Note 1

UECM2453 Financial Economics II
Topic 1 Brownian motions and Itô’s lemma
Kuang Kee Seng
Universiti Tunku Abdul Rahman
kuangks@utar.edu.my
Kuang Kee Seng (UTAR) Topic 1 1 / 129

Brownian motions and Itô’s lemma
Brownian Motions
Random Walk
A random walk can be generated by flipping a coin each period and
moving one step, with the direction determined by whether the coin is
heads or tails. Let the position at time t be Zt , and Yt be the outcome of
toss at time t , then we have
(
+1 with probability 0.5
Yt =
−1 with probability 0.5
and
t
Zt = ∑ Yk
k=0
where Z0 = 0.

Brownian Motions
We call Zn a random walk.The random walk may be considered a pri-

mary building block of financial modeling. Note that the binomial tree
model is a variant of the random walk model with asymmetric probabili-
ties.

Brownian Motions
Brownian Motion (Wiener Process)

Brownian motion is a random walk occurring in continuous time, with
movements that are continuous rather than discrete. To generate Brow-
nian motion, we would flip the coins infinitely fast and take infinitesimally
small steps at each point.

Brownian Motions
Suppose that each ∆t time unit we take a step of of size ∆y either to the
left of the right with equal probabilities. If we let Z(t) denote the position
at time t then
Z(t) = ∆y(Y1 +Y2 + · · · +Yb t c )
∆t
where
(
+1 if the i-th step of length ∆y is to the right
Yk =
−1 if the i-th step of length ∆y is to the left
and ∆tt is the largest integer less than or equal to ∆tt , and where the Yk

are assumed independent with
1
P(Yk = 1) = P(Yk = −1) = .
2
Brownian Motions
As
E(Yk ) = 0 and V (Yk ) = E(Yk2 ) = 1
we have jt k
2
E[Z(t)] = 0 and V [Z(t)] = ∆y
∆t
We shall now let ∆y and ∆t go to 0.
√
Let ∆y = σ ∆t , then when ∆t → 0,
E[Z(t)] = 0 and V [Z(t)] = (∆y)2 → σ2t

Brownian Motions
By Central Limit Theorem,
Z(t) → N(0, σ2t)
In addition, because the changes of value of the random walk in nonover-

lapping time intervals are independent, we have Z(t), t ≥ 0 has indepen-
dent increments, i.e. for all t1 < t2 < · · · < tn , Z(tn ) − Z(tn−1 ), Z(tn−1 ) −
Z(tn−2 ), · · · , Z(t2 ) − Z(t1 ), Z(t1 ) are independent.

Brownian Motions
Finally, because the distribution of the change in position of the random

walk over any time interval depends only on the length of that interval,
it would appear that Z(t), t ≥ 0 has stationary increments, i.e. the dis-
tribution of Z(t + s) − Z(t) does not depend on t and depends only on
s.
When σ = 1, the process is called a Standard Brownian Motion.

Brownian Motions
Properties of a Standard Brownian Motion

(1) Z(0) = 0
(2) Z(t) ∼ N(0,t)
(3) Z(t), t ≥ 0 has independent increments, i.e. for all t1 < t2 < · · · < tn ,
Z(tn ) − Z(tn−1 ), Z(tn−1 ) − Z(tn−2 ), · · · , Z(t2 ) − Z(t1 ), Z(t1 )
(4) Z(t), t ≥ 0 has stationary increments, i.e. the distribution of

Brownian Motions
From property (4), Z(t + s) − Z(t) has the same distribution as Z(s) −
Z(0). Since Z(0) = 0, we have
Z(t + s) − Z(t) = Z(s) ∼ N(0, s)
by property (3), Z(t + s) − Z(t) does not depend on Z(t), so we have
Z(t + s) − Z(t)|Z(t) ∼ N(0, s)

Brownian Motions
In general, Z(t + s) − Z(t) does not depend on the history of the Brown-
ian motion up to and including time t , which means
Z(t + s) − Z(t)|{Z(u) : 0 ≤ u ≤ t} ∼ N(0, s)
Note that given the history of {Z(u) : 0 ≤ u ≤ t}, Z(t) is a constant not
a random variable. By adding Z(t) both sides, we have
Z(t + s)|{Z(u) : 0 ≤ u ≤ t} ∼ N(Z(t), s)

Brownian Motions
Example 1
Calculate the followings:
(a) P(Z(4) ≤ 4).
(b) P(−0.4 < Z(3) < 0.4).
(c) P(−6 ≤ Z(5) ≤ 3).

Brownian Motions
(Left blank for rough work.)

Brownian Motions
Example 2
Find the expected value and variance of Z(8) − Z(5).

Brownian Motions
Example 3
Calculate the following:
(a) Cov[Z(s), Z(t)] for 0 ≤ s < t.
(b) E[Z(s)Z(t)].

Brownian Motions
Example 4
Calculate the followings:
(a) E[Z(5)Z(2)]
(b) V [Z(1) + Z(3)]
(c) E[Z(8)|Z(5)]
(d) V [Z(8)|Z(5)]

Brownian Motions

Brownian Motions
Arithmetic Brownian Motions

Random walk model and Standard Brownian Motions are not appropriate
to model stock prices because:
Stock prices cannot be negative
The stock should have a positive return, but the mean of random
walk and Standard Brownian Motions are both zero.

