Chapter 2 Itô Integral and Itô’s Lemma

2.1 The Challenge of Stochastic Integration

In regular calculus, we integrate smooth functions:

\[\int_0^t f(s) \, ds = \lim_{\Delta s \to 0} \sum_{i} f(s_i) \Delta s\]

For smooth functions \(f\), it doesn’t matter whether we evaluate at the left endpoint, right endpoint, or midpoint of each interval - we get the same answer in the limit.

But what about:

\[\int_0^t f(s) \, dB(s) \quad ?\]

This means integrating \(f\) with respect to Brownian motion. Instead of accumulating tiny areas \(f(s_i) \Delta s\), we’re accumulating random contributions \(f(s_i) \Delta B_i\) where \(\Delta B_i = B(s_{i+1}) - B(s_i)\).

2.1.1 The Problem

Because Brownian motion is so rough (nowhere differentiable), the choice of evaluation point matters critically! Different choices give different answers, even in the limit.

This isn’t just a technical nuisance - it reflects a fundamental ambiguity about how to define integration with respect to a rough, random path.

2.2 The Itô Integral

Kiyoshi Itô made a choice that turned out to be mathematically natural and practically useful: always evaluate at the left endpoint.

2.2.1 Definition

The Itô integral is defined as:

\[\int_0^t f(s) \, dB(s) = \lim_{n \to \infty} \sum_{i=0}^{n-1} f(s_i) [B(s_{i+1}) - B(s_i)]\]

where \(0 = s_0 < s_1 < \cdots < s_n = t\) is a partition that gets progressively finer, and we use \(f(s_i)\) from the left of each interval.

2.2.2 Why the Left Endpoint?

This choice makes \(f(s_i)\) independent of \(\Delta B_i = B(s_{i+1}) - B(s_i)\), because \(f(s_i)\) depends only on information up to time \(s_i\), while \(\Delta B_i\) is the future increment.

This independence gives us beautiful properties:

  1. Martingale property: \(\int_0^t f(s) \, dB(s)\) is a martingale (under appropriate conditions on \(f\))
  2. Zero expectation: \(E\left[\int_0^t f(s) \, dB(s)\right] = 0\)
  3. Isometry: \(E\left[\left(\int_0^t f(s) \, dB(s)\right)^2\right] = E\left[\int_0^t f^2(s) \, ds\right]\)

The third property is called the Itô isometry and is fundamental for proving convergence.

2.3 A Crucial Example: \(\int_0^t B(s) \, dB(s)\)

Let’s compute this integral using the definition. We want:

\[\lim_{n \to \infty} \sum_{i=0}^{n-1} B(s_i) [B(s_{i+1}) - B(s_i)]\]

Here’s a clever algebraic trick. Note that:

\[B^2(s_{i+1}) - B^2(s_i) = [B(s_{i+1}) - B(s_i)]^2 + 2B(s_i)[B(s_{i+1}) - B(s_i)]\]

Rearranging:

\[B(s_i)[B(s_{i+1}) - B(s_i)] = \frac{1}{2}[B^2(s_{i+1}) - B^2(s_i)] - \frac{1}{2}[B(s_{i+1}) - B(s_i)]^2\]

Summing over all intervals:

\[\sum_{i=0}^{n-1} B(s_i) \Delta B_i = \frac{1}{2}[B^2(t) - B^2(0)] - \frac{1}{2}\sum_{i=0}^{n-1} (\Delta B_i)^2\]

The first term telescopes to give \(\frac{1}{2}B^2(t)\). But what about that second sum?

2.3.1 The Quadratic Variation Miracle

Each \((\Delta B_i)^2\) has expected value \(E[(\Delta B_i)^2] = s_{i+1} - s_i = \Delta t_i\).

As the partition gets finer, by the law of large numbers:

\[\sum_{i=0}^{n-1} (\Delta B_i)^2 \to t\]

This is the quadratic variation we mentioned earlier. Remarkably, it converges to the deterministic value \(t\)!

Therefore:

\[\boxed{\int_0^t B(s) \, dB(s) = \frac{1}{2}B^2(t) - \frac{1}{2}t}\]

2.3.2 The Shock

In regular calculus, \(\int_0^t x \, dx = \frac{1}{2}x^2\). But here we get an extra \(-\frac{t}{2}\) term!

This correction term is the signature of stochastic calculus - it comes from the non-zero quadratic variation of Brownian motion.

2.4 Quadratic Variation and the Formal Rule \((dB)^2 = dt\)

The key insight is:

\[\sum_{i=0}^{n-1} (\Delta B_i)^2 \to t \quad \text{as } n \to \infty\]

In differential notation, we write this as the formal rule:

\[(dB)^2 = dt\]

This is not literally true (both sides are zero!), but it’s a mnemonic for the limiting behavior.

2.4.1 Multiplication Rules

From \((dB)^2 = dt\), we can derive multiplication rules for stochastic differentials:

Term Value Reason
\(dt \cdot dt\) \(0\) Second order in deterministic time
\(dt \cdot dB\) \(0\) Deterministic times random of order \(\sqrt{dt}\)
\(dB \cdot dB\) \(dt\) Quadratic variation!

