Financial Mathematics10

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 ).
MATHG508 PLEASE TURN OVER
1
1. (a) Write down the general principle used for valuing forwards. Using this, calculate
the one year future on Morgan Stanley (MS) shares given that:
(i) MS is currently trading at 30 USD per share
(ii) USD interest rates are at 2%
(iii) MS pays a dividend of 0.60 USD in 6 month’s time.
(b) In the context of a one-period multi-state model of asset prices define what is
meant by arbitrage opportunity and risk-neutral measure.
(c) State and prove the one-period No-Arbitrage Theorem.
(d) State and prove the Put-Call Parity Theorem.
MATHG508 CONTINUED
2
2. Consider the following model for the share S where the interest rate r = 0:
ω S(0) S(1) S(2)

ω1 100 120 150
ω2 100 120 110
ω3 100 90 110
ω4 100 90 70
(a) For a long European call on S with strike equal to the current share price:
(i) Calculate the number of shares required at each node of the tree in order to
hedge the exposure to the share price.
(ii) Calculate the risk-neutral probability for each path ω. Hence, or otherwise,
derive the value of the call option.
b) In a one-period model, the share price starts at S and in one month’s time is
either SU or S/U where U > 1. Assuming rates are zero, show that the risk-neutral
probability p of the upmove is given by p = 1/(U + 1). Hence, or otherwise, deduce
that the probability of the share price increasing in this model is always less than
50%.
(c) 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.
3
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 call
option with exercise price K = $90 written on an asset where the asset prices in
dollars are given below, the interest rate per period is zero, and a dividend of $5 is
paid between time 0 and time 1.
ω S(0) S(1) S(2)

ω1 100 115 145
ω2 100 115 105
ω3 100 85 105
ω4 100 85 65
(b) Explain why Put-Call Parity is not satisfied by American options.

(c) In the equity market, the American and European versions of the same call
contract are trading at the same price. How could you realise any arbitrage oppor-
tunities?
MATHG508 CONTINUED
4
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) Find expressions for the following Itô integrals:
(i)
Z T
tdW (t)
0
ii)
Z T
exp[S(t) − t/2]dW (t)
0
(d) Now assume that S is a model for stock prices obeying the stochastic equation
dS = µSdt + σSdW
What is the mean and variance of the risk-neutral probability of S given its value
S(t) at time t?
5
5. Write an essay on the Black-Scholes model. You should describe the stochastic dif-
ferential equation and state the model’s assumptions. Derive the partial differential
equation using delta-neutral hedging and show how Feynman-Kac may be used to
solve the p.d.e. in the case of a European call option.
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

(c) State and prove the one-period No-Arbitrage Theorem.

(d) State and prove the Put-Call Parity Theorem.

ω S(0) S(1) S(2)

for some n̂ which you must find.

MATHG508 PLEASE TURN OVER

ω S(0) S(1) S(2)

(b) Explain why Put-Call Parity is not satisfied by American options.

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

MATHG508 PLEASE TURN OVER

MATHG508 END OF PAPER

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