Conceptual difficulty in understanding how to integrate a stochastic differential equation

57 Views Asked by At

I'm trying to understand how to integrate stochastic differential equations using Ito's lemma. In my textbooks, I've noticed that different SDEs seem to be integrated in different ways and I cannot seem to understand the concept behind that. I would really appreciate any help.

Take for example, two equations:

$$ dX_t = -aXdt + \sigma dW_t $$

and

$$ dX_t = \mu Xdt + \sigma X dW_t $$

To solve the first equation, the method shows to let $$ f(t,x) = e^{at}x $$ such that $$ \begin{align*} d(e^{at}X_t) = df(t,X_t) &= \partial_t f(t,X_t)dt + \partial_x f(t,X_t)dX_t + \frac 12 \partial_{xx}f(t,X_t)dt \\ &= ae^{at}X_tdt + e^{at}(-aX_tdt + \sigma dW_t) \\ &= \sigma e^{at}dW_t. \end{align*} $$ which gives $$ X_t = X_0+\sigma \int_0^t e^{-a(t-u)} dW_u $$

Whereas, for the second SDE, the method is: let $$ f=log X $$ such that $$\begin{align*} df &= \partial_x fdX_t + \frac 12 \sigma^2 x^2 \partial_{xx}f dt \\ &= (\mu-\frac12 \sigma^2) dt \ +\sigma dW_t \\ \end{align*} $$ which gives $$\begin{align*} f_t = f_0 + (\mu-\frac12 \sigma^2) t \ +\sigma (W_t-W_0) \\ or, X_t = X_0 exp^ {(\mu-\frac12 \sigma^2) t \ +\sigma (W_t-W_0)} \end{align*} $$

The two SDE seems almost similar, yet the function $f$ for each differs. Which brings me to my question : How do I choose which function $f$ would be appropriate for my SDE?