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Brownian Motion
A standard Brownian motion is a continuous time analogue of the simple random walk.
• There exists a probability distribution over the set of continuous function B:ℝ → ℝ satisfying the
following conditions:
i. 𝐵 0 =0
iii. (Independent Increment) The random variables 𝐵 𝑡𝑖 − 𝐵(𝑠𝑖 ) are mutually independent if the
intervals [𝑠𝑖 , 𝑡𝑖 ] are non overlapping.
• Proposition
𝑎
𝑃 𝑀 𝑡 ≥ 𝑎 = 2. 𝑃 𝐵 𝑡 > 𝑎 = 2 − 2Φ( )
𝑡
𝑖+1 𝑖 2
Theorem (Quadratic variation)- F𝑜𝑟 𝑎𝑙𝑙 𝑇 > 0 lim ∑ 𝐵 𝑇−𝐵 𝑇 =𝑇
𝑛→ 𝑛 𝑛
𝑑𝐵𝑡
• In other words, the differentiation does not exist.
𝑑𝑡
′
𝛥𝐵𝑡 2 (ΔBt )3 ′′′
𝛥𝑓 = 𝛥𝐵𝑡 . 𝑓 𝐵𝑡 + 𝑓 ′′(Bt )+ f′ 𝐵𝑡 + … . .
2 6
2
• Since 𝐵𝑡 is a Brownian motion, we know that 𝐸 Δ𝐵𝑡 = Δ𝑡
1 ′′
𝑑𝑓 𝐵𝑡 = 𝑓′ 𝐵𝑡 𝑑𝐵𝑡 + 𝑓 𝐵𝑡 . 𝑑𝑡
2
This equation known as the Ito’s lemma is the main equation of Ito’s calculus.
𝜕𝑓 𝜕𝑓 1 𝜕2𝑓 2
𝜕𝑓 1 𝜕 2 𝑓 𝜕𝑓
𝑑𝑓 𝑡, 𝐵𝑡 = . 𝑑𝑡 + . 𝑑𝐵𝑡 + 𝑑𝐵𝑡 = + . 𝑑𝑡 + . 𝑑𝐵𝑡
𝜕𝑡 𝜕𝑥 2 𝜕𝑥 2 𝜕𝑡 2 𝜕𝑥 2 𝜕𝑥
• Theorem ( Ito’s lemma)
Let 𝑓 𝑡, 𝑥 be a smooth function of two variables, and let 𝑋𝑡 be a stochastic process satisfying
𝑑𝑋𝑡 = 𝜇𝑡 𝑑𝑡 + 𝜎𝑡 𝑑𝐵𝑡 for a Brownian motion 𝐵𝑡 . Then,
𝜕𝑓 𝜕𝑓 1 2 𝜕 2 𝑓 𝜕𝑓
𝑑𝑓 𝑡, 𝑋𝑡 = + 𝜇𝑡 + 𝜎 2
𝑑𝑡 + 𝑑𝐵𝑡
𝜕𝑡 𝜕𝑥 2 𝜕𝑥 𝜕𝑥
𝐹 𝑡, 𝐵𝑡 = න 𝑓 𝑡, 𝐵𝑡 𝑑𝐵𝑡 + න 𝑔 𝑡, 𝐵𝑡 𝑑𝑡
• Definition – Let 𝑋𝑡 be a stochastic process. A process ∆𝑡 is called an adapted process (with respect
to 𝑋𝑡 ) if for all 𝑡 ≥ 0, the random variable ∆𝑡 depends only on 𝑋𝑠 for 𝑠 ≤ 𝑡.
• Theorem. Let B(t) be a Brownian motion, and let ∆(t) be a nonrandom function of time. Suppose
that a stochastic process I(t) satisfies
𝑑𝐼 = Δ 𝑠 𝑑𝐵𝑠 𝑖. 𝑒. 𝐼 𝑡 = න Δ 𝑠 𝑑𝐵𝑠 ,
𝑡 𝑇
𝐸[(න ∆ 𝑠 𝑑𝐵𝑠 )2 ] = 𝐸[න ∆ 𝑠 2 𝑑𝑠]
0 0
• Let 𝐵𝑡 be a Brownian motion. Then for all adapted processes 𝑔 𝑡, 𝐵𝑡 , the integral
න 𝑔 𝑡, 𝐵𝑡 𝑑𝐵𝑠
𝑡
ඵ 𝑔2 𝑡, 𝐵𝑡 𝑑𝑡𝑑𝐵𝑡 < ∞
0
𝑑𝑋 = 𝜇 𝑡, 𝑋 𝑡 𝑑𝑡 + 𝜎 𝑡, 𝑋 𝑡 𝑑𝐵𝑡
𝑇 𝑇
𝑋 𝑇 = න 𝜇(𝑡, 𝑋 𝑡 )𝑑𝑡 + න 𝜎 𝑡, 𝑋 𝑡 𝑑𝐵𝑡
0 0
• Theorem – (Existence and uniqueness) If the coefficients of the stochastic differential equation
𝑑𝑋 = 𝜇 𝑡, 𝑋 𝑡 𝑑𝑡 + 𝜎 𝑡, 𝑋 𝑡 𝑑𝐵𝑡 , with X 0 = x0 and 0 ≤ 𝑡 ≤ 𝑇, satisfy the following
conditions:
2 2 2
𝜇 𝑡, 𝑥 − 𝜇 𝑡, 𝑦 + 𝜎 𝑡, 𝑥 − 𝜎 𝑡, 𝑦 ≤𝐾 𝑥−𝑦
2 2 2
and 𝜇 𝑡, 𝑥 + 𝜎 𝑡, 𝑥 ≤𝐾 1+ 𝑥 ,