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CQF Exercise

The document contains exercises related to Stochastic Differential Equations (SDEs) and Itô's lemma, focusing on various functions of Brownian motion and their corresponding SDEs. It includes tasks such as deriving SDEs for specific functions, exploring conditions for zero drift in certain functions, and applying Itô's lemma to demonstrate properties of martingales. Additionally, it covers the moments of Brownian motion and conditions for random walks to be martingales or submartingales.

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aman
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© © All Rights Reserved
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5 views

CQF Exercise

The document contains exercises related to Stochastic Differential Equations (SDEs) and Itô's lemma, focusing on various functions of Brownian motion and their corresponding SDEs. It includes tasks such as deriving SDEs for specific functions, exploring conditions for zero drift in certain functions, and applying Itô's lemma to demonstrate properties of martingales. Additionally, it covers the moments of Brownian motion and conditions for random walks to be martingales or submartingales.

Uploaded by

aman
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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CQF Module 1.

3 Exercises

Throughout this problem sheet, you may assume that Wt is a Brownian Motion (Weiner Process) and dWt
is its increment; and W0 = 0:

1. Use Itô’s lemma to obtain a SDE for each of the following functions

(a) y (Wt ) = exp (Wt )


(b) g (Wt ) = ln Wt
(c) h (Wt ) = sin Wt + cos Wt
(d) f (Wt ) = aWt ; where the constant a > 1
(e) f (Wt ) = (Wt )n

2. Using the formula below for stochastic integrals, for a function F (Wt ; t) ;
Z t Z t
@F @F 1 @2F
dWt = F (Wt ; t) F (W0 ; 0) + d
0 @Wt 0 @ 2 @W 2

show that we can write


Z t Z t
a. Wt3 dW = 41 W 4 (t) 3
2
W 2d
0 0
Z t Z t
b. dW = tWt W d
0 0
Z t Z t
1 1
c. (W + ) dW = 2
Wt2 + tWt W + 2
d
0 0

1
CQF Module 1.4 Exercises
Stochastic Di¤erential Equations and Itô’s Lemma

Throughout this problem sheet, you may assume that Wt or W (t) is a


Brownian Motion (Weiner Process) and dWt (or dW (t)) is its increment. W0 =
0:

1. The change in a share price S (t) satis…es

dS = A (S; t) dWt + B (S; t) dt;

for some functions A and B: If f = f (S; t) ; then Itô’s lemma gives the
following stochastic di¤erential equation

@f @f 1 @2f @f
df = +B + A2 2 dt + A dWt :
@t @S 2 @S @S

Can A and B be chosen so that a function g = g (S) has a change which


has zero drift, but non-zero di¤usion? State any appropriate conditions.

2. Show that F (Wt ) = arcsin (2aWt + sin F0 ) is a solution of the stochastic


di¤erential equation

dF = 2a2 (tan F ) sec2 F dt + 2a (sec F ) dWt ;

where F0 and a is a constant.


3. Show that
Z t Z t
W 2( )
W( ) 1 e dW ( ) = F (W (t)) + G (W (t)) d :
0 0

where the functions F and G should be determined.


4. Consider a two factor model in which the stock price dynamics St ; follows
Geometric Brownian Motion and the stock variance vt is itself stochastic
and follows a square root process
p
dSt = St dt + vt St dW1 (t);
p
dvt = (vt v)dt + vt dW2 (t):
The two processes have a correlation coe¢ cient , i.e.

dW1 (t)dW2 (t) = dt

The parameters ; ; v and are all constant. Let F = F (t; St ; vt ):


Using Itô, consider the SDE for dF and integrate over [0; t] to obtain an
expression for F (t; St ; vt ):

1
Module 1 Further Exercises in SDEs 2015

Throughout this problem sheet, you may assume that Wt is a Brownian Motion (Weiner Process) and dWt
is its increment. You may assumeW0 = 0: SDE(s) refers to Stochastic Di¤erential Equation(s).