Brownian Motions
Thus, to construct a model for stock prices, we extend Standard Brow-

nian Motions to Arithmetic Brownian Motion with drift coefficient α and
variance parameter σ2 (or volatility σ) if
X(t) = X(0) + αt + σZ(t).
The drift coefficient α is also called the instantaneous mean per unit time
and the variance parameter σ2 is called the instantaneous variance per
unit time. If α = 0, the Arithmetic Brownian Motion is said to be driftless.

Brownian Motions
Since {Z(t) : t ≥ 0} has stationary and independent increments, thus,

{X(t) : t ≥ 0} also has stationary and independent increments.
As
E[X(t)] = E[X(0) + αt + σZ(t)] = 0 + αt + σE[Z(t)] = αt
V [X(t)] = V [X(0) + αt + σZ(t)] = V [σZ(t)] = σ2t

Thus,
X(t) ∼ N(αt, σ2t)

Brownian Motions
Example 5
Let {X(t) : t ≥ 0} be an Arithmetic Brownian Motion with α = 1 and
σ = 4. Find the probability that 0 < X(2) < 1 given X(1) = 2.

Brownian Motions
Example 6
The price of a stock follows Arithmetic Brownian Motion of the form
X(t) = X(0) + t + 0.2Z(t). The current price of the stock is 40. Deter-
mine the probability that the price of the stock at time 4 is less than 43.

Brownian Motions
Extra example
The price of a stock follows an arithmetic Brownian motion process of
the form S(t) = S(0) + αt + 0.3Z(t). The current price of the stock is 52.
Given the probability that the stock price is greater than 53 at time 0.5 is
0.2514, determine the drift parameter, α.

Brownian Motions
Geometric Brownian Motions

Arithmetic Brownian Motion has several drawbacks:
There is nothing to prevent X(t) from becoming negative, so it is a
poor model for stock prices.
The mean and variance of changes in dollar terms are independent
of the level of the stock price.
To eliminate these criticisms, we consider Geometric Brownian Motion.
Let {X(t) : t ≥ 0} be a Brownian Motion with drift and Y (0) be a constant.
Then
Y (t) = Y (0)eX(t) = Y (0)eµt+σZ(t)
is called a Geometric Brownian Motion.

Brownian Motions
By taking logarithm,
lnY (t) = lnY (0) + X(t) = lnY (0) + µt + σZ(t)
E[lnY (t)] = lnY (0) + µt

V [lnY (t)] =σ2t
Thus,
lnY (t) ∼ N(lnY (0) + µt, σ2t)
Since lnY (t) follows a normal distribution, then Y (t) follows
√ a lognormal
∗ ∗
distribution with parameter µ = lnY (0) + µt and σ = σ t .
√
Y (t) ∼ LN(µ∗ = lnY (0) + µt, σ∗ = σ t)

Brownian Motions
Example 7
Let {Z(t) : t ≥ 0} be a standard Brownian Motion and Y (t) be a time-t
price of stock. It is given that
Y (t) = 100e0.035t+0.3Z(t)
(a) Find P(98 ≤ Y (2) ≤ 103).

(b) Find P(98 ≤ Y (2) ≤ 103|Y (1) = 102).

Brownian Motions

Brownian Motions
Extra example
The time-t price of a stock is S(t). The stock price is modeled as follow-
ing Geometric Brownian Motion. You are given:
The stock’s continuously compounded expected rate of return is
0.15.
The stock’s continuously compounded dividend yield is 0.04.
The stock’s volatility is 0.3.
S(0) = 45.
S(0.6) = 47.
Calculate P(S(1) < 45) given the above facts.

Brownian Motions

Stochastic Calculus
Stochastic Differential Equations

Suppose that the rate of change in x(t) depends on the time t and the
value of x(t) itself, i.e.
dx(t)
= f (t, x(t))
dt
Multiply both sides with dt to obtain
dx(t) = f (t, x(t))dt
This equation is a differential equation, which says that the change in x

over a very short time interval [t,t + dt] is given by f (t, x(t)).

Stochastic Calculus
Suppose that
dX(t) = a[t, X(t)]dt + b[t, X(t)]dZ(t)

or
dX = adt + bdZ
This is called a stochastic differential equation (SDE) and X is said to
be a diffusion.
dZ(t) is the change in the Brownian Motion over [t,t + dt]. We may
view dZ(t) as Z(t + dt) − Z(t) and hence dZ(t) ∼ N(0, dt).
dX(t) the change in X over [t,t + dt]. We may view dX(t) as X(t +
dt) − X(t).
It follows from independent increments that dZ(t) is independent
of the history {Z(u) : 0 ≤ u ≤ t}. In particular, dZ(t) and Z(t) are
independent.
Stochastic Calculus
Given the value of X(t), the terms a[t, X(t)] and b[t, X(t)] are no
longer random, and hence
E[dX(t)] = a[t, X(t)]dt
and
V [dX(t)] = b2 [t, X(t)]dt
a(x,t) and b(x,t) are called the drift and volatility.
for standard Brownian Motion, a(x,t) = 0 and b(x,t) = 1.
for Arithmetic Brownian Motion, a(x,t) = α and b(x,t) = σ.
for Geometric Brownian motion, a(x,t) = ξX(t) and b(x,t) = σX(t).

