Question

In the derivation of the Itô-Doeblin formula, Theorem 4.4.1, we considered only the case of the function $f(x)=\frac{1}{2} x^2$, for which $f^{\prime \prime}(x)=1$. This made it easy to determine the limit of the last term, $$ \frac{1}{2} \sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2, $$ appearing in (4.4.5). Indeed, $$ \begin{aligned} \lim _{\|\Pi\| \rightarrow 0} \sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2 & =\lim _{\|\Pi\| \rightarrow 0} \sum_{j=0}^{n-1}\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2 \\ & =[W, W](T)=T \\ & =\int_0^T f^{\prime \prime}(W(t)) d t . \end{aligned} $$ If we had been working with an arbitrary function $f(x)$, we could not replace $f^{\prime \prime}\left(W\left(t_j\right)\right)$ by 1 in the argument above. It is tempting in this case to just argue that $\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2$ is approximately equal to $\left(t_{j+1}-t_j\right)$, so that $$ \sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2 $$ is approximately equal to $$ \sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left(t_{j+1}-t_j\right) $$

     In the derivation of the Itô-Doeblin formula, Theorem 4.4.1, we considered only the case of the function $f(x)=\frac{1}{2} x^2$, for which $f^{\prime \prime}(x)=1$. This made it easy to determine the limit of the last term,
$$
\frac{1}{2} \sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2,
$$
appearing in (4.4.5). Indeed,
$$
\begin{aligned}
\lim _{\|\Pi\| \rightarrow 0} \sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2 & =\lim _{\|\Pi\| \rightarrow 0} \sum_{j=0}^{n-1}\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2 \\
& =[W, W](T)=T \\
& =\int_0^T f^{\prime \prime}(W(t)) d t .
\end{aligned}
$$

If we had been working with an arbitrary function $f(x)$, we could not replace $f^{\prime \prime}\left(W\left(t_j\right)\right)$ by 1 in the argument above. It is tempting in this case to just argue that $\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2$ is approximately equal to $\left(t_{j+1}-t_j\right)$, so that
$$
\sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2
$$
is approximately equal to
$$
\sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left(t_{j+1}-t_j\right)
$$
Show more…
Stochastic Calculus for Finance II : Continuous-Time Models
Stochastic Calculus for Finance II : Continuous-Time Models
Steven E. Shreve 1st Edition
Chapter 4, Problem 14 ↓

Instant Answer

verified

Step 1

The formula provides a way to compute the differential of a function of a stochastic process. In the specific case discussed, the function considered is \( f(x) = \frac{1}{2} x^2 \), which simplifies the computation because its second derivative \( f''(x) = 1 \)  Show more…

Show all steps

lock
AceChat toggle button
Close icon
Ace pointing down

Please give Ace some feedback

Your feedback will help us improve your experience

Thumb up icon Thumb down icon
Thanks for your feedback!
Profile picture
In the derivation of the Itô-Doeblin formula, Theorem 4.4.1, we considered only the case of the function $f(x)=\frac{1}{2} x^2$, for which $f^{\prime \prime}(x)=1$. This made it easy to determine the limit of the last term, $$ \frac{1}{2} \sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2, $$ appearing in (4.4.5). Indeed, $$ \begin{aligned} \lim _{\|\Pi\| \rightarrow 0} \sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2 & =\lim _{\|\Pi\| \rightarrow 0} \sum_{j=0}^{n-1}\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2 \\ & =[W, W](T)=T \\ & =\int_0^T f^{\prime \prime}(W(t)) d t . \end{aligned} $$ If we had been working with an arbitrary function $f(x)$, we could not replace $f^{\prime \prime}\left(W\left(t_j\right)\right)$ by 1 in the argument above. It is tempting in this case to just argue that $\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2$ is approximately equal to $\left(t_{j+1}-t_j\right)$, so that $$ \sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left[W\left(t_{j+1}\right)-W\left(t_j\right)\right]^2 $$ is approximately equal to $$ \sum_{j=0}^{n-1} f^{\prime \prime}\left(W\left(t_j\right)\right)\left(t_{j+1}-t_j\right) $$
Close icon
Play audio
Feedback
Powered by NumerAI
Need help? Use Ace
Ace is your personal tutor. It breaks down any question with clear steps so you can learn.
Start Using Ace
Ace is your personal tutor for learning
Step-by-step explanations
Instant summaries
Summarize YouTube videos
Understand textbook images or PDFs
Study tools like quizzes and flashcards
Listen to your notes as a podcast
Continue solving this problem
Create a free account to:
  • View full step-by-step solution
  • Ask follow-up questions with Ace AI
  • Save progress and study later
Continue Free
Join the community

18,000,000+

Students on Numerade


Trusted by students at 8,000+ universities

Numerade

Get step-by-step video solution
from top educators

Continue with Clever
or



By creating an account, you agree to the Terms of Service and Privacy Policy
Already have an account? Log In

A free answer
just for you

Watch the video solution with this free unlock.

Numerade

Log in to watch this video
...and 100,000,000 more!


EMAIL

PASSWORD

OR
Continue with Clever