Continuous Time Stochastic Processes Jesús Fernández-Villaverde November 9, 2013 University of Pennsylvania

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Continuous Time Stochastic Processes
Jesús Fernández-Villaverde
University of Pennsylvania
November 9, 2013
Jesús Fernández-Villaverde (PENN)
Stochastic Processes
November 9, 2013
1 / 10
Continuous Time Stochastic Processes
Filtration
Fix a probability space (Ω, F , P ) .
De…ne t 2 [0, ∞) = R+ .
Filtration: a family F = fFt : t
contained in F :
Fs
0 g of increasing σ algebras
Ft for 8s
t and Ft
F
Clearly, F∞ = F is the smallest σ algebras containing 8Ft .
(Ω, F, P ): …ltered probability space.
Jesús Fernández-Villaverde (PENN)
Stochastic Processes
November 9, 2013
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Continuous Time Stochastic Processes
Stochastic Processes
Continuous-time stochastic process: a mapping x : [0, ∞) Ω ! R
which is measurable with respect to B+ F (where B+ are the Borel
sets of R+ ).
A stochastic process is adapted to F if x (t, ω ) is Ft -measurable 8t.
x (t, ): Ft -measurable function of ω.
x ( , ω ): realization, trajectory, or sample path of the process.
Continuous stochastic process: x ( , ω ) 2 C [0, ∞), a.e. ω 2 Ω.
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Stochastic Processes
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Continuous Time Stochastic Processes
Brownian Motions: De…nition
A Wiener processes (or Brownian motion) is a stochastic process W
having:
1
continuous sample paths.
2
independent increments.
3
W (t )
N (0, t ) , 8t.
Basic Result
If a stochastic process fX (t ) , t 0g has continuous sample paths with
stationary, independent, and i.i.d. increments, then it is a Wiener process.
Di¤erential:
dW = lim (W (t + dt )
dt #0
Jesús Fernández-Villaverde (PENN)
Stochastic Processes
W (t ))
November 9, 2013
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Continuous Time Stochastic Processes
Properties of Di¤erentials
Moments:
1
2
E [dW ] = 0.
h
i
E (dW )2 = dt.
Also, as dt ! 0 (we skip the proof):
o
p
1
dW
dt .
2
h
i
(dW )2 ! E (dW )2 = dt.
Note that, while W (t ) has a continuous path, it is not di¤erentiable:
p
dt
o
dW
=
! ∞ as dt ! 0
dt
dt
Jesús Fernández-Villaverde (PENN)
Stochastic Processes
November 9, 2013
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Continuous Time Stochastic Processes
Di¤usions I
A Brownian motion with drift:
dX (t ) = µdt + σdW (t ) with X (0) = x0
More generally, we have a di¤usion:
dX (t ) = µ (t, x ) dt + σ (t, x ) dW (t ) 8t, 8ω
Properties:
1
Et [dX ] = µ (t, x ) dt.
2
vart [dX ] = σ2 (t, x ) dt.
Jesús Fernández-Villaverde (PENN)
Stochastic Processes
November 9, 2013
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Continuous Time Stochastic Processes
Di¤usions II
Di¤usion are important in arbitrage-free asset pricing. Aït-Sahalia
(2006).
Particularly useful cases are:
1
Geometric Brownian motion
dX = µXdt + σXdW
2
Ornstein-Uhlenbeck process
dX =
Jesús Fernández-Villaverde (PENN)
θ (X
µ) dt + σ (t, x ) XdW
Stochastic Processes
November 9, 2013
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Continuous Time Stochastic Processes
Functions of Stochastic Processes I
Let F (t, x ) be a function that is at least once di¤erentiable in t and
twice in x.
We approximate the total di¤erential of F (t, X (t, ω )) by a Taylor
expansion:
1
1
dF = Ft dt + Fx dX + Ftt (dt )2 + Fxx (dX )2 + Fxt dt (dX ) + ...
2
2
We substitute in:
dF
= Ft dt + Fx [µdt + σdW ]
1
+ Ftt (dt )2
2
h
i
1
+ Fxx µ2 (dt )2 + 2µσdtdW + σ2 (dW )2
2
+Fxt dt (µdt + σdW )
+H.O.T ...
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Stochastic Processes
November 9, 2013
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Continuous Time Stochastic Processes
Functions of Stochastic Processes II
Itō’s lemma: we can drop the terms that have order higher than dt or
(dW )2 and use (dW )2 ! dt:
dF
1
= Ft dt + Fx [µdt + σdW ] + σ2 Fxx (dW )2
2
1
=
Ft + µFx + σ2 Fxx dt + σFx dW
2
Since E [dW ] = 0,
E [dF ] =
1
Ft + µFx + σ2 Fxx dt
2
Var [dF ] = E [dF
Jesús Fernández-Villaverde (PENN)
E [dF ]]2 = σ2 Fx2 dt
Stochastic Processes
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Continuous Time Stochastic Processes
Functions of Stochastic Processes III
Particular case F (t, x ) = e
E [dF ] =
rt f
(x ):
1
rf + µf 0 + σ2 f 00 e
2
rt
dt
and when r = 0 (that is, F (t, x ) = f (x ), an often relevant case in
economics)
1
E [dF ] = µf 0 + σ2 f 00 dt
2
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Stochastic Processes
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