Financial Derivatives

Section 6
Itos Lemma and Stock Price Evolution
Michail Anthropelos
anthropel@webmail.unipi.gr
http://web.xrh.unipi.gr/faculty/anthropelos/
University of Piraeus
Spring 2011
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 1 / 23
Outline
1
Stochastic Analysis: Prerequisites
The Wiener process (Brownian Motion)
Itos Process - Itos Lemma
2
A Process for Stock Prices
The Model
The Interpretation of the Model
A Simple Idea for Volatility Estimation
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 2 / 23
Outline
1
Stochastic Analysis: Prerequisites
The Wiener process (Brownian Motion)
Itos Process - Itos Lemma
2
A Process for Stock Prices
The Model
The Interpretation of the Model
A Simple Idea for Volatility Estimation
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 3 / 23
The Markov Property and the Weak Form of the EMH
Markov property
A stochastic process has the Markov property if only the present value is
relevant for the prediction (probabilities) of the future values.
For example, if S(t) is a discrete time stochastic process with the Markov
property then:
P[S(T) > K|S(1) = s
1
, S(2) = s
2
, ..., S(T 1) = s
T1
] = P[S(T) > K|S(T 1) = s
T1
].
The weak form of the Ecient Market Hypothesis
If we assume that the stock prices are Markov stochastic processes, we also
assume that the weak form of the ecient market hypothesis holds.
According to the weak form of the EMH, the present stock price incorporates all
the information contained in the record of past prices.
Note: If EMH is true, the technical analysis is useless.
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 4 / 23
The Wiener Process (Brownian Motion)
Consider a continuous time stochastic process z(t) with the following properties:
1. Continuous function
z(t) is a continuous function of time.
2. Normality of the changes

z() = z( + t) z() =

t
for every time , where t is a (small) time interval and is a random variable
that such that N(0, 1). Or in other words:

z( + t) z() N(0,

t)
3. Independent increments
For every time points t
1
< t
2
t
3
< t
4
, the random variables: z(t
2
) z(t
1
) and
z(t
4
) z(t
3
) are independent.
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 5 / 23
Facts about the Wiener Process
It follows from the last property that z(t) is a Markov process.
It is an immediate consequence of the second property that:
z(t
2
) z(t
1
) N(0,

t
2
t
1
)
for every time points t
1
< t
2
. (we usually set z(0) = 0).
The Wiener process is an appropriate model for the so-call white noise that
occurs in the natural phenomena of continuous time.
It is usually called standard Brownian Motion.
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 6 / 23
Simulation of Wiener Process
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 7 / 23
The Generalized Wiener Process
Consider a continuous time stochastic process x(t) where:
x() = x( + t) x() = at + b

t
where a and b are constant numbers. This implies that:
x() = x( + t) x() N(at, b

t).
The parameter a is called drift (the average change per time unit):
a =
E[x( + t) x()]
t
.
The parameter b
2
is called the variance rate (the variance of change per time
unit):
b
2
=
Var (x( + t) x())
t
.
We denote the change of x(t) in innitesimal time interval dt as
dx(t) = adt + bdz(t).
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 8 / 23
Simulation of Generalized Wiener process
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 9 / 23
It os Process
We can generalize the Wiener process more, by considering the drift and the
variance rate as functions of time and x(t).
This is the case of Itos process:
dx(t) = a(x(t), t)dt + b(x(t), t)dz(t).
In order to approximate an Itos process, we can consider small time intervals of
length t and suppose that the functions a(x, t) and b(x, t) remains the same
within the intervals [, + t].
x( + t) x() = a(x(), )t + b(x(), )

t.
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 10 / 23
Geometric Brownian Motion
An important example
An important example of an Itos process is the Geometric Brownian Motion
(GBM):
a(x(t), t) = x(t) and b(x(t), t) = x(t),
or in other words,
dx(t) = x(t)dt + x(t)dz(t).
where R and > 0 are constants.
Normality of rate change
Directly from the denition of the GBM, we get that for every > 0
x( + t) x()
x()
N
_
t,

t
_
.
Simulation of Geometric Brownian Motion
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 12 / 23
The Itos Lemma
If we suppose that the stock price follows a particular Ito process (such as
GBM), what are the dynamics of a derivative written on this stock?
More precisely, if C(S(t), t) is the price of such a derivative at time t, we want to
nd how dC(S(t), t) looks like.
dC(S(t), t) =(

??? )dt+(

??? )dz(t)
The answer is given by Itos lemma.
It os lemma
Suppose that x(t) is an Ito process:
dx(t) = a(x(t), t)dt + b(x(t), t)dz(t)
and C(x, t) is a twice dierentiable function. Then, the dynamics of the
stochastic process C(x(t), t) are the following:
dC(x(t), t) =

