Chapter 14

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.

14.1 Brownian Motion

4 3'120()'&%#$!"  d) X    !rq 3  !q 3  8DCAB@ 3   

(See Fig. 13.3.) Brownian motion,



1.


Technically,

2.

is a continuous function of , , then the increments

 X p5cVe  d)"ci  h`g`f`gfUVe

3. If

are independent,normal, and

9#a6yExste  dw X uvste

14.2 First Variation

D

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

Figure 14.1: Example function

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:
)

Denition 14.1 (First Variation) Let

be a partition of
`P16

The mesh of the partition is dened to be

`C s 0d X u s  X p5c 9

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

9 9@U 78s 56342

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

' '  t 

1E

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 

"#$!

Denition 14.2 (Quadratic Variation) The quadratic variation of a function on an interval is

'
`

'
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

In particular, the paths of Brownian motion are not differentiable.

6 Yg G `F


A

@3

and Remark 14.1 (Quadratic Variation of Differentiable Functions) If is differentiable, then , because

14.3 Quadratic Variation

and

CHAPTER 14. The It Integral o

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

%#$!

Proof: (Outline) Let be a partition of . Dene the sample quadratic variation

156

. To simplify notation, set

We want to show that

1 E@EGF E@E

2"CDB

 s e

d) X uvs e

For

This has expectation 0, so

Consider an individual summand

, the terms

and

0d

X u



are independent, so

(if

is normal with mean 0 and variance

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

Thus we have , then )

F

3
b

CHAPTER 14. The It Integral o

F )

157

Remark 14.2 (Differential Representation) We know that

`%#76 yi st0d X u st d xst  d) X u sF  !q 3

We showed above that

` bsF d X u sF

When

is small,

is very small, and we have the approximate equation

st0d X u si

14.4 Quadratic Variation as Absolute Volatility

On any time interval

, we can sample the Brownian motion at times

and compute the squared sample absolute volatility

` xte   s   d ) X vte u s   X p c U 78s X H Q d

This is approximately equal to

` Q 6 X X

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

which we can write informally as

6hytfsF0d

`"#T6)P d



X u st

st

F sF

d X u st

1 E@EGF E@E 2"CDB  s  6   X

dw X u ste

X uvs e

X !

!g

3

 s 

X us 

'"'

'"'

As

#'1P d

3
f

, so

158

14.5 Construction of the It Integral o

 U

The integrator is Brownian motion following properties: 1.



, with associated ltration

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

, where (i.e., is adapted)



-measurable

is square-integrable:
U q3

We want to dene the It Integral: o

`9#

Remark 14.3 (Integral w.r.t. a differentiable function) If we can dene


U

is a differentiable function, then

`

This wont work when the integrator is Brownian motion, because the paths of Brownian motion are not differentiable.

14.6 It integral of an elementary integrand o

)

Let

be a partition of

, i.e.,
`P16 ci

Assume that is constant on each subinterval elementary process.



(see Fig. 14.2). We call such a

The functions

and

can be interpreted as follows:



Think of

as the price per unit share of an asset at time .

`P%

$ e#

F)

y X uvstIsF !

&

WI`b`b`aWPX'WBUi6#

F

$

6)" )V$

9#$!

3. For are independent of

, 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

6)F 3 X u st   W    W si

!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

Then the It integral o

bste

Linearity If

14.7 Properties of the It integral of an elementary process o

In general, if

CHAPTER 14. The It Integral o

Adaptedness For each

Think of trading date

then Think of

t

" !te 3

0=t0

( t ) = ( t ) 0

as the number of shares of the asset acquired at trading date .

can be interpreted as the gain from trading at time ; this gain is given by:

as the trading dates for the asset.

Figure 14.2: An elementary function .

t1

( t ) = ( t 1 )

is

-measurable.

6)te 3

( t ) = ( t 2 )

t2

( t )= ( t 3 )

t3

t4 = T

and held until 159

 

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

Theorem 7.45 (Martingale Property)

We prove the martingale property for the elementary process case.

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.

Figure 14.3: Showing and in different partitions.

t l+1

.....

k+1

are in different (See

y X u s  s  !

y X uEC !'

s 

We compute conditional expectations:

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

These rst two terms add up to

Since the cross terms have expectation zero,

U

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

Proof: To simplify notation, assume

Theorem 7.46 (It Isometry) o

CHAPTER 14. The It Integral o

has expectation 0, and different

. We show that the third and fourth terms are zero.

