All questions may be attempted but only marks obtained on the best four solutions will

count.
The use of an electronic calculator is not permitted in this examination.

NOTE: In the questions which follow the current price of an asset (or similar instrument)
will often be denoted either by St or simply by S with the time subscript suppressed.
Reference may be made to the following definitions:

(x)+ = max{x, 0},

Z x
1 −t2
N (x) = √ exp( )dt,
2π −∞ 2
1 −x2
n(x) = √ exp( ),
2π 2
ln(S/K) + (r + 12 σ 2 )t
d1 = √ ,
σ t
ln(S/K) + (r − 12 σ 2 )t
d2 = √ ,
σ t
where K denotes the exercise price, r the riskless rate, σ the volatility and t is the time
to expiry. The Black-Scholes formula for pricing a European call is

C = SN (d1 ) − Ke−rt N (d2 ).

1. Write an essay to explain the principles of arbitrage and how it is used to price
financial derivatives. You should consider definitions of arbitrage, derive put-call
parity and demonstrate how arbitrage can be used to price a forward and an option.
State relevant theorems.

MATHG508 PLEASE TURN OVER

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 2. Consider the following model, with r = 0:

ω S(0) S(1) S(2)

ω1 S aS a2 S
ω2 S aS S
ω3 S a−1 S S
ω4 S a( − 1)S a( − 2)S

S is the initial asset level at time 0 and a is a constant.

(a) In this model, replicate the European option with strike equal to the initial asset
level S over the two periods and so find the fair price of the claim.
(b) Find all the one period risk-neutral probabilities and the corresponding proba-
bility on Ω = {ω1 , ω2 , ω3 , ω4 }. Confirm that EQ [X] is the fair price.
(c) Suppose we have a model where in each period the asset can either double or
half. Show that the value of an option struck at initial asset level S is S/3.

(d) Now consider the T −period binomial model extended from the model above by
multiplying or dividing the asset level by a at each step.
Show that the risk-neutral measure Q is given by
  T −n
T a
Q(NT = n) =
n (a + 1)T

where NT is the number of up moves in the path. Confirm that this agrees with the
risk-neutral measure in part (b).

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 3. (a) A barrier option becomes worthless if at any time the underlying asset goes above
the barrier level. Give a brief explanation of the idea behind dynamic programming
as applied to the valuation of barrier options. Use the method to value a barrier
call option with strike price K = 4 dollars and barrier level B = 15 dollars written
on an asset where the asset prices in dollars are given below, the interest rate per
period is zero.

S(0) S(1) S(2) S(3)

ω1 8 14 19 22
ω2 8 14 19 16
ω3 8 14 9 16
ω4 8 14 9 6
ω5 8 6 9 16
ω6 8 6 9 6
ω7 8 6 5 6
ω8 8 6 5 4

(b) Why is this barrier option worth less than the european call option struck at
K = 4? Construct an arbitrage opportunity for the case where the european and
barrier option have the same initial value.
(c) Explain the differences between risk-neutral pricing and pricing based on the
expected value of the underlying asset. If a hedge fund buys an option from a bank,
how is it possible that they may both make money from the transaction?

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 4. (a) Let f (S, t) be a function of two variables (continuously twice differentiable in
S and once in t). State Itô’s Formula for df (S(t), t), where S(t) is an asset price
obeying the stochastic equation

dS = µdt + σdW

in which W = W (t) is standard Brownian motion and µ, σ are continuous functions

of S and t. Give a plausability argument in support of the formula.
(b) What form does Itô’s Formula take when the function f is independent of time?
Using this formula, explain how we can obtain a relationship between the stochastic
integral and a standard integral.
(c) Show that
Z T Z T
1
W dW = W (T )3 −
2
W dt
0 3 0

(d) Now assume that S is a model for stock prices obeying the stochastic equation

dS = µSdt + σSdW

Show that S(T )/S(0) is lognormally distributed and calculate the mean and variance
of the distribution.

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 5. (a) Let V (S, t) denote the value at time t ≤ T of a European option when the price
of the underlying asset is S. Assume that the asset price process S(t) follows the
stochastic equation

dS = µSdt + σSdW

where W = W (t) is a standard Brownian motion, µ, σ are constants and r is a

constant riskless interest rate applicable throughout the life of the option.

Use Itô’s Formula to derive the Black-Scholes equation satisfied by the function
V (S, t), namely

∂V ∂V 1 ∂2V
+ rS + σ 2 S 2 2 = rV.
∂t ∂S 2 ∂S
(b) Use the Feynman-Kac formula to solve the Black-Scholes equation in the case of
a european call option and thus verify the Black-Scholes formula given at the start
of this paper.
c) Sketch a graph for the payoff of a european call option with strike = K. On the
same graph sketch the value of the option at time t = 0.

MATHG508 END OF PAPER