Lecture 5 MF

Lecture 5
Ito Formula
(Quadratic Variation)
Prof. Dr. Svetlozar Rachev
Institute for Statistics and Mathematical Economics

University of Karlsruhe
Mathematical Finance, 2007
Prof. Dr. Svetlozar Rachev (University of Karlsruhe) Lecture 5 Ito Formula 2007 1 / 27
Copyright
These lecture-notes cannot be copied and/or distributed without

permission.
Prof. Svetlozar (Zari) T. Rachev

Chair of Econometrics, Statistics
and Mathematical Finance
School of Economics and Business Engineering
University of Karlsruhe
Kollegium am Schloss, Bau II, 20.12, R210
Postfach 6980, D-76128, Karlsruhe, Germany
Tel. +49-721-608-7535, +49-721-608-2042(s)
Fax: +49-721-608-3811
http://www.statistik.uni-karslruhe.de
Ito Formula
Ito Formula
If M is a continuous local martingale and f is twice continuously

differentiable real-valued function on R, then
Zt Zt
0 1
f (Mt ) − f (M0 ) = f (Ms )dMs + f 00 (Ms )d[M]s
2
0 0
1
Rt
2 f 00 (Ms )d[M]s is the "new" term that differentiate, the classical
0
real analysis and the stochastic analysis;
([M]s , s ≥ 0) = Quadratic variation ("square bracket") process.
Ito Formula
Formal Definition of [M]t
Ito Formula
(Mt )t≥0 is a continuous local martingale;

(n) (n)
πt := 0 = t0,n < t1,n < . . . < tk ,n = t ∆πt := max |tj+1,n − tj,n |;
j

(n) (n)
Let πt ; n ≥ 1 be a sequence of partitions, such that ∆πt → 0
as n → ∞.
(n) (n) P 2
Define for each πt , St = Mtj+1,n − Mtj,n .
j
Ito Formula
Theorem
(n)
The sequence St converges in probability to a limit;
we call the limit "quadratic variation at time t", and denote [M]t ; as
(n) p
n → ∞, St → [M]t .
Furthermore, if Mt is L2 -bounded on [0, t], i.e.
sup E|Ms |2 < ∞
0≤s≤t
for each t, then
(n) L2
St → [M]t
and
Rt
[M]t = Mt2 − (M0 )2 − 2 Ms dMs
0
Ito Formula
Remark:
Notice that
Rt
[M]t = Mt2 − (Ms )2 − 2 Ms dMs
0
is exactly the Ito formula with
Rt 1
Rt
f (x) = x 2 : f (Mt ) − f (M0 ) = f 0 (Ms )dMs + 2 f 00 (Ms )d[Ms ]
0 0
Ito Formula
Ito Formula
Example:
If Mt = Bt is a Brownian Motion on R+ , then [M]t ≡ t.

(n)
In fact, if πt = jtn , 0 ≤ j ≤ n , denote tj,n = itn and consider
n
X 2
Stn = Btj+1,n − Btj,n
j=1
Ito Formula
Ito Formula
L2
Let us show that Stn → t, and thus, [M]t ≡ t, as the limit [M]t is
uniquely determined.
 !2 
2  n−1 
(n) P
E St − t =E ∆j,n ,
 j=0 
2
where ∆j,n = B(tj+1,n ) − B(tj,n − nt
(independent random variables), 0 ≤ j ≤ n − 1.
Next,
!2
n−1 n−1 n−1
∆2j,n + 2
P P PP
E ∆j,n =E E∆i,n ∆j,n
j=0 j=0 i=0 j<i
where for j < i,
E∆i,n ∆j,n = E E(∆i,n ∆j,n /(F )j,n ) =

