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The It Integral o
The following chapters deal with Stochastic Differential Equations in Finance. References: 1. B. Oksendal, Stochastic Differential Equations, Springer-Verlag,1995 2. J. Hull, Options, Futures and other Derivative Securities, Prentice Hall, 1993.
1.
Technically,
2.
3. If
Quadratic variation is a measure of volatility. First we will consider rst variation, . function
F)
153
`sF0d
X usF6
eyixsie
QR6PHI#76)GF9#E
d X uvsie
cV'WI`b`b`aWYX'WDUVT6S#
is given, always in the background, even when not explicitly mentioned. , has the following properties: ,
89#76)5# F
, of a
154
f(t)
t2 t1 T t
For the function pictured in Fig. 14.1, the rst variation over the interval
`v5&t% $ieE#2dt Fe 6 !" D yiX) d) eG ! d yi5#) d)XeG !R6h U
Thus, rst variation measures the total amount of up and down motion of the path. The general denition of rst variation is as follows:
)
be a partition of
`P16
Suppose is differentiable. Then the Mean Value Theorem implies that in each subinterval there is a point such that
` xsF dX u sFg Ps
y X u st st !
'
xsteG
dw X u sieG
'
X p c
We then dene
1 E@EGF E@E
yi
0%#$!
)
y%#$!
dG
) !
F)
. is given by:
!
H c %`g`f`g X U fA
c
WI`b`b`aW
a6) st)
7Is U H
X 'W
2"CDB
` 6
'
6
U 6#
d)CX u sF)
6)h
tee
'"'
'"'
AU
'(U
6
, i.e.,
D
s PQ
16)Pb
Theorem 3.44
`9#a6 U
'"' )
'"'
U
1E
EG EF E 2"C B
6
'
xst dX u st Ps
' U 78s U H
X p c
EG EF E '"' 2"C B ` )
'"'
U
1E
EG EF E 2"C B
W
bV
'
xst0d X u sie Ps e
'
U
'
7Is '"' H ` )
'"'
W
X p c Ps e
'
6 xst d)X u st
'
U
xst0d
X u sie
#
' U 78s H
X p c
6
fi
'
` xst d)CX u sie
' U 7Is U H
X p c
1 E@E
2CB
F E@E
6
"#$!
'
`
'
U teE
U
'
xst d X uvst Ps
'
78s U H
1E
EG EF E 2"C B
6)h
AU
X p5c
'
Cxsi d X usF Ps
'
6 xsieG dw X uvsteG
' U 78s H
X p c
' U 78s H
Then
X p5c
or more precisely,
7Is H
# X p c
` QR6YHS
A
@3
and Remark 14.1 (Quadratic Variation of Differentiable Functions) If is differentiable, then , because
155
'"'
`Y@`
'"'
#
W
P d d
F F
"3
g
9#76)P
rq 3
''
`Y U gst d X u st
) )
'' ''
6 W
7s ' ' H
!
X p c U"7Is s 0d X u s
6
6)
q3
y s
X u s e
s
d
X u s
d
s 0d
X u s e" !
y xst0d
X u sFT
fsF0dX u st"
d s d s
!q 3
yibsF
dX u sie
3
!C d
s
X u s
`9#76 yibsF d
X usF
78s H
q 376
q3
X p c
`gfsF
dX u std
ytfsF
dvX u sF
!
6)xst
dX u st d
`"#T6
`tyi sF0d
X usF
7Is H
6 d
Then
X p c
` s
7Is H
6
H cE%`b`b`b X5UVfA 6
X p5c
6Bs
%#$!
156
1 E@EGF E@E
2"CDB
s e
d) X uvs e
For
, the terms
and
0d
X u
are independent, so
(if
X p c U"7Is
H
6 X p c U"7Is
H
6 X p c U"7Is
H
X p c
6)P d
3
b
157
When
is small,
As we increase the number of sample points, this approximation becomes exact. In other words, Brownian motion has absolute volatility 1. Furthermore, consider the equation
`%#
This says that quadratic variation for Brownian motion accumulates at rate 1 at all times along almost every path.
16 cV
`v5
6 y %t X
W `f`b`TW
v
6)F
Q
F
X 'WBUi
d w
16) b
b
6hytfsF0d
`"#T6)P d
X u st
st
F sF
d X u st
dw X u ste
X uvs e
X !
!g
3
s
X us
'"'
'"'
As
#'1P d
3
f
, so
158
every set in
cV WI`b`b`aW t
is also in ,
,
X p cV d)IcV %`g`f`gC X d) Cie
2.
is
-measurable,
F
The integrand is 1. 2. is
F te
-measurable
is square-integrable:
U q3
This wont work when the integrator is Brownian motion, because the paths of Brownian motion are not differentiable.
