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3.

The Wiener Process and Rare Events in


Financial Markets
The Wiener process works as a mathematical
model for continuous time stock price.
To make the process even more realistic oc-
casional rare events causing jumps into the
sample paths are added by modeling with
some point processes.
Consider rst the modeling the ordinary
events with Wiener process (Brownian mo-
tion) (see here for a heuristic construction of
the Brownian motion).
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Denition 3.1: A Wiener process, W
t
, rela-
tive to a family of information sets {I
t
} (l-
tration), is a stochastic process such that
1. W
0
= 0 (with probability one).
2. W
t
is continuous.
3. W
t
is adapted to the ltration {I
t
}.
4. For s t, W
t
W
s
is independent of I
s
,
with E[W
t
W
s
] = 0 and Var[W
t
W
s
] =
E(W
t
W
s
)
2
= t s.
2
Equivalently we can dene:
Denition 3.2: A random process B
t
, t
[0, T] is a (standard) Brownian motion if
1. B
0
= 0.
2. B
t
is continuous.
3. Increments of B
t
are independent. I.e., if
0 t
0
< t
1
< < t
n
, then B
t
1
B
t
0
, . . . , B
t
n

B
t
n1
are independent.
4. If 0 s t, B
t
B
s
N(0, t s).
-20
-10
0
10
20
30
80 82 84 86 88 90 92 94 96 98 00
Time
W
(
t
)
+std
-std
Figure 3.1: Three sample paths of a standard
Brownian motion.
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Properties:
(a) W
t
is an I
t
-martingale.
(b) W
t
has independent increments.
(c) E[W
t
] = 0 for all t.
(d) Var[W
t
] = t.
(e) The law of iterated logarithms
lim sup
t
W
t

2t loglogt
= 1 (with probability one)
(f) W
t
/t 0 w.p.1 as t .
(g) W
2
t
t is an I
t
-martingale.
(h) exp{W
t
(
2
/2)t} is an I
t
-martingale.
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Proof: (a) Let s t, then E[W
t
W
s
|I
s
] =
E[W
t
W
s
] = 0. So E[W
t
|I
s
] = W
s
.
(b) Let 0 s < t < u then W
t
W
s
is I
t
-
measurable (W
s
, W
t
I
t
I
u
) and W
u

W
t
is independent of I
t
, which implies that
W
u
W
t
is independent of W
t
W
s
.
(c) 0 = E[W
t
W
0
] = E[W
t
].
(d) Var[W
t
] = Var[W
t
W
0
] = t 0 = t.
(e) Will not be proven, but means that if b >
1, for suciently large t, W
t
< b

2t loglogt.
(f) Follows from the law of iterated loga-
rithms.
(g) and (f) Left as exercises.
5
-40
-30
-20
-10
0
10
20
30
40
80 82 84 86 88 90 92 94 96 98 00
W
_
t
Time
std
log-log
Figure 3.2: The law of iterated logarithms.
6
Example 3.1:
S
t
= S
0
e
(
1
2

2
)t+Wt
,
where S
0
> 0, and and > 0 are constants. This is an example
of generalized Brownian motion, called also a Geometric Brow-
nian motion, and serves as a basic model for stock prices. The
distribution of logS
t
is normal with mean
logS
0
+
_

1
2

2
_
t
and variance
2
t. The continuously compounded return to the
stock, per unit of time (e.g. if annual, then annualized cumula-
tive returns), over time interval [t, t +u], u > 0, is
R
u
=
1
u
(logS
t+u
logS
t) =
1
2

2
+
1
u
(W
t+u
W
t
).
Because for xed t, W
t+u
W
t
is a standard Brownian motion
with time index u, property (f) above implies that
R
u

1
2

2
as u .
Note. E[S
t
] = S
0
e
t
.
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0
400
800
1200
1600
2000
80 82 84 86 88 90 92 94 96 98 00
S
(
t
)
Time
E[S(t)]
Figure 3.3: Sample paths of monthly stock price processes S
t
=
S
0
e
(
1
2

