9.3 Itô integral and Itô's lemma

The Itô integral is a cornerstone of stochastic calculus, enabling integration with respect to random processes like Brownian motion. It's crucial for modeling phenomena with randomness in finance, physics, and engineering, forming the basis for analyzing stochastic systems.

Itô's lemma extends the chain rule to stochastic processes, allowing us to compute differentials of functions of Itô processes. This powerful tool is essential for deriving pricing formulas in finance and analyzing transformed stochastic processes across various fields.

Definition of Itô integral

• The Itô integral is a key concept in stochastic calculus that allows integration with respect to stochastic processes, particularly Brownian motion
• It forms the foundation for modeling and analyzing various phenomena in fields such as finance, physics, and engineering where randomness plays a significant role

Itô integral vs Riemann integral

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• The Itô integral differs from the Riemann integral in that it is defined for stochastic processes, which have random fluctuations, rather than deterministic functions
• Itô integral takes into account the quadratic variation of the stochastic process, which captures the accumulated variance over time
• Unlike the Riemann integral, the Itô integral is not defined as a limit of Riemann sums but rather through a limiting procedure involving simple stochastic processes

Itô integral for simple processes

• The Itô integral is initially defined for simple processes, which are stochastic processes that can be written as a finite sum of the product of deterministic functions and indicator functions of intervals
• For a simple process $X(t) = \sum_{i=1}^n X_i \mathbf{1}_{(t_i, t_{i+1}]}(t)$ and a Brownian motion $W(t)$, the Itô integral is defined as: $\int_0^T X(t) [dW](https://www.fiveableKeyTerm:dw)(t) = \sum_{i=1}^n X_i (W(t_{i+1}) - W(t_i))$
• This definition ensures that the Itô integral is a martingale and has zero mean

Itô isometry

• The Itô isometry is a fundamental property of the Itô integral that relates the expected value of the square of the integral to the expected value of the integrated process
• For a square-integrable process $X(t)$, the Itô isometry states: $\mathbb{E}\left[\left(\int_0^T X(t) dW(t)\right)^2\right] = \mathbb{E}\left[\int_0^T X(t)^2 [dt](https://www.fiveableKeyTerm:dt)\right]$
• This property is crucial for proving the continuity and extension of the Itô integral to a larger class of processes

Extension to square-integrable processes

• The Itô integral can be extended from simple processes to the class of square-integrable processes, which are stochastic processes satisfying $\mathbb{E}\left[\int_0^T X(t)^2 dt\right] < \infty$
• The extension is done through a limiting procedure, where a sequence of simple processes converges to the desired square-integrable process in the $L^2$ sense
• This extension allows the Itô integral to be applied to a wide range of stochastic processes encountered in applications

Properties of Itô integral

• The Itô integral possesses several important properties that make it a powerful tool in stochastic calculus and its applications
• These properties are essential for deriving key results, such as Itô's lemma and the martingale representation theorem

Linearity

• The Itô integral is linear, meaning that for square-integrable processes $X(t)$ and $Y(t)$ and constants $a$ and $b$: $\int_0^T (aX(t) + bY(t)) dW(t) = a \int_0^T X(t) dW(t) + b \int_0^T Y(t) dW(t)$
• This property allows for the manipulation and simplification of stochastic integrals involving linear combinations of processes

Continuity

• The Itô integral is a continuous function of the integrand in the $L^2$ sense
• If a sequence of square-integrable processes $X_n(t)$ converges to $X(t)$ in $L^2$, i.e., $\mathbb{E}\left[\int_0^T (X_n(t) - X(t))^2 dt\right] \to 0$ as $n \to \infty$, then: $\int_0^T X_n(t) dW(t) \to \int_0^T X(t) dW(t)$ in $L^2$
• This continuity property is crucial for approximating and computing Itô integrals

Martingale property

• The Itô integral of a square-integrable process is a martingale
• For a square-integrable process $X(t)$ adapted to the filtration generated by the Brownian motion, the process $M(t) = \int_0^t X(s) dW(s)$ is a martingale, meaning:
  • $\mathbb{E}[|M(t)|] < \infty$ for all $t \geq 0$
  • $\mathbb{E}[M(t) | \mathcal{F}_s] = M(s)$ for all $s \leq t$, where $\mathcal{F}_s$ is the information available up to time $s$
• The martingale property is fundamental in deriving other important results and in applications such as pricing financial derivatives

