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UNIVERSITY OF KENT
MATHEMATICS OF FINANCIAL DERIVATIVES MA537/MA837
PRACTICE QUESTIONS SET 3
1.
The share price of the ABC corporation, St , satisfies the following Stochastic Differential
Equation (SDE):
dSt = St dBt + dt ,
where Bt is a Brownian motion under the real-world measure P . The continuously compounded constant risk-free rate of interest is r. Assume that the corporation does not intend
pay dividends on its shares in the foreseeable future.
The corporation is currently, at time t = 0, considering a new pay structure for its CEO,
whereby in addition to a basic salary the CEO will be entitled to a one-off bonus payment at
the end of T = 2 years based on the performance of the corporation. The formula of the bonus
payment is currently under discussion and the following alternatives are being considered:
ST
;
S0
ST
A log
;
S0
A ST S0 ;
A max ST S0 , 0 ;
A max ST 2S0 , 0 .
X1 = A
X2 =
X3 =
X4 =
X5 =
(a) Discuss the rationale behind each of the alternative formula, explaining the pros and
cons of each.
[ 5 marks ]
(b) The corporation wants to hedge the risk involved in the future bonus payment. The
corporation is willing to pay for a self-replicating strategy at time 0 to meet the bonus
payment at the end of 2 years. Calculate the value (or price) of the bonus at time 0 for each
of the alternative formula, when S0 = 10, A = 100, 000, = 6% per annum, r = 3% per
annum and = 20% per annum.
[ 15 marks ]
(c) Explain the differences in the values of bonus payment for all suggested formulae.
Comment on the suitability of choosing a particular formula based on its value.
[ 5 marks ]
(d) For the bonus formula X3 , suggest a self-replicating strategy that the corporation should
follow from time 0 to 2 years. Show that the strategy work.
[ 5 marks ]
[ Total: 30 marks ]
Although not required for the assessment, can you solve part (d) for all bonus formula?
Turn over
MA537/MA837/Set3
2.
Let St denotes the price of a non-dividend paying share at time t. Suppose the share-price
process is governed by the following Stochastic Differential Equation (SDE):
dSt = St dBt + dt ,
where Bt is a Brownian motion under the real-world measure P . The continuously compounded constant risk-free rate of interest is r.
Consider a particular derivative contract which promises to make a payment at time T of:
X=A
ST
; where A > 0.
S0
(a) Using Itos Lemma, show that St = S0 exp Bt + ( 1/2 2 )t is a solution to the SDE
under measure P .
[ 5 marks ]
(b) Defining Dt = ert St and using Itos Lemma, show the dDt = Dt dBt + ( r)dt
under measure P .
[ 3 marks ]
(c) Using the Cameron-Martin-Girsanov theorem, establish a new measure Q under which
t , where B
t is a standard Brownian motion under the measure Q.
dDt = Dt dB
[ 2 marks ]
t + rdt under measure Q.
[ 2 marks ]
(d) Show that dSt = St dB
(e) Using Itos Lemma, derive an expression for Dt under the measure Q. Show that
EQ Dt Fu = Du and conclude Dt is a Q-martingale.
[ 5 marks ]
t B
u ) + (r 1/2 2 )(t u) under measure Q
(f) For u < t, show that St Fu = Su exp (B
and hence find the distribution of St Fu under the measure Q.
[ 5 marks ]
(g) Defining Vt = er(T t) EQ X Ft , show that Vt = ASt /S0 .
[ 2 marks ]
Aert St
dBt .
S0
Can we conclude that Et is a Q-martingale?
[ 3 marks ]
rt
(i) Show directly (NOT using Tower Law) that EQ Et Fu = EQ e ASt /S0 Fu = Eu
and conclude Et is a Q-martingale.
[ 3 marks ]
(h) Define Et = ert Vt = ert ASt /S0 . Using Itos Lemma, show that dEt =
(j) Using results from parts (c) and (h), show that dEt = t dDt where t = A/S0 . Explain
why t is a previsible process.
[ 3 marks ]
(k) Defining t = Et t Dt , show that t = 0. Explain why t is a previsible process.
[ 2 marks ]
(l) Explain why V0 = A is the arbitrage-free price at time 0 for the derivative contract by
showing how the self-replication strategy will work from time 0 to time T , so that the payoff
is met at time T for this particular derivative contract.
