-2
$\begingroup$

I want to understand the logic for why this is:

We have our model for the stock price behaviour:

$$d{S_t} = \mu {S_t}dt + \sigma {S_t}d{\tilde W_t}$$

It describes the development of a stock price over time using the risk-adjusted expected return $\mu$ and the real uncertainty in the stochastic term. We want to change the probability measure in such a way that the stochastic process remains a Brownian motion but with a drift of r instead of $\mu$. .... To repeat the manner of speaking, we want the process to change gear from an instantaneous increase of $\mu$ to r and leave the rest as before.

$$d{S_t} = r{S_t}dt + \sigma {S_t}d{\tilde W_t}$$

$\endgroup$

closed as off-topic by LocalVolatility, noob2, vonjd, amdopt, Bob Jansen Apr 25 '17 at 21:22

This question appears to be off-topic. The users who voted to close gave this specific reason:

  • "Basic financial questions are off-topic as they are assumed to be common knowledge for those studying or working in the field of quantitative finance." – LocalVolatility, noob2, vonjd, amdopt, Bob Jansen
If this question can be reworded to fit the rules in the help center, please edit the question.

1
$\begingroup$

they change the measure to get the arbitrage free price. Check the link below, or have a look at Hull for an easy introduction.

https://en.wikipedia.org/wiki/Risk-neutral_measure

$\endgroup$
  • $\begingroup$ can you not get the arbitrage free price while using $\mu$? $\endgroup$ – k b Apr 21 '17 at 20:58
  • $\begingroup$ @kb - the point is that a perfectly hedged option where the underlying follows the Black Scholes process would be risk free. If an asset is risk free, then it cannot earn any amount different from the risk free rate $r$. $\endgroup$ – FinanceGuyThatCantCode Apr 21 '17 at 21:23
  • $\begingroup$ risk-adjusted expected return $\mu$ is not the same as r ? $\endgroup$ – k b Apr 21 '17 at 21:27
  • $\begingroup$ mu could be any number, does not have to be the same as r. In order to get the drift to equal r, we change the measure. $\endgroup$ – mbison Apr 21 '17 at 21:50
  • $\begingroup$ @k b: who said that $\mu$ is "risk adjusted"? $\mu$ is just the expected return. $\endgroup$ – noob2 Apr 21 '17 at 22:14

Not the answer you're looking for? Browse other questions tagged or ask your own question.