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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.
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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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