1.

Stochastic Calculus
The standard reference for the Itō calculus is [1]. These notes just give
color and are not a replacement. An excellent introduction to the more
general notion of stochastic integration is [2], but that is not covered here.

1.1. Brownian Motion. If (Xt )t≥0 is a continuous stochastic process that

is stationary and has independent normally distributed increments then
there exist constants µ, σ ∈ R with Xt = µt+σBt , where (Bt )t≥0 is standard
Brownian motion.

Theorem 1.1. (Relection Principle) For any measurable function f and

constant a > 0,

E[f (Bt )1(max Bs > a)] = E[f (Bt )1(Bt > a)] + E[f (2a − Bt )1(Bt > a)]
s≤t

Proof. Define Ta = inf{t > 0 : Bt > a}. The reflection priciple for Brownian
motion states that Bt0 = Bt for t < Ta and Bt0 = 2a − Bt for t > Ta is also a
Brownian motion.

E[f (Bt )1(max Bs > a)]

s≤t
= E[f (Bt )1(max Bs > a, Bt > a)] + E[f (Bt )1(max Bs > a), Bt < a]
s≤t s≤t
= E[f (Bt )1(Bt > a)] + E[f (Bt0 )1(max Bs0 > a), Bt0 < a]
s≤t
= E[f (Bt )1(Bt > a)] + E[f (2a − Bt )1(max Bs0 > a), 2a − Bt < a]
s≤t
= E[f (Bt )1(Bt > a)] + E[f (2a − Bt )1(Bt > a)]

Theorem 1.2. Girsanov If (Bt )t≥0 is Brownian motion under the measure
dQ|
P , then (Bt −θt)t≥0 is Brownian motion under the measure Q where dP |FFt =
t
2 t/2
eθBt −θ .

1.2. Itō Integrals. Let (Bt )t≥0 be standard Brownian motion on Ω =

C[0, ∞), Ft the smallest σ-algebra for which {Bs : s ≤ t} are measur-
able, and P be Wiener measure. For θ : [0, ∞) × Ω → R measurable with
ω 7→ θ(t, ω) Ft measurable (adapted) and t 7→ θ(t, ω) continuous, define
Z t n−1
X
θ(s, ω) dBs (ω) = lim θ(tj , ω)(Btj+1 (ω) − Btj (ω)),
0 ∆t→0
j=0

where the limit is with respect to the net of finite partitions of [0, t] ordered
by inclusion and convergence is in probability. Note the left endpoint is used
when evaluating the integrand.
1
2

1.3. Itō Processes. The solution of the SDE dXt = µ dt + σ dBt , Xt0 = x0
for µ and σ measurable, adapted, and continuous is given by
Z t Z t
Xt (ω) = x0 + µ(s, ω) ds + σ(s, ω) dBs (ω),
t0 t0
where the first integral is a Riemann integral and the second is the Itō
integral. The solution is called an Itō process. The µ term is the drift and
σ is the volatility or dispersion.
1.4. Itō Diffusions. An Itō diffusion is a stochastic process, (Xt )t≥0 that
satisfies a SDE of the form dXt = µ(t, Xt ) dt + σ(t, Xt ) dB where µ and σ
are Lipschitz continuous. More explicitly, if Xt0 = x0 is the initial condition,
then
Z t Z t
Xt (ω) = x0 + µ(s, Xs (ω)) ds + σ(s, Xs (ω)) dBs (ω)
t0 t0
Note µ, σ : [0, ∞) × R → R and if (Xt )t≥0 is adapted then ω → µ(t, Xt (ω))
is Ft measurable.
Oksendal (chapter 7) assumes µ and σ do not depend on t. He works with
multi-dimensional Brownian motion and special cases the time dimension as
a diffusion with drift 1 and dispersion 0.
1.5. Itō’s Lemma. If dX = µ dt + σ dB is an Itō diffusion and f : [0, ∞) ×
R → R has one continuous derivative in the first variable and two continuous
derivatives in the second, then Yt = f (t, Xt ) is also an Itō diffusion and
satisfies the SDE
1
dYt = (ft (t, Xt ) + µfx (t, Xt ) + σ 2 fxx (t, Xt )) dt + σfx (t, Xt ) dBt
2
One can use the Itō calculus to informally derive this. If we let Y =
f (t, X) then dY = ft dt + fx dX + (1/2)fxx (dX)2 = ft dt + fx (µ dt + σ dB) +
(1/2)fxx σ 2 dt = (ft + fx µ + (1/2)fxx σ 2 )dt + fx σ dB.
More explicitly, dY = ν dt+τ dB where ν(t, y) = D1 f (t, y)+µ(t, y)D2 f (t, y)+
(1/2)σ 2 (t, y)D22 f (t, y) and τ (t, y) = σ(t, y)D2 f (t, y), where Dj f denotes the
derivative with respect to the j-th argument of f .
1.6. Generator of a Diffusion. The generator of an Itō diffusion is a linear
operator defined on functions f : R → R by
E x [f (Xt )] − f (x)
Af (x) = lim .
t↓0 t
If f is twice differentiable, it can be shown Af = µf 0 + (1/2)σ 2 f 00
1.7. Dynkin Formula and Kolmogorov Backward Equation. RT If T is
a stopping time, Dynkin’s formula is E x [f (XT )] = f (x) + E x [ 0 Af (Xt ) dt].
A simple consequence of this is the Kolmogorov backward equation. If we
define v(t, x) = E x [f (Xt )] then vt = µvx + (1/2)σ 2 vxx . Note v(0, x) = f (x).
This shows the connection between SDE’s and PDE’s.
 3

2. Remarks
Meyer [?], p. 68, proves the difficult result that every measurable and
adapted stochastic process has a progressively measurable modification. A
much simpler fact is that every adapted stochastic process having right-
continuous (or left-continuous) sample paths is progressively measurable.

3. References
[1] Oksendal, Bernt K. (2007), Stochastic Differential Equations: An In-
troduction with Applications. Berlin: Springer.
[2] Protter, Philip E. (2004), Stochastic Integration and Differential Equa-
tions (2nd ed.) Springer.