Stochastic Calculus Cheatsheet

Standard Brownian Motion / Wiener process

E[dX 2 ] = dt

E[dX] = 0

limdt0 dX 2 = dt

Discrete approx: dX = dt where N (0, 1)

dX is O(dt1/2 )

dtdX is O(dt3/2 )

Ito Product Rule

Characterization:
1.
2.
3.
4.

X(0) = 0
Continuous everywhere, differentiable nowhere
X(t) X(s) N (0, |t s|)
X(t + s) X(t) is independent of X(t)

Levys characterization:
3. Xt is a martingale w.r.t. the filtration Ft
4. |X|2 t is a martingale w.r.t. the filtration Ft

If dXt = dt + dWt and dYt = dt + dWt ,

d(Xt Yt ) = Xt dYt + Yt dXt + dXdY
1
= Xt dYt + Yt dXt + dt
2

Stochastic Differential Equations (General Form)

dS

= f (t, S) dt + g(t, S) dXi

dSi

= fi (t, S0 , . . . , Sn ) dt + gi (t, S0 , . . . , Sn ) dXi

where f is the drift, g is the diffusion

Itos Lemma and Basic Stochastic Integration

For F (Xt )
dF
1 d2 F
dF =
dXt +
dt
dX
2 dX 2

Z
F (Xt ) = F (X0 ) +
0

dF
1
dX +
dX
2

Z
0

d2 F
d
dX 2

For F (Xt , t)
dF =

F
dXt +
X

F
1 2F
+
t
2 X 2

Z
dt

F (Xt , t) = F (X0 , 0) +
0

F
dX +
X

Z t
0

1 2F
F
+
t
2 X 2

Functions of Stochastic Functions

1-dimensional: V (t, S)
dV

=
=

1. Apply Taylor expansion on V

2. Apply Itos Lemma:

V
V
1 2V
dt +
dS + g 2 2 dt
t
S
2 S


V
V
1 2V
V
+f
+ g 2 2 dt + g
dX
t
S
2 S
S

dXi2 dt
dXi dXj ij dt
3. Regroup the terms in dt and dXi
4. Sto.integ.: integrate the resulting DE

2-dimensional: V (t, S1 , S2 )

dV =

V
V
V
1 2V
2V
1 2V
+ f1
+ f2
+ g12 2 + g1 g2
+ g22 2
t
S1
S2
2 S1
S1 S2
2 S2


dt + g1

V
V
dX1 + g2
dX2
S1
S2

n-dimensional: V (t, S1 , . . . , Sn )

dV =

n
X

n
1X

V
V
+
fi
+
t
S
2
i
i=1

i=1

gi2

n
X

n
X
V
V
V
+

g
g
dt
+
gi
dXi
ij i j
Si2 i=1,j>1
Si Sj
S
i
i=1
2

Transition Density Functions

Solution

Forward Kolmogorov


1 2
p

=
B(y 0 , t0 )2 p 0 (A(y 0 , t0 )p)
0
02
t
2 y
y

log
p(S, t; S 0 , t0 ) =

1
S 0

2(t0 t)

S
S0

2
+ 21 2 (t0 t)
2 2 (t0 t)

Common Processes/Dynamics
Geometric Brownian Motion (Lognormal)
Brownian Motion with Drift

dS = S dt + S dX

dS = dt + dX

dS
= dt + dX
S

Cox, Ingersoll, Ross

Vasicek (1977)
dS = (
r r) dt + dX
FIXME TODO add others, Ho Lee and company...

dS = ( S) dt + S 2 dX

All you need to know about Sto.Calc

(FIXME integrate these words of wisdom from Antoine.)
If Xt N (, ) then E(xXt ) = e+

2
2

Ito: d(f (Xt ))

Ito: d(Xt Yt ) = Xt dYt + Yt dXt + 12 dt where dXt = dt + dWt and dYt = dt + dWt
R
E[ Xt dWt ] = 0
R
R
V ar[ Xt dWt ] = Xt2 dt
Girsanovs theorem.
Generating correlated X and Y .

Martingales

Probability Spaces

Unconditional Expectation

Let (, F, P) be a probability space. . .

Expected value under a prob. measure (Lebesgue integral):

Z
Z
Z
E[h(X)] =
h(x)p(x)dx =
h(x)d(P(x)) =
h(x)d P

Z
Z
E[1{XA} ] =
1{XA} d P = d P = P(A)

: sample space
F: filtration (information set),
(Note that Ft1 Ft2 FT F)
P: probability measure

Conditional Expectation

Martingales (Definition)

(Use these to prove that a process is a Martingale; use the definition.)

