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Modelling stock price movements

By: A V Vedpuriswar

July 31, 2009

Modelling stock price movements


To measure the market risk of an asset portfolio, we
have to understand the pattern of movement of the
underlying.
We should be able to model the price of the underlying.
The most celebrated modeling has been done for stocks.
But this work can be extended to other asset classes too.
Before we look at the modeling techniques, we need to
gain a basic understanding of stochastic processes.

Stochastic processes
When the value of a variable changes over time in an
uncertain way, we say the variable follows a stochastic
process.
In a discrete time stochastic process, the value of the
variable changes only at certain fixed points in time.
In case of a continuous time stochastic process, the
changes can take place at any time.
Stochastic processes may involve discrete or continuous
variables.
The continuous variable continuous time stochastic
process is usually used for describing stock price
movements.
3

Markov Process
In a Markov process, the past cannot be used to predict
the future.
Stock prices are usually assumed to follow a Markov
process.
All the past data have been discounted by the current
stock price.
Suppose we have a coin tossing game where for every
head we gain $1 and for every tail, we lose $1.
Then the expected value of the gains after i tosses will
be zero.
For every toss, the expected value of the gains is zero.
4

Suppose we use Si to denote the total amount of money


we have actually won up to and including the ith toss.
Then the expected value of Si is zero.
On the other hand, let us say we have already had 4
tosses and S4 is the total amount of money we have
actually won.
The expected value of the fifth toss is zero.
Thus the expected value after five tosses is nothing but
S4.
That is no change is expected in the variable.
This leads to the idea of Wiener process.
5

Wiener Process
A stochastic Markov process with mean change = 0 and variance
= 1 per year is called a Wiener process.
A variable z follows a Wiener process if the following conditions
hold:
Change z during a small period of time t is given by
z = t,
is a standard normal random variable(mean = 0, std devn = 1)
The values of z for any two different short intervals of time, t
are independent.
Mean of z

Variance of z = t

0
or Standard deviation = t

Illustration
To illustrate, say a variable follows a Wiener process
and has an initial value of 20, at the end of one year.
The expected change in the value of the variable is 0.
The variable will be normally distributed with a mean
of 20 and a standard deviation of 1.0.
At the end of 5 years, the mean will remain 20 but
the standard deviation will be 5.
This is an extension of the principle used to scale
volatility as we go further out in time.

Generalized Wiener Process


Here the mean does not remain constant.
Instead, it drifts at a constant rate.
This is unlike the basic Wiener process which has a
drift rate of 0 and variance of 1.
The generalized Wiener process can be written as:

dx

a dt + bdz

or

dx

a dt + bt

Suppose the value of a variable is currently 40.


The drift rate is 10 per year while the variance is 900 per year.
This means the expected change in the variable is 10 in a year.
If we consider a period of 1 year the variable will be normally
distributed, with
mean of 40+10 = 50
std deviation of 30.

If we consider a period of 6 months, the variable will be


normally distributed with
mean of 40+5 = 45
std devn of 30.5 = 21.21.

Ito Process
The generalised Wiener process is useful but needs to be
modified to make it useful for modelling stock prices.
An Ito process is nothing but a generalized Wiener process
Each of the parameters, a, b, is a function of the value of
both the underlying variable x and time, t.
Earlier a was a function only of t.
In an Ito process, the expected drift rate and variance
rate of an Ito process are both liable to change over time.

x = a (x, t) t + b (x, t) t

A process called Itos Lemma will come in handy while


developing the Black Scholes equation.

10

Geometric Brownian Motion


It is tempting to write ds = dt + dz, where ds is the
change in stock price.
But this is not logical.
The most widely used model of stock price behaviour
is given by the equation:

dS
S

dt + dz

is the volatility of the stock price


is the expected return.
This model is called Geometric Brownian motion.
The first term on the right is the expected return and
the second is the stochastic component.
14

Riskless protfolio
In general, many variables can be broken down into a
predictable deterministic component and a risky
stochastic or random component.
When we construct a risk free portfolio, our aim will be
to eliminate the stochastic component.
The component which moves linearly with time has no
risk.

15

Illustration
Suppose a stock has a volatility of 20% per annum and provides an
expected return of 15% per annum with continuous compounding.
The process for the stock price can be written as:

dS
S

.15dt + .20dz

or

S
S

.15 t + .20 z

or

S
S

.15 t + .20 t

If the time interval = 1 week = .0192 years and the initial stock price is
50. S

50 (.15 x .0192 + .20 .0192)

.144 + 1.3856

16

Understanding Geometric Brownian Motion


To get a good intuitive understanding of Geometric
Brownian motion, we draw on the work of Neil A Chriss.
Consider a heavy particle suspended in a medium of light
particles.
These particles move around and crash into the heavy
article.
Each collision slightly displaces the heavy particle.
The direction and magnitude of this displacement is
random.
It is independent of other collisions.
Each collision is an independent, identically distributed
random event.
17

The stock price is equivalent to the heavy article.


Trades are equivalent to the light particles.
We can expect stock prices will change in proportion to
their size.
As the returns we expect do not change with the stock
prices.

