This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON

MT3043 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance

and the Social Sciences, the Diplomas in Economics and Social Sciences and
Access Route

Mathematics of Finance and Valuation

Friday, 29 May 2015 : 14:30 to 16:30

Candidates should answer FOUR of the following FIVE questions. All questions carry
equal marks. If more than four are attempted, only the best four will be taken into
account.
Workings should be submitted for all questions requiring calculations. Any necessary
assumptions introduced in answering a question are to be stated.

PLEASE TURN OVER

University of London 2015

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NOTE: In the questions which follow the current price of an asset (or similar
instrument) will typically be denoted either by St or simply by S with the time
subscript suppressed. Reference is made to the following denitions:
(x)+
(u)
d+

maxfx; 0g;
Z u
z2
1
p
expf
g dz;
2
2 1

log(S=K) + (r + 12  2 )(T
p
 T t

t)

log(S=K) + (r 12  2 )(T t)
p
:
 T t
The Black-Scholes formula for pricing a European call option is:
d

S(d+ )

Ke

r(T t)

(d ):

Starred symbols indicate discounted values to present value. The symbol

1[X<a]
denotes a characteristic function; it is dened on a sample space
dictated by
context, has value 1 on the set f! 2
: X(!) < ag; and 0 on the complement.

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1. (a) State and prove the No-Arbitrage Theorem in the case of a one-period
model.
(b) A one-period model, with two states ! 1 ; ! 2 at time t
1; for the asset prices of a riskless and a risky asset is given below. All the constants
S0 ; SH ; SL and r are positive and SH > SL .
Asset No. t

Sn (0)

Sn (1; ! 1 )

Sn (1; ! 2 )

1+r

1+r

S0

SH

SL

Deduce from the No-Arbitrage Theorem that there are no arbitrage opportunities if and only if SL < (1 + r)S0 < SH :
(c) The model given in part (b) is now used to model ex-dividend prices
of a risky asset which pays a dividend of value D just shortly before t 1:
Deduce from your answer to part (b) the necessary and sucent conditions
that this model has no arbitrage opportunities.
(d) At time t
0 two parties, the buyer and the seller, of the risky asset
modelled in part (c), agree a price F and a contract to exchange one unit
of the said risky asset for the price F at time t 1.
(i) Let X denote the state-dependent value of the contract at time t
the seller. Write X explicitly in terms of the constants of the model.

1 to

(ii) By referring to a replication portfolio for the asset X dened in (i), determine the value to the seller at time t 0 of the contract. (You should
neglect any interest accruing to the holder of the dividend in the short time
interval between the dividend payment and the time t 1).
(iii) Determine the value for F which makes the contract have value zero at
time t 0.

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2. The table below models the evolution over the times t 0; 1; 2 of the price
St (!) of one risky asset according to four possible states of nature. The
model assumes the existence of a riskless asset having a constant price 1, at
all times, in all four states of nature.
state t 0 t 1 t 2
3
5
8
!1
!2
3
5
4
3
2
4
!3
!4
3
2
1
Let u

f! 1 ; ! 2 g; d

f! 3 ; ! 4 g;

f! 1 ; ! 2 ; ! 3 ; ! 4 g, and P1

fu; dg.

(a) Write down the risk-neutral probabilities Qu ; Qd ; Q

of the three oneperiod submodels dened by the three nodes u; d;
.
From these three nodes, construct the risk-neutral measure Q for the twoperiod model, and explain why
(Q
(u); Q
(d))

(Q(u); Q(d)):

(b) The payo of the lookback style put option with exercise price 7 written
at time t 0 on the risky asset modelled in the table is dened by
Y (!)

(7

minfSt (!) : t

0; 1; 2g)+ :

Write down the numerical values of Y in the four states (! 1 ; ! 2 ; ! 3 ; ! 4 ) which

the holder generates at time t 2.
(c) Let c1 (u) and c1 (d) denote respectively the time t 1 risk-neutral values
of the given Asian style put in the two one-period models starting at the
nodes u and d.
Find c1 (u) and c1 (d) for the Asian style put with strike 7 in the model stated
above.
(d) The claim X pays c1 (u) or c1 (d) at time t 2 depending on which of
the two nodes u or d respectively is reached at time t 1.
What is the time t 0 risk-neutral value of this claim?
(e) Verify that the following expressions hold:
X(u)

EQ [Y jP1 ](u) and X(d)

EQ [Y jP1 ](d):

Explain why these expressions imply that the valuation under Q of Y (!)
equals the valuation of X given in part (d)?

