AN INTRODUCTION TO STOCHASTIC CALCULUS

VALERIE HAN

Abstract. This paper will introduce the Ito integral, one type of stochastic
integral. We will discuss relevant properties of Brownian motion, then con-
struct the Ito integral with analogous properties. We end with the stochastic
calculus analogue to the Fundamental Theorem of Calculus, that is, Ito’s For-
mula.

Contents
1. Introduction 1
2. Preliminaries 2
3. Random Walk 3
4. Brownian Motion 4
5. Motivating the Stochastic Integral 6
6. Construction of Ito Integral 7
7. Ito’s Formula 12
Acknowledgments 14
References 14

1. Introduction
Stochastic calculus is used in a number of fields, such as finance, biology, and
physics. Stochastic processes model systems evolving randomly with time. Un-
like deterministic processes, such as differential equations, which are completely
determined by some initial value and parameters, we cannot be sure of a stochastic
process’s value at future times even with full knowledge of the state of the system
and its past. Thus, to study a stochastic process, we study its distribution and the
behavior of a sample path. Moreover, traditional methods of calculus fail in the
face of real-world data, which is noisy. The stochastic integral, which is the integral
of a stochastic process with respect to another stochastic process, thus requires a
whole different set of techniques from those used in calculus.
The most important and most commonly used stochastic process is the one that
models random continuous motion: Brownian motion. We discuss in Section 3 how
Brownian motion naturally arises from random walks, the discrete-time analogue
of Brownian motion, to provide one way of understanding Brownian motion. In
Section 4, we actually define Brownian motion and discuss its properties. These
properties make it very interesting to study from a mathematical standpoint, are
also useful for computations, and will allow us to prove Ito’s formula in Section 7.
However, some of Brownian motion’s properties, such as its non-differentiability,
make it difficult to work with. We discuss its non-differentiability in Section 5
1
2 VALERIE HAN

to provide some motivation for the construction of the Ito integral in Section 6.
Just as with Riemann integrals, computing with the definitions themselves is often
tedious. Ito’s formula discussed in Section 7 is often referred to as the stochastic
calculus analogue to the Fundamental Theorem of Calculus or to the chain rule.
It makes computations of the integral much easier as well as being a useful tool in
understanding how the Ito integral is different from the Riemann integral.
This paper will assume familiarity with the basics of measure theory and prob-
ability theory. We will be closely following Lawler’s book [1] on the subject.

2. Preliminaries
We begin by reviewing a few important terms and discussing how they can be
understood as mimicking information.
Definition 2.1. A family S of subsets of a nonempty set X is a σ-algebra on X if
(i) ∅ ∈ S.
(ii) If A ∈ S, then X \ A ∈ S.
(iii) If An ∈ S for all n ∈ N, then ∪n An ∈ S.
Remark 2.2. A σ-algebra represents known information. By being closed under the
complement and countable unions, the set of information becomes fully filled out;
given some information, we have the ability to make reasonable inferences, and the
σ-algebra reflects that.
Definition 2.3. Let A, B be σ-algebras on X. The σ-algebra A is a sub-σ-algebra
of B if A ⊆ B.
Definition 2.4. A filtration is a family {Ft } of sub-σ-algebras of F with the prop-
erty that Fs ⊆ Ft , for 0 ≤ s < t.
Remark 2.5. Note that a filtration can be understood as the information over time.
For each t, Ft is a σ-algebra, which mimics known information as we discussed in
Remark 2.2. Moreover, just as information (theoretically) cannot be lost, Fs ⊆ Ft
for s < t.
Definition 2.6. Let Ft be a sub-σ-algebra of σ-algebra F , and let X be a random
variable with E[X] < ∞. The conditional expectation E(X | Ft ) of X with respect
to Ft is the random variable Y such that
(i) E(X | Ft ) is Ft -measurable.
(ii) For every Ft -measurable event A, E[E(X | Ft )1A ] = E[X 1A ], where 1
denotes the indicator function.
Notation 2.7. We distinguish conditional expectation from expectation by denot-
ing conditional expectation E(·) and expectation E[·].
Note that the conditional expectation always exists and is unique in that any
two random variables that fulfill the definition are equal almost surely. See proof
of Proposition 10.3 in [3] for the proof.
Since the definition of conditional expectation is difficult to work with, the fol-
lowing properties are helpful for actually computing the conditional expectation.
See proof of Proposition 10.5 in [3] for the proof.
Proposition 2.8. Let X, Y be random variables such that E[X], E[Y ] < ∞. Let
Fs , Ft be sub-σ-algebras of σ-algebra F such that s < t. Then,
 AN INTRODUCTION TO STOCHASTIC CALCULUS 3

(i) (Linearity) If α, β ∈ R, then E(αX + βY | Ft ) = αE(X | Ft ) + βE(Y | Ft ).

