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2015 Examinations
2015 Examinations
PART II
MATHEMATICS & STATISTICS
MSc Quantitative Finance
Math 580 : Financial Stochastic Processes 2 Hours
Question 1.
Consider a portfolio consisting of a riskless asset and two stocks. An amount y invested in the
riskless asset will be worth 1.1y. If amounts x1 and x2 are invested in the two stocks respec-
tively, these will be worth x1 R1 and x2 R2 where the dependent random variables (R1 , R2 )
satisfy !
0.01 0.01
E[(R1 , R2 )] = (1.2, 1.4), and Var[(R1 , R2 )] = .
0.01 0.09
(a) Consider an investment of y in the riskless asset, and x1 and x2 in the two stocks. The
return will be X = 1.1y + x1 R1 + x2 R2 . Write down the expected return, E(X) and the
variance of the return, Var(X). [3]
(b) Assume the initial investment satisfies y + x1 + x2 = 1. Calculate the choice of y, x1 and
x2 for which Var(X) is smallest, subject to E(X) = 1.2. [7]
1
Math 580 Financial Stochastic Processes continued
Question 2.
Let Xt be a standard Wiener process. For a fixed value of t, Xt has a normal distribution
with mean 0 and variance t:
Xt ∼ N (0, t).
Xt − Xs ∼ N (0, t − s).
You may use without proof that if Z ∼ N (µ, σ 2 ), with σ > 0, then Z has probability density
function
(z − µ)2
1
fZ (z) = √ exp − for − ∞ < z < ∞,
2πσ 2 2σ 2
and Z has moment generating function
1 2 2
MZ (t) = E(exp{tZ}) = exp µt + σ t .
2
2
Math 580 Financial Stochastic Processes continued
Question 3.
(a) We model the future value of a stock as a random variable X, where X has cumulative
distribution function
FX (x) = 1 − exp{−λx}, for x > 0.
(0.1t)r
P(Nt = r) = exp{−0.1t}.
r!
(i) Calculate the probability density function for the time until the first crash. [3]
(ii) What is the probability of precisely one crash in each of the next two years? [2]
(iii) Calculate P(N10 = 1|N10 ≥ 1). [3]
(iv) For 0 < s < t, calculate P(Ns = 0|Nt = 1). What is the distribution of the time
until the first crash given Nt = 1? [6]
end of exam