ELEMENTARY STOCHASTIC CACULUS ‘with Finance in View Tort Moses Ct Deutschen ee Beeb staatlichen Bauerschaft (KOLX03‘aELEMENTARY STOCHASTIC CALCULUS with Finance in View Tl cosch Ve World Scientific Singapore Now lrey-London HongKongUke: So Mn Soe Reg NL tem one eh ie cm = (Abend a Ap quae oe Nanogen fers ek foe BAN. Ese ae apg 00 y Wat Sie Ring Ce a : ‘Ar oe ops ere met crepe aye ya an ‘aca cg paper roy rd ! (emer nen orb tal nets pris foes sr For phi of mat tne. la ai eh Cri ‘oc em io ee Preface ‘Ten yours ago I would not have dared to wit bok ike his: no-sgoous ‘treatin of mathemati theory admit tat T would have be ane, land Tam aad tha most of my elleagucs in mathemati link He th Floweer, my experience with students and practitioners coined me that there iss etzong demand for popular mathemati, Tstarvd wetng this bok at ote note In 192 wes Ipespared a course on stochastic ealeuls for the students of th Commerce Faculty at Vicon University Welington (Now Zealand). Since! had fein ving toils orfloUhary and investment anal I wat expected to tach something Tinew batter At that tine, seff members of economics snd athemates departments already discased the wo the Dlack and Soles option ping formula course on stochastic nance were offered a lng netatons nc as BTH Zirich, Columbia and Stanford: and there was geeral agrement that ot only sadests and staf members of couemcr ad snathenatis de Dartneas, but aso practioner in nati Istiatons should Know more oat tis new top ‘Soon Treaiaed that thre was mot very much erature which could be ed for teaching stodastie cleus at rather sementary level at ily ‘ararect the fact thats combination of 'lentary" and “Mocastie cea? Ibe contradiction niece. Sorat alu rqutes advan matbenatieal techniques this theory cannot be fly understood one does ot tuw sbout the bar of acu theory, fanctosl analyse an the theory of wochastie ‘racemes, However, Lezogly belive that an interested person wo knows About demeatary probably thory and who can handle the rues of inte ‘atin and direnntion abl to understand the tai Mes of occ faleulus. This is supported by my experience which Tne in coures fr ‘conomics, stasis and matbematis students at VUW Weligton andthe Degarineat of Mathematics in Groningen. T gt the sane inresion ss & lecturer of erash cures om stocatc enue st the Samet Schoo of the“ PREFACE Ses Assocation of Actares a Lausanne 1004, the Workshop om Financia Mathes in Groningen 1097 anda the Univeral of Leuven in ay 1298 "Various eallagus, ends and stants had read my let no and suggested that Textend the to 4 snail book. Among those are Chia Kisppelberg and Paul Embrehts, my coshor rom «book abou extemal tents, and David Vero-Jone my fore college tthe Istitate of Sai {cs and Operations Research in Wallington. Clan alo propane to gt in fenract with Ole BandorNielsn whol the eitr ofthe pbb sree ff World Scientia indebted to him for encouraging me Uroaghoat the ting proven of writing this boo Many colleagues and students helped in proofreading pats ofthe book at vas stages In pariuar, T would lke to thank Leigh Roberts fem ‘Welngtan, Bojn Barak and Diemer Salome fo Groningen. Tek ete vas vey bl Iam mr gratfil to Carle Proctor fo Susie Univesity Se was a cinetane source of inepttion, hot on style and atta Issue Tl tae plesure in banking the Department of Mathematics atthe ‘University of Groningen, my ealaguead stents fo thr mich apprecit ‘Thomas Misch Groninge, Jane 1, 1998 Contents Reader Guidelines 1 Preliminaries TLD Random Votre ELS. Independence and Dependence Stochastic Prosser 122. Proceae Derived fsa Briwaian Maton 13 Simulation of Brovaian Sump Pathe 14 Gondsonal Expectation TA2 About Fide TAR ‘The General Conta Expectation 44 Riles forthe Calealaton of Condtonal Expectations LAS The Projection Property of Conditional Expectations 182 Examples 153 The ltterpretaton ofa Mating as Flr Game 2 The Stochastic Integral, 212 The Riemann Stele Integral 22 Tho Ro Isa 2 m“a conTeNTS 222. ‘The Rb Stochastic Integral or Simple Processes 101 223. The Genera lo StecastieIntgel tr 23 The ko Lerma iB 25.1 The Clasical Chain eof Diferetiaton 3 232 A Sinple Veron ofthe ld Lemna ut 233 Extended Verso ofthe Ie Lema 47 24 The Seratoncvch sod Othe tgs 13 | Stochastic Differential Equations a1 ‘BL Deterministic Difeential Eqesons 132 32. Ro Stochastic Diftrental Equations 134 321. What wa Stochste Dierenial Byuitos ah 322 Solving Ib Stochaste ieentil Equations by the Ka Tema, 1s cake 33. The General Linse Dien Equation 331 Linear Equations with Additive Noise 332 Homogeneous Equations with Mulupicatie Nae 333. The Genal Caw 334 The Expectation and Vaiane Funcians of the Suton 34 Nomar! Sotion es Dilleatil Bgeadions va Strtonovic Cal 4 Applications of Stochastic Calculus in Finance 167 AUT The Black Scholes Option Pig Forula 168 ALL A'Shor Excursion into Finance 1s 412 What ian Option? 0 {E13 A Machematcal Formulation ofthe Option Prcag Boe ter 41.6 The Black and Sie orale 42 A Useful Teebique Change of Meare 421" What a Change af te Underlying Measure? 422 Anluepretaton of te Black Sales Formula by Cha Appendi 186 TA” Modes of Convergence 185 2 Inquaites i" ‘CONTENTS as XS Non-Ditereatiabiity and Unbound Variation of Brownian Sn Pro of th Exton fhe General Shi ged The Ravon-Nikodym Theorem Proof ofthe Existence ad Uniques ofthe Conia Be Bibtiogeaphy List of Abbreviations and Symbols 10 wos 195Reader Guidelines ‘hiebook grew out flere notes fra course on stochastic acu for er bomicsstdests, When I prepare the fs letesIealiaed that there was to ada oxtbook eaten for non-mathematicans- Othe os band, there was and indeed isan increasing demand to arn abot stocharte ea ‘ty, in parla in economies, surance, Aaa, conor The mal econ fr this inter crgnates tn the fact that this matheratal tary 1s the bis fo pricing nancial derivatives sucha opine and futures. ‘The fundamental da of Bac, Scholes and Maton ftom 1973 to use I soc tie clef for pricing an badging of derivative instruments as conquered the ral wold finn the Blac Seles Jormala has bon known to macy people in mathematic and econmics long before Merton nad Scholes were {Sarde the Nobel prize for economic in 1097. For whom i th book written? Tn contrast the increasing popu of nancial mathematics, ts reicl nis is by mens teva Who ever ted to roa the ist fw page of & book on stochastie eaeuus wil certainly agree. Tol rom mani theory nd fanetional analysts are usualy requred. In this book {hae tried to Kop the mathematical lvl lw. The render Wl tbe bardend with rare thoy, teat be asd loge ‘Thon we wil have to rly om bmurtiearguments, stressing the undeling “eas rtbee than techolcal deta. Notions such se measurable faction ad ‘memrable tare no ntoduce, ad therefore the formulate and pool veri statements and rete ar noes incomplete or niger “This may sometnes dosoarage the machematicaly orieted reser, hit foe those excellent mathematical testboats on stochastic calls exit Tn dscusions with economists and paciones from barks and isu ance companies I equety listened ta the argument "ed elelu ean be2 [READER GUIDELINES undertond ondy iy mathematicians” 1 che main objective ofthis bok to ‘ere thi operation ‘Prey teat tory ha ts root neal Me. Therefore the notions | of Wo integral [lnm nd toca diereatal equation ean be explained {o anybody wo ever attended sours n slstry elena probity hoor yt casts, bsg, ear, engineers econo. Ta th courte ofthis book the ear wil ara about the baste us of stochastic {leur Pally, yo wil be able to save some sinple ache dierent ‘Sinton, to siulate thee solitons on computer and to uoderstand the fined welogy bend the modern theory of opion peng [ova re the reo ‘You should be fair with tele of negation and dierent. daly Joo aso know about difeeiial equations, bt i snot omental. You must now about sereataryprotaty theory. Chapter 1 wil blp you to reall ‘wwe face about probability, expertation, stebuton, et, bat this will ot {i proper bi for the rst ofthe bak You would ave to read one ibe rocmmene bos on probably thay thin i ew to You, belre ‘om attempt to read ths book. ow should you read thie Book? i depen on your Kaovdge of probably theory. 1 remammend that you Tome throug the "bors" of Chapter 1 you know everthing that ‘ren theres you can start with Chapter 2 It stochastic cles aod ‘tine with Chapter 3 stochastic diferent equations. "You cannot proceed inthis way fom geno ae with te following toxic won: atcha prices Droveian motion, colina expectation ‘ed martingale ‘Thote f'n doubt that you wil ugg with the notion of Cendlinal expectation, ules you lave some background measure the ‘oy. Conditional expectation le One ofthe hry notions underlying star "Te eal rade can handle imation on a computer. Computer sap of Browolan motion and soltions to stchaste dierent equations wil help Sou to experience the theory. The tewetial tools for these simulations will fe provided Soto 13.3 and 34 "hve nt inc le of eee, bu I wil ak you vious questions In the course of this ok Try to answer them. They are not dif, but thy a a tenting the evel of our understanding, tes for this book? READER GUIDELINES 2 sides Sections 13-15, th cone serial i cotsined in Chapter 2 ad the fist sesons of Chapter 3. Chapter? provides the construction ofthe Integral ada heuriti dertion of te I emanate chai ue of occ falls. In Chapter 3 you wl learn bow to sive some simple sochastie ‘ieremialeqotions. Seton 3.3 on lina ochatie diferent eqntion i Ian inclided n order to exec te ae of the 15 nmuna. Seton 3.4 ll beintresting wo thee who wast to visual clutons ta tachastie erential ‘equations. (Chapter 4 for those readers who want to so how stochatc eae cera fence apletions Prior Kovwlage of cones theory oot te ‘led, but we wl induce a minimum of economle emily which can be understood by everybody. If you cau feed though Section 4.1 on option pricing without major difcaties a egardsstochaste ales, you wil have eed the examination on thi coarse lrenarysochnteclels ‘At the end of this book you may want to Kbow more about stochastic ‘lean and ts sppiations. Referee o tote dane erature ae ge in the Note and Comments atthe end of ech section. "Thee refeteno® att tt exhaustive, they dont ince the theoretically most raced tertbook tteatments, Dut they can be wef forthe continuation of our sue, ‘You are now ready to start, Good luck! 1,1 Preliminaries a tis chapter we calc some bas facts need for defining stochastic inte ‘als. Ata fest reading, mere prt ofthis chapter ean be skipped, provided {ou have some basi knowedge of probably theory and tachasie proces You may then want to mat with Chapter 2 on Ho orhostic cleus a tec ene faces fom this chapter tery. Tu Seton 11 we eal elementary notios fom probability theory such 3 random sri rand veto, diatruion,diation incon, den ‘ty capecaton, moment, variance nd covariance. This sal ev can feplare'a whole course on probabil, and 0 you are well eommend to fensult your old lecture notes ora stad textbook. Secon 12 abot ‘ocasic procesen A stocuatic proces Is 2 tral tel fr desing the evolution of teal proces, ejects and sytem in tie and space. (ne parila stochastic pron plays central len ths Book Brom ‘motion. We ietdace iin Socton 1.3 and discs sone ofits etary oper, in articular the nodiferentality andthe unbounded eration fits sample pats, These ropa india tha Brownian snp pat ae ‘ery arog and therefore anew, stochastic eleles hast be introduced {or ftegrle with ep to Broa ten Ta Section LA we shorty review rondtonal expectations, The prcie einiton i sed on erp mithemtia hry, ad therefore we ay ve ome inom on ths cacepe The mae remark appli to Setion 18, where ‘re inte an import elas of stoiarte proceser: the martingaen Include Brownian motion and indefinite le negra at pater carpi‘ (CHAPTER 1 1.1 Basie Concepts from Probability Theory Ld Random Variables ‘The outcome of an expernent or game i andom. simple example is cin toning the pose otcomes “bea” tall” ae uot predictable in the verse thar they appear acordng toa anor mochasim whic is etre bythe pile! properties ofthe cai. A mote competed exerioet e the tock Franke, There the random osteoma the broker activities (whch actualy present ermomi tendon, politeal interest and tei wn instinct) ate fer example share pics an exchange ates. Another gate called om etn” and an be watehed where produts ar onsale: the price of 1 Sasa, sy the cateome ofa game between the shop owners cn the ont land, aed between the shop owners and the estore, Ue ote band “Tinea treatinnt of an experient ques tht we asi a umber teach rand outcome. When toning acon, we can wite "1" for “head” {tudor “ah Tse gt random arable X= X(4) € (0,1), where ‘Delong tothe eateome space f= (hen Te value of shave pce of Stock svedy random smber, ands the banana pein reno Thee nurs (0) provide or with iafrzation about te experimen we do not know who plays the game or what dives “Mathenatiiang make 2 ear cat between realty and a mathematical modes they deine na alta pace ellotng al pole outcomes of the “ieryngexpernent, I ean strat space, e. It dows ot really mater ‘That che sae. In mathemati language, the random rorcle X= X(o) {Eng bute) fnction defined on Tenens step in th pocen ofabetration om realty ste probabilistic description of the random viable X Which are the most ely values X (a), what ae they concentrated arvand ‘hat the pend? “Te approach these problems, one ist colts “god” robets of, he evens, ina las sy, tn adeoeed textbooks ical fil ot 6-algba; ee 1.62 fora proce edition, Such cla supposed vo contain al intersting nis, Wat coud be for oi toning” Cert, (0: X(e) = 0) = (cl) Sh (0: X(0) 21) = (bend) mae belong to 7 bat alo te nn, diference, Ittersction of any events in 7, the wt (1 = (Deal and its complement, the empty 0. Thi avn example, but ews what F should belie: ACF, coals complemen A, and A,B 7, 20 ae ANB, AUB, AUB, BU AS, AOBe, BNA et 1L1. BASIC CONCEPTS FROM PROBABILITY THEORY 7 If we coasider a share rice X, nt only the events fo: (a) = ) should long to F bat bo fore porener 3, peo Se Fgwe 1.2 an haat ° In contrast to discrete distributions and random variables, tbe dition fancion ofa contiouus random variate Jos ot hare fmpe, bene PU 2) =O brall = or equaleaty By Fele+ 0) = Fee) forall, 03) i. sucha random variable astm any particular vale with probity 0. A ‘ofthe diteivatonfaneton Fy0 (CHAPTER 1 Figure 1.1.2 Lele the probes P 1,3. of te Poin dat Fiona pumeter NTO, Right the coreaoning dahon ncn. Plgure 1:1. Lat he deni of andrd normal tiation (mt 0, rine ISR: he creping arto ft igure 4 Lethe amity of th Learns Xp = HY — Dans of the dy fling pos Yeo the Se nds The SP ne of he Bae US madre ‘eh errata ncn A someon wih Pare 113 1L1, BASIC CONCEPTS FROM PROBABILITY THEORY " ratd= [teint 208, ee 10920 weer senond 7 Sxydr=t Example 1.1.5 (The normal and unin dstibont) ‘An imporeat continnooedsribaton ithe normal or Ganson ditriasion Niguet) ith pararcersj€ a! 50.1 Ban dest es)= geo SPY, en ay 1X is (0,1) (andar normal) we write forthe denty fy and forthe etn fagetin Fi For a ateation of he standard normal density ‘and the crespondingdistebutio function, se Figure 13. ‘The anform dstibaton Ua) on (ab) hae density Pe say postive el mamier Clearly, here ar ech ition: Sampater (Gr pocket ealculator i not cable of saving the value of an exchange rate wich infitely many digs, V2 gy every mabe nthe compters memory I rounded off. Therefore any random vara of practical interest i actual Aine Hones tate contniet to think of sucha vara a & onions ne Thre maybe theoretical reasons. For example, the noel Sintetbution appear as nit dstbution vn the cata int here se 45. Many factions ofa sample are thee approximately normal, ence ‘ein dstribatio ie ontinnous. Dv there ar no practical eon Se ‘fos Iw tos to work with welded continues dstbuton (Suh ‘he nena exponential, gama, unr) because we cen ee standad ae fg in partial, standard sofware plage) about deny, moet, ‘ane, te, and we can ponubly obtain sme ice expel expressions ft2 cuapre 1 Expectation, Variance and Moments Interesting characterises of random vvableX are the expectation EX, the trian var(X) and the momenta BUX “The capectaion or mean ele ofa random vane X with deny inven by x= [7 stxte)de ‘The wariance of Xb defied as oh = at) [Lemna Bex!) = [2 pete Fora ral-valod function g the expectation of X) ven by saan [sein "The expectation or mean sale of « date random varabie with robablitin py = P(X = 24) ven by aoe “The waranc of bs ied ee aX) = Flea | ont ment Xe ded B= Dan. 1L1. BASIC CONCEPTS FROM PROBABILITY THEORY 3 For a vealed nton gt expectation of (X) ie oe by Ba(X)= Yolen) on We can regard the expectation jx ae the enter af gravity” of he random variable Ny Le. the random voles X(a) ate concentrated around the now ‘random number jn. The expectation is ite fen tae ax roger thesizea the andom varie. For example sa snple mse preising the fare values inane ei, ‘The spread or dispersion ofthe random values X(w) around the expect tion jn i dari hy the variance ok ‘var(X) = E(X = px)® BUX? 2g +) = BUN?) ~ 2 Bo") ad the standard destin Recall the normal dens fom (13). The praneter the expectation ex andthe parameter ois the raviance eof «random tatiable X wich ‘lng (13) Ta wellxown fe (and ear to wey example withthe computer) that fran N(jyo) random vaable X, Pur 1860 2) <2 0%, 2>0, Shc provides ws with a sulcenly accurate bound of the probity that ‘he abctte deviation ofthe random vara from ts expectation exceed ‘ome testou CHAPTER 1 1.1.2 Random Vectors 1a what lows we ruently make eof fte-dimensioal and infinite tension random stractare, We comuence with itedimemsonal random ‘Neto a aise sep toward the defaion of «stochastic proces (Bigs) an edimeioal ado wctr I components te Gnetimenstonal elle random variables, 1 we interpret ¢ = 20pm as equditant tata of dime, X; can stand forte ontome ofan experiment at tne Such ime tren tay, fr ‘ramp, cont of BMW share pies Xy at wsucreing days. Cleary ¢ ‘heat! tne", thus nohing bot an Inder ora counting vale, For ratpl, random vector can deeb oe state of the weater in Wellington ($2) at given tines XY, could be the erperature, Xp the at pressure and a the winder (the ters wsualy close to inti), “Anaagoaly to oneinnslona random variables ome can trode the isibationfitien, the expectation moments and he covariance matrix ‘fe random weetor im order to deserve te distbuton ands dependence Structure, The ater aspect a new one dependence doce Bt ke sense ‘hen we alle just about one random variable Probability, Distribution and Disteibution Function Ton afr xin twin, We conser the four pais (HH), (1,7), (HLT) Ad (fH) (head, Total) ar ootemes of the experinent “ping a coin {vie Thos for te conta the outcome space ft. A before, we aig tof and 0 to 7 Inthe way we obtain two random variables Xy abd Xs fed X= (Xj, ,) ia two dnensonal random rector: Notice that (0.1), XUHT) X(HH) = (41), X(0.7) 0,0), X(0.H) 1 he coins inde sr, we an aig the probability 0.25 to each ofthe four Pa: Xtw) = (0) =025, Le {0} As before, we considera clletion F of utes of and defioe a probity Imeaste ont a. me ign a number P(A) € [1 teach Ae 1.1, BASIC CONCEPTS FROM PROBABILITY THEORY (ast (bt) » “Te collection of he probabiities Fa) = PUL Say. Ma Stn) rr) Plo: ¥ls) S215 Nelo) S20) X= lence) EB, the dation faction Fi 0X 1 provides us with the probity of the event that X assumes vale inthe rectangle (eb) fac For example, i X i two-inensooa, PRE sa) + Bes) ~ Fala) ~ Fab). (Check tat hi formulas coet se aio Figure 1.6. As in the case of ‘one-dimensional atom vrais, dase probate aproxinate POX € B) for wey goal ts.6 (CHAPTER 1 “Th eolleton of he probabilities P(B) = for suitabe sts BC BY comsiates the datribtion of X. i:X(e) €B) (KeD) Stable subsets of Rate the Borel sets which are obtained by a countable umber of operons U © acing on the ltrs in sep 8 for a bre defntion. For cxaple, pot ts, ball abd rectangle re Borel sts [rs mathematical see, the dirbation and the dibationfancton of & adn vector X are equalst notions Both, Fy and Pi, can be Used t falls the probably of any event (XB) ‘Notice thatthe dstibution of X= (Xj--, contains the whole i= faxmation aout the distbion ofthe components X, pais (XX) eps (Coy Xs), ees This ea sen frm (13). yom go the datrbaton fe tion of Xy by formally setting zy =~" = 24 =o, te dtution funtion of (x). by meting 25 =~ =e et “Anlogoaly to random vale oe ca introduce dnrete and cont ‘us fandom sectors and debtors For oor parposs, coins random Sectors wth ndesty will berevant ad ao we ms rest out atenton tot Tie dition oa random vector Xa denaity ome can epson the dittbutlon function Fx of X as Retest me foto) Macc ee (eine ni 20 fee 2 is fins alana In vector X has deaty fx, al components Xj, he vectary of the pales (x, Xp) tiles (XiXy A) ey ae deny ‘They ae elle marginal LL BASIC CONCEPTS FROM PROBABILITY THEORY " ‘Example 1.1.7 (Marginal densi: the ease ‘We conser the ease n= 3. ‘Then the marginal densities are ota at foo le) = ff tedden, tree = J xan, le) tain tating fe) wh ret Fs integrating fle) with spect to 2 ‘One case is patel simple fhe density f(x) cat be written as. product ‘ftom negative fntons 9 Ix(o) =o.) aalen), xB To this case (oe) dy = 1 f= 1... the fetons oe) ace cow-dinensonal pobaiity dense, and thn seocarly Ise) = ale), Ix.xleue))= ale) fas), Veet ist Example 1.8 (Gansianeadom rectce) ‘8 Gentian or normal random vector bas 4 Gansnn of vont distribution. The n-dimensionl normal or Gees dtriaton sven by es dense J) xeR’, (16) aerrtaayre Honea} 8 cei dla nd who ees re he eng otn aN) They Seas pe Expectation, Varlance and Covariance ‘The expectation of a randoen vector has a smi une a he ean vale fa random variable. The ylbes X(.) are coneatrated around i “The expectation or men vl ofa random vector Xe sven by“ CHAPTER 1 “Te coariance mari of Xs dele ws Bix = (am(Xi NG) hj = Ben were eXiK) = BK Hx Xs ~ 0) BN) — es ste coarianc of X, and Xj. Novice that cor Ni Xi) = 9% ‘Example 1.1.9 (Continaton of Example 1.18) Fecal rn (1.0) the density of ulate Gates random vector X. The ormeter ithe expectation jx of X, and Sis eavastance matic x Thos the deny of Gatasan vector (hence ts distbuton) i eompletly ‘eternal rine expectation and comslance matrix Tn partular, td Sis the m-imesional ett mats yy we have de y= Vad I The dent fi then snply the prove a standard normal densities Saleyeos tn) = olen) ~ glen) ‘Wo write NS) fr the dlstsibution of an wtimensonal Gausin vector X sith expectation ad covaianer matrix © Sch a yector has the appealing [roperty at texas Gata ser linear transformations (ral that? nda dente the tanepwer of and A especie) Xq) have an Ny) dneibaion and Ae an m x (aie AEA) alstbation 1s convenient to standadie covariances by dividing the corresponding ran ‘ho vara by ti andar devon The resulting quantity centtity = SD = BUM sa a isthe eoreation of X and Xz, At a esl of hi standadlaton the core Tation of tr undo arabes i always betwen 1 and 1. Chak thi fee yan aplication of te Case Sears inequality; wep 18 1.1, BASIC CONCEPTS FROM PROBABILITY THEORY 9 JX oy a Pie 14.30 Do 1.1.8 Independence and Dependence Far con vce a et the nm mune), Xs) € (0.1) be Scouting tome th fi nf send eer say sayin POL =X (i= BPO =D, hte (0,0) “Tua propry ie ele ndpndece fhe und vale Xy ard Xt {ski nde ms hatte et expert des i ac the ‘tc oases Forex, da i low Oe to predict the value of X, and vice versa. — Daw we real oe ofthe ctl defitns and properties finde vende ewe a npn fsa "Two events Ay and Ay ae ipenden Pla As) = PLA) PA).» ccuHAPreER 1 “Two random variables Ny and Ny are sndpenden i Xi € Bh) PUL € Bs) | POX € By, XB) forall eitable subsets By and By of R_ This means cht the events {Oty By) and {X3 € Bae independent Alueratively, one can defo independence vi distribution functions and den Sie Phe random viable yan ae independent and only Fryleize) = Plat) Flea), 21522 €R, Assume that (XX) has deny fc with marginal densities fx, and fs fee p18. Then she raidom variables Xy ad are ndependest and only fsaslercs) = fa) flea), 2182 ER, “The defition f independence can be extended to arbitrary alte mu ter ofevents and random vectors Nols that inependene ofthe components af a random vector imps the independence of each pal of ts emmponents tut the converse en general not tre “The events Ai os y ae dependent for every cole of nes Tepe ehh Sand ters LSS, Pdi, 10 Ay) = Plan) = PAG) “Te random valle Xs. Xa ar dependent for ewe chic | Indios 1 iy Ihave expetaion nro, Ths coo(X,X2) = BCX) ~ BX EX) = 0, De X and X ace claty dependent: since (X € [-1.1}} = (X? € (0). 