Solutions to Stochastic Calculus for Finance I (Steven Shreve)

Dr. Guowei Zhao

Department of Mathematics and Statistics
McMaster University
Hamilton,ON L8S 4K1
September 9, 2013

Contents
1 Chapter 1
1.1 Exercise 1.3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.2 Exercise 1.4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.3 Exercise 1.8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2
2
2
2

2 Chapter 2
2.1 Exercise
2.2 Exercise
2.3 Exercise
2.4 Exercise
2.5 Exercise
2.6 Exercise

2.3 .
2.4 .
2.6 .
2.7 .
2.9 .
2.13

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4
4
4
5
5
6
6

3 Chapter 3
3.1 Exercise
3.2 Exercise
3.3 Exercise
3.4 Exercise
3.5 Exercise

3.2
3.3
3.4
3.6
3.7

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7
7
8
9
10
11

4 Chapter 4
4.1 Exercise 4.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.2 Exercise 4.3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.3 Exercise 4.5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11
11
13
14

5 Chapter 5
5.1 Exercise 5.2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.2 Exercise 5.4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.3 Exercise 5.5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16
16
18
19

Email:

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zhaog22@mcmaster.ca

Introduction
This solution manual will be updated anytime, and is NOT intended for any business use. The author
suggests this manual as a reference book to the metioned book by Steven Shreve. Also anyone involved
in any mathematical finance courses shall not copy the solutions in this book directly. This is ideally
for self-check purpose.
If anyone find any mistakes or misprints in this book, please inform me. Thanks.

Chapter 1

1.1

Exercise 1.3
p =

1 + 41
2 21

1
2

1
,
2

q =

1
2

Then by the neutral pricing formula (1.1.10) of Text,

1
[
pV1 (H) + qV1 (T )]
1 + 14
4
pS1 (H) + qS1 (T )]
= [
5

4 1
1
=
8+ 2
5 2
2

V0 =

=4
Therefore V1 = S1 implies V0 = S0 .

1.2

Exercise 1.4

The case of n = 0 is given by the definition. Suppose its true for n, now for n + 1:
Xn+1 (1 . . . n T ) = n (1 . . . n )dSn (1 . . . n ) + (1 + r)(Xn (1 . . . n ) n (1 . . . n )Sn (1 . . . n ))
To simplify the notation, we suppress (1 . . . n ) and rewrite it as
Xn+1 (T ) =n dSn + (1 + r)(Xn n Sn )
=(1 + r)Xn + n Sn (d (1 + r))
Vn+1 (H) Vn+1 (T )
ud
=
pVn+1 (H) + qVn+1 (T ) (
pVn+1 (H) + qVn+1 (T ))
=(1 + r)Vn + (d (1 + r))

=Vn+1 (T )
This completes the proof.

1.3

Exercise 1.8

1. For the three-period model of the stock price

S3 (HHH) = 32
S2 (HH) = 8
S3 (HHT ) = 8
S1 (H) = 8
S3 (HT H) = 8
S2 (HT ) = 4
S3 (HT T ) = 2
S0 = 4
S3 (T HH) = 8
S2 (T H) = 4
S3 (T HT ) = 2
S1 (T ) = 2
S3 (T T H) = 2
S2 (T T ) = 1
S3 (T T T ) = 0.5
The correponsding pairs of (s, y) are:
(32, 60)
(16, 28)
(8, 36)
(8, 12)
(8, 24)
(4, 16)
(2, 18)
(4, 4)
(8, 18)
(4, 10)
(2, 12)
(2, 6)
(2, 9)
(1, 7)
(0.5, 7.5)
At time three, there are 8 possible pairs for (S3 , Y3 ), namely
(32, 60),

(8, 36),

(8, 24),

(2, 18),

(8, 18),

(2, 12),

(2, 9),

(0.5, 7.5)

