Chair of Mathematical Finance

Department of Mathematics
Technical University of Munich
Financial Mathematics 1
Aleksey Min, Henrik Sloot, and Ben Spies

Exercise sheet 5
The exercise sheet will be discussed in two groups of in-person exercise sessions on November 24,
2021, and in videos available on the Moodle page. For details, see the course’s Moodle
announcements. You should try to solve the exercises at home before the exercise. Grading bonus
and homework submission rules: https://www.moodle.tum.de/mod/page/view.php?id=1863336.

Exercise 5.1
Consider a single-period financial market with one risky asset, K = 3, T = 1, and risk-free interest rate
r = 1/4. The price process P1 of the risky asset is given by P1 (0) = 2, P1 (1, ω1 ) = 25/4, P1 (1, ω2 ) = 10/4,
and P1 (1, ω3 ) = 3/4. In Exercise 4.3 we have shown that the set M of all risk-neutral probability measures
is given by    
7 − 22 q̃1 15q̃1 7
M = Q̃ : Q̃ = q̃1 , , , 0 < q̃1 < .
7 7 22
a) Show that the market is not complete.
Solution: We have r = 0.25 and
P1 (1, ω3 ) = 3/4

P1 (0) = 2 P1 (1, ω2 ) = 10/4

P1 (1, ω1 ) = 25/4

We analyse the matrix A = (P0 (1), P1 (1), . . . , PN (1)). By Lemma 2.19, the market is complete if
and only if rg(A) = K, with K denoting the number of states as usual. In this case,
 
1 + r 25/4
A = 1 + r 10/4 ,
1 + r 3/4

since there is only one risky asset. This implies rg(A) = 2 < 3 = K: the market is not complete.
Alternatively, by Exercise 4.3, we know that
   
7 − 22q̃1 15
M = Q̃ = q̃1 , , q̃1 , q̃1 ∈ (0, /22) .
7
7 7

Now by Theorem 2.22, |M| = ∞, implying that the market is not complete.
b) Consider a contingent claim D = D(1) with D(1, ω1 ) = 70, D(1, ω2 ) = 35 and D(1, ω3 ) = 42 and
compute the upper bound VD+ (0) and the lower bound VD− (0) for an arbitrage-free price.

© Technical University of Munich, Chair of Mathematical Finance

 2

Solution: We use Theorem 2.23 and the results we obtained in Exercise 4.3:
 
h i D(1)
EQ̃ D̃(1) = EQ̃
1+r
1
= (70q̃1 + 35q̃2 + 42q̃3 )
1 + 1/4
 
4 7 − 22q̃1 15
= 70q̃1 + 35 · + 42 · q̃1
5 7 7
= 40q̃1 + 28.

This allows us to calculate

n h i o
VD− (0) = inf EQ̃ D̃(1) : Q̃ ∈ M = inf {40q̃1 + 28} = 28,
q̃1 ∈(0,7/22)
n h i o 40 · 7
VD+ (0) = sup EQ̃ D̃(1) : Q̃ ∈ M = sup {40q̃1 + 28} = + 28 ≈ 40.7273.
q̃1 ∈(0,7/22) 22

Exercise 5.2
Assume that K = 3, N = 1, r = 1/9, P1 (0) = 5, P1 (1, ω1 ) = 20/3, P1 (1, ω2 ) = 40/9, and P1 (1, ω3 ) = 10/3

(see the example on lecture slide 104). The set of risk-neutral measures is given by

M = {(q̃, 2 − 3q̃, 2q̃ − 1) : q̃ ∈ (1/2, 2/3)}.

a) Determine the range of arbitrage-free prices for a contingent claim with D(1, ω1 ) = 1, D(1, ω2 ) = 2,
D(1, ω3 ) = 5/2, state whether it is attainable, and, if that is the case, determine a hedging strategy.
Solution: With a risk-neutral probability measure Q̃ ∈ M, i.e., for some q̃ ∈ (1/2, 2/3), we calculate
 
h i D(1)
EQ̃ D̃(1) = EQ̃
1+r
1
= (q̃1 D(1, ω1 ) + q̃2 D(1, ω2 ) + q̃3 D(1, ω3 ))
1+r
 
