Nie Ms cxpectation and covariance funtion ace in 8 Lit tae, oweds a psi = ant cxtr={ ‘We have already iaoduced Gaurian process by speiyng thr Bis as laste Gatsian, Another wa of casing locas process consis ‘imposing 4 wpecal dependence stent "Te proces X= (nl eT), T © Bis strictly satmary fe false Swain wor sie ft Index (SoM forall pone coins of inns t-te ©, m 21 and such that b+ oooste +h €T. Here © stands fr the Meaty ofthe distributions; ase Dt forthe det Foe herd vectors (1.9) thi mans that ele tisribaion faction ave ential (Bien Metal as)»” CHAPTER 1 Example 1.24 (Stationary Gavia process) Comtlr a proces X= (Nit € 7) ath P= oe) on T = ZA tila ‘jap ofa sled staonary procts i sequen of randoms variable: Wi 86 2 Since a Gausin process X is determined by expectation sad covrtance functions, omen (19) reds to pox(t+0) = ps0) and exlts) =en(t Ae) for alt € T such that 4 4¢+8 € T. But tht mesos that jx(t) dix(0) fr all, whereas cx (8) = Ext ~ a for some fonecon Zo one ‘ariable Hence, fr a Gauaan procs, srt staenarty mans that the ‘expectation function constant and the covariance function cn depen on the distance a Move generally, (psalyaoo-Gavsta) proms X baw the tro alornestione! proper it called a statnary (i the wie ene) ‘or (ccond-orde)sationary prose. a ve dari a ee process by 2 (strc or inthe wi sone) stationary orate procs, thane belie thatthe caracteratiepropertieof this roo do ot change who tne gos ty, The dependence structure deseibod Ly the is or the eovriance fection nmsion under site of te. Thit 18a roativaly strong retriton onthe underyng proces. However, i fs 8 staard assumption in ean probebilty related ele och at aise and ‘Stationary can alo be inpose on the beremeats of & proce, ‘The proces iis ten aot meer ations [IA X=.c677 tease poms and TCR Iwate | | x isi to have steinary eoremonts if efor t.2€ and hth 4he+h 67. Xi sa wo have independent inermende if or every cic o 1, € 7 ith es etgandn Sy | seinen rand vara Nin Xy ‘One of thn prime examples of proses wth independent statonary incr ‘ments the omograroue Poison proces, Homage Is e aote word. ing fr stationarity ofthe neements 12, STOCHASTIC PROCESSES a Figure 1.2.9 Semple pte of «homage Penn pros (Xt 6 00) wth faonnty Las Beople10 The sch nde stand fr Be xpetton2 (CHAPTER 1 Example 1.2.10 (Homogeneous Poston poss) A stocharoe proces (Xt [0.25) i eilled aa hamapenaus Poison p ‘aro simply » Pouson proce wath tteny orate > Ofte following, ‘Sndioes av and: Heatats at seo: Xo + Teas stationary, independent increment + For very > 0 Xa Poison Poi) itebuton soe Bape 1.1 fort defion of ee Paso datebaton Figue 1.29 shows sever! Poison sample pats. Notie that, by stationarity ofthe Snenmonte, X) — Xp with €> # has the Smo sition at Xy-y y= Leen Le @ PALE) stein, ‘An alternative dition ofthe Poison proc given by XeHeT st, (0 (ato) here #4 doses the nunbar of elanents of any particular set A, Te = Yi Yq and (7) ina saqnace of id exponential Bsp(3) random varabiee ‘eh common dition faction PO) 6 fae covariance faneson (real te deBastion ra p25) colts) = EB —B) + B18] = FB, B,) BA) + BBE = BE,-B,)BBsee04e=s, OSs Since» Gausian process echaracern hy ie expectation and eotartancs funvton we Example 125), we can give an aerntive deaton Figure 18.1 Sarl ae of Bromion tion 0 0.1 us() <0 and ep(ts) = mia 0 cu* cuspren 1 1. BROWNIAN MOTION e Path Properties: Now Differentability and Unbound Variation In what follows, we one ssple path By), € > 0, and conse ts prope ‘is, Wi already know froma te deition of Brownian mote that is sarple th are continuous However, agar a sulted Brora poten ‘Tately convinces ur that tee fonctions of tare exzemcly segue they ‘elas wildly The rain reason th the increments of B ae indpendent In partic, ioeeeats of rowan ote on adcet ners ar ode Pendent waive the lng of eaters, Since we ean imagine the sacle tha constsucted fom ks independ neem on aac terval Frater sarprsng tot contin oft path oval ‘Thus How iets ¢ Brownian sample poh? Before we anew his question we make short excursion ta a cao stocas the process which contain Browatan motion a pil case, All motets ff ee clase have regula sample ps [A socate procs (3. € 0,20) Hef sir for some > O18 it sia the condlon (PB THe fer evry 7> 0, any hae a 20,4 Iyoesyn and mI rruesosBing) (112) ‘Siinarity a drbtiona, nt paths property. J (L.12}, one mst rt relace © wt Roughly speaking, selsnarity moran that Ue propel sealed patterns of a ‘rope path nay small large tne lateral have ilar shape, but they rene esa See Figure 1.52 for an istration ‘The sample pats of a sefsinilar process are nowhere difeentiable; se Propeiton 83.1.0 p88 And here case ‘Drowsian motion & 0 acifalar, be (PBT BL) EBrnyooBru) G19) | Figure 132 Slay: te sue Broan sample ah on diferent seer for vty > 0, ay cof 20,1 ad ‘2B ig fee of Bee a a rb ey tity eae sale alae notre feria a eeePy (CHAPTER 1 Figure 1.3 Lato een ftom. A ery pent grep mn be apr Inaed by otis ouch te amine tangent a Har pont Rh Ue [fon net Aontae atx = Ther re niey man tangs tothe ‘tw of het te po (ne ca ly heck the ditional ety (1.13). Tada, the He and ‘igt-and ides of (113) aro Gauarian andor eto, pd thereat suies {o very that they hae the sme expectation and Covariance matrix. Check these properties yang (11) Difernibly of fuctho froonns that ts graph sooth Indeed, i the bint i, flg0+ Sa) fl) Fie vss ads ii for sore x € (0,0, sy, then we may mite for sal S004 2) = fe) + feo) de + Hs Bade, rhe Neu.) +0 a8 A +0. Hence, small neighborhood af x, the Function fs oughly nea (aration of 2). Thsenplainsts smoothes [Armas deentabity of fat plone mela a unique angen. fore curve i he function fat his pent we Figure 133 fran stration Tn this figure you ean alo ace a feaction which isnot difrentabe a one "Now try to imagine © nowhere difeetial funtion: the graph of his function dang shape inthe mighborhood of any pat Ina completly ‘oorpedctable way You wil adie that you cannot Yealy imagine sch 3 tr 1 BROWNIAN MOTION » function: ts pysely impossible. Neverthe, Brownian motion cos fae very god appronmation to many rea He phenomena. We wil cea ‘Sion 13. tint Brownian mation mt procs fcr sm process The nse propery of Brownian motion has aie enseqieace forth sation of tarp pth Ie order fo sale pth om 7] siesta ute one pt on 1, thea ele the tab terval by the factor ‘Pande sample path bythe fetor Than wear done, Th sme Boks ne an nd the lam that the Hint tay (B=) ase sez cs theres pth ot Broan tn ae ot iGreen ya ‘ow ty ot ong ono to ‘sin th i te po eo oe i ca es irae ein tn ws der saline 8c Sch cen wut Wa. "Scaled a eeu ar ry ty pt spn: stun na cer ote ree am te: Carey (led tarot aw pes A het maa speck faye Ble Ove oe wie ees Cages 2 me tr inde ft nego Boeing ab gen by lowing ct ‘Browaian sample paths do aot he bounded variation om any finite Inter 0,7], Tas ona Ut sp S [Pat ne the supremum op. 21 fo es deft) taken oer al pos $e pariionsr 0» tp oor Oand u€ R_Chaariy i Gatsian proces (wh?) with xpretation and covariate antins t+ 0B., 120, x(t) =e and ey(ta) =e miata), 120‘The expectation fanetonjx(t) = wt (the determine “ei” ofthe pro feos) enetialy determines te charters shape ofthe sample path 00 Vigue 16 for sm wtation ‘Therefore i lok Brownian motan atk (Gree) fe 3 ‘With he fundsieta dicoery of Bache in 190 that price of ky assets sock ints exthange ratty share pics, ee) can e wall deserved by Brownian mio, a ae ara of application of sohasi process mas born omever Brownian motion, 6 a Gaussian proce, may assoe agai al tech ent very desta property ofa pre. th elebrated peers {fou 1073, Black, Scholes and Marton sugared another stochastic proces os ‘inode fc plate prices. In Section 4 we onder ther apres to the ring of Europe el option in tor deta exon of the promising fndinonting example for the ws of achat ales Example 1.3.8 (Geomerie Broa enton) The proce ggtted by Ble, Scholes and Merton igor by Leite the exponetial of Brownian toton with di; se Example 13.7. (Gears, 8 nota Gatsnn poses ty For the purpose of ater wr, we alate the exportation and covariance fan tion of geomet Brownian roti for rece, fanae with prcty ‘hor, you may eal tat fora 1V(0,1) random variable Z Bet oe, dew cs) Heze we ved the fic that (25)-¥Fenp{—(e — AP/2 fs the dey of an QI) random sara rom (1.18) andthe seismicity of Brownian moton i follors immediatly 6) 13. BROWNIAN MOTION Figur 1.8.9 Supe pth af emetic Brounen motion Xy = exp{0.01¢+ 0125) ‘nthe eet eto) (ued) on the poh fhe ene Int) xt) Cady The later res hve ob ted wth ta er {edt of he Re re nt nora For 9 Os sme Bod constant. Ie expectation and covariance fnctions pel) 20 and one) =A +H) male MO, ase Notie that exe) = Oi ¢—# > h nce Xe and X, are independent, but Wee ehcex(te) = Ro2h~ (Es). Sige X is Gatsan and cx) 8 function ony of #8 tahnary (ee Example 128) (Ces, Bas ifeesibl, we cond It in (19) go to xr, and inthe Timi we would obtain he ordinary derivative of B att But, w& wo Know, {hie argument not appa The vastnce faction of) =A” gives an Indication thatthe Buewatoe feo alse become age as hdnresee Simolted paths of colored ie oo very mich ike the sample pats La 1.3.3. Simulation of Brownian Sample Paths "This section isnot essary or the udestanig of tortie. How err wl characterize Browsian ution atu stebutona ee of petal Sim proms socal func cental init tora). Ths observation ‘lly you odes he Brownian pth properties (nn-diferentailiy bound natn) much Detter A second ajc of this seton ist ‘how tht Browolan sample pat an aly be silt by sing tard stivare ‘Vong almost ulmi poms of madera computes, you can visuals | the pt of ost every stochastic poe This te doable beans we He {ove sample pats In eer to understand the stacaaie proces beter. On ‘ether Hand. stalaione of the pt of taham prosaes ee sometines Ciovoiable if you wat to ay something about te dteibtiona propertits tf such a prooss,In ort cower, we eat determine the exact sition 1.3 BROWNIAN MOTION “6 of «mache proces and is functionals sich as ie asin or nem ne given ineral). Then simulating and muerel ieciqus ofr some ‘Stenstive to elle these distributions ‘Simulation va the Function (Central Lime Theorem From an slementary course in probability theory we know about the central limit theorem (CLD. isa faunal rn. expe why he real ‘isteouton pls sac an portant rl probably theory and stati ‘The CLT sap thatthe properly normalized nd eotared partial sums of ao ld Bite sriance segoenoe conser in dsition tom none triton To bepress et Yn ¥5,--e bd mandegencrate (se nam eomtant) ram aval wit ben y= BY and variance of = var). Dene the parti) Fyn0, RymViboobYy, mB Recall hat # denotes the dstsibuton funtion of «standard nonin aon TET; as no variance, Chen the saquence (obeys the CLT, 1 “| 2)-0] 10 oa ‘Tn fr large nthe lstsbuton of (ft ~ ym (oni appeals standard normal. This an amazing fat, since the CLT holds pendently The CLT bas an analogue for stochastic procemes Consider the process ith continuous sample pals oa s0-( Soyenson,, dene (12) In Figures 13.1 and 1:12 you wil find relations of Sy for vations ‘Assume forthe moment that the Yi are bt 20,1) and eoaider the esti of the process Sy othe pit fn We imedtly So thatthe foloning properties hold + Sy starts at bee: §,(0) =6 HAPTER 1 18, BROWNIAN MOTION ” +5, tas indopendnt increment, ofr all neg Of $ Sig tthe random varies | SuQhafm) ~ Sallis Sb) ~ Salinas) a independent \ 4 Por overy 054 Sm, Sls) a arma NO.) dsabuton ‘Tha, $y and Brownian otan Bn 0,1) when retsiced to the polts i, he wry mich the same pope. the definition of Bromninn moton ot 38. Natural the hed property abot ot ald i we dep the eymption thatthe Ys arid Gatslan However, nan ympttie see the socaste proces lotto Browaian tation Ts fnew tn mae) dn he tea] 1h to ele Dor ers pas The wes | Scrcgti cen ora see Bi gue 1.311 Som ma of te pac 4 fo one ef rats Wiehe toe) and Convergence in detibution of Sy has txo-old seaing. ‘The fit one is ‘teal 4 The ls of , converge to the corresponding fis of B, Le POS) $ 21. Sellm) $m) PCB, $2100 Bhg $2) ta for al posible coi of € 0,1], 25 €R, #= 1... ym, and all iatopre But convergeace ofthe Ss i ot sient fo the cowie in ditsiba toa of stochastic procanes Fh converges detamines the Causa 0) be a serene of ed0 HAPTER 1 13. BROWNIAN MOTION Gl 1¥(0,2 sandom aia, then Bile) = Zabel + srw Male) ME, ce fo.2n). 0.29) ‘Tis sees converges or every Suet bt alo wiformly for € [02 ie the |. rateafeanvergae is ompatale or all Foran appiation ofthis ol ‘ne ha to die about he number Mot sine functions and the wanber 4 of aicrtzation points at mich the se functions wil be evaluated. “This Ssmodnts to causing the vale yin Behan + sia 026, | ‘The problem of choosing the “vight™ values fr Mand 3 i ilar to the FeO ‘holt ofthe spl size nin the functional CLT clo se ple ful of thu forthe choles of Yad Tn Figure 13.14 you can see thatthe shape ofthe sample paths does nat ‘hang wery much Ione sites fern Mf = 100 to A= 40 ine cons. ‘sta inspection in the case A = 100 ges the mpreson tha the same ath slo smooth, Tl Is oe completely suring since a um of MT Site fantom i feet; only inthe Ul as M+ ox) doe ee neierentibl sample path, “The Paley-Wener representation i just oe of initly many posible ¥] series repeeratios of Brovaian motion. Anater lk sch ep | Sts defo Loy ithe ay peta he sn oe ‘lee ty cpl econ Smee aso), | “ote pci, tat ete one coe son} alors | iy = cae oa me, ately Figure 13:4 Snastn ne ESS efi Plo Wicrnrsoao 8 a rr fee a hee pao So = 0, chewter,2 (CHAPTER 1 ) a, ve PEELE oro, v ref A). 0, ciewbere, Bansal) = med From tne fants die the mem fhe Sune fonction [1 by teat the Harton at © [Maorde, n= 1,2 Figures 1.315 and 13.16 show the graphs of Hy and Fly forthe fist A ‘ete epesentation foe a Brows sample path on 0 5 then gna bp Bie = s)at), 16 Bal), (25) where the convergence of his serie wnifor for €€ [1] andthe Z5(s)s ‘re ean of ad (0,1 sequence (Z,) As for simulations of Brow an motion via sme function, cme has to chook a troeaton pint M of the fite sees (128). In Fguve 1317 ne show bow a Brora sample Dah i sporonimatd by th soperpeition of the fst A ter in the wren Fepreetation (1.25) In contra to Fire 1.1, the plygonal shape of the Schade fncon already antpates the ierepuatbehator ofa Brownian th its sonifeetiabe) fo lative stall "The Paey-Wiener aed Lévy eopresenttone are at tw finitely many possible sees represtatins of rownian motion. They are special cass of {he eval Leny-Cheselt representation. Cieselkl showed that Brownian ‘oto on 3] en be repented efor aww laine, coma, random variables nd (4) 5 complete orthonaemal Bie) where 2 ze (0 Fanction ater [61 Notes and Comments Brownian motion i the est suid stochastic process. Varios tooks art evted tot, for example Boro and Salminen (1908), Hida 1980), Karteas neat 13. BROWSAN MOTION s Figure 1.35 The Hao facts Hin He- a CHAPTER 1 12, BROWNIAN MOTION 8 “|i - | — 1 ae 1« CHAPTER 1 sd Shreve (1088) and Revs and Yor (101). The vader ofthese books mst te falar withthe theory of acai pote fneionl ana, pe funetons at measure thy. Every eotbook on slocastie process also Contains atleast ene chapter about Brownian motion so the refeences oo pu. Te ion tothe non difrenshilty and uebounded rasriton, Broan soto his any nore ein path a ditbutoal properties. Hk (1080) i god eefsenc to read abot thre, ‘The functional CLT soe ound in adres extooks on tohasti peo- ses the convergence of probably measur: ee or exarple Bligley (1958) or Pile (198). The sre represensaions of Brownian totlon ean ‘be fod in Hid (1080) abo Ciel 1905). 