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School of Mathematics

Programmes in the School of Mathematics Final Examination

Programmes involving Mathematics Final Examination

MSM3G11 06 20444 Level H

Mathematical Finance

MSM4G11 06 20443 Level M

Mathematical Finance

Summer examinations 2012-13

Three Hours

Full marks will be obtained with complete answers to FOUR out of SIX questions. If more than
FOUR questions are attempted then only the best FOUR will count towards the final mark.

An indication of the number of marks allocated to parts of questions is shown in square brackets.
Calculators may be used in this examination but must not be used to store text. Calculators with
the ability to store text should have their memories deleted prior to the start of the examination.

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1. (a) Give an example of an arbitrage opportunity, and explain why the concept of arbitrage
plays an important role in Financial Mathematics. [3]

(b) What are dividends? How does the payment of dividends effect the value of the underlying
S? [2]

(c) Briefly discuss what is meant by short-selling. [2]

(d) Explicitly derive the Put Call Parity relationship for European options where the underlying
S does not pay dividends. [5]

(e) What is your overall profit/loss for each of the following?

(i) You write a European Vanilla Call option today with a strike price of 100 pence and
sell the option for 10 pence. The holder chooses to exercise the option on the expiry
date. On this date, the underlying is worth 120 pence. [1]

(ii) You are the holder of a cash-or-nothing European call option with pay-off function
BH(S − E) where H is the Heaviside step function, B = 20 pence, the strike price
E = 250 pence and the underlying has price S. You paid 10 pence for this option.
On the expiry date the underlying price is S = 260 pence. [1]

(iii) You are the holder of an asset-or-nothing European call option where the strike price
is 100 pence, and you paid 20 pence for the option. On the expiry date, the price of
the underlying is 110 pence. [1]

(f) Consider an American Perpetual put V with an underlying S which pays a constant divi-
dend yield of D0 = 0.1. The exercise price is E = 5, the value of the volatility is σ = 0.3
and the value of the risk-free interest rate is r = 0.05. Determine an expression for the
current value of the option V and the value of the optimal exercise boundary S f . (Retain
4 significant digits in all numerical calculations.) [10]

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2. (a) What is the key distinction between an American option and a European option? Which is
more valuable: an American Vanilla Put or a European Vanilla Put? When is an American
Vanilla Call more valuable than a European Vanilla Call? [4]

(b) The Black Scholes formula for a European Vanilla Put option P is given by

P(S,t) = Ee−r(T −t) N(−d2 ) − SN(−d1 )

where N is the cumulative distribution function for a standardized normal random variable
given by Z x
1 2 /2
N(x) = √ e−y dy,
2π −∞

log(S/E) + (r + σ 2 /2)(T − t)
d1 = √
σ T −t
and
log(S/E) + (r − σ 2 /2)(T − t)
d2 = √ .
σ T −t
In the above S is the underlying, t is time, E is the exercise price, T is the expiry date, r is
the risk-free interest rate and σ is the volatility.

(i) Show that the above expression for P(S,t) satisfies the Payoff function for a Vanilla
Put option at time t = T . [3]

(ii) Determine an expression for the Delta of a Vanilla Put option where ∆ = ∂ P/∂ S. [8]

(iii) Briefly describe the role of Delta-hedging in the derivation of the Black Scholes
Equation. [2]

(c) Use arbitrage arguments only (without recourse to Put-Call Parity) to prove the following
simple bounds on European Vanilla Call options:

(i) C ≤ S; [4]

(ii) C ≥ S − Ee−r(T −t) . [4]

In the above S is the value of the underlying, t is time, T is the expiry date, E is the
exercise price, r is the risk-free interest rate and C represents the value of the call.

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3. (a) The Black-Scholes equation for a European Vanilla Call option, C(S,t), where the under-
lying does not pay out any dividends can be transformed into the diffusion equation

∂ u ∂ 2u
= 2
∂τ ∂x
using the transformation

(k − 1)x (k + 1)2 τ
 
C = Eu(x, τ)exp − −
2 4

where S = Eex , t = T − 2τ/σ 2 , k = 2r/σ 2 , where t is time, the expiry date is T , σ is the
volatility and r is the interest rate.

(i) What is the transformed pay-off function for a European Vanilla Call option? [3]

(ii) Briefly describe how to construct a numerical grid that can be used to solve the
diffusion equation with regards to the determining the value of financial options.
With specific reference to the European Vanilla Call, state the appropriate initial
conditions and boundary conditions commenting on the appropriate values of x at
which to apply the boundary conditions. [6]

(iii) Describe an algorithm that can be used to solve for the value of a European Vanilla
Call option using an explicit finite difference scheme. How can you verify the accu-
racy of your numerical method? [6]

(b) The forward price of an asset (which does not pay dividends) has a value

F = Ser(T −t)

where t is time, r is the risk-free interest rate, T is the expiry date of the forward contract
and S is the value of the underlying asset at time t . Determine the appropriate equation
which must be satisfied by a European Vanilla Call option C as a function of F and t where
the underlying is a future with a forward price F as given above. What are the appropriate
boundary conditions and and pay-off function for this option. [10]

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4. (a) Write the payoff function for each of the following options (clearly defining all terms used):

(i) Average Rate Call, [1]

(ii) Russian, [1]

(iii) Lookback Rate Put, [1]

(iv) Lookback Strike Call. [1]

(b) Consider continuously sampled arithmetic average strike options.