40 tain P(x I-11, 3 6.1) > Pe -LApPUx? [o.a) revere rarer2 CHAPTER 1 xample 1.113 (Astocorlations of a ne sce) Fora time seis Nyy, Xi. te autocorrelation at lg hs defined by fors(tin Xa), A= sly Achim which an foquently be found nthe erates that nancial ime ries derived fom stock ine, share price, xchange eae, ee) are nearly unestlated This supported bythe sample ‘itoortationsof the alloy eturns X, of te SEP nde ae Figure LL. In contrast to ths oberaton the timated autocorrelation ofthe absste ‘aloe [| ae diferent fm aero even fo lags lags This indents hat {here dependence tn this tine srs. 2 Figure 11.14 The etimoll strrlation ofthe SP ines (et) and of {Motte lis (gs we Beonpe 1719 of he cmmente a Pipe In what folloms, we wil len deal with inte cllactoas (Xi.t € T) of ‘aon vibes Ky, be. a nite nde eI hi stp, we mn aso Introduce independence ‘Ti coletion of vandom vas (Xt € 7) s independent io very ce of distinct adios yy €F adm 2 1 the andor variables Xir-yXi ae independent ‘This collcion independent ad iden tity distriated (i ii independent and all random valables Xi tare the me diate, Notes and Comments 1a this suction we real some slementary probability theory which can be find in evry texto om the topic sme instance Pitan (198) for an a ee 12, STOCHASTIC PROCESSES Ey ‘loestary lvl and Gut (1905) fr a intermediate course. Alu many txt thookaon states olen begin with an itodetion to probably thory we fer example Mendenhall, Wacker ad Schaller (190) 1.2. Stochastic Processes ‘We muppase thatthe exchange ate NZS/USS at evry Exel instant¢ between Dam and 10am thi morang ls random. ‘Thetfore we ean Interpret ‘en realeton X(s) ofthe random triable Xj, and so me obese Xi), Dics 10 lnonkstomaben gunsat lam. about theexchangerite X)y(2) Ac Lam, (i teaoanbe to lok at the whole evolution of (a) beeween Damm. and 10 am This als « domand ofthe high standard echnical ‘considered. A mathematical model for deseibing wach a phenomenon i aed Ste procs. haha nT occa twa | teen) | endo ee nc | Xi(u), t€7 we), or our purpwes Ti oon an inter, fr example 7 = [08 fo8 ofc) for a'c b Tn we call X's contnmonedime process contrat to dacrete tine process. In the lter case, Ta Hte or countably nat st Foe vic roaons, the index tof the random arabe Xi fequnty refereed “Aston proces X i funclon of oo variable, Kr= Miu), wen or fl andor outcome» € 0, a fction of ne MaKe), ter “hie function ie alle rnztion, trjrtory o sample pat ofthe ‘These two aspects of todas ross are iustrated in Figure 12a CHAPTER 1 igure 1.22 5 sample tof shat rcs (Xit (01). Top: cory pth rapier € Me nds al ea eset ieCte 12, STOCHASTIC PROCESSES as Figure 1.2.2 The (ald) aly alas of the SP ines “re grph syste at we conser the SUP tine teresa he antnsas tine praca re are mans fe sre uh tha he Stans ote eT are ese” nan tra throne ay want terete {ecw time pcs ore sontnaurtone pro. The tangle ps of rae neourtne pc ar ny tort hace stants of tine Depending to the ntaton oe ato mae ¢ dein sich model (ure: or conan ino mare ear Example 1.2.3 A tine series Isa drt time procs ith P= 2 {0,142}. Tne ws constiute fu important dss of sichastie process. They ee relevant models in many Sopliation, where one i intrested nthe evolution of rae proce ‘Such sree represent, fr example, the dy body teperatare of «pallet in Shoepital, the dally returns of peice or tbe may uber o i trate fmengert ia the US. The must popular theoreti te sree models are the ARICA (AutoRressve Moving Average) proses. They ae gies by tertaindiferene equation in wich an id sequence (2) (xp. 22), the 3 Called note, rivaled. Bor example, a moving average of cedet¢ > 1 Is ened ae co POD AD legs CEE,” CHAPTER 1 snd an autoregressive proces of onder 1 i given by x Mat Zi, tz, ere 6)... and are sven ral parameters. ‘Te serie models ean be ‘nderatoad as dicraions of eocaatiediferecil equations We wil ee {his or the autoreve proses on . 14 Figure 1.24 showa to examples, a igure 1.2.4 Two tne series Xi = 100. Lal 100 saci daly Lp Fears ofthe SUP index se igre [1-4 igh «small sample path of he eorgranee proces Xe USK Z, mee 2, oe dl) random sere see Beample 123 We we thatthe conopts of random variable X and ofa stochastic process (Xt 7) are no ao much diferent. Both have adem ealzations, bat tbe ‘ealation Xa) of random vvable sa numer, whereas the realization Kile),t eT, of a stocastie proves is function on. So we ae completely ‘tet If we understand a stohastie procs to be a random element” tak ‘ng finctions as Moreover, we ea interpret random vale at ‘random vector a peialstochatc process witha fate inex set Distribution 1 nology to random vablos and random vectors we want to introduce son-rapom charctrnics ofa stocaatie proses nich am ite datibutin, xpetation, ce. and dre is dependence tactre. This is tsk much aptamer ome 12, STOCHASTIC PROCESSES ” mote complicated than the dacrgtion of a random vector. Indeed, aon Iva seciatc pron X= (Xy,t © 7) with ifie index set Te an Jafnite-ensonal cet ean be understood athe infinite election of the random writs jt € 7. Sine the valves of are fanesons on The erin oS sabe elo at ota “atin PEA), ACF, as) where Fis coltion of stable subsets ofthis space of functions. "This Sppreach i pombe, but rogues advanced mathematics and so metry 0 {ind se ipl meas The key uervation that stochastic procs canbe nerpeeted a a calleton of random vectors “Te fnte-dimensional ditions (fas) of the stochastic proces X ] {te the dtritioe of the Gite danesonal vectors, (Rie Xade Boot for al posible choles of times tory €T and every m2 We an imagine the iis much caer than the compte dation (1) of A sochastie proces. I canbe shown that dhe fis decenioe the dstibution (EX. Ta ts sense, we reer othe colection of the Bisa the dition of te stchate proces Stocastle proses can be cesifed according to dlfeent extra. One of thom i the Kind ofS. Example 1.2.5 (Gaussian process) Recal from (1.6) the efnion of an w-dimensional Gausian density. A Aortic procs i called Gasson i alt sare multivariate Gaus. ‘We ears s Example 1.19 thatthe parameters and Tof« Gassan vector teits expectation and comrance mate, rept. Hence the distibation fs Gaussian stochastic process determined only by the cllction ofthe expectations and covariance maties ofthe fis A simple Gaasan process ox T = [0,1 coms of lid (0,1 random vas te this eave Ue i are cratered by the dstibution functions PUR, Sticky Sta) PUM, $2) PUR, St) = Men) 8)By (CHAPTER 1 osases <1, (eee eR ‘The sample paths of thi proces are very gular, Soo Figure 1.26 fr an sri 3 Figura 1.2.6 sample path of the Gosson pres (Xi € [sp where he Xie SEO a Be £5 The een fn pu) 9 a te Expectation and Covariance Function Foe random vector X= (X),-.Xa) We defined the expetation jog (EX, E%q) and te covariant ox = (COF(Xy Xj) aaj = Beem) A tochsie process X= (Xie € 7) can be enaidred atthe ellen of the andoes vectors (Xiyg-ny Xi) ft ti-wste €7 abd m > 1 For each of {hem we an determine the expectation and covariance matrb. Ateroatively, vec conse thew quanti se functions of “The exertion function of X given by px) =ax=BX, tT. The covariance function of X ie pve by BUS —ay(O) Xe —avle GET exlt) =cor%.X) 12, STOCHASTIC PROCESSES » “The variance function of Xb ven by ou ‘We learnt in Example 1.25 tha Gavan procumes are dete only via their exportation and enerincefanctogs. "This ls not eoretfor a bow Gain proce ‘A fra ram veto, the expectation faction yy) deterministic quai around wich the sample path of X are caneanttatel. The covariance ftndon ey) # a mesure of dpendeace in the ocean X. The trance faorsion of) can be consdered as mesa of wea of dhe sample pate GEN aroun px (In contract tothe one-dimensional ease, a sateen The “00% of al sample pate between the graph of ex) - Bae) and iax(t) + 22x(0)” very dlcal to show (ove for Causa process) and f'n groral not caret. We wil sometnes consider computer grap with Datla of eran stochastic proossrs and alo indicate the cares yx) ad fix(t)£2ra(t), £6. Tho ater ave tobe iatrpretd or every Bd fe fr every iodvidal random variable Xy. Only ina eure sense, do they fe bow forthe pat fe pros. See Figure 126 for anton Example 1.2.7 (Continuation of Example 1.25) Consider the Gnssan proces (Xy€ (0) of id 302) andor varias Ir Mscxpectaion and covariance functions ore hen by 1 it tne, ou eee 8 Dependence Structure We have slay introduced Gausian process by speing thr fis as alsasiate Gatsran, Another way of casing stochastic process coms Gtimpsing a specaldopendencenrcture The proces N= (Kast €T),T ©, ke tly stationary ifthe Bs axe nwa oder sli of te dex (Mier Sad nates Mate) as) forall posible choles of indies 1, €, m2 and he such that, + Icuste +h €T. Here £ stands fr the eat ofthe dstebatons, see Bi forthe det Roe he random wets in (1.9) this nana tha thle fistribation function ave Went 0 and ext oi» | » cuaPren 1 12, STOCHASTIC PROCESSES a example 1.28 (Stationary Gausian process) Consider a proves = (Xi, € 1) with T = [036) or T = Z. A trial ‘fap of «steely statoany procs sequen of random variable: Xt € 2. Since a Gassan process X is determined hy its expectation and arince fnctins, eondion (19) rede to pxtt4+8) = srl) and ex(te) =ex(t+ he A) for all y¢ © T such that #4 yt 8 € T. But this emacs that x(t) ix (0) fr allt, whereas ex (8) = Ex(t~ for some function 2 of 096 Variable Hence, for a Gauasian proc, srt staonarfy meena tht the ‘expectation fac constant ahd the ovaries function cul depends on ‘he distance a More generally, (psalynoo-Gavasa) proms bac the two aloramestioel proper i called & stationary (the wide ens) or (ncond-ode)sationry prose, 2 we describe a ele procs by suey or inthe wide soe) tationney forhasie process, then we believe thatthe chatactrate properties ofthis procs do not change ben tine gos by The dependence structure decid by the Bs or the eovariance faction i msion der site of te, ‘Tit 16a relatively song rticton on the underlying proces. Homes, i is 8 andar assimpton in many probability raed fle och ax Haas ad ‘Staonarsy canal be impose on the Increment of « proces, ‘The pce itis then not ecenarysatonny [te = (4.067) bea mochastie proces and TC be an tral | x insaid to have stetinary increments if ea for a t2€T and h with t+ ha¢ eT. X ts ad wo have independent increments if for evry chica of € | with tress tm ann Ke Kiyedes =i ners Poin prot (Xi 6.) with fi weg sod ie sands or he ection Figure 12.9 Sonpe pte of « faenny 1s os Boog 0 Sram i) = | scene random aie One of thn prime examples of process with Independent, statonary incre ‘ments the homograrousPolsoa prooss. Homage is here note word | ing fr saionrty of the neremens ose ee er2 (CHAPTER 1 Example 1.210 (Homogeneous Poston process) [A stocane proces (rt € [.2)) ealled ax Hamapenaue Potson pro ‘ear ce simply » Ptson proces wth iteniy ot rte 2 > OX te flowing, ‘toes ae and: + Ia stationary, independent increment. 1 For every > 0, Xs basa Poison Poi) dstsbation; ss Example 1.1.1 fort efition of eh Poo stebaton Figure 1.29 shows sever! Poison sample pats. Notie that, by stationarity ofthe ineeents, Xj —X, with €> # has the same dstrbtion a8 Nig No = Xess 8 Pai ~ 9) stein, ‘An alternative definition ofthe Poison procs i given by Maths, 0, (0) here #A denotes the number of elements of any particular set A, Tre = Yit-=-+ Yo and (Fina mqunac of id exponential Bsp(3) random varabiee ‘eh comnondrbution fnetion PO <2) #20. This deiiton shows nicely what kd of sample path a Posen paces ha. Wi pure jmp function: fe constant on [Za Tyy) and has upward jumps ofslae at the random tes Ty ‘The reo the Poisson procs and ts modiations and ramiaton is xm abil with the eof Brownian main, ‘The Poison roc sa counting Drone (1:10), Behar a large arty of applications the most fect fie. To name 2 fw: fra given time interval [fy Xq Isa ode! forthe umber of + tephone calls wo be handled by an operator, + customers wating fr service in a queue, + lain reving in a insurance porto, 8 13, BROWNIAN MOTION s Notes and Comments Introductions othe theory of stochastic proome ar based on non-lementary facts rom neste theory ond foto analy. Standard texts are Ah and Gardner (1975), Gita and Skaokhod (1975), Karn and Tayo (197,191) finfrnny cers An etetalning introduction othe tory f apple stots fic process esnie(1082). Grint and Stnaker (100) a ntodaion Sltiout trdening the render with great det of mane theory” 1.3. Brownian Motion 1.3.1 Defining Properties Brownlan ction plays central sein probability theory, the theory of tochastle proces, pcs finance and ao in his book, We stare with the deiiton ofthis important poss, ‘Then we conte with ome of 1 siotatc groses B = (Bat €[020)) i called (wanda) Brownian ‘notion ota Wiener procs the following conditions are satis tarts at aco: By = + eho atloonry, independent increments np. 30 fr the det thot For eery £0, yh anormal (0!) dsb + Khas comtinuous spl paths: “uo jumps ‘See Figure 13.1 fora viunlination of Brown sage pats. romnian motion snare ale the logst Robert Drown whose research aie tothe 182s, Baty inthis ontury, Louis Backer (100), Abert B- Sein (105) and Norbert Winer (1923) began developing the materateal try of Brownian motion. The construction of Baceber (1900) was error tou but it eptared many of the sential properties ofthe proces. Winer (0025) was het to pot Broweian moti on fim mathematical bss Distribution, Expectation and Covariance Functions ‘The fi of roman motion ae multivariate Gausan, hence B is a Gans tian proves. Check this tateent by observing that Brownian eotion hasu CHAPTER 1 1 BROWNIAN MOTION 3% independent Gausan creme and y sing the formal fo fnar tans ations of Gaus random vector. 18 “The random varinbles B,—B, and By_, have an N(0,¢ =) dstebution fire ct “This flows rm the stationarity of the increments. Ide, By — By has the sine disttbuion at B,-y~ Bp ~ B,- which s nocd with mean 20 and shane fx Than a Varian proper 6 tis hgh of he ral Int This eno intel: th ager he interval, he age the Bsctaaions (of Brorsinn motion on thi intra. ‘This clacton also supported by ‘mulated Broweian sample paths be for example Figure 13.2. Notice: The datribtonl identity By By £ By, fn gene, dees wo imply patie identity Bile) Bula) # [eis worth o compare Brownian mation withthe Polson proces sce Example 12.10, "Their destin conedeInsfr that hey Are prooemee with rations independent increta. "The eral diene isthe Kid of distribution of the erent The rqueent of the Potson dstsbution ‘ake the sample paths pure jump faneins, wheres the Gauslan assumption ‘ke he sample path contoun. Ts immdat rom the deniton that Brownian motion has expectation [> tuncion o(@= BB, =0, +20 sd since the increments By ~ By = By and By ~ B,areindependent fo > 6 hae covariance fandom (rl ts defation ror p28) colts) = BIB —B,)+ BB, (Bs ~B,) Be] + EB | BUB,—B)EB,+e= 0405, OSs Of its ay the condition (BoB) foe vey 7 > Os any cho of, 2 BryyBry) (129) Joon and n> ‘Soinarity a datribtiona, nt paths property. Jn (12), one mt nat replace £ wt Roughly speaking, selsnarity means that de peopel sealed patterns of « ‘temple path in any all or large ine lateral have a sar shape, but they reno esa See Figure 1.3.2 fran Ustaton "Te sample pats of sellin proces ae nowhere erential; se Propedton Ad.'on 188. And hee comes ‘Brownian motion Ocal, Le (PBT PB) EBreosBru) 8) Sor evry T> 0; any cole of 0 and 921 Hence it sample paths ae nowhere 13, BROWMAN MOTION Figure 1.3.2 Salfsinty the ume Brownian sample ath on diferent eles {he saga of he cares Set intra ak sar bt ey emt py eae ops of eh oePy (CHAPTER 1 Figure 1.8.3 Lato feel fnton. A ery pon graph be apr Iselin fon ths the aiue tangent ir pont Rh ie (fonlon's net Arontae att =e That oy many tangent othe ‘tw ofthe ftion oh pt (One can aly check th dstibutional entity (1.13). Indo, the le and ‘ight ide of (113) re Gatarian andor vectors, nd therefore utes to verify tat they have the same expectation and covariance mates. Check ‘hose properties bye (11) ileriblty of thon f ronan that graphs smooth, Indeed, i the int as) = fm, Bo2 83) = Le) exists ands iit for ve x € (0,0 sy then we may mite for small 2 flay) = fn) + feo) Ae Mo, Aa), where gu, 2) +0 a8 Az -> 0. Hence, na small neighborhood af z, the function fs oaghy nea (ar afc of 2). Thsexplains ts othe. [Arnley difeentality of fat po that weave a unique angen fete curve the function fat hi pnt ee Figure 133 for an stration Tn this figte you can alo ace a finction which isnot diferentable atone pt "Now ty to imagine nowhere difeetiable function: the graph of his function ange a shape inthe neighbor of any pait Ia empletly ‘onepedictable way You wil adie that you cannot realy imagine uch 3 1. BROWNIAN MOTION o funeson: i physically impossible. Nevrteles, Broan motion scone fc aa vry good approimation to many rea fe phenomena. We wil cea ‘Sion 13. that Browoian mation a at proce of era um process he slesmlaity property of Brownian motion has a ice consequence fac the sinslation fe sample pat In order to snust a path oa (0,71 shifices to nut one path en [1 then ale the tae interval by tht factor and the sample path by Ue fctr Than wea dove, a sme books ne ca find the claim eat the Hit sam (Bets) ws doesnot exist and therefore the spl paths of Brownian motion are nomi feral I easy to check (doit) thatthe Lint (114) des no exis, but choot frter theory it would be wrong to eoncude fom this disibutional Tent thatthe paths of he process re nom diferentiable "The existence fs omlere diferente ceatinvus uxetion was dco ‘cd in the 10th century. Such a fncion was constructed by Weestrass, Te tras considered a a cto, fr ama fom any protcalappction. Bowt- Tan motion fa process wth rowbere diferente spl paths. Current considered w one ofthe prone whieh havea multe of ppatons in vey dierent elds One of than is stoharte exes se Chapters 2 and After indeation of the regularity of Brownian sample path ven bythe allowing fc: ‘Browsan sample paths do nt have bounded valaton ob any fe ‘ater 0,7), Ths ena at sap SA) bere the supremum (ep. 21 fo ite det) i taken oer al pow be pariionsr! O= ty <==" O and sR. Clery it is Gassian proces (why?) with sxpetation and coma ants W+0B, 120, walt) = at and extta) =2 (CHAPTER 1 ‘The expectation funtion jx®) = a (he tematic “dei” of the po- eu) enetilydesermincs te charters shape ofthe sample path 00 Figue 186 for sn iwtation ‘Therefore X i alo Brownian motion wath (Gime) af 3 ‘Withee fundamental covery of Bache in 190 that pris of sky assets (stock ince, exchange ras, share pres, ete.) can be well deacibed by ‘Browain notin, «new are of applications of stochastic process mas bor. omever, Brownian motion, sa Gaussian procs, may asume negative val ‘ie which smote rable property of price. Un her enlebrated papers ‘Eom 10TS, Blac, Scholes and Merton suggested another stochastic proces as ‘dl fc perlative prices. In Section 4.1 we conser ther approach to ‘he ping of Eutopean call poo more dea Tone of the promising tnd miming example forthe ws of aca cael Example 1.3.8 (Geometric Brownian moti) The process suggested ly Back, Seles and Meron i given by ica ta, le It the exponential of Brownian motion with dit; we Example 13.7. (leary, Xs note Cassin procs (wt) For the prpon of ater ar we alae the expectation and eorariance fe tions of goometsic Broweian motion. Tor ver, falar with probability hoor, you may eal that for ae (0,1 random vale Z, Bae, dew as) 18 ey dried a shown below wet = hg [eet orgs [lerne ero wo used the fact that (2r)*/#exp((¢~ ¥/2) isthe dens of an N01 som variable From (1.18) andthe seismicity of Brownian motion it follows immediatly that nx(t) = eBe™ metpetl™D a dese us) 13. BROWMAN MOTION o Figur 1.9 Sule pth of pometne Brounen motion Xy = exp{0O1¢+40125) i tection ftion x0 (shed) ond he rope anton rigid cra med For 9- Os sme Bd constant. Is expectation and eovarlance fnctions se ven by Xe t20, (9) bel) =O and ex(a) = Ale +8)—minle+ hol, ast Notie that ex(:¢) =O ¢— 9 >, nce, and X, ae independent, but Htasechexlta) = Rath (¢~a)} Since X is Gaosan and ex (ye) 8 function ony of stathnary (ee Example 1.28) (Ceasy,i B was difecetiabe, we cond let in (1.19) go to ser, and inthe limit we would obtain the ordinary derivative of Batt But we know, this argument not appa The vastance function o() =A ives an Indintion thatthe Bactation of colored ose become age as dares Simulated pth of clare oie ok wry mich ke the ample pats a Figure 128. 