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Shreve

**Stochastic Calculus for Finance I
**

Student’s Manual: Solutions to Selected Exercises

December 14, 2004

Springer

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Contents

1

The Binomial No-Arbitrage Pricing Model . . . . . . . . . . . . . . . . 1.7 Solutions to Selected Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1 1 7 7

2

Probability Theory on Coin Toss Space . . . . . . . . . . . . . . . . . . . . 2.9 Solutions to Selected Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3

State Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 3.7 Solutions to Selected Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

4

American Derivative Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 4.9 Solutions to Selected Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

5

Random Walk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 5.8 Solutions to Selected Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

6

Interest-Rate-Dependent Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 6.9 Solutions to Selected Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

1 The Binomial No-Arbitrage Pricing Model

**1.7 Solutions to Selected Exercises
**

Exercise 1.2. Suppose in the situation of Example 1.1.1 that the option sells for 1.20 at time zero. Consider an agent who begins with wealth X0 = 0 and at time zero buys ∆0 shares of stock and Γ0 options. The numbers ∆0 and Γ0 can be either positive or negative or zero. This leaves the agent with a cash position of −4∆0 − 1.20Γ0 . If this is positive, it is invested in the money market; if it is negative, it represents money borrowed from the money market. At time one, the value of the agent’s portfolio of stock, option and money market is X1 = ∆0 S1 + Γ0 (S1 − 5)+ − 5 (4∆0 + 1.20Γ0 ) . 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) = 8∆0 + 3Γ0 − (4∆0 + 1.20Γ0 ), 4 5 X1 (T ) = 2∆0 + 0 · Γ0 − (4∆0 + 1.20Γ0 ) 4 Adding these, we get X1 (H) + X1 (T ) = 10∆0 + 3Γ0 − 10∆0 − 3Γ0 = 0, or, equivalently,

with S0 = 4. 2.2. u = 2. + 1 v3 (s. then at time one the bank has an option worth $0. (ii) Apply the algorithm developed in (i) to compute v0 (4. Taking into account that both p > 0 and q > 0. the bank has an option 5 worth $3.6 (Hedging a long position . 1. In particular.8 (Asian option). and must pay $4 to cover the short position in the stock. X1 (H) = −X1 (T ). which ties up capital V0 = 1.e. The bank wants to earn the interest rate 25% on this capital until time one.). whose payoﬀ at time three is + 1 ). and must pay $1 to cover the short position in stock. and take the interest rate r = 4 . without investing any more money.1.. the bank owns this option. At time zero.50. as desired. For n = 0. write a formula for vn in terms of vn+1 . Exercise 1. if the stock goes up in value.1. The call expires at time one and has strike price K = 5. after collecting the payoﬀ from the option (if any) at time one. This leaves the bank with $1. which generates $2 income. she should short 2 share of stock. 3. y) = 4 y − 4 . then there is a positive probability that X1 is negative. Solution. y) denote the price of this option at time n if Sn = s and Yn = y. 4). Consider an Asian call option that expires at time three and has strike K = 4 (i. so that 2 n 1 p = q = 2 . Again.50 in the money market. In Section 1. Let vn (s. Specify how the bank’s trader should invest in the stock and money market to accomplish this. and regardless of how the coin tossing turns out. still has $2.1. or they have opposite signs.. we determined the time-zero price of this call to be V0 = 1.50 in the money market.50 4 at time one. has $ 4 · 2 = $2. This is like a European call. She should invest this in the money market. we conclude that if there is a positive probability that X1 is positive.1. (i) Develop an algorithm for computing vn recursively.20.20.2.e.2 1 The Binomial No-Arbitrage Pricing Model In other words. as desired.20 = 1. Consider the three-period model of Example 1 1. i. In particular.50. the bank wants to have 5 · 1. At time one. if the stock goes down in value. Consider a bank that has a long position in the European call written on the stock price in Figure 1. The trader should use the opposite of the replicating portfolio 1 strategy worked out in Example 1. Exercise 1. d = 1 .one period. except the payoﬀ of the option is 4 Y3 − 4 based on the average stock price rather than the ﬁnal stock price. On the other hand.1. either X1 (H) and X1 (T ) are both zero. In particular. . deﬁne Yn = ˜ ˜ k=0 Sk to be the sum of the stock prices between times zero and n. the bank has $1. the price of the Asian option at time zero.

(i).40. Then if the (n + 1)-st toss results in H. y + ds) δn (s. Yn+1 = Yn + Sn+1 = y + ds. v3 (8. v3 (2. Yn+1 = Yn + Sn+1 = y + us. = 1. v3 (8. v3 (2. 36) = (36/4 − 4)+ = 5.50. v3 (2. 60) = (60/4 − 4)+ = 11. 7. y) = 1 [˜vn+1 (us. We next use the algorithm from (i) to compute the relevant values of v2 : v2 (16. v3 (. y + us) − vn+1 (ds. we have Sn+1 = us. 9) + v3 (. v3 (8. formulas (1.50/4 − 4)+ = 0. Therefore. which are v3 (32. 7) = 4 1 1 v3 (32. If the (n + 1)-st toss results in T .16) and (1. Sn = s and Yn = y. 9) = (9/4 − 4)+ = 0.1. 24) + v3 (2. y) = . us − ds (ii) We ﬁrst list the relevant values of v3 . 4 1 1 v3 (2. 12) 5 2 2 = 6. 18) = (18/4 − 4)+ = 0. the number of shares of stock which should be held by the replicating portfolio at time n if Sn = s and Yn = y. 16) = v2 (4.50) = (7. y).7 Solutions to Selected Exercises 3 (iii) Provide a formula for δn (s.17) take the form vn (s. 18) 5 2 2 1 4 1 v3 (8. 24) = (24/4 − 4)+ = 2. we have instead Sn+1 = ds. y + us) + q vn+1 (ds.50.2. 18) + v3 (2.50) = 0. y + ds)]. 60) + v3 (8.2. 28) = v2 (4. = 0.20. 36) 5 2 2 4 1 1 v3 (8. 5 2 2 . 18) = (18/4 − 4)+ = 0. Solution.50. (iii) Assume that at time n. 10) = v2 (1. 7. 12) = (12/4 − 4)+ = 0. p ˜ 1+r vn+1 (us.50.

ωn ) are allowed to depend on n and on the ﬁrst n coin tosses ω1 ω2 . S1 (H) = 90. expiring at time ﬁve. . Assume the interest rate is always zero. ωn ). the “up factor” un (ω1 ω2 . . . . (i) Let N be a positive integer. ωn ) < 1 + rn (ω1 ω2 . d0 S0 if ω1 = T. One dollar invested in or borrowed from the money market at time zero grows to an investment or debt of 1 + r0 at time one. the stock price at time one is given by S1 (ω1 ) = u0 S0 if ω1 = H. What is the price of this call at time zero? . . the “down factor” dn (ω1 ω2 . . . . . ωn ωn+1 ) = un (ω1 ω2 . . . ωn ) at time n + 1. 28) 1 2 v2 (4. one dollar invested in or borrowed from the money market at time n grows to an investment or debt of 1 + rn (ω1 ω2 . ωn )Sn (ω1 ω2 . 1 + 2 v2 (1.96. ωn ) holds. 4) = 1 4 1 v1 (8. . Consider a European call with strike price 80. and the initial interest rate r0 are not random. ωn ) if ωn+1 = T. the stock price at time n + 1 is given by Sn+1 (ω1 ω2 . . . We also assume that 0 < d0 < 1 + r0 < u0 . . S2 (HH) = 100. for n ≥ 1. Exercise 1. etc. We assume that for each n and for all ω1 ω2 . and the interest rate rn (ω1 ω2 .216. ωn )Sn (ω1 ω2 . S1 (T ) = 70. In other words. ωn . .9 (Stochastic volatility. and with each tail the stock price decreases by 10. . . 7) = 0. random interest rate). . More speciﬁcally. Consider a binomial pricing model.08. . In the model just described. 16) = 2. for n ≥ 1. and. we may now compute v0 (4.4 1 The Binomial No-Arbitrage Pricing Model We use the algorithm again to compute the relevant values of v1 : v1 (8. dn (ω1 ω2 . 12) = v1 (2. . The initial up factor u0 . the no-arbitrage condition 0 < dn (ω1 ω2 . ωn ). the initial down factor d0 . . 10) 1 + 2 v2 (4. . (ii) Provide a formula for the number of shares of stock that should be held at each time n (0 ≤ n ≤ N − 1) by a portfolio that replicates the derivative security VN . 12) + v1 (2. Finally. provide an algorithm for determining the price at time zero for a derivative security that at time N pays oﬀ a random amount VN depending on the result of the ﬁrst N coin tosses. . but at each time n ≥ 1. ωn ) if ωn+1 = H. 6) 5 2 2 = 1. . with each head the stock price increases by 10. ωn ) < un (ω1 ω2 . ωn . . . (iii) Suppose the initial stock price is S0 = 80. and. . 6) = 4 5 4 5 1 2 v2 (16.

. 1. . ωn ) . . . we can easily compute the risk-neutral prob1 1 5 ability of an arbitrary sequence ω1 ω2 ω3 ω4 ω5 to be 2 = 32 . . . ωn T ) . un (ω1 ω2 . . . . .2 to this case by deﬁning p0 = ˜ 1 + r 0 − d0 .1. is the same as the proof given for Theorem 1. . ˜ ˜ 1+r (ii) The number of shares of stock that should be held at time n is still given by (1. 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 . . . Vn (ω1 ω2 . . . .2. . . u0 − d 0 and for each and and for all ω1 ω2 . . ωn ) = ˜ 1 + rn (ω1 ω2 . The corresponding riskx x neutral probabilities are pn = ˜ qn = ˜ 1 − dn = un − d n un − 1 = un = d n x+10 x 1− x−10 x − x−10 x = = 1 . That means that the up factor is un = x+10 and the down factor is dn = x−10 .2. . 2 x+10 x −1 x+10 x−10 x − x Because these risk-neutral probabilities do not depend on the time n nor on the coin tosses ω1 . ωn . (i) We adapt Theorem 1. . . ωn . ωn ) .2. . . ωn T ) The proof that this hedge works. ωn ) − dn (ω1 ω2 . ωn H) − Sn+1 (ω1 . (iii) If the stock price at a particular time n is x. ωn H) − Vn+1 (ω1 . . . .16). ωn T ) . ωn ) un (ω1 ω2 . . . . . ωn )Vn+1 (ω1 ω2 . . . u0 − d 0 q0 = ˜ u0 − 1 − r 0 . .7 Solutions to Selected Exercises 5 Solution.2. . then the stock price at the next time is either x + 10 or x − 10.2. . ωn ) = and for the the case n = 0 we adopt the deﬁnition V0 = 1 p0 V1 (H) + q0 V1 (T ) . 2 1 . . . N − 2. . . ωn H) ˜ 1+r +˜n (ω1 ω2 . ωn ) − dn (ω1 ω2 . . . ωn ) − dn (ω1 ω2 . ωn ) = ˜ un (ω1 ω2 . . . . pn (ω1 ω2 . Sn+1 (ω1 . ..e. qn (ω1 ω2 . ωn ) 1 pn (ω1 ω2 . q In place of (1. we deﬁne for n = N − 1. i. . ωn )Vn+1 (ω1 ω2 . .17): ∆n (ω1 . . ωn ) − 1 − rn (ω1 ω2 . ωn ) = Vn+1 (ω1 .

and so there are ﬁve sequences that have four heads and one tail. the risk-neutral probability of four heads 5 and one tail is 32 . or result in three heads and two tails 1 (S5 = 90). result in four heads and one tail (S5 = 110). 32 32 32 . If a tail occurs. there 10 ways to choose the two tosses that are tails. The time-zero price 32 of the call is V0 = 1 5 10 · (130 − 80) + · (110 − 80) + · (90 − 80) = 9. the riskneutral probability of three heads and two tails is 10 . if there are two tails in a sequence of ﬁve tosses. it can occur on any toss. Therefore.375. Finally. Therefore. The risk-neutral probability of ﬁve heads is 32 .6 1 The Binomial No-Arbitrage Pricing Model 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).

