1

Chapter 20
Brownian Motion and
Its Lemma
2
Introduction
Stock and other asset prices are commonly assumed to follow a
stochastic process called geometric Brownian motion.


Given that a stock price follows geometric Brownian motion, we
want to characterize the behavior of a claim that has a payoff
dependent upon the stock price.

We will discuss Itos Lemma, which permits us to study the
process followed by a claim that is a function of the stock
price.
3
The Black-Scholes Assumption
about Stock Prices
The original paper by Black and Scholes begins by assuming that
the price of the underlying asset follows a process like the
following:

(20.1)
where
S(t) is the stock price,
dS(t) is the instantaneous change in the stock price,
o is the continuously compounded expected return on the
stock,
o is the continuously compounded standard deviation
(volatility),
Z(t) is a normally distributed random variable that follows a
process called Brownian motion.
dZ(t) is the change in Z(t) over a short period of time.
) (
) (
) (
t dZ dt
t S
t dS
o o + =
4
The Black-Scholes Assumption
about Stock Prices
A stock obeying equation (20.1) is said to follow a process
called geometric Brownian motion.

Expressions like equation (20.1) are called stochastic
differential equations.

There are 2 important implications of equation (20.1):
1. Suppose the stock price now is S(0). If the stock price
follows equation (20.1), the distribution of S(T) is
lognormal, i.e.,
ln [S (T)] ~ N (ln [S (0)] + [o 0.5o
2
]T, o
2
T)

2. Geometric Brownian motion allows us to describe the
path the stock price takes in getting to a terminal point.
5
A Description of
Stock Price Behavior
The normal distribution provides an unrealistic description of the
stock price. However, normality can be a plausible description of
continuously compounded returns.
If the continuously compounded return is R(0,T), the price is
S(0) e
R(0,T)
, which is always positive.


It can be reasonable to assume that over very short periods of
time effective stock returns, S(t + h)/S(t), are normally
distributed.
6
A Description of
Stock Price Behavior
Suppose that
h, the length of each time period, is small,
the return on the stock, r
h
, is normally distributed with
mean and variance oh and o
2
h.

Thus,
S(t + h) = S(t)(1 + r
h
) (20.2)
with
r
h
= ~ N (oh, o
2
h)
7
A Description of
Stock Price Behavior
The continuously compounded return from 0 to T is



The logarithm of a normal random variable is not normal.
However, as h 0, the continuously compounded return from 0
to T is normal. Therefore, S(T) tends toward lognormality.

=
+ =
n
i
ih
r ln S T S ln

1
) 1 ( )] 0 ( / ) ( [
8
Brownian Motion

Brownian motion is a random walk occurring in continuous time,
with movements that are continuous rather than discrete.

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.

To generate Brownian motion, we would flip the coins
infinitely fast and take infinitesimally small steps at each
point.
9
Brownian Motion
Let Z(t) represent the value of the random walkthe cumulative
sum of all the movesafter t periods.

Technically, Brownian motion is a random walk with the following
characteristics:
Z(0) = 0.

Z(t + s) Z (t) is normally distributed with mean 0 and variance
s.

Z(t + s
1
) Z(t) is independent of Z(t) Z(t s
2
), where s
1
, s
2
>0.
That is, nonoverlapping increments are independently
distributed.

Z(t) is continuous.
10
Brownian Motion
We can think of Brownian motion being approximately
generated from the sum of independent binomial draws with
mean 0 and variance h.


Let h get arbitrarily small, and rename h as dt.
Denote the change in Z as dZ(t).


11
Brownian Motion
Then,
(20.5)

where Y(t) is a random draw from a binomial distribution, such that Y(t)
is 1 with probability 50%.


Equation (20.5) says Over small periods of time, changes in the
value of the process are normally distributed with a variance that
is proportional to the length of the time period.
dt t Y t dZ ) ( ) ( =
12
Brownian Motion
Since Z(T) is the sum of individual dZ(t)s, we can write

(20.6)

The integral here is called a stochastic integral.
The process Z(t) is also called a diffusion process.


Among properties of Brownian motion are:
infinite-crossing property, and
infinite variation.
}
+ =
T
t dZ Z T Z
0
) ( ) 0 ( ) (
13
Arithmetic Brownian Motion
With pure Brownian motion, the expected change in Z is 0, and
the variance per unit time is 1. We can generalize this to allow
an arbitrary variance and a nonzero mean.
(20.8)


This process is called arithmetic Brownian motion.
o is the instantaneous mean per unit time,
o
2
is the instantaneous variance per unit time,
the variable X(t) is the sum of the individual changes dX.
X(t) is normally distributed, i.e., X(T) X(0) ~ N (oT, o
2
T).
) ( ) ( t dZ dt t dX o o + =
14
Arithmetic Brownian Motion
An integral representation of equation (20.8) is



Here are some properties of the process in equation (20.8):
X(t) is normally distributed because it is created by
adding together many normally distributed dXs.