1.8.8 Simulation of Brownian Sample Paths ‘This wetion fot nosey or the understanig of tochatc cleus. How- err wil characterize Brows totion ast ditebutonal ie of petal Sim prow (coca uncle cetal ini tora). This observation tril bly you to undestand the Brownian pth ropetns(nu-diferentaiy, bound raaton) much Detter A second abjecive of this eeton ist ‘how that Browoian sample path an cal be simulate by using tard stare ‘Vang the slot alii powe of moders computers, you can vistlin| the ato inet every och proce, Tse darable Because we ike {oversample puts In ener to understand the sacbaae proces beter. Ot {he ater hand, simulations ofthe paths of tchastic proses are someties invoke if you wast to ay something about the dstutional properties tf sch a proces, In ort cows, we cannot determine the exact dstibution 13, BROWMAN MOTION 6 fw stochastic proces and is factional (such sits asim o wininn fn s given intra). Then simulations and merical tenis er Some ‘Sternative to cleslate these distributions ‘Simmulation via the Functional Central Limit Theorem From a elementary course in probability tory we know about the centre limit eorem (CLD. ia fadamental reli exp why the ara 0) be a vence oidHAPTER 1 3.14 Smaltion of one Brownian sample path rm the drei 3 hn actin ih =.” de rath aly or M = 4. ston Met Af 10. 13. BROWNIAN MOTION 1 .N(0,2)eandom varias, then Bera nrgtrse te Fetiell, seman. 0s ‘Tis sere converges for every Sad, but alo uniformly for [2a ie the rate of eonvernnc is comparable ll or an appication of hs formal foe ha to decide about the number M of sine funetions and the mamber 0 of alscetization points at wich the sie functios wil be evaluated. “This amounts to eaeuating the ales Baledegthra + ips Paley 29 BE fet tooad ‘The problem of choosing tho “ight” values fr Mf and i sma to the Choice ofthe spl sie mn the onethonal CLT it diel to gv a imple ful of thu fr the cies of and In Figure 1.14 you ca see thatthe shape ofthe sample paths docs aot hang very much fone swith a AU ~ 100 to Mt = 80 sine Fanci ‘Avista ispecton inthe case = 100 gles the nprenin thatthe ample path is til foo stot. This i not comply surpiing ince sum of Mf sine fanesons i diferetiable; only Inthe limi (8 A> ex) do we ga 8 ‘ow diferetiale sample path “The Paley-Wener representation i just oe of iniitely many posible sevesrprestatation of Browaian motion. Another elo sch rep Seotaion i du to Lévy. In the Léty representation the sae funetions are ‘replaced by certain polygonal fanctions (the Sebader factions) ‘To be preci, Sit define the Hear Junctions Hao [1] flo: my = 4 Hit)2 (CHAPTER 1 Hawsald) = re BRA). 0, ewtere, LeegP1y mao From thse functions define the system ofthe Schauer functions on (0,1 by inegeating the Har anctions fo = fonds, = 1.2, Figuet 1.115 and 13.16 show the graphs of Hy and Fy forthe fst ne A ‘eres epresetation for 4 Bromaian sarple pth o 0 then given by le) = Sze te Wal a2) ‘nee the convergence ofthis wre i wir for [01] and the Zs (as {re rations of aad (0,1 quence (Z,) As fr simulations of Brow. au motion via sine functions, ne has to loose a truncation pint M of the afte series (125). ln Fgite L217 ne show bow a Brownian sample path is approved by the superpeiton of the few A term in the series Fepreentaton (125) ln contra to Figure 1.1, the plygoval shape ofthe Schade facto already antpats the iereguae behavior ofa Brownian th ite uon-ifeentiabi) fo elativey stall "The Paley-Wiener and Lévy eopresertatons are jut tw finitely many possible wre repreestatoas of Brownian motion. They are special cases of {he socal Lény-Cenelt representation. Cis showed tht Brownian ‘oto 3} en be represented the Form $209 feos, vera ihre a are ie (0,1 aor ible ond (fy) it a complet etna aeton sytem ox (0,1) Be) Notes and Comments Brownian motion i the best stud stochastic process. Varios books are ‘evo fr exople Borodin and Saline (1908), Hida (1080), Karaaas 13 BROWNIAN MOTION13. BROWNIAN moTION CHAPTER 1« CHAPTER 1 sd Shreve (1085) and Reva and Yur (1001). The vader ofthese books mst ‘efi withthe haory of toast processes, fnctonal aay, special fetons and measure theory. Every toxbook on socastie process also ‘tai atleast one chapter bout Brownlanmotan, se he reeences ob Pe Tn aiton tothe aon ifrentshity and uaboundd varition, Broan ‘moto has any snore ening pth ab dntabutoal properties. Ha (180) {good rerncr to ead about then "The functional CLT sto be found in advanced exthooks on stochastic peo cscs the convergence of probebity measur ee or example Binley (1968) or Pollard (198). The series repesensations of Brownian motion can ‘be found in Hida (180); se also Cis (1965). 1.4 Conditional Expectation ‘You cannot avoid this section; i contains material whichis essential forthe “understanding of matngaes, and more generally, Roca neal If you ate not intersted in ets you may try to Fad ro ont box to voters At the ead of Section 1 pou shoud Hao + th ald yeerated by a rand arable, a random vector ora toch 13 proces se Section 142, + tho condtioal expectation of «random variable given a of see Secon 143, + eh most cmon rl or aula conditional expectations; Se You should tart with Section 1.1, whee an example of conditional expec: tation i give. Tt wll give you some moc fr the abstract notion of ‘aol expectation glen a a-el, and everytime when yoo gt ot fa this section, yon boa erat Seton 1-41 and ty to gre ot what the 1.4.1 Conditional Expectation under Discrete Condition Fm a elementary course on probability thory we know the conditional probability of A given Be Peal ay = PAN) PB) |L4 CONDITIONAL EXPECTATION 7 AnB Figure 164.1 The clan! condtonl poi fw hw hat B ecard, tte patty Carl, PAB) For the defsiton of P(A| 8) i racial that PCB) i postive, 1s the objective of Seti 1.43 to sla this condition “The probability P|) canbe ieterpreted a flows. Assume the event occurred. ‘This aooal norton which eabraaily change te ‘nderyng proallity meas, Tn parla, we aig the new peobabiie (to (ne know that B wl ot happen) and Iwo B. The evet B bees four ew probability space 1, say. Allert of interest are ow bart of fF ANBCA In order wget anew probably measure on MF we have (0 ‘ommalze the old probable P(AMB) by PUB). Tn sum, the occurence of ‘anaes ou orginal space shrink of, and he olga! proabities PA) Ive to be eplend with PCA) “Given that P(B) > 0, we ca line the conditional triton faneton of random varia X given B P(A). fan only 4 ad B ar independ. PX <2. B) Fy(e|B) = POSand als the conditional esetation of X given (128) were a crue (120), me asm fr the moment that f= Re If X ie discrete random, variable wth wales 2,25. hen (1.2) bones Bix|B) = Yon Pile rs EX has density fy then (126) becomes BOXIB) = pigs [7 stole rarer = amy [exer 1 icommuan wage to writ fj (ee for [oleate Example 1442 (The conditional expectation of x wifrm random variable) ‘We conser the random variable X(a) =a onthe space f= (01), eowed se the probability measre such that (a,b) =3-a, (8). ears, X has aif disibuion om (0,1: it disbution fueton ie sve by Fyle) = P(e: X@)=e es) PO) =0 #<0, = | Poe) =2 eee Pot) =A wez>t 14, CONDITIONAL EXPECTATION 0 Figure 1.4.8 Let: « afr random rr X on (1 le a) onde ection (dn) ve Buampl 4.2 ugh the reno vrai X (de i) Se ab een 1) Gt) ae = 4 H ‘crete random suraie E(X) wath datinct constant ulus on the seis AL ee Eearot ee Both, the random variable X and its expectation EX in Figre 143, Now stun that oo of the events 5, age represented A= (= D/nifal, T= Bosom, occured, Recall that f(e) = 10n (1 and notice that PA) Jn. Tren arise gis fsteeneenn fou}! aan ‘The comitonal expectations E(X| Ay) ave iusteted ln Figure 143. The value E(X |) ie the updated expectation onthe me space A en the Information that, occured. o ‘Now we coder a dinate random variable Yon f thar asues the stint value om the eta yb Ar= fw: Ye)=u), f= 12,o CHAPTER 1 (Cleary (Ay) it dint partion of 0, Andy fe i#j od Yana (028) ‘We au ass for comvenienc that P(A) > forall i Tora random variable X on with E/X] < 20 we define he conditional ‘expectation of given Va the dacrete random variable BX) = BUA)= BUI =w) ewe a, fen, 29 we know that Ay occured, we may rstitourcves tows in Ay. For tone {on EL |Y )o) coincides wih the call conditional expectation B(X [A ox (128) Bxample 144 (Continuation of Esampe 1.42) Weimtrprt the B(X [Asin (1.27) asthe values ofa discrete andor variable E(X|Y) where iseonstanton theses A, = ((-1))nsfn. See Figure 43 for an istration of this random vail nhs sense, (XT) i thing Daca wif he el ren ua, ah potion to X, given he aformatio that any of the As crue Jn what flows we sve some slmetary properties of the randotn viable E(X|Y). The ont property can be ens chk (D0) "Th condlinal expectation Ucar fr random vriabln Xi, Xa and ilaX, + eX) IY) =o £41Y) + BOI), ‘Tn expcttions of and E(X|¥) ae the mee Bi HEAT, ‘This flows by a direct application of the defining properties (1.29), (1.20) an by the observation that E(X is ieee rom variable miecriyy = Sonex an ria 1 CONDITIONAL EXPECTATION 0 = e(xEu) =e Here we also use (1.28) so tat Dia atop 16 and are independent, then (XY) (ua) Recall fom p20 that independenr of and ¥ Splice PINAY =p) = PIXE) POY =p) = PLE A)PLA). (131) Consider the random wsiable I, and otic that fo 40) =1) ‘Ths we can remit (131) flows PIXE Ay Ia, =1)= PE ADP ‘The analogous relation, where {Z4, = 1} i epacd with (7, = 0}, abo hols rnc the random variables X and 4, ar adependnt an roe erry) = Bora) = BEA) BEAD px, Pua mart) +17) = Pt ‘Tis pron (130) Up to this point, we have earn: —— + The contonal exportation B(X "of X given adsete random ‘rele Yea dacrete random wsible | te coincides withthe clase! condtlonal expetation E(X Y= hon hess 4, = (02 Y (0) =e In this ses, coarser vernon of Xs again Figure 143,@ ‘CUAPTER 1 1 CONDITIONAL EXPECTATION 6 | + Tefen values Yas, the care the random variable E(X [¥), 1m particular, FY = coma, then E(X|Y) = EX: IY assumes to datint tales, 0 dew BCX [Ye 4 The conditional expectation EUX|¥) is mot a function of, but tery afnetion of Y. The eandom vaiale X only etersines {he kindof funtion, Ind, wean wie Sew a0), where ot) i) Fyn. | | aan | 14.2 About o-Pields In the previous scion we introdued the conditional expectation E(X |Y) cf random variable X under the dserte condition (ve dace random avi) Recall om (129) tat the vals of ¥ di not realy mater or the defen of BUX), batt was rua hat ¥ assumed Udine ae ‘yon thessts Ay, Thus te conditional expectation (XY) can actualy be understood ara random aiale constructed ro a collection (8 of sabsts of So we may, in a syabole wa, write BUX IY) = B(x 007) ‘Obvis, the election 9°) provide with the Snfrmation about the ‘race ofthe random variable Y (0) a fnetion of 1 1 what fas, we wat to mabe pels what “colton oY) of subsets o£ 0 means. We wl eal la. 6-feld 0 ¢-lra es definition follows ‘oid F (on Beacon of wb of aig owing | ‘cotios: Te not empty: 0 F and. e F WAGE thm EF An Assos € Fo then Geer ca iiaes Example 145 (Sona elementary Beds) Check that the following cline of mubaets of are oS Fe = 0.0), Fx = (00,49) forsome Ay Wand Ax m, Fa = PIM) ={A:Ac a} iis the smallest oe on 9, and 7, the power sto i the biggst one, it ents all pousble subsets of 5 Now suppose that Cs clacton of subset ff, but ot necessarily a6 By adding moce sets to C, one ean always obtain sold, for example the power set P(0). Homeer, thee ar mathematical sone showing tint (O) Bin general too big” But one can also prove tat, fora ven collection C of sabes of, there exists a amulet o-fldo(C) om 1 consining Wo cal o(6) tho fd yeneratd by Example 146 (Generating ols fom elleesans of subsets of 0) Recall the o-Selds ram Example 148, Prove that = o(C), where =), =a), =F tng the definition of ld, you have to check which ets necesary belong to the oneld of) ow conser {A.B} and = (4.8.0), there 4,8,C C 0 and determine o(C) and o(Cs). Belore you start: st hin about the atzuctre of the element In 9(6) and (Cy). Nati that you an ge every cent of (Cy taking all posible unions ofthe ets 9, Ang, a'nB, AnBs, ane or o(¢) su ca proceed in ilar wa. a6 (CHAPTER 1 1 general its diel, i not imposible, to give a comstretve description of the elements in o(C). The asd oY) generated by dsrete randy quale Ya an exception, Example 147 (The o-eldgoorted bya discrete random variable) Recall the sup of Seton 141. We conadered a dacrte random variable Y ith distin rls yy and dese the subsets = (2: Ys) =), whieh ‘omelet parton of. Choose = (dn Sine o(C) i old must contain all sts of thee Ua. as) where 6 any subst of B= (1,2...) ineuding f= 9 (ving A = 8) and TN (giving A=) Verify that te sete (1.2) const ao-Bldo(Y). Sine the ses (1.52) mecevary belong wo (0), the salt old eosin Cyrew alo have @(Y) = o(C) Later we wl call o(F) the afeldyeneratal wr Notice that o(F) cota ll ts af he fora Aaa = (YE (a)) = (4:8 < YW) <8}, -v0 a ‘We arnt that the o-ldo(Y) is nonvialobjet. In what fallow, we ‘rant tote the flowing rae of thumb in order to beable to nage of} Fora random valle, a random vecor ora scsi proces Yon 1, the eed 9(7) gented by Y contains the ental Inormation ‘hoot the stdctute of ¥ aa function of. € Icons of al sabia {:Y(e) €C} for stable sets C. Because Y generates aol, we also sy that ¥ contain information represented by o(¥) oY cries the information 000) We concade with « wefil remark Let {be a fimction acing on Y, and inter the ot fess") ec} for suitable sts ©. For nice” function f thie et Belong 0 a(V), our c ol) “This means that a fnction f ating on ¥ dos not provide new fformation bout the structure of Y We sy that the Information cated by 0) ‘contain inthe information 9(), We give simple example: 4, CONDITIONAL EXPECTATION o Bxample 1.410 As before et B be Brownian mation and die the olde Fin alBut St), 120, Consider the function f(B) = By fr » Bxod Given that we know the structure ofthe whole pros (B,2 <1) on then weal know the strate of the random variable, thus 0(B,) CF. The converse early not tre Ti we know the random variable By we eannot reconstruct the while procs: (Bre 50) fom ie a 14.8 The General Conditional Expectation a Seton 1.41 we dein the conditional expectation BUX |Y) of random asiable given the dsete random veeable ¥. This deiton dow aot Inake expt use ofthe vals yy of ¥, but it depends onthe suet = (oY) =n) off. We karat in Example 147 thatthe caletion of the set A, generates the ofl o(Y). "Tibi the starting pot forthe 0, P(B") > and define Fa = o((8}). We kom ftom Example 14.6 that Fp = (08,8, 2"). An appeal to Example L411 elds that BUX |Fe)(s) = BUI) forse B ‘Thies the clase! nation of conditional expectation. If we specify X= La for sme vent A, we obtain for w€ Plane BUlal Fado) = BU4|B) = PURE The right-hand side ste lial conditional probability of A given 2,» (CHAPTER 1 1.44 Rules for the Calculation of Conditional Expecta- tions “The defining peopety (1.8) of BLX|-F) suo a contctive on. Therefore els in gooeal difleu, not impossible to aeaate BCX |). The ese Fmol¥) for a daerete random mable Y, which was dacused in Exar ple 1411 i exception. Fortis eason, Is nportat tobe able o work ‘sith condtonal expectations withont ining ther partir Jorma. Tht Teas we veto know a fw res inorder to da! with ondtonal expect "a what flows, we coll the most common rues. In some cases we will, ve emo fr tse rules, nthe ther tations we ave to rey or initve Irgumeats, We sat with an existence and niques eal WELT < the cndiona expectation BUX] ) eit and i unin in the tows toca in Appetin A 1a Seton 141 we encountered ules fo the ealeltion f contol expe- tacts ude adsrete condition, They remain valid inthe general case Rale 1 The conditional expectations ne: for random varabes Xi, Xe and BllaX +aXIIF)=a BINA) eer BSF. (135) his allows by an application ofthe defiaing propety (8) vo the ight- and fan aes of (1.35) (ey to prone), ‘Now take A= Ain property (13). Yu immetiately obtain: Rule? “The expectations of and B(X Far the same: BX = BIEWIS) Als the hed an (ee (1.0) ears owe om the discrete case: | CONDITIONAL EXPECTATION a Rule 3 TEX and the old F ae independent, then BUX F) = EX. In patcla, i X and Y are edependent, then BUCY) = EX. ‘This satement nooks me dann: what does independence between X sed F mean We mans that we do ot gan ay aformation aout Xy i we ow F and vice versa. Moee formally the random variable X and ly are Independent fo all F. Nom, by independence, BUX I4) = EX Ely = EX P(A) = EVEN) Li], ACF empaon with (139) yields that the constant random variable Z = BX ‘he conditional expectation E(X| 9). "This prove ae 3. Tale «| he old o( 1X), generated by the random variable Xe eantlned a Frith BuIA) a patcular, IF sa fanetion of Y,o(X) €o(P)s thus ELX|Y) "This means that the information contained in F provides us with the whole Information sbout the random varale X- It we know everything shout the structure of, we ean dea with sift was nonrandom and wet the value (a) in fom Of the copia expectation E(0|) = (X(s)|F) = XW) EULA) = ‘This rule can be extend to more genera tutions BX FI) w) Ble 5 he of (%), generated by te random variable X, conta i FF, then fr any naam aiale G, BUXG|F) = XBGIF) Ty partiag, if Xie a funtion of ¥, o(X)Co(Y), thus EUGIY) = XEUGIY).2 CHAPTER 1. Indeed, given Fw can deal with X asf wa a constant, nce wo can pl X(o) out ofthe updated expectation aad wate rent of E(G 12) Tale 6 WF and Fare oo ols with F CP, then BXIF) = BELXIFIF, (136) IXIA) = BEIXLAIF), asa) Fr abvows reasons, Rule 6 is smote allel the tower propery of cond onal exertions Rule (17) can be justified by Hale & since F'C F", BUCI-F does nat ‘tain more information than”, Le gien J, we cam dea with EX |?) BEXIFIF) ule (1.38 ean foray be derived mn the dining property (1.8) which says that for Ae F and Z = EX), B(XIs) = BEL). 