T11 Solution

STAT3603 Stochastic Processes
Tutorial 11: Brownian Motions and Pricing

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Department of Statistics and Actuarial Science

The University of Hong Kong
November 29, 2024
Liu Ruihan rhliu@connect.hku.hk STAT3603

Brownian Motion with Drift
{X(t) : t ≥ 0} is a Brownian motion with drift if
X(t) = µt + σB(t) ⇐⇒ dX(t) = µdt + σdB(t),
where B(t) is a standard Brownian motion. Moreover, the

Brownian motion with drift process can be generalized to the
Ito (diffusion) process:
dX(t) = µ(X(t), t)dt + σ(X(t), t)dB(t),
that is, both drift term and volatility term are allowed to
depend on X(t) and t.

Geometric Brownian Motion
{S(t) : t ≥ 0} is a Geometric Brownian motion if

h σ2 i
S(t) = S(0) exp µ− t + σB(t) ,
2
which is equivalent to
dS(t) = µS(t)dt + σS(t)dB(t).
To prove it, the key idea is the Ito’s lemma, i.e. show that
σ2
d log(S(t)) = µ − dt + σdB(t)
2

Stock Options
▶ Call option gives its holder the right to buy a certain

amount of an underlying asset by a certain date for a
certain price.
▶ Put option gives its holder the right to sell a certain
amount of an underlying asset by a certain date for a
certain price.
▶ The buying or selling price is known as the exercise price or
strike price.
▶ The date that an option expires is called expiration date or
maturity date.

European options
European option: can be exercised only at the maturity date.

Let K be the strike price and T the maturity date. Then the
payoff of the options is
▶ Call: max(S(T ) − K, 0),
▶ Put: max(K − S(T ), 0),
where S(t) is the price of options. The question is how to
determine the price of options.

Black-Scholes formula
Suppose that S(t) is a geometric Brownian motion. Given

S(0) = S0 (current price of the stock), the price of a European
call option with expiration date T and strike price K is given by
√
C(0) = S0 Φ(σ T + b) − Ke−αT Φ(b), (0.1)
where Φ(·) is the cdf of standard normal distribution and
log(S0 /K) + (α − σ 2 /2)T

α = µ + σ 2 /2, b= √ . (0.2)
σ T

Exercise 1
Let B(t) be a standard Brownian motion.

(a) Let U (t) = B 2 (t), t ≥ 0, does the process U (t) possess the
independent increment property? Specify your reason
clearly.
(b) Let V (t) = B(t) + B(t2 ), find the pdf of V (t) for each t > 0.

Solution of Exercise 1
(a) Note that
U (s + t) − U (t) = B 2 (s + t) − B 2 (t)
= (B(s + t) − B(t) + B(t))2 − B 2 (t)
= (B(s + t) − B(t))2 + 2(B(s + t) − B(t))B(t)
Here (B(s + t) − B(t))2 is independent with U (t) = B 2 (t),

but (B(s + t) − B(t))B(t) is not. So U (t) does not possess
the independent increment property.

However, note that
E(B(s + t)B(t)) = E ((B(s + t) − B(t))B(t)) + E (B(t)B(t))

= E B 2 (t)

Cov (B(s + t) − B(t))B(t), B 2 (t)

= Cov B(s + t)B(t), B 2 (t) − Cov B 2 (t), B 2 (t)

= E (B(s + t)B(t) − E(B 2 (t)) (B 2 (t) − E(B 2 (t)) − V ar(B 2 (t))

= E (B(s + t)B 3 (t) − E(B 2 (t))E [(B(s + t)B(t)] − V ar(B 2 (t))

= E (B 2 (t))2 − E(B 2 (t))2 − V ar(B 2 (t)) = 0.

It shows that (B(s + t) − B(t))B(t) and B 2 (t) are uncorrelated

but dependent.
(b) If t ≥ 1, then
V (t) = B(t)+B(t2 ) = 2B(t)+[B(t2 )−B(t)] ∼ N (0, t2 +3t).
So the pdf is given by
2
1 − x
f (x) = p e 2t2 +6t .
2π(t2 + 3t)
If 0 < t < 1, then

V (t) = B(t)+B(t2 ) = [B(t)−B(t2 )]+2B(t2 ) ∼ N (0, 3t2 +t).
So the pdf is given by
2
1 − x
f (x) = p e 6t2 +2t .
2π(3t2 + t)

Exercise 2
Let {Wt }t≥0 and {Bt }t≥0 be two independent standard

Brownian motions. Define
Zt = αWt + βBt , t ≥ 0.
Find the condition on (α, β) such that {Zt }t≥0 is again a

standard Brownian motion.

