Itô's Stochastic Calculus and Its Applications

D. N. Shanbhag and C. R. Rao, eds., Handbookof Statistics, Vol.
19 ~'~
.g... ,,.2
2001 ElsevierScienceB.V. All rights reserved.
It6's Stochastic Calculus and Its Applications
Shinzo Watanabe
O. Introduction
It6's stochastic calculus is one of the most important methods in modern prob-
ability theory to analyze various probability models. In up-to-date applications,
for example, it provides us with a basic tool in the theory of mathematical finance
such as theory of derivative pricing.
A general framework of this calculus is usually given as a sample functions
analysis for a class of stochastic processes called semimartingales or generalized
Itd processes. A characteristic feature of a semimartingale is that it represents a
random motion in time perturbed by a noise; the noise is assumed to be a
martingale which represents a fluctuation around the main motion and the main
motion is assumed to be adapted and smooth in the sense that its sample function
is of bounded variation in time. Here, the martingale property and adaptedness are
referred to a given filtration on the probability space.
In this framework, we can develop a differential integral calculus for sample
functions. A basic notion here is stochastic integrals' and, by using this notion, a
fundamental formula in this calculus, now very well-known as Itd'sformula, can
be obtained. It is a formula for the change of variables or the chain-rule under the
differentiation for sample functions of semimartingales and, when applied suc-
cessively, leads to the Taylor expansion formula.
We can associate for semimartingales some of their characteristic quantities
such as quadratic covariational processes and compensating random measures for
jumps which may be considered as a natural extension of covariance parameters
of Gaussian components and L~vy measures, respectively, in the L~vy-Kchinchin
characteristic of infinitely divisible distributions or associated L6vy processes.
What is crucially important in this framework is the fact that fundamental noises
in probability models in continuous time such as Gaussian white noise (equiva-
lently Wiener process) or Poisson point process can be characterized in terms of
these characteristics of semimartingales. From this fact, we can extract funda-
mental noises in stochastic models; in other words, we can see how these models
are combined with noises. So, roughly, we could obtain stochastic equations
governing stochastic models. Typically, this is an It6's stochastic differential
873
874 S. Watanabe
equation for the Kolmogorov diffusion model. Using these stochastic equations,
we can construct and analyze the structure of stochastic models. Thus, besides
analytical methods based on differential equations. Fourier analysis and func-
tional and potential analytic methods like Hille-Yosida's theory of semigroups
and Fukushima's theory of Dirichlet forms, among others, stochastic calculus
also provides us with efficient and sometimes more direct probabilistic methods in
the study of probability models; such a probabilistic approach could in many
cases give a deeper understanding of results obtained by an analytical approach.
1. Semimartingales and stochastic integrals
1.1. General notions on stochastic processes

Let (~2,S , P ) be a probability space, i.e., a a-additive probability measure P
defined on a a-field @ of subsets in g2. We assume always that it is complete,
i.e., if A c B, B E Y and P(B) = 0, then A E S so that P(A) = 0. Let X =
{A g IP(A) = 0).
In this article, we consider random phenomena depending on the continuous
time; t E [ 0 , ~ ) . Of course, there are corresponding notions or results in the
discrete time case and they can be stated much simpler because there are much
less mathematical technicalities involved.
By afiltration, we mean an increasing family {St}tE[0,~) of sub a-fields of S :
StCS fortE[0,~) andStcSs if0<t<s .
A filtration is said to satisfy the usual conditions if

(i) Y C S 0 so that X c S t for every t c [0, ec).
(ii) t H S t is right-continuous in the sense that S t = ~s>tS~ for every t E [0, oc).
In the following, we assume that a filtration satisfies the usual conditions unless
otherwise stated.
By a random time, we mean a random variable T with values in [0, oc]. Given a
filtration {St}, a random time T is called an {St}-stopping time (or simply a
stopping time if the filtration is well understood), if
[T < t](:= {colT(co) _< t}) c S t for every t c [0, oo) .
Because of the right-continuity of {~-~t}, T is an St-stopping time if and only if

IT < t] E S t for every t E [0, oc). For an St-stopping time T, define a sub-a-field
S r of S by
Sr={AES[An[T_<t]ESt for a l l t ~ [ 0 , oc)} .
We introduce several notions concerning stochastic processes, i.e., a family
X = (X(t, co)) of random variables depending on the time t E [0, oo). We consider
a stochastic process X = (X(t, co)) taking values in a Polish space S; a Polish space
is a topological space with the topology given by a metric under which it is
Itd's stochastic calculus and its applications 875
separable and complete. Let 5 ~ be the a-field of Borel subsets of 5:, i.e., 5 ~ is the
smallest a-field on 5: containing all open subsets of S. X defines a m a p
x: [0, (t, co) x(t, co) s .
X is called {~-dt}-adapted if for each t E [0, oc), the map f2 ~ co~-~X(t, co) E 5: is
o~t/SP-measurable. X is called {~t}-progressively measurable if, for every
t E [0, ec), the map X : [0, t] x f2 ~ (u, co) ~ X ( u , co) E S is N[0, t] ~ t - m e a s u r -
able. If X is {~t}-progressively measurable, then it is { ~ t } - a d a p t e d .
Two stochastic processes X and Y with the same state space 5: are considered as
the same and we write X = Y if
{col3t, x(t, co) y(t, co)} J< .
X is called right-continuous (left-continuous), or cfid (resp. cfig), if

\ {colt ~ X(t, co) is right continuous (resp. left-continuous)} ~ Y .
X is called right-continuous with left-hand limits, or cfidlfig, if
Q \ {co[t~--,X(t, co)is right continuous with left-hand limits} E Y .
X is called continuous if it is both right- and left-continuous. I f X is { f f t } - a d a p t e d

and cfid or {~-t}-adapted and cfig, then it is {fft}-progressively measurable. I f X
and Y with the same state space are cfid, or cfig, then X = Y if and only if, for
every t E [0, oo), {co[X(t, co) Y(t, co)} c Y .
Let ~ ((9) be the smallest a-field on [0, t ] x (2 with respect to which all {~-t}-
adapted, R-valued and cflg (resp. all {~-t}-adapted, R-valued and cfid) processes
X : [0, oc) f2 --+ R are measurable. Then it holds that ~ c (9. This can be seen
from the fact that N coincides with the smallest a-field on [0, t] ~2 with respect to
which all {~,~t}-adapted continuous processes are measurable.
is called the predictable a-field and (9 the optional a-field. 5: being a Polish
space, an 5:-valued stochastic process X is called {~t}-predictable ({~t}-optional)
if the map X : [0, oc) x f2 ~ (t, co) ~ X ( t , co) E S is N / ~ - m e a s u r a b l e (resp. (9/5 p-
measurable). Since ~ c (9, an {~-t}-predictable process is an { ~ t } - o p t i o n a l
process. An {~'t}-optional process is an {~-t}-progressibly measurable process.
1.2. Martingales and processes of bounded variation

Suppose that we are given a filtration {Yt}tc[0,o~) on a complete probability space
which satisfies the usual conditions. An R-valued stochastic process X =- (X(t, co))
is called an {~t}-martingale if it satisfies:
(i) it is adapted to {~-t}, i.e., X(t) is ~ t - m e a s u r a b l e for every t E [0, ec),
(ii) X(t) is integrable for every t c [0, ec), i.e., X ( t ) E La(f~,P) for every
t [o,
(iii) for every t > s > O,
E(X(t)h~-, ) = X(s) a.s.
i,e., E(X(t)IA) = E(X(s)I~) for all A E ~ s -
876 S. Watanabe
For a martingale X, we always assume that it is cfidlfig; this is no loss of generality

because, for any {~-t}-martingale X, there is a cfidlfig {~t}-martingale X ~ such
that X(t) = X'(t), a.s. for every t E [0, ec). I f X = (X(t, co)) is an {Yt}-martingale
and T is an {Yt}-stopping time, then the stopped process X r = (Xr(t, co)) defined
by
x (t, co) -- x(r(co) A t, co)

is also an {~t}-martingale. This fact is known as Doob's optional stopping
theorem. Noting it, we give the following definition: a cfidlfig {~t}-adapted
process X = (X(t, co)) is called an {~t}-local martingale if there exists a sequence
{ T,n}n=l
Oo of {~t}-stopping times such that T, < T~+I, limnTooTn = ec a.s. a n d X r',
is {~t}-martingale for each n. Also, the following characterization of martingales
in terms of stopping times is useful: A cfidlfig {~t}-adapted process X is an {~t}-
martingale if and only if for every bounded {Yt}-stopping time T, X(T) is
integrable and E(X(T)) = E(X(O)). Here, T is called bounded if T(co) < K a.a. co
for some constant K > 0.
Introduce the space M2 of square-integrable martingales by
M2 = {M = (M(t, co))]M is an{~t}-martingale with

M(0) = 0 a.s., and E(X(t) 2) < oc for every t E [0, oc)} (1)
and the space Ma,ioc of locally square-integrable martingales by
M2,~oc = {M = (M(t, co))]3{Tn} : a sequence of {@t}-stopping

times such that Tn _< T~+I,
limT~ = oc a.s. and M r" E M2 for n = 1 2,...
)
I (2)
/,/Too
Let
A = {A = (A(t, co))lA is {~t)-adapted, cfidl~tg,
A(0, co) -- 0 and t~-+A(t, co) is increasing for a.a. co} (3)
and
A1 = {A = (A(t, CO))[A E A and E(At) < oc for every t C [0, ec)} . (4)
Denote by A pred and Apred their subclasses formed of all predictable elements,
respectively. Set, further,
V = {V = (V(t, co))l~A1 = (Al(t, co)) e A,A2 = (Az(t, co)) E A
such that V(t, co) = Al(t, co) -A2(t, co)} (5)
and define V1, wPred' --lXtypred'similarly by replacing A with A1, A pred and Apred
--1 ,
respectively, in (5). A E A is called an {t}-increasing process and V V an
{ ~ t }-process of bounded variation.
Let
M~ = {M c M2[M is continuous},
M = {M E M2,1oclM is continuous}
and V c , V c1 are -1 Note also
defined similarly. Obviously, V c V pred and V c1 C vpred
that M is exactly the class of all continuous {Yt}-local martingales M with
M(0) = 0 and V is the class of all {~-t}-adapted continuous processes V such
that V(0) = 0 and [0, t] H V(t) is of bounded variation for every t > 0, a.s..
An important consequence of the Doob-Meyer decomposition theorem for
submartingales (cf. Dellacherie-Meyer, 1980) is that, for M, N c M2,1oo,(M2), there
exists unique V E V pred, (resp. vPred), such that M(t)N(t) - V(t) is an {Wt}-local
martingale (resp. {o~t}-martingale). This V is denoted by (M, N) and is called the
quadratic co-variationalprocess of M and N. (M, M) E A pred (resp. A pred1 ) and this is
simply denoted by (M). (M, N) is continuous if, at least, one of M and N is continuous.
1.3. Wiener martingales and Wiener processes

Let M = (M(t)) E (M) d, M(t) = ( M l ( t ) , . . . ,Md(t)), be a d-dimensional contin-
uous {~-t}-local martingale with M(0) = 0, i.e., M i E M for i = 1 , . . . , d. It is
called a d-dimensional {~t}-Wiener martingale if
(Mi,MJ)(t) = (~i,j . t for i , j = 1 , . . . , d . (6)
A d-dimensional Wiener process (Brownian motion) X = (X(t)) is, as usual, a

continuous Rd-valued process with stationary independent increments with
N(O, (t - s)I) as the law of X ( t ) - X(s) for t > s > O. [N(m, V) stands for the
multivariate normal distribution with the mean vector m and the covariance matrix
V.] I f X = (X(t)) is a d-dimensional Wiener process, then it is easy to see that the
process M = (M(t)), defined by M(t) = X ( t ) - X(O), is { J t } - W i e n e r martingale if
the filtration {Yt} is the natural filtration of X, i.e., J~t is the smallest a-field
containing all P-null sets and with respect to which all X(s), 0 < s < t, are mea-
surable. (This filtration is always right-continuous.) Conversely, we have the fol-
lowing result known as P. Ldvy's martingale characterization theorem for Wiener
process. This result is basically important in stochastic analysis:
TI~EORE~ 1. Suppose that X = (X(t)) is an Rd-valued, continuous and {Wt}-

adapted process (defined on a probability space with a filtration { ~ t } ) such that
M = (M(t)) defined by M(t) = X ( t ) - X(O) is {~-t}-Wiener martingale. Then X is
a d-dimensional Wiener process. Furthermore, for every s >_ 0, the family
X ( t ) - X(s), t > s, is independent of the a-field Ys. (Such a Wiener process is
usually called {~-o~t}-Wiener process.)
1.4. Stochastic integrals

If V ~ V, then, for each t E [0, oo), s C [0, t] ~ V(s) is of bounded variation, a.s.
and we denote by lIVIl(t) its total variation on [0, t]. Then IIVII E A. For
878 S. Watanabe
{@t}-predictable processes ~ = ( q ) ( t , co)) and t P = ( T ( t , co)), the following

Schwarz-type inequality holds for every t E [0, co), a.s.:
fo~+l~)(u)~(u)I
"dlI(M,N)H(u)<_ I/or+~(u)2d(M)(u)]I/2
[Jot+~(u)2d(N)(u)l 1/2 (7)
For a given M E ~/I2,1oc, let

(
~2,1oc(M) = J ~ = (~(t, co))l~b is {~t}-predictable and there exist a
sequence {Tn} of {~t}-stopping times such that

Tn -+ oc a.s. and, for every t E [0, ec) and
n = 1,2,..., E q~(s)2d(M)(s < oc (8)
and
(
=~2(m) = ~ ~ = (~(t, ~o))1~ is {~-t}-predictable and
E '+~(s)2d(M)(s )l <ooforallt>0 } . (9)
THEOREM 2. For given M E Mz,mc and 4)c L-q'2,1oc(M), there exists a unique
N C M2,ioc such that, for every L E M2,1oc, the following identity holds a.s.;
<L,N)(t)=
f0'+ ~(u).d(L,M)(u) (I0)
The right-hand side of (10) is an co-wise Lebesgue-Stieltjes integral which is well-
defined because of the inequality (7). We denote this N by
N(t, co) =
J0' ~(u, co)- dM(., co) ,
or simply by
/0' e(.).an(.) or
/ e.d~,
and call it the stochastic integral of (b(u) by M.

Itd's stochasticcalculusand its applications 879
The following are the fundamental properties of stochastic integrals:

1) If M E M c and E Y2,1oc(M), then f~b. dM E M c, i.e., the stochastic
integral by a continuous local martingale is again a continuous local martingale.
2) I f M E M2,1oc, q~ C Y2,1oc(M) and 7~ E 5~2,1oc(f~b- dM), then ~ 7 j E ~2,1oc
(M) and
/ ~ d(/~b - d M ) = ./4~k~ dM .
3) If ~, 7j E 5e2joc(M), then for every e,/? C R, ~b +/~T =

(~b(t) + / ~ ( t ) ) C S2,1oc(M) and
/ (o~b+ fl~P) . dM = c~f q~. dM+ fl / Tt . dM .
4) If M, NEM2,1oc, and ~bESC'2(M) nS~2(N), then for every c~,/~ER,

E L-~2,1oc(c~M+/~N) and
f ~.d(~M+~N)=~/~.dM+~/~.dN.
5) IfM, N E M2,1oc, and C 52,1oc(M), kv E ~2,1oc(N), then
(f ~'dM,./ ~" dX)(') = f'+~(u)~(u) "dIM,N)(u).

The right-hand side is well-defined as a Lebesgue-Stieltjes integral because of the
inequality (7). In particular,
I / q~.dM)(t)= fot+~(u)2.d(M)(u) .
6) If 45 is given in the form

~(t) - - l [ T < t ] - (p
where T is {ft}-stopping time and ~o is a bounded fir-measurable real random

variable, then 4~ E 52,1oc(M) for every M C M2,1oc and we have
fo ~ ~(~) . da(~) = ~o. (M(t) - M ( t A r ) ) , t _> 0 .
In particular, we have
f0 t l[,_<r]-dM(u) = M ( T A t), t>0 .