Stochastic Calculus
Summary of SDE
Given an Ito’s Process of the form
dS
= ξdt + σdZ(t)
S
The stock follows the Black-Scholes Framework
The continuous rate of increase in the stock, which is continuously
compounded rate of return on the stock (α) minus the continuous
dividend rate (δ) is ξ.
The volatility is σ.

Stochastic Calculus
Extra example
You are given an Ito’s process of the form
dS(t) = 0.25S(t)dt + 0.10S(t)dZ(t)
Calculate the probability that S(t) is at least 5% higher than S(0).

at time t = 0.1.
at time t = 1.

Stochastic Calculus

Stochastic Calculus
Extra example
S(t) follows an Ito process of the form
dS(t) = 0.1S(t)dt + 0.05S(t)dZ(t)
S(0) = 40 and S(7) = 35. Calculate the probability that S(12) ≤ 48.

Itô’s Lemma
Itô’s Lemma
In many problems involving Itô processes and Geometric Brownian Mo-
tion, we will encounter situations where we need to multiply dZ by itself,
dt by itself, or dZ by dt . Rules for these products are known as multipli-
cation rules. But first we define the following: For α > 1, we will define
(dt)α = 0.

Itô’s Lemma
Example 8
(a) Show that E[(dZ)2 ] = dt.
(b) Show that V [(dZ)2 ] = 0.
(c) Show that (dZ)2 = dt.

Itô’s Lemma
Example 9
(a) Show that E[dZ × dt] = 0.
(b) Show that E[(dZ × dt)2 ] = 0.
(c) Show that V [dZ × dt] = 0.
(d) Show that dZ × dt = 0.

Itô’s Lemma
Example 10
Let Z and Z 0 be two standard Brownian Motions. Show that dZ × dZ 0 =
ρdt where ρ = E[Z(t)Z 0 (t)] is also known as the correlation of the un-
derlying assets driven by the different Brownian Motions.

Itô’s Lemma
Summarizing, the multiplication rules are:

dt × dt = 0
dt × dZ = 0
dZ × dZ = dt
if Z(t) and Z 0 (t) are two Brownian Motions having correlation ρ,
then dZ × dZ 0 = ρdt

Itô’s Lemma
Itô’s Lemma
Let
Y (t) = f (t, X(t))
and
then
1
dY (t) = ft dt + fx dX(t) + fxx (dX(t))2
2
where
∂Y
ft = ∂t is the partial derivative of Y (t) with respect to t
∂Y
fx = ∂X is the partial derivative of Y (t) with respect to X(t)
2
∂Y
fxx = ∂X 2 is the second partial derivative of Y (t) with respect to
X(t)
Itô’s Lemma
If X(t) = Z(t) and Standard Brownian Motion, then

a[t, X(t)] = 0
b[t, X(t)] = 1
(dX)2 = dt .
Thus,
1
dY (t) = ft dt + fz dZ(t) + fzz dt.
2

Itô’s Lemma
Example 11
Let Z(t) be a Standard Brownian Motion. Find dY (t) for the following:
(a) Y (t) = Z 2 (t).
(b) Y (t) = tZ 2 (t).

Itô’s Lemma

Itô’s Lemma
Example 12
Let Z(t) be a Standard Brownian Motion and Y (0) be a constant. Find
dY (t) for the following:
(a) Y (t) = Y (0) + µ + σZ(t).
σ2
(b) Y (t) = Y (0)e(µ− 2 )t+σZ(t) .

Itô’s Lemma

Itô’s Lemma
Integral Representation
Consider the Stochastic Differential Equation
Integrating both sides from 0 to t , we get

Z t Z t
X(t) − X(0) = a[s, X(s)]ds + b[s, X(s)]dZ(s)
0 0
Rt
Here, 0 b[s, X(s)]dZ(s) is called a stochastic integral.

Itô’s Lemma
Both equations are equivalent ways to express the dynamics of X . Let

a(t, x) = 0, the equivalent between the two equations means
Z t
dX(t) = b[t, X(t)]dZ(t) ⇐⇒ X(t) − X(0) = b[s, X(s)]dZ(s)
0
and Z t
dX(t) − dX(0) = d b[s, X(s)]dZ(s)
0
Since dX(0) = 0, then
Z t
d b[s, X(s)]dZ(s) = b[t, X(t)]dZ(t)
0

Itô’s Lemma
Example 13
Let Y (t) = 0t e−λ(t−s) dZ(s). Find dY (t).
R

Itô’s Lemma
Solutions of Three SDEs

Type I: Arithmetic Brownian Motions
The SDE
dY (t) = αdt + σdZ(t)
has a solution of the form of an Arithmetic Brownian Motion with drift
(including an intercept):
Y (t) = Y (0) + αt + σZ(t)

