Stochastic Differential Equations With Applications
Stochastic Differential Equationswith ApplicationsDecember 4, 2012
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Contents1 Stochastic Differential Equations1.11.27Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71.1.18Meaning of Stochastic Differential Equations . . . . . . . . . . . . . . . . . . .Some applications of SDEs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101.2.1Asset prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101.2.2Population modelling1.2.3Multi-species models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Continuous Random Variables2.12.22.3The probability density function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132.1.1Change of independent deviates . . . . . . . . . . . . . . . . . . . . . . . . . . . 132.1.2Moments of a distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13Ubiquitous probability density functions in continuous finance . . . . . . . . . . . . . . 142.2.1Normal distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142.2.2Log-normal distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142.2.3Gamma distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14Limit Theorems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152.3.12.413The central limit results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17The Wiener process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172.4.1Covariance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182.4.2Derivative of a Wiener process . . . . . . . . . . . . . . . . . . . . . . . . . . . 182.4.3Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 Review of Integration213
4CONTENTS3.1Bounded Variation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213.2Riemann integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233.3Riemann-Stieltjes integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243.4Stochastic integration of deterministic functions . . . . . . . . . . . . . . . . . . . . . . 254 The Ito and Stratonovich Integrals4.127A simple stochastic differential equation . . . . . . . . . . . . . . . . . . . . . . . . . . 274.1.1Motivation for Ito integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284.2Stochastic integrals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294.3The Ito integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314.3.14.44.5Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33The Stratonovich integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334.4.1Relationship between the Ito and Stratonovich integrals . . . . . . . . . . . . . 354.4.2Stratonovich integration conforms to the classical rules of integration . . . . . . 37Stratonovich representation on an SDE . . . . . . . . . . . . . . . . . . . . . . . . . . . 385 Differentiation of functions of stochastic variables5.15.241Ito’s Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415.1.1Ito’s lemma in multi-dimensions . . . . . . . . . . . . . . . . . . . . . . . . . . 445.1.2Ito’s lemma for products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45Further examples of SDEs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455.2.1Multi-dimensional Ornstein Uhlenbeck equation . . . . . . . . . . . . . . . . . . 455.2.2Logistic equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465.2.3Square-root process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475.2.4Constant Elasticity of Variance Model . . . . . . . . . . . . . . . . . . . . . . . 485.2.5SABR Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485.3Heston’s Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495.4Girsanov’s lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495.4.1Change of measure for a Wiener process . . . . . . . . . . . . . . . . . . . . . . 515.4.2Girsanov theorem. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526 The Chapman Kolmogorov Equation55
CONTENTS6.1Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556.1.16.26.36.45Markov process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56Chapman-Kolmogorov equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576.2.1Path continuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 576.2.2Drift and diffusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 596.2.3Drift and diffusion of an SDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60Formal derivation of the Forward Kolmogorov Equation . . . . . . . . . . . . . . . . . 616.3.1Intuitive derivation of the Forward Kolmogorov Equation . . . . . . . . . . . . 666.3.2The Backward Kolmogorov equation . . . . . . . . . . . . . . . . . . . . . . . . 67Alternative view of the forward Kolmogorov equation . . . . . . . . . . . . . . . . . . 696.4.1Jumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 706.4.2Determining the probability flux from an SDE - One dimension . . . . . . . . . 717 Numerical Integration of SDE7.175Issues of convergence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 757.1.1Strong convergence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 757.1.2Weak convergence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 767.2Deterministic Taylor Expansions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 777.3Stochastic Ito-Taylor Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 787.4Stochastic Stratonovich-Taylor Expansion . . . . . . . . . . . . . . . . . . . . . . . . . 807.5Euler-Maruyama algorithm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 817.6Milstein scheme . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 827.6.1Higher order schemes8 Exercises on SDE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8385
6CONTENTS
