Lecture 1 - The Random Behavior of

Asset Prices

Prof. Massimo Guidolin

Prep Course in Quant Methods for Finance

August-September 2017
Plan of the lecture
 Fundamental, technical, and quantitative analyses

 Why do we need to model randomness?

 Developing a Gaussian model for asset returns

 The random walk model

 The continuous time limit and Wiener processes

 What are differential equations?

Lecture 1 - The Random Behavior of Asset Prices 3

Motivation: three types of analyses
Even though fundamental and technical analyses are logically
important and seem to work, modern finance employs quant analysis
 Three forms of ‘analysis’ commonly used in the financial world:
o Fundamental
o Technical
o Quantitative
 Fundamental analysis is all about trying to determine the ‘cor-
rect’ worth of a company by an in-depth study of balance sheets,
management, patent applications, competitors, lawsuits, etc.
 Two difficulties with this approach: 1) It is hard (most important
stuff can be hidden ‘off balance sheet.’); 2) As Keynes put it , “The
market can stay irrational longer than you can stay solvent”
 Technical analysis is when you only care for the information
contained in the stock price history
o You draw trendlines, look for specific patterns in the share price
and make predictions accordingly
Lecture 1 - The Random Behavior of Asset Prices 4
Motivation: three types of analyses
Example of resistance

Example of support

 The final form of analysis is the

Trends and corridors
foundation of modern portfolio
theory, derivatives pricing and risk
management: quantitative analysis
 It is about treating financial
quantities such as stock prices or
interest rates as random
o ⇒ choose best models for that
randomness Lecture 1 - The Random Behavior of Asset Prices
5
 Why do we need a model for randomness?
 To see the importance of randomness, let’s work on one example
o The example requires that you know that the payoff of a European call
option is given by V = max{0, ST – K}, where St is the price of the
underlying, K is the strike (exercise) price, and T is maturity
• V represents the value at expiry
o The stock price today is 100; in one year’s time it could be 50 or 150,
with both equally likely
o We want to evaluate a call option with
a strike of 100 on this stock
o Because we expect the stock price to
be 100 in one year, the payoff for the
call option would then be 0,
0=max{0, E[ST]– K}=max{0, 100–100}
and the present value of this is 0
o However you expect the value to be
positive, because half the time there
is positive payoff
Lecture 1 - The Random Behavior of Asset Prices 6
Why do we need a model for randomness?
o In one state 50=max{0, 150–100} and in the other 0 =max{0, 50–100}
o The average payoff is therefore 25, which we could discount to give us
some idea of the option’s value
 This calculation illustrates the order in which we do the payoff
calculation and the expectation matters
 This is called Jensen’s inequality
o In the example, we had Payoff (Expected [Stock price]) = 0 whereas
Expected [Payoff(Stock price)] = 25
 According to Jensen’s inequality, if we have a convex function f(S)
(the payoff function) of a random variable S, then
E[f(S)] ≥ f(E[S])
o In the case of a a concave function f(S) of a random variable S, then
E[f(S)] ≤ f(E[S])
 We can get an idea of how much greater the LHS is than the RHS by
using a Taylor series approximation around the mean of S,
Lecture 1 - The Random Behavior of Asset Prices 7
Why do we need a model for randomness?
When asset prices contain stochastic components, these affect
derivative pricing applications and must be carefully modeled

where E[] =0 so that E[2] = Var[]

o Because of the convexity of f(·), > 0 so that E[f(S)] ≥
f(E[S]) as claimed
o One day, some MSc. professor will explain to you that its payoff
convexity adds value to an option
 The difference is governed by the term Var[] and depends on the
fact that at each point in time, , i.e., the price of the stock
differs from its mean by a random quantity 
 Therefore finding good models for the stochastic term  is
essential for the pricing of important securities, such as options
Lecture 1 - The Random Behavior of Asset Prices 8
Some more details
o Where does the expression

come from?
o It is a special case of a second-order Taylor expansion around  = 0:

o What is the economic meaning of ? It just means that you are

splitting the behavior of prices (S) between a deterministic
component (S) and a pure random shock ()
o We assume E[] = 0 and Var[] > 0
Lecture 1 - The Random Behavior of Asset Prices 9
Developing a Gaussian model for returns
 Typically, in finance we build and empirically test the properties of
asset returns and not prices:

 The reason is that relative changes are more interesting (e.g.,

because comparable across different assets) than absolute changes
 Supposing we believe that returns are close enough to Normal, one
simple and yet powerful model features a known, constant, non-
zero mean and a known, constant, non-zero standard deviation:

o φ is the standard normal

distribution with probability
density function:

o Should we believe in the

Normal assumption? Stay
tuned… 10
Lecture 1 - The Random Behavior of Asset Prices
Developing a Gaussian model for returns
 How do the mean and standard deviation of returns scale with the
time step between asset price measurements?
o Typically, the time step is one day, but suppose we sampled at hourly
intervals or weekly, how would this affect the distribution?
o Call the time step δt =T/M, (total time interval )/(number of intervals)
 The mean of the return scales with the size of the time step, i.e., the
larger the time between sampling, the more the asset will have
moved in the meantime, on average: mean = μ·δt, for some μ
o μ represents the annualized average return or drift
o This implies that

or more generally:
 Ignoring randomness for the moment, our model is simply

that derives from (1 + μ·δt)M=exp[M log(1 + μ·δt)]≈exp(μM·δt)

Lecture 1 - The Random Behavior of Asset Prices 11
Developing a Gaussian model for returns
o In the limit as the time step tends to zero with the total time T fixed,
this approximation becomes exact
o If we had chosen to scale the mean of the returns distribution with
any other power of δt it would have resulted in either a trivial model
(ST = S0) or infinite values for the asset
 As for the standard deviation of returns, in order for it to remain
finite as we let δt tend to zero, the individual terms in the
expression must each be of O(δt)
o We say that g(δt) is O(δt) if g(δt)/δt → constant as δt → 0
 Because each term in the classical definition of standard deviation,

is a square of a return, the standard deviation of the asset return

over a time step δt must be O(δt1/2), standard deviation = σ·δt1/2
 σ is some parameter measuring the amount of randomness
Lecture 1 - The Random Behavior of Asset Prices 12
The random walk model
 Plugging these scalings explicitly in the model, we have:

 This equation is a random walk model for the asset price

o Statistically the drift μ is very hard to measure since the mean scales
with the usually small parameter δt
o It can be estimated by

o The parameter σ is called the

volatility of the asset and can be
estimated by

Lecture 1 - The Random Behavior of Asset Prices 13

The random walk model
 The drift is not apparent over
short timescales for which the
volatility dominates
 Over longer timescales, the
drift becomes important
o In this example the
confidence interval repre-
sents one standard deviation
• With the assumption of Normality this means that 68% of the time
the asset should be within this range
 The mean path is growing linearly in time and the confidence
interval grows like the square root of time
 Why do we like the normal distribution φ so much?
 The Normal distribution occurs “naturally” and has nice properties
o Consider coin tossing: toss one coin, heads you win one euro, tails you
lose it Lecture 1 - The Random Behavior of Asset Prices 14
The central limit theorem
o We show the resulting
probability distribution
o Now toss two coins,
same rules, for each
head you get one euro,
but lose one for each
tail, and we plot the PDF
o The sequence of figures
shows the probability
density function of
winnings/losses after an increasing number of tosses
o It increasingly looks like the bell-shaped Normal distribution…
 This is a demonstration of the Central Limit Theorem: Let X1, X2, …
be a sequence of independent identically distributed (i.i.d.) random
variables with finite means m and variances s2>0; then the sum
Sn = X1 + X2 + . . . + Xn
in the limit as n → ∞ is distributed normally with mean nm and
variance ns2 Lecture 1 - The Random Behavior of Asset Prices 15
The continuous time limit
o If we rescale,
tends to the standardized Normal distribution
 The point is that if we add up enough i.i.d. random variables (with
finite mean and standard deviation) we end up with something
that’s Normally distributed
 We now take the “continuous time limit” of the random walk model,
i.e., we will go to the limit δt → 0
o The notation d· means “the change in” some quantity: e.g., dS is the
“change in the asset price”, but this change will be in continuous time
o The problem is that while the first δt on the right-hand side of

