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SAFprob 6 - Wide ranging stochastic problems - deals with

SAFIII
Stochastic Analysis in Finance (The University of Edinburgh)

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FIM, FMO, CMF

STOCHASTIC ANALYSIS IN FINANCE
PROBLEM SET 6

I. Gyöngy, Room 5612

R
(1) Let X := 0t gs dWs , t ∈ [0, T ], where g is a deterministic process such
R R
that, 0T gs2 ds < ∞. Show that E(Xt Xs ) = 0t∧s gs2 ds for all s, t ∈ [0, T ].
(2) Consider the equation
dXt = bXt dt + σdWt , X0 = ξ,
where W is an Ft -Wiener martingale, ξ is an F0 -measurable random
variable and b, σ are positive constants.
(i) Show that this equation has a unique solution
Z t
bt
Xt := ξe + σb eb(t−s) Ws ds + σWt .
0
(ii) Show that Z t
bt
Xt := ξe + σ eb(t−s) dWs .
0
(iii) Compute the expectation and the variance of Xt .
(v) Let ξ be a positive number a. Show that P (Xt < C) > 0 for C ∈ R
and 0 < t ≤ T .
(3) Solve the equation
dXt = (aXt + b)dt + (σXt + β)dWt , X0 = ξ,
where a, b, σ, β are given numbers.
(4) In the Vasicek model the interest rate process (rt )t≥0 satisfies the follow-
ing equation:
drt = a(b − rt )dt + σdWt , r0 = 1,
where a, b, σ are positive constants. Find the solution rt of this equation.
Show that rt takes negative values with positive probability, for each
t > 0.
(5) Let X := (Xt )t∈[0,T ] be a positive Ft -martingale, where Ft is the history
of a Wiener process W . Assume that EXT2 < ∞. Prove that
Z t 1Zt 2
Xt = X0 exp( σs dWs − σ ds), t ∈ [0, T ]
0 2 0 s
for some stochastic process σ ∈ S.

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