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 Quantitative Finance and Derivatives I
Finanza Quantitativa e Derivati I
code 20188
a.y. 2014/15, January 2015

POINTS WILL BE AWARDED ONLY TO ANSWERS SUPPORTED BY A

DETAILED LOGICAL JUSTIFICATION

EXERCISE 1 (45 points out of 100).

Consider a multiperiod discrete market with t = 0; 1; 2 and with the following information structure:

% !1
f11
& !2
%
f10
&
% !3
f21
& !4

Two securities are traded in the market. The …rst is a locally risk-free asset B that provides the
locally riskless interest rate

r(0) = 2%; r(1)(f11 ) = 4% and r(1)(f21 ) = 1%:

The second security is a risky asset S; with time 0 price

S(0) = 10;

with time 1 prices

S(1)(f11 ) = 10:4 and S(1)(f21 ) = 9:9
and with time 2 prices

S(2)(! 1 ) = 10:92; S(2)(! 2 ) = 9:88; S(2)(! 3 ) = 10:296; S(2)(! 4 ) = 9:306:

1. (3 points) Compute the price process of the locally riskless security B = fB (t)gt=0;1;2 :
2. (5 points) Is the market dynamically complete?
3. (12 points) Determine the set of risk neutral probabilities Q for the market, specifying Q(! k )
for k = 1; :::; 4: Is the market free of arbitrage opportunities?
4. (9 points) Consider the following three Zero Coupon Bonds: the …rst is issued at time t = 0
and matures at time t = 1; the second is also issued at time t = 0 and matures at time t = 2;
the third is issued at time t = 1 and matures at time t = 2. By de…nition of Zero Coupon
Bond, these three bonds deliver a cash‡ow equal to 1 at their maturity and 0 otherwise.
Determine the no-arbitrage price processes p0;1 = fp0;1 (t)gt=0;1 ; p0;2 = fp0;2 (t)gt=0;1;2 and
p1;2 = fp1;2 (t)gt=1;2 of these three Zero Coupon Bonds.
5. Consider a swap contract between Party I and Party II written on S, with maturity T = 2 and
starting at date t = 0. The swap contract requires Party I to pay to Party II a …xed amount
Fswap , called the swap price, at the times t = 1; 2, while Party II is required to pay to Party I
the amounts S (1) at t = 1; and S (2) at T = 2
(3 points) Write the cash‡ow of Party I at t = 1; 2:

1
 (2 points) Is it possible to replicate the …xed out‡ow of Party I in the swap contract at
t = 1; 2 with a portfolio of the zero coupon bonds de…ned in the previous point?
(3 points) The swap price Fswap is settled at time t = 0 in such a way that the initial
no-arbitrage value of the swap contract is 0: Use this fact to compute the swap price Fswap :
n o
(5 points) Compute Sswap = Sswap (t)t=0;1;2 the no-arbitrage values of the swap contract
(i.e. Party I cash‡ow) at the times t = 0; 1; 2:
6. (3 points) Consider a swaption on the swap contract de…ned in the previous point. The
swaption is settled at time 0, matures at time 1; and it gives to the holder the right to enter
the swap contract on S at the maturity date 1. The holder of the swaption enters the swap
contract at t = 1 if and only if the time t = 1 market value of the swap contract is positive.
Thus the payo¤ of the swaption at maturity t = 1 is

max (Sswap (1) ; 0)

Determine the no-arbitrage value of the swaption at t = 0:

EXERCISE 2 (35 points out of 100).

Consider a Black-Scholes market with the riskless security B(t) = e t and the lognormal risky
security S with drift and volatility under the historical probability P: Assume the following
values for the parameters: S(0) = 1; = 2%; = 4%, = 10%, and T = 4:

1. (5 points) Determine the historical probability P that a European call option on S with strike
price K = 2 closes out of the money at the maturity T .
2. Consider the European digital option on S whose payo¤ at maturity T is

1 if S (T ) > S (0)
X=
0 otherwise.

(9 points) Compute SX (0) ; the no-arbitrage price of the digital option at t = 0.

(6 points) If the volatility increases, does the initial price of the digital option SX (0)
increase or does it decrease? (Justify your answer)
n o
3. (4 points) Let t 2 (0; T ) and consider the event S(T )
S(t) > S(0)
S(t) . Rewrite this event in terms
of a normal Ft measurable random variable and a normal random variable independent of
Ft with respect to the risk-neutral probability Q.
n Use this decomposition
(6 points) o to compute the Ft conditional risk neutral probability of
the event S(T )
S(t) > S(0)
S(t) in terms of the risk neutral standard Brownian motion at t.

4. (5 points) Compute SX (t) ; the no-arbitrage price of the digital derivative of Point 2 at any
t 2 (0; T ). Write SX (t) in terms of the current value of the underlying asset S (t) :

Express your results in terms of the distribution function N ( ) of a standard Normal random variable.

QUESTION (20 points out of 100).

State (5 points) and derive (15 points) the Black Scholes Partial Di¤erential Equation for a
European derivative whose …nal payo¤ is a deterministic function of the terminal underlying asset
price.

2
 SOLUTIONS TO EXERCISES

Exercise 1

1. The prices of security B are B(0) = 1;

B(1)(f11 ) = B(1)(f21 ) = 1:02

and at the …nal date T = 2

B(2)(! 1 ) = B(2)(! 2 ) = 1:02 1:04 = 1: 060 8
B(2)(! 3 ) = B(2)(! 4 ) = 1:02 1:01 = 1: 030 2:

2. The market is dynamically complete, because each one-period submarket is complete (in your
exam check explicitly that the rank of the terminal payo¤ matrix of each one-period submarket
has rank 2).
3. We look for risk neutral probabilities Q for the market. We have to solve the systems
8 1
< S(0) = 1+r(0) S(1)(f11 )Q[f11 ] + S(1)(f21 )Q[f21 ]
Q[f11 ] + Q[f21 ] = 1 (1)
:
Q[f11 ]; Q[f21 ] > 0

for m0 ; 8 1 1 1 1
< S(1)(f1 ) = 1+r(1)(f11 ) S(2)(! 1 )Q[! 1 jf1 ] + S(2)(! 2 )Q[! 2 jf1 ]
1 1 (2)
Q[! 1 jf1 ] + Q[! 2 jf1 ] = 1
:
Q[! 1 jf11 ]; Q[! 2 jf11 ] > 0
for m1;1 ; and
8 1 1 1 1
< S(1)(f2 ) = 1+r(1)(f21 ) S(2)(! 3 )Q[! 3 jf2 ] + S(2)(! 4 )Q[! 4 jf2 ]
Q[! 3 jf21 ] + Q[! 4 jf21 ] = 1 (3)
:
Q[! 3 jf21 ]; Q[! 4 jf21 ] > 0

System (1) can be rewritten as

8 1
< 10 = 1:02 10:4 Q[f11 ] + 9:9 Q[f21 ]
Q[f1 ] + Q[f21 ] = 1
1
:
Q[f11 ]; Q[f21 ] > 0

and is solved by

Q[f11 ] = 0:6
Q[f21 ] = 0:4

System (2) can be rewritten as

8 1
< 10:4 = 1:04 10:92 Q[! 1 jf11 ] + 9:88 Q[! 2 jf11 ]
Q[! 1 jf1 ] + Q[! 2 jf11 ] = 1
1
:
Q[! 1 jf11 ]; Q[! 2 jf11 ] > 0

and is solved by

Q[! 1 jf11 ] = 0:9

Q[! 2 jf11 ] = 0:1

3
 and System (3) can be rewritten as
8 1
< 9:9 = 1:01 10:296 Q[! 3 jf21 ] + 9:306 Q[! 4 jf21 ]
Q[! 3 jf2 ] + Q[! 4 jf21 ] = 1
1
:
Q[! 3 jf21 ]; Q[! 4 jf21 ] > 0

and is solved by

Q[! 3 jf21 ] = 0:7

Q[! 4 jf21 ] = 0:3

Therefore

Q[! 1 ] = 0:6 0:9 = 0:54

Q[! 2 ] = 0:6 0:1 = 0:06
Q[! 3 ] = 0:4 0:7 = 0:28
Q[! 4 ] = 0:4 0:3 = 0:12

Since there exists a unique risk neutral probability measure, the market is arbitrage free and
complete (by the 2nd FTAP).
4. The Zero Coupon Bond p0;1 settled at t = 0 with maturity 1 has a time t = 1 the payo¤
p0;1 (1) = 1: Its initial no-arbitrage price is

p0;1 (1) 1
p0;1 (0) = EQ = = 0:980 39:
1 + r (0) 1 + 0:02

The Zero Coupon Bond p0;2 settled at t = 0 with maturity 2 has a time T = 2 the payo¤
p0;2 (2) = 1: Its no-arbitrage prices at t = 1 are
8 1
< 1+0:04 = 0:961 54 if f11
Q 1
p0;2 (1) = E P1 =
1 + r (1) : 1
1+0:01 = 0:990 10 if f21

and at t = 0
p0;2 (1) 0:6 0:961 54 + 0:4 0:990 10
p0;2 (0) = EQ = = 0:953 89:
1 + r (0) 1:02

The Zero Coupon Bond p1;2 settled at t = 1 with maturity 2 has a time T = 2 the payo¤
p1;2 (2) = 1: Its no-arbitrage prices at t = 1 coincide with those of p0;2 at t = 1 :
8 1
< 1+0:04 = 0:961 54 if f11
Q 1
p1;2 (1) = E P1 =
1 + r (1) : 1
1+0:01 = 0:990 10 if f21

5. The cash‡ow of Party I (‡oating minus …xed) at t = 1; 2 is Xswap (t) = S (t) Fswap :
The …xed out‡ow of part I of the swap contract on S with maturity T = 2 is

Fswap for t = 1; 2:

The portfolio of zero coupon bonds de…ned in the previous point that replicates this …xed
cash‡ow is
constituted of Fswap units of p0;1 and Fswap units of p0;2 :

4
In fact, the cash‡ow provided by is

X (1) = Fswap p0;1 (1) + 0 = Fswap 1 = Fswap at t = 1

X (2) = 0 + Fswap p0;2 (1) = Fswap 1 = Fswap at t = 2:

The swap price Fswap is settled at time t = 0 such that the initial no-arbitrage value of the
swap contract is 0; i.e. " #
X Xswap (t)
Q
Sswap (0) = E =0
t=1;2
B (t)

Then we get
" #
X (S (t) Fswap )
EQ = 0
t=1;2
B (t)
" # " #
X S (t) X Fswap
Q Q
E = E (4)
t=1;2
B (t) t=1;2
B (t)
| {z } | {z }
t=0 no-arbitrage value of the ‡oating leg t=0 no-arbitrage value of the …xed leg

Therefore, the initial no-arbitrage value of the …xed leg coincides with the initial no-arbitrage
value of the ‡oating leg. Since and the …xed leg have the same cash‡ow, by no-arbitrage
their initial price must coincide too:
" #
X Fswap
EQ = (0) :
t=1;2
B (t)

By our previous computations

(0) = Fswap p0;1 (0) + Fswap p0;2 (0)

= Fswap (p0;1 (0) + p0;2 (0))

The initial value of the ‡oating leg in (4) is

" #
X S (t) S
Q
E = S (0) + S (0) = 2S (0) because is a Q martingale
t=1;2
B (t) B

By equation (4) we get

Fswap (p0;1 (0) + p0;2 (0)) = 2S (0)

| {z } | {z }
t=0 no-arbitrage value of the …xed leg t=0 no-arbitrage value of the ‡oating leg

And therefore
2S (0)
Fswap =
p0;1 (0) + p0;2 (0)
2 10
= = 10: 340
0:980 39 + 0:953 89
The cash‡ow of Party I of the swap contract (‡oating minus …xed) at t = 1 is
8
< 10:4 10: 340 = 0:06 if f11
Xswap (1) = S (1) Fswap =
:
9:9 10: 340 = 0:44 if f21

5
 and t = 2
8
>
> 10:92 10: 340 = 0:58 if !1
<
9:88 10: 340 = 0:46 if !2
Xswap (2) = S (2) Fswap =
>
> 10:296 10: 340 = 0:044 if !3
:
9:306 10: 340 = 1: 034 if !4
Its no-arbitrage prices at at t = 2 are
Sswap (2) = Xswap (2)
and at t = 1 the risk-neutral valuation formula
Xswap (2)
Sswap (1) = EQ P1
1 + r(1)
delivers
Xswap (2)
Sswap (1) f11 = EQ P1 f11
1 + r(1)
0:58 0:9 0:46 0:1
= = 0:457 69
1:04
and
Xswap (2)
Sswap (1) f21 = EQ P1 f21
1 + r(1)
0:044 0:7 1: 034 0:3
= = 0:337 62
1:01
Sswap (0) = 0 by de…nition.
6. The payo¤ of the swaption at maturity t = 1 is
8
< 0:457 69 if f11
max (Sswap (1) ; 0) =
:
0 if f21
The no-arbitrage value of the swaption at t = 0 is
max (Sswap (1) ; 0) 0:6 0:457 69 + 0:4 0
EQ = = 0:269 23:
1 + r(0) 1:02

Exercise 2.
1. The historical probability P that a European call option on S with strike price K = 2 closes
out of the money at the maturity T is
2
T + WT K
P [S(T ) < K] = P e 2
<
S(0)
2
K
= P T + WT < ln
2 S(0)
2
1 K P
= P Z< p ln T where Z N (0; 1)
T S(0) 2
2
1 K
= N p ln T
T S(0) 2
1 2 0:102
= N p ln 0:04 4
0:10 4 1 2
= N (2: 765 7)

6
2. The no-arbitrage price of the European derivative whose terminal payo¤ X at maturity T is
1 if S (T ) > S (0)
X= :
0 otherwise.

is given by
T
SX (0) = e EQ [X]
T
= e Q [S (T ) > S (0)] :

We compute
2
Q [S (T ) > S (0)] = Q T + W Q (T ) > 0
2
2 p
= Q T + ZQ T > 0
2
2 2
3
2 T Q
= Q 4Z Q > p 5 where Z Q N (0; 1)
T
2 2 p 3
2 T
= Q 4Z Q < 5

0 2 p 1
2 T
= N@ A

0 p 1
0:102
0:02 2 4
= N@ A = N (0:3)
0:10

and therefore

SX (0) = e T Q [S (T ) > S (0)]

= e 0:02 4 N (0:3)
= 0:923 12 N (0:3) :

We compute the derivative of SX (0) with respect to

0 2 p 1
@ @ 2 T
SX (0) = e TN @ A
@ @

T
2
@
= e e 2
@
with
2 p
2 T
=
p p
T T
=
2
Then p p
@ T T
= 2
< 0 for any > 0; ; T 0
@ 2

7
 Thus
@ T
2
@
SX (0) = e| {ze } @ < 0 for any
2 > 0; ; T 0
@ |{z}
>0
<0

and therefore SX (0) decreases if increases. We can deduce the same conclusion by observing
that the expression
2 p
2 T
T
SX (0) = e N ( ) with =

entails only in the argument of the cumulative normal distribution N: Since N is increasing
with respect to ; SX (0) is increasing with respect to if and only if is increasing with respect
to : SX (0) is decreasing with respect top if andp
only if is decreasing with respect to : By
@ T T
exploiting our computations on @ = 2 2 < 0; we conclude that SX (0) is decreasing
with respect to :
3. For any t 2 (0; T ) the event
8 2
9
S (T ) S (0) < S (0) e 2 T + W Q (T )
S (0) =
> = >
S (t) S (t) : 2
t+ W Q (t)
2
t+ W Q (t) ;
S (0) e 2
S (0) e 2

2 2
= (T t) + W Q (T ) W Q (t) > ( t) W Q (t)
2 2
2
= W Q (T ) W Q (t) > T W Q (t)
2

where W Q (t) is a normal Ft measurable random variable and a W Q (T ) W Q (t) is a normal

random variable independent of Ft with respect to the risk-neutral probability Q.
n o
The Ft conditional risk neutral probability of the event S(T ) S(0)
S(t) > S(t) is

2
S (T ) S (0)
Qt > = Qt W Q (T ) W Q (t) > T W Q (t) :
S (t) S (t) 2
Qt p
Since W Q (t) is Ft measurable and W Q (T ) W Q (t) ZQ T t is independent of Ft ; we
set x = W Q (t) and obtain
2 p 2
Qt W Q (T ) W Q (t) > ( T) W Q (t) = Q ZQ T t> ( T) x
2 2
2 2
3
2 ( T) x
= Q 4Z Q
> p 5
T t
2 2
3
2 ( T) x
= Q 4Z Q < p 5
T t
2 2
3
2 T+ x
= Q 4Z Q < p 5
T t
0 2
1
2 T+ x
= N@ p A with x = W Q (t)
T t

8
4. The no-arbitrage price of the digital derivative of Point 2 at any t 2 (0; T ) is

SX (t) = e (T t)
EQ
t [X]
(T t)
= e Qt [S (T ) > S (0)]
(T t) S (T ) S (0)
= e Qt >
S (t) S (t)
0 2
1
2 T + x
= e (T t)
N@ p A with x = W Q (t)
T t

that is
0 1
0:12
0:02 2 4 + 0:1x
SX (t) = e 0:02(4 t)
N@ p A
0:1 4 t

0:02(4 t) 0:06 + 0:1x

= e N p with x = W Q (t)
0:1 4 t

Or, in terms of the current value of the underlying asset S (t) ; we rewrite
2
S (t) 1
W Q (t) = ln t
S (0) 2

and obtain
0 1
0:12
0:02 2 4 + 0:1x
SX (t) = e 0:02(4 t)
N@ p A
0:1 4 t
2
0:02(4 t) 0:06 + 0:1x S (t) 1
= e N p with x = ln t :
0:1 4 t S (0) 2

9
 Quantitative Finance and Derivatives I
Finanza Quantitativa e Derivati I
codice 20188
a.a. 2014/15, 28 gennaio, 2015
GIUSTIFICARE DETTAGLIATAMENTE TUTTE LE RISPOSTE

ESERCIZIO 1 (45 punti su 100).

