Brownian Motion and Itô's Lemma

Chapter 20
Brownian Motion
and Its Lemma
Introduction
Stock and other asset prices are commonly
assumed to follow a stochastic process called
geometric Brownian motion
Given that a stock price follows geometric
Brownian motion, we want to characterize the
behavior of a claim that has a payoff
dependent upon the stock price
We will discuss Its Lemma, which permits us to

study the process followed by a claim that is a
function of the stock price
Copyright 2006 Pearson Addison-Wesley. All rights reserved.
20-2
The Black-Scholes Assumption

About Stock Prices
The original paper by Black and Scholes begins by assuming that

the price of the underlying asset follows a process like the
following
dS (t )
dt dZ (t )
S (t )
(20.1)
where
S(t) is the stock price

dS(t) is the instantaneous change in the stock price
is the continuously compounded expected return on the stock
is the continuously compounded standard deviation (volatility)
Z(t) is a normally distributed random variable that follows a process
called Brownian motion
dZ(t) is the change in Z(t) over a short period of time
20-3
The Black-Scholes Assumption

About Stock Prices (contd)
A stock obeying equation (20.1) is said to follow a
process called geometric Brownian motion
Expressions like equation (20.1) are called stochastic
differential equations
There are 2 important implications of equation (20.1)
Suppose the stock price now is S(0). If the stock price follows
equation (20.1), the distribution of S(T) is lognormal, i.e.
In[S(T )] ~ N(In[S(O)] [ 0.5 2 ]T , 2T )
Geometric Brownian motion allows us to describe the path the

stock price takes in getting to a terminal point
20-4
A Description of Stock Price Behavior

The normal distribution provides an unrealistic
description of the stock price. However,
normality can be a plausible description of
continuously compounded returns
If the continuously compounded return is R(0,T),

the price is S(0) eR(0,T), which is always positive
It can be reasonable to assume that over very

short periods of time effective stock returns,
S(t + h)/S(t), are normally distributed
20-5
A Description of Stock
Price Behavior (contd)
Suppose that
h, the length of each time period, is small,
the return on the stock, rh, is normally

distributed with mean and variance h and
2h
Thus,
S(t h) S(t)(1 rh )
with
rh ~ N( h, h)
20-6
A Description of Stock
Price Behavior (contd)
The continuously compounded return from 0 to T is
ln[ S (T ) / S (0)] i 1 ln(1 rih )
n
The logarithm of a normal random variable is not

normal. However, as h 0, the continuously
compounded return from 0 to T is normal. Therefore,
S(T) tends toward lognormality
20-7
Brownian Motion
Brownian motion is a random walk occurring in
continuous time, with movements that are
continuous rather than discrete
A random walk can be generated by flipping a coin

each period and moving one step, with the direction
determined by whether the coin is heads or tails
To generate Brownian motion, we would flip the

coins infinitely fast and take infinitesimally small
steps at each point
20-8
Brownian Motion (contd)

Let Z(t) represent the value of the random walkthe
cumulative sum of all the movesafter t periods
Technically, Brownian motion is a random walk with
the following characteristics
Z(0) = 0
Z(t + s) Z (t) is normally distributed with mean 0

and variance s
Z(t + s1) Z(t) is independent of Z(t) Z(t s2), where

s1, s2 >0. That is, nonoverlapping increments are
independently distributed
Z(t) is continuous
20-9

We can think of Brownian motion being
approximately generated from the sum of
independent binomial draws with mean 0 and
variance h
Let h get arbitrarily small, and rename h as dt.
Denote the change in Z as dZ(t)
20-10

Then
dZ (t ) Y (t ) dt
(20.4)
where Y(t) is a random draw from a binomial

distribution, such that Y(t) is 1 with probability 50%
Equation (20.4) says Over small periods of

time, changes in the value of the process are
normally distributed with a variance that is
proportional to the length of the time period.
20-11

Since Z(T) is the sum of individual dZ(t)s, we
can write
T
Z (T ) Z (0) dZ (t )
0
The integral here is called a stochastic integral
The process Z(t) is also called a diffusion process
Among properties of Brownian motion are
infinite-crossing property and
infinite variation
20-12
Arithmetic Brownian Motion

With pure Brownian motion, the expected change in Z
is 0, and the variance per unit time is 1. We can
generalize this to allow an arbitrary variance and a
nonzero mean
dX (t ) dt dZ (t )
(20.8)
This process is called arithmetic Brownian motion
is the instantaneous mean per unit time
2 is the instantaneous variance per unit time
The variable X(t) is the sum of the individual changes dX.

