HONMD23/101/0/2012

Tutorial letter 101/0/2012

Introduction to the mathematical
modelling of derivative instruments II
(HONMD23)
Department of Decision Sciences
Departement Besluitkunde
Lefapha la Disaense tsa Tshweetso
This tutorial letter contains important
information about your module
HONMD23/0/101
Contents
1 INTRODUCTION AND WELCOME 3
1.1 Tutorial matter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Language policy in this module . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2 PURPOSE AND OUTCOMES OF THIS MODULE 3
2.1 Purpose of the module . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 Outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3 LECTURER AND CONTACT DETAILS 5
3.1 Lecturer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
3.2 Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
3.3 College . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
3.4 University . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4 MODULE RELATED RESOURCES 6
4.1 Prescribed book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.2 Recommended books . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.3 Electronic Reserves (e-Reserves) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
4.4 Study guides . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
4.5 Computer software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
5 STUDENT SUPPORT SERVICES 7
6 MODULE SPECIFIC STUDY PLAN 7
7 MODULE PRACTICAL WORK AND WORK INTEGRATED LEARNING 9
8 ASSESSMENTS 9
8.1 Assessment plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
8.2 Assignment due dates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
8.3 Assignment enquiries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
9 ASSIGNMENTS 11
9.1 Assignment 01 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
9.2 Assignment 02 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
9.3 Assignment 03 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
10 EXAMINATION 19
11 OTHER ASSESSMENT METHODS 19
12 FREQUENTLY ASKED QUESTIONS 19
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HONMD23/0/101
1 INTRODUCTION AND WELCOME
Dear student
Welcome to the Department of Decision Sciences and the module, HONMD23. We hope that you will nd
this module interesting and that you will complete it successfully.
It is essential that you read this Tutorial Letter 101, as well as Tutorial Let-
ter 301, very carefully. Tutorial Letter 101 contains important information on
this module. Tutorial Letter 301 contains general information relevant to all
undergraduate students in the Department of Decision Sciences.
1.1 Tutorial matter
In this course the delivery of study material will be mainly via the Internet. This is the last tutorial letter
which you will receive by mail specically for this module, except for the general tutorial letters for all
Honours students in the Department of Decision Sciences and general correspondence from the University.
You will be able to access all tutorial letters, announcements and additional study materials via myUnisa
from http://my.unisa.ac.za.
1.2 Language policy in this module
For 2012, this tutorial letter will be placed on myUnisa in Afrikaans as well as English but will be printed
in English only. Please contact the lecturer(s) if you would like to receive a printed copy in Afrikaans by
postal mail. Apart from myUnisa, you might be able to nd a copy of this tutorial letter on the public
Internet by searching for the term HONMD23/0/101.
You are welcome to write your assignments as well as your answers in the examination in any ocial
language of the Republic of South Africa. Wherever practical, the lecturer(s) will give feed-back in your
language of choice but for practical reasons it is possible that you will receive feedback in English. If this
is not acceptable, please let your lecturer(s) know.
2 PURPOSE AND OUTCOMES OF THIS MODULE
2.1 Purpose of the module
In this module we cover a comprehensive and rigorous discussion of (derivative) asset pricing theory. The
pricing theory is based on probability theory and the application of arbitrage arguments. We handle both
discrete- and continuous-time pricing of options and therefore need to discuss stochastic processes,
measures, ltrations and martingales in the frameworks of discrete and continuous probability.
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The discussion leads to the derivation of the famous Black-Scholes formula and its use in practice. After
this we study optimal stopping times and American options. The aim of this module is to give a rigorous