Si consideri un mercato multiperiodale discreto con t = 0; 1; 2 e la seguente struttura informativa:

% !1
f11
& !2
%
f10
&
% !3
f21
& !4

Nel mercato ci sono due titoli …nanziari. Il primo è quello localmente privo di rischio B che fornisce
il tasso di interesse localmente privo di rischio

r(0) = 2%; r(1)(f11 ) = 3% e r(1)(f21 ) = 1%:

Il secondo è il titolo rischioso S; il cui prezzo al tempo 0 è

S(0) = 10;

quelli al tempo 1 sono

S(1)(f11 ) = 10:3 e S(1)(f21 ) = 9:8
e quelli al tempo 2 sono

S(2)(! 1 ) = 10:712; S(2)(! 2 ) = 9:682; S(2)(! 3 ) = 10:094; S(2)(! 4 ) = 9:604:

1. (3 punti) Si calcoli il processo di prezzo del titolo localmente privo di rischio B = fB (t)gt=0;1;2 :
2. (5 punti) Il mercato è dinamicamente completo?
3. (12 punti) Si determini l’insieme delle probabilità neutrali al rischio Q per il mercato, speci-
…cando Q(! k ) perr k = 1; :::; 4: Il mercato è privo di arbitraggio?
4. (10 punti) Un contratto futures con scadenza T = 2 sul titolo rischioso S è caratterizzato
dalla successione di prezzi futures f (0) ; f (1) dove f (0) è stabilito al tempo t = 0 mentre f (1)
è stabilito in t = 1 in base a P1 : Una posizione lunga in un contratto futures al tempo t = 0
genera i ‡ussi di cassa
Xf ut (1) = f (1) f (0)
al tempo t = 1; e
Xf ut (2) = S(2) f (1)
al tempo t = 2. I prezzi futures f (0) ; f (1) devono soddisfare la condizione che il valore di
non-arbitraggio di una posizione lunga nel contratto futures sia 0 sia alla data t = 0 che alla
data t = 1. Si determinino f (0) e f (1).
5. (6 punti) Si ponga f (2) = S (2) : Il processo dei prezzi futures f = ff (t)gt=0;1;2 è una
Q martingala?

1
 6. (9 punti) Un derivato barriera X su S con scadenza T = 2 paga un coupon C = 100 alle
date t 2 f1; 2g se S (t) > S (t 1) e termina. Il suo ‡usso di cassa è quindi X = fX (t)gt=1;2
dato da 8
< C se S (1) > S (0)
X (1) =
:
0 altrimenti
in t = 1 e 8
>
> 0 se S (1) > S (0)
>
>
<
X (2) = C se S (1) S (0) e S (2) > S (1)
>
>
>
>
:
0 se S (1) S (0) e S (2) S (1)
alla data T = 2: Si calcoli il ‡usso di cassa X = fX (t)gt=1;2 : Si determini il processo di
prezzo di non arbitraggio di questo derivato SX = fSX (t)gt=0;1;2 :

ESERCIZIO 2 (35 punti su 100).

Si consideri un mercato di Black-Scholes con il titolo privo di rischio B(t) = e t e il titolo rischioso
lognormale S con drift e volatilità rispetto alla misura di probabilità storica P: Si assumano i
seguenti valori per i parametri: S(0) = 1; = 1%; = 6%, = 10%, e T = 2:
1. (5 punti) Si determini la probabilità storica P che un’opzione put europea su S con prezzo
d’esercizio K = 1 chiuda in the money alla scadenza T (Lasciare indicata la funzione di
distribuzione di probabilità N ( ) di una variabile aleatoria normale standard).
2. Si consideri il derivato X su S con il seguente ‡usso di cassa
T T T
X = 1000 ln S alla data t =
2 2 2
e X (T ) = 1000 ln (S (T )) alla data t = T;
T
e X (t) = 0 per tutti i t 6= 2 ; T:
(9 punti) Si calcoli SX (0) ; il prezzo di non arbitraggio del derivato in t = 0.
(6 punti) Se la volatilità cresce, il prezzo iniziale del derivato SX (0) aumenta o diminuisce?
T
3. (4 punti) Con riferimento al derivato del punto 2., si calcoli SX (t) per t 2 2 ; T in termini
del valore corrente di S (t) :
(4 punti) Con riferimento al derivato del punto 2., si calcoli SX (t) per t 2 0; T2 in termini
del valore corrente di S (t) :
4. (4 punti) Con riferimento ai punti 2. e 3. si trovi la strategia di replicazione del derivato per
t 2 T2 ; T .
5. (3 punti) Si dica se la seguente uguaglianza è vera
T T
P ln S > 0 \ (ln (S (T )) > 0) = P ln S >0 P [(ln (S (T )) > 0)]?
2 2

Suggerimento: si può rispondere senza calcolare numericamente le probabilità coinvolte.

DOMANDA (20 punti su 100)

Si enunci la formula di Ito per un processo di di¤ usione generico (5 punti). Si applichi la formula
di Ito per risolvere l’equazione di¤erenziale stocastica che descrive la dinamica del titolo rischioso
nel modello di Black e Scholes (15 punti)

2
 SOLUTIONS TO EXERCISES

Exercise 1

1. The prices of security B are B(0) = 1;

B(1)(f11 ) = B(1)(f21 ) = 1:02

and at the …nal date T = 2

B(2)(! 1 ) = B(2)(! 2 ) = 1:02 1:03 = 1: 050 6
B(2)(! 3 ) = B(2)(! 4 ) = 1:02 1:01 = 1: 030 2:

2. The market is dynamically complete, because each one-period submarket is complete (in your
exam check explicitly that the rank of the terminal payo¤ matrix of each one-period submarket
has rank 2).
3. We look for risk neutral probabilities Q for the market. We have to solve the systems
8 1
< S(0) = 1+r(0) S(1)(f11 )Q[f11 ] + S(1)(f21 )Q[f21 ]
Q[f11 ] + Q[f21 ] = 1 (1)
:
Q[f11 ]; Q[f21 ] > 0

for m0 ; 8 1 1 1 1
< S(1)(f1 ) = 1+r(1)(f11 ) S(2)(! 1 )Q[! 1 jf1 ] + S(2)(! 2 )Q[! 2 jf1 ]
1 1 (2)
Q[! 1 jf1 ] + Q[! 2 jf1 ] = 1
:
Q[! 1 jf11 ]; Q[! 2 jf11 ] > 0
for m1;1 ; and
8 1 1 1 1
< S(1)(f2 ) = 1+r(1)(f21 ) S(2)(! 3 )Q[! 3 jf2 ] + S(2)(! 4 )Q[! 4 jf2 ]
Q[! 3 jf21 ] + Q[! 4 jf21 ] = 1 (3)
:
Q[! 3 jf21 ]; Q[! 4 jf21 ] > 0

System (1) can be rewritten as

8 1
< 10 = 1:02 10:3 Q[f11 ] + 9:8 Q[f21 ]
Q[f1 ] + Q[f21 ] = 1
1
:
Q[f11 ]; Q[f21 ] > 0

and is solved by

Q[f11 ] = 0:8
Q[f21 ] = 0:2

System (2) can be rewritten as

8 1
< 10:3 = 1:04 10:712 Q[! 1 jf11 ] + 9:682 Q[! 2 jf11 ]
Q[! 1 jf1 ] + Q[! 2 jf11 ] = 1
1
:
Q[! 1 jf11 ]; Q[! 2 jf11 ] > 0

and is solved by

Q[! 1 jf11 ] = 0:9

Q[! 2 jf11 ] = 0:1

3
 and System (3) can be rewritten as
8 1
< 9:8 = 1:01 10:094 Q[! 3 jf21 ] + 9:604 Q[! 4 jf21 ]
Q[! 3 jf21 ] + Q[! 4 jf21 ] = 1
:
Q[! 3 jf21 ]; Q[! 4 jf21 ] > 0

and is solved by

Q[! 3 jf21 ] = 0:6

Q[! 4 jf21 ] = 0:4

Therefore

Q[! 1 ] = 0:8 0:9 = 0:72

Q[! 2 ] = 0:8 0:1 = 0:08
Q[! 3 ] = 0:2 0:6 = 0:12
Q[! 4 ] = 0:2 0:4 = 0:08

Since there exists a unique risk neutral probability measure, the market is arbitrage free and
complete (by the 2nd FTAP).
4. A futures contract with maturity T = 2 on the risky security S is characterized by a sequence
of futures prices f (0) ; f (1) where f (0) is settled at time t = 0 while f (1) is settled at t = 1
based on P1 : A long position in a futures contract at time t = 0 generates the cashlow

Xf ut (1) = f (1) f (0)

at time t = 1; and
Xf ut (2) = S(2) f (1)
at time t = 2. The futures prices f (0) ; f (1) must satisfy the condition that, under no-
arbitrage, the value of a long position in the futures contract is 0 both at time t = 0 and a
time t = 1. Determine f (0) and f (1).
We start by determining f (1) : To this aim we impose the condition that the value of a long
position in the futures contract at time t = 1 is zero:

