Concept of Brownian Motion and Ito’s Lemma

Normal and Lognormal Distribution

Before we get into this topic, let us review and confirm on the understanding of normal
and lognormal distribution.

Whenever we say that X being a random variable follows lognormal distribution, it

means that, when we take the logarithm of X, ie, Y= ln X, it becomes normally
distributed, ie, Y follows normal distribution. This random variable Y has 2 parameters,
which are μ and σ, each being E(Y) and square root of Var(Y). What about random
variable X? What is E(X)? E(X) is just exp(μ+0.5σ²), MOD(X) is exp(μ-σ²) and
MEDIAN(X) is exp(μ). (In other word, there is more than probability of 50% that the
stock price will underperform the expected price. Think about it)

In the other hand, if we are given that X follows normal distribution. What is the
relationship of Y and X, such that Y follows lognormal distribution? If the reader is good
in probability, straight away it can be recognized that the answer is Y= e^X. Compare this
to the above paragraph. Ln Y indeed follows normal distribution. I purposely exchange
the use of X and Y, so that clear picture can be seen.

Brownian Motion

Brownian motion is defined to be a kind of random walk, with probability of 0.5 each of
moving with a magnitude of 1 and -1. It is applied for modeling price movement. There
are some characteristics about this model:

1. Z(0) = 0
2. It is normally distributed with mean Z(0) and standard deviation σ.
3. Z(t) is continuous with t.
4. The variance is the sum of the time.

Now, since at t=0, Z(0) also equals to 0, it has to be modified, so that this model can
represent price movement. Generally, this model is not used to find the expected price,
but the expected movement of price. (Actually, from the expected movement we can
find the expected price) This is illustrated by:

Example 1
Given the price of stock follows Brownian Motion. The price of stock at t=3 is 52.
Determine the probability that the price is more than 60 at t=10.

Answer
Since the last given t is 3, and the last given price is 52, we have Z(3) = 52. The answer
wanted is P{Z(10)> 60 | Z(3) = 52}. From the property of Brownian motion, the expected
value is the current value, and the variance is the sum of square of time. So, mean= 52,
variance= 10-3 = 7. Hence, the volatility, σ is 7^0.5. So,
P{Z(10)> 60 | Z(3) = 52}= 1- N[(60-52)/ 7^0.5] = 0.00125

You can solve it in other way of thinking, which is, to let the difference of price being
normally distributed. So, we have P{Z> [(60-52)-0]/ 7^0.5}, which yields the same
answer. ***

However, the expected value of a stock is not necessarily the current price. Some stock is
surely going up in the coming time. Let the expected increase rate be β at t. This is called
drift. So, having made a modification of this model, the price X(t) is:
X(t)- X(0) = βt + σ Z(t)
This is reasonable and intuitive. The expected change is β multiplying by the time (so,
actually β is a rate, that is, the rate of increase of price). In addition to this, there is a
deviation, and this is called the noise, which is implied by the latter part of the right hand
side of the equation. So, the price follows normal distribution with mean X(t) + βt
and standard deviation of σ*t^0.5.

Note that the above definition is quite confusing. So, let us stick to the principle: Let the
difference of the prices be normally distributed. Hence, we have dX= βt + σ Z(t): the
difference of the prices is normally distributed with mean βt and standard deviation
of σ*t^0.5.

The bolded sentences mean the same.

Example 2
Given the price of a stock follows arithmetic Brownian Motion with drift 1 and volatility
0.2. The current price is 40. What is the probability that the price is less than 43 at t=4.

Answer
Let X(t) be the price of the stock. We have β=1 and σ=0.2. Applying this model we have
mean = 40 + 4(1) = 44, and volatility (standard deviation) = 0.2. So,
P{X(4) < 43 | X(0) = 40} = N[(43-44)/0.2(2)] = 0.0062 ***

However, there is a shortage for this model, which we call arithmetic Brownian Motion,
because it may give negative value, which is impossible for a price. Hence, further
modification is needed, which, as we will see later, is made by exponentiating arithmetic
Brownian motion.

Let us discuss some logical and theoretical matters with regard to this. When we model
stock price, we always have the current price, and based on that price, we would like to
find the expected price of the stock after time t. Hence, we always need to compare the
current price, X(0) and the future price X(t), which is unknown. How do we compare?
Mathematically, we can: 1. Take the difference; 2. Take the ratio.

