Chapter 4

Brownian Motion and Stochastic Calculus

Brownian motion is a continuous-time stochastic process having stationary

and independent Gaussian distributed increments, and continuous paths.
This chapter presents the constructions of Brownian motion and its asso-
ciated Itô stochastic integral, which will be used for the random modeling of
asset and portfolio prices in continuous time.

4.1 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

4.2 Three Constructions of Brownian Motion . . . . . . . . 145
4.3 Wiener Stochastic Integral . . . . . . . . . . . . . . . . . . . . . . 150
4.4 Itô Stochastic Integral . . . . . . . . . . . . . . . . . . . . . . . . . . 159
4.5 Stochastic Calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

4.1 Brownian Motion

We start by recalling the definition of Brownian motion, which is a funda-

mental example of a stochastic process. The underlying probability space
(Ω, F, P) of Brownian motion can be constructed on the space Ω = C0 (R+ )
of continuous real-valued functions on R+ started at 0.

Definition 4.1. The standard Brownian motion is a stochastic process

(Bt )t∈R+ such that

1. B0 = 0,

2. The sample trajectories t 7→ Bt are continuous, with probability one.

3. For any finite sequence of times t0 < t1 < · · · < tn , the increments

Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btn − Btn−1

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 N. Privault

are mutually independent random variables.

4. For any given times 0 ⩽ s < t, Bt − Bs has the Gaussian distribution

N (0, t − s) with mean zero and variance t − s.
In particular, for t ∈ R+ , the random variable Bt ≃ N (0, t) has a Gaussian
distribution with mean zero and variance t > 0. Existence of a stochastic pro-
cess satisfying the conditions of Definition 4.1 will be covered in Section 4.2.
In Figure 4.1 we draw three sample paths of a standard Brownian motion
obtained by computer simulation using (4.3). Note that there is no point
in “computing” the value of Bt as it is a random variable for all t > 0.
However, we can generate samples of Bt , which are distributed according to
the centered Gaussian distribution with variance t > 0 as in Figure 4.1.

Bt3
Bt2

Bt1
0 t1 t2 t3

-1
0 0.2 0.4 0.6 0.8 1

Fig. 4.1: Sample paths of a one-dimensional Brownian motion.

In particular, Property 4 in Definition 4.1 implies

E[Bt − Bs ] = 0 and Var[Bt − Bs ] = t − s, 0 ⩽ s ⩽ t,

and we have

Cov(Bs , Bt ) = E[Bs Bt ]
= E[Bs (Bt − Bs + Bs )]
= E Bs ( Bt − Bs ) + ( Bs ) 2
 

= E[Bs (Bt − Bs )] + E (Bs )2

 

= E[Bs ]E[Bt − Bs ] + E (Bs )2

 

= Var[Bs ]
= s, 0 ⩽ s ⩽ t,

hence
Cov(Bs , Bt ) = E[Bs Bt ] = min(s, t), s, t ⩾ 0, (4.1)
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 Notes on Stochastic Finance

cf. also Exercise 4.2-(4.1). The following graphs present two examples of
possible modeling of random data using Brownian motion.

Fig. 4.2: Evolution of the fortune of a poker player vs number of games played.

Fig. 4.3: Web traffic ranking.

In what follows, we denote by (Ft )t∈R+ the filtration generated by the Brow-
nian paths up to time t, defined as

F t : = σ ( Bs : 0 ⩽ s ⩽ t ) , t ⩾ 0. (4.2)

Property 3 in Definition 4.1 shows that Bt − Bs is independent of all Brownian

increments taken before time s, i.e.

⊥ (Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btn − Btn−1 ),

( Bt − Bs ) ⊥

0 ⩽ t0 ⩽ t1 ⩽ · · · ⩽ tn ⩽ s ⩽ t, hence Bt − Bs is also independent of the

whole Brownian history up to time s, hence Bt − Bs is in fact independent
of Fs , s ⩾ 0.
Definition 4.2. A continuous-time process (Zt )t∈R+ of integrable random
variables is a martingale under P and with respect to the filtration (Ft )t∈R+
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if
E[Zt | Fs ] = Zs , 0 ⩽ s ⩽ t.
Note that when (Zt )t∈R+ is a martingale, Zt is in particular Ft -measurable
at all times t ⩾ 0. As in Example 2 on page 2, we have the following result.
Proposition 4.3. Brownian motion (Bt )t∈R+ is a continuous-time martin-
gale.
Proof. We have

E[Bt | Fs ] = E[Bt − Bs + Bs | Fs ]
= E[Bt − Bs | Fs ] + E[Bs | Fs ]
= E [ Bt − Bs ] + Bs
= Bs , 0 ⩽ s ⩽ t,

because it has centered and independent increments, cf. Section 7.1. □

The n-dimensional Brownian motion can be constructed as (Bt1 , Bt2 , . . . , Btn )t∈R+
where (Bt1 )t∈R+ , (Bt2 )t∈R+ , . . .,(Btn )t∈R+ are independent copies of (Bt )t∈R+ .
Next, we turn to simulations of 2 dimensional and 3 dimensional Brownian
motions in Figures 4.4 and 4.5. Recall that the movement of pollen particles
originally observed by Brown (1828) was indeed 2-dimensional.
2

1.5

0.5

-0.5

-1

-1.5

-2
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5

Fig. 4.4: Two sample paths of a two-dimensional Brownian motion.

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 Notes on Stochastic Finance

-1

-2
-1
0
1 2
1
0
2 -1
-2

Fig. 4.5: Sample path of a three-dimensional Brownian motion.

Figure 4.6 presents an illustration of the scaling property of Brownian motion.

Fig. 4.6: Scaling property of Brownian motion.∗

4.2 Three Constructions of Brownian Motion

We refer the reader to Chapter 1 of Revuz and Yor (1994) and to Theo-
rem 10.28 in Folland (1999) for proofs of existence of Brownian motion as a
stochastic process (Bt )t∈R+ satisfying the Conditions 1-4 of Definition 4.1.

Brownian motion as a random walk

For convenience, we will informally regard Brownian motion as a random

walk over infinitesimal time intervals of length ∆t, whose increments
∗
The animation works in Acrobat Reader on the entire pdf file.

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∆Bt := Bt+∆t − Bt ≃ N (0, ∆t)

over the time interval [t, t + ∆t] will be approximated by the Bernoulli random
variable √
∆Bt = ± ∆t (4.3)
with equal probabilities (1/2, 1/2). According to this representation, the
paths of Brownian motion are not differentiable, although they are continuous
by Property 2, as we have
√
dBt ± dt 1
≃ = ± √ ≃ ±∞. (4.4)
dt dt dt
Figure 4.7 presents a simulation of Brownian motion as a random walk with
∆t = 0.1.
3

2.5

1.5
Bt
1

0.5

-0.5

-1
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
t

Fig. 4.7: Construction of Brownian motion as a random walk with B0 = 1.∗

Note that we have

1√ 1√
E[∆Bt ] = ∆t − ∆t = 0,
2 2
and
1 √ 1 √ 1 1
Var[∆Bt ] = E (∆Bt )2 = (+ ∆t)2 + (− ∆t)2 = ∆t + ∆t = ∆t.
 
2 2 2 2
In order to recover the Gaussian distribution property of the random variable
BT , we can split the time interval [0, T ] into N subintervals

k−1
 
k
T, T , k = 1, 2, . . . , N ,
N N
∗
The animation works in Acrobat Reader on the entire pdf file.

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 Notes on Stochastic Finance

of same length ∆t = T /N , with N “large”.

0 T 2T T
N N

Defining the Bernoulli random variable Xk as

√
Xk := ± T

with equal probabilities (1/2, 1/2), we have Var(Xk ) = T and

X √
∆Bt := √ k = ± ∆t
N
is the increment of Bt over ((k − 1)∆t, k∆t], and we get
X X1 + X2 + · · · + XN
BT ≃ ∆Bt ≃ √ .
0<t<T
N

Hence by the central limit theorem we recover the fact that BT has the cen-
tered Gaussian distribution N (0, T ) with variance T , cf. point 4 of the above
Definition 4.1 of Brownian motion, and the illustration given in Figure 4.8.
Indeed, the central limit theorem states that given any sequence (Xk )k⩾1 of
independent identically distributed centered random variables with variance
σ 2 = Var[Xk ] = T , the normalized sum

X1 + X2 + · · · + XN
√
N

converges (in distribution) to the centered Gaussian random variable N (0, σ 2 )

with variance σ 2 as N goes to infinity. As a consequence, ∆Bt could in fact
be replaced by any centered random variable with variance ∆t in the above
description.
N=1000; t <- 0:N; dt <- 1.0/N; dev.new(width=16,height=7); # Using Bernoulli samples
nsim=100;X <- matrix((dt)^0.5*(rbinom( nsim * N, 1, 0.5)-0.5)*2, nsim, N)
X <- cbind(rep(0, nsim), t(apply(X, 1, cumsum))); H<-hist(X[,N],plot=FALSE);
layout(matrix(c(1,2), nrow =1, byrow = TRUE));par(mar=c(2,2,2,0), oma = c(2, 2, 2, 2))
plot(t*dt, X[1, ], xlab = "", ylab = "", type = "l", ylim = c(-2, 2), col = 0,xaxs='i',las=1,
cex.axis=1.6)
for (i in 1:nsim){lines(t*dt, X[i, ], type = "l", ylim = c(-2, 2), col = i)}
lines(t*dt,sqrt(t*dt),lty=1,col="red",lwd=3);lines(t*dt,-sqrt(t*dt), lty=1, col="red",lwd=3)
lines(t*dt,0*t, lty=1, col="black",lwd=2)
for (i in 1:nsim){points(0.999, X[i,N], pch=1, lwd = 5, col = i)}
x <- seq(-2,2, length=100); px <- dnorm(x);par(mar = c(2,2,2,2))
plot(NULL , xlab="", ylab="", xlim = c(0, max(px,H$density)), ylim = c(-2,2),axes=F)
rect(0, H$breaks[1:(length(H$breaks) - 1)], col=rainbow(20,start=0.08,end=0.6), H$density,
H$breaks[2:length(H$breaks)]); lines(px,x, lty=1, col="black",lwd=2)

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−1

−2
0.0 0.2 0.4 0.6 0.8 1.0

Fig. 4.8: Statistics of one-dimensional Brownian paths vs Gaussian distribution.

