Stochastic Calculus

Brandon Lee

15.450 Recitation 3

Brandon Lee Stochastic Calculus

Brownian Motion

Defining properties of Brownian motion Zt are

1 Z0 = 0.
2 It has continuous paths.
3 It has independent increments: if t1 < t2 ≤ s1 < s2 , then
Zt2 − Zt1 and Zs2 − Zs1 are independent random variables.
4 Its increments are normally distributed: Zt2 −t1 ∼ N (0, t2 − t1 ).

Brownian motion is the continuous time analogue of random

walk in discrete time. Brownian motion is the basic building
block that we use to model uncertatinty or random
movements in our continous time finance models.

Brandon Lee Stochastic Calculus

Ito Processes

An Ito process Xt is of the form

Z t Z t
Xt = µs ds + σs dZs
0 0

or in differential form

dXt = µt dt + σt dZt

Heuristically speaking, over a very small time interval ∆, the

increment Xt+∆ − Xt has normal distribution with mean µt ∆
and variance σt2 ∆. Call µt the instantaneous drift and σt the
instantaneous volatility or diffusion coefficient.

Brandon Lee Stochastic Calculus

Ito’s Lemma
Suppose Xt is an Ito process. Ito’s Lemma states that f (t, Xt )
is an Ito process as well and shows how to compute the drift
and diffusion coefficient of df (t, Xt ).
Ito’s Lemma: Suppose
dXt = µt dt + σt dZt
then
1 ∂ 2 f (t, Xt ) 2
 
∂ f (t, Xt ) ∂ f (t, Xt ) ∂ f (t, Xt )
d (f (t, Xt )) = + µt + 2
σ t dt + σt dZt
∂t ∂ Xt 2 ∂ Xt ∂ Xt
Remember the rule
(dt)2 = o (dt)
dt · dZt = o (dt)
(dZt )2 = dt
In other words, the first two are of smaller order than dt, and
we can ignore them in Ito’s lemma.
Brandon Lee Stochastic Calculus
Example of Ito’s Lemma

Suppose
dSt
= rdt + σ dZt
St
and define Yt = f (t, St ) = e −rt St . Calculate dYt .
Use’s Ito’s lemma:
1 ∂ 2 f (t, St ) 2 2
 
∂ f (t, St ) ∂ f (t, St ) ∂ f (t, St )
dYt = + rSt + σ St dt + σ St dZt
∂t ∂ St 2 ∂ St2 ∂ St
= −re −rt St + re −rt St + 0 dt + e −rt σ St dZt

= σ Yt dZt

Why does Yt have zero drift?

Brandon Lee Stochastic Calculus

Another Example
Suppose ηt is some stochastic process. Define
 Zt Z t 2 
ηs
ξt = exp − ηs dZs − ds
0 0 2

Calculate dξt .
Rt R t ηs2
Define Xt = 0 ηs dZs + 0 2 ds. Note that

ηt2
dXt = dt + ηt dZt
2
and ξt = exp (−Xt ).
Apply Ito’s Lemma and we get

dξt = −ξt dXt + ξt (dXt )2

= −ξt ηt dZt

Practice and make sure you can do those calculations!

Brandon Lee Stochastic Calculus
Example of Multivariate Ito’s Lemma

Suppose
dXt
= µx dt + σx dZt1
Xt
dYt
= µy dt + σy dZt2
Yt
where
dZt1 · dZt2 = ρdt
Define
Xt
Mt =
Yt
dMt
What is the instantaneous volatility of Mt ?

Brandon Lee Stochastic Calculus

Continued
Xt
Let Mt = f (Xt , Yt ) = Yt . Then by Ito’s Lemma,
∂ f (Xt , Yt ) ∂ f (Xt , Yt )
dMt = dXt + dYt
∂ Xt ∂ Yt
 2
∂ 2 f (Xt , Yt ) ∂ 2 f (Xt , Yt )

1 ∂ f (Xt , Yt ) 2 2
+ (dX t ) + 2 dXt · dYt + (dYt )
2 ∂ Xt2 ∂ Xt ∂ Yt ∂ Yt2
Carry out the calculation and arrive at
dMt = Mt µx − µy − ρσx σy + σy2 dt + Mt σx dZt1 − Mt σy dZt2

dMt
= µx − µy − ρσx σy + σy2 dt + σx dZt1 − σy dZt2


Mt
Note that
dMt 2
 

2
= σx dZt1 − σy dZt2
Mt
= σx2 + σy2 − ρσx σy dt

so that instantaneous volatility of dM t

Mt is
q
σx2 + σy2 − ρσx σy
Brandon Lee Stochastic Calculus
 MIT OpenCourseWare
http://ocw.mit.edu

15.450 Analytics of Finance

Fall 2010

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