6.4 Geometric Brownian Motion.

When we model a stock price X(t) using Brownian motion we have to take into account the fact that the magnitude of a stock's price has an effect on how it changes. For example a 25 increase in the price of a stock whose current price is $5.00 is similar to a $2.50 increase in the price of a stock whose current price is $50.00. In order to take this into account we model the logarithm Y(t) of the stock's price as a Brownian motion rather than the price itself. When we do this we say the stock price itself is being modeled by a geometric Brownian motion. The Brownian motion parameters and for Y(t) are called the drift and volatility of the stock price. Example 1. Let X(t) be the price of FMC stock at time t years from the present. Assume that X(t) is a geometric Brownian motion with drift = 0.05 / yr and volatility = 0.4 / yr1/2. If the current price of FMC stock is $2.50, what is the probability that the price will be at least $2.60 one year from now. Since X(t) is a geometric Brownian motion, log(X(t)) is a regular Brownian motion with drift rate

= - 0.05 / yr and = 0.4 / yr1/2. We want to know the probablity that log(X(1)) log(2.60) given that
log(X(0)) log(2.50). This means 2.60 log(X(1)) - log(X(0)) log(2.60) - log(2.50) = log 2.50 = log(1.04) 0.0392 In this case Z = (log(X(1)) - log(X(0)) t)/( t) = (log(X(1)) - log(X(0)) - (- 0.05)(1))/(0.4)( 1)) = (log(X(1)) - log(X(0)) +0.05)/0.4 is a standard normal random variable. So Pr{log(X(1)) - log(X(0)) > 0.0392} = Pr{log(X(1)) - log(X(0)) + 0.05 > 0.0392 + 0.05} = Pr{ log(X(1)) - log(X(0)) + 0.05 0.0392 + 0.05 > } = Pr{ Z > 0.223} 0.4 0.4

= 1 - Pr{ Z 0.293} = 1 - (0.293) = 1 0.5884 = 0.4116 41% 1 2 e-u /2 du is the distribution function of a standard normal random variable. Here (z) = Pr{Z z} = 2
- z

Example 2. Let X(t) be the price of JetCo stock at time t years from the present. Assume that X(t) is a geometric Brownian motion with zero drift and volatility = 0.4 / yr1/2. If the current price of JetCo stock is $8.00, what is the probability that the price will be at least $8.40 six months from now. Since X(t) is a geometric Brownian motion, log(X(t)) is a regular Brownian motion with zero drift and = 0.4 / yr1/2. We want to know the probablity that log(X(1/2)) log(8.40) given that log(X(0)) log(8.00). This means 8.40 log(X(1/2)) - log(X(0)) log(8.40) - log(8.00) = log 8.00 = log(1.05) 0.0488 In this case Z = (log(X(1/2)) - log(X(0)) (0)(1/2))/(0.4 0.5) = (log(X(1/2)) - log(X(0)))/0.283 is a standard normal random variable. So

6.4.1 - 1

Pr{log(X(1/2)) - log(X(0)) > 0.0488} = Pr{

log(X(1/2)) - log(X(0)) 0.0488 > } 0.283 0.283

= Pr{ Z > 0.172} = 1 - Pr{ Z 0.172} = 1 - (0.172) = 1 0.568 = 0.432 43% Example 3. Redo Example 2 if the drift rate is 0.02 / yr instead of zero. Now Z = (log(X(1/2)) - log(X(0)) (- 0.02)(1/2))/(0.4 0.5) = (log(X(1/2)) - log(X(0)) + 0.01)/0.283 is a standard normal random variable. So log(X(1/2)) - log(X(0)) + 0.01 0.0488 + 0.01 Pr{log(X(1/2))-log(X(0)) > 0.0488} = Pr{ > } 0.283 0.283 = Pr{ Z > 0.21} = 1 - Pr{ Z 0.21} = 1 - (0.21) = 1 0.5832 = 0.4168 42% Expected Values: Geometric Brownian motion has a little quirk, namely its expected value is higher than one might think at first. If X(t) is a regular Brownian motion with zero drift then E{X(t) X(0)} = 0 for all t. However, this is not true for geometric Brownian motion with zero drift. Proposition 1. Suppose X(t) is a geometric Brownian motion with drift and volatility . Then E{X(t)} = E{X(0)}e( +
2/2)t

Proof. Since X(t) is a geometric Brownian motion with the given drift and volatility, Y(t) = log(X(t)) is a regular Brownian motion and Y(t) Y(0) = tZ(t) + t where Z(t) is a standard normal random variable. So X(t) = eY(t) = eY(t) Y(0) + Y(0) = eY(0)eY(t) Y(0) = X(0)et
t
1/2Z(t) + t

= X(0)etet
2

1/2Z(t)

. Since Y(t) Y(0) is

independent of Y(0) one has E{X(t)} = E{X(0)}e E{e

t1/2Z(t)

}. In order to complete the proof it suffices to

show that if Z is a standard normal random variable then E{eZ} = e /2. One has

Z
2 2 2 z 1 -z2/2 1 e-(z2 - 2)/2 dz = 1 e-(z - 2 + - )/2 dz E {e } = e 2 e dz = 2 2 - -

= e

2/2

2 2 2 2 1 1 e-(z - ) /2 dz= e /2 e-u /2 dz = e /2 2 - 2 -

Example 4. Let X(t) be the price of FMC stock at time t years from the present. Assume that X(t) is a geometric Brownian motion with drift = 0.05 / yr and volatility = 0.4 / yr1/2. If the current price of FMC stock is $2.50, what is the expected price six months from now. By Proposition 1 one has E{X(t)} = E{X(0)}e( +
2/2)t

= (2.5)e(- 0.05 + (0.4)

2/2)(1/2)

= (2.5)e(- 0.05 + 0.08)(1/2)

= (2.5)e0.015 = (2.5)(1.0151) = $2.538 Interest. There is one more factor that enters into the pricing of stock options. This is the effect of interest. An alternative to investing in the stock market is to put one's money in an investment that is guaranteed to pay a certain amount of interest such as a certificate of deposit. In certain situations putting one's money in a guaranteed investment might by better than investing in stocks or stock options. Let's suppose

6.4.1 - 2

r = interest rate on guaranteed investments. So an investment of M grows Mt = M(1 + r)t = amount M grows to after a time t.

Example 1. How much does $8.00 grow to after two years if the annual interest rate is 1%? In this case M = $8.00, r = 0.01 and t = 2. After two years this grows to M2 = M(1 + r)t = (8)(1 + 0.01)2 = (8)(1.01)2 = (8)(1.0201) = $8.1608. When one is modeling investments in continuous time it is convenient to express the factor (1 + r)t in terms of e. Let

= log(1 + r) = instantaneous interest rate

so (1 + r) = e (1 + r)t = et Mt = M(1 + r)t = Met = amount an investment of M grows to in t years Example 2. What is the instantaneous interest rate if the regular interest rate is 1% per year? In this case r = 0.01 so = log(1 + r) = log(1 + 0.01) = log(1.01) = 0.00995 / yr. Example 3. How much does $8.00 grow to after two years if the instantaneous annual interest rate is 1%? In this case M = $8.00, = 0.01 and t = 2. After two years this grows to M2 = Met = (8)e(0.01)(2) = (8)e0.02 = (8)(1.0202) = $8.1616. One effect of interest is that a future payment of a certain amount is not same as a payment of the same amount right now. If we are to get a payment of an amount v at a time t in the future then this is the same as a payment of M now where Met = v. So M = ve-t. Thus a payment of an amount v at a time t in the future is the same as a payment of ve-t now. This is called the present value of the future payment and e-t is called the discount factor, because it is the amount funture payments are discounted to get their present value. So vt = ve-t = present value of a payment of v at a future time v e-t = discount factor of future payments at time t Example 4. What is the present value of a payment of $8.00 to be made in two years if the instantaneous annual interest rate is 1%?

6.4.1 - 3

In this case M = $8.00, = 0.01 and t = 2. The present value is v2 = vet = (8)e-(0.01)(2) = (8)e-0.02 = (8)(0.980199) = $7.84159. In the previous section we saw that the expected value of a geometric Brownian motion at time t was E{X(t)} = E{X(0)}e( +
2/2)t

In order to get the present value of this we need to multiply by the discount factor e-t. So E{e-tX(t)} = E{X(0)}e( +
2/2 - )t

= present value of a geometric Brownian motion at time t

Example 4. Let X(t) be the price of FMC stock at time t years from the present. Assume that X(t) is a geometric Brownian motion with drift = 0.05 / yr and volatility = 0.4 / yr1/2. If the current price of FMC stock is $2.50, what is the expected present value of its price six months from now if the annual interest rate is 5%. The instanteous interest rate is = log(1.05) = 0.0487. Using the above formula one has

2 + 2 - = - 0.05 + (0.4)2/2 0.0487 = 0.08 0.0987 = - 0.0187

E{X(t)} = E{X(0)}e( +
2/2 - )t

= (2.5)e(- 0.0187)(1/2) = (2.5)e(- 0.00935

= (2.5)(0.990694) = $2.47673 Arbitrage. If the value of the price of a certain stock follows a geometric Brownian motion and x0 is its current price then by the above formula the present value of its expected price at time t is x0e( + the factor +
2/2 - )t

Whether or not it is better to invest in the stock or put one's money in a guaranteed investment depends on

2
2

- .

2 + 2 - > 0 2 + 2 - < 0 2 + 2 - = 0

Stock is better Guaranteed investment is better Stock and guaranteed investment are equal

Some people believe the stock's drift rate adjusts so that investing in the stock has the same expected outcome as a guaranteed investment, i.e. so

2 + 2 - = 0
When this happens an arbitrage is said to occur. We shall assume this happens below.

6.4.1 - 4

Problem 1. Suppose the current price of DTE stock is $49, the price has a volatility of = 0.15 / yr1/2 and the current interest rate is = 0.05 / yr. Assume that arbitrage is working so the drift is = - 2/2. a. b. What is the probability that the stock price will be at least $50 in 3 months? What is the expected stock price in 3 months?

6.4.1 - 5