Combining this with 2, we can conclude that, if c Ya,loc(M), M C M2,1oo, then,
for every {ft}-stopping time T, (l[t_<r]~b(t)) ~ ~2,~oc(M) and
,~0t f TAt
~(u) l [ ~ r l ' d M ( u ) = ~(u).dM(u), t_> 0 .
./0
880 S. Watanabe
Furthermore, if ~0 is given in the form

N
(t) = ~o0. l[t=0] + Z q)k l[Tk<t<T~+~] (11)
k-0
for a sequence fT~ 1N+I of {~t}-stopping times such that To = 0 and Tk < T~+I,
"t k;k=0
a.s. and bounded Yvk-measurable real random variables %, k = 0 , . . . ,N, then
~b E ogaZ,loc(M) for any M E M2,1oc and
fo ~b(u).dM(u)=~-~Cpk.(M(Tk+lAt)-M(TkAt)) ,
k=0
t>_O . (12)
A predictable process ~b of the form (11) is often called a bounded simple pre-
dictable process. The assumption that (p and q~k are bounded is not needed when
M E M C. Then the formula (12) holds for every simple predictable process ~, i.e.,
~ok in (11) need not be bounded.
7) For M E M2,1oc and ~b E oocza2,ioc(M), f ~b- dM E M2 if and only if
~b E ~Cza2(M). Then we have
E
I(/0 qS(s).dM(s =E ~b(s)2-d(M)(s
,1
, t> 0 .
More generally,
=E
[/o q~(s)gJ(s).d(M,N)(s),
] t>0
if E ~2(M) and ~g E ~2(N).
1.5. Point processes and Poisson point processes

Let (if, ~_=) be a measurable space. By a point function on E, we mean a mapping
p : I)p c (o, ~) ~ t ~ p(t) c s
where the domain Dp o f p is a countable subset of (0, oo). p defines a counting

measure Np(ds, d~) on (0, ~ ) x E with the product a-field ~(0, oo) ~ z by
Np((O,t]x U ) = ~ 1u(p(s)), t>0, UE~z

sEDp,s<t
Let Hz be the totality of point functions on E and ~(/Tz) be the smallest o--field
o n / 7 ~ with respect to which the all the mappings Flz ~pHNp((O,t] x U) C N,
for t > 0 and U c ~ e , are measurable.
Let (Y2,W,P) and {fit} be as above. A point process is obtained by ran-
domizing the notion of point functions; a point process p on E is a (//z, ~ ( H s ) ) -
valued random variable, i.e., p : (2 --+ H3 which is ~-/2(Hz)-measurable. p is

called {~t}-adapted if, for every t > 0 and U E 2 s , Np((O, t] x U) is ~t-mea-
surable, p is called a-finite if there exist U, c 2 e , n = 1 , 2 , . . . , such that
Un C gn+l, U U, ----~ and Np((O, t] Un) < oo

n
a.s. for e v e r y t > 0 a n d n .
Let p be an {Wt}-adapted, a-finite point process. We say that p possesses the

compensator Np if a nonnegative random measure Np(ds, d~) on [0, oc) x e exists,
i.e., for E c 2([0, oc)) 2 z , Np(E) is [0, eel-valued random variable and, with
probability one, E ~ N p ( E ) is a measure on ([0, oc) 3, 2([0, oc)) 2 z ) , such
that the following hold:
(i) t~Np([O,t] U) is {Yt}-predictable for every U E if,
(ii) if U, are those subsets in the definition of a-finiteness of p, then
Np([0, t]x U ~ ) < o c a . s . for every t>0andn ,
(iii)
t~--~ Np([O,t] (Un 718))

-Np([O,t](Un Me)) C M2,1oc for every n and B E 2 s
Np, when exists, is uniquely determined from p by these properties and
satisfies always
2Vp({s}xB)_< 1 a.s. for e v e r y s _ > 0 a n d B c 2 3
The existence of the compensator is assured fairly generally: For example, if S is a
Polish space and 2 s is the Borel a-field, the compensator always exists. Note that
the existence of Np([0, t] (U~ A B)) in (iii) above for a fixed B and n is guaranteed
by the Doob-Meyer decomposition theorem.
Suppose that p possesses the compensator Np and set
/Vp([O, t] B) = Np([O, t] x B) - Np([O, t] x B) .
Then
t~--~Np([O,t l x B ) cM2.,oc, ifBc U,, f o r s o m e n
and it holds, for B, B' E 2 s such that B, B' C U, for some n and t > 0,
/Np([0, t] B),Np([0, t] B'))--NA[0, t] (B riB'))
B) B,).
s<t
A function IO, oc) S f2 ~ (t, 3, co) ~-+g(t, 3, co) E R is called {~t}-predict-

able, if, as a function ([0, oo) Q) 3 E ((t, co), 3) ~-~g(t, 3, co) E R, it is ~ 2 s -
measurable. Introduce the following classes of predictable functions:
882 S. Watanabe
f
Fp = ~f(t, 4, co)If is {~t}-predictable and
]f(s,~,co)lNp(ds, d~) < ec a.s., for all t > 0
Vlp= {f(t, ~,co)]f is {fft}-predictable and
E rf0t+j~sz If(s, ~, co)]. Np(ds, d~)] < oo for all t > 0}
{f(t, 4, co)If is {St}-predictable and
E If(s,~,co)12.~ip(ds, d~) < oc for all t > 0
{f(t, 4, co)If is {@t}-predictable and there exists a sequence
{T,} of {~t}-stopping times such that T, ~ oc a.s. and
l[0,r,,](t)' f(t, ~, co) E I~2 for n = 1,2,... } .
We are now going to define the stochastic integral fo+ fsf(s, 4, co)Np(ds, d~)
f o r f E F~ '1c so that [t~ fo+ fzf(s, ~, co)Np(ds, d~)] is an element in M2,,oo. Note
that integrals fo+ fzf(s, 4, co)Np(ds,d4) for f E Fp and fo+ fzf(s, 4, co)Np(ds, d~)
for f c F~ can be defined by co-wise Lebesgue-Stieltjes integrals. However, the
first integral can not be defined as a difference of the second and the third inte-
grals; in other words, it can not be defined an absolutely convergent integrals.
Details are given as follows:
First we remark that, f o r f E Fp, fo+ fzf(s, 4, co)Np(ds,d4) is well-defined as a
Lebesgue-Stieltjes integral and coincides with the absolutely convergent sum
E f(s,p(s),co) .
s<t,sEDp
Next, let f E Fp1. Then we have
E [f0t+ ~ If(s, ~, co)]- Np(ds, d~)l = E[f0t+ fz [f(s, ~, co)]' Np(ds, d4)l
and hence, F1 C Fp. Define
ft+ fzf(s,~,co)~p(ds, d~) = ft+ fzf(s, 4, co)Np(ds,d4)
-.fot+ f=f(s,~,co)Np(ds, d~)

for f E Fp1. If f E Fpa n F 2, then we can see that
[t~-~ fot+ f f(s,~,co)Np(ds, d~)] EM2

and
i fot+ fzf(s,~,co)~p(ds, d~)) : fo t+f f(s,~,co) 2Np(ds,

~ d~)
I f f E Fp2, we can show that there exists a unique M = (M(t)) E ~/I2 having the
property that
E M(t)- fn(s,~,co)Np(ds, d~) ---+0 asn--+c~
for any sequence fn E F 1 n F 2 such that
E
[J02 ]f~(s,~,co)-f(s,~,co)12"Np(ds, d~)---+0
] asn--+oc .
We define (So+Li(s, 4, co)Np(ds, d~) ) ,>0 by this M. Finally, i f f ~ _p , we can

show that there exists a unique M = (M(t)) E Mz,~oc having the following prop-
erty: F o r every { ~ t } - s t o p p i n g time T such that f(s, ~, co)l[0,r] (s) E Fp2, it holds
that
M T(t) = M(t A T) =
f0'Zf(s, 4, co) l[0,r] (s)Np(as, d~) .
This M is, by definition, the stochastic integral (f~t+fzf(,s ~, co)Np(ds, d~))t>_

0"_
If M(t) -- fo+ fzf(s, 4, co)Np(ds, d~) and ~b = (~(t)) is {~-t}-predictable, then
~b E Y2,1oc(M) if and only if (f(t, 4, co)q~(t)) E F 2'lc. Under this condition, it holds
that
The most important class of point processes is that of Poisson point processes.
Generally, a point process p on .~ is called a Poisson point process if the following
are satisfied:
(i) if E1,...,E,c.~([O, oc))Nz are disjoint, then Np(E1),...,Np(En) are
mutually independent,
(ii) f o r E C N([0, oc)) Nz, Np(E) is Poisson distributed, the caseNp(E) = ec a.s.
being allowed as a Poisson r a n d o m variable with infinite expectation.
884 S. Watanabe
An {~t}-adapted Poisson point process is called an {Yt}-Poisson point

process if, for every s > 0, the family Np((S,t] x B),t >_s,B E ~ , is inde-
pendent of the a-field ~ . An {~t}-Poisson point process p is a-finite if and
only if Vp defined by
vp(E) = E[Np(E)]
is a a-finite measure on ([0, ec) x S, ~([0, oc)) -~z) in the sense that there exist
Un E Ne, n = 1,2,..., such that Un c U~+I, U~ U~ = ~ and vp([0, t] x Un) < oc
for every t > 0 and n. Vp satisfies always
Vp({S} x S) = 0 . (13)
This corresponds to the fact that Np({s} 3) _< 1, a.s., which is obvious because
Np is a counting measure of a point process.
A a-finite {~-t}-Poisson point process p possesses the compensator Np which
coincides with the deterministic measure Vp. Just as the L~vy theorem in the case
of the Wiener process, this property characterizes a Poisson process. Namely, we
have the following fundamental fact (cf. Ikeda-Watanabe, 1988):
THEOk~M 3. If an {~-t}-adapted a-finite point process p possesses the compen-

sator which is a deterministic measure on ([0, ec) ~, N([0, oc)) ~ s ) , t h e n p is
an {~t}-Poisson point process. Conversely, given an infinite and a-finite deter-
ministic measure v on ([0, ec) ~, N([0, oo)) ~ ) having the property (13),
there exists an {~t}-Poisson point process (on a suitable probability space with a
filtration) having v as its compensator.
A family of {Y/}-Poisson point processes are always independent of any family
of {~-t}-Wiener processes and, furthermore, if p l , . . . ,p, are a family of { ~ t } -
Poisson point processes, then they are mutually independent if and only if their
domains Dp, are mutually disjoint, a.s.
1.6. Semimartingales
Let (~2,~,P) and { ~ t } be as above. An R-valued, {@~}-adapted and cfidlfig
process X = (X(t)) is called an {Yt}-semimartingale if it is represented in the
form
X(t) = X(O) + M(t) + V(t) (14)
where X(0) is ~0-measurable, M = (M(t)) E Ma,loc and V = (V(t)) E V. The

class of semimartingales is important in the study of random phenomena in
continuous time: Very roughly, V(t) is the noiseless motion (mean motion) which
is, however, disturbed by a noise and the fluctuation from the mean motion
caused by the noise is given by M(t).
It is sometimes convenient to define the stochastic integral by a semimartingale.
I f X = (X(t)) is an {~t}-semimartingale given in the form of (14), then we define
~b = (4~(t)) E (X) if and only if is {~t}-predictable, E ~2,1oc(M) and
J'0+ I~(s)ldll vii(s ) < oe a.s. for every t > 0. The stochastic integral fo + Cb(s)dX(s)
of E S ( X ) by X is, by definition, an {Yt}-semimartingale defined by
= ~b(s)dM(s) 4- ~b(s)dV(s)
,Io
where the second integral in the right-hand side is the co-wise Lebesgue-Stieltjes
integral. Although the expression of X in the form (14) may not be unique, in
general, the definition is irrelevant of a particular expression and the stochastic
integral is uniquely defined from ~b and X.
We introduce a seemingly restricted class of semimartingales; this class is,
however, equivalent to the class of all {Yt}-semimartingales, as we shall see. Let
X = (X(t)) be an R-valued, {Yt}-adapted and c/Ldlfig process given in the form
X(t) = X(O) 4, M(t) 4. V(t) 4. f(s, ~, co)Np(ds, d~)
+ f'+ g(s, #, (15)

where
(i) X(0) is an fr0-measurable real random variable,
(ii) M C M C so, in particular, M(0) = 0,
(iii) V E V C so, in particular, V(0) = 0,
(iv) p is an {ft}-adapted, a-finite point process on some state space (3, Ne)
possessing the compensator Np, f E Fp and g E F2'1c such that f . 9 - 0.
It is not difficult to see that X given in the form (15) is an {ft}-semimartingale.
Conversely, any {ft}-semimartingale X can be represented in the form for a
suitably chosen { f t } - a d a p t e d point process p: Indeed, p is naturally defined
by the discontinuities of X as 3 = R \ { 0 } , D p = {tE (O, oc)lX(t ) C X ( t - ) } ,
p(t) = X(t) - X ( t - ) , t E Dp and
f(t,~,co) = ~,. 1[[~1>1](~), g(t,~,co) = ~-111~_1_<1](~) .
Cf. Jacod-Shiryaev, 1987 for details. Thus, it is no loss of generality to introduce

this class of R-valued processes as semimartingales.
In (15), M is uniquely determined from X: We call it the continuous martingale
part of X and denote it by Mx. If, in particular, X is continuous, then the de-
composition X(t) = X(O) 4, M(t) 4. V(t) is unique. We call V the drift part of the
continuous semimartingale X and denote it by Vx. The decomposition
x(t) = x(o) + Mx(t) + vx(t) (16)
is called the canonical decomposition or semimartingale decomposition of the
continuous semimartingale X.
Consider a particular case in which Mx and Vx are given in the form
886 S. Watanabe
Mx(t)= f0 eb(s)dB(s), Vx(t)= f0t ~U(s)ds ,
where B is a one-dimensional {@t}-Wiener martingale, E ~2,ioc(B), i.e.,

f0 I~(s)l 2ds < oc for every t > 0, a.s. and 7~ is an {Yt}-predictable process such
that J0 I~(s)[ as < oc for every t >_ 0, a.s., so that X is given in the form
X(t) = X(O) + f0 t ~b(s)dB(s) + T(s)ds .
Such a process X is called an Itd process. Thus, semimartingales are a general-

ization of classical It6 processes and, therefore, they are sometimes called gen-
eralized It6 processes.
2. Stochastic calculus for semimartingales
2.1. Itd's formula

Let (Q, ~ - , P ) and {fit} be as above. Suppose, on this space, the following are
given:
(i) xi(o), i = 1 , . . . , d; Y0-measurable real r a n d o m variables,
(ii) M i c M c, i = 1 , . . . , d ,
(iii) V i E V c, i = 1,..., d,
(iv) an { ~ t } - a d a p t e d , a-finite point process p on some state space (Z,-~z)
possessing the compensator Np a n d f i = (fi(t, 4, co)) E Fp, gi = (gi(t, 4, (9)) E
F 2'lc such that fi(t, 4, co)" gi(t, 4, co) - 0, i 1 , . . . , d; furthermore, we as-
sume that gi(t, 4, co) are bounded, i.e., there exists a positive constant M such
that Igi(t, 4, co)] < M for all i, t, 4, co.
Define a d-dimensional {Yt}-semimartingale X = (X(t)), X ( t ) = (Xl(t),...,
xd(t)), by
xi(t) = xi(o) -[- Mi(t) + vi(t) + fi(s, ~, co)Np(ds, d~)
+ gi( s, 4, co)Np(ds, d~) (17)
for i = 1 , . . . , d . Denote also f = ( f l , . . . , f d ) and g = (gl,...,gd).

An It6's formula is stated as follows:
THEOREM 4. Let F(x) = F ( x l , . . . ,Xd) be a real-valued cg2-function on R e. Then

F(X) = (F(X(t)) = F ( X l(t),... ,Xd(t))) is also an {~t}-semimartingale and the
following holds:
d t
F(X(t))- F(X(O))= ~ ~o (SiF)(X(s-))dMi(s)
d t
+ E f (aiF)(X(s-))dVi(s)
i=1
+ 2 ~,~1,
= (a?Y) (X(s -)) d (Mi (s)' Mqs)) (s)
+ [ t + [ {F(X(s-) + f(s, 4, ")) - F(X(s-))}Np(ds, d4)

,10 dE
+ {F(X(s-) + g(s, 4, ")) - F(X(s-))}Np(ds, d4)
+
7o7 { e(X(s-) + g(s, 4, ")) - g(X(s-))
-- E gi(t' ~' ")" (aif)(X(S--)) (ds, d4) .

i=1
Here, ~iF = ~F/Oxi.
If, in particular, X(t)= (Xl(t),...,xd(t)) is a continuous d-dimensional
semimartingale given by
xi(t) = xi(O) + Mi(t) + vi(t), i= 1,...,d ,
then
F(X(t)) - F(X(O)) = E /ot(

i=1
aiF)(X(s))dMi(s) + /ot(
i=1
5iF)(X(s))dVi(s)
l d ~ot
+ 2i.~j ~i.= (~j~iF)(X(s))d(Mi(s)'MJ(s))(s) .
In other words, the martingale part MFoX and the drift part VFoX of the contin-
uous semimartingale F o X = (F(X(t)) in its canonical decomposition are given
by
d t
MFoX(t) = E fO (5iF) (X(s))dM i(s)
i=1
and
d t
aox(t) = ~ f (aiF)(X(~)ldV'(s)
i=1
+ 2 ~,~j l fot (ajaiF)(X(s))dIM'(s)'MJ(s))(s) "

888 S. Watanabe
2.2. Itd's formula in stochastic differentials and

the Stratonovich stochastic differentials
Let (~2, Y , P ) and {Yt} be as above. Let S be the totality of continuous
{~t}-semimartingales X = (X(t)) with the canonical decomposition
x ( t ) = x ( o ) + Mx(t) + vx(t) . (18)
We write formally
X(t) -X(s) = dX(u) (19)
and call dX (denoted also by dX(t) or dXt) the stochastic differential o f X E S. To

be precise, dX(t) m a y be considered as the equivalence class containing X E S
under the equivalence relation ~ defined by; X ~ Y , X , Y E S, if and only if
X ( t ) - X(O) = Y(t) - Y(0), t >_ 0, a.s. Let dS be the space of all stochastic dif-
ferentials dX for X E S. N o w (19) may be considered as the definition of the
integral in the right-hand side for dX E dS. Denote by dM and dV the subclasses
of dS formed of all stochastic differentials of elements in M c and V C, respectively,
so that dS = dM dV (a direct sum). For dX, d Y E dS and cq/~ E R, define
~dX +/?dY E dS by d(0d2 +/~Y), and define d X . dY E dS by d{Mx, My), so that
dS is a commutative algebra over R under these operations. Note that
d X - d Y E dV and d X . d Y = 0 if one of dX and dY is in d r . In particular,
dX- dY. dZ = 0 for every dX, dY, dZ E dS.
Let B be the totality of R-valued {Jt}-predictable processes such that
SUpsci0,t] I@(s)[ < oc, a.s, for all t > 0. Then, B C 5~2,1oc(M) for every M E M C.
Define @ dX E dS for ~ c B and dX E 1S by
@.dX=d(/q~.dX)=d(f@-dMx)+d(.f@.dVx)
@ dX is uniquely determined from @ c B and dX c dS. Note that @- dX E dM if

dX E dM.
Ito's formula can be stated, in this context, as follows: Let X ( t ) =
( X l ( t ) , . . . , X a ( t ) ) , X i E S, i = 1 , . . . , d , and F be a cg2-function: R d ~ R. Then
F ( X ) = (F(X(t)) E S and
a 1 a
dF(X) = Z ( a i F ) ( X ) . dX i + ~ Z(ajaiF)(X) . (dX i. d X j) . (20)
i=1 i.j=l
We are going to introduce an important operation on the space OS; that of

Stratonovich differentials. Noting S c B, define X o d Y E dS for X, Y c S by
XodY=X.dY + 2 dX.dY . (21)
X o dY is uniquely determined from X and dY and is called the Stratonovich

stochastic differential or a stochastic differential o f the Stratonovich type. These
stochastic differentials obey the following rule: for X, Y, Z E S,
X o (dY + dZ) = X o d Y + X o d Z ,
( X + Y) o d Z = X o d Z + Y o d Z ,
X o (dY. dZ) = (iVo dY). dZ = X . (dY. dZ),
Xo(YodZ)=(XY)o(dZ) .
The process f x o d~Y = ( fo X o dY = f~ X(s) o dY(s))t>o is called the stochas-

tic integral of X by Y in the sense of Stratonovich or of the Stratonovich type
whereas the process f X- d Y = ( f0 X . d Y = fo X (s). d Y(s))t>0 that in the sense of
Itd or of the Itd type. Using this operation, It6's formula (20) can be rewritten as
follows: Let X(t) = (Xl(t),... ,Xd(t)), X ~ E S, i = 1,... ,d, and F be a @-func-
tion: R a -+ R. Then F(X) = (Y(X(t)), (SiF)(X) = ((SiF)(X)(t)) C S and
d
de(X) = Z ( ~ i [ / ' ) ( X ) o dX i . (22)
i=1
This chain rule for stochastic differentials takes the same form as in the ordinary
differential calculus. This is the reason why the use of Stratonovich stochastic
differentials is quite convenient in transferring notions used in ordinary calculus
into stochastic calculus and in defining intrinsic (i.e., coordinate-free) notions
probabilistically.
2.3. Stochastic calculus for complex martingales and conformal martingales

Let (~2,Y , P) and {~t} be as above. Let Z = (Z(t)), Z(t) = (Z 1(t),..., Zn(t)) be a
Cn-valued, continuous and {@t}-adapted process. Write
z (t) = x (t) + = 1,..., n .
We say that Z is an n-dimensional {~,~t}-conformal martingale (local conformal

martingale) if, for every ~ = 1 , . . . , n, Y~(t) and Y~(t) are {~t}-martingales (resp.
local martingales) satisfying the following conditions:
dX?. dX[ = dYt~. dYt/3, dXt~ . d Y f - - - d X / 3 . d Y t ~, a,/3= 1 , . . . , n .

