When using following risk-neutral random walk
$$\delta S = rS \delta t + \sigma S \sqrt{\delta t} \phi$$
where $\phi \sim N(0,1)$.
Now when a text mentions drift = 5% does that mean that interest rate (r) is 5%?
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2 Answers
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Yes. The risk neutral and the real path share the same volatility, so the difference is in the drift rate, where the risk-neutral path drifts with the risk-free rate r.
You may want to check out Paul Willmots book, esp. ch. 26, for applications.
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When using Monte Carlo for option pricing you numerically approximate expectation under a risk-neutral probability measure $Q$. Your undiscounted stock price process in GBM framework has as a drift equal to risk free rate under $Q$. So the answer to your question is affirmative.
answered Mar 16, 2013 at 20:43
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$\begingroup$ Thanks Alexey. May be a basic question, what does GBM stand for? $\endgroup$– bytefireMar 17, 2013 at 7:56
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2$\begingroup$ @bytefire Geometric Brownian motion $\endgroup$ Mar 17, 2013 at 9:40