becomes dt but the second term is more complicated

 We cannot simply write dt1/2 instead of δt1/2: if so, as δt → 0, then
any random dt1/2 term will dominate any deterministic dt term
o The reason is that as δt → 0, taking a square root makes it > δt
Lecture 1 - The Random Behavior of Asset Prices 16
The continuous time limit: Wiener processes
We can take a meaningful continuous time limit of the discrete
random walk to obtain , based on a Wiener process
o However, the factor in front of dt1/2 has a mean of zero, so maybe it
does not outweigh the drift after all
 It turns out that because the variance of the random term (φ·dt1/2)
is O(δt) we can take a sensible continuous-time limit
 This brings us to defining Wiener processes, say
φ·dt1/2 = dX
 We can think of dX as being a random variable, drawn from a
Normal distribution with mean zero and variance dt:
E[dX] = 0 and E[dX2] = dt
 The asset price model in the continuous-time limit, using the
Wiener process notation, can be written as:

Lecture 1 - The Random Behavior of Asset Prices 17

What are differential equations?
o Technically this model is a stochastic differential equation (SDE)
o One of our objectives is to clarify its meanings and the meaning of the
notion of finding a solution to it
 We will return to many of these details, but before let’s ask: what is
a plain vanilla, simple differential equation?
 A differential equation is a mathematical equation that relates some
function of one or more variables to its derivatives
o Differential equations arise whenever a deterministic relation
involving some continuously varying quantities (modeled by
functions) and their rates of change in space and/or time (expressed
as derivatives) is known or postulated
o (Ordinary) Differential equations (ODEs) are studied in the
perspective of their solutions — the set of functions that satisfy them
o Only the simplest differential equations are solvable by explicit
formulas; however, some properties of solutions of a given differential
equation may be determined without finding their exact form
Lecture 1 - The Random Behavior of Asset Prices 18
What are differential equations?
o If a self-contained formula for the solution is not available, the solution
may be numerically approximated using computers
• For example, a homogeneous first-order linear constant coefficient
ordinary differential equation is:
(dy/dx) + ay = 0
• The solution is y(x) = Ae-ax, where A is a constant; in fact
(dy/dx) = -aAe-ax (dy/dx) + ay = 0
o A partial differential equation (PDE) is a differential equation in which
the unknown function is a function of multiple independent variables
and the equation involves its partial derivatives
o A differential equation is linear if the unknown function and its
derivatives appear to the power 1 (products of the unknown function
and its derivatives are not allowed) and nonlinear otherwise
o There are very few methods for solving nonlinear differential equations
exactly; those that are known typically depend on the equation having
particular symmetries
Lecture 1 - The Random Behavior of Asset Prices 19
Familiarizing with
• The only symbol in our SDE whose role is not yet entirely clear is dX
• If we were to cross out the term involving dX, by taking σ = 0, we would
simply have dS = µS·dt
• The price would be deterministic and we can predict the future price of
the asset with certainty: a simple ODE, dS/S = µS·dt or dS/dt = µS
• When µ is constant this can be solved exactly to give exponential
growth in the value of the asset, i.e.
o Consistent with earlier solution: S = Aeµt where A ≡ S0e -µt0 and t = x
• The SDE model cannot be solved
to give a deterministic path for the
price, but it can give information
concerning the behavior of S in a
probabilistic sense
• Suppose that today's date is t0 and
today's asset price is S0
• If the price at a later date t’ is S', then S' will be distributed about S0
with a lognormal PDF
Lecture 1 - The Random Behavior of Asset Prices 20
Readings

 P. WILMOTT, Paul Wilmott introduces quantitative finance. John

Wiley & Sons, 2007, chapter 4 and Appendix B
 It may be entertaining to take a look at:
http://www.youtube.com/watch?v=CNj1PPOBzSo&list=PLEF50A
712024D59F3&index=4

Lecture 1 - The Random Behavior of Asset Prices 21