Bernt Oksendal Stochastic Differential Equations An Introduction with Applications Sixth Edition With 14 Figures & SpringerBernt Oksendal Department of Mathematics University of Oslo Box 1053, Blindern 0316 Oslo, Norway e-mail: [email protected] ‘Cover Art: ‘The front cover shows five sample paths X;(w1), Xe(wa), Xe(ws), Xe(wa) and X+(ws) of a geometric Brownian motion X;(w), ie. of the solution of a (1- dimensional) stochastic differential equation of the form Dt ota WOX £20; Xo=e where z,r and a are constants and W; = W(w) is white noise, This process is often used to model “exponential growth under uncertainty”, See Chapters 5, 10, 11 and 12. ‘The figure is a computer simulation for the case = value of Xe, B[X¢] = exp(t), is also drawn. Courtesy of Jan Ubse, Norwegian School of Economics and Business Administra- tion, Bergen. Library of Congress Cataloging in-Publiation Data ‘@rsendal,B. K. (Bernt Karsten), 1945- cist ite qutn an intron wit apo / Bart Ohana — hed. pcm ~ (Universite) Includes bibliographical reforences and index. ISBN 3-540-04758-1 (softcover: alk paper) 1, Stochastic differential equations, I Tile. 0.6. The mean (Q4274.23.047 2003 5192-8621 2003052637 ISBN 3-540-04758-1 Springer-Verlag Berlin Heidelberg New York Mathematics Subject Classification (2000): 60H10, 60635, 60640, 60644, 93E20, 60145, 60]25 This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broedcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use mast always be obtained from Springer-Verlag. Violations are liable for prosecution ‘under the German Copyright Law. ‘Springer-Verlag Berlin Heidelberg New York ‘a member of BertelsmannSpringer Science+Business Media GmbH butpuhwwespringer de © Springer-Verlag Berlin Heidelberg 1985, 989, 1992, 995, 1998, 2003 Printed in Germany ‘The use of general descriptive names, registered names, trademarks, etc. inthis publication oes not imply, even inthe absence ofa specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Cover design: design & production GmbH, Heidelberg ‘Typeset by the authors using a BIRX macro package Printed on acid-free paper ausuick 54921To My Family Eva, Elise, Anders and KarinaWe have not succeeded in answering all our problems. The answers we have found only serve to raise a whole set of new questions. In some ways we feel we are as confused as ever, but we believe we are confused on a higher level and about more important things. Posted outside the mathematics reading room, ‘Troms¢ University sienna nner tenets net iPreface to the Sixth Edition ‘This edition contains detailed solutions of selected exercises. Many readers have requested this, because it makes the book more suitable for self-study. At the same time new exercises (without solutions) have been added. They have all been placed in the end of each chapter, in order to facilitate the use of this edition together with previous ones. Several errors have been corrected and formulations have been improved. ‘This has been made possible by the valuable comments from (in alphabetical order) Jon Bohlin, Mark Davis, Helge Holden, Patrick Jaillet, Chen Jing, Natalia Koroleva, Mario Lefebvre, Alexander Matasov, Thilo Meyer-Brandis, Keigo Osawa, Bjgrn Thunestvedt, Jan Ubge and Yngve Willassen. I thank them all for helping to improve the book. My thanks also go to Dina Haraldsson, who once again has performed the typing and drawn the figures with great skill. Blindern, March 2003 Bernt OksendalPreface to the First Corrected Printing, of the Fifth Edition ‘The main corrections and improvements in this corrected printing are from Chapter 12. I have benefitted from useful comments from a number of peo- ple, including (in alphabetical order) Fredrik Dahl, Simone Deparis, Ulrich Haussmann, Yaozhong Hu, Marianne Huebner, Carl Peter Kirkebg, Niko- lay Kolev, Takashi Kumagai, Shlomo Levental, Geir Magnussen, Anders @ksendal, Jiirgen Potthoff, Colin Rowat, Stig Sandnes, Lones Smith, Set- suo Taniguchi and Bjorn Thunestvedt. I want to thank them all for helping me making the book better. I also want to thank Dina Haraldsson for proficient typing. Blindern, May 2000 Bernt OksendalPreface to the Fifth Edition The main new feature of the fifth edition is the addition of a new chapter, Chapter 12, on applications to mathematical finance. I found it natural to include this material as another major application of stochastic analysis, in view of the amazing development in this field during the last 10-20 years. Moreover, the close contact between the theoretical achievements and the applications in this area is striking. For example, today very few firms (if any) trade with options without consulting the Black & Scholes formula! ‘The first 11 chapters of the book are not much changed from the previous edition, but I have continued my efforts to improve the presentation through- out and correct errors and misprints. Some