9 5
= q̃ · 1 + (2 − 3q̃) · 2 + (2q̃ − 1) ·
10 2
 
9 5 9 3 27
= q̃ + 4 − 6q̃ + 5q̃ − = · = .
10 2 10 2 20

Since EQ̃ [D̃(1)] does not depend on q̃, it is constant on the whole set M and therefore, by Theo-
rem 2.21, D(T ) is attainable. By Theorem 2.17, since there are no arbitrage opportunities, the price
VD (0) = EQ̃ [D̃(1)] = 27/20 is unique. Our hedging strategy φ = (φ0 , φ1 ) needs to satisfy the three
equations
10
D(1, ωi ) = φ0 · + φ1 · P (1, ωi ), i ∈ {1, 2, 3}.
9

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in two groups of in-person exercise sessions on November 24, 2021, and in videos available
on the Moodle page. For details, see the course’s Moodle announcements. You should try to solve the exercises at home before
the exercise. Grading bonus and homework submission rules: https://www.moodle.tum.de/mod/page/view.php?id=1863336.
 3

Solving the corresponding system of linear equations

10 20
φ0 · + φ1 · =1
9 3
10 40
φ0 · + φ1 · =2
9 9
10 10 5
φ0 · + φ1 · =
9 3 2
leads to the solution φ = (18/5, −9/20). Checking the initial value of this strategy of course yields
18 45 27
V (φ, 0) = φ0 · 1 + φ1 · 5 = − = .
5 20 20

b) Determine the range of arbitrage-free prices for a contingent claim with D(1, ω1 ) = 1, D(1, ω2 ) = 2,
D(1, ω3 ) = 3, state whether it is attainable, and, if that is the case, determine a hedging strategy.
Solution: In this case,
h i 9 9
EQ̃ D̃(1) = (q̃ · 1 + (2 − 3q̃) · 2 + (2q̃ − 1) · 3) = (q̃ + 1).
10 10
Therefore, the price is not constant on M and by Theorem 2.21, this contingent claim is not attain-
able. We thus cannot find hedging strategy. The range of arbitrage-free prices, by Theorem 2.23, is
given by       
9 1 9 2 27 3
VD (0) ∈ +1 , +1 = , .
10 2 10 3 20 2

c) Given a short reasoning whether the financial market is complete or not.

Solution: We know that |M| = ∞, thus by Theorem 2.22, the market is not complete.

Exercise 5.3
Consider a single-period financial market with a riskless back account with interest rate r = 0.05 and
a risky asset with price P (0) = 1 and outcomes P (1, ω1 ) = 1.1, P (1, ω2 ) = 1.05, and P (1, ω3 ) = 0.9.
Furthermore, consider a call option on P with strike 1.
a) Show that the call option is not attainable.
Solution: The situation is the following:
P1 (1, ω3 ) = 0.9

P1 (0) = 1 P1 (1, ω2 ) = 1.05

P1 (1, ω1 ) = 1.1
The value of the call option the three states ω1 , ω2 , ω3 is 0.1, 0.05 and 0, respectively. Thus, a

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in two groups of in-person exercise sessions on November 24, 2021, and in videos available
on the Moodle page. For details, see the course’s Moodle announcements. You should try to solve the exercises at home before
the exercise. Grading bonus and homework submission rules: https://www.moodle.tum.de/mod/page/view.php?id=1863336.
 4

replicating portfolio φ = (φ0 , φ1 ) has to satisfy the system of linear equations

φ0 · 1.05 + φ1 · 1.1 = 0.1

φ0 · 1.05 + φ1 · 1.05 = 0.05
φ0 · 1.05 + φ1 · 0.9 = 0.

Now subtracting the second from the first equation leads to

φ1 · 0.05 = 0.05 ⇔ φ1 = 1,

while subtracting the third from the first equation yields

φ1 · 0.2 = 0.1 ⇔ φ1 = 0.5.

This is obviously a contradiction, so there is no hedging strategy for this call option and it is not
attainable.
b) Find the smallest amount of money xM = φ0 + φ1 ∈ R such that
φ0 (1 + r) + φ1 P (1, ωi ) ≥ C(1, ωi ) ∀i ∈ {1, 2, 3}.

Solution: Consider an attainable contingent claim Y such that Y (1) ≥ C(1). Since Y is attainable,
there exists a hedging strategy φ = (φ0 , φ1 ) for Y and we have
 
Y (1)
VY (0) = EQ̃ = φ0 · P0 (0) + φ1 · P1 (0) = φ0 + φ1 .
1+r

We aim at computing the minimal amount of money xM = φ0 +φ1 such that φ0 ·(1 + r)+φ1 ·P1 (1) ≥
C(1), i.e.

inf {φ0 + φ1 : φ0 · (1 + r) + φ1 · P1 (1) ≥ C(1)}

   
Y (1)
= inf EQ̃ : Y (1) ≥ C(1), Y attainable
1+r
= VC+ (0),

where we used Theorem 2.23 in the last step. Now, using Theorem 2.23 again, we can calculate
VC+ (0) via n h i o
VC+ (0) = sup EQ̃ C̃(1) : Q̃ ∈ M .

To this end, we first compute Q̃ via Definition 2.11:

 

Q̃ = Q̃(ω1 ), Q̃(ω2 ), Q̃(ω3 ), 

 
| {z } | {z } | {z }
q̃1 q̃2 q̃3

is a risk-neutral probability measure on Ω = {ω1 , ω2 , ω3 } if, and only if,

(i) q̃1 + q̃2 + q̃3 = 1,

(ii) Q̃ > 0,
h i
(iii) P̃1 (0) = EQ̃ P̃1 (1) .

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in two groups of in-person exercise sessions on November 24, 2021, and in videos available
on the Moodle page. For details, see the course’s Moodle announcements. You should try to solve the exercises at home before
the exercise. Grading bonus and homework submission rules: https://www.moodle.tum.de/mod/page/view.php?id=1863336.
 5

From (i), we get q̃3 = 1 − q̃1 − q̃2 , which we can then use in (iii) to obtain

1.05 = q̃1 · 1.1 + q̃2 · 1.05 + 0.9 · (1 − q̃1 − q̃2 )

0.15 − 0.2q̃1
⇔ q̃2 = .
0.15
Plugging this back into our expression for q̃3 leads to q̃3 = 0.05/0.15q̃1 . The positivity conditions for
q̃1 , q̃2 and q̃3 eventually yield q̃1 ∈ (0, 0.15/0.2). Thus,
   
0.15 − 0.2q̃1 0.05 3
M= q̃1 , , q̃1 : q̃1 ∈ 0, .
0.15 0.15 4

Finally, we can calculate

n h i o
VC+ (0) = sup EQ̃ C̃(1) : Q̃ ∈ M
  
1 0.15 − 0.2q̃1 0.05
= sup q̃1 · 0.1 + · 0.05 + q̃1 · 0
q̃1 ∈(0, 34 )
1.05 0.15 0.15
  
1 1 1 1
= sup · · · q̃1 +
q̃1 ∈(0, 4 )
3 1.05 10 3 2
 
1 1 1 1
= · · + ≈ 0.0741.
1.05 10 4 2

Exercise 5.4
Consider an arbitrage-free single-period financial market consisting of a riskless bank account with interest
rate r > 0 and a risky asset with price P (0) and a random price P (1). Further, let C = C(1) =
max {P (1) − X, 0} be a call option where X denotes the strike price. Show that we have the following
bounds for the range of prices for the call option
 
X
max P (0) − , 0 ≤ VC− (0) ≤ VC+ (0) ≤ P (0),
1+r

where VC− (0), VC+ (0) are defined as in Theorem 2.23.

Hint: Use Jensen’s inequality.

Solution: Since P (T ) and X both are assumed to be non-negative, we have C(T ) = max {P (T ) − X, 0} ≤
P (T ) and    
C(T ) P (T )
EQ̃ ≤ EQ̃ = P (0), ∀Q̃ ∈ M.
1+r 1+r
Now by Theorem 2.23,
   
C(T )
VC (0) ≤ VC+ (0) = sup EQ̃ : Q̃ ∈ M ≤ P (0).
1+r

Furthermore, note that the payoff function of a call option is convex. We can thus apply Jensen’s

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in two groups of in-person exercise sessions on November 24, 2021, and in videos available
on the Moodle page. For details, see the course’s Moodle announcements. You should try to solve the exercises at home before
the exercise. Grading bonus and homework submission rules: https://www.moodle.tum.de/mod/page/view.php?id=1863336.
 6

inequality to obtain
      
C(T ) max {P (T ) − K, 0} P (T ) X
EQ̃ = EQ̃ = EQ̃ max − ,0
1+r 1+r 1+r 1+r
       
P (T ) X P (T ) X
≥ max EQ̃ − , 0 = max EQ̃ − ,0
1+r 1+r 1+r 1+r
 
X
= max P (0) − ,0
1+r

for all Q̃ ∈ M. By Theorem 2.23,

     
C(T ) X
VC (0) ≥ VC− = inf EQ̃ : Q̃ ∈ M ≥ max P (0) − ,0 .
1+r 1+r

Programming exercise 5.5

Let X1 , X2 , . . . , XT , T ∈ N, be iid N (0, σ 2 )-distributed random variables with σ > 0 and assume that
the stock price process is iteratively given by
t  
Y 1
St := s0 exp Xi − σ 2 ,
i=1
2

for t ∈ {1, . . . , T }, and by s0 > 0.

a) Write an R-function simulate_gbm that simulates one trajectory of the process S. Plot several of
those trajectories using s0 = 100, T = 20, and σ = 20 %.
Solution:
set . seed (1234)
library ( boot )
library ( tidyverse )

5 simulate _ gbm <- function (n , s0 , sigma , to ) {

x <- matrix (
rnorm ( n * to , mean = -0.5 * sigma ^2 , sd = sigma ) ,
nrow = n , ncol = to )

10 s0 * exp ( t ( apply (x , 1 , cumsum )))

}

s0 <- 100
sigma <- 20 e -2
15 to <- 20

simulate _ gbm (10 , s0 , sigma , to ) % >%

as _ tibble (. name _ repair = function ( x ) as . character ( seq _ along ( x ))) % >%
rownames _ to _ column ( " Scenario " ) % >%
20 mutate ( ‘0 ‘ = s0 ) % >%
pivot _ longer (
matches ( " [[: digit :]]+ " ) ,
names _ to = " Timestep " , values _ to = " Value " ) % >%

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in two groups of in-person exercise sessions on November 24, 2021, and in videos available
on the Moodle page. For details, see the course’s Moodle announcements. You should try to solve the exercises at home before
the exercise. Grading bonus and homework submission rules: https://www.moodle.tum.de/mod/page/view.php?id=1863336.
 7

mutate ( across (. fns = as . numeric )) % >%

25 arrange ( Scenario , Timestep ) % >%
ggplot ( aes ( x = Timestep , y = Value , group = Scenario )) +
geom _ line () +
theme _ minimal () +
theme ( axis . title = element _ blank ())

b) Check numerically whether St satisfies the following martingale property: E[St ] = s0 , for all t ∈
{0, 1, . . . , T }.
Solution:
alpha <- 5e -2
num _ tests <- to
alpha _ bonferroni <- alpha / num _ tests

5 simulate _ gbm (1 e3 , s0 , sigma , to ) % >%

as _ tibble (. name _ repair = function ( x ) as . character ( seq _ along ( x ))) % >%
rownames _ to _ column ( " Scenario " ) % >%
mutate ( ‘0 ‘ = s0 ) % >%
pivot _ longer (
10 matches ( " [[: digit :]]+ " ) ,
names _ to = " Timestep " , values _ to = " Value " ) % >%
mutate ( across (. fns = as . numeric )) % >%
arrange ( Scenario , Timestep ) % >%
select ( - Scenario ) % >%
15 group _ by ( Timestep ) % >%
summarise (
Mean = mean ( Value ) ,
CID = sd ( Value ) / sqrt ( n ()) * qnorm (1 - alpha _ bonferroni / 2) ,
. groups = " drop " ) % >%
20 ggplot ( aes ( x = Timestep , y = Mean )) +
geom _ line () +
geom _ ribbon ( aes ( ymin = Mean - CID , ymax = Mean + CID ) , alpha = 0.3) +
theme _ minimal () +
theme ( axis . title = element _ blank ())

Warning: Assessment of empirical mean values in comparison to theoretical expectations should

always be performed on the basis of confidence intervals or statistical tests. If multiple tests are
performed, a prudent approach is the Bonferroni correction that scales α with the number of tests;
however, note that this might not be optimal in the case of strong dependence between the tests.

Programming exercise 5.6

Let ξ1 , ξ2 , . . . , ξT be a sequence of iid Bernoulli distributed random variables, i.e.,

0 < P(ξ1 = 1) = p = 1 − P(ξ1 = 0) < 1.

Define a process X with X(0) = 0, and X(t) = ξ1 + · · · + ξt , for t ∈ {1, . . . , T }. Moreover, for α, β ∈ R,
consider the stochastic process Y = {Y (t) : t ∈ {0, 1, . . . , T }} defined by

Y (t) = αX(t) − yβt, t ∈ {0, 1, . . . , T }.

a) Write an R-function simulate_y that simulates trajectories of Y .

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in two groups of in-person exercise sessions on November 24, 2021, and in videos available
on the Moodle page. For details, see the course’s Moodle announcements. You should try to solve the exercises at home before
the exercise. Grading bonus and homework submission rules: https://www.moodle.tum.de/mod/page/view.php?id=1863336.
 8

Solution:
simulate _ binomial <- function (n , p , alpha , beta , to ) {
x <- alpha * matrix ( rbinom ( n * to , 1 , p ) , nrow = n , ncol = to ) - beta

t ( apply (x , 1 , cumsum ))
5 }

b) Set the input parameters as follows: s = 10, t = T = 100, α = β = 1, p = 0.2. Use your code in a) to
simulate 10’000 realizations of (Y (s), Y (t)) to verify numerically that Cov(Y (s), Y (t)) = α2 sp(1 − p).
Solution:
p <- 2e -1
alpha <- 1
beta <- 1
to <- 100
5 s <- 10
t <- to

cov _ boot <- function (x , R = NROW ( x ) , alpha = 0.05) {

b <- boot :: boot (x , function (x , i , ...) { cov ( x [i , 1] , x [i , 2]) } , R = R )
10 ci <- boot :: norm . ci (b , conf = 1 - alpha )
tibble ( Mean = b $ t0 , Lower = ci [[2]] , Upper = ci [[3]])
}

simulate _ binomial (1 e4 , p , alpha , beta , to ) % >%

15 as _ tibble (. name _ repair = function ( x ) as . character ( seq _ along ( x ))) % >%
rownames _ to _ column ( " Scenario " ) % >%
rename _ with ( ~ { " s " } , any _ of ( as . character ( s ))) % >%
rename _ with ( ~ { " t " } , any _ of ( as . character ( t ))) % >%
select ( Scenario , s , t ) % >%
20 mutate ( across (. fns = as . numeric )) % >%
arrange ( Scenario ) % >%
summarise ( cov _ boot ( tibble (s , t ) , alpha = 0.05 , R = 1 e3 )) % >%
mutate ( across ( everything () , ~ {. / ( ! ! alpha ^2 * ! ! s * ! ! p * (1 - ! ! p ))})) % >%
ggplot ( aes ( x = Mean , y = 0)) +
25 geom _ pointrange ( aes ( xmin = Lower , xmax = Upper , y = 0) , linetype = " dashed " ) +
theme _ minimal () +
theme ( axis . title = element _ blank () , axis . text . y = element _ blank ())

Warning: Assessment of empirical estimators in comparison to theoretical parameters should always

be performed on the basis of confidence intervals or statistical tests. For non-mean estimators,
bootstrapping confidence intervals is often a quick and easy method.

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in two groups of in-person exercise sessions on November 24, 2021, and in videos available
on the Moodle page. For details, see the course’s Moodle announcements. You should try to solve the exercises at home before
the exercise. Grading bonus and homework submission rules: https://www.moodle.tum.de/mod/page/view.php?id=1863336.