An Introduction to Stochastic Calculus through theory and exercises Paolo Baldi Universita di Roma - Tor Vergata Spring 2016Table of contents Introduction 1 0. Elements of probability 1 Probability spaces, random variables (02 Variance, covariance, law of at, (03 Independence, product measure 04 Probabilities on (05 Convergence of probabilities and random variables (04 Characteristi Functions 0.7 Gaussian laws 08 Simulation (09 Measure theoretic arguments 1. Stochastic processes a LL General facts a 1.2. Kolmogorov's continuity theorem 24 1.3 Constretion of stochastic processes 2 2. Brownian motion 31 2.1 Definition and general facts u 2.2. ‘The law of a continuous process, Wiener measure %6 233. Regularity ofthe paths a 214 Asymptotcs ey 2.5, Stopping times “4 2.6 ‘The stopping theorem a 2.3. ‘The simulation of Brownian motion 30 3. Conditional probability 33 3.4 Conditioning 3 32 Conditional expectations Ey 33 Conditional laws 63 34 Conditional lass of Gaussian vectors ot 35. The augmented Brownian filtration 6table of contents 4, Martingales 41 Definitions and general facts 42. Discrete time martingales 43. Discrete time martingales: as. convergence 444 Doob’s inequality; L? convergence, the p > | case 45 Uniform integrability and convergence iL! 44 Continuous time Martingales 4.7 Complements: Laplace transform 5. Markov Processes 5.1, Definitions and general facts 5.2. The Feller and strong Markov properties 53. Canonical processes 54 Semigroup associated toa transition function, diffusions 6. The stochastic integral 6.1 Inoduetion 6.2 Elementary processes 6.3 The stochastic integral 64 The martingale property 65 The stochastic integral im Mz, 64 Local mantingales 7. Stochastic calculus TLL to's formula 7.2. Application: exponential martingales 73. Application: L? estimates 74 The multidimensional stochastic integral 7S. Accase study: recurrence of the multidimensional Brownian mation 8. Stochastic Differential Equations 8.1. Definitions 82. Examples 83. Existence for Lipschitz continuous coeicients 84. Localization and existence for locally Lipschitz coefficients B5_ Uniqueness inlaw 86 The Markos propery 8.7. L? bounds and dependence on the initial dat 88 Square root of a matrix field and solution of the problem of diffusions 889 The simulation of diffusion processes 9. PDE problems and diffusions ‘9.1. Representation ofthe solutions of a PDE problem 92. The Dirichlet problem 9.3. Parabolic equations 94. The Feynman-Kae formula 9.5. The density of he transition function, the backward equation 9.46 Construction of the solutions ofthe Dirichlet problem o 0 n 6 7 » 93 93 loa 107 113 3 na 116 12 126 133 133 140 144 159 139) m3table of contents i 10. More stochastic calculus 213 10.1 Girsanov's Theorem 213 10.2. The Cameron-Martin formula 233 103 ‘The maringales ofthe Brownian filtration 235 104 Equivalent probability measures, 229 11. An application: finance 231 ILL. Stocks and options 231 112 Trading strategies and arbitrage 232 113. Equivalent martingale measures 235 11.4, Replicating strategies and market completeness 237 115. The generalized Black-Scholes models 239 11.6 Pricing and hedging inthe Black-Scholes model Das ILT The standand Black and Seholes model 250 EXERCISES Exorcises for chaprer 0 Exercises for chapter | Exercises for chapter 2 xereises for chapter 3 Exercises for chapter 4 Exotcises for chapier 5 Exercises for chapter 6 Exercises for chapter 7 Exeteises for chapter 8 Exercises for chapter 9 Exctcises for chapier 10 Exoreses for chaprer 11 SOLUTIONS e313 References 487 Index 459Introduction ‘The aim of this book isto introduce to Stochastic Calculus, This isa theory that has been developed starting from the middle ofthe lst century, inorder to construct and investigate stochastic processes, Stochastic Calculus is therefore a io! that s required in many applications (contol, finance.) “whenever one needs fo devise random model appropriate to investigate a particular application. ‘The goal oF his book isto teach the main points ofthis theory an to tain students othe correct. use of them. This last goal is pursued in particular with the help of a certain number of exercises ‘that are provided together with their solution. Inthe solutions the use ofthe main points of the theory is panicularly highlighted, so that theory and exercises ste hardwired, ‘The contents ofthis book re probably suitable fora 2-semester teaching atthe Boundary between ‘undergraduate and graduate level Fortis reason many important chapters of stochastic caleulus are missing a stochastic integral “with respect toa continuous square integrable martingale, local times, weak existence theory of SDE’s,e.. The material ofthis book is however sulicient in oder to deal with many’ applications and am also confident