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Kamal saeed

ID 571-9580

Introduction

Stochastic process: Any variable that

changes over time in uncertain way

Stochastic Process

Discrete

Variable

Continuous

Variable

The value of the variable

can change only at certain

fixed points in time.

The underlying variable

can take any value within

a certain range

13.1 Markov Property

Particular Stochastic process where

on the current value of a variable is

relevant for predicting future.

Past history is irrelevant to use to

predict future price of stock.

Probability distribution for predicting

future price movement.

Weak form of market Efficiency.

13.2 CONTINUOUS-TIME

STOCHASTIC PROCESSES

Value that follows Markov Stochastic

process

its current value is 10 and that the change

in its value during a year is , where

denotes a probability distribution that is

normally distributed with mean m and

variance

Two independent variable , mean is the sum

of the means and the variance is the sum of

variance. Uncertainty is consider as square

root of time.

Wiener Processes

The process followed by the variable is known as a Wiener

process. particular type of Markov stochastic process with a

mean change of zero and a variance rate of 1.0 per year.

Generalized Wiener Process

known as the drift rate and the variance per unit time is

known as the variance rate. The basic Wiener process, dz,

that has been developed so far has a drift rate of zero and

a variance rate of 1.0. The drift rate of zero means that the

expected value of z at any future time is equal to its

current value. The variance rate of 1.0 means that the

variance of the change in z in a time interval of length T

equals T. A generalized Wiener process for a variable x can

be defined in terms of dz as

The adt term implies that x has an expected drift

rate of a per unit of time. Without the bdz term,

the equation is dx= adt, which implies that

dx/dt= a. Integrating with respect to time

1.0. It follows that b times a Wiener process has a

variance rate per unit time of b2. In a small time

interval t, the change x in the value of x is given by

equations (13.1) and (13.3) as

Ito Processes

This is a generalized Wiener process in which the parameters a

and b are functions of the value of the underlying variable x and

time t. An Ito process can be written algebraically as

process are liable to change over time. In a small time

interval between t and t+ t, the variable changes from x to

x+^x where

13.3 THE PROCESS FOR A STOCK

PRICE

Generalized Wiener process; that is, that it has a constant

expected drift rate and a constant variance rate. However, this

model fails to capture a key aspect of stock prices. This is that the

expected percentage return required by investors from a stock is

independent of the stocks price. If investors require a 14% per

annum expected return when the stock price is $10, then, ceteris

paribus, they will also require a 14% per annum expected return

when it is $50

should be assumed to be uS for some constant parameter u . This

means that in a short interval of time, t, the expected increase in

uS is ^t. The parameter is the expected rate of return on the

stock, expressed in decimal form

In practice, of course, there is uncertainty. A reasonable assumption is that

the variability of the percentage return in a short period of time, t, is the

same regardless of the stock price. In other words, an investor is just as

uncertain of the percentage return when the stock price is $50 as when it

is $10. This suggests that the standard deviation of the change in a short

period of time t should be proportional to the stock price and leads to the

model

Discrete-Time Model

The discrete-time version of the

model is

Monte Carlo Simulation

A Monte Carlo simulation of a stochastic process is a procedure for

sampling random outcomes for the process. We will use it as a

way of developing some understanding of the nature of the stock

price process in equation (13.6).

the nature of the stock price process in equation (13.6). Example

13.3 where the expected return from a stock is 15% per annum

and the volatility is 30% per annum. The stock price change over

1 week was shown to be

A path for the stock price over 10 weeks can be simulated by

sampling repeatedly for ffrom 0; and substituting into equation

(13.10).

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