Exercise Session 6. Solutions.

Fixed Income and Credit Risk

Question 1. The dynamics of a given asset is supposed to satisfy dS = µSdt + σSdW. A risk free account satisfies
dB = rBdt. The aim of the following problem is to obtain the price at time t of an option with payoff K − ST2 if
ST2 < K and 0 otherwise. We will denote the price of such an option by P. Options where the underlying is taken
to some power are called power options. If an option gives the right to exchange a power of underlying against a
fixed price then the option is a call. Otherwise it is a put option.

1. Determine the dynamics of P .

Apply Ito’s lemma to P = P (St , t):

 
1 2 2
dP = Pt + µSPS + σ S PSS dt + σSPS dW.
2

2. You plan to sell an unit of this option. Indicate how many units of the underlying you need to trade as to
obtain an instantaneous risk-free portfolio.

The portfolio Π consists of δ units of the underlying asset and one (short) put option. The dynamics of the
portfolio is:
 
1 2 2
dΠ = d(δS − P ) = δ(µSdt + σSdW ) − Pt + µSPS + σ S PSS dt − σSPS dW =
2
 
1
= δµS − Pt − µSPS − σ 2 S 2 PSS dt + (δσS − σSPs ) dW.
2

Set δ = PS to drive the volatility term to zero and the portfolio dynamic to:
 
1 2 2
dΠ = − Pt + σ S PSS dt.
2

Since dΠ does not contain a stochastic part, Π is riskless over dt.

3. Use the arbitrage argument to obtain the FPDE (Fundamental Partial Differential Equation) that this deriva-
tive asset needs to satisfy.

Since Π is riskless over dt, it must earn a risk-free rate over dt (otherwise there would exist an arbitrage

1
 opportunity). Therefore,

rΠdt = dΠ ⇐⇒
 
1 2 2
r(PS S − P )dt = − Pt + σ S PSS dt ⇐⇒
2
1
rP = Pt + rPS S + σ 2 S 2 PSS .
2

The last line is the Fundamental Partial Differential Equation (FPDE).

In order to solve the FPDE, you need to obtain the transition probability associated with this FPDE. Consider
some dynamics dSt = adt + bdWt where a and b are some parameters, potentially depending on St , t, etc. Suppose
that the transition probability leading from St at time t to ST at time T is denoted p(ST , T |St , t). For some general
function h(·), consider
g(St , t) ≡ E[h(ST )|St , t].

4. Show that g is a martingale in two ways: using the law of iterated expectation and using an argument based
on integrals (Chapman-Kolmogorov). Hint:
Z
E[h(ST )|St , t] = h(ST )p(ST , T |St , t)dST .
ST

Using the law of iterated expectations:

Take 0 < t < s < T .

E[g(Ss , s)|St , t] = E[E[h(ST ) | Ss , s)] | St , t]E[h(ST ) | St , t] = g(St , t).

Using the argument based on the transition probability:

Z
I = E[g(Ss , s) | St , t] = g(Ss , s)p(Ss , s | St , t)dSs
Ss

R
But g(Ss , s) = E[h(ST ) | Ss , s] = h(ST )p(ST , T | Ss , s)dST and hence
Z Z
I = h(ST )p(ST , T | Ss , s) dST p(Ss , s | St , t) dSs
Ss ST
Z Z
= h(ST ) p(ST , T | Ss , s) p(Ss , s | St , t) dSs dST
ST Ss
Z
= h(ST )p(ST , T | St , t) dST = g(St , t).
ST

5. Deduce the PDE (Partial Differential Equation) that g must satisfy.

The previous result shows that g is a martingale, thus the drift of dg is zero (see Exercise Session 5, Question 1).

2
 We obtain the dynamics of g using Ito’s lemma
 
1 2
dg = gt + agS + b gSS dt + bgS dW,
2

and we get
1
gt + agS + b2 gSS = 0
2
by setting the drift equal to zero.

6. Using a Dirac function, determine the PDE that p must satisfy (with respect to the St and t argument).

Using the rules of differentiation under the integral (Leibnitz) and Ito’s lemma, obtain
Z  
1 2
h(ST ) pt + apS + b pSS dST = 0.
2
ST

Since this expression holds for any h function, take for h(·) the Dirac function
(
0 if ST 6= y
h(ST ) = δy (ST ) = ,
1 if ST = y
R
and such that δy (ST )dST = 1. At all points different from ST = y, the integral will be equal to zero. At
ST
the point y, the expression pt + apS + 21 b2 pSS is like a constant and may be taken out of the integral. One
obtains, therefore, an expression such as
 Z
1
pt + apS + b2 pSS δy (ST )dST = 0,
2
ST

which implies:
1
pt + apS + b2 pSS = 0.
2
In other words, the transition probability p = p(ST , T |St , t) satisfies the same PDE as the function g(St , t) ≡
E[h(ST )|St , t].

Consider now as a candidate solution to the FPDE P (St , t) = e−r(T −t) g(St , t) for a particular choice of the h
function.

7. Show that P (St , t) is a solution to the FPDE for a well chosen dynamics of St (specify the values of a and
b). Indicate the boundary condition that it satisfies.