The random term is multiplied by a scale factor that
enables us to change variance.

The odt term introduces a nonrandom drift into the
process.
} }
+ + =
T T
t dZ dt X T X
0 0
) ( ) 0 ( ) ( o o
15
Arithmetic Brownian Motion
Arithmetic Brownian motion has several drawbacks:

There is nothing to prevent X 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.


Both of these criticisms will be eliminated with geometric
Brownian motion.
16
The Ornstein-Uhlenbeck Process
We can incorporate mean reversion by modifying the drift
term:
(20.9)

When o = 0, this equation is called an Ornstein-Uhlenbeck
process.
The parameter measures the speed of the reversion: If
is large, reversion happens more quickly.
In the long run, we expect X to revert toward o.
As with arithmetic Brownian motion, X can still become
negative.
( ) [ ( )] ( ) dX t X t dt dZ t o o = +
17
Example of Mean-Reverting Process
-0.2
0
0.2
0.4
0.6
0.8
1
0 1000 2000 3000 4000 5000 6000
18
Geometric Brownian Motion
An equation, in which the drift and volatility depend on the
stock price, is called an It process.

Suppose we modify arithmetic Brownian motion to make
the instantaneous mean and standard deviation
proportional to X(t):


This is an It process that can also be written

(20.11)

This process is known as geometric Brownian motion.
) (
) (
) (
t dZ dt a
t X
t dX
o + =
) ( ) ( ) ( ) ( t dZ t X dt t X a t dX o + =
19
Geometric Brownian Motion
The percentage change in the asset value is normally
distributed with instantaneous mean o and instantaneous
variance o
2
.


The integral representation for equation (20.11) is


} }
+ =
T T
t dZ t X dt t X X T X
0 0
) ( ) ( ) ( ) 0 ( ) ( o o
20
Example of Geometric Brownian
Motion
0
5
10
15
20
25
30
35
40
45
50
0 1000 2000 3000 4000 5000 6000
21
Lognormality

If a variable is distributed in such a way that instantaneous
percentage changes follow geometric Brownian motion, then
over discrete periods of time, the variable is lognormally
distributed.
22
Relative importance of the drift and
noise terms
Over short periods of time, the character of the Brownian
process is determined almost entirely by the random
component.
Consider the ratio of the per-period standard deviation to the
per-period drift:


The ratio becomes infinite as h approaches dt.

As the time interval becomes longer, the mean becomes more
important than the standard deviation.
h
h t X
h t X
o
o
o
o
=
) (
) (
23
Relative importance of the drift and
noise terms







The results in the table hold for both geometric Brownian motion
and arithmetic Brownian motion.
24
Correlated It processes
Let W
1
(t) and W
2
(t) be independent Brownian motions.
Then,

(20.16)
This is the Cholesky decomposition.

The correlation between Z(t) and Z'(t) is


The second term on the right-hand side is 0 because W
1
(t) and
W
2
(t) are independent.
) ( 1 ) ( ) (
) ( ) (
2
2
1
1
t W t W t Z
t W t Z
'
+ =
=
0 )] ( ) ( [ 1 ] ) ( [ )] ( ) ( [
2 1
2 2
1
+ = + = t t W t W E t W E t Z t Z E
'

25
Multiplication rules
We can simplify complex terms containing dt and dZ by
using the following multiplication rules:
dt dZ = 0 (20.17a)
(dt)
2
= 0 (20.17b)

(dZ)
2
= dt (20.17c)

dZ dZ' = dt (20.17d)

The reason behind these multiplication rules is that the
multiplications resulting in powers of dt greater than 1 vanish.
26
The Sharpe Ratio
If asset i has expected return o
i
, the risk premium is defined as
Risk premium
i
= o
i
r
where r is the risk-free rate.

The Sharpe ratio for asset i is the risk premium, o
i
r, per unit
of volatility, o
i
:

(20.18)
i
i
i
r
o

= ratio Sharpe
27
The Sharpe Ratio
We can use the Sharpe ratio to compare two perfectly
correlated claims, such as a derivative and its underlying
asset.

Two assets that are perfectly correlated must have the same
Sharpe ratio, or else there will be an arbitrage opportunity.

Consider the processes for two non-dividend paying
stocks:
dS
1
= o
1
S
1
dt + o
1
S
1
dZ (20.19)
dS
2
= o
2
S
2
dt + o
2
S
2
dZ (20.20)

Because the two stock prices are driven by the same dZ,
it must be the case that (o
1
r)/ o
1
= (o
2
r)/ o
2
.
28
The risk-neutral process
Suppose the true price process is



where o is the dividend yield on the stock.

