FiMa1 ExerciseSheet06 Solution

Chair of Mathematical Finance
Department of Mathematics
Technical University of Munich
Financial Mathematics 1
Aleksey Min, Henrik Sloot, and Ben Spies
Exercise sheet 6
The exercise sheet will be discussed in two groups of Zoom exercise sessions on December 1, 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 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
HH P (3, ω6 ) = 0 Q(ω6 ) = 0.2
HH
H
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.
Solution: By Slide 114 in the lecture notes, the information structure is fully described by a se-
quence P(0) =: P0 , P1 , . . . , Pt of partitions of Ω, with P0 = {Ω} and PT = {{ω1 }, . . . , {ωK }},
satisfying the property that each A ∈ Pt is the union of some elements in Pt+1 for every t < T .
The subsets in partition Pi correspond to the nodes in our tree at time point t = i. For the tree
displayed above, we obtain:
P3 = {{ω1 }, {ω2 }, {ω3 }, {ω4 }, {ω5 }, {ω6 }, {ω7 }},

P2 = {{ω1 , ω2 }, {ω3 }, {ω4 , ω5 }, {ω6 , ω7 }},
P1 = {{ω1 , ω2 , ω3 , ω4 , ω5 }, {ω6 , ω7 }},
P0 = {Ω}.
© Technical University of Munich, Chair of Mathematical Finance

2
In order to determine the filtration F, we need to specify the smallest σ-algebra Ii containing all
elements of partition Pi for all time points i = 0, 1, 2, 3. At each time point, we do the following:
• Include Ω and ∅.
• Include all partition elements (which are subsets of Ω) from Pi .
• Add all conjunctions partition elements from Pi .
In our case, this yields:
I0 = {∅, Ω},
I1 = {∅, Ω, {ω1 , ω2 , ω3 , ω4 , ω5 }, {ω6 , ω7 }},
I2 = {∅, Ω, {{ω1 , ω2 }, {ω3 }, {ω4 , ω5 }, {ω6 , ω7 }, {ω1 , ω2 , ω3 }, {ω1 , ω2 , ω4 , ω5 },
{ω1 , ω2 , ω6 , ω7 }, {ω3 , ω4 , ω5 }, {ω3 , ω6 , ω7 }, {ω4 , ω5 , ω6 , ω7 }, {ω1 , ω2 , ω3 , ω4 , ω5 },
{ω1 , ω2 , ω3 , ω6 , ω7 }, {ω1 , ω2 , ω4 , ω5 , ω6 , ω7 }, {ω3 , ω4 , ω5 , ω6 , ω7 }}.
I3 = P(Ω),
where P(Ω) denotes the power set of Ω.

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.

Solution: Since I0 does not contain any additional information, we calculate:
7
X
E[P (3) | I0 ] = E[P (3)] = P (3, ωi ) · Q(ωi )
i=1
= 5 · 0.15 + 4 · 0.05 + 3 · 0.2 + 2 · 0.05 + 1 · 0.25 + 0 · 0.02 + 6 · 0.1
= 2.5.
At time t = 2, however, we need to distinguish four different cases:


E[P (3) | {ω1 , ω2 }], ω ∈ {ω1 , ω2 },


E[P (3) | {ω }], ω ∈ {ω3 },
3
X
E[P (3) | I2 ](ω) = E[P (3) | A] · 1A (ω) =
E[P (3) | {ω4 , ω5 }], ω ∈ {ω4 , ω5 },
A∈P2 

E[P (3) | {ω6 , ω7 }], ω ∈ {ω6 , ω7 }.

