Lecture 21: Stochastic Differential Equations

In this lecture, we study stochastic differential 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 differential equations of the form
dX = µ(t, X(t))dt + σ(t, X(t))dB(t)
for given functions a and b, and a Brownian motion B(t). A function (or a
path) X is a solution to the differential equation above if it satisfies
ˆ T ˆ T
X(T ) = µ(t, X(t))dt + σ(t, X(t))dB(t).
0 0
Following is a quote from [3].
Stochastic differential equations provide a link between prob-
ability theory and the much older and more developed fields
of ordinary and partial differential equations. Wonderful con-
sequences flow in both directions. The stochastic modeler
benefits from centuries of development of the physical sci-
ences, and many classic results of mathematical physics (and
even pure mathematics) can be given new intuitive interpre-
tations.
We first state a result saying that SDEs can be solved.
Theorem 1.1. (Existence and uniqueness) If the coefficients of the stochas-
tic differential equation
dX = µ(t, X(t))dt + σ(t, X(t))dB(t), with X(0) = x0 and 0 ≤ t ≤ T,
satisfy a space-variable Lipshictz condition
|µ(t, x) − µ(t, y)|2 + |σ(t, x) − σ(t, y)|2 ≤ K|x − y|2
and the spatial growth condition
|µ(t, x)|2 + |σ(t, x)|2 ≤ K(1 + |x|2 ),
then there is a continuous adapted solution X(t) such that (L2 bound). More-
over, if X(t) and Y (t) are both continuous solutions satisfying the L2 bound,
then
P(X(t) = Y (t) for all t ∈ [0, T ]) = 1.
The proof of this theorem is quite technical and can be found in [3].
Thanks to this theorem, we know that most SDEs in fact have a solution.
We now discuss some simple (but important) examples of SDEs which have
closed form solutions.
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1.1. Coefficient matching method. One of the most natural, and most
important, stochastic differntial equations is given by
dX(t) = µX(t) dt + σX(t) dB(t) with X(0) = x0 > 0,
where −∞ < µ < ∞ and σ > 0 are constants.
Let us pretend that we do not know the solution and suppose that we
seek a solution of the form X(t) = f (t, B(t)). For this candidate, we have
 ∂f 1 ∂2f  ∂f
dX (t) = + dt + dB(t),
∂t 2 ∂x2 ∂x
hence if we must have
∂f 1 ∂2f ∂f
µf = + and σf = .
∂t 2 ∂x2 ∂x
The second equation gives f (t, x) = eσx+g(t) . Using this in the first equation
gives
σ2
µf = g 0 (t)f + f.
2
0 σ2
Therefore, g (t) = µ − 2 , and we see that
2 /2)t
f (t, x) = x0 eσx+(µ−σ .
Therefore, X(t) = x0 e (µ−σ 2 /2)t+σB(t) .
1.2. Coefficient matching for product processes. Let α and σ be pos-
itive constants and consider the following SDE
dX(t) = −αX(t)dt + σdB(t) with X(0) = x0 .
Ornstein and Uhlenbeck first used (a version of) this equation to study the
behavior of gasses. It has been applied (or rediscovered) in a variety of
contexts. This SDE exhibits the ‘mean reversion’ behavior (when α > 0).
Coefficient matching method failes for this SDE, so we try a different test
function ˆ t
 
X(t) = a(t) x0 + b(s)dB(s) ,
0
where a(0) = 1. By differentiating each side we get,
a0 (t)
dX(t) = X(t) dt + a(t)b(t)dB(t),
a(t)
where we assume that a(t) > 0 for all t. This should match the given SDE,
so we must have
a0 (t)
−α = and σ = a(t)b(t).
a(t)
Therefore, a(t) = e−αt and b(t) = σeαt . From this, we see that
ˆ t
X(t) = x0 e−αt + σeα(s−t) dB(s).
0
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2. Numerical methods
Most PDE and SDE do not have closed form solutions. In this case we
can use numerical methods such as finite difference method, tree method,
or Monte Carlo simulation to find an approximate solution. We will briefly
discuss the some of the methods.

2.1. Finite difference methods. Here is an example of using finite differ-

ence method in solving an ordinary differential equation.
Example 2.1. Suppose we want to solve u0 (x) = 5u(x) + 2, u(0) = 0 to
compute u(1).
Step 1. Choose a small value of h. Our plan is to compute the (ap-
proximate) value of u at the points x = 0, h, 2h, 3h, 4h, 5h, · · · , kh where
kh = 1. We hope that the numerical value approaches the real value as we
take smaller values of h. (For example, take h = 1/2)
Step 2. Use Taylor’s formula to compute
u((i + 1)h) ≈ u(ih) + h · u0 (ih)
(2.1) = u(ih) + h · (5u(ih) + 2).
Note that u((i + 1)h) can be computed approximately based on the value
of u(ih). Hence we can continue computing the values of u at our sample
points.
For h = 1/2, we see that u( 12 ) ≈ u(0) + 12 u0 (0) = u(0) + 21 (5 · u(0) + 2) = 1,
and u(1) ≈ u( 21 ) + 12 u0 ( 12 ) = u( 12 ) + 12 (5u( 12 ) + 2) = 92 .
This method can easily be extended to partial differential equations. For
example, when studying a function u(x, y) of two variables, we may compute
the value of u at the intersection points of some fine grid, i.e., we choose some
small real h, and compute the values u(ih, jh) for integers i = 0, 1, 2, · · · and
j = 0, 1, 2, · · · .
This method cannot be directly applied to solve SDEs. This is because
in SDEs, the equation corresponding to (2.1) involves random variables.
2.2. Monte Carlo simulation. Monte Carlo simulation is a method that
is used to simulate a probability space by taking independent samples from
the space according to the probability distribution.
Monte Carlo simulation can be used to resolve this issue for SDEs. Sup-
pose that we have a SDE of the form
df (t, Bt ) = g(t, Bt )dBt + h(t, Bt )dt.
If we already know the path Bt , then the equation now becomes a PDE,
hence one can use the finite difference method to solve it.
Monte Carlo simulation (applied to this setting) involves the following
three steps.
Step 1: Choose a random sample path Bt according to the probability
distribution.
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Step 2: Use the sample path from Step 1 and finite difference method to
solve the SDE for the particular choice of sample path.
Step 3: Repeat Step 1 and 2 many times.
This gives a probability distribution of the random stochastic process
f (t, Bt ). Monte Carlo simulation is based on the idea that the resulting
probability distribution of this method will converge to the distribution of
the stochastic process that solves the SDE.

