Chapter 1

Basic Building Blocks and Stochastic

Differential Equation Models

This chapter contains an introduction to the basic mathematics required for derivative pricing and financial
engineering. We provide building blocks for modeling assets in the form of Brownian motion and Poisson
processes. With these two building blocks we create more complicated models by using Brownian motion and
Poisson processes to drive differential equations (which are then known as stochastic differential equations).
The presentation here is tutorial and heuristic. However, don’t let that fool you. If you gain intuition from
it, then you have received a powerful tool to add to your toolbox for problem solving.

1.1 Brownian Motion and Poisson Processes

Brownian motion and Poisson processes are our fundamental building blocks for creating models of asset
prices. The key features are that Brownian motion has continuous sample paths (with probability 1), and
Poisson processes jump! We begin with Brownian motion which is built on the Gaussian random variable.

1.1.1 Gaussian Random Variables

An n-dimensional Gaussian (Normal) random variable is a random variable with density function:
 
1 1 T −1
X ∼ fX (x) = exp − (x − µ) Σ (x − µ) (1.1)
(2π)n/2 |Σ|1/2 2

where µ ∈ Rn is the mean and Σ ∈ Rn×n is the covariance matrix:

µ = E[X], (1.2)

Σ = E[(X − µ)(X − µ)T ]. (1.3)

1.1.2 Brownian Motion

Brownian motion (also known as a Wiener Processes) is a stochastic process built upon the Gaussian random
variable as follows. A real-valued stochastic process z(t) : t ∈ R+ is a Brownian Motion if:

1. z(0) = 0.

2. z(t) − z(s) ∼ N (0, t − s) for t > s.

3. z(t2 ) − z(t1 ), z(t3 ) − z(t2 ), . . . , z(tn ) − z(tn−1 ) are independent for t1 ≤ t2 ≤ · · · ≤ tn .

1
2CHAPTER 1. BASIC BUILDING BLOCKS AND STOCHASTIC DIFFERENTIAL EQUATION MODELS

You should remember the following facts about Brownian motion, as they make Brownian motion an ideal
building block for unpredictable but continuous asset price movements:

• There exists a version of Brownian motion that has continuous sample paths.

• Brownian motion is nowhere differentiable with probability 1.

The first property says that Brownian motion is appropriate for price processes that don’t jump. In many
cases, price processes do jump, hence we will need to introduce the Poisson process next to model jumps.
The second property can be interpreted in the context of predictability. If a curve is differentiable at a
point, then that means that locally it can be approximated by a line, with the slope of the line being the
derivative of the curve at that point. But this means that we can predict (to order dt) the future value of
the curve. In finance, we often want to assume that we cannot predict future prices. Non-differentiability
indicates that in the sense mentioned above, future prices are not predictable.
Therefore, Brownian motion is an ideal building block upon which to build asset price processes. A
sample path of Brownian motion is given in Figure 1.1.

Sample Path of Brownian Motion

0.4

0.2

−0.2
z(t)

−0.4

−0.6

−0.8

−1
0 0.2 0.4 0.6 0.8 1
time

Figure 1.1: A typical sample path of Brownian motion.

Just as there are vector Gaussian random variables, we can define a vector Brownian motion as follows.
A vector Brownian motion z(t) ∈ Rn with covariance structure Σ ∈ Rn×n is a stochastic process satisfying

1. z(0) = 0.

2. z(t) − z(s) ∼ N (0, Σ(t − s)) for t > s.

3. z(t2 ) − z(t1 ), z(t3 ) − z(t2 ), . . . , z(tn ) − z(tn−1 ) are independent for t1 ≤ t2 ≤ · · · ≤ tn .

Thus a vector Brownian motion is build upon the vector Gaussian random variable.
1.1. BROWNIAN MOTION AND POISSON PROCESSES 3

Brownian motion has continuous sample paths. That is too well behaved for some events we would like
to model. For instance, market crashes, bankruptcy, etc. are often discontinuous price movements. Hence,
we need a process that jumps! Poisson processes, which are built on the Poisson random variable, are what
we are looking for.

1.1.3 Poisson Random Variables

A discrete random variable X taking values in the whole numbers is Poisson with parameter λ > 0 if

λk
P (X = k) = exp(−λ) k = 0, 1, ... (1.4)
k!
The mean of a Poisson random variable is E[X] = λ and the variance is V ar(X) = λ.

1.1.4 Poisson Process

A Poisson process is a stochastic process built on Poisson random variables as follows. A Poisson process
with parameter (intensity) λ is a stochastic process π(t; λ) : t ∈ R+ that satisfies

1. π(0) = 0.