125 .4.375 . ˜ 1 (ii) Compute ES1 . ES2 . q = 1 . and ES3 .1. ˜ 2 q = 2.2.3. Consider the stock price S3 in Figure 2.4. E Therefore.125 (ii) By Theorem 2. this becomes ˜ 1 ˜ 1 2 . S2 S1 S3 =E =E = ES0 = S0 = 4.50 p3 3˜2 q 3˜q 2 q 3 ˜ p ˜ p˜ ˜ With p = 2 . 3 Solution. q = 2 .50 32 8 .2 Probability Theory on Coin Toss Space 2. What is the average rate of growth of the stock price under P? 2 (iii) Answer (i) and (ii) again under the actual probabilities p = 3 . (i) The distribution of S3 under the risk-neutral probabilities p and q is ˜ ˜ 32 8 2 . (i) What is the distribution of S3 under the risk-neutral probabilities p = 1 . 3 2 (1 + r) (1 + r) (1 + r) .9 Solutions to Selected Exercises Exercise 2.375 .

ES2 = 1.8125. let M0 .2222 .25 · ES1 . ES3 = 1.4444 . In particular. we have En Mn+1 = Mn . ϕ(M1 ). . Show that ϕ(M0 ).25)2 (4) = 6.50 32 . Thus. In other words. 2 1 · 2 + · 12 = 1. Exercise 2. so that ES1 = 1. we reason as follows: En Sn+1 = En Sn In our case. the average rate of growth of the stock price under P is the same as the interest rate of the money market. ϕ(MN ) is a submartingale. . ES3 = (1 + r)3 S0 = (1. ES2 = (1 + r)2 S0 = (1.3. . the average rate of growth of the stock price under the actual probabilities is 50%.2963 . .25 · ES2 . . we see that ES3 = 1.5 · ESn .0371 To compute the average rate of growth.5. taking expectations. . Finally. .25)(4) = 5. By the martingale property. Sn+1 Sn = S n En Sn+1 Sn = (pu + qd)Sn . q = 3 . ES1 = 1. this becomes 8 2 .25. (iii) The distribution of S3 under the probabilities p and q is 32 8 2 .5 · ES0 = 6. 3 3 In other words.50 3 2 p 3p q 3pq 2 q 3 2 1 With p = 3 .8 2 Probability Theory on Coin Toss Space ES1 = (1 + r)S0 = (1. . Show that a convex function of a martingale is a submartingale. . M1 .5 · ES2 = 13.25)3 (4) = 7.5 · ES1 = 9. Solution Let an arbitrary n with 0 ≤ n ≤ N − 1 be given. ES2 = 1.50. MN be a martingale and let ϕ be a convex function. we have pu + qd = ESn+1 = E En Sn+1 = 1.25 · S0 .

. . I1 . (ii) Let VN be the payoﬀ at time N of some derivative security.. we get En ϕ(Mn+1 ) ≥ ϕ(Mn ). n = 1. ∆n and Mn depend on only the ﬁrst n coin tosses.9 Solutions to Selected Exercises 9 and hence ϕ(En Mn+1 ) = ϕ(Mn ). .. MN be martingales under the riskneutral measure P. for each n between 0 and N . . . . . M1 .2.. M1 . and let ∆0 .16) of Chapter 1. by the conditional Jensen’s inequality. . Deﬁne recursively VN −1 . ϕ(MN ) is a submartingale. ϕ(M1 ). I1 . En [Mn+1 ] = Mn . Show that V0 . . . . Suppose M0 . . Combining these two. MN is a martingale. V0 by the algorithm (1. . which is the martingale property. . . .. V1 VN −1 VN . This is a random variable that can depend on all N coin tosses. and we conclude that En [In+1 ] = In . Consider an N -period binomial model. then. Deﬁne the discrete-time stochastic integral (sometimes called a martingale transform) I0 . N. . IN by setting I0 = 0 and n−1 In = j=0 ∆j (Mj+1 − Mj ). Show that if MN = MN (for every possible outcome of the sequence of coin tosses). . . . . we have Mn = Mn (for every possible outcome of the sequence of coin tosses). . ∆1 . . VN −2 . and since n is arbitrary. However.2. Because In+1 = In + ∆n (Mn+1 − Mn ) and In . . this implies that the sequence of random variables ϕ(M0 ).6 (Discrete-time stochastic integral). . . Exercise 2. ∆N −1 be an adapted process. Show that I0 . IN is a martingale. . . . . . M1 . (i) Let M0 .8. MN and M0 . . . Exercise 2. we have En ϕ(Mn+1 ) ≥ ϕ(En Mn+1 ). . . we may “take out what is known” to write En [In+1 ] = En In + ∆n (Mn+1 − Mn ) = In + ∆n En [Mn+1 ] − Mn . Solution. 1+r (1 + r)N −1 (1 + r)N is a martingale under P. . . . On the other hand.

this equality and the martingale property imply Mn = En [MN ] = En [MN ] = Mn . This is the martingal Vn property for (1+r)n . V En Vn+1 (1 + r)n+1 1 VN En+1 (1 + r)n+1 (1 + r)N −(n+1) 1 VN = En En+1 (1 + r)n (1 + r)N −n VN 1 En = (1 + r)n (1 + r)N −n Vn = . . . .16). the algorithm (1.11) of Chapter 2). (i) We are given that Mn = MN . is a martingale.. n (iii) The martingale property for (1+r)n follows from the iterated conditioning property (iii) of Theorem 2..3. . (1 + r)n VN . .e. (iv) Conclude that Vn = Vn for every n (i.2.4. deﬁne Vn = En Show that V0 . .2. . for n between 0 and n − 1. n = 0. ωn H) +q ˜ =p ˜ n+1 (1 + r) (1 + r)n+1 Vn (ω1 ω2 . (ii) For n between 0 and N − 1. 1. .. For n between 0 and N − 1.4.11) of this chapter. ωn ) = . According to this property.2. (1 + r)N −n VN −1 VN V1 . (1 + r)n = En . . ωn ) (1 + r)n+1 Vn+1 (ω1 ω2 .2 of Chapter 1 gives the same derivative security prices as the riskneutral pricing formula (2..16) of Theorem 1.2. we compute the following conditional expectation: En Vn+1 (ω1 ω2 . . N − 1. N −1 (1 + r)N 1+r (1 + r) where the second equality follows from (1. . .. . Solution. ωn T ) Vn+1 (ω1 ω2 .10 2 Probability Theory on Coin Toss Space (iii) Using the risk-neutral pricing formula (2.

P(T T ). random interest rate). (1 + r0 )(1 + r1 ) (iii) Suppose an agent sells the option in (ii) for V0 at time zero. (i) Determine risk-neutral probabilities P(HH).1. P(HT ).9 of Chapter 1. The stock prices and interest rates are shown in Figure 2. (iv) Suppose in (iii) that the ﬁrst coin toss results in head.9 Solutions to Selected Exercises 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 . random interest rate model. P(T H). Exercise 2. V1 (H). they must agree at all earlier times because of (i). A stochastic volatility. and V1 (T ).8. the value of her portfolio is V1 . such that the time-zero value of an option that pays oﬀ V2 at time two is given by the risk-neutral pricing formula V0 = E V2 . S2 (HH) = 12 S1 (H) = 8 1 r1 (H) = 4 S0 = 4 r0 = 1 4 S1 (T ) = 2 r1 (T ) = 1 2 S2 (T T ) = 2 S2 (HT ) = 8 S2 (T H) = 8 Fig. Consider a two-period stochastic volatility. Compute V0 . What position ∆1 (H) should the agent now take in the stock to be sure that. 2.2. regardless (ii) Let V2 = (S2 − 7)+ .9 (Stochastic volatility. . Compute the position ∆0 she should take in the stock at time zero so that at time one. random interest rate model of the type described in Exercise 1.8. regardless of whether the ﬁrst coin toss results in head or tail.1.

is p1 (H) = ˜ 1+ 1 −1 1 1 + r1 (H) − d1 (H) = 3 4 = . then the up factor for the second toss is u1 (H) = 12 3 S2 (HH) = = . is q1 (H) = ˜ u1 (H) − 1 − r1 (H) = u1 (H) − d1 (H) 3 2 −1− 3 2 −1 1 4 = 1 . the up factor is u0 = 2 and the down factor is d0 = 2 . S1 (T ) 2 and the down factor for the second toss is d1 (H) = 2 S2 (T T ) = = 1.12 2 Probability Theory on Coin Toss Space of whether the second coin toss results in head or tail. given that the ﬁrst toss is a H. then the up factor for the second toss is u1 (T ) = S2 (T H) 8 = = 4. 2 and the risk-neutral probability of T on the ﬁrst toss is q0 = ˜ 1 4 = 1 . Therefore. 1 (i) For the ﬁrst toss. S1 (T ) 2 It follows that the risk-neutral probability of getting a H on the second toss. 2 If the ﬁrst toss results in T . the value of her portfolio at time two will be (S2 − 7)+ ? Solution. S1 (H) 8 It follows that the risk-neutral probability of getting a H on the second toss. 2 If the ﬁrst toss results in H. given that the ﬁrst toss is a T . S1 (H) 8 2 and the down factor for the second toss is d1 (H) = S2 (HT ) 8 = = 1. u1 (H) − d1 (H) 2 2 −1 and the risk-neutral probability of T on the second toss. the risk-neutral probability of a H on the ﬁrst toss is p0 = ˜ 1+ 1 − 1 + r 0 − d0 4 = 1 u0 − d 0 2− 2 2−1− u0 − 1 − r 0 = 1 u0 − d 0 2− 2 1 2 = 1 . given that the ﬁrst toss is a H. is .

