FM 330: Homework 2 Solutions

October 12, 2011

Problem 1
(a) P is an equivalent martingale measure iff (pu , pm , pd ) := (P({ωu }), P({ωm }), P({ωd })) satisfies
 
1.2 180 0
  1  
1 90 30 = pu pm pd  1.2 120 30 
 
1.2
1.2 60 60
and pu , pm , pd > 0. (The physical probability of each state is nonzero, hence the risk-neutral
probability of each state must be nonzero; see the definition of equivalent martingale measure
in L2.3, or recall its application in L2.21 which says pu , pm , pd are positive.)
The solutions (all equivalent martingale measures) are

pu = 0.2 − α, pm = 0.4 + 2α, pd = 0.4 − α, for − 0.2 < α < 0.2

There is more than one equivalent martingale measure, so the market is incomplete.

(b) No, because there is no solution to

    
1.2 180 0 θB 90
 1.2 120 30   θS  =  30  .
    
1.2 60 60 θC 0

Problem 2
(a) P is an equivalent martingale measure iff (pu , pm , pd ) := (P({ωu }), P({ωm }), P({ωd })) satisfies
 
1.2 180 0
  1  
1 90 35 = pu pm pd  1.2 120 60 
 
1.2
1.2 60 60
and pu , pm , pd > 0. The solution is

pu = 0.3, pm = 0.2, pd = 0.5.

There is only one equivalent martingale measure, so the market is complete.

(b) Solving     
1.2 180 0 θB 90
 1.2 120 60   θS  =  30  ,
    
1.2 60 60 θC 0
we find that θB = 0, θS = 0.5, θC = −0.5 units of respectively B, S, C together replicate X.

1
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 (c) Using the replicating portfolio gives the price 0.5 × 90 − 0.5 × 35 = 27.5.
Using the risk-neutral probabilities gives the price (1/1.2)×(0.3×90+0.2×30+0.5×0) = 27.5.

Problem 3
(a) Solve 70 = pup × 100 + (1 − pup ) × 50 to obtain pup = 0.4 and pdown = 1 − pup = 0.6.
So put price at D is 0.4 × 0 + 0.6 × 40 = 24.

(b) Put price at U is 0, because UU and UD both give 0 payout.

Find the number of shares a0 and bank acct units b0 such that

a0 × 150 + b0 × 1 = 0
a0 × 70 + b0 × 1 = 24

Solve to obtain: −0.3 shares, 45 bank account units.

(c) A portfolio of (−0.8 share, 80 bank account) subreplicates the put, because the portfolio pays
40, 0, and −80 in respectively the terminal down, middle, and up states; compare this to the
put which pays 40, 0, 0. The subreplicating portfolio has time-0 value −0.8 × 90 + 80 = 8,
hence C0 ≥ 8.

2
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