Chapter 1Stochastic Differential Equations1.1IntroductionClassical mathematical modelling is largely concerned with the derivation and use of ordinary andpartial differential equations in the modelling of natural phenomena, and in the mathematical andnumerical methods required to develop useful solutions to these equations. Traditionally these differential equations are deterministic by which we mean that their solutions are completely determinedin the value sense by knowledge of boundary and initial conditions - identical initial and boundaryconditions generate identical solutions. On the other hand, a Stochastic Differential Equation (SDE)is a differential equation with a solution which is influenced by boundary and initial conditions, butnot predetermined by them. Each time the equation is solved under identical initial and boundary conditions, the solution takes different numerical values although, of course, a definite patternemerges as the solution procedure is repeated many times.Stochastic modelling can be viewed in two quite different ways. The optimist believes that theuniverse is still deterministic. Stochastic features are introduced into the mathematical model simplyto take account of imperfections (approximations) in the current specification of the model, but thereexists a version of the model which provides a perfect explanation of observation without redressto a stochastic model. The pessimist, on the other hand, believes that the universe is intrinsicallystochastic and that no deterministic model exists. From a pragmatic point of view, both will constructthe same model - its just that each will take a different view as to origin of the stochastic behaviour.Stochastic differential equations (SDEs) now find applications in many disciplines including interalia engineering, economics and finance, environmetrics, physics, population dynamics, biology andmedicine. One particularly important application of SDEs occurs in the modelling of problemsassociated with water catchment and the percolation of fluid through porous/fractured structures.In order to acquire an understanding of the physical meaning of a stochastic differential equation(SDE), it is beneficial to consider a problem for which the underlying mechanism is deterministic andfully understood. In this case the SDE arises when the underlying deterministic mechanism is not7
8CHAPTER 1. STOCHASTIC DIFFERENTIAL EQUATIONSfully observed and so must be replaced by a stochastic process which describes the behaviour of thesystem over a larger time scale. In effect, although the true mechanism is deterministic, when thismechanism cannot be fully observed it manifests itself as a stochastic process.1.1.1Meaning of Stochastic Differential EquationsA useful example to explore the mapping between an SDE and reality is consider the origin of theterm “noise”, now commonly used as a generic term to describe a zero-mean random signal, but inthe early days of radio noise referred to an unwanted signal contaminating the transmitted signal dueto atmospheric effects, but in particular, imperfections in the transmitting and receiving equipmentitself. This unwanted signal manifest itself as a persistent background hiss, hence the origin of theterm. The mechanism generating noise within early transmitting and receiving equipment was wellunderstood and largely arose from the fact that the charge flowing through valves is carried in unitsof the electronic charge e (1.6 10 19 coulombs per electron) and is therefore intrinsically discrete.Consider the situation in which a stream of particles each carrying charge q land on the plate of aleaky capacitor, the k th particle arriving at time tk 0. Let N (t) be the number of particles to havearrived on the plate by time t thenN (t) H(t tk ) ,k 1where H(t) is Heaviside’s function1 . The noise resulting from the irregular arrival of the chargedparticles is called shot noise. The situation is illustrated in Figure 1.1RqqCqFigure 1.1: A model of a leaky capacitor receiving charges qLet V (t) be the potential across the capacitor and let I(t) be the leakage current at time t then1The Heaviside function, often colloquially called the ‘Step Function”, was introduced by Oliver Heaviside (18501925), an English electrical engineer, and is defined by the formula xH(x) δ(s) ds Clearly the derivative of H(x) is δ(x), Dirac’s delta function H(x) 1120x 0x 0x 0
1.1. INTRODUCTION9conservation of charge requires that CV q N (t) tI(s) ds0where V (t) RI(t) by Ohms law. Consequently, I(t) satisfies the integral equation tCR I(t) q N (t) I(s) ds .(1.1)0We can solve this equation by the method of Laplace transforms, but we avoid this temptation.Another approachConsider now the nature of N (t) when the times tk are unknown other than that electrons behaveindependently of each other and that the interval between the arrivals of electrons of the plate isPoisson distributed with parameter λ. With this understanding of the underlying mechanism inplace, N (t) is a Poisson deviate with parameter λt. At time t t equation (1.1) becomes t tCR I(t t) q N (t t) I(s) ds .0After subtracting equation (1.1) from the previous equation the result is that t tCR [I(t t) I(t)] q [N (t t) N (t)] I(s) ds .(1.2)tNow suppose that t is sufficiently small that I(t) does not change its value significantly in theinterval [t, t t] then I I(t t) I(t) and t tI(s) ds I(t) t .tOn the other hand suppose that t is sufficiently large that many electrons arrive on the plateduring the interval (t, t t). So although [N (t t) N (t)] is actually a Poisson random variablewith parameter λ t, the central limit theorem may be invoked and [N (t t) N (t)] may beapproximated by a Gaussian deviate with mean value λ t and variance λ t. ThusN (t t) N (t) λ t λ W ,(1.3)where W is a Gaussian random variable with zero mean value and variance t. The sequence ofvalues for W as time is traversed in units of t define the independent increments in a Gaussianprocess W (t) formed by summing the increments W . Clearly W (t) has mean value zero and variancet. The conclusion of this analysis is that CR I q (λ t λ W ) I(t) t(1.4)with initial condition I(0) 0. Replacing I, t and W by their respective differential formsleads to the Stochastic Differential Equation (SDE) q λ(qλ I)dt dW .(1.5)dI CRCRIn this representation, dW is the increment of a Wiener process. Both I and W are functions whichare continuous everywhere but differentiable nowhere. Equation (1.5) is an example of an OrnsteinUhlenbeck process.
