Ex4 22

MA 372 : Stochastic Calculus for Finance
July - November 2022

Department of Mathematics, Indian Institute of Technology Guwahati
Exercises 4
October 28, 2022
1. We shall call f (t), t ∈ [0, T ] a simple process if there is a finite sequence of

numbers 0 = t0 < t1 < · · · < tn = T P and square integrable random variables
n−1
η0 , η1 , · · · , ηn−1 such that f (t, w) = j=0 ηj (w)I[tj ,tj+1 ) (t), where ηj is Ftj -
measurable. The set of simple processes will be denoted by Mstep 2 ([0, T ] × Ω)
2 ([0, T ]×Ω) is a vector space, that is, af +bg ∈ M 2 ([0, T ]×

a) Show that Mstep step
2 ([0, T ] × Ω) and a, b ∈ R.
Ω) for any f, g ∈ Mstep
b) Show that I : Mstep2 ([0, T ] × Ω) → L2 is a linear map, i.e., for any f, g ∈

2
Mstep ([0, T ] × Ω) and a, b ∈ R
I(af + bg) = aI(f ) + bI(g).
2 ([0, T ] × Ω)
c) For any f, g ∈ Mstep
h i hZ T i
E I(f )I(g) = E f (t)g(t)dt
0
2. Check whether the following processes X(t) are martingale with respect to
Brownian filtration
a) X(t) = W (t) + 4t R b) X(t) = W 2 (t)
t
c) X(t) = t2 W (t) − 2 0 sW (s)ds
3. Use Ito’s formula to prove that the following stochastic process are martingale
with respect to Brownian filtration
t t
a) X(t) = e 2 cos W (t) b) X(t) = e 2 sin W (t)
t t
c) X(t) = eW (t)− 2 d) X(t) = (W (t) + t)e−W (t)− 2
4. Define βk (t) = E[W k (t)]; k = 0, 1, 2, · · · ; t ≥ 0
Use Ito’s formula to prove that
Z t
1
βk (t) = k(k − 1) βk−2 (s)ds; k ≥ 2
2 0
a) Deduce that E[W 4 (t)] = 3t2 and find E[W 6 (t)].

k
b) Show that E[W 2k+1 (t)] = 0 and E[W 2k (t)] = (2k)!t
2k k!
5. For c, α constants, define

X(t) = ect+αW (t) .
Prove that
1
dX(t) = (c + α2 )X(t)dt + αX(t)dW (t)
2
1
P2
6. Let h(t) = j=0 (j + 1)I[j,j+1) (t). Define
Z t
I(t) = h(s)dW (s), 0 ≤ t ≤ 3.
0
Find the distribution function of the random variable I(2). Find the variance
of the random variable I(3).
7. Let Π = {t0 , t1 , · · · , tn } be a partition of [0, T ] with 0 = t0 < t1 < · · · < tn = T .

For α ∈ [0, 1], consider the sum
n−1
Xh i
Sα (Π) = (1 − α)W (tj ) + αW (tj+1 ) (W (tj+1 ) − W (tj )).
j=0
Evaluate the limit lim Sα (Π) (in L2 ), where kπk = max (tj − tj−1 ).
||Π||→0 j=1,2,···,n
8. If f (t, x) = et/2 (sin x + cos x), then check whether the process f (t, W (t)) is a
martingale with respect to Brownian filtration.
9. Let Π = {t0 , t1 , · · · , tn } be a partition of [0, T ] with 0 = t0 < t1 < · · · < tn = T .

For α ∈ [0, 1], consider the sum
n−1
Xh i
Sα (Π) = (W (tj+1 ) − W (tj ))2 − (tj+1 − tj ) .
j=0
Evaluate the limit lim Sα (Π) (in L2 ), where kπk = max (tj − tj−1 ).
||Π||→0 j=1,2,···,n
10. If f (t, x) = x5 − 10tx3 + 15t2 x, then check whether the process f (t, W (t)) is a
martingale with respect to Brownian filtration.
11. Suppose that {W (t); t ≥ 0} is a standard Brownian motion with W (0) = 0.

Determine an expression for
Z t
sin(W (s))dW (s)
0
that does not involve Ito integrals.

Rt
12. Suppose f (t) is a deterministic function. Let X(t) = X(0) + 0 f (s)dW (s).
Determine an expression for
Z t
f (s)X(s)dW (s)
0
that does not involve Ito integrals.

Rt
13. Suppose f (t) is a deterministic function. Let X(t) = 0 f (t)[sin(W (t) +
cos(W (t))]dW (t). Find the mean and variance of the random variable X(2).
2
14. The solution to the BSM PDE with the specified terminal and boundary con-
ditions is given by
c(t, x) = xN (d+ (T − t, x)) − Ke−r(T −t) N (d− (T − t, x)) 0 ≤ t < T, x > 0 ,

2
where d± (T − t, x) = σ√1T −t [log(x/K) + (r ± σ2 )(T − t)] and N is the CDF of
N (0, 1). Note that c(t, x) is not defined for t = T and x = 0. But c(t, x) is
defined in such a way that limt→T c(t, x) = (x − K)+ and limx↓0 c(t, x) = 0.
(a) Verify that Ke−r(T −t) N 0 (d− ) = xN 0 (d+ ).

(b) Prove that cx (t, x) = N (d+ (T − t, x)).
(c) Prove that ct (t, x) = −rKe−r(T −t) N (d− (T − t, x)) − √σx N 0 (d+ (T
2 T −t
−
t, x)).
(d) Prove that cxx (t, x) = √1
σx T −t
N 0 (d+ (T − t, x)).
(e) Use the above formulas to show that c(·, ·) satisfies the BSM PDE.

Ex4 22

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Ex4 22

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MA 372 : Stochastic Calculus for Finance

July - November 2022

1. We shall call f (t), t ∈ [0, T ] a simple process if there is a finite sequence of

2 ([0, T ]×Ω) is a vector space, that is, af +bg ∈ M 2 ([0, T ]×

b) Show that I : Mstep2 ([0, T ] × Ω) → L2 is a linear map, i.e., for any f, g ∈

a) Deduce that E[W 4 (t)] = 3t2 and find E[W 6 (t)].

5. For c, α constants, define

7. Let Π = {t0 , t1 , · · · , tn } be a partition of [0, T ] with 0 = t0 < t1 < · · · < tn = T .

9. Let Π = {t0 , t1 , · · · , tn } be a partition of [0, T ] with 0 = t0 < t1 < · · · < tn = T .

11. Suppose that {W (t); t ≥ 0} is a standard Brownian motion with W (0) = 0.

that does not involve Ito integrals.

that does not involve Ito integrals.

c(t, x) = xN (d+ (T − t, x)) − Ke−r(T −t) N (d− (T − t, x)) 0 ≤ t < T, x > 0 ,

(a) Verify that Ke−r(T −t) N 0 (d− ) = xN 0 (d+ ).

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