Exercise Session 3. Solutions.

Fixed Income and Credit Risk

Question 1. Demonstrate the Leibnitz rule of differentiating under the integral which says that if
Z b(t)
f (t) = g(t, u) du
a(t)

then
Z b(t)
df (t) db(t) da(t) ∂g(t, u)
= g(t, b(t)) − g(t, a(t)) + du.
dt dt dt a(t) ∂t

Define a function Z y
F (t, y) = g(t, u) du,
u1

where u1 is a constant in the domain of u and y is a variable integral limit. Then, one can re-write
Z u1 Z b(t) Z b(t) Z a(t)
f (t) = g(t, u)du + g(t, u)du = g(t, u)du − g(t, u)du = F (t, b(t)) − F (t, a(t)).
a(t) u1 u1 u1

Now, differentiate f (t) using a chain rule:

    !     !
df (t) ∂F (t, y) ∂F (t, y) db(t) ∂F (t, y) ∂F (t, y) da(t)
= + · − + · .
dt ∂t y=b(t) ∂y y=b(t) dt ∂t y=a(t) ∂y y=a(t) dt

Now, observe that

    Z b(t) Z a(t) Z b(t)
∂F (t, y) ∂F (t, y) ∂g(t, u) ∂g(t, u) ∂g(t, u)
− = du − du = du,
∂t y=b(t) ∂t y=a(t) u1 ∂t u1 ∂t a(t) ∂t
 
∂F (t, y)
= g(t, b(t)),
∂y y=b(t)
 
∂F (t, y)
= g(t, a(t)),
∂y y=a(t)

and the result follows.

Question 2. (Application of Leibniz) Consider a function

Z x3
1 2
f (x) = x ydy.
x2 2

df
Find dx two ways: a) using an explicit integration with subsequent differentiation, b) using the Leibniz rule.

1
With explicit integration, we obtain:
 x3
1 2 2 1 8 1 6
f (x) = x y = x − x ,
4 x2 4 4

and
df 3
= 2x7 − x5 .
dx 2
Using the Leibniz rule, we get:
    Z x3  x3
df 2 1 2 3 1 2 2 3 7 5 1 2
= 3x x x − 2x x x + xydy = x − x + xy =
dx 2 2 x2 2 2 x2
3 1 1 3
= x7 − x5 + x7 − x5 = 2x7 − x5 .
2 2 2 2

Question 3. (Another application of Leibniz) Consider the price of a European call option C as a function
of its strike K: Z ∞
C(K) = e−rT (ST − K)+ q(ST )dST ,
0

where (ST − K)+ = max {0, ST − K} and q(ST ) is an appropriate density of ST . Compute, using the Leibniz rule,
dC d2 C
dK and dK 2 . Interpret the results.

Observe first that

Z K Z ∞ Z ∞
−rT −rT −rT
C(K) = e 0 · q(ST )dST + e (ST − K)q(ST )dST = e (ST − K)q(ST )dST .
0 K K

Now, using the Leibniz rule, obtain Z ∞

dC
= −e−rT q(ST )dST ,
dK K

and
d2 C
= e−rT q(K).
dK 2
Think of a collection of Arrow-Debreu securities AD(y), each of which pays 1 unit at maturity T if the price of the
dC
underlying at maturity, ST , equals y. Then, dK is the (negative) discounted price of such collection of AD-securities
d2 C
for y ∈ [K, +∞]. Similarly, dK 2 is the discounted price of a single AD security for y = K.

Question 4: Assume that f and g are two deterministic functions. Show by using heuristic arguments similar to
the ones you have seen in class that :
RT RT RT
i) 0 f (t)dWt + 0 g(t)dWt = 0 (f (t) + g(t))dWt ,
In the following we will give an informal proof. There are some tricky issues to be considered, but that we will
not bother with. Let us start with the right hand side. Consider a discretization of [0, T ] where t0 = 0 < t1 <

2
 · · · < tN = T. Assume a mesh that decreases to 0 as N converges to infinity. By definition of Ito integration

Z T N
X
(f (t) + g(t))dWt = lim (f (ti−1 ) + g(ti−1 ))(Wti − Wti−1 )
0 N →∞
i=1
N
X
= lim f (ti−1 )(Wti − Wti−1 ) +
N →∞
i=1
N
X
lim g(ti−1 )(Wti − Wti−1 )
N →∞
i=1
Z T Z T
= f (t)dWt + g(t)dWt .
0 0

Rt Rt Rt
ii) E[( 0 f (s)dWs )( 0 g(s)dWs )] = 0 f (s)g(s)ds.
Again take a discretization as above. With the usual approximation we obtain (we drop the limit sign below
but you should still think of N as approaching ∞):
" N N
#
X X
E f (ti−1 )(Wti − Wti−1 ) g(ti−1 )(Wti − Wti−1 )
i=1 i=1
" N
#
X
2
= E f (ti−1 )g(ti−1 )(Wti − Wti−1 ) +
i=1
 
X
E f (ti−1 )g(tj−1 )(Wti − Wti−1 )(Wtj − Wtj−1 )
i6=j
N
X
= [f (ti−1 )g(ti−1 )(ti − ti−1 )] +
i=1
| {z }
(A)
X  
E f (ti−1 )g(tj−1 )(Wti − Wti−1 )(Wtj − Wtj−1 ) .
i6=j

The term (A) follows from the fact that one can view the increment of the BM as

Wti − Wti−1 ∼ N (0, ti − ti−1 )

and thus
E[(Wti − Wti−1 )2 ] = V[Wti − Wti−1 ] = ti − ti−1

In the last line, the sum is zero. The sum in (A) is no longer stochastic. Thus, the result follows.
Rt
iii) E[ 0 f (s)dW (s)]=0.

3
Proceed in a way similar to the one above:
" N
#
X
E f (ti−1 )(Wti − Wti−1 )
i=1
N
X  
= E f (ti−1 )(Wti − Wti−1 )
i=1
N
X 

= E E f (ti−1 )(Wti − Wti−1 ) | tt−1 , Wti−1
i=1
N
X 

= E f (ti−1 )E (Wti − Wti−1 ) | tt−1 , Wti−1
i=1
N
X
= E [f (ti−1 ) · 0]
i=1
= 0.