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Chapter 12
Stochastic Processes
xt = a + bxt 1 + t
mean.
Continuous time; discrete variable
Continuous time; continuous variable
Questions
10
z= t where is (0,1)
11
i =1
Mean of [z (T ) z (0)] is 0
Variance of [z (T ) z (0)] is T
Standard deviation of [z (T ) z (0)] is T
12
Taking Limits . . .
dz = dt
What does an expression involving dz and dt
mean?
It should be interpreted as meaning that the
corresponding expression involving z and t is
true in the limit as t tends to zero
In this respect, stochastic calculus is analogous to
ordinary calculus
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14
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x = at + b t
Mean change in x in time T is aT
Variance of change in x in time T is b2T
Standard deviation of change in x in time T is b T
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17
Why
b t
?(1)
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Why
b t
?(2)
Why b
?(3)
h = b t
a
a
1
1
t ], q =
t ]
[1 +
[1
p=
2
2
b
b
a
a
p q=
t = 2 h
b
b
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Why b
?(4)
and variance
a
h
t 2 h
=
at
b
t
a 2 b 2 t
t[1 ( ) t]
b 2t
b
t
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x (t) =
x0 + a ( x, t ) ds + b ( x, t ) dz
=
x a( x, t)t + b( x, t) t
dS S dt + S dz
=
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=
S 0.00288S + 0.0416S
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Week
Stock Price at
Start of Period
Random
Sample for
Change in Stock
Price, S
100.00
0.52
2.45
102.45
1.44
6.43
108.88
-0.86
-3.58
105.30
1.46
6.70
112.00
-0.69
-2.89
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G
G
G=
x +
t
x
t
In stochastic calculus this becomes
G
G
2G
2
G
=
x+
t + ?
x
x
t
x2
because x has a component which is of order t
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Substituting for x
Suppose
=
dx a(x ,t)dt + b(x ,t)dz
so that
x=at+b t
Then ignoring terms of higher order than t
G
G
2G 2 2
G
=
x +
t + ?
b t
2
x
t
x
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The 2t Term
Since (0,1) , E( ) = 0
E( 2 ) [ E( )]2 =
1
E( 2 ) = 1
It follows that
E( 2 t) =t
G
G
1 2G 2
G
b t
=
x +
t +
2
x
t
2x
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Taking Limits
Taking limits:
G
G
2G 2
dG =
dx +
dt + ?
b dt
2
x
t
x
Substituting:
dx a dt + b dz
=
We obtain:
G
G
2G 2
G
dG=
a+
b
dt
b dz
+?
+
2
t
x
x
x
This is Ito's
Lemma
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Examples
1. The forward price of a stock for a contract
maturing at time T
G = S e r (T t )
( r )G dt + G dz
dG =
2. G = ln S
2
dG =
2
dt + dz
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Examples
Suppose F(x,y)=xy, where x and y each follow geometric
Brownian motions:
=
dx ax xdt + bx xdz x
=
dy a y ydt + by ydz y
with E ( dzidz j ) = ijdt .
Whats the process followed by F(x,y) and by G=logF?
= ( ax + a y + bxby ) Fdt + ( bx dz x + by dz y ) F
1 2 1 2
dG = ax + a y bx by dt + bx dz x + by dz y
2
2
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