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Question 1
Portfolio A: Holding a unit of stock (S0 =64)
Portfolio B: Holding 1 call option (c0 =5) and having 60e0.124/12 + 0.8e0.12/12 in money account
At the end of the first month
Portfolio A: Holding a unit of stock and 0.8 in money account
Portfolio B: Holding 1 call option and having 60e0.123/12 + 0.8 in money account
At maturity,
AT = ST + 0.8e0.123/12
BT = max(ST 60, 0) + 60 + 0.8e0.123/12 = max(ST , 60) + 0.8e0.123/12 > AT
4
. However,
Value of Portfolio A should be less than or equal to that of Portfolio B at t 12
value of Portfolio A at time 0 is 64 and value of Portfolio B at time 0 is 63.44. So arbitrage
opportunity exists. Arbitrageur can long Portfolio B and short Portfolio A to realize a risk-free
profit of 0.56 at time 0. Of course, one can get another profit of K ST at maturity if ST < K.
Question 2
u = e0.2
0.25
x5
50
x+25
150
5 x 10
10 < x 25
(
F (x) =
(x5)2
100
2
1 (25x)
300
5 x 10
10 < x 25
(a)
1. Generate U U nif (0, 1).
p
2. If U 0.25, then set X = 2 + 100U . If U > 0.25 , then set X = 25 300(1 U )
(b) ex , x > 0
f (x)
=
g(x)
Set =
1
15
such that
f (x)
g(x)
x5 x
e
5
50
(25x) x
e
150
x 10
10 < x 25
c=
Algorithm:
1. Generate U1 U nif (0, 1)
2. Set Y = 15ln(1 U1 ).
3. Generate U2 U nif (0, 1).
f (Y )
4. If U2 cg(Y
, then set X = Y , otherwise return step 1.
)
(
Y 5 2/3 Y /15
e
e
5 Y 10
f (Y )
5
= 25Y
cg(Y )
e2/3 eY /15 10 < Y 25
15
(c) h(x) =
1
20
5 x 25
f (x)
=
h(x)
f (x)
h(x)
2
(x 5) 5
5
2
(25 x)
15
x 10
10 < x 25
Algorithm:
1. Generate U1 U nif (0, 1).
2. Set Y = 5 + 20U1 .
3. Generate U2 U nif (0, 1).
f (Y )
4. If U2 ch(Y
, then set X = Y , otherwise return step 1.
)
(
1
(Y 5) 5 Y 10
f (Y )
= 51
ch(Y )
(25 Y ) 10 < Y 25
15
Question 5
(a) Suggested simulation algorithm (one-shoot)
1. Generate Zi N (0, 1).
(i)
2. Set ST = S0 exp[(r 0.5 2 )T + T Zi ]
(i)
3. Pi = max(ST er(1T ) K, 0)
4. Repeat step 1 to 3 10000 times.
5. Call price =erT P .
(b) Total number of random variables needed=10000 standard normal.
(c) We can repeat the above algorithm for 100 times (or even more) to compute 100
option prices. Then we can obtain the sample mean x and sample standard deviation s.
And see whether the S.D is large.
(d) One way to improve the accuracy is by increasing the number of sample paths.
Question 6
(a)
1
Z
t dWt = 0
E(X) = E
0
t4 dt =
V ar(X) =
0
1
5
(b)
1
Z
tWt dWt = 0
E(X) = E
0
V ar(X) =
t3 dt =
E(tWt ) dt =
0
1
4
(c)
h W1 i
1
1
1
E(X) = E e 2 = e 2 (1) 4 = e 8
W 1 1 2
1
1
V ar(X) = E e
e8 = e2 e4
(d)
Z
Z
Wt dt = W1
X=
0
1
Z
(1 t)dWt
E(X) = E
(1 t)dWt
tdWt =
=0
Z
V ar(X) =
(1 t)2 dt =
1
3
Question 8
(a)
1
2
dlnSt = r(t) (t) dt + (t)dWt
2
Z T
Z T
1 0.04t
1 0.02t
lnST = lnS0 +
0.1(1 + sint) + 0.03t e
dt +
e
dWt
8
0
0 2
1
1
3 2 25 0.04T 121
E(lnST ) = ln100 + T cosT +
T + e
10
10
200
8
40
25
0.04T
)
V ar(lnST ) = (1 e
4
lnST N (E(lnST ), V ar(lnST ))
(b)
RT
(c)
CE (0) 12.27