Introduction to Stochastic Finance with

Market Examples, Second Edition

Nicolas Privault

Solutions Manual

Chapter 1

Exercise 1.1 The payoff C is that of a put option, whose strike price K = $3
can be determined by trial and error.

Exercise 1.2 Each of the two possible scenarios yields one equation:

 5α + β = 0  α = −2
 

with solution
2α + β = 6, β = +10.
 

The hedging strategy at t = 0 is to shortsell −α = +2 units of the asset

S priced S0 = 4, and to put β = $10 on the savings account. The price
V0 = αS0 + β of the initial portfolio at time t = 0 is

V0 = αS0 + β = −2 × 4 + 10 = $2,

which yields the price of the claim at time t = 0. In order to hedge then
option, one should:
i) At time t = 0,
a. Charge the $2 option price.
b. Shortsell −α = +2 units of the stock priced S0 = 4, which yields $8.
c. Put β = $8 + $2 = $10 on the savings account.
ii) At time t = 1,
a. If S1 = $5, spend $10 from savings to buy back −α = +2 stocks.
b. If S1 = $2, spend $4 from savings to buy back −α = +2 stocks, and
deliver a $10 - $4 = $6 payoff.
Pricing the option by the expected value IE∗ [C] yields the equality

$2 = IE∗ [C]
= 0 × P∗ (C = 0) + 6 × P∗ (C = 6)
= 0 × P∗ (S1 = 2) + 6 × P∗ (S1 = 5)
= 6 × q∗ ,

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 Solutions Manual

hence the risk-neutral probability measure P∗ is given by

2 1
p∗ = P∗ (S1 = 5) = and q ∗ = P∗ (S1 = 2) = .
3 3

Exercise 1.3
a) Each of the stated conditions yields one equation, i.e.

 4α + β = 1 α = 2
 

with solution
5α + β = 3, β = −7.
 

Therefore, the portfolio allocation at t = 0 consists to purchase α = 2

unit of the asset S priced S0 = 4, and to borrow −β = $7 in cash.

We can check that the price V0 = αS0 + β of the initial portfolio at

time t = 0 is
V0 = αS0 + β = 2 × 4 − 7 = $1.
b) This loss is expressed as

α × $2 + β = 2 × 2 − 7 = −$3.

Note that the $1 received when selling the option is not counted here be-
cause it has already been fully invested into the portfolio.

Exercise 1.4
a) i) Does this model allow for arbitrage? Yes | ✓ No |

ii) If this model allows for arbitrage opportunities, how can they be real-
ized? By shortselling | By borrowing on savings | ✓ N.A. |

b) i) Does this model allow for arbitrage? Yes | No | ✓

ii) If this model allows for arbitrage opportunities, how can they be real-
ized? By shortselling | By borrowing on savings | N.A. | ✓

c) i) Does this model allow for arbitrage? Yes | ✓ No |

ii) If this model allows for arbitrage opportunities, how can they be real-
ized? By shortselling | ✓ By borrowing on savings | N.A. |

Exercise 1.5

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Introduction to Stochastic Finance with Market Examples, Second Edition

a) We need to search for possible risk-neutral probability measure(s) P∗ such

 (1)  (1)
that IE∗ S1 = (1 + r)S0 . Letting
 !
(1) (1)
(1) (1) S1 − S0
∗
= ∗
= (1 + = ∗
=


p S S a) a ,


 P 1 0 P (1)
S0







 !
 (1) (1)

(1) (1) S1 − S0
θ∗ = P∗ S1 = S0 (1 + b) = P∗ =


(1)
b ,


 S0



 !
 (1) (1)
 q ∗ = P∗ S (1) = (1 + c)S (1) = P∗ S1 − S0 = c ,




 1 0 (1)
S0


We have

 (1 + a)p∗ S0(1) + (1 + b)θ∗ S0(1) + (1 + c)q ∗ S0(1) = (1 + r)S0(1)



p∗ + θ∗ + q ∗ = 1,


from which we obtain

(1 − θ∗ )c + θ∗ b − r

p = ∈ (0, 1),
∗
 p a + θ∗ b + q ∗ c = r,
 ∗ 

c−a

=⇒
 q ∗ = r − (1 − θ )a − θ b ∈ (0, 1).
∗ ∗
p∗ + θ∗ + q ∗ = 1.
 


c−a
In order for p∗ and q ∗ to belong to the interval (0, 1), we should have

 0 < (1 − θ∗ )c + θ∗ b − r < c − a,


0 < r − (1 − θ∗ )a − θ∗ b < c − a,


i.e. r−c r−a

 < θ∗ < ,
b−c b−c



 r − c < θ∗ < r − a .


b−a b−a
Therefore, there exists an infinity of risk-neutral probability measures de-
pending on the value of
    
r−c r−c r−a r−a
θ∗ ∈ max , , min , ,
b−c b−a b−c b−a

in which case the market is without arbitrage but not complete. This is
the case when a < r < c.

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 Solutions Manual

b) Hedging a claim with possible payoff values Ca , Cb , Cc would require to

solve 
(1) (1) (0) (0)
 (1 + a)ξ S0 + (1 + r)ξ S0 = Ca





(1) (0)
(1 + b)ξ (1) S0 + (1 + r)ξ (0) S0 = Cb




(1) (0)
(1 + c)ξ (1) S0 + (1 + r)ξ (0) S0 = Cc ,



for ξ (0) and ξ (1) , which is not possible in general due to the existence of
three conditions with only two unknowns.

Exercise 1.6
a) The risk-neutral condition IE∗ [R1 ] = 0 reads

bP∗ (R1 = b) + 0 × P∗ (R1 = 0) + (−b) × (R1 = −b) = bp∗ − bq ∗ = 0,

hence
1 − θ∗
p∗ = q ∗ = ,
2
since p∗ + q ∗ + θ∗ = 1.
b) We have
" #
(1) (1)
S1 − S0
Var∗ = IE∗ R12 − (IE∗ [R1 ])2
 
(1)
S0
= IE∗ R12
 

= b2 P∗ (R1 = b) + 02 × P∗ (R1 = 0) + (−b)2 × (R1 = −b)

= b2 (p∗ + q ∗ )
= b2 (1 − θ∗ )
= σ2 ,

hence θ∗ = 1 − σ 2 /b2 , and therefore

1 − θ∗ σ2
p∗ = q ∗ = = 2,
2 2b
provided that σ 2 ≤ b2 .

Exercise 1.7
a) We denote the risk-neutral measure by p∗ = P∗ (S1 = 2), q ∗ = P∗ (S1 = 1).

i) Yes | No | ✓ Comment: No loss is possible, while a 100%

profit is possible with non-zero probability 1/3.

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Introduction to Stochastic Finance with Market Examples, Second Edition

ii) Yes | No | ✓ Comment: The (unique) risk-neutral measure

(p , q ) = (0, 1) is given by
∗ ∗

$2 × p∗ + $1 × q ∗ = $1 × (1 + r) = $1 and p∗ + q ∗ = 1,

and is not equivalent to P given by (p, q) = (1/3, 2/3).

b) We denote the risk-neutral measure by p∗ = P∗ (S1 = 2), θ∗ = P∗ (S1 = 1),
q ∗ = P∗ (S1 = 0).

i) Yes | ✓ No | Comment: The risk-neutral measure (p∗ , θ∗ , q ∗ )

is given by the equations

$2 × p∗ + $1 × θ∗ + $0 × q ∗ = $1 × (1 + r) = $1 and p∗ + θ∗ + q ∗ = 1,
(S.1.1)
which clearly admit solutions, see (biv) below.

ii) Yes | ✓ No | Comment: Realizing arbitrage would mean

building a portfolio achieving no strictly negative return with prob-
ability one, which is impossible since the probability of 100% loss is
P(S1 = 0) = 1 − 1/4 − 1/9 = 23/36 > 0.

iii) Yes | No | ✓ Comment: Examples of claims that cannot be

attained can be easily constructed in this market. For example, the
claim 1{S1 >0} cannot be attained since there is no portfolio allocation
(α, β) satisfying 
$2 × α + β = $1

$1 × α + β = $1
$0 × α + β = $0.



iv) Yes | No | ✓ Comment: The risk-neutral measure is clearly

not unique, as for example

(p∗ , θ∗ , q ∗ ) = (1/4, 1/2, 1/4) and (p∗ , θ∗ , q ∗ ) = (1/3, 1/3, 1/3)

are both solutions of (S.1.1).

Exercise 1.8
a) The possible values of R are a and b.
b) We have

IE∗ [R] = aP∗ (R = a) + bP∗ (R = b)

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 Solutions Manual

b−r r−a
=a +b
b−a b−a
= r.

c) By Theorem 1.6, there do not exist arbitrage opportunities in this market

since from Question (b) there exists a risk-neutral probability measure P∗
whenever a < r < b.
d) The risk-neutral probability measure is unique hence the market model is
complete by Theorem 1.13.
e) Taking
α(1 + b) − β(1 + a) β−α
η= and ξ = ,
π1 (b − a) S0 (b − a)
we check that
 ηπ1 + ξS0 (1 + a) = α if R = a,


ηπ1 + ξS0 (1 + b) = β if R = b,


which shows that

ηπ1 + ξS1 = C
in both cases R = a and R = b.
f) We have

π0 (C) = ηπ0 + ξS0

α(1 + b) − β(1 + a) β − α
= +
(1 + r)(b − a) b−a
α(1 + b) − β(1 + a) − (1 + r)(α − β)
=
(1 + r)(b − a)
αb − βa − r(α − β)
= . (S.1.2)
(1 + r)(b − a)

g) We have

IE∗ [C] = αP∗ (R = a) + βP∗ (R = b)

b−r r−a
=α +β . (S.1.3)
b−a b−a
h) Comparing (S.1.2) and (S.1.3) above, we do obtain
1
π0 (C) = IE∗ [C]
1+r
i) The initial value π0 (C) of the portfolio is interpreted as the arbitrage-
free price of the option contract and it equals the expected value of the
discounted payoff.
j) We have

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Introduction to Stochastic Finance with Market Examples, Second Edition

 11 − S1 if K > S1 ,


C = (K − S1 ) = (11 − S1 ) =
+ +

0 if K ≤ S1 .


k) We have S0 = 1, a = 8, b = 11, α = 2, β = 0, hence

β−α 0−2 2
ξ= = =− ,
S0 (b − a) 11 − 8 3

and
α(1 + b) − β(1 + a) 24
η= = .
π1 (b − a) 3 × 1.05
l) The arbitrage-free price π0 (C) of the contingent claim with payoff C is

π0 (C) = ηπ0 + ξS0 = 6.952.

Exercise 1.9 Letting R denote the price of one right, it will require 10R/3 to
purchase one stock at €6.35, hence absence of arbitrage tells us that
10
R + 6.35 = 8,
3
from which it follows that
3
R= (8 − 6.35) = €0.495.
10
Note that the actual share right was quoted at €0.465 according to market
data. See also Exercise 17.8 for the pricing of convertible bonds.

Exercise 1.10 Let a := (152 − 180)/180 = −7/45 and b := (203 − 180)/180 =

23/180 denote the potential market returns, with r = 0.03. From the strike
price K and the risk-neutral probabilities
r−a b−r
p∗r = = 0.6549 and qr∗ = = 0.3451,
b−a b−a
the price of the option at the beginning of the year is given from Proposi-
tion 1.16 as the discounted expected value
1 1
IE∗ [(K − S1 )+ ] = p∗ (K − 203)+ + qr∗ (K − 152)+ .


1+r 1+r r
Equating this price with the intrinsic value (K − 180)+ of the put option
yields the equation
1
(K − 180)+ = p∗ (K − 203)+ + qr∗ (K − 152)+


1+r r

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 Solutions Manual

which requires K > 180 (the case K ≤ 152 is not considered because both
the option price and option payoff vanish in this case). Hence we consider the
equation
1
K − 180 = p∗ (K − 203)+ + qr∗ (K − 152)+ ,


1+r r
with the following cases.
i) If K ∈ [180, 203] we get

(1 + r)(K − 180) = qr∗ (K − 152),

hence
(1 + r)180 − qr∗ 152 (1 + r)180 − qr∗ 152
K= = = 194.11.
1 + r − qr∗ p∗r + r

ii) If K ≥ 203 we find

180(1 + r) − 203p∗r − 152qr∗

K= < 203,
r
which is out of range and leads to a contradiction.
We note that the above formula
(1 + r)180 − qr∗ 152 28b − 180a + r(180(b − a) + 152)
K= =
p∗r + r (b + 1 − a)r − a

yields a decreasing function K(r) of r in the interval [0, 100%], although the
function is not monotone over R+ .

150

140

130

120

110
K(r)

100

90

80

70

60
0 0.5 1 1.5 2
r

Fig. S.1: Strike price as a function of risk-free rate r.

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Introduction to Stochastic Finance with Market Examples, Second Edition

Chapter 2

Exercise 2.1 Let m := $2, 550 denote the amount invested each year.
a) By (2.1), the value of the plan after N = 10 years becomes
N
X (1 + r)N − 1
m (1 + r)k = m(1 + r) ,
r
k=1

which in turns becomes

N
X (1 + r)N − 1
(1 + r)N m (1 + r)k = m(1 + r)N +1 ,
r
k=1

after N additional years without further contributions to the plan. Equat-

ing
(1 + r)N − 1
A = 30835 = m(1 + r)N +1
r
shows that
(1 + r)2N +1 − (1 + r)N +1 A
= ,
r m
with m = 2550, or

(1 + r)21 − (1 + r)11 30835

= ≃ 12.09215,
r 2550
hence r ≃ 1.23% according to Figure S.2, which is typical of an annual
fixed deposit interest rate.

14

13.5

13

12.5

12

11.5

11

10.5

10
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2
r in %

Fig. S.2: Graph of r 7−→ ((1 + r)21 − (1 + r)11 )/r.

In the hypothesis r = 3.25% we would find

(1 + r)N − 1
A = m(1 + r)N +1 = 42040.42.
r

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 Solutions Manual

b) Taking N = 10, m = 2, 550 and r = 0.0325, we find

N
X
A2N : = m(1 + r)N (1 + r)N −k+1
k=1
N
X
= m(1 + r) N
(1 + r)k
k=1
(1 + r)N − 1
= m(1 + r)N +1
r
= $42, 040.42.

c) In this case, with N = 10, m = 2, 550 and r = 0.0325, we find

N
X (1 + r)N − 1
A2N = AN = m (1 + r)N −k+1 = m(1 + r) = $30, 532.79.
r
k=1

Exercise 2.2
a) Let m := $3, 581 denote the amount invested each year. After multiplying
(2.1) by (1 + r)N in order to account for the compounded interest from
year 11 until year 20, we get the equality

(1 + r)N − 1
A = m(1 + r)N +1
r
shows that
50862
(1 + r)21 − (1 + r)11 = r ≃ 14.2033r,
3581
showing that r ≃ 2.28% according to Figure S.3.

16

15.5

15

14.5

14

13.5

13

12.5

12

11.5
1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3
r in %

Fig. S.3: Graph of r 7−→ ((1 + r)21 − (1 + r)11 )/r.

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Introduction to Stochastic Finance with Market Examples, Second Edition

b) Taking N = 10, m = 3, 581 and r = 0.0325, we find

N
X
A2N : = m(1 + r)N (1 + r)N −k+1
k=1
N
X
= m(1 + r) N
(1 + r)k
k=1
(1 + r)N − 1
= m(1 + r)N +1
r
= $59, 037.94.

c) In this case, we find

N
X (1 + r)N − 1
A2N = m (1 + r)N −k+1 = m(1 + r) = $42, 877.61.
r
k=1

Exercise 2.3
a) We find m = $10, 000.
b) Denoting by Ak the amount owed by the borrower at the beginning of
year no k = 1, 2, . . . , N , the amount A1 = A can be decomposed at the
beginning of the first year as

A1 = m + (A1 − m),

where A1 − m is subject to interests at the rate r = 2% i.e. at the end

of the first year there remains A2 = (A1 − m)(1 + r) to be refunded.
Similarly, the amount A2 due at the beginning of the second year can be
decomposed as A2 = m − (A2 − m), i.e. at the end of the second year
there remains

(A2 − m)(1 + r) = ((A1 − m)(1 + r) − m)(1 + r)

= A1 (1 + r)2 − m(1 + r)2 − m(1 + r)

to be refunded. After repeating the argument, we find that at the end of

year k there remains
k
X 1 − (1 + r)k
(1 + r)k A1 − m (1 + r)l = (1 + r)k A1 − m(1 + r)
1 − (1 + r)
l=1
1 − (1 + r)k
= (1 + r)k A1 + m(1 + r)
r
to be refunded. At the end of year N , the loan will be completely repaid
if hence AN = 0, which reads

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 Solutions Manual

1 − (1 + r)N
(1 + r)N −1 A + m = 0,
r
and yields

(1 + r)N −1 rA rA
m= = .
(1 + r)N − 1 (1 + r)(1 − (1 + r)−N )

Taking N = 10, A = 100, 000 and r = 0.02, we find

rA 0.02 × 100, 000
m= = = $10, 914.36.
(1 + r)(1 − (1 + r)−N ) 1.02 × (1 − 1.02−10 )

c) In this case, amount remaining on the account at the end of the first
year is (A − m)(1 + r), and at the end of the second year it becomes
((A − m)(1 + r) − m)(1 + r). After repeating the argument, we find that
at the end of year k there remains
k−1
!
X (1 + r)k − 1
(1 + r)k−1 A − m (1 + r)l (1 + r) = (1 + r)k A − m(1 + r)
r
l=0

on the account. Therefore, what is left at the end of year N is

(1 + r)N − 1
(1 + r)N A − m(1 + r) .
r
Taking N = 10, A = 100, 000 and r = 0.02, we find

1.0210 − 1
1.0210 × 100, 000 − 10, 000 × 1.02 × = $10, 212.29.
0.02

Exercise 2.4
a) By (2.1), the the discounted value of the loan after N months is
N −1
X 1 − (1 + r)N 1 − (1 + r)−N
m(1 + r)−N (1 + r)k = m(1 + r)−N =m ,
1 − (1 + r) r
k=0

which should match A = $3, 000 with m = $275 and N = 12, hence as in
Proposition 2.1 we have

1 − (1 + r)−12 A
= = 10.909090909,
r m
see Equation (2.2), hence

r ≃ 1.49767% per month.

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Introduction to Stochastic Finance with Market Examples, Second Edition

b) The yearly interest rate is given by

(1 + r)N − 1 = (1 + r)12 − 1 = 1.014976712 − 1 ≃ 19.529% per year.

Remark: Computing the interest rate as

12 × $275
− 1 = 0.1 = 10%
$3000
is not correct because this implicitly means that the 12 × $275 = $3, 300
are repaid as one lump sum at the end of the 12th month, which is not
the case.
c) The analysis of replies to Question (c) shows that “All of the above” was
the most popular answer, followed by “Block”.

Fig. S.4: Histogram of replies to Question c).

Exercise 2.5 We check that for any P∗ of the form

P∗ (Rt = −1) := p∗ , P∗ (Rt = 0) := 1 − 2p∗ , P∗ (Rt = 1) := p∗ ,

we have
IE∗ [S1 ] = S0 (2p∗ + 1 − 2p∗ ) = S0 ,
and similarly
IE∗ [S2 | S1 ] = S1 (2p∗ + (1 − 2p∗ )) = S1 ,
hence the probability measure P∗ is risk-neutral.

Exercise 2.6
a) In order to check for arbitrage opportunities we look for a risk-neutral
probability measure P∗ which should satisfy

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 Solutions Manual

 (1) (1)
IE∗ Sk+1 | Fk = (1 + r)Sk , k = 0, 1, . . . , N − 1,


 (1)
with r = 0. Rewriting IE∗ Sk+1 | Fk as


 (1)
IE∗ Sk+1 | Fk


(1) (1)
= (1 − b)Sk P∗ (Rk+1 = −b | Fk ) + Sk P∗ (Rk+1 = 0 | Fk )
(1)
+ (1 + b)Sk P∗ (Rk+1 = b | Fk )
(1) (1) (1)
= (1 − b)Sk P∗ (Rk+1 = −b) + Sk P∗ (Rk+1 = 0) + (1 + b)Sk P∗ (Rk+1 = b),

k = 0, 1, . . . , N − 1, it follows that any risk-neutral probability measure

P∗ should satisfy the equations

 (1 + b)Sk(1) P∗ (Rk+1 = b) + Sk(1) P∗ (Rk+1 = 0) + (1 − b)Sk(1) P∗ (Rk+1 = −b) = Sk(1)



P∗ (Rk+1 = b) + P∗ (Rk+1 = 0) + P∗ (Rk+1 = −b) = 1,



k = 0, 1, . . . , N − 1, i.e.

 bP (Rk = b) − bP∗ (Rk = −b) = 0,

 ∗

P∗ (Rk = b) + P∗ (Rk = −b) = 1 − P∗ (Rk = 0),



k = 1, 2, . . . , N , with solution
1 − θ∗
P∗ (Rk = b) = P∗ (Rk = −b) = ,
2
k = 1, 2, . . . , N .
b) We have
" (1) (1)
#
Sk+1 − Sk 1  (1) (1)
IE∗ = (1) IE∗ Sk+1 − Sk | Fk

(1)
Fk
Sk Sk
1  (1)  (1)
= (1) IE∗ Sk+1 | Fk − IE∗ Sk | Fk
 

Sk
1  (1) (1)

= (1) IE∗ Sk+1 | Fk − Sk

Sk
= 0,

and
(1) (1)
" #
∗ Sk+1 − Sk
Var (1)
Fk
Sk

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
(1) (1)
!2  " (1) (1)
#!2
∗ Sk+1 − Sk Sk+1 − Sk
= IE  (1)
Fk  − IE∗ (1)
Fk
Sk Sk

(1) (1)
!2 
Sk+1 − Sk
= IE∗  (1)
Fk 
Sk
= b2 P∗σ (Rk+1 = −b | Fk ) + b2 P∗σ (Rk+1 = b | Fk )
1 − P∗σ (Rk+1 = 0) 1 − P∗σ (Rk+1 = 0)
= b2 + b2
2 2
= b2 (1 − θ∗ )
= σ2 ,

k = 0, 1, . . . , N − 1, hence

σ2
P∗σ (Rk = 0) = θ∗ = 1 − ,
b2
and therefore
1 − P∗σ (Rk = 0) σ2
P∗σ (Rk = b) = P∗σ (Rk = −b) = = 2,
2 2b
k = 0, 1, . . . , N − 1, under the condition 0 < σ 2 < b2 .

Exercise 2.7
a) The possible values of Rt are a and b.
b) We have

IE∗ [Rt+1 | Ft ] = aP∗ (Rt+1 = a | Ft ) + bP∗ (Rt+1 = b | Ft )

b−r r−a
=a +b = r.
b−a b−a
c) Letting p∗ = (r − a)/(b − a) and q ∗ = (b − r)/(b − a) we have
k  
X k
IE∗ [St+k | Ft ] = (p∗ )i (q ∗ )k−i (1 + b)i (1 + a)k−i St
i=0
i
k  
X k i k−i
= St (p∗ (1 + b)) (q ∗ (1 + a))
i=0
i
k
= St (p∗ (1 + b) + q ∗ (1 + a))
 k
r−a b−r
= St (1 + b) + (1 + a)
b−a b−a
= (1 + r)k St .

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Assuming that the formula holds for k = 1, its extension to k ≥ 2 can also
be proved recursively from the tower property of conditional expectations,
as follows:

IE∗ [St+k | Ft ] = IE∗ [IE∗ [St+k | Ft+k−1 ] | Ft ]

= (1 + r) IE∗ [St+k−1 | Ft ]
= (1 + r) IE∗ [IE∗ [St+k−1 | Ft+k−2 ] | Ft ]
= (1 + r)2 IE∗ [St+k−2 | Ft ]
= (1 + r)2 IE∗ [IE∗ [St+k−2 | Ft+k−3 ] | Ft ]
= (1 + r)3 IE∗ [St+k−3 | Ft ]
= ···
= (1 + r)k−2 IE∗ [St+2 | Ft ]
= (1 + r)k−2 IE∗ [IE∗ [St+2 | Ft+1 ] | Ft ]
= (1 + r)k−1 IE∗ [St+1 | Ft ]
= (1 + r)k St .

Exercise 2.8
a) We check that

IE∗ [Rt+1 | Ft ] = aP∗ (Rt+1 = a | Ft ) + bP∗ (Rt+1 = b | Ft )

b−r r−a
=a +b = r.
b−a b−a
b) We have
1
IE∗ Set+1 Ft = E∗ [St+1 | Ft ]
 
A0 (1 + r)t+1
1
= (1 + a)St P∗ (Rt+1 = a | Ft ) + (1 + b)St P∗ (Rt+1 = b | Ft )


A0 (1 + r)t+1
1
 
b−r r−a
= (1 + a)St + (1 + b)St
A0 (1 + r)t+1 b−a b−a
b − a + (b − a)r
= St
e
(1 + r)(b − a)
= Set , t = 0, 1, . . . , N − 1.

c) We have

N
!β 
Y
∗ ∗
IE (SN ) = S0 IE
β
(1 + Rk ) 
 

k=1

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" N
#
Y
∗
= S0 IE (1 + Rk ) β

k=1
N
Y
= S0 IE∗ (1 + Rk )β ,
 

k=1

after using the independence of the returns (Rk )k=1,2,...,N , with

b−r r−a
IE∗ (1 + Rk )β = (1 + a)β + (1 + b)β k = 0, 1, . . . , N,
 
,
b−a b−a
hence we find
 N
b−r r−a
IE∗ (SN )β = S0β (1 + a)β + (1 + b)β
 
.
b−a b−a

d) We have
 
St
P∗ St ≥ αAt for some t ∈ {0, 1, . . . , N } = P∗ max


≥α
t=0,1,...,n At

IE (MN )
 β

≤
αβ
 β  N
S0 b−r r−a
= (1 + a)β + (1 + b)β ,
(1 + r) αA0
N b−a b−a

since the discounted price process

 
St
(Mt )t=0,1,...,N :=
At t=0,1,...,N

is a nonnegative martingale by part (b).

e) Since (Mt )t=0,1,...,N is a nonnegative martingale, we have

IE[St+1 | Ft ] = IE[Mt+1 At+1 | Ft ]

= At+1 IE[Mt+1 | Ft ]
= At+1 Mt
≥ At M t
= St , t = 0, 1, . . . , N − 1,

because r ≥ 0, hence (St )t=0,1,...,N is a nonnegative submartingale. There-

fore, we have
  IE (M )β 
N
P∗ max St ≥ x ≤
t=0,1,...,n xβ

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 β  N
S0 b−r r−a
≤ (1 + a)β + (1 + b)β .
x b−a b−a

Chapter 3

Exercise 3.1 (Exercise 2.5 continued). We consider the following trinomial

tree.
S2 = 4, C = 0
p∗
1 − 2p∗
S1 = 2 S2 = 2, C = 0

p∗
∗
S2 = 0, C = 1
p
S2 = 2, C = 0
p∗
1 − 2p∗ 1 − 2p∗
S0 = 1 S1 = 1 S2 = 1, C = 0

p∗
S2 = 0, C = 1
p∗
S2 = 0, C = 1
p∗
1 − 2p∗
S1 = 0 S2 = 0, C = 1

p∗
S2 = 0, C = 1

At time t = 0, we find
1
π0 (C) = IE∗ [(K − S2 )+ ]
(1 + r)2
= p∗ (p∗ + (1 − 2p∗ ) + p∗ ) + (1 − 2p∗ )p∗ + (p∗ )2
= p∗ + (1 − 2p∗ )p∗ + (p∗ )2
= 2p∗ − (p∗ )2 .

At time t = 1, we find
1
π1 (C) = IE∗ [(K − S2 )+ | S1 ]
1 +
 ∗r
p
 if S1 = 2S0 ,



= p∗ if S1 = S0 ,



1 if S1 = 0.



Exercise 3.2 We have p∗ = (r−a)/(b−a) = 1/2 and q ∗ = (b−r)/(b−a) = 1/2,

and the following underlying asset price tree:

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Introduction to Stochastic Finance with Market Examples, Second Edition

S2 = 4, C = 3
p∗
S1 = 2
p∗
q∗
S0 = 1 S2 = 2, C = 1
p∗
q∗
S1 = 1
q∗
S2 = 1, C = 3.

We first price, and then hedge. At time t = 1, by Theorem 3.5 we have

3p + q ∗ 4
 ∗
 1 + r = 3 if S1 = 2


4 p∗ + q ∗ 8

π1 (C) = V1 = and π0 (C) = V0 = = .
 p + 3q
∗ ∗
4 3 1 + r 9
= if S1 = 1,


1+r 3


This leads to the following option pricing tree:

S2 = 4, V2 = 3
p∗
V1 = 4/3
∗
S1 = 2
p
q∗
V0 = 8/9
S2 = 2 V2 = 1
S0 = 1
p∗
q∗
V1 = 4/3
S1 = 1
q∗
S2 = 1 V2 = 3.

Regarding hedging, if S1 = 2 the condition ξ 2 · S 2 = ξ2 S2 + η2 A2 = V2 reads

 4ξ2 + η2 (1 + r)2 = 3


S1 = 2 =⇒
2ξ2 + η2 (1 + r)2 = 1,


hence (ξ2 , η2 ) = (1, −4/9). On the other hand, if S1 = 1 we have

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 2ξ2 + η2 (1 + r)2 = 1


S1 = 1 =⇒
ξ2 + η2 (1 + r)2 = 3,


hence (ξ2 , η2 ) = (−2, 20/9). Finally, at time t = 0 with S0 = 1 the condition

ξ 1 · S 1 = ξ1 S1 + η1 A1 = V1 yields
 4
 2ξ1 + η1 (1 + r) = 3



 ξ + η (1 + r) = 4 ,


1 1
3
hence (ξ1 , η1 ) = (0, 8/9). The results can be summarized in the following
table:

S1 = 2, V1 = 4/3 S2 =4
S0 = 1 ξ2 = 1, η2 = −4/9 V2 =3
V0 = 8/9 S2 =1
ξ1 = 0 V2 =3
η1 = 8/9 S1 = 1, V1 = 4/3 S2 =1
ξ2 = −2, η2 = 20/9 V2 =3

Table S.1: CRR pricing and hedging table.

In addition, it can be checked that the portfolio strategy (ξk , ηk )k=1,2 is self-
financing, as we have
8 3
ξ1 S1 + η1 A1 = ×
9 2
 4 3
2 − 9 × 2


=
 −2 + 20 × 3


9 2
= ξ2 S1 + η2 A1 .

Exercise 3.3
a) We have

IE∗ [St+1 | Ft ] = IE∗ [St+1 | St ]

St ∗
= P (Rt = −0.5) + St P∗ (Rt = 0) + 2St P∗ (Rt = 1)
2 ∗ 
r
= + q ∗ + 2p∗ St
2
= St , t = 0, 1,

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Introduction to Stochastic Finance with Market Examples, Second Edition

with r = 0.
b) We have the following graph:
S2 = 4, C = 2.5
4
p∗ = 1/
q ∗ = 1/4
S1 = 2 S2 = 2, C = 0.5

r ∗ = 1/
4 2
1/ S2 = 1, C = 0
∗ =
p
S2 = 2, C = 0
4
p∗ = 1/
q ∗ = 1/4 q ∗ = 1/4
S0 = 1 S1 = 1 S2 = 1, C = 0

r ∗ = 1/
2
S2 = 0.5, C = 0
r∗
=
1/
2 S2 = 1, C = 0
p∗ = 1/4
q ∗ = 1/4
S1 = 0.5 S2 = 0.5, C = 0

r ∗ = 1/
2
S2 = 0.25, C = 0

c) The down-an-out barrier call option is priced at time t = 0 as

3
V0 = IE∗ [C] = 2.5 × (p∗ )2 + 0.5 × p∗ q ∗ = .
16
At time t = 1 we have
1 1 3
V1 = 2.5 × p∗ + 0.5 × q ∗ = 2.5 × + 0.5 × =
4 4 4
if S1 = 2, and V1 = 0 in both cases S1 = 1 and S1 = 0.5.
d) This market is not complete, and not every contingent claim is attainable,
because the risk-neutral probability measure P∗ is not unique, for example
(r∗ , q ∗ , p∗ ) = (1/4, 5/8, 1/8) and (r∗ , q ∗ , p∗ ) = (1/2, 1/4, 1/4) are both
risk-neutral probability measures.

Exercise 3.4 The CRR model can be described by the following binomial tree.

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(1 + b)2 S0
p∗

(1 + b)S0
p∗
q∗
S0 = 1 (1 + a)(1 + b)S0
p∗
q∗
(1 + a)S0

q∗
(1 + a)2 S0

a) By the formulas
1 1
V1 = IE∗ [V2 | F1 ] = IE∗ [V2 | S1 ]
1+r 1+r
S0 (1 + b)2 − 8 ∗
= P (S2 = S0 (1 + b)2 | S1 )
1+r
(S0 (1 + b)2 − 8)
= p∗ 1{S1 =S0 (1+b)} ,
1+r
and
1
V0 = IE∗ [V1 | F0 ]
1+r
1 (S0 (1 + b)2 − 8)
 
= p∗ × P∗ (S1 = S0 (1 + b)) + 0 × P∗ (S1 = S0 (1 + a))
1+r 1+r
∗ 2 (S0 (1 + b) − 8)
2
= (p ) ,
(1 + r)2

we find the table

S2 =9
S1 = 3, V1 = 1/4 V2 =1
S0 = 1 S2 =3
V0 = 1/16 V2 =0
S1 = 1, V1 = 0 S2 =1
V2 =0

Table S.2: CRR pricing tree.

Note that we could also directly compute V0 from

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Introduction to Stochastic Finance with Market Examples, Second Edition

1
V0 = IE∗ [V2 | F0 ].
(1 + r)2

b) When S1 = S0 (1 + b), the equation ξ2 S2 + η2 A2 = V2 reads

 ξ2 S0 (1 + b)2 + η2 A0 (1 + r)2 = S0 (1 + b)2 − 8



ξ2 S0 (1 + b)(1 + a) + η2 A0 (1 + r)2 = 0,


which yields

S0 (1 + b)2 − 8 (S0 (1 + b)2 − 8)(1 + a)

ξ2 = and η2 = − . (S.3.4)
S0 (b − a)(1 + b) (b − a)A0 (1 + r)2

When S1 = S0 (1 + a), the equation ξ2 S2 + η2 A2 = V2 reads

 ξ2 S0 (1 + a)2 + η2 A0 (1 + r)2 = 0


ξ2 S0 (1 + b)2 + η2 A0 (1 + r)2 = 0,


which has the unique solution (ξ2 , η2 ) = (0, 0). Next, the equation ξ1 S1 +
η1 A1 = V1 reads

p∗ (S0 (1 + b)2 − 8)

 ξ1 S0 (1 + b) + η1 A0 (1 + r) =
 ,
1+r

ξ1 S0 (1 + a) + η1 A0 (1 + r) = 0,


which yields

S0 (1 + b)2 − 8 (1 + a)(S0 (1 + b)2 − 8)

ξ1 = p∗ and η1 = −p∗ .
S0 (b − a)(1 + r) (b − a)A0 (1 + r)2
(S.3.5)
This can be summarized in the following table:

S1 = 3, V1 = 1/4 S2 =9
S0 = 1 V2 =1
V0 = 1/16 ξ2 = 1/6, η2 = −1/8 S2 =3
ξ1 = 1/8 S1 = 1, V1 = 0 V2 =0
η1 = −1/16 S2 =1
ξ2 = 0, η2 = 0 V2 =0

Table S.3: CRR pricing and hedging tree.

When S1 = S0 (1 + a) at time t = 1 the option price is V1 = 0 and the

hedging strategy is to cut all positions: ξ2 = η2 = 0. On the other hand,

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if S1 = S0 (1 + b) then there is a chance of being in the money at maturity

and we need to increase our position in the underlying asset from ξ1 = 1/8
to ξ2 = 1/6.

Note that the self-financing condition

ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1 , (S.3.6)

is verified. For example when S1 = S0 (1 + a) we have

1 1
× S1 − A1 = 0 × S1 + 0 × A1 = 0,
8 16
while when S1 = S0 (1 + b) we find
1 1 1 1 1
× S1 − A1 = × S1 − × A1 = .
8 16 6 8 4
c) We can also use the self-financing condition (S.3.6) to recover (S.3.5) by
rewriting the system of equations as

 ξ1 S0 (1 + b) + η1 A0 (1 + r) = ξ2 S0 (1 + b) + η2 A0 (1 + r)


ξ1 S0 (1 + a) + η1 A0 (1 + r) = 0,


with (ξ2 , η2 ) given by (S.3.4), which recovers

3 2 1
 − = if S1 = 3,
8 16 4


V1 = ξ1 S1 + η1 A1 =
 1 − 2 = 0 if S = 1.


1
8 16

Exercise 3.5
a) We build a portfolio based at times t = 0, 1 on αt+1 units of stock and
$βt+1 in cash. When S1 = 2, we should have

4α2 + β2 = 0


2α2 + β2 = 1,

hence (α2 , β2 ) = (−1/2, 2). On the other hand, when S1 = 1 we should

have
2α1 + β1 = 1


α1 + β1 = 0,
hence (α2 , β2 ) = (1, −1).
b) When S1 = 2, the price of the claim at t = 1 is

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Introduction to Stochastic Finance with Market Examples, Second Edition

α2 S1 + β2 = (−1/2) × 2 + 2 × 1 = 1.

When S1 = 1, the price of the claim at t = 1 is α2 S1 +β2 = 1×1−1×1 = 0.

c) At time t = 1 we build a portfolio using α1 units of stock and $β1 in cash.
We should have
2α1 + β1 = 1

α1 + β1 = 0,
hence (α1 , β1 ) = (1, −1).
d) The price of the claim C at time t = 0 is α1 S0 + β1 = 1 × 1 + (−1) × 1 = 0.
e) The probabilities (p∗ , q ∗ ) = ((r − a)/(b − a), (b − r)/(b − a)) = (0, 1) are
clearly risk-neutral in the sense of Definition 2.12, as they yield

IE∗ [S2 | S1 ] = S1 and IE∗ [S1 | S0 ] = S0 .

with the risk-free rate r = 0. However, this does not form a risk-neutral
probability measure P∗ equivalent to P in the sense of Definition 2.14 when
q = P(R1 = 0) = P(R2 = 0) > 0.

In case (p, q) = (0, 1), the probabilities (p∗ , q ∗ ) = (0, 1) would yield an
equivalent risk-neutral probability measure.
f) According to Theorem 2.15 this model allows for arbitrage opportuni-
ties as the unique available risk-neutral probability measure P∗ are not
be equivalent to the historical probability measure P when q = P(R1 =
0) = P(R2 = 0) > 0. In this case, arbitrage opportunities are easily
implemented by purchasing the option at the price 0 of part (d) while
receiving a strictly positive payoff at maturity. More generally, arbitrage
opportunities exist when the underlying price may increase with nonzero
probability, without a possibility of strict decrease.

In case (p, q) = (0, 1), no arbitrage is possible as prices remain constant.

Exercise 3.6 We have the model-free answer

1
πk (C) = IE∗ [h(SN ) | Fk ]
(1 + r)N −k
1
= IE∗ [α + βSN | Fk ]
(1 + r)N −k
α β
= + IE∗ [SN | Fk ]
(1 + r)N −k (1 + r)N −k
α
= Ak + βSk , k = 0, 1, . . . , N.
(1 + r)N

The hedging portfolio strategy is to hold β units of the underlying asset

priced Sk and α/(1 + r)N units of the riskless asset priced Ak = (1 + r)k at

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time k = 0, 1, . . . , N .

Note that in the particular case of the CRR model, this answer is also com-
patible with (3.19)-(3.20).

Exercise 3.7 Call-put parity.

a) The relation (x − K)+ = x − K + (K − x)+ can be verified by successively
checking the cases x ≤ K and x ≥ K.
b) Respectively denoting by C(k) and P (k) the call and put prices at time
k = 0, 1, . . . , N , by part (a) we have

C(k) = (1 + r)−(N −k) IE∗ (SN − K)+ Fk

 

= (1 + r)−(N −k) IE∗ SN − K + (K − SN )+ Fk

 

= (1 + r)−(N −k) IE∗ [SN | Fk ] − (1 + r)−(N −k) K

+(1 + r)−(N −k) IE∗ (K − SN )+ Fk
 

= Sk − (1 + r)−(N −k) K + (1 + r)−(N −k) IE∗ (K − SN )+ Fk

 

= Sk − (1 + r)−(N −k) K + P (k).

Exercise 3.8
a) Taking q ∗ = 1 − p∗ = 1/4, we find the binary tree

6.25 = (1 + b)2
p∗

2.5 = 1 + b
p∗
q∗
S0 = 1 1.25 = (1 + a)(1 + b)
p∗
q∗
0.5 = 1 + a

q∗
0.25 = (1 + a)2

b) We find the binary tree

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Introduction to Stochastic Finance with Market Examples, Second Edition

S2 = 6.25 and V2 = 0
p∗

S1 = 2.5 and V1 = 0
p∗
q∗
S0 = 1 and V0 = 1/64 S2 = 1.25 and V2 = 0
p∗
q∗
S1 = 0.5 and V1 = 1/8

q∗
S2 = 0.25 and V2 = 1

and the table

S2 = 6.25
S1 = 2.5, V1 = 0
V2 = 0
S0 = 1 S2 = 1.25
V0 = 1/64 V2 = 0
S1 = 0.5, V1 = 1/8 S2 = 0.25
V2 = 1

Table S.4: CRR pricing tree.

c) Here, we compute the hedging strategy from the option prices. When
S1 = S0 (1 + b) we clearly have ξ2 = η2 = 0. When S1 = S0 (1 + a), the
equation ξ2 S2 + η2 A2 = V2 reads

 ξ2 S0 (1 + a)2 + η2 (1 + r)2 = (K − S0 (1 + a)2 )



ξ2 S0 (1 + b)(1 + a) + η2 (1 + r)2 = 0


hence
(K − S0 (1 + a)2 ) (K − S0 (1 + a)2 )(1 + b)
ξ2 = − and η2 = .
S0 (b − a)(1 + a) S0 (b − a)(1 + r)2

Next, at time t = 1 the equation ξ1 S1 + η1 A1 = V1 reads

q ∗ (K − (1 + a)(1 + b))

 ξ1 S0 (1 + a) + η1 (1 + r) = S0
 ,
1+r

ξ1 S0 (1 + b) + η1 (1 + r) = 0


which yields

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q ∗ (K − S0 (1 + a)(1 + b)) q ∗ (K − S0 (1 + a)(1 + b))(1 + b)

ξ1 = − and η1 = .
S0 (b − a)(1 + r) S0 (b − a)(1 + r)2

This can be summarized in the following table:

S1 = 2.5, V1 = 0 S2 = 6.25
S0 = 1 V2 = 0
V0 = 1/64 ξ2 = 0, η2 = 0 S2 = 1.25
ξ1 = −1/16 S1 = 0.5, V1 = 1/8 V2 = 0
η1 = 5/64 S2 = 0.25
ξ2 = −1, η2 = 5/16 V2 = 1

Table S.5: CRR pricing and hedging tree.

If S1 = S0 (1 + a) then there is a chance of being in the money at maturity

and we need to short sell further by decreasing ξ1 from ξ1 = −1/16 to
ξ2 = −1. Note that the self-financing condition

ξ1 S1 + η1 A1 = ξ2 S1 + η2 A1

is satisfied.

Exercise 3.9
a) The binary call option can be priced under the risk-neutral probability
measure P∗ as
1
π0 (C) = IE∗ [C]
1+r
1
= IE∗ [1[K,∞) (SN )]
1+r
1
= P∗ (SN ≥ K)
1+r
p∗
= ,
1+r
with p∗ := P∗ (SN ≥ K).
b) Investing $p∗ by purchasing one binary call option yields a potential net
return of
$1 − p∗ $1

 = ∗ − 1 if SN ≥ K,
 p∗

 p

 $0 − p = −100% if SN < K.

 ∗

p ∗

c) The corresponding expected return is

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Introduction to Stochastic Finance with Market Examples, Second Edition

1
 
p∗ × − 1 + (1 − p∗ ) × (−1) = 0.
p∗

d) The corresponding expected return is

p∗ × 0.86 + (1 − p∗ ) × (−1) = p∗ × 1.86 − 1,

which will be negative if

1
p∗ < ≃ 0.538.
1.86
That means, the expected gain can be negative even if

0.538 > p∗ = P∗ (SN ≥ K) > 0.5.

Similarly, the expected gain

(1 − p∗ ) × 0.86 + p∗ × (−1) = 0.86 − p∗ × 1.86,

on binary put options will be negative if 1 − p∗ > 1/1.86, i.e. if

0.86
p∗ > ≃ 0.462.
1.86
That means, the expected gain can be negative even if 1 − 0.462 >
P∗ (SN < K) > 0.5. In conclusion, the average gains of both call and
put options will be negative if p∗ ∈ (0.462, 0.538).