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 = 4.00444. We can conﬁrm this price by computing according to the risk-neutral pricing formula in part (i) of the exercise: .9 Solutions to Selected Exercises 13 p1 (T ) = ˜ 1+ 1 −1 1 1 + r1 (T ) − d1 (T ) 2 = = . 1 V0 = [˜0 V1 (H) + q0 V1 (T )] p ˜ 1 + r0 4 1 1 = · 2.2.1111 5 2 2 = 1.40. 5 12 . 6 The risk-neutral probabilities are P(HH) = p0 p1 (H) = ˜ ˜ P(HT ) = p0 q1 (H) = ˜ ˜ P(T H) = q0 p1 (T ) = ˜ ˜ P(T T ) = q0 q1 (T ) = ˜˜ (ii) We compute V1 (H) = 1 p1 (H)V2 (HH) + q1 (H)V2 (HT ) ˜ ˜ 1 + r1 (H) 1 4 1 · (12 − 7)+ + · (8 − 7)+ = 5 2 2 = 2.40 + · 0. 1 2 1 2 1 2 1 2 · · · · 1 2 1 2 1 6 5 6 1 = 4. = = 1 12 . given that the ﬁrst toss is a T . u1 (T ) − d1 (T ) 4−1 6 and the risk-neutral probability of T on the second toss. is q1 (T ) = ˜ 4−1− u1 (T ) − 1 − r1 (T ) = u1 (T ) − d1 (T ) 4−1 1 2 = 5 .

. 1.04444 + 0 = 1. n = 0. N − 1.14 2 Probability Theory on Coin Toss Space V0 = E V2 (1 + r0 )(1 + r1 ) V2 (HH) V2 (HT ) = · P(HH) + · P(HT ) (1 + r0 )(1 + r1 (H)) (1 + r0 )(1 + r1 (H)) V2 (T H) V2 (T T ) + · P(T H) + · P(T T ) (1 + r0 )(1 + r1 (T )) (1 + r0 )(1 + r1 (T )) (8 − 7)+ 1 1 (12 − 7)+ · + = 1 1 1 1 · 4 (1 + 4 )(1 + 4 ) 4 (1 + 4 )(1 + 4 ) (2 − 7)+ (8 − 7)+ 1 5 · 1 1 1 · 12 + (1 + 4 )(1 + 2 ) (1 + 4 )(1 + 1 ) 12 2 = 0. . The price Cn of this call at earlier times is given by the risk-neutral pricing formula (2.381481. + (iii) Formula (1.111111 = = 0. 1. The price of this contract at time N is FN = SN − K. (1 + r)N −n Consider also a put with payoﬀ PN = (K − SN )+ at time N .4. 1. (1 + r)N −n Finally. .00444. and its price at earlier times is Fn = E n FN . whose price at earlier times is Pn = E n PN . A European call has payoﬀ CN = (SN − K)+ at time N .2. . . N − 1. .11 (Put–call parity).11): Cn = En CN . . . N − 1. .80 + 0.) . S1 (H) − S1 (T ) 8−2 (iv) Again we use formula (1. n = 0. (1 + r)N −n (Note that. Consider a stock that pays no dividend in an N -period binomial model.17) still applies and yields ∆0 = V1 (H) − V1 (T ) 2. S2 (HH) − S2 (HT ) 12 − 8 Exercise 2. the forward contract requires that the stock be purchased at time N for K dollars and has a negative payoﬀ if SN < K. .17). unlike the call. .40 − 0. . n = 0.16 + 0.2. this time obtaining ∆1 (H) = (12 − 7)+ − (8 − 7)+ V2 (HH) − V2 (HT ) = = 1. consider a forward contract to buy one share of stock at time N for K dollars.

2.9 Solutions to Selected Exercises

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 put–call 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 ; In all three cases, we see that CN = FN + PN . Case III: SN < K. Then CN = 0 and PN = K − SN = −FN .

(ii) Cn = En = En (iii) F0 = E SN − K FN =E N (1 + r) (1 + r)N SN K K . =E −E = S0 − N N (1 + r) (1 + r) (1 + r)N FN + P N CN = En N −n (1 + r) (1 + r)N −n FN PN + En = Fn + Pn . N −n (1 + r) (1 + r)N −n

16

2 Probability Theory on Coin Toss Space

(iv) At time zero, your portfolio value is F0 = S0 + (F0 − S0 ). At time N , the value of the portfolio is SN + (1 + r)N (F0 − S0 ) = SN + (1 + r)N = SN − K = F N . (v) First of all, if K = (1 + r)N S0 , then, by (iii), F0 = 0. Further, if F0 = 0, then, by (ii), C0 = F0 + P0 = P0 . (vi) No. This would mean, in particular, that CN = PN , and hence (SN − K)+ = (K − SN )+ , which in turn would imply that SN (ω) = K for all ω, which is not the case for most values of ω. Exercise 2.13 (Asian option). Consider an N -period binomial model. An Asian option has a payoﬀ based on the average stock price, i.e., VN = f 1 Sn N + 1 n=0

N

−

K (1 + r)N

,

where the function f is determined by the contractual details of the option. (i) Deﬁne Yn = k=0 Sk and use the Independence Lemma 2.5.3 to show that the two-dimensional process (Sn , Yn ), n = 0, 1, . . . , N is Markov. (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

n

n+1 and whereas Sn and Yn depend only on the ﬁrst n tosses, SSn depends 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

2.9 Solutions to Selected Exercises

17

En [hn+1 (Sn+1 , Yn+1 )] = En hn+1 Sn · = hn (Sn , Yn ), where hn (s, y) = Ehn+1 s ·

Sn+1 Sn+1 , Yn + Sn · Sn Sn

Sn+1 Sn+1 ,y + s · Sn Sn = phn+1 (su, y + su) + q hn+1 (sd, y + sd). ˜ ˜

Because En [hn+1 (Sn+1 , Yn+1 )] can be written as a function of (Sn , Yn ), the two-dimensional process (Sn , Yn ), n = 0, 1, . . . , N , is a Markov process. (ii) We have the ﬁnal condition VN (s, y) = f

y N +1

we have from the risk-neutral pricing formula (2.4.12) and (i) above that Vn = where vn (s, y) = 1 pvn+1 (su, y + su) + q vn+1 (sd, y + sd) . ˜ ˜ 1+r 1 1 En Vn+1 = En vn+1 (Sn+1 , Yn+1 ) = vn (Sn , Yn ), 1+r 1+r

. For n = N − 1, . . . , 1, 0,

.

Z facilitates the switch from E to E in the same way Z facilitates the switch from E to E. show the following analogues of properties (i)–(iii) of that theorem: (i ) P 1 Z > 0 = 1.3 State Prices 3. Under the conditions of Theorem 3. Z 1 In other words. the ratio 1 P(ω) = Z(ω) P(ω) is deﬁned and positive for every ω ∈ Ω. . 1 (ii ) E Z = 1.1.1. EY = E 1 ·Y . 1 = Z 1 P(ω) = Z(ω) P(ω) ω∈Ω (ii ) We compute E ω∈Ω P(ω) P(ω) = ω∈Ω P(ω) = 1.1.7 Solutions to Selected Exercises Exercise 3. Solution (i ) Because P(ω) > 0 and P(ω) > 0 for every ω ∈ Ω. (iii ) for any random variable Y .

2. Verify that Mn . Exercise 3. M2 (HT ) = M2 (T H) = M2 (T T ) = + + + = = = We next compute M1 from the formula M1 = E1 [S3 ]: M1 (H) = 4 2 2 1 S3 (HHH) + S3 (HHT ) + S3 (HT H) + S3 (HT T ) 9 9 9 9 4 2 2 1 = · 32 + · 8 + · 8 + · 2 9 9 9 9 = 18.50 = 24. = 6. Using the stock price model of Figure 3. = 1. We compute M2 from the formula M2 = E2 [S3 ]: 2 M2 (HH) = 3 S3 (HHH) + 1 S3 (HHT ) = 2 2 3 S3 (HT H) 2 3 S3 (T HH) 2 3 S3 (T HH) 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. Solution We note that M3 = S3 . 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 9 9 9 9 = 4. n = 0.3.1. = 6. .50. 1. q = 1 . is a martingale.1. Fill in the values of Mn in a tree like that of Figure 3. 1.1 and the actual 2 probabilities p = 3 .1.50. 3.50 27 27 27 27 27 27 27 27 = 13. 2. Finally. deﬁne the estimates of S3 at various times by 3 Mn = En [S3 ]. 2 2 1 4 M1 (T ) = S3 (T HH) + S3 (T HT ) + S3 (T T H) + S3 (T T T ) 9 9 9 9 2 2 1 4 = · 8 + · 2 + · 2 + · 0. 3.20 3 State Prices (iii ) We compute E 1 ·Y Z = ω∈Ω P(ω) P(ω) Y (ω)P(ω) = ω∈Ω Y (ω)P(ω) = EY. n = 0.50.

50 !! aa aa aa S3 (T T T ) = . which we do below: 1 2 E1 [M2 ](H) = 3 M2 (HH) + 3 M2 (HT ) = 2 1 3 · 24 + 3 · 6 2 1 3 · 6 + 3 · 1. An estimation martingale. P(HT ) = .9 of Chapter 2. Note that Z0 = EZ = 1. = 4. 3.9 of Chapter 2. is .7 Solutions to Selected Exercises 21 !! M0 = 13. We verify the martingale property.50 = M0 . Comy pute Z1 (H). Z2 satisﬁes Z2 = Z. We have M2 = E2 [M3 ] because M3 = S3 and we used the formula M2 = E2 [S3 ] to compute M2 . Z1 (T ) and Z0 .50 Fig. Assume that the actual probability measure is P(HH) = 2 2 1 4 .7.6) appropriate for this model. Consider the model of Exercise 2. Z1 . We must check that M1 = E1 [M2 ] and M0 = E0 [M1 ] = E[M1 ]. (iii) The version of the risk-neutral pricing formula (3.2. P(T H) = .50 = 18 = M1 (H). which does not use the risk-neutral measure. P(T T ) = .50 2 1 3 · 18 + 3 · 4. E1 [M2 ](T ) = M0 = 1 2 M2 (T H) 2 3 M1 (H) + + 1 2 M2 (T T ) 1 3 M1 (T ) = = Exercise 3.3. (i) Compute the Radon-Nikod´m derivative Z(HH).50 M1 (H) = 18 M2 (HH) = 24 ! !! aa ! S3 (HHH) = 32 aa Z Z M2 (HT ) = M2 (T H) = 6 aa S3 (HHT ) = S3 (HT H) = S3 (T HH) = 8 Z Z S (HT T ) = S3 (T HT ) !! 3 = S3 (T T H) = 2 Z Z M1 (T ) = 4. = 13.5 (Stochastic volatility.1. 9 9 9 9 The risk-neutral measure was computed in Exercise 2. Z(T H) and y Z(T T ) of P with respect to P (ii) The Radon-Nikod´m derivative process Z0 . Z(HT ).50 Z Z !! M2 (T T ) = 1.50 = M1 (T ). random interest rate).

the Radon-Nikod´m derivative is y Z(HH) = 1 9 9 P(HH) = · = . V1 (T ) and V0 when V2 = (S2 − 7)+ .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).9 of Chapter 2. P(T T ) = . Compare to your answers in Exercise 2. Solution (i) In Exercise 2. the risk-neutral probabilities are P(HH) = 1 1 1 5 .6(ii) of Chapter 2. E (1 + r0 )(1 + r1 ) Use this formula to compute V1 (H). P(T H) = . P(HH) 4 4 16 P(T H) 1 9 3 = · = . 4 4 12 12 Therefore. Z1 (H)(1 + r1 (H)) Z2 1 + r0 E1 V2 (T ) Z1 (T ) (1 + r0 )(1 + r1 ) 1 E1 [Z2 V2 ](T ). P(HT ) 4 2 8 P(T T ) 5 9 15 = · = . P(HT ) = . P(T H) 12 2 8 Z(HT ) = P(HT ) 1 9 9 = · = . P(T T ) 12 1 4 Z(T H) = (ii) Z(T T ) = Z1 (H) = E1 [Z2 ](H) = Z2 (HH)P{ω2 = H given that ω1 = H} +Z2 (HT )P{ω2 = T given that ω1 = 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 + 9 · 8 2 9 4 9 + 2 9 . Z1 (T )(1 + r1 (T )) Z2 V2 .