101.21.2.1CHAPTER 1. STOCHASTIC DIFFERENTIAL EQUATIONSSome applications of SDEsAsset pricesThe most relevant application of SDEs for our purposes occurs in the pricing of risky assets andcontracts written on these assets. One such model is Heston’s model of stochastic volatility whichposits that S, the price of a risky asset, evolves according to the equationsdSSdV V ( 1 ρ2 dW1 ρ dW2 ) κ (γ V ) dt σ V dW2 µ dt (1.6)in which ρ, κ and γ take prescribed values and V (t) is the instantaneous level of volatility of thestock, and dW1 and dW2 are differentials of uncorrelated Wiener processes. In the course of theselectures we shall meet other financial models.1.2.2Population modellingStochastic differential equations are often used in the modelling of population dynamics. For example,the Malthusian model of population growth (unrestricted resources) isdN aN ,dtN (0) N0 ,(1.7)where a is a constant and N (t) is the size of the population at time t. The effect of changingenvironmental conditions is achieved by replacing a dt by a Gaussian random variable with non-zeromean a dt and variance b2 dt to get the stochastic differential equationdN aN dt bN dW ,N (0) N0 ,(1.8)in which a and b (conventionally positive) are constants. This is the equation of a Geometric RandomWalk and is identical to the risk-neutral asset model proposed by Black and Scholes for the evolutionof the price of a risky asset. To take account of limited resources the Malthusian model of populationgrowth is modified by replacing a in equation (1.8) by the term α(M N ) to get the well-knownVerhulst or Logistic equationdN α N (M N ) ,dtN (0) N0(1.9)where α and M are constants with M representing the carrying capacity of the environment. Theeffect of changing environmental conditions is to make M a stochastic parameter so that the logisticmodel becomesdN aN (M N ) dt b N dWin which a and b 0 are constants.(1.10)
1.2. SOME APPLICATIONS OF SDES11The Malthusian and Logistic models are special cases of the general stochastic differential equationdN f (N ) dt g(N ) dW(1.11)where f and g are continuously differentiable in [0, ) with f (0) g(0) 0. In this case, N 0 is asolution of the SDE. However, the stochastic equation (1.11) is sensible only provided the boundaryat N is unattainable (a natural boundary). This condition requires that there exist K 0 suchthat f (N ) 0 for all N K. For example, K M in the logistic model.1.2.3Multi-species modelsThe classical multi-species model is the prey-predator model. Let R(t) and F (t) denote respectivelythe populations of rabbits and foxes is a given environment, then the Lotka-Volterra two-speciesmodel posits thatdR R(α β F )dtdF F (δ R γ) ,dtwhere α is the net birth rate of rabbits in the absence of foxes, γ is the natural death rate of foxesand β and δ are parameters of the model controlling the interaction between rabbits and foxes. Thestochastic equations arising from allowing α and γ to become random variables aredR R(α β F ) dt σr R dW1 .dF F (δ R γ) dt σf F dW2 .The generic solution to these equations is a cyclical process in which rabbits dominate initially,thereby increasing the supply of food for foxes causing the fox population to increase and rabbitpopulation to decline. The increasing shortage of food then causes the fox population to decline andallows the rabbit population to recover, and so on.There is a multi-species variant of the two-species classical Lotka-Volterra multi-species model withdifferential equationsdxk (ak bkj xj )xk ,k n.s. ,(1.12)dtwhere the choice and algebraic signs of the ak ’s and the bjk ’s distinguishes prey from predator. Thesimplest generalisation of the Lotka-Volterra model to stochastic a environment assumes the originalak is stochastic to getdxk (ak bkj xj )xk dt ck xk dWk ,knot summed.(1.13)The generalised Lokta-Volterra models also have cyclical solutions. Is there an analogy with businesscycles in Economics in which the variables xk now denote measurable economic variables?
