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Geometric Brownian Motion with Ito's lemma

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 Geometric Brownian Motion with Itos Lemma
Approach to Evaluate Market Fluctuations: A case
study on Colombo Stock Exchange
R.M. Kapila Tharanga Rathnayaka , Wei Jianguo, D.M.K.N Seneviratna
School of Economics
Wuhan University of Technology
Wuhan, P.R. China.
kapilar@sab.ac.lk, weijg@whut.edu.cn, seneviratna@is.ruh.ac.lk

Abstract The data forecasting in economical time series market predictions. Some of these methodologies are only
provides a significant guidance for making decisions in the applicable at the level of theoretical assumptions; especially
financial markets today. It can be widely applied for solving high order fuzzy algorithms, Markov- Fourier Grey Models,
economic problems with uncertainty and instability patterns. Auto regressive moving average methods and clustering
Forecasting high volatile fluctuations with instability behavioral
Genetic Fuzzy systems etc [2]. However, most of the constant
patterns make complicated problems in stock markets around
the world today. volatility models have shown the deficient fit of predictions.
The main focus of this study is to develop a forecasting Specially, the classic financial time series approaches such as
model based on Geometric Brownian Motion approach for ARCH was proposed to model the characteristic of time series
estimating share price indices in short-term investments in the that have volatility clustering and fat tails [3]. As a result,
Colombo Stock Exchange (CSE), Sri Lanka. Furthermore, many researches around the world have been carrying out
traditional ARIMA approach was used to compare the miscellaneous type of studies for predicting the stock indices
predictions. The results reveal that, the new proposed model is under the different types of modernized constraints.
more significant for investors in making their investment Arbitrage price theory (APT) has introduced by Ross to
decisions wisely.
explore the link between stock returns to economic variables
[1, 2]. In the initial step, it defined as a normative equilibrium
Keywords Geometric Brownian Motion, ARIMA, CSE, ASPI method which can be used for estimating only for the price of
and SAP. assets. However using APT approach, Chen examined the
long and short term influences with respect the USA stock
I. INTRODUCTION indices based on selected macro-economic variables. Froelich
Capital Investments in stock market is the easiest and fastest did a similar type of study based on the Beta distributional
way for building healthy financial foundation for future life. analysis to discuss the stock market volatility and long and
As a result, stock markets have become more institutionalized short run relationships with respect to the macro as well as
in the past few decades and advanced as the main forms of micro economic factors [4, 5].
investments for numerous organizations as well as individuals According to the Omar and Jaffars study, economic
to arrange large investment funds to the general public. Day forecasting methodologies can be categorized into three main
by day investors have been accessing the capital markets categories as; fundamental analysis, technical analysis and
around the world and exchanging vast array of financial technological methods [4]. Fundamental analyse is mainly
products. concerned the fundamentals which can be evaluated by past
The global growths of the market prices and trade volume performances as well as the financial aspects of the company.
rates have been changing with highly volatile fluctuations. It But concept of the technical analysis is totally deviated and
is common phenomenon that, when the company has obtained can be used for determine the future price patterns of the
their capital needed, the shareholders will benefit through stocks based solely on the past price behaviours [6].