new exercises have been added. Moreovet, to facilitate the use of the book each chapter has been divided into subsections. If one doesn’t want (or doesn’t have time) to cover all the chapters, then one can compose a course by choosing subsections from the chapters. The chart below indicates what material depends on which sections. Chapters 1-5 |—-{ caners Chapter 8 |Segtion|—] Chapter 7 Fp] | $5400 Chopier 9 ‘Chapter 10 ‘Chapter 11 For example, to cover the first two sections of the new chapter 12 it is recom- mended that one (at least) covers Chapters 1-5, Chapter 7 and Section 8.6.XI Preface to the Fifth Edition Chapter 10, and hence Section 9.1, are necessary additional background for Section 12.3, in particular for the subsection on American options. In my work on this edition I have benefitted from useful suggestions from many people, including (in alphabetical order) Knut Aase, Luis Al- varez, Peter Christensen, Kian Esteghamat, Nils Christian Framstad, Helge Holden, Christian Irgens, Saul Jacka, Naoto Kunitomo and his group, Sure Mataramvura, Trond Myhre, Anders Oksendal, Nils Ovrelid, Walter Schacher- mayer, Bjarne Schielderop, Atle Seierstad, Jan Ubge, Gjermund Vage and Dan Zes. I thank them all for their contributions to the improvement of the book. Again Dina Haraldsson demonstrated her impressive skills in typing the manuscript ~ and in finding her way in the LATpX jungle! I am very grateful for her help and for her patience with me and all my revisions, new versions and revised revisions ... Blindern, January 1998 Bernt OksendalPreface to the Fourth Edition In this edition I have added some material which is particularly useful for the applications, namely the martingale representation theorem (Chapter IV), the variational inequalities associated to optimal stopping problems (Chapter X) and stochastic control with terminal conditions (Chapter XI). In addition solutions and extra hints to some of the exercises are now included. Moreover, the proof and the discussion of the Girsanov theorem have been changed in order to make it more easy to apply, e.g. in economics. And the presentation in general has been corrected and revised throughout the text, in order to make the book better and more useful. During this work I have benefitted from valuable comments from several persons, including Knut Aase, Sigmund Berntsen, Mark H. A. Davis, Helge Holden, Yaozhong Hu, Tom Lindstrom, Trygve Nilsen, Paulo Ruffino, Isaac Saias, Clint Scovel, Jan Ubge, Suleyman Ustunel, Qinghua Zhang, Tusheng Zhang and Victor Daniel Zukowski. I am grateful to them all for their help. My special thanks go to Hékon Nyhus, who carefully read large portions of the manuscript and gave me a long list of improvements, as well as many other useful suggestions. Finally I wish to express my gratitude to Tove Maller and Dina Haralds- son, who typed the manuscript with impressive proficiency. Oslo, June 1995 Bernt OksendalPreface to the Third Edition The main new feature of the third edition is that exercises have been included to each of the chapters II-XI. The purpose of these exercises is to help the reader to get a better understanding of the text. Some of the exercises are quite routine, intended to illustrate the results, while other exercises are harder and more challenging and some serve to extend the theory. T have also continued the effort to correct misprints and errors and to improve the presentation. I have benefitted from valuable comments and suggestions from Mark H. A. Davis, Hdkon Gjessing, Torgny Lindvall and Hakon Nyhus, My best thanks to them all. A quite noticeable non-mathematical improvement is that the book is now typed in TX. Tove Lieberg did a great typing job (as usual) and I am very grateful to her for her effort and infinite patience. Oslo, June 1991 Bernt OksendalPreface to the Second Edition In the second edition I have split the chapter on diffusion processes in two, the new Chapters VII and VIII: Chapter VII treats only those basic properties of diffusions that are needed for the applications in the last 3 chapters. The readers that are anxious to get to the applications as soon as possible can therefore jump directly from Chapter VII to Chapters IX, X and XI. In Chapter VIII other important properties of diffusions are discussed. While not strictly necessary for the rest of the book, these properties are central in today’s theory of stochastic analysis and crucial for many other applications. Hopefully this change will make the book more flexible for the different purposes. I have also made an effort to improve the presentation at some points and I have corrected the misprints and errors that I knew about, hopefully without introducing new ones. I am grateful for the responses that have received on the book and in particular I wish to thank Henrik Martens for his helpful comments. Tove Lieberg