Financial Mathematics09

All questions may be attempted but only marks obtained on the best four solutions will
count.
The use of an electronic calculator is not permitted in this examination.
NOTE: In the questions which follow the current price of an asset (or similar instrument)
will often be denoted either by St or simply by S with the time subscript suppressed.
Reference may be made to the following definitions:
(x)+ = max{x, 0},

Z x
1 −t2
N (x) = √ exp( )dt,
2π −∞ 2
1 −x2
n(x) = √ exp( ),
2π 2
ln(S/K) + (r + 12 σ 2 )t
d1 = √ ,
σ t
ln(S/K) + (r − 12 σ 2 )t
d2 = √ ,
σ t
where K denotes the exercise price, r the riskless rate, σ the volatility and t is the time
to expiry. The Black-Scholes formula for pricing a European call is
C = SN (d1 ) − Ke−rt N (d2 ).
1. Write an essay to explain the concept of risk-neutrality and how it is used to price
financial derivatives. You should define risk-neutrality, give a simple example of
how to construct the risk-neutral probability and state and prove a version of the
no-arbitrage theorem.
MATHG508 PLEASE TURN OVER
1
2. Consider the following model where the interest rate r = 0:
ω S(0) S(1) S(2)

ω1 5 8 11
ω2 5 8 5
ω3 5 2 5
ω4 5 2 0
(a) Given a European put option with payoff
X(2) = (7 − S(2))+ ,
replicate the option over the two periods using the above model and so find the fair
price of the claim.
(b) Find all the one period risk-neutral probabilities and the corresponding proba-
bility on Ω = {ω1 , ω2 , ω3 , ω4 }. Confirm that EQ [X] is the fair price.
(c) Now suppose we have a put option on this model with strike K. Using the
risk-neutral probabilities, show that the value of this option is:
(i) K −5 if K > 11,

3
(ii) K if K 6 5,
10
3 9
(iii) K− otherwise.
4 4
(d) In the T −period binomial model, if the asset price is S at any time, the next
periods’s price will be either SU or SD. The interest rate per period r is positive and
D∗ < 1 < U ∗ , where the star denotes discounting. Interest rates are continuously
compounded.
(i) Describe the risk-neutral measure Q.
(ii) A digital option pays one dollar at time t = T if the asset price is above a fixed
level K and is worthless otherwise. Using Q show that the option value at time
t = 0 is equal to
X T
−rT T −n
e qUn qD
n≥n̂
n
for some n̂ which you must find.
MATHG508 CONTINUED
2
3. (a) Give a brief explanation of the idea behind dynamic programming as applied
to the valuation of an American option. Use the method to value an American put
option with exercise price K = 7 dollars written on an asset where the asset prices
in dollars are given below, the interest rate per period is zero, and a dividend of one
dollar is paid between time 1 and expiry.
ω S(0) S(1) S(2)

ω1 5 8 15
ω2 5 8 5
ω3 5 2 5
ω4 5 2 0
(b) For each path ωi , write down the stopping time.

(c) Calculate the value of the American call option with K = 7 using the above
model and show that for American options, Put-Call Parity is not satisfied.
MATHG508 PLEASE TURN OVER
3
4. (a) Consider the integral
Z T
I= W (t)dW (t)
0
By partitioning T show that

N −1
1 1X
I(π) = W (T )2 − ∆W (ti )2 ,
2 2 i=0
and show that the expectation of the final term is T .

(b) Let f (S, t) be a function of two variables (continuously twice differentiable in
S and once in t). State Itô’s Formula for df (S(t), t), where S(t) is an asset price
obeying the stochastic equation
dS = µdt + σdW
in which W = W (t) is standard Brownian motion and µ, σ are continuous functions

of S and t. Give a plausability argument in support of the formula.
(c) What form does Itô’s Formula take when the function f is independent of time?
Using this formula, explain how we can obtain a relationship between the stochastic
integral and a standard integral.
(d) Now evaluate the integral
Z T
W (t)dW (t)
0
using Itô’s Formula.
MATHG508 CONTINUED
4
5. (a) Let V (S, t) denote the value at time t ≤ T of a European option when the
price of the underlying asset is S. A share price process S(t) follows the stochastic
equation
dS = µSdt + σSdW
where W = W (t) is a standard Brownian motion and µ, σ are constants. Assume

r is the constant riskless interest rate applicable throughout the life of the option
and that there are no dividends.
Construct a delta-hedged portfolio to derive the Black-Scholes equation satisfied by

the function V (S, t), namely
∂V ∂V 1 2 2 ∂ 2V
+ rS + σ S = rV.
∂t ∂S 2 ∂S 2
(b) Use the Feynman-Kac formula to solve the Black-Scholes equation in the case of
a European call option and thus verify the Black-Scholes formula given at the start
of this paper.
(c) Sketch a graph of the payoff of a European call option with strike = K. On the
same graph sketch the value of the option at time t = 0.
MATHG508 END OF PAPER

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All questions may be attempted but only marks obtained on the best four solutions will

(x)+ = max{x, 0},

C = SN (d1 ) − Ke−rt N (d2 ).

MATHG508 PLEASE TURN OVER

ω S(0) S(1) S(2)

(a) Given a European put option with payoff

(i) K −5 if K > 11,

for some n̂ which you must find.

ω S(0) S(1) S(2)

(b) For each path ωi , write down the stopping time.

MATHG508 PLEASE TURN OVER

By partitioning T show that

and show that the expectation of the final term is T .

in which W = W (t) is standard Brownian motion and µ, σ are continuous functions

using Itô’s Formula.

where W = W (t) is a standard Brownian motion and µ, σ are constants. Assume

Construct a delta-hedged portfolio to derive the Black-Scholes equation satisfied by

MATHG508 END OF PAPER

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