[ 5 marks ]
[ Total: 40 marks ]
3.
MA537/MA837/Set3
Consider a non-dividend paying share whose price at time t is denoted by St . Suppose the
share-price process is governed by the following SDE:
dSt = St dBt + dt ,
where Bt is a standard Brownian motion under the real-world probability measure P . Let r
be the continuously compounded constant risk-free rate of interest.
Consider a derivative contract which promises to make a payment of X = ST2 , at time T .
(a) Defining Dt = ert St :
(i) Establish a measure Q for which dDt = Dt dBt , where Bt is a standard Brownian
motion under measure Q.
[ 3 marks ]
(ii) Show that, EQ Ds Ft = Dt , for s > t, where Ft denotes filtration up to time t.
[ 4 marks ]
2
[ 3 marks ]
(b) Defining Vt = er(T t) EQ X Ft , show that, Vt = e( +r)(T t) St2 .
(c) Defining Et = ert Vt :
[ 4 marks ]
[ 4 marks ]
dEt
and t = Et t Dt :
dDt
2Vt
(i) Show that, t =
.
St
(d) Defining t =
[ 1 mark ]
[ 1 mark ]
[ 1 mark ]
(e) Using the definition Vt = ert Et , use Itos lemma to show that, dVt = rVt dt + 2Vt dBt .
[ 2 marks ]
(f) Consider a portfolio of t shares and t ert cash at time t. If the portfolio is unchanged
over the short interval (t, t + dt), show that, t dSt + t er(t+dt) ert dVt .
[ 3 marks ]
(g) Explain why Vt is the arbitrage-free price of the derivative contract at time t.
[ 1 marks ]
[ Total: 27 marks ]
4.
Consider the function, f (t, St ) = e( +r)(T t) St2 , where St is the price of a share at time t, r
is the continuously compounded constant risk-free rate of interest and T > t.
(a) Show that f (t, St ) satisfies the Black-Scholes PDE.
[ 4 marks ]
[ 1 mark ]
(c) State the assumptions under which f (t, St ) will be a valid price of a derivative contract.
[ 2 marks ]
[ Total: 7 marks ]
Turn over
MA537/MA837/Set3
5.
[ 2 marks ]
(d) Let (t , t ) denotes the number of shares and bonds respectively in a self-financing
portfolio at time t. For the particular derivative contract given in part (c):
(i) Determine (t , t ), i.e. the self-financing portfolio at time t.
rt
r(t+dt)
[ 5 marks ]
.
[ 3 marks ]
[ 1 mark ]
(e) Show that the price given in part (c) satisfies the Black-Scholes PDE and the necessary
boundary condition.
[ 4 marks ]
[ Total: 22 marks ]
6.
ABCorp is currently negotiating its CEOs pay structure which will include a year-end bonus
based on her performance over the year. Two bonus formula under consideration are:
X = A max log S1 log S0 , 0 ,
Y = A max S1 S0 , 0 .
St is ABCorps share price at time t satisfying the SDE: dSt = St dBt + dt , where Bt
is a standard Brownian motion under the real-world measure P and = 20% per annum.
Assume that S0 = 10, A = 10, 000 and ABCorp does not intend to pay dividends over the
next year. The continuously compounded constant risk-free rate of interest is r = 3%.
(a) For bonus structure X, show that the value of the bonus at time 0 is given by:
er (r 1/2 2 )(d) + (d) ,
where d = (r 1/2 2 )/. () and () are cumulative distribution and density functions of
standard Normal distribution respectively.
[ 7 marks ]
(b) Determine the (numerical) values of both bonus structures X and Y . Explain which of
the bonus structure is more lucrative to the CEO and why.
[ 6 marks ]
[ Total: 13 marks ]
7.
MA537/MA837/Set3
Consider a non-dividend paying share whose price St follows a geometric Brownian motion.
The current price of the share is S0 = 125 and volatility of the share price is = 20% per
annum. The continuously compounded risk-free rate of interest is r, where er = 1.10.
(a) Using the Black-Scholes option pricing formula calculate the price of a European call
option on the share with strike price K = 125 and time to expiry T = 2 years.
[ 5 marks ]
(b) State and prove the formula of put-call parity for European options on non-dividend
paying shares defining all the notations used.
