Why transform before approximating a transition
For a discretely observed diffusion, a likelihood contribution depends on the transition density between successive observations. When the diffusion coefficient varies with the state, a Gaussian approximation made directly in the original state can misrepresent the local scale of the transition. For a scalar diffusion with a smooth, nonzero coefficient, the Lamperti transform changes coordinates so that the transformed process has unit diffusion. A Gaussian short-interval approximation is then natural in the transformed coordinate, but converting its density back requires a Jacobian.
The earlier material on Lamperti Coordinates and Boundary-Aware Simulation introduced the coordinate change in a simulation setting. Here the focus is the transition-density approximation used for discretely observed data. Throughout, suppose that on an open interval \(I\), the process satisfies
where \(W_t\) is standard Brownian motion, \(b\) is the drift, and \(\sigma\) is the diffusion coefficient. Assume \(\sigma(x)>0\) on \(I\), and that \(b\) and \(\sigma\) are sufficiently smooth and locally Lipschitz for a non-explosive solution up to any boundary or exit time under consideration. The positivity assumption fixes an orientation; if \(\sigma<0\) throughout the state interval, its absolute value can be used in the coordinate definition.
The transformed drift and its transition approximation
Because \(\Phi'(x)=1/\sigma(x)\) and \(\Phi''(x)=-\sigma'(x)/\sigma(x)^2\), Itô’s formula gives the transformed dynamics. The correction involving \(\sigma'\) is essential: transforming the drift by simply dividing \(b\) by \(\sigma\) omits the Itô correction.
To verify the result, apply Itô’s formula to \(Y_t=\Phi(X_t)\):
The stochastic coefficient is exactly one because \(\Phi'(x)\sigma(x)=1\). Writing the drift as a function of \(Y_t\) means evaluating the displayed expression at \(x=\Phi^{-1}(Y_t)\). This proves the transformed SDE. \(\square\)
For an observation interval of length \(h>0\), starting from \(X_t=x\), the transformed Euler approximation freezes the transformed drift at the starting value:
This is an approximation, not an assertion that the transformed process has constant drift over the interval. Its Gaussian density in the transformed endpoint \(y'=\Phi(x')\) is converted to a density in \(x'\) by the change-of-variables rule. Since \(dy'/dx'=1/\sigma(x')\), the endpoint coefficient appears in the denominator.
The Jacobian is not optional. For fixed \(x\), if \(q_h(y'\mid\Phi(x))\) denotes the approximating density in transformed coordinates, then \(dy'=dx'/\sigma(x')\), so \(\widetilde p_h(x'\mid x)=q_h(\Phi(x')\mid\Phi(x))/\sigma(x')\). This establishes the formula from the Gaussian approximation and the density change of variables. \(\square\)
Worked calculations
Worked Example: A Nonconstant Coefficient and the Endpoint Jacobian
Let \(I=(0,\infty)\), \(b(x)=0.4-0.2x\), and \(\sigma(x)=0.5x\). Take \(x=1.2\), \(x'=1.3\), and \(h=0.10\). Since \(1/\sigma(x)=2/x\), one possible Lamperti coordinate is \(\Phi(x)=2\log x\).
At the starting state, \(\sigma(1.2)=0.6\), \(b(1.2)=0.16\), and \(\sigma'(1.2)=0.5\). Thus \(\mu(\Phi(1.2))=0.16/0.6-0.5(0.5)=0.0166667\). The transformed endpoint increment is \(2\log(1.3/1.2)=2\log(13/12)\approx0.160085\).
The centered increment in the exponent is therefore \(0.160085-(0.0166667)(0.10)\approx0.158419\). Its squared value divided by \(2h=0.20\) is approximately \(0.1255\). The Gaussian standard-deviation factor is \(\sqrt{2\pi(0.10)}\approx0.792665\), and the endpoint coefficient is \(\sigma(1.3)=0.65\). Consequently,
\(\widetilde p_h(1.3\mid1.2)\approx [0.65(0.792665)]^{-1}\exp(-0.1255) \approx1.941(0.8821)\approx1.712.\)
The value is a density per unit of the original \(x'\)-scale. The factor \(1/0.65\) converts from transformed scale; omitting it would give a density with respect to the wrong coordinate.
Worked Example: A Case Where the Approximation Is Exact
Consider geometric Brownian motion \(dX_t=0.1X_t\,dt+0.4X_t\,dW_t\), with \(x=2\), \(x'=2.2\), and \(h=0.25\). On \(I=(0,\infty)\), \(\Phi(x)=\log(x)/0.4\). The transformed drift is constant: \(\mu=0.1/0.4-0.4/2=0.05\).
In this case the transformed SDE is exactly Brownian motion with constant drift \(0.05\), so its Gaussian transition law is exact, not merely a frozen-drift approximation. The transformed increment is \(\log(2.2/2)/0.4=\log(1.1)/0.4\approx0.238276\), and its mean over the interval is \(0.05(0.25)=0.0125\). The endpoint Jacobian is \(1/\sigma(2.2)=1/(0.4(2.2))=1/0.88\).
