2007 Examination ST330 Stochastic and Actuarial Methods in Finance Suitable for all candidates Instructions to candidates Time allowed: 3 hours This paper contains 9 questions. Answer ALL questions. You are supplied with; Formulae and Tables for Actuarial Examinations {Institute of Actuaries) Murdoch and Barnes Statistical Tables You may also use: Electronic calculator (as prescribed by the exam- ination regulations). ©LSE 2007 S330 Page 1 of 51. We consider a particular economic agext, having an initial wealth of wp. She has an exponential utility function U(x) = 1 ~yexp(—2a). (a) What are her economic characteristics? 3] (b) ‘There is a financial product in the market with a payoff of £1000 with probability 0.2, £400 with probability 0.4 or £200 with prob. ability 0.4. Its market price is p = £350. Will the agent be interested in buying such a product, when y= 100? 13) {total=6} 2. Let X be a future risky position of bank. (0) Recall the definition of the Value at Risk at a given level ¢ for this risky position. How should it be interpreted in terms of capital requirements? [242] (b) What are the three key properties of the Value at Risk? {3 (c) What is the main problem of the Value at Risk? (you should justify your answer) @] {total=10) 3. Consider a financial market with two risky assets A and B and a risk free asset. Their characteristics are given in the following table: Asset | Expected Return | Standard Deviation A oa = 5% B op = 6%, ‘The covariance between A and B is equal to 0.2% and the return of the risk-free asset is rp = 10% (a) An agent wants an expected return of 20%. What is the corre- sponding efficient. portfolio? (4) () The total market capitalization is £ 700.000, and the capitaliza- tion of asset A is £ 200.000. What is the composition of the market portfolio? What is its expected return? (241) (c) What can you say about the relationship between any efficient portfolio and the market portfolio? Propose an alternative method to answer question (2). [242] [total=11) @LSE 2007 $7330 Page 2 of 54, All the assumptions of the CAPM hold true. Let Fe and op denote the ‘expected return and the standard deviation of a portfolio P. ‘What ie the Sharpe ratio of an efficient portfolio? (You should justify your answer). {total=3] 5. Consider s forward contract: on gold. Suppose that there is a fixed storage cost of £¢ per ounce, paid at the end of the period. ¢ is the same for any time period less than one year. Denoting by S; the spot price of one ounce of gold at time f, by r the instantaneous risk-free rate (assumed to be constant), derive the price at time £ of a forward contract written on one ounce of gold, with maturity T (Z' is supposed to be less than one year). [total=3] 6. Consider a two-period binomial model for a stock whose current price is So = 120. Suppose that: - Over each of the next six-month periods, the stock price can either move up by a factor w= 1.2 or down by d= 0.8; - The continuously compounded risk-free rate is 5% per period. (a) Calculate the initial price of a European call option written on S with strike price A’ = 120 and maturity one year. fs] {b) Deduce the initial price of a European put option written on S with the same characteristics. (Justify your answer). 2 (0) Find a replicating portfolio for the cail option at time ¢ = 0 for 1 3 time (d) Find the price of an American put option written on S with strike price K’ = 120 and maturity one year. (a) (e) Consider now an Up&Out European put option, with strike price = 120 and maturity one year. The owner of such an option loses her rights if the stock price goes above the level L = 130 during the life of the option. Find the initial prive of such an option. 3) [total=15) 7. (1) Consider a financial market with d risky assets and a risk-free asset. (1a) Recall the definition of an arbitrage opportunity. 2] In the discrete-time framework, prove the following two results: @LSE 2007 ST330 Page 3 of 5(Lb) Let ® be an equivalent martingale measure for the discounted price process 5 and y be a self-financing strategy. Then the wealth process V* is a P*-martingale. ia) (le) If an equivalent martingale measure exists for 5, then the associated market is arbitrage-free. (al (2) Consider now a one-pericd financial market model with three states of the world © = {w,122,ws} at the end of the period. ‘Assume there exist three assets in the market. ‘Their prices are denoted by 5, $® and $® respectively. At time 0, (Sf, SP), S$) = (20, 100, 40) and at time T = 1, the price of each asset depends on the state of the universe as follows: S{ (0) $1 (we) 84 (ws) 1 40 30 52 (uw) (we) S$ (ws) | = { 100 120 150 $1 (wr) 1 (ue) $2" (ws) eee (2a) Prove whether or not this market is arbitrage-free. 1s it com- plete? (44) (2b) Find the price at time 0 of the contingent claim with the following cash-flow at time 1, Z = (Z(w1), Z(w2), Z(ws)) (20, 30, 10), using two different methods. [343] {total=22] 8 Let (0, F,P, (Fast 2 0)) be a filtered probability space and (W;t 2 0) be a standard (P, F,)-Brownian motion. There exists a risky asset with a dynamics with respect to P given by: S = adt + od There is also a risk-free asset, with a constant instantaneous rate of return, equal tor. ‘The objective of this exercise is to find the value at time 0 of a digital lookback option, whose payoff at the maturity 7’ is fixed amount K’ if the underlying price has reached a certain level L during the life of the option, and otherwise the payoff is 0. {a} Let us denote by 9(t, S,) the price of a derivative depending on S, al any date ¢ € [0,7]. Find the fundamental P.D.E, satisfied by 4g. (Write carefully each step of the derivation) fal @ISE 2007 $7330 Page 4 of 5(b) Write the price of the derivative at time 0 as a conditional exp. tation. What is the probability measure on which the expectation is based? We denote this probability measure by @. What are the dynamics of $ with respect to Q? [242] (c) Finally, determine the price of this derivative at time t= 0. Hint: ret br te T ‘aB, + bt) > 0) =N (= }+e%, : Prt (age 00 20) =a (Sige) Bw (=p) where N(.) is the cumulative distribution of a Normal random variable N(0,1), and B ts a Brownian motion is] {total=14] 9. (1) Let us denote by B(t, 7) the price at time t of a zero-coupon bond with maturity T. Explain the conditions under which the bond market is arbitrage- free and complete? What: are the implications for the dynamics of BET)? Derive the zero-coupon bond price for any t < T’ and write it. as a conditional expected value (2424) (2) We now consider a swap contract with notional amount V signed at time 0 by two agents who have agreed to exchange the one-year Libor rate against a fixed rate R every year during 10 years. We denote by s; the one-year Libor rate paid at time i (2a) Draw a diagram representing the various cash flows for one of the agents, say the agent receiving the fixed rate 2} (2b) Using the previous notation, determine the swap rate R. (Write carefully each step of the derivation) (6) [total=14] @LSE 2007 ST330 Page 5 of 5