Problem Set 3

1. Given a process of the form

dX  aXdt   ( X , t )dZ (where “a” is a constant expected rate of return),

show that, no matter how complicated the function  (.) may be, we always have:
E[ X T | X t ]  X t ea (T t )
Hint: Use Feynman-Kac to identify the PDE that you need to solve along with what the
boundary/terminal condition is, given the fact that we want f(Xt,t) = E[XT|Xt]. Then, just
like in HW#1, posit a solution of the form f(Xt,t) = a(t) + b(t)Xt and solve for f(Xt,t).

2. An index (such as the S&P 500) yielding an instantaneous dividend yield  must satisfy
(by Feynman-Kac) the following equation:

 t
T
 t
T
t  
St  EQ ST exp   ru du   exp   ru du  S d St 




Assume that r and  are constant. Given that the index follows the stochastic process
dS = (r-)Sdt + SdZ , use the result from question 1 to verify that the expression on the
right-hand side does indeed collapse to St (by taking the expectation through the terms).

3. Noting that

  
b a

 f (u)du    f (u)du    F(a)  F(b)   f (a)

a a a b a
( where the function F(x) is the integral of the function f(x) )

and that a European call option on a non-dividend paying stock can be expressed as

C  e r T t   Max(ST  K,0) Q ST | St  S dST
0

or therefore as C  e  r T t   (ST  K) Q ST | St  S dST
K

 2C
Prove that  e  r T  t   Q  K  by differentiating the Call expression twice with
K 2

respect to the strike price K.