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Practice problems and solutions for SOA MFE

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Solutions

**SOA Sample Exam Solutions
**

Solution 1

A

Chapter 1, Put-Call Parity

We can use put-call parity to solve this problem:

CEur ( K ,T ) + Ke - rT = S0 + PEur ( K ,T )

[CEur ( K ,T ) - PEur ( K ,T )] - S0 = - Ke -rT

0.15 - 60 = -70e -4r

-59.85 = -70e -4r

Ê 59.85 ˆ

ln Á

= -4r

Ë 70 ˜¯

r = 0.03916

Solution 2

D

Chapter 2, Arbitrage

**Let X be the number of calls with a strike price of $55 that are purchased for Mary’s
**

portfolio. If we assume that the net cost of establishing the portfolio is zero, then we can

solve for X:

11 - 3 ¥ 6 + 1 + 3 X = 0

X =2

The table below shows that regardless of the stock price at time T, Mary’s payoff is

positive. Therefore, Mary is correct. This implies that John is incorrect.

Mary’s Portfolio

Time T

Transaction

Time 0

ST < 40

40 £ ST £ 50

50 £ ST £ 55

55 < ST

Buy 1 of C(40)

–11.00

0.00

ST - 40

ST - 40

ST - 40

Sell 3 of C (50)

3(6.00)

0.00

0.00

-3(ST - 50)

-3(ST - 50)

Buy 2 of C(55)

–2(3.00)

0.00

0.00

0.00

2(ST - 55)

-1.00

erT

erT

erT

erT

0.00

erT

erT + ST - 40

erT + 110 - 2ST

erT

Lend $1

Total

© ActuarialBrew.com 2014

Page

1

SOA Sample Exam MFE/3F

Solutions

Let Y be the number of calls and puts with a strike price of $50 that are sold for Peter. If

we assume that the net cost of establishing the portfolio is zero, then we can solve for Y:

2 ¥ 3 - 2 ¥ 11 + 11 - 3 + 2 - Y ¥ 6 + Y ¥ 8 = 0

2Y = 6

Y =3

In evaluating Peter’s portfolio, we can make use of the fact that purchasing a call option

and selling a put option is equivalent to purchasing a prepaid forward on the stock and

borrowing the present value of the strike price. We can see this by writing put-call parity

as:

CEur ( K ,T ) - PEur ( K ,T ) = F0,PT ( S ) - Ke - rT

Therefore, purchasing a call option and selling a put option results in a payoff of:

ST - K

Since Peter purchases offsetting amounts of puts and calls for any given strike price, we

can use this result to evaluate his payoffs.

Peter’s Portfolio

Transaction

Time 0

Buy 2 of C (55) 2(11.00 - 3.00)

& sell 2 of P(55)

Buy 1 of C(40) 3.00 - 11.00

& sell 1 of P(40)

Sell 3 of C (50) 3(6.00 - 8.00)

& buy 3 of P(50)

Lend $2

Total

Time T

2(ST - 55)

ST - 40

-3(ST - 50)

-2.00

2erT

0.00

2erT

**Peter’s portfolio is certain to have a positive payoff at time T, so Peter is correct.
**

Solution 3

13.202%

Chapter 2, Application of Option Pricing Concepts

We are told that the price of a European put option with a strike price of $103 has a value

of $15.21. The payoff of the put option at time 1 is:

Max [0,103 - S (1)]

If we can express the payoff of the single premium deferred annuity in terms of the

expression above, then we will be able to obtain the price of the annuity.

© ActuarialBrew.com 2014

Page

2

SOA Sample Exam MFE/3F

Solutions

The payoff at time 1 is:

È S (1)

˘

Time 1 Payoff = p (1 - y%) Max Í

,1.03˙

100

Î

˚

1

= p (1 - y%) ¥

¥ Max [S (1),103]

100

1

= p (1 - y%) ¥

¥ Max [0,103 - S (1)] + S (1)

100

(

)

**The current value of a payoff of Max [0,103 - S (1)] at time 1 is $15.21, and the current
**

value of a payoff of S (1) at time 1 is 100. Therefore, the current value of the payoff is:

Current value of payoff = p (1 - y%) ¥

1

(15.21 + 100)

100

**For the company to break even on the contract, the current value of the payoff must be
**

equal to the single premium of p :

1

(15.21 + 100) = p

100

1

(1 - y%) ¥

(15.21 + 100) = 1

100

y% = 0.13202

p (1 - y%) ¥

Solution 4

C

Chapter 4, Two-Period Binomial Model

Since the stock does not pay dividends, the price of the American call option is equal to

the price of an otherwise equivalent European call option.

The stock price tree and the associated option payoffs at the end of 2 years are:

32.9731

Call Payoff

10.9731

22.1028

0.1028

14.8161

0.0000

25.6800

20.0000

17.2140

The risk-neutral probability of an upward movement is:

p* =

e( r -d )h - d e(0.05 - 0.00)1 - 0.8607

=

= 0.4502

u-d

1.2840 - 0.8607

© ActuarialBrew.com 2014

Page

3

6550 The tree of prices for the American put option is found by working from right to left.85856 0.09)0.1.08 .0.46257 ud 1.5600 .0000 0.9731) 2(0.6573 1.2.5059 0. 1.6490] = 0.09)(0.2216] = 0.rf )h -s h = e(0.85856 d=e The risk-neutral probability of an upward movement is: p* e ( r rf )h d e(0.SOA Sample Exam MFE/3F Solutions The value of the call option is: V (S0 .30 0.5600 .rf )h +s h = e(0.0000 0.0000 0.2255 The values of u and d are: u=e ( r .0000 Max [0. 1.5600 .2216 0. 1.05(2) (0.1028) 0 2.4502)(0.15893 ( r .85856 The tree of pound prices and the tree of option prices are below: Pound 1.3384 Max [0.4502)2 (10. The rightmost column is found as follows: Max [0. K .0585 Solution 5 Chapter 4.9050] = 0.2259] = 0.2259 1.0.9207 1.08 0.25 = 1.1783 0.com 2014 Page 4 .9050 American Put 0.25 + 0.25 = 0.1.4300 1. hn) i 0 e 0.6490 1.2255 0.6550 © ActuarialBrew.0541 2.5600 .25 .08 .30 0.0000 Max [0.0.25) 0.3473 0. K . Three-Period Binomial Model for Currency 0.0) e r( hn ) n n i ( p*)(n i) (1 p*)i V (S0un idi .09)0.4502)(1 0. 1.0939 0.3384 0.0.4229 1.15893 0.2277 1.

1.0. Solution 6 C Chapter 7.46257)(0.1.25) [(0.3607} = 0.1.75786) 0.4229 { = Max {0.05 .08(0.4300 = Max {0.6550)] .08(0.1300} = 0.1. Black-Scholes Call Price The first step is to calculate d1 and d2 : d1 = ln( S / K ) + (r .46257)(0.s T = -1.0.03020 © ActuarialBrew.0939 } Max e -0.08(0.1.25) [(0.25 = -1.9207 { = Max {0.46257)(0.d + 0.0.0. -0.0000)] .1. -0.08(0.08(0.5 ¥ 0.5600 .46257)(0.5600 .25 = -1.5059} = 0.5059)] .46257)(0.03 + 0.0.1783) + (1 .1783.25) [(0.0000.4985. then early exercise is optimal: { } Max e -0.3384)] .6573 { = Max {0.0.3323} = 0.2277 = Max {0. If the exchange rate falls to 1.46257)(0.1.0000) + (1 .25 0.2255 The value of the American put option at time 0 is 0.1371} = 0.46257)(0.0939) + (1 .5600 .3384) + (1 .0.0.1.46257)(0.0000 } Max e -0.0000) + (1 .75786 d2 = d1 .25) [(0.3473)] .0.46257)(0.0541 = Max {0.25) [(0.0.08(0.5600 .3473.1.0939.2255.242 ) ¥ 0.5600 .SOA Sample Exam MFE/3F Solutions The prices after 6 months are found using the risk-neutral probabilities.2255.0000) + (1 .1.75786 .5059 The prices after 3 months are: { } Max e -0.1783)] .1783 } Max e -0.1.87786 We have: N (d1 ) N ( 1.com 2014 Page 5 .46257)(0.46257)(0.0541 at the end of 6 months.0973} = 0.46257)(0.24 0.25) [(0.1.03939 N (d2 ) N ( 1.3473 The current price of the option is: { } Max e -0.5600 .0.5s 2 )T s T = ln(20 / 25) + (0.0.24 0.87786) 0.

Since the dollar per yen exchange rate follows geometric Brownian motion.00261712 © ActuarialBrew. and the current value of the one yen is: 1 = 0.62 million Chapter 7.03020 0.0083333 dollars 120 x0 = Since the option is at-the-money.5%.5%: r = 3.5% The volatility of the yen per dollar exchange rate is equal to the volatility of the dollar per yen exchange rate.03939 25e 0.03629 = 3. the strike price is equal to the value of one yen: K= 1 = 0. the Black-Scholes framework applies.05(0. and the foreign interest rate is 1. This means that put and call options on yen can be priced using the Black-Scholes formula. Currency Options and Black-Scholes We can draw a couple of conclusions from Statement (vi): Since the logarithm of the dollar per yen exchange rate is an arithmetic Brownian motion.5% rf = 1.25) 0.629 Solution 7 $7. the dollar per yen exchange rate follows geometric Brownian motion. The domestic currency is dollars.00261712 ¥ 365 = 0.0083333 dollars 120 The domestic interest rate is 3.05 Page 6 .com 2014 1 365 = 0.03(0.03629 The value of 100 of the European call options is: 100 ¥ 0.25) 0. We convert the daily volatility into annual volatility: s = sh h = 0.SOA Sample Exam MFE/3F Solutions The value of one European call option is: CEur Se T N (d1 ) Ke rT N (d2 ) 20e 0. Company A has decided to buy a dollar-denominated put option with yen as the underlying asset.

5s 2 )T s T = ln(1) + (0.302 )0.25 0. r. Since the stock does not pay dividends.015 + 0.SOA Sample Exam MFE/3F Solutions The values of d1 and d2 are: d1 = ln( x0 / K ) + (r .05 0. K .30 0.0. .000 ¥ 0. the price of the American call option is equal to the price of the otherwise equivalent European call option.d + 0.00 The formula for d1 can be solved for the risk-free rate of return: d1 = ln(S / K ) + ( r . ) Ke rT N ( d2 ) Se rf T N ( d1 ) 1 0.18750) = 0.000. delta is equal to N (d1 ) : DCall = e -d T N (d1 ) 0.035 .30 0.000 the value of the put option in dollars is: 120.00 = s T ln(40 / 41.25 = -0.25 = 0.00 .50) + ( r .052 )0.50 d1 0.21250 .42563 The value of a put option on one yen is: PEur (S .42563 0.5s 2 )T 0.05 0.T .15 © ActuarialBrew.538 Solution 8 D Chapter 8.25 = 0.035(0.000.18750 We have: N ( -d1 ) = N ( -0.0 + 0.21250 d2 = d1 .000.50 e00.25) 0.5 ¥ 0.618.0.5 ¥ 0.015(0.41586 e e 120 120 0.25 N (d1 ) N (d1 ) 0.41586 N ( -d2 ) = N ( -0.25 0.0.000.com 2014 Page 7 .0000634878 Since the option is for ¥120.25 r = 0.21250) = 0.0000634878 = 7.s T = 0.25) 1 0.rf + 0. Black-Scholes and Delta Since the stock does not pay dividends.102256 The value of d2 is: d2 = d1 .s T = 0.

.453 0.125 2 0. Market-Maker Profit The market-maker’s profit is zero if the stock price movement is one standard deviation: One standard deviation move = s St h To answer the question.0(0. K . r.138 0. ) Se T N (d1 ) Ke rT N (d2 ) 40(0.25 N ( 0.453 1 N (0.025 0.15 0.453N (0.15) 20. Solution 9 B Chapter 9.25 0.15) 40.15) 20.3 We can use the formula for d1 to solve for the value of s : d1 ln(S / K ) (r 0.com 2014 Page 8 .025 0 © ActuarialBrew.15) 20 40.453 2 16.SOA Sample Exam MFE/3F Solutions The value of the call option is: CEur (S .453 40. this implies that: d1 = 0.453 The correct answer is D.453 40.10 0 0.5) 41.T .15 0.5 2 )T 0. We can determine the value of N (d1 ) : Call e T N (d1 ) 0.5x 2 e dx 20.61791 N (d1 ) Using the cumulative normal distribution calculator.5e 0. we must determine the value of s .15 0.30 T ln(50 / 50) (0.5 x 2 1 e dx 20.453N (0.1022560.5 2 )0.25 0.15 0.25) N (d1 ) 0.125 2 0.61791 e 0.

then we do not obtain one of the answer choices: 1 = 2. the natural log of stock prices follows arithmetic Brownian motion.SOA Sample Exam MFE/3F Solutions We make use of the quadratic formula: 0.15)2 .0. stock prices are lognormally distributed: ( ln S (t + h ) .ln S (t )] = s 2h The quickest way to analyze statement (iii) is to convert the expression into its continuous form: n Â nÆ• lim j =1 2 ÈÎ X ( jT / n ) . Statement (ii) is true. we have: Var[ X (t + h ) .X (( j .X (t )] = Var[ln S (t + h ) . 0.6171 365 s St h = 1.5s 2 dt + s dZ (t ) © ActuarialBrew.5234.5s 2 )h.125)(0.0 .125) or s = 0.4(0. and the stock price moves either up or down by 0. s 2h ) Since the stock prices are lognormally distributed.5234 365 If we use s = 1.20. because when the Black-Scholes framework applies.1)T / n )˘˚ = T Ú [dX (t )] 2 0 The natural log of the stock prices follows arithmetic Brownian motion: ( ) dX (t ) = d [ln S (t )] = a .ln S (t ) N (a .20 .0 s = The first of these volatility values. seems more reasonable.20 ¥ 50 ¥ 1 = 0. and indeed.15 ± ( -0.20 s = 1.0.d .com 2014 Page 9 . because when the Black-Scholes framework applies.025) 2(0. Black-Scholes Framework Statement (i) is true. we conclude that s = 0.0 ¥ 50 ¥ Therefore. it produces one of the answer choices: s St h = 0. Solution 10 E Chapter 14.

