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Shreve Solutions1
Shreve
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Contents
State Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
3.7 Solutions to Selected Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Random Walk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.8 Solutions to Selected Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Interest-Rate-Dependent Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
6.9 Solutions to Selected Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
1
The Binomial No-Arbitrage Pricing Model
5
(40 + 1.200 ) .
4
Assume that both H and T have positive probability of occurring. Show that
if there is a positive probability that X1 is positive, then there is a positive
probability that X1 is negative. In other words, one cannot find an arbitrage
when the time-zero price of the option is 1.20.
Solution. Considering the cases of a head and of a tail on the first toss, and
utilizing the numbers given in Example 1.1.1, we can write:
5
X1 (H) = 80 + 30 (40 + 1.200 ),
4
5
X1 (T ) = 20 + 0 0 (40 + 1.200 )
4
Adding these, we get
X1 (H) + X1 (T ) = 100 + 30 100 30 = 0,
or, equivalently,
X1 (H) = X1 (T ).
In other words, either X1 (H) and X1 (T ) are both zero, or they have opposite
signs. Taking into account that both p > 0 and q > 0, we conclude that if
there is a positive probability that X1 is positive, then there is a positive
probability that X1 is negative.
Exercise 1.6 (Hedging a long position - one period.). Consider a bank
that has a long position in the European call written on the stock price in
Figure 1.1.2. The call expires at time one and has strike price K = 5. In
Section 1.1, we determined the time-zero price of this call to be V0 = 1.20.
At time zero, the bank owns this option, which ties up capital V0 = 1.20.
The bank wants to earn the interest rate 25% on this capital until time one,
i.e., without investing any more money, and regardless of how the coin tossing
turns out, the bank wants to have
5
1.20 = 1.50
4
at time one, after collecting the payoff from the option (if any) at time one.
Specify how the banks trader should invest in the stock and money market
to accomplish this.
Solution. The trader should use the opposite of the replicating portfolio
strategy worked out in Example 1.1.1. In particular, she should short 21 share
of stock, which generates $2 income. She should invest this in the money
market. At time one,
if the stock goes up in value, the bank has an option
worth $3, has $ 45 2 = $2.50 in the money market, and must pay $4 to cover
the short position in the stock. This leaves the bank with $1.50, as desired.
On the other hand, if the stock goes down in value, then at time one the bank
has an option worth $0, still has $2.50 in the money market, and must pay
$1 to cover the short position in stock. Again, the bank has $1.50, as desired.
Exercise 1.8 (Asian option). Consider the three-period model of Example
1
1.2.1, with S0 = 4, u = 2, d = 12 , and take the
Pn interest rate r = 4 , so that
1
p = q = 2 . For n = 0, 1, 2, 3, define Yn =
k=0 Sk to be the sum of the
stock prices between times zero and n. Consider an Asian call option that
expires at time three and has strike K = 4 (i.e., whose payoff at time three is
+
1
). This is like a European call, except the payoff of the option is
4 Y3 4
based on the average stock price rather than the final stock price. Let vn (s, y)
denote the price of this option at time n if Sn = s and Yn = y. In particular,
+
v3 (s, y) = 41 y 4 .
(i) Develop an algorithm for computing vn recursively. In particular, write a
formula for vn in terms of vn+1 .
(ii) Apply the algorithm developed in (i) to compute v0 (4, 4), the price of the
Asian option at time zero.
(iii) Provide a formula for n (s, y), the number of shares of stock which should
be held by the replicating portfolio at time n if Sn = s and Yn = y.
Solution.
(i), (iii) Assume that at time n, Sn = s and Yn = y. Then if the (n + 1)-st
toss results in H, we have
Sn+1 = us,
vn (s, y) =
4
5
1
2 v2 (16, 28)
4
5
1
2 v2 (4, 10)
+ 21 v2 (4, 16) = 2.96,
+ 21 v2 (1, 7)
= 0.08.
Solution.
(i) We adapt Theorem 1.2.2 to this case by defining
p0 =
1 + r 0 d0
,
u0 d 0
q0 =
u0 1 r 0
,
u0 d 0
1 + rn (1 2 . . . n ) dn (1 2 . . . n )
,
un (1 2 . . . n ) dn (1 2 . . . n )
un (1 2 . . . n ) 1 rn (1 2 . . . n )
.
qn (1 2 . . . n ) =
un (1 2 . . . n ) dn (1 2 . . . n )
pn (1 2 . . . n ) =
1
pn (1 2 . . . n )Vn+1 (1 2 . . . n H)
1+r
+
qn (1 2 . . . n )Vn+1 (1 2 . . . n T ) ,
1
p0 V1 (H) + q0 V1 (T ) .
1+r
(ii) The number of shares of stock that should be held at time n is still given
by (1.2.17):
n (1 . . . n ) =
Vn+1 (1 . . . n H) Vn+1 (1 . . . n T )
.
Sn+1 (1 . . . n H) Sn+1 (1 . . . n T )
The proof that this hedge works, i.e., that taking the position n in the
stock at time n and holding it until time n + 1 results in a portfolio whose
value at time n + 1 is Vn+1 , is the same as the proof given for Theorem
1.2.2.
(iii) If the stock price at a particular time n is x, then the stock price at the
next time is either x + 10 or x 10. That means that the up factor is
un = x+10
and the down factor is dn = x10
x
x . The corresponding riskneutral probabilities are
pn =
1 dn
=
un d n
qn =
un 1
=
un = d n
x10
x
x10
x
1
,
2
x+10
x 1
x+10
x10
x
x
1
.
2
x+10
x
There are three ways for the call with strike 80 to expire in the money
at time 5: either the five tosses result in five heads (S5 = 130), result in
four heads and one tail (S5 = 110), or result in three heads and two tails
1
(S5 = 90). The risk-neutral probability of five heads is 32
. If a tail occurs,
it can occur on any toss, and so there are five sequences that have four
heads and one tail. Therefore, the risk-neutral probability of four heads
5
and one tail is 32
. Finally, if there are two tails in a sequence of five tosses,
there 10 ways to choose the two tosses that are tails. Therefore, the riskneutral probability of three heads and two tails is 10
32 . The time-zero price
of the call is
V0 =
1
5
10
(130 80) +
(110 80) +
(90 80) = 9.375.
32
32
32
2
Probability Theory on Coin Toss Space
Solution.
(i) The distribution of S3 under the risk-neutral probabilities p and q is
32 8
2 .50
p3 3
p2 q 3
pq2 q3
With p = 21 , q = 21 , this becomes
2 .50
32 8
.125 .375 .375 .125
(ii) By Theorem 2.4.4,
Therefore,
e
E
S3
e S2
e S1 = ES
e 0 = S0 = 4.
=E
=E
3
2
(1 + r)
(1 + r)
(1 + r)
e 1 = (1 + r)S0 = (1.25)(4) = 5,
ES
e 2 = (1 + r)2 S0 = (1.25)2 (4) = 6.25,
ES
e 3 = (1 + r)3 S0 = (1.25)3 (4) = 7.8125.
ES
e 3 = 1.25 ES
e 2 , ES
e 2 = 1.25 ES
e 1 , ES
e 1 = 1.25 S0 .
ES
e is the same
Thus, the average rate of growth of the stock price under P
as the interest rate of the money market.
2
1
2 + 12 = 1.5.
