FRE6083, Midterm Examination,

Monday, October 24 2022, 2pm-4:30pm

1. Number of pages including this one: 2

2. For this examination, you may use a 2-page cheat sheet (A4 format) and a calculator. No other
notes, books or electronic devices may be used. Cell phones may not be used. Any violation of
this policy will result in a grade of zero for this exam. You must justify your answers clearly
and rigorously.

Problem 1 (22 points)

We consider the Binomial tree model seen in class, with 3 periods (i.e. N = 3) and with the
parameters
r = 1/4, d = 1/2, u = 2,
where r is a simple interest rate, d and u respectively represent the down and up factors. Next,
consider a stock price with value S0 = 32 at time 0. We consider the price Vn of a put option, at
time n, with payoff
V3 = (64 − S3 )+ ,
at time 3.

1. (2 points) Specify the risk-neutral probability weights.

2. (8 points) Compute the price V0 of the put option at time 0.

3. (6 points) Give also the delta hedging strategies ∆0 , ∆1 , and ∆2 at the respective times n = 0, 1
and n = 2.

4. (6 points) Consider an agent who is short 20 put options. How many shares of underlying stock
does the agent hold in the hedging portfolio during the first time period? What is the agent’s
cash position at time 0? Does the agent invest in or borrow from the money market account
to finance the hedging strategy during the first time period?

Problem 2 (26 points) Consider the Markov chain X with matrix probability matrix
 
0 1/2 1/2 0
1/2 1/4 0 1/4
P =1/2

0 0 1/2
0 0 3/4 1/4

1. (4 points) Plot a diagram that represents this Markov Chain.

2. (4 points) Is this chain irreducible?

3. (10 points) Is it aperiodic? Justify your answer.

1
 4. (8 points) Is X ergodic? Justify your answer and compute the limit.

Problem 3 (16 points)

We consider the random walk seen in class
n
X
Xn = Yi , X0 = 0,
i=1

where Yi is defined as

1 with probability p
Yi = ,
−1 with probability q = 1 − p
with p ∈ (0, 1). We also assume that the random variables Yi are independent.
Next, we consider the process
Mn = (q/p)Xn .
Show that Mn is a martingale with respect to the process (Yi )i .

Problem 4 (36 points)

We consider the Poisson process {N (t), t ∈ [0, +∞)} with rate λ > 0, which represents the number
of insurance claims received by an insurance company. Next, we define the aggregate loss
N (t)
X
L(t) = Xi ,
i=1

where the variables Xi are independent and identically distributed with common mean µ and variance
σ 2 , and are also independent of N (t), for all t. Furthermore, the insurance company receives premium
income at the rate of α > 0 per year and starts with the initial reserve x > 0, at time 0.

1. (5 points) Write an expression for the surplus function R(x, t), in terms of x, α, t and L(t).

2. (5 points) Compute the expectation of R(x, t).

3. (8 points) Compute the variance of R(x, t).

4. (5 points) Use the total probability rule to write an expression for the probability of ruin at
time t, ie. P[R(x, t) < 0].

5. (13 points) We assume here that all the claim amounts Xi are equal to the same constant µ
(and we consequently have σ = 0). Compute the above probability in this case, i,.e, express
it as the Poisson cumulative distribution function at a specific point n0 that depends on x, α, t
and µ.