Remark 4.4. The choice of the square root in (4.3) is in fact not fortuitous.
Indeed, any choice of ±(∆t)α with a power α > 1/2 would lead to explosion
of the process as dt tends to zero, whereas a power α ∈ (0, 1/2) would lead
to a vanishing process, as can be checked from the following code.
The following code plots the yearly returns of the S&P 500 index from
1950 to 2022, see Figure 4.9, together with their histogram.

library(quantmod); getSymbols("^GSPC",from="1950-01-01",to="2022-12-31",src="yahoo")
stock<-Cl(`GSPC`); s=0;y=0;j=0;count=0;N=250;nsim=72; X = matrix(0, nsim, N)
for (i in 1:nrow(GSPC)){if (s==0 && grepl('-01-0',index(stock[i]))) {if (count==0 ||
X[y,N]>0) {y=y+1;j=1;s=1;count=count+1;}}
if (j<=N) {X[y,j]=as.numeric(stock[i]);};if (grepl('-02-0',index(stock[i]))) {s=0;};j=j+1;}
t <- 0:(N-1); dt <- 1.0/N;dev.new(width=16,height=7);
layout(matrix(c(1,2), nrow =1, byrow = TRUE));par(mar=c(2,2,2,0), oma = c(2, 2, 2, 2))
plot(t*dt, X[1,]/X[1,1]-1, xlab = "", ylab = "", type = "l", ylim = c(-0.5, 0.5), col = 0,
xaxs='i',las=1, cex.axis=1.6)
for (i in 1:nsim){lines(t*dt, X[i,]/X[i,1]-1, type = "l", col = i)}
m=mean(X[,N-10]/X[,1]-1);sigma=sd(X[,N-10]/X[,1]-1)
lines(t*dt,sigma*sqrt(t*dt),lty=1,col="red",lwd=3);lines(t*dt,-sigma*sqrt(t*dt), lty=1,
col="red",lwd=3)
lines(t*dt,0*t, lty=1, col="black",lwd=2)
for (i in 1:nsim){points(0.999, X[i,N]/X[i,1]-1, pch=1, lwd = 5, col = i)}
x <- seq(-2,2, length=100); px <- dnorm(x,m,sigma);par(mar = c(2,2,2,2))
H<-hist(X[,N-10]/X[,1]-1,plot=FALSE);
plot(NULL , xlab="", ylab="", xlim = c(0, max(px,H$density)), ylim = c(-2,2),axes=F)
rect(0, H$breaks[1:(length(H$breaks) - 1)], col=rainbow(20,start=0.08,end=0.6), H$density,
H$breaks[2:length(H$breaks)]); lines(px,x, lty=1, col="black",lwd=2)

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 Notes on Stochastic Finance

0.4

0.2

0.0

−0.2

−0.4

0.0 0.2 0.4 0.6 0.8

Fig. 4.9: Statistics of S&P 500 yearly returns from 1950 to 2022.

Lévy’s construction of Brownian motion

Figure 4.10 represents the construction of Brownian motion by successive

linear interpolations, see Problem 4.20 for a proof of existence of Brownian
motion based on this construction.
0.4

0.2

0.0

−0.2

−0.4

−0.6

0.0 0.2 0.4 0.6 0.8 1.0

Fig. 4.10: Lévy’s construction of Brownian motion.∗

The following code is used to generate Figure 4.10.†

∗
The animation works in Acrobat Reader on the entire pdf file.
†
Download the corresponding code or the IPython notebook that can be run
here.

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dev.new(width=16,height=7); alpha=1/2;t <- 0:1;dt <- 1; z=rnorm(1,mean=0,sd=dt^alpha)

plot(t*dt,c(0,z),xlab = "t",ylab = "",col = "blue",main = "",type = "l", xaxs="i", las = 1)
k=0;while (k<12) {readline("Press <return> to continue")
k=k+1;m <- (z+c(0,head(z,-1)))/2;y <- rnorm(length(t)-1,mean=0,sd=(dt/4)^alpha)
x <- m+y;x <- c(matrix(c(x,z), 2, byrow = T));n=2*length(t)-2;t <- 0:n
plot(t*dt/2, c(0, x), xlab = "t", ylab = "", col = "blue", main = "", type = "l", xaxs="i", las
= 1);z=x;dt=dt/2}

Construction by series expansions

Brownian motion on [0, T ] can also be constructed by Fourier synthesis via

the Paley-Wiener series expansion
√
X 2T X sin((n − 1/2)πt/T )
Bt = Xn fn (t) = Xn , 0 ⩽ t ⩽ T,
π n − 1/2
n⩾1 n⩾1

where (Xn )n⩾1 is a sequence of independent N (0, 1) standard Gaussian ran-

dom variables, as illustrated in Figure 4.11.∗
2

2
n=35
4

10

0 200 400 600 800

Fig. 4.11: Construction of Brownian motion by series expansions.†

4.3 Wiener Stochastic Integral

In this section, we construct the Wiener stochastic integral of square-
integrable deterministic functions of time with respect to Brownian motion.
Recall that the price St of risky assets was originally modeled in Bachelier
(1900) as St := σBt , where σ is a volatility parameter. The stochastic integral

∗
Download the corresponding IPython notebook that can be run here.
†
The animation works in Acrobat Reader on the entire pdf file.

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 Notes on Stochastic Finance

wT wT
f (t)dSt = σ f (t)dBt
0 0
can be used to represent the value of a portfolio as a sum of profits and
losses f (t)dSt where dSt represents the stock price variation and f (t) is the
quantity invested in the asset St over the short time interval [t, t + dt].
A naive definition of the stochastic integral with respect to Brownian mo-
tion would consist in letting
wT wT dBt
f (t)dBt := f (t) dt,
0 0 dt
and evaluating the above integral with respect to dt. However, this definition
fails because the paths of Brownian motion are not differentiable, cf. (4.4).
Next we present Itô’s construction of the stochastic integral with respect to
Brownian motion. Stochastic integrals will be first constructed as integrals
of simple step functions of the form
n
ai 1(ti−1 ,ti ] (t),
X
f (t) = 0 ⩽ t ⩽ T, (4.5)
i=1

i.e. the function f takes the value ai on the interval (ti−1 , ti ], i = 1, 2, . . . , n,

with 0 ⩽ t0 < · · · < tn ⩽ T , as illustrated in Figure 4.12.

f (t)
a2
a1
a4

t0 t1 t2 t3 t4 t

Fig. 4.12: Step function t 7→ f (t).

ti<-c(0,2,4.5,7,9)
ai<-c(0,3,1,2,1,0)
plot(stepfun(ti,ai),xlim = c(0,10),do.points = F,main="", col = "blue")

Recall that the classical integral of f given in (4.5) is interpreted as the area
under the curve f , and computed as
wT n
X
f (t)dt = ai (ti − ti−1 ).
0
i=1

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 N. Privault

f (t)
6
a2 b r
b r b r
a1
a4 b r
-
t0 t1 t2 t3 t4 t

Fig. 4.13: Area under the step function t 7→ f (t).

In the next Definition 4.5 we use such step functions for the construction
of the stochastic integral with respect to Brownian motion. The stochastic
integral (4.6) for step functions will be interpreted as the sum of profits and
losses ai (Bti − Bti−1 ), i = 1, 2, . . . , n, in a portfolio holding a quantity ai of
a risky asset whose price variation is Bti − Bti−1 at time i = 1, 2, . . . , n.
Definition 4.5. The stochastic integral with respect to Brownian motion
(Bt )t∈[0,T ] of the simple step function f of the form (4.5) is defined by

wT n
X
f (t)dBt := ai (Bti − Bti−1 ). (4.6)
0
i=1

In what follows, we will make a repeated use of the space L2 ([0, T ]) of square-
integrable functions.
Definition 4.6. Let L2 ([0, T ]) denote the space of (measurable) functions
f : [0, T ] −→ R such that
wT
r
∥f ∥L2 ([0,T ]) := |f (t)|2 dt < ∞, f ∈ L2 ([0, T ]). (4.7)
0

In the above definition, ∥f ∥L2 ([0,T ]) represents the norm of the function f ∈
L2 ([0, T ]).
For example, the function f (t) := tα , t ∈ (0, T ], belongs to L2 ([0, T ]) if
and only if α > −1/2, as we have

+∞ if α ⩽ −1/2,

wT wT



f 2 (t)dt = t2α dt =  1+2α t=T
0 0 t T 1+2α
= < ∞ if α > −1/2,


1 + 2α t=0 1 + 2α


see Figure 4.14 for an illustration.

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 Notes on Stochastic Finance

20 20

15 15

10 10

5 5

0 0
0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0

(a) Infinite area, α = −1 < −1/2. (b) Finite area, α = −1/4 > −1/2.

Fig. 4.14: Infinite vs finite area under the curve t 7→ t2α .

wT
In the next Lemma 4.7 we determine the probability distribution of f (t)dBt
0
and we show that it is independent of the particular representation (4.5) cho-
sen for f (t).
Lemma 4.7. Let f be a simple step function f of the form (4.5). The stochas-
wT
tic integral f (t)dBt defined in (4.6) has the centered Gaussian distribution
0
wT  wT 
f (t)dBt ≃ N 0, |f (t)|2 dt
0 0
hw T i
with mean E f (t)dBt = 0 and variance given by the Itô isometry
0
hw T i h w T 2 i w T
Var f (t)dBt = E f (t)dBt = |f (t)|2 dt. (4.8)
0 0 0
Proof. Recall that if X1 , X2 , . . . , Xn are independent Gaussian random vari-
ables with probability distributions N (m1 , σ12 ),. . .,N (mn , σn2 ), then the sum
X1 + · · · + Xn is a Gaussian random variable with distribution

N m1 + · · · + mn , σ12 + · · · + σn2 .

As a consequence, the stochastic integral

wT n
X
f (t)dBt = ak (Btk − Btk−1 )
0
k =1

of the step function

n
ak 1(tk−1 ,tk ] (t),
X
f (t) = 0 ⩽ t ⩽ T,
k =1

has the centered Gaussian distribution with mean 0 and variance

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hw T
" n #
i X
Var f (t)dBt = Var ak (Btk − Btk−1 )
0
k =1
n
X
= Var[ak (Btk − Btk−1 )]
k =1
X n
= |ak |2 Var[Btk − Btk−1 ]
k =1
X n
= (tk − tk−1 )|ak |2
k =1
X n w tk
= |ak |2 dt
tk−1
k =1
n wT
1(tk−1 ,tk ] (t)dt
X
= |ak |2
0
k =1
wT X
n
= |ak |2 1(tk−1 ,tk ] (t)dt
0
k =1
wT
= |f (t)|2 dt,
0

since the simple function

n
a2i 1(ti−1 ,ti ] (t),
X
f 2 (t) = 0 ⩽ t ⩽ T,
i=1

takes the value a2i on the interval (ti−1 , ti ], i = 1, 2, . . . , n, as can be checked

from the following Figure 4.15.

f2
6
a22 b r
b r b r
a21
a24 b r
-
t0 t1 t2 t3 t4 t

Fig. 4.15: Squared step function t 7→ f 2 (t).

□
The norm ∥ · ∥L2 ([0,T ]) on L2 ([0, T ])
induces a distance between any two
functions f and g in L2 ([0, T ]), defined as

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 Notes on Stochastic Finance

wT
r
∥f − g∥L2 ([0,T ]) := |f (t) − g (t)|2 dt < ∞,
0

cf. e.g. Chapter 3 of Rudin (1974) for details.