3
3
In other words, the average rate of growth of the stock price under the
actual probabilities is 50%. Finally, taking expectations, we have
ESn+1 = E En Sn+1 = 1.5 ESn ,
pu + qd =
so that
Exercise 2.3. Show that a convex function of a martingale is a submartingale. In other words, let M0 , M1 , . . . , MN be a martingale and let be a
convex function. Show that (M0 ), (M1 ), . . . , (MN ) is a submartingale.
Solution Let an arbitrary n with 0 n N 1 be given. By the martingale
property, we have
En Mn+1 = Mn ,
and hence
(En Mn+1 ) = (Mn ).
On the other hand, by the conditional Jensens inequality, we have
En (Mn+1 ) (En Mn+1 ).
Combining these two, we get
En (Mn+1 ) (Mn ),
and since n is arbitrary, this implies that the sequence of random variables
(M0 ), (M1 ), . . . , (MN ) is a submartingale.
Exercise 2.6 (Discrete-time stochastic integral). Suppose M0 , M1 , . . . ,
MN is a martingale, and let 0 , 1 , . . . , N 1 be an adapted process. Define
the discrete-time stochastic integral (sometimes called a martingale transform)
I0 , I1 , . . . , IN by setting I0 = 0 and
In =
n1
X
j=0
j (Mj+1 Mj ), n = 1, . . . , N.
V1
VN 1
VN
,...,
,
1+r
(1 + r)N 1 (1 + r)N
e
is a martingale under P.
10
(iii) Using the risk-neutral pricing formula (2.4.11) of this chapter, define
VN
en
Vn0 = E
, n = 0, 1, . . . , N 1.
(1 + r)N n
Show that
V00 ,
VN0 1
VN
V10
,...,
,
N
1
1+r
(1 + r)
(1 + r)N
is a martingale.
(iv) Conclude that Vn = Vn0 for every n (i.e., the algorithm (1.2.16) of Theorem
1.2.2 of Chapter 1 gives the same derivative security prices as the riskneutral pricing formula (2.4.11) of Chapter 2).
Solution.
0
(i) We are given that Mn = MN
. For n between 0 and N 1, this equality
and the martingale property imply
e n [MN ] = E
e n [M 0 ] = Mn .
Mn = E
N
n
(iii) The martingale property for (1+r)
n follows from the iterated conditioning
property (iii) of Theorem 2.3.2. According to this property, for n between
0 and n 1,
0
Vn+1
1
VN
e
e
e
= En
En+1
En
(1 + r)n+1
(1 + r)n+1
(1 + r)N (n+1)
1
VN
e
e
=
En En+1
(1 + r)n
(1 + r)N n
VN
1
e
En
=
(1 + r)n
(1 + r)N n
0
Vn
=
.
(1 + r)n
11
(iv) Since the processes in (ii) and (iii) are martingales under the risk-neutral
probability measure and they agree at the final time N , they must agree
at all earlier times because of (i).
S2 (HH) = 12
S1 (H) = 8
r1 (H) = 41
S2 (HT ) = 8
S0 = 4
r0 = 14
S2 (T H) = 8
S1 (T ) = 2
r1 (T ) = 12
S2 (T T ) = 2
such that the time-zero value of an option that pays off V2 at time two is
given by the risk-neutral pricing formula
V2
e
V0 = E
.
(1 + r0 )(1 + r1 )
(iii) Suppose an agent sells the option in (ii) for V0 at time zero. Compute the
position 0 she should take in the stock at time zero so that at time one,
regardless of whether the first coin toss results in head or tail, the value
of her portfolio is V1 .
(iv) Suppose in (iii) that the first coin toss results in head. What position
1 (H) should the agent now take in the stock to be sure that, regardless
12
of whether the second coin toss results in head or tail, the value of her
portfolio at time two will be (S2 7)+ ?
Solution.
(i) For the first toss, the up factor is u0 = 2 and the down factor is d0 = 21 .
Therefore, the risk-neutral probability of a H on the first toss is
p0 =
1 + 14
1 + r 0 d0
=
u0 d 0
2 21
1
2
1
,
2
21
u0 1 r 0
=
u0 d 0
2 21
1
4
1
.
2
If the first toss results in H, then the up factor for the second toss is
u1 (H) =
12
3
S2 (HH)
=
= ,
S1 (H)
8
2
S2 (HT )
8
= = 1.
S1 (H)
8
1+ 1 1
1
1 + r1 (H) d1 (H)
= 3 4
= ,
u1 (H) d1 (H)
2
2 1
and the risk-neutral probability of T on the second toss, given that the
first toss is a H, is
q1 (H) =
u1 (H) 1 r1 (H)
=
u1 (H) d1 (H)
3
2
1
3
2 1
1
4
1
,
2
If the first toss results in T , then the up factor for the second toss is
u1 (T ) =
S2 (T H)
8
= = 4,
S1 (T )
2
2
S2 (T T )
= = 1.
S1 (T )
2
p1 (T ) =
13
1 + 12 1
1
1 + r1 (T ) d1 (T )
=
= ,
u1 (T ) d1 (T )
41
6
and the risk-neutral probability of T on the second toss, given that the
first toss is a T , is
q1 (T ) =
41
u1 (T ) 1 r1 (T )
=
u1 (T ) d1 (T )
41
1
2
5
.
6
e T ) = q0 q1 (T ) =
P(T
1
2
1
2
1
2
1
2
1
2
1
2
1
6
5
6
= 41 ,
= 41 ,
=
=
1
12 ,
5
12 .
1
p1 (H)V2 (HH) + q1 (H)V2 (HT )
1 + r1 (H)
1
4 1
+
+
(12 7) + (8 7)
=
5 2
2
= 2.40,
1
V1 (T ) =
p1 (T )V2 (T H) + q1 (T )V2 (T T )
1 + r1 (T )
5
2 1
(8 7)+ + (2 7)+
=
3 6
6
= 0.111111,
1
V0 =
[
p0 V1 (H) + q0 V1 (T )]
1 + r0
4 1
1
=
2.40 + 0.1111
5 2
2
= 1.00444.
V1 (H) =
14
V2
(1 + r0 )(1 + r1 )
V2 (HH)
V2 (HT )
e
e
=
P(HH)
+
P(HT
)
(1 + r0 )(1 + r1 (H))
(1 + r0 )(1 + r1 (H))
V2 (T H)
V2 (T T )
e H) +
e T)
+
P(T
P(T
(1 + r0 )(1 + r1 (T ))
(1 + r0 )(1 + r1 (T ))
(8 7)+
1
1
(12 7)+
+
=
1
1
1
1
(1 + 4 )(1 + 4 ) 4 (1 + 4 )(1 + 4 ) 4
e
V0 = E
(2 7)+
(8 7)+
1
5
1
1 12 +
(1 + 4 )(1 + 2 )
(1 + 41 )(1 + 12 ) 12
= 0.80 + 0.16 + 0.04444 + 0
= 1.00444.
+
V1 (H) V1 (T )
2.40 0.111111
=
= 0.381481.
S1 (H) S1 (T )
82
Finally, consider a forward contract to buy one share of stock at time N for
K dollars. The price of this contract at time N is FN = SN K, and its price
at earlier times is
FN
en
, n = 0, 1, . . . , N 1.
Fn = E
(1 + r)N n
(Note that, unlike the call, the forward contract requires that the stock be
purchased at time N for K dollars and has a negative payoff if SN < K.)
15
(i) If at time zero you buy a forward contract and a put, and hold them until
expiration, explain why the payoff you receive is the same as the payoff
of a call; i.e., explain why CN = FN + PN .
(ii) Using the risk-neutral pricing formulas given above for Cn , Pn , and Fn
and the linearity of conditional expectations, show that Cn = Fn + Pn for
every n.
