Problem bank

Problem 331 of 333MediumStochastic CalculusP331

How long to tell a good stock from a flat one?

  1. Two analysts watch the same stock, which follows a GBM with volatility σ=20%\sigma = 20\%. Analyst A says its drift is μ=10%\mu = 10\%. Analyst B says the drift is 00. You observe the whole price path continuously on [0,T][0, T].

    (a) Use Girsanov to write the likelihood ratio dPA/dPBd\mathbb P_A/d\mathbb P_B in terms of the path. Which part of the path does it depend on?

    (b) Suppose A is right. What is the probability that the likelihood ratio favours A after 10 years? How many years of data do you need for that probability to reach 95%?

    (c) Analyst C agrees with B about the drift but says σ=25%\sigma = 25\%. Why does one day of continuous data settle the argument between B and C?