Module 1 Assignment January 2024

Instructions: This is a non-assessed assignment; there are a number of exercises to help consolidate some
of the key material covered in module 1. The aim should be to work through the numerous problems in
this sheet to help measure understanding and performance. Complete solutions will follow. Throughout this
sheet W; W (t) ; Wt all refer to a standard Brownian motion.

1. a. Itô’s lemma can be used to deduce the following formula for stochastic di¤erential equations and
stochastic integrals
Z t Z t
@F @F 1 @2F
dW ( ) = F (W (t) ; t) F (W (0) ; 0) + d
0 @W 0 @ 2 @W 2
for a function F (W (t); t) where dW (t) is an increment of a Brownian motion.
If W (0) = 0 evaluate
Z t
2
sin W dW ( ):
0
b. Suppose the stochastic process S (t) evolves according to Geometric Brownian Motion (GBM),
where
dS = Sdt + SdW:
Obtain a SDE df (S; t) for each of the following functions
i f (S; t) = t + tS n , are constants
ii f (S; t) = log tS + cos tS
2. Consider a function V (t; St ; rt ) where the two stochastic processes St and rt evolve according to a two
factor model given by
(1)
dSt = St dt + St dWt
(2)
drt = (m rt ) dt + cdWt ;
h i
(1) (2)
in turn. and where E dWt dWt = dt: The parameters ; ; ; m and c are constant. Let
V (t; St ; rt ) be a function on [0; T ] with V (0; S0 ; r0 ) = v. Using Itô, deduce the integral form for
V (T; ST ; rT ).
3. An equity price S evolves according to Geometric Brownian Motion
dSt = St dt + St dWt ;
where and are constants. We know that an explicit solution is
2
St = S0 e( =2)t+ Wt

where S0 is St at time t = 0:
By working through all the integration steps, deduce that the expected value of St at time t > 0; given
S0 , is
E [ St j S0 ] = S0 e t :
You are required to present all your integration steps to obtain the expectation.
4. Consider the di¤usion process for the state variable u which evolves according to the Ornstein-
Uhlenbeck process
du = udt + dW:
Both and are constants. Obtain the steady state probability distribution p1 (u), which is given
by r
2
exp 2
u2 :

By looking at p1 ; write down the mean and standard deviation for this distribution.

1
5. Consider the spot rate r, which evolves according to the popular form
dr = u (r) dt + r dW ; (1)

where and are constants.

Suppose such a model has a steady state transition probability density function p1 (r) that
satis…es the forward Fokker Planck Equation.
Show that this implies that the drift structure of (1) is given by

2 1 d
u (r) = r2 1
+ 2 2
r (log p1 ) :
2 dr
a. Let Xt ; Yt be two one-dimensional stochastic processes, where
(1)
dXt = a (t; Xt ) dt + b (t; Xt ) dWt ;
(2)
dYt
= c (t; Yt ) dt + d (t; Yt ) dWt : (2)
h i
(1) (2)
The Wiener processes are correlated such that E Wt Wt = t:
i. By applying the two-dimensional form of Itô’s lemma with f (X; Y ) = XY derive the Itô
product rule
d (Xt Yt ) = Xt dYt + Yt dXt + dXt dYt :
ii. Show Z Z Z
t t t
Xs dYs = Xt Yt X0 Y0 Ys dXs dXs dYs :
0 0 0
iii. Derive the Itô quotient rule
!
2
X X dX dY dXdY dY
d = +
Y Y X Y XY Y

b. Consider a function V (t; Xt ; Yt ) ; where Xt ; Yt are de…ned by (1:1) : Using Itô and suitable inte-
gration over [0; T ] obtain an expression for V (T; XT ; YT ) :
c. Suppose the pair of stochastic di¤erential equations (2) are to be simulated as discrete processes.
(1)
Outline a scheme for doing this. Your discussion should include a method for correlating Wt
(2)
and Wt :

6. In this question t 0:

a. For which values of k is the process

Yt = Wt4 6tWt2 + kt2 ;
a martingale?
2
t=2
b. Show that Xt = cosh ( Wt ) e ; 2 R; is a martingale.

7. Consider the following model, where the risk-free interest rate r = 0 :

! S (0) S (1) S (2)
!1 S aS a2 S
!2 S aS S
!3 S a 1S S
!4 S a 1S a 2S
S is the initial asset value at t = 0 and a > 1 is a constant.

a. Find all the one period risk-neutral probabilities and the corresponding probability measure Q on
= f! 1 ; ! 2 ; ! 3 ; ! 4 g : Con…rm that EQ [X] is the fair price, where X is the payo¤ function.
b. Now consider a model where in each period the asset can either double or half. Show that the
value of an option struck at the initial asset value S is S=3: