MATH 571

Mathematical Models of Financial Derivatives

Homework Four

Course Instructor: Prof. Y.K. Kwok

1. Let X be a normally distributed random variable with mean µ and variance σ 2 . Show that the higher
central moments of the normal random variable are given by

n 0, n odd
µn (X; µ) = E[(X − µ) ] =
(n − 1)(n − 3) · · · 3· 1σ n , n even.

2. Suppose Z(t) is a standard Brownian process, show that the following processes defined by

X1 (t) = kZ(t/k 2 ), k > 0



1
X2 (t) = tZ t for t > 0
0 for t = 0

and
X3 (t) = Z(t + h) − Z(h), h>0
are also Brownian processes.
Hint: To show that Xi (t) is a Brownian process, i = 1, 2, 3, it is necessary to show that

Xi (t + s) − Xi (s)

is normally distributed with zero mean, and

E[[Xi (t + s) − Xi (s)]2 ] = t.

Also, the increments over disjoint time intervals are independent, and Xi (t) is continuous at
t = 0.

3. Consider the Brownian motion with drift defined by

X(t) = µt + σZ(t), X(0) = 0, Z(t) is the standard Brownian motion,

find E[X(t)|X(t0 )], var(X(t)|X(t0 )) and cov(X(t1 ), X(t2 )).

1
4. Let Z(t) denote the standard Brownian process. Show that
Z t1 Z
n 1 n+1 n+1 n t1
(a) Z(t) dZ(t) = [Z(t1 ) − Z(t0 ) ]− Z(t)n−1 dt,
t0 n+1 2 t0
for any positive integer n,
(b) E[Z 4 (t)] = 3t2 .

5. Let Z(t), t ≥ 0, be the standard Brownian process, f(t) and g(t) are differentiable functions over [a, b].
Show that
"Z Z b #
b
′ ′
E f (t)[Z(t) − Z(a)] dt g (t)[Z(t) − Z(a)] dt
a a
Z b
= [f(b) − f(t)][g(b) − g(t)] dt.
a

Hint: Interchange the order of expectation and integration, and observe

E[[Z(t) − Z(a)][Z(s) − Z(a)]] = min(t, s) − a.

6. Show that
Z T
σ [Z(u) − Z(t)] du
t

has zero mean and variance σ 2 (T − t)3 /3.

Hint: Consider
Z !
T
var [Z(u) − Z(t)] du
t
"Z Z #
T T
=E [Z(u) − Z(t)][Z(v) − Z(t)] dudv
t t
Z T Z T
= E[{Z(u) − Z(t)}{Z(v) − Z(t)}] dudv
t t
Z T Z T
= [min(u, v) − t] dudv.
t t

7. Suppose the stochastic variables S1 and S2 follow the Geometric Brownian processes where

dSi
= µi dt + σi dZi , i = 1, 2.
Si
Let ρ12 denote the correlation coefficient between the Wiener processes dZ1 and dZ2 . Let f = S1 S2 ,
show that f also follows the Geometric Brownian process of the form

df
= µ dt + σ dZf
f

S1
where µ = µ1 + µ2 + ρ12 σ1 σ2 and σ 2 = σ12 + σ22 + 2ρ12 σ1 σ2 . Similarly, let g = , show that
S2
dg
=µ
e dt + σ
e dZg
g

2
 e = µ1 − µ2 − ρ12 σ1 σ2 + σ22 and σ
where µ e2 = σ12 + σ22 − 2ρ12 σ1 σ2 .
Hint : Note that  
1
d S2
1
= −µ2 dt + σ22 dt − σ2 deZ2 .
S2

Treat S1 /S2 as the product of S1 and 1/S2 and use the result obtained for the product of Geometric
Brownian processes.

8. Define the discrete random variable X by

(
2 if ω = ω1
X(ω) = 3 if ω = ω2 ,
4 if ω = ω3

where the sample space Ω = {ω1 , ω2 , ω3 }, P [ω1] = P [ω2 ] = P [ω3] = 1/3. Find a new probability measure
Pe such that the mean becomes EPe[X] = 3.5 while the variance remains unchanged. Is Pe unique?

