You are on page 1of 3

ACTS 4302

Instructor: Natalia A. Humphreys


HOMEWORK 10
Lesson 16: Brownian Motion.
Lesson 17: Itos Lemma, Black-Scholes Equation.
Due: December 9, 2014 (Tue)
Sufficient work must be shown to get credit for a correct answer. Partial credit may be given for
incorrect answers which have some positive work.
Problem 1
Stock I and stock II open the trading day at the same price. Let X(t) denote the dollar amount
by which stock Is price exceeds stock IIs price when 100t percent of the trading day has elapsed.
{X(t), 0 t 1} is modeled as an arithmetic Brownian motion process with drift 0.1 and variance
parameter = 0.3.
After 5/12 of the trading day has elapsed, the price of stock I is 51.75 and the price of stock II is 51.65.
Calculate the probability that X(11/12) 0
Problem 2
S(t) denotes the price of the stock at time t. A stocks price follows geometric Brownian motion. The
process has a drift = 0.15 and volatility = 40%. S(0), the initial price of the stock, is $60.
Determine P r (55 < S(3) < 70).
Problem 3
A stock price is governed by a geometric Brownian motion model with the following parameters:
(i) Current stock price is $45
(ii) Volatility is 60% per annum
(iii) Expected return is 15% per annum, continuously compounded
(iv) The stock pays no dividends
(v) There are no transaction costs when it is bought or sold
Calculate the probability that a two and a half-year European call option purchased today with a strike
price of $65.00 will be exercised.
Problem 4
Consider a European call option on a stock with nine months to expiry and strike price 80. The
underlying stock follows the It
o process
dS(t)
= 0.17dt + 0.45dZ(t)
S(t)
You are given:
(i) S(0) = 70
(ii) The continuously compounded dividend rate is 3%.
(iii) The Sharpe ratio of the stock is 0.35.
Calculate the price of the option.

Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. HOMEWORK 10.

Problem 5
Consider a call option C(S, t) on a non-dividend paying stock. The stock follows the process
dS(t)
= 0.15dt + 0.35dZ(t)
S(t)
where {Z(t)} is a Brownian motion. The call option follows the process
dC(S, t)
= 0.37dt + C dZ(t),
C(S, t)
The risk free rate is 0.05.
Determine C
Problem 6
A contract will give you one share of stock at the end of a year if the price of the stock is less than 45
at that time.
You are given:
(i) The stock follows the process
dS(t)
= 0.14 dt + 0.18 dZ(t)
S(t)
(ii) S(0) = 55
(iii) The continuously compounded dividend rate is 3%.
(iv) The continuously compounded risk free rate is 5%.
Calculate the value of the contract.
Problem 7
The time-t price of a non-dividend paying stock is S(t). S(t) follows an arithmetic Brownian motion
with = 0.15, = 0.25.
The time-t price of an exotic option on the stock is C(t). The partial derivatives of C(t) are:
2C
C
C
= 0.6,
= 0.08,
= 0.12
2
S
S
t
Determine the drift and the volatility of the Ito process followed by C.
Problem 8
The stochastic process X(t) can be expressed as
X(t) = (tZ(t))2 + 4 t3 Z(t)
Using Itos lemma, express dX(t) in terms of dt and dZ(t).
Problem 9
For an option on a stock, you are given
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)

The price of the option is 15.2


= 0.85
= 0.02
= 1.96 per year.
The stock pays dividends at a continuous rate of 2% per year.
The stocks volatility is 30% per year.
The continuously compounded risk-free rate is 4%.
Page 2 of 3

Copyright Natalia A. Humphreys, 2014

ACTS 4302. AU 2014. HOMEWORK 10.

Determine the price of the stock.


(A) 18.21

(B) 26.56

(C) 33.34

(D) 37.77

(E) 44.80

Problem 10
For two options on a non-dividend paying stock following the Black-Scholes framework, you are given:
Option

Option Premium

0.5500 0.0700 -0.015

2.95

0.3200

1.08

0.030

-0.007

is expressed per day. The stocks price is 51.


Determine r, the continuously compounded risk-free rate.

Page 3 of 3