Note that the average of call and put option gains will still be negative,
as
p∗ × 1.86 − 1 0.86 − p∗ × 1.86 0.86 − 1
+ = < 0.
2 2 2

Exercise 3.10
a) Based on the price map of the put spread collar option:

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 Solutions Manual

130
Put spread collar price map f(S)
y=S
120

110

100

90

80

70
60 70 80 90 100 110 120 130
SN
K1 K2 K3

Fig. S.5: Put spread collar price map.

we deduce the following payoff function graph of the put spread collar
option in the next Figure S.6.

20
Put spread collar payoff function
15

10

-5

-10

-15

-20
60 70 80 90 100 110 120 130
K1 K2 SN K3

Fig. S.6: Put spread collar payoff function.

b) The payoff function can be written as

−(K1 − x)+ + (K2 − x)+ − (x − K3 )+

= −(80 − x)+ + (90 − x)+ − (x − 110)+ ,

see also https://optioncreator.com/stp7xy2.

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20
-(K1-x)++(K2-x)+
15 -(x-K3)+

10

-5

-10

-15

-20
60 70 80 90 100 110 120 130
K1 K2 SN K3

Fig. S.7: Put spread collar payoff as a combination of call and put option payoffs.∗

Hence this collar option payoff can be realized by

1. issuing (or shorting/selling) one put option with strike price K1 = 80,
and
2. purchasing and holding one put option with strike price K2 = 90, and
3. issuing (or shorting/selling) one call option with strike price K3 = 110.

Exercise 3.11
a) Based on the price map of the call spread collar option:

140
Call spread collar price map f(S)
130 y=S

120

110

100

90

80

70

60
60 70 80 90 100 110 120 130
SN
K1 K2 K3

Fig. S.8: Call spread collar price map.

we deduce the following payoff function graph of the call spread collar
option in the next Figure S.9.
∗
The animation works in Acrobat Reader on the entire pdf file.

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 Solutions Manual

20
Call spread collar payoff function
15

10

-5

-10

-15

-20
60 70 80 90 100 110 120 130
SN
K1 K2 K3

Fig. S.9: Call spread collar payoff function.

b) The payoff function can be written as

−(K1 − x)+ + (x − K2 )+ − (x − K3 )+
= −(80 − x)+ + (x − 100)+ − (x − 110)+ ,

see also https://optioncreator.com/st3e4cz.

20
-(K1-x)++(x-K2)+
15 -(x-K3)+

10

-5

-10

-15

-20
60 70 80 90 100 110 120 130
K1 SN K2 K3

Fig. S.10: Call spread collar payoff as a combination of call and put option payoffs.∗

Hence this collar option payoff can be realized by

1. issuing (or shorting/selling) one put option with strike price K1 = 80,
and
2. purchasing and holding one call option with strike price K2 = 100, and
∗
The animation works in Acrobat Reader on the entire pdf file.

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Introduction to Stochastic Finance with Market Examples, Second Edition

3. issuing (or shorting/selling) one call option with strike price K3 = 110.

Exercise 3.12 We have

S1 + · · · + SN ϕ(S1 ) + · · · + ϕ(SN )
    
IE∗ ϕ ≤ IE∗ since ϕ is convex,
N N
∗ ∗
IE [ϕ(S1 )] + · · · + IE [ϕ(SN )]
=
N
IE∗ [ϕ(IE∗ [SN | F1 ])] + · · · + IE∗ [ϕ(IE∗ [SN | FN ])]
= because (Sn )n∈N is a martingale,
N
IE∗ [IE∗ [ϕ(SN ) | F1 ]] + · · · + IE∗ [IE∗ [ϕ(SN ) | FN ]]
≤ by Jensen’s inequality,
N
IE∗ [ϕ(SN )] + · · · + IE∗ [ϕ(SN )]
= by the tower property.
N
= IE∗ [ϕ(SN )].

The above argument is implicitly using the fact that a convex function ϕ(Sn )
of a martingale (Sn )n∈N is itself a submartingale, as

ϕ(Sk ) = ϕ(IE∗ [SN | Fk ]) ≤ IE∗ [ϕ(SN ) | Fk ], k = 1, 2, . . . , N.

Exercise 3.13 (Exercise 2.7 continued).

a) The condition VN = C reads

 ηN πN + ξN (1 + a)SN −1 = (1 + a)SN −1 − K


ηN πN + ξN (1 + b)SN −1 = (1 + b)SN −1 − K,


from which we deduce the (static) hedging strategy ξN = 1 and ηN =

−K(1 + r)−N /π0 .
b) We have

 ηN −1 πN −1 + ξN −1 (1 + a)SN −2 = ηN πN −1 + ξN (1 + a)SN −2


ηN −1 πN −1 + ξN −1 (1 + b)SN −2 = ηN πN −1 + ξN (1 + b)SN −2 ,


which yields ξN −1 = ξN = 1 and ηN −1 = ηN = −K(1 + r)−N /π0 . Simi-

larly, solving the self-financing condition

 ηt πt + ξt (1 + a)St−1 = ηt+1 πt + ξt+1 (1 + a)St−1



ηt πt + ξt (1 + b)St−1 = ηt+1 πt + ξt+1 (1 + b)St−1



at time t yields
K
ξt = 1 and ηt = −(1 + r)−N , t = 1, 2, . . . , N.
π0

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c) We have

πt (C) = Vt
= ηt πt + ξt St
πt
= St − K(1 + r)−N
π0
= St − K(1 + r)−(N −t) .

d) For all t = 0, 1, . . . , N we have

(1 + r)−(N −t) IE∗ [C | Ft ] = (1 + r)−(N −t) IE∗ [SN − K | Ft ],

= (1 + r)−(N −t) IE∗ [SN | Ft ] − (1 + r)−(N −t) IE∗ [K | Ft ]
= (1 + r)−(N −t) (1 + r)N −t St − K(1 + r)−(N −t)
= St − K(1 + r)−(N −t)
= Vt = πt (C).

For a future contract expiring at time N we take K = S0 (1 + r)N and the

contract is usually quoted at time t using the forward price (1+r)N −t (St −
K(1 + r)N −t ) = (1 + r)N −t St − K = (1 + r)N −t St − S0 (1 + r)N , or sim-
ply using (1 + r)N −t St . Future contracts are “marked to market” at each
time step t = 1, 2, . . . , N via a positive or negative cash flow exchange
(1 + r)N −t St − (1 + r)N −t+1 St−1 from the seller to the buyer, ensuring
that the absolute difference |(1 + r)N −t St − K| has been credited to the
buyer’s account if it is positive, or to the seller’s account if it is negative.

Exercise 3.14
a) We write

 ξN SN −1 (1 + 1/2) + ηN = (SN −1 (1 + 1/2))2



VN =
ξN SN −1 (1 − 1/2) + ηN = (SN −1 (1 − 1/2))2 ,


which yields
 ξN = 2SN −1


ηN = −3(SN −1 )2 /4.


b) i) We have

IE∗ [(SN )2 | FN −1 ] = p∗ (SN −1 )2 (1 + 1/2)2 + (1 − p∗ )(SN −1 )2 (1 − 1/2)2

1
= (SN −1 )2 (1 + 1/2)2 + (1 − 1/2)2


2
= 5(SN −1 )2 /4.

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Introduction to Stochastic Finance with Market Examples, Second Edition

ii) We have

 ξN −1 SN −2 (1 + 1/2) + ηN −1


ξN −1 SN −1 + ηN −1 A0 =
ξN −1 SN −2 (1 − 1/2) + ηN −1

= VN −1
= 5(SN −1 )2 /4
 5(SN −2 (1 + 1/2))2 /4


=
5(SN −2 (1 − 1/2))2 /4,


hence
 ξN −1 = 5SN −2 /2


ηN −1 = −15(SN −2 )2 /16.


iii) We have

ξN −1 SN −1 + ηN −1 A0 = 5SN −2 SN −1 /2 − 15(SN −2 )2 /16

 5(SN −2 )2 (1 + 1/2)/2 − 15(SN −2 )2 /16


=
5(SN −2 )2 (1 − 1/2)/2 − 15(SN −2 )2 /16


 15(SN −2 )2 /4 − 15(SN −2 )2 /16



=
5(SN −2 )2 − 15(SN −2 )2 /16


 45(SN −2 )2 /16


=
5(SN −2 )2 /16,


and on the other hand,

ξN SN −1 + ηN A0 = 2(SN −1 )2 − 3(SN −1 )2 /4
 2(SN −2 )2 (1 + 1/2)2 − 3(SN −2 )2 (1 + 1/2)2 /4


=
2(SN −2 )2 (1 − 1/2)2 − 3(SN −2 )2 (1 − 1/2)2 /4


 45(SN −2 )2 /16


=
5(SN −2 )2 /16.


Remark: We could also determine (ξN −1 , ηN −1 ) as in Proposition 3.12,

from (ξN , ηN ) and the self-financing condition

ξN −1 SN −1 + ηN −1 A0 = ξN SN −1 + ηN AN −1 ,

as

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 Solutions Manual

 ξN −1 SN −2 (1 + 1/2) + ηN −1


ξN −1 SN −1 + ηN −1 A0 =
ξN −1 SN −2 (1 − 1/2) + ηN −1

= ξN SN −1 + ηN A0
= 2(SN −1 )2 − 3(SN −1 )2 /4
 2(SN −2 )2 (1 + 1/2)2 − 3(SN −2 )2 (1 + 1/2)2 /4


=
2(SN −2 )2 (1 − 1/2)2 − 3(SN −2 )2 (1 − 1/2)2 /4,


which recovers ξN −1 = 5SN −2 /2 and ηN −1 = −15(SN −2 )2 /16.

Exercise 3.15
a) By Theorem 2.19 this model admits a unique risk-neutral probability mea-
sure P∗ because a < r < b, and from (2.16) we have

b−r 0.07 − 0.05

P∗ (Rt = a) = = ,
b−a 0.07 − 0.02
and
r−a 0.05 − 0.02
P(Rt = b) = = ,
b−a 0.07 − 0.02
t = 1, 2, . . . , N .
b) There are no arbitrage opportunities in this model, due to the existence
of a risk-neutral probability measure.
c) This market model is complete because the risk-neutral probability mea-
sure is unique.
d) We have
C = (SN )2 ,
hence
e = (SN ) = h(XN ),
2
C
(1 + r)N
with
h(x) = x2 (1 + r)N . (S.3.7)
Now we have
Vet = ṽ(t, Xt ),
where the function v(t, x) is given from Proposition 3.8 as
N −t  k  N −t−k !
1+b 1+a
 
X N −t
ṽ(t, x) = (p∗ )k (q ∗ )N −t−k h x .
k 1+r 1+r
k=0

Using (S.3.7) and the binomial theorem, we find

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N −t  
X N −t
ṽ(t, x) = x2 (1 + r)N
k
k=0
2k  2(N −t−k)
1+b 1+a

×(p∗ )k (q ∗ )N −t−k
1+r 1+r
N −t  
X N − t
= x2 (1 + r)N
k
k=0
2 k
N −t−k
(r − a)(1 + b) (b − r)(1 + a)2
  
×
(b − a)(1 + r)2 (b − a)(1 + r)2
N −t
(r − a)(1 + b)2 (b − r)(1 + a)2

= x2 (1 + r)N +
(b − a)(1 + r)2 (b − a)(1 + r)2

N −t
x (r − a)(1 + b) + (b − r)(1 + a)2
2 2
=
(1 + r)N −2t (b − a)N −t

N −t
x (r − a)(1 + 2b + b2 ) + (b − r)(1 + 2a + a2 )
2
=
(1 + r)N −2t (b − a)N −t

N −t
x2 r(1 + 2b + b2 ) − a(1 + 2b + b2 ) + b(1 + 2a + a2 ) − r(1 + 2a + a2 )
=
(1 + r)N −2t (b − a)N −t
(1 + r(a + b + 2) − ab)N −t
= x2 .
(1 + r)N −2t

e) We have
   
1+b
v t, 1+r Xt−1 − v t, 1+a
1+r Xt−1
ξt1 =
Xt−1 (b − a)/(1 + r)
 2  2
1+b
1+r − 1+a
1+r (1 + r(a + b + 2) − ab)N −t
= Xt−1
(b − a)/(1 + r) (1 + r)N −2t
(1 + r(a + b + 2) − ab)N −t
= St−1 (a + b + 2) , t = 1, 2, . . . , N,
(1 + r)N −t

representing the quantity of the risky asset to be present in the portfolio

at time t. On the other hand we have
Vt − ξt1 Xt
ξt0 =
Xt0
Vt − ξt1 Xt
=
π0
Xt − Xt−1 (a + b + 2)/(1 + r)
= Xt (1 + r(a + b + 2) − ab)N −t
π0 (1 + r)N −2t

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St − St−1 (a + b + 2)
= St (1 + r(a + b + 2) − ab)N −t
π0 (1 + r)N
N −t (1 + a)(1 + b)
= −(St−1 ) (1 + r(a + b + 2) − ab)
2
,
π0 (1 + r)N

t = 1, 2, . . . , N .
f) Let us check that the portfolio is self-financing. We have

ξ t+1 · S t = ξt+1
0
St0 + ξt+1
1
St1
(1 + a)(1 + b) 0
= −(St )2 (1 + r(a + b + 2) − ab)N −t−1 S
π0 (1 + r)N t
(1 + r(a + b + 2) − ab)N −t−1
+(St )2 (a + b + 2)
(1 + r)N −t−1
(1 + r(a + b + 2) − ab)N −t−1
= (St )2
(1 + r) N −t

× ((a + b + 2)(1 + r) − (1 + a)(1 + b))

1
= (Xt )2 (1 + r(a + b + 2) − ab)N −t
(1 + r)N −3t
= (1 + r)t Vt
= ξt · St, t = 1, 2, . . . , N.

Exercise 3.16
a) We have

Vt = ξt St + ηt πt
= ξt (1 + Rt )St−1 + ηt (1 + r)πt−1 .

b) We have

IE∗ [Rt |Ft−1 ] = aP∗ (Rt = a | Ft−1 ) + bP∗ (Rt = b | Ft−1 )

b−r r−a
=a +b
b−a b−a
r r
=b −a
b−a b−a
= r.

c) By the result of Question (a), we have

IE∗ [Vt | Ft−1 ] = IE∗ [ξt (1 + Rt )St−1 | Ft−1 ] + IE∗ [ηt (1 + r)πt−1 | Ft−1 ]
= ξt St−1 IE∗ [1 + Rt | Ft−1 ] + (1 + r) IE∗ [ηt πt−1 | Ft−1 ]
= (1 + r)ξt St−1 + (1 + r)ηt πt−1
= (1 + r)ξt−1 St−1 + (1 + r)ηt−1 πt−1

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= (1 + r)Vt−1 ,

where we used the self-financing condition.

d) We have
1
Vt−1 = IE∗ [Vt | Ft−1 ]
1+r
3 8
= P∗ (Rt = a | Ft−1 ) + P∗ (Rt = b | Ft−1 )
1+r 1+r
1 0.25 − 0.15 0.15 − 0.05
 
= 3 +8
1 + 0.15 0.25 − 0.05 0.25 − 0.05
1 3 8
 
= +
1.15 2 2
= 4.78.

Problem 3.17 CRR model with transaction costs.

a) i) In the event of an increase in the stock position ξt , the corresponding
cost of purchase (1 + λ)(ξt+1 − ξt )St > 0 has to be deducted from the
savings account value ηt At , which becomes updated as

ηt+1 At = ηt At − (1 + λ)(ξt+1 − ξt )St ,

hence we have

ηt+1 At + (1 + λ)ξt+1 St = ηt At + (1 + λ)ξt St .

ii) In the event of a decrease in the stock position ξt , the corresponding

sale profit (ξt −ξt+1 )(1−λ)St > 0 has to be added to from the savings
account value ηt At , which becomes updated as

ηt+1 At = ηt At + (ξt − ξt+1 )(1 − λ)St ,

hence we have

ηt+1 At + ξt+1 (1 − λ)St = ηt At + ξt (1 − λ)St .

b) We have:
i) If ξt+1 (βSt−1 ) > ξt (St−1 ),

(ξt (St−1 ) − ξt+1 (βSt−1 ))β ↑ Set−1 = (ηt+1 (βSt−1 ) − ηt (St−1 ))ρ.

ii) If ξt+1 (βSt−1 ) < ξt (St−1 ),

(ξt (St−1 ) − ξt+1 (βSt−1 )) β↓ Set−1 = (ηt+1 (βSt−1 ) − ηt (St−1 ))ρ,

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and
iii) If ξt+1 (αSt−1 ) > ξt (St−1 ),

(ξt (St−1 ) − ξt+1 (αSt−1 )) α↑ Set−1 = ρηt+1 (αSt−1 ) − ρηt (St−1 ).

iv) If ξt+1 (αSt−1 ) < ξt (St−1 ),

(ξt (St−1 ) − ξt+1 (αSt−1 )) α↓ Set−1 = ρηt+1 (αSt−1 ) − ρηt (St−1 ).

c) We find

gβ (ξt (St−1 ), ξt+1 (βSt−1 )) ξt (St−1 )−ξt+1 (βSt−1 ) Set−1 = ρηt+1 (βSt−1 )−ρηt (St−1 ).

and

gα (ξt (St−1 ), ξt+1 (αSt−1 )) ξt (St−1 )−ξt+1 (αSt−1 ) Set−1 = ρηt+1 (αSt−1 )−ρηt (St−1 ).

d) The equation is

Set−1 gβ (ξt (St−1 ), ξt+1 (βSt−1 )) ξt (St−1 ) − ξt+1 (βSt−1 )

−Set−1 gα (ξt (St−1 ), ξt+1 (αSt−1 )) ξt (St−1 ) − ξt+1 (αSt−1 )

= ρηt+1 (βSt−1 ) − ρηt+1 (αSt−1 ),

which can be rewritten as

f (x, St−1 ) = 0 (S.3.8)

at x = ξt (St−1 ). The function

x 7→ f (x, St−1 )

is continuous by construction, and its derivative is the function

x 7→ gβ (x, ξt+1 (βSt−1 )) − gα (x, ξt+1 (αSt−1 )),

which can only take four values β ↑ − α↑ , β ↑ − α↓ , β↓ − α↑ , β↓ − α↓ , which

are all strictly positive due to the conditions

α := α(1 + λ) < β(1 − λ) =: β↓ ,
↑

α↓ := α(1 − λ) < β(1 − λ) := β↓ ,
α := α(1 + λ) < β(1 + λ) =: β ↑ .

 ↑

Hence x 7→ f (x, St−1 ) is strictly increasing, and we have

lim f (x, St−1 ) = −∞ and lim f (x, St−1 ) = ∞.

x→−∞ x→∞

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Therefore, Equation (S.3.8) admits a unique solution x = ξt (St−1 ).

e) We have

ηt+1 (βSt−1 ) − ηt+1 (αSt−1 )

ξt (St−1 ) = ρ
Set−1 gβ (ξt (St−1 ), ξt+1 (βSt−1 )) − gα (ξt (St−1 ), ξt+1 (αSt−1 ))

ξt+1 (βSt−1 )gβ (ξt (St−1 ), ξt+1 (βSt−1 )) − ξt+1 (αSt−1 )gα (ξt (St−1 ), ξt+1 (αSt−1 ))
+ ,
gβ (ξt (St−1 ), ξt+1 (βSt−1 )) − gα (ξt (St−1 ), ξt+1 (αSt−1 ))

and

ηt (St−1 )
gα (ξt (St−1 ), ξt+1 (αSt−1 ))gβ (ξt (St−1 ), ξt+1 (βSt−1 ))ξt+1 (βSt−1 )
= Set−1
ρgα (ξt (St−1 ), ξt+1 (αSt−1 )) − ρgβ (ξt (St−1 ), ξt+1 (βSt−1 ))
g β (ξt (St−1 ), ξt+1 (βSt−1 ))gα (ξt (St−1 ), ξt+1 (αSt−1 ))ξt+1 (αSt−1 )
− Set−1
ρgα (ξt (St−1 ), ξt+1 (αSt−1 )) − ρgβ (ξt (St−1 ), ξt+1 (βSt−1 ))
gα (ξt (St−1 ), ξt+1 (αSt−1 ))ηt+1 (βSt−1 ) − gβ (ξt (St−1 ), ξt+1 (βSt−1 ))ηt+1 (αSt−1 )
+ .
gα (ξt (St−1 ), ξt+1 (αSt−1 )) − gβ (ξt (St−1 ), ξt+1 (βSt−1 ))

f) i) In case f (ξt+1 (αSt−1 ), St−1 ≥ 0 we have ξt (St−1 ) ≤ ξt+1 (αSt−1 )

because f is increasing, hence

gα (ξt (St−1 ), ξt+1 (αSt−1 )) = α↑ (1 + λ)α.

ii) In case f ξt+1 (αSt−1 ), St−1 < 0 we have ξt (St−1 ) > ξt+1 (αSt−1 )

because f is increasing, hence

gα (ξt (St−1 ), ξt+1 (αSt−1 )) = α↓ = (1 − λ)α.

Note that in case f ξt+1 (αSt−1 ), St−1 = 0 we have ξt (St−1 ) = ξt+1 (αSt−1 )

hence there is no transaction from St−1 to αSt−1 . Similarly,

iii) If f ξt+1 (βSt−1 ), St−1 ≥ 0 then ξt (St−1 ) ≤ ξt+1 (βSt−1 ), hence

gβ (ξt (St−1 ), ξt+1 (βSt−1 )) = β ↑ (1 + λ)β.

iv) If f ξt+1 (βSt−1 ), St−1 < 0 then ξt (St−1 ) > ξt+1 (βSt−1 ), hence

gβ (ξt (St−1 ), ξt+1 (βSt−1 )) = β↓ = (1 − λ)β.

Note that in case f ξt+1 (βSt−1 ), St−1 = 0 we have ξt (St−1 ) = ξt+1 (βSt−1 )

hence there is no transaction from St−1 to βSt−1 .

g) With the parameters N = 2, K = $2, S0 = 8, ρ = 1, α = 0.5, β = 2, and
the transaction cost rate λ = 12.5%, we find the tree of asset prices

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 Solutions Manual

S2 = 32

S1 = 16

S0 = 8 S2 = 8

S1 = 4

S2 = 2.

Fig. S.11: Tree of market prices with N = 2.

At maturity time N we use the equations (4.4.4)-(4.4.5) of Proposi-

tion 4.11, which read here

h(βSN −1 ) − h(αSN −1 )
ξN SN −1 = , (4.4.4)
(β − α)SN −1

where h(t, x) = (x − K)+ , and

βh(αSN −1 ) − αh(βSN −1 )
ηN (SN −1 ) = , (4.4.5)
(β − α)AN

as the evaluation of the terminal payoff is not affected by bid/ask prices.

This yields

(η2 (16), ξ2 (16)) = (−2, 1) and (η2 (4), ξ2 (4)) = (−2, 1).

In this case we check that f (ξ2 (16), S0 ) = f (1, 8) = 0 and f (ξ2 (4), S0 ) =
f (1, 8) = 0, which yields the hedging strategy ξ1 (8) = ξ2 (16) = ξ2 (4) = 1
and η1 (8) = η1 (15) = η1 (4) = −2 as the portfolio is self-financing. This
static hedging involves no transaction costs and gives the initial price
V0 = 8 × 1 − 2 × 1 = $6.

Due to the simplicity of the case K = $2, we now consider the case K = $4.
In this case, (4.4.4) and (4.4.5) give

(η2 (16), ξ2 (16)) = (−4, 1) and (η2 (4), ξ2 (4)) = (−4/3, 2/3),

which yields

f (ξ2 (16), S0 ) = f (1, 8)

−4 − (−4/3)
= gβ (1, 1)(1 − 1) − gα (1, 2/3)(1 − 2/3) −
8
1 1
= − α↓ +
3 3

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1 1
= − (1 − λ)α +
3 3
1 1 1
= − × 0.875 × +
3 2 3
> 0,

hence
gβ (ξ1 (S0 ), ξ2 (βS0 )) = β↑ = (1 + λ)β.
We also have

f (ξ2 (4), S0 ) = f (2/3, 8)

−4 − (−4/3)
= gβ (2/3, 1)(2/3 − 1) − gα (2/3, 2/3)(2/3 − 2/3) −
8
1 1
= − β↑ +
3 3
1 1
= − (1 + λ)β +
3 3
2 1
= − × 1.125 +
3 3
< 0,

hence
gα (ξ1 (S0 ), ξ2 (αS0 )) = α↓ = (1 − λ)α.
Therefore, we find

η2 (βS0 ) − η2 (αS0 )
ξ1 (S0 ) = ρ
Se0 gβ (ξ1 (S0 ), ξ2 (βS0 )) − gα (ξ1 (S0 ), ξ2 (αS0 ))

ξ2 (βS0 )gβ (ξ1 (S0 ), ξ2 (βS0 )) − ξ2 (αS0 )gα (ξ1 (S0 ), ξ2 (αS0 ))
+
gβ (ξ1 (S0 ), ξ2 (βS0 )) − gα (ξ1 (S0 ), ξ2 (αS0 ))
η2 (βS0 ) − η2 (αS0 ) ξ2 (βS0 )(1 + λ)β − ξ2 (αS0 )(1 − λ)α
=ρ
+
Se0 (1 + λ)β − (1 − λ)α (1 + λ)β − (1 − λ)α
−4 − (−4/3) 1.125 × 2 − (2/3) × 0.875 × 0.5
=
+
8 1.125 × 2 − 0.875 × 0.5 2 × 1.125 − 0.5 × 0.875
= 0.8965,

and
gα (ξ1 (S0 ), ξ2 (αS0 ))gβ (ξ1 (S0 ), ξ2 (βS0 ))ξ2 (βS0 )
η1 (S0 ) = Se0
ρgα (ξ1 (S0 ), ξ2 (αS0 )) − ρgβ (ξ1 (S0 ), ξ2 (βS0 ))
gβ (ξ1 (S0 ), ξ1 (βS0 ))gα (ξ1 (S0 ), ξ2 (αS0 ))ξ2 (αS0 )
−Se0
ρgα (ξ1 (S0 ), ξ2 (αS0 )) − ρgβ (ξ1 (S0 ), ξ2 (βS0 ))
gα (ξ1 (S0 ), ξ2 (αS0 ))η2 (βS0 ) − gβ (ξ1 (S0 ), ξ2 (βS0 ))η2 (αS0 )
+
gα (ξ1 (S0 ), ξ2 (αS0 )) − gβ (ξ1 (S0 ), ξ2 (βS0 ))

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 Solutions Manual

(1 − λ)α(1 + λ)βξ2 (βS0 ) e (1 + λ)β(1 − λ)αξ2 (αS0 )

= Se0 − S0
ρ(1 − λ)α − ρ(1 + λ)β (1 − λ)αρ − (1 + λ)βρ
(1 − λ)αη2 (βS0 ) − (1 + λ)βη2 (αS0 )
+
(1 − λ)α − (1 + λ)β
0.875 × 0.5 × 1.125 × 2 − 1.125 × 2 × 0.875 × 0.5 × 2/3
=8
0.875 × 0.5 − 1.125 × 2
0.875 × 0.5 × (−4) − 1.125 × 2 × (−4/3)
+
0.875 × 0.5 − 1.125 × 2
= −2.1379.

This leads to the initial option price

V0 = 0.8965 × 8 − 2.1379 = 5.0345.

Remark: Note that with λ = 0 and K = 4 we would find

8 20 44
ξ1 (S0 ) = = 0.88, η1 (S0 ) = − = −2.22, and V0 = = 4.88.
9 9 9
Therefore, the presence of transaction costs increases the price of the
option, and requires a higher stock position and a higher level of debt.
h) Please refer to the attached IPython notebook.∗

Remark: Transaction costs in the CRR model were originally introduced in

Boyle and Vorst (1992). The present solution is based on the method of
Mel′ nikov and Petrachenko (2005), which originally also takes into account
different borrowing and lending rates ρ↑ = 1 + r↑ and ρ↓ = 1 + r↓ , which can
be regarded as bid/ask prices for the riskless asset, and can also represent
transaction costs.

Problem 3.18 CRR model with dividends (1).

a) Denoting Sb2 the asset price at time 2 before the dividend is paid at the
rate α, we find that the ex-dividend asset price S2 after dividend payment
is
S2 = Sb2 − αSb2 ,
hence

V2 = ξ2 S2 + η2 A2 + αξ2 Sb2
S2
= ξ2 S2 + η2 A2 + αξ2
1−α
S2
= ξ2 + η 2 A2 .
1−α
∗


Right-click to save as attachment (may not work on .

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Introduction to Stochastic Finance with Market Examples, Second Edition

b) Denoting Sb1 the asset price at time 1 before the dividend is paid at the
rate α, we find that the ex-dividend asset price S1 after dividend payment
is
S1 = Sb1 − αSb1 ,
hence

V1 = ξ1 S1 + η1 A1 + αξ1 Sb1
S1
= ξ1 S1 + η1 A1 + αξ1
1−α
S1
= ξ1 + η 1 A1 .
1−α
c) If S1 = 3 we have

9ξ2

 1 − α + η2 2 = $1 if S2 = 9,

 2

S2
V2 = ξ2 + η 2 A2 =
1−α  3ξ2
+ η2 22 = 0 if S2 = 3,


1−α


hence (ξ2 , η2 ) = ((1 − α)/6, −1/8).

If S1 = 1 we have
3ξ2

 1 − α + η2 2 = 0 if S2 = 3,

 2

S2
V2 = ξ2 + η 2 A2 =
1−α  ξ2
+ η2 22 = 0 if S2 = 1,


1−α


hence (ξ2 , η2 ) = (0, 0).

d) We have
1−α 1 1 − 2α

 V1 = ξ2 S1 + 2η2 = 3 ×
 −2× = if S1 = 3,
6 8 4

V1 = ξ2 S1 + 2η2 = 0 × 1 + 0 × 2 = 0 if S1 = 1.


e) We have

3ξ1 1 − 2α

 1 − α + 2η1 = if S1 = 3,

4


S1
V1 = ξ1 + η 1 A1 =
1−α  ξ1
+ 2η1 = 0 if S1 = 1,


1−α


hence (ξ1 , η1 ) = ((α − 1)(2α − 1)/8, (2α − 1)/16).

f) At time k = 0 we have

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 Solutions Manual

(α − 1)(2α − 1) 2α − 1 (2α − 1)2

V0 = ξ1 S0 + η1 = + = .
8 16 16
g) Multiplying the prices (Sk )k=1,2 of the original tree by
k k  k
1 1 4
 
= = ,
1−α 1 − 1/4 3

we find the prices (S k )k=1,2 = (Sk /(1 − α)k )k=1,2 as in the following tree:
S 2 = 16
p∗

S1 = 4
p∗
q∗
S0 = 1 S 2 = 16/3
p∗
q∗
S 1 = 4/3

q∗
S 2 = 16/9

h) The market returns found in Question (g) are a = 1/3 and b = 3, with
r = 1%. Therefore we have
r−a 1 − 1/3 1 3−1 b−r 3
p∗ = = = and q ∗ = = = .
b−a 3 − 1/3 4 3 − 1/3 b−a 4

i) If S1 = 3 we have

1 p∗ 1
IE∗ (S2 − K)+ | S 1 = 3] = $1 × = ,

1+r 2 8
which coincides with
3 2 1
V1 = ξ2 S1 + 2η2 = − = .
8 8 8
If S1 = 1 we have
1
IE∗ (S2 − K)+ | S 1 = 1] = 0,

1+r
which coincides with
V1 = ξ2 S1 + 2η2 = 0.
j) At time k = 0 we have

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Introduction to Stochastic Finance with Market Examples, Second Edition

1 (p∗ )2 1
IE∗ (S2 − K)+ ] = =

,
(1 + r)2 (1 + r)2 64

which coincides with

3 1 1
V0 = ξ1 S0 + η1 = − = .
64 32 64
We also have
1 p∗ 1 1 1 1
IE∗ V1 ] = × = × =

.
1+r 1+r 8 8 8 64

Problem 3.19 CRR model with dividends (2).

a) We have
 
(1)
 (1 + b)(1 − α)Sk−1 if Rk = b 
 
(1)
Sk =
 (1 + a)(1 − α)S (1)

if Rk = a 

k−1
(1)
= (1 + Rk )(1 − α)Sk−1 , k = 1, 2, . . . , N,

and
k
(1) (1)
Y
Sk = S0 (1 + Ri ), k = 0, 1, . . . , N,
i=1

with the binary tree

(1)
(1 + b)(1 − α)S0

(1)
S0

(1)
(1 + a)(1 − α)S0

(1)
b) The asset price before dividend payment is Sk /(1−α), hence the dividend
amount is
(1) (1)
Sk (1) αSk
− Sk = ,
1−α 1−α
therefore, the dividend value represents a percentage α/(1 − α) of the ex-
(1)
dividend price Sk . Moreover, the return of the risky asset satisfies the
following relation

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 Solutions Manual

(1)
" #
∗ Sk+1 (1)
IE Fk = IE∗ (1 + Rk )Sk Fk
 
1−α
r−a (1) b−r (1)
= (1 + b)Sk + (1 + a)Sk
b−a b−a
(1)
= (1 + r)Sk , k = 0, 1, . . . , N − 1.
α (1)
c) When reinvesting the dividend amount ξk Sk into the new portfolio
1−α
allocation, we have
(1) (0)
Vk = ξk+1 Sk + ηk+1 Sk
(1) (0) α (1)
= ξk Sk + ηk Sk + ξk Sk
1−α
(1)
Sk (0)
= ξk + ηk Sk ,
1−α
at times k = 1, 2, . . . , N − 1. Moreover, at time N we will similarly have
(1)
(1) α (1) (0) S (0)
VN = ξN SN + ξN SN + ηN SN = ξN N + ηN SN ,
1−α 1−α
therefore the self-financing condition reads
(1)
Sk (0)
V k = ξk + ηk Sk , k = 1, 2, . . . , N. (S.3.9)
1−α
d) By the self-financing condition (S.3.9) we have
(1) (1)
S S
Vek − Vek−1 = ξk+1 k(0) + ηk+1 − ξk k−1
(0)
− ηk
Sk Sk−1
(1) (1)
ξk Sk Sk−1
= (0)
+ η k − ξk (0)
− ηk
Sk (1 − α) Sk−1
(1)
(1)
!
Sk Sk−1
= ξk (0)
− (0)
, k = 1, 2, . . . , N,
Sk (1 − α) Sk−1

which allows us to conclude from Question (b) that

IE∗ Vek | Fk−1 − Vek−1 = IE∗ Vek − Vek−1 | Fk−1

   

(1)
" (1)
! #
∗ Sk Sk−1
= IE ξk × (0)
− (0) Fk−1
Sk (1 − α) Sk−1

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(1)
" (1)
#
∗ Sk Sk−1
= ξk IE (0)
− (0) Fk−1
Sk (1 − α) Sk−1
" (1) # !
ξk Sk (1)
= IE∗ Fk−1 − (1 + r)Sk−1
Sk
(0) (1 − α)
= 0, k = 1, 2, . . . , N,

therefore Vek k=0,1,...,N −1 is a martingale under P∗ .

e) Assuming that the portfolio strategy attains the claim C we have C = VN

and Ce = VeN , hence by the martingale property of Vek under


k=0,1,...,N −1
P∗ , we find

Vek = IE∗ VeN Fk = IE∗ C k = 0, 1, . . . , N,

   
e Fk ,

which shows that

1
Vk = IE∗ [C | Fk ], k = 0, 1, . . . , N,
(1 + r)N −k

f) By a binomial probability computation, we have

1
Vk = IE∗ [h(SN ) | Fk ]
(1 + r)N −k
" N
! #
1 ∗
Y
= IE h x (1 + R l ) F k ,
(1 + r)N −k
l=t+1 x=Sk
(1)

1
=
(1 + r)N −k
N −k  
X N −k (1)
(p∗ )l (q ∗ )N −k−l h Sk (1 + b)k (1 + a)N −k−l (1 − α)N −k


×
l
l=0
(1)
= C0 k, Sk (1 − α)N −k , N, a, b, r .

g) We “absorb” the dividend rate α into new market returns by taking

aα , bα , rα such that

1 + aα = (1 + a)(1 − α), 1 + bα = (1 + b)(1 − α), 1 + rα = (1 + r)(1 − α),

i.e.

aα = −α + a(1 − α), bα = −α + b(1 − α), rα = −α + r(1 − α).

As a consequence, we have
1
Vk =
(1 + r)N −k

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N −k  
X N −k (1)
(p∗ )l (q ∗ )N −k−l h Sk (1 + b)k (1 + a)N −k−l (1 − α)N −k


×
l
l=0
N −k 
(1 − α)N −k X N − k

(1)
= (p∗ )k (q ∗ )N −k−l h Sk (1 + bα )k (1 + aα )N −k−l


(1 + rα )N −k l
l=0
(1)
= (1 − α)N −k C0 k, Sk , N, aα , bα , rα ,

where
rα − aα r−a
p∗ := P∗ (Rk = b) = = > 0,
bα − aα b−a
and
bα − rα b−r
q ∗ := P∗ (Rk = a) = = > 0,
bα − aα b−a
k = 1, 2, . . . , N .
h) We have
1 (1)
Vek = k = 0, 1, . . . , N,


Cα k, Sk , N, aα , bα , rα ,
(1 + r)N

hence by the martingale property we have

1 (1)
Vek =


Cα k, Sk , N, aα , bα , rα
(1 + r)k
= IE∗ Vek+1 | Fk
 

1 (1)
= IE∗ Cα k + 1, Sk+1 , N, aα , bα , rα Fk


(1 + r)k+1
1 
(1)
= p∗ Cα k + 1, Sk (1 + bα ), N, aα , bα , rα


(1 + r)k+1
(1)

+q ∗ Cα k + 1, Sk (1 + aα ), N, aα , bα , rα .

This yields
(1)
(1 + r)Cα k, Sk , N, aα , bα , rα

(1) (1)
= p∗ Cα k + 1, Sk (1 + bα ), N, aα , bα , rα + q ∗ Cα k + 1, Sk (1 + aα ), N, aα , bα , rα .

i) We find the equations


(0) (1) (1)
 ηk Sk + ξk (1 + aα )Sk−1 = Cα k, (1 + aα )Sk−1 , N, aα , bα , rα




 η S (0) + ξ (1 + b )S (1) = C k, (1 + b )S (1) , N, a , b , r
,


k k k α k−1 α α k−1 α α α

which imply

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(1) (1)
Cα k, (1 + bα )Sk−1 , N, aα , bα , rα − Cα k, (1 + aα )Sk−1 , N, aα , bα , rα



ξk = (1)
(bα − aα )Sk−1
(1)
C k, (1 + bα )Sk−1 , N, aα , bα , rα


N −k 0
= (1 − α) (1)
(bα − aα )Sk−1
(1)
C0 k, (1 + aα )Sk−1 , N, aα , bα , rα


− (1 − α)N −k (1)
,
(bα − aα )Sk−1

and
(1)
(1 + bα )Cα k, (1 + bα )Sk−1 , N, aα , bα , rα


ηk = (0)
(bα − aα )Sk−1
(1)
(1 + aα )Cα k, (1 + aα )Sk−1 , N, aα , bα , rα


− (0)
(bα − aα )Sk−1
(1)
(1 + bα )C0 k, (1 + bα )Sk−1 , N, aα , bα , rα


= (1 − α)N −k (0)
(bα − aα )Sk−1
(1)
(1 + aα )C0 k, (1 + aα )Sk−1 , N, aα , bα , rα


− (1 − α)N −k (0)
,
(bα − aα )Sk−1

k = 1, 2, . . . , N .
j) A possible answer: We have
N −k 
1

X N −k
ξk = (1)
(p∗ )k (q ∗ )N −k−l
(b − a)Sk−1 l=0 l

(1)
× h (1 − α)N −k Sk (1 + b)k+1 (1 + a)N −k−l

(1)

−h (1 − α)N −k Sk (1 + b)k (1 + a)N −k−l+1

and
N −k 
1

X N −k
ηk = (1)
(p∗ )k (q ∗ )N −k−l
(b − a)Sk−1 l=0 l

(1)
× (1 + b)h (1 − α)N −k Sk (1 + b)k (1 + a)N −k−l+1



(1)
−(1 + a)h (1 − α)N −k Sk (1 + b)k+1 (1 + a)N −k−l ,

k = 1, 2, . . . , N . Differentiation with respect to α of the general term inside

the above summations yields respectively

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 Solutions Manual

(1 + a)yh′ ((1 + a)y) − (1 + b)yh′ ((1 + b)y) (S.3.10)

for ξk , and

(1 + b)yh′ ((1 + b)y) − (1 + a)yh′ ((1 + a)y), (S.3.11)

(1)
for ηk , with y := (1 − α)N −k Sk (1 + b)k (1 + a)N −k−l and a < b.

We note that the sign of the above quantities (S.3.10)-(S.3.11) depends on

whether the function x 7−→ xh′ (x) is non-decreasing, which is the case for
example for the payoff functions h(x) = (x − K)+ and h(x) = (K − x)+
of both European call and put options.

In particular, when the function x 7−→ xh′ (x) is non-decreasing, the

amount invested on the risky (resp. riskless) asset will be lower (resp.
higher) in the presence of a higher dividend.

We also note that the expected return

p∗ (1 + b)(1 − α) + q ∗ (1 + a)(1 − α) = r(1 − α)

and the variance

p∗ (1 + b)2 (1 − α)2 + q ∗ (1 + a)2 (1 − α)2 − r2 (1 − α)2

= (1 − α)2 p∗ (1 + b)2 + q ∗ (1 + a)2 − r2

of returns are lower in the presence of dividends.

Problem 3.20
a) In order to check for arbitrage opportunities we look for a risk-neutral
probability measure P∗ which should satisfy
 (1) (1)
IE∗ Sk+1 Fk = (1 + r)Sk , k = 0, 1, . . . , N − 1.


 (1)
Rewriting IE∗ Sk+1 Fk as


 (1) (1) (1)

IE∗ Sk+1 Fk = (1 + a)Sk P∗ (Rk+1 = a | Fk ) + Sk P∗ (Rk+1 = 0 | Fk )


(1)
+(1 + b)Sk P∗ (Rk+1 = b | Fk )
(1) (1)
= (1 + a)Sk P∗ (Rk+1 = a) + Sk P∗ (Rk+1 = 0)
(1)
+(1 + b)Sk P∗ (Rk+1 = b),

k = 0, 1, . . . , N − 1, it follows that any risk-neutral probability measure

P∗ should satisfy the equations

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Introduction to Stochastic Finance with Market Examples, Second Edition

(1)
 (1 + r)Sk =





(1) (1) (1)
 (1 + b)Sk P∗ (Rk+1 = b) + Sk P∗ (Rk+1 = 0) + (1 + a)Sk P∗ (Rk+1 = a),



P∗ (Rk+1 = b) + P∗ (Rk+1 = 0) + P∗ (Rk+1 = a) = 1,


k = 0, 1, . . . , N − 1, i.e.

 bP (Rk = b) + aP∗ (Rk = a) = r,

 ∗

P∗ (Rk = b) + P∗ (Rk = a) = 1 − P∗ (Rk = 0),



k = 1, 2, . . . , N , with solution

r − (1 − P∗ (Rk = 0))a r − (1 − θ∗ )a
P∗ (Rk = b) = = ,
b−a b−a
and
(1 − P∗ (Rk = 0))b − r (1 − θ∗ )b − r
P∗ (Rk = a) = = ,
b−a b−a
k = 1, 2, . . . , N . We check that this ternary tree model is without arbitrage
if and only if there exists θ∗ := P∗ (Rk = 0) ∈ (0, 1) such that

(1 − θ∗ )a < r < (1 − θ∗ )b, (S.3.12)

or  r
 1 − b if r ≥ 0,
  

r−a b−r
0 < θ∗ < min , =
−a b
 1 − r if r ≤ 0.


a
Condition (S.3.12) is necessary in order to have

P∗ (Rk = b) > 0 and P∗ (Rk = a) > 0,

and it is sufficient because it also implies

P∗ (Rk = b) = 1 − θ∗ − P∗ (Rk = a) ≤ 1

and
P∗ (Rk = a) = 1 − θ∗ − P∗ (Rk = b) ≤ 1.
b) We will show that this ternary tree model is without arbitrage if and only
if a < r < b.

(i) Indeed, if the condition a < r < b is satisfied there always exists
θ ∈ (0, 1) such that

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 Solutions Manual

a < (1 − θ)a < r < (1 − θ)b < b,

as can be seen by taking

  
r−a b−r
θ∈ 0, min , ,
−a b

hence there exists a risk-neutral probability measure P∗θ , and the market
model is without arbitrage.

