Intro to Mathematical Finance (Final 2022)

-Sample solution-

Responsible lecturer: Dr. Nestor Parolya

Teaching assistants: Lisa de Vries

March 7, 2022

Question 1 solution (15 points): Consider the two-period binomial model with the up-factor u = 1 + √1N , the
down-factor d = 1 − √1N , r is a risk-free rate and N = 2 number of periods.
As usual, for any n ∈ {1, . . . , N } the price evolves as Sn = uSn−1 in case the head (H) appears, and Sn = dSn−1
in case of the tail (T). The initial asset price is given by S0 = 1.

S2 (HH) = u2

S1 (H) = u

S0 = 1 S2 (HT ) = S2 (T H) = ud

S1 (T ) = d

S2 (T T ) = d2

Figure 1: Two-period binomial model

A. (10 points) Complete (1 point) the above diagram (round to 4 decimal places if needed).
Solution. The diagram should be completed with the entries S1 (H) = 1.7071, S2 (HT ) = S2 (T H) = ud =
0.5, S2 (HH) = 2.9142, S1 (T ) = 0.2928 and S2 (T T ) = 0.0857.

i. (1 point) find the risk neutral probabilities p̃ and q̃ as functions of the risk-free rate r;
Solution.

1+r−d 1 + r − 1 + √1N r + √1N

p̃ = = =
u−d 1 + √1N − 1 + √1N √2
N
1 √
r+ N
√
r N +1
= = ,
√2 2
N

q̃ = 1 − p̃ .

ii. (2 points) find for which values of the risk-free rate r the non-arbitrage condition is valid.
Solution. For non-arbitrage must hold:
1 1
0<d<1+r <u ⇔ 0<1− √ <1+r <1+ √ ,
N N
which is always valid as far as − √1N < r < √1 .
N

1
 – iii. (3 points) Fix r = N1 . What is the distribution of SN under the risk-neutral probabilities?
(a) (1 point) Compute P e (S2 = s), where s ∈ {S2 (HH), S2 (HT ), S2 (T H), S2 (T T )}.
Solution.
2
√ !2 
√1 +1 u2
Pe (S2 = S2 (HH)) = p̃2 =
r N +1
2
(r=1/N )
=
N
4
=
4
(N =2)
= 0.7285,

Pe (S2 = S2 (HT )) = Pe (S2 = S2 (T H)) = p̃q̃ = 0.125,

Pe (S2 = S2 (T T )) u 2

= q̃ 2 = 1 − = 0.0214 .
2
(b) (2 points) Calculate E
e (S1 ) and E
e (S2 ). What is the average rate of growth of the stock price under P
e?
Solution.
Ee (S1 ) = S1 (H)P

e (S1 = S1 (H)) + S1 (T )P
  
e (S1 = S1 (T ))
1 1
= 1+ √ p̃ + 1 − √ (1 − p̃)
N N
2
(r=1/N ) u u

= up̃ + d (1 − p̃) = +d 1−
  2 2
2 1
1 + √N + N 1 − N1


1
= − +1− √
2 2 N
1 N =2
= 1+ = 1.5 .
N

Ee (S2 ) = S2 (HH)Pe (S2 = S2 (HH)) + S2 (HT )P e (S2 = S2 (HT ))

+ S2 (T H)P
e (S2 = S2 (T H)) + S2 (T T )P
e (S2 = S2 (T T ))
= u2 p̃2 + 2ud (1 − p̃) p̃ + d2 (1 − p̃)2
(r=1/N ) u4 u u  u 2
= + 2ud 1− + d2 1 −
4 2 2 2
= (E
u  u 2 e (S1 ))2
= +d 1−
2 2
 2
1 N =2
= 1+ = 2.25 .
N
Average growth rates:

r̃0 =
Ẽ(S1 ) − 1 = 1 +1
−1=
1 N =2
= 0.5
S0 N N
Ẽ(S2 ) − 1 = 1 + N1 2 − 1 = 1 N==2 0.5


r̃1 =
Ẽ(S1 ) 1 + N1 N
– iv. (3 points) Show that discounted price Sn and discounted portfolio Xn = ∆n−1 Sn + (1 + r)(Xn−1 −
∆n−1 Sn−1 ) for n ∈ {1, . . . , N } are martingales under risk-neutral probabilities. The positions ∆n are
assumed to be adapted (known) at time n.
Solution. Discounted asset price. Using risk-neutral evaluation formula Sn = Ẽn S1+r
 
n+1
and dividing
it by (1 + r)n on both sides we immediately get

= Ẽn
 
Sn Sn+1
.
(1 + r)n (1 + r)n+1
Discounted portfolio.

