Edhec Business School

Foundations of Asset Pricing

R. Uppal Practice Questions

These practice questions have two parts. Part A consists of a large number of practice
questions that will help you improve your understanding of the material covered in class.
Part B of consists of a small number of more challenging questions that test your
understanding of the material; all the questions in Part B are from past final exams.
Note that these questions are provided only to give you the opportunity to practice the
material we have covered in class. Your answers to these questions do not have to be
submitted to me.

A Practice Questions
Q1. Market completeness

1.1 What do we mean when we say financial markets are complete?

1.2 In the real world, are financial markets complete or incomplete?

1.3 For valuing financial assets, is it reasonable to assume markets are complete?

1.4 When markets are complete, what method of valuation gives answers that are
close to the price of the security? Why?

1.5 When markets are not complete, how can we value securities?

Q2. Suppose that at date 0 you are asked to value a stream of fixed (risk-free) cashflows
for the next 10 years; that is, {C(1), C(2), . . . , C(10)}. You are also give the prices
of zero-coupon bonds for maturities 1 to 10 years; let us denote these prices as
{Z(0, 1), Z(0, 2), . . . , Z(0, 10)}.

2.1 What is the value at date 0 of receiving one unit of the cashflow in date t?
2.2 How would you value the stream of ten cashflows described above?

Q3. Consider a two date (single-period) binomial model where the current price of the
stock is S(0) and it can take only one of two possible values at T , Su and Sd . There
is a bond in this economy whose current price is R(0) = 1 and at T its price will
be R(T ) = er T in both the up and down state. Suppose we wish to value a put
option with strike price K in this model.

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 3.1 Write down the two equations that show how to determine the portfolio of
stock and bond that replicates the payoff to the put option.

3.2 From these two replicating equations, identify the state prices. Find the value
of the put option using these state prices. Show that the stock and bond price
can also be valued using the state prices.

3.3 Find the risk-neutral probabilities from the state prices. Find the value of the
put option in terms of the risk-neutral probabilities. Show that the stock can
also be valued using the risk-neutral probabilities.

3.4 Now, change the numeraire from cash to the underlying stock. Find the prob-
abilities that correspond to this numeraire. Find the value of the put option
and the bond in terms of this numeraire using martingale pricing.

Q4. Consider a two-date (one period) trinomial model, where the stock price at T can
take one of three values. One can also invest in a risk-free bond. We wish to value
a call option in this model.

4.1 Explain why one cannot value the call option if the stock can take one of three
values at T .

4.2 Explain how you could change the model so that even if the stock can take
one of three values at T it is still possible to value the option. That is, what
would you have to allow an investor to do so that it becomes possible to
hedge/replicate this option exactly, and hence, value it using our standard
arguments. This is an important question, so please give it serious thought
before looking at the solution.

Q5. We wish to value an option in a model where at T the stock can take a continuum
of values. In addition to the stock, there is also available a bond with a risk-free
rate that is constant between date 0 and T .

5.1 Suppose that there are also a continuum of state-securities (corresponding to

each of the states) that are available. In this case, how would you find the
value of the option?

5.2 Now suppose that only the stock and bond are available for trading, and
state-securities are not available. Is it possible to find the value of the option?
If not, what additional assumption do you need to make so that it becomes
possible to value the option using our standard approach. Think carefully
this is the principal insight of the Black-Scholes-Merton model.

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Q6. One of the simplest Ito processes is the arithmetic Brownian motion:

dX = dt + dB,

where B is a Brownian motion under the actual probability measure, and and
are constants.

6.1 Show that the solution to the above stochastic differential equation is

X(t) = X(0) + t + B(t).

6.2 Show that X(t) has a Normal distribution with mean X(0) + t and variance
equal to 2 t.
6.3 What happens to the variance of X(t) as time goes to infinity?
6.4 Is this a good process to use for modeling stock prices? Explain your answer.

Q7. (From Hull) A companys cash position, measured in millions of dollars, follows an
arithmetic Brownian motion with = 0.10 per month and 2 = 0.16 per month.
The initial cash position is 2 million.

7.1 What is the probability distributions of the cash position after 6 months?
7.2 What is the probability of a negative cash position after 6 months?

Q8. Let dX = dt + dB. Consider a function Y = f (X). Using Itos formula,

compute dY for the following functions:

8.1 Y = X , where is a constant.

8.2 Y = log (X).
8.3 Y = exp (X).

Q9. We studied in class the geometric Brownian motion, which is the process used in
the Black-Scholes model:

dX = X dt + X dB, where and are constants,

and where B is a Brownian motion under the physical (actual) probability measure.

9.1 Show that the solution to the above equation is

 
1 2
X(t) = X(0) exp t t + B(t) .
2

9.2 Show that now it is
log X(t) that follows a Normal distribution with mean
log X(0) + 12 2 t and variance 2 t.

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 9.3 What happens to the variance of log X(t) as time goes to infinity?
9.4 Is this a good process to use to model stock prices? Why?

