Prof.

Roberto Steri Derivatives I - Problem Set 9 Spring 2019

Problem Set 9
Suggested Deadline: 22/05/2019

The Black and Scholes Model

1
Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

t
1. In a Black-Scholes market two security are traded: the riskless security B(t) = e and the
risky security S whose price evolves following
1 2 )t
( + W (t)
S(t) = S(0)e 2

where W is a standard Brownian motion under the historical probability measure P. Suppose
that S(0) = 20; = 8% = 18% and = 25%.

a) Find the historical probability P that at maturity a European call option on S with
strike price K = 10 and maturity T = 3 is in the money (denote with N ( ) the cumula-
tive distribution function of a standard normal random variable and determine the right
argument for N ( )).
b) Consider the European derivative whose cash‡ow is zero before maturity and whose
payo¤ at maturity T = 3 is

S(3)
X(3) = ln + (W (3))2
S(0)

where W is the standard Brownian motion under the historical probability P. Find the
No-Arbitrage price of the derivative at time t = 0.

Solution.

a) The historical probability that the call option closes in the money is given by
2 3
1 2
( )T + W (T )
P [ S (T ) > K] = P 4S(0)e 2 > K5 (1)

The distribution of W (T ) is

W (T ) N ormal(0; T )

and can be espressed in terms of a standard normal distribution as

p
W (T ) TZ

where Z N ormal(0; 1):As a consequence, (1) can be rewritten as

2 3
1 2 p
( )T + TZ
P [ S (T ) > K] = P 4S(0)e 2 > K5

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Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

from which we obtain

2
1 K
P [ S (T ) > K] = P Z > p ln T (2)
T S(0) 2

Plugging the numerical data into (2) yields

P [ S (T ) > K] = P [Z > 2:6313] = N (2:6313)

b) The no arbitrage price of the derivative is

S(3)
SX (0) = e T
E Q [X(T )] = e T
E Q ln + (W (3))2
S(0)
Recalling that
W (t) = W Q (t) t

where W Q is a standard brownian motion under the risk-neutral measure Q, we obtain

" #
2
S(T )
SX (0) = e T E Q ln + W Q (T ) T =
S(0)
" #
2
S(T )
= e T E Q ln + W Q (T )2 + T 2W Q (T ) T
S(0)

By the properties of brownian motions we have E Q W Q (T )2 = V arQ W Q (T ) = T

and E Q W Q (T ) = 0. Moreover we have

S(T ) 1 2
ln = T + W (T )
S(0) 2
and, under the risk-neutral measure Q
S(T ) 1 2
ln = T + W Q (T )
S(0) 2
Hence " #
2
T 1 2
SX (0) = e T +T + T (3)
2
Plugging the numerical data into (3) yields:
" #
2
1 0:18 0:08
SX (0) = e 0:08 3 0:08 (0:25)2 3 + 3 + 3 = 3:6077
2 0:25

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Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

2. In a Black-Scholes market two securities are traded: the riskless security B(t) = e t and the
risky security S whose price is
1 2 )t
( + W (t)
S(t) = S(0)e 2

where W is a standard Brownian motion under the historical probability measure P. Suppose
that S(0) = 10; = 6%; = 10% and = 16%.

a) Find the historical probability P that an European put option on S with strike price K =
10 and maturity T = 4 is out of the money (denote with N ( ) the cumulative distribution
function of a standard normal random variable and determine the right argument for
N ( )).
b) In a forward contract the delivery price F is the price at which the buyer (long position)
of the forward contract must buy S at the maturity T: The forward price F is determined
in such a way that the no-arbitrage value of the forward contract is 0 at time t = 0. Find
the forward price F in a forward contract on S with maturity T = 4:

Solution.

a) The historical probability that the put option closes out of the money is given by
2 3
1 2
( )T + W (T )
P [ S (T ) > K] = P 4S(0)e 2 > K5 (4)

The distribution of W (T ) is
W (T ) N ormal(0; T )
and can be espressed in terms of a standard normal distribution as
p
W (T ) TZ
where Z N ormal(0; 1):As a consequence, (4) can be rewritten as
2 3
1 2 p
( )T + TZ
P [ S (T ) > K] = P 4S(0)e 2 > K5

from which we obtain

2
1 K
P [ S (T ) > K] = P Z > p ln T (5)
T S(0) 2
Plugging the numerical data into (5) yields
P [ S (T ) > K] = P [Z > 1:09] = N (1:09)

