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Financial Mathematics 1 Assignment 6

This document contains an assignment question involving probability theory. It defines partitions and filtrations of a sample space Ω. It then asks to calculate the expected value of a partition P(3) given the filtrations I0 and I2. It provides the calculations and shows that the expected values are equal. The second exercise defines a risk-neutral probability measure involving four outcomes and sets up equations to solve for the unique risk-neutral probability measure.

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21 views

Financial Mathematics 1 Assignment 6

This document contains an assignment question involving probability theory. It defines partitions and filtrations of a sample space Ω. It then asks to calculate the expected value of a partition P(3) given the filtrations I0 and I2. It provides the calculations and shows that the expected values are equal. The second exercise defines a risk-neutral probability measure involving four outcomes and sets up equations to solve for the unique risk-neutral probability measure.

Uploaded by

r l
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Financial mathematics 1 MA3407

RL Assignment 6 November 30, 2021

Exercise 6.1
a)

Partitions Filtration
P(0) = {Ω} I0 = {∅, Ω}
P(1) = {{ω1 , ω2 , ω3 , ω4 , ω5 }, {ω6 , ω7 }} I1 = {∅, Ω, {ω1 , ω2 , ω3 , ω4 , ω5 }, {ω6 , ω7 }}
P(2) = {{ω1 , ω2 }, {ω3 }, {ω4 , ω5 }, {ω6 , ω7 }} I2 = {∅, Ω, {ω1 , ω2 }, {ω3 }, {ω4 , ω5 }, {ω6 , ω7 },
{ω1 , ω2 , ω3 }, {ω1 , ω2 , ω4 , ω5 }, {ω1 , ω2 , ω6 , ω7 }, {ω3 , ω4 , ω5 },
{ω3 , ω6 , ω7 }, {ω4 , ω5 , ω6 , ω7 },
{ω1 , ω2 , ω3 , ω4 , ω5 }, {ω1 , ω2 , ω3 , ω6 , ω7 },
{ω1 , ω2 , ω4 , ω5 , ω6 , ω7 }, {ω3 , ω4 , ω5 , ω6 , ω7 }}

P(3) = {{ω1 }, {ω2 }, {ω3 }, {ω4 }, {ω5 }, {ω6 }, {ω7 }} I3 = 2Ω , i.e. the power set of Ω
Table 1: Partitions and the filtration

b)

Case E[P (3)|I0]:


E[P (3)|I0 ](ω) = E[P (3)|Ω] since every ω ∈ Ω and Ω is the only set in P0 , hence

P
ω∈Ω P (3, ω) · Q(ω)
E[P (3)|Ω] = = 5·0.15+4·0.05+3·0.2+2·0.05+0.25+0+6·0.1 = 2.5
Q(Ω)

Since E[P (3)|I0 ](ω) is the same for every ω, we must have that E[P (3)|I0 ] = 2.5.

Case E[P (3)|I2]:


In the following equations I make use of the same formula as previously and the fact that
all sets A in a partition are disjoint, meaning summing over sets A in the partition is only
non-negative in one case.
For ω1 and ω2 it holds that
5·0.15+4·0.05
E[P (3)|I2 ](ω) = E[P (3)|{ω1 , ω2 }] = 0.15+0.05
= 4.75
For ω3 it holds that
3·0.2
E[P (3)|I2 ](ω3 ) = E[P (3)|{ω3 }] = 0.2
=3
For ω4 and ω5 it holds that

1
Financial mathematics 1 MA3407
RL Assignment 6 November 30, 2021

2·0.05+1·0.25 7
E[P (3)|I2 ](ω) = E[P (3)|{ω4 , ω5 }] = 0.05+0.25
= 6
≈ 1.17
For ω6 and ω7 it holds that
0·0.2+6·0.1
E[P (3)|I2 ](ω) = E[P (3)|{ω6 , ω7 }] = 0.3
=2

c)
In the case of ω1 and ω2 , which happens with probability 0.2, E[P (3)|I2 ] = 4.75.
In the case of ω3 , which happens with probability 0.2, E[P (3)|I2 ] = 3.
In the case of ω4 , ω5 , which happens with probability 0.3, E[P (3)|I2 ] = 67 .
In the case of ω6 , ω7 , which happens with probability 0.3, E[P (3)|I2 ] = 2.

Then, E[E[P (3)|I2 ]] is the weighted sum of all these possible outcomes which equals 0.95 +
0.6 + 0.35 + 0.6 = 2.5. To prove the equality E[P (3)] = 5 · 0.15 + 4 · 0.05 + 3 · 0.2 + 2 · 0.05 +
0.25 + 0 + 6 · 0.1 = 2.5. Hence, E[E[P (3)|I2 ]] = E[P (3)]

Exercise 6.2
Let K = 2, T = 2, P0 (t) = (11/10)t for t = {0, 1, 2} and the definition of risk-neutral
probability measure




 (i) Q̃ > 0      

P0 (t) (11/10)t 11 −s
(ii) P1 (t) = EQ̃ P0 (t+s) · P1 (t + s)|It = EQ̃ (11/10)(t+s) · P1 (t + s)|It = ( 10 ) · EQ̃ P1 (t + s)|It



 for all t= 0,...T, s = 0,...,T-t
(1)

Condition (ii) allows us to set up the following equations.


   
11
t=0 s=1 (I) ( 10 ) = 2 · Q̃(ω1 ) + Q̃(ω2 ) + 1/2 · Q̃(ω3 ) + Q̃(ω4 )

s=2 (II) ( 11
10
)2 = 5/2· Q̃(ω1 )+3/2· Q̃(ω2 )+ Q̃(ω3 )+1/4· Q̃(ω4 )
5/2·Q̃(ω1 )+3/2·Q̃(ω2 )
t=1 s = 1 (A = {ω1 , ω2 }) (III) 2 · ( 11
10
)= Q̃(ω1 )+Q̃(ω2 )
1 11 Q̃(ω3 )+1/4·Q̃(ω4 )
t=1 s = 1 (A = {ω3 , ω4 }) (IV ) 2
· ( 10 )= Q̃(ω3 )+Q̃(ω4 )

trivially (V ) Q̃(ω1 ) + Q̃(ω2 + Q̃(ω3 ) + Q̃(ω4 ) = 1

2
Financial mathematics 1 MA3407
RL Assignment 6 November 30, 2021

2
Using (I) and (V) we get Q̃(ω2 ) = 5
− Q̃(ω1 ). Substituting into (III) leads to

(5/2)Q̃(ω1 ) + (6/10) − (3/2) · Q̃(ω1 ) 22 44 7


= ⇐⇒ Q̃(ω1 ) + 6/10 = ⇐⇒ Q̃(ω1 ) =
2/5 10 50 25

Hence,

7 3
Q̃(ω2 ) = 2/5 − =
25 25

Using substitution in (V) again we have

3 3
Q̃(ω3 ) + Q̃(ω4 ) = ⇐⇒ Q̃(ω4 ) = − Q̃(ω3 )
5 5
.
Now we use (IV) and obtain

(3/4)Q̃(ω3 ) + (3/20) 11 6
= ⇐⇒ Q̃(ω3 ) =
(3/5) 20 25

Then,

15 6 9
Q̃(ω4 ) = − =
25 25 25

The set of all risk-neutral probability measures contains one unique element and equals
7 3 6 9
M = {( 25 , 25 , 25 , 25 )}

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