Itô’s Lemma
Solutions of Three SDEs

Type II: Geometric Brownian Motions
The SDE
dY (t) = (α − δ)Y (t)dt + σY (t)dZ(t)
or
dY (t)
= (α − δ)dt + σdZ(t)
Y (t)
has a solution of the form of an Geometric Brownian Motion:
σ2
Y (t) = Y (0)e[(α−δ− 2 )t+σZ(t)]

Itô’s Lemma
Geometric Brownian Motions:

The followings are equivalent representations:
(i) Y (t) follows a Geometric Brownian Motion with rate of appreciation
α − δ and volatility σ.
(ii) dY (t) = (α − δ)Y (t)dt + σY (t)dZ(t) or
dY (t)
Y (t) = (α − δ)dt + σdZ(t)
2
(iii) d[lnY (t)] = (α − δ − σ2 )dt + σdZ(t) or
(t) 2
ln YY(0) = (α − δ − σ2 )t + σZ(t)
σ 2
(iv) Y (t) = Y (0)e(α−δ− 2 )t+σZ(t)
2
(v) ln (Y (t)|Y (0)) ∼ N(lnY (0) + (α − δ − σ2 )t, σ2t)

Itô’s Lemma
Example 14
Suppose dY (t) = (α − δ)Y (t)dt + σY (t)dZ(t).
Show that
σ2
d[lnY (t)] = (α − δ − )dt + σdZ(t).
2

Itô’s Lemma
Example 15
Stock prices follow Geometric Brownian Motion
d ln S(t) = 0.026dt + 0.19dZ(t)
Suppose S(0) = 47. Calculate P[S(1) < 45].

Itô’s Lemma
Example 16
You are given:
dS(t) = (α − δ)S(t)dt + σS(t)dZ(t)
F(t) = S(t)e(r−δ)(T −t)
F p (t) = S(t)e(−δ)(T −t)
Find dF(t) and dF p (t).

Itô’s Lemma
Process for a Forward

The forward process is
Ft,T (S(T )) = S(t)e(r−δ)(T −t)
If dS(t) = (α − δ)S(t)dt + σdZ(t), then
dFt,T
= (α − r)dt + σdZ(t)
Ft,T
So the forward follows Geometric Brownian Motions with the same volatil-
ity as the stock, and with rate of growth α − r. Similarly,
p
dFt,T
p = αdt + σdZ(t)
Ft,T

Itô’s Lemma
Example 17
You are given the following information:
S(t) is the value of one British pound in U.S. dollars at time t.
dS(t)
S(t) = 0.1dt + 0.4dZ(t)
The continuously compounded risk-free interest rate in the U.S. is
r = 0.08.
The continuously compounded risk-free interest rate in Great Britain
is r∗ = 0.10.
∗
G(t) = S(t)e(r−r )(T −t) is the forward price in U.S. dollars per British
pound, and T is the maturity time of the currency forward contract.
Find dG(t).

Itô’s Lemma

Itô’s Lemma
Example 18
You are given:
S(t) = S(0)e0.15t+0.3Z(t)
δ = 0.02
Ft,T is a forward on the stock.
r = 0.05
d(ln F) follows the process αdt + σdZ(t). Determine α.

Itô’s Lemma
Type III: The Ornstein-Uhlenback Process

The SDE
dY (t) = λ[α −Y (t)]dt + σdZ(t)
has a solution of the form:
Z t
−λt −λt
Y (t) = e Y (0) + α(1 − e )+σ e−λ(t−s) dZ(s)
0

Itô’s Lemma
Suppose that λ > 0. Then the drift term is λ[α −Y (t)].

Y (t) < α, then the drift is positive, pulling Y (t) up toward α.
Y (t) > α, then the drift is negative, pulling Y (t) down toward α.
Y (t) = α, then the drift is negative.
We say that Y exhibits mean reversion, with λ being the speed of the
reversion and α being the equilibrium level.

Itô’s Lemma
Example 19
Let Z(t) be a standard Brownian Motion. You are given:
Z t
Y (t) = 5 + 5e−0.5t + 0.3 e−0.5(t−s) dZ(s)
0
Let X(t) = Y 3 (t). Suppose that
dX(t) = a(t, X(t))dt + b(t, X(t))dZ(t).
Find a(1, 1).

Itô’s Lemma

Itô’s Lemma
Example 20
Interest rates r(t) satisfy the SDE
p
dr(t) = 0.22(0.16 − r(t))dt + 0.23 r(t)dZ(t)
A solution for r(t) is

Z t p
Ct Et
r(t) = A + (r(0) + B)e + De eFt r(s)dZ(s)
0
where A, B, C, D, E and F are constants.

Determine B +C + D + E + F.