Let
be a partition of
, i.e.,
`P16 ci
The functions
and
Think of
`P%
$ e#
F)
y X uvstIsF !
&
WI`b`b`aWPX'WBUi6#
F
$
6)" )V$
9#$!
, the increments .
Cte
dw X e
# te
F
, and the
6)Fh3
"
U
s e
H c 9`b`b`b X U gA
te
t
t
F
X 'W2
6F'W
F 6
an
#
G"
U
6ie
G
C"
$
6)th3
F0
F 3x
`tyixst
d)F
!ggste
yi
dw X u
7 H
!g
X pCs
W 'W
'W
X
i y
e
d wie
!
e
i X y
y ti X
d )
e
! X ! C X
i U y ibi y U
ty bUV
d ) X d ) X
! U ! bV U
d )te
X
W 'W
#
U U 7 7
d)F F 3
! bUV
X u sF
st
cV `b`f`gCX5Ui
bste
Linearity If
In general, if
then Think of
t
" !te 3
0=t0
( t ) = ( t ) 0
can be interpreted as the gain from trading at time ; this gain is given by:
t1
( t ) = ( t 1 )
is
-measurable.
6)te 3
( t ) = ( t 2 )
t2
( t )= ( t 3 )
t3
t4 = T
yi
'
d)
! e
d yE
X u
!rq 3 e U
7 H
6S
i
d) X u
g
q 3
U"7
H
q3
`
e
d) X u
b
d X u
7 H
f
X pt
X pt
yi sF
d)F
!Cxsie
yV e
d) X u
!C
yie
d) X uV
!
yt
d) X u
X uvsi
W'W
`
0
6 th3
160
and
be given. We treat the more difcult case that and Proof: Let subintervals, i.e., there are partition points and such that and Fig. 14.3).
st
iyixste
d)F
!gfsF
yi
d) X u
7 H
6)th3
!C
X p s
th3
is a martingale.
Martingale
is a martingale.
t l+1
.....
k+1
y X u s s !
y X uEC !'
s
X u
X pCs
7 H
6 F3
!C
X pt
W#
Write
$ 5
U
7 H
s
q 3a6
q 3a6 U
$
7 H
s
0d
X u
b q 3
x
q3
F
d)X u
U q3 s U s
7 H
7 H
6)tefI3 q3
!q 3
y
d) X u
!g
$"
q 3a6 te 3
xte s
U " 7
'
t
! q gF 3 s
d Vft y s
q a6 3
d yi
U 7 ' X u
!
q 3
X uV
7 H
e
q3
X p s X u
d X u
7 H
6
f
q3
q3
X pCs
7 H
s
7 H
s
e
6)te 3
U"7
H
6)te 3
st6)
q3
xte s
d )F
s b F
q3
F
d) X u
X u
7 H
b
e
X pCs
Each
, so
q3
162
path of 4
path of
0=t0
t1
t2
t3
t4 = T
, over
y%#$!
such that
`%#a6)5
7 c H%c
F c
'
$Fc
d)te c
1 2"CDB c
'
6F
6)P c3
%# !
q3
$te
1 2"C B c
"
F
F
te
#'
q3
163
The only difculty with this approach is that we need to make sure the above limit exists. Suppose and are large positive integers. Then
has a limit.
is
-measurable.
Martingale. Continuity.
It Isometry. o
`C
0
&'%$#!"
and
G"
#
then
6 t
F
'
d)t
5
'
t
'
G
q3
die
##
'
6ie
7 c Hv c3 A
'
'
t
t
$"
dwie c
d)Fhc
C"
6)th3
'
'
$
6)th3
" !te 3
(It Isometry:) o
6
F
#yiF
yiF
dwie c
dwt c
! !
U
$"
F
q 35
q 3a6 q3 q3
!
6)th3
U
te 3
# !
q 3T6)F 3
d
c 3
W Fh3 q3
Fh3
&
D
i ' FD
$
E hD X
i ' hD D p E hD p T i ' FD T p
E hD
E hD
H ' % 3q
X p
X D p s
E hD
H ' % 32 H ' % 32
p T p T p
E ts
E hD
H ' % (&
H ' ' % 32
&
i ' FD
E hD
H ' ' % rq
H ' % 32
EhD
X ' ihp D
E hD
X i ' hD
E FD
' iFD
$
d eQ
&
IGc
abD
Q `
I G YS
X CQ
VWUI S T G
Q R
IPGH EFD
H '3%&
!
)4'3%2 #
%# !
