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---
title: "Dynkin's formula"
sort_title: "Dynkin's formula"
date: 2021-11-28
categories:
- Mathematics
- Stochastic analysis
layout: "concept"
---
Given an [Itō diffusion](/know/concept/ito-calculus/) $$X_t$$
with a time-independent drift $$f$$ and intensity $$g$$
such that the diffusion uniquely exists on the $$t$$-axis.
We define the **infinitesimal generator** $$\hat{A}$$
as an operator with the following action on a given function $$h(x)$$,
where $$\mathbf{E}$$ is a
[conditional expectation](/know/concept/conditional-expectation/):
$$\begin{aligned}
\boxed{
\hat{A}\{h(X_0)\}
\equiv \lim_{t \to 0^+} \bigg[ \frac{1}{t} \mathbf{E}\Big[ h(X_t) - h(X_0) \Big| X_0 \Big] \bigg]
}
\end{aligned}$$
Which only makes sense for $$h$$ where this limit exists.
The assumption that $$X_t$$ does not have any explicit time-dependence
means that $$X_0$$ need not be the true initial condition;
it can also be the state $$X_s$$ at any $$s$$ infinitesimally smaller than $$t$$.
Conveniently, for a sufficiently well-behaved $$h$$,
the generator $$\hat{A}$$ is identical to the Kolmogorov operator $$\hat{L}$$
found in the [backward Kolmogorov equation](/know/concept/kolmogorov-equations/):
$$\begin{aligned}
\boxed{
\hat{A}\{h(x)\}
= \hat{L}\{h(x)\}
}
\end{aligned}$$
{% include proof/start.html id="proof-kolmogorov" -%}
We define a new process $$Y_t \equiv h(X_t)$$, and then apply Itō's lemma, leading to:
$$\begin{aligned}
\dd{Y_t}
&= \bigg( \pdv{h}{x} f(X_t) + \frac{1}{2} \pdvn{2}{h}{x} g^2(X_t) \bigg) \dd{t} + \pdv{h}{x} g(X_t) \dd{B_t}
\\
&= \hat{L}\{h(X_t)\} \dd{t} + \pdv{h}{x} g(X_t) \dd{B_t}
\end{aligned}$$
Where we have recognized the definition of $$\hat{L}$$.
Integrating the above equation yields:
$$\begin{aligned}
Y_t
= Y_0 + \int_0^t \hat{L}\{h(X_s)\} \dd{s} + \int_0^\tau \pdv{h}{x} g(X_s) \dd{B_s}
\end{aligned}$$
As always, the latter [Itō integral](/know/concept/ito-integral/)
is a [martingale](/know/concept/martingale/), so it vanishes
when we take the expectation conditioned on the "initial" state $$X_0$$, leaving:
$$\begin{aligned}
\mathbf{E}[Y_t | X_0]
= Y_0 + \mathbf{E}\bigg[ \int_0^t \hat{L}\{h(X_s)\} \dd{s} \bigg| X_0 \bigg]
\end{aligned}$$
For suffiently small $$t$$, the integral can be replaced by its first-order approximation:
$$\begin{aligned}
\mathbf{E}[Y_t | X_0]
\approx Y_0 + \hat{L}\{h(X_0)\} \: t
\end{aligned}$$
Rearranging this gives the following,
to be understood in the limit $$t \to 0^+$$:
$$\begin{aligned}
\hat{L}\{h(X_0)\}
\approx \frac{1}{t} \mathbf{E}[Y_t - Y_0| X_0]
\end{aligned}$$
{% include proof/end.html id="proof-kolmogorov" %}
The general definition of resembles that of a classical derivative,
and indeed, the generator $$\hat{A}$$ can be thought of as a differential operator.
In that case, we would like an analogue of the classical
fundamental theorem of calculus to relate it to integration.
Such an analogue is provided by **Dynkin's formula**:
for a stopping time $$\tau$$ with a finite expected value $$\mathbf{E}[\tau|X_0] < \infty$$,
it states that:
$$\begin{aligned}
\boxed{
\mathbf{E}\big[ h(X_\tau) | X_0 \big]
= h(X_0) + \mathbf{E}\bigg[ \int_0^\tau \hat{L}\{h(X_t)\} \dd{t} \bigg| X_0 \bigg]
}
\end{aligned}$$
{% include proof/start.html id="proof-dynkin" -%}
The proof is similar to the one above.
