Sir John Templeton

Let’s start with

some good
words from
him…
INVESTING MANTRA

"Search for
companies
around the world
that offered low
prices and an
excellent long-
term outlook."
Let’s have a quick
look at what we
discussed in the
previous class…
WE TALKED ABOUT RANDOM WALK…
•Assume that D → dt where dt is a very small positive
number such that dta = 0 whenever a > 1. Then, we get …

W(t+ dt) = W(t) + e(t+ dt);

Where
W(0) = W0;
e ~ i.i.d. N(0, dt)

•We define dW(t) = W(t+ dt) - W(t) = e(t+dt)

Note this…it represents random

process
STANDARD WIENER PROCESS …
•It can be expressed either in

Differential form:
dW(t) with W(0)
or
Integral form:
t
W(t) = W(0) +0∫ dW(u)

Please note that the Wiener Process and

Brownian Motion are used interchangeably.
GENERIC CONTINUOUS WIENER PROCESS…
•Consider the following:

dX(t) = a(X(t),t) dt + s(X(t),t) dW(t); X(0)= X0

DRIFT VOLATILITY

Diffusion
The term "diffusion" comes from the Latin
word diffundere, which means "to spread out."

•Please note that dW(t) is the main building

block of any stochastic process.
THIS GENERIC CONTINUOUS WIENER
PROCESS OR BROWNIAN MOTION WILL HELP
US IN DEFINING DIFFERENT TYPES OF
PROCESS…

dX(t) = a(X(t),t) dt + s(X(t),t) dW(t); X(0)= X0

Then, we started with
the type of Stochastic
Processes
First we talked about…

…ARITHMETIC BROWNIAN MOTION

ARITHMETIC BROWNIAN MOTION…

•A Brownian process dX(t) is said to be

Arithmetic Brownian Motion if –
dX(t) = a dt + s dW(t)
Where
a = Drift which is constant and independent of ‘t’;
s = Volatility parameter which is constant and
independent of ‘t’.
ARITHMETIC BROWNIAN MOTION – SINGLE SERIES
ARITHMETIC BROWNIAN MOTION – MULTIPLE SERIES
ARITHMETIC BROWNIAN MOTION…(CONTINUED)
•Properties of Arithmetic Brownian Motion –
1. X(t) may be positive or negative.

2. If u > t, then Xu is a future value of the process relating

to time t. The distribution of Xu given Xt is normal with
mean Xt + a(u-t) and variance s2(u-t).

3. The variance of a forecast Xu tends to infinity as u tends

to infinity.
ARITHMETIC BROWNIAN MOTION…(CONTINUED)
•Application of Arithmetic Brownian Motion –
1. This process is more appropriate for those economic and financial
variables that grow at a linear rate and exhibit increasing uncertainty.

2. It is more appropriate for those variables which may take positive or

negative values.

3. It is more suitable for those which may have normally distributed

forecast errors and have forecasting variance increasing linearly over
time.
After this, we discussed…

…GEOMETRIC BROWNIAN MOTION

GEOMETRIC BROWNIAN MOTION… (CONTINUED)

•In deferential form, we can represent Geometric Brownian

Motion as –
dX = a X dt + s X dW
 dX/X = a dt + s dW
Note that it
is a ratio!
•This process is appropriate for those financial variables that
grow exponentially at an average rate of a and have
volatility proportional to the level of the variable.

•This process also shows increasing rate of uncertainty in

forecasting.
KINDLY NOTE THAT…

The average growth

rate is DRIFT (a or m)
GEOMETRIC BROWNIAN MOTION…SINGLE SERIES
GEOMETRIC BROWNIAN MOTION – MULTIPLE
SERIES
GEOMETRIC BROWNIAN MOTION… (CONTINUED)

•Properties of Geometric Brownian Motion –

1. If X(t) starts at a positive value, then it will remain
positive.
2. If X(t) hits zero, then it will remain zero and hence,
zero is called absorbing barrier.
3. The Conditional distribution of Xu given Xt is
lognormal.
4. The conditional mean of log(Xu) for u > t is
Log(Xt)+a(u-t) – ½ s2(u-t) or Log(Xt)+(a – ½ s2)(u-t)
and the conditional variance is s2(u-t).
5. The variance of a forecast Xu tends to infinity as u
tends to infinity.
GEOMETRIC BROWNIAN MOTION…MOMENTS#1
•Let W(t), t ≥ 0 be a Brownian motion process with drift parameter μ and
variance parameter σ2, and let X(t) = eW(t), t ≥ 0. The process X(t), t ≥ 0,
is said to be a Geometric Brownian Motion process with drift
parameter μ and variance parameter σ2.
•Then,

 X (t  y ) 
log  
 X (y ) 

has a normal distribution with mean μt and variance tσ2.