Definition 4.8. Convergence in L2 ([0, T ]). We say that a sequence (fn )n∈N
of functions in L2 ([0, T ]) converges in L2 ([0, T ]) to another function f ∈
L2 ([0, T ]) if
wT
r
lim ∥f − fn ∥L2 ([0,T ]) = lim |f (t) − fn (t)|2 dt = 0.
n→∞ n→∞ 0

dev.new(width=16,height=7)
f = function(x){exp(sin(x*1.8*pi))}
for (i in 3:9){n=2^i;x<-cumsum(c(0,rep(1,n)))/n;
z<-c(NA,head(x,-1))
y<-c(f(x)-pmax(f(x)-f(z),0),f(1))
t=seq(0,1,0.01);
plot(f,from=0,to=1,ylim=c(0.3,2.9),type="l",lwd=3,col="red",main="",xaxs="i",yaxs="i",
las=1)
lines(stepfun(x,y),do.points=F,lwd=2,col="blue",main="");
readline("Press <return> to continue");}

2.5

2.0
f

1.5

1.0

0.5

0.0 0.2 0.4 0.6 0.8 1.0

Fig. 4.16: Step function approximation.∗

By e.g. Theorem 3.13 in Rudin (1974) or Proposition 2.4 page 63 of Hirsch

and Lacombe (1999), we have the following result which states that the set
of simple step functions f of the form (4.5) is a linear space which is dense
in L2 ([0, T ]) for the norm (4.7), as stated in the next proposition.
Proposition 4.9. For any function f ∈ L2 ([0, T ]) satisfying (4.7) there ex-
ists a sequence (fn )n∈N of simple step functions of the form (4.5), converging
to f in L2 ([0, T ]) in the sense that

∗
The animation works in Acrobat Reader on the entire pdf file.
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 N. Privault

wT
r
lim ∥f − fn ∥L2 ([0,T ]) = lim |f (t) − fn (t)|2 dt = 0.
n→∞ n→∞ 0
wT
In order to extend the definition (4.6) of the stochastic integral f (t)dBt
0
to any function f ∈ L2 ([0, T ]), i.e. to f : [0, T ] −→ R measurable such that
wT
|f (t)|2 dt < ∞, (4.9)
0

we will make use of the space L2 (Ω) of square-integrable random variables.

Definition 4.10. Let L2 (Ω) denote the space of random variables F : Ω −→
R such that q  
∥F ∥L2 (Ω) := E F 2 < ∞.

The norm ∥ · ∥L2 (Ω) on L2 (Ω) induces the distance

q 
E (F − G)2 < ∞,

∥F − G∥L2 (Ω) :=

between the square-integrable random variables F and G in L2 (Ω).

Definition 4.11. Convergence in L2 (Ω). We say that a sequence (Fn )n∈N
of random variables in L2 (Ω) converges in L2 (Ω) to another random variable
F ∈ L2 (Ω) if
q 
lim ∥F − Fn ∥L2 (Ω) = lim E (F − Fn )2 = 0.

n→∞ n→∞

The next proposition allows us to extend Lemma 4.7 from simple step func-
tions to square-integrable functions in L2 ([0, T ]).
wT
Proposition 4.12. The definition (4.6) of the stochastic integral f (t)dBt
wT 0
can be extended to any function f ∈ L2 ([0, T ]). In this case, f (t)dBt has
0
the centered Gaussian distribution
wT  w
T

f (t)dBt ≃ N 0, |f (t)|2 dt
0 0
w 
T
with mean E f (t)dBt = 0 and variance given by the Itô isometry
0

w  "
wT 2 # w
T T
Var f (t)dBt = E f (t)dBt = |f (t)|2 dt. (4.10)
0 0 0

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 Notes on Stochastic Finance

Proof. The extension of the stochastic integral to all functions satisfying

(4.9) is obtained by a denseness and Cauchy∗ sequence argument, based on
the isometry relation (4.10).
i) Given f a function satisfying (4.9), consider a sequence (fn )n∈N of sim-
ple functions converging to f in L2 ([0, T ]), i.e.
wT
r
lim ∥f − fn ∥L2 ([0,T ]) = lim |f (t) − fn (t)|2 dt = 0
n→∞ n→∞ 0

as in Proposition 4.9.
ii) By the isometry (4.10) and the triangle inequality† we have
wT wT
fk (t)dBt − fn (t)dBt
0 0 L2 (Ω)
v "
u w wT 2 #
u T
= E
t fk (t)dBt − fn (t)dBt
0 0
v "
u w 2 #
u T
= E
t (fk (t) − fn (t))dBt
0

= ∥fk − fn ∥L2 ([0,T ])

⩽ ∥fk − f ∥L2 ([0,T ]) + ∥f − fn ∥L2 ([0,T ]) ,
r 
T
which tends to 0 as k and n tend to infinity, hence 0 fn (t)dBt
n∈N
is a Cauchy sequence
r in L (Ω) by
2
 for the L (Ω)-norm.
2
T
iii) Since the sequence 0 fn (t)dBt is Cauchy and the space L2 (Ω) is
n∈N
complete, cf. e.g. Theorem 3.11 in Rudin (1974) or Chapter 4 of Dudley
wT
(2002), we conclude that fn (t)dBt converges for the L2 -norm
0 n∈N
to a limit in L2 (Ω). In this case we let
wT wT
f (t)dBt := lim fn (t)dBt ,
0 n→∞ 0

which also satisfies (4.10) from (4.8) From (4.10) we can check that the
limit is independent of the approximating sequence (fn )n∈N .
iv) Finally, from the convergence of Gaussian characteristic functions
  w    w 
T T
E exp iα f (t)dBt = E lim exp iα fn (t)dBt
0 n→∞ 0

∗
See MH3100 Real Analysis I.
†
The triangle inequality ∥fk − fn ∥L2 ([0,T ]) ⩽ ∥fk − f ∥L2 ([0,T ]) + ∥f − fn ∥L2 ([0,T ])
follows from the Minkowski inequality.
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 N. Privault

  w 
T
= lim E exp iα fn (t)dBt
n→∞ 0

α2 w T
 
= lim exp − |fn (t)|2 dt
n→∞ 2 0
α2 w T
 
= exp − |f (t)|2 dt ,
2 0
wT
f ∈ L2 ([0, T ]), α ∈ R, we check that f (t)dBt has the centered Gaus-
0
sian distribution
wT  w
T

f (t)dBt ≃ N 0, |f (t)|2 dt ,
0 0

see Theorem 23.13.

□
The next corollary is obtained by bilinearity from the Itô isometry (4.10).
Corollary 4.13. The stochastic integral with respect to Brownian motion
(Bt )t∈R+ satisfies the isometry
w wT  w
T T
E f (t)dBt g (t)dBt = f (t)g (t)dt,
0 0 0

for all square-integrable deterministic functions f , g ∈ L2 ([0, T ]).

Proof. Applying the Itô isometry (4.10) to the processes f + g and f − g and
the relation xy = (x + y )2 /4 − (x − y )2 /4, we have
w wT 
T
E f (t)dBt g (t)dBt
0 0
w wT 2 w wT
" 2 #
1 T T
= E f (t)dBt + g (t)dBt − f (t)dBt − g (t)dBt
4 0 0 0 0

w w
" 2 # " 2 #
1 T 1 T
= E (f (t) + g (t))dBt − E (f (t) − g (t))dBt
4 0 4 0
w
1 T 1 Tw
= (f (t) + g (t))2 dt − (f (t) − g (t))2 dt
4 0 4 0
1wT
(f (t) + g (t))2 − (f (t) − g (t))2 dt


=
4 0
wT
= f (t)g (t)dt.
0

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 Notes on Stochastic Finance

wT
For example, the Wiener stochastic integral e −t dBt is a random variable
0
having centered Gaussian distribution with variance
wT 2 # w
"
T −2t
E e −t dBt = e dt
0 0
t=T
1

= − e −2t
2 t=0
1 −2T
= 1− e ,


2
as follows from the Itô isometry (4.8).
wT
Remark 4.14. The Wiener stochastic integral f (s)dBs is a Gaussian
0
random variable which cannot be “computed” in the way standard integral
are computed via the use of primitives. However, when f ∈ L2 ([0, T ]) is in
C 1 ([0, T ]),∗ we have the integration by parts relation
wT wT
f (t)dBt = f (T )BT − Bt f ′ (t)dt. (4.11)
0 0

When f ∈ L2 (R+ ) is in C 1 (R+ ) we also have following formula

w∞ w∞
f (t)dBt = − Bt f ′ (t)dt, (4.12)
0 0

provided that limt→∞ t|f (t)|2 = 0 and f ∈ L2 (R+ ), cf. e.g. Exercise 4.5 and
Remark 2.5.9 in Privault (2009).

4.4 Itô Stochastic Integral

In this section we extend the Wiener stochastic integral from deterministic
functions in L2 ([0, T ]) to random square-integrable (random) adapted pro-
cesses. For this, we will need the notion of measurability.
The extension of the stochastic integral to adapted random processes is
actually necessary in order to compute a portfolio value when the portfolio
process is no longer deterministic. This happens in particular when one needs
to update the portfolio allocation based on random events occurring on the
market.
A random variable F is said to be Ft -measurable if the knowledge of F
depends only on the information known up to time t. As an example, if
t =today,
∗
This means that the function f is continuously differentiable on [0, T ].

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 N. Privault

• the date of the past course exam is Ft -measurable, because it belongs to

the past.

• the date of the next Chinese new year, although it refers to a future event,
is also Ft -measurable because it is known at time t.

• the date of the next typhoon is not Ft -measurable since it is not known
at time t.

• the maturity date T of the European option is Ft -measurable for all

t ∈ [0, T ], because it has been determined at time 0.

• the exercise date τ of an American option after time t (see Section 15.1)
is not Ft -measurable because it refers to a future random event.

In the next definition, (Ft )t∈[0,T ] denotes the information flow defined in
(4.2), i.e.
F t : = σ ( Bs : 0 ⩽ s ⩽ t ) , t ⩾ 0.
Definition 4.15. A stochastic process (Xt )t∈[0,T ] is said to be (Ft )t∈[0,T ] -
adapted if Xt is Ft -measurable for all t ∈ [0, T ].
For example,
- (Bt )t∈R+ is an (Ft )t∈R+ -adapted process,
- (Bt+1 )t∈R+ is not an (Ft )t∈R+ -adapted process,
- (Bt/2 )t∈R+ is an (Ft )t∈R+ -adapted process,
- B√t t∈R is not an (Ft )t∈R+ -adapted process,


+

- Maxs∈[0,t] Bs )t∈R+ is an (Ft )t∈R+ -adapted process,

w 
t
- Bs ds is an (Ft )t∈R+ -adapted process,
0 t∈R+
w 
t
- f (s)dBs is an (Ft )t∈[0,T ] -adapted process when f ∈ L2 ([0, T ]).
0 t∈[0,T ]

In other words, a stochastic process (Xt )t∈R+ is (Ft )t∈[0,T ] -adapted if the
value of Xt at time t depends only on information known up to time t. Note
that the value of Xt may still depend on “known” future data, for example
a fixed future date in the calendar, such as a maturity time T > t, as long as
its value is known at time t.
The next Figure 4.17 shows an adapted portfolio strategy on two assets,
constructed from a sign-switching signal based on spread data, see § 2.5 in
Privault (2021a) and this code.
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 Notes on Stochastic Finance

350
Pair trading

0.2

300

0.1

250

Performance
Spread

0.0

200

−0.1

150

−0.2

100

−0.3
2017 2018 2019 2020 2017 2018 2019 2020

Fig. 4.17: Adapted pair trading portfolio strategy.