Compute the derivatives of P = e−r(T −t) g:

∂P ∂2P ∂P
= PS = e−r(T −t) gS ; = PSS = e−r(T −t) gSS ; = Pt = re−r(T −t) g + e−r(T −t) gt ,
∂S ∂S 2 ∂t

and plug them back to the FPDE:

1
re−r(T −t) g = re−r(T −t) g + e−r(T −t) gt + rSe−r(T −t) gS + σ 2 S 2 e−r(T −t) gSS .
2

3
 Cancel out terms and multiply by er(T −t) to obtain:

1
gt + rSgS + σ 2 S 2 gS S = 0.
2

The last equation must hold for a = rS and b = σS, as follows from the answer to Question 5.

In other words, under the dynamic dS = rSdt + σSdW the function P (St , t) = e−r(T −t) Et [h(ST )] solves the
FPDE with the boundary condition is
(
K − ST2 if ST2 < K,
h(ST ) =
0 else.

To denote that the discounted conditional expectation of a terminal payoff (i.e., the solution to the FPDE) is
computed under a special dynamic of S, we are going to denote such conditional expectation with a superscript
Q:
e−r(T −t) EQ
t [h(ST )] .

This is often called ‘an expectation computed under a risk-neutral measure’ to emphasize that under such
special dynamic, S grows on average at the risk-free rate r over a small time interval dt.

8. Obtain the option price P (St , t).

Hint: it is not necessary to redo all the algebraic computations. Proceed by analogy with the slides Solving
the FPDE, Part 2 and in particular slide 40/40 being careful with the handling of St2 (consider applying
Ito’s lemma to Yt = St2 , it might help).

Fast way using the result from lectures:

Apply Ito’s lemma to the dynamic of Y = S 2 :

1
dS 2 = 2S(rSdt + σSdW ) + 2σ 2 S 2 dt = 2r + σ 2 S 2 dt + (2σ)S 2 dW,


2

therefore
dY
= (2r + σ 2 )dt + (2σ)dW.
Y
Hence, Y is a GBM with drift 2r + σ 2 and volatility 2σ. Knowing that, apply the result from slide 40
of the ‘Solving the FPDE 2’ deck A) setting m = 2r + σ 2 and s = 2σ, and B) using the call-put parity
C(Yt , t) − P (Yt , t) = Yt − e−r(T −t) K:

2
P = C − Yt + e−r(T −t) K = e−r(T −t) e(2r+σ )(T −t)
Yt Φ(d1 ) − e−r(T −t) KΦ(d2 ) − Yt + e−r(T −t) K =
2 2
)(T −t)
= e(r+σ Yt (Φ(d1 ) − 1) − e−r(T −t) K (Φ(d2 ) − 1) = e−r(T −t) KΦ(−d2 ) − e(r+σ )(T −t)
Yt Φ(−d1 ) =
−r(T −t) (r+σ 2 )(T −t)
=e KΦ(−d2 ) − e St2 Φ(−d1 ),

where d1 and d2 are:

St2
 
Yt s2 ln + (2r + 3σ 2 )(T − t)


ln K + (m + 2 )(T − t) K
d1 = √ = √ ,
s T −t 2σ T − t
St2
 
Yt 2
+ (m − s2 )(T − t) ln + (2r − σ 2 )(T − t)


ln K K
d2 = √ = √ .
s T −t 2σ T − t

4
Full derivation using the results from exercise sessions:

Recall that in Exercise Session 4 we have proved for X ∼ ln N (m, s2 ):

m + s2 − ln k
 
2
m+ s2
E [X · 1X>k ] = e Φ ,
s

which implies that

m + s2 − ln k ln k − m − s2
   
2 2 2
m+ s2 m+ s2 m+ s2
E [X · 1X6k ] = E[X] − E [X · 1X>k ] = e −e Φ =e Φ .
s s

You can adapt this result to the problem at hand. Indeed,

P = e−r(T −t) EQ
t [(K − YT )1YT 6K ] = e
−r(T −t)
KQt [YT 6 K] − e−r(T −t) EQ
t [YT 1YT 6K ] .

Here, Qt [YT 6 K] is a time-t conditional risk-neutral probability that YT 6 K. To compute it, take the
Q−dynamic of Y and integrate it to find YT explicitly:

2
)(T −t)+2σWT −t
YT = eln Yt +(2r−σ .

Therefore,  
 √ 2 
2

YT ∼ N Q ln
| Yt + (2r − σ )(T − t) , 2σ T − t ,

{z } | {z }
M
Σ2

and YT 6 K is equivalent to
eM +Σ 6 K,

where  ∼ N (0, 1). Hence, YT 6 K is also equivalent to

ln K − M
6 ,
Σ

and the Q−probability of this happening is

ln K − ln St2 + (2r − σ 2 )(T − t)

   
ln K − M
Qt [YT 6 K] = Φ =Φ = Φ(−d2 ).
Σ 2σ(T − t)

To complete the derivation, we need to compute EQ

t [YT 1YT 6K ]. Adapting the result from Exercise Session
4, you obtain:

M + Σ2 − ln K
 
Σ2
M+
EQ
t [YT 1YT 6K ] = e Φ −
2 =
Σ
ln St2 + (2r − σ 2 )(T − t) + 4σ 2 (T − t) − ln K
 
2
= Yt e(2r+σ )(T −t) Φ − √ =
2σ T − t
ln St2 + (2r + 3σ 2 )(T − t) − ln K
 
(2r+σ 2 )(T −t)
= Yt e Φ − √ =
2σ T − t
2
)(T −t)
= St2 e(2r+σ Φ(−d1 ),

which is identical to what you found with a shortcut above.