Stochastic Processes and Models

COMPANION TO FINANCIAL DERIVATIVES, Robert Kolb, James Overdahl, eds., Palgrave, Forthcoming

30 Pages Posted: 19 Mar 2008

See all articles by A. (Tassos) G. Malliaris

A. (Tassos) G. Malliaris

Loyola University of Chicago - Department of Economics

George Chalamandaris

Athens University of Economics and Business - Department of Accounting and Finance

Date Written: March 12, 2008

Abstract

This chapter introduces the reader to definitions and key properties of stochastic processes that are important in finance. The discussion starts from the description of Brownian motion that describes the idea of a continuous random walk and proceeds to Ito processes that incorporate both trend and volatility. The emphasis of the exposition is the applicability of stochastic processes in financial modeling. The paper demonstrates that ordinary calculus cannot tackle the problems that arise in continuous time financial economics because of the presence of randomness. We offer a brief presentation of the main concepts of stochastic calculus by reviewing the Ito integral and the Ito formula. Finally, the Binomial tree model is presented as an intuitive way to approximate a stochastic process in discrete time.

Keywords: Stochastic, Processes, Models

JEL Classification: C02, C60, G13

Suggested Citation

Malliaris, A. (Tassos) G. and Chalamandaris, George, Stochastic Processes and Models (March 12, 2008). COMPANION TO FINANCIAL DERIVATIVES, Robert Kolb, James Overdahl, eds., Palgrave, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1107996

A. (Tassos) G. Malliaris (Contact Author)

Loyola University of Chicago - Department of Economics ( email )

16 E. Pearson Ave
Quinlan School of Business
Chicago, IL 60611
United States
312-915-6063 (Phone)

George Chalamandaris

Athens University of Economics and Business - Department of Accounting and Finance ( email )

76 Patission Street
GR-104 34 Athens
Greece

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