(ii) Conversely, if this ternary tree model is without arbitrage there exists
some θ = P∗ (Rt = 0) ∈ (0, 1) such that

(1 − θ)a < r < (1 − θ)b.

c) When r ≤ a < 0 < b the risky asset overperforms the riskless asset,
therefore we can realize arbitrage by borrowing from the riskless asset to
purchase the risky asset. When a < 0 < b ≤ r the riskless asset overper-
forms the risky asset, therefore we can realize arbitrage by shortselling
the risky asset and save the profit of the short sale on the riskless asset.
d) Under the absence of arbitrage condition a < r < b, every value of θ ∈
(0, 1) such that  
r−a b−r
0 < θ < min ,
−a b
satisfies
(1 − θ)a < r < (1 − θ)b,
and gives rise to a different risk-neutral probability measure, hence the
risk-neutral measure is not unique and by Theorem 5.11 this ternary tree
model is not complete.

In particular, every risk-neutral probability measure P∗θ will give rise to a

different claim price

(θ) 1
πt (C) = IE∗ C Ft , t = 0, 1, . . . , N.
 
(1 + r)N −t θ

e) We have
(1) (1)
" #
Sk+1 − Sk
Var∗ (1)
Fk
Sk

(1) (1)
!2  " (1) (1)
#!2
∗ Sk+1 − Sk Sk+1 − Sk
= IE  (1)
Fk  − IE∗ (1)
Fk
Sk Sk

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Introduction to Stochastic Finance with Market Examples, Second Edition


(1) (1)
!2 
∗ Sk+1 − Sk
= IE  (1)
Fk  − r 2
Sk
= a2 P∗σ (Rk+1 = a | Fk ) + b2 P∗σ (Rk+1 = b | Fk ) − r2
(1 − P∗σ (Rk+1 = 0))b − r r − (1 − P∗σ (Rk+1 = 0))a
= a2 + b2 − r2
b−a b−a
= ab(θ − 1) + r(a + b) − r2
= σ2 ,

k = 0, 1, . . . , N − 1, hence

σ 2 + r2 − r(a + b)
P∗σ (Rk = 0) = θ = 1 + ,
ab
and therefore
r − (1 − P∗σ (Rk = 0))a σ 2 − r(a − r)
P∗σ (Rk = b) = = ,
b−a b(b − a)

and
(1 − P∗σ (Rk = 0))b − r r(b − r) − σ 2
P∗σ (Rk = a) = = ,
b−a a(b − a)
k = 1, 2, . . . , N , under the condition

σ 2 > max(−r(r − a), r(b − r)),

in addition to the condition 0 < θ < 1, i.e.

r(b − r) + rb < σ 2 < (b − r)(r − a).

Finally, we find
−r(r − a) < σ 2 < (b − r)(r − a),
if r ∈ (a, 0], and
r(b − r) < σ 2 < (b − r)(r − a),
if r ∈ [0, b).
f) In this case the ternary tree becomes a trinomial recombining tree, and
the expression of the risk-neutral probability measure becomes

r(b + 1) + (1 − θ)b
P∗θ (Rk = b) = ,
b2 + 2b
and
(1 − θ)b − r
P∗θ (Rk = a) = (b + 1) ,
b2 + 2b

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 Solutions Manual

k = 1, 2, . . . , N . The market model is without arbitrage if and only if there

exists θ := P∗θ (Rk = 0) ∈ (0, 1) such that

b
−(1 − θ) < r < (1 − θ)b,
b+1
or
r
0<θ <1− .
b
g) Using the tower property of conditional expectations, we have

(1)
1
f k, Sk = IE∗ [C | Fk ]
(1 + r)N −k
1
= IE∗ [IE∗ [C | Fk+1 ] | Fk ]
(1 + r)N −k
1 (1)

= IE∗ (1 + r)N −(k+1) f k + 1, Sk+1 Fk
 
(1 + r)N −k
1 (1)

= IE∗ f k + 1, Sk+1 Fk
 
1+r
1  (1) (1)

= f k + 1, Sk (1 + a) P∗θ (Rk = a) + f k + 1, Sk P∗θ (Rk = 0)


1+r

(1)
+f k + 1, Sk (1 + b) P∗θ (Rk = b) .

h) In this case we have f (N, x) = (K − x)+ .

i) See the attached code.∗†
j) Taking θ = 0.5 we find the following graph:

4.0 0.0

2.0 2.0 0.24 0.0

1.0 1.0 1.0 0.74 0.82 1.0

0.5 0.5 1.32 1.5

0.25 1.75

(a) Underlying asset prices. (b) Put option prices.

Fig. S.12: Put option prices in the trinomial model.

∗
Download the modified (trinomial) IPython notebook that can be run here or
here.
†
Download the corresponding (binomial) IPython notebook. The Anaconda distri-
bution can be installed from https://www.anaconda.com/distribution/ or tried online
at https://jupyter.org/try.

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Introduction to Stochastic Finance with Market Examples, Second Edition

There also exists extensions of the trinomial model to five states (pentanomial
model), six states (hexanomial model), etc.

Chapter 4

Exercise 4.1 If 0 ≤ s ≤ t, using the facts that IE[Bt ] = 0 and IE Bt2 = 0,

 

t ≥ 0, we have

IE[Bt Bs ] = IE[(Bt − Bs )Bs ] + IE Bs2

 

= IE[(Bt − Bs )] IE[Bs ] + IE Bs2

 

= 0+s
= s,

and similarly we obtain IE[Bt Bs ] = t when 0 ≤ t ≤ s, hence in general we

have
IE[Bt Bs ] = min(s, t), s, t ≥ 0.

Exercise 4.2 We need to check whether the four properties of the definition
of Brownian motion are satisfied.
a) Conditions 1-2-3 can be checked using the time shift t 7→ c + t. As for
Condition 4, Bc+t − Bc+s clearly has the centered Gaussian distribution
with variance c + t − (c + s) = t − s. We conclude that (Bc+t − Bc )t∈R+
is a standard Brownian motion.
b) We note that Bct2 is a centered Gaussian random variable with variance
ct2 - not t, hence (Bct2 )t∈R+ is not a standard Brownian motion when
c ̸= 1.
c) Similarly, checking Conditions 1-2-3 does not pose any particular problem
using the time change t 7→ t/c2 . As for Condition 4, Bc+t − Bc+s clearly
has a centered Gaussian distribution with

Var c Bt/c2 − Bs/c2 = c2 Var Bt/c2 − Bs/c2

= (t − s)c2 /c2
= t − s.

As a consequence, Bt/c2 t∈R+ is a standard Brownian motion.

d) This process does not have independent increments, hence it cannot be a

Brownian motion. For example, by (4.1) we have

IE Bt + Bt/2 − Bs + Bs/2 Bs + Bs/2






= IE Bt Bs + Bt Bs/2 + Bt/2 Bs + Bt/2 Bs/2

 

− IE Bs Bs + Bs Bs/2 + Bs/2 Bs + Bs/2 Bs/2

 

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 Solutions Manual

s s s s s
= s+ +s+ −s− − −
2 2 2 2 2
s
= ,
2
which differs from 0, hence the two increments are not independent. In-
deed, independence of Bt + Bt/2 − Bs + Bs/2 ) and Bs + Bs/2 would yield

IE Bt + Bt/2 − Bs + Bs/2 ) Bs + Bs/2 )




= IE Bt + Bt/2 − Bs + Bs/2 ) IE Bs + Bs/2 )

   

= 0.

Exercise 4.3 By Definition 4.5, we have

wT
2dBt = 2(BT − B0 ) = 2BT ,
0

which has a Gaussian distribution with mean 0 and variance 4T . On the other
hand, by Definition 4.5 again, we have
wT
(2 × 1[0,T /2] (t) + 1(T /2,T ] (t))dBt = 2(BT /2 − B0 ) + (BT − BT /2 )
0
= BT + BT /2 ,

which has a Gaussian distribution with mean 0 and variance

Var[BT + BT /2 ] = Var[(BT − BT /2 ) + 2BT /2 ]

= Var[BT − BT /2 ] + 4 Var[BT /2 ]
T 4T
= +
2 2
5T
= .
2
Equivalently, using the Itô isometry (4.8), we have
w 
T
Var (2 × 1[0,T /2] (t) + 1(T /2,T ] (t))dBt
0
wT
" 2 #
= IE (2 × 1[0,T /2] (t) + 1(T /2,T ] (t))dBt
0
wT
2 × 1[0,T /2] (t) + 1(T /2,T ] (t) dt

2
=
0
w T /2 wT
=4 dt + dt
0 T /2
5T
= .
2

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Introduction to Stochastic Finance with Market Examples, Second Edition

w 2π
Exercise 4.4 By Proposition 4.12, the stochastic integral sin(t) dBt has
0
a Gaussian distribution with mean 0 and variance
w 2π 1 w 2π
sin2 (t)dt = (1 − cos(2t))dt = π.
0 2 0

Exercise 4.5 By the Itô formula (4.28), we have

d(f (t)Bt ) = f (t)dBt + Bt df (t) + df (t) • dBt

= f (t)dBt + Bt f ′ (t)dt + f ′ (t)dt • dBt
= f (t)dBt + Bt f ′ (t)dt,

and by integration on both sides we get

wT wT wT
f (t)dBt + Bt f ′ (t)dt = d(f (t)Bt )
0 0 0
= f (T )BT − f (0)B0
= 0,

since f (T ) = 0 and B0 = 0, hence the conclusion. Note that this result can
also be obtained by integration by parts on the interval [0, T ], see (4.11).

Exercise 4.6
r1
a) The stochastic integral 0 t2 dBt is a centered Gaussian random variable
with variance
w1 2 # w
"
1 1
IE 2
t dBt = t4 dt = .
0 0 5
r 1 −1/2
b) The stochastic integral 0 t dBt has the variance

w1 2 # w
"
1 1
IE t −1/2
dBt = dt = +∞.
0 0 t

r1
In fact, the stochastic integral 0 t−1/2 dBt does not exist as a random
variable in L (Ω) because the function t 7→ t−1/2 is not in L2 ([0, 1]).
2

Remark. Writing Relation (4.11) with f (t) = t−1/2 gives

w1 BT 1 w 1 −3/2
t−1/2 dBt = √ + t Bt dt,
0 T 2 0

however this is only a formal statement as f is not in C 1 ([0, 1]). Informally,

wT
we can check that the term t−3/2 Bt dt has the infinite variance
0

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 Solutions Manual

w w  w
" 2 # 
T T T
IE Bt f ′ (t)dt = IE Bt f ′ (t)dt Bs f ′ (s)ds
0 0 0
w w 
T T
= IE Bs Bt f ′ (s)f ′ (t)dsdt
0 0
wT wT
= f ′ (s)f ′ (t) IE[Bs Bt ]dsdt
0 0
w w
1 T T −3/2 −3/2
= s t min(s, t)dsdt
4 0 0
1 w T w t 1 w T −5/2 w T −3/2
= t−3/2 s−5/2 dsdt + t s dsdt
4 0 0 4 0 t
1 w T −3/2 w t −5/2 1 w T −5/2 w T −3/2
= t s dsdt + t s dsdt
4 0 0 4 0 t
= +∞,

where we used Relation (4.1) or the result of Exercise 4.1

Exercise 4.7
a) By Proposition 4.12, the probability distribution of Xn is Gaussian with
mean zero and variance
w 2π
" 2 #
Var[Xn ] = IE sin(nt)dBt
0
w 2π
= sin2 (nt)dt
0
w
1 2π 1 w 2π
= cos(0)dt − cos(2nt)dt
2 0 2 0
= π, n ≥ 1.

b) The random variables (Xn )n≥1 have same Gaussian distribution, and they
are pairwise independent as from Corollary 4.13 we have
w w 2π 
2π
IE[Xn Xm ] = IE sin(nt)dBt sin(mt)dBt
0 0
w 2π
= sin(nt) sin(mt)dt
0
1 w 2π 1 w 2π
= cos((n − m)t)dt − cos((n + m)t)dt
2 0 2 0
=0

and the vector (Xn , Xm ) is jointly Gaussian, for n, m ≥ 1 such that n ̸=

m. Note that this condition implies independence only when the random
variables have a Gaussian distribution.

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Introduction to Stochastic Finance with Market Examples, Second Edition

Exercise 4.8 We have Xt = f (Bt ) with f (x) = sin2 x, f ′ (x) = 2 sin x cos x =
sin(2x), and f ′′ (x) = 2 cos(2x), hence

dXt = d sin2 (Bt )

= df (Bt )
1
= f ′ (Bt )dBt + f ′′ (Bt )dt
2
= sin(2Bt )dBt + cos(2Bt )dt.

Exercise 4.9
a) Using the Itô isometry (4.16), we have
w  wT 
T
IE BT3 = IE dBt T + 2
 
Bt dBt
0 0
w  w wT 
T T
= T IE dBt + 2 IE dBt Bt dBt
0 0 0
w 
T
= 2 IE Bt dt
0
wT
=2 IE[Bt ]dt
0
= 0.

We also have
wT
" 2 #
IE BT4 = IE T +2
 
Bt dBt
0

wT w
" 2 #
T
= IE T + 4T2
Bt dBt + 4 Bt dBt
0 0
w  "
w 2 #
T T
= T 2 + 4T IE Bt dBt + 4 IE Bt dBt
0 0
w 
T
= T 2 + 4 IE |Bt |2 dt
0
wT
= T +4
2
IE |Bt |2 dt
 
0
wT
= T2 + 4 tdt
0
2
T
= T2 + 4
2
= 3T 2 .

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b) If X ≃ N (0, σ 2 ), we have X ≃ BT with σ 2 = T , hence the answer to

Question (a) yields

IE X 3 = 0 and IE X 4 = 3σ 4 .
   

We note that those moments can be recovered directly from the Gaussian
probability density function as
1 w∞ 2 2
IE X 3 = √ x3 e−x /(2σ ) dx = 0
 
2πσ −∞
2

and w∞
1 2 2
IE X 4 = √ x4 e−x /(2σ ) dx = 3σ 4 .
 
2πσ −∞
2

Exercise 4.10 Taking expectation on both sides of (4.39) shows that

0 = IE (BT )3
 
 wT 
= IE C + ζt,T dBt
0
w 
T
= C + IE ζt,T dBt
0
=0

by (4.17), hence C = 0. Next, applying Itô’s formula to the function f (x) = x3

shows that

(BT )3 = f (BT )
wT 1 w T ′′
= f (B0 ) + f ′ (Bt )dBt + f (Bt )dt
0 2 0
wT wT
=3 Bt2 dBt + 3 Bt dt.
0 0

By the integration by parts formula (4.11) applied to f (t) = t, we find

wT wT wT
Bt dt = T BT − tdBt = (T − t)dBt ,
0 0 0

hence
wT  wT 
(BT )3 = 3 Bt2 dBt + 3 T BT − tdBt
0 0
wT
=3 (T − t + Bt2 )dBt ,
0

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Introduction to Stochastic Finance with Market Examples, Second Edition

and we find ζt,T = 3(T − t + Bt2 ), t ∈ [0, T ]. This type of stochastic integral
decomposition can be used for option hedging, cf. Section 7.5.

Exercise 4.11
a) We have
h rT i rt h rT i
IE e 0 f (s)dBs Ft = e 0 f (s)dBs IE e t f (s)dBs Ft
rt h rT i
= e 0 f (s)dBs IE e t f (s)dBs
w
1wT

t
= exp f (s)dBs + |f (s)|2 ds ,(S.4.13)
0 2 t

0 ≤ t ≤ T , where we used the Gaussian moment generating function

2
wT
IE eX = eσ /2 for X ≃ N (0, σ 2 ) and the fact that f (s)dBs ≃
 
 w  t
T
N 0, f 2 (s)ds by Proposition 4.12.
t
b) We have
w
1wt 2
  
t
IE exp f (s)dBs − f (s)ds Fu
0 2 0
1wt 2
   w  
t
= exp − f (s)ds IE exp f (s)dBs Fu
2 0 0

1wt 2
   w wt  
u
= exp − f (s)ds IE exp f (s)dBs + f (s)dBs Fu
2 0 0 u
w
1wt 2
  w  
u t
= exp f (s)dBs − f (s)ds IE exp f (s)dBs Fu
0 2 0 u
w
1wt 2
  w 
u t
= exp f (s)dBs − f (s)ds IE exp f (s)dBs
0 2 0 u
w
1wt 2 1wt 2

u
= exp f (s)dBs − f (s)ds + f (s)ds
0 2 0 2 u
w
1wu 2

u
= exp f (s)dBs − f (s)ds , 0 ≤ u ≤ t.
0 2 0

This result can also be obtained by directly applying (S.4.13).

c) We apply the conclusion of Question (b) to the constant function f (t) :=
σ, t ≥ 0.

Exercise 4.12 We have

(1) (2)

dSt = d St − St
(1) (2)
= dSt − dSt

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 Solutions Manual

(1) (1) (2) (2)

= µSt dt + σ1 dWt − µSt dt + σ2 dWt
(1) (2)
(1) (2)
= µ St − µSt dt + σ1 dWt − σ2 dWt .
(1) (2)
The process Mt := σ1 Wt − σ2 Wt is a continuous martingale, with
(1) (2)
(1) (2)

dMt • dMt = σ1 dWt − σ2 dWt • σ1 dWt − σ2 dWt
(1) (1) (1) (2) (2) (2)
= σ12 dWt • dWt − 2σ1 σ2 dWt • dWt + σ22 dWt • dWt
= (σ12 − 2ρσ1 σ2 + σ22 )dt.

Therefore, letting q
σ := σ12 − 2ρσ1 σ2 + σ22
and
Mt σ1 (1) σ2 (2)
Wt := = W − Wt ,
σ σ t σ
by the Lévy characterization theorem, see e.g. Theorem IV.3.6 in Revuz
and Yor (1994), the process (Wt )t∈R+ is a standard Brownian motion with
quadratic variation dWt • dWt = dt, with
(1) (2)
(1) (2)
dSt = µ St − St dt + σ1 dWt − σ2 dWt
= µSt dt + σdWt .

Remark: Since ρ ∈ [−1, 1], we have

σ12 − 2ρσ1 σ2 + σ22 ≥ σ12 − 2σ1 σ2 + σ22 = (σ1 − σ2 )2 ≥ 0.

Exercise 4.13
a) Using (4.31), we have
  w 
T 2
IE exp β = IE eβ(BT −T )/2
 
Bt dBt
0
h 2
i
= e−βT /2 IE eβ(BT ) /2
e−βT /2 w ∞ βx2 /2 −x2 /(2T )
= √ e e dx
2πT −∞
e−βT /2 w ∞ (β−1/T )x2 /2
= √ e dx
2πT −∞
e−βT /2 w ∞ e−x /(2/(1/T −β))
2

= √ dx
1 − βT −∞ 2π/(1/T − β)
p

e−βT /2
= √ ,
1 − βT

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for all β < 1/T , knowing

√ that BT ≃ N (0, T ).
b) The function β 7→ 1/ 1 − βT can be identified as the moment generating
function of the gamma distribution with shape parameter λ = 1/2, scaling
parameter 1/T and probability density function
1
y 7→ (yT )−1/2 e−y/T ,
Γ (1/2)

due to the relation

T −λ w ∞ βy λ−1 −y/T 1
e y e dy = , β < 1/T,
Γ (λ) 0 (1 − βT )λ
wT
therefore T + Bt dBt = BT2 has a gamma distribution with shape
0
parameter 1/2 and scaling parameter T . In other words, the square
wT √
1+ Bt dBt /T = BT2 /T of the normal random variable BT / T ≃
0
N (0, 1) has a χ2 distribution with one degree of freedom.

Exercise 4.14
a) Letting Yt = ebt Xt , we have

dYt = d(ebt Xt )
= bebt Xt dt + ebt dXt
= bebt Xt dt + ebt (−bXt dt + σe−bt dBt )
= σdBt ,

hence wt wt
Yt = Y0 + dYs = Y0 + σ dBs = Y0 + σBt ,
0 0
and
Xt = e−bt Yt = e−bt Y0 + σe−bt Bt = e−bt X0 + σe−bt Bt .
Alternatively, we can also search for a solution Xt of the form Xt =
f (t, Bt ), with

∂f ∂f 1 ∂2f
dXt = df (t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂x2
from the Itô formula. Matching this expression to the stochastic differen-
tial equation (4.40) would yield

∂f 1 ∂2f
(t, Bt ) + (t, Bt )dt = −bXt = −bf (t, Bt )
∂t 2 ∂x2
and

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∂f
(t, Bt ) = σe−bt ,
∂x
hence
∂f 1 ∂2f ∂f
(t, x) + (t, x)dt = −bf (t, x) and (t, x) = σe−bt ,
∂t 2 ∂x2 ∂x
x ∈ R, which can be solved as f (t, x) = f (t, 0) + σxe−bt and

∂f
(0, x) = −bf (t, 0),
∂t
which gives f (t, 0) = f (0, 0)e−bt , and recovers

Xt = f (t, Bt ) = X0 e−bt + σe−bt Bt , t ≥ 0.

b) Letting Yt = e Xt , we have
bt

dYt = d(ebt Xt )
= bebt Xt dt + ebt dXt
= bebt Xt dt + ebt − bXt dt + σe−at dBt

= σe(b−a)t dBt ,

hence we can solve for Yt by integrating on both sides as

wt wt
Yt = Y0 + dYs = Y0 + σ e(b−a)s dBs , t ≥ 0.
0 0

This yields the solution

wt
Xt = e−bt Yt = e−bt X0 + σe−bt e(b−a)s dBs , t ≥ 0.
0

Comments:
(i) This type of computation appears anywhere discounting by the factor
e−bt is involved.
(ii) In part (b) the solution cannot take the form Xt = f (t, Bt ) when
a ̸= b. Indeed, solving
∂f
(t, x) = σe−at
∂x
gives f (t, x) = f (t, 0) + σxe−at , yielding

∂f 1 ∂2f ∂f
(t, x) + (t, x) = (t, 0) − aσxe−at ,
∂t 2 ∂x2 ∂t
which cannot match −bf (t, x) unless a = b.

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wt
(iii) The stochastic integral e(b−a)s dBs cannot be computed in closed
0
form. It is a centered Gaussian random variable with variance
wt e2(b−a)t − 1
e2(b−a)s ds =
0 2(b − a)

if b ̸= a, and variance t if a = b. Using integration by parts on [0, t],

we may also write
wt wt
e−(a+r)s dBs = e−(a+r)t Bt + (a + r) e−(a+r)s Bs ds, t ≥ 0.
0 0

Exercise 4.15
a) Note that the stochastic integral
wT 1
dBs
0 T −s
is not defined in L2 (Ω) as the function s 7→ 1/(T − s) is not in L2 ([0, T ]),
and by the Itô isometry (4.8) we have

wT 1 2 # w
" ∞
1 1

T
IE dBs = ds = = +∞.
0 T −s 0 (T − s) 2 T −s 0

On the other hand, by (4.27) and (4.42) we have

1 1
     
Xt dXt
d = + Xt d + dXt • d
T −t T −t T −t T −t
dXt Xt
= + dt
T − t (T − t)2
dBt
=σ ,
T −t
hence, by integration over the time interval [0, t] and using the initial
condition X0 = 0, we find

X0 w t w t dB
 
Xt Xs s
= + d =σ , 0 ≤ t < T.
T −t T 0 T −s 0 T −s

b) By (4.17), we have
w
1

t
IE[Xt ] = (T − t)σ IE dBs = 0, 0 ≤ t < T.
0 T −s

c) By the Itô isometry (4.8), we have

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 Solutions Manual

w
1

t
Var[Xt ] = (T − t)2 σ 2 Var dBs
0 T −s
wt 1
" 2 #
= (T − t)2 σ 2 IE dBs
0 T −s
wt 1
= (T − t)2 σ 2 ds
0 (T − s)2

1 1
 
= (T − t)2 σ 2 −
T −t T
T − t
= σ2 t , 0 ≤ t < T.
T
d) We have

t2
 
lim ∥Xt ∥L2 (Ω) = lim Var[Xt ] = σ 2 lim t− = 0.
t→T t→T t→T T

Exercise 4.16 Exponential Vašíček (1977) model (1). Applying the Itô for-
mula (4.29) to Xt = ert = f (rt ) with f (x) = ex , we have

dXt = dert
1
= f ′ (rt )drt + f ′′ (rt )drt • drt
2
1
= ert drt + ert drt • drt
2
1
= ert ((a − brt )dt + σdBt ) + ert ((a − brt )dt + σdBt )2
2
σ 2 rt
= e ((a − brt )dt + σdBt ) +
rt
e dt
 2
 2
σ
= Xt a + − b log(Xt ) dt + σXt dBt
2
= Xt (e a − ebf (Xt ))dt + σg(Xt )dBt ,

hence
σ2
a=a+ and eb = b
2
e

the functions f (x) and g(x) are given by f (x) = log x and g(x) = x. Note
that this stochastic differential equation is that of the exponential Vasicek
model.

Exercise 4.17 Exponential Vasicek model (2).

wt
a) We have Zt = e−at Z0 + σ e−(t−s)a dBs .
0

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Introduction to Stochastic Finance with Market Examples, Second Edition

θ wt
b) We have Yt = e−at Y0 + 1 − e−at + σ e−(t−s)a dBs .


 a 2  0
σ
c) We have dXt = Xt θ + − a log Xt dt + σXt dBt .
2

θ wt 
d) We have rt = exp e−at log r0 + 1 − e−at + σ e−(t−s)a dBs .


a 0
2
e) Using the Gaussian moment generating function identity IE[eX ] = eα /2
for X ≃ N (0, α2 ) and the variance formula (4.10), we have
 
θ wt  
IE[rt | Fu ] = IE exp e−at log r0 + 1 − e−at + σ e−(t−s)a dBs


Fu
a 0

r   w  
t
e−at log r0 + a
θ
1−e−at +σ 0u e−(t−s)a dBs
=e IE exp σ e−(t−s)a dBs Fu
u

ru   w 
−at θ −at −(t−s)a t
= ee log r0 + a 1−e +σ 0 e dBs
IE exp σ e−(t−s)a dBs
u

θ wu σ 2 w t −2(t−s)a

= exp e −at
log r0 + 1 − e −at
+σ e −(t−s)a
dBs + e


ds
a 0 2 u

θ wu σ 2

= exp e−at log r0 + 1 − e−at + σ e−(t−s)a dBs + 1 − e−2(t−u)a



a 0 4a
 
θ wu 
= exp e −(t−u)a
e−au
log r0 + 1 − e −au
+σ e−(u−s)a


dBs
a 0
2

θ σ
+ 1 − e−(t−u)a + 1 − e−2(t−u)a



a 4a

σ2
 
θ
= exp e−(t−u)a log ru + 1 − e−(t−u)a + 1 − e−2(t−u)a


a 4a
2
 
−(t−u)a θ σ
= rue exp 1 − e−(t−u)a + 1 − e−2(t−u)a .



a 4a

In particular, for u = 0 we find

σ2
 
−at θ
IE[rt ] = r0e exp + 1 − e−at + 1 − e−2at .


a 4a

f) Similarly, we have
 
2θ wt  
IE[rt2 | Fu ] = IE exp 2e−at log r0 + 1 − e−at + 2σ e−(t−s)a dBs


Fu
a 0
r
  w  
t


2e−at log r0 + 2θ 1−e−at +2σ 0u e−(t−s)a dBs
=e a IE exp 2σ e−(t−s)a dBs Fu
u
r u −(t−s)a
  w 
t


2e−at log r0 + 2θ −at
=e a 1−e +2σ 0
e dBs
IE exp 2σ e−(t−s)a dBs
u

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2θ wu wt 
= exp 2e−at log r0 + 1 − e−at + 2σ e−(t−s)a dBs + 2σ 2 e−2(t−s)a ds


a 0 u

2θ wu σ 2

= exp 2e−at log r0 + 1 − e−at + 2σ e−(t−s)a dBs + 1 − e−2(t−u)a



a 0 a
 
2θ wu 
= exp 2e −(t−u)a
2e −au
log r0 + 1−e −au
+ 2σ e −(u−s)a


dBs
a 0

2θ 2

σ
+ 1 − e−(t−u)a + 1 − e−2(t−u)a



a a
2θ
σ2
 
= exp 2e−(t−u)a log ru + 1 − e−(t−u)a + 1 − e−2(t−u)a


a a
2θ 2
 
−(t−u)a σ
= ru2e exp 1 − e−(t−u)a + 1 − e−2(t−u)a ,



a a

hence

Var[rt | Fu ] = IE[rt2 | Fu ] − (IE[rt | Fu ])2

2θ
σ2
 
−(t−u)a
= ru2e exp 1 − e−(t−u)a + 1 − e−2(t−u)a


a a
2θ
σ2
 
2e−(t−u)a
exp 1−e −(t−u)a
+ 1 − e−2(t−u)a


−ru
a 2a
2θ
σ2
 
2e−(t−u)a
= ru exp 1−e −(t−u)a
+ 1 − e−2(t−u)a


a a
σ2
  
× 1 − exp − 1−e −2(t−u)a


.
2a

σ2
 
θ
g) We find lim IE[rt ] = r0 exp + and
t→∞ a 4a

2θ σ 2 σ2
   
lim Var[rt ] = exp + 1 − exp −
t→∞ a a 2a
2θ
   2 
σ
= exp exp −1 .
a a

Exercise 4.18 Cox-Ingersoll-Ross (CIR) model.

a) We have
wt wt√
rt = r0 + (α − βrs )ds + σ rs dBs , t ≥ 0. (S.4.14)
0 0

b) Taking expectations on both sides of (S.4.14) and using the fact that the
expectation of the stochastic integral with respect to Brownian motion is
zero, we find

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u(t) = IE[rt ]
 wt wt√ 
= IE r0 + (α − βrs )ds + σ rs dBs
0 0
 wt 
= IE r0 + (α − βrs )ds
0
w 
t
= r0 + IE (α − βrs )ds
0
wt
= r0 + (α − β IE[rs ])ds
0
wt
= r0 + (α − βu(s))ds,
0

which yields the differential equation u′ (t) = α − βu(t). Letting w(t) :

eβt u(t), we have

w′ (t) = βeβt u(t) + eβt u′ (t) = αeβt ,

hence

IE[rt ] = u(t)
= e−βt w(t)
 wt 
= e−βt w(0) + α eβs ds
0
 
α βt
=e −βt
u(0) + (e − 1)
β
α
= e r0 +
−βt
1 − e−βt , t ≥ 0. (S.4.15)


β

c) By applying Itô’s formula (4.29) to

 wt wt√ 
rt2 = f r0 + (α − βrs )ds + σ rs dBs ,
0 0

with f (x) = x , we find

2

1
d(rt )2 = f ′ (rt )drt + f ′′ (rt )drt • drt
2
= 2rt drt + drt • drt
3/2
= rt (σ 2 + 2α − 2βrt )dt + 2σrt dBt

or, in integral form,

wt wt
rt2 = r02 + rs (σ 2 + 2α − 2βrs )ds + 2σ rs3/2 dBs , t ≥ 0. (S.4.16)
0 0

d) Taking again the expectation on both sides of (S.4.16), we find

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v(t) = IE[rt2 ]
 wt wt 
= IE r02 + rs (σ 2 + 2α − 2βrs )ds + 2σ rs3/2 dBs
0 0
w 
t
= r02 + IE rs (σ 2 + 2α − 2βrs )ds
0
wt
= r02 +
(σ 2 IE[rs ] + 2α IE[rs ] − 2β IE[rs2 ])ds
0
wt
= v(0) + (σ 2 u(s) + 2αu(s) − 2βv(s))ds,
0

and after differentiation with respect to t this yields the differential equa-
tion
v ′ (t) = (σ 2 + 2α)u(t) − 2βv(t), t ≥ 0.
By (S.4.15) we find
   
α α −βt
v ′ (t) = (σ 2 + 2α) + r0 − e − 2βv(t), t ≥ 0.
β β

Looking for a solution of the form

v(t) = c0 + c1 e−βt + c2 e−2βt , t ≥ 0,

we find

v ′ (t) = −βc1 e−βt − 2βc2 e−2βt

   
α α −βt
= (σ 2 + 2α) + r0 − e − 2β(c0 + c1 e−βt + c2 e−2βt )
β β
 
α α −βt
= (σ 2 + 2α) + (σ 2 + 2α) r0 − e − 2βc0 − 2βc1 e−βt − 2βc2 e−βt ,
β β

t ≥ 0, hence
α 2
0 = β (σ + 2α) − 2βc0 ,




 
 α
−βc1 = (σ 2 + 2α) r0 − − 2βc1 ,


β

and
σ 2 + 2α
 
α α
c0 = (σ 2 + 2α), c1 = r0 − ,
2β 2 β β
with
r02 = v(0) = c0 + c1 + c2 ,
which yields

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c2 = r02 − c0 − c1
σ 2 + 2α
 
α α
= r02 − 2 (σ 2 + 2α) − r0 −
2β β β
 
r0 α
= r0 − (σ + 2α)
2 2
− 2 ,
β 2β

and

IE[rt2 ] = v(t)
= c0 + c1 e−βt + c2 e−2βt
σ 2 + 2α
 
α α −βt
= (σ 2
+ 2α) + r 0 − e
2β 2 β β
  
r0 α
+ r02 − (σ 2 + 2α) − 2 e−2βt , t ≥ 0.
β 2β

e) We have

Var[rt ] = IE[rt2 ] − (IE[rt ])2

σ 2 + 2α
 
α α −βt
= (σ 2 + 2α) + r0 − e
2β 2 β β
  
r0 α
+ r02 − (σ 2 + 2α) − 2 e−2βt
β 2β
   2
α α −βt
− + r0 − e
β β
σ 2 + 2α
 
α α −βt
= (σ 2
+ 2α) + r0 − e
2β 2 β β
  
r0 α
+ r02 − (σ 2 + 2α) − 2 e−2βt
β 2β
 2  2 !
2α
 
α α −βt α α
− − r0 − e − r0 − 2r0 +
2
e−2βt
β β β β β
σ 2 −βt ασ 2 ασ 2 ασ 2 −2βt
= r0 e − e−2βt + − 2 e−βt + e


β 2β 2 β 2β 2
σ 2 −βt ασ 2
2
= r0 e − e−2βt + 1 − e−βt , t ≥ 0.


β 2β 2

Problem 4.19
a) The Itô formula cannot be applied to the function f (x) := (x − K)+
because it is not (twice) differentiable.
b) The function x 7→ fε (x) can be plotted as follows with K = 1.

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fε

0
0 K-ε K K+ε
x

Fig. S.13: Graph of the function x 7→ fε (x).

We note that fε converges uniformly on R to the function x 7→ (x − K)+

as we have
ε
0 ≤ fε (x) − (x − K)+ ≤ , x ∈ R. (S.4.17)
4
c) Applying the Itô formula to the function fε we find
wT 1 w T ′′
fε (BT ) = fε (B0 ) + fε′ (Bt )dBt + f (Bt )dt
0 2 0 ε
wT 1 w T
= fε (B0 ) + fε′ (Bt )dBt + 1(K−ε,K+ε) (Bt )dt,
0 4ε 0
and to conclude it suffices to note that
wT
t ∈ [0, T ] : K − ε < Bt < K + ε = 1(K−ε,K+ε) (Bt )dt.


ℓ
0

d) The derivative fε′ (x) of fε (x) is given by

1 if x > K + ε,





1


fε′ (x) := (x − K + ε) if K − ε < x < K + ε,

 2ε



0 if x < K − ε.


Hence we have
w∞
∥1[K,∞) (·) − fε′ (·)∥2L2 (R+ ) = 1[K,∞) (x) − fε′ (x) dx

2
0
w K+ε
= 1 + |fε′ (x)|2 dx


K−ε
1 w K+ε
2
≤ 2ε + 2 x − K + ε dx
4ε K−ε
1 h
3 iK+ε
= 2ε + x−K +ε
12ε2 K−ε

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f'ε

0
0 K-ε K K+ε
x

Fig. S.14: Graph of the derivative x 7→ fε′ (x).

2ε
= 2ε + .
3
e) i) We have
w  wT
T h
2 i
1[K,∞) (Bt ) − fε′ (Bt ) dt = 1[K,∞) (Bt ) − fε′ (Bt )

2
IE IE dt
0 0
wT w∞ 1
1[K,∞) (x) − fε′ (x) e−x

2 2
= /(2t)
dx √ dt
0 −∞ 2πt
w T w K+ε 1
1[K,∞) (x) − fε′ (x) e−(K−ε)

2 2
/(2t)
≤ dx √ dt
0 K−ε 2πt
wT 1
≤ ∥1[K,∞) (·) − fε′ (·)∥2L2 (R+ )
2
e−(K−ε) /(2t) √ dt
0 2πt
w
2ε 1

T 2
≤ 2ε + e−(K−ε) /(2t) √ dt,
3 0 2πt
where
wT 1 wT2 2 1
e−(K−ε)
dt < e−K /(8t) √
/(2t)
√ dt < ∞,
0 2πt 0 2πt
w 
T
1[K,∞) (Bt ) − fε′ (Bt ) dt = 0, and

2
for ε < K/2, hence lim IE
ε→0 0
by the Itô isometry
w 2 
∞ hw ∞
2 i
IE 1[K,∞) (Bt ) − fε (Bt ) dBt = IE 1[K,∞) (Bt ) − fε (Bt ) dt


0 0

we find that
w
∞ w∞ 2 
lim IE 1[K,∞) (Bt )dBt − fε (Bt )dBt = 0,
ε→0 0 0

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r∞ w∞
which shows that 0
fε (Bt )dBt converges to 1[K,∞) (Bt )dBt in
0
L2 (Ω) as ε tends to zero.
ii) By (S.4.17) we have
h
2 i ε
IE (BT − K)+ − fε (BT ) ≤ ,
4
hence fε (BT ) converges to (BT − K)+ in L2 (Ω).
iii) Similarly, fε (B0 ) converges to (B0 − K)+ for any fixed value of B0 .
As a consequence of (ei), (eii) and (eiii) above, the equation (4.47) shows
that
1 
ℓ t ∈ [0, T ] : K − ε < Bt < K + ε


2ε
admits a limit in L2 (Ω) as ε tends to zero, and this limit is denoted by
[0,T ] . The formula (4.48) is known as the Tanaka formula.
LK

Problem 4.20
a) We have

0 ≤ IE[(X − ε)+ ]
1 w∞ 2 2
= √ (x − ε)e−x /(2σ ) dx
2πσ ε2

1 w∞ 2 2 ε w∞ 2 2
= √ xe−x /(2σ ) dx − √ e−x /(2σ ) dx
2πσ ε2 2πσ ε
2

σ 2 h −x2 /(2σ2 ) i∞
= −√ e − εP(X ≥ ε)
2πσ 2 ε
2
σ 2 2
= √ e−εx /(2σ ) − εP(X ≥ ε),
2πσ 2
which leads to the conclusion.
b) We have

P(X ∈ dx and X + Y ∈ dz)

P(X ∈ dx | X + Y = z) =
P(X + Y ∈ dz)
P(X ∈ dx and Y ∈ (dz) − x)
=
P(X + Y ∈ dz)
2 2 2 2
2π(α2 + β 2 ) e−x /(2α )−(z−x) /(2β )
p
= dx
2παβ e −z 2 /(2(α2 +β 2 ))

1/β + 1/α −(x2 (1+β 2 /α2 )+(x2 +z2 −2xz)(1+α2 /β 2 )−z2 )/(2(α2 +β 2 ))
p
2 2
= √ e dx
2π
1/β 2 + 1/α2 −(x2 (2+β 2 /α2 +α2 /β 2 )+z2 α2 /β 2 −2xz(1+α2 /β 2 ))/(2(α2 +β 2 ))
p
= √ e dx
2π

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1/β 2 + 1/α2 −(x(β/α+α/β)−zα/β)2 /(2(α2 +β 2 ))

p
= √ e dx
2π
1/β 2 + 1/α2 −(x((α2 +β 2 )/(αβ))−zα/β)2 /(2(α2 +β 2 ))
p
= √ e dx
2π
1/β 2 + 1/α2 −(x−zα2 /(α2 +β 2 ))2 /(2/(1/α2 +1/β 2 )))
p
= √ e dx.
2π
c) Given that Bu = x we decompose

Bv = (Bv − B(u+v)/2 ) + (B(u+v)/2 − Bu ) + x,

and apply the result of Question (b) by taking

X = B(u+v)/2 − Bu and Y = Bv − B(u+v)/2 ,

i.e.
v−u
and z = y − x, α2 = β 2 =
2
which shows that the distribution of B(u+v)/2
 = x + X given that Bu = x
x+y v−u

and Bv = y is Gaussian N , with mean
2 4

α2 z y−x x+y α2 β 2 v−u

x+ =x+ = and variance = .
α2 + β2 2 2 α2 + β 2 4

d) Four linear interpolations are displayed in Figure S.15.

n= 0 n= 1 n= 2 n= 3
2.0

2.0

2.0

2.0
1.5

1.5

1.5

1.5
1.0

1.0

1.0

1.0
0.5

0.5

0.5

0.5
0.0

0.0

0.0

0.0

0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0

t t t t

Fig. S.15: Samples of linear interpolations.

(0)
e) Clearly, the statement is true for n = 0 because Z1 and B1 have the
same N (0, 1) distribution. Next, assuming that it holds at the rank n, we
note that the terms appearing in the sequence
(n+1) (n+1) (n+1) (n+1) (n+1)

Z (n+1) = 0, Z1/2n+1 , Z2/2n+1 , Z3/2n+1 , Z4/2n+1 , . . . , Z1 .

can be written for any k = 0, 1, . . . , 2n − 1 as

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 
(n+1) (n+1)
Z2k/2n+1 + Z(2k+2)/2n+1
. . . , Z (n+1) + N 0, 1/2 n+2 (n+1)


2k/2n+1 , 2
, Z(2k+2)/2n+1 , . . .
 
(n) (n)
(n)
Z2k/2n+1 + Z(2k+2)/2n+1 (n)
= . . . , Z n , + N 0, 1/2 n+2


, Z(k+1)/2n , . . .
k/2 2
   
(n) (n)
(n)
Z2k/2n+1 + Z(2k+2)/2n+1 1  (n)
= . . . , Z n , N  , n+2 , Z(k+1)/2n , . . . .
k/2 2 2

(S.4.18)

On the other hand, the result of Question (c) shows that given that
B2k/2n+1 = x and B(2k+2)/2n+1 = y, the distribution of B(2k+1)/2n+1 is

B2k/2n+1 + B(2k+2)/2n+1 (2k + 2)/2n+1 − (2k + 2)/2n+1

 
N ,
2 4
B2k/2n+1 + B(2k+2)/2n+1 1
 
=N , n+2 . (S.4.19)
2 2

Given that Z (n) and B (n) have same distribution, we conclude by com-
paring (S.4.18) and (S.4.19) that Z (n+1) and B (n+1) also have same dis-
tribution.
f) We have
!
(n+1) (n)
P sup |Zt − Zt | ≥ εn
t∈[0,1]
 
(n+1) (n)
=P max |Z(2k+1)/2n+1 − Z(2k+1)/2n+1 | ≥ εn
k=0,1,...,2n −1
 
n o
(n+1) (n)
[
≤ P |Z(2k+1)/2n+1 − Z(2k+1)/2n+1 | ≥ εn 
k=0,1,...,2n −1
n
2X −1
(n+1) (n)

≤ P |Z(2k+1)/2n+1 − Z(2k+1)/2n+1 | ≥ εn
k=0
(n+1) (n)
= 2n P |Z1/2n+1 − Z1/2n+1 | ≥ εn


 
(n) (n)
(n+1)
Z0/2n + Z1/2n
= 2 P Z1/2n+1 −
n 
≥ εn  .
2

g) Since
(n) (n)
(n+1)
Z0 + Z1/2n (n)
Z1/2n+1 = + N (0, 1/2n+2 ) = Z1/2n+1 + N (0, 1/2n+2 ),
2

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we have
!
(n+1) (n) (n+1) (n)
sup ≤ 2n P |Z1/2n+1 − Z1/2n+1 | ≥ εn


P |Zt − Zt | ≥ εn
t∈[0,1]
 
(n) (n)
(n+1)
Z0/2n + Z1/2n
= 2 P  Z1/2n+1 −
n
≥ εn 
2

= 2n P N (0, 1/2n+2 ) ≥ εn

2n/2 −ε2n 2n+1

≤ √ e ,
εn 2π
where we applied the bound of Question (a) to the Gaussian random
variable
(n) (n)
(n+1)
Z0/2n + Z1/2n
Z1/2n+1 − ≃ N (0, 1/2n+2 ).
2
h) We have
!
(n+1) (n)
X
X
P ∥Z (n+1)
− Z ∥∞ ≥ 2
(n) −n/4
= P sup |Zt − Zt | ≥ εn
n≥0 n≥0 t∈[0,1]

X 2n/2 2 n+1
≤ √ e−εn 2
n≥0
ε n 2π
1 X 3n/4 −21+n/2
= √ 2 e < ∞,
2π n≥0

since
1+(n+1)/2
23(n+1)/4 e−2 1+n/2
√
lim = 23/4 lim e−2 ( 2−1)
= 0.
n→∞ 23n/4 e−21+n/2 n→∞

Hence the Borel-Cantelli lemma shows that

P ∥Z (n+1) − Z (n) ∥∞ ≥ 2−n/4 for infinitely many n = 0,

therefore we have

P ∥Z (n+1) − Z (n) ∥∞ < 2−n/4 except for finitely many n = 1.

i) The result of Question (h) shows that with probability one we have
p−1
X
lim ∥Z (p) − Z (q) ∥∞ = lim Z (n+1) − Z (n)
p,q→∞ p,q→∞
n=q ∞

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p−1
X
≤ lim ∥Z (n+1) − Z (n) ∥∞
p,q→∞
n=q
X
≤ lim ∥Z (n+1) − Z (n) ∥∞
p→∞
n≥q
= 0,

hence the sequence Z (n) n≥0 is Cauchy in C0 ([0, 1]) for the ∥ · ∥∞ norm.