Since the payoff of the option at time three is given by v3 (s, y) = ( 41 y 4)+ , then
v3 (32, 60) = 11,

v3 (8, 36) = 5,

v3 (8, 24) = 2,

v3 (8, 18) = 0.5,

v3 (2, 12) = 0,

v3 (2, 9) = 0,

v3 (2, 18) = 0.5

v3 (0.5, 7.5) = 0

Then the algorithm of Theorem 1.2.2 of Text can be written as



1
1
1
s
s
2h
s
s i
vn (s, y) =
v
(2s,
y
+
2s)
+
v
(
,
y
+
)
=
v
(2s,
y
+
2s)
+
v
(
,
y
+
)
n+1
n+1
n+1
n+1
2
2
2
5
2
2
1 + 41 2
(1.1)
3

2. By (1.1), we continue the computation as

2
[v3 (32, 60) + v3 (8, 36)] = 6.4
5
2
v2 (4, 16) = [v3 (8, 24) + v3 (2, 18)] = 1
5
2
v2 (4, 10) = [v3 (8, 18) + v3 (2, 12)] = 0.2
5
2
v2 (1, 7) = [v3 (2, 9) + v3 (0.5, 7.5)] = 0
5

v2 (16, 28) =

Then we compute
2
[v2 (16, 28) + v2 (4, 16)] = 2.96
5
2
v1 (2, 6) = [v2 (4, 10) + v2 (1, 7)] = 0.08
5

v1 (8, 12) =

Eventually
v0 (4, 4) =

2
[v1 (8, 12) + v1 (2, 6)] = 1.216
5

3. At each time n = 0, 1, 2, the number of shares of stock that shoudl be held by replicating portfolio
is
vn+1 (2s, y + 2s) + vn+1 ( 2s , y + 2s )
n (s) =
2s 2s

Chapter 2

2.1

Exercise 2.3

By Jensens Inequality
En [(Mn+1 )] (En [Mn+1 ]) = (Mn )
The latter is by the martingale property of Mn .

2.2

Exercise 2.4

1.
1
1
Mn+1 (1 . . . n H) + Mn+1 (1 . . . n T )
2
2
1
1
= (Mn (1 . . . n ) + 1) + (Mn (1 . . . n ) 1)
2
2
= Mn (1 . . . n )

En (Mn+1 )(1 . . . n ) =

so Mn is martingalge.
2.
1
1
Sn+1 (1 . . . n H) + Sn+1 (1 . . . n T )
2
2
1
2
1
2
= Sn (1 . . . n )e1
+ Sn (1 . . . n )e(1)
2
e + e
2
e + e
= Sn (1 . . . n )

En (Sn+1 )(1 . . . n ) =

so Sn is martingalge.
4

2.3

Exercise 2.6

We suppress the arguments (1 . . . n ) for simplier notations.

En [In+1 ]

n
X
=En
j (Mj+1 Mj )
j=0

n1
X

=En

j (Mj+1 Mj ) + En [j (Mn+1 Mn )]

j=0

n1
X

j (Mj+1 Mj ) + n En [Mn+1 ] n Mn

j=0

=In + n Mn n Mn
=In
Therefore I0 ,I1 ,I2 ,. . . ,IN is a martingale.

2.4

Exercise 2.7

We construct the following binomial tree.

S3 (HHH) = 12
S2 (HH) = 9
S3 (HHT ) = 6
S1 (H) = 6
S3 (HT H) = 4
S2 (HT ) = 3
S3 (HT T ) = 2
S0 = 4
S3 (T HH) = 6
S2 (T H) = 3
S3 (T HT ) = 0
S1 (T ) = 2
S3 (T T H) = 2
S2 (T T ) = 1
S3 (T T T ) = 0
Here if the current result is H, then the next step would be 3 with equal probabilities; if the
current result is T, then then next step will be 1 with equal probabilities. Then it is very clear that
for any n
En [Xn+1 ] = Xn
which means this process is martingale.
Now let f (x) = x2 . We investigate
1 2
4 +
2
1
E2 [f (M3 )](T H) = 62 +
2
E2 [f (M3 )](HT ) =

1 2
2 = 10
2
1 2
0 = 18
2

Note that M2 (HT ) = M2 (T H) = 3, so there cannot be a function g such that

(
E2 [f (M3 )](HT ) = g(M2 (HT ))
E2 [f (M3 )](T H) = g(M2 (T H))
i.e.,
(

10 = g(3)
18 = g(3)

Therefore this process is not Markov.

