1

Elementary Stochastic Calculus 1 In this lecture. . .

G G G G G G

all the stochastic calculus you need to know, and no more the meaning of Markov and martingale Brownian motion stochastic integration stochastic differential equations Its lemma in one and more dimensions

2 Introduction
Stochastic calculus is very important in the mathematical modeling of financial processes. This is because of the underlying random nature of financial markets.

3 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.
2

0 0 1 2 3 4 5 6 7

-1

-2

1.The outcome of a coin tossing experiment.

4
G 5

denotes the random amount, either $1 or -$1, you make on the Lth toss:
L

( >5 L@



( >5

 L@

and

( >5 L5

M@



In this example it doesnt matter whether or not these expectations 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.
G

Introduce 6 L to mean the total amount of money you have won up to and including the Lth toss so that
6
L

5 M  ,

M 

Later on it will be useful if we have 6 money.

i.e., you start with no

5 If we now calculate expectations of 6 L it does matter what information we have. If we calculate expectations of future events before the experiment has even begun then
( >6 L@ 

and

( >6 L @

( >5

 

 5

5 

 ???@

L

On the other hand, suppose there have been five tosses already, can we use this information and what can we say about expectations for the sixth toss?
G

This is the conditional expectation. The expectation of 6  conditional upon the previous five tosses gives
( >6  M5
     5  (

 6 

4 The Markov property

G

The expected value of the random variable 6 L conditional upon all of the past events only depends on the previous value $ L>  . This is the Markov property. We say that the random walk has no memory beyond where it is now. Note that it doesnt have to be the case that the expected value of the random variable $ L is the same as the previous value. This can be generalized to say that given information about $ M for some values of  T M  L then the only information that is of use to us in estimating 6 L is the value of 6 M for the largest M for which we have information.

5 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. Y our expected winnings after the sixth toss, and indeed after any number of tosses if we keep playing, is just the amount you already hold.
G

The conditional expectation of your winnings at any time in the future is just the amount you already hold:
( >$ LM$ M  M  L@  $ M 

This is called the martingale property.

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

> $

 M>  

M 

Because you either win or lose an amount $1 after each toss, M$ M $ M >  M   . Thus the quadratic variation is always L:

> $

M>

L

M 

We are going to use the coin-tossing experiment for one more demonstration. And that will lead us to a continuous-time random walk.

7 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 W, so each toss will take a time W  . Second, the size of the bet will not be $1 but 9  . This new experiment clearly still possesses both the Markov and martingale properties, and its quadratic variation measured over the whole experiment is

U7 
9 

> $

M>

 @

 9

M 

10 Change the rules again, to speed up the game.

G

We will have Q tosses in the allowed time W, with an amount 9 3 riding on each throw. Again, the Markov and martingale properties are retained and the quadratic variation is still

;
Q

U7 
9 3

> $

M>  

3 @

 9

M 

Now make Q larger and larger. This speeds up the game, decreasing the time between tosses, with a smaller amount for each bet. But the new scalings have been chosen very carefully, the timestep is decreasing like Q >  but the bet size only decreases by Q >    .

11
2

1.5

0.5

0 0 -0.5 0.2 0.4 0.6 0.8 1

-1

2.A series of coin tossing experiments.

12 As we go to the limit 3   , the resulting random walk stays finite. It has an expectation, conditional on a starting value of zero, of
 >$ 9@ 

and a variance
 >$ 9 @


9

We use 6 W to denote the amount you have won or the value of the random variable after a time W.
G

The limiting process for this random walk as the timesteps go to zero is called Brownian motion, and we will denote it by ; W.

13 The important properties of Brownian motion are as follows.

G

Finiteness : Any other scaling of the bet size or increments with timestep 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 timestep. Continuity : The paths are continuous, there are no discontinuities. Brownian motion is the continuous-time limit of our discrete time random walk. Markov : The conditional distribution of ; up until  W depends only on ;  . Martingale : Given information up until expectation of ; W is ;  .
W

G G

given information
W

the conditional

14
G

Quadratic variation : If we divide up the time  to W in a partition with Q   partition points WL  L W Q then

;
Q

; WM  > ; WM >   

9

(Technically almost surely.)

; WL>   9L>


M 

Normality : Over finite time increments WL>  to 9L, ; WL > is Normally distributed with mean zero and variance 9L >

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

8 Stochastic integration
Define a stochastic integral by

: W

1   G ;  

3 

OLP

;
3 M 

1 9M >   ; WM  > ; WM >  

with
9M  MW Q 

Note that the function I W is evaluated in the summation at the left-hand point WM >  . 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.

17

9 Stochastic differential equations

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

: W

1   G ;  

(1)

That shorthand comes from differentiating (1) and is

G: I W G ; 

Think of G ; as being an increment in ; , i.e. a Normal random variable with mean zero and standard deviation G W   .

