FINANCIAL MODELING

LECTURE NOTES 5

Professor Moisă ALTĂR ,

R A U, Bucharest, 2023

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 LECTURE

Wiener Processes and Itô’s Lemma

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 Norbert Wiener (1894 – 1964)

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 Fischer Black Myron S. Scholes Robert C. Merton

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 Stochastic Processes

 Describes the way in which a variable such as a stock price,

exchange rate or interest rate changes through time
 Incorporates uncertainties

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 Stochastic character of stock prices

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 Stochastic character of indices

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 Example 1

 Each day a stock price

– increases by $1 with probability 30%
– stays the same with probability 50%
– reduces by $1 with probability 20%

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 Example 2

Each day a stock price change is drawn from a normal

distribution with mean $0.2 and standard deviation $1

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 Markov Processes

 In a Markov process future movements in a variable depend only on

where we are, not the history of how we got to where we are
 Is the process followed by the temperature at a certain place
Markov?
 We assume that stock prices follow Markov processes

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 Weak-Form Market Efficiency

 This asserts that it is impossible to produce consistently

superior returns with a trading rule based on the past history
of stock prices. In other words technical analysis does not
work.
 A Markov process for stock prices is consistent with weak-
form market efficiency

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 Example

 A variable is currently 40
 It follows a Markov process
 Process is stationary (i.e. the parameters of the process do
not change as we move through time)
 At the end of 1 year the variable will have a normal probability
distribution with mean 40 and standard deviation 10

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 Questions

 What is the probability distribution of the stock price at the

end of 2 years?
 ½ years?
 ¼ years?
 Dt years?

Taking limits we have defined a continuous stochastic

process

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 Variances & Standard Deviations

 In Markov processes changes in successive periods of time

are independent
 This means that variances are additive
 Standard deviations are not additive

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 A Wiener Process

 Define f(m,v) as a normal distribution with mean m and

variance v

 A variable z follows a Wiener process if

– The change in z in a small interval of time Dt is Dz
–
– The values of Dz for any 2 different (non-overlapping) periods of
time are independent

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 Properties of a Wiener Process

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 Generalized Wiener Processes

 A Wiener process has a drift rate (i.e. average change per

unit time) of 0 and a variance rate of 1
 In a generalized Wiener process the drift rate and the
variance rate can be set equal to any chosen constants

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 Generalized Wiener Processes
(continued)

 Mean change in x per unit time is a

 Variance of change in x per unit time is b2

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 Taking Limits . . .

 What does an expression involving dz and dt mean?

 It should be interpreted as meaning that the corresponding
expression involving Dz and Dt is true in the limit as Dt tends
to zero
 In this respect, stochastic calculus is analogous to ordinary
calculus

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 The Example Revisited

 A stock price starts at 40 and has a probability distribution of f(40,100)

at the end of the year
 If we assume the stochastic process is Markov with no drift then the
process is
dS = 10dz
 If the stock price were expected to grow by $8 on average during the
year, so that the year-end distribution is f(48,100), the process would
be
dS = 8dt + 10dz

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 Itô Process

 In an Itô process the drift rate and the variance rate are
functions of time
dx=a(x,t) dt+b(x,t) dz
 The discrete time equivalent

is true in the limit as Dt tends to

zero

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 Why a Generalized Wiener Process Is Not
Appropriate for Stocks

 For a stock price we can conjecture that its expected

percentage change in a short period of time remains constant
(not its expected actual change)
 We can also conjecture that our uncertainty as to the size of
future stock price movements is proportional to the level of
the stock price

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 An Ito Process for Stock Prices

where m is the expected return s is the volatility.

The discrete time equivalent is

The process is known as geometric Brownian motion

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 Interest Rates

 What would be a reasonable stochastic process to assume

for the short-term interest rate?

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 Monte Carlo Simulation

 We can sample random paths for the stock price by sampling

values for e
 Suppose m= 0.15, s= 0.30, and Dt = 1 week (=1/52 or 0.192
years), then

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 Monte Carlo Simulation – Sampling one Path

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 Correlated Processes

Suppose dz1 and dz2 are Wiener processes with correlation r

Then

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 Itô’s Lemma

 If we know the stochastic process followed by x, Itô’s lemma

tells us the stochastic process followed by some function G
(x, t )
 Since a derivative is a function of the price of the underlying
asset and time, Itô’s lemma plays an important part in the
analysis of derivatives

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 Taylor Series Expansion

 A Taylor’s series expansion of G(x, t) gives

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 Ignoring Terms of Higher Order Than Dt

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 Substituting for Dx

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 Substituting for Dx

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 The e2Dt Term

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 Taking Limits

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 Application of Ito’s Lemma
to a Stock Price Process

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 Examples

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 LECTURE

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 The Stock Price Assumption
 Consider a stock whose price is S
 In a short period of time of length Dt, the return on the stock is
normally distributed:

where m is expected return and s is volatility

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 The Lognormal Property

 It follows from this assumption that

 Since the logarithm of ST is normal, ST is lognormally

distributed
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 The Lognormal Distribution

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 Continuously Compounded Return

If x is the realized continuously compounded return

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 The Expected Return

 The expected value of the stock price is S0emT

 The expected return on the stock is
m – s 2/2 not m

This is because

are not the same

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 m and m −s 2/2

 m is the expected return in a very short time, Dt, expressed

with a compounding frequency of Dt
 m −s2/2 is the expected return in a long period of time
expressed with continuous compounding (or, to a good
approximation, with a compounding frequency of Dt)

