We want to simulate …

Indices
Chapter 3: Brownian Motions
and its simulation

1 2

Computer generated paths for

Interest rates
a Brownian Motion

3 4

Wiener Process
Definition. A Wiener process (standard
Brownian motion) is a stochastic process
which satisfies the following properties:
For s<t, W(t) – W(s) is a N(0, t-s) random
variable.
For t1 < t2 ≤ t3 < t4, W(t4) - W(t3) is
uncorrelated with W(t2) - W(t1). This is known
as the independent increment property.
W(t0) = 0 with probability one.
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Simulation of Wiener Process
Partition [0,1] into n subintervals each with length
1/n. For each t in [0,1], let [nt] denote the greatest
integer part of the number nt.
For each t in [0,1], define a stochastic process
S[nt] = Σi=1[nt] e(i)/√n, e(i) iid N(0,1). Clearly,
S[nt] = S[nt]-1 + e([nt])/ √n, a special form of the
additive model defined at the beginning with ∆t
=1/n and W(t)= S[nt].
At time t=1, S[nt] = Sn = Σi=1n e(i)/√n, which has a
standard normal distribution. Even if e(i)s are not
normally distributed, CLT shows that Sn will still
be normally distributed as long as n is big. This is
the key idea in constructing a Brownian motion. 7
Wiener Processes: Brownian
Motions, Ito Processes
W(tk+1)= W(tk) + e(tk) √∆t, where ∆t = tk+1 –
tk, k=0,…,N, t0 = 0, and e(tk) iid N(0,1).
For j<k, W(tk) - W(tj) = Σi=jk-1 e(ti) √∆t.
The right-hand side is normally distributed,
so is the left-hand side.
Clearly, E(W(tk) - W(tj) ) = 0.
Var (W(tk) - W(tj)) = E [Σi=jk-1 e(ti) √∆t]2
= (k-j) ∆t = tk – tj.
For t1 < t2 ≤ t3 < t4, W(t4) - W(t3) is
uncorrelated with W(t2) - W(t1).
By letting n goes to infinity (∆t goes to 0),
Donsker (1953) proved that the stochastic
process S[nt] constructed in this way tends
to a Brownian motion. This result is known
as the Functional Central Limit Theorem or
the Invariance Principle.
Therefore, the above equation provides a
means to simulate the path of a Brownian
motion. All we have to do is to iterate the
equation: S[nt] = S[nt]-1 + e([nt])/ √n
by taking n bigger and bigger and in the
limit, we have a Brownian motion. 8
When ∆t goes to 0, the discrete-time
random walk equation
S[nt] = S[nt]-1+e([nt])/√n,
can be approximated by the continuous-
time equation dW(t) = e(t)√dt .
A simplified version
Set Y0 = 0
Set Yj = Yj-1 + ε*sqrt(∆t)
Joining Yj and Yj-1 by a straight line.

In there, Yj is replicating the value of Bt

when t = j∆t, where Bt follows a
standard Brownian (Wiener) process.
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An example