Itô’s Lemma

Modeling Stock Price Dynamics
Modeling Stock Prices with a Geometric Brownian Motions Let S(t)

be the time-t price of a stock. Then
dS(t)
S(t)
is the instantaneous change of stock price at time t . This ratio may be
assumed to follow a normal distribution. In particular, we may consider
the following process:
dS(t)
= (α − δ)dt + σdZ(t)
S(t)
We interpret α as expected rate of return per, (α−δ) as the continuously

compounded rate of appreciation on the stock, and σ as the volatility per
annum.
The solution to the above SDE is

σ2
S(t) = S(0)e[(α−δ− 2 )t+σZ(t)] ,
which implies that

√
S(t)|S(0) ∼ LN(µ∗ = ln S(0) + (α − δ − σ2 /2)t, σ∗ = σ t)
Note that if Y ∼ LN(µ, σ), then

1 2
(σ)2
E(Y k ) = ekµ+ 2 k

So,
1 2
)t+ 12 k2 σ2 t
E[Sk (t)] =ek(ln S(0))+α−δ− 2 σ
1 2t
=[Sk (0)]ek(α−δ)t+ 2 k(k−1)σ
The mean and variance are
E[S(t)] =S(0)e(α−δ)t
2
V [S(t)] =E 2 [S(t)][(eσ t − 1)]

For t < u, let

S(t) S(u)
Q1 = and Q2 = ,
S(0) S(t)
then Q1 and Q2 cover non-overlapping intervals and are independent.
1 2t
E(Qk1 ) = ek(α−δ)t+ 2 k(k−1)σ
1 2 (u−t)
E(Qk2 ) = ek(α−δ)(u−k)+ 2 k(k−1)σ
E[S(t)S(u)] = S2 (0)E[Q21 Q2 ]
1 2
= S2 (0)e2((α−δ)+ 2 σ )t e(α−δ)(u−t)

Example 21
Let S(t) be the time-t price of a non-dividend-paying stock, you are
given that the stock price process is
d[ln S(t)] = −0.0048dt + 0.36dZ(t), S(0) = 2
where Z(t) is a standard Brownian Motion under the true probability

measure.
Calculate Cov(S2 (2), S4 (4)).


Example 22
The price of a stock follows the stochastic differential equation as be-
low:
dS(t)
= 0.036dt + 0.29dZ(t)
S(t)
where Z(t) is a standard Brownian Motion. Consider the geometric
average
1
G = [S(1)S(3)S(4)] 3 .
Find the variance of ln G.


Lognormality of Stock Price

For
σ2 √
S(t) ∼ LN(µ = ln S(0) + (α − δ − )t, σ02 = (σ t)2 )
2
then,
σ2 √
ln S(t) ∼ N(µ = ln S(0) + (α − δ − )t, σ0 = σ t)
2
2
(ln s−µ)
1 −
f (s) = √ e 2(σ0 )2 , s > 0
2πσ0 s

P[S(t) > k] =P[ln S(t) > ln k]

2
ln k − ln S(0) − (α − δ − σ2 )t
=P[Z > √ ]
σ t
2
ln S(0) + (α − δ − σ2 )t
=P[Z > − K √ ]
σ t
=P[Z > −dˆ2 ]
=N(dˆ2 )
Similarly, we can obtain
P[S(t) ≤ k] = N(−dˆ2 )
The Conditional Expected Price

For
σ2 √
S(t) ∼ LN(µ = ln S(0) + (α − δ − )t, σ0 = σ t),
2
E[S(t)I(S(t) > k)] = E[S(t)]N(dˆ1 )
where
2
ˆ ln S(0)
K + (α − δ + σ2 )t
d1 = √
σ t


Similarly,
E[S(t)I(S(t) < k)] = E[S(t)]N(−dˆ1 )
As
P[S(t) ≤ k] = N(−dˆ2 ) and P[S(t) > k] = N(dˆ2 ),
we have
E[S(t)]N(−dˆ1 )
E[S(t)|S(t) < k] =
N(−dˆ2 )
and
E[S(t)]N(dˆ1 )
E[S(t)|S(t) > k] =
N(dˆ2 )
ln
S(0)
K +(α−δ−
σ2
2 )t
√
Note that dˆ2 = √
σ t
= dˆ1 − σ t .

Example 23
Consider a stock with the following characteristics:
The current price of the stock is 30.
The stock pays no dividends.
The stock’s volatility is 20%.
P[S(2) < 20] = 0.025
(a) Calculate the expected return α on the stock.
(b) Calculate E[S(2)|S(2) < 20].


Example 24
The price of a stock at time t, denoted by St , follows the Black-Scholes
framework. You are given
S0 = 50
The annual return on the stock is 12% compounded continuously.
The dividend rate is 2% compounded continuously.
Annual volatility is 30%.
Calculate E[S1 |S1 > 50].


Example 25
The time-t price of a stock, S(t), follows the Itô process
dS(t)
= 0.16dt + 0.3dZ(t).
S(t)
The initial price of the stock, S(0), is 60. A 9-month European call
option on the stock has strike price 70. Calculate the expected payoff of
the call option, given that it is pays off.


Example 26
For a non-dividend-paying stock with price S(t) at time t, you are given:
S(0) = 60
The continuously compounded expected annual rate of return is
0.14.
The volatility is 0.22.
1 2 3 3 1
G = [S( 12 )S( 12 )S( 12 )]
Calculate E[(G − 72.8)I(G > 72.8)|G > 72.8].


