Chapter 1

What you need to know about Itō

Calculus

In this chapter we introduce the famous Itō’s integral, a building block of stochastic cal-
culus. The necessity to introduce this new type of integral Remerges because we cannot use
t
standard calculus techniques to study objects of the form 0 f (s)dB(s), since B(s) is not
a BV function.
We will first introduce the new integral and study its basic properties. Then we will move
to the well-known Itō-Doeblin formula (or lemma), which we can use to find the di↵erential
of a time-dependent function of a stochastic process. Later on, we will use this formula to
study the fundamental Black-Scholes-Merton model.
The topics discussed in the present chapter constitute the necessary basis for studying
stochastic di↵erential equations.
The interested reader can find additional materials in [2] and [8].

1.1 Introduction
Imagine we own a portfolio whose value at time t is P (t). For simplicity we assume that our
portfolio only contains securities whose value depends on the interest rate on the market.
Let r(t) be the instantaneous interest rate at time t. It may be interesting to study an
equation like
d
P (t) = r(t)P (t), t 0, (1.1)
dt
which tells us how the value of our portfolio varies over time, when we consider infinitesimal
time variations1 . Equation (1.1) is a common example of di↵erential equation, whose
solution is studied in any calculus course.
1
If you are familiar with the Greeks in finance, this should remind you of T heta.

7
8 CHAPTER 1. WHAT YOU NEED TO KNOW ABOUT ITŌ CALCULUS

Now assume that we can express r(t) as follows

r(t) = r + aW (t),
where r and a are two constants, and where W (t) is a “white noise”, that is to say a
stochastic process such that
• W(t) and W(s) are independent for t 6= s;
• For t1 < ... < th and k > 0, we have that
(W (t1 ), ..., W (th )) =d (W (t1 + k), ..., W (th + k));

• E(W (t)) = 0, 8t.

Equation (1.1) can thus be rewritten as
d
P (t) = rP (t) + a(P (t)W (t)). (1.2)
dt
This equation now includes random quantities expressed by the process W (t). As a con-
sequence we cannot solve equation (1.2) in the usual way, since we should consider it as
an ordinary di↵erential equation for every trajectory of W (t), which is a rather “irregular”
object.
In any case, similarly to what we usually do with equations like (1.1), a solution for (1.2)
could be thought as the solution of the following (stochastic) integral equation
Z t Z t
P (t) = P (0) + r P (s)ds + a P (s)W (s)ds.
0 0
Unfortunately, the last term on the right-hand side of the previous equation cannot be
easily defined. Rt Rt
A possibility would be to substitute 0 P (s)W (s)ds with something like 0 P (s)dB(s),
where B(s) is a Brownian motion, and W (s) ⇡ dB(s)/ds,R so that dB(s) = W (s)ds.
t
Anyway, even this solution is not feasible: if we interpret 0 P (s)dB(s) as a Riemann-
Stieltjes integral, we immediately have to remember that B(s) is not a BV function.
Finally, we can notice that the quantity
n
X
P ( i )[B(si ) B(si 1 )],
i=1
Rt
which should approximate 0 P (s)dB(s), converges to di↵erent values, depending on the
choice of i 2 [si 1 , si ]. The main reason of such a behavior is the irregularity of the real-
izations of B(s).
So, how can we solve the problem of evaluating (1.2)?
The only solution seems to define another type of integral. Over the years di↵erent possi-
bilities have been introduced, but the most successful - and now widely accepted - one is
due to Kiyoshi Itō.
1.2. DEFINITION OF THE INTEGRAL 9

1.2 Definition of the integral

Following the steps of Itō, given a Brownian motion B(t, !), we want to define the integral
Z T
I(f )(!) := f (t, !)dB(t, !), (1.3)
0

for a sufficiently large class of functions f . Notice that the presence of ! 2 ⌦ in the
arguments of f indicates that f can be a random function (but naturally also a traditional,
deterministic one).
Mimicking what happens in standard calculus, a natural way of defining I(f )(!) is to set
Z T n
X1
I(f )(!) := f (t, !)dB(t, !) = lim f (tk , !)[B(tk+1 , !) B(tk , !)],
0 n!1
k=0

for 0 = t0 < t1 < ... < tn = T , with maxk (tk+1 tk ) ! 0 as n ! 1.