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in two groups of Zoom exercise sessions on December 1, 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
There remains to calculate:

2
X Q(ωi )
E[P (3) | {ω1 , ω2 }] = P (3, ωi ) ·
i=1
Q(ω1 ) + Q(ω2 )
0.15 0.05
=5· +4· ≈ 4.75,
0.15 + 0.05 0.15 + 0.05
E[P (3) | {ω3 }] = P (3, ω3 ) = 3,
5
X Q(ωi )
E[P (3) | {ω4 , ω5 }] = P (3, ωi ) ·
i=4
Q(ω4 ) + Q(ω5 )
0.05 0.25
=2· +1· ≈ 1.1667,
0.05 + 0.25 0.05 + 0.25
7
X Q(ωi )
E[P (3) | {ω6 , ω7 }] = P (3, ωi ) ·
i=6
Q(ω6 ) + Q(ω7 )
0.2 0.1
=0· +6· = 2.
0.2 + 0.1 0.2 + 0.1
c) Verify that E[E[P (3) | I2 ]] = E[P (3)] without using the tower rule.
Solution: We start with the left-hand side and treat E[P (3) | I2 ] as a standard random variable:

Q(ω1 ) Q(ω2 )
E[E[P (3) | I2 ]] = P (3, ω1 ) · + P (3, ω2 ) · · Q({ω1 , ω2 })
Q(ω1 ) + Q(ω2 ) Q(ω1 ) + Q(ω2 )
+ P (3, ω3 ) · Q({ω3 })

Q(ω4 ) Q(ω5 )
+ P (3, ω4 ) · + P (3, ω5 ) · · Q({ω4 , ω5 })
Q(ω4 ) + Q(ω5 ) Q(ω4 ) + Q(ω5 )

Q(ω6 ) Q(ω7 )
+ P (3, ω6 ) · + P (3, ω7 ) · · Q({ω6 , ω7 })
Q(ω6 ) + Q(ω7 ) Q(ω6 ) + Q(ω7 )

Q(ω1 ) Q(ω2 )
= P (3, ω1 ) · + P (3, ω2 ) · · (Q(ω1 ) + Q(ω2 ))
Q(ω1 ) + Q(ω2 ) Q(ω1 ) + Q(ω2 )
+ P (3, ω3 ) · Q({ω3 })

Q(ω4 ) Q(ω5 )
+ P (3, ω4 ) · + P (3, ω5 ) · · (Q(ω4 ) + Q(ω5 ))
Q(ω4 ) + Q(ω5 ) Q(ω4 ) + Q(ω5 )

Q(ω6 ) Q(ω7 )
+ P (3, ω6 ) · + P (3, ω7 ) · · (Q(ω6 ) + Q(ω7 ))
Q(ω6 ) + Q(ω7 ) Q(ω6 ) + Q(ω7 )
= P (3, ω1 ) · Q(ω1 ) + P (3, ω2 ) · Q(ω2 ) + P (3, ω3 ) · Q(ω3 )
+ P (3, ω4 ) · Q(ω4 ) + P (3, ω5 ) · Q(ω5 ) + P (3, ω6 ) · Q(ω6 ) + P (3, ω7 ) · Q(ω7 )
7
X
= P (3, ωi ) · Q(ωi )
i=1
= E[P (3)].
Exercise 6.2

4
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.
Solution: We once more use the definition of a risk-neutral probability measure, where in this two-period
model, the crucial equation is slightly adapted to
h i
EQ̃ ∆P̃i (t + 1) | It = 0,
which now has to be satisfied for all t ∈ {0, 1} and for all assets i. Analysing this requirement at time
t = 0 gives

h i 10 1
EQ̃ ∆P̃1 (1) | I0 = 0 ⇔ · 2 · Q̃({ω1 , ω2 }) + · Q̃({ω3 , ω4 }) = 1
11 2
1 11
⇔ 2 · (q̃1 + q̃2 ) + · (q˜3 + q̃4 ) = .
2 10
The same condition at time t = 1 gives us two more conditions:
 h i
h i E P̃1 (2) | {ω1 , ω2 } = P̃ (1, ω1 ) = P̃ (1, ω2 )
Q̃
EQ̃ ∆P̃1 (2) | I1 = 0 ⇔ h i
E P̃1 (2) | {ω3 , ω4 } = P̃ (1, ω3 ) = P̃ (1, ω4 )
Q̃

 100 · 5 · q̃1 + 3 · q̃2 10
121 2 q̃1 +q̃2 2 q̃1 +q̃2 = 2 · 11
⇔
 100 · 1 · q̃3 + 1 · q̃4 1 10
121 q̃3 +q̃4 4 q̃3 +q̃4 = 2 · 11
(
3q̃1 − 7q̃2 = 0
⇔
3q̃3 − 2q̃4 = 0.
P4
Together with the requirement that k=1 q̃k = 1, these equations form a system of four linear equations
for four unknown variables. Solving this system leads to the unique solution

7 3 6 9
M= , , , .
25 25 25 25
Note that this solution satisfies q̃k > 0 for all k ∈ {1, . . . , 4}.
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}.