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3. (a) Let Pt be a partition of a nite sample space

(set of states) corresponding to the times t with t 0; 1; :::; T , and let fPt : t 0; :::; T g be a
ltration on
. A process fZ(t) : t 0; 1; :::; T g is given to be adapted to
this ltration and the process fH(t) : t 1; :::; T g predictable with respect
to the ltration. Let P be a probability measure on
such that the process
fZ(t) : t 0; 1; :::; T g is a P -martingale.
(i) Dene the ve italicized terms in the paragraph above.
(ii) In this context given above suppose that G(t) is the process dened by:
G(t) :

Xs

s 1

H(s)(Z(s)

Z(s

1)):

State and prove the Martingale Transform Lemma establishing the connection between the processes Z and G.
(b) Dene what is meant by a T -period binomial model for the evolution
1. A
of the price St of an asset for t
0; 1; :::; T and assume that S0
+
+
European bull spread option pays (St 4)
(St 7) at time t T .
Show that the option value at time t
1
(1 + R)T


n
e 
X
T
(U n DT
n

0 may be written in the form

4)qun qdT

n n
b



T
X
T
n
+
3qun qdT
n
n n
e+1

e (all of which you should

b and n
for some probabilities qu ; qd and integers n
identify), and where R is the inter-period compounding factor.

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4. (a) Let zt denote a standard Brownian motion with z0 0. An asset value

is modelled by a process St obeying the stochastic equation
dSt

St dt + St dzt ; with S0 given,

where ;  are positive constants. For a function f (S; t) of two variables,

twice continuously dierentiable in S and once in t, dene a process Yt by
Yt f (St ; t):
(i) State Its Formula for dYt , that is for df (St ; t):
p
(ii) By specializing to the case of a function f (S; t) 2 S, use the formula
to check that


1
1
1 2
 Yt dt + Yt dzt :

dYt
2
4
2
(b) A bank oers a deposit scheme with maturity at time t
T whereby
for each dollar deposited at time t 0 the bank either returns the money
(without interest) or else pays an amount of ST =S0 dollars, whichever is
the higher, where 0 <  < 1 and St denotes the value at time t of a specied
market-indicator modelled as in part (a).
(i) Show that this is equivalent to the bank oering its depositors a number
of units of a call option on the market indicator struck at k times S0 where
k 1= in return for an amount equivalent to the riskless interest payable
on a straight deposit. Assume the riskless interest rate is constant over
the life of the contract. (Hint: Show the two possible payments equalize
ST
S0 = K and decompose the claim as a combination of 1ST <K and
1ST K .)
(ii) Show also how to select  (without computing its value) so that the
contract is fairly priced using the Black-Scholes formula given at the start
of this examination paper.
(iii) Given an arbitrary  what is the investors gain or loss?

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5. (a) Show that the time independent solutions of the Black-Scholes equation
1 2 2 @2V
@V
@V
 S
+ rS
+
rV:
2
2
@S
@S
@t
take the form AS  + BS  for constants A, B for suitably chosen positive
,  which you should specify.
(b) A traded asset has price process S
dSt

(St ) modelled by the equation

St dt + St dzt ;

where zt is a standard Brownian motion, ;  are positive constants and

r is a positive, constant, riskless interest rate applicable for all time. The
following perpetual American bear spread power option, with strike prices
5 and 3 dollars, is written on the underlying asset S. It may be exercised
once, and, if exercised at time t, pays
8
>
if 0 < St < 3;
<16;
4
G(St )
(5 St ) ; if 3  St < 5;
>
:
0;
if St  5:

Assume that optimal exercise of the option requires the holder to wait until
the process S falls below some level E with 3  E < 5.
Sketch the graph of the function G(St ) dened above.
Write down the system of equations to be satised by the option value function V (S) at the optimal exercise boundary E including the smooth pasting
condition at the boundary.

(c) Using part (a) and the continuity condition at the boundary E from
part (b), show that the option value function, for S > E, takes the form
  
4 S
V (S) (5 E)
:
E
(d) Knowing that E  3 and using the smooth pasting condition for the
value function at the optimal exercise boundary E from part (b), prove that
the boundary E is given by
5
:
E
+4

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