Chair of Mathematical Finance

Department of Mathematics
Technical University of Munich
Financial Mathematics 1
Aleksey Min, Ben Spies, and Michel Kschonnek

Exercise sheet 6
The exercise sheet will be discussed in one in-person exercise session on November 30, 2022, 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. Note that there is no exercise session on
December 1, 2022 due to the Dies Academicus.

Exercise 6.1
Consider a probability space (Ω, I, Q) for a three-period financial market model with one risky asset
P = {P (t) : t ∈ {0, 1, 2, 3}} as in the tree below. Furthermore, let P = {P(t) : t ∈ {0, 1, 2, 3}} be the
sequence of partitions describing the information structure of the multi-period market (see slide 114) and
let F = {Ij : j ∈ {0, 1, 2, 3}} be the corresponding (natural) filtration.
P (3, ω1 ) = 5 Q(ω1 ) = 0.15




 P (3, ω2 ) = 4 Q(ω2 ) = 0.05




 P (3, ω3 ) = 3 Q(ω3 ) = 0.2
HH
 HH
 H
  H
H P (3, ω4 ) = 2 Q(ω4 ) = 0.05
HH HH
H H
HH HH
HH
HH
HH P (3, ω5 ) = 1 Q(ω5 ) = 0.25
HH
H
H
H
H P (3, ω6 ) = 0 Q(ω6 ) = 0.2
HH
HH
HH P (3, ω7 ) = 6 Q(ω7 ) = 0.1

t=0 t=1 t=2 t=3

a) Determine the sequence of partitions P describing the information structure and the corresponding
filtration F.
b) Compute the conditional expectations E[P (3) | I0 ] and E[P (3) | I2 ].
Hint: These conditional expectations are random variables on Ω given by:
X
E[P (3) | Ii ](ω) = E[P (3) | A]1A (ω), i ∈ {0, 1, 2},
A∈Pi

where 1A (ω) = 1 if ω ∈ A and 1A (ω) = 0 else.

c) Verify that E[E[P (3) | I2 ]] = E[P (3)] without using the tower rule.

© Technical University of Munich, Chair of Mathematical Finance

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Exercise 6.2
Consider a probability space (Ω, I, Q) with four states Ω = {ωj : j ∈ {1, 2, 3, 4}} for a two-period fi-
nancial market model with a riskless bank account with rate r = 1/10 and one risky asset P1 =
{P1 (t) : t ∈ {0, 1, 2}} with outcomes as follows:

ω P (0) P1 (1, ω) P1 (2, ω)

ω1 1 2 5/2

ω2 1 2 3/2

ω3 1 1/2 1
ω4 1 1/2 1/4

Determine the set of all risk-neutral probability measures M.

Lemma. A stochastic process X = {X(t) : t ∈ {0, . . . , T }}, adapted to the filtration F, with EQ [|X(t)|] < ∞
for all t ∈ {0, . . . , T } is a martingale under the probability measure Q if EQ [X(t + 1) | It ] = X(t), for all
t ∈ {0, . . . , T − 1}.

Homework 6.3 (10 points)

Consider a probability space (Ω, I, Q) and let ξ1 , ξ2 , . . . , ξT be a sequence of i.i.d. random variables with
distribution given by 0 < Q(ξ1 = 1) = p = 1 − Q(ξ1 = 0) < 1. Furthermore, define X(0) := 0 and
X(t) := ξ1 + · · · + ξt for t ∈ {1, . . . , T } and let F = {Ii : i ∈ {0, 1, . . . , T }} denote the filtration generated
by the process X = {X(t) : t ∈ {0, 1, . . . , T }}, i.e., I0 = {∅, Ω} and for t ∈ {1, . . . , T }, It is the smallest
algebra such that X(1), . . . , X(t) are measurable with respect to It . Moreover, for α, β ∈ R consider the
stochastic processes Y = {Y (t) : t ∈ {0, 1, . . . , T }} and Z = {Z(t) : t ∈ {0, 1, . . . , T }} defined by:

Y (t) := αX(t) − βt,

Z(t) := exp {Y (t)}.

a) Determine α, β such that Y is a martingale (with respect to F).

b) Determine α, β such that Z is a martingale (with respect to F).
c) For s, t ∈ {0, . . . , T } show that Cov[Y (s), Y (t)] = α2 (s ∧ t)p(1 − p).
d) Let the stochastic process P = {P (t) : t ∈ {0, . . . , T }} be adapted to the filtration F = {Ft : t ∈
{0, . . . , T }} with EQ [|P (t)|] < ∞, for all t ∈ {1, . . . , T } and

EQ [∆P (t + 1) | Ft ] = 0 for ∆P (t + 1) := P (t + 1) − P (t) and t ∈ {0, . . . , T − 1}.

Show, without using the Lemma on this sheet, that P is a martingale with respect to the filtration
F under the probability measure Q, i.e., show that EQ [P (t + s) | Ft ] = P (t), for all t ∈ {0, . . . , T },
and s = 0, . . . , T − t.
Hint: Make use of the telescoping sum first and then use the tower rule.

Exercise 6.4
a) Let ξ1 , ξ2 , . . . , ξT be a sequence of i.i.d. random variables on a probability space (Ω, F, Q) with a
distribution given by
1
0 < Q(ξ1 = 1) = = 1 − Q(ξ1 = −1).
2

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in one in-person exercise session on November 30, 2022, 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. Note that there is no exercise session on December 1, 2022 due to the Dies Academicus.
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Furthermore, define the two (dependent) stochastic processes X = {X(t) : t ∈ {0, 1, . . . , T }} and
Y = {Y (t) : t ∈ {0, 1, . . . , T }} by X(0) = 0, X(t) = ξ1 + · · · + ξt for t ∈ {1, . . . , T }, and Y (t) =
exp {X(t)} for t ∈ {0, 1, . . . , T }. Show that the stochastic process Y is a submartingale with respect
to its natural filtration.
Hint: Apply Jensen’s inequality for expectations.
b) Consider a probability space (Ω, F, Q) with a filtration F = {Fi : i ∈ {0, 1, . . . , T }} let the process
Z = {Z(t) : t ∈ {0, 1, . . . , T }} be a martingale with respect to F. Furthermore, let the random
variable N : Ω → {0, . . . , T } be a stopping time, i.e., [N = t] ∈ Ft for all t ∈ {0, . . . , T }. Show that
PT
E[Z(N )] = E[Z(T )]. Hint: Rewrite Z(N ) = t=0 Z(t)1[N =t] .

Programming exercise 6.5

Consider the financial market from Exercise 5.2 (see also the Example on lecture slide 104): K = 3,
N = 1, r = 1/9, P1 (0) = 5, P1 (1, ω1 ) = 20/3, P1 (1, ω2 ) = 40/9, P1 (1, ω3 ) = 10/3. Furthermore, Consider the
contingent claim D from Exercise 5.2 b) with payoff D(1, ωi ), i ∈ {1, 2, 3}, at maturity T = 1. Recall,
that D(1, ω1 ) = 1, D(1, ω2 ) = 2, D(1, ω3 ) = 3. By using the (infinite) set of risk-neutral probability
measures, we found that
VD− (0) = 1.35, VD+ (0) = 1.50.
a) Find the maximal amount of money xM = ϕ0 + 5ϕ1 such that ϕ0 (1 + r) + ϕ1 P1 (1) ≤ D for all three
possible outcomes of P1 (1).
Hints: (1) An implementation of the simplex algorithm, which solves linear programming problems
of the form
min a0 x s.t. Ax ≤ b and x ≥ 0, (6.3)
x

is the R-function boot :: simplex .

(2) Transform the optimization given in this exercise to the form in (6.3) by switching from maxi-
mization to minimization and by splitting up each variable in a positive and a negative part.
b) Similarly, find the minimum amount of money xm = ϕ0 + 5ϕ1 such that ϕ0 (1 + r) + ϕ1 P1 (1) ≥ D
for all three possible outcomes of P1 (1).
c) Now, consider the contingent claim D of Exercise 5.2 a) where D(1, ω1 ) = 1, D(1, ω2 ) = 2,
D(1, ω3 ) = 5/2. Run your code from ?? and ?? again with this different derivative payoff and
state your conclusions

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in one in-person exercise session on November 30, 2022, 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. Note that there is no exercise session on December 1, 2022 due to the Dies Academicus.