1.4 Conditional Expectation You cannot avoid tis section; t contains material which eset for the Uetaning of mareingln abd more generally 1 stochateitqras Tf you are not intrested in dete you may fry to Fa from one box to anatter A the end of Seton 1A you shoud know + th ald secre yarn variable a random vctoror a stock + the condo! expectation of a random vaible gen a of see Seon 13, + She most cmon rl or aula condinal expectations: So You should tart wit Section 1.1, whee an example of conditional exes: tation ts given Te will give you same motatio fr the abstract wotion of ‘onal expectation given acl, an everytime when y00 ge etn this section, yon boa era to Seton I-41 ad ty to gure ot what the aa Fm a lecentaty course on probability thoory we know the conditional probability ofA gen Be Conditional Expectation under Discrete Condition pane, Pulp) PB) y 1. CONDITIONAL EXPECTATION a Figs 14 Te bial i Yo ee grab Cust, mala) For the definition of P(A) ti racial tnt PUD} fs postive. tis the objective of Stetion 1.43 to sla thi coniton “Te probability P|) canbe ietrpreted a flows. Asse the event B occured. This alana information which sultantily changes the ‘undersing eotitlty mesure, In parla, we aig the te pebbles (to ne know that Dw ot happen) and 1 to B. The erect B becomes four cw probably space, ay Alerts of nec ae no bate of ANB CA Ia order w get anew probability measure on 8 we have t0 omalze the old probabilities P(AMB) by P(B). Tn sum the ccrurrene of B mai ar orignal ypace 9 snk ta, tad the ginal pains PLA) have to be repens with PA] 2) “Given that P\B} > 0, we an defi che enaitional dtbution function of arandam save X gen B P(A) ifand only 4 ad B ar independent PU <2, B) By(e1B) = PEand ls the conditional eset of X given (126) wor {) eos (126), me amine Sr the moment tht — RIX ie decree rao ‘asa wich vale 2,25, then (1.28) becomes Bux) EX has density fy then (1.26) becomes BUX|B) = Fig [_eteiteie = ai [ieee 1 i common usage to writ fe} for J, (eal Example 1.42 (The conditional expectation of» uniform random valle) ‘Wie cone the random arabe X(u) = en the space f2— (0,3), enowod set the probability tease suc that Pile) =b-2, (68) Clears, has wif dbsibution om (0,1: its dso functions Brea ty Fels) = P(e: Me)=w es) PO) =0 #250, Poe) =z ze (01, POA) =A E> d 14, CONDITIONAL EXPECTATION 0 Figure 1.4.3 Leto afr random srl X on (1 led ne) onde erin (cin) se Buampl 48 ugh the rondo ral X (de oe 1d the onion! epecttons E(X|4) (i na, hore A= (41/849), "5. These conta experts cae rll the ves of ‘Aree rondo ure BURY) ah snl constant aac he At ‘Some hh Both, the random variable X and is expectation EX in Figure 142, Now ese cat one of terete 05, are rpeesemed 4e=(6- mil Fa cs ea int ft) =] ni hat) = ' - Buia ply fateendeen [ stee2E aay The conditional expectations E(X|.) ate seated in Figure 1.43. The false E(X |) the spdated aporaton onthe ew spacey given the Infomation that occured 2 ‘Now we comicer a divete random variable Y on $1 that assumes the isting vals 9, om the set Ay be Ava fo: Yw)=ob, 4-12,0 (CHAPTER 1 (Ces (4, «dint partion of, a. ana, (228) We ako assum fr convenience that PU) > 0 fo al Tora random variable ¥ op wih E[X] < so we define hn conditional tspectation of X piven atthe dace random vara BUX) = BUCLA)= IY =y) frwe a, f=12, 2) wo know that Ay otcrred, we may roti ourcve tows in Ay. For those ‘sn BLX | (o coins with the cli conta expectation BCX | = (128), Example 144 (Contnution of Esamp 1.42) Weinterpres the E( [Asin (127) asthe values ofa dncrte random variable BLC|Y) where ieonstaton theses A, = ((-1))nfn) See Figure 143 for an istration of thi random rable nhs setae, (XY) fs thing Ita corer versio ofthe ral ridom rariable Xs, a spptimation ave the formation Ut ato the Ss crue, € Ip wat fellows we pve some slmetaty properties of the saad vile E(X|Y). The nt property can be ny chs. (Doe) “Te conditional expotation i ar for random variable, yan BileXi + XY) =6 £OG1Y) + 4 BOI) HEAT, “The expectations of N and E(X|Y) ae the mer BI This follows by a iret application ofthe defining properties (1.29), (1.26) an by the observation that E(X |) sa eet rom variable Bein) = Sax ianrtas 14. CONDITIONAL EXPECTATION a 5 e(eEn)-28 Here wes nd (1.28) 0 that 1X and ¥ are independent, then EL) tum) Recall fm pth independence of and pion PU €A,¥ =) = PIN EA)PIY =y) = PE ADPLAY). (E31) Consider the random wv I, and otic that fo alo) =} Tt we cn rete (131 8 fllome PIXE Asta, =1)= PW EAP, fo: Yio)= 0 ). ‘The analogous relation, where {= 1) ie ceracd wth (74 0}, ao ols ence th rodom sariablesX and Ty, af Sndepenent aa ro ey E.XIy) _ EXEUL Play = PCA) BUN YM) = BLA) Ex BL, PAR) + APA) = PLA) ‘Tis proves (1380. ——————— | Thecondiionl expectation BUX 1Y) ogre dee random | 7 cashier dice eadon saab, 41 ciacion wih de lea conlonal expeeaton BCX} hon the sats y= (w Yo) =e@ ‘CHAPTER 1 The ove ales ba, Ue corer the andom variable EX |Y). In para if Y= conat then E(X|Y) = EX: HY” ansties faite! wales so doce BUX TY ee 4 The conitinal expectation (XY) i ant a fanetion of but they a fnetion of "The eando vaiale X only deters fhe kindof fnetion. Indo, we ean wie oar Saw 60), where 9) i) Fyn. 1.4.2 About o-Pields In the previous scion we introduced the conditional expectation BUX |Y) cf random variable X ade the dserte condition (vedas radon aria) 1 Recall fom (120) tat the als of di ot rally matter or the defaitio of BX], bate was ruc hat Yaad Medinet as 400 tha wsots Ay, Thus th conditional exportation (XY) ean actualy te uderstood as random wcable onatructed fom a callono(¥) sy sabes of So we may, la a sytabobe way. wre BUX IY) = BUX e079) ‘Obvious, the cllertion oY") provide with the formation about the ‘race f the random variable (a) su fnetion of. Th wbat fos, we wt to wake precise what “colton Yo subsets of 0" means. We wl el ia 6-feld 0 ola es definition follows “ho fel (on) ea vlston of ies of aig elon | stein noccmpty Ge F and te = eC thm EF 14, CONDITIONAL BXPECTATION e MA Aas then iho hie Example 146 (Sona elementary -felds) Check tha the flowing collections of stnes of ape oe: Fi = (0,0), Fe = (804A) forsome A xdand Ag m, Fe = PIM) ={ArAca} i ie the smallest oeld on and J, the power ato the iggost one S61 conte all pone subse of 3 Now suppose that Cis cxilction of subsets of, bu ot necessarily aol Dy ading more sets to C, one ean always bean old, for example the power set P(A), However there are athemtial sons showing tat PS) Sie general oo big” But one ca als prove tat, for aioe clectionC of sabes of, ther exists a alle old 0(C) om 12 containing Wo cal o(6) too fell yeneratl by Bxample 1.46 (Generating oes fom eallecsons of subsets of 2) ecal the o-flds ram Example 148, Prove that = o(}, whete 4 =, A= ta), =r singh defini fil, you have check whic ets nessun belong to the onl of) Now conser {A.B} and G=14,8.0) wher 4,16 C 0 and determine o() and o(C,). Bulore you start: Hest Che about the tuctre af the leant in 9(C) and (Cy) Noi that You an ge every cman of (Ca) by taking all posible won ofthe ts 9, Ang, aR, Ane, ane or o(¢) you ca procted in sina way. a6 (CHAPTER 1 In gee i fe, sok impomabl, 2 ive a connective deeripion ff te elements in o(C). The als a1) gperted by a dsrete rath fasable Finan exci, Example 1.4.7 (The old generate by a dsrete random valle) ecal the st-up of Seen 141. We conadeed » docrete random variable Veith distinc aon y sn dened the roets y= (2° (6) = whe which stitute a dione partition of Choose Aida Sine o(C) i fil mst anti all ts of the em Ua. a3) wher 1 6 any subst of W = (1,2...) ineuding 7 = 9 (giving A = 9) and TN (giving A=) Verify tat te sete (1.32) const a o-Bald Stor th ses (1.52) meoarary belong wo fC) he salt o-fld eosin Crime also have oY) = o(C) Later we will all o(¥) the afeld general wr Notice that o(¥) conta al sts ofthe orn das = (Cla = (era < Ya) £8), ~wcacbeo, Indod, th sot = (@24< yy 4) ia suber of Nene Aw =U lere)=n) €or) a Example 1.48 (The Bor 5) ‘Take = B aod ee “Thoin 8, = a(C) cotsinn very general suet of Re called the ore oi ts sloments are the Borel setsA normal buna bel canoe image the lange rarity of Borel en. For eat, ea te fac, nak ‘cy to very, chat Bis age subs of tho pow et PU (One can alto introduc th old ofthe w-dimenstonl Berl ty = a(C™), sree = 3 and Joe a bc ooh Cl lab] 90 a Wo iarot that the old o()”) a wove objet In wh flows, we ‘rant ne the flowing a of tm moder tobe ab to agin 9} dm water oF a stochastic proces Yon 1, he ia 97) genta By Y contain the eet iors shout th structure of Yas afanction af €f.Iecomsts ofall | for 740) € Ch for stale ats Because Y genrats aol, we alo say that ¥ contain information represented by oY) of ¥ ears the information 200) We conclude with a wacful remark Let f be « function acting on ¥, and fesse EC} for stabi sets ©. For nice” functions this et Slong to a(V), our c ol) ‘Thi means that a function f ating on ¥ docs at pone new information about the structure of YWe sy that to lnfrmatin cated by 1) ‘contain eth nfration a), We give simple ample 14, CONDITIONAL EXPECTATION or Bxample 1.410 Asoo, lt B be Brownian mation and define te olde FinalBntst), 120 Consider the faction f(B) = By fr 4 Bead Given that we know the structure ofthe whole pros (2y.# <1) then we also kapw the strate tf he random viable, thus (5) CF. The converse char noe tre Ii we know the random variable ne eannot construct the whle poss (Bae 8 rome 2 14.8 The General Conditional Expectation a Seton 1.4.1 we deine the conditional expectation BY) of asd variable given he dgrte fandom vaeable This definition does act make expose ofthe vals of Fb St depends onthe suet fo: ¥(0) =n) off. Welkarw: in Example 147 thatthe eallction of the sts Ay generates the o-eld9(P). "This the starting plat fr the ‘aon ofthe general condisonalexpctation B(X | ) gin Bel F 00 1. In applications we wll nays choose 9) fr appropeae sade ‘aval, random vetrs of stochastic processes Y. Tn he previous scion te tied to eames you tha the emeainiformaton abot te strict of Y iscontained inthe oe of], generated by Yn hws, we may that Y caries the information oY) EY, yb random vrabe, adam econ or ochatie prooros nfl and # be natal on 4 the information of ¥ st contin in For ¥ dae not contain ne Information then thal contained in if oY) Po aad 4%, canine more iformaton than ¥ Hf oY) ¢ oC) ‘Now we are prepared give rigorous nition of the conditional expectation BUX |) under a brat Bld8 cHapre 1 “A random variable Z is called the conditional expectation of X given the Ohad we write 2 ECE) +2 doesnot contain more information than that contin in F owe + Zsa the ration BUXIs) = BIZ) forall AEF. (138) 1 Appendix AG we show the existence and ulauenes of E(X| 7) by measure ‘hore mean Property (1.33) shows that the random variables X and B(X|7) are “ost each eer, not a the sae tat they oie for any bt ae gc (xpctations) of and BUX -F) on stable seta A ye th samo. This Supports ourimagiatioe about the random varable EX |F) which we gained Snoetion 1 ‘Tie contol expectation EU] 7) ia coarser vason of the oil random variable ‘Wo mation thatthe defining property (118) leaves us sme feadam forthe construction af the random varabe Z= E(X|.). This means tat thee can fe eens 2" of ELC F) which can ier from Z on sts of probaly 0 For thi ron, all rations noting F(X |) shuld actualy be terete fan alma sure sour and me should ao indeate tis une all ‘levator with the lab "as". However once hang pated ot this ‘cr, we will I esuveont to suppres this abel everywhere Example 14.11 (Conditional expectation unde dsr condition) ‘Wor want to show that the definition of BUX) im Section 141 yids a special eae of the above deaition of BUX [F) whan F = (7). Racal fom Example 147 tht ovary heat A of e(Y) i of te orn UseUterean 108 ase) {n (120) we defined EC |Y) athe random valle Z such that 2s) = BUNA) forwe As 14. CONDITIONAL EXPECTATION oo We earn on p62 that Z is moro a fnetion of Y nat of X, baseeo(2) (Ys the discon tthe end of Srtion 1.2, Moro, To A ven by ee (On she ater hand, wee that 214 ss dint random variable with expe Dewi ayriay = Daw) on) Thaw Z safes the defniog elation (1.33) and ie dos not contain more Information han (tie funtion of). Therefore idl the conionad ‘expetatin of glee tho ld oY). 3 1 the cat fw dnrote random vaisle we have jost art that E(X|Y) fh BUX 00) repreent the sane radon variable: Thin sages the fo Towing dete: 1 bea randow valle, a random vestor ora morte proces oa | | and of) then ld gverted by ‘The emtitional expectation ofa random variable X given ¥ i di BUX IY) = BUX a0) Example 1.4.12 (The classical conditional prbbilty and cmon ex: eta) ‘The chisel condtiona probability and conitoes expectation ace speci ‘ase of the general oto of conioeal expectation dened on p68. Ino, let B be such that PLS) > 0, PUBS) > and dine Fp a(8}). We know from Example 146 that Fp = (B,0,,0"]. An appeal to Exstple 412 yee sat BUX Fe)lo) = BUC) forse B “This the classical notion of condos expectation. we pel for somo vent 4, wo bla for eB, A pane, BUtal Fae) = BUt4|) = PSB) The sgh hand side cho lil conditional probably of A given B,» (CHAPTER 1 tional Expecta- The defining peopety (1.8) of E(X Fs wot a constrctive ove, Therefore iets in gooeraldiflcut, Wf not imposabie, to eaeunte E(X |). The ease Fmol¥) fora dacete random variable Y, wich was ducased in Exar ple 1411 i a exception Forth ean, ls portant tobe able to work ‘vier conditional expectations withoxt knowing her partintar Jorma. Tht teas we veto know af cles inorder to da! wih condoms expect nat fellows, we coll the nt cominon rues. In some cates will ve enon fortes rues, othe ther tations we ave to lyon ive fruits, We sat with existence and unigoeneas ese TEV < othe condsonal expectation EX) exists ad eique in the snot ts dace in Append AG In Seton 14.1 we encountered cues for he ealelation of condo! expe ‘icons uoder a dicrete condition. They tena valid inthe general ese Raed Tee conional expectations ner: for rndom variables Xi, Xe and BileXs +aX]IF) =e BMF) eer BISA. (135) hi ollows by application ofthe deiaing ropety (1.5) Uo the ight ad lean ade of (135) (ry to pone) Now take 4 =n property (133). You mmestely obtain [Rates “The expectations of and B(X Fae the sme BX = EIB F) ‘Als he ei lan (ne (1-0) eases ve rom the crete eae | CONDITIONAL EXPECTATION n aoe see] TEX and th old F ae independent, then E(X|F) = EX. In pasta, X and Y are edependont, thn BUCY) = EX. “This gatemem ooo re dscunsion: what does independence between X ted 7 enn? leans that we do wot gal ay infomation shout Xt we nw Fs and vie sora. Ace formally te random viable and Fy are Independent fo all F. Now, by independens, BUXI4) = EXE EXP(A)= HEX), ACF. ‘A comparison with (1:3) yes eat the constant random variable 2 = EX isthe conditional exportation E(X |). This prove Rae the eld o(X), generated by the random variable X, le contin in Petter Bux Tn patel, ta function of ¥,o(X) €o(F) thus ELEY) = X ‘This means that the information contlned ln F provides us with the whole lofomatlon about the cand valale X Iwo know eerthing shout the ‘tare of we cn deal wit it aif was nom rondom ad wrt he vale "X(o) in ot ofthe conttonal expectation ELI) = BUX Fe) = BUX) F) = XW) BLA = ‘Tiare canbe extend to moe oneal tutions ) Boles ete ofl (), grated by the random vasiableX, contained ie F then fe any nado ale G, EUXG|F) = XBG)2) I purine, if X ie a fanstion of ¥, o(X)Co(Y), thas EWGIY) = XEIGIY).2 CHAPTER 1 Inde, givin F, we com del with asf wae a constant, hence we can pall X(o) out of the pated expectation aad waite oat of (G17) Tale 6 EF apd F aco ols with F CF, then BL) | Bux) BEX FIFI, (136) BELXIFIFY. as) ir obvious reasons, Rule 6 ie smote cle the tower propery of cond tional expectations ule (1.37) can be jie by ale & since FCF, BUCI-F does mat contain mote infrmation than”, Le given J, we cam dea with EX (F) (ELIF) F) = BUF) ELLE) = BX) le (1.36) can orally be dered rom the ding property (18) which sayethat for Ae F and Z = E(X |), BUX) = B21) 138) (On the otber hand, by ule Sand since Ae F CF" UEIX|F)|F) La = BUEN LF Va|F) = BCE F YL) ‘ove ale expectations and apply Rl 2 tothe right and sie E(B |) 1F) = £14) EUELX |F")|F) lo satis (138), but since B(X | 7) i ian, we mst bave Z = 2", whch proves (1.26) ‘Werinsh with a geeralztion of Rae 3 1X independent of F, and he information cried hy the eandorn ‘aval, the random veer or the toca proces Ci omtained i F hen br ny feo M9), BIO.) = ELEM GILID whee By[A(XG)] means that we Sx Cand ake the expectation with respect OX, 14, CONDITIONAL EXPECTATION n We tosrte Re 7 ty an expe, Example 1413 Lot and be independencandom variables, ‘Then aes Tand Save E(XY|V) = BLER(XY)IY) = BOVEXIY)=VEX, BUX 4 |¥) = BLE R(+Y)|1) = BIEN + YY) BX 4 1 the following two examples we want to eerie the eues for eaeaating endtoal expectations Example 1.414 (Troxnian oton) eval the ésntion of Browasan motion 2 = (B,t > 0) from p88. We ‘ssocate with B a ocreasing stream of iforeation about the stuctze of the proces which repeated bythe o-elds J = o(Ba,2 <3). We want ‘ovate BU) F) = E(B Be, 2 4) for 420 (heats 52 1, Fs 2 Fi and 0 Rl gives BB FA = By Now assuine# ~0 oral Ze L40}, ent eX 22> te mmol fr aaa 1 thin see, E(X | F) ite proton of he rn variate X onthe ape 12(F) ofthe rand vas 2 eserying pat he iformion Flo soe the coment to Figure 16. WF = o(F), BUX |Y) i that function of ¥ which bas ite wand "omen ad which clot to inthe ne ce tee In wat follows, we aometines rele to E(X|.F) asthe bast prodition of X siven F This ans tha sation (130) bods, To give sn eaing tothe ‘ford petition’, we rosonide Examples 44 and L415. We proved that freee Ee, = SA = By and BOP t| By, x <9) = BE formation about Brownian motion uni the preset time s, ace the presentCHAPTER 1 values B, and BPs, respectively. This property careers the whole clase STonaringsles with ae second moments the best prdton of the fare Yalu of te stocharte proces I the preset value se Section 15.1 Tn what alos, we deat the steps fr the proaf ofthe retin prope ety (130). We oly makes of therefor clelting conditional expect tons, Fist note that the andor arabe 2 BCX) bongs to LCF) iteates nbrmation only about F snd bas ite second moment. The ter property follows by an aplication of nse’ inant (ee (82) om p. 188) Sn combination with Re 2 UEC F)F) BIBL] = BX So stra thc be ojtin opty.) et Z be do BUX 2F = BUN Z) 4 2-2) BLN = 217 + Be" — 2)? + BEL 22" ~2)) Wo uoat the trms onthe ight hand side separately. Firat eosin BU Z(2" = Z}). ‘Sine bot, Z and 2, belong to L'), so dows Z~ Ze partcula, by Rule 5, BUX = 292'-2)|F) = (Z—zIBLX-Z1F) B= 2'|F) = BUA) BF) = 2! ‘Thus we proved BUX — 2)8 = Bex — 2" + BIZ! — 298 Hence, BUX 2)8 2 BUX 2% foal random vsabes Zn 122), (40) ‘Wo ako so that equity in (LAD) i achieved i 2 = 21, 0 2" = EUX|F) realy represents that element of L'),for which the mining of EX 2)* $ ataeed. This pow (130), 15. MARTINGALES Notes atid Comments “The notion af eontonalexpctaton i one ofthe most fc onesin prob abit theor: ut it also ne ofthe mst powell Ite dfn 63 ‘andor variate vn ld goes back to Blog. Fite complete the ‘etcal undertaning, mease theoreti palit toy Ie unawedae, ‘The onion expectation rented in every advanced textbook on prob abit theory, se for exanple Billige (1995) Willa (1900, 1.5. Martingales 1.5.1 Defining Properties ‘The notion of a martial sere forthe understanding af the IS soca tic integra. Indefinite I stochaeic nega are contrite ts uch 2 way that hey const mastngales The den underlying nating fs fe tae wee the oe winnings ase evaluated via eoniional expectations, For Sina; now have this powefl etre nou ol aw so Section “Asse that (120) ea caletion of e-aldson the same space nd that al Fis ae ruben oa larger oft #00 1 ‘The callin (F820) of Felson alle a lation Fich toradocese "Thay Strain ea increasing strom of infra, (Fyn =O...) se sequence af olds on and Fy C Fao fr all we eal Fa) ration aswell For our applications, eatin usually inked yp with « stockantie procs: { Me soetasieproces ¥= (it 0) sald to bw adapted to he flr tion (Ft OM oO)CF forat20, ‘The stochastic proces Y is always adapted to the natural ration gen Fimaissh ‘Thus adaptednes of @ chaste prooss ¥ means thatthe Ys do wot carry8 (CHAPTER 1 isa dace proves we define aptadae in an aotgous way Or eBltaion (Fyn = On) we Yue that aC F Bxample 15.1 (Examples of adapted process) Let (Bt > 0) be Brin mation nd (Ft > 0) be the coresponding natural eatin. Stochastie processes of the frm R= HB), 120, sehece fia futon of to vale, are adapted to (Fi, 0). Thies X19 =o}, xf = af XB, XP ‘ut abo process, which may depend onthe whole past of Brownian motion, ‘a he adapted. Por exarpie, Xi" = par Bor 2" = pin BE ihe steciate procs ¥ le adapted to the matral Brovaan Slaton (Fe 2 0), we wl say that YI adaped to Brounten motion. This neon that se fanelon of By St "The following procaues are not adapted to Brownian motos iB, xP + Br XI = Bass, XP? eho T> 08 fixe uber. Inde, these process require he knowledge Cf Broenin main at ft instants of tne. For example, consider Xi" For ite defnition sou hae to kw Bip a tines <7 3 Cheats, one can enlarge the natura ltetion and obtain another Btation to hich the stochastic proces saat, Bxample 1.5.2 (Enlarging Strain) Consider Brovaian motion B = (Bhyt > C) and the coceponding natural Fiaton Fr = o(B,.0 © 1), 2 0. The stance proces Xp = BE generate ‘he naa tration nwt s29, 120, 15, MARTINGALES hich i malier than (J). Inde, or every &, #2 © Fi since we can only Feconstut the whole ifrmatin aoa 0 fom Bf, but not haut fe we fa sy nothing abou the sigh of B. Then (2) aloo «ration for (D3). Thus we can work with dient Station fr the same proces, To se lente his aspect fom an applied post af view, me easier Sn example rn Stochastic nance. In iS, beled that shave pics, exclange rates, inveret aes, ete, canbe modelled by slations of stochastic dieret equa tons ebich ae diver by Brownian motion; see Chapter 4 The slutions fe then functions of Brownian motion. Tis proces modes the Sutton: (fe Banal marke (independent tones up a dwn on digit time Ineral) ‘These actuation actully rpceset the lfrnaion abot the ‘market. This eleva knowlege conned inthe ata tetion, Te dos ‘ot tke infrmaton fom outside to secout. Hower i nace he re lisa people who know mor than the ober. Fur earpl, hey might kom that a een! pla dchon wil be ae i the wey haere which ‘il completely ange the Banca landscape. This enables the terme pe. fons ta act with inte competence than the others Ts tey bae ths ove Aleatons wtih ean be tng thas the naturel eaten a Nom case ochasi process X= (Xa 0) on 6 and suppose you hase (he infrmation J, atthe present tne How does tis information yflurnce our knowledge abot the bhai of the ‘roves X inthe future? WF, and are dependent, we can expt tat ou information rows the Uuncetiiny about the values of Xy at ftw stat of tame fe ko that certian events append i the pat me ay elude this nowt ia ‘ur caleuations That can be beter predict wit the ffnmaion J than without IA mathematical tol to deeb this gin of afration the conditional expectation of Xy gv BIR) for Oseee ‘We lara in Seton 1.45 that B{%,| 5) the best polition af; given the information Jy Ako recall fom Examples 114 and 14.1 thatthe ochatie procaaes Ay Brand X; = BF — (i Brownian toten) sty tho condton £(%, |) =X, fr s < (Por tase proces, the Bet prediton ofthe fue value, ven Fy the preset ale ky Clary this may ange if we oad snater tain, and therefore we ms alas Sy ubih Beatin we oie“ CHAPTER 1 ‘The stochastic post N= (Nj. 4 20) called a cotinuoas time mar langle ith reaper tothe lation (Ft 2 )- we wee (Fe 1 BN |< for all> 1+ X adap to (Fi): see p77 fr the definition. BUVIFI=% orabosset aay Le My the bet priton of yen Iii ao pombe tn dine a dere ine martingale X = (X In this ene, me adapt the defining property (0) allows EvXupt Fa) =Xay #20. (an) We show tha isles to equ (142) fr K-= 1 Inde, realing Ral from p. Nagi |Fo) = BUE(Nasal Fuss) |Fol = BU asa Fa) BIE Fas LF Kees Fa) E\Xnse|Fe) Now wr define a martingale inthe dere tine cate The stochastic proms X= (Xa.m =O, ,__) i elled dicetedime martingale wih resect tothe filtration (Fayn = Only we write oa + Eg < 90 forall n= 01, + ls aapted to (F). BUX Fa a Xa ithe best proiton of Na ven Fo Xe frail {es ut dic to a tat te defining propery (AS) en beeen in the fon edhe (L4H Uns Fn) =, whee Yags = Nass ~ Xe 15, MARTINGALES a ‘The saquence (¥) the ella martingale diferenc sequence wih respect tothe ftration Tn what follows, we often say that “(Xt > 0), respectively (ayn = 0.1), 48 a actingal” without pata out which Staton me we. This srl a ea om the sone ace bom ee avin isthe emarlable property that ts expectation Fenton is constant an Indeed, sing the ining property ECKs[Z;) = Xa or 6 <€ and Rte 7 on BX, = BEX forall and “his provides an easy way of proving tit stochastle proces i ota ma tingle. For examples 8 in Beownsan tition, E87 =e ll Hence (BP) fame be martingale. However, we canot tie this cane to prove Wat a Stochastic proes fy @ martingnle, nce pres that has a constant expe tation funtion nol ot be e matingae athe following amie shows we ave BB})= Ofer al but (BP) alo oto martingale Eagle 15.8 1.5.2 Examples 1 this eon we collect some simple examples of sochatc processes which have the matinee propery Example 1.5.3 (Paral sams of independent rand viable conse & sarin) et (Zp) be a sequence of independent randoms viable wth nite expel tons and Zy =O: Coser the acti sams By = Bott ly, 020 sd the corresponding natal lean Fr = (Rf) hr m0. Notice tha Fue elon 2y)y 920. Indeed, the random vetoes (2-2) al (By) contain the sane Information ine P= Zy + -~) Zand Z, = Re By far -s An application of Rules 1, 5 and 4 Section It yee E\ltoys | Fa) = Ea Fa) + E\Zay Fa) = Bo + Bley Hence I Ezy = forall, then en Gon athh). 0,1, isa mtingale wit spec,2 HAPTER 1 Example 1.5.4 (Collin information about «random variable) LZ bea random vale on with Ej <0 and (Fj 20) bea heaton fon, Define the thane procens Xa lows Me BWZ\F). 20. Since F; inczeses when tne goes by, Xi wines us ore and ote infomation bout the random vatable Zn parila, IF 9(2) J for sme t, then Xy= Z. Weshow tat X ica matings ‘An appeal to Jensen's inequality (A.2) on p 188 an to Rule 2am pT yields BEI Fi EIB al <2 Mowsover, Xi obtained by conditioning onthe inlormation F. Hence it hows ot eottain more Inormation than Fi, x0 9%) © Fee ene to heck (LAT) Let #<. Then an appliation of Rule 6 on p. 72 yields BUN) = BELEN F|= E217) =X Thus X obeys the defining properties of &cnstinuoustime warngale se a : 3 Example 1.5.5 (Drosoian motion is» martingale) Lee df= (it > 0) be Brownian mation. We eonetide fom Exaopes 1.14 Sid 1.615 tha both (84> 0) and (BP € O), ae marinas with respect to the aural Bltraion Fy = (Bn < 8 1 th same wa, yu ca stow (08) that (9-36) 3) Sea matings ‘Ty to fod astocastic process (4) sue that (1-4 4,),(F) isa martingale Hin: est caleulate B((B, ~ B,) + B,)*|F,] Or 8 0) na {Gren Broan sro path and a deine ft othe sample faih of machi procan. Te farcry we call the Ries tegrl {BJ te canal ner od soe ft proper. Then we eas iamann-Sctip gas sich re ow i spe othe patie nega J stodeia). Weil etn dese eeethnss coos on fhe ier loli we dee ne la pot out ht or era he Riemann-Stiltjes integral By(a)dB\(o) cannot be defined. 24.1 The Ordinary Riemann Integral We want to recall the soton of oninary intra, which ix sso cll the Riemann intra, You doll be far with tis ntegral rom » ours ‘emery clas ‘Supp, or simply ony, that J. « raked function deine on (aft nce we cold consider any etre Considers partion of the tera [1 a dee elec Am intermediate partion om afr is given by any values ysatishing fh < Bt forts hes Boe on pions sandy wc det he Toman som Se =Sulomen) = Softw —t) Sf) Tus Riemann sum is nothing but weighted average of the wales (3) were the weights ae the coespanig lengths 4, ofthe intervals ft) Wo al kaw that, ap apeosination tthe area betwee the grap of 21, THE RIEMANN AND RIEMANN STIELTIES INTEGRALS 49 4 eel Figure 2141 A hobaion of Rionans sm with portion) snd trace tion]. The nono the meangtr ae poze the ae betcen the Bork fi nda room te OTOH the faeton and the taxis, provided J omy assumes nonnegative ales, Sex Figure 2.11 for an ihatraton Now let the mesh ofthe partition ry go to seo, be ax, A= spa tor) 9 0. we proceed in tis wa, the points = fel have to depend cnn, but wesuppres this dependence ou notation 1 te lieie = Ins fig, Sosimna, existe as mehr) -¥ and Si independent of the nce ofthe pat tons y and titrate partitions oy, then Si alld the ord ary oF Riemann integral of fo 1)We wate (ing the wl cr i oral Wie know that ff J) at exif i eliintly smooth, or example, ems se corte tat tous or pleoewis ota 03) Lnin-) aT Azalogotly, take the ited pots ofthe interval [1 SP = Slates * carrer 2 2.4, THE RIEMANN AND RIEMANN-STIELTIES INTEGRALS 91 ad coneude again wing (2), tat | spe A mae Now chose the yas the mide pots of the tervals (4 — 1) and denote the coresponding Riana suns by SI") Since $< Si Si we may coelue tha: 54" “+ $= 05 3 Figure 2.1.2 Tos Rima rant forthe nel [44s Beagle 2.1.9. The ee eae farton goon yf font re. TRC Ce ig) and te gt Re ee eee Cen pn 8 el nd eo asa reer etd teal eae ey eee ce ed it ine 7 with ose ie Sh popes Ser bs Te Res, ean J lf se i] ‘Example 2.1.3 We want to calculate the integral {2 tdt asthe limit of eetai an Le oa eee ct er ee 1 [saa [now [le ste esse sudan patton of (0.1 hehe pct ene) enti [raf nas fs04 sess2 CHAPTER 2 : ae ee + One can define te indefinite Riemann intoal function ofthe [10a [romana oes 2.1.2 The Riemann-Stieltjes Integral 1a probably theory ci usual to denote the expectation of andom variable Xby exe [sare ‘hare Fy deoots the dstibution funtion of X, Thi tation refers to the fact that EX ie defn ae Riomans- Stir integral, oe a a Lab Ste integral. Ths mean, roughly speaking hat [seen Seat Bte for spt 4) of Rd comesponding termediate partion (y)- Alo fel fom a coupe on semestary ecole hat yo en foe th geal [est = fe Ogee, provided the dative ye ‘Both, J tdFx(t) and J! f( dalth, are examples of bow one could p- rout the plans negating one fence wasp oat fone Tong ies the am a oe pte chapter fo mga ome eto Tn rrr, we would ie to basa nga of pe 1) 420), wre 7 Econ or sets roe on fj ant Brown sage ll We hae nai ifely i Sting such a integral see the ath Bic) dor have ndtv, ne Seton 13.1" Howto, oe ean id Scie Lin of patina negal ic somts alws oe to erat th Integral (dle), Thi of integral the Rema Sees iecgat e as cl any Slo mathemati Ta wht flows wo ie apo dion of the Race SUshjo ate ya aslo the Reman nog coer parton oe er rat Owen etna Cte 21, THE RIEMANN AND RIEMANN-STIELTJES INTEGRALS a en inlermatiae partition oy of Let f m9 be eno aka funetons on 0,1 an define Bug alt) altddy i ‘The Riemann-Stejes sum corresponding to abd ven by Se (aon) = $5 Ka daa = YF te) ~ at Notice the siniarity with Riemann sum ce (2.1). Ta ha case, () = & ‘Ths a RlsoannStljex sum toate by weighing te valves /) with the ierements Aig of the tervals 8 We aie hou 8. = ex 3 fon 9 ets a6 mehr) “+ Dand 8 Se ndependen of the cic of he pas- {ions ra and tie iteretite prions 9, then lle he Rieman-Stjes intel off with epectt gon — [1090 When dns he fiona Sees nol fe) ext ad it uc fey = fr Dron "hic quatin dee not have imple aaaeer and neds some more enpiien- ‘ian, soe textbks oe a the lowing pata are +The function f and 9 must not have dscontinsite 3 the same pint rep Assume that fs continuous and ts unde srt, oe Hoseatere hesapenim Ks deitonon p21) ean neal oie Jasons ral “hen he Rema Siena 4) exit. Notice tat the ne al ot apple to dhe eral 194. Indoor ra a Sat 131 eh Brownian ample pth Bo) do nt tae bounded varie, Nowe Sounded werition of i 0k neesary forthe existence of he ere Steer tral fy 0 da tlthough the contrary cai ean be fond in sme Books. Weaker conitont forthe existeors of (dy) tent very wll kxown, bat they wee ales found ty LC. Young fn 1586 oe the vee papers by Dudley and Novia, (08a) fran exten dss, Without gong Ino deta ww i a suiintconiton for Rinna ‘Stele integrability wich i owe to oeceity First we give debeton “Te ea-valved fanetion fom sid to Rave bounded poartion forvome p> 018 sup SEIN) MP < 0, tee the supreme ovr ll partons of 0 Note Wat has Bounded variation ip = 2 [tee Remaan-sone ep fj/)aq) ets te lowing o- | + The fanetions f and g donot havedscontaits at the same point fel. The funtion fa ove prion and the fasetion 9 Ihe bounded qstinton fr some p>O and q> 0 such that risgton In some cases thew conditions can be werd, We gow an example fr the Integral Jp FO ABRC 24, THE RIEMANN AND RIEMANN STIELTJES INTEGRALS 9 Example 2.1.4 As before, B = (Bt > 0) denotes Brownian motion. Ite tral that spe pal of Brinn san have Bounded aration tn any fae nie nese, provide tat p> 2, and abounded praration foe p©2 Se Tale (1972), Now consider deterministic function #0) om [0] or a sample path of a ‘orhutie posse flys). Acording to the above they, we ca dite the Renan Sueljes integral Jy (AB) with respect to the sample path Bi(o), povided f hae bounded garntion fr some q < 2 This satis fi 7 ht bod vaiation ia ‘Assume that Ji diferentablefanction with ound devote f'), Then ‘aloe by a application of he ea va here that un = 0 whee K > Oi constant depen on J. Then EkG-m, act sup 3 1) Ha SH SE ta) = cow Hence has bounded vain, ad s the flowing statement hold ‘sun a deerme ction or the tame ph of stochastic proces: fi iferentiabte with abounded deiative on [yl en The Risa Seles ttgeel [s0a00 ext or every Brownian sample pth 84) 1 prtclar, you can define the following integrals as Rensann-Steljes ate als [ee [amos [rane ree “This doesnot mean tat yous evauate ce nga xpi tems 2 Beowaian toon. 3 ‘The abve discussion ty be sight isang since suggests Chat one a0 Anse nepal ff) ABs) or ery gener avg fa 2 Hina ‘Stieltjes integral with expect to « Brownian sample path. However, this oot eee6 CHAPTER 2, the ate. A fam exp, which i alo one ofthe motivating examples for the ntoducon ofthe Ie thas tera i the agra roy = ff Bale) dB) Sronsinn motion ha bounded pit i p> 2, trp € 2a so {hemlet ont pet 1 fr th exec of (2) Cee») tot Sate Frcre, canbe Shs ta tha sg nga es me 2S Rieonnn Stee neal Maeve, ne cam sow he flowing fd) eats 8 ea Siena al ons oes fa thn erry as Downe arate Ptr (1002), There 32 Sno of oan odie he egal J) a) al eatin date eons {on} he ewan See integral epoch at fl ner Brownian ‘ample pote dont have unde wat om ay Sate ner. Tels objective uth lowing sonst fd ner spon testa tg. Sie par eration wi ep ot Brownian ‘ole uth spss y the Reta: Sls itgr dae nd flit lege cs of ftpabe fonctions, we wl ty to def th intel ara probe aeage. Thi appl ba be daaranige at I inate than the Rann Son gra garding te fr tho egal. Notes and Comments ‘The Riemann and Rlcmann-Sieijesiategrale are treated bx textbooks 08 Calculus. Honever ts #ot easy to find 9 comprebeive treatment of the Fiemana-Stje iatgtal Young (1986) i sll one ofthe est relearn ‘nthe tpt. Pxtonsons of the Ream Sto nepal ae treated a the ect work by Duy and Norval (1065). 2.2. The Ité Integral 2.2.1 A Motivating Example {the nlf vio etn we la hat simp odie he tga eB a) path by pha RS negra inate B= (84221) dents Brownian ton oe 2 22, THE ITO INTEGRAL w understand what is ing on, we onside he Riemann-Sties ums S=S.A8, en tea patton of [and fr any Faction fo (0, 6) — My $= hea ae the covtesponing ncemeats of J end af ad Beetntens Feo ‘Thr the Riemsen-Stijos sm Sy corresponds to the parton rand the internat portion y) with yp t,he. te elt end pot ofthe Intro [4-H This cole pia fe Ue defiton ofthe Ko stochastic Intagral We wl also su hat another choke of iterate pation () 18h sto the deftion of another type of stochastic nega ‘Notice that Sy ean be writen the lowing om Sao dao (Choc yang the Biomol (By, By)? = BE + Bh, 2B, Recal that Brownlan ton as indpennt and stationary increments (ne P83). Hence “These immed that BQu( = 5 BBY = SA = a8 ‘cuapren 2 td, ecaln by the independent increments of Brownian motion and since the feation var X) = BCC) ~ (EXT has, swaun) = Soomavee) = $1610.01 ~ a3 te ix a wtb fact that forthe (0,1) sande vsable Bh, ES Hence, a8) = EBL, rhe pts ta elaoal varQuio) = 2S a ‘Ths ax, 0, mesh) + 0 Shae Sine art EXQu(t)~ 0 we showe: ‘Qa{f) converges to t io mean square, benee in probability; awe Ap Dec Al for the difetetsnads of snvergen, The ining anethn f() = Hs caracteristicoly for Brownian motion Ws called the qudrte waitin of Broa motion 0 [0 (ne ca shw that Qu) ds not eannege for 2 gown Brownian sae path td autable den f partion 7. This fot dearly ndcats that we cannot kein Baloo} a & Rien Seles ntgtl. However, le could define ff By dB, « men square ot Ine, doe Su = 0.510% ~ Qu) enon in mean are 20.50 — 1), cul ae th ita the abe oft nel fe BB. Late Cosi ei slr of the Woche ge iG Bab, Btn 29) i | 22, THE ITO INTEGRAL ” om tic evaluation we have learnt vious farts which wil be fil in wht felon Tete with rape to Broian sample paths whch eannot be de Bred in the Reman Site sense, can Bop be defi the ‘To incement A,B = By, — By, om te interval saisie BAB and E(A\0) = By" 21 The mean square lini of q(t) 8 The properties age that (30) i ofthe nde Te er of difreatas, we wie (UB, = (Bisa 8)? =a en st interme of tgs [ons [lane The righthand side isthe quadratic variation of Brownian maton on (ot es) [At Ue omen, rations (2.7) and (28) ae muting but Meri ale. They an be made matheaatiealy core (i the mean square ses). In his book ‘redo nt ave the mathemati santo prove te. In what fll, we Two (27) and (25) sr hen sul hey bp ts to undead the "esl of alls ptculr the Inne in Seton 23 ‘Next we ty to understand! why cz the lean Sti sus Syn (2.4) in suck a pei way: the values of Brownian mason were esate at {he lt ond pint ofthe tral 1h Assume that we havea pan 7 ff (anim (25). We art in Example 1.7 thatthe matings transom Beas given by Eaae Sti a marge with gpet to the lation 9B) By kle k Ac reuls the mean sare int 05 (1) ofthe approsating Rann Ses ins atingle wth respotto the natural Bran lesion0 CHAPTER 2, Another deisiton of the Rlemann-Sies sus makes thet lo the rmatingae property Aa 8 intr of fart we men hat, for parton ry = (apo wath pay)“ 0, the Rian Stes sss ave the msn sae mit 0.5.7 (yo ea check this by the sane arguments sn tole ar gem for). The quasity cane interpreted as th tle of another nachatietgral, [By od say. The Reman Steljs sume AB, AB, = 1, do no conte a martingale, and eter dove ‘eT pros 058) (de 0}. However, the ltr pots enjoys anther ee property The elation [cas india that the sana chai ral ol e9 To be prec, ett) ba determi detente funeton with WO) = kao that oes Bae a Integrating both sds, we obtain by the dasa ral of ele, bf PO aoa Lee = fe) ae = f verane if = 480 [4) Beans [vera eee 1 formally reper the function Wt) with Brownian motion By, we obtain the sae vale a forthe torhasticintegral (20). Home, ely formal replacment, ice the cain rule pplable to diretablefonetions, tt {o Brownian same paths "The stochastic negra, which i obtain st the mean agua bit of ‘he Riemanm-Steljes sn, enlated tthe mide pint of the laterals ltt clled a Sttnowch tne, We sl consi iin Srton 2. 