Itô processes

• Itô processes are a class of stochastic processes that can be represented as the sum of an integral with respect to time and an Itô integral with respect to Brownian motion
• They form the basis for modeling a wide range of phenomena in various fields, including finance, physics, and engineering

Definition and examples

• An Itô process $X(t)$ is a stochastic process that satisfies the following stochastic differential equation: $dX(t) = \mu(t, X(t)) dt + \sigma(t, X(t)) dW(t)$ where $\mu(t, X(t))$ is the drift coefficient, $\sigma(t, X(t))$ is the diffusion coefficient, and $W(t)$ is a standard Brownian motion
• Examples of Itô processes include:
  • Geometric Brownian motion: $dX(t) = \mu X(t) dt + \sigma X(t) dW(t)$, used to model stock prices
  • Ornstein-Uhlenbeck process: $dX(t) = \theta (\mu - X(t)) dt + \sigma dW(t)$, used to model mean-reverting processes
  • Cox-Ingersoll-Ross (CIR) process: $dX(t) = \theta (\mu - X(t)) dt + \sigma \sqrt{X(t)} dW(t)$, used to model interest rates

Quadratic variation of Itô processes

• The quadratic variation of an Itô process $X(t)$ is a measure of the accumulated variance of the process over time
• For an Itô process $X(t)$ with diffusion coefficient $\sigma(t, X(t))$, the quadratic variation is given by: $[X](t) = \int_0^t \sigma(s, X(s))^2 ds$
• The quadratic variation is a key concept in stochastic calculus and plays a crucial role in Itô's lemma and other important results

Stochastic differential equations

• Stochastic differential equations (SDEs) are differential equations that involve stochastic processes, such as Itô processes
• SDEs are used to model the evolution of systems subject to random fluctuations and are widely applied in various fields
• The general form of an SDE is: $dX(t) = \mu(t, X(t)) dt + \sigma(t, X(t)) dW(t)$ where $\mu(t, X(t))$ is the drift coefficient, $\sigma(t, X(t))$ is the diffusion coefficient, and $W(t)$ is a standard Brownian motion
• Solving SDEs requires techniques from stochastic calculus, such as Itô's lemma and numerical methods adapted for stochastic processes

Itô's lemma

• Itô's lemma is a fundamental result in stochastic calculus that provides a rule for computing the differential of a function of an Itô process
• It is the stochastic counterpart of the deterministic chain rule and is essential for deriving pricing formulas, such as the Black-Scholes equation, and analyzing the dynamics of transformed processes

Statement of Itô's lemma

• Let $X(t)$ be an Itô process satisfying the SDE: $dX(t) = \mu(t, X(t)) dt + \sigma(t, X(t)) dW(t)$
• For a twice continuously differentiable function $f(t, x)$, Itô's lemma states that the process $Y(t) = f(t, X(t))$ is also an Itô process and satisfies the SDE: $dY(t) = \left(\frac{\partial f}{\partial t}(t, X(t)) + \mu(t, X(t)) \frac{\partial f}{\partial x}(t, X(t)) + \frac{1}{2} \sigma(t, X(t))^2 \frac{\partial^2 f}{\partial x^2}(t, X(t))\right) dt + \sigma(t, X(t)) \frac{\partial f}{\partial x}(t, X(t)) dW(t)$

Itô's lemma for functions of time and Itô processes

• Itô's lemma can be applied to functions that depend on both time and an Itô process
• For a function $f(t, x)$ and an Itô process $X(t)$, Itô's lemma provides the SDE for the transformed process $Y(t) = f(t, X(t))$
• The resulting SDE includes terms involving the partial derivatives of $f$ with respect to time and the Itô process, as well as the quadratic variation of the process

Comparison with deterministic chain rule

• Itô's lemma differs from the deterministic chain rule due to the presence of the quadratic variation term
• In the deterministic case, the chain rule for a function $f(t, x)$ and a differentiable function $x(t)$ states: $\frac{df}{dt}(t, x(t)) = \frac{\partial f}{\partial t}(t, x(t)) + \frac{dx}{dt}(t) \frac{\partial f}{\partial x}(t, x(t))$
• Itô's lemma includes an additional term involving the second partial derivative of $f$ with respect to $x$ and the quadratic variation of the Itô process, which accounts for the stochastic nature of the process

Applications of Itô's lemma

• Itô's lemma has numerous applications in various fields, particularly in financial mathematics and physics
• In finance, Itô's lemma is used to derive pricing formulas for options and other derivatives, such as the Black-Scholes equation
• In physics, Itô's lemma is applied to study the dynamics of stochastic systems, such as particle motion in fluid dynamics and the evolution of quantum systems subject to noise
• Other applications include signal processing, control theory, and stochastic optimization

