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    Exercise Stoc Calculus

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    puterinayli02
    This document contains 4 questions regarding stochastic calculus exercises: 1) Derive the SDE for the process Xt3 given the SDE for Xt is dXt = μXt dt + σXt dWt. 2) Find the SDEs for various processes given the SDE dXt = σXt dWt + μXt dt, including for processes like etXt, Xt2, logWt, and functions of Wt. 3) For a geometric Brownian motion process defined by St = exp(μt + σWt): a) write the SDE for Xt = logSt, b) derive the SDE for St using Ito's lemma

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    Exercise Stoc Calculus

    Uploaded by

    puterinayli02
    14 views3 pages
    This document contains 4 questions regarding stochastic calculus exercises: 1) Derive the SDE for the process Xt3 given the SDE for Xt is dXt = μXt dt + σXt dWt. 2) Find the SDEs for various processes given the SDE dXt = σXt dWt + μXt dt, including for processes like etXt, Xt2, logWt, and functions of Wt. 3) For a geometric Brownian motion process defined by St = exp(μt + σWt): a) write the SDE for Xt = logSt, b) derive the SDE for St using Ito's lemma

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    This document contains 4 questions regarding stochastic calculus exercises: 1) Derive the SDE for the process Xt3 given the SDE for Xt is dXt = μXt dt + σXt dWt. 2) Find the SDEs for various processes given the SDE dXt = σXt dWt + μXt dt, including for processes like etXt, Xt2, logWt, and functions of Wt. 3) For a geometric Brownian motion process defined by St = exp(μt + σWt): a) write the SDE for Xt = logSt, b) derive the SDE for St using Ito's lemma

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    14 views3 pages

    Exercise Stoc Calculus

    Uploaded by

    puterinayli02
    This document contains 4 questions regarding stochastic calculus exercises: 1) Derive the SDE for the process Xt3 given the SDE for Xt is dXt = μXt dt + σXt dWt. 2) Find the SDEs for various processes given the SDE dXt = σXt dWt + μXt dt, including for processes like etXt, Xt2, logWt, and functions of Wt. 3) For a geometric Brownian motion process defined by St = exp(μt + σWt): a) write the SDE for Xt = logSt, b) derive the SDE for St using Ito's lemma

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 3

    EXERCISES FOR STOCHASTIC CALCULUS

    Question 1
    A process 𝑋𝑋𝑡𝑡 satisfies the stochastic differential equation:
    𝑑𝑑𝑋𝑋𝑡𝑡 = 𝜇𝜇𝑋𝑋𝑡𝑡 𝑑𝑑𝑑𝑑 + 𝜎𝜎𝑋𝑋𝑡𝑡 𝑑𝑑𝑊𝑊𝑡𝑡
    Where 𝑊𝑊𝑡𝑡 is a standard Brownian motion. Deduce the SDE for the process 𝑋𝑋𝑡𝑡3 .

    Question 2
    Find the SDE for each of the following processes given:
    𝑑𝑑𝑋𝑋𝑡𝑡 = 𝜎𝜎𝑋𝑋𝑡𝑡 𝑑𝑑𝑊𝑊𝑡𝑡 + 𝜇𝜇𝑋𝑋𝑡𝑡 𝑑𝑑𝑑𝑑
    Where 𝑊𝑊𝑡𝑡 is a standard Brownian motion.
    a) 𝐺𝐺𝑡𝑡 = 𝑒𝑒 𝑋𝑋𝑡𝑡
    b) 𝑄𝑄𝑡𝑡 = 𝑋𝑋𝑡𝑡2
    c) 𝐽𝐽𝑡𝑡 = 𝑙𝑙𝑙𝑙𝑊𝑊𝑡𝑡 (standard Brownian motion)
    d) 𝐾𝐾𝑡𝑡 = 5𝑊𝑊𝑡𝑡3 + 2𝑊𝑊𝑡𝑡 (standard Brownian motion)

    Question 3
    Let 𝑆𝑆𝑡𝑡 be a geometric Brownian motion process defined be the equation 𝑆𝑆𝑡𝑡 = 𝑒𝑒𝑒𝑒𝑒𝑒(𝜇𝜇𝜇𝜇 + 𝜎𝜎𝑊𝑊𝑡𝑡 ),
    where 𝑊𝑊𝑡𝑡 is a standard Brownian motion and 𝜇𝜇 𝑎𝑎𝑎𝑎𝑎𝑎 𝜎𝜎 are constants.

    a) write down the SDE satisfied by 𝑋𝑋𝑡𝑡 = 𝑙𝑙𝑙𝑙 𝑆𝑆𝑡𝑡


    b) by applying Ito’s Lemma, derive the SDE satisfied by 𝑆𝑆𝑡𝑡
    c) the price of a share follows a geometric Brownian motion with 𝜇𝜇 = 0.06 𝑎𝑎𝑎𝑎𝑎𝑎 𝜎𝜎 = 0.25. find the
    probability that, over a given one-year period, the share price will fall.

