Mathematical Finance - Exam question examples

The exam will consist for 40% of 10 multiple choice questions, resulting in 4 points
per mc question if the answer is correct and adequately explained. Three or Four
open questions determine the other 60% of your grade, where the division of the
points over the questions is given in the headers of the question.
The formula sheet, as published at Canvas before the exam, is available in printed
form.
You are only allowed to use a (clean graphical) calculator. The use of anything else,
like the book of Hull or self-prepared formula sheets is prohibited.
In case you are asked to perform a calculation, you should provide the formulas you
used. Only the numerical result will not suffice.
Note on the sample exam questions below: they are representative for the level and
type of questions, but NOT for the size of the exam nor the coverage of all topics -
an overview of study material is given in the sheets.

Multiple Choice Questions

Question 1
The following is true w.r.t. the Risk Neutral (RN) probabilites in a binomial tree
for option pricing:
A) The RN probability of an up-move should always exceed the RN probability
of a down-move.
B) If the average of the stock values in the two end-nodes equals the stock value
in the initial node, the RN probability of the up-move should exceed the RN
probability of the down-move.

C) If the average of the stock values in the two end-nodes equals the stock value
in the initial node, the RN probability of the up-move should exceed the RN
probability of the down-move in case the risk-free rate is positive.
D) If the average of the stock values in the two end-nodes equals the stock value
in the initial node, the RN probability of the up-move should exceed the RN
probability of the down-move in case the risk-free rate is negative.
E) None of the above.

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Question 2
Within the exotic options, you have the class of barrier options. Barrier options
come in knock-in and knock-out variety and have a payoff like a put or a call.
Suppose that p, pui , puo are the prices of the standard put, the up-and-in put and
the up-and-out put respectively. Assume the barrier H is above the initial stock
price. Consider the following statements:
I: p = pui + puo .
II: pui > puo since H is above the initial stock price.

A) I and II are both correct

B) Only I is correct
C) Only II is correct
D) Both are incorrect

Question 3
Regarding the concepts of a stochastic process, the Generalized Wiener (GW) pro-
cess and the Geometric Brownian Motion (GBM), the following is true:
A) Every GW is a GBM
B) Every GBM is a GW
C) The two classes are nearly disjoint
D) None of the other options are true

Question 4
If you run an option book, the Greeks are important. Consider the following state-
ments regarding the Γ and Θ of two at-the-money call options X and Y , with
maturity TX = 1 and TY = 5 respectively (in years). The risk-free rate is 0.5%.
I: ΓX > ΓY > 0
II: 0 > ΘY > ΘX .

A) I and II are both correct

B) Only I is correct
C) Only II is correct
D) Both are incorrect

Question 5
There are several well-known numerical procedures that can be used for option
pricing. Which of the following methods is most straightforward to value Look-
back options? [don’t forget a brief explanation why the other methods are less
straightforward].
A) Binomial tree method
B) Monte Carlo method
C) Finite difference method

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Question 6
Consider the following statements about the market price of risk of two derivatives F
and G on the same underlying variable θ that follows the process dθ = mθdt + sθdz.
Suppose that the derivative price processes f and g for respectively F and G satisfy
df = µf f dt + σf f dz and dg = µg gdt + σg gdz.
I: the derivatives F and G must have the same market price of risk, i.e., (µf −r)/σf =
(µg − r)/σg .
II: the process f /g follows a martingale
A) I and II are both correct
B) Only I is correct
C) Only II is correct
D) Both are incorrect

Question 7
Vasicek’s model for the short rate process r under risk-neutral (RN) probabilities
is given by dr = a(b − r)dt + σdz with a, b, σ constants. The Rendleman-Bartter
model, on the other hand, postulates a Geometric Brownian Motion for the RN
short rate process. Choose the best statement:
A) Vasicek’s model cannot model humped yield curves (first up, then down) due
to the mean-reversion effect.
B) The Rendleman-Bartter model always has drift rate r in the GBM, analogous
to the RN model for share prices in the standard Black-Scholes model.
C) The reason that the Rendleman-Bartter model is much more popular than
Vasicek’s nowadays, is that it excludes negative interest rates.
D) The reason that Vasicek’s model is much more popular than Rendleman-
Bartter’s nowadays is that Vasicek’s model incorporates mean-reversion.

Question 8,9,10
The exam will have 10 mc questions, but this sample exam only has 7.

Open Questions
Open Question 1 (x points)
The Black-Scholes model uses the geometric Brownian motion as model for the
stock price proces S, given by the stochastic differential equation
dS(t) = µS(t)dt + σS(t)dz(t) (1)
Its forward price at time t is defined as F (S, t) := S(t)er(T −t) with r the (continu-
ously compounded, constant) risk-free rate.
a) Determine the stochastic differential equation for the forward price process F ,
on the basis of Itô’s lemma.
b) For which value of µ is F a martingale?
c) For which value of µ is S forward risk neutral with respect to the money
market account as numeraire?

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Open Question 2 (y points)
Consider a non-dividend paying share S that is trading at S(0) = 100 and has
historical volatility σ = 0.4. The continuously compounded interest rate is 3%.

a) Determine the Black-Scholes price of the European at-the-money call and put
with maturity 2 years and underlying share S.
b) Show how put-call parity follows from the Black-Scholes formulas in general.
Also check the parity for the call and put prices determined in the previous
part.

Suppose the implied volatility induced by the market quotes of the at-the-money
European options is also 0.4. You use this value of σ also to determine the Black-
Scholes prices of two other options, on the same underlying S, with the same ma-
turity of 2 years: a European call with strike 120, and a European put with strike
80.
c) Based on the common pattern for the volatility smile of put-and call options
for equity, do you expect the actual market prices for these options to be above
or below these values? Answer separately for the 120-call and the 80-put.
Suppose that actually there are also American versions of the options above in the
market. You use binomial trees to price these options.
d) Explain the essence of adapting the binomial tree approach for European
options for American options, in a few words, without formulas.
e) Comment on the statement that put-call parity still must hold for American
options, in those nodes of the tree where early exercise is not optimal.

Open Question(s) (z points)

This sample exam has two open questions, the actual exam will have one or two
more.