Stochastic Calculus

Midterm exam
Prof. D. Filipović, E. Hapnes
29.10.2019

Time: 9:15-12:00. Full credit is for the correct answer and explanation.
Exercise 1: A fund manager can be skilled (S = H) or unskilled (S = L). If the fund manager
is skilled, then the return of her fund is good, RG , with probability q > 12 and bad, RB , with
probability 1 − q. If the fund manager is unskilled, then the return is RG with probability
1 − q and RB with probability q. Your prior belief is P rob(S = H) = 12 . Define Pn (m) as the
probability that the fund manager is skilled if you have n observations where the return is RG
in m of them.

(a) Find an expression for Pn (m).

(b) Define the random variable M , which takes the values M = 0, 1, ..., n, as the number of
times you observe the return RG . For n = 1, show that E[P1 (M )|S = H] > 21 .

(c) Calculate E[P1 (M )].

q
Hint: Find your solutions in terms of ρ = (1−q)
.

10 points

Exercise 2: Let Xt and Yt for t = 1, 2, ... be sequences of independent and identically dis-
2
tributed random variables with means µX and µY , and variances σX and σY2 . Consider the
stochastic process
Zt = Y1 X1 + Y2 X2 + · · · + Yt−1 Xt−1 + Yt Xt .

(a) Show that Zt is a Markov process.

(b) Calculate E[Zt+1 |Zt ] and V ar(Zt+1 |Zt ).

10 points
Exercise 3: Let St have the dynamics

dSt = µSt dt + σSt dWt

where Wt is a Brownian motion, S0 = s > 0, and µ and σ > 0 are constants.

(a) Calculate d log(St ).

(b) Show that the distribution of log(St ) is normal. What is its mean and variance?

(c) Calculate E[1{St ≥K} ] for some constant K > 0. Here, 1{St ≥K} is an indicator function that
takes the value 1 when St ≥ K and 0 otherwise.

10 points

Exercise 4: Let X be a random variable with mean µ and moment generating function MX (t).

(a) Show that:

• MX (t) ≥ eµt .
• P (X ≥ α) ≤ e−αt MX (t) for 0 ≤ t and any α as long as the moment generating
function exists.

(b) Let Y = a + bX. Calculate the moment generating function of Y as a function of the
moment generating function of X and the parameters a and b.

(c) Let X ∼ N (0, 1) and Y = X 2 . Calculate the moment generating function of Y , and
evaluate E[Y ] and V ar(Y ).

10 points