Ẽn Ẽn + Ẽn (Xn − ∆n Sn )

   
Xn+1 ∆n Sn+1
=
(1 + r) (1 + r)

∆n Ẽn
 
Sn+1
= +Xn − ∆n Sn
(1 + r)
| {z }
Sn
= Xn .

2
 Dividing the right and left hand side by (1 + r)n finishes the proof of the martingale property.
1
B. (5 points) Fix r = and assume you own an exotic ”Asian-Lookback-Up-and-Down” option, which gives you a payoff
N
 N
−1
1 −1
P
max Sn − N +1 Sn at the last period of expiry N = 2; but, at the same time, it pays you 1 euro
n≤N n=0
everytime the price changes its direction (from up to down or from down to up), otherwise it pays you zero
euros. Calculate the option price V0 at time zero.
Solution. First we need to compute V2 (ω) for ω ∈ {T T, HH, T H, HT }. It holds
V2 (HH) = u2 − 3/(1 + 1/u + 1/u2 )−1 = 1.3589, V2 (HT ) = u − 3/(1 + 1/u + 1/(ud))−1 + 1 = 1.8705
V2 (T H) = 1 − 3/(1 + 1/d + 1/(ud))−1 + 1 = 1.5323, V2 (T T ) = 1 − 3/(1 + 1/d + 1/d2 )−1 = 0.8133 (1 point)

Next, we proceed to V1 (H) and V1 (T ):

1
V1 (H) = (p̃V2 (HH) + q̃V2 (HT )) = 0.9559 (1 point)
1+r
and, similarly,
1
V1 (T ) = (p̃V2 (T H) + q̃V2 (T T )) = 0.9513 (1 point)
1+r
At last,
1
V0 = (p̃V1 (H) + q̃V1 (T )) = 0.6368 (2 points)
1+r
C. (5 points) Consider your exotic option from Question 1B and make it American, i.e., you are allowed to exercise (stop)
it at every time point n ∈ {0, 1, 2} and not only at N = 2. Find the time-zero value V0 and optimal exercise
policy (optimal stopping time) for such American option.
 N
−1
1 −1
P
Solution. The exotic option we need to consider has a payoff max Sn − N +1 Sn . So the American
n≤N n=0
 τ
 −1
1
Sn−1
P
variant has a payoff Gτ = max Sn − τ +1 , where τ ∈ {0, 1, 2}. We can calculate each of the
n≤τ n=0
intrinsic values in the following way:
G2 (HH) = V2 (HH) = 1.3589
G2 (HT ) = V2 (HT ) = 1.8705
G2 (T H) = V2 (T H) = 1.5323
G2 (T T ) = V2 (T T ) = 0.8133

G1 (H) = u − 2/(1 + 1/u)−1 = 0.4459

G1 (T ) = 1 − 2/(1 + 1/d) = 0.5469
G0 = 1 − 1 = 0.
Now to find the value V0A of the American Range option we use Theorem 4.4.3, which states for N = 2 that
V2A (w1 w2 ) = max{G2 (w1 w2 ), 0},
 i
1 h
V1A (w1 ) = max G1 (w1 ), p̃V2A (w1 H) + q̃V2A (w1 T ) ,
1+r
 i
1 h
V0A = max G0 , p̃V1A (H) + q̃V1A (T ) .
1+r
As the intrinsic values and p̃ and q̃ are known, we can calculate the time-zero value. For each choice of u, we
will find that
V2A (w1 w2 ) = G2 (w1 w2 ), (1)
1 h i
V1A (w1 ) = p̃V2A (w1 H) + q̃V2A (w1 T ) , (2)
1+r
1 h i
V0A = p̃V1A (H) + q̃V1A (T ) . (3)
1+r

