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CQF January 2022 M1L4 Exercises

1. This document discusses stochastic calculus concepts including Itô's lemma, Brownian motion, stochastic differential equations, and stochastic integrals. 2. Itô's lemma is used to derive SDEs for various functions of Brownian motion such as (Wt)n, exp(Wt), log(Wt), sin(Wt)+cos(Wt), and aWt where a is a constant. 3. Stochastic integrals are evaluated for functions of Brownian motion and time, and properties such as linearity of integration are demonstrated. 4. A method of reducing a linear parabolic PDE to the heat equation using an exponential substitution is presented.

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25 views2 pages

CQF January 2022 M1L4 Exercises

1. This document discusses stochastic calculus concepts including Itô's lemma, Brownian motion, stochastic differential equations, and stochastic integrals. 2. Itô's lemma is used to derive SDEs for various functions of Brownian motion such as (Wt)n, exp(Wt), log(Wt), sin(Wt)+cos(Wt), and aWt where a is a constant. 3. Stochastic integrals are evaluated for functions of Brownian motion and time, and properties such as linearity of integration are demonstrated. 4. A method of reducing a linear parabolic PDE to the heat equation using an exponential substitution is presented.

Uploaded by

adds.mahmood786
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Stochastic Calculus and Itô’s lemma

Throughout this problem sheet, you may assume that Wt is a Brownian Mo-
tion (Wiener Process) and dWt is its increment; and W0 = 0: SDE is Stochastic
Di¤erential Equation.

1. Let be a random variable which follows a standardised normal distribution,


i.e. N (0; 1) :
Calculate the
p expected value and variance given by E [ ] and V [ ] ; in turn,
where = dt : dt is a small time-step. Note: No integration is required.

2. Consider the following examples of SDEs for a di¤usion process G. 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
dy
b. = (A + By) dt + (Cy) dWt
y
c. dS = ( S)dt + dWt + 4dS

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

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

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

show that we can write

1
a. Z t Z t
1 3
W dW = Wt4
3
W 2d
0 4 2 0

b. Z t Z t
dW = tWt W d
0 0
c. Z t Z t
1 1
(W + ) dW = Wt2 + tWt W + d
0 2 0 2

5. Consider the linear parabolic partial di¤erential equation

@u @2u @u
= 2
+a + bu;
@t @x @x
for the function u (x; t) ; where a and b are constants. By using a substitution
of the form
u (x; t) = e x+ t v (x; t) ;
and suitable choice of and ; show that the PDE can be reduced to the heat
equation
@v @2v
= :
@t @x2

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