The stochastic integral of adapted processes is first constructed as integrals

of simple predictable processes.
Definition 4.16. A simple predictable processes is a stochastic process
(ut )t∈R+ of the form
n
Fi 1(ti−1 ,ti ] (t),
X
ut := t ⩾ 0, (4.13)
i=1

where Fi is an Fti−1 -measurable random variable for i = 1, 2, . . . , n, and

0 = t0 < t1 < · · · < tn−1 < tn = T .
For example, a natural approximation of (Bt )t∈R+ by a simple predictable
process can be constructed as
n n
Fi 1(ti−1 ,ti ] (t) := Bti−1 1(ti−1 ,ti ] (t),
X X
ut = t ⩾ 0, (4.14)
i=1 i=1

since Fi := Bti−1 is Fti−1 -measurable for i = 1, 2, . . . , n, as in Figure 4.18.

N=10000; t <- 0:(N-1); dt <- 1.0/N;

dB <- rnorm(N,mean=0,sd=sqrt(dt));X <- rep(0,N);X[1]=0
for (j in 2:N){X[j]=X[j-1]+dB[j]}
plot(t/(N-1), X, xlab = "t", ylab = "", type = "l", ylim = c(1.05*min(X),1.05*max(X)),
xaxs="i", yaxs="i", col = "blue", las = 1, cex.axis=1.6, cex.lab=1.8)
abline(h=0)
t1=c(0.15,0.37,0.49,0.65,0.72,0.91)
Bt=c(0,X[t1[1]*N],X[t1[2]*N],X[t1[3]*N],X[t1[4]*N],X[t1[5]*N],X[t1[6]*N])
lines(stepfun(t1,Bt),xlim =c(0,T),xlab="t",ylab=expression('N'[t]),pch=1, cex=0.8,
col='black', lwd=3, main="")

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 N. Privault

2.0

1.5

1.0

0.5

0.0
0.0 0.2 0.4 0.6 0.8 1.0
t

Fig. 4.18: Step function approximation of Brownian motion.

The notion of simple predictable process makes full sense in the context
of portfolio investment, in which Fi will represent an investment allocation
decided at time ti−1 and to remain unchanged over the time interval (ti−1 , ti ].
By convention, u : Ω × R+ −→ R is denoted in what follows by ut (ω ),
t ∈ R+ , ω ∈ Ω, and the random outcome ω is often dropped for convenience
of notation.
Definition 4.17. The stochastic integral with respect to Brownian motion
(Bt )t∈R+ of any simple predictable process (ut )t∈R+ of the form (4.13) is
defined by
wT Xn
ut dBt := Fi (Bti − Bti−1 ), (4.15)
0
i=1
with 0 = t0 < t1 < · · · < tn−1 < tn = T .
The use of predictability in the definition (4.15) is essential from a financial
point of view, as Fi will represent a portfolio allocation made at time ti−1 and
kept constant over the trading interval [ti−1 , ti ], while Bti − Bti−1 represents
a change in the underlying asset price over [ti−1 , ti ]. See also the related
discussion on self-financing portfolios in Section 5.3 and Lemma 5.14 on the
use of stochastic integrals to represent the value of a portfolio.
Definition 4.18. Let L2 (Ω × [0, T ]) denote the space of stochastic processes

u : Ω × [0, T ] −→ R
(ω, t) 7−→ ut (ω )

such that
s 
wT 
∥u∥L2 (Ω×[0,T ]) := E |ut |2 dt < ∞, u ∈ L2 (Ω × [0, T ]).
0

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 Notes on Stochastic Finance

The norm ∥ · ∥L2 (Ω×[0,T ]) on L2 (Ω × [0, T ]) induces a distance between two

stochastic processes u and v in L2 (Ω × [0, T ]), defined as
s 
wT 
∥u − v∥L2 (Ω×[0,T ]) = E |ut − vt |2 dt .
0

Definition 4.19. Convergence in L2 (Ω × [0, T ]). We say that a sequence

u(n) n∈N of processes in L2 (Ω × [0, T ]) converges in L2 (Ω × [0, T ]) to an-

other process u ∈ L2 (Ω × [0, T ]) if

s 
wT 
(n)
lim u − u(n) L2 (Ω×[0,T ]) = lim E |ut − ut |2 dt = 0.
n→∞ n→∞ 0

By Lemma 1.1 of Ikeda and Watanabe (1989), pages 22 and 46, or Propo-
sition 2.5.3 in Privault (2009), the set of simple predictable processes forms
a linear space which is dense in the subspace L2ad (Ω × R+ ) made of square-
integrable adapted processes in L2 (Ω × R+ ), as stated in the next proposi-
tion.
Proposition 4.20. Given u ∈ L2ad (Ω × R+ ) a square-integrable adapted
process there exists a sequence (u(n) )n∈N of simple predictable processes con-
verging to u in L2 (Ω × R+ ), i.e.
s 
wT 
(n) 2
lim u − u(n) L2 (Ω×[0,T ]) = lim E ut − ut dt = 0.
n→∞ n→∞ 0

The next Proposition 4.21 extends the construction of the stochastic integral
from simple predictable processes to square-integrable (Ft )t∈[0,T ] -adapted
processes (ut )t∈R+ for which the value of ut at time t can only depend on
information contained in the Brownian path up to time t.
This restriction means that the Itô integrand ut cannot depend on future
information, for example a portfolio strategy that would allow the trader to
“buy at the lowest” and “sell at the highest” is excluded as it would require
knowledge of future market data. Note that the difference between Rela-
tion (4.16) below and Relation (4.10) is the presence of an expectation on
the right-hand side.

Proposition 4.21. The stochastic integral with respect to Brownian motion

(Bt )t∈R+ extends to all adapted processes (ut )t∈R+ such that
w 
T
∥u∥2L2 (Ω×[0,T ]) := E |ut |2 dt < ∞,
0

with the Itô isometry

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 N. Privault

wT wT w
" 2 #
2 T

ut dBt := E ut dBt =E |ut |2 dt . (4.16)
0 L2 (Ω) 0 0

In addition, the Itô integral of an adapted process (ut )t∈R+ is always a cen-
tered random variable: w 
T
E ut dBt = 0. (4.17)
0

Proof. We start by showing that the Itô isometry (4.16) holds for the simple
predictable process u of the form (4.13). We have

 !2 
wT n
" 2 # X
E ut dBt = E Fi (Bti − Bti−1 ) 
0
i=1
 ! n 
n
X X
= E Fi (Bti − Bti−1 )  Fj (Btj − Btj−1 )
i=1 j =1
 
n
X
= E Fi Fj (Bti − Bti−1 )(Btj − Btj−1 )
i,j =1
n
" #
X
=E |Fi |2 (Bti − Bti−1 )2
i=1
 
X
+2E  Fi Fj (Bti − Bti−1 )(Btj − Btj−1 )
1⩽i<j ⩽n
n
X
E |Fi |2 (Bti − Bti−1 )2
 
=
i=1
X
+2 E Fi Fj (Bti − Bti−1 )(Btj − Btj−1 )
 

1⩽i<j ⩽n
n
X
= E[E[|Fi |2 (Bti − Bti−1 )2 |Fti−1 ]]
i=1
X
+2 E[E[Fi Fj (Bti − Bti−1 )(Btj − Btj−1 )|Ftj−1 ]]
1⩽i<j ⩽n
n
X
= E[|Fi |2 E[(Bti − Bti−1 )2 |Fti−1 ]]
i=1
X
+2 E Fi Fj (Bti − Bti−1 ) E[Btj − Btj−1 | Ftj−1 ]
 

1⩽i<j ⩽n
| {z }
=0
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 Notes on Stochastic Finance

n
X
E |Fi |2 E (Bti − Bti−1 )2
  
=
i=1
X
+2 E[Fi Fj (Bti − Bti−1 ) E[Btj − Btj−1 ]]
1⩽i<j ⩽n
| {z }
=0
n
X
= E[|Fi | (ti − ti−1 )]
2

i=1
n
" #
X
=E 2
|Fi | (ti − ti−1 )
i=1
hw T i
=E |ut |2 dt ,
0

where we applied the tower property (23.41) of conditional expectations and

the facts that Bti − Bti−1 is independent of Fti−1 , with

E[Bti − Bti−1 ] = 0, E (Bti − Bti−1 )2 = ti − ti−1 , i = 1, 2, . . . , n.

 

u2
6
F22 b r
b r b r
F12
F42 b r
-
t0 t1 t2 t3 t4 t

Fig. 4.19: Squared simple predictable process t 7→ u2t .

The extension of the stochastic integral to square-integrable adapted pro-

cesses (ut )t∈R+ is obtained by a denseness and Cauchy sequence argument
using the isometry (4.16), in the same way as in the proof of Proposition 4.12.
i) By Proposition 4.20 given u ∈ L2 (Ω × [0, T ]) a square-integrable adapted
process there exists a sequence (u(n) )n∈N of simple predictable processes
such that
r hw i T (n) 2
lim ∥u − u(n) ∥L2 (Ω×[0,T ]) = lim E ut − ut dt = 0.
n→∞ n→∞ 0

ii) Since the sequence (u(n) )n∈N converges it is a Cauchy sequence in
r T (n)
L2 (Ω × R+ ), hence by the Itô isometry (4.16), the sequence 0 ut dBt
n∈N
is a Cauchy sequence in L2 (Ω), therefore it admits a limit in the com-
plete space L2 (Ω). In this case we let

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 N. Privault

wT wT
(n)
ut dBt := lim ut dBt
0 n→∞ 0

and the limit is unique from (4.16) and satisfies (4.16).

wT
iii) The fact that the random variable ut dBt is centered can be proved
0
first on simple predictable process u of the form (4.13) as
w  " n #
T X
E ut dBt = E Fi (Bti − Bti−1 )
0
i=1
n
X
= E[E[Fi (Bti − Bti−1 ) | Fti−1 ]]
i=1
Xn
= E[Fi E[Bti − Bti−1 | Fti−1 ]]
i=1
Xn
= E[Fi E[Bti − Bti−1 ]]
i=1
= 0,

and this identity extends as above from simple predictable processes to

adapted processes (ut )t∈R+ in L2 (Ω × R+ ).

□
As an application of the Itô isometry (4.16), we note in particular the identity

wT w  w wT
" 2 #
T T T2
E =E |Bt |2 dt = E |Bt |2 dt = ,
 
Bt dBt tdt =
0 0 0 0 2

with
wT L2 (Ω)
n
X
lim


Bt dBt = Bti−1 Bti − Bti−1
0 n→∞
i=1

from (4.14).
The next corollary is obtained by bilinearity from the Itô isometry (4.16) by
the same argument as in Corollary 4.13.
Corollary 4.22. The stochastic integral with respect to Brownian motion
(Bt )t∈R+ satisfies the isometry
w wT  w 
T T
E ut dBt vt dBt = E ut vt dt ,
0 0 0

for all square-integrable adapted processes (ut )t∈R+ , (vt )t∈R+ .

