Stochastic Calculus and Itô’s lemma

Throughout this problem sheet, you may assume that Wt is a Brownian Mo-
tion (Wiener Process) and dWt is its increment; and W0 = 0: SDE is Stochastic
Di¤erential Equation.

1. Let be a random variable which follows a standardised normal distribution,

i.e. N (0; 1) :
Calculate the
p expected value and variance given by E [ ] and V [ ] ; in turn,
where = dt : dt is a small time-step. Note: No integration is required.

2. Consider the following examples of SDEs for a di¤usion process G. Write these
in standard form, i.e.

dG = A(G; t)dt + B(G; t)dWt :

Give the drift and di¤usion for each case.

p
a. df + dWt dt + 2 tf dt + 2 f dWt = 0
dy
b. = (A + By) dt + (Cy) dWt
y
c. dS = ( S)dt + dWt + 4dS

3. Use Itô’s lemma to obtain a SDE for each of the following functions:

a. f (Wt ) = (Wt )n
b. y (Wt ) = exp (Wt )
c. g (Wt ) = log Wt
d. h (Wt ) = sin Wt + cos Wt
e. f (Wt ) = aWt ; where the constant a > 1

4. Using the formula below for stochastic integrals, for a function F (Wt ; t) ;
Z t Z t
@F @F 1 @2F
dW = F (Wt ; t) F (W0 ; 0) + d ;
0 @W 0 @ 2 @W 2

show that we can write

1
 a. Z t Z t
1 3
W dW = Wt4
3
W 2d
0 4 2 0

b. Z t Z t
dW = tWt W d
0 0
c. Z t Z t
1 1
(W + ) dW = Wt2 + tWt W + d
0 2 0 2

5. Consider the linear parabolic partial di¤erential equation

@u @2u @u
= 2
+a + bu;
@t @x @x
for the function u (x; t) ; where a and b are constants. By using a substitution
of the form
u (x; t) = e x+ t v (x; t) ;
and suitable choice of and ; show that the PDE can be reduced to the heat
equation
@v @2v
= :
@t @x2