(iii) Using the fact that the discounted stock price is a martingale under the
K
risk-neutral measure, show that F0 = S0 (1+r)
N .
(iv) Suppose you begin at time zero with F0 , buy one share of stock, borrowing
money as necessary to do that, and make no further trades. Show that
at time N you have a portfolio valued at FN . (This is called a static
replication of the forward contract. If you sell the forward contract for
F0 at time zero, you can use this static replication to hedge your short
position in the forward contract.)
(v) The forward price of the stock at time zero is defined to be that value of
K that causes the forward contract to have price zero at time zero. The
forward price in this model is (1 + r)N S0 . Show that, at time zero, the
price of a call struck at the forward price is the same as the price of a put
struck at the forward price. This fact is called putcall parity.
(vi) If we choose K = (1 + r)N S0 , we just saw in (v) that C0 = P0 . Do we
have Cn = Pn for every n?
Solution
(i) Consider three cases:
Case I: SN = K. Then CN = PN = FN = 0;
Case II: SN > K. Then PN = 0 and CN = SN K = FN ;
(ii)
FN + P N
CN
e
= En
(1 + r)N n
(1 + r)N n
FN
PN
e
e
= En
+ En
= Fn + Pn .
(1 + r)N n
(1 + r)N n
en
Cn = E
(iii)
SN K
FN
e
=E
(1 + r)N
(1 + r)N
SN
K
K
e
e
.
=E
E
= S0
N
N
(1 + r)
(1 + r)
(1 + r)N
e
F0 = E
16
SN + (1 + r) (F0 S0 ) = SN + (1 + r)
(1 + r)N
= SN K = F N .
(ii) According to Theorem 2.5.8, the price Vn of the Asian option at time n is
some function vn of Sn and Yn ; i.e.,
Vn = vn (Sn , Yn ), n = 0, 1, . . . , N.
Give a formula for vN (s, y), and provide an algorithm for computing
vn (s, y) in terms of vn+1 .
Solution
(i) Note first that
Sn+1 = Sn
Sn+1
,
Sn
Yn+1 = Yn + Sn
Sn+1
,
Sn
depends
and whereas Sn and Yn depend only on the first n tosses, SSn+1
n
only on toss n + 1. According to the Independence Lemma 2.5.3, for any
function hn+1 (s, y) of dummy variables s and y, we have
17
e n [hn+1 (Sn+1 , Yn+1 )] = E
e n hn+1 Sn Sn+1 , Yn + Sn Sn+1
E
Sn
Sn
= hn (Sn , Yn ),
where
e n+1 s Sn+1 , y + s Sn+1
hn (s, y) = Eh
Sn
Sn
= phn+1 (su, y + su) + qhn+1 (sd, y + sd).
e n [hn+1 (Sn+1 , Yn+1 )] can be written as a function of (Sn , Yn ),
Because E
the two-dimensional process (Sn , Yn ), n = 0, 1, . . . , N , is a Markov process.
(ii) We have the final condition VN (s, y) = f Ny+1 . For n = N 1, . . . , 1, 0,
we have from the risk-neutral pricing formula (2.4.12) and (i) above that
Vn =
where
1 e
1 e
En Vn+1 =
En vn+1 (Sn+1 , Yn+1 ) = vn (Sn , Yn ),
1+r
1+r
vn (s, y) =
1
pvn+1 (su, y + su) + qvn+1 (sd, y + sd) .
1+r
3
State Prices
1
Z
> 0 = 1;
e 1 = 1;
(ii0 ) E
Z
1
Y .
Z
e
(i0 ) Because P() > 0 and P()
> 0 for every , the ratio
1
P()
=
e
Z()
P()
(ii ) We compute
e1 =
E
Z
X P()
X
1 e
e
P()
=
P() =
P() = 1.
e
Z()
P()
20
3 State Prices
(iii0 ) We compute
X
X
P()
1
e
e
Y =
Y ()P()
=
E
Y ()P() = EY.
e
Z
P()
Exercise 3.3. Using the stock price model of Figure 3.1.1 and the actual
probabilities p = 32 , q = 13 , define the estimates of S3 at various times by
Mn = En [S3 ], n = 0, 1, 2, 3.
Fill in the values of Mn in a tree like that of Figure 3.1.1. Verify that Mn ,
n = 0, 1, 2, 3, is a martingale.
Solution We note that M3 = S3 . We compute M2 from the formula M2 =
E2 [S3 ]:
M2 (HH) = 32 S3 (HHH) + 12 S3 (HHT ) =
M2 (T H) =
2
3 S3 (HT H)
2
3 S3 (T HH)
M2 (T T ) =
2
3 S3 (T HH)
M2 (HT ) =
1
3 S3 (HT T )
1
3 S3 (T HT )
1
2 S3 (T HT )
2
1
3 32 + 3 8
2
1
3 8+ 3 2
2
1
3 8+ 3 2
2
1
3 2 + 3 0.50
= 24,
= 6,
= 6,
= 1.50.
M1 (H) =
Finally, we compute
M0 = E[S3 ]
8
4
4
4
=
S3 (HHH) + S3 (HHT ) + S3 (HT H) + S3 (T HH)
27
27
27
27
2
2
1
2
+ S3 (HT T ) + S3 (T HT ) + S3 (T T H) + S3 (T T T )
27
27
27
27
8
4
4
4
2
2
2
1
=
32 +
8+
8+
8+
2+
2+
2+
0.50
27
27
27
27
27
27
27
27
= 13.50.
!!
M2 (HH) = 24
aa
!
!!
aa
M1 (H) = 18
Z
Z
M0 = 13.50
Z
Z
M2 (HT ) = M2 (T H) = 6
M1 (T ) = 4.50
Z
Z
!!
!!
21
S3 (HHH) = 32
aa S3 (HHT ) = S3 (HT H)
= S3 (T HH) = 8
Z
Z S (HT T ) = S3 (T HT )
!! 3
= S3 (T T H) = 2
M2 (T T ) = 1.50
aa
aa
aa S3 (T T T ) = .50
1
2 M2 (T H)
2
3 M1 (H)
+
+
1
2 M2 (T T )
1
3 M1 (T )
=
=
2
1
3 24 + 3 6
2
1
3 6 + 3 1.50
2
1
3 18 + 3 4.50
= 18 = M1 (H),
= 4.50 = M1 (T ),
= 13.50 = M0 .
2
2
1
4
, P(HT ) = , P(T H) = , P(T T ) = .
9
9
9
9
22
3 State Prices
V1 (H) =
=
V1 (T ) =
=
V0 =
Z2
1 + r0
E1
V2 (H)
Z1 (H)
(1 + r0 )(1 + r1 )
1
E1 [Z2 V2 ](H),
Z1 (H)(1 + r1 (H))
Z2
1 + r0
E1
V2 (T )
Z1 (T )
(1 + r0 )(1 + r1 )
1
E1 [Z2 V2 ](T ),
Z1 (T )(1 + r1 (T ))
Z2
V2 .