(23)
(23) implies, in particular, that
dX[_ff,dYt~ = 0, ~ = 1,...,n . (24)
A one-dimensional {~t}-conformal martingale (local conformal martingale) is

simply called an {~t}-conformal martingale (resp. local conformal martingale).
We complexify the spaces M c, V c, S and the corresponding spaces of stochastic
differentials in an obvious way and denote them by the same notations. Then (23)
is equivalent to
dZ/- dZt~ = 0, ~,/3 = 1 , . . . , n (25)
890 S. Watanabe
so that Z(t) = (Z l(t),..., Zn(t)) is an n-dimensional {~,~t}-conformal martingale

(local conformal martingale) if and only if Z ~ is {~t}-martingale (resp. local
martingale) for every e and satisfies (25).
A typical example of n-dimensional {gt}-conformal martingale is the
n-dimensional { ~-t}-complex Brownian motion Z = (Z( t) ) which is defined by
Za(t) ~- B2a-l(t) -}- ~-gB2C~(t), 0~= 1,... ,n
where B(t) = (B 1(t), B 2(t),..., B 2~ ~(t),B 2~(t)) is a 2n-dimensional {~t}-Wiener

process. By the L~vy characterization theorem of Section 1.3, we have the fol-
lowing characterization theorem for an n-dimensional {~-t}-complex Brownian
motion:
THEOREM 5. A C~-valued, continuous {~,~t}-adapted process Z = (Z(t)) is an

n-dimensional {~t}-complex Brownian motion if and only if
dZ[EdM, dZ[.dZ~=0, dZ~.d2~=28~./~dt, e, f l = l , . . . , n .
Let f ( x l , . . . , x~,yl,..- ,Yn) be a complex-valued cg2-function on R 2n. By setting

z~ = x~ + v/-ZTy~, ~ = 1,... ,n, it can be regarded as a (g2-function f ( z l , . . . ,&) on
C ". Introduce the differential operators as usual:
&~-2 ~x~ - v / T ] - ' e~-2 ~ v/-L7
Then It6's formula for an 2n-dimensional continuous semimartingale

= (xl(t),... ,xn(0, rl(t),..., ,
given in the form of stochastic differentials as
df(((t)) = Z~=1 ~x~

a f (((t)). dX~ (((t))- d ~ ~
1 d a2f
ak
+ 2~x~-7(((t)). (dX?. dYf)
+ ~(~(t)) - (dYt~- dYf)
can be rewritten in the complex form as follows: Setting Z(t) = (Z 1(t),..., Zn(t))
where Z"(t) = X ~ + x/TTf~(t),
df(Z(t)) = Z ~77z~(Z(t)). dZt + ~ (Z(t)). d27

cz= ]
52f Z (t))" ( d Z / - d Z f )
+ ~c~,p~_l(~Z--~(
eV
+ 2~z-~ (Z(t)). ( d Z / . dZ~)
+ ~
~2f (~(t)) (dZ~. di~t~)
) . (26)
If Z(t) = (Z 1( t ) , . . . , Z n (t)) is an n-dimensional {o~t}-local conformal martingale,

then by (25),
df(Z(t) ) = + ( S f (Z(t)). dZ~ + ~ (Z(t))" d Z t )

~ \Sz~
+ (Z(t)). (dZ t dZt~) . (27)

c(,fl=l P
Hence, i f f is holomorphic i.e., 8f/~2~ = 0, then
df(Z(t)) = + ~f (Z(t)). dZ t
~ az~ (28)
F r o m this, we can conclude that f(Z(t)) is a local conformal martingale. M o r e

generally, i f D is a domain in C ~ and f : D --+ C m is holomorphic, then = (~(t))
defined by
~(t) = f(Z(t A r))
is an m-dimensional {fft}-local conformal martingale provided that Z = (Z(t)) is
an n-dimensional {Yt}-local conformal martingale and T is an {Yt}-stopping
time such that Z(t A T) E D for all t > 0, a.s..
2.4. Time change

It is important to notice and apply in m a n y problems the fact that the notion of
semimartingales is invariant under a class o f time changes.
Let A E A c, i.e., A = (A(t)) is an { ~ t } - a d a p t e d continuous process such that
A(0) - 0 and t ~ A(t) is increasing, a.s.. Assume further that t ~ A(t) is strictly
increasing and limtTooA(t) = oo, a.s.. Let u ~ A~-1 := min{tlA(t ) > u} be the in-
verse function of t ~ A(t). Then, for each fixed u _> 0, A~-1 is an {~,~t}-stopping
time. Define a new filtration {Yt} by ~,~t = ~A;,, t >>_O. The spaces S, M c, V c
with respect to this filtration are denoted, respectively, by S, NI c, ~c.
892 S. Watanabe
For an {Yt}-progressively measurable (-predictable, -optional) process

X = (X(t)), define a new process X A = (XA(t)) by X A ( t ) = X ( A [ 1 ) , t >_ O. Then,
X A = (xA(t)) is {~t}-progressively measurable (resp.-predictable,-optional). We
call X A the time change of X determined by A. Essentially by Doob's optional
sampling theorem, we have that the mapping X ~ X A defines a bijection between
the spaces S and S, which, restricted, defines a bijection between M c and lVl~,
and a bijection between V C and 9c. In particular, we have MxA = ( M x ) A and
VxA = (Vx) A for any semimartingale X ~ S . Furthermore, it holds that
{ M A , N A} = ( ( M , N } ) A for every M , N C M C. An invariance of the stochastic
integrals under the time change can stated as follows: If ~ E 52,1oc(M) then
Vt E ~2,1oc(MA) and we have
If, in particular, M E M c, t ~ (M)(t) is strictly increasing and

limtTo~(M)(t) = e~, a.s., then we can take A := {M} to make a time change. Then
we have
:= M (M) = M((M}t 1) E 1VIc and (M)(t) = { M } ( ( M } t 1) = t .
Hence ~t is an {~t}-Wiener process by L6vy's characterization theorem. In this

way, we have the following representation of M by means of an {Wt}-Wiener
process B := ~r;
M(t) = B((M)(t)) .
Such a representation of a continuous martingale by a Wiener process is valid in a

more general situation. Namely, we have the following fact (cf. Ikeda-Watanabe,
1988):
THEOREM 6. If X = (X(t)) is such that M = (M(t)), defined by M ( t ) =

X(t)-X(O), is in M c, then there exists a one dimensional Wiener process
B = (B(t)) with B(0) = X(0) such that
x(t) =B((M)(t)), t_> 0 .
This representation theorem for continuous local martingales can be further ex-
tended to the multidimensional case. Indeed, we have the following important
result due to F. Knight:
THEOREM 7. L e t X i = (Xi(t)) C S, i = 1 , . . . ,d, be given and satisfy the following

condition;
M i ( t ) := x i ( t ) - x i ( o ) E M c and ( M i , M J ) ( t ) = O, i,j= l,. . . , d .
Then there exists a d-dimensional Wiener process B = (B(t)), B(t) =

(B l ( t ) , . . . , Bd(t)), with B(0) = X(0) = (X 1(0),... ,Xd(0)) such that
It6"s stochastic calculus and its applications 893
x i ( t ) =Bi((Mi)(t)), t >_ O, i = 1,... ,d .

Next we consider the time change for complex martingales. It is easy to see that
the class of conformal martingales are invariant under the time change:
THEOREM 8. I f Z ( t ) = ( z l ( t ) , . . . ,Zn(t)) is an n-dimensional {~t}-local con-

formal martingale. Then ZA(t)= (ZI(A~-I),...,Zn(A2I)) is an n-dimensional
{~t}-local conformal martingale.
Also, there are similar representation theorems for conformal martingales
by complex Brownian motions. We state a result in the case of the complex
dimension 1 only; we can extend the Knight theorem in the context of multi-
dimensional conformal martingales, though.
THEOREM 9. Let Z = (Z(t) = X(t) + ~ L 1 Y ( t ) ) be a C-valued continuous { ~ t } -

local conformal martingale, i.e., dZ E dM and d Z . dZ = 0, equivalently, dX,
dYEdM, dX.dX=dY.dY and d X - d Y = 0 . Then there exists a complex
Brownian motion z(t) = x(t) + ~ f y ( t ) , equivalently, a planar Brownian motion
(x(t),y(t)), such that
z(t) = z((Z)(t)), t _> 0 ,
where we set
(z)(t)=2 dZ,.d2,
(/0'
= dX~-dX~,=
f0' d~.d~
) .
As a typical application, we note that if z(t) is a complex Brownian motion and

f : C ~ C is holomorphic, then f(z(t)) is a local conformal martingale. By It6's
formula, we see (f(z(t))} = fo ]~f/Sz]Z(z(s)) ds" Hence we can find another com-
plex Brownian motion ((t) such that
f(z(t)) = ( (z(s))ds , t> 0 . (29)
This result can be localized for a holomorphic function f in a domain D c C as
f ( z ( t A r)) = ~ (4s))ds (30)
for a stopping time T such that z(t A T) ~ D, t > O. The representation formula
(29) or (30) is useful in the probabilistic approach to problems in complex
analysis; for example, B. Davis applied it to prove Picard's theorem (Davis, 1975).
2.5. The exponentials and iterated integrals of semimartingales

Given X -- (X(t)) E S and an ~ 0 - m e a s u r a b l e real random variable t/, there exists
a unique Y = (Y(t)) E S which satisfies
894 S. Watanabe
dY(t) = Y(t).dX(t), Y(0) = t/ (31)

and this Y = (Y(t)) is given explicitly by
Y(t) = r/. e x p ( (X(t)- X ( O ) ) _ 1 f t ( d X . d X ) ( s ) }
= q.exp (Mx(t) + Vx(t)) - 5 {Mx)(t) (32)
where X(t) = X(O) + Mx (t) + Vx (t) is the canonical decomposition ofX. This fact
can be shown by an easy application of ItS's formula. If, on the other hand, the
Eq. (31) is given in the Stratonovich form as
dY(t) = Y(t) odX(t), r(0) = ~ , (33)
then the unique solution is given simply by
Y(t) = ~. exp{X(t) - x ( 0 ) } . (34)
I f M = (M(t)) E M e, in particular, we have
{
exp M(t) -~(M)(t) , } - 1E
because X(t):--exp{M(t)- (M)(t)/2} satisfies d X ( t ) = X ( t ) , dM(t) dM. Thus
exp{M(t) - (M)(t)/2} is a positive local martingale and hence satisfies
E [exp { M(t)-~IM)(t)
1 }1 _<1 for allt_>0 .
It is a true martingale, equivalently,

[ { 1 }]
E exp M(t)-~IM)(t) =1 for allt_>0
if the following condition, known as Novikov's condition, is satisfied;
E[exp{lIM}(t)}J <oc forallt>_0. (35)
Hence if, in particular, (M)(t) <_ C. t for all t 2 0 a.s., for some constant C > 0,
then exp{M(t) - (M}(t)/2} is a true martingale.
Given a continuous semimartingale X E S, define X~ E S, n = 1,2,..., by
X 1 (t) ~- X ( t ) - X ( O ) ,
x2(t) =
jo Xl(~)dX(s),...,x,(O =
jo x, l(~)dX(s),...
X,(t) is called the n-fold iterated integral of X. If dX dM, then Xn ~ M c for

every n.
I t d ' s s t o c h a s t i c calculus a n d its applications 895
Let
Hn[t,x]=(-t) nexp ~ ~5;x,exp ~ , xER, t>0, n=0,1,... ,
be the Hermite polynomials so that
Ho It, x] = 1, H1 [t, x] = x, H2 [t, x] = x 2 - - t, [-I3 [t, x I = x 3 - - 3xt,... .

Let X ( t ) = X(O) + m x ( t ) + Vx(t) be the canonical decomposition of X. Then we
have the following explicit formulas for iterated integrals:
X,(t)=~Hn[(Mx)(t),X(t). -X(0)], t>_0, n = l , Z , . . . . (36)
These formulas are obvious, at least formally, from the relation

j~2
Y).(t) := exp [ 2 ( X ( t ) - X ( 0 ) ) - ~ ( M x ) ( t ) l
e~ ~n
- H, [(Mx)(t), X ( t ) - x(0)]
n=0
co
= Z nxo(t)
n--O
This relation is a consequence of a formula for Hermite polynomials:
and the fact we saw above that Y~o(t)is the unique solution of the equation
dYA(t) = )~Y,~(t) . dX(t), Y,z(O) = 1 .
2.6. Change of drift ( M a r u y a m ~ G i r s a n o v transformation)

Let (f~,Y,P) and { Y t ) be as above. Let M E M c and set
1
DM(t) = exp i.M(t ) - ~ (M)(t) } (37)
Then, as we saw above, DM(t) is a positive local martingale and we assume that it
is a true martingale. For this, it is sufficient to assume the Novikov condition (35)
as we saw above.
So we have E[DM(t)] = 1 for all t _> 0. Then there exists a unique probability
measure/5 on (t2, @) (when (O, ~ ) is a nice measurable space and ~- = Vt>0 ~ t ,
which we can assume without loss of generality) such that/5(A) = E[DM(t-) 1A]
for all A E ~-t, t _> 0.
896 s. Watanabe
THEOREM 10. Let X be a continuous semimartingale, i.e., X E S, with the ca-

nonical decomposition
X(t) = X(O) + Mx(t) + Vx(t) . (38)
On the probability space (g2, Y,/3) with the same filtration {@t}, X is still a
continuous {Yt}-semimartingale but its canonical decomposition is given by
x ( t ) = x ( o ) + ;4x(t) + ; x ( t ) , (39)
with
f/ix(t) = Mx(t) - (Mx,M)(t) and x(t) = vx(t) + (Mx,M)(t) .