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 Notes on Stochastic Finance

Proof. Applying the Itô isometry (4.16) to the processes u + v and u − v, we

have
w wT 
T
E ut dBt vt dBt
0 0
w wT 2 w wT
" 2 #!
1 T T
= E ut dBt + vt dBt − ut dBt − vt dBt
4 0 0 0 0

w w
" 2 # " 2 #!
1 T T
= E (ut + vt )dBt −E (ut − vt )dBt
4 0 0
 w w
1
 
T T
= E (ut + vt )2 dt − E (ut − vt )2 dt
4 0 0
w
1

T
= E (ut + vt ) − (ut − vt )2 dt
2


4 0
w 
T
=E ut vt dt .
0

□
In addition, when the integrand (ut )t∈R+ is not a deterministic function of
wT
time, the random variable ut dBt no longer has a Gaussian distribution,
0
except in some exceptional cases.

Definite stochastic integral

The definite stochastic integral of an adapted process u ∈ L2ad (Ω × R+ ) over

an interval [a, b] ⊂ [0, T ] is defined as
wb wT
ut dBt := 1[a,b] (t)ut dBt ,
a 0

with in particular
wb wT
dBt = 1[a,b] (t)dBt = Bb − Ba , 0 ⩽ a ⩽ b,
a 0

We also have the Chasles relation

wc wb wc
ut dBt = ut dBt + ut dBt , 0 ⩽ a ⩽ b ⩽ c,
a a b

and the stochastic integral has the following linearity property:

wT wT wT
(ut + vt )dBt = ut dBt + vt dBt , u, v ∈ L2 (R+ ).
0 0 0

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 N. Privault

4.5 Stochastic Calculus

Fig. 4.20: NGram Viewer output for the term "stochastic calculus".

Stochastic modeling of asset returns

In the sequel we will construct the return at time t ∈ R+ of the risky asset
(St )t∈R+ as

dSt
= µdt + σdBt , or dSt = µSt dt + σSt dBt . (4.18)
St
with µ ∈ R and σ > 0. Using the relation
wT
XT = X0 + dXt , T > 0,
0

which holds for any process (Xt )t∈R+ , Equation (4.18) can be rewritten in
integral form as
wT wT wT
ST = S0 + dSt = S0 + µ St dt + σ St dBt , (4.19)
0 0 0

hence the need to define an integral with respect to dBt , in addition to the
usual integral with respect to dt. Note that in view of the definition (4.15),
this is a continuous-time extension of the notion portfolio value based on a
predictable portfolio strategy.
In Proposition 4.21 we have defined the stochastic integral of square-
integrable processes with respect to Brownian motion, thus we have made
sense of the equation (4.19), where (St )t∈R+ is an (Ft )t∈[0,T ] -adapted pro-
cess, which can be rewritten in differential notation as in (4.18).
This model will be used to represent the random price St of a risky asset
at time t. Here the return dSt /St of the asset is made of two components: a

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 Notes on Stochastic Finance

constant return µdt and a random return σdBt parametrized by the coefficient
σ, called the volatility.
Our goal is now to solve Equation (4.18), and for this we will need to introduce
Itô’s calculus in Section 4.5 after a review of classical deterministic calculus.

Deterministic calculus

The fundamental theorem of calculus states that for any continuously differ-
entiable (deterministic) function f we have the integral relation
wx
f (x) = f (0) + f ′ (y )dy.
0

In differential notation this relation is written as the first-order expansion

df (x) = f ′ (x)dx, (4.20)

where dx is “infinitesimally small”. Higher-order expansions can be obtained

from Taylor’s formula, which, letting

∆f (x) := f (x + ∆x) − f (x),

states that
1 1 1
∆f (x) = f ′ (x)∆x + f ′′ (x)(∆x)2 + f ′′′ (x)(∆x)3 + f (4) (x)(∆x)4 + · · · .
2 3! 4!
Note that Relation (4.20), i.e. df (x) = f ′ (x)dx, can be obtained by neglecting
all terms of order higher than one in Taylor’s formula, since (∆x)n << ∆x,
n ⩾ 2, as ∆x becomes “infinitesimally small”.

Stochastic calculus

Let us now apply Taylor’s formula to Brownian motion, taking

√
∆Bt = Bt+∆t − Bt ≃ ± ∆t,

and letting
∆f (Bt ) := f (Bt+∆t ) − f (Bt ),
we have

∆f (Bt )
1 1 1
= f ′ (Bt )∆Bt + f ′′ (Bt )(∆Bt )2 + f ′′′ (Bt )(∆Bt )3 + f (4) (Bt )(∆Bt )4 + · · · .
2 3! 4!
From
√ the construction of Brownian motion by its small increments ∆Bt =
± ∆t, it turns out that the terms in (∆t)2 and ∆t∆Bt ≃ ±(∆t)3/2 can
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 N. Privault

be neglected in Taylor’s formula at the first order of approximation in ∆t.

However, the term of order two
√
(∆Bt )2 = (± ∆t)2 = ∆t

can no longer be neglected in front of ∆t itself.

Basic Itô formula

For f ∈ C 2 (R),∗ Taylor’s formula written at the second order for Brownian
motion reads
1
df (Bt ) = f ′ (Bt )dBt + f ′′ (Bt )dt, (4.21)
2

for “infinitesimally small” dt. Note that writing this formula as

df (Bt ) dBt 1
= f ′ ( Bt ) + f ′′ (Bt )
dt dt 2
does not make sense because the pathwise derivative
√
dBt dt 1
≃± ≃ ± √ ≃ ±∞
dt dt dt
of Bt with respect to t does not exist. Integrating (4.21) on both sides and
using the relation wt
f (Bt ) − f (B0 ) = df (Bs )
0
together with (4.21), we get the integral form of Itô’s formula for Brownian
motion, i.e.
wt 1 w t ′′
f (Bt ) = f (B0 ) + f ′ (Bs )dBs + f (Bs )ds.
0 2 0

Itô processes

We now turn to the general expression of Itô’s formula, which is stated for
Itô processes.
Definition 4.23. An Itô process is a stochastic process (Xt )t∈R+ that can
be written as
wt wt
Xt = X0 + vs ds + us dBs , t ⩾ 0, (4.22)
0 0
∗
This means that f is twice continuously differentiable on [0, T ].
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 Notes on Stochastic Finance

or in differential notation

dXt = vt dt + ut dBt ,

where (ut )t∈R+ and (vt )t∈R+ are square-integrable adapted processes.
Given (t, x) 7→ f (t, x) a smooth function of two variables on R+ × R, from
∂f
now on we let denote partial differentiation with respect to the first (time)
∂t
∂f
variable in f (t, x), while denotes partial differentiation with respect to
∂x
the second (price) variable in f (t, x).
Theorem 4.24. (Itô formula for Itô processes). For any Itô process (Xt )t∈R+
of the form (4.22) and any f ∈ Cb1,2 (R+ × R),∗ we have

f (t, Xt )
w t ∂f w t ∂f w t ∂f
= f (0, X0 ) + (s, Xs )ds + vs (s, Xs )ds + us (s, Xs )dBs
0 ∂s 0 ∂x 0 ∂x
1wt ∂2f
+ |us |2 2 (s, Xs )ds. (4.23)
2 0 ∂x

Proof. The proof of the Itô formula can be outlined as follows in the case
where (Xt )t∈R+ = (Bt )t∈R+ is a standard Brownian motion and f (x) does
not depend on time t. We refer to Theorem II-32, page 79 of Protter (2004)
for the general case.
Let {0 = tn0 ⩽ tn1 ⩽ · · · ⩽ tnn = t}, n ⩾ 1, be a refining sequence of
partitions of [0, t] tending to the identity. We have the telescoping identity
n
X
f (Btni ) − f (Btni−1 ) ,


f ( Bt ) − f ( B0 ) =
k =1

and from Taylor’s formula

∂f 1 ∂2f
f (y ) − f (x) = (y − x) (x) + (y − x)2 2 (x) + R(x, y ),
∂x 2 ∂x
where the remainder R(x, y ) satisfies R(x, y ) ⩽ o(|y − x|2 ), we get
n n
X ∂f 1X ∂2f
f ( Bt ) − f ( B0 ) = (Btni − Btni−1 ) (Btni−1 ) + |Btni − Btni−1 |2 2 (Btni−1 )
∂x 2 ∂x
k =1 k =1

∗
This means that f is continuously differentiable on t ∈ [0, T ] and twice differentiable
in c ∈ R, with bounded derivatives.

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 N. Privault

n
X
+ R(Btni , Btni−1 ).
k =1

It remains to show that as n tends to infinity the above converges to

w t ∂f 1 w t ∂2f
f ( Bt ) − f ( B0 ) = (Bs )dBs + (Bs )ds.
0 ∂x 2 0 ∂x2
□
From the relation
wt
df (s, Xs ) = f (t, Xt ) − f (0, X0 ),
0

we can rewrite (4.23) as

wt wt ∂f w t ∂f
df (s, Xs ) = vs (s, Xs )ds + us (s, Xs )dBs
0 0 ∂x 0 ∂x
w t ∂f 1wt ∂2f
+ (s, Xs )ds + |us |2 2 (s, Xs )ds,
0 ∂s 2 0 ∂x
which allows us to rewrite (4.23) in differential notation, as

df (t, Xt ) (4.24)
∂f ∂f ∂f 1 ∂2f
= (t, Xt )dt + vt (t, Xt )dt + ut (t, Xt )dBt + |ut |2 2 (t, Xt )dt.
∂t ∂x ∂x 2 ∂x

In case the function x 7→ f (x) does not depend on the time variable t we get

∂f ∂f 1 ∂2f
df (Xt ) = ut (Xt )dBt + vt (Xt )dt + |ut |2 2 (Xt )dt.
∂x ∂x 2 ∂x

Taking ut = 1, vt = 0 and X0 = 0 in (4.22) yields Xt = Bt , in which case

the Itô formula (4.23)-(4.24) reads
w t ∂f w t ∂f 1 w t ∂2f
f (t, Bt ) = f (0, B0 ) + (s, Bs )ds + (s, Bs )dBs + (s, Bs )ds,
0 ∂s 0 ∂x 2 0 ∂x2
i.e. in differential notation:
∂f ∂f 1 ∂2f
df (t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt. (4.25)
∂t ∂x 2 ∂x2

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 Notes on Stochastic Finance

Bivariate Itô formula

Next, consider two Itô processes (Xt )t∈R+ and (Yt )t∈R+ written in integral
form as wt wt
Xt = X0 + vs ds + us dBs , t ⩾ 0,
0 0
and wt wt
Yt = Y0 + bs ds + as dBs , t ⩾ 0,
0 0
or in differential notation as

dXt = vt dt + ut dBt , and dYt = bt dt + at dBt , t ⩾ 0.

The Itô formula can also be written for functions f ∈ C 1,2,2 (R+ × R2 ) of two
state variables as

∂f ∂f 1 ∂2f
df (t, Xt , Yt ) = (t, Xt , Yt )dt + (t, Xt , Yt )dXt + |ut |2 2 (t, Xt , Yt )dt
∂t ∂x 2 ∂x
∂f 1 2
2∂ f ∂2f
+ (t, Xt , Yt )dYt + |at | (t, Xt , Yt )dt + ut at (t, Xt , Yt )dt.
∂y 2 ∂y 2 ∂x∂y
(4.26)

Itô multiplication table

Applying the bivariate Itô formula (4.26) to be function f (x, y ) = xy shows

that

d(Xt Yt ) = Xt dYt + Yt dXt + at ut dt = Xt dYt + Yt dXt + dXt • dYt (4.27)

where the product dXt • dYt is computed according to the Itô rule

dt • dt = 0, dt • dBt = 0, dBt • dBt = dt, (4.28)

which can be encoded in the following Itô multiplication table:

• dt dBt
dt 0 0
dBt 0 dt

Table 4.1: Itô multiplication table.