5
Exercise 6.3
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).

Solution: According to the previous lemma, we have to check three conditions for Y to be a
martingale:
(I) Y is adapted to the filtration F.
(II) EQ [|Y (t)|] < ∞ for all t ∈ {0, 1, . . . , T }.

(III) EQ [Y (t + s) | It ] = Y (t) for all t ∈ {0, 1, . . . , T } and s ∈ {0, 1, . . . , T − t}.
Since Y (t) is a continuous function of X(t), condition (I) is satisfied. Furthermore, to check condi-
tion (II), we can calculate:
EQ [|αX(t) − βt|] ≤ |α| · EQ [|X(t)|] + |β| · t < ∞.
Since |X(t)| = |ξ1 + · · · + ξt | = ξ1 + · · · + ξt ≤ t < ∞, we conclude that condition (II) is satisfied as

well. Now, using that X(t) is adapted to the filtration and that ξ1 , . . . , ξt are i.i.d. random variables,
we obtain
EQ [Y (t + s) | It ] = EQ [αX(t + s) − β(t + s) | It ]
= EQ [α(ξ1 + · · · + ξt+s ) − β(t + s) | It ]
= EQ [αX(t) | It ] + EQ [αξt+1 | It ] + · · · + EQ [αξt+s | It ] − β · (t + s)
= α · X(t) + αEQ [ξt+1 ] + · · · + αEQ [ξt+s ] − β · (t + s)
= α · X(t) + α · s · EQ [ξ1 ] − β · (t + s)
= α · X(t) + α · s · (p · 1 + (1 − p) · 0) − β · (t + s)
= α · X(t) − β · t + α · s · p − β · s.
Condition (III) thus is equivalent to
β
Y (t) = α · X(t) − β · t + α · s · p − β · s ⇔ αX(t) − βt = α · X(t) − β · t + s · (αp − β) ⇔ α = .
p
b) Determine α, β such that Z is a martingale (with respect to F).

Solution: With the same argument as above, condition (I) is satisfied for Z. Furthermore,
EQ [|exp {Y (t)}|] = EQ [exp {αX(t) − βt}]

≤ EQ [exp {αt − βt}] < ∞,

6
which proves condition (II). Now, again using that ξ1 , . . . ξt are i.i.d. and that X is adapted to the
filtration, we calculate
EQ [Z(t + s) | It ] = EQ [exp {αX(t + s) − β(t + s)} | It ]

h i
= EQ exp {αX(t)} · exp {αξt+1 } · · · · · exp {αξt+s } · exp {−β(t + s)} | It
= exp {αX(t)} · EQ [exp {αξt+1 }] · · · · · EQ [exp {αξt+s }] · exp {−β(t + s)}
s
= exp {αX(t)} · (p · exp {α} + (1 − p) · exp {0}) · exp {−β(t + s)}.
This implies that condition (III) is equivalent to

s
exp {αX(t) − βt} = exp {αX(t)} · (p · exp {α} + (1 − p)) · exp {−β(t + s)}
⇔ (p exp {α} + (1 − p)) · exp {−β} = 1
exp {β} − (1 − p)
⇔ exp {α} = .
p
c) For s, t ∈ {0, . . . , T } show that Cov[Y (s), Y (t)] = α2 (s ∧ t)p(1 − p).

