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Problem Set 3/FIN4110: Stochastic Processes and Itô Calculus

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Yahia Ezzat
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8 views

Problem Set 3/FIN4110: Stochastic Processes and Itô Calculus

Uploaded by

Yahia Ezzat
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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Problem Set 3/FIN4110

Due: week 5
Options and Futures

CUHK(SZ)

Stochastic Processes and Itô Calculus


Problem 1. (☀☀) A stock price follows a geometric Brownian motion dSt = µSt dt + σSt dWt . Let Yt be
the nth power of St , i.e. Yt = Stn .
(a) What is the stochastic differential equation (SDE) followed by Yt ?
(b) Compute E (STn ) for given S0 .

Problem 2. (☀) Your cash position in millions of pounds, denoted by X, follows a Brownian motion with
drift 0.5 per quarter and variance 4.0 per quarter. That is, dXt = 0.5dt + 2dWt . Let X0 denote your
current cash position. What is the probability distribution of your cash position a year from now (let
the time unit be one quarter, one year from now on means t = 4)? How high does X0 have to be for you
to have a less than 5% chance of a negative cash position after 1 year? Write your answer in terms of
the standard normal cdf Φ, and then give a numerical answer using the norminv function in Excel/R.

Problem 3. (☀ ) If you know the BS formula for a call on a non-dividend paying underlying, it is easy to
write down the corresponding formula for a dividend-paying underlying or for a put. For a dividend-
paying underlying with dividend yield q, replace S with e−q(T −t) S. For a put, reverse all the 4 signs in
the call formula. Alternatively, use put-call parity: C = P + e−q(T −t) S − e−r(T −t) K.
Thus the BS formula for a put option on an underlying with dividend yield q is

P (S, t) = e−r(T −t) KΦ (−d2 ) − e−q(T −t) SΦ (−d1 )

where
log(S/K) + (r − q + σ 2 /2) (T − t) √
d1 = √ , d2 = d1 − σ T − t
σ T −t
(a) Entering a long straddle position involves buying a call and a put with the same strike price and
expiration date. Suppose the current price of the underlying is 50, its annual volatility is 22%, and
the riskfree rate is 5%. What is the cost of entering a straddle at strike price 50 and maturity 4
months?
(b) Entering a long butterfly position involves buying a call option with a low strike price, buying
another call option with a high strike price, and selling two call options with an intermediate strike
price. Suppose the current S&P500 index is at 1420, its annual volatility is 19%, its dividend yield
is 0.3%, and the riskfree rate is 5%. What is the cost of entering a butterfly at strike prices 1400,
1420 and 1440 and maturity 2 months?
(c) A bear put spread involves buying a put option at a given strike price and selling one at a lower
strike price. Suppose the dollar is currently at 0.51 ($1 = £0.51 ), its volatility is 15%, the UK
riskfree rate is 5.25%, the US riskfree rate is 5%. You are based in London. What is the cost of
entering a bear spread on the dollar with strike prices 0.51 and 0.41 and with a maturity of one
year?

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