It follows from the Itô Table 4.1 that

dXt • dYt = (vt dt + ut dBt ) • (bt dt + at dBt )

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 N. Privault

= bt vt (dt)2 + bt ut dtdBt + at vt dtdBt + at ut (dBt )2

= at ut dt.

Hence we also have

(dXt )2 = (vt dt + ut dBt )2

= (vt )2 (dt)2 + (ut )2 (dBt )2 + 2ut vt (dt • dBt )
= (ut )2 dt,

according to the Itô Table 4.1. Consequently, (4.24) can be rewritten as

∂f ∂f 1 ∂2f
df (t, Xt ) = (t, Xt )dt + (t, Xt )dXt + (t, Xt )dXt • dXt ,
∂t ∂x 2 ∂x2
(4.29)

and the Itô formula for functions f ∈ C 1,2,2 (R+ × R2 ) of two state variables
can be rewritten as

∂f ∂f 1 ∂2f
df (t, Xt , Yt ) = (t, Xt , Yt )dt + (t, Xt , Yt )dXt + (t, Xt , Yt )(dXt )2
∂t ∂x 2 ∂x2
∂f 1 ∂2f ∂2f
+ (t, Xt , Yt )dYt + (t, Xt , Yt )(dYt )2 + (t, Xt , Yt )(dXt • dYt ).
∂y 2 ∂y 2 ∂x∂y

Examples

Applying Itô’s formula (4.25) to Bt2 with

Bt2 = f (t, Bt ) and f (t, x) = x2 ,

and
∂f ∂f 1 ∂2f
(t, x) = 0, (t, x) = 2x, (t, x) = 1,
∂t ∂x 2 ∂x2
we find

d(Bt2 ) = df (Bt )
∂f ∂f 1 ∂2f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂x2
= 2Bt dBt + dt.

Note that from the Itô Table 4.1 we could also write directly

d(Bt2 ) = Bt dBt + Bt dBt + (dBt )2 = 2Bt dBt + dt.

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 Notes on Stochastic Finance

Next, by integration in t ∈ [0, T ] we find

wT wT wT
BT2 = B0 + 2 Bs dBs + dt = 2 Bs dBs + T , (4.30)
0 0 0

hence the relation

wT 1
BT2 − T , (4.31)


Bs dBs =
0 2
wT
see Exercise 4.13 for the probability distribution of Bs dBs .
0
Similarly, we have
i) d Bt3 = 3(Bt )2 dBt + 3Bt dt.

Letting f (x) := x3 with f ′ (x) = 3x2 and f ′′ (x) = 6x, we have

1
d(Bt3 ) = df (Bt ) = f ′ (Bt )dBt + f ′′ (Bt )dt = 3(Bt )2 dBt + 3Bt dt.
2
1
ii) d(sin Bt ) = cos(Bt )dBt − sin(Bt )dt.
2
Letting f (x) := sin(x) with f ′ (x) = cos(x), f ′′ (x) = − sin(x), we have

d sin(Bt ) = df (Bt )
1
= f ′ (Bt )dBt + f ′′ (Bt )dt
2
1
= cos(Bt )dBt − sin(Bt )dt.
2
1 Bt
iii) d e Bt = e Bt dBt + e dt.
2
Letting f (x) := e with f ′ (x) = e x , f ′′ (x) = e x , we have
x

d e Bt = df (Bt )
1
= f ′ (Bt )dBt + f ′′ (Bt )dt
2
1
= e tBt dBt + e tBt dt.
2
1 1
iv) d log Bt = dBt − dt.
Bt 2 ( Bt ) 2
Letting f (x) := log x with f ′ (x) = 1/x and f ′′ (x) = −1/x2 , we have

1 dBt dt
d log Bt = df (Bt ) = f ′ (Bt )dBt + f ′′ (Bt )dt = − .
2 Bt 2 ( Bt ) 2

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 N. Privault

t2 tBt
v) d e tBt = Bt e tBt dt + e dt + t e tBt dBt .
2
Letting f (t, x) := e xt with

∂f ∂f ∂2f
(t, x) = x e xt , (t, x) = t e xt , (t, x) = t2 e xt ,
∂t ∂x ∂x2
we have

d e tBt = df (t, Bt )
∂f ∂f 1 ∂2f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂x2
t2
= Bt e tBt dt + t e tBt dBt + e tBt dt.
2
1
vi) d cos(2t + Bt ) = −2 sin(2t + Bt )dt − sin(2t + Bt )dBt + cos(2t + Bt )dt.
2
Letting f (t, x) := cos(2t + x) with

∂f ∂f ∂2f
(t, x) = −2 sin(2t + x), (t, x) = − sin(2t + x), (t, x) = cos(2t + x),
∂t ∂x ∂x2
we have

d cos(2t + Bt ) = df (t, Bt )
∂f ∂f 1 ∂2f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂x2
1
= −2 sin(2t + Bt )dt − sin(2t + Bt )dBt + cos(2t + Bt )dt.
2

Notation

We close this section with some comments on the practice of Itô’s calculus. In
certain finance textbooks, Itô’s formula for e.g. geometric Brownian motion
(St )t∈R+ given by
dSt = µSt dt + σSt dBt
can be found written in the notation
wT ∂f wT ∂f
f (T , ST ) = f (0, X0 ) + σ St (t, St )dBt + µ St (t, St )dt
0 ∂St 0 ∂St
w T ∂f 1 w T 2
∂ f
+ (t, St )dt + σ 2 St2 2 (t, St )dt,
0 ∂t 2 0 ∂St
or
∂f ∂f 1 ∂2f
df (St ) = σSt (St )dBt + µSt (St )dt + σ 2 St2 2 (St )dt.
∂St ∂St 2 ∂St
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 Notes on Stochastic Finance

∂f
The notation (St ) can in fact be easily misused in combination with the
∂St
fundamental theorem of classical calculus, and potentially leads to the wrong
identity
∂f 

df (S =  (St )dSt ,
t) 
  ∂St
as in the following actual example:

Fig. 4.21: Wrong application of Itô’s formula (sample).

Similarly, writing

∂f 1 ∂2f
df (Bt ) = (Bt )dBt + (Bt )dt
∂x 2 ∂x2
is consistent, while writing

∂f (Bt ) 1 ∂ 2 f ( Bt )
df (Bt ) = dBt + dt
∂Bt 2 ∂Bt2

is a potential source of confusion. Note also that the right-hand side of the Itô
formula uses partial derivatives while its left-hand side is a total derivative.

Stochastic differential equations

In addition to geometric Brownian motion there exists a large family of

stochastic differential equations that can be studied, although most of the
time they cannot be explicitly solved. Let now

σ : R+ × Rn −→ Rd ⊗ Rn

where Rd ⊗ Rn denotes the space of d × n matrices, and

b : R+ × Rn −→ R

satisfy the global Lipschitz condition

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 N. Privault

∥σ (t, x) − σ (t, y )∥2 + ∥b(t, x) − b(t, y )∥2 ⩽ K 2 ∥x − y∥2 ,

t ∈ R+ , x, y ∈ Rn . Then there exists a unique “strong” solution to the

stochastic differential equation
wt wt
Xt = X0 + b(s, Xs )ds + σ (s, Xs )dBs , t ⩾ 0, (4.32)
0 0

i.e., in differential notation

dXt = b(t, Xt )dt + σ (t, Xt )dBt , t ⩾ 0,

where (Bt )t∈R+ is a d-dimensional Brownian motion, see e.g. Protter (2004),
Theorem V-7. In addition, the solution process (Xt )t∈R+ of (4.32) has the
Markov property, see § V-6 of Protter (2004).
The term σ (s, Xs ) in (4.32) will be interpreted later on in Chapters 8-9 as a
local volatility component.
Stochastic differential equations can be used to model the behaviour of a
variety of quantities, such as
• stock prices,
• interest rates,
• exchange rates,
• weather factors,
• electricity/energy demand,
• commodity (e.g. oil) prices, etc.
Next, we consider several examples of stochastic differential equations that
can be solved explicitly using Itô’s calculus, in addition to geometric Brown-
ian motion. See e.g. § II-4.4 of Kloeden and Platen (1999) for more examples
of explicitly solvable stochastic differential equations.

Examples of stochastic differential equations

1. Consider the mean-reverting stochastic differential equation

dXt = −αXt dt + σdBt , X0 = x0 , (4.33)

with α > 0 and σ > 0.

N=10000; t <- 0:(N-1); dt <- 1.0/N;alpha=5; sigma=0.4;
dB <- rnorm(N,mean=0,sd=sqrt(dt));X <- rep(0,N);X[1]=0.5
for (j in 2:N){X[j]=X[j-1]-alpha*X[j-1]*dt+sigma*dB[j]}
plot(t*dt, X, xlab = "t", ylab = "", type = "l", ylim = c(-0.5,1), col = "blue")
abline(h=0)

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 Notes on Stochastic Finance

0.6

0.5

0.4

0.3
Xt
0.2

0.1

-0.1

-0.2
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t

Fig. 4.22: Simulated path of (4.33) with α = 10, σ = 0.2 and X0 = 0.5.

We look for a solution of the form

 wt 
Xt = a(t)Yt = a(t) x0 + b(s)dBs
0

where a(·) and b(·) are deterministic functions of time. After applying
rt
Theorem 4.24 to the Itô process x0 + 0 b(s)dBs of the form (4.22) with
ut = b(t) and v (t) = 0, and to the function f (t, x) = a(t)x, we find

dXt = d(a(t)Yt )
= Yt a′ (t)dt + a(t)dYt
= Yt a′ (t)dt + a(t)b(t)dBt . (4.34)

By identification of (4.33) with (4.34), we get

 ′
 a (t) = −αa(t)

a(t)b(t) = σ,


hence a(t) = a(0) e −αt = e −αt and b(t) = σ/a(t) = σ e αt , which shows
that wt
Xt = x0 e −αt + σ e −(t−s)α dBs , t ⩾ 0, (4.35)
0
Using integration by parts, we can also write
wt
Xt = x0 e −αt + σBt − σα e −(t−s)α Bs ds, t ⩾ 0, (4.36)
0

Remark: the solution of the equation (4.33) cannot be written as a func-

tion f (t, Bt ) of t and Bt as in the proof of Proposition 5.15.
2. Consider the stochastic differential equation
2 /2
dXt = tXt dt + e t dBt , X0 = x0 . (4.37)

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 N. Privault

N=10000; T<-2.0; t <- 0:(N-1); dt <- T/N;

dB <- rnorm(N,mean=0,sd= sqrt(dt));X <- rep(0,N);X[1]=0.5
for (j in 2:N){X[j]=X[j-1]+j*X[j-1]*dt*dt+exp(j*dt*j*dt/2)*dB[j]}
plot(t*dt, X, xlab = "t", ylab = "", type = "l", ylim = c(-0.5,10), col = "blue")
abline(h=0)

 rt 
Looking for a solution of the form Xt = a(t) X0 + 0 b(s)dBs , where
a(·) and b(·) are deterministic functions of time, we get a′ (t)/a(t) = t
2 2
and a(t)b(t) = e t /2 , hence a(t) = e t /2 and b(t) = 1, which yields
2 /2
Xt = e t (X0 + Bt ), t ⩾ 0.
7

4
Xt
3

-1
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
t

Fig. 4.23: Simulated path of (4.37).