Since C0 ([0, 1]) is a complete space for the ∥ · ∥∞ norm, this implies that,
with probability one, the sequence (Z (n) )n≥0 admits a limit in C0 ([0, 1]).
(n)
j) 1. By construction we have Z0 = 0 for all n ∈ N, hence Z0 =
(n)
limn→∞ Z0 = 0, almost surely.

2. The sample trajectories t 7→ Zt are continuous, because the limit Z

belongs to C0 ([0, 1]) with probability 1.

3. The result of Question (e) shows that for any fixed m ≥ 1, the sequences

Zt1 − Zt0 , Zt2 − Zt1 , . . . , Ztm − Ztm−1

and
Bt1 − Bt0 , Bt2 − Bt1 , . . . , Btm − Btm−1
have same distribution when the t′k s are dyadic rationals of the form
tk = in /2n , k = 0, 1, . . . , n. This property extends to any sequence
t0 , t1 , . . . , tm of real numbers by approximation of each tk > 0 by a
sequence (in )n∈N such that tk = limn→∞ in /2n and taking the limit as
n tends to infinity.
4. By a similar argument as in the above point 3, one can show that for
any 0 ≤ s < t, Zt − Zs has the Gaussian distribution N (0, t − s).

Problem 4.21
a) We have
n
 (n)  X
IE QT = IE (BkT /n − B(k−1)T /n )2
 

k=1
n  
X T T
= k − (k − 1)
n n
k=1
= T, n ≥ 1.

b) We have

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 !2 
n
 (n) 2  X
IE (QT ) = IE  (BkT /n − B(k−1)T /n )2 
k=1
 
n
X
= IE  (BkT /n − B(k−1)T /n ) (BlT /n − B(l−1)T /n )
2 2

k,l=1
n
X
= IE (BkT /n − B(k−1)T /n )4
 

k=1
X
+2 IE (BkT /n − B(k−1)T /n )2 IE (BlT /n − B(l−1)T /n )2
   

1≤k<l≤n
n
X
=3 (kT /n − (k − 1)T /n)2
k=1
X
+2 (kT /n − (k − 1)T /n)(lT /n − (l − 1)T /n)
1≤k<l≤n

T2 n(n − 1)T 2
=3 +
n n2
2T 2
=T +
2
, n ≥ 1,
n
hence
 (n)   (n)
2   (n) 
2 2T 2
Var QT = IE QT − IE QT = , n ≥ 1.
n
c) We have
(n)  (n) (n)
∥QT − T ∥2L2 (Ω) = IE (QT − IE[QT ])2

 (n) 
= Var QT
n(n + 2)T 2
= − T2
n2
2T 2
= ,
n
hence
(n) 2T 2
lim ∥QT − T ∥2L2 (Ω) = lim = 0,
n→∞ n→∞ n
showing that
(n)
lim QT = T
n→∞

in L2 (Ω).
d) We have

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n n
X 1X 2
(BkT /n − B(k−1)T /n )B(k−1)T /n = 2
BkT /n − B(k−1)T
2 /n
k=1 k=1
n
1X
− (BkT /n − B(k−1)T /n )(BkT /n − B(k−1)T /n )
2
k=1
1
= ((BT )2 − (B0 )2 )
2
n
1X
− (BkT /n − B(k−1)T /n )(BkT /n − B(k−1)T /n )
2
k=1
1 (n)

= (BT )2 − QT ,
2
which converges to ((BT )2 − T )/2 in L2 (Ω) as n tends to infinity, hence
wT n
X
Bt dBt = lim (BkT /n − B(k−1)T /n )B(k−1)T /n
0 n→∞
k=1
(BT ) − T
2
= .
2
e) We have
n
 (n)  X
IE Q = IE (B(k−1/2)T /n − B(k−1)T /n )2
 
e
T
k=1
Xn
= ((k − 1/2)T /n − (k − 1)T /n)
k=1
T
= , n ≥ 1.
2
Next, we have
 !2 
n

2 
2
e (n)
X
IE = IE 

Q T B(k−1/2)T /n − B(k−1)T /n 
k=1
 
n
X
= IE  (B(k−1/2)T /n − B(k−1)T /n ) (BlT /n − B(l−1)T /n )
2 2

k,l=1
n
X
= IE (B(k−1/2)T /n − B(k−1)T /n )4
 

k=1
X
+2 IE (B(k−1/2)T /n − B(k−1)T /n )2 IE (B(l−1/2)T /n − B(l−1)T /n )2
   

1≤k<l≤n

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n
X
=3 ((k − 1/2)T /n − (k − 1)T /n)2
k=1
X
+2 ((k − 1/2)T /n − (k − 1)T /n)((l − 1/2)T /n − (l − 1)T /n)
1≤k<l≤n

T2 n(n − 1)T 2
=3 +
4n 4n2
n(n + 2)T 2
= , n ≥ 1.
4n2
Finally, we find

e (n) − T /2∥2 2
 (n)
e (n) 2
L (Ω) = IE (QT − IE[QT ])

∥Q T
e
 (n) 
= Var Q e
T
n(n + 2)T 2 T2
= −
4n 2 4
T2
= ,
2n
hence
(n) T2
lim ∥Q L (Ω) = lim
e − T /2∥2 2 = 0,
n→∞ T n→∞ 2n

showing that
e (n) = T
lim Q
n→∞ T
2
in L2 (Ω).
f) We have
n
X

BkT /n − B(k−1)T /n B(k−1/2)T /n
k=1
n
X
=


BkT /n − B(k−1/2)T /n B(k−1/2)T /n
k=1
Xn
+


B(k−1/2)T /n − B(k−1)T /n B(k−1/2)T /n
k=1
n
1 X
= 2
BkT 2
/n − B(k−1/2)T /n
2
k=1
n
1 X


− BkT /n − B(k−1/2)T /n BkT /n − B(k−1/2)T /n
2
k=1
n
1X 2
+ 2
B(k−1/2)T /n − B(k−1)T
2 /n
k=1

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n
1X
+



B(k−1/2)T /n − B(k−1)T /n B(k−1/2)T /n − B(k−1)T /n
2
k=1
n
1 1X
= (BT )2 −



BkT /n − B(k−1/2)T /n BkT /n − B(k−1/2)T /n
2 2
k=1
n
1X
+



B(k−1/2)T /n − B(k−1)T /n B(k−1/2)T /n − B(k−1)T /n ,
2
k=1

which converges to ((BT )2 − T + T )/2 = (BT )2 /2 in L2 (Ω) as n tends to

infinity, hence
wT n
X (BT )2
Bt ◦ dBt = lim (BkT /n − B(k−1)T /n )B(k−1/2)T /n = ,
0 n→∞ 2
k=1

see Section 2.4 of Mikosch (1998) for further details on the Stratonovich
integral.
g) We have
n
 (n)  X
2 
IE Q = IE B(k−α)T /n − B(k−1)T /n

e
T
k=1
Xn
= ((k − α)T /n − (k − 1)T /n)
k=1
T
= (1 − α) , n ≥ 1.
2
Next, we have
 !2 
n
e (n) 2
X
IE = IE  (B(k−α)T /n − B(k−1)T /n ) 2


Q T

k=1
 
n
X
= IE  (B(k−α)T /n − B(k−1)T /n ) (BlT /n − B(l−1)T /n )
2 2

k,l=1
n
X
= IE (B(k−α)T /n − B(k−1)T /n )4
 

k=1
X
+2 IE (B(k−α)T /n − B(k−1)T /n )2 IE (B(l−α)T /n − B(l−1)T /n )2
   

1≤k<l≤n
n
X
=3 ((k − α)T /n − (k − 1)T /n)2
k=1
X
+2 ((k − α)T /n − (k − 1)T /n)((l − α)T /n − (l − 1)T /n)
1≤k<l≤n

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T2 n(n − 1)T 2
= 3(1 − α)2 + (1 − α)2
n n2
2 n(n + 2)T
2
= (1 − α) , n ≥ 1.
n2
Finally we find
(n)  (n) 
2 
e − (1 − α)T /2∥2 2 e (n) − IE Q
L (Ω) = IE

∥QT Q T
e
T
 (n) 
= Var Qe
T
n(n + 2)T 2
= (1 − α)2 − (1 − α)2 T 2
n2
2
T
= 2(1 − α)2 ,
n
hence

(n) T2
lim ∥Q
e − (1 − α)T ∥2 2
T L (Ω) = (1 − α) lim
2
= 0.
n→∞ n→∞ n
Next, we have
n
X
(BkT /n − B(k−1)T /n )B(k−α)T /n
k=1
n
X n
X
= (BkT /n − B(k−α)T /n )B(k−α)T /n + (B(k−α)T /n − B(k−1)T /n )B(k−α)T /n
k=1 k=1
n n
1 X 1X
= 2
BkT 2
/n − B(k−α)T /n − (BkT /n − B(k−α)T /n )(BkT /n − B(k−α)T /n )
2 2
k=1 k=1
n
1X 2
+ 2
B(k−α)T /n − B(k−1)T
2 /n
k=1
n
1X
+ (B(k−α)T /n − B(k−1)T /n )(B(k−α)T /n − B(k−1)T /n )
2
k=1
n
1 1X
= (BT )2 − (BkT /n − B(k−α)T /n )(BkT /n − B(k−α)T /n )
2 2
k=1
n
1X
+ (B(k−α)T /n − B(k−1)T /n )(B(k−α)T /n − B(k−1)T /n ),
2
k=1

which converges to

(BT )2 − αT + (1 − α)T (BT )2 + (1 − 2α)T

=
2 2

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in L2 (Ω) as n tends to infinity, hence

wT n
X
Bt ◦ dα Bt = lim (BkT /n − B(k−1)T /n )B(k−α)T /n
0 n→∞
k=1
(BT ) + (1 − 2α)T
2
= .
2
In particular we find
wT n
X (BT )2 + T
Bt ◦ d0 Bt = lim (BkT /n − B(k−1)T /n )BkT /n = ,
0 n→∞ 2
k=1

and we note that

wT 1 wT
 wT 
Bt ◦ dBt = Bt dBt + Bt ◦ d1 Bt .
0 2 0 0

h) We have
n  
X T T T
lim (k − α) k − (k − 1)
n→∞ n n n
k=1
n
T X T
= lim (k − α)
n→∞ n n
k=1
n n
T X T T XT
= lim k − α lim
n→∞ n n n→∞ n n
k=1 k=1
n(n + 1) T2
= T lim2
− α lim
n→∞ 2n2 n→∞ n
T2
= ,
2
which does not depend on α ∈ [0, 1]< hence the stochastic phenomenon
of the previous questions does not occur when approximating the deter-
rT
ministic integral 0 tdt = T 2 /2 by Riemann sums.

In quantitative finance we choose to use the Itô integral (which corre-

sponds to the choice α = 1) because it is suitable for the modeling of
market returns as
dSt St+∆t − St
≃ = µ∆t + σ∆Bt = µ∆t + (Bt+∆t − Bt )σ
St St
or

dSt ≃ St+∆t − St = µSt ∆t + σSt ∆Bt , = µSt ∆t + σSt (Bt+∆t − Bt ),

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based on the value St at the the left endpoint of the discretized time
interval [t, t + ∆t].

Chapter 5

Exercise 5.1 For all x ∈ R, we have

2
P(ST ≤ x) = P S0 eσBT +(µ−σ /2)T ≤ x

σ2
   
x
= P σBT + µ − T ≤ log
2 S0
1 σ2
    
x
= P BT ≤ log − µ− T
σ S0 2
w (log(x/S0 )−(µ−σ2 /2)T )/σ 2 dy
= e−y /(2T ) √
−∞ 2πT
w (log(x/S0 )−(µ−σ2 /2)T )/(σ√T )
−z 2 /2 dz
= e √
−∞ 2π
1 2
    
x σ
=Φ √ log − µ− T ,
σ T S0 2

where wx 2 dy
Φ(x) := e−y /2
√ , x ∈ R,
−∞ 2πT
denotes the standard Gaussian cumulative distribution function. After differ-
entiation with respect to x, we find the lognormal probability density function

dP(ST ≤ x)
f (x) =
dx
∂ w (log(x/S0 )−(µ−σ2 /2)T )/σ −y2 /(2T ) dy
= e √
∂x −∞ 2πT
1 σ2
    
∂ x
= Φ √ log − µ− T
∂x σ T S0 2
1 1 σ2
    
x
= √ φ √ log − µ− T
xσ T σ T S0 2
1 2 2 2
= √ e−(−(µ−σ /2)T +log(x/S0 )) /(2σ T ) , x > 0,
xσ 2πT
where
1 2
φ(y) = Φ′ (y) := √ e−y /2 , y ∈ R,
2π
denotes the standard Gaussian probability density function.

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Exercise 5.2
a) We have

1 1 σ2
d log St = dSt − (dSt )2 = rdt + σdBt − dt, t ≥ 0.
St 2St2 2

b) We have f (t) = f (0)ect (continuous-time interest rate compounding), and

2
St = S0 eσBt −σ t/2+rt
, t ≥ 0,

(geometric Brownian motion).

c) Those quantities can be directly computed from the expression of St as a
function of the N (0, t) random variable Bt . Namely, we have
2
IE[St ] = IE S0 eσBt −σ t/2+rt
 
2
= S0 e−σ t/2+rt IE eσBt
 

= S0 ert ,

where we used the Gaussian moment generating function (MGF) formula,

i.e. 2
IE eσBt = eσ t/2
 

for the normal random variable Bt ≃ N (0, t), t > 0. Similarly, we have
2
IE[St2 ] = IE S02 e2σBt −σ t+2rt
 
2
= S02 e−σ t+2rt IE e2σBt
 
2
= S02 eσ t+2rt
, t ≥ 0.

d) We note that from the stochastic differential equation

wt wt
St = S0 + r Ss ds + σ Ss dBs ,
0 0

the function u(t) := IE[St ] satisfies the Ordinary Differential Equation

(ODE) u′ (t) = ru(t) with u(0) = S0 and solution u(t) = IE[St ] = S0 ert .
On the other hand, by the Itô formula we have

dSt2 = 2St dSt + (dSt )2 = 2rSt2 dt + σ 2 St2 dt + 2σSt2 dBt ,

hence letting v(t) = IE St2 and taking expectations on both sides of

 

wt wt wt
St2 = S02 + 2r Su2 du + σ 2 Su2 du + 2σ Su2 dBu ,
0 0 0

we find

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v(t) = IE St2
 
w  w 
t t
= S02 + (2r + σ 2 ) IE Su2 du + 2σ IE Su2 dBu
0 0
wt
= S02 + (2r + σ 2 ) IE Su2 du
 
0
wt
= S02 + (2r + σ 2 ) v(u)du,
0

hence v(t) := IE St satisfies the ordinary differential equation

 2


v ′ (t) = (σ 2 + 2r)v(t),

with v(0) = S02 and solution

2
v(t) = IE St2 = S02 e(σ +2r)t ,
 

which recovers

Var[St ] = IE St2 − (IE[St ])2

 

= v(t) − u2 (t)
2
= S02 e(σ +2r)t
− S02 e2rt
2
= S02 e2rt (eσ t − 1), t ≥ 0.

Exercise 5.3 Using the bivariate Itô formula (4.26), we find

∂f ∂f
df (St , Yt ) = (St , Yt )dSt + (St , Yt )dYt
∂x ∂y
1∂ f
2
1∂ f
2
∂2f
+ (St , Yt )(dSt )2 + (St , Yt )(dYt )2 + (St , Yt )dSt • dYt
2 ∂x 2 2 ∂y 2 ∂x∂y
∂f ∂f
= (St , Yt )(rSt dt + σSt dBt ) + (St , Yt )(µYt dt + ηYt dWt )
∂x ∂y
2 2 2 2 2 2
σ St ∂ f η Yt ∂ f ∂2f
+ (St , Yt )dt + (St , Yt )dt + ρσηSt Yt (St , Yt )dt.
2 ∂x2 2 ∂y 2 ∂x∂y

Exercise 5.4 Taking expectations on both sides of (5.24) shows that

w 
T
IE[ST ] = C(S0 , r, T ) + IE ζt,T dBt = C(S0 , r, T ),
0

hence

C(S0 , r, T ) = IE[ST ]
2
= IE[S0 erT +σBT −σ T /2
]

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2
= S0 erT −σ T /2
IE[eσBT ]
2
T /2+σ 2 T /2
= S0 erT −σ
= S0 erT
,

where we used the moment generating function

2
IE[eσBT ] = eσ T /2

of the Gaussian random variable BT ≃ N (0, T ). On the other hand, the

discounted asset price Xt := e−rt St satisfies dXt = σXt dBt , which shows
that wT
XT = X0 + σ Xt dBt .
0

Multiplying both sides by erT shows that

wT wT
ST = erT S0 + σ erT Xt dBt = erT S0 + σ e(T −t)r St dBt ,
0 0

which recovers the relation C(S0 , r, T ) = S0 erT , and shows that ζt,T =
σe(T −t)r St , t ∈ [0, T ].

Exercise 5.5
a) We have St = f (Xt ), t ≥ 0, where f (x) = S0 ex and (Xt )t∈R+ is the Itô
process given by
wt wt
Xt := σs dBs + us ds, t ≥ 0,
0 0

or in differential form

dXt := σt dBt + ut dt, t ≥ 0,

hence

dSt = df (Xt )
1
= f ′ (Xt )dXt + f ′′ (Xt )(dXt )2
2
1
= ut f ′ (Xt )dt + σt f ′ (Xt )dBt + σt2 f ′′ (Xt )dt
2
1
= S0 ut eXt dt + S0 σt eXt dBt + S0 σt2 eXt dt
2
1
= ut St dt + σt St dBt + σt2 St dt.
2
b) The process (St )t∈R+ satisfies the stochastic differential equation

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1
 
dSt = ut + σt2 St dt + σt St dBt .
2

Exercise 5.6
a) We have IE[St ] = 1 because the expected value of the Itô stochastic integral
is zero by Relation (4.17) in Proposition 4.21. Regarding the variance,
using the Itô isometry (4.16), we have

wt
" 2 #
σBs −σ 2 s/2
Var[St ] = σ IE
2
e dBs
0
w   2
t 2
= σ 2 IE dseσBs −σ s/2
0
w t  2
2 
=σ 2
IE eσBs −σ s/2 ds
0
wt h 2
i
=σ 2
IE e2σBs −σ s ds
0
wt 2
= σ2 e−σ s
IE e2σBs ds
 
0
wt 2 2
= σ2 e−σ s e2σ s ds
0
wt 2
= σ2 eσ s ds
0
2
= eσ t − 1.

b) Taking f (x) = log x, we have

d log(St ) = df (St )
1
= f ′ (St )dSt + f ′′ (St )(dSt )2
2
σBt −σ 2 t/2 1 2
= σf (St )e
′
dBt + σ 2 f ′′ (St )e2σBt −σ t dt
2
σ σBt −σ2 t/2 σ 2 2σBt −σ2 t
= e dBt − e dt. (S.5.20)
St 2St2
2
c) We check that letting Zt := eσBt −σ t/2
, t ≥ 0, we have

σ2
log Zt = σBt − σ 2 t/2, and d log Zt = σdBt − dt.
2
On the other hand, we also have

σ2 σ σBt −σ2 t/2 σ 2 2σBt −σ2 t

σdBt − dt = e dBt − e dt,
2 Zt 2Zt2

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showing by (S.5.20) that the equation

σ σBt −σ2 t/2 σ 2 2σBt −σ2 t

d log Zt = e dBt − e dt
Zt 2Zt2

is satisfied. By uniqueness of solutions to (S.5.20) we obtain

log St = log Zt = σBt − σ 2 t/2,

2
and we conclude that St = Zt = eσBt −σ t/2
, t ≥ 0.

Exercise 5.7
a) Leveraging with a factor β : 1 means that when the fund value is Ft , the
amount ξt St = βFt is actually invested on the risky asset priced St . In
this case, the fund value Ft at time t ≥ 0 decomposes into the portfolio
Ft Ft
Ft = ξt St + ηt At = β St − (β − 1) At , t ≥ 0,
St At

with ξt = βFt /St and ηt = −(β − 1)Ft /At , t ≥ 0.

b) We have

dFt = ξt dSt + ηt dAt

Ft Ft
= β dSt − (β − 1) dAt
St At
Ft
= β dSt − (β − 1)rFt dt
St
= βFt (rdt + σdBt ) − (β − 1)rFt dt
= rFt dt + βσFt dBt , t ≥ 0.

The above equation shows that the volatility βσ of the fund is β times
the volatility of the index. On the other hand, the risk-free rate r remains
the same.
c) By Proposition 5.15 we have
2
σ 2 t/2
Ft = F0 eβσBt +rt−β
2
t/2 β
= F0 eσBt +rt/β−βσ


2
t/2−(1−1/β)rt−(β−1)σ 2 t/2 β
= F0 eσBt +rt−σ


2
t/2 β −(β−1)rt−β(β−1)σ 2 t/2
= F0 eσBt +rt−σ e


2
t/2 β −(β−1)rt−β(β−1)σ 2 t/2
= S0 eσBt +rt−σ e


2
= Stβ e−(β−1)rt−β(β−1)σ t/2
, t ≥ 0.

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Exercise 5.8
a) For t ∈ [0, T ] and i = 1, 2 we have
 (i)   (i) (i) 2
IE St = IE S0 eµt+σi Wt −σi t/2

2 (i) 
(i)
= S0 eµt−σi t/2 IE eσi Wt


(i) 2 2
= S0 eµt−σi t/2+σi t/2
(i)
= S0 eµt .

b) For all t ∈ [0, T ] and i = 1, 2, we have

(i)
2  (i)
2 2µt+2σi Wt(i) −σi2 t 
IE = IE e
 
St S0
(i) 
(i)
2 2µt−σi2 t
= S0 e IE e2σi Wt


(i)
2 2µt−σi2 t+2σi2 t

= S0 e
(i)
2 2µt+σi2 t
= S0 e ,

hence
 (i)   (i)
2   (i) 

Var St = IE St − IE St
(i) 2 2µt+σi t
2 (i)
2 2µt
= S0 e e


− S0
(i)
2 2µt σi2 t
= S0 e e − 1 , t ∈ [0, T ], i = 1, 2.

c) We have
 (2) (1)   (1)   (2)  (1) (2)

Var St − St = Var St + Var St − 2 Cov St , St

with
 (1) (2)   (1) (2) (1) 2 (2) 2
IE St St = IE S0 S0 e2µt+σ1 Wt −σ1 t/2+σ2 Wt −σ2 t/2

2 2 (1) (2) 
(1) (2)
= S0 S0 e2µt−σ1 t/2−σ2 t/2 IE eσ1 Wt +σ2 Wt


1 
 
(1) (2) 2 2 (1) (2)
2 
= S0 S0 e2µt−σ1 t/2−σ2 t/2 exp IE σ1 Wt + σ2 Wt ,
2

with
(1) (2)
2  (1)
2  (1) (2)  (2)
2 
IE σ1 Wt + σ2 Wt = IE σ1 Wt + 2 IE σ1 Wt σ2 Wt + IE σ2 Wt
   

= σ12 t + 2ρσ1 σ2 t + σ22 t,

hence  (1) (2)  (1) (2)

IE St St = S0 S0 e2µt+ρσ1 σ2 t ,
and

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(1) (2)
 (1) (2)   (1)   (2)  (1) (2)

Cov St , St = IE St St −IE St IE St = S0 S0 e2µt (eρσ1 σ2 t −1),

and therefore
 (2) (1) 
Var St − St
(1)
2 2µt σ12 t (2)
2 2µt σ22 t (1) (2)
= S0 e (e − 1) + S0 e (e − 1) − 2S0 S0 e2µt (eρσ1 σ2 t − 1)
(1) 2 σ1 t
2 (2) 2 σ2 t
2 (1) (2) (2) (1)
2

= e2µt S0 e + S0 e − 2S0 S0 eρσ1 σ2 t − S0 − S0



.

2
Exercise 5.9 Letting Xt := f (t)eσBt −σ t/2
and noting the relation
2 2
deσBt −σ t/2
= σf (t)eσBt −σ t/2
dBt , t ≥ 0,

see Proposition 5.15 and Relation (5.22) with µ = 0, we have

2 2
dXt = eσBt −σ f (t)dt + f (t)deσBt −σ
t/2 ′ t/2
2 2
= eσBt −σ t/2 f ′ (t)dt + σf (t)eσBt −σ t/2
dBt
f ′ (t)
= Xt dt + σXt dBt
f (t)
= h(t)Xt dt + σXt dBt ,

hence
d f ′ (t)
log f (t) = = h(t),
dt f (t)
which shows that wt
log f (t) = log f (0) + h(s)ds,
0
and
2
Xt = f (t)eσBt −σ t/2
w
σ2

t
= f (0) exp h(s)ds + σBt − t
0 2
w
σ2

t
= X0 exp h(s)ds + σBt − t , t ≥ 0.
0 2

Exercise 5.10
a) We have

St = eXt
wt wt 1 w t 2 Xs
= eX0 + us eXs dBs + vs eXs ds + u e ds
0 0 2 0 s
wt wt σ 2 wt
= eX0 + σ eXs dBs + ν eXs ds + eXs ds
0 0 2 0

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wt wt σ2 w t
= S0 + σ Ss dBs + ν Ss ds + Ss ds.
0 0 2 0
b) Let r > 0. The process (St )t∈R+ satisfies the stochastic differential equa-
tion
dSt = rSt dt + σSt dBt
when r = ν + σ 2 /2.
c) We have

Var[Xt ] = Var[(BT − Bt )σ] = σ 2 Var[BT − Bt ] = (T − t)σ 2 , t ∈ [0, T ].

d) Let the process (St )t∈R+ be defined by St = S0 e σBt +νt

, t ≥ 0. Using the
time splitting decomposition
ST
ST = St = St e(BT −Bt )σ+ντ ,
St
we have

P(ST > K | St = x) = P(St e(BT −Bt )σ+(T −t)ν > K | St = x)

= P(xe(BT −Bt )σ+(T −t)ν > K)
= P(e(BT −Bt )σ > Ke−(T −t)ν /x)
1
 
BT − Bt
=P √ log Ke−(T −t)ν /x


> √
T −t σ T −t

!
log Ke−(T −t)ν /x
= 1−Φ √
σ τ

!
log Ke−(T −t)ν /x
=Φ − √
σ τ
log(x/K) + ντ
 
=Φ √ ,
σ τ

where τ = T − t.

Problem 5.11 (Exercise 4.19 continued).

a) The option payoff is (BT − K)+ at maturity.
b) We can ignore what happens between two crossings as every crossing resets
the portfolio to its state right before the previous crossing. Based on this,
It is clear that every of the four possible scenarios will lead to a portfolio
value (BT − K)+ at maturity:
i) If B0 < 1 and BT < 1 we issue the option for free and finish with an
empty portfolio and zero payoff.

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ii) If B0 < 1 and BT > 1 we issue the option for free and finish with
one AUD and one SGD to refund, which yields the payoff BT − 1 =
(BT − 1)+ .
iii) If B0 > 1 and BT < 1 we purchase one AUD and borrow one SGD
at the start, however the AUD will be sold and the SGD refunded
before maturity, resulting into an empty portfolio and zero payoff.
iv) If B0 > 1 and BT > 1 we purchase one AUD and borrow one SGD
right before maturity, which yields the payoff BT − 1 = (BT − 1)+ .
Therefore we are hedging the option in all cases. Note that P(BT = K) = 0
so the case BT = 1 can be ignored with probability one.
c) Since the portfolio strategy is to hold AU$1 when Bt > K and to and
borrow SG$1 when Bt > K, we let

ξt := 1(K,∞) (Bt ) and ηt := −1(K,∞) (Bt ), t ∈ [0, T ],

which is called a stop-loss/start-gain strategy.

wt
d) Noting that ηs dAs = 0 because At = A0 is constant, t ∈ [0, T ], we find
0
by the Itô-Tanaka formula (4.48) that
wt wt wT
ηs dAs + ξs dBs = 1[K,∞) (Bt )dBt
0 0 0
1
= (BT − K)+ − (B0 − K)+ − LK .
2 [0,T ]
e) Question (d) shows that
wt wt 1
(BT − K)+ = (B0 − K)+ + ηs dAs + ξs dBs + LK ,
0 0 2 [0,T ]
i.e. the initial premium (B0 − K)+ plus the sum of portfolio profits and
losses is not sufficient to cover the terminal payoff (BT − K)+ , and that
we fall short of this by the positive amount 12 LK [0,T ] > 0. Therefore the
portfolio allocation (ξt , ηt )t∈[0,T ] is not self-financing.
Additional comments:
The stop-loss/start-gain strategy described here is difficult to implement in
practice because it would require infinitely many transactions when Brownian
motion crosses the level K, as illustrated in Figure S.16.

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-1 -0.5 0 0.5 1

Fig. S.16: Brownian crossings of level 1.∗

The arbitrage-free price of the option can in fact be computed as the expected
discounted option payoff

πt = e−(T −t)r IE∗ [(BT − K)+ | Ft ]

= e−(T −t)r IE∗ [(BT − Bt + x − K)+ | Ft ]x=Bt
= e−(T −t)r IE∗ [(BT − Bt + x − K)+ ]x=Bt
w∞ 2 dy
= e−(T −t)r (y + Bt − K)+ e−y /(2(T −t)) p
−∞ 2π(T − t)
w∞ 2 dy
= e−(T −t)r (y + Bt − K)e−y /(2(T −t)) p
K−Bt 2π(T − t)
w∞ 2 dy
= e−(T −t)r ye−y /(2(T −t)) p
K−Bt 2π(T − t)
w∞ 2 dy
+(Bt − K)e−(T −t)r e−y /(2(T −t)) p
K−Bt 2π(T − t)
w∞ 2 dy
= e−(T −t)r √ ye−y /2 √
(K−Bt )/ T −t 2π
w∞ 2 dy
+(Bt − K)e−(T −t)r √ e−y /2 √
(K−Bt )/ T −t 2π
e−(T −t)r h −y2 /2 i∞
= √ −e √
2π (K−Bt )/ T −t
 
Bt − K
+(Bt − K)e−(T −t)r Φ √
T −t
e−(T −t)r −(K−Bt )2 /(2(T −t))
= √ e
2π

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Bt − K
+(Bt − K)e−(T −t)r Φ √
T −t
=: g(t, Bt ),

where the function

e−(T −t)r −(K−x)2 /(2(T −t))
 
x−K
g(t, x) := √ e +(x−K)e−(T −t)r Φ √ , t ∈ [0, T ),
2π T −t
solves the Black-Scholes heat equation

∂g ∂g 1 ∂2g
(t, x) + r (t, x) + (t, x) = 0
∂t ∂x 2 ∂2x
with terminal condition g(T, x) = (x − K)+ . The Delta gives the amount to
be invested in AUD at time t and is given by
∂g
ξt = (t, Bt )
∂x
e−(T −t)r −(K−Bt )2 /(2(T −t))
= (K − Bt ) √ e
2π(T − t)
e−(T −t)r −(Bt −K)2 /(2(T −t))
 
Bt − K
+ (Bt − K) p e + e−(T −t)r Φ √
2π(T − t) T −t
!
Bt − K
= e−(T −t)r Φ p
(T − t)
=: h(t, Bt ),

with  
x−K
h(t, x) := e−(T −t)r Φ √ , t ∈ [0, T ),
T −t
and h(T, x) = 1[K,∞) (x).

Bt

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Fig. S.17: Brownian path started at B0 > 1.

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(Bt-K)+
g(t,Bt)

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Fig. S.18: Risk-neutral pricing of the FX option by πt (Bt ) = g(t, Bt ) vs stop-loss/start-

gain pricing.

1[K,∞ )(Bt)
h(t,Bt)

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Fig. S.19: Delta hedging of the FX option by ξt = h(t, Bt ) vs the stop-loss/start-gain

strategy.

The “one or nothing” stop-loss/start-gain strategy is not self-financing be-

cause in practice there is an impossibility to buy/sell the AUD at exactly
SGD1.00 to the existence of an order book that generates a gap between
bid/ask prices as in the sample of Figure S.20 with 383.16964 < 384.07141.

Fig. S.20: Bitcoin XBT/USD order book.

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The existence of the order book will force buying and selling within a certain
range [K − ε, K + ε], typically resulting into selling lower than K = 1.00 and
buying higher than K = 1.00. This potentially results into a trading loss that
can be proportional to the time

ℓ t ∈ [0, T ] : K − ε < Bt < K + ε



spent by the exchange rate (Bt )t∈[0,T ] within the range [K − ε, K + ε].

The Itô-Tanaka formula (4.48)

wT 1
(BT − K)+ = (B0 − K)+ + 1[K,∞) (Bt )dBt + LK
[0,T ] ,
0 2
precisely shows that the trading loss equals half the local time LK
[0,T ] spent
by (Bt )t∈[0,T ] at the level K. When ε is small we have

1 K 1
L ≃ ℓ({t ∈ [0, T ] : K − ε < Bt < K + ε}),
2 [0,T ] 4ε
therefore the trading loss is proportional to the time spent by Brownian
motion (Bt )t∈R+ within the interval (K − ε, K + ε), with proportionality
coefficient 1/(4ε).

Bt

K+ε

K-ε

0 0.05 0.1 0.15 0.2

Fig. S.21: Time spent by Brownian motion within the range (K − ε, K + ε).

More generally, one could show that there is no self-financing (buy and hold)
portfolio that can remain constant over time intervals, and that the self-
financing portfolio has to be constantly re-adjusted in time as illustrated
in Figure S.19. This invalidates the stop-loss/start-gain strategy as a self-
financing portfolio strategy.

Chapter 6

Exercise 6.1

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a) By the Itô formula, we have

∂g ∂g 1 ∂2g
dVt = dg(t, Bt ) = (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt. (S.6.21)
∂t ∂x 2 ∂x2
Consider a hedging portfolio with value Vt = ηt At + ξt Bt , satisfying the
self-financing condition

dVt = ηt dAt + ξt dBt = ξt dBt , t ≥ 0. (S.6.22)

By respective identification of the terms in dBt and dt in (S.6.21) and

(S.6.22) we get

 0 = ∂g (t, Bt )dt + 1 ∂ g (t, Bt )dt,

2


2 ∂x2

 ∂t

 ξt dBt = ∂g (t, Bt )dBt ,




∂x
hence
1 ∂2g

∂g
 0 = ∂t (t, Bt ) + 2 ∂x2 (t, Bt ),




 ξt = ∂g (t, Bt ),



∂x
and
1 ∂2g

∂g
0 = (t, Bt ) + (t, Bt ),


 ∂t 2 ∂x2

 ξt = ∂g (t, Bt ),



∂x
hence the function g(t, x) satisfies the heat equation

∂g 1 ∂2g
0= (t, x) + (t, x), x > 0, (S.6.23)
∂t 2 ∂x2
with terminal condition g(T, x) = x2 , and ξt is given by the partial deriva-
tive
∂g
ξt = (t, Bt ), t ≥ 0.
∂x
b) In order to solve (S.6.23) we substitute a solution of the form g(t, x) =
x2 + f (t) in to the partial differential equation, which yields 1 + f ′ (t) = 0
with the terminal condition f (T ) = 0. Therefore we have f (T − t) = T − t,
and
g(t, x) = x2 + f (t) = x2 + T − t, 0 ≤ t ≤ T.
c) By (6.3), we have

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 Solutions Manual

∂g
ξt = ξt (Bt ) = (t, Bt ) = 2Bt , 0 ≤ t ≤ T,
∂x
which recovers the value of ξt found page 163 in the power option example.
We also have

ηt At = ηt A0 = g(t, Bt ) − ξt Bt = T − t − Bt2 , 0 ≤ t ≤ T.

Exercise 6.2 By the Itô formula, we have

dVt = dg(t, St ) (S.6.24)

∂g ∂g 1 ∂2g p ∂g
= (t, St )dt + β(α − St ) (t, St )dt + σ 2 St 2 (t, St )dt + σ St (t, St )dBt .
∂t ∂x 2 ∂x ∂x
By respective identification of the terms in dBt and dt in (6.36) and (S.6.24)
we get

 rg(t, St )dt + β(α − St )ξt dt − rξt St dt



 ∂g ∂g 1 ∂2g
= (t, St )dt + β(α − St ) (t, St )dt + σ 2 St 2 (t, St )dt,



∂t ∂x 2 ∂x


 σξt St dBt = σ St ∂g (t, St )dBt ,

 p p

∂x
hence
1 2 ∂2g

∂g ∂g
 rg(t, St ) + β(α − St )ξt − rξt St = ∂t (t, St ) + β(α − St ) ∂x (t, St ) + 2 σ St ∂x2 (t, St ),




 ξt = ∂g (t, St ),



∂x
and
1 2 ∂2g

∂g
 rg(t, St ) − rξt St = ∂t (t, St ) + 2 σ St ∂x2 (t, St ),




 ξt = ∂g (t, St ),



∂x
hence the function g(t, x) satisfies the PDE

∂g ∂g 1 ∂2g
rg(t, x) = (t, x) + rx (t, x) + σ 2 x 2 (t, x), x > 0,
∂t ∂x 2 ∂x
and ξt is given by the partial derivative
∂g
ξt = (t, St ), t ≥ 0.
∂x

Exercise 6.3

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Introduction to Stochastic Finance with Market Examples, Second Edition

a) Let Vt := ξt St + ηt At denote the hedging portfolio value at time t ∈ [0, T ].

Since the dividend yield δSt per share is continuously reinvested in the
portfolio, the portfolio change dVt decomposes as

dVt = ηt dAt + ξt dSt + δξt St dt

| {z } | {z }
trading profit and loss dividend payout
= rηt At dt + ξt ((µ − δ)St dt + σSt dBt ) + δξt St dt
= rηt At dt + ξt (µSt dt + σSt dBt )
= rVt dt + (µ − r)ξt St dt + σξt St dBt , t ≥ 0.

b) By Itô’s formula we have

∂g ∂g
dg(t, St ) = (t, St )dt + (µ − δ)St (t, St )dt
∂t ∂x
1 ∂2g ∂g
+ σ 2 St2 2 (t, St )dt + σSt (t, St )dBt ,
2 ∂x ∂x
hence by identification of the terms in dBt and dt in the expressions of
dVt and dg(t, St ), we get
∂g
ξt = (t, St ),
∂x
and we derive the Black-Scholes PDE with dividend
∂g ∂g 1 ∂2g
rg(t, x) = (t, x) + (r − δ)x (t, x) + σ 2 x2 2 (t, x). (S.6.25)
∂t ∂x 2 ∂x
c) In order to solve (S.6.25) we note that, letting f (t, x) := e(T −t)δ g(t, x) and
substituting g(t, x) = e−(T −t)δ f (t, x) into the PDE (S.6.25), we have

∂f ∂f 1 ∂2f
rf (t, x) = δf (t, x) + (t, x) + (r − δ)x (t, x) + σ 2 x2 2 (t, x),
∂t ∂x 2 ∂x
hence f (t, x) := e(T −t)δ g(t, x), satisfies the standard Black-Scholes PDE
with interest rate r − δ, i.e. we have

∂f ∂f 1 ∂2f
(r − δ)f (t, x) = (t, x) + (r − δ)x (t, x) + σ 2 x2 2 (t, x),
∂t ∂x 2 ∂x
with same terminal condition f (T, x) = g(T, x) = (x − K)+ , hence we
have

f (t, x) = Bl(x, K, σ, r − δ, T − t)
= xΦ dδ+ (T − t) − Ke−(r−δ)(T −t) Φ dδ− (T − t) ,

where
log(x/K) + (r − δ ± σ 2 /2)(T − t)
dδ± (T − t) := √ .
σ T −t

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 Solutions Manual

Consequently, the pricing function of the European call option with divi-
dend rate δ is

g(t, x) = e−(T −t)δ f (t, x)

= e−(T −t)δ Bl(x, K, σ, r − δ, T − t)
= xe−(T −t)δ Φ dδ+ (T − t) − Ke−(T −t)r Φ dδ− (T − t) , 0 ≤ t ≤ T.

We also have

g(t, x) = Bl xe−(T −t)δ , K, σ, r, T − t

= e−(T −t)δ Bl x, Ke(T −t)δ , σ, r, T − t , 0 ≤ t ≤ T.

d) As in Proposition 6.4, we have

∂g
ξt = (t, St ) = e−(T −t)δ Φ dδ+ (T − t) , 0 ≤ t < T.


∂x

Exercise 6.4
a) We check that gc (t, 0) = 0, as when x = 0 we have d+ (T −t) = d− (T −t) =
−∞ for all t ∈ [0, T ). On the other hand, we have

 +∞, x > K,





lim d+ (T − t) = lim d− (T − t) = 0, x = K,
t↗T t↗T 



−∞, x < K,


which allows us to recover the boundary condition

gc (T, x) = lim gc (t, x)

t↗T

xΦ(+∞) − KΦ(+∞) = x − K,
 

 x>K


 

 
x K
 
= − = 0, x=K = (x − K)+


 2 2 



 

xΦ(−∞) − KΦ(−∞) = 0,
 
x<K

at t = T . Regarding the Delta of the European call option, we find

Φ(+∞) = 1, x > K 
 

 

 

1

 

lim Φ(d+ (T − t)) = Φ(0) = , x=K
t↗T 
 2 


 

 
Φ(−∞) = 0, x < K
 

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Introduction to Stochastic Finance with Market Examples, Second Edition

see Figure 6.5. Similarly, we can check that


σ2
+∞, r> ,


2







σ2

lim d− (T − t) = 0, r= ,
T →∞ 

 2


σ2



 −∞,
 r< ,
2
and limT →∞ d+ (T − t) = +∞, hence

lim Bl(x, K, σ, r, T − t)
T →∞

= x lim Φ(d+ (T − t)) − lim e−(T −t)r Φ(d− (T − t))

T →∞ T →∞
= x, t ≥ 0.

b) We check that gp (t, 0) = Ke−(T −t)r and gp (t, ∞) = 0 as when x = 0 we

have d+ (T − t) = d− (T − t) = −∞ and as x tends to infinity we have
d+ (T − t) = d− (T − t) = +∞ for all t ∈ [0, T ). On the other hand, we
have
KΦ(+∞) − xΦ(+∞) = K − x, x < K 
 

 

 

 
K x
 
gp (T, x) = − = 0, x = K = (K − x)+


 2 2 



 

KΦ(−∞) − xΦ(−∞) = 0,
 
x>K

at t = T . Regarding the Delta of the European put option, we find

 Φ(−∞) = 0,
 
 x>K 

 

1

 

− lim Φ(−d+ (T − t)) = −Φ(0) = − , x = K
t↗T 
 2 


 

 
−Φ(+∞) = −1, x < K
 

see Figure 6.11. Similarly, we can check that

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 Solutions Manual


σ2
+∞, r> ,


2







σ2

lim d− (T − t) = 0, r= ,
T →∞ 

 2


σ2



 −∞,
 r< ,
2
and limT →∞ d+ (T − t) = +∞, hence

lim Blp (x, K, σ, r, T − t) = 0, t ≥ 0.