(40)
Furthermore, it holds that
(~lx,A4y) = (Mx,My), X, Y E S . (41)
This result is known as Girsanov's theorem. The transformation of the proba-

bility measures given above is called a transformation of drift or a Maruyama-
Girsanov transformation since it produces a change of drift part in the semimar-
tingale decomposition as given by (40).
In the above, we started with a given density DM and then constructed a
probability/3 which is equivalent to P in the sense that P a n d / 3 are mutually
absolutely continuous if they are restricted to Y t for every t > 0. Conversely, we
can show the following:
THEOREM 11. Assume that M2,1oc = M c, that is, every {~,~t}-martingale is a

continuous martingale. Then, if P is a probability on (O, Y ) which is equivalent
to P in the above sense, then there exists a unique M E M C such that the density
d['/dP, restricted to @t, is given by DM(t) in (37) for every t _> 0.
2.7. Filtrations and martingales

Let (O, Y , P) and { ~ t } be as above. We assume that the filtration is separable in
the sense that the Hilbert space L2 (Q, Vt>0 Yt, P) formed of all square-integrable
Vt>0 ~t-measurable real random variables is separable. In order to know the
filtration {~,~t}, it is essential to know the space of martingales M2,1oc or Me.
Indeed, it is an important and interesting problem to study the structure of these
spaces of martingales. Here is an important general result due to M.H. Davis and
P. Varaiya (Davis-Varaiya, 1974):
THEOREM 12. There exist M1,M2,... E M2 such that

(Mi,mj) = 0 ifiCj, (M1} >> (m2) >> "'"
and every M E M2 can be represented as a sum of stochastic integrals for some

N-predictable processes q~i E ~2(Mi):
M= fe dMi.
If N1, N2,.. is another such sequence, then
(M1) ~ (N1), (M25 ~ (N25,...
In particular, the number of such M1, M2,. is an invariant of the filtration {~t}
which we call the multiplicity of {Jr}.
Here, >> and ~ denote the co-wise absolutely continuity and the equivalence,
holding almost all co, of the Stieltjes measures associated with increasing pro-
cesses, respectively.
We give two important cases in which we can completely describe the structure
of the spaces M2,1oc and M2.
(1) The Brownian filtration

Let X(t) = ( x l ( t ) , . . . ,Xd(t)) be a d-dimensional Wiener process defined on a
complete probability space (f2, ~ , P) and let { ~ x } be the natural filtration of X;
J~tx for t _> 0 is the smallest a-field on ~2 containing all P-null sets and with respect
to which all X(s), s <_ t are measurable. This filtration is always right-continuous
so that it satisfies the usual conditions. The spaces M2,1oc and M2 of Section 1.2
with respect to the filtration ~-~ are denoted by M2,1oc({Jtx}) and Mz({~tx}),
respectively. Set
Bi(t) = xi(t) - xi(o), i= 1,...,d , (42)
so that B i (Bi(t)) E Mz({~-x}).
THEOREM 13. (Kunita-Watanabe, 1967, Dellacherie, 1974) Let M E M2({~-x})

(M2,1oc({~x})). Then, there exists an {~tX}-predictable process ~i with
E[fol~i(s)12ds] < oo for all t > 0 (resp. f~l~i(s)12ds < oc for all t_> 0, a.s.),
i = 1 , . . . , d, such that
t
M ( t) q~i(s)dB i (S) . (43)
That is, every martingale with respect to the natural filtration {Y~} of X can be
represented as a sum of stochastic integrals by the basic martingales {B i} of (42).
COROLLARY 1.
M2({~-x}) = M~({~,~x}) and M2,1oc({~x}) MC({~tx}) .
From this, we can see that every (not necessarily square-integrable) martingale
M (M(t)) with respect to the filtration { ~ x } such that M ( 0 ) = 0 is in
MC({~x}) and hence has the representation (43). This is because M can be
approximated, compact uniformly in t in probability, by bounded martingales
898 S. Watanabe
which are necessarily continuous and hence M is continuous. Then note that any
continuous (local) martingale is always locally square-integrable.
COROLLARY 2. Let N > 0 and F be an ~-X-measurable and integrable real ran-

dom variable. Then, there exists {ytX}-predictable q~i with fN i~i(s)12ds < oc,
a.s., i = 1 , . . . , d , such that
F = E(FI@ x) + ~i(s)dBS(s) . (44)

S=I 0
E[J N I~i(s)12ds] < oc for a l l / = 1 , . . . , d if and only if F - E ( F I ~ -x) is square-

integrable.
(2) The Poissonian filtration

Let p be a a-finite Poisson point process on a complete probability space (Q, ~,~)
with values in (E, Nz) and, for each t _> 0, ~ P be the a-field on ~ generated by
P-null sets and random variables Np((O, s] x U), s < t and U E -~z.
THEOREM 14. (Dellacherie, 1974, Ikeda-Watanabe, 1989) Every M E M2({~P})

(Mz,loc({~P})) can be represented in the form
M(t) = ['+ [
/ 0 ,]~
f(,, (45)
for s o m e f E F p (2{ ~p,}),(resp. Fp.

2.1oc
({ ~--p
t})-
2.8. Applications to mathematical finance

Consider a simple financial market in which two kinds of assets, a riskless cash
bond and a risky stock, are traded. As a mathematical model, we consider a
probability space (f2, Y , P) with a filtration {Yt}t>_0 satisfying the usual condi-
tions and denote the price per unit of the cash bond and the stock, at time t, by
B(t) and S(t), respectively. (B(t)) and (S(t)) are {o~t)-adapted stochastic pro-
cesses. In the following, we only consider the time t in the finite interval E0, T]
where T is a positive constant called the maturity.
We consider a model introduced by F. Black and M. Scholes (Black-Scholes,
1973), now well-known as Black-Scholes model: B(t) and S(t) are given by
B(t)=exp(rt), S(t)=So.exp(aW(t)+ [#-a---~]t) . (46)
Here, W(t) is a one-dimensional {J~}-Wiener process with W(0) = 0, and r _> 0,

a > 0 and # c R are constants called, riskless interest rate, the stock volatility and
the stock drift, respectively. So is a positive constant. B(t) and S(t) are uniquely
determined by the following equations on stochastic differentials:
dB(t) = rB(t)dt, B(0) = 1 (47)
dS(t) = ~S(t)dW(t) #S(t)dt, S(O) = So (48)
Indeed, it is obvious for B(t). (48) is the case of Eq. (31) of Section 2.5 with
X(t) = a W ( t ) + # t and, since d X ( t ) - d X ( t ) = o-2dt, the solution Y(t) in (32)
coincides with S(t) in (46). In the Black-Scholes model, we assume always that
the filtration { ~ t } is the natural filtration of W = (W(t)).
By a strategy or portfolio, we mean a pair ~z = (~b, 0) of {~-t}-predictable
processes q~ = (~b(t)) and ~, = (0(t)) such that
s)[2ds +
/0 10(s)[ds < ec, a . s . .
~b(t) and 0(t) denote the a m o u n t (i.e., the number of units) of the stock and the
cash bond we hold at time t, respectively. They may take negative values so that
we allow unlimited short selling of the stock and cash bond. The value
V(t) = V~(t) of the portfolio ~ -- (~b, 0) at time t is given, therefore, by
v(t) = 4)(t)s(t) + O(t)B(t)
We identify two portfolios rc = (~b,) and ~ ' = (~b', 0') and write ~ = ~' if
f0 qS(s)ds = J~ qT(s)ds and f0 O(s)ds = f~ O'(s)ds for all t E [0, T], a.s..
A portfolio 7c = (~b, 0) is called self-financing if it satisfies V~ c S and
dV~(t) = d?(t)dS(t) + O(s)dB(t) . (49)
An intuitive meaning of a self-financing portfolio is that t h e c h a n g e in its value

depends only on the change of asset prices. Let S ( t ) = e rtS(t) and
V~(t) = e-rtV~(t) so that S(t) and V~(t) are the discounted stock price and the
discounted value of the portfolio at time t, respectively_It is easy to see by It6's
formula that n = (~b, 0) is self-financing if and only if V~ c S and
dV~(t) = ~b(t)dS(t) . (50)
L e t X be a nonnegative ~ r - m e a s u r a b l e r a n d o m variable. We call it apayoffor a

claim; we consider it as a payoff or a claim which we can receive at time T of
maturity. F o r example, consider a contract that, at maturity T, we have a right (but
not an obligation) to buy a unit of the stock by paying a predetermined price K. K is
called the strike price or the exercise price. The payoff of this contract is obviously
(S(T) - K)+ = (S(T) - K) V 0. This contract is called an European call option.
F o r a given p a y o f f X , we say that a portfolio ~ = (~, 0) replicates X or rc is a
replicating strategy for X if it satisfies the following:
(i) ~ is self-financing,
(ii) V~(t) >_ O, t E [0, T], a.s.,
(iii) V~(T) = X, a.s..
If a replicating strategy for X exists, we say that the payoff X is replicable.
By Theorems 10 and 11 of Section 2.6, we can see that there exists a unique
probability measure P* on ( ~ , Y r ) such that it is equivalent to P and
S(t) = e ~tS(t) is {~t}-martingale under P*. It is given explicitly by
900 S. Watanabe
on
THEOREM 15. Let X be a payoff and assume that it is integrable under P*. Then it
is replicable and a replicating strategy 7c = (q~,$) f o r X is unique. Its value V=(t) at
time t is given by
V~(t) =E*[e r(r-t)"Xlgt], in particular, V~(0)=E*[e rr.X] . (52)
V,(t) in this theorem is called the arbitrage price at time t of the payoff X at
maturity and V~(0) arbitrage price of the p a y o f f X at maturity. The reason is as
follows: If we make a contract to receive the payoffX at maturity T and if we buy
this contract by paying price v at time 0, then, if v > V~(0), the seller of this
contract uses the replicating strategy ~ for X with the initial investment V~(0) to
attain X and thus obtain a gain v - V~(0). If v < V~(0), then the buyer of this
contract makes a short selling of the replicating portfolio for X thus gets a gain
V~(0) - v at time 0 and clear the short selling at maturity T by the p a y o f f X he
receives. In either case, there is an opportunity of riskless gain (an arbitrage
opportunity) for the seller or buyer. Thus, only possible price we pay at time 0 to
buy the contract without arbitrage opportunity is V~(0).
In particular, for the European call option with the exercise price K, the payoff
is (S(T) - K ) + , and hence, the arbitrage price of the option given by (52) can be
computed explicitly from (46) and (51); it is given by
E*[e (s(r)-K)+l = 'r(S0) (s3)

and, more generally, the aritrage price of the option at time t is given by
E*[e (r '). (S(T) - K)+l~a ] = '/*(r_,)(S(t)) . (54)
Here, the function ~o(x), 0 > O,x > O, is given by
~Po(x) = xN(dl) - Ke-rN(d2) , (55)

where
log(x/K) + (r + a2/2)0
dl= d2 d l - a~/-0,
av/0
1 fa -t2/2
N(d) = --x/2~J~ e dt
These formulas are known as the Black-Seholes option pricing formula.

As for the proof of Theorem 15, we remark the following; if ~ is a replicating
strategy for X, then (52) is obvious because e-rtV~(t) is a martingale under P*.
Conversely, for an integrable payoff X, the existence of a replicating strategy is
essentially a consequence of Corollary 2 to Theorem 13, cf. Lamberton-Lapeyre,

1996 and Baxter-Rennie, 1996, for details.
3. Stochastic differential equations
Stochastic differential equations (SDE's) were first rigorously formulated by

K. It6 in 1942, (cf. the paper [2] in K. It6, Selected Papers, 1987), to construct
diffusion processes corresponding to Kolmogorov's differential equations. Given
a time-dependent differential operator
1 d 52 d
Lt = ~ ~ = l a i ' ( t ' x ) ~ + i~=lbi(t'x)~ixi
on R d where aiJ(t,x) is symmetric and nonnegative definite, the problem is to

construct and analyze a probability model associated to this operator: The model
is a diffusion process (a Markov process with continuous paths) whose system of
transition probability densities is given by the fundamental solution to the heat
equation ~St = L t. A more convenient probabilistic formulation of the model is
given by D.W. Stroock and S.R.S. Varadhan (Stroock-Varadhan, 1979); it is an
Rd-valued continuous {~t}-adapted process X = (X(t)) defined on a probability
space with a filtration {Yt} such that, for every smooth function f(t,x) on
[0, oc) R d,
f(t,X(t)) - f ( 0 , X ( 0 ) ) = M(t) + V(t)
where M = (M(t)) C M c and V = (V(t)) E V c such that
t 5
This is equivalent to saying that X = (X(t)),X(t) = (X 1(t),... ,Xd(t)), satisfies
X i = (Xi(t)) c S, i.e., a continuous semimartingale,

dX] . dX/ = aiJ (t,X( t) )dt,
dVx~(t)=bi(t,X(t))dt, i,j= 1,...,d .
i r
If (ak(t , x))k= 1 is any system of functions satisfying
F
i
Z %(t,x)~(t,x) = aiJ(t,x) ,
k 1
then such X can be given in the form
dXi(t) = ~ aik(t,X(t))dWk(t) + bi(t,X(t))dt, i = 1,...,d ,

k--1
902 S. Watanabe
where W(t)= (l/vl(t),..., Wr(t)) is an r-dimensional Wiener martingale. The

equation we thus found for the stochastic differentials of the process X is exactly
what we call It6's SDE. This equation is said to be of M a r k o v i a n type because the
coefficients aik(t,X(t)) and bi(t,X(t)) depend only on the present position X(t) of
the system X = (X(t)).
3.1. SDE's based on Gaussian white noise (Wiener noise): The basic definitions
We start by giving a general formulation of SDE's in which the coefficients may
depend on the past history of the system. Let W d be the space of all d-dimensional
continuous paths: W d = g(I0, oc) ~ R d) endowed with the topology of the uniform
convergence on every finite interval (which is a Polish topology) and ~ ( W d) be the
Borel a-field (i.e., the topological a-field). F o r each t _> 0, define Pt : We -+ We by
(p,w)(s) = w(t A s), s > o
and let .~t(W e) = p;-1 (~(Wd)). Generally, we say that a function F = (F(t, w))
defined on [0, oo) x W e with values in a Polish space S endowed with the Borel
a-field 5~, is called non-anticipating if, for each t >_ 0, the map W e ~ w
Y(t, w) E S is ~t(We)/5~-measurable.
Let A e'r be the totality of functions ~(t,w)= (c~(t,w)): [0, o o ) x W d - - +
R e Rr(;= the totality of d x r real matrices) which are ~([0, o c ) ) ~ ( W e ) -
measurable and non-anticipating. An important case of ~ E A e'r is when it is given
as co(t, w) = a(t, w(t)) by a Borel function a(t,x) : [0, ec) x R d ~ R d @ R ~. In this
case, ~ is said to be independent of the past history or of Markovian type.
F o r a given c E A d'~ and/3 C A d'~, we consider the following SDE:
F
dXi(t) = ~ i k ( t , X ) d W k ( t ) + fli(t,X)dt, i= 1,...,d (56)

k--1
or denote it simply in the matrix notation as
dX(t) = ~(t,X)dW(t) + fl(t,X)dt . (56)'
Here, X = (X(t)),X(t)= ( x l ( t ) , . . . ,Xe(t)), is a continuous Re-valued process

and W = (W(t)), W(t) = ( w l ( t ) , . . . , W~(t)), is an r-dimensional Wiener process
with W(0) = 0. A precise formulation is as follows: We say that X = (X(t)) is a
solution to the SDE (56) if there exists a probability space (~, ~ , P) with a fil-
tration {~-t} such that
(i) x i = (xi(t)) E S for i = l , . . . , d ,
(ii) W = (W(t)) is an r-dimensional {~-t}-Wiener martingale,
(iii) ~(t,X) E ~2,ioo((Wk(t))) and ~(t,X) E 51,1oo for i = 1 , . . . ,d, k = 1 , . . . ,r,
where 2'1,1oc is the totality of {~-t}-predictable processes f = 0r(t)) satis-
fying fo [f(s)lds < oo for all t _> 0, a.s.,
(iv) the stochastic differentials dXi(t),i = 1,...,d, satisfy the relation (56), or
equivalently,
X(t) - X(O) = f0 t ~(s,X)dW(s) + /0 t fi(s,X)ds, t >_ 0 ,
holds, a.s..
Thus, a solution X is always accompanied by a Wiener process W. To em-
phasize this, we often call X a solution with the Brownian motion W or simply call
the pair (X, W) itself a solution of (56). Since W is an {Yt}-Wiener process and X
is {~'t}-adapted, we see that, for each t > 0, the family of r a n d o m variables
W(u) - W(v),u > v > t, and the family of r a n d o m variables (X(s), W(s)),s <_ t,
are mutually independent. Conversely, if this independence property holds, then,
setting { ~ t } to be the natural filtration of the pair (X(t), W(t)), W = (W(t)) is an
{~,~t}-Wiener process.
When c~ and /? are of Markovian type; c~(t,w)=a(t,w(t)) and
/?(t, w) = b(t, w(t) ), the equation
dX ( t) = ~( t , X (t) )dW( t) + b( t , X ( t) )dt (57)
is called a SDE of Markovian type. Furthermore, if cr(t,x) and b(t,x) are inde-
pendent of t, i.e., a(t,x) = a(x) and b(t,x) = b(x), the equation
dX(t) = a(X(t))dW(t) + b(X(t))dt (58)
is called a SDE of time-independent (or time-homogeneous) Markovian type. Note

that the time-dependent Eq. (57) can be made time-independent by adding one
more component X(t) = t to the solution X(t); we can regard )?(t) = (t,X(t)) as
a solution of time-independent SDE with coefficients #(X(t)) = cr(t,X(t)) and
b(X(t)) = b(t,X(t)). Note also that when the coefficient o-(x) is sufficiently
smooth, the Eq. (58) can be transformed into an equivalent equation in the form
of Stratonovich differentials:
dX(t) = a(X(t) ) o dW(t) + b(X(t) )dt (58)'
where
r i
g'(x) = b*(x) - 51 J=, ~7"~a~(x) ~ ( x ) , i= 1,...,d . (59)
Next, we define the notion of uniqueness of solutions. There are two kinds of
uniqueness; uniqueness in the sense of law (uniqueness in law) and pathwise
uniqueness. When we consider a SDE as a tool to construct a stochastic process,
the uniqueness in law is sufficient. I f we consider a SDE as a machine which
produces the solution as a output when we input a Wiener process, in other words,
if we would like to obtain the solution as a functional of the Wiener process, the
notion of pathwise uniqueness is more natural and more important; As we shall
see, this notion is closely connected with the notion of strong solutions.
Here are basic definitions. For a solution X = (X(t)) of SDE (56), we call X(0)
the initial value and its law on R d the initial law or the initial distribution. The law on
904 s. Watanabe
W a of X is called the law of the solutionX. We say that the uniqueness in the sense of
law of solutions holds if the law of a solution is uniquely determined by its initial law;
that is, i f X a n d X 1are any two solutions of (56) whose initial laws coincide, then the
laws of X and X I coincide. This definition is equivalent to a seemingly less restrictive
definition in which we restrict ourselves to solutions whose initial values are con-
stants, i.e., the initial laws are 6-distributions at some points in R a.
Next, we say that the pathwise uniqueness of solutions holds if, whenever X
and X ~ are solutions of (56) defined on a same probability space (f~, Y , P) with a
same filtration { ~ t } and with a same {~t}-Wiener process W = (W(t)) such that
X(0) = X'(0), a.s., then it holds that X(t) = X'(t) for all t _> 0, a.s. In this case,
also, the definition is equivalent to that in which we restrict solutions to those
having n o n r a n d o m initial values.
A solution X = (X(t)) of SDE (56) is called a strong solution i f X is adapted to
the natural filtration {~-~} of the accompanying Wiener process W = (W(t)).
For a strong solution X, X(0) must be a constant a.s., because of the Blumenthal
0-1 law for the Wiener process. We give a more refined notion of strong solutions
as follows.
We say that SDE (56) has a unique strong solution if there exists a function
F : R d x W'~ 9 ( x , w ) ~ F(x,w) E W d ,
where W~) = {w C Wr]w(0) = 0}, with the following properties:

(i) F is Borel-measurable and, for each fixed t >_ 0 and x c R d, the
m a p W~o ~ w ~ F(x, w)(t) E R g is ~t(W~)/~(Rd)-measurable. [~t(W~) =
(ii) For any Ra-valued r a n d o m variable X(0) and an r-dimensional Wiener

process W = (W(t)) with W ( 0 ) = 0 which are mutually independent, the
continuous d-dimensional process X = (X(t)) defined by X = F(X(O), W) is
a solution of SDE (56) with the Brownian motion W.
(iii) Conversely, for any solution (X,W) of SDE (56), it holds that
X = F(X(O), W) a.s..
I f a unique strong solution F(x, w) exists, then X = F(x, w) itself is a strong
solution of SDE (56) realized on the r-dimensional Wiener space
(W~,N(W~),pW) (pW: the r-dimensional standard Wiener measure) with the
initial value x and with the canonical Wiener process w = (w(t)) E W~). It is
obvious that the existence of a unique strong solution implies the pathwise
uniqueness of solutions. Its converse is also true. Namely, we have the following
general facts due to T. Y a m a d a and S. Watanabe and refined by O. Kallenberg,
(cf. Ikeda-Watanabe, 1989 and Kallenberg, 1996):
THEOREM 16. (1) The pathwise uniqueness of solutions implies the uniqueness in
law of solutions.
(2) If the pathwise uniqueness for (56) holds and if a solution of (56) exists for
any given initial law, then there exists a unique strong solution for (56).
3.2. Existence and uniqueness results for solutions

The first result for the existence and the uniqueness of solutions for SDE's was
obtained by K. It6 in the case of SDE's of Markovian type under the condition of
Lipschitz continuity of coefficients (cf. papers [2] and [12] in K. It6, Selected
Papers, 1987). He applied Picard's method of successive approximation to con-
struct a solution; the solution is pathwise unique and the unique strong solution
in the sense of the previous subsection can be directly constructed in this case. In
more general cases in which the coefficients are not necessarily Lipschitz con-
tinuous, however, such a direct construction of solutions can not be applied and it
is more convenient to discuss the existence and the uniqueness of solutions sep-
arately and appeal to Theorem 16 above to obtain the unique strong solution.
Also, there are several equations which have unique solutions in law but have no
strong solutions.
The existence of solutions was discussed by A.V. Skorokhod. If the coefficients
c~(t, w) and ~(t, w) are bounded and continuous on [0, ec) x W d, then a solution of
(56) exists for any given initial law. A standard proof for this fact is to show the
tightness on the path space W d of probability laws of approximate solutions
obtained by Cauchy's polygonal method. Then the limit process in law can be
shown to a solution. The boundedness assumption can be relaxed to, e.g., the
condition that, for every T > 0, a constant Kr > 0 exists such that
l~(t,w)l + I/~(t,w)l _< f r ( 1 + Ilwl[t), t E [0, T], w c W d (60)
where Ilwllt =max0<~_<tlw(s)l. In the case of Markovian equation (57), it is

sufficient to assume that a(t,x) and b(t,x) are continuous and satisfy:
Io-(t,x)l + Ib(t,x)l <_Kr(1 + lx[), t E [0, T], x E Rd . (61)
If these conditions are violated, a solution does not exist globally in time, in
general, but exists only up to a time e, called the explosion time, at which we have
limtTe IX(t)[ -- oc if e < co. We can extend the notion of solutions to include such
a case of explosions; we replace the path space W d by the space ~d which consists
of all continuous paths w [0, co) ~ R e U {A} (the one-point compactification of
R d) such that w(t) = A for t >_ e(w) := inf{tiw(t) = A}.
N.V. Krylov discussed a class of SDE's of Markovian type with not necessarily
continuous but Lesbegue measurable coefficients. Such equations are necessary in
stochastic control problems (cf. Krylov, 1980).
Now we consider the conditions for the uniqueness of solutions. A well-known
sufficient condition for the pathwise uniqueness is the local Lipschitz condition.
In the general non-Markovian equation (56), it is formulated as follows: Set
W(T) = {w E Wdli[w]lr _< T}. For each T > 0, there exists a constant Kr > 0
such that
[c~(t,w) -c~(t, w')[ + [/?(t, w) - / ? ( t , w')l
<_Kr(llw-w'llt), t~[O,T], w,w' C W ( T ) . (62)

906 S. Watanabe
In the case of Markovian equation, it is sufficient to assume that
- + Ib(t,x) - b(t,z')L
<_Kr(Ix-x'l), x,x' E B ( T ) (63)
where B(T) = {x E Rdllxl < r}.
THEOREM 17. Under the Lipschitz conditions (62) and (63), the pathwise
uniqueness of solutions holds for Eqs. (56) and (57), respectively. If we assume
further the conditions (60) and (61), then the unique strong solutions can be
constructed directly by Picard's successive approximation: If we define, for each x,
n -- 0, 1 , 2 , . . . and a given Wiener process W = (W(t)) with W(0) = 0, a sequence
of d-dimensional continuous processes Xn = (Xn(t)), each adapted to the natural
filtration of W, successively by
Xo(t) = x, Xn(t) = x +
/0 ~(s,X~ 1)dW(s) +
/0 fl(s,Xn_l)ds ,
then Xn converges uniformly in t E [0, T] for every T > 0, a.s. as n --+ oc, to
X = (X(t)) which is a strong solution of (56) with the initial value x. If this
construction is carried out on the r-dimensional Wiener space (W~, N(Wf)),P w)
with respect to the canonical Wiener process w = (w(t)), then X = F(x, w) is the
unique strong solution of (56).
Consider the case d = 1 and the equation of the Markovian type (57).
THEOREM 18. (Yamada-Watanabe, cf. Ikeda-Watanabe, 1989) Suppose that a is

H61der-continuous of order 1/2 and b is Lipschitz continuous, i.e., for every
T > 0, there exists a constant Kr > 0 such that
I (t,x) - 2 + Ib(t,x) - b(t,x')l
<_Kr(Ix-x'l), tc[O,T], x,x' E B ( T ) . (64)
Then the pathwise uniqueness of solutions holds. Hence, if furthermore the
condition (61) is satisfied, then a unique strong solution exists for (57).
In this theorem, we may replace the drift coefficient b(t,x) by a non-Markovian
drift coefficient //(t, w); if fl(t, w) satisfies the same Lipschitz condition and the
growth condition as (62) and (60), respectively, we have the same conclusion as
Theorem for the equation
dX(t) = a ( t , X ( t ) ) d W ( t ) +/3(t,X)dt .
Typical examples of such a are, a(t,x) = v/x V O, a(t,x) = ~/x(1 - x) - l{0_<x_<a},etc.
THEOREM 19. (Stroock-Varadhan, 1979) Consider a Markovian SDE (57) and

assume that coefficients a(t,x) and b(t,x) are continuous, and that the d x d-
matrix
k=l
)
is uniformly positive definite. Then the uniqueness in law of solutions holds.
However, the pathwise uniqueness does not hold, in general; a counter example
was given by M. Barlow (Barlow, 1982).
The change of drift (Maruyama-Girsanov transformation) of Section 2.6 can
be used to show the existence and the uniqueness in law of SDE's in the following
form
dX(t) = dW(t) + fl(t,X)dt , (65)
i.e., the case d = r, a(t, w) = I: d x d identity matrix.
THEOREM 20. Assume that fl(t,w) C A d'l is bounded. Then a solution of (65)
exists for any given initial distribution and the uniqueness in the sense of law
holds.
This theorem can be shown in the following way: Given a d-dimensional distri-
bution #, we set up, on a suitable probability space (g2,f f , P ) with a filtration
{fit} such that ~- = Vt>0Yt, a d-dimensional {Yt}-Wiener process X = (X(t))
with the initial distribution #. Set
~V(t) = X(t) - X(O) and
M(t) = exp If0 t fi(s,X), d ~ - ( s ) - 1.f0t ]fi(s,X)[ 2 ds] .
As we saw in Section 2.5, M(t) is an {~t}-martingale and we can obtain a new

probability/5 on ((2, ~ ) by the M a r u y a m ~ G i r s a n o v transformation. Then, on
the probability space (~2,~,/5), we see by Theorem 10 that
W ( t ) = VV(t)- IV~, f fi(s,X)dVg(s))(t)
= ~V(t) -
2 fi(s,X)ds = X(t) - X(O) -
/0 fi(s,X)ds
is {fft}-Wiener martingale so that (X, W) is a solution to Eq. (65). Any solution

can be obtained in this way and hence, the uniqueness in law holds.
More generally, we can deduce by the same method the existence and the
uniqueness in law of the equation
dX(t) - o(t,X)dW(t) + [fi(t,X) + c(t,X)7(t,X)]dt
for c(t,w)E A a'r, f l ( t , w ) c A d'l and bounded 7(t,w)C A r'l, if we can show,
beforehand, the the existence and uniqueness in law of the equation
dX(t) = e(t,X)dW(t) + fi(t,X)dt .
908 S. Watanabe
Cf. Ikeda-Watanabe, 1989.

The pathwise uniqueness of solutions for the Eq. (65) does not hold in general:
Indeed, B. Tsirel'son gave such an example of fi(t, w):
0, t_>t0 a n d t = 0
fi(t,w) = O(W(,,+l)-W(,i+2)~ t e [t/+l ti), i = 0 , 1 , 2 ,
\ ti+l-ti+2 /~ , "'"
where {tn} is a sequence such that 0 < . . . < t n < t , 1 <'"<t0=l and
lim,~o~ tn = 0, and O(x) = x - Ix] is the decimal part of x c R.
The time change of Section 2.4 can be applied to solve a class of SDE's. Let
d = 1 and consider an equation of non-Markovian type:
dX(t) = c @ , X ) d W ( t ) (66)
where ~(t,w) satisfies that C1 <_ e(t,w)~(t,w)* = Ic~(t,w)l2 _< C2 for all (t,w) for
some constants 0 < C1 < C2. Given a one-dimensional Brownian motion
B = (B(t)) with a prescribed initial law # on R, we consider the following equation
for a continuous strictly increasing function A = (A(t)) with A(0) = 0:
A(t) = 1 ds, t> 0 (67)

le(A(s),BA)I 2
where B A = (BA(t)) is defined, as in Section 2.5, by BA(t) = B ( A - I ( t ) ) , t H A-l(t)

being the inverse function of t ~ A(t).
THEOREM 21. (Ikeda-Watanabe, 1989) If, for almost all sample paths of
B = (B(t)), there exists one and only one continuous function A = (A(t)) which
satisfies the Eq. (67), then X = B A = (BA(t)) is a solution to SDE (66) with a
certain Wiener process W. Furthermore, the uniqueness in the sense of law holds
for SDE (66).
Thus, the problem of the unique existence of solutions for (66) is reduced to the
problem of the unique existence of solutions for the Eq. (67) along each sample
path of B = (B(t)). For a simple example, if e(t, w) = a(w(t)) by a function a(x)
on R, then c~(A(s),B A) = a ( B A ( A ( t ) ) ) = a(B(t)) and hence the Eq. (67) has the
unique solution A ( t ) = f~ la(B(s))l-2ds. Consequently, the existence and the
uniqueness in law for the SDE
dX(t) = a(X(t) )dW(t)
holds and a solution is given by X ( t ) = B(A -1 (t) ) with A(t) = .1~ la(B(s) )l-Z ds.
More generally, if a(t,x) is Lipschitz continuous in t, then the equation
A(t) = 1 2 ds, t _> 0
has the unique solution A for every sample path of B and hence the SDE
dX(t) = a ( t , X ( t ) )dW(t)
Itd's stochasticcalculusand its applications 909
has a unique solution in law given by X(t)= B(A-1(t)). This fact was first
remarked by M.P. Yershov.
A more interesting and nontrivial example is the case of e(t, w) given by
~(t, w) = a y + w(s))ds
where y E R is a constant, f(x) is a locally bounded Borel function on R and a(x)
is a bounded Borel function on R such that a(x) >_c for all x for some constant
c > 0. The Eq. (67) is now
t ( I'A(s) x~-2
A(t) = f a y + \ Jo f(BA(u))du) ds
which can be solved uniquely, for each given sample (B(s)) of B, as
A(t) ~ta(y+~-l[foSf(B(u))dul) 2ds
where x--+ ~b-l(x) is the inverse function of x--+ ~b(x)= foa(Y+z)2dz. In this
way, the equation
dX(t) =a[Y+.footf(X(s))dsldW(t)
can be solved uniquely in law and a solution is given by X(t) = B(A -1 (t)). This
example was given by M. Nisio.
3.3. SDE's based on Gaussian and Poissonian noise

So far we have considered SDE's driven by a Gaussian white noise or, equiva-
lently, by a Wiener process. For such equations, the solutions are necessarily
continuous processes. We can consider more general SDE's which are driven by a
Poisson random measure as well as a Wiener process. Then the solutions are
usually discontinuous processes. Here we formulate a Markovian type SDE only.
Let (S, ~ z ) be a measurable space and n(d~) be an infinite and a-finite measure
on (S, Nz). We can consider, on a suitable probability space (f2, ~ , P ) with a
filtration { ~ t } , an r-dimensional {Yt}-Wiener martingale W = (W(t)) and an
{Yt}-Poisson point process p on (ff, Nz) with compensator Np(ds, d ~ ) =
ds. n(d~). Then W and p are necessarily mutually independent. We fix ~0 c Nz
such that n(S \ So) < oc.
Let a(x) = (a~(x)) be a Borel function R a --+ R d R r, b(x) = (bi(x)) be a Borel
function R d --+ R d a n d f ( x , 4) = (f(x,
t
4)) be a ~ ( R d) ~z-measurable function
R d x S---+ R d such that the following growth condition is satisfied for some
constant K > 0:
I~(x)12 + [b(x)12 + Z If(x, ~)12n(d~) _< K(1 + Ix[2), x E Rd . (68)

o
910 S. W a t a n a b e
Consider the following SDE:
xi(t) = x i ( 0 ) +
k=l 0
aik(X(s--))dWk(t) + f
,0' bi(X(s-))ds
+ .L '+ . f i ( X ( s - ) , ~ ) " ls0(~). Np(ds, d~)
+ f i ( X ( s - ) , ~ ) " lz\z0(~).Np(ds, d~), i= 1,...,d .
(69)
Here, as in Section 1.5,
Np(ds, d~) = Np(ds, d~) - Np(ds, d~)
= Np(ds, d~) - ds-n(d~) .
By a solution of the Eq. (69), we mean an Rd-valued cfidlAg process X - (X(t))
defined on a probability space (O, Y, P) with a filtration {~-~}, on which there
exist an r-dimensional {~t}-Wiener martingale W = (W(t)) and an {~t}-Poisson
point process on (E, Nz) with the compensator ds- n(d~), such that X is { J r } -
adapted and satisfies the Eq. (69). Since f~ IX(s)]2ds < e~ for all t > 0, we see by
(68) that (a~(X(t-))) E 52,1oc((Wk(t)) and f i ( X ( s - ) , 4) c Fp2~1c so that the inte-
grals in the right-hand side of (69) are well-defined as c/tdlfig processes.
THEOREM 22. (Ikeda-Watanabe, 1989) If a(x), b(x) and f(x, 3) satisfy, besides
the growth condition (68), the following Lipschitz condition for some constant
K>0:
I~(x) - ~(y)l 2 + Ib(x) - b(y)l 2
+{ [f(x,~)-f(y,~)12n(d~) < K l x - Y [ 2, x,yER d , (70)

o
then, on any probability space (O, ~-, P) with a filtration {t}, on which there are
given an r-dimensional {~'t}-Wiener martingale W = (W(t)), an {~t}-Poisson
point process on (E, Nz) with the compensator ds-n(d~) and a d-dimensional
W0-measurable random variable X0, there exist a unique {~-t}-adapted solution
X of SDE (69) with initial value X0.
3.4. SDE's and diffusion processes

Consider a time-independent Markovian type SDE (58) with continuous coeffi-
cients on Ra;
dX(t) = a(X(t) )dW(t) + b(X(t) )dt . (58)
Then a solution admitting an explosion always exists. Assume further that the
uniqueness in law of solutions holds for (58). Then, denoting by Px the law on "~(a
of a solution X = (X(t)) with X(0) = x, the system {Px} defines a diffusion process
(a strong Markov process with continuous paths) on R d with the point at infinity
A as a terminal point. Set
aiJ(x) = ~ ak(x)~(x),
i " i , j = 1,...,d
k--1
and define a second-order differential operator A by
1 d ~ ~ d
A = 2~i,j-I aij(x) ~iXi~Xj @ ~ bi(x) X," (71)
","= i~ l t
with the domain Cg(R d) (the space of all cg2-functions on R d with compact
supports). We set always f(A) = 0 for f C Cg(Rd).
By It6's formula applied to a solution X of (58), we have for f E C2(Rd),
f(X(t)) -I(X(O)) = Z ~-5~(X(s))~k(X(s))dW (s)

i=1 k=I dO tz+i
+
/0 (Af)(X(s))ds .
Hence, f ( w ( t ) ) - f ( x ) - fo(Af)(w(s))ds is a martingale under Px for every

f c Cg(Rd) and this property characterizes the diffusion process {Px}. The
diffusion {Px} is generated by the differential operator A in this sense. Further-
more, if for some 2 > 0, (2 -A)(C~(Rd)) is dense in Coo(Rd): ( = t h e closure of
C2 (R a) under the supremum norm), then the transition semigroup of the diffusion
is a Feller semigroup (a positive contraction and strongly continuous semigroup)
on C~ (R d) and its infinitesimal generator/1 in Hille-Yosida's sense is the closure
of (A, C2(Rd)). In particular, u(t,x) = E~[f(w(t))] for f C C02(Rd) is the unique
solution of the evolution equation
du(t)/dt = Au(t), u(O) = f .
Ifc(t,x) is continuous and v(t,x) is sufficiently smooth in (t,x) on [0, ec) R d,
then by It6's formula, we have for a solution X of (58) with X(0) = x,
v(t,X(t))exp{fotC(s,X(s))dsl -v(O,x)
explfSc(,,X(z))drl ~V (s'X(s) )ak(X(s)