138) (On the other and, by Rule 5 and since Ae FCF, EUEIX|F)|F) fa = BBX |F Ya] F) = BELA F)) ‘Now take expectation and apply Re 2 tothe right-hand ie BLEUE |) 19) La) = XL) ‘Thus 2" = B(ELX |") |) lo sti (138), but since B(X |) i nig west bave Z = 2", whch proves (1.6) ‘We nish with a generalization of Ral 3. Tale? FX fs independent of F, andthe information cari by the random ‘able, the random vcr or the stochaetie pros G contained in F then or any aeons), FUNC) = BESMXOF). ‘where Ex[M(X,6)] mean that wee Gad tke the expectation wth respec 10 1. CON TIONAL EXPECTATION n We thstrate Re 7 by an example. Bxample 1413 Lot X and” be independent cand variables, Then Ras Tand Sve BUXY |[Y) = B(BN(XY) |) = BEX |Y) =VEX, BUSY) = BIEN +Y)IY) BEN SYIYV=EXEY. g 1 the following two examples we want to eer the rues for eaeaating endtonal expectations Example 1414 (Brownian motion) Real the dition of Brownian motion B= (B,t > 0) frm p. 9. We ‘soda wth B a neeasing stream of lafrmation about the tuctre of the proces wich i vepesated bythe o-elds 7 = o(By,2 <«). We wast toralalate (DF) = E(B (Bey 2 <4) for #20. (tory i 92 fF > Fis and so Rae 4 gives BHF) = Be Now asume# 0. Te same arguments ss Example 1414 yield BUI F)=N foe #26m (CHAPTER 1 Ries we write a = (8 -B)+BP-« (B,~ B,) + BE +2B,(B, —B,)—1 ‘aking conditional expectations, we obtain BUNA) = Hl\Be~ By 1F] + EF) + 2B — B18 ‘Notice that By ~ By and (8 ~ B,)? are independant of F,, and tat (82) © 2(B,) CF. Appling Res 3-5; me oain BRIA) = BB) ~ By) + BE +28, £10 ~B, (ot Bt H0-t= x, Finals, BUF) = Xan ‘Later we wil abe this elation a he deaing property for a martingale ce a) a 1.4.5 The Projection Property of Conditional Expecta- tions Jn what folloms, Fla o-ld and 12(F) ste eallaeton of and variables Zon 0, ain the following condo 1 That a faite sexond moment: BZ? < 00, 1 The intrmatin cased by Z i contained in F:o(2) F.C F = o(Y) {his means that Ze a function oY. “The random varabe B(X|.F) can be understood as an updated version ofthe ‘expertation of, gen th formation F The conditional expetation hat ‘etain opty propery inthe dass 12) “The Projection Property Let X bea random vale with BX < oo, The contional expecta tion E(X (7) i tht random valle in (3) which scenes 1X i ‘the mean square seme. Thi ears tt BUX —EUXIFIF = ia, BUX — 2) (139) 1. CONDITIONAL EXPECTATION cy X- BX F) 017) Pr) Figure 14.18 An Ustncion ofthe poe property of he condition eg tion (XIE) We mention thal ¢ 2.7 5 B(2Y) fr ZY th BZ" Coe and EBV" a dine on ner pote end [ZY = YE=V HAYS datece ‘ten Z and YA Ben spc we tay that 2 ond Y re topo S27 3a 0. nh some, ECL) w the etogoal potion of Xen (5) EX B(x|FhZ>~0 oral Ze) ante XL Z> minimal fr aaa 1 thi sense, E(X | F) ithe proton of he rnd varae X on the apace (5) ofthe rand vray 2 eaerying past the fformation la soe ‘the comments vo Figure L416 (OY) thas function of ¥ which has ike sod ‘morent and which i ches to the rvam vue soe what flows, we sometines rele vo F(X) 8 the best praiction of X ‘sin F The mean that relation (1.0) holds. To ive some meaning #0 the ‘ord petition", werocsonider Examples 44 and 115. We proved that trict E(B|Be, 25) =B, and BOP ~t| Be, x <9) = BE formation about Brownian motion uni the preset time s, are the present70 CHAPTER 1 values Band BE —s, respectively. This property characteris the whole ass ‘Tinarttgalee with Be soca moment the bse pton of the fre ‘aloes of the store proces the preset tlue se Section 15.1 1 what alo, we indent the steps fr the proaf ofthe projet rope ‘erty (1.30). We aly make ue of the reo calculating conditional expec tons, Fmt notio that the sudan vale 2 BCX) belongs to (2) it carvesinfrmaton oly about F and basa aie second moment. Theater ee eT ‘combination with Re 2 B|EL| FP) < BELA? || = BX? Now weare going to check he projection property (1.38). Let 2 be ay random variable in (9). Then BUR 2F = EUR -Z)4 (2-2)? BUX = 217 + B22) + BBY 2912" 2) ‘We teat the terms oo the right-hand side separately. Fie comtider EX — ZZ" ~ Z}). Sine both, Z and 2, belong wo LF), so dows Z~ 2". x partial, ale 8, is BUX = ZY 2IF) = (ZV EX But by Rao ad 4, -27). BUX 215) = BX) BEI ‘Thus we proved IX -2y (x24 Ba 2 Hee, UX 2)8 2 BUX 2" focal random variates Zn 122), (40) Wo aso oo that equality in (L40) i achiev if Z = 2, 0 2! = £(X|F) realy reproents hat element of (7), for which the mining of E(X~ 2)? suai. This proves (130), 15. MARTINGALES 7 Notes atid Comments ‘The notion af eotionl expectation i one of the most dict ones in pob- ably theory, but it also ne ofthe most power tol Its dfnion m2 ‘anda vail gen aoe oes ack to Kolmogoron, For compete the (eatcal understanding, mene theoreti probity thoy Ie unavdale, The anton expctation seated in every advan ebook on p> abit theory se for exanpe Bingley (995) o Walla (1900, 1.5. Martingales 1.5.1 Defining Properties “The notion of martingale cri fo the understanding of the Ii sorhar tic integral. Indefinite I toca nega are costed i uch away ‘hat hey catia martngales ‘The den underlying martingale i ft {ame wee the net wionings sre eluate via contol expectations, For naa we now have his poweflestruent n ou ol ba x Secon “Asse that (120) ea collation of e-Bels on the same space ad hat all Fis ae suet ofa larger old F om 0 ‘he collection (Ft 3 0) foes on alle ration Fick foralosest ‘Thay a Station ea increasing sr of information, 1G, ) is sequence of elds on and Fr C Fue fr all 1 we call) ration aswel For ou applications, eatin usually kod yp with stodartie procs: “The socastie process ¥ = (Vt 0) sald to bw adapted to he fir tion (Fit 20 oO) C fora 20, ‘The stochastic proces Y is always adapted to the natural lation gen ated iy Finalise “Thus adaptedoos of sochastie proses Y meas thatthe Ya donot carey ‘nor biormin than J8 (CHAPTER 1 a dace tine proven we define adapta Oh) we equ that Example 1.5.1 (Examples of adapted process) {at (Girt > 0) be Brownian maon and (Ft > 0) be the corapond satura tgtion. Stochastie processes of the fra X= 4B), #20. where fia function of wo variables, are adapted vo (i,t 0), Thies the proomes MY =B, xP az, xP ot ‘But alo processes, which may depend onthe whole past of Brownian motion, ca be adapted. For exam, Bo x xi? = pas B, oc XI? = ln BE Tithe striate procs Vi adapted to the natral Browaian ration (Ft 20), we wil say that ¥ Isolated fo Brounen motion, This means that Ye function of By St “The elloing process are not edaped to Brownian matin: + Br A= Bis, X= Br—B, XS" hee T> 06 a fie number. Inde, these proces require the knowledge of Brownin mation at fate instars of tne For example, consider Xi" For ite dion you hae to know By a ines ¢ 0) and the coreqonding natural Station Fy = o(B,.0 <1), 2 0. The stochastic proces Xp = Bf generates ‘he naar tration owt <9, #20, 15, MARTINGALES 70 hich i smaller than (F). Inde, or every &, #2 © Fi sce we can only Tecmartrut the whole infrmatin abou om BF, but not aout Be we fan sy nothing abou the sign of B,. Then (%;) als tration or (5). ‘hs wo can work with difeatfetins for che same pres, Tue teate his aspec rom an applied pot of view, we coer sn example rh ‘todas Hance. Un ths Bd bebo ha share es exchange ae, Interet ates te, canbe modelled by ston of sochasti dieret ea. tions which ae diver by Brownian motion; sce Chapter 4 The solatons ‘a then functions of Brownian motion. This prosan model the Aoctations fe Sandal marke (independent movements up ad dwn x dit time Itarvle).These Aacestions actualy roprewot the lfrmaton about the ‘market. This evant knowlege contained inthe natal eatin, It does ‘ot take information fom outside into account. However, i nance he re alma people no know mor than the oars. Fur earl, they might know ‘hat an eset political decison willbe taken inthe very ne tare hich ‘ill eompetaly ange the nadia landsape This enables the armel pe fons to act with more competence than the others The they hae ht owe ‘vations which can be tigger than the natural lratsn. 2 ‘Now conser a stochastic process X = (X,,t 0) onan appose you have the infrmation Fy atthe post tne How docs tis information nlurce our knowledge abo! the behavior of the "vena X inthe future? WF, and X are depen, we can expt tat ou information rows the tunetalny bout the ales of Ny at fire instant of tne ff we know ‘that certain events bappene inthe pt, we may inde this knowledge a ‘ur caleuations Thus, can be beter predicted with the information 7, than without IA mathematical tol to deserbe this gin of nfrmation the conitional expectation of X; glen Fy KF) for Oseer We lant in Seton 1.45 that, B{%,|%) the best paliction of; given the information Jy Alo reall fom Examples 1-14 and 18 thatthe ‘ochatle prosaaes Xy~ Band X;= EP —¢ (@ i rowan notion) satis tho eondton BX |) = X, fr e < tor these proces, the bat prodieton ofthe fate value gown J i the present ralue X,- Clty, {Bi tay change if we coder anther liraion, ad therfore we tos always sy whi eatin we coseo CHAPTER 1 { Te stochastic prooss X= (¥;.t 2 0) called a continuous-time mar Lingle ith reaper to the lation (3,t 2 0), we wie (X. (Fe 4 BIN | <2 fr all> 0 1+ Xs adap to (F): 50 p77 forthe dfn. BREAN, Grabocece aay i, Xe the best prediction of Xi se Fi It is alo posible to deine a dicot time martingale X = (Xn In this ee, we adapt the defining property (Ll) allows E\Xape Fa) =Xay #20. a) ‘We show that t sf to rue (142) for k= 1, Indo, recaling Ful 6 fom p72 EWSngs Fa) = ELEN nial Fuss) Fol = Bata Fa) E\Xnga | Fa) Ful = Bn Jn) = = EU la) Now we deine a martingale the discrete-time ase ‘ “The odie proces X= (gn = 0,1...) I ald a dcrtadine martingale wih reset tothe filtration (Faym = Oyen) we we Cc) © BIy| <0 forall n= 1, +X ls aptad to (F) BUXopn|Fa)= Xe forall (ss) Le Xa ithe best protiction of Nags sven Fo {et dic to a tat te defining propery (48) can be reweten in the ota Qin Fa) =. vehece Yass Xap Ney MeO ens (148) 15, MARTINGALES a tothe flration Ih what flows, we often say that “(Xt > 0), respectively (ayn = 0,1,.),i8 a martingale” without plata out which tatlon me we. This srl bc hen rom the sone Inded, wing the dining property EX, = Xa or # <¢ and Rule 2 on pT, we obtain EX, = BIELXIF |= EX; for all and ¢ “This provides an cay way’ of proving tht @ ochasle proces not a mat tingle. For example 8 in Brownian tation, EBF = or all Hence (BP) famioe bea martingale. However, cantot i this ans to prove tat a Stochastic presi «martingale, ince procs that has a constant expec tation function nel ot be ematigae athe following exami shows, we have EB} = 0 for al but (Bf) alo nota martingale; ee Example 15.3. 1.5.2 Examples In this ection we collect some simple examples f stochastic proces which ave the martingale property Example 1.5.8 (Partial sams of independent random viable constete & ‘martingale et (Zp) be a sequence of independent radon viable with Fite expecta ios atid Zq"=0: Coser the partial ums Ry Bot ty 20. sd the corresponding natal eatin Fy = (Ry. fr n> 0. Notice hae Frum alone Ba)y 020. Indeed, the random vectors (Z,..,24) ad (RyRy) contain the sae Infomation sine “Ea and 2) Ry By or ‘Aa sppietion of Rl 1 3 and in Section 1A yee Xe) = BUR | Fa) + B\Zays Fe] = Ba + Bless 1.) ea mtg with spec2 cHaPreR 1 Example 1.54 (Collin nfrmation about random variable) TAZ hea random vara on with 2 <0 and (> 0) bea fon. Define the ect procent X at flows Me B\F), €20. Since F; increases when tne goes by, X; gies us more and more information shout the random vacuble Zin parear If (2) for sme then Xr Z. We show tat ea martingale ‘An appeal o Jensen's incquaty(A.2) on p18 and to ale 2 on p70 yes BIZ] <2 BL = IBLF < ELBALIFD Moveover, Xj s obtained by coationing onthe information ;. Hence it dows not eortain more Information than Fi, x0 e(%) © Fe renaina to ‘heck (Lal). et # 0) be Brownian motion. We conte from Examples 14.14 sd 1.615 tha both (8,2 0) and (BP #2 0), ae marinas with fespet tothe natural lation F = (Be <0 Inthe sow, you cam show (dot) Ut (St), (J) martingale Try tofiad aston con (4) eta (+A) (F) nama ine fest enelate E(B, ~ B,) + BF] rs 0) na {Gres Browaan sample pth and hu termine fn te samp Path o's soa pce i prt, we eal the Risa neal I, £0) te cael ee nd se fs rope. Then weds Hanan Sil gals ich are dow i pte othe pat nel .J1)dBi(0). We wl tnt, tne sae mnothen contin of. tho iter gral iw dtd nd we wil ao pt on tht or eam, he imann Blin f(a) 4B) cant be dened 21.1 The Ordinary Riemann Integral We want to recall the soton of oninay intra which isso called the ‘icra integra. You ould be Gani with tas integral rom » rare on ‘dementary cata ‘Suppose, for simply ony, hat i raid function deine on [aft instead we cold conser any itr ‘Gone pottion othe intra and dece Betimtons An intermediate partition om afr is given Dy any values y satisfying t-1 < es t fr = hrnsum Boe given partitions rand yw can define the Tiemann sam ee S.= Salta) Srwote ‘Thus Riemann sun i alhing but & weghed average of the values J), bere the weight are the corresponding lengths of the Sterns 14 ‘ora know thit'S, is an appraimation tothe are betwen the graph of Fra. an 21, THE RIEMANN AND RIEMANN:STIELIJES INTEGRALS $0 70) penne sy a an a a Figure 21 As thobation of Ronen sm with partion) and iatrmaite ton}. The smo he meangler ses appreciates the ae he te {pork of 10} and he ean ef Jae the function f and the tis, provided F onl asumes non-negative ales See Figure 2.11 for an ihtraton Now let the mesh ofthe pasion r go Wo sto, be str me, B= spas tte) 9 0. we proce inthis way, the pots = 1" lly hae to depend on, but we suppres this dependence ou notation, —— |, | 5 Jim Se fin SH | ess mh) 0a inept i fh a | ‘Eero | ‘ip mao mt fo~ ‘CHAPTER 2 oe sf 190 Weboow that Jia xia acy smoot fr example cot veut or mee etna.) igure 21.2 Two Roman wus forthe ier! [ at se Brame 21.9. The urtton igen yf ioe = On 6. TACK (ig) end Se at Ere ae nd ptt of th nt 8 tb prt of Example 2.1.8 We want wo calculate the integral [date init of certain ‘cman suns, See Figure 21.2 for an istration. We already know that {i tat = 05; repress the teiangular area beewen the graph of 0) hd the taxis. Ro numeral spreximation ee convenient to choo a sudistant patton of (1) usta the fend pists of the inter [¢—1) or the it partons 21, THE RIEMANN AND RIEMANN'STIELTJES INTEGRALS 91 Using the wel nen um ool e) se conclude hat 1 nin) aor Analogously, ake the ight end pots ofthe interval [¢— 1). spe and comcade again wing (22), dat sore met 7 Now choose they ae the mile pots of the itera (4 — 1)/m in and enate the coresponding iemana suns by 81") Since $< i © Si ‘we may coche that 5 + 5 = 05 ‘2 The Riemann integra stan asa model for the definition of any type of integral. The new kind of inter shold ave ar ay properties i emo wih the Rima integral as posible, Such properties pve below Fr Riemann intgrablefuntons J, fs and fy om [1 te lowing ‘properties +The Riemann integral is ina, efor any constants, and ey 1 [nose f wow The Riemann integrals near on aon otras [roa=[roas roa te acest [eso-+ane2 (CHAPTER 2 + On cn define the indefinite Reman integral nfo ofthe | [10a= [romana oes 2.1.2 The Riemann-Stieltjes Integral Ua otty hoy od pain radon wie bis i axe far, shee Fx denotes the distribution funtion of X. Thi notation resto the fact that BX fn fed ar Roeman Slr intepal oe as 2 Lebge™ Sete ntegral The menor, roughly speaking, hat [atx = Sutra) Fe) for parton 4) oon cmepondng internet parton (1). Alo tral fom. coupe ou sentry Cena it yu cn Acne te ings , He) fe fg a, provided the derive ge Bath, [5 £4Fs(?) and [70 dl) ar examples how oe cold 3p aeonch te pte of eta ene cen fh espe Tomer ne Gong. isthe em of the pret chapter fo mga oe methods In Part, we wold eto ain an gal pe fe 0) 420), f fast or soc rom on] and ya) a Brownin sanpie bth We have nmol difely i Sang such nepal sce the pach ‘Bio) dw nt have deli, me Srila 1 Hover one ean Sid cue Ln ef paling which cee awa conto elt te ‘opal 0400). Tle Kn of tga ele the Reman Stes ihogal ea atic ol a any Slo mathematics “what follow ne ge a pce Jain fie Rian Stee inte gal As the Nemans nog we coer parton oh tera rat OREN So tet Cle 2. THE RIEMANN AND MIEMANN-STIELTIES INTEGRALS 98 si a ilermaliate partition oy of Let { and 9 be ow aka funtion on 0,1 and define dig= alt) alten), 6 ‘The Riemann-Stejes sum comespodng 0% and eve by Sa = Slsaven) =H Sa = $F) it) — 6s Notice the sinilarity with » Riemann sums (2 ‘Tins a Raman Steljes su obtained by wei the increments Sig of gin the intervals i that cae, g(t) = 6 ing the ees J) th Tair ; = a Se= gi Ss ets at mehr) “+O and $i independent of the chic ofthe pat= ‘ions 7 and ter intermediate partitions og, thea is called the Reema Steer ata off wth respect to gon [3 We write [1040 When dos he onan Sen nol 2D) tad seu tke 9B fr Drown on on "This question does not hve simple name and needs ome more sophie tion, some textbooks one an fed the allowing paral answer 1+ Te fuetionsf and mist not have dicate: tthe same pint rept “+ Acime that ff coins and g has Bound aration,o cuapren 2, ‘where the supetum (its einition on p21) taken overall pole barons ro 0.1) The the Riemann Stele lea Jd) ees ote ta the ner el ot apple to he ines ff) a) Indeed, we erat a Scion 13.1 that Brownian sample pats Bi(u) do mat tive bounded aration. Momeve, ation of 9 8 m0 necessary or the existence ofthe ema tees tral f 10) da), stough the cota lim ean be fou in ae Doks. Weaker cations forthe existence of (dy) a6 208 very wel known, but they were aleady found ty LC. Young in 199 ae the veces papers by Duley an Norval, (0084) fran exten dscsion, ‘Without gag ato detal, we give a suficent condition for Riemann Stes integrable which owe tanec. ist we ie debation “Te ra-valvd function ho [0] mld to Bave Bounded pearition forvome p> 018 sup SIME) — Mt < 20, ‘tere the supremtcn taken overall partons of) Sots hat i ode writin i= “Rema Ses rl J) 4) eta he lowing cn ‘Now weal 4+ The ations f andy donot have dscontinltis tthe same pint fel) The function f baw bounded prriation and the fanetion g the bounded qsariaton fr nome p >O and q>O such that Piet In some cases these conditions canbe veri. We lve an example forthe Intel Jp S(O dBi) 21, THE RIEMANN AND RIEMANN STIELTJES INTEGRALS 9 Bxample 2.14 As bre, = (> 0) dete rowan min Hs Salle iat pi t Broa men av unl pit Sr uy foed tke ner pve het p> 2, sd tnd pation fey 22 Se Tar (972) Now some «stint uncon f() 1 or 8 mle path of 2 Sotho (ra Acting th soe thay, wee tn the ison Sent Je) with roost te te ah Biro Yas boul yt fr sone © 2h eat £053 Fa one ation 8 ‘oeme tha fr een ton with ond dative Then ale ty saponin ran ae re hat WN) =f eK O-a), #8 where > 018 a constant depending on f. Then wo Eine rteatse Se Hence has bounded vation, ad x the fllowing statement hol 2K eo ‘ewan [is a decrmniicfocion or the employ of uobaatle procs. It fi ileretiable with abounded derivative on [1 thea "he Minana- Sls intgzl [roam exit for every Brownian sample pth By) 1 prec, you can defn the following intra as Resann-Steljes ate wal [fein [mune flee. v20. aa acre Hl Te above discussion may be sight miseading since suggests that one can ie the nteral ff) ABs) very goer atta fas «Riana Stites intepal nth rspct toa Brownian sample path. Homeer his ot6 CHAPTER 2, the ese. A famous example, which i alo one of the motivating exampes for the mroducion ofthe to tachasti tera the nega 19) = [Boa Brownian motion tas hounded priation for p > 2, not for < 2, and so the sfc condition pr" > 1 for the existence of 1B) (ep. 9) Ts mak ‘ati. Furthermore, can be shown tha thi splinter doc mt exit [24 Reman Stele integral. “Moreover on a show the following: (ets a Rina ‘Stieltjes integral for all continuous fanetionsf on [0,1], then gnecrasariy as Sounded varation; so Procter (1002), Theor 52 Since one of ou ms x ‘0 define te integrals J f(t) ABe(s) for all continuous deterministic functions {fon (0.1), he Rema Steljes intel approach must fal since Browsian ‘ample pat do aot have bounded variation on any le Interval. Tis the abjcive of the following sections to find ster approach the stochastic integral. Siace paths tegration with respect to Brownian ‘ample path, as sgt by the Rieman Stites integral, de not lend to 2 sufictaly lage case of lterable uncions J, we wily to define the integral as a probable average. This approach kar the disadvantage that Its ts inate than the Riemann tne integra, ogading the oh he integral Notes and Comments ‘The Riemann and Rlemann-Stijes integrals are treated in textbooks om faleulus. Honever, ts wot eary to find comprehensive treatnnt of the Fiemano-Stjesiatgtel Young (1986) i stl one ofthe bt relrneee ‘on the topic. Bxtensons of the Reman Ses integral ae treated in the ‘cmt work by Day and Nort (10084). 2.2 The Ité Integral 2.2.1. A Motivating Example ‘AL the end th previ ection we let tnt simple to define the intel ff Bo) (opts by pth ae «Roane Sale ate. Hee fan wat flowy, B~ (Bt'20) dno Browsian wo. a ere 22 THB ITO INTEGRAL o understand what is ging on, we cosier th Riemann Stes sums SLB, es fet ORG CHC eta ola isa patton of [and for any Faction fon (1, es af Ad 6) ~My $= tenes se the corresponding ncements of and a 7 ‘Thus the Riemann Stidjos sum Sy corepoads to the partition ry and the intermatiate partition (y) with yx ty be. te heft end pot ofthe Inurl [ft This cole (pia fo the dition ofthe Ko stochastic Tnvgeal We wil also so that another cole of iterate pation (i) {Svs sto the defntion of another type of sacha integra "Nofie that Scan writen nthe lowing frm 1S aad a 1 Fo.wo (Choc by sing the boom ola (Bi Bucs = BR + BE, 2B Bana) ecalshat Browalan motion has independent and stationary increments (ee p83) Hence 6, wes FUMDSD=) sac QB) mtbr =O, Amd ‘Tee imoudae hat Bau = So B(a.By = Sas8 ‘CHAPTER 2 td, again by the independent increments of Brownian motion and since the reson vat) = BUX) ~ (EX) bal, sariQu(t) = Sova duo?) Dieta.oy- a3) ee a wtb fact that for the (0,1) random wsable Bi, EE Hence, (A.B) = EB, an [aoa varQa(o) = 23 a8 ‘Ths if 2s, 0, var(Qa) $2 meshing) J Ay = 2t mera) 0 Since var alt) BLQs(t)~ 0 we show: ‘Qul) converges to € im mean square, bone i probity oe AP pendix Al fo the diferent inde of convergence, “The limiting fasetln f() = ts characteristic oly or Brownian motion [incall the quadrte variation of Broan mation on 0. ‘One can show that Qa() dos no eanwege for a goon Brownian se path td sultble ces af partion ry This ft dearly indicates that we cannot ‘eon Bo) ABs} a a Rieti Sek grl. However, 1 could define ff By dB « mea sare it Inde ioe Ss = 0.50% ~ Qu) comvngs in mean gure 05 (0-1), conte thi iit a chev of tht fs BB Later wl hse ttt he elo the he soca ge [os }i-o. as) 22, THE ITO INTEGRAL ~ ‘rom this evasion we have erat ious ft which willbe wf in what {alo Teter with rape to Drowrian sample paths, wish eannot be de fin ithe Rian Stiles sense can hopefly be dei in the ‘The increment AB = BB, om the interval [ff] iin BAB = 0 ho ean square lini of Qqlt) 8. Those Te er of ilzeatab, we wre (4B, (Broa ~ B= a en tt nfm of gr, fans [fu ‘The right-hand side is the quadratic vatiaton of Brownian mation on wa. es [Av the moment elton (27) and (28) ave nothing bt hei ale. Thy an be made matbemataly core (thera agree). Ts book treo nt have he mathematic as to prone then nt fll, oe Tisai and (28) sr given soe hey wil ip us to understand he Tels off calls, arta the Rd lena in Seton 23, ‘Next wy toundertand why we cose the Hanne us Sn (24) in ch a soe wa: the vals of Brownian motion were eased {he een points ofthe traf. Asse that Wehae a partion Of. ann (2.5). We ere fn Expl 157 tat the marine tas Be AB given by Ease ina martingale with spect to the fltrtion (Bd = Yen), = yo Ast result the mean square lini 0 5(B}~1) of th appointing Rema Stes sums artingale with respect tothe natal Brownian fteaton. Foto Bi.) &100 CHAPTER 2, Another deisiton of the Rlemann-Sitjes sums makes then lose the rating property. As 8 mater of fac we met that, fr patos Ty = (i) of, wath sh)“, the Riana Stes sus ee een eee ee Seren oe eee Sect aye sere fens indiats thatthe sana chai ral bol "To be pei let i) ba deter ferential fanction with 0) = 0, Welw that 18) yy tie 2a ae Integrating bot sides, we obtain by the casa uk fcalelu, j[e. Le es a= [a= ‘sae & 1 we formally replace the faction Hf) with Browaian motion By, we obtain the same tale a forthe tchasticintegral (20). However, tony formal replacement, ince this cain rule applcabl odifrentable functions, not {0 Brownian sample pats "The chai Intgrl, which i obtained atthe mea square lat of the Riemann Stiles sn, evlted at the mide pints ofthe Intervals [testi clled« Stonowch inter. Wo sil conse iin Seton 2.4. 