Introduction to Weiner

Process & ITOs Lemma

Ordinary Calculus
Any differential in ordinary calculus raised to a power greater
than 1->0 .
For any well behaved mathematical function F(x,t), a taylor
series expansion is given by:

F
F
1 2 F 2 1 2 F 2 2 F
dF
dx
dt
dx
dt
dxdt ...
2
2
x
t
2 x
2 t
x t
Since, dx2->0 and dt2-> 0, we write it as

F
F
dF
dx
dt
x
t
But in ordinary calculus x is non stochastic.

How would a stochastic rv look like

Price (t)
160.0000
140.0000
120.0000
100.0000
80.0000

Price (t)

60.0000
40.0000
20.0000

241

229

217

205

193

181

169

157

145

133

121

109

97

85

73

61

49

37

25

13

0.0000

Ordinary Calculus applied to a

Stochastic Random Variable
Say

dx dt dzt
say , dt h and dzt t h
For the derivative to exist
x(t h) x(t )
E(
) should converge
h
In other words,
lim(

h h

h 0

) 2 should converge

h
But, lim( 2 2 / h)
h 0

Stochastic Calculus
If x is stochastic, then at each point in time, x
can take a domain of values.
Information about such a domain of values is
typically captured in terms of the expected
values and variances. Consequently, dx2 is no
longer zero.

Setting up a Brownian Motion

Consider any number Wt.
We shall move ahead to time t+1 by drawing a no. t 1
from a standard normal distribution and add it to Wt+1.
If we want to accommodate time intervals between t
and t+1, then Wt dt Wt t dt
However in limit as dt->0, variance of Wt+1 also would
tend to a even smaller number.
Hence,
Wt dt Wt t dt
E(Wt+1)=
Var(Wt+1)=
dwt=

dt

Brownian Motion Intuition (Discrete Time)

In finance we are more concerned about dwt which we
can say is governed by a standard normal variate
mapped onto a very small time interval dt.
Say W0=0 has a binomial outcome which can take
values +1 or -1 in the next time period with equal
probability.
E ( W0 )

Var( W )=
0

Characteristics of B.M.
The process starts at zero and is continuous
Variable (Wt) is normally distributed with expectation
zero and variance t at time t.
Increments W are independent and normally
distributed. (Memory less property Efficient Markets)
Squared increment is no longer stochastic.

Connecting Stock Markets, Brown,

Weiner and Ito!!
Characteristics of Stock Price that make it an
eligible candidate for applying Ito:
Over a long run stock prices go up (drift)
Stock Prices are random- Weiner too is random but
you cant use the weiner in its basic form as we
have seen earlier because different stocks have
different volatilities.
It is tougher to forecast stock prices further into the
future.
Stock prices cant be negative

Stock Returns and Weiner Process

Properties of a stocks return can be described by its
mean and variance.
Let E(R) be the stocks mean return and 2 its
variance.
Let Rt be the return for the holding period t then,
Rt=E(R)dt+g
Where g is the random component of the stocks
return.
If variance over a year is 2 then variance over a
holding period t is 2t

Stock Returns and Weiner Process

If prices follow a wiener process then:
S.D.(g) = t dt
Or
= dwt
Rt E(R)dt t dt

dSt
dt t dt
St
dSt
dt dwt
St

If Returns Follow a Log Normal Distribution

E(

dSt
) dt
St

Var (

dSt
) 2 dwt
St

S
S
S
ST
( 1dt )( 2 dt )........( Tdt )
S0
S0 S1dt
ST 1dt

By CLT

St dt
ln(
)
St

N ( , 2 )

Say Log returns follow:

d ln( St ) dt dwt

E (d ln(St )) dt
Var (d ln(St )) dwt

Remember, we need to connect these equations to dSt for

which the above hypothesized results are proved.

If returns follow a log normal

distribution
Say, Gt=ln(St)
=> St=exp(Gt)
A taylor series expansion of St gives
s
1 2s
dS
dG
dG 2
2
G
2 G

1
dS SdG SdG 2
2

Since, dG dt dw and
dSt
dt dwt
St

dG 2 2 dt

Itos lemma
Itos lemma is an important mathematical result that
shows how
A small change in the value of a function of a random
variable is related to a small change in the variable itself.

Why is this important?

Because the price of an option is a function of the same
random variable that drives the underlying stock price.
Generally, the value of a derivative contract is a function of
the underlying asset price.

Itos lemma
Suppose S follows a gbm process, and let f(S) be a
smooth function of S.
To a second-order approximation,
2

df
1d f
2
df
dS
dS
dS
2 dS 2

Itos lemma
Expanding dS2 gives

dS Sdt Sdz
2

2 S 2 dt 2 2S 2 dtdz 2 S 2 dz 2

Since dz is on the order of the square root of dt,

the third term dominates this expression for small dt.
In fact, as dt goes to zero, dz2 goes to dt and dS2 goes to

dS2 2S 2dt

Itos lemma
Using this result and the expression for dS, gives Itos
lemma:
2

df
1 2 2d f
df
Sdt Sdz S 2 dt
dS
2
dS
2

df
df 1 2 2 d f
S dz S
S
dt
2
dS
dS
dS 2

The lognormal property

As an example, consider f(S) = log S. Then

df 1 d 2 f
1
;
2
2
dS S dS
S
So, using Itos lemma, and simplifying

1 2
df d log S dt dz
2

The lognormal property

This means that the change in log S from time 0 to
some time T > 0 is a random variable that is
Normally distributed with
A mean of ((1/2)2)T and
A variance of 2T

1 2 2
log ST log S0 ~ N T, T
2

so

1 2 2
log ST ~ N log S0 T, T
2

Distribution of returns
Suppose y is the continuously compounded rate of
return on S over the time interval 0 to T.
That is, ST = S0eyT

Then y = (1/T)log(ST/S0) so that

1 2 2
y ~ N ,
2 T

Example
A stock has an expected return per year () of
15%, and a volatility rate () of 25% per annum.
What is the distribution of the continuously
compounded annual return over the next 5 years?
2

1
2 .25
y 5 ~ N.15 (.25) ,
N .1188,.0125
5
2

What is the 95% confidence interval for y5?

Estimating
is typically estimated from historical data on
stock prices.
High frequency data (daily or weekly) is most commonly
used. Let n be the number of time intervals (days or
weeks) in one year.
Use trading days rather than calendar days.
Returns are computed as log(St/St-1)
The sample standard deviation, sstd, of these returns is
computed as usual.
The sample standard deviation is annualized by
multiplying sstd by the square root of n.

A bit more on Itos lemma

When f = f(S, t) is a function of both t and S, Itos
lemma becomes
2

f
f 1 2 2 f f
df S dz S S
dt
2
S
S
t
S 2

Example
Consider a forward contract on S that expires at time
T. Assume that S pays no dividends and let r be the
constant risk-free rate. Then

F0 S0e

rT

At some time t < T, the forward price will be

Ft St e

rT t

Example
Note that the forward price is a function of S and t.

F
F
rT t F
rT t
e
;

0;

rSe
2
S
S
t
2

So, by Itos lemma

dF rFdt Fdz
dF
rdt dz
F