has impressed me with her unique combination of typing accuracy and speed. I wish to thank her for her help and patience, together with Dina Haraldsson and Tone Rasmussen who sometimes assisted on the typing. Oslo, August 1989 Bernt OksendalPreface to the First Edition ‘These notes are based on a postgraduate course I gave on stochastic dif. ferential equations at Edinburgh University in the spring 1982. No previous knowledge about the subject was assumed, but the presentation is based on some background in measure theory. There are several reasons why one should learn more about stochastic differential equations: They have a wide range of applications outside mathe- matics, there are many fruitful connections to other mathematical disciplines and the subject has a rapidly developing life of its own as a fascinating re- search field with many interesting unanswered questions. Unfortunately most of the literature about stochastic differential equa- tions seems to place so much emphasis on rigor and completeness that it scares many nonexperts away. These notes are an attempt to approach the subject from the nonexpert point of view: Not knowing anything (except ru- mours, maybe) about a subject to start with, what would I like to know first of all? My answer would be: 1) In what situations does the subject arise? 2) What are its essential features? 3) What are the applications and the connections to other fields? I would not be so interested in the proof of the most general case, but rather in an easier proof of a special case, which may give just as much of the basic idea in the argument. And I would be willing to believe some basic results without proof (at first stage, anyway) in order to have time for some more basic applications. These notes reflect this point of view. Such an approach enables us to reach the highlights of the theory quicker and easier. Thus it is hoped that these notes may contribute to fill a gap in the existing literature. The course is meant to be an appetizer. If it succeeds in awaking further interest, the reader will have a large selection of excellent literature available for the study of the whole story. Some of this literature is listed at the back. In the introduction we state 6 problems where stochastic differential equa- tions play an essential role in the solution. In Chapter II we introduce the basic mathematical notions needed for the mathematical model of some of these problems, leading to the concept of Ito integrals in Chapter III. In Chapter IV we develop the stochastic calculus (the Ito formula) and in Chap-XX Preface to the First Edition ter V we use this to solve some stochastic differential equations, including the first two problems in the introduction. In Chapter VI we present solution of the Kinear filtering problem (of which problem 3 is an example), using the stochastic calculus. Problem 4 is the Dirichlet problem. Although this is purely deterministic we outline in Chapters VII and VIII how the introduc- tion of an associated Ito diffusion (ic. solution of a stochastic differential equation) leads to a simple, intuitive and useful stochastic solution, which is the cornerstone of stochastic potential theory. Problem 5 is an optimal stop- ping problem. In Chapter IX we represent the state of a game at time t by an Ito diffusion and solve the corresponding optimal stopping problem. The so- lution involves potential theoretic notions, such as the generalized harmonic extension provided by the solution of the Dirichlet problem in Chapter VIII. Problem 6 is a stochastic version of F.P. Ramsey’s classical control problem from 1928. In Chapter X we formulate the general stochastic control prob- lem in terms of stochastic differential equations, and we apply the results of Chapters VI and VIII to show that the problem can be reduced to solving the (deterministic) Hamilton-Jacobi-Bellman equation. As an illustration we solve a problem about optimal portfolio selection. After the course was first given in Edinburgh in 1982, revised and ex- panded versions were presented at Agder College, Kristiansand and Univer- sity of Oslo. Every time about half of the audience have come from the ap- plied section, the others being so-called “pure” mathematicians. ‘This fruitful combination has created a broad variety of valuable comments, for which I am very grateful. I particularly wish to express my gratitude to K.K. Aase, L. Csink and A.M. Davie for many useful discussions. I wish to thank the Science and Engineering Research Council, U.K. and Norges Almenvitenskapelige Forskningstid (NAVF), Norway for their finan- cial support. And I am greatly indebted to Ingrid Skram, Agder College and Inger Prestbakken, University of Oslo for their excellent typing - and their patience with the innumerable changes in the manuscript during these two years. Oslo, June 1985 Bernt Dksendal Note: Chapters VIII, IX, X of the First Edition have become Chapters IX, X, XI of the Second Edition.Table of Contents Introduction 1.1 Stochastic Analogs of Classical Differential Equations . 