Xf ut (2)
EQ P1 = 0
1 + r (1)
S(2) f (1)
EQ P1 = 0
1 + r (1)
S(2) f (1)
EQ P1 = EQ P1 (4)
1 + r (1) 1 + r (1)
f (1)
S(1) =
1 + r (1)
h i
S(2)
where we exploited the de…nition of risk neutral measure that yields S(1) = EQ 1+r(1) P1
h i
f (1) f (1)
and the fact that f (1) and r (1) are P1 measurable, thus implying EQ 1+r(1) P1 = 1+r(1) :
Therefore
8
< 10:3 (1 + 0:03) = 10: 609 if f11
f (1) = S(1) (1 + r (1)) =
:
9:8 (1 + 0:01) = 9: 898 if f21

4
 We then determine f (0) : To this aim we impose the condition that the value of a long position
in the futures contract at time t = 0 is zero:
Xf ut (1) Xf ut (2)
EQ + =0
1 + r (0) (1 + r (0)) (1 + r (1))
From our previous step we know that f (1) is such that
Xf ut (2)
EQ P1 = 0
1 + r (1)
Therefore
Xf ut (1) Xf ut (2)
0 = EQ +
1 + r (0) (1 + r (0)) (1 + r (1))
Xf ut (1) 1 Xf ut (2)
= EQ + EQ EQ P1 be the tower property
1 + r (0) 1 + r (0) 1 + r (1)
Xf ut (1) 1
= EQ + EQ 0
1 + r (0) 1 + r (0)
Hence f (0) must be settled such that
Xf ut (1)
EQ = 0
1 + r (0)
f (1) f (0)
EQ = 0
1 + r (0)
leading to
f (0) f (1)
= EQ
1 + r (0) 1 + r (0)
f (0) = EQ [f (1)] dividing by the constant 1 + r (0) (5)
= 10: 609 0:8 + 9: 898 0:2 = 10: 467:

5. To show that the futures prices process f = ff (t)gt=0;1;2 is a Q martingale, we …rst observe
that equation (4) delivers
1 1
EQ [ S(2)j P1 ] = EQ [ f (1)j P1 ] because 1 + r (1) is P1 meas.
1 + r (1) 1 + r (1)
EQ [ S(2)j P1 ] = EQ [ f (1)j P1 ]
EQ [ S(2)j P1 ] = f (1) because f (1) is P1 meas.
since 1 + r (1) is P1 measurable.
By imposing the terminal condition f (2) = S (2) we observe that this is exactly the martin-
gality requirement
f (1) = EQ [ S(2)j P1 ] = EQ [ f (2)j P1 ]
from t = 1 to t = 2: The further condition from t = 0 to t = 1 is
f (0) = EQ [f (1)]
which is the Equation (5) we imposed above.
This proves that the futures prices process f = ff (t)gt=0;1;2 is a Q martingale. You can also
prove the property be numerically verifying that
f (0) = EQ [f (1)] and f (1) = EQ [ f (2)j P1 ] :

5
 6. The barrier derivative X on S with maturity T = 2 pays a coupon C = 100 at t 2 f1; 2g if
S (t) > S (t 1) and then terminates has a cash‡ow
8
< C if f11 where S (1) > S (0)
X (1) =
:
0 if f21 where S (1) S (0)
and 8
>
> 0 on ! 1 and ! 2 ; since S (1) > S (0)
>
>
<
X (2) = C on ! 3 where S (1) S (0) and S (2) > S (1)
>
>
>
>
:
0 on ! 4 where S (1) S (0) and S (2) S (1)
Its no-arbitrage price process SX = fSX (t)gt=0;1;2 is given by
8
< C on ! 3
SX (2) = X (2) =
:
0 on ! 1 ; ! 2 ; ! 4
at maturity. At t = 1
8
< 0 if f11
Q X(2)
SX (1) = E P1 =
1 + r (1) : 100 0:6+0 0:4
1:03 = 59:406 if f21
and at t = 0
X(1) + SX (1)
SX (0) = EQ
1 + r (0)
100 + 0 0 + 59:406
= 0:8 + 0:2
1:02 1:02
= 90:079

Exercise 2.
1. The historical probability P that a European put option on S with strike price K = 1 closes
in the money at the maturity T is
2
T + WT K
P [S(T ) < K] = P e 2
<
S(0)
2
K
= P T + WT < ln
2 S(0)
2
1 K P
= P Z< p ln T where Z N (0; 1)
T S(0) 2
2
1 K
= N p ln T
T S(0) 2
1 1 0:102
= N p ln 0:06 2
0:10 2 1 2
= N ( 0:777 82)

2. The initial no-arbitrage price SX (0) of the derivative X on S whose cash‡ow is

T T T
X = 1000 ln S at t =
2 2 2
and X (T ) = 1000 ln (S (T )) at t = T;

6
 T
and X (t) = 0 for all t 6= 2 ; T is
T T
SX (0) = EQ X e 2 + X (T ) e T
:
2
And therefore
T T
SX (0) = e 2 EQ 1000 ln S +e T
EQ [1000 ln (S (T ))]
2
2
T T T
= e 2 EQ 1000 ln (S (0)) + + WQ +e T
EQ 1000 ln (S (0)) +
2 2 2 2
2 2
T T T
= e 2 1000 ln (S (0)) + +e 1000 ln (S (0)) + T
2 2 2
T
because W Q (T ) and W Q 2 have zero Q-expectation. Thus

0:01 1 0:12 2 0:01 2 0:12

SX (0) = e 1000 ln (1) + 0:01 +e 1000 ln (1) + 0:01 2
2 2 2
= 1000 0:01475 = 14: 75

Then, we compute the derivative of SX (0) with respect to

2 2
@ @ T T T
SX (0) = 1000 e 2 ln (S (0)) + +e ln (S (0)) + T
@ @ 2 2 2
T T T
= 1000 e 2 ( ) +e ( ) T <0
2
Hence SX (0) is decreasing with respect to :
T
3. The no-arbitrage price at t 2 2 ; T of X includes the only outstanding cash‡ow at T; thus
leading to
SX (t) = e (T t)
EQ
t [X (T )]
We compute therefore
EQ
t [X (T )] = 1000 EQ
t [ln (S (T ))] =
2
= 1000 EQ
t ln (S (0)) + T + W Q (T )
2
2
= 1000 ln (S (0)) + T + W Q (t)
2
because W Q (t) is a Q martingale. This leads to
2
(T t)
SX (t) = 1000 e ln (S (0)) + T + W Q (t)
2
2
and in terms of S (t) = S (0) exp 2 t + W Q (t) we can write
0 1
B 2 2 C
(T t) B C
SX (t) = 1000 e Bln (S (0)) + t + W Q (t) + (T t)C
@ 2 2 A
| {z }
ln S(t)
2
(T t)
= 1000 e ln S (t) + (T t)
2
0:01(2 t)
= 1000 e (ln S (t) + 0:005 (T t))

7
 Afterwards, the no-arbitrage price for X at t 2 0; T2 includes the two cash‡ows at T
2 and
at T: Therefore for t 2 0; T2 we have

( T2 t) T
SX (t) = EQ
t e X +e (T t)
X (T )
2
( T2 t) T
= e EQ
t X +e (T t)
EQ
t [X (T )]
2

We compute therefore

EQ
t X 2
T
T
= EQ
t ln S =
1000 2
2
T T
= EQ
t ln (S (0)) + + WQ
2 2 2
2
T
= ln (S (0)) + + W Q (t)
2 2

because W Q (t) is a Q martingale. As computed before,

EQ
t [X (T )]
2
= ln (S (0)) + T + W Q (t)
1000 2

Hence
2
( T2 t) T
SX (t) = e 1000 ln (S (0)) + + W Q (t) +
2 2
2
(T t)
+e 1000 ln (S (0)) + T + W Q (t)
2

Since
2
S (t) 1
W Q (t) = ln t
S (0) 2
by plugging W Q (t) into SX (t), we …nd
2
( T2 t) T
SX (t) = 1000 e t + ln (S (t)) +
2 2
2
(T t)
+e (T t) + ln (S (t))
2

that is
0:01(1 t)
SX (t) = 1000 e (0:005 (1 t) + ln (S (t))) +
0:01(2 t)
+e (0:005 (2 t) + ln (S (t)))

T
4. The replicating strategy of the derivative for t 2 2 ; T can be found as

@
#1 (t) = F (t; S (t))
@S
where
0:01(T t)
F (t; S) = 1000 e (ln S + 0:005 (T t))

8
 Hence we compute
@ @ 0:01(T t)
F (t; S) = 1000 e (ln S + 0:005 (T t))
@S @S
0:01(T t) 1
= 1000 e
S
leading to
0:01(2 t) 1
#1 (t) = 1000 e
S (t)
T
units of S at time t 2 2 ; T : The riskless component
t
#0 (t) = (F (t; S (t)) #1 (t) S (t)) e
0:01(2 t) 0:01(2 t) 1 0:01 t
= 1000 e (ln S (t) + 0:005 (2 t)) e S (t) e
S (t)
0:01 (2 t) 0:01 t
= 1000 e (ln S (t) + 0:005 (2 t) 1) e
0:01 (2)
= 1000 e (ln S (t) + 0:005 (2 t) 1)

5. The equation

T T
P ln S > 0 \ (ln (S (T )) > 0) = P ln S >0 P [(ln (S (T )) > 0)]?
2 2

T
does not hold because the two events ln S 2 > 0 and (ln (S (T )) > 0) are not indepen-
dent. In fact from the equality
2
T T
+ (W (T ) W ( T2 ))
S (T ) = S e 2 2

2
T
the dependence of S (T ) on S 2 is apparent.

9
 Quantitative Finance and Derivatives I
Finanza Quantitativa e Derivati I
code 20188
a.y. 2014/15, January 28th, 2015

POINTS WILL BE AWARDED ONLY TO ANSWERS SUPPORTED BY A

DETAILED LOGICAL JUSTIFICATION

EXERCISE 1 (45 points out of 100).

