Stochastic processes

Hull, J.C., (2012), Options, futures, and other derivatives (8th ed.). (London: Pearson.) Ch 13
'Wiener processes and It's lemma' (including appendix) and Ch. 14.

A stochastic (i.e. probabilistic) variable follows a Markov process if only the current
value of the variable is relevant for predicting the future i.e. if the past is irrelevant.
A particular type of Markov process is the Wiener process (also called Brownian
motion). Consider a variable z that satisfies:
1. The change z in a small time-interval satisfies z =t, where ~N(0,1) (using
the notation N(,2), consistent with Hull.
2. The zs for pairs of non-overlapping t are independent.
A Wiener process is the limit of this as t0.
The reason for " " above is the additive property of variance (assuming
independence):

e.g.

if

z1~N(1,12)

and

z2~N(2,22),

and

z=z1+z2,

then

z2=E(z11+z22)2=12+22+212, but 12=0 (zero correlation is implied by

independence), so z2=12+22. Thus if we assume that the variance is proportional to
time, it is ti during ti, and ti over ti. Then, standard deviation is proportional to

time.
The most usual representation of stock-price (S) behaviour begins with:

S = St + Sz, where and are constants, and are respectively the expected
value & standard deviation of the continuously compounded annual rate of return on
the stock, and z is a Wiener process. In the limit as t0, we have dS = Sdt + Sdz,
geometric Brownian motion. Equivalently, dS/S = dt + dz. The term S is the
drift-rate of the process for S. Notice that if we ignore the stochastic term so that dS
= Sdt, then S(t) = S(0)et.

We distinguish this from the generalized Wiener process dS = adt + bdz where a
and b are constants. Here the drift rate is constant so that as a proportion of S it
declines as S rises. This process is rejected as a model of stock prices (on the
assumption that investors' required returns (%) are independent of S), but it is
nevertheless important, as we shall see.

A further generalization of the Wiener process is obtained as: x = a(x,t)t + b(x,t)z,

which becomes the It process when we take limits so that dx = a(x,t)dt + b(x,t)dz.

A fundamental proposition in stochastic calculus is It's lemma, which states that if x

is an It process and G(x,t) is any differentiable function then
G
G
2G 2
G
dG =( a +
+ 2 b )dt + bdz
x
t
x
x

Proof.
First note that we can make a first-order approximation to any small change G:
G

G x x + t t = ( x a + t )t + x bz, which (in the limit) differs from the

expression in the statement of the lemma by the second-order term. To get a better
approximation to dG, we take a second-order Taylor expansion:
G

2G

2G

2G

G x x + t t +{ x2 x2+ t2 t2+xtxt}. In conventional calculus, when we

go to the limit we may neglect all the second-order (& higher) terms. However, here:

x = a(x,t)t + b(x,t)z=a(x,t)t + b(x,t)t, and x2 = b22t + higher-order terms in

t, so that we may not neglect x2 in the limit: in the limit we have to retain the limit
of b22t. In fact, E(2) = var()=1, so E(2t) = t, while var(2t)=t2var(2), which
goes to zero as t goes to zero. Thus in the limit 2dt may be treated as non-stochastic
and equal to its expectation dt, and dx2 = b2dt
Thus as t0, we have
dG =

G
G
2G
G
G
2G
dx +
dt + 2 dx2= (a(x,t)dt + b(x,t)dz) +
dt + 2 b2dt
x
t
x
x
t
x
G
G
2G
G
a + + 2 b2)dt + b(x,t)dz). Thus G is also an It process, and has the
x
t
x
x

=(

same underlying source of uncertainty as x: i.e. the Wiener process z.

Applications
1. Stock prices. Suppose that S follows geometric Brownian motion, so dS = Sdt +
G
G
2G
Sdz. What of log S? If G(S,t) = log S, then S =1/S, t =0, and S2 = 1/S2. Then

dG = ((1/S)S + 0 + (1/S2)2S2)dt + (1/S)Sdz = (2)dt +dz, i.e. a

generalized Wiener process. Moreover, we have dz=dt, and ~N(0,1), so dz2= dt
and over a finite interval T we have z2=T.
Thus log S(T)logS(0) = G(T)G(0) ~N((2)T,2T), or equivalently
[log S(T)logS(0)]/T = log[S(T)/S(0)]1/T~N((2),2/T), using E(y/T)=E(y)/T and
var(y/T) = var(y)/T2. Note that [S(T)/S(0)]1/T is equal to (1+ annual average rate of
return), and hence log[S(T)/S(0)]1/T is approximately the annual average rate of return,
using log(1+y) y for y reasonably small.

Thus if the rate of return on the stock follows geometric Brownian motion (and is
therefore normally distributed), the stock price itself is log-normally distributed.
2. Option pricing. Again assume that dS = Sdt + Sdz and assume that there exists
a European call option on the stock: i.e. the right to buy a unit of the stock at a
specified exercise price E on a fixed future date, time T. Assume that there are no
dividends on the stock in the interim. The writer of an option in effect creates the
option, sells it to the buyer for the price c, and takes on the obligation to deliver the
stock to the buyer at date T if the buyer chooses to exercise. In that event the writer
receives E from the buyer of the option. The option is an asset for the buyer but a
liability for the writer, so it enters the writers portfolio with a negative sign:
conceptually if the writer wanted to liquidate his entire portfolio he would sell
components that he holds long, but to liquidate a written option he would have to
buy an equivalent option (for exchange-traded options, a traderss net exposure is the
sum of long and short positions).

If SE at expiry the option will be exercised at the price E, it being less than the
market price of the stock, to give a profit SE. If SE the option dies unexercised and
is worth nothing.

The price c of the call depends on S, and using It's lemma,

c
c
2c
c
dc=( S + + 22S2)dt + Sdz. S and c have the same underlying Wiener
S
t
S
S

process, i.e. the same source of uncertainty. Consider a portfolio containing 1 unit of

the call (i.e. one written call) plus

c
units of the stock. The value of the portfolio at
S

c
any date is =c+ S, and then (using the expressions for dc and dS)
S
c
c
c
2c
c
c
d=dc+ dS = ( S + + 22S2)dt Sdz + (Sdt + Sdz)
S
S
t
S
S
S

=(

c
2c
+ 22S2)dt, which is riskless because it does not contain z: this is the point
t
S

of choosing

c
as the 'hedge ratio'. A riskless portfolio must return the riskless rate r if
S

arbitrage opportunities are to be eliminated, i.e. d =rdt, so

c
2c
c
c
c
2c
( + 22S2)dt=r(c+ S)dt or
+rS
+ 2S2 2=rc. This is the Blackt
S
S
t
S
S

Scholes-Merton partial differential equation, and it may be solved for c(t) subject to
the boundary condition c(T)=max(S(T)E, 0) to yield the well-known Black and
Scholes (or Black-Scholes-Merton) equation of option pricing:
c=SN(d1) EerTN(d2)
ln(S/E)+(r +2)T
where d1=
T
and

d2=

ln(S/E)+(r 2)T
= d1T
T

where N(d) is the area under the left-hand tail of the standard normal distribution (i.e.
zero mean and unit variance), up to d.

December 2014.