dividends paid by companies. So, the shareholders have Multidimensional analysis techniques have been widely
alternatives for transferring or selling their ownerships as their applied for extracting the required data and information
requirements. The prices of the stocks mainly depend on the among Chinas financial markets today [7]. Wang applied the
financial stability of the market, turn over value, share volume, GARCH model to evaluate the dynamic fluctuations and
variety of financials and etc. [1]. solutions approached for 20 sectors which have taken from the
The successful prediction of stock's prices could yield Shanghai stock exchange, China [8]. Kong and Li also did
significant profit for investors. Numerous types of similar type of study to create a computerized stock picking
methodologies can be found in the literature to estimate the
model for Danish stock exchange based on Bayesian network
algorithms [9].
Data mining techniques based on computational
approaches successfully applied for the stock market
predictions during the past two decades. In the beginning of
time only focused on estimating the level of the returns on
stock price indices. Hengshan successfully applied
miscellaneous type of analysis techniques such as Linear
Discriminant analysis, Quadratic discriminant analysis, Least
squares support vector machine (LS- SVM) and Naive Bayes
kernel estimation to predict the price movement patterns in the
Hong Kong stock market based on daily market indices [10].
Composite Index and Component Index are principal
indices running under the Shanghai and Shenzhen Stock
Exchanges in China today. Using Skewness-Kurtosis test and
Kolmogorov-Smirnov test, Wang introduced new
mathematical approach based on continuous time Markov
process to discuss the fluctuations in Shenzhen stock
exchange [11]. Experimental results suggested that, corporate
performance with ownership structure has substantially
affected on the stock price volatility [11].
Overall, existence of nonlinear relationships with respect
to the stock returns and trading volume is widely documented
in the literature. Current study we seek to develop a
forecasting model based on Geometric Brownian Motion
approach for estimating share price indices in short-term
investments in Colombo Stock Exchange (CSE), Sri Lanka.
Problem Definition
Colombo Stock Exchange (CSE) is one of the most
modernized stock exchange in South Asia with a fully
automated trading platform. It is one of the best preforming
stock market in the world have been maintaining market
capitalization over US$23 billion with average daily turnover
rising to over US$18 billion. Currently, 295 listed local and
foreign companies have been offering variety of investment
options for local and global investors [10, 12]. Two price
indices are mainly manipulating in the CSE namely All Share
Price Index (ASPI) and the S&P Sri Lanka 20 Price Index
(S&P SL20) [13]. The ASPI is the principal stock index,
which measures the movement of share prices of all listed
companies [14].
This study mainly takes an attempt to understand the
trends and behavioural patterns in the CSE and predict the
future estimations under the new proposed Geometric
Brownian Motion (GBM) frame work.
The rest of the paper is organized as follows. Section 3
explains the methodology about pro-posed work with
Geometric Brownian Motion algorithm. Section 4 explains
about experimental results and Section 5 ends up with
conclusion and future work.
II. METHODOLOGY
Highly volatile fluctuations with instability patterns are
common phenomenon in the CSE. Innumerable micro and
macro-economic conditions with market conditions directly
affected to generate high volatile fluctuations [1, 4, 5].
The methodology of the study can be describes as follows.
In the first phase, stock market validations were identified
using traditional auto regressive methods such as ARMA and
ARIMA models. In the second part, new proposed GBM