1 ‘llr otto bes una ol fr soving Ho soca dierent eatin ‘Ths we have arnt one ae aed it. 22. THE ITO INTEGRAL wo ‘The fra [3B = 05.0 — 1 sgt tat te asl chan tule ofitgeation done not old fore seas integral In Se on 23 ee wl nd chain ale wich wl uid or eeprom he mona 2.2.2 The Itd Stochastic Integral for Simple Processes ‘We start th investigation ofthe Te atcha tg er a las of process hae pater ony a fie ber of val Asus, = (2 20) {econ Brows maton, cd Fre olBaest, ¢20, isthe correponing natural ftraton. Rell hat 2 stochastic process (0020) adapted to Browolan motion I br alapted to (Ft > 0) This ea thal, for every, Xe fneton oft ast and presen of Brownian Inch flowy, we consider al proeses om a ie terval 0.7 Fie otoviue an appropiate elas of 5 itera process, “Tw sosaste procs C = (Cj, (0,7) i anid tobe vingle {sf the fling poopie: ‘Thee exes a patton of am variables ach that 2a it cm ZW wasten, The sequen (2) apt t9 (Fy = Ban he, Zsa fnetion of Brownian motion upto te 1 hd we BZ hl Example 221 (Some single proses) The deerminte function Soh eer, wid es102 cuspren 2 Plgure 2.22 Teo eprosintion of Brownian sme aby simple prone rele), 210), ‘estupfuneson, nce it x simple pre Now dfn the procs ew) TH ple proven: the pat ae pic function of rownin motion a ne Fora Tascam the proces C fr tno feet partons se Figure 222 “TR osha ital of «angle proses C00 [0.7 sven by 22, THE ITO INTEGRAL 9 ‘The Id staan eral of ewe pres Com Ut fans SES ta Af 6Foatort0, =F 2.8.8 + 2B Pad MY [me 22.800 ‘erie fie Wiha, te Ran: Sty ‘vt. eanl h pat r ihr cyt pt mal Pata heat ae pct MEW Figure 22.8 The 18 svbatie tal [Cs 4B, cnn the pth of © nd pon a Pg 28 Example 22-4 (Coninuation of Example 22:1) Real te simple proces fan fom Example 22.1. The corresponding [Mo tochte latgral re tn gen. by [noe. ba =) Bae)18 cuapren 2. for £6 (1) /nAjn}, ad by [oan-$0 for €€ test Sow gus 222 and 223 fora viulization ofthe sample Dts of BC andthe crespoving I stodhasti ttgral We kaow from Example 21.4 tat taf where the right-hand side if Riemann Stee integral with ape toa [Sven Browolan srl path, Wo alo een in Seton 212 tht the rao Stole ums (212) do nt la general converge esh(ty) > for a ven stipe path of Brownian main. a ABH E(B Ba em (oaeniey= fsa. “Th form ofthe ed stchastic integral for Spl proves very ouch eins 1s ofamartingale tanner, On p.m inode oe martngae tans Cay, tare (ern 0, ey) Tan, wena, Hee ¥ {6 martingale difernee sequence with respet to a given faton apt © = (,) iv preiaibie rqarnon. I hi wns, the sequen 13 stochastic nega (ff 6.80. b= 0...n) fs simple proves (Cys #) sa matings transform with respect 0 Blration Fh k =O) Bt eve ire tre ‘The stocastie process L(C) = [fC [0,7], ea matings with spect tothe natural Bsn tation (i 4 fF | We duck the defining properties of « martingale; ave. For ornenence see reall thm in ttn of TC} 1 AC) <0 fora ¢€ (0.7) 22, THE ITO INTEGRAL 10s # HC) i atapted 1 (F). UIC) FA=1(C) for sce (ei) “The fest property follows, for example, fom the nomety property (2.18) sven twlow “Adapted of J(C) to Brownian motlon a easly sen: at te f the sande varlaesZy.+Zy and 3yBy--, 4B, Be By, ocean in te defnng ison (211), areal epetone of Bran maton up to tine 1M emia to show the eral elation (213) This le good erie in using the rales of condita expectation, which we suggest you ty Fe Soursef ‘We lave not indicate whic roles to wie ax we sume Chat Ts ante tat j, the random variables 1, and W; ae uae rela main that Wand 2, at functions of rowan maton upto tne Tier they are iepmndet of 8. We code that ON2) 4.8) ‘Ths the ers E(W) in (215) vaio rf J, ands we obtala Dewasy ‘The rght-hand side nothing bt the Riemann itera ff) of the step function f(e)= BCE, wich eines with £22 fry Ste (heck this, ‘This we ave proved the lumetey propery of th Ie soxhasi tepral The Ko stochastic Integral has several properties In conon wid he Rican sod Riana Sees integral 22, THEITO INTEGRAL 17 For constants a simple processes C° and Con (071 [oor sac? anna [ore +0 fora, The seating a tn [oun fc, + [cun, “The proof of he invari not lieu ty your. Before you star you awe to define Cl and Co th anne patton, This aways posible i 1th partition eorerponing to C™ and? the partition crtspooding 1.0, you gta ent partatin rit at mot nm dine points hy tak the union afr and Clearly thet a rfinment ofthe two oil pains. The vals of the (C1) emi the same with haw parton eat follows fem the arty of the undedsing Rbeano- Stes sum The seat on adjacent inter om fom, se wee C2" = Cains) and CP? = Cyne) ate to spe proces inal, we state the fllowig property “Te proses (0) hs comtnnous sample pth, “This flows frm the dein of 1(C) the vation WC) AC) + 2B ~ Baad cab, = [ [et + oP] an,, Nos andthe sample pats of Browaian motion are continuous 2.2.8 The General It Stochastic Integral In the previo section we introduced the I stochastic integral for simple poceset ce fo socastie proces whote samples ar ste fn. ‘The to sochasti tegral JC AB then simply the Reriann-Steessumvas cHapren 2 fC. lute at the tend points ofthe neva [1 ts mth espe to ‘Brownian motion, We leat Section 212 ta, gna, we canoe dee the to storks insegel ata pate lit of Rename Siler saa ta Seton 22] wesuggsted tht re dee the I lochastiotgrl eth sin ‘uate lil of stable Riemann-Stlje sims. This en works under gate ‘At a certain point we will ed some tools from Hilbert space theuey, which we ‘do not requie ar cminonkowladge Then we wil depend onsote heute ‘rgumeats, However, te interested ws can Bod roof ofthe exons functional analysis, im Appendie Ad Tn what flows, the proms C=C, [0,7 serves a the integrand ‘steed “Asem os on the Tategrand Proces Cr 1 Cis apt to Brown motion om 0,7, i is funtion Basen The ge BCE de osc that te Asunpins ac ii said or» sinple poco: PI. (Wey ten) note a of snc negands itis he Serie fants et) on [7] with Je eC) dee c-Rel he ‘onion fanetion om 7) ‘nha flowy we yeu usc approach to the achat ing ca al tow we procter the et ft gal fp Be ln Section 22 «Fore anda given patton () of we needed the Riemann SMikje same 28 Bu (Dh By) + Nie: n Stn 2.2.2 df erty Pe Reman -Ser me te the Ki starsat = C2 4B, ofthe sng fae thas wih aut ve By 2h tra.) Then we consider the mean st in of he Riemann-Sijos sume HO) and obtained the vale 0.5 (BF = “This approach can be made to wok for prose C sal the Assumptions "We cmoace wih an interesting cbeeraton 22, THE ITO INTEGRAL 19 Tt Cb procs satafing the Assumptions, Then onc cn Bd uence (C1 of spe prose uch that, | Pde > 0, [90-6 ‘Te eof thispropety i yd the sce of thi bok aw Append AA fication “Thus te simple promees C1 cnvegein acorn mean suse ete to ‘he integrand prone. Sine O% snp we can eraluate the Wo sora fnegrals (C= [C14 a every nat The ext sep isto show that the sure (1(C°) of Rd stochastic Ted one can sow the cxstene of a process (C) on (0F] sch tat 5 gp, [tir - ue Ste Appendix AA for & prot, ‘The sna square imi () lle the Id sacha egal of ©. eden by no= [oan cen Sele sus repent (211). | Alter hs general dfntion we do not el very comfortable wi the ation of Te socastelmeggl. We have lt the anton bras eaten ble to write the ntegel fy CoB sperms of roman mation. In pte iss we wl be abl to obtain ex foanule or It stchatic ntegraly ‘but this equ knowledge ofthe Ie a ge Seton 29. For our gel inulin, adr practi pare, he fling rae of hun pfA | iw CHAPTER 2 fet 22. THE ITO INTEGRAL ad ‘The No stochastic eyes (C) = ff Cyd €€ 0}, constte @ fat On CH Setar Sh dan € facta the random vaca (C) i loa” to the Ran Steer sn Fee Bi 4, and his aprunimation i the coe inthe mean square sense) to the tal of fe} the ore Gente the partion re [7 Properties ofthe General KG Stochastic Integral ‘The general No stochastic integral abet the proper af the I stochastic Integral for wple proce, ave Socton 222 In oneal, we wil tbe ble {optove thee properties, Homer some roa an be founda Appi Ai The stochastic provost (C 16 [0T} a mareingne wth respect to the natural Brown Beaton (Fy, ¢€ (7), ‘Thi eal fam the particular coke af the approving Riemann Siijee us of, which are evaluated tthe cad pols af the interval.) oc te prof ofthe exsence ofthe Wd atachaniintgral the emery op ‘ey (218) fr stp proces ln ental, Ie seman va the gener 5 (f(ca,)'=[ecta, even ‘The stochastic inegtal als has some properties In common with the Re ‘hana and Reman Stl integralne (CHAPTER 2 The Ho stochastic egal er or constants ead processes C1 and CO [7 saying the sumptions, [oe «act amen [‘oan, + [eran The Wa stochastic integral carom ajcen eral : ee + [ca, luli, we sate te flowing propery [ te process 1(C) has continuous sample paths. Notes and Comments ‘The dein ofthe stochastic integral oes Back to 6 (10821948) who Intodeed the soca ltgrl witha random itagran. Doob (1053) re aed the conneim of 18 etgration od martngsle tory. 18 tegration 5 by nor pat of rane textbooks on probably they aed stochastic econ Standard references ate Chung aed Willams (1000), Theda end ‘Waraoabe (080), Karate and Shreve (1038), Oksendal (1085) and Prot ter (1992). Nowa sme text on Sine a conta 3 survival Bt ot "orate integration oe fo example Lambetan and Lapeye (1005) ‘Sime ofthe nlorcentioned books dice the socal ngrl wich te spect to proaies more general than Brownian oto leudig processes ik jump Marcon, dhe assumption J EC3dh < e fr the existence of 4, CAB, can be eben claed 2.8. The Ité Lemma In the last wo sections port about the 3 sachs neg. Now we hom the negra! CyB i ebined, but wih te exception of ple ProcenesC we dot Rae the tole ocala I tochasbe ltera and {o peace wth sone simple operations on thn. I tthe objective tit ‘eton to provide ah toothed es. 23, THE ITO LEMMA na 2.8.1 The Classical Chain Rule of Differentiation, The 1 ema isthe stochastic analogue of the dase chain ae fdr ‘alti. We neatione the chain rule om p. 100 a putea case, There sve real that, fra ieetiable Fonction 1a) _ area ith 80) = 0, b[BMae tens [Mba [roa cw {We annotsnply replace n (2.1) the deters function Hs) with sam ple path (a) of Brownian motion. Indeed uch path were ees Table Using some clemgotary aan we dcneed in Sete 2.21 tha the Te stockate nepal fe By, ae le 0'5(B3~ 1), Thin conta to (246). Nate that the integral value 05 (21) the value 5 wb ‘be expected fom the aseal chain rue of ifleetiacon, corrected by ~08¢ This ugget that we have oad a orem svt lassie hain ale “Anotee appeal to the dination a Section 22 ells to hs tern comes ‘Eom the mean square limit ofthe qa fantional St (Be — 2, ) Te oder to weston she strhstio cha ule, eel he deter nite chain ue. For mpi, we mre W'(), (ee, forthe ordinay Arivacves of the faction hat Tat F aod be difcotabe feos, Then the las chain rule of ‘iret ols: Wolof = Fain) en Because we ee intrested in integrals, we rewrite (2.17) in integral form, se intgate hoses of (217) “The cha al i ital orn flo) ~ fot) Fatsnaierar [' Fasndas). (248)tales a ueniating forthe Ie eta, Inthe nguage of diferent, (217) trecmes ofp) = Fhe diferent cane interpreted athe fret. ode Fight) + dale) ~ Stal) = Pate date) + 5 SKOOL? + >. C9) ee dt) +) ~ the eee 90 ft, Under ale Povo aa : 25.2 A Simple Version ofthe 1t6 Lemma Now mune hat fa tric eee acto, ba ep (29) Sith Same pih Ba) Drown ction Wie y= Brg = fr Se ltrmeat of Bo ra, Ug these gues as bor ne tan 1.40) = 189 = 1840, + LeBNaBY? +. (22 6 p99 meavexme motion tha he ated feel (40, an be mrp Th ‘contrat athe deri cate, the contrition of he econ ender erm inthe Tar expansion (2.20) te nt eile This fact i he eon fo the deviation frm eh asi chi ae, nterating both of (2.20) i a formal sense nd gen ters of order tiger Un Son the right hand ie, we oben fr + [401 = 18-10 om = [resi 3 ['mone. an The flowing question atually ass Ho dome Boe to interpret the inter n (2.21) and (2.22)? ‘Th it nepal in (222) ie na toca intgral ff"), and he sco ntgral hast be htrpeted asthe Riemann ietgal ff"). Relation 221) defines the quaity [ef (B,) whic ran snalogue of a elecoping in, at 23. THE ITO LEMMA us therfore tis msural oan the vale (By) ~f(B,) tt la wha allow, tn alway give the vale 1,1, tothe apc itegrl Ja, whatever the Flosaste pros V Tat f be ice onto diereatable HB) - HB.) [rnd +3 frends, ver, 2) tea spl for of the 16 le of the 16 formal Using sophisticated methods, wich ae beyond the spe of Hs book, one an show that (223) mathematically correct. Now wo mau ose the I sen ator, eral Ss al Fiuce 28.1 Ou sole pt fh prs {48,09 (0 0, Se ae Example 23.2 Choose (0) [eS emma yids for 3 3 Example 2.2.3 (The exponential function i ot th ed expat) Incase cleus the expmentil anton f() = expt) has the spectacular property that 0) = fe) Eqsaets, [now HOH Minds [x00 set a2 1 the I sue? This would bea candidate for the fd exponent. Since the {lass rals of itgratin fain geoeal when Brownian ration is inlet ‘eemay lag export that f(Be)=exp(D,) sat he I exponetil. Thea ree t ees eeeeet ees “ [feria (Obi, second, Rina, egal yds a postive val, and so (228) ‘nat be std A the moment we cannot sive an anew tothe above question. We wll {evar to thn problem when we ave ne advanced ac ofthe ena; oe Beagle 235. 5 23, THE ITO LEMMA a 2.3.8 Extended Versions of the It6 Lemma Jn thin anton we exten the simple lemma, ven in (2.21) (2.22), sn ‘We mart with an ed lena for the thas proces f(¢B). Assume that f(s) as continous partial decvtves of at fart Scand orden A ‘ofestion ofthe Tvl expansion aguante in Section 232 I len ‘ces a thie more general ase. Recall hate secu der Taylor expansion yids thet He eBay) 1B) = 25 WB a + ft). + Eiptespcan® + 2 fale mate + fle) (40%)) Beer, and in what los, wee the lowing notation fr the parti dive tren ff reads Stevan tena, on ire 2 smnil tana ‘Asn clase els, ihr order terns in (2.28) are nelle, and so ae the tee with actor dtd and (a However, nce we tres (4B,)® fl the tem with (4B) ete epee. Arging te me way 8 fn Sontion 2.2 formal integrating th ot and an pk aad se Sn (225) and eallecting al eos wit and dB, separately we end up wath the folowing formule: ‘Extension I ofthe 1 Lemmas at f(2) bea function who sco onde aril derivatives are com ‘invour. "Then Ht) ~ Ho. B.) = e20)| [bien }ratnea) ee + fnieesabs, veths cnapren 2 Figure 2.34 One sample pth of tea of rowan maton xp) nd of thei exponent! empl Wt) (ou) forthe ne a of Bf. rar We apply thi formula to find the 1 exponent Example 22.8 (The I exponestil) Welearot in Example 2.33 thatthe sachs pocess exp (2) i not the ‘spon a the tau of (224), Now we coo the neti Moz) ‘Then dite calelaton shows that Mba) = ftae), ltr) ft21, fate) = ta) An apptication of the above I lena ee pum) 108)« f He.n0e%, In the sense of (2.28), f[.2) i the 1b exponential See Figure 23.4 for a pion ofthe at of the proce explB,} and xp{B)—O5t). Example 2.3.6 (Geometsic Brownian notion) Comiders particu fom f gem Brownlan motion (f. Example 18): eons sed em Mis tBu 23 THEITO LEMMA uo wee «and @ > Oar constants, Notice tha flea) = ease, figs) = (e054 fina), fits) = eflta), falta) = ot fe21 A applieation of the Ilene (220) ys that the proces sain te Tie stocasie diferent equation For later use ne will eed an eves more general wes af the lena. We vil consider process of he fon fe) where Xen by Xia Xe + [su + [re (220) st both, 4! and A are adapted to Brown ition. Hane tie assed that he above neal re well dene nthe Reman and sears, teetvty 1 process X, which tat sepreentaton (229), alld an Td procen | One can show thatthe pronsaes A and A at iguly determined in the sense that, I X has representation (220), mere the AU are replaced with afapted processes D', thew A) and Di necaecy Recall thatthe gomese Boman snton (227 eatin (228), Hence it is a6 process oth A = eX and Al = 0X, ‘Now. ung snl argument wth Tylor expasson a above. one a stow the falling formula0 cuapre 2, Extension Hof the Ie Lenina Lee X be an a process with representation (2.20) and f(z} be a feton whine ec order pata decvtives are coins, Ther LOX Flak = 0) Lt + fan. Give ajifcation