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Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

b) Under no-arbitrage the forward price F must be such that the value of the forward
contract is null at time t = 0, that is

EQ [S(4) F] = 0

Therefore:
F = EQ [S(4)]

The dynamic of S(t) under Q is given by

1
( 2 )t + W Q (t)
S(t) = S(0)e 2

where W Q (t) is a standard Brownian motion under the risk-neutral measure.

Hence:
t
EQ [S(t)] = S(0)e
so that for T = 4
F = EQ [S(4)] = S(0)e0:06 4 = 12:712:

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Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

3. In a Black-Scholes market two securities are traded: the riskless security B(t) = e t and the
risky security S whose price is
2
t+ W (t)
S(t) = S(0)e 2

where W is a standard Brownian motion under the historical probability measure P. Suppose
that: S(0) = 20; = 4%; = 8% and = 10%.

a) Suppose that two European call options on S are traded in the market, both with ma-
turity T = 1 but with di¤erent strike prices, in particular suppose that K1 = 10 and
K2 = 16 respectively. Find the historical probability P that both the call options are
in the money (indicate the proper argument of the standard normal cumultative distribution
function N ( )).
b) Determine the price at t = 0 of a derivative whose payo¤ at maturity T = 1 is given by
X(1) = W 2 (1)
where W is a standard Brownian motion under the historical probability measure P:

Solution.

a) The historical probability that the both options close in the money is given by
2 3
1 2
( )T + W (T )
P [ S (T ) > max(K1 ; K2 )] = P 4S(0)e 2 > K2 5 (6)

The distribution of W (T ) is
W (T ) N ormal(0; T )
and can be espressed in terms of a standard normal distribution as
p
W (T ) TZ
where Z N ormal(0; 1):As a consequence, (6) can be rewritten as
2 3
1 2 p
( )T + TZ
P [ S (T ) > K2 ] = P 4S(0)e 2 > K2 5

from which we obtain

2
1 K2
P [ S (T ) > K2 ] = P Z > p ln T (7)
T S(0) 2
Plugging the numerical data into (7) yields
P [ S (T ) > K2 ] = P [Z > 2:9814] = N (2:9814)

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Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

b) The no arbitrage price of the derivative is

SX (0) = e T
E Q [X(T )] = e T
E Q [(W (1))2 ]

Recalling that
W (t) = W Q (t) t

where W Q is a standard brownian motion under the risk-neutral measure Q, we obtain

" #
2
T Q Q
SX (0) = e E W (T ) T = (8)
" #
2
T Q Q 2 Q
= e E W (T ) + T 2W (T ) T

By the properties of brownian motions we have E Q W Q (T )2 = V arQ W Q (T ) = T

and E Q W Q (T ) = 0. Hence
" #
2
T
SX (0) = e T+ T

Plugging the numerical data into (8) yields:

" #
2
0:08 0:04
SX (0) = e 0:04 1 1 + 1 = 1:1145
0:10

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Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

4. The Black-Scholes model is a continuous-time security market in which the price of the risk-
free security is B(t) = e t while the price of the risky security is lognormal with drift and
volatility under the historical probability P. In this exercise, assume the following values
for the parameters: S(0) = 0:4, = 5%, = 8%, = 14%:

a) Write the stochastic di¤erential equation that describes the dynamics of under the his-
torical probability P.
b) Employ Ito’s Lemma to determine the stochastic di¤erential equation that describes the
dynamics of the quantity
Y (t) = e2 t (S(t))3
under the risk-neutral probability/equivalent martingale measure Q of the Black-Scholes
market. Does Y follow a lognormal process? If your answer is positive, write down
explicitly the drift and volatility of Y under Q.
c) Consider now an European derivative written on Y; with maturity T = 1; whose payo¤
at T = 1 is Y (1) (the Y process is still the one introduced in the previous point). What
is the no-arbitrage price of the derivative at time t = 0? Can you replicate the derivative
with a self-…nancing strategy constituted by S and B? If your answer is positive, which
is the cost at time t = 0 of such strategy?
d) Consider now the derivative described in point c), but with maturity T 0 = 0:5: In other
words, the payo¤ of this European contract at the maturity T 0 = 0:5 is Y (0:5) (the
Y process is still the one introduced in point c). What is the no-arbitrage price of this
derivative at time t = 0? Can you replicate it with a self-…nancing strategy constituted
by S and B? If your answer is positive, which is the cost at time t = 0 of such strategy?
May this strategy be the same that replicates the derivative with maturity T = 1 in
point c)?

