1.

Consider the process

d (log y) = ( log y) dt + dXt :
The parameters ; ; are constant. Use Its lemma to show that y satises
dy 1 2
= log y + dt + dXt :
y 2

2 By considering the function S (X) = A + 1 Xt ; where A and are constants use Its lemma to
show that S (X) satises
dS = 13 S 1=3 dt + S 2=3 dX;
and determine the value of :
3 A spot rate r, evolves according to the popular form

dr = u (r) dt + r dXt ; (I)

where and are constants.

Suppose such a model has a steady state transition probability density function p1 (r) that
satises the forward Fokker Planck Equation.
Show that this implies that the drift structure of (I) is given by

2 1 d
u (r) = r2 1
+ 2 2
r (log p1 ) :
2 dr
Explain how you obtain any constant of integration.

1
 4 Consider the following Stochastic Dierential Equation for the volatility process ;

d = a( ; t)dt + b( ; t)dXt :

The drift and diusion will be abbreviated to a and b respectively. The Forward Kolmogorov Equation,
for the steady state transition pdf p1 = p( 0 ) is

1 d2 2 d
(b p1 ) (ap1 ) = 0;
2 d 02 d 0
where the primed variable refers to a future state. Solve this equation to derive the steady state solution
given by Z
0 C 2a 0
p1 ( ) = 2 exp b2 d ;
b
where C is a constant. Any conditions used should be stated.

5. The Ornstein-Uhlenbeck process is given by

dUt = Ut dt + dXt ; U0 = u;

where ; are constants. Starting with the solution for Ut derived in class, obtain E [Ut ] and V [Ut ] in
its simplest form: NB you are not required to redo the working for Ut :
6 The Black-Scholes partial dierential equation is given by

@V 1 2 @2V @V
+ S2 2
+ rS rV = 0;
@t 2 @S @S
for the function V (S; t) : and r are constants. Look for separable solutions of the form V (S; t) =
(S) (t) by following the set of instructions:

(i) By substituting V (S; t) = (S) (t) into the given PDE show that
1 2
0
2 S2 00
rS 0
+r
=

(ii) Set both sides equal to a constant and solve the resulting dierential rst order ODE and Euler
dierential equation respectively
0
=
1 2 2 00 0
S + rS +( r) = 0:
2
For the Euler equation you are only required to consider roots of the Auxiliary equation when
b2 > 4ac (two real distinct roots) and b2 = 4ac (real two-fold root):
(iii) Hence show that the two solutions of the PDE are
1 r
V (S; t) = e t S 2 2
AS d+ + BS d
!
2 2
r 1 1 r
V (S; t) = exp 2
+ t S2 2
(C + D log S)
2 2
where A; B; C; D are constants and
s
2
r 1 2
d = 2
+ 2
2