algorithm was applied for predicting future predictions.
Finally, testing accuracies techniques were used for
comparing our results.
A. Derivative of Geometric Brownian Motion
Time series analysis is a popular data mining task for
making the proper decisions based on relevant information in
financial sector today. Different types of artificial intelligence
models can be seen in the literature. However, most of these
models have been shown the poor realistic approach to
volatility modellings. As a result, Geometric Brownian motion
approaches are generally used for predicting short term and
long term predictions in finance today [4, 5, 15].
The closing price represents the most closed up-to-date
valuation of stocks or indices until trading commences again
on the next trading day. The volatility of the closing prices
provides an uncertainty to invest capitals to stocks over the
time. The Daily closing price values can be converted into
daily return as follows [16].
S St 1
Rt = t (1)
St 1
Where; Rt denotes the market return index and S t and S (t 1)
represents the asset values of the tth day and their previous day
respectively. Moreover, if the price on two consecutive days
was not available, it would be assumed that the price remained
unchanged and hence return is zero. The positive values of the
return indices indicate the profit while negative values
represent the loss of investments. Besides that, higher rate of
returns gave higher profit gaining.
According to the definition, the mean of return distribution
of drift can be defined as follows [4, 5, 17].
1 M
=R= Rt
M t =1
(2)
Where; number of returns in the sample defined by M. The
volatility of the function is a better indicator for measuring the
fluctuations of shares up and down. It can be used for
measuring the risk level of the function. The volatility or
sample standard deviation is given by equation (3).
1 M
=r=
( M 1) t
(R
t =1
t R) 2 (3)
B. Model Assumptions
Generally, the returns can be assumed as a random variable,
which has closed enough to a normal distribution with a non-
zero mean and standard deviation. So the distribution of asset
returns can be defined as follows.
S S t 1 Mean + Standard deviation (4)
Rt = t =
S t 1
Statistically, it is difficult to measure mean scale of the
distribution with the small parameter t which represents the
time gap between assets. The drift rate or growth rate of WT = sqrt(TS) *[0; cumsum(randn(N,1))]; % approximation to the
the distribution can be assumed as a constant and defined as Normal distribution
equation (5). W = (MU - 0.5*SIGMA^2) *T + SIGMA * WT
Mean = t (5) GBM = s(0)* exp( W ); assets forecasting
The volatility (standard deviation) of the distribution is
significant and elusive quantity in the theory of derivatives. C. Model Identification
The standard deviation of the asset returns over a time step t
Model identification process is an important as well as the
is given as equation (6) [18]. initial step for determining the stationary, non-stationary
conditions. In the literature, several methods can be seen to
Standard Deviation = t 1/ 2 (6) determine it. They are; Augmented Dickey-Fuller test (ADF),
Putting these scalings explicitly from equation (5) and (6) Phillips-Perron test (PP) and Kwiatkowski-Phillips-Schmidt-
into asset return model represents in equation (4). Then we Shin test (KPSS) and etc.
have;
S S t 1 (7)
C.1Augmented Dickey-Fuller Test (ADF)
Rt = t = t + t 1 / 2
S t 1
Among the several tests, ADF or Dickey-Fuller test can be
The term dwt be a random variable, from normally
used to test the existence of a unit root in a time series [19].
distributions with mean zero and variance t . So equation (7) Three models can be seen in the literature. Equation (13), (14)
can be simplified as follows. and (15) represent these model I, model II and model III
respectively.
dS t = S t t + St dwt (8)
Integrating equation (8) w.r.t t; Yt = Yt 1 + t , t = 1,2,3... ; Y0 = 0 (13)

