M.PHIL.

IN STATISTICAL SCIENCE

Tuesday 3 June 2003 1.30 to 4.30

ADVANCED FINANCIAL MODELS

Attempt FOUR questions. There are six questions in total. The questions arry
equal weight.

DO NOT START READING THE QUESTIONS PRINTED ON THE

SUBSEQUENT PAGES UNTIL INSTRUCTED TO DO SO BY THE
INVIGILATOR.

[TURN OVER

2
Let A0 be a xed ve tor in Rr and A1 a random ve tor taking values in Rr .
Prove that exa tly one of the following alternatives (a) or (b) holds:
(a) there exists a ve tor x 2 Rr satisfying either

(i) x> A0 6 0; x> A1 > 0 and

or (ii) x> A0 < 0 and x> A1 > 0;

x>A

>0 >0

(b) there exists a positive random variable  , P ( > 0) = 1, with E k  A1 k < 1

su h that A0 = E (  A1 ).
Explain brie y the relevan e of this result to the hara terization of la k of arbitrage
in a one-period nan ial model.
2
In a multi-period, dis rete-time sto hasti model operating over times r =
0; 1; : : : ; n, let fSr g denote the pri es of the assets whi h are adapted to a ltration
fFr g; let X = fXr g be a trading strategy with asso iated dividend sequen e fDrX g
and let fBr g be an appropriate dis ounting sequen e. Develop the theory of the
model to the point of establishing the relationship
0

Br

Xr>Sr = E Q 

n
X

j =r+1



X
Bj Dj 

Fr A ;

for 0 6 r 6 n 1, where Q is an equivalent martingale probability.

Explain how this relationship leads to a pri ing formula for any attainable
ontingent laim.
3
Let Ta;b denote the rst hitting time of the line a + bs by a standard Brownian
motion, where a > 0 and 1 < b < 1 and let Ta = Ta;0 represent the rst hitting
time of the level a.
p


For  > 0, by using the
fa t that E e T = e a 2 , or otherwise, derive an
expression for E e T for ea h b, 1 < b < 1.
Hen e, or otherwise, show that, for t > 0,
a

a;b

P (Ta;b

6 t) = e

2ab

bt

a
t

+1 

a + bt

Use this result, in the ontext of the Bla k{S holes model, to derive the pri e at
time 0 of a barrier digital all whi h pays 1 at time t0 if and only if the sto k pri e
rea hes a predetermined barrier > S0 , at or before that time, where S0 is the
initial pri e of the sto k.

3
Suppose that in the Bla k{S holes model, the sto k pri e at time t is St , the
xed interest rate is  and the volatility is . Show that f (St ; t) is the value of a selfnan ing portfolio if and only if the fun tion f = f (x; t) satises the Bla k{S holes
equation
1 2 x2  2 f + x f + f f = 0:
2
x2
x
t

Now onsider the ase where the underlying asset pays a dividend ontinuously in
time and whi h is proportional to the sto k pri e, so that at the instant t the rate
of dividend payment is St per unit time, where  is a onstant. Determine how
the Bla k{S holes equation should be modied in this situation.
Suppose further that q(x; t) denotes the pri e at time t of a laim paying f (St0 ) at
time t0 > t, when St = x. Show that q(x; t) = e (t0 t) p(x; t), where p(x; t) is the
pri e of the laim when no dividend is paid but the interest rate is  .
5
Write an essay on utility maximization in the ontext of the Bla k{S holes
model. Your a ount should in lude dis ussion of the ase where the investor
derives utility ontinuously over time in addition to the utility of his nal wealth
and it should also provide a detailed treatment of at least one example.
6
Write an essay on Gaussian models for interest rates. The essay should over
one, or more, of the following topi s:
(i) one-fa tor models;
(ii) general random-eld models;
(iii) pri ing aps;
(iv) Markovian properties and stationarity of random-eld models.
A areful treatment of any one of these topi s may earn full marks.

[TURN OVER