9. Given that St is a Geometric Brownian motion which follows

dSt
= µ dt + σ dZt
St

where Zt is P -Brownian motion. Find another measure Pe by specifying the Radon-Nikodym derivative
dPe
such that St is governed by
dP
dSt et
= µ′ dt + σ dZ
St

under the measure Pe, where Z

et is Pe-Brownian motion and µ′ is the new drift rate.

10. Consider a forward contract on an underlying commodity, find the portfolio consisting of the underlying
commodity and bond (bond’s maturity coincides with forward’s maturity) that replicates the forward
contract. Show that the hedge ratio △ is always equal to one. Give the financial argument to justify
why the hedge ratio is one. Let B(t, T ) denote the price at current time t of the unit-par zero-coupon
bond maturing at time T and S denote the price of commodity at time t. Show that the forward price
F (S, τ ) is given by

F (S, τ ) = S/B(t, T ), τ = T − t.

11. Consider a portfolio containing ∆ units of asset and M dollars of riskless asset in the form of money
market account. The portfolio is dynamically adjusted so as to replicate an option. Let S and V (S, t)
denote the value of the underlying asset and the option, respectively. Let r denote the riskless interest
rate and Π denote the value of the self-financing replicating portfolio. When the self-financing trading
strategy is adopted, explain why

Π = ∆S + M and dΠ = ∆ dS + rM dt,

where r is the riskless interest rate. Here, the differential term S d∆ does not enter into dΠ. Assume
that the asset price dynamics follows the Geometric Brownian process:

dS
= ρ dt + σ dZ.
S
3
 Using the condition that the option value and the value of the replicating portfolio should match at all
times, show that the number of units of asset held must be given by

∂V
∆= .
∂S

How to proceed further in order to obtain the Black-Scholes equation for V ?

12. From the Black-Scholes price function c(S, τ ) for a European vanilla call on a non-dividend paying asset,
show that the limiting values of the call price at vanishing volatility and infinite volatility are the lower
and upper bounds of the European call price respectively, namely,

lim c(S, τ ) = max(S − Xe−rτ , 0),

σ→0+

and
lim c(S, τ ) = S.
σ→∞

Give the appropriate financial interpretation of the above results.

13. When a European option is currently out-of-the-money, show that a higher volatility of the asset price
or a longer time to expiry makes it more likely for the option to expire in-the-money. What would be
the impact on the value of delta? Do we have the same effect or opposite effect when the option is
currently in-the-money?

14. Show that when the European call price is a convex function of the asset price, the elasticity of the call
price is always greater than or equal to one. Give the financial argument to explain why the elasticity
of the price of a European option increases in absolute value when the option becomes more out-of-
the-money and closer to expiry. Can you think of a situation where the European put’s elasticity has
absolute value less than one, that is, the European put option is less riskier than the underlying asset?

15. Suppose the greeks of the value of a derivative security are defined by

∂f ∂ ∂2f
Θ= , △= , Γ= .
∂t ∂S ∂S 2

(a) Find the relation between Θ and Γ for a delta-neutral portfolio where △ = 0.
(b) Show that the theta may become positive for an in-the-money European call option on a continuous
dividend paying asset when the dividend yield is sufficiently high.
(c) Explain by financial argument why the theta value tends asymptotically to −rXe−rτ from below
when the asset value is sufficiently high.

16. Let Q∗ denote the equivalent martingale measure where the asset price St is used as the numeraire.
Suppose St follows the lognormal distribution with drift rate r and volatility σ under Q∗, where r is the
riskless interest rate. Show that

dQ∗ ST −rT σ2
= e = e− 2 +σZT ,
dQ S0

where Q is the martingale measure with the money market account as the numeraire and ZT is a
Brownian motion under Q. Using the Girsanov Theorem, show that

ZT∗ = ZT − σT

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is a Brownian motion under Q∗ . Explain why
   
σ2
ln SX0 + r + 2
T
EQ∗ [1{ST ≥X} ] = N  √ ,
σ T

then deduce that

   
σ2
ln SX0 + r + 2 T
EQ [ST 1{ST ≥X} ] = erT S0 N  √ .
σ T