MA537/MA837/Set3

UNIVERSITY OF KENT
MATHEMATICS OF FINANCIAL DERIVATIVES MA537/MA837
PRACTICE QUESTIONS SET 3
1.

The share price of the ABC corporation, St , satisfies the following Stochastic Differential
Equation (SDE):


dSt = St dBt + dt ,

where Bt is a Brownian motion under the real-world measure P . The continuously compounded constant risk-free rate of interest is r. Assume that the corporation does not intend
pay dividends on its shares in the foreseeable future.
The corporation is currently, at time t = 0, considering a new pay structure for its CEO,
whereby in addition to a basic salary the CEO will be entitled to a one-off bonus payment at
the end of T = 2 years based on the performance of the corporation. The formula of the bonus
payment is currently under discussion and the following alternatives are being considered:
ST
;
S0
 
ST
A log
;
S0


A ST S0 ;


A max ST S0 , 0 ;


A max ST 2S0 , 0 .

X1 = A
X2 =
X3 =
X4 =
X5 =

(a) Discuss the rationale behind each of the alternative formula, explaining the pros and
cons of each.
[ 5 marks ]
(b) The corporation wants to hedge the risk involved in the future bonus payment. The
corporation is willing to pay for a self-replicating strategy at time 0 to meet the bonus
payment at the end of 2 years. Calculate the value (or price) of the bonus at time 0 for each
of the alternative formula, when S0 = 10, A = 100, 000, = 6% per annum, r = 3% per
annum and = 20% per annum.
[ 15 marks ]
(c) Explain the differences in the values of bonus payment for all suggested formulae.
Comment on the suitability of choosing a particular formula based on its value.
[ 5 marks ]
(d) For the bonus formula X3 , suggest a self-replicating strategy that the corporation should
follow from time 0 to 2 years. Show that the strategy work.
[ 5 marks ]
[ Total: 30 marks ]
Although not required for the assessment, can you solve part (d) for all bonus formula?

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MA537/MA837/Set3

2.

Let St denotes the price of a non-dividend paying share at time t. Suppose the share-price
process is governed by the following Stochastic Differential Equation (SDE):


dSt = St dBt + dt ,
where Bt is a Brownian motion under the real-world measure P . The continuously compounded constant risk-free rate of interest is r.
Consider a particular derivative contract which promises to make a payment at time T of:
X=A

ST
; where A > 0.
S0

(a) Using Itos Lemma, show that St = S0 exp Bt + ( 1/2 2 )t is a solution to the SDE
under measure P .
[ 5 marks ]


(b) Defining Dt = ert St and using Itos Lemma, show the dDt = Dt dBt + ( r)dt
under measure P .
[ 3 marks ]
(c) Using the Cameron-Martin-Girsanov theorem, establish a new measure Q under which
t , where B
t is a standard Brownian motion under the measure Q.
dDt = Dt dB
[ 2 marks ]


t + rdt under measure Q.
[ 2 marks ]
(d) Show that dSt = St dB

(e) Using Itos Lemma, derive an expression for Dt under the measure Q. Show that
  
EQ Dt Fu = Du and conclude Dt is a Q-martingale.
[ 5 marks ]



t B
u ) + (r 1/2 2 )(t u) under measure Q
(f) For u < t, show that St Fu = Su exp (B

and hence find the distribution of St Fu under the measure Q.
[ 5 marks ]



(g) Defining Vt = er(T t) EQ X Ft , show that Vt = ASt /S0 .
[ 2 marks ]

Aert St
dBt .
S0
Can we conclude that Et is a Q-martingale?
[ 3 marks ]
 
 rt
  
(i) Show directly (NOT using Tower Law) that EQ Et Fu = EQ e ASt /S0 Fu = Eu
and conclude Et is a Q-martingale.
[ 3 marks ]

(h) Define Et = ert Vt = ert ASt /S0 . Using Itos Lemma, show that dEt =

(j) Using results from parts (c) and (h), show that dEt = t dDt where t = A/S0 . Explain
why t is a previsible process.
[ 3 marks ]
(k) Defining t = Et t Dt , show that t = 0. Explain why t is a previsible process.
[ 2 marks ]
(l) Explain why V0 = A is the arbitrage-free price at time 0 for the derivative contract by
showing how the self-replication strategy will work from time 0 to time T , so that the payoff
is met at time T for this particular derivative contract.
[ 5 marks ]
[ Total: 40 marks ]

3.

