BA3203 Actuarial Aspects of Asset Valuation

Tutorial 9 – 5-Step Method and Martingale Approach (2)

1) Evaluate the expression, 𝑉𝑡 = 𝑒 −𝑟(𝑇−𝑡) 𝐸𝑄 (𝑋|𝐹𝑡 ) for a European put option on a non-
dividend paying share, i.e. 𝑋 = max{𝐾 − 𝑆𝑇 , 0}.

2) An investor is trying to replicate a 6-month European call option with strike price 500,
which was purchased 4 months ago. If 𝑟 = 0.05, 𝜎 = 0.2 , and the current share price
is 475, what portfolio should the investor be holding, assuming that no dividends are
expected before the expiry date?

𝛾2
3) Use Ito’s lemma to show that the SDE for 𝐴𝑡 = 𝑒 −𝑟𝑡 𝜂𝑡 , where 𝜂𝑡 = 𝑒 −𝛾𝑍𝑡− 2 𝑡 , is 𝑑𝐴𝑡 =
−𝐴𝑡 (𝑟𝑑𝑡 + 𝛾𝑑𝑍𝑡 ).

4) Evaluate the expression, 𝑉𝑡 = 𝑒 −𝑟(𝑇−𝑡) 𝐸𝑄 (𝑋|𝐹𝑡 ) for a European put option on a dividend
paying share, i.e. 𝑋 = max{𝐾 − 𝑆𝑇 , 0}.

5) You are given that the fair price to pay at time 𝑡 for a derivative paying 𝑋 at time 𝑇 is 𝑉𝑡 =
𝑒 −𝑟(𝑇−𝑡) 𝐸𝑄 (𝑋|𝐹𝑡 ), where 𝑄 is the risk-neutral probability measure and 𝐹𝑡 is the filtration
with respect to the underlying process. The price movements of a non-dividend-paying
share are governed by the stochastic differential equation 𝑑𝑆𝑡 = 𝑆𝑡 (𝜇𝑑𝑡 + 𝜎𝑑𝐵𝑡 ), where 𝐵𝑡
is standard Brownian motion under the risk-neutral probability measure.

a) Solve the above stochastic differential equation.

b) Determine the probability distribution of 𝑆𝑇 |𝑆𝑡 .
c) Hence, show that the value at time 𝑡 for a forward on this share, with forward price
𝐾 (determined at time 0) and time to expiry 𝑇 − 𝑡, is: 𝑉𝑡 = 𝑆𝑡 − 𝐾𝑒 −𝑟(𝑇−𝑡).

6) The evolution of a stock price 𝑆𝑡 is modelled by 𝑆𝑡 = 𝑆0 𝑒 𝜇𝑡+𝜎𝐵𝑡 , where 𝐵𝑡 represents a

standard Brownian motion, 𝜇 and 𝜎 are fixed parameters and the initial value of the stock
is 𝑆0 = 1.

a) Derive an expression for 𝑃{𝑆𝑡 ≤ 𝑥}.

b) Derive expressions for the median of 𝑆𝑡 and the expectation of 𝑆𝑡 .
c)
i) Determine an expression in terms of the share price 𝑆𝑠 for the conditional
expectation 𝐸(𝑆𝑡 |𝐹𝑠 ), where 𝑠 < 𝑡 and {𝐹𝑠 : 𝑠 ≥ 0} denotes the filtration associated
with the process 𝑆.
ii) Find conditions on 𝜇 and 𝜎 under which the process {𝑆𝑡 : 𝑡 ≥ 0} is a martingale.
iii) State, with reasons, whether or not the stock would be a good long-term
investment in this case.

7) The price 𝑆𝑡 of a share that pays no dividend follows a geometric Brownian motion,
𝑑𝑆𝑡 = 𝑆𝑡 (𝜇𝑑𝑡 + 𝜎𝑑𝑍𝑡 ),
where 𝑍𝑡 is a standard Brownian motion.

A derivative is available on this share that can only be exercised at time 𝑇. The price of
the derivative at time 𝑡, 𝑓(𝑡, 𝑆𝑡 ), depends on the time and the current share price. A cash
bond is also available that offers a risk-free rate of return of 𝑟 (continuously compounded).
The price of the bond is 𝐵𝑡 . You wish to set up a replicating portfolio for the derivative
made out of shares and cash, so that

1
 𝜙𝑡 𝑆𝑡 + 𝜓𝑡 𝐵𝑡 = 𝑓(𝑡, 𝑆𝑡 ) (*)

a) Write down the differential equation that is satisfied by 𝐵𝑡 .

b) What does it mean for the portfolio to be self-financing? Give a differential equation
that must be satisfied by the portfolio considered above in order that this is the case.
c) By applying Ito’s lemma to the right-hand side of equation (*) and using your answer
to part (b), deduce that
𝜕
i) 𝜙𝑡 = 𝑓(𝑡, 𝑆𝑡 ),
𝜕𝑠
𝜎2
ii) 𝜃 + 𝑟𝑆𝑡 ∆ + 2 𝑆𝑡2 𝛤 = 𝑟𝑓,
where 𝜃, ∆ and 𝛤 are symbols that you should define.

8) A company’s directors have decided to provide senior managers with a performance

bonus scheme. The bonus scheme entitles the managers to a cash payment of $10,000
should the company share price have increased by more than 20% at the end of the next
6 months. In addition, the managers will be entitled to 5,000 free shares each, should the
share price have increased by more than 10% at the end of the next 6 months

You are given the following data:

Current share price: $7.81
Risk-free rate: 5% 𝑝𝑎 (continuously-compounded)
Share price volatility: 25% 𝑝𝑎
No dividends to be paid over the next 6 months

By considering the terms of the Black-Scholes call option pricing formula, calculate the
value of the bonus scheme to one manager.