Wiener Processes and Itô's Lemma

Chapter 13
Wiener Processes and

Itô’s Lemma
1
Stochastic Processes
• Describes the way in which a variable
such as a stock price, exchange rate or
interest rate changes through time
• Incorporates uncertainties
2
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%
3
Example 2
• Each day a stock price change is drawn
from a normal distribution with mean $0.2
and standard deviation $1
4
Markov Processes (See pages 280-81)
• 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
5
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
6
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
7
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 stochastic process
8
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
9
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
A Wiener Process (See pages 282-84)
• Define(,v)as a normal distribution

with mean  and variance v
• A variable z follows a Wiener process if

– The change in z in a small interval of time
t is z
–
–  z  values
The t where
of z isfor
(0,1)
any 2 different (non-
overlapping) periods of time are
independent

11
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
12
Generalized Wiener Processes
(See page 284-86)
• 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
13
Generalized Wiener Processes
(continued)
x  a t  b  t
• Mean change in x per unit time is a

• Variance of change in x per unit
time is b2
14
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
15
The Example Revisited
• A stock price starts at 40 and has a probability
distribution of(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 (48,100), the process would be
dS = 8dt + 10dz
16
Itô Process (See pages 286)
• 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
x  a ( x, t ) t  b( x, t ) t
is true in the limit as t tends to

zero
17
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
18
An Ito Process for Stock Prices
(See pages 286-89)
dS  S dt  S dz
where  is the expected return  is
the volatility.
The discrete time equivalent is
S  St  S t
The process is known as

geometric Brownian motion
19
Interest Rates
• What would be a reasonable stochastic
process to assume for the short-term
interest rate?
20
Monte Carlo Simulation
• We can sample random paths for the

stock price by sampling values for 
• Suppose = 0.15, = 0.30, and t = 1
week (=1/52 or 0.192 years), then
ΔS  0.15  0.0192 S  0.30  0.0192ε
or
S  0.00288 S  0.0416 S
21
Monte Carlo Simulation – Sampling
one Path (See Table 13.1, page 289)
Stock Price at Random Change in Stock
Week Start of Period Sample for  Price, S
0 100.00 0.52 2.45

1 102.45 1.44 6.43
2 108.88 −0.86 −3.58
3 105.30 1.46 6.70
4 112.00 −0.69 −2.89
22
Correlated Processes
Suppose dz1 and dz2 are Wiener processes with
correlation 
Then
z1   1 t
z 2   2 t
where  1 and  2 are random samples
from a bivariate standard normal
distributi on where correlatio n is 
23
Itô’s Lemma (See pages 291)
• 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
24
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
25
Ignoring Terms of Higher
Order Than t
In ordinary calculus we have

G G
G  x  t
x t
In stochastic calculus this becomes
G G  2G 2
G  x  t  ½ 2
x
x t x
because x has a component which is
of order t
26
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 2
b  t
x t x
27
The 2t Term
Since   (0,1), E ()  0
E ( 2 )  [ E ()] 2  1
E ( 2 )  1
It follows that E ( 2 t )  t
The variance of t is proportion al to t 2 and can
be ignored. Hence
G G 1  2G 2
G  x  t  2
b t
x t 2 x
28
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
29
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 and t
 G G  2G 2 2  G
dG   S   ½ 2  S dt  S dz
 S t S  S
30
Examples
1. The forward price of a stock for a contract
maturing at time T
G  S e r (T  t )
dG  (  r )G dt  G dz
2. The log of a stock price

G  ln S
 2 
dG     dt   dz

 2 
31

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Chapter 13

Wiener Processes and

• In a Markov process future movements

Taking limits we have defined a

• In Markov processes changes in

• In our example it is correct to say that

• Define(,v)as a normal distribution

• A variable z follows a Wiener process if

• A Wiener process has a drift rate (i.e.

• Mean change in x per unit time is a

• In an Itô process the drift rate and the

is true in the limit as t tends to

The process is known as

• We can sample random paths for the

0 100.00 0.52 2.45

• If we know the stochastic process

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

In ordinary calculus we have

The stock price process is

2. The log of a stock price

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