These rules are essential for applying Itô’s lemma.

2.5 Itô’s Lemma: The Fundamental Theorem

Now we come to the crown jewel - the chain rule for stochastic calculus.

In regular calculus, if \(x(t)\) is differentiable and \(f\) is smooth:

\[\frac{d}{dt}f(x(t)) = f'(x(t)) \cdot \frac{dx}{dt}\]

Or in differential form: \(df = f'(x) \, dx\)

Question: If \(B(t)\) is Brownian motion and \(f\) is smooth, what is \(df(B(t))\)?

Naive guess: \(df = f'(B) \, dB\)? Wrong!

2.5.1 The Derivation

Use Taylor expansion for small changes:

\[f(B(t + dt)) - f(B(t)) = f'(B) \cdot dB + \frac{1}{2}f''(B) \cdot (dB)^2 + \frac{1}{6}f'''(B) \cdot (dB)^3 + \cdots\]

In regular calculus, \((dx)^2\) and higher terms vanish as \(dt \to 0\). But \((dB)^2 = dt\)!

So the second-order term becomes:

\[\frac{1}{2}f''(B) \cdot (dB)^2 = \frac{1}{2}f''(B) \cdot dt\]

This term survives! The higher terms \((dB)^3, (dB)^4, \ldots\) do vanish (they’re of order \(dt^{3/2}, dt^2, \ldots\)).

2.5.2 Itô’s Lemma for \(f(B(t))\)

\[\boxed{df(B) = f'(B) \, dB + \frac{1}{2}f''(B) \, dt}\]

The extra \(\frac{1}{2}f''(B) \, dt\) term is the Itô correction - the price we pay for the roughness of Brownian motion.

2.6 Verification: Recovering Our Earlier Result

Let’s verify with \(f(x) = x^2\), so \(f'(x) = 2x\) and \(f''(x) = 2\).

Itô’s lemma gives:

\[d(B^2) = 2B \, dB + \frac{1}{2} \cdot 2 \, dt = 2B \, dB + dt\]

Integrating from 0 to \(t\):

\[B^2(t) - B^2(0) = 2\int_0^t B(s) \, dB(s) + t\]

Since \(B(0) = 0\):

\[B^2(t) = 2\int_0^t B(s) \, dB(s) + t\]

Therefore:

\[\int_0^t B(s) \, dB(s) = \frac{1}{2}B^2(t) - \frac{1}{2}t \quad \checkmark\]

Perfect match!

2.7 Example: The Exponential

Take \(f(x) = e^x\), so \(f'(x) = f''(x) = e^x\).

Itô’s lemma:

\[d(e^B) = e^B \, dB + \frac{1}{2}e^B \, dt = e^B \left(dB + \frac{1}{2}dt\right)\]

Integrating:

\[e^{B(t)} = 1 + \int_0^t e^{B(s)} \, dB(s) + \frac{1}{2}\int_0^t e^{B(s)} \, ds\]

This is an integral equation for the exponential of Brownian motion.

Taking expectations (the stochastic integral has zero mean):

\[E[e^{B(t)}] = 1 + \frac{1}{2}\int_0^t E[e^{B(s)}] \, ds\]

Let \(m(t) = E[e^{B(t)}]\). Then \(m'(t) = \frac{1}{2}m(t)\) with \(m(0) = 1\).

Solution: \(E[e^{B(t)}] = e^{t/2}\)

You can verify this directly: since \(B(t) \sim N(0,t)\), the moment generating function gives \(E[e^{B(t)}] = e^{t/2}\). ✓

2.8 General Itô’s Lemma

For a function \(f(t, x)\) of both time and space, and a process \(X(t)\):

\[\boxed{df(t, X) = \frac{\partial f}{\partial t}dt + \frac{\partial f}{\partial x}dX + \frac{1}{2}\frac{\partial^2 f}{\partial x^2}(dX)^2}\]

This is the form we’ll use most often in applications.

2.8.1 The Pattern

To apply Itô’s lemma:

  1. Identify the function \(f\) and the stochastic process \(X\)
  2. Compute the partial derivatives: \(\frac{\partial f}{\partial t}\), \(\frac{\partial f}{\partial x}\), \(\frac{\partial^2 f}{\partial x^2}\)
  3. Compute \((dX)^2\) using the multiplication rules
  4. Substitute everything into the formula

This becomes second nature with practice!

2.9 Why Itô’s Choice?

Other choices for the evaluation point lead to other stochastic calculi:

  • Stratonovich integral: Uses the midpoint, gives different rules
  • Backward integral: Uses the right endpoint

Itô’s calculus won out because:

  1. Martingale property: Itô integrals are martingales
  2. Natural for finance: Fits the “no-anticipation” principle
  3. Connection to PDEs: Leads naturally to Feynman-Kac
  4. Computational advantage: Easier to simulate

The Itô convention is now standard in probability, finance, and most applications.