Let us now characterize the class M2 [0, T ] of functions f for which we can define Itō’s
integral.
Definition 1. A function f : [0, +1) ⇥ ⌦ ! R belongs to the class M2 [0, T ] if
• f (t, !) is B ⇥ F measurable, where B = B(R[0,+1) ), and F is given by the space
(⌦, F, P ) on which B(t) is defined;

• f (t, !) is Ft measurable, i.e. f (t, !) is non-anticipating, i.e. adapted to Ft ;

⇣R ⌘
T
• E 0 f 2 (t, w)dt < +1.

Definition 2. A function 2 M2 [0, T ] is called simple process (or elementary function)

if
n
X1
(t, !) = aj (!)1[tj ,tj+1 ] (t),
j=0

where 0 = t0 < ... < tn = T .

In the previous definition, please notice that
• aj (!) can be a random quantity;

• Since 2 M2 [0, T ], each aj (!) must be Ftj measurable!

Definition 3. If 2 M2 [0, T ] is a simple process (or elementary function), then its Itō’s
integral is
Z T n
X1
(t, !)dB(t, !) := aj (!) [B(tj+1 , !) B(tj , !)] .
0 j=0
10 CHAPTER 1. WHAT YOU NEED TO KNOW ABOUT ITŌ CALCULUS

Proposition 1 (Properties of simple processes). Let 1 and 2 be two simple processes in

M2 [0, T ]. Then
RT RT RT
1. 0 ( 1 + 2 )dB = 0 1 dB + 0 2 dB;
RT RT
2. 0 c 1 dB = c 0 1 dB, for any constant c;
hR i
T
3. E 0 1 dB = 0;
hR RT i hR i
T T
4. E 0 1 dB · 0 2 dB = E 0 ( 1· 2 )dt .

The last property is known as the Itō Isometry.

Proof. Points 1., 2. and 3. are left as exercises.
To prove point 4. we start with the case 1 = 2 . Hence
2 !2 3 2
Z T n
X1 2
E4 1 (t, !)dB(t, !)
5 = E4 a2j (!) [B(tj+1 , !) B(tj , !)] + (1.4)
0 j=0
3

X 7
7
+ 2 aj (!) [B(tj+1 , !) B(tj , !)] ak (!) [B(tk+1 , !) B(tk , !)]7
7.
0j<kn 1 5
| {z }
C

In order to further work with equation (1.4), let us consider the following:

• E[(B(tj+1 , !) B(tj , !))2 ] = tj+1 tj ;

• for k > j the elements aj (!) [B(tj+1 , !) B(tj , !)] ak (!) are independent from
B(tk+1 , !) B(tk , !). Hence C = 0.

Thus, equation (1.4) simplifies to

" ✓Z 2 3
T ◆2 # n
X1
E 1 (t, !)dB(t, !) = E4 a2j (!) [B(tj+1 , !) B(tj , !)]2 5
0 j=0
n
X1 h i
= E[a2j (!)]E (B(tj+1 , !) B(tj , !))2
j=0
n
X1 n
X1
= E[a2j (!)](tj+1 tj ) = E [a2j (!)](tj+1 tj )
j=0 j=0
Z T
2
= E 1 (t, !)dt
0
1.2. DEFINITION OF THE INTEGRAL 11

For the case 1 6= 2,we can consider 3 = 1 + 2.

Thus
" ✓Z ◆2 # " ✓Z ◆2 # " ✓Z Z ◆2 #
T T T T
E 3 dB = E ( 1 + 2 )dB =E 1 dB + 2 dB
0 0 0 0
Z T Z T Z T Z T
2 2
= E 1 dt + 2E 1 dB · 2 dB + E 2 dt .
0 0 0 0

But we also know that

" ✓Z ◆2 # Z Z
T T T
2 2 2
E 3 dB = E 3 dt =E ( 1 +2 2 2 + 2 )dt
0 0 0
Z T Z T Z T
2 2
= E 1 dt + 2E 1 2 dt +E 2 dt
0 0 0

Then, by equating the last two equations, we get the final result.

Exercise 1. Prove points 1.,2. and 3. of Proposition 1.