(1). Note that W0 = B0 = 0 so that Z0 = 0;
(2). (Independent increments). It suffices to prove
Zt − Zs ⊥ Zu , 0 < u ≤ s < t.
To see this, recall that
Zt − Zs = α(Wt − Ws ) + β(Bt − Bs ), Zu = αWu + βBu
and
Wt − Ws ⊥ Wu , Bt − Bs ⊥ Bu ,
together with {Wt }t≥0 and {Bt }t≥0 are independent, we see
Zt − Zs ⊥ Zu must hold. In other words, {Zt }t≥0 has
independent increments;
(3) (Stationary normal increments). If {Zt }t≥0 is a standard
Brownian motion, then it should have
Zt − Zs = α(Wt − Ws ) + β(Bt − Bs ) ∼ N (0, t − s).
Note that {Wt }t≥0 and {Bt }t≥0 are independent. We have
Zt − Zs indeed follows a centered normal distribution with
variance
var(Zt − Zs ) = α2 var(Wt − Ws ) + β 2 var(Bt − Bs )

= (α2 + β 2 )(t − s).
Thus, under the assumption α2 + β 2 = 1,

Zt − Zs ∼ N (0, t − s);
(4) (Continuous paths). Since linear combination of two

continuous functions are still continuous, Zt is of course
continuous.
To recap, {Zt }t≥0 becomes a standard Brownian motion if and
only if α2 + β 2 = 1.

Exercise 3
The current price of a stock is 100. Suppose that the price of

the stock changes follows a geometric Brownian motion with
drift coefficient µ = 0.05 and variance parameter σ 2 = 1. Give
the Black-Scholes cost of an option to buy the stock at time 10
for a cost of 100 per unit.

The parameters of this problem are
S0 = 100, µ = 0.05, σ 2 = 1, T = 10, K = 100.
By (0.2), α = µ + σ 2 /2 = 0.55 and
log(S0 /K) + (α − σ 2 /2)T

b= √ = −1.423025.
σ T
By (0.1)
√
C(0) = S0 Φ(σ T + b) − Ke−αT Φ(b) = 91.20809.

– End of Tutorial 11 –

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STAT3603 Stochastic Processes

Tutorial 11: Brownian Motions and Pricing

Department of Statistics and Actuarial Science

November 29, 2024

Liu Ruihan rhliu@connect.hku.hk STAT3603

{X(t) : t ≥ 0} is a Brownian motion with drift if

X(t) = µt + σB(t) ⇐⇒ dX(t) = µdt + σdB(t),

where B(t) is a standard Brownian motion. Moreover, the

dX(t) = µ(X(t), t)dt + σ(X(t), t)dB(t),

Liu Ruihan rhliu@connect.hku.hk STAT3603

{S(t) : t ≥ 0} is a Geometric Brownian motion if

dS(t) = µS(t)dt + σS(t)dB(t).

Liu Ruihan rhliu@connect.hku.hk STAT3603

▶ Call option gives its holder the right to buy a certain

Liu Ruihan rhliu@connect.hku.hk STAT3603

European option: can be exercised only at the maturity date.

Liu Ruihan rhliu@connect.hku.hk STAT3603

Suppose that S(t) is a geometric Brownian motion. Given

where Φ(·) is the cdf of standard normal distribution and

log(S0 /K) + (α − σ 2 /2)T

Liu Ruihan rhliu@connect.hku.hk STAT3603

Let B(t) be a standard Brownian motion.

Liu Ruihan rhliu@connect.hku.hk STAT3603

(a) Note that

Here (B(s + t) − B(t))2 is independent with U (t) = B 2 (t),

Liu Ruihan rhliu@connect.hku.hk STAT3603

E(B(s + t)B(t)) = E ((B(s + t) − B(t))B(t)) + E (B(t)B(t))

Cov (B(s + t) − B(t))B(t), B 2 (t)

= Cov B(s + t)B(t), B 2 (t) − Cov B 2 (t), B 2 (t)

= E (B(s + t)B(t) − E(B 2 (t)) (B 2 (t) − E(B 2 (t)) − V ar(B 2 (t))

= E (B(s + t)B 3 (t) − E(B 2 (t))E [(B(s + t)B(t)] − V ar(B 2 (t))

= E (B 2 (t))2 − E(B 2 (t))2 − V ar(B 2 (t)) = 0.

It shows that (B(s + t) − B(t))B(t) and B 2 (t) are uncorrelated

If 0 < t < 1, then

Liu Ruihan rhliu@connect.hku.hk STAT3603

Let {Wt }t≥0 and {Bt }t≥0 be two independent standard

Find the condition on (α, β) such that {Zt }t≥0 is again a

Liu Ruihan rhliu@connect.hku.hk STAT3603

To see this, recall that

Zt − Zs = α(Wt − Ws ) + β(Bt − Bs ), Zu = αWu + βBu

Zt − Zs = α(Wt − Ws ) + β(Bt − Bs ) ∼ N (0, t − s).

var(Zt − Zs ) = α2 var(Wt − Ws ) + β 2 var(Bt − Bs )

Thus, under the assumption α2 + β 2 = 1,

(4) (Continuous paths). Since linear combination of two

Liu Ruihan rhliu@connect.hku.hk STAT3603

The current price of a stock is 100. Suppose that the price of

Liu Ruihan rhliu@connect.hku.hk STAT3603

The parameters of this problem are

S0 = 100, µ = 0.05, σ 2 = 1, T = 10, K = 100.

By (0.2), α = µ + σ 2 /2 = 0.55 and

log(S0 /K) + (α − σ 2 /2)T

Liu Ruihan rhliu@connect.hku.hk STAT3603

Liu Ruihan rhliu@connect.hku.hk STAT3603

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