3
 We find

V2A (HH) = max{1.3589, 0} = 1.3589,

V2A (HT ) = max{1.8705, 0} = 1.8705,
V2A (T H) = max {1.5323, 0} = 1.5323,
V2A (T T ) = max {0.8133, 0} = 0.8133,

V1A (H) = max {0.4459, 0.9559} = 0.9559 = V1 (H),

V1A (T ) = max {0.5469, 0.9513} = 0.9513 = V1 (T ),

V0A = max {0, 0.6368} = V0 = 0.6368 .

The final part of this exercise is to find the optimal stopping time τ ∗ for the American Range option. By Theorem
4.4.5 we know that τ ∗ = min{n : VnA = Gn }. So if we take a look at Equations (1)-(3) we see that VnA equals
Gn if and only if n = 2. This implies that τ ∗ = 2, i.e.,

τ ∗ (HH) = τ ∗ (HT ) = τ ∗ (T H) = τ ∗ (T T ) = 2.

Therefore, the value of the American option is exactly the same as the value of the European option.

D. (5 points) Construct the replicating portfolio Xn , which replicates your American option from Question 1C, i.e.,
i. (3 points) find the portfolio weights ∆0 , ∆1 (H) and ∆1 (T ) such that your portfolio will replicate the option’s
payoff.
Solution. Using the ”delta hedging formula” we get
V1 (H) − V1 (T )
∆0 = = 0.0032 (1 point)
S1 (H) − S1 (T )
V2 (HH) − V2 (HT )
∆1 (H) = = −0.2118 (1 point)
S2 (HH) − S2 (HT )
V2 (T H) − V2 (T T )
∆1 (T ) = = 1.7357 (1 point)
S2 (T H) − S2 (T T )

ii. (2 points) Interpret your result in terms of an investment strategy, in that you explicitly provide how much money
you invest into the market and into the risk asset at every point of time.
Solution. First the investor short-sells the stock for V0 = 0.6368. Using this money he/she at the time
point t = 0 the investor buys 0.0032 share of stocks for 0.0032 × 1 EUR and invests the rest 0.6368 −
0.0032 = 0.6336 into the bank. At time point t = 1, in case of “heads” (H) the portfolio value is
X1 (H) = 0.0032 × 1.7071 + 1.5 × 0.6336 = 0.9559 = V1 (H). The investor shorts 0.2118 shares of
stock for 0.2118 × 1.7071 = 0.3615 EUR and puts everything 0.3615 + 0.9559 = 1.3174 EUR in the
bank. In case of “tails” (T), the portfolio value at t = 1 is X1 (T ) = 0.0032 × 0.2928 + 1.5 × 0.6336 =
0.9513 = V1 (T ), and the investor buys 1.7357 shares of stock for 1.7357 × 0.2928 = 0.5082 EUR and
puts the rest 0.9513 − 0.5082 = 0.4431 EUR into the bank. Similarly, at time point t = 2 the investor
fully replicates the option’s payoff, such that X2 (ω) = V2 (ω) for all ω.

Question 2 (10 points): Let’s build a stock price Sn (t) on the time interval [0, t] constructing a binomial model
for Sn (t) that takes n steps per unit of time. Assume that nt is an integer and the probability of the price going up on
each coin toss is p = 21 . Let the random variable Xj = 1 if on the jth coin toss the price goes up and Xj = −1 if on
the jth toss the price goes down. Consider the stochastic process
nt
X
Mnt = Xj , n ≥ 1 with M0 = 0 ,
j=1

where all Xj are independent. Assume that the price Sn (t) per every time step t evolves similarly to Question 1, i.e.,
it jumps n-times per unit of time with up-factor un = 1 + √σn and down-factor dn = 1 − √σn . Assume for simplicity
zero risk-free rate r = 0.