2.5

Exercise 2.9

1.
1+ 1 1
1
P (HH) = 12 4
=
2
8 1
1+
P (T H) = 8
2

1
2

1
1
=
6
1

1
P (HT ) =
2
5
P (T T ) =
6

2. Since V2 (HH) = 5,V2 (HT ) = V2 (T H) = 1,V2 (T T ) = 0,

4 1
1
( V2 (HH) + V2 (HT )) = 2.4
5 2
2
2 1
5
1
V1 (T ) = ( V2 (T H) + V2 (T T )) = 0.1111
3 6
6
9
4 1
1
V1 (T ) = ( V1 (H) + V1 (T )) 1.0044
5 2
2

V1 (H) =

3.
0 =

V1 (H) V1 (T )
2.4 0.1111
=
0.3815
S1 (H) S1 (T )
82

To see it more clearly, we compute the value of the portfolio at time one
1
X1 (H) = 0 S1 (H) + (1 + r)(V0 0 S0 ) = 0.3815 8 + (1 + )(1 0.3815 4) = 2.3945 2.40 = V1 (H)
4
1
X1 (T ) = 0 S1 (T ) + (1 + r)(V0 0 S0 ) = 0.3815 2 + (1 + )(1 0.3815 4) = 0.1055 0.1111 = V1 (T )
4
4.
1 (H) =

2.6

51
V2 (HH) V2 (HT )
=
=1
S2 (HH) S2 (HT )
12 8

Exercise 2.13

1. Let Z = Sn+1 /Sn , which only depends on the (n + 1)th coin toss, then
Sn+1
Sn
=Yn + Sn+1 = Yn + Sn Z

Sn+1 =Sn
Yn+1

We need to compute for arbitrary choice of function h,

En [h(Sn+1 , Yn+1 )] = En [h(Sn Z, Yn + Sn Z)]
6

Now we define
g(s, y) = E[h(sZ, y + sZ)] = ph(su, y + su) + qh(sd, y + sd)
Then we have
En [h(Sn+1 , Yn+1 )] = g(Sn , Yn )
which means (Sn , Yn ) is a Markov process.
Similarly for the case under the risk-neutral probability.
2. First for n = N ,
N
1 X
Sn
N + 1 n=0

VN (SN , YN ) = VN = f


=f

YN
N +1

Replacing by dummy variables, we have


VN (s, y) = f

y
N +1

Then for n = N 1, N 2, . . . , 0, we have

vn (Sn , Yn )


vN (SN , YN )

=En
(1 + r)N n
1
=
En [Vn+1 ]
r+1
1
En [vn+1 (Sn+1 , Yn+1 )]
=
r+1


1
Sn+1
Sn+1
=
En vn+1 (Sn
, Yn + Sn
)
r+1
Sn
Sn
Replacing by dummy variables, we have
vn (s, y) =

1
[
pvn+1 (us, y + us) + qvn+1 (ds, y + ds)]
r+1

Chapter 3

3.1

Exercise 3.2

1.
P () =

P () =

Z()P () = EZ = 1

2.
=
EY

Y ()P () =

Y ()Z()P () = E[ZY ]

3. Since P (Z 0) = 1, we can apply Holders inequality as:

"
# "
#
"
#
X
X
X
X
X
0 P (A) =
P () =
Z()P ()
P ()
Z() = P (A)
Z() = 0
A

therefore P (A) = 0 implies P (A) = 0.

7

4. Under the assumption P (Z > 0) = 1,

0 P (A) =

P () =

X
A

"
#
#
"
# "
X 1
X
X 1
1

= P (A)
=0
P ()
P ()
Z()
Z()
Z()
A

therefore P (A) = 0.
5.
P (A) = 1 P (Ac ) = 0 P (Ac ) = 0 P (A) = 1
which means the equivalent probability measures also agree with which events have probability
1.
6. We consider the following example in which the given two probability measures are not equivalent:
S1 (H) = 2

S0 = 1

S1 (T ) = 0.5
with P (H) = 1/2 = P (T ) and P (H) = 1, P (T ) = 0. Then
Z(H) =

P (H)
= 2,
P (H)

Z(T ) =

P (T )
=0
P (T )

which gives P (Z 0) = 1. However P (T ) = 0 6= 1/2 = P (T ), so they are not equivalent.