18 Pursuing this idea further, imagine what might be meant by

G:  J W G W  I W G ; 

(2)

This is simply shorthand for

: W

J   G 

1   G ;  

Equations like (2) are called stochastic differential equations. Their precise meaning comes, however, from the technically more accurate equivalent stochastic integral.

19

10 The mean square limit

This is useful in the precise definition of stochastic integration. Examine the quantity
(

 ;   
3

; WM  > ; WM >   >

  9 


M 

where
9M  MW Q 

20 This can be expanded as

3

 ; 

; WM  > ; WM >    

; ;
3 L  M L

; WL > ; WL>   ; WM  > ; WM >  

M 

> 9

;
3 M 

; WM  > ; WM >   

 9 


Since ; WM  > ; WM >   is Normally distributed with mean zero and variance 9 3 we have


A ;

WM  > ; WM >

B  
 

9 Q 9 3


and
(

A ;

WM  > ; WM >

B  

21 Thus the required expectation becomes

Q W Q
 

 Q Q >  

W Q


>  93

9 3

 9

M N
3

As Q

this tends to zero. We therefore say that

;
3

; WM  > ; WM >  

M 

in the mean square limit. This is often written, for obvious reasons, as

G ; 

W

Whenever we talk about equality in the following proof we mean equality in the mean square sense.

22

11 Functions of stochastic variables and Its lemma

Now well see the idea of a function of a stochastic variable. Below is shown a realization of a Brownian motion ; W and the function ) ;  ; .
0.4 0.3 0.2 0.1 0 0 -0.1 -0.2 -0.3 -0.4 0.1 0.2 0.3 0.4 0.5 Brownian motion Square of Brownian motion

3.A realization of a random walk and its square.

23 If )
G
;


is it true that G )

; G ;

? No.

The ordinary rules of calculus do not generally hold in a stochastic environment. Then what are the rules of calculus? We now derive the most important rule of stochastic calculus, Its lemma.

24 In this derivation we will need various timescales. The first timescale is very, very small. Denote it by
sW Q  K ; W  K  G) G;


This timescale is so small that the function ) proximated by a Taylor series:

) ; W  K  > ) ; W

can be ap-

; W  K  > ; W
 ; 

; W  ; W  ??? 

W  K  > ; W

G )


G;

25 From this it follows that

) ; W  K  > ) ; W  ) ; W   K  > ) ; W  K   ???  ) ; W  Q K  > ) ; W  Q >  K 

;
3

; W  M K  > ; W  M >  K 

G) G;

; W  M >  K 

M 

 

G ) G;


; W

;
3 M 

; W  M K  > ; W  M >  K   ??? 

This has used the approximation

G ) G;
 

; W  M >  K 

G ) G;


; 9

This is consistent with the order of accuracy we require.

26 The first line in this becomes simply

) ; W  Q K  > ) ; W ) ; W  s W > ) ; W

The second is just the definition of

9 I 9

G) G;

G;

and the last is

 

G ) G;


; Ws W

in the mean square sense. Thus we have

=
9

9 I 9

) ; W s W> ) ; W

G) G;

;  G ;  

 

=
9

9 I 9

G ) G;


;  G 

27 We can now extend this result over longer timescales, from zero up to W, over which ) does vary substantially to get

) ; W

) ;  

G) G;

;  G ;  

 

/  /;


;  G 

This is the integral version of Its lemma, which is usually written as

G) G) G; G; 
 

G ) G;


G W

28
;  what stochastic difWe can now answer the question, If ) ferential equation does ) satisfy? In this example G) G; ;

and

G ) G;




Therefore Its lemma tells us that

G) ; G ;  G W

This is not what we would get if ; were a deterministic variable. In integrated form
;


=
>

) ; 

)   

; G ;

9

 /Q 

; G ;

 W

Therefore

; G;

  ; 

 9 

29

12 It and Taylor
If we were to do a naive Taylor series expansion of ) , completely disregarding the nature of ; , and treating G ; as a small increment in ; , we would get
) ;  G;  ) ;   G) G; G; 
 

G ) G;


G;

  G;  >

ignoring higher-order terms. We could argue that ) ;  was just the change in ) and so
G) G) G; G; 
 

) ;

G ) G;


G;

This is very similar to the proper It result with the only difference being that there is a G ;  instead of a G W. However, since in a sense 9   G ;  W we could perhaps write G ; G W

30 This lacks any rigor but it does give the correct result.
G

You can, with little risk of error, use Taylor series with the rule of thumb
G;


 G W

and in practice you will get the right result.

