Mth 3251

Assignment 2

1.[15 pts] Suppose that Xt satisfies the following stochastic differential equation
dXt = 5Xt dt + Xt dBt .

Suppose that X0 = 1. Find a constant a ∈ R such that eat Xt is a martingale. Is this a unique?

2. [25 pts]

• Find a martingale Xt , with t ∈ [0, 1] with zero mean, and V ar(Xt ) = 0.2t5 .

• Find 2 different continuous martingales with independent increment. The examples should not be
multiple of each other.

• Consider the martingale Xt = eBt −t/2 . Find limt→∞ Xt . Hint: Find

lim P (|Bt | < t),

t→∞

for all  > 0.

3.[25pts] Solve the integral Z T

IT = eBt dBt .
0
Moreover

• Find the variance of IT .

• Find the mean of IT .

• Is P (IT > 0) = 1?

4.[15pts] Consider the Black and Scholes model, and consider the portfolio at = 1/2, bt = Ste−rt/2. Show
that this portfolio replicates one share of stock. State with reason if it is self-financing. Moreover, give
another portfolio which replicates one share of stock and is self-financing.

5.[10pts] Let Bt be a Brownian motion. Prove that the process

Xt = eBt +t/2 + eBt −t/2 ,

is a solution of the differential equation

dXt = Xt dBt + eBt +t/2 dt.

Is Xt a martingale?

6.[10pts] Consider a two-step Binomial model, and show that Sn/rn is a martingale for n = 0, 1, 2 under
p = (r − d)/(u − d).