ofthis formula. Use a Tylor expansion for f+ Xion) fle) ani (225), where B i replaced with Nand X has repreeation (2.0) Neglect higher orde terms tarelag with terms olin (4) and {dB and rakes of (Bs) = ora (2-30) oq ge he fllonng fr W848) AP dt] £3) S04 esp | as, Apldy + Aga The ater Hen i ymbaie way of wing the Ld representation (229), The negra with eespet to Xin (23) has tobe iterpeted a allows: [swsnesy= [39 sinners [Aenea 2s Fay, wv consider the 1 lomma for chase proces af the frm AeX}",XP), where both, X" and, are Ita processes with reper to sitent's [atta f dB, bata aay 23, THE ITO LEMMA ma A Tayo ein expansion agar isto the one above ye the fll ing toma: ‘Extension HK of the ee Lemanas {at Xan Xe two processes given by (238) and ta) be ‘ Tuncton whee second onde paral derivatives ae conineout, The $1 XLXEY = f(a, XP, XB) (234) = [noxaprar +E [soxp.apreny HDD [soap apyapnayoa ) see the partial derivatives of f(z.) i ad th vasa, especie pT ate fit2320), fal respect woe i he ‘The integrate with respect toX{" have to be interpreted in the sine way ss in (252). Formula (234) can be extended in the strsghrward way 40 Functions £1". whee the XID are proceses wih expect tothe ane Brownian motion, We mention that cn cn ls come uth a Teel fr proce with rept to diferent Drown atone. However, ths tees that me define the ho stochastic iter for such a etn ‘The flowing example an aplication ofthe es lemma (234) Example 2.8.7 (avegztion by pst) Consider the fanetian J(2122) = 223. Then we obtain (we suppres the srgoments of th feos) k=O ham A ‘ow apy form 234) to obtais and fswe CHAPTER 2, “The Integration by Parts Formula: et Xan XC be tno 10 process sen by 288) Then AXP xP = xPaxlY + xfant + AP MAM a — eas) ‘sing th 5 rpeeetation (285), we obtain an alteative expesion forthe ‘retin ag?xP) = dal? +e xPlalM = aBPAP ya sea) xPAP aa, ‘As porter examples we conser Obvious, Wc, abhen, aoa, allan — [ornaen- [nea Move genera, show ths for any comtnaoucy dieemiable function J [0.7] ee owing eatin Ble: [rv Notes and Comments Hebe [0 Bae ° ‘The Its lena i the most important sonia caleuls. We wll use Ie eey sften in the fllonng arcane A Sst versio of his fundamental result was proved yl (161) Various verso of the Irma and thr roa ean be rnd in wath taharticlesi, for example Ching nd Wins (0), Theda and Waaabe (1985), Ketatzs and Shreve (1988), Oks {1085} ar Pst (102) 24, ‘THE STRATONOVICH AND OTHER INTEGRALS we 2.4 The Stratonovich and Other Integrals Ta this ection we dicus some ober tochasicatgrale a thi tion with th tach setegral. I cetaialy eeu fo you to eal tha thete a lange vrety of other integral, the TI interal Bag Jost one meee ‘ft faily On the ober an, you donot nest the iformation of hie Sect (hich i alos edna) nes you ae intrested in sling Hi orate diferent equations by the socalled Seavonovi eles Tn the previous shons we studied the I stochaste ntegrals HC) fea, ter) Hse aia what flows, = (2,2 0) Brownian mation and C= (Ct [BF fa proces adap othe natural Browolan ration Fi = (By © 1D, Fe [OF The main pe in the dation of he Te stochastic ‘asthe approximation of (C) by Merann-Stelijes sums ofthe orm Te aeee, (B—Bu) Oe istst, — 36) for partons Daweh crete cteet sch hat 90. sme) = ape, = As usu, we write A = Bh = Bis Tn the Riana su (2 36) we chs che als of Cet the left td pnt of he biter fy Ths choice was ade for mathematical venience: Our gain was thatthe tacasie proce (IC)! € [07 hae vik matbenatieal structure. Te inher the martingale propery from the Sponomsting Reanim (26) "Thu x high level of the theaey ‘etoctatc proce con be api. As ubsidiry properties we get thatthe txpesnion ofthe I stochatc aegal lias oa its vara can be ‘rrr bya application othe onery property. Te rer owe hast pay forthe nice tatheroalealstretre fe thatthe chin rule of ae eles ‘sto vali anymore, In calls, the eli replaces the elas chain tle In this reson we cansderanober type of chai inte the Se tenevish tachatc tte. We start ih it ition inthe ease that thea CHAPTER 2, Itegran process C eve by G=K8), 120.71, for vce lifereriabe fonction fon (0,7. Define the Remane- Stee 5 Sropaw ean ‘Ove can sow thatthe mean square lint of the mann Stes sue S, tr if ra) 0. ‘easy as forthe stochastic integral, we can deine te toca proces ofthe Stratonoich laces integrate sun [{saean, eben, Sa fora sien pardon ry of [0.7], Wao retin that aot dial to esl thatthe sequence (Sy) bs the mea guace Knit OS 2. ‘This tthe {aloe of the coespontig Sratonoveh suchas neg: ex) 24, THE STRATONOVICH AND OTHER INTEGRALS us Figure 2.42 One sep ath f the praca f 9340, (owe cute) and of the rest 2 €B, (appre) fr he we Broo sms ath Cbriouy, the tockantc procs (0.58, € (0,7) ota martingale, How ters mete thatthe Sttonivch oct integral (28) formal sibs ‘he las hain ae re p. 10D fr 4 dseussion 2 The formal vali of the lai an rule the eso for he we of Stato frvch achat ltgrls, "Ts despite the “pot” mathematical srvetore tf ee Staton stocks nega, has the an” proper: We wll ‘aploe we we solve RB tohaai ietal equation, To ge ms eling for he Staton atachasi negra, we consider a ‘romsmation frou whih i the sid the corespoling Static ‘ovate gral withthe oe lterand process J(B)- We ase [[rveorace ot [arintacce. ex) i snd dh son Sao toca ‘gal S(t) det creel 7) 100) HB) + FB By, — Ba16 CHAPTER 2. Stee su for Sr F}) can be wee a ftom Evo = SABE L MGB Bad AB + DAB VBS LB MBy, ~ Bo ENB Be B Bud + oro: (om St has the mean square limit fg f(B,)aB,- An application of condition (2.30) shows that $i” has the mean square limit zero, and some calculations w+} [rae in mean square, Combining the mean square convergences ofS = 1,23, ‘we Bally obtain the llowing ra ot (24). Asse the function Fett (2.90), Then the treaformation formal het [lrercans [naan 4 frase. ex om this arma itis immedinte that (S02), 0.7) does ot conse ‘Sting Check hs by faking expectations in (240 ‘Now take the pacar Function 7) =. An application ofthe Ra emma (228) to Yom a8) vies wean = [sone 04 [saa 24, THe STRATONOVICH AND OTHER INTEGRALS im = ff nosan + fl rose tt he rgh-hand side sel 0 JF f(B,) 2B. And so we have The Satonovich mosaic iegrl sts the ein ae flan ‘ale [Notice this sateen de not ean Ha the Statonovich stocking teal (Riana) intel. We only cit thatthe corresponding Example 2.45 3) Tae ft) tae ‘Then g'(@) = 2 We oben fom (242) £ Predd, Thies in agreement with ou previous servations about the ale ofS (B) 1) Take) = expt). Then 9) =o) We obeain rom (2.42) tat fe 96m We conclude om the Iter lation that the proves y= exp Be), € (0.71 1s the Stratononch exponential Also recall fom Example B.3 that the Ki ‘sponse tally diferent proces . Tn what folos, me want to ve transformation fra forthe Staton “tochaseinegrl which more gona than (241). "Tece we only aden integrand pocones C = f(B). Now we ature that the integrand of the foe Ga MuX), Cer, eas) hee (2) ba funtion wth continuous paral derivatives of de two, The Process X ir suposed to be an RS proces fare. 11) gen by the socastic {ere egeton x os [ou Xode [oe.xoas,na CHAPTER 2, whece the continuous fantom o(t2) and Mt-2) satisfy the existence and Tignes condions on p18, For inerands (248) isnot staghttorward ow to get extenon of the intceal with C = f(B). One poe way 1o dene the Steaenoviekstchaste iategrl l la apprainating Reta ‘Sten ne The mean square limit f(,%,)odB of these Riemann-Stielyjes ums exits € [sue Kid < oo (One can sow Ut tht dion Is consistent with the previous one (with Hlsz)= f(a, X~ B andthe appromating Reman Seelies suns (237) ‘nde the assumptions on F and given above, the following trnsfor | ‘mation formals bois [l1xveen aay frwxaans} [wx nixon, where asus, fe) the part deve ff wth respet to 2 om the above dranon it might ave Deco clear that we can define ety feet stochastic inesals. For every p€ [1 «even pation Ty {tf [0.7] ands proce € adapted to rowan mosin, we can define te Riomum Stes ame lp) = toa toe 24, THE STRATONOVICH AND OTHER INTEGRALS 9 1 weer) > 0; the an squae lint of the Rlemann-Sijos sma Si ‘tints provided satis soe iter sumptions The mite be Se the ip)-stachaste sara a C rc) wf c.an, ‘We sted two particular cases: p= Oe I cae) ad p= 0.5 (the Seato- sonic ean) Foran teva integrand the vals 1 (C) dif for distinct ‘mor example, wing argent sna to the tb and Sratonciek nes ‘ne nn ow tat 9 fan, = 404+ (v3) 7 Te ako pba to get transformation forma sch as (244) in order 29 relate the (peter p € 10,1, tothe carespondang 1 or Statonovich Imegrals For applications, the 1 andthe Satanovch itera are most ‘erat ‘The rents mee existed above. So lo Chapter 3 on sachastie Aieeta equatin. Notes and Comments ‘he Stestanovichstockani integral was into yy Fisk, wd odpe dil by Stratonoieh (1966). The maibenaial tory of he Staton luvegtal canbe found ia Srstonoic (1080) see also Arpad (1973). oui, thet and Stratonovih ters, are deed io etbemaialy ‘arte way. In applications one has to ke a des av which stochate leegrl appropriate. This ie hen & question of modeling ral the + Explicit sation of ilfeeniaaguaons are the exception fom the tule In geoeral ne has to vely om eter salons (0 ‘ferent gations + Inegraing th side of the diferent uation (32) one obtains sn quia gral ution xo ass festa [Although cis transformed equation sin general not of grat use fon finding the tolton of (3.1, ges an dea of how we could ii a stachae dileretialéquaion a8 stochastic Inte 3.2 Itd Stochastic Differential Equations 3.2.1 What is a Stochastic Differential Equation? Consider the detente deen eqvation Aoi = atte ae, 20) ‘The caret way to intodace randamnes in this equation i 1 randomize ‘he inital condone soliton x) then becomes 8 Mochasie proce (rer a8 =att.knde, Nol) te) 32, ITO STOCHASTIC DIFFERENTIAL EQUATIONS as igure 32.110 sins Xj Na! ofthe random difowntialquation dX. = rat sth iol contin Ne = expN}, where W has on 8,64) dabation, ia 001: Rie 2” = 000 Such an equi i called a random dferntl equation. Re solution does tt reife stchare clean we ea st the easel ethos and ajat {he elution to the emesponing otcome of the nial condition. Random ‘feria equations can be considered ae determine diferent equations ‘ith a prcrbed tia onion. Te Investigation canbe of ees one Tents to sy the robustness of the solution to diferent equation under ‘sal change of ee nial conitin. For example, Figure 82.1 shows that ‘he slson offered equation can change ie dratcaly, evn the hang of the inal eondion stall For our prpors the andornes a the diferent equations introdvend ak, = ft Nae HE MAB, Nolw) = Ye). 69 ere, as url, = (Bit > 0) denotes Brownian motion, and a2) and ise) ve determinate functions, ‘The sition X, i exit then 8 ochatie proces. The andomness of X= (Xt € [0.1 rests on the oe hand, fom the nal condo, anton the ther Rand, the noise (eneratd by Bria motion 1 tive interpretation of (36) tel ot tat the eange AX = Nigar ~ Xi is cata by a hanged of thoe, with actor af %) i embinan with S Ghage dB, = Bree Be of Drownian motion, with fcr eX) Snee rowan motion doesnt have diferente sue pats (oe Seton 1.3.1, the ellomingqucston natural avs:16 CHAPTER a Ih which sense can we interpret (3.0)7 ‘tery, thre no wiqueanewe to this qutton. Bt ise we know about nb alealu, we en pope the flowing Thuan (6) asthe stochastic integral euaton x Bat fatnxnder [urna o5es7, an here the fast tga on therght band side Riemann ater ant tho stcond cea To stochante ets Equation (27) alla an 18 sacasic dierent equation ‘To call equation (3.7) a diferenta equation is counterintuitive. Ty same gases om the sym equation (3.6), tt theater nena les ‘ne says wha the diferent re. We lon the general custom adel (37) ‘sn occ difeetal equation Brownian motion Bie eallod the ding proves ofthe Ib atcha Aietetal equation (3.2, 1s ponte vo replace Brownian mation by ote diving proctnes, bot this requies odie more general stochastic intr. This nota opie of his Took We refr to the monograpla by Chung and Willams (1000) or Pret (900) who introduce the sachaste intgeal with spect to semimaringales ‘Thelaer clas of process containe Downian motion, bi aoa lane arty of Jump procasen "They are unl tole when nei interested a modeling tha ump ehaacter of Yate process, fr example, the strong clon foreign change rte eases of the stock marke Mina proto lear whether th ate (87) ae well define. For ‘example, can we ensure that Be %) i ated to Brownian motion aad BE Elle X,) Pete? Theor the crucial onion or te deiton of ed stochastic integral; sox p 108. But ean one check thee condition i we 4 at know the station X Soon we will ce that there eit simple con tions forthe existenoe and niguene of sation od soccer We ist attnpt the question What solution o the Ii stochastic ferential equation (8.7)? 32, ITO STOCHASTIC DIFFERENTIAL EQUATIONS sr Surprisingly thre no unique aamee. We wil id two ins of sltions to ‘oct diferetial equation. "Thee ze called tong ad weak ution rong soaton othe wachaatio afore equation (37) fe & ochae process X= (XB) wich sates the flowing cor ‘toa 1X is adapted to Brownian motion, te, at time i a fanction of + The nega occuring in (.7) ar wll defied ae Riana or stochastic integral, spc. + Xs function of th uneryng Brownian sample pat and ofthe ‘eatin ncn a2) an (2). “Thus ang solton to (8.7) i based on the pth of the widen Brownian ‘oto If'me were to change the Brownian motion by another Brown riotion we woul gee nate strong sition whieh woud be given by the ‘one fcional relationship, but with the new Bran olin ‘Bl wha snow 0 weak soluton? or thse solutions the path bebavioe ot eet, we ae only intersted Inthe dseribtin of The nil onda Xp and Ue cote fctons tits) and 82) ar giv and we have to id Brownian motion och that (G5) teks We easton that shore exit Rb stochatie difrentl equation tric ave only weak ston; sw Chang and Willen (1900), p28, or Srexanple. ‘Weak slions X are wifcient inorder wo determine che dstibutional ‘characteristic of aur the expectation, fasiance ad covarianefetons ‘the proce thease, edo mot fo ow the sample paths of. "A song or weak ston X ofthe eb stachstedifretal equation (a7) icalled a difucion. lo paris, thing atts) = 0 and 83) = Int) we se that wi ten ion proces In wat folio, we oly conser sang solations of I atachante erential Fist we eve alfisent conditions forthe exntence and uniqueness of such ‘lions. A proof the flowing result ca be ond, example in Kloten Sh Paten (2092), Section 48, ot tn Olaendal (185), Theor 331 cHapren 3. ‘ASsume tential condition No has a ie ssoad moments EXP <0, andi adependeat of (21.2 0) Assume that forall [0] and 29 € Ry the coeficient functions faty2) and 2) satis the flowing eons “They satay a Lipecte onton with ep othe cond wa se To.2) ala) + IKt2) - Men < Khe ol ‘Then the I stochastic ferential equation (37) has unique tang sett om Example 3.2.2 (Line sochastle deel equation) (Consider the roca ferential uation Karis [oreaus [lorena ceton. am 2 The above eontons are sted (heck hen) for 2)=az4e ad Kta)=a2+e 69) ‘An Tb stochaiedifreata equation (88) with arn 2) cout fan thous a2) and, 2) teal linear tb tach feretal eatin. In Stina 3.3 we wl gv she slut ofthe gearal near toca iret tsustion By vst of the abe theory, lata tach diferent eaters hve unig strong solton on every itera (7), whatever the hoe of the onsets and a 5.2.2. Solving It0 Stochastic Differential Equations by the 18 Lemma In this steon we solve some seamentary hd sachastie diferent ensations ‘yung the RS Temma. Cleary, the Art enndidates are near socate Aiea uations They ae “ninpe” and have wig song salutons ob etry Hee itera ,7) se Example 322 42, 190 STOCHASTIC DIFFERENTIAL EQUATIONS. 