Now, we have 2 models to fit these 2 comparisons, which are normal distribution and
lognormal distribution. Let’s list them down:
 1. The difference of stock price follows Normal Distribution
2. The ratio of stock price follows Normal Distribution
3. The difference of stock price follows Lognormal Distribution
4. The ratio of stock price follows Lognormal Distribution

Note that what we have just done so far is the first method, in which we assume the
difference of stock price to follow normal distribution. This is intuitively nice, but there is
a drawback: the modeled stock price can go negative, which will not happen in real
world. For this reason, we seek a better method.

If we were to use the second method, we have X(t)/X(0) being normally distributed.
Notwithstanding, we know that X(t) and X(0) must be positive, and letting their ratio to
follow normal distribution doesn’t make sense, since there is 0.5 probability that the ratio
can go negative according to normal distribution. Thus, this method is out.

If we were to use the third method, we have X(t)- X(0) being lognormally distributed.
Again, as some of the reader might guess, this doesn’t make sense because Y= X(t)-X(0)
might be negative, and lnY is not defined. Hence, this method is also out.

Finally, we have the fourth method, which as mentioned, is the best way out of 4 to
model stock price. In this method, we assume the ratio of the stock price to be
lognormally distributed:
X(t)/X(0)~Lognormal OR ln[X(t)/X(0)]~Normal ***

Notice that arithmetic Brownian Motion follows normal distribution. As we modify it by

exponentiation, it becomes lognormally distributed. We call this modified model:
Geometric Brownian Motion. So,
lnX(t)- lnX(0) = μt + σZ(t)
OR
X(t) = X(0)e^[( α - 0.5σ²)t + σZ(t)]

Perhaps you may wonder: Why is the mean μ= α - 0.5σ²?

Recall that α stands for the expected return rate of the stock. It means, if the continuously
compounded rate of return of the stock is normally distributed, then the mean of that
normal distribution is μ. This implies, stock will follow lognormal distribution with mean
e^α = e^(μ + 0.5σ). By this, you get the above bolded equation.

For this reason, whenever we are asked to find probability related to Geometric Brownian
Motion, we need to be careful of the parameter. This is illustrated by example below:

Example 3
A stock’s price is modeled as geometric Brownian Motion with continuous return α =
0.15, continuous dividends δ = 0.04 and volatility 0.03.
If the stock’s price is 45 at time 0 and 47 at time 0.6, calculate the probability that the
stock’s price is less than 45 at time 1.

Solution
Notice that this is Geometric Brownian Motion. This implies that lognormal distribution
is applied on the ratio of the stock. In order to evaluate probability, we need the parameter
of normal distribution μ. This can be easily obtained by equating
μ + 0.5σ²= α – δ
=> μ = α – δ – 0.5σ²= 0.065
=> μ*t = 0.065*(1-0.6) = 0.026
=> P{X(1)|X(0.6)=47} = N{ [ln(45/47) – 0.026]/ [0.3*0.4^0.5] }= 0.3557***

Just remember, Arithmetic Brownian Motion says that the difference of stock prices is
normally distributed, whereas Geometric Brownian Motion says that the quotients of the
stock prices are lognormally distributed.

Ito’s Process
Now, we can go further to see that we can represent the model with differentials:
1. Arithmetic Brownian Motion: dX(t)= α dt + σ dZ
2. Geometric Brownian Motion: d[lnX] = (α - δ - 0.5σ²)t + σZ(t)
=>dX(t) = α X(t) dt + σ X(t) dZ. Any process of these form are called Ito process.

Before we get into the details of Ito process and Ito’s Lemma, let us spend some time in
differential equation and some motivations of learning these.

Now we already have model to forecast the future stock price. We can further modify
these model, particularly Geometric Brownian Motion, so that this model can be
generalized for any function f[ X(t) ]. For example, the payoff of a call option is also a
kind of function with variable X(t). To generalize the function is not easy, but later we
will see that Ito’s Lemma helps us much in this matter.

Intrinsically, MFE students are exposed to these chapters unto the ability of deriving
Black Scholes formula, but it seems that the exam does not require it.

