STOCHASTIC DIFFERENTIAL EQUATION

A 'stochastic differential equation (SDE)' is a differential equation in which one or more of the terms is a stochastic process, thus resulting in a solution which is itself a stochastic process. Typically, SDEs incorporate white noise which can be thought of as the derivative of Brownian motion (or the Wiener Process); however, it should be mentioned that other types of random fluctuations are possible, such as jump processes (see [1]).

Contents

Background

Terminology

Stochastic Calculus

Numerical Solutions

Use in Physics

Note on "the Langevin equation"

Use in probability and financial mathematics

Existence and uniqueness of solutions

References

See also

External links

Background

The earliest work on SDEs was done to describe Brownian motion in Einstein's famous paper. This work was followed upon by Langevin. Later Ito and Stratonovich put SDEs on more solid mathematical footing.

Terminology

In physical science, SDEs are usually written as Langevin equations. These are sometimes confusingly called "the Langevin equation" even though there are many possible forms. These consist of an oridinary differential equation containing a deterministic part and an additonal random white noise term. A second form is the Fokker-Planck equation. The Fokker-Planck equation is a partial differential equation that describes the time evolution of the probability distribution function. The third form is the stochastic differential equation. This is similar to the Langevin form, but it is usually written in differential form. This form is used frequently by mathematicians and in quantitative finance. SDEs come in two varieties, corresponding to two versions of stochastic calculus.

Stochastic Calculus

Brownian motion or the Wiener process was discovered to be exceptionally complex mathematically. The Wiener process is non-differentiable; thus, it requires its own rules of calculus. Two versions of stochastic calculus are used, the Ito stochastic calculus and the Stratonovich stochastic calculus. It is somewhat ambiguous when one should use one or the other. Conveniently, one can readily convert an Ito SDE to an equivalent Stratonovich SDE and back again to aid in solution; however, one must be careful which calculus to use when the SDE is initially written down.

Numerical Solutions

Numerical solution of stochastic differential equations and especially stochastic partial differential equations is a young field relatively speaking. Almost all algorithms that are used for the solution of ordinary differential equations will work very poorly for SDEs, having very poor numerical convergence.

Use in Physics

In Physics, one typically writes down an SDE in the Langevin form and refers to it as "the Langevin equation." For example, a general coupled set of first-order SDEs is often written in the form:
:
where $mathbf\{x\}=\{x\_i|1le\; ile\; k\}$ is the set of unknowns, the $f\_i$ and $g\_i$ are arbitrary functions and the $eta\_m$ are random functions of time, often referred to as "noise terms". This form is usually usable because there are standard techniques for transforming a higher-order equations into several coupled first-order equations by introducing new unknowns. If the $g\_i$ are constants, the system is said to be subject to additive noise, otherwise it is said to be subject to multiplicative noise. Additive noise is the simpler of the two cases. One can often find the correct solution using ordinary calculus. In particular, one can use the ordinary chain rule of calculus. However, in the case of mulitplicative noise, the Langevin equation is not a well-defined intenty on its own, and one must specify whether the Langevin equation should be interpreted as an Ito SDE or a Stratonovich SDE.
In Physics, the main method of solution is to find the probability distribution function as a function of time using the equivalent Fokker-Planck equation (FPE). The Fokker-Planck equation is a deterministic partial differential equation. It tells how the probability distribution function evolves in time similarly to how the Schrödinger equation gives the time evolution of the quantum wave function or the diffusion equation gives the time evolution of chemical concentration. Alternatively numerical solutions can be obtained by Monte Carlo simulation. Other techniques include the path integration that draws on the analogy between statistical physics and quantum mechanics (for example, the Fokker-Planck equation can be transformed into the Schrödinger equation by rescaling a few variables.) or by writing down ordinary differential equations for the statistical moments of the probability distribution function.

Note on "the Langevin equation"

"the" in "the Langevin equation" is somewhat ungrammatical nomenclature. Each individual physical model has has its own Langevin equation. Perhaps, "a Langevin equation" or "the associated Langevin equation" would conform better with common English usage.

Use in probability and financial mathematics

The notation used in probability theory (and in many applications of probability theory, for instance financial mathematics) is slightly different. The reason is that the random function of time $eta\_m$ in the physics formulation can typically not be chosen as a usual function, but only as a generalized function. The following formulation avoids this mathematical complication.
A typical equation is of the form
:$mathrm\{d\}\; X\_t\; =\; mu(X\_t,t),\; mathrm\{d\}\; t\; +\; sigma(X\_t,t),\; mathrm\{d\}\; B\_t\; ,$
where $B$ denotes a Wiener process (Standard Brownian motion).
This equation should be interpreted as an informal way of expressing the corresponding integral equation
:$X\_\{t+s\}\; -\; X\_\{t\}\; =\; int\_t^\{t+s\}\; mu(X\_u,u)\; mathrm\{d\}\; u\; +\; int\_t^\{t+s\}\; sigma(X\_u,u),\; mathrm\{d\}\; B\_u\; .$
The equation above characterizes the behavior of the continuous time stochastic process ''X''_''t'' as the sum of an ordinary Lebesgue integral and an Itō integral. A heuristic (but very helpful) interpretation of the stochastic differential equation is that in a small time interval of length ''δ'' the stochastic process ''X''_''t'' changes its value by an amount that is normally distributed with expectation ''μ''(''X''_''t'', ''t'') ''δ'' and variance ''σ''(''X''_''t'', ''t'')² ''δ'' and is independent of the past behavior of the process. This is so because the increments of a Wiener process are independent and normally distributed. The function ''μ'' is referred to as the drift coefficient, while ''σ'' is called the diffusion coefficient. The stochastic process ''X''_''t'' is called a diffusion process, and is usually a Markov process.
The formal interpretation of an SDE is given in terms of what constitutes a solution to the SDE. There are two main definitions of a solution to an SDE, a strong solution and a weak solution. Both require the existence of a process ''X''_''t'' that solves the integral equation version of the SDE. The difference between the two lies in the underlying probability space (Ω ''F'', Pr). A weak solution consists of a probability space and a process that satisfies the integral equation, while a strong solution is a process that satisfies the equation and is defined on a given probability space.
An important example is the equation for geometric Brownian motion
:$mathrm\{d\}\; X\_t\; =\; mu\; X\_t\; ,\; mathrm\{d\}\; t\; +\; sigma\; X\_t\; ,\; mathrm\{d\}\; B\_t.$
which is the equation for the dynamics of the price of a stock in the Black Scholes options pricing model of financial mathematics.
There are also more general stochastic differential equations where the coefficients ''μ'' and ''σ'' depend not only on the present value of the process ''X''_''t'', but also on previous values of the process and possibly on present or previous values of other processes too. In that case the solution process, ''X'', is not a Markov process, and it is called an Itō process and not a diffusion process. When the coefficients depends only on present and past values of ''X'', the defining equation is called a stochastic delay differential equation.

Existence and uniqueness of solutions

As with deterministic ordinary and partial differential equations, it is important to know whether a given a given SDE has a solution, and whether or not it is unique. The following is a typical existence and uniqueness theorem for Itō SDEs taking values in ''n''-dimensional Euclidean space 'R'^''n'' and driven by an ''m''-dimensional Brownian motion ''B''; the proof may be found in Øksendal (2003, §5.2).
Let ''T'' > 0, and let
:$mu\; :\; mathbb\{R\}^\{n\}\; imes\; [0,\; T]\; o\; mathbb\{R\}^\{n\};$
:$sigma\; :\; mathbb\{R\}^\{n\}\; imes\; [0,\; T]\; o\; mathbb\{R\}^\{n\; imes\; m\};$
be measurable functions for which there exist constants ''C'' and ''D'' such that
:
:
for all ''t'' ∈ [0, ''T''] and all ''x'' and ''y'' ∈ 'R'^''n'', where
:$|\; sigma\; |^\{2\}\; =\; sum\_\{i,\; j\; =\; 1\}^\{n\}\; |\; sigma\_\{ij\}\; |^\{2\}.$
Let ''Z'' be a random variable that is independent of the ''σ''-algebra generated by ''B''_''s'', ''s'' ≥ 0, and with finite second moment:
:
Then the stochastic differential equation/initial value problem
:$mathrm\{d\}\; X\_\{t\}\; =\; mu\; (X\_\{t\},\; t)\; ,\; mathrm\{d\}\; t\; +\; sigma\; (X\_\{t\},\; t)\; ,\; mathrm\{d\}\; B\_\{t\}\; mbox\{\; for\; \}\; t\; in\; [0,\; T];$
:$X\_\{t\}\; =\; Z;$
has a Pr-almost surely unique ''t''-continuous solution (''t'', ''ω'') |→ ''X''_''t''(''ω'') such that ''X'' is adapted to the filtration ''F''_''t''^''Z'' generated by ''Z'' and ''B''_''s'', ''s'' ≤ ''t'', and
:$mathbb\{E\}\; left[\; int\_\{0\}^\{T\}\; |\; X\_\{t\}\; |^\{2\}\; ,\; mathrm\{d\}\; t$
ight] < + infty.

References

★ Stochastic systems, , George, Adomian, Academic Press Inc., 1983,

★ Nonlinear stochastic operator equations, , George, Adomian, Academic Press Inc., 1986,

★ Nonlinear stochastic systems theory and applications to physics, , George, Adomian, Kluwer Academic Publishers Group, 1989,

★ Stochastic Differential Equations: An Introduction with Applications, , Bernt K., Øksendal, Springer, 2003, ISBN 3-540-04758-1

★ Encyclopedia of Actuarial Science, Teugels, J.and Sund B. (eds.), , , Wiley, 2004,

See also

★ Langevin dynamics

★ Stochastic volatility

External links

★ Archive of well-known stochastic differential equations, sitmo.com