9 Figure 92.3 Sanlu of metre Brownian Obra o 000 Rigi oO Example 3.24 (Geometric Browniaa motion atthe slain of near 1 ochatie diferent equation with maleate nase (Consider the Linear I stocastie deena uation x ote [ Xuaere [x.a0, t€l07], (10) for poe constants ¢ a > 0 1m the serond, 1, ates, Broan motion and de proces X ore inked in somlpcative way, Therefore the i stochastic diferent equation (2.10) ‘oovelerrd to asa linear stohaste diferent maton with multe Feo (2.28) wo kao ‘The particular geomettie Browalan motion pene R, re [OT eu solos (3:10), and fom Example 1.22 we cone hat i the ange tottion of (310), Figue 323 shows two path ofthis proces x Recall how we wer thas X sie (3.10 we appli the 10 ema, Now tre are face with the inverse pole:10 ‘CHAPTER 3, ne te 1 lemma 0 fed the slain (8.31) fom (3.10) Suppose + = f(tB%) for some smooth function J2) aod recall the 1s Tena fons (238): were [readme ['nmavan, aim rai see Rice cttaa) = east om ee ea aw) From (3.10) we obtain #121 fale. ‘Thay the no derail equine (3.1) and (2.14) can be simi (= 0504) f(a) = flea), a fee) Tey to we (2) a a product of wo faneons He2) = 0162) pits). (315) “The (115) bees 080%) =010, oe) =H) Both of hem can bese by sept of sales (ne Exaple2.1.2): =H)", Haye nOVE Ths we aban M2) = 0) nopale-neve ‘Nom cal that Xo= (0.B4) = f(0,0)= (0) (0), "Thiel gies 6B) = Koc OHFB, re [07] 22, 176 STOCHASTIC DIFFERENTIAL EQUATIONS Ma sich agrcs with (3.1), ‘Thu the maton toa ed stochastic ferential equation can smatimes be lived tthe sltton of (termini) pata diferent equation, Example 3.2.5 (The Oreutsin- Unlenbeck proces) ‘Wecosder another incr atchane diferent equation: ee oe Equation (16) is usualy reed to a Langevin equation ‘Langevia (1008) sade this Kad of stochastic decal equation to model the welt ofa Brownian patil, hie was lng Before otal thoy or ochasie dirt equations exited In contrat to (810), Brownian ooton and the proces X are oot ieciy Tino nthe Ie intel peo (818). Ta the pytes Berar, the random forcing in (3-16) i ale adie nee which an adequate desertion of Mode! (3.16) relate othe word of tine serio analysis. Wet (216) inthe AM sede + eB, nd formally set dt = 1. Then we have Byer Meeks + o(Bi — B) me aXi + 2 shee 4 = 6+ 118 a constant and the random variables Z =o (Bho ~ 2) onsite a ld Sequence of (0,0?) random variables, This sa aor ‘rosive procs of order 1 cf, Example 123. ‘This tne series model can Te consldred ne 8 dseree analogue of the anluion to the Langevin equation Gi, ‘To lve (3:16) the following tranforeation of X 5 convent yaete, Note that bot proceses X and Ysa the same intial conton10 CHAPTER 2 | | tl shmasfret| i fen ie Figure 32.6 Fie sample pts of the Oraten-Ubente procs (317), takes hewotaet, Aight Ay=10,co chat Applying the es (230) with Moa\=es, Hh62)= e462), fe) AM eX and AB =a, flee-tes "The proses, at an selves the Langevin state diferent equation (3.16), 32. ITO STOCHASTIC DIFFERENTIAL EQUATIONS 1 Fe aman ital tion ys ri ada rin | Figure 326 shows several paths of ths proces 1 oder wo ery thatthe process. X, ven by (8.17), atu a tonto (8.10), apply the 1 Tema (2.50) tthe oocese Xi = ul) where a [ova and uft.e) =e" Xy + wets Moreover, since the Langevin uation is sea stockade equation, we tay concide from Example 122 that Xf the onto song solution to 316) Wo ely thatthe Ornscn-Unenbck procs Gaui process, Aste for snl that Ne = &. Recall frm the dention of the ho stocastlc 6 the mean sqore mit of appraising Remsann-Siie suas Dee Ba) 2, far pactiioos ra = (4a with esr)“ 0, The ater as ort station with ast nd wane Sew ta) as) (Chek thst) orice that (2.18) is «Ra ssn approximation tothe te ha-emy Since mean square coavergence inp convergence in dsibution (ae Ape nd Al) we au eonlae shat the shan sua init ya the dma Aitcinted Memana-Steljes sums Sy ix orally debuted, Tie flows fem the ange given in Example ALL on p 186, We have fr Xy EXpn0 and matty a (24-1)‘| ry: & Hl | * pie Figure 22:7 Tee pth of the two-dimensional proce (9,1), 6 (7 Show Bend Bre ao independent Broan tons Set Beale 9.88 Using the same Riemann Sts sum approach you can alo exelate the ‘covariance nein fan Ortsan-Unenbck oar with Xp =O corks di) = E (0 0-4) vet ein) Sino X is a mean zeo Gauslan proces, this omrinee function is ara terse forthe Oran Uhenbeck process, 3 Example 3.2.8 (Aste deat equation with twolependen de ‘ng Browoion mations) Le B= (B,¢ 2 0) be two indepmodent Brownian mio and o,# = 1.2, ‘al number Soe Figure 3.27 fr a station of he two-dimen po” Define the process lo vo" (8 ¢0.8) sig tbe independence of Band i st lel ta see that EB, =0 wad cov(B Bi) = inks, ‘eB has exactly the same expectation and covariance fonctions as standard Brownian motion sep. 38. Henee Bisa Brownian motion Now conde he integral equation 2, ITO STOCHASTIC DIFFERENTIAL EQUATIONS Ms for constants ead XinXs = « [xa + [safone! + one] of Xute + tsa!” [xi (32) ‘which i an Wd stochasi ifeentil equation with diving Browaian tion BB From Example 3.21 we ca ead of the sltion Ky = Xyloontettetenetoeb™A, 1h the above definition (3.20) ofthe socal ata ne were quite Iueky ‘because X appears asa mutperin both integrals Fong sna patterat forthe dition af the ho stohaste integral te ako past oduct [anany + [Lacrange for more general procenes A. Morne, the Brownian motions ean be Oand Xo =0, Then 2) lal +) and it Xi) ak Bb180 ‘CHAPTER a Notes and Comments ‘The sation of stochastic dierntialoqutons it treata in all vxtbonke ‘Thich ae seated Loa elles; ee or example che lerencs on. 112 Ts applleauns of stochastic diferent uations one has to make a de lon af whieh vd of integral, RO or Stratonrieh, i more appropriate "Thee is no car answer a to which type of dierent eqeationthosld be nd. Both Kids of oyatont sre mathematically reatngfel. ‘The same ‘depends on ow pescily we intend the oo procs the dill use tonto model he real nee Clasel calcula ease on clase of snot fctoes, in particular eileen functions, Real prorees ae oten tooth with tlt spall degen of correlation. This ease thatthe ose [eSetclty regular, nthe seen eaouable to todel the process ya Satonovie stochastic ferential uation tease the aes of cssieal 3.3 The General Linear Differential Equation could ‘The Gonoral Linear Stochastic Differential Equation MeXyeeslell dB, Le 1.7) (32) The (determi) eoefentfancions «and 3 Fe contnots, hence ‘hooded fT) and 0 le nt lel to see that the sxtence fn ungoense conditions on p. 138 guarate that (2.32) has que Strong seaion ‘This equations important for many applleations. es parcels atason {pcan i san epson i tenn of the coniintfnetons and of ‘he underlying Brown spl path In wht lows, we derive thi slation ‘by multiple ut of diferent rant ef the 1 lem. serefinmnenioneef 3.3.1 Linear Equations with Additive Noise Soting (2) =O (9.32), we obtao 53 THE GENERAL LINEAR DIFFERENTIAL EQUATION 1s seins fiom sabotesftnttn teh. 039 1 terms fleet it can be writen a AX = LO(OXe HolOlad +oul de, Le T The procs X isnot detlyivaved i the stochastic integral, and terete (655) gaol ir mame, The slain of (3.9) partial spl ‘One way to salve a dfn equation isto guts is form om some barca exaples. Tis is perhaps nt the mort sstitory appeseh sce ne cecal nods alo of experience for su a gest Ana, eo ese ve) 10%) of-[[oia} an for some snot funtion (2). Av application of the lemma (20) pia pels ay =a (tol) at + on(yi8 ah Inierating both sides and wong st 40) = 1, ence No = 2, we bean “The Solution of (8.33) niawier' (se aim [otonioan). 39 1 Xp i constant this defines a Gassan process (You can eck this ly observing that the stack iota the tran equate ii, heat the Tit in distbutien, of Remane Stele sums which ae Gauslan random ‘arabes sine the Ivesatd os (0y(@) i determin Example ALL on piss)tsa CHAPTER 3. thn (839) wit et) = evel = Dal on!) = fr constants cand 2. The xs tae" fe "4B, ¢€[0,T) We lars in Example 325 that is called Orastsin-Uenbeck process roel yi cptant ‘The covariance fancton ofthis Gann races sven in 19). a 5 lal pt eta Figure 43:2 The sample pts of the Vasc ntoret rate madd = ree ‘hati at fh il ae 0 = 05 ote tan vale 2 8 he el Example 2.3.3 (Th Vaso intrest rate mol fd eg oocyte rate la tated to br a constant tat & andor factor of tie . Sle > any change at ery santo hae {sal alo the ttentanara intrest ae the Vanek made sen " rote [u-nlase aB,, 0.7) (335) or the angigirl ay Wy=nidt+ots, 610.7) 414. THE GENERAL LINEAR DIFFERENTIAL EQUATION 189 where cand are pote constants. The eatinale of hi model is that Fluceate sound the vale . When deviates ur it wl mene Be ‘raw bak toys one sa tha reverts to the mean yo The speed 8k which this happens fs adsted bythe paameerc. "This point is twseratl well in Figure 3.32, This can alo be ain fom the foto the expetation and ‘rlace fates: se (3.36) and (37) The tied parameter gis a meaare forthe order ofthe magultude of the Ructatlous of around ys (297). From the goer solution (334) we ean ead off he slain 0 (3.35) rene tulle) toe f eneB, ‘We ase tha ry a cnstant. Then it Gatasian procs. For = 0 we tain ao Orase-Unlebeck proses, 1 not dit to alate Bn ane +n) (30) air) = Za em (37) ‘You can thc thes frmula by using the resus forthe Orosela-Unesbaek rons ane Example 25. Altman jou can in the rele Soo ‘Ast co, the random variable, converges ditibution to an Ny ?/(20)) ‘arable. Sine Gausan, tastes ppative valves with paste prob- big This propery tot wey desirable for an interest rate. Neverthe, IE is are nd o5/(2) tsa opr wh ltl kobe age tive; ee Figure 8.3.2 for an stration of ample pts of the Vanek proce ‘There are vious oer models fr aera ates which overcome ths paboog- lea property of the Vasa proces sc for example Lamberton and Lapeyte (996, ty 3.8.2 Homogeneous Equations with Multiplicative Noise Aooter spc cas of the neal nar stochastie diferetia quai (3:2)184 (CHAPTER 3, “The Homogencous Linear Equation: ror [lairretes [nite te.7, 39 _ | & UO Nodes o4(0XaBe, C&O. Sine 3, appear at factor ofthe neromets of Brownian moti, (838) scale Stout diferent equation with malate noite I called homayeneous because cl) = on0) =O fo alt Since we may divide bok sider of (38) ty Xp thes we muy tue that Xg= I (The cae Xy = 0 ooeresponds tothe trivial casey =O forall ‘hich is no first) Since we expen exponential frm ofthe elton, ‘Pe assume Ny >0 forall Thi allows one to consider Y= In Ny = f(XG) do apply the lena (230) 00 p10 wth, Huz)=lez, fills) =0, falta) = fata) We obtain lat) ~05ef(0]at +oy( a, ox) Fst intarate both sides of this eguaio, the take exponentials ad Sally ‘oret forthe til vale Xp # I “The Solution of the Homogeneous Equation (3.38): sea[fi-aseoees nen). ten (340) You cam check that i a sotution (dot) by applying the I emma to 408) = Nyesp(¥), whore di given by (2.29. Example 8.4 (Gooretic Brownian motion} Themestprominet example of « honogenaus toca diretaleqvation 433. THE GENERAL LINEAR DIFFERENTIAL EQUATION 155, with mulipintiv oie wasted in Bxanplo 324 (0) 6,040) ‘Satantsand a, We dacovred thatthe geometric Brownian ion Ree Kae Ot M Ge (OT) iste nique sng ston in ths ese, Thi gross with the solution (3.0) Othe general homogeraone stochastic diferent equation (238) Geomee fie Brownian motion of majo importance fr sppiestion i Raune see (Chapt 3 8.3.3 The General Case Now we azo well prepared to slve the goueral ear stochastic diferent uation (232) We aciee this by emboddng (332) so = ayten of two hate diferent equations eral the slation¥ of te homogeneous stochastic diferent equation (438) wih Yp= 1 Tels goon by formula (340) (with X replaced by Y). [Cons the to proses Apply the om (2.30) on p10 20°? (th (2) afte some cl) + aR@ AIM ae 000 PB, ‘An apes othe integration by pats formula (235) yells ax i Xf) fle) (ote) XP at) x1 A Now iterate both sides and rel hat forms of Xana Xe ial ave at Having in min the patear “The Solution ofthe General Linear Equation (8.83): x: = H(te flow-noue'ae [ots'en) ven on186 cHapren 3. sto be replaced with) withthe tal conden [As a mater of fc, we alu deri the slut of the corzesponding deter ‘nist dieetial equation ao latte) reaolae, re 0,2) for all Wo wil ge this fact or cating the fxpetation and seond moment futons of in Sion 334 3.34 The Expectation and Variance Functions of the So- lution Iwo havo the explet solaton ofa stochastic diferent equation we can in ciple detcemite Is expectation, conan and variance fictions, We Sere able to proceed in thin way fr she Ornstin-Ublenbeck proces (se (S19) np. 148) and for geometric Brownian moto (ae (1.16) and (217) on “wha follows we go another way to calle nel) = BX and gol) = EXO), 6 0.7] Chars, then we cn alo calculate 00) = var) call the oneal near stochastic dire cqaton netie [foiorraines [irnseiiee, 1b. Tate expectations om both sides and gts that the stochastic integral has ‘hsp ir oa qua i 0) a earn in mind the rata the end af the previows ston, we ca write den the softin x a tis ieeta equation aterm of andy. Derive 44. NUMERICAL SOLUTION ur ey forthe Orstein-Unlebek process and for gcometce Brornan motion ‘So compare wih te kaowe foe ‘Shall onan proce for gy). To obai a stochastic dential sunt for XP, er apply the ed lems (2.0) on p. 120 sesedXe + elo) HleXs + oles + rxsnnscentonan. ene exenten eo = e014 fale settle ott seven sella) ae “Thien a gonna ow dierent equation for gx) (oie that px) 6 lt) =o) oan 4 Ao) + (Bent ante) +280 ‘whose solution cane desi ta special case of (41); the oma at {he end ofthe yeviow sevton. No doubt: the slsins yy and gy loc in evra ite tes, Lut the ce of cormtantcotietent Flos and 2 Sou might ty toatl the expectation and velanceanctions of X 3.4 Numerical Solution Stochastic difeetial equations wich admit an expt slain ae the ex eption from the ae. Therefore mural tacos forthe apprexination ine sation toa toate deena equation re cael fon what Flows, such an approxiation felled numeral solution ‘einer salu ce teed fr dice als. One purpose is oi eatin a vary of mpl patina the solution. A eolletoa af sock paths emetic ale a seer I ives a inpresion ofthe posible same path ‘ehario. Inti sos nec tse ibd of pedicuo”af he stochastic process a faucet of tine. Bot a xesnnro tas to be iterpeted with ‘ena ie we never now the Brownian same pth diving he soca {i diferent ovation, andthe sation of coupe of such paths snot teprsetaive or the general pete188 ‘CHAPTER 3, A secs objective (petaps the most npotant one) to ew reason ste approsmatons to the nebo eharaceriti ofthe ston #9 8 toch diferemal sqnton. They fcude experations, since, coach sacesand higher-order monte. Thiriindeedaniportat mater sit aly naw eaesaneis ale to give xpi formule or hee quantities, ad eve then Chey fequety involve spec funcians which have tobe prorated ‘merely. Numeral sluts allo o simulta many atnple pats fi we was: they comsttve the bse for Monte-Carlo tecguns foal the ditbatooa ascents Fr the prpon of lostration we teste urea othe numerical oe tion ofthe sorte dierent equation AX eof) HOC AB,, re LT) ay ‘where, as wna, B denotes Brornian motion, andthe “ferential esuation” [Saeealy amachatic integral equtin. We als ace tat the curt factions o(2} and Ws) mre Ligete continoons Hin ation EG < 2, these assumptions gurantee existence td uniqueness ofa tong anation see 18, 3.4.1 The Euler Approximation A numeric! soision X= (X4,€€ (7) of te stochastic dereatia pintion (342) isa locas prose that approximates the slation (st 0.7) of 42) nm weme to be mae prc late, Sich solution shavacterc by a partition ty af (0,7) rei Dm tact Cnc tnt aT nein stot) = ae, ‘The process Xi cleat nly at the pits taf the preiion ra ad so ate some fest to choose X'* ea the ltevale t-te we te interested i slsons A with contouoos sample phe we wll acne ‘hat X!" op (1s) btn by simple nar iterpoation of the points ea XD ad a KEN, "A mineral approvimation scheme determine X' atthe pint i A sive way to abain nrc slton st replace the deena inthe ‘ochame difratia onton (012) with ifeenes. This lade tothe fa 4, NUMERICAL SOLUTION 19 “The Euler Approximation Scheme: Aeshmter and B=, — ix Ss aaa, + Naw, =X + aia, + wri anw, = MD, + ODDO + =D + ote + nprasce one wily choos edit points sock hat 4 testa) = Tn ood AP met AD gd HH ad . 60) Figure 24.1 and 9.4.2 show how the Euler approximation wor in peat. Several questions naturally wise: (0) Te wich sense the numerical sation XV close othe ation XP (0) How am we measure the ua ofthe aprosimation of X by X'™® (©) te there on appanimation 2X whichis eter tha the Euler shee? ‘The third question has postive anes se Section 3-2. The est ad seco austons have several aanwers I wear intersted in th pathvse Spproxination of X, we mol ike that Xo) “lose to the sample path 2X(0) Tora given Browean path Bla). In practin we never nw the ltr160 CHAPTER 3 Figure .4.1 The cudnt Fae seme (4) a was sumer slot (sted tc) and ‘tet solution to he uacarteifernil spatn ke = Nya OU dt ty mth Ky 434, NUMERICAL SOLUTION vot path, ut we can cay simulate Brownian pats onthe computer: se Sec on 133 or tit ntodactio o his wpe. As a mesure ofthe qual of ftvitespproamation oe en choose the qantty tba) = BIN) ~ XII [olin tates indeed dere the w-vite (Le paths) compart of and XO att =f. The inden "fey sands for "ston, a puthwise A960". tation of Xie ually called strong numerical sltion se low. There and; oe of them could be Esper Mis) ~ XI (0- However, the tr quaniy more diffe to del Stk heretical. So et blew {ha the paths X10) and X(4) are se whenever hey ae das atthe ed sf the itera 0,7} We say eh Xi stony aes slation of he stochastic di tial egeton (32) (6a) $0 96-5 =r} +0. Te contest toa strong sume salut, weak numerical sltion as at the approrimation ofthe moments ofthe sluon X Tn thir cae i wot soul how lose Xia) and X"4) relly are. What mates i chat the “iterence of tomes a) = [BCX = EVLA Issn Hore chown fom las of smooth factions fo example certain [olynomils o funetions wha specie Peyocal growth, Wert ro Aisconngthove lasses of functions because thle defiitions a teheical, and thy aa dif ia theLerature, The "wn ew stands for eal’ A= before, ‘we tny wonder why we compare the moments B/(X) and BG(XP") only or (P27, bot agai, thi for torte smc ‘We sy that X19) a weal omer soon of the stochastic der celal equation (842) 17 uly) 20 a6 by =m82 (CHAPTER a, I order to measure te quality af the apposition of X by 3° on intr ers the oder of convene The sumer ation X09) omeerger strongly a X with arr 9 >| there ents cnstant > O such that alba) SER, for be Sh “The muwerical station X' comeres weal to X wth ender» > 0 there ext constant > Och Phat exlBa) SER for be Sb ‘The oguldtat Baler apoaimation (3.4) eonverges strongly wih ade 3 abd weakly with oder 1.0 (fora class of fotos with po. Priatepolycmial growth) 3.4.2 The Milstein Approxi The Baer approximation can bo farther improved. We strate is by in leony the Aste apprsamation At bear, we rns the socastle Areata equation nats [ante [xadn, cen For the points ofthe partition my we ean ener the diene XX. sd obtae Xi Kat aoxades f° WX)MB, at (ae) ‘The Kale apposition x based ona discretion ofthe integrals in (3.4) Tosee thi fst conae the aprosiations [f oouenatsicndss [P Msoaneensi.gst sad then eeplace X, with X{% oy FAN HOB, 34. NUMERICAL SOLUTION 16 The Missin approimation expt ole Taylor expansion of teladon (34) The idea consists of applying the 16 lemma on. 120 to the integrands o(X,) and (X,) i (3.44). To mae the foros below mote ‘compact we mre arb tatend of a8), My) Sy re I oss Oe fl (me pre) ane [we] a 1 ff [eos [ (ore few) + [2 wan] an al AEB JAR, 048) where the emnder erm it gen by RoR ene f [faa 40) ‘The double stochastic integral! is thon approximated by f : (f. ) a, ean eae the double agra on the righthand sie by J The evan of que delicate” Reel fom p. 90 chat (0B,) = de, and therfore [woof a » (Le) (Ce) =f (Lam) HP HX IM. a Alternatively, we iaterpet the ter cg n a eure sense a L( f 4) 0, fi (fam) an. f° canoe14 CHAPTER 3 seed a, eo) af (fw oiing (47) ith (8 a (40, ve HL WS IIRBP=B). 