Perhaps the second differential equation of Geometric Brownian Motion looks weird.
However, we have Ito’s Lemma that can help us to relate the value of the changes of the
function of asset to the value of changes of asset. In other words, if we have X following
Brownian motion, and we would like to know how does Y=e^X behaves, Ito’s Lemma
helps us to relate them. In fact, the second is derived by Ito’s Lemma.

Example 4
Given an Ito process
dS= 0.25 S(t) dt + 0.1 S(t) dZ
Calculate the probability that S(t) is at least 5% higher than S(0) at t=1.

Answer
Since the given information is on geometric Brownian Motion (refer to the second
equation), it is lognormally distributed. To calculate the probability, we have to convert it
to normal distribution, or, associated arithmetic Brownian Motion. Hence, we have this
“converted” geometric Brownian Motion follows normal distribution with mean μ =
0.25- 0.5*(0.01) = 0.245 and volatility = 0.1. Hence, probability is 1- N[(ln1.05 –
0.0245)/ 0.1] = 0.2206 ***

Ito’s Lemma

dC= Cs dS + 0.5 Css (dS) ² + Ct dt

Where we are given the function C[S(t)], and S(t) is the stock price at time t.

Example 5
You are given Ito processes dX and dY. dY is defined by:
dY(t)/ Y(t) = 0.1 dt + 0.5 dZ(t)
And X=Ye^0.02t.

dX can be expressed as
dX(t) = α X(t) dt + σ X(t) dZ(t)

Using Ito’s Lemma, determine α and σ.

Answer

Recognize that X in this question is the C in the Ito’s Lemma.

Xy = 0.02t e^0.02t = X/Y

Xyy = 0
Xt = 0.02 Ye^0.02t = 0.02 X

Therefore, dX(t) = X/Y dY + 0.02X dt

= X/Y [0.1 Y(t) dt + 0.5 Y(t) dZ(t)] + 0.02X(t) dt
= 0.1 X dt + 0.5 X dZ + 0.02X dt
= 0.12X dt + 0.5 X dZ

Hence, α = 0.12, σ = 0.5 ***

Note that there is possibility that Css is not zero. In this case, (dS)² will be encountered,
and resulting in dt², dZ², and dZdt. Of these, all equal zero except dZ²= dt. Reason?
Unknown.

Sharpe Ratio
Sharpe ratio is the risk premium of a stock divided by its volatility, or, standard deviation.
Recall from the chapter in which we study option Greeks, where it is mentioned that the
risk premium of option equals the risk premium of underlying stock multiply by the
absolute value of elasticity:
γ-r = (α-r)|Ω|
In other words, Sharpe ratio is simply:
φ = (α-r) / σ

For exam purpose, you need to know the following ideas:

1. For 2 ito processes involving the same dZ, the Sharpe Ratios are equal, where
Sharpe Ratio, φ = (α-r)/σ. Remember, the Sharpe Ratios are only equal when the
Ito process are in geometric motion form.
2. For 2 Ito’s processes involving the same dZ, the Sharpe Ratio are equal.
Remember, when you pick the α and σ from the ito’s process, make sure that they
are in geometric Brownian Motion form, ie, dX/ X = (α-δ) dt + σ dZ

Example 6
For two nondividend paying assets X(t) and Y(t), you are given the following stochastic
equations:
d[ln X(t)] = 0.08 dt + 0.2 dZ
d[ln Y(t)] = A dt + 0.4 dZ

The risk free rate is 0.04, find A.

Answer
Note that these 2 stochastic equations are not in geometric Brownian motion form. It is
in arithmetic form. It says that the logarithm of X(t)/X(0) and Y(t)/Y(0) follow normal
distribution with μx = 0.08, μy = A. So, we have αx = 0.08 + 0.5(0.2)² = 0.1. Since they
are sharing the same dZ, the Sharpe ratio of X and Y should be the same, or,
(αx-r) / σx = (αy-r) / σy
=> (0.1-0.04)/0.2 = (αy – 0.04) / 0.4
=> 0.3 = (αy – 0.04) / 0.4
=> αy = 0.16
=> A = 0.16 – (0.5)0.4² = 0.08***