1 ‘ll ur ot to bea vertu ol for saving 15 stachate dieentilegatins “Ths we Hae lear ne more well fac: 22 THE ITO INTEGRAL mo ‘Te fra [3 B,D, = 05 (8 —#) sgt tat the asic chain file of ltegraion dots not hl for io suck integae Tn Se ‘on 23 wl ind chain ule whith wl uted or negation he mona 2.2.2 The Itd Stochastic Integral for Simple Processes ‘We start the investigation ft Te atcha tga er a clas of processes whose paths atmane oly a finite numberof vals As ual, B= (2, 20) egos Brownian motion, sed Fre oPnest), 120, isthe crssponing natural tration. Real tht a stochastic proses X = (i, 0) adapted to Brownian motion XS adapted to (Fst > 0. This meas thal far every, Xe 8 feton of te asta present of Brownian In cht floes, we consider al proenes om id aera 0.7 Fit we atoucn an ppeopite clas of I integrable process, “Te soshaste procs C = (C,,4€ [Tf aid tobe wnple {sf the fling properties ‘There casts a parton ‘Te sequence (2) adapted to (Fy Issam. Zsa foneton ‘of Brownian mation up to time tad aie BZ? < oo fal Example 2.21 (Some siple proses) ‘The deminktie funtion n-{02 ‘CHAPTER 2 22, THE ITO INTEGRAL Figure 2.22 The eprosination of « Brownian tamale by simple prone tale), pie by (210), 15a step function, hence tis a simple proms, Now dfn the process «| fora given partition ry of (0,7. I siaple proces: the paths are pice ‘we constant, and; isa function of Brownian motion wl tine For an Tsteathn the paces C fr two diferent partons se Figure 222." weer, Wuistetiy Peto au) “The 1b stochastic integral ofa spe proces C on [0,7] i given by — Tas sha eps saa pam Tem tis SPS yi [oun ! [f ctoaerto, =F 2.2.84 26a) a0) | \ . 7 | tee Sha | “Thos the val of the I tactic latgsl J CyB he Riemann Stes ‘him ofthe path of C, eva tthe een pot of Ue intervals 1 tit expect to Brownian tion IY < ty the pat € ca tals Prete athe lt point of the partion of Figure 22:8 The 1d shat neal [Cs 4B, capa the pats of © od pon Pee 8 Example 2.2-4 (Continuation of Example 22.) Tecate snp proses fo and C for Example 22.1. The corresponding Mostochate atgrals ace en given by fre, « $5! (2n Bu-nya) +2 (4 Baa) «rn Haren a. fer 6 (kD /nkfn}, and by [ow for €€ tert Soe Figures 222 and 223 fra visualization ofthe sample paths of B,C andthe coraponding I stochastic lateral, We know rom Example 2.1.4 tat ae where the sight-band sid i» Riemann-Sttjes ictgral wth respect to & {Given Brownlan sample path. Wealrleaot in Seton 21.2 that he Rea Sno sus (212 dat in eer cove ash) or en ‘spe path of Brownian main, a SP AB +B (BB) em) [1000. ‘The frm ofthe I stocastielategral for mpl procestes wry much ends 1 ofamartingale transform, On p83 ne inteoduced trating tans Ca¥, wbare Cer EGH, wan Corn ere Y= (Va) a martingale difeeence mqueoce with respect to a given fraton and © = (C,) is previa equene. In hi sens, the sequence 119 stochastic integrals (fate 428-9) 0) 16a martingale transfor with rept tothe vn) But eve ire tn ‘The socusti process (0) martingale with eapect tothe hatarl Brown eaten (Fy WED. ‘We check the dining propertin of « martingale cep 60. For convenience see eal them in tet of 10) EC) <0 forall ¢€ (0.7 22, THE ITO INTEGRAL 105 # HC) i adapted vo (Fi) BUCO) AC) fw oct es) “The fist property lloms fr example, from the omtry property (2.10) ve alow “Alaptodns of 1(C) to Brownian motlon is ealy sen: at tie tthe random valablesZi..0)Z4 and ByBy--,2-1B, By ~ By, ocearting in the dfing ration (211), areal epetoae of Brown motion up ote 1 ramsins to show the ec elation (2.19) This ls good excl in wing the rules of condone expectation, which we suggest you ty Fe ourself We have not Indicted which rls to ae ax we sume Cat 08 ist anuine hat» <¢ and € tate: Note that HC) = In(C)+ 24 (Be ~ Br) + 2e(Bs— = O42 where [(C) and Zs are fonctions of Brownian mation wp totine and BB Bindependent oF. Hence, BUC) iC) + 24 E(B, ~B,) = 1(C). ‘hie proves (213) inthis ease "Th ce, when + € ft and © [tt for some < Bean be han et analogy. Check (213) tke we the dasomposton 2 HO) = [y-s(0) +2(B,~ Bo, + [am -o0+ 3 nase = 10) +R, sad dow that (R40 1F) = Properties of the Ita Stochastic Integral for Simple Processes Tec easy toe that E1(C) = O since Zand AB in the defiition (2.11) are Indepentent, nd £(Z; 3,8) = £2, EA,B =O. Ths106. CHAPTER 2 ‘The Hb wocastic neal bas expectation tee ‘Alternatvly, we can argue allows: since () i & martingale, has & ‘oosant expectation function. Moreover, by definition, Zo(C) = 0. and so EI(©) = Bl(C) =0. “Another property of the 19 storhantc integral or spl proces wil ‘tor on oe fla or the dition ofthe gearal Ie stochastic integral “The I soca intgral sti the homey propery 2([om,)'=f‘ecta, tenn. ew eso is reper. th uy eatin, we min a = 1 some Ended, funy << ty observe that 0= bye tey j the random variables Wy and 1 are uocor ‘oat notie that 1, and Zar functions of Browsian motion wp to tne {os ace they are independent of 4B. We conclude that BUWAN) = EZ) BAB) ‘Thus the terms E(W) in (2.15) vais for fj, and 3 we obtaln Yew BNO = 5 8(2.8.8)" = 82} BLABY 5 ‘he sght-hand side nothing bt the Riemann itera ff) do the step function f(2)= BC2, which coincides with £2} fry Sth (check hn, ‘has we ve prowed the isometry property ofthe led stochastic integral "The Ie stochnste Integral has sveral properties in common wid the Riemana and Riana Sees intel 22. THE ITO INTEGRAL wr “The b socastic nega car For constants, ¢ and simple proeses Cand C® on 0,7, [[oo? +00?) a0, ‘he stochastic integral lino aaent intra Forost 3 Example 2.38 (The exponential function i not the It exponential) In casi cleus the exponential anton f() = expt) has the spectacular property tat f'(0) = fl). Equals, 1-10 fro HaX, [x00., at, a2 ‘nthe 1 sense This woud be a cana fr the I exponential. Since tha lass rals of integration fal in goeal when Brownian ration is involved, ‘ee may als expert that f(B2)=exp( 8) soot he I exponential. This ca TS etd ute eas sce (0) = P() = 70) the Ha lemma ye or ote fiteaa ot fae ‘Otro, th second, Riemann, tg yds a postive valu, and wo (228) ‘anne b sated, A the moment we cannot pve an answer tothe above question. We wll ‘ete to thin probles when we hae ore aan om of te demas Soe Example 235. 5 23, THE ITO Lena 2.3.3 Extended Versions of the It6 Lemma In this section we exten the simple RO lemma, given in (221) (2.2), in varus ways, ‘We mart with an Id Inuma for the tochasti process f(t). Assume that (2) has continous pata derivatives of at lest send onde. A ‘motidcalion of the Tajlor expansion argent teed in Seton 232 ie ao ‘ces ths moe general case. Recall hat asad order Taylor expansion yids that Hed Besa) 1081) = ex) ABs + HBB + Eipue soca? + 2 fle si deat + ft (AB) ez, and in what lis, we se the follwing notation fr the arti devi tier ff n= 2 teva (a oo rae Pe Pee eave As alas alas, higher order tems in (2.25) are nelle, also are ‘the terms with factors dt dB, and (dt) However, since we interpret (@B,)® tthe rm wth (4) cannot be ogee, Arguing inthe sre way a8 fn Sontion 232. ermal integrating the et had and ph hand sides (225) and elleting al ens with dt and dB, separately, we ed up with ce folowing formu: at f(y2) bea function whose second onder partial derivatives are com tinsoun. "Then $6) ~ Ho. B,) = 225) [{[ie20}imteto] + [{nindodee, +tus cHapre 2 hy ie v a, igure 23.4 One comple uh of expen of Brownian matin exp, Qe) nd of the xponentol empl) (ou) for the ne pa of Bf. Bram ‘We apply ths formula to find the exponen Example 23.5 (The ld expovetil) Welearat in Example 23.3 that the stochastle process exp() I wot the Ih spon in the sna of (224), Now we cow the anetion Hee) =e ‘Then dre calelton shows that Mea) = Eye), tar) = F162), fatsn) = 1b) An application of the above I lemma ges H&B) ~ 16.8.) SleB, dB, In the sense of (2.24), t,B) in the 1b exponential Seo Figure 2.4 for a ompaion ofthe path of the process xptB,} abd exp{B,—05t). Exaunple 2.3.6 (Goometsic Brownian notion) Consider parte for of geomet Brownian motion (. Example 1.8): seared om X= KB 23. THE ITO LEMMA 9 were ean @ > Oar constants, Notice tha flea) = dleaseriren, figs) = (e054 fie), filler) = ofl2), fala) = oP M2) An application of the I ken (226 ys that the proces X sain the lina stochastic diferent! equation snaase fixate vo [xm 2s) or Inter use we wil ped an een more general eon ofthe Bo lena. We sll consider proceso he for f(r), hare Xb ven by Xie Xe + [ou + le Agas, (220) and bth, 4" and A® are adaped to Brownlan motion. Here i ss {hat he above integral re well deine nh Rann and 1 sense, tectvety 1 press, which kas representation (2.20), alla an Hb proces ‘One can show that the proses AU"! anda are uniquely determined in the sone that, if has a representation (220), mere the Aare pled with adapted process DW, then A and Di eter [eteie. Recall hatte ome Browaansnton (227) satisfies (228). Hence itis ‘a0 Rd pros with A) eX and ACI = a ‘Now, sing similar argument with Tylor expacon a abow, ane en show the flowing fare120 CHAPTER 2 ‘Extension H ofthe 1 Lemna Lae X be an Ho proess with representation (2.29) and (2) be a ‘teton whine ec order pata derivatives re continous. Then 1) 10.89) om) I [ooex9 449m Sap a] + [AP wasnaey, ce Give jotfcation ofthis forma. Uae a Tylor expansion for f(¢+at, Xo): AleX) asi (225), where B i replaced with Nand X bas eprsenation (2:0) Neglect higher order terns strelng with tems volving (4) and ‘id, ant ake eof (B,)* = ormala (2-0) reqmty ges i the fllorng form MeX)~ Ih ean [ [oes Figrr iss] os fnesres, Ady + Aga “he atria symbolic way of writing the Iu representation (229). ‘he eter wi epee to X in (231) has tobe lntepreted ws alos [rinses fas sournar + fap su.xan,. 230 Finally, wv consider the 16 Jemma for occ procames of the frm Xxf,XP9), whe both, X'0 and X03, are 9 proces with spect to Ki a xf Aedes f 4B,, 6912. aaa) 23, THE ITO LEMMA m A Taylor eis expansion argument snr to the ane above eld the fallow: ing orm: ‘Extension IT of the Lemna: Let X19 and Xb two process given by (238) and (la be ' Taton whose second oeder paral devatives are counaoue The 0 X0P.XE) ~ 6,X, 82) 239) f s6oxp.xeray +S fesse HSE [laorm amare Hare fit2s.22,Ju(tse12) ate the pata dexatoes of f(--20) eh epee to tho the ch and th vslabls, respectively pT ‘he intgrals with respect to Xf have tobe iaterpetd inthe same may sin (232), Formula (234) can be extended in the sealghforeard way to Functions 46,1." where the XI are He proceses with espect to the ae Brownian meton, We mention that one cn ls conser such a {lepuafr I process with epest to diferent Brownian masons Howeve, ‘his rquites that we deine the Hd stochastic integra oe wch a wetting ‘The flowing example an application ofthe Ie omens (234) Bxample 2.3.7 (avgzation by pst) (Consider the fanetion J(2129) = 2123. Then we obtain (we suppres the srguments ofthe funcsions) h=0 hom, h ‘Now apply formula (23) to obtain and fia = far ns fabs1a cuarren 2 “The Integration by Parts Formula: et X01 and X be two ed process given by (289). Then AxEOKP) « xP aK! 4 XM aR + APP (235) sing the rpreetation (285), we btn a alternative expen forthe erate axg?xP) = OPAL? 4xPAl! + APPaP ya +00 4 xP) AP ham, ‘Aspartic examples we conser l= f[ te APY m0, A m0, AP x! and XP =2.= 1a, Obvious, ae Heace, integration by parts ils [een [nee Mare general, show tht for any continaoulydifeetiable function fx [0.7] te flowing elation Bld: [me Notes and Comments 0m [ Fat ° ‘The tb lemma i the mort important tol in ed calculus. We wll use very tte in the fllonng aceon A Sst version of this fundamental result was trove by Ii (161) Vaio yerson of the le lrma nd ths pros ean be Enna ia textbook on tote clel, for example Chung nd Wiaae (100), Theda and Watanabe (185), Keates and Shreve (1988), Oksenahl (1085) ar Prost (102), 24, ‘THE STRATONOVICH AND OTHER INTEGRALS i 2.4 The Stratonovich and Other Integrals In tha etion we cus some ober tochasticatgrale ao the ation with the 1 sacha Setegral. I cetalaly we fo you to ral that tere a large variety of other intial, the TI integral bing Just one member af tis family On the ctr ban, you do not ne the information of this ‘ection (which alo slight tecnica) unless you ae intrested in solving Hb ‘och diferent equations by te socalled Seatonovih eles Inthe povious actions we ded the RO tochasti nega HO) [680 4.7) Heze and ia what follows, B= (Bt > 0) Brownian mation and C= (Ct [B,7) fa proces adapted tothe natural Brownian filtration F = o(By< 10,6 [0.7] The main post in tho dfiion of the 1 stochasti inegral ‘Wes the approximation of f(C) by Riemann Sites ume of the fr Faeroe Bi) be wastsa, Oa spn fas Detect con ete CA makin) = pte te) 9 0 As usual, we wtito xB = By, ~ By "In the Rienano-Sticjs sums (36) we chose the vals of C a het ed pit ofthe subitervals fy4, Ths cole was defor mathoatical onveniene. Our gain was that the stochastic pres ((C)t (0,7) has ‘rch athena! treture- Beier the martingale property fram the Spprednating Reman Stier (26) "Thus hgh level of the theory tf stckatc proms can be apie. As subsidiary properties we get thatthe xpesaion ofthe stochastic nega salva oo adits variance can be ‘xpresol by an application ofthe semery propery. "The price one hast py {er the nce ahora state fe that the chain rl of lane ealeae ‘sto al anymore In ales, the ed lemma replaces the elasical chain re, In this ection we consider anober type af stochastic integral the Sta fenovich lachatc tte. Wo start with it ition inthe case that them HAPTER 2. Interand process Cs gen by G (B,), te DoT, for eves diferente function f on (0,7 Define the Riemann Stele 5 Ere a8 ean hee (Ove can show that che mean square lini of the Riemann-Stejes sume 5, exis if hr) 0. The wnlqu mean quar init 5((B) of oe ema Sia as 5 ext ff /°(0) et < ce. The lt elle the Sttonnch achat tga off) ei decid by Sri f(B)) 1B.) edB,. ‘Charly forthe ed stochastic integral, we can define te stochastic proce ofthe Stralonoich tachasic integrals SU fireiean, seo, 1 the mean guar init of the corresponding Riana tls suns Example 24:1 On p10 we considered the Riemana-Stelies sus Saw tr gen prton7f .7), We ao mene ht tite o ery tht the sequence (Sy) fh the ean square Kit 0. 9. ‘This the “aloe ofthe coresponing Stratonoveh sachs nega so) [ b,ouD, = 4} ry 24. THE STRATONOVICH AND OTHER INTEGRALS Pe ; pth one r hos Nai Figure 2.4.2 One sel ath of the praca [5 0340, (ower care) and of the prov J.B 2B, (appr ccs) fr he ome Brosion spe ath, COtvouay, the stcharc procs (0.582, 0,7) nota martingale. How. tre tht te Sonic ca gl 298 oma aii "he laa hai ae ep. 100 fra discussion ‘The formal val of the clas ain rules eso for he use of Stzato- oveh stochastic Integrals. Ths, despite the “poor” mathematical strvetare tthe Staonovich stocks nega, hs the oe” property: We wl flat it when we solve io tachi flere equation, "To ge vme feng fo the Staton tacts negra, we conser & tramtormation fora wih ns the ed aod the corresponding Statonovich oat integrals withthe sue ltegvand process J(B). We ase [rveipace ot [syiontace. amy 1 tunnel he ition of he Sih the Meglio ar toate 1b) = 10.) FB,1y Bas bods where we neglect higher order terms. Ths an appsniating Rann16 (CHAPTER 2. Stee sum for Sf) can be writen a lows Le se = HBL LBs) Gu Bind MB + ‘ewe again nega hghe ne terme. By inion ofthe ate, 51" ha he sean square iit J (8,) 4B, An application of contion (2.30) shows tnt 32h the men square int ro, and ome aleltins S fot [roa in mean square. Combining the mesn square converges ofS, = 1,23, tv aly sbtin the following srl fo (240) ‘Assune te fapton J satis (2.30). Then the aormation form [lesan [ries [rae o| From this oral tis imei tha (5 [07 doesnot commie tating. Chock this by taking expectations i (2) "Now tak the parcel function J) = g(). AN aplcation of the 1 emma (223) 0 Y= 98.) ils 10)-aty = [Lvtonen 03 [rane (240) 24, THE STRATONOVICH AND OTHER INTEGRALS ro = ff ronan, +3 {rena sod the ight ides ail to [79 =. And 0 we hae “Tie Statonvich Noche gral sts the cain rae of causal ‘slat [le <000-48). aan oti this sane dos not ean that the Steatonovich stchantcinegrl Isa lassi (e- Mlmana) intel. We only cat Unt the coresponding Example 2.45 s) Take gt) =. Then gt) = 2% We obtin fom (242) a i [r0a.= }04 “Thies in agement with ou previous observations about the ae of 5 (B) 1) Take) = exe). Then 2) = 90). We obtain rm (242) tat [etess. We concateom the later lation thatthe proves X; = exp), (0.7, is the Stratonoch exponential Also recall om Example 2. that the is ‘exponential a ttl dilret proces, ° 1 what alos, wo want to iva transformation formula forthe Statonvieh ‘toatcinegral which more gna than (241). These me oni aed integrand procemes C= (B). Now we sume iat the integrand i ofthe form G=s%), te (0.71, as) here (2b faction wth continuous partial dxvatives of nde two, The JroctesXis supposed to Bean 1 proces (te p. 119) given bythe socastic here ogaton Kot [ou cs aa + fve.xnde,18 CHAPTER 2 where the continuous fanctions o((2) and Mice) satisfy the existence and “niques onions on . 138, For integrands (24) sot staghtorward aw to yt a extension of the integral mith C = f(B). One pone way 1o dfn the Steatonoviehstchastelacgeal lb i apprainating Rian ‘Stljer se LN 05%,. + KNAB. The mean again Jf X)odl of he Rinker ses i [200 XP dt <0: ‘One can show that his defntion const wth the previous one (with £62) fle), X= B and the approxinatingRimann- Seles suns (27) Under the assumptions on f and X given above, the follwing transfor | ‘ation forme bos [[roxvea, | [roast Pxonera, | whee as usual, (2) the puta dative of J with epee to. From the above dlcuston it might have bone clear that we can define ‘ery diferent socastle integrals. For every» € [a gien parila rs hf (.T] anda process C adapted to Browolan main, we can die the ‘lemate- Stes ems hee 24, THE STRATONOVICH AND OTHER INTEGRALS 9 Ie meer) +0, the mean square nit ofthe Riemann Sisijos sums Si? ‘cists, provided estes some farther sanmpion Tho fmt can be or Se othe ip)-stachastie taro Pe) = 0 [" ean, ‘We tied two particular cases: =O (be Ics) ad p= 0.5 (the Sratr eich eae). For notviaintegrands C the vals 1(C) ifr for distinet. jm. Fr example, wing srgunents slr 10 Ue Is and Stetomorch cases ‘ne an show tat to ff rads bobs (¢-3) 3 Tes abo posible co get transformation frm sch a (244) in onde 20 relace the (ping, » € [01], to the corresponding hd or Strtanoveh inegrals For applications, the M3 andthe Straanovch itera are most ‘elerint. The eons were explipd above. Sov also Chapter on och Arent equation. Notes and Comments ‘The Steatanovichstochanie integral was itor by Fisk, and Sndpen auly by Strstonovich (196). The matbematcal theory of the Strtonaich Tvl canbe found in Srtonoic (1060); see also Arbol (1973). Both, the 6 and Stratonvih integrals, are defined oa atbumatialy ‘ret way. In applications on sto mak decison about which stochatie laugeal i appropiate. This then a question of modeling: tr alo the lseuson on p15 Tm Section 3.2. we wil se the ul of Steatoouvch clea (Le. the es of lasiealcalelu) forthe solution of stocastle dient equation.3 Stochastic Differential Equations ‘This chape sdevotd to thas ferential sustions ad their solution, In Seton 3.1 me sat with a short introduction to odary dient un floss Stocari difereatl equations can be understood as deterministic “rental equations which ace perturb! by random nase "Tn Section 3.2.1 we intsdace achat difeential equations and ex plain ‘wnt slon le wil turnout hat stochastic equ tion are actually stochasceintgral equations which involve ordinary ado ochatic integrals Therefore the notion of "dientaleqaton” might be Slghy misleading, but since tthe goed castor toe this tt, we ol flow i. ln Seton 3:21 we formulate condition fo the exience nd Unlaunes of solutions toe tabard equations, a Sere 922 te Brea simple method fr salving Id stochastic diferent equations. Ik bad on the 13 lemma. We continue in Scion 32.3 wich the sltion (Tb stochastic difeential equation which ave derived fom an eaivalnt ‘Steuonoich oc diferent equation, Tn Seton 3.3 we consider the general ina stochastic diferent us tion. le iss apeil cae of stot feet equation which hive flict solution Sn term ofthe cofiiet fonctions and of the undeing ‘rowan motion, Linear stocker difereail equations ae relevant in ay applications. We also provide « method lor elsating the expectation sd ‘lane fesons inthis case, “A or detereiistie diferent oquations, very exceptional to obtain ‘neal soliton to a tochasti diflrental anton In genera, x htim CHAPTER 3 rely on numero! methods se Sction 3 fran introduction to this opie 3.1 Deterministic Differential Equations ‘The theory of diferent! cqusios isthe cradle of daca eaeas. Sach cuntions were the moti examples for Ue eration of the dierent and Integral calls. "The de underyng dfeentialequatlon isp: we are ‘ie fanetiona laonslp Moat.202"Oo) 20, OSEST, on involving the time fan oninown fnction2() andi deste. the Sm Yo fd function 20) which sts (31) Teale 9 slain of he ‘igerentia uation (3.1). Hopf, this saluton i unique form given tid fndition 20) = 2,2 ‘The simplest diferent equations ae tho of order 1. They inal only t,2() andthe ft deviate (0) Ideally, such dient equation ‘ven tn the oan a a(t), 20) at) 4 we @ fora know Fanci fen. 2) standard to write (8.2) in the more inttive del) = atx) a8, 200) 20 as) 1 you interpret (0) the location of one-dimensional parte in ace at time t, (33) drier the change of loeton of the partie in small ne Intra + 4. Relason (3.3) then tse hat de) = at) —2() te proportional tothe te eceanent de with actor off). Alternatively, (G2) tells ws thatthe yl 20) of the pate en ge fenton of Ce Pie leaion 3) Example 3.1.1 (Soa single diferent equations) ‘Asure thi the loi only a fone 0 2 = a0) Tngegraton on both side ye the ston xo =200+ fina 3.1, DETERMINISTIC DIFFERENTIAL EQUATIONS i ‘This ste simples form of dierent equstion, bt i i alo till on6 ‘een the righ band side does ot depend on the ukown fusction 2). Now trun thatthe wloty 2) x proportional to the lation 2): Fo =ext) for some constant ¢ Hee simple tegration door sot ep. But we know the sltion to this deena equation tt excel fncion 2) = s(0)expet) a With an clametary tk one can sometimes save the diferent equation 3, Example 8.1.2 (Separation of vaiales) Suppose that the righthand ie of (3.2) can be separated ita product of to factor: (0) = anton) Symbol, we rewrite this deren eqution a ae henna on Now intgate both sides (0 - Loe as (On the leh side we obtain fanction of (0), on the right-hand sie « function of: Hopefly, we obtain an exp frm f the funtion (2), ‘This approach I usted by dieratiting beh sides of (8) a negra of the upper its. ‘Then we obtain, a at acy 0) hie another form of wring (34). We apply this method tothe difaeatil equation 2!) = (0) for sme 0) 20 Thenit cuapren s ‘rom the above dicusson we art about some ofthe important apects of inary diferent equations: MmEnn iinet homens | + Suation of dierent equations are fancios. They dese the | ‘volition or dynamics of a rele proces over a given period of +e order to obtain aie solution, one has to Know the ‘mdition (0) = 3y_ If thn sigue solstion s(t) stats fom a rity atthe present = 0 say he anti 20) Is completly ‘tered in he fue, La, fr €> 0 + Expl suutons of diferent equations ar the exception from the rule Ingoteral be has to vely on mumercl solutions 10 ‘hiratiat eations «+ Iiegraing th side of the dential quation (32) on obtain suit gal eatin 2) (0) [oles Although this transformed equation ein general not of ret se for finding th tlton of (3) i ves a ea of how we could shine ascitic dileretial equation asa socastic intra, 3.2 Ito Stochastic Differential Equations 3.2.1 What is a Stochastic Differential Equation? Consider the determine diferent equation del) = atx) at, 210) =. ‘The caret way to introduce randomness in tis equation i to randomize ‘he inal condition” The solution (0) then becomes a stochastic process (re lo.7): Xia, 42, 170 STOCHASTIC DIFFERENTIAL EQUATIONS 18 Figure 82.110 sins Xj Xa! of the rndom diowilquation dX = rat thiol cndtn Ne = expN}, where W baron Ne) dnrbation, ia = O01 Rie o* = 001 ‘Such an sqaton is ile a random dirental equation. ts slution dows tot require stocharte clea: we can se the aseal ethos and ajat the elution to the eonesponding btcome of the intial eondion. Random ‘feral equations can be considered as deere difreta equations tit epetrbed inital eondion, Ter teatiqaton canbe of tee ioe ‘ants to std the robustness of he solution 0 ferential equation under ‘smal change ofthe initial condition. For example, Figure 32.1 shows that ‘he ction of ifeentl equation can change ite draticaly, even If the ‘hang ofthe inal condition Is sal For ou parpones the randoms the deel equations introduc in a edna random nae er ak, = at Na+ HEA ABL, Nolo) = YU). 