30 erm sesumptins onthe cof funetins ae) and) ae an show hat isan eomparzon with f°. Th the ate tam determines the onder of agit oR elatuns ($45) and (830) give the motion for the deottion a the Mtn apprarmation scheme. Notice that thi shee 5 the Euler approximation with a0 aldol correction tr cocaling the Squared inreente of Broan ton ‘The Milstein Approximation Scheme: XNA. HH ae oan wextranr =a ‘The Minsnapprosimtion eds toa substan improvement ofthe quality ef the mame ato The oqidisant Misi approcmation converge srngly with deri, ™ improvement estrella Figure 342 Notes and Comments ‘The Mistein pprosination canbe further improved by applying the I ome to the integrand in the remainder tor Ree OG). The fom of the ‘merical nation then beets mote and mre complet. Honeve, ofthe power of moder computer, thie tan sue ce ato weey stot “Tayler 18 expansions suchas (8) evolve multiple stochastic teal Tie rgoustentmentroqies 8 more advancd lawl of the theory Ths slko conser the derivation of (150); theatarrelton a btn Wy 206 eure arguments 34 NUMERICAL SOLUTION 105 Figure 2.62 A camporon ofthe giditant Esler (Gi sala scomen fe etery Bre» name {Se est sli fh tcc ferent oa ep, wah ke Le pom. Hate he ian! provement ote apr Into by he tense for lem paren o te end of einer, fama) tn Mein16 CHAPTER 2 Tae mumercalslation of sacaic deen equations is tlatiey sw at of appli yrobalty theory. An overview o the exiting mere techniqs eon in Kledes and Pat 1992) and the companion book Dy ‘ioe, Pitan spd Schre (1904) The later book ams a the troduction tovstachsiediferileqotions ond et nomena olan via compe 4 Applications of Stochastic Calculus in Finance Sis the cleratt papers by Blak ad Scales (173) and Merton (1973) the ido faring sachs calls for modeling pie of ky atc (share Prices af sch, toc inde sch the Dow Jon, Nike or DAX, frig change ates, iterest rates, te) bas bon gealy accepted. This Ted to ‘new brane o apple probably they, the eld of mathematica nace Ie symbiosis of stocietie madsing, ceoomietexonog and pete! foancia engioeig inthis chapter we consider the Blick Scholes model fr pricing a Buo- ean call optim. Do ot worry i ym doa ve uch pio Knowidge about ooac ad Baan prone. As els, you wll ed se words of conoaie langvage, and ae maximum, the lemma. Ia Section Le wll ‘rola the base terancogyof nanos: Bond, sock, option, porflo, ela ty, trading sty, hedging, matuy of ntact aelffnancing, hire ‘rl be the catchy word The Black Soh oral for pling & European {all option wl be abled as ce solaton ofa parti’ patal deel ‘Since notions ike epialnt martingale measure and change of mearae ave become pedonoant inthe finan Heratare, we give in Section 42 ee inteodution to ths azeu This equts some kowiedge of meanare hovrete to, but aus, we wl lth theory on low level. We ope that the Key doe wil cnn tranparet, and we give a second devon of ‘the Bae Sele forma by using the change of ensue esogy18 (CHAPTER 4, 4.1 The Black-Scholes Option Pricing Formula 4.1.1 A Short Excursion into Finance Wo assume thatthe pricey of rity ane (elle soc) at tine ven by protic Brownian motion of the fn B= fm) = Noone tem aa ‘whereas wal, B = (Bt > 0 i Browrian motion, nd Xo ie assed to be {dependent of. The toivaon fr this sumption eX comes fo the faet that Xi the unique song solution of th near stocks diferent] equation Keokare [Xie te [xan, (42) ‘hich we can formally write at ax, Xedt 4 0 NAB ‘This was proved in Example 3.24. Ife iterpret chi equntion na nave wa weave a fot Nigar NemeNedt 4 a Kee aqui ‘The quant onthe ethan ide the relate return fom thea nthe eto of tine e+ a. Tells ws that there ssn tend et wh Astrbad by stochastic wos etm @ dB, The conta «> O's the ocd ‘meg rte of return, and > sth rly A glance a femal (11 tlt Us thatthe larger, the arse the ctsations of Xe You et aso heck this eth the formula for he variance function of grometse Brownian mation, ‘hich is provided in (18) Thos 6a measure of the rin of the set Ie beleed that the model (£2) Is reasoable, though ere, fest pprouintion to area rice pres If yo forget fr the momest the ern ‘ith, te. amine ¢ 0, then (42) i 2dr dierent equation ‘Thich the wolcknown solution X= Xy expe). Thus, fa > 0, we should xyes to obtain a randoly erated exponential faneon, ad thse ehe {gometsic Brownian motion (41). People i osoomics brie in expoonai row, au therefore ey ace que satis6ed wit cis model. 4.1. THE BLACK-SCHOLES OPTION PRICING FORMULA 108 Naw aun tht you have & ntihy ase sch a aban acount ka Sinanca troy, eed Bon ‘We save tha a invest of ‘ond pede an amount of f= me tine € ‘That your Sil eapital has bees contol compourded ‘ith constant tere rate > This san elation sins the ites {ate changes wit time a well Note that sie the deerme ey a yr fi nae (4a) In general, you want 0 old caren amounts of sare: oy instock and 1 in bond. They costtate sour portfio We sere that abd ‘ocnateproceca alate to Browian olin and al the ple fen), ¢€10.7) «rad strategy Clo, you waut to choose a strategy, whore you donot Ieee Hom ocho (on) na earoable way, wl be diaciwe blow. Noe that your weal (or the nae of your portfolio) at time now given by Maes Weallow both, a and to asim any postin or negative vals. A nage valu fa mens sort ule trk,e.you al thestock a tinet. A negative “ali of meat that jou orow topey atte Bod los ner eae Tn reality you wold have to pay tact conor operations on stack ad sale, bat we rele tem bere frst: Moreover, me dona sue that 1, and ae bouded. Son prac, you should have ptenaly afte ‘mou of expt, and 00 shoul allow Tor bonded dear wil. Clea fall we sre that you spend no money on eter purposes Le You do wat ala your poral ser by conrmption ‘Wess that your trading satay (bh) is selffnancing. This means thatthe inrereuts of ou mele Tres oly from change of the price Xpand fr of your asec We formlate the seffnencing cdo in terms dierent AV, = dlaXi +b) = OLAX +d, ich we ner lathe ed sea athe elation foes. + [us Win wie [dace tay™m ‘CHAPTER 4 ‘Te integral cathe sight-hand sid lay ake sensei you replace dX, with eXydo+ eX, dB, ste (42), and d3, with 3 dee (43) Hence he sale Ve ff your porto nt tine x precedy ua to the ial inestment eos Capital gains from tock and bond upto tine 4.1.2 What is an Optio Nom suppose you purchase ticket, called an option at tne 10 which totes you to buy on share foc wale tne, the time of matty (oF time of expt ofthe opto. I you ean exces his pon at Seed Brice K,ealled the exerie price o te price of Ue option, only tne of ‘att T, ths called European cal option. yo ea exer it wl (Fat Uane Ts called an American el option, Note tha tere ae may ror diferene hinds of optan nthe ral world of Eaance bt we wil not be she to incu them inthis bol, The older of ll options not obliged to exert, Ths iat tine T te peice Xr i la tha, the Hoe ofthe iret would be sly to exercise te (ou coal buy ove share oe Xe the market!) nd 9 tke expes asa worthless contact. Ihe pice Xy exceeds K, ie wort eerie the call Leone buys the shave atthe pice K, then tras around asl it atthe pie Xp for aoe proft Xp — Tn tum, the purchaser of a Buropean call option is cote wo payment Xr-K, it Xp>K, ot Xrsk “ (Xr— Ky" = man xref Seo Figure 41.1 for an station Aptis an option to sel stock tien price on or wl a prtelar dacofmaturity. A Borpean pet options exer oly at ine of mati, Sn dmerican pat can te caecend ail or at tine 7 Th purhaer of 8 Europea put males prot KX, Xrek, In cur theoretical considerations we csc ourselves to European cals This thes mle recon’ inthis ase we can derive exp oitons and compare from now on a opin a Burpee cl option 41, THE BLACK-SCHOLES OPTION PRICING FORMULA 171 se A The sale of «Baoan As an aside, i icaronting to note that cho situation canbe lage co fly sa game where the renard isthe payoff the option and the option Toler pay fee (the optic pis) for playing the game ‘Shae you do narkow the pie Np at tne #0, when you paras the cal, nc! qosion aries: "ow much would you be wiling wo pay for such a lket, Le wat Ire ‘atonal rice for hi opion ae =O" Blac, Seles and Meton din sor a value a flown + An indivi, afer investing ration! vale of money i stock ‘ed bond at tine t=, ean manag isher pot sesording 0 ‘sling strategy (ne p 10D) 036 id he same pal (ofp — A) asi te option ta been purchased # tte opton werd at any price oter than ths ational ae, ‘hore wold be an gpportunity of rbtmge, Ls. for unbounded Drofs ithou a aeons il of se‘CHAPTER 4, 4.1.3 A Mathematical Formulation of the Option Pricing Problem Nom mippote we watt fd ase acing trateay (yh) and am orate sale pros suc that Waa bhaewT=tm), C6007], for some smooth determisistie function w(t). Cay, this a resteletion: ou aioe that the val V of your porto depends ina sooth way on end XI sour am wo Bad thi fonction u(t) Slace the valve Vp of the poral at tne of mature 7 shal be (Xr), we ge the terial Yau.) =(r— 49" aa {nthe financial erature, the protest of bldg sel inancing strategy ech thar (44) olds sealed edging agunat the contingent cata (Xr ~ KE ‘We intend to apply the ho Tema tothe value process Y= wT =f Xy). Write f(z} = all fz) and notice ae Alter) = wT —t2), falta) =e —62), false) = val —b2) orca hat X sisi the 1 integral uation X= rare f’ save [x.a0, Now a splieaion of he I lemma (230) with A) = eX apd A =e yields chat VWs = 6X) 10,%) = fw + f [oXs fle. X4Be Ny) #0%s fae, Mo) +050 XP fal Xl] de x) = [cman rexsntr— 40508 Neal = de + [lexan ws 441, THE BLACK-SCHOLES OPTION PRICING FORMULA 178 (nthe ater band, ab) 8 el-Boaning: vinve= flava, + [nay (4s) Since f= Se" area rsa an Moreoes, Ve = a4 48h has (8) won = fiaare fi [fost + [[ot-nxow ile cakede + fo [econ sats» [femme aD. (49) Now compare forme (48) and (49). We karat on p. 119 that cafieent functions of ko prooenes rine. Thus we mn formal dey the ie ‘Bands ofthe Rismana and Io integrals eect a (45) a0 (9) walt 1.49), (a0) (eMac Xe tru =X) = (ene XY Xetra 6X) Mah 1.X) HeX el 60) 40508 XPT — 1X). Since Xj may astm ay positive wale, me an wet the lst Meaty as Daria diferent eqeation ("partial fore othe ne of the partial dasratives a tule) = 0804Muadtse) +rewlis) rue), an) 250,46 (07)14 ‘CHAPTER 4 Recalling the terminal condition (44) me aio reuice tht Vp w0,Xr) = OX This leds the detrminste termina endton wo.2} fem KY, 230. ann) 4.14 ‘The Black and Scholes Formula 1 general bard to soe a partial feria equation excl, ad 30 ‘one has to rly on numerical solutions. $0 le somensatsorriaing thatthe Darin diferencia equation (4-1) hasan exc soliton (Ths perhaps ‘ne ofthe eons forthe popularity of the Black Sete Merton appre, The prt derail equation (4.11) with tenninal endian (112) bas Seen esto se for example Zaudere (1980. bas the expt solution Mbps) = £ Malt 2)) KE OCAL2), were iia) = eIK stesso Mes) = ales)-o8, od si gi [1 ef 208 ‘nthe tandard nol detibution fnetion, ‘Aer all he clesltons at i we actualy pin? eealng our starting pot on p. 171, we we tht Y= u(t, Xa) = Ko gM Xe))— Ke" OAT, Xl) (419) i a rational price tte t= 0 fora European cal option with exercise The stochastic proces = w(t, Xs the value of your s-snaneng pti at tine 1.1) 4.1, THE BLACK-SCHOLES OPTION PRICING FORMULA 1 “The eal-nancingwetegy (ah) given by wt.) aXe a wT 4X) sad by an 10) and (48), A tne of maturity the fom (619) yi dhe net porto vale of| (kp KY" Mewes, oe a show that > Ofor al € (but by 0 tot exe, Thus shor sale of sock donot occur, but bocroving tnaney th bond's constant intrest rater > 0 may cone necessary. "Equation (413) he elated Black Seoles option pring fora ‘Wesee ee i independent of the ean rate of tra fr he pie 2a, tutit depends onthe volatity 2 1 we want to understand g = w(F Xa) a a rational val in crs of eb trap, oppose tat the nial option pce pg p>, ppl the following strug! atte t=O ‘sel Ue option to someane abe a the pie pad + loves instock and bond according othe sal nancng strategy (4.1) Thus you gain an iii ae profit of p— g> 0, At time of maturty 7, the potions ale ar bry = (Xp ~}*,andyou have the obligation {Opa the value (Xy — "10 the pcre of the option This mean Xp> K, you mast buy the stock fr yan elo the psion elder at ie eee pie or a et ks of Np K- IEXy nom the pr ‘tse ofthe cpion wll male arbitral biget pols witout accompanying vie Notes and Comments “The idea of using Brownian motion in nance ows bak to ache (1910), ‘ut nly aftr 197, when Blank, Snes and Merton punked thir papers176 CHAPTER & id the theory each a more advanced level, Sige then, options, fata and any ter asa! derivatives have conqureed the ineratonal werd of nance ‘This led toa nem applied, denon ofan advanced tba thon stachartic ell Ar we bvelearat in this book this theory reqies ‘ome non vial matheratcal tools ‘190, Merton and Scholes mre avatded the Nob prize or economic Mos ok which are ded Yo mathenaieal ance, rege the bowl cgeofmeasace tory ad ineiona analy or ths reas they can De ead aly fer eral ore of university edcatia! Here ae afew references: Date (1006), Muna and Rhos (1997 and Kazatas end Shreve (1995), land asthe chaper about nace Kartza an Shreve (1958) By non; thecal ei afew texts on mathomatical Enace which address an eesatary ot Inermofiate ve. Barter and Remse (1900) 1 an ea introduction with minim of mathemati, but tl rece ad with goo ‘xplnation of he eonomi background. The book by Wilnot, Howson ne Dwyane (1205) focae on paral diferent equations and svede obese falls whenever yoble. court o inane aod stchart calls ive Ur tantertan and Lapeyr (1006) who area a internet eel bse on toate Knowledge of tare thor. Pk (1997) an into to nance ‘ing ony dacretecine models 4.2. A Useful Technique: Change of Measure In thissecton we cose very powerful tetnigu of oka ealelus: the (hang ofthe nding protymraure. Inthe erate often appears Aner the symoayun Girsanov' tharem oe Cameron Martn fou. Ta what fous, ne canoe completely avd measure torte arguments. 1 you donot have the meoneary background on ase theory, you shoal ft Tes tay to understand the msi ea by considering he apleatons io Section 422, 4.2.1 What is a Change of the Underlying Measure? "Te main eu of te chang of rasue ecu cossts of neoducing ‘Snow probability measure waa s-eled denny fonction which si eweral ot prot deast Fenton ‘We start wth a sinple example of wo dirbutons onthe ral ine, Recall 412 4 USEFUL PECHNIQUE: CHANGE OF MEASURE i he peobabilty density of « oemal Nix, vane) tento)= [ rentddn 20m forthe consponingdsteibution function, Cooder two pss (2168) std (se) of paramo and deine Aiea fat a 40) te std [Brent es and - taal f bbdenatde ap Thee fact he sty onetime oa tnd fit Sig ncton ct #y wit pe Apa, Cay, Fa ‘sent post ets 8 ae tie es he ele sea cerarer eeereaied) hor we odes mee pal oe Let P and @ be two probability measures oa the old F. Wf there fists tongue fonction fy auch that a [ree ser an) sresay that fy the domly of wih esp! to Pad weal say tat Gis taney contins ath ret to P. ‘The integra (417) ve to be interpreted in the are chore sen. Ts avsinlar way, changing the wes of P and Q, we can inte the ena fo of P th eget te Q, pea soc a non-native fnetion ex. 1fP is abana contnaoas with respect to Q. and @ sabalutely con Sour mtseapect oP weany that P and are epunlent profniityom (4.15) and (4.16) we may cnacidetha wo Gaumian probably ee fer on the el ine are eqn Tora characterization of alla comity va the Radon-Nikodan the orn se Append AS ‘Aetna, B~ (Byt€ 0,7) denotes tandard Brownian motion. The Avfction of Browaian motion om p33 holy depends onthe undeling Drobabitty meatare P.Inded, for the deiaton ofthe Independent, se ‘onary incemeate of Band for es Gassan ditrbation we mast know the ‘obablty reaste Po the od Uy, we donot pay attention to thie fact, Pr simply gem, but i wht fellows, Ve wll be a eral arpect or example, conser the one-dimensional dtrbtion fsnetion PUB, © 2), ER ese he drbtion fonction of a9 (04) random variable, ba fw tere to change P for sother probably measreQ, this fabction ould der fro s normal dab egetion. AL the moment, ths remark may sound a ide aber, at we wl see son tat Ue ebange of mesure it very art teclaige. ‘We are intersted in procs ofthe form Bea bevat, te (0.0 as) for some constant 4. With the only exception when g = 0, isnot standard Btowian motion. However, i we change the undeiag probity measure Doran appeopriatepobaity mente Q. B canbe showa to be a standard smu moti wr the new probably mesewe Q. This sanpy means {Har B sats the defining propre of = randard Brownian mation on 8, whun you eplaceP with Q. This the content ofthe flowing anes "el te for example Karate and Shreve (1988 for «poof. As uta, FixolBne<0, t€(0.T1, (a9) 1s the Brownia lean ‘Girsanov's Theorem "Te flowing statements hold 1+ The stochastic proces Mi of-en-fei}, tenn, aan ea martingale with cespect to the natural Brownian flration (40) under ee probaly measure P 42. A USEFUL TECHNIQUE: CHANGE OF MEASURE 19 The elation dias fartenarey, 467, aay lings a pebabilcy mesure @ on F whi is quae oP. 1 Unde the probably measure @, te proces B defied by (4.18) fea standard Brown motion. + The proms B Is adapted to the lrtion (4.19). The probably measure Qi alld an euialent martingale measure ‘The change of wwasute serves the purpone of minting te df een in a Stochastedilfrenal nqusion. ‘This wl be sea inthe application blow We ilustate ufc by the folowing inp eat Example 4.2.1 (Elmioation of the dt in a Horse tochastc diferent sequin) Consider the oer todas drain equation aXe eXedtpeXidB, +e (0.71, ann wit constant coins ¢ and 4 > 0. Welkom fom Example 3.24 that this ‘equation has solace Aya xylene, Fe (0,7) 429) Inseoduce . Be=B+(efo\t, rep, and rewite (422) a follows: We =okedlcfe)t +o B= oXdB, ee (07). (424) By Girsnow's there, Ba standard Brownian motion under th equivalent ‘rsingae mente gen by (421) with ¢= ea The en toast ifr ‘lal equason (4.2) dows ot have a deter: alton X ea martingale Under. but aot x martingale under PV am ead of he slain (of (428) om (428) (aoe € = 0 and replace with Xp = Xyerowteved KaslbeHeOs +6 0,7)180 CHAPTER 4 “Thine ho sottion to the oii stodhatic dirt equation (422 ven we. Te sems that we dd pt gain much, However, If we had knoe the solution (4.20) oly for =, we ald have derived the solution (128) or geal © from the sltionin he coe c= 0. Moreover nce X tsa martingale under Q, ‘he at make we ofthe martagale property for proving vrtous Fests about 5X" We ell use his trick for pricing Buropan cal option in Sotion 4.22 42.2 An Interpretation of the Black-Scholes Formula by ‘Change of Measure In this mction we review the Black-Scholes option pricing form. We wll ‘how th it ean be terpreced as the conto expetatin of the dieoustad overshot (Xr ~ KY at matuey ist eel. ‘The Black-Scholes Model 4 The price of one share ofthe esky asset (sock) i desi by the ‘Noche erential equation aks ekde sonra, Le (0.71, (125) where eis the mean rate of return, 0 the vl is standard Brow ‘San ioton (ander P) and 8th ome of maar of te po. The pie ofthe tes att (bond) ie denribed by the detec Bwrdd, ce (0.7), ne 7 > Os te interes rate of the bond + Your porto atte # consists of shar of sock and by shares of We axrtha, C6 (07) 1 The por i efnancing A= adi thd, (0.7) 42 A USEFUL TECHNIQUE: CHANGE OF MEASURE as 1 Ar time of matty. Vp © agus to ee contingent asm MX) for 2 ‘ven fneton A For a Europa cll option, Mz) = = KY, whee [ete stake price ofthe opin, and fer & Baron put opi, hs) = waa Ts Section 4.1.4 w deriv «rational rie for & Baropean cal option sn showed tht thee exis ef navigate nh) sucht Vr (ir). ln what allows, we give an ntti ieterprecation of hip Feemala ty applying the Gitano tore, Te were ive we cll argu a flows, Your gl fot he option time ofmatury Is (Nr—K)*. Ta erder to detente ale of ths aout ff money at tne eo you hve to scout wt ven eter at etary (125) We do not know Xr in adance, a0 let's sume that X sais the near stodhasttedifeentil equation (125), ae imply tak the expcaton of (426) {8 the pice forthe opti at te ser. Tass unde ronttcng although we did ok ws any tory. And because we ld ot epply any thro we wil a hat we ae ligly wg with our lrguments, we do not get the lack Sclke pief hi way. el ara ft that te easional Blak Seas price th expected val of (428), bat ‘e wll ave to adjust out expectation by changing the sng rly ‘eames (29) fo he cones ol This change ofthe patty ase P wl be poids in wck away thc the dacontal pre af ne hare sock Xi, ee (on, wil come a martingale under the new pebabitiy suasureQ. Weite Kes) and apply the Ra ea (2) on 120 (otc hat fo mre Nb (aay Xd e-" eal lE = Sille-nar +oaBy oki, (428)19 cnapren 4 BeBe le-nelt e107) Fon Girsno’s theorem we kw hat tere ext an eguialent martingale rieasre Q which tore B ito standard Browaiea motion. The sluion of (28) nen by Ha Koerereh, reper) turns nde @ iat matings with spect othe natal Brownian tration “ie existence ofthe euvalentmnarengle meri allows fora ative laverpetton ofthe Dace Seoles frm “asume ip the Blak Sens wade chr dere exits slnaneing rata (ay) su thatthe vale Vj of our pose ine ti ie by Wsaxi tha, bez, that Vr sequal the contigs lim A(X). ‘The the valu of ee porto at tine ts gven by vezales™ namin]. ten, an there B9(A|F) denotes the contin expectation of the rade var Be ds gen Je = oles Sf) ander the tew probably asa @ Ui som, the conditional expectation BUA) = Bp(AF) wan always ‘iled under the egal robblty measure P, and 20 we id ot ineeate Fist me want 0 show that (429) cere, and then me wil we (4.29) to elute the price of» Burpean eal option ‘Consiser the discounted vale proces Teenie Xi + ht) The Sms (231) yds ai = ane ay Now wee the fat that (ay) tf nein togeber with (4.27) ay = re aXe gH aed +b) are dee aN) adi 430) 42. A USEFUL TECHNIQUE: CHANGE OF MEASURE 1 erie tha Vy. From (4.30) and (428) we have fast) ‘Under the equlvalen: marge measure Q, i standard Brownian mation ad the proces (0yXt (7) adapted to (Ft € [BT]. Hee (431) fenstittes a martingale with reapect to). Ths neo the base popentie ‘tthe I nvegeal see 111. In parti, the matingale property pes a(Wr1F), Ce (0.71, 7 Hece oN = Ba oT) | Fi or equbaleauy, the vale ofthe porto given by (1.29), Now we want to alealate the vale Yj of ou polio and the Blak Scho rice in the case of «European option Example 42.2 (The valve of « European optn) o=T-+ be tep.r) By (420), te value of be por a ne ¢eresponing toe continget ata Vp = Ns) I ven by We = Foe") | = Bg feta (xeer-nr rented) |) At me f Xi fnetion of By henge (5) C Fi, ae so we ea tren Under #7 a5 war a conten. Moreover, under Q, By ~ By independent ff 3 and hasan N (0,6) dstetbaion. An splieton of Rl? 2 pede ta 16%) fae vere coh.a (CHAPTER 4 and yy) denotes the andard normal deity: For a Eaopea ell option, a) maf 20(2))— Ker (= KY = mani. — 10) and v0 hee (=) the standard normal distibution funtion, ayo MGI) + (405040 : oa “This inpxacy te fom ort pice of a European eal pson. The pric of the European put option (with A) talelated in the sameway oth ) that we ds on p. 174 forthe atonal (29°) om be Keron) 28-5) fea Verity hin formula 8 Notes and Comments ‘The derivation ofthe Black Soles pice via a change oft desing ea se (loll change of mamera) as nite y the Fandamenel paper ty Hacison and Pk (1981). Sine then tit ecbique belong to the sa the rope of mathematical Bnance se for example Karasas sad Shes (00s) amber and Lapepe (1906) or Masel and Rutowski (1097). The ‘tinea ofthe Back Scholes formula sea conan expectation and ‘elated reals ean be found in ay of these bok '\ proof of Grsano's theorem ean be found in advanced textbooks on robsbity tory and stochastic poses see for example Kalleberg (1997) fF Karate and Shrove (1988). Appendix Al Modes of Convergence ‘The foiowing chor canbe foun for instance in Fler (198), Kare (1995) La (1098). ‘We intodace the main modes of convergence for & sequeace of random vasiabes Aa Convergence in Distribution “Te sequence (1) comers tm dsibtian or camnerges wealy fo He rand sariale 4 (y 4 A for al bounded, ominous faneons J thereon EL(Ag) + BMA), 0-00, ks Notice: y fs Hos fend only forall contnuty post of the dist bution fnetion Fy the ration Fale) Falah, ab wy Issa. Fy continuous then (A.1) can even be seenghtaned our sup|Fa(2) ~ Fate) +0, n 00.166 APPENDIX 1s also wel known that convergence in dirteibation seule to patie ‘coavergene of the corresponding characteristic bens Ay SA tend oaly if Be + B64 for allt Example ALL1 (Convergence in distrbation of Gasson random variables) ‘Assume tht (Ay) oa sequence final Nm, 02) random variables Fest suppose tt jy -4 pando 9, where aed ae faite numbers ‘Then the eorrepontng etaractraefuntns converge for every 6 et a Oty gate "The right-and ke the character funeson of a0 (62) rand vas le A. Hee Ay ‘lo the converse i rue. If we kaow that p45 A, then the characteristic fetons et 4 cesar etvege forever From this fat we le tha here exist eal numbers and sch tha i» fad of + ‘This imple thae Ab ceca anormal Ne) sandeo variate” Convergence in Prob wy “Toe squeace (Ay) converges tm probly to the random vara (4p 4) for al pee the ration Pllde—Al>e) 40, soe. eda APPENDIX 1s "Fs eae that PAy A) = Plas Aalo) AU) ‘Convergence wth probly 1 nls convergence in probaly, hence oo ‘erence in distbtion Convergence In probaly doesnot imply conve. ence as. However, ay E54 ipo hat y, $5 A for a stable subse ‘uence (a) Pr-Convergence [icc pp0. The mane (As) emcees m Do ph mean to A (Ge 2 4) WE + AP] 2) $<°PE|Ay~ AP fr postive pane ‘Ts Ay A implies that dy £+ A. The converses in general not true. orp = 2, we ny that (An) converge in mean sare fo A. Tis notion ‘ean be extended to stochastic process se fr example Appx AA Mea Stare convecpete i emergence inte Hilbert mace Bo LIME PL = 1X: EX? <0} avowed with the inner product < X,Y >= B(XY) and the oem |X] CConvrgece in probability inplies convergence In tition, The convene ie tour if and only 4 = a forse constant Almost Sure Convergence “The waacace Ay) covergey elms! sry (a) with probity 1 to ‘he random earae (Ay 29 A) ithe wt fe wth Acfa) + Ala), 2420, as probably [X,X). The symbol stand fo he equivalence as of random vasa, ¥ sataying X 4. A2_ Inequalities {a ths scion we give zome standard Inequalities which are quent wr in this bole Tie Chater ewwlig= | PUX-EX|>2) ¢ etal), #50. |ms APPENDIX ‘The Cauchy” Schware inequality BUNT] < (ex? (EV ‘The Jensen inequality Lat f bes convex fenton oR. IFEX] ad BY(X)| ae Bite, then MEX) § BUD, ln paca, (EXD < (XPM for v 0) be Browolan mation. Recall he deiitons fan Hae sinilar pros rm (12) on pb ad prose with stationary insets fiom p. We aso know that Browolan mation i 4 Oster prowess ‘ith Sstionary, independent cements Seton 1.3, We show the som Aiecentabity of Brownian sample pt a the ore neal conte of se similar process. patton Ab (So -ieiy oni pen Sys eerie oc yh Cr ——O_ON a ape NDI 9 Proof, Without los of gresalcy we chowe ty =0. Let (fy) bea sequence Sich that ty 0. Theo, by Helens, No O as, and hence ? (ten, oe 8 |>+) . i) Dsup "> 2) 1, #90, Hence, with probity 1 me4p, fa) = 2 for any sequence 0 Proposition A8.2 (Unbounded vacation of Brownian sample pts) Porno al Brownian semple pati, (Bt) sp FJ) Ba = 99 a8, cher the eprom is taker over all ponsile partitions = 0 feoT of 0.7) Proof For crnesien, assume T= 1. Suppose that Ba) < 00 fr a given oie () be a sequene of prisons ry 1O= fy <<< ta lady Sethe mesh)» 0. Real that AB = BB, The flowing hin Tinequlies bas = Sas a 18,81) So 1ABIa) pax 1A.) (B16) aa) Since B has continuous simple paths wid probably 1, me may asuie that Bile) a coninusfaneson oft Tis ls wifrmly continuous on [0.1] ich in embination its mst), pi ated, cB) + Dr Mece the ight baa ie of (43) converges to ar, ping ule) 90 aa190 APPENDIX (On the otter hand, we know fom p88 that Qu FI, hence Qs) 28 1 fora sutale subsequence (ny) seep. 187 Tha (At) irony posable on 3 ile, and so Pa: ve) =) Ad Proof of the Existence of the General Ité Stochastic Integral In this ection we giv a proof ofthe existence of the I stochastic nega This reqs some howled ofthe spcte L? of square Integrable Functions sud of measure tere arguments Ifyou tink thi ito moh or so Yo Should sid this section, bt a short glance at the proof woud be ul We not give all the deta; sometimes we reer a some ober book ‘As usa B = (Bvt >0) ls Browhlah motion, and (Ft > 0) i theca. responding natural Station, Ut C= (Ct € (0.7) be sorbate process ‘tihng the Assumptions on p. 108, which we eal bre for convenience + Gbaticnal By 9 ct off nct Oy EP (ap, iio —n6c%1 >)Am appa tothe Boe Cane ena (se fr example Kare (105) ike ‘hae the pronessesZ(C1™=") conser anfomly (0,11 to a stochastic process IC), sy, ith probity 1 Sine the (nora) enmeeping proces Nave ‘onto sample pot, has the Iting process 1). ‘Now, Teting in (A0) go to nia, we conte tat © ep 0) COP 48 [1G ca By Lemma AL, the right and sid convergy to era n+ 20, and so we have proved thatthe it 1(C] doesnot depend i the pvt sie of ‘he appronimatingsequnce (Cf simple posse, [The tiie proons 1(6) i the desired I stochastic integral proces eo by ney = [ow repr) I sample pth ae eoninoue with pobity L | Lemma AAS The pir (1(C).(¥3) constitutes « martingale Proof We know that (1(C!).(J) x martingale (ep 108) fo all Tn parte lt sadapted to (F). This doesnot change fn the Lit Moroes, fora UIC”) Fy HC} for ae Uaing Lebesgue dominated convergence and, if cers, pang 0 a sub sequence (ly) auth that :(Ch)} converges to ToC) unio ff, wlth probability I we obtain ia UMC BONA) Hence 1C) ls « matings > Lemuna AGA The 1 stochastic integra 2(f cas)’ = f'ecte, ven as tics the iaometry property APPENDIX 193, Proof, We know that 1[C) sts this property ee (214) By (8), (25) and since the Lane continuo, EMOTE = FICC) FHC) = BUOY? +040) SG EICI"P as = ff BNC —C) +6, = (6 2ctae + 0) Sine the to left-hand sides alee, by the sometry property for 11), sw obain arn 90 the des ome elton (8) 6 ‘Lemme AAS Fora sgle proces Cth partialar Riemann Ste sume She defintion (21) coed wth he Id sachs tara IC), ‘The prot makes use of the fat that simple procenne C'S! ar dens inthe AS The Radon-Nikodym Theorem Let [0,7 be » measurable spare, Le Ft a eld on. Consider wo reasres and von, We ay tha absaataly continnons with eget ewe fort AGF: o(A) = Dimples that Wesay tha and » are etlen menawren fj and “The Radon-Nikodym Theorem Assume and are oo finite manures, (This iin particular satisfied ifthe ae probaly mesures) Then bode and only hare | err non-negative measurable function f such that | ays [aia 405 TF his lain holds wih J replaced by another non-negative faction weal= ‘The vamos everywbere unique function J call the density of ith eect ov Foca pot of his ren, ee Bingley (195) or Duley (180), Sesion 55.AG Proof of the Existence and Uniqueness of the Conditional Expectation et [0,F,P] be a probably space, Le. Fb a ofld on Mand P is a probably mesure ou F, Consist fei" F and denote by P* the estrietion of P to Lat X be a random wstable on ‘Theorem AB. IfE}X| < 2, then there ets «random srihleZ such (ot) CF ond © fratacr, [ure fxorun. ser (6) ond (0) ha wth Z repo by another random variate 2" then pian’ a We ell Z the conduional expectation of X pen the o-feld 7, and we write 2 BX) Proof. A) Assume that X > 0-8 Consider the (sma) probability pace [7% Ph and deine he ensre a [Xora ser I P(A) =0,then X14 =0 Pas, and vo od) = E{XI4) =0. Hence

=a sua i — ot eet Seen 0 ‘Strong elation a Eee ate sar Tay 6 expan 163 tec george Time srs 25 "ARIA roca 25 torre pros 6, sting merge oc 1 enon eatery 109 ‘Tajedary ofa chase pots ‘Traneation casts 19 Tangata ter ha and Steno ite. rior ditetaton 1 wats socal proces 20 ‘Vase intr rte model 152 ‘apectation and eovaance aaah 8 Weak comvergnace 185 Weak sue fa loka diferent auaion 157 Weak sunt ion ‘fa tchase deena Eqution 16 «ond convergence 162 Weal a wee porfllo woe aie’ ce Browolan msionList of Abbreviations and Symbols es re ch pose ey eid nein ad ‘Utes arcioms “Toe it bee pie mont OMe ane. Comey ‘sed mathematical symbols are tt xplaied Symbol Expla ». B, Bi Browlan motien = Bini) cml datribution with parameters mand p ° cur” otal ii eon 6 fore(X,Y)crelton ofthe random viable X and Y & fex¥) covariance ofthe andon arial X and ¥ 18 (Gs) covariance faction of the process X 2 a Heng toy of the tera fa iy ineramen ofthe fasion fon ft: B= Me) — fen) EX expect of the random variable 2 EX Sxpectation ofthe atta yrtor X " BUX|Y) condor exertation of the rand vail X, given {he random variable the random wer or the asehaatic oes 7 o E(X|) Conditional expectation ofthe sandom aiale given thee keld ap(A) exponential dstsibution with parameter FCLT funciona central ii theorem fds Snitimenionaldstibios of «stochastic proces Godin pata dene off ith reapet tothe ity Fh salableBey et) belo N Myo) Nw2) Noo.) a ‘ FPL Pp Pua) % rio : symBons lds e ‘emit ofthe andor aiable " ‘enty ofthe anon vector X 6 intibuion function of andor aa Gisteibation function of the rand sariable X 5 Sitcibation fnetion of the random vetor X 5 lndieatr function ofthese (event) A a [eS stochastic integral othe proce C 09 independency istated Bs Sen sequence a el muses qn = ~sip(~Ae) ‘The supremum is define! Slow orm fate ier se, Infncy = en ‘egarm with bass © eof feguvalence lass of) random variables Z wth Biz <0 pace of auiaence classes of) random variable Z with EZ? Cox and o(2) CF tt agoen orld F on ‘mes f the pation ‘ipectaton a he random variable X ‘Spectaion faction of the secastic proces X ‘Srpeation of the random vector X Set of the postive integers Set of te non-native nega ‘Gaussian (nocd sibs with mean and ‘ltvarate Gausian (nota) dsuibution with men {in covalance matrix ‘andard norma tition Eten othe sae utcone space empty set probability space Probability meaware Drobabty of the event {Eneibuion of the random variable X ‘or the stoeastie proces X Sisibaton of he random vector X power set of {lento te standard normal isrbaton sandal oral dition faneson Po " 2 2% " svatnoxs Pai) ® Polson distribution with parameter 3 ° rel tine ‘eeimensonl Euclidean space Sratonvich integral ofthe proces C mt variance of the random variable 2 {aviancefancion of the prowess X Ey variance matte of the random vetor X ” ‘rll generated by the elation of et © cy eld generated by a random variable, random veto fra sacaatie process Y oo rag he supe of sequence ofl numbers ig Wate o> forall» and fr every > 0 there sea ach thal ae cay a= co, ton fr every MW'> Others exitaaouch that > MF. Por finite Ines set Ts tye t= Mi ‘fran ear sarable o 8) u acne of the rand variate X B Fandom variable roche proces (a) =) ane that (2) apprimately (oughly) of {he sare order as 3). It oly toed in hearst sn, Inter pat of 2 fenton part of 2) =max(,2) 2 = min,2) Complement ofthe set ‘Ae ih Asa. convergence 15 A, 44 A: converges in distbution 135 A, Zs As convergence LF, th mean convergence 187 An 2 A: convergence in L2, mean square convergence 187 ‘Aa 2s As convergence in probably 186, {AE B tbe anom elements (random variable, random ‘ecto stockatic proce) Aan # have the same ‘Sutton se. PU C) = PUB € C) forall suitable SC. Forvandom variables and random vectors A, this {ea that thir dation functions ae the se.