Course Description & Lecture 6: Introduction to Financial Products for Risk Management

Alan Holland aholland@4c.ucc.ie

University College Cork

Stochastic Optimisation and Derivatives

Random Behaviour

Developing a Model

Simulating Asset Price Behaviour

Summary

The Random Behaviour of Assets

1

Random Behaviour Introduction Normal distribution Developing a Model Probability distribution for returns Drift and volatility Simulating Asset Price Behaviour Random Walk Inputs and steps Model Summary

Random Behaviour

Developing a Model

Simulating Asset Price Behaviour

Summary

Overview
1

Random Behaviour Introduction Normal distribution Developing a Model Probability distribution for returns Drift and volatility Simulating Asset Price Behaviour Random Walk Inputs and steps Model Summary

Random Behaviour Introduction

Developing a Model

Simulating Asset Price Behaviour

Summary

Topics covered
So far we have examined: Products and Markets Derivatives Payoff diagrams Basic mathematics Valuing an option: The Binomial Model We shall look at the following topics in todays and subsequent lectures: Random Behaviour of Assets Quantifying Random Behavour Lemma Itos Black-Scholes Model, solution methods, the Greeks Multiple assets

Random Behaviour Introduction

Developing a Model

Simulating Asset Price Behaviour

Summary

This lecture. . .

This lecture consists of Common notation for describing randomness in quantitative nance How to examine time-series data to examine returns The Wiener process for modelling random behaviour The Generalised Wiener Process A simple model for asset prices Monte Carlo simulation

Random Behaviour Introduction

Developing a Model

Simulating Asset Price Behaviour

Summary

Introduction

Continuous time Previously, we adopted a simplied model of asset movements, using discrete price movements at discrete time intervals. We now move onto a continuous-time model. Tools for analysing movements in continuous-time Continuous-time price movements cannot be modelled using a tree and requires the introduction of stochastic calculus and Wiener processes.

Random Behaviour Introduction

Developing a Model

Simulating Asset Price Behaviour

Summary

Returns

Investors seeks returns on assets. Denition A return indicates the percentage growth in the value of an asset, together with accumulated dividends, over a certain period: return = Change in Value + Accumulated Cashows . Original Value

Random Behaviour Introduction

Developing a Model

Simulating Asset Price Behaviour

Summary

Examining returns

Figure: Microsoft share price

Because there is so much randomness, any mathematical model of a nancial asset must acknowledge the randomness and have a probabilistic foundation.

Random Behaviour Introduction

Developing a Model

Simulating Asset Price Behaviour

Summary

Examining Returns
Denoting the asset value on the i th day by Si , then the return from day i to day i + 1, Ri , is given by: Ri = Si +1 Si . Si

Random Behaviour Introduction

Developing a Model

Simulating Asset Price Behaviour

Summary

BP returns

Random Behaviour Normal distribution

Developing a Model

Simulating Asset Price Behaviour

Summary

Mean and Standard Deviation

The mean of the returns distribution is 1 R= M

M

Ri
i =1

and the sample standard deviation is 1 M 1

M

(Ri R )2 ,
i =1

Random Behaviour Normal distribution

Developing a Model

Simulating Asset Price Behaviour

Summary

Histogram

Random Behaviour Normal distribution

Developing a Model

Simulating Asset Price Behaviour

Summary

Histogram
Normal distribution Now we can compare the distribution of returns with the Normal distribution. It is often called the bell curve because the graph of its probability density resembles a bell.
(x )2 1 ( ) 2 2 f (x : , ) = e 2

De Moivre developed the normal distribution as an approximation to the binomial distribution.

Random Behaviour

Developing a Model

Simulating Asset Price Behaviour

Summary

Overview
1

Random Behaviour Introduction Normal distribution Developing a Model Probability distribution for returns Drift and volatility Simulating Asset Price Behaviour Random Walk Inputs and steps Model Summary

Random Behaviour

Developing a Model

Simulating Asset Price Behaviour

Summary

Probability distribution for returns

Using a probability distribution as an approximation

Normal distribution Supposing that we believe that the empirical returns are close enough to Normal for this to be a good approximation, then we have come a long way towards a model. We are going to write the returns as a random variable, drawn from a Normal distribution with a known, constant, non-zero mean and a known, constant, non-zero standard deviation

Random Behaviour

Developing a Model

Simulating Asset Price Behaviour

Summary

Probability distribution for returns

Timescales

Decreasing timestep How do the mean and standard deviation of the returns time series scale with the timestep between asset price measurements? In our example the timestep is one day, but suppose we sampled at hourly intervals or weekly, how would this affect the distribution? Call the timestep t . The mean of the return scales with the size of the timestep, mean = t , for some we shall assume to be constant.