E[Mt ] <
E[Mt+1 |Ft ] = Mt

0 s t

E[Mt+1 |Ft ] Mt

(supermartingale)

E[Mt+1 |Ft ] Mt

(submartingale)

1. Linearity: E[aX + bY |F] = aE[X|F] + bE[Y |F]

2. Tower Property: if F G,
E[E[X|G] |F] = E[X|F]

Wiener Martingale (driftless) Markov (memoryless) nonMarkov

E[E[X|F]] = E[X]
3. Taking out what is known:

Equivalent Measures

E[X|F] = X

Absolute continuity: if P (A) = 0 Q(A) = 0

Q is absolutely continuous w.r.t. P, and Q << P.

A.

It is allright to tinker with the probabilities as

long as we do not tinker with the
(im)possibilities.
Equivalent measures: if Q << P and P << Q.

Radon-Nikodym Theorem
Q(A) =

Z
A

dP

E[XY |F] = XE[Y |F]

4. Independence: if X is independent from F,

E[X|F] = E[X]
5. Positivity: if X 0 then E[X|F] 0
6. Jensen Inequality: if f is a convex function, then
f (E[X|F]) E[f (X)|F]

Exponential Martingale

dQ
is the R.N. derivative.
dP

where =

(if X is F-measurable but not Y :)

M (t) = exp(St + f (t))

where f (t) = ( +

1 2
)t
2

Ito Integrals & Martingales

Properties of Ito Integrals

Ito integrals are Martingales:

Z

1. Linearity:

E[

g(t, Xt )dXt ] = 0
0

Z
(f (t)+g(t))dXt =

Martingale Representation Theorem

If M is a Martingale, there exists g(t, X) such that
Z

MT = M0 +

g(t, X)dXt
0

Z
f (t)dXt +

g(t)dXt
0

2. Isometry:

2
"Z
#
Z T

T


E 
f (t)dXt  = E
|f (t)|2 dt
 0

0

The rightmost term is an Ito integral (and thus also a Martingale).

3. Martingale:
"Z

Fubinis Theorem
"Z
E

f (Xt )dt =
0

E [f (Xt )] dt
0

 # Z

s

f (t)dXt Fs =
f (t)dXt

0

Application of Martingales to Asset Pricing

Warning: I still need to complete and arrange this page of notes.

Fundamental Asset Pricing Formula

Value = E Meas. [P V (expected cash flows)]

Novikov Condition
h 1 RT 2 i
E e 2 0 s ds <

Risk-free Asset
dBt = rBt dt,

Mt = e(

B(0) = B0

B(t) = B0 ert

s dXs 21

Rt

s2 ds)

is a Martingale

Girsanovs Theorem
Rt
Rt 2
1
dQ
= e( 0 s dXs 2 0 s ds)
dP
Z t
XtQ = XtP +
(s)ds

Underlying S
dSt = St dt + St dX,
S(t) = S0 e

Rt

S(0) = S0

t 12 2 +Xt

Provides an expression for the Radon-Nikodym

derivative.

Removing the TVM

Gives an explicit correspondence btw P and Q in

terms of their Brownian motion.

S(T )
S (T ) = rt
e
1 2

S (t) = S0 e(r 2 )t+Xt

dS = ( r)S dt + S dX

Self-financing Portfolios

. . . but does not tell you what is. We assume and

check that it satisfies the Novikov condition. Then we
have the RN derivative, and we can change measures!

Doleans/Stochastic Exponential

Trading Strategy:
t

Z

t = (St , B
t ) processes


s dXs

s dXs

Value :

Vt () =

St St

+
Z t

Vt () = V0 () +

t [0, T ]
Z t
Su dSu +
B
u dBu


s2 ds

(s)ds

Feynman-Kac Equivalence

Arbitrage opportunity:

PDE:

V0 () = 0
and

1
2

B
t Bt

with P (VT () > 0) > 0

XtQ = XtP

Self-financing portfolio: no in/out flows.

Z
= exp

P (VT () < 0) = 0

V
V
1 2V
+
+ 2 2 rV = 0,
t
S
2 S
dSt = (t, St )dt + (t, St )dXt

V (T, S) = G(S)

m
Expectation: V (t, St ) = er(T t) E [G(ST )|Ft ]