introduction to the very important eld of quantitative nance and nancial modelling.
2.2 Outcomes
Learning outcome 1. Demonstrate an understanding of the concepts of probability measures,
ltrations and martingales within the discrete and continuous framework.
Assessment criteria
1. Dene and give examples of key concepts: -algebra, ltration, probability measure, conditional
expectation, martingales, equivalent probability measures, stopping times . . .
2. Prove dierent properties of conditional expectation and martingales
Learning outcome 2 Construct and apply the Cox-Ross-Rubinstein model
Assessment criteria
1. Construct binomial tree models to value options and determine the associated risk neutral
probability measures
2. Calculate the price of various European options in a binomial tree model
3. Construct a replicating portfolio in a binomial tree model
4. Perform calculations with the Black-Scholes call option price formula and be able to prove various
steps in the derivation of the Black-Scholes call option price formulae using martingale properties
5. Demonstrate an understanding of the concept of optimal stopping times apply it to price American
options.
Learning Outcome 3. Demonstrate and understanding of the concepts of Stochastic integral and
stochastic dierential equation and apply these to derive Black-Scholes option pricing formula.
Assessment criteria
1. Discuss Brownian motion with drift and Geometric Brownian motion
2. Explain the basic concepts and the construction of the Ito integral
3. Solve problems involving stochastic integration and elementary stochastic analysis
4. Explain and apply elementary Ito calculus
5. Evaluate basic Ito integrals.
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6. Construct pay-o functions for various nancial derivatives
7. Apply Itos lemma and perform calculations with the lognormal probability density function
8. Apply the Black-Scholes partial dierential equation for option valuation and construct the
corresponding delta hedging portfolio
9. Apply the Black-Scholes formulae for European call options
10. Construct solutions in the form of an integral to the diusion equation and to transform the
Black-Scholes partial dierential equation into a diusion equation
11. Perform calculations and analysis of the solution in the form of an integral of the Black Scholes
partial dierential equation
12. Value and analyze exotic options such as compound options, barrier options, Asian options,
lookback options, Russian option and more general path-dependent options.
3 LECTURER AND CONTACT DETAILS
3.1 Lecturer
You will nd the name of the lecturer responsible for this module in Tutorial Letter 301. We suggest that
you write the name and contact details of the lecturer in the space below.
Lecturer:
The lecturer will assist you with any problems you may experience with the contents of the study
material. Feel free to contact the lecturer, but please phone beforehand to make an appointment if you
wish to see the lecturer in person.
3.2 Department
Department Decision Sciences
Tel: 012 429 4012
Fax: 012 429 4898
E-mail: qm@unisa.ac.za
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3.3 College
College of Economic and Management Sciences
Tel: 012 429 3925
E-mail: CEMSenquiries@unisa.ac.za
The Department of Decision Sciences is located in Unisas College of Economic and Management Sciences
(CEMS).
3.4 University
If you need to contact Unisa about any administrative matters, please send an e-mail to info@unisa.ac.za.
Quote your student number whenever you communicate with Unisa.
4 MODULE RELATED RESOURCES
4.1 Prescribed book
The following free lecture notes has been prescribed for this module.
Bass, R. F. 2003.
The basics of Financial Mathematics
available on: http://www.math.uconn.edu/
~
bass/finlmath.pdf
Other lecture notes prepared by the lecturers involved in this module will be made available on myUnisa
and you will be notied by myUnisa announcement.
4.2 Recommended books
The following books are recommended (but not prescribed):
Introduction to the Mathematics of Finance, 2004, by Steven Roman. Springer-Verlag. ISBN
0-387-21364-3 (soft cover); ISBN 0-387-21375-9 (hard cover). The book is no longer in print, but
there may be copies in libraries and book stores and you can also contact Springer directly.
Investment Science, 1998, by David G Luenberger. Oxford University Press.
Introduction to Mathematical Finance: Discrete Time Models, 1999, by Stanley R Pliska. Blackwell
Publishers.
Measure, Integral and Probability, 2nd ed., 2004, by Marek Capinski and Ekkehard Kopp.
