Chair of Mathematical Finance

Department of Mathematics
Technical University of Munich
Financial Mathematics 1
Aleksey Min, Ben Spies, and Michel Kschonnek

Exercise sheet 7
The exercise sheet will be discussed in two groups of in-person exercise sessions on December 7/8,
2022, and in videos available on the Moodle page. For details, see the course’s Moodle
announcements. You should try to solve the exercises at home before the exercise.

Exercise 7.1
Consider a two-period binomial model with P (0) = 100, u = 1.2, d = 0.8, and r = 5 %. We want to
price a European call option with maturity T = 2 and strike K = 90, whose payoff at maturity and price
process are denoted by C(2) and VC = {VC (t) : t ∈ {0, 1, 2}}, respectively.
a) Draw a binomial tree diagram with the values of the security at each node and determine the set of
all risk-neutral probability measures M.
b) Use Theorem 4.3 (see slide 163) to determine the option price VC (t) at time points t ∈ {0, 1, 2}.

Homework 7.2 (10 points)

Consider a two-period binomial model with P (0) = 100, u = 1.25, d = 0.8 and r = 10 %. Furthermore,
denote Y (t) = max {P (s) : s ≤ t}, t ∈ {0, 1, 2}.
a) Draw a tree diagram (see slide 151) and determine the risk-neutral probability for an upward move-
ment q̃.
b) Write the elements of the sample set Ω and their corresponding probabilities under the risk-neutral
measure Q̃.
c) Consider a knock-in barrier option with exercise price K = 90, barrier B = 110 and maturity T = 2;
its payoff is given by:
D1 (2) = max {P (2) − K, 0}1[Y (2)≥B] .
Determine the payoff D1 (2, ω) for all ω ∈ Ω and use Theorem 4.3 (see slide 163) to calculate the
option price at time t = 0.
d) Use Theorem 3.28 (see slide 156) to determine the probability Q̃(Y (2) ≥ P (0)ui ), i ∈ {0, 1, 2}, and
use the result to price a digital barrier option with payoff at maturity T = 2 given by D2 (2) =
1[Y (2)≥B] for B = 110.

Exercise 7.3
Consider the two-period financial market model from Exercise 6.2 with a riskless interest rate r = 0.
Then, the set of all risk neutral probability measures is given by:
n
0 o
M = 1/6 1/6 2/9 4/9 .

Construct a hedging strategy for a European put option with strike K = 2 and maturity T = 2.

Exercise 7.4
a) Let X and Y be two random variables on a probability space (Ω, F, Q) fulfilling E[X 2 ], E[Y 2 ] < ∞.
Let G ⊂ F be an arbitrary sub-algebra of F. Show: If E[X | G] = Y and E[X 2 | G] = Y 2 almost
surely, then X = Y almost surely.
2
Hint: Calculate E[(X − Y ) ].

© Technical University of Munich, Chair of Mathematical Finance

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b) Let Ω = {ω1 , ω2 , ω3 } with probabilities Q(ω1 ) = 1/2, and Q(ω2 ) = Q(ω3 ) = 1/4 and define the
random variable Z by Z(ω1 ) = 1, Z(ω2 ) = 2 and Z(ω3 ) = 4. Calculate the conditional expectation
E[E[Z | H1 ] | H2 ] for the algebras H1 = {∅, {ω1 }, {ω2 , ω3 }, Ω} and H2 = {∅, {ω1 , ω2 }, {ω3 }, Ω}.
Hint: Recall the definition of conditional expectations from Exercise 6.1.

Programming exercise 7.5

Let r ≥ 0 and σ > 0 and consider an n-period binomial tree with final maturity T > 0 and step-size
∆t = T /n. The goal of this exercise is to check numerically that the formulas for the arbitrage-free prices in
the (discrete-time) binomial model converge to the formulas obtained in the well-known (continous-time)
Black-Scholes model if we decrease the step size via letting n → ∞.
a) Write an R-function StockPriceDensity returning a distr::DiscreteDistribution object of the
(discrete) distribution of the final stock price P1 (T, ωk ), k ∈ {1, . . . , n + 1}. The arguments are the
initial price s0 , the inter-period interest rate r, and the upwards and downwards movement u and
d, respectively, and the number of periods n.
Hint: Draw the corresponding (recombining!) tree first; use the R-function dbinom .

Let T = 5, r = 3 %, σ = 20 %, and s0 = 100. Furthermore, define the upwards

√ and downwards movement
and the inter-period interest rate for the n-period tree by un = exp {σ ∆t}, dn = 1/un , and rn = r∆t,
respectively.
b) Plot the counting density of P1 (T ), i.e., the graph of the mapping


{P1 (T, ω1 ), . . . , P1 (T, ωn+1 )} → [0, 1], P1 (T, ωk ) 7→ P P1 (T ) = P1 (T, ωk ) ,

for n = 100 using a log-scale for the states ωk with k ∈ {1, . . . , n + 1}.
c) Show numerically, using the method distrEx::E, for n = 100 that
h i
−n
s0 = P1 (0) = EQ̃ P1 (T ) · (1 + rn ) .

Now, consider a digital call option D, i.e., with payoff D(T ) = 1{P1 (T )≥K} for some K > 0.
d) Create a plot for n ∈ {1, . . . , 1000} to show that the arbitrage-free price of the digital call option
with K = s0 converges to
!
log (s0 /K) + r − 21 σ 2 T
Φ − √ ,
σ T
where Φ is the cumulative distribution function of the standard normal distribution. (Note that this
corresponds to the fair price of the digital call in the continuous-time Black-Scholes model.) Create
√
a second plot to show that the convergence happens at rate O(1/ n), i.e., there exists n0 , m ∈ N s.t.
the error terms n , n ∈ N, fulfil
|n | ≤ K ∀n ≥ n0 .

Financial Mathematics 1 — Exercise

The exercise sheet will be discussed in two groups of in-person exercise sessions on December 7/8, 2022, and in videos available
on the Moodle page. For details, see the course’s Moodle announcements. You should try to solve the exercises at home before
the exercise.