T →∞

Exercise 6.5 (Exercise 3.14 continued).

a) Substituting g(x, t) = x2 f (t) in (6.37), we find f ′ (t) = −(r + σ 2 )f (t),
hence 2 2
f (t) = f (0)e−(r+σ )t = f (T )e(r+σ )(T −t) ,
2 2
hence g(x, t) = f (T )x2 e(r+σ )(T −t) = x2 e(r+σ )(T −t) due to the terminal
condition g(x, T ) = x2 .
∂g 2
b) We have ξt = g(St , t) = 2St e(r+σ )(T −t) , and
∂x
1
ηt = (g(St , t) − ξt St )
At
1 2 2
= S 2 e(r+σ )(T −t) − 2St2 e(r+σ )(T −t)


A0 ert t
S2 2
= − t e(T −2t)r+(T −t)σ , t ∈ [0, T ].
A0

Exercise 6.6
a) Counting approximately 46 days to maturity, we have

(r − σ 2 /2)(T − t) + log(St /K)

d− (T − t) = √
σ T −t
(0.04377 − (0.9)2 /2)(46/365) + log(17.2/36.08)
=
0.9 46/365
p

= −2.461179058,

and
d+ (T − t) = d− (T − t) + 0.9 46/365 = −2.14167602.
p

From the standard Gaussian cumulative distribution table we get

Φ(d+ (T − t)) = Φ(−2.14) = 0.0161098

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 Introduction to Stochastic Finance with Market Examples, Second Edition

and
Φ(d− (T − t)) = Φ(−2.46) = 0.00692406,
hence

f (t, St ) = St Φ(d+ (T − t)) − Ke−(T −t)r Φ(d− (T − t))

= 17.2 × 0.0161098 − 36.08 × e−0.04377×46/365 × 0.00692406
= HK$ 0.028642744.

For comparison, running the corresponding Black-Scholes script of Fig-

ure 6.20 yields

BSCall(17.2, 36.08, 0.04377, 46/365, 0.9) = 0.02864235.

b) We have

∂f
ηt = (t, St ) = Φ(d+ (T − t)) = Φ(−2.14) = 0.0161098, (S.6.26)
∂x
Print hence one should only hold a fractional quantity equal to 16.10 units in
the risky asset in order to hedge 1000 such call options when σ = 0.90.
c) From the curve it turns out that when f (t, St ) = 10 × 0.023 = HK$ 0.23,
the volatility σ is approximately equal to σ = 122%.

This approximate value of implied volatility can be found under the col-
Derivative Warrant Search
umn “Implied Volatility (IV.)” on this set of market data from the Hong
Kong Stock Exchange: http://www.hkex.com.hk/dwrc/se
Updated: 6 November 2008

Basic Data
DW Issuer UL Call DW Listing Maturity Strike Entitle- Total O/S
Code /Put Type (D-M-Y) (D-M-Y) ment Issue (%)
Ratio^
Link to Relevant Exchange Traded Options Size
01897 FB 00066 Call Standard 18-12-2007 23-12-2008 36.08 10 138,000,000 16.43

04348 BP
00066 Call Standard 18-12-2007 23-02-2009 38.88 10 300,000,000 0.25
Market Data
04984 AA 00066 Call Standard 02-06-2005 22-12-2008 12.88 10 300,000,000 0.36
trike Entitle- Total O/S Delta IV. Day Day Closing T/O UL Base Listing Su
ment Issue (%) (%) (%) High Low Price # ('000) Price Document
05931 SB 00066 Call Standard 27-03-2008 29-12-2008 27.868 10 200,000,000 0.04
Ratio^ Size ($) ($) ($) ($) Ann
36.08 09133 CT 16.43
10 138,000,000 000660.780
Call125.375
Standard 31-01-2008
0.000 0.000 08-12-2008
0.023 36.88 0 17.200
10 200,000,000 0.15

38.88 13436 SG 0.25

10 300,000,000 000660.767
Call 88.656
Standard 14-05-2008
0.000 0.000 30-04-2009 32 0 17.200
10 200,000,000
0.024 Corporation. 0.10
Fig. S.22: Market data for the warrant #01897 on the MTR
12.88 13562 BP 0.36
10 300,000,000 000668.075
Call128.202
Standard 26-05-2008
0.000 0.000 08-12-2008
0.540 30 0 17.200
10 150,000,000 0.00

7.868 13688 RB 0.04

10 200,000,000 000662.239
Call126.132
Standard 04-06-2008
0.000 0.000 20-02-2009
0.086 26.6 0 17.200
10 200,000,000 7.17

36.88 13764 SG 0.15

10 200,000,000 000660.416
Call133.443
Standard 13-06-2008
0.000 0.000 26-02-2009
0.010 28 0 17.200
10 300,000,000 0.31
" 107
32 June 13785
17, 2024 ML 0.10
10 200,000,000 000661.059
Call 61.785
Standard 17-06-2008
0.000 0.000 19-01-2009
0.031 27.38 0 17.200
10 100,000,000
https://personal.ntu.edu.sg/nprivault/indext.html 0.50

30 13821 JP 0.00
10 150,000,000 000660.987
Call127.080
Standard 18-06-2008
0.000 0.000 18-12-2008
0.026 28.8 0 17.200
10 100,000,000 0.81
 Solutions Manual

Remark: a typical value for the volatility in standard market conditions

would be around 20%. The observed volatility value σ = 1.22 per year is
actually quite high.

Exercise 6.7
a) We find h(x) = x − K.
b) Letting g(t, x), the PDE rewrites as

(x − α(t))r = −α′ (t) + rx,

hence α(t) = α(0)ert and g(t, x) = x − α(0)ert . The final condition

g(T, x) = h(x) = x − K

yields α(0) = Ke−rT and g(t, x) = x − Ke−(T −t)r .

c) We have
∂g
ξt = (t, St ) = 1,
∂x
hence
Vt − ξt St g(t, St ) − St St − Ke−(T −t)r − St
ηt = = = = −Ke−rT .
At At At
Note that we could also have directly used the identification

Vt = g(St , t) = St − Ke−(T −t)r = St − Ke−rT At = ξt St + ηt At ,

which immediately yields ξt = 1 and ηt = −Ke−rT .

d) It suffices to take K = 0, which shows that g(t, x) = x, ξt = 1 and ηt = 0.

Exercise 6.8
a) We develop two approaches.
(i) By financial intuition. We need to replicate a fixed amount of $1 at
maturity T , without risk. For this there is no need to invest in the
stock. Simply invest g(t, St ) := e−(T −t)r at time t ∈ [0, T ] and at
maturity T you will have g(T, ST ) = e(T −t)r g(t, St ) = $1.

(ii) By analysis and the Black-Scholes PDE. Given the hint, we try plug-
ging a solution of the form g(t, x) = f (t), not depending on the vari-
able x, into the Black-Scholes PDE (6.38). Given that here we have

∂g ∂2g ∂g
(t, x) = 0, (t, x) = 0, and (t, x) = f ′ (t),
∂x ∂x2 ∂t
we find that the Black-Scholes PDE reduces to rf (t) = f ′ (t) with
the terminal condition f (T ) = g(T, x) = 1. This equation has

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Introduction to Stochastic Finance with Market Examples, Second Edition

for solution f (t) = e−(T −t)r and this is also the unique solution
g(t, x) = f (t) = e−(T −t)r of the Black-Scholes PDE (6.38) with ter-
minal condition g(T, x) = 1.
b) We develop two approaches.
(i) By financial intuition. Since the terminal payoff $1 is risk-free we do
not need to invest in the risky asset, hence we should keep ξt = 0.
Our portfolio value at time t becomes

Vt = g(t, St ) = e−(T −t)r = ξt St + ηt At = ηt At

with At = ert , so that we find ηt = e−rT , t ∈ [0, T ]. This portfolio

strategy remains constant over time, hence it is clearly self-financing.

(ii) By analysis. The Black-Scholes theory of Proposition 6.1 tells us that

∂g
ξt = (t, x) = 0,
∂x
and
Vt − ξt St Vt e−(T −t)r
ηt = = = = e−rT .
At At ert

Exercise 6.9 Log contracts.

a) Substituting the function g(x, t) := f (t) + log x in the PDE (6.39), we
have
σ2
0 = f ′ (t) + r − ,
2
hence
σ2
 
f (t) = f (0) − r − t,
2
σ2
 
with f (0) = r − T in order to match the terminal condition
2
g(x, T ) := log x, hence we have

σ2
 
g(x, t) = r − (T − t) + log x, x > 0.
2

b) Substituting the function

σ2
  
h(x, t) := u(t)g(x, t) = u(t) r− (T − t) + log x
2

in the PDE (6.39), we find u′ (t) = ru(t), hence u(t) = u(0)ert = e−(T −t)r ,
with u(T ) = 1, and we conclude to

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 Solutions Manual

σ2
  
h(x, t) = u(t)g(x, t) = e−(T −t)r r− (T − t) + log x ,
2

x > 0, t ∈ [0, T ].
c) We have
∂h e−(T −t)r
ξt = (t, St ) = , 0 ≤ t ≤ T,
∂x St
and
1
ηt = h(t, St ) − ξt St


At
e−rT σ2
  
= r− (T − t) + log x − 1 ,
A0 2

0 ≤ t ≤ T.

Exercise 6.10 Binary options.

a) From Proposition 6.1, the function Cd (t, x) solves the Black-Scholes PDE

∂Cd ∂Cd 1 ∂ 2 Cd

 rCd (t, x) =
 (t, x) + rx (t, x) + σ 2 x2 (t, x),
∂t ∂x 2 ∂x2

Cd (T, x) = 1[K,∞) (x).




b) We can check by direct differentiation that the Black-Scholes PDE is

satisfied by the function Cd (t, x), together with the terminal condition
Cd (T, x) = 1[K,∞) (x) as t tends to T .

Exercise 6.11
a) By (4.35) we have
wt
St = S0 eαt + σ e(t−s)α dBs .
0

b) By the self-financing condition (5.8) we have

dVt = ηt dAt + ξt dSt

= rηt At dt + αξt St dt + σξt dBt
= rVt dt + (α − r)ξt St dt + σξt dBt , (S.6.27)

t ≥ 0. Rewriting (6.41) under the form of an Itô process

wt wt
St = S0 + vs ds + us dBs , t ≥ 0,
0 0

with

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Introduction to Stochastic Finance with Market Examples, Second Edition

ut = σ, and vt = αSt , t ≥ 0,
the application of Itô’s formula Theorem 4.24 to Vt = C(t, St ) shows that

∂C ∂C
dC(t, St ) = vt (t, St )dt + ut (t, St )dBt
∂x ∂x
∂C 1 2
∂ C
+ (t, St )dt + |ut |2 2 (t, St )dt
∂t 2 ∂x
∂C ∂C 1 ∂2C ∂C
= (t, St )dt + αSt (t, St )dt + σ 2 2 (t, St )dt + σ (t, St )dBt .
∂t ∂x 2 ∂x ∂x
(S.6.28)

Identifying the terms in dBt and dt in (S.6.27) and (S.6.28) above, we get
2 2

 rC(t, St ) = ∂C (t, St ) + rSt ∂C (t, St ) + σ ∂ C (t, St ),

2 ∂x2

∂t ∂x
 ξt = ∂C
(t, St ),


∂x
hence the function C(t, x) satisfies the usual Black-Scholes PDE

∂C ∂C 1 ∂2C
rC(t, x) = (t, x) + rx (t, x) + σ 2 2 (t, x), x > 0, 0 ≤ t ≤ T,
∂t ∂x 2 ∂x
(S.6.29)
with the terminal condition C(T, x) = ex , x ≥ 0.
c) Based on (6.42), we compute

σ2
  
∂C
(t, x) = r + xh ′
(t) + h(t)h′
(t) C(t, x),


∂t 2r






∂C
(t, x) = h(t)C(t, x)


 ∂x
2

 ∂ C (t, x) = (h(t))2 C(t, x),



∂x2
hence the substitution of (6.42) into the Black-Scholes PDE (S.6.29) yields
the ordinary differential equation

σ2 ′ σ2
xh′ (t) + h (t)h(t) + rxh(t) + (h(t))2 = 0, x > 0, 0 ≤ t ≤ T,
2r 2
which reduces to the ordinary differential equation h′ (t) + rh(t) = 0 with
terminal condition h(T ) = 1 and solution h(t) = e(T −t)r , t ∈ [0, T ], which
yields

σ 2 2(T −t)r
 
C(t, x) = exp −(T − t)r + xe(T −t)r + (e − 1) .
4r

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d) We have

σ 2 2(T −t)r
 
∂C
ξt = (t, St ) = exp St e(T −t)r + (e − 1) .
∂x 4r

Exercise 6.12
2
a) Noting that φ(x) = Φ′ (x) = (2π)−1/2 e−x /2
, we have the

∂h √

(S, d) = Sφ d + σ T − Ke−rT φ(d)
∂d
√
2
S K 2
= √ e− d+σ T /2 − √ e−rT e−d /2
2π 2π
S 2
√ 2 K 2
= √ e−d /2−σ T d−σ T /2 − √ e−rT e−d /2 ,
2π 2π
∂h
hence the vanishing of (S, d∗ (S)) at d = d∗ (S) yields
∂d
S 2
√ 2 K 2
√ e−d∗ (S)/2−σ T d∗ (S)−σ T /2 − √ e−rT e−d∗ (S)/2 = 0,
2π 2π

log(S/K) + rT − σ 2 T /2
i.e. d∗ (S) = √ . We can also check that
σ T

∂2h S − d∗ (S)+σ√T 2 /2
 
∂ K −rT −d2∗ (S)/2


(S, d∗ (S)) = √ e − √ e e
∂d2 ∂d 2π 2π
√
S − d (S)+σ√T
2 /2 K 2
= − d∗ (S) + σ T √ e ∗
+ √ d∗ (S)e−rT e−d∗ (S)/2
2π 2π
√
K 2 K 2
= − d∗ (S) + σ T √ e−rT e−d∗ (S)/2 + √ d∗ (S)e−rT e−d∗ (S)/2
2π 2π
√ K 2
= −σ T √ e−rT e−d∗ (S)/2 < 0,
2π
√

hence the function d 7−→ h(S, d) := SΦ d + σ T − Ke−rT Φ(d) admits a
maximum at d = d∗ (S), and
√

h(S, d∗ (S)) = SΦ d∗ (S) + σ T − Ke−rT Φ(d∗ (S))
log(S/K) + (r + σ 2 /2)T log(S/K) + (r − σ 2 /2)T
   
= SΦ √ − Ke−rT Φ √
σ T σ T
is the Black-Scholes call option price.
∂d (S, d∗ (S)) = 0, we find
b) Since ∂h

d ∂h ∂h
∆= h(S, d∗ (S)) = (S, d∗ (S)) + d′∗ (S) (S, d∗ (S))
dS ∂S ∂d

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√
log(S/K) + rT + σ 2 T /2
 
= Φ d∗ (S) + σ T = Φ √ .
σ T

Exercise 6.13
a) When σ > 0 we have

∂gc
∂
∂
= xΦ′ d+ (T − t) d+ (T − t) − Ke−(T −t)r Φ′ d− (T − t) d− (T − t)
∂σ ∂σ ∂σ
∂
= xΦ′ d+ (T − t) d+ (T − t)


∂σ
∂
−Ke−(T −t)r Φ′ d+ (T − t) e(T −t)r+log(x/K) d− (T − t)


∂σ

∂
= xΦ′ d+ (T − t) d+ (T − t) − d− (T − t)


∂σ

∂ √
= xΦ′ d+ (T − t)


σ T −t
√ ∂σ
= x T − tΦ′ d+ (T − t) ,

where we used the fact that

1 2
Φ′ d− (T − t) = √ e−(d− (T −t)) /2


2π
1 2
= √ e−(d− (T −t)) /2+(T −t)r+log(x/K)
2π
= Φ′ d+ (T − t) e(T −t)r+log(x/K) .

Relation (6.43) can be obtained from the equalities

2
2
d+ (T − t) − d− (T − t)
= d+ (T − t) + d− (T − t) d+ (T − t) − d− (T − t)



x
= 2r(T − t) + 2 log .
K
Due to the call-put parity relation (6.23), the Black-Scholes call and put
Vega are identical, i.e.
∂gp ∂gc √
= = x T − tΦ′ d+ (T − t) .


∂σ ∂σ
The Black-Scholes European call and put prices are increasing functions
of the volatility parameter σ > 0.
b) We have

∂gc ∂ ∂
= xΦ′ (d+ (T − t)) d+ (T − t) − Ke−(T −t)r Φ′ (d− (T − t)) d− (T − t)
∂r ∂r ∂r

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+(T − t)Ke−(T −t)r Φ(d− (T − t))

∂
= xΦ′ (d+ (T − t)) d+ (T − t)
∂r
∂
−Ke−(T −t)r Φ′ (d+ (T − t))e(T −t)r+log(x/K) d− (T − t)
∂r
+(T − t)Ke−(T −t)r Φ(d− (T − t))
∂
= xΦ′ (d+ (T − t)) d+ (T − t) − d− (T − t) + (T − t)Ke−(T −t)r Φ(d− (T − t))


∂r
∂ √
= xΦ′ (d+ (T − t)) σ T − t + (T − t)Ke−(T −t)r Φ(d− (T − t))


∂r
= (T − t)Ke−(T −t)r Φ(d− (T − t)),

where we used the fact that

1 2
Φ′ (d− (T − t)) = √ e−(d− (T −t)) /2
2π
1 2
= √ e−(d− (T −t)) /2+(T −t)r+log(x/K)
2π
= Φ′ (d+ (T − t))e(T −t)r+log(x/K) .

The same relationship is used to simplify the formulas of the Black-Scholes

Delta and Vega. We note that the Black-Scholes European call price is an
increasing function of the interest rate parameter r.

Regarding put option prices gp (t, x), the call-put parity relation (6.23)
yields
∂gp ∂
= gc − (x − Ke−r(T −t) )


∂r ∂r
= (T − t)Ke−(T −t)r Φ(d− (T − t)) − (T − t)Ke−r(T −t)
= (T − t)Ke−(T −t)r (Φ(d− (T − t)) − 1)
= −(T − t)Ke−(T −t)r Φ(−d− (T − t)),

therefore the Black-Scholes European call price is a decreasing function

of the interest rate parameter r.

Exercise 6.14
a) Given that

rN − aN 1 bN − rN 1
p∗ = = and q ∗ = = ,
bN − aN 2 bN − aN 2
Relation (3.14) reads

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1
ve(t, x) = ve t + T /N, x(1 + rT /N )(1 − σ T /N )
p

2
1
+ ve t + T /N, x(1 + rT /N )(1 + σ T /N ) .
p

2
After letting ∆T := T /N and applying Taylor’s formula at the second
order we obtain
1 √
0= ve t + ∆T, x 1 + r∆T − σ ∆T − ve(t, x)




2
1 √
+ ve t + ∆T, x 1 + r∆T + σ ∆T − ve(t, x) + o ∆T





2
1 ∂e
v √
∂e
v
= ∆T (t, x) + x r∆T − σ ∆T (t, x)
2 ∂t ∂x
2 √ 2

x
2 ∂ ve
+ r∆T − σ ∆T (t, x) + o(∆T )
2 ∂x 2

1 √

∂ev
∂e
v
+ ∆T (t, x) + x r∆T + σ ∆T (t, x)
2 ∂t ∂x
2 √ 2

x
2 ∂ ve
+ r∆T + σ ∆T (t, x) + o(∆T ) + o ∆T


2 ∂x2
∂ev ∂ev x2 √
2 ∂ 2 ve
= ∆T (t, x) + rx∆T (t, x) + (t, x) + o ∆T ,


σ ∆T
∂t ∂x 2 ∂x2
which shows that


∂e
v ∂e
v σ 2 ∂ 2 ve o ∆T
(t, x) + rx (t, x) + x2 (t, x) = − ,
∂t ∂x 2 ∂x2 ∆T
hence as N tends to infinity (or as ∆T tends to 0) we find∗

∂e
v ∂e
v σ 2 2 ∂ 2 ve
0= (t, x) + rx (t, x) + x (t, x),
∂t ∂x 2 ∂x2
showing that the function v(t, x) := e(T −t)r ve(t, x) solves the classical
Black-Scholes PDE
∂v ∂v σ2 2 ∂ 2 v
rv(t, x) = (t, x) + rx (t, x) + x (t, x).
∂t ∂x 2 ∂x2
b) Similarly, we have

(1) v (t, (1 + bN )x) − v (t, (1 + aN )x)

ξt (x) =
x(bN − aN )
∗
The notation o(∆T ) is used to represent any function of ∆T such that
lim∆T →0 o(∆T )/∆T = 0.

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v t, (1 + r/N )(1 + σ T /N )x − v t, (1 + r/N )(1 − σ T /N )x
p p
=
2x(1 + r/N )σ T /N
p

∂v
→ (t, x),
∂x
as N tends to infinity.

Problem 6.15
a) When the risk-free rate is r = 0 the two possible returns are (5 − 4)/4 =
25% and (2 − 4)/4 = −50%. Under the risk-neutral probability measure
given by P∗ (S1 = 5) = (4−2)/(5−2) = 2/3 and P∗ (S1 = 2) = (5−4)/(5−
2) = 1/3 the expected return is 2 × 25%/3 − 50%/3 = 0%. In general the
expected return can be shown to be equal to the risk-free rate r.
b) The two possible returns become (3×5−4−2×4)/4 = 75% and (3×2−4−
2 × 4)/4 = −150%. Under the risk-neutral probability measure given by
P∗ (S1 = 5) = (4−2)/(5−2) = 2/3 and P∗ (S1 = 2) = (5−4)/(5−2) = 1/3
the expected return is 2×75%/3−150%/3 = 0%. Similarly to Question (a),
the expected return can be shown to be equal to the risk-free rate r when
r ̸= 0.
c) We decompose the amount Ft invested in one unit of the fund as

Ft = βF − (β − 1)Ft ,
| {z t} | {z }
Purchased/sold Borrowed/saved

meaning that we invest the amount βFt in the risky asset St , and bor-
row/save the amount −(β − 1)Ft from/on the saving account.
d) We have

Ft Ft
Ft = ξt St + ηt At = β St − (β − 1) At , t ≥ 0,
St At
with ξt = βFt /St and ηt = −(β − 1)Ft /At , t ≥ 0.
e) We have

dFt = ξt dSt + ηt dAt

Ft Ft
= β dSt − (β − 1) dAt
St At
Ft
= β dSt − (β − 1)rFt dt (S.6.30)
St
= βFt (rdt + σdBt ) − (β − 1)rFt dt
= rFt dt + βσFt dBt , t ≥ 0.

By (S.6.30), the return of the fund Ft is β times the return of the risky
asset St , up to the cost of borrowing (β − 1)r per unit of time.

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f) The discounted fund value (e−rt Ft )t∈R+ is a martingale under the risk-
neutral probability measure P∗ as we have

d(e−rt Ft ) = βσe−rt Ft dBt , t ≥ 0.

g) We have
2
σ 2 t/2
Ft = F0 eβσBt +rt−β
and  β
2 2
Stβ = S0 eσBt +rt−σ t/2 = F0 eβσBt +βrt−βσ t/2 ,

hence 2
Ft = Stβ e−(β−1)rt−β(β−1)σ t/2
, t ≥ 0.
Note that when β = 0 we have Ft = e , i.e. in this case the fund Ft
rt

coincides with the money market account.

h) We have

e−(T −t)r IE∗ (FT − K)+ | Ft

 

log(Ft /K) + (r + β 2 σ 2 /2)(T − t)

 
= Ft Φ √
|β|σ T − t
log(Ft /K) + (r − β 2 σ 2 /2)(T − t)
 
−(T −t)r
− Ke Φ √ ,
|β|σ T − t

t ∈ [0, T ).
i) We have

log(Ft /K) + (r + β 2 σ 2 /2)(T − t)

 
Φ √
|β|σ T − t
2
!
log(Stβ e−(β−1)rt−β(β−1)σ t/2 /K) + (r + β 2 σ 2 /2)(T − t)
=Φ √
|β|σ T − t
!
log(Stβ /K) − (β − 1)rt − β(β − 1)σ 2 t/2 + (r + β 2 σ 2 /2)(T − t)
=Φ √
|β|σ T − t
2
!
log(Stβ /(Ke(β−1)rT −(T /2−t)(β−1)βσ )) + (T − t)βr + (T − t)βσ 2 /2
=Φ √
|β|σ T − t
log(St /Kβ (t)) + (r + σ 2 /2)(T − t)
 
=Φ √ , 0 ≤ t < T,
σ T −t
2
if β > 0, with Kβ (t) := K 1/β e(β−1)(rT /β−(T /2−t)σ ) .
j) When β < 0 we find that the Delta of the call option on FT with strike
price K is

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log(Ft /K) + (r + β 2 σ 2 /2)(T − t)

 
Φ √
|β|σ T − t
!
log(Stβ /Kβ ) + (T − t)βr + (T − t)βσ 2 /2
=Φ √
|β|σ T − t
log(St /Kβ (t)) + (r + σ 2 /2)(T − t)
 
=Φ − √ , 0 ≤ t < T,
σ T −t
which coincides, up to a negative sign, with the Delta of the put option
2
on ST with strike price Kβ (t) := K 1/β e(β−1)(rT /β−(T /2−t)σ ) .

Chapter 7

Exercise 7.1 (Exercise 6.1 continued). Since r = 0 we have P = P∗ and

g(t, Bt ) = IE∗ BT2 | Ft

 
∗
= IE (BT − Bt + Bt )2 | Ft
 

= IE∗ (BT − Bt + x)2 x=Bt

 

= IE∗ (BT − Bt )2 + 2x(BT − Bt ) + x2 x=Bt

 

= IE∗ (BT − Bt )2 + 2x IE∗ [BT − Bt ] + Bt2

 

= Bt2 + T − t, 0 ≤ t ≤ T,

hence ξt is given by the partial derivative

∂g
ξt = (t, Bt ) = 2Bt , 0 ≤ t ≤ T,
∂x
with
g(t, Bt ) − ξt Bt
ηt =
A0
Bt2 + (T − t) − 2Bt2
=
A0
(T − t) − Bt2
= , 0 ≤ t ≤ T.
A0

Exercise 7.2 Since BT ≃ N (0, T ), we have

2
IE[ϕ(ST )] = IE ϕ S0 eσBT +(r−σ /2)T



1 w ∞ 2 2
= √ ϕ(S0 eσy+(r−σ /2)T )e−y /(2T ) dy
2πT −∞

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1 w∞ 2 2 2 dx
= √ ϕ(x)e−((σ /2−r)T +log x) /(2σ T )
2πσ 2 T −∞ x
w∞
= ϕ(x)g(x)dx,
−∞

under the change of variable

2 2
x = S0 eσy+(r−σ /2)T
, with dx = σS0 eσy+(r−σ /2)T
dy = σxdy,

i.e.
(σ 2 /2 − r)T + log(x/S0 ) dx
y= and dy = ,
σ σx
where
1 2 2 2
g(x) := √ e−((σ /2−r)T +log(x/S0 )) /(2σ T )
x 2πσ 2 T
is the lognormal probability density function
√ with location parameter (r −
σ 2 /2)T + log S0 and scale parameter σ T .

Exercise 7.3
a) By the Itô formula, we have

p(p − 1) p−2
dStp = pStp−1 dSt + St dSt • dSt
2
p(p − 1) p−2
= pStp−1 (rSt dt + σSt dBt ) + St (rSt dt + σSt dBt ) • (rSt dt + σSt dBt )
2
p(p − 1)
= prStp dt + σpStp dBt + σ 2 Stp dt
2
p(p − 1)
 
= pr + σ 2 Stp dt + σpStp dBt .
2

b) By the Girsanov Theorem 7.3, letting

1 p(p − 1)
 
ν := (p − 1)r + σ 2 ,
pσ 2

the drifted process

bt := Bt + νt,
B 0 ≤ t ≤ T,

is a standard (centered) Brownian motion under the probability measure

Q defined by
ν2
 
dQ(ω) = exp −νBT − T dP(ω).
2
Therefore, the differential of (Stp )t∈R+ can be written as

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p(p − 1)
 
dStp = pr + σ 2 Stp dt + σpStp dBt
2
= (r + pσν) Stp dt + σpStp dBt
= rStp dt + σpStp (dBt + νdt)
= rStp dt + σpStp dBbt ,

hence the discounted process Set := e−rt Stp satisfies dSet = σpSet dB
bt , and
(Set )t∈R+ is a martingale under the probability measure Q.

Exercise 7.4 We have

IE∗ [ϕ(pST1 + qST2 )] ≤ IE∗ [pϕ(ST1 ) + qϕ(ST2 )] since ϕ is convex,
= p IE∗ [ϕ(ST1 )] + q IE∗ [ϕ(ST2 )]
= p IE∗ [ϕ(IE∗ [ST2 | FT1 ])] + q IE∗ [ϕ(ST2 )] because (St )t∈R+ is a martingale,
≤ p IE∗ [IE∗ [ϕ(ST2 ) | FT1 ]] + q IE∗ [ϕ(ST2 )] by Jensen’s inequality,
= p IE∗ [ϕ(ST2 )] + q IE∗ [ϕ(ST2 )] by the tower property,
= IE∗ [ϕ(ST2 )], because p + q = 1,

see Exercise 13.7 for an extension to arbitrary summations.

Remark: This kind of technique can provide an upper price estimate from
Black-Scholes when the actual option price is difficult to compute: here the
closed-form computation would involve a double integration of the form

h  2 2
i
IE∗ [ϕ(pST1 + qST2 )] = IE∗ ϕ pS0 eσBT1 −σ T1 /2 + qS0 eσBT2 −σ T2 /2
h  2
 2
i
= IE∗ ϕ S0 eσBT1 −σ T1 /2 p + qe(BT2 −BT1 )σ−(T2 −T1 )σ /2
1 w∞ w∞  2
 2

= ϕ S0 eσx−σ T1 /2 p + qeσy−(T2 −T1 )σ /2
2π −∞ −∞
2 2 dxdy
×e−x /(2T1 )−y (2(T2 −T1 )) p
T1 (T2 − T1 )
1 w∞ w∞  2
 2
 +
= S0 eσx−σ T1 /2 p + qeσy−(T2 −T1 )σ /2 − K
2π −∞ −∞
2 2 dxdy
×e−x /(2T1 )−y (2(T2 −T1 )) p
T1 (T2 − T1 )
1 w
=
2π {(x,y)∈R2 : S0 eσx (p+qeσy−(T2 −T1 )σ2 /2 )≥Keσ2 T1 /2 }
2 2
(S0 eσx−σ T1 /2
(p + qeσy−(T2 −T1 )σ /2
) − K)
2 2 dxdy
×e−x /(2T1 )−y (2(T2 −T1 ))
T1 (T2 − T1 )
p

= ···

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Exercise 7.5
a) The European call option price C(K) := e−rT IE∗ [(ST − K)+ ] decreases
with the strike price K, because the option payoff (ST − K)+ decreases
and the expectation operator preserves the ordering of random variables.
b) The European put option price C(K) := e−rT IE∗ [(K − ST )+ ] increases
with the strike price K, because the option payoff (K − ST )+ increases
and the expectation operator preserves the ordering of random variables.

Exercise 7.6
a) Using Jensen’s inequality and the martingale property of the discounted
asset price process (e−rt St )t∈R+ under the risk-neutral probability mea-
sure P∗ , we have

+
e−(T −t)r IE∗ [(ST − K)+ | Ft ] ≥ e−(T −t)r IE∗ [ST − K | Ft ]

+
= e−(T −t)r e(T −t)r St − K
+
= St − Ke−(T −t)r , 0 ≤ t ≤ T.

Black-Scholes European call price

Lower bound
80
70
60
50
40
30
20
10
0
120
100
80 10 5
Underlying (HK$) 20 15
60
Time to maturity T-t

Fig. S.23: Lower bound vs Black-Scholes call price.

In terms of the break-even price defined as

BEPt := K + e−(T −t)r IE∗ [(ST − K)+ | Ft ],

we obtain the bound

+
BEPt ≥ K + St − Ke−(T −t)r .

b) Similarly, by Jensen’s inequality and the martingale property, we find

+
e−(T −t)r IE∗ [(K − ST )+ | Ft ] ≥ e−(T −t)r IE∗ [K − ST | Ft ]

+
= e−(T −t)r K − e(T −t)r St

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+
= Ke−(T −t)r − St , 0 ≤ t ≤ T.

Black-Scholes European put price

Lower bound
30
25
20
15
10
5
0
120

100

Underlying (HK$)
0
80 5
10
15 Time to maturity T-t
20

Fig. S.24: Lower bound vs Black-Scholes put option price.

We may also use the fact that a convex function of the martingale
(ert St )t∈R+ under the risk-neutral probability measure P∗ is a submartingale,
showing that

ert IE∗ [(e−rT K − e−rT ST )+ | Ft ] ≥ ert (e−rT K − e−rt St )+

+
= Ke−(T −t)r − St , 0 ≤ t ≤ T.

In terms of the break-even price defined as

BEPt := K − e−(T −t)r IE∗ [(ST − K)+ | Ft ],

we obtain the bound

+
BEPt ≤ K − Ke−(T −t)r − St .

Exercise 7.7
a) (i) The bull spread option can be realized by purchasing one European
call option with strike price K1 and by short selling (or issuing) one
European call option with strike price K2 , because the bull spread
payoff function can be written as

x 7−→ (x − K1 )+ − (x − K2 )+ .

see https://optioncreator.com/st3ce7z.

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150
(x-K1)+
-(x-K2)+

100

50

-50
0 50 100 150 200
K1 ST K2

Fig. S.25: Bull spread option as a combination of call and put options.∗

(ii) The bear spread option can be realized by purchasing one European
put option with strike price K2 and by short selling (or issuing) one
European put option with strike price K1 , because the bear spread
payoff function can be written as

x 7−→ −(K1 − x)+ + (K2 − x)+ ,

see https://optioncreator.com/stmomsb.

150
-(K1-x)+
(K2-x)+

100

50

-50
0 50 100 150 200
K1 ST K2

Fig. S.26: Bear spread option as a combination of call and put options.†

b) (i) The bull spread option can be priced at time t ∈ [0, T ) using the
Black-Scholes formula as
∗
The animation works in Acrobat Reader on the entire pdf file.
†
The animation works in Acrobat Reader on the entire pdf file.

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 Solutions Manual

Bl(St , K1 , σ, r, T − t) − Bl(St , K2 , σ, r, T − t).

(ii) The bear spread option can be priced at time t ∈ [0, T ) using the
Black-Scholes formula as

Bl(St , K2 , σ, r, T − t) − Bl(St , K1 , σ, r, T − t).

Exercise 7.8
a) The payoff of the long box spread option is given in terms of K1 and K2
as

(x−K1 )+ −(K1 −x)+ −(x−K2 )+ +(K2 −x)+ = x−K1 −(x−K2 ) = K2 −K1 .

b) By standard absence of arbitrage, the long box spread option payoff is

priced (K2 − K1 )/(1 + r)N −k at times k = 0, 1, . . . , N .
c) From Table S.6 below, we check that the strike prices suitable for a long
box spread option on the Hang Seng Index (HSI) are K1 = 25, 000 and
K2 = 25, 200.

Table S.6: Call and put options on the Hang Seng Index (HSI).

d) Based on the data provided, we note that the long box spread can be
realized in two ways.
i) Using the put option issued by BI (BOCI Asia Ltd.) at 0.044.
In this case, the box spread option represents a short position priced

0.540
| {z } ×7, 500 −0.064 ×8, 000 −0.370 ×11, 000 +0.044 ×10, 000 = −92
| {z } | {z } | {z }
Long call Short put Short call Long put

index points, or −92 × $50 = −$4, 600 on 02 March 2021.

Note that according to Table 7.2, option prices are quoted in index
points (to be multiplied by the relevant option/warrant entitlement
ratio), and every index point is worth $50.

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Introduction to Stochastic Finance with Market Examples, Second Edition

ii) Using the put option issued by HT (Haitong Securities) at 0.061.

In this case, the box spread option represents a long position priced

0.540
| {z } ×7, 500 −0.044 ×8, 000 −0.370 ×11, 000 +0.061 ×10, 000 = +78
| {z } | {z } | {z }
Long call Short put Short call Long put

index points, or 78 × $50 = $3, 900 on 02 March 2021.

e) As the option built in di) represents a short position paying $4, 600 today
with an additional $50 × (K2 − K1 ) = 200 = $10, 000 payoff at maturity
on June 29, I would definitely enter this position.
As for the option built in dii) it is less profitable because it costs $3, 900,
however it is still profitable taking into account the $10, 000 payoff at
maturity on June 29.
By the way, the put option at 0.061 has zero turnover (T/O).
In the early 2019 Robinhood incident, a member of the Reddit community
/r/WallStreetBets realized a loss of more than $57,000 on $5,000 principal
by attempting a box spread. This was due to the use of American call and
put options that may be exercised by their holders at any time, instead
of European options with fixed maturity time N . Robinhood subsequently
announced that investors on the platform would no longer be able to open
box spreads, a policy that remains in place as of early 2021
Remark. Searching for arbitrage opportunities via the existence of profitable
long box spreads is a way to test the efficiency of the market (Billingsley and
Chance (1985)). The data used for this test in Table 7.1 was in fact modified
market data. The original 02 March 2021 data is displayed in Table S.7, and
shows that the call option with strike price K2 = 25, 200 was actually not
available for trading (N/A) at that time, with 0% outstanding quantity and
zero turnover (T/O).

Table S.7: Original call/put options on the Hang Seng Index (HSI) as of 02/03/2021.

Exercise 7.9

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 Solutions Manual

a) The payoff function can be written as

(x − K1 )+ + (x − K2 )+ − 2(x − (K1 + K2 )/2)+

= (x − 50)+ + (x − 150)+ − 2(x − 100)+ , (S.7.31)

see also https://optioncreator.com/stnurzg.

150
(x-K1)++(x-K2)+
-2(x-K1/2-K2/2)+

100

50

-50
0 50 100 150 200
K1 ST K2

Fig. S.27: Butterfly option as a combination of call options.∗

Hence the butterfly option can be realized by:

1. purchasing one call option with strike price K1 = 50, and
2. purchasing one call option with strike price K2 = 150, and
3. issuing (or selling) two call options with strike price (K1 +K2 )/2 = 100.
b) From (S.7.31), the long call butterfly option can be priced at time t ∈ [0, T )
using the Black-Scholes call formula as

Bl(St , K1 , σ, r, T −t)+Bl(St , K2 , σ, r, T −t)−2Bl(St , (K1 +K2 )/2, σ, r, T −t).

c) For example, in the discrete-time Cox-Ross-Rubinstein (Cox et al. (1979))

model, denoting by ϕ(x) the payoff function, the self-financing replicating
portfolio strategy (ξt (St−1 ))t=1,2,...,N hedging the contingent claim with
payoff C = ϕ(SN ) is given as in Proposition 3.10 by
h  QN   QN i
IE∗ ϕ x(1 + b) j=t+1 (1 + Rj ) − ϕ x(1 + a) j=t+1 (1 + Rj )
ξt (x) =
(b − a)(1 + r)N −t St−1
∗
The animation works in Acrobat Reader.

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Introduction to Stochastic Finance with Market Examples, Second Edition

with x = St−1 . Therefore, ξt (x) will be positive (holding) when x = St−1

is sufficiently below (K1 + K2 )/2, and ξt (x) will be negative (short selling)
when x = St−1 is sufficiently above (K1 + K2 )/2.

1
0.8
0.6
0.4
0.2
0
-0.2
-0.4 15 200
-0.6
-0.8 10 150
-1 Time to maturity T-t 100
5
50
0 0
Underlying price

Fig. S.28: Delta of a butterfly option with strike prices K1 = 50 and K2 = 150.

Exercise 7.10
a) We have

Ct = e−(T −t)r IE∗ [ST − K | Ft ]

= e−(T −t)r IE∗ [ST | Ft ] − Ke−(T −t)r
= ert IE∗ e−rT ST Ft − Ke−(T −t)r
 

= ert e−rt St − Ke−(T −t)r

= St − Ke−(T −t)r .

We can check that the function g(x, t) = x−Ke−(T −t)r satisfies the Black-
Scholes PDE
∂g ∂g σ2 2 ∂ 2 g
rg(x, t) = (x, t) + rx (x, t) + x (x, t)
∂t ∂x 2 ∂x2
with terminal condition g(x, T ) = x−K, since ∂g(x, t)/∂t = −rKe−(T −t)r
and ∂g(x, t)/∂x = 1.
b) We simply take ξt = 1 and ηt = −Ke−rT in order to have

Ct = ξt St + ηt ert = St − Ke−(T −t)r , 0 ≤ t ≤ T.

Note again that this hedging strategy is constant over time, and the rela-
tion ξt = ∂g(St , t)/∂x for the option Delta, cf. (S.6.26), is satisfied.

Exercise 7.11 Option pricing with dividends (Exercise 6.3 continued).

a) Let P∗ denote the probability measure under which the process (B
bt )t∈R
+
defined by

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µ−r
bt =
dB dt + dBt
σ
is a standard Brownian motion. Under absence of arbitrage the asset price
process (St )t∈R+ has the dynamics

dSt = (µ − δ)St dt + σSt dBt

= (r − δ)St dt + σSt dB
bt ,

and the discounted asset price process (Set )t∈R+ = (e−rt St )t∈R+ satisfies

dSet = −δ Set dt + σ Set dB

bt .

Assuming that the dividend yield δSt per share is continuously reinvested
in the portfolio, the self-financing portfolio condition

dVt = ηt dAt + ξt dSt + δξt St dt

| {z } | {z }
Trading profit and loss Dividend payout

= rηt At dt + ξt ((r − δ)St dt + σSt dB

bt ) + δξt St dt
= rηt At dt + ξt (rSt dt + σSt dBt )
b
= rVt dt + σξt St dB
bt , t ≥ 0.

In other words, no arbitrage is induced by the dividend payout. This yields

dVet = d e−rt Vt

= −re−rt Vt dt + e−rt dVt

= σξt e−rt St dB
bt
= σξt Set dB
bt
= ξt (dSet + δ Set dt), t ≥ 0.

Therefore, we have
wt
Vet − Ve0 = dVeu
0
wt
= σ ξu Seu dB bu
0
wt wt
= ξu dSeu + δ Seu du, t ≥ 0.
0 0

Here, the asset price process (eδt St )t∈R+ with added dividend yield satis-
fies the equation

d eδt St = reδt St dt + σeδt St dB

bt ,

and after discount, the process (e−rt eδt St )t∈R+ = (e−(r−δ)t St )t∈R+ is a
martingale under P∗ .

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Introduction to Stochastic Finance with Market Examples, Second Edition

b) We have
wt
Vet = Ve0 + σ ξu Seu dB
bu , t ≥ 0,
0
which is a martingale under P from Proposition 7.1, hence
∗

Vet = IE∗ VeT Ft

 

= e−rT IE∗ [VT | Ft ]

= e−rT IE∗ [C | Ft ],

which implies

Vt = ert Vet = e−(T −t)r IE∗ [C | Ft ], 0 ≤ t ≤ T.

c) After discounting the payoff (ST − K)+ at the continuously compounded

interest rate r, we obtain

Vt = e−(T −t)r IE∗ (ST − K)+ | Ft

 

2
+
= e−(T −t)r IE∗ S eσBbT +(r−δ−σ /2)T − K | F
 
0 t
2
+
= e−(T −t)δ e−(T −t)(r−δ) IE∗ S0 eσBbT +(r−δ−σ /2)T − K | Ft
 

= e−(T −t)δ Bl(x, K, σ, r − δ, T − t)

= e−(T −t)δ St Φ dδ+ (T − t) − Ke−(T −t)(r−δ) Φ dδ− (T − t)

= e−(T −t)δ St Φ dδ+ (T − t) − Ke−(T −t)r Φ dδ− (T − t) , 0 ≤ t < T,

where
log(St /K) + (r − δ + σ 2 /2)(T − t)
dδ+ (T − t) := √
|σ| T − t
and
log(St /K) + (r − δ − σ 2 /2)(T − t)
dδ− (T − t) := √ .
|σ| T − t
We also have

g(t, x) = Bl xe−(T −t)δ , K, σ, r, T − t

= e−(T −t)δ Bl x, Ke(T −t)δ , σ, r, T − t , 0 ≤ t ≤ T.

d) In view of the pricing formula

Vt = e−(T −t)δ St Φ dδ+ (T − t) − Ke−(T −t)r Φ dδ− (T − t) ,

the Delta of the option is identified as

ξt = e−(T −t)δ Φ dδ+ (T − t) , 0 ≤ t < T,

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 Solutions Manual

which recovers the result of Exercise 6.3-(d).

Exercise 7.12 We start by pricing the “inner” at-the-money option with payoff
(ST2 − ST1 )+ and strike price K = ST1 at time T1 as

e−(T2 −T1 )r IE∗ (ST2 − ST1 )+ | FT1

 

(r + σ 2 /2)(T2 − T1 ) + log(ST1 /ST1 )

 
= ST1 Φ √
σ T2 − T1
(r − σ 2 /2)(T2 − T1 ) + log(ST1 /ST1 )
 
−ST1 e−(T2 −T1 )r Φ √
σ T2 − T1
r + σ 2 /2 p r − σ 2 /2 p
   
= ST1 Φ T2 − T1 − ST1 e−(T2 −T1 )r Φ T2 − T1 ,
σ σ

where we applied (7.24) with T = T2 , t = T1 , and K = ST1 . As a consequence,

the forward start option can be priced as

e−(T1 −t)r IE∗ e−(T2 −T1 )r IE∗ (ST2 − ST1 )+ | FT1 Ft

   

= e−(T1 −t)r
r + σ 2 /2 p r − σ 2 /2 p
     
× IE∗ ST1 Φ T2 − T1 − ST1 e−(T2 −T1 )r Φ T2 − T1 Ft
σ σ
= e−(T1 −t)r
r + σ 2 /2 p r − σ 2 /2 p
    
× Φ T2 − T1 − e−(T2 −T1 )r Φ T2 − T1 IE∗ [ST1 | Ft ]
σ σ
r + σ 2 /2 p r − σ 2 /2 p
    
= St Φ T2 − T1 − e−(T2 −T1 )r Φ T2 − T1 ,
σ σ

0 ≤ t ≤ T1 .

