Financial Mathematics07

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. (a) Explain how covered interest-rate arbitrage can be used to value a forward F (T )
to time T on a foreign exchange rate S. Write a formula for the value of this forward
using annually-compounded interest rates.
(b) In the context of the multiperiod model with a filtration (Pt )Tt=0 and an adapted
sequence of random variables S = (St )Tt=0 , define what is meant when we say S is
a martingale. When is a sequence of random variables H(t) previsible with respect
to a filtration? What is an arbitrage opportunity and when is a probability measure
Q said to be risk-neutral?
(c) State and prove the Multiperiod No-Arbitrage Theorem.
MATHG508 PLEASE TURN OVER
1
2. A digital option pays one dollar at time t = T if the asset price is above a fixed level
K and is worthless otherwise. Consider the following model, with r = 0:
ω S(0) S(1) S(2)

ω1 4 7 11
ω2 4 7 6
ω3 4 3 6
ω4 4 3 1
(a) In this model, replicate the digital option with strike K = 5 over the two periods
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) For the same model, find the value of the range digital option which pays one
million dollars when the final value of S is between 5 and 8.
(d) In the T −period binomial model, if the asset price is S at any time, the next
period’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.
Describe the risk-neutral measure Q and 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) A barrier option becomes worthless if at any time the underlying asset goes above
the barrier level. Give a brief explanation of the idea behind dynamic programming
as applied to the valuation of barrier options. Use the method to value a barrier
call option with strike price K = 2 dollars and barrier level B = 8 dollars written
on an asset where the asset prices in dollars are given below, the interest rate per
period is zero.
S(0) S(1) S(2) S(3)

ω1 4 7 11 14
ω2 4 7 11 9
ω3 4 7 6 9
ω4 4 3 6 9
ω5 4 7 6 4
ω6 4 3 6 4
ω7 4 3 1 4
ω8 4 3 1 1
(b) Why is this barrier option worth less than the european call option struck at
K = 2? Construct an arbitrage opportunity for the case where the european and
barrier option have the same initial value.
(c) Explain the differences between risk-neutral pricing and pricing based on the
expected value of the underlying asset. If a hedge fund buys an option from a bank,
how is it possible that they may both make money from the transaction?
MATHG508 PLEASE TURN OVER
3
4. (a) 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.
(b) 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.
(c) Show that
Z T Z T
1
W dW = W (T )3 −
2
W dt
0 3 0
(d) Now assume that S is a model for stock prices obeying the stochastic equation
dS = µSdt + σSdW
Show that S(T )/S(0) is lognormally distributed and calculate the mean and variance
of the distribution.
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. Assume that the asset price process S(t) follows the
stochastic equation
dS = µSdt + σSdW
where W = W (t) is a standard Brownian motion, µ, σ are constants and r is a

constant riskless interest rate applicable throughout the life of the option.
Use Itô’s Formula to derive the Black-Scholes equation satisfied by the function
V (S, t), namely
∂V ∂V 1 ∂2V
+ rS + σ 2 S 2 2 = rV.
∂t ∂S 2 ∂S
(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 for 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)

for some n̂ which you must find.

S(0) S(1) S(2) S(3)

MATHG508 PLEASE TURN OVER

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

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

MATHG508 END OF PAPER

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