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Tampere University of Technology

Post-Graduate Seminar on Applied Mathematics


presentation by Tams Bencsik

Stochastic Integration

Introduction
In this chapter we will study two type of integrals:

f Hs, wL s and gHs, wL W Hs, wL


t

for a t b

where f , g stochastic process on HW, , PL.


If f and g satisfy certain conditions and are stochastic process in Hilbert space HSP , then the integrals will also be stochastic
process in HSP .
Stochastic integrals are important in the study of stochastic differential equations and properties of stochastic integrals
determine properties
of stochastic differential equations.
In this chapter we will
- define the Ito stochastic integral and some important properties
- describe a method to approximate Ito stochastic integrals
- describe the stochastic differentials
- derive the Ito's formula
- define the Stratonovich stochastic integrals

Stochastic Integration.nb

Integrlas of the form a f Hs, wL s


t

Denotation:

J H f L = J H f L HwL := f Hs, wL s
b

for a t b

J H f L HtL = J H f L Ht, wL := f Hs, wL s


t

for a t b

In this and the next section there are 3 other conditions in addition to f HSP
Hc1L
Hc2L
Hc3L

f HaL HRV . Hence, f HaL2RV = E f HaL2 k1 , where k1 is a positive constant

f Ht2 L - f Ht1 L2RV = E f Ht2 L - f Ht1 L2 k2 t2 - t1 for any t1 , t2 e @a, bD for a positive constant k2
f is nonanticipating on @a, bD

Notice that if f HSP satisfies Hc1L and Hc2L, then


f HtLRV

k2 Hb - aL + f HaLRV

for any t e @a, bD

The third conditions means that f Ht, wL doesn't depend on time t ' for t ' > t.
Example:

f1 HtL = 3 CosIW 2 HtLM + 4 W HtL - 5 t is nonanticipating


f2 HtL = W I

Hence,

t+b
M
2

is anticipating for a t b.

EH f1 HtL HW Ht 'L - W HtLLL = 0 for t ' > t


EH f2 HtL HW Ht 'L - W HtLLL =

t ' - t, for t t '


b-t
,
2

for

t+b
2

t+b
2

t' b

To motivate the definition of J H f L = J H f L HwL := f Hs, wL s for f HSP ,


b

the integral for a step function approximation to f is considered.

Definition: Let fm Ht, wL =i=0 fiHmL HwL Ii HtL be an element of SSP. Then
m-1

J H fm L = fm HsL s = i=0 fiHmL Hti+1 - ti L,


b

m-1

where a = t0 t1 ... tm = b and maxi ti+1 - ti 0 as m , fiHmL HwL = f Hti , wL and let Ii HtL =
for i = 0, ..., m - 1
Notice: J H fm L HRV
proof!

1 for ti t ti+1
0 otherwise

Stochastic Integration.nb

Notice: 8J H fm L<
Cauchy sequence in HRV .
m=1
proof!
Thus, 8J H fm L<
m=1 converges in HRV as m . This limit is defined to be J H f L.
Definition: f HSP and a sequence 8 fm <
m=1 SSP such that f - fm SP 0 as m , then
J H f L = f HsL s :=limm
b

fm HsL s = limm i=0 fiHmL Hti+1 - ti L


m-1

Notice: EK f HsL sO Hb - aL E f HsL2 s


b

Notice: f HSP that satisfies Hc2L, then

m-1
a f HsL s = limm i=0 f Hti L Dt
b

where Dt =

b-a
, ti
m

Notice: f - fm 2SP 0 as m .
proof!
Now consider integrals of the form

J H f L HtL = J H f L Ht, wL := f Hs, wL s


t

for a t b

In this case, the integral is defined for each value of t for a t b.


Notice: J H f L HtL HSP .
proof!
Notice: J H f L HtL is cuntinuous in HRV with respect to t on @a, bD.
proof!
Example: EI-WHtL M = 2
t

Example: EIJ I-W MM = 2 K 2 - 1O.


T

= a + i Dt

Stochastic Integration.nb

Ito Stochastic Integral


Denotation:

IH f L = IH f L HwL := f Hs, wL W Hs, wL


b

for a t b

IH f L HtL = IH f L Ht, wL := f Hs, wL W Hs, wL


t

for a t b

Like the prewious section f HSP and satisfis the three conditions.
Definition: For nonanticipating fm SSP where fm Ht, wL =i=0 fiHmL HwL Ii HtL and fiHmL HRV for each i and m, then
m-1

IH fm L = fm HsL W HsL = i=0 fiHmL DWi ,


b

m-1

where DWi = W Hti+1 , wL - W Hti , wL, a = t0 t1 ... tm = b and Ii HtL =

1 for ti t ti+1
0 otherwise

for i = 0, ..., m - 1

Notice: IH fm L HRV .
proof!
Notice: 8IH fm L<
m=1 is a Cauchy sequence in HRV.
proof!
HmL
= b where tiHmL = i Dt + a for i = 0, 1, ..., m and Dt =
Define a family of partitions of @a, bD by a = t0HmL t1HmL ... tm

