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Itō's lemma
From Wikipedia, the free encyclopedia.

In mathematics, Itō's lemma is a theorem of stochastic calculus that shows that second order differential terms of Wiener
processes become deterministic under stochastic integration. It is somewhat analogous in stochastic calculus to the chain
rule in ordinary calculus. The lemma is widely employed in mathematical finance.

Contents
1 Statement of the lemma
2 Informal proof
3 See also
4 External links

Statement of the lemma

Let x(t) be an Itō (or generalized Wiener) process. That is, let

where Wt is a Wiener process.

If f(x, t) is a function with continuous second derivatives in both x and t, then

This result is often — not quite correctly — shortened to

Informal proof
A formal proof of the lemma requires us to take the limit of a sequence of random variables, which is not handled
carefully here.

Expanding f(x, t) from above in a Taylor series in x and t we have

and substituting (adt + bdW) for dx gives

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Itō's lemma - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/It%C5%8D%27s_lemma

Reordering this to combine like differential terms, we have

where e (an error term) is

In the limit as dt tends to 0, the dt2 and dt dW terms disappear but the dW2 term tends to dt. The latter can be shown if we
prove that

since

The proof of this statistical property is however beyond the scope of this article.

Substituting this dt in and reordering the terms so that the dt and dW terms are collected, we obtain

as required.

The formal proof, which is not included in this article, requires defining the stochastic integral, which is an advanced
concept in between functional analysis and probability theory.

See also
Wiener process
Itō calculus

External links
Derivation (http://www2.sjsu.edu/faculty/watkins/ito.htm) , Prof. Thayer Watkins
Discussion (http://www.quantnotes.com/fundamentals/backgroundmaths/ito.htm) , quantnotes.com
Informal proof (http://www.ftsmodules.com/public/texts/optiontutor/chap6.8.htm) , optiontutor

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Categories: Stochastic processes | Lemmas

This page was last modified 02:08, 4 September 2005.

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