GEOMETRIC BROWNIAN MOTION…MOMENTS#2
•Let W(t), t ≥ 0 be a Brownian motion process with drift
parameter μ and variance parameter σ2, and let X(t) = eW(t), t
≥ 0. The process X(t), t ≥ 0, is said to be a Geometric
Brownian Motion process with drift parameter μ and
variance parameter σ2.

•Then, the mean of log(Xt) is (Log(X0)+mt) and the

variance is s2t.
Please note that here we are
talking about the distribution of
Log(Xt) with drift m and volatility s2
GEOMETRIC BROWNIAN MOTION…MOMENTS#3
•The process X(t), t ≥ 0, is said to be a Geometric Brownian
Motion process if we have –
𝑑𝑋 𝑡 = 𝜇 𝑋 𝑡 𝑑𝑡 + 𝜎𝑋 𝑡 𝑑𝑊
𝑑𝑋 𝑡
= 𝜇 𝑑𝑡 + 𝜎 𝑑𝑊
𝑋 𝑡

The above equation is called Stochastic Differential Equation, solving

the above we get –
𝜎2
𝜇− 𝑡+ 𝜎𝑊
2
𝑋 𝑡 = 𝑋 0 𝑒

Then, the mean of log(Xt) is (Log(X0)+mt – ½ s2t)) or

(Log(X0)+(m – ½ s2)t) and the variance is s2t.
GEOMETRIC BROWNIAN MOTION…MOMENTS#4
•Let W(t), t ≥ 0 be a Brownian motion process with drift
parameter μ and variance parameter σ2, and let X(t) = eW(t), t
≥ 0. The process X(t), t ≥ 0, is said to be a Geometric
Brownian Motion process with drift parameter μ and
variance parameter σ2.

•Then,
𝜎2
𝜇+ 𝑡
𝐸 𝑋𝑡 = 𝑋0 𝑒 2

2 (2𝜇𝑡+σ2𝑡) σ2 𝑡
𝑉𝑎𝑟 𝑋𝑡 = 𝑋0 𝑒 (e −1)
GEOMETRIC BROWNIAN MOTION… DEFINED AS …
•Let W(t), t ≥ 0 be a Brownian motion process with drift parameter μ and
variance parameter σ2, and let X(t) = eW(t), t ≥ 0. The process X(t), t ≥ 0,
is said to be a Geometric Brownian Motion process with drift
parameter μ and variance parameter σ2.
•Then,

 X (t  y ) 
log  
 X (y ) 

has a normal distribution with mean μt and variance tσ2.

GEOMETRIC BROWNIAN MOTION… (CONTINUED)

•Application of Geometric Brownian Motion –

1. This process is often used to model security returns since

the proportional changes in security prices are
independent and identically normally distributed.

2. It is more appropriate for those variables which take

positive values and on an average increases at a constant
exponential rate.
Any question before
we start further?
WE HAVE A QUESTION …
•Assume that a given company’s share follows Geometric
Brownian Motion with a drift of Rs. 3 per year and diffusion
(s2) of 27.02. What is the probability that its share price will
be at least twice its current price after two years?
 X (t  y ) 
log  
•Use either –  X (y ) 
has a normal distribution with mean μt and
variance tσ2.

Or
Log(Xt) which is normally distributed and has mean
(Log(X0)+mt) and the variance is s2t.
 ITC LTD - DAILY RETURN
0.3

0.2

0.1

-0.1

-0.2

ITC Limited Why such a

-0.3 issued bonus sharp fall?
– 2:1

-0.4
Next Type of Brownian Motion

…MEAN REVERTING BROWNIAN

MOTION OR STOCHASTIC PROCESS
MEAN REVERTING STOCHASTIC PROCESS…
•Let W(t), t ≥ 0 be a Brownian motion process with drift parameter μ and variance
parameter σ2. Then, the process X(t), t ≥ 0, is said to be a Mean Reverting
Stochastic Process with drift parameter μ and variance parameter σ2 if
dX  k (m  X )dt  s dW
where k is known as speed-of-adjustment parameter, and m is long-run
mean.

•The Mean - Reverting process is also known as Ornstein-Uhlenbeck Process.