0.d .Z (t ) = Y (t + h) h © ActuarialBrew.d .5s 0 Ú 0 È(a .5s 2 )dt + s dZ (t ) ˘ Î ˚ 2 2 ) dt 2 + 2(a .5s 2 dt + s dZ (t ) Therefore: ( ) X (t ) = a .5s 2 )dt ¥ s dZ (t ) + s 2 (dZ (t )) ˘ ˚˙ 2 2 We make use of the following multiplication rules to simplify the expression above: dt 2 =0 and dt ¥ dZ (t ) = 0 and [dZ (t )]2 = 0 The stochastic integral can now be simplified: T Ú ÈÎÍ(a . because when the Black-Scholes framework applies.d .5s 2 )dt ¥ s dZ (t ) + s 2 (dZ (t )) ˘ ˚˙ 2 2 T È 0 + 0 + s 2 dt ˘ = s 2 dt = s 2T Î ˚ Ú 0 Therefore Statement (iii) is true.0.5s 2 t + s Z (t ) Recall that we use Y (t ) to denote a random draw from a binomial approximation. For small values of h.0.d .d . we have: T Ú [dX (t )] 2 0 T = Ú [d ln S(t )] 2 = 0 T = T Ú ÈÎÍ(a .0. we have: Z (t + h ) .0.d .5s 0 T = Ú 0 2 ) dt 2 + 2(a .d .0.0.com 2014 Page 10 . Alternate solution for Statement (iii) Statement (iii) is true. The correct answer is Choice E. the natural log of the stock prices follows arithmetic Brownian motion: ( ) dX (t ) = d [ln S (t )] = a .SOA Sample Exam MFE/3F Solutions Substituting into the stochastic integral above.

5s 2 ( j . The first of these terms is zero because: È È 2 Ê T ˆ2 ˘ 2 Ê T ˆ2 ˘ Í a .d .d .5s ÁË n ˜¯ s Y ÁË n ˜¯ + n ˙ Í a .1)T / n)˘˚ n Æ• lim 2 j =1 n È a . Consider the value that is obtained if the binomial random variable Y ( jT / n ) is always equal to 1: 3/2 È ˘ ÊT ˆ Í 2 a .0.5s 2 Á ˜ ˙ Ë n ¯ ˙ nÆ• Í Ë n¯ ˙ nÆ• j =1 ÍÎ ˚ Î ˚ 2 2 È1 ˘ 2 2 = a .5s 2 Á ˜ s ˙ = 2 a .X (( j .0.d .0.d .5 lim = lim + + Í ˙ ÁË n ˜¯ ÁË n ˜¯ ÁË n ˜¯ ˙ Í n n Æ• n Æ• n Æ• Í ˙ Í ˙˚ j =1 Î j =1 Í j =1 Î ˙ ˚ Î ˚ n Â ( ) Â ( ) ( ) Â ( ) Â We now consider each of the three terms separately.d .0.SOA Sample Exam MFE/3F Solutions We therefore can write: n Â ÈÎ X ( jT / n) .com 2014 Page 11 .5s 2 Á ˜ s Y ( jT / n )˙ Ë n¯ n Æ• ˙˚ j =1 ÍÎ n lim Â ( ) 3/2 ˘ È ÊT ˆ 2 Í2 a .0.1)T / n )˘ ) ( ) Â ÍÎ ( ˚˙ n Æ• = lim 2 j =1 n Â ÈÍÎ(a .0.d .0.d .5s 2 (T ) lim Í ˙ = a .5s T / n + s Y Á ˙ Ë n ˜¯ n ˙˚ n Æ• j =1 ÍÎ Â 2 3 È ˘ 2 2 Í Ê jT ˆ s 2T ˙ 2 ÊT ˆ 2 ÊT ˆ2 = lim ÁË n ˜¯ + 2 a .0.0.0.d .5s ˙ a d s s Y lim 2 0.5s 2 T ¥ 0 = 0 © ActuarialBrew.d .5s n Æ• j =1 Í ˙ Î ˚ 3 ˘ n È n È n È 2 ˘ 2 Ê T ˆ2 ˘ s T ÊT ˆ2 Ê jT ˆ ˙ Í 2 2 Í a .s Z (( j .d .Z (( j .d .0.1)T / n .d .0.0.5s 2 T lim Ë ¯ n n Æ• Í n Æ• n ˙˚ Î ( ( ) ( ) ) = 2 a .d .d . This is because both the maximum possible value and the minimum possible value of the second term are zero.5s 2 (T ) ¥ 0 = 0 nÆ• Î n ˚ n lim Â ( ) ( ) ( ) ( ) The second term is also zero.0.d .1)T / n)˘˚ ˘˙˚ n Æ• = lim 2 j =1 n ( ) È Ê jT ˆ T ˘ 2 = lim Í a .0.5s 2 jT / n + s Z ( jT / n ) .5s Á ˜ s˙ = lim Ë n¯ n Æ• ˙˚ j =1 ÍÎ n Â ( ) 3/2 ˘ È 1 ÊT ˆ = lim Ín ¥ 2 a .5s 2 Á ˜ ˙ = lim Í n ¥ a .a .0.5s 2 ) T / n + s ÈÎZ ( jT / n) .d .

d .d .ln S (t ) N (a .d .5s 2 T ¥ 0 = 0 Since the maximum possible value of the second term approaches zero.0.5s 2 Á ˜ s Y ( jT / n )˙ Ë n¯ nÆ• ˙˚ j =1 ÍÎ n lim Â ( ) 3/2 È ˘ ÊT ˆ Í2 a . s 2h ) Var ÈÎ ln( S (t + h ) S (t ) ˘˚ = s 2h © ActuarialBrew.5s 2 )h. the third term is: n n T T È 2T˘ = lim s 2 s 1] = lim s 2 n = lim s 2T = s 2T [ Í ˙ n ˚ n Æ• n j =1 n n Æ• n Æ• n Æ• j =1 Î lim Â Â Therefore. and the minimum possible value of the second term approaches zero. this implies: ( ln S (t + h ) N ln S (t ) + (a . because when the Black-Scholes framework applies.5s 2 T lim = .X (( j .0. the stock prices are lognormally distributed: ( ln S (t + h ) . we have: n Â ÈÎ X ( jT / n) .5s 2 Á ˜ s ¥ ( -1) ˙ Ë n¯ nÆ• ˙˚ j =1 ÍÎ 3/2 ˘ È 1 ÊT ˆ s ˙ = -2 a .1)T / n)˘˚ n Æ• lim 2 = s 2T j =1 The solution using the multiplication rules is much quicker than this alternate solution! Solution 11 E Chapter 14.com 2014 Page 12 . then the second term is: 3/2 È ˘ ÊT ˆ Í 2 a .5s 2 )h.0.5s 2 Á ˜ Ë ¯ n nÆ• Í nÆ• n ˙˚ Î = lim n Â ( ) ( ) ( ( ) ) = -2 a .d . Finally.d .d .0. Black-Scholes Framework Statement (i) is true. we conclude that the second term approaches zero as n becomes very large.0. s 2h ) If we are given S (t ) .lim Ín ¥ 2 a .SOA Sample Exam MFE/3F Solutions If the binomial variable Y ( jT / n ) is always -1 .d .0.0.

085dZ (t ) and d [ln Y (t )] = A .5B 2 dt + BdZ (t ) A .d )dt + s dZ (t ) S (t ) The variance is: È dS (t ) ˘ Var Í S (t ) ˙ = Var [(a . we have: Var ÈÎS (t + dt ) S (t ) ˘˚ = Var ÈÎS (t ) + dS (t ) S (t ) ˘˚ = 0 + Var ÈÎdS (t ) S (t ) ˘˚ = Var ÈÎ(a .d )dt + s dZ (t )] = 0 + s 2Var [dZ (t )] = s 2dt Î S (t ) ˚ Statement (iii) is true.0. the stock prices follow geometric Brownian motion: dS (t ) = (a .5s 2 dt + s dZ (t ) Therefore: dY (t ) = Adt + BdZ (t ) Y (t ) ¤ ( ) d [ln Y (t )] = A . because when the Black-Scholes framework applies.d )S (t )dt + s S (t )dZ (t ) S (t ) ˘˚ = 0 + s 2 [S (t )] Var [dZ (t )] 2 = s 2 [S (t )] dt 2 Solution 12 B Chapter 15. Sharpe Ratio When the price follows geometric Brownian motion.0. the natural log of the price follows arithmetic Brownian motion: dS (t ) = a S (t )dt + s S (t )dZ (t ) ¤ ( ) d [ln S (t )] = a .5B 2 = m B = 0.085 © ActuarialBrew. the stock prices follow geometric Brownian motion: dS (t ) = (a .d )S (t )dt + s S (t )dZ (t ) Therefore.SOA Sample Exam MFE/3F Solutions Statement (ii) is true.0.5B 2 dt + BdZ (t ) The arithmetic Brownian motion provided in the question for d [ln Y (t )] allows us to solve for B: ( ) d [ln Y (t )] = m dt + 0.0.com 2014 Page 13 . because when the Black-Scholes framework applies.

2tZ (t )dt Î ˚ For the first term.0.04 = 0.06125 Solution 13 E Chapter 15.12 0.SOA Sample Exam MFE/3F Solutions Since X and Y have the same underlying source of risk. the drift is zero for dU.1dt 2 2 = 2Z (t )dZ + 1dt . the partial derivatives are: VZ = 2Z VZZ = 2 Vt = -1 This results in: 1 1 dV (t ) = VZ dZ + VZZ (dZ )2 + Vt dt = 2Z (t )dZ + ¥ 2(dZ )2 .07 . the partial derivatives are: UZ 2 U ZZ 0 Ut 0 This results in: 1 dU (t ) = U Z dZ + U ZZ ( dZ )2 + Ut dt = 2dZ + 0 + 0 = 2dZ 2 Since there is no dt term. (i) For the first equation.085 A = 0. This allows us to solve for A: a X . we must use Itô’s Lemma. Let’s define: X (t ) = t2Z (t ) The partial derivatives are: X Z = t2 © ActuarialBrew.1dt = 2Z (t )dZ Since there is no dt term. the drift is zero for dV.0.r aY .04 A . Itô’s Lemma The drift is the expected change in the asset price per unit of time.r = sX sY 0. (ii) For the second equation. (iii) We must find: dW (t ) = d Èt2Z (t ) ˘ . they must have the same Sharpe ratio.com 2014 X ZZ = 0 Xt = 2tZ Page 14 .

T ) = B(t.05. t.2tZ (t )dt = dX (t ) .0.T ) in the Vasicek model: q(r . the drift is zero for dW.4) We now make use of the following formula for q(r . t .com 2014 Page 15 .r )dt + s dZ Therefore.6(b .6 In the Vasicek model.2tZ (t )dt = t2dZ (t ) + 2tZ (t )dt .05 q(0. we have: f= a (r.T )s (r ) = B(t . T ) Since the Sharpe ratio is constant: a (0.r )dt + s dZ ﬁ a = 0.2) .1.0.4) . t. Solution 14 0.2tZ (t )dt Î ˚ = t 2dZ (t ) Since there is no dt term. and T. for any r.05. the Sharpe ratio is constant: f (r.04 q(0.1. t.T ) .04.r q( r .0517 Chapter 19.SOA Sample Exam MFE/3F Solutions This results in: dX (t ) = X Z dZ + 1 1 X ZZ (dZ )2 + Xt dt = t 2dZ + ¥ 0 ¥ ( dZ )2 + 2tZdt 2 2 = t 2dZ (t ) + 2tZ (t )dt Therefore: dW (t ) = d Èt 2Z (t ) ˘ .0. Vasicek Model The Vasicek model of short-term interest rates is: dr = a(b .0.04. t ) = f Therefore.2) = a (0.T )s © ActuarialBrew. we can determine the value of a: dr = 0. t.

Black-Derman-Toy Model In each column of rates.05.168 rddd = 0.30% 11.4) 0.2) (0.05 q(0.05 B(0. the missing rate in the third column is: 0.00% 10.4) 0.00139761 1e 0. t.6(4 1) 0.1.com 2014 Page 16 .106 0.59% 13.168 rduu = 0.11e -2s 3 1 = 0.6 0.1.6(2 0) (0.6(2 0) 0.4) 0.SOA Sample Exam MFE/3F Solutions Substituting this expression for q(r.4) 0.1359 0.8347 (0.135 ¥ = 0.04139761 0.05 1 e 0.110 ∏ = 0.05.2) 0.135e -2s 2 1 = 0.4) 0.90% © ActuarialBrew.05.168e -2s 3 1 = 0.135 rdd = 0.04.05.172 The missing rates in the fourth column are: 0.04.05.0890 0.04.2) B(1.6988 0.4) 0.05.3264 Chapter 18.20% 12.04 1e 0.4) : (0. each rate is greater than the rate below it by a factor of: e2s i h Therefore.0.0.0.05 1 e 0.1.00% 13.4) (0.05.04 (0.60% 8.0516694 Solution 15 1.1.1.05 0.04 q(0.110 The tree of short-term rates is: 16.2) 0.1.1.1.110 0.168 ∏ = 0.05.80% 17.50% 9.T ) into the preceding equality allows us to solve for a (0.6(4 1) 0.60% 9.6 (0.4) 0.00139761 (0.

0.3264 2.0000 The value of the year-4 caplet is $1.4505 0.105) = 0.1588 1. The payoff table is: Time 0 Time 1 Time 2 Time 3 5.0000 0.com 2014 Page 17 .0000 2.3264.1680 . if the interest rate increases at the end of the first year and at the end of the second year.1100 We work recursively to calculate the value of the caplet.1100 .4505 1.7329 0.0000 0.5 ¥ 2.105) = 5. © ActuarialBrew.4632 2.4632 1.2036 0. The calculations for the tree above are shown below: 100 ¥ (0.0.3938 1.3938 0.0000 0.7238 1.1680 100 ¥ (0.5 ¥ 5. then its value at the end of the second year is: 0.3938 3.3984 0.7238 = 3.7238 1.1359 .3938 + 0.7238 0.0000 0. For example.105) = 2.5%.1720 The completed tree is: Time 0 Time 1 Time 2 Time 3 5.0000 The payments have been converted to their equivalents payable at the end of 3 years.4505 0.0000 0.1359 100 ¥ (0.SOA Sample Exam MFE/3F Solutions The caplet pays off only if the interest rate at the end of the third year is greater than 10.0.

