Department of Mathematics MTL 733 (Stochastics of Finance) Tutorial Sheet No. 1

Department of Mathematics
MTL 733 (Stochastics of Finance)

Tutorial Sheet No. 1
1. Trace the path of the following stochastic processes
(a) {X(t), t ∈ [0, ∞)} where X(t) is the total number of shares held by an investor at any time t.
(b) {Xn , n = 1, 2, . . .} where Xn is the value of one US dollar (USD) in rupees at the end of n-th day.
(c) {X(t), t ∈ [0, ∞)} where X(t) is the stock price of a particular item at any time t.
(d) {Xn , n = 1, 2, . . .} where Xn is the total number of shares held by a particular person at the end of n-th
day.
√ −1
2. Let Xn , for n even take values +1 and −1 each with probability 0.5, and for n odd, take values a, √ a
with
1 a
probability a+1 , a+1 respectively (a > 0, a 6= 1). Further, let Xn ’s be independent, show that {Xn , n =
1, 2, . . .} is covariance/wide sense stationary but not strict stationary.
3. Let {X(t), t ≥ 0} with X(0) = 0 be a stochastic process having independent increments. Show that
V ar{X(s)}, for 0 ≤ s ≤ t;
cov{X(s), X(t)} =
V ar{X[min(s, t)]}, for any s, t (t, s > 0).
4. Let {W (t), t ≥ 0} be a Wiener process. Find the conditional distribution of W (t) given that W (s) = c (where
c is a constant) when s < t.
5. Let {W (t), t ≥ 0} be the Brownian motion. Prove that, E((W (t) − W (s))4 ) = 3(t − s)2 .
6. Let {W (t), t ≥ 0} be the Brownian motion. Prove that (W (t1 ), W (t2 ), . . . , W (tn )) is jointly normal dis-
tributed. Also find the mean and variance for the random variable W (t).
7. Let S(t) be the stock price at any time t. Assume that {S(t), t ≥ 0} follows a geometric Brownian motion.
σ2
)
Prove that E(S(t)) = S(0)et(µ+ 2 where S(0) is the initial price, µ is the drift parameter and σ is the
volatility parameter.
8. Suppose that {S(t), t ≥ 0}, is a geometric Brownian motion with drift parameter µ = 0.01 and volatility
parameter σ = 0.2. If S(0) = 100. Find
(a) E[S(10)].
(b) P [S(10) > 100].
9. The price of a stock follows a geometric Brownian motion with drift µ = 12% per year and variance σ 2 = 9%
per year. If the present price of the stock is Rs.40, what is the probability that a call option having four
months to exercise time and with a strike price K = Rs.42, will be exercised?
10. Let X be a normally distributed random variable with mean µ and variance σ 2 . Let u be a fixed number in
R and define the convex function φ(x) = eux for all x ∈ R. Prove that
2
1
σ2
(a) E(φ(X)) = euµ+ 2 u .
(b) Verify the Jensen’s inequality holds E(φ(X)) ≥ φ(E(X)).
11. Show that for any T > 0, V (t) = W (t + T ) − W (T ) is a Wiener process if {W (t), t ≥ 0} is a Wiener process.
12. Let {W (t), t ≥ 0} be a Brownian motion. Prove that {tW (1/t), t ≥ 0} where tW (1/t) is taken to be zero
when t = 0, is a Brownian motion.
13. Consider the process
W (t), t<1
Y (t) =
W (t) + Z, t ≥ 1
where {W (t), t ≥ 0} is a Wiener process and Z ∼ N (0, 1) and is independent of W (t). Show that {Y (t), t ≥ 0}
not a Levy process.
1
14. Let {W (t), t ≥ 0} be a brownian motion. Find the conditional expectation of Ws given Wt = x for 0 < s < t.
15. Let X1 , X2 , . . . be a sequence of iid random variables each takes 0 or 2 with equal probabilities. Let Yn =
X1 X2 . . . Xn , (n = 1, 2, . . .). Prove that, {Yn , n = 1, 2, . . .} is a martingale.
16. Let
Pn Xi , i = 1, 2, . . . be a sequence of iid random variables with common distribution N (0, 1). Define Sn =
n 2
i=1 X i . For what values of α, exp{αS n − 2 α } is a Fn martingale.
17. For every n = 0, 1, . . . , N , let an and bn be the number of stocks and bonds respectively bought at time n
and held over the period [n, n + 1). The bond price is modelled according to B0 = 1, Bn = (1 + r), n =
1, 2, . . . N where r > −1 is the constant rate of return for the bond. The stock price is modelled according
to S0 = s, Sn = (1 + Rn )Sn−1 , n = 1, 2, . . . , N where s > 0 and {Rn , n = 1, 2, . . . , N } is a sequence of iid
random variables. Let {Vn , n = 0, 1, . . . , N } be the portfolios consisting of the bond and the stock. Let
Vn = an Sn + bn Bn
be the value of the portfolio over [n, n + 1). Let {Fn , n = 1, 2, . . . , N } be the filtration given by Fn =
σ(R1 , R2 , . . . , Rn ), n = 1, 2, . . . , N . Show that Vn /Rn is martingale with respect to the filtration {Fn , n =
1, 2, . . . , N } if E(Rn+1 | Fn ) = r.
18. Let {Xn , n = 0, 1, 2, . . .}, {Yn , n = 0, 1, 2, . . .} be stochastic processes. We say {Xn } is a martingale with
respect to {Yn } iff
(a) E[|Xn |] < ∞ and (b) E[Xn+1 /Y0 , Y1 , Y2 , . . . , Yn ] = Xn .
Prove that {Xn } is a martingale with respect to {Yn } where Xn = Y1 + Y2 + . . . + Yn , n ≥ 1, Y0 = 0,
{Yi , i = 1, 2, . . .} are independent random variable with E(Yn ) = 0.
19. Let Xn be a symmetric random walk and Fn be a filtration. Show that Yn = (−1)n cos(πXn ) is a martingale
with respect to Fn .
20. Let Xn be a sequence of square integrable random variables. Show that if Xn is a martingale with respect
to a filtration Fn , then Xn2 is a sub martingale with respect to the same filtration. (Hint: Use Jensen’s
inequality with convex function φ(x) = x2 )
21. Show that X(t) = [W (t)]2 − t is a martingale, where {W (t), t ≥ 0} is a brownian motion. But Y (t) = [W (t)]2
is not a martingale. Further, let Z(t) = [W (t)]3 . Check if Z(t) is a martingale.
22. Let {X(t), t ≥ 0} be a Poission process with rate 1. Which of the following are martingales.
(a) {X(t) − t, t ≥ 0}
(b) {X(t)2 − t, t ≥ 0}
(c) {(X(t) − t)2 − t, t ≥ 0}
Justify your answer.
23. Let S be the stochastic process defined by
S(t) = exp(σW (t) + α + βt)
For which choice of parameters α, β and σ is S a martingale? Justify your answer.
24. Consider the binomial tree model. Let Sn be the stock price at time n (risky asset).

uSn with probability p
Sn+1 = n = 0, 1, . . .
dSn with probability 1 − p
Find the value of p such that discounted process {S0 , e−r S1 , e−2r S2 , . . .} is a martingale where r is the interest
rate. Justify your answer.

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MTL 733 (Stochastics of Finance)

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