Springer-Verlag, London.
A course in Financial Calculus, 2002, by Alison Etheridge. Cambridge University Press.
Arbitrage Theory in Continuous Time, 2006, by Tomas Bjork.
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Stochastic Calculus for Finance I, 2005, by Steven E Shreve.
Stochastic Calculus for Finance II, 2008, by Steven E Shreve.
Options, Futures and other Derivatives, 2003 (or any recent edition), by John C. Hull
Introduction to probability models, 2003 (or any other recent edition), by Sheldom M. Ross
On the Internet there are numerous websites that contain notes on mathematical nance, tutorials,
and problems with solutions.
4.3 Electronic Reserves (e-Reserves)
There are no e-Reserves for this module.
4.4 Study guides
There are no formal study guides for this module.
4.5 Computer software
No computer software is required for this module.
5 STUDENT SUPPORT SERVICES
See the My Studies @ Unisa brochure for student support services rendered.
6 MODULE SPECIFIC STUDY PLAN
We suggest that you approach the study material as follows:
Start with Bass, section 1. Basic denitions and properties of options can be found in the book by
Hull (Options, Futures and other derivatives). You probably have the book since it is prescribed in
other modules in our Department. Review chapter 1 of Hull. It is important to understand the
probabilistic nature of options and other derivatives in general.
After this, study Bass, sections 2 and 3. These are some elementary notions of probability. To
reinforce your understanding of probability which is critical for this module, we recommend that you
also read Ross (Introduction to Probability models), chapters 1 and 2. You should nd most of this
material relatively easy.
Now, study the notion of conditional expectation, one of the key concept of this module. Study
Bass, section 3 and our lecture notes (You will the notes on myUnisa), sections 1 and 2. It is very
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important that you understand the denition and properties of conditional expectation. Some
complementary information can be found in Ross, chapter 3, sections 3.1 to 3.5.
You are now prepared to study the notion of martingale. You will see that this module is all about
martingale in nance. Study Bass, sections 4 and 5 in parallel with our lecture notes, section 3.
At this point we study the binomial asset pricing model. Preparatory material can be found in Hull,
chapter 10 (Introduction to Binomial trees) and it is recommended. Now, study Bass, sections 6 and
7 in parallel with lecture notes, section 5. Note that in Hull, the discount factor is taken to be e
rT
but in Bass, it is taken to be (1 +r)
T
(where r is the interest rate and T is a given period of time).
Study Bass, section 8 and Hull, chapter 10, section 5 (American options). I also recommend, Hull,
chapter 18, section 1. (Numerical procedures, Binomial trees).
You are now ready to do Assignment 01 successfully.
After submitting Assignment 01, read Bass, section 9 in parallel with our lecture notes, section 7, 8
and 9.
Study Bass, sections 11 and 12 in parallel with the corresponding sections in our lecture notes. The
notion of stochastic integral is very important. The denition and properties must be very well
mastered.
Study Bass, section 13 (Itos formula) and the corresponding section in our lecture notes. If you
have problems with some calculus notions used in this module, we recommend that you read your
rst or second year calculus materials or any book on elementary calculus.
Study Bass, section 15 (Stochastic dierential equations) in parallel with the corresponding section
in our lecture notes and do the exercises (given in the lecture notes).
Study Bass, section 14 (The Girsanov theorem) in parallel with the corresponding section in our
lecture notes.
Study Bass, sections 16 and 17 and corresponding sections in our lecture notes. We also recommend
Hull, chapter 11 (Model of the behavior of stock prices).
You can now do Assignment 02.
After submitting Assignment 02, study Bass, sections 18, 19 and 20 and the corresponding sections
in our lecture notes. Understand the examples and their solutions.
Study Bass, section 21 and 22 in parallel with corresponding sections in our lecture notes.
understand the examples and do the exercises. Here we also recommend to read Hull, chapter 12
(The Black-Scholes model)
Study Bass, section 23, 24, 25 and 26 and corresponding section in our .
We recommend that you read Hull, chapter 19 (Exotic options).
You should now be able to do Assignment 03.