(ii) (Projection or Tower Property) E(E(X | Ft ) | Fs ) = E(X | Fs ).
(iii) (Pulling out what’s known) If Y is Ft -measurable and E[XY ] < ∞, then
E(XY | Ft ) = Y E(X | Ft ).
(iv) (Irrelevance of independent information) If X is independent of Ft , then
E[X | Ft ] = E[X].
Remark 2.9. Each of these four properties is true almost surely. Here and in the
rest of the paper, statements about conditional expectation contain an implicit “up
to an event of measure zero.”
Definition 2.10. Let T ⊆ R>0 be a set of times. A stochastic process {Xt }t∈T is
a collection of random variables defined on the same probability space indexed by
time.
Remark 2.11. T is most often N or R>0 , and these are what we will use for random
walk and Brownian motion, respectively.
Notation 2.12. Note that a stochastic process Xt has two “inputs” as a function,
one of which is usually omitted from notation. (The other is t.) Since Xt is a
random variable, any depiction of Xt is of a realization or sample path of Xt , where
we in fact mean Xt (ω) for some ω in the sample space Ω.
Definition 2.13. A stochastic process {Xt } is adapted to filtration {Ft } if Xt is
Ft -measurable for all t.
Remark 2.14. Recall that the random variable X being F -measurable means that
the preimage under X of any Borel set is in F . We will see F -measurability appear
throughout this paper because we want to measure the probability of a random
variable X belonging to the nice sets in R – the Borel sets. Since probabilities
only make sense (ie. are countably additive) for sets in the σ-algebra F , we need
{X ∈ B} ∈ F for all Borel sets B.

3. Random Walk
Since discrete time processes are often easier to understand and describe, we will
start by considering the discrete time analogue to Brownian motion: the random
walk.
Definition 3.1. Let X1 , . . . , Xn be independent random variables such that P (Xi =
1) = P (Xi = −1) = 21 . The random variable Sn := X1 + · · · + Xn is a random walk.
As the name suggests, a random walk can be understood by considering the po-
sition of a walker who does the following every time increment: He walks forwards
one step if a flipped coin turns up heads and backwards if tails.

We can make a few observations immediately. By linearity of expectation,

E[Sn ] = E[X1 ] + · · · + E[Xn ] = 0. Since the random variables Xi are indepen-
dent, Var[Sn ] = Var[X1 ] + · · · + Var[Xn ] = E[X12 ] + · · · + E[Xn2 ] = n.
This matches our intuition that although it should be equally likely for the walker
to end up in a positive or negative position, the higher n is, that is, the higher the
number of steps taken, the higher the likelihood he will be far away from the origin,
spreading out the distribution.
4 VALERIE HAN

Let ∆t denote the time increment and ±∆x denote the position change each
time increment. (The position change above is 1.) Suppose ∆t = 1/N , and Bn∆t =
∆x(X1 + · · · + Xn ). What happens when N grows very large and ∆x becomes
small?
The graph of Bn∆t against t begins to look like the graph of a continuous func-
SN
tion. Moreover, by the Central Limit Theorem, the distribution of √ N
approaches
the standard normal distribution. Both of these qualities are qualities of Brownian
motion.
In fact, it can be shown that Brownian motion is the limit of random walks, but
the proof is complicated. The interested reader is encouraged to read the proof
of Theorem 5.22 in [4]. This fact legitimizes the intuition that Brownian motion
and random walk have similar properties. Moreover, in order to simulate Brownian
motion, one must simulate random walks as we have done here with time and space
increments being very small.