2. π(t) − π(s) is Poisson distributed with parameter λ(t − s) for t > s.

3. π(t2 ) − π(t1 ), π(t3 ) − π(t2 ), . . . , π(tn ) − π(tn−1 ) are independent for t1 ≤ t2 ≤ · · · ≤ tn .

For us, the most important property of Poisson processes is that they jump! Hence, they are good models for
market crashes, jumps, bankruptcy, and other unexpected discontinuous price movements. A typical sample
path from a Poisson process with intensity λ = 1 is given in Figure 1.2.
The parameter λ is often called the intensity (or sometimes the propensity) of the Poisson process. You
can think of it as the expected number of jumps in a single time period. Alternatively, you expect to see a
single jump every λ1 time periods. Therefore, the larger the intensity, the more frequent the jumps.
We will assume that a Poisson process is continuous from the right, and not the left. That is, at the
exact time that a Poisson process jumps, it takes on the new value that it jumped to. Functions that are
right-continuous and have left-limits are called rcll functions (or cadlag or R-functions, etc). In a Poisson
process, it is important to remember that at a jump time it takes on the new value, thus making sample
paths of a Poisson process rcll functions.

1.1.5 Increments of Brownian Motion and Poisson Processes

Here are the intuitive pictures that I keep in mind when thinking of Brownian motion and Poisson Processes.
Over a small ∆t Brownian motion and Poisson Processes can be thought of in simple and intuitive ways.
We intuitively think of ∆t as a small increment in t. When dealing with a stochastic process X(t), we will
also think of ∆X(t) as the change the occurs in X over a small time period ∆t. That is

∆X(t) = X(t + ∆t) − X(t). (1.5)

This notion of an increment of a stochastic process will guide our intuition. In this way, we can look at
increments of Brownian motion and Poisson processes.

Brownian Motion
Over a small time ∆t, Brownian motion looks like

∆z(t) = z(t + ∆t) − z(t) ∼ N (0, ∆t) (1.6)

4CHAPTER 1. BASIC BUILDING BLOCKS AND STOCHASTIC DIFFERENTIAL EQUATION MODELS

Sample Path of a Poisson Processes with Intensity 1

5

4.5

3.5

3
π(t)

2.5

1.5

0.5

0
0 1 2 3 4 5
time

Figure 1.2: A typical sample path of a Poisson process.

or, written slightly differently √

∆z(t) = ǫ ∆t where ǫ ∼ N (0, 1) (1.7)
where this follows from the second defining property of Brownian
√ motion. That is, a Brownian motion
differential looks like a standard Gaussian multiplied by ∆t. Thus, we will often use E[∆z] = 0 and
E[(∆z)2 ] = ∆t.
An even simpler picture arises from a binomial approximation
 √
∆z ≈ √∆t w.p. 1/2 (1.8)
− ∆t w.p. 1/2

where w.p. stands for ”with probability”. This is depicted in figure 1.3.

Figure 1.3: Binomial model of an increment in Brownian motion .

1.2. STOCHASTIC DIFFERENTIAL EQUATIONS 5

Poisson Process
A Poisson Process can also be approximated over a small time period ∆t. Over ∆t it is

∆π(t; λ) = π(t + ∆t; λ) − π(t; λ) = X where X ∼ P oisson(λ∆t). (1.9)

A binomial approximation to a Poisson process is


1 w.p. λ∆t
∆π(λ) ≈ (1.10)
0 w.p. 1 − λ∆t

A simple picture of this heuristic increment model is given in Figure 1.4. Note that for a Poisson process,

Figure 1.4: Binomial model of an increment of a Poisson process.

∆π is either 0 or 1 to order ∆t.

Thus, note the key difference between a Brownian motion and a Poisson process. From the simple
binomial model approximations, we see that in a Brownian motion the size of the move scales with the
square root of ∆t. Hence over short periods of time the move in a Brownian motion is also small. This is
why Brownian motion has continuous paths. On the other hand, in a Poisson process, from the binomial
model we see that the move size can always be 1, regardless of how small ∆t is. On the other hand, the
probability of having a jump of size 1 scales with ∆t and is small if ∆t is small. Thus, Poisson processes jump
when they move. Over small periods of time the probability of a jump is also small. This is the essential
difference between Brownian motion and the Poisson process.

