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Geometric Brownian motion

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, perhaps more precisely, a Wiener process. 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 S_t is said to follow a GBM if it satisfies the following Wiener process or Brownian motion and u ('the percentage drift') and v ('the percentage volatility') are constants.

The equation has an analytic solution:

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

for an arbitrary initial value S₀. The correctness of the solution can be verified using Itô's lemma. The random variable log( S_t/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'.