Exercise 7.13 From the Black-Scholes formula we have

" + # !
STk (r + σ 2 /2)(Tk − Tk−1 ) − log K
e−(Tk −Tk−1 )r IE∗ −K FTk−1 = Φ p
STk−1 σ Tk − Tk−1
!
−(Tk −Tk−1 )r (r − σ 2 /2)(Tk − Tk−1 ) − log K
−Ke Φ p .
σ Tk − Tk−1

As a consequence, for t = T0 = 0 we have

" + # " " + ##
STk STk
IE∗ −K Ft = IE∗ IE∗ −K FTk−1
STk−1 STk−1

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Introduction to Stochastic Finance with Market Examples, Second Edition

" !
(r + σ 2 /2)(Tk − Tk−1 ) − log K
= IE∗ e(Tk −Tk−1 )r Φ p
σ Tk − Tk−1
!#
(r − σ 2 /2)(Tk − Tk−1 ) − log K
−KΦ p
σ Tk − Tk−1
!
(r + σ 2 /2)(Tk − Tk−1 ) − log K
=e(Tk −Tk−1 )r
Φ p
σ Tk − Tk−1
!
(r − σ 2 /2)(Tk − Tk−1 ) − log K
− KΦ p .
σ Tk − Tk−1

Hence, the cliquet option can be priced at time t = T0 = 0 as

n
" + #
X STk
e−rTk IE∗ −K
STk−1
k=1
n
!
X (r + σ 2 /2)(Tk − Tk−1 ) − log K
= e−rTk−1 Φ p
k=1
σ Tk − Tk−1
!!
(r − σ 2 /2)(Tk − Tk−1 ) − log K
−Ke−rTk Φ p .
σ Tk − Tk−1

Exercise 7.14 (Exercise 6.9 continued). We have

C(t, St ) = e−(T −t)r IE∗ log ST | Ft

 

2
   
= e−(T −t)r IE∗ log St + (B bT − B bt )σ + r − σ (T − t) | Ft
2
σ2
 
=e −(T −t)r
log St + e −(T −t)r
r− (T − t), 0 ≤ t ≤ T.
2

Exercise 7.15 (Exercise 6.5 continued).

a) By (5.20), for all t ∈ [0, T ], we have

C(t, St ) = e−(T −t)r IE[ST2 | Ft ]

S2
 
= e−(T −t)r IE St2 T2 Ft
S
 2t 
S
= e−(T −t)r St2 IE T2 Ft
S
 2t 
ST
=e St IE
−(T −t)r 2
St2
 2(BT −Bt )σ−(T −t)σ2 +2(T −t)r 
=e St IE e
−(T −t)r 2

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 Solutions Manual

2
= e−(T −t)r St2 e−(T −t)σ +2(T −t)r
IE e2(BT −Bt )σ
 
2
= St2 e(r+σ )(T −t)
,

where we used the Gaussian moment generating function (MGF) formula,

i.e. 2
IE e2(BT −Bt )σ = e2(T −t)σ
 

for the normal random variable BT − Bt ≃ N (0, T − t), 0 ≤ t < T .

b) For all t ∈ [0, T ], we have

∂C 2
ξt = (t, x)|x=St = 2St e(r+σ )(T −t) ,
∂x
i.e. 2
ξt St = 2St2 e(r+σ )(T −t)
= 2C(t, St ),
and
C(t, St ) − ξt St e−rt 2 (r+σ2 )(T −t) 2
ηt = = St e − 2St2 e(r+σ )(T −t)


At A0
S2 2
= − t eσ (T −t)+(T −2t)r ,
A0
i.e.
At σ2 (T −t)+(T −2t)r 2
ηt At = −St2 e = −St2 eσ (T −t)+(T −t)r = −C(t, St ).
A0
As for the self-financing condition, we have
2
dC(t, St ) = d St2 e(r+σ )(T −t)


2 2
= −(r + σ 2 )e(r+σ )(T −t)
St2 dt + e(r+σ )(T −t)
d St2


2 2
= −(r + σ 2 )e(r+σ )(T −t)
St2 dt + e(r+σ )(T −t)
2St dSt + σ 2 St2 dt


2 2
= −re(r+σ )(T −t)
St2 dt + 2St e(r+σ )(T −t)
dSt ,

and
2 St2 σ2 (T −t)+(T −2t)r
ξt dSt + ηt dAt = 2St e(r+σ )(T −t)
dSt − r e At dt
A0
2 2
= 2St e(r+σ )(T −t)
dSt − rSt2 eσ (T −t)+(T −t)r
dt,

which recovers dC(t, St ) = ξt dSt + ηt dAt , i.e. the portfolio strategy is

self-financing.

Exercise 7.16 (Exercise 6.11 continued).

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a) The discounted process Xt := e−rt St satisfies

dXt = (α − r)Xt dt + σe−rs dBs ,

which is a martingale when α = r by Proposition 7.1, as in this case it be-

comes a stochastic integral with respect to a standard Brownian motion.
This fact can be recovered by directly computing the conditional expecta-
tion IE[Xt | Fs ] and showing it is equal to Xs . By (4.35), see Exercise 6.11,
we have wt
St = S0 eαt + σ e(t−s)α dBs ,
0
hence wt
Xt = S0 + σ e−rs dBs , t ≥ 0,
0
and
 wt 
IE[Xt | Fs ] = IE S0 + σ e−ru dBu Fs
0
w 
t
= IE[S0 ] + σ IE e−ru dBu Fs
0
w  w 
s t
= S0 + σ IE e−ru
dBu Fs + σ IE e−ru dBu Fs
0 s
ws w
t

= S0 + σ e−ru dBu + σ IE e−ru dBu
0 s
ws
= S0 + σ e−ru dBu
0
= Xs , 0 ≤ s ≤ t.

b) We rewrite the stochastic differential equation satisfied by (St )t∈R+ as

dSt = αSt dt + σdBt = rSt dt + σdB

bt ,

where
α−r
bt :=
dB St dt + dBt ,
σ
which allows us to rewrite (4.35), by taking α := −r therein, as
 wt  wt
St = ert S0 + σ e−rs dB
bs = S0 ert + σ e(t−s)r dB
bs . (S.7.32)
0 0

Taking
α−r
ψt := St , 0 ≤ t ≤ T,
σ
in the Girsanov Theorem 7.3, the process (B
bt )t∈R is a standard Brownian
+
motion under the probability measure Pα defined by

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 Solutions Manual

 w
1wT 2

dPα T
:= exp − ψt dBt − ψt dt
dP 0 2 0
w 1 α−r wT 2
 2 !
α−r T
= exp − St dBt − St dt ,
σ 0 2 σ 0

and (Xt )t∈R+ is a martingale under Pα .

c) Using (S.7.32) under the risk-neutral probability measure P∗ , we have

C(t, St ) = e−(T −t)r IEα [exp(ST ) | Ft ]

  wT  
= e−(T −t)r IEα exp erT S0 + σ e(T −u)r dBbu Ft
0
  wt wT  
=e −(T −t)r
IEα exp e S0 + σ e(T −u)r dB
rT bu + σ e(T −u)r dB
bu Ft
0 t
    wT  
= exp − (T − t)r + e(T −t)r St IEα exp σ e(T −u)r dB bu Ft
t
    wT 
= exp − (T − t)r + e (T −t)r
St IEα exp σ e(T −u)r dB bu
t
   σ2 w T 
= exp − (T − t)r + e(T −t)r St exp e2(T −u)r du
2 t
 σ 2 2(T −t)r 
= exp − (T − t)r + e(T −t)r St + (e − 1) , 0 ≤ t ≤ T.
4r
d) We have

∂C  σ 2 2(T −t)r 
ξt = (t, St ) = exp St e(T −t)r + (e − 1)
∂x 4r
and
C(t, St ) − ξt St
ηt =
At
e−(T −t)r  σ 2 2(T −t)r 
= exp St e(T −t)r + (e − 1)
At 4r
St  σ 2 2(T −t)r 
− exp St e(T −t)r + (e − 1) .
At 4r
e) We have
 σ 2 2(T −t)r 
dC(t, St ) = re−(T −t)r exp St e(T −t)r + (e − 1) dt
4r
 σ 2 2(T −t)r 
−rSt exp St e(T −t)r + (e − 1) dt
4r
σ2  σ 2 2(T −t)r 
− e(T −t)r exp St e(T −t)r + (e − 1) dt
2 4r

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 σ 2 2(T −t)r 
+ exp St e(T −t)r + (e − 1) dSt
4r
1  σ 2 2(T −t)r 
+ e(T −t)r exp St e(T −t)r + (e − 1) σ 2 dt
2 4r
 σ 2 2(T −t)r 
= re−(T −t)r exp St e(T −t)r + (e − 1) dt
4r
 σ 2 2(T −t)r 
−rSt exp St e(T −t)r + (e − 1) dt + ξt dSt .
4r
On the other hand, we have

ξt dSt + ηt dAt = ξt dSt

 σ 2 2(T −t)r 
+re−(T −t)r exp St e(T −t)r + (e − 1) dt
4r
 σ 2 2(T −t)r 
−rSt exp St e(T −t)r + (e − 1) dt,
4r
showing that
dC(t, St ) = ξt dSt + ηt dAt ,
and confirming that the strategy (ξt , ηt )t∈R+ is self-financing.

Exercise 7.17
a) Using (S.7.32) under the risk-neutral probability measure P∗ , we have

C(t, St ) = e−(T −t)r IEα [ST2 | Ft ]

wT
" 2 #
= e−(T −t)r IEα erT S0 + σ e(T −u)r dB
bu Ft
0

wt wT
" 2 #
=e −(T −t)r
IEα erT
S0 + σ e(T −u)r bu + σ
dB e (T −u)r
dB
bu Ft
0 t

wt
" 2 #
= e−(T −t)r IEα erT S0 + σ e(T −u)r dB
bu Ft
0
 wt  w
T

+2σe−(T −t)r erT S0 + σ e(T −u)r dB bu IEα e(T −u)r dB
bu Ft
0 t
wT
" 2 #
+σ 2 e−(T −t)r IEα e(T −u)r dB
bu Ft
t

wt w
 2 " 2 #
T
= e−(T −t)r erT S0 + σ e(T −u)r dB
bu + σ 2 e−(T −t)r IEα e(T −u)r dB
bu
0 t
 wt 2 wT
= e−(T −t)r erT S0 + σ e(T −u)r dB
bu + σ 2 e−(T −t)r e2(T −u)r du
0 t

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σ 2 (T −t)r
= e(T −t)r St2 + e − e−(T −t)r


2r
sinh((T − t)r)
= e(T −t)r St2 + σ 2 , 0 ≤ t ≤ T.
r
b) We find
∂C
ξt = (t, St ) = 2e(T −t)r St , 0 ≤ t ≤ T.
∂x

Exercise 7.18 (Exercise 5.8 continued, see Proposition 4.1 in Carmona and
(2) (1)

Durrleman (2003)). Letting α := IE∗ [ST ] = ert S0 − S0 and
 (2) (1) 
η 2 := Var∗ St − St
(1)
2 σ12 t (2)
2 σ22 t (1) (2) (2) (1)
2

= e2rt S0 e + S0 e − 2S0 S0 eρσ1 σ2 t − S0 − S0 ,

we approximate

e−rt w ∞ 2 2
e−rt IE∗ [(ST − K)+ ] ≃ p (x − K)+ e−(x−α) /(2η ) dx
2πη 2 −∞
e−rt w ∞ 2 2
= p (x − K)e−(x−α) /(2η ) dx
2πη 2 K
e−rt w ∞ −(x−α)2 /(2η2 ) Ke−rt w ∞ −(x−α)2 /(2η2 )
= p xe dx − p e dx
2πη 2 K 2πη 2 K
ηe−rt w ∞ 2 Ke−rt w ∞ 2
= √ (x + α)e−x /2 dx − √ e−x /2 dx
2π (K−α)/η 2π (K−α)/η
ηe−rt h −x2 /2 i∞
 
K −α
=−√ e − (K − α)e−rt Φ −
2π (K−α)/η η
ηe−rt −(K−α)2 /(2η2 )
 
K − α
= √ e − (K − α)e−rt Φ − .
2π η

Remark: We note that the expected value IE∗ [ϕ(ST − K)] can be exactly
computed from
w∞w∞
(2) (1)

IE∗ [ϕ(ST )] = IE∗ ϕ ST − ST = ϕ x − y φ1 (x)φ2 (y)dxdy,


0 0

where
1 (−(r − σi2 /2)T + log(x/S0 ))2
 
φi (x) = √ exp −
xσi 2πT 2σi2 T
(i)
is the lognormal probability density function of ST , i = 1, 2. In particular,
we have

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w∞
(2) (1)

IE∗ [ϕ(ST )] = IE∗ ϕ ST − ST =


ϕ z φ(z)dz,
0

where
w∞
φ(z) = φ1 (z + y)φ2 (y)dydy
w∞ 0 2 2 2 2 2 2
= e−(−(r−σ1 /2)T +log((z+y)/S0 )) /(2σ1 T )−(−(r−σ2 /2)T +log(y/S0 )) /(2σ2 T )
0
dy
×
2πT σ1 σ2 (z + y)y

is the probability density function of ST .

1.6
1.4
1.2
1
0.8
0.6
0.4
0.2 Gaussian PDF
Integral formula
0
-1 -0.5 0 0.5 1
z

Fig. S.29: Gaussian approximation of spread probability density function.

0.12
Integral evaluation
0.1 Monte Carlo estimation
Gaussian approximation
0.08

0.06

0.04

0.02

0
0 0.2 0.4 0.6 0.8 1
K

Fig. S.30: Gaussian approximation of spread option prices.

Exercise 7.19 (Exercise 6.2 continued). If C is a contingent claim payoff of

the form C = ϕ(ST ) such that (ξt , ηt )t∈[0,T ] hedges the claim payoff C, the

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arbitrage-free price of the claim payoff C at time t ∈ [0, T ] is given by

πt (X) = Vt = e−r(T −t) IE∗ [ϕ(ST ) | Ft ], 0 ≤ t ≤ T,

where IE∗ denotes expectation under the risk-neutral measure P∗ . Hence,

from the noncentral Chi square probability density function

fT −t (x)

!  αβ/σ2 −1/2
2β 2β x + rt e−β(T −t) x
=
exp −
σ 1−e σ 2 1 − e−β(T −t) rt e−β(T −t)


2 −β(T −t)
p !
4β rt xe−β(T −t)
× I2αβ/σ2 −1
,
σ 2 1 − e−β(T −t)

of ST given St , x > 0, we find

g(t, St ) = e−r(T −t) IE∗ [ϕ(ST ) | Ft ]

w∞ αβ/σ2 −1/2
2βe−r(T −t) β(x+St e−β(T −t) )

x −2
= 2 ϕ(x) e σ2 (1−e−β(T −t) )
σ 1 − e−β(T −t) 0 St e−β(T −t)


p !
4β xSt e−β(T −t)
× I2αβ/σ2 −1
dx
σ 2 1 − e−β(T −t)

0 ≤ t ≤ T , under the Feller condition 2αβ ≥ σ 2 .

Exercise 7.20
a) We have

∂f ∂f
(t, x) = (r − σ 2 /2)f (t, x), (t, x) = σf (t, x),
∂t ∂x
and
∂2f
(t, x) = σ 2 f (t, x),
∂x2
hence

dSt = df (t, Bt )
∂f ∂f 1 ∂2f
= (t, Bt )dt + (t, Bt )dBt + (t, Bt )dt
∂t ∂x 2 ∂x2
1 2 1
 
= r − σ f (t, Bt )dt + σf (t, Bt )dBt + σ 2 f (t, Bt )dt
2 2
= rf (t, Bt )dt + σf (t, Bt )dBt
= rSt dt + σSt dBt .

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b) We have

IE eσBT Ft = IE e(BT −Bt +Bt )σ Ft

   

= eσBt IE e(BT −Bt )σ Ft

 

= eσBt IE e(BT −Bt )σ

 
2
= eσBt +σ (T −t)/2
.

c) We have
2
IE[ST | Ft ] = IE eσBT +rT −σ T /2 Ft
 
2
= erT −σ T /2 IE eσBT Ft
 
2
T /2 σBt +σ 2 (T −t)/2
= erT −σ e
rT +σBt −σ 2 t/2
=e
2
= e(T −t)r+σBt +rt−σ t/2

=e (T −t)r
St , 0 ≤ t ≤ T.

d) We have

Vt = e−(T −t)r IE[C | Ft ]

= e−(T −t)r IE[ST − K | Ft ]
= e−(T −t)r IE[ST | Ft ] − e−(T −t)r IE[K | Ft ]
= St − e−(T −t)r K, 0 ≤ t ≤ T.

e) We take ξt = 1 and ηt = −Ke−rT /A0 , t ∈ [0, T ].

f) We find
VT = IE[C | FT ] = C.

Exercise 7.21 Binary options. (Exercise 6.10 continued).

a) By definition of the indicator (or step) functions 1[K,∞) and 1[0,K] we
have
 1 if x ≥ K,  1 if x ≤ K,
 

1[K,∞) (x) = resp. 1[0,K] (x) =

0 if x < K, 0 if x > K,
 

which shows the claimed result by the definition of Cb and Pb .

b) We have

πt (Cb ) = e−(T −t)r IE[Cb | Ft ]

= e−(T −t)r IE 1[K,∞) (ST ) St
 

= e−(T −t)r P(ST ≥ K | St )

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= Cb (t, St ).

c) We have πt (Cb ) = Cb (t, St ), where

Cb (t, x) = e−(T −t)r P(ST > K | St = x)

(r − σ 2 /2)(T − t) + log(St /K)
 
= e−(T −t)r Φ √
σ T −t
= e−(T −t)r Φ (d− (T − t)) ,

with
(r − σ 2 /2)(T − t) + log(St /K)
d− (T − t) = √ .
σ T −t
d) The price of this modified contract with payoff

Cα = 1[K,∞) (ST ) + α1[0,K) (ST )

is given by

πt (Cα ) = e−(T −t)r IE 1[K,∞) (ST ) + α1[0,K) (ST ) St

 

= e−(T −t)r P(ST ≥ K | St ) + αe−(T −t)r P(ST ≤ K | St )

= e−(T −t)r P(ST ≥ K | St ) + αe−(T −t)r (1 − P(ST ≥ K | St ))
= αe−(T −t)r e−(T −t)r + (1 − α)P(ST ≥ K | St )
(T − t)r − (T − t)σ 2 /2 + log(St /K)
 
= αe−(T −t)r + (1 − α)e−(T −t)r Φ √ .
σ T −t

1.2
1
0.8
0.6
0.4
0.2
0

15

10 200
150
5 100
Time to maturity T-t 50
0 Underlying (HK$)
0

Fig. S.31: Price of a binary call option.

e) We note that

1[K,∞) (ST ) + 1[0,K] (ST ) = 1[0,∞) (ST ),

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almost surely since P(ST = K) = 0, hence

πt (Cb ) + πt (Pb ) = e−(T −t)r IE[Cb | Ft ] + e−(T −t)r IE[Pb | Ft ]

= e−(T −t)r IE[Cb + Pb | Ft ]
= e−(T −t)r IE 1[K,∞) (ST ) + 1[0,K] (ST ) Ft
 

= e−(T −t)r IE 1[0,∞) (ST ) Ft

 

= e−(T −t)r IE[1 | Ft ]

= e−(T −t)r , 0 ≤ t ≤ T.

f) We have

πt (Pb ) = e−(T −t)r − πt (Cb )

(T − t)r − (T − t)σ 2 /2 + log(x/K)
 
= e−(T −t)r − e−(T −t)r Φ √
σ T −t
= e−(T −t)r (1 − Φ(d− (T − t)))
= e−(T −t)r Φ(−d− (T − t)).

g) We have

∂Cb
ξt = (t, St )
∂x
(T − t)r − (T − t)σ 2 /2 + log(x/K)
 
∂
= e−(T −t)r Φ √
∂x σ T −t x=St
1 −(d− (T −t))2 /2
=e −(T −t)r
e
σSt 2(T − t)π
p

> 0.

The Black-Scholes hedging strategy of such a call option does not involve
short selling because ξt > 0 at all times t, cf. Figure S.32 which represents
the risky investment in the hedging portfolio of a binary call option.

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Fig. S.32: Risky hedging portfolio value for a binary call option.

Figure S.33 presents the risk-free hedging portfolio value for a binary call
option.

Fig. S.33: Risk-free hedging portfolio value for a binary call option.

h) Here, we have

∂Pb
ξt = (t, St )
∂x
(T − t)r − (T − t)σ 2 /2 + log(x/K)
 
∂
= e−(T −t)r Φ − √
∂x σ T −t x=St
1 2
= −e−(T −t)r p e−(d− (T −t)) /2
σ 2(T − t)πSt
< 0.

The Black-Scholes hedging strategy of such a put option does involve short
selling because ξt < 0 for all t.

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Exercise 7.22 Applying Itô’s formula to e−rt ϕ(St ))t∈R+ and using the fact
that the expectation of the stochastic integral with respect to (Bt )t∈R+ is
zero, cf. Relation (4.17), we have

C(x, T ) = IE e−rT ϕ(ST ) S0 = x (S.7.33)

 
 wT wT
= IE ϕ(x) − r e ϕ(St )dt + r
−rt
e St ϕ (St )dt
−rt ′
0 0
wT 1 w T −rt ′′

+σ e−rt St ϕ′ (St )dBt + e ϕ (St )σ 2 (St )dt S0 = x
0 2 0
w  w 
T T
= ϕ(x) − r IE e ϕ(St )dt S0 = x + r IE
−rs
e−rt St ϕ′ (St )dt S0 = x
0 0
w
1

T
+ IE e−rt ϕ′′ (St )σ 2 (St )dt S0 = x
2 0
wT wT
= ϕ(x) − re−rt IE ϕ(St ) S0 = x dt + r e−rt IE St ϕ′ (St ) S0 = x dt
   
0 0
1 w T −rt  ′′
+ e IE ϕ (St )σ 2 (St ) S0 = x dt,

2 0
hence, by differentiation with respect to T we find
∂ −rT
ThetaT = e IE[ϕ(ST ) | S0 = x]


∂T
= −re−rT IE ϕ(ST ) S0 = x + re−rT IE ST ϕ′ (ST ) S0 = x
   

1
+ e−rT IE ϕ′′ (ST )σ 2 (ST ) S0 = x .
 
2

Problem 7.23 Chooser options.

a) We take conditional expectations in the equality

(ST − K)+ − (K − ST )+ = ST − K

to find

C(t, St , K, T ) − P (t, St , K, T )
= e−(T −t)r IE∗ [(ST − K)+ | Ft ] − e−(T −t)r IE∗ [(K − ST )+ | Ft ]
= e−(T −t)r IE∗ [ST − K | Ft ]
= e−(T −t)r IE∗ [ST | Ft ] − Ke−(T −t)r
= St − Ke−(T −t)r , 0 ≤ t ≤ T.

b) The price this contract at time t ∈ [0, T ] can be written as

e−(T −t)r IE∗ [P (T, ST , K, U ) | Ft ]

h i
= e−(T −t)r IE∗ e−(U −T )r IE∗ (K − SU )+ | FT | Ft
 

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= e−(U −t)r IE∗ (K − SU )+ | Ft

 

= P (t, St , K, U ).

c) From the call-put parity (7.47) the payoff of this contract can be written
as

max(P (T, ST , K, U ), C(T, ST , K, U ))

= max(P (T, ST , K, U ), P (T, ST , K, U ) + ST − Ke−(U −T )r )
= P (T, ST , K, U ) + max(ST − Ke−(U −T )r , 0).

d) The contract of Question (c) is priced at any time t ∈ [0, T ] as

e−(T −t)r IE∗ [max(P (T, ST , K, U ), C(T, ST , K, U )) | Ft ]

= e−(T −t)r IE∗ [P (T, ST , K, U ) | Ft ]
h i
+e−(T −t)r IE∗ max(ST − Ke−(U −T )r , 0) | Ft
= e−(T −t)r IE∗ [e−(U −T )r IE∗ [(K − SU )+ | FT ] | Ft ]
+e−(T −t)r IE∗ max ST − Ke−(U −T )r , 0 Ft



= e−(U −t)r IE∗ [(K − SU )+ | Ft ]

+e−(T −t)r IE∗ max ST − Ke−(U −T )r , 0 Ft



= P (t, St , K, U ) + C t, St , Ke−(U −T )r , T . (S.7.34)

100
90
80
70
60
50
40
30
20
10
8
6 140
4 100 120
Time to maturity T-t 2 60 80
0 20 40
0 Underlying
Fig. S.34: Black-Scholes price of the maximum chooser option.

e) By (S.7.34) and Relation (6.3) in Proposition 6.1 we have

∂C
∂P
ξt = t, St , Ke−(U −T )r , T + (t, St , K, U )
∂x ∂x
log(e(U −T )r St /K) + (r + σ 2 /2)(T − t)
 
=Φ √
σ T −t
log(St /K) + (r + σ 2 /2)(U − t)
 
−Φ − √
σ U −t

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log(St /K) + (U − t)r + (T − t)σ 2 /2

 
=Φ √
σ T −t
log(St /K) + (r + σ 2 /2)(U − t)
 
−Φ − √ .
σ U −t

0.5

-0.5

-1

2.5
2
1.5 140
Time to maturity T-t 1 120
100
0.5 80
0 60
40 Underlying

Fig. S.35: Delta of the maximum chooser option.

f) From the call-put parity (7.47) the payoff of this contract can be written
as

min(P (T, ST , K, U ), C(T, ST , K, U ))

= min C(T, ST , K, U ) − ST + Ke−(U −T )r , C(T, ST , K, U )

= C(T, ST , K, U ) + min(−ST + Ke−(U −T )r , 0)

= C(T, ST , K, U ) − max(ST − Ke−(U −T )r , 0).

g) The contract of Question (f) is priced at any time t ∈ [0, T ] as

e−(T −t)r IE∗ min P (T, ST , K, U ), C(T, ST , K, U ) Ft




= e−(T −t)r IE∗ [C(T, ST , K, U ) | Ft ]

−e−(T −t)r IE∗ max ST − Ke−(U −T )r , 0 Ft



= e−(T −t)r IE∗ [e−(U −T )r IE∗ [(SU − K)+ | FT ] | Ft ]

−e−(T −t)r IE∗ max ST − Ke−(U −T )r , 0 Ft



= e−(U −t)r IE∗ (SU − K)+ | Ft

 

−e−(T −t)r IE∗ max ST − Ke−(U −T )r , 0 Ft




= C(t, St , K, U ) − C t, St , Ke−(U −T )r , T . (S.7.35)

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8
7
6
5
4
3
2
1
0

8
6
4 140
Time to maturity T-t 120
100
2 80
60
40
0 20
0 Underlying

Fig. S.36: Black-Scholes price of the minimum chooser option.

h) By (S.7.35) and Relation (6.3) in Proposition 6.1 we have

∂C ∂C
ξt = (t, St , K, U ) − t, St , Ke−(U −T )r , T


∂x ∂x
log(St /K) + (r + σ 2 /2)(U − t)
 
=Φ √
σ U −t
log(e(U −T )r St /K) + (r + σ 2 /2)(T − t)
 
−Φ √
σ T −t
log(St /K) + (r + σ 2 /2)(U − t)
 
=Φ √
σ U −t
log(St /K) + (U − t)r + (T − t)σ 2 /2
 
−Φ √ .
σ T −t

0.6
0.4
0.2
0
-0.2
-0.4

8
6
140
4 120
Time to maturity T-t 100
2 80
60
40
0 20 Underlying
0

Fig. S.37: Delta of the minimum chooser option.

i) Such a contract is priced as the sum of a European call and a European put
option with maturity U , and is priced at time t ∈ [0, T ] as P (t, St , K, U ) +
C(t, St , K, U ). Its hedging strategy is the sum of the hedging strategies of

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Questions (e) and (h), i.e.

log(St /K) + (r + σ 2 /2)(U − t)

 
ξt = Φ √
σ T −t
log(St /K) + (r + σ 2 /2)(U − t)
 
−Φ − √
σ T −t
log(St /K) + (r + σ 2 /2)(U − t)
 
= 2Φ √ − 1.
σ T −t

j) When U = T , the contracts of Questions (c), (f) and (i) have the respective
payoffs
• max((ST − K)+ , (K − ST )+ ) = |ST − K|,

• min((ST − K)+ , (K − ST )+ ) = 0, and

• (ST − K)+ + (K − ST )+ = |ST − K|,

where |ST − K| is known as the payoff of a straddle option.

Problem 7.24
a) The self-financing condition reads

dVt = ηt dAt + ξt dSt

= rηt At dt + µξt St dt + σξt St dBt
= rVt dt + (µ − r)ξt St dt + σξt St dBt ,

hence
wT wT
VT = V0 + (rVt + (µ − r)ξt St )dt + σ ξt St dBt
0 0
wT wT
= Vt + (rVs + (µ − r)ξs Ss )ds + σ ξs Ss dBs .
t t

b) The portfolio value Vt rewrites as

wT  µ−r
 wT
Vt = VT − rVs + πs ds − πs dBs
t σ t
wT wT
= VT − r Vs ds − πs dB
bs .
t t

c) We have
wT wT
Vt = VT − r Vs ds − πs dB
bs ,
t t

hence

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dVt = rVt dt + πt dB
bt ,

and after discounting we find

dVet = −re−rt Vt dt + e−rt dVt

= −re−rt Vt dt + e−rt (rVt dt + πt dB
bt )
= e πt dBt ,
−rt b

which shows that wT

VeT = V0 + e−rt πt dB
bt ,
0

after integration in t ∈ [0, T ].

d) We have

dVt = du(t, St )
∂u ∂u ∂u
= (t, St )dt + µSt (t, St )dt + σSt (t, St )dBt
∂t ∂x ∂x
1 ∂2u
+ σ 2 St2 2 (t, St )dt. (S.7.36)
2 ∂x
e) By matching the Itô formula (S.7.36) term by term to the BSDE (7.50)
we find that Vt = u(t, St ) satisfies the PDE

1 ∂2u
 
∂u ∂u ∂u
(t, x) + µ (t, x) + σ 2 x2 2 (t, x) + f t, x, u(t, x), σx (t, x) = 0.
∂t ∂x 2 ∂x ∂x

f) In this case we have

∂u ∂u 1 ∂2u ∂u
(t, x) + µx (t, x) + σ 2 x2 2 (t, x) − ru(t, x) − (µ − r)x (t, x) = 0,
∂t ∂x 2 ∂x ∂x
which recovers the Black-Scholes PDE
∂u ∂u 1 ∂2u
ru(t, x) = (t, x) + rx (t, x) + σ 2 x2 2 (t, x).
∂t ∂x 2 ∂x
g) In the Black-Scholes model the Delta of the European call option is given
by
(r + σ 2 /2)(T − t) + log(St /K)
 
ξt = Φ √ ,
σ T −t
hence
(r + σ 2 /2)(T − t) + log(St /K)
 
πt = σξt St = σSt Φ √ , 0 ≤ t ≤ T.
σ T −t

h) Replacing the self-financing condition with

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dVt = ηt dAt + ξt dSt − γSt (ξt )− dt

= rηt At dt + µξt St dt + σξt St dBt − γSt (ξt )− dt
= rVt dt + (µ − r)ξt St dt − γSt (ξt )− dt + σξt St dBt ,

we get the BSDE

wT wT
Vt = VT − rVs + (µ − r)πs + γ(πs )− ds −


πs dBs .
t t

i) In this case we have

µ−r
f (t, x, u, z) = −ru − z − γz −
σ
and the BSDE reads

dVt = ru(t, St )dt + (µ − r)ξt St dt − γSt (ξt )− dt + σξt St dBt .

j) We find the nonlinear PDE

−
1 ∂2u

∂u ∂u ∂u
(t, x) + rx (t, x) + σ 2 x2 2 (t, x) − γσx (t, x) = ru(t, x),
∂t ∂x 2 ∂x ∂x
(S.7.37)
with the terminal condition u(T, x) = g(x).
k) The self-financing condition reads

dVt = r1{ηt >0} At ηt dt + R1{ηt <0} At ηt dt + ξt dSt

= rAt ηt dt + (R − r)1{ηt <0} At ηt dt + ξt dSt
= rVt dt − rSt ξt dt − (R − r)(ηt At )− dt + ξt dSt
= rVt dt + (µ − r)St ξt dt − (R − r)(Vt − ξt St )− dt + σξt St dBt ,

which yields the BSDE

wT wT
Vt = VT − rVs + (µ − r)πs − (R − r)(Vs − ξs Ss )− ds −


πs dBs ,
t t

hence we have
(µ − r)  z −
f (t, x, u, z) = −ru − z + (R − r) u −
σ σ
and the nonlinear PDE
1 ∂2u
 
∂u ∂u ∂u
(t, x) + µ (t, x) + σ 2 x2 2 (t, x) + f t, x, u(t, x), σx (t, x) =0
∂t ∂x 2 ∂x ∂x
rewrites as

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−
1 ∂2u

∂u ∂u ∂u
(t, x)+r (t, x)+ σ 2 x2 2 (t, x) = ru(t, x)+(r−R) u(t, x) − x (t, x) .
∂t ∂x 2 ∂x ∂x

l) The sum of profits and losses of the portfolio (ξt , ηt )t∈R+ is

wT wT wT wT
V0 + ηt dAt + ξt dSt = V0 + dVt + dUt
0 0 0 0
= VT + UT − U0
> VT = C,

hence the corresponding portfolio strategy superhedging the claim payoff

VT = C.

Exercise 7.25 Girsanov Theorem. For all n ≥ 1, let

:= 1{ψt ∈[−n,n]} ψt ,
(n)
ψt 0 ≤ t ≤ T.
(n)
Since (ψt )t∈[0,T ] is a bounded process it satisfies the Novikov integrability
condition (7.11), hence for all n ≥ 1 and random variable F ∈ L1 (Ω) we have
  w·   w
T 1 w T (n) 2

IE[F ] = IE F B· + ψs(n) ds exp − ψs(n) dBs − (ψs ) ds ,
0 0 2 0

which yields
  w·   w
T 1 w T (n) 2

IE[F ] = lim IE F B· + ψs(n) ds exp − ψs(n) dBs − (ψs ) ds
n→∞ 0 0 2 0
  w·   w
T 1 w T (n) 2

≥ IE lim inf F B· + ψs ds exp −
(n) (n)
ψs dBs − (ψs ) ds
n→∞ 0 0 2 0
  w·   w
T 1wT

= IE F B· + ψs ds exp − ψs dBs − (ψs )2 ds ,
0 0 2 0

where we applied Fatou’s Lemma.∗

Problem 7.26
a) We have

Cov(dSt /St , dMt /Mt )

Var[dMt /Mt ]
Cov((r + α)dt + β(dMt /Mt − rdt) + σS dWt , µdt + σM dBt )
=
Var[µdt + σM dBt ]
∗
IE[limn→∞ Fn ] ≤ limn→∞ IE[Fn ] for any sequence (Fn )n∈N of nonnegative random
variables, provided that the limits exist, see MH4100 Real Analysis II.

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Cov (r + α)dt + β(µdt + σM dBt − rdt) + σS dWt , µdt + σM dBt

=
Var[µdt + σM dBt ]
Cov βσM dBt + σS dWt , σM dBt


=
Var[σM dBt ]
Cov βσM dBt , σM dBt + Cov σS dWt , σM dBt



=
Var[σM dBt ]
Cov βσM dBt , σM dBt


=
Var[σM dBt ]
Cov σM dBt , σM dBt


= β
Var[σM dBt ]
= β.

b) We have
 
dMt
dSt = (r + α)St dt + β − r St dt + σS St dWt
Mt
= (r + α)St dt + βSt (µdt + σM dBt − rdt) + σS St dWt
= (r + α + β(µ − r))St dt + St βσM dBt + σS dWt

2 + σ 2 βσpM dBt + σS dWt

q
= (r + α + β(µ − r))St dt + St β 2 σM S 2 + σ2
.
β 2 σM S

Now, we have
!2
2
2
βσM dBt + σS dWt βσM dBt + βσM σS dBt • dWt + σS dWt
2 + σ2
= 2 + σ2
β 2 σM
p
β 2 σM S S

β 2 σM
2
(dBt )2 + σS2 (dWt )2
= 2 + σ2
β 2 σM S
β 2 σM
2
dt + σS2 dt
= 2 2 + σ2
β σM S
= dt.

By the characterization of Brownian motion as the only continuous mar-

tingale whose quadratic variation is dt, it follows that the process (Zt )t∈R+
defined by
βσM dBt + σS dWt
dZt = p 2 + σ2
β 2 σM S
is a standard Brownian motion, see e.g. Theorem 7.36 page 203 of Kle-
baner (2005). Hence, we have

dSt = (r + α + β(µ − r))St dt + St βσM dBt + σS dWt

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q
= (r + α + β(µ − r))St dt + St 2 + σ 2 dZ .
β 2 σM S t

In what follows we assume that β is allowed to depend locally on the state

of the benchmark market index on Mt , as β(Mt ), t ∈ R+ .
c) We take
µ−r
dBt∗ = dBt + dt (S.7.38)
σM
and
α
dWt∗ = dWt + dt (S.7.39)
σS
in order to have
 dM
t

 = µdt + σM dBt = rdt + σM dBt∗ ,


 Mt



(S.7.40)
 
dSt dMt
= (r + α)dt + β(Mt ) × − rdt + σS dWt
St Mt



= (r + α)dt + σM β(Mt )dBt∗ + σS dWt




= rdt + σM β(Mt )dBt + σS dWt∗ .
∗


d) By the Girsanov theorem, (Bt∗ )t∈[0,T ] is a standard Brownian motion un-

der the probability measure P∗B defined by its Radon-Nikodym density

dP∗B (µ − r)2
 
µ−r
= exp − BT − T ,
dP σM 2σM
2

and (Wt∗ )t∈[0,T ] is a standard Brownian motion under the probability

measure P∗W defined by its Radon-Nikodym density

dP∗W α2
 
α
= exp − WT − 2 T .
dP σS 2σS

We conclude that (Bt∗ )t∈[0,T ] and (Wt∗ )t∈[0,T ] are independent standard
Brownian motions under the probability measure P∗ defined by its Radon-
Nikodym density

dP∗ dP∗B dP∗W (µ − r)2 α2

 
µ−r α
= × = exp − BT − WT − T − 2T .
dP dP dP σM σS 2σM
2 2σS

Indeed, for any sequence t0 = 0 < t1 < · · · < tn−1 < tn = T we have
 ∗ 
dP
IE∗ f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1 = IE f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1



dP
h
= IE f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1

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(µ − r)2 α2
 
µ−r α
× exp − BT − T − W T − T
σM 2σM2 σS 2σS2
(µ − r)2
  
µ − r
= IE f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1 exp −


BT − T
σM 2σM
2

α2
  
α
× IE exp − WT − 2 T
σS 2σS
(µ − r)2
  
µ−r
= IE f Bt∗1 − Bt∗0 , . . . , Bt∗n − Bt∗n−1 exp −


BT − T
σM 2σM
2

= IE f Bt1 − Bt0 , . . . , Btn − Btn−1 ,




and similarly for (Wt∗ )t∈[0,T ] .

e) By (S.7.40), the discounted price processes

(Set )t∈R+ := (e−rt St )t∈R+ and (M

ft )t∈R := (e−rt Mt )t∈R
+ +

satisfy
ft = σM M
ft dB ∗ ,

 dM t

dSt = σM β(Mt )Set dBt∗ + σS Set dWt∗ ,

 e

hence by the Girsanov theorem of Question (d) the discounted two-

dimensional process Set , M is a martingale under the probability


ft
t∈R+
measure P , showing that P is a risk-neutral probability measure. There-
∗ ∗

fore, by Theorem 6.8 the market made of St and Mt is without arbitrage

opportunities due to the existence of a risk-neutral probability measure
P∗ .
f) The self-financing condition for the portfolio strategy (ξt , ζt , ηt )t∈[0,T ]
reads

ηt+dt At+dt + ξt+dt St+dt + ζt+dt Mt+dt , = ηt At+dt + ξt St+dt + ζt Mt+dt

which yields
At+dt dηt + St+dt dξt + Mt+dt ζt = 0,
i.e.

dAt • dηt + dSt • dξt + dMt • dζt + At dηt + St dξt + Mt dζt = 0,

hence

dVt = ηt dAt + ξt dSt + ζt dMt

+At dηt + dηt • dAt + St dξt + dξt • dSt + Mt dζt + dζt • dMt
= ηt dAt + ξt dSt + ζt dMt
= 0.

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g) By the self-financing condition we have

dVt = df (t, St , Mt )
= ξt dSt + ζt dMt + ηt dAt
= ξt (rSt dt + σM β(Mt )St dBt∗ + σS St dWt∗ ) + ζt (rMt dt + σM Mt dBt∗ ) + rηt At dt
= rξt St dt + σM β(Mt )ξt St dBt∗ + σS ξt St dWt∗ + rζt Mt dt + σM ζt Mt dBt∗ + rηt At dt
= rξt St dt + rηt At dt + σS ξt St dWt∗ + rζt Mt dt + (σM β(Mt )ξt St + σM ζt Mt )dBt∗
= rVt dt + σS ξt St dWt∗ + (σM β(Mt )ξt St + σM ζt Mt )dBt∗ . (S.7.41)

On the other hand, by the Itô formula for two state variables, we have

∂f ∂f 1 ∂2f
df (t, St , Mt ) = (t, St , Mt )dt + (t, St , Mt )dSt + (t, St , Mt )(dSt )2
∂t ∂x 2 ∂x2
∂f 1 ∂2f ∂2f
+ (t, St , Mt )dMt + (t, St , Mt )(dMt )2 + (t, St , Mt )dSt • dMt
∂y 2 ∂y 2 ∂x∂y
∂f ∂f
= (t, St , Mt )dt + (t, St , Mt )(rSt dt + σM β(Mt )St dBt∗ + σS St dWt∗ )
∂t ∂x
1 ∂2f
+ (t, St , Mt )(σM 2
β 2 (Mt )St2 + σS2 St2 )dt
2 ∂x2
∂f 1 ∂2f
+ (t, St , Mt )(rMt dt + σM Mt dBt∗ ) + (t, St , Mt )σM 2
Mt2 dt
∂y 2 ∂y 2
∂2f
+ σM2
St Mt β(Mt ) (t, St , Mt )dt
∂x∂y
∂f ∂f ∂f
= (t, St , Mt )dt + rSt (t, St , Mt )dt + σM β(Mt )St (t, St , Mt )dBt∗
∂t ∂x ∂x
∂f 1 ∂2f
+ σS St (t, St , Mt )dWt∗ + (t, St , M t )(σ 2
β 2
(M t )St dt + σS St dt)
2 2 2
∂x 2 ∂x2 M

∂f ∂f
+ rMt (t, St , Mt )dt + σM Mt (t, St , Mt )dBt∗
∂y ∂y
1 ∂2f ∂2f
+ (t, St , Mt )σM2
Mt2 dt + σM 2
St Mt β(Mt ) (t, St , Mt )dt
2 ∂y 2 ∂x∂y
∂f ∂f ∂f
= (t, St , Mt )dt + rMt (t, St , Mt )dt + rSt (t, St , Mt )dt
∂t ∂y ∂x
1 2 2
2∂ f 1 2 2 2
2∂ f
+ σM Mt (t, St , Mt )dt + σM β (Mt )St 2 (t, St , Mt )dt
2 ∂y 2 2 ∂x
1 ∂2f ∂2f
+ σS2 St2 2 (t, St , Mt )dt) + σM 2
St Mt β(Mt ) (t, St , Mt )dt
2 ∂x ∂x∂y
 
∂f ∂f
+ σM β(Mt )St (t, St , Mt ) + σM Mt (t, St , Mt ) dBt∗ (S.7.42)
∂x ∂y
∂f
+ σS St (t, St , Mt )dWt∗ .
∂x

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By identification of the terms in dt in (S.7.41) and (S.7.42), we find

∂f ∂f
rf (t, St , Mt ) =(t, St , Mt ) + rSt (t, St , Mt )
∂t ∂x
1 ∂2f
+ (σS2 + σM
2
β 2 (Mt ))St2 2 (t, St , Mt )
2 ∂x
∂f 1 2 ∂2f ∂2f
+ rMt (t, St , Mt ) + σM Mt2 2 (t, St , Mt ) + σM
2
St Mt β(Mt ) (t, St , Mt )dt,
∂y 2 ∂y ∂x∂y
which yields the PDE

rf (t, x, y) (S.7.43)
∂f ∂f 1 2 2 ∂2f
= (t, x, y) + rx (t, x, y) + x (σS + σM β (y)) 2 (t, x, y)
2 2
∂t ∂x 2 ∂x
∂f 1 2 2 ∂2f ∂2f
+ry (t, x, y) + σM y (t, x, y) + σM xyβ(y)
2
(t, x, y),
∂y 2 ∂y 2 ∂x∂y
with the terminal condition

f (T, x, y) = h(x, y), x, y > 0.

h) By identification of terms in dBt∗ and dWt∗ in (S.7.41) and (S.7.42), we

find
∂f
ξt = (t, St , Mt )
∂x
and
∂f ∂f
σM β(Mt )St (t, St , Mt )+σM Mt (t, St , Mt ) = σM β(Mt )ξt St +σM ζt Mt ,
∂x ∂y
hence
∂f
ζt = (t, St , Mt ),
∂y
and by the relation Vt = ξt St + ζt Mt + ηt At we find
Vt − ξt St − ζt Mt
ηt =
At
∂f ∂f
f (t, St , Mt ) − St (t, St , Mt ) − Mt (t, St , Mt )
∂x ∂y
= , 0 ≤ t ≤ T.
A0 ert
i) When the option payoff depends only on ST we can look for a solution of
(S.7.43) of the form f (t, x), in which case (S.7.43) simplifies to

∂f ∂f 1 ∂2f
rf (t, x, y) = (t, x, y) + rx (t, x, y) + x2 (σS2 + σM
2
β 2 (y)) 2 (t, x, y),
∂t ∂x 2 ∂x
(S.7.44)

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When β(Mt ) = β is a constant, (S.7.44) becomes the Black-Scholes PDE

with squared volatility parameter

σ 2 := σS2 + σM
2
β2.