4. Brownian Motion
Brownian motion is one of the most commonly used stochastic processes. It is
used to model anything from the random movement of gas molecules to the often
(seemingly) random fluctuations of stock prices.
In order to model random continuous motion, we define Brownian motion as
follows. For simplicity, we only discuss standard Brownian motion.
Definition 4.1. A stochastic process {Bt } is a (standard) Brownian motion with
respect to filtration {Ft } if it has the following three properties:
(i) For s < t, the distribution of Bt − Bs is normal with mean 0 and variance
t − s. We denote this by Bt − Bs ∼ N (0, t − s).
(ii) If s < t, the random variable Bt − Bs is independent of Fs .
(iii) With probability one, the function t 7→ Bt is a continuous function of t.
Brownian motion is often depicted as, and understood as, a sample path, as in
Figure 1(A). However, Figure 1(B) depicts the random nature of the random vari-
able Bt , exposing the hidden ω in Bt (ω). The density of the sample paths gives a
sense of Brownian motion’s normal distribution, as well as showing that, like the
random walk, the paths of Brownian motion spread out the further they are from
t = 0.

It may not be clear from the definition why (or if) Brownian motion exists. In
fact, Brownian motion does exist. We can show this by first defining the process
{Bt } for the dyadic rationals t. After proving that with probability one the function
t 7→ Bt is continuous on the dyadics, we can extend Bt to all real t by continuity.
The interested reader can see Section 2.5 of [1] for the full proof and construction.

We now introduce a property of Brownian motion that is useful in computing the

conditional expectation: the martingale property. Note that the first two properties
in the definition of Brownian motion mean that we can “start over” Brownian
motion at any time t. The value Bt for s < t does not depend on knowing the
previous values Br where r < s, and the distribution of Bt , given the value of
Bs , is identical except shifted vertically by the value Bs . The martingale property
partially captures this characteristic. Given the stream of information up to time s,
 AN INTRODUCTION TO STOCHASTIC CALCULUS 5

(a) A realization of Brow- (b) Multiple (differently

nian motion. colored) realizations of
Brownian motion.

Figure 1. Brownian motion simulated with random walk as de-

scribed in Section 3, adopted from [7].

the best guess of any future value of a martingale is precisely the random variable’s
value at time s.
Definition 4.2. Let {Mt } be a process adapted to filtration {Ft } such that
E[Mt ] < ∞. The process {Mt } is a martingale with respect to {Ft } if for each
s < t, E(Mt | Fs ) = Ms .
Remark 4.3. If no filtration is specified, we assume that the filtration is the one
generated by {Ms : s ≤ t}.
Definition 4.4. A martingale Mt is a continuous martingale if with probability
one the function t 7→ Mt is continuous.
Proposition 4.5. Brownian motion is a continuous martingale.
Proof. The function t → Bt is continuous with probability one by definition, so all
we need to show is E(Bt | Fs ) = Bs , which easily follows from the properties of
conditional expectation.
E(Bt | Fs ) = E(Bs | Fs ) + E(Bt − Bs | Fs ) by Proposition 2.8(i)
= Bs + E[Bt − Bs ] by Proposition 2.8(iii),(iv)
= Bs since Bt − Bs ∼ N (0, t − s).

Now we turn to another property of Brownian motion that is useful in compu-
tations and will come into use when proving Ito’s formula in Section 7. While we
shall see in Section 5 that Brownian motion has unbounded variation, its quadratic
variation is bounded.
Definition 4.6. Let {Xt } be a stochastic process. The quadratic variation of Xt
is the stochastic process
X 2
hXit = lim Xj/n − X(j−1)/n .
n→∞
j≤tn
6 VALERIE HAN

Proposition 4.7. The quadratic variation of Bt is the constant process hBit = t.

Proof. For ease of notation, we prove the Proposition for t = 1. Thus, we want to
show that the variance of hBit is 0 and the expectation is 1.

Consider
n
X  2
Qn = Bj/n − B(j−1)/n .
j=1

In order to more easily compute the variance and expected value, we express Qn
in terms of a distribution we are familiar with. Let
Bj/n − B(j−1)/n 2
 
Yj = √ .
1/ n
Then,
n
1X
Qn = Yj ,
n j=1

and the random variables Y1 , . . . , Yn are independent, each with distribution Z 2 ,

where Z is the standard normal distribution. Thus, E[Yj ] = E[Z 2 ] = 1, E[Yj2 ] =
E[Z 4 ] = 3, and Var[Yj ] = E[Yj2 ] − E[Yj ]2 = 3 − 1 = 2.
We can now easily calculate the expectation and variance of Qn .
n
1X
E[Qn ] = E[Yj ] = 1.
n j=1

n
1 X 2
Var[Qn ] = Var[Yj ] = .
n2 j=1 n
Thus,
E[hBit ] = lim E[Qn ] = 1, and
n→∞

Var[hBit ] = lim Var[Qn ] = 0,

n→∞
as desired. 