thatthe student who has been working this book is ina good condition in ‘order 1 approach more advanced chapters ofthe theory. Chapter 0 contains a recollection of basic important facts that are usually developed in any first course in Probability with measure theory. Chapters Ito 5 introduce the general facts concern- ing stochastic processes (Brownian motion, martingales, Markov processes), whereas chapter 6 introduces the tool of stochastic intgration with respect to the Brownian motion, which is the starting point of the sequel: To's formula and applications in chapter 7, stochastic differential {equations (SDE) in chapter 8. Chapter 9 develops the link between SDE’s and partial differential problems and chapter 11 contains an inttoduetion to mathematical finance. Chapter 10 develops inher elements of stochastic calculus (Girsanov's theorem and martingale representations) that are neoded in chapter 110 Elements of probability 0.1 Probability spaces, random variables A measurable space is a couple (E.8) where + Eisasel # Gis ao-algebra of subsets of E. A probability space isa wiple (2, P) where * Disaset, is ao-algebra of subsets of & (ie. (@, SF isa measurable space) ++ Pisa positive measure on 3 such that PC) = 1 The elements of ate called events, Pa probability (measure), If (Q, F, P) is probability space and (E, €) a measurable space, a random variable (ex.) is 3 smeastrable Funetion X : > B, is. such that X-1(A) € whenever A c'6. Itis a real random variable if E = Rand & = CB) (Borel sets of B. Fora real rv. X on (8, , P) we can speak of integral. IF X is integrable we shall usually write ELX1 instead of f X dP. ELX isthe mathematical eypectaion. Sometimes also the terms mean for mean value are use TEX = (Xie, Nw) is CB", E))-valued we shall speak as of m-dimensional evs and, i the components X; are integrable, we define FIX] = FG bs EXD ‘We say that two rvs X, ¥ are equivalent if LX = Y) ‘The spaces LP. 1 = p < +20, and L® ave defined as usually as well as the norms |X\jp ‘and Xj. Recall in particular that L? is the set of equivalence classes of ev's X such that [Mp = BLX 1" < +50, Ibis worth to point out that L? is a set of equivalence class and not of 1.¥s; even if often, inorder to simplify the statements, we shall identify a. and its equivalence RU (yoo) lower semi-continuous convex function; then the Fv. (X) is lower semi-integrable and on FOU] = BED, (possibly one or hoth sides inthe previous inequality can be equal to + Holder's inequality. Let Z. a+ B=1.Then ‘be real positive rv. and a, f posi 2) BIZ" Ww] < BIZELWIP Fron (0.2) follows Dat Xs F a wal vv and po ptve ner sac hat 4 then 3) IXY] < BUX MPE[ Which also goes under the name of Holder's inequality “Minkowsk's inequality. Lat X,¥ be weal 8, p = Vthen 4 1+ Py 1X +1 lp -Minkowskis inequality, in particular, implies that LP, p >I, isa veotor space. I p > q Jensen's inequality applied tothe continuous convex Fanetion (x) = nl?" gives xup = BUX [OEX|] > OEENXTT Exieye? and therefore taking the pth root, os) WX > WX y In paticular if p = 4. LP cL 0.2. Variance, covariance, law of a rv. Let X be areal square imegrable rv. (Le. belonging to L2), Is variance isthe quantity Var(X) = E(O¢ — ELXD?] = EL?) EXP Ha > 0,the quantity f|x¢;(x) isthe absolute moment of order a of. Weis. a positive integer the quantity / x je(d). it exists init, isthe moment of order a of 10.2Variance, covariance, awofary. 5 ‘Markov inequality, For every 8 > 0, > Owe have a _ EUXV =o Tis apparent from is definition that the variance of ar. is vo much larger as X takes values far from its mean E[X], This imitive Tact is made precise by the following 06) PURI =a) ‘Chebyshev inequality. Let X © L2, Then for every a > 0 vari) PUX -E[X)| = @) = ‘This iva very Important inequality. It is of eourse a particular ease ofthe Markov inequality “The covariance, Cov(X, ¥),of two rx’ X and ¥ is defined as CovtX, ¥) = FLX] — ELUTED IeCov(X, ¥) =0, X and ¥ ate said to be uncorrelated. Let X be ary. with values in the measurable space (F,). It is easy to see that the s sx defined on € as function x(a) = POX"AD) isitset'a probability measure (on). 21s the faw of X. Itis the image (or pullback) of P through 1X. The following proposition provides a formula for the computation of integrals with respeet 10 fan image law. We shall make use oft all along, (Proposition O41 Let X= (2,9, P) > (F,€) bea tv, sy the law of X. Then a measurable function f : (E, ©) + (B, (B)) is jry-inegrable if and only if f(X) is P-integrable and shen we have In particular, if X is areal ev. we have tins fanaa, Hixel= f weeds) “Therefore X € L? if and only iits law has a finite absolute moment of order p By the notations X ~ 1, X-~ ¥ we shall mean that X fas law ye and that X and ¥ have the same law respectively Given two probabilities P and Q on (9, 5), we say that Q is absolutely continuous wi to Pi P(A) = 0 implies Q¢A) = 0. This relation is denoted by P > Q. The Radon- ‘Theorem states that if P > Q then there exists rv. Z > 0 such that respect a= f Zar(the converse is obvious). P and Q are said to be equivalent if both P > Q and Q.