Consider a multiperiod discrete market with t = 0; 1; 2 and with the following information structure:

% !1
f11
& !2
%
f10
&
% !3
f21
& !4

Two securities are traded in the market. The …rst is a locally risk-free asset B that provides the
locally riskless interest rate

r(0) = 2%; r(1)(f11 ) = 3% and r(1)(f21 ) = 1%:

The second security is a risky asset S; with time 0 price

S(0) = 10;

with time 1 prices

S(1)(f11 ) = 10:3 and S(1)(f21 ) = 9:8
and with time 2 prices

S(2)(! 1 ) = 10:712; S(2)(! 2 ) = 9:682; S(2)(! 3 ) = 10:094; S(2)(! 4 ) = 9:604:

1. (3 points) Compute the price process of the locally riskless security B = fB (t)gt=0;1;2 :
2. (5 points) Is the market dynamically complete?
3. (12 points) Determine the set of risk neutral probabilities Q for the market, specifying Q(! k )
for k = 1; :::; 4: Is the market free of arbitrage opportunities?
4. (10 points) A futures contract with maturity T = 2 on the risky security S is characterized
by a sequence of futures prices f (0) ; f (1) where f (0) is settled at time t = 0 while f (1) is
settled at t = 1 based on P1 : A long position in a futures contract at time t = 0 generates the
cash‡ow
Xf ut (1) = f (1) f (0)
at time t = 1; and
Xf ut (2) = S(2) f (1)
at time t = 2. The futures prices f (0) ; f (1) must satisfy the condition that, under no-
arbitrage, the value of a long position in the futures contract is 0 both at time t = 0 and a
time t = 1. Determine f (0) and f (1).

1
 5. (6 points) Let f (2) = S (2) : Is the futures prices process f = ff (t)gt=0;1;2 a Q martingale?
6. (9 points) A barrier derivative X on S with maturity T = 2 pays a coupon C = 100 at
t 2 f1; 2g if S (t) > S (t 1) and then terminates. Its cash‡ow X = fX (t)gt=1;2 is hence
8
< C if S (1) > S (0)
X (1) =
:
0 otherwise
at t = 1 and 8
>
> 0 if S (1) > S (0)
>
>
<
X (2) = C if S (1) S (0) and S (2) > S (1)
>
>
>
>
:
0 if S (1) S (0) and S (2) S (1)
at T = 2: Compute the cash‡ow X = fX (t)gt=1;2 : Determine its no-arbitrage price process
SX = fSX (t)gt=0;1;2 :

EXERCISE 2 (35 points out of 100).

Consider a Black-Scholes market with the riskless security B(t) = e t and the lognormal risky
security S with drift and volatility under the historical probability P: Assume the following
values for the parameters: S(0) = 1; = 1%; = 6%, = 10%, and T = 2:
1. (5 points) Determine the historical probability P that a European put option on S with
strike price K = 1 closes in the money at the maturity T . Express your results in terms of
the distribution function N ( ) of a standard Normal random variable.
2. Consider the derivative X on S with the following cash‡ow
T T T
X = 1000 ln S at t =
2 2 2
and X (T ) = 1000 ln (S (T )) at t = T;
T
and X (t) = 0 for all t 6= 2 ; T:
(9 points) Compute SX (0) ; the no-arbitrage price of the derivative at t = 0.
(6 points) If the volatility increases, does the initial price of the derivative SX (0) increase
or does it decrease?
T
3. (4 points) Compute SX (t) ; the no-arbitrage price of the derivative of Point 2, at t 2 2 ;T
in terms of the current value of S (t) :
(4 points) Compute SX (t) ; the no-arbitrage price of the derivative of Point 2, at t 2 0; T2
in terms of the current value of S (t) :
4. (4 points) Consider the derivative of Points 2 and 3. Find its replicating strategy for t 2
T
2;T .

5. (3 points) Is it true that

T T
P ln S > 0 \ (ln (S (T )) > 0) = P ln S >0 P [(ln (S (T )) > 0)]?
2 2

Hint: you can answer without computing the probabilities.

QUESTION (20 points out of 100)

State Ito formula for a general di¤usion process (5 points). Apply Ito formula to solve the stochastic
di¤erential equation driving the dynamics of the stock price in the Black Scholes model (15 points)

2
 SOLUTIONS TO EXERCISES

Exercise 1

1. The prices of security B are B(0) = 1;

B(1)(f11 ) = B(1)(f21 ) = 1:02

and at the …nal date T = 2

B(2)(! 1 ) = B(2)(! 2 ) = 1:02 1:03 = 1: 050 6
B(2)(! 3 ) = B(2)(! 4 ) = 1:02 1:01 = 1: 030 2:

2. The market is dynamically complete, because each one-period submarket is complete (in your
exam check explicitly that the rank of the terminal payo¤ matrix of each one-period submarket
has rank 2).
3. We look for risk neutral probabilities Q for the market. We have to solve the systems
8 1
< S(0) = 1+r(0) S(1)(f11 )Q[f11 ] + S(1)(f21 )Q[f21 ]
Q[f11 ] + Q[f21 ] = 1 (1)
:
Q[f11 ]; Q[f21 ] > 0

for m0 ; 8 1 1 1 1
< S(1)(f1 ) = 1+r(1)(f11 ) S(2)(! 1 )Q[! 1 jf1 ] + S(2)(! 2 )Q[! 2 jf1 ]
1 1 (2)
Q[! 1 jf1 ] + Q[! 2 jf1 ] = 1
:
Q[! 1 jf11 ]; Q[! 2 jf11 ] > 0
for m1;1 ; and
8 1 1 1 1
< S(1)(f2 ) = 1+r(1)(f21 ) S(2)(! 3 )Q[! 3 jf2 ] + S(2)(! 4 )Q[! 4 jf2 ]
Q[! 3 jf21 ] + Q[! 4 jf21 ] = 1 (3)
:
Q[! 3 jf21 ]; Q[! 4 jf21 ] > 0

System (1) can be rewritten as

8 1
< 10 = 1:02 10:3 Q[f11 ] + 9:8 Q[f21 ]
Q[f1 ] + Q[f21 ] = 1
1
:
Q[f11 ]; Q[f21 ] > 0

and is solved by

Q[f11 ] = 0:8
Q[f21 ] = 0:2

System (2) can be rewritten as

8 1
< 10:3 = 1:04 10:712 Q[! 1 jf11 ] + 9:682 Q[! 2 jf11 ]
Q[! 1 jf1 ] + Q[! 2 jf11 ] = 1
1
:
Q[! 1 jf11 ]; Q[! 2 jf11 ] > 0

and is solved by

Q[! 1 jf11 ] = 0:9

Q[! 2 jf11 ] = 0:1

3
 and System (3) can be rewritten as
8 1
< 9:8 = 1:01 10:094 Q[! 3 jf21 ] + 9:604 Q[! 4 jf21 ]
Q[! 3 jf21 ] + Q[! 4 jf21 ] = 1
:
Q[! 3 jf21 ]; Q[! 4 jf21 ] > 0

and is solved by

Q[! 3 jf21 ] = 0:6

Q[! 4 jf21 ] = 0:4

Therefore

Q[! 1 ] = 0:8 0:9 = 0:72

Q[! 2 ] = 0:8 0:1 = 0:08
Q[! 3 ] = 0:2 0:6 = 0:12
Q[! 4 ] = 0:2 0:4 = 0:08

Since there exists a unique risk neutral probability measure, the market is arbitrage free and
complete (by the 2nd FTAP).
4. A futures contract with maturity T = 2 on the risky security S is characterized by a sequence
of futures prices f (0) ; f (1) where f (0) is settled at time t = 0 while f (1) is settled at t = 1
based on P1 : A long position in a futures contract at time t = 0 generates the cash‡ow

Xf ut (1) = f (1) f (0)

at time t = 1; and
Xf ut (2) = S(2) f (1)
at time t = 2. The futures prices f (0) ; f (1) must satisfy the condition that, under no-
arbitrage, the value of a long position in the futures contract is 0 both at time t = 0 and a
time t = 1. Determine f (0) and f (1).
We start by determining f (1) : To this aim we impose the condition that the value of a long
position in the futures contract at time t = 1 is zero:

Xf ut (2)
EQ P1 = 0
1 + r (1)
S(2) f (1)
EQ P1 = 0
1 + r (1)
S(2) f (1)
EQ P1 = EQ P1 (4)
1 + r (1) 1 + r (1)
f (1)
S(1) =
1 + r (1)
h i
S(2)
where we exploited the de…nition of risk neutral measure that yields S(1) = EQ 1+r(1) P1
h i
f (1) f (1)
and the fact that f (1) and r (1) are P1 measurable, thus implying EQ 1+r(1) P1 = 1+r(1) :
Therefore
8
< 10:3 (1 + 0:03) = 10: 609 if f11
f (1) = S(1) (1 + r (1)) =
:
9:8 (1 + 0:01) = 9: 898 if f21

