Tag: Semimartingale

Special Semimartingales

For stochastic processes in discrete time, the Doob decomposition uniquely decomposes any integrable process into the sum of a martingale and a predictable process. If {\{X_n\}_{n=0,1,\ldots}} is an integrable process adapted to a filtration {\{\mathcal{F}_n\}_{n=0,1,\ldots}} then we write {X_n=M_n+A_n}. Here, M is a martingale, so that {M_{n-1}={\mathbb E}[M_n\vert\mathcal{F}_{n-1}]}, and A is predictable with {A_0=0}. By saying that A is predictable, we mean that {A_n} is {\mathcal{F}_{n-1}} measurable for each {n\ge1}. It can be seen that this implies that

\displaystyle A_n-A_{n-1}={\mathbb E}[A_n-A_{n-1}\vert\mathcal{F}_{n-1}]={\mathbb E}[X_n-X_{n-1}\vert\mathcal{F}_{n-1}].

Then it is possible to write A and M as

\displaystyle \setlength\arraycolsep{2pt} \begin{array}{rl} \displaystyle A_n&\displaystyle=\sum_{k=1}^n{\mathbb E}[X_k-X_{k-1}\vert\mathcal{F}_{k-1}],\smallskip\\ \displaystyle M_n&\displaystyle=X_n-A_n. \end{array} (1)

So, the Doob decomposition is unique and, conversely, the processes A and M constructed according to equation (1) can be seen to be respectively, a predictable process starting from zero and a martingale. For many purposes, this allows us to reduce problems concerning processes in discrete time to simpler statements about martingales and separately about predictable processes. In the case where X is a submartingale then things reduce further as, in this case, A will be an increasing process.

The situation is considerably more complicated when looking at processes in continuous time. The extension of the Doob decomposition to continuous time processes, known as the Doob-Meyer decomposition, was an important result historically in the development of stochastic calculus. First, we would usually restrict attention to sufficiently nice modifications of the processes and, in particular, suppose that X is cadlag. When attempting an analogous decomposition to the one above, it is not immediately clear what should be meant by the predictable component. The continuous time predictable processes are defined to be the set of all processes which are measurable with respect to the predictable sigma algebra, which is the sigma algebra generated by the space of processes which are adapted and continuous (or, equivalently, left-continuous). In particular, all continuous and adapted processes are predictable but, due to the existence of continuous martingales such as Brownian motion, this means that decompositions as sums of martingales and predictable processes are not unique. It is therefore necessary to impose further conditions on the term A in the decomposition. It turns out that we obtain unique decompositions if, in addition to being predictable, A is required to be cadlag with locally finite variation (an FV process). The processes which can be decomposed into a local martingale and a predictable FV process are known as special semimartingales. This is precisely the space of locally integrable semimartingales. As usual, we work with respect to a complete filtered probability space {(\Omega,\mathcal{F},\{\mathcal{F}_t\}_{t\ge0},{\mathbb P})} and two stochastic processes are considered to be the same if they are equivalent up to evanescence.

Theorem 1 For a process X, the following are equivalent.

  • X is a locally integrable semimartingale.
  • X decomposes as
    \displaystyle X=M+A (2)

    for a local martingale M and predictable FV process A.

Furthermore, choosing {A_0=0}, decomposition (2) is unique.

Theorem 1 is a general version of the Doob-Meyer decomposition. However, the name `Doob-Meyer decomposition’ is often used to specifically refer to the important special case where X is a submartingale. Historically, the theorem was first stated and proved for that case, and I will look at the decomposition for submartingales in more detail in a later post. Continue reading “Special Semimartingales” →

Predictable FV Processes

By definition, an FV process is a cadlag adapted stochastic process which almost surely has finite variation over finite time intervals. These are always semimartingales, because the stochastic integral for bounded integrands can be constructed by taking the Lebesgue-Stieltjes integral along sample paths. Also, from the previous post on continuous semimartingales, we know that the class of continuous FV processes is particularly well behaved under stochastic integration. For one thing, given a continuous FV process X and predictable {\xi}, then {\xi} is X-integrable in the stochastic sense if and only if it is almost surely Lebesgue-Stieltjes integrable along the sample paths of X. In that case the stochastic and Lebesgue-Stieltjes integrals coincide. Furthermore, the stochastic integral preserves the class of continuous FV processes, so that {\int\xi\,dX} is again a continuous FV process. It was also shown that all continuous semimartingales decompose in a unique way as the sum of a local martingale and a continuous FV process, and that the stochastic integral preserves this decomposition.

Moving on to studying non-continuous semimartingales, it would be useful to extend the results just mentioned beyond the class of continuous FV processes. The first thought might be to simply drop the continuity requirement and look at all FV processes. After all, we know that every FV process is a semimartingale and, by the Bichteler-Dellacherie theorem, that every semimartingale decomposes as the sum of a local martingale and an FV process. However, this does not work out very well. The existence of local martingales with finite variation means that the decomposition given by the Bichteler-Dellacherie theorem is not unique, and need not commute with stochastic integration for integrands which are not locally bounded. Also, it is possible for the stochastic integral of a predictable {\xi} with respect to an FV process X to be well-defined even if {\xi} is not Lebesgue-Stieltjes integrable with respect to X along its sample paths. In this case, the integral {\int\xi\,dX} is not itself an FV process. See this post for examples where this happens.

Instead, when we do not want to restrict ourselves to continuous processes, it turns out that the class of predictable FV processes is the correct generalisation to use. By definition, a process is predictable if it is measurable with respect to the set of adapted and left-continuous processes so, in particular, continuous FV processes are predictable. We can show that all predictable FV local martingales are constant (Lemma 2 below), which will imply that decompositions into the sum of local martingales and predictable FV processes are unique (up to constant processes). I do not look at general semimartingales in this post, so will not prove the existence of such decompositions, although they do follow quickly from the results stated here. We can also show that predictable FV processes are very well behaved with respect to stochastic integration. A predictable process {\xi} is integrable with respect to a predictable FV process X in the stochastic sense if and only if it is Lebesgue-Stieltjes integrable along the sample paths, in which case stochastic and Lebesgue-Stieltjes integrals agree. Also, {\int\xi\,dX} will again be a predictable FV process. See Theorem 6 below.

In the previous post on continuous semimartingales, it was also shown that the continuous FV processes can be characterised in terms of their quadratic variations and covariations. They are precisely the semimartingales with zero quadratic variation. Alternatively, they are continuous semimartingales which have zero quadratic covariation with all local martingales. We start by extending this characterisation to the class of predictable FV processes. As always, we work with respect to a complete filtered probability space {(\Omega,\mathcal{F},\{\mathcal{F}_t\}_{t\ge0},{\mathbb P})} and two stochastic processes are considered to be equal if they are equivalent up to evanescence. Recall that, in these notes, the notation {[X]^c_t=[X]_t-\sum_{s\le t}(\Delta X_s)^2} is used to denote the continuous part of the quadratic variation of a semimartingale X.

Theorem 1 For a process X, the following are equivalent.

  1. X is a predictable FV process.
  2. X is a predictable semimartingale with {[X]^c=0}.
  3. X is a semimartingale such that {[X,M]} is a local martingale for all local martingales M.
  4. X is a semimartingale such that {[X,M]} is a local martingale for all uniformly bounded cadlag martingales M.

Continue reading “Predictable FV Processes” →

Continuous Semimartingales

A stochastic process is a semimartingale if and only if it can be decomposed as the sum of a local martingale and an FV process. This is stated by the Bichteler-Dellacherie theorem or, alternatively, is often taken as the definition of a semimartingale. For continuous semimartingales, which are the subject of this post, things simplify considerably. The terms in the decomposition can be taken to be continuous, in which case they are also unique. As usual, we work with respect to a complete filtered probability space {(\Omega,\mathcal{F},\{\mathcal{F}_t\}_{t\ge0},{\mathbb P})}, all processes are real-valued, and two processes are considered to be the same if they are indistinguishable.

Theorem 1 A continuous stochastic process X is a semimartingale if and only if it decomposes as

\displaystyle X=M+A (1)

for a continuous local martingale M and continuous FV process A. Furthermore, assuming that {A_0=0}, decomposition (1) is unique.

Proof: As sums of local martingales and FV processes are semimartingales, X is a semimartingale whenever it satisfies the decomposition (1). Furthermore, if {X=M+A=M^\prime+A^\prime} were two such decompositions with {A_0=A^\prime_0=0} then {M-M^\prime=A^\prime-A} is both a local martingale and a continuous FV process. Therefore, {A^\prime-A} is constant, so {A=A^\prime} and {M=M^\prime}.

It just remains to prove the existence of decomposition (1). However, X is continuous and, hence, is locally square integrable. So, Lemmas 4 and 5 of the previous post say that we can decompose {X=M+A} where M is a local martingale, A is an FV process and the quadratic covariation {[M,A]} is a local martingale. As X is continuous we have {\Delta M=-\Delta A} so that, by the properties of covariations,

\displaystyle -[M,A]_t=-\sum_{s\le t}\Delta M_s\Delta A_s=\sum_{s\le t}(\Delta A_s)^2. (2)

We have shown that {-[M,A]} is a nonnegative local martingale so, in particular, it is a supermartingale. This gives {\mathbb{E}[-[M,A]_t]\le\mathbb{E}[-[M,A]_0]=0}. Then (2) implies that {\Delta A} is zero and, hence, A and {M=X-A} are continuous. ⬜

Using decomposition (1), it can be shown that a predictable process {\xi} is X-integrable if and only if it is both M-integrable and A-integrable. Then, the integral with respect to X breaks down into the sum of the integrals with respect to M and A. This greatly simplifies the construction of the stochastic integral for continuous semimartingales. The integral with respect to the continuous FV process A is equivalent to Lebesgue-Stieltjes integration along sample paths, and it is possible to construct the integral with respect to the continuous local martingale M for the full set of M-integrable integrands using the Ito isometry. Many introductions to stochastic calculus focus on integration with respect to continuous semimartingales, which is made much easier because of these results.

Theorem 2 Let {X=M+A} be the decomposition of the continuous semimartingale X into a continuous local martingale M and continuous FV process A. Then, a predictable process {\xi} is X-integrable if and only if

\displaystyle \int_0^t\xi^2\,d[M]+\int_0^t\vert\xi\vert\,\vert dA\vert < \infty (3)

almost surely, for each time {t\ge0}. In that case, {\xi} is both M-integrable and A-integrable and,

\displaystyle \int\xi\,dX=\int\xi\,dM+\int\xi\,dA (4)

gives the decomposition of {\int\xi\,dX} into its local martingale and FV terms.

Continue reading “Continuous Semimartingales” →

The Bichteler-Dellacherie Theorem

In this post, I will give a statement and proof of the Bichteler-Dellacherie theorem describing the space of semimartingales. A semimartingale, as defined in these notes, is a cadlag adapted stochastic process X such that the stochastic integral {\int\xi\,dX} is well-defined for all bounded predictable integrands {\xi}. More precisely, an integral should exist which agrees with the explicit expression for elementary integrands, and satisfies bounded convergence in the following sense. If {\{\xi^n\}_{n=1,2,\ldots}} is a uniformly bounded sequence of predictable processes tending to a limit {\xi}, then {\int_0^t\xi^n\,dX\rightarrow\int_0^t\xi\,dX} in probability as n goes to infinity. If such an integral exists, then it is uniquely defined up to zero probability sets.

An immediate consequence of bounded convergence is that the set of integrals {\int_0^t\xi\,dX} for a fixed time t and bounded elementary integrands {\vert\xi\vert\le1} is bounded in probability. That is,

\displaystyle \left\{\int_0^t\xi\,dX\colon\xi{\rm\ is\ elementary},\ \vert\xi\vert\le1\right\} (1)

is bounded in probability, for each {t\ge0}. For cadlag adapted processes, it was shown in a previous post that this is both a necessary and sufficient condition to be a semimartingale. Some authors use the property that (1) is bounded in probability as the definition of semimartingales (e.g., Protter, Stochastic Calculus and Differential Equations). The existence of the stochastic integral for arbitrary predictable integrands does not follow particularly easily from this definition, at least, not without using results on extensions of vector valued measures. On the other hand, if you are content to restrict to integrands which are left-continuous with right limits, the integral can be constructed very efficiently and, furthermore, such integrands are sufficient for many uses (integration by parts, Ito’s formula, a large class of stochastic differential equations, etc).

It was previously shown in these notes that, if X can be decomposed as {X=M+V} for a local martingale M and FV process V then it is possible to construct the stochastic integral, so X is a semimartingale. The importance of the Bichteler-Dellacherie theorem is that it tells us that a process is a semimartingale if and only if it is the sum of a local martingale and an FV process. In fact this was the historical definition used of semimartingales, and is still probably the most common definition.

Throughout, we work with respect to a complete filtered probability space {(\Omega,\mathcal{F},\{\mathcal{F}_t\}_{t\ge0},{\mathbb P})}, and all processes are real-valued.

Theorem 1 (Bichteler-Dellacherie) For a cadlag adapted process X, the following are equivalent.

  1. X is a semimartingale.
  2. For each {t\ge0}, the set given by (1) is bounded in probability.
  3. X is the sum of a local martingale and an FV process.

Furthermore, the local martingale term in 3 can be taken to be locally bounded.

Continue reading “The Bichteler-Dellacherie Theorem” →

The General Theory of Semimartingales

Having completed the series of posts applying the methods of stochastic calculus to various special types of processes, I now return to the development of the theory. The next few posts of these notes will be grouped under the heading `The General Theory of Semimartingales’. Subjects which will be covered include the classification of predictable stopping times, integration with respect to continuous and predictable FV processes, decompositions of special semimartingales, the Bichteler-Dellacherie theorem, the Doob-Meyer decomposition and the theory of quasimartingales.

One of the main results is the Bichteler-Dellacherie theorem describing the class of semimartingales which, in these notes, were defined to be cadlag adapted processes with respect to which the stochastic integral can be defined (that is, they are good integrators). It was shown that these include the sums of local martingales and FV processes. The Bichteler-Dellacherie theorem says that this is the full class of semimartingales. Classically, semimartingales were defined as a sum of a local martingale and an FV process so, an alternative statement of the theorem is that the classical definition agrees with the one used in these notes. Further results, such as the Doob-Meyer decomposition for submartingales and Rao’s decomposition for quasimartingales, will follow quickly from this.

Logically, the structure of these notes will be almost directly opposite to the historical development of the results. Originally, much of the development of the stochastic integral was based on the Doob-Meyer decomposition which, in turn, relied on some advanced ideas such as the predictable and dual predictable projection theorems. However, here, we have already introduced stochastic integration without recourse to such general theory, and can instead make use of this in the theory. The reasons I have taken this approach are as follows. First, stochastic integration is a particularly straightforward and useful technique for many applications, so it is desirable to introduce this early on. Second, although it is possible to use the general theory of processes in the construction of the integral, such an approach seems rather distinct from the intuitive understanding of stochastic integration as well as superfluous to many of its properties. So it seemed more natural from the point of view of these notes to define the integral first, guided by the properties of the (non-stochastic) Lebesgue integral, then show how its elementary properties follow from the definitions, and develop the further theory later. Continue reading “The General Theory of Semimartingales” →

Failure of Pathwise Integration for FV Processes

A non-pathwise stochastic integral of an FV Process
Figure 1: A non-pathwise stochastic integral of an FV Process

The motivation for developing a theory of stochastic integration is that many important processes — such as standard Brownian motion — have sample paths which are extraordinarily badly behaved. With probability one, the path of a Brownian motion is nowhere differentiable and has infinite variation over all nonempty time intervals. This rules out the application of the techniques of ordinary calculus. In particular, the Stieltjes integral can be applied with respect to integrators of finite variation, but fails to give a well-defined integral with respect to Brownian motion. The Ito stochastic integral was developed to overcome this difficulty, at the cost both of restricting the integrand to be an adapted process, and the loss of pathwise convergence in the dominated convergence theorem (convergence in probability holds intead).

However, as I demonstrate in this post, the stochastic integral represents a strict generalization of the pathwise Lebesgue-Stieltjes integral even for processes of finite variation. That is, if V has finite variation, then there can still be predictable integrands {\xi} such that the integral {\int\xi\,dV} is undefined as a Lebesgue-Stieltjes integral on the sample paths, but is well-defined in the Ito sense. Continue reading “Failure of Pathwise Integration for FV Processes” →

Martingales are Integrators

A major foundational result in stochastic calculus is that integration can be performed with respect to any local martingale. In these notes, a semimartingale was defined to be a cadlag adapted process with respect to which a stochastic integral exists satisfying some simple desired properties. Namely, the integral must agree with the explicit formula for elementary integrands and satisfy bounded convergence in probability. Then, the existence of integrals with respect to local martingales can be stated as follows.

Theorem 1 Every local martingale is a semimartingale.

This result can be combined directly with the fact that FV processes are semimartingales.

Corollary 2 Every process of the form X=M+V for a local martingale M and FV process V is a semimartingale.

Working from the classical definition of semimartingales as sums of local martingales and FV processes, the statements of Theorem 1 and Corollary 2 would be tautologies. Then, the aim of this post is to show that stochastic integration is well defined for all classical semimartingales. Put in another way, Corollary 2 is equivalent to the statement that classical semimartingales satisfy the semimartingale definition used in these notes. The converse statement will be proven in a later post on the Bichteler-Dellacherie theorem, so the two semimartingale definitions do indeed agree.

Continue reading “Martingales are Integrators” →

Semimartingale Completeness

A sequence of stochastic processes, {X^n}, is said to converge to a process X under the semimartingale topology, as n goes to infinity, if the following conditions are met. First, {X^n_0} should tend to {X_0} in probability. Also, for every sequence {\xi^n} of elementary predictable processes with {\vert\xi^n\vert\le 1},

\displaystyle \int_0^t\xi^n\,dX^n-\int_0^t\xi^n\,dX\rightarrow 0

in probability for all times t. For short, this will be denoted by {X^n\xrightarrow{\rm sm}X}.

The semimartingale topology is particularly well suited to the class of semimartingales, and to stochastic integration. Previously, it was shown that the cadlag and adapted processes are complete under semimartingale convergence. In this post, it will be shown that the set of semimartingales is also complete. That is, if a sequence {X^n} of semimartingales converge to a limit X under the semimartingale topology, then X is also a semimartingale.

Theorem 1 The space of semimartingales is complete under the semimartingale topology.

The same is true of the space of stochastic integrals defined with respect to any given semimartingale. In fact, for a semimartingale X, the set of all processes which can be expressed as a stochastic integral {\int\xi\,dX} can be characterized as follows; it is precisely the closure, under the semimartingale topology, of the set of elementary integrals of X. This result was originally due to Memin, using a rather different proof to the one given here. The method used in this post only relies on the elementary properties of stochastic integrals, such as the dominated convergence theorem.

Theorem 2 Let X be a semimartingale. Then, a process Y is of the form {Y=\int\xi\,dX} for some {\xi\in L^1(X)} if and only if there is a sequence {\xi^n} of bounded elementary processes with {\int\xi^n\,dX\xrightarrow{\rm sm}Y}.

Writing S for the set of processes of the form {\int\xi\,dX} for bounded elementary {\xi}, and {\bar S} for its closure under the semimartingale topology, the statement of the theorem is equivalent to

\displaystyle \bar S=\left\{\int\xi\,dX\colon \xi\in L^1(X)\right\}. (1)

Continue reading “Semimartingale Completeness” →

Further Properties of the Stochastic Integral

We move on to properties of stochastic integration which, while being fairly elementary, are rather difficult to prove directly from the definitions.

First, recall that for a semimartingale X, the X-integrable processes {L^1(X)} were defined to be predictable processes {\xi} which are ‘good dominators’. That is, if {\xi^n} are bounded predictable processes with {\vert\xi^n\vert\le\vert\xi\vert} and {\xi^n\rightarrow 0} pointwise, then {\int_0^t\xi^n\,dX} tends to zero in probability. This definition is a bit messy. Fortunately, the following result gives a much cleaner characterization of X-integrability.

