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You ask 2 questions and I try to answer: 1) Why do we use geometric Brownian motion ($\ln S_t-\ln S_0$ is normally distributed)? In this case you have $$ S_t = S_0 \exp( (\mu-\sigma^2/2) t + \sigma B_t), $$ which means that you model positive prices. Furthermore the log-return $$ \ln(S_t/S_0) = (\mu-\sigma^2/2) t + \sigma B_t, $$ is normally distributed. ...


3

You know that Brownian motion {W(t)} is a stochastic process with the following properties: (Independence of increments) W(t) − W(s) , for t > s , is independent of the past, that is, of W(u) , 0 ≤ u ≤ s, or of $F_s$ , the σ-field generated by W(u), u ≤ s. (Normal increments) W(t) − W(s) has Normal distribution with mean 0 and variance t − s. This implies ...


2

There are many ways answering this, here is one: We assume the asset price at $t=T$, $S_T = S_{T-1} \times (S_T / S_{T-1})$. Assuming continuous compounding, we can write, $S_T = S_{T-1} \times \exp(R_{T-1})$. Working the same way for the previous period, we get $S_{T} = S_{T-2} \times \exp(R_{T-1}+R_T)$. Working all the way back to the initial value of ...


1

One way to start thinking about this is to work out a couple of Discrete versions of Ito's lemma Øksendal (6th edition) Example 3.1.9: almost surely, $$ B_t^2 - t = \int_0^t 2B_s dB_s $$ This has a discrete version which holds everywhere: let $X_n=\pm 1$ and $S_n=\sum_{i=1}^n X_i$, then $$ S^2_n-n = 2\sum_{i=0}^{n-1} S_i X_{i+1} $$ To verify ...



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