SOA Sample Exam MFE/3F

Solutions

Solution 16

Chapter 15, Prepaid Forward Price of S a

B

We make use of the following expression for the prepaid forward price of the derivative:

FtP,T

x ( r ) 0.5 x ( x 1) 2 (T t )

S (T )x e r(T t ) S (t )x e

**We can substitute this expression for the prepaid forward price in the equation provided
**

in the question:

FtP,T S (T )x S (t )x

e

r(T t )

2

x x ( r ) 0.5x ( x 1) (T t )

e

S (t )

r x ( r ) 0.5 x ( x 1) 2 (T t )

e

S (t )x

1

r x ( r ) 0.5x ( x 1) 2 (T t ) 0

r x (r ) 0.5x ( x 1) 2 0

Putting in the risk-free interest rate of 4%, the volatility of 20% and the dividend yield of

0%, we have:

r x (r ) 0.5x ( x 1) 2 0

0.04 x (0.04 0.00) 0.5x 2 (0.20)2 0.5x (0.20)2 0

0.02x 2 0.02x 0.04 0

x2 x 2 0

( x 1)( x 2) 0

x 1

or

x 2

**We were told in the question that 1 is a solution. The other solution is -2.
**

Solution 17

A

Chapter 13, Estimating Volatility

**Notice that the price increases by 25% 4 times and it decreases by 25% 4 times. This
**

means that the mean return is zero, and each of the deviations is the same size. This

simplifies the calculations below.

**Since we have 9 months of data, we can calculate 8 monthly returns, and k = 8 . Each
**

monthly return is calculated as a continuously compounded rate:

Ê S ˆ

ri = ln Á i ˜

Ë Si -1 ¯

© ActuarialBrew.com 2014

Page

18

SOA Sample Exam MFE/3F

Solutions

**The next step is to calculate the average of the returns:
**

k

r =

Â ri

i =1

k

**The returns and their average are shown in the third column below:
**

Month

Price

1

2

3

4

5

6

7

8

9

80

64

80

64

80

100

80

64

80

Ê S ˆ

ri = ln Á i ˜

Ë Si -1 ¯

(ri - r )2

–0.22314

0.22314

–0.22314

0.22314

0.22314

–0.22314

–0.22314

0.22314

0.049793

0.049793

0.049793

0.049793

0.049793

0.049793

0.049793

0.049793

r = 0.00000

Â (ri - r )2 = 0.398344

8

i =1

**The fourth column shows the squared deviations and the sum of squares.
**

The estimate for the standard deviation of the monthly returns is:

k

sh =

Â (ri - r )2

i =1

s1 =

12

k -1

0.398344

= 0.23855

7

We adjust the monthly volatility to obtain the annual volatility. Since h =

1

:

12

1

= 0.23855 12 = 0.82636

h

s = sh

**This problem isn’t very difficult if you are familiar with the statistical function of your
**

calculator.

On the TI-30X IIS, the steps are:

[2nd][STAT]

(Select 1-VAR)

[ENTER]

[DATA]

Ê 64 ˆ

[ENTER]

80 ˜¯

X1= ln Á

Ë

© ActuarialBrew.com 2014

ØØ

(Hit the down arrow twice)

Page

19

SOA Sample Exam MFE/3F

Solutions

Ê 80 ˆ

[ENTER]

64 ˜¯

ØØ

Ê 64 ˆ

[ENTER]

Ë 80 ˜¯

ØØ

Ê 80 ˆ

[ENTER]

64 ˜¯

ØØ

Ê 100 ˆ

[ENTER]

80 ˜¯

ØØ

Ê 80 ˆ

[ENTER]

100 ˜¯

ØØ

Ê 64 ˆ

[ENTER]

Ë 80 ˜¯

ØØ

X2= ln Á

Ë

X3= ln Á

X4= ln Á

Ë

X5= ln Á

Ë

X6= ln Á

Ë

X7= ln Á

Ê 80 ˆ

[ENTER]

64 ˜¯

X8= ln Á

Ë

[STATVAR]

Æ Æ

¥

[ENTER]

(12)

(Arrow over to Sx)

**The result is: 0.826363140
**

To exit the statistics mode:

[2nd] [EXITSTAT]

[ENTER]

**On the BA II Plus calculator, the steps are:
**

[2nd][DATA]

[2nd][CLR WORK]

64/80

=

LN

[ENTER]

ØØ (Hit the down arrow twice)

80/64

=

LN

[ENTER]

ØØ

64/80

=

LN

[ENTER]

ØØ

80/64

=

LN

[ENTER]

ØØ

100/80 =

LN

[ENTER]

ØØ

80/100 =

LN

[ENTER]

ØØ

64/80

=

LN

[ENTER]

ØØ

80/64

=

LN

[ENTER]

¥

[2nd][STAT]

(12)

=

**The result is: 0.82636314
**

To exit the statistics mode: [2nd][QUIT]

© ActuarialBrew.com 2014

Page

20

s T = 0.130 ∂d1 ∂S ∂d2 ∂S = N (d1 ) + S = N (d1 ) + SN '(d1 ) ∂d1 ∂d .5x dx N '(d ) 1 2 e 0. Delta-Hedging Gap Call Options The price of the gap call option is: CGapCall = Se -d T N (d1 ) .5 © ActuarialBrew.5 ﬁ N (d1 ) = 0.69146 d2 = d1 .5d 2 The derivatives of d1 and d2 with respect to the stock’s price are shown below: d1 = Ê Se -d T ˆ s 2 T ln Á ˜+ 2 Ë K 2e -rT ¯ s T d2 = d1 .130 N (d2 ) The delta of the option is the derivative of the option price with respect to the stock’s price: DGapCall = ∂CGapCall ∂S ∂N ( d1 ) ∂N (d2 ) .1 1 = -0.5 .com 2014 Page 21 .130 N '(d2 ) 2 ∂S ∂S Note that: N (d ) d 1 2 2 e 0.130 ∂S ∂S ∂N ( d1 ) ∂d1 ∂N (d2 ) ∂d2 = N (d1 ) + S .s T ﬁ = Ê e -d T ˆ s 2 T ln (S ) + ln Á ˜+ 2 Ë K 2e -rT ¯ s T ﬁ ∂d1 1 1 = = ∂S Ss T S 1 1 ∂d2 = = ∂S Ss T S Let’s calculate the values of d1 and d2 that we’ll need for the formula for delta: d1 = Ê Se -d T ˆ s 2 T ln Á ˜+ 2 Ë K 2 e -rT ¯ s T = Ê 100e -0 ¥1 ˆ 12 ln Á ¥1 ˜+ Ë 100e -0 ¥1 ¯ 2 1 1 = 0.K1 e -rT N (d2 ) CGapCall = SN ( d1 ) .SOA Sample Exam MFE/3F Solutions Solution 18 A Chapter 10.

1.84 Solution 19 C Chapter 11.5 ¥ 0.000 of the gap call options. the values of d1 and d2 will be: d1 = ln( S / K ) + (r .08 N (d2 ) = S1 ¥ 0.41667 d2 = d1 . the call option will be worth 0.S1e -0.41667 .08 .66154 .S1 e -0. the value of the call option can be expressed in terms of the stock price at that time: CEur (S1 ) = S1 N (d1 ) .5s 2 )T s T = ln(S1 / S1 ) + (0. © ActuarialBrew.com 2014 Page 22 .11667) ª 0.15711 shares of stock.69146 + e .08 N (d2 ) In one year. the value of the call option will be: CEur (S1 ) = S1e -d T N (d1 ) .000 ¥ 0.d + 0.54644 = 0.30 1 = 0.130 e 100 2p 2p DGapCall = N (d1 ) + SN '(d1 ) = 0.5( -0.5 ¥ 0.69146 + 1 2p 2 e -0.0.S1 e -0.0.58584 = 585. the market-maker multiplies the delta of one call option by 1.41667) ª 0.11667 From the normal distribution table: N ( d1 ) = N (0.Ke -rT N (d2 ) = S1 N (d1 ) .69146 + S e .58584 Since the market-maker sells 1.54644 In one year.08 ¥ 0.66154 N ( d2 ) = N (0.30 1 = 0.130 N '(d2 ) 2 ∂S ∂S 2 1 -0.3) = 0.5 ¥ 0.130 e S S 2p 2p 1 -0. Forward Start Option In one year.5d1 1 1 -0.5 (1 .s T = 0.00 + 0.SOA Sample Exam MFE/3F Solutions Now we can calculate the delta of the gap call option: ∂d1 ∂d .15711 ¥ S1 In one year.000 to determine the number of shares that must be purchased in order to delta-hedge the position: 1.52 1 -0.302 )(1) 0.5)2 1 = 0.5d22 1 = 0.

4 = 2WCall We now have system of 2 equations with 2 unknowns: 54 = 8.45 + 1.90WCall + 1.90 54 = 8.90 2 ¥ 4.90 .15711 ¥ 92.90W Put 153 = 8.90WCall .3W Put 45 45 153 = 8.08 F0.31163 = 14.45 + 1.70WPut Let’s subtract the second equation from the first equation: -99 = 7.15711 shares of stock in one year is: 0.5.1 (S ) = e -0.0263 © ActuarialBrew.4 = 2DCall .5033 Solution 20 D Chapter 8.70W Put 3.31163 The value today of 0.90WCall + 1.T (S ) P F0.90WCall .1 (S ) = 92.PT (S ) = e -rT F0.90W Put We can express the delta of an option in terms of the elasticity of the option: W= SD V ﬁ D=W V S The delta of portfolio B is the sum of the deltas of its components: D Port = n Â qi Di i =1 3.90 5= WCall + WPut 2 ¥ 4.5.com 2014 Page 23 .08 ¥ 100 P F0.3D Put 4. Portfolio Delta and Elasticity The elasticity of portfolio A is the weighted average of the elasticities of its components: WPort = n Â wi Wi i =1 2 ¥ 4.45 1.45 1.SOA Sample Exam MFE/3F Solutions The prepaid forward price of one share of stock is: F0.1 (S ) = e -0.1 ( S ) P F0.60WPut W Put = -13.

04 B(11.13) .5r + 0.T ) . t.SOA Sample Exam MFE/3F Solutions Solution 21 C Chapter 19.05 = B(7.13) .T ) .r B(t.T )s ( r ) a (r .05.3 The risk-neutral process follows: dr = [a( r ) + s (r )f (r.048 Solution 22 D Chapter 19.9) .15 . t ) = f r = s fr = a (r.13)f (0.9) provided in the question: f ¥ 0. t ) f (r.04) = 0.7.20(0. t )] dt + s (r )dZ We can use the coefficient of the first term of the risk-neutral process to solve for the Sharpe ratio. Cox-Ingersoll-Ross Model We begin with the Sharpe ratio and parameterize it for the CIR model: f (r.13) a (0.9) 0.5r & s (r ) = 0.5r = 0. t. we have: f ¥ 0.com 2014 Page 24 . Risk-Neutral Process & Sharpe Ratio The realistic process for the short rate follows: dr = a(r )dt + s (r )dZ where: a(r ) = 0. t ) 0.0.0. t ) : 0.0.05) B(7.05.r q( r .11.0.01 = B(7.T ) We use the value of a (0.9) = B(11.0.05 = a (0. t ) = 0.06 .T ) .09 . t.20 Making use of the fact that B(7.r B(t .09 .04 + B(11.5r = a( r ) + s (r )f (r.0.9)f (0. T ) a (r.0.04.3f (r.05 f ¥ 0.04 = a (0. t .04 + 0.20 © ActuarialBrew. f (r .05 B(7.04) = 0.9) 0.04.9)f = 0.15 .13) = 0.11.7.

04 s = g .0.10 .04 s = g .10 .com 2014 ﬁ g = 0. S.5s V 6 We can now solve for g : 0.SOA Sample Exam MFE/3F Solutions The derivative. t ) = 0.20: m -r g 0. Let’s rearrange the differential equation for g.0.5s © ActuarialBrew.08) g Solution 23 C Chapter 16.0.20 = 0. D = VS . times the cost of each share. so that we can more easily observe its Sharpe ratio: dg m = dt .0.04 sC The cost of the shares required to delta-hedge the call option is the number of shares required. must have a Sharpe ratio of 0. Sharpe Ratio The stock and the call option must have the same Sharpe ratio: 0.4dZ g g m ﬁ -r g f ( r. based on statement (iv) in the question.4 Since the Sharpe ratio is 0.13 Page 25 . we have: VS ¥ S = 9 We can find the volatility of the call option in terms of the volatility of the underlying stock: sC = SVS 9 s = s = 1.4 0.08 = m -r g m = (r + 0.0.04 1. Therefore. like all interest-rate dependent assets in this model.20.

lt Í l s È e dZ ( s) + s e d e dZ ( s) ˙ =sd e Î ˚ Í ˙ 0 Î0 ˚ t Ê ˆ = .ls Á e . so their differentials are easy to find. We can pull the t-dependent portion out of the integral.lt + al e .lt ˘ ls . The third term will be more difficult: dX (t ) = .lt Á e l sdZ ( s)˜ dt + s e . so its differential form is easy to find: dX (t ) = È .s ) . We then use the following version of the product rule to find the differential: d [U (t )V (t )] = dU (t )V (t ) + U (t )dV (t ) The differential of the third term is: t È t ˘ È ˘ . Choice A does not contain a random variable.lt Í ˙ Í d s e dZ ( s) = s d e e l sdZ ( s) ˙ Í ˙ Í ˙ 0 Î 0 ˚ Î ˚ Ú Ú t Èt ˘ . Ornstein-Uhlenbeck Process Let’s find the differential form of each choice.SOA Sample Exam MFE/3F Solutions Solution 24 E Chapter 14.l X (0)e .lt e lt dZ (t ) ÁË ˜¯ 0 Ú Ú Ú Êt ˆ = .s )dZ ( s )˜ dt + s dZ (t ) ÁË ˜¯ 0 Ú © ActuarialBrew.lt dt + la e . The first two terms do not contain random variables.l (t .com 2014 Page 26 .l (t .l X (0)e . so that we are finding the differential of a product.s )dZ ( s) ˙ Í ˙ Î0 ˚ Ú The third term has a function of t in the integral.ls e .lt Èt ˘ dt + d Í s e .l (t .lt ˘ dt Î ˚ Choice B is easily recognized as an arithmetic Brownian motion: dX (t ) = a dt + s dZ (t ) Choice C is easily recognized as a geometric Brownian motion: dX (t ) = a X (t )dt + s X (t )dZ (t ) Choice D is: dX (t ) = al e lt dt + s e lt dZ (t ) Choice E contains 3 terms.