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 Mutual Fund Returns

 Suppose that returns in successive years are 15%, 20%, 30%, −20%
and 25% (ann. comp.)
 The arithmetic mean of the returns is 14%
 The returned that would actually be earned over the five years (the
geometric mean) is 12.4% (ann. comp.)
 The arithmetic mean of 14% is analogous to m
 The geometric mean of 12.4% is analogous to m−s2/2

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 The Volatility

 The volatility is the standard deviation of the continuously

compounded rate of return in 1 year
 The standard deviation of the return in a short time period
time Dt is approximately
 If a stock price is $50 and its volatility is 25% per year what is
the standard deviation of the price change in one day?

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 Estimating Volatility from Historical Data

1. Take observations S0, S1, . . . , Sn at intervals of t years (e.g.

for weekly data t = 1/52)
2. Calculate the continuously compounded return in each
interval as:

3. Calculate the standard deviation, s , of the ui´s

4. The historical volatility estimate is:

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 Nature of Volatility

 Volatility is usually much greater when the market is open

(i.e. the asset is trading) than when it is closed
 For this reason time is usually measured in “trading days” not
calendar days when options are valued
 It is assumed that there are 252 trading days in one year for
most assets

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 Example

 Suppose it is April 1 and an option lasts to April 30 so that the

number of days remaining is 30 calendar days or 22 trading
days
 The time to maturity would be assumed to be 22/252 =
0.0873 years

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 The Concepts Underlying Black-Scholes-
Merton

 The option price and the stock price depend on the same
underlying source of uncertainty
 We can form a portfolio consisting of the stock and the option
which eliminates this source of uncertainty
 The portfolio is instantaneously riskless and must
instantaneously earn the risk-free rate
 This leads to the Black-Scholes-Merton differential equation

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 The Derivation of the Black-Scholes
Differential Equation

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 The Derivation of the Black-Scholes
Differential Equatio continued

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 The Derivation of the Black-Scholes Differential
Equation continued

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 The Differential Equation

 Any security whose price is dependent on the stock price satisfies

the differential equation
 The particular security being valued is determined by the
boundary conditions of the differential equation
 In a forward contract the boundary condition is ƒ = S – K when t
=T
 The solution to the equation is
ƒ = S – K e–r (T – t )

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 The Black-Scholes-Merton Formulas)

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 The N(x) Function

 N(x) is the probability that a normally distributed variable with

a mean of zero and a standard deviation of 1 is less than x

 See tables
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 Properties of Black-Scholes Formula

 As S0 becomes very large c tends to S0 – Ke-rT and p tends to

zero
 As S0 becomes very small c tends to zero and p tends to Ke-rT
– S0
 What happens as s becomes very large?
 What happens as T becomes very large?

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 Risk-Neutral Valuation

 The variable m does not appear in the Black-Scholes-Merton

differential equation
 The equation is independent of all variables affected by risk
preference
 The solution to the differential equation is therefore the
same in a risk-free world as it is in the real world
 This leads to the principle of risk-neutral valuation

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 Applying Risk-Neutral Valuation

1. Assume that the expected return from the stock price is the
risk-free rate
2. Calculate the expected payoff from the option
3. Discount at the risk-free rate

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 Valuing a Forward Contract with
Risk-Neutral Valuation

 Payoff is ST – K
 Expected payoff in a risk-neutral world is S0erT – K
 Present value of expected payoff is
e-rT[S0erT – K]=S0 – Ke-rT

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 Implied Volatility

 The implied volatility of an option is the volatility for which the

Black-Scholes price equals the market price
 There is a one-to-one correspondence between prices and
implied volatilities
 Traders and brokers often quote implied volatilities rather
than dollar prices

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 The VIX S&P500 Volatility Index

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 An Issue of Warrants & Executive Stock
Options

 When a regular call option is exercised the stock that is delivered must
be purchased in the open market
 When a warrant or executive stock option is exercised new Treasury
stock is issued by the company
 If little or no benefits are foreseen by the market the stock price will
reduce at the time the issue of is announced.
 There is no further dilution (See Business Snapshot 14.3.)

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 The Impact of Dilution

 After the options have been issued it is not necessary to take

account of dilution when they are valued
 Before they are issued we can calculate the cost of each
option as N/(N+M) times the price of a regular option with the
same terms where N is the number of existing shares and M
is the number of new shares that will be created if exercise
takes place

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 Dividends

 European options on dividend-paying stocks are valued by

substituting the stock price less the present value of
dividends into Black-Scholes
 Only dividends with ex-dividend dates during life of option
should be included
 The “dividend” should be the expected reduction in the stock
price expected

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 American Calls

 An American call on a non-dividend-paying stock should

never be exercised early
 An American call on a dividend-paying stock should only
ever be exercised immediately prior to an ex-dividend date
 Suppose dividend dates are at times t1, t2, …tn. Early exercise
is sometimes optimal at time ti if the dividend at that time is
greater than

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 Black’s Approximation for Dealing with
Dividends in American Call Options

Set the American price equal to the maximum of two European

prices:
1. The 1st European price is for an option maturing at the
same time as the American option
2. The 2nd European price is for an option maturing just
before the final ex-dividend date

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