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Now you can do a practise examination. Solve the Jan/Feb 2012 examination paper and e-mail it
directly to the lecturer for comments. You should solve it in 3 hours. The paper is available on
myUnisa.
7 MODULE PRACTICAL WORK AND WORK INTEGRATED LEARNING
There are no practicals for this module.
8 ASSESSMENTS
8.1 Assessment plan
The Management of the University has introduced compulsory assignments in all modules so that
students can benet fully from Unisas formative tuition and assessment.
This tutorial letter contains three assignments. Assignments 01, 02 and 03 will count 30%, 40% and 30%
respectively towards the year mark. The year mark contributes 10% to the nal mark.
Th rst two assignments are compulsory and must be submitted on/before the due date to
obtain admission to the examination.
Admission will be obtained by submitting the compulsory assignments on time and not by the marks
you obtain for it. Please ensure that these assignments reach the University before the due dates. Late
submission of these assignments will result in you not being admitted to the examination.
8.2 Assignment due dates
The unique numbers and due dates are as follows:
Assignment Due date Unique number
01 2012-06-25 321259
02 2012-08-31 362749
03 2012-10-05 337728
8.3 Assignment enquiries
The lecturer can assist you with any enquiries relating to the study material, the assignment questions
and the solutions to them.
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HONMD23/0/101
However, note that neither the Department of Decision Sciences nor the School of Economic Sciences will
be able to answer your general assignment enquiries. If you wish to nd out whether your assignment has
been received, registered, processed or returned, please check on myUnisa at https://my.unisa.ac.za.
For detailed information on and requirements for assignments, see the booklet My studies @ Unisa.
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9 ASSIGNMENTS
Refer to Section 6 of this tutorial letter for assignment preparation.
ASSIGNMENT 01: Questions 1 to 12
ASSIGNMENT 02: Questions 13 to 18
ASSIGNMENT 03: Question 19 to 23
9.1 Assignment 01
Question 1
(a) Let X be normally distributed with mean 1 and variance 4. Use tables or any spreadsheet to nd
P[2 < X < 3], P[X < 3] and P[X 20].
(b) The random variable whose probability density function is given by
f(x) =
_
1
2
e
x
for x 0
1
2
e
x
for x > 0
is said to have a Laplace distribution.
b.1 Verify that f is actually a probability density function.
b.2 Show that the distribution function of a Laplace random variable is
F(x) =
_
1
2
e
x
for x 0
1
1
2
e
x
for x > 0.
Question 2
(a) In any year, the interest rate per annum eective on monies invested with a given bank has mean
value j and standard deviation s and is independent of the interest rates in all previous years. Let
S
n
be the accumulated amount after the end of year n of a single investment of $1 at time t = 0.
Denote by r
n
the interest rate for year n (n 1).
a.1 Find S
n
.
a.2 Show that E[S
n
] = (1 +j)
n
.
a.3 Show that the variance V ar(S
n
) is given by
V ar[S
n
] = (1 + 2j +j
2
+s
2
)
n
(1 +j)
2n
.
(b) The interest rate per annum eective in (i), in any year, is equally likely to be i
1
or i
2
(with i
1
> i
2
).
No other values are possible.
b.1 Derive expressions for j and s
2
in terms of i
1
and i
2
.
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b.2 The accumulated value at time n = 25 years of $1 million invested with the bank at time t = 0
has expected value $5.5 million and standard deviation $0.5 million. Calculate the values of i
1
and i
2
.
Question 3 Consider that = {
1
,
2
,
3
,
4
} is the sample space after 2 successive daily share price
movements:
1
= HH;
2
= HT;
3
= TH;
4
= TT (H stands for up and T for down). We suppose
that (, F, P) is a probability space where F is the power set of and
P{
1
} = 0,2; P{
2
} = 0,1; P{
3
} = 0,3; P{
4
} = 0,4.
Let A = {
1
; {
2
,
3
}; {
4
)}}. Assume that S and X are random variables dened by:
S(
1
) = 4; S(
2
) = 6; S(
3
) = 6; S(
4
) = 3 and X(
1
) = 1; X(
2
) = 3; X(
3
) = 2; X(
4
) = 1.
(a) Find the -algebra generated by A. Denote it by G
(b) Justify why X and S are really random variables.
(c) Are the random variables X and S measurable with respect to G? Justify your answer.
(d) Are the random variables, X and S independent? Justify your answer.
(e) Find the -algebra generated by X.
(f) Determine E[S] and E[X].
(g) Find E[S|G] and E[X|G].
(h) Verify that
E[E[S|G]] = E[S]
.
(i) Verify that
E
_
(S E[S|G])
2

