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Economics 4113, Spring 2013, University of Minnesota. Instructor: David Rahman.

Homework 2
Due Date: Due February 20, in class. Please substantiate your answers. Question 1 (Random walk ). Recall the random walk representation of Brownian motion from class. Given t, let h = t, p = 1 [1 + t] and q = 1 p, where 2 and are constants. Suppose that x follows a random walk with the parameters above. Let F be any twice continuously dierentiable function of x. Show that as t 0, the increments F (xt+t ) F (xt ) follow the stochastic dierential equation dF = 2F F F 1 + 2 2 2 dt + dz x x x
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1 by showing that Et [dF ] = [ F + 2 2 F ]dt and Var(dF ) = ( F )2 dt. x x2 x

Question 2 (Itos Lemma). Here is some heuristic motivation for the claim that (dz)2 = dt, not just that Var(dz) = dt. (a) Show that (dz 2 ) = dz 2 2zdz. (Hint: In the random walk representation of Wiener process (with = 0 and = 1), expand (z)2 and take the limit as t 0.) (b) Use Itos Lemma to nd the law of motion for z 2 . What is the variance of (dz)2 ? Question 3. Suppose that the price of a stock follows geometric Brownian motion: dS = Sdt + Sdz. (a) Calculate the conditional expectation E0 [St ] as a function of t. (b) Use your answer to part (a) and Itos Lemma to derive Var0 (St ). Hint: Use Itos lemma to derive the law of motion for St2 . (c) Now suppose that the price follows a mean-reverting process: dS = (S S)dt + dz. Derive both E0 [St ] and Var0 (St ) in this case.

Question 4 (Volatility of returns). Suppose that the price of a stock follows the following square-root process dS = Sdt + Sdz. (a) Derive the law of motion for ln S. (b) Calculate the mean and variance of St as a function of S0 . (Hint: The dierential equation x = a + bet cx with initial condition x0 has solution xt = ect x0 + b (a/c)(1 ect ) + c (ect et ).) (c) Repeat part (b) for the process dr = (r r)dt + rdz. What are the limiting mean and variance as t ?