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Geometric Brownian motion

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A Geometric Brownian motion (occasionally, exponential Brownian motion and, hereafter, GBM) is a continuous-time stochastic process in which the logarithm of the randomly varying quantity follows a Brownian motion. It is appropriate to mathematical modelling of some phenomena in financial markets. It is used particularly in the field of option pricing[?] because a quantity that follows a GBM may take any value strictly greater than zero. This is precisely the nature of a stock price.

A stochastic process St is said to follow a GBM if it satisfies the following stochastic differential equation[?]:

<math>dS_t=u\,S\,dt+v\,S\,dW_t</math>

where {Wt} is a Wiener process or Brownian motion and u ('the percentage drift') and v ('the percentage volatility') are constants.

The equation has a analytic solution:

<math>S_t=S_0\exp\left((u-v^2/t)t+vW_t\right)</math>

for an arbitrary initial value S0. The correctness of the solution can be verified using Ito's Lemma. The random variable log( St/S0) is Normally distributed with mean (u-v.v/2).t and variance (v.v).t, which reflects the fact that increments of a GBM are Normal relative to the current price, which is why the process has the name 'geometric'.



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