K .l (t .lt Í dZ ( s)˜ .100.1) 20 = CEur (95.lt + s Á e . t1 ) Price of Chooser Option = CEur (95.l Í X (0)e . K .3) = 11 © ActuarialBrew.s )dZ ( s)˜ .l X (0)e .a ˙ dt + s dZ (t ) = .SOA Sample Exam MFE/3F Solutions Putting the three differentials together. Chooser Options The price of the chooser option can be expressed in terms of a call option and put option: ( Price of Chooser Option = CEur (S0 .100.100.3) + PEur (95.100.1) We can use put-call parity to find the value of the 1-year call option: CEur (95.3) + 9 CEur (95.lt + s Á e .lt + a .lt dt + la e .T ) + e -d (T -t1 ) PEur S0 .l (t .e ) + s Á e Í ˙ ÁË ˜¯ 0 Î ˚ = .s )dZ ( s)˜ dt + s dZ (t ) ÁË ˜¯ 0 Ú È Êt ˆ˘ = .s )dZ ( s)˜ ˙ dt + s dZ (t ) Í ÁË ˜¯ ˙ 0 Î ˚ t È ˘ Ê ˆ = . so the put option has the same strike price as the call option: ( Price of Chooser Option = CEur (S0 .s ) .l (t .1) + K = S0 + PEur (95. we have: dX (t ) = . t1 ) The risk-free interest rate and the dividend yield are both zero.a e .lt .com 2014 Page 27 .lt .100.100.100.100.X (t )]] dt + s dZ (t ) Solution 25 B Chapter 11. Ke -( r -d )(T -t1 ) .ls Á e .T ) + e -d (T -t1 ) PEur S0 .3) + PEur (95.a ˙ dt + s dZ (t ) Í ˙ ÁË ˜¯ 0 Î ˚ È ˘ Êt ˆ .l X (0)e + a (1 .l Í X (0)e .a ]] dt + s dZ (t ) Ú Ú Ú = l [a .l (t .100.lt Êt ˆ dt . Ke -( r -d )(T -t1 ) .l [ X (t ) .1) = 9 We can now solve for the price of the 3-year call option: Price of Chooser Option = CEur (95.100.a e .1) 4 + 100 = 95 + PEur (95.1) PEur (95.

we can see that it is possible for the American put option to have a tighter lower bound than the European put option. we have: Max È0. which narrows the answer choices to (D) and (E). Therefore.5) = 95.St ] £ PEur (St . which still leaves answer choices (D) and (E). and we can conclude that Graph IV corresponds to the European put option. the American call option has the same price as the European call option. so the call options must correspond to either Graph I or Graph II. From the inequality above.T .T .SOA Sample Exam MFE/3F Solutions Solution 26 D Chapter 2. we can see that it is possible for the European put option to have a tighter upper bound than the American put option.r(T -t ) = 100e -0. K .t ) £ 100 For the European put option. Ke . as shown in Graph III. © ActuarialBrew. K . a European put option cannot have a price greater than the present value of the strike price.12 .95.t ) £ St The left portion of the inequality above describes the lower boundary of Graph II. From the inequality above.T . The value of a call increases with the stock price. In fact. and choice (D) is correct. K .com 2014 Page 28 . Therefore. K .t ) £ C Amer (St . St . This is described by the upper boundary of Graph III. In fact. For the put options.12.Ke -r(T -t ) ˘ £ CEur (St .12 Since the stock does not pay dividends. K . the call options correspond to Graph II.T . the upper boundary is $95.t ) £ PAmer (St . so both call options correspond to the same graph.t ) £ K Î ˚ Max [0.T . The right portion of the inequality above describes the upper boundary of Graph II. Bounds on Option Prices Let’s begin by noting the prepaid forward price of the stock and the present value of the strike price: FtP.r(T -t ) . K .5)St = St Ke . the lower boundary is the maximum of zero and the exercise value.t ) £ PAmer (St .T . K .FtP.t ) £ C Amer (St .10(0.T (S ) .T .t ) £ St Î ˚ Max [0. the left portion of the inequality above describes the lower boundary of Graph IV. Therefore. FtP. K .12] £ CEur (St .95. The American put option could have a price as high as the strike price of $100 if the stock price falls to zero.T . since the American put option can be exercised at any time. Graph III corresponds to the American put option.T (S ) = e -d (T -t )St = e -0 ¥ (0.T (S ) ˘ £ PEur (St . For call options we have: Max È0.

10 = 0 Outcome 3: Subtracting the second equation from the first equation allows us to find X: 150 X = -105 X = -0. Let’s define the following variables: X = Number of shares of Stock X to purchase Y = Number of shares of Stock Y to purchase Z = Amount to lend at the risk-free rate We have 3 equations and 3 unknown variables: Outcome 1: 200 X + Outcome 2: 50 X + 0Y + Ze0. We can replicate those payoffs by determining the proper amount of Stock X. Replication The end-of-year payoffs of the call and put options in each scenario are shown in the table below.com 2014 Page 29 .10 = 0 Y = -0.CX Payoff Payoff Payoff Outcome 1 $200 $0 105 95 –10 Outcome 2 $50 $0 0 95 95 Outcome 3 $0 $300 0 0 0 We need to determine the cost of replicating the payoffs in the rightmost column above.7 We can put this value of X into the first equation to find the value of Z: 200( -0.629e0.6289 We can use this value of Z in the third equation to find the value of Y: 300Y + 117.SOA Sample Exam MFE/3F Solutions Solution 27 A Chapter 3.10 = 130 Z = 117. End of Year Price of Stock X End of Year Price of Stock Y CX PY PY .10 = 95 0 X + 300Y + Ze0.10 = -10 Ze0.4333 © ActuarialBrew.7) + Ze0.10 = -10 0Y + Ze0. Stock Y. and the risk-free asset to purchase. The rightmost column is the payoff resulting from buying the put option and selling the call option.

we must find the derivative of the price with respect to the stock price: ( ∂ 100 ¥ e -0.4333) + 117.02 N '( d2 ) ∂d2 ∂S The derivative of d2 with respect to the stock price is: Ê Ê Se -d T ˆ s 2 ˆ T Á ln Á . Y shares of Stock Y. K .20 ¥ 1 ( ) The current value of d2 is: d2 = Ê Se -d T ˆ s 2 ln Á T ˜2 Ë Ke -rT ¯ s T Ê 10 ˆ 0.T ) = 100 ¥ e . the final stock price must be greater than 10: [S(1)]2 > 100 ¤ S (1) > 10 Therefore.5 10 ¥ 0.02 N (d2 ) To find the delta of the option. the option described in the question is 100 cash-or-nothing call options that have a strike price of 10.30 Solution 28 A Chapter 11.SOA Sample Exam MFE/3F Solutions The cost now of replicating the payoffs resulting from buying the put and selling the call is equal to the cost of establishing a position consisting of X shares of Stock X.02 ∂ ( N (d2 )) ∂S = 100e -0.20 The density function for the standard normal random variable is: N '( x ) = 1 2p e -0.6289 = 4.s T 1 = = = = ∂S ∂S ∂S Ss T s T 1 = = 0.rT ˜ + ˜ 2 ¯ Á Ë Ke ˜ ∂Á -s T ˜ s T Á ˜ Ke -rT e -d T ¥ Á ˜ Ë ¯ Se -d T Ke -rT ∂d2 ∂ d1 . The current value of the option is: 100 ¥ CashCall(S . All-or-Nothing Options For the square of the final stock price to be greater than 100.02 ¯˜ = =0 0.22 ln Á 2 Ë 10e -0.02 N ( d2 ) ∂S ) = 100e -0.5x © ActuarialBrew.rT N (d2 ) = 100 ¥ e -0. and Z invested at the risk-free rate: 100 X + 100Y + Z = 100 ¥ ( -0.com 2014 2 Page 30 .7) + 100 ¥ ( -0.

9804 The calculations to obtain these prices are: P (2.06 = 0.9665 + 0.3.3.02 ˜¯ 4 s 2 = ln Á The interest rate for the node above 2% is: 0.5 = 100e -0.02e2 ¥ 0. Solution 29 D Chapter 18.5 ∂S 2p 2p = 19.9665) = 0.3. P(0.9665 0.9095 P (1. This means that 6% is e4s 2 times as large as 2%: 0.9804) = 0.3) because we do not know the value of r0 .9095 0. rdu ) = 1 = 0.02e2s 2 = 0. © ActuarialBrew. 19.034641 1 = 0.SOA Sample Exam MFE/3F Solutions We can now calculate the delta of the option: 100e -0.5d22 1 e = 100e -0. ru ) = 1. ruu ) = 1 = 0.034641 The tree of prices for the 3-year bond is: 0.3.02 ¥ e0 ¥ 0.5(0.9451 P (1.05 0. rdd ) = We cannot calculate the current price of the bond.06 P (2.27465 = 0.9434 + 0.02 0.06 ˆ 1 ¥ = 0.03 P (2. rd ) = 1.552 shares must be purchased to delta-hedge the option.5(0.02 N '( d2 ) ∂d2 1 -0.9434 ? 0.com 2014 Page 31 .9451 0.02 ¥ 0.3.552 Therefore.9434 1. Black-Derman-Toy Model Each node is e2s i h times the one below it. but we do not need P(0.3. rud ) = P (2.9665 1.27465 Ë 0.9804 1.02e4s 2 Ê 0.3) to answer this question.

1 ˙˚ The yield volatility of the 3-year bond is: È 0. © ActuarialBrew.9451-1 /(3 -1) .5 ¥ ln Í ˙ ÍÎ P (1.9434 1 + r0 ﬁ r0 = 6% s1 = 10% The first part of the interest rate tree is: ru = R1e2s1 r0 rd e0. The tree must correctly price the 2-year zerocoupon bond. Black-Derman-Toy Model The value of r0 is the same as the yield on the 1-year zero-coupon bond.9434(0.SOA Sample Exam MFE/3F Solutions The formula for the one-year yield volatility for a T-year zero-coupon bond is: È P (1.5 ¥ ln Í ˙ = 0.1 ˘ u Yield volatility = 0.8850 = 0.20 ﬁ 6% rd = R1 rd We need to determine the value of rd .8754 0.20 1 0.T .9095-1 /(3 -1) .5) 1 (0. rd )-1 /(T -1) .5) Á + 0.5) Á + 0.06 Ë 1 + rd e d¯ Ê 1 1 ˆ 0.8850.20 1 + r ˜ 1.1 ˙˚ Solution 30 A Chapter 18. and the yield volatility of the 2-year bond is s1 : 1 = 0. let’s try a lower short rate. r )-1 /(T -1) .1 ˘ Yield volatility = 0.8754 is less than 0.26435 ÍÎ 0.20 1 + r ˜ d¯ Ë 1 + rd e The quickest way to answer this question is to use trial and error. Let’s try Choice C first: 1 1 0.9434(0.T .com 2014 Page 32 .07)e0.2) = Ê 1 1 1 ˆ (0. so: P (0.07 Since the 0.

20)2 (0.D60 We can find the values of delta using: DCall = e -d T N (d1 ) and d1 = ln(S / K ) + (r .51981 © ActuarialBrew.com 2014 Page 33 .8850 1 (0. Solution 31 B Chapter 8.04965 = -1.5) 0.56946 With T = 0.20 0. Let’s assume that the bull spread consists of calls.25 and K = 60 . the delta of the bull spread is: D50 .05 + 0.64822) = 0.5s 2 )T s T With T = 0.25 N ( -1.d + 0.04965 = 0.56946 .25) 0.SOA Sample Exam MFE/3F Solutions Let’s try Choice A: 1 1 0.04965 Therefore.20 1 0.0594)e0.5(0.56946 = 0.04965) = 0. we have: d1 = ( ) ln(50 / 50) + 0.17500 D50 = e -0 ¥ 0.17500) = 0. we have: d1 = ( ) ln(50 / 60) + 0. Delta The delta of a bull spread is the same regardless of whether it is constructed of calls or puts. the delta of the bull spread is initially: D50 .25 and K = 50 .D60 = 0.64822 D60 = e -0 ¥ 0. Since the bull spread consists of purchasing the lower-strike call and selling the higherstrike call.20)2 (0.05 + 0.20 0.25 N (0.5(0.9434(0.25 (0.25 (0.56946) = 0.0.25) 0.0594 Choice A is the correct answer.

14289) = 0.01830 = 0.01830 Therefore.0. the delta of the bull spread after 1 month is: D50 . we have: d1 = ( ln(50 / 50) + 0.09009 0.20)2 0.55681 D50 = e -0 ¥ 2 / 12 (0. we have: d1 = ( ln(50 / 60) + 0.D60 = 0.05 + 0.0.0. Therefore.14289 N (0.51981 = 0.53851 The change in the delta of the bull spread is: 0. the price can be expressed as: W (t ) Èja + (1 -j )r . because the final term in Choice (A) does not include the factor j .01870 Solution 32 E Chapter 14.20 D60 = e -0 ¥ 2 / 12 (0. Therefore.com 2014 Page 34 .01830 ) 122 = -2.20 2 12 ) 122 = 0.5(0.01830) = 0. we see that W (t ) is a geometric Brownian motion.j )rdt = [ja + (1 . Geometric Brownian Motion The instantaneous return on the mutual fund is the weighted average of the return on the stock and the return on the risk-free asset: dW (t ) dS (t ) =j + (1 .55681) = 0.j )r ] dt + js dZ (t ) The expression above does not match Choice (A).5j 2s 2 ˘t +js Z (t ) ˚ = W (0)e Î © ActuarialBrew. we can rule out Choice (A).20)2 2 12 N ( -2.55681 With T = 2 /12 and K = 60 .05 + 0.SOA Sample Exam MFE/3F Solutions With T = 2 /12 and K = 50 .55681 .09009) = 0.j )rdt W (t ) S (t ) = j [a dt + s dZ (t )] + (1 . As written above.5(0.53851 .