1.2. Filtering Problems : 1.3. Stochastic Approach to Deterministic Boundary Value Prob- lems 14 Optimal Stopping . 1.5 Stochastic Control . 1.6 Mathematical Finance . Some Mathematical Preliminaries ......................+ 2.1 Probability Spaces, Random Variables and Stochastic Processes 2.2 An Important Example: Brownian Motion ................- Exercise 06. e tenn etn n eee eee Ité Integrals 3.1 Construction of the It6 Integral : 3.2. Some Properties of the Ité Integral . 3.3. Extensions of the It6 Integral Exercises The Ité Formula and the Martingale Representation Theo- 4.1. The 1-dimensional It6 Formula . 4.2. The Multi-dimensional Ité Formula ...... 43 The Martingale Representation Theorem . Exercises .. Stochastic Differential Equations ... 5.1 Examples and Some Solution Methods . 5.2 An Existence and Uniqueness Result . 5.3. Weak and Strong Solutions ExercisesXXII Table of Contents 10. 11. The Filtering Problem . 6.1 Introduction .... 6.2 The 1-Dimensional Linear Filtering Problem 6.3 The Multidimensional Linear Pikering | Problem Exercises ..........---.-s0 eee eee Diffusions: Basic Properties 0.000.000.0020 .00000e cscs 7.1 The Markov Property 7.2. The Strong Markov Property 7.3. The Generator of an It6 Diffusion 7.4 The Dynkin Formula. 7.5 The Characteristic Operator . Exercises Other Topics in Diffusion Theory 8.1 Kolmogorov’s Backward Equation. The Resolvent 8.2 The Feynman-Kac Formula, Killing . 8.3. The Martingale Problem 84 When is an Ité Process a Diffusion? 8.5 Random Time Change . 8.6 The Girsanov Theorem. Exercises Applications to Boundary Value Problems 9.1 The Combined Dirichlet-Poisson Problem. Uniqueness. 9.2. The Dirichlet Problem. Regular Points . 9.3. The Poisson Problem Exercises Application to Optimal Stopping . 10.1 The Time-Homogeneous Case 10.2 The Time-Inhomogeneous Case 10.3 Optimal Stopping Problems Involving an Integral . 10.4 Connection with Variational Inequalities...... Exercises Application to Stochastic Control. 11.1 Statement of the Problem ..... 11.2 The Hamilton-Jacobi-Bellman Equation 11.3 Stochastic Control Problems with Terminal Conditions Exercises . 104 - 105 83 83 85, 113 .113 116 im 124 + 126 . 128 . 139 . 139 . 143 . 146 - 148 . 153 - 159 . 168 10: - 175 178 - 190 ia . 205 . 205 . 217 + 222 . 224 . 228 . 235 . 235 » 237 - 251 » 252Table of Contents XXIII 12. Application to Mathematical Finance - 261 12.1 Market, Portfolio and Arbitrage - 261 12.2 Attainability and Completeness . 271 12.3 Option Pricing . 279 Exercises . 298 Appendix A: Normal Random Variables .............00.....05 305 Appendix B: Conditional Expectation ...................06065 309 Appendix Uniform Integrability and Martingale Conver- gence Appendix D: An Approximation Result.................0..065 315 Solutions and Additional Hints to Some of the Exercises..... 319 References ....... 6.0. oe cee cece ee eceeeceeeeeeeeeeeeeeeteeeeees 345 List of Frequently Used Notation and Symbols ............... 353 Index1, Introduction To convince the reader that stochastic differential equations are an important subject let us mention some situations where such equations appear and can be used: 1.1 Stochastic Analogs of Classical Differential Equations If we allow for some randomness in some of the coefficients of a differential equation we often obtain a more realistic mathematical model of the situation. Problem 1. Consider the simple population growth model “ =a(t)N(), —_N(0) = No (constant) (1.1.1) where N(t) is the size of the population at time t, and a(¢) is the relative rate of growth at time ¢. It might happen that a(t) is not completely known, but subject to some random environmental effects, so that we have a(t) = r(t) + “noise” , where we do not know the exact behaviour of the noise term, only its prob- ability distribution. The function r(t) is assumed to be nonrandom. How do we solve (1.1.1) in this case? Problem 2. The charge Q(t) at time ¢ at a fixed point in an electric circuit satisfies the differential equation L-QME) + RQ J -Ql0) = Fl, Q0) = Qo, Q"(0) = fo (11.2) where L is inductance, R is resistance, Cis capacitance and F(t) the potential source at time t, Again we may have a situation where some of the coefficients, say F(t), are not deterministic but of the form F(t) = G(t) + “noise” (1.1.3)2 1. Introduction How do we solve (1.1.2) in this case? More generally, the equation we obtain by allowing randomness in the coefficients of a differential equation is called a stochastic differential equa- tion. This will be made more precise later. It is clear that any solution of a stochastic differential equation must involve some randomness, i.e. we can only hope to be able to say something about the probability distributions of the solutions. 