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Brownian motion
Suppose Wt follows a Wiener process
Then Xt = µt + σWt is called a Brownian
motion with a drift of µ and volatility of σ.
An alternative way to present Brownian
motion is by the differential form:
dXt = µdt + σdWt
The last representation is usually
referred to the name: diffusion process.
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Properties of Wiener Process
For each t, W(t) is normally distributed.
For t<s, E(W(s)|W(t)) =
E(W(s)-W(t)+W(t)|W(t))=W(t), hence a martingale.
With probability 1, W(t) is nowhere differentiable.
E[W(s)-W(t)/(s-t)]2 =1/(s-t) which tends to infinity
when s tends to t. Consequently, the process ξ(t)
= dW(t)/dt is undefined mathematically.
When used formally, the process ξ(t) = dW(t)/dt is
known as the white noise in the engineering field,
but its mathematical meaning remains to be
defined. It has to be interpreted in terms of
solution to the integral equation ∫ ξ(t)dt = W(t).
But be cautious whenever using such a definition.16
 Diffusion Processes
Consider dX(t) = µdt +σdW(t), integrating this
equation, we get
X(t) = X(0) + µt +σW(t). In other words, the
process X(t) is the solution to the integral
equation ∫dX(t)=µ ∫dt + σ∫dW(t).
X(t) defined in this way is known a diffusion
process. It can be expressed explicitly in
terms of W(t) and the constants µ and σ. To
generalize, we have:
17
Stock Returns
Recall the multiplicative model log S(k+1) =
log S(k)+w(k), w(k) iid N(ν,σ2).
The continuous-time approximation is dlog
S(t) = νdt + σdW(t). Integrating this equation,
we have
log S(t) = log S(0) + νt + σW(t). For t fixed,
the right-hand side is a normally distributed
random variable with mean logS(0) + νt and
variance σ2t. The process S(t) is known as
the geometric Brownian motion.
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Generalized Wiener Process
Definition. An Ito’s process or a generalized
Wiener process is a stochastic process which
satisfies the following stochastic differential
equation
dX(t) = µ(x,t)dt + σ(x,t) dW(t),
where µ(x,t) is known as the drift function and
σ(x,t) is known as the diffusion function.
This equation has to be interpreted through
integration.
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Definition. A stochastic process S(t) is said to be a
geometric Brownian motion with drift parameter µ if the
process X(t) =logS(t) is a Brownian motion with drift ν =
µ-σ2/2 and variance σ2, that is,
dX(t) = νdt + σdW(t), or equivalently,
dlogS(t) = (µ-σ2/2)dt + σdW(t).
The following figure are simulations of S(t)=exp{0.01t +
0.01W(t)}. Notice the linear growth of the mean, ν=.01.
20
Let S(0)=z. An equivalent way of defining a
geometric Brownian motion is that the process S(t)
satisfies
S(t) = z e X(t) = z exp{νt + σW(t)}
=z exp{(µ-σ2/2)t + σW(t)}.
Consider the successive ratios S(t1)/S(t0),
S(t2)/S(t1), …,S(tn)/S(tn-1). Since the Brownian
motion has independent increments, these ratios
are independent random variables.
log S(t) = X(t) ~ N(logS(0) + νt, σ2 t).
As S(t)=ze X(t), to find the moments of S(t), consider
E(S(t)) = E(E(S(t)|S(0)=z))
=E(E(z exp{(µ-σ2/2)t + σW(t)}|S(0)=z))
= z exp{(µ-σ2/2)t}E(eσW(t)) 21
Table
STD of % return = 0.404
STD of log-return = 0.376
Mean1 – 0.5x var2 = 0.0276
23
= z exp{(µ-σ2/2)t}E(e σ√t ξ), ξ~N(0,1),
= z exp{(µ-σ2/2)t}exp{σ2 t/2} =zeµt=S(0)eµt.
For µ>0, E(S(t)) tends to infinity as t gets large.
But for 0< µ< σ2/2, the process X(t) = X(0) + (µ-
σ2/2)t + σW(t) has a negative drift, which means
X(t) tends to negative infinity as t gets bigger.
Consequently, the price S(t) = S(0)eX(t) tends to
zero as t tends to infinity. In other words, the
geometric Brownian motion S(t) drifts to zero but
at the same time, its mean is drifting to infinity.
Using the mean value can be misleading in
describing the process.
‰ Similarly, we can show that
Var S(t) = S(0)2 e 2µt (exp{σ2 t}-1). (check)
22
Ito’s Formula
In the preceding section, we define the
geometric Brownain motion in terms of
dlogS(t) = νdt + σdW(t).
From ordinary calculus, dS(t)/S(t)=dlogS(t)
Guess: dS(t)/S(t) = νdt + σdW(t).
Unfortunately, this is not correct. We need
an extra correction term.
Rule: Whenever dW(t) is involved, we need
to account for a correction term. This is the
essence of the Ito’s calculus.
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 The correct formula is
dS(t)/S(t) = (ν+σ2/2)dt + σdW(t)
= µdt + σdW(t), as ν=µ-σ2/2.
The extra term σ2/2 when transforming dlogS(t)
to dS(t) is known as the Ito’s lemma.
Remarks:
1. The above equation describes the dynamics of
the instantaneous return process dS(t)/S(t).
2. When σ=0, the process is deterministic and the
above equation leads back to S(t)=S(0)eµt .
3. One can simulate S(t) from the above equation,
S(tk+1) – S(tk) = µS(tk)∆t + σS(tk)ε(tk)√∆t, or
S(tk+1) =[1+ µ∆t + σε(tk)√∆t]S(tk), ε(tk) iid N(0,1).
This is a multiplicative model in S(t), but the
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coefficient is normal, not lognormal.
Proof. It will only be a sketch. Recall from
Ito’s Lemma
Theorem. Let x(t) be a diffusion
process that satisfies