Define $$Y_t = h(X_t)$$ and use Itō’s lemma:
$$\begin{aligned}
\dd{Y_t}
&= \bigg( \pdv{h}{x} f(X_t) + \frac{1}{2} \pdvn{2}{h}{x} g^2(X_t) \bigg) \dd{t} + \pdv{h}{x} g(X_t) \dd{B_t}
\\
&= \hat{L} \{h(X_t)\} \dd{t} + \pdv{h}{x} g(X_t) \dd{B_t}
\end{aligned}$$
And then integrate this from $$t = 0$$ to the provided stopping time $$t = \tau$$:
$$\begin{aligned}
Y_\tau
= Y_0 + \int_0^\tau \hat{L}\{h(X_t)\} \dd{t} + \int_0^\tau \pdv{h}{x} g(X_t) \dd{B_t}
\end{aligned}$$
All [Itō integrals](/know/concept/ito-integral/)
are [martingales](/know/concept/martingale/),
so the latter integral's conditional expectation is zero for the "initial" condition $$X_0$$.
The rest of the above equality is also a martingale:
$$\begin{aligned}
0
= \mathbf{E}\bigg[ Y_\tau - Y_0 - \int_0^\tau \hat{L}\{h(X_t)\} \dd{t} \bigg| X_0 \bigg]
\end{aligned}$$
Isolating this equation for $$\mathbf{E}[Y_\tau \!\mid\! X_0]$$ then gives Dynkin's formula.
{% include proof/end.html id="proof-dynkin" %}
A common application of Dynkin's formula is predicting
when the stopping time $$\tau$$ occurs, and in what state $$X_\tau$$ this happens.
Consider an example:
for a region $$\Omega$$ of state space with $$X_0 \in \Omega$$,
we define the exit time $$\tau \equiv \inf\{ t : X_t \notin \Omega \}$$,
provided that $$\mathbf{E}[\tau | X_0] < \infty$$.
To get information about when and where $$X_t$$ exits $$\Omega$$,
we define the *general reward* $$\Gamma$$ as follows,
consisting of a *running reward* $$R$$ for $$X_t$$ inside $$\Omega$$,
and a *terminal reward* $$T$$ on the boundary $$\partial \Omega$$ where we stop at $$X_\tau$$:
$$\begin{aligned}
\Gamma
= \int_0^\tau R(X_t) \dd{t} + \: T(X_\tau)
\end{aligned}$$
For example, for $$R = 1$$ and $$T = 0$$, this becomes $$\Gamma = \tau$$,
and if $$R = 0$$, then $$T(X_\tau)$$ can tell us the exit point.
Let us now define $$h(X_0) = \mathbf{E}[\Gamma | X_0]$$,
and apply Dynkin's formula:
$$\begin{aligned}
\mathbf{E}\big[ h(X_\tau) | X_0 \big]
&= \mathbf{E}\big[ \Gamma \big| X_0 \big] + \mathbf{E}\bigg[ \int_0^\tau \hat{L}\{h(X_t)\} \dd{t} \bigg| X_0 \bigg]
\\
&= \mathbf{E}\big[ T(X_\tau) | X_0 \big] + \mathbf{E}\bigg[ \int_0^\tau \hat{L}\{h(X_t)\} + R(X_t) \dd{t} \bigg| X_0 \bigg]
\end{aligned}$$
The two leftmost terms depend on the exit point $$X_\tau$$,
but not directly on $$X_t$$ for $$t < \tau$$,
while the rightmost depends on the whole trajectory $$X_t$$.
Therefore, the above formula is fulfilled
if $$h(x)$$ satisfies the following equation and boundary conditions:
$$\begin{aligned}
\boxed{
\begin{cases}
\hat{L}\{h(x)\} + R(x) = 0 & \mathrm{for}\; x \in \Omega \\
h(x) = T(x) & \mathrm{for}\; x \notin \Omega
\end{cases}
}
\end{aligned}$$
In other words, we have just turned a difficult question about a stochastic trajectory $$X_t$$
into a classical differential boundary value problem for $$h(x)$$.
## References
1. U.H. Thygesen,
*Lecture notes on diffusions and stochastic differential equations*,
2021, Polyteknisk Kompendie.
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