Solution: We start by using the well-known formula for the covariance:
Cov[Y (s), Y (t)] = E[Y (s) · Y (t)] − E[Y (s)] · E[Y (t)]
= E[(αX(s) − βs) · (αX(t) − βt)] − E[αX(s) − βs] · E[αX(t) − βt]
= E α2 X(s)X(t) − αβX(s)t − αβX(t)s + β 2 ts

(6.1)
− (αE[X(s)] − βs) · (αE[X(t)] − βt).
At this point, we again use that ξ1 , . . . ξt are i.i.d. random variables. Without loss of generality, we
assume that s ≤ t, the remaining case is shown analogously. We obtain:
E [X(t)X(s)] = E[(X(s) + ξs+1 + · · · + ξt ) · X(s)]
h i
2
= E X(s) + ξs+1 · X(s) + · · · + ξt · X(s)
h i
2
= E X(s) + E[X(s)] · E[ξs+1 ] + · · · + E[X(s)] · E[ξt ]. (6.2)
Recalling that
h i
2 2
E X(s) = Var[X(s)] + (E[X(s)])
2
= Var[ξ1 + · · · + ξs ] + (sp)
h i
2
= s · E (ξ1 − E[ξ1 ]) + s2 p2

2 2
= s p(1 − p) + (1 − p)(0 − p) + s2 p2
= (1 − p)sp + s2 p2 .
This allows us to continue with Eq. (6.2) to obtain
E[X(t)X(s)] = (1 − p)sp + s2 p2 + E[X(s)] · E[ξs+1 ] + · · · + E[X(s)] · E[ξt ]
= (1 − p)sp + s2 p2 + (t − s)spE[ξ1 ]
= (1 − p)sp + s2 p2 + (t − s)sp2
= (1 − p)sp + tsp2 .

7
Using this for Eq. (6.1) yields
Cov[Y (s), Y (t)] = α2 E[X(t)X(s)] − αβtE[X(s)] − αβsE[X(t)] + β 2 ts − α2 E[X(t)]E[X(s)]

+ αβE[X(s)]t + αβE[X(t)]s − β 2 st
= α2 (1 − p)ps.
Including the case where t < s gives exactly the formula that we were required to show.
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.
Solution: We follow the hint and compute the expectations using a telescopic sum, before applying
the tower rule to the elements of the sum:
EQ [P (t + s) | It ] = EQ [P (t) + P (t + 1) − P (t) + · · · + P (t + s) − P (t + s − 1) | It ]
= EQ [P (t) | It ] + EQ [P (t + 1) − P (t) | It ] + · · · + EQ [P (t + s) − P (t + s − 1) | It ]
= EQ [P (t) | It ] + EQ [P (t + 1) − P (t) | It ]
+ EQ [EQ [P (t + 2) − P (t + 1) | It+1 ] | It ] + . . .
+ EQ [EQ [P (t + s) − P (t + s − 1) | It+s−1 ] | It ].
Now by assumption, all elements of this sum, except for the very first one P (t), are equal to zero,
yielding
EQ [P (t + s) | Ft ] = P (t).
Exercise 6.4
a) Let X and Y be two random variables on a probability space (Ω, F, Q) fulfilling E[X 2 ], E[Y 2 ] < ∞.
Let G ⊂ F be an arbitrary sub-algebra of F. Show: If E[X | G] = Y and E[X 2 | G] = Y 2 almost
surely, then X = Y almost surely.
2
Hint: Calculate E[(X − Y ) ].
h i
2 2
Solution: Note that (X − Y ) is a.s. non-negative. Thus, if E (X − Y ) = 0, we know that
X = Y also holds almost surely. We therefore follow the hint and show
h i
2
E (X − Y ) = E X 2 − 2XY + Y 2

= E X 2 − 2E[XY ] + E Y 2

= E E X 2 | G − 2E[E[XY | G]] + E Y 2

= E Y 2 − 2E Y 2 + E Y 2 = 0.

b) Let Ω = {ω1 , ω2 , ω3 } with probabilities Q(ω1 ) = 1/2, and Q(ω2 ) = Q(ω3 ) = 1/4 and define the
random variable Z by Z(ω1 ) = 1, Z(ω2 ) = 2 and Z(ω3 ) = 4. Calculate the conditional expectation

