Chap 4

CHAPTER 4.
BROWNIAN MOTION
50
Chapter 4
Brownian motion
The binomial-tree model can be mathematically described as a stochastic process.1 A stochastic process is a system which evolves in time while undergoing
chance fluctuations. The time can change discretely or continuously. The variable
can have discrete values or continuous values. The binomial model assumed a
discrete-valued and discrete-time stochastic process. 2 In Financial Mathematics,
the stochastic behaviour of share prices is studied under the Markovian approximation. A Markovian process is a process whose future does not depend on its
past history. The prediction of a future event depends only on the present state
for a Markovian process.
The Markov process is related to the weak form of the efficient-market hypothesis3 .
1
2
The word stochastic is a jargon for random.

We will see that Black and Scholes assume a continuous-valued and continuous-time stochas-
tic process for the asset movement.

3
When economists say that the securities market is efficient, they mean that information is
widely and cheaply available to investors and that all relevant and ascertainable information
is already reflected in security prices. The efficient-market hypothesis comes in three different
flavours. The weak form of the hypothesis states that prices efficiently reflect all the information
contained in the past series of stock prices. In this case it is impossible to earn superior returns
simply by looking for patterns in stock prices as price changes are random. The semi-strong
form of the hypothesis states that prices reflect all published information. That means it is
CHAPTER 4. BROWNIAN MOTION
4.1
51
Brownian motion
The observation that, when suspended in water, small pollen grains are found
to be in a very animated and irregular state of motion, was first systematically
investigated by Robert Brown in 1827, and the observed phenomenon took the
name Brownian motion because of his fundamental pioneering work.
Brownian motion, which is a limiting process of a random walk, is a Markov
process with a continuous state space and a continuous time set. The process
and its many generalisations occupy a central role in an option pricing model.
We can derive the diffusion equation underlying the Brownian motion process.
4.1.1
Einsteins Brownian motion
Brownian motion was mathematically formulated by Einstein. He found the

following equation to solve the probability u(x, t) of particles being found in x at
t for one-dimensional Brownian motion:
u
2 2 u
=
.
t
2 x2
(4.1)
Here, 2 is the diffusion coefficient. The formal solution of Eq.(4.1) is a Gaussian

function or a normal function
1
2
2
u(x, t) =
ex /2 t .
2
2 t
(4.2)
This is a Gaussian function. The expectation value of x is zero and the variance
is determined by the diffusion coefficient:
E[x] = 0
and var[x] = 2 t.
(4.3)
impossible to make consistently superior returns just by reading the newspaper, looking at the
companys annual accounts and so on. The strong form of the hypothesis states that stock
prices effectively impound all available information. It tells us that inside information is hard to
find because in pursuing it you are in competition with thousands, perhaps millions of active,
intelligent and greedy investors.
52
The expectation value and variance of x are found as

Z
E[x] =
var[x] =
xu(x)dx
x2 u(x)dx E[x]2 .
This is the definition of the expectation value and the variance

when the probability function u(x) is continuous (See Section 2.6
for the discrete case.)
Gaussian integrals
The Gaussian function is so important in statistics and it is useful to know its
integrals.
Z
2n px2
x e
(2n 1)!!
dx =
2(2p)n
and
Z
x2n+1 epx dx =
n!
2pn+1
where p > 0 and n = 0, 1, 2 and (2n 1)!! = (2n 1)(2n 3)(2n 5) 1.

Beware the range of integral. Simple cases are
Z
4.1.2
dx =
Z
Z
px2
xepx dx = 0
x2 epx dx =
1
2p
.
p
Random walk
We consider one-dimensional discrete random walk which yields Brownian motion4 under the continuum limit. Let {Xi } be random variables with
P (xi = k) = p
4
and
P (xi = k) = q,
(4.4)
When the mean displacement is not zero, the system is not the Brownian motion by standard
definition but we will conventionally call it a Brownian motion.
53
where k denotes the size of the ith step, with probability p that the walk is toward
the positive direction and with probability q toward the negative direction. It is
easy to verify that the expected value and the variance are
E[xi ] = (p q)k
and var[xi ] = 4pqk 2
(4.5)
For n = 1, 2, , let Xn = x1 + + xn . Then Xn denotes the position of the

random walk after n steps on an Xn plane. The stochastic process {Xn , n 0}
is called a random walk process. The expectation value and variance of X n are
E[Xn ] = (p q)nk
and var[Xn ] = 4pqk 2 n.
(4.6)
We now extend this idea to the continuum limit. Suppose there are r random
walks per unit time, then = 1/r is the time interval between two random walks.
In the continuum limit, we take
r ( 0)
and
n = t.
(4.7)
We denote the mean displacement and variance per unit time by and 2 , respectively. Using Eq.(4.6),
E[Xn ]
k
= (p q)
n
var[Xn ]
k2
= 4pq .
n
=
2 =
(4.8)
(4.9)
Using p + q = 1 and Eq.(4.8), we find that

1
1+
p=
2
k

and q =
1
.
2
k

(4.10)
With use of Eqs.(4.9) and (4.10), we find

2 =
k2
k2
2 ,
(4.11)
where small has been assumed.