When the option is the European call option with strike price K on ST ,
its solution is given by the Black-Scholes function

f (t, x) = Bl(x, K, σ, r, T − t)
= xΦ d+ (T − t) − Ke−(T −t)r Φ d− (T − t) ,

with
log(x/K) + (r + (σS2 + σM
2
β 2 )/2)(T − t)
d+ (T − t) := √ ,
|σ| T − t
log(x/K) + (r − (σS2 + σM
2
β 2 )/2)(T − t)
d− (T − t) := √ ,
|σ| T − t

and
∂f
ξt = (t, St , Mt ) = Φ d+ (T − t) ,


∂x
with
K −(T −t)r K
ηt = − e Φ d− (T − t) = − e−T r Φ d− (T − t) , 0 ≤ t < T.



At A0
j) Similarly to Question (i), when the option is the European put option
with strike price K on ST , its solution is given by the Black-Scholes put
price function

f (t, x) = Ke−(T −t)r Φ − d− (T − t) − xΦ − d+ (T − t) ,

with
∂f
ζt = (t, St , Mt ) = −Φ − d+ (T − t) , 0 ≤ t < T.


∂y
and
K −T r
ηt = e Φ − d− (T − t) , 0 ≤ t < T.


A0
Remark. By the answer to Question (b) we have
q
dSt = (r + α + β(µ − r))St dt + St β 2 σM
2 + σ 2 dZ
S t

where (Zt )t∈R+ is a standard Brownian motion, hence the answers to

Questions (i) and j can be recovered from the pricing relation

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Introduction to Stochastic Finance with Market Examples, Second Edition

f (t, St ) = e−(T −t)r IE∗ ϕ(ST ) | Ft ], 0 ≤ t ≤ T.



Problem 7.27
1) a) It suffices to let τn := T , n ≥ 1. Then, the sequence (τn )n≥1 clearly sat-
isfies Conditions (v)−(vi), and the process (Mτn ∧t )t∈[0,T ] = (Mt )t∈[0,T ]
is a (true) martingale under P.
b) Applying
i) the local martingale property to a suitable sequence (τn )n≥1 of
stopping times, and
ii) Fatou’s lemma to the non-negative sequence (Mτn ∧t )n≥1 ,
we have

IE[Mt | Fs ] = IE lim Mτn ∧t Fs

 
n→∞
≤ lim inf IE[Mτn ∧t | Fs ]
n→∞
= lim inf Mτn ∧s
n→∞
= lim Mτn ∧s
n→∞
= Ms , 0 ≤ s ≤ t ≤ T,

which shows that (Mt )t∈[0,T ] is a supermartingale.

c) Since (Mt )t∈[0,T ] is a supermartingale by Question (1b), for any t ∈
[0, T ] we have IE[MT | Ft ] − Mt ≤ 0 a.s., and there exists t ∈ [0, T ]
such that IE[IE[MT | Ft ] − Mt ] < 0, otherwise we would have IE[MT |
Ft ]−Mt = 0 a.s. for all t ∈ [0, T ], and (Mt )t∈[0,T ] would be a martingale
by the tower property.∗ Therefore, using again the tower property, we
find

IE[MT − M0 ] = IE[IE[MT | Ft ] − M0 ] ≤ IE[IE[MT | Ft ] − Mt ] < 0.

d) We have

C(0, M0 ) − P (0, M0 ) = e−rT IE[(erT MT − K)+ − (K − erT MT )+ ]

= IE[(MT − e−rT K)+ − (e−rT K − MT )+ ]
= IE[MT − e−rT K]
< IE[M0 ] − e−rT K,

showing that the call-put parity relation C(0, M0 ) − P (0, M0 ) =

IE[M0 ] − e−rT K is not satisfied.
2) a) The stochastic differential
√ equation can be rewritten as dSt = σ(t, St )dBt
where σ(t, x) = x/ T − t, t ∈ [0, T − ε], satisfies the global Lipschitz
condition
∗
If Mt = IE[MT | Ft ] for all t ∈ [0, t] then Ms = IE[MT | Fs ] = IE[IE[MT | Ft ] | Fs ] =
IE[MT | Fs ], 0 ≤ s ≤ t ≤ T .

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x−y |x − y|
|σ(t, x) − σ(t, y)| = √ ≤ , x, y ∈ R.
T −t T −ε

Hence by e.g. Theorem V-7 in Protter (2004) this stochastic differential

equation admits unique (strong) solution such that
wt Ss
St = S0 + dBs , 0 ≤ t ≤ T − ε.
0 T −s
Next, we have
w
1 w t ds

dB
t
St = S0 exp √ s −
T −s 2
0 0 T −s
w
1

t dBs T
= S0 exp √ − log
0 T −s 2 T −t
r w 
t t dBs
= S0 1 − exp √ , 0 ≤ t ≤ T − ε.
T 0 T −s

b) We have ST = 0, as can be checked from the graphs of Question (d)

below.
c) Consider the stopping times

1
  
τn := 1− T ∧ inf{t ∈ [0, T ] : |St | ≥ n}, n ≥ 1.
n

for all n ≥ 1 the stopped process (Sτn ∧t )t∈[0,T ] is given by

w τn ∧tSu wt S
Sτn ∧t = S0 + √ dBu = S0 + 1[0,τn ] (u) √ u dBu ,
0 T −u 0 T −u
√
0 ≤ t ≤ T , and the process (1[0,τn ] (u)Su / T − u)0≤u≤τn ∧t is square
integrable as
w w
S2 n2
 
T (1−1/n)T
IE 1[0,τn ] (u) u du ≤ IE 1[0,τn ] (u) du ,
0 T −u 0 T −u

hence by Proposition 8.1 the stopped process (Sτn ∧t )t∈[0,T ] is a (true)

martingale under P for all n ≥ 1, and therefore (St )t∈[0,T ] is a local
martingale on [0, T ]. Finally, we note that since 0 = IE[ST ] ̸= S0 , the
process (St )t∈[0,T ] is not a martingale.
d) The following
√ code solves the stochastic differential equation dSt =
St dBt / 1 − t by the Euler scheme.

N=10000; t <- 0:N; dt <- 1.0/N;

dB <- rnorm(N,mean=0,sd=sqrt(dt));S <- rep(0,N+1);S[1]=1.0
for (k in 2:(N-1)){S[k]=S[k-1]+S[k-1]*dB[k]/sqrt(1-k*dt)}
plot(t*dt, S, xlab = "t", ylab = "", type = "l", ylim = c(0,1.05*max(S)), col = "blue",
xaxs = "i", yaxs = "i",cex.axis=1.6,cex.lab=1.8)

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7
6
5
4
3
2
1
0

0.0 0.2 0.4 0.6 0.8 1.0

t
√
Fig. S.38: Sample path of dSt = St dBt / 1 − t.

3) a) The following code solves the stochastic differential equation dSt =

St2 dBt by the Euler scheme.

N=10000; t <- 0:N; dt <- 1.0/N;

dB <- rnorm(N+1,mean=0,sd=sqrt(dt));S <- rep(0,N+1);S[1]=1.0
for (k in 2:(N+1)){S[k]=S[k-1]+S[k-1]^2*dB[k]}
plot(t*dt, S, xlab = "t", ylab = "", type = "l", ylim = c(1.05*min(S),1.05*max(S)), col
= "blue", xaxs = "i", yaxs = "i",cex.axis=1.6,cex.lab=1.8)
6
5
4
3
2
1

0.0 0.2 0.4 0.6 0.8 1.0

t

Fig. S.39: Sample path of dSt = St2 dBt .

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3.5
3.0
2.5
2.0
1.5
1.0

0.0 0.2 0.4 0.6 0.8 1.0

t

Fig. S.40: Sample path of dSt = St2 dBt .

b) With the change of variable y = 1/x and dy = −dx/x2 , we have

w∞
IE[ST ] = xφT (x)dx
0
w∞ S
 
(1/x − 1/S0 )2
 
(1/x + 1/S0 )2

= √0 exp − − exp − dx
0 x2 2πT 2T 2T
w∞ S 
(y − 1/S0 ) 2
 w ∞ S

(y + 1/S0 )2

= √ 0 exp − dy − √ 0 exp − dy
0 2πT 2T 0 2πT 2T
w∞ S

y2
 w∞ S

y2

= √ 0 exp − dy − √ 0 exp − dy
−1/S0 2πT 2t 1/S0 2πT 2T
w∞ S
 2
y w ∞ S
 2
y
= √ √ 0 exp − dy − √ √ 0 exp − dy
−1/(S0 T ) 2π 2 1/(S0 T ) 2π 2
√ √
= S0 Φ(1/(S0 T )) − S0 Φ(−1/(S0 T ))
√
= S0 (1 − 2Φ(−1/(S0 T ))).

c) We have

1 1
   
IE[ST ] = 2S0 Φ √ −
S0 T 2
w √ w0 
1/(S0 T ) 2 dx 2 dx
= 2S0 e−x /2 √ − e−x /2 √
−∞ 2π −∞ 2π
w 1/(S0 √T )
−x2 /2 dx
= 2S0 e √
0 2π
w 1/√T 2 dy
=2 e−(y/S0 ) /2 √ ,
0 2π
hence by the dominated convergence theorem we have

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w 1/√T 2 dy
lim IE[ST ] = lim 2 e−(y/S0 ) /2
√
S0 →∞ S0 →∞ 0 2π
w 1/√T
−(y/S0 )2 /2 dy
=2 lim e √
0 S0 →∞ 2π
w 1/√T dy
=2 1√
0 2π
2
r
= .
πT

d) With the change of variable y = 1/x and dy = −dx/x2 , we have

w∞
IE[(ST − K)+ ] = (x − K)+ φT (x)dx
0
w∞ x−K  
(1/x − 1/S0 )2
 
(1/x + 1/S0 )2

= S0 √ exp − − exp − dx
K x3 2πT 2T 2T
w 1/K S  
(y − 1/S0 ) 2
 
(y + 1/S0 )2

= √ 0 exp − − exp − dy
0 2πT 2T 2T
w 1/K y  
(y − 1/S0 )2
 
(y + 1/S0 )2

−KS0 √ exp − − exp − dy
0 2πT 2T 2T
w 1/K−1/S0 S 
y 2
 w 1/K+1/S0 S

y 2

= √ 0 exp − dy − √ 0 exp − dy
−1/S0 2πT 2T 1/S0 2πT 2T
w 1/K−1/S0 y + 1/S 
y2

0
−KS0 √ exp − dy
−1/S0 2πT 2T
w 1/K+1/S0 y − 1/S 
y 2

0
+KS0 √ exp − dy
1/S0 2πT 2T
1 1 1
   
= S0 Φ √ − √ − S0 Φ − √
K T S0 T S T
 0
1 1 1
  
−S0 Φ √ + √ + S0 Φ √
K T S0 T S0 T
√ 1 1 √ 1 1
   
+KS0 T φ √ − √ − KS0 T φ √ + √
K T S0 T K T S0 T
1 1 1
   
−KΦ √ − √ + KΦ − √
K T S0 T S0 T
1 1 1
   
−KΦ √ + √ + KΦ √
K T S0 T S T
 0
1 1 1
  
= S0 Φ √ − √ − S0 Φ − √
K T S0 T S T
 0
1 1 1
  
−S0 Φ √ + √ + S0 Φ √
K T S0 T S0 T

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√ 1 1 √ 1 1
   
+KS0 T φ √ − √ − KS0 T φ √ + √
K T S0 T K T S0 T
1 1 1 1
   
−KΦ √ − √ − KΦ √ + √ +1
K T S0 T K T S T
 0
1 1 1
  
= S0 Φ √ − √ − S0 Φ − √
K T S0 T S0 T
1 1 1
   
−S0 Φ √ + √ + S0 Φ √
K T S0 T S0 T
√ 1 1 √ 1 1
   
+KS0 T φ √ − √ − KS0 T φ √ + √
K T S0 T K T S0 T
1 1 1 1
   
+KΦ √ − √ − KΦ √ + √ ,
S0 T K T K T S0 T
2 √
where φ(z) := e−z / 2π is the standard normal probability density
function, see Relation (2.1.2) in Jacquier (2017).
e) We have

IE[(ST − K)+ ] ≤ IE[ST ]

w 1/√T 2 dy
=2 e−(y/S0 ) /2 √
0 2π
w 1/√T dy
≤2 √
0 2π
2
r
≤ .
πT

Fig. S.41: “Infogrames” stock price curve.

Problem 7.28

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a) Relation (7.54) can be checked to hold first on the event Aα , and then
on its complement Acα . Taking the Q-expectation on both sides of (7.54)
yields
     
dP dP
IEQ − α (21Aα − 1) ≥ IEQ − α (21A − 1) ,
dQ dQ
i.e.
   
dP dP
IEQ (21Aα − 1) −α IEQ [21Aα −1] ≥ IEQ (21A − 1) −α IEQ [21A −1],
dQ dQ
i.e.

2P(Aα ) − 1 − α(2Q(Aα ) − 1) ≥ 2P(A) − 1 − α(2Q(A) − 1),

which shows that

P(Aα ) − P(A) ≥ α(Q(Aα ) − Q(A)),

allowing us to conclude to P(Aα ) − P(A) ≥ 0 since α ≥ 0.

b) We check that dQ∗ /dP∗ ≥ 0 since C ≥ 0, and
w
Q∗ (Ω) = dQ∗
Ω
w dQ∗
= dP∗
Ω dP∗
w C
= dP∗
Ω IEP∗ [C]
 
C
= IEP∗
IEP∗ [C]
IEP∗ [C]
=
IEP∗ [C]
= 1.

In the next questions we consider a nonnegative contingent claim payoff

C ≥ 0 with maturity T > 0, priced e−rT IEP∗ [C] at time 0 under the risk-
neutral measure P∗ .

Budget constraint. We assume that no more than a certain fraction

β ∈ (0, 1] of the claim price e−rT IEP∗ [C] is available to construct the
initial hedging portfolio V0 at time 0.

Since a self-financing portfolio process (Vt )t∈R+ started at V0 = βe−rT IEP∗ [C]
may not able to hedge the claim C when β < 1, we will attempt to max-
imize the probability P(VT ≥ C) of successful hedging.

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For this, given A an event we consider the portfolio process (VtA )t∈[0,T ]
hedging the claim C 1A , priced V0A = e−rT IEP∗ [C 1A ] at time 0, and such
that VTA = C 1A at maturity T .
c) Using the probability measure Q∗ , we rewrite the condition (7.56) as

dQ∗ IEP∗ [C 1A ]
 
Q∗ (A) = IEQ∗ [1A ] = IEP∗ 1A ∗ = ≤ β,
dP IEP∗ [C]
i.e.
Q∗ (A) ≤ Q∗ (Aα ) = β.
By the Neyman-Pearson Lemma, for any event A, the inequality Q∗ (A) ≤
Q∗ (Aα ) = β implies P(A) ≤ P(Aα ), which shows that the event A = Aα
realizes the maximum under the required condition.
d) The obvious inequality is

P(Aα ) ≤ P(C 1Aα ≥ C) = P VTAα ≥ C .

In
 the other direction, we note that the event Bα := {C 1Aα ≥ C} =
VTAα ≥ C satisfies (7.56), as

e−rT IEP∗ VTBα = e−rT IEP∗ C 1Bα

   

= e−rT IEP∗ C 1{C 1Aα ≥C}

 

= e−rT IEP∗ C 1Aα

 

= βe−rT IEP∗ [C],

where the last equality IEP∗ C 1Aα = β IEP∗ [C] follows from Q∗ (Aα ) = β
 

and the definition (7.55) of Q∗ .

Therefore, by the result of Question (c) we have

P(C 1Aα ≥ C) = P VTAα ≥ C = P(Bα ) ≤ P(Aα ).

e) This hedging strategy starts from the initial amount

V0Aα = e−rT IEP∗ [C 1Aα ] = βe−rT IEP∗ [C],

and it satisfies

P VTAα ≥ C = P(C 1Aα ≥ C) = P(Aα )

which is the maximum hedging probability under the constraint (7.56).

f) We have
2
St = S0 eσBt +rt−σ t/2
= S0 eσBt = S0 eBt , t ≥ 0.

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g) We have

P VTAα ≥ C = P(Aα )


 
dP
=P ∗
>α
dQ
dQ∗
 
dP
=P > α
dP∗ dP∗
 
dP C
=P >α
dP ∗ IEP∗ [C]
= P (αC < IEP∗ [C])
= P (ST − K)+ < IEP∗ [C]/α

= P ST − K < IEP∗ [C]/α

= P ST < K + IEP∗ [C]/α

= P S0 eBT < K + IEP∗ [C]/α

= P (BT < log(K + IEP∗ [C]/α))

log(K + IEP∗ [C]/α)
 
=Φ √ .
T
h) We have
IEP∗ [C]
α= √ .
exp T Φ−1 P VTAα ≥ C




−K
i) We have

IEP∗ [C 1Aα ] = IEP∗ [(ST − K)+ 1Aα ]

h i
= IEP∗ (ST − K)+ 1{BT <log(K+IEP∗ [C]/α)}
h i
= IEP∗ eBT − K 1{BT <log(K+IEP∗ [C]/α)}

+

w log(K+IEP∗ [C]/α)/√T 2 dx
= ex − K e−x /2 √


√
(log K)/ T 2π
w log(K+IEP∗ [C]/α)/√T 2 dx
= √ ex e−x /2 √
(log K)/ T 2π
w log(K+IEP∗ [C]/α)/√T
−x2 /2 dx
−K √ e √
(log K)/ T 2π
w log(K+IEP∗ [C]/α)/√T
1/2−(x−1)2 /2 dx
= √ e √
(log K)/ T 2π
−K Φ(log(K + IEP∗ [C]/α)) − Φ(log K)


√ √
w −1/ T +log(K+IEP∗ [C]/α)/ T 2 dx
= √ e1/2−x /2 √
(−1+log K)/ T 2π
−K Φ(log(K + IEP∗ [C]/α)) − Φ(log K)

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√ −1 + log(K + IEP∗ [C]/α) −1 + log K

    
= e Φ √ −Φ √
T T
log(K + IEP∗ [C]/α) log K
    
−K Φ √ −Φ √ ,
T T
hence

e−rT IEP∗ [C 1Aα ]

−1 + log(K + IEP∗ [C]/α) −1 + log K
    
= e−rT +1/2 Φ √ −Φ √
T T
log(K + IEP∗ [C]/α) log K
    
−Ke−rT Φ √ −Φ √ .
T T
j) i) We have d+ (T ) = 1, d− (T ) = 0, hence by the Black-Scholes formula
we find
√
IEP∗ [(ST − K)+ ] = eS0 Φ(d+ (T )) − KΦ(d− (T ))
= 1.64872 × 0.84134 − 1/2
= 0.88713,

and

e−rT IEP∗ [(ST − K)+ ] = S0 Φ(d+ (T )) − Ke−T r Φ(d− (T ))

= 0.84134 − 0.60653/2
= 0.53807.

ii) By the result of Question (h), we have

IEP∗ [C]
α=
exp Φ−1 P VTAα ≥ C




−K
0.88714
=
exp (Φ−1 (0.9)) − 1
0.88714
= 1.28 = 0.34165.
e −1
iii) By the result of Question (i), we find

e−rT IEP∗ [C 1Aα ] = Φ(−1 + log(K + IEP∗ [C]/α)) − Φ(−1 + log K)

−Ke−1/2 Φ(log(K + IEP∗ [C]/α)) − Φ(log K)

= Φ(−1 + log(1 + IEP∗ [C]/α)) − Φ(−1)

−e−1/2 Φ(log(1 + IEP∗ [C]/α)) − Φ(0)

= Φ(−1 + log(1 + 0.88713/0.34165)) − Φ(−1)

−e−1/2 Φ(log(3.596604712)) − Φ(0)

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= Φ(0.27999) − Φ(−1)




−0.60653 × Φ(1.279990265) − Φ(0)
= (0.61026 − 0.158655) − 0.60653 × (0.899726 − 0.5)
= 0.20915.

In addition, we find

e−rT IEP∗ [C 1Aα ] 0.20915

β= = = 37.53%.
e−rT IEP∗ [C] 0.53807

Chapter 8

Exercise 8.1 We need to compute the average

w
1 1 wT 1 wT

T
IE vt dt = IE[vt ]dt = u(t)dt,
T 0 T 0 T 0

where u(t) := IE[vt ]. Taking expectation on both sides of the equation

wt wt√
vt = v0 − λ (vs − m)ds + η vs dBs ,
0 0

we find

u(t) = IE[vt ]
 wt wt√ 
= IE v0 − λ (vs − m)ds + η vs dBs
0 0
w 
t
= v0 − λ IE (vs − m)ds
0
wt
= v0 − λ (IE[vs ] − m)ds
0
wt
= v0 − λ (u(s) − m)ds, t ≥ 0,
0

hence by differentiation with respect to t ∈ R we find the ordinary differential

equation
u′ (t) = λm − λu(t),
cf. e.g. Exercise 4.18-(b). This equation can be rewritten as

(eλt u(t))′ = λeλt u(t) + eλt u′ (t) = λmeλt ,

which can be integrated as

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 wt 
eλt u(t) = u(0) + λm eλs ds
0

= IE[v0 ] + m(eλt − 1)
= meλt + IE[v0 ] − m t ∈ R+ ,

from which we conclude that

u(t) = m + (IE[v0 ] − m)e−λt , t ∈ R+ ,

and
w
1 1 wT

T
IE vt dt = u(t)dt
T 0 T 0
w
1 T
= m + (IE[v0 ] − m)e−λt dt


T 0
IE[v0 ] − m w T −λt
= m+ e dt
T 0

1 − e−λT
= m + IE[v0 ] − m .
λT

Exercise 8.2
a) By e.g. Exercise 4.18-(b), we have

IE[vt ] = IE[v0 ]e−λt + m(1 − e−λt ), t ∈ R+ ,

hence
w
1 T 1

VST = IE (dS t ) 2
T 0 St2
w
1 T 1  (1)
2 
= IE (r − αvt )St dt + St β + vt dBt
p
T 0 St 2
w
1

T
= IE (β + vt )dt
T 0
1 wT
=β+ IE[vt ]dt,
T 0
which yields
1 wT
VST = β + (IE[v0 ]e−λt + m(1 − e−λt ))dt
T 0
1 wT
=β+ (IE[v0 ]e−λt + m(1 − e−λt ))dt
T 0
1 wT
= β + m + (IE[v0 ] − m) e−λt dt
T 0

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eλT − 1
= β + m + (IE[v0 ] − m) .
λT
Note that if the process (vt )t∈R+ is started in the gamma stationary dis-
tribution then we have IE[v0 ] = IE[vt ] = m, t ∈ R+ , and the variance swap
rate VST = β + m becomes independent of the time T .
(2)
b) The stochastic differential equation dσt = ασt dBt is solved as
(2)
−α2 t/2
σt = σ0 eαBt , t ∈ R+ ,

hence we have
w
1 T 1

VST = IE 2 (dSt )2
T 0 St
w
1 T 1

(1)
2
= IE 2 σt St dBt
T 0 St
w
1

T
= IE σt2 dt
T 0

σ02 w T h 2αBt(2) −α2 t i

= IE e dt
T 0
σ02 w T −α2 t h 2αBt(2) i
= e IE e dt
T 0
σ02 w T −α2 t+2α2 t
= e dt
T 0
σ02 w T α2 t
= e dt
T 0
σ02 α2 T
= (e − 1).
α2 T

Exercise 8.3
a) Taking x = R0,T and x0 = IE R0,T , we have
2
 2 

 2 
2
− IE R0,T − IE R0,T
2
 2  2
q  2  R0,T R0,T
R0,T ≈ IE R0,T + q  −  2 
3/2 , (S.8.45)
2 IE R0,T 8 IE R0,T
2


provided that R0,T is sufficiently close to IE R0,T .

2
 2 

b) Taking expectations on both sides of (S.8.45), we find

2 
 2  IE R0,T − IE R0,T IE R0,T − IE[R0,T ]
q  2   2   2 2
IE∗ [R0,T ] ≈ IE R0,T + q  −  2 
3/2
2 IE R0,T 8 IE R0,T
2


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 2 
2 
 2  IE − IE R0,T
2

q R0,T
= IE R0,T −  2 
3/2
8 IE R0,T
Var
 2 
q  R0,T
= IE R0,T
2

−  2 
3/2 ,
8 IE R0,T

provided that R0,T is sufficiently close to IE R0,T .

2
 2 

Exercise 8.4 We have

wT 
"N  2 # " 2 #
T
X STk St
IE log = IE log dNt
n=1
STk−1 0 St-
w 
T
2
= IE ZNt- dNt
0
wT
2 
=λ IE

ZNt- dt
0
wT
=λ (η 2 + δ 2 )dt
0
= λ(η + δ 2 )T.
2

Exercise 8.5
2
a) We have St = S0 eσBt −σ t/2+rt , t ∈ R+ .
2
b) Letting Set := e−rt St , t ∈ R+ , we have SeT = S0 eσBT −σ T /2 and dSet =
σ Set dBt , hence
wT
SeT = S0 + σ Set dBt ,
0
and
" #
e−rT ST e−rT ST
 
SeT SeT
2 IE∗ log = 2 IE∗ log
S0 S0 S0 S0
w T Se
" ! #
σ2 T

∗ t
= 2 IE 1+σ dBt σBT −
0 S0 2
w w T Se
" # " #
2
 
σ T T Set t
= 2 IE∗ σBT − + 2σ 2 IE∗ BT dBt − σ 2 T IE∗ dBt
2 0 S0 0 S0

wT w T Se
" #
t
= −σ 2 T + 2σ 2 IE∗ dBt dBt
0 0 S0

w T Se
" #
t
= −σ 2 T + 2σ 2 IE∗ dt
0 S0

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wT
" #
Set
= −σ 2 T + 2σ 2 IE∗ dt
0 S0
wT
= −σ T + 2σ
2 2
dt
0
= −σ T + 2σ T
2 2

= σ 2 T.

Alternatively, we could also write

" #
e−rT ST e−rT ST
 
SeT SeT
2 IE∗ log = 2 IE∗ log
S0 S0 S0 S0
h 2 2
i
= 2 IE∗ eσBT −σ T /2 log eσBT −σ T /2
σ2 T
  
2
= 2 IE∗ eσBT −σ T /2 σBT −
2
2 2
= 2σe−σ T /2 IE∗ BT eσBT − σ 2 T IE∗ eσBT −σ T /2
   

2 ∂ ∗  σBT 
= 2σe−σ T /2 IE e − σ2 T
∂σ
2 ∂ 2
= 2σe−σ T /2 eσ T /2 − σ 2 T
∂σ
2 2
= 2σ 2 T e−σ T /2 eσ T /2 − σ 2 T
= σ 2 T.

Exercise 8.6
a) By the Itô formula, we have

ST w T dS 1 w T σt2
t
log = log ST − log S0 = − dt.
S0 0 St 2 0 St2

b) By (8.47) we have
w  w   
T T dSt ST
IE∗ σt2 dt Ft = 2 IE∗ Ft − 2 IE∗ log Ft
0 0 St S0
w t dS 
ST

u ∗
=2 + 2r(T − t) − 2 IE log Ft .
0 Su S0

c) At time t ∈ [0, T ] we check that

w
2

t dSu
Lt + e−(T −t)r St + 2e−rT + (T − t)r − 1 At
St 0 Su
w t dS
u
= Lt + 2r(T − t)e −(T −t)r
+ 2e−(T −t)r
0 Su

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= Vt .

d) By (8.48) we have
 w t dS 
u
dVt = d Lt + 2r(T − t)e−(T −t)r + 2e−(T −t)r
0 Su

= dLt − 2re−(T −t)r dt + 2r2 (T − t)e−(T −t)r dt

w t dS dSt
u
+2re−(T −t)r dt + 2e−(T −t)r
0 Su St
w
2

t dSu
= dLt + e−(T −t)r dSt + 2e−rT + (T − t)r − 1 dAt ,
St 0 Su

with dAt = rert dt, hence the portfolio is self-financing.

Exercise 8.7 By second differentiation of the moment generating function

(8.9), we find the two expressions
" 2 # " 2 #
ST ST ST
IE∗ R0,T = 4 IE∗ log + 2 log = 4 IE∗ log −4 IE∗ R0,T
 4   2 
,
F0 F0 F0

and
"  2 !#
∗ ∗ ST ST ST
IE R0,T = 4 IE log − 2 log
 4 
F0 F0 F0
"  2 #
ST ST
= 4 IE∗ log − 4 IE∗ R0,T
 2 
.
F0 F0

Chapter 9

Exercise 9.1
∂C ∂f  x
a) We have (T − t, x, K) = T − t, and
∂x ∂z K
∂C ∂   x 
(T − t, x, K) = Kf T − t,
∂K ∂K K
 x x ∂f  x
= f T − t, − T − t,
K K ∂z K
1 x ∂C
= C(T − t, x, K) − (T − t, x, K),
K K ∂x
hence

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∂C 1 K ∂C
(T − t, x, K) = C(T − t, x, K) − (T − t, x, K).
∂x x x ∂K
∂2C 1 ∂2f  x
b) We have (T − t, x, K) = T − t, and
∂x2 K ∂z 2 K
∂2C
(T − t, x, K)
∂K 2
x ∂f  x x ∂f  x x2 ∂f  x
=− 2 T − t, + 2 T − t, + 3 T − t,
K ∂z K K ∂z K K ∂z K
x2 ∂ 2 f  x
= 3 2 T − t,
K ∂z K
x2 ∂ 2 C
= 2 (T − t, x, K),
K ∂x2
hence
∂2C K 2 ∂2C
2
(T − t, x, K) = 2 (T − t, x, K).
∂x x ∂K 2
c) Noting that
∂C ∂C
(T − t, x, K) = − (T − t, x, K),
∂t ∂T
we can rewrite the Black-Scholes PDE as
∂C
rC(T − t, x, K) = − (T − t, x, K)
∂T
1

K ∂C
+rx C(T − t, x, K) − (T − t, x, K)
x x ∂K
σ 2 x2 K 2 ∂ 2 C
+ (T − t, x, K),
2 x2 ∂K 2
i.e.
∂C ∂C σ 2 x2 K 2 ∂ 2 C
(T − t, x, K) = −rK (T − t, x, K) + (T − t, x, K).
∂T ∂K 2 x2 ∂K 2

Remarks:
1. Using the Black-Scholes Greek Gamma expression

∂2C 1
(T − t, x, K) = √ Φ′ (d+ (T − t))
∂x2 σx T − t
1 2
= e−(d+ (T −t)) /2 ,
σx 2π(T − t)
p

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we can recover the lognormal probability density function φT (y) of geo-

metric Brownian motion ST as follows:

∂2C
φT (K) = e(T −t)r (T − t, x, K)
∂K 2
2 2
x ∂ C
= e(T −t)r 2 (T − t, x, K)
K ∂x2
e(T −t)r
x 2
= e−(d+ (T −t)) /2
σK 2 2π(T − t)
p

1 2
= e−(d− (T −t)) /2
σK 2π(T − t)
p

2 !
1 (r − σ 2 /2)(T − t) + log(x/K)
= exp − ,
2π(T − t) 2(T − t)σ 2
p
σK

knowing that
2
1 1 log(x/K) + (r − σ 2 /2)(T − t)


2
− d− (T − t) = − √
2 2 |σ| T − t
2
1 log(x/K) + (r + σ 2 /2)(T − t)

x
=− √ + (T − t)r + log
2 |σ| T − t K
1
2 x
= − d+ (T − t) + (T − t)r + log ,
2 K
which can be obtained from the relation

2
2
d+ (T − t) − d− (T − t)
= d+ (T − t) + d− (T − t) d+ (T − t) − d− (T − t)



x
= 2r(T − t) + 2 log .
K
2. Using the expressions of the Black-Scholes Greeks Delta and Theta we can
also recover
∂C ∂C
(T − t, x, K) + rK (T − t, x, K)
2 ∂T ∂K
2
∂ C
K2 (T − t, x, K)
∂K 2
1
 
∂C x ∂C
− (T − t, x, K) + rK C(T − t, x, K) − (T − t, x, K)
∂t K K ∂x
=2 2
2∂ C
x (T − t, x, K)
∂x2

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√
xσΦ′ (d+ (T − t))/(2 T − t) + rKe−(T −t)r Φ(d− (T − t))
=2 √
x2 Φ′ (d+ (T − t))/(xσ T − t)
rC(T − t, x, K) − rxΦ(d+ (T − t))
+2 √
x2 Φ′ (d+ (T − t))/(xσ T − t)
= σ2 .

Exercise 9.2 We have

2
∂C e−(K−S0 ) /(2T )
(S0 , K, T ) = −(K − S0 ) √
∂K 2πT
   
K − S0 K − S0 K − S0
−Φ − √ + √ φ − √
T T T
 
K − S0
= −Φ − √ ,
T
and
∂C 2 1 2
(S0 , K, T ) = √ e−(K−S0 ) /(2T ) ,
∂K 2 2πT
which is the Gaussian probability density function of ST = S0 + BT . We also
have
r
∂C 1 2 (K − S0 )2 T −(K−S0 )2 /(2T )
(S0 , K, T ) = √ e−(K−S0 ) /(2T ) − e
∂T 2 2πT 2T 2 2π
(K − S0 )2
 
K − S0
+ φ − √ .
2T 3/2 T
1 2
= √ e−(K−S0 ) /(2T )
2 2πT
1 ∂C 2
= (S0 , K, T ),
2 ∂K 2
hence
v v
u ∂C M ∂C M ∂C M
u
u2 (t, y) + 2ry (t, y) u
u 2 (t, y)
u
1 1
r
u ∂t ∂y ∂t
|σ(t, y)| = u =u = = ,
u
2 M 2 M y2 |y|
2∂ C t 2∂ C
(t, (t,
t
y y) y y)
∂y 2 ∂y 2

and the equation satisfied by (St )t∈R+ is

St
dSt = St σ(t, St )dBt = dBt = sign (St )dBt = dWt ,
|St |

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where dWt := sign (St )dBt is also a standard Brownian motion by the Lévy
characterization theorem, σ(t, y) = 1/y, and St = S0 + Bt . Indeed, as in Quiz
2 of FE8815, the price of the call option in the Bachelier model is given by

C(S0 , K, T ) = IE[(ST − K)+ ]

= IE[(S0 + BT − K)+ ]
w∞ 2 dx
= (x + S0 − K)e−x /(2T ) √
K−S0 2πT
w∞ w∞
−x2 /(2T ) dx 2 dx
= xe √ − (K − S0 ) e−x /(2T ) √
K−S0 2πT K−S0 2πT
w∞
r
T h −x2 /(2T ) i∞ −y 2 /2 dy
= −e − (K − S0 ) √ e √
2π K−S0 (K−S0 )/ T 2π
r  
T −(K−S0 )2 /(2T ) K − S0
= e − (K − S0 )Φ − √ .
2π T

Exercise 9.3
a) We have

∂MC ∂C ∂C
(K, S, r, τ ) = (K, S, σimp (K), r, τ ) + σimp
′
(K) (K, S, σimp (K), r, τ ).
∂K ∂K ∂σ
b) We have

∂C ∂C
(K, S, σimp (K), r, τ ) + σimp
′
(K) (K, S, σimp (K), r, τ ) ≤ 0,
∂K ∂σ
which shows that
∂C
(K, S, σimp (K), r, τ )
′
σimp (K) ≤− ∂K
∂C
(K, S, σimp (K), r, τ )
∂σ
c) We have

∂P ∂P
(K, S, σimp (K), r, τ ) + σimp
′
(K) (K, S, σimp (K), r, τ ) ≥ 0,
∂K ∂σ
which shows that
∂P
(K, S, σimp (K), r, τ )
′
σimp (K) ≥ − ∂K
∂P
(K, S, σimp (K), r, τ )
∂σ

Exercise 9.4

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 Introduction to Stochastic Finance with Market Examples, Second Edition

a) We have

K +S
 
σimp (K, S) ≃ σloc
2
2
K +S

= σ0 + β − S0
2
β
= σ0 + (K − (2S0 − S))2 .
4

20 20

15 15
σ in %

σ in %

10 10

5 5

σimp in % σimp in %
σloc in % σloc in %
0 0
0 50 100 150 200 0 50 100 150 200
S S

(a) At the money K = S0 . (b) Out of the money K > S0 .

Fig. S.42: Implied vs local volatility.

b) We find

∂

∂Bl
Bl S, K, T, σimp (K, S), r = x, K, T, σimp (K, S), r x=S


∂S ∂x
∂σimp ∂Bl
+


x, K, T, σ, r σ=σimp (K,S)
∂S ∂σ
β
= ∆ + ν (K − (2S0 − S)),
2
where
∂Bl
∆=
x, K, T, σimp (K, S), r x=S


∂x
is the Black-Scholes Delta and
∂Bl
ν=


S, K, T, σ, r σ=σ (K,S)
∂σ imp

is the Black-Scholes Vega, cf. §2.2 of Hagan et al. (2002).

Exercise 9.5 We take t = 0 for simplicity. We start by showing that for every
λ > 0, we have

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 Solutions Manual

1 h  wτ  i 2erτ w F0 dK w∞ dK

IE exp λ σt2 dt − 1 = pλ P (τ, K) 2−p + C(τ, K) 2−p .
λ 0 S0 0 K λ F0 K λ

By Lemma 8.2, we have

1 h  wτ  i 1  S pλ 
τ
IE exp λ σt2 dt − 1 = IE −1 , λ > 0.
λ 0 λ F0

Using Relation (9.18), i.e.

