MTH403-2023/24-SEM1 CW(Assignment) XJTLU

1. Let (Wt )t≥0 be a Brownian motion, and let (Ft )t≥0 be a filtration for this
Brownian motion. Show that (Wt2 − t)t≥0 is a martingale with respect to
(Ft )t≥0 . [10 marks]
2. Let (Wt )t≥0 be a Brownian motion and T be a positive number, then choose
a sequence of partitions (Πn )n≥1 with points 0 = tn0 < tn1 < tn2 < · · · <
tnpn = T such that limn→∞ ∥Πn ∥ = 0, where ∥Πn ∥ is the length of the longest
subinterval of the partition Πn . Show that
"p −1 #2
Xn  2
lim E Wtnj+1 − Wtnj − T = 0.
n→∞
j=0

Recall that for a standard normal random variable X, the variance of X 2 is

2. [10 marks]
3. Let (Wt1 )t≥0 and (Wt2 )t≥0 be two Brownian motions relative to a filtration
(Ft )t≥0 . Assume in addition that [W 1 , W 2 ]t = 0 for all t ≥ 0. Show that for
any t ≥ 0,
1 2 1 2 1 2
Eeu1 Wt +u2 Wt = e 2 u1 t · e 2 u2 t , u1 , u2 ∈ R.
[20 marks]
4. Let T be a fixed positive number. Let (Wt )0≤t≤T be a Brownian motion
on a probability space (Ω , F, P), and let (Ft )0≤t≤T be a filtration for this
Brownian motion. Consider a stock price process (St )0≤t≤T whose differential
is
dSt = αt St dt + σt St dWt , 0 ≤ t ≤ T.
The mean rate of return αt and the volatility σt are allowed to be adapted
processes. We assume that, for all t ∈ [0, T ], σt is almost surely not zero. In
addition, suppose we have an adapted interest rate process (Rt )0≤t≤T . We
define the discount process
Rt
− Rs ds
Dt = e 0 , 0 ≤ t ≤ T.
(a) Suppose (Rt )0≤t≤T is continuous in t. Compute dDt . [5 marks]
(b) Compute d(Dt St ). [10 marks]
(c) Construct a probability measure P, e such that P
e and P are equivalent,
and (Dt St )0≤t≤T is a martingale under P.
e [15 marks]

1
5. Consider the standard two-period binomial model, with S0 = 4, u = 2, d =
1/2, r = 1/4, so that p̃ = q̃ = 1/2.

(a) Determine the price at time zero, denoted V0P , of the American put that
expires at time two and has intrinsic value

gP (s) = (4 − s)+ .

[5 marks]
(b) Determine the price at time zero, denoted V0C , of the American call that
expires at time two and has intrinsic value

gC (s) = (s − 4)+ .

[5 marks]
(c) Determine the price at time zero, denoted V0S , of the American straddle
that expires at time two and has intrinsic value

gS (s) = gP (s) + gC (s).

[5 marks]
(d) Explain why
V0S = V0P + V0C .
[15 marks]