The Sharpe Ratio and Black-Scholes Equation
The Black-Scholes Framework By Black-Scholes framework, we mean

the following:
The underlying asset S(t) follows a Geometric Brownian Motion.
The underlying asset is either non-dividend-paying or pays divi-
dends continuously at a level proportional to its price.
The risk-free interest rate is constant.
There are no transaction cost or taxes.
It is possible to purchase or short-sell any units of the underlying
asset.
The borrowing rate and the lending rate are both equal to the risk-
free interest rate.
There are no arbitrage opportunities.

The most important assumption is Geometric Brownian Motion. The five

statements below are equivalent:
(1) S(t) is a Geometric Brownian Motion with drift α − δ and volatility σ.
dS(t)
(2) S(t) = (α − δ)dt + σdZ(t) where Z(t) is a standard Brownian Mo-
tion.
2
(3) d[ln S(t)] = (α − δ − σ2 )dt + σdZ(t)
σ 2
(4) S(t) = S(0)e(α−δ− 2 )t+σZ(t)
2
(5) ln S(t) is normal distributed with mean ln S(0) + (α − δ − σ2 )t and
variance σ2t .

The Sharpe Ratio

Let X(t) be the price of an asset. The Sharpe ratio of X at time t is
defined as the ratio of the instantaneous average risk premium to the
instantaneous volatility. In other word, the Sharpe ratio is a measure of
the risk return trade off.

Assuming the following:

(i) The dynamic of X(t) follows
dX(t)
= mdt + sdZ(t)
X(t)
(ii) The assets pays dividends continuously at a rate proportional to its
price. The continuous dividend yield is δ. The dollar amount of
dividend over an infinitesimally short period (t,t + dt) is
X(t)δdt
dX(t)
(iii) X(t) is instantaneous return due to capital gains.

dX(t)
(iv) mdt = E[ X(t) ] is the expected instantaneous return due to capital
gains.
dX(t)
(v) s2 dt = Var[ X(t) ] is the variance of the instantaneous return due to
capital gains.
The total return on X is the sum of capital gains and dividends. Thus, the
instantaneous risk premium is m + δ − r. The Sharpe ratio is defined by
the ratio of the instantaneous risk premium to the instantaneous standard
deviation.
dX(t)
If X(t) = mdt + sdZ(t) and the continuous dividend yield δ, then the
Sharpe ratio is
m+δ−r
φ=
s

Example 27
Consider the Black-Scholes model for a stock price S(t).
Find the Sharpe ratio.

Example 28
The time-t price of an asset S(t) follows S(t) = 10e−0.01t+0.2Z(t) where
Z(t) is a standard Brownian Motion. The asset pays dividends continu-
ously at a rate proportional to its price. The dividend yield is 2%. If the
continuously compounded risk-free interest rate is 4%, find the Sharpe
ratio of the stock.

Equality of Sharpe Ratios

The Sharpe ratios of two assets driven by the same Brownian motion
must be the same. In particular, any contingent claim written on a stock
that follows a Geometric Brownian Motion must have a Sharpe ratio of
φ = α−rσ .



Example 29
Consider two assets X and Y . There is a single source of uncertainty
which is captured by a standard Brownian Motion {Z(t)}. The stochas-
tic process of X satisfies the stochastic differential equations
d[ln X(t)] = 0.02dt + σdZ(t), σ > 0
while the price of Y satisfies Y (t) = 100e0.08t+0.25Z(t) .

You are also given that
Y pays dividends continuously at a rate proportional to its price.
The dividend yield is 0.04.
X is non-dividend-paying.
The continuously compounded risk-free interest rate is 0.06.
Determine σx .

Example 30
Let S(t) be the time-t price of a non-dividend-paying stock. The price
process for S(t) is
dS(t) = 0.26S(t)dt + 0.036S(t)dZ(t)
where Z(t) is a standard Brownian motion. The continuous compounded

risk-free rate is 0.07. For another non-dividend-paying stock whose
time-t price is Q(t):
Q(0) = 80
P(Q(1) ≥ 90) = 0.95
dQ(t) = AQ(t)dt + BQ(t)dZ(t) with B < 1.
Determine A.


The Black-Scholes Equation

Consider a derivative whose time-t price when the stock price is S(t) is
V [S(t),t].
By using Itô’s lemma, obtain dV [S(t),t].

Find m and s.

Since the stock and derivative has Brownian Motion Z(t). They
have the same Sharpe ratio, using this fact, derive the Black Sc-
holes Equation.

The Black-Scholes Equation for a derivative is
1
Vt + (r − δ)SVs + σ2 S2Vss = rV
2
∂V 2
where Vt = ∂V ∂V
∂t , Vs = ∂s , and Vss = ∂s2 .
The pricing formula for any derivative must satisfy the Black-Scholes
Equation.

Example 31
Assume the Black-Scholes framework.
(a) Show that V [S(t),t] = S(t)e−δ(T −t) , 0 ≤ t ≤ T , is the price of a
certain derivative.
(b) What derivative does V represent?


Example 32
Let S(t) be the time-t price of a stock, and V (t) is the time-t price of a
derivative security of the stock. Given:
V (t) = e0.06t (0.026t + ln s(t)).
The stock pays dividends of 0.041S(t)dt between times t and t +dt.
The derivative security does not pay dividends.
Determine σ2 , the square of volatility of the stock.