= E ∆j,n E(∆i,n /Fj,n ) = E(∆j,n E∆i,n ) = 0
Ito Formula
Ito Formula
Ito Formula
Ito Formula
!2
n−1 n−1 n−1
∆2j,n = E∆2j,n , with
P P P
So, E ∆j,n =E
j=0 j=0 j=0
4 2 t2
E∆2j,n = E B(tj+1,n ) − Bj,n − 2 nt E B(tj+1,n ) − B(tj,n ) + n2
=
2 t2 2
= 3 nt 2 − 2 nt nt + n2
= 2 nt 2
Finally, we arrive at
n o n−1
(n) 2t 2
E (St − t)2 = E∆2j,n =
P
n → 0 as n → ∞,
j=0
L
that is Stn →2 t, implying [M]t = t
Ito Formula
Properties of Quadratic Variation

Theorem
Let M be a continuous martingale. Then
1 ([M]t )t≥0 is a continuous integrable increasing process with
[M]0 = 0;
Rt
2 ( Ms dMs )t≥0 is a continuous martingale with zero mean;
0
3 The isometry
 !2 
R∞
X 2 dµM , (µM - Doleans measure)
R
E Xs dMs =
0 R+ ∗R
can be re-written in terms of [M]t :
!2
R∞ R∞
E Xs dMs = E Xs2 d[M]s ,
0 0
for any predictable process (Xs ) ∈ Z 2 .
Ito Formula
Properties of Quadratic Variation
Remark: (Doob-Meger Decomposition)

Let M be a continuous local martingale.
Then, Mt2 can be "uniquely decomposed", as
Mt2 = Nt + At ,
where Mt2 - submartingale,

Nt - "continuous local martingale",
At - "continuous increasing process, starting at 0".
Furthermore, Nt and At are, in fact,
Rt
Nt = M02 + 2 Ms dMs
0
and
At = [M]t (a.s.)
Ito Formula
One-Dimensional Ito Formula
A process (Vt )t≥0 is locally of bounded variation if (Vt )t≥0 is

adaped to the filtration (Ft )t≥0 and (Vt (ω))t≥0 is locally of
bounded variation for almost all ω ∈ Ω, i.e. for each t > 0.
n−1
!
X
1 = P ω: sup Vt (ω) − Vt (ω) < ∞
i+1 i
0=t0 <t1 <...<tn =t t=0
(the variation of Vs (ω) in s ∈ [0, t]).
Ito Formula
Theorem
Let (Mt )t≥0 be a continuous martingale, and (Vt )t≥0 be a
continuous process which is locally of bounded variation.
Let f : R 2 → R be a continuous function with continuous
derivatives:
∂f ∂2f ∂2f
(x, y ), (x, y ), (x, y ) for all x, y ∈ R2 .
∂x ∂x 2 ∂x∂y
Then, for each t,

Rt ∂f
Rt ∂f
f (Mt , Vt ) − f (M0 , V0 ) = ∂x (Ms , Vs )dMs + ∂y (Ms , Vs )dVs →
0 0
1
Rt ∂2f
→ 2 ∂x 2
(Ms , Vs )d[M]s (1)
0
Ito Formula
Remark:
Shortly, we write (1) in the form:
∂f ∂f 1 ∂2f
df (Mt , Vt ) = ∂x (Mt , Vt )dMt + ∂y (Mt , Vt )dVt + 2 ∂x 2 (Mt , Vt )d[M]t = dt (2)
Example
Let f (x) = x p for some p > 0, and Mt = Bt =Brownian Motion,
then (2) implies
1
d(Bt )p = p(Bt )p−1 dBt + p(p − 1)Btp−2 d[B]t
2
For p = 2, we have
dBt2 = 2Bt dBt + dt.
Ito Formula
Sketch of the Proof of Ito Formula