MA537/MA837/Set3

Consider a non-dividend paying share whose price at time t is denoted by St . Suppose the
share-price process is governed by the following SDE:


dSt = St dBt + dt ,
where Bt is a standard Brownian motion under the real-world probability measure P . Let r
be the continuously compounded constant risk-free rate of interest.
Consider a derivative contract which promises to make a payment of X = ST2 , at time T .
(a) Defining Dt = ert St :
(i) Establish a measure Q for which dDt = Dt dBt , where Bt is a standard Brownian
motion under measure Q.
[ 3 marks ]
  
(ii) Show that, EQ Ds Ft = Dt , for s > t, where Ft denotes filtration up to time t.
[ 4 marks ]



2
[ 3 marks ]
(b) Defining Vt = er(T t) EQ X Ft , show that, Vt = e( +r)(T t) St2 .
(c) Defining Et = ert Vt :

(i) Use Itos lemma to show that, dEt = 2Et dBt .

  
(ii) Show that, EQ Es Ft = Et , for s > t.

[ 4 marks ]
[ 4 marks ]

dEt
and t = Et t Dt :
dDt
2Vt
(i) Show that, t =
.
St

(d) Defining t =

[ 1 mark ]

(ii) Show that, t = ert Vt .

[ 1 mark ]

(iii) Show that, t St + t ert = Vt .

[ 1 mark ]

(e) Using the definition Vt = ert Et , use Itos lemma to show that, dVt = rVt dt + 2Vt dBt .
[ 2 marks ]
(f) Consider a portfolio of t shares and t ert cash at time t. If the portfolio is unchanged


over the short interval (t, t + dt), show that, t dSt + t er(t+dt) ert dVt .
[ 3 marks ]
(g) Explain why Vt is the arbitrage-free price of the derivative contract at time t.

[ 1 marks ]
[ Total: 27 marks ]
4.

Consider the function, f (t, St ) = e( +r)(T t) St2 , where St is the price of a share at time t, r
is the continuously compounded constant risk-free rate of interest and T > t.
(a) Show that f (t, St ) satisfies the Black-Scholes PDE.

[ 4 marks ]

(b) State the boundary condition satisfied by f (t, St ).

[ 1 mark ]

(c) State the assumptions under which f (t, St ) will be a valid price of a derivative contract.
[ 2 marks ]
[ Total: 7 marks ]
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MA537/MA837/Set3

5.

Consider a non-dividend paying share, whose price at time t, denoted by St , is governed

by the following stochastic differential equation (SDE): dSt = St dBt + dt where Bt is
a Brownian motion under the real-world probability measure P and r is the continuously
compounded constant risk-free rate of interest.
(a) Using the Cameron-Martin-Girsanov theorem, show that there exists a measure Q under
which Dt = ert St is a Martingale.
[ 4 marks ]

(b) Determine the distribution of ST Ft under measure Q, where Ft denotes the filtration up
to time t.
[ 4 marks ]
(c) Consider a derivative contract which promises to make a payment of (log ST ) at time T.
Show that the price at time t of the derivative contract is given by:


Vt = er(T t) log St + (r 1/2 2 )(T t) .

[ 2 marks ]

(d) Let (t , t ) denotes the number of shares and bonds respectively in a self-financing
portfolio at time t. For the particular derivative contract given in part (c):
(i) Determine (t , t ), i.e. the self-financing portfolio at time t.
rt

(ii) Show that Vt = t St + t e

r(t+dt)

and Vt+dt = t St+dt + t e

(iii) Explain the implication of the results in part (d)(ii).

[ 5 marks ]
.

[ 3 marks ]
[ 1 mark ]

(e) Show that the price given in part (c) satisfies the Black-Scholes PDE and the necessary
boundary condition.
[ 4 marks ]
[ Total: 22 marks ]
6.

ABCorp is currently negotiating its CEOs pay structure which will include a year-end bonus
based on her performance over the year. Two bonus formula under consideration are:


X = A max log S1 log S0 , 0 ,


Y = A max S1 S0 , 0 .


St is ABCorps share price at time t satisfying the SDE: dSt = St dBt + dt , where Bt
is a standard Brownian motion under the real-world measure P and = 20% per annum.
Assume that S0 = 10, A = 10, 000 and ABCorp does not intend to pay dividends over the
next year. The continuously compounded constant risk-free rate of interest is r = 3%.
(a) For bonus structure X, show that the value of the bonus at time 0 is given by:


er (r 1/2 2 )(d) + (d) ,

where d = (r 1/2 2 )/. () and () are cumulative distribution and density functions of
standard Normal distribution respectively.
[ 7 marks ]
(b) Determine the (numerical) values of both bonus structures X and Y . Explain which of
the bonus structure is more lucrative to the CEO and why.
[ 6 marks ]
[ Total: 13 marks ]

7.