3.2

Exercise 3.3

For n = 3,
M3 = E3 [S3 ] = S3
For n = 2,
1
2
32 + 8 = 24
3
3
2
1
M2 (HT ) =E2 [S3 ](HT ) = 8 + 2 = 6
3
3
2
1
M2 (T H) =E2 [S3 ](HH) = 8 + 2 = 6
3
3
2
1 1
M2 (T T ) =E2 [S3 ](HH) = 2 + = 1.5
3
3 2

M2 (HH) =E2 [S3 ](HH) =

For n = 1,
2
1
24 + 6 = 18
3
3
2
1
M1 (T ) =E1 [S3 ](T ) = E1 [E2 [S3 ]](T ) = 6 + 1.5 = 4.5
3
3

M1 (H) =E1 [S3 ](H) = E1 [E2 [S3 ]](H) =

For n = 0,
M0 = E0 [S3 ](H) = E0 [E1 [S3 ]](H) =

2
1
18 + 4.5 = 13.5
3
3

Therefore the binomial tree of Mn is:

M3 (HHH) = 24

M2 (HH) = 24

M1 (H) = 18

M3 (HHT ) = M3 (HT H) = M3 (T HH) = 8

2
3

M0 = 13.5

M2 (HT ) = M2 (T H) = 6
1
3

M1 (T ) = 4.5

M3 (HT T ) = M3 (T T H) = M3 (T HT ) = 2

M2 (T T ) = 1.5

M3 (T T T ) = 0.5
Note that the above computation of Mn is also the verfication of the martingale property by
iteration property of the conditional expectation, which is for n = 0, 1, 2:
En [Mn+1 ] = En [En+1 [S3 ]] = En [S3 ] = Mn

3.3

Exercise 3.4

1.
3 (HHH) =

27
Z3 (HHH)
27
64
=
=
1
3
3
(1 + r)
125
(1 + 4 )

3 (HHT ) =3 (HT H) = 3 (T HH) =

3 (HT T ) =3 (HT T ) = 3 (T T H) =
3 (T T T ) =

27
54
Z3 (HHH)
32
=
=
(1 + r)3
125
(1 + 41 )3
27
Z3 (HT T )
108
16
=
=
(1 + r)3
125
(1 + 41 )3

27
Z3 (T T T )
216
8
=
=
1
3
3
(1 + r)
125
(1 + 4 )

2.
V0 =E[V3 ] =

V3 ()3 ()P ()

27 8
54 4
54 4
108 2

+5

+2

+ 0.5
+
125 27
125 27
125 27
125 27
54 4
108 2
108 2
216 1
+ 0.5

+0

+0

+0

125 27
125 27
125 27
125 27
4104
=
125 27
=1.216
=11

which is the same as Exercise (1.3).

3.
2 (HT ) = 2 (T H) =

18
Z2 (HT )
=
25
(1 + 14 )2

4.


1
2
1
V2 (HT ) =
=
3 (HT H)V3 (HT H) + 3 (HT T )V3 (HT T )
2 (HT )
3
3


25 2
54
1 108
25 5 54
=

2+
0.5 =

=1
18 3 125
3 125
18 3 125


2
1
1
V2 (T H) =
=
3 (T HH)V3 (T HH) + 3 (T HT )V3 (T HT )
2 (T H)
3
3


25 2
54
1 108
25
54
=

0.5 +
0 =

= 0.2
18 3 125
3 125
18 3 125
Note that V2 (HT ) = v2 (4, 16) 6= v2 (4, 10) = V2 (T H).