    JULY 2022 QUESTION 4


    a) The term structure of interest rate at time 𝑡𝑡 implied by the market prices of treasury bills is
    defined by the stochastic differential equation

    �𝑡𝑡
    𝑑𝑑𝑟𝑟𝑡𝑡 = 0.4(0.06 − 𝑟𝑟𝑡𝑡 )𝑑𝑑𝑑𝑑 + 0.03𝑑𝑑𝑊𝑊

    �𝑡𝑡 is a standard Brownian motion.


    where 𝑊𝑊
    i) Solve this stochastic differential equation using the integrating factor 𝑒𝑒 0.4𝑡𝑡 to find an
    expression of 𝑟𝑟𝑡𝑡 involving a stochastic integral.

    This is a vasicek model (mean-reverting process). We can use the integrating factor 𝑒𝑒 0.4𝑡𝑡 to
    solve for the SDE:
    Multiplying through by the integrating factor 𝑒𝑒 0.4𝑡𝑡 :
    𝑒𝑒 0.4𝑡𝑡 𝑑𝑑𝑟𝑟𝑡𝑡 = 𝑒𝑒 0.4𝑡𝑡 (0.4)(0.06 − 𝑟𝑟𝑡𝑡 )𝑑𝑑𝑑𝑑 + 𝑒𝑒 0.4𝑡𝑡 (0.03)𝑑𝑑𝑊𝑊𝑡𝑡
    Thus, we obtain:
    𝑡𝑡
    −0.4(𝑡𝑡−0) −0.4(𝑡𝑡−0)
    𝑟𝑟𝑡𝑡 = 𝑒𝑒 𝑟𝑟0 + 0.06�1 − 𝑒𝑒 � + 0.03 � 𝑒𝑒 −0.4(𝑡𝑡−𝑠𝑠) 𝑑𝑑𝑊𝑊𝑠𝑠
    0

    ii) Calculate the mean and variance of 𝑟𝑟3 given 𝑟𝑟0 = 0.04.
    𝐸𝐸 [𝑟𝑟3 ] = 0.053976
    Using ito isometry,
    0.032
    𝑉𝑉𝑉𝑉𝑉𝑉[𝑟𝑟3 ] = �1 − 𝑒𝑒 −0.8(3) � = 0.001022942
    0.8

    FEB 2022 QUESTION 4


    a) Consider that a share price at time 𝑡𝑡 denoted as 𝑆𝑆𝑡𝑡 follows a process defined by the stochastic
    differential equation given below:
    𝑑𝑑𝑆𝑆𝑡𝑡 = 𝑆𝑆𝑡𝑡 (0.05𝑑𝑑𝑑𝑑 + 0.04𝑑𝑑𝑊𝑊𝑡𝑡 )
    where 𝑊𝑊𝑡𝑡 is a standard Brownian motion.
    By applying the function of ln 𝑆𝑆𝑡𝑡 to the Ito diffusion, solve the SDE above to find the expression
    for 𝑆𝑆𝑡𝑡 . Hence, calculate the mean and variance of ln 𝑆𝑆2 given 𝑆𝑆0 = 10.

    i) Here we want the probability that 𝑆𝑆1 > 𝑆𝑆0


    𝑆𝑆1
    𝑃𝑃[𝑆𝑆1 > 𝑆𝑆0 ] = 𝑃𝑃 � > 1� ~ (1 mark)
    𝑆𝑆0
    𝑆𝑆
    𝑆𝑆1 𝑙𝑙𝑙𝑙 1 −0.07 ln(1)−0.07
    𝑆𝑆0
    = 𝑃𝑃 �𝑙𝑙𝑙𝑙 > ln (1)� = 𝑃𝑃 � > � ~ (2 marks)
    𝑆𝑆0 0.2 0.2

    Therefore,
    𝑃𝑃[𝑆𝑆1 > 𝑆𝑆0 ] = 𝑃𝑃[𝑍𝑍 > −0.35] = Φ(0.35) = 0.63683 ~ (1 mark)
    Note: To answer this, we need to find the cdf of a standard normal distribution, Φ(0.35)
    using the z-score table.
    So, there is a probability of almost 64% that the share price will increase over the next year.
    ii) Here we want the probability that 𝑆𝑆1 < 1.20𝑆𝑆0
    𝑆𝑆1
    𝑃𝑃[𝑆𝑆1 < 1.20𝑆𝑆0 ] = 𝑃𝑃 � < 1.20� ~ (1 mark)
    𝑆𝑆0
    𝑆𝑆
    𝑆𝑆1 𝑙𝑙𝑙𝑙 1 −0.07 ln(1.20)−0.07
    𝑆𝑆0
    = 𝑃𝑃 �𝑙𝑙𝑙𝑙 < ln (1.20)� = 𝑃𝑃 � < �
    𝑆𝑆0 0.2 0.2

    Therefore,
    𝑃𝑃[𝑆𝑆1 < 1.20𝑆𝑆0 ] = 𝑃𝑃[𝑍𝑍 < 0.5616] = Φ(0.5616) = 0.71281
    So, there is a probability of about 71% that the share will yield a return of less than 20% over
    the next year.

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