V2 (HT ) = 1. = 4 2 + 9 9 + 3 · 2 2 1 + 9 9 We may also check directly that EZ = 1.3.7 Solutions to Selected Exercises 23 Z1 (T ) = E1 [Z2 ](T ) = Z2 (T H)P{ω2 = H given that ω1 = T } +Z2 (T T )P{ω2 = T given that ω1 = T } P(T T ) P(T H) + Z2 (T T ) = Z2 (T H) P(T H) + P(T T ) P(T H) + P(T T ) 1 9 2 3 · 2 9 8 9+ 3 = . = + + 4 4 12 12 (iii) We recall that V2 (HH) = 5. 3 2 = . V2 (T T ) = 0. 3 1 = . 2 Z0 = E0 [Z1 ] = + 15 · 4 1 9 2 9 + 1 9 = E[Z1 ] = Z1 (H) P(HH) + P(HT ) + Z1 (T ) P(T H) + P(T T ) 3 · 4 = 1. 4 9 4 +2 9 9 2 9 4 +2 9 9 2 9 2 +1 9 9 1 9 2 1 9+9 2 . 3 1 = . 3 = . V2 (T H) = 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. We computed in part (ii) that P{ω2 = H given that ω1 = H} = P{ω2 = T given that ω1 = H} = P{ω2 = H given that ω1 = T } = P{ω2 = T given that ω1 = T } = Therefore.

Exercise 3. n = ζ 0. . N . 1 V1 (T ) = E1 [Z2 V2 ](T ) Z1 (T ) 1 + r1 (T ) = = 3 3 · 2 2 −1 Z2 (T H)V2 (T H)P{ω2 = H given that ω1 = T } +Z2 (T T )V2 (T T )P{ω2 = T given that ω1 = T } 4 3 2 15 1 = ·1· + ·0· 9 8 3 4 3 = 0. Show that the optimal wealth process cor0 responding to the optimal portfolio process is given by Xn = Xn .1 in an N -period binomial model with the utility function U (x) = ln x.24 3 State Prices V1 (H) = = 1 E1 [Z2 V2 ](H) Z1 (H) 1 + r1 (H) 3 5 · 4 4 −1 Z2 (HH)V2 (HH)P{ω2 = H given that ω1 = H} +Z2 (HT )V2 (HT )P{ω2 = T given that ω1 = H} 16 9 2 9 1 ·5· + ·1· 15 16 3 8 3 = 2. Solution From (3.111111. where ζn is the state price density process deﬁned in (3.6. . .2. Consider Problem 3. .40. .3.7).25) we have XN = I λZ (1 + r)N = I(λζN ). and V0 = E Z 2 V2 (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 )) 5 5 · 4 4 + −1 = 9 4 ·5· + 16 9 −1 5 5 · 4 4 −1 9 2 ·1· + 8 9 5 3 · 4 2 −1 3 2 ·1· 8 9 5 3 15 1 · ·0· 4 2 4 9 8 1 16 5 16 1 · + · + · = 25 4 25 4 15 12 = 1.3.00444. 1.

we have = 1 Z N XN En Zn (1 + r)N = 1 X0 En [ζN XN ] = . calling the random variable given ∗ by (3. (1 + r)N (3. . This permits us to use the notation XN for an arbitrary (not necessarily optimal) random variable satisfying (3.22). ζN is a martingale under the risk-neutral measure P. Zn ζn Exercise 3. which in this case is the vector (p1 ζ1 . (3. In other words. We begin by changing the notation. The solution could also be neither a maximizer nor a minimizer.3. then the optimal solution must satisfy the Lagrange multiplier equations (3. which in this case takes the form X0 = E ζN I(λζN ) = 1 .19). Zn Zn Xn XN = En (1 + r)n (1 + r)N Therefore. λ Substituting this into the previous equation. even when this hypothesis is satisﬁed.8. 1 x and the inverse function of U is I(y) = XN = 1 λζN We must choose λ to satisfy (3. in this exercise.3. ∗ XN = I λ Z .25) XN rather than XN .5 has hypotheses that we did not verify in the solution of that problem. Xn = (1 + r)n X0 X0 = .7 Solutions to Selected Exercises 25 1 y. When U (x) = ln x.3.3.1) where λ is the solution of equation (3. we outline a diﬀerent method for verifying that the random variable XN given by (3.26). pm ζm ).6. is not the zero vector. . We must show that ∗ EU (XN ) ≤ EU (XN ).3.26). so this hypothesis is satisﬁed. However.3. The Lagrange Multiplier Theorem used in the solution of Problem 3. Therefore. This gradient is not the zero vector. the theorem states that if the gradient of the constraint function.6. .25) maximizes the expected utility. the solution to the Lagrange multiplier equations may in fact minimize the expected utility. . we obtain XN = Because Xn (1+r)n X0 . In particular. U (x) = Therefore.2) .3.3. the theorem does not guarantee that there is an optimal solution.

and this is zero if and only if U (x) = y.2). Solution (i) Because U (x) is concave. Conclude that U (x) − yx ≤ U (I(y)) − yI(y) for every x. and show that the function of x given by U (x)−yx is maximized by y = I(x).3) (ii) In (3. and for each ﬁxed y > 0.6. we obtain (3. . The inequality (3.6. (ii) Making the suggested replacements.6. we have E XN Z = X0 = E I (1 + r)N (1 + r)N λZ (1 + r)N .26).26 3 State Prices (i) Fix y > 0. yx is a linear function of x.3. which is equivalent to x = I(y). (3.3.and right-hand sides of the above equation.19) and (3.2) holds. replace the dummy variable x by the random variable XN λZ and replace the dummy variable y by the random variable (1+r)N . A concave function has its maximum at the point where its derivative is zero.19) and (3.26) to conclude that (3.2) is just this statement.3).3.6.6. we obtain U (XN ) − λZXN ≤U (1 + r)N I λZ (1 + r)N − λZ I (1 + r)N λZ (1 + r)N . The derivative of this function is U (x) − y. Taking expectations under P and using the fact that Z is the RadonNikod´m derivative of P with respect to P. we obtain y EU (XN ) − λE ≤ EU XN (1 + r)N I λZ (1 + r)N − λE Z I (1 + r)N λZ (1 + r)N . Cancelling these terms on the left. Take expectations of both sides and use (3. the diﬀerence U (x) − yx is a concave function of x. From (3.3.

(iii) Determine the price at time zero.2. = V3P (T T H) = (4 − 2)+ = 2. denoted V0P .2 of Chapter 1. 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. of the American call that expires at time three and has intrinsic value gC (s) = (s − 4)+ . (iv) Explain why V0S < V0P + V0C . In the three-period model of Figure 1. of the American put that expires at time three and has intrinsic value gP (s) = (4 − s)+ . let the 1 interest rate be r = 4 so the risk-neutral probabilities are p = q = 1 . = 0. the value of the put at time two is . of the American straddle that expires at time three and has intrinsic value gS (s) = gP (s) + gC (s). denoted V0S . ˜ ˜ 2 (i) Determine the price at time zero.50)+ Because 1 1 ˜ ˜ 2 1+r p = 1+r q = 5 .1.9 Solutions to Selected Exercises Exercise 4.4 American Derivative Securities 4. (ii) Determine the price at time zero.50. = V3P (T HH) = (4 − 8)+ = 0. denoted V0C . = 3.

V3P (HT H) + V3P (HT T ) 5 5 2 2 = max 4 − 4)+ . · 2 + · 3.80. 0. 2 + 2 V2P (T H) = max 4 − S2 (T H) . V3P (HHH) + V3P (HHT ) 5 5 2 2 = max (4 − 16)+ . 0. 1. · 0 + · 2 5 5 = max{0. · 0 + · 2 5 5 = max{0. At time one the value of the put is V1P (H) = max 2 2 . 2. The value of the put at time zero is . · 0 + · 0.50 5 5 = max{3.80} = 0.28 4 American Derivative Securities V2P (HH) = max 2 2 . V3P (T T H) + V3P (T T T ) 5 5 2 2 = max (4 − 1)+ . · 0.32} = 0.80 + · 3 5 5 = max{2.80. V2P (T T ) = max 2 2 . 2 + 2 V1P (T ) = max 4 − S1 (T ) .52} 4 − S1 (H) + = 2. V3P (T HH) + V3P (T HT ) 5 5 2 2 = max 4 − 4)+ .80} 4 − S2 (HH) + = 0. 2 + 2 V2P (HT ) = max 4 − S2 (HT ) . V2P (T H) + V2P (T T ) 5 5 2 2 = max (4 − 2)+ . 0} = 0.32. 0. · 0 + · 0 5 5 = max{0.80 5 5 = max{0.20} 4 − S2 (T T ) + = 3. V2P (HH) + V2P (HT ) 5 5 2 2 = max (4 − 8)+ .

9 Solutions to Selected Exercises 29 2 2 V0P = max (4 − S0 )+ . 1. V1P (H) + V1P (T ) 5 5 2 2 = max (4 − 4)+ . · 0 + · 0 5 5 = max{0. · 28 + · 4 5 5 = max{12. V3C (T HH) + V3C (T HT ) 5 5 2 2 = max 4 − 4)+ .928.928} = 0.8.60} S2 (HT ) − 4 = 1. = V3C (T HH) = (8 − 4)+ = 4.50 − 4)+ Because 1 1 ˜ ˜ 2 1+r p = 1+r q = 5 .4.8} S2 (HH) − 4 = 12.60. = 0. V3C (HHH) + V3C (HHT ) 5 5 2 2 = max (16 − 4)+ . 12. 2 + 2 V2C (T T ) = max S2 (T T ) − 4 . · 4 + · 0 5 5 = max{0. = 28. 0.60} = 1. the value of the call at time two is + V2C (HH) = max 2 2 . = V3C (T T H) = (2 − 4)+ = 0.60. + V2C (T H) = max 2 2 . · 4 + · 0 5 5 = max{0. (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 ) = (0.32 + · 2 5 5 = max{0. V3C (HT H) + V3C (HT T ) 5 5 2 2 = max 4 − 4)+ . V3C (T T H) + V3C (T T T ) 5 5 2 2 = max (1 − 4)+ . 0} S2 (T H) − 4 = 0. + V2C (HT ) = max 2 2 . 1. · 0. At time one the value of the call is .

