4 It

o integral, It
os formula and SDEs

2, if 0 t 1,


1. (a) Let X(t) = 3, if 1 < t 3,
5, if 3 < t 4.

or in oneR formula X(t) = 2I[0,1] (t) + 3I(1,3] (t) 5I(3,4] (t). Give the Ito
integral 04 X(t)dB(t) as a sum of random variables, give its distribution,
specify the mean and the variance.
Solution.
Z 4 Z 1 Z 3 Z 4
X(t)dB(t) = 2dB(t) + 3dB(t) + 5dB(t)
0 0 1 3
= 2(B(1) B(0)) + 3(B(3) B(1)) 5(B(4) B(3)).

This can be seen as the sum of independent Normal random variables:

Z 4
X(t)dB(t) = 2N (0, 1) + 3N (0, 2) 5N (0, 1)
0
= N (0, 22 ) + N (0, 2(32 )) + N (0, (5)2 )
= N (0, 47)
R4
Thus, the Ito integral 0 X(t)dB(t) is Normally distributed with mean 0
and variance 47.

2. Give the values of for which the stochastic integral 01 s dB(s) is defined.
R

In the case when the integral is defined, give its mean and variance.
Solution.
Stochastic integral 01 s dB(s) is defined if and only if 01 s2 ds < (see
R R

Proposition on p. 34), i.e. 2 <R1 or < 1/2. R

In the case when it is defined, 01 E(s2 )ds = 01 s2 ds < , the first two
moments exist (see Chapter 8.7 on pp 34 - 35) and
Z 1 
E s dB(s) = 0,
0
Z 1  Z 1 2 ! Z 1  

V ar s dB(s) = E s dB(s) = E s2 ds
0 0 0
#1
s12
Z 1 "
1
= s2 ds = = .
0 1 2 0
1 2

3. Using Itos formula, find the following stochastic differentials dXt and give
their integral representations.

(a) Xt = eBt
 Solution.
Take f (x) = ex . Then f 0 (x) = f 00 (x) = ex . So we have
1
dXt = d(eBt ) = f 0 (Bt )dBt + f 00 (Bt )dt
2
1
= eBt dBt + eBt dt.
2
Integral representation:
Z t
Bt B0 1 Z t Bs
Bs
e = e + e dBs + e ds
0 2 0
Z t Z t
1
= 1+ eBs dBs + eBs ds.
0 2 0
(b) Xt = sin(Bt )
Solution.
Take f (x) = sin(x). Then f 0 (x) = cos(x) and f 00 (x) = sin(x). So we
have
1
dXt = d(sin(Bt )) = cos(Bt )dBt + ( sin(Bt ))dt
2
1
= cos(Bt )dBt sin(Bt )dt.
2
Integral representation:
Z t
1Z t
sin(Bt ) = sin(B0 ) + cos(Bs )dBs sin(Bs )ds
0 2 0
Z t
1Z t
= cos(Bs )dBs sin(Bs )ds.
0 2 0

(c) Xt = sin(Bt2 )
Solution.
Take f (x) = sin(x2 ). Then f 0 (x) = 2x cos(x2 ) and f 00 (x) = 2 cos(x2 )
4x2 sin(x2 ). So we have
1 
d(sin(Bt2 )) = 2Bt cos(Bt2 )dBt + 2 cos(Bt2 ) 4Bt2 sin(Bt2 ) dt
2 
= 2Bt cos(Bt )dBt + cos(Bt2 ) 2Bt2 sin(Bt2 ) dt.
2

Integral representation:
Z t Z t 
sin(Bt2 ) = sin(B02 ) + 2Bs cos(Bs2 )dBs + cos(Bs2 ) 2Bs2 sin(Bs2 ) ds
0 0
Z t Z t 
= 2 Bs cos(Bs2 )dBs + cos(Bs2 ) 2Bs2 sin(Bs2 ) ds.
0 0
 (d) Xt = t + Bt2 .
Solution.
d(t + Bt2 ) = dt + d(Bt2 ). For d(Bt2 ), take f (x) = x2 . Then f 0 (x) = 2x and
f 00 (x) = 2. So we have
1
d(Bt2 ) = 2Bt dBt + (2)dt
2
= 2Bt dBt + dt.

Hence,

d(t + Bt2 ) = dt + d(Bt2 )

= dt + 2Bt dBt + dt
= 2Bt dBt + 2dt.

Integral representation:
Z t Z t
t+ Bt2 = 0+ B02 +2 Bs dBs + 2 ds
0 0
Z t
= 2 Bs dBs + 2t.
0

Rt
4. Show that 0 Bs dBs , 0 t T , is a martingale

(a) by using its closed form expression

(b) by checking conditions for Ito integral to be a martingale

Solution.
(a) From Question 3(d) (or Example on p.37) we have
Z t
1
Bs dBs = (Bt2 t).
0 2
Let Mt = 12 (Bt2 t). We check the integrability and the martingale property
of Mt . Integrability:
1
E|Mt | = E|Bt2 t|
2
1
(E|Bt2 | + t) by triangular inequality
2
1
= (t + t) = t < .
2
Martingale property: We first compute E (Bt2 |Bu , u s) for s < t,
   