3.4

Exercise 3.6

When the utility function U (x) = ln x, U 0 (x) = 1/x, then the equation (3.3.24) of Textbook yields
1
Z
=
XN
(1 + r)N
(1 + r)N
XN =
Z
Then (3.3.29) of Text becomes
Z
(1 + r)N
E

(1 + r)N
Z



= X0

which implies = 1/X0 . Therefore

XN =

(1 + r)N
(1 + r)N
X0 (1 + r)N
X0
=
=
=
Z
Z/X0
Z
N

Then we treat it as the payoff of a derivative security. Then by (3.2.6) of Text,

Xn = Vn =

1
1
1
X0
X0
En [N VN ] = En [N XN ] = En [N
]=
n
n
n
N
n
10

3.5

Exercise 3.7

When the utility function U (x) = p1 xp , U 0 (x) = xp1 , then the equation (3.3.24) of Textbook yields
Z
(1 + r)N
1
 p1

Z
=
(1 + r)N

p1
XN
=

XN
Then (3.3.29) of Text becomes
"

Z
E

(1 + r)N
"

1
p1

Z
(1 + r)N

1 #
 p1

= X0
#

Z 1+ p1

= X0

(1 + r)N (1+ p1 )

which implies
1

p1 =

X0 (1 + r)p/(p1)
E[Z p/(p1) ]

Therefore

XN =
=

Z
(1 + r)N

1
 p1

X0 Z 1/(p1)
p

E[Z p1 ]


=

Z
(1 + r)N

1
 p1

X0 (1 + r)p/(p1)
p

E[Z p1 ]
1

(1 + r)N ( p1 p1 ) =

X0 (1 + r)N Z p1
p

E[Z p1 ]

Chapter 4

4.1

Exercise 4.1

1. For the American put, g(s) = 4 s, (or (4 s)+ ), then we follow the American algorithm (4.2.5)
and (4.2.6) of Text as:
v3 (32) = max{4 32, 0} = 0
v3 (8) = max{4 8, 0} = 0
v3 (2) = max{4 2, 0} = 2
v3 (0.5) = max{4 0.5, 0} = 3.5
2
v2 (16) = max{4 16, (v3 (32) + v3 (8))} = max{12, 0} = 0
5
2
v2 (4) = max{4 4, (v3 (8) + v3 (2))} = max{0, 0.8} = 0.8
5
2
v2 (1) = max{4 1, (v3 (2) + v3 (0.5))} = max{3, 2.2} = 3
5
2
v1 (8) = max{4 8, (v2 (16) + v2 (4))} = max{4, 0.32} = 0.32
5
2
v1 (2) = max{4 2, (v2 (4) + v2 (1))} = max{2, 1.52} = 2
5
2
v0 (4) = max{4 4, (v1 (8) + v1 (2))} = max{0, 0.928} = 0.928
5
So V0P = 0.928.
11

2. For the American call, g(s) = s 4, (or (s 4)+ ), then we follow the American algorithm (4.2.5)
and (4.2.6) of Text as:
v3 (32) = max{32 4, 0} = 28
v3 (8) = max{8 4, 0} = 4
v3 (2) = max{2 4, 0} = 0
v3 (0.5) = max{0.5 4, 0} = 0
2
v2 (16) = max{16 4, (v3 (32) + v3 (8))} = max{12, 12.8} = 12.8
5
2
v2 (4) = max{4 4, (v3 (8) + v3 (2))} = max{0, 1.6} = 1.6
5
2
v2 (1) = max{1 4, (v3 (2) + v3 (0.5))} = max{3, 0} = 0
5
2
v1 (8) = max{8 4, (v2 (16) + v2 (4))} = max{4, 5.76} = 5.76
5
2
v1 (2) = max{2 4, (v2 (4) + v2 (1))} = max{2, 0.64} = 0.64
5
2
v0 (4) = max{4 4, (v1 (8) + v1 (2))} = max{0, 2.56} = 2.56
5
So V0C = 2.56.
3. For the straddle option, g(s) = (4 s)+ + (s 4)+ = |s 4|. Then we follow the American
algorithm (4.2.5) and (4.2.6) of Text as:
v3 (32) = max{|32 4| , 0} = 28
v3 (8) = max{|8 4| , 0} = 4
v3 (2) = max{|4 2| , 0} = 2
v3 (0.5) = max{|4 0.5| , 0} = 3.5
2
v2 (16) = max{|16 4| , (v3 (32) + v3 (8))} = max{12, 12.8} = 12.8
5
2
v2 (4) = max{|4 4| , (v3 (8) + v3 (2))} = max{0, 2.4} = 2.4
5
2
v2 (1) = max{|1 4| , (v3 (2) + v3 (0.5))} = max{3, 2.2} = 3
5
2
v1 (8) = max{|8 4| , (v2 (16) + v2 (4))} = max{4, 6.08} = 6.08
5
2
v1 (2) = max{|2 4| , (v2 (4) + v2 (1))} = max{2, 2.16} = 2.16
5
2
v0 (4) = max{|4 4| , (v1 (8) + v1 (2))} = max{0, 3.2964} = 3.296
5
So V0P = 3.296.
4. Note that V0P = 3.296 < 3.488 = 0.928 + 2.56 = V0P + V0C .
Inspried by the above computation, especially the three v1 (2) values, 2.16 < 2 + 0.64, we can
conclude the reason why V0P < V0P + V0C . For the American call, it is never optimal to exercise
the option before time three. For the American put, it is optimal to make the early exercise at
time one at the node v1 (2). However, for the straddle, the optimal policy is not to exercise at
time one at the node v1 (2). As the result, the expected return of the straddle will be strickly
less than the summation of two separate American call and put options which have their own
different optimal exercise time.
12