t Yt = + Yt 1 + t , t = 1,2,3... ; Y0 = 0 (14)
dS
o St t = t + wt (9)

Yt = + t + Yt 1 + t , t = 1,2,3... ; Y0 = 0 (15)
Where; let we assume that, w0 = 0 . It is clear that, term
S t under the Ito process. So we used Itos calculation for our The main focus of the three models is to test that the
further study. coefficient is equals to zero or not. Coefficent have zero
values means that the given time series has a unit root.
dSt 1 2 (10) Otherwise the series can be considered as stationary series or
d (ln S t ) = dt satisfies a random walk [20].
St 2
Now, substitute equation (10) into the equation (8) we get; Phillips-Perron Test (PP) also used to test the stationarity
1 of a series which is similar to ADF test up to some extent and
d (ln S t ) = dt + dwt 2 dt (11)
give the same conclusions as well. It differs from ADF test
2
based on the serial correlation [21].
Integrating both sides with respect to the t, we get;
D. ARIMA Model Approach
1 (12)
S t = S 0 exp 2 t + wt The Autoregressive integrated moving average (ARIMA)
2
models have been successfully applied today in wide areas for
Where; wt = xt x0 . Equation (12) indicated continuous predicting future movements of non-stationary data patterns.
stochastic process of Geometric Brownian motion that we ARIMA model is a generalization of an Autoregressive
used for simulated the forecast of stock market indices. moving average model. Basically, it consists three parts. They
Furthermore, following algorithm can be used for our further are; the auto regressive parameter (p), the number of
evaluations. differencing passes (d) and moving average parameter (q).
The moving average process (16) and auto regressive process
%Assuming the following parameters (17) can be written as follows [10, 22];
s=0; % Daily asset prices
R= ((s(t)-s(t-1)*100))/s(t-1); % asset returns X t = + Z t + 1 Z t 1 + 2 Z t 2 + ..., ... + q Z t q (16)
M= (0:1: N); % total number of observations
X t = c + 1 X t 1 + 2 X t 2 + ..., ... + p X t p + Z t (17)
MU=sum (R)/ (M); % drift rate
TS=1% constant time difference between two samples Where; Z t ~ WN (0, 2 ) and i , i and represent the
SIGMA= sqrt([sum(r-MU)^2]/((M-1)*(TS))) ;% volatility rate
constants. Considering properties of AR and MA processes,
T = (0:1: N) *TS; time interval
ARMA (p, q) can be written as;
%Geometric Brownian Morton Approach
 ( B) X t = ( B) Z t (18) TABLE I
MODEL ACCURACY TESTING
Where;
(Z ) = 1 1 Z ... ... 1 Z p and (Z ) = 1 + 1 Z + ... ... + q Z q . MAPE Judgment of Forecast Accuracy
<10% Highly Accurate
11% to 20% Good Forecast
The likelihood estimation method is used for identification 21% to 50% Reasonable Forecast
and estimation patterns. Autoregressive Integrated moving >51% Inaccurate Forecast
average (ARIMA) models are an extension of ARMA process
by intergrade (I) part. ARIMA model is generally referred to III. CASE STUDY: COLOMBO STOCK EXCHANGE
as ARIMA (p, d, q), where p, d and q represent the order of The current study was carried out on the basis of secondary
auto regressive process (AR (p)), integrated (I(d)) and moving data, which were obtained from Colombo Stock Exchange,
average process (MA (q)) respectively [23]. Central Bank Financial reports, different types of background
Moreover, minimum values of Akaike information criterion readings and other relevant sources. Daily trading data for
(AIC), Schwarz criterion (SBIC) and HannanQuinn thirty six months period from January 2011 to December 2013
information criterion (HQIC) methods applied to select more were extracted and tabulated for calculations.
appropriate models. The stage criterion which described under In this study, new proposed algorithm based on GBM were
figure 1 can be used for selecting suitable ARIMA approach. widely applied for identifying the market validations with the
combination of volatility, randomness and expected rate of
market return in CSE .
A. Stationary/Non Stationary Model Checking
TABLE II
ADF AND PP TEST RESULTS
Sector Significance Results Sector Significance Results
Level data 1st Difference
ADF Test PP TEST ADF PP TEST
Test
SAP 0.5759 0.5536 SAP 0.0432 0.0475
ASPI 0.3759 0.3875 ASPI 0.0373 0.0375

