Stochastic Process and Itō's Lemma

Brownian motion (Wiener process)

z observed at 0, Δt, 2Δt, ... , nΔt (=T) denoted as z(0), z(Δt), z(2Δt), ...,
z(T).

Let ∆𝑧𝑧̃ = 𝑧𝑧(𝑡𝑡 + ∆𝑡𝑡) − 𝑧𝑧(𝑡𝑡) = √∆𝑡𝑡 ∙ 𝜖𝜖̃

𝜖𝜖̃ is i.i.d. where 𝐸𝐸 (𝜖𝜖̃) = 0 and 𝑉𝑉𝑉𝑉𝑉𝑉(𝜖𝜖̃) = 1

Note: we don't need to specify the distribution of 𝜖𝜖̃. First and second
moments will be sufficient statistics when ∆𝑡𝑡 → 0. That is, normal
distribution will be a sufficient condition.

Thus, 𝐸𝐸 (∆𝑧𝑧̃ ) = 0 and 𝑉𝑉𝑉𝑉𝑉𝑉(∆𝑧𝑧̃ ) = ∆𝑡𝑡 where ∆𝑧𝑧̃ is i.i.d.

Let's consider the change in z over t = 0 to T

𝐸𝐸 (𝑧𝑧(𝑇𝑇) − 𝑧𝑧(0)) = 𝐸𝐸 (∑𝑛𝑛1 ∆𝑧𝑧̃ ) = 0

𝑉𝑉𝑉𝑉𝑉𝑉�𝑧𝑧(𝑇𝑇) − 𝑧𝑧(0)� = 𝑉𝑉𝑉𝑉𝑉𝑉(∑𝑛𝑛1 ∆𝑧𝑧̃ )

= ∑𝑛𝑛1 𝑉𝑉𝑉𝑉𝑉𝑉(∆𝑧𝑧̃ ) + 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 (= 0)
= 𝑛𝑛 ∙ ∆𝑡𝑡 = 𝑇𝑇 (i.e. independent of n)

Now consider the continuous time limit, i.e., let ∆𝑡𝑡 → 0, 𝑛𝑛 → ∞, but
keeping 𝑛𝑛 ∙ ∆𝑡𝑡 constant and thus T remains constant.

Note that we still have

𝐸𝐸 (𝑧𝑧(𝑇𝑇) − 𝑧𝑧(0)) = 0 and 𝑉𝑉𝑉𝑉𝑉𝑉�𝑧𝑧(𝑇𝑇) − 𝑧𝑧(0)� = 𝑇𝑇

1
We can say one more thing about 𝑧𝑧(𝑇𝑇) − 𝑧𝑧(0). By central limit
theorem, summation of i.i.d. variables approaches normal distribution
when 𝑛𝑛 → ∞.

𝑧𝑧(𝑇𝑇) − 𝑧𝑧(0)~Φ(0, √𝑇𝑇) standard deviation of √𝑇𝑇

Define 𝑑𝑑𝑧𝑧̃ ≡ lim (Δ𝑧𝑧̃ ) = lim (√Δt ∙ 𝜖𝜖̃)

∆𝑡𝑡→0 ∆𝑡𝑡→0

Note: 𝐸𝐸 (𝑑𝑑𝑧𝑧̃ ) = 0 and 𝑉𝑉𝑉𝑉𝑉𝑉(𝑑𝑑𝑧𝑧̃ ) = lim ∆𝑡𝑡 ≡ 𝑑𝑑𝑑𝑑.

∆𝑡𝑡→0

𝑑𝑑𝑧𝑧̃ is referred as Brownian motion or Wiener process – the building

block of diffusion process.

We can also express the finite change in terms of a stochastic integral.

𝑇𝑇
𝑧𝑧(𝑇𝑇) − 𝑧𝑧(0) = ∫0 𝑑𝑑𝑧𝑧̃ (𝑡𝑡).

We say z(t) follows a continuous process.

2
Other diffusion processes

We can add a "drift" term (i.e. deterministic rate of change) and change
the "volatility" (i.e., the square of standard deviation) of the Wiener
process to obtain a more general diffusion process.