1.2 Filtering Problems Problem 3. Suppose that we, in order to improve our knowledge about the solution, say of Problem 2, perform observations Z(s) of Q(s) at times 8 0 is a constant. (ii) A risky investment (e.g. a stock), where the price X,(t) per unit at time ¢ satisfies a stochastic differential equation of the type discussed in Problem 1: dX, dt where p > p and o € R \ {0} are constants. = (u+o- “noise” )X, (1.5.2) At each instant t the person can choose how large portion (fraction) u; of his fortune Z, he wants to place in the risky investment, thereby placing (1—1u,)Z: in the safe investment. Given a utility function U and a terminal time T the problem is to find the optimal portfolio u, € (0, 1] (ie. find the investment distribution uz; 0 < ¢ < T) which maximizes the expected utility of the corresponding terminal fortune 2%: max {E [viz )]} (1.5.3) O R”. Every random variable induces a probability measure x on R", defined by #x(B) = P(X7"(B)) . Lux is called the distribution of X. If [ |X (w)|dP(w) < co then the number a BIx}= [x(o)aPw) = f edux(e) 4 Re is called the expectation of X (w.r.t. P). More generally, if f:R” R is Borel measurable and J lf(X(w))|dP(w) < oo then we have a BO= [ 1xXWyaPe 7 J H2)dux(2). a Re The L?-spaces If X : Q + R® is a random variable and p € (1,00) is a constant we define the L?-norm of X, ||X|p, by : Xp = 1Xluree) = ( [1X )PEPW))?. 4 If p = 00 we set IX Ilo = IXlliece) = sup(|X(w)kw € 2}. The corresponding L?-spaces are defined by L?(P) = L*(2) ={X + 2+ R*;||Xllp < co} With this norm the L?-spaces are Banach spaces, i.e. complete normed linear spaces (see Exercise 2.19). If p = 2 the space L?(P) is even a Hilbert space, i.e. a complete inner product space, with inner product (X,Y )uypy = B[IX-¥); X,Y € 1°(P). The mathematical model for independence is the following:10 2. Some Mathematical Preliminaries Definition 2.1.3. Two subsets A,B € F are called independent if P(ANB) = P(A): P(B). A collection A = {H,;i € I} of families H; of measurable sets is independent if P(Hi, 1-0 Ay) = P(Hi,) + Pix) for all choices of Hi, € Hiz,-++, Hi, € Ha, with different indices in,...,in- A collection of random variables {X;;i € I} is independent if the collec- tion of generated o-algebras Hx, is independent. If two random variables X,Y: — R are independent then E|XY] = E[X]E(Y) , provided that E[|X|] < oo and El|Y'|] < oo. (See Exercise 2.5.) Definition 2.1.4. A stochastic process is a parametrized collection of ran- dom variables {Xther defined on a probability space ({2,F, P) and assuming values in R”. The parameter space T' is usually (as in this book) the halfline [0, 00), but it may also be an interval [a,b], the non-negative integers and even subsets of R” for n > 1. Note that for each t € T fixed we have a random variable woX(w); we. On the other hand, fixing w € 2 we can consider the function t>oX(w); ter which is called a path of X;. It may be useful for the intuition to think of t as “time” and each w as an individual “particle” or “experiment”. With this picture X;(w) would represent the position (or result) at time ¢ of the particle (experiment) w. Sometimes it is convenient to write X(t,w) instead of X;(w). Thus we may also regard the process as a function of two variables (tw) + X(tw) from T x @ into R*. This is often a natural point of view in stochastic analysis, because (as we shall see) there it is crucial to have X(t,w) jointly measurable in (t,w). Finally we note that we may identify each w with the function t > Xi(w) from T into R". Thus we may regard (2 as a subset of the space { = (R")? of all functions from T into R". Then the g-algebra F will contain the o-algebra B generated by sets of the form2.2 An Important Example: Brownian Motion iW {wiw(th) € Fis swlte) € Fe}, FC R” Borel sets (B is the same as the Borel o-algebra on @ if T = (0,00) and @ is given the product topology). Therefore one may also adopt the point of view that a stochastic process is a probability measure P on the measurable space ((R")", B) The (finite-dimensional) distributions of the process X = {X;}rer are the measures ji1,,...,t, defined on R™, k = 1,2,..., by Mtryoute (Fi X Fa X00 Fe) = P[Xy € Fis Xu € Felis €T. Here F,,..., Fx denote Borel sets in R”. ‘The family of all finite-dimensional distributions determines many (but not all) important properties of the process X. Conversely, given a family {v4,,..,4.;k € N,t; € T} of probability mea- sures on R™ it is important to be able to construct a stochastic process Y = {Yheer having vy,..,x. a8 its finite-dimensional distributions. One of Kolmogorov’s famous theorems states that this can be done provided {¥t,,.ute} Satisfies two natural consistency conditions: (See Lamperti (1977).) ‘Theorem 2.1.5 (Kolmogorov’s extension theorem). For all ty,...,th €T, KEN let r4,,...