MSc/Diploma/Certificate Module

Stochastic Simulation
Unit 3 Stochastic integrals

Contents
1 Ito stochastic integral 1
Ito Integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

2 Problems 4

1 It
o stochastic integral
Before we consider a stochastic integral, let us briefly recall how the standard deterministic
Riemann integral can be defined. Given a bounded function g : [0, T ] R we can define
the Riemann integral using the Riemann sum
Z T N
X 1
g(t)dt = lim g(zj )(tj+1 tj ) (1)
0 t0
j=0

where 0 = t0 < t1 < . . . < tN is a partition of the interval [0, T ], t = max1jN |tj+1 tj |
and we take any zj [tj , tj+1 ]. The key elements are : to say for which functions the
integral holds, define the partition and to examine the limit as more points are added to
the partition (and so as t 0).
In the stochastic case we will need to say what type of functions we can integrate and
how we take the limit. It will also turn out that the choice of zj will also become important
when we try and integrate a stochastic process.
It is standard to illustrate the ideas of a stochastic integral by considering
Z T N
X 1
I= W (s)dW (s) := lim SN , SN := W (zj )(W (tj+1 ) W (tj )), (2)
0 N
j=0

where zj = (1 )tj + tj+1 and the limit as N refines the partition on [0, T ]. The
idea of defining I in (2) follows by analogy with the deterministic integral (1). For the
stochastic integrals we examine these limits in a mean square sense. Note that for = 0,
zj = tj (this will correspond the the Ito integral) and for = 1/2, zj = (tj + tj+1 )/2 (which
will correspond to a Stratonovich integral).

Lemma 1.1 Let 0 = t0 < t1 < . . . < tN = T be a partition of [0, T ] where it is understood
that t := max1jN |tj+1 tj | 0 as N . Then in mean square we have that

(W (T ))2
 
1
I = lim SN = + T.
N 2 2
Stochastic Simulation, Unit 3 2

Proof Let Wj := W (tj+1 ) W (tj ). Then

N 1 N 1
1X 2 2 1X
SN = (W (tj+1 ) W (tj ) ) (Wj )2
2 2
j=0 j=0
N
X 1 N
X 1
+ (W (zj ) W (tj ))2 + (W (tj+1 ) W (zj ))(W (zj ) W (tj ))
j=0 j=0

=:A + B + C + D.

Now the first sum A is a telescoping sum so that A = 12 (W (T ))2 . By lemma on quadratic
variation the second sum B T /2 as N and a similar Lemma gives that C T .
For D, using that the increments in the sum are independent, it can be shown that D 0
as N . Rt 
Lemma 1.1 shows that for 0 W (s)dW (s) the choice of for zj is important.

When = 1/2 an average is taken of W over the time interval tj = tj+1 tj and
gives rise to the Stratonovich integral which is denoted by and we have
Z T
1
W (s) dW (s) = (W (T ))2 . (3)
0 2

This follows directly from Lemma 1.1 with = 1/2. The result is like the deterministic
RT
integral where 0 sds = T 2 /2.

When = 0 on the interval we have the important case of the Ito integral. From
Lemma 1.1, with = 0, we find the Ito integral
Z T
1 T
W (s)dW (s) = (W (T ))2 . (4)
0 2 2
Compared to the deterministic integral we have an additional term. On the interval
tj we only use information at tj and no information in the future and this gives
the It
o integral some special and useful properties. Because the Ito integral does not
anticipate the future it is widely used in financial modelling.

We now discuss in detail the It

o version of the stochastic integral.

It
o Integral
Now let us extend the definition of the Ito integral (2) (where = 0) to a wider class of
functions. We define the It
o integral through the mean square limit as follows
Z T N
X 1
X(t)dW (t) := lim X(tj ) (W (tj+1 ) W (tj )) ,
0 N
j=0

where 0 = t0 < t1 < . . . < tN = T is a partition as in Lemma 1.1. We need to say something
about the sort of X that we can integrate, as we have seen X may be a stochastic process.
Most importantly for the It o integral we do not want X to see into the future - the ideas
required to make this precise are in the following paragraph.
We have the idea that the stochastic process, X(t), is a model something that evolves in
time and we can therefore ask at time t questions about the past s < t (X(t) is known from
observations of the past) and the future s > t. A probability space (, F, P ) consists of
Stochastic Simulation, Unit 3 3

a sample space , a set of events F and a probability measure P . A filtered probability

space consists of (, F, Ft , P ) where Ft is a filtration of F. The filtration Ft is a way of
denoting the events that are observable by time t and so as t increases Ft contains more
and more events. If X(t), t [0, T ] is non-anticipating (or Ft adapted) then X(t) is Ft
measurable for all t [0, T ] (roughly X(t) does not see into the future). Finally X(t) is
predictable if it is non-anticipating and can be approximated by a sequence X(sj ) X(s)
if sj s for all s [0, T ], sj < s.