18

Thus we would expect 20% return on Reliance shares


whether they are trading at Rs. 50 or Rs. 500.
So the expected price change will depend on the
current price of the stock.
So we write:

s = S (dt + dz).

Because we scale by S, it is called Geometric


Brownian Motion.

Short and long run


In the short run, the return of the stock price is
normally distributed.
The mean of the distribution is t.
The std devn is t.
is the instantaneous expected return.
is the instantaneous standard deviation.

20

The long run


In the long term, things are different.
Let S be the stock price at time, t.
Let be the instantaneous mean.
Let be the instantaneous standard deviation.
The return on S between now (time t) and future
time, T is normally distributed with a mean of (-2/2)
(T-t) and std devn of T-t.
Why do we write (-2/2) and not ?
What is the intuitive explanation?
21

Geometric Brownian Motion


We need to first understand that volatility tends to depress
the returns below what the short term returns suggest.
Expected returns reduce because volatility jumps do not
cancel themselves.
A 5% jump multiplies the current stock price by 1.05; A 5%
fall multiplies the amount by .95.
If a 5% jump is followed by a 5% fall or vice versa, the stock
price will reach 0.9975, not 1!
In general, if a positive return x is followed by a negative
return x, the price will reach (1+x) (1-x) = 1- x 2
How do we estimate the value of x?
Consider a random variable x.
variance of x as follows:

We can calculate the


22

2 = E [x2] {E[x]}2 = E [x2]


and downs in x cancel out)

(assuming E[x] = 0, ie., ups

Thus the expected value of x 2 is the variance.


But the amount by which the returns are depressed when a
positive movement of x is followed by an equal negative
movement is x2.
For two moves, the depression is x2.
So we could say that the average depression per move is
x2/2.
But the expected value of x2 is 2 .
So we can write 2 /2 as the expected value of the amount by
which the returns fall from the mean.
That is why we write (-2/2) and not .
23

Geometric Brownian Motion


Can we make some prediction about the kind of distribution followed by the
stock price under the assumption of a Geometric Brownian Motion? Let us
begin with the assumption that the stock returns are normally distributed.
Annualised return from t0 to T =

1
S
ln T
T t 0 S t0

ST = future price St0 = current price, T-t0 is expressed in years.


Annualised return

1
1
lnST
lnSt0
T t0
T t0

Let random variable X

1
1
lnST
lnS t0
T t0
T t0

Let us define a new random variable

X+

1
lnS t0
T t0

The second term of the expression is a constant. So the basic characteristics


of the distribution are not affected. Only the mean
changes.
Also

X+

or (T-t0) X + ln St0

1
lnS t0
T t0

1
lnST
T t0

ln ST

24

Geometric Brownian Motion


The mean return on S from time t to time T is (T-t) (r-2/2), while the std
devn is T-t
The return on S from time t to T = ln ST /St
The random variable
= 1.

is normally distributed with mean = 0 and std devn

Suppose a call option on the stock with strike price, K is in the money at
expiration.
We want to estimate the probability of the stock price exceeding the strike
price.

ST K

ST/St K/St

ln (ST/St) ln (K/S
t)
2
S

ln T (T t )(r
)
St
2
T t

ln

K
2
(T t )(r )
ST
2
T t
25

Geometric Brownian Motion

ln

St
2
ln
(T t )(r )
ST
2
T t

of both sides and noting that

St
2
(T t )(r
)
K
2
T t
(Taking

ln

S
K
ln t
ST
K

ln

the

negative

S
ST
ln t
St
ST

The probability of the stock price exceeding the strike price can be
written as:
2
lnSt / K (T t )(r / 2)
P (ST K) = N [ (=
]
( T t )
But r(T-t) = ln er(T-t)
( x = elnx)
2

Or P (ST K) =

(ln
N[

St

r (T t ) (T t )( )
K
2 ]
T t

St
lne r (T t ) (T t ) 2 / 2
N[ k
]
( T t )
St e r (T t )
ln
(T t ) 2 / 2
K
N
( T t )
(ln

26

Geometric Brownian Motion


This expression reminds us of the Black Scholes formula!
Indeed, GBM is central to Black Scholes pricing.
GBM assumes stock returns are normally distributed.
But empirical data reveals that large movements in stock price are
more likely than a normally distributed stock price model suggests.
The likelihood of returns near the mean and of large returns is greater
than that predicted by GBM while other returns tend to be less likely.
There is also evidence that monthly and quarterly volatilities are
higher than annual volatility.
Daily volatilities are lower than annual volatilities.
So stock returns do not scale as they are supposed to.

27

Itos lemma
Let us move closer to the Black Scholes formula.
Black and Scholes formulated a partial differential equation which
they later solved, with the help of Merton by setting up boundary
conditions.
To understand the basis for their differential equation, we need to
appreciate Itos lemma.
Consider G, a function of x.
The change in G for a small change is x can be written as:
G =

G
x
dx

We can understand this intuitively by stating that the change in G


is nothing but the rate of change with respect to x multiplied by
the change in x.
If we want a more precise estimate,
we can use the Taylor series:
3
2
G =

dG
x
dx

1d G
(x) 2
2
2 dx +

1d G
(x)3 .....
3
6 dx

28

Itos lemma
Now suppose G is a function of two variables, x and t.
We will have to work with partial derivatives.
This means we must differentiate with respect to one variable at a time, keeping
the other variable constant. We could write:
G =

G
G
x
t
dx
dt
Again, if we want to get a more accurate estimate, we could use the Taylor

series:

G =

G
G
1 2G
2G
1 2G
2
x
t
(x)
(x)(t )
(t ) 2
2
2
x have
t a variable
2 x
xdtfollows the
2 tIto process.
Suppose we
x that

dx = a (x,t) dt+ b(x,t) dz

or

x = a(x,t) t + b(x,t)t

or

x = a t + b t

follows a standard normal distribution, with mean = 0 and standard deviation =


1.

29

Itos lemma
We can write (x)2 = b22 t + other terms where the power of t is
higher.
If we ignore these terms assuming they are too small, we can write:

x2 = b22 t

All the other terms have t with power 2 or more. They can be ignored.
But x2 itself is big enough and cannot be ignored.
G
1 G
2
Let us now goG
back
x to Gand
t write:
(

x
)
x
t
2 x 2

G =

But (x)2 = b22 t as we just saw a little earlier.


It can be shown (beyond the scope of this coverage) that the expected
value of 2 t is t, as t becomes very small.
Thus

(x)2

b2t

30

Itos lemma
But dx = a(x,t) dt + b(x,t) dz
So we can rewrite:
2

G
1

G 2
dG
=
(adt bdz )
dt
b dt
2
x
t
2 x

G
1

G 2
G
= (a

b
)
dt

b
dz
x t 2 x 2
x

This is called Itos lemma.


It is very much a type of generalised Weiner process.

31

The Black Scholes differential equation


The Itos lemma is very useful when it comes to framing the Black
Scholes differential equation.
Let us assume that the stock price follows Geometric Brownian motion,
i.e.,
S
t t
S

Or S = St + Sz

Let f be the price of a call option written on the stock whose price is
modeled as S.
f is a function of S and t.
or S = a (S,t) dt +b (S,t) dS.
Applying Itos lemma, we can relate the change in f to the change in S .
Comparing with the general expression for Itos Lemma, we get:
G = f , a = S and b = S, x =2 S,

or

f
f 1 f 2 2
f
s

Sz

2
t 2 S
s
s

32

The Black Scholes differential equation


Our aim is to create a risk free portfolio whose value does not depend on
the S, the stochastic variable. Suppose we create a portfolio with a long
f
position
of
shares and a short position of one call option.
s
The value of the portfolio will be

= -f +s

(Value means the net positive investment made. So a purchase gets a


plus sign and a short sale gets a negative sign.)
f

We will see later that s


is nothing but delta and the technique used
to create a risk free portfolio is called delta hedging.
Change in the value of the portfolio will be:

- f +

f
s

f
f 1 f 2 2
f
f

s
S t Sz s
2
t 2 s
s
s
s

33

The Black Scholes differential equation


But s = St+Sz
or =

or =

f
f
1 2 f 2 2
f
f
st t

( st sz )
s
t
2 s 2
s
s
f
f
1 2 f 2 2
f
f
f
St t
s t Sz st sz
2
s
t
2 s
s
s
s
f
1 2 f 2 2
t
s t
t
2 s 2

f 1 2 f 2 2

s t
2

t
2

This equation does not have a s term.


It is a riskless portfolio, with the stochastic or risky component having been
eliminated.
The total return depends only on the time. That means the return on the portfolio
is the same as that on other short term risk free securities. Otherwise, arbitrage
would be possible.
So we could write the change in value of the portfolio as:
= r t where r is the risk free rate. (Because this is a risk free portfolio)

34

The Black Scholes differential equation


But = -f +f s
s
and

f 1 2 f 2 2
(
s )t
t 2 s 2

or -

f 1 2 f 2 2

s t
2
t 2 s

or

rf

or

r f
s

s t

f 1 2 f 2 2
f

s r s
2
t 2 s
s

f
f 1 2 2 2 f
rf
rs s
t
s 2
s 2

This is the Black Scholes differential equation.


The portfolio used in deriving the Black Scholes differential equation is
f
riskless only for a very short period of time
when
is constant.
s
f

With change in stock price and passage of time,


s

can change.

So the portfolio will have to be continuously rebalanced to achieve what


is called a perfectly hedged or zero delta position.
This is also called dynamic hedging.
Solving the equation with appropriate boundary conditions gives us the
black Scholes formula.
35

The Black Scholes formula


Let C be the value of the call, P that of the put, K the
strike price
C

= S0 N(d1) Ke-rT N(d2)

d1

= [ln(S0/k) + (r+2/2)T] / T

d2

= d1 - T

C P =

S0 Ke-rT

or P =

C S0 + Ke-rT

S0N(d1) Ke-rT N(d2) S0 + Ke-rT

Ke-rT [1 N(d2)] + S0 [N (d1) 1]

Ke-rT N(-d2) S0 N(-d1)