· 12.76.8 + · 1.64} = 0. 2. 12. V3S (HT H) + V3S (HT T ) 5 5 2 2 = max 4 − 4)+ .8. the value of the straddle at time two is ˜ ˜ 5 V2S (HH) = max 2 2 S2 (HH) − 4 . .50.60 5 5 = max{4. S1 (H) − 4 + The value of the call at time zero is 2 2 V0C = max (S0 − 4)+ . V3S (T T T ) = |0. V2C (HH) + V2C (HT ) 5 5 2 2 = max (8 − 4)+ . 2. V3S (HHT ) = V3S (HT H) = V3S (T HH) = |8 − 4| = 4. 5. · 4 + · 2 5 5 = max{0. 2 + 2 V1C (T ) = max S1 (T ) − 4 . · 5.40} S2 (HT ) − 4 + = 2.40. · 28 + · 4 5 5 = max{12.56} = 2.76} = 5.50 − 4| = 3. 1 1 Because 1+r p = 1+r q = 2 .64.8} = 12. V2C (T H) + V2C (T T ) 5 5 2 2 = max (2 − 4)+ . · 1. V1C (H) + V1C (T ) 5 5 2 2 = max (4 − 4)+ .60 + · 0 5 5 = max{0. V2S (HT ) = max 2 2 .56.30 4 American Derivative Securities V1C (H) = max 2 2 . We see that the payoﬀ of the straddle is the payoﬀ of the put given in the solution to (i) plus the payoﬀ of the call given in the solution to (ii).64 5 5 = max{0. 0.76 + · 0. V3S (HHH) + V3S (HHT ) 5 5 2 2 = max |16 − 4|. (iii) Note that gS (s) = |s − 4|. V3S (HT T ) = V3S (T HT ) = V3S (T T H) = |2 − 4| = 2. The payoﬀ of the straddle at expiration time three is V3S (HHH) = |32 − 4| = 28.

296.32 + 5.08. 2.08} = 6. · 2 + · 3.16. . At time one the value of the straddle is V1S (H) = max 2 2 S1 (H) − 4 . · 2. V2S (T H) + V2S (T T ) 5 5 2 2 = max |2 − 4|.40 5 5 = max{4.40} = 2.928 + 2.8 + · 2. 2.76 = V1P (H) + V1C (H).16} = 2.08 = 0. V3S (T HH) + V3S (T HT ) 5 5 2 2 = max 4 − 4)+ .40 + · 3 5 5 = max{2.296} = 3. · 6. We have V1S (H) = 6.16 5 5 = max{0. V3S (T T H) + V3S (T T T ) 5 5 2 2 = max |1 − 4|.4.64 = V1P (T ) + V1C (T ).40. S2 (T H) − 4 + One can verify in every case that V2S = V2P + V2C . but V1S (T ) = 2. 2 2 V1S (T ) = max S1 (T ) − 4 . 3. We have V0S = 3.56 = V0P + V0C .20} = 3.50 5 5 = max{3.08 + · 2. 6. 2 2 V2S (T T ) = max S2 (T T ) − 4 . V1S (H) + V1S (T ) 5 5 2 2 = max |4 − 4|. 2. · 12.296 < 0. The value of the straddle at time zero is 2 2 V0S = max |S0 − 4|.9 Solutions to Selected Exercises 31 V2S (T H) = max 2 2 . · 4 + · 2 5 5 = max{0. V2S (HH) + V2S (HT ) 5 5 2 2 = max |8 − 4|.16 < 2 + 0.

2.2 of Chapter 1. whereas the value of continuing is 0. This intrinsic value is a put on the average stock price between time zero and time n.52} = 2.80 + · 3 5 5 = max{2. V2S (T H) + V2S (T T ) 5 5 2 2 = max |2 − 4|. n = 0. 1. 3.16. it is optimal to exercise at time one. let the interest rate be r = 1 so the risk-neutral probabilities are p = q = 1 . we see that it is not optimal to exercise the straddle at time one if the ﬁrst toss results in T . In other words. On the other hand. this value is less than would be achieved if one could exercise the put part and let the call part continue. Find ˜ ˜ 4 2 the time-zero price and optimal exercise policy (optimal stopping time) for the path-dependent American derivative security whose intrinsic value at each 1 time n. This loss of value at time one results in a similar loss of value at the earlier time zero: V0S < V0P + V0C . Greater value is achieved by not exercising both parts than would be achieved by exercising both. Therefore. 1. and thus V1S (T ) < V1P (T ) + V1C (T ).64. both parts of the payoﬀ are received. It would be optimal to exercise the put part. This can be seen from the equation V1P (T ) = max 2 2 . 4 − S1 (T ) + which shows that the intrinsic value at time one if the ﬁrst toss results in T is greater than the value of continuing. the call should not be exercised at time one if there is a tail on the ﬁrst toss. When it is exercised. · 2. In the computation of the straddle price V1S (T ) = max 2 2 S1 (T ) − 4 . The straddle has the intrinsic value of a put plus a call. 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. 2.32 4 American Derivative Securities (iv) For the put.16} = 2. but not the call part. n + . V2P (T H) + V2P (T T ) 5 5 2 2 = max (4 − 2)+ . · 0.40 + · 3 5 5 = max{2. is 4 − n+1 j=0 Sj .3. However. it is not an American put plus an American call. Exercise 4. In the three-period model of Figure 1. 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. and the straddle cannot exercise one part without exercising the other. 2. if there is a tail on the ﬁrst toss.

V3 (HT H) = G3 (HT H) = = 4− 4− S0 + S1 (H) + S2 (HT ) + S3 (HT H) 4 4+8+4+8 4 + + = 0. V3 (HHH) = G3 (HHH) = = 4− 4− S0 + S1 (H) + S2 (HH) + S3 (HHH) 4 4 + 8 + 16 + 32 4 + + = 0. = 0.6667. the intrinsic value G3 agrees with the option value V3 . 4− 4+8 + 2 4+2 + 2 S0 +S1 (H)+S2 (HH) 3 S0 +S1 (H)+S2 (HT ) 3 S0 +S1 (T )+S2 (T H) 3 S0 +S1 (T )+S2 (T T ) 3 = 4− = = 4− = 4+8+16 + 3 4+8+4 3 4+2+4 + 3 4+2+1 3 At time three.6667.4. = 0. = 1. = 1. In other words.9 Solutions to Selected Exercises 33 Solution The intrinsic value process for this option is G0 = G1 (H) = G1 (T ) = G2 (HH) = 4 − G2 (HT ) = 4 − G2 (T H) = G2 (T T ) = 4− 4− (4 − S0 ) + + + + + + + = = = 4− S0 +S1 (H) 2 S0 +S1 (T ) 2 4− 4− 4− r− (4 − 4)+ = 0. = 0. . V3 (HT T ) = G3 (HT T ) = = 4− 4− S0 + S1 (H) + S2 (HT ) + S3 (HT T ) 4 4+8+4+2 4 + + = 0. V3 (HHT ) = G3 (HHT ) = = 4− 4− S0 + S1 (H) + S2 (HH) + S3 (HHT ) 4 4 + 8 + 16 + 8 4 + + = 0. = 0.

V3 (T T T ) = G3 (T T T ) = = 4− 4− S0 + S1 (T ) + S2 (T T ) + S3 (T T T ) 4 4 + 2 + 1 + 0. · 0 + · 0 5 5 = 0. 2 2 V2 (HT ) = max G2 (HT ).125. V3 (T HT ) = G3 (T HT ) = = 4− 4− S0 + S1 (T ) + S2 (T H) + S3 (T HT ) 4 4+2+4+2 4 + + = 1. to obtain 2 2 V2 (HH) = max G2 (HH). · 0 + · 0 5 5 = 0. .75. V3 (T T H) = G3 (T T H) = = 4− 4− S0 + S1 (T ) + S2 (T T ) + S3 (T T H) 4 4+2+1+2 4 + + = 1. We use the algorithm of Theorem 4.3. V3 (HHH) + V3 (HHT ) 5 5 2 2 = max 0.50 4 + + = 2. V3 (HT H) + V3 (HT T ) 5 5 2 2 = max 0. noting that p ˜ 1+r = q ˜ 1+r 2 = 5 .34 4 American Derivative Securities V3 (T HH) = G3 (T HH) = = 4− 4− S0 + S1 (T ) + S2 (T H) + S3 (T HH) 4 4+2+4+8 4 + + = 0.4.

With the intrinsic value Gn = 4 − 1 n+1 n j=1 Sj + deﬁned in the exercise. 2 2 V0 = max G0 . V2 (HH) + V2 (HT ) 5 5 2 2 = max 0.6667 5 5 = max{1. Continuing. V1 (T ) = G1 (T ). · 0 + · 1 5 5 = max{0. If the payoﬀ were 4 − n+1 j=1 Sj . V2 (T H) + V2 (T T ) 5 5 2 2 = max 1. To ﬁnd the optimal exercise time.75 + · 2.6667. V1 (H) + V1 (T ) 5 5 2 2 = max 0. .55} = 1. V3 (T T H) + V3 (T T T ) 5 5 2 2 = max 1.40} = 0.6667.6667. If the ﬁrst toss results in H. Since V0 > G0 . 1. the option is destined always be out of the money.6667. we have 2 2 V1 (H) = max G1 (H).9 Solutions to Selected Exercises 35 2 2 V2 (T H) = max G2 (T H). 0. we work forward. one should not exercise at time zero. 0.6667. · 0 + · 1 5 5 = max{0.6667. · 1. 2 2 V2 (T T ) = max G2 (T T ). 2 2 V1 (T ) = max G1 (T ).40.6667 + · 1.40} = 0. 0. V3 (T HH) + V3 (T HT ) 5 5 2 2 = max 0. then one should allow the option to expire unexercised. so that exercising out of the money is costly (as one would expect in practice). · 0.125 5 5 = max{1. However. · 0 + · 0 5 5 = 0.9334} = 1. it does not matter what n 1 exercise rule we choose in this case. so it is optimal to exercise at time one if there is a T on the ﬁrst toss.4.

and from among those. The 26 stopping times in the two-period binomial model are tabulated below.4. τ (HT ). For each stopping time τ in the latter set. List all the stopping times in S0 (there are 26).7).5). the one which makes this quantity equal to the 1. Verify that the largest value for this quantity is given by the stopping time of (4.4. and we can specify a stopping time by listing its values τ (HH). the maximum is computed over all stopping times in S0 .36 4 American Derivative Securities Exercise 4.6). and τ (T T ). 4 τ compute E I{τ ≤2} 5 Gτ . The stopping time property requires that τ (HH) = 0 if and only if τ (HT ) = τ (T H) = τ (T T ) = 0.36 computed in (4.4.5. In equation (4. Stopping Time HH HT TH TT τ1 τ2 τ3 τ4 τ5 τ6 τ7 τ8 τ9 τ10 τ11 τ12 τ13 τ14 τ15 τ16 τ17 τ18 τ19 τ20 τ21 τ22 τ23 τ24 τ25 τ26 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 ∞ 2 ∞ 1 2 ∞ 2 ∞ 1 2 ∞ 2 ∞ 1 2 ∞ 2 ∞ 1 2 ∞ 2 ∞ The intrinsic value process for this option is given by . Solution A stopping time is a random variable. list the stopping times that never exercise when the option is out of the money (there are 11). Similarly. τ (T H). τ (HH) = 1 if and only if τ (HT ) = 1 and τ (T H) = 1 if and only if τ (T T ) = 1.