164
T/4
2T/4
3T/4
with
if
&
%
so
H '3%2
, over
165
Therefore,
or equivalently
p
$
Then
6)Fg 3
` Y
$"
6 P
but
q3
#T6
6)th3
&"
q3
comes from the nonzero quadratic variation of Brownian motion. It has to be (It integral is a martingale) o
$
E#" G
d )Y
` CP X
"
6)"
6w
)V$ )
term) If
is differentiable with
#T6G5#)
&
'
X
p p '
Let
, then
&
I G Q
V WT I S G
p
D
H ' ' % 32
hD E
i ' hD p
E FD X
p p
X ' p
p
' p
I G
D
X
' ihD X RQ
V `T I c G
EhD
IPGS EFD @
H '(%&
$" f
''
''
) 1 d d9d9d%dVd 1
U
xsi d
$
5
78s H
6 U
X p5c
X u sFbxsie
'"'
78s H
6)tf 3V
It follows that
X p c
'"'
`C sF
X usFbbst
1d9d"d%d d #'1
yt
d) X u
!
U X p
h3 !
H bsF
U X p
yi
7 H
h3
d X u
6) stf 3V
d) X uvsteg 3i
so
yi
d)CX u
! gsF
"
$bst
6)
dw X u
h3
` X u st 6 H
W `b`b`aW X
WBU
6Pst bstf 3V
9`b`b`bbX
fU
dwX u stg 3V
U"7Is
`Iyi sFb 3V
d X u sFg 3V !
H
X p c
6)ib 3V
X usF'W WBst fst
62F
`v5$F
t
This holds even if is not an elementary process. The quadratic variation formula says that at each time , the instantaneous absolute volatility of is . This is the absolute volatility of the ) in the Brownian motion. Informally, Brownian motion scaled by the size of the position (i.e. we can write the quadratic variation formula in differential form as follows:
cVT6G
6 Fh3
$F 3
F
Then Let us compute 166 . Let be the partition for , i.e., . We have be a partition
Chapter 15
It s Formula o
15.1 It s formula for one Brownian motion o
We want a rule to differentiate expressions of the form , where is a differentiable function. If were also differentiable, then the ordinary chain rule would give
Ct "G ` t ) F
However, is not differentiable, and in particular has nonzero quadratic variation, so the correct formula has an extra term, namely,
5 F E
This is It s formula in differential form. Integrating this, we obtain It s formula in integral form: o o
`
Remark 15.1 (Differential vs. Integral Forms) The mathematically meaningful form of It s foro mula is It s formula in integral form: o
`
167
$"
$"
V
V
X
X
t
te
t
$
$
ie
awt 6
Va6
a6F
V#
V#
$F
)
E#T6
Gi
6)5#
6 5#
U
te
d)te
d)te
)V
F
168 This is because we have solid denitions for both integrals appearing on the right-hand side. The rst,
is a Riemann integral, the type used in freshman calculus. For paper and pencil computations, the more convenient form of It s rule is It s formula in differo o ential form:
There is an intuitive meaning but no solid denition for the terms and appearing in this formula. This formula becomes mathematically respectable only after we integrate it.
Let
In the general case, the above equation is only approximate, and the error is of the order of . The total error will have limit zero in the last step of the following argument.
)
Fix
and let
X
be a partition of
d X uvs"
s fF
e@ ixt y s
` t F y s
d ) X vt u s
d w X F u s
09# !
gs e#xs
X p c
7 s H
U 78s ! H
#
p X 5c
t s
t F y s
y s ifF
6) V
X uvs"
y s Vfixt
d ) X vt u s
6)xs" )
#
d G X u t s
#
d ) X vt u s
X
d) X uvs" )
! xt s
d
d)
)$!
U
Consider
, so that
is a quadratic function.
F
Ct
`
$F
)V
F
$"
&"
V
$F
%
U
T6 t
)V X U U 6 X p c p X 5c p X 5c
7 8s H
7 8s H
7 8s H
" 6 6 6 6
X u s s" #'
` "
G
U
$"
#E
6)F
CF
$t
5
d 6 X X 5 a6
X t v)E 6t
F
$
` "
6 B
6 D
X
"
B
X
"
GF
5A
#
6)t
` X
" )
X
e@ U
"
X
"
$
V
P g
U
G"
&"
6)5#
d)P
) # 1
We let
'"' )
'"'
Dene
# 0F
6t
# 0F
X
"
`CF
)a6)F
5A
#E
6) eG
According to It s formula, o
so
Then where
and
to obtain
are constant.
169
170
on
is
As , the above approximation becomes exact. In other words, the instantaneous relative volatility of is . This is usually called simply the volatility of .