o integral) Let X(t), t [0, T ] be a predictable stochastic process such

Theorem 1.2 (It
that  Z t 1/2
2
E |X(s)| ds < .
0
Then
Rt
1. 0 X(s) dW (s) for t [0, T ] has continuous sample paths.
Rt
2. The It
o integral has the martingale property
Rr . That is, best predictions of 0 X(s) dW (s)
based on information
hR up to time
i r is 0 X(s) dW (s). In particular the integral has
t
mean zero : E 0 X(s) dW (s) = 0.

3. We have the It
o isometry
 Z t 2  Z t 
E |X(s)|2 ds,

X(s) dW (s) = t [0, T ]. (5)
 
E 
0 0

Example 1.3 Reconsider the stochastic integral

Z t
I(t) = W (s) dW (s), t 0.
0

The martingale property gives E[I(t)] = 0 and the It

o isometry (5) gives
Z t Z t
2 2 1
s ds = t2 .
   
E I(t) = E (W (s)) ds = (6)
0 0 2

Note that using (4) we can write I(t) as I(t) = 21 (W (t))2 2t , or rearranged 1
2 (W (t))
2 =
1
2 t + I(t). This is often written in shorthand as

1 1
d( (W (t))2 = dt + W (t)dW (t). (7)
2 2
The Ito integral can be extended to be vector-valued.
Definition 1.4 Let W(t) = (W1 (t), W2 (2), . . . , Wm (t))T Rm and let X Rdm be such
that each Xij is a predictable stochastic process such that
 Z t 1/2
2
E |Xij (s)| ds < . (8)
0
Rt
Then 0 X(s)dW (s) is the random variable in Rd with ith component
m Z
X t
Xij (s)dWj (s).
j=1 0
Stochastic Simulation, Unit 3 4

It can be shown that the following properties hold for the vector valued Ito integral.
Rt
1. The integral 0 X(s) dW(s) for t [0, T ] is a predictable process.

2. The martingale property holds and the Ito integral has mean zero :
Z t 
E X(s) dW(s) = 0.
0

3. Given two stochastically integrable processes X and Y , i.e. X and Y are predictable
and (8) holds, then if t := min(t1 , t2 ),
"*Z +# Z m
t1 Z t2 t X hD Ei
E X(s) dW(s), Y (s) dW(s) = E Xi (s), Yi (s) ds,
0 0 0 i=1

where Xi , Yi denotes the ith column of X and Y and , is the Rd inner product.



From this the It

o isometry follows
 Z t  Z t
2
E kX(s)k2F ds, t [0, T ].
 
E k X(s) dW(s)k2 = (9)
0 0

In fact the class of processes for which the stochastic integral can be developed is wider,
see for example [1, 2]. With this definition we can examine systems of Ito SDEs.

References
[1] Peter E. Kloeden and Eckhard Platen. Numerical Solution of Stochastic Differential
Equations, volume 23 of Applications of Mathematics. Springer, 1992.

[2] Bernt ksendal. Stochastic Differential Equations. Universitext. Springer, Berlin, sixth
edition, 2003.

2 Problems
Rt
1. Evaluate r dW (s).
Rt Rt
2. Show that the distribution of both 0 W (s) ds and 0 s dW (s) is N (0, t3 /3).
P 1
3. Let g(t) = gk for t [tk , tk+1 ] be predictable. Let SN = N j=0 gj (W (tj+1 ) W (tj )).
Show that E[SN ] = 0.
hP i
N 1
Show that E (SN )2 = E 2
 
j=0 (gj ) (tj+1 tj ) .
RT
4. Write out the components of the following stochastic integrals 0 X(s)dW(s) where
W(s) R2 and X given by
   
X11 (s) 0 X11 (s) 0
X(s) = X(s) =
0 X22 (s) X21 (s) X22 (s)
 
X11 (s) X12 (s)

X(s) = X(s) = X11 (s) X12 (s)
0 X22 (s)