4.2

Exercise 4.3

For the three-period model of the stock price

S3 (HHH) = 32
S2 (HH) = 8
S3 (HHT ) = 8
S1 (H) = 8
S3 (HT H) = 8
S2 (HT ) = 4
S3 (HT T ) = 2
S0 = 4
S3 (T HH) = 8
S2 (T H) = 4
S3 (T HT ) = 2
S1 (T ) = 2
S3 (T T H) = 2
S2 (T T ) = 1
S3 (T T T ) = 0.5
Denote Yn =

Pn

j=0

Sj as Exercise 1.8. Then the correponsding pairs of (s, y) are:

(32, 60)
(16, 28)
(8, 36)
(8, 12)
(8, 24)
(4, 16)
(2, 18)

(4, 4)
(8, 18)
(4, 10)
(2, 12)
(2, 6)
(2, 9)
(1, 7)
(0.5, 7.5)
At time three, there are 8 possible pairs for (S3 , Y3 ), namely
(32, 60),

(8, 36),

(8, 24),

(2, 18),

13

(8, 18),

(2, 12),

(2, 9),

(0.5, 7.5)

Since the payoff of the option at time three is given by vn (s, y) = (4

y
+
n+1 )) ,

then


+
1
v3 (32, 60) = 4 60
=0
4

+
1
v3 (8, 36) = 4 36
=0
4

+
1
v3 (8, 24) = 4 24
=0
4

+
1
v3 (2, 18) = 4 18
=0
4
+

1
=0
v3 (8, 18) = 4 18
4

+
1
v3 (2, 12) = 4 12
=1
4

+
1
v3 (2, 9) = 4 9
= 0.75
4
+

1
= 2.125
v3 (0.5, 7.5) = 4 7.5
4
Then we continue Theorem 4.4.3 of Text as:
v2 (16, 28) = max{(4
v2 (4, 16) = max{(4
v2 (4, 10) = max{(4
v2 (1, 7) = max{(4
v1 (8, 12) = max{(4
v1 (2, 6) = max{(4
v0 (4, 4) = max{(4

1
3
1
3
1
3
1
3
1
2
1
2
1
1

2
28)+ , (0 + 0)} = 0
5
+ 2
16) , (0 + 0)} = 0
5
2
+ 2
10) , (0 + 1)} =
5
3
5
+ 2
7) , (1.75 + 2.125)} =
5
3
+ 2
12) , (0 + 0)} = 0
5
5
+ 2 2
6) , ( + )} = 1
5 3 3
+ 2
4) , (0 + 1)} = 0.4
5