Remark 4.8. Informally, this Proposition tells us that the squared difference of the
values of Brownian motion on a small interval is just the length of the interval.
This gives us the intuition (dBt )2 = dt, which is often used in stochastic integral
calculations.

5. Motivating the Stochastic Integral

In Section 4, we discussed some of the properties that make Brownian motion
easy to work with. In contrast, the property we discuss in this section is the non-
differentiability of Brownian motion.
Theorem 5.1. With probability one, the function t → Bt is nowhere differentiable.
Remark 5.2. Note that this is stronger than the statement “For every t, the deriv-
ative does not exist at t with probability one.”
 AN INTRODUCTION TO STOCHASTIC CALCULUS 7

Rather than including a formal proof of this fact, which is located in many
different places (e.g. see proof of Theorem 2.6.1 in [1]), we give a more intuitive
explanation for why this fact should not be surprising.
−Bs
Suppose Bt were differentiable at time s. Then, the limit limt→s Btt−s would
exist, so both the right and left hand limits would exist and be equal. However,
this would mean that knowing Br for 0 ≤ r ≤ s would tell us something about
Bs+∆t − Bs for ∆t sufficiently small, which seemingly contradicts with the fact
that Bs+∆t − Bs is independent of the information given by Br for r ≤ s.
The non-differentiability of Brownian motion also implies that Brownian motion
has unbounded variation (see Corollary 25 in [5]), which means we cannot simply
use the Riemann-Stieltjes integral to define an integral with respect to Bt .

6. Construction of Ito Integral

As explained in Section 5, due to Brownian motion’s non-differentiability and
unbounded variation,R we cannot simply use Riemann-Stieltjes integration for an
t
integral of the form 0 As dBs . However, we can use a similar strategy as the one
used to define the Lebesgue integral.
Recall that, in the construction of the Lebesgue integral, we first defined the
integral for simple functions and then approximated other, more general, functions
with simple functions. Similarly, for the Ito integral, we first define the integral for
simple processes, and then approximate other functions with simple processes.
Definition 6.1. A process At is a simple process if there exist a finite number of
times 0 = t0 < t1 < · · · < tn < ∞ and associated Ftj -measurable random variables
Yj such that At = Yj on the associated interval tj < t < tj+1 . We denote tn+1 = ∞.
Simple processes, like the simple functions used in the construction of the Lebesgue
integral, are an extension of step functions. Any realization of a simple process looks
like a step function with a finite number of intervals, with the last interval’s right
“endpoint” being ∞, as in Figure 2.

4 At
Y1

Y2
2

Y0 t
1 2 3 4 5 Y3 6

−2

Figure 2. A realization of a simple process At with t0 = 0, t1 = 1,

t2 = 2, and t3 = 5.
8 VALERIE HAN

We can now define the integral of a simple process, much like how we would
define the Riemann-Stieltjes integral. However, unlike with Riemann-Stieltjes inte-
gration, where the endpoint chosen does not affect the properties of the integral, the
endpoint chosen for the stochastic integral is significant. As we shall see in 6.4, the
martingale property of the integral relies on choosing the left endpoint. Moreover,
from an intuitive standpoint, given the use of stochastic processes to model real
world systems evolving with time, we may want to only use “past” values, which
corresponds to the left endpoint, rather than “future” ones.
Definition 6.2. Let At be a simple process as in Definition 6.1. Let t > 0 such
that tj ≤ t < tj+1 . Define the stochastic integral of a simple process to be
Z t Xj
As dBs = Yi (Bti+1 − Bti ) + Yj (Bt − Btj ).
0 i=0