69 Here, sural, = (Bit > 0) denotes Brownian motion, and a2) and ts) are determine fnetios.‘The soliton X, i iets, i then 9 orate proces. The randomness of X= (Nyt €[07}) rests on the ‘ne had, ftom the Intl conto, and on the other hand, ro the noise ‘goeatd by Brownian motion. “Ronve interpretation of (96) tele ut tat the change AX; = Xie i is comand bya change d of the, with factor a, %) smb with 1 cage dB, ~ Brea ~ By of Brownian motion, with frvor Mi%)_ Since rowan motion dows nt have diferente supe pats (ee Section 1.3.1, the flowing qucton natural ais:136 CHAPTER a A hich sense can we interpre (28)F ‘teary theres no unique answer wo this question. But since we know about ub ealeuas, we can propose the flowing Thterpre (6) asthe soca negra epuaton sor [0 where the fest otgrl on theright-band sid Riemann ntegrl {he second ote ea I stochante ietgral Equation (27) is ale an 18 secant dierent equation x Xpdet [oe.x at, osteT, (7 ‘To all equation (3.7) a diferntal upton Is counterintuitive. Ts name ‘xguaes om the yma equation (3), bt te late fetes les ‘oe sas wha the diferent re. We follow the general custom and call (37) ‘an ko stochastic diferent equation Aiecentia equation (8.7), 11s posite wo replace Brownian motion by otber diving proces, bat this quite to deine more general stochatieistprals Thi sot opie of hit "ook We refr to the monograpls by Chung and Wiliams (1000) or Potter (#2) who introduce the stochastic tng wit espect to semimartingale ‘The later cla of procs contain Drownian motion, bit la lange arty of Jump proces They are asf tools when nei interested a modeling the jump character of Yea ie process, fr example, the strong oclaos | ferig echnnge rte crashes of the stock market iia prior not clear whether che ntl in (7) ae well deine. oe ‘example, can we ensure that %,) adapted to Brownian motion ad BE Elle, X,)P de Grite? Thee are the crucial onions or the deiton of ‘led stochastic iategra sep. 108 Dut ean one ek these onions if me <> ot know the seation X? Soon we wll ce that there eit snp con tions for the existence and uniqueness of ston o kd stochastic diferent ‘We ist attempt the question: What solution o the Ii lechastic ferential equation (8.1)? 42, 170 STOCHASTIC DIFFERENTIAL EQUATIONS st Surprise thre no unique ager. We wil nd two kinds of stone to ‘roche diferatialequation Thee are calle stung ad weak sation “A song wolton tothe Id orkut dierent equation (37) ® ochaie process X= (Xt Pa) which sts the flowing com ‘ition: 4X is alptod to Brownian motion, Le atte sa faction of The integra occuring in (8.7) ar wel defined as Riemann o stochastic integral, respectively. + X isa function of the underying Brownian sample path and ofthe ‘onicen Finca) and (2). ‘Thaw strong wolton va (27) fb on the pth of he underlying Brownian ‘motion. fre were to change the Brownian motion by anocher Brownian ‘tion we would pt another strong solution ic would be gven by the ‘ine fnctionl relationship, but with the new Brownian mola i ‘Bl whan weak solution? For thse solutions the path etavoe i ot eet, we ae only interested inthe dein of The nil contin Ng and We colin functions falta) and tx) are given, and we have od a Brownian mation such that (3) holds We wnsion tat ther exist 6 stochastic dificental equations hie bave only weak ston, so Chang and Walls (1580), p28, or tienmple ‘Weak sluions X are sifcent in order wo determin the distributional ‘characteristic of ac the expectation, wastance abd covariane factions ‘the procs hi cae, edo ot uw fo now the sample paths of. “A strong or weak solution X of the I atcha diferent equation (817) iweallodndifusion. i aria, ahing (2) =O and Bs) = 1 In?) wesc that rowan tnoton ie dfsion proces. In what flowy, we oly consider strong solatins of Hb atochasti ileal Fst we pve alison conditions forthe exnteace and uniqueness of such ‘stirs. A proof the following result ca be found, fo example, in Klose hd Plate (1092), Section 43 ot in Olaendal (195), Theor 53.1 cHaPre 3. ‘Assume the itl onion Xy has a Gite second moment: EX} < so, andi independent of (B,¢ > 0) Assume tat, forall ¢€ [0,7] and zy €R, the coeficient functions ft2) and 2) satis the allowing eondtins ‘They tly a Lipect condition with epect othe second vat. she Jot2) ala) + te) Ken] < Kol Then the 1 stochastic dtrential equation (27) has « unique strong sett X on 7 Example 3.2.2 (Linear socal difeetil equation) Consider tbe edocs ferential ation (oy Xetos)dB,, €€ (0.71, (38) name [loxioee [ for constants 6 and 0, = 1,2 ‘Ths above conditions ar suined (dock chem) for or 69) 2)=e2te and Kt.3) ‘An Td stochate dfn equation (38) with nar (n 2) cote fan tion aff2) and W,2 called ulnar 10 stochastic ferential eatin. In ‘Section 3.3 we wil give te aolition othe geal near soca diferestil sustion. By virtue the above ther; ier stochate dierent egutons ‘hea ungue strong solution on every inerval(0,T], whatever the cole of the constants and a 8.2.2. Solving Ito Stochastic Differential Equations by the 18 Lemma {ise equations They ae “ninpe” and have nique song slutlons 00 every Gate itera (0,7) se Example 322 32, ITO STOCHASTIC DIFFERENTIAL EQUATIONS 19 Figure 92:8 Sant pai of omc Brownian matin (ht bao = O01 Hight oO Example 3.2.4 (Geometrie Brownian motion asthe slain of nea kb ‘socamtedifenal equation with maltipleative acs) Consider the ner I stochastie dilretia equation x sore [’ for ven constants ¢ and > 0 codete [XaB,, tel], 10) a the second, Id, otegrl, Broan motion and dhe proce are ed in aula wy. Therefore the stochastic diferent equation (2.10) ‘cleo ase linseed stochaste diferent ation with malice From (2.28) we how ‘The particular gometrie Brownian motion Me KelO4eR, re 0,7), om solves (3.10), and fom Example 3.22 we conchae that Xi the unique sotton of (3.10. Figure 823 shows two path ofthis proces Recall how we wri that X sts (3.10 we appli the 19 lemma, Now fv are fared wi the lavere pole:wo CHAPTER 3 ne te 1 Lamm to fd the slain (311) from (3:10) Suppose + = f(t) for some smooth function J2) abd recall the Ws ema rm (2:8): wake [imredadeni] as [edn am 2 om Xo rn em te ERERILAASNES ag omy ana es iiheeenty cometary taney a infant om re ener) fae ae hae ne exit) = flee) + falta), a) oflta) = fz) a rom (3.10) we obtain #12) halt). "Thus the wo diferent equations (3.1) and (314) canbe spied (c= 0504) f(u2) = fits), afte) ‘Tay to wre J(,2} a8 a product of two faneson: pit). (3.5) ‘hen (3.15) becomes (e080) Both of thm can be sled by spation of variable o Example 3.1.2) =9(0. ee) =m) 0) = g10)e-894, le) = Hoyer ‘Ths we obtain Hle2) = 0) Moyle oor ‘Now recall that 1(0.Be) = (0.0) = (0) 40) ‘Tie Hall gies e= JB) = Koel OtMB, 6 [0.7 22, 170 STOCHASTIC DIFFERENTIAL EQUATIONS ua srhich agro with (3.1) ‘Thus te ection to an I stochastic ferential equation can tmetimes be eid a the soliton of (Stemi) pata dflretial equation. Example 3.2.5 (The Orsten-Unlerback proces) ‘We conser another near stocane diferent equation Keser [naee [an senna Equation (3:16) s usally ese to as Langevin equation ‘Langevia (108) sade this Kind of stochastic difentil equation to model the wlocty of Brownian pase, This ws lang before a goeal tory for achat diferatialequatins existed, 1s consas wo (810), Brownian motion and the pros X are not dvctly linked inthe ed integral paseo (8.18), Th the phys Herat, the random forcing in (3-10) i ald edie nee which aon hlegote Gxrption of this phenomenon Model (3.16 related othe word of tine sero analysis. Wet (316) inthe Xd + 0B, nd formally set dt = 1. Then we have Bia —Meseks + oi) arse + 2 whee 4 = ¢4+1 isa comstant and the random vsiables Z =o (Bis ~ B) ‘oust and Sequence of (0,0?) random variables, Thi sa ator ‘sive procs of ode I cf, Example 123. This tne series model can The considered nea dere analogue of the slutign wo he Langevin equation G10, ‘To ove (9.10) the following transformation of convenient Yate Note that both procetesX and sat the sam ntl codon:1 cHarrer 3 Figure 3.2.0 Fie sample pots of te Ornain-UNenbeck proves (317) ete ipews 91, Rh Xy=10,e= let Applying the Id lems (230) with Mea}=e4s, filt-2)=mefl6-, fee) ~ 7 vow =f fimxosenmnxrete nate] + [essnxaie, [covrensoa + [ieras, [oor oma solves the Lange stoic dirt equation (3.18) 82. ITO STOCHASTIC DIFFERENTIAL EQUATIONS M8 Fir a constant inital condition fe coat this proses called an Ore Figure 326 shows several path of this pros In oer to ery thatthe process. X,gven ty (8.17), actually a auton to (8.10), appiy the lemma (2:30) to the process Xi = ul, Z), whee a= [ovan, and u(t,2) =e Xy + oes Moreover, since the Langevin equation isa nea stockade ‘equation, we sy conclude fom Example 8.2 thal X iy the amine stone satan te 16) Wo vey that the Ornsten-Unenbck proces Gaui process, Asie for simply that Np =O. Recall fom the destion of the ho socastle satel that ‘6 the mean square iit of appraising Riemann Stes sas 48, Deve, s, for pacttions ra = (a0 with mesh) +0, The ater vm has normal 0 be two indepen Brownian metions and oy = 1,2, ‘al amber, Soe Fite 3.27 fra stration of he two-dimensional po” Define the process By = (o} +08) (0B +0501") Ung the independence of and, 8 i to that 2B, =0 and cov(B,B,) = mins, fe. B has exactly the same expectation and covariance funtion as standard Brownian rotons sep. 36. HeneeB ia Brownian motion Now consider the integral equation 32, 170 STOCHASTIC DIFFERENTIAL EQUATIONS wove frees [tan +o [ an, for constants cand wom = ef'xaes ['xa{oo +02] we ffxues ed fina, cm “thch i an 1d stochstie dierent equation with driving Brownian mation 1B From Example 3.24 we ca ead ff the ston Ne = Xydostttebevetseb!™B, = ye Os et seb es en) 1 the above dtiton (3.20) ofthe stochastic integral ne wee quite ncky because X appa saul n both integra Faloing sna patent forthe dition af the stoke integral, ako posible to toduce {he tachasi integral [rear + [aan for more general process A. Mover, the Brownian motions can be 0) denotes Brownian motion A stochastic proces X i called ‘ cotaton ft obeys (321). Tet common to weit (321) In the language of ‘erential S ax, =a Nae + HEX 0a. ‘Now sue that X ithe sluion ofthe toch diferent equation mw tes fronxntes [' Xo)dBs, CET, a2) share the coficent functions af,2} and tz) satisfy te existence and “niques endltlans on. 138 Reval the transformation fra (244 fr Stratanoveh nepali terms of and Riemann integral [rexvean = f[rexyane} [uaxonnxoe om feb wc [[oexnan.=- [[saxoninxoae + [ues 48 om Phugeng this relation ito (822), we reve at the Statonovich stochastic [iret eaton faxoas f'suxoed,, a9 (6.2) Fea) bt) ‘The le stockade estion (3.2) seulalent othe Stator ove stochastic feet equation (3.25) a the sans hat bth have {he me stong solution povided exit or on ofthe 42, ITO STOCHASTIC DIFFERENTIAL EQUATIONS ro Consider the stochastic proces ¥ = ut, X), where Xs the sation to (2.22) (uae, to (3.25) and (2) Isa sooth function, An appion of ‘he Ho emma (2.90) with A" =a, Xi) and Af? = WE.) yds vam es ffrenedten] as f'mma. ean ie cb sd iin ty in td ene i eae Naan ee is formula more cope An appication ofthe taniormation formule (223) foe = bya fp = a +B lds [freaoe= ff maeet.—} ft te be CCombixng this ration with (8:20), we finaly cba: Ho = m4 [osteo nlae fhe w+ fimsmias mean, am ‘Tis formula ete exact analogue of the elascal cain ral for twice Aieretiable function (te) Tndewd, neue forthe moment that 2() satin the eterno uation dt) = 2) + lV 4 ‘where et) isa difeeniable funtion. Then the clases rles of dierentation {oe the following formal leat + de) — lta) = ule) uate) de oa s2) +82) ona] + Ws) oad “This rma naogy with (1.7) allows net lv Stomach toch {ie diferent equations by sig the rls of clase alesus CHAPTER a, shat flows, we ge some example Example 3.2.9 (Slvng an It stchastie disreta equation by solving an ‘crude Siratonovchstchatedifrentl equation) Let f be a diferaable fnction. |A) Consider he I stochste diferent equation meme} [nereses [rea 2 Th at, Lille) at Mie) = ‘The corresponding Stratonvih stochastic diretal equation (se (3.25) With cuit fanticsS(s) 0 anda) i then gen by oe [ nea, Te coreponds tothe detente diferent equation 219 = se0) da), where) sa liflerentible function, Using class separation of variables (sce Brample 312), we obtain for sme function g(z). Then rplace2() with X; and 0) with By Ki) ~ 0%) = Be Hopefully, you can solve this equation for to get an expt slution of Gas, ‘Now ule the RO mocha diferent equation oad [xia 42, 170 STOCHASTIC DIFFERENTIAL EQUATIONS ua fora postive integer n > 1 B) A slghtly moe complicated steht dierent equation Is ie by Bin X 2 = [foe da ran) ues [sve for constant Nowin thae site) afte + 24) Fle) and Wes) = 10). “ee oan Steer soit dient equation i = —— ; wresid + [rayean,. aan] | “Tisch the determin diferent equation dels) =eflto)dt + Flt), oan shee isa diferentibl fanction. You can wie the piace of separation {tara 1a sl ths equtin [enero fate fae eto for some function gf). You can check the validity of thi apron by dit ferntting the inegrals onthe right and e-hand sides: you obtain (33). An appeal tothe Stratonoich chain ule (3.27) ges ste alton to (330) Ince to (329), by replacing 2() with X, and 0) with By +B, 4+ for# > Oand Xo =0, Then ) — 9X0 Now consider the flowing example f(e 4 Dy ie150 ‘CHAPTER 3, Notes and Comments ‘The sation of stochastic diferentalogutions i treated in all textbooks ‘hich ave slated oI ella; ee or example the references oa. 112 applies of stochastic diferent equations one hus to make a de lon at which kind of negra, 1 of Satonvich, i more appropiate ‘Thee is no car ante a to which te of difeetial equation thou be ‘hod. Both de of cyatioas are cuthernatcallymeatngfl, ‘Te ter ‘epee on how precly we Intend the tee proces in the difletal que tonto model the ral noee_ Caml calcu kb on ane of soath ction, i parcnar qu estiablefncions, Beal proces are ten etc wih at at pall degre of corration. This means thatthe noise 1 Selclenty regular, in thie seen eaouable to model the process bya Straonoviel stochastic differential equation because te ules of classical 3.3 The General Linear Differential Equation coalder ‘The Gonoral Lint Stochastic Differential Equation: n@)Xstoro]aBe, + 0.7) (3) ‘The (deterministic) cotcent anetions ean are continuo, hence ‘Sounded an 0,7}, and so Its not df to se that the existence sd unlgutness conditions on p. 138 guarantee that (8.2) has x unique ‘sro ston Hi X0¢ [oaxeratnaes ft ‘This equtio is important for many apleations. 1s paral attractive ‘eens i hs an expt solution In tetas of the coniientFuetions and of thundering Brownia sample path In what lows, we derive thi slation ‘by multiple we of dierent rasan of Ue Hemi 3.3.1 Linear Equations with Additive Noise Seting (2) =O (882), we btn 35. THE GENERAL LINEAR DIFFERENTIAL EQUATION 1 “The Lin Equation with Additive Noise x wefan ratte [aioe tena 05 1 terms of fects it can be writen at lal telO e+ oltdBs, #6 1,7) Te process X snot detlyiyaed in the stochastic negra, and trefne (655) gamed ir mame, The slain of (3.9) patealy spl ‘One way o sale ferential equation isto guts form fom same articular example. This i perhaps nt the mort stator approach sce ne certainly neds ot of experience fr sch ges Ayes ase sor Lore) ot for some smooth fasion Jt,2)- An aplication of he I lsum (2:0) on pu yields wo 10%) ay = ayo (dee) dt + ony a Integrating both sides and noticing that (0) = 1, ace No = Yo, we obeain "The Solution of (8.33) s 0 forall This allows one to consider Y,= ln Xy = f(Xi) So apply the 6 Tenma (230) on p. 120 with Hu2)=Inz, fills) =0, falta) =2, falta) We obtain i= lal ~O5eF(O]ae + o()4B, ox) Fret integrate both sides of his equation, then take exponentials ad fly ‘oret forte til vale lf Xy # ‘The Solution of the Homogencou Equation (3.38): so e0{ [1 -oseiées nolan te(.7 0) You cam check that Xi solution (dot) by applying the Ik ern to $08) = Nyesp{¥} where di goes by (2.20). Bxample $4 (Goometie Brownian notion) ‘The most prominent example of «homogeneous stochastic diferent equation 433. THP GENERAL LINEAR DIFFERENTIAL EQUATION 15, sith mulkipentive aise wa tented in Eeample 324 (1) = 04) ‘untants cand 9, We dacovered thatthe geometric Brownian ion te(0.7) inthe nique strong sation in this ese, Thi agree with the solution (240) ‘tthe gaeral homoge stcharte ferential equation (338). Geom bie Brownian notin eof major importance fr application Baan ee Chapter 4 3 um Kogt-080 40 33.3 The General Case [Now we are well prepared to solve the general iar stochartc diferent quution (232). We aciewe thie by embodding (332) in maytem of two cll the solution ¥ of the homogeneous stochastic diferent equation (2.9) with Y= 1 It legen by forma (3-40) (with X replace by Y). {Conse the ts procs xe Apply the 1 lens (20) on p10 (ith (2) ‘lruetion we obtan Ate ome ax}? = alo teftonat ae (9 "4B, ‘An appeal wo the integration by pasts formula (238) yells AUP XP) = ot) ~ou(oa( AL de +060) 2 a ‘Now iterate both sides and rel that Yo forms of Xan Xe Say arcs at ‘aving i ind he partial “The Solution ofthe General Linear Equation (8-33): x: = u(t floto-ntouonstee [osone'an) cep oan156 cuapre 3 ere the proses ¥ the solution (840) of he amogensons equation (38) (where has to be replaced with) withthe ital conden Asa mater of ct, we alo derived the solution ofthe conesponding deter ‘nisl diferent equation nite) He(elde, 16 7) Simply ston forall We wil se thi ft for clung the ‘expetation and seat moment funtiogs of Xia Scion 3.4 3.3.4 The Expectation and Variance Functions of the So- lution It we hav the expt solaon ofa stochatiediferatial equation we can in ‘incple dete Its expetation, covariance and variance fonctions. We Were able to proceed inthis way fr the Ornstei-Ublenbeck proces (ee (8:10) on p. 148) and for grometic Brownian motion (one (1.16) and (1.17) on "in what follows we go another way to calle x)= BX and gx()=EX*0), 6 0.71 Chars, then we can alo calealate of) = var) Recall the oneal near stochastic diferetial equation nome [ok eatin [Iniisotae, seh “uke expectations om both sides and ati thatthe stochastic integral has ‘expectation zeus p. 11. Hence sat) «1000+ eat ae ‘scent gu a ts ten 0) =p) +010 Bearing in mind the rena at the ca of the previous ston, we cn write dwn the solution i of this direta equation in terms ofan cy. Deve 44, NUMERICAL SOLUTION ur ex forthe Omtin-Ublebeck process and for geomette Brownian mation ‘So compare wi the now fone ‘Sully onan prose for gy). To obtain a stochastic dient ssuntion fr X7 fort apply the ld Tema (2.90) on. 120 AP = 33+ ['RXMo(X, +019) + falo%s +ovloF lee + flexsoux, + oroniea, hen ae expectations anid) = axi0)+ fale) +ot(lex(9) +2hal0 reveals) sotto) as ‘This a general ear difesentia equation for qx) (ooo that px) toowe) elt) = Re) + of axl) Ae + ou(on(elax(0) +0. ‘whose ston can he ern asa spec cave of (4); se the ema at {he cad ofthe previous section. No doubt: the sltions yy and gy lok in eral ite te, but in he eae of cormtantcotiintfnctions ad Sou might try to bean the expettion and vsiance factions of 3.4 Numerical Solution Stochastic feel equations whih admit an expt slain are the ex feption from the rae. Therein eric techniques forthe approximation fine stint a ohana oquton are ale for.” In what Flows, suc an approxiaton ical numeral slain ‘Noirs ge teed fr dient al One purpose is oi svat a vary of sample pt of the solution. A colleton af och paths otetne ale a secure I ives an impresion of the pol sone pth Tehsil thi sete we ct tme ibd of “peedicuo” af the stochastic ‘roves fature inca of tine Bot a seems has to be interpreted with ‘ee nea fe we never ow the Brownian sample pth diving the soca i fret oqaton, andthe snlation of coupe of such pat snot repteeratve fr the genera plete.ss CHAPTER 3 ‘A scondabjctive(pehaps the most aypartant on) to eee reason she appranations to the distin character ofthe ston 0 8 ‘tochtediferentaleqaton. They icude expectations, yainee, coach ‘ocean higherorder nomeets. This isndeed an importan¢ ater sce aly Inti eases ones able to give xpi formule or hee quantities, and ee theo they fequeny vale spel functions whieh have tobe spraximated imerialy: Numerical sltogs allow ux to smblae as aay supe pts {re wan, they continte the br for Monte-Carlo technique fo obtain the dstibutinal characteris, or the prone of Mnsteation we restrict ourselves othe muri so tion ofthe wochetedieratil equation AX; wala HOC ABL, PET ea) ‘whee a usual, denotes Brownian motion, andthe “iret uation” 'S aeealy astachstie integral equation. We als acune tat the curt functions o(2) and We) a Lipeete continues Hin adition EX} < on ‘hese assumptions guarantee the existence and uiguenes ofa tng scaton soe 18, 3.4.1 The Euler Approximation A numeri sation X'0! = (X{"¢ € [0] of the stochastic direst equation (342) isa stochastic procs that approrimats the slution (st 1.7) of 3:2) in nem co be made prc Iter, Such solution ‘hacer by a partion ry of (0.7) Tei Omtact cos K tea cay, eh mesh = ery) = mae (4) = rae Ae ‘The process Xb eleuated only at the pts tof the partition ra nd so ate some fed to coos X' oa the ltervale sf. Site we fe intersted in slcons X with continuous sample phe we wll acune thar X1" on (1s) btn by simple lpariaterpalation of the points eae XM) and (80, ation scheme determines X' af the pointe fA uve way to obtain anmerclsluton to replace the dllerenal inthe chante difereatia ation (212) with dfeences. Thi lade tothe fl 44, NUMERICAL SOLUTION 10 ‘The Euler Approximation Scheme Denote, wl, Acstoter and B=, Teen aps he, |x = + waa + vata, aan + waxfpae, mesh) = Tn Xn = Nani +R ri) ot MX yr) AB . 