Stochastic Process

specification of the model. First Try

Wtti = Wt + Ettilat M
E(WEN) = E({++, Jat + Wt = Wt
Var(WTH)= E( WE EI) - E(WEN)?
. = E(WE) +2E(WE. Exict) + (at)}- WE

secured tre
second try
>
not a desived property.
)
Wtti =
We t Et an dt
dWt = Et Jat
new
specification
This process is
Brownian Motion
incremental of Brownian
Motion,
by Weiner Process.
dWt k
a
random process or number
t
(due} = (Na) random.
dWt = Et vat
A
random variable
also called quaradit
New definition) (dwt)" = this is the variable of Interest,
E[avi] = {legat) a dto E({{") = at variatio
var [auf ] = EL QwE] - E [ awe ]
- E[[{edt)] - (at)
- E[(&)*] (dt)" (at)? to varience =0

Any variable that has zero varience can be expressed as lits expected vale
F891) 8 model in the stock price.
Barefore the stock return.
Rth = ECRJ. ht It It is the random component.
ADA
El geJ=0
varlgt) = no?
Tvanience over a year is 02.
varience over the hold
his a fraction
of year!
ge= r Et Jat
#Et ~N(01)
=odwt
Let ha dt E(R)=2
REME E(R) Att GEt lat

E
Ito Process (Tar mean tap 1, ZOTAT
also called
random p.)
for this particular process
" GMBY
ast = dodt + GEt rat
St
this is the model specification with market consideration
translate from
retum to stock price (profess) which is what we want.
Distribution
4
- adtt Scroduit
lognormal distribution
o Return
dst
normal distribution
(dS) = adt + odwt.
☺
☺
♡
Return Rate a St
or percentage retum Jo
Stock Price St
Relative Retun Streda
Ć
+
St= Soe (9) Trow,
in Stree): udt + odWt
in Streak ) = act to a Wt
I lognormal distribution
I lognormal distribution
in normal distribution
rmal distribution
©
Log retum dust

if So-20
dst tot
there is an end on the down side,
No end on the upside.
Boinne
proportional change.
Change ast
s proportional Change: change in proportion
in percentage aso
It.
Taeminine
I USE A MOSDE, 5 In Sta) a SDE ask.
Bioza
relative return
relative return
See more s
log Retom in (star)
return:
dst
In(St) - in (at a la Sala de
+ il 3)

random variable
BUT, due to central
limit theorm, we say
>/sum of random variable, Still a random variable.
Ln(SI) is normally
7 distributed
By Induction, in(Sat) or
normally distinction?"
the specify. In (State) ~ Nl was, to)
|
= dln St
R
"
ue
this is Calculus
definition.
din St = udt + odwt : In State) = ln Strat)- In (St) @
E(dinst)= udt
Var(dInSt)= ridt Tigma in Stadt ) e normally distinted .
Sendo log normally distributed. )
Let Gt-in St
then St-e at
45-85 846 + i 35 Ga” ( By Ito as (a+ $) de + duit
2.
z lat +
&

É
dG +
E By Ito
25 IdG)
+
si na Specification/
M
ERRET ,
4.2.
then: de sidst sazinie
= xo dt + odWt
dG= udt + odit <ht'>
E By Draqualic Variation Proof.
dGQ=o? dt
dS= Socult to dwt) +ása. Jdt -
solving this SDE, we can get
E(St)= Soe latest
Spi Soe at towe
son at
G Refer back to original SOE.
din St = udt + o dut
aso = adt + Gaut
a=
MES
Forward Stock price is
expectation &. So, grow
at percentage vetem of a.

togp specification F.
Notice, My Tiña dSt M232 & adtto dut.
Baud dln St m2 32 32 333 (u- en ) at to dwt.
aptationis. See sme ca o at + out
FRM 10 Vietto specify dlust is SIDE.
Don't be confused!
Sta Sore ans
dvig: Use out + odule o
f(t.S) = Incs) . E guess
df = otagas + 2 si de a 15 347 to.
${n})= 5(23) + 3 + 52 (als)
dins (due todwo). i felfort)
Rites dins ma SOE
specification confused 3
ad WE 1-
TERELAINE
TROS DE

ought = (2-3) at + od Wt
Calculus in soc (4-8) + GWE
Cjrite throu
Stage & & Je towe,
Jones 2 = ut e
then da si sa
solation >> Sta Sove ut
Sty-PR 22 42 -32.
ut towt