Financial Engineering & Risk Management

MFIM 7111

Tamirat T.(PhD)
February 19, 2025
Addis Ababa University
School of Comerce

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Table of Contents

Wiener Processes and Itô’s Lemma

The Markov Property
Continuous-Time Stochastic Processes
Stochastic differential equations
Itô’s lemma for diffusion process
The Process for a Stock Price
Labs

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Wiener Processes and Itô’s
Lemma
 Wiener Processes and Itô’s Lemma

Stochastic Processes

• Describes the way in which a variable such as a stock price,

exchange rate or interest rate changes through time
• Incorporates uncertainties

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Wiener Processes and Itô’s Lemma

Example 1
• Each day a stock price
✓ increases by $1 with probability 30%
✓ stays the same with probability 50%
✓ reduces by $1 with probability 20%

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Wiener Processes and Itô’s Lemma

Example 2
Each day a stock price change is drawn from a normal distribution with
mean $0.2 and standard deviation $1.

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 Wiener Processes and Itô’s Lemma
The Markov Property

Markov Processes

• Markov process: only current value relevant for predicting future.

• Future movements in variable depend only on current state, not
history.
• Stock prices assumed to follow Markov processes.

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 Wiener Processes and Itô’s Lemma
The Markov Property

Weak-Form Market Efficiency

• This asserts that it is impossible to produce consistently superior

returns with a trading rule based on the past history of stock prices.
• In other words technical analysis does not work.
• A Markov process for stock prices is consistent with weak-form
market efficiency.

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Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

Example

• Consider a variable that follows a Markov process,

• currently value is S0 = 40
• Process is stationary (i.e. the parameters of the process do not
change as we move through time)
• Change in its value during a year is ϕ(0, 1) ,
• At the end of 1 year the variable will have a normal probability
distribution with mean 40 and standard deviation 1.

S1 = S0 + ϕ(0, 1) = 40 + ϕ(0, 1).

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Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

Questions

• What is the probability distribution of the stock price at the end of 2

years?
S2 = S1 + ϕ(0, 1) = S0 + ϕ(0, 1) + ϕ(0, 1).
1
• 2 years? ϕ(0, 0.5),
1
• 4 years? ϕ(0, 0.25),
• ∆t years? ϕ(0, ∆t).
• Taking limits we have defined a continuous stochastic process

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Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

Variances and Standard Deviations

• In Markov processes changes in successive periods of time are

independent
• This means that variances are additive
• Standard deviations are not additive
• In our example it is correct to say that the variance is 100 per year.
• It is strictly speaking not correct to say that the standard deviation
is 10 per year.

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 Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

A Wiener Process/Brownian motion

• Define ϕ(µ, ν) as a normal distribution with mean µ and variance ν

• A variable W follows a Wiener process if
√
✓ The change in W in a small interval of time ∆t is ∆W = ε ∆t
where ε is ϕ(0, 1)
✓ The values of ∆W for any 2 different (non-overlapping) periods of
time are independent.

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 Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

Properties of a Wiener Process

• It follows form the first property that ∆W itself has a normal

distribution with
mean of ∆W = 0
√
standard deviation of ∆W = ∆t
variance of ∆W = ∆t.

1.2

1.0

0.8

0.6
W

0.4

0.2

0.0

−0.2

0.0 0.2 0.4 0.6 0.8 1.0

t

Figure 1: Brownian motion 12

Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

• Change in the value of W during a relatively long period of time, T .

This can be denoted by W (T ) − W (0).
• It can be regarded as the sum of the changes in W in N small time
intervals of length ∆t, where
T
N= .
∆t
• Thus,
N
X √
W (T ) − W (0) = εi ∆t, εi = ϕ(0, 1)(i = 1, 2, . . . , N )
i=1

✓ Mean of [W (T ) − W (0)] = 0.
✓ Variance of [W (T ) − W (0)] = N ∆t = T .
√
✓ Standard deviation of [W (T ) − W (0)] = T .

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 Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

Generalized Wiener Processes

• A Wiener process has a drift rate (i.e. average change per unit time)
of 0 and a variance rate of 1
• In a generalized Wiener process the drift rate and the variance rate
can be set equal to any chosen constants
√
∆X = a∆t + bε ∆t
• Mean change in X per unit time is a
• Variance of change in X per unit time is b2

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Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

It follows that ∆X is normally distributed, with

mean of ∆X = a∆t,
variance of ∆X = b2 ∆t,
√
standard deviation of ∆X = b ∆t.

10.5

10.4

10.3
X

10.2

10.1

10.0

0.0 0.2 0.4 0.6 0.8 1.0

t

Figure 2: A simulation generalized Brownian motion with a = 0.3, b = 0.2

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Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

Similarly, the change in the value of X in any time interval T is normally

distributed with

mean of change in X = aT,

√
standard deviation of change in X = b T ,
varaince of change in X = b2 T.

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 Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

Taking Limits. . .

• What does an expression involving dW and dt mean?