E
(1 + r0 )(1 + r1 )
Z(T H) =
e
1 9
9
P(HH)
=
=
,
P(HH)
4 4
16
Z(HT ) =
e H)
P(T
1 9
3
=
= ,
P(T H)
12 2
8
Z(T T ) =
e
P(HT
)
1 9
9
=
= ,
P(HT )
4 2
8
e T)
P(T
5 9
15
=
=
,
P(T T )
12 1
4
(ii)
Z1 (H) = E1 [Z2 ](H)
= Z2 (HH)P{2 = H given that 1 = H}
+Z2 (HT )P{2 = T given that 1 = H}
P(HT )
P(HH)
+ Z2 (HT )
= Z2 (HH)
P(HH) + P(HT )
P(HH) + P(HT )
9
16
3
= ,
4
4
9
4
9
2
9
2
9
4
9
2
9
23
Z1 (T ) = E1 [Z2 ](T )
= Z2 (T H)P{2 = H given that 1 = T }
2
3
2 9
8 9+
3
= ,
2
Z0 = E0 [Z1 ]
1
9
15
1
9
2
9
1
9
= E[Z1 ]
= Z1 (H) P(HH) + P(HT ) + Z1 (T ) P(T H) + P(T T )
3
4 2
3
2 1
=
+
+
+
4
9 9
2
9 9
= 1.
We may also check directly that EZ = 1, as follows:
EZ = Z(HH)P(HH) + Z(HT )P(HT ) + Z(T H)P(T H) + Z(T T )P(T T )
9 4 9 2 3 2 15 1
+ + +
=
16 9 8 9 8 9
4 9
1
5
1 1
+
= 1.
= + +
4 4 12 12
(iii) We recall that
V2 (HH) = 5, V2 (HT ) = 1, V2 (T H) = 1, V2 (T T ) = 0.
We computed in part (ii) that
P{2 = H given that 1 = H} =
4
9
2
4
+
9
9
2
9
4
2
+
9
9
Therefore,
e 2 = T given that 1 = T } =
P{
2
9
2
1
+
9
9
1
9
2
1
9+9
2
,
3
1
= ,
3
2
= ,
3
1
= .
3
=
24
3 State Prices
1
E1 [Z2 V2 ](H)
Z1 (H) 1 + r1 (H)
1
3 5
=
Z2 (HH)V2 (HH)P{2 = H given that 1 = H}
4 4
V1 (H) =
Z 2 V2
V0 = E
(1 + r0 )(1 + r1 )
Z2 (HT )V2 (HT )
Z2 (HH)V2 (HH)
P(HH) +
P(HT )
=
(1 + r0 )(1 + r1 (H))
(1 + r0 )(1 + r1 (H))
Z2 (T T )V2 (T T )
Z2 (T H)V2 (T H)
P(T H) +
P(T T )
+
(1 + r0 )(1 + r1 (T ))
(1 + r0 )(1 + r1 (T ))
1
1
1
5 5
9
9
3
4
5 5
2
5 3
2
=
5 +
1 +
1
4 4
16
9
4 4
8
9
4 2
8
9
1
5 3
15
1
+
0
4 2
4
9
8 1
16 5 16 1
+
+
=
25 4 25 4 15 12
= 1.00444.
Z
(1 + r)N
= I(N ).
1
x
25
1
y.
XN =
1
N
We must choose to satisfy (3.3.26), which in this case takes the form
1
X0 = E N I(N ) = .
Xn
(1+r)n
X0
.
N
e we have
is a martingale under the risk-neutral measure P,
1
1
Xn
X0
XN
Z N XN
en
=
=
=
E
E
En [N XN ] =
.
n
(1 + r)n
(1 + r)N
Zn
(1 + r)N
Zn
Zn
Therefore,
Xn =
(1 + r)n X0
X0
=
.
Zn
n
Exercise 3.8. The Lagrange Multiplier Theorem used in the solution of Problem 3.3.5 has hypotheses that we did not verify in the solution of that problem.
In particular, the theorem states that if the gradient of the constraint function,
which in this case is the vector (p1 1 , . . . , pm m ), is not the zero vector, then
the optimal solution must satisfy the Lagrange multiplier equations (3.3.22).
This gradient is not the zero vector, so this hypothesis is satisfied. However,
even when this hypothesis is satisfied, the theorem does not guarantee that
there is an optimal solution; the solution to the Lagrange multiplier equations may in fact minimize the expected utility. The solution could also be
neither a maximizer nor a minimizer. Therefore, in this exercise, we outline a
different method for verifying that the random variable XN given by (3.3.25)
maximizes the expected utility.
We begin by changing the notation, calling the random variable given
by (3.3.25) XN
rather than XN . In other words,
Z ,
(3.6.1)
XN = I
(1 + r)N
where is the solution of equation (3.3.26). This permits us to use the notation XN for an arbitrary (not necessarily optimal) random variable satisfying
(3.3.19). We must show that
EU (XN ) EU (XN
).
(3.6.2)
26
3 State Prices
(i) Fix y > 0, and show that the function of x given by U (x)yx is maximized
by y = I(x). Conclude that
U (x) yx U (I(y)) yI(y) for every x.
(3.6.3)
U
I
I
.
U (XN )
(1 + r)N
(1 + r)N
(1 + r)N
(1 + r)N
Taking expectations under P and using the fact that Z is the Radone with respect to P, we obtain
Nikod
ym derivative of P
XN
(1 + r)N
Z
Z
Z
E
.
I
EU I
(1 + r)N
(1 + r)N
(1 + r)N
e
EU (XN ) E
Cancelling these terms on the left- and right-hand sides of the above equation,
we obtain (3.6.2).
4
American Derivative Securities
(iii) Determine the price at time zero, denoted V0S , of the American straddle
that expires at time three and has intrinsic value gS (s) = gP (s) + gC (s).
(iv) Explain why V0S < V0P + V0C .
Solution
(i) The payoff of the put at expiration time three is
V3P (HHH) = (4 32)+
V3P (HHT ) = V3P (HT H)
V3P (HT T ) = V3P (T HT )
V3P (T T T ) = (4 0.50)+
Because
1
1
= 1+r
q = 25 ,
1+r p
= 0,
= V3P (T HH) = (4 8)+ = 0,
= V3P (T T H) = (4 2)+ = 2,
= 3.50.
28
+ 2 P
2
, V3 (HHH) + V3P (HHT )
5
5
2
2
= max (4 16)+ , 0 + 0
5
5
= max{0, 0}
= 0,
+ 2
2
V2P (HT ) = max 4 S2 (HT ) , V3P (HT H) + V3P (HT T )
5
5
2
2
= max 4 4)+ , 0 + 2
5
5
= max{0, 0.80}
= 0.80,
+ 2
2
V2P (T H) = max 4 S2 (T H) , V3P (T HH) + V3P (T HT )
5
5
2
2
= max 4 4)+ , 0 + 2
5
5
= max{0, 0.80}
4 S2 (HH)
= 0.80,
+ 2
2
V2P (T T ) = max 4 S2 (T T ) , V3P (T T H) + V3P (T T T )
5
5
2
2
= max (4 1)+ , 2 + 3.50
5
5
= max{3, 2.20}
= 3.
At time one the value of the put is
+ 2
2
V1P (H) = max 4 S1 (H) , V2P (HH) + V2P (HT )
5
5
2
2
= max (4 8)+ , 0 + 0.80
5
5
= max{0, 0.32}
= 0.32,
+ 2 P
2 P
P
V1 (T ) = max 4 S1 (T ) , V2 (T H) + V2 (T T )
5
5
2
2
= max (4 2)+ , 0.80 + 3
5
5
= max{2, 1.52}
= 2.
The value of the put at time zero is
29
2
2
V0P = max (4 S0 )+ , V1P (H) + V1P (T )
5
5
2
2
= max (4 4)+ , 0.32 + 2
5
5
= max{0, 0.928}
= 0.928.
