3.

The Wiener Process and Rare Events in

Financial Markets

The Wiener process works as a mathematical

model for continuous time stock price.

To make the process even more realistic oc-

casional rare events causing jumps into the
sample paths are added by modeling with
some point processes.

Consider first the modeling the ”ordinary”

events with Wiener process (Brownian mo-
tion) (see here for a heuristic construction of
the Brownian motion).

1
Definition 3.1: A Wiener process, Wt, rela-
tive to a family of information sets {It} (fil-
tration), is a stochastic process such that
1. W0 = 0 (with probability one).
2. Wt is continuous.
3. Wt is adapted to the filtration {It}.
4. For s ≤ t, Wt − Ws is independent of Is,
with E[Wt − Ws] = 0 and Var[Wt − Ws] =
E(Wt − Ws)2 = t − s.

2
Equivalently we can define:

Definition 3.2: A random process Bt, t ∈

[0, T ] is a (standard) Brownian motion if
1. B0 = 0.
2. Bt is continuous.
3. Increments of Bt are independent. I.e., if
0 ≤ t0 < t1 < · · · < tn, then Bt1 −Bt0 , . . . , Btn −
Btn−1 are independent.
4. If 0 ≤ s ≤ t, Bt − Bs ∼ N (0, t − s).

30

20
+std

10
W(t)

-10

-std
-20
80 82 84 86 88 90 92 94 96 98 00

Time

Figure 3.1: Three sample paths of a standard

Brownian motion.
3
Properties:
(a) Wt is an It-martingale.
(b) Wt has independent increments.
(c) E[Wt] = 0 for all t.
(d) Var[Wt] = t.
(e) The law of iterated logarithms
Wt
lim sup √ =1 (with probability one)
t→∞ 2t log log t
(f) Wt/t → 0 w.p.1 as t → ∞.
(g) Wt2 − t is an It-martingale.
(h) exp{σWt − (σ 2/2)t} is an It-martingale.

4
Proof: (a) Let s ≤ t, then E[Wt − Ws|Is] =
E[Wt − Ws] = 0. So E[Wt|Is] = Ws.
(b) Let 0 ≤ s < t < u then Wt − Ws is It-
measurable (Ws, Wt ∈ It ⊂ Iu) and Wu −
Wt is independent of It, which implies that
Wu − Wt is independent of Wt − Ws.
(c) 0 = E[Wt − W0] = E[Wt].
(d) Var[Wt] = Var[Wt − W0] = t − 0 = t.
(e) Will not be proven, but means that if b >
√
1, for sufficiently large t, Wt < b 2t log log t.
(f) Follows from the law of iterated loga-
rithms.
(g) and (f) Left as exercises.

5
 40

30 log-log

20
std
10
W_t

-10

-20

-30

-40
80 82 84 86 88 90 92 94 96 98 00
Time

Figure 3.2: The law of iterated logarithms.

6
Example 3.1:
1 2
St = S0 e(µ− 2 σ )t+σWt ,
where S0 > 0, and µ and σ > 0 are constants. This is an example
of generalized Brownian motion, called also a Geometric Brow-
nian motion, and serves as a basic model for stock prices. The
distribution of log St is normal with mean
³ ´
1
log S0 + µ − σ 2 t
2
and variance σ 2 t. The continuously compounded return to the
stock, per unit of time (e.g. if annual, then annualized cumula-
tive returns), over time interval [t, t + u], u > 0, is
1 1 1
Ru = (log St+u − log St ) = µ − σ 2 + σ (Wt+u − Wt ).
u 2 u
Because for fixed t, Wt+u − Wt is a standard Brownian motion
with time index u, property (f) above implies that
1 2
Ru → µ − σ as u → ∞.
2

Note. E[St ] = S0 eµt .

7
 2000

1600

1200
S(t)

800

E[S(t)]
400

0
80 82 84 86 88 90 92 94 96 98 00

Time

Figure 3.3: Sample paths of monthly stock price processes St =

1 2
S0 e(µ− 2 σ )t+σWt
with S0 = 100, and annual rate of return µ = 10%

and volatility σ = 25%.

8
 30

20
Monthly return (%)

10

-10

-20

-30
80 82 84 86 88 90 92 94 96 98 00

Month

Figure 3.4: Monthly log-returns Rt = 100(log St − log St−s ) for

the sample period 1980:1 to 2001:12.