$"
` t
X
t
y s ibF
# 0te
d )X u t s
6t
X p c
U 78s X H
0 X !
Fix volatility of
. Let
be a partition of
$te
0 X @!
t
t
# 0te
H9ci"`f`g`f5UVbA
"
$"
G
6 te
6)F
6 t
$F
is differentiable with
$
$"
U
$
6F
U
#
t
6 t
6wte
W
. In differential notation,
F
W0#
171
can be random, but must be adapted. The investor nances his investing by borrowing or lending at interest rate .
5 yiF
Risk premium
Equating the
coefcients, we obtain:
(where
and
) which simplies to
If an investor starts with and uses the hedge for all , and in particular, .
F
6)F
`C
6P
6 P
"
e
5#
F
%#E
e
i
t
` F
t
for all , we equate coefcients in their differentials. Equating the -hedging rule:
# y
A hedging portfolio starts with some initial wealth time tracks . We saw above that
ie
5
Value of an option. Consider an European option which pays the value of this option at time if the stock price is is option at each time
6 F
`Ct
Aytt
t
t
ie
P
d)t
yiie
`CF
F
0t
d F
! 6
t
t
#
#
#
!R6t
#F
F
te
6 te
t
0te
te
%# !
v
v
6t
t
6)t
e
5
v
6)t
Let
t
at each
6)t
q3 #
2"C B
F
"6
!6t
q3
!6
d # G5
t
q3
` CbQ
F
te
` %
6
q3
q3
6
F 6 )t
q3
Ct
q3
d %
6 F
q3
d
q3
q3
# #
6 F
q3
`
$"
5#E
6)i
ie 5$F
$t ! F
F
5&t
$t !
d 5$F
&t
d d
$t
F
$t
5$F
d
F
$te
5 F
$F
$ie
%
X
#F
$t
te
6 "
t
F U
`
$"
5#E
6)i
#
Cie
$t
% te
6)F
Differentiation yields
F
Integration yields
6 #
dt
q3
te
6 6
V#T6 Gi16)te
"
where
We solve for
p
6)t
q3
If
Taking expectations and remembering that the expectation of an It integral is zero, we obtain o
The mean of
172
, then
and
for every . If
. This is
, then
, where
F
X p cV
d)cV
"`f`g`fCt
d X
c WI`b`f`TW X W
ie
t
H ie
p
p
# 5
# 5
` CF q3
q 3
t
q3
G%
q3
6
G%
6 )t
t
te
Ct
q3
d
d t
q 3
U
$"
q3
q3
`
$" !
!
$
d
$
F
F
Variance of
t
te
F
9`g`f`b F X
6F
G
p
p
Q Q
t
d #
G G
G
q 3 )t d
d #
p
d #
q3
q3
t
7 #
F
a #
Differentiation yields
i%s
6 q a6 3
te
q3
6)te
q3
6 F
Each
If
are independent of
For each
. , the vector increments and is and integrating the last equation, after considerable -measurable; are independent. is such that 173
#a6
q3
#'1 U
3
F
'"'
`Y `
'"'
6)fsF
st0d
X u ste
7Is H
6)
3
d X u sF
X p c sF0d X usF
yibst
dwvX u sF U !
yixsi
` yifst
d) X u sie
! yixst
d)X u st
7Is H F
q 376
X p c
q 376)
3
s !
yVbsF
d) X uvste
!IyigsF
dw X usF
!b` yt
d) X u
!xyt
d) X u e
X p c
xsF
d) X uvst
st
d X usF
78s H
X p c
3
`%#T6
q3
9#$!
H%cV `g`f`b5UVfA
#a6)t
F
`v5
6)t
F
174
However, we have:
Theorem 9.49 If
The increments appearing on the right-hand side of the above equation are all independent of one another and all have mean zero. Therefore,
!
F
6
`5yixst
d)X u sF
!IyVfst
d)X u st
7Is H
X p c
be a partition of
. For
y9# !
We compute
As
But expectation
All the increments appearing in the sum of cross terms are independent of one another and have mean zero. Therefore,
, we have
to be
, so
'"' )
'"'
175
Such processes, consisting of a nonrandom initial condition, plus a Riemann integral, plus one or more It integrals, are called semimartingales. The integrands o and can be any adapted processes. The adaptedness of the integrands guarantees that and are also adapted. In differential notation, we write
where
, for
, and
y
"
y
"
X X
H 5Q A
#
X X
C5#
y
%#)
C"
and
as decribed earlier and with all the variables lled in, this equation
` y
'
Let be a function of three variables, and let have the corresponding It formula: o
$! X
and
be semimartingales. Then we
U X x X
X
ie
b
X X
$
X X X X X Xx
XX
X X
X
and
C" `C
$ $
"
" X #
X
XX
5
#
$"
#
X X
5#E
#
6)F
6)t
X X
Ct
)a6
U
I v)
I v)V
)
Let
and