E
_
S X)
2

.
Question 4 Let X be a random variable on a probability space (, F, P) and (F
t
: t 0) be a ltration
of sub -algebras of F. Prove that the stochastic process (Y
t
: t 0) dened by Y
t
= E[X|F
t
] is a
martingale.
Question 5 Consider again a probability space (, F, P). Let X
1
, X
2
, . . . , be a sequence of independent,
identically distributed random variables such that E[X
n
] = 0 and E
_
X
2
n

=
2
< for every n. Let
(F
n
: 0 n < ) be the natural ltration of F. Show that the sequence (M
n
: n = 1, 2, . . .) dened by
M
n
=
_
n

k=1
X
k
_
2

2
n
is a martingale with respect to the natural ltration.
Question 6 Under the hypothesis of Question 12, assume that X
1
, X
2
, ... are independent identically
distributed Bernoulli random variables with parameter p, and let
S
n
=
n

j=1
X
j
.
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Dene
Z
n
=
_
q
p
_
2S
n
n
.
Prove that Z
1
, Z
2
, . . .is a martingale relative to the natural ltration.
Question 7
Let X be a random variable on a probability space (, F, P). Let G = {, }, prove that E[X|G] = E[X].
Question 8 Suppose M
0
, M
1
, . . . , M
N
is a martingale with respect to a ltration (F
k
: k = 1, 2, . . . ,N)
and
0
,
1
, . . . ,
N1
is a sequence of random variables adapted to (F
k
). Prove that the process
I
0
, I
1
, . . . , I
N
dened by I
0
= 0 and
I
k
=
k1

j=0

j
(M
j+1
M
j
), k = 1, 2, . . . , N
is a martingale.
Question 9 We consider a binomial asset pricing model as in section 7 of the notes by Bass, except that,
after each movement of the stock price, a dividend is paid and the stock price is reduced accordingly. To
describe this equation, we dene
Y
k+1
(
1

2
. . .
n
) =
_
u, if
k+1
= H,
d, if
k+1
= T.
Note that Y
k+1
depends only on the (k +1)st movement of the stock price. In the binomial model, Y
k+1
S
k
was the stock price at time k + 1. In the dividend-paying model considered here, we have a random
variable A
k+1
(
1

2
. . .
n
), taking values in the interval (0, 1), and the dividend paid at time k + 1 is
A
k+1
Y
k+1
S
k
. After the dividend is paid, the stock price at time k + 1 is
S
k+1
= (1 A
k+1
)Y
k+1
S
k
.
An agent who begins with initial capital W
0
and at each time k takes a position of
k
shares of stock,
where
k
depends only on the rst k movements of the stock (in the original model), has a portfolio value
governed by the wealth equation
W
k+1
=
k
S
k+1
+ (1 +r)(W
k

k
S
k
) +
k
A
k+1
Y
k+1
S
k
(1)
=
k
Y
k+1
S
k
+ (1 +r)(W
k

k
S
k
).
Note that as usual, the risk neutral measure is still dened by the equations
p =
1 +r d
u d
, q =
u 1 r
u d
.
(a) Justify the rst equality in relation (1).
(b) Prove that

E[Y
k+1
|F
k
] = 1 +r.
(c) Show that the discounted wealth process is a martingale under the risk-neutral measure (i.e.,
Proposition 7.2, on page 30 in Bass, still holds for the wealth process (W
k
).
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(d) Show that the discounted stock price is not a martingale under the risk-neutral measure (i.e.,
Proposition 7.1 on page 29 no longer holds). However, if A
k+1
is a constant a (0, 1), regardless of
the value of k and the movement (
1

2
. . .
n
), then
S
k
(1 a)
k
(1 +r)
k
is a martingale under the risk-neutral measure.
Question 10
Consider a special kind of two-steps (European) put option on a non-dividend paying share. The current
share price is 80 and the current strike price is 80. After the rst period, if the share price is below 70
then the strike price is lowered to 70. Otherwise the strike price does not change. Take the risk-free rate
to be 5% and model the stock price by a binomial model with u = 1.2 and d = 0.8. What is the
risk-neutral probability of the strike price being reduced? Compute the present fair value of the option.
Question 11
Prove that (X
t
) is a super-martingale with respect to a ltration (F
t
) if and only if (X
t
) is a
sub-martingale with respect to the same ltration.
Question 12 The states of the economy in a 2-step binomial market model are = {HH, HT, HT, TT},
(H stands for up and T for down). The market consists of the risk-free bank account B(t) with
B(0) = 1 and r = 0; and a risky share with price process S
t
(.) such that S
0
() = 80 for any ;
S
1
(HH) = S
1
(HT) = 85; S
1
(TH) = S
1
(TT) = 78. S
2
(HH) = 90; S
2
(HT) = 80; S
2
(TH) = 80;
S
2
(TT) = 75. (You may like to draw a state tree). Assume the model is a complete and a no-arbitrage
model. Let X be a contingent claim (derivative) on S such that: X
2
(HH) = 100; X
2
(HT) = 90;
X
3
(TH) = 80; X
2
(TT) = 70. In order to duplicate the outcome of the claim, consider the following
portfolio:
0
is the amount placed in bank at the beginning of step 1,
1
(H) is the amount to have in the
bank account at the beginning of step 2 in case where the rst movement of the market is up, and
1
(T)
when the market goes down. (0) is the number of shares of the stock to hold at the beginning of step 1,
and
1
(H), (1, T) is the number of shares of the stock to hold at the beginning of step 2 in case where
the market goes up, goes down respectively.
(a) Explain why, at the end of step 2, the following equations must be satised:

1
(H) +
1
(H)S
2
(HH) = X
2
(HH)

1
(H) +
1
(H)S
2
(HT) = X
2
(HT)

1
(T) +
1
(T)S
2
(TH) = X
2
(TH)

1
(T) +
1
(T)S
2
(TT) = X
2
(TT)
(b) Explain why, at the end of step 1, the following equations must be satised:

0
+
0
S
1
(H) =
1
(H) +
1
(H)S
1
(H)

0
+
0
S
1
(T) =
1
(T) +
1
(T)S
1
(T)
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(Note that here S
1
(H) actually stands for S
1
(HH) which is equal to S
1
(HT), also S
1
(T) means
S
1
(TT) or S
1
(TH))
(c) Solve the two systems to nd the values of
0
,
1
(H),
1
(T),
0
,
1
(H) and
1
(T).
(d) Justify why
0
+
0
S
0
is the arbitrage-free price of the claim at time 0.
(e) Apply the same procedure to nd the price (at time 0) of the following look-back option with payo
X
2
() = max{S
n
() 80 : n = 0, 1, 2}
.....................end of Assignment 01
9.2 Assignment 02
Question 13
In what follows W is the Brownian motion.
Compute the stochastic dierential dZ when
(a) Z(t) = exp(t) where is a constant.
(b) Z(t) =
_
t
0
g(s)dW(s) where g(s) = e
s
.
(c) Z(t) = exp(W(t)) where is a constant.
(d) Z(t) = exp[X(t)], where X has stochastic dierential dX(t) = dt +dW(t), and are
constants.
(e) Z(t) = X
2
(t), where X has stochastic dierential dX(t) = X(t)dt +X(t)dW(t), and are
constants.
Question 14
(a) Compute the stochastic dierential for Z when Z(t) = 1/X(t) and X has the stochastic dierential
dX(t) = X(t)dt +X(t)dW(t), and are constants.
(b) Let W be the Brownian motion and (F
t
: t 0) be its natural ltration. Show, using stochastic
calculus, that the following processes are martingales.
(b.1) M(t) = W
2
(t) t,
(b.2) M(t) = exp
_
W(t)
2 t
2
_
, where is a xed real number.
Question 15 Suppose that X satises the SDE
dX(t) = X(t)dt +X

(t)dW(t)
where , and are constants and W is a Brownian motion.
(a) Consider the process
Y (t) = exp
_
aX
b
(t) +c t
_
.
Find dY (t) and determine the values of the constants a, b and c such that the process Y (t) is a
martingale.
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HONMD23/0/101
(b) Compute E[X(t)] when = 1/2.
(c) Compute V ar[X(t)] when = 1/2.
Question 16 Let X and Y satisfy the following system of stochastic dierential equations
dX(t) = X(t)dt +Y (t)dW(t); X(0) = x
0
,
dY (t) = Y (t)dt X(t)dW(t); Y (0) = y
0
,
Note that x
0
and y
0
are deterministic (that is non-random) constants .
(a) Let R(t) = X
2
(t) +Y
2
(t). Using the equality R(t) = f(X(t), Y (t)) where f(x, y) = x
2
+y
2
and the
multi-dimensional Itos formula, prove that
dR(t) = (2 + 1)R(t)dt; R(0) = x
2
0
+y
2
0
.
Deduce that
R(t) = R
0
e
(2+1)t
.
(b) Find E[X(t)] and E[Y (t)].
(c) Let Z(t) = X(t)Y (t). Use an appropriate Itos formula to nd dZ(t), and deduce that
E[Z(t)] = x
0
y
0
+
_
t
0
(2 1)E[Z(s)] ds.
Show nally that E[Z(t)] = x
0
y
0
e
21)t
and
Cov(X(t), Y (t) = x
0
y
0
e
2t
(e
t
1).
Question 17 Let X and Y be given by
dX(t) = X(t)dt +X(t)dW
1
(t); X(0) = x
0
,
dY (t) = Y (t)dt +Y (t)dW
2
(t); Y (0) = y
0
,
where , , and are constants and W
1
and W
2
are independent Brownian motions. Using an
appropriate Itos formula, nd dZ(t) where Z(t) = X(t)Y (t) and deduce E[X(t)Y (t)] .
Question 18 Use Itos formula to show that
_
T
0
W(t)dW(t) =
1
2
([W(T)]
2
T).
========end of Assignment 02 =========
9.3 Assignment 03
Question 19
(a) Show that if W is the Wiener process and is a positive real number then
E[e
W(t)
] = e

