FIM/MA547 Homework 02

1. Assume that market is observable at 𝑡! = 0, 𝑡" = 0.25 𝑎𝑛𝑑 𝑡# = 0.5. In addition, assume that
the annual interest rate is 5% over [𝑡! , 𝑡" ] and 6% over [𝑡" , 𝑡# ]. The current price of the stock price
XYZ is 80 per share, and the stock price can increase by 20% with a probability of 1⁄2 or decrease
by 20% with a probability of 1⁄2 over each period ([𝑡! , 𝑡" ] 𝑜𝑟 [𝑡" , 𝑡# ]). Calculate the fair price of
a put option on this stock with 𝐾 = 90 𝑎𝑛𝑑 𝑇 = 𝑡# , and find the replicating portfolio of this option
at 𝑡! 𝑎𝑛𝑑 𝑡" .
2. Assume that 𝑡! = 0, 𝑡" = 0.25, 𝑡# = 0.5 𝑎𝑛𝑑 𝑡$ = 0.75. The current price pf a stock is 𝑆! =
100 and during each period, the stock price can go up by $20 or go down by $10. Assume that the
interest rate is 𝑟 = 0 and the stock price at time 𝑡% is denoted by 𝑆% , 𝑛 = 0,1,2,3.
Find the risk-neutral probability measure ℚ and verify that {𝑆% }!&%&$ is a (ℚ, {ℱ% }!&%&$ ) -
martingale, where {ℱ% }!&%&$ is the natural filtration generated by {𝑆% }!&%&$ .
?% }!&%&$ is a ℚ - martingale where 𝑆
3. For problem #2, if 𝑟 = 3%, find ℚ show that {𝑆 ?% =
'()!
𝑒 𝑆% .
4. Assume {𝑆% }!&% is a stochastic process with a natural filtration {ℱ% }!&% . Let ℂ be a r.v. defined
by ℂ = 𝑓(𝑆* ), where 𝑁 is a positive integer and 𝑓 is a given function. Let ℙ be a probability
measure and define 𝑉% = 𝐸 ℙ [ℂ|ℱ% ], 𝑛 = 0,1, … 𝑁. Show that {𝑉% }!&%&* is a (ℙ, {ℱ% }!&%&* ) -
martingale.