TOM MBOYA UNIVERSITY

COLLEGE
UNIVERSITY EXAMINATIONS
MAC 40: COMPUTATIONAL FINANCE
INSTRUCTIONS
• Answer Question ONE (COMPULSORY) and any other TWO questions.
• Question ONE carries 30 marks, the rest 20 marks each.

Question 1

a) Define the following terms

i. arbitrage opportunity (1 mark)
ii. intrinsic value (1 mark)
iii. forward contact (1 mark)
b) State what is meant by put-call parity. (2 mark)
c) Company X issues 3-month European call options on its own shares with a strike
price of 120p. They are currently priced at 30 pence per share. The current share
price is 123p and the current force of interest is 𝛿= 6% p.a and dividends are
payable continuously at a rate of q = 12% pa then calculate the fair price for put
options on the share price at the same strike price.
(4 mark)
1 2
d) Let 𝑥𝑡 = ⅇ𝜆𝐵−2𝜆𝑡 , where 𝜆 is any constant. Show that Xt is a martingale with
respect to Ft , the filtration associated with Bt . (5 mark)
e) State the defining properties of standard Brownian motion Bt. (5 mark)
f) Let Xt be a diffusion process: dXt = 𝜇(t, Xt )dt +𝛿(t, Xt )dZt where Zt is a

standard Brownian motion. Find the stochastic differential equation for f (t, Xt)
using Ito’s Lemma and check your answer using a Taylor’s series expansion for
two variables. (5 mark)
 g) A forward contract is arranged where an investor agrees to buy a share at time T
for an amount K. It is proposed that the fair price for this contract at time t is:
𝑓(𝑠𝑡,𝑡 ) = 𝑠𝑡 − 𝑘ⅇ −𝑟(𝑇−𝑡)
Show that this:
i. satisfies the boundary condition (1 mark)
ii. satisfies the Black-Scholes PDE. (5 mark)

Question 2

a) A building society issues a one-year bond that entitles the holder to the return on a
weighted-average share index (ABC500) up to a maximum level of 30% growth
over the year. The bond has a guaranteed minimum level of return so that
investors will receive at least x% of their initial investment back. Investors cannot
redeem their bonds prior to the end of the year. The volatility of the ABC500
index is 30% pa and the continuously compounded risk-free rate of return is 4% pa
Assuming no dividends, use the Black-Scholes pricing formulae to determine the
value of x (to the nearest 1%) that the building society should choose to make
neither a profit nor a loss. (10 mark)
b) An investor claims to be able to value an unusual derivative on a non-dividend
paying share using the pricing formula:
𝑣𝑡 = 𝑠𝑡2 ⅇ −4𝑠𝑡
where St denotes the price of the share at time t .
(i) Derive formulae for the delta and gamma of the derivative, based on the
pricing formula above. (6 mark)
(ii) For each of the following scenarios, calculate the number of shares that
must be purchased or sold along with a short holding in one derivative, in
order to achieve a delta-hedged portfolio:
When the current share price is 1, when the current share price is 3.
 (2 mark)
(iii) Explain which of the scenarios in (ii) is likely to involve more portfolio
management in the near future if the investor is determined to maintain a
delta-hedged portfolio. (2 mark)

QUESTION 3
a) In the context of a non-dividend-paying security, define the Greeks (in both
words and using formulae) and state whether each has a positive or negative
value for a call option and a put option. (10 marks)

b) Using the standard Black-Scholes call option price formula, calculate the price of
a European call on a non-dividend-paying stock with the following features:
risk-free rate 5% pa (continuously compounded)
volatility 20% pa
time to expiry 1 year
current price of underlying 100p
strike price 100p. (5 marks)

c) What is the difference between a European option and an American option?

(1 mark)
d) 𝑧𝑡 = ⅇ 𝛼𝑥(𝑡) where x has the stochastic differential dXt = 𝜇dt +𝛿dZt, Compute the

stochastic differential ⅆ𝑧 (4marks)

QUESTION 4

a) consider a two-period binomial model of a stock whose current price is 40.

Suppose that:
Over the first period, the stock price can either move up to 60 or down to 30.
Following an up-movement in the first period, the stock price can either move up
to 80 or down to 50.
Following a down-movement in the first period, the stock price can either move
up to 40 or down to 25.
The real-world probability of an up-movement is always equal to ½.
The continuously-compounded risk-free rate of return is 5% per time period. find
V0 , the current value of a two-period European call option, that has an exercise
price of 45. (12 marks)

b) Compute the following stochastic differential ⅆ𝑧 when

i. 𝑧𝑡 = ⅇ 𝛼𝑡 (4 marks)
𝑡
ii. 𝑧𝑡 = ∫ 𝑔(𝑠) ⅆ𝑤(𝑠) (4 marks)
𝑜
QUESTION 5

a. Let Bt be a standard Brownian motion, and let Ft =𝛿 [𝐵𝑠 , 0 ≤ 5 ≤ 𝑡 ] be its natural

filtration.
i. Derive the conditional expectations 𝐸 [𝐵𝑡2 |𝐹𝑠 ] and 𝐸 [𝐵𝑡4 |𝐹𝑠 ] where 𝑠 ≤ 𝑡
You may assume that the third and fourth moments of a random variable with
distribution 𝑁[0, 𝛿 2 ] are 0 and 3𝛿 24 respectively. (8 marks)

b. An investment banker wishes to model exchange rate movements between US Dollars

and Euros as a geometric Brownian motion. Suppose she decides to use the following
stochastic differential equation for this purpose:
ⅆ𝑥𝑡 = (𝑟𝑖 − 𝑟𝑒 )𝑥𝑡 ⅆ𝑡 + 𝛿𝑥𝑡 ⅆ𝐵𝑡
where:
𝑥𝑡 represents the value of US Dollars in terms of Euros
𝑟𝑖 𝑎𝑛ⅆ 𝑟𝑒 are the short-term interest rates in the US and the Eurozone respectively
𝐵𝑡 is a standard Brownian motion.
i. Explain why the value of the US Dollar is likely to increase when
𝑟𝑖 𝑔𝑟ⅇ𝑎𝑡ⅇ𝑟 𝑡ℎ𝑎𝑛 𝑟𝑒 . (2 marks)
ii. By considering the function 𝑓 𝑥𝑡 = 𝑙𝑜𝑔 𝑥𝑡 , use Ito’s Lemma to solve the above
( )
stochastic differential equation for Xt. (5 marks)
1
iii. Let 𝐺𝑡 = denote the value of the Euro in terms of US Dollars. Derive the
𝑥𝑡
stochastic differential equation for t G and comment on your answer.
(5 marks)