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The fundamentals of
Stochastic Financial
Mathematics

Seminar 6

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Seminar 6.
Brownian motion
and the assumptions of
the Black-Scholes model
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The Geometric Brownian Motion
In efficient markets, financial prices should
display a random walk pattern.
More precisely, prices are assumed to follow a
Markov process, which is a particular
stochastic process independent of its history
the entire distribution of the future price relies
on the current price only.
The past is irrelevant.

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The Geometric Brownian Motion
These processes are built from the
following components, described in order
of increasing complexity:
The Wiener process
The generalized Wiener process
The Ito process
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The Geometric Brownian Motion
A particular example of Ito process is the geometric
Brownian motion (GBM), which is described for the
variable S as


The process is geometric because the trend and volatility
terms are proportional to the current value of S.
This is typically the case for stock prices, for which
rates of returns appear to be more stationary than
raw dollar returns,
It is also used for currencies
S S t S z o A = A + A
S A
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The Geometric Brownian Motion
Because represents the capital
appreciation only, abstracting from dividend
payments, represents the expected total rate
of return on the asset minus the rate of income
payment, or dividend yield in the case of stocks.
S S A
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Example 1: A Stock Price Process
Consider a stock that pays no dividends,
has an expected return of10%per annum,
and volatility of 20% per annum.
If the current price is $100, what is the
process for the change in the stock price
over the next week?
What if the current price is $10?
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Example 1: Solution
(A Stock Price Process)
The process for the stock price is


where is a random draw from a standard normal
distribution.
If the interval is one week, or

the mean is

and
( )
S S t t o c A = A + A
1 52 0.01923 t A = =
c
( )
0.10 1 52 0.001923 t A = =
0.20 1 52 0.027735 t o A = =
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Example 1: Solution
(A Stock Price Process)
The process is


With an initial stock price at $100, this gives


With an initial stock price at $10, this gives


The trend and volatility are scaled down by a factor of ten
0.1923 2.7735 S c A = +
0.01923 0.27735 S c A = +
( )
$100 0.001923 0.027735 S c A = +
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This model is particularly important
because it is the underlying process for
the Black-Scholes formula
The key feature of this distribution is the fact that the
volatility is proportional to S.
This ensures that the stock price will stay positive.

Indeed, as the stock price falls, its variance decreases,
which makes it unlikely to experience a large down move
that would push the price into negative values
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As the limit of this model is a normal
distribution for dS/S = d ln(S),
S follows a lognormal distribution.
This process implies that, over an interval

the logarithm of the ending price is distributed as



where is a standardized normal variable.
T t t =
2
ln ln
2
T
S S
t
o
t o t c
| |
= + +
|
\ .
c
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Example: A Stock Price Process
(Continued)
Assume the price in one week is given by
S = $100exp(R), where R has annual
expected value of 10% and volatility of
20%.
Construct a 95% confidence interval for S
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Example: A Stock Price Process (Continued)
The standard normal deviates that corresponds to a 95%
confidence interval are min = 1.96 and max = 1.96.
In other words, we have 2.5% in each tail.
The 95% confidence band for R is then



and


This gives Smin = $100exp(0.0524) = $94.89,
and Smax = $100exp(0.0563) = $105.79.
min
1.96
0.001923 1.96 0.027735 0.0524
R t t o = A A =
= =
max
1.96
0.001923 1.96 0.027735 0.0563
R t t o = A + A =
= + =
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The choice
lognormal & normal assumption
Whether a lognormal distribution is much better than the
normal distribution depends on the horizon considered.
If the horizon is one day only, the choice of the
lognormal versus normal assumption does not really
matter.
It is highly unlikely that the stock price would drop below
zero in one day, given typical volatilities.
On the other hand, if the horizon is measured in years,
the two assumptions do lead to different results.
The lognormal distribution is more realistic, as it
prevents prices from turning negative.
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In simulations:
this process is approximated by small steps with a normal
distribution with mean and variance given by



