An Informal Derivation of Ito’s Lemma

Matt Krems
August 11, 2008

1 Ito’s Equation
We start out by looking at an equation for the time derivative of a stochastic variable X(t). The form we
will look at is
Ẋ(t) = µ + σl(t) (1)
where µ and σ are constants and l(t) is a fluctuating term with the following properties:
hl(t)i = 0 (2)
hl(t)l(t0 )i = δ(t − t0 ) (3)
These two properties mean the fluctuating term is “white noise”, i.e. zero ensemble average and δ-autocorrelation.
We can now look at the value of the stochastic variable, X(t), at a slightly later time, t + , such that
X(t + ) = X(t) + ∆X(t) where
Z t+ Z t+ Z t+
0 0
∆X(t) = dt Ẋ(t) = dt [µ + σl(t)] = µ + σ dt0 l(t0 ) (4)
t t t
Consider now a Taylor expansion of an arbitrary function, f (X(t)):
1 00 1
f (X(t+)) = f (X(t)+∆X(t)) = f (X(t))+f 0 (X(t))∆X(t)+ f (X(t))[∆X(t)]2 + f 000 [∆X(t)]3 +. . . (5)
2! 3!
The linear term, ∆X(t), has the average
Z t+
h∆X(t)i = hµi + σ dt0 hl(t0 )i ≈ µ
t

where I use Eq.(2) and only keep terms of order  or smaller. The average of the quadratic term, h[∆X(t)]2 i
is
Z t+ Z t+
h[∆X(t)]2 i = dt1 dt2 h[µ + σl(t1 )][µ + σl(t2 )]i
t t
2 2 2
≈  µ + σ hl(t1 )l(t2 )i
Now the second term is of order  due to the δ-function correlation. Thus we find that:
h[∆X(t)]2 i = σ 2 + h.o.t
The average of the cubic term gives higher order terms (h.o.t.) than  and so on. Thus we find that in the
limit  → 0:
1
hf˙(X(t))i = hf 0 (X(t))ihẊ(t)i + hf 00 (X(t))i (6)
2
In fact, as it turns out, this is not just true for the average, but for the derivative f˙(X(t)) itself1 , i.e. f (X(t))
obeys the stochastic differential equation
1
f˙(X(t)) = f 0 (X(t))Ẋ(t) + f 00 (X(t)) (7)
2
We note that if X(t) was a deterministic variable, then the extra term 12 f 00 (X(t)) would not be here. This
is a fundamental result and the primary difference of the Ito calculus.
1 see Section 18.13.3 of “Path Integrals in Quantum Mechanics, Statistics, Polymer Physics, and Financial Markets” by H.

Kleinert

1
2 Ito’s Equation in Differential Form
We can write Eq.(1) in differential form:

dX(t) = µdt + σl(t)dt (8)

and define
l(t)dt ≡ dW (t) (9)
where W (t) is a Wiener process corresponding to Brownian motion, which has the appropiate properties2 .
We arrive at
dX(t) = µdt + σdW (t). (10)
Now we can look at f (X(t)) which can be written as f (t, W ) due to Eq.(11). We can do a multi-variable
Taylor expansion in the increment df = f (t) − f (t0 ) 3 where dt = t − t0 and keeps terms up to order dt:

∂f ∂f 1 ∂2f
dt +
df (t, W ) = dW + dW dW + . . . (11)
∂t ∂W 2 ∂W ∂W
√ 4
We can infer from the previous analysis that dW ∝ dt such that dW dW is of order dt and we get

1 ∂2f
 
∂f ∂f
df (t, W ) = + dt + dW (12)
∂t 2 ∂W ∂W ∂W

2 Thisis an intentionally vague comment as I need to figure out exactly why Brownian motion is relevant here.
3 SinceW is also a function of t, we can write the function f solely as a function of t.
4 There is indeed a hint of this but I need to see a more formal proof of this feature.