(ii) The payoff of the call at expiration time three is
V3C (HHH) = (32 4)+
V3C (HHT ) = V3C (HT H)
V3C (HT T ) = V3C (T HT )
V3C (T T T ) = (0.50 4)+
Because
1
1
= 1+r
q = 25 ,
1+r p
= 28,
= V3C (T HH) = (8 4)+ = 4,
= V3C (T T H) = (2 4)+ = 0,
= 0.
+ 2 C
2
, V3 (HHH) + V3C (HHT )
5
5
2
2
= max (16 4)+ , 28 + 4
5
5
= max{12, 12.8}
S2 (HH) 4
= 12.8,
+ 2
2
V2C (HT ) = max S2 (HT ) 4 , V3C (HT H) + V3C (HT T )
5
5
2
2
= max 4 4)+ , 4 + 0
5
5
= max{0, 1.60}
= 1.60,
+ 2
2
V2C (T H) = max S2 (T H) 4 , V3C (T HH) + V3C (T HT )
5
5
2
2
= max 4 4)+ , 4 + 0
5
5
= max{0, 1.60}
= 1.60,
+ 2
2
V2C (T T ) = max S2 (T T ) 4 , V3C (T T H) + V3C (T T T )
5
5
2
2
= max (1 4)+ , 0 + 0
5
5
= max{0, 0}
= 0.
At time one the value of the call is
30
+ 2 C
2
, V2 (HH) + V2C (HT )
5
5
2
2
= max (8 4)+ , 12.8 + 1.60
5
5
= max{4, 5.76} = 5.76,
+ 2 C
2 C
C
V1 (T ) = max S1 (T ) 4 , V2 (T H) + V2 (T T )
5
5
2
2
= max (2 4)+ , 1.60 + 0
5
5
= max{0, 0.64} = 0.64.
S1 (H) 4
+ 2 S
2
, V3 (T HH) + V3S (T HT )
5
5
2
2
= max 4 4)+ , 4 + 2
5
5
= max{0, 2.40}
= 2.40,
2
2
V2S (T T ) = max S2 (T T ) 4, V3S (T T H) + V3S (T T T )
5
5
2
2
= max |1 4|, 2 + 3.50
5
5
= max{3, 2.20}
= 3.
V2S (T H) = max
S2 (T H) 4
31
One can verify in every case that V2S = V2P + V2C . At time one the value
of the straddle is
2 S
2 S
S
V1 (H) = max S1 (H) 4 , V2 (HH) + V2 (HT )
5
5
2
2
= max |8 4|, 12.8 + 2.40
5
5
= max{4, 6.08}
= 6.08,
2 S
2 S
S
V1 (T ) = max S1 (T ) 4 , V2 (T H) + V2 (T T )
5
5
2
2
= max |2 4|, 2.40 + 3
5
5
= max{2, 2.16}
= 2.16.
We have V1S (H) = 6.08 = 0.32 + 5.76 = V1P (H) + V1C (H), but V1S (T ) =
2.16 < 2 + 0.64 = V1P (T ) + V1C (T ).
The value of the straddle at time zero is
2 S
2 S
S
V0 = max |S0 4|, V1 (H) + V1 (T )
5
5
2
2
= max |4 4|, 6.08 + 2.16
5
5
= max{0, 3.296}
= 3.296.
We have V0S = 3.296 < 0.928 + 2.56 = V0P + V0C .
32
(iv) For the put, if there is a tail on the first toss, it is optimal to exercise at
time one. This can be seen from the equation
+ 2 P
2 P
P
V1 (T ) = max 4 S1 (T ) , V2 (T H) + V2 (T T )
5
5
2
2
= max (4 2)+ , 0.80 + 3
5
5
= max{2, 1.52}
= 2,
which shows that the intrinsic value at time one if the first toss results
in T is greater than the value of continuing. On the other hand, for the
call the intrinsic value at time one if there is a tail on the first toss is
(S1 (T ) 4)+ = (2 4)+ = 0, whereas the value of continuing is 0.64.
Therefore, the call should not be exercised at time one if there is a tail on
the first toss.
The straddle has the intrinsic value of a put plus a call. When it is exercised, both parts of the payoff are received. In other words, it is not
an American put plus an American call, because these can be exercised
at different times whereas the exercise of a straddle requires both the
put payoff and the call payoff to be received. In the computation of the
straddle price
2 S
2 S
S
V1 (T ) = max S1 (T ) 4 , V2 (T H) + V2 (T T )
5
5
2
2
= max |2 4|, 2.40 + 3
5
5
= max{2, 2.16}
= 2.16,
we see that it is not optimal to exercise the straddle at time one if the first
toss results in T . It would be optimal to exercise the put part, but not the
call part, and the straddle cannot exercise one part without exercising the
other. Greater value is achieved by not exercising both parts than would
be achieved by exercising both. However, this value is less than would be
achieved if one could exercise the put part and let the call part continue,
and thus V1S (T ) < V1P (T ) + V1C (T ). This loss of value at time one results
in a similar loss of value at the earlier time zero: V0S < V0P + V0C .
Exercise 4.3. In the three-period model of Figure 1.2.2 of Chapter 1, let the
interest rate be r = 14 so the risk-neutral probabilities are p = q = 12 . Find
the time-zero price and optimal exercise policy (optimal stopping time) for
the path-dependent American derivative security whose intrinsic value at each
+
Pn
1
time n, n = 0, 1, 2, 3, is 4 n+1
. This intrinsic value is a put on
j=0 Sj
the average stock price between time zero and time n.
33
G1 (H) =
G1 (T ) =
(4 S0 )
4
4
S0 +S1 (H)
2
S0 +S1 (T )
2
+
+
=
+
2 (HH)
G2 (HH) = 4 S0 +S1 (H)+S
3
+
2 (HT )
G2 (HT ) = 4 S0 +S1 (H)+S
3
+
2 (T H)
G2 (T H) = 4 S0 +S1 (T )+S
3
+
G2 (T T ) = 4 S0 +S1 (T 3)+S2 (T T )
=
=
=
=
=
(4 4)+
+
4 4+8
2
+
4 4+2
2
+
4 4+8+16
3
4 4+8+4
3
+
4 4+2+4
3
r 4+2+1
3
= 0,
= 0,
= 1,
= 0,
= 0,
= 0.6667,
= 1.6667.
At time three, the intrinsic value G3 agrees with the option value V3 . In other
words,
V3 (HHH) = G3 (HHH)
+
S0 + S1 (H) + S2 (HH) + S3 (HHH)
= 4
4
+
4 + 8 + 16 + 32
= 4
4
= 0,
V3 (HHT ) = G3 (HHT )
+
S0 + S1 (H) + S2 (HH) + S3 (HHT )
= 4
4
+
4 + 8 + 16 + 8
= 4
4
= 0,
V3 (HT H) = G3 (HT H)
+
S0 + S1 (H) + S2 (HT ) + S3 (HT H)
= 4
4
+
4+8+4+8
= 4
4
= 0,
V3 (HT T ) = G3 (HT T )
+
S0 + S1 (H) + S2 (HT ) + S3 (HT T )
= 4
4
+
4+8+4+2
= 4
4
= 0,
34
V3 (T HH) = G3 (T HH)
+
S0 + S1 (T ) + S2 (T H) + S3 (T HH)
= 4
4
+
4+2+4+8
= 4
4
= 0,
V3 (T HT ) = G3 (T HT )
+
S0 + S1 (T ) + S2 (T H) + S3 (T HT )
= 4
4
+
4+2+4+2
= 4
4
= 1,
V3 (T T H) = G3 (T T H)
+
S0 + S1 (T ) + S2 (T T ) + S3 (T T H)
= 4
4
+
4+2+1+2
= 4
4
= 1.75,
V3 (T T T ) = G3 (T T T )
+
S0 + S1 (T ) + S2 (T T ) + S3 (T T T )
= 4
4
+
4 + 2 + 1 + 0.50
= 4
4
= 2.125.