Risk-neutral Valuation
Recall in the single-period binomial model, we used risk-neutral valuation
to price derivatives.
The probability of up move is
e(r−δ)h − d
p∗ =
u−d
The most important point in risk-neutral valuation is that α is not involved
in the calculation. The quantity α only indicates the degree of risk aver-
sion in the market.

To study risk-neutral valuation in continuous time, we rearrange the dy-

namics of S so that the drift of S becomes (r − δ)S(t).
dS(t)
=(α − δ)dt + σdZ(t)
S(t)
=(r − δ)dt + σdZ(t) + (α − r)dt
α−r
=(r − δ)dt + σ[dZ(t) + dt]
σ
=(r − δ)dt + σd[Z(t) + φt]
Thus, we move to the a world where
Z̃(t) = Z(t) + φt

Let Z(t) be a standard Brownian Motion in P, and φ be the Sharpe ratio

as S, then
Z̃ = Z(t) + φt
is a standard Brownian Motion in Q.

Table below gives the summary of how the distribution of S(t) changes
from the true measure to the risk-neutral measure.
True Measure Risk-neutral Measure
Binomial (α−δ)h (r−δ)h
p = e u−d−d p∗ = e u−d
Model
Z(t) is a Z̃(t) = Z(t) + φt is a
Black-Scholes
standard Brownian standard Brownian
Model
Motion Motion
Notice that Z̃(t) is an arithmetic Brownian Motion with drift φ and unit
volatility under P, and Z(t) is an arithmetic Brownian Motion with drift
−φ and unit volatility under Q.

To compute the time-t price of a European derivative

Step 1: Compute the risk-neutral expected payoff,
E ∗ [V (S(T ).T )|S(t)].
Step 2: Discount the risk-neutral expected payoff using risk-free

rate, r
V (s(t),t) = e−r(T −t) E ∗ [V (S(T ), T )|S(t)]
A useful method to compute E ∗ [V (S(T ).T )|S(t)] is to compute
E[V (S(T ), T )|S(t)]
under the P measure. Then replace α with r.

Example 33
You are given:
S(t) is the time-t price of a stock.
The stock pays dividend continuously at a constant rate propor-
tional to its price.
The true stock price process is given by
dS(t)
= cdt + σdZ(t)
S(t)
where Z(t) is a standard Brownian motion under the true probabil-

ity measure, and c and σ are constant.

(Cont...)
The risk-neutral stock price process is given by
dS(t)
= 0.056dt + 0.18d Z̃(t)
S(t)
where Z̃(t) is a standard Brownian motion under the risk-neutral

measure.
Z(5) = Z̃(5) − 2.05
Find c.


Example 34
Assume the Black-Scholes framework. By using the risk-neutral valu-
ation, find the time-t price of a prepaid forward contract that pays one
share at T .

Valuing a Claim on Sa
Valuing a Claim on Sα
For a claim that has the time T payoff V (S(T ), T ), we can compute it
time-t price, V (S(t),t) as
V (S(t),t) = e−r(T −t) E0∗ [V (S(T ), T )]
where E0∗ represents an expectation under the risk-neutral distribution.

Suppose a stock with an expected instantaneous return of α, dividend
yield of δ, and instantaneous volatility σ follows geometric Brownian mo-
tion
dS(t) = (α − δ)S(t)dt + σS(t)dZ(t)
Consider a claim maturing at time T that pays
V [S(T ), T ] = Sα (T ).

If S follows
dS(t) = (α − δ)S(t)d(t) + σS(t)dZ(t),
using Itô’s Lemma, we obtain
1
dSa =asa−1 dS + a(a − 1)sa−2 (σS)2 dt
2
dS 1
=aSa + a(a − 1)Sa σ2 dt
S 2
1
=aSa [(α − δ)dt + σdZ(t)] + a(a − 1)Sa σ2 dt
2
1
=[a(α − δ) + a(a − 1)σ2 ]Sa dt + aσSa dZ(t)
2

Thus, Sa follows Geometric Brownian Motion with drift a(α − δ) + 12 a(a −

1)σ2 and volatility aσ.
If α is the expected return for S, if we let γ be the total return on V = Sa ,

then
γ = a(α − r) + r
and the risk premium is a(α − r).

Another way to obtain the drift term is by writing

2 )(T −t)+aσZ(T −t)
Sa (T ) = Sa (t)ea(α−δ−0.5σ
and hence
1 2 (T −t)
E[Sa (T )] = Sa (t)ea(α−δ)(T −t)+ 2 a(a−1)σ
The time-t price of an option whose payoff is Sa (T ) at time T is
V (S(t),t) =e−r(T −t) E ∗ [V (S(T ), T )]
=e−r(T −t) E ∗ [(Sa (T ))]
1 2 ](T −t)
=e−r(T −t) Sa (t)e[a(r−δ)+ 2 a(a−1)σ
1 2 ](T −t)
=Sa (t)e[−r+a(α−δ)+ 2 a(a−1)σ
p 1 2 ](T −t)
V (S(t),t) = Ft,T (Sa ) = Sa (t)e[−r+a(α−δ)+ 2 a(a−1)σ
Example 35
Let S(t) be time-t price of a non-dividend paying stock. You are given
The true stochastic process of S(t) is
d[ln S(t)] = 0.15dt + 0.27dZ(t)
ity measure.
For 0 ≤ t ≤ T , the time-t preparid forward price for a delivery of 1
p
share of S3 at time T if Ft,T (S3 ). The risk-neutral stochastic process
p
of Ft,T (S3 ) is
p
d[ln Ft,T (S3 )] = gdt + hd Z̃(t)
where Z̃(t) is a standard Brownian motion under the risk neutral
measure.
Example 36
(Cont...)
Find g.