1.2 Stochastic Differential Equations

A simple way to think of a stochastic differential equation is as a differential equation that is driven by a
stochastic process. We will use this point of view here. Also, to avoid the technicalities of stochastic calculus,
we will present a simple intuitive approach to stochastic differential equations and stochastic differentials.

1.2.1 Differentials
Roughly speaking, the notion of a differential or infinitesimal of a process is the idea that in an increment

∆X(t) = X(t + ∆t) − X(t) (1.11)

we can take ∆t to be infinitesimally small. In such a case we would write

dX(t) = X(t + dt) − X(t) (1.12)

where dt is ”just a little bit of t”, to quote Gillespie [6]. However, (1.12) has a problem when it comes to
processes that jump that are assumed to be right continuous. The Poisson process is a good example.
6CHAPTER 1. BASIC BUILDING BLOCKS AND STOCHASTIC DIFFERENTIAL EQUATION MODELS

The Problem with Jumps

We have to be very careful when a process has jumps and we assume right continuity of paths. Here is the
problem. Assume that a Poisson process is currently at 0. That is π(t) = 0. Now, assume that a jump
occurs at time s. Our convention will be to assume that at the exact time of the jump, the Poisson process
jumps to 1. That is π(s) = 1. This means that for us, Poisson processes, and all other processes with jumps,
will be continuous from the right. Hence,
lim π(h) = π(s) (1.13)
h↓s

A picture of this situation is shown in Figure 1.5.

Figure 1.5: A jump at time s.

Since this is our convention, now let’s consider defining the differential of a Poisson process as

dπ(t) = π(t + dt) − π(t) (1.14)

where dt > 0.
Now, we know that a jump occurred at time s, so intuitively we should have dπ(s) = 1. However, let us
take the limit of dπ(t) for any t (including s) as dt ↓ 0. We obtain

lim dπ(t) = lim π(t + dt) − π(t) = π(t) − π(t) = 0 (1.15)

dt↓0 dt↓0

where this calculation followed by right continuity as defined by equation (1.13). But this indicates that π
never jumps! Something must be wrong!!
What is wrong is that we have assumed that π is right continuous, and then when add dt to the current
time, we are implicitly taking the limit from the right. Hence, we are guaranteed never to capture the jump!
This is purely a problem that arises from our convention to assume that Poisson processes are right
continuous. If we had assumed left continuity, then we wouldn’t have any problem. However, it is common
in the literature to assume processes are right continuous, so we have adopted this convention. Therefore,
we need to adjust our notion of a differential of a stochastic process slightly to account for our convention.

1.2.2 The Differential

The solution to the above problem is that for a differential, we should think of the following

dX(t) = X(t + dt) − X(t−) (1.16)

where X(t−) = limh↑t X(h) is the limit from the left of X at time t. By using the limit from the left, we
make sure to capture jumps of the process, no matter how small dt is made.
1.2. STOCHASTIC DIFFERENTIAL EQUATIONS 7

We will develop this point of view (which unfortunately can’t be made rigorous, but provides the proper
intuition). Hence, reviewing from above, with Brownian motion we would have:

dz(t) = z(t + dt) − z(t) ∼ N (0, dt). (1.17)

Note that since Brownian motion has continuous sample paths, z(t−) = z(t). However, for a Poisson process,
we should think of differentials as

dπ(t; λ) = π(t + dt; λ) − π(t−; λ) ∼ P oisson(λdt) (1.18)

in order to make sure that we capture jumps.

Don’t forget that we also have the binomial model approximations of Figures 1.3 and 1.4. Those binomial
models provide the proper intuition, and in both cases, sums of them will limit as Brownian motion or a
Poisson process. For the differential, we simply replace ∆t by dt in (1.8) and (1.10), giving
 √
dz ≈ √dt w.p. 1/2 (1.19)
− dt w.p. 1/2

and 
1 w.p. λdt
dπ(λ) ≈ . (1.20)
0 w.p. 1 − λdt

1.2.3 Compound Poisson Process

When Poisson processes jump, they jump up by 1. We can generalize this and allow them to jump randomly.
Let π(t; λ) be a Poisson process with jump times t1 , t2 , .... Construct a new process π Y (t; λ), by assigning
jump Y1 at time t1 , Y2 at time t2 , etc. where Y1 , Y2 , ... are iid random variables. This process can be
written as
π(t;λ)
X
Y
π (t; λ) = Yi . (1.21)
i=0

That is, at time t it is the sum of π(t; λ) iid copies of Y , where π(t; λ) is a standard Poisson process. Processes
of this form can also conveniently be written as integrals,
π(t;λ) Z t
X
π Y (t, λ) = Yi = Ys dπ(s; λ). (1.22)
i=0 0

For this reason, we represent the differential form of a compound Poisson process by Y dπ(t, λ). That is, we
may write
dπ Y = Y dπ. (1.23)
Following along the lines of the binomial approximation to a Poisson process as in Figure 1.4, an infinitesimal
model of a compound Poisson process can be thought of as

Yi w.p. λdt
Y dπ(λ) ≈ (1.24)
0 w.p. 1 − λdt

and a heuristic infinitesimal picture of this is given in Figure 1.6.