3. Consider the stochastic differential equation

p
dYt = (−2αYt + σ 2 )dt + 2σ Yt dBt , (4.38)

where α ∈ R and σ > 0.

N=10000; t <- 0:(N-1); dt <- 1.0/N;mu=-5;sigma=1;

dB <- rnorm(N,mean=0,sd=sqrt(dt));Y <- rep(0,N);Y[1]=0.5
for (j in 2:N){
Y[j]=max(0,Y[j-1]+(2*mu*Y[j-1]+sigma*sigma)*dt+2*sigma*sqrt(Y[j-1])*dB[j])}
plot(t*dt, Y, xlab = "t", ylab = "", type = "l", ylim = c(-0.1,1), col = "blue")
abline(h=0)

√
Letting Xt := Yt , we find that dXt = −αXt dt + σdBt , hence by (4.35)
we obtain
 wt 2
e −αt e −(t−s)α dBs
p
Yt = (Xt )2 = Y0 + σ .
0

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 Notes on Stochastic Finance

0.7

0.6

0.5

0.4
Yt
0.3

0.2

0.1

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t

Fig. 4.24: Simulated path of (4.38) with α = −5 and σ = 1.

Exercises

Exercise 4.1 Compute E[Bt Bs ] in terms of s, t ⩾ 0.

Exercise 4.2 Let (Bt )t∈R+ denote a standard Brownian motion. Let c > 0.
Among the following processes, tell which is a standard Brownian motion
and which is not. Justify your answer.
a) (Xt )t∈R+ := Bc+t − Bc t∈R ,


+
b) (Xt )t∈R+ := Bct2 t∈R ,


+
c) (Xt )t∈R+ := cBt/c2 t∈R ,



+
d) (Xt )t∈R+ := Bt + Bt/2 t∈R .
+

Exercise 4.3 Let (Bt )t∈R+ denote a standard Brownian motion. Compute
the stochastic integrals
wT wT
2dBt and 2 × 1[0,T /2] (t) + 1(T /2,T ] (t) dBt


0 0

and determine their probability distributions (including mean and variance).

Exercise 4.4 Determine the probability distribution (including mean and

w 2π
variance) of the stochastic integral sin(t) dBt .
0

Exercise 4.5 Let T > 0. Show that for f : [0, T ] 7→ R a differentiable function
such that f (T ) = 0, we have
wT wT
f (t)dBt = − f ′ (t)Bt dt.
0 0

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 N. Privault

Hint: Apply Itô’s calculus to t 7→ f (t)Bt .

Exercise 4.6 Let (Bt )t∈R+ denote a standard Brownian motion.

r1
a) Find the probability distribution of the stochastic integral 0 t2 dBt .
r1
b) Find the probability distribution of the stochastic integral 0 t−1/2 dBt .

Exercise 4.7 Given (Bt )t∈R+ a standard Brownian motion and n ⩾ 1, let
the random variable Xn be defined as
w 2π
Xn := sin(nt)dBt , n ⩾ 1.
0

a) Give the probability distribution of Xn for all n ⩾ 1.

b) Show that (Xn )n⩾1 is a sequence of identically distributed and pairwise
independent random variables.
1
Hint: We have sin a sin b = cos(a − b) − cos(a + b) , a, b ∈ R.


2

Exercise 4.8 Apply the Itô formula to the process Xt := sin2 (Bt ), t ⩾ 0.

Exercise 4.9 Let (Bt )t∈R+ denote a standard Brownian motion.

a) Using the Itô isometry and the known relations
wT wT
BT = dBt and BT2 = T + 2 Bt dBt ,
0 0

compute the third and fourth moments E[BT3 ] and E[BT4 ].

b) Give the third and fourth moments of the centered normal distribution
with variance σ 2 .

Exercise 4.10 Let (Bt )t∈R+ denote a standard Brownian motion. Given
T > 0, find the stochastic integral decomposition of (BT )3 as
wT
( BT ) 3 = C + ζt,T dBt (4.39)
0

where C ∈ R is a constant and (ζt,T )t∈[0,T ] is an adapted process to be de-

termined.

Exercise 4.11 Let f ∈ L2 ([0, T ]), and consider a standard Brownian motion
(Bt )t∈[0,T ] .

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 Notes on Stochastic Finance

a) Compute the conditional expectation

h rT i
E e 0 f (s)dBs Ft , 0 ⩽ t ⩽ T,

where (Ft )t∈[0,T ] denotes the filtration generated by (Bt )t∈[0,T ] .

b) Using the result of Question (a), show that the process
w
1wt 2

t
t 7−→ exp f (s)dBs − f (s)ds , 0 ⩽ t ⩽ T,
0 2 0

is an (Ft )t∈[0,T ] -martingale, where (Ft )t∈[0,T ] denotes the filtration gen-
erated by (Bt )t∈[0,T ] .
c) By applying the result of Question (b) to the function f (t) := σ 1[0,T ] (t),
2
show that the geometric Brownian motion process e σBt −σt /2 t∈[0,T ] is

an (Ft )t∈[0,T ] -martingale for any σ ∈ R.

(1) (2)
Exercise 4.12 Consider two assets whose prices St , St follow the Bachelier
dynamics
(1) (1) (1) (2) (2) (2)
dSt = µSt dt + σ1 dWt , dSt = µSt dt + σ2 dWt , t ∈ [0, T ],
(1)
(2)

where Wt t∈[0,T ] , Wt t∈[0,T ] are two Brownian motions with correlation
(1) (2)
ρ ∈ [−1, 1], i.e. we have dWt • dWt = ρdt. Show that the spread St :=
(2) (1)
St − St also satisfies an equation of the form

dSt = µSt dt + σdWt ,

where µ ∈ R, (Wt )t∈R+ is a standard Brownian motion, and σ > 0 should

be given in terms of σ1 , σ2 and ρ.
Hint: By the Lévy characterization theorem, Brownian motion (Wt )t∈R+ is
the only continuous martingale such that dWt • dWt = dt.

Exercise 4.13
a) Compute the moment generating function
  w 
T
E exp β Bt dBt
0

for all β < 1/T .

Hint: Expand (BT )2 using the Itô formula as in (4.30).
wT
b) Find the probability distribution of the stochastic integral β Bt dBt .
0

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 N. Privault

Exercise 4.14
a) Solve the stochastic differential equation

dXt = −bXt dt + σ e −bt dBt , t ⩾ 0, (4.40)

where (Bt )t∈R+ is a standard Brownian motion and σ, b ∈ R.

b) Solve the stochastic differential equation

dXt = −bXt dt + σ e −at dBt , t ⩾ 0, (4.41)

where (Bt )t∈R+ is a standard Brownian motion and a, b, σ > 0 are posi-
tive constants.

Exercise 4.15 Given T > 0, let (Xt )t∈[0,T ) denote the solution of the stochas-
tic differential equation
Xt
dXt = σdBt − dt, t ∈ [0, T ), (4.42)
T −t
under the initial condition X0 = 0 and σ > 0.
a) Show that
wt σ
Xt = (T − t) dBs , 0 ⩽ t < T.
0 T −s
Hint: Start by computing d(Xt /(T − t)) using the Itô formula.
b) Show that E[Xt ] = 0 for all t ∈ [0, T ).
c) Show that Var[Xt ] = σ 2 t(T − t)/T for all t ∈ [0, T ).
d) Show that limt→T Xt = 0 in L2 (Ω). The process (Xt )t∈[0,T ] is called a
Brownian bridge.

Exercise 4.16 Exponential Vašíček (1977) model (1). Consider a Vasicek

process (rt )t∈R+ solving of the stochastic differential equation

drt = (a − brt )dt + σdBt , t ⩾ 0,

where (Bt )t∈R+ is a standard Brownian motion and σ, a, b > 0 are positive
constants. Show that the exponential Xt := e rt satisfies a stochastic differ-
ential equation of the form

a − ebf (Xt ) dt + σg (Xt )dBt ,

dXt = Xt e

where the coefficients e

a and eb and the functions f (x) and g (x) are to be
determined.

Exercise 4.17 Exponential Vasicek model (2). Consider a short-term rate

interest rate process (rt )t∈R+ in the exponential Vasicek model:
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 Notes on Stochastic Finance

drt = (η − a log rt )rt dt + σrt dBt , (4.43)

where η, a, σ are positive parameters and (Bt )t∈R+ is a standard Brownian

motion.
a) Find the solution (Zt )t∈R+ of the stochastic differential equation

dZt = −aZt dt + σdBt

as a function of the initial condition Z0 , where a and σ are positive pa-

rameters.
b) Find the solution (Yt )t∈R+ of the stochastic differential equation

dYt = (θ − aYt )dt + σdBt (4.44)

as a function of the initial condition Y0 . Hint: Let Zt := Yt − θ/a.

c) Let Xt = e Yt , t ∈ R+ . Determine the stochastic differential equation
satisfied by (Xt )t∈R+ .
d) Find the solution (rt )t∈R+ of (4.43) in terms of the initial condition r0 .
e) Compute the conditional mean∗ E[rt |Fu ].
f) Compute the conditional variance

Var[rt |Fu ] := E[rt2 |Fu ] − (E[rt |Fu ])2

of rt , 0 ⩽ u ⩽ t, where (Fu )u∈R+ denotes the filtration generated by the

Brownian motion (Bt )t∈R+ .
g) Compute the asymptotic mean and variance limt→∞ E[rt ] and limt→∞ Var[rt ].

Exercise 4.18 Cox-Ingersoll-Ross (CIR) model. Consider the equation

√
drt = (α − βrt )dt + σ rt dBt (4.45)

modeling the variations of a short-term interest rate process rt , where α, β, σ

and r0 are positive parameters and (Bt )t∈R+ is a standard Brownian motion.
a) Write down the equation (4.45) in integral form.
b) Let u(t) = E[rt ]. Show, using the integral form of (4.45), that u(t) satisfies
the differential equation

u′ (t) = α − βu(t),

and compute E[rt ] for all t ⩾ 0.

c) By an application of Itô’s formula to rt2 , show that

drt2 = rt (2α + σ 2 − 2βrt )dt + 2σrt3/2 dBt . (4.46)

2
/2
∗
One may use the Gaussian moment generating function E[ e X ] = e α for X ≃
N (0, α2 ).

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 N. Privault

d) Using the integral form of (4.46), find a differential equation satisfied by

v (t) := E[rt2 ] and compute E[rt2 ] for all t ⩾ 0.
e) Show that

σ 2 −βt
ασ 2
2
Var[rt ] = r0 e − e −2βt + 1 − e −βt , t ⩾ 0.
β 2β 2

Problem 4.19 Itô-Tanaka formula. Let (Bt )t∈R+ be a standard Brownian

motion started at B0 ∈ R.
a) Does the Itô formula apply to the European call option payoff function
f (x) := (x − K )+ ? Why?
b) For every ε > 0, consider the approximation fε (x) of f (x) := (x − K )+
defined by

if x > K + ε,


 x−K


1


fε (x) := (x − K + ε)2 if K − ε < x < K + ε,

 4ε



0 if x < K − ε.