Solution.

a) The stochastic di¤erential equation that describes the dynamics of S under the historical
probability P is
dS(t) = S(t)dt + S(t)dW (t);
with = 8%; = 14%, and where W (t) is a standard Brownian motion under the
historical probability P:
b) We apply Ito Lemma to '(t; S) = e2 t S 3 , where S(t) is the lognormal process governing
the dynamic of the.risky security under P, that is

dS(t) = a(t; S(t))dt + b(t; S(t))dW P (t) (9)

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Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

with a(t; S(t)) = S(t) and b(t; S(t)) = S(t). We have

@'(t;S) @'(t;S) @ 2 '(t;S)
@t
=2 e2 t
S 3; @S
= 3 e2 t
S 2; @S 2
= 6 e2 t
S

The stochastic di¤erential of Y (t) with respect to the historical measure P is

dY (t) = d'(t; S(t)) = (10)

1
2 e2 t S(t)3 + S(t)3e2 t S(t)2 + ( S(t))2 6e2 t S(t) dt + S(t)3e2 t S(t)2 dW P (t)
2
that is
2
dY (t) = Y (t) 2 +3 +3 dt + 3 dW P (t)
Recalling that
dW P (t) = dW Q (t) dt

we get the the stochastic di¤erential of Y (t) with respect to the risk neutral measure Q,
that is
2
dY (t) = dY (t) = Y (t) 2 +3 +3 dt + 3 dW Q (t) 3( )dt (11)

Simplifying and rearranging (11) yields

2
dY (t) = Y (t) 5 +3 dt + 3 dW Q (t) (12)

Hence the process Y (t) is lognormal under Q with

2
drif t = 5 + 3 = 0:3088

and
volatility = 3 = 0:42

c) The no-arbitrage price of the European derivative is equal to

1
SY (0) = EQ e Y (1) = e Y (0)edrif t 1 = S(0)3 e edrif t = 0:82904

The derivative can be replicated because the market is complete. Since the market is
arbitragre free, its price at t = 0 must be equal to the no-arbitrage price SY (0):The
replicating portfolio (t) [ 0 (t); 1 (t)]T in the assets S and B for the derivative must
be such that
V# (1) = 0 (1)e 1 + 1 (1)S(1) = f (t; S(t)) = Y (1)
under the self-…nancing condition, that is

dV# (t) = 0 (t)dB(t) + 1 (t)dS(t)

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Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

By the no-arbitrage requirement we have, for any t 1:

t
V# (t) = 0 (t)e + 1 (t)S(t) = F (t; S(t)) (13)

where F (t; S(t)) is the no-arbitrage price of the derivative at time t, that is

Y (t)e(5 )(T
+3 2 t)
(T t)
F (t; S(t)) = e Y (t)edrif t (T t)
=e (T t)
(14)

Rearranging (14) we obtain, for T = 1,

2 2t
F (t; S(t)) = S(t)3 e4 2 t+3 3

Applying Ito’s lemma to both sides of (13) yields

0 (t) et+ 1 (t) S(t) dt + 1 (t) S(t)dW Q (t) = (15)

