Derivative Securities

Exercise Set I: Stochastic Processes and Black-Scholes

1.

2.

Assume that variable X1 and X2 follow generalized Wiener processes, with drift rates 1 and 2
and variances 1 and 2 , respectively. What process does (X1 + X2) follow if:
(a)

The changes in X1 and X2 during any short time interval are uncorrelated?

(b)

There is correlation between changes in X1 and X2 during any short time interval?

Assume that variable S (e.g. an asset price) follows the process

dS = dt + dz
For the first three years = 2 and = 3, while for the next three years = 3 and = 4. If the
initial value of variable S is +5.00, then what is the probability distribution of the value of S at
the end of year 6?

3.

It has been suggested that short-term interest rates (r) often follow the stochastic process
dr = a(b-r)dt + rcdz
where a, b and c are positive constants and dz is a Wiener process. Carefully describe the
nature of this process.

4.

Suppose that stock price S follows geometric Brownian motion with expected return and
volatility . What process is followed by the variable Sn?

5.

Suppose that x is the yield to maturity with continuous compounding on a zero-coupon bond
that pays off 1 SEK at time T. Assume that x follows the process
dx = a(x0 x)dt + sxdz
where a, x0 and s are positive constants and dz is a Wiener process. What is the process
followed by the bond price?

6.

7.

Suppose that a stock price has an expected return of 16% per annum and a volatility of 30%
per annum. If the current stock price is 50 SEK, then calculate the following:
(a)

The expected stock price after one day.

(b)

The standard deviation of this expected stock price.

(c)

The 95% confidence interval around this expected stock price.

Suppose that x is the continuously-compounded yield on a perpetual government bond that

pays interest at the rate of 1 SEK per annum. Assume that interest is paid continuously on the
bond and that x follows the process
dx = a(x0 x)dt + sxdz
where a, x0 and s are positive constants and dz is a Wiener process. What is the process
followed by the bond price? What is the expected instantaneous return (including interest and
capital gains) to the holder of the bond?

8.

If S follows geometric Brownian motion, then what is the process followed by:
(a)

y = 2S

(b)

y = S2

(c)

y = eS

(d)

y = er(T-t)/S

In each case express the coefficients for dt and dz in terms of y rather than S.
9.

Calculate the price of a 3-month European put option on a stock with a strike price of 50 SEK
when the current stock price is 50 SEK, the risk-free rate of interest is 10% per annum, the
volatility is 30% per annum and a stock dividend of 1.5 SEK is expected in 2 months.

10.

Assume that a stock price follows geometric Brownian motion with an expected return of 16%
and a volatility of 35%. The current stock price is 38 SEK.

11.

(a)

What is the probability that a European call option on the stock with an exercise price of
40 SEK and a maturity of 6 months will be exercised?

(b)

What is the probability that a European put option on the stock with the same exercise
price and maturity will be exercised?

Assume that a non-dividend-paying stock has an expected return of and a volatility of . An

innovative financial institution has just announced that it will trade a security that pays off a
cash amount equal to lnST at time T, where ST denotes the stock price at maturity of the
security.
(a)

Use risk-neutral valuation to calculate the price of the security at time t in terms of St.

(b)

Confirm that your calculated price satisfies the Black-Scholes PDE.

12.

What is the price of a European put option on a non-dividend-paying stock when the current
stock price is 69 SEK, the strike price is 70 SEK, the risk-free rate of interest is 5% per annum,
the volatility is 35% per annum and the time to maturity is 6 months?

13.

Consider an American call option on a stock. The current stock price is 50 SEK, the time to
maturity is 15 months, the risk-free rate of interest is 8% per annum, the exercise price is 55
SEK and the volatility is 25%. Dividends of 1.5 SEK are expected in 4 months and 10 months.
Show that it can never be optimal to exercise the option on either of the two dividend dates.
Calculate the price of the option.

14.

Show that 2/ could be a valid price for a traded security.

15.

A stock price is currently 50 SEK. Assume that the expected return from the stock is 18% and
its volatility is 30% per annum. What is the probability distribution for the stock price in 2
years? Calculate the mean and standard deviation of the distribution. Determine the 95%
confidence interval.

16.

Suppose that observations on a stock price (in SEK) at the end of each of 15 consecutive weeks
are as follows:
30.2, 32.0, 31.1, 30.1, 30.2, 30.3, 30.6, 33.0, 32.9, 33.0, 33.5, 33.5, 33.7, 33.5, 33.2
Use this data to estimate the stock price volatility. What is the standard error of your
estimate?

17.

18.

19.

Consider on option on a non-dividend-paying stock when the current stock price is 30 SEK, the
strike price is 29 SEK, the risk-free rate of interest is 5%, the volatility is 25% per annum and
the time to maturity is 4 months.
(a)

What is the price of the option if it is a European call?

(b)

What is the price of the option if it is an American call?

(c)

What is the price of the option if it is a European put?

(d)

Verify that put-call parity holds.

Assume that the stock in the previous question is due to go ex-dividend in 6 weeks. The
expected dividend is 0.5 SEK.
(a)

What is the price of the option if it is a European call?

(b)

What is the price of the option if it is a European put?

(c)

If the option is an American call, are there any circumstances under which it will be
exercised early?

Consider an American call option when the current stock price underlying the option is 18 SEK,
the strike price is 20 SEK, the time to maturity is 6 months, the volatility is 30% per annum and
the risk-free rate of interest is 10% per annum. Two equal dividends are expected during the
life of the option with ex-dividend dates at the end of 2 months and 5 months. Assume the
dividends are 0.4 SEK. Use Blacks approximation to value the option. How high can the
dividends be without the American option being worth more than the corresponding European
option?