Let

fm Ht, wL = i=0 f ItiHmL , wM IiHmL HtL

where IiHmL HtL =

m-1

HmL
1 for tiHmL t ti+1
0 otherwise

Notice: f - fm 2SP 0 as m .
*proof!
Definition: (Ito stochastic integral)
Let f HSP satisfy conditions Hc1L - Hc3L. Then,
IH f L = limm

HmL
fm HtL W HtL = limm i=0 f ItiHmL M IW Iti+1
M - W ItiHmL MM
m-1

where tiHmL = a + i

b-a
m

Now consider integrals of the form

IH f L HtL = IH f L Ht, wL := f Hs, wL W Hs, wL


t

for a t b, where f HSP and f satisfies Hc1L - Hc3L.

In this case, the integral is defined for each value of t for a t b.


Notice: IH f L HtL HSP
proof!
Notice: I H f L HtL HRV is continuous with respect to variable t on @a, bD in HRV.

b-a
.
m

Stochastic Integration.nb

proof!
Definiton: (Ito stochastic integral)
Let f HSP satisfy conditions Hc1L - Hc3L. Then,

HmL
IH f L HtL = limm i=0 f ItiHmL M IW Iti+1
M - W ItiHmL MM

where tiHmL = a + i

m-1

t-a
m

Properities: Let f , g HSP satisfy Hc1L - Hc3L, c constant.


HaL
HbL
HcL
HdL

J H f + gL = J H f L + J HgL

I H f + gL = I H f L + IHgL

J Hc f L = c J H f L

IHc f L = c IH f L
EHIH f LL = 0

E I H f L2 = a E f HtL2 t
b

proof!
Example: Let IH f L = t W HtL. Then,
1

EHIH f LL = 0 and E I H f L2 = t2 t =

Example: Let IH f L = W HtL W HtL. Then,

1
3

EHIH f LL = 0 and E I H f L2 = E W HtL2 t = t t =

Example: Let IH f L =
2

-W HtL

1
2

W HtL

EHIH f LL = ? (0) and E I H f L2 = ? (2 (-1))

Example: Let I(1,2)=

t+Dt

W1 HrL W2 HsL where W1 and W2 are two independent Wiener process.

This double integral can't be evaluated exactly so approximations must be used to estimated this integral.
`
I H1, 2L = m-1
i=0

ti

ti+1

ti
0

W1 HrL W2 HsL = i=0 HW1 Hti L - W1 Ht0 LL HW2 Hti+1 L - W2 Hti LL where
m-1

The purpose of this example is to show that


`
2
HDtL2
IH1, 2L - I H1, 2L = M
RV

ti = t + i

Dt
,t
M M

= t + Dt

Stochastic Integration.nb

Stochastic Integralfunction
WHtL
1.0

0.5

0.2

0.4

0.6

0.8

1.0

-0.5

-1.0

-1.5

-2.0
t

WHsLs
0

0.4
0.2

0.2

0.4

0.6

0.8

1.0

-0.2
-0.4
-0.6
-0.8
-1.0
t

WHsLWHsL
0

1.5

1.0

0.5

0.2

-0.5

0.4

0.6

0.8

1.0

Stochastic Integration.nb

Approximation of Stochastic Integrals


Let J H f L = f HtL t where f HSP satisfies Hc1L - Hc3L.
b

a = t0 ... t M = b where ti = a + i Dt for i = 0, 1, ..., N and Dt =

b-a
.
N

J H f L J N H f L := i=0 f Hti L Dt
N-1

Then

J H f L - J N H f L2RV

Hb-aL3 k2
,
2N

implying that J H f L - J N H f LRV = OK

Let IH f L = f HtL W HtL where f HSP satisfies Hc1L - Hc3L.

1
N

a = t0 ... t M = b where ti = a + i Dt for i = 0, 1, ..., N and Dt =

b-a
.
N

IH f L IN H f L := i=0 f Hti L DWi and DWi = W Hti+1 L - W Hti L.


N-1

Then

IH f L - IN H f L2RV

Hb-aL3 k2
,
2N

implying that J H f L - J N H f LRV = OK

1
N

Notice that in either approximation, J N H f L or IN H f L, the respective integral is estimated for only one sample path. To approximate expectations involving stochastic integrals, many sample paths are needed.
For example:
EHgHIH f LLL

Examlpe 3.11: Let

1
M

Mj=1 gJINH jL H f LN,

t W HtL W HtL,

M = 1 000 000, N = 4, 8, 16, ..., 256

EHI H f LLa = EK t W HtL W HtLO =


a

for a = 1 or 2 and tiHNL =

i
N

H jL

where IN H f L is the jth sample-path approximation for j = 1, 2, ..., M .