6a) Figues 24.1 and 9.4.2 show how the Bur approximation wor in peat. Several questions naturally rs: (0) Is whch sense the numerical station XV! close ta the ation XP (©) How con we measure the quality of he apprasimation of X by X'0)? (6) fethere on apprasimation X which beter han the Baer scheme? ‘Te third question bs a pose answer se Section 3.2. The st and secon gistions have several aanvers I we are intersted in Uo pate “Spprosntio of X, we would Ue that Xo) flow” to the sap pa 1X(0) for ven Brownian path Ba). In practice we never knw the later160 ‘CHAPTER 3, Figure 3.4.1 The eda ote scheme (3.48) a wats numeri slton (lied tic) and erst ston fo hr nhac sera epaion Xe Dx as O01%, as ho 34, NUMERICAL SOLUTION vot Path, ut we can easly simulate Brownian pats onthe compute; so So. on 133 for ati ntrodactio wo ths wpe As a measure ofthe qual of thse approximation on ean choose the quantity lb) = BIN (a) ~ XPM] oti that ey indnd dere these (Lath) comparison of X and “he index "in ey sands for “tong” a pate appre tio of X is usualy called 8 stony numerical solution, se below. There fre certainly more appropriate eitera to debe the pte clovenen of X and X°; one of them could be Bsupjeq Xs) ~ X{"(a)|. Homer, ‘he ntrquanity e more dic to del Stk heretical, So et ws blieve {hat the paths X1(0) and X(4) ate clase whenever they ave dose atte ed ‘the intra 0,7} ‘Wo my that X19 es strong momerial olution f the toca die catia equation (82) (6a) 40 a6 by =mush(ra) +0. 1 coteast to a strong sume lution, a weak numerical solution aie at the approsimation ofthe moat ofthe solution X- Ta ths cae I is mot ‘soential how close Xa(u) and X{"(w) really are. What matters is that he “ietene of monet alba) = [Ef ~ BFP )| Inna, Here f chown fom clas of smooth functions, for example crn ‘olynonils 0 fastioos witha specie peyacaal growth, We retain from Ascsng these lasses of functions because tee definitions are technica, and thy aa dif a the Urata, The “vIn ew stands for eal, Ax before, ‘wemay wonder why we compare the moments BJ(X) and BG(X) only or 27, bot aa, thi for thors simplicity Wesay ‘weak momeria solution of the stochastic der all equation (842) colby) 40 a8 by = mbna) +0.162 (CHAPTER 3 In ordrto measure the quality of the approximation of X by Xone into- ees tho oder of eonseryence ‘The mare olution X09) conerges strongly ta X with arr 7 > 01 there ents a constant > O sch tat fs) S08 for 8, Of there ext constant > Och tnt enlby) SER for be Sb ‘The oquldstant Euler approximation (we (3.43) converges strongly with oder 0.3 and weakly wit oder 1.0 (lr a clas of fancions with pro. Prat polyoma grove), 3.4.2 The Milstein Approximati The Baer approximation can be frtber improved. We strate this by in leony the Milstein apprnimation Axor, we conser the stohastle erat equation nates [anus [xen te0.n For the poits ofthe partition ry we can conser the difrence Ny, — Xi, ‘and bean: Ke Beem (Bt) Xa +f acxyaes WX)EB, 6 ‘The Kuler apposition ix based ona dneretination ofthe itera in (3.4) ‘Dooce te st cote i opeorimaion exp dina df Mad mM.) B and then replace X, with," yg, FOOD) +4019), 34. NUMERICAL SoLUTION 1 The Missin approximation explits a oa Taylor expansion of telaon (3:4). The iden consists of applying the Id lemena np. 120 0 the integrands a(X,) and 8(X,) bm (3.44). To make the fre bow sone fompace we write aa instead of aX). ya"), erat [fost [oer re)ae fan] off feore fl (orton) ae [2 wan] a. AL IAEA) AMER, oy where the remade term is ven by 0 a Li [Lmae]oene ese ‘The double stochastic integral Ri" is then approximated by RP wy HK Jam aay L(f Dee hed neg nh ih iy Te ato ine Re en pba oad ne [wor Consider the double ints sr a) : (2) (Lm) ( 20), Arnie, we nerpet he ter intgraln eure sense a [- (fan)ane[ (f'an) ae [an gS<2 ff (fen a Padua) 0 ‘Under mld wnumpions onthe coethnics a) and =) one can show hat Riana n omparzon with. The theater tem determines the lrder of mageue of Relat (3.45) and (3.30) gv the motiation fr the deiition of the Mein apprsimation scheme. Notice that this scheme 5 the Euler approximation with an adonalcotecton term conaling the Squared increments of Broan maton iksiein Approximetion Scheme Ay and or xf XP = ab +eatvasur ae hun Kawa, ‘Tie Mien approximation lad oa substantial improvement of the quality tthe mineral slate The cjidisant Mise approsination converge suongly with oF deri, ‘This improvement erated wll in Figure 3.42. Notes and Comments ‘The Milstein approximation canbe further mproved by applying the 1 omen to the integrand in the remainder form Rn (246). The form of them ‘merical ations hen becomes more and mre complet However, new the power of moder computer, thse tan oe coe hat to wey tot “Taylor 1d expansions sucha (S48) involve multiple stochastic egal ‘Tair rigrous tetment requires 4 ore advan’ lee of the thors. The slso concerns the derivation of (50; the Int elaton a btn Wy 206 eure arguments 24, NUMERICAL SOLUTION 105 Figure 3.4.2 A compares ofthe osetia Qt chins) nd Mien {oi cura) sclomen In cory fare mor “ the cut sltin tothe tcc ere oparon AX, = NK dt +2 dy 6h ih =I we ponte sient pen be pra by he ste sce for lye m parte te end of enter,106 cHapren s ‘Tee mumerclsluion of chat leet equations is a relatively ‘new ara of eplied probaly theory. An overview o the exiting sumer techniqas ge in Kledes and Pat (1902) and the cmpaaion book by Kioedn,Plsten sed Schre (104) The later book ams at the introduction to stochastic diferent equations and thr numerical ston via computer 4 Applications of Stochastic Calculus in Finance Since the cleratd papers by Black and Sco (1073) and Merton (1973) the on of ering socket alas fr modeling pce of ky anes (hare rics of tack, tack indies sch a the Dow Jone, Nike or DAX, forelgn xchange aes itrest rates, te) bas bon general accepted. This ed to ‘nw branch of apple probability theory, the eld of mathematical nance. It's mmbiods of stocinetie dling, seoomie reaoning and peti flancial engineering nts chapter we conser the Black-Scholes mal for pricing a Bao- pean call option. Do not worry yo donot have much poe knowedge abot fonda and Haaneal process. Ase mls, you wll ed sme words of fconomie language, and net maximum, te Ie lemma, In Section 1 we wll "nln the bake terminology of mance: Bond, stack, option, porfl, ela ty, trading sty, hedging, maturity of ontract selffnanciny, erbirage trl be the catchy word ‘he Black Sales formula or pling & European {all option wl be abled asthe soluton of «patel patal diferent ‘Since notions ike epialnt martingale masvure and change of mearare fave become pedonioant inthe Banal erature, we ive In Section 42 2 thee ineoduction to this agen This equts some knowledge of mature {eotete tol, but, as usu, we wil ep the theory on a ow level. We hope thatthe Key dowel become transparent and we give a scan derivation of ‘the Blade Sele foi by using te change of measure econ168 CCAPTER 4, 4.1 The Black-Scholes Option Pricing Formula 4.1.1 A Short Excursion into Fi Wo astume thatthe price X; of rity ate (cllod soc) a time ¢ is ven ty geometric Brownian motion of the fr {6B = XyoeOse ie, an whee as usa, B = (8, > 0 is Brownian motion, and Xe enue to be Independent of. The moivation fr this sumption en Xcomes fom the fet that X isthe unique stong solution of the near stochasie difeesti equation a Kiekere fx, de « [xan, heh we cn faraly write as ax, edt + 0 Nid ‘This was proven Example 324 If we interpret this equation na nave way we have oa foe Mie MeseXedt + o Xd aviv, x edt + 9B, % ‘The quantity onthe left-hand side the relate return fom the ast nthe evi of ino [+d]. Te tells us chat there a near fended which Aistrbal bya stobastie nose etn od, The costae > O's the socalled ‘mca rte of retard > the rly A gance a femal (41 tlt 1 thatthe larger, the large the Huetuatons of Xe You can alo heck ‘thir withthe formula fo the variance function of geoetsie Brownian mation, ‘hich is provided in (1). Thus 6 a measure of the rkins ofthe ame Ik is blieved thatthe model (42) Ie reaoaaie, though crude, Bat spprdnation to a real price procem: I you forget forthe moment th erm Th 9, Le. asume ¢ = 0, then (42) isa determin diferent equation ‘hich has the we-known solution X= Xy expe}. Thus if2 > 0, we sould Tipet to obtain a randomly perturbed expontalfaneton, and so the {gometric Brownian motion (41). People i ceramics belle In exponential row, and heer fey are que stised with this model. 41. THE BLACK-SCHOLES OPTION PRICING FORMULA 160 Now stuns tht you havea noni ate ach a a bank account ka ‘inna voy, ee clled Bond We asm that an nvextment ‘ond pede an amount of A= Be tte & ‘That your iil eapial y hasbeen continuously compounded ‘rithm constant terest rte > 0, This an Wealintion ins the tres Tate changes with time a well. Note that sates the deere ntegrl m +0 [aw (4a) In general, you want o old certain amounts of shares: oy instock and 1 in bond. They cotitate your portfio We assume that and b ae ‘ociate proce adapted to Browian otlon and eal the pale (eu), €€10,7) «trading strategy. Clos, ou wank to choose a states, where you donot Toe Hom to choow (or) na weanable wa, wil be dace blow. Noe that your wealth; (or the wae of you orf) at ime ts naw gven by WaaXi thd, ‘Weallow both ay and hy, to assume any postive or negative values. A negative value of mens sort aloft, e. You sl the stock at tine. A ogative “al of mean that you forow money atte Bo ilo inert ate Te reality you mould have to pay raat coos or Operations on stock ad sale bat we neglect them bee for simply: Moreover, we donot assume that ‘and ae bounded, on rape you sould ave a potential inaite ‘oust of expitl, and you shoul allo for unbounded debs as well ley {hi ea simpleton, which make ou natematial problems eae And finaly, me sume that you spend no money oo lle purposes Le. you do ot male jour petal salle by coneumption ‘Wessun that your trading strategy (ub) is sffrancing. This means ‘that the increments of your wealth Y, Fest only from change ofthe pos Xpand af your amet We frmlae the selffnencing condition in terns diferente Wi, =dlaXe + Wh) = dX +d, which we interpret Inthe Tt seas asthe relation [ones [ra, Wi-M [aaxernay1m ‘CHAPTER 4, ‘The intgralson the sight-hand side chal make sense ou replace dX, with eXsdo+ oX, dB, se (42), and d3, with ryder (43). Hone hese Ve Sf your proto tte is pees ual to he iil iene Vo pt ‘acta gn foc ck and bond upto tine 4.1.2, What is an Option? Now suppose you purchase a tcket, called an option, a tne £= 0 which ‘nities yout buy one share of tk unt crate The te of matory ‘oF time of expiration ofthe option. I you ean execs his option at See Brice K,ealled the exerise price or ste price of te opto, oly tne of tut T, ths called European cal option. yon can exe il ‘eat tne 7, salle an Amerson eal option. Note hat there ace may ore difene kinds of optons nthe ral wld of Eance bt we wil not be thet ince thm inthis bok, The bolder of cll options not obliged to exes it, Thus ia tine T the pee Xr i a than, the Hode f the let would be silly to exercine e (pou could buy ove share oe Xo the market!) undo eck expires asa worthless contac. Ihe pice Xy excndsK, is wort eerie ‘the cal Le one bus the shae atte ree K, den tars around and slat at the prie Xp for amet prot Xp —K. In Sum, the purchaser of a European call option is cated to payment Ar-K, Aro, ow oxrek. “ (r— Ky* = max, ar-ny={ Seo Figure 4.1.1 for an station, A guts an option tose stck ta given price A on or ut particular date ofmatarity A Borpean pt option a exer only at io mati, te: Ancien pot Can ho rood val r of tee Tin perner of 6 Europea put males pet foe, fer toxr. Tn cur theoretical considerations we reset ourselves to European cal This has simple reason: In this case we can derive expt solitons and exmpact fermalne for ovr ping probens Thue, {from now on, an opin ea Burp cll opin 41, THE BLACK-SCHOLES OPTION PRICING FORMULA 171 crm=o iar 411 Mea of «Bourn al opin with ei re tie af ‘Asan sie i is nsrating to note that the station can be imagined a fly sa game where the reward isthe payoff the option and the option older pay fee (the option pie) for playing te game ‘Since you do norkow the peice Xp at tne #0, when you purchase the "ow och would you be wing to pay for sud et, Le what I ® atonal price or thi option a he = 0° Black, Sele and Merton define ork a value a flow “+ Aa individu, fer investing this ational vale of money instock So bond at ine = 0, ean manag is/x pot sesording 0 ‘tFinancing strategy (ne p 10D) so abo id the same pat (fp — A) ast opton had boon purchated ‘Ibe option were offered at any pie other han this asional value there would be an gpportunity of arbitrage, Le. for unbounded profs without a acompanying io leim (CHAPTER 4, 4.1.3 A Mathematical Formulation of the Option Pricing Problem ‘Now mppose we want to find a ef ancing strategy (yh) and an moda VnaXithasut-t8), 16 (0.7) for some snoth determinate function u(t). Cea, thi Is restrton: Cand yt i our aim to Gad this fanesion u(t). Since the value Vr of fal at time of maturity T shal be (Xr—)*, we ge the terminal Vi =ul0,X7) = (Xe) “o 1 he Sinn ratre, te poss of bulge sl ianeing strategy such that (44) olds is called edging aginst the contingent eli (Xr ~ ‘We intend to np the Ie lemma to the va process Y= (= Xe) Wate (G2) =a(T = 2) and notice hak Alter) =u —t2), fate) =n —62), false) = un —t.2) Ao el hat. X sll he i neg ogntion Now an application ofthe Ie emma (2.80) with AO) = eX and A) = 0 X yes chat vw £680) $(0.%9) [iw « [lox neato, X,) + 0%, foe, Xo) +050" X3 fle, Xl] de = flemr-nxaveronrny +050* XZuz(T ~ 4.X)]d8 « [lorena xan, ws 44, THE BLACK-SCHOLES OPTION PRICING FORMULA 173 (fn the ater hand, (ob) selina vinte= [oars + f 6.0, 6) Sine f= Be" =r Betta ra an Moreoves, Ve = 0 Xi+ bh has 43) Combining (45)-(4.8), me obtain another expression for nts = floats + [Spe rna [losis + [foo-nrna few w+ fio [te-raxernae f X,aB, + f F(Ve~ay Xs) ayX,)4B,- (49) Now compare formulae (48) and (49). We karat on p. 119 that codfieent functions of kd procents cin. ‘Ths we may formal dent the ine ‘ands ofthe Rusmana and 1d integrals, repectively a (45) so (49) a = ot), (0) (e-MacXetruT 6X) = (ensue 6X) Xe trMeT— 6%) Mah 1,Xi) +eX lt) 4050? Xana — 1X). Since Xj may astme any positive rae, me can write the last eit as 9 aria dfn eqstion ("prt fore ote ne of he pail darativee a ue) = 0504 vadtse) +reualha) rate), aD) 250,46 (07)Recalling the terminal condition (LA) me alo rue tht Vp = WO.) = (Xr - RY ‘This leds the determine ternal condition wo.) fe KY, 230, au) 4.1.4 The Black and Scholes Formula 1 general i ard to solve a partial dierent equation exlicly, and 20 ‘one has to rely on numerical solrions. $0 it somewhat surprising Chat the Darl difeenial equation (4.11) has an exc solution. (This perhape {ne ofthe enon for the poplaity af he Black Sebo Marton approach) The pr diferatil equation 411) with enna conden (C12) hat Boon voltae se for example Zaudere (1980). Tbs the expt sltion Mbps) = x(t 2)) Ke" #UH(2), vere ale) 7 Me2) = altz)-08', sod ergy, eR, 1 90) = gn fs the standard normal dsibation funetion, ‘After ll thee calculations, hat did we actualy gin? Recalling our artng point on p. 17 we so that Y= u(t, Xy) = Xo g(TXy))— Ker OOCT, a) (419) is a rtional price at tine = 0 for a European cal option with excise price “The stochastic proces ¥ = wTP=t, Xi) iste value of your slang pti at tne [7 4.1, THE BLACK-SCHOLES OPTION PRICING FORMULA 1% "Tel ancing ney (eh) in given by w= tX)—a%s a ulT =X) and by x aay se (410) and (48) Ac tne of mati T, the forma (413) ried che net porfto value of (Xp K)" Moreover, ae a ow that o> O for all € (0.7), bat by < Trot exced, Tux shor sale of stock donot oat, but borrowing nancy athe ood’ constant interest rate F> O may beoe mec. Equation (619) the elabratd Blak Seles option pricing formal Were tht independent of the rea rte of turn fr the pice 2X, butit depends onthe volt 2 1 we want to understand q = w(F, a) as a rational vale in ters of ar trap, oppose thatthe nial option price pg p> a ppl the following strategy! at tne t= 0 + sl he option to sormane ela at the pice, and «+ vest qin stock and bond according othe sl Snancing strategy (4.1), Tons you gain an initial wet profit of p— ¢> 0, At time of matuy 7, the otf as ale ar Xr br r= (Xp — A) and you have the obligation {op the value (Xp ~ "tothe purchases of the option. This means Xp> K, you aust buy the sooe ry, and el 9 the option Bol ie ees pie Ko et las of Np KATA ©, you do ot have to ay anything, nce the option wil not be exec. Ths the total terminal he eae of thin game ean be increased array, by sling » options for np a ime nro ad by lavesting ng instock and bod according to the selAancing strategy (nay) The net ptt will bem (pq). Ths the ‘opportunity for attrac lage pte eas witout a aecompanng sk ls. This sean arbitrage Saar arguments aply iq > pom the pur ‘fase fe cpio will mae arbitrarily big et pelts without accompanying, ike Notes and Comments ‘The iden of using Brownian motion in finance goes back to chai (1900), ‘ht only ar 197, when Black, Sens and Merton pubiaked their paps1 CHAPTER & id the theory rch more advanced lew. Since chen, options, Futures and any other aco derivatives have conquered the tneratonal world of France, This ed toa new, app, denna ofan advanced matbenatieal thor tachartic elas” Ar we bvelearat io this book this theory requires ‘ene novia mathemati oak "in 1907, Meron and Scholes were awarded the Nob rae or economic. Most bok, wich ae devoted to matheeatcal france, equi the know ce of measure theory and fonetional aly For ths reso they can be ea nly for several yor of university edaratia! Here ae afew references: uli (199), sin and Rathowa (197) and Kagates aod Shreve (1908), fn alm the chapter about Suaace in Karatzas and Shreve (1988) By nom there ls exe afew texts on mathematical ace which address ‘an semeatary ot Inermmite lve. Barter and Rene (1900) i an cary [ntzoduton with a minima of mathematic, bot stl pele and with a god ‘explanation of he wnmomi background. The bok by Wilt, Howson and Dwyane (1905) focus on paral diferent equations and sve stochastic ‘alas whenever onal, cours on fiance and toca ealcls en Ur Lamberton and Lapeyre (1905) who adres a intermodal based on shane Knowledge of mare tory. Pk (1997) an itoduction to nance ting ony dleetedine modes 4.2 A Useful Technique: Change of Measure {inthis section we conse ery powetl technique of sohaatiealelus: the Change ofthe dering probity measure. tn the teratre often appears lndr the symnyas Grsanv's threm or Cameron-Mertn forma Tn wha! aus, we cannot completely avid ensure tore arguments. It you donot have the necewary background on ease they, you shoud at Teast ey to understand the tsi Men by considering the apleations in Section 422, 4.2.1 What is a Change of the Underlying Measure? "Te main ea of the chang