1. Let be a random variable which follows


p a standardised normal distribution, i.e. N (0; 1) :
Calculate E [ ] and V [ ] where = dt : dt is a small time-step. Note: No integration is
required.
2. Consider the following examples of Stochastic Di¤erential Equations (SDE); Write these in standard
form, i.e. dG = A(G; t)dt + B(G; t)dWt . Give the drift and di¤usion for each case.
p
(a) df + dWt dt + 2 tf dt + 2 f dWt = 0 where f = f (Wt ; t)
dy
(b) = (A + By) dt + (Cy) dWt where y = y (Wt ; t)
y
(c) dS = ( S)dt + dWt + 4dS
3. Show that Z Z
1 1
(1 t) cos Wt dWt = (a + bt) sin Wt dt;
0 0
and determine the values of a and b:
4. The function V (S; t) = log (tS), where S evolves according to the SDE dS = Sdt + SdWt ; show
that

1 1 2
dV = + dt + dX:
t 2

5. Show that
G = exp t + aeWt
is a solution of the stochastic di¤erential equation
dG (t) = G 1 + 21 (ln G t) + 21 (ln G t)2 dt + G (ln G t) dWt

6. Consider the stochastic di¤erential equation


dG (t) = a (G; t) dt + b (G; t) dWt :
Find a (G; t) and b (G; t) where
(a) G (t) = Wt2
(b) G (t) = 1 + t + eWt
(c) G (t) = ft Wt ; where ft is a bounded and continuous function.
7. Use Itô’s lemma to show that
d (cos Wt ) = (cos Wt ) dt + (sin Wt ) dWt
&
d (sin Wt ) = (sin Wt ) dt (cos Wt ) dWt
and determine the constants & :

1
CQF Module 2, Session 5: Martingales I
Exercises
CQF

1. Use Itô’s formula to determine whether the following are martingales:

(i) Y (t) = e1/2t cos X(t);


(ii) Y (t) = eαt sin X(t) for some constant α with 0 < α < 1. Does
the answer depend on the value of α?
(iii) Y (t) = (X(t) + t) exp − 21 t − X(t) .


2. Moments of the Brownian Motion X(t) - Consider the function


mn (t) defined as

mn (t) = E[X n (t)], n = 1, 2, . . . (1)

where X(t) is a standard Brownian motion.

Applying Itô’s formula, show that:


Z t
1
mn (t) = n(n − 1) mn−2 (s)ds (2)
2 0

for n = 2, 3, . . .

Deduce from (2) that


m4 (t) = 3t2 (3)

compute m6 (t).

3. Let Xn , n = 1, . . . be i.i.d random variables where P (Xn = 1) = p and


P (Xn = −1) = 1 − p. You can think of Xn as being the nth coin
toss in a sequence. Let Sn , n = 1, . . . be the associated random walk,
defined as

Sn = X1 + X2 + . . . + Xn (4)

1
Sn can be viewed as the P&L of the entire coin toss game. We also
introduce the filtration Fn generated by the Xn and such that Xn is
Fn -adapted.

Find conditions under which the random walk is (a) a martingale, (b)
a submartingale (c) a supermartingale.

4. Let Yt = Xt4 where Xt is a Brownian motion. Using Itô’s lemma, ex-


press the SDE for Yt . Then, deduce the stochastic integral for Yt over
[0, T ]. Finally, deduce from the stochastic integral an expression for
E[Yt ].

5. Discrete Time Martingale: Let Y1 , . . . , Yn be a sequence of inde-


pendent random variables such that E[Yi ] = 0 for i = 1, . . . , n. Let Fn
be the filtration generated
P by the sequence Y1 , . . . , Yn . Consider the
random variable Sn = ni=1 Yi . Prove that Sn is a martingale for all n.

Reminder - proving that a process Sn is a martingale involves proving


that E[|Sn |] < ∞ and that E[Sn+1 |Fn ] = Sn

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