1
M

N-1 HNL
HNL
ti W H jL ItiHNL M IW H jL Iti+1
M - W H jL ItiHNL MMN
Mj=1 Ji=0

for i = 0, 1, ..., N

Stochastic Integration.nb

The computer result (for the book):


Value of N EHI H f LL2 EHI H f LL2 - 0.25
22

0.14071

0.10929

0.19151

0.05849

0.21906

0.03094

25

0.23508

0.01492

0.24209

0.00791

0.24486

0.00514

0.24821

0.00179

The exact values are E HIH f LL = 0 and EHI H f LL2 = 0.25.


My result:
Value of N EHI H f LL2 EHI H f LL2 - 0.25
22

0.14149

0.10851

0.18790

0.06209

24

0.20798

0.04201

0.23636

0.01363

0.26143

0.01143

27

0.24132

0.00867

0.24669

0.00330

Let IH f L =
2

Exercise 3.4:

-W HtL
2

W HtL

E I H f L2 = ? (2 (-1))

Stochastic integral, m = 1 000 000

Value of N EHI H f LL2 EHI H f LL2 - 2 H - 1L


22

3.69026

0.25369

23

3.56893

0.13236

24

3.49926

0.06269

3.44867

0.01210

26

3.44178

0.00521

27

3.43668

0.00011

3.44086

0.00429

Stochastic Integration.nb

2 -W HtL
2
0

W HtLF

Exercise 3.4 (with EB


Let IH f L =
2

-W HtL
2

W HtL

E I H f L2 = ? (2 (-1))

Use N = 200, M = 20 000.


k := 2
n := 200
m := 20 000
TimingBDoB
Clear@aD
ForBj = 1, j < m + 1, j ++,
T = Table@ 1 + 2 Random@IntegerD, 8s, 1, n<D;
j

Sn = TableB T@@iDD, 8j, 1, n<F;


i=1
2
k

a@jD =

n1

i=1

Sn@@iDD
n

T@@i + 1DD

F
PrintB"E=", M1 = AbsBNB

1
m

F
E=3.33538
8337.055, Null<

Error
0.10118

Varriance
162.713

a@jDFFF, 81<F
j=1

10

Stochastic Integration.nb

Exercise 3.4 (with EB -W HtL tF )


0

k := 2
n := 200
m := 20 000
TimingBDoB
Clear@bD
ForBj = 1, j < m + 1, j ++,
T = Table@ 1 + 2 Random@IntegerD, 8s, 1, n<D;
j

Sn = TableB T@@iDD, 8j, 1, n<F;


i=1

k
b@jD =
n

n1

k
n

Sn@@iDD

i=1

F
PrintB"E=", M2 = AbsBNB

1
m

F
E=3.4289
8319.069, Null<

Error
0.00766223

Varriance
17.2767

b@jDFFF, 81<F
j=1

Stochastic Integration.nb

Stochastic Differentials and Ito's Formula


In this section, the following stochastic process is considered :
H*L

X HtL = X HaL + f HsL s + gHsL W HsL


t

for a t b,

where f , g HSP , X HaL HRV and f , g satisfy Hc1L - Hc3L.


Notice: X HSP because of f HsL s and gHsL W HsL HSP .
t

Notice: If f (or g) satisfies Hc1L - Hc3L, then

f HtLRV f HtL - f HaLRV + f HaLRV


Therefore,

E f HtL2 2 k2 Hb - aL + 2 f HaL2RV

k2 Hb - aL + f HaLRV for a t b.
for any t @a, bD

Notice: X HtL is a continuous stochastic process in HRV .


proof!
Consider this stochastic differential:
X HtL = f HtL t + gHtL W HtL

for a t b.

An important result is Ito's formula which says that a smooth function, F Ht, X HtLL, of the stochastic process X HtL also
satisfies a stochastic differential.
Hc4L
Hc5L

For function G : @a, bD  , there exists a nonnegative constant k3 such that for any
t1 , t2 @a, bD and any X HSP then
E G Ht2 , X Ht2 LL - G Ht1 , X Ht1 LL2 k3 It2 - t1 + E X Ht2 L - X Ht1 L2 M.

For function G : @a, bD  , then GHa, X HaLL HRV if X HaL HRV .

Theorm (Ito's Formula):


Let X HSP satisfy H*L for t @a, bD, where f and g satisfy Hc1L - Hc3L and
f 2 HtLRV , g2 HtLRV k4

for t @a, bD.