0.5js ( -j +1)˘˚t e = W (0) Í ˙ Î S (0) ˚ j 2 È S (t ) ˘ (1 -j ) ÈÎr + 0.5j 2s 2 + 0.76074 From the cumulative normal distribution calculator: N ( d1 ) N ( 0. it is slightly different from both choices.76074) 0.5js 2 )t +js Z (t ) e = Í S (0) ˙ Î ˚ We can now describe the process of the mutual fund with: Èja + (1 -j )r .22341 © ActuarialBrew.25 0.90S ) (r 0.5j s + 0.5js ˘˚t = W (0) Í e ˙ Î S (0) ˚ j 2 È S (t ) ˘ ÈÎ(1 -j )r + 0.00 0.3 0.0.5j 2s 2 ˘t +js Z (t ) ˚ W (t ) = W (0)e Î Èja .5js ˘˚t e = W (0) Í ˙ Î S (0) ˚ Solution 33 C Chapter 11.91074) 0.3 0.32 )(0.18122 N ( d2 ) N ( 0. Therefore.91074 d2 d1 T 0.0.90) (0.5 0.9107 0.SOA Sample Exam MFE/3F Solutions Although the expression above is close to Choices (B) and (C).25) 0.5s )t +s Z (t ) j È S (t ) ˘ j (a . we turn to Choices (D) and (E).0.08 0. Since Choices (D) and (E) contain [S (t ) / S (0)]j .5s 2 )t +js Z (t ) Í S (0) ˙ = e Î ˚ j È S (t ) ˘ (ja . let’s find the value of this expression: 2 S (t ) = S (0)e(a .5js 2 ˘t ˚ ˚ eÎ = W (0)e Î j 2 2 2 È S (t ) ˘ ÈÎ(1 -j )r .5js 2 ˘t +js Z (t ) È(1 -j )r .0.com 2014 Page 35 .0.5 2 )T T ln(0. Forward Start Options The values of d1 and d2 for a 3-month put option with a strike price that is 90% of the current stock price are: d1 ln( S / 0.25 0.0.

8562 Solution 34 A Chapter 14.Se -d T N ( -d1 ) = 0.01587S Therefore.90Se -rT N ( -d2 ) .90S .1)h]} = [dZ (t )]3 Ú 0 We can now use the multiplication rules to evaluate the integral: T Ú [dZ (t )] 3 0 T Ú 2 = [dZ (t )] ¥ dZ (t ) = 0 T T 0 0 Ú dt ¥ dZ (t ) = Ú 0 = 0 The expected value and variance of zero are both zero: N (0. Multiplication Rules As n goes to infinity.01587 shares of stock. each of the 3-month put options can be purchased with 0.25 ¥ 0.08 N ( -d2 ) .00 N ( -d1 ) = S È0.0) Solution 35 B Chapter 14.0.02 (0.0. Since the current stock price is $45.25) = 0.90Se -0. The cost of purchasing all 4 of the options now is equal to the cost of acquiring 4 ¥ 0. the partial derivatives of X (t ) are: X R = 2R X RR = 2 Xt = 0 We can use Itô’s Lemma to find an expression for the differential of X (t ) : dX (t ) = X R dR(t ) + © ActuarialBrew.90e -0.01587 = 0.06347 shares of stock.Se -0.com 2014 1 X RR [ dR(t )]2 + X t dt 2 Page 36 . we can replace the summation with an integral: n lim n Æ• Â j =1 3 T {Z[ jh] .22341) . Itô’s Lemma Since X R2 .0.SOA Sample Exam MFE/3F Solutions The cost of a 3-month put option that has a strike price of 90% of the current stock price is a function of the then-current stock price: PEur (S .Z[( j .06347 ¥ 45 = 2.18122 ˘ Î ˚ = 0. this cost is: 0.

1e t dt t s 0 e R( s)dZ ( s) 0.1 e s t R( s)dZ ( s) dt 0.1e -t et R(t )dZ (t ) R( s)dZ ( s ) + 0.1 R(t )dZ (t ) 0 R(t )dt 0. we see that: [dR(t )]2 = 0.1e -t dt = -0.05e t dt 0.05 0.1 R(t )dZ (t ) 0 t R(0)e t 0. We then use the following version of the product rule to find the differential: d [U (t )V (t )] = dU (t )V (t ) + U (t )dV (t ) The differential of the third term is: t t È ˘ È ˘ d Í0.1 e s -t R( s)dZ ( s ) ˙ 0 Î ˚ Ú The third term has a function of t in the integral. so that we are finding the differential of a product.1 e s t R( s)dZ ( s) dt 0.05e t 0. so their differentials are easy to find.1e -t es R( s)dZ ( s) ˙ 0 0 Î ˚ Î ˚ Ú Ú = -0. The third term will be more difficult: t È ˘ dR(t ) = .1e t e s R( s)dZ ( s) dt 0.1 e s -t R( s )dZ ( s) ˙ = d Í 0.05e -t dt + d Í 0.SOA Sample Exam MFE/3F Solutions Let’s find dR(t ) .05dt 0.1 R(t )dZ (t ) Making use of the multiplication rules.1 R(t )dZ (t ) t R(0)e t 0.05dt 0.R(0)e -t dt + 0.05(1 e t ) 0.com 2014 Page 37 .1 R(t )dZ (t ) Putting all three terms together. we have: dR(t ) R(0)e t dt 0.05e t 0. We can pull the t-dependent portion out of the integral.05dt 0.1 R(t )dZ (t ) 0 t R(0)e t 0.1e -t dt t s Ú0 e t s e 0 Ú R( s)dZ ( s ) + 0. The first two terms of R(t ) do not contain random variables.01R(t )dt © ActuarialBrew.

2 X 3 / 4 dZ Solution 36 E Chapter 16.11R .com 2014 Page 38 .2R3 / 2dZ Î ˚ We are given that X is equal to R2 : X = R2 ﬁ X =R Substituting for R.1 RdZ ] + 0.2R3 / 2dZ Î ˚ = ÈÎ0. let's set the exponent in the price of the derivative security equal to a: 2 V S k / S a The partial derivatives are shown below: VS aS a 1 VSS a(a 1)S a 2 Vt 0 © ActuarialBrew. To simplify the notation.01Rdt = -2R2dt + 0.2R2 ˘ dt + 0.2R3 / 2dZ + 0.2 X ˘˚ dt + 0. we use R for R(t ) and X for X (t ) below: 1 X RR (dR )2 + X t dt 2 1 = 2RdR + ¥ 2(dR )2 + 0dt 2 dX = X R dR + = 2RdR + (dR )2 = 2R[ . we have: dX = È0.SOA Sample Exam MFE/3F Solutions We can now find the differential of X (t ) .10 Rdt + 0.2R2 ˘ dt + 0.05dt + 0.11R .11 X .Rdt + 0. Black-Scholes Equation To simplify the notation.01Rdt = È0.

01h.03dt + 0.com 2014 S S0 1 S0 2 1 S2 3 S3 3 S2 S1 Page 39 .04 .08 Solution 37 D Chapter 14.1)(0.04) = 0 a .1) + 0.0.1) + (0. and therefore a cannot be equal to 1: a k 2 0.1)S a .d .5s 2a + 0.08 a = 1 or a = - s2 The question specifies that k is positive. Brownian Motion We make use of the following equivalency: dS (t ) = (a .04 = 0 0.SOA Sample Exam MFE/3F Solutions The Black-Scholes Equation gives us: 0.04h ) Î S (t ) ˚ ) To avoid a cluttered appearance.5s 2S 2VSS + (r .1 = 0 or 0. we use St to represent S (t ) in the solution below.d )dt + s dZ (t ) S (t ) ¤ dS (t ) = 0.5s 2a( a .5s )h.5s 2a( a .5s 2S 2a(a .2dZ (t ) S (t ) ¤ ( È S (t + h ) ˘ 2 2 ln Í ˙ N (a . so that it is the product of independent random variables: 1/3 G S1 S2 S3 1/3 S S S S S S S0 1 S0 1 2 S0 1 2 3 S0 S0 S 1 S0 S 1 S2 1/3 S3 S 2 S S03 1 2 3 S03 S12 S2 © ActuarialBrew.04( a . 0.0)a = 0.04S a 0.2 + (0.04 0.1) + 0. so a must be negative.04a .0)SaS a -1 + 0 + 0 = 0.08 2 k 0.1) = 0 (a .08 2 0. s h S ( t ) Î ˚ È S (t + h ) ˘ ln Í ˙ N (0.0.d )SVS + Vt + D(t ) = rV 0.04 = 0 0. We can rewrite the expression for G .5s 2a + 0.04 .5s 2a( a .

com 2014 Page 40 .03.03.3)]2 P (0.3) È1 + 0.T )r = [ B(t.02] 2 [ B(0.02] Pr (0.05.3) ª P (0.0408 P (0. t.3) © ActuarialBrew.03.[ -0.03.05. from the expression above: P [r(t + h).5 ¥ ( -0.5 [ -0.T )e .r(t )] Pr + 0.0.05.0.B(t .0.03.3) P (0. and we replace r(t + h) with 0.0408 ª = 1.05.3) P (0. t.0. t.06222 3 3 Solution 38 B Chapter 19.04 (0.T ] ª [r(t + h) . t.0.0408 Therefore.5 [ -0.05.05.T )r = .3) + 0.P [r(t ).T ) = .B(t .3) + 0.P (0. Pt h .02] Prr (0.03. we have: P (r.04) 0.05.3) PEst (0.T )r Pr (r .r(t )] Prr 2 We replace r(t ) with 0.T ] .B(t .r(t )] Prr + Pt h 2 This question asks us to use only the delta and gamma portions of the approximation.0.05.0.3) ¥ 1.05. t + h.0.02)2 ¥ 22 ˘ Î ˚ PEst (0.0.0.T ) 2 2 The delta-gamma-theta approximation is: P [r(t + h ).3) + [ -0.T ) Prr (r.SOA Sample Exam MFE/3F Solutions Taking the natural log. t .3) ª [ -0.0.3) ª P (0.0.T )] P (r.3)P (0.0.0.P [r(t ).05. t. t + h. so we remove the theta term.3) + 0.5 [r(t + h) .5 [r(t + h) .05.T ] .T )e .3) 2 PEst (0.T ) A(t.0.3) ¥ 1.3) .0.05.r(t )] Pr + 0.T )] A(t. t . we have: PEst (0.T ) = A(t .B(t .3) ª P (0.5 [ -0.3) ª P (0.3) 2 PEst (0.B(t .02] B(0.05.05.03.T ] ª [r(t + h ) . The delta-gamma approximation is therefore: PEst (0.T )e .0.02 ¥ 2 + 0.02] Prr (0.02] Pr (0.3) .05.0.0. we have a sum of independent random variables: S 2 S 1 S ln G ln S0 ln 1 ln 2 ln 3 S0 3 S1 3 S2 The variance is: 2 2 2 1 Var ln G 0 0.T )P (r .0.04) (0. Delta-Gamma Approximation for Bonds In the model described in the question.T ) = [ B(t.

so the correct answer must be Choice (D) or Choice (E). then the zero-coupon bond will have a value of P (0.15 3 1 at time 1. A bull spread consists of purchasing a low-strike option and selling a high-strike option. This material is covered on page 87 of the second edition of the Derivatives Markets textbook. © ActuarialBrew.06 3 1.05 Î 3 1.95 0. In the profit diagram below.SOA Sample Exam MFE/3F Solutions Solution 39 B Chapters 3 & 18.100 = 108 ¥ 0.100 We can use the stock prices to determine the risk-neutral probability that the up state of the world occurs: p* e( r )h d (1 r0 )h d (1.2) to denote the price of a 2-year zero-coupon bond that matures for $1.04 The time 0 value is found using the risk-neutral probabilities and the risk-free rate at time 0: If the up state occurs. and 1. then the zero-coupon bond will have a value of at time 1.C (108) = 108 ¥ P (0.100 = -2. Option Strategies This question is probably more appropriate for Exam FM than for Exam MFE/3F.90423 Í 1. Risk-Neutral Probability Let’s use P (0. which is assigned for Exam FM but is not assigned for Exam MFE/3F.95 0.06 1 if the down state occurs. the dotted line represents zero profit.2) .10 2 ud ud 1.10 0.com 2014 Page 41 . The profit diagram shows the pattern of profits at the end of 1 year: Bull Spread The diagram above matches Portfolio IV.2) . 1.90423 .2) = 1 È2 1 1 1 ˘ ¥ + ¥ = 0. We can make use of put-call parity: C (108) + 108 ¥ P (0.04 ˙˚ We can now use the equation for put-call parity described above to find the solution: P (108) .05)1 0.3429 Solution 40 D Chapter 2.2) = S0 + P (108) P (108) .C (108) = 108 ¥ P (0.

To find the value of this contingent claim.07 .31097 © ActuarialBrew.0.25 1 = 0. A collar consists of the purchase of a put and the sale of a call with a higher strike price.25 1 = 0.56097 d2 = d1 . Elasticity The contingent claim can be replicated with a portfolio consisting of the present value of $42 and a short position in a European put option with a strike price of $42.5 ¥ 0. It’s profit diagram matches Portfolio III.252 ) ¥ 1 0. the pattern indicates that Portfolio I is the collar: Collar A strangle consists of the purchase of a put and the purchase of a call with a higher strike price.d + 0.com 2014 Page 42 . Nonetheless.s T = 0. we must find the value of the put option: The first step is to calculate d1 and d2 : d1 = ln(S / K ) + (r . For the sake of completeness. We would need more information to know where it would produce zero profit.0. The profit diagram shows the pattern of the profits at the end of 1 year: Straddle The diagram above matches Portfolio II.56097 .03 + 0.5s 2 )T s T = ln(45 / 42) + (0. so the correct answer must be Choice (D).SOA Sample Exam MFE/3F Solutions A straddle consists of the purchase of a call and a put with the same strike price. let’s consider the other two strategies as well. so the dotted line has been left off of the graph below. Strangle Solution 41 C Chapter 8.