dx(t) = a(x,t)dt + b(x,t)dW(t).
Let the process y(t) = F(x,t) for some
function F. Then y(t) satisfies the Ito’s
equation
dy(t) = [(∂F/∂x)a + ∂F/∂t +
(1/2)(∂2F/∂x2)b2]dt + (∂F/∂x)bdW(t).
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4. Alternatively, we can discretize dlogS(t)
= νdt+σdW(t) to simulate
logS(tk+1)- logS(tk)=ν∆t+σε(tk)√∆t, or
S(tk+1) = exp{ν∆t+σε(tk)√∆t}S(tk).
This time we have a multiplicative model
again, but with lognormal coefficient. In
practice, as long as ∆t is small, both
expressions can be used to simulate
S(t).
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calculus that for a function of two variables
y(t)=F(x,t),
dy(t) = (∂F/∂x) dx + (∂F/∂t) dt
= (∂F/∂x)(adt + bdW) + (∂F/∂t) dt.
Comparing this with the Ito’s equation, we see
that there is the extra correction term
(1/2)(∂2F/∂x2)b2 in front of the coefficient dt in the
Ito’s equation. The reason for this correction is
due to the fact that dW is of order √dt, and as dx
is expressed in terms of dW, it is also of order
√dt. To see how this is done, consider the
Taylor’s expansion of F up to the order of dt.
Specifically, calculate the expression
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F(x+∆x, t+∆t) = F(x,t) + (∂F/∂x)∆x + (∂F/∂t)∆t + (1/2)(∂2F/∂x2)(∆x)2
= F(x,t)+(∂F/∂x)(a∆t+b∆W)+(∂F/∂t)∆t + (1/2)(∂2F/∂x2)(a∆t+b∆W)2.
Consider this quadratic term, expanding
(a∆t+b∆W)2 = a2 (∆t)2 + 2ab (∆t)(∆W) + b2(∆W)2.
Note that both the first term and the second term of the right hand
side are of higher order than ∆t. Recall the fact that since dW ~
e(t)√dt, ∆W is of order √∆t and thus, (∆W)2 ~ ∆t. Using this fact
and remembering that we are expanding y only up to order ∆t (i.e.
terms of order higher than ∆t can be ignored), we get (a∆t+b∆W)2
~ b2 ∆t. Substituting this into the pink term,
F(x+∆x, t+∆t) = F(x,t) + [(∂F/∂x)a + (∂F/∂t) + (1/2)(∂2F/∂x2)b2] ∆t
+ (∂F/∂x)b∆W.
Taking limit ∆t goes to zero, the Ito’s formula is obtained. ♣
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Example. ∫ sdW(s) =? First a guess,
tW(t) - ∫ W(s)ds. To check,
1. Let X(t)=W(t), dX(t)=dW(t) and identify
a=0, b=1.
2. Let Y(t)=F(W(t))=tW(t). Then ∂F/∂W=t,
∂2F/∂W2=0, and ∂F/∂t =W(t).
3. Substitute these into the Ito’s lemma,
dY(t)=tdW(t) + W(t)dt. Integrating,
4. Y(t) =tW(t)= ∫sdW(s) + ∫W(s)ds, that is,
∫sdW(s) = tW(t) - ∫W(s)ds as expected.♣
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Example. Consider the geometric Brownian
motion S(t) that satisfies
dS(t) = µS(t)dt + σS(t)dW(t).
Consider the process y(t)=F(S(t))=logS(t).
What kind of equation does y satisfy? To find
out, use Ito’s lemma.
1. Identify a= µS and b= σS.
2. We know ∂F/∂S=1/S and ∂2F/∂S2=-1/S2.
3. Plug these into Ito’s formula,
dlogS =[a/S – (1/2)(b2/S2]dt + (b/S)dW
=(µ- σ2/2)dt + σdW,
which agrees with the earlier derivation. ♣30
Example. ∫ W(s)dW(s) = ? To find out, first guess
an answer W2(t)/2. Is this correct? Use Ito’s
formula to check.
1. Let X(t)=W(t), dX(t)=dW(t) and identify a=0, b=1.
2. Let Y(t)=F(X(t))= W2(t)/2. Then ∂F/∂W=W,
∂2F/∂W2=1, and ∂F/∂t =0.
3. Recite Ito’s lemma:
dy(t) = [(∂F/∂x)a + ∂F/∂t+(1/2)(∂2F/∂x2)b2]dt +
(∂F/∂x)bdW(t) so that dY(t) = (1/2)dt + W(t)dW(t).
Now integrate both sides of this equation, we
have
4. W2(t)/2 = Y(t) = t/2 + ∫ W(s)dW(s), that is,
∫ W(s)dW(s) = W2(t)/2 - t/2. This time, our initial
guess wasn’t correct. We need the extra
correction term from the Ito’s lemma. ♣ 32
 Asset Dynamics
In the physical world,
dS
= µ dt + σ dW
S
In the risk-neutral world,
Options Pricing with Monte dS
= rdt + σ dW
Carlo Simulations S

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Pricing a call in terms of

MC Simulation
expectation
Call option payoff = max(S – K, 0) A computation method for calculating
Present value of the call option: expected value by the means of simulation.

C(t, S) = e−r (T −t ) EQ [max(ST − K,0)]

where Q refers to the risk-neutral
probability
It consists of the following steps:
z Generate possible scenarios
z Estimate expected value by the sample mean of
the scenarios
The estimate converges to the actual
number because of the law of large number.

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 Valuing a call Convergence of the estimate
Simulate n sample paths, ends at t = T,
according to the risk-neutral asset
dynamics;
Collect all the end points of the paths,
I.e. ST(j), j = 1, 2, …, n.
The option price is given by

e −r (T −t ) 1 n
∑
n j =1
(
max ST − K ,0
( j)
)
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Apply to exotic options Barrier Options

Forward Start options:
max(ST2 – ST1, 0)
Forward start options are options that are paid for
now but will start at some time in the future. They
are sometimes used in employee incentive
schemes. The terms of the option are usually
chosen so that the options will be at the money
(S = K) at the time they start.
Barrier options are options where the payoff
depends on whether the underlying asset's
price reaches a certain level during a certain
period of time.
Example: down-and-out call
DOC = max(ST - K, 0) I(min(S) > B)

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