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 concept of risk-neutrality and how it is used to price
financial derivatives. You should define risk-neutrality, give a simple example of
how to construct the risk-neutral probability and state and prove a version of the
no-arbitrage theorem.

MATHG508 PLEASE TURN OVER

1
 2. Consider the following model where the interest rate r = 0:

ω S(0) S(1) S(2)

ω1 5 8 11
ω2 5 8 5
ω3 5 2 5
ω4 5 2 0

(a) Given a European put option with payoff

X(2) = (7 − S(2))+ ,

replicate the option over the two periods using the above model 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) Now suppose we have a put option on this model with strike K. Using the
risk-neutral probabilities, show that the value of this option is:

(i) K −5 if K > 11,

3
(ii) K if K 6 5,
10
3 9
(iii) K− otherwise.
4 4

(d) In the T −period binomial model, if the asset price is S at any time, the next
periods’s price will be either SU or SD. The interest rate per period r is positive and
D∗ < 1 < U ∗ , where the star denotes discounting. Interest rates are continuously
compounded.
(i) Describe the risk-neutral measure Q.
(ii) A digital option pays one dollar at time t = T if the asset price is above a fixed
level K and is worthless otherwise. Using Q show that the option value at time
t = 0 is equal to
X T 
−rT T −n
e qUn qD
n≥n̂
n

for some n̂ which you must find.

MATHG508 CONTINUED

2
 3. (a) Give a brief explanation of the idea behind dynamic programming as applied
to the valuation of an American option. Use the method to value an American put
option with exercise price K = 7 dollars written on an asset where the asset prices
in dollars are given below, the interest rate per period is zero, and a dividend of one
dollar is paid between time 1 and expiry.

ω S(0) S(1) S(2)

ω1 5 8 15
ω2 5 8 5
ω3 5 2 5
ω4 5 2 0

(b) For each path ωi , write down the stopping time.

(c) Calculate the value of the American call option with K = 7 using the above
model and show that for American options, Put-Call Parity is not satisfied.

MATHG508 PLEASE TURN OVER

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 4. (a) Consider the integral
Z T
I= W (t)dW (t)
0

By partitioning T show that

N −1
1 1X
I(π) = W (T )2 − ∆W (ti )2 ,
2 2 i=0

and show that the expectation of the final term is T .

(b) 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.
(c) 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.
(d) Now evaluate the integral
Z T
W (t)dW (t)
0

using Itô’s Formula.

MATHG508 CONTINUED

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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. A share price process S(t) follows the stochastic
equation

dS = µSdt + σSdW

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

r is the constant riskless interest rate applicable throughout the life of the option
and that there are no dividends.

Construct a delta-hedged portfolio to derive the Black-Scholes equation satisfied by

the function V (S, t), namely

∂V ∂V 1 2 2 ∂ 2V
+ rS + σ S = rV.
∂t ∂S 2 ∂S 2
(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 of 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