Consider partitions of [0, t] into 0 = t0 < t1 < . . . < tn = t, with
ti = itn .
Then, we write ∆ := f (Mt , Vt ) − f (M0 , V0 ) as
P
∆= f (Mtj+1,n , Vtj+1,n ) − f (Mtj+1,n , Vtj,n ) +
j
P
+ f (Mtj+1,n , Vtj,n ) − f (Mtj,n , Vtj,n ) := I1 + I2
j
For I1 , as in the standard real calculus, as n → ∞,
P ∂f R∞ ∂f
I1 ≈ ∂y (M tj,n , V tj,n )(Vtj+1,n − Vtj,n ) ≈ ∂y (Ms , Vs )dVs .
j 0
For I2 we use the Taylor expression up to the second term, n → ∞:
P ∂f 1 P ∂f
I2 ≈ ∂x (Mtj,n , Vtj,n )(Mtj+1,n − Mtj,n ) + 2 ∂x 2
(Mtj,n , Vtj,n )(Mtj+1,n − Mtj,n )2
j j
∂f 1
R∞ ∂ 2 f
≈ ∂x (Ms , Vs )dMs + 2 ∂x 2
(Ms , Vs )d[M]s
0
Ito Formula
Multi-Dimensional Ito Formula: Mutual Variation

Process
Let (Mt )t≥0 and (Nt )t≥0 be a continuous local martingales, and for
each fixed t > 0, let tj = dtn .
Then, as n → ∞
X
(Mtj+1 − Mtj )(Ntj+1 − Ntj )
j
converges in probability to a limit Yt , which we call mutual

variation of (Mn , Nn )0≤n≤t and denote by hM, Nit .
Ito Formula
Properties of the Mutual Variation Process (hM, Nit )t≥0
Property 1
hM, Mit = [M]t , where [M]t is the "square-bracket" (the quadratic
variation) process.
Property 2
For any t, hM, Nit = ([M + N]t − [M − N]t ) (a.s.)
Property 3: Minkowski Inequality

p
|hM, Nit | ≤ [M]t × [N]t
Ito Formula
Properties of the Mutual Variation Process (hM, Nit )t≥0
Property 4
Let (Xt )t ≥ 0 be a predictable L2 -process w.r.t. the local martingale
(Mt )t≥0 , i.e.
X ∈ Z 2 ([0, t] × Ω, P, µM ),
where P is the predictable σ-field and µM is the Doleans measure on
P generated by
λM 2 ((s, t) × F ) = EIF (Mt − Ms ) for F ∈ Fs .
Ito Formula

Process
Denote
Zt
(X × M)t := Xs dMs .
0
Then
Zt
hX × M, Y × Nit = Xs Ys dhM, Ni
0
and, in particular,
Zt
[X × M]t = (Xs )2 d[M]s .
0
Ito Formula

Process
Example
Let Bt = (Bt1 , . . . , . . . Btd ), t ≥ 0, be a d-dimensional Brownian
motion, and each components (Bti )t≥0 is an unvaried Brownian
motion; all components are independent processes.
Then
(1) hBti , Bti i = [B i ]t = t
(2) hBti , Btj i = 0 for i 6= j.
Ito Formula

Process
Remark:
(1) was shown.
To see (2) use "conditioning" to get
E(Btik +1 −Btik )(Btjk +1 −Btjk ) = EBtik +1 (Btjk +1 −Btjk )−EBtik (Btjk +1 −Btjk ) := I1 +I2
To compute I1 we use the fact that B j and B i are independent:

n o
I1 = E [Btik +1 (Btik +1 − Btik )/σ(Bni , n ≤ tk +1 )] =
n o
= E Btik +1 E (Btjk +1 − Btjk )/σ(Bni , n ≤ tk +1 ) ≡0

I2 = E[E(Btik (Btjk +1 − Btjk )/Ftk )] = E(Btik +1 E (Btjk +1 − Btjk )/Ftk = 0.
Ito Formula