M M
∂2C ∂2P
φτ (K) = erτ (τ, y) = erτ 2 (τ, y),
∂y 2 ∂y
we have
1 h  wτ  i 1  S pλ 
τ
IE exp λ σt2 dt − 1 = IE −1
λ 0 λ F0
1 pλ 
= IE
 p
S λ
− F
λF0pλ τ 0

1 w ∞ pλ 
= pλ K φτ (K)dK − F0pλ
λF0 0
w w∞
1

F0
= pλ K pλ φτ (K)dK + K pλ φτ (K)dK − F0pλ
λF0 0 F0

1
 w F0 ∂ 2
P w∞ ∂2C

= pλ erτ K pλ 2
(τ, K)dK + erτ K pλ 2
(τ, K)dK − S0pλ .
λS0 0 ∂K F0 ∂K

Next, integrating by parts over the intervals [0, F0 ] and [F0 , ∞) and using the
boundary conditions
∂P ∂C
P (τ, 0) = C(τ, ∞) = 0, (τ, 0) = (τ, ∞) = 0,
∂K ∂K
with the relation
∂P ∂C
(τ, K) − (τ, K) − e−rτ = 0
∂K ∂K
and the call-put parity

P (τ, F0 ) − C(τ, F0 ) = S0 − F0 erτ = 0

as boundary conditions, we find

1 h  wτ  i
IE exp λ σt2 dt − 1
λ  0
1 ∂P w F0 ∂P
= pλ erτ S0pλ (τ, F0 ) − pλ erτ K pλ −1 (τ, K)dK
λS0 ∂K 0 ∂K

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∂C w∞ ∂C

−erτ S0pλ (τ, F0 ) − pλ erτ K pλ −1 (τ, K)dK − S0pλ
∂K F0 ∂K
w w∞
erτ

F0 ∂P ∂C
= −pλ pλ K pλ −1 (τ, K)dK + K pλ −1 (τ, K)dK
λS0 0 ∂K F0 ∂K
pλ erτ
 w F0
pλ −1
= S0 P (τ, F0 ) + (pλ − 1) K pλ −2
P (τ, K)dK
λS0pλ 0
w∞ 
−S0pλ −1 C(τ, F0 ) + (pλ − 1) K pλ −2 C(τ, K)dK
F0
pλ (pλ − 1) rτ w F0 pλ −2 w∞
 
= pλ e K P (τ, K)dK + K pλ −2 C(τ, K)dK
λS0 0 F0

2erτ w F0 w∞
 
dK dK
= P (τ, K) + C(τ, K)
S0pλ 0 K 2−pλ F0 K 2−pλ
2erτ w F0 w∞
 
dK dK
= pλ P (τ, K) 2−p + C(τ, K) 2−p .
S0 0 K λ F0 K λ

Finally, taking
pλ := p−
λ = 1/2 − 1/4 + 2λ
p

and letting λ tend to zero, we find

hw τ i 1 h  wτ  i
IE σt2 dt = lim IE exp λ σt2 dt − 1
0 λ→0 λ 0
2erτ w F0 w∞
 
dK dK
= lim pλ P (τ, K) 2−p + C(τ, K) 2−p
λ→0 S0 0 K λ F0 K λ
w
dK w ∞

F0 dK
= 2erτ
P (τ, K) 2 + C(τ, K) 2 .
0 K F0 K

Exercise 9.6 (Exercise 8.7 continued). Taking ϕ(x) = (log(x/F0 ))2 with
y = F0 , we have

2 2
 
x x
ϕ′ (x) = log and ϕ′′ (x) = 2 1 − log ,
x F0 x F0

hence
 2
ST
log = ϕ(F0 ) + (ST − F0 )ϕ′ (F0 )
F0
w F0 w∞
+ (z − ST )+ ϕ′′ (z)dz + (ST − z)+ ϕ′′ (z)dz
0 F0
w F0  
K dK
=2 (K − ST )+ 1 − log
0 F0 K 2
w∞  
K dK
+2 (ST − K)+ 1 − log .
F0 F0 K 2

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Therefore, we have
w F0 w∞
" 2 #
ST dK dK
IE∗ log =2 IE∗ [(K − ST )+ ] 2 + 2 IE∗ [(ST − K)+ ] 2
F0 0 K F0 K
w F0 K dK w ∞ K dK
−2 IE∗ [(K − ST )+ ] log −2 IE∗ [(ST − K)+ ] log
0 F0 K 2 F0 F0 K 2
w F0 K dK w∞ K dK
= IE∗ R0,T − 2erT P (T, K) log − 2erT C(T, K) log
 2 
,
0 F0 K 2 F0 F0 K 2
and
w F0  
F0 dK w∞  
K dK
IE∗ R0,T = 8erT P (T, K) log rT
log
 4 
−8e C(T, K) .
0 K K2 F0 F0 K 2
(S.9.46)
Alternatively, taking ϕ(x) = (x/F0 )(log(x/F0 ))2 with y = F0 , we have
2
1 2

x x
ϕ′ (x) = log + log
F0 F0 F0 F0

and
2 2 2
 
x x
ϕ′′ (x) = log + = 1 + log ,
xF0 F0 xF0 xF0 F0
hence

ST
2 w F0 2

K

log = (K − ST )+ 1 + log dK
F0 0 KF0 F0
w∞ 2

K

+ (ST − K)+ 1 + log dK.
F0 KF0 F0

Therefore, we have
" 2 # w
2
 
∗ ST F0 K
IE log = IE[(K − ST )+ ] 1 + log dK
F0 0 KF0 F0
w∞ 2

K

+ IE[(ST − K)+ ] 1 + log dK.,
F0 KF0 F0

and
8 rT w F0
 
K dK
IE∗ R0,T = e P (T, K) 1 + log
 4 
F0 0 F0 K
8 rT w ∞
 
K dK
+ e P (T, K) 1 + log − 4 IE∗ R0,T
 2 
.
F0 F0 F0 K

Exercise 9.7

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a) We have
w ∞ e−νx − e−µx w ∞ e−νx − e−µx
ρ+1
dx = dx
0 x 0 xρ+1
1 w ∞ −νe−νx + µe−µx
∞
1 e−νx − e−µx

=− ρ
+ dx
ρ x 0 ρ 0 xρ
ν w ∞ −νx −ρ µ w ∞ −µx −ρ
=− e x dx + e x dx
ρ 0 ρ 0
µρ − ν ρ
= Γ (1 − ρ).
ρ

b) Taking ν = 0 and µ = Rt,T , we find

w 
ρ ∞ 2
dλ
IE∗ [Rt,T ] = IE∗ 1 − e−λRt,T ρ+1
Γ (1 − ρ) 0 λ
ρ w∞  −λR2 
dλ
∗
= 1 − IE e t,T ,
Γ (1 − ρ) 0 λρ+1

see § 3.1 in Friz and p

Gatheral (2005) with ρ = 1/2.
c) Letting p±λ := 1/2 ± 1/4 − 2λ, we have

ρ w∞ 2 
dλ
IE∗ [Rt,T ] = 1 − IE∗ e−λRt,T

Γ (1 − ρ) 0 λρ+1
"  ± #!
ρ w ∞ ± ST λ
p
dλ
= 1 − e−rpλ T IE∗
Γ (1 − ρ) 0 S0 λρ+1
w∞
"   p± #
ρ ST λ dλ
= IE∗ 1 −
Γ (1 − ρ) 0 F0 λρ+1
w 1/8
"   p± #
ρ ∗ ST λ dλ
= IE 1 −
Γ (1 − ρ) 0 F0 λρ+1
w∞
" #
i√
r 
ρ ST ST dλ
+ IE∗ 1 − exp ± 8λ − 1 log
Γ (1 − ρ) 1/8 F0 2 F0 λρ+1
w 1/8
"  p± #
8ρ ρ ST λ dλ
= + IE∗ 1 −
ρ + 1 Γ (1 − ρ) 0 F0 λρ+1
w∞
"r #
1√

ρ ∗ ST ST dλ
− IE cos 8λ − 1 log
Γ (1 − ρ) 1/8 F0 2 F0 λρ+1
ρ w 1/8 dλ ρ
= IE∗ [ϕλ (ST )] ρ+1 + IE∗ [ψ(ST )] ,
Γ (1 − ρ) 0 λ Γ (1 − ρ)

where

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 p±
x λ
ϕλ (x) = 1 − ,
F0
we have
± ± ±
xpλ −1 xpλ −2 xpλ −2
ϕ′λ (x) = −p±
λ and ϕ′′λ (x) = −p± ±
λ (pλ − 1) = 2λ ,
p± p± p±
F0λ
F0 λ
F0 λ

hence with y := F0 we have ϕλ (y) = 0 and

IE∗ [ϕλ (ST )]

 
p ± w F0 p± −2 w∞ p± −2
+K +K
λ λ
∗
= IE (ST − F0 ) λ − 2λ (K − ST ) dK − 2λ (ST − K) dK 
F0 0 p± F0 p±
F0 λ F0 λ
w F0 ±
K pλ −2 w∞ ±
K pλ −2
= 2λ IE∗ [(K − ST )+ ] dK + IE∗ [(ST − K)+ ] dK
0 p± F0 p±
F0 λ
F0 λ
w w
erT

F0 ± ∞ ±
= 2λ P (T, K)K pλ −2 dK + C(T, K)K pλ −2 dK .
p± 0 F0
F0 λ

Taking now
w∞  r
x

1√ x

dλ
ψ(x) := 1− cos 8λ − 1 log ,
1/8 F0 2 F0 λρ+1

we have
1 w∞ 
1√ x

dλ
ψ ′ (x) = − √ cos 8λ − 1 log
2 F0 x 1/8 2 F0 λρ+1
1 w∞ 
1√ x √

dλ
+ √ sin 8λ − 1 log 8λ − 1 ρ+1 ,
2 F0 x 1/8 2 F0 λ

which converges provided that ρ > 1/2, while ψ ′′ (x) cannot be written as
a converging integral but can be estimated numerically from ψ ′ (x). Hence,
we have

IE∗ [Rt,T ]
ρerT
=
Γ (1 − ρ)

w 1/8 2
w
F0 ±
w∞ ±

dλ
× √ P (T, K)K pλ −2 dK + C(T, K)K pλ −2 dK
0 ± 1/4−2λ 0 F0 λp
F0
w F0 w∞ 
+ P (T, K)ψ ′′ (K)dK + C(T, K)ψ ′′ (K)dK .
0 F0

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library(quantmod)
today <- as.Date(Sys.Date(), format="%Y-%m-%d"); getSymbols("^SPX", src = "yahoo")
lastBusDay=last(row.names(as.data.frame(Ad(SPX))))
S0 = as.vector(tail(Ad(SPX),1)); T = 30/365;r=0.02;F0 = S0*exp(r*T)
maturity<- as.Date("2021-07-07", format="%Y-%m-%d") # Choose a maturity in 30 days
SPX.OPTS <- getOptionChain("^SPX", maturity)
Call <- as.data.frame(SPX.OPTS$calls); Put <- as.data.frame(SPX.OPTS$puts)
Call_OTM <- Call[Call$Strike>F0,];Call_OTM$dif = c(min(Call_OTM$Strike)-F0,
diff(Call_OTM$Strike))
Put_OTM <-Put[Put$Strike<F0,];Put_OTM$dif = c(diff(Put_OTM$Strike),
F0-max(Put_OTM$Strike))

pl <- function(lambda){return( 1/2+sqrt(1/4-2*lambda ))}; rho=0.9

g1 <- function(x){ f1 <- function(lambda){ - cos ( 0.5*sqrt(lambda*8-1)*log
(x/F0))/lambda^(rho+1)/sqrt(x*F0)/2}; return(f1)}
g2 <- function(x){ f2 <- function(lambda){ sin ( 0.5*sqrt(lambda*8-1)*log
(x/F0))/lambda^(rho+1)/sqrt(lambda*8-1)/sqrt(x*F0)/2}; return(f2)}
g3 <- function (x) { integrate(g1(x), lower=0.125, upper=Inf,stop.on.error = FALSE)$value}
g4 <- function (x) { if (x>F0) {integrate(g2(x), lower=0.125, upper=1000000,stop.on.error =
FALSE)$value} else {integrate(g2(x), lower=0.125, upper=100000,stop.on.error =
FALSE)$value}}
eps=1;psi2nd <- function(x){(g3(x+eps)+g4(x+eps)-g3(x)-g4(x))/eps}
f <- function(lambda){ return (2*(sum(Put_OTM$Last*Put_OTM$Strike**(pl(lambda)-2)
*Put_OTM$dif)) +sum(Call_OTM$Last *Call_OTM$Strike**(pl(lambda)-2)
*Call_OTM$dif)/F0**pl(lambda)/lambda**rho)}
(sum(Put_OTM$Last*as.numeric(lapply(Put_OTM$Strike,psi2nd)) *Put_OTM$dif)
+sum(Call_OTM$Last*as.numeric(lapply(Call_OTM$Strike,psi2nd))
*Call_OTM$dif)+integrate(Vectorize(f), lower=0,
upper=0.125)$value)*rho*exp(r*T)/gamma(1-rho)

Chapter 10

Exercise 10.1
a) By differentiating (10.2) with respect to T , we find

∂
φτa (T ) = P(τa < T )
∂T
∂
= 2 P(WT > a)
∂T
2 ∂ w ∞ −x2 /(2T )
= √ e dx
2πT ∂T a
2 ∂ w∞ 2
= √ √ e
−y /2
dy
2π ∂T a/ T
a 2
= √ e−a /(2T ) , T > 0. (S.10.47)
2πT 3
b) By differentiating (10.13) with respect to T , we find

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∂
φτ̃a (T ) = P(τ̃a < T )
∂T
∂
= − P(τ̃a ≥ T )
∂T
∂
= bT ≤ a


− P X
∂T  0   
∂ a − µT ∂ −a − µT
= − Φ √ + e2µa Φ √
∂T T ∂T T
 
a µ −(a−µT )2 /(2T )
= √ +√ e
2 2πT 3 2πT
 
a µ 2
+ √ −√ e2µa−(a+µT ) /(2T )
2 2πT 3 2πT
a 2
= √ e−(a−µT ) /(2T ) , T > 0.
2 2πT 3

c) By differentiating (10.15) with respect to T , for x > S0 we find

∂
φτ̂x (T ) = P(τ̂a < T )
∂T
∂
=− P(τ̂x ≥ T )
∂T
∂
=− P MT ≤ x


∂T  0
−(r − σ 2 /2)T + log(x/S0 )

∂
=− Φ √
∂T σ T
 1−2r/σ2
−(r − σ 2 /2)T − log(x/S0 )
 
S0 ∂
+ Φ √
x ∂T σ T
log(x/S0 ) 1
 
= √ exp − 2 ((r − σ /2)T − log(x/S0 ))2 ,
2
T > 0,
σ 2πT 3 2σ T

which can also be recovered from (S.10.47) by taking a := log(S0 /x)/σ

and µ := r/σ − σ/2. Similarly, when 0 < x < S0 we can differentiate
(10.18) in Corollary 10.8 to find

∂
φτ̂x (T ) = P(τ̂x < T )
∂T
∂
= P mT ≤ x


∂T  0
−(r − σ 2 /2)T + log(x/S0 )

∂
= Φ √
∂T σ T
 1−2r/σ2
(r − σ 2 /2)T + log(x/S0 )
 
S0 ∂
+ Φ √
x ∂T σ T

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log(S0 /x) 1
 
= √ exp − 2 ((r − σ 2 /2)T − log(x/S0 ))2 , T > 0,
σ 2πT 3 2σ T

which yields

| log(S0 /x)| 1
 
φτ̂x (T ) = √ exp − 2 ((r − σ 2 /2)T − log(x/S0 ))2 , T > 0,
σ 2πT 3 2σ T

for all x > 0.

Exercise 10.2
a) We use Relation (10.14) and the integration by parts identity
w∞ w∞
v ′ (z)u(z)dz = u(+∞)v(+∞) − u(0)v(0) − v(z)u′ (z)dz
0 0

with
2µ 2µy/σ
 
−y − µT /σ
u(y) = Φ √ and v ′ (y) = ye
T σ
which satisfy
1 2 σ 2µy/σ
u′ (y) = − √ e−(y+µT /σ) /(2T ) and v(y) = ye2µy/σ − e ,
2πT 2µ

we have
   
IE max W ft = σ IE max (Wt + µt/σ)
t∈[0,T ] t∈[0,T ]

2 w ∞ −(y−µT /σ)2 /(2T ) w∞

r  
−y − µT /σ
=σ ye dy − 2µ ye2µy/σ Φ √ dy
πT 0 0 T
2 w ∞ −(y−µT /σ)2 /(2T ) w∞
r
=σ ye dy − σ v ′ (y)u(y)dy
πT 0 0

2 w ∞ −(y−µT /σ)2 /(2T ) w∞

r
=σ ye dy − σu(+∞)v(+∞) + σu(0)v(0) + σ u′ (y)v(y)dy
πT 0 0
√
2 w ∞ −(y−µT /σ)2 /(2T )
r !
σ2 µ T
=σ ye dy − Φ −
πT 0 2µ σ
σ w ∞ 2µy/σ−(y+µT /σ)2 /(2T ) σ2 w∞ 2
−√ ye dy + √ e2µy/σ−(y+µT /σ) /(2T ) dy
2πT 0 2µ 2πT 0
2 w ∞ −(y−µT /σ)2 /(2T ) σ w ∞ −(y−µT /σ)2 /(2T )
r
=σ ye dy − √ ye dy
πT 0 2πT 0
2
√ ! 2 w
σ µ T σ ∞ 2
− Φ − + √ e−(y−µT /σ) /(2T ) dy
2µ σ 2µ 2πT 0

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√ !
σ w ∞ −(y−µT /σ)2 /(2T ) σ2 µ T
= √ ye dy − Φ −
2πT 0 2µ σ
σ2 w∞ 2
+ √ e−(y−µT /σ) /(2T ) dy
2µ 2πT 0
√ !
σ w∞ σ2
 
µT −y 2 /(2T ) µ T
= √ y+ e dy − Φ −
2πT −µT /σ σ 2µ σ
σ 2 w ∞ 2
+ √ e−y /(2T ) dy
2µ 2πT −µT /σ
√ !
σ w∞ 2 µT + σ 2 /(2µ) w ∞ 2 σ2 µ T
= √ ye−y /(2T ) dy + √ e−y /(2T ) dy − Φ −
2πT −µT /σ 2πT −µT /σ 2µ σ
√ ! √ ! √ !
σ h
−y 2 /(2T )
i∞ µ T σ2 µ T σ2 µ T
= √ −T e + µT Φ + Φ − Φ −
2πT −µT /σ σ 2µ σ 2µ σ
r  2
 √ !
2
√ !
T −µ2 T /2 σ µ T σ µ T
=σ e + µT + Φ − Φ − .
2π 2µ σ 2µ σ

As σ tends to zero, we find

  µT Φ(+∞) = µT if µ ≥ 0,


IE max Wt = f
t∈[0,T ]
µT Φ(−∞) = 0 if µ ≤ 0.


We also have
r √ ! √ ! √ !!
σ2
 
IE max W ft = σ T e−µ2 T /2 + µT Φ µ T
+ Φ
µ T
−Φ −
µ T
t∈[0,T ] 2π σ 2µ σ σ
r √ ! 2 w √
T −µ2 T /2 µ T σ µ T /σ 2
=σ e + µT Φ + √ √ e−y /2 dy.
2π σ 2µ 2π −µ T /σ

Hence, as µ tends to zero we find

  r √ ! r
IE max W ft = σ T e−µ2 T /2 + µT Φ µ T
+σ
T
+ o(µ), [µ → 0],
t∈[0,T ] 2π σ 2π

and for µ = 0 and σ = 1 we recover the average maximum of standard

Brownian motion  r
2T

IE max Wt = ,
t∈[0,T ] π
which represents two times the expected maximum

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1 w∞ 2
IE[max(WT , 0)] = √ max(y, 0)e−y /(2T )
dy
2πT −∞
1 w∞ 2
= √ ye−y /(2T )
dy
2πT 0
1 h 2
i∞
= √ −T e−y /(2T )
2πT 0
r
T
= .
2π
b) By part (a) the identity in distribution (−Wt )t∈R+ ≈ (Wt )t∈R+ , we have
   
IE min W ft = σ IE min (Wt + µt/σ)
t∈[0,T ] t∈[0,T ]
 
= −σ IE max (−Wt − µt/σ)
t∈[0,T ]
 
= −σ IE max (Wt − µt/σ)
t∈[0,T ]
r √ ! √ !
σ2 σ2
 
T −µ2 T /2 −µ T µ T
= −σ e + µT + Φ − Φ .
2π 2µ σ 2µ σ

In particular, as σ tends to zero, we find

  µT Φ(+∞) = µT if µ ≤ 0,


IE min Wt = f
t∈[0,T ]
µT Φ(−∞) = 0 if µ ≥ 0.


Exercise 10.3
a) We have St = S0 eσWt , t ∈ R+ .
b) We have
2
IE[ST ] = S0 IE eσWT = S0 eσ T /2 .
 

c) We have
  w∞ 2 dx
P max Wt ≥ a = 2 e−x /(2T ) √ , a ≥ 0,
t∈[0,T ] a 2πT
and   wa 2 dx
P max Wt ≤ a =2 e−x /(2T )
√ , a ≥ 0,
t∈[0,T ] 0 2πT
hence the probability density function φ of max Wt is given by
t∈[0,T ]

2 −a2 /(2T )
r
φ(a) = e 1[0,∞) (a), a ∈ R.
πT

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d) We have
   w∞
IE M0T = S0 IE exp σ max Wt = S0 eσx φ(x)dx
 
t∈[0,T ] 0

2S0 w ∞ σx−x2 /(2T ) 2S0 w ∞ −(x−σT )2 /(2T )+σ2 T /2

= √ e dx = √ e dx
2πT 0 2πσ 2 T 0
2S0 σ2 T /2 w ∞ 2 2S0 2 w ∞
−x2 /2
= √ e e−x /(2T ) dx = √ eσ T /2 √ e dx
2πT −σT 2π −σ T
√
2
w σ T 2
= 2S0 eσ T /2 e−x /2 dx
−∞
2 √

= 2S0 eσ T /2 Φ σ T
√

= 2 IE[ST ]Φ σ T .

Remarks:
(i) From the inequality

0 ≤ IE[(WT − σT )+ ]
1 w∞ 2
= √ (x − σT )+ e−x /(2T ) dx
2πT −∞
1 w∞ 2
= −√ (x − σT )e−x /(2T ) dx
2πT σT
1 w ∞ −x2 /(2T ) σT w ∞ −x2 /(2T )
= √ xe dx − √ e dx
2πT σT 2πT σT
T w∞ σT w ∞ −x2 /2
r
−x2 /2
= √ xe dx − √ √ e dx
2π σ T 2π σ T
√

r
T h −x2 /2 i∞
= e √ − σT Φ − σ T
2π σ T
√


r
T −σ2 T /2
= e − σT 1 − Φ σ T ,
2π
we get
2
√
e−σ T /2
Φ σ T ≥1− √ ,
σ 2πT
hence
2 √

IE M0T = 2S0 eσ T /2 Φ σ T
 
2
!
σ 2 T /2e−σ T /2
≥ 2S0 e 1− √
σ 2πT
!
−σ 2 T /2
e
= 2 IE[ST ] 1 − √
σ 2πT

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Introduction to Stochastic Finance with Market Examples, Second Edition

1
 
2
= 2S0 eσ T /2 − √ .
σ 2πT
(ii) We observe that the ratio between the expected gains by
√ selling at
the maximum and selling at time T is given by 2Φ σ T , which

cannot be greater than 2.

2
2 Φ(σT1/2)

1.5
ratio

0.5

0
0 0.5 1 1.5 2 2.5 3 3.5 4
time T

Fig. S.43: Average return by selling at the maximum vs selling at maturity.

e) By a symmetry argument, we have

   
P min Wt ≤ a = P − max (−Wt ) ≤ a
t∈[0,T ] t∈[0,T ]
 
= P − max Wt ≤ a
t∈[0,T ]
 
= P max Wt ≥ −a
t∈[0,T ]
w∞ 2 dx
=2 e−x /(2T )
√ , a < 0,
−a 2πT
i.e. the probability density function φ of min Wt is given by
t∈[0,T ]

2 −a2 /(2T )
r
φ(a) = e 1(−∞,0] (a), a ∈ R.
πT
f) We have
  
IE mT0 = S0 IE exp σ min Wt
 
t∈[0,T ]
w0
= S0 eσx φ(x)dx
−∞
2S0 w 0 2
= √ eσx−x /(2T ) dx
2πT −∞

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 Solutions Manual

2S0 w 0 −(x−σT )2 /(2T )+σ2 T /2

= √ e dx
2πT −∞
2S0 σ2 T /2 w −σT 2
= √ e e−x /(2T ) dx
2πT −∞

2S0 2 w −σ√T 2
= √ eσ T /2 e−x /2 dx
2π −∞
2 √

= 2S0 eσ T /2 Φ − σ T
√

= 2 IE[ST ]Φ − σ T .

Remarks:
(i) From the inequality

0 ≤ IE[(−σT − WT )+ ]
1 w∞ 2
= √ (−σT − x)+ e−x /(2T ) dx
2πT −∞
1 w −σT 2
= −√ (σT + x)e−x /(2T ) dx
2πT −∞
σT w −σT −x2 /(2T ) 1 w −σT −x2 /(2T )
= −√ e dx − √ xe dx
2πT −∞ 2πT −∞
w √ r
w √
σT −σ T 2 T −σ T −x2 /2
= −√ e−x /2 dx − xe dx
2π −∞ 2π −∞
√
√

r
T h −x2 /2 i−σ T
= −σT Φ − σ T + e
2π −∞
√

r
T −σ2 T /2
= −σT Φ − σ T + e ,
2π
we get
2 √
1 2S
eσ T /2
hence IE mT0 ≤ √ 0 .
 
Φ −σ T ≤ √ ,
σ 2πT σ 2πT
(ii) The ratio between the expected √ gains

by maturity T vs selling at the
minimum is given by 2Φ − σ T , which is at most 1 and tends to
0 as σ and T tend to infinity.

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Introduction to Stochastic Finance with Market Examples, Second Edition

2
2 Φ(-σT1/2)
2 Φ(σT1/2)

1.5
ratio

0.5

0
0 0.5 1 1.5 2 2.5 3 3.5 4
time T

Fig. S.44: Average returns by selling at the minimum vs selling at maturity.

√

(iii) Given that IE M0T = 2 IE[ST ]Φ σ T , we find the bound
 

√
√

2 IE[ST ]Φ − σ T ≤ IE[ST ] ≤ 2 IE[ST ]Φ σ T ,

with equality if σ = 0 or T = 0. We also have

2 √


2 IE[ST ] − IE M0T = 2eσ T /2 1 − Φ σ T
 
2 √
= 2eσ T /2 Φ − σ T

= IE m0 ,
 T

hence we have

IE mT0 +IE M0T = 2 IE[ST ], or IE[ST ]−IE mT0 = IE M0T −IE[ST ],

       

and
2S0
2 IE[ST ] − √ ≤ IE M0T ≤ 2 IE[ST ].
 
σ 2πT

Exercise 10.4 (Exercise 10.3 continued).

a) Regarding call option prices we have, assuming K ≥ S0 ,
"   + #

+ 
IE M0T − K = S0 IE exp σ max Wt − K

t∈[0,T ]
w∞
= (S0 e − K) φ(x)dx
σx +
0
2 w∞
+ 2
= √ S0 eσx − K e−x /(2T ) dx
2πT 0
2 w∞ 2
= √ S0 eσx − K e−x /(2T ) dx


2πT σ−1 log(K/S0 )
2S0 w ∞ 2
= √ eσx−x /(2T ) dx
2πT σ−1 log(K/S0 )

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2K w ∞ 2
−√ e−x /(2T ) dx
2πT σ−1 log(K/S0 )
2S0 w ∞ 2 2
= √ e−(x−σT ) /(2T )+σ T /2 dx
2πT σ−1 log(K/S0 )
2K w ∞ 2
−√ e−x /(2T ) dx
2πT σ−1 log(K/S0 )
2S0 σ2 T /2 w ∞ 2
= √ e e−x /(2T ) dx
2πT −σT +σ −1 log(K/S0 )
2K w ∞ 2
−√ e−x /(2T ) dx
2πT σ−1 log(K/S0 )
2 √ √

= 2S0 eσ T /2 Φ σ T + σ −1 log(S0 /K)/ T
√

−2KΦ σ −1 log(S0 /K)/ T .

When K ≤ S0 , by “completion of the square” and use of the Gaussian

cumulative distribution function Φ(·), we find
h + i h i
IE max St − K = IE max St − K
t∈[0,T ] t∈[0,T ]
h i
= IE max St − IE[K]
t∈[0,T ]
h i
= IE max St − K
t∈[0,T ]
  
= S0 IE exp σ max Wt −K
t∈[0,T ]
w∞
= S0 eσx φ(x)dx − K
0
2S0 w ∞ σx−x2 /(2T )
= √ e dx
2πT 0
2S0 w ∞ 2 2
= √ e−(x−σT ) /(2T )+σ T /2 dx − K
2πT 0
2S0 σ2 T /2 w ∞ −x2 /(2T )
= √ e e dx − K
2πT −σT
σ 2 T /2
√

= 2S0 e Φ σ T −K
σ 2 T /2
 √

= 2S0 e 1−Φ −σ T −K
√

= 2 IE[ST ]Φ σ T − K,

hence
2
+  √
2
e−σ T /2
IE M0T − K = 2S0 Φ σ T − Ke−σ T /2 .


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Recall that when r = σ 2 /2 the price of the finite expiration American call
option price is the Black-Scholes price with maturity T , with

BlCall (S0 , K, σ, r, T )
√ √
2 √

= S0 Φ σ T + σ −1 log(S0 /K)/ T − Ke−σ T /2 Φ σ −1 log(S0 /K)/ T

√ √
2 √

2S0 Φ σ T + σ −1 log(S0 /K)/ T − 2Ke−σ T /2 Φ σ −1 log(S0 /K)/ T


if K ≥ S0 ,




≤ √
2
2S Φ σ T − Ke−σ T /2


 0


if K ≤ S0 .

 2 × BlCall (S0 , K, σ, r, T ) if K ≥ S0 ,


= √
2
2S0 Φ σ T − Ke−σ T /2 if K ≤ S0 ,

 √
2

= max 2 × BlCall (S0 , K, σ, r, T ), 2S0 Φ σ T − Ke−σ T /2 .
2.0

Upper bound
Black−Scholes call price
1.5
price

1.0
0.5
0.0

0.0 0.5 1.0 1.5 2.0

Fig. S.45: Black-Scholes call price upper bound with S0 = 1.

b) Regarding put option prices we have, assuming S0 ≥ K,

"  + #
T +
IE K − m0 = S0 IE K − exp σ min Wt


t∈[0,T ]
w∞
= (K − S0 e ) φ(x)dx
σx +
0
2 w0
+ 2
= √ K − S0 eσx e−x /(2T ) dx
2πT −∞
2 w σ−1 log(K/S0 ) 2
= √ K − S0 eσx e−x /(2T ) dx


2πT −∞

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2K w σ−1 log(K/S0 ) −x2 /(2T )

= √ e dx
2πT −∞
2S0 w σ −1
log(K/S0 ) 2
−√ eσx−x /(2T ) dx
2πT −∞
2K w σ−1 log(K/S0 ) −x2 /(2T )
= √ e dx
2πT −∞
2S0 w σ −1
log(K/S0 ) 2 2
−√ e−(x−σT ) /(2T )+σ T /2 dx
2πT −∞
2K w σ−1 log(K/S0 ) −x2 /(2T )
= √ e dx
2πT −∞
w
2S0 σ2 T /2 −σT +σ log(K/S0 ) −x2 /(2T )
−1

−√ e e dx
2πT −∞
√
= 2KΦ(−σ −1 log S0 /K)/ T


2 √ √

−2S0 eσ T /2 Φ − σ T − σ −1 log(S0 /K)/ T ,

with 2
+  2 √

e−σ T /2
IE K − mT0 = Ke−σ T /2
− 2S0 Φ − σ T


if S0 ≤ K. Therefore we deduce the bounds

BlPut (S0 , K, σ, r, T )
2 √
√ √

= Ke−σ T /2
Φ − σ −1 log(S0 /K)/ T − S0 Φ − σ T − σ −1 log(S0 /K)/ T

≤ American put option price

−σ 2 T /2
√
√ √

 2Ke Φ − σ −1 log(S0 /K)/ T − 2S0 Φ − σ T − σ −1 log(S0 /K)/ T


if S0 ≥ K,

≤

 2 √

Ke−σ T /2 − 2S0 Φ − σ T if S0 ≤ K,


 2 × BlPut (S0 , K, σ, r, T ) if S0 ≥ K,


= √
2
Ke−σ T /2 − 2S0 Φ − σ T if S0 ≤ K,


 2 √

= max 2 × BlPut (S0 , K, σ, r, T ), Ke−σ T /2 − 2S0 Φ − σ T

for the finite expiration American put option price when r = σ 2 /2.

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1.0
0.8
0.6 Upper bound
Black−Scholes put price
price

0.4
0.2
0.0

0.0 0.5 1.0 1.5 2.0

Fig. S.46: Black-Scholes put price upper bound with S0 = 1.

Exercise 10.5 (Exercise 10.4 continued).

a) Using the expression

2 −(x−µT )2 /(2T ) x + µT
r  
φ T (x) = e + 2µe2µx Φ √ x ≤ 0.
b
,
X 0 πT T
of the probability density function of the minimum
b
T
X 0 := min W ft = min (Wt + µt)
t∈[0,T ] t∈[0,T ]

of drifted Brownian motion W ft = Wt + µt over t ∈ [0, T ] given in Propo-

sition 10.7, we find
h i w0
IE min St = S0 eσx φ T (x)dx
b
t∈[0,T ] −∞ X 0
w0 r
2 −(x−µT )2 /(2T )
= S0 eσx e dx
−∞ πT
w0 
x + µT

+2µS0 eσx e2µx Φ √ dx
−∞ T
2 √
2µS0 √

= 2S0 eσ T /2−µσT Φ (µ − σ) T + Φ −µ T
2µ − σ
2µS0 σ2 T /2−µσT √

− e Φ (µ − σ) T ,
2µ − σ

with µ := r/σ − σ/2, which yields

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σ2 r − σ 2 /2 √
h i    
IE
min St = S0 1 − Φ T
t∈[0,T ] 2r σ
σ2 r + σ 2 /2 √
   
+S0 1 + Φ − T .
2r σ
h i
See Exercise 12.1-(b) for the computation of IE mint∈[0,1] St when r = 0.
b) When S0 ≤ K, we have
h + i h i
IE K − min St = IE K − min St
t∈[0,T ] t∈[0,T ]
h i
= K − IE min St
t∈[0,T ]

σ2 r − σ 2 /2 √
   
= K − S0 1 − Φ T
2r σ
σ2 r + σ 2 /2 √
   
−S0 erT
1+ Φ − T .
2r σ

Next, when S0 ≥ K we have, using the probability density function

φ T (x),
b
X 0
b
h + i h T + i

IE K − min St = IE K − S0 min eσX 0

t∈[0,T ] t∈[0,T ]
w0
σx +
= K − S0 e (x)dx

b
φ T
−∞ X 0

2 w0
r

+ 2
= S0 K − S0 eσx e−(x−µT ) /(2T ) dx
πT −∞
w0
+

x + µT

+2µS0 K − S0 eσx e2µx Φ √ dx
−∞ T
(r − σ /2)T + log(S0 /K)
2
 
= KΦ − √
σ T
 1−2r/σ  2
(r − σ 2 /2)T + log(K/S0 )

S0
+K Φ √
K σ T
  −2r/σ2 
σ2 (r − σ 2 /2)T + log(K/S0 )
 
S0
−S0 1 − Φ √
2r K σ T
σ2 (r + σ 2 /2)T + log(S0 /K)
   
−S0 erT
1+ Φ − √ .
2r σ T
In Figure S.47, using a finite expiration American put option pricer from
the fOptions package, we plot the graph of American put option price
vs (S.10.48)-(S.10.49), together with the European put option price, ac-
cording to the following code.

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1.0 Upper bound

American put price
Black−Scholes put price
0.8
0.6
Price

0.4
0.2
0.0

0.0
0.0 0.5
0.5 1.0
1.0 1.5 2.0

Fig. S.47: “Optimal exercise” put price upper bound with S0 = 1.

d1 <- function(S,K,r,T,sig) {return((log(S/K)+(r+sig^2/2)*T)/(sig*sqrt(T)))}

d2 <- function(S,K,r,T,sig) {return(d1(S, K, r, T, sig) - sig * sqrt(T))}
BSPut <- function(S, K, r, T, sig){return(K*exp(-r*T) * pnorm(-d2(S, K, r, T, sig)) -
S*pnorm(-d1(S, K, r, T, sig)))}
Optimal_Put_Option <- function(S,K,r,T,sig){
if (r==0) {if (S>=K) {return(K*pnorm(d1(K,S,0,T,sig))-S*(1+sig*sig*T/2
+log(S/K))*pnorm(-d1(S,K,0,T,sig))
+S*sig*sqrt(T/(2*pi))*exp(-d1(S,K,0,T,sig)*d1(S,K,0,T,sig)/(2*sig*sig*T)))}
else {return(K-2*S*(1+sig*sig*T/4)*pnorm(-sig*sqrt(T)/2)
+S*sig*sqrt(T/(2*pi))*exp(-sig*sig*T/8))}}
else {if (S>=K) {return(K*pnorm(-d2(S,K,r,T,sig))
+K*(S/K)**(1-2*r/sig/sig)*pnorm(d2(K,S,r,T,sig))
-2*S*exp(r*T)*pnorm(-d1(S,K,r,T,sig))
-S*(1-sig*sig/2/r)*(S/K)**(-2*r/sig/sig)*pnorm(d1(K,S,r,T,sig))
+S*exp(r*T)*(1-sig*sig/2/r)*pnorm(-d1(S,K,r,T,sig)))}
else {return(K-S*(1-sig*sig/2/r)*pnorm((r-sig*sig/2)*sqrt(T)/sig)
-S*(1+sig*sig/2/r)*pnorm(-(r+sig*sig/2)*sqrt(T)/sig))}}}
r=0.5;sig=1;S=1;T=1
library(fOptions)
curve(BAWAmericanApproxOption("p",S,x,T,r,b=0,sig,title = NULL, description =
NULL)@price, from=0.01, to=2 , xlab="K", lwd = 3, ylim=c(0,1),ylab="",col="orange")
par(new=TRUE)
curve(BSPut(S,x,r,T,sig), from=0, to=2 , xlab="K", lwd = 3, ylim=c(0,1),
ylab="Price",col="blue")
par(new=TRUE)
curve(Optimal_Put_Option(S,x,r,T,sig), from=0, to=2 , xlab="K", lwd = 3,
ylim=c(0,1),ylab="",col="red")
grid (lty = 5)
legend(.0,1.0,legend=c("Upper bound","American put price","Black-Scholes put
price"),col=c("red","orange", "blue"), lty=1:1, cex=1.)

c) When r = 0 and S0 ≤ K, we find

√ ! r
σ2 T
+ i  
h σ T T −σ2 T /8
IE K− min St= K−2S0 1 + Φ − +σS0 e .
t∈[0,T ] 4 2 2π
(S.10.48)
Next, when r = 0 and S0 ≥ K, we find

σ T /2 + log(K/S0 )
h + i  2 
IE K − min St = KΦ √ (S.10.49)
t∈[0,T ] σ T

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σ2 T σ 2 T /2 + log(S0 /K)
   
S0
−S0 1 + log + Φ − √
K 2 σ T
r
T −(σ T /2+log(S0 /K))2 /(2σ2 T )
2
+S0 σ e .
2π
From the above code we can check that when r ≃ 0 the price of the
finite expiration American put option coincides with the price of the stan-
dard European put option, as noted in Proposition 15.9.

Exercise 10.6
a) We have

P (τa ≥ t) = P (Xt > a)

w∞
= φXt (x)dx
ra w
2 ∞ −x2 /(2t)
= e dx, y > 0.
πt y
b) We have

d
φτa (t) = P (τa ≤ t)
dt
d w∞
= φXt (x)dx
dt r a

1 2 −3/2 w ∞ −x2 /(2t) 1 2 −3/2 w ∞ x2 −x2 /(2t)

r
= − t e dx + t e dx
2 π a 2 π a t
1 2 −3/2
r  w∞ 2 2
w∞ 2

= t − e−x /(2t) dx + ae−a /(2t) + e−x /(2t) dx
2 π a a
a 2
= √ e−a /(2t) , t > 0.
2πt3
c) We have
 w ∞ −2
IE (τa )−2 = t φτa (t)dt

0
a w ∞ −7/2 −a2 /(2t)
= √ t e dt
2π 0
2a w ∞ 4 −a2 x2 /2
= √ x e dx
2π 0
3
= 4,
a
by the change of variable x = t−1/2 , i.e. x2 = 1/t, t = x−2 , and
dt = −2x−3 dx.

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Remark: We have
a w ∞ −1/2 −a2 /(2t)
IE[τa ] = √ t e dt = +∞.
2π 0

Exercise 10.7 Starting from the probability density function

1 2
r
1
2 2
φXb0T ,W (a, b) = {a≥max(b,0)} (2a − b)eµb−(2a−b) /(2T )−µ T /2
eT T πT

of the drifted Brownian motion W fT := WT + µT and its maximum X b0T =

max Wt , we take µ := r/σ − σ/2 and let the functions f and g be defined
f
t∈[0,T ]
as
1 x 1 y
f (x, y) := log and g(x, y) := log ,
σ S0 σ S0
with the Jacobian
∂f ∂f 1
∂x ∂y 0 1
|J(x, y)| = = σx 1 = σ 2 xy ,
∂g ∂g 0
∂x ∂y σy

x, y > 0, which yields the joint density

φM0T ,ST (x, y) = |J(x, y)|φX e T (f (x, y), g(x, y))

b0T ,W
2 !
1 2 1
r
x2 x2
  
µ y 2T
= 3 1{x≥max(y,S0 )} log exp log − 2 log −µ
σ T xy πT S0 y σ S0 2σ T S0 y 2

of ST and its maximum M0T = maxt∈[0,T ] St over t ∈ [0, T ], x, y > 0.

Chapter 11

Exercise 11.1 Barrier options.

a) By (11.26) and (12.15) we find
     
∂g T −t St T −t St
ξt = (t, St ) = Φ δ+ − Φ δ+
∂y K B
  −2r/σ2  
2r
  2    
K −(T −t)r St T −t B T −t B
+ e 1− 2 Φ δ− − Φ δ−
B σ B KSt St

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−1−2r/σ2  
2r
  2    
St T −t B T −t B
+ Φ δ+ − Φ δ+
σ2 B KSt St
 2 !
2 1
  
K T −t St
− p 1− exp − δ ,
σ 2π(T − t) B 2 + B

0 < St ≤ B, 0 ≤ t ≤ T , cf. also Exercise 7.1-(ix) of Shreve (2004) and

Figure 11.11 above. At maturity for t = T we find ξT = 1[K,B] (ST ).
b) We find

P(YT ≤ a and WT ≥ b) = P(WT ≤ 2a − b), a < b < 0,

hence
dP(YT ≤ a and WT ≤ b) dP(YT ≤ a and WT ≥ b)
fYT ,WT (a, b) = =− ,
dadb dadb
a, b ∈ R, satisfies

2 (b − 2a) −(2a−b)2 /(2T )

r
fYT ,WT (a, b) = 1(−∞,min(0,b)] (a) e
πT T

r
2 (b − 2a) −(2a−b)2 /(2T )
e a < min(0, b),


 ,
= πT T

0, a > min(0, b).



c) We find

1 2
r
1(−∞,min(0,b)] (a)
2 2

b T (a, b) = (b − 2a)e−µ T /2+µb−(2a−b) /(2T )

b
f
Y T ,W T πT

 r
1 2 2 2
(b − 2a)e−µ T /2+µb−(2a−b) /(2T ) , a < min(0, b),



= T πT

0, a > min(0, b).



d) The function g(t, x) is given by the Relations (11.10) and (11.11) above.

Exercise 11.2
a) By Corollary 10.8, the probability density function of the minimum

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Introduction to Stochastic Finance with Market Examples, Second Edition

0 =
m∆τ min Sτ +s
s∈[0,∆τ ]

with Sτ = B is given by

1 (−(r − σ 2 /2)∆τ + log(x/B))2

 
φm∆τ (x) = √ exp −
0
σx 2π∆τ 2σ 2 ∆τ
 1−2r/σ2
1 ((r − σ 2 /2)∆τ + log(x/B))2
 
B
+ √ exp −
σx 2π∆τ x 2σ 2 ∆τ
  1−2r/σ2 
1 2r (r − σ /2)∆τ + log(x/B)
2
 
B
+ − 1 Φ √ ,
x σ2 x σ ∆τ
0 < x ≤ B, see also Proposition 10.7 for the probability density function of
the minimum of the drifted Brownian motion W ft = Wt +µt over t ∈ [0, T ].
Hence, we have
h + i wB
IE min Sτ +s − K Fτ = (x − K)+ φm∆τ
0
(x)dx
s∈[0,∆τ ] 0

σ2 σ√  log(B/K) + (r − σ 2 /2)∆τ

   r  
= B 1+ er∆τ Φ − + ∆τ + KΦ − √
2r σ 2 σ ∆τ
σ2 log(B/K) + (r + σ 2 /2)∆τ
   
−B 1 + er∆τ
Φ − √
2r σ ∆τ
σ2 σ√ 
   r
+B 1 − Φ − ∆τ
2r σ 2
2
2r/σ
σ2 K log(B/K) − (r − σ 2 /2)∆τ
   
+B Φ − √ − K,
2r B σ ∆τ
with r > 0.
b) When r = 0, we find

σ2 σ√ 
h +
i   
IE min Sτ +s − K Fτ = B 2 + ∆τ Φ − ∆τ
s∈[0,∆τ ] 2 2
2
σ2
! !
σ2 log(B/K) + σ2 ∆τ log(B/K) −
 
B 2 ∆τ
−B 1 + ∆τ + log Φ − √ + KΦ − √ .
2 K σ ∆τ σ ∆τ
1 √ 2 2
− √ σB ∆τ e−σ ∆τ /8 − e−d+ /2 − K.


2π
c) By the solution of Exercise 10.1-(c), the probability density function of
τB is given by

| log(S0 /B)| 1
 
φτB (x) = √ exp − 2 ((r − σ 2 /2)x − log(B/S0 ))2 , x > 0.
σ 2πx3 2σ x

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d) We have
h  + i
e−∆τ IE e−τ 1[0,T ] (τ ) min St − K
t∈[τ,τ +∆τ ]
h h + ii
=e −∆τ
IE e −rτ
1[0,T ] (τ ) IE min St − K Fτ
t∈[τ,τ +∆τ ]
 h + i
=e −∆τ
IE e−rτ 1[0,T ] (τ ) IE min

St − K Fτ ,
t∈[τ,τ +∆τ ]

h + i
where IE mint∈[τ,τ +∆τ ] St − K Fτ is given by Questions (a)-(b),
and
 w T −rx
IE e−rτ 1[0,T ] (τ ) = e φτB (x)dx

0
S0 w T −rxτ 1 1
 
= log e √ exp − 2 ((r − σ 2 /2)x − log(B/S0 ))2 dx
B 0 σ 2πx3 2σ x

!
log(B/S0 ) r − σ 2 /2 − (r − σ 2 /2)2 + 2rσ 2
p
S0
= log exp
B σ2
wT 1

1
2

exp − 2 x (r − σ 2 /2)2 + 2rσ 2 − log(B/S0 )
p
× √ dx
0 σ 2πx3 2σ x
!
log(B/S0 ) r − σ 2 /2 − (r − σ 2 /2)2 + 2rσ 2
p

= exp
σ2
wT 1

1
2

exp − 2 x (r − σ 2 /2)2 + 2rσ 2 − log(B/S0 )
p
× √ dx
0 σ 2πx3 2σ x
2
√
  r−σ /2− (r−σ2 /2)2 +2rσ2 /σ


2 !
log(B/S0 ) − T (r − σ 2 /2)2 + 2rσ 2
p
B
= Φ √
S0 σ T
  r−σ2 /2+√(r−σ2 /2)2 +2rσ2 /σ2

!
log(B/S0 ) + T (r − σ 2 /2)2 + 2rσ 2
p
B
+ Φ √ ,
S0 σ T

where the last identity follows from Proposition 10.4 and the relation
   
a − µT −a − µT
− e2µa Φ =P X b0T ≤ a


Φ √ √
T T
= P(τ̃a ≤ T )
wT
= φτ̃a (x)dx
0
1wT a 2
= √ e−(a−µx) /(2x) dx, T > 0.
2 0 2πx3

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with a := log(B/S0 )/σ, for a Brownian motion with drift µ = (r − σ 2 /2)2 + 2rσ 2 /σ,
p

see Exercise 10.1-(b).

Exercise 11.3 Barrier forward contracts.

a) Up-and-in barrier long forward contract. We have
 
 
 
 
e IE[C | Ft ] = e (ST − K) 1
IE 
−(T −t)r −(T −t)r
 
  Ft 

  
 
 
 max Su > B  
 0≤u≤T
 

= 1  (St − Ke−(T −t)r ) + 1  ϕ(t, St ),


 
 
 

max S > B  max S ≤ B 
 0≤u≤t u
   0≤u≤t u
 

(S.11.50)

where the function

T −t T −t
ϕ(t, x) := xΦ δ+ (x/B) − Ke−(T −t)r Φ δ− (x/B)



2
T −t
+B(B/x)2r/σ Φ −δ+ (B/x)


2
T −t
−Ke−(T −t)r (B/x)−1+2r/σ Φ −δ− (B/x)

solves the Black-Scholes PDE with the terminal condition

 2r/σ2  !
B K
ϕ(T, x) = x − K + B−x 1[B,∞) (x),
x B

as in the proof of Proposition 11.3. Note that only the values of ϕ(t, x)
with x ∈ [0, B] are used for pricing.

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20

15

10

0
75
70 100
120
Underlying 65 140
60 160
180
55 200 Time in days
220

Fig. S.48: Price of the up-and-in long forward contract with K = 60 < B = 80.

As for the hