A formal proof of the lemma relies on taking the limit of a sequence of random variables. This approach is not presented here since it involves a number of technical details. Instead, we give a sketch of how one can derive Itô's lemma by expanding a Taylor series and applying the rules of stochastic calculus.
Substituting Xt for x and therefore μtdt + σtdBt for dx gives
In the limit as dt → 0, the terms dt2 and dtdBt tend to zero faster than dB2, which is O(dt). Setting the dt2 and dtdBt terms to zero, substituting dt for dB2, and collecting the dt and dB terms, we obtain
We may also define functions on discontinuous stochastic processes.
Let h be the jump intensity. The Poisson process model for jumps is that the probability of one jump in the interval [t, t + Δt] is hΔt plus higher order terms. h could be a constant, a deterministic function of time, or a stochastic process. The survival probability ps(t) is the probability that no jump has occurred in the interval [0, t]. The change in the survival probability is
Let S(t) be a discontinuous stochastic process. Write for the value of S as we approach t from the left. Write for the non-infinitesimal change in S(t) as a result of a jump. Then
Let z be the magnitude of the jump and let be the distribution of z. The expected magnitude of the jump is
Itô's lemma can also be applied to general d-dimensional semimartingales, which need not be continuous. In general, a semimartingale is a càdlàg process, and an additional term needs to be added to the formula to ensure that the jumps of the process are correctly given by Itô's lemma. For any cadlag process Yt, the left limit in t is denoted by Yt−, which is a left-continuous process. The jumps are written as ΔYt = Yt − Yt−. Then, Itô's lemma states that if X = (X1, X2, ..., Xd) is a d-dimensional semimartingale and f is a twice continuously differentiable real valued function on Rd then f(X) is a semimartingale, and
This differs from the formula for continuous semi-martingales by the additional term summing over the jumps of X, which ensures that the jump of the right hand side at time t is Δf(Xt).
There is also a version of this for a twice-continuously differentiable in space once in time function f evaluated at (potentially different) non-continuous semi-martingales which may be written as follows:
where denotes the continuous part of the ith semi-martingale.
The correction term of − σ2/2 corresponds to the difference between the median and mean of the log-normal distribution, or equivalently for this distribution, the geometric mean and arithmetic mean, with the median (geometric mean) being lower. This is due to the AM–GM inequality, and corresponds to the logarithm being convex down, so the correction term can accordingly be interpreted as a convexity correction. This is an infinitesimal version of the fact that the annualized return is less than the average return, with the difference proportional to the variance. See geometric moments of the log-normal distribution for further discussion.
The Doléans-Dade exponential (or stochastic exponential) of a continuous semimartingale X can be defined as the solution to the SDE dY = Y dX with initial condition Y0 = 1. It is sometimes denoted by Ɛ(X). Applying Itô's lemma with f(Y) = log(Y) gives
The term ∂f/∂SdS represents the change in value in time dt of the trading strategy consisting of holding an amount ∂ f/∂S of the stock. If this trading strategy is followed, and any cash held is assumed to grow at the risk free rate r, then the total value V of this portfolio satisfies the SDE
This strategy replicates the option if V = f(t,S). Combining these equations gives the celebrated Black–Scholes equation
^* Bru, Bernard; Yor, Marc (January 2002), "Comments on the life and mathematical legacy of Wolfgang Doeblin", Finance and Stochastics (Berlin / Heidelberg: Springer-Verlag) 6 (1): 3–47, doi:10.1007/s780-002-8399-0, MR1885582