Theorem 1 Let X be a semimartingale. Then, a predictable process {\xi} is X-integrable if and only if the set

\displaystyle \left\{\int_0^t\zeta\,dX\colon\zeta\in{\rm b}\mathcal{P},\vert\zeta\vert\le\vert\xi\vert\right\} (1)

is bounded in probability for each {t\ge 0}.

Continue reading “Further Properties of the Stochastic Integral” →

Existence of the Stochastic Integral

The principal reason for introducing the concept of semimartingales in stochastic calculus is that they are precisely those processes with respect to which stochastic integration is well defined. Often, semimartingales are defined in terms of decompositions into martingale and finite variation components. Here, I have taken a different approach, and simply defined semimartingales to be processes with respect to which a stochastic integral exists satisfying some necessary properties. That is, integration must agree with the explicit form for piecewise constant elementary integrands, and must satisfy a bounded convergence condition. If it exists, then such an integral is uniquely defined. Furthermore, whatever method is used to actually construct the integral is unimportant to many applications. Only its elementary properties are required to develop a theory of stochastic calculus, as demonstrated in the previous posts on integration by parts, Ito’s lemma and stochastic differential equations.

The purpose of this post is to give an alternative characterization of semimartingales in terms of a simple and seemingly rather weak condition, stated in Theorem 1 below. The necessity of this condition follows from the requirement of integration to satisfy a bounded convergence property, as was commented on in the original post on stochastic integration. That it is also a sufficient condition is the main focus of this post. The aim is to show that the existence of the stochastic integral follows in a relatively direct way, requiring mainly just standard measure theory and no deep results on stochastic processes.

Recall that throughout these notes, we work with respect to a complete filtered probability space {(\Omega,\mathcal{F},\{\mathcal{F}_t\}_{t\ge 0},{\mathbb P})}. To recap, elementary predictable processes are of the form

\displaystyle \xi_t=Z_01_{\{t=0\}}+\sum_{k=1}^n Z_k1_{\{s_{k}<t\le t_k\}} (1)

for an {\mathcal{F}_0}-measurable random variable {Z_0}, real numbers {s_k,t_k\ge 0} and {\mathcal{F}_{s_k}}-measurable random variables {Z_k}. The integral with respect to any other process X up to time t can be written out explicitly as,

\displaystyle \int_0^t\xi\,dX = \sum_{k=1}^n Z_k(X_{t_k\wedge t}-X_{s_k\wedge t}). (2)

The predictable sigma algebra, {\mathcal{P}}, on {{\mathbb R}_+\times\Omega} is generated by the set of left-continuous and adapted processes or, equivalently, by the elementary predictable process. The idea behind stochastic integration is to extend this to all bounded and predictable integrands {\xi\in{\rm b}\mathcal{P}}. Other than agreeing with (2) for elementary integrands, the only other property required is bounded convergence in probability. That is, if {\xi^n\in{\rm b}\mathcal{P}} is a sequence uniformly bounded by some constant K, so that {\vert\xi^n\vert\le K}, and converging to a limit {\xi} then, {\int_0^t\xi^n\,dX\rightarrow\int_0^t\xi\,dX} in probability. Nothing else is required. Other properties, such as linearity of the integral with respect to the integrand follow from this, as was previously noted. Note that we are considering two random variables to be the same if they are almost surely equal. Similarly, uniqueness of the stochastic integral means that, for each integrand, the integral is uniquely defined up to probability one.

Using the definition of a semimartingale as a cadlag adapted process with respect to which the stochastic integral is well defined for bounded and predictable integrands, the main result is as follows. To be clear, in this post all stochastic processes are real-valued.

Theorem 1 A cadlag adapted process X is a semimartingale if and only if, for each {t\ge 0}, the set

\displaystyle \left\{\int_0^t\xi\,dX\colon \xi{\rm\ is\ elementary}, \vert\xi\vert\le 1\right\} (3)

is bounded in probability.

Continue reading “Existence of the Stochastic Integral” →