Geometric Brownian motion
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A geometric Brownian motion (GBM) (occasionally, exponential Brownian motion) is a continuous-time stochastic process in which the logarithm of the randomly varying quantity follows a Brownian motion, or a Wiener process. It is applicable 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, and only the fractional changes of the random variate are significant. This is a reasonable approximation of stock price dynamics.
A stochastic process St is said to follow a GBM if it satisfies the following stochastic differential equation:
where Wt is a Wiener process or Brownian motion and μ ('the percentage drift') and σ ('the percentage volatility') are constants.
The equation has an analytic solution:
for an arbitrary initial value S0. The correctness of the solution can be verified using Itō's lemma. The random variable log(St/S0) is normally distributed with mean (μ − σ2 / 2)t and variance σ2t, 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'.