E Bt2 |Bu , u s = E (Bs + (Bt Bs ))2 |Bu , u s
  
= E Bs2 + 2Bs (Bt Bs ) + (Bt Bs )2 |Bu , u s
 
= Bs2 + 2Bs E (Bt Bs |Bu , u s) + E (Bt Bs )2 |Bu , u s
 
= Bs2 + 2Bs E (Bt Bs ) + E (Bt Bs )2 by independence
= Bs2 + 2Bs (0) + (t s) as Bt Bs N (0, t s)
= Bs2 + t s.
Then, for s < t,
1 2
 
E (Mt |Mu , u s) = E (B t)|Bu , u s
2 t
1  2  
= E Bt |Bu , u s t
2
1 2 
= Bs + t s t
2
1 2 
= Bs s = Ms
2
Rt
Thus, 0 Bs dBs = 12 (Bt2 t) is a martingale.
(b) Ito integral 0t Bs dBs , 0 t T is a martingale if
RT
E(Bs2 )ds < (see
R
0
Proposition at top of p. 38). Since we have
#T
s2 T2
Z T Z T "
E(Bs2 )ds = sds = = < ,
0 0 2 0
2
Rt
the Ito integral 0 Bs dBs is a martingale.
5. Show that eBt t/2 is a martingale by using Itos formula for the function ext/2
and properties of Itos integral.
Solution.
Let Xt = Bt and f (x, t) = ext/2 . We use Itos formula for f (Xt , t) (see p. 41):
f f 1 2f
df (Bt , t) = (Bt , t)dBt + (Bt , t)dt + (Bt , t)dt
x t 2 x2
ext/2 2 ext/2 ext/2
Since x
= ext/2 , x2
= ext/2 and t
= 21 ext/2 , we have
1 1
d(eBt t/2 ) = eBt t/2 dBt eBt t/2 dt + eBt t/2 dt = eBt t/2 dBt
2 2
Z t
eBt t/2 = 1 + eBs s/2 dBs
0

Using exponential moment of Normal distribution (Theorem 3 p. 9),

Z T Z T Z T
E(eBt t/2 )2 dt = E(e2Bt t )dt = e2tt dt <
0 0 0
 thus the Ito integral 0t eBs s/2 dBs is a martingale (see proposition at very top
R

of p. 38). Because a martingale plus a constant is still a martingale (see

question 8, section 3 of Exercise Book), eBt t/2 is a martingale.

6. Solve the SDE

dXT = 0.2dt + 0.4Bt , X0 = 0

Give the distribtuion of Xt . Give the probability density function for X1 .

Solution.
The meaning of a stochastic differential is in its integral form,
Z t Z t Z t
dXs = 0.2ds + 0.4dBs
0 0 0
Xt X0 = 0.2(t 0) + 0.4(Bt B0 )
Xt = 0.2t + 0.4Bt
d d
Hence Xt = N (0.2t, 0.16t), so X1 = N (0.2, 0.16) with probability density
function (see p.6)
1 (x0.2)2
fX1 (x) = e 0.32 .
20.4

7. Solve the SDE

dXt = 0.2Xt dt + 0.4Xt dBt , X0 = 1

Give the distribution of Xt . Give the probability density function for X1 .

Solution
This is the Black-Scholes PDE. Itos formula with f (x) = ln(x) gives
1 1
d(ln Xt ) = dXt 2
(dXt )2
Xt 2Xt
1 1
= (0.2Xt dt + 0.4Xt dBt ) 0.16Xt2 dt
Xt 2Xt2
= 0.2dt + 0.4dBt 0.08dt
= 0.12dt + 0.4dBt

With Yt = ln Xt we have in integral form Yt = Y0 + 0.12t + 0.4Bt , so taking

exponential on both sides we have

Xt = exp(Y0 + 0.12t + 0.4Bt )

= X0 exp(0.12t + 0.4Bt )
= exp(0.12t + 0.4Bt )
 d d
This has a lognormal distribution, Xt = LN (0.12t, 0.16t). Hence X1 =
LN (0.12, 0.16) and its probability density function is given by (see p.23)
1 (ln x0.12)2
fX1 (x) = e 0.32
20.4x

8. Solve SDE

dXt = Xt dt + dBt , X0 = 1

Solution
This is the Ornstein-Uhlenbeck process. Use transformation Yt = Xt et and
the product rule (Section 9.5, p. 42)

dYt = et dXt + Xt d(et )

= et (Xt dt + dBt ) + et Xt dt
= et dBt

Hence,
Z t
Yt = Y0 + es dBs
0
Z t
Xt et = 1 + es dBs
0
Z t
Xt = et + et es dBs
0

9. The price of stock is given by St = 10eBt , 0 t 1, t denotes time in years.

(a) Derive the SDE for St .

Solution
Use Itos formula with function f (x) = 10ex , then

dSt = 10eBt dBt + 5eBt dt

1
= St dBt + St dt, S0 = 10
2

(b) Find the mean of St

Solution
St = 10eBt = eln 10+Bt , thus St is lognormally distributed and its mean is

E[St ] = E[10eBt ] = 10E[eBt ] = 10et/2

(c) Find the probability that the stock at the end of the year will outperform
its mean, i.e. find the probability P (S1 > E(S1 )).
Solution

P (S1 > E(S1 )) = P (S1 > 10e1/2 ) = P (10eB1 > 10e1/2 )

= P (eB1 > e1/2 ) = P (B1 > 1/2)
= 1 P (B1 1/2)
= 1 (1/2) = (1/2)

where denotes the CDF of a standard Normal (N (0, 1)).