2
)t+Wt
with S
0
= 100, and annual rate of return = 10%
and volatility = 25%.
8
-30
-20
-10
0
10
20
30
80 82 84 86 88 90 92 94 96 98 00
M
o
n
t
h
l
y

r
e
t
u
r
n

(
%
)
Month
Figure 3.4: Monthly log-returns R
t
= 100(logS
t
logS
ts
) for
the sample period 1980:1 to 2001:12.
-60
-40
-20
0
20
40
60
80 82 84 86 88 90 92 94 96 98 00
A
n
n
u
a
l
i
z
e
d

c
u
m
u
l
a
t
i
v
e

r
e
t
u
r
n

(
%
)
Month
Figure 3.5: Annualized cumulative log-returns R
A
t
= 100
12
t
(logS
t

logS
0
) for the period 1980:1 to 2001:12 (monthly observations).
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Remark 3.1: In the above example the geometric Brow-
nian motion is usually given in the dierential form
dS
t
S
t
= dt + dW
t
,
(model of the return) or
dS
t
= S
t
dt + S
t
dW
t
.
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Rare Events and Poisson Process
In stock markets we occasionally observe sud-
den jumps in the prices due to some impor-
tant or extreme event that aects the price.
To model these a reasonable assumption could
be that the jumpsbeing consequences of
extreme shocksare independent of the usual
information driving innovations dW
t
.
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Following Merton

we can introduce a model


where the asset price has jumps superim-
posed upon a geometric Brownian motion
such that
dS
t
S
t
= ( )dt + dW
t
+dJ
t
, (1)
where the assets expected return, is
the jump intensity (e.g. average number of
jumps per year), is the average size of the
jump as a percentage of the asset price,
is the return volatility, and J
t
is related to
the (independent) Poisson process generat-
ing the jumps.
Once the jump occurs we can superimpose it
into the process by assuming that it is gen-
erated from a normal distribution with mean
and standard deviation equaling the jump
volatility.

Merton, R.C. (1976). Option pricing when underlying stock


returns are discontinuous. Journal of Financial Economics, No.
3, 125144.
12
Example 3.2: Consider a situation where the underly-
ing process has a jump frequency one per year ( = 1/2)
(i.e., on average once every two year). The average
percentage jump size is assumed for simplicity to be
equal to zero and the volatility of the jump is 20%.
Suppose the stock price now is 100, the drift is 8%,
= 15%. Below are four sample baths from the dif-
fusion process
dS
t
S
t
= dt + dW
t
+dJ
t
.
We model dJ
t
as dJ
t
= 0.20Z U, where Z is a standard
normal variable and U is a random variable such that
P(U = 1) = dt and P(U = 0) = 1 dt. In addition
Z and U are independent.
A discrete approximation of the above dierence equa-
tion is
S
t
= S
th
_
1 +0.08h +0.15

hZ
t
+dJ
t
_
,
13
0
100
200
300
400
500
600
700
90 92 94 96 98 00 02 04 06
S1 S2 S3 S4
Sample paths of a jump process:
S(t) = S(t-dt)*[1 + 0.08dt + 0.15 sqrt(dt) Z(t) + dJ(t)],
dJ(t) = 0.2 Z U(t), with P(U(t) = 1) = 0.5 dt
Month
S(t)
14
We can rewrite the diusion process in this example
as
dS
t
S
t
= ( )dt + dW
t
if the Poisson event does not occur, and
dS
t
S
t
= ( )dt + dW
t
+0.20Z
if the Poisson event occurs.
It can be shown that the process then is
S
t
= S
0
exp
__

1
2

_
t +W
t
_
J(N
t
),
where
J(N
t
) = exp
_
N
t

i=1
J
i
_
with J
i
= 0.20Z
i
, and Z
i
are independent N(0, 1) ran-
dom variables. N
t
has the Poisson distribution, dis-
cussed more closely below.
15
In order to model the jump intensity, let N
t
denote the total number of extreme (unordi-
nary) shocks until time t (counting process).
Then once the event occurs, N
t
changes by
one unit and remains otherwise unchanged.
Conceptually we can model this within an in-
nitesimal interval dt by
dN
t
=
_
1 with probability dt
0 with probability 1 dt
(2)
This causes a discrete jump (once it occurs),
because the size does not depend on dt (the
size can be a random variable as in the pre-
vious example).
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Poisson process has the following properties:
(1) During a small interval h, at most one
event occurs with probability 1.
(2) The information up to time t does not
help to predict the occurrence of the event
in the next instant.
(3) Events occur at a constant rate .
Remark 3.2: Within any time interval [t, t +h], N
t+h
=
N
t+h
N
t
has the Poisson distribution
P(N
t+h
= k) =
(h)
k
k!
e
h
, k = 0, 1, . . . (3)
E[N
t+h
] = h = Var[N
t+h
]. (4)
However, if h is small
P(N
t+h
= 1) = (h)e
h
h (5)
as stated above. We denote N
t+h
Po(h). Thus
because N
0
= 0, we have in the previous example
N
t
Po(t).
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