Final Exam Stochastic Calculus, July 2004 Write your name and student number on all your work. This is not an open-book exam; a list with tech- nical results is included with the exam. For each question the maximum number of points is indicated. 1. Consider a stock with price S; that satisfies the following two-period binomial tree: i 1 t=2 S2(uu) = 16 , \ S2(ud) = So(du) 2 \ Sa(dd) =1 ‘The market also contains a cash bond with price 1, = (3)' (= e”* with continuously compounded n (3) interest rater (a) [5] Calculate the risk-neutral probability of an upward move, and check that under the com responding probability measure Q, there is no compensation for risk. (b) [10] Let P; denote the price of a American put option on S} with strike price K = 5 and maturity time 7 = 2. Obtain the no-arbitrage value of P; at each node of the tree. Is it ever ” useful to exercise the option before time T= (©) [10] Obtain the portfolio weights at time f = 0 and t = 1 of the self-financing portfolio that replicates the payoff of the American option (at the optimal time of exercise). (A) [5] Let C; be the price of an American call option on a non-dividend-paying stock, with strike price K’ and maturity time T. Show, by comparing suitable portfolios, that Cy + and deduce that it never optimal to exercise this option before T. 2. {Wi }e>o isa standard Brownian motion. (a) [5] Use It6's formula to show that fj W2dW, = 4W? — fj Weds. (b) [10] Let Xy Obtain the stochastic differential equation +m dX; = plt, Xi)dt + o(t, Xai satisfied by X; (i., obtain express ons for y(t, X;) and o(t, X;)).3. We consider a market consisting of a stock with price S; (which does not pay any dividend), a cash bond with price By = e", and a digital put option with price P; which pays, at time T and 0, ifSp>K, Praf f8r2K, 1, if Sr 0, The stock price is assumed to be generated by dS, = rSudt + oSidX, where {X;) is a standard Brownian motion under the risk-neutral measure Q, and where o¢ is a bounded (0 < a < M for some M < 0) non-stochastie function of t (a) [5] Show that the stochastic differential equation for S; has as its solution .= Sex ( f oe jas [ot%s) b A (b) [5] Show that this solution implies Sp = Sex» ([r- a (P= 1) +a/(T HY), 1) under Q. where 9? = 74; fi? ods, and ¥ ~ (©) [5] Consider a dynamic portfolio of ¢, shares in the stock and q, cash bonds, such that its value is Vi = oS + UeBr. Under which condition is this portfolio called self-financing? Explai (@) [10] Explain how the martingale representation theorem implies that the payoff Py (or any other payoff) can be replicated by a self-financing portfolio, and how no arbitrage therefore implies P= et? EC [Py|Fi, where {F;) is the filtration generated by {Xr} (©) [10] Show that (b) and (4) together imply P: Black-Scholes variable (see the list of technical results), with « replaced by a. v(T-8@(—d3), where dz is the usual (8) [10] Obtain an expression for @, the delta of the digital put option. (g) [10] Now consider a digital call option C;, with payoff Cr = 1 if Sp > K and zero otherwise, Derive a put-call parity for digital options, and use this to obtain an expression for C; and its deltaTechnical results ‘* Arbitrage Theorem: Consider a market with an Nx 1 price vector P and an N x n payoff ‘matrix D (NV assets, n states of the world), Then the absence of arbitrage implies and is implied by the existence of a state-price vector y >> 0 such that P = Du, ‘* Binomial Representation Theorem: When {X,} is binomial martingale with respect to { F,} and P, and {Zn} is another martingale with respect to the same filtration and measure, then there exists a previsible process {¢,,} such that Bn = Zo +O ba(Xies ~ Xi). et {Xz} be an It6 process given by dX; = jdt + odW,, and let f(t,:r) be a function with continuous first- and second-order partial derivatives f(t ox’ © It’s formul ” Ff (t,2) pra) = PH » fhe) = Of (t, a) ita) = Fea) Then aft, Xe) = F(t Xidt + f(t. XOdX + att Xo. integration by parts / product rule: Let {Y;} and {Z;} be two It6 processes driven by the same Brownian motion {1}. Then d(ViZ1) = Yed% + Zid; + (d¥i)(A2i), ‘where the final term may be evaluated using the multiplication table ‘+ Martingale representation theorem: Let { F;} be the filtration generated by a Brownian motion process {IV;}, and let {X+) be a martingale with respect to {F} satisfying E[X?] < oo for allt ‘Then there exists an adapted process {0,} such that dX, = 0,411, or If {2} is another square-integrable { F;}-martingale, and 6, # 0, ¥'s, then there exists an adapted process {0} such that dZ, = dX, or a= m+ [ bd. lo