8
E[E[Z | H1 ] | H2 ] for the algebras H1 = {∅, {ω1 }, {ω2 , ω3 }, Ω} and H2 = {∅, {ω1 , ω2 }, {ω3 }, Ω}.
Hint: Recall the definition of conditional expectations from 1.
Solution: We use the definitions from Exercise 1 and compute
(
E[Z | {ω1 }] = Z(ω1 ) = 1 ω = ω1 ,
E[Z | H1 ](ω) = 1 1
E[Z | {ω2 , ω3 }] = 2 · 1 + 1 + 4 · 1 + 1 = 3 ω ∈ {ω2 , ω3 }.
4 4
4 4 4 4
In the second case, we obtain

( 1 1
5
E[E[Z | H1 ] | {ω1 , ω2 }] = 1 · 1
2
+ 1 +3· 1
4
+ 1 = 3 ω ∈ {ω1 , ω2 },
E[E[Z | H1 ] | H2 ](ω) = 2 4 2 4
E[E[Z | H1 ] | {ω3 }] = 3 ω = ω3 .
Exercise 6.5
a) Let ξ1 , ξ2 , . . . , ξT be a sequence of iid random variables on a probability space (Ω, F, Q) with a
distribution given by
1
0 < Q(ξ1 = 1) = = 1 − Q(ξ1 = −1).
2
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.
Solution: We again rely on conditions (I) — (III) from Exercise (3), replacing the last one by
(III′ ) EQ [Y (t + s) | It ] ≥ Y (t).
I our case, condition (I) is satisfied with the same arguments as before. Furthermore, for all t ∈
{0, . . . , T },
EQ [|Y (t)|] = EQ [|exp {X(t)}|] = EQ [exp {X(t)}]

≤ EQ [exp {t}] < ∞,
proving condition (II). For the last condition, we apply Jensen’s inequality for expectations with the
exponential function to obtain
EQ [Y (t + s) | It ] = EQ [exp {X(t + s)} | It ]

≥ exp {EQ [X(t + s) | It ]}
= exp {EQ [X(t) + ξt+1 + · · · + ξt+s | It ]}
= exp {EQ [X(t) | It ] + EQ [ξt+1 | It ] + . . . + EQ [ξt+s | It ]}
= exp {X(t) + EQ [ξt+1 ] + · · · + EQ [ξt+s ]}
= exp {X(t) + s · EQ [ξ1 ]} = exp {X(t) + s · 0} = Y (t),
showing that Y is indeed a submartingale.

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

9
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] .
Solution: We follow the hint and use that Z is a martingale to calculate
" T # " T #
X X
E[Z(N )] = E Z(t)1[N =t] = E E[Z(T ) | Ft ]1[N =t]
t=0 t=0
T
" # T
X X
=E E Z(T )1[N =t] | Ft = E E Z(T )1[N =t] | Ft
t=0 t=0
T
" T
#
X X
= E Z(T )1[N =t] = E Z(T )1[N =t]
t=0 t=0
" T
#
X
= E Z(T ) 1[N =t] = E[Z(T )].
t=0
Note that we also used that 1[N =t] (ω) is Ft measurable, the fact that the expectation operator is
linear (twice) and the tower rule.
Remark. An implementation of the simplex algorithm, which solves linear programming problems of the form
min a′ x s.t. Ax ≤ b and x ≥ 0,

x
is the R-function boot :: simplex implements the simplex-algorithm.
Programming exercise 6.6

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).
Solution: We have the optimization problem
   

φ0 (1 + r) P (1, ω1 ) D(1, ω1 )
φ
max 1 5 · s.t. (1 + r) P (1, ω2 ) · 0
≤ D(1, ω2 )
φ0 ,φ1 ∈R φ1 φ1
(1 + r) P (1, ω3 ) D(1, ω3 )
which can be rewritten as

 ′  +   +
−1 φ0   φ0  
−5 φ+  (1 + r) P (1, ω1 ) −(1 + r) −P (1, ω1 ) φ+  D(1, ω1 )
  1  s.t. (1 + r) P (1, ω2 ) −(1 + r) −P (1, ω2 ) ·  −
1
min−   1  · φ− φ0  ≤ D(1, ω2 ) .
 
