MT3470MT4570: Problem Set 8

Let Wt = (Wt , t ≥ 0) be standard BM.

1. Let St = 100e2Wt for t ≥ 0. Use Ito’s formula to find the stochastic differential dSt .

2. Suppose that a stock price St follows the log-normal process with expected return µ = 40%
and volatility σ = 20% (per annum) and S0 = £1. What is the probability that the stock price
exceeds £2.61 in 1 year?

3. Recall the BS-formula for the price P of a European put option with strike K and maturity T

P = −S(1 − Φ(x1 )) + Ke−rT (1 − Φ(x0 )),

where S = S(0), r is the risk-free interest rate compounded continuously,

log(S/K) + (r + σ 2 /2)T log(S/K) + (r − σ 2 /2)T

x1 = √ and x0 = √ .
σ T σ T

Consider the option price as a function of maturity T (keeping all other variables fixed), that
is, P = P (T ). Find the limit of P (T ), as T → 0 in the cases i) S > K (the put option is out
the money) and ii) S < K (the put option is in the money).

4. With reference to Black-Scholes formula for the price C of a European call option with strike
K and maturity T , show that
x2
1 x2
0
(a) Se− 2 − Ke− 2 = 0, where S = S(0) (you may assume that the risk-free interest rate
r = 0).
∂C
(b) Use the result of the preceding part of the question to show that ∂S
= Φ(x1 ) (i.e. that
the delta of the call option is equal to Φ(x1 )).

In all questions: state all facts that you use, justify your answer (giving just the answer is not
sufficient).