8069 Semester 2, 2010

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The University of Sydney

Faculties of Arts, Economics, Education,
Engineering and Science

MATH3975: Financial Mathematics

Lecturer: A/Prof. Christian-Oliver Ewald

Time allowed: 2 hours

This booklet contains 4 pages.

• This examination paper is for ADVANCED level students only and contains
four questions. Candidates may answer all questions and all questions are
worth equal marks.

• Provide adequate reasons and show all working in your answers. Marks are
awarded for correct working and methods, not necessarily final answers.

• No aids other than University provided calculators are permitted.

• Start each new question on a new page.

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 8069 Semester 2, 2010 page 2 of 4

1. Utility theory:

(a) Briefly explain the intuition behind the following terminology:

1. utility function
2. certainty equivalence price
3. risk premium.
(b) Show that the function u(x) = a − bx−γ with a, b and γ positive constants, is
a risk averse utility function.
(c) Compute the absolute and relative risk aversion coefficient for the utility func-
tion u(x) from (b).
(d) Show that an investor using the utility function u(x) from (b) would associate
1/γ
the certainty equivalence price X0 = 21 (2γ+1 − 1) to the St. Petersburg coin
tossing game discussed in the lecture.

2. General one period market model:

(a) Answer the following questions in the context of the general one-period market
model discussed in the lecture:
1. What does the fundamental theorem of asset pricing say? Intuitively ex-
plain how the separating hyperplane theorem is used to prove this theorem.
2. What does it mean that a market is complete?
3. How can one recognize attainable contingent claims in a possibly incom-
plete market without computing a replicating strategy?
(b) Consider the following single period market model with state space Ω = {ω1 , ω2 , ω3 },
consisting of one stock with initial stock price S01 = 6 and a money market ac-
count with interest rate r = 0. The stock price evolution is given by the
following table
ω1 ω2 ω3
S11 4 6 8
1. Is the model arbitrage free ?
2. Is the model complete ?
3. Compute the set of risk neutral measures.
4. Now assume that in addition to the first stock, a second stock is traded on
the market with initial price S02 = 9 and payoff according to
ω1 ω2 ω3
2
S1 4 9 15
In this market, compute the price for the European call option (S12 − 6)+ .

3. Multi-period market model:

Consider the following two period market model, with money market account B

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 8069 Semester 2, 2010 page 3 of 4

evolving according to B0 = 1, B1 = 1 + r, B2 = (1 + r)2 with r = 0.25 as well as one

stock S evolving according to the following diagram below.

1. Compute the actual probabilities of the states ω1 , ω2 , ω3 , ω4 .

2. Compute a risk neutral measure for the model.
3. Compute a self financing hedging strategy for a European put (8 − S2 )+ with
strike 8 and maturity T = 2.
4. Compute an arbitrage free price at time t = 0 for an American put option with
strike price K = 6. Will the option be exercised early?

S2 = 10 ω1
2
rrrr9
rrr
5

rrr
S1B = 7L
 LLL 3
 LL5L
 LLL
3  %

 ω2
5
S2 = 6




S0 =8 5
88
88
88
88 25
88 S2 =4 ω3
88
88
3
rrrr9
rrr
5
88
 rrr
S1 = 3L
LLL 2
LL5L
LLL
%
S2 = 2 ω4

4. Black-Scholes:

Consider the standard Black-Scholes model consisting of one stock and a riskless
money market account as discussed in the lecture.
(a) Briefly describe the intuition behind the assumption on the stock price dynam-
ics?
(b) For an arbitrary option with payoff function h(x), write down the Black-
Scholes equation and briefly describe how this equation can be derived from
the Feynman-Kac theorem.
(c) Assuming a general interest rate r and volatility σ, compute the price of an
option with payoff h  x i2
h(x) = log .
k

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 8069 Semester 2, 2010 page 4 of 4

Hint: Assume that the solution of the Black-Scholes equation is of the form

V (x, t) = A(τ ) y 2 (x, τ ) + B(τ )

 
x  1 2

y(x, τ ) = log + r − σ τ,
k 2

with τ = T − t and A(τ ), B(τ ) functions to be determined.

(d) Verify your result from (c) by computing the option price via
(    )
2
ST
V (x, t) = e−rτ EQ log  St = x ,

k 

where Q denotes the risk-neutral measure.

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