MATH39032

2 hours

Tables of the cumulative distribution function are provided.

THE UNIVERSITY OF MANCHESTER

MATHEMATICAL MODELLING IN FINANCE

1 June, 2015
2:00pm – 4:00pm

Answer all 4 questions in Section A (60 marks in all) and

Electronic calculators may be used, provided that they cannot store text.

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 MATH39032
SECTION A

Answer ALL 4 questions

A1.
Consider a contract V (S, t) which satisfies the Black Scholes equation, namely

∂V 1 ∂ 2V ∂V
+ σ 2 S 2 2 + rS − rV = 0.
∂t 2 ∂S ∂S
(in the usual notation), with a payoff at expiry t = T

V (S, T ) = S 2 − K 2 .

By seeking a solution of the form V (S, t) = S 2 f1 (t) + f2 (t), determine V (S, t). Explain how to hedge
the contract.

[15 marks]

A2.

(i) A European binary put option Bp (S, t) on an underlying of value S has the payoff

0 if S > X
Bp (S, T ) = .
K if S < X

State the payoff for the corresponding European binary call Bc (S, T ).

(ii) By considering Bc (S, T ) + Bp (S, T ), determine the put-call parity relationship between Bc (S, t)
and Bp (S, t), where the (constant) risk-free interest rate is r.

(iii) Suppose that it is only possible to buy and sell European vanilla calls and European binary
calls (with K = 1) on the same underlying S with exercise prices £70, £80, £90 and £100 all
with exercise time T . Construct a portfolio of options such that


 0, S < 70
 80 − S, 70 < S < 80


Π(S, T ) = 0, 80 < S < 90 .
S − 90, 90 < S < 100




0, S > 100


[15 marks]

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A3.
Consider an asset whose value 6 months before the expiration of an option is £22. The exercise
price of the option is £21, the risk-free interest rate (constant) is 4% per annum, and the volatility
1
(constant) is 15% per (annum) 2 .
By what amount does the asset price have to rise for the purchaser of a European call option to
break even, and by what amount must the asset price have to fall for the purchaser of a European
put option to break even?
You may assume (in the usual notation) that the solution of the Black-Scholes equation for a
European put option paying no dividends is

P (S, t) = Xe−r(T −t) N (−d2 ) − SN (−d1 ),

where
log(S/X) + (r + 12 σ 2 )(T − t)
d1 = √ ,
σ T −t
log(S/X) + (r − 12 σ 2 )(T − t)
d2 = √ ,
σ T −t
and N (x) should be determined by interpolation from the tables of the cumulative distribution
function, provided herewith. You may assume put-call parity for vanilla options, i.e.

S + P − C = Xe−r(T −t) ,

without proof.

[15 marks]

A4.
Draw the expiry payoff diagram for each of the following portfolios (all options are vanilla and
have the same expiry date):

(i) Long two assets, short three puts with exercise X.

(ii) Long two calls, short three puts, all with exercise X.

(iii) Long two puts both with exercise price X1 and long two calls both with exercise price X2 .
Compare the cases X1 > X2 , X1 = X2 , X1 < X2 .

[15 marks]

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SECTION B

Answer 2 of the 3 questions

B5.
Consider the Black-Scholes equation for an option V (S, t) (in the usual notation), namely

∂V 1 ∂ 2V ∂V
+ σ 2 S 2 2 + rS − rV = 0,
∂t 2 ∂S ∂S
where the volatility σ and interest rate r are both constants.

(i) By using the substitution V (S, t) = S α V1 (S, t), where α = 1 − 2r/σ 2 , find the equation satisfied
by V1 (S, t).

(ii) By using the further substitution V1 (S, t) = V2 (ξ, t), where ξ = Sd2 /S, where Sd is constant,
show that V2 (ξ, t) satisfies the Black-Scholes equation.
2
(iii) Explain why CDO = AV (S, t) + B( SSd )1−2r/σ V (Sd2 /S, t), where A and B are constants, must
also satisfy the Black-Scholes equation.

(iv) Consider a down-and-out call option CDO , which, in the usual notation, has a payoff max(S −
X, 0), but is worthless if the asset value falls below a prescribed value, Sd , where Sd < X (the
strike price). Find appropriate values for the coefficients A and B in (iii) where V (S, t) is a
vanilla European call option with strike X, such that CDO values a down-and-out call and
confirm that the final condition is satisfied.

[20 marks]

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B6.

(i) Consider an asset of value S which pays just one dividend, Sdy per share, during the lifetime
of a put option, at t = td . In the absence of factors such as taxes and transaction costs, how is
the value of the asset after payment S(t+ d ) related to the value before payment S(td )? Justify
−

your answer.

(ii) How does the value of a put option on the asset, Pd (S, t) change across the dividend date?
Justify your answer.

(iii) Using the above, compare the value of a European put option Pd (S, t) on a single dividend-
paying asset, with that of a non-dividend paying (vanilla) European put option P (S, t, X),
+
both with exercise price X. Consider the regimes 0 < t ≤ t−
d and td ≤ t < T (the expiry date)
separately. What effect does the dividend payment have on the value of the put?

(iv) Suppose that the asset pays n dividends Sd1 , Sd2 , . . . , Sdn per share during the lifetime of the
option, at corresponding times t1 , t2 , . . . , , tn . What is the value of this dividend-paying option
at time t, where t is between two dividend dates (0 ≤ tk−1 < t < tk ≤ tn ), compared with the
corresponding vanilla European put option?

[20 marks]

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B7.
Consider an option V (S1 , S2 , t) where the two underlyings S1 and S2 have volatilities σ1 and σ2
respectively, and drifts µ1 , µ2 respectively; the risk-free interest rate is r.

(i) Justify the use of the following stochastic processes to model underlyings (i = 1, 2):

dSi = µi Si dt + σi Si dWi

where the dWi are Wiener processes, such that

E[dWi2 ] = dt, E[dW1 dW2 ] = ρdt.

(ii) By considering a portfolio (using the dSi in (i) above)

Π = V (S1 , S2 , t) − ∆1 S1 − ∆2 S2 ,

find the choices of ∆1 and ∆2 for which the portfolio is perfectly hedged.

(iii) Equating the hedged portfolio in (ii) above to the risk-free return on the portfolio, show that
the option value is determined from

∂V 1 ∂ 2V 1 ∂ 2V ∂ 2V ∂V ∂V
+ σ12 S12 2 + σ22 S22 2 + ρσ1 σ2 S1 S2 + rS1 + rS2 − rV = 0.
∂t 2 ∂S1 2 ∂S2 ∂S1 ∂S2 ∂S1 ∂S2

(iv) Now consider a perpetual American put option on a basket of two assets (S1 , S2 ). Assuming
that there is no correlation between the two assets (i.e. ρ = 0), show that a solution exists of
the form
V = A1 S1λ1 + A2 S2λ2
where you are to determine λ1 and λ2 .

(v) If the payoff is max(X − S1 − S2 , 0), show that the critical asset prices S1∗ and S2∗ at which it
is optimal to exercise satisfy the condition

B1 S1∗ + B2 S2∗ = X,

where you are to determine B1 and B2 . Why is this solution not valid for small values of S1 or
S2 ?

[20 marks]

END OF EXAMINATION PAPER