𝑑𝑑𝑥𝑥� (𝑡𝑡) = 𝜇𝜇 (𝑥𝑥, 𝑡𝑡)𝑑𝑑𝑑𝑑 + 𝜎𝜎(𝑥𝑥, 𝑡𝑡)𝑑𝑑𝑧𝑧̃

where μ and σ could be functions of t and contemporaneous value of x.

It remains Markovian. That is, the instantaneous change in x is only a
function of t and current (but not prior) value of x. Current value of x is
a sufficient statistics.

Over discrete interval T

𝑇𝑇 𝑇𝑇 𝑇𝑇
𝑥𝑥 (𝑇𝑇) − 𝑥𝑥 (0) = � 𝑑𝑑𝑥𝑥� = � 𝜇𝜇(𝑥𝑥, 𝑡𝑡)𝑑𝑑𝑑𝑑 + � 𝜎𝜎(𝑥𝑥, 𝑡𝑡)𝑑𝑑𝑧𝑧̃
0 0 0
which need not be normally distributed.

Now consider,
𝜇𝜇(𝑥𝑥, 𝑡𝑡) = 𝜇𝜇 (𝑡𝑡)
𝜎𝜎(𝑥𝑥, 𝑡𝑡) = 𝜎𝜎(𝑡𝑡)

are integralable deterministic functions of t only. Then,

𝑇𝑇 𝑇𝑇 𝑇𝑇
𝑥𝑥 (𝑇𝑇) − 𝑥𝑥 (0) = � 𝑑𝑑𝑥𝑥� = � 𝜇𝜇 (𝑡𝑡)𝑑𝑑𝑑𝑑 + � 𝜎𝜎(𝑡𝑡)𝑑𝑑𝑧𝑧̃
0 0 0

Thus,
𝑇𝑇
𝐸𝐸[𝑥𝑥(𝑇𝑇) − 𝑥𝑥 (0)] = � 𝜇𝜇 (𝑡𝑡)𝑑𝑑𝑑𝑑
0
𝑇𝑇
𝐸𝐸 [𝑥𝑥(𝑇𝑇)] = 𝑥𝑥 (0) + � 𝜇𝜇 (𝑡𝑡)𝑑𝑑𝑑𝑑
0

3
Note that:
𝑇𝑇 𝑛𝑛
� 𝜇𝜇 (𝑡𝑡)𝑑𝑑𝑑𝑑 = lim � 𝜇𝜇 (𝑡𝑡) ∙ ∆𝑡𝑡 = sum of area under curve of μ
0 ∆𝑡𝑡→0 1

and

𝑉𝑉𝑉𝑉𝑉𝑉[𝑥𝑥 (𝑇𝑇) − 𝑥𝑥 (0)]

= lim [𝑉𝑉𝑉𝑉𝑉𝑉(∆𝑥𝑥1 ) + 𝑉𝑉𝑉𝑉𝑉𝑉(∆𝑥𝑥2 ) + ⋯ + 𝑉𝑉𝑉𝑉𝑉𝑉(∆𝑥𝑥𝑛𝑛 ) + Covariance terms]
∆𝑡𝑡→0
= lim [𝑉𝑉𝑉𝑉𝑉𝑉(∆𝑥𝑥1 ) + 𝑉𝑉𝑉𝑉𝑉𝑉(∆𝑥𝑥2 ) + ⋯ + 𝑉𝑉𝑉𝑉𝑉𝑉(∆𝑥𝑥𝑛𝑛 )] = lim [𝜎𝜎(∆𝑡𝑡)2 ∙ ∆𝑡𝑡 +
∆𝑡𝑡→0 ∆𝑡𝑡→0
)2
𝜎𝜎(2∆𝑡𝑡 ∙ ∆𝑡𝑡 + ⋯ + 𝜎𝜎(𝑛𝑛∆𝑡𝑡 ∙ ∆𝑡𝑡])2
𝑇𝑇
= ∫0 𝜎𝜎(𝑡𝑡)2 ∙ 𝑑𝑑𝑑𝑑
= 𝜎𝜎 2 ∙ 𝑇𝑇 (if 𝜎𝜎(𝑡𝑡) is a constant)