As an initial step, stationary and non-stationary conditions

were measured using Unit root approaches namely ADF and
PP. Table 2 results suggested that, levels of first differences
are significantly stationary under the 0.05 level of significance.
Fig. 1 The Stage of building ARIMA [24] As a result, ARIMA is more significant and applicable for
predicting future results.
E. Model Accuracy Testings As a next step, minimum values of AIC, SBIC and HQIC
Time series forecasting considered as a technique which selection criteria were used to select more appropriate model
can be used for predicting future aspects of many operations. between ARIMA(0,0) to ARIMA(5,5). The Table III and
Numerous methods have been carried out by many research Table IV result suggests that, ARIMA (2, 1, 3) (AIC (-6.707158),
works to accomplish their goals. In our study, Mean absolute SBIC (-6.738000), and HQIC(-6.697706)) and ARIMA (1, 1, 1) (AIC
deviation (MAD), mean absolute percentage error (MAPE) (-6.695156), SBIC (-6.70608) , and HQIC(-6.675741)) models are most
and mean square error (MSE) were used to compare the suitable for predicting future patterns of ASPI and SAP
prediction accuracy of our approach models. The accuracy respectively.
models are defined as follows [25, 26] TABLE III
1 M X XP ARIMA MODEL SELECTION FOR THE ASPI DATA
MAPE = A (19)
M j =1 XA AIC, SBIC, and HQIC
p/q 0 1 2 3
M 0 - -6.799428 -6.798081 -6.797447
1
MAD =
M
X
j =1
A XP (20) -6.789632
-6.795552
-6.778490
-6.790330
-6.768060
-6.785820
1 -6.804548 -6.801188 -6.804029 -6.799080
-6.794735 -6.781561 -6.774589 -6.759826
Where; X A and X P represent the actual value and predicted -6.800665 -6.793422 -6.792380 -6.783549
2 -6.800339 -6.801362 -6.797375 -6.707158
value of the indices respectively. Table I represents the scale -6.780676 -6.771867 -6.758049 -6.738000
of judgment of forecast accuracy regarding to Error (MAPE) -6.792559 -6.789691 -6.781813 -6.697706
and clearly indicated that, minimum values of MAPE make 3 -6.798542 -6.790362 -6.805900 -6.800410
more accuracy for forecasting future predictions [4]. -6.768993 -6.755863 -6.756652 -6.741312
-6.786848 -6.779670 -6.786410 -6.777023
 TABLE V
ARIMA MODEL SELECTION FOR THE SAP DATA
As a next step, the selected aforesaid models were used to
AIC, SBIC, and HQIC assess the out-of-sample forecasting performance for the
p/q 0 1 2 3 horizon of one month ahead (testing sample). The
0 - -6.796117 -6.803644 -6.826059 corresponding results are summarized in Table V below
-6.756935 -6.754667 -6.747116 (figure 2). The reported results in Table V represent the
-6.780615 -6.784267 -6.794815 differences and similarities between forecasting results with
1 -6.792864 -6.695156 -6.796830 -6.868806
respect to the actual data patterns. According to the error
-6.753392 -6.706088 -6.737949 -6.779995
-6.777242 -6.675741 -6.773533 -6.833656 analysis results, new proposed GMB is highly accurate (less
2 -6.790066 -6.832449 -6.833665 -6.865625 than 10%) with lowest MAPE error values. Moreover, MAPE
-6.740635 -6.773460 -6.764844 -6.766764 values suggested that our proposed algorithm (ASPI_GMB:
-6.770500 -6.809107 -6.806433 -6.826494 0.1522%, SAP_GMB: 0.298%) is more significant than
3 -6.788361 -6.806513 -6.813944 -6.833610
-6.739022 -6.737565 -6.735147 -6.764535
traditional ARIMA methods (ASPI_ARIMA (2,1,3): 7.318%,
-6.768833 -6.779228 -6.782761 -6.806272 SAP_ARIMA (1,1,1) : 11.657% ) for forecasting short time
predictions.