•It states that the change in the next time period is proportional to the difference
between the mean and the current value, with the addition of random term.
WHAT CLICKS INTO YOUR MIND WHEN YOU
SEE THE FOLLOWING? CAN YOU APPLY THIS
MODEL IN THE STOCK MARKET?

dX  k (m  X )dt  s dW

What about the

bond market?
MEAN REVERTING STOCHASTIC PROCESS …
Mean Reverting Stochastic Process
0.12

0.11

0.1

0.09

0.08

0.07

0.06

0.05

0.04
MEAN REVERTING STOCHASTIC PROCESS– MULTIPLE
SERIES
Mean Reverting Stochastic Process
0.3

0.25

0.2

0.15

0.1

0.05

-0.05

-0.1
We may have
different versions of
Mean Reverting
Stochastic Process.
WE MAY HAVE DIFFERENT TYPE OF MEAN REVERTING
STOCHASTIC PROCESS:
•No #1: Simple or Arithmetic Mean Reverting Stochastic
Process:

•It is –
dX  k (m  X )dt  s dW

•This may have positive values as well as negative values.

WE MAY HAVE DIFFERENT TYPE OF MEAN REVERTING
STOCHASTIC PROCESS:
•No #2: Geometric Mean Reverting Stochastic Process:

•It is –

dX  k (m  X ) X dt  s X dW
•In this, X will have positive values.
WE MAY HAVE DIFFERENT TYPE OF MEAN REVERTING
STOCHASTIC PROCESS:
•No #3: Generic Mean Reverting Stochastic Process:

•It is –

dX  k (m  X ) dt  s X g dW
•When g = 1, the Mean Reverting Stochastic Process is known
as Ornstein – Uhlenbeck Stochastic Process.
WE MAY HAVE DIFFERENT TYPE OF MEAN REVERTING
STOCHASTIC PROCESS:
•No #4: Square Root Mean Reverting Stochastic Process:

•It is –
dX  k (m  X ) dt  s X dW
MEAN REVERTING STOCHASTIC PROCESS (CONTINUED)

•When g = 1, and we assume that m and k are positive, then X(t) is positive as
long as X(t) starts with a positive value.

•This process is appropriate for those positive financial variables that tend
toward a long-run mean but may be clouded by short term volatility.

•If X(t) approaches to zero, then the drift will be positive and volatility will
vanish.

•The variance of a forecast Xu tends to be a finite number as u tends to

infinity.
MEAN REVERTING STOCHASTIC PROCESS: SHORT-TERM
BEHAVIOUR…
•If we have the following Simple or Arithmetic Mean Reverting
Process:
dX  k (m  X )dt  s dW

then, in the short run, X will follow Normal Probability

Distribution with the following parameters:

Mean= 𝜇 + 𝑋0 − 𝜇 𝑒 −𝜅𝑡 = 𝑋0 𝑒 −𝜅𝑡 + 𝜇 1 − 𝑒 −𝜅𝑡

𝜎2
Variance = (1 − 𝑒 −2𝜅𝑡 )
2𝜅
 Mean Reverting Stochastic Process of Bond Yield

0.2

0.18

0.16

0.14

0.12

0.1

0.08

0.06

0.04

0.02

Time --->
Your observations,
please!
MEAN REVERTING STOCHASTIC PROCESS: LONG-TERM
BEHAVIOUR…
•If we have the following Simple or Arithmetic Mean Reverting Process:

dX  k (m  X )dt  s dW
then, in the long run, X will follow Normal Probability
Distribution with the following parameters:

Mean= 𝜇
𝜎2
Variance =
2𝜅
PROBLEM NO. 1:
•A company has entered into an option agreement
(European call option) to borrow money from a bank at 15%
after 4 years from now. The Bank’s present lending rate to the
company is 18%. Assume that interest rates are following
Simple Mean Reverting Stochastic Process with parameters -
𝜇 = 14.50%; 𝜎 = 3.23% 𝑎𝑛𝑑 𝜅 = 0.60 . You are required to
determine the probability that the company will exercise the
option to borrow from the bank.
PROBLEM NO. 2:
•Assume that annual inflation rate (measured using CPI) is
following Mean Reverting Stochastic Process with
parameters - 𝜇 = 5.50%; 𝜎 = 0.56% 𝑎𝑛𝑑 𝜅 = 0.40 . Presently,
the inflation rate is 5%. A person is having an inflation-
indexed bond carrying 2.50% p.a. real interest rate with a
face value of Rs. 1,000. If the bond is having 3 years to
maturity and the estimated spot rates are given below, you
are required to find the EXPECTED VALUE of the BOND at
present.
Years 1 2 3
Nomial Spot Rates 7.25% 7.75% 8.00%
MEDITATE AND THINK HOW MUCH YOU HAVE LEARNT ABOUT RANDOM
WALK AND BROWNIAN MOTION.
Time to meditate
on what we have
studied so far
about types of
stochastic
processes.
 WE DEFINED RANDOM WALK AS…
•For discrete case:
W(t+1) = W(t) + e(t+1);
Where
W(0) = W0;
e ~ i.i.d. N(0,1)

•For a continuous case:

dW(t) = W(t+ dt) - W(t) = e(t+dt)
BROWNIAN MOTION …
•The collection of random variables X(t), t≥0 is said to be a
Brownian motion with drift parameter μ and variance parameter
σ2 if the following hold:
(a) X(0) is a given constant.