Therefore.3278 © ActuarialBrew. a regular call option with a strike price of $60 can be read from the bottom line of the table: C (60) = 4..7583 4. we have: H Up-and-out Call Up-and-in Call 70 0.56097) 0.2.28741 N ( d2 ) N ( 0. zero) minus the delta of the put: D = 0 .1294 4.9567 80 0.27892 = = 0.0861 The value of the corresponding up-and-in calls can be determined with the parity relationship for barrier options: Up-and-in call + Up-and-out call = Ordinary call For the $70 and $80 barriers.24795 = 36. the price of the up-and-out call approaches the price of a regular call.com 2014 Page 43 .37791 The value of the European put option is: P (42) Ke rT N ( d2 ) Se T N ( d1 ) 42e 0.24795 The current value of the contingent claim is the present value of $42 minus the value of the put: V = 42e -0.27892) = 0.28741 2.0861 .03 ¥ 0.7583 = 3.SOA Sample Exam MFE/3F Solutions We have: N ( d1 ) N ( 0.31097) 0.e -d T N ( -d1 ) = -e -0.34003 V 36.28741 = -0.91259 The delta of the put option is: D Put = .( -0.0861 .0.07 0. Barrier Options As the barrier of an up-and-out call approaches infinity.0.37791 45e 0.27892 The delta of the contingent claim is the delta of the present value of $42 (i.27892 The elasticity of the contingent claim is: W= S D 45 ¥ 0.91259 Solution 42 D Chapter 10.07 .1294 = 3.03 0.e.

0.3278 = 4.0000 41.6102 375 .0002 0.r€ .5s 2 )t . This is indicated by the bolding of those two nodes in the tree above.1000 Early exercise is optimal if the stock price falls to $210 at the end of 1 year or falls to $147 at the end of 2 years.d e = = 0.5s 2 )t .5s 2 + 0.r€ .2500 90.s dZ (t ) Î ˚ y(t ) Solution 44 D Chapter 4. Therefore.065) ¥1 210 . the price of the special option is: 2 ¥ 3.r + 0.s Z (t ) = e = e x (t ) x (0) x (0) This implies that: dy(t ) È = r€ .r + 0.d )dt + s dZ (t ) S (t ) ¤ 2 S (t ) = S (0)e(a -d .9567 . we make use of the following relationship: dS (t ) = (a .0000 14.r + s 2 )dt . © ActuarialBrew.7263 0.4603 0.210 u-d 300 300 The tree of prices for the American put option is shown below: American Put 39.3.0000 153.5856 Solution 43 E Chapter 14.0.0000 116.0000 197.5s )t +s Z (t ) Therefore. y(t ) is: y(t ) = 1 1 -( r .5s )t +s Z (t ) We can write x (t ) as: 2 x (t ) = x (0)e( r .SOA Sample Exam MFE/3F Solutions The special option consists of 2 of the 70-barrier up-and-in calls and a short position in 1 of the 80-barrier up-and-in calls.300 e ( r .s dZ (t ) = (r€ .d )h .0. Three-Period Binomial Tree The risk-neutral probability of an upward movement is: p* = (0. Geometric Brownian Motion For this question.s Z (t ) 1 ( r€ .5( -s )2 ˘ dt .10 .com 2014 Page 44 .0.

0.( -0.SOA Sample Exam MFE/3F Solutions The price of the option is: e -0. Options on Futures Contracts We are given that the ratio of the factors applicable to the futures price is: uF 4 = dF 3 The formula for the risk-neutral probability of an up move can be used to find uF and dF : p* = 1 . h) = D(Su.0651 0.1863 .0651 0.9087) = = 0.dF F d . Greeks in the Binomial Model We need to calculate the two possible values of delta at the end of 1 year: Vuu Vud 0.2 3 © ActuarialBrew.9087 2 262. h ) -0.00 41.dF p* = 1 dF uF dF d .10 ¥1 [0.D(Sd.75 262.210 Su .dF uF . h ) e h ud e 0.6102) ¥ 90] = 39.00 e 0.com 2014 Page 45 .00 (Sd.004378 375 . h ) .00 Sud Sd (Su.7263 Solution 45 C Chapter 4.1 = 4 -1 3 3 dF = 0.00 153. h ) e h We can now calculate gamma: G(S .9 uF = 4 ¥ dF = 1.1863 2 468.4603 + (1 .Sd Solution 46 E Chapter 4.50 147.0) ª G(Sh .dF F 1 1 dF .50 Su Sud V Vdd 41.6102 ¥ 14.

05 ¥ 0.7838 = 0.t ) = 50 + 0.0000 86.08830 Solution 47 B Chapter 9.8000 The tree of prices for the European call option is: European Call 30.7838 The tree of prices for the American call option is: American Call 30.7284 + (2 / 3)(0. The price of the American call option exceeds the price of the European call option by: 3.2000 10. Market-Maker Profit Let’s assume that “several months ago” was time 0.2000 11.4000 72. We can use put-call parity to obtain a system of 2 equations.7838 1.0000 + (2 / 3)(0.4551)] = 3.4551 0.4551)] = 3. 8.88 + Ke -rT = 40 + 1. and this is indicated by the bolding of that node above.42 + Ke -r(T .0000 The price of the European call is: e -0.8721 If the futures price moves up at the end of 6 months.63 14.7284 3.4000 0.4000 0. then early exercise of the American option is optimal.4551 0.05 ¥ 0. let’s assume that the options expire at time T and that the current time is time t. Further.5 [(1 / 3)10.0000 80.0000 64.0000 3.3.com 2014 Page 46 .8721 1.26 © ActuarialBrew.2000 96.5 [(1 / 3)11.8721 .SOA Sample Exam MFE/3F Solutions The tree of futures prices is therefore: Futures Prices 115.0000 The price of the American call is: e -0.

was: Value –888. From the market-maker’s perspective.00 Since the market-maker received only $888. was: Delta of a short position in 100 calls = -100 ¥ (0.00 The initial position. and this is the profit.88 24. the value of the funds that were borrowed at the risk-free rate changed by: ( ) Ê 35.8.00 794.12 The change in the value of the position is $24.84 Ô˛ ﬁ ert = 35. © ActuarialBrew. the differential was borrowed.00 –2.84 ˆ -2.00 3.1˜ = -215.SOA Sample Exam MFE/3F Solutions This can be solved to find ert : Ke .00 from the sale of the calls. The value of the loan. Component Gain on Options Gain on Stock Interest Overnight Profit Change –554.88) = -554.794) = -79.com 2014 Page 47 .42 .00 After t years elapsed.00 Component Options Shares Risk-Free Asset Net After t years elapsed. from the perspective of the market-maker.288.4 To delta-hedge the position.4 ¥ (50.88 Ë 32. the value of the shares of stock changed by: 79.00 Á .288.1 = -2.00) = 794.75 ¸Ô ˝ Ke -r(T .00 .88 = -888.75 The market-maker sold 100 of the call options.00 The delta of the position.00 3.40. the market-maker purchased 79.4 shares of stock.12.75 ¯ The sum of these changes is the profit. from the perspective of the market-maker.00 –215.176. was: 888.176.rT = 32.288. The value of this position was: 79.00 ert .4 ¥ 40 = 3.84 32. the value of the options changed by: -100 ¥ (14. from the perspective of the market-maker.00 0.00 2.t ) = 35. the value of this short position was: -100 ¥ 8.176.00 After t years elapsed.288.

94 © ActuarialBrew.8694 The risk-free probability of an upward movement is: p* = e( r .00)0.03S2 dt .04 0.e. the dZ term) is: 2 =4 0.0.50 When the return on Stock 1 is added to the return on 4 shares of Stock 2.04 0.04 0.25 0..8694 The stock price tree is: 117.06(100)dt + 0.3 0.01(50)dZ = 1.5dZ Since the investor purchases 1 share of Stock 1.35 100 86.1736 .0.5dZ ) 12dt Solution 49 B Chapter 4.1735 d e( r )h h e(0. the amount of Stock 2 that must be purchased to remove the random term (i.3 0. Sharpe Ratio The Sharpe ratio of Asset 1 must be equal to that of Asset 2: 0.06S1dt + 0.02 k k 0. American Put Option The values of u and d are: u e( r )h h e(0.01S2 dZ = 0.02(100)dZ = 6.SOA Sample Exam MFE/3F Solutions Solution 48 E Chapter 15.0dt 2dZ Return on 4 shares of S2 4 (1.8694 = = 0.04 0.25 0.03(50)dt .00)0.4626 u-d 1.04 .00)0.0.0. there is no random term: Return on S1 6.25 1.01 Over the next instant.02S1dZ = 0.0.25 0.25 .0dt + 2dZ Return on S2 = 0.d )h .d e(0.0. the returns on Stock 1 and Stock 2 are: Return on S1 = 0.5dt .06 0.com 2014 Page 48 .5dt 0.03 0.

26 0.10 2 ) = 0. for which an investor will exercise the put option at the beginning of the period must be at least $100. the value of exercising now must exceed the value of holding the option: K 100 ( K 86.25) K 100 ( K 86.35 that results in immediate exercise.SOA Sample Exam MFE/3F Solutions The strike price K.15 The z-value associated with the upper limit of the 90% confidence interval is found below: ( P (z > z P (z > z P (z < z ) 2p ) = 0.04(0.05 ) = 0.5) + 0. let’s begin by determining whether there is a strike price that is greater than $100 but less than $117.35 )(0.d = 0.25) K 100 0.25e(0.94)(1 0.25 s = 0. Lognormal Confidence Intervals We are given: S0 = 0.4626)e 0.5 = 0.35 a .4679 K 53.64485 0.39265 © ActuarialBrew.5 ¥ 0.35 ¥1.74 K 114. Since we are seeking the lowest strike price that results in immediate exercise.85 The smallest integer that satisfies this inequality is $115.94)(1 p*)e 0. Solution 50 A Chapter 5.95 P z > zU = U U U zU = 1.04(0.5321K 46.com 2014 Page 49 .0.64485 The upper limit of the confidence interval is calculated using the associated z-value: 2 U U ST = St e(a -d . since otherwise the payoff to immediate exercise would be zero. If there is such a strike price.0.15 .5s )(T -t ) +s z T -t 2 = 0.

03836) N ( zˆ2 ) F (0. Estimating Parameters of a Lognormal Distribution First.103541414.77000 Page 50 . press [2nd] [STAT] and choose 1-VAR and press [ENTER] [DATA]. press [2nd] [EXITSTAT] [ENTER].98300) N ( zˆ1 ) F (0. we determine the monthly mean and the monthly standard deviation using a calculator.340625623 h Solution 52 C Chapter 12.02302506. and then we determine the annualized standard deviation and the annualized expected return. Press → again and the monthly standard deviation is shown as 0. Since the dividend rate is zero. we determine the annualized expected return by multiplying the monthly mean return by 12 and adding to that amount one half of the annualized variance: ˆ r 0.358677982 0. Using the TI-30X IIS calculator.com 2014 zˆ1 2. Normal Random Variables as Quantiles We convert the draws from the uniform distribution into draws from the standard normal distribution: F (0. Multiply this number by the square root of 12 to get the annualized standard deviation of 0. Perform the following sequence: X1 = LN(56/54) [ENTER] ↓↓ (Hit the down arrow twice) X2 = LN(48/56) [ENTER] ↓↓ X3 = LN(55/48) [ENTER] ↓↓ X4 = LN(60/55) [ENTER] ↓↓ X5 = LN(58/60) [ENTER] ↓↓ X6 = LN(62/58) [ENTER] Press [STATVAR] and → and the monthly mean is shown as 0.SOA Sample Exam MFE/3F Solutions Solution 51 E Chapter 13.5 0.5ˆ 2 0.12007 zˆ2 1.77004 zˆ3 0.02302506 12 0 0.77935) N ( zˆ3 ) © ActuarialBrew. To exit the statistics mode.35867798.

51624 = 88.30 (0.45 if ST > 40 The cash-or-nothing call option has the following payoff: 1.77004) 2 29. Cash-Or-Nothing Call Option A European call option has the same gamma as an otherwise equivalent European put option.00 0.3 )2 0.000 if ST 40 The cash-or-nothing call option can be replicated by purchasing 200 of the call options and selling 200 of the gap call options: 200 [Call .75434 3 Solution 53 B Chapter 11.10933 2 3.SOA Sample Exam MFE/3F Solutions We use these draws to find the new stock prices: 2 ST St e( 0. and its payoff is: ST .10933 + 85. Therefore.07: ST .45)] = 200 ¥ 5 = 1.08.00 Solution 54 A Chapter 1. S2 50e(0. which we will call Asset X. which has a payoff of: X1 Min[2S1 (1).0 Max X1 17.12007) 2 151.15 0. Exchange Options Consider an asset.51624 The average of the stock prices is: 151.000 if ST > 40 The gamma of the position is: 200 [0.00 0.30 (2.0 © ActuarialBrew.63746 + 29. with a strike price of 17. S2 50e(0. is 1.5 0. S2 (1)] From statement (vi).01) = -2.40) .00 0.07 .15 0.30 ( 1.0. The payoff of this call option is: Max Min 2S1 (1).5 0. S2 50e(0.15 0.com 2014 Page 51 .3 )2 0.5 )(T t ) z T t 2 1. S2 (1) 17.08] = 200 ¥ ( -0.77000) 2 85.GapCall ] = 200 [(ST .40 if ST > 40 The gap call option described in the question has a gamma of 0. the gamma of a call option with the payoff described below is 0.3 )2 0.(ST . we know that the price of a European call option on Asset X.63746 2 2.632.5 0.