@F @F 1 @2F @F
= + S(t) + 2
( S(t))2 dt + S(t)dW Q (t)
@t @S 2 @S @S

Since we want to replicate the derivative almost surely we equal the coe¢ cients of dW Q (t)
in (15). Therefore:
@F 2 2
1 (t) = = 3S(t)2 e4 2 t+3 3 t
@S
The units of the risky asset in the replicating portfolio can be worked out from (13).
Hence:
t 2 2
0 (t) = e [F (t; S(t)) 1 (t)S(t)] = 2e4 3 t+3 3 t S(t)3
Finally, as we pointed out above, the cost of (t) at t = 0 in equal to the no-arbitrage
price SY (0). In fact:
2 2
V# (0) = 0 (0) + 1 (0)S(0) = 2e4 +3
S(0)3 + 3e4 +3
S(0)3 =
2
= e4 +3
S(0)3 = S(0)3 e edrif t = 0:82904 = SY (0)

d) The no-arbitrage price of the European derivative is equal to

SY0 (0) = EQ e 0:5

Y (0:5) = e 0:5
Y (0)edrif t 0:5 = S(0)3 e 0:5 drif t 0:5
e = 0:07284

The derivative can be replicated because the market is complete. Since the market is
arbitragre free, its price at t = 0 must be equal to the no-arbitrage price SY0 (0): Hence,
since SY0 (0) 6=tSY (0), the replicating strategy cannot be the same that replicates the
derivative with maturity T = 1 in point 4. More precisely, repeating the steps in point
4 for T 0 = 0:5, we have

Y (t)e(5 )(T 0
2
(T 0 t) 0 (T 0 t) +3 t)
F (t; S(t)) = e Y (t)edrif t (T t)
=e (16)

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Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

Rearranging (16) we obtain, for T 0 = 0:5,

2 t+ 23 2 2t
F (t; S(t)) = S(t)3 e2 3

0
The replicating strategy (t) [ 00 (t); 0
1 (t)]
T
is given by

0 @F 2 t+ 32 2 2t
1 (t) = = 3S(t)2 e2 3
@S
and
0 t 0 3 t+ 32 2 2t
0 (t) =e [F (t; S(t)) 1 (t)S(t)] = 2e2 3
S(t)3
0
Finally, as we pointed out above, the cost of (t) at t = 0 in equal to the no-arbitrage
price SY0 (0). In fact:
0 0 + 23 2 + 23 2
V#0 (0) = 0 (0) + 1 (0)S(0) = 2e2 S(0)3 + 3e2 S(0)3 =
2 + 32 2
= e S(0) = S(0)3 e
3 2 edrif t 0:5 = 0:07284 = SY0 (0)

The strategy 0 (t) would be the same that replicates the derivative with maturity T = 1
in point 4 only if
0
0 (t) = 0 (t)
0
1 (t) = 1 (t)

for each t 2 0; 12 . However, the system

( 2 2 3 2 2t
2e4 3 t+3 3 t S(t)3 = 2e2 3 t+ 2 3
S(t)3
2 2 3 2 2t
3S(t)2 e4 2 t+3 3 t = 3S(t)2 e2 2 t+ 2 3

has no solutions because

3 2
2 + 6= 0
2

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Prof. Roberto Steri Derivatives I - Problem Set 9 Spring 2019

5. In a …nancial market the following securities are traded in continuous time: a riskless asset,
yielding a risk-free rate = 5%; a risky security S with price process with initial value
S(0) = 20 and evolving according to the SDE

dS(t) = S(t)dt + S(t)dW (t);

with = 10%; = 12% and W (t) a standard Brownian motion under P.

a) What is the share to be invested in S to set up a portfolio of S and B with di¤usion

coe¢ cient = 8:4%: What is the instantaneous return of portfolio ?
b) Compute the expected value of S(2) under the physical measure P and the risk-neutral
measure Q.
c) Suppose that in the market traded are a call and a put option on S, with maturity T = 2
and strike price K = 15. The call price is c = 6:4381, while the put price is p = 0:2. Is
the market arbitrage-free? Justify your answer.

Solution.

a) Let be the share invested in S: Portfolio has dynamics described by the SDE
d (t)
= dt + dW (t);
(t)
with = + (1 ) and = : Hence, in order to have = 8:4% we must set

= = 0:7

and consequently = + (1 ) = 0:085:

b)

EP [S(2)] = S(0)e T
= 24:4280
EQ [S(2)] = S(0)e T
= 22:1034

c) The put-call parity

T
c p = S(0) Ke
does not hold, since in our case
T
c p = 6:2381 6= 6:4274 = S(0) Ke

and thus the market is not arbitrage-free.

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