Stochastic Calculus

Midterm exam

30.10.2018

Time: 9:15-12:15. Full credit is for the correct answer and explanation.
1 − |x−a|
Exercise 1: The Laplace distribution has a density f (x) = 2b
e b for x ∈ R with b > 0.

a) Show that the Laplace distribution is indeed a probability distribution.

b) Compute the mean, variance and moment generating function of the Laplace distribution.
X−a
Hint: The transformation Y = b
can be useful to calculate the moment generating function.

10 points

Exercise 2:

a) A stock takes the value X ∈ {−1, 0, 1} with equal probability. The market observes a
signal Y = X + Z where Z ∈ {−1, 0, 1} with P (Z = 1) = P (Z = −1) = p and P (Z =
0) = 1 − 2p. X and Z are independent. Calculate the price of the stock V (Y ) = E[X|Y ]
for Y ≥ 0.

b) A stock takes the value X ∼ N (µ, σ 2 ). The market observes a signal Y = X + Z where
Z ∼ N (0, σz2 ) and sets the price V (Y ) = E[X|Y ]. X and Y are independent.

• Find the distribution of X conditional on Y .

• Find Var(X − V (Y )) and Var(V (Y )).

c) Let the stock price and value be as in part (b). An investor knows X, but not Y . The
investor wants to maximize E[−e−Aw |X] where w = α(X −V (Y )) and the investor choose
the number of shares to buy, α. Find the α that solves the maximization problem

maxα∈R E[−e−Aw |X].

10 points
Exercise 3: Consider a Markov process with values x1 and x2 and transition probabilities
p11 = p22 and p12 = p21 . The hitting time T1 is defined as the first time the process hits x1
after hitting x2 once.

a) Calculate E[XT |X0 = x1 ].

b) Calculate E[ ∞ −rt
P
t=0 e Xt |X0 = x1 ].

c) Calculate E[sT1 |X0 = x1 ] and use this to find E[T1 |X0 = x1 ] and Var(T1 |X0 = x1 ).
 n    
n p11 p12 1 −1 1 (p11 − p12 )n 0 −1 1
Hint: Π = =2 .
p12 p11 1 1 0 1 1 1

10 points

Exercise 4: Let XN be a lottery where the payoff has the distribution


−i
2
 x = 2i , i = 1, 2, · · · , N − 1
P (XN = x) = 21−N x = 2N

0 otherwise


a) Show that P (XN = x) is a probability measure for any N ≥ 1.

b) Find the expected value of E[XN ]. What happens when N → ∞?

c) A gambler decides to participate in a special lottery. In this lottery the gambler plays
a series of one or more games. Every game costs m and has a payoff XN . The gambler
has wealth w and run out of money if w < m. Define fm (w) as the probability that a
gambler will eventually run out of money. Find a difference equation for fm (w). You do
not have to solve the difference equation or find its boundary conditions.

10 points