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3 Brownian Motions
Timeline:
1828 the Brownian Motion is introduced by the Scottish royal botanist Robert
Brown in an attempt to describe the irregular motion of pollen grains sus-
pended in liquid
1900 Louis Bachelier considers Brownian motion as a possible model for stock mar-
ket values
1905 Albert Einstein considers Brownian motion as a model of the motion of a
particle in suspension and uses it to estimate Avogadro’s number
1923 Norbert Wiener defines and constructs Brownian motion rigorously for the
first time. The resulting stochastic process is often called the Wiener process
in his honour.
1. W0 = 0
2. for s ≤ t, Wt − Ws is independent of the past history of W until time s, i.e. the
Brownian motion has increments which are independent of the natural filtration
Fs = σ(Wτ : 0 ≤ τ ≤ s)
3. for 0 ≤ s ≤ t, Wt − Ws and Wt−s have the same distribution, which is Gaussian
D
with mean zero and variance (t − s), i.e. Wt − Ws = Wt−s ∼ N(0, t − s)
4. W has continuous sample paths
√
Exercise 1 a) Define a process by Xt := tξ where ξ is a standard Gaussian random
variable. Explain why X is not a Wiener process.
b) Define a process by Xt := 10Wt +100t where Wt is a standard one-dimensional Wiener
process. Compute the probability of the event that X1 < −900.
0 c Laura Ballotta - Do not reproduce without permission.
2 3 BROWNIAN MOTIONS
0.5 0.16
0.4 0.14
0.12
0.3
0.1
0.2
0.08
Bt = µ t + σ Wt
0.1
Wt
0.06
0
0.04
−0.1
0.02
−0.2
0
−0.3 −0.02
−0.4 −0.04
0 28 56 84 112 140 168 196 224 252 280 308 336 364 0 28 56 84 112 140 168 196 224 252 280 308 336 364
1.15
1.1
X = e(µ − σ /2)t + σ Wt
1.05
2
1
t
0.95
0.9
0 28 56 84 112 140 168 196 224 252 280 308 336 364
Figure 1: Sample trajectories of the Wiener process, the arithmetic Brownian motion and the
geometric Brownian motion. Parameter set: T = 1 year; µ = 0.1 p.a.; σ = 0.2 p.a.
√
c) Define a process by Xt := t − sξ where ξ is a standard Gaussian random variable.
Explain why X is not a Wiener process.
• Bt = −Wt , for t ≥ 0.
3.1 The Martingale Property 3
1
• Bt = √ Wct , for t ≥ 0 and c > 0.
c
tW1/t for t > 0
• Bt = .
0 for t = 0
dP̂
Y = ;
dP
Exercise 5 Let W be a one-dimensional standard Brownian motion. Show that the pro-
cess Wt2 − t is a martingale with respect to the natural filtration Ft = σ (Ws : 0 ≤ s ≤ t).
Exercise 6 An analyst wishes to use a model which is based on Brownian motion, but
which does not become too large and positive for large t. The model proposed is
Xt = Wt e−cWt ,
St = eµt+σWt
3. Determine an expression for the conditional expectation E (St |Fu ), where u < t and
F denotes the filtration associated with the process S.
EXi = 0, V ar(Xi ) = 1.
Proof.
(i) Convergence in probability is hard to check. But convergence in mean square works
and implies convergence in probability. Hence we want to show that E |V (2) − T |2 →
Then
2 2
Xn Xn n
X
E ∆Wt2i − T = E ∆Wt2i − ∆ti
1 1 1
2
Xn
2
= E ∆Wti − ∆ti
1
2
Xn
= E Zi
1
n
X XX
= E(Zi2 ) + E(Zi Zj ),
1 i j6=i
6 3 BROWNIAN MOTIONS
Theorem 6.(i) simply tells us that the Brownian motion accumulates quadratic varia-
tion at rate 1 per unit of time, i.e.