, so

are independent. 161

q3

162

path of 4

path of

0=t0

t1

t2

t3

t4 = T
, over
y%#$!

14.8 It integral of a general integrand o

Fix . Let be a process (not necessarily an elementary process) such that is -measurable,
`& y

Theorem 8.47 There is a sequence of elementary processes

te

such that

Proof: Fig. 14.4 shows the main idea.

In the last section we have dened

ie 

for every . We now dene

` F

Figure 14.4: Approximating a general process by an elementary process

`%#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

 

CHAPTER 14. The It Integral o

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

which is small. This guarantees that the sequence

has a limit.

14.9 Properties of the (general) It integral o

`C"

Here is any adapted, square-integrable process. Adaptedness. For each , Linearity. If


U

is

-measurable.


Martingale. Continuity.

is a martingale. is a continuous function of the upper limit of integration .



It Isometry. o

Example 14.1 () Consider the It integral o



We approximate the integrand as shown in Fig. 14.5

`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

H ' ' % (&

p D

E   hD

H ' % 3q
X p

X D p s

E   hD

H ' % 32 H ' % 32

p T p T p
 

p ' p ' p ' p

E   ts

E   hD

H ' % (&


H ' ' % 32
& 

i ' FD

E   hD

H ' ' % rq

H ' % 32
  EhD

X ' ihp D

E   hD

H ' ' % 3&

X i ' hD

E    FD

H ' ' % 3&

' iFD

$

98785f   !" $ BC@g



 

d eQ  
&


IGc

 abD

Q ` 

I G YS

X CQ


VWUI S T G  


Q R 

IPGH  EFD

987856   !"   BC@A



 

H '3%&

  

!

 )4'3%2 #

  

%# !

164

Figure 14.5: Approximating the integrand

T/4

2T/4

3T/4

with

if

&



 1   )0'(%& #$" & &'&  




% 

  

so

H '3%2

We compute To simplify notation, we denote By denition, if if

, over

CHAPTER 14. The It Integral o

H ' ' % 3q H '3%q

165

Therefore,

or equivalently
p


In contrast, for Brownian motion, we have

`

14.10 Quadratic variation of an It integral o

Theorem 10.48 (Quadratic variation of It integral) Let o
`C"

$

Then
6)Fg 3

` Y

$"

6  P

but
q3

#T6

6)th3

&"

q3

The extra term there, because

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$ )

 

Remark 14.4 (Reason for the



term) If

is differentiable with

#T6G5#)

&

'

X 

  p  p '

 $ !" 

Let

and use the denition of quadratic variation to get

, 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

H9cV"`b`b`b X  UEbA `v5 6)F

`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:

Proof: (For an elementary process ). Let for . To simplify notation, assume

cVT6G

6 Fh3

$F 3

Compare this with

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

which could be written in differential notation as

&ie 
 t 

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 an It integral, dened in the previous chapter. The second, o

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.
 

15.2 Derivation of It s formula o

`5Q 6)" V

Let

be numbers. Taylors formula implies

`  Cgs V@f"   s d u s X v" X

In this case, Taylors formula to second order is exact because


 s

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

. Using Taylors formula, we write:

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

H%ci `g`b`b X 5UibA

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

and Geometric Brownian motion in integral form is

 

# 0F

6t

Thus, Geometric Brownian motion in differential form is

  t

   # 0F

 


X

"

`CF

)a6)F

5A

#E

6) eG

According to It s formula, o

so

Then where

15.3 Geometric Brownian motion

This is It s formula in integral form for the special case o

CHAPTER 15. It s Formula o

Denition 15.1 (Geometric Brownian Motion) Geometric Brownian motion is

and

to obtain

are constant.

169

170

15.4 Quadratic variation of geometric Brownian motion

In the integral form of Geometric Brownian motion,
 

is not differentiable. It has quadratic variation

`

15.5 Volatility of Geometric Brownian motion

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 .

15.6 First derivation of the Black-Scholes formula

Wealth of an investor. An investor begins with nonrandom initial wealth and at each time , shares of stock. Stock is modelled by a geometric Brownian motion: holds
U

  $"

` 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

. The squared absolute sample

$te

0 X @!

t

t

# 0te

H9ci"`f`g`f5UVbA

Thus the quadratic variation of we write

is given by the quadratic variation of

"

$"

G

6 te

6)F

6 t

$F

is differentiable with

. This term has zero quadratic variation. The It integral o

$

the Riemann integral

U

$"


U

 

$

6F


U

 #
t

6 t

6wte

 
W

. In differential notation,

F

W0#

CHAPTER 15. It s Formula o

F

171

can be random, but must be adapted. The investor nances his investing by borrowing or lending at interest rate .
5 yiF

Risk premium

The differential of this value is

Equating the

coefcients, we obtain:

(where

and

) which simplies to

In conclusion, we should let



be the solution to the Black-Scholes partial differential equation

 "  

If an investor starts with and uses the hedge for all , and in particular, .


F



6)F

`C

6P

6  P

satisfying the terminal condition

62U



 "  

 

 

 e

  

5#

F

%#E

 e

i

t

But we have set we obtain

e

, and we are seeking to cause

to agree with . Making these substitutions,

` F



 

t

To ensure that coefcients, we obtain the

for all , we equate coefcients in their differentials. Equating the -hedging rule:

, then he will have

#  y

A hedging portfolio starts with some initial wealth time tracks . We saw above that

and invests so that the wealth

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

at time . Let denote . In other words, the value of the

 

`Ct

Aytt

t

t

ie

P

d)t






  

yiie

`CF

F

 

0t



d F

!  6

t

t

 # 


# 

# 

!R6t

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F

te

6 te

 t

0te

te

%# !

v

v

6t

t

6)t

e

5

v

6)t

Let

denote the wealth of the investor at time . Then

t

at each

6)t

q3  #

2"C B

F

 "6


 !6t

q3

 !6

d  # G5

t

q3

`  CbQ

  

   F





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` %

 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    

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d     5$F



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   $t


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   $t

5$F     

d  

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   $te

5 F    


   $F

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X

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$t
te

6 " 

t

F U

 

` 

  $"

 

5#E

6)i

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   $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

which implies that

Taking expectations and remembering that the expectation of an It integral is zero, we obtain o

The mean of

We apply It s formula to compute o

15.7 Mean and variance of the Cox-Ingersoll-Ross process

172

The Cox-Ingersoll-Ross model for interest rates is

, then

and

. The integral form of the CIR equation is

are positive constants. In integral form, this equation is

for every . If

. This is

, then

, where

exhibits mean reversion: . We obtain

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

Using the formula already derived for algebra we obtain

Associated with a -dimensional Brownian motion, we have a ltration

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  #

with the following properties:

15.8 Multidimensional Brownian Motion

 

F

a  #

which implies that

Differentiation yields

Taking expectations, we obtain

CHAPTER 15. It s Formula o

Denition 15.2 ( -dimensional Brownian Motion) A -dimensional Brownian Motion is a process

For each , the random vector

i%s

 
6 q a6 3

  te

q3

 

6)te

 

q3

6 F

Each

If

, then the processes

are independent of


For each

. The integral form of the equation derived earlier for

is a one-dimensional Brownian motion;

. , the vector increments and is and integrating the last equation, after considerable -measurable; are independent. is such that 173

   

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q3

#'1 U

3
F

'"'
`Y `

'"'
6)fsF

U 7Is ' ' ) ' ' dX u st H W X p c

 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


15.9 Cross-variations of Brownian motions

174

Because each component

However, we have:

Theorem 9.49 If

Proof: Let of and on

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

is a one-dimensional Brownian motion, we have the informal equation

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

and . It follows that

. First note that

, so

converges to the constant

'"' )

'"'

are independent of one another, and each has

, dene the sample cross variation

CHAPTER 15. It s Formula o

175

15.10 Multi-dimensional It formula o

To keep the notation as simple as possible, we write the It formula for two processes driven by a o two-dimensional Brownian motion. The formula generalizes to any number of processes driven by a Brownian motion of any number (not necessarily the same number) of dimensions.
  
6 F  U U

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"

In integral form, with is

dte

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

Given these two semimartingales

 

and

, the quadratic and cross variations are:

C" `C

$ $

"

" X #
 

$" XX $ X GX

 X

 XX

 

 

5

# 



$"

 

 

 

# 




X X

5#E

 #


 

 

 

6)F

6)t

X X

Ct

)a6


 
U

I v)

I v)V

 

)

Let

and

be processes of the form