Remark 6.3. More generally, to start integrating from a non-zero time, we define
Z t Z t Z r
As dBs = As dBs − As dBs
r 0 0
.
This newly defined integral has a number of properties we’d expect from an in-
tegral, such as linearity and continuity. However, it also has other useful properties
that come into use for computations, as well as for proving Ito’s formula in Section
9.
Proposition 6.4. Let Bt be a standard Brownian motion with respect to a filtration
{Ft }, and let At , Ct be simple processes. Then, the following properties hold.
(i) (Linearity) Let a, b ∈ R. Then, aAt + bCt is also a simple process, and
Z t Z t Z t
(aAs + bCs )dBs = a As dBs + b Cs dBs .
0 0 0
Moreover, if 0 < r < t,
Z t Z r Z t
As dBs = As dBs + As dBs .
0 0 r
Rt
(ii) (Continuity) With probability one, the function t 7→ 0 As dBs is a contin-
uous function. Rt
(iii) (Martingale) The process Zt = 0 As dBs is a martingale with respect to
{Ft }.
Rt
(iv) (Ito isometry) The process Zt = 0 As dBs has variance
Z t
2
Var[Zt ] = E[Zt ] = E[A2s ]ds.
0

Proof. Let At be a simple process as in Definition 8.1. Let tj ≤ t < tj+1 .

(i) Linearity easily follows from the definition of a simple process and the defi-
nition of the stochastic integral
Rt for simple processes.
Pj
(ii) By Definition 8.3, 0 As dBs = i=0 Yi (Bti+1 − Bti ) + Ytj (Bt − Btj ). Then,
since
Rt the function t 7→ Bt is continuous with probability one, the function t 7→
0
A s dB s is also continuous with probability one.
(iii) We show E(Zt | Fs ) = Zs for s < t.
 AN INTRODUCTION TO STOCHASTIC CALCULUS 9

Let s < t. We only consider the case of s = tj and t = tk , where the meat of the
argument lies. (Note that since s < t, j < k.)
Then, we have
k−1
X
Zt = Zs + Yi [Bti+1 − Bti ].
i=j
We will now use the properties of conditional expectation to compute E(Zt | Fs ).
k−1
X
E(Zt | Fs ) = E(Zs | Fs ) + E(Yi [Bti+1 − Bti ] | Fs ) by Proposition 2.8(i)
i=j
k−1
X
= Zs + E(Yi [Bti+1 − Bti ] | Fs ) by Proposition 2.8(iii)
i=j

Consider the sum. Since j ≤ i ≤ k − 1, ti ≥ s. Hence, by Proposition 2.8(ii),

each term of the sum can be expressed as
E(Yi [Bti+1 − Bti ] | Fs ) = E(E(Yi [Bti+1 − Bti ] | Fti ) | Fs ).
Recall that Yi is Fti measurable by definition of a simple process and Bti+1 − Bti
is independent of Fti by definition of Brownian motion.
E(Yi [Bti+1 − Bti ] | Fti ) = Yi E(Bti+1 − Bti | Fti ) by Proposition 2.8(iii)
= Yi E(Bti+1 − Bti ) by Proposition 2.8(iv)
= 0 since Bti+1 − Bti ∼ N (0, ti+1 − ti ).
Thus, all the terms of the sum are 0, giving us E(Zt | Fs ) = Zs .
(iv) We compute Var[Zt ] = E[Zt2 ] − E[Zt ]2 again using the properties of condi-
tional expectation.
We again only consider the case t = tj , giving us
j−1
X
Zt = Yi [Bti+1 − Bti ] and
i=0
j−1 X
X j−1
Zt2 = Yi [Bti+1 − Bti ]Yk [Btk+1 − Btk ].
i=0 k=0
We first show E[Zt ] = 0, which gives us Var[Zt ] = E[Zt2 ].
j−1
X
E[Zt ] = E[Yi [Bti+1 − Bti ]] by linearity of expectation
i=0
j−1
X
= E[E(Yi [Bti+1 − Bti ] | Fti )] by Proposition 2.8(ii)
i=0
j−1
X
= E[Yi E([Bti+1 − Bti ] | Fti )] by Proposition 2.8(iii)
i=0
j−1
X
= E[Yi E[[Bti+1 − Bti ]]] by Proposition 2.8(iv)
i=0
= 0 since Bti+1 − Bti ∼ N (0, ti+1 − ti ).
10 VALERIE HAN

