Derivatives (ECONM3017)

Lecture Eight: Options III

(Wiener Processes and Itô’s Lemma)

Nick Taylor
nick.taylor@bristol.ac.uk

University of Bristol

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Table of contents

1 Learning Outcomes

2 Stochastic Process Types

3 Continuous-time Stochastic Processes

4 An Alternate Representation

5 Functions of Stochastic Variables

6 Summary

7 Reading

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Learning Outcomes

At the end of this lecture you will be able to:

1 Distinguish between a variety of stochastic processes.
2 Provide a mathematical description of the process followed by asset prices
(in continuous time).
3 Represent approximations to stochastic processes diagrammatically.
4 Apply Itô’s lemma.

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Stochastic Process Types

A Stochastic Process
Any variable whose value changes over time in an uncertain way.
Stochastic processes can be categorised as follows:
Discrete-time stochastic process.
Continuous-time stochastic process.
Discrete-variable stochastic process.
Continuous-variable stochastic process.

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Stochastic Process Types (cont.)

A Markov Process
A stochastic process where only the current value of a variable is
relevant for predicting the future.
The Markov property of stock prices is consistent with weak-form
market efficiency.

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Continuous-time Stochastic Processes)

A Wiener Process (aka Brownian Motion)

Let z follow a type of Markov process called a Wiener process. Consider
changes in z, denoted ∆z, over short periods of time, denoted ∆t.
√
Property One: ∆z and ∆t are related by ∆z =  ∆t, where  has a
standard normal distribution N(0, 1).
Property Two: For any two different ∆t’s, the values of ∆z are
independent. This implies that z will follow a Markov process.
Strictly speaking z is a Wiener process
√
only when ∆t → 0, hence dz =  dt.

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Continuous-time Stochastic Processes (cont.)

A Wiener Process (cont.)

Some additional information:
√ √
E(∆z) = E( ∆t) = E() × ∆t = 0,

and √
var(∆z) = var( ∆t) = var() × ∆t = ∆t.
Both of which imply that ∆z ∼ N(0, ∆t).

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Continuous-time Stochastic Processes (cont.)

A Generalised Wiener Process

A Wiener process has a drift rate of zero and a variance rate of one (that is,
var(∆z) = 1 × time interval used). By contrast, a generalised Wiener
process, x, has a drift rate of a and a variance rate of b 2 . Such a process is
given by the following equation:

dx = a dt + b dz,
√
= a dt + b  dt.

A discrete version of this process is given by

∆x = a ∆t + b ∆z,
√
= a ∆t + b  ∆t.

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Continuous-time Stochastic Processes (cont.)

A Generalised Wiener Process (cont.)

Some additional information:
√
E(∆x) = E(a ∆t + b  ∆t) = E(a ∆t) = a ∆t,

and √ √
var(∆x) = var(a ∆t + b  ∆t) = var(b  ∆t) = b 2 ∆t.
Both of which imply that ∆x ∼ N(a ∆t, b 2 ∆t).

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Continuous-time Stochastic Processes (cont.)

A Generalised Wiener Process (cont.)

The following graphs contain plots of generalised Wiener processes.

Note: The first plot assumes that a = 1 and b = 1/2, while the second
assumes that a = 1 and b = 2. Both plots are based on 10000 observations
with ∆t = 1/1000.

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Continuous-time Stochastic Processes (cont.)

An Itô Process
This is a generalised Wiener process that allows the parameters a and b to
be functions of the value of the underlying variable x, and time t. This is
represented as follows:

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

A discrete version of this process is given by

√
∆x = a(x, t) ∆t + b(x, t)  ∆t,

where it is assumed that a(x, t) and b(x, t) remain constant during the time
interval between t and t + ∆t.

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Continuous-time Stochastic Processes (cont.)

A Process for Stock Prices

Consider the following expected price processes:
Time Stock A Stock B Stock A Stock B
Period Price Price Return Return
1 100 100 / /
2 110 110 10% 10%
3 120 121 9.1% 10%
4 130 133 8.3% 10%

Which process is more appropriate?

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Continuous-time Stochastic Processes (cont.)

A Process for Stock Prices (cont.)

Regarding Stock A and Stock B:
The process underlying Stock A (generalised Wiener process) is
inappropriate.
The process underlying Stock B is more appropriate.

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Continuous-time Stochastic Processes (cont.)

A Process for Stock Prices (cont.)

If the variance rate of Stock B price is zero then,
dS
dS = µ S dt, or = µ dt.
S
Integrating between time 0 and time T , we obtain

ST = S0 e µt ,

where S0 and ST are the stock prices at time 0 and T , respectively. Variance
is also allowed to vary with the stock price. Specifically, stock prices are
assumed to follow the Itô process (aka Geometric Brownian Motion):

dS
= µ dt + σ dz, or dS = µ S dt + |{z}
σ S dz.
S |{z}
a(S) b(S)

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Continuous-time Stochastic Processes (cont.)

A Process for Stock Prices (cont.)

A discrete-time version of the above process is given by
∆S √
= µ ∆t + σ  ∆t,
S
where    
∆S ∆S
E = µ ∆t and var = σ 2 ∆t,
S S
imply that
∆S
∼ N(µ ∆t, σ 2 ∆t).
S

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Continuous-time Stochastic Processes (cont.)

A Process for Stock Prices (cont.)

The following graph contains a plot of geometric Brownian motion:

Note: This plot assumes that µ = 0.15 and σ = 0.3, and is based on 10000
observations with ∆t = 1/1000.

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An Alternative Representation

A Binomial Model
This is a discrete-time/discrete-value representation (approximation) of the
above continuous-time/continuous-value model of stock prices.
A One-Step Binomial Model
Su

p
S
@ 1−p
@
R
@
Sd
Starting at S, the stock price is allowed to move up (with probability
p) to Su or down (with a probability 1 − p) to Sd.

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An Alternative Representation (cont.)

A Binomial Model (cont.)

A Two-Step Binomial Model
Suu

p2
Su
@ p(1 − p)
p @
S R Sud
@
@ 1−p 
@ (1 − p)p
R
@
Sd@ (1 − p)2
@
R
@
Sdd
This can be extended to an n-step binomial model.

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An Alternative Representation (cont.)

A Binomial Model (cont.)

The variables, u, d, and p are chosen so that the expected return in ∆t is
µ∆t, and the variance of the return in ∆t is σ 2 ∆t. To achieve this goal, the
following formulae are used:
√ 1 e µ∆t − d
σ ∆t
u=e , d= , p= .
u u−d
So, if µ and σ are given in annualised terms, and you wish to consider stock
prices over one year, then ∆t will equal 1/n, where n is the number of steps
assumed in the model.

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An Alternative Representation (cont.)

A Binomial Model (cont.)

Example
Consider a stock with a current price of $100, with an expected annual return
of 10% and annual standard deviation of 30%. Using a two-step binomial
model, we wish to approximate the price process over the next year (implying
that ∆t = 1/2). Given this information, we can calculate the following:
√ √
u = eσ ∆t
= e 0.30 0.5
= 1.2363,
1 1
d= = = 0.8089,
u 1.2363
e µ∆t − d 1.0513 − 0.8089
p= = = 0.5671.
u−d 1.2363 − 0.8089

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An Alternative Representation (cont.)

A Binomial Model (cont.)

Example (cont.)
Therefore,

Su = 100 × 1.2363 = 123.6311,

Sd = 100 × 0.8089 = 80.8858,
Suu = 100 × 1.2363 × 1.2363 = 152.8465,
Sud = 100 × 1.2363 × 0.8089 = 100,
Sdd = 100 × 0.8089 × 0.8089 = 65.4251.

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An Alternative Representation (cont.)

A Binomial Model (cont.)

Example (cont.)
Diagrammatically: 152.8465

0.3216
123.6311
@ 0.2455
0.5671 @
100 R 100
@
@ 0.4329 
@ 0.2455
R
@
80.8858
@ 0.1874
@
R
@
Note that prices are in dollars. 65.4251

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An Alternative Representation (cont.)

A Binomial Model (cont.)

Example (cont.)
Letting ST denote the stock price in one year’s time, and using the above
binomial model, the expected value of this stock price can be calculated as
follows:

E(ST ) = p 2 Suu + 2p(1 − p)Sud + (1 − p)2 Sdd,

= (0.3216 × 152.8465) + (2 × 0.2455 × 100) + (0.1874 × 65.4251),
= 110.5171.

Alternatively,

E(ST ) = Se µ = 100e 0.1 = 110.5171.

This provides a nice check on the validity of the binomial model.

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Functions of Stochastic Variables

Itô’s Lemma
Assuming that x follows the Itô process

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

where a and b are functions of x and t, then Itô’s lemma enables us to

express a function of x, denoted by G , as an alternative Itô process. This
alternative process is given by the following expression:

1 ∂2G 2
 
∂G ∂G ∂G
dG = a+ + b dt + b dz,
∂x ∂t 2 ∂x 2 ∂x

where dz is the same Wiener process as considered previously.

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Functions of Stochastic Variables (cont.)

Itô’s Lemma (cont.)

It follows that G also follows an Itô process, with a drift rate of

∂G ∂G 1 ∂2G 2
a+ + b ,
∂x ∂t 2 ∂x 2
and a variance rate of
 2
∂G
b2 .
∂x

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Functions of Stochastic Variables (cont.)

Itô’s Lemma (cont.)

Example (Forward Contracts)

The cost of carry model states that

F = Se rT ,

where F is the current forward price on the stock with maturity at time T , and
r is the risk-free interest rate. Furthermore, assume that stock prices follow the
Itô process,
σS dz.
dS = µS dt + |{z}
|{z}
a b

The partial differentials take the following values:

∂F ∂2F ∂F
= e rT , = 0, = −rSe rT .
∂S ∂S 2 ∂t

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Functions of Stochastic Variables (cont.)

Itô’s Lemma (cont.)

Example (Forward Contracts, cont.)

Using the above partial differentials, and the expression for dS, Itô lemma can
be used to give an expression for the process followed by the forward contract
price,  
dF = e rT µS − rSe rT dt + e rT σS dz.

Substituting in the expression, F = Se rT , gives

dF = (µ − r )Fdt + σFdz.

Thus F follows geometric Brownian motion (as does S).

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Functions of Stochastic Variables (cont.)

Itô’s Lemma (cont.)

Example (The logarithm of stock prices)

Consider the following logarithmic transformation of stock prices:

G = ln S.

Associated partial differentials are given by

∂G 1 ∂2G 1 ∂G
= , 2
= − 2, = 0.
∂S S ∂S S ∂t

All of which implies that

σ2
 
dG = µ− dt + σdz.
2
Therefore, logarithmic stock prices follow a generalised Wiener process (as a
and b do not depend on S or t).

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Functions of Stochastic Variables (cont.)

Itô’s Lemma (cont.)

Example (The logarithm of stock prices, cont.)

It follows that ∆G has a normal distribution with a mean of

σ2
 
µ− ∆t,
2

and a variance of,

σ 2 ∆t.
Moreover, if ∆t equals T then:

σ2
  
2
ln ST − ln S ∼ N µ− T, σ T ,
2
σ2
   
2
⇒ ln ST ∼ N ln S + µ − T, σ T .
2

Thus, stock prices have a log-normal distribution.

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Functions of Stochastic Variables (cont.)

Itô’s Lemma (cont.)

Example (The logarithm of stock prices, cont.)

It is also possible to derive the distribution of the continuously compounded
rate of return. Recall,

ST = Se ηT ,
where η is the continuously compounded rate of return. Rearranging,
 
1 ST
η= ln .
T S

As ln(ST /S)(= ln(ST ) − ln(S)) has a normal distribution it follows that

σ2 σ2
 
η∼N µ− , .
2 T

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Summary

Continuous-time Stochastic Processes

Wiener, generalised Wiener, and Itô processes.
Binomial Trees
One-step, two-step, ..., and n-step binomial models.
Transforming Stochastic Processes
Itô’s lemma with two applications.

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Reading

Essential Reading
Chapters 13 and 14, Hull (2015).
Further Reading
Fama, E., 1970, Efficient capital markets: A review of theory and empirical
work, Journal of Finance 25, 383–417.

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