Stochastic Calulus

Stochastic Calculus and Itô’s
Lemma
In this lecture. . .
• The meaning of Markov and martingale
• Brownian motion
• Stochastic differential equations
• Itô’s lemma
Certificate in Quantitative Finance

1
By the end of this lecture you will be able to
• understand where Brownian motion and diffusion processes

come from
• manipulate functions of random variables

2
Introduction
Stochastic calculus is very important in the mathematical mod-

eling of financial processes. This is because of the underlying
(assumed) random nature of financial markets.

3
Stochastic calculus: A motivating example
Toss a coin. Every time you throw a head you receive $1, every
time you throw a tail you pay out $1. In the experiment below
the sequence was THHTHT, and you finished even.
0
0 1 2 3 4 5 6 7
-1
-2

4
• Ri denotes the random amount, either $1 or -$1, you make
on the ith toss:
E[Ri] = 0, E[Ri2] = 1 and E[RiRj ] = 0.
In this example it doesn’t matter whether or not these expecta-

tions are conditional on the past. In other words, if you threw
five heads in a row it does not affect the outcome of the sixth
toss.
• Introduce Si to mean the total amount of money you have

won up to and including the ith toss so that
i

Si = Rj .
j=1
Later on it will be useful if we have S0 = 0, i.e., you start
with no money.

5
If we now calculate expectations of Si it does matter what in-
formation we have. If we calculate expectations of future events
before the experiment has even begun then
E[Si] = 0 and E[Si2] = E[R1

2 + 2R R + · · ·] = i.
1 2
On the other hand, suppose there have been five tosses already,
can we use this information and what can we say about expec-
tations for the sixth toss?
• This is the conditional expectation.
The expectation of S6 conditional upon the previous five tosses

gives
E[S6|R1, . . . , R5] = S5.

6
The Markov property
• The distribution of the value of the random variable Si con-

ditional upon all of the past events only depends on the
previous value Si−1. This is the Markov property.
We say that the random walk has no memory beyond where it is

now. Note that it doesn’t have to be the case that the expected
value of the random variable Si is the same as the previous value.
This can be generalized to say that given information about Sj

for some values of 1 ≤ j < i then the only information that is of
use to us in estimating Si is the value of Sj for the largest j for
which we have information.

7
The martingale property
The coin tossing experiment possesses another property that can

be important in finance. You know how much money you have
won after the fifth toss. Your expected winnings after the sixth
toss, and indeed after any number of tosses if we keep playing,
is just the amount you already hold.
• The conditional expectation of your winnings at any time in

the future is just the amount you already hold:
E[Si|Sj , j < i] = Sj .
This is called the martingale property.

8
Quadratic variation
The quadratic variation of the random walk is defined by

i
2
Sj − Sj−1 .
j=1
Because you either win or lose an amount $1 after each toss,
|Sj − Sj−1| = 1. Thus the quadratic variation is always i:
i
2
Sj − Sj−1 = i.
j=1
We are going to use the coin-tossing experiment for one more

demonstration. And that will lead us to a continuous-time ran-
dom walk.

9
Brownian motion
Change the rules of the coin-tossing experiment slightly.
First of all restrict the time allowed for the six tosses to a period
t, so each toss will take a time t/6. Second, the size of the bet
will not be $1 but t/6.
This new experiment clearly still possesses both the Markov and
martingale properties, and its quadratic variation measured over
the whole experiment is
 2
6
2 t
Sj − Sj−1 = 6 ×  = t.
j=1 6

10
Change the rules again, to speed up the game.
• We
will have n tosses in the allowed time t, with an amount
t/n riding on each throw.
Again, the Markov and martingale properties are retained and

the quadratic variation is still
 2
n
2 t
Sj − Sj−1 = n ×  = t.
j=1 n
Now make n larger and larger. This speeds up the game, de-
creasing the time between tosses, with a smaller amount for each
bet. But the new scalings have been chosen very carefully, the
time step is decreasing like n−1 but the bet size only decreases
by n−1/2.

11
1.2
0.8
0.6
0.4
0.2
0
0 0.2 0.4 0.6 0.8 1
-0.2
-0.4
-0.6
-0.8
-1
A series of coin tossing experiments.