X(t) is normally distributed, i.e., X(T) X(0) ~ N (T, 2T)
20-13
Arithmetic Brownian Motion (contd)

An integral representation of equation (20.8) is
T
X (T ) X (0) dt dZ (t )
Here are some properties of the process in

equation (20.8)
X(t) is normally distributed because it is created by

adding together many normally distributed dXs
The random term is multiplied by a scale factor that
enables us to change variance
The dt term introduces a nonrandom drift into
the process
20-14
Arithmetic Brownian Motion (contd)

Arithmetic Brownian motion has
several drawbacks
There is nothing to prevent X from becoming

negative, so it is a poor model for stock prices
The mean and variance of changes in dollar terms

are independent of the level of the stock price
Both of these criticisms will be eliminated with

20-15
The Ornstein-Uhlenbeck Process

We can incorporate mean reversion by modifying
the drift term
dX (t ) [a X (t )] dt dZ (t )
(20.9)
When = 0, this equation is called an OrnsteinUhlenbeck process
The parameter measures the speed of the reversion:

If is large, reversion happens more quickly
In the long run, we expect X to revert toward
As with arithmetic Brownian motion, X can still
become negative
20-16
Geometric Brownian Motion

An equation, in which the drift and volatility depend on
the stock price, is called an It process
Suppose we modify arithmetic Brownian motion to make

the instantaneous mean and standard deviation proportional
to X(t)
dX (t ) a X (t ) dt X (t )dZ (t )
This is an It process that can also be written
dX (t )
a dt dZ (t )
X (t )
(20.11)
This process is known as geometric Brownian motion
20-17
Geometric Brownian Motion (contd)

The percentage change in the asset value is
normally distributed with instantaneous mean
and instantaneous variance 2
The integral representation for equation
(20.11) is
T
X (T ) X (0) X (t )dt X (t )dZ (t )
20-18
Lognormality
If a variable is distributed in such a way
that instantaneous percentage changes
follow geometric Brownian motion, then
over discrete periods of time, the
variable is lognormally distributed
20-19
Relative Importance of the

Drift and Noise Terms
Over short periods of time, the character of the
Brownian process is determined almost entirely by the
random component
Consider the ratio of the per-period standard deviation to the

per-period drift
X (t ) h
X (t )h h
The ratio becomes infinite as h approaches dt
As the time interval becomes longer, the mean

becomes more important than the standard deviation
20-20
Relative Importance of the

Drift and Noise Terms (contd)
The results in the table hold for both geometric

Brownian motion and arithmetic Brownian motion.
20-21
Correlated It Processes
Let W1(t) and W2(t) be independent Brownian motions.
Then
Z (t ) W1 (t )
Z ' (t ) W1 (t ) 1 2 W2 (t )
(20.16)
This is the Cholesky decomposition
The correlation between Z(t) and Z'(t) is

E[ Z (t ) Z ' (t )] E[W1 (t ) 2 ] 1 2 E[W1 (t )W2 (t )] t 0
The second term on the right-hand side is 0 because W1(t)

and W2(t) are independent.
20-22
Multiplication Rules
We can simplify complex terms containing dt and dZ
by using the following multiplication rules
dt dZ = 0
(20.17a)
(dt)2 = 0
(20.17b)
(dZ)2 = dt
(20.17c)
dZ dZ' = dt
(20.17d)
The reason behind these multiplication rules is that the

multiplications resulting in powers of dt greater than 1 vanish.
20-23
The Sharpe Ratio

If asset i has expected return i, the risk premium is
defined as
Risk premiumi = i r
where r is the risk-free rate
The Sharpe ratio for asset i is the risk premium, i r,

per unit of volatility, I
i r
Sharpe ratio i
i
(20.18)
20-24
The Sharpe Ratio (contd)

We can use the Sharpe ratio to compare two perfectly
correlated claims, such as a derivative and its
underlying asset
Two assets that are perfectly correlated must have the
same Sharpe ratio, or else there will be an arbitrage
opportunity
Consider the processes for two non-dividend paying stocks
dS1 1S1dt 1S1dZ

dS2 2 S2 dt 2 S2 dZ
(20.19)
(20.20)
Because the two stock prices are driven by the same dZ, it
must be the case that ( 1 r) / 1 ( 2 r) / 2
20-25
The Risk-Neutral Process