1.2.4 Ito Stochastic differential equations

Stochastic integrals can be defined in different ways. The most useful for us is the Ito stochastic integral. At
this point, I will not delve into the depths of the stochastic integral (because often people are never able to
return!), but merely provide the intuition that you should take away when considering stochastic differential
equations.
8CHAPTER 1. BASIC BUILDING BLOCKS AND STOCHASTIC DIFFERENTIAL EQUATION MODELS

Figure 1.6: Infinitesimal model of a compound Poisson process.

A stochastic differential equation will be written as:

dx(t) = a(x(t), t)dt + b(x(t), t)dz(t) (1.25)

where in this case, it is being driven by Brownian motion z(t). (At this stage, I will ignore the technical
conditions that must be placed on a and b in order to make such an equation well defined.) We will interpret
this equation as follows:

x(t + dt) − x(t) = a(x(t), t)dt + b(x(t), t)(z(t + dt) − z(t)). (1.26)

Since z(t) has independent increments, and a(x(t), t) and b(x(t), t) are evaluated at time t, they are inde-
pendent of dz(t) = z(t + dt) − z(t). This is important! It allows us to do the following simple calculations
of the instantaneous drift and variance.

Instantaneous Drift and Variance

We can interpret a(x(t), t) as related to the instantaneous drift and b(x(t), t) as related to the instantaneous
volatility as follows:

E[dx|x(t)] = E[a(x(t), t)dt + b(x(t), t)dz(t)|x(t)] (1.27)

= a(x(t), t)dt + b(x(t), t)E[dz(t)|x(t)] (1.28)
= a(x(t), t)dt. (1.29)

Therefore, a(x(t), t) determines the instantaneous drift. On the other hand, we can compute the instanta-
neous variance of x as follows

E[(dx − a(x(t), t)dt)2 |x(t)] = E[b(x(t), t)2 dz(t)2 |x(t)] (1.30)

= b2 (x(t), t)E[dz(t)2 |x(t)] (1.31)
= b2 (x(t), t)dt (1.32)

Hence, b2 (x(t), t) determines the instantaneous variance of x.

1.2.5 Poisson Driven Differential Equations

We can also drive a differential equation by a Poisson process

dx(t) = a(x(t−), t)dt + b(x(t−), t)Y dπ(t; λ) (1.33)

where note that we have written x(t−) in the arguments of a and b. By x(t−) we mean x(t−) = limh↓0 x(t−h).
That is, x(t−) is the limit from the left at time t. We will assume that a and b are left continuous in the t
1.3. SUMMARY 9

argument so that we may use t instead of t− in the second argument of a and b. We will also sometimes use
the notation x− when we want to suppress the argument t, or even a− when suppressing the arguments of
a. The reason for using limits from the left is that in a Poisson process, we interpret our differential as

dπ(t) = π(t + dt) − π(t−)

and for the Ito integral, we assume that the coefficients a and b are evaluated at the point in time that the
differential starts from. This is t−.
This limit from the left is also important in a and b because we want a and b to be independent of dπ.
The only way we can do this is to make sure that we use left limits. Note that this means that if π(t) jumps
at time t, which also causes a jump in x at time t, we evaluate x(t−) in a and b which immediately preceeds
the jump.
With that established, once again, we can compute the instantaneous mean and variance:

E[dx(t)|x(t−)] = E[a(x(t−), t)dt + b(x(t−), t)Y dπ(t)|x(t−)] (1.34)

= a(x(t−), t)dt + b(x(t−), t)E[Y dπ(t)|x(t−)] (1.35)
= a(x(t−), t)dt + b(x(t−), t)E[Y ]λdt (1.36)

Hence, in this case, the dπ(t) term can contribute to the instantaneous mean. This can make things messy!
It is often nicer to think of the first term as the ”mean” term, and the second as the ”risk” term. To do
this, we would like the second term to have zero instantaneous mean. Hence, we will often ”compensate” the
Poisson process to give it zero mean. This is done by simply subtracting off the instantaneous mean from
the second term and adding it to the first.