4. For all other exercise situations.9 Solutions to Selected Exercises 37 G0 = 1. G is positive. 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). G1 (H) = −3.80. = 25 25 25 1 16 1 16 = · G2 (HT ) + · G2 (T H) 4 26 4 25 4 4 = ·1+ · 1 = 0.20. This leaves us with τ1 and the ten stopping times τ17 –τ26 . 25 5 1 16 1 16 1 16 = · G2 (HT ) + · G2 (T H) + · G2 (T T ) 4 26 4 25 4 25 4 4 4 ·1+ ·1+ · 4 = 0. 25 25 . 25 25 1 16 1 16 = · G2 (HT ) + · G2 (T T ) 4 26 4 25 4 4 = ·1+ · 4 = 0. G2 (T T ) = 4.96. 25 25 1 16 = · G2 (HT ) 4 26 4 = · 1 = 0. G2 (HH) = −11. 25 1 4 = · G1 (T ) 2 5 2 = · 3 = 1.80. 5 1 16 1 16 = + · G2 (T H) + · G2 (T T ) 4 25 4 25 4 4 = ·1+ · 4 = 0. so the option is in the money.36. Also.16. E I{τ1 ≤2} E I{τ17 ≤2} 4 5 4 5 τ Gτ1 = G0 = 1. This rules out τ7 –τ16 . G2 (HT ) = G2 (T H) = 1. τ Gτ17 = E I{τ18 ≤2} 4 5 τ Gτ18 E I{τ19 ≤2} 4 5 τ Gτ19 E I{τ20 ≤2} 4 5 τ Gτ20 E I{τ21 ≤2} 4 5 τ Gτ21 E I{τ22 ≤2} 4 5 τ Gτ22 E I{τ23 ≤2} 4 5 τ Gτ23 1 16 1 4 · G2 (HT ) + · G1 (T ) 4 26 2 5 4 2 = · 1 + · 3 = 1.32. 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 τ2 – τ6 . G1 (T ) = 3. We evaluate the risk-neutral expected payoﬀ of these eleven stopping times.

3). If τ is a stopping time satisfying τ (ω) ≤ N for every sequence of coin tosses ω. N . we must in fact have equality: . = 25 τ 4 1 16 Gτ25 = + · G2 (T T ) 5 4 25 4 = + · 4 = 0. Determine the time-zero value and optimal exercise policy for this derivative security. N . 25 τ 4 Gτ26 = 0. 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 .8. τ τ (1 + r) (1 + r)N max E On the other hand. .36. is a submartingale. let Gn = Sn − K. If the purchase has not been made at time N .τ ≤N 1 1 G ≤E GN . . E Therefore.16. 5 4 5 τ The largest value. V0 = τ ∈S0 . (Assume r ≥ 0. . this becomes EYτ ≤ EYN . or equivalently. n = 0. .) 1 Solution Set Yn = (1+r)n (Sn − K). . we have En [Yn+1 ] = En Sn+1 K − En n+1 (1 + r) (1 + r)n+1 Sn K = − (1 + r)n (1 + r)n+1 K Sn − . τ τ (1 + r) (1 + r)N 1 1 G ≤E GN . . . . 1.38 4 American Derivative Securities E I{τ24 ≤2} E I{τ25 ≤2} E I{τ26 ≤2} 1 16 Gτ24 = + · G2 (T H) 4 25 4 · 1 = 0. We assume r ≥ 0. it must be made then. 1.3.6 whose time-zero price is given by (4. 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.3 (Optional Sampling—Part II). is obtained by the stopping time τ17 . 1. Exercise 4.7.64. Because the discounted stock price is a martingale under the risk-neutral K measure and (1+r)n+1 is not random. According to Theorem 4. EYN ∧τ ≤ EYN whenever τ is a stopping time. n = 0. ≥ (1 + r)n (1 + r)n This shows that Yn . For the class of derivative securities described in Exercise 4.

9 Solutions to Selected Exercises 39 V0 = τ ∈S0 . τ τ (1 + r) (1 + r)N Hence.4. .τ ≤N max E 1 1 G =E GN . it is optimal to exercise at the ﬁnal time N regardless of the outcome of the coin tossing.

.

5 Random Walk 5. the process Sn = eσMn is a martingale. Solution. (iii) Show that for σ > 0. we have f (0) = p − q > 0. If the random walk never reaches this level.1). (i) Deﬁne f (σ) = peσ + qe−σ . e−σ = E I{τ1 <∞} Conclude that P{τ1 < ∞} = 1. 1 f (σ) τ1 n 1 f (σ) . Show that f (σ) > 1 for all σ > 0. f is always positive and f is convex.8 Solutions to Selected Exercises Exercise 5. (iv) Compute Eατ1 for α ∈ (0. (v) Compute Eτ1 . (First passage time for random walk with upward drift) Consider the asymmetric random walk with probability p for an up step and probability q = 1 − p for a down step. Under the assumption p > 1/2 > q.2. 1). . and the convexity of f implies that f (σ) > 1 for all σ > 0. let τ1 be the ﬁrst time the random walk starting from level 0 reaches the level 1. (ii) Show that when σ > 0. In the notation of (5. where 1 < p < 1 so that 2 1 0 < q < 2 . (i) The function f (σ) satisﬁes f (0) = 1 and f (σ) = peσ −qe−σ . then τ1 = ∞. f (σ) = f (σ).2. Since f is always positive.

(iv) We now introduce α ∈ (0. and 0 < 1/f (σ) < 1. we obtain 1 = E I{τ1 <∞} eσ or equivalently. (iii) Because Sn∧τ1 is a martingale starting at 1.1). (5. 1) and solve the equation α = This equation can be written as αpeσ + αqe−σ = 1.8.42 5 Random Walk (ii) We compute En [Sn+1 ] = = = 1 f (σ) 1 f (σ) 1 f (σ) n+1 En eσ(Mn +Xn+1 ) n+1 eσMn E eσXn+1 n+1 eσMn peσ + qe−σ 1 f (σ) n = eσMn = Sn . We let σ ↓ 0 to obtain the formula 1 = EI{τ1 <∞} = P{τ1 < ∞}. Letting n → ∞ in (5. which may be rewritten as αq e−σ and the quadratic formula gives 2 1 f (σ) for e−σ .8.8. the positive random variable eσMn∧τ1 is bounded above by eσ . lim eσMn∧τ1 1 f (σ) n∧τ1 n→∞ = I{τ1 <∞} eσ 1 f (σ) τ . e−σ = E I{τ1 <∞} 1 f (σ) 1 f (σ) τ1 . − e−σ + αp = 0.2) This equation holds for all positive σ.1) For σ > 0. (5. Therefore. we have 1 = ESn∧τ1 = EeσMn∧τ1 1 f (σ) n∧τ1 . . τ1 .

According to Theorem 5. we obtain the formula Eατ1 = 1− 1 − 4α2 pq . 2αq (5. starting from level 0.8 Solutions to Selected Exercises 43 e−σ = 1± 1 − 4α2 pq . 1).2. 2. = Eτ1 = 2 2q(1 − 2q) 1 − 2q p−q 2q 1 − 4pq 2q (1 − 2q) Exercise 5. . reaches the level 2.4 (Distribution of τ2 ).3.2).5. and let τ2 be the ﬁrst time the random walk.8. Consider the symmetric random walk.8.4) (v) Diﬀerentiating (5. Hence we take the negative sign.21). Using the power series (5.8. 2αq Substituting this into (5. Eα τ2 = 1− √ 1 − α2 α 2 for all α ∈ (0.2. 2αq (5. . (k + 1)!k! (i) Use the above power series to determine P{τ2 = 2k}. .3) We want σ to be positive.4) with respect to α leads to Eτ ατ −1 = 1− 1 − 4α2 pq .8. . k = 1. we may write the right-hand side as 1− √ 1 − α2 α 2 = √ 2 1 − 1 − α2 · −1 α α ∞ = −1 + ∞ j=1 α 2 2j−2 (2j − 2)! j!(j − 1)! = j=2 ∞ α 2 α 2 2j−2 (2j − 2)! j!(j − 1)! = k=1 2k (2k)! . . so we need e−σ to be less than 1. 2α2 q 1 − 4α2 pq and letting α ↑ 1. obtaining e−σ = 1− 1 − 4α2 pq . we obtain √ 1 − (1 − 2q)2 1 1 1 − (1 − 2q) 1 − 1 − 4pq √ = = = .

. ∞ ∞ Eατ2 = k=1 α2k P{τ2 = 2k} = k=1 α 2 2k (2k)! . − = 1 2 2k 1 2 (2k − 2)! (2k − 2)! + (k − 1)!(k − 1)! k!(k − 2)! 2k + 1 2 4(2k − 2)! (2k)! − (k − 1)!(k − 1)! k!k! 2k (2k)! (2k)! + k!k! (k + 1)!(k − 1)! 4(2k − 2)! (2k)! − k!(k − 2)! (k + 1)!(k − 1)! . . 2. . 2. . . every path has the same probability. . Thus. . (k + 1)!k! Equating coeﬃcients. . A path is of the last type if and only if its reﬂected path exceeds level 2 at time 2k. . Solution (i) Since the random walk can reach the level 2 only on even-numbered steps. Therefore. the number of paths that reach or exceed level 2 by time 2k is equal to the number of paths that are at level 2 at time 2k plus the number of paths that exceed level 2 at time 2k plus the number of paths that reach the level 2 before time 2k but are below level 2 at time 2k. P{τ2 = 2k} = P{τ2 ≤ 2k} − P{τ2 ≤ 2k − 2} = 1 2 2k−2 (2k)! k!k! 1 2 2k − (2k)! (k + 1)!(k − 1)! 1 2 2k . For the symmetric random walk. P{τ2 = 2k − 1} = 0 for k = 1. k = 1. (ii) For k = 1. . the number of paths that reach or exeed level 2 by time 2k is equal to the number of paths that are at level 2 at time 2k plus twice the number of paths that exeed level 2 at time 2k. . . 2. . and hence P{τ2 ≤ 2k} = P{M2k = 2} + 2P{M2k ≥ 4} = P{M2k = 2} + P{M2k ≥ 4} + P{M2k ≤ −4} = 1 − P{M2k = 0} − P{M2k = −2} = 1− Consequently. 2.44 5 Random Walk (ii) Use the reﬂection principle to determine P{τ2 = 2k}. . k = 1. we conclude that P{τ = 2k} = (2k)! (k + 1)!k! 1 2 2k . . .