361802 ¥ 1 ln Á ˜+ 2 Ë 20e -0 ¥1 ¯ 0.8712 The current value of Asset X is: X 0 2S1 (0) ExchangeCallPrice 2 10 2.36180 1 = -0.t ) = St + PEur 1.05 ¥1 = X 0 + PEur If we can find the current value of Asset X.36180 1 = 0.0 Max 17 X1 .18090 d2 = d1 .25) = 0.com 2014 Page 52 .0] The current value of Asset X is: X 0 2S1 (0) ExchangeCallPrice The exchange call option is an exchange call option with 2 shares of Stock 1 as the underlying asset and 1 share of Stock 2 as the strike asset.42822 The value of the exchange call option is: ExchangeCallPrice Se ST N (d1 ) Ke K T N (d2 ) 2 10e0 1 (0.252 .57178 N ( d2 ) = N ( -0.42822) 2. Asset X can be replicated by purchasing 2 shares of Stock 1.40)(0.0 We recognize this as a European put option on Asset X.s T = 0. From put-call parity.36180 The values of d1 and d2 are: d1 = Ê Se -d ST ˆ s 2T ln Á ˜+ 2 Ë Ke -d K T ¯ s T = Ê (2 ¥ 10)e -0 ¥1 ˆ 0. we have: CEur + Ke -r(T .2( -0. we find the appropriate volatility parameter: 2 s = s S2 + s K . To find the value of this exchange call option.182 + 0.632 + 17e -0.18090) = 0. and selling an exchange call option that allows its owner to exchange 1 share of Stock 2 for 2 shares of Stock 1: X1 Min[2S1 (1). then we can solve for the value of the put option.1288 © ActuarialBrew.SOA Sample Exam MFE/3F Solutions We are asked to find the price of an option that has the payoff described below: Max 17 Min 2S1 (1).2 rs S s K = 0. S2 (1)] 2S1 (1) Max[2S1 (1) S2 (1).8717 17.57178) 20e0 1 (0.18090 .18090) = 0.18)(0.18090 From the normal table. we have: N ( d1 ) = N (0. S2 (1) .0.

TF .5 T We can find N ( -d1 ) in terms of N ( -d2 ) : ( ) N ( -d2 ) = N (0.10999 0.5s T ) N ( -d1 ) = N -0.5 T T 0.10999 d2 0. Options on Futures Contracts At time 0.54379 d2 0.5 T 0.05 = 17.5 0.10 0.com 2014 Page 53 .T .5 2T T d2 d1 T 0.075 N ( d2 ) 1 N ( d2 ) 1. r ) Ke rT N ( d2 ) F0.10 0.N ( -d2 ) We can substitute this value of N ( -d1 ) into the time 0 formula for the price in order to find d2 : PEur ( F0.632 + 17e -0.SOA Sample Exam MFE/3F Solutions We can now use put-call parity to find the value of the put option: 1.6741 Solution 55 D Chapter 7.1288 + PEur PEur = 0.625 0.TF / K 0.75 N ( d2 ) 20e 0.25401 © ActuarialBrew.10999 We can now find s : d2 0.625 20e 0.632 + 17e -0.75 0.05 ¥1 = X 0 + PEur 1.075 2N ( d2 ) 1 e 20 N ( d2 ) 0.TF e rT N ( d1 ) 1.625 20e 0.5 T 0. K . r . the values of d1 and d2 are: d1 ln F0.5 2T T ln 20 / 20 0.5s T N ( -d1 ) = 1 . .75 N ( d1 ) 1.

10 ¥ 0.54318 Ë ¯ The covariance is: ÈS ˘ Cov[S1 .2 (2 .d )(T .1ˆ Ë ¯ ÈS Cov[St .5 0.s .t ) Ê es (T .1ˆ = 1.17.59037 0.SOA Sample Exam MFE/3F Solutions After 3 months.25401 0.0) Ê e0.1ˆ = 2.25401 0.10 ¥ 0.TF e -rT N ( -d1 ) = 20e -0.59037 d2 d1 T 0.5 2T T ln 17.2 (1 .5 0.70e -0.18538 Î S1 ˚ © ActuarialBrew.TF / K 0.76998) = 0.5 0.05)(1 .t ) Î St ˚ 2 Var ÈÎST St ˘˚ = St2 e2(a .rT N ( -d2 ) . r . S2 ] = E Í 2 ˙ Var ÈÎS1 S0 ˘˚ = e0.com 2014 Page 54 . the new values of d1 and d2 are: d1 ln F0.76998 We can look up the values of N ( -d1 ) and N ( -d2 ) from the normal distribution table: N ( -d1 ) = N (0. ST ] = E Í T Î St ˘ ˙ Var ÈÎSt S0 ˘˚ ˚ The variance of A(2) is: Var [ A(2)] = 1 {Var[S(1) + Var[S(2)] + 2Cov[S(1).d )(T .t ) .77934 .0) . K .77934 After 3 months.12757 = 1.72253 N ( -d2 ) = N (0.59037) = 0.0) .TF . S(2)]} 4 The variances of S (1) and S (2) are: 2 Var ÈÎS1 S0 ˘˚ = 52 e2(0. we use the following formulas: ÈS ˘ E Í T ˙ = e(a .72253 = 2.F0.0) Ê e0.T . Covariance of St and ST To answer this question.05)(2 .05(2 -1) ¥ 1.66156 Solution 56 A Chapter 5.12757 Ë ¯ 2 Var ÈÎS2 S0 ˘˚ = 52 e2(0.5 ¥ 0.7 / 20 0.5 ¥ 0. the value of the put option is: PEur ( F0.254012 0.5 0. r ) = Ke .

0. Y will be the dependent variable and X will be the independent variable.50).54318 + 2 ¥ 1. The lower of the two values in this segment is the fifth one: 0.50. Stratified Sampling Method The stratified sampling method assigns the first and fifth uniform (0. 0.18538} = 1. 1) random variables to the segment (0.4482 uˆ 4 = 0.25).4482. 1) random variables to the segment (0.1) = 0.( -1. the third and seventh uniform (0. 0. 1) random numbers to the segment (0.0793 4 Z5 = N -1 (0. 1.com 2014 Page 55 .00). The lowest simulated normal random variables will come from the segment (0. The higher of the two values in this segment is the fourth one: 0.40980 The highest simulated normal random variable will come from the segment (0.08958 .25.08958 The difference between the largest and smallest simulated normal random variates is: 1.00. so we use it to find the corresponding standard normal random variable: u4 = 0.75).3172.51038 4 Var [ A(2)] = Solution 57 E Chapter 12.75.SOA Sample Exam MFE/3F Solutions We can now find the variance of A(2) : 1 {Var[S(1) + Var[S(2)] + 2Cov[S(1).86205) = 1.4482 + (4 . 1. © ActuarialBrew. 0. Control Variable Method with Beta Let the variable Y be associated with the $42-strike option and the variable X be associated with the $40-strike option. 1) random variables to the segment (0.40980) = 2.49938 Solution 58 B Chapter 12.3172 + (1 . the second and sixth uniform (0. so we use it to find the corresponding standard normal random variable: u5 = 0.86205 4 Z4 = N -1 (0.25).75.1) = 0.12757 + 2.3172 uˆ5 = 0.0793) = -1. In the regression analysis.00.00). and the fourth and the eighth uniform (0. S(2)]} 4 1 = {1.

30 40.00 1.00 0.29 37.90 The values in the two rightmost columns are the payoffs.35 43.90 L2 0. and then press [enter]. it is more efficient to let the calculator perform the regression and determine the slope coefficient. Using the TI-30XS Multiview calculator. The resulting slope coefficient is: b = 0.764211 During the exam.65 8.00 0.00 0. times erT .Y )( Xi .00 0.00 0.00 0.25 payoffs from the table above.65 48. The estimate for b is: n b = Â (Yi .00 0.02 i 0.02 0.65 8.90 0. Fill out the table as shown below: L1 0.X )2 i =1 We get the same estimate for b regardless of whether we use the time 0 prices or the time 0.35 3.SOA Sample Exam MFE/3F Solutions The payoffs depend on the simulated stock prices: Payoff With Strike = 40 Stock Price (X e ) 33. X i and Yi . we use the time 0.90 © ActuarialBrew. To save time.25 payoffs (as shown in the rightmost expression above).35 3.X )2 Â ( Xi .00 0.Y )( Xi .90 i Payoff With Strike = 42 (Y e ) 0.X ) i =1 n Â = 2 n (e ) rT Â (Yi . which means that they are the discounted Monte Carlo prices.65 6.65 6. We perform a regression using the 2nd column in the table above as the x-values and the third column as the y-values. we first clear the data by pressing [data] [data] ↓↓↓ until Clear ALL is shown.X ) i =1 i =1 2 n ( ) erT ( X i .00 1.com 2014 L3 ----------- Page 56 .

Solution 59 B Chapter 12. Cox-Ingersoll-Ross Model The CIR model is: dr = a(b .02 = 2.com 2014 Page 57 . Select CALC and then [enter] Scroll down to: a = 0.SOA Sample Exam MFE/3F Solutions Next. Exit the statistics mode by pressing [2nd] [quit].90 ¥ e -0. Control Variable Method with Beta Since the 40-strike call is our control. its yield approaches: r 2ab ln[ P (r.5289) 1. press: [2nd] [stat] 2 (i.90 ¥ e -0. t ) = f r s & f (r.764211005.7847 2.5289 5 0 + 0 + 0 + 1.e.65 + 6.8716 Solution 60 E Chapter 19.65 + 8.02 = 1. t ) = c r ﬁ c= f s In the CIR model.764211(2.35 + 3.11 s = 0.08 We can define c in terms of f : f (r.r )dt + s rdZ From the partial differential equation provided in the question.6761 Y = 5 X = The estimate for the price of the $42-strike option is: C * (42) Y * Y ( X X ) 1. we can obtain the following parameters for the CIR model: a = 0. we have: 0 + 0 + 0. t. select 2-Var Stats) Select L1 for x-data and press [enter]..T )] Lim T t (a ) T © ActuarialBrew.6761 0. Select L2 for y-data and press [enter].1 b = 0. as the maturity of a zero-coupon bond approaches infinity.

01 .06 When the stock price process is a geometric Brownian motion.0084 f = 0. Risk-Neutral Process In the Black-Scholes framework: dS (t ) = (a .1 ) 0.d = 0.f )2 + 2s 2 f + 0.01909 0.1 0.44f = 0.0144 = (0.1 .12 We can substitute this value into the formula for g : g = (a .08)2 f 2 + 0.10.0144 = (0. we know that the rightmost portion is equal to 0.1 0.08 Solution 61 D Chapter 15.f )2 + 2(0.05 s = 0.0.10 (0.10 (a ) 2 0.05 ﬁ a = 0.2f + f 2 ) + 0.f )2 + 2(0. Therefore: 2ab 0.SOA Sample Exam MFE/3F Solutions From the information provided in part (ii) of the question.d )dt + s dZ (t ) S (t ) We can use statements (ii) and (iii) in the question to find a and s : a .0.24f + 0.25 ﬁ a . the relationship between Z (T ) and Z (T ) is described by: a -r Z (T ) = Z (T ) + T s © ActuarialBrew.22 0.24f + 0.01 = 0.com 2014 Page 58 .1 .0128 0.11 0.12 = (0.01909 The value of c is: c 0.08)2 f 2 + 0.2386 0.

25 r = 0.0.com 2014 Page 59 . we have: S(t )2 e2 0.16(T t ) S (t ) e Setting this expression equal to the forward price provided in statement (ii).52(2 1)0.18 0.5 0.16(T t ) S(t )2 e0.06 ¥ 0.045 -0. we have: E * [Z (0.5a( a 1) 2 (T t ) a Ft .5 r .03 = Solution 62 A Chapter 15.T S (T )a S (t ) e 2 2 2 2 0.40 (T t ) e S (t ) 2 0. so: a -r ˘ È E * ÈÎ Z (T ) ˘˚ = E * Í Z (T ) + T˙ s Î ˚ a -r T 0 = E * [Z (T )] + E * [Z (T )] = r -a s s T Since the expectation of Z (0.SOA Sample Exam MFE/3F Solutions Under the risk-neutral probability measure Z (T ) is a pure Brownian motion.5)] = r -a s ¥ 0.03 .d )dt + s dZ (t ) S (t ) We observe that: m = r -d and s = 0.18(T t ) 2 0.4 The formula for the forward price of S 2 is: a( r ) 0.5) is -0.16 0.01 © ActuarialBrew. Risk-Neutral Process The risk-neutral price process is: dS (t ) = (r .

An infinite number of zeros is summed. we have: 2 2 2 V2. Quadratic Variation The quadratic variation is the sum of the squared increments of the process. The subsequent increments.4 2 Ú [dW ] = 0 (ii) 2 Ú [2tdt ] 0 2.4 = 2.4 (W ) < V2.4 = 2 Ú [dY ] 2.81(dZ )2 = 0. dt ¥ dt = 0 .4 = 0 Ú 0.81dt The quadratic variation is: 2 V2.81 ¥ (2.1).9dZ )2 = 0.944 < 2 . The subsequent increments are again 0 until t = 2 . and its differential is found below: W (t ) = t 2 dW = 2tdt Making use of the multiplication rule. But when t = 1 .4 .81dt = 0.4 (W ) 2. X jumps from 0 to 1.0) = 1.4 (X ) 2.4 (Y ) 2.com 2014 Page 60 .9Z dY = 2dt + 0. (i) W is not stochastic. we obtain the quadratic variation: 2 V2.4 (X ) © ActuarialBrew.4 (Y ) < V2.SOA Sample Exam MFE/3F Solutions Solution 63 A Chapter 15. and their sum is zero.4 = 2 Ú [dX ] = 02 + + 02 + 12 + 02 + + 02 + 12 + 02 + + 02 = 2 0 (iii) We can determine dY by finding the partial differential of each of the terms of Y: Y = 2t + 0.4 .4 = Ú 4t 2 (dt ¥ dt )] = 0 0 The increments to X are 0 across the interval [0.944 0 Since 0 < 1. up to t = 2.9dZ Making use of the multiplication rules. The two non-zero increments (of 1 each) sum to 2: 2 V2. are 0. we have: (dY )2 = (2dt + 0. at which point X jumps from 1 to 2.

50 The upper z-value for the 90% prediction interval is found below: ( ) P z > zU = p 2 ( ) ﬁ P z > zU = 1 .10 .t ).5s 2 = 0.07 In (vii).5s Y )T +s Y z T 2 = 64e(1.2 s Y = -0. from (iii).d .0626 The corresponding upper limit of the prediction interval for S (2) is the square root of the upper limit for Y (2) : U = 1.d .2 .5s 2 = 0. and so from (iv).64485 The upper limit of the prediction interval for Y (2) is: 2 U Y (0)e(aY -dY .dY = 1. Elasticity and Risk Premium Since the Black-Scholes framework applies.5s 2 )(5 .50 s Y = s Y = -0.r = 0.03 Subtracting the expression above from the one obtained from (iii).5 ¥ 0.SOA Sample Exam MFE/3F Solutions Solution 64 C Chapters 15.t ) ˘ Î ˚ Ë St ¯ Therefore.0. we know that one of the following is true: S D = 20 or © ActuarialBrew.50 = 0.0.5s 2 )(T . Therefore.d .50 )(2) + 0. we are not told if the put option being hedged has been purchased or sold.com 2014 . we have: ÊS ˆ ln Á T ˜ N È(a .0.0.9293 Solution 65 C Chapter 8.03 = 0. Prediction Intervals Y (t ) follows geometric Brownian motion with the following parameters: aY .758.d .758.0.64485 ¥ 2 = 1.0.0626 = 41.90 2 ( ) ﬁ P z < zU = 0.50 ¥1. we have the risk premium for the stock: a .S D = 20 Page 61 . we have: (r . the expected return is r.3) = 0. we have: a . s 2 (T .0.0.10 Under the risk-neutral probability measure.06 r .95 ﬁ zU = 1.