The Gaussian standard deviation is \(\sqrt{0.25}=0.5\), or equivalently its density denominator is \(\sqrt{2\pi(0.25)}\approx1.253314\). The exponent is \(- (0.238276-0.0125)^2/(0.5)\approx-0.10195\). Therefore the exact original-scale density is approximately \([0.88(1.253314)]^{-1}\exp(-0.10195)\approx0.9067(0.9031)\approx0.819\). Here the Lamperti expression reproduces the exact density because the transformed drift is constant.
Worked Example: A Square-Root Coefficient Near a State Boundary
Take \(b(x)=0.5(2-x)\), \(\sigma(x)=\sqrt{x}\), and \(I=(0,\infty)\). The Lamperti coordinate is \(\Phi(x)=2\sqrt{x}\). The transformed drift is \(\mu(\Phi(x))=b(x)/\sqrt{x}-1/(4\sqrt{x})\). At \(x=4\), this is \([0.5(2-4)]/2-1/8=-0.5-0.125=-0.625\).
For \(x'=4.4\) and \(h=0.10\), the transformed increment is \(2\sqrt{4.4}-2\sqrt{4}\approx4.195235-4=0.195235\). The centered increment is \(0.195235-(-0.625)(0.10)=0.257735\), giving exponent \(-0.257735^2/0.20\approx-0.3322\). Since \(\sigma(4.4)=\sqrt{4.4}\approx2.097618\), the prefactor is \([2.097618(0.792665)]^{-1}\approx0.6016\). Thus the approximate density is \(0.6016\exp(-0.3322)\approx0.432\).
The computation is local to positive states. A Gaussian approximation on the whole transformed line assigns positive probability to \(Y_{t+h}<0\), even though the valid transformed state space here is \(J=(0,\infty)\). If boundary behavior is relevant over the observation interval, an unrestricted Gaussian approximation may therefore need a boundary-aware alternative.
Using the approximation in a likelihood
For observations \(x_0,\ldots,x_n\) at times with intervals \(h_i=t_i-t_{i-1}>0\), the approximation supplies one transition factor for each adjacent pair:
The model quantities \(b\), \(\sigma\), and \(\Phi\) in each factor depend on the parameter value \(\theta\). Both the exponent and the Jacobian can therefore contribute to parameter estimation. In particular, dropping \(1/\sigma(x_i)\) does not merely alter a constant: if the diffusion coefficient has unknown parameters, the omitted factor can change the likelihood’s dependence on \(\theta\).
A direct Gaussian approximation in the original state instead freezes the original drift and diffusion, giving a normal increment with mean \(b(x)h\) and variance \(\sigma(x)^2h\). That approximation is simple but uses a local scale based only on the starting state. The Lamperti approximation accounts for the nonlinear coordinate and endpoint Jacobian. Neither approximation is universally accurate: the direct version can be useful for very short intervals with mild coefficient variation, while the transformed version can be more appropriate when state-dependent scale is prominent and the transform is well behaved.
Diagnostics, assumptions, and limitations
The approximation presumes that the path remains in the region where \(\sigma\) is nonzero and the Lamperti map is smooth. If \(\sigma\) vanishes, changes sign, or has a singular derivative within the relevant state range, the stated transform and drift formula may fail or require a restricted domain. Likewise, large observation intervals allow the transformed drift to vary substantially, so freezing it at the starting point may be inaccurate.
Useful checks include verifying that \(\Phi'(x)\sigma(x)=1\), retaining the \(-\sigma'(x)/2\) drift correction, and checking that the Jacobian uses the endpoint \(x'\), not the starting point \(x\). For fitted models, inspect transformed standardized increments \[ \frac{\Phi(x_i)-\Phi(x_{i-1})-\mu(\Phi(x_{i-1}))h_i}{\sqrt{h_i}}. \] Systematic trends in these residuals with state or interval length, or strong changes in estimates when long intervals are excluded, can signal inadequate local approximation. A Gaussian approximation may also place mass outside the transformed state space; apparent numerical stability does not make those transitions physically valid.
Check Your Understanding
Work each item, then compare with the brief solutions below.
- For \(\sigma(x)=3x\) on \(x>0\), find a Lamperti coordinate.
- For \(b(x)=ax\) and \(\sigma(x)=cx\), where \(c>0\), derive the transformed drift.
- Why does the approximate density contain \(\sigma(x')\) rather than \(\sigma(x)\) in its Jacobian?
- Name two warning signs that the short-interval approximation may be unreliable.
Solutions. (1) Integrating \(1/(3x)\) gives \(\Phi(x)=\log(x)/3\), up to an additive constant. (2) Since \(b/\sigma=a/c\) and \(\sigma'=c\), the transformed drift is the constant \(a/c-c/2\). (3) The density change of variables uses the derivative at the endpoint: \(d\Phi(x')/dx'=1/\sigma(x')\). (4) Examples include transformed residuals that vary systematically with state, strong sensitivity to interval length, or appreciable Gaussian probability outside the transformed state space.