Random Behaviour

Developing a Model

Simulating Asset Price Behaviour

Summary

Probability distribution for returns

Timescales
Ignoring randomness momentarily, our model is Si +1 Si = t Si Si +1 = Si (1 + t ) After m timesteps: SM = S0 (1 + t )M S0 eM t = S0 eT , where S0 is the initial asset value. So in the absence of randomness, the assets undergoes exponential growth.

Random Behaviour

Developing a Model

Simulating Asset Price Behaviour

Summary

Probability distribution for returns

Standard deviation and timescaling

So, how does the standard deviation of the return scale with the timestep t ?
T Again, consider what happens after t timesteps each of size t (i.e. after a total time of T). Since each term is a square of a return, the standard deviation of the asset return over a 1 timestep t must be O( t 2 ), where is a measure of the randomness.

Putting these scalings explicitly into our asset return model: Si +1 Si = Si t + S t 2 .

1

(1)

The left-hand side of this equation is the change in the asset price from timestep i to timestep i + 1. The right-hand side is the model.

Random Behaviour

Developing a Model

Simulating Asset Price Behaviour

Summary

Probability distribution for returns

Random Walk
We can think of this equation as a model for a random walk of the asset price. We know exactly where the asset price is today but tomorrows value is unknown. It is distributed about todays value according to Equation 1.

Random Behaviour Drift and volatility

Developing a Model

Simulating Asset Price Behaviour

Summary

The drift

The parameter is called the drift rate (alternatively the expected return or growth rate) Statistically it is very hard to measure since the mean scales with the usually small parameter t . It can be estimated by 1 MRi = M t
i =1

The unit of time that is usually used is the year, in which case is quoted as an annualized growth rate.

Random Behaviour Drift and volatility

Developing a Model

Simulating Asset Price Behaviour

Summary

Volatility

The parameter is called the volatility of the asset. This is a measure of the standard deviation of the returns. Again, this is usually quoted in annualised terms. The volatility is the most important and elusive quality in the theory of derivatives.

Random Behaviour Drift and volatility

Developing a Model

Simulating Asset Price Behaviour

Summary

The effects of time on drift and volatility

Because of their scaling with time, the drift and volatility have different effects on the asset path. The drift is not apparent over short timescales and volatility dominates Over long time periods, e.g. decades, the drift becomes more signicant.

Random Behaviour Drift and volatility

Developing a Model

Simulating Asset Price Behaviour

Summary

Random Behaviour
Path of the logarithm of an asset price, its expected path and one standard deviation above and below.

Random Behaviour

Developing a Model

Simulating Asset Price Behaviour

Summary

Overview
1

Random Behaviour Introduction Normal distribution Developing a Model Probability distribution for returns Drift and volatility Simulating Asset Price Behaviour Random Walk Inputs and steps Model Summary

Random Behaviour Random Walk

Developing a Model

Simulating Asset Price Behaviour

Summary

The random walk on a spreadsheet

The random walk can be written as a recipe for generating Si +1 from Si : 1 Si +1 = Si (1 + t + t 2 ) Simulating the above model with Excel is relatively easy is a number drawn from a Normal distribution

Random Behaviour Inputs and steps

Developing a Model

Simulating Asset Price Behaviour

Summary

Inputs

There are several input parameters required: A starting value for the asset A timestep t The drift rate The volatility The total number of timesteps

Random Behaviour Inputs and steps

Developing a Model

Simulating Asset Price Behaviour

Summary

Adding randomness
At each timestep, we must choose a random number , taken from a Normal distribution, that simulates daily random uctuations. An approximation to a Normal variable is to simply summate n random variables drawn from a uniform distribution over zero to one, and subtract n 2

Random Behaviour Inputs and steps

Developing a Model

Simulating Asset Price Behaviour

Summary

The Wiener Process

Towards continuous time So far we have a model that allows the asset to take any value after a timestep. This is a step forward but we have still not reached our goal of continuous time, we still have a discrete timestep. We now use the notation d to mean the change in some quantity. But this change will be in continuous time, and we will go to the limit t 0. The rst t on the right-hand side of Si +1 Si = Si t + Si 2 becomes t but the second term is more complicated.
1

