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CFRM 544 Homework 1

Complete these exercises and submit your answers as a single (multipage) pdf document. There are 100
points possible and 10 points are reserved for presentation. The use of a typesetting program (e.g. LATEX)
is encouraged. Handwritten work should be scanned using a flatbed scanner (photographed work in particular, mobile phone pictures will receive 0 presentation points). It is your responsibility to demonstrate
to the grader how you arrived at each one of your answers: show your work. Homework solutions should be
done independently, any instance of copying/plagiarism will result (at a minimum) in a score of zero for the
entire assignment.
1. (10 points)
a) When is this homework assignment due and where did you look to find out?
b) When will the Homework 1 dropbox on the course Canvas site close?
c) What is the penalty for late submission?
d) Is it possible to submit homework after the dropbox closes?
e) What are the dates of the midterm exams and the final exam?

2. (20 points)
a) Define the following notation (in the context of an option contract).
i. K
ii.
iii. T
iv. S0
v. ST
b) Which of these quantities are known precisely when the contract is written?
c) For each of the following contracts/positions
give an expression for the function at expiration,
plot the payoff function in terms of the price of the underlying at expiration,
explain how a point on the slanted part of the payoff curve might be realized.
Use the notation (and only this notation, (u) , max, min, etc. are not allowed)
(
u u>0
+
(u) := max(u, 0) =
0 u0
to describe the hockey stick style payoff functions.
a) A short position in a futures contract with delivery price K = $50.
b) A long position in a futures contract with delivery price K = $30.
c) A short position in a European call option with strike price K = $120.

d) A short position in a European put option with strike price K = $45.


e) A long position in a European call option with strike price K = $75.
f) A long position in a European put option with strike price K = $0.75.

3. (20 points) Let X1 , . . . , Xn be iid Bernoulli random variables taking value 1 with probability p and value
0 with probability 1 p and let
Sn =

n
X

Xk .

k=1

a) What are the mean n and variance n2 of the random variable Sn ?


b) What is the distribution of Sn ?
c) Determine the limit:


Sn n
<x .
lim P
n
n

4. (20 points) Let X be a normal random variable with mean and standard deviation . Calculate the
expected value of each of the following functions of X (for (b) and (c), express your answer in terms of
the standard normal CDF, ()).
a) eaX ,

aX

b) (e

b) ,

c) (X a)+ ,

R, b > 0
aR
a

5. (20 points) Suppose X1 and X2 are independent standard normal random variables. Let [1, 1], i
and i2 (i = 1, 2) be given.
a) Construct normal random variables Y1 and Y2 with correlation and means 1 and 2 , respectively,
and variances 12 and 22 , respectively.
b) What are the mean and variance of aY1 + bY2 , where a, b

R?