In what follows we want to define the Itō’s integral for a general f 2 M2 [0, T ]. In order
to do so, we need to introduce some extra definitions and results.
In particular, we will follow the following procedure:

1. We start from the definition of Itō’s integral for simple processes, as given in Definition
3.

2. We then show that any function f 2 M2 [0, T ] can be approximated by a proper

sequence of simple processes { n }.
RT RT
3. Finally we define 0 f (t, !)dB(t, !) as the limit of 0 n (t, !)dB(t, !), for n ! f
as n ! 1.

Definition 4 (Approximating sequence in M2 ). Consider f (t, !) 2 M2 [0, T ]. A collection

{ n } of simple processes in M2 [0, T ] is an approximating sequence for f , if
Z T
2
lim E |f (t, !) n (t, !)| dt = 0. (1.5)
n!1 0

Now, let us consider the following sequence of Itō’s integrals for simple processes
Z T
I( n )(!) = n (t, !)dB(t, !);
0

and let us also assume that { n } is an approximating sequence for f 2 M2 [0, T ], so that
Equation (1.5) holds. The we can state the following.
12 CHAPTER 1. WHAT YOU NEED TO KNOW ABOUT ITŌ CALCULUS

Theorem 1. For f 2 M2 [0, T ], let { n } 2 M2 [0, T ] be an approximating sequence for f .

Then the sequence of integrals {I( n )(!)} converges in quadratic mean.
Proof. We simply have to show that {I( n )(!)} is a Cauchy sequence in quadratic mean.
Consider two elements l and m of the sequence { n }. Clearly
" ✓Z Z T ◆2 # " ✓Z ◆2 #
T T
E l dB m dB =E ( l m )dB .
0 0 0

Since l and m are simple processes, it is easy to see that l m is a simple process in
M2 [0, T ] as well. Hence, for what we have seen in Proposition 1,
" ✓Z ◆2 # Z Z
T T T
2 2
E ( l m )dB =E ( l m ) dt = E [( l f ) + (f m )] dt .
0 0 0

But this implies that

" ✓Z ◆2 #  ✓Z Z ◆
T T T
E ( l m )dB E 2 | l f |2 dt + |f 2
m | dt ! 0,
0 0 0

as l, m ! 1.

It is worth noticing that the previous theorem implies that if { n } and {⌘m } are two dif-
ferent approximating sequences for f , then the limits limn!1 I( n )(!) and limm!1 I(⌘m )(!)
exist and they must be the same.
We can now introduce the most important result of the present section, with which we
show that every f 2 M2 [0, T ] can be approximated by a properly chosen approximating
sequence, so that we can define the Itō integral of f in terms of limits.
Theorem 2 (Itō’s approximation). For every f 2hM2 [0, T ], there exists at least
i a sequence
RT
of functions {hn } in M2 [0, T ] such that limn!1 E 0 |f (t, !) hn (t, !)|2 dt = 0. In other
words, {hn } is an approximating sequence for f .
To prove this theorem we will make use of three di↵erent lemmas. Our aim is to show
that
1. If a function g 2 M2 [0, T ] is bounded and continuous, it can be approximated by a
proper sequence of simple processes { n }.

2. If a function h 2 M2 [0, T ] is bounded, it can be approximated by a proper sequence

of bounded and continuous functions {gn }.

3. Every function f 2 M2 [0, T ] can be approximated by a proper sequence of bounded

functions {hn }.
1.2. DEFINITION OF THE INTEGRAL 13

Lemma 1. For every g 2 M2 [0, T ] which is bounded and continuous, there exists a sequence
{ n } of simple processes in M2 [0, T ] such that
Z T
2
lim E |g(t, !) n (t, !)| dt = 0.
n!1 0

Proof. Since g 2 M2 [0, T ] is continuous, the function

n
X1
n (t, !) := g(tj , !)1[tj ,tj+1 ) (t)
j=0

2
is a simple process and it converges uniformly to g, i.e. (g n ) ! 0 uniformly. Then
RT 2
R T 2
limn!1 0 (g n ) dt = 0 limn!1 (g n ) dt = 0. Now, given that g n is bounded,
RT 2
we have that 0 (g n ) dt  D < 1, and we can apply the dominated converge theorem
to complete the proof.