Plot the graph of the function x 7→ fε (x) for ε = 1 and K = 10.

c) Using the Itô formula, show that
wT
fε (BT ) = fε (B0 ) + fε′ (Bt )dBt (4.47)
0
1 
+ ℓ t ∈ [0, T ] : K − ε < Bt < K + ε ,


4ε
where ℓ denotes the measure of time length (Lebesgue measure) in R.
d) Show that limε→0 ∥1[K,∞) (·) − fε′ (·)∥L2 (R+ ) = 0.
e) Show, using the Itô isometry,∗ that the limit
1
[0,T ] : = lim
LK
ε→0 2ε
ℓ({t ∈ [0, T ] : K − ε < Bt < K + ε})

exists in L2 (Ω), and prove the Itô-Tanaka formula

wT 1
(BT − K )+ = (B0 − K )+ + 1[K,∞) (Bt )dBt + LK
[0,T ] . (4.48)
0 2
The quantity LK [0,T ] is called the local time spent by Brownian motion at
the level K.
hwT
2 i
∗
Hint: Show that lim E 1[K,∞) (Bt ) − fε′ (Bt ) dt = 0.
ε→0 0

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 Notes on Stochastic Finance

Problem 4.20 Lévy’s construction of Brownian motion. The goal of this

problem is to prove the existence of standard Brownian motion (Bt )t∈[0,1] as
a stochastic process satisfying the four properties of Definition 4.1, i.e.:
1. B0 = 0 almost surely,

2. The sample trajectories t 7→ Bt are continuous, with probability 1.

3. For any finite sequence of times t0 < t1 < · · · < tn , the increments

Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btn − Btn−1

are independent.

4. For any given times 0 ⩽ s < t, Bt − Bs has the Gaussian distribution

N (0, t − s) with mean zero and variance t − s.
The construction will proceed by the linear interpolation scheme illustrated
in Figure 4.10. We work on the space C0 ([0, 1]) of continuous functions on
[0, 1] started at 0, with the norm

∥f ∥∞ := Max |f (t)|
t∈[0,1]

and the distance

∥f − g∥∞ := Max |f (t) − g (t)|.
t∈[0,1]

The following ten questions are interdependent.

a) Show that for any Gaussian random variable X ≃ N (0, σ 2 ), we have
σ 2 2
P(|X| ⩾ ε) ⩽ √ e −ε /(2σ ) , ε > 0.
ε π/2

Hint: Start from the inequality E[(X − ε)+ ] ⩾ 0 and compute the left-
hand side.

b) Let X and Y be two independent centered Gaussian random variables

with variances α2 and β 2 . Show that the conditional distribution

P(X ∈ dx | X + Y = z )

of X given X + Y = z is Gaussian with mean α2 z/(α2 + β 2 ) and variance

α2 β 2 / ( α2 + β 2 ) .

Hint: Use the definition

P(X ∈ dx and X + Y ∈ dz )
P(X ∈ dx | X + Y = z ) :=
P(X + Y ∈ dz )
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 N. Privault

and the formulas

1 2 / (2α2 ) 1 2 2
dP(X ⩽ x) := √ e −x dx, dP(Y ⩽ x) := p e −x /(2β ) dx,
2πα2 2πβ 2

where dx (resp. dy) represents a “small” interval [x, x + dx] (resp. [y, y +
dy ]).
c) Let (Bt )t∈R+ denote a standard Brownian motion and let 0 < u < v. Give
the distribution of B(u+v )/2 given that Bu = x and Bv = y.

Hint: Note that given that Bu = x, the random variable Bv can be written
as
Bv = (Bv − B(u+v )/2 ) + (B(u+v )/2 − Bu ) + x, (4.49)
and apply the result of Question (b) after identifying X and Y in the
above decomposition (4.49).
d) Consider the random sequences

(0)

 Z (0) = 0, Z1






(1) (0)

Z (1) = 0, Z1/2 , Z1









(2) (1) (2) (0)


Z (2) = 0, Z1/4 , Z1/2 , Z3/4 , Z1








(3) (2) (3) (1) (3) (2) (3) (0)


Z (3) = 0, Z1/8 , Z1/4 , Z3/8 , Z1/2 , Z5/8 , Z3/4 , Z7/8 , Z1



.. ..


. .









(n) (n) (n) (n) (n)

Z (n) = 0, Z1/2n , Z2/2n , Z3/2n , Z4/2n , . . . , Z1









 Z (n+1)= 0, Z (n+1) , Z (n) , Z (n+1) , Z (n+1) , Z (n+1) , Z (n+1) , . . . , Z (n+1)



1/2n+1 1/2n 3/2n+1 2/2n 5/2n+1 3/2n 1

(n)
with Z0 = 0, n ⩾ 0, defined recursively as
(0)
i) Z1 ≃ N (0, 1),
(0) (0)
(1)Z0 + Z1
ii) Z1/2 ≃ + N (0, 1/4),
2
(1) (1) (1) (0)
(2) Z0 + Z1/2 (2) Z + Z1
iii) Z1/4 ≃ + N (0, 1/8), Z3/4 ≃ 1/2 + N (0, 1/8),
2 2
and more generally
(n) (n)
(n+1)
Zk/2n + Z(k+1)/2n
Z(2k+1)/2n+1 = + N (0, 1/2n+2 ), k = 0, 1, . . . , 2n − 1,
2
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 Notes on Stochastic Finance

where N (0, 1/2n+2 ) is an independent centered Gaussian sample with

(n+1) (n)
variance 1/2n+2 , and Zk/2n := Zk/2n , k = 0, 1, . . . , 2n .
(n)

In what follows we denote by Zt t∈[0,1] the continuous-time ran-
dom path obtained by linear interpolation of the sequence points in
(n)

Zk/2n k=0,1,...,2n .
(0)
(1)

Draw a sample of the first four linear interpolations Zt t∈[0,1] , Zt t∈[0,1] ,
(2) (3) (n)
Zt t∈[0,1] , Zt t∈[0,1] , and label the values of Zk/2n on the graphs for

k = 0, 1, . . . , 2 and n = 0, 1, 2, 3.
n

e) Using an induction argument, explain why for all n ⩾ 0 the sequence

(n) (n) (n) (n) (n)

Z (n) = 0, Z1/2n , Z2/2n , Z3/2n , Z4/2n , . . . , Z1

has same distribution as the sequence

B (n) := B0 , B1/2n , B2/2n , B3/2n , B4/2n , . . . , B1 .

Hint: Compare the constructions of Questions (c) and (d) and note that
under the above linear interpolation, we have
(n) (n)
(n)
Zk/2n + Z(k+1)/2n
Z(2k+1)/2n+1 = , k = 0, 1, . . . , 2n − 1.
2
f) Show that for any εn > 0 we have
(n+1) (n)
P Z (n+1) − Z (n) ⩾ εn ⩽ 2n P |Z1/2n+1 − Z1/2n+1 | ⩾ εn .



∞

Hint: Use the inequality

2n −1 n −1
2X
!
[
P Ak ⩽ P ( Ak )
k =0 k =0

for a suitable choice of events (Ak )k=0,1,...,2n −1 .

g) Use the results of Questions (a) and (f) to show that for any εn > 0 we
have
  2n/2 2 n+1
P Z (n+1) − Z (n) ∞ ⩾ εn ⩽ √ e −εn 2 .
εn 2π
h) Taking εn = 2−n/4 , show that
 
X
P Z (n+1) − Z (n) ∞
< ∞ = 1.
n⩾0

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 N. Privault

Hint: Show first that

X  
P Z (n+1) − Z (n) ∞
⩾ 2−n/4 < ∞,
n⩾0

and apply the Borel-Cantelli lemma. n o

(n)

i) Show that with probability one, the sequence Zt t∈[0,1] , n ⩾ 1 con-
verges uniformly on [0, 1] to a continuous (random) function (Zt )t∈[0,1] .

Hint: Use the fact that C0 ([0, 1]) is a complete space for the ∥ · ∥∞ norm.
j) Argue that the limit (Zt )t∈[0,1] is a standard Brownian motion on [0, 1]
by checking the four relevant properties.

Problem 4.21 Consider (Bt )t∈R+ a standard Brownian motion, and for any
n ⩾ 1 and T > 0, define the discretized quadratic variation
n
(n)
X
QT := (BkT /n − B(k−1)T /n )2 , n ⩾ 1.
k =1
h i
(n)
a) Compute E QT , n ⩾ 1.
(n)
b) Compute Var[QT ], n ⩾ 1.
c) Show that
(n)
lim QT = T,
n→∞

where the limit is taken in L2 (Ω), that is, show that

(n)
lim ∥QT − T ∥L2 (Ω) = 0,
n→∞

where q
(n)  (n)
2 
QT − T L2 ( Ω )
:= E QT − T , n ⩾ 1.

d) By the result of Question (c), show that the limit

wT n
X
Bt dBt := lim (BkT /n − B(k−1)T /n )B(k−1)T /n
0 n→∞
k =1

exists in L2 (Ω), and compute it.

Hint: Use the identity

1 2
(x − y )y = (x − y 2 − (x − y )2 ), x, y ∈ R.
2

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 Notes on Stochastic Finance

e) Consider the modified quadratic variation defined by

n
e (n) : =
X
Q T (B(k−1/2)T /n − B(k−1)T /n )2 , n ⩾ 1.
k =1

(n)
Compute the limit limn→∞ Q e
T in L ( Ω ) by repeating the steps of Ques-
2

tions (a)-(c).
f) By the result of Question (e), show that the limit
wT n
X
Bt ◦ dBt := lim (BkT /n − B(k−1)T /n )B(k−1/2)T /n
0 n→∞
k =1

exists in L2 (Ω), and compute it.

Hint: Use the identities

1 2
(x − y )y = (x − y 2 − (x − y )2 ),
2
and
1 2
(x − y )x =(x − y 2 + (x − y )2 ), x, y ∈ R.
2
g) More generally, by repeating the steps of Questions (e) and (f), show that
for any α ∈ [0, 1] the limit
wT n
X
Bt ◦ dα Bt := lim (BkT /n − B(k−1)T /n )B(k−α)T /n
0 n→∞
k =1

exists in L2 (Ω), and compute it.

h) Comparison with deterministic calculus. Compute the limit
n  
X T T T
lim (k − α ) k − (k − 1)
n→∞ n n n
k =1

for all values of α in [0, 1].

Exercise 4.22 Let (Bt )t∈R+ be a standard Brownian motion generating the
information flow (Ft )t∈R+ .
a) Let 0 ⩽ t ⩽ T . What is the probability distribution of BT − Bt ?
b) From the answer to Exercise S.4-(c), show that
r  
T − t −B 2 /(2(T −t)) Bt
E[(BT )+ | Ft ] = e t + Bt Φ √ ,
2π T −t

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This version: September 16, 2022
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