To simulate the future price path for S, we start from the
current price St and generate a sequence of independent
standard normal variables , for i = 1, 2, . . . , n.
( )
2
,
S
N t t
S
o
A
e A A
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In simulations:
The next price is built as


The following price is taken as


and so on until we reach the target horizon, at which
point the price should have a
distribution close to the lognormal.
( )
1 1 t t t
S S S t t oc
+
= + A + A
( )
2 1 1 2 t t t
S S S t t oc
+ + +
= + A + A
2 t
S
+
1 t
S
+
t n T
S S
+
=
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Simulating a Price Path

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Shortcomings of the model
While very useful to model stock prices, this
model has shortcomings.
Price increments are assumed to have a normal
distribution.
In practice, we observe that price changes have
fatter tails than the normal distribution.
Returns may also experience changing
variances.
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Shortcomings of the model
In addition, as the time interval shrinks,
the volatility shrinks as well.
This implies that large discontinuities cannot
occur over short intervals.
In reality, some assets experience discrete
jumps, such as commodities. The stochastic
process, therefore, may have to be changed to
accommodate these observations

t A
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1. A fundamental assumption of the random
walk hypothesis of market returns is that
returns from one time period to the next are
statistically independent.
This assumption implies
a. Returns from one time period to the next can never be
equal.
b. Returns from one time period to the next are
uncorrelated.
c. Knowledge of the returns from one time period does not
help in predicting returns from the next time period.
d. Both b) and c) are true.
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2. Consider a stock with daily
returns that follow a random walk.
The annualized volatility is 34%.
Estimate the weekly volatility of this stock
assuming that the year has 52 weeks.
a. 6.80%
b. 5.83%
c. 4.85%
d. 4.71%
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3. Assume an asset price variance increases
linearly with time. Suppose the expected
asset price volatility for the next two months
is 15% (annualized), and for the one month
that follows, the expected volatility is 35%
(annualized).
What is the average expected volatility over the
next three months?
a. 22%
b. 24%
c. 25%
d. 35%
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4. In the geometric Brown motion
process for a variable S,