Random Behaviour Inputs and steps

Developing a Model

Simulating Asset Price Behaviour

Summary

The Wiener Process

We cannot straightforwardly write dt 2 instead of t 2 . We 1 are going to write the term t 2 as dX . dX can be considered to be a random variable drawn from a Normal distribution with mean = 0 and variance = dt E [dX ] = 0, E [dx 2 ] = dt This is the Wiener Process, we can build models of asset-price movements in a continuous-time manner instead of using Normal distributions and discrete time.
1 1

Random Behaviour Inputs and steps

Developing a Model

Simulating Asset Price Behaviour

Summary

The Generalised Wiener Process

Our asset price model in the continuous-time limit, using the Wiener process notation, can be written as dS = Sdt + SdX . This is our rst stochastic differential equation. It is a continuous-time model of an asset price. It is a major building block for most of quantitative nance. It is the most widely accepted model for equities, currencies, commodities and indices.

Random Behaviour Inputs and steps

Developing a Model

Simulating Asset Price Behaviour

Summary

Example

Example Consider a stock that pays no dividends with the following properties: volatility = 30% per annum drift (or expected return) = 15% per annum with continuous compounding.

Random Behaviour Inputs and steps

Developing a Model

Simulating Asset Price Behaviour

Summary

Example continued...
In this case, = 0.15 and = 0.30. The Wiener process for the stock price is: dS = 0.15dt + 0.30dz . S If S is the stock price at a particular time and S is the increase in the stock price in the next small interval of time, t , then S = 0.15 t + 0.30 t , S where is a random drawing from a standardised normal distribution.

Random Behaviour Inputs and steps

Developing a Model

Simulating Asset Price Behaviour

Summary

Example continued...

Consider a time interval of one week (0.0192 years), and suppose that the initial stock price is $100. Then t = 0.0192, S = 100, and S = 100(0.00288 + 0.0461 ) or S = 0.288 + 4.16 , demonstrating that the price increase is a random drawing from a normal distribution with mean $0.288 and standard deviation $4.16.

Random Behaviour Model

Developing a Model

Simulating Asset Price Behaviour

Summary

Review of the Model

Brownian Motion The model of the stock price behaviour developed in this section is known as geometric Brownian motion. The discrete-time version of the model is S = t + t S or S = S t + S t

The variable S is the change in the stock price S in a small time interval t , and is a random drawing from a standardised normal distribution ((0, 1)), and is the expected rate of return per unit of time, and is the volatility.

Random Behaviour Model

Developing a Model

Simulating Asset Price Behaviour

Summary

Review of the Model continued

is the return provided by the stock in a short period of time. The term t is the expected value of this return The term t is the stochastic component of the return is normally distributed with mean t and standard deviation t
S S

S S

Random Behaviour Model

Developing a Model

Simulating Asset Price Behaviour

Summary

Monte Carlo Simulation

Denition A Monte Carlo simulation of a stochastic process is a procedure for sampling random outcomes for the process. Example Suppose = 0.14 and = 0.20 per annum for some stock. Let t = 0.01, so S = 0.0014S + 0.02S A sample path for the future stock price can be simulated by sampling repeatedly for from (0, 1)

Random Behaviour Model

Developing a Model

Simulating Asset Price Behaviour

Summary

Monte Carlo Simulation

Example Stock 20.000 20.236 20.847 20.518 20.146 Random 0.52 1.44 -0.86 1.46 -0.69 Change 0.236 0.611 -0.329 0.628 -0.262

This process can easily be replicated in an Excel spreadsheet to model possible future price paths.

Random Behaviour Summary

Developing a Model

Simulating Asset Price Behaviour

Summary

Summary
Stochastic processes describe the probabilistic evolution of the value of a variable through time. A Wiener process, dz , is a process of describing the evolution of a normally distributed variable. The drift of the Wiener process is 0 and the standard deviation is 1.0 per unit time. A generalised Wiener process, dx = a dt + b dz , adds drift of a per unit time and variance rate b2 per unit time A good way to gain an intuitive understanding of a stochastic process for a variable is to simulate the behaviour. The future probability for asset prices can thus be calculated (this is Monte Carlo simulation).

Random Behaviour Summary

Developing a Model

Simulating Asset Price Behaviour

Summary

Exercise

Exercise Take historical price data for some asset, say gas prices, determine the drift and volatility and derive random future asset price paths.