CH 9 Brownian Motion and Martingales

 Knowledge of Stochastic Process (NEED)

4 categories of Stochastic Process

State Space: discrete, Time Domain: State Space: discrete, Time Domain: discrete
continuous
Random Walk
Markov Jump
State Space: continuous, Time Domain: State Space: continuous, Time Domain:
continuous discrete

Brownian Motion Time Series

Standard Brownian Motion (SBM/Wiener Process)

Need to satisfy 5 properties

A stochastic Process, wt, t>= 0, is a wiener process

If

1. W0 = 0
2. Wt has continuous sample paths OR t wt
3. For 0<= s<t, the increment wt-ws is normally distributed with wt-ws~N(0,t-s)
4. Stationary Increments wt-ws ~N(0, t-s)
a. so Wt+k – Ws+k ~ N(0,t-s)

Result:

1. Wt is a Markov Process
2. Wt is a martingale
3. Covariance of Wiener process
a. Cov (Ws,Wt) = min (s,t)
4. Wt

Levy’s Theorem

If a stochastic process has the property that

Cov (Xs, Xt) = min (s,t)
Then the process Xt is a Wiener Process/SBM.

Scaled Wiener process

Xt = 1/sqrt c * wct
If c<1, e.g. c=1/4

Xt=1/sqrt(1/4) *wt/4

so process has speeded up and shrunk

Time – inverted Wiener Process

If this is Wiener process? How to check – we use Levy’s them. And take out Covariance.

Xt = t * w1/t

if s<t,

cov (xs,xt) = cov (s w1/s, t w1/t)

= st cov (w1/s, w1/t)

=st min (1/s, 1/t)

=st *1/t

=s

General Brownian motion (GBM)

5 properties

SBM is a type of GBM:

A stochastic process, Zt, t>=0 is a GBM if,

1. Z0 may be zero or not.

2. Zt has continuous sample path
3. Zt – Zs ~ N(Mu(t-s), sigma2(t-s))
a. Mu is drift coefficient
b. Sigma: Volatility / Diffusion Coefficient
4. Stationary
5. Ind inc

Relationship between SBM and GBM:

Zt = Z0 + Mu*t + sigma*wt