4) in the stock.. Your hedge is to ﬁrst consume the amount c(s) = v(s) − and then take a position δ(s) = v(2s) − v s 2s − 2 s 2 1 s 4 1 v(2s) + v 5 2 2 2 (5.2 of Chapter 4.2.7.4 and are hedging the short position in this put.3) and (5. (k + 1)!k! (4k 2 − 4)(2k − 2)! − (4k 2 − 2k))(2k − 2)! (k + 1)!(k − 1)! 2k = = = 2k 2k Exercise 5.) If you hedge this way. Suppose you have sold the perpetual American put of Section 5.5. (i) Compute c(s) when s = 2j for the three cases j ≤ 0. (ii) Compute δ(s) when s = 2j for the three cases j ≤ 0.4). Suppose at the current time the stock price is s and the value of your hedging portfolio is v(s). . then regardless of whether the stock goes up or down on the next step. the value of your hedging portfolio should agree with the value of the perpetual American put. j = 1 and j ≥ 2.7. (Hedging a short position in the perpetual American put).3) (5.7. j = 1 and j ≥ 2. (See Theorem 4. i.8 Solutions to Selected Exercises 45 = 1 2 2k 2k · 2k(2k − 2)! − 2k(2k − 1)(2k − 2)! k!k! 1 2 2k + = 1 2 2k 4k 2 (2k − 2)! − (4k 2 − 2k)(2k − 2)! k!k! 1 2 2k (2k + 2)(2k − 2)(2k − 2)! − 2k(2k − 1)(2k − 2)! (k + 1)!(k − 1)! + = 1 2 1 2 1 2 1 2 2k 2k(2k − 2)! 2(k − 2)(2k − 2)! + k!k! (k + 1)!(k − 1)! (2k − 2)! (2k(k + 1) + 2(k − 2)k (k + 1)!k! (2k − 2)! 2k(2k − 1) (k + 1)!k! (2k)! .e. Cn = c(Sn ) and ∆n = δ(Sn ).7. The processes Cn and ∆n in that theorem are obtained by replacing the dummy variable s by the stock price Sn in (5.7.

j = 1 and j ≥ 2 that the hedge works (i. 2j For j = 1. c(2j ) = v(2j ) − 4 2 − j 2 5 2 4 = j − 2 5 = 0.4. 5 Finally.. regardless of whether the stock goes up or down. we use (5. if j ≥ 1. Solution (i) Throughout the following computations. j+1 − 2j−1 2 2j+1 − 2j−1 4 1 1 v(2j+1 ) + v(2j−1 ) 5 2 2 4 4 + j−1 2j+1 2 16 4 + j+1 j+1 2 2 . the value of your hedging portfolio at the next time is equal to the value of the perpetual American put at that time). = (ii) For j ≤ 0. for j ≥ 2. if j ≤ 1. we have c(2) = v(2) − 1 4 1 v(4) + v(1) 5 2 2 2 = 2 − [1 + 3] 5 2 = .6): v(2j ) = For j ≤ 0.46 5 Random Walk (iii) Verify in each of the three cases s = 2j for j ≤ 0. 5 1 1 v(2j+1 ) + v(2j−1 ) 2 2 4 − 2j+1 + 4 − 2j−1 8 − 5 · 2j−1 4 − 2j . we have δ(2j ) = 4 − 2j+1 − 4 − 2j−1 v(2j+1 ) − v(2j−1 ) = = −1. 4 . we have c(2j ) = v(2j ) − 4 5 2 = 4 − 2j − 5 2 = 4 − 2j − 5 4 = .e.

When she exercises. so our portfolio is valued at 4 − 2j+1 . If the stock goes up to 5 j+1 2 . so we are maintaining a cash position of 4. 5 5 which is invested in the money market.5. which will cover our short position. she will deliver the share of stock. 4−1 4−1 3 (iii) If the stock price is 2j . 5 the money market investment grows to 4 · 16 = 4. If the stock price is 2. 2 1−3 2 v(4) − v(1) = =− . we have δ(2) = Finally. our short stock position has value −2j+1 . When we go to the next period. we must pay her 4. At the beginning of any period in which she fails to exercise. which is the option value also in this case. and we are prepared for that by being short one share of stock. which is the option value in this case. our portfolio is valued at 4 − 2j−1 . δ(2j ) = v(2j+1 ) − v(2j−1 ) 2j+1 − 2j−1 4 4 − j−1 2j+1 2 = j+1 2 − 2j−1 4 − 16 1 = j+1 · 2 (4 − 1)2j−1 4 = − 2j .8 Solutions to Selected Exercises 47 For j = 1. If the stock goes up 15 3 . then we have a portfolio valued at v(2j ) = 4 − 2j . When the stock price is 2j with j ≤ 0. the owner of the option should exercise. 5 3 15 which is invested in the money market. 5 the money market investment grows to 4 · 44 = 11 . then we have a portfolio valued at v(2) = 2. We 2 2 consume c(2) = 2 and short 3 of a share of stock (δ(2) = − 3 ). But when she exercises. for j ≥ 2. If the stock goes down to 2j−1 . We consume c(2j ) = 4 and short one share of stock 5 (δ(2j ) = −1). This creates a cash position of 4 − 2j − 4 16 + 2j = . When we go to the next period. This 5 creates a cash position of 2− 44 2 2 + ·2= . we get to consume the present value of the interest that will accrue to this cash position over the next period. where j ≤ 0.

13) for the value of the perpetual American put in Section 5. 2j 2j This creates a cash position of 4 8 4 + 2j · 2j = j . If the stock 2 goes down to 1. (i) We ﬁrst determine v(s) for large values of s. We consume c(2j ) = 0 and short 24 shares of stock (δ(2j ) = − 24 ). Exercise 5. j 2 2 2 2 which is the option value also in this case.4. 2j 2 2 which is invested in the money market. so the 3 2 11 portfolio is valued at 3 − 3 = 3. which is the option value also in this case. j 2 2 2 2 which is the option value in this case.9.4. the short stock position has value − so the portfolio is valued at 10 2 8 4 − j = j = j−1 . the short stock position has value − 3 · 4 = − 8 . When s is large. the short stock position has value − so the portfolio is valued at 10 8 2 4 − j = j = j+1 . When we go to the next period.4. 4 2 2 If the stock goes up to 2j+1 . Finally. so the maximum in (5. (Provided by Irene Villegas. if the stock price is 2j . where j ≥ 2. 5 5 2 2 4 · 2j−1 = − j . then we have a portfolio valued 4 at 2j . the money market investment grows to 5 8 10 · j = j. 22j 2 8 4 · 2j+1 = − j .) Here is a method for solving equation (5. the short stock position has value − 3 · 1 = − 2 . If the stock goes down to 2j−1 .13) will be given by the second term. it is not optimal to exercise the put. 22j 2 . which is the option value in this case. 1 s 4 1 v(2s) + v 5 2 2 2 = 2 s 2 v(2s) + v .48 5 Random Walk 2 to 4. so the portfolio is 3 8 11 valued at 3 − 3 = 1.

v(s) = B for some s constant B still to be determined. (ii) The general solution to (5.7) Which values of B and sB give the owner the largest option value? (v) For s < sB .e. i. Using the second boundary condition in (5. the derivative of vB (s) is vB (s) = −1. (iii) We have thus established that for large values of s. Substitute sp into (5. It remains to evaluate A and B. show that A must be zero. Then the discounted risk-neutral expected payoﬀ of the put is vB (S0 ). For s > sB . this function does not take the value 0 for any s > 0.4. B if s ≥ sB .6) v(s) = As + .5). the two formulas for vB (s) give the same answer at s = sB ). for some s > 0. if s ≤ sB . Show that. or linear combinations of functions of this form.e.5). s For large values of s. when B > 4.e.8 Solutions to Selected Exercises 49 We thus seek solutions to the equation v(s) = 2 s 2 .7. We must choose B so these two functions coincide at some point. This leads to the values p = 1 and p = −1. v1 (s) = s and v2 (s) = 1 are s solutions to (5. and solve to obtain 2p = 2 or 2p = 2 . B (5.e. this B derivative is vB (s) = − s2 . B fB (s) = − (4 − s) s equals zero.7.7. Show that the best value of B for the option owner makes the derivative of vB (s) continuous at s = sB (i. i. Suppose further that the owner of the perpetual American put exercises the ﬁrst time the stock price is sB or smaller. For small values of s. the value of the put is its intrinsic value 4 − s.5) All such solutions are of the form sp for some constant p. the equation fB (s) = 0 has a solution. sB = 2j for some integer j).e. obtain a 1 quadratic equation for 2p . s. (5.15). when B ≤ 4.. where vB (s) is given by the formula vB (s) = 4 − s.7..5. v(2s) + v 5 5 2 (5.7..6).5) is a linear combination of v1 (s) and v2 (s). (iv) Let B be less than or equal to 4 and let sB be a solution of the equation fB (s) = 0. . but. i. we must ﬁnd a value for B so that...7. the value of the perpetual American put must be given by (5. Suppose sB is a stock price which can be attained in the model (i.7.

2 (iv) Since vB (s) = B for all large values of s. then fB (sc ) = 0 and sc is the only solution to the equation fB (s) = 0 in (0. ∞). 2 a quadratic equation in 2p . and hence fB s3 attains a minimum at sc . .5) becomes sp = Mulitplication by 2p sp 2 p p 2 1 p ·2 s + · ps . For values of B < 4. in which case fB (s) = 0 has no solution in (0.. ∞) is √ fB (sc ) = 2 B − 4. We note that the second derivative. is positive on (0. To ﬁnd the minimizing value of s.50 5 Random Walk Solution (i) With v(s) = sp . If B = 4. fB (s) takes the value zero for some s ∈ (0. the curve B lies s below the curve 4 (see Figure 5.8. The s boundary condition lims→∞ v(s) = 0 implies therefore that A is zero.e. so the function is convex. The solution to this equation is 2p = 1 2 5 ± 2 25 −4 4 = 1 2 5 3 ± 2 2 . 2B . ∞).7. 5 5 2 leads to 2p = 2 p 2 2 (2 ) + . ∞). we maximize this by choosing s B as large as possible. s √ This results in the critical point sc = B. we have lims→∞ v(s) = ±∞ unless A = 0. 5 5 and we may rewrite this as (2p ) − 2 5 p · 2 + 1 = 0. we must have B > 0. (5. (ii) With v(s) = As + B . ∞) if and only if its minimium over (0. and values of B > 4 are not possible s because of part (iii). The minimal value of fB on (0. (iii) Since v(s) is positive. This is positive if B > 4. B = 4. We note that lims↓0 fB (s) = lims→∞ fB (s) = ∞. i. ∞) is less than or equal to zero. and hence either p = 1 or p = −1. then fB (sc ) < 0 and the equation fB (s) = 0 has two solutions in (0. ∞). we set the derivative of fB (s) equal to zero: B − 2 + 1 = 0. We thus have either 2p = 2 or 2p = 1 . If 0 < B < 4.1). Therefore.