of asuetciniqae const of ntoducing ‘new probability measure va a s-cled denny fonction which si ener at polity das fancton, ‘We start wth sinple ample of two dstsbutons onthe ral ine, Recall 42. A USEFUL TECHNIQUE: CHANGE OF MEASURE 7 se pobabily density fa aemal (02) random vale: Foal) del eet Kanan forthe caresponding deteibtionfanctan, Conde to pars (nse8) and (iso of paramecor and define fio) fae an = le suatel= | Aenatne a5 and ar nat f° bdenadbe rey The fue fae be deny Faction oy wh et 2 ya tnd fisted action of yh pe Oyo. Chay, fa ‘at not probity densities te re ast ane at the Ital SE iende a1 arent cao foe wes gemalSnest at P and @ be two probobllty manures oa the old FW tae fists now ngative fonction fy such cht a [rwure, ser, an we say tat fy the deity of wih spt to Pan we als sa that i ebstuaycomtinos with rene! to P. ‘The integra (17) veto be ieterpetd a the manure eborte sen. anlar way, changing the ees of P and Q, we ean Into tho enaity fa of P wth reget te Q, en sod a non-native faneton exists. is abwstly contnnoun with espe to and Q abla oan with apt to Pema that P and ae equtalnt probityom (4.15) and (4.16) we may coach tht wo Gaunian probability mew fuer onthe eel in are eqn Tora characterization of alclueconinty va the Radon-Nikodym the orem, se Append AS. sail, B= (Bet €[0,]) denotes standard Brownian motion. The Aeition of Brownian motion om p33 how depends on the undelying Drobabiity mearare P. Indeed, for che definion of the Independent, stax ‘naiy iacemente of Band fore Gassan ditebation we must kaow the Soba trate Pon the old Uma, we donot pay attention to this fact, P's simply given, but i wht fellows, ie wl be a eri arpect For example, coer the one-dimensional ditrbtion fanetion PB, <2), FER Tei the daribution fiction oft (04) random variable, bat fw ‘tre to Gang Pfr ancer probity measure , is function could ier fo s normal dstibutio fenetion. AL the moment ths remark may sound a ‘te basse, ut we wl ee son Wnt the change of measire it very wet teaknige ‘We ae interest in procs ofthe form Bea Brat, tet as) for some constant 4. With the ony exception when g = 0, B isnot standard Brownian motion. However, if we change the underyng probeblty mesure Doran appropriate probaly menace Q, can be shown to be a standard Bwmuna motion wner the new probbhty meanre Q. "This simpy meas tha B wats the defining properie of» randard Brownian mation co 83, whom you eplaceP with Q. This the content ofthe folowing Tamcus sul; ee for example Kats sod Shreve (188 fora proc. Ass, FizelBne, We know frm Example 3.2 that this ‘uation has slation B= Rade O HOM, ¢ [0,7 (429) Introd nt BaD +(olo\t, te [oi ad rewrite (422) a follows: Wi =okdlefo)t+o B= oXdB., ee fT]. (424) By Girsanow’s theorem, Bia standard Brownian motion under the equivalent ating measure gven by (421) with g= a. The linea thas dies: lal aquaton (4.2) dot ot have adel vem: soliton X ea martingale under Q, but its nota martingale under You an ead off he sluion X ‘of (428) fam (428) (haan e = 0 and replace B with) Ke = Xyertteited, = elteneR, ceo.180 CHAPTER 4 ‘Thine the mltion to the original stochastic drat equation (4.22) ven we. 1 scms that we dd nt gain much, However, f we bad knoe the slution (423) ony fore = 0, we oad a deriv he solution of (4.23) for general ¢ from the solution in the case c= 0. Moreover, nce is martingale wade ‘oe ca ake we ofthe martingale property for proving vstous rss about 1X. We wil uo this trick for pricing European call option in Seton 4.22 4.2.2 An Interpretation of the Black-Scholes Formula by Change of Measure a thie mction we rv the Black-Scholes option pricing formal. We wll Sow that canbe lterprete athe condioalexpectatn ofthe discount erst (Xr ~ KY at matuty Fest eal. ‘The Black-Scholes Model 4 The price of one share ofthe risky asset (stack) i described by the Meche fleet eatin Ak eXidesonaB., 16 (0.71, (425) where sthe mean rte of return, ¢ the soaiity, i standard Drow ‘a motion (der P) and i the time of matty othe option “The pic of the sss asset (bond) i desebed by the determine Aiea ation Bwrdd, te (071, wee >is the interest rate ofthe bond, + Your porfoto at tne # consist of shar of sock and by shares of (bad. Ts alot ts Ei get by We ake+ ha, t€ [07 1 The por i aef-naning a= adie thd, (0.7) 42. A USEFUL TECHNIQUE: CHANGE OF MEASURE 181 At ime of maturity, Vp equa to the contingent aim MX) for a {Brea function h. For a Europe ell option, Ma) = (eK), where Ib te ake price ofthe osm, and for Eiopesa pt opto hs) wna In Section 4.1.4 wo deriv a rational rie fora European cal option ud showed tht there exits set nancing strategy Cu) auch that (pK). ln what allows, ne give an inti nterprecation of thi pig Ferma by applying the iano thore Ie were sive we could arg flows. Your gan fom he option a time of maturity is (Xr), lnarder to determine the ale of hs amount ‘of money at tine 20, you have to coun with given terest rate 7: errr (425) We do not know iy in adance, wo let's atume that X satis the Hear ‘tochastedifeentil equation (1.25), and imply ta the expectation of (4.26) 1s the price er the option ate ais suns convincing, altbough we did wot use any theory: And beats we dd ot apply sey theory we wl no hat we ae sligly wong with our laguments, we do aot get the Black Shoks pif hs way. I wl ara ft that the rational Black See price the expctd value of (26), but ‘re wll ave to adjust our expectation by changing the sndesing probity ‘measure; se (429) fr the coe rl, "This chang ofthe probabty measire P wil be provide nwa a way thar the dicot price af ne shar of sack ae"%,, 46 (071, wil come a martingale under the new prbabiliy measure Q. Wie Kes) and apply the ema (21) on. 120 (otc hat ft) a = eta teat, (en reo dee eal + = Rille-nat rap) ok di, (2s)192 CHAPTER 4. Ba B+ le-relt, ¢€(0,7) ota Girsanov’s theorem we knw tat cere exists a equalent martingale rieasre Q which torn B ito standard Brownian enoton. ‘The sltion of (428), ven by Be repr under Q into martingale with respect tothe natal Brownian ration "The eistence of the equlalnt mangle tease lows fra itive laverpetaton ofthe Blac Scols frm ‘Asus the Black Seals model chat there exists « slnancng | ftrategy (a,b) sh thatthe vale Vo out posi a ine i ie sax. tha, 1.21, ud that Vr sequal the contingent lam A(X). "The the vale ofthe peta tne ¢ sven by ralewonxnia], tenn. aan * whee Bo(A| i denotes te contol expectation ofthe random ate Shed given 71 = o(By, <1), adr the new probebly measure Q. ‘Unit or, the eanditonal expectation E(A|IR) = Bp(A] 7%) was alas lelined under the erignal robablity mesure P, and wo we id ot indate ie we wa to show that (429) correc, and then me wil we (4.29) to eae the pric of European al option ‘Consiéer the discounted ral proces re lacks + bh) ‘Te Wd Je (231) yds ai = desea, Now wee the ft that (ah) tl nein togeber with (427) My = re (aXe 4 AAO aed + bd) agro dee aN) at, a0) 42. A USEFUL TECHNIQUE: CHANGE OF MEASURE 19 Notie that 75 = Wp. From (30) and (4.28) we have - wr fin = tate f aka, as ‘Under the equivalent martingale measure Q, B standard Brownian motion and the proces (Xt (7) adapted to (Ft € [T]). Hence (431) fenstittes a martingale with rapt to). This eo th base popertie ‘ofthe I nvegral se 111. In partic, the martingale property ples Fa(VrIF), tet, but FM) Heace evi = Bg lo") | Fi] or, equbaleauy, the vale ofthe porto given by (4.2. Now we went to ealealte the value ¥ of our portfaio and the Black Scholes rics in the caso a «European option, Example 42.2 (The valve o Earpesn option) wate o=T-¢ © te (or) By (420), the value ofthe portion ane crresponing to he contingent dam Vr = NOE) I ven by Mi = Fo lerMxr)| Fi) = Be feta (xd esereeite-) | AL ime f 4 a fantion of By, hace a(%) € Fi dso we can tea it Under F050 war a coartan. Moreover under Q, By ~ Bye independent 7 and has a N04) ttn A pein of Rl Fo 72 ie $00) fae whe™ (CHAPTER 4 and gy) denotes the standard normal density. For @ Bropea cll option, ne) (=) = mas(o.2- 4), and v0 ea) = [ foessevene we 20(2)) Kea), here) the standard normal dstsbution function, ayo WUA/K) +(e +0502 7 a “This is cay the fom ort The price ofthe Earopean put option (with M2) calcein these way With hat we ered on p. 174 fr the ational (6-294) an be fle) Notes and Comments ‘The desivation of the Black-Scholes pric vi a change ofthe nderying me se (loll change of memera) as nity the Fares paper ty Hation and Pika (1981). Sine then thi echaiqae long to the sa tard reperor of mathematical Snancey se fr exarplaKarntaus and Shreve (00s) Lamberton and Lapeye (190) or Musil abd RuthowsRt (1987). Tha Itteptatin ofthe Black Soe formula asa conditional expectation and ‘elated eal canbe fond i ay of then books "A poof of Girtanow’s theorem ci be fund in advanced textbooks os rbablity tory nd stochastic process see far example Kalleber (1097) (or Karate and Shore (1988). Appendix Al Modes of Convergence ‘Tho fowing thor can be fous for instance in Feller (1968), Kare (185) Gr Lote (98), ‘We atrodace the main modes of convergence for & sequence of random vatiabls AAs Convergence in Distribution The quence (Ay) eonseryes in disribtian or omnerges walt the random sariale 4 (4y + A) for al bounded, ominous fanetons f the raion EL(Ag) + BILAL, n-420, ks Notice: dy #5 Holds fend only forall contnuty poate dis ution fanetion Fy tbe ration Fale) 9 Fulah, 2900 ay sailed, fF contigo then (A.1) can even be sseghtend oof sp Fa(2)~ Fale} 40, 008186 APPENDIX 1s als wl known that convergence in dnteibation is quialeat to patio ‘oavergence ofthe corresponding characteristic funeions Ag A Wand only if Bo! 4 Bo! forall Example ALL} (Converge is distribution of Gaussian random variables) Asume that (Ay) a sequence of normal (dq, 68) random valbles Fret suppose tht jy 4p and o2 > ?, where and o? ae five numbers ‘Then the corresponng ebaractrae functions converge fr every ¢ € Be dae asete yeast ‘The nlgh-hand dee he carci unto fan Ngo) random a able A Hee da 8 ‘Ao te convene ewe know that Ay 4, thn th arate fenedom coro 4 pecry cere every From his ate lett here ext eal number and och tat gan 08 ‘Tings thar Ais mcamrlytnrmal Nes) andom male’ Convergence in Probability “The eauence (Ay) converges im probability tothe random earl (ay £4) for al poi the ration PUldg—A1> 940, nv, lds. APPENDIX 1 "Fs cae that Pay +A) = Pll: Auto) AULI) CCoavengence wth probity 1 implies convergence in probity, hence oo ‘ewe dint. Convergence in probably does at imply conver tence as However, dy 5A impos hat y, 25% A for a stable subse ‘cence (4) P-Convergence Tak p> 0 Th seqnce (An) eoneerge tw Por in pth mean to A (a 2s) Ella + [AP] < 2 fo ll and Elly AP 40, 40 By Marhn'sinaqulty,P(lAy~A] >) $ «PE Ay — Al fr pasitive pane ‘Ts Ay % A implies that dy P+ A. The converses in general not tre. orp = 2, we say that (An) cower in mean square fo A. This notion ‘an be exendnd to tochasi paces ne for example Appendix AA Mean Savare convergence i comvergmce inthe Hulbert space 1 a D9, 5,P]= (2 BX? <0} avowed with the ier product < X,Y >= E(XY) and the oem |X] = CConvergece in probability implies convergence in distribution. The converse ie true and oly if A= a for soe constant Almost Sure Convergence “The mqucace (Ay) converges almost sry (a) oF with probability to ‘he random variable A (Ay 29 A) ithe wt of with Ale) “+ Als), 900, ae probability (XG,X). The symbol stand for the equivalence cas of random variables Y satisying X 4. A2_ Inequalities 1a this section wo give sme standard inequalities which are frequently we in this bole ‘The Chebyshev inequality: =I PUX-BXI>2) < Fax), 290us APPENDIX ‘The Cauchy-Schware inequality BUX] < (ex (eV ‘The Jensen inequality Lat f be a convex fenton om R CEN] ad BUf(X)| are Bite then | HEX) < BU), 1 partic, (XM < (XPT for Oger. "Ths Lyapunoe'sinoaalty “Jensen's inequality remain ald for condiinal exactions: Wt F be 0 ‘Seldon ‘Then MERA) = BDIF) a2) 1m pater, HELP < BON) ead [EXP < B1X?12), A3_ Non-Differentiability and Unbounded Va- riation of Brownian Sample Paths let B= (Bist > 0) be Browolan mation. Recall he deiiton ofan Hale Star proce em (112) emp 6 ad joc wit stationary intents fiom p. 0. We aso know that Browoian tion i 8 Oa inlr roves ‘ith Stationary, independent increments; wr Section 1.3.1 We show the aon “iferentabiity of Brownian spl pat a the ore oneal context fe Similar process Proposition A3.1 (Non-ierestisblity of weifsimilr proceses) ‘Stppase(%) i H-selEsnaar with stationary nerements for some H€ (0,1). Then for evry Rel, Pu Xal fe. sample pate of H-efsintar process ee nowhere diferente with roa APPENDIX 0 Proof, Without los of grcenlcy we chose ty =0- Let (ta) bea sequence veel) ~ man) > snmp ((%|>2) asap? ("48> 2) enc, wth proba 1 spy N= 90 Fr ay seen 4 Proposition A8.2 (Unbounded variation of Brownian sample pats) ‘or coat ll roan smple pa, (BQ) = sap Fo [Bale)~ Bh (s)| = 9 am cher the spromam is taker over all possible partitions = 0 i= T 10.7) Proof. For conveiene, assim T = 1. Suppose that (Bl) < 0 for a SP Ce) be a sequene of partons 70 ta <<< ty 1 Mece the ight de of (3) converges to eo, ming hat ule) +0 aa190 APPENDIX (On the other hand, we know from p88 that Qy £1, hence Qua (s) 24 1 fora sutable subsequence (ny) seep. 187 Th (At) only posible on & sulle, and 0 P((a: o(B(W)) = 2) Ad Proof of the Existence of the General Ito Stochastic Integral In this ection we giv a proof ofthe existence of the I stochastic nega This requires some knowledge ofthe spaces? of square ltgeable functions sud of measure teorei arguments Ifyou tink this ito much so, on ‘Stoud avoid this scion, bata short glance atthe proof would be wel. We ont give altho dtl; sometimes we reer some aber book "As url, B = (Dint > 0) is Brownian mio, aad (Ft > 0) i he co responding natural Station, Ut C= (Ct € (0,T) bea stostare process tihng the Astumptans on p18, which we real hore for convenience: + Gina fietion of By, # <4 + BC} <0 All stochastic proces ae supposed to lve on the same probity apace (0,F,P| (Pi probaly mesure on theo Bell). Lemma Ad.t If C satisfies the Asrumptions, then thee exists «sequence (CO) of single process (cep. 101 forthe defition such that [[r0-cora +o ws) A proof an be found fo example, a Kloaden nd Pat (1902), Lem 3.21. "Thus simple proces C'°! are dense inthe space 120 x 0.7]? = ‘dj, Relation (A.3) tence exactly thi tn the norm of ths space, Cea be ‘approximated arbitrary wel by spe process C'™ ‘Axim, not by nem) [oe tepn, the 18 stochatcintgral ofthe sinple procs C1. ei well deine as a ‘Rian Stljes sme (21), APPENDIX i Lemma A4.2 Under the Astmptions, the following relation hols forall, B sw mere) — nome cae [Ici ci Pat. (a8) Proof Hot, 1(6) and 1('%*) are martingale with respect to Browaian Iroton, hence HOH} — 10%) = 1(00") CO) la martingale with espe 10 (Fo) or a genral martingale (2%) on 0,7}, Do's squared masa in ‘equality (efor example Dallchve aod Meyer (1962), Theoren 9 np 164) tell hat B sup MP < AEM. In pac, Ep HC COP ABUL —C)P. (AT) 2 he metry property (21, apd othe prac (C*"-C'%, erigicbend te aE fe cP dt, we otter wth (7, rv (8). ° Sino (A.5) bos, (2°) isa Canchy snquence in LA (0,T] AP). This pli, in partial, that te sight band ion (A) converges to wero. That sre cane subsequence (fy), ay such that gto -ctop « This and the Chey Inequality om p 187 ply that, for every > 0, Ee gp,nucrr ue >2) 3 Ee gp tuto 8we APPENDIX A appa to the Bord Cane ema (ne fr example Kar (180) vide ‘hat the processes 1(C) converge uo on [0,7] to toca process 11), sy, th probity 1 Since the (norms) coneesng proces have ‘ontnot sample pats, has the ting procs 1). ‘Now esting tn (A0) go to laity, we contd tat 2 gp Wo-wome sae [-pa By Lemma AC, the ight side comment mo a #02, ad 30 we have proved thatthe limit 1(C) doesnot depend on the prt cee of ‘he appranimatingsequnce (C) of simple proce, “The lit proaas 1(C) i the dese a soshari nepal proce, dena by no) [ cvao., t€ (0,7) es sample pat are continous with probability Lemma AA.8 The pir (1(C).(F3) constitutes « martingale Proof We kaow that (1(C\), (5) ex martingale (ep 108) or all In tical, ts adapted to (8). This does mat change tn them. Meroe, fora EUKC*)|F,)=11C%) tr vce Using Lebesgue dominated covergence and, if necessry, pasting 0 a sab sequence (fy) such that Js(C™)) converges to LC) unio foe f, with probability 1 we obtain ln BUC )1F2) = Bim, MC) 1F) = BUC) Ba o™!) =110) Hence 1C) Is # matings ° Lemme AGA The locas integral 1(C) sais the isometry property #([cvss,)'=f'xctu, repo as) APPENDIX 193 Proof, We how that 1(C) stn this property ee (2.4). By (6), (265) and since the norm x cntinoons, BUNCE = BUIC-C)+ HCY? = BCI? +04) BIC Pae = ff BCI —C) +e. = ff BCae + 0) Since the two left-hand sides cole, by the sometry property for 1(C), swe obeain arn 20 the ds omer tlaton (A) 8 Lemma AdS Fora simple process C, the particular Rieman-Stljes sums ‘the defination (211) comede wth he Id stochastic neal 1(C) ‘The prot makes we of the fact that simple proces C'! are dans inthe AS The Radon-Nikodym Theorem Let (0,77 be « measurable space, Le Ft a afeld on. Consider two eases and v on. We ay tha abet continuous with eget tov went forall Ae F: (A) = Dimples thaw) We say that aod var utlen menewres i and “The Radon-Nikodym Theorem: eae | Assume and re two o-Bate measures. (This iin particular aiid ifthe ae probablty measures) Then holds and nly if here cists a not-rgatve measurable function f such tat | wide [rere 465 This lation holds with J replaced by another no-zegative faction thes weal= ‘The almost everywbore unique function J call the density of th respec a Foc pot of his rn, ee Bilin (195) ot Duley (180), Seton 5.5.AG Proof of the Existence and Uniqueness of the Conditional Expectation et [0,F,P] be probability space, Le. F bs a old on and P is a probability mesure on F. Conier the efskd 7" F and denote by the restriction of P to" Lat X be a random wash oa 0 ‘Theorem AGL If E}X| < 2, then there ets «random erie Z such at (@) (2) CF ond © frataer, [rowers [xo ser 10) ond (0) ha wth Z rpc by anther random vriae Z' then Pez) as) We ell the endtonal expectation of X given the o-feld and we write Za EXIF), Proof. A) Assim that X > 0-8 Consider the (smal) probability pace [7% Py and deine the nase [xen ser P(A) =0,then X14 =0 Pia. and so o(d) = E(XI4) =0. Hence» P, where both iearurs, Pan v, are dn oa 3. By virtue of the Radon” ‘ikodyn theorem on. 18, thee exists enon-egtive random variable Z on [9,7] suc cae ays [zur 407 ‘and We random vaviable Z unique inthe sense of (A.0). Moreover, ean ‘the doiton of the integral and sing that o(Z) CF", one ean show that J, 2} 4P"(s) = f, 20) €PL}, BB) Assume tht £1X} < co, Wite X = X+— X~, where X* = ax(0,X) and X= . BB, Brownan notiea = inf) Soma dation wih parameters n and p ° Cu” conta iit theorem o fore{X,Y) correlation of the ratdom vile X ane Y # foxX.¥) covariance ofthe random alae X and ¥ 18 xls) covariance function ofthe proces 8 a Heng fe of the intra a iy incramet ofthe aston fon B= Me) Hon) EX espoctaton ofthe random vaiale X EX Gxpectation ofthe anon vector X " BUX|Y) conditional expectation of the rand viable X, given {he random variable the random wer or the echaatic bros ¥ o E(X|) Contional expectation ofthe sandom arable given the ofall Eop(A) exponential dsteibation with parameter \ FCLT finial central i theorem {ids Saitedimensonaldstibutions of» stocastie proces Sodidin pata derivatives ff with repet tothe te Sudth valleo PA smb(7) bel syupois fells e ent ofthe random variable 1 ‘deity ofthe and YctorX 6 ‘atebuton function of «random variable ‘itebton fantom of the anda anal X 5 ‘dateiation funtion ofthe random vector X 1 lndieatr function ofthese (event) A Ps [nb och integral ofthe proces C 100 Independent, ential isteuted 2 fen sequence of el tubers Inf. = ~sup(~t) ‘The supremum is define Below ur Bate dex st, {nfney = fen de logarithm with bas © pce of equtalence lass of) random variables Z wth Biz coo pace of enuialence class of) random valle Z wth (EZ! < co and o(Z) CF tora given ld F on ‘wea af the partion + ‘spectation of the random variable X ‘cpetation faction of the stochastic proce X ‘expectation af the random veetae X Set of the postive integers Set of te now-oatve neg ‘Gaussian (nema) rteibotion with mean and ‘ultvrate Gausian (normal) dsteibtion with en {tnd covarlance matric E ‘Standard rma stbton ei oteome othe space ‘utc space empty st probability space Probably ofthe evert ‘Ecteutian ofthe andor vale X ‘or the stocastle proces X ‘itebaton oft random vector X power set of ‘Senay ofthe standard normal dsibution vamos Pai) ® Polson dstsibtion with paraneter 3 teal ine ‘elmensionl Euclidean space Siratonvich integral ofthe proces C tariance af the random variable X Tasance faction of the proces X Tlvarance atts of the random vector eld generated by the elleto of ets © ‘eld generated by random vriable, random vector Supa: the supremum of a sequence of eal mumbers ig ae Ro > ay forall and for every > 0 thee fits such that @™e-< ay Ma = oy thon for every > O there existe «such that ay > Mf, For finite index st Ty tyes = Mine ‘fr random ible 0 8) arlance of the random variable X Fandom rviable or rochate proces set mteges (2) =) teane that (2) approimately (oughly) of {he sate order 2). Te oly toed ina east sen. Interest of | fesctonl part of 2 =max(02) =" mn2) franpoe of he vector compemeat ofthe st A ‘Ae 5 A a. convergence A, Ay A: convergence in istibation ‘A.-Z, A: convergence in L, pth moan convergence ‘Ac A: convergence in L?, mean are convergence ‘Aa Eo A: convergence in probability {AE the random elements (random variables, random {retoe stochastic pros) A and have the same ‘Sstninion te. PU C) = PUB C) forall stable tr. Forvandom viable and random vectors A,B this {eat that their drbuten functions ae the sae m4 a a 2 185 187 187 186