• It should be interpreted as meaning that the corresponding
expression involving ∆W and ∆t is true in the limit as ∆t tends to
zero
• In this respect, stochastic calculus is analogous to ordinary calculus

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 Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

The Example Revisited

• A stock price starts at 40 and has a probability distribution of

ϕ(40, 100) at the end of the year
• If we assume the stochastic process is Markov with no drift then the
process is
dS = 10dW
• If the stock price were expected to grow by $8 on average during the
year, so that the year -end distribution is ϕ(48, 100), the process
would be
dS = 8dt + 10dW

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 Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

Itô’s lemma for Brownian motion

If f is a twice differentiable function, then

Z t
1 t ′′
Z
f (Wt ) − f (W0 ) = f ′ (Ws )dWs + f (Ws )ds, for all 0 ≤ t ≤ T.
0 2 0
(1)

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Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

Example 3
Let us compute the stochastic integral:
Z T
Wt dWt .
0

To use the Itô’s lemma, we choose f (x) = x2 /2, then f ′ (x) = x and
f ′′ (x) = 1. By Itô’s lemma, we have
T T T
WT2 W2
Z Z Z
1 T
− 0 = Wt dWt + 1dt = Wt dWt +
2 2 0 2 0 0 2

Thus,
T
WT2
Z
T
Wt dWt = − .
0 2 2

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 Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

Diffusion processes

A diffusion processes X = {Xt , 0 ≤ t ≤ T } is a continuous-time

stochastic process that can be written in the following form:
Z t Z t
Xt − X0 = a(Xs )ds + b(Xs )dWs , (2)
0 0

where a(·) and b(·) are deterministic functions and where X0 = x0 ∈ R

initial value of the processes X.

• a(x) is known as drift coefficient

• b(x) is called the diffusion or volatility coefficient

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Wiener Processes and Itô’s Lemma
Continuous-Time Stochastic Processes

• Diffusion process is generalization of linear Brownian motions.

Recall that, a linear Brownian motion Xt = X0 + µt + σWt can be
written as Z Z t t
Xt = X0 + µds + σdWs .
0 0
• In other words, such linear Bm is diffusion process as with a
constant drift coefficient a(x) = µ and a constant volatility
coefficient b(x) = σ.

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 Wiener Processes and Itô’s Lemma
Stochastic differential equations

Stochastic differential equations

• A stochastic differential equation (SDE) is a stochastic equation: for

given functions a(·) and b(·), we are looking for a process X such
that
dXt = a(Xt )dt + b(Xt )dWt , (3)
with initial condtion X0 = x0 .
• More rigorously, we are looking for a diffusion process X such that
Z t Z t
Xt − X0 = a(Xs )ds + b(Xs )dWs ,
0 0

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 Wiener Processes and Itô’s Lemma
Itô’s lemma for diffusion process

Itô’s lemma for diffusion process

• Let f (t, x) be a function of two variables, i.e. of time and space

∂2f
respectively, such that ∂f
∂t and ∂x2 are both continuous.
• If X = {Xt , 0 ≤ t ≤ T } is a diffusion process solving the general
SDE given in (3), then the process Yt = f (t, Xt ) solves the following
SDE:
∂f ∂f 1 ∂2f
df (t, Xt ) = (t, Xt )dt+ (t, Xt )dXt + (t, Xt )(dXt )2 . (4)
∂t ∂x 2 ∂x2
Here (dXt )2 = (b(Xt ))2 dt.

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Wiener Processes and Itô’s Lemma
Itô’s lemma for diffusion process

Hence substituting dXt by its expression in (3) and reorganizing equation

(4), we get

∂2f
 
∂f ∂f 1
df (t, Xt ) = (t, Xt ) + a(Xt ) (t, Xt ) + (b(Xt ))2 2 (t, Xt ) dt
∂t ∂x 2 ∂x
∂f
+ (t, Xt )b(Xt )dWt (5)
∂x

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Wiener Processes and Itô’s Lemma
Itô’s lemma for diffusion process

Why a Generalized Wiener Process is Not appropriate for Stocks

• For a stock price we can conjecture that its expected percentage

change in a short period of time remains constant (not its expected
actual change)
• We can also conjecture that our uncertainty as to the size of future
stock price movements is proportional to the level of the stock price

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Wiener Processes and Itô’s Lemma
The Process for a Stock Price

• The generalized Wiener process has a constant expected drift rate

and a constant variance rate.
• However, this is not appropriate for modeling stock price movements,
as it fails to capture a fundamental aspect of stock prices.
• Specifically, it does not account for the fact that the expected
percentage return required by investors from a stock is independent
of the stock’s price.

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Wiener Processes and Itô’s Lemma
The Process for a Stock Price

• The assumption of a constant expected drift rate should be replaced

by the assumption that the expected return is constant.
• If S represents the stock price at time t, then the expected drift rate
in S should be assumed to be µS for some constant parameter µ.
• This implies that within a short interval of time, ∆t, the expected
increase in S is µS∆t.
• The parameter µ serves as the expected rate of return on the stock.

