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When we model a stock price X(t) using Brownian motion we have to take into account the fact that the
magnitude of a stock's price has an effect on how it changes. For example a 25 increase in the price of a
stock whose current price is $5.00 is similar to a $2.50 increase in the price of a stock whose current price
is $50.00. In order to take this into account we model the logarithm Y(t) of the stock's price as a
Brownian motion rather than the price itself. When we do this we say the stock price itself is being
modeled by a geometric Brownian motion. The Brownian motion parameters and for Y(t) are called
the drift and volatility of the stock price.
Example 1. Let X(t) be the price of FMC stock at time t years from the present. Assume that X(t) is a
geometric Brownian motion with drift = 0.05 / yr and volatility = 0.4 / yr1/2. If the current price of
FMC stock is $2.50, what is the probability that the price will be at least $2.60 one year from now.
Since X(t) is a geometric Brownian motion, log(X(t)) is a regular Brownian motion with drift rate
= - 0.05 / yr and = 0.4 / yr1/2. We want to know the probablity that log(X(1)) log(2.60) given that
log(X(0)) log(2.50). This means
log(X(1)) - log(X(0)) log(2.60) - log(2.50) = log = log(1.04) 0.0392
In this case Z = (log(X(1)) - log(X(0)) t)/() = (log(X(1)) - log(X(0)) - (- 0.05)(1))/(0.4)()) = (log(X(1))
- log(X(0)) +0.05)/0.4 is a standard normal random variable. So
Pr{log(X(1)) - log(X(0)) > 0.0392} = Pr{log(X(1)) - log(X(0)) + 0.05 > 0.0392 + 0.05}
= Pr{ > } = Pr{ Z > 0.223}
= 1 - Pr{ Z 0.293} = 1 - (0.293) = 1 0.5884 = 0.4116 41%
Here (z) = Pr{Z z} = is the distribution function of a standard normal random variable.
Example 2. Let X(t) be the price of JetCo stock at time t years from the present. Assume
that X(t) is a geometric Brownian motion with zero drift and volatility = 0.4 / yr1/2. If the
current price of JetCo stock is $8.00, what is the probability that the price will be at least
$8.40 six months from now.
Since X(t) is a geometric Brownian motion, log(X(t)) is a regular Brownian motion with zero
drift and = 0.4 / yr1/2. We want to know the probablity that log(X(1/2)) log(8.40) given
that log(X(0)) log(8.00). This means
log(X(1/2)) - log(X(0)) log(8.40) - log(8.00) = log = log(1.05) 0.0488
In this case Z = (log(X(1/2)) - log(X(0)) (0)(1/2))/(0.4) = (log(X(1/2)) - log(X(0)))/0.283 is
a standard normal random variable. So
Pr{log(X(1/2)) - log(X(0)) > 0.0488} = Pr{ > }
= Pr{ Z > 0.172} = 1 - Pr{ Z 0.172} = 1 - (0.172) = 1 0.568 = 0.432
43%
6.4.1 - 1
= e2/2 = e2/2
= e2/2
Example 4. Let X(t) be the price of FMC stock at time t years from the present. Assume that X(t) is a
geometric Brownian motion with drift = 0.05 / yr and volatility = 0.4 / yr1/2. If the current price of
FMC stock is $2.50, what is the expected price six months from now. By Proposition 1 one has
E{X(t)} = E{X(0)}e( + 2/2)t = (2.5)e(- 0.05 + (0.4)2/2)(1/2) = (2.5)e(- 0.05 + 0.08)(1/2)
= (2.5)e0.015 = (2.5)(1.0151) = $2.538
Interest. There is one more factor that enters into the pricing of stock options. This is the effect of
interest. An alternative to investing in the stock market is to put one's money in an investment that is
guaranteed to pay a certain amount of interest such as a certificate of deposit. In certain situations putting
one's money in a guaranteed investment might by better than investing in stocks or stock options. Let's
suppose
r = interest rate on guaranteed investments.
So an investment of M grows
Mt = M(1 + r)t
Example 1. How much does $8.00 grow to after two years if the annual interest rate is 1%?
6.4.1 - 2
In this case M = $8.00, r = 0.01 and t = 2. After two years this grows to M2 = M(1 + r)t = (8)(1 + 0.01)2 =
(8)(1.01) 2 = (8)(1.0201) = $8.1608.
When one is modeling investments in continuous time it is convenient to express the factor (1 + r)t in
terms of e. Let
6.4.1 - 3
In order to get the present value of this we need to multiply by the discount factor e-t. So
E{e-tX(t)} = E{X(0)}e( + 2/2 - )t = present value of a geometric Brownian motion at time t
Example 4. Let X(t) be the price of FMC stock at time t years from the present. Assume that X(t) is a
geometric Brownian motion with drift = 0.05 / yr and volatility = 0.4 / yr1/2. If the current price of
FMC stock is $2.50, what is the expected present value of its price six months from now if the annual
interest rate is 5%.
The instanteous interest rate is = log(1.05) = 0.0487. Using the above formula one has
+ - > 0
Stock is better
+ - < 0
+ - = 0
Some people believe the stock's drift rate adjusts so that investing in the stock has the same expected
outcome as a guaranteed investment, i.e. so
+ - = 0
When this happens an arbitrage is said to occur. We shall assume this happens below.
Problem 1. Suppose the current price of DTE stock is $49, the price has a volatility of
= 0.15 / yr1/2 and the current interest rate is = 0.05 / yr. Assume that arbitrage is working so
the drift is = - 2/2.
a.
What is the probability that the stock price will be at least $50 in 3 months?
b.
6.4.1 - 4