2
t/2
.
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HONMD23/0/101
(b) The fairly unknown company F&H INC has blessed the market with a new derivative, the Mean.
With eective period given by [T
1
, T
2
], the holder of a Mean contract will, at date of maturity T
2
,
obtain the amount
1
T
2
T
1
_
T
2
T
1
S(t)dt.
Determine the arbitrage-free price at time 0 of the Mean contract. Assume that 0 < T
1
< T
2
, the
risk free interest rate r is constant and that the dynamic of the stock price S is given by
dS(t) = S(t)dW(t) +S(t)dt
where and are positive real constants and W is the Wiener process.
Question 20
Consider an asset, the price of which satises the geometric Black-Scholes model with drift = 0,07 and
volatility = 0,2. The current price of the asset is S
0
= 100 and the risk-free rate is r = 5%.
(a) What would be the mean and variance of the price S
T
of the asset at time T?
(b) Give the probability that a call option with strike price K = 120 and maturity T = 5 would be
in-the-money at maturity.
(c) What is the probability that S
2
is greater than E[S
2
].
Question 21
Let
k
(t) = E[(W(t))
k
] where W is the standard Brownian motion. Show, using Itos formula, that for all
integers k 2,

k
(t) =
1
2
k(k 1)
_
t
0

k2
(s)ds
and derive from this expression the value of E[(W(t))
4
].
Question 22
Let S
t
be the price at time t of a certain non-dividend paying stock with annual volatility . A derivative
will pay log(S
T
) at a future time T (so if S
T
< 1, the owner if the derivative has to pay the issuer of the
derivative). Apply a risk-neutral valuation argument to nd the value of the derivative at time t < T.
Find also the hedging strategy that duplicates the outcome of derivative. (Here log means ln.)
Question 23
Let S denote the price of a stock price paying no dividends, and consider a derivative on this stock which
entitles the holder to one payo at time T; the amount of this payo is $1 if the stock price S
T
at time T
is at most A, for some positive number A, and zero otherwise. The options are known as digital or binary
options. Assume all interest rates are constant and are equal to r. Again assume that S follows the process
dS = Sdt +SdW
for constants , and where W is a Brownian motion.
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HONMD23/0/101
Find the probability in a risk-neutral world of the event S
T
A. Apply a risk-neutral valuation argument
to show that, for any 0 t T, the value if this derivative equals
e
r(Tt)

_
log(a/S
T
) (r
2
/2)(T t)

T t
_
where is the cumulative distribution function of the standard normal distribution.
========end of Assignment 03 =========
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HONMD23/0/101
10 EXAMINATION
Use your my Studies @ Unisa brochure for general examination guidelines and examination preparation guidelines.
To be admitted to the examination you must submit the compulsory assignments to reach Unisa
before the due dates.
If for some reason you cannot write the examination, you will have to re-register (and pay again!) for the next
semester.
The duration of the examination is three hours.
You will be allowed to use a programmable pocket calculator in the examination, but a non-
programmable calculator will be more than sucient.
To pass this module, you must obtain a nal mark of at least 50%.
11 OTHER ASSESSMENT METHODS
No other assessment methods exist for this module.
12 FREQUENTLY ASKED QUESTIONS
The my Studies @ Unisa brochure contains an A-Z guide of the most relevant study information.
1. MATTERS PERTAINING TO REGISTRATION
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during the registration process?
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know that you denitely can no longer submit the assignment.
19
HONMD23/0/101
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101. Assignments are not marked or returned prior to the due dates.
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HONMD23/0/101
3. EXAMINATION
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SECTION B: ACADEMIC MATTERS
1. CALCULATORS
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contact details.
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constitutional right to privacy we may not disclose the details of students to their fellow students.
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students. Old questions will not necessarily be repeated in subsequent examination papers and students
are warned not to rely on old examination papers in order to pass the module.
21