Dominated Convergence Theorem

If a sequence of functions {fn } on (⌦, F, µ) converges to a function f , and it is
dominated byRanother function g, so that |fn (x)|  g(x) for all x 2 ⌦ and n = 1, 2, ...,
then limn!1 ⌦ |fn f |dµ = 0.

Lemma 2. Let h 2 M2 [0, T ] be a bounded function. Then there exists a sequence {gn } 2
M2 [0, T ] of bounded and continuous functions, for every ! and n, such that
Z T
lim E |h(t, !) gn (t, !)|2 dt = 0.
n!1 0

We omit the proof of this lemma; however it may be interesting to know that the
sequence {gn } can be defined as
Z t
gn (t, !) = n h(s, !)ds, 0  t  T.
1
max(t n ,0)

Lemma 3. Let f 2 M2 [0, T ] be a generic function. Then there exists a sequence {hn } 2
M2 [0, T ] of bounded functions, such that
Z T
lim E |f (t, !) hn (t, !)|2 dt = 0.
n!1 0
14 CHAPTER 1. WHAT YOU NEED TO KNOW ABOUT ITŌ CALCULUS

Proof. Let us assume that f is non-negative, i.e. f 0, and define the sequence
(
f (t, w) f  n
hn (t, !) = .
n f >n

Since f 2 M2 [0, T ], we know that f 2 is integrable a.s. and h2n  f 2 . Hence we get
RT 2
0 hn (t, !)dt < 1 a.s. Moreover |f hn |2  f 2 , and limn!1 hn = f . The dominated
RT
convergence theorem thus guarantees that 0 |f hn |2 dt ! 0.
RT RT RT 2
However, 0 |f hn |2 dt  0 f 2 dt, with
hR E( 0 f dt) i < 1. The dominated convergence
T
theorem then tells us that limn!1 E 0 |f hn |2 dt = 0.
For a general f , it is sufficient to use the decomposition f = f+ f , where f+ =
max(f, 0) 0 and f = max( f, 0) 0.

Combining the previous three lemmas we can thus prove Theorem 2. The next (and
last) step for the definition of the Itō’s integral for every f 2 M2 [0, T ] is therefore contained
in the following definition.
Definition 5 (The fundamental definition). Let f be a function belonging to the class
M2 [0, T ]. Let { n } be an approximating sequence for f . We define Itō’s integral of f the
following limit
Z T Z T
I(f )(!) = f (t, !)dB(t, !) := lim I( n )(!) = lim n (t, !)dB(t, !).
0 n!1 n!1 0

1.3 Some basic properties

In this section we analyze some properties of the integral I(f )(!) we have defined so far.
For example, we can start by showing that I(f )(!) inherits some important properties
from I( )(!), where is a simple process in M2 [0, T ].
Proposition 2. If f 2 M2 [0, T ] then
Z T
E f (t, !)dB(t, !) = 0,
0
hR i
T 2 dt
Proof. Let { n} be such that limn!1 E 0 |f n| = 0. Then
Z T Z T
lim n (t, !)dB(t, !) = f (t, !)dB(t, !)
n!1 0 0

in quadratic mean. As a consequence

Z T Z T
E n (t, !)dB(t, !) ! E f (t, !)dB(t, !) .
0 0
1.3. SOME BASIC PROPERTIES 15
hR i hR i
T T
But we know that E 0 n (t, !)dB(t, !) = 0, hence E 0 f (t, !)dB(t, !) = 0 as well.

Proposition 3. If f 2 M2 [0, T ] then

" ✓Z ◆2 # Z
T T
E f (t, !)dB(t, !) =E f 2 (t, !)dt .
0 0

Proof. The proof of this proposition is left as exercise; see below.

Exercise 2. Prove Proposition 3.

Hint: Just notice that, for what we have seen so far,
" ✓Z ◆2 # " ✓Z ◆2 #
T T
E n (t, !)dB(t, !) !E f (t, !)dB(t, !) .
0 0

Now you can apply point 4. of Proposition 1 to conclude the proof.