We use the algorithm of Theorem 4.4.3, noting that
p
1+r
q
1+r
= 52 , to obtain
2
2
V2 (HH) = max G2 (HH), V3 (HHH) + V3 (HHT )
5
5
2
2
= max 0, 0 + 0
5
5
= 0,
2
2
V2 (HT ) = max G2 (HT ), V3 (HT H) + V3 (HT T )
5
5
2
2
= max 0, 0 + 0
5
5
= 0,
35
2
2
V2 (T H) = max G2 (T H), V3 (T HH) + V3 (T HT )
5
5
2
2
= max 0.6667, 0 + 1
5
5
= max{0.6667, 0.40}
= 0.6667,
2
2
V2 (T T ) = max G2 (T T ), V3 (T T H) + V3 (T T T )
5
5
2
2
= max 1.6667, 1.75 + 2.125
5
5
= max{1.6667, 1.55}
= 1.6667.
Continuing, we have
2
2
V1 (H) = max G1 (H), V2 (HH) + V2 (HT )
5
5
2
2
= max 0, 0 + 0
5
5
= 0,
2
2
V1 (T ) = max G1 (T ), V2 (T H) + V2 (T T )
5
5
2
2
= max 1, 0.6667 + 1.6667
5
5
= max{1, 0.9334}
= 1,
2
2
V0 = max G0 , V1 (H) + V1 (T )
5
5
2
2
= max 0, 0 + 1
5
5
= max{0, 0.40}
= 0.40.
To find the optimal exercise time, we work forward. Since V0 > G0 , one
should not exercise at time zero. However, V1 (T ) = G1 (T ), so it is optimal to
exercise at time one if there is a T on the first toss. If the first toss results in
H, the option is destined always be out of the money. With the intrinsic value
+
Pn
1
defined in the exercise, it does not matter what
Gn = 4 n+1
j=1 Sj
Pn
1
exercise rule we choose in this case. If the payoff were 4 n+1
S
j=1 j , so
that exercising out of the money is costly (as one would expect in practice),
then one should allow the option to expire unexercised.
36
Exercise 4.5. In equation (4.4.5), the maximum is computed over all stopping times in S0 . List all the stopping times in S0 (there are 26), and from
among those, list the stopping times that never exercise when the option is
out of the money
(there
are
11). For each stopping time in the latter set,
compute E I{ 2} 54 G . Verify that the largest value for this quantity is
given by the stopping time of (4.4.6), the one which makes this quantity equal
to the 1.36 computed in (4.4.7).
Solution A stopping time is a random variable, and we can specify a stopping
time by listing its values (HH), (HT ), (T H), and (T T ). The stopping
time property requires that (HH) = 0 if and only if (HT ) = (T H) =
(T T ) = 0. Similarly, (HH) = 1 if and only if (HT ) = 1 and (T H) = 1
if and only if (T T ) = 1. The 26 stopping times in the two-period binomial
model are tabulated below.
Stopping
Time
HH
HT
TH
TT
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
0
1
1
1
1
1
2
2
2
2
2
2
2
2
2
2
0
1
1
1
1
1
2
2
2
2
2
2
2
2
2
2
0
1
2
2
1
2
2
1
2
2
1
2
2
1
2
2
0
1
2
1
2
1
2
1
2
1
2
37
G0 = 1, G1 (H) = 3, G1 (T ) = 3,
G2 (HH) = 11, G2 (HT ) = G2 (T H) = 1, G2 (T T ) = 4.
The stopping times that take the value 1 when there is an H on the first toss
are mandating an exercise out of the money (G1 (H) = 3). This rules out 2
6 . Also, the stopping times that take the value 2 when there is an HH on the
first two tosses are mandating an exercise out of the money (G2 (HH) = 11).
This rules out 7 16 . For all other exercise situations, G is positive, so the
option is in the money. This leaves us with 1 and the ten stopping times
17 26 . We evaluate the risk-neutral expected payoff of these eleven stopping
times.
4
G1 = G0 = 1,
E I{1 2}
5
1 16
1 4
4
E I{17 2}
G17 = G2 (HT ) + G1 (T )
5
4 26
2 5
4
2
=
1 + 3 = 1.36,
5
25
1 16
1 16
1 16
4
G18 = G2 (HT ) + G2 (T H) + G2 (T T )
E I{18 2}
5
4 26
4 25
4 25
4
4
4
1+
1+
4 = 0.96,
=
25
25
25
1 16
1 16
4
G19 = G2 (HT ) + G2 (T H)
E I{19 2}
5
4 26
4 25
4
4
=
1+
1 = 0.32,
25
25
1 16
4
1 16
E I{20 2}
G20 = G2 (HT ) + G2 (T T )
5
4 26
4 25
4
4
=
1+
4 = 0.80,
25
25
4
1 16
G21 = G2 (HT )
E I{21 2}
5
4 26
4
=
1 = 0.16,
25
1 4
4
G22 = G1 (T )
E I{22 2}
5
2 5
2
= 3 = 1.20,
5
4
1 16
1 16
E I{23 2}
G23 = + G2 (T H) + G2 (T T )
5
4 25
4 25
4
4
=
1+
4 = 0.80,
25
25
38
1 16
4
G24 = + G2 (T H)
E I{24 2}
5
4 25
4
1 = 0.16,
=
25
4
1 16
E I{25 2}
G25 = + G2 (T T )
5
4 25
4
= + 4 = 0.64,
25
4
E I{26 2}
G26 = 0.
5
The largest value, 1.36, is obtained by the stopping time 17 .
Exercise 4.7. For the class of derivative securities described in Exercise 4.6
whose time-zero price is given by (4.8.3), let Gn = Sn K. This derivative
security permits its owner to buy one share of stock in exchange for a payment
of K at any time up to the expiration time N . If the purchase has not been
made at time N , it must be made then. Determine the time-zero value and
optimal exercise policy for this derivative security. (Assume r 0.)
1
Solution Set Yn = (1+r)
n (Sn K), n = 0, 1, . . . , N . We assume r 0.
Because the discounted stock price is a martingale under the risk-neutral
K
measure and (1+r)
n+1 is not random, we have
Sn+1
K
e
e
e
En [Yn+1 ] = En
En
(1 + r)n+1
(1 + r)n+1
Sn
K
=
(1 + r)n
(1 + r)n+1
K
Sn
(1 + r)n
(1 + r)n
V0 =
max
S0 , N
e
E
1
1
e
G E
GN .
(1 + r)
(1 + r)N
On the other hand, because the stopping time that is equal to N regardless
of the outcome of the coin tossing is in the set of stopping times over which
the above maximum is taken, we must in fact have equality:
V0 =
max
S0 , N
e
E
1
1
e
=
E
.
G
G
N
(1 + r)
(1 + r)N
39
5
Random Walk
1
f ()
n
is a martingale.
(iii) Show that for > 0,
e
= E I{1 <}
1
f ()
1
(v) Compute E1 .
Solution.
