Summer Assessment 2021

Assessment paper and instructions to candidates:

FM320 – Quantitative Finance

Suitable for all candidates

Instructions to candidates

This paper contains four questions, each worth 25 marks. Answer all four questions.

If at any point in this examination you feel that anything is unclear, please make any
additional assumptions that you feel are necessary, state them clearly, and proceed
with your answers.

Precision, clarity, and legibility will all be valued and rewarded in grading.

Specify the question numbers that you answered in the box provided on the
coversheet for submission.

Instructions on how to scan and upload your answers can be found on the course
Moodle page. It is your responsibility to ensure that your answers are legible,
including the scanned versions of your answers.

Time Allowed: You have a 24-hour window to complete and submit your assignment.
The exam was written with the intention that it should take 2 hours for students to
complete. We recommend that you spend 15 minutes reading the exam paper before
you begin writing your answers.

Permitted materials: This is an open-book, open-notes exam.

Calculators: Calculators are permitted in this assessment.

© LSE ST2021/FM320 Page 1 of 5

 1. (a) Consider a two-date economy with three states of the world and three assets. The assets
pay off in 5 years’ time, and the payoff matrix is
 
2 0 1
D =  4 2 3 .
0 4 2

The (i, j)’th entry of D is the payoff of the j’th asset in the i’th state. The price of all
three assets is 1 at the initial date.
i. [3 marks]
Show that there is no arbitrage.
ii. [6 marks]
Calculate the no-arbitrage riskfree rate. If the riskfree rate is not uniquely pinned
down, calculate the range of values of the riskfree rate that is consistent with absence
of arbitrage. Quote the interest rate as an annual rate with continuous compound-
ing.
(b) Consider an American option with expiration date T and strike price K. An American
option is just like a European option except that it can be exercised at any time until the
expiration date. If exercised at t, t ∈ [0, T ], the payoff at t is St −K for an American call
and K − St for an American put. In the following questions assume that the underlying
does not pay any dividends over the life of the option.
i. [4 marks]
Show that it is never optimal to exercise an American call option prior to the
expiration date.
ii. [12 marks]
Consider an American put option with strike price K and two months to expiration.
Suppose the stock price follows a binomial process. The current stock price is £100.
It goes up by 10% or down by 30% each month. The monthly interest rate is 5% for
both months, and is not compounded within the month. Find the range of strike
prices K such that the option is not exercised immediately, but is exercised in one
month if the stock price goes down during that month.

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 2. Suppose the Black-Scholes assumptions are satisfied. In particular, there is a stock whose
price follows a geometric Brownian motion:

dSt = µSt dt + σSt dWt ,

and a money market account with a constant interest rate r:

dBt = rBt dt.

(a) Consider a derivative that pays off STn at T . It can be shown that its price at t < T
takes the form
h(t, T )Stn ,
where h is a function that only depends on time t and the expiration date T .
i. [9 marks]
By substituting into the Black-Scholes partial differential equation, derive the (or-
dinary differential) equation satisfied by h.
ii. [8 marks]
Show that
h(t, T ) = exp (n − 1)(r + nσ 2 /2)(T − t) .
 

(b) [8 marks]
Now directly derive the price at t < T of the derivative that pays off STn at T , using the
risk-neutral pricing approach. (You should be able to answer this part even if you were
not able to answer part (a)).

c LSE ST2021/FM320 Page 3 of 5
 3. (a) [8 marks]
Suppose the Black-Scholes assumptions are satisfied, and the interest rate on the money
market account is zero. Then the theta of a European call option is given by
Sσ
Θcall = − √ Φ0 (d1 ),
2 T −t
where Φ(·) is the standard normal cdf, and

log(S/K) √
d1 = √ + (1/2)σ T − t.
σ T −t
Using this expression for the theta of a European call, derive formulas for the theta and
gamma of a European put.
You must use the above expression for Θcall to answer this question. Do not use the
Black-Scholes formula for a call or a put, or the formulas for theta and gamma in the
lecture notes.
(b) Consider a European call and put on a non-dividend paying underlying with the same
maturity date T and strike price K. There is a also a money market account with
instantaneous interest rate r. We write the call price Ct at time t ≤ T as the sum of its
intrinsic value CtIV and time value CtTV , and likewise for the put price Pt :

Ct = CtIV + CtTV ,
Pt = PtIV + PtTV ,

where the intrinsic values are defined below.

i. [9 marks]
Suppose the interest rate r is constant, and the intrinsic values are defined as follows:

CtIV := [St − e−r(T −t) K]+ ,

PtIV := [e−r(T −t) K − St ]+ .

Derive a no-arbitrage relationship between CtTV and PtTV , the time values of the
call and the put.
ii. [8 marks]
Now suppose the interest rate r follows a stochastic process, and the intrinsic values
are defined as follows:

CtIV := [St − B(t, T )K]+ ,

PtIV := [B(t, T )K − St ]+ ,

where B(t, T ) is the time t price of a zero-coupon bond with face value 1 maturing
at T . Once again, derive a no-arbitrage relationship between CtTV and PtTV , the
time values of the call and the put.

c LSE ST2021/FM320 Page 4 of 5
 4. In this question all interest rates are annual rates with semi-annual compounding, and all
bonds have face value £100. All interest rates that you are asked to calculate should also
be quoted as annual rates with semi-annual compounding. Do your calculations to at least
three decimal places.
Suppose the 6-month riskfree rate evolves according to a binomial process, going up or down
every 6 months with equal probability. It is currently 6% and will be either 8% or 2% in 6
months’ time. The current prices of zero-coupon bonds with maturity 1 year and 1.5 years
are respectively £95 and £90.

(a) [7 marks]
Price of a 6-month put option on the 1-year zero, with strike price £98.
(b) [6 marks]
Suppose you wish to save £100 in 6 months’ time for a period of 1 year. Show how you
can trade zero-coupon bonds today in order to fix the interest rate on this saving. What
must this rate be?
(c) [6 marks]
What is the fair swap rate on an interest rate swap with semi-annual payments (starting
in 6 months) over the next 1.5 years? Explain your reasoning. Do not use a formula for
the fair swap rate.
(d) [6 marks]
Consider a swaption that gives you the right to receive a fixed rate of 8% on a 1.5-year
swap with semi-annual payments (starting in 6 months) and notional £100,000. The
swaption expires today. What is its value? Explain your reasoning.

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