4
 We then determine f (0) : To this aim we impose the condition that the value of a long position
in the futures contract at time t = 0 is zero:
Xf ut (1) Xf ut (2)
EQ + =0
1 + r (0) (1 + r (0)) (1 + r (1))
From our previous step we know that f (1) is such that
Xf ut (2)
EQ P1 = 0
1 + r (1)
Therefore
Xf ut (1) Xf ut (2)
0 = EQ +
1 + r (0) (1 + r (0)) (1 + r (1))
Xf ut (1) 1 Xf ut (2)
= EQ + EQ EQ P1 be the tower property
1 + r (0) 1 + r (0) 1 + r (1)
Xf ut (1) 1
= EQ + EQ 0
1 + r (0) 1 + r (0)
Hence f (0) must be settled such that
Xf ut (1)
EQ = 0
1 + r (0)
f (1) f (0)
EQ = 0
1 + r (0)
leading to
f (0) f (1)
= EQ
1 + r (0) 1 + r (0)
f (0) = EQ [f (1)] dividing by the constant 1 + r (0) (5)
= 10: 609 0:8 + 9: 898 0:2 = 10: 467:

5. To show that the futures prices process f = ff (t)gt=0;1;2 is a Q martingale, we …rst observe
that equation (4) delivers
1 1
EQ [ S(2)j P1 ] = EQ [ f (1)j P1 ] because 1 + r (1) is P1 meas.
1 + r (1) 1 + r (1)
EQ [ S(2)j P1 ] = EQ [ f (1)j P1 ]
EQ [ S(2)j P1 ] = f (1) because f (1) is P1 meas.
since 1 + r (1) is P1 measurable.
By imposing the terminal condition f (2) = S (2) we observe that this is exactly the martin-
gality requirement
f (1) = EQ [ S(2)j P1 ] = EQ [ f (2)j P1 ]
from t = 1 to t = 2: The further condition from t = 0 to t = 1 is
f (0) = EQ [f (1)]
which is the Equation (5) we imposed above.
This proves that the futures prices process f = ff (t)gt=0;1;2 is a Q martingale. You can also
prove the property be numerically verifying that
f (0) = EQ [f (1)] and f (1) = EQ [ f (2)j P1 ] :

5
 6. The barrier derivative X on S with maturity T = 2 pays a coupon C = 100 at t 2 f1; 2g if
S (t) > S (t 1) and then terminates has a cash‡ow
8
< C if f11 where S (1) > S (0)
X (1) =
:
0 if f21 where S (1) S (0)
and 8
>
> 0 on ! 1 and ! 2 ; since S (1) > S (0)
>
>
<
X (2) = C on ! 3 where S (1) S (0) and S (2) > S (1)
>
>
>
>
:
0 on ! 4 where S (1) S (0) and S (2) S (1)
Its no-arbitrage price process SX = fSX (t)gt=0;1;2 is given by
8
< C on ! 3
SX (2) = X (2) =
:
0 on ! 1 ; ! 2 ; ! 4
at maturity. At t = 1
8
< 0 if f11
Q X(2)
SX (1) = E P1 =
1 + r (1) : 100 0:6+0 0:4
1:03 = 59:406 if f21
and at t = 0
X(1) + SX (1)
SX (0) = EQ
1 + r (0)
100 + 0 0 + 59:406
= 0:8 + 0:2
1:02 1:02
= 90:079

Exercise 2.
1. The historical probability P that a European put option on S with strike price K = 1 closes
in the money at the maturity T is
2
T + WT K
P [S(T ) < K] = P e 2
<
S(0)
2
K
= P T + WT < ln
2 S(0)
2
1 K P
= P Z< p ln T where Z N (0; 1)
T S(0) 2
2
1 K
= N p ln T
T S(0) 2
1 1 0:102
= N p ln 0:06 2
0:10 2 1 2
= N ( 0:777 82)

2. The initial no-arbitrage price SX (0) of the derivative X on S whose cash‡ow is

T T T
X = 1000 ln S at t =
2 2 2
and X (T ) = 1000 ln (S (T )) at t = T;

6
 T
and X (t) = 0 for all t 6= 2 ; T is
T T
SX (0) = EQ X e 2 + X (T ) e T
:
2
And therefore
T T
SX (0) = e 2 EQ 1000 ln S +e T
EQ [1000 ln (S (T ))]
2
2
T T T
= e 2 EQ 1000 ln (S (0)) + + WQ +e T
EQ 1000 ln (S (0)) +
2 2 2 2
2 2
T T T
= e 2 1000 ln (S (0)) + +e 1000 ln (S (0)) + T
2 2 2
T
because W Q (T ) and W Q 2 have zero Q-expectation. Thus

0:01 1 0:12 2 0:01 2 0:12

SX (0) = e 1000 ln (1) + 0:01 +e 1000 ln (1) + 0:01 2
2 2 2
= 1000 0:01475 = 14: 75

Then, we compute the derivative of SX (0) with respect to

2 2
@ @ T T T
SX (0) = 1000 e 2 ln (S (0)) + +e ln (S (0)) + T
@ @ 2 2 2
T T T
= 1000 e 2 ( ) +e ( ) T <0
2
Hence SX (0) is decreasing with respect to :
T
3. The no-arbitrage price at t 2 2 ; T of X includes the only outstanding cash‡ow at T; thus
leading to
SX (t) = e (T t)
EQ
t [X (T )]
We compute therefore
EQ
t [X (T )] = 1000 EQ
t [ln (S (T ))] =
2
= 1000 EQ
t ln (S (0)) + T + W Q (T )
2
2
= 1000 ln (S (0)) + T + W Q (t)
2
because W Q (t) is a Q martingale. This leads to
2
(T t)
SX (t) = 1000 e ln (S (0)) + T + W Q (t)
2
2
and in terms of S (t) = S (0) exp 2 t + W Q (t) we can write
0 1
B 2 2 C
(T t) B C
SX (t) = 1000 e Bln (S (0)) + t + W Q (t) + (T t)C
@ 2 2 A
| {z }
ln S(t)
2
(T t)
= 1000 e ln S (t) + (T t)
2
0:01(2 t)
= 1000 e (ln S (t) + 0:005 (T t))

7
 Afterwards, the no-arbitrage price for X at t 2 0; T2 includes the two cash‡ows at T
2 and
at T: Therefore for t 2 0; T2 we have

( T2 t) T
SX (t) = EQ
t e X +e (T t)
X (T )
2
( T2 t) T
= e EQ
t X +e (T t)
EQ
t [X (T )]
2

We compute therefore

EQ
t X 2
T
T
= EQ
t ln S =
1000 2
2
T T
= EQ
t ln (S (0)) + + WQ
2 2 2
2
T
= ln (S (0)) + + W Q (t)
2 2

because W Q (t) is a Q martingale. As computed before,

EQ
t [X (T )]
2
= ln (S (0)) + T + W Q (t)
1000 2

Hence
2
( T2 t) T
SX (t) = e 1000 ln (S (0)) + + W Q (t) +
2 2
2
(T t)
+e 1000 ln (S (0)) + T + W Q (t)
2

Since
2
S (t) 1
W Q (t) = ln t
S (0) 2
by plugging W Q (t) into SX (t), we …nd
2
( T2 t) T
SX (t) = 1000 e t + ln (S (t)) +
2 2
2
(T t)
+e (T t) + ln (S (t))
2

that is
0:01(1 t)
SX (t) = 1000 e (0:005 (1 t) + ln (S (t))) +
0:01(2 t)
+e (0:005 (2 t) + ln (S (t)))

T
4. The replicating strategy of the derivative for t 2 2 ; T can be found as

@
#1 (t) = F (t; S (t))
@S
where
0:01(T t)
F (t; S) = 1000 e (ln S + 0:005 (T t))

8
 Hence we compute
@ @ 0:01(T t)
F (t; S) = 1000 e (ln S + 0:005 (T t))
@S @S
0:01(T t) 1
= 1000 e
S
leading to
0:01(2 t) 1
#1 (t) = 1000 e
S (t)
T
units of S at time t 2 2 ; T : The riskless component
t
#0 (t) = (F (t; S (t)) #1 (t) S (t)) e
0:01(2 t) 0:01(2 t) 1 0:01 t
= 1000 e (ln S (t) + 0:005 (2 t)) e S (t) e
S (t)
0:01 (2 t) 0:01 t
= 1000 e (ln S (t) + 0:005 (2 t) 1) e
0:01 (2)
= 1000 e (ln S (t) + 0:005 (2 t) 1)

5. The equation

T T
P ln S > 0 \ (ln (S (T )) > 0) = P ln S >0 P [(ln (S (T )) > 0)]?
2 2

T
does not hold because the two events ln S 2 > 0 and (ln (S (T )) > 0) are not indepen-
dent. In fact from the equality
2
T T
+ (W (T ) W ( T2 ))
S (T ) = S e 2 2

2
T
the dependence of S (T ) on S 2 is apparent.

9
 Quantitative Finance and Derivatives I
Finanza Quantitativa e Derivati I
codice 20188
a.a. 2014/15, Settembre 2015
GIUSTIFICARE DETTAGLIATAMENTE TUTTE LE RISPOSTE

ESERCIZIO 1 (40 punti su 100).