31 Suppose our stochastic differential equation is

G 6  D 6 G W  E 6 G ; 

(3)

say, for some functions D 6  and E 6 . Here G ; is the usual Brownian increment. Now if we have a function of 6 , 9 6 , what stochastic differential equation does it satisfy? The answer is
G9 G9 G6 G6 
 E   G 9 

G6

G W

We could derive this properly or just cheat by using Taylor series with G ;  G W. We could, if we wanted, substitute for G 6 from (3) to get an equation for G 9 in terms of the pure Brownian motion ; :

G9

, $ 

/' /$

 - $ 

/

N '


/$

G W  E 6 G ; 

32

13 It in higher dimensions
In financial problems we often have functions of one stochastic variable 6 and a determinisic variable W, time: 9 6  W. If
G6 D 6  WG W  E 6 WG ; 

then the increment G 9 is given by

G9 #9 #W GW  #9 #6 G6 
  E 

# 9 #6


G W

Again, this is shorthand notation for the correct integrated form.

33 Occasionally, we have a function of two, or more, random variables, and time as well: 9 6   6   W. Lets write the behaviour of 6  and 6  in the general form
G6


D  6   6   WG W  E  6   6   WG ;

and
G6


D  6   6   WG W  E  6   6   WG ;



Note that we have two Brownian increments G ;  and G ;  . We can think of these as being Normally distributed with variance G W, but they are correlated. The correlation between these two random variables we will call  . This can also be a function of 6  , 6  and W but must satisfy
>  T  T 

34
G

The rules of thumb can readily be imagined:

G;
 

 G W

G;

 

 GW

and
#9 #6
 

G;

G ; 

  G W

Its lemma becomes

G9  #9 #W
 E  

GW 


#9 #6


G6

G6


 E    # 9 

# 9

#6

 

G W   E E

# 9 # 6 # 6


GW 

#6

 

G W

35

14 Some pertinent examples

The first example is like the simple Brownian motion but with a drift:
G6
0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 0 -0.05 0.2 0.4 0.6 0.8 1

{ GW  G; 

4.A realization of G 6

{ GW  G;

In this realization 6 has gone negative.

36 This stochastic differential equation integrated exactly to give

6 W G6 { GW  G;

can be

6    { W  ; W > ;  

37 Our second example is similar to the above but the drift and randomness scale with 6 :
G6
5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 0 0.2 0.4 0.6 0.8 1

{ 6 GW  6 G; 

5.A realization of G 6

{ 6 GW  6 G;

If 6 starts out positive it can never go negative; the closer that 6 gets to zero the smaller the increments G 6 .

38 This property of this random walk is clearly seen if we examine the function ) 6  OR J 6 using Its lemma. From It we have
G) G) G6 G6  G    6  


)


? { >
G6

GW 
  P 

 6

@/ 9 

{ 6 G W  6 G ;  > G; 

  P /9 

This shows us that OR J 6 can range between minus and plus infinity but cannot reach these limits in a finite time, therefore 6 cannot reach zero or infinity in a finite time.

39 The integral form of this stochastic differential equation follows simply from the stochastic differential equation for OR J 6 :
6 W 6  H
{ >   W ; W> ;    

The stochastic differential equationG 6  { 6 G W  6 G ; will be particularly important in the modeling of many asset classes. If we have some function 9 6  W then from It it follows that
G9 #9 #W GW  #9 #6 G6 
  

#

)


#6

G W

40 The third example is

G6
1.2

| > { 6 G W  G ; 

0.8

0.6

0.4

0.2

0 0 0.2 0.4 0.6 0.8 1

6.A realization of G 6

| > { 6 G W  G ;

41 The random walk

G6 | > { 6 G W  G ;

is an example of a mean-reverting random walk. If 6 is large, the negative coefficient in front of G W means that 6 will move down on average, if 6 is small it rises on average. There is still no incentive for 6 to stay positive in this random walk. With U instead of 6 this random walk is the Vasicek model for the short-term interest rate.

42 The final example is similar to the third but we are going to adjust the random term slightly:
G6 | > { 6 G W  6
 

G; 

Now if 6 ever gets close to zero the randomness decreases, perhaps this will stop 6 from going negative? Lets play around with this example for a while. And well see It in practice. Write )  6    . What stochastic differential equation does ) satisfy? Since
G) G6 
 >  6 

and

/  /$


 >

 >  $ 

we have
/ 

M | >
)

>

 { 

N
/9 

 

G; 

43 We have just turned the original stochastic differential equation with a variable coefficient in front of the random term into a stochastic differential equation with a constant random term. In so doing we have made the drift term nastier. In particular, the drift is now singular at )  6  . Continuing with this example, instead of choosing )  6    , can we find a function ) 6  such that its stochastic differential equation has a zero drift term? For this we will need
| > { 6  G) G6 
  6 

G ) G6


 

44 This can be integrated once to give

G) G6  $ 6
>

| 

{ 6 

(4)

for any constant $ . If

|


M 

we cannot integrate (4) at $  . This makes the origin nonattainable. In other words, if the parameter | is sufficiently large it forces the random walk to stay away from zero. This particular stochastic differential equation for 6 will be important later on, it is the Cox, Ingersoll & Ross model for the short-term interest rate.