C
x
a(x(t), t) +
C
t
+
1
2

2
C
x
2
b
2
(x(t), t)

dt +

C
x
b(x(t), t)

dz(t)
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 13 / 23
The Itos Lemma, an example
As we have seen, the price of the futures contract is given by
F(t, T) = S(t)e
r (Tt)
, when there is no dividend payments from the underlying
asset. We ask the following:
What is the dynamics of F(t, T) if the stock price follows a GBM:
dS(t) = S(t)dt + S(t)dz(t)?
The answer is given by the Itos lemma.
F
S
= e
r (Tt)
,
F
t
= rS(t)e
r (Tt)
= rF(t, T) and

2
C
S
2
= 0
dF(t, T) =
_
S(t)e
r (Tt)
rF(t, T)
_
dt + S(t)e
r (Tt)
dz(t)
dF(t, T) = ( r )F(t, T)dt + F(t, T)dz(t)
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 14 / 23
Outline
1
Stochastic Analysis: Prerequisites
The Wiener process (Brownian Motion)
Itos Process - Itos Lemma
2
A Process for Stock Prices
The Model
The Interpretation of the Model
A Simple Idea for Volatility Estimation
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 15 / 23
Building a Model for Stock Prices
Constant expected rate of return
We assume that the expected rate of return of a stock price is equal to a constant
:
1
t
E
_
S( + t) S()
S()
_
=
For t 0, this implies that:
E
_
dS()
S()
_
= d,
or in other words, on average (i.e. when there is no noise) it holds that:
dS()
S()
= d dS() = S()d,
for every time > 0. Hence for every T > 0, on average we have
S(T) = S(0)e
T
.
Building a Model for Stock Prices contd
Constant variance rate
Of course, a stock price does exhibit variability.
We assume that the variance of the rate of return is equal to a constant
2
:
1
t
Var
_
S( + t) S()
S()
_
=
2
The parameter is called the volatility of the stock price.
A model for how the stock price evolves
Including both the above assumptions, we end up to the following Ito process for
the stock price dynamics:
dS(t) = S(t)dt + S(t)dz(t),
where z(t) is a Wiener process (standard Brownian Motion).
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 17 / 23
Interpretation of the GBM Model (Part I)
For small interval of time t, we have:
S(t)
S(t)
= t +

t,
where N(0, 1). This means that the rate of return of the stock price
follows the Normal distribution:
S(t)
S(t)
N(t,

t).
The GBM model for the stock price is keeping with the weak-form of ecient
market hypothesis.
The parameter , can be considered as the expected continuously
compounded return per annum earned by the stock price. The fact that we
consider it constant is a big assumption.
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 18 / 23
Lognormality of the Stock Prices
The stock price dynamics are given below:
dS(t) = S(t)dt + S(t)dz(t).
How the function G(S(t)) = ln(S(t)) evolves? We apply Itos lemma:
G
S
=
1
S
,

2
G
S
2
=
1
S
2
and
G
t
= 0.
Hence,
d ln(S(t)) =
_


2
2
_
dt + dz(t).
This means that
ln(S(T)) ln(S(0)) = ln
_
S(T)
S(0)
_
N
__


2
2
_
T,

T
_
,
or equivalently,
ln (S(T)) N
_
ln (S(0)) +
_


2
2
_
T,

T
_
.
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 19 / 23
Interpretation of the GBM Model (Part II)
The stock price at time T obeys the Log-normal distribution, with
E[S(T)] = S(0)e
T
and
Var (S(T)) = S
2
(0)e
2T
_
e

2
T
1
_
.
A Way to Estimate the Volatility
One way to estimate the volatility of the stock price is the following:
1
Choose the frequency of stock price data (every hour, every day etc) (denote
this time length by ).
2
Choose the number of observations of stock prices that is going to be used
for the estimation (denote this number by n).
3
If S
i
denotes the stock price at the end of the i -th interval, calculate the
series:
u
i
= ln
_
S
i
S
i 1
_
, for i = 1, 2, ..., n.
4
Then estimate the standard deviation of u
i
s by:
s =

_
1
n 1
n

i =1
(u
i
u)
2
where u is the mean of u
i
s.
5
Estimate the volatility of the stock price by: =
s

.
6
Standard error=

2n
.
A Way to Estimate the Volatility, an example
As an example, we estimate the OTE stock price volatility using its daily close
price for the 60 days.
= 1/252 and n = 60
The estimation for the OTE stock volatility is 35.32%.
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 22 / 23
A Way to Estimate the Volatility, another example
At the same time period, we estimate the ALPHA stock price.
= 1/252 and n = 60
The estimation for the ALPHA stock volatility is 75.32%.
M. Anthropelos (Un. of Piraeus) Itos Lemma Spring 2011 23 / 23