Functional Itô Calculus

Abstract

Itô calculus deals with functions of the current state whilst we deal with functions of the current path to acknowledge the fact that often the impact of randomness is cumulative. We express the differential of the functional in terms of adequately defined partial derivatives to obtain an Itô formula. We develop an extension of the Feynman-Kac formula to the functional case and an explicit expression of the integrand in the Martingale Representation Theorem, providing an alternative to the Clark-Ocone formula from Malliavin Calculus. We establish that under certain conditions, even path dependent options prices satisfy a partial differential equation in a local sense.

Keywords: Itô calculus, path dependent options, functionals

JEL Classification: G13