Now we note that v2 (4, 10), v2 (1, 7) and v1 (2, 6) are the nodes where Vn = Gn . Then by Definition
4.3.1 or (4.4.21) of Text, we can conclude that the optimal exercising policy/stopping time as:
(HHH) = (HHT ) = (HT H) = (HT T ) =
(T HH) = (T HT ) = (T T H) = (T T T ) = 1

4.3

Exercise 4.5

By the property of the stopping times, the cases such as (T T ) = 1 but (T H) = 2, or (HH) = 1
but (HT ) = 1, are not allowed. Therefore, all the 26 stopping times in S0 are:

14

 (HH)
0
1
1
1
1
1
2
2
2
2
2
2
2
2
2
2

(HT )
0
1
1
1
1
1
2
2
2
2
2

2
2
2
2
2

(T H)
0
1
2
2

1
2
2

1
2
2

1
2
2

1
2
2

(T T )
0
1
2

1
2

1
2

1
2

1
2

But we note that when (HH) = 2, or (HH) = 1, the option will be out of money as the intrinsic
value will be negative, so we shall not exercise in these cases. Therefore the remaining 11 possible sets
of stopping times are:
(HH)
0

(HT )
0
2
2
2
2
2

15

(T H)
0
1
2
2

1
2
2

(T T )
0
1
2

1
2





I{ 2} 4 G with the values in Fig.4.4.1 of Text. In
Then we compute the V0 = max 0 E
5
advance we compute the terms for the immediate later use:
 1
4
G1 (T ) =2.4
5
 2
4
G2 (HT ) =0.64
5
 2
4
G2 (T H) =0.64
5
 2
4
G2 (T T ) =2.56
5
Then we have
(HH)
0

(HT )
0
2
2
2
2
2

(T H)
0
1
2
2

1
2
2

(T T )
0
1
2

1
2

V0
1
1.36
0.96
0.32
0.80
0.16
1.2
0.80
0.16
0.64
0

Note that the largest value is the second row with (, 2, 1, 1), which gives 1.36 as (4.4.7) of Text.

Chapter 5

5.1

Exercise 5.2

1. Since
f 0 () = pe qe = e (pe2 q)
and also 0 < q < 1/2 < p, for any 0, pe2 q p q > 0, so we have f 0 () > 0 for any
0. Then f () > f (0) = p + q = 1 for any > 0.
2. By

En [Sn+1 ] =En Sn
=Sn

1 Xn+1
e
f ()

1
pe + qe
f ()

=Sn
we can conclude that Sn is a martingale.
3. As the symmetric random walk in Section 5.2 of Text, since Sn1 is a martingale, hence
"

n1 #
1
Mn1
1 = S0 = E[Sn1 ] = E e
(5.1)
f ()
16

We would like to take the limit n .

First, since 0 <

1
f ()

< 1,

lim

1
f ()

(

n1
=

1
f ()

 1

if 1 <

(5.2)

1 =

Second, since
0 eMn1 e

(5.3)

and
lim eMn1 = eM1 = e

if m <

(5.4)

Then by (5.2), (5.3) and (5.4), we have

lim e

Mn1

1
f ()

n1
=

 1
( 
1
,
e f ()

if 1 <
1 =

which is equivalent to
lim e

Mn1

1
f ()

n1
= I{1 <} e

1
f ()

1

Now we apply this result to (5.1) by taking the limit n , we will have


1 
1

E I{1 <} e
=1
f ()
Immediately,



 1 
1
E I{1 <}
= e
f ()

(5.5)

By taking the limit 0+, we will have E[I{1 <} ] = 1, which implies P (1 < ) = 1.
4. For any fixed number (0, 1), there is always a such that
=

1
1
=
f ()
pe + qe

which is
pe + qe 1 =0
p + qe2 e =0
e

1 42 pq
2q
p
1 1 42 pq
=
2q
=

since > 0, e < 1

It is also clear that this > 0.

Then immediately (5.5) yields
1

E [ ] =

p
1 42 pq
2q

by dropping I{1 <} due to the condition P (1 < ) = 1.

