Behaviour of Stock Prices

10
Model of the
Behavior
of Stock Prices
Chapter 10
Options, Futures, and Other Derivatives, 4th edition © 1999 by John C. Hull
10
Categorization of Stochastic
Processes
• Discrete time; discrete variable
• Discrete time; continuous variable
• Continuous time; discrete variable
• Continuous time; continuous variable
10
Modeling Stock Prices

• We can use any of the four types of
stochastic processes to model stock
prices
• The continuous time, continuous
variable process proves to be the most
useful for the purposes of valuing
derivative securities
10
Markov Processes (See pages 218-9)

• In a Markov process future
movements in a variable depend only
on where we are, not the history of
how we got where we are
• We will assume that stock prices

follow Markov processes
10
Weak-Form Market
Efficiency
• The assertion is 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
clearly consistent with weak-form market
efficiency
10
Example of a Discrete Time

Continuous Variable Model
• A stock price is currently at $40

• At the end of 1 year it is
considered that it will have a
probability distribution
of(40,10) where (,) is a
normal distribution with mean 
and standard deviation 
10
Questions
• What is the probability distribution of
the stock price at the end of 2 years?
• ½ years?
• ¼ years?
• t years?
Taking limits we have defined a
continuous variable, continuous time
process
10
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
10
Variances & Standard

Deviations (continued)
• In our example it is correct to say
that the variance is 100 per year.
• It is strictly speaking not correct to
say that the standard deviation is 10
per year.
10.1
A Wiener Process (See pages 220-1)

• We consider a variable z whose value
changes continuously
• The change in a small interval of time t is
z
• The variable follows a Wiener process if
1. z   t where  is a random drawing from (0,1)
2. The values of z for any 2 different (non-
overlapping) periods of time are independent
10.1
Properties of a Wiener
Process
• Mean of [z (T ) – z (0)] is 0
• Variance of [z (T ) – z (0)] is T
• Standard deviation of [z (T ) – z (0)] is
T
10.1
Taking Limits . . .
• What does an expression involving dz and dt

mean?
• It should be interpreted as meaning that the
corresponding expression involving z and t is
true in the limit as t tends to zero
• In this respect, stochastic calculus is analogous to
ordinary calculus
10.1
Generalized Wiener Processes

(See page 221-4)
• A Wiener process has a drift rate

(ie average change per unit time) of
0 and a variance rate of 1
• In a generalized Wiener process
the drift rate & the variance rate
can be set equal to any chosen
constants
10.1

(continued)
The variable x follows a generalized

Wiener process with a drift rate of a
& a variance rate of b2 if
dx=adt+bdz
10.1

(continued)
x  a t  b  t
• Mean change in x in time T is aT
• Variance of change in x in time T is b T 2
• Standard deviation of change in x in time

T is
b T
10.1
The Example Revisited
• A stock price starts at 40 & has a probability
distribution of(40,10) 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 (48,10), the process is
dS = 8dt + 10dz
10.1
Ito Process (See pages 224-5)

• In an Ito 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
x  a ( x , t ) t  b( x , t ) t
is only true in the limit as t tends to
zero
10.1
Why a Generalized Wiener Process

is not Appropriate for Stocks
• For a stock price we can conjecture that its
expected proportional change in a short period
of time remains constant not its expected
absolute change in a short period of time
• 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
10.1
An Ito Process for Stock Prices

(See pages 225-6)
dS  Sdt  Sdz
where  is the expected return 

is the volatility.
The discrete time equivalent is
S  St  S t
10.2
Monte Carlo Simulation

• We can sample random paths for the
stock price by sampling values for 
• Suppose = 0.14, = 0.20, and t =
0.01, then
S  0.0014 S  0.02 S
10.2
Monte Carlo Simulation – One Path
(continued. See Table 10.1)
Stock Price at Random Change in Stock

Period Start of Period Sample for  Price, S
0 20.000 0.52 0.236

1 20.236 1.44 0.611
2 20.847 -0.86 -0.329
3 20.518 1.46 0.628
4 21.146 -0.69 -0.262
10.2
Ito’s Lemma (See pages 229-231)

• If we know the stochastic process
followed by x, Ito’s lemma tells us the
stochastic process followed by some
function G (x, t )
• Since a derivative security is a function of
the price of the underlying & time, Ito’s
lemma plays an important part in the
analysis of derivative securities
10.2
Taylor Series Expansion

• A Taylor’s series expansion of G (x , t ) gives
G G 2G
G  x  t  ½ 2 x 2
x t x
2G 2G 2
 x t  ½ 2 t 
xt t
10.2
Ignoring Terms of Higher Order

Than t
In ordinary calculus we get
G G
G  x t
x t
In stochastic calculus we get
G G  2G
G   x t ½ x 2
x t x 2
because x has a component which is of order t
10.2
Substituting for x
Suppose
dx  a( x, t )dt  b( x, t )dz
so that
x = a t + b  t
Then ignoring terms of higher order than t
G G 2G 2 2
G  x  t  ½ b  t
x  t x 2
10.2
The 2t Term
Since   (0,1) E ()  0
E (  2 )  [ E (  )]2  1
E ( )  1
2
It follows that E (  2 t )  t
The variance of t is proportional to t and can 2
be ignored. Hence
G G 1 G 2 2
G  x  t  b t
x t 2 x 2
10.2
Taking Limits
G G 2G 2
Taking limits dG  dx  dt  ½ 2 b dt
x t x
Substituting dx  a dt  b dz
 G G  2G 2  G
We obtain dG   a  ½ 2 b  dt  b dz
 x t x  x
This is Ito's Lemma
10.2
Application of Ito’s Lemma

to a Stock Price Process
The stock price process is
d S   S dt   S d z
For a function G of S & t
 G G  2G 2 2  G
dG   S  ½ 2  S  dt   S dz
S t S  S
10.2
Examples
1. The forward price of a stock for a contract
maturing at time T
G  S er ( T  t )
dG  (  r )G dt  G dz
2. G  ln S
 2 
dG      dt   dz
 2

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10

Modeling Stock Prices

Markov Processes (See pages 218-9)

• We will assume that stock prices

Example of a Discrete Time

• A stock price is currently at $40

Variances & Standard

Variances & Standard

A Wiener Process (See pages 220-1)

• What does an expression involving dz and dt

Generalized Wiener Processes

• A Wiener process has a drift rate

Generalized Wiener Processes

The variable x follows a generalized

Generalized Wiener Processes

• Standard deviation of change in x in time

Ito Process (See pages 224-5)

Why a Generalized Wiener Process

An Ito Process for Stock Prices

where  is the expected return 

Monte Carlo Simulation

Stock Price at Random Change in Stock

0 20.000 0.52 0.236

Ito’s Lemma (See pages 229-231)

Taylor Series Expansion

Ignoring Terms of Higher Order

because x has a component which is of order t

Application of Ito’s Lemma

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