For the specific case of:

𝑑𝑑𝑥𝑥� (𝑡𝑡) = 𝜇𝜇(𝑡𝑡)𝑑𝑑𝑑𝑑 + 𝜎𝜎(𝑡𝑡)𝑑𝑑𝑧𝑧̃

By central limit theorem, given that dx is independently (though not

necessarily identically) distributed, the discrete-time change of x is
normally distributed

𝑇𝑇 𝑇𝑇
𝑥𝑥 (𝑇𝑇) − 𝑥𝑥(0)~Φ(� 𝜇𝜇 (𝑡𝑡)𝑑𝑑𝑑𝑑 , �� 𝜎𝜎 2 (𝑡𝑡)𝑑𝑑𝑑𝑑 )
0 0
But, in general, with 𝜇𝜇(𝑥𝑥, 𝑡𝑡) and 𝜎𝜎(𝑥𝑥, 𝑡𝑡), dx is not independent over time
and thus CLT does not work, i.e., not normally distributed.

4
Discrete approximation of diffusion processes

Let's consider the simplest case where both μ and σ are constants.

𝑑𝑑𝑥𝑥� (𝑡𝑡) = 𝜇𝜇 ∙ 𝑑𝑑𝑑𝑑 + 𝜎𝜎 ∙ 𝑑𝑑𝑧𝑧̃

We can choose any discrete distribution of ∆𝑧𝑧 which satisfy:

(a) 𝐸𝐸 [∆𝑧𝑧] = 0,
(b) 𝑉𝑉𝑉𝑉𝑉𝑉[∆𝑧𝑧] = ∆𝑡𝑡
(c) 𝐸𝐸 [∆𝑧𝑧𝑡𝑡 ∙ ∆𝑧𝑧𝑡𝑡+1 ] = 0.

One possible specification is:

+√∆𝑡𝑡 with probability p = 0.5

∆𝑧𝑧 = �
−√∆𝑡𝑡 with probability p = 0.5

Check that this specification satisfy the above 3 conditions!

Thus,
𝜇𝜇 ∙ ∆𝑡𝑡 + 𝜎𝜎 ∙ √∆𝑡𝑡 with probability p = 0.5
∆𝑥𝑥 = �
𝜇𝜇 ∙ ∆𝑡𝑡 − 𝜎𝜎 ∙ √∆𝑡𝑡 with probability p = 0.5

We can thus construct a binomial lattice of x(t).

We could have chosen other discrete distributions, e.g.

+𝑢𝑢 with probability p

∆𝑧𝑧 = �
−𝑣𝑣 with probability (1-p)
such that,
𝐸𝐸 [∆𝑧𝑧] = 0 ⇒ 𝑢𝑢 ∙ 𝑝𝑝 = 𝑣𝑣 ∙ (1 − 𝑝𝑝)
𝑉𝑉𝑉𝑉𝑉𝑉[∆𝑧𝑧] = ∆𝑡𝑡 ⟹ 𝑢𝑢2 ∙ 𝑝𝑝 + 𝑣𝑣 2 ∙ (1 − 𝑝𝑝) = ∆𝑡𝑡

5
Solve for u, v and p with 2 equations. That is, more than one set of (u, v,
p) will work. The advantage of (√∆𝑡𝑡, √∆𝑡𝑡, 0.5) ensures we can
approximate normal distribution in fewer steps.

Taylor series expansion and Itō's lemma

We can approximate a function using a polynomial. For example,

expanding function f(x) around x0.

𝜕𝜕𝜕𝜕 1 𝜕𝜕 2 𝑓𝑓
𝑓𝑓(𝑥𝑥 ) = 𝑓𝑓(𝑥𝑥0 ) + � (𝑥𝑥 − 𝑥𝑥0 ) + ∙ 2 � (𝑥𝑥 − 𝑥𝑥0 )2
𝜕𝜕𝜕𝜕 𝑥𝑥=𝑥𝑥0 2 𝜕𝜕𝑥𝑥 𝑥𝑥=𝑥𝑥
0
+ higher order terms

𝜕𝜕𝜕𝜕 𝜕𝜕2 𝑓𝑓
Notation: 𝑓𝑓𝑥𝑥 ≡ and 𝑓𝑓𝑥𝑥𝑥𝑥 ≡ .
𝜕𝜕𝜕𝜕 𝜕𝜕𝑥𝑥 2

For a function of two variables x and y, we have:

1
𝑓𝑓(𝑥𝑥, 𝑦𝑦) = 𝑓𝑓(𝑥𝑥0 , 𝑦𝑦0 ) + 𝑓𝑓𝑥𝑥 ∙ (𝑥𝑥 − 𝑥𝑥0 ) + 𝑓𝑓𝑦𝑦 ∙ (𝑦𝑦 − 𝑦𝑦0 ) + 𝑓𝑓𝑥𝑥𝑥𝑥 ∙ (𝑥𝑥 − 𝑥𝑥0 )2
2
1
+ 𝑓𝑓𝑦𝑦𝑦𝑦∙ (𝑦𝑦 − 𝑦𝑦0 )2 +𝑓𝑓𝑥𝑥𝑥𝑥 ∙ (𝑥𝑥 − 𝑥𝑥0 ) ∙ (𝑦𝑦 − 𝑦𝑦0 )
2
+ higher order terms

∆𝑓𝑓 ≡ 𝑓𝑓(𝑥𝑥, 𝑦𝑦) − 𝑓𝑓(𝑥𝑥0 , 𝑦𝑦0 )

1
= 𝑓𝑓𝑥𝑥 ∙ (𝑥𝑥 − 𝑥𝑥0 ) + 𝑓𝑓𝑦𝑦 ∙ (𝑦𝑦 − 𝑦𝑦0 ) + 𝑓𝑓𝑥𝑥𝑥𝑥 ∙ (𝑥𝑥 − 𝑥𝑥0 )2
2
1
+ 𝑓𝑓𝑦𝑦𝑦𝑦∙ (𝑦𝑦 − 𝑦𝑦0 )2 +𝑓𝑓𝑥𝑥𝑥𝑥 ∙ (𝑥𝑥 − 𝑥𝑥0 ) ∙ (𝑦𝑦 − 𝑦𝑦0 )
2
+ higher order terms

We can apply Taylor series expansion to derive the process followed by

any function f of a diffusion process x.

6
Suppose,
𝑑𝑑𝑥𝑥� (𝑡𝑡) = 𝜇𝜇 ∙ 𝑑𝑑𝑑𝑑 + 𝜎𝜎 ∙ 𝑑𝑑𝑧𝑧̃

where μ and σ could be functions of both x and t.

Most likely, f is a function of both x and t, i.e., 𝑓𝑓 = 𝑓𝑓(𝑥𝑥, 𝑡𝑡).

Now, use Taylor series expansion (let y be t).

1 1
∆𝑓𝑓 = 𝑓𝑓𝑥𝑥 ∙ (∆𝑥𝑥 ) + 𝑓𝑓𝑡𝑡 ∙ (∆𝑡𝑡) + 𝑓𝑓𝑥𝑥𝑥𝑥 ∙ (∆𝑥𝑥 )2 + 𝑓𝑓𝑡𝑡𝑡𝑡∙ (∆𝑡𝑡)2
2 2
+𝑓𝑓𝑥𝑥𝑥𝑥 ∙ (∆𝑥𝑥 ∙ ∆𝑡𝑡) + higher order terms (1)

Note that,
∆𝑥𝑥 = 𝜇𝜇 ∙ ∆𝑡𝑡 + 𝜎𝜎 ∙ ∆𝑧𝑧
(∆𝑥𝑥)2 = 𝜇𝜇 2 ∙ (∆𝑡𝑡)2 + 𝜎𝜎 2 ∙ (∆𝑧𝑧)2 + 2𝜇𝜇 ∙ 𝜎𝜎 ∙ ∆𝑡𝑡 ∙ ∆𝑧𝑧
∆𝑥𝑥 ∙ ∆𝑡𝑡 = 𝜇𝜇 ∙ (∆𝑡𝑡)2 + 𝜎𝜎 ∙ ∆𝑡𝑡 ∙ ∆𝑧𝑧

