Quantitative Finance

MATH 449/MATH 524/FINN 422

Midterm Exam
Due by 11:00 am 20th March 2023

Instructions:

You may not consult with each other or anyone else on the exam
Any resources used besides the notes and prescribed books should be mentioned
If there is anything unclear, please email me
There are 4 questions on the exam worth 25 points each
Answers should be typed or written in very clear and legible hand
The answers should be in provided in order of the question number
All graphs and codes that generated them must be attached

Please write down and sign the following honor pledge at the end of your answer sheet

I have not sought nor given anyone any help with the exam and the text written here has been
composed during the exam period entirely on my own

Name:______________________________

Signature:___________________________
1. Consider creating a call spread by taking a short position in 𝛼 European calls with strike 90 and
a long position in 𝛽 European calls with strike 110. This is used to hedge a binary call option
(being traded at $B) with strike 100, i.e. the option pays $1 if 𝑆(𝑇)>100 and 0 if 𝑆(𝑇) <
100. Note that we want

𝐵 − 𝛼𝐶1 + 𝛽𝐶2=0
Where 𝐶1 and 𝐶2 are prices of the European calls.
a. Create a payoff diagram for the call spread that offsets the binary call.
b. If 𝐶1 = $14.81 and 𝐶2 = $4.94 find quantities such that 𝛼 = 𝛽 that offsets the payoff of the
binary call in (a) which is being traded at $0.5. This is the hedge that was referred to earlier.
c. Construct the payoff diagram of the basket of all three options using the values obtained in
b.

2. (a) Consider the process

𝑑𝑣 = (𝛿 2 + 2𝛼√𝑣 − 2𝛽𝑣)𝑑𝑡 + 2𝛿 √𝑣𝑑𝑊

Using Ito’s lemma find an expression for 𝑑√𝑣

(b) Consider the process
𝑎2 𝑡
𝑋(𝑡) = 𝑒 𝑎𝑊(𝑡)−2

i. Show that 𝑋(𝑡) = 𝑋(𝑡 − 𝑠)𝑋(𝑠)

ii. Prove that 𝑋(𝑡) is a martingale.

3. Consider a cash or nothing call option which pays one unit of cash if the spot at the time of
expiry is above the strike and nothing if it is below the strike. Suppose that 𝑟 = 4%, 𝜎 = 30%,
𝑋 = 90, 𝑆(0) = 100 and 𝑇 = 6 𝑚𝑜𝑛𝑡ℎ𝑠.
1
a. Use the binomial model with 𝛿𝑡 = 16 to determine the price of the call option at 𝑡 = 0.
b. Use the explicit scheme (BTCS) to price the option, use 𝛿𝑆 = 10 and an appropriate time
step 𝛿𝑡. Hence find the price at t=0.
c. The Black Scholes formula to for this option is 𝑽(𝑺, 𝒕) = 𝒆−𝒓(𝑻−𝒕) 𝑵(𝒅𝟐 ), (Wilmott pg. 120)
use this to compute the exact (BS) price and compare your results.
 4. The solution of the IVP
1
𝑢𝑡 = 𝑢𝑥𝑥 0 ≤ 𝑥 ≤ 2, 𝑡 > 0
4
𝜋𝑥
𝑢(𝑥, 0) = 2sin ( ) − sin(𝜋𝑥) + 4sin(2𝜋𝑥)
2
𝑢(0, 𝑡) = 0, 𝑢(2, 𝑡) = 0
Is given by
𝜋2 𝑡 𝜋𝑥 𝜋2 𝑡 2
− −
(𝑥,
𝑢𝑒𝑥𝑎𝑐𝑡 𝑡) = 2𝑒 16 sin ( ) − 𝑒 4 sin(𝜋𝑥) + 4𝑒 −𝜋 𝑡 sin(2𝜋𝑥)
2
a. Use a FTCS (forward in time center in space) scheme to obtain a numerical solution to the
problem for 𝑡 = 0 → 2

b. Plot the error v.s time at 𝑥 = 1, where the error is given by

𝑒(1, 𝑡) = |𝑢𝑒𝑥𝑎𝑐𝑡 (1, 𝑡) − 𝑢𝑛𝑢𝑚 (1, 𝑡)|

c. Plot the error at 𝑥 = 1 and 𝑡 = 1, keeping Δ𝑥 = 0.2 fixed and taking Δ𝑡 =

0.01, 0.005, 0.0025, 0.0001
You are being asked to plot 𝑒(1,1) v.s. Δ𝑡 for the different values of Δ𝑡