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Utrecht University
Mathematical Institute

Answers re-Examation Introduction to Financial Mathematics,

WISB373
Wednesday July 21th 2021, 15:15-18:15 o’clock (3 hours examination)

1. The stock price of company AB at time t0 = 0 equals S0 = 10.0e. A call

option on this stock with exercise in 60 days and strike price K = 10.5e
costs c(t0 ) = 1e. Prepare a table in which the stock price on the exercise
date in the first row varies from 9.5e to 12.5e. In the second row, put
the profit/loss, in percentage, when buying the stock at t0 and selling it
at t = T ; in the third row, the profit/loss at time t = T , in percentage,
when buying the option at t0 . Compare the gains and losses in the option
and stock returns.

stock price at time t = T

9.5 e 10 e 10.5 e 11 e 11.5 e 12 e 12.5 e
profit stock -5 0 5 10 15 20 25
profit option -100 -100 -50 0 50 100 150

2. Show that, for a continuously, differentiable function g(t), the process

Z t
X(t) = g(t)W (t) − g 0 (z)W (z)dz,
0

is a martingale w.r.t. the natural filtration generated by the Brownian

motion W (t), where g 0 (t) is the first derivative of g(t), and subsequently
show that Z t 
E[e2t W (t)] = E 2e2z W (z)dz .
0

Answer Ex. 2.: The corresponding SDE must not contain a drift term, if it represents
a martingale process. The differential process of the integral equation is
found to be,

dX(t) = d(g(t)W (t)) − g 0 (t)W (t)dt

= g 0 (t)W (t)dt − g(t)dW (t) − g 0 (t)W (t)dt
= −g(t)dW (t),

where the differentiation, denoted by d, is in the Itô sense. Hence, the

process is a martingale, as we don’t encounter any dt-term.

Express the term e2t W (t) in its integral form. as follows,

d(e2t W (t)) = 2e2t W (t)dt + e2t dW (t)

Z 0
e2t W (t) = (2e2u W (u)du + e2u dW (u)),
t

where W (0) = 0 is used in the second equation. Taking the expectation at

Rt
both sides and using E[ 0 e2u dW (u)] = 0, because infinitesimal increments
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of Brownian motion are governed by a normal distribution with zero mean.

Therefore,

 t 2u
Z
E[e2t W (t)] = E

2e W (u)dt .
0

3. A strangle, St(t), is an option construction in which the investor takes a

long position in a call and a put with different strike prices (K1 for the
call, and K2 for the put, with K1 > K2 ), but with the same exercise date
T and on the same stock S.
List the payout on the exercise date, distinguishing three different areas
for the St(T ) share price. When would an investor buy a strangle in the
case K2 << K1 and K2 < S0 < K1 ?
Answer 3.: As it is clear from the diagram, there are three pay-off possibilities at
the expiry date. In the left side of the diagram, the put option pay-off
is positive whereas in the middle of the plot one does not gain anything
from both options, and in the high asset value side of the plot one profits
from the call option.
If the volatility of the asset prices is high and investment is unreliable, an
investor can buy a strangle to prevent huge losses.

4. Suppose that X(t) satisfies the following Stochastic Differential Equation

(SDE):
dX(t) = 0.02X(t)dt + σX(t)dW (t),
and Y (t) satisfies:

dY (t) = βY (t)dt + 0.1Y (t)dW (t).

Parameters β, σ are positive constants and both processes are driven by

the same Brownian Motion W (t).
For a given process
Y (t)
Z(t) = + (λ − σ)t,
X(t)
with λ ∈ R.
(a). Find the SDE for Z(t).
(b). For what values of β, σ and λ is process Z(t) a martingale?

Answer 4a. We have:

σ2
X(t) = eσW (t)− 2 t+0.02t
,
dX(t) = 0.02X(t)dt + σX(t)dW (t).

0.01
Y (t) = e0.1W (t)− 2 t+βt ,
dY (t) = βY (t)dt + 0.1Y (t)dW (t).

Using the expressions for X(t) and Y (t), we get,

0.01 σ2
Z(t) = e(0.1−σ)W (t)+(−0.02− 2 +β+ 2 )t
+ (λ − σ)t.
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Answer 4b. A martingale process does not contain a drift term. We have,

dZ(t) = (Z − (λ − σ)t)(−0.025 + β + 0.5σ 2 )dt

+(λ − σ)dt + (Z − (λ − σ)t)(0.1 − σ)dW (t).

With β and σ constant, and λ ∈ R+ , the necessary conditions for a

vanishing drift term are λ = σ and

To check this result we employ the Itô’s derivative rules for multi-
variate functions, i.e.,

dY (t) Y (t)dX(t) dY (t)dX(t) Y (t)dX 2 (t)

 
dZ(t) = − − + = (λ − σ)dt
X(t) X 2 (t) X 2 (t) X 3 (t)


= (Z(t) + λt) (0.04 − β − 0.1σ + 0.01)dt + (σ − 0.1)dW (t) + (λ − σ)dt,

which yields the same constraints.

5. Let {(W1 (t), W2 (t)) : t ≥ 0} be a two-dimensional Brownian motion

defined on a probability space (Ω, F, P). Consider the two processes
{Z(t) : t ≥ 0} and {B(t) : t ≥ 0}, defined by
Z t
Z(t) = 1 + e−W1 (t) eW1 (u) dW2 (u),
0

and
Z t Z t
1 Z(u)
B(t) = p dW1 (u) − p dW2 (u).
0 1+ Z 2 (u) 0 1 + Z 2 (u)

(a). Use Lévy’s characterization to prove that process {B(t) : t ≥ 0} is a

one-dimensional Brownian motion.
(b). Prove that the process {Z(t) : t ≥ 0} can be written as
Z t
1 t
Z
Z(t) = 1 + W2 (t) − (Z(u) − 1)dW1 (u) + (Z(u) − 1)du.
0 2 0

Proof 5(a): We will use Levy’s characterization of a Brownian motion. Clearly

B(0) = 0 and since Itô integrals have continuous paths and are mar-
tingales, we see that {B(t) : t ≥ 0} has continuous paths and is a
sum of two martingales; hence it is also a martingale. It remains to
show that [B, B](t) = t. Note that

1 Z(t)
dB(t) = p dW1 (t) − p dW2 (t),
1 + Z 2 (t) 1 + Z 2 (t)

thus
1 Z 2 (t)
dB(t)dB(t) = 2
dt + dt = dt.
1 + Z (t) 1 + Z 2 (t)
So, [B, B](t) = t and by Lévy’s characterization, {B(t) : t ≥ 0} is a
one-dimensional Brownian motion.
Rt
Proof 5(b) Let X(t) = e−W1 (t) and Y (t) = 0 eW1 (u) dW2 (u), then
Z(t) = 1 + X(t)Y (t).
By definition, we have dY (t) = eW1 (t) dW2 (t). We will now derive the
SDE for the process {X(t) : t ≥ 0}, using the Itô-Doeblin formula
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applied to the function f (x) = e−x . We have fx (x) = −f (x) and

fxx (x) = f (x), thus
1
dX(t) = (W1 (t)) = −X(t)dW1 (t) + X(t)dt,
2
that is Z t Z t
1
X(t) = 1 − X(u)dW1 (u) + X(u)du.
0 2 0

Since W1 (t) and W2 (t) are independent, dX(t)dY (t) = 0. Applying

the Itô product rule, we have,

dZ(t) = d(1 + X(t)Y (t)) = X(t)dY (t) + Y (t)dX(t) + dX(t)dY (t)

