Advanced Financial Models Michael Tehranchi

Example sheet 4 - Michaelmas 2014

Problem 1. (implied volatility) Consider a market model with zero interest rate r = 0 and
non-negative stock price (St )t≥0 . Suppose the initial call prices are given by
C(T, K) = EQ [(ST − K)+ ]
where Q is an equivalent measure such that S is a Q- martingale.
The implied total variance V (T, K) is defined implicitly as the unique non-negative solu-
tion of the equation
BS(V (T, K), K/S0 ) = C(T, K)/S0
where
√ √ √ √
BS(v, m) = Φ(− log m/ v + v/2) − mΦ(− log m/ v − v/2).
p
The implied volatility is then defined by Σ(T, K) = V (T, K)/T .
(a) Show for fixed T > 0 the following inequality (due to Roger Lee in 2003)
V (T, K)
lim sup ≤ 2.
K→∞ log K
Is the constant 2 on the right side best possible?
2
Useful fact: ex /2 Φ(−x) → 0 as x → +∞.
(b) Challenge: Assume that C(T, K) → S0 as T → ∞ for all K. Show for fixed 0 < K1 < K2
the following inequality (due to Chris Rogers and me in 2009)
|V (T, K2 ) − V (T, K1 )|
lim sup ≤ 4.
T →∞ log(K2 /K1 )
Is the constant 4 on the right side best possible?
2
Useful fact: xex /2 Φ(−x) → √12π as x → +∞.

Problem 2. (more implied volatility) Now suppose the stock price dynamics are
dSt = St σt dWt
where σ is independent of the Q-Brownian motion W .
(a) Show that there is a family of measures µT on [0, ∞) such that
Z
C(T, K) = S0 BS(v, K/S0 )µT (dv).

(b) If there are constants a ≤ b such that a ≤ σt ≤ b a.s., show that the implied volatility
satisfies
a ≤ Σ(T, K) ≤ b.
(c) Show the equality Σ(T, K) = Σ(T, S02 /K), i.e. the function x 7→ Σ(T, S0 ex ) is even. Hint:
First prove the identity
BS(v, m) = 1 − m + mBS(v, 1/m).
1
Problem 3. (local volatility) Suppose that
dSt = St σ(t, St )dWt
for a smooth function σ bounded from below and above. Also, suppose that
E[(ST − K)+ ] = S0 BS(V (T ), K/S0 )

p all T, K where T 7→ V (T ) is a given smooth increasing function. Show that σ(t, S) =

for
V 0 (t) for all t, S.
Problem 4. (CEV model) Let the local martingale S satisfy the equation
1−α/2
dSt = cSt dWt
√
for some 0 < α < 2, where c = 2/α.
(a) Let
Z S α /τ
1 1
U (τ, S) = 1

z α −1 e−z dz
Γ α 0
where Γ is the usual gamma function. For fixed T > 0, show that the process defined by
U (T − t, St ) is a local martingale. Why is it a true martingale?
(b) Use part (a) to conclude that P(ST > 0) = U (T, S0 ).
Problem 5. (Forward measure) Let (rt )t≥0 be a continuous and suitably integrable process,
and suppose Rτ
P (t, τ ) = EQ (e− t rs ds |Ft )
for all τ ≥ t. For fixed T > 0, define a measure QT on (Ω, FT ) by
RT
dQT e− 0 rs ds
= .
dQ P0 (T )
(a) Show that for all τ > 0, the process (P (t, τ )/P (t, T ))t∈[0,τ ∧T ] is a martingale for QT .
(b) Show that the forward rate (f (t, T ))t∈[0,T ] is a martingale for QT .
(c) Show that there is no arbitrage if the European claim with maturity T and bounded
payout ξT has time-t price
ξt = P (t, T ) EQT (ξT |Ft ).
Problem 6. (Vasicek model) Suppose
drt = λ(r̄ − rt )dt + σdWt
where W is a Q-Brownian motion. Fix a time horizon S > 0 and let QS be the S-forward
measure.
(a) Using the fact that the forward rate (f (t, S))t∈[0,S] is a QS -martingale, show that the
process W S defined by
σ
dWtS = dWt + (1 − e−λ(S−t) )dt
λ
is a QS -Brownian motion.
(b) Show that the minimal replication cost of a European call option maturing at time S
with strike K, written on a zero-coupon bond with maturity T > S is given by the formula
 2 
σ −λ(T −S) 2 −2λS KP (0, S)
P (0, T ) BS (1 − e ) (1 − e ), .
2λ3 P (0, T )
2
Hint: Use part (c) of the previous problem.
Problem 7. (Hull–White extension of Cox–Ingersoll–Ross) Consider the short rate model
given by √
drt = λ(r̄(t) − rt ) dt + σ rt dWt
for positive constants λ and σ and a deterministic function r̄ : R+ → R. Find the initial
forward rate curve f0 = f (0, ·) for this model.
Problem 8. (a) Let X1 , X2 , . . . be a sequence of non-negative random variables such that
E(Xn ) = 1 for all n. Use the Borel–Cantelli lemma to show
lim sup Xn1/n ≤ 1 a.s.
n→∞

(b) If y(t, T ) is the yield of a bond maturing at time T , the long rate is defined as `t =
limT →∞ y(t, T ) whenever the limit exists. Assuming that the bonds are priced by expectation,
show that the long rate is non-decreasing, that is
`t ≥ `s a.s. for all 0 ≤ s ≤ t,
a fact first discovered by Dybvig, Ingersoll & Ross in 1996.
Problem 9. (strictly local martingales) (a) Suppose that X is positive martingale with
X0 = 1. Fix T > 0 and let
dQ
= XT .
dP
Let Yt = 1/Xt for all t ≥ 0. Show that (Yt )0≤t≤T is a positive martingale under Q.
(b) Continuing from part (a), now suppose that X has dynamics
dXt = Xt σt dWt
where W is a Brownian motion under P. Show that there exists a Q-Brownian motion Ŵ
such that
dYt = Yt σt dŴt
(c) Let X be a positive local martingale with X0 = 1 and dynamics
dXt = Xt2 dWt .
Our goal is to show that X is a strictly local martingale. For the sake of finding a contra-
diction, suppose X is a true martingale. In the notation of parts (a) and (b), show that
P(Yt > 0) = 1 but Q(Yt > 0) = Φ(t−1/2 ).
Why does this contradict the assumption that X is a true martingale?