Proposition 4. If f 2 M2 [0, T ] then
Z t
Q(t) = f (s, !)dB(s, !), t 0,
0

is a martingale with respect to the natural filtration Ft generated by B(t, !), and the prob-
ability measure P of (⌦, F, P ).
Proof. We have to check the di↵erent properties of martingales, in order to complete our
proof.
The fact that Q(t) is Ft measurable is evident.
We also know that (we drop (s, !) in the notation)
Z " ✓Z ◆2 # 12 Z 1
t t t 2
2
E[|Q(t)|] = E f dB E f dB E f ds < 1.
0 0 0

Rt
Now, let us take into consideration In (t) = 0 n (s, !)dB(s, !), where { n} is an approxi-
mating sequence for our f . For t s, we have
2
m
X1
E[In (t)|Fs ] = E 4 j (tj , !) [B(tj+1 , !) B(tj , !)]
j=0
n
#
X1
+ k (tk , !) [B(tk+1 , !) B(tk , !)] Ftm ,
k=m
16 CHAPTER 1. WHAT YOU NEED TO KNOW ABOUT ITŌ CALCULUS

where 0 = t0 < t1 < ... < tm = s < tm+1 < ... < tn = t.
Hence
m
X1
E[In (t)|Fs ] = j (tj , !) [B(tj+1 , !) B(tj , !)] (for measurability) (1.6)
j=0
X
+ E[ k (tk , !) [B(tk+1 , !) B(tk , !)]| Ftm ] .
k m
| {z }
A

Now notice that the second addend A in Equation (1.6) is equal to 0. In fact, for t s,
the increments B(tk+1 , !) B(tk , !) are independent from k (tk , !), and

E[ k (tk , !) [B(tk+1 , !) B(tk , !)]| Ftm ] = E[ k (tk , !)] E [B(tk+1 , !) B(tk , !)|Ftm ] = 0.
| {z }
=0

This means that, for t s,

m
X1 Z s
E[In (t)|Fs ] = j (tj , !) [B(tj+1 , !) B(tj , !)] = n (r, !)dB(r, !) = In (s).
j=0 0

In order to conclude the proof, it is sufficient to apply a well-known result about conditional
expectations, i.e. if Xn !r X, r 1, and G is a algebra, then E[Xn |G] !r E[X|G],
whereR“!r ” indicates
R t convergence in Rthe r th mean (orR in the Lr norm, ifR you prefer).
t t t t
Now, 0 n dB ! 0 f dB, so that E[ 0 n dB|Ft ] !2 E[ 0 f dB|Ft ]. But E[ 0 n dB|Ft ] =
2
Rt 2
R t R t R s
0 n dB ! E[ 0 f dB]. Therefore E[ 0 f dB|Fs ] = 0 f dB.

We conclude this section by stating an important proposition that, for the moment, we
do not prove. We will come back to it later on, when needed.
Rt
Proposition 5. If f belongs to the class M2 [0, T ], then Q(t) = 0 f (s, !)dB(s, !) always
admits a continuous modification for every T t 0.

1.4 The Itō-Doeblin formula

The definition of Itō’s integral as given in Definition 5 is essential for the development of
stochastic calculus, as much as the fundamental theorem of calculus is for the definition
and the study of “standard” integrals. However, Definition 5 alone (and the construction
behind it) is not very useful for the actual computation of stochastic integrals. We need in
fact some sort of rule, or formula, we can apply to practically compute these new objects.
The aim of this section is to introduce this formula, known as the Itō-Doeblin formula (or
Itō-Doeblin lemma).
1.4. THE ITŌ-DOEBLIN FORMULA 17

Before introducing the formula, it is interesting to stress that the class M2 [0, T ] of functions,
for which the integral I(f )(!) can be defined, can be extended to a slightly more general
class, called H2 [0, T ].

Definition 6. A function f belongs to the class H2 [0, T ] if

• f (t, !) is B ⇥ F measurable;

• There exists a filtration {Mt } ✓ F such that B(t, !) is a martingale with respect to
{Mt };

• f (t, !) is Mt measurable;
RT
• P ( 0 f 2 (t, w)dt < +1) = 1.

For this new class of functions we can show that there always exists a sequence { n}
RT 2
of simple processes such that 0 |f n | dt ! 0 in probability. Hence we can set

Z T
I(f )(!) = P-limn n dB.
0

From now on, all the functions f will belong to H2 [0, T ].

A couple of definitions will be very useful to introduce the Itō-Doeblin formula.

