Ito’s Lemma is a fundamental result in stochastic calculus that extends the classical chain rule from deterministic calculus to functions of stochastic processes, particularly those following a Brownian motion. It provides a way to compute the differential of a function , where is a stochastic process described by a stochastic differential equation (SDE). The lemma states that if is twice continuously differentiable, then the differential can be expressed as:
where is the volatility and represents the increment of a Brownian motion. This formula highlights the impact of both the deterministic changes and the stochastic fluctuations on the function . Ito's Lemma is crucial in financial mathematics, particularly in option pricing and risk management, as it allows for the modeling of complex financial instruments under uncertainty.
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