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Assignment 5 Mathematical Finance

Mathematocal Finance Itos Formula, Mathematical finance, also known as quantitative finance, is a field of applied mathematics, concerned with financial markets. Generally, mathematical finance will derive and extend the mathematical or numerical models without necessarily establishing a link to financial theory,

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451 views

Assignment 5 Mathematical Finance

Mathematocal Finance Itos Formula, Mathematical finance, also known as quantitative finance, is a field of applied mathematics, concerned with financial markets. Generally, mathematical finance will derive and extend the mathematical or numerical models without necessarily establishing a link to financial theory,

Uploaded by

Yueng
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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MATH4210 FINANCIAL MATHEMATICS

ASSIGNEMNT 5
Due Date is 8th April, 2015. Please put your assignment in the assignment box opposite to the
General Office of the Department of Mathematics (Rm 220, LSB) before 8:00 p.m.
Please give your answers within 2 decimal places whenever necessary.

Answer All Questions


(1) Let Wt be a Brownian motion and let
q

dXt = dt + 2 Xt dWt .
Define

2t
2
1 exp
2(2 )
2
to be a deterministic time change. If Yt is defined as




Yt = exp(t)X1/2
Show that we have

dYt = Yt dt + Yt 2 dWt .
(2) Suppose r is the risk-free interest rate and a stock price S follows the geometric Brownian
process dS = Sdt + SdZ, where is the expected return and is the volatility.
(a) What is the process followed by S n , n Z+ ?
(b) Consider a European derivative that pays off S(T )n at time T , use risk free neutral
valuation to calculate the price of the derivative at time t( T ) in terms of the stock
price S at time t.
(c) Show that the price in (b) satisfies the Black-Scholes equation.
(3) Use risk neutrality to price a European put option, i.e., evaluate
h   
 i2
erT Z V (s) ln Ss0 r 22 T /22 T
p(0) = E(V (S0 , 0)) =
e
ds,
s
2T 0

where
V (s) = max {E s, 0}
(4) Recall that the delta is the rate of change of a portfolio with respect to the underlying
asset price, i.e.,

=
S
1

MATH4210 FINANCIAL MATHEMATICS

ASSIGNEMNT 5

In the derivation of the Black-Scholes equation, delta is used to eliminate the stochastic
term in the lower order of the Its lemma. The resulting hedging strategy is called delta
hedging. There are more sophisticated trading strategies using higher order derivatives.
For example, the gama, theta, vega and rho of a portfolio are defined respectively by
=

2
,
S 2

,
t

.
r

With a suitable balance of the underlying asset and other derivatives, hedgers can eliminate
the short term dependence of the portfolio on movement in time, asset price, volatility or
interest rate.
(1) Prove the following expressions of gamma, theta, vega and rho for the European call option:
(a)
=

N 0 (d1 )

S T t

(b)

= SN 0 (d1 )
+ rEer(T t) N (d2 )
2 T t
(c)

= SN 0 (d1 ) T t
(d)
= (T t)Eer(T t) N (d2 )
where
1 Z d 1 s2
N (d) =
e 2 ds.
2

(e) Consider a 1-year European call option on a non-dividend paying stock when the stock
price is $30, the strike price is $30, the annual interest rate is 5%, and the volatility is
25%. Calculate the option price, delta, gamma, theta, vega and rho.
(f) Find the relationship between and for a delta-neutral portfolio, i.e. = 0. Hence,
deduce the change of of the delta-neutral portfolio when is large and positive.
(2) The table below shows the stock prices winthin a period.

MATH4210 FINANCIAL MATHEMATICS

ASSIGNEMNT 5

Date
Stock price
31/03/15
11.05
01/04/15
11.56
02/04/15
11.45
03/04/15
11.35
04/04/15
11.67
06/04/15
12.03
07/04/15
12.56
08/04/15
12.12
09/04/15
11.56
10/04/15
12.01
13/04/15
12.67
14/04/15
12.87
15/04/15
13.05
16/04/15
13.11
17/04/15
12.65
20/04/15
12.34
21/04/15
13.24
22/04/15
11.57
23/04/15
12.23
24/04/15
13.02
(a) Determine and using the stock prices in the table. Show all your calculation steps
in details.
(b) Use the Black Scholes formula to determine the value of a call with strike price $ 13
and 6 months to expiration. We also assume the interest rate is 3%.

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