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Questions tagged [itos-lemma]

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14
votes
3answers
9k views

What is Ito's lemma used for in quantitative finance?

Further to my question asked here: prior post and which left some points unanswered, I have reformulated the question as follows: What is Ito's lemma used for in quantitative finance? and when is it ...
12
votes
2answers
2k views

Solution of Merton's Jump-Diffusion SDE

In many textbooks and also in the original Merton's paper the solution of the SDE $$ dS_t = S_t\,\mu\,dt+S_t\,\sigma\,dW_t+S_{t^-}\,d\left(\sum_{j=1}^{N_t}V_j-1\right) $$ is written as $$ S_t = ...
14
votes
5answers
2k views

Monte carlo methods for vanilla european options and Ito's lemma.

I understand that by applying Ito's lemma to the following SDE $$dX=\mu\,X\,dt+\sigma\,X\,dW$$ one obtains a solution to the above SDE which is as follows: $${X}\left( t\right) =\mathrm{X}\left( 0\...
1
vote
1answer
973 views

Partial derivative of an integral

Suppose I have a model for the short rate $r$ as ($W(t)$ is standard Brownian motion) $r(t) = c+ \int_0^t \sigma (s) ^2 (t-s) ds+ \int_0^t \sigma (s) dW(s)$ I then want to find the dynamics of $r$, ...
3
votes
1answer
474 views

How to express the volatility of two correlated Ito processes $Wt_1, Wt_2$ expressed in terms of $W_t$?

Having two correlated Ito processes ($W_t^1$ and $W_t^2$ are correlated Brownian motions with correlation $\rho$) $dX_{t} =\mu_{1} dt + \sigma_1 dWt_1 $ $dY_{t} = \mu_{2} dt + \sigma_2 dWt_2 $ ...
2
votes
1answer
260 views

Quantile normal and lognormal

Let's assume we have a normal distribution $X\sim \mathcal{N}(\mu,\sigma^2)$. In a normal distribution the quantile can be calculated as follows: \begin{equation} \Phi_X ^{-1}(p)=\mu +\sigma {\sqrt {...
2
votes
1answer
323 views

Intuition behind Ln transformation of stock price when applying Ito lemma [closed]

I am able to replicate steps and arrive to the option price using Black Scholes framework. Here however I am more interested to understand, at least intuitively, why the ln transformation of price ...
0
votes
1answer
206 views

Self-Financing Portfolio

Why when we are using self-financing portfolios to replicate some external payoff we do not consider the quadratic variation of the portfolio weights? Say, in Black-Scholes world, when we are using $...
0
votes
1answer
158 views

Is there a better, more rigorous explanation for why this partial derivative is 0 using Ito's Lemma?

I encountered the following slide in a lecture on Ito's Lemma. The lecturer explained that $$\frac{\partial V}{\partial t} = 0$$ because the first two derivatives on the slide already took into ...
7
votes
1answer
470 views

Baxter & Rennie HJM: differentiating Ito integral

From Baxter and Rennie, page 138: $$f(t,T)=\sigma W_t+f(0,T)+\int_0^t\alpha(s,T)ds$$ $$Z_t=\exp-\bigg(\sigma(T-t)W_t+\sigma\int_0^tW_sds+\int_0^Tf(0,u)du+\int_0^t\int_s^T\alpha(s,u)ds\bigg)$$ $$dZ_t=...
5
votes
1answer
386 views

Ito's Lemma - Integrand depends on upper limit of integration

A problem I came across while practicing using Ito's Lemma had a process with an integral whose integrand depends on the upper limit of integration (the goal is to find $dZ_{t}$): $Z_{t}=\int_{0}^{t}...
3
votes
2answers
260 views

Application of Ito's lemma

Let $X_t$ be some stochastic process driven by wiener process ($W_t)$ so it can be expressed as: $$dX_t=(...)dt+(...)dW_t$$ Let $f(t,x)$ be some $C^2$ function. Define the process $Z_s=f(t-s,X_s)$ ...
2
votes
1answer
2k views

How to get Geometric Brownian Motion's closed-form solution in Black-Scholes model?

The Black Scholes model assumes the following dynamics for the underlying, well known as the Geometric Brownian Motion: $$dS_t=S_t(\mu dt+\sigma dW_t)$$ Then the solution is given: $$S_t=S_0\,e^{\...
-1
votes
1answer
2k views

Given $S$ is a Geometric Brownian Motion, how to show that $S^n$ is also a Geometric Brownian Motion?

Suppose that a stock price $S$ follows Geometric Brownian Motion with expected return $\mu$ and volatility $\sigma:$ $$dS = \mu S dt +\sigma S dz$$ How to find out the process followed by variable $...