Why Asset Prices Are Not Necessarily Standard Brownian Motion
Summary
The document examines whether Lévy’s characterization implies that every discounted traded asset price is Brownian motion. It distinguishes the cited result—that a continuous martingale with continuous paths and finite quadratic variation can be represented as Brownian motion under a change of time—from the more specific characterization of standard Brownian motion, which requires a zero starting value and quadratic variation equal to calendar time. A generic asset price process is not shown to meet those conditions merely by being a martingale.
The discussion raises assumptions behind continuous-time asset pricing, including continuity of prices and finite quadratic variation, and notes that these assumptions may be questionable in real markets. It asks whether Brownian motion is instead intended as a modeling choice rather than a conclusion about actual prices. The excerpt presents the question and motivating claims but does not provide a full resolution. It offers no empirical test, and its claims about discounted prices depend on equilibrium and model assumptions that are not established for every asset or market.
Key ideas
- Lévy’s result permits a continuous martingale to be represented as Brownian motion run on a changed time scale.
- Standard Brownian motion requires a specified starting value and quadratic variation equal to elapsed time.
- The martingale property alone does not establish those standard Brownian motion conditions for asset prices.
- Continuity and finite quadratic variation are modeling assumptions that may fail or be contested in real markets.
- The excerpt raises the distinction between a mathematical consequence and using Brownian motion as a practical model.
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Full text
# Does the Lévy characterization imply that the price process of any asset is a Brownian motion? # Does the Lévy characterization imply that the price process of any asset is a Brownian motion? While studying Brownian motion applied to mathematical finance, I came across these lecture notes by prof Steve Lalley. In the prologue, he gives this explanation for the occurrence of Brownian motion in the theory of asset pricing > In equilibrium, the discounted price process of any tradeable asset, observed at discrete times, is a martingale; therefore, in continuous time, it is also a martingale. Moreover, the prices of traded assets seem to vary continuously with time$^1$ and seem to have finite quadratic variation. Brownian motion now rears its head for the following basic reason, a fundamental theorem of Paul Lévy: Theorem. Every continuous–time martingale with continuous paths and finite quadratic variation is a time-changed Brownian motion. $^1$ This, along with the technical assumption that price processes have finite quadratic variation, is somewhat controversial. Discrepancies between theoretical (Black–Scholes) and actual prices of derivative securities may in fact be due to the failure of one or both of these assumptions in real markets. Summarizing: the discounted price process of any tradeable asset is a martingale, it varies continuosly in time and it has finite variation, so it satisfies all the hypotheses of the Lévy characterization and hence is a Brownian motion. However, the Lévy characterization of Brownian motion that I studied in my course is a little more specific, in particular, the quadratic variation not only has to be finite but it has to be equal to $t$, moreover the process must start at the origin: > Lévy characterization of Brownian motion. The Wiener process $W$ is an almost surely continuous martingale with $W_0 = 0$ and quadratic variation $[W]_t=t$ (which means that $W_t^2 − t$ is also a martingale). But how can we prove that the discounted price process of any tradeable has quadratic variation equal to $t$? And what about the other hypotheses? Is it really true that the discounted price process of any tradeable satisfies all the hypotheses of the Lévy characterization and so can be considered a Brownian motion? Maybe I misunderstood his words and what he actually means is that Brownian motion is just a good candidate to model the price process. However, in these related questions other users explain that the Brownian motion is not that good in modeling prices, so at this point is really hard for me to think that the discounted price process of any tradeable is a Brownian motion. Why should we expect geometric Brownian motion to model asset prices? Shortcomings of generalized Brownian motion for asset price modelling
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