Answer key to Homework 1

S(n) + div(n) S(n 1) S(1) + 3 S(0)

1) In general, K(n) = . So KA = (2 pts) and KB =
S(n 1) S(0)
S(2) S(1)
(2 pts). Then S(1) = S(0)(1 + KA ) 3 and S(2) = S(1)(1 + KB ). Thus we get
S(1)

Scenario S(0) S(1) S(2)

1 80 85 89.25 (2 pts)
2 80 81 76.95 (2 pts)
3 80 73 80.3 (2 pts)

S(2)S(1) S(2) S(1)S(0) S(1)

2) Since K(2) = S(1) = S(1) 1 and K(1) = S(0) = S(0) 1, 2K(1) = 3K(2) implies
that    
S(1) 100
2 1 =3 1 (3 pts)
80 S(1)
2
equation in S(1): S (1) + 40S(1) 12000 = 0 (2 pts), which solves that
So we get a quadratic
2
40 40 + 4 12000
S(1) = = 20(1 + 31)(or 91.35) and 20(1 + 31) (3 pts), ignore
2
the latter one because the stock price can not be negative (2 pts).
   
 

3) We know from Proposition 3.3 that 1 + E K(0, 2) = 1 + E K(1) 1 + E K(2) (2 pts).
     
Since K(1), K(2), K(3), K(4) are i.i.d. we see that E K(1) = E K(2) . Thus 1 + E K(0, 2) =
 
2
1 + E K(1) (2 pts). Then

  q   q  
E K(1) = 1 + E K(0, 2) 1 = 1 + E K(0, 2) 1 = 3.92% (2 pts).
   
4    
4
Similarly, 1 + E K(0, 4) = 1 + E K(1) (2 pts), so E K(0, 4) = 1 + E K(1) 1 =
16.63%, 16.54% (2 pts) ( which depends on the rounding in the last step.)

4) For binomial tree model, S(n) has n + 1 different values S(0)(1 + u)i (1 + d)ni , i = 0, 1, , n
with the corresponding probability ni pi (1 p)ni (2 pts). In this problem, n = 4, u = 0.2, d =

0.1, p = 1/3.

Scenario S(4) P robability

1
i=4 165.888 81 (1 pt)
8
i=3 124.416 81 (1 pt)
24
i=2 93.312 81 (1 pt)
32
i=1 69.984 81 (1 pt)
16
i=0 52.488 81 (1 pt)

1
 48 16
Thus prob{S(4) < 80} = prob{i = 0} + prob{i = 1} = 81 = 27 (3 pts).

5) We can list the following equations

S(0)(1 + u) = 100 (i) (1 pt)


S(0)(1 + d) = 80 (ii) (1 pt)

S(0)(1 + u)2 = 110

(iii) (2 pts)
(iii) (i) gives that 1 + u = 1.1 (2 pts), so u = 0.1. Then we can solve from (i) that
100 80
S(0) = 1.1 = 90.91 (2 pts). Then we see from (ii) that d = S(0) 1 = 0.12 (2 pts). (Students
are allowed to use the approximate decimals Here.)

6) In general, E [S(n)] = S(0)(1+r)n . So 110 = E [S(4)] = 80(1+r)4 (3 pts), which implies that

1/4
7/4
r = 11 8 1 = 0.083 (3 pts). Then E [S(7)] = 80 (1 + r)7 = 80 11
8 = 139.675 or 139.794
(4 pts) (which depends on the rounding in r.)