"~ixi i ) " dWk(s)
i=1 k ~ l 0 LJo /
+ /o'exp [/0sc(%X(v))dr )
. ~ + (A +c) (s,X(s))ds .
The first term (denote it by M(t)) in the right-hand side of this equation is a sum
of stochastic integrals by Wiener processes so that it is a local martingale. Hence,
if an {Yt}-stopping time T satisfies E({M)(T)) < oc, then we have E N ( T ) ] = 0
912 S. Watanabe
by Doob's optional stopping theorem. If, for example, v satisfies the heat equa-
tion
8v
8t + (A + c)v = O ,
we have from this that
v(O,x) = E{v(T,X(T))exp[fo~C(s,X(s))ds] } .
This formula can be used to obtain the probabilistic representations, in terms of

the diffusion X, of solutions for initial or boundary value problems related to the
operator A. On these topics, cf. e.g., Friedman, 1975.
3.5. SDE's and stochastic flows of diffeomorphms

Consider again the SDE (58):
dX(t) = a(X(t) )dW(t) + b(X(t) )dt . (58)
We assume that coefficients o- and b are smooth; we assume here that they are (g~o
with bounded derivatives of all orders > 1, for simplicity, although a more refined
result may be stated which depends on the order of regularity of coefficients.
Under this condition, the unique strong solution for (58) exists, that is,
on the r-dimensional Wiener space (W~,~(W~),Pr/), there exists a family
{X x = (X(t, x; W))}xeRd of Rd-valued continuous processes where X x is the unique
solution of the SDE (58) with initial value x and with respect to the canonical
Wiener process w E W~. Thus, we obtain, for almost all w E W~, the map
[0, o~) R ~ ~ (t,x) ~ x ( t , ~ ; w ) ~ R ~

If we consider this as a map
Rd ~ x ~ [t H x ( t , x ; .)] c w ~ ,
then it induces the law P~ on W a. As we saw in Section 3.4, the system {P~} is the
diffusion process generated by the operator A.
If we regard it as a map
[0, ~ ) ~ t ~ [~ ~ x ( t , x ; )1 ,
then we have the following important result due to J.-M. Bismut and H. Kunita
(cf. Kunita, 1990):
THEOREM 23. With probability one, for all t >_ 0, the map [x ~ X ( t , x ; . ) ] is a
diffeomorphism of R d. Furthermore, introducing a natural topology on the group
G formed of all diffeomorphisms of R d, the map
is continuous, a.s.
The continuous process with values in the group G, thus obtained from the
solutions of SDE (58), is called the stochastic flow ofdiffeomorphisms associated to
SDE (58). The above theorem may be regarded as one of the most refined results
concerning the dependence of solutions of a SDE on its initial values. The
dependence on initial values of solutions has been studied from the beginning of
SDE theory mainly by Russian and Ukrainian schools; by Yu. N. Blagovescen-
skii, M.I. Freidlin, I.I. Gikhman, A.V. Skorokhod, among others.
As an application, we can show that the function u(t,x), t > O, x E R d, defined
by u(t,x) = EW[f(X(t,x, w)], f C C02(Rd), is (~2 inx and satisfies ~u/at = Au where
A is the differential operator (71).
3.6. SDE's and the Malliavin calculus

We consider the same SDE (58) under the same conditions on coefficients as in
Section 3.5; the coefficients are cg~ with bounded derivatives of order _> 1. Also,
we consider the solution X ( t , x ; w ) of (58) with initial value x realized on the
Wiener space ( W ~ , 2 , P w) where Y is the completion of ~(W~) with respect
to pW.
Since t -+ f ( X ( t , x; w)) - f ( x ) - f o ( A f ) ( X ( s , x; w))ds is a martingale under pre
for f c C~ (R d) (the space of all ~ - f u n c t i o n s on R a with compact supports), we
have
EPe[f(X(t,x;w))] = f ( x ) + EW{(Af)(X(s,x;w))]ds .
/0 '
This relation implies that the transition probability P(t,x, dy) --
p W ( x ( t , x ; w ) E dy) is, for each x, a distribution solution of ( 8 / t - A * ) p = 0
where A* is the adjoint operator of A. Hence if the operator ~ / ~ t - A* is hy-
poelliptic, we can conclude that P(t, x, dy) possesses a smooth density p(t, x, y) by
appealing to the theory of partial differential equations. We can also discuss this
problem probabilistically by applying the Malliavin calculus to the solution
x(t, x; w).
The Malliavin calculus is an infinite dimensional differential calculus for
PW-measurable functions, i.e., Wiener functionals, on the Wiener space
(W~), ~ , pW). Since the space W~ is a linear topological space by the topology of
uniform convergence on finite intervals, we can consider the (Fr6chet) derivative
for functions defined on W~) in the direction of an element in W~. However, the
Rd-valued Wiener functional w H X ( t , x ; w ) for each fixed t _> 0 and x E R d is
not differentiable in this sense, in general; it is not even continuous, in general,
or, what is worse, it is not a function on W~ in a naive sense but is an equiv-
alence class of functions on W~ coinciding each other PW-almost everywhere so
that we can not even define its value at each specified point of W~. An important
discovery of P. Malliavin is that, nevertheless, these Wiener functionals can be
differentiated as many times as we want so that they may be called smooth if the
notion of derivatives is modified suitably: Firstly, we restrict the directions of
derivatives to be in the Cameron-Martin subspace H of the Wiener space W~.
914 S. Watanabe
Here, the Cameron-Martin subspace H is a Hilbertian subspace of W~ defined

by
H= hEW~l~hEL2([0, oc)~Rr), h(t)= h(s)ds
with the norm

1
IlhliH = lihllL2ctO,~)-~Rr>-- Ih(s)] ds .
Secondly, the derivative is defined in a similar way as the Sobolev weak derivative,
equivalently, as the Schwartz distribution derivative in the usual analysis for
functions on a Euclidean space. The class of real valued Wiener functionals,
having the derivatives of all orders in this sense and, furthermore, these deriva-
tives having the moments of all orders with respect to the Wiener measure, is
denoted by Doe. We call Doe the space of test Wiener funetionals on the Wiener
space. It should be remarked that a test Wiener functional is not necessarily
continuous; indeed, there exists a test functional which can not be made con-
tinuous on W~ by any modification of its values on a PW-null set; in other words,
the Sobolev imbedding theorem on a Euclidean space no longer holds on Wiener
space. Malliavin's first important remark is that the Rd-valued Wiener functional
X(t,x;w) for each fixed t _> 0 and x E R d is in the space (D~) d, i.e., each of its
d-components is in the test functional space.
We can define, in the same way as the Schwartz theory of distributions on a
Euclidean space, the notion of generalized Wiener functionals or distributions on
the Wiener space: We introduce a natural topology on the space Doe (by means of
the family of Sobolev-type norms defined on it) and then consider the topological
dual, i.e. the space of all continuous linear functionals on Doe. We denote it by
D - ~ and call its element a generalized Wiener functional.
A typical example of generalized Wiener functional is given by a formal ex-
pression 6y(F(w)) where 6y(.) is the Dirac delta-function on R d with the pole at
y E R d and F is an R d -valued Wiener functional. In the frame of the Malliavin
calculus, this formal expression can be rigorously defined as an element in D -~ if
F satisfies the following conditions:
(i) F E (D~) a, i.e. F = ( F 1 , . . . ,F d) with F i C D e for i = 1,... ,d,
(ii) F is non-degenerate in the sense of Malliavin that
[det ~F(w)] 1 has moments of all orders with respect to pW .
Here CrF(W) = ((OFi(w), DfJ(w))) and Ofi(w) is an H-valued Wiener functional

uniquely determined by DFi(w)[h] = (DFi(w),h)H, h c H, where DFi(w)[h] is
the derivative of F i in the direction of h E H and (% ')~r is the H-inner product.
Under the condition (i) above, (DFi(w),DFJ(w))H c Doe for all i,j and aF(W) is
nonnegative definite for PW-almost all w. OfF(W) is called the Malliavin
covariance of F.
Ira's stochastic calculus and its applications 915
Suppose that an Rd-valued Wiener functional F satisfies the above conditions (i)
and (ii) so that 6y(F(w)) is well-defined as an element in D oo. Then the coupling
(6y(F(w)), ~) (i.e., the value of the linear functional at ~)is well-defined for (b c D .
This coupling is called a generalized expectation of 6y(F(w)). ~ and is denoted by
EWI6y(F(w) ) . ~)] .
The notion of generalized expectations indeed generalizes the notion of the

Wiener functional expectations; when a Wiener functional ~ is pth power in-
tegrable for some p > 1, then the coupling of ~ E Lp c D - ~ against c D is
exactly the expectation by the Wiener measure pW of the product ~g. ~, which is
now an integrable Wiener functional. The Wiener functional taking the constant
value 1, denoted by 1, is a test Wiener functional and the generalized expectation
PF(Y) := {6y(F(w)), 1) = EW[cSy(F(w)]

is well-defined. By the Malliavin calculus, we can show that PF is ~oa and this
coincides with the density of the law of the Rd-valued Wiener functional F. A
generalized expectation EW[6y(F(w)) ~b] for a test Wiener functional is also c ~
in y and this coincides with EW[~b(w)IF(w) = Yl PF(Y). In this way, the Malliavin
calculus provides us with an efficient probabilistic method to study the existence
and the smoothness for the density of laws of Wiener functionals and also the
smoothness of conditional expectations.
We know that the solution X(t,x; w) of SDE (58) satisfies the condition (i)
above for all t > 0 and x c R d. If we can show that it also satisfies the condition
(ii) for t > 0 and x c R d, then the generalized expectation
p(t,x,y) =EWlby(X(t,x;w))], t > O, x E R d

is well-defined and defines a ~~-function of (t,x,y) E (0, ~ ) R d R d. p(t,x,y)
thus obtained is the density of the transition probability P(t,x, dy) and, at the
same time, is a fundamental solution to the parabolic partial differential equation
8u/Ot = Au.
A simple sufficient condition for the nondegeneracy condition (ii) of the
Malliavin covariance of X(t,x,w) is the ellipticity of the operator A, i.e.,
det[a ij](x) > 0. A more delicate condition can be given in terms of Poisson
brackets of vector fields
d ~ ,
= Z k = 1 , . .. , r,
i=1
Vo(x)= ~ bi 1
i=1 - ~ k=l ~ axj
which corresponds to the H6rmander condition for the hypoellipticity in the

theory of partial differential equations. Cf. Kusuoka-Stroock, 1985, on these
topics.
916 S. Watanabe
F o r a general account on the Malliavin calculus, cf. e.g., Malliavin, 1997,

I k e d a - W a t a n a b e , 1989 and W a t a n a b e , 1983.
3.7. Skorokhod equations and reflecting barrier diffusions

Let X = (X(t)) be a one-dimensional Brownian m o t i o n and define a continuous
process X + = (X+(t)) by X+(t) -- IX(t)l. Then, X + is a diffusion process on the
positive half line [0, oc) with the transition probability
+expE
It is called the reflecting Brownian motion on [0, cx~).
This diffusion can also be obtained as a unique solution of the following
equation introduced by A.V. Skorokhod: Consider the equation
X(t) = X(O) + W(t) + ~(t) (72)
where
(i) X = (X(t)) is a continuous process on [0, oe),
(ii) W = (W(t)) is a one-dimensional Brownian m o t i o n with W(0) = 0 which is
independent of X(0),
(iii) ~b = (q~(t)) is a continuous, increasing process such that, with probability
one, ~b(0) = 0 and t ~ qS(t) increases only on such t that X(t) = 0, i.e.,
fo t l {o} (X(s) )d4(s) = ( t) for all t >0 .
THEOREM 24. Given a [0, oe)-valued r a n d o m variable X(0) and a one-dimen-

sional Brownian m o t i o n W = (W(t)) with W(0) = 0 which are mutually inde-
pendent, there exists a unique pair (X, ~b) of a continuous process X = (X(t)) on
[0, oc) and a continuous increasing process q5 = (~b(t)) which satisfies the p r o p e r t y
(iii) above and the S k o r o k h o d equation (72). X = (X(t)) is a reflecting Brownian
m o t i o n on [0, co) and ~b = (~b(t)) is given f r o m X by
1 t
q~(t) = l i r a - - f l[o,2l(X(s))ds, t>0 .
4o 2e J0
~b = (~b(t)) is called the local time at x - 0 of the reflecting Brownian m o t i o n X.
It is easy to find explicit forms of X and qS:
X(t) = X ( 0 ) + W(t) - min {(X(0) + W(s)) A 0},

0<s<t
q~(t) = - m i n { ( X ( 0 ) + W(s))A 0} .
O<_s<_t
These formulas for the reflecting Brownian m o t i o n and its local time were first
obtained by P. L6vy (L6vy, 1948).
The Skorokhod equation can be considered on more general domains, First,

consider the case of finite interval I = [a, b], a < b. Then it is given by
X(t) = X(O) + W(t) + c~(t) (73)
where X(0) is a random variable with values in I, W = (W(t)) is a one-dimen-

sional Brownian motion with W(0) = 0 which is independent of X(0), X = (X(t))
is a continuous process on I, ~b = (qS(t)) is a continuous increasing process with
qS(0) = 0 and J0 l{a,b}(X(s))d(o(s) = ~b(t) for all t _> 0, a.s., i.e., qS(t) increases only
on such t that X(t) = a or X(t) = b. In the same way as Theorem 24, X and q5 exist
uniquely for given X(0) and W. X is called a reflecting Brownian motion on I.
Next, we consider the Skorokhod equation in the multidimensional case. Let D
be a domain in R d with a @-boundary ~D and let/7) ~ x ~ n ( x ) ~ R d be given
such that it is @ and, for x E ~D, n(x) is a non-tangential and inward-pointing
unit vector. Consider the Skorokhod equation in D = D U OD:
X(t) = X(O) + W(t) +

/0 ' n(X(s))dO(s) (74)
where X(0) is a / ) - v a l u e d random variable and W = (W(t)) is a d-dimensional

Wiener process with W ( 0 ) = 0 such that they are mutually independent,
and X = (X(t)) and 4 = (~b(t)) are such that X is a / ) - v a l u e d continuous pro-
cess, ~b is a continuous increasing process with ~b(0)=0 and satisfies
fo leD(X(s))dO(s) = ~b(t). Again, for given X(0) and W, X and ~bexist uniquely. X
is called an obliquely reflecting Brownian motion in D in the direction n(x) of
reflection at the boundary. If n(x) is the normal vector at each boundary point
x E D, then X is called a reflecting Brownian motion. IfPx is the law of a solution
of (74) with X(0) = x, then the system {Px} defines a diffusion process on /)
generated by the differential operator A/2 (A: Laplacian) and the boundary
condition ~u/~n = 0 in the sense that the transition expectation u(t,x)=
Ex~f(w(t))] is characterized by the solution to the initial and boundary values
problem:
~u 1 ~u
St-2Au inD, ~ =0, ult=0 = f .
~D
The Eq. (74) can be further extended to the following SDE: We write it in the
equivalent form using stochastic differentials;
dX(t) = a(X(t))dW(t) + b(X(t))dt + n(X(t))d(o(t) (75)
where a(x) : / ) --+ R d R r and b(x) : / ) --+ R a are continuous functions. The
increasing process 4) has the same meaning as above. We can show the exis-
tence and the uniqueness of solutions for a given independent pair of X(0) and
an r-dimensional Wiener process W if a and b satisfy the Lipschitz condition
i n / ) . The solutions of (75) define a diffusion process o n / ) which is generated
by the differential operator A given by (71) and the boundary condition
~u/~n = O.
918 S. Watanabe
The Skorohod equation in a multidimensional region was first studied by

H. Tanaka (Tanaka, 1979, cf. e.g., Lions-Sznitman, 1984 and Saisho, 1987 for
extensions and refinements).
There are many works on SDE's for diffusion processes in domains with more
general boundary conditions than reflections (cf. e.g., Ikeda-Watanabe, 1989,
Takanobu-Watanabe, 1988).
3.8. Examples
(1) Linear and exponential diffusions
Consider the following one-dimensional SDE:
dX(t) = [a(t)X(t) + b(t)]dW(t) + Ic(t)X(t) + d(t)]dt
where a(t), b(t), c(t), d(t) are deterministic call-functions of t E [0, to), (0 < to _< oc)
and W(t) is a one-dimensional Wiener process. The equation is equivalent to that
in the form of Stratonovich differentials:
dX(t) = a(t)X(t) o dW(t)
+ [c(t) - a2(t)]X(t)dt + b(t). dW(t) + [d(t) - la(t)b(t)] dt .
Set
M(t) = exp -
{ J0' a(s)dW(s) --
J0'
C(S) -- ~a
}
1 2 (s)] ds , t c [0, to) .
Then
M(t)-' o dM(t) = -{a(t)dW(t) + [c(t) - ~al2(t)] dt}

and hence,
dX(t) = - X ( t ) M ( t ) -1 o dM(t) + b(t) . dW(t) + [d(t) - a(t)b(t)] dt ,

i.e.,
d(M(t)X(t)) = b(t)M(t) o dW(t) + [d(t) - a(t)b(t)]M(t) dt .

From this, the solution X(t), t c [0, to), with the initial value X(0) is uniquely
obtained by
X(t) = M(t) -1 (X(O)q- j[otb(s)M(s)o dW(s)
+ ~o't[d(s) - a(s)b(s)]M(s) ds) .
If, in particular, a(t) = 0 and X(O) is Gaussian random variable independent of

W = (W(t)), then the solution X = (X(t)) is a Gaussian process. The case of
Langevin's equation; a(t) =- d(t) =- O, b(t) - 1, c(t) = - 7 , (7 > 0), is a typical ex-
ample and the solution
(
X ( t ) = e -'/t X ( O ) +
/0' e 'lsdW(s
is well-known as Ornstein-Uhlenbeck's Brownian motion.

, tE[O, oc)
The case of a(t)=_0, b ( t ) = 1, c ( t ) = - 1 / ( t 0 - t ) and d ( t ) = y / ( t o - t ) , for

0 < to < oc and y E R, is the SDE for the pinned Brownian motion; the solution
XJ,Y(t), 0 < t < to with the initial value x is a Brownian motion B(t) conditioned
by B(0) = x and B(to) = y.
Note also that the Eq. (48) for the Black-Scholes model of Section 2.8 is the
case of a(t) = a, b(t) - O, c(t) - tt and d(t) =_ O.
(2) The square of Bessel processes

Let a, c, d be real constants such that a > 0 and d _> 0, and consider the following
one-dimensional SDE:
dX(t) = (2aX(t) V o)l/2dW(t) + (cX(t) + d) dt .
By Theorem 18, the unique solution X(t) exists for a given initial value, and, if
X(0) > 0 a.s., then X(t) >_ 0 for all t _> 0, a.s.. The solutions define a diffusion
process on [0, ec) generated by the differential operator:
d2 d
A = axe+ (cx + d)
The case of c = d = 0 has been considered by W. Feller (Feller, 1951) in

connection with a scaling limit of critical Galton-Watson branching processes.
Let a = 2 and c = 0. If X = (X(t)) is the corresponding diffusion on [0, oc),
then 2 -- (X(t)) defined by X(t) = X ~ is a diffusion process on [0, oc) corre-
sponding to the differential operator
--x "
This diffusion on [0, oc) is known as the Bessel diffusion of dimension d. It is well-
known that, when d is a positive integer, the radial motion of a Brownian motion
on R d is a Bessel diffusion of dimension d.
(3) SDE's related to genetic models

Consider the following one-dimensional SDE:
dX(t) = azv/{X(t)(a - X(t))} V 0. dW(t) + c(X(t)) dt
where c(x) is Lipschitz-continuous and satisfies that c(0) _> 0 and c(1) < 0. By
Theorem 18, the unique solution exists for a given initial value, and, if
X(0) E [0, 1] a.s., then X(t) E [0, 1] for all t > 0, a.s. Thus, the solution defines a
diffusion process on [0, 1]. This class of diffusions appears as scaling limits of
M a r k o v chain models for gene frequencies in population genetics; cf. e.g., Sato,
1976, for examples of such SDE's and their multi-dimensional extensions.
920 S. Watanabe
4. Stochastic differential equations on manifolds
So far, we considered SDE's on a Euclidean space. Just as in the case of dy-

namical systems, however, natural state spaces on which SDE's are to be con-
sidered are manifolds: SDE's on manifolds provide us with basic tools in the
probabilistic study of problems in analysis and geometry on manifolds.
Throughout this section, we only consider strong solutions of SDE's so that,
we always take, as our basic probability space, the r-dimensional Wiener space
(W~), ~ , pW) where ~- is the completion of ~(W~) with respect to pW. We always
consider SDE's based on the canonical Wiener process w = ( w ( t ) ) c W~;
w(t) = ( w l ( t ) , . . . , w r ( t ) ) . When we speak of a filtration { ~ t } on the Wiener
space, it is always the natural filtration of the canonical Wiener process.
4.1. SDE's on manifolds: The basic theory

Let M be a connected a-compact cg%manifold of dimension d and let
WM = C([0, ~ ) ~ M)
be the space of all continuous paths on M. When M is not compact, let

_~/= M tA {A} be the one-point compactification of M and WM be the space of all
continuous paths on M with A as a trap, i.e., w(t) = A for all t _> s if w(s) = A.
WM and W~2 are endowed with the topology of the uniform convergence on finite
intervals and N(WM) and N(W~?) be the topological a-field on WM and W~2,
respectively.
Suppose that we are given a system of cg~-vector fields A0,A1,..., Ar on M. We
write a SDE on M in the following form:
dX(t) = Ak(X(t) ) o dwk(t) + Ao(X(t) ) dt . (76)
Here, we adopt the usual convention for the omission of the summation sign.
A precise meaning of the SDE (76) is as follows. We say that X = (X(t)) is a
solution to SDE (76) i f X is an {Wt}-adapted continuous process on F / w i t h A as
a trap, such that, for any f C C~ (M) (:= the space of all cg%functions on M with
compact support; we s e t / ( A ) = 0 when we consider on ~/), f ( X ) = ( f ( X ( t ) ) ) c S
(i.e., a continuous semimartingale) and satisfies
d f ( X ( t ) ) = (Agf)(X(t)) o dwk(t) + (aof)(X(t)) dt , (77)
where o is the Stratonovich differentials defined in Section 2.2. If
Ak(x) = ak(x ~ , k=l, ... ,r, and Ao(x) = bi(x) ~ i
in a local coordinate, then X - ( X ( t ) ) is a solution of (76) if and only if

X(t) = (X 1(t),... ,Xd(t)), in each local coordinate, is a d-dimensional continuous
semimartingale and satisfies
dXi(t) : i o awe(t) + bi(X(t))dt
: aik(x(t))" dwk(t) bi 2 k--1 "4 (X(t))dt (78)
Note that the Eq. (78) has an intrinsic (i.e., coordinate-free) meaning because the
Stratonovich differentials obey the usual chain rule.
THEOREM 25. For each x E M, there exists a unique strong solution X ~ = (XX(t))
of (76) with X~(0) = x. Setting XX(t; w) = (X(t,x; w)), X(t,x; w) is an M-valued
Wiener functional for each (t, x), and the system {Px}x~M, where Px is the law on
W~ of It ~-+X(t,x; .)], defines a diffusion process on M which is generated by the
second order differential operator A of the H6rmander type:
1 r
A=~k~__IAZ+A0 .
Furthermore, except on a set ofPW-measure 0, the following holds: For each fixed
(t, x0, w) such X(t, x0; w) c M, the map x ~ X(t, x; w) is a diffeomorphism between
a neighborhood of x0 and a neighborhood o f X ( t , xo; w).
The unique existence of solutions can be deduced by solving the Eq. (78) in
each local coordinate and then putting these solutions together. We can also
imbed the manifold M in a higher dimensional Euclidean space by appealing to
Whitney's imbedding theorem (Whitney, 1957) and apply the result in the
Euclidean case. The form of the differential operator A can be deduced from It6's
formula. Also, the diffeomorphic property of solutions as stated in the theorem
can be deduced from Theorem 23 of Section 3.5.
4.2. Brownian motions on Riemannian manifolds
Let M be a Riemannian manifold. A diffusion process on M (more precisely, a

diffusion process on M U {A} with A as a trap) is called a (minimal) Brownian
motion on M if it is generated by AM/2 where AM is the Laplacian, i.e. Laplace-
Beltrami operator, on M. A Brownian motion on M exists uniquely: It is a family
{Px} of probability measures on W~2 such that Px(w(O) = x) = 1 and, for every
f C C~ (M),
t 1
is a martingale under Px.

There are two general methods to construct the Brownian motion on M using
SDE's. The first method is to obtain it as the trace (i.e. projection) on M of the
stochastic moving frame over M which will be discussed in the next Section 4.3.
The second method is based on the imbedding of the manifold: We imbed M into
a higher dimensional Euclidean space R r so that the Riemannian metric on M is
922 S. Watanabe
induced f r o m the Euclidean metric o f R r. If TxM is the tangent space at x E M of

M, then we m a y consider that TxM C R r as a linear subspace and the Riemannian
n o r m o f TxM is the restriction o f the Euclidean n o r m o f R r. Let
P(x): R r ~ ~ ~ P(x)[~] E rxM
be the o r t h o g o n a l projection of R r onto TxM. Define & ( x ) ~ TxM, x E M,

k = 1 , . . . , r, by Ak(x) = P(x)[6k], where [61,..., 6~1 is the canonical base o f R~:
k-th
c~k=(0,...,0, 1 ,0,...,0), k=l,...,r .
Then A 1 , . . . ,At are s m o o t h vector fields on M and we can consider S D E
dX(t) = A~(X(t)) o dw~(t) (79)
on the r-dimensional Wiener space. If we denote by Px the law on W~2 o f the

solution X = (X(t)) of (79) with initial value x c M, then the family {Px} defines
the Brownian m o t i o n on M. N o t e that, using the imbedding M c R', S D E (79)
can be solved as an S D E on Rr: we extend the vector fields A 1 , . . . ,A~ to s m o o t h
vector fields A 1 , . . . ,A, on R ~ and consider the S D E
dX(t) = ~lk(X(t) ) e dwk(t)

on R r. If the initial value x is in M, the solution stays in M for all t > 0 and is
irrelevant to the way o f extensions of vector fields.
As an example, consider the case o f the unit sphere S d imbedded in R d+l as
Sd z x z (Xl,. . ,Xd+l) E R d+l x k2 ~ 1 .
Then
d+l ~
Ak(x) = Z(g)i -- XkXi) ~Xi k = 1,..., d + 1 .
i=1
Hence, if we consider the following S D E on R d+l defined on the ( d + 1)-

dimensional Wiener space:
d+l
dXi(t) = dwi(t) - xi(t) Z Xk(t) o dwk(t)
k=l
d+l
: dwi(t) - xi(t) Z X k ( t ) dwk(t)
k=l
d
-~.xi(t)dt, i = 1 , . . . , d + 1,
then the solution X = (X(t)) stays on the sphere S d for all t > 0 if X(0) = x c S d
and this solution is a Brownian m o t i o n on S d. This construction o f the spherical
Brownian m o t i o n is due to D.W. Stroock.
As another example, we consider a Brownian motion on the Lobachevskii

plane; the Lobachevskii plane or hyperbolic plane is a two-dimensional, complete,
simply connected Riemannian manifold of constant negative curvature which
we realize, as usual, by the upper half plane H2 = {(x,y)[y > 0} with the
Riemannian metric ds 2 (dx 2 Av d y 2 ) / y 2. Then the Laplacian is given by AI-I2 =
=
yZ(~2/Sx2 + ~2/~y2). Hence, SDE for the Brownian motion is given, on two-
dimensional Wiener space, by
dX(t) = Y(t)dwl(t), dY(t) = Y(t)dw2(t) .
By the result in Section 2.5, we see that the unique solution (X(t), Y(t)) with the
given initial value (X(0), Y(0)) = (x,y) c H2 is given by
X(t) = x + g(s) dwl(s) = x y exp w 2 ( s ) - ~ dwl(s),
Y(t) = yexp[w2(t) - 2 ] "
This (X(t), Y(t)) defines the Brownian motion on H2 starting at (x,y).

For the Brownian motion on H2 and its applications, c.f.e.g., papers by J.-C.
Gruet, and by L. Alili and J.-C. Gruet, in Yor (ed.), 1997 and Ikeda-Matsumoto,
1999,
4.3. Stochastic moving frames

Let M be a Riemannian manifold of dimension d and x c M. By a frame at x, we
mean an orthonormal base (ONB) e = [ e l , . . . , ed] of the tangent space TxM at x.
Thus a frame r at x ~ M can be described as r = (x, e), x c M, e = [ e l , . . . , ed]. The
totality of frames at all points in M is denoted O(M). The projection
re: O(M) -+ M is defined by ~(r) = x if r = (x, e). O(M) is called the bundle of
orthonormalframes over M,
We can identify r C O(M) with an isometric isomorphism 7 : R d ~
TxM, x = z(r), defined by sending each of the canonical base 6i, 6i =
/-th
( 0 , . . . , 0, 1 , 0 , . . . , 0), in R # to el, i = 1 , . . , , d, where r -- (x, e), e = [ e l , . . . , ed].
is called the canonical isomorphism associated to the frame r. There is a natural
right action on O(M) of the orthogonal group O(d):
Rg : O(M) O(d) (r, g) rg O(M)

defined by r9 = r o g, where O(d) is identified with the group of all isometric
isomorphisms of R d. N o w O(M) can be given a natural structure of manifold so
that it is a principal fibre bundle over M with the structure group O(d).
There is an important r a n d o m motion of frames which we call a stochastic
moving frame over M. This notion can be defined precisely by means of SDE
on the bundle O(M) of orthonormal frames. Before giving a formal definition,
however, we explain the idea in a simple case of M being a two dimensional
sphere S 2. We take a plane R 2 and let w = w(t) be a Brownian curve in R 2
924 S. Watanabe
starting at the origin 0; that is, w W := W~ endowed with the standard two-
dimensional Wiener measure pW on W so that (W,P W) is the two-dimensional
Wiener space. We assign at each point w(t)E R 2 the canonical ONB
3l = (1,0) and 32 = (0,1) so that 3 = [31,32] forms an ONB in the tangent
space Tw(t)R2 ~- R 2 at w(t). Then these bases at different points along the curve
w(t) are parallel to each other. Given a sphere S 2, choose a point x c S 2 and
an ONB e = [el, e2] in the tangent space TxS2 at x. We put the sphere S 2 on
the plane R 2 so that x touches at the origin 0 and the ONB e coincides with
the ONB 3. N o w we role the sphere S2 on the plane R 2 along the Brownian
curve w(t) without slipping. Suppose that the Brownian curve w(t) is traced in
ink. Then the trace of w(t) together with the ONB 6 at w(t) is transferred into
a curve x(t) on S 2 with an ONB e(t)--[el(t),e2(t)t in Tx(t)S 2. The random
curve r(t) = (x(t), e(t)) thus transferred is what we call stochastic moving frame
over S 2. Also, the random curve x(t) thus obtained is a Brownian motion on
the sphere S 2.
A formal definition of the stochastic moving frame is as follows. In differential
geometry, there is a notion of the system of canonical horizontal vector fields
A1,... ,Ad on the orthonormal frame bundle O(M): For each i = 1,..., d, Ai(r) is
a smooth vector field on O(M) uniquely determined by the property that the
integral curve (i.e. the solution) r(t) on O(M) of the following ordinary differential
equation on O(M) with the initial value r E O(M):
dr(t)
dt -Ai(r(t)), r(O)=r=(x,e), e={el,...,edl ,
coincides with the curve

r(t) = (x(t),e(t)), e(t) = [el(t),...,ed(t)] ,
where x(t) is the geodesic on M with x(0) = x and ax It=0 = ei and e(t) is the
parallel translate, in the sense of Levi-Civita, of e = [ e l , . . . , ed] along the curve
4t).
Let (W0d, 2 , P v/) be the d-dimensional Wiener space. The stochastic moving
frame over M starting at a frame r C O(M) is, by definition, the solution
r(t) = (r(t, r; w)), r(t, r; w) = (x(t, r; w), e(t, r; w))
of the SDE
dr(t) = A/~(r(t)) o dwk(t) (80)
on O(M) with the initial value r.

As for the action of the orthogonal group O(d) on O(M), we have for each
g E O(d) (being identified with an isometric isomorphism on R d) that
r(t,r;w)g=r(t, rg;g-lw), t >O, r e O(M) ,
where g lw E W d is defined by (g-lw)(t) = g l[w(t)], t > O.
In particular, if x(t, r; w) = ~[r(t, r; w)],
x(t,r;w) =4t,~g;g-lw), t ~ o, ~ e O(M), g c O(d) . (81)

Since g lw ----
d w by the rotation invariance of Wiener process, we deduce that
{~(t, ~g; w), t > o} {x(t, ~; w), t _> 0}, ~ c O(M), g ~ O(d) . (82)
In other words, the law P~ on W~? of [t H x(t, r; w)l satisfies Prg = P, for all
g c O(d). This implies that P, depends only on x -- To(r) so that we may write
Pr ----Px. Then, the system {Px} defines a diffusion on M with A as a trap and we
can show that it is generated by AM/2, that is, it is a Brownian motion on M. In
this way, the Brownian motion on M can be obtained by projecting the stochastic
moving frame over M.
Another important application of the stochastic moving frame will be given in
the next section. The notion of stochastic moving frames has been first introduced
by J. Eells and D.K. Elworthy (Eells-Elworthy, 1976) to realize an idea of K. It6
on the parallel displacement of tensor fields along the Brownian curve (the paper
[23] in It6, 1987). Cf. Ikeda-Watanabe, 1989 for details.
4.4. Probabilistic representations of heat kernels by

Wiener functional expectations
In m a n y problems in analysis and geometry of Riemannian manifolds, an im-
portant role is played by the heat kernels, i.e., the fundamental solutions to heat
equations; for example, there are so-called heat equation methods used effectively
in such problems as asymptotics of the eigenvalues of the Laplacian, Atiyah-
Singer index theorem, Morse inequalities for Morse functions and so on. Here, we
discuss a probabilistic approach based essentially on SDE theory and the Mal-
liavin calculus to obtain heat kernels by Wiener functional expectations.
F r o m now on, we consider on a compact Riemannian manifold M, for sim-
plicity. Let r(t) = (r(t, r; w)), t > O, r E o(m), w E W0d be the stochastic moving
frame over M as discussed in the previous section. Note that, since M is compact,
it does not explode in finite time, a.s.. F o r each (t, r) C [0, 1] o(m), r(t, r; w) is a
smooth O(M)-valued Wiener functional in the sense that f(r(t, r; w)) E D ~ for
every smooth function f on O(M). Hence the M-valued Wiener functional
X(t, r; w) is smooth in the same sense. Also for fixed t > 0 and r E O(M), it is non-
degenerate in the sense of Malliavin (this notion can be defined similarly as in
Section 3.6.) Then, as we saw in Section 3.6, we can define the formal expression
by(X(t, r; w)) as an element in D -~ where by is the Dirac delta function with the
pole at y ~ M.
By (82), we have
x ( . , r; w) d x ( . , rg; w), g ~ O(d) ,
and hence the generalized expectation EV/by(X(t, r; w)) depends only on x = ~(r)
so that we may write
926 S. Watanabe
p(t, x, y) = EW6y(X(t, r; w) ) . (83)
This p(t, x, y) is the heat kernel, i.e., the fundamental solution to the heat equation
Su 1
St - 2 Avu . (84)
If, instead of (80), we consider SDE with a parameter e > 0:
dr(t) = eAk(r(t)) o dwk(t), r(0) = r (85)

and if we denote the solution by r~(t, r; w), then we have, by the scaling property
of Wiener process, that
{r( 2t, r; w), t _> 0} r; w), t _> 0}

and hence
p(eZ,x,y) = EW~Sy(X~(1,r; w) ) . (86)
From this expression of the heat kernel p(t,x,y), we can deduce its regularity in
(t,x,y) and study its short-time asymptotic properties (cf. e.g., Ikeda-Watanabe,
1988, Watanabe, 1990). Furthermore, if V is a smooth function on M, then the
Wiener functional exp{-e 2 f~ V(X~(s, r; w))ds} of the Feynman-Kac type is in the
space D , i.e, a test functional, so that the generalized expectation
EW Iexp{-e2 fot V(X~(s,r; w))ds}6y(X~(t,r; w)) ]

is well defined. By the same reason as above, it depends only on x = ~(r) and
p(~2,x,y) =EW[exp{-~2 fol V(x~(s,r;w))ds}~y(X~(1,r;w)) 1 (87)
defines the heat kernel for the heat equation with a potential:
Su 1
St - 2 AMU -- Vu . (88)
We now consider a heat equation on a vector bundle; for simplicity, we con-

sider the case of the exterior product of cotangent bundle over M so that its
sections are differential forms on M. The canonical isomorphism "~ : R d ~ TxM
naturally induces an isomorphism "~:Ra--+ Tx*M and an isomorphism
7: i ~ R d ~ A T~*M by sending bases 6 i = (~) and 6il A-../~6i~ to fi and
fi~A...Afip; for i = 1 , . . . , d and 1_<il < . - . < i p < _ d , respectively, where
f=~.l...,fd] is the ONB in TxM dual to e = [ e l , . . . , e d ] . Here,
/~ R d = ~pd=0 A p R d is the exterior product of R d which is a 2d-dimensional
Euclidean space with the canonical basis 6i~/~ ""/~ 6/p. Let End(A R d) be the
algebra of linear transformations on A Rd and let ai* E End(A R d) be defined by
a~@) = (~i A )~, ,)v ~ A Rd' i = 1 , . . . , d .