Si consideri un mercato uniperiodale con il titolo certo B che fornisce il tasso di interesse privo di
rischio r = 3%; ed un titolo rischioso S1 i cui prezzi al tempo T = 1 sono

S1 (1)(! 1 ) = 12
S1 (1)(! 2 ) = 10
S1 (1)(! 3 ) = 9

1. (3 punti) Il mercato è completo?

2. (11 punti) Se il titolo rischioso S1 è negoziato al tempo t = 0 al prezzo

S1 (0) = 10

esistono probabilità neutrali al rischio/vettori di prezzi per gli stati? In caso a¤ermativo,
trovare sia l’insieme di probabilità neutrali al rischio che quello dei vettori di prezzi per gli
stati e discutere l’assenza di arbitraggio nel mercato.
3. (8 punti) Si consideri un’opzione digitale che paga a scadenza T = 1
8
< 10:3 if S1 (1) < 10
X (1) =
:
0 altrimenti

Si scriva X (1) in ogni scenario ! k per k = 1; 2; 3: L’opzione può essere replicata con B ed S1 ?
Si determini l’insieme di prezzi di non arbitraggio in t = 0 per l’opzione digitale su S1 : Qual
è il minimo costo di super-replicazione del payo¤ …nale dell’opzione digitale?
4. (10 punti) Si supponga che l’opzione digitale del Punto 3 sia contrattata al prezzo iniziale
SX (0) = 3: Il mercato esteso è privo di arbitraggio? In caso a¤ermativo si calcoli la probabilità
neutrale al rischio per il mercato esteso. Il mercato esteso è completo?
5. (8 punti) Si assuma che la probabilità storica P sia uniforme su , ovvero P(! k ) = 13 per
k = 1; 2; 3: Si consideri l’opzione digitale del punto 3. Si trovi una strategia # = (#0 ; #1 ) il cui
costo iniziale sia V# (0) = SX (0) = 3 e il cui valore …nale V# (1) minimizzi l’errore quadratico
di replicazione di X (1) sotto la probabilità storica P dato da
h i
2
EP (V# (1) X (1)) :

1
ESERCIZIO 2 (40 punti su 100).
Si consideri un mercato di Black-Scholes con il titolo certo B(t) = e t e il titolo lognormale S con
drift e volatilità rispetto alla probabilità storica P: Si assumano i seguenti valori per i parametri:
S(0) = 1; = 4%; = 6%, = 16%, e T = 1:

1. (5 punti) Si determini la probabilità storica P che un’opzione put Europea su S con prezzo
d’esercizio K = 1 chiuda alla scadenza T out of the money.

2. Si consideri il derivato Europeo il cui payo¤ a scadenza T è

X= W (T ) ;

ove W è il moto Browniano standard sotto la probabilità storica P:

(10 punti) Si calcoli SX (0) ; il prezzo di non arbitraggio del derivato in t = 0.
(7 punti) Si calcoli la derivata del prezzo iniziale SX (0) rispetto alla volatilità : Il prezzo
SX (0) è una funzione monotona di ?
3. (5 punti) Si caloli la probabilità neutrale al rischio che il payo¤ …nale del derivato di cui al
Punto 2 sia positivo alla scadenza T:
4. (7 punti) Si calcoli SX (t) ; il prezzo di non-arbitraggio del derivato di cui al Punto 2 in ogni
t 2 (0; T ). Si scriva SX (t) in termini del valore corrente del sottostante, S (t) :
5. Sia t 2 (0; T ) e si consideri l’evento

f W (T ) > 0g :

(2 punti) Si riscriva questo evento in termini di una variabile normale e Ft misurabile ed

una variabile normale e indipendente da Ft rispetto alla probabilità neutrale al rischio Q.
(4 punti) Si usi questa decomposizione per calcolare la probabilità neutrale al rischio con-
dizionata a Ft dell’evento f W (T ) > 0g in termini del moto Browniano neutrale al rischio
in t ed anche in termini del valore corrente del titolo S (t).
La probabilità neutrale al rischio condizionata a Ft dell’evento f W (T ) > 0g cresce o decresce
se il valore del sottostante S (t) aumenta alla data t?

Le risposte ai Punti 1,3 e 5 vanno formulate in termini della funzione di distribuzione della normale
standard N ( ).

DOMANDA (20 punti su 100).

Si enunci (5 punti) la formula di Ito e la si applichi (15 punti) per risolvere l’equazione di¤erenziale
stocastica del modello di Black e Scholes.

2
 Quantitative Finance and Derivatives I
Finanza Quantitativa e Derivati I
code 20188
a.y. 2014/15, September 2015

POINTS WILL BE AWARDED ONLY TO ANSWERS SUPPORTED BY A

DETAILED LOGICAL JUSTIFICATION

EXERCISE 1 (40 points out of 100).

Consider a one period market with the riskless asset B yielding a risk-free rate r = 3%; and a risky
security S1 whose prices at time T = 1 are

S1 (1)(! 1 ) = 12
S1 (1)(! 2 ) = 10
S1 (1)(! 3 ) = 9

1. (3 points) Is the market complete?

2. (11 points) Suppose that the risky security S1 trades at t = 0 at the price

S1 (0) = 10

Do state price vectors/risk neutral probabilities exist? If your answer is positive, …nd both
the set of state price vectors and that of risk neutral probabilities, and discuss no-arbitrage in
the market.
3. (8 points) Consider a digital option that pays at maturity
8
< 10:3 if S1 (1) < 10
X (1) =
:
0 otherwise

Write X (1) in ! k for k = 1; 2; 3: Can this option be replicated with B and S1 ? Determine the
set of no-arbitrage prices at t = 0 for the digital option on S1 : What is the minimum cost to
super-replicate the …nal payo¤ of the digital option?
4. (10 points) Suppose that the digital option of Point 3 trades at the initial price SX (0) = 3: Is
the extended market arbitrage free? If your answer is positive, compute the risk neutral
probabilities for the extended market. Is the extended market complete?

5. (8 points) Assume the historical probability P is uniform on , i.e. P(! k ) = 13 for k = 1; 2; 3:

Consider the digital option of Point 3. Find a strategy # = (#0 ; #1 ) whose initial cost is
V# (0) = SX (0) = 3 and whose …nal value V# (1) minimizes the historical quadratic error of
replication of X (1) given by h i
2
EP (V# (1) X (1)) :

1
EXERCISE 2 (40 points out of 100).
Consider a Black-Scholes market with the riskless security B(t) = e t and the lognormal risky
security S with drift and volatility under the historical probability P: Assume the following
values for the parameters: S(0) = 1; = 4%; = 6%, = 16%, and T = 1:

1. (5 points) Determine the historical probability P that a European put option on S with strike
price K = 1 closes out of the money at the maturity T .

2. Consider the European derivative whose payo¤ at maturity T is

X= W (T ) ;

where W is the historical standard Brownian motion driving S:

(10 points) Compute SX (0) ; the no-arbitrage price of the derivative at t = 0.
(7 points) Compute the sensitivity of the derivative’s initial price SX (0) with respect to the
volatility : Is SX (0) a monotone function of ?
3. (5 points) Compute the risk neutral probability that the …nal payo¤ of the derivative is
positive at maturity T:
4. (7 points) Compute SX (t) ; the no-arbitrage price of the derivative of Point 2 at any t 2
(0; T ). Write SX (t) in terms of the current value of the underlying asset S (t) :
5. Let t 2 (0; T ) and consider the event

f W (T ) > 0g :

(2 points) Rewrite this event in terms of a normal Ft measurable random variable and a
normal random variable independent of Ft with respect to the risk-neutral probability Q.
(4 points) Use this decomposition to compute the Ft conditional risk neutral probability of
the event f W (T ) > 0g in terms of the risk neutral standard Brownian motion at t and in
terms of the current value of the asset S (t).
Does the Ft conditional risk neutral probability of the event f W (T ) > 0g increase or de-
crease if the current value of the asset S (t) increases at date t?

Express your answers to Points 1,3 and 5 in terms of the distribution function N ( ) of a standard
Normal random variable.

QUESTION (20 points out of 100).

State (5 points) Ito Formula and apply it (15 points) to solve the stochastic di¤erential equation
of the Black Scholes model.

2
 SOLUTIONS TO EXERCISES

Solution of EXERCISE 1

1. The market is incomplete, because the number of scenarios K = 3 > 2; the number of traded
securities.
2. Since the market is incomplete, the risk-neutral measures (if any) cannot be unique. Denoting
by qi = Q(! i ) > 0 for i = 1; :::; 3; we have that
0 1
1 B C
@12q1 + 10q2 + 9(1 q1 q2 )A = 10
1:03 | {z }
q3

q2 = 1:3 3q1

that gives 8
< q1 > 0
q2 = 1:3 3q1 > 0
:
q3 = 1 q1 (1:3 3q1 ) = 2q1 0:3 > 0
13
The system of inequalities is satis…ed for q1 2 0:15; : Thus the set of risk neutral proba-
30
bilities is 8 13
>
< q1 2 0:15; 30
q2 = 1:3 3q1
>
:
q3 = 2q1 0:3:

The state price vectors are

Q(! i )
i = i = 1; 2; 3
1+r
so that 8 0:15 13 1
>
> 1 2 1:03 ; 30 1:03 = (0:1456 ; 0:4207 )
<
1
2 = 1:3 1:03 3 1 = 1:262 1 3 1
>
>
: 1
3 =2 1 0:3 1:03 =2 1 0:291 26
st
By the 1 FTAP the market is arbitrage free, because the set of risk neutral probabilities (or,
equivalently, the set of state price vectors) is nonempty.
3. The …nal payo¤ of the digital option on S1 at maturity T = 1 is

X (1) (! 1 ) = 0
X (1) (! 2 ) = 0
X (1) (! 3 ) = 10:3

and cannot be replicated because

2 3
1:03 12 0
det 4 1:03 10 0 5= 21:22 6= 0
1:03 9 10:3

implies that the 2 3

1:03 12 0
ran 4 1:03 10 0 5 = 3;
1:03 9 10:3

3
 i.e. the option payo¤ is linearly independent from the terminal prices of B and S1 :
Hence there is an interval of no-arbitrage prices at t = 0 for the option on S1 : To retrieve such
interval we compute for any risk neutral probability Q
1 0 q1 + 0 q2 + 10:3 q3
EQ [X (1)] =
1+r 1:03
= 10q3
= 10 (2q1 0:3)

therefore
1
inf EQ [X (1)] = 10 (2 0:15 0:3) = 0
Q 1+r
1 13
sup EQ [X (1)] = 10 2 0:3 = 5:667:
Q 1+r 30
Hence the no-arbitrage interval for the call option is (0; 5:667). The minimum cost to super-
replicate X(1) is 5.667.
4. If the digital option of Point 3 trades at the initial price SX (0) = 3, the extended market
is arbitrage free, because SX (0) = 3 2 (0; 5:667) ; which is the no-arbitrage interval for the
digital option. The risk neutral probabilities for the extended market are obtained imposing
the additional constraint

10q3 = 3
q3 = 0:3

that implies
q3 = 2q1 0:3 = 0:3
that is
q1 = 0:3
and …nally
q2 = 1:3 3 0:3 = 0:4
The extended market is complete, because the number of independent securities at T = 1 is
2 3
1:03 10 0
rank 4 1:03 12 0 5 = 3 = K;
1:03 9 10:3

as we veri…ed in Point 3. We can reach the same conclusion by applying the 2nd FTAP: in
fact, we have just found that there exists a unique risk neutral probability measure for the
extended market. The 2nd FTAP implies that the market is free of arbitrage opportunities
and complete.

5. In order to …nd the strategy # = (#0 ; #1 ) ; we …rst impose

V# (0) = SX (0) = 3

leading to

1#0 + 10#1 = 3
#0 = 3 10#1

4
We compute 8
< V# (1)(! 1 ) = 1:03 (3 10#1 ) + 12#1 = 1:7#1 + 3:09
V# (1)(! 2 ) = 1:03 (3 10#1 ) + 10#1 = 3:09 0:3#1
:
V# (1)(! 3 ) = 1:03 (3 10#1 ) + 9#1 = 3:09 1:3#1
The quadratic error of replication with respect to the historical uniform probability is
h i 1h i
2 2 2 2
EP (V# (1) X (1)) = (1:7#1 + 3:09 0) + (3:09 0:3#1 0) + (3:09 1:3#1 10:3)
3
1
= 4:67(#1 )2 + 27:398#1 + 71: 08 :
3

The quadratic function of #1 reaches the minimum at

27:398
#1 = = 2:933 4:
2 4:67
Thus the required strategy is

#0 = 3 10#1 = 3 10 ( 2:933 4) = 32:334

#1 = 2:933 4:

5
Solution of EXERCISE 2 .

1. The historical probability P that a European put option on S with strike price K = 1 closes
out of the money at the maturity T is
2
T + W (T ) K
P [S(T ) > K] = P e 2
> where W is the P standard Brownian motion
S(0)
2
K
= P T + W (T ) > ln
2 S(0)
2
1 K P
= P Z> p ln T where Z N (0; 1)
T S(0) 2
2
1 K
= P Z< p ln T
T S(0) 2
2
1 K
= N p ln T
T S(0) 2
1 1 0:162
= N p ln 0:06 1
0:16 1 1 2
= N (0:295)

2. The no-arbitrage price of the European derivative whose terminal payo¤ X at maturity T is

X= W (T ) ;

is given by
T
SX (0) = e EQ [ W (T )] :
We compute

EQ [ W (T )] = EQ W Q (T ) T because W Q (T ) = W (T ) + T

= EQ W Q (T ) + T
Q
= 0+ T since W Q (T ) N (0; T )
0:06 0:04
= 1 = 0:125
0:16
and therefore

SX (0) = e T EQ [ W (T )]
= e 0:04 1 0:125
= 0:120:

We compute the derivative of SX (0) with respect to

@ @ T
SX (0) = e T
@ @
T @ 1
= e ( )T
@
T 1
= e ( )T 2
< 0:

6
 Then
@
SX (0) < 0 for any > 0; ; T 0
@
and therefore SX (0) decreases if increases, and is a monotone function of :
3. The risk neutral probability that the …nal payo¤ of the derivative is positive at maturity T is

Q [ W (T ) > 0] = Q W Q (T ) T >0 =

= Q W Q (T ) < T
p Q
= Q T ZQ < T where Z Q N (0; 1)
p
= Q ZQ < T
p 0:06 0:04 p
= N T =N 1
0:16
= N (0:125)

4. The no-arbitrage price of the derivative of Point 2 at any t 2 (0; T ) is

SX (t) = e (T t)
EQ
t [X]
(T t) Q
= e Et [ W (T )]

= e (T t)
EQ
t W Q (T ) T

= e (T t)
EQ
t W Q (T ) + e (T t)
T

We compute
EQ
t W Q (T ) = EQ Q
t W (T ) = W Q (t)
because W Q is a Q martingale. Hence

(T t)
SX (t) = e W Q (t) + e (T t)
T

Or, in terms of the current value of the underlying asset S (t) ; we rewrite
2
S (t) 1
W Q (t) = ln t
S (0) 2

and obtain

(T t)
SX (t) = e W Q (t) + e (T t)
T
2
(T t) S (t) 1
= e x+ T with x = ln t ;
S (0) 2

that is
0:04(1 t)
SX (t) = e ( x + 0:125)
2
0:16 1
where x = ln S (t) 0:04 2 t 0:16 = 6:25 (ln S (t) 0:0272 t) :

7
5. The event f W (T ) > 0g can be rewritten as

f W (T ) > 0g = W Q (T ) T >0

= W Q (T ) < T

= W Q (T ) W Q (t) < T W Q (t)

where W Q (T ) W Q (t) is a normal Ft independent random variable and W Q (t) is a normal

Ft measurable random variable with respect to Q:
The Ft conditional risk neutral probability of the event
f W (T ) > 0g :
is therefore

Qt [ W (T ) > 0] = Qt W Q (T ) W Q (t) < T W Q (t) :

Qt p
Since W Q (t) is Ft measurable and W Q (T ) W Q (t) ZQ T t is Q independent of Ft ;
we set x = W Q (t) and obtain for any t 2 (0; 1)
p
Qt W Q (T ) W Q (t) < T W Q (t) = Q ZQ T t< T x
" #
T x
= Q ZQ < p
T t
!
T x
= N p
T t
0:125 x
= N p with x = W Q (t)
1 t

The Ft conditional risk neutral probability of the event f W (T ) > 0g

0:125 x
Qt [ W (T ) > 0] = N p with x = W Q (t)
1 t
is a decreasing function of x = W Q (t) ; because the argument of N is decreasing with respect
to x and N is an increasing function. The current value of the risk-neutral Brownian motion
can be rewritten in terms of the current value of the underlying asset S (t) as
2
S (t) 1
x = W Q (t) = ln t :
S (0) 2
Thus
0 S(t) 2
1
1
0:125 x 0:125 ln S(0) 2 t
f W (T ) > 0g = N p =N@ p A
1 t 1 t

that is a decreasing function of S (t) : Hence, if S (t) increases, the Ft conditional risk neutral
probability of the event f W (T ) > 0g decreases. This answers the question. We can provide
an alternative and more formal answer as follows. Let y = S (t). By our previous computations
2
y 1
x = W Q (t) = ln t
S (0) 2

8
and
@ @ 0:125 x @x
Qt [ W (T ) > 0] = N p
@y @x 1 t @y
0:125 x 1 @x
= fN (0;1) p p
1 t 1 t @y
0:125 x 1 1 1
= fN (0;1) p p <0
1 t 1 t y

since
@x 1 1
= :
@y y
Being
@
Qt [ W (T ) > 0] < 0;
@y
the Ft conditional risk neutral probability of the event f W (T ) > 0g is a decreasing function
of y = S (t) :