Midterm Intro to Mathematical Finance WI3417TU (2nd of November 2021, 18:30-21:30)

Before you start writing the exam you should notice the following:
I Please, note the last digit of your student ID and denote it z. In case
this number is 0 you take to be equal to 10, in case it is 1 you take 11.
II Only very basic calculator is allowed. No formula sheets, no notes etc.
1. [25 points] Consider the two-period binomial model with the up-factor u = 2, the
down-factor d = 1/u, r = d2 denotes a risk-free rate and N = 3 number of periods.
As usual, for any n ≥ 1 the price evolves as Sn = uSn−1 in case the head (H) appears,
and Sn = dSn−1 in case of the tail (T). The initial asset price is given by S0 = z.

Figure 1: Three-period binomial model

1A. (5 points) Complete (1 point) the above diagram (round to 4 decimal places if needed).
Thereafter,
i. (2 points) find the risk neutral probabilities p̃ and q̃;
ii. (2 points) check whether the non-arbitrage condition is valid.
1B. (5 points) Assume you own an exotic ”Asian Lookback” option, which gives you a payoff
N
max{Sn } − N1+1
P
Sn at the last period of expiry N = 3. Calculate the price
n≤N n=0
V0 at time zero of this option.
1C. (5 points) Construct the replicating portfolio of your option, i.e.,
i. (3 points) find the portfolio weights ∆0 , ∆1 (H) and ∆1 (T ) such that your
portfolio will replicate the option’s payoff.
ii. (2 points) Interprete your result in terms of an investment strategy, in that
you explicitly provide how much money you invest into the market and into
the risk asset at every point of time.
1D. (5 points) Consider your exotic option from Question 1B and make it American, i.e., you
are allowed to exercise (stop) it at every time point n ∈ {0, 1, 2, 3} and not only
 at N = 3. Find the time-zero value V0 and optimal exercise policy (optimal
stopping time) for such American option.
1E. (5 points) Suppose that you meet your friend who says that he obeys an insider information
and proposes you to use the following stopping rule

ρ = (T T T ) = 3, ρ(T T H) = ρ(T HT ) = ρ(T HH) = 2,

ρ(HHT ) = ρ(HT H) = ρ(HHH) = ρ(HT T ) = 1.

i. (2 points) Is this stopping rule a proper stopping time due to definition

provided in the lecture?
ii. (2 points) Find the intristic value of your option using such a rule and
determine the risk-neutral value of its payoff, discounted from the time of
payment back to zero.
iii. (1 point) Compare this result with time-zero price of the option computed
in Question 1D and deduce whether your friend is lying you or not, i.e.,
whether this insider information has any value for you.
2. [10 points] You toss a coin repeatedly. Assume the probability of head on each toss
is p. Let Xj = 1 if the jth toss results in head and Xj = −1 if the jth toss results in
tail. Consider the stochastic process M0 , M1 , M2 , . . . , with M0 = 0 and
n
X
Mn = Xj , n ≥ 1.
j=1

This is a general random walk process.

2A. (5 points) Show that there is no number p ∈ (0, 1) (independent of Mn and n) such that
2
e(Mn −n) is a martingale.
2
2B. (5 points) Show that e(Mn −n) is Markov for p = 1/2. Thereafter, assume that p 6= 1/2 and
specify a minimal information we need to make this process Markov again.
3. (15 points) Consider the three-period binomial model from Question 1. Assume
that the actual probability of having the head (H) is p = 1 − 1/z (rememer last digit
of student ID?).
3A. (4 points) Calculate the actual probability measure and risk-neutral probability measure
in this model.
3B. (6 points) Using 3A calculate the Radon-Nikodym derivative Z and the corresponding
Radon-Nikodym process Zn for n ∈ {0, 1, 2, 3}.
3C. (5 points) Let X0 , X1 , X2 and X3 be the optimal wealth process in our three-period model.
√
Assume that the corresponding utility function is hyperbolic, i.e., U (y) = 2 y.
You start with initial capital X0 = z (last digit in your student ID). Compute
X1 , X2 and X3 together with the optimal portfolio weights ∆0 , ∆1 (H), ∆1 (T ),
∆2 (HH), ∆2 (HT ), ∆2 (T H) and ∆2 (T T ).