%5. be probability measures on R™ s.t. Moeryetegny (Pa X00 Fe) = Ver este Fo-1ay % 1+ X Fe-1(4)) (K1) for all permutations o on {1,2,...,k} and Yet FRC FE) = Vey otistiettonitetm (FIX Fk x RXR") (K2) for allm €N, where (of course) the set on the right hand side has a total of k+m factors. Then there exists a probability space (2,F,P) and a stochastic process {Xi} on 2X QR, ot Ves onte (Fi X 0° X Fe) = P(X, € Fy for allt; €T, k EN and all Borel sets F, ++) Xey © Fr], 2.2 An Important Example: Brownian Motion In 1828 the Scottish botanist Robert Brown observed that pollen grains sus- pended in liquid performed an irregular motion. The motion was later ex- plained by the random collisions with the molecules of the liquid. To describe the motion mathematically it is natural to use the concept of a stochastic process B,(w), interpreted as the position at time t of the pollen grain w. We will generalize slightly and consider an n-dimensional analog.12 2. Some Mathematical Preliminaries To construct {B;}:>0 it suffices, by the Kolmogorov extension theorem, to specify a family {%4,,..,1.} of probability measures satisfying (K1) and (K2) ‘These measures will be chosen so that they agree with our observations of the pollen grain behaviour: Fix 7 € R” and define le- of 2 If0 St < te <-++- < ty define a measure %,,.,4, on R™* by p(t, x,y) = (2at)7"/? - exp(— ) for yeR",t>0 Vey, ote(Fa X02 x Fk) = (2.2.1) = ] (ti, ©, 21)p(to—t1, 21,02) ++ P(e tea) Te 1, Te )day +++ dary Fook where we use the notation dy = dy;---dy, for Lebesgue measure and the convention that p(0, x, y)dy = 6:(y), the unit point mass at x. Extend this definition to all finite sequences of t;’s by using (K1). Since JS p(t,2,y)dy = 1 for all t > 0, (K2) holds, so by Kolmogorov’s theorem Re there exists a probability space ({2, F, P*) and a stochastic process {Bz}1>0 on @ such that the finite-dimensional distributions of B, are given by (2.2.1), ie. PP(By € Fis - / p(t. 2,21) -+- p(t — tee te-ite)der...dz_, (2.2.2) Fx Fi Bu, © Fr) = Definition 2.2.1. Such a process is called (a version of) Brownian motion starting at x (observe that P¥(Bo = 2) = 1). ‘The Brownian motion thus defined is not unique, i.e. there exist. several quadruples (By, 2, F, P*) such that (2.2.2) holds. However, for our purposes this is not important, we may simply choose any version to work with. As we shall soon see, the paths of a Brownian motion are (or, more correctly, can be chosen to be) continuous, a.s. Therefore we may identify (a.a.) w € 2 with a continuous function t + B,(w) from {0, 00) into R". Thus we may adopt the point of view that Brownian motion is just the space C([0, 00), R) equipped with certain probability measures P* (given by (2.2.1) and (2.2.2) above). ‘This version is called the canonical Brownian motion. Besides having the advantage of being intuitive, this point of view is useful for the further anal- ysis of measures on C((0,00),R”), since this space is Polish (ie. a complete separable metric space). See Stroock and Varadhan (1979). We state some basic properties of Brownian motion:2.2 An Important Example: Brownian Motion 13, i) Brisa Gaussian process, i.e. for all 0 < ty <--- < ty the random variable Z=(Byy---) By) € R™ has a (multi)normal distribution, This means that there exists a vector Mf € R™ and a non-negative definite matrix C = [ejm} € R™**"* (the set of all nk x nk-matrices with real entries) such that. nk E* [exp ( yy z)) =exp (- BD ujesmtin +E Dum) (2.2.3) i Sm 3 for all u = (t1,.--)tne) € R™, where i = YI is the imaginary unit and E¥ denotes expectation with respect to P#. Moreover, if (2.2.3) holds then M = E*[Z]_ is the mean value of Z (2.2.4) and ¢jm = E*((Z; -— Mj)(Zm — Mm)] is the covariance matrix of Z . (2.2.5) (See Appendix A). To see that (2.2.3) holds for Z = (Bz,,..., By,) we calculate its left hand side explicitly by using (2.2.2) (see Appendix A) and obtain (2.2.3) with M = EF(2] = (a,2,---,2) eR (2.2.6) and tn tiln + tila tin tatn ++: taln CHl : (2.2.7) tiln tealn +++ thIn Hence E(Bl=x forall t>0 (2.2.8) and E*|((B, — z)*] = nt, E*[(B, — z)(Bs—2)] =n min(s,t). (2.2.9) Moreover, E*|(By— B.)"] =n(t—s)ift>s, (2.2.10) since E*((B, — B,)"|] = E*((By — 2)? — 2(B, — 2)(Bs ~ 2) + (By ~ 2)*} = n(t—2s +s) =n(t—s),whent>s.14 2. Some Mathematical Preliminaries (ii) By has independent increments, i.e. Bu, By — Bus, By, ~ Bry, are independent for all O< ty < tg: < te. (2.2.11) To prove this we use the fact that normal random variables are inde- pendent iff they are uncorrelated. (See Appendix A). So it is enough to prove that E*((Br, — By_,)(Be, — Br_,)] =0 when ti t. (iii) Finally we ask: Is t + B,(w) continuous for almost all w? Stated like this the question does not make sense, because the set H = {w;t + B,(w) is continuous} is not measurable with respect to the Borel o-algebra B on (R”)l°) mentioned above (H involves an uncountable