Process
Theorem
Let Mt = (Mt1 , . . . , Mtm ) consists of m continuous local martingales,
and Vt = (Vt1 , . . . , Vtn ) consists of n-continuous processes which
are locally of bounded variations. Denote Zt = (Mt , Vt ).
Let f (x, y ) : R2 → R be continuous function with continuous
derivatives:
∂f ∂2f ∂f 2
∂xi , ∂xi ∂xj , ∂yk on R .
Then a.s. for all t, we have the following multivariable Ito formula:
m Rt n
P ∂f i
P ∂f
f (zt ) − f (zs ) = ∂xi (zs )dMs + ∂yk (zs )dVs +
i=1 0 k =1
m Rt
m P
∂2f
+ 21 i , Mj i
P
∂xi ∂xj (zs )dhM s
i=1 j=1 0
Ito Formula

Process
Remark:
Shortly, we write the multivariate Ito formula as:
P 0 P 0
df (Mt , Vt ) = fXi (Mt , Vt )dMti + fYk (Mt , Vt )dVtk +
1≤i≤m 1≤k ≤n
R 00
+ 12 fX00i Xj (Mt , Vt )dhM i , M j i
P
1≤i≤m
1≤j≤m
Ito Formula

Process
Example
Let Bt = (Bt1 , . . . , Btd ) be a d-dimensional Brownian Motion and
f (x), x ∈ R be a continuous function having continuous
derivatives:
∂f ∂f
∂xi and ∂xi ∂xj for all i, j and (x, y ) ∈ R.
Then
d d
X ∂f 1 X ∂2f
df (Bt ) = (Bt )dBti + 2
(Bi )dt, as
∂xi 2 ∂xi
i=1 i=1
(
t, i = j;
hB i , B j it =
0, i 6= j.
Ito Formula
For Further Reading I
D. Duffie.
Dynamic Asset Pricing Theory.
Princeton University Press, 1996 (or newest edition).
G. Samorodnitsky, M.S. Taqqu
Stable Non-Gaussian Random Processes.
Chapman & Hall/CRC, 1994.
Supplemental Readings:
J.C. Hull
Options, Futures and Other Derivatives.
Prentice-Hall, 1997 (or newest edition).
K.L. Chung, R.I. Williams
Introduction to Stochastic Integration.
Birkhäuser, 1990.

Lecture 5 MF

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Lecture 5

Prof. Dr. Svetlozar Rachev

Institute for Statistics and Mathematical Economics

Mathematical Finance, 2007

These lecture-notes cannot be copied and/or distributed without

Prof. Svetlozar (Zari) T. Rachev

If M is a continuous local martingale and f is twice continuously

Formal Definition of [M]t

Formal Definition of [M]t

(Mt )t≥0 is a continuous local martingale;

Formal Definition of [M]t

Formal Definition of [M]t

Properties of Quadratic Variation

Properties of Quadratic Variation

Remark: (Doob-Meger Decomposition)

where Mt2 - submartingale,

One-Dimensional Ito Formula

A process (Vt )t≥0 is locally of bounded variation if (Vt )t≥0 is

(the variation of Vs (ω) in s ∈ [0, t]).

One-Dimensional Ito Formula

Then, for each t,

One-Dimensional Ito Formula

dBt2 = 2Bt dBt + dt.

Sketch of the Proof of Ito Formula

Multi-Dimensional Ito Formula: Mutual Variation

converges in probability to a limit Yt , which we call mutual

Properties of the Mutual Variation Process (hM, Nit )t≥0

Property 3: Minkowski Inequality

Properties of the Mutual Variation Process (hM, Nit )t≥0

λM 2 ((s, t) × F ) = EIF (Mt − Ms ) for F ∈ Fs .

Multi-Dimensional Ito Formula: Mutual Variation

Multi-Dimensional Ito Formula: Mutual Variation

Multi-Dimensional Ito Formula: Mutual Variation

To compute I1 we use the fact that B j and B i are independent:

Multi-Dimensional Ito Formula: Mutual Variation

Multi-Dimensional Ito Formula: Mutual Variation

Multi-Dimensional Ito Formula: Mutual Variation

For Further Reading I

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