Now we compute E[Zt2 ]. By linearity of expectation, we have

j−1 X
X j−1
E[Zt2 ] = E[Yi [Bti+1 − Bti ]Yk [Btk+1 − Btk ]].
i=0 k=0

Each term with i < k can be expressed as

E[Yi [Bti+1 − Bti ]Yk [Btk+1 − Btk ]] = E[E(Yi [Bti+1 − Bti ]Yk [Btk+1 − Btk ] | Ftk )].
Note that for i < k, Yi , Bti+1 − Bti , and Yk are Ftk -measurable, and Btk+1 − Btk
is independent of Ftk , allowing us to compute the conditional expectation inside
each term.
E(Yi [Bti+1 − Bti ]Yk [Btk+1 − Btk ] | Ftk ) = Yi [Bti+1 − Bti ]Yk E([Btk+1 − Btk ] | Ftk )
by Proposition 2.8(iii)
= Yi [Bti+1 − Bti ]Yk E[[Btk+1 − Btk ]]
by Proposition 2.8(iv)
= 0 since Btk+1 − Btk ∼ N (0, tk+1 − tk ).
The same argument holds for i > k, so we are left with
j−1
X
E[Zt2 ] = E[Yi2 (Bti+1 − Bti )2 ].
i=0

By Proposition 2.8(ii), we can express each term as

E[Yi2 (Bti+1 − Bti )2 ] = E[E(Yi2 [Bti+1 − Bti ]2 | Fti )].
Since Yi2 is Fti -measurable and (Bti+1 −Bti )2 is independent of Fti , we can again
use the properties of conditional expectation.
E(Yi2 [Bti+1 − Bti ]2 | Fti ) = Yi2 E([Bti+1 − Bti ]2 | Fti ) by Proposition 2.8(iii)
= Yi2 E[(Bti+1 − Bti )2 ] by Proposition 2.8(iv)
= Yi2 (ti+1 − ti ) since E[(Bti+1 − Bti )2 ] = Var[Bti+1 − Bti ].

Thus, we have
j−1
X
(6.5) E[Zt2 ] = E[Yi2 ](ti+1 − ti )
i=0

Note that the function s 7→ E[A2s ] is a step function with the value E[Yi2 ] for
Rt
ti ≤ s < ti+1 . Thus, (6.5) gives us E[Zt2 ] = 0 E[A2s ]ds. 
Now that we have the stochastic integral for simple processes, we consider a
more general process. We show that we can approximate bounded processes with
continuous paths with a sequence of simple processes that are also bounded.
Lemma 6.6. Let At be a process with continuous paths, adapted to the filtration
Ft , such that there exists C < ∞ such that with probability one |At | ≤ C for all t.
(n)
Then there exists a sequence of simple processes At such that for all t,
Z t
(6.7) lim E[|As − A(n) 2
s | ]ds = 0.
n→∞ 0
 AN INTRODUCTION TO STOCHASTIC CALCULUS 11

(n)
Moreover, with probability one, for all n, t, |At | ≤ C.
(n) (n)
Proof. We define At as a simple process approximation of At by letting At =
R j/n
A(j, n) for nj ≤ t < j+1
n , where A(0, n) = A0 and A(j, n) = n (j−1)/n As ds.
(n)
Note that by construction, At are simple processes, and with probability one
(n)
|At | ≤ C.
R 1 (n)
Let Yn = 0 [At − At ]2 dt.
(n)
Note that At is essentially a step function approximation to At , which is con-
(n)
tinuous with probability one, so At → At . Then, by the bounded convergence
theorem applied to Lebesgue measure, limn→∞ Yn = 0.
Since the random variables Yn are uniformly bounded,
Z 1 
(n) 2
lim E [At − At ] dt = lim E[Yn ] = 0.
n→∞ 0 n→∞


Given the Lemma, we can now define the stochastic integral of bounded processes
with continuous paths in terms of the integrals of simple processes. Fortunately,
because of the constructive nature of the proof, we can actually find the sequence
described in the Lemma and not merely know that it exists.
(n)
Definition 6.8. Let At and At be as in Lemma 8.7. Define
Z t Z t
As dBs = lim As(n) dBs .
0 n→∞ 0

The same properties as those in Proposition 6.4 hold because all the properties
are preserved under L2 limits. See proof of Proposition 3.2.3 in [1] for the full proof.
Remark 6.9. This definition easily extends to piecewise continuous paths. Let t > 0.
If As has discontinuities at 0 ≤ t0 < t1 < · · · < tn ≤ t, then we can define
Z t Z t1 Z t2 Z t
As dBs = As dBs + As dBs + · · · + As dBs .
0 0 t1 tn