number of t's). However, if modified slightly the question can be given a positive answer. To explain this we need the following important concept: Definition 2.2.2. Suppose that {Xi} and {¥%;} are stochastic processes on (2,F, P). Then we say that {X;} is a version of (or a modification of) {Y;} if P({w; Xe(w) = ¥i(w)}) = 1 for all t. Note that if Xi is a version of Yi, then X; and Y; have the same finite- dimensional distributions. Thus from the point of view that a stochastic pro- cess is a probability law on (R)I) two such processes are the same, but nevertheless their path properties may be different. (See Exercise 2.9.) ‘The continuity question of Brownian motion can be answered by using another famous theorem of Kolmogorov: Theorem 2.2.3 (Kolmogorov’s continuity theorem). Suppose that the process X = {Xz}e>o satisfies the following condition: For all T > 0 there exist positive constants a,{3,D such that E[\Xe— Xs|°] < D-|t—s|'48 ; O0, 1 flax)PIX = an) . im 2.2. Let X:2 — R be a random variable. The distribution function F of X is defined by F(a) = PIX 0 be a measurable function on R. We say that X has the density p if F(a) = f p(y)dy for all. Thus from (2.2.1)-(2.2.2) we know that 1-dimensional Brownian motion By at time ¢ with By = 0 has the density 2 1 (x) = Tra POR Find the density of B?. reR. 2.3. Let {Hi}ser be a family of o-algebras on 2. Prove that H= (Viet is again a o-algebra. 2.4. a) Let X: {2 R” be a random variable such that E\|X|P] <0o for some p, 0A) < spElAr for all \>0. Hint: f |X|PdP > f |X|PdP, where A = {w:|X| >A}. b) Suppose there exists & > 0 such that M = Blexp(k|X|)] < 00. Prove that Pi|X| >) < Me~™ for all A>0.Exercises 17 Let X,Y: —+ R be two independent random variables and assume for simplicity that X and Y are bounded. Prove that E[XY] = E[X]E|¥] . (xine: Assume |X| < M, |Y| < N. Approximate X and Y by sim- ple functions p(w) = > aiXr,(w), ¥w) = Do bj; XG, (w), respectively, a =1 3 where Fy = X7¥(a;,ai41)), Gj = ¥7"((by,Bj41)), —M = ao aids PUR G)).. ) : rey Let (2,F,P) be a probability space and let Ai, Ap,... be sets in F such that SY P(Ak) < 00 ta Prove the Borel-Cantelli lemma: rr) U ay=o, mal kom ie. the probability that w belongs to infinitely many Aj.s is zero. a) Suppose Gi,G2,...,Gn are disjoint subsets of 2 such that Prove that the family G consisting of @ and all unions of some (or all) of Gi,...,G, constitutes a o-algebra on 22. b) Prove that any finite o-algebra F on 9? is of the type described in a). c) Let F be a finite o-algebra on @ and let X:2 + R be F- measurable. Prove that X assumes only finitely many possible values. More precisely, there exists a disjoint family of subsets F,..., Fm © F and real numbers ¢),...,¢m such that X(w) = Satn(u) : Let B, be Brownian motion on R, By = 0. Put E = E°18. 2.9. 2.10. 2.11. 2, Some Mathematical Preliminaries a) Use (2.2.3) to prove that Ele] = exp(-3ut) for allueR. b) Use the power series expansion of the exponential function on both sides, compare the terms with the same power of u and deduce that EB?) = 30? and more generally that, (2k)! a, E[BM|=ae-qth: REN. c) If you feel uneasy about the lack of rigour in the method in b), you can proceed as follows: Prove that (2.2.2) implies that EIs(B)] = pee [ S(e)e Fade Z for all functions f such that the integral on the right converges Then apply this to f(z) = 2% and use integration by parts and induction on k. 4) Prove (2.2.14), for example by using b) and induction on n. To illustrate that the (finite-dimensional) distributions alone do not give all the information regarding the continuity properties of a pro- cess, consider the following example: Let (2, F, P) = (0,00), B, 2) where B denotes the Borel a-algebra on (0,00) and p is a probability measure on [0,00) with no mass on single points. Define ' 1 ift=w HXalw) = { 0 otherwise and ¥;,(w) =0 for all (t,w) € [0, 00) x (0,00) . Prove that {X,} and {¥,} have the same distributions and that X; is a version of Y;. And yet we have that t + ¥;(w) is continuous for all w, while t + X;(w) is discontinuous for all w. A stochastic process X; is called stationary if {X;} has the same dis- tribution as {X;4,} for any h > 0. Prove that Brownian motion B, has stationary increments, i.e. that the process {Bi4n — Bi}n>0 has the same distribution for all t. Prove (2.2.15).+12. -13. 14, 15. -16. 17. Exercises 19 Let B be Brownian motion and fix to > 0. Prove that Bu= Bust—-Byi t20 is a Brownian motion Let B, be 2-dimensional Brownian motion and put D,={cER?