Q10. (From Hull) A stock price follows a geometric Brownian motion process with current
price 50. Assume that = 16% p.a. and = 30% p.a.

10.1 What is the probability distribution for the log of the stock price in two years?
What are the mean and standard deviation of the log of the stock price in two
years.
10.2 Determine the 95% confidence interval for the stock price in two years.

Q11. Suppose that a stock price S, follows a geometric Brownian motion:

dS = S dt + S dB, where and are constants,

and where B is a Brownian motion under the actual probability measure. Consider
a function Y = f (S). Compute dY for the following functions, and explain if the
process for Y is a geometric Brownian motion (which means that it has a constant
mean and a constant volatility):

11.1 Y = S , where is a constant.

11.2 Y = log (S).
11.3 Y = exp (S).

Q12. (From Hull) Find the value of a three-month at-the-money European call option
on a stock index, when the index is at 250, the continuously-compounded risk-free
interest rate is 10% p.a., the volatility of the index is 18% p.a., and the dividend
yield on the index is 3% p.a.

Q13. (From Hull) Find the value of an eight-month European put option on currency
with a strike price HC 0.50/FC. The current exchange rate is HC 0.52/FC, the
volatility of the exchange rate is 12% p.a., the domestic risk-free interest rate is 4%
p.a., and the foreign risk-free interest rate is 8% p.a.

Q14. Consider a 3-month put option on a non-dividend paying stock when the stock
price is $60, the strike price is $60, the continuously-compounded risk-free interest
rate is 10% p.a., and the volatility is 45% p.a.

14.1 Determine the parameters of the binomial model if the time interval between
each rebalancing date is one month.
14.2 Use a binomial tree with a time interval of one month to find the value of the
put option if it is a European option.

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 14.3 Use a binomial tree with a time interval of one month to find the value of the
put option if it is an American option (that is, you can choose to exercise it
before the maturity date). At which date is it optimal to exercise the option?
14.4 What is the early-exercise premium? That is, how valuable is the choice to
exercise early?

Q15. Suppose you wish to use Monte Carlo methods to value an option.

15.1 Explain how you would simulate a geometric Brownian stock price process.

15.2 Explain how you would use the simulated stock price process to find the ex-
pected (average) payoff to a call option.

15.3 Explain how you would find the value of the call option.

15.4 Now consider a non-dividend paying stock whose current price is $50 and
volatility is 30% per annum. Let the continuously-compounded risk-free in-
terest rate be 10% p.a. Use Monte Carlo methods with 100,000 draws to
calculate the price of a three-month European call option on this stock if the
strike price is $50. (The Black-Scholes model price of this option is $3.61045.)

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B Questions to Test Your Understanding
Q1. Suppose that you are the treasurer of a Japanese firm Aiwa. You have decided to
raise new financing for your firm in the eurodollar bond market by issuing one-year
discount bonds. The face value of each bond you issue is USD1000 and the bond
gives an effective return of 5% at the end of the year; that is, erU SD = 1.05. The
current exchange rate is JPY 200/USD and the yen bond gives an effective return
of 1% at the end of the year; that is, erJP Y = 1.01. At maturity, the principal
amount of the bonds may be redeemed, at the owners option, for dollars or for yen
at an exchange rate of JPY 200/USD. Assume that one year from now the spot
rate can be either JPY 225/USD or JPY175/USD; these are the only two values of
the future exchange rate that you need to consider (that is, a binomial setting).
1.1 Explain how to decompose the security Aiwa is issuing into simpler financial
contracts.
1.2 Find the value today of the security Aiwa is issuing using the risk-neutral
valuation approach.
1.3 Find the value today of the security Aiwa is issuing using the replication
approach.
1.4 You, the treasurer of Aiwa, wish to be fully hedged against changes in the
spot exchange rate. That is, you wish to know exactly how many dollars you
will need at the end of the year to pay off the buyer of the bond-option. What
is your exposure to USD after issuing each of these bonds. How can you
hedge your position using forward contracts?
Q2. A stock price is currently $40. At the end of the month it will either be $42 or $38.
The risk-free rate is 8% p.a. with continuous compounding.
2.1 What are the risk-neutral probabilities in this model?
2.2 What are the state prices (prices of Arrow-Debreu securities) in this model?
2.3 Suppose the numeraire is the stock instead of the bond. What are the proba-
bilities that correspond to this numeraire?
2.4 What is the value of a one-month European call option with strike price $40?
2.5 What is the value of a one-month European put option with strike price $40?
2.6 Verify that the call and put prices satisfy the put-call parity relation.
2.7 What is the value of a one-month option that pays out log Su in the up state
and log Sd in the down state?
2.8 What is the value of a one-month option that pays out the square of the stock
price at maturity; that is, Su2 in the up state and Sd2 in the down state?
Q3. Find the differential equation that a contract must satisfy if the payoff to the con-
tract depends on the prices of two non-dividend paying traded securities. Assume
that the price of each of the underlying securities follows a geometric Brownian
motion and that the correlation between the Brownian motions for the two prices
has a correlation of .