Main Examination period 2019

MTH6154 / MTH6154P: Financial Mathematics I

Duration: 2 hours

Apart from this page, you are not permitted to read the contents of this question
paper until instructed to do so by an invigilator.

You should attempt ALL questions. Marks available are shown next to the ques-
tions.

Only non-programmable calculators that have been approved from the college list
of non-programmable calculators are permitted in this examination. Please state
on your answer book the name and type of machine used.

Complete all rough work in the answer book and cross through any work that is not
to be assessed.

Possession of unauthorised material at any time when under examination conditions

is an assessment offence and can lead to expulsion from QMUL. Check now to ensure
you do not have any unauthorised notes, mobile phones, smartwatches or
unauthorised electronic devices on your person. If you do, raise your hand and give
them to an invigilator immediately.

It is also an offence to have any writing of any kind on your person, including on
your body. If you are found to have hidden unauthorised material elsewhere,
including toilets and cloakrooms, it will be treated as being found in your possession.
Unauthorised material found on your mobile phone or other electronic device will be
considered the same as being in possession of paper notes. A mobile phone that
causes a disruption in the exam is also an assessment offence.

Exam papers must not be removed from the examination room.

Examiners: Dr. S. Muirhead, Prof. I. Goldsheid

c Queen Mary University of London (2019)

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 Page 2 MTH6154 / MTH6154P (2019)

Unless stated otherwise, give all numerical answers to two decimal places. Where
the answer is a rate, this refers to the number of decimal places when written as a
percentage, i.e. a rate of 0.02344 to two decimal places is 2.34% not 0.02.

Question 1. [28 marks] A bank offers interest at nominal rate r that is continuously
compounded.

(a) Write down the effective rate reff in terms of r. [3]

(b) Suppose that r = 2%. If you deposit £100 in an account today, how many years
will it take for the account value to grow to £120? [4]

A creditor owes you three payments: (i) £150 due in 1 year’s time, (ii) £250 due in 2
years’ time, and (iii) £400 due in 4 years’ time.

(c) Using the continuously compounded interest rate from part (b), calculate the
present value and effective duration of the total credits owed. [6]

(d) Your creditor proposes paying you the total amount due, £800, in 3 years’ time.
By comparing present values, decide whether you should accept their offer. [3]

A second bank offers term deposits of 1 and 3 years’ duration with respective spot
rates s1 and s3 .

(e) Explain briefly what is meant by the forward rate f t1 ,t2 . [3]

(f) Write down a formula for f 1,3 in terms of s1 and s3 . [4]

A 3 year bond with face-value £10 million, redeemable at par, with 4% annual
coupons is priced at £8 million.

(g) Show that the yield r of this bond is a solution to the equation:

20(1 + r )3 − (1 + r )2 − (1 + r ) − 26 = 0. [5]

c Queen Mary University of London (2019)

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 MTH6154 / MTH6154P (2019) Page 3

Question 2. [19 marks] An experiment has three possible outcomes A, B or C. You

are offered odds on these outcomes of o A = 2, o B = 3/2 and oC = 3.

(a) Suppose you place a bet of £2 on outcome B. Write down the return function of
this bet. [4]

(b) Explain briefly what is meant by an arbitrage opportunity. [3]

(c) Determine whether the odds listed above give rise to an arbitrage opportunity. [4]

Recall that the Arbitrage Theorem states that, given a set of outcomes and a set of
return functions over these outcomes, either (i) there exists an arbitrage opportunity
or (ii) there exists a risk-neutral distribution over the outcomes.

(d) Explain briefly what is meant by a risk-neutral distribution. [3]

(e) You are offered two investments whose payoffs depend on which of two
possible outcomes, X or Y, occurs:

Investment 1, which pays £10 if outcome X occurs and £15 if outcome Y

occurs.
Investment 2, which pays £5 if outcome X occurs and £20 if outcome Y
occurs.

If Investment 1 costs £12, find the fair price of Investment 2 assuming there is
no arbitrage opportunity. [5]

Question 3. [13 marks] A share is currently priced at £80. You wish to model the
future price of the share using a stochastic process.

(a) Give one reason why it would not be appropriate to model the share price as an
i.i.d. sequence of random variables. [3]

You decide to model the year-on-year values S(n) of the share price as a log-normal
process with parameters S = 80, µ = 0.2 and σ2 = 0.2. You ask your broker to
purchase a European call option on the share with strike K = 140 and expiry T = 10.

(b) Plot the payoff of this option as a function of the share price. [4]

(c) Find the probability that this option ends up ‘out-of-the-money’, i.e. has zero
payoff. You may use the value of the standard normal c.d.f. Φ(1.0185) = 0.85. [6]

c Queen Mary University of London (2019)

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Question 4. [25 marks] A share price is modelled via a two-period binomial model
with parameters S = 60, u = 3/2, d = 1/2, and interest rate per time-period r = 2%.
(a) Verify that the no-arbitrage assumption is valid in this model. [4]

(b) Show that the risk-neutral probabilities of up and down movements in the
share price are
p̃u = 0.52 and p̃d = 0.48. [4]

You are considering buying a European put option on the share with strike K = 40
and expiry T = 2.
(c) Find the no-arbitrage price at t = 0 of this option. [9]
Your stock broker advises you to consider buying an American put option.
(d) Explain the difference between an American put option and a European put
option. [3]

(e) Find the no-arbitrage price at t = 0 of an American put option with strike
K = 200 and expiry T = 1. [5]

Question 5. [15 marks] Recall that ‘put-call parity’ is an equation that relates the
prices of put and call options written on the same share with identical strike prices
and expiry times.
(a) Write down the formula for put-call parity in the case of continuously
compounded interest. [3]

(b) Using a ‘replicating portfolios’ argument or otherwise, prove this formula. [4]
The Black–Scholes formula for a European call option with strike K and expiry T
written on a stock with current price S, drift µ and volatility σ is
√
C = SΦ(η ) − Ke−rT Φ(η − σ T ),

where
log KS + rT 1 √
η= √ + σ T.
σ T 2
(c) Prove that the Black–Scholes price of a call option is no more than the current
stock price, i.e. C ≤ S. [4]

(d) Without calculating a derivative, show that C is a non-increasing function of

the strike K. [4]

End of Paper.

c Queen Mary University of London (2019)

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