12
As we go to the limit n = ∞, the resulting random walk stays
finite. It has an expectation, conditional on a starting value of
zero, of
E[S(t)] = 0
and a variance
E[S(t)2 ] = t.
We use S(t) to denote the amount you have won or the value of
the random variable after a time t.
• The limiting process for this random walk as the time steps
go to zero is called Brownian motion, and we will denote it
by X(t).

13
The important properties of Brownian motion are as follows.
• Finiteness: Any other scaling of the bet size or ‘increments’

with time step would have resulted in either a random walk
going to infinity in a finite time, or a limit in which there was
no motion at all. It is important that the increment scales
with the square root of the time step.
• Continuity : The paths are continuous, there are no disconti-

nuities. Brownian motion is the continuous-time limit of our
discrete time random walk.
• Markov : The conditional distribution of X(t) given informa-

tion up until τ < t depends only on X(τ ).

14
• Martingale: Given information up until τ < t the conditional
expectation of X(t) is X(τ ).
• Quadratic variation: If we divide up the time 0 to t in a

partition with n + 1 partition points ti = i t/n then
n
2
X(tj ) − X(tj−1) → t. (Technically ‘almost surely.’)
j=1
• Normality : Over finite time increments ti−1 to ti, X(ti ) −

X(ti−1) is Normally distributed with mean zero and variance
ti − ti−1.

15
Having built up the idea and properties of Brownian motion from
a series of experiments, we can discard the experiments, to leave
the Brownian motion that is defined by its properties. These
properties will be very important for our financial models.

16
Very Important Notation
We have seen X as the ‘end result’ of a random walk, up to

some time t.
We will often work with the amount by which X changes from

moment to moment.
• Think of dX as being an increment in X, i.e. a Normal ran-

dom variable with mean zero and standard deviation dt1/2.

17
Functions of stochastic variables and Itô’s lemma
Now we’ll see the idea of a function of a stochastic variable.

Below is shown a realization of a Brownian motion X(t) and the
function F (X) = X 2.
0.35
0.3
Brownian motion
0.25 Square of Brownian motion
0.2
0.15
0.1
0.05
0
-0.05 0 0.1 0.2 0.3 0.4 0.5
-0.1
-0.15
-0.2

18
Whenever we have functions of a variable it is natural to want
to know how to differentiate and manipulate these functions.
What are the rules of calculus when variables are stochastic?

19
The first point to note is that in the stochastic world we really
have two ‘variables.’
These are time t and the Brownian motion X.

20
We are used to writing ordinary and partial differential equations
in the form
dF
d·
or
∂F
∂·
where the quantities on the bottom are the independent vari-

ables.
So might expect something similar in the stochastic world.

21
We immediately hit a problem, however.
√
Because dX is of size dt it is much bigger than dt.
This means that we have to be careful whenever we think about

gradients/slopes/derivatives/sensitivities, since these are limits
as dt goes to zero.

22
For this reason, in the stochastic world we instead work with
stochastic differential equations.
These take the form
dF = · · · dt + · · · dX.

23
So, what are the rules of calculus?
Since X is stochastic, so is F , and we can ask ‘what is the

stochastic differential equation for F ?’
If F (X) = X 2 what is the equation for dF ?

24
If F = X 2 is it true that dF = 2X dX?
No.
• The ordinary rules of calculus do not generally hold in a

stochastic environment.
Then what are the rules of calculus?

25
We are going to throw caution to the wind, pretend that there
are no problems or subtleties, use Taylor series. . . and see what
happens!

26
Taylor Series . . . and Itô
If we were to do a naive Taylor series expansion of F , com-

pletely disregarding the nature of X, and treating dX as a small
increment in X, we would get
dF 1 d2F 2
F (X + dX) = F (X) + dX + 2 2
dX ,
dX dX
ignoring higher-order terms.
We could argue that F (X + dX) − F (X) was just the ‘change in’
F and so
dF d2F
dF = dX + 1 dX 2.
dX 2 dX 2
This is almost correct.

27
Because of the way that we have defined Brownian motion, and
have seen how the quadratic variation behaves, it turns out that
the dX 2 term isn’t really random at all.
The dX 2 term becomes (as all time steps become smaller and
smaller) the same as its average value, dt.

28
Taylor series and the ‘proper’ Itô are very similar. The only
difference being that the correct Itô’s lemma has a dt instead of
a dX 2.

29
• You can, with little risk of error, use Taylor series with the
‘rule of thumb’
dX 2 = dt.
and in practice you will get the right result.
Let’s get some intuition now, and then shortly we will do Itô’s
lemma properly!