Example 37
Assume the Black-Scholes framework for an non-dividend paying stock
whose volatility is 37%. A contingent claim pays S(6)S(5)
S2 (4)
at time 6.
Calculate the time-3 price of contingent claim.


Example 38
Let S(t) be time-t price of a non-dividend paying stock, you are given
that:
The stock price process under the true probability measure is
d[ln S(t)] = −0.01705dt + 0.39dZ(t), S(0) = 1

ity measure.
The sharpe ratio stock price risk is 0.05897.
p
Compute the price of a contingent claim that pays S(4) at time 4.


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UECM2453 Financial Economics II

Topic 1 Brownian motions and Itô’s lemma

Kuang Kee Seng

Universiti Tunku Abdul Rahman

Kuang Kee Seng (UTAR) Topic 1 1 / 129

Kuang Kee Seng (UTAR) Topic 1 2 / 129

We call Zn a random walk.The random walk may be considered a pri-

Kuang Kee Seng (UTAR) Topic 1 3 / 129

Brownian Motion (Wiener Process)

Kuang Kee Seng (UTAR) Topic 1 4 / 129

are assumed independent with

E[Z(t)] = 0 and V [Z(t)] = (∆y)2 → σ2t

Kuang Kee Seng (UTAR) Topic 1 6 / 129

By Central Limit Theorem,

Z(t) → N(0, σ2t)

In addition, because the changes of value of the random walk in nonover-

Kuang Kee Seng (UTAR) Topic 1 7 / 129

Finally, because the distribution of the change in position of the random

When σ = 1, the process is called a Standard Brownian Motion.

Kuang Kee Seng (UTAR) Topic 1 8 / 129

Properties of a Standard Brownian Motion

Kuang Kee Seng (UTAR) Topic 1 9 / 129

Z(t + s) − Z(t) = Z(s) ∼ N(0, s)

by property (3), Z(t + s) − Z(t) does not depend on Z(t), so we have

Z(t + s) − Z(t)|Z(t) ∼ N(0, s)

Kuang Kee Seng (UTAR) Topic 1 10 / 129

Z(t + s) − Z(t)|{Z(u) : 0 ≤ u ≤ t} ∼ N(0, s)

Z(t + s)|{Z(u) : 0 ≤ u ≤ t} ∼ N(Z(t), s)

Kuang Kee Seng (UTAR) Topic 1 11 / 129

Kuang Kee Seng (UTAR) Topic 1 12 / 129

(Left blank for rough work.)

Kuang Kee Seng (UTAR) Topic 1 13 / 129

Kuang Kee Seng (UTAR) Topic 1 14 / 129

Kuang Kee Seng (UTAR) Topic 1 15 / 129

Kuang Kee Seng (UTAR) Topic 1 16 / 129

(Left blank for rough work.)

Kuang Kee Seng (UTAR) Topic 1 17 / 129

Arithmetic Brownian Motions

Kuang Kee Seng (UTAR) Topic 1 18 / 129

Thus, to construct a model for stock prices, we extend Standard Brow-

X(t) = X(0) + αt + σZ(t).

Kuang Kee Seng (UTAR) Topic 1 19 / 129

Since {Z(t) : t ≥ 0} has stationary and independent increments, thus,

E[X(t)] = E[X(0) + αt + σZ(t)] = 0 + αt + σE[Z(t)] = αt

V [X(t)] = V [X(0) + αt + σZ(t)] = V [σZ(t)] = σ2t

Kuang Kee Seng (UTAR) Topic 1 20 / 129

Kuang Kee Seng (UTAR) Topic 1 21 / 129

Kuang Kee Seng (UTAR) Topic 1 22 / 129

Kuang Kee Seng (UTAR) Topic 1 23 / 129

Geometric Brownian Motions

Kuang Kee Seng (UTAR) Topic 1 24 / 129

lnY (t) = lnY (0) + X(t) = lnY (0) + µt + σZ(t)

E[lnY (t)] = lnY (0) + µt

Kuang Kee Seng (UTAR) Topic 1 25 / 129

(a) Find P(98 ≤ Y (2) ≤ 103).

Kuang Kee Seng (UTAR) Topic 1 26 / 129

(Left blank for rough work.)

Kuang Kee Seng (UTAR) Topic 1 27 / 129

Kuang Kee Seng (UTAR) Topic 1 28 / 129

(Left blank for rough work.)

Kuang Kee Seng (UTAR) Topic 1 29 / 129

Stochastic Differential Equations