2.3. Tree method. Tree method uses the idea that the Brownian motion
can be seen as a limit of a simple random walk. Suppose that we would like
to compute the value of f (t, Bt ) at some time t = T , where
df (t, Bt ) = g(t, Bt )dBt + h(t, Bt )dt.
We begin by taking sample points t0 , t1 t2 , · · · of the time domain [0, T ].
We replace the occurences of Bt in the SDE by a simple random walk
which either goes up one step or down one step during each time interval
[ti , ti+1 ] (where the step size is appropriately chosen). This gives an inductive
way to approximately find the probability distribution of f (T, BT ).

Hull [4] illustrates how these methods are used in financial applications.

3. Heat equation
Our last topic of study is a well-known PDE, heat equation. It is well
known that the Black-Scholes equation can be turned into a heat equation
after a suitable change of variables.
Let u(x, t) be a function of two varaibles, space and time (denoted x and
t) .The following differential equation is known as the one dimensional heat
equation (diffusion equation):
∂u ∂2u
= .
∂t ∂x2
This is one of the few partial differential equations that is very well under-
stood (and has a closed form solution).
Example 3.1. Let u(x, t) represent the temparature in a long, thin, uniform
bar of material whose sides are perfectly insulated so that its temperature
varies only with distance x along the bar (and with time t). Then u(x, t)
satisfies the heat equation (this is where the name of the equation comes
from).
Our goal is to solve various initial value problems for the heat equation.
The initial values that we consider will be given as
u(0, x) = u0 (x) (for −∞ < x < ∞),
for some function u0 .
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Observation 1. Heat equation is linear, i.e., if u1 (x, t) and u2 (x, t)

satisfies the heat equation, then (u1 + u2 )(x, t) also satisfies the heat equa-
tion. More ´generally if we have a collection of solutions us (x, t) indexed by
∞
s ∈ R,then −∞ us (x, t) · c(s)ds is also a solution (as long as the integral ex-
ists and is differentiable up to appropriate order). This means that we can
superimpose solutions of ‘easy’ initial value problems to obtain a solution
to a more general initial value problem.
Observation 2. The ‘easy’ initial value problem we are going to use is
when the initial value is given as a Dirac delta function. Let δ(x) be the
Dirac delta function and suppose that u0 = δ so that we are solving

u(0, x) = δ(x).

The solution for this initial value problem is known to be

1 2
uδ (x, t) = √ e−x /(4t) (for −∞ < x < ∞,t > 0).
2 πt
Note that the solution ’converges to’ the Dirac delta function as t tends to
zero. Also note that for fixed value of t > 0, this is a probability distribution
function of the normal random variable.
x
Exercise 3.2. Derive the solution above by using ξ = √
t
, and U (ξ) =
t1/2 u(x, t), and restating the heat equation as an ODE.

Now suppose that a function u0 is given. We can understand u0 as a

function obtained by superimposing Dirac delta functions, i.e.,
ˆ ∞
u0 (x) = δ(x − s)u0 (s)ds.
−∞

Consider the following function obtained by superimposing the solutions

accordingly:
ˆ ∞
u(x, t) = uδ (x − s, t) · u0 (s)ds
−∞

(such function need not be well-defined since the integration might not ex-
ist).
However, if the function u0 is ‘reasonable’ then we can show that
(3.1) ˆ ∞ ˆ ∞ 2
∂u ∂uδ ∂2u ∂ uδ
(x, t) = (x−s, t)·u0 (s)ds and 2
(x, t) = 2
(x−s, t)·u0 (s)ds.
∂t −∞ ∂t ∂x −∞ ∂x

This implies that u(x, t) satisfies the heat equation as well. Note that
u0 (x, 0) = u0 (x), and hence as long as a ‘reasonable’ initial condition u0
is given (so that u(x, t) is well-defined and (3.1) holds), we see that u(x, t)
solves the initial value problem.
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References
[1] P. Wilmott, S. Howison, J. Dewynne, The mathematics of financial derivatives
[2] S. Shreve, Stochastic calculus for finance II: continuous-time models
[3] M. Steele, Stochastic calculus and financial applications
[4] J. Hull, Options, futures, and other derivatives
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18.S096 Topics in Mathematics with Applications in Finance

Fall 2013

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