I. S is normally distributed.
II. d ln(S ) is normally distributed.
III. dS/S is normally distributed.
IV. S is lognormally distributed.
a. I only
b. II, III, and IV
c. IV only
d. III and IV
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5. Consider that a stock price S that follows a
geometric Brownian motion dS = aSdt + bSdz,
with b strictly positive
Which of the following statements is false?
a. If the drift a is positive, the price one year from
now will be above todays price.
b. The instantaneous rate of return on the stock
follows a normal distribution.
c. The stock price S follows a lognormal distribution.
d. This model does not impose mean reversion
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6. If follows a geometric Brownian motion
and follows a geometric Brownian motion
which of the following is true?
a. ln(S1 + S2) is normally distributed.
b. S1 S2 is lognormally distributed.
c. S1 S2 is normally distributed.
d. S1 + S2 is normally distributed
2
S
1
S
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7. Which of the following statements best
characterizes the relationship between
the normal and lognormal distributions?
a. The lognormal distribution is the logarithm of the
normal distribution.
b. If the natural log of the random variable X is
lognormally distributed, then X is normally distributed.
c. If X is lognormally distributed, then the natural log of
x is normally distributed.
d. The two distributions have nothing to do with one
another
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8. Consider a stock with an initial price of $100.
Its price one year from now is given by
S = 100 exp(r ),
The rate of return r is normally distributed with
a mean of 0.1 and a standard deviation of 0.2.
With 95% confidence, after rounding, S will be
between
a. $67.57 and $147.99
b. $70.80 and $149.20
c. $74.68 and $163.56
d. $102.18 and $119.53
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9. Which of the following
statements are true?
I. The sum of two random normal variables is also a
random normal variable.
II. The product of two random normal variables is also a
random normal variable.
III. The sum of two random lognormal variables is also a
random lognormal variable.
IV. The product of two random lognormal variables is
also a random lognormal variable.
a. I and II only
b. II and III only
c. III and IV only
d. I and IV only
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10. For a lognormal variable X, we know that
ln(X) has a normal distribution
with a mean of zero and a standard deviation
of 0.5
What are the expected value and the
variance of X?
a. 1.025 and 0.187
b. 1.126 and 0.217
c. 1.133 and 0.365
d. 1.203 and 0.399
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Question 1
What would it mean to assert that the
temperature at a certain place follows a
Markov process? Do you think that
temperatures do, in fact, follow a Markov
process?
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Question 1. Solution
Imagine that you have to forecast the future
temperature from
a) the current temperature,
b) the history of the temperature in the last week, and
c) a knowledge of seasonal averages and seasonal trends.
If temperature followed a Markov process, the history of
the temperature in the last week would be irrelevant.
To answer the second part of the question you might
like to consider the following scenario for the first week
in May:
(i) Monday to Thursday are warm days; today,
Friday, is a very cold day.
(ii) Monday to Friday are all very cold days.
What is your forecast for the weekend? If you are more
pessimistic in the case of the second scenario,
temperatures do not follow a Markov process.
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Question 2
Can a trading rule based on the past
history of a stock's price ever produce
returns that are consistently above
average? Discuss
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Question 2. Solution
The first point to make is that any trading
strategy can, just because of good luck, produce
above average returns.
The key question is whether a trading strategy
consistently outperforms the market when
adjustments are made for risk.
It is certainly possible that a trading strategy
could do this.
However, when enough investors know about
the strategy and trade on the basis of the
strategy, the profit will disappear.
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Question 2. Solution
As an illustration of this, consider a phenomenon
known as the small firm effect.
Portfolios of stocks in small firms appear to have
outperformed portfolios of stocks in large firms when
appropriate adjustments are made for risk.
Papers were published about this in the early 1980s and
mutual funds were set up to take advantage of the
phenomenon.
There is some evidence that this has resulted in the
phenomenon disappearing.
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Question 3
A company's cash position (in millions of dollars)
follows a generalized Wiener process with
a drift rate of 0.5 per quarter
a variance rate of 4.0 per quarter.
How high does the company's initial cash
position have to be for the company to have a
less than 5% chance of a negative cash position
by the end of one year?
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Question 3. Solution
Suppose that the company's initial cash position
is x.
The probability distribution of the cash position
at the end of one year is


where is a normal probability
distribution with mean and standard
deviation .
( )
( )
4 0.5, 4 4 2.0, 4 x x | | + = +
( )
, | o

o
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Question 3. Solution
The probability of a negative cash position at the
end of one year is


where is the cumulative probability that
a standardized normal variable (with mean zero
and standard deviation 1.0) is less than x.



( )
N x
2.0
4
x
N
+
| |

|
\ .
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Question 3. Solution
From normal distribution tables




when:

i.e., when x = 4.5796.
The initial cash position must therefore be $4.56 million.
2.0
1.6449
4
x +
=
2.0
0.05
4
x
N
+
| |
=
|
\ .
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Question 4
Consider a variable S that follows the process


For the first three years, and ;
for the next three years, and .

If the initial value of the variable is 5, what is
the probability distribution of the value of the
variable at the end of year 6?
dS dt dz o = +
2 =
3 o =
3 = 4 o =
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Question 4. Solution
The change in S during the first three years
has the probability distribution


The change during the next three years has
the probability distribution

( )
( )
2 3, 3 3 6, 5.20 | | =
( )
( )
3 3, 4 3 9, 6.93 | | =
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Question 4. Solution
The change during the six years is the sum of:
a variable with probability distribution
and a variable with probability distribution
The probability distribution of the change is
therefore

Since the initial value of the variable is 5, the
probability distribution of the value of the
variable at the end of year six is


( )
6, 5.20 |
( )
9, 6.93 |
( )
20, 8.66 |
( )
( )
2 2
6 9, 5.20 6.93 15, 8.66 | | + + =
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Question 5
Stock A and stock both follow geometric
Brownian motion. Changes in any short
interval of time are uncorrelated with each
other.
Does the value of a portfolio consisting of
one of stock A and one of stock follow
geometric Brownian motion? Explain your
answer.
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Question 5. Solution
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Question 5. Solution