[ 5 marks ]
(c) Using (d) or otherwise, calculate the price of a European put option on the share with
strike price K = 125 and time to expiry T = 2 years.
[ 3 marks ]
(d) Define delta for an individual derivative. Sketch a graph of the delta of a European
put option against all possible values of the current share price S0 with strike price K = 125.
Explain the key features of the graph. Explain how the shape of the graph will change if
the volatility, , is increased or decreased?
[ 10 marks ]
[ Total: 23 marks ]
8.
Let f (t, St ) = St Ker(T t) be the price of a derivative contract, where St is the price of the
underlying non-dividend paying share at time t, r is the continuously compounded constant
risk-free rate of interest and T > t.
(a) Define the following Greeks: , and .
[ 3 marks ]
[ 2 marks ]
(c) Determine the boundary condition satisfied by f (t, St ) and identify the derivative contract for which f (t, St ) is the arbitrage-free price.
[ 2 marks ]
[ Total: 7 marks ]
Turn over
MA537/MA837/Set3
9.
The price of a non-dividend paying share, St , follows a geometric Brownian motion process.
(a) A European call option maturing at time T is at-the-money at time t if St = Ker(T t) .
Show that for an at-the-money call option, the price can be approximated by:
ct 0.4St T t.
1
1
[ 3 marks ]
+ x.
2
2
(b) The current price of the share is 100 and volatility of the share price process is 10%
per annum. The continuously compounded risk-free rate of interest is 5% per annum. If a
European call option with 2 years to maturity is currently at-the money, calculate the price of
the option using both the Black-Scholes formula and the approximate formula.
[ 4 marks ]
Hint: (x)
[ Total: 7 marks ]
10.
The share price of a UK company follows a geometric Brownian motion process. The current
share price is 100 and the volatility of the share price process is = 10% per annum. The
company does not intend to pay dividends in the next two years.
The company is planning to recruit a new CEO immediately and is currently finalising her
pay structure which will include a bonus based on the companys performance over the next
two years.
You may assume that the constant continuously compounded risk-free rate of interest is
r = 5% per annum.
(a) One possible bonus structure, A, is to provide an option to the CEO to buy 20,000 shares
each at a price of 100 at the end of two years. Determine the current value of this bonus
structure A.
[ 4 marks ]
(b) One of the director of the company has proposed an alternative structure, B, where the
bonus payment at the end of two years will be based on the following formula:
p
S1 S2 S0 , 0 ,
20,000 max
where St denotes the companys share price at time t.
(i) Show that under the risk-neutral measure,
p
1 2 5 2
3
r , .
S1 S2 Lognormal log S0 +
2
2
4
Hint: If {Bt } is a standard Brownian motion process, then Cov(Bt , Bs ) = min(t, s).
[ 4 marks ]
(ii) Determine the current value of this alternative bonus structure B.
[ 8 marks ]
(c) Compare and contrast the bonus structures A and B, described in parts (a) and (b)
above, from both the companys and the prospective CEOs perspective.
[ 4 marks ]
[ Total: 20 marks ]
11.
MA537/MA837/Set3
The price of a non-dividend paying share, St , follows a geometric Brownian motion process
with stochastic differential equation (SDE): dSt = St dBt + dt , where Bt is a standard
Brownian motion under the real-world probability measure P . Let the continuously compounded constant risk-free rate of interest be r.
(a) Using the Cameron-Martin-Girsanov theorem, show that there exists a probability mea
t + rdt , where B
t is a standard Brownian motion under
sure Q under which dSt = St dB
the probability measure Q.
[ 3 marks ]
(b) Using Itos Lemma on the function f (t, St ) = log St , show that:
T + (r 1/2 2 )T ,
ST = S0 exp B
is a solution to the SDE governing the share-price process under probability measure Q.
[ 4 marks ]
(c) Show that under probability measure Q:
log S1 F0 N log S0 + (r 1/2 2 ), 2 ,
[ 3 marks ]
and X2 = I[S1 S0 ],
(r 1/2 2 )
and
P2 = e
(r 1/2 2 )
.
[ 8 marks ]
(ii) Show that P1 + P2 = er and explain the rationale behind this relationship.
[ 3 marks ]
[ Total: 21 marks ]