Let u(x, t) denote the probability that the particle takes the position x at time
t, then
u(x, t) = P (Xn = x)
at
t = n.
(4.12)
54
The probability function satisfies the recurrence relation

u(x, t + ) = pu(x k, t) + qu(x + k, t).
(4.13)
The Taylor expansion of Eq.(4.13) is

u(x, t)
u(x, t) k 2 2 u(x, t)
u(x, t)
+ O(2 ) = u(x, t) + k(q p)
+
+ O(k 3 )
t
x
2
x2

u(x, t)
k u(x, t)
k 2 2 u(x, t)
= (q p)
+
(4.14)
t
x
2 x2
under the assumption , k 0. With use of Eqs.(4.11) in Eq.(4.14), we obtain

the partial differential equation
u(x, t)
u(x, t) 2 2 u(x, t)
=
+
t
x
2
x2
(4.15)
This is called the forward Kolmogorov equation for the drift rate and the diffusion rate 2 . The formal solution of Eq.(4.15) is
#
"
(x t)2
u(x, t) =
.
exp
2 2 t
2 2 t
1
(4.16)
This is again a Gaussian function of its peak at x = t and its width 2 t. Note
that the peak and the width are time dependent. They grow as time goes.
From Eq.(4.11) we find that X = t. Without drift, when t goes to 0,

(dX(t))2 = 2 dt
(4.17)
thus the generalised Brownian motion with drift is written as

dX(t) = dt + dZ
(4.18)
where (dZ)2 = dt.

Taylor expansion: In the vicinity of a point x 0 , the value of a
function f (x) is Taylor expanded as follows:
f (x)
f (x) = f (x0 ) + (x x0 )
x
1
+ (x x0 )2
2
"
2 f (x)
x2
x=x0
x=x0
4.2
55
Geometric Brownian motion
When X(t) denotes the Brownian motion with drift rate and variance rate 2 ,
the stochastic process defined by
y(t) = ex(t)
(4.19)
is called the Geometric Brownian motion. The probability density function for
y(t) is
"
1
(ln y t)2
u(y, t) =
exp
2 2 t
y 2t
, y>0
(4.20)
The mean and variance of y(t) are, respectively,

2 t
E[y(t)|y(0) = yo ] = y0 exp t +
2

var[y(t)|y(0) = yo ] = y02 e2t e t 1 .
4.3
(4.21)
Normal and lognormal distributions
The density function of a normally distributed random variable x with mean

and variance 2 is given by
"
(x )2
u(x) =
.
exp
2 2
2 2
1
(4.22)
The sum of n independent normally distributed variables X i , i = 1, 2, , N , is also

normally distributed. Let Y = X1 + X2 + +Xn , then the mean and variance
of Y are respectively
E[Y ] = E[X1 ] + E[X2 ] + + E[Xn ]
and
var[Y ] = var[X1 ] + var[X2 ] + + var[Xn ]
(4.23)
If the normal variable has its mean zero and its variance unity, it is said to
be the standard normal random variable whose density n(x) and distribution
56
functions N (x) are

1
2
ex /2 and
2
Z x
1
2
et /2 dt.
2
n(x) =
N (x) =
(4.24)
The lognormal density function for z = e x is

"
(ln z x )2
1
exp
g(z) =
2x2
2x z
(4.25)
where the mean and variance of x are denoted by x and x . The truncated
mean of z, defined as E[z; z > a], is
E[z; z > a] =
=
4.4
zg(z)dz
"
1
2
x ln a
exp x + x N
+ x .
2
x

(4.26)
Itos lemma
A prominent generalisation of Brownian motion is the class of processes known

as Ito processes. Since publication of the seminal paper of Black and Scholes in
1973, Ito processes have remained in the centre stage of continuous-time finance.
If X follows an Ito process:
dX(t) = a(X, t)dt + b(X, t)dZ(t)
(4.27)
where the parameters a and b are functions of the value of the underlying variable,
X, and t and dZ(t) is a Wiener process. Itos lemma shows that a function, Y ,
of X and t follows the process
dY =
Y
Y
1 2Y 2
Y
a+
+
b dt +
bdZ.
2
X
t
2 X
X
(4.28)
Thus Y also follows an Ito process with the drift rate

Y
Y
1 2Y 2
a+
+
b
X
t
2 X 2
and the variance rate

Y
X
2
b2 .
(4.29)
(4.30)
57
Proof
By the Taylor expansion of Y , which is a function of X and t, we obtain
Y
Y
X +
t +
Y =
X
t
+
1
2
2Y
2Y
2Y
X 2 + 2
Xt +
t2
2
X
Xt
t2
X
+ t
3!
X
t