60
Annualized cumulative return (%)

40

20

-20

-40

-60
80 82 84 86 88 90 92 94 96 98 00

Month

Figure 3.5: Annualized cumulative log-returns RtA = 100 12

t
(log St −

log S0 ) for the period 1980:1 to 2001:12 (monthly observations).

9
Remark 3.1: In the above example the geometric Brow-
nian motion is usually given in the differential form
dSt
= µ dt + σ dWt,
St
(”model of the return”) or
dSt = µ St dt + σ St dWt.

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Rare Events and Poisson Process

In stock markets we occasionally observe sud-

den jumps in the prices due to some impor-
tant or extreme event that affects the price.

To model these a reasonable assumption could

be that the jumps—being consequences of
extreme shocks—are independent of the usual
information driving innovations dWt.

11
Following Merton∗ we can introduce a model
where the asset price has jumps superim-
posed upon a geometric Brownian motion
such that
dSt
(1) = (µ − λ ν)dt + σ dWt + dJt,
St
where µ the asset’s expected return, λ is
the jump intensity (e.g. average number of
jumps per year), ν is the average size of the
jump as a percentage of the asset price, σ
is the return volatility, and Jt is related to
the (independent) Poisson process generat-
ing the jumps.

Once the jump occurs we can superimpose it

into the process by assuming that it is gen-
erated from a normal distribution with mean
ν and standard deviation equaling the jump
volatility.

∗ Merton, R.C. (1976). Option pricing when underlying stock

returns are discontinuous. Journal of Financial Economics, No.
3, 125–144.

12
Example 3.2: Consider a situation where the underly-
ing process has a jump frequency one per year (λ = 1/2)
(i.e., on average once every two year). The average
percentage jump size ν is assumed for simplicity to be
equal to zero and the volatility of the jump is 20%.

Suppose the stock price now is 100, the drift is 8%,

σ = 15%. Below are four sample baths from the dif-
fusion process
dSt
= µ dt + σ dWt + dJt .
St
We model dJt as dJt = 0.20 Z U , where Z is a standard
normal variable and U is a random variable such that
P (U = 1) = λdt and P (U = 0) = 1 − λdt. In addition
Z and U are independent.

A discrete approximation of the above difference equa-

tion is
³ √ ´
St = St−h 1 + 0.08h + 0.15 h Zt + dJt ,

13
 Sample paths of a jump process:
S(t) = S(t-dt)*[1 + 0.08dt + 0.15 sqrt(dt) Z(t) + dJ(t)],
dJ(t) = 0.2 Z U(t), with P(U(t) = 1) = 0.5 dt
S(t) 700

600

500

400

300

200

100

0
90 92 94 96 98 00 02 04 06
Month
S1 S2 S3 S4

14
We can rewrite the diffusion process in this example
as
dSt
= (µ − λν)dt + σ dWt
St
if the Poisson event does not occur, and
dSt
= (µ − λν)dt + σ dWt + 0.20Z
St
if the Poisson event occurs.

It can be shown that the process then is

·µ ¶ ¸
1 2
St = S0 exp µ − σ − λν t + σWt J(Nt ),
2
where
" Nt
#
X
J(Nt) = exp Ji
i=1
with Ji = 0.20Zi , and Zi are independent N (0, 1) ran-
dom variables. Nt has the Poisson distribution, dis-
cussed more closely below.

15
In order to model the jump intensity, let Nt
denote the total number of extreme (unordi-
nary) shocks until time t (counting process).

Then once the event occurs, Nt changes by

one unit and remains otherwise unchanged.

Conceptually we can model this within an in-

finitesimal interval dt by
(
1 with probability λ dt
(2) dNt =
0 with probability 1 − λ dt
This causes a discrete jump (once it occurs),
because the size does not depend on dt (the
size can be a random variable as in the pre-
vious example).

16
Poisson process has the following properties:
(1) During a small interval h, at most one
event occurs with probability ≈ 1.
(2) The information up to time t does not
help to predict the occurrence of the event
in the next instant.
(3) Events occur at a constant rate λ.

Remark 3.2: Within any time interval [t, t + h], ∆Nt+h =

Nt+h − Nt has the Poisson distribution
(λh)k λh
(3) P (∆Nt+h = k) = e , k = 0, 1, . . .
k!
(4) E[∆Nt+h] = λh = Var[∆Nt+h].
However, if h is small
(5) P (∆Nt+h = 1) = (λh)e−λh ≈ λh

as stated above. We denote ∆Nt+h ∼ Po(λh). Thus

because N0 = 0, we have in the previous example
Nt ∼ Po(λt).

17