Definition 7 (Stochastic integral). Let B(t, w) be a Brownian motion on (⌦, F, P ). A

stochastic integral is a process X(t) on (⌦, F, P ) such that
Z t Z t
X(t) = X(0) + u(s, !)ds + v(s, !)dB(s, !),
0 0
Rt
where u, v 2 H2 [0, T ] and P ( 0 |u(s, !)|ds < +1) = 1.

Definition 8 (Stochastic di↵erential). If X(t) is a stochastic integral, its stochastic dif-

ferential is
dX(t) = u(t, !)dt + v(t, !)dB(t, !).

Theorem 3 (Itō-Doeblin formula). Let X(t) be a stochastic integral with stochastic dif-
ferential
dX(t) = u(t, !)dt + v(t, !)dB(t, !),
Rt
with u, v 2 H2 [0, T ] and P ( 0 |u(s, !)|ds < +1) = 1.
Let g(t, x) : [0, +1)⇥R ! R be a function such that gt0 , gx0 and gxx
00 exist and are continuous.

The process Y (t) = g(t, X(t)) is still a stochastic integral with stochastic di↵erential
1 00
dY (t) = gt0 (t, X(t))dt + gx0 (t, X(t))dX(t) + gxx (t, X(t))(dX(t))2 .
2
18 CHAPTER 1. WHAT YOU NEED TO KNOW ABOUT ITŌ CALCULUS

We will not give a formal proof of the previous theorem, since it goes beyond the scope
of these lecture notes.
However it is interesting to observe that Itō-Doeblin formula can also be written as
✓ ◆
1 00 2
dY (t) = gt + gx u + gxx v dt + gx0 vdB.
0 0
(1.7)
2

Equation (1.7) can be obtained by writing the Taylor series of Y (t) = g(t, X(t)) up to the
second order, always remembering that dX(t) = u(t, !)dt + v(t, !)dB(t, !). This leads to
1 00
dY (t) = gx0 (u(t, !)dt + v(t, !)dB(t, !)) + gt0 dt + gxx (u(t, !)dt + v(t, !)dB(t, !))2 .
2
The term 12 gxx
00 (u(t, !)dt + v(t, !)dB(t, !))2 can be re-written as

1 00
g ((u(t, !))2 (dt)2 + (v(t, !))2 (dB(t, !))2 + 2u(t, !)v(t, !)dtdB(t, !)).
2 xx
Now, for dt ! 0, we have (dt)2 = 0 = dtdB, while (dB)2 = dt for what we have seen
before. Rearranging the terms (and dropping (t, !) in the notation) gives us Equation
(1.7).
We finish this section and chapter by giving two examples of the use of the Itō-Doeblin
formula. Later on, when introducing the model of Black-Scholes-Merton, or when dealing
with risk-neutral pricing, we will see many interesting financial applications of the formula.

Example 1. Assume we want to compute

Z t
B n (s, !)dB(s, !), n 1.
0

1
Set u(t, !) = 0, v(t, !) = 1, g(t, x) = n+1 xn+1 . We have that gt0 = 0, gx0 = xn and
00
gxx = nx n 1 . The Itō-Doeblin formula then gives
1
dg(t, B(t, !)) = nB n 1
(t, !)dt + B n (t, !)dB(t, !).
2
From this we get
Z t Z t
n 1 n
B (s, !)dB(s, !) = B n+1 (t, !) Bn 1
(s, !)ds.
0 n+1 2 0

For n = 1 we obtain Z t
1 t
B(s, !)dB(s, !) = B 2 (t, !) ,
0 2 2
which represents an interesting case we will see later on in applications.
1.4. THE ITŌ-DOEBLIN FORMULA 19

Example
Rt 2. Let f be a non-random function with bounded variation. How to compute
0 f (s)dB(s, !)?
Let us set u(t, !) = 0, v(t, !) = 1, g(t, x) = xf (t). Then gt0 = xdf (t), gx0 = f (t) and
00 = 0. Hence
gxx Z t Z t
B(t, !)f (t) = B(s, !)df (s) + f (s)dB(s, !),
0 0
that is Z Z
t t
f (s)dB(s, !) = B(t, !)f (t) B(s, !)df (s).
0 0