We can write a risk-neutral version of this process by
subtracting the risk premium, o r, from the drift, o o:

(20.25)

The probability distribution (dZ*(t)) associated with
the risk-neutral process is said to be the risk-
neutral measure.
When we switch to the risk-neutral process, the
volatility remains the same.
) ( ) (
) (
) (
t dZ dt
t S
t dS
o o o + =
) ( ) (
) (
) (
*
t dZ dt r
t S
t dS
o o + =
29
Its Lemma
Suppose a stock with an expected instantaneous return of o,
dividend yield of o, and instantaneous volatility o follows
geometric Brownian motion:
dS(t) = (o o)S(t)dt + oS(t)dZ(t) (20.26)

C[S(t), t] is the value of a derivative claim that is a function of the
stock price.

How can we describe the behavior of this claim in terms of the
behavior of S?
30
Its Lemma
Its Lemma (Proposition 20.1) If C[S(t), t] is a
twice-differentiable function of S(t), then the change
in C is


(20.27)





where we recognize the delta-gamma approximation.



2
1
( , ) ( )
2

S SS t
dC S t C dS C dS C dt = + +
31
Its Lemma
In the case where S follows a Geometric
Brownian motion, we have:








where C
S
= cC/cS, C
SS
= c
2
C/cS
2
, and C
t
= cC/ct.


The terms in square brackets are the expected
change in the option price.

2 2
( )
1
( )
2
S SS t S
dS Sdt SdZ and so
dC SC S C C dt SC dZ
o o
o o o
= +
(
= + + +
(

32
Its Lemma Application
Let C(S) = ln(S) so that the value of C is
the logarithm of S.

Let dS = oSdt + oSdZ

Compute the path for the changes in C,
i.e. compute the expression for dC.

33
Its Lemma Application: solution
C
S
= cC/cS = c(ln(S))/cS = 1/S.
C
SS
= c
2
C/cS
2
= c(1/S)/cS = -1/S
2
.
C
t
= cC/ct = 0 because C = ln(S) and is
not a function of t.

Therefore dC = [o (1/2)o
2
]dt + odZ
34
Multivariate Its Lemma
A derivative may have a value depending on more than one
price, in which case we can use a multivariate generalization of
Its Lemma.

Multivariate Its Lemma (Proposition 20.2) Suppose we
have n correlated It processes:




Denote the pairwise correlations as E(dz
i
dz
j
) =
i,j
dt.
n i dz dt
t S
t dS
i i i
i
i
., . . , 1 ,
) (
) (
= + = o o
35
Multivariate Its Lemma
If C(S
1
, . . ., S
n
, t) is a twice-differentiable function of the S
i
s, we
have




The expected change in C per unit time is


= = =
+ + =
n
i
n
i
t
n
j
S S j i i S n
dt C C dS dS dS C t S S dC
j i i 1 1 1
1
2
1
) , ., . . , (

= = =
+ + =
n
i
t
n
j
S S j i ij j i
n
i
S i i n
C C S S C S t S S dC E
dt
j i i 1 1 1
1
2
1
)] , ., . . , ( [
1
o o o
36
Valuing a Claim on S
a
Suppose a stock with an expected instantaneous return of o,
dividend yield of o, and instantaneous volatility o follows
geometric Brownian motion:
dS(t) = (o o)S(t)dt + oS(t)dZ(t)


Now suppose that we also have a claim with a payoff depending
on S raised to some power.
For example, we may have a claim that pays S(T)
2
at time T.

37
Valuing a Claim on S
a
Proposition 20.3 The value at time 0 of a claim paying
S(T)
a
the prepaid forward priceis

(20.29)

The forward price for S(T)
a
is

(20.30)


T a a r a
a rT a P
T
e S e T S F
] ) 1 (
2
1
) ( [
, 0
2
) 0 ( ] ) ( [
o o +

=
T a a r a
a a
T
e S T S F
] ) 1 (
2
1
) ( [
, 0
2
) 0 ( ] ) ( [
o o +
=
38
The process followed by S
a
Consider a claim maturing at time T that pays C[S(T),
T] = S(T)
a
.

We can use Its Lemma to determine the process
followed by S
a
.


Give it a try, by using:

2
1
( , ) ( )
2

S SS t
dC S t C dS C dS C dt = + +
39
The process followed by S
a
We get:

(20.31)


Thus, S
a
follows geometric Brownian motion with drift
a (o o) + 1/2a (a 1)o
2
and risk aodZ.

