.

The stochastic calculus

Karol Dziedziul

Gdansk

Karol Dziedziul The stochastic calculus

 .

A schedule of the lecture

Stochastic differential equations

Ito calculus, Ito process
Ornstein - Uhlenbeck (OU) process
Heston model
Stopping time for OU process

Karol Dziedziul The stochastic calculus

 .

Stochastic differential equations

Stochastic differential equations studied in this lecture are typically of the

form
dXt = a(t, Xt )dt + b(t, Xt )dWt , (1)
where Wt is the Wiener process. More explicitly the equation (1) has to
be understood as
Z t Z t
Xt = X0 + a(s, Xs )ds + b(s, Xs )dWs .
0 0

Both integrals exist: the first in the sense of the Lebesgue integration,
the second in the sense of the Ito integration when the functions a and b
have to fulfill integrability conditions
Z t
(|a(s, Xs )| + |b(s, Xs )|2 )ds, a.s., t ≥ 0.
0

Karol Dziedziul The stochastic calculus

 .

Usually we assume that the functions a, b satisfy the Lipschitz condition

in the second variable, i.e. there is constant K such that for all x, y ∈ R ,
t ∈ [0, T ]

|a(t, x) − a(t, y )| + |b(t, x) − b(t, y )| ≤ K |x − y |.

We also assume that there is constant K such for all x ∈ R , t ∈ [0, T ]

|a(t, x)| + |b(t, x)| ≤ K (1 + |x|).

In that cases the equation (1) has a unique solution Xt , 0 ≤ t ≤ T (so

called a strong solution).
In spite of the difficulties of the mathematical language there is a
numerical procedure which can be helpful to solve (1) and to catch the
ideas. This procedure is based on a discrete version of the equation (1).
In discrete time 0 = t0 < t1 < t2 < · · · < tn = T we consider a recursive
formula
Xtj+1 − Xtj = atj (tj+1 − tj ) + btj (Wtj+1 − Wtj ).

Karol Dziedziul The stochastic calculus

 .

Geometric Brownian motion

Symbolically a recursive formula is written as

∆Xt = a(t, Xt )∆t + b(t, Xt )∆Wt .

In this way we obtain the piecewise linear sample path of the process. If

sup{|tj − tj−1 | : 0 ≤ j ≤ n} → 0

then we obtain the solution of (1). We apply this method to the

Geometric Brownian motion . Samuelson provided the arguments that
the price of an asset St follows the Geometric Brownian motion, i.e.

dSt = St µdt + St σdWt . (2)

♣ Use Program 28 to find out that the price of the asstet ST /S0 (the
solution of (2)) in the moment T has lognormal distribution, where S0 is
an initial value of the asset.

Karol Dziedziul The stochastic calculus

 .

Lognormal distribution

We say that a positive random variable X has the lognormal distribution

with parameter m, s, if log X , (log X = loge X = ln X ) has the normal
distribution N(m, s 2 ). Moreover, the mean and the variance are given by
2
EX = e m+s /2
,
2 2
VarX = (e s − 1)e 2m+s .
Using the Itô calculus we will show that the exact solution of (2) is given
by
ln(ST /S0 ) = (µ − σ 2 /2)T + σWT .
♣ Compare the estimated parameters of solution ST /S0 : s- a shape and
m -a scale parameters in Program 28 with the exact value

m = µ − σ2 , s = σ.

Karol Dziedziul The stochastic calculus

 .

Itô process

Let us define the Ito processes, the important class of stochastic

processes, using the differential form:

dYt = at dt + bt dWt . (3)

More explicitly Z t Z t
Yt = Y0 + as ds + bs dWs .
0 0

We assume that the processes a, b satisfy the integrability conditions:

Z T
|as |ds < ∞ a.s.
0

and Z T
|bs |2 ds < ∞ a.s.
0

Karol Dziedziul The stochastic calculus

 .

Itô calculus
Theorem (Itô formula)
Let Yti , i = 1, 2 be two Itô processes

dYti = ati dt + bti dWt .

