Advanced Financial Models Michael Tehranchi

Example sheet 1 - Michaelmas 2014

Problem 1. Consider a two-asset model with prices given by

(P 1 , P 2 ) (3, 9)
w;
ww
1/4
w
ww
ww
(4, 6) / (6, 8)
GG 1/4
GG
GG
1/2 GG#
(6, 4)
Is there arbitrage in this market? If not, find all martingale deflators.
Problem 2. Consider the one-asset model with price process Pt = 1{t<τ } where τ is a
random variable taking values in {1, 2, . . .}.
(a) Suppose that there is a non-random time T > 0 such that τ ≤ T almost surely. Show
that there is an arbitrage.
(b) Suppose P(τ = k) = (1 − p)k−1 p for a constant 0 < p < 1, so τ has the geometric
distribution. Show that there is no arbitrage. Can you find a martingale deflator?
Problem 3. Consider a three-asset model with asset 1 cash so that P01 = P11 = 1 and assets
2 and 3 given by
(P 2 , P 3 ) (9, 8)
;
ww
ww
1/3
ww
ww
(6, 7)
GG
GG
GG
2/3 GG#
(3, 5)
Is there arbitrage in this market? If not, find all equivalent martingale measures with respect
to the cash numéraire.
Problem 4. Let (Ω, F, P) be a probability space, and let W be a random vector with the
d-dimensional normal Nd (0, I) distribution, where I is the d × d identity matrix. Fix a
constant vector α ∈ Rd and define an equivalent measure Q on (Ω, F) by the density
dQ 2
= eα·W −|α| /2 .
dP
Prove that the random variable Ŵ = W − α has the Nd (0, I) distribution under Q.
Problem 5. Consider a d+1 asset model P = (1, S), where the first asset is cash while assets
2, . . . , d + 1 have time-0 price S0 ∈ Rd and time-1 prices S1 with the Nd (µ, V ) distribution,
where µ ∈ Rd and V is a positive semi-definite d × d matrix. Find necessary and sufficient
conditions on the data S0 , µ and V such that there is no arbitrage. When there is no
arbitrage, use the previous problem to find a martingale deflator.
1
Problem 6. (Stiemke’s theorem) Let A be a m × n matrix. Prove that exactly one of the
following statements is true:
• There exists an x ∈ Rn with xi > 0 for all i = 1, . . . , n such that Ax = 0.
• There exists a y ∈ Rm with (AT y)i ≥ 0 for all i = 1, . . . , n such that AT y 6= 0.
What does this have to do with finance?
Problem 7. Consider a discrete time model with n asset with prices (Pt )t≥0 and dividends
(δt )t≥1 . Explain why an appropriate self-financing condition is
Ht · (Pt + δt ) = Ht+1 · Pt + ct .
Let Z be a positive process such that the process
t
!
X
Zt Pt + Zs δs
s=1 t≥0

is a martingale. Show that there is no arbitrage in this market.

Problem 8. Consider a discrete time model with a asset with positive prices (Pt )t≥0 and
non-negative dividends (δt )t≥1 . Show that there is
 a self-financing trading strategy with cor-
Qt δs
responding wealth process Qt = Pt s=1 1 + Ps . What is the financial significance of this
process? Let Z be a positive adapted process. Show that the process Zt Pt + ts=1 Zs δs t≥0
P

is a martingale if and only if (Zt Qt )t≥0 is.

Problem 9. In discrete-time models, an asset is called risk-free iff its price process is pre-
dictable. Suppose that asset 1 and asset 2 are risk-free, that the market with prices (P 1 , P 2 )
has no arbitrage, and that P01 = P02 . Show that Pt1 = Pt2 a.s. for all t ≥ 0.
Problem 10. A bond1 is an asset that pays a fixed amount (the principal) at a fixed future
time (the maturity date). Suppose that assets 1, . . . , n are bonds, each of principal amount
£1, where asset i matures at time i. Show that if there is no arbitrage in the market, then
each bond is a numéraire asset. Let H be the investment strategy of holding bond t during
the interval (t − 1, t]. Show that the corresponding wealth process (called the money-market
account) is risk-free.
Problem 11. Let X and Y be martingales (with respect to the same filtration). Show that
if XT = YT almost surely for some non-random T > 0, then Xt = Yt almost surely for all
0 ≤ t ≤ T.
Problem 12. (Bayes’s formula) Let P and Q be equivalent probability measures defined on
(Ω, F) with density Z = dQ
dP
. Let G ⊆ F be a sigma-field. Prove the identity:
EP (ZX|G)
EQ (X|G) =
EP (Z|G)
for each bounded random variable X.
1Many real world bonds pay the bondholder a fixed amount on a regular basis, every three months for
instance, before the maturity date. These payments are called ‘coupons.’ The bonds we are now considering
here are actually zero-coupon bonds.
2
Problem 13. Consider a single period market with two assets. The first asset is a riskless
bond with prices B0 = 1 and B1 = 1 + r for a constant r. The second asset is a stock with
prices (St )t∈{0,1} .
Let (φ∗ , π ∗ ) be the optimal solution to the problem
maximise EU (φB1 + πS1 ) subject to φB0 + πS0 = x
for a given concave increasing utility function U . Prove that the investor is holds a non-
negative number of shares of the stock if
E S1 > (1 + r)S0
Does this agree with your intuition?
Problem 14. (Tower property of conditional expectation) Let X and Y be identically
distributed random variables taking values in the set {2n : n ≥ 0} such that X/Y ∈ {1/2, 2}
almost surely and
1
P(X = 2n , Y = 2n+1 ) = 2−n = P(X = 2n+1 , Y = 2n ) for n ≥ 0.
4
1
(a) Show that P(X = 1) = 4 and
3
P(X = 2n ) = 2−n for n ≥ 1.
4
(b) Show that P(Y = 2|X = 1) = 1 and
1
P(Y = 2n+1 |X = 2n ) = = 1 − P(Y = 2n−1 |X = 2n ) for n ≥ 1.
3
(c) Let Z = Y − X. Show that E(Z|X = 1) = 1 and
E(Z|X = 2n ) = 0 for n ≥ 1.
(d) From part (c) we have E(Z|X) = 1{X=1} and hence
1
E(Z) = E[E(Z|X)] = > 0.
4
However, by symmetry we also have E(Z|Y ) = −1{Y =1} and
1
E(Z) = E[E(Z|Y )] = − < 0.
4
What has gone wrong?!