Stochastic calculus

• Stochastic calculus is a branch of mathematics that extends the concepts of calculus to stochastic processes, such as Brownian motion and Itô processes
• It provides a framework for analyzing and modeling systems subject to random fluctuations and has applications in various fields, including finance, physics, engineering, and biology

Stochastic integration by parts

• Stochastic integration by parts is a formula that relates the product of two Itô processes to their individual Itô integrals and quadratic covariation
• For two Itô processes $X(t)$ and $Y(t)$, the stochastic integration by parts formula states: $X(t)Y(t) = X(0)Y(0) + \int_0^t X(s) dY(s) + \int_0^t Y(s) dX(s) + [X, Y](t)$ where $[X, Y](t)$ is the quadratic covariation of $X(t)$ and $Y(t)$, defined as: $[X, Y](t) = \lim_{\Delta t_i \to 0} \sum_i (X(t_{i+1}) - X(t_i))(Y(t_{i+1}) - Y(t_i))$
• Stochastic integration by parts is a useful tool for deriving other important results in stochastic calculus, such as the Itô product rule and Itô's lemma for multiple processes

Integration with respect to martingales

• In addition to integration with respect to Brownian motion, stochastic calculus also considers integration with respect to other types of processes, such as martingales
• A martingale is a stochastic process $M(t)$ that satisfies:
  • $\mathbb{E}[|M(t)|] < \infty$ for all $t \geq 0$
  • $\mathbb{E}[M(t) | \mathcal{F}_s] = M(s)$ for all $s \leq t$, where $\mathcal{F}_s$ is the information available up to time $s$
• Integration with respect to martingales shares many properties with Itô integration, such as linearity and the martingale property of the integral
• Martingale representation theorems, such as the Brownian martingale representation theorem, play a crucial role in stochastic calculus and its applications

Girsanov's theorem

• Girsanov's theorem is a fundamental result in stochastic calculus that allows for the change of probability measure for Itô processes
• It states that, under certain conditions, an Itô process can be transformed into a martingale under a new probability measure, called the equivalent martingale measure
• The change of measure is achieved by multiplying the original probability measure by a specific martingale, known as the Radon-Nikodym derivative
• Girsanov's theorem has important applications in finance, particularly in the pricing of derivatives and risk-neutral valuation, where the change of measure is used to simplify calculations and derive pricing formulas

Applications of Itô calculus

• Itô calculus has numerous applications in various fields, where stochastic processes are used to model and analyze systems subject to random fluctuations
• The tools and techniques of Itô calculus, such as Itô's lemma and stochastic differential equations, are essential for deriving key results and solving practical problems in these areas

Financial mathematics and Black-Scholes model

• In financial mathematics, Itô calculus is the foundation for the development of option pricing models, such as the Black-Scholes model
• The Black-Scholes model assumes that the price of the underlying asset follows a geometric Brownian motion, which is an Itô process
• Using Itô's lemma, the Black-Scholes partial differential equation for the option price is derived, which can be solved to obtain the famous Black-Scholes formula for European call and put options
• Itô calculus is also used to model and analyze other financial instruments, such as bonds, interest rates, and credit derivatives

Stochastic differential equations in physics

• Stochastic differential equations (SDEs) are widely used in physics to model systems subject to random fluctuations, such as Brownian motion of particles, diffusion processes, and quantum systems
• Itô calculus provides the tools for solving and analyzing these SDEs, allowing for the study of the dynamics and properties of the stochastic systems
• Examples of SDEs in physics include the Langevin equation for particle motion, the Fokker-Planck equation for the probability density of a stochastic process, and the stochastic Schrödinger equation for quantum systems subject to noise

Filtering theory and stochastic control

• Filtering theory is concerned with estimating the state of a stochastic system based on noisy observations
• Itô calculus is used to derive filtering equations, such as the Kalman filter for linear systems and the Kushner-Stratonovich equation for nonlinear systems, which provide optimal estimates of the system state
• Stochastic control theory deals with the problem of finding optimal control strategies for stochastic systems, where the objective is to minimize a cost function or maximize a performance measure
• Itô calculus is employed to formulate and solve stochastic control problems, leading to the development of techniques such as the Hamilton-Jacobi-Bellman equation and the maximum principle for stochastic systems
• Applications of filtering and stochastic control include navigation systems, robotics, finance, and resource management