φ+
0 ,φ0 , 0

(1 + r) P (1, ω3 ) −(1 + r) −P (1, ω3 ) D(1, ω3 )
φ+ −
1 ,φ1 ≥0 5 φ−
0 φ−
0

10
Solution:
library ( tidyverse )
library ( boot )
r <- 1 / 9
5 p0 <- 5
p1 <- c (20 / 3 , 40 / 9 , 10 / 3)
a <- c (1 , p0 )
a <- c (a , -a )
10 A <- matrix ( c ( rep (1 + r , 3) , p1 ) , nrow = 3 , ncol = 2)
A <- cbind (A , -A )
d <- c (1 , 2 , 3)
15 phi _ res <- simplex ( -a , A , d )

( phi <- phi _ res $ soln [1:2] - phi _ res $ soln [2 + (1:2)])
( x _ M <- - phi _ res $ value )
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).
Solution:
phi _ res <- simplex (a , -A , -d )
( x _ m <- phi _ res $ value )
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 a) and b) again with this different derivative payoff and
state your conclusions
Solution:
d <- c (1 , 2 , 5 / 2)
phi _ res <- simplex ( -a , A , d )

5 ( x _ M <- - phi _ res $ value )
phi _ res <- simplex (a , -A , -d )

( x _ m <- phi _ res $ value )
In this case, VD− (0) = VD+ (0) implies that the contigent claim is attainable.


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Chair of Mathematical Finance

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

P3 = {{ω1 }, {ω2 }, {ω3 }, {ω4 }, {ω5 }, {ω6 }, {ω7 }},

© Technical University of Munich, Chair of Mathematical Finance

In our case, this yields:

where P(Ω) denotes the power set of Ω.

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

At time t = 2, however, we need to distinguish four different cases:

Financial Mathematics 1 — Exercise

There remains to calculate:

Financial Mathematics 1 — Exercise

ω P (0) P1 (1, ω) P1 (2, ω)

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

Financial Mathematics 1 — Exercise

Y (t) := αX(t) − βt,

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

(I) Y is adapted to the filtration F.

(II) EQ [|Y (t)|] < ∞ for all t ∈ {0, 1, . . . , T }.

EQ [|αX(t) − βt|] ≤ |α| · EQ [|X(t)|] + |β| · t < ∞.

Since |X(t)| = |ξ1 + · · · + ξt | = ξ1 + · · · + ξt ≤ t < ∞, we conclude that condition (II) is satisfied as

Condition (III) thus is equivalent to

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

EQ [|exp {Y (t)}|] = EQ [exp {αX(t) − βt}]

Financial Mathematics 1 — Exercise

EQ [Z(t + s) | It ] = EQ [exp {αX(t + s) − β(t + s)} | It ]

This implies that condition (III) is equivalent to

c) For s, t ∈ {0, . . . , T } show that Cov[Y (s), Y (t)] = α2 (s ∧ t)p(1 − p).

Financial Mathematics 1 — Exercise

Using this for Eq. (6.1) yields

Cov[Y (s), Y (t)] = α2 E[X(t)X(s)] − αβtE[X(s)] − αβsE[X(t)] + β 2 ts − α2 E[X(t)]E[X(s)]

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

Financial Mathematics 1 — Exercise

In the second case, we obtain

EQ [|Y (t)|] = EQ [|exp {X(t)}|] = EQ [exp {X(t)}]

EQ [Y (t + s) | It ] = EQ [exp {X(t + s)} | It ]

showing that Y is indeed a submartingale.

Financial Mathematics 1 — Exercise

min a′ x s.t. Ax ≤ b and x ≥ 0,

is the R-function boot :: simplex implements the simplex-algorithm.

Programming exercise 6.6

which can be rewritten as

Financial Mathematics 1 — Exercise

15 phi _ res <- simplex ( -a , A , d )

phi _ res <- simplex ( -a , A , d )

phi _ res <- simplex (a , -A , -d )

Financial Mathematics 1 — Exercise

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