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SDE Intro

The document provides 3 examples of applying Ito's formula to stochastic differential equations (SDEs): 1) Computing E[Wt4] by applying Ito's formula to Wt4, resulting in E[Wt4] = 3t2. 2) Applying Ito's formula to Wt2 to compute the integral from 0 to t of Ws dWs, resulting in Wt2 - t/2. 3) Applying Ito's formula to the geometric Brownian motion SDE dS(t) = St[μdt + σdWt] to compute E[St/S0], resulting in eμt.

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76 views

SDE Intro

The document provides 3 examples of applying Ito's formula to stochastic differential equations (SDEs): 1) Computing E[Wt4] by applying Ito's formula to Wt4, resulting in E[Wt4] = 3t2. 2) Applying Ito's formula to Wt2 to compute the integral from 0 to t of Ws dWs, resulting in Wt2 - t/2. 3) Applying Ito's formula to the geometric Brownian motion SDE dS(t) = St[μdt + σdWt] to compute E[St/S0], resulting in eμt.

Uploaded by

Atul Rai
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Introductory Problems in SDE

Ophir Gottlieb

3/21/2007

1. Compute E[Wt 4 ] by applying Ito’s formula to Wt 4 .

1
dWt4 = 4Wt3 dWt + · 4 · 3 · Wt2 (dWt )2 ; (Wt4 (0) = 0) (1)
2

= 4Wt3 dWt + 6Wt2 dt

Integrate:

Z t Z t
Wt4 =4 Ws3 dWs +6 Ws2 ds + 0
0 0

Take Expectations and apply Fubini to move the expectation inside the integral:

Z t
E[Wt4 ] =0+6 E[Ws2 ]ds
0

Z t
=6 sds
0

E[Wt4 ] = 3t2 (2)

2. Apply Ito’s formula to Wt 2 to compute:

Z t
WS dWs (3)
0

1
dWt2 = 2Wt dWt + · 2 · dt; (Wt2 = 0)
2
Integrate:

1
Z t Z t
Wt2 =2 Ws dWs + ds
0 0

Z t
1 1
Ws dWs = Wt2 − t (4)
0 2 2

3. Apply Ito’s formula to compute E[St /S0 ] from Geometric Brownian Motion defined as:

dS(t) = St [µdt + σdWt ] (5)


S0 = s (6)

In order to solve for E[St /S0 ] we will apply Ito to dlnSt :

1 1 1
dlnSt = dSt − dS 2
St 2 St2 t

1 1 1 2 2
= St [µdt + σdWt ] − S [σ dWt2 ]
St 2 St2 t

1
dlnSt = µdt + σdWt − σ 2 dt
2

Then we integrate and apply the fundamental theorem of calculus to get:

1
lnSt − lnS0 = (µ − σ 2 )t + σWt
2

1 2 )t+σW
St = S0 e(µ− 2 σ t

Take the expectations:


1 2 )t+σW
E[St ] = E[S0 e(µ− 2 σ t
]

Recall the general formula for the expected value of a Gaussian random variable:

1 2
E[eX ] = E[eµ+ 2 σ ]

where X has the law of a normal random variable with mean µ and variance σ 2 . We know that
Brownian Motion ∼N (0, t). Applying the rule we get:

2
1 2 )t
E[St ] = S0 e(µ− 2 σ · E[eσWt ]

1 2 )t
E[St /S0 ] = e(µ− 2 σ · E[eσWt ]

E[St /S0 ] = eµt (7)

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