Wt − Wt 2
i i−1
≈ 1;
ti − ti−1
informally, we can then write (dWt ) (dWt ) = 1 × dt. Note that most functions which are
continuous (and have continuous derivatives) have zero quadratic variation. The paths
of the Brownian motion are unusual in that their quadratic variation is not zero. This
is one of the reasons why ordinary calculus does not work for Brownian motions. The
other important reason is in the property of the total variation. Consider some ordinary
function, continuous and differentiable, then the Mean Value Theorem says that in each
subinterval [ti−1 , ti ] of our partition, there exists a t∗i such that
f (ti ) − f (ti−1 )
= f ′ (t∗i ) .
ti − ti−1
This implies that the total variation of the function f can be written as
n
X n
X
V (f ) = |f (ti ) − f (ti−1 )| = |f ′ (t∗i ) (ti − ti−1 )|
i=1 i=1
Z T
= |f ′ (t)| dt,
0
3.4 The Reflection Principle and Functionals of a Brownian Motion 7
where the last equality follows by recognizing the Riemann sum of the function f . How-
ever, for the case of the Brownian motion, we have just shown that V −→ ∞, which
essentially implies that there are some problems with the quantity “|Wt′ |”. In fact, the
Brownian motion is not differentiable, as we will show in more details in Unit 4. This is
consistent with intuition. In fact, the differential of a function tells you the angle of the
tangent to the curve in any specific point. But if you are able to calculate such a quantity,
you know where the function is going to be in the next dt period of time. However, you
should not forget that the function in our case is represented by a random process. Since
it is random, you cannot predict the outcome in the next period of time.
Other variation processes that are of interest for us are the following:
• Cross Variation: limn→∞ ni=1 Wti − Wti−1 (ti − ti−1 ) = 0, due to the fact that
P
the Brownian motion is a continuous process. Informally, we can write (dWt ) (dt) =
0;
Pn
• limn→∞ i=1 |ti − ti−1 |2 = 0, which is trivial, and implies (dt) (dt) = 0.
Definition 7 (First passage time) For a Brownian motion we define the first passage
time to a ∈ R to be the stopping time Ta given by
Ta = inf{t ≥ 0 : Wt = a},
0.25
0.2
0.15 W t
0.1
a
0.05
B
t
−0.05
−0.1
Time, t
function of Ta . Then
Z t
P[Ta < t ∩ Wt < x] = fa (s) dsP[Wt < x|Ta = s]
0
Z t
= fa (s) dsP[Wt < x|Ws = a]
0
Z t
= fa (s) dsP[Wt − Ws < x − a]
0
Z t
= fa (s) dsP[Wt − Ws > a − x]
0
Z t
= fa (s) dsP[Wt > 2a − x|Ws = a]
0
Z t
= fa (s) dsP[Wt > 2a − x|Ta = s]
0
= P[Ta < t ∩ Wt > 2a − x].
Proposition 9 Let {Wt : t ≥ 0} be a standard Brownian motion and Ta the first passage
time to a. Then
P[Ta < t] = 2P[Wt > a]
and Ta is almost surely finite.
we may take
p
Wt = ρXt + 1 − ρ2 Zt ,
Proof. Any process of the form Wt = aXt + bZt possesses the stationary, indepen-
dent increment property, has continuous sample paths and starts from 0pat time t. The
distribution of Wt = aXt + bZt is N (0, (a2 + b2 )t). Choosing a = ρ, b = 1 − ρ2 implies
that V ar(Wt ) = t, so that Wt is a standard Brownian motion, and that
p
Cov(Wt , Xt ) = Cov(ρXt + 1 − ρ2 Zt , Xt ) = ρV ar(Xt ) = ρt.
where X (1) and X (2) are independent copies of the given process X.
(1) (2)
b) Consider two Brownian motions Wt and Wt with representation as in part (b.i),
i.e.
(i) √ p (i)
Wt = ρBt + 1 − ρZt , i = 1, 2.
(1) (2)
Calculate Cov Wt , Wt .
3.6 Simulating trajectories of the Brownian motion - part 1 11
3 1
0.8
2
0.6
1
Bt = µ t + σ Wt
0.4
t
W
0.2
−1
0
−2
−0.2
−3 −0.4
0 28 56 84 112 140 168 196 224 252 280 308 336 364 0 28 56 84 112 140 168 196 224 252 280 308 336 364
2
1.8
1.6
t
(µ − σ /2)t + σ W
1.4
2
X =e
1.2
t
0.8
0 28 56 84 112 140 168 196 224 252 280 308 336 364
Figure 3: 10 sample trajectories of the Wiener process, the arithmetic Brownian motion and
the geometric Brownian motion. Parameter set: T = 1 year; µ = 0.1 p.a.; σ = 0.2 p.a.
3.6 Simulating trajectories of the Brownian motion - part 1 13
300
200
100
0
−5 −4 −3 −2 −1 0 1 2 3 4 5
300
200
100
0
−5 −4 −3 −2 −1 0 1 2 3 4 5