Let ai be the dual of a*. Then the system
ai~ai2 . . .aipajla;2 ...ajq ,

where 1 _< il < ... < ip <_ d, 1 <_j~ < ... < jq < d, p , q = O, 1 , . . . , d , forms a
basis in End(ARd), cf. Cycon et al., 1987.
Let JiJk1(r)= (o}([Ak,Az])r be the scalarization of the Riemann curvature
tensor. (co = (co}) is the connection form for the Levi-Civita connection, cf.
Kobayashi-Nomizu, 1963, which is a so(d)-valued 1-form on O(M) and {Ak} is
the system of canonical horizontal vector fields introduced above.) Let
D2(J)(r) E E n d ( A R e) be defined by D2(J)(r) = jijkl(r)a*aja~al. Let r~(t, r; w) be
the stochastic moving frame as defined above by the solution to SDE (85) and
define an End(fRd)-valued process M~(t, r; w) by the solution to the following
differential equation on End(A Re):
dM(t) e2
dt - 2 D2(J)(re(t'r;w))M(t)' M(O) = I . (89)
Let 5y(X~(1, r; w)) be the generalized Wiener functional defined above and con-
sider the following generalized expectation:
7E W[M~(1, r; w ) ; ( 1 , r; w) -~ 5y(X~(1, r; w))] .
Here,
~(1,r;w) : A Re --+ A Tx(',r;w)M and 7: A Rd --+ A T*M
are canonical isomorphisms defined above. By a theory on a refinement of gen-

eralized expectations in the Malliavin calculus (called quasi-sure analysis in the
Malliavin calculus) due to H. Sugita and H. Airault-P. Malliavin (Sugita, 1988,
Airault-Malliavin, 1988), we may assume that Xe(1, r; w) = y in this expectation.
In particular, we can assume that
#(,,r;w) Hom(AVM,ARd)
and hence this generalized expectation is well defined and takes values in
-om(Ar;i, Ar;v)
Here, Hom(/d, V2) stands for the space of linear transformations from F] to V2, in
general. By considering the action of O(d), we deduce as above that it depends
only on x = ~(r). Thus we may set
p@2,x,y) = 7;Eve [Me(l, r; w)~(1, r; w)-' 6y(X~(1, r; w))] (90)
and this kernel defines the heat kernel for the heat equation on the section
F ( A T ' M ) of the exterior product bundle f T*M , i.e., on the space A(M) of
differential forms on M:
928 S. Watanabe
Ou 1
a t = ~ Au (91)
where A = - ( d * d + dd*) is the de Rham-Kodaira Laplacian acting on A(M). Cf.

Ikeda-Watanabe, 1989 and Watanabe, 1990 for details and applications. The
original probabilistic approach is due to J.-M. Bismut (Bismut, 1984).
4.5. Brownian motions on Lie groups

Let G be a Lie group. A stochastic process {g(t)}0<t<~ is called a right-(left)
invariant Brownian motion on G if it satisfies the following:
(i) with probability one, g(0) = e (the identity) and t ~ g(t) is continuous,
(ii) for every t > s, 9(t). g(s) -1 (resp. g(s) -1 g(t)) and {g(u); u _ s} are inde-
pendent,
(iii) for every t>_ s, g(t). g(s) -1 (resp. g(s) -1.g(t)) and g ( t - s ) are equally
distributed.
Let A0,Ax,...,Am be the system of right-(left-)invariant vector fields on G and
consider the SDE on the r-dimensional Wiener space:
r
dg(t) = ~--~Ak(g(t)) o dw~(t)+Ao(g(t))dt . (92)

k=l
Then the solution with 9(0) = e exists uniquely and globally. We denote it by
g(t; w). Then it is a right-(resp, left-)invariant Brownian motion on G and con-
versely, every right-(resp, left-)invariant Brownian motion can be obtained in this
way. The stochastic flow of diffeomorphisms t ~ [g ~ g(t, g; w)] defined by the
solution of SDE (92) is given as
t ~-+ [g~-+g(t;w).g] (resp. t~[g~g.g(t;w)]) .
EXAMPLE 1. (Linear Lie groups) Let G be a linear Lie group, i.e. a Lie subgroup
of the general linear group GL(d, R) or GL(d, C); the multiplication group of all
d x d nonsingular matrices. The Lie algebra ~ of G is a Lie subalgebra of gl(d, R)
or gl(d, C); the algebra of all d x d matrices. By identifying ~ with the space of all
left-invariant vector fields on G in the usual way, a system A0,A1,...,Am of left-
invariant vector fields is given by do,a1,... ,at C ~. Then the SDE (92) can be
written simply, in the matrix notation, as
dg(t) = ~ g(t) " ak o dwk(t) + g ( t ) . aodt = g(t) o d~(t) ,

k=l
where w(t) is a N-valued continuous semimartingale given by

#(t) = ~ = 1 wk(t)ak + tao. The solution g(t) with g(0) = Ed (d x d identity ma-
trix) is a left-invariant Brownian motion on G.
If we consider, instead, the S D E in the martix notation: dg(t ) =

o d#(t).g(t), then the solution g(t) with g ( 0 ) = E d is a right-invariant
Brownian m o t i o n on G.
EXAMPLE 2. (Nilpotent Lie groups and L6vy's stochastic area integrals) Let r _> 2
be an integer and d = r(r + 1)/2. Set
H~(~R d~R r xso(d)) :--{x= (xk,x(i,j)) ,1 <_k < r, 1 <_ i < j << r} .
Hr is a Lie group under the group multiplication z = x- y, x, y E H~, defined by
Zk ~- Xk -1- Yk, Z(i~/) ~ X(ij) -]- Y(i,j) -- I(xiYj -- xjYi)
where x = (xk, x(~,j)), y = (Yx, y(~,j)), z = (Zk, Z(gd)). It is called the f r e e nilpotent Lie
group o f step 2 with r generators. H2 is called the Heisenberg group. We define a
system A o , A 1 , . . . ,Ar of vector fields on Hr by A0 = 0 and
Ai(X)=~_~+ "-:=-'.z
) , , i= 1,...,r .
j;j<l j;j>i ~X(id)
Then, these are all right-invariant vector fields on Hr and, writing

g(t) = (Xk(t),x(id)(t)), the S D E (92)is given by
dXk(t) = dwk(t), 1 < k < r,
dXIiJl(t) ----xi(t) o dw](t) - Xi(t)-o dwi(t), 1< i< j < r .

2 2 - -
The solution X ( t ) with Y(0) = 0 is given by X k ( t ) = wk(t), k = 1 , . . . , r, and
X (i'j) (t) = S (i'j) (t) := ~1 ~0 t [wZ(s) o dw/(s) - w / (s) o d w i(s)l
=~ [wi(s) - dw/(s) - wJ(s) dwi(s)], 1 _< i < j < r .
s0,z) denotes, intuitively, an algebraic area of two dimensional region surrounded

by the Brownian curve (w 1 (s), w2(s))o<s<t and the chord connecting the initial and
terminal points of the Brownian curve. This notion has been introduced by
P. L6vy (L6vy, 1948) and so it is called L~vy's stochastic area.
The following formula, essentially due to L6vy (L6vy, 1951), is very i m p o r t a n t
in m a n y applications: cf. e.g., Bismut, 1988, W a t a n a b e , 1997: F o r
a = (aij) c so(r) (:= the totality of r x r skew symmetric real matrices),
w,1, 01
In particular, for r = 2, i.e., for w(t) = (wl(t), w2(t)),
930 S. Watanabe
EP[exp(aS(l'2)(1)lw(1) = 0)]
_
sin ~/2' I~l < 2re ,
or, equivalently,
E P[exp(ic~S(l'a)(1)lw(1) = 0)] - sinh a / 2 ' ~ E R .
Additional remarks on references

(1) For more complete treatments of materials discussed above, the following
books are recommended: Ikeda-Watanabe, 1981, 1989; Rogers-Williams, 1987;
Karatzas-Shreve, 1988 and Revuz-Yor, 1991, t999. Important books on SDE
theory published before 1980 are, among others, McKean, 1969; Gihman-
Skorohod, 1979 (Russian original, 1975) and Friedman, 1975, 1976. As a short
introduction to stochastic calculus, we would add an expository article by M. Yor
in the Bourbaki Seminar (Yor, 1982).
(2) We could not give a full account on the so-called "general theory of
processes" and theory of semimartingales and stochastic integrations based on it,
as have been developed in the most complete and elegant form by P.A. Meyer, C.
Dellacherie, J. Jacod, K. Bichteler, and many others. For these, we would refer
the reader to Dellacherie-Meyer, 1975, 1980; Jacod-Shiryaev, 1987; Protter, 1990
and also, an expository article "A short presentation of stochastic calculus" by
P.A. Meyer in the appendix of Emery, 1989.
(3) For applications of conformal martingales to problems in complex anal-
ysis, cf. e.g., McKean, 1969; Durrett, 1984; Bass, 1995.
(4) For approximation schemes of solutions of SDE's and numerical methods,
cf. Kloeden-Platen, 1965. For approximation of solutions of SDE's by solutions of
ODE's, cf. e.g., Wong-Zakai, 1965; Stroock-Varadhan, 1972; Kunita, 1990. In this
connection, we should mention of recent works by T. Lyons on the differential
equations driven by rough signals (Lyons, 1998) An important implication of his
theory is that, a strong solution ofa Markovian SDE is a continuous functional of a
driving Wiener process and its stochastic area integrals put together, that is, the
discontinuities on the Wiener space of solution is essentially caused by the discon-
tinuities of stochastic areas.
(5) The formula for Wiener chaos expansion (ItS's multiple Wiener integral
expansion) for solutions of Markovian SDE's has been obtained by Veretenni-
kov-Krylov, 1976.
(6) For applications to nonlinear filtering theory, cf., e.g., Kallianpur, 1996.
For applications to stochastic control problems, cf. Krylov, 1980.
(7) For examples of SDE's involving Poisson point processes, cf. e.g., Tanaka,
1972, for models connected with Boltzmann's equation of Maxwellian gas,
Takanobu-Watanabe, 1988 for the process on the boundary of a diffusion process
in a domain with Wentzell's boundary conditions.
(8) For additional references to the Malliavin calculus, we would list two
expository articles, Kusuoka, 1990; Watanabe, 1992. In statistical problems,
N. Y o s h i d a , 1992, 1993 gave a p p l i c a t i o n s o f the M a l l i a v i n calculus to a s y m p t o t i c

p r o b l e m s o f statistics in the m o d e l o f small diffusions.
(9) F o r stochastic calculus o n m a n i f o l d s a n d its a p p l i c a t i o n s , the following
b o o k s m a y p r o v i d e useful i n f o r m a t i o n s : M c K e a n , 1969; M a l l i a v i n , 1978;
E l w o r t h y , 1982; I k e d a - W a t a n a b e , 1989; E m e r y , 1989.
(10) To discuss the stochastic flows o f d i f f e o m o r p h i s m s in a full generality, we
need to c o n s i d e r m o r e general S D E ' s t h a n those t r e a t e d in this article: C o n s i d e r
the S D E (76) on a m a n i f o l d M. I f we set A(t)(x) = ~ 1 A k ( x ) w k ( t ) -]- A o ( x ) t , then
t ~ A(t) is a stochastic process t a k i n g values in the space V ( M ) f o r m e d o f all
vector fields on M. It m a y well be called a V ( M ) - v a l u e d W i e n e r process because it
is c o n t i n u o u s u n d e r the n a t u r a l t o p o l o g y on V(M) a n d o f s t a t i o n a r y i n d e p e n d e n t
increments. T h e r e exist, however, m o r e general V ( M ) - v a l u e d W i e n e r processes
t h a n those given in the f o r m o f A(t). The n o t i o n o f S D E ' s can be generalized to
a n y V ( M ) - v a l u e d W i e n e r process a n d we can o b t a i n m o r e general stochastic flows
o f d i f f e o m o r p h i s m s f r o m solutions. Cf. K u n i t a , 1990 on these topics.
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D. N. Shanbhag and C. R. Rao, eds., Handbookof Statistics, Vol.

It6's Stochastic Calculus and Its Applications

1. Semimartingales and stochastic integrals

1.1. General notions on stochastic processes

A filtration is said to satisfy the usual conditions if

Because of the right-continuity of {~-~t}, T is an St-stopping time if and only if

X is called right-continuous (left-continuous), or cfid (resp. cfig), if

X is called continuous if it is both right- and left-continuous. I f X is { f f t } - a d a p t e d

1.2. Martingales and processes of bounded variation

For a martingale X, we always assume that it is cfidlfig; this is no loss of generality

x (t, co) -- x(r(co) A t, co)

M2 = {M = (M(t, co))]M is an{~t}-martingale with

and the space Ma,ioc of locally square-integrable martingales by

M2,~oc = {M = (M(t, co))]3{Tn} : a sequence of {@t}-stopping

1.3. Wiener martingales and Wiener processes

A d-dimensional Wiener process (Brownian motion) X = (X(t)) is, as usual, a

TI~EORE~ 1. Suppose that X = (X(t)) is an Rd-valued, continuous and {Wt}-

1.4. Stochastic integrals

{@t}-predictable processes ~ = ( q ) ( t , co)) and t P = ( T ( t , co)), the following

[Jot+~(u)2d(N)(u)l 1/2 (7)

For a given M E ~/I2,1oc, let

sequence {Tn} of {~t}-stopping times such that

n = 1,2,..., E q~(s)2d(M)(s < oc (8)

E '+~(s)2d(M)(s )l <ooforallt>0 } . (9)

and call it the stochastic integral of (b(u) by M.

The following are the fundamental properties of stochastic integrals:

3) If ~, 7j E 5e2joc(M), then for every e,/? C R, ~b +/~T =

/ (o~b+ fl~P) . dM = c~f q~. dM+ fl / Tt . dM .

4) If M, NEM2,1oc, and ~bESC'2(M) nS~2(N), then for every c~,/~ER,

(f ~'dM,./ ~" dX)(') = f'+~(u)~(u) "dIM,N)(u).

6) If 45 is given in the form

where T is {ft}-stopping time and ~o is a bounded fir-measurable real random

fo ~ ~(~) . da(~) = ~o. (M(t) - M ( t A r ) ) , t _> 0 .

f0 t l[,_<r]-dM(u) = M ( T A t), t>0 .

Furthermore, if ~0 is given in the form

if E ~2(M) and ~g E ~2(N).

1.5. Point processes and Poisson point processes

where the domain Dp o f p is a countable subset of (0, oo). p defines a counting

Np((O,t]x U ) = ~ 1u(p(s)), t>0, UE~z

valued random variable, i.e., p : (2 --+ H3 which is ~-/2(Hz)-measurable. p is

Un C gn+l, U U, ----~ and Np((O, t] Un) < oo

a.s. for e v e r y t > 0 a n d n .

Let p be an {Wt}-adapted, a-finite point process. We say that p possesses the

t~--~ Np([O,t] (Un 718))

/Vp([O, t] B) = Np([O, t] x B) - Np([O, t] x B) .

/Np([0, t] B),Np([0, t] B'))--NA[0, t] (B riB'))

A function IO, oc) S f2 ~ (t, 3, co) ~-+g(t, 3, co) E R is called {~t}-predict-

]f(s,~,co)lNp(ds, d~) < ec a.s., for all t > 0

Vlp= {f(t, ~,co)]f is {fft}-predictable and

E rf0t+j~sz If(s, ~, co)]. Np(ds, d~)] < oo for all t > 0}

{f(t, 4, co)If is {St}-predictable and

E If(s,~,co)12.~ip(ds, d~) < oc for all t > 0

{f(t, 4, co)If is {@t}-predictable and there exists a sequence

{T,} of {~t}-stopping times such that T, ~ oc a.s. and

l[0,r,,](t)' f(t, ~, co) E I~2 for n = 1,2,... } .

Next, let f E Fp1. Then we have

ft+ fzf(s,~,co)~p(ds, d~) = ft+ fzf(s, 4, co)Np(ds,d4)

-.fot+ f=f(s,~,co)Np(ds, d~)

for f E Fp1. If f E Fpa n F 2, then we can see that

[t~-~ fot+ f f(s,~,co)Np(ds, d~)] EM2

i fot+ fzf(s,~,co)~p(ds, d~)) : fo t+f f(s,~,co) 2Np(ds,

E M(t)- fn(s,~,co)Np(ds, d~) ---+0 asn--+c~

for any sequence fn E F 1 n F 2 such that

We define (So+Li(s, 4, co)Np(ds, d~) ) ,>0 by this M. Finally, i f f ~ _p , we can

Itô's Stochastic Calculus and Its Applications

Itô's Stochastic Calculus and Its Applications