42
5 Random Walk
(ii) We compute
e n [Sn+1 ] =
E
1
f ()
1
f ()
n+1
n+1
h
i
e n e(Mn +Xn+1 )
E
eMn E eXn+1
n+1
1
eMn pe + qe
f ()
n
1
Mn
=e
= Sn .
f ()
=
1
f ()
n1
(5.8.1)
Mn1
1
f ()
n1
= I{1 <} e
1
f ()
,
1 = E I{1 <} e
f ()
or equivalently,
e
= E I{1 <}
1
f ()
1
(5.8.2)
This equation holds for all positive . We let 0 to obtain the formula
1 = EI{1 <} = P{1 < }.
(iv) We now introduce (0, 1) and solve the equation =
This equation can be written as
pe + qe = 1,
which may be rewritten as
q e
2
e + p = 0,
1
f ()
for e .
1 42 pq
.
2q
43
(5.8.3)
e =
.
2q
Substituting this into (5.8.2), we obtain the formula
p
1 1 42 pq
1
E =
.
2q
(5.8.4)
1 (1 2q)2
1
1
1 (1 2q)
1 1 4pq
p
=
=
=
.
=
E1 =
2
2q(1 2q)
1 2q
pq
2q 1 4pq
2q (1 2q)
1 1 2
2
E =
for all (0, 1).
Using the power series (5.2.21), we may write the right-hand side as
!2
2 1 1 2
1 1 2
=
1
= 1 +
=
=
2j2
X
(2j 2)!
2
j!(j
1)!
j=1
2j2
X
(2j 2)!
2
j!(j
1)!
j=2
2k
X
k=1
(2k)!
.
(k + 1)!k!
44
5 Random Walk
k=1
2k P{2 = 2k} =
2k
X
k=1
(2k)!
.
(k + 1)!k!
= 1 P{M2k = 0} P{M2k = 2}
2k
2k
1
(2k)!
(2k)! 1
.
= 1
k!k! 2
(k + 1)!(k 1)! 2
Consequently,
P{2 = 2k}
= P{2 2k} P{2 2k 2}
2k2
(2k 2)!
(2k 2)!
1
+
=
2
(k 1)!(k 1)! k!(k 2)!
2k
1
(2k)!
(2k)!
+
2
k!k!
(k + 1)!(k 1)!
2k
1
4(2k 2)!
(2k)!
=
2
(k 1)!(k 1)!
k!k!
2k
1
4(2k 2)!
(2k)!
+
2
k!(k 2)!
(k + 1)!(k 1)!
45
2k
1
2k 2k(2k 2)! 2k(2k 1)(2k 2)!
=
2
k!k!
2k
(2k + 2)(2k 2)(2k 2)! 2k(2k 1)(2k 2)!
1
+
2
(k + 1)!(k 1)!
2k 2
2
4k (2k 2)! (4k 2k)(2k 2)!
1
=
2
k!k!
2k
2
1
(4k 4)(2k 2)! (4k 2 2k))(2k 2)!
+
2
(k + 1)!(k 1)!
2k
1
2k(2k 2)! 2(k 2)(2k 2)!
=
+
2
k!k!
(k + 1)!(k 1)!
2k
1
=
2
2k
1
=
2
2k
1
=
2
(2k 2)!
(2k(k + 1) + 2(k 2)k
(k + 1)!k!
(2k 2)!
2k(2k 1)
(k + 1)!k!
(2k)!
.
(k + 1)!k!
s
2
(5.7.4)
46
5 Random Walk
1
4 1
j+1
j1
v(2 ) + v(2 )
c(2 ) = v(2 )
5 2
2
2
4 2j+1 + 4 2j1
= 4 2j
5
2
j
= 42
8 5 2j1
5
4
= .
5
j
For j = 1, we have
1
4 1
v(4) + v(1)
c(2) = v(2)
5 2
2
2
= 2 [1 + 3]
5
2
= .
5
Finally, for j 2,
4 1
1
j+1
j1
c(2 ) = v(2 )
v(2 ) + v(2 )
5 2
2
4
2
4
4
= j
+ j1
2
5 2j+1
2
2
16
4
4
+ j+1
= j
2
5 2j+1
2
= 0.
j
4 2j+1 4 2j1
v(2j+1 ) v(2j1 )
=
= 1.
(2 ) =
2j+1 2j1
2j+1 2j1
j
47
For j = 1, we have
(2) =
13
2
v(4) v(1)
=
= .
41
41
3
Finally, for j 2,
v(2j+1 ) v(2j1 )
2j+1 2j1
4
4
j1
j+1
2
2
= j+1
2
2j1
4 16
1
= j+1
2
(4 1)2j1
4
= 2j .
2
(2j ) =
4
16
+ 2j =
,
5
5
44
2 2
+ 2=
,
5 3
15
48
5 Random Walk
8
4
2j+1 = j ,
22j
2
2
4
2j1 = j ,
22j
2
49
2 s
2
.
v(2s) + v
5
5 2
(5.7.5)
All such solutions are of the form sp for some constant p, or linear combinations of functions of this form. Substitute sp into (5.7.5), obtain a
quadratic equation for 2p , and solve to obtain 2p = 2 or 2p = 21 . This
leads to the values p = 1 and p = 1, i.e., v1 (s) = s and v2 (s) = 1s are
solutions to (5.7.5).
(ii) The general solution to (5.7.5) is a linear combination of v1 (s) and v2 (s),
i.e.,
B
(5.7.6)
v(s) = As + .
s
For large values of s, the value of the perpetual American put must be
given by (5.7.6). It remains to evaluate A and B. Using the second boundary condition in (5.4.15), show that A must be zero.
(iii) We have thus established that for large values of s, v(s) = Bs for some
constant B still to be determined. For small values of s, the value of the
put is its intrinsic value 4 s. We must choose B so these two functions
coincide at some point, i.e., we must find a value for B so that, for some
s > 0,
B
fB (s) =
(4 s)
s
equals zero. Show that, when B > 4, this function does not take the value
0 for any s > 0, but, when B 4, the equation fB (s) = 0 has a solution.
(iv) Let B be less than or equal to 4 and let sB be a solution of the equation
fB (s) = 0. Suppose sB is a stock price which can be attained in the model
(i.e., sB = 2j for some integer j). Suppose further that the owner of the
perpetual American put exercises the first time the stock price is sB or
smaller. Then the discounted risk-neutral expected payoff of the put is
vB (S0 ), where vB (s) is given by the formula
4 s, if s sB ,
(5.7.7)
vB (s) = B
if s sB .
s,
Which values of B and sB give the owner the largest option value?
0
(v) For s < sB , the derivative of vB (s) is vB
(s) = 1. For s > sB , this
B
0
derivative is vB (s) = s2 . Show that the best value of B for the option
owner makes the derivative of vB (s) continuous at s = sB (i.e., the two
0
formulas for vB
(s) give the same answer at s = sB ).
50
5 Random Walk
Solution
(i) With v(s) = sp , (5.7.5) becomes
sp =
Mulitplication by
2p
sp
2 p p 2 1 p
2 s + ps ,
5
5 2
leads to
2p =
2 p 2 2
(2 ) + ,
5
5
(2p )
5 p
2 + 1 = 0,
2
4 =
2 2
4
2 2 2
We thus have either 2p = 2 or 2p = 12 , and hence either p = 1 or p = 1.
This results in the critical point sc = B. We note that the second derivative, 2B
s3 , is positive on (0, ), so the function is convex, and hence f B
attains a minimum at sc . The minimal value of fB on (0, ) is
fB (sc ) = 2 B 4.