02 = 0.d X = 0.10 Solution 66 A Chapter 15. we have: m = aY .r = sX sY 0.06 + 0.20 aY = 0.04 = -2 ¥ (0.0.07) g = -0.dY . the second expression above must be true.SOA Sample Exam MFE/3F Solutions Since the D of a put is negative.20 ﬁ a X = 0.06 + d X = 0.10 We can now find m : m = aY .5 ¥ ( -0.06 s X = 0.5s Y2 = 0.0.0.r aY .0.01 From (ii).01 .0.04 0. we have: d X = 0. we have: a X .5s Y2 s Y = -0.r ) g .10 Stocks X and Y must have the same Sharpe ratio: a X .005 © ActuarialBrew. Therefore.02 = -0. Sharpe Ratio From (i).02 dY = 0.02 .08 From (iii).0. we have: S D = -20 We can now find the elasticity of the put option: W= S D -20 = = -2 V 10 The formula for the risk premium of the option allows us to solve for the absolute value of its expected return: g .r = W ¥ (a .com 2014 Page 62 .04 aY .10 g = 0.dY .10)2 = 0.08 .0.

04 = 20 m 0.01.l (t .0.0.06 Since the two stocks have the same source of uncertainty.20)2 = 0.5s 22 = 0.l t + s e . so its parameters are: a 2 .s ) dZ ( s) = e -3t Í X (0) + 2 e3s dZ ( s) ˙ Í ˙ 0 0 Î ˚ ( ) Ú Ú In this form.20 m .04 0.04 Solution 68 D Chapter 14.01 .X (t )]dt + s dZ (t ) ¤ ( ) t X (t ) = X (0)e .e -3t + 2 e -3(t .SOA Sample Exam MFE/3F Solutions Solution 67 A Chapter 15.20 a 2 .0. so its parameters are: a1 = m s1 = 20 m and Stock 2 has a dividend yield of 0.d 2 . Sharpe Ratio Stock 1 does not pay dividends.03 a 2 = 0. and D is: A +C + D = 3+2+3 = 8 © ActuarialBrew.04 = 2 m m = -0.03 s 2 = 0.06 .l t + a 1 . we can observe that: A =3 B = X (0) C=2 D=3 The sum of A.com 2014 Page 63 .e .s ) dZ ( s) Ú 0 The parameters of the process are: l =3 a =0 s =2 Therefore the solution is: t t È ˘ X (t ) = X (0)e -3t + 0 ¥ 1 .r a 2 . C. Ornstein-Uhlenbeck Process The key to this question is recognizing that the process is an Ornstein-Uhlenbeck process: dX (t ) = l ¥ [a . they must have the same Sharpe ratio: a1 .0.0.0.5 ¥ (0.r = s1 s2 m .

05)dt = 0.2000 58. The completed tree is shown below.0353 6.2381 = = -0.2381 2.20(0.0) 2 2h Since we have S = Sud = 120 .8.SOA Sample Exam MFE/3F Solutions Solution 69 C Chapter 4.V 2h The risk-neutral probability of an upward move is: p* = 120e0.10dt + 0. this simplifies to: q (S .96 = 0.com 2014 Page 64 .V 6.10 . The value of theta can now be found: q (S .20rdt W (t ) Î S (t ) ˚ = 0.V .80 [0.0000 0.0) - (Sud . Portfolio Returns The instantaneous percentage increase of the fund is the weighted average of the return on the stock (including its dividend yield) and the return on the risk-free asset: dW (t ) È dS (t ) ˘ = 0.0) = Vud .80 Í + d dt ˙ + 0.02dt ] + 0.0000 43.(Sud .9892 .106dt + 0. Theta in the Binomial Model The formula for theta is: q (S . 0.96 Since the put option is an American option.S ) D(S .0000 24.5600 The bolded entries in the table above indicate where early exercise is optimal.16dZ (t ) © ActuarialBrew.0000 8.20dZ (t ) + 0.S )2 G(S .6245 2h 2 ¥1 Solution 70 C Chapter 14.67816 150 .0) = Vud .0) = Vud . we solve for its value from right to left.9892 24.0000 0.

we can convert the partial differential equation into an expression for the value of the fund: dW (t ) = (aW .4 Z (t ) ˙ = 1 + 0.0.12 s = 0.16E * Í Z (1) ¥ e0. we can obtain the risk-free rate and the volatility parameter: r .08 .d = 0.5 ¥ 0.4 Z (1) ¥ Z (1) ˙ Î ˚ Î ˚ 2 ˘ È = 1 + 0.5s W )t +s W Z (t ) ¤ 2 W(t ) = W (0)e(0.40 We can use the following equivalency: dS (t ) = (r .04 = 0.0.0932t + 0.0.08 ﬁ r = 0.d )dt + s dZ (t ) S (t ) From statement (iii).4 Z (t ) = e0.40dZ (t ) S (t ) ¤ 2 S (t ) = S (0)e( r -d .4 / 2 ˘˙ = 1.SOA Sample Exam MFE/3F Solutions Since the fund’s value follows geometric Brownian motion.4 Z (1) ˙ Î ˚ { } Since Z (1) is a standard normal random variable.42 e0.4 Z (t ) Let’s find the expected value of the derivative security under the risk-neutral probability measure: { } 2˘ È 2 E * ÍÈ1 + S (1) ¥ ln [S (1)] ˙˘ = E * Í1 + e0.4 )t + 0.16e0.16Z (t ) Solution 71 C Chapter 15.d )dt + s dZ (t ) S (t ) dS (t ) = 0.16dZ (t ) W (t ) 2 W(t ) = W (0)e(aW -dW .com 2014 Page 65 .16 )t + 0.106 .4Z (1) ¥ ln È e0.5s )t +s Z (t ) ¤ 2 S (t ) = S (0)e(0.4 Z (1) ¥ 0.08dt + 0.106dt + 0.dW )dt + s W dZ (t ) W (t ) dW (t ) = 0.08 + 0.16 ÈÍ 1 + 0.16 E * Í Z (1) ¥ e0.16Z (t ) ¤ Simplifying the lower right-hand expression above.20106 Î ˚ Î ˚ © ActuarialBrew.0. we have: W(t ) = W (0)e0. Risk-Neutral Pricing The risk-neutral price process is: dS (t ) = (r .4Z (1) ˙ = 1 + E * Í 0.5 ¥ 0.4 Z (1) ˘ ˙ ÍÎ ˙˚ ˙ Î ˚ ÎÍ ˚ { } { } { } 2˘ 2˘ È È = E * Í1 + e0. we can use statement (v) to obtain: { } ( ) 2 2 ˘ È 1 + 0.

5a(a .10 ]0.30a + 0.d ) + 0.1)s 2 = -0.07 -d ) + 0. a .2745 = e -0.075 -d ) d = 0.2d ]0.rT = Se -d T + GapPut The first term on the right side of the equation is the prepaid forward price of the underlying asset.6534 = 100e(0.30 and s = -s .r = 1.035 ¥ 100e[0. so we have: dS (t ) = 0.07(0.as dZ (t ) Î ˚ From statement (ii). so we replace S with S 2 : GapCall + K1e .02 Solution 73 B Chapter 15.5 ¥ 2(2 -1)0.06524 Solution 72 A Chapter 15.5a(a .PT (S (T )2 ) + GapPut 2 a Èa( r -d ) + 0.4.542 + 95e -0.5 . so we can also write the put-call parity expression as: GapCall + K1e -rT = F0.SOA Sample Exam MFE/3F Solutions The time-0 price is obtained by discounting the expected value at the risk-free rate: 1.20106 ¥ e .5a(a .PT (S ) + GapPut In this case.30dt .6 © ActuarialBrew.66 Ì ÔÓ -as = 0. we have the following 2 equations and 2 unknowns: ÏÔ0.1)s 2 ˘ dt + as dZ (t ) Î ˚ In this case. the underlying asset is S 2 .5) = e -0.745 105.d = 0.s dZ (t ) S (t ) ﬁ d(S a ) S a = È0.d )dt + s dZ (t ) S (t ) ﬁ d(S a ) S a = È a(a .rT = e -rT [S (0)] e Î + GapPut 2 5.12 = 1. Claim on S a The usual relationship is: dS (t ) = (a .1)s 2 ˘ dt .745 97.5 . Gap Put-Call Parity and S a The usual put-call parity expression for gap calls and gap puts is: GapCall + K1 e .rT = F0.5a( a -1)s ˚˘T GapCall + K1e .5) ¥ 102 e[2(0.com 2014 Page 66 .30a + 0.07(0.4.15 .20106 ¥ e -0.

66 ˜ ˜ Í Ë s ¯ Ë s ¯Î s ˚ -0.Max [0.6 s .(40 .3s 2 + 0.8s . the put option must be in-the-money.6 ˆ È -0.(40 .2 = 0 s = 0.3s = 0 0.99 Î ˚ P È F (1.99 Î ˚ © ActuarialBrew.02)4 . the following must be negative: F (1. the put option’s nonzero payoff must be greater than F (1.66 s -0.18 + 0. so: P È F (1.SOA Sample Exam MFE/3F The second equation can be written as a = Solutions -0.6 ˘ 0.30 Á + 0. and we can substitute this value of a into the first equation: 0.02)4 .18 + 0.2 or -6=0 + 3) = 0 or s + 3 = 0 s = -3 Since we are told that s is a positive constant.02)4 .0.F (1.99 Î ˚ P È S4 > 40 .40 . we conclude that s = 0. Probability that Stock Price is Greater Than K Let F be the fund amount.6 ˆ Ê -0.40 + S4 > 0 ˘ = 0.S4 ) The company wants the probability of a nonnegative cash flow to be 99%.5 Á .S4 ] For this cash flow to be negative.02)4 ˘ = 0. The time-4 cash flow to the company that sold the put option is: F (1.0.2 . Furthermore.84 + 0.3s = -0. That is.30a + 0.5a(a .com 2014 Page 67 .02)4 .1)s 2 = -0.18 s + 0.6 = 0 10s 2 + 28s (10s .66 Ê -0.2)(s 10s .84s .18 = 0 s 2 + 2.1˙ s 2 = -0. Solution 74 E Chapter 5.S4 ) > 0 ˘ = 0. meaning that S4 must be less than 40.02)4 .

0) 4˜ Ë 40 .172 ¥ 0.0 .5s 2 )(T . so we switch the roles of X and Y: ( Var [ X * ] = Var ÈÎ X ˘˚ 1 .02)4 ¯ F = 25.F (1.02) ¯ 0.r 2 X .106 = 0.02)4 We can use the normal distribution table to find dˆ2 : N ( dˆ2 ) = 0.F (1.com 2014 rud = ruu ¥ rdd = 0.30 4 . however.8 ) = 9 2 2 Solution 76 D Chapter 18.32635 = s T -t Ê ˆ 40 ln Á + (0. so: rud ruu = rdd rud ﬁ © ActuarialBrew. Variance of Control Variate Estimate The formula from the ActuarialBrew.32635 ﬁ We have: dˆ2 = ÊS ˆ ln Á t ˜ + (a .0 Ê ˆ 40 1.t ) ËK¯ 2. the control variate is denoted by Y and the control variate estimate is denoted by X * .com Study Manual that has X as the control variate and Y * as the control variate estimate is: ( Var [Y * ] = Var ÈÎY ˘˚ 1 .302 )(4 .r 2 X .55102 Solution 75 D Chapter 12.1350 Page 68 .Y ) = 5 (1 .F (1.d .99 dˆ2 = 2.SOA Sample Exam MFE/3F Solutions We make use of the following formula for the probability of the price of a stock exceeding a threshold: Prob (ST > K ) = N (dˆ2 ) with K = 40 .5 ¥ 0.17581 = ln Á ˜ Ë 40 .Y ) In this question.0.0. BDT Interest Rate Cap The ratio of each interest rate to the rate above it in the tree is constant for any column within the tree.10 .0.

5%.0900 0.093 © ActuarialBrew.09 1.000 = 97.4358 1.09 1.126 1.172 0.09 1.1720 0. a 2-year caplet.126 The payoff for the 3-year caplet is positive when the short-term rate is 17.2% or 13.4358 (0.126 ﬁ 0.5)2 (0.1350 0.172 R2 0.8124 1.126 .K R ˘˚ 1 + RT -1 ¥ Notional A 3-year cap consists of a 1-year caplet.6909 176.172 0.com 2014 Page 69 .126 1.115 ¥ 10. RT -1 .5)2 (0.4358 0.135 0.0000 0.000 486. The payoff for the 1-year caplet is zero since 9% is less than 11.1) = Max ÈÎ 0. and a 3-year caplet.135 0.6%: R1 = 0.0279 1. Therefore.6909 1.135 The possible payoffs from the cap are illustrated in the tree below: 486.SOA Sample Exam MFE/3F Solutions The completed tree of interest rates is: 0.0.5%: R2 0.1260 0.0000 The value of the 2-year caplet is: Value of 2-year caplet 0.5 97.115 10. the value of the 1-year caplet is zero.6909 44. The payoff for the 2-year caplet is positive only when the short-term interest rate increases to 12.3481 1.0000 0.000 176.115 10.0930 0.3481 176.5)2 172.1060 Although the cap payments are made at the end of each year.09 The value of the 3-year caplet is: Value of the 3-year caplet 486. we will value them at the beginning of each year using the following formula: T -year caplet payoff at time (T .4358 176.3481 97.

000 44.com 2014 Page 70 .SOA Sample Exam MFE/3F Solutions The value of the 3-year cap is: (1-year caplet) (2-year caplet) (3-year caplet) 0.0279 216.8214 172.8402 © ActuarialBrew.

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