Let F be a function of t and x. Assume that F Ht, xL has the cintinuous derivates
FHt,xL FHt,xL 2 FHt,xL 2 FHt,xL 2 FHt,xL
, x , t2 , 2 x , t x
t

and that F and these derivates satisfy Hc4L - Hc5L.


Suppose also that the functions

for t @a, bD and x 

11

12

Stochastic Integration.nb

f HtL

FHt,xL
,
x

1
2

gHtL

2 FHt,xL
FHt,xL
, gHtL
x
x2

satisfy Hc4L - Hc5L. Let

FHt,xL
FHt,xL
f Ht, xL =
+ f HtL
+
t

1
2

g2 HtL

2 FHt,xL
x2

and
FHt,xL

gHt, xL = gHtL
.
x

Then, F satisfies the stochastic differential

FHt, X HtLL = f Ht, X HtLL t + gHt, X HtLL W HtL


proof!
Example: s W HsL = - W HsL s + t W HtL.
t

Example: W HsL W HsL =


t

Example:

1
2

IW 2 HtL - W 2 H0LM - 2 .
t

0 W HzL z s = t 0 W HsL s - 0 s W HsL s.


s

Example: WHtL - 1 =

t1

0 2

WHsL s + WHsL W HsL


t

Example: Let r HtL = EIWHtL M show that rHtL satisfies the initial value problem

rHtL = EIWHtL M = 2 .
t

Stratonovich Stochastic Integral


Recall that the Ito stochastic integral is defined as
HmL
HmL
HmL
m-1
a f Ht, wL W Ht, wL = limm i=0 f Iti , wM IW Iti+1 , wM - W Iti , wMM
b

where tiHmL = a + i

b-a
m

for i = 0, 1, ..., m and the sum convergent in HRV .

Definition: (Stratonovich Stochastic Integral)

f HtL W HtL = limm i=0

HmL
HmL
m-1 f Iti M+ f Iti+1 M

HmL
IW Iti+1
M - W ItiHmL MM

r HtL
t

1
2

rHtL with rH0L = 1. Thus

Stochastic Integration.nb

In the summation,

HmL
f ItiHmL M+ f Iti+1
M

HmL
and IW Iti+1
M - W ItiHmL MM are not likely to be independent. Consequently, Ito and Stratonovich

integrals generally have different values.


Example: W HsL W HsL =
t

IW 2 HtL - W 2 H0LM

1
2

It is useful to be aware that Ito and Stratonocich stochastic differential equations are closely related. In particular, if X HtL
satisfies the Stratonovich stochastic differential equation
X HtL = X H0L + f Hs, X HsLL s + gHs, X HsLL W HsL
t

then X HtL satisfies the Ito stochastic differential equation


X HtL = X H0L + J f Hs, X HsLL +
t

1 gHs,X HsLL
2
x

gHs, X HsLLN s + gHs, X HsLL W HsL


t

Multidimensional Ito' s Formula


Consider in this section is the multidimensional stochastic differential
for a t b
XHt, wL = f Ht, wL t + GHt, wL WHt, wL
where

XHt, wL = @X1 Ht, wL, X2 Ht, wL, ..., Xn Ht, wLDT


f Ht, wL = @ f1 Ht, wL, f2 Ht, wL, ..., fn Ht, wLDT

WHt, wL = @W1 Ht, wL, W2 Ht, wL, ..., Wm Ht, wLDT


HG Ht, wLLij = gij Ht, wL
In particular, notice that WHtL is an m-dimensional Wiener process where the elements Wi and W j are independent if i j.
In this case:

Xi Ht, wL = fi Ht, wL t + j=1 gij Ht, wL W j Ht, wL


m

Hence,

Xi Ht, wL = Xi Ha, wL + fi Ht, wL t +


t

for i = 1, 2, ..., n

mj=1 gijHt, wL W j Ht, wL

for i = 1, 2, ..., n

n .
Let FHt, XL be a smooth function of t and X. That is, F : @a, bD HSP

In this case the Multidimensional Ito's Formula:


FHt, XL = K t + i=1
F

F
xi

fi + i=1 j=1 k=1


n

1 2 F
2 xi x j

gik g jk O t + i=1 j=1 x gij W j HtL


n

Consider the following example where n = 1 and m = 2.


X1 Ht, wL = f1 Ht, wL t + g11 W1 + g12 W2
FHt, X1 L = K t +
F

F
x1

f1 +

1 2 F
2 x21

2
2
Ig11
+ g12
MO t +

F
x1

g11 W1 +

F
x1

g12 W2

Example: Let X1 HtL = a W1 HtL + b W2 HtL with X1 H0L = 0 and a and b are nonzero constants. Let FHt, X1 L = X12 .
In this case:

0 W1 HsL W2 HsL + 0 W2 HsL W1 HsL = 2 HW1 HtL W2 HtL - W1 H0L W2 H0LL


t

13

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