Midterm Exam IMF

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Tuesday 30 October, 2018, 18.30-21.30

All questions have equal weight

1 Consider the three-period binomial model, with u = 2, d = 0.5, r = 0.25, and N = 2. The
initial asset price is S0 = 4 euros, as in the figure above. An Asian option is like a European
call, except the payoff of the Asian option depends on the average stock price rather than the
final stock price. The payoff at time three is
 
S0 + S1 + S2 + S3
max − K, 0
4

A Compute the value of an Asian option with strike price K = 5.

B Compute the number of shares of stock that should be held by the replicating portfolio
∆ 0 , ∆1 , ∆2 .
2 The holder of a forward contract agrees to buy one share of stock at time N for K euros. The
price of this contract at time N is
FN = SN − K
The forward price at time zero is defined to be that value of K that causes the forward contract
to have price zero at time zero.

A Use risk-neutral valuation  

VN
V0 = E
e
(1 + r)N
to compute the forward price.
B Show that, at time zero, the price C0 of a European call struck at the forward price is
the same as the price P0 of a European put struck at the forward price.
C Do we have that the call and the put have equal value Cn = Pn for all n if the contracts
are struck at the forward price? Motivate your answer.

3 Consider the three-period binomial model of Exercise 1. Assume that the actual probability
measure is
8 4
P(HHH) = , P(HHT ) = P(HT H) = P(T HH) = ,
27 27
2 1
P(HT T ) = P(T HT ) = P(T T H) = , P(T T T ) =
27 27

A Let Z be the Radon-Nikodym derivative of P̃ with respect to P. Compute E1 [ZS2 ].

B If X0 , X1 , X2 , X3 is an optimal wealth process in this three-period model, then
 
λZ
X3 = I
(1 + r)3

where I is the inverse of the derivative U 0 of the utility function, and λ is the Lagrange
multiplier . Use this equation to compute X3 (T T T ) if U (x) = ln x. Choose λ such that
X0 = 64.

4 Consider the three-period binomial model of Exercise 1.

A List all stopping times τ such that τ (ω1 ω2 ω3 ) ≤ 2.

B Consider the American forward. This derivative security permits the owner to buy one
share of stock in exchange for a payment of K at any time up to N = 3. If the purchase
has not been made at time 3, it must be made then. Determine the time-zero value and
optimal exercise policy for this derivative security with strike price K = 5.