Ito’s product and quotient rules are a corollary of the Ito lemma, and are one of the most important parts of the stochastic-calculus toolkit.

When I first started working as a quant I managed to find an alternative form for the rules which sits well in a Black-Scholes type of world and corresponds more closely to a trader’s way of describing a trade.

My versions were often useful to me in terms of developing an intuitive understanding of the risk positions in the derivatives trading book (eg for quanto-ed or payment-delay trades).

Firstly, the standard way to write the product rule is something like:

If we instead write this in terms of the relative changes (eg dX/X or dY/Y) then we get:

At this point I read this expression in terms of risks:

we are long both X and Y, and are long correlation.

Explanation: we are effectively saying that the expectation of the product will increase as X and Y increase (or rather their starting points for our diffusion increase), and will also increase if we had a higher correlation between the two variables that diffuse.

The same trick works for the quotient rule:

I would read this as saying:

we are long X, and short Y

we are long vol of Y,

we are short correlation.

So here are two alternative ‘trader-like’ wordy versions of the two Ito rules:

**Ito product rule**: we buy correlation when we have a product

**Ito quotient rule**: we sell correlation when we have a ratio, and we are long vol of the denominator.

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Tags: derivatives risks, ito calculus, ito product rule, ito quotient rule

This entry was posted on December 28, 2011 at 1:45 pm and is filed under Finance, Mathematics. You can follow any responses to this entry through the RSS 2.0 feed.
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