12CHAPTER 1. STOCHASTIC DIFFERENTIAL EQUATIONS
Chapter 2Continuous Random Variables2.1The probability density functionFunction f (x) is a probability density function (PDF) with respect to a subset S Rn provided (a) f (x) 0 x S,(ii)f (x) dx 1 .(2.1)SIn particular, if E S is an event then the probability of E is p(E) f (x) dx .E2.1.1Change of independent deviatesSuppose that y g(x) is an invertible mapping which associates X SX with Y SY where SY isthe image of the original sample space SX under the mapping g. The probability density functionfY (y) of Y may be computed from the probability density function fX (x) of X by the rulefY (y) fX (x)2.1.2 (x1 , · · · , xn ). (y1 , · · · , yn )(2.2)Moments of a distributionLet X be a continuous random variable with sample space S and PDF f (x) then the mean value ofthe function g(X) is defined to be ḡ g(x)f (x) dx .SImportant properties of the distribution itself are defined from this definition by assigning variousscalar, vector of tensorial forms to g. The moment Mpq···w of the distribution is defined by the formula Mp q···w E [ Xp Xq · · · Xw ] (xp xq · · · xw ) f (x) dx .(2.3)S13
14CHAPTER 2. CONTINUOUS RANDOM VARIABLES2.2Ubiquitous probability density functions in continuous financeAlthough any function satisfying conditions (2.1) qualifies as a probability density function, thereare several well-known probability density functions that occur frequently in continuous finance andwith which one must be familiar. These are now described briefly.2.2.1Normal distributionA continuous random variable X is Gaussian distributed with mean µ and variance σ 2 if X hasprobability density function[ (x µ)2 ]1f (x) .exp 2σ 22πσBasic properties If X N (µ, σ 2 ) then Y (X µ)/σ N (0, 1) . This result follows immediately by change ofindependent variable from X to Y . Suppose that Xk N (µk , σk2 ) for k 1, . . . , n are n independent Gaussian deviates thenmathematical induction may be used to establish the resultX X1 X2 . . . Xn Nn( µk ,k 12.2.2n )σk2 .k 1Log-normal distributionThe log-normal distribution with parameters µ and σ is defined by the probability density functionf (x ; µ, σ) [ (log x µ)2 ]11exp 2σ 22π σ xx (0, )(2.4)Basic properties If X is log-normally distributed with parameters (µ, σ) then Y log X N (µ, σ 2 ). This resultfollows immediately by change of independent variable from X to Y . If X is log-normally distributed with parameters (µ, σ) independent Gaussian deviates then222E [X] eµ σ /2 and V [X] e2µ σ (eσ 1) and the median of X is eµ .2.2.3Gamma distributionThe Gamma d
STOCHASTIC DIFFERENTIAL EQUATIONS fully observed and so must be replaced by a stochastic process which describes the behaviour of the system over a larger time scale. In effect, although the true mechanism is deterministic, when this mechanism cannot be fully observed it manifests itself as a stochastic process.
Lecture 21: Stochastic Differential Equations In this lecture, we study stochastic di erential equations. See Chapter 9 of [3] for a thorough treatment of the materials in this section. 1. Stochastic differential equations We would like to solve di erential equations of the form dX (t;X(t))dtX (t; (t))dB(t)
1.2. Rewrite the linear 2 2 system of di erential equations (x0 y y0 3x y 4et as a linear second-order di erential equation. 1.3. Using the change of variables x u 2v; y 3u 4v show that the linear 2 2 system of di erential equations 8 : du dt 5u 8v dv dt u 2v can be rewritten as a linear second-order di erential equation. 5
69 of this semi-mechanistic approach, which we denote as Universal Di erential 70 Equations (UDEs) for universal approximators in di erential equations, are dif- 71 ferential equation models where part of the di erential equation contains an 72 embedded UA, such as a neural network, Chebyshev expansion, or a random 73 forest. 74 As a motivating example, the universal ordinary di erential .
General theory of di erential equations of rst order 45 4.1. Slope elds (or direction elds) 45 4.1.1. Autonomous rst order di erential equations. 49 4.2. Existence and uniqueness of solutions for initial value problems 53 4.3. The method of successive approximations 59 4.4. Numerical methods for Di erential equations 62
Unit #15 - Di erential Equations Some problems and solutions selected or adapted from Hughes-Hallett Calculus. Basic Di erential Equations 1.Show that y x sin(x) ˇsatis es the initial value problem dy dx 1 cosx To verify anything is a solution to an equation, we sub it in and verify that the left and right hand sides are equal after
Ordinary Di erential Equations by Morris Tenenbaum and Harry Pollard. Elementary Di erential Equations and Boundary Value Problems by William E. Boyce and Richard C. DiPrima. Introduction to Ordinary Di erential Equations by Shepley L. Ross. Di
1 Introduction XPP (XPPAUT is another name; I will use the two interchangeably) is a tool for solving di erential equations, di erence equations, delay equations, functional equations, boundary value problems, and stochastic equations. It evolved from a chapter written by
1 Introduction XPP(XPPAUT is anothername; I will use the twointerchangeably)is a tool for solving di erential equations, di erence equations, delay equations, functional equations, boundary value problems, and stochastic equations. It evolved from a chapter written by