4
A. (5 points) Show that the evolution of the stock price Sn (t) in such model can be written as
1 1
(nt+Mnt ) (nt−Mnt )
Sn (t) = S(0)un2 dn2 .
Solution. By construction of Sn (t) we have
Sn (t) = S(0)uH nt Tnt
n dn .

with Hnt number of heads and Tnt number of tails. It is clear that
Mnt = Hnt − Tnt .
On the other hand,
nt = Hnt + Tnt .
Thus, we get
nt + Mnt
Hnt = ,
2
nt − Mnt
Tnt = .
2
The result follows immediately.

B. (5 points) It is known that in case the price Sn (t) jumps very often per unit of time t, i.e., n → ∞, the limit of Sn (t) is a
Geometric Brownian motion given by
1 2
lim Sn (t) = S(t) = S(0)eσW (t)− 2 σ t ,
n→∞

where W (t) stands for a standard Brownian motion. Show that S(t) is a martingale. What is the distribution
of S(t)? Hint: The moment generating function E(euY ) of some random variable Y ∼ N (0, σ 2 ) is given by
u2 σ 2
e 2 .
Solution. Suppose without loss of generality that S(0) = 1. For 0 ≤ s ≤ t we have

E(S(t)|Fs ) = E eσW (t)− 21 σ2 t |Fs = E eσ(W (t)−W (s)) eσW (s)− 12 σ2 t |Fs
   

eσW (s)− 2 σ t E eσ(W (t)−W (s)) |Fs

1 2
 
LIE
=

eσW (s)− 2 σ t E eσ(W (t)−W (s))

1 2
 
Ind.
=
M GF 1 2 1 2 1 2
= eσW (s)− 2 σ t e 2 σ (t−s)
= eσW (s)− 2 σ s
= S(s) .
Thus, S(t) is a martingale with respect to Brownian filtration Ft . Its distribution is obviously lognormal be-
cause it is an exponential taken from the normallly distributed random variable σW (t)− 21 σ 2 t ∼ N (− 21 σ 2 t, σ 2 t).

Question 3 (10 points): Let W (t), t ∈ [0, T ] be a standard Brownian motion and Ft its corresponding filtration.
A. (5 points) Consider a discounted sine function of W (t), namely X(t) = sin(W (t))et/2 . Using Itó-Döblin formula show
that Z T
sin(W (T )) = e−(T −t)/2 cos(W (t))dW (t).
0
Explain whether the process X(t) could be a martingale.
Solution. Applying Ito-Döblin to F (W (t), t) = sin(W (t))et/2 we get
1 t/2 1
dX(t) = e sin(W (t))dt + et/2 cos(W (t))dW (t) − et/2 sin(W (t)) (dW (t))2
2 2 | {z }
dt
t/2
= e cos(W (t))dW (t) .
In the integral form we get
ZT ZT
dX(t) = X(T ) − X(0) = et/2 cos(W (t))dW (t).
| {z }
0 =0 0

Noting that X(T ) = sin(W (T ))eT /2 and multiplying both sides of the above equality by e−T /2 gives us the
desired result. X(t) is a martingale because it is solely an Ito-integral, which is always a martingale (dt part
is missing).

5
B. (5 points) Using Itó-Döblin formula find now the integral representation for Z(t) = X 2 (t) − dX(t)dX(t) and conclude
whether Z(t) is a martingale.

Solution. First, it must be noted that the expression dX(t)dX(t) must be understood as a quadratic variation of the
process X(t) and not as (dX(t))2 . But it holds d(dX(t)dX(t)) = (dX(t))2 . Because this notation was not properly
defined/explained in the exam no points were subtracted.
Let’s use Ito-Döblin for X 2 (t) first. It holds

dX 2 (t) = 2X(t)dX(t) + (dX(t))2 .

Thus, we have

dZ(t) = dX 2 (t) − (dX(t))2 = 2X(t)dX(t) + (dX(t))2 − (dX(t))2

= 2X(t)dX(t) .

Thus, we get using 3A

dZ(t) = 2X(t)dX(t) = et sin(W (t)) cos(W (t))dW (t) .

Or, using integral form,

ZT
Z(T ) − Z(0) = 2 et sin(W (t)) cos(W (t))dW (t) .
| {z }
=0 0

And because the dt-part is missing, this process is an Ito-integral, thus, martingale.