3
Y + .
(4.31)
The discretised form of Eq.(4.27) is
X = a(X, t)t + b(X, t) t.
(4.32)
In the limit of t 0, we realise that X 2 b2 (X, t)t. Substituting this into

Eq.(4.31) we obtain
dY
=
=
Y
1 2Y 2
Y
dX +
dt +
b (X, t)dt
X
t
2 x2 !
Y
Y
1 2Y 2
Y
a+
+
b dt +
bdZ.
2
X
t
2 X
X
(4.33)
The second line in the right-hand side has been obtained by using Eq.(4.27).
Application to Geometric Brownian motion

Let us assume the following Brownian motion
dM = rdt + dZ
(4.34)
Then the governing equation for the variable S = e M is

2
dS = S r +
2
dS
2
= r+
S
2
dt + SdZ
dt + dZ
(4.35)
which has been obtained using Itos lemma and

S
S
2S
= eM = S ,
=0,
= eM = S.
M
t
M 2
(4.36)
58
Stock price
If there is no uncertainty in the stock market, when the expected rate of return
on the stock is , the stock price at time T is S t e(T t) which is a solution of the
equation
dS
= dt
S
(4.37)
If the uncertainty of the stock price is described by the geometric Brownian

motion,
dS
= dt + dZ
S
dS = Sdt + SdZ
(4.38)
where is the market volatility. Comparing Eq.(4.36) with Eq.(4.38) we can see
that the stock price undergoes geometric Brownian motion.
Application to Forward contracts

Let the risk-free interest rate equal to r, the forward price is F = Se r(T t) .
Assume that the share price S follows geometric Brownian motion as shown in
Eq.(4.38) with expected return and volatility . As
2F
F
F
= er(T t) ,
=0 ,
= rSer(T t) ,
2
S
S
t
(4.39)
using Itos lemma (4.28),

dF
= [er(T t) S rSer(T t) ]dt + er(T t) SdZ

= ( r)F dt + F dZ.
(4.40)
The second line in the right-hand side shows that F also follows geometric Brownian motion.

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CHAPTER 4.

The word stochastic is a jargon for random.

tic process for the asset movement.

CHAPTER 4. BROWNIAN MOTION

Einsteins Brownian motion

Brownian motion was mathematically formulated by Einstein. He found the

Here, 2 is the diffusion coefficient. The formal solution of Eq.(4.1) is a Gaussian

CHAPTER 4. BROWNIAN MOTION

The expectation value and variance of x are found as

This is the definition of the expectation value and the variance

where p > 0 and n = 0, 1, 2 and (2n 1)!! = (2n 1)(2n 3)(2n 5) 1.

definition but we will conventionally call it a Brownian motion.

CHAPTER 4. BROWNIAN MOTION

and var[xi ] = 4pqk 2

For n = 1, 2, , let Xn = x1 + + xn . Then Xn denotes the position of the

and var[Xn ] = 4pqk 2 n.

Using p + q = 1 and Eq.(4.8), we find that

With use of Eqs.(4.9) and (4.10), we find

where small has been assumed.

CHAPTER 4. BROWNIAN MOTION

The probability function satisfies the recurrence relation

The Taylor expansion of Eq.(4.13) is

under the assumption , k 0. With use of Eqs.(4.11) in Eq.(4.14), we obtain

From Eq.(4.11) we find that X = t. Without drift, when t goes to 0,

thus the generalised Brownian motion with drift is written as

where (dZ)2 = dt.

CHAPTER 4. BROWNIAN MOTION

Geometric Brownian motion

The mean and variance of y(t) are, respectively,

var[y(t)|y(0) = yo ] = y02 e2t e t 1 .

Normal and lognormal distributions

The density function of a normally distributed random variable x with mean

The sum of n independent normally distributed variables X i , i = 1, 2, , N , is also

var[Y ] = var[X1 ] + var[X2 ] + + var[Xn ]

CHAPTER 4. BROWNIAN MOTION

functions N (x) are

The lognormal density function for z = e x is

A prominent generalisation of Brownian motion is the class of processes known

Thus Y also follows an Ito process with the drift rate

CHAPTER 4. BROWNIAN MOTION

The discretised form of Eq.(4.27) is

X = a(X, t)t + b(X, t) t.

In the limit of t 0, we realise that X 2 b2 (X, t)t. Substituting this into

Application to Geometric Brownian motion

Then the governing equation for the variable S = e M is

which has been obtained using Itos lemma and

CHAPTER 4. BROWNIAN MOTION

If the uncertainty of the stock price is described by the geometric Brownian

Application to Forward contracts

using Itos lemma (4.28),

= [er(T t) S rSer(T t) ]dt + er(T t) SdZ

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