TABLE V
ASPI AND SAP FORECASTED RESULTS
Dates ASPI SAP
(2013) Actual ARIMA Residual GBM Residual Actual ARIMA Residual GBM Residual
Values (2,1,3) Values (1,1,1)
2 / 12 5774.10 5777.133 -3.033 5774.09 0.01 3174.63 3193.243 -18.613 3180.435 -5.805
3/ 12 5773.12 5777.273 -4.153 5772.01 1.11 3165.88 3178.687 -12.807 3170.412 -4.532
4/ 12 5782.92 5774.894 8.026 5779.38 3.54 3160.94 3170.341 -9.401 3165.31 -4.370
5/ 12 5780.58 5781.06 -0.48 5781.92 -1.34 3165.05 3184.219 -19.169 3170.16 -5.110
6/ 12 5810.24 5784.109 26.131 5799.58 10.66 3161.62 3182.344 -20.724 3169.321 -7.701
9/ 12 5821.30 5810.316 10.984 5814.99 6.31 3183.09 3130.133 52.957 3170.12 12.970
10/ 12 5778.52 5823.213 -44.693 5762.3 16.22 3194.3 3196.716 -2.416 3179.123 15.177
11/ 12 5787.81 5768.016 19.794 5780.02 7.79 3176.62 3201.216 -24.596 3189.765 -13.145
12/ 12 5793.19 5816.972 -23.782 5782.91 10.28 3182.27 3206.902 -24.632 3192.217 -9.9470
13/ 12 5795.66 5809.66 -14 5790.49 5.17 3189.44 3212.681 -23.241 3198.414 -8.974
17/ 12 5811.88 5800.433 11.447 5803.66 8.22 3185.67 3199.247 -13.577 3198.627 -12.957
18/ 12 5811.76 5822.281 -10.521 5808.88 2.88 3193.87 3232.176 -38.306 3202.987 -9.117
19/ 12 5867.00 5833.138 33.862 5850.96 16.04 3191.71 3192.502 -0.792 3223.731 -32.021
20/ 12 5857.36 5877.892 -20.532 5850.01 7.35 3224.46 3258.329 -33.869 3233.436 -8.976
23/ 12 5846.42 5861.822 -15.402 5840.96 5.46 3228.17 3231.613 -3.443 3224.117 4.053
24/ 12 5845.93 5855.089 -9.159 5842.92 3.01 3224.24 3210.474 13.766 3228.214 -3.974
26/ 12 5848.49 5831.222 17.268 5842.93 5.56 3225.13 3216.941 8.189 3229.113 -3.983
27/ 12 5876.66 5853.191 23.469 5867.21 9.45 3223.12 3221.311 1.809 3220.112 3.008
30/ 12 5899.20 5837.424 61.776 5867.16 32.04 3240.63 3223.362 17.268 3233.623 7.007
31/ 12 5912.78 5982.163 -69.383 5938.16 -25.38 3267.45 3234.312 33.138 3249.425 18.025
MAPE (%) 7.318 0.1521 11.657 0.298
MAD 21.394 8.891 18.636 9.543
*denotes the model with the minimum error values
ASPI SAP
6000 3280
Actual Values Actual Values
ARIMA(2,1,3) 3260 ARIMA(1,1,1)
GBM GBM
5950
3240

3220
Market Returns

Market Returns

5900

3200

5850
3180

3160
5800

3140

5750 3120
0 10 20 30 40 0 10 20 30 40
Day Day

Fig. 2: ASPI and SAP out-of-sample forecasting performance (2013/ 12/ 01 to 2013/ 12/ 31)

IV. CONCLUSIONS
Economical Time series models are widely used to develop
the economic relationships, especially for the nonlinear
models under the stationary and non-stationary frameworks.
Different type of research studies have been carried out to find
the best forecasting methods to predict long and short term
predictions in the real-world applications; especially under the
areas in finance and investments.
In the past few decades, research works show that, time
series approaches such as ARMA and ARIMA were widely
applied for data forecastings and predictions. However after
2000 computational algorithms such as Geometric Brownian
Motion, Artificial Intelligence such as Artificial Neural
networks have been successfully applied to real-world
problems.
In the current study, new proposed GBM approach and
ARIMA approach were widely used to discuss our result. The
minimum values of Akaike information criterion and Schwarz
criterion suggested that, ARIMA (2, 1, 3) and ARIMA (1, 1, 1)
models are most suitable for predicting short term patterns of
ASPI and SAP price indices respectively. Furthermore, the
mean absolute percentage error (MAPE) results also reveal
that ( MAPE[ARIMA (2, 1, 3)] > MAPE [GBM] , MAPE [ ARIMA
(1, 1, 1)]> MAPE [GBM]), new proposed GBM model is more
significant and gives best solution for predicting short term
predictions in high volatility fluctuations than traditional
forecasting approaches.
Generally, stock prices are chaotic and show both linear and
nonlinear behaviours. Therefore, the accuracy of forecast
might be enhanced by modelling the non-linear behaviours of
the series as well. Therefore, further modifications could be
included to the selected model to enhance the accuracy of the
forecast.
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