Math 530A Homework 2 Due: 9/28

1. Consider the CRR binomial model introduced in §2. Assume the market is arbitrage
free and lP∗ is the risk neutral measure. For any European option XT ∈ lL0 (FT ), by
backward induction we can show that there exists a hedging portfolio h, namely h is self-
financing and VT (h) = XT (you do not need to prove it here). Then it is obvious that the
fair price of XT at time t is Yt = Vt (h).
Vt (h)
(1) For any self-financing portfolio h, show that the discounted portfolio wealth (1+r)t
is a lP∗ -martingale. (Yes, we already did it in class! Redo it.)

(2) Show that Yt = 1

(1+r)T −t
IE ∗ [XT |Ft ].

(3) Use (2) to derive the put-call parity. That is, assume CT = (ST − K)+ , PT =
(K − ST )+ and let C0 , P0 denote their price at time t = 0, find C0 − P0 .

2. Let X ∈ lL0 (lF) and fix a probability measure lP.

(1) Show that X is a submartingale if and only if IE[Xt |Fs ] ≥ Xs for all 0 ≤ s < t ≤ T .

(2) Assume X is a martingale. Show that X 2 is a submartingale.

3. Consider the two period model in Hw1, #4. Assume the interest rate over [0, 1] is
r1 = 5%, over [1, 2] is r2 = 6%, the stock price S and another process X are shown in Figure
1 (see next page). Denote their discounted prices Sbt := St and X bt := Xt , where
Bt Bt

B0 = 1, B1 = 1 + r1 , B2 = (1 + r1 )(1 + r2 ).

(1) Find the risk neutral measure lP∗ (over each possible path ω).
h i h i
∗ b ∗
(2) Compute Y 0 := max0≤t≤2 IE Xt and Y 0 := IE max0≤t≤2 Xt . b

(3) Compute IE lP [S2 |F1 ] and IE ∗ [S2 |F1 ]. Here lP is the market measure as in Figure 1.
(Note that they are random variables, so you need to specify their values on each node of
S1 .)

(4) Verify that Sb2 is a lP∗ -supermartingale, that is, IE ∗ [Sb22 |F1 ] ≥ Sb12 and IE ∗ [Sb12 ] ≥ Sb02 .

(5) Use the backward induction to find the fair price Y0E of the European option with
terminal time 2 and terminal payoff X2 , and then find the hedging portfolio hE (this is
essentially the same as Hw1, #4).

1
 1/2 340 1/2 110
320 1/2 100 1/2
1/3 1/3
305 10
300 10
3/4 330 3/4 20
2/3 2/3
300 1/4 5 1/4
290 5

Figure 1: Left for S and right for X