Let
F : [0, t] × R 2 → R
be twice differentiable. Then ξt = F (t, Yt1 , Yt2 ) is the Ito process such
that
∂F ∂F ∂F
dξt = (t, Yt1 , Yt2 )dt + (t, Yt1 , Yt2 )dYt1 + (t, Yt1 , Yt2 )dYt2
∂t ∂x1 ∂x2

1 ∂2F 1 2 1 2 1 ∂2F
+ (t, Yt , Yt )(b t ) dt + (t, Yt1 , Yt2 )(bt2 )2 dt
2 ∂x12 2 ∂x22
∂2F
+ (t, Yt1 , Yt2 )bt1 bt2 dt.
∂x1 ∂x2
Karol Dziedziul The stochastic calculus
 .

Geometric Brownian motion

We will use the Itô formula to check that the process

Z t Z t
2 2
ln(St /S0 ) = (µ − σ /2)t + σWt = (µ − σ /2)ds + σdWs .
0 0

or equivalently
(µ−σ 2 /2)ds+ 0t σdWs
Rt R
St = S0 e 0 .
is the solution of the Geometric Brownian motion, i.e. solution of the
equation
dSt = St µdt + St σdWt . (4)

Karol Dziedziul The stochastic calculus

 .

We define
Z t Z t
2 2
Yt = (µ − σ /2)t + σWt = (µ − σ /2)ds + σdWs .
0 0

Note that Yt is the Ito process and

St = S0 exp(Yt ).

The function F (x) = S0 e x is a smooth function, so twice differentiable

and F 0 (x) = S0 e x , F 00 (x) = S0 e x . By the Itô formula and (4) we get

1
dSt = S0 e Yt dYt + SeYt σ 2 dt
2
1
= S0 e Yt ((µ − σ 2 /2)dt + σdWt ) + S0 e Yt σ 2 dt = St µdt + St σdWt .
2

Karol Dziedziul The stochastic calculus

 .

Ornstein - Uhlenbeck process

In the physics , a relaxation means the return of a perturbed system into
equilibrium. Such processess are modeled by Ornstein - Uhlenbeck
process given by
dXt = θ(µ − Xt )dt + σdWt , (5)
where θ, σ > 0 and µ ∈ R. To solve this equation let us consider
f (Xt , t) = Xt e θt ,
where Xt is the solution of (5). From the Itô formula we obtain
df (Xt , t) = θXt e θt dt + e θt dXt .
Since dXt is the solution of (5) then
df (Xt , t) = θXt e θt dt + e θt (θ(µ − Xt )dt + σdWt )
= θXt e θt dt + e θt θµdt − e θt θXt dt + e θt σdWt
= e θt θµdt + e θt σdWt
Thus Z t Z t
Xt e θt = X0 + e θs θµds + e θs σdWs .
0 0
Karol Dziedziul The stochastic calculus
 .

Consequently, the solution of (5), i.e. the Ornstein - Uhlenbeck process is

given by
Z t
Xt = X0 e −θt + µ(1 − e −θt ) + e θ(s−t) σdWs .
0

From the Itô integral theory we get that the stochastic process
Z t
Ut = e θ(s−t) σdWs
0

is the Gaussian process, Ut ∈ N(0, VarUt ), where

2
Z t
VarUt = σe −θt e 2θs ds.
0

Hence
e 2θt − 1 1 − e −2θt
VarUt = σ 2 e −2θt = σ2 .
2θ 2θ

Karol Dziedziul The stochastic calculus

 .

Consequetly,

EXt = X0 e −θt + µ(1 − e −θt ), VarXt = VarUt .

Since θ > 0 we get that

lim EXt = µ, (6)
t→∞

σ2
lim VarXt = . (7)
t→∞ 2θ
♣ Use Program 29 to create a sample path of the Ornstein - Uhlenbeck
process for large n. Note that a trajectories according to (6) return to µ
and their oscilations stabilize according to (7).

Karol Dziedziul The stochastic calculus

 .

Heston model
One of the generalizations of the Samuelson model, is the Heston model.
We assume that the price of an asset is given by
dSt = µSt dt + σt St dZt1 , (8)
where σt is the Ornsteina-Uhlenbeck process
dσt = −βσt dt + δdZt2 . (9)
We assume that the Wiener processes (Zt1 , Zt2 )
are correlated, i.e
Cov (Zt1 , Zt2 ) = ρt.
To obtain the equivalent formula of Heston model let us define
νt = σt2 .
From the Itô formula
1
dνt = 2σt dσt + 2δ 2 dt.
2
√
Taking (9) and puting σt = νt we get
√ √ 1
dνt = 2 νt (−β νt dt + δdZt2 ) + 2δ 2 dt.
2
Karol Dziedziul The stochastic calculus
 .