Besides, note that 𝑉𝑉𝑉𝑉𝑉𝑉[∆𝑧𝑧] = 𝐸𝐸 [(∆𝑧𝑧)2 ] = ∆𝑡𝑡. That is, in expected

sense, (∆𝑧𝑧)2 is of order ∆𝑡𝑡, and thus (∆𝑧𝑧)2 converges to 0 at the same
rate as ∆𝑡𝑡. In other words, ∆𝑧𝑧 converges to 0 at a "slower" rate than ∆𝑡𝑡.

It can actually be shown that lim (∆𝑧𝑧)2 = ∆𝑡𝑡. Not surprising if we

∆𝑡𝑡→0
consider the previous discretized representation.

+√∆𝑡𝑡 with probability p = 0.5

∆𝑧𝑧 = �
−√∆𝑡𝑡 with probability p = 0.5

As ∆𝑡𝑡 → 0, we therefore have (keeping only terms converging to 0 at a

rate equal to or slower than ∆𝑡𝑡),
∆𝑥𝑥 = 𝜇𝜇 ∙ ∆𝑡𝑡 + 𝜎𝜎 ∙ ∆𝑧𝑧
(∆𝑥𝑥)2 = 𝜎𝜎 2 ∙ (∆𝑧𝑧)2
∆𝑥𝑥 ∙ ∆𝑡𝑡 = 0
7
Substituting into Equation (1) and again ignoring all terms converging to
0 faster than ∆𝑡𝑡 (also switching discrete-time notation Δ to continuous-
time notation of d), we have

1
𝑑𝑑𝑑𝑑 = 𝑓𝑓𝑥𝑥 ∙ (𝜇𝜇 ∙ 𝑑𝑑𝑑𝑑 + 𝜎𝜎 ∙ 𝑑𝑑𝑑𝑑) + 𝑓𝑓𝑡𝑡 ∙ 𝑑𝑑𝑑𝑑 + 𝑓𝑓𝑥𝑥𝑥𝑥 ∙ 𝜎𝜎 2 (𝑑𝑑𝑑𝑑)2
2

Substituting dt for (𝑑𝑑𝑑𝑑)2 and rearranging we have Itō's lemma.

1
𝑑𝑑𝑑𝑑 = �𝑓𝑓𝑥𝑥 ∙ 𝜇𝜇 + 𝑓𝑓𝑡𝑡 + 𝑓𝑓𝑥𝑥𝑥𝑥 ∙ 𝜎𝜎 2 � ∙ 𝑑𝑑𝑑𝑑 + 𝑓𝑓𝑥𝑥 ∙ 𝜎𝜎 ∙ 𝑑𝑑𝑑𝑑
2

That is, if x follow a diffusion process, its function f also follows a

diffusion process of the same Wiener process dz.

Stock price process (Geometric Brownian Motion)

Arithmetic Brownian Motion: 𝑑𝑑𝑥𝑥� (𝑡𝑡) = 𝜇𝜇 ∙ 𝑑𝑑𝑑𝑑 + 𝜎𝜎 ∙ 𝑑𝑑𝑧𝑧̃

Geometric Brownian Motion (GBM): 𝑑𝑑𝑥𝑥� (𝑡𝑡) = 𝜇𝜇 ∙ 𝑥𝑥 ∙ 𝑑𝑑𝑑𝑑 + 𝜎𝜎 ∙ 𝑥𝑥 ∙ 𝑑𝑑𝑧𝑧̃

GBM is a commonly used representation of stock price process.

Some characteristics (suitability in describing stock price):

𝑑𝑑𝑥𝑥�
1. Independent stock price return (market efficiency): � � is
𝑥𝑥 1
𝑑𝑑𝑥𝑥�
independent of � �
𝑥𝑥 2

2. When starting with a positive x0, 𝑥𝑥𝑡𝑡 > 0 ∀𝑡𝑡 > 0. That is a limited
liability securities. Zero liability in walking away from a contract.