> P. In other words, two probabilities are equivalent i and only if they have the same negligible events, Recall that © is negligible if PW) = 0. Conversely P and Q are said to be orthogonal if here exists fan event such that P(A) = L and Q(A) = 0. If P and Q are orthogonal, of course, itis not possible for one of them to be absolutely continuous with respect to the other one 0.3 Independence, product measure 1, @ ave o-algcbras of evens of F let us denote by € v8 the smallest o-algebra containing both and d, This is well defined: acwally its immediate that the intersection of any nonempty family of algebras is still a o-algebra. We ean therefore consider the family of all o-algebras containing both € and 8 This is non empty as ceainly P(E) (all subsets of) is one of them ‘Then € v€ will be the intersection ofthis family of e-algebras, This aument wil e used fem now on to define o-algbras as “the smallest algebra sch that..." Let Xs (@,,P) > (E,) bear, and denote by o(X) the o-algebra generated byX. i.e the smallest sub-a-aigebra of F wih respect wo which X is measurable. Iti easy to se that o(X) is formed by the events oF of he for X—!A’) with A’ e 6. The following lemma characterizing {he real o(X)-measurable ras is often very useful {emma 02 (Boobs measly ererion) Lt X=(@.5.P) = (E-) Beats. Then en ‘o(X)-measurable ev, is of the form f(X), where f° (E, 8) — (R, B(R) isa measurable fad ‘The r.¥'s X;,...+ Xe taking values respectively in (Ey... (Ey. 8) ae sal to be indepen dent if, for every Ay €'81y..-1 Ay © Ewes P(X) © Aj eaes Xn © Aly) = PO © AY) Py € Ay) ‘The events Ai... Aw € ate said to be independent if and only if PUAN, 1. Ai) = PLAG)- PCAL) for every choice of 1 = f= mand of 1 < iy < iz <... © €» is fixed, the wo measures on F, Apes PAY Aa) and Aye P(A)PCAD) ‘ae finite and coincide on €; they have also the same total mass (= P(Aa)). By Carathéodory’s| criterion, Theorem 04, they coincide on F; hence (08) is verified for every A, © I, Az © 42. By a repetition ofthis argument with Ay © 3; fixed, (0.8) holds for every Ay €F.A2 € Fz, ie. 9, and ¥; are independent. ‘A case of particular interest appears when F, =a(X, X €J),Fa—a(¥, ¥ ¢ #) are a-algebras generated by families # and J of v's respectively. If we assume that every X is independent of every ¥ € Jj is this enough to guarantee the independence of F and J? ‘Thinking about this abit i is clear thatthe answer is negative, as even in elementary classes in probability one deals with examples of e's that are independent pairwise but not globally. It right therefore happen thatthe rv.’s Xy and Y are independent, as well as X3 and ¥, whereas the couple (X, Xa) is nor independent of ¥, (Xy,X2) = ¥ and (Y] = F provides therefore a ‘counterexample.It however we assume that for every choice of X,..-.%_ € and Vis... Ye € J the tv's (Xi, Ma) and (Foy Fa) af independent, then necessarily the two generated a-algebras F ‘and 3 are independent ‘Actually, let us denote by (£,,) and (G),°6)) the measurable spaces where the 1.8 Xi. ¥) take the their values respectively. Let us consider the classy ofthe events of the form [Xe Aj e Xe Ab for some nt = 1. Xie Xn € 5. Ay 681s +25 Ay © by and similarly define as, the class of the ‘events ofthe form, 6 Bi Tee forsomek = 1, Yis---.¥s €$. Bl © Gig... Bl €%e. One verities immediately that 6) and'€3 are stable with respect finite inteseetions and generate o(X, X 9) and a(Y, ¥ © 9) respectively Moreover (0.8) is satisfied for every Ay c€;, Az ©. Actually as the 978 (X)....5 Xx) and (,-++. Yi) are assumed to be independent, the two events AY =) Aigo Xu © AN) = (Ko Xa) © A CAG) Aa = 1, € Bloons Ye © BY) =U oeee Ye) © BY x22 BU ae independent. Therefore, by the previous criterion, F and Fz are independent. In other words {and JF ave independent i and only ifthe rx. X1,--.,% and Ys...» Yk ate independent for every choice of nk and of X),...,Xqe eS and Yy,..-.%e eI: ‘We sll see later that if thers of # and § form together a Gaussian family, then this eriterion ‘ean be considerably simplified. The following result willbe of constant use in the sequel ‘ively on the measurable spaces (Ey, €)). able function such that one atleast of the| Theorem 0:7 Pubiniy Let jay 2 measures resp (Ey, €) and et fs Ey x By > Ba, @ meas following is tue 1) is integrable with respect 0 5 @ 2 2) is positive Then 4) the funetions 09) nie fsouoe som f senna are respectively 6y-measurable and 3-measurable. »