MA537/MA837/Set3

Consider a non-dividend paying share whose price St follows a geometric Brownian motion.
The current price of the share is S0 = 125 and volatility of the share price is = 20% per
annum. The continuously compounded risk-free rate of interest is r, where er = 1.10.
(a) Using the Black-Scholes option pricing formula calculate the price of a European call
option on the share with strike price K = 125 and time to expiry T = 2 years.
[ 5 marks ]
(b) State and prove the formula of put-call parity for European options on non-dividend
paying shares defining all the notations used.
[ 5 marks ]
(c) Using (d) or otherwise, calculate the price of a European put option on the share with
strike price K = 125 and time to expiry T = 2 years.
[ 3 marks ]
(d) Define delta for an individual derivative. Sketch a graph of the delta of a European
put option against all possible values of the current share price S0 with strike price K = 125.
Explain the key features of the graph. Explain how the shape of the graph will change if
the volatility, , is increased or decreased?
[ 10 marks ]
[ Total: 23 marks ]

8.

Let f (t, St ) = St Ker(T t) be the price of a derivative contract, where St is the price of the
underlying non-dividend paying share at time t, r is the continuously compounded constant
risk-free rate of interest and T > t.
(a) Define the following Greeks: , and .

[ 3 marks ]

(b) Show that f (t, St ) satisfies the Black-Scholes PDE:

+ rSt + 1/2 2 St2 = rf,
where is the volatility of the share price process.

[ 2 marks ]

(c) Determine the boundary condition satisfied by f (t, St ) and identify the derivative contract for which f (t, St ) is the arbitrage-free price.
[ 2 marks ]
[ Total: 7 marks ]

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MA537/MA837/Set3

9.

The price of a non-dividend paying share, St , follows a geometric Brownian motion process.
(a) A European call option maturing at time T is at-the-money at time t if St = Ker(T t) .
Show that for an at-the-money call option, the price can be approximated by:

ct 0.4St T t.
1
1
[ 3 marks ]
+ x.
2
2
(b) The current price of the share is 100 and volatility of the share price process is 10%
per annum. The continuously compounded risk-free rate of interest is 5% per annum. If a
European call option with 2 years to maturity is currently at-the money, calculate the price of
the option using both the Black-Scholes formula and the approximate formula.
[ 4 marks ]
Hint: (x)

[ Total: 7 marks ]
10.

The share price of a UK company follows a geometric Brownian motion process. The current
share price is 100 and the volatility of the share price process is = 10% per annum. The
company does not intend to pay dividends in the next two years.
The company is planning to recruit a new CEO immediately and is currently finalising her
pay structure which will include a bonus based on the companys performance over the next
two years.
You may assume that the constant continuously compounded risk-free rate of interest is
r = 5% per annum.
(a) One possible bonus structure, A, is to provide an option to the CEO to buy 20,000 shares
each at a price of 100 at the end of two years. Determine the current value of this bonus
structure A.
[ 4 marks ]
(b) One of the director of the company has proposed an alternative structure, B, where the
bonus payment at the end of two years will be based on the following formula:

p
S1 S2 S0 , 0 ,
20,000 max
where St denotes the companys share price at time t.
(i) Show that under the risk-neutral measure,




p
1 2 5 2
3
r , .
S1 S2 Lognormal log S0 +
2
2
4
Hint: If {Bt } is a standard Brownian motion process, then Cov(Bt , Bs ) = min(t, s).
[ 4 marks ]
(ii) Determine the current value of this alternative bonus structure B.

[ 8 marks ]

(c) Compare and contrast the bonus structures A and B, described in parts (a) and (b)
above, from both the companys and the prospective CEOs perspective.
[ 4 marks ]
[ Total: 20 marks ]

11.

MA537/MA837/Set3

The price of a non-dividend paying share, St , follows a geometric Brownian motion process


with stochastic differential equation (SDE): dSt = St dBt + dt , where Bt is a standard
Brownian motion under the real-world probability measure P . Let the continuously compounded constant risk-free rate of interest be r.
(a) Using the Cameron-Martin-Girsanov theorem, show that there exists a probability mea

t + rdt , where B
t is a standard Brownian motion under
sure Q under which dSt = St dB
the probability measure Q.
[ 3 marks ]
(b) Using Itos Lemma on the function f (t, St ) = log St , show that:


T + (r 1/2 2 )T ,
ST = S0 exp B
is a solution to the SDE governing the share-price process under probability measure Q.
[ 4 marks ]
(c) Show that under probability measure Q:



log S1 F0 N log S0 + (r 1/2 2 ), 2 ,

where Ft denotes filtration up to time t.

[ 3 marks ]

(d) Consider two 1-year derivative contracts with maturity payoffs:

X1 = I[S1 > S0 ]

and X2 = I[S1 S0 ],

where St is defined above and I() is the indicator function.

Let P1 and P2 be the current prices of the derivative contracts with payoffs X1 and X2
respectively.
(i) Show that:
P1 = e

(r 1/2 2 )

and

P2 = e


(r 1/2 2 )

.

[ 8 marks ]
(ii) Show that P1 + P2 = er and explain the rationale behind this relationship.
[ 3 marks ]
[ Total: 21 marks ]