If o is the expected return for S, the expected return of a
claim with price S
a
will be
a (o r) + r (20.32)

and the risk premium will be a (o r). This is necessary
to have the same Sharpe ratios.
dZ a dt a a a
S
dS
a
a
o o o o +
(

+ = ) 1 (
2
1
) (
2
40
Examples
Claims on S: Suppose a = 1. Equation (20.29) then gives us

the prepaid forward price on a stock:


Claims on S
0
: If a = 0, the claim does not depend on the
stock price. Since S
0
= 1, it is a bond. Setting a = 0 gives us


the price of a T-period pure discount bond:
T
e S V
o
= ) 0 ( ) 0 (
rT
e V

= ) 0 (
41
Examples
Claims on S
2
: When a = 2, the claim pays S(T)
2
. From
equation (20.30), the forward price is


(20.35)


Thus, the forward price on the squared stock price is the squared
forward price times a variance term.
T
T
T T r
T r rT
T
e S F e e S
e S e S F
2 2
2
2
, 0
) ( 2 2
] 2 [ 2 2
, 0
)] ( [ ) 0 (
) 0 ( ) (
o o o
o o
= =
=

+
42
Examples
Claims on 1/S: If a = 1, the claim pays 1/S. Using
equation (20.30), we get



As with the squared security, the forward price is increasing in
volatility.

The payoffs for both the S
2
and 1/S securities are
convex. Therefore, according to Jensens inequality, the
price is higher when the asset price is risky than when it
is certain.
2
( )
0,
(1/ ) [1/ (0)]
r T T
T
F S S e e
o o
=
43
Valuing a claim on S
a
Q
b
Suppose a claim pays S(T)
a
Q(T)
b
, where S follows

(20.36)

and Q follows

(20.37)

where
S S S S
dZ dt
S
dS
o o o + = ) (
Q Q Q Q
dZ dt
Q
dQ
o o o + = ) (
dt dZ dZ
Q S
=
44
Valuing a claim on S
a
Q
b
Proposition 20.4 Suppose that the forward prices for S
a

and Q
b
are given by Proposition 20.3. Then the forward
price for S
a
Q
b
is


The forward price for S
a
Q
b
is the product of those two forward
prices times a factor that accounts for the covariance between the
two assets.

The variance of S
a
Q
b
is given by

) (
, , ,
) ( ) ( ) (
t T ab
b
T t
a
T t
b a
T t
Q S
e Q F S F Q S F

=
o o
Q S Q S
ab b a o o o o 2
2 2 2 2
+ +
45
Valuing a claim on S
a
Q
b
The squared security, S
2
, is a special case of Proposition 20.4.

When S = Q, a = b = 1, and = 1, the covariance term becomes



This gives us the same result as equation (20.35) for the forward price
for a squared stock.
2
S Q S
ab o o o =
46
Valuing a claim on S
a
Q
b
Proposition 20.4 can be generalized.

Suppose there are n stocks, each of which follows the
process

(20.40)

where dz
i
dz
j
=
ij
dt. Let

(20.41)
The forward price for V is then

(20.42)
i i i i
i
i
dz dt
S
dS
o o o + = ) (
[
=
=
n
i
a
i
i
S t V
1
) (
[
=

=

= + =
n
i
a a
a
i T T
n
i
n
i j
j i j i ij
i
e S F V F
1

, 0 , 0
1
1 1
)] ( [ ) (
o o
47
Jumps in the Stock Price
One objection to the Brownian process as a model of the stock
price is that Brownian paths are continuousthere are no
discrete jumps in the stock price.

In practice, asset prices occasionally seem to jump (e.g., on
October 19, 1987).

One way to model such jumps is by using the Poisson
distribution mixed with a standard Brownian process.

48
Jumps in the Stock Price
Let q(t) represent the cumulative jump and dq the change in the
cumulative jump.
When there is no jump, dq = 0.
When there is a jump, we let the random variable Y denote
the magnitude of the jump, and k = E(Y) 1 is then the
expected percentage change in the stock price.

If is the expected number of jumps per unit time over an
interval dt, then
Prob(jump) = dt
Prob(no jump) = 1 dt
49
Jumps in the Stock Price
We can write the stock price process as

dS(t)/S(t) = (o k)dt + odZ + dq (20.43)
where
0 if there is no jump
dq =
Y-1 if there is a jump

and E(dq) = kdt.

When no jump is occurring, the stock price S evolves as geometric
Brownian motion. When the jump occurs, the new stock price is
YS.
50
Example of Jumps in the Process
0
10
20
30
40
50
60
70
80
0 1000 2000 3000 4000 5000 6000
51
Jumps in the Stock Price
Proposition 20.5 Suppose an asset follows equation (20.43).
If C(S, t) is a twice continuously differentiable function of the
stock price, the process followed by C is


(20.44)

The last term in the equation is the expected change in the
option price conditional on the jump times the probability of the
jump.
)] , ( ) , ( [
2
1
) , (
2 2
t S C t SY C E dt C dt S C dS C t S dC
Y t SS S
+ + + = o