Monte Carlo Methods in Finance

Homework: Chapter 1
Please enter your answers in the homework unit at the end of the Chapter. The solutions to this homework will be posted in a separate unit after the due date. 1. Consider the time series of daily closing prices of IBM, GOOGLE and SIEMENS shares, which are stored in the rst, second, and third columns of the data le closingPrices_IBM_GOOG_SI_2007_07_01_2013_06_30.txt, respectively (see the reference How do I obtain the time series of prices of a nancial asset? in Unit 1.0 for details on how to create this le). Open a session in either Octave or Matlab. Load these time series and store them in a matrix S by entering the command S = load(closingPrices_IBM_GOOG_SI_2007_07_01_2013_06_30.txt); in the Octave/MATLAB command window. The series of IBM prices will be stored in S(:,1), the rst column of S , the GOOGLE prices in S(:,2) and the SIEMENS prices in S(:,3). From the time series of daily closing prices, compute the time series of daily log returns using the command logRetS = log(S(2:end,:)./S(1:end-1,:)); Make a plot of the time series of daily closing prices and of the corresponding log returns for the three assets. Compute the average and the standard deviation of both types of time series. Which of the following statements are true? For each of the three assets the average of the log returns is approximately zero. For each of the three assets the average of the log returns is approximately one. The average of GOOGLE prices is higher than the average of SIEMENS prices.

 The historical volatility (i.e. the standard deviation of the log returns) of GOOGLE is higher than the historical volatility of SIEMENS. The time series of prices are approximately stationary in the weak sense. Hint: Plots in Octave or MATLAB can be generated with the command plot. Use the function mean to compute the means and the function std to compute the standard deviations. 2. We continue studying the time series of asset prices from the previous exercise. What is the approximate value of the correlation between the log returns of IBM and GOOGLE? 0.0 0.3 0.4 0.5 0.6 Hint: Correlations can be computed using the Octave/MATLAB function corr. 3. We continue with the analysis of the time series from the previous exercises. We will now compute the autocorrelations of the time series of log returns, assuming that they are stationary. The autocovariance at lag n of a stationary time series {X1 , X2 , . . . , XN } is n = E [(Xm E[Xm ]) (Xm+n E[Xm+n ])] . The lag-n autocorrelation is the autocovariance normalized by the standard deviations n = E [(Xm E[Xm ]) (Xm+n E[Xm+n ])] var[Xm ] var[Xm+n ] .

The autocorrelations provide a measure of the linear predictability of the future values of the series in terms of the current values of the series. What is the closest value to the lag-1 autocorrelation of the IBM log returns? And of the the square of the IBM log returns? 1 [log-ret] = 0.2, 1 [log-ret] = 0.2, 1 [log-ret] = 0.2, 1 [log-ret] = 0.0, 1 [log-ret] = 0.0, 1 [log-ret2 ] = 0.2 1 [log-ret2 ] = 0.0 1 [log-ret2 ] = 0.2 1 [log-ret2 ] = 0.2 1 [log-ret2 ] = 0.0 2

 1 [log-ret] = 0.0,

1 [log-ret2 ] = 0.2

Hint: The lag-n autocorrelation of a time series can be obtained by computing the correlation between the values of the time series and the values of the same series displaced n time steps. Assuming that the time series is stored in vector X the Octave/MATLAB command to compute the lag-n autocorrelation is autocorr = corr(X((1+n):end), X(1:(end-n))); 4. Consider an asset whose initial price at t0 (today) is S (t0 ) = S0 . The owner of a European digital call option on this asset with maturity t0 + T receives an amount of money A if the value of S (t0 + T ) is above K (the strike of the option) and 0 otherwise. Therefore, the payo at maturity of this digital call option is payo (S (t0 + T )) = A 0 if S (t0 + T ) K if S (t0 + T ) < K

Compute the price of a digital option whose parameters are S0 = 100, K = 90, r = 0.05, T = 2, = 0.4 and A = 90. 91.05 78.22 30.76 51.27 43.32 24.76 Hint: The price of this derivative product can be computed by means of the function priceEuropeanOption. This function requires as input a handle to another function that computes the payo of the option. For the digital call, the handle is digitalPayoff = @(ST)((ST >= K)*A); Recall that in Octave/MATLAB the expression (ST >= K) evaluates to 1 if ST K and to 0 otherwise. If either ST or K are vectors, the comparison is made element by element. 5. Consider an asset whose initial price is S (t0 ) = S0 . A European call option is a derivative product that gives the owner the right to buy a specied number of shares of the asset at some time in the future t0 + T (maturity), for a price K (the strike), which is set at t0 , the time when the option is written. To acquire this right one needs to pay a fee, which is called the premium or price of the option. At maturity, the seller (or writer) of the 3

call option has the obligation to sell the asset at the agreed price (K ) if the owner of the option decides to exercise her right to buy. A European put option is a derivative product that gives the owner the right to sell a specied number of shares of the asset at some time in the future t0 + T (maturity), for a price K (the strike), which is set at t0 , the time when the option is written. At maturity, the seller (or writer) of the put option has the obligation to buy the asset at the agreed price (K ) if the owner of the option decides to exercise her right to sell. Let C be the price of the European call and P the price of the European put. Derive the so-called Put-Call parity relation, which is a closed-form expression for C - P , the dierence between the prices of the call and the put options. Use this expression to answer the following question: how does C P behave when , the volatility of the underlying asset, increases? C P decreases. C P increases. C P increases if S0 KerT and decreases if S0 < KerT . C P decreases if S0 KerT and increases if S0 < KerT . C P is independent of the volatility. Hint: The price of a derivative product is the discounted expected value of the corresponding payo under risk-neutral probability Price(t0 ) = erT E[Payo(t0 + T )], where r is the risk-free interest rate. The payo at maturity for a call option is max(S (t0 + T ) K, 0). Derive the expression of the payo of a put option. Consider an investor who purchases a call option and writes a put option. The payo of this investors portfolio is the payo of the call minus the payo of the put. Compute the value of this portfolio as the discounted expected value of the payo under risk-neutral probability. This value is C P , the dierence between the prices of the call and the put options. In the derivation you will need to use the following results: The discounted expectation of the value of the asset at any time in the future is its price today er(tt0 ) E [S (t)] = S0 , t > t0 .

The expected value of a constant is the constant itself E [K ] = K

 Taking expectations is a linear operation E[a g1 (X ) + b g2 (X )] = aE[g1 (X )] + bE[g2 (X )], where a and b are arbitrary real constants.