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You are on page 1of 38

Chapter 12

Stochastic Processes

over time that is at least in part random. i.e., temperature

and IBM stock price.

the evolution of a variable xt over time t. For given times,

we can calculate the probability that the corresponding

values x1,x2, x3,etc., lie in some specified range.

Discrete time; discrete variable

Random walk: xt = xt 1 + t

if t can only take on discrete values

Discrete time; continuous variable

xt = a + bxt 1 + t

mean.

Continuous time; discrete variable

Continuous time; continuous variable

processes to model stock prices

proves to be the most useful for the purposes of

valuing derivatives

variable depend only on where we are, not the

history of how we got where we are.

processes.

consistently superior returns with a trading rule

based on the past history of stock prices. In other

words technical analysis does not work.

with weak-form market efficiency

Continuous Variable Model

a normal probability distribution of with mean $40

and standard deviation $10

Questions

stock price at the end of 2 years?

years?

years?

t years?

variable, continuous time process

In Markov processes changes in successive periods

of time are independent

This means that variances are additive

Standard deviations are not additive

(continued)

variance is 100 per year.

standard deviation is 10 per year.

10

We consider a variable z whose value changes

continuously

Define (,v) as a normal distribution with mean

and variance v

The change in a small interval of time t is z

The variable follows a Wiener process if

z= t where is (0,1)

periods of time are independent

11

z (T ) z (0)=

i =1

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

12

Taking Limits . . .

dz = dt

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

13

(See page 263-65)

change per unit time) of 0 and a variance rate of 1

the variance rate can be set equal to any chosen

constants

14

(continued)

with a drift rate of a and a variance rate of b2 if

dx=adt+bdz

or: x(t)=x0+at+bz(t)

15

(continued)

x = at + b t

Mean change in x in time T is aT

Variance of change in x in time T is b2T

Standard deviation of change in x in time T is b T

16

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

f(48,100), the process would be

dS = 8dt + 10dz

17

Why

b t

?(1)

(xT-x0)depend on T and not on the number of

steps.

1.Divide time up into n discrete periods of

length t, n=T/t. In each period the

variable x either moves up or down by an

amount h with the probabilities of p and q

respectively.

18

Why

b t

?(2)

E(x)=(p-q) h

E[(x)2]= p(h)2+q(-h)2

So, the variance of x is:

E[(x)2]-[E(x)]2=[1-(p-q)2](h)2

3. Since the successive steps of the random walk are

independent, the cumulated change(xT-x0)is a binomial

random walk with mean:

n(p-q) h=T(p-q) h/ t

and variance:

n[1-(p-q)2](h)2= T [1-(p-q)2](h)2 / t

19

Why b

?(3)

variance of (xT-x0) to remain unchanged, and to be

independent of the particular choice of p,q, h and t.

The only way to get it is to set:

h = b t

a

a

1

1

t ], q =

t ]

[1 +

[1

p=

2

2

b

b

a

a

p q=

t = 2 h

b

b

20

Why b

?(4)

distribution converges to a normal

distribution, with mean

and variance

a

h

t 2 h

=

at

b

t

a 2 b 2 t

t[1 ( ) t]

b 2t

b

t

21

calculating a trajectory for xt using the

equation:

xt =+

xt 1 0.01667 + 0.2887 t

0.0167 per month. A variance of 1.0 per year

implies a variance of 0.0833 per month, so

that the standard deviation in monthly terms

is 0.2887.

See Investment under uncertainty, p66

the forecasted value of x for a time T months

beyond Dec. 1974 is given by:

x0.01667

=

x1974 +

1974

+T

In the long run, the trend is the dominant

determinant of Brownian Motion, whereas

in the short run, the volatility of the process

dominates.

Not Appropriate for Stocks

percentage change in a short period of time remains

constant, not its expected absolute change in a short

period of time

size of future stock price movements is proportional

to the level of the stock price

24

rate are functions of time

=

dx a( x, t)dt + b( x, t)dz

t

x (t) =

x0 + a ( x, t ) ds + b ( x, t ) dz

=

x a( x, t)t + b( x, t) t

25

(See pages 269-71)

dS S dt + S dz

=

volatility.

The discrete time equivalent is

S= St + S t

26

by sampling values for

(=1/52 years), then

=

S 0.00288S + 0.0416S

27

12.1, page 268)

Week

Stock Price at

Start of Period

Random

Sample for

Change in Stock

Price, S

100.00

0.52

2.45

102.45

1.44

6.43

108.88

-0.86

-3.58

105.30

1.46

6.70

112.00

-0.69

-2.89

28

by x, Its lemma tells us the stochastic

process followed by some function G (x, t )

of the underlying and time, Its lemma

plays an important part in the analysis of

derivative securities

29

G

G

2G 2

G

=

x +

t + 2 x

x

t

x

2G

2G 2

+

x t + ?

t +

2

x t

t

30

In ordinary calculus we have

G

G

G=

x +

t

x

t

In stochastic calculus this becomes

G

G

2G

2

G

=

x+

t + ?

x

x

t

x2

because x has a component which is of order t

31

Substituting for x

Suppose

=

dx a(x ,t)dt + b(x ,t)dz

so that

x=at+b t

Then ignoring terms of higher order than t

G

G

2G 2 2

G

=

x +

t + ?

b t

2

x

t

x

32

The 2t Term

Since (0,1) , E( ) = 0

E( 2 ) [ E( )]2 =

1

E( 2 ) = 1

It follows that

E( 2 t) =t

Hence,

G

G

1 2G 2

G

b t

=

x +

t +

2

x

t

2x

33

Taking Limits

Taking limits:

G

G

2G 2

dG =

dx +

dt + ?

b dt

2

x

t

x

Substituting:

dx a dt + b dz

=

We obtain:

G

G

2G 2

G

dG=

a+

b

dt

b dz

+?

+

2

t

x

x

x

This is Ito's

Lemma

34

to a Stock Price Process

The stock price process is

=

d S S dt + S d z

For a function G of S and t

G

G

2G 2 2

G

=

+?

dG

S +

S dt +

S dz

2

t

S

S

S

35

Examples

1. The forward price of a stock for a contract

maturing at time T

G = S e r (T t )

( r )G dt + G dz

dG =

2. G = ln S

2

dG =

2

dt + dz

36

time and of the m Ito process x1,x2,,xm,

where

dxi =

ai ( x1 , x2 ,..., xm , t ) dt + bi ( x1 , x2 ,..., xm , t ) dzi , i =

1,2,..., m

Then Itos Lemma gives the differential dF as

F

F

1

2 F

dF =dt + dxi +

dxidx j

t

2 i j xi x j

i xi

37

Examples

Suppose F(x,y)=xy, where x and y each follow geometric

Brownian motions:

=

dx ax xdt + bx xdz x

=

dy a y ydt + by ydz y

with E ( dzidz j ) = ijdt .

Whats the process followed by F(x,y) and by G=logF?

= ( ax + a y + bxby ) Fdt + ( bx dz x + by dz y ) F

1 2 1 2

dG = ax + a y bx by dt + bx dz x + by dz y

2

2

38

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