30
We can now answer the question, “If F = X 2 what is dF ?” In
this example
dF d2F
= 2X and 2
= 2.
dX dX
Therefore Itô’s lemma tells us that
dF = dt + 2X dX.
This is an example of a stochastic differential equation.

31
Stochastic differential equations
Stochastic differential equations are used to model random quan-

tities, a stock price for example.
They have two parts to them, a deterministic and a random.

32
Suppose we want to model a stock price as a random quantity.
Let’s use S to denote that stock price.
A stochastic differential equation for S would look something like

this:
dS = Deterministic + Random .
In words: “The change in the stock price has a predictable com-

ponent and a random component.”

33
More precisely
dS = Something dt + Something else dX.
The randomness is captured by the dX term.
But what are these ‘somethings’ ?

34
In the standard models they would be functions of S and time,
t.
dS = f (S, t) dt + g(S, t) dX.
The function f (S, t) captures how the predictable bit of the stock
model varies with S and t and the g(S, t) function captures the
randomness.

35
dS = f (S, t) dt + g(S, t) dX.
We sometimes call the f (S, t) function the growth rate or the

drift.
The g(S, t) is related to the volatility of S.

36
Some pertinent examples
The first example simple Brownian motion but with a drift:
dS = µ dt + σ dX.
0.3
0.25
0.2
0.15
0.1
0.05
0
0 0.2 0.4 0.6 0.8 1
-0.05
-0.1
-0.15
In this realization S has gone negative.

37
Our second example is similar to the above but the drift and
randomness scale with S:
dS = µS dt + σS dX.
3.5
2.5
1.5
0.5
0
0 0.2 0.4 0.6 0.8 1
If S starts out positive it can never go negative; the closer that

S gets to zero the smaller the increments dS.

38
The third example is
dS = (ν − µS)dt + σ dX.
1.2
0.8
0.6
0.4
0.2
0
0 0.2 0.4 0.6 0.8 1

39
The random walk
dS = (ν − µS)dt + σ dX
is an example of a mean-reverting random walk.
If S is large, the negative coefficient in front of dt means that

S will move down on average, if S is small it rises on average.
There is still no incentive for S to stay positive in this random
walk.
With r instead of S this random walk is the Vasicek model for

the short-term interest rate.

40
The final example is similar to the third but we are going to
adjust the random term slightly:
dS = (ν − µS)dt + σS 1/2 dX.
Now if S ever gets close to zero the randomness decreases, per-

haps this will stop S from going negative?
This particular stochastic differential equation for S will be im-

portant later on, it is the Cox, Ingersoll & Ross model for the
short-term interest rate.

41
And now for Itô’s lemma done properly!
Our goal is to justify the short cut of using dX 2 = dt and to

show some generalizations.

42
Stochastic integration
Define a stochastic integral by

t n

W (t) = f (τ ) dX(τ ) = lim f (tj−1 ) X(tj ) − X(tj−1)
0 n→∞
j=1
with
jt
tj = .
n
• Note that the function f (t) is evaluated in the summation at

the left-hand point tj−1.

43
It will be crucially important that each function evaluation does
not know about the random increment that multiplies it, i.e. the
integration is non-anticipatory.
In financial terms, we will see that we take some action such as

choosing a portfolio and only then does the stock price move.
This choice of integration is natural in finance, ensuring that we
use no information about the future in our current actions.

44
Stochastic differential equations again
Stochastic integrals are important for any theory of stochastic

calculus since they can be meaningfully defined. However, it is
very common to use a shorthand notation for expressions such
as

t
W (t) = f (τ ) dX(τ ).
0
That shorthand comes from ‘differentiating’ this and is
dW = f (t) dX.
• Think of dX as being an increment in X, i.e. a Normal ran-

dom variable with mean zero and standard deviation dt1/2.