Thus
√ √
dνt = 2δ νt dZt2 + (δ 2 − βνt )dt = 2δ νt dZt2 + β(δ 2 /β − νt )dt
We obtain the system of equations equivalent to (8) i (9),
 √
 dSt = µSt dt + νt St dZt1
√
dνt = 2β(δ 2 /β − νt )dt + δ νt dZt2 .


A solution of (9) is Ornstein Uhlenbeck process

Z t
−βt
σt = σ0 e +δ e β(s−t) dZs2
0

Using similar calculations as in the solution of the Geometric Brownian

Motion we get (see (2.2.2) Jeanblanc, Yor Chesney)
 Z t 2 Z t 
σs
St = S0 exp µt − ds + σs dZs1 .
0 2 0

This form is VERY Complicated!!

♣ Use Program 30 to create sample paths of St and νt in the Heston
model.
Karol Dziedziul The stochastic calculus
 .

Extension of the Heston model

Extension of the Heston model with stochastic interest rates is given in

the paper by Grzelak and Oosterlee [2011], SIAM J. Fin. Math. pp.
255–286.. Assume that the dynamics of an asset is given by following
equations corresponding to a risk-neutral measure.
 √ 1
 dSt /St = rt dt + νt dW √t
dνt = κ(ν − νt )dt + γ νt dWt2
√
drt = λ(θ − rt )dt + η rt dWt3 ,


with parameters κ, ν, γ, λ, θ, η. We assume that the Wiener processes

(Wti , Wtj ) are correlated, i.e Cov (Wti , Wtj ) = ρij t. It seems reasonable to
take ρ13 = 0. Write a program to value an call option (ST − K )+ , see
Paul Glasserman Monte Carlo Methods in Financial Engineering Springer
2003.

Karol Dziedziul The stochastic calculus

 .

Hitting time- Ornstein -Uhlenbeck processes

Recall that Xt = −θXt dt + dWt , X0 = x > 0 is OU processes, where

µ = 0, σ = 1. Let

T0OU = inf{t ≥ 0 : Xt = 0}.

Theorem
For any x > 0 the density function of T0 equals
p x
f (t) = A0 (t)φ(−2x/ A(t)) ,
A(t)3/2

where Z t
A(t) = e 2ks ds
0

and φ is the density function of N(0, 1).

Karol Dziedziul The stochastic calculus

 .

Proof

The solution OU is given by

Z t
Xt = e −θt (x + e ks dWs ).
0

Thus Z t
T0OU = inf{t ≥ 0 : x + e ks dWs = 0}.
0

It is known that for a function f such that

Z t
f 2 (s)ds < ∞, for all t≥0
0

the processes Z t
Mt = f (s)dWs
0

is a martingale.

Karol Dziedziul The stochastic calculus

 .

Martingale =Dubins Schwarz’s Theorem

A continuous martingale M such that
Z ∞
< M >∞ = f 2 (s)ds = ∞
0

is a time changed of Brownian motion. In other words, there exists a

Brownian motion W such that

Mt = W<M>t = WB(t) ,

where Z t
B(t) = f 2 (s)ds.
0
From Dubins Schwarz’s Theorem there is BM W such that

T0OU = inf{t ≥ 0 : WA(t) = −x}.

Consequently

P(A(T0OU ) ≤ t) = P(T0OU ≤ A−1 (t)) = P(T−x ≤ t).

Karol Dziedziul The stochastic calculus

 .

Mixed Processes involving Compound Poisson Processes

Let X be a compound Poisson process, i.e.
N(t)
X
Xt = Yj ,
j=1

where N(t) is a Poisson process with intensity λ and {Yj } i.i.d. and
independent of N(t). Let us consider the stochastic equation with
constants µ and σ
dSt = St− (µdt + σdWt + dXt ),
where St− is left continuous version of St .
Theorem
The process St e −rt , t ≥ 0 is a martingale iff µ + λEY1 = r .

If Yj ≥ −1 then the solution of the stochastic equation is given by

N(t)
2 X
St = e µt e σWt −1/2σ t exp( ln(1 + Yj )).
j=1

Karol Dziedziul The stochastic calculus