1 Stochastic Process

Stochastic Process:
A collction of r.v’s X(t) which denotes the state of the process at time t.
The time parameter and state of the process can be of the following types:

1. Discrete time, discrete space process:

Time parameter is discrete where t ∈ {1, 2, ...} and state of the process
is discrete. Example: Total number of persons served at a service centre
on each working day.

2. Discrete time continuous space process:

Example: Temperature at noon on each day in a city.

3. Continous time discrete, continuous space process:

Example: Number of person in a queue during a day

4. Contiuous time, continuous state process:

Example: Speed of a car moving on a highway

Process with independent increments:

X(t) denotes the state of the process at t, which is subject to increase and/or
decrease in [0, t]. For example, X(t) may stand for the market price of a
particular share of a company traded in a day in the market where it is
observed that the price changes during a one period is independent of the
change in another non-overlapping period. That is,for time points t0 ≤ t1 ≤
t2 , X(t1 ) − X(t0 ) and X(t2 ) − X(t1 ) are independent r.v’s. Examples are
Poisson Process and Brownian Motion.

1.1 Poisson Process

X(t) is a continuous time, discrete space stochastic process. X(t) denotes
the total number of events that took place durinf [0, t]. Events take place in
the interval of time [0, t] at different time points X(t) is the number of events
in [0, t]. X(t) is a Poisson r.v. with parameter λt. That is: P (X(t) = n) =
e−λt λtn /n!, n = 0, 1, ..., ∞. It can be shown that X(t) becomes a Poisson r.v.
by adding changes taking place in small intervals of time during [0, t].

For n, divide [0, t] into equal parts of length ∆ = t/n.

Let the change made in [(k − 1)∆, k∆], k = 1, 2, ..., n be a binomial r.v
Y taking values 1 or 0 with P (Y = 1) = λ∆.

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 n binomial trials are made, each trial represented by the r.v Yi , i =
1, 2, ...n.

Let Y = ΣYi .
n(n − 1)...(n − r + 1)
P (Y = r) = Crn (λ∆)r (1−λ∆)n−r = (λ∆)r (1−λ∆)n−r
r!

(1 − n1 )...(1 − (r−1)
) λt n−r
= n
nr (λt/n)r (1 − )
r! n
r
which tends to e−λt (λt)
r!
as n− > ∞.

Inter occurnace time is exponential

Suppose that events in the Poisson Process occur at times t1 , t2 , ..., it can be
shown that (tk − tk−1 ) has exponential distribution with parameter λ.
Consider the first occurance at time t1 . We can think of the interval [0, t1 )
as composed of m small non-overlapping intervals each of length ∆, so that
m∆ = t1 . The event occurs at t1 for the first time implies that it does not
occur before t1 and it occurs in the interval [t1 , t1 + dt) where dt is infinites-
imily small.

P(Occurance of event in interval of length ∆) = λ∆. Therefore,

P(Event occurs for the first time in [t1, t1 + dt1 ))

= (1 − λ∆)m λdt = (1 − λ(t1 /m))m λdt1 − > e−λt1 λdt1 .

as m− > ∞.
Since Poisson Process is a process with independent increments, what
happens in the intervals [0, t1 ], [t1 , t2 ], ... are independent events. So, the
inter-occurance of events are each distributed exponentially. When arrival
takes place starting from time 0, with inter-arrival time following exponential
distribution, the number of arrivals in the interval [0, t] which is represented
by the stochastic variable X(t), is distributed as a Poisson variate.
Question:

Share price of a company changes by increase of Rs.10 or decrease by

Rs.10 with probabilty 0.5. The waiting time for a change to take place is
exponentially distributed with expected waiting time of 2 months. What is
the expected gain in holding one unit of the share for two years ?
(Hint: E(X) = 1/λ for an exponentially distributed X with parameter λ)

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1.2 Brownian Motion
Brownian motion is a stochastic process X(t) : t ≥ 0 with independent
increments.
X(t) has Normal distribution with mean µt and variance σ 2 t.
X(t) denotes the accumulated value of the process from time 0 to t,
the intial value being X(0).
If the time interval, [0, t] is divided into n small intervals each of length
∆, in each interval, there is some addition (either increase or decrease).
The n additions, viz. X(k∆) − X(((k − 1)∆), k = 2, 3, ..., n are i.i.d
variables distributed as X(∆).
X(t) = X1 (∆) + X2 (∆) + ..., Xn (∆) where the n r.v’s are each dis-
tributed as X(∆)
As in the case of Poisson Process, we can derive the distribution
√ of
X(t) by taking X(∆) to be a Binomial variate which takes on σ (∆)
with probabilty p = 21 (1 + σµ sqrt∆)
Derivation:
√ √ √ √
E(X(∆)) = σ ∆(p − q) = (2p − 1)σ ∆ = ( σµ ∆σ ∆
= µ∆.
√ √ √
V (X(∆)) = (σ ∆)2 p + (−σ ∆)2 q − (µ∆)2 = (σ ∆)2 − (µ∆)2
E(X) = nE(X(∆)) = (t/∆)nE(X(∆)) = µt.
V (X) = nV (X(∆)) = (t/∆)(σ 2 ∆) − tµ2 ∆− > σ 2 t as n− > ∞
Then, according to the Central Limit Theorem, X(t) the sum on n i.i.d
variates is a Normal variate wioth mean µt and variance σ 2 t.
Geometric Brownian Motion S(t) is a geometric Brownian motion if log(S(t))
is Brownian motion.
If the intial value of X(t), i.e. X(0) = a, then S(t) = ea+X(t) = seX(t) ,
where ea = s
If X is a Normal variate with mean µ and variance σ 2 , then E(eX ) =
2
eµ+σ /2
2 /2 2 /2)t
E(S(t)) = seµt+tσ = se(µ+σ
log( S(t+y)
S(y)
) = X(t + y) − X(y).