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Wiener Processes and Itô's Lemma
Wiener Processes and Itô's Lemma
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Stochastic Processes
• Describes the way in which a variable
such as a stock price, exchange rate or
interest rate changes through time
• Incorporates uncertainties
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Example 1
• Each day a stock price
– increases by $1 with probability 30%
– stays the same with probability 50%
– reduces by $1 with probability 20%
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Example 2
• Each day a stock price change is drawn
from a normal distribution with mean $0.2
and standard deviation $1
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Markov Processes (See pages 280-81)
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Weak-Form Market Efficiency
• This asserts that it is impossible to
produce consistently superior returns
with a trading rule based on the past
history of stock prices. In other words
technical analysis does not work.
• A Markov process for stock prices is
consistent with weak-form market
efficiency
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Example
• A variable is currently 40
• It follows a Markov process
• Process is stationary (i.e. the
parameters of the process do not
change as we move through time)
• At the end of 1 year the variable will
have a normal probability distribution
with mean 40 and standard deviation
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Questions
• What is the probability distribution
of the stock price at the end of 2
years?
• ½ years?
• ¼ years?
• t years?
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Variances & Standard Deviations
(continued)
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A Wiener Process (See pages 282-84)
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Properties of a Wiener Process
• Mean of [z (T ) – z (0)] is 0
• Variance of [z (T ) – z (0)] is T
• Standard deviation of [z (T ) – z (0)] is T
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Generalized Wiener Processes
(See page 284-86)
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Generalized Wiener Processes
(continued)
x a t b t
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Taking Limits . . .
• What does an expression involving dz
and dt mean?
• It should be interpreted as meaning that
the corresponding expression involving
z and t is true in the limit as t tends
to zero
• In this respect, stochastic calculus is
analogous to ordinary calculus
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The Example Revisited
• A stock price starts at 40 and has a probability
distribution of(40,100) at the end of the year
• If we assume the stochastic process is Markov
with no drift then the process is
dS = 10dz
• If the stock price were expected to grow by $8 on
average during the year, so that the year-end
distribution is (48,100), the process would be
dS = 8dt + 10dz
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Itô Process (See pages 286)
dS S dt S dz
where is the expected return is
the volatility.
The discrete time equivalent is
S St S t
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Monte Carlo Simulation
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Monte Carlo Simulation – Sampling
one Path (See Table 13.1, page 289)
Stock Price at Random Change in Stock
Week Start of Period Sample for Price, S
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Correlated Processes
Suppose dz1 and dz2 are Wiener processes with
correlation
Then
z1 1 t
z 2 2 t
where 1 and 2 are random samples
from a bivariate standard normal
distributi on where correlatio n is
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Itô’s Lemma (See pages 291)
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Taylor Series Expansion
G G 2G
G x t ½ 2 x 2
x t x
2G 2G 2
x t ½ 2 t
xt t
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Ignoring Terms of Higher
Order Than t
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Substituting for x
Suppose
dx a( x, t )dt b( x, t )dz
so that
x = a t + b t
Then ignoring terms of higher order than t
G G 2G 2 2
G x t ½ 2
b t
x t x
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The 2t Term
Since (0,1), E () 0
E ( 2 ) [ E ()] 2 1
E ( 2 ) 1
It follows that E ( 2 t ) t
The variance of t is proportion al to t 2 and can
be ignored. Hence
G G 1 2G 2
G x t 2
b t
x t 2 x
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Taking Limits
G G 2G 2
Taking limits : dG dx dt ½ 2 b dt
x t x
Substituting : dx a dt b dz
G G 2G 2 G
We obtain : dG a
½ 2 b dt b dz
x t x x
This is Ito' s Lemma
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Application of Ito’s Lemma
to a Stock Price Process
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Examples
1. The forward price of a stock for a contract
maturing at time T
G S e r (T t )
dG ( r )G dt G dz
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