Similarly, to Lebesgue integration, we can extend the definition of the stochastic

integral to unbounded processes, by pushing the bounds further and further and
then taking the limit. Suppose At is an unbounded adapted process with continuous
paths. We have two options. The option that may seem more straightforward is
cutting off everything above C on At , such that it becomes bounded by C, and
then taking the limit as C → ∞. This is the approach that is often taken for
constructing the Lebesgue integral. For example, see Chapter 2 of [6]. However,
the intuition for stochastic integral is different. Since stochastic integrals model a
quantity evolving with time, we instead want to “stop time” at a certain point T ,
and then take the limit as T → ∞. Note that we still have the upper bound on At
monotonically increasing.
Definition 6.10. Let As be adapted with continuous paths. For each n ∈ N, let
(n)
Tn = min{t : |At | = n}, and let As = As∧Tn , where s ∧ Tn = min{s, Tn }. Define
Z t Z t
(6.11) As dBs = lim As(n) dBs.
0 n→∞ 0
12 VALERIE HAN

By making the path have the constant value n after time Tn , we have “stopped”
(n)
the process and obtained bounded, continuous processes As . Thus, the integral
R t (n)
0
As dBs is well defined.
Moreover, the limit in (6.11) is also well-defined, as we shall now show.
Let Kt = max0≤s≤t |As |, which exists because [0, t] is compact and As is contin-
uous.
(n)
Then, for all n ≥ Kt , As is bounded by Kt for 0 ≤ s ≤ t, so As = As for
Rt R t (n)
0 ≤ s ≤ t. Thus, 0 As dBs = 0 As dBs for n ≥ Kt , so the limit is well-defined.
Note that Kt is a random variable that depends on the path. Although the other
three properties hold, this integral may not satisfy the martingale property. (See
Section 4.1 in [1] for more details.)

7. Ito’s Formula
Now that we’ve defined the stochastic integral, we might wonder if there exists
a stochastic calculus analogue to the Fundamental Theorem of Calculus. Indeed,
there is: Ito’s formula.
Theorem 7.1. (Ito’s formula I) Suppose f is a C 2 function. Then for every t,
Z t
1 t 00
Z
(7.2) f (Bt ) = f (B0 ) + f 0 (Bs )dBs + f (Bs )ds
0 2 0
Alternatively, we can write
1
(7.3) df (Bt ) = f 0 (Bt )dBt + f 00 (Bt )dt
2
Remark 7.4. Ito’s formula is also called the chain rule of stochastic calculus, refer-
encing the differential form (7.3).
Proof. This proof omits some of the technical details in favor of focusing on the
bigger ideas. See the proof of Theorem 3.3.1 in [1] for a similar proof with the
technical details added. Alternatively, for an even more technical proof, see proof
of Theorem 8.6.1 in [2] for a different proof.
For ease of notation, we prove the Theorem for t = 1. Consider f (B1 ) − f (B0 ).
First write this as the telescoping sum
n
X
(7.5) f (B1 ) − f (B0 ) = f (Bj/n ) − f (B(j−1)/n )
j=1

so that we can examine the infinitesimal changes in f as well as put it in a form

that is closer to the stochastic integral of a simple process.
Now let us look at the second-order Taylor expansion for each term in the sum.
Ordinarily, for normal calculus, the second-order term goes to 0, but because of the
added randomness, this does not happen here.
Let ∆j,n = Bj/n − B(j−1)/n . Then, the second-order Taylor expansion gives us
1
(7.6) f (Bj/n ) − f (B(j−1)/n ) = f 0 (B(j−1)/n )∆j,n + f 00 (B(j−1)/n )∆2j,n + o(∆2j,n ).
2
Since (7.5) and (7.6) hold for all n ∈ N, we have that f (B1 ) − f (B0 ) is the sum
of the following three limits
X n
(7.7) lim f 0 (B(j−1)/n )∆j,n ,
n→∞
j=1
 AN INTRODUCTION TO STOCHASTIC CALCULUS 13

n
1 X
(7.8) lim f 00 (B(j−1)/n )∆2j,n , and
2 n→∞ j=1

n
X
(7.9) lim o(∆2j,n )
n→∞
j=1

The first limit is just R 1a 0simple process approximation to a stochastic integral.

Thus, (7.7) is equal to 0 f (Bt )dBt .
The third limit is actually just the quadratic variation, and so we have that (7.9)
is limn→∞ o(1) = 0.
Now consider the second limit. Comparing with R 1 the statement of the Theorem,
we can see that we’d like to show that (7.8) is 21 0 f 00 (Bt )dt.
Recall again the quadratic variation. Note that if we could somehow pull f 00 (B(j−1)/n )
out of the sum, the limit of the sum would again be the quadratic variation. Yet,
the second derivative need not be constant, so we cannot quite do that. However,
because f is C 2 , we can approximate f 00 by a step function, which allows us to do
this trick on the intervals where the step function is constant.
Call f 00 (Bt ) = h(t). Since h is continuous, we can approximate h(t) by the step
function h (t) such that for all t, |h(t) − h (t)| < .
On each interval where h is constant, we can pull out h , leaving us with a
Riemann sum. Thus, by the linearity of the Riemann integral, we get
n
1 1
Z
1X
h ((j − 1)/n)∆2j,n = h (t)dt.
2 j=1 2 0

Now we show that the sums with h and h are sufficiently close. This is easy to
show because of how how we defined h .
n
X n
X
[h(t) − h (t)]∆2j,n ≤  ∆2j,n → .
j=1 j=1

Thus, we have
 
X n Z 1 Z 1 Z 1
lim lim
 2 
h (t)∆j,n = lim h (t)dt = h(t)dt = f 00 (Bt )dt,
→0 n→∞ →0 0 0 0
j=1
R1
giving us that (7.8) is 1
2 0
f 00 (Bs )ds, as desired. 

We give an example that emphasizes the difference between the Ito integral and
the normal calculus integral.
Example 7.10. Let f (x) = x2 . Then, f 0 (x) = 2x and f 00 (x) = 2. Thus,
Z t
1 t 00
Z
Bt2 = B02 + f 0 (Bs )dBs + f (Bs )ds by Ito’s formula
0 2 0
Z t
1 t
Z
=0+ 2Bs dBs + 2ds
0 2 0
Z t
=2 Bs dBs + t,
0
14 VALERIE HAN

giving us
Z t
1 2
[B − t].
Bs dBs =
0 2 t
Note that this is different from what we might naively expect without seeing
Ito’s formula, as normal calculus would have us incorrectly guess
Z t
1
Bs dBs = Bt2 .
0 2
Ito’s formula also has other more general forms. We state one of these here. The
interested reader is encouraged to read Theorem 3.4.2 and 3.4.3 in [1] for two even
more general versions.
Theorem 7.11. (Ito’s formula II) Suppose f (t, x) is a function that is C 1 in t and
C 2 in x. Then for every t,
Z t Z t
1 ∂2f

∂f ∂f
(7.12) f (t, Bt ) = f (0, B0 ) + (s, Bs )dBs + (s, Bs ) + (s, Bs ) ds
0 ∂x 0 ∂s 2 ∂x2
Again, we can also write this as
1 ∂2f
 
∂f ∂f
(7.13) df (t, Bt ) = (s, Bs )dBs + (s, Bs ) + (s, Bs ) ds
∂x ∂s 2 ∂x2
The proof is similar to Ito’s formula I, except that the Taylor expansion gives us
another term. See the proof of Theorem 3.4.2 in [1] for more details.

We end with an example that uses Ito’s formula II, this time using the differential
form of Ito’s formula.
∂f ∂f
Example 7.14. Let f (t, x) = eat+bx . Then, ∂t (t, x) = af (t, x), ∂x (t, x) = bf (t, x),
2
∂ f 2
and ∂x2 (t, x)
= b f (t, x).
Let Xt = f (t, Bt ) = eat+bBt . Then,
1 ∂2f
 
∂f ∂f
dXt = (s, Bs )dBs + (s, Bs ) + (s, Bs ) ds by Ito’s formula II
∂x ∂s 2 ∂x2
b2
 
= bXt dBt + a + Xt dt.
2

Acknowledgments
I’d like to thank my mentor Yucheng Deng for answering my questions and re-
viewing my paper. I would also like to thank Abhimanyu Choudhary for helping me
understand filtrations. Finally, I’d like to thank Professor Peter May for organizing
the program.

References
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[6] Elias Stein and Rami Shakarchi. Real Analysis: Measure Theory, Integration, and Hilbert
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