8
 𝑑𝑑𝑥𝑥�
3. Constant mean return on price: 𝐸𝐸 � � = 𝜇𝜇 ∙ 𝑑𝑑𝑑𝑑.
𝑥𝑥

𝑑𝑑𝑥𝑥�
4. Constant return volatility: 𝑉𝑉𝑉𝑉𝑉𝑉 � � = 𝜎𝜎 2 ∙ 𝑑𝑑𝑑𝑑.
𝑥𝑥

Consider the natural log of GBM process x. What is the process

followed by f(x,t) = ln(x)? Use Itō's lemma.

If f = ln(x) is normally distributed, 𝑥𝑥 (𝑡𝑡) = 𝑒𝑒 𝑓𝑓(𝑡𝑡) is lognormally

distributed. That is GBM has lognormal distribution over finite interval
t.
1 2
�ln�𝑥𝑥(0)�+�𝜇𝜇−2𝜎𝜎 �𝑇𝑇+𝑍𝑍��
𝑥𝑥 (𝑇𝑇) = 𝑒𝑒
1
�𝜇𝜇−2𝜎𝜎2 �𝑇𝑇
= 𝑥𝑥(0) ∙ 𝑒𝑒 ∙ 𝑒𝑒 𝑍𝑍�
where
𝑍𝑍�~Φ(0, �𝜎𝜎 2 𝑇𝑇 )

Note that:
1
�𝜇𝜇−2𝜎𝜎 2 �𝑇𝑇
𝐸𝐸[𝑥𝑥 (𝑇𝑇)] ≠ 𝑥𝑥(0) ∙ 𝑒𝑒

What are 𝐸𝐸[𝑥𝑥(𝑇𝑇)], 𝑉𝑉𝑉𝑉𝑉𝑉[𝑥𝑥(𝑇𝑇)], and probability density function (PDF)

of x(t)?

9
Multivariate Itō's lemma

Suppose n securities (i = 1, 2, ..., n)

𝑑𝑑𝑥𝑥�𝑖𝑖 (𝑡𝑡) = 𝜇𝜇𝑖𝑖 ∙ 𝑑𝑑𝑑𝑑 + 𝜎𝜎𝑖𝑖 ∙ 𝑑𝑑𝑧𝑧̃𝑖𝑖

where
𝑑𝑑𝑧𝑧̃𝑖𝑖 𝑑𝑑𝑧𝑧̃𝑗𝑗 = 𝜌𝜌𝑖𝑖,𝑗𝑗 𝑑𝑑𝑑𝑑
𝑑𝑑𝑧𝑧̃𝑖𝑖 𝑑𝑑𝑧𝑧̃𝑖𝑖 = 𝑑𝑑𝑑𝑑

From Itō's lemma, we have

𝑛𝑛 𝑛𝑛 𝑛𝑛
1
𝑑𝑑𝑑𝑑 = [�(𝑓𝑓𝑥𝑥𝑖𝑖 ∙ 𝜇𝜇𝑖𝑖 + 𝑓𝑓𝑥𝑥𝑖𝑖 𝑥𝑥𝑖𝑖 ∙ 𝜎𝜎𝑖𝑖2 ) + 𝑓𝑓𝑡𝑡 + � � 𝑓𝑓𝑥𝑥𝑖𝑖 𝑥𝑥𝑗𝑗 ∙ 𝜎𝜎𝑖𝑖 ∙ 𝜎𝜎𝑗𝑗 ∙ 𝜌𝜌𝑖𝑖𝑖𝑖 ] ∙ 𝑑𝑑𝑑𝑑
2
𝑖𝑖=1 𝑖𝑖=1 𝑗𝑗>𝑖𝑖
𝑛𝑛

+ � 𝑓𝑓𝑥𝑥𝑖𝑖 ∙ 𝜎𝜎𝑖𝑖 ∙ 𝑑𝑑𝑧𝑧𝑖𝑖

𝑖𝑖=1

10