Department of Statistics

Savitribai Phule Pune University

ST-F3 - Stochastic Models in Finance - Tutorial II

March 23, 2018

Q.1. If Q(t) denotes quadratic variation of a stochastic process at time t, show that Q(t) is an
increasing function of t.

Q.2. A realization of a stochastic process for first 5 time points is given by,
X1 = 1, X2 = 3, X3 = 2, X4 = 2, X5 = 1. Compute the quadratic variation of the process
at time 4 and 5.
er(T −t)
Q.3. If S follows geometric Brownian motion process, what is the process followed by y = ?
S
Express the result in terms of y rather than S.

Q.4. Stock A and Stock B both follow geometric Brownian motion. Changes in any short interval
of time are uncorrelated with each other. Does the value of a portfolio consisting of one of
stock A and one of stock B follow geometric Brownian motion? Explain your answer.

Q.5. If S follows the geometric Brownian motion process, what is the process followed by y = S 2 ?

Q.6. Suppose that the stock price has an expected return of 16% per annum (i.e., µ = 0.16) and
a volatility of 30% per annum. When the stock price at the end of the certain day is Rs. 50,
calculate the following:

i) The expected stock price at the end of the next day.

ii) The standard deviation of the stock price at the end of the next day.

iii) The 95% confidence limits for the stock price at the end of the next day.

Q.7. Compute the prices of the following European options on the non-dividend paying stocks.

i) CE with S0 = 48, K = 45, r = 12% pa, Volatility = 20% pa, T = 6 months

ii) PE with S0 = 96, K = 92, r = 10% pa, Volatility = 25% pa, T = 3 months

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 Q.8. A stock price follows geometric Brownian motion with an expected return of 16% and a
volatility of 35%. The current price is $38. What is the probability that a European call
option on the stock with an exercise price of $40 and maturity date in six months will be
exercised? What is the probability that a European put option with the same exercise price
and maturity will be exercised?

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Q.9. What is the condition for f to be the price of a tradeable derivative? Can f = S −2r/σ be
price of a tradeable security?

Q.10. Consider a derivative that pays off STn at time T , where, ST is the price of the underlying
stock at that time. When the stock price follows geometric Brownian motion, it can be
shown that the price of this derivative at time t ≤ T , has the form,

G(S, t) = h(t, T )S n ,

where S is the stock price at time t and h is not a function of S.

i) If G(S, t) satisfies the Black-Scholes-Merton partial differential equation, derive the or-
dinary differential equation satisfied by h(t, T ), by substituting the value of G(S, t) in
BSM differential equation.

ii) What is the boundary condition for the differential equation for h(t, T )?

iii) Show that

h(t, T ) = exp[{0.5σ 2 n(n − 1) + r(n − 1)}(T − t)]

Q.11. Give two reasons why the early exercise of an American call option on a non-dividend-paying
stock is not optimal. The first reason should involve time value of money. The second should
apply even if interest rates are zero.

Q.12. “The early exercise of an American put is a trade-off between the time value of money and
the insurance value of a put.” Explain this statement.