Martingales, Wiener Processes & Ito's Lemma
Martingales, Wiener Processes & Ito's Lemma
Sankarshan Basu
Professor of Finance
Indian Institute of Management Bangalore
MARTINGALES
Martingales
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• Y (Price) = aX (time) + b
– a > 0; b > 0 – feasible solution price is a monotonically increasing function of time
– a > 0; b < 0 – feasible in parts, infeasible in parts
– a < 0; b > 0 – infeasible in parts, feasible in parts
– a < 0; b < 0 – infeasible solution
• Know S0 – want to find ST
• Assume normality;
– Min(St) = - ; Max(St) = +
• St = K + at + b Random Term
– Random Term – Brownian Motion / Weiner Process
– It is defined as Z where z = t; N(0, 1)
• ST = S0 + St = S0 + (at + bz)
• St = a t + Random Term = at + bz
– Change in St = function (Change in time; change in the Random Term)
– Assume normality on St
– Also assume rate of return to be constant and write the equation as
• St = a St t + b St z (St / St)= at + bz
• (dSt / St)= adt + bdz; integrate this equation between (0, T) and reorder – you will get a function of ST
• ln ST – ln S0 = aT + bdz ln ST = (ln S0 + aT) + bdz = Constant + bdz
• (dSt / St)= dt + dz – Black Scholes Price Equation
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Stochastic Process
• Any variable whose value changes over time in an
uncertain way is said to follow a stochastic process.
• Continuous-time, continuous variable stochastic
process means that the underlying variable can take
any value within a certain range and that can take
place at any time.
• The continuous time, continuous variable process
proves to be the most useful for the purposes of
valuing derivatives.
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Markov Processes
• A Markov process is a particular type of stochastic
process where only the present value of a variable
is relevant for predicting the future.
• The past history of the variable and the way in
which the present has emerged from the past are
irrelevant.
• We assume the Markov property for stock price
implying that the probability distribution of the
price at any particular future time depends only
on the current stock price.
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Wiener Process
• A Wiener process is a particular type of Markov
stochastic process with a mean change of Zero and
variance rate of 1 per year.
1. z t where is (0,1)
2. The values of z for any two different (non-
overlapping) short periods of time are
independent.
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Wiener Process – contd.
• It follows from the first property that δz itself
has a normal distribution with
Mean of δz = 0
Standard deviation of δz = √δt
Variance of δz = δt
• The second property implies that z follows a
Markov process.
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Wiener Process – contd.
• Consider the increase in the value of z during a relatively long
period of time, T.
• This can be denoted by z(T) - z(0).
• It can be regarded as the sum of the increases in z in N small
time intervals of length δt, where
T
N
t
N
Thus, z(T) - Z(0) i t
i 1
where, the i (i 1, 2, ....., N) are random drawing from (0, 1)
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Properties of Wiener Process
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Generalized Wiener Processes
• The mean change per unit time for a stochastic
process is known as drift rate and the variance per
unit time is variance rate
• A Wiener process has a drift rate of 0 and a variance
rate of 1
• In a GWP the drift rate and the variance rate can be
set equal to any chosen constants.
• The variable x follows a GWP with a drift rate of a
and a variance rate of b2 if
dx=a dt+b dz
where a and b are constants.
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Generalized Wiener Processes – contd.
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Itô Process
• In an Itô process the drift rate and the
variance rate are functions of time
dx=a(x,t) dt+b(x,t) dz
• The discrete time equivalent is:
x a( x, t )t b( x, t ) t
is only true in the limit as t tends to
zero.
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Itô’s Lemma
• If a variable x follows Itô process, then a
function of the variable say G (x, t ) follows
Itô’s lemma.
• Since a derivative security is a function of the
price of the underlying and time, Itô’s lemma
plays an important part in the analysis of
derivative securities.
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Itô’s Lemma
If x follows the process dx a dt b dz
G G 2G 2 G
Then the process for G is dG a ½ b dt b dz
x t x x
2
This is Ito' s Lemma
Thus G also follows Ito process with :
G G 2G 2
Drift rate a ½ b
x t x 2
2
G 2
Variance rate b
x
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The Process for A Stock Price - The Discrete Time
Equivalent Model
S
t t
S
S St S t
This equation shows that S/S is normally distributed with
mean t and standard deviation t
In other words,
S
~ ( t , t )
S
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Application of Ito’s Lemma to a Stock Price Process
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Application of Ito’s Lemma to a Stock Price Process
We know, G ln S
Since ,
2
G 1 G 1 G
, , 0
S S S 2
S 2 t
We get,
2
dG dt dz
2
G follows Generalize d Wiener Process.
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Lognormal Property of Stock Price
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Problem No. 1 (Ans. – Part a.)
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Problem No. 1 (Ans. – Part b.)
( 1 2 ) t, ( 12 22 2 1 2 ) t
If 1 , 2 , 1 , 2 and are all constant, arguments show
that the change in a longer period of time T is :
( 1 2 ) T, ( 12 22 2 1 2 )T
The variable, X 1 X 2 , therefore follows a generalize d
Wiener process with drift rate 1 2 and variance rate
12 2
2 2 1 2 .
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Problem No. 2
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Problem No. 2 (Ans.)
If G(S, t) Sn , then
G G n 1 2
G n 2
0, nS and n(n 1)S
t S S2
Using Ito' s lemma :
1
dG nG n(n 1) 2 G dt n Gdz
2
This shows that G Sn follows geometric Brownian motion where
1
the expected return is n n(n 1) 2
2
and the volatility is n .
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Problem No. 3
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Problem No. 3 (Ans.)
Part a :
The probability distributions are :
(2.0 0.1, 0.16 ) (2.1, 0.4)
(2.0 0.6, 0.16 * 6 ) (2.6, 0.98)
(2.0 1.2, 0.16 * 12 ) (3.2, 1.39)
Part b :
The chance of a random sample from (2.6, 0.98) being negative is
2.6
N N 2.65
0.98
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Problem No. 3 (Ans. – contd.)
Part b : contd.
N(x) Cumulative probability that a standardized normal variable i.e.,
a variable with probability distribution (0, 1) is less than x
Now, N(2.65) 0.0040
Hence, the probability of a negative cash position at the end of six months
0.04%
3.2
Again, N N(2.30) 0.0107
1.39
Hence, the probability of a negative cash position at the end of one year
1.07%
Part c :
In general the probability distribution of the cash position at the
end of x months is
(2.0 0.1x, 0.4 x )
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Problem No. 3 (Ans. – contd.)
Part c : contd.
The probability of the cash position being negative is maximized when :
2.0 0.1x
is minimized.
0.4 x
1 1
2.0 0.1x
Define y 5x 2 0.25x 2
0.4 x
3 1
dy
2.5x 2 0.125x 2
dx
3
x 2 ( 2.5 0.125x)
2
This is zero when x 20 and it is easy to verify that y
d
2 0 for this value of x.
dx
It therefore gives minimum value of y.
Hence, the probability of a negative cash position is greatest after 20 months.
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Thank You!
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