This is positive if B > 4, in which case fB (s) = 0 has no solution in
(0, ). If B = 4, then fB (sc ) = 0 and sc is the only solution to the
equation fB (s) = 0 in (0, ). If 0 < B < 4, then fB (sc ) < 0 and the
equation fB (s) = 0 has two solutions in (0, ).
(iv) Since vB (s) = Bs for all large values of s, we maximize this by choosing
B as large as possible, i.e., B = 4. For values of B < 4, the curve Bs lies
below the curve 4s (see Figure 5.8.1), and values of B > 4 are not possible
because of part (iii).
51
(iv) We see from the tangency of the curve y = 4s with the intrinsic value
y = 4 s at the point (2,2) in Figure 5.8.1 that y = 4s and y = 4 s have
the same derivative at s = 2. Indeed,
4
d 4
= 2
= 1,
ds s s=2
s s=2
and as noted in the statement of the exercise,
d
(4 s) = 1.
ds
y
(2, 2)
y=
4
s
y =4s
1
3
B
s
y=
4
for B = 3 and B = 4.
3
s
6
Interest-Rate-Dependent Assets
= c1
e n+1 = n+1 , . . . , N = N |1 = 1 , . . . , n = n }
P{
X
X( 1 . . . n n+1 . . . N )
n+1 ,..., N
e n+1 = n+1 , . . . , N = N |1 = 1 , . . . , n = n }
P{
X
Y ( 1 . . . n n+1 . . . N )
+c2
n+1 ,..., N
e n+1 = n+1 , . . . , N = N |1 = 1 , . . . , n = n }
P{
e n [X]( 1 . . . n ) + c2 E
e n [Y ]( 1 . . . n ).
= c1 E
(ii) Taking out what is known. If X depends only on the first n coin
tosses, then
54
6 Interest-Rate-Dependent Assets
e n [XY ]( 1 . . . n )
E
X
X( 1 . . . n )Y ( 1 . . . n n+1 . . . N )
=
n+1 ,..., N
e n+1 = n+1 , . . . , N = N |1 = 1 , . . . , n = n }
P{
X
Y ( 1 . . . n n+1 . . . N )
= X( 1 . . . n )
n+1 ,..., N
e n+1 = n+1 , . . . , N = N |1 = 1 , . . . , n = n }
P{
e n [Y ]( 1 . . . n )
= X( 1 . . . n )E
|1 = 1 , . . . , n = n }
e n+1 = n+1 , . . . , m = m |1 = 1 , . . . , n = n },
= P{
we have
en E
e m [X] ( 1 . . . n )
E
X
e m [X]( 1 . . . m )
E
=
n+1 ,..., N
n+1 ,..., m
n+1 ,... m
m+1 ,..., N
e n+1 = n+1 , . . . , m = m |1 = 1 , . . . , n = n }
P{
X
X
X( 1 . . . m m+1 . . . N )
e m+1 = m+1 , . . . , N = N |1 = 1 , . . . , m = m }
P{
e n+1 = n+1 , . . . , m = m |1 = 1 , . . . , n = n },
P{
55
e m [X]( 1 . . . m )
E
X
X( 1 . . . m m+1 . . . N )
=
m+1 ,..., N
e m+1 = m+1 , . . . , N = N |1 = 1 , . . . , m = m }
P{
e m+1 = m+1 , . . . , N = N |1 = 1 , . . . , m = m }
P{
e n+1 = n+1 , . . . , m = m |1 = 1 , . . . , n = n }
P{
e m [X] ( 1 . . . n )
en E
we may write the last term in the above formula for E
as
e m [X] ( 1 . . . n )
en E
E
X
X
X( 1 . . . m m+1 . . . N )
=
n+1 ,..., m m+1 ,..., N
e n+1 = n+1 , . . . , N = N |1 = 1 , . . . , n = n }
P{
X
X( 1 . . . N )
n+1 ,..., N
e n+1 = n+1 , . . . , N = N |1 = 1 , . . . , n = n }
P{
e n [X]( 1 . . . n ).
=E
(iv) Conditional Jensens inequality. This follows from part (i) just like
the proof of part (v) in Appendix A.
Exercise 6.2. Verify that the discounted value of the static hedging portfolio
e
constructed in the proof of Theorem 6.3.2 is a martingale under P.
Solution The static hedging portfolio in Theorem 6.3.2 is, at time n, to short
Sn
Bn,m zero coupon bonds maturing at time m and to hold one share of the
asset with price Sn . The value of this portfolio at time k, where n k m,
is
Sn
Xk = S k
Bk,m , k = n, n + 1, . . . , m.
Bn,m
For n k m 1, we have
e k [Dk+1 Xk+1 ] = E
e k [Dk+1 Sk+1 ] Sn E
e k [Dk+1 Bk+1,m ] .
E
Bn,m
56
6 Interest-Rate-Dependent Assets
Using the fact that the discounted asset price is a martingale under the
risk-neutral measure and also using (6.2.5) first in the form Dk+1 Bk+1,m =
e k+1 [Dm ] and then in the form Dk Bk,m = E
e k [Dm ], we may rewrite this as
E
e k+1 [Dm ]
ek E
e k [Dk+1 Xk+1 ] = Dk Sk Sn E
E
Bn,m
Sn e
= D k Sk
Ek [Dm ]
Bn,m
Sn
= D k Sk
Dk Bk,m
Bn,m
= D k Xk .
V2 (HH) =
1
1
V3 (HH) = ,
1 + R2 (HH)
3
V2 (HT ) = V2 (T H) = V2 (T T ) = 0.
Indeed, if one is hedging a short position in the caplet and has a portfolio
valued at 13 at time two in the event 1 = H, 2 = H, then one can simply
invest this 31 in the money market in order to have the 23 required to pay off
the caplet at time three.
2
21
(i) Determine V1 (H) and V1 (T ), the price at time one of the caplet in the
events 1 = H and 1 = T , respectively.
2
at time zero and invest in the money market
(ii) Show how to begin with 21
and the maturity two bond in order to have a portfolio value X1 at time
one that agrees with V1 , regardless of the outcome of the first coin toss.
Why do we invest in the maturity two bond rather than the maturity
three bond to do this?
(iii) Show how to take the portfolio value X1 at time one and invest in the
money market and the maturity three bond in order to have a portfolio
value X2 at time two that agrees with V2 , regardless of the outcome of the
first two coin tosses. Why do we invest in the maturity three bond rather
than the maturity two bond to do this?
57
Solution.
(i) We determine V1 by the risk-neutral pricing formula. In particular,
1 e
E1 [D2 V2 ](H)
D1 (H)
e 2 = H|1 = H}D2 (HH)V2 (HH)
= P{
e 2 = T |1 = H}D2 (HT )V2 (HT )
+P{
V1 (H) =
2 6 1 1 6
4
+ 0 =
,
3 7 3 3 7
21
1 e
E1 [D2 V2 ](T ) = 0.
V1 (T ) =
D1 (T )
=
(ii) We compute the number of shares of the time-two maturity bond by the
usual formula:
0 =
V1 (H) V1 (T )
=
B1,2 (H) B1,2 (T )
4
21 0
6
5
7 7
4
.
3
2
21
and compute
V2 (HH) V2 (HT )
=
B2,3 (HH) B2,3 (HT )
1
3
1
2
0
2
= .
3
1
58
6 Interest-Rate-Dependent Assets
We do not use the maturity two bond because B2,2 (HH) = B2,2 (HT ), and
this bond therefore provides no hedge against the second coin toss.