45
Pursuing this idea further, imagine what might be meant by
dW = g(t) dt + f (t) dX.
• Equations like this are called stochastic differential equa-

tions. Their precise meaning comes, however, from the tech-
nically more accurate equivalent stochastic integral.
This equation above is shorthand for

t
t
W (t) = g(τ ) dτ + f (τ ) dX(τ ).
0 0

46
The mean square limit
This is useful in the precise definition of stochastic integration.
Examine the quantity

 2 
n
 
E (X(tj ) − X(tj−1 ))2 − t 
j=1
where
jt
tj = .
n

47
This can be expanded as

n

E (X(tj ) − X(tj−1 ))4
j=1
n

+2 (X(ti ) − X(ti−1))2(X(tj ) − X(tj−1))2
i=1 j<i

n

−2t (X(tj ) − X(tj−1))2 + t2 .
j=1
Since X(tj )−X(tj−1 ) is Normally distributed with mean zero and
variance t/n we have
t
2
E (X(tj ) − X(tj−1 )) =
n
and
3t2
4
E (X(tj ) − X(tj−1)) = 2.
n
48
Thus the required expectation becomes

3t2 t2 t 1
n 2 + n(n − 1) 2 − 2tn + t2 = O .
n n n n
As n → ∞ this tends to zero. We therefore say that
n

(X(tj ) − X(tj−1))2 = t
j=1
in the ‘mean square limit.’ This is often written, for obvious

reasons, as

t
(dX)2 = t.
0
Whenever we talk about ‘equality’ in the following ‘proof’ we

mean equality in the mean square sense.

49
Functions of stochastic variables and Itô’s lemma
We now derive the most important tool of stochastic calculus,

Itô’s lemma.
We will have a function of X, F (X), and derive the equation for

dF .

50
In this derivation we will need various timescales.
The first timescale is very, very small. Denote it by
δt
= h.
n
This timescale is so small that the function F (X(t + h)) can be

approximated by a Taylor series:
dF
F (X(t + h)) − F (X(t)) = (X(t + h) − X(t)) (X(t)) +
dX
2
1 (X(t + h) − X(t))2 d F (X(t)) + · · · .
2 dX 2

51
From this it follows that
(F (X(t + h)) − F (X(t))) + (F (X(t + 2h)) − F (X(t + h))) + · · ·
+ (F (X(t + nh)) − F (X(t + (n − 1)h)))
n
dF
= (X(t + jh) − X(t + (j − 1)h)) (X(t + (j − 1)h))
j=1 dX
2F n

d 2
+1
2 dX 2 (X(t)) (X(t + jh) − X(t + (j − 1)h)) + ···.
j=1
This has used the approximation
d2F d2F
2
(X(t + (j − 1)h)) = 2
(X(t)).
dX dX
This is consistent with the order of accuracy we require.

52
The first line in this becomes simply
F (X(t + nh)) − F (X(t)) = F (X(t + δt)) − F (X(t)).
The second is just the definition of

t+δt
dF
dX
t dX
and the last is
2
1 d F (X(t))δt,
2 dX 2
in the mean square sense. Thus we have

t+δt
dF
F (X(t + δt)) − F (X(t)) = (X(τ ))dX(τ )
t dX

t+δt 2
d F
+1
2 t 2
(X(τ ))dτ.
dX

53
We can now extend this result over longer timescales, from zero
up to t, over which F does vary substantially to get

t
t 2
dF d F
F (X(t)) = F (X(0)) + (X(τ ))dX(τ ) + 1
2 2
(X(τ ))dτ.
0 dX 0 dX
This is the integral version of Itô’s lemma, which is usually

written as
dF d2F
dF = dX + 1
2 dX 2 dt.
dX

54
Suppose our stochastic differential equation is
dS = a(S)dt + b(S)dX,
say, for some functions a(S) and b(S).
Now if we have a function of S, V (S), what stochastic differential

equation does it satisfy?
The answer is
dV 2
1 2d V
dV = dS + 2 b 2
dt.
dS dS
We could derive this properly or just cheat by using Taylor series

with dX 2 = dt.

55
Itô in higher dimensions
In financial problems we often have functions of one stochastic

variable S and a deterministic variable t, time: V (S, t). If
dS = a(S, t)dt + b(S, t)dX,
then the increment dV is given by
∂V ∂V 1 2 ∂ 2V
dV = dt + dS + 2 b dt.
∂t ∂S ∂S 2
Again, this is shorthand notation for the correct integrated form.

56
The example we will be seeing a lot of is the sde commonly used
to model an equity price
dS = µS dt + σS dX,
with V (S, t) being the value of an option. The sde for V (S, t) is
then
∂V ∂V 2
1 2 2∂ V
dV = dt + dS + 2 σ S 2
dt.
∂t ∂S ∂S
Remember this!

57
Occasionally, we have a function of two, or more, random vari-
ables, and time as well: V (S1, S2, t).
Let’s write the behaviour of S1 and S2 in the general form
dS1 = a1(S1, S2, t)dt + b1(S1, S2, t)dX1

and
dS2 = a2(S1, S2, t)dt + b2(S1, S2, t)dX2 .
Note that we have two Brownian increments dX1 and dX2. We
can think of these as being Normally distributed with variance
dt, but they are correlated.
The correlation between these two random variables we will call

ρ. This can also be a function of S1, S2 and t but must satisfy
−1 ≤ ρ ≤ 1.

58
• The ‘rules of thumb’ can readily be imagined:
dX12 = dt, dX22 = dt and dX1dX2 = ρ dt.
Itô’s lemma becomes

∂V ∂V ∂V
dV = dt + dS1 + dS2 +
∂t ∂S1 ∂S2
∂ 2V ∂ 2V ∂ 2V
1 b2 dt + ρb b dt + 1 b2
1
2 ∂S 2 1 2
∂S ∂S 2 2 ∂S 2 dt.
1 1 2 2

59
Summary
Please take away the following important ideas
• Functions of random variables can’t be differentiated in quite

the same way as functions of deterministic variables.
• Instead of using Taylor series you must use Itô’s lemma.

However, they are very similar and a simple rule of thumb
can usually be used to get from Taylor to Itô.

60

Stochastic Calulus

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Stochastic Calculus and Itô’s

• The meaning of Markov and martingale

• Stochastic diﬀerential equations

Certiﬁcate in Quantitative Finance

• understand where Brownian motion and diﬀusion processes

• manipulate functions of random variables

Certiﬁcate in Quantitative Finance

Stochastic calculus is very important in the mathematical mod-

Certiﬁcate in Quantitative Finance

Certiﬁcate in Quantitative Finance

In this example it doesn’t matter whether or not these expecta-

• Introduce Si to mean the total amount of money you have

Certiﬁcate in Quantitative Finance

E[Si] = 0 and E[Si2] = E[R1

• This is the conditional expectation.

The expectation of S6 conditional upon the previous ﬁve tosses

Certiﬁcate in Quantitative Finance

• The distribution of the value of the random variable Si con-

We say that the random walk has no memory beyond where it is

This can be generalized to say that given information about Sj

Certiﬁcate in Quantitative Finance

The coin tossing experiment possesses another property that can

• The conditional expectation of your winnings at any time in

This is called the martingale property.

Certiﬁcate in Quantitative Finance

The quadratic variation of the random walk is deﬁned by

We are going to use the coin-tossing experiment for one more

Certiﬁcate in Quantitative Finance

Change the rules of the coin-tossing experiment slightly.

Certiﬁcate in Quantitative Finance

Again, the Markov and martingale properties are retained and

Certiﬁcate in Quantitative Finance

A series of coin tossing experiments.

Certiﬁcate in Quantitative Finance

Certiﬁcate in Quantitative Finance

• Finiteness: Any other scaling of the bet size or ‘increments’

• Continuity : The paths are continuous, there are no disconti-

• Markov : The conditional distribution of X(t) given informa-

Certiﬁcate in Quantitative Finance

• Quadratic variation: If we divide up the time 0 to t in a

• Normality : Over ﬁnite time increments ti−1 to ti, X(ti ) −

Certiﬁcate in Quantitative Finance

Certiﬁcate in Quantitative Finance

We have seen X as the ‘end result’ of a random walk, up to

We will often work with the amount by which X changes from

• Think of dX as being an increment in X, i.e. a Normal ran-

Certiﬁcate in Quantitative Finance

Now we’ll see the idea of a function of a stochastic variable.

Certiﬁcate in Quantitative Finance

What are the rules of calculus when variables are stochastic?

Certiﬁcate in Quantitative Finance

These are time t and the Brownian motion X.

Certiﬁcate in Quantitative Finance

where the quantities on the bottom are the independent vari-

So might expect something similar in the stochastic world.

Certiﬁcate in Quantitative Finance

This means that we have to be careful whenever we think about

Certiﬁcate in Quantitative Finance

These take the form

Certiﬁcate in Quantitative Finance

Since X is stochastic, so is F , and we can ask ‘what is the

If F (X) = X 2 what is the equation for dF ?

Certiﬁcate in Quantitative Finance