17

(5.6)

5. By taking the derivative with respect to in (5.6), we have

E [1 ]

p
1 1 42 pq
=

2q

E[1 1 1 ] =



p
1
12 (1 42 pq) 2 (8pq)2q 1 1 42 pq 2q
42 q 2

Then by taking the limit 1, we have

1
8pq 2 (1 4pq) 2 2q 1 1 4pq
4q 2

8pq 2 2q 1 4pq + 2q(1 4pq)

=
4q 2 1 4pq

2q 2q 1 4pq

=
4q 2 1 4pq

E[1 ] =

5.2

(1 4pq)1/2 1
2q

Exercise 5.4

1. First note that the random walk can reach lelve 2 only on a even-numbered step. Hence we may
rewrite

X
E[2 ] =
2k P (2 = 2k)
k=0

Since we also have

1

E[ ] =

!2

1 2

 2k
X

k=0

(2k)!
k!(k + 1)!

The above two equations are true for any (0, 1). By equating them, we must have
2k P (2 = 2k) =

 2k
2

(2k)!
k!(k + 1)!

which implies
P (2 = 2k) =

 2k
1
(2k)!
2
k!(k + 1)!

2. By the reflection principle, for any k = 1, 2, 3, . . .

P (2 2k) =P (M2k = 2) + 2P (M2k 4)
=P (M2k = 2) + P (M2k 4) + P (M2k 4)
=1 P (M2k = 0) P (M2k = 2)
Now

in order for M2k to be 0 in the first 2k tosses, there must be k heads and2kk tails. There are
2k
k paths that have this property, and each such path has probability (1/2) . Hence
P (M2k

 2k    2k
1
2k
1
(2k)!
= 0) =
=
2
k
2
k!k!
18

Similarly,
P (M2k = 2) =

 2k 
  2k
1
2k
1
(2k)!
=
2
k1
2
(k 1)!(k + 1)!

Now for any k = 2, 3, 4, . . . ,

P (2 = 2k)
=P (2 2k) P (2 2k 2)
=P (M2k2 = 0) + P (M2k2 = 2) P (M2k = 0) P (M2k = 2)
 2k2
 2k2
 2k
 2k
1
(2k 2)!
1
(2k 2)!
1
(2k)!
1
(2k)!
=
+

2
(k 1)!(k 1)!
2
(k 2)!k!
2
k!k!
2
(k 1)!(k + 1)!
 2k
 2

1
4k (k + 1) 4k(k 1)(k + 1)
(2k)!
=

+
(k + 1) k
2
k!(k + 1)! 2k(2k 1)
2k(2k 1)
 3

 2k
2
(2k)!
8k + 4k 4k
1

(2k + 1)
=
2
k!(k + 1)!
2k(2k 1)
 2k
 3

1
8k + 4k 2 4k 2k(4k 2 1)
(2k)!
=

2
k!(k + 1)!
2k(2k 1)

 2k

2
4k 2k
1
(2k)!

=
2
k!(k + 1)! 2k(2k 1)
 2k
1
(2k)!
=
2
k!(k + 1)!

2 (2)!
For k = 1, P (2 = 2) = 1/4, which is the same as 12 1!(1+1)!
. Therefore for any k = 1, 2, 3, . . . ,
 2k
1
(2k)!
P (2 = 2k) =
2
k!(k + 1)!

5.3

Exercise 5.5

1. For the symmetic random walk, it is easy to see that for any 0 j n,
P (Mn = b|Mj = k) = P (Mn = 2k b|Mj = k)
Then
P (Mn m, Mn = b) = P (Mn m, Mn = 2m b) = P (Mn = 2m b)
The latter equality is because m b, so Mn = 2m b m implies

Mn

(5.7)

m.

In order for Mn to be 2mb, we need N heads and nN tails. Then the number N is determined
as
nb
N (n N ) = 2m b = N = m +
2



n
n
Note that there are N
paths that have this property and each such path has probability 12 .
Hence by (5.7)
P (Mn m, Mn = b) = P (Mn m, Mn = 2m b) = P (Mn = 2m b)
 n
1
n!




=
nb
2
m + 2 ! n m nb
!
2
 n
n!
1

n+b


=
nb
2
m+ 2 ! 2 m !
2.

19