(b) For all positive y and t, the random variable X(t + y)− X(y) is independent of the process values up to time y and has a normal distr

ibution with mean μt and variance tσ2.

ARITHMETIC BROWNIAN MOTION…
•A Brownian process dX(t) is said to be
Arithmetic Brownian Motion if –
dX(t) = a dt + s dW(t)
Where
a = Drift which is constant and independent of ‘t‘;
s = Volatility parameter which is constant and
independent of ‘t‘.
GEOMETRIC BROWNIAN MOTION…
•Let W(t), t ≥ 0 be a Brownian motion process with drift parameter μ and variance
parameter σ2, and let X(t) = eW(t), t ≥ 0. The process X(t), t ≥ 0, is said to be a
Geometric Brownian Motion process with drift parameter μ and variance
parameter σ2.

•Since log(X(t)) = W(t), t ≥ 0, is Brownian motion and log(X(t + y)) − log(X(y)) =

log(X(t+y)/X(y) ), it follows from the Brownian motion definition that for all
positive y and t,

 X (t  y ) 
log  
 X (y ) 
is independent of the process values up to time y and has a normal distribution
with mean μt and variance tσ2.
MEAN REVERTING STOCHASTIC PROCESS…
•Let W(t), t ≥ 0 be a Brownian motion process with drift parameter μ and variance
parameter σ2. Then, the process X(t), t ≥ 0, is said to be a Mean Reverting
Stochastic Process with drift parameter μ and variance parameter σ2 if
dX  k (m  X )dt  s dW
where k is known as speed-of-adjustment parameter, and m is long-run
mean.

•The Mean - Reverting process is also known as Ornstein-Uhlenbeck Process.

•It states that the change in the next time period is proportional to the difference
between the mean and the current value, with the addition of random term.
IDENTIFY THE PROCESSES…

•X(t) = eW(t), t ≥ 0

•dX(t) = a dt + s dW(t)

• dX  k (m  X )dt  s dW
Do you appreciate the
difference in the
processes?
… how to value Convertible Bonds?
 Plain or
simple bond
component

Convertible
Bond

Option
component
EMBEDDED OPTION!
… follow a two step
model:
• First determine the
price of the
convertible bond as
a simple bond.

• Second, determine
the value of OPTION
using any method of
valuation and then,
finally add them to
get the value.
 Assume that a convertible bond has a face value of Rs. 1,000 with a coupon

of 10% having a maturity of 3 years and yield-to-maturity of 12%. Further

assume that the bond will be converted into 10 equity shares of Rs. 110 each
at the time of maturity.

 If the risk free interest rate is 6.75% and the volatility of the underlying

share is 30%, then you are required to determine the value of the
convertible bond. (Use Black and Scholes)
 Assume that a convertible bond has a face value of Rs. 1,000 with a coupon

of 10% having a maturity of 3 years and yield-to-maturity of 12%. Further

assume that the bond will be converted into 10 equity shares of Rs. 110 each
at the time of maturity.

 Assuming that share prices follow binomial stochastic process with UP

factor of 1.20 and probability of 0.8 and with a DOWN factor of 0.80 with a
probability of 0.2. The present price of the share is Rs. 90.
 (1+Risk Free Rate) - DOWN Multiplier
Risk Neutral Probability (UP) =
UP Multiplier - DOWN Multiplier

UP Multiplier - (1+Risk Free Rate)

Risk Neutral Probability (DOWN) =
UP Multiplier - DOWN Multiplier
 Model the underlying stochastic behaviour of prices and then

determine the value of a convertible bond.

 Assume that a convertible bond has a face value of Rs. 1,000 with a coupon
of 10% having a maturity of 3 years and yield-to-maturity of 12%. Further
assume that the bond will be converted into 10 equity shares of Rs. 110 each
at the time of maturity.

 Assume that the present price of the share is Rs. 90 and the share price of a
company can be modeled as Geometric Brownian Motion with drift α = 12%
p.a. and volatility, s = 0.24 p.a. Determine the EXPECTED price of the
convertible bond.
 Properties of Geometric Brownian
Motion –
1. The Conditional distribution of Xu
given Xt is lognormal.

2. The conditional mean of log(Xu) for

u > t is Log(Xt)+a(u-t) – ½ s2(u-t)
and the conditional variance is
s2(u-t).
AFTER UNDERSTANDING THE BASICS OF STOCHASTIC
PROCESSES…

•… the next challenge before us is to learn its

CALCULUS!

That’s
NEXT
TIME!!!!