Suppose the true price process is
dS (t )
( )dt dZ (t )
S (t )
where is the dividend yield on the stock
We can write a risk-neutral version of this process by

subtracting the risk premium, r, from the drift,
dS (t )
(r )dt dZ * (t )
S (t )
(20.26)
The probability distribution (dZ*(t)) associated with the riskneutral process is said to be the risk-neutral measure
When we switch to the risk-neutral process, the volatility
remains the same
20-26
Its Lemma
Suppose a stock with an expected
instantaneous return of , dividend yield of ,
and instantaneous volatility follows
dS(t) ( )S(t)dt S(t)dZ(t)

C[S(t), t] is the value of a derivative claim that
is a function of the stock price
How can we describe the behavior of this
claim in terms of the behavior of S?
20-27
Its Lemma
Its Lemma (Proposition 20.1)
If C[S(t), t] is a twice-differentiable function of S(t), then

the change in C is
1
dC ( S , t ) CS dS C SS (dS ) 2 Ct dt
2
1 2 2
( ) SC S S CSS Ct dt SC S dZ
2
where CS = C/S, CSS = 2C/S2, and Ct = C/t
The terms in square brackets are the expected change

in the option price
20-28
Its Lemma (contd)

The extra term involving the variance is the
Jensens inequality correction due to the
uncertainty of the stochastic process
If there is no uncertainty, that is if = 0, then

Its Lemma reduces to the calculation of a
total derivative
dC(S,t) CS dS Ct dt
20-29
Multivariate Its Lemma

A derivative may have a value depending on
more than one price, in which case we can use
a multivariate generalization of Its Lemma
Multivariate Its Lemma (Proposition 20.2)
dSi (we
t ) have n correlated It processes
Suppose
i dt i dzi ,
i 1, . . ., n
Si (t )
Denote the pairwise
E(dz correlations
dz ) as
dt
i
i, j
20-30
Multivariate Its Lemma (contd)

If C(S1, . . ., Sn, t) is a twice-differentiable
function of the Sis, we have
dC ( S1 , . . ., S n , t ) i 1 C Si dSi
n
1 n
n
dSi dS j C Si S j Ct dt
i 1 j 1
2
The expected change in C per unit time is

1
1 n
n
n
E[dC ( S1 , . . ., S n , t )] i 1 i S i CSi i 1 j 1 i j ij Si S j C Si S j Ct
dt
2
20-31

Brownian Motion and Itô's Lemma

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Chapter 20

We will discuss Its Lemma, which permits us to

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

The Black-Scholes Assumption

The original paper by Black and Scholes begins by assuming that

S(t) is the stock price

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

The Black-Scholes Assumption

In[S(T )] ~ N(In[S(O)] [ 0.5 2 ]T , 2T )

Geometric Brownian motion allows us to describe the path the

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

A Description of Stock Price Behavior

If the continuously compounded return is R(0,T),

It can be reasonable to assume that over very

h, the length of each time period, is small,

the return on the stock, rh, is normally

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

The logarithm of a normal random variable is not

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

A random walk can be generated by flipping a coin

To generate Brownian motion, we would flip the

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Brownian Motion (contd)

Z(t + s) Z (t) is normally distributed with mean 0

Z(t + s1) Z(t) is independent of Z(t) Z(t s2), where

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Brownian Motion (contd)

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Brownian Motion (contd)

where Y(t) is a random draw from a binomial

Equation (20.4) says Over small periods of

Brownian Motion (contd)

The integral here is called a stochastic integral

The process Z(t) is also called a diffusion process

Among properties of Brownian motion are

infinite-crossing property and

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Arithmetic Brownian Motion

This process is called arithmetic Brownian motion

is the instantaneous mean per unit time

2 is the instantaneous variance per unit time

The variable X(t) is the sum of the individual changes dX.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Arithmetic Brownian Motion (contd)

Here are some properties of the process in

X(t) is normally distributed because it is created by

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Arithmetic Brownian Motion (contd)

There is nothing to prevent X from becoming

The mean and variance of changes in dollar terms

Both of these criticisms will be eliminated with

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

The Ornstein-Uhlenbeck Process

When = 0, this equation is called an OrnsteinUhlenbeck process

The parameter measures the speed of the reversion:

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Geometric Brownian Motion

Suppose we modify arithmetic Brownian motion to make

This is an It process that can also be written

This process is known as geometric Brownian motion

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Geometric Brownian Motion (contd)

X (T ) X (0) X (t )dt X (t )dZ (t )