dx(t) = (a(x(t−), t) + b(x(t−), t)E[Y ]λ)dt + b(x(t−), t)(Y dπ(t) − E[Y ]λdt) (1.37)

Then we can also compute the instantaneous variance:

E[(dx(t) − (a(x(t−), t) + b(x(t−), t)E[Y ]λ)dt)2 |x(t−)] = E[b2 (x(t−), t)(Y dπ(t) − E[Y ]λdt)2 |x(t−)](1.38)
= b2 (x(t−), t)V ar(Y dπ(t)) (1.39)
= b2 (x(t−), t)(E[Y 2 dπ(t)2 ) − E[Y ]2 E[dπ(t)](1.40)
2
)
2 2 2 2 2 2
= b (x(t−), t)(E[Y ]E[dπ(t) ] − E[Y ] λ dt (1.41))
2 2 2 2 2 2 2
= b (x(t−), t)(E[Y ](λdt + λ dt ) − E[Y ] λ(1.42) dt )
= b2 (x(t−), t)E[Y 2 ]λdt + O(dt2 ) (1.43)

Hence, to order dt, the instantaneous variance is given by b2 (x(t−), t)E[Y 2 ]λ.

1.3 Summary
Brownian motion (built upon the Gaussian random variable) and the Poisson Process (built upon the Poisson
random variable) are the basic building blocks used to create models of prices. In particular, we use these two
processes to drive differential equations and that will allow us to capture a wide range of price phenomena.
Due to the continuity of Brownian motion, it is good for modeling price paths and variables that do not
jump. On the other hand, Poisson processes are an essential building block for modeling jumps in price
processes or variables.
Much intuition can be gained from simple ”incremental” and ”differential” models of processes and
stochastic differential equations. The simple binomial approximations to Brownian motion and Poisson
processes are enough to correctly guide your intuition in the vast majority of cases. Thus, for modeling
purposes, make sure you have a solid understanding of these two building block processes.
10CHAPTER 1. BASIC BUILDING BLOCKS AND STOCHASTIC DIFFERENTIAL EQUATION MODELS

1.4 Problems

Problem 1: Verify that our infinitesimal model of a Poisson process over small time dt:

1 wp. λdt
dπ = (1.44)
0 wp. 1 − λdt
has a mean and variance that agree with a Poisson random variable with parameter λdt to order dt.

Problem 2: Poisson Processes

Consider the time interval [0, 1]. Chop this time interval into n parts of equal length. Over each interval
define the independent and identically distributed random variables Xi where

1 w.p. λ/n
Xi = (1.45)
0 w.p. 1 − λ/n
Let
n
X
Y = Xi (1.46)
i=1

(a) What is P r(Y = 0)?

(b) In your answer in (a), take the limit as n → ∞. What do you get?
(b) What is P r(Y = 1)?
(c) Again take the limit. What is your answer?
(d) Now consider an arbitrary but fixed k with k < n. What is P r(Y = k).
(e) Again take the limit as n → ∞, and show that this√ converges1 to the Poisson random variable. (You
will probably want to use Stirling’s formula n! ∼ 2πe−n nn+ 2 . This calculation is a bit tricky!)
(Note: In this problem we converge to a Poisson random variable with parameter λ since we took the time
interval to be 1. If the time interval is t, we will converge to a Poisson random variable with parameter λt.
As a function of t, we arrive at a Poisson process.)

Problem 3: Poisson Processes again.

Consider the following Markov chain. Let the state space be the whole numbers x = 0, 1, 2, .... Consider the
following transition probabilities over the time instant dt:
P r(x(t + dt) = n|x(t) = n) = 1 − λdt (1.47)
P r(x(t + dt) = n + 1|x(t) = n) = λdt (1.48)
Let pn (t) = P r(x(t) = n).
(a) Write down a differential equation for p0 (t). (hint: to derive a differential equation, consider the
amount of probability that flows into and out of the state x = 0 over time dt.)
(b) Assume p0 (0) = 1 (that is, at time zero, x = 0 with probability 1). Solve the differential equation for
p0 (t).
(c) Derive a differential equation for pn (t), n > 0. Given your answer in (a), solve for p1 (t). Explain how
you could solve for pn (t) for any n.
(Note: again we have arrived at a Poisson process, but this time through Markov chain theory. A Poisson
process is an example of a continuous time Markov process, and the set of differential equations you derived
is the ”forward equation” for this process.)