*;|2| 0- Compute P°|Be € Dy). Let B, be n-dimensional Brownian motion and let K C R" have zero n-dimensional Lebesgue measure. Prove that the expected total length of time that B, spends in K is zero. (This implies that the Green measure associated with B, is absolutely continuous with respect to Lebesgue measure. See Chapter 9). Let By be n-dimensional Brownian motion starting at 0 and let UeR"*" be a (constant) orthogonal matrix, ie. UUT =I. Prove that By: = UB, is also a Brownian motion. (Brownian scaling). Let B, be a 1-dimensional Brownian motion and let c > 0 be a constant. Prove that is also a Brownian motion. If X,(-): @ — R is a continuous stochastic process, then for p > 0 the p’th variation process of X;, (X,X)\”) is defined by (XX) (w) = slim | ST [Xa )-Xe,(w))? (limit in probability) test where 0 = t) < tz <...< ty =t and At, = ty41 — te. In particular, if p = 1 this process is called the total variation process and if p = 2 this is called the quadratic variation process. (See Exercise 4.7.) For Brownian motion B, ¢ R we now show that the quadratic variation process is simply (B, B)(w) = (B, BY (w) =t as. Proceed as follows:20 2. Some Mathematical Preliminaries a) Define ABy = Buys ~ Bu and put. ¥(tw) = S>(ABx(w))? teSt Show that. E\(Y0(ABx)? — #)7] = 2S (Ate)? teSt teSt and deduce that ¥(t,-) + t in L?(P) as Aty oo. b) Use a) to prove that a.a. paths of Brownian motion do not have a bounded variation on [0,t], ie. the total variation of Brownian motion is infinite, a.s. 2.18. a) Let 2 = {1,2,3,4,5} and let U/ be the collection U = {(1,2,3}, (3,4,5}} of subsets of (2. Find the smallest o-algebra containing U (i.e. the o-algebra Hy generated by U). b) Define X : 2+ R by X(1)=X(2)=0, X(3)=10, X(4) = X(5)=1 Is X measurable with respect to Hu? c) Define Y : 2 4 R by YQ) =0, Y(2)=¥(3)=¥(4)=¥(5) =1 Find the o-algebra Hy generated by ¥ 2.19. Let (2,F,u) be a probability space and let p € {1,00]. A sequence {fn}%21 of functions fy, € L?() is called a Cauchy sequence if fn -fmllp 70 as nym — oo. ‘The sequence is called convergent if there exists f € L?(s) such that fn f in L(y). Prove that every convergent sequence is a Cauchy sequence A fundamental theorem in measure theory states that the converse is also true: Every Cauchy sequeence in L?(s) is convergent. A normed linear space with this property is called complete. Thus the L?(s1) spaces are complete. 2.20. Let B, be 1-dimensional Brownian motion, o € R. be constant and OSs Wz, and W,, are independent. (ii) {W,} is stationary, i.e. the (joint) distribution of {Wi +.- does not depend on t. (iii) B[W;} =0 for all t. West} However, it turns out there does not exist any “reasonable” stochastic process satisfying (i) and (ii): Such a W cannot have continuous paths. (See Exercise 3.11.) If we require E{W?] = 1 then the function (t,w) + W,(w) cannot even be measurable, with respect to the a-algebra B x F, where B is the Borel c-algebra on (0, 00]. (See Kallianpur (1980, p. 10).) Nevertheless it is possible to represent W, as a generalized stochastic process called the white noise process. That the process is generalized means that it can be constructed as a probability measure on the space S’ of tempered distributions on (0, 00), and not as a probability measure on the much smaller space R!), like an22 3. Ito Integrals ordinary process can. See e.g. Hida (1980), Adler (1981), Rozanov (1982), Hida, Kuo, Potthoff and Streit (1993) or Holden, Oksendal, Ubge and Zhang (1996). We will avoid this kind of construction and rather try to rewrite equation (3.1.2) in a form that suggests a replacement of W; by a proper stochastic process: Let 0 = to < t) < ++: < tm = t and consider a discrete version of (3.1.2): Xeai — Xp =O te, Xe) Ate + o(te, Xe)WeAte , (3.1.3) where X;=X(ts) We=We, Ate =teyr—te- We abandon the Wg-notation and replace W, Ate by AVk = Vi, — Ve» where {V;}:30 is some suitable stochastic process. The assumptions (i), (ii) and (iii) on W; suggest that V; should have stationary independent increments with mean 0. It turns out that the only such process with continuous paths is the Brownian motion By. (See Knight (1981). Thus we put V; = B, and obtain from (3.1.3): ket koa Xp = Xo+D W(t, Xj) Aty + Do (ty, Xj)AB;- (3.1.4) = ja0 Is it possible to prove that the limit of the right hand side of (3.1.4) exists, in some sense, when At; — 0? If so, then by applying the usual integration notation we should obtain ‘ ‘ Xs Xo [ oe, Xa)ds+ « [ ols, X4)dB,” (3.1.5) 3 a and we would adopt as a convention that (3.1.2) really means that X, = X;(w) is a stochastic process satisfying (3.1.5). Thus, in the remainder of this chapter we will prove the existence, in a certain sense, of : « [Hs dB.oy" where B,(w) is 1-dimensional Brownian motion starting at the origin, for a wide class of functions f: 0, 00] x 92 + R. Then, in Chapter 5, we will return to the solution of (3.1.5). Suppose 0 < S$ Byam g20 2(t,w) = D> By srya-n(w) - Ay.2-n,y4ry2-m)(t) - 320 ) + jam uaaya-my (t) Then 1 E| f ereuntei(ay] = 30 BIB (BB) 3 = since {B,} has independent increments. But t ef oalt,w)dBe)| = PBIB. (Buss ~ By) 3 320 = DEB ys - 320 T, by (2.2.10) . So, in spite of the fact that both @; and ¢2 appear to be very reasonable approximations to S(tw) = Bw) ,