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Wiener Processes and Itô’s Lemma
The Process for a Stock Price

If the coefficient of dW is zero, so that there is no uncertainty, then this

model implies that
∆S = µS∆t,
in the limit, as ∆t → 0, so that:

dS = µSdt,

or
dS
= µdt.
S
Integrating between time 0 and time T , we get

ST = S0 eµT (6)

Equation (6) shows that, when there is no uncertainty, the stock price
grows at a continuously compounded rate of µ per unit of time. In
reality, there is uncertainty.
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Wiener Processes and Itô’s Lemma
The Process for a Stock Price

• A reasonable assumption is that the variability of the return in a

short period of time, ∆t, is the same regardless of the stock price.
• This suggests that the standard deviation of the change in a short
period of time ∆t should be proportional to the stock price and
leads to the model
dS = µSdt + σSdW,
or
dS
= µdt + σdW. (7)
S

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Wiener Processes and Itô’s Lemma
The Process for a Stock Price

• Equation (7) is the most widely used model of stock price behavior.
• The variable µ is the stock’s expected rate of return. The variable σ
is is the volatility of the stock price.
• The variable σ 2 is referred to as its variance rate.
• The model in equation (7) represents the stock price process in the
real world. In a risk-neutral world, µ equals the risk-free rate r.

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 Wiener Processes and Itô’s Lemma
The Process for a Stock Price

Discrete-Time Model

The model of stock price behavior (7) is known as geometric Brownian

motion. The discrete-time version of the model is
∆S √
= µ∆t + σε ∆t, (8)
S
or √
∆S = µS∆t + σSε ∆t. (9)

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Wiener Processes and Itô’s Lemma
The Process for a Stock Price

Remark 1
• ∆S is the change in the stock price S in a small time interval ∆t,
• ε has a standard normal distribution.
• The left-hand side of equation (8) is the discrete approximation to
the return provided by the stock in a short period of time, ∆t.
• The term µ∆t is the expected value of this return, and
√
• the term σε ∆t is the stochastic component of the
return. The variance of the stochastic component is σ 2 ∆t.
• Equation (8) shows that ∆S
S is approximately normally distributed
√
with mean µ∆t and standard deviation σ ∆t. In other words,

∆S
∼ ϕ(µ∆t, σ 2 ∆t) (10)
S

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 Wiener Processes and Itô’s Lemma
The Process for a Stock Price

Monte Carlo Simulation

• We can sample random paths for the stock price by sampling values
for ε
1
• Suppose µ = 0.15, σ = 0.30, and ∆t = 1 week (= 52 or 0.0192
years), then
√
∆S = 0.15 × 0.0192S + 0.30 × 0.0192Sε

or
∆S = 0.00288S + 0.0416Sε

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 Wiener Processes and Itô’s Lemma
The Process for a Stock Price

Monte Carlo Simulation - Sampling one Path

Weak Stock price at Random Change in Stock

start of Period Sample for ε Price, ∆S
0 100.00 0.52 2.45
1 102.45 1.44 6.43
2 108.88 -0.86 -3.58
3 105.30 1.46 6.70
4 112.00 -0.69 -2.89

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 Wiener Processes and Itô’s Lemma
The Process for a Stock Price

Correlated Processes

Suppose that the the processes followed by two variables X1 and X2 are

dX1 = a1 dt + b1 dW1 and

dX2 = a2 dt + b2 dW2 ,

where dW1 and dW2 are Wiener processes. The discrete-time

approximations for these processes are:
√
∆X1 = a1 ∆t + b1 ε1 ∆t and
√
∆X2 = a2 ∆t + b2 ε2 ∆t,

where ε1 and ε2 are random samples form a standard normal distribution.

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Wiener Processes and Itô’s Lemma
The Process for a Stock Price

Let ρ be the correlation of the processes X1 and X2 . To sample standard

normal variables ε1 and ε2 with correlation ρ, we can set
p
ε1 = u and ε2 = ρu + 1 − ρ2 v

where u and v are sampled as uncorrelated variables with standard

normal distributions.

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 Wiener Processes and Itô’s Lemma
The Process for a Stock Price

Application of Itô’s Lemma to a Stock Price Process

The stock price process is

dS = µSdt + σSdW

For a function G of S and t

∂G 1 ∂ 2 G 2
 
∂G ∂G
dG = a+ + b dt + bdW
∂x ∂t 2 ∂x2 ∂x

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 Wiener Processes and Itô’s Lemma
The Process for a Stock Price

Examples

1. The forward price of a stock for a contract maturing at time T

G = Ser(T −t)

dG = (µ − r)Gdt + σGdW
2. The log of a stock price
G = ln S
σ2
 
dG = µ− dt + σdW
2

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 Wiener Processes and Itô’s Lemma
Labs

Labs

1. Simulation of Wiener process

2. Simulation of generalized Wiener process
3. Monte Carlo simulation
4. Simulation of correlated stock process

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References

For further reading: (Hull, 2021, Chapter 14)

References

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Hull, J. C. (2021). Options futures and other derivatives. Pearson
Education India.

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