The curve y = . 5.8 Solutions to Selected Exercises 51 (iv) We see from the tangency of the curve y = 4 with the intrinsic value s y = 4 − s at the point (2. s Fig. Indeed. ds y 4 (2.8.8.5. d 4 ds s =− 4 s2 = −1. d (4 − s) = −1.1. s=2 s=2 and as noted in the statement of the exercise.1 that y = 4 and y = 4 − s have s the same derivative at s = 2.2) in Figure 5. 2) y= 4 s y =4−s 1 2 3 B s y= 3 s 4 for B = 3 and B = 4.

.

ω n ) + c2 En [Y ](ω 1 . . .. ×P{ωn+1 = ω n+1 . .2. If X depends only on the ﬁrst n coin tosses. ω N ) ω n+1 . ωN = ω N |ω1 = ω 1 . . . ω n ω n+1 . . . ω n ). According to Deﬁnition 6. . (iii) and (v) of Theorem 2. . .3. .. ω n ω n+1 .. (iii) and (v) of Theorem 2. . . . ω N ) + c2 Y (ω 1 . . . ..2 in turn. . .ω N = c1 +c2 ×P{ωn+1 = ω n+1 . . . .3. . . . then . ω N ) ω n+1 . . (ii). . . ω n ω n+1 . (Part (iv) is not true in the form stated in Theorem 2. .1.. ωN = ω N |ω1 = ω 1 . (ii). (i) Linearity of conditional expectations..3.. . .. . . . ω n ω n+1 . .. . .6 Interest-Rate-Dependent Assets 6. ωn = ω n } Y (ω 1 ..2. . .ω N c1 X(ω 1 . . .ω N = c1 En [X](ω 1 .. Prove parts (i). ω n ) = ω n+1 .2 when the coin tosses are not independent. ωN = ω N |ω1 = ω 1 . ω N ) ×P{ωn+1 = ω n+1 . .2.2.9 Solutions to Selected Exercises Exercise 6. .) Solution We take each of parts (i). . En [c1 X + c2 Y ](ω 1 .2 when conditional expectation is deﬁned by Deﬁnition 6. .. ωn = ω n } X(ω 1 . ωn = ω n } (ii) Taking out what is known. .

. . .. . . ωn = ω n }. .. . . ω n ) = ω n+1 . .. .. ωN = ω N = ω n+1 . . .ω N = ×P{ωn+1 = ω n+1 . . . .. ωm+1 = ω m+1 . .. . ωm = ω m . .. ω N ) ω n+1 ... ωm+1 = ω m+1 .. . ω m ) = ×P{ωn+1 = ω n+1 . ω n ) = X(ω 1 .. . . . .ω N ×P{ωn+1 = ω n+1 . ... . . ωN = ω N |ω1 = ω 1 . . . . ωn = ω n } (iii) Iterated conditioning.. ..... . where we have used the deﬁnition ×P{ωm+1 = ω m+1 .. . ωm = ω m |ω1 = ω 1 .. .. . ω N ) ×P{ωn+1 = ω n+1 . . .ω N |ω1 = ω 1 . . . . ωn = ω n } Em [X](ω 1 . ω n )En [Y ](ω 1 . . .. . . Em [X](ω 1 .. . .ω m ω m+1 . ωn = ω n } X(ω 1 . ωm = ω m |ω1 = ω 1 . ω n ) = ω n+1 . . ωm = ω m } . . . .. .54 6 Interest-Rate-Dependent Assets En [XY ](ω 1 .ω N = P{ωn+1 = ω n+1 . .. . . .ω N X(ω 1 .. . . . then because Em [X] depends only on the ﬁrst m coin tosses and P{ωn+1 = ω n+1 . . . . ωN = ω N |ω1 = ω 1 .. . . . . . . ω n )Y (ω 1 . . .ω N = X(ω 1 . ωn = ω n } Em [X](ω 1 . . . . ωN = ω N |ω1 = ω 1 . ωn = ω n } Y (ω 1 . . . . ω m ) ω n+1 . . . . ω n ω n+1 . ω N ) ω n+1 . . ωn = ω n }. . . .ω m ω m+1 . ω n ω n+1 . .ω m |ω1 = ω 1 .. . . ω n ) ×P{ωn+1 = ω n+1 . . . . . . . . . . . ω m ω m+1 . . ωm = ω m . . .. ωm+1 = ω m+1 . . . . ωn = ω n } we have En Em [X] (ω 1 . ωN = ω N |ω1 = ω 1 . . . .. . If 0 ≤ n ≤ m ≤ N . .. . . .. ωm = ω m . ωN = ω N ω m+1 . . . .. . .. ωm = ω m |ω1 = ω 1 .. . ω m ) ×P{ωn+1 = ω n+1 .

.. .3. . . . . .. . Using the fact that P{ωm+1 = ω m+1 .m zero coupon bonds maturing at time m and to hold one share of the asset with price Sn . ωN = ω N |ω1 = ω 1 . . ωn = ω n } we may write the last term in the above formula for En Em [X] (ω 1 ..6. . . ω N ) ω n+1 . ω m ω m+1 .9 Solutions to Selected Exercises 55 Em [X](ω 1 . .m For n ≤ k ≤ m − 1. . ωm = ω m . . . . . ω n ). Exercise 6. . . ×P{ωn+1 = ω n+1 .2 is. . . . n + 1. . . .ω m ω m+1 .ω N X(ω 1 . . at time n. .m . . ... . to short Sn Bn. . where n ≤ k ≤ m. .. . . ωN = ω N |ω1 = ω 1 . ω m ) = ω m+1 . . . . . . ωN = ω N |ω1 = ω 1 . ωN = ω N |ω1 = ω 1 . .. ωn = ω n } X(ω 1 . . ... . . ωm = ω m } in the last step. . . . . ω N ) ×P{ωm+1 = ω m+1 . . . . . .. .. The value of this portfolio at time k. ω m ω m+1 .m . . ω N ) ×P{ωn+1 = ω n+1 . . Verify that the discounted value of the static hedging portfolio constructed in the proof of Theorem 6. . . is Sn Xk = S k − Bk. . ωN = ω N |ω1 = ω 1 . . . . ωn = ω n } = P{ωn+1 = ω n+1 .m ] . .. . . . Solution The static hedging portfolio in Theorem 6. ×P{ωn+1 = ω n+1 . ωn = ω n } (iv) Conditional Jensen’s inequality. .3. . . . ωn = ω n }. .ω N = = En [X](ω 1 ... m. . . . ωm+1 = ω m+1 . . .ω N X(ω 1 . .2. we have Ek [Dk+1 Xk+1 ] = Ek [Dk+1 Sk+1 ] − Sn Ek [Dk+1 Bk+1. Bn. This follows from part (i) just like the proof of part (v) in Appendix A. . . ωN = ω N |ω1 = ω 1 . . . k = n.. ωm = ω m |ω1 = ω 1 . .2 is a martingale under P. ωm = ω m } = P{ωn+1 = ω n+1 . ω n ) as En Em [X] (ω 1 . ω n ) = ω n+1 .. Bn.

10)). we may rewrite this as Ek [Dk+1 Xk+1 ] = Dk Sk − Sn Ek Ek+1 [Dm ] Bn.9.56 6 Interest-Rate-Dependent Assets Using the fact that the discounted asset price is a martingale under the risk-neutral measure and also using (6.5) ﬁrst in the form Dk+1 Bk+1. 1 + R2 (HH) 3 V2 (HT ) = V2 (T H) = V2 (T T ) = 0.9. V3 (HT ) = V3 (T H) = V3 (T T ) = 0.m = Ek [Dm ].3.2.4. This is the martingale property. the price at time one of the caplet in the events ω1 = H and ω1 = T . 2 (ii) Show how to begin with 21 at time zero and invest in the money market and the maturity two bond in order to have a portfolio value X1 at time one that agrees with V1 . Using the data in Example 6. the price of the caplet at time two can be determined by discounting: V3 (HH) = V2 (HH) = 1 1 V3 (HH) = . Indeed. (i) Determine V1 (H) and V1 (T ).m Sn = D k Sk − Dk Bk. then one can simply 3 1 invest this 3 in the money market in order to have the 2 required to pay oﬀ 3 the caplet at time three. regardless of the outcome of the ﬁrst two coin tosses.3.3. the time-zero price of the caplet is determined to be (see (6. respectively. this exercise constructs a 1 hedge for a short position in the caplet paying (R2 − 3 )+ at time three.m Sn = D k Sk − Ek [Dm ] Bn. 3 Since this payoﬀ depends on only the ﬁrst two coin tosses. 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 . 2 21 In Example 6. if one is hedging a short position in the caplet and has a portfolio valued at 1 at time two in the event ω1 = H.3. Why do we invest in the maturity three bond rather than the maturity two bond to do this? . Exercise 6.m = D k Xk . We observe from the second table in Example 6.9 that the payoﬀ at time three of this caplet is 2 .m = Ek+1 [Dm ] and then in the form Dk Bk.m Bn. ω2 = H.

=− · + = 3 2 6 21 3 7 3 X2 (HT ) = ∆1 (H)B2. (i) We determine V1 by the risk-neutral pricing formula.3 (H) = B1.2 (T ) + (1 + R0 )(X0 − ∆0 B0. = · + 3 7 21 3 14 21 X1 (T ) = ∆0 B1. 3 7 3 3 7 21 1 E1 [D2 V2 ](T ) = 0. (iii) In the event of a T on the ﬁrst coin toss.9 Solutions to Selected Exercises 57 Solution.2 ) 4 5 2 4 11 = · + − · = 0 = V1 (T ). 3 6 21 3 7 .2 (T ) 4 21 − 0 6 5 7 − 7 = 4 . we hedge by taking in the maturity three bond the position ∆1 (H) = V2 (HH) − V2 (HT ) = B2.6. 3 7 21 3 14 We do not use the maturity three bond because B1.2 ) 2 4 11 4 4 6 − · = = V1 (H).3 (H)) 2 7 4 2 4 = − ·1+ + · = 0 = V2 (HT ). In particular.3 (HT ) + (1 + R1 (H))(X1 (H) − ∆1 (H)B1.3 (T ). and no further hedging is required. 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 ) = B1.3 (H)) 2 4 2 1 7 4 1 + · = V2 (HH). Set X0 = V0 = and compute X1 (H) = ∆0 B1. the hedging portfolio has zero value. V1 (H) = 1 E1 [D2 V2 ](H) D1 (H) = P{ω2 = H|ω1 = H}D2 (HH)V2 (HH) +P{ω2 = T |ω1 = H}D2 (HT )V2 (HT ) 2 6 1 1 6 4 = · · + · ·0 = . We compute X2 (HH) = ∆1 (H)B2.3 (HH) − B2.2 (H) + (1 + R0 )(X0 − ∆0 B0.3 (HH) + (1 + R1 (H))(X1 (H) − ∆1 (H)B1. the caplet price is zero.3 (HT ) 1 3 1 2 −0 2 =− . 3 2 21 It is straight-forward to verify that this works. 3 −1 It is straight-forward to verify that this works. In the event of a H on the ﬁrst toss. and this bond therefore provides no hedge against the ﬁrst coin toss.2 (H) − B1.

2 (HT ).58 6 Interest-Rate-Dependent Assets We do not use the maturity two bond because B2. and this bond therefore provides no hedge against the second coin toss.2 (HH) = B2. .

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