(i) Write down the appropriate Black Scholes equation for the value of the option V (S, I,t)
defining all variables. [3]

(ii) Use a similarity reduction of the form V (S, I,t) = SH(R,t) where R = I/S to obtain
an equation for H(R,t) showing all calculations. [6]

(iii) Consider a portfolio Π(S, I,t) which is long one arithmetic average strike call and
short one arithmetic average strike put. Using the similarity reduction Π(S, I,t) =
SH(R,t) determine the value of H(R, T ) where t = T is the expiry date. [3]

(c) Consider the derivation of the binomial method. Given that the value of the underlying is
Sm at time step mδt , the expected value Sm+1 at time step (m + 1)δt under a risk neutral
continuous random walk is
Z ∞
Ec [S m+1 m
|S ] = S0 pc (Sm , mδt; S0 , (m + 1)δt)dS0 = erδt Sm
0

where pc (S,t; S0 ,t 0 ) is the probability density function

1 0 1 2 0 2 2 0
pc (S,t; S0 ,t 0 ) = p e−(log(S/S )−(r− 2 σ )(t −t)) /2σ (t −t) .
S0 σ 2π(t 0 − t)

Similarly the expected value of (Sm+1 )2 is

Z ∞
2 )δt
Ec [(Sm+1 )2 |Sm ] = (S0 )2 pc (Sm , mδt; S0 , (m + 1)δt)dS0 = e(2r+σ (Sm )2 .
0

In the discrete binomial method we assume that Sm+1 = uSm with probability p and that
Sm+1 = dSm with probability 1 − p, where u > 1, 0 < d < 1 and 0 < p < 1. For the case
of ud = 1 derive expressions for u, d and p. [9]

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5. (a) Let V (t; T ) be the value of a bond at time t with maturity date T and Payoff Z . There is a
time-dependent continuous interest rate r(t) and a continuous coupon payment K(t). Use
arbitrage arguments to derive a differential equation for V as a function of time. Hence
show that
T
RT
 Z RT

− r(τ)dτ 0 t0 r(τ)dτ 0
V (t; T ) = e t Z+ K(t )e dt .
t

If it is assumed that V (t; T ) is continuously differentiable as a function of T and that

K(t) = 0, derive an expression for r(T ) showing all calculations. [10]

(b) What are transaction costs? What are the primary assumptions that must be made to
incorporate transaction costs into the valuation of options within a Black Scholes frame-
work? Write down the Black Scholes equation for options incorporating the effect of trans-
action costs (you need not derive this equation). Hence conclude that the value of an
option is not unique if transaction costs are considered. [5]

(c) Consider a call on a put compound option where the call C1 has an expiry date T1 = 1
and exercise price E1 = 10 and the put P2 has an expiry date T2 = 3 and exercise price
E2 = 110. Both the put and the call are of European type. The underlying is denoted by
S.

(i) What is the payoff function for call C1 ? [1]

(ii) What is the payoff function for put P2 ? [1]

(iii) Assume that S = 100 at time t = 0. Apply the binomial method to determine the
value of C1 at time t = 0. Use a time step δt = 1. The interest rate is r = 0.05.
Consider the case of p = 1/2 and suppose the volatility is such that u = 1.25 and
d = 0.9. [8]

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6. (a) Briefly answer each of the following.

(i) What is a barrier option? [1]

(ii) Why would someone wish to buy a put option with a down and out barrier? [1]

(iii) Describe in-out parity for barrier options. [2]

(iv) Explain the distinction between continuous and discrete sampling when valuing bar-
rier options. [2]

(v) What is a lookback option? [1]

(vi) What is a Russian option? [1]

(vii) Use the principle of arbitrage to construct a lower bound for the value of a Russian
option [1]

(viii) From the viewpoint of the holder of a Russian option, what is the worst case sce-
nario? How can this be hedged against? [1]

(ix) What is a chooser option? [1]

(x) What is a bond? Who issues bonds and why? Are bonds risk-free? [3]

(xi) How can the affect of continuous dividends be incorporated into the binomial method?
[2]

(xii) How can the binomial method be used to determine the value of American options?
[2]

(b) Consider an asset S with price function


 1+t

 for t ∈ [0, 1],
S(t) = 3t − 1 for t ∈ [1, 3],

 14 − 2t for t ∈ [3, 5].


(i) Sketch the graph of S(t). [1]

(ii) Calculate the continuous arithmetic average of S over the interval 0 ≤ t ≤ 5. [2]

(iii) Calculate the discrete arithmetic and discrete geometric average of S where the
discrete sampling points are take at time t = 0, 1, 2, 3, 4 and 5. [2]

(iv) Consider a stop-loss option with λ = 0.95. At what time will this option be exercised?
What will be the payoff? [2]

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