1
= X(t)(eW1 (t) dW2 (t)) + Y (t)(−X(t)dW1 (t) + X(t)dt)
2
1
= dW2 (t) − X(t)Y (t)dW1 (t) + X(t)Y (t)dt
2
1
= dW2 (t) − (Z(t) − 1)dW1 (t) + (Z(t) − 1)dt.
2
Since Z(0) = 1, the above shows that
Z t Z t
1
Z(t) = 1 + W2 (t) − (Z(u) − 1)dW1 (u) + (Z(u) − 1)du.
0 2 0

6. Let {(W1 (t), W2 (t)) : t ≥ 0} be a 2-dimensional Brownian motion, defined

on a probability space (Ω, F, P). Consider two price processes {S1 (t) : t ≥
0} and {S2 (t) : t ≥ 0} with corresponding SDE given by:

dS1 (t) = αS1 (t)dW1 (t) + βS1 (t)dW2 (t)

dS2 (t) = γS2 (t)dt + σS2 (t)dW1 (t),

where α, β, γ, σ are positive constants.

(a). Show that {S1 (t)S2 (t) : t ≥ 0} is a 2-dimensional Itô-process.
(b). Consider a finite expiration date T , and suppose the interest rate is
constant, R(t) = r for all t > 0. Show that the market price equations
have a unique solution, and determine the risk-neutral probability
measure P̃ for the process {(S1 (t), S2 (t) : 0 ≤ t ≤ T }.
Proof 6(a): We apply Itô’s product rule, as follows,

d(S1 (t)S2 (t)) = S1 (t)dS2 (t) + S2 (t)dS1 (t) + dS1 (t)dS2 (t).

Using dS1 (t) = αS1 (t)dW1 (t) + βS1 (t)dW2 (t), dS2 (t) = γS2 (t)dt +
σS2 (t)dW1 (t), and simplifying, we get

d(S1 (t)S2 (t)) = (γ+ασ)S1 (t)S2 (t)dt+(σ+α)S1 (t)S2 (t)dW1 (t)+βS1 (t)S2 (t)dW2 (t).

Equivalently,
Z t
S1 (t)S2 (t) = S1 (0)S2 (0) + (γ + ασ)S1 (u)S2 (u)du
0
Z t Z t
+ (σ + α)S1 (u)S2 (u)dW1 (u) + βS1 (u)S2 (u)dW2 (u).
0 0

Hence, {S1 (t)S2 (t) : t ≥ 0} is a 2-dimensional Itô process.

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Proof 6(b): Using the notation of the book, we have

α1 = 0, σ11 = α, σ12 = β, α2 = γ, σ21 = σ, σ22 = 0.

The market price equations in this case form the system,

−r = αθ1 (t) + βθ2 (t)

γ−r = σθ1 (t)

Solving for θ1 (t), θ2 (t), we get

γ−r
θ1 (t) =
σ
σr + α(γ − r)
θ2 (t) = −
σβ
Setting
( Z )
T Z T
1
θ12 (t) + θ22 (t) dt


Z = exp − (θ1 (t)dW1 (t) + θ2 (t)dW2 (t)) −
0 2 0

(γ − r)2 (σr + α(γ − r))2

   
γ−r σr + α(γ − r) 1
= exp − W1 (T ) + W2 (T ) − 2
+ T
σ σβ 2 σ σ2 β 2
R
The risk-neutral measure is given by P̃(A) = A ZdP. To check this,
we set
γ−r
W̃1 (t) = t + W1 (t)
σ
and
σr + α(γ − r)
W̃2 (t) = − t + W2 (t).
σβ
By the 2-dimensional Girsanov Theorem, the process {(W̃1 (t), W̃2 (t)) :
0 ≤ t ≤ T } is a 2-dimensional Brownian motion under P̃.
Rewriting e−rt S1 (t), e−rt S2 (t) in terms of W̃1 (t), W̃2 (t), we get after
applying the Itô product rule

d(e−rt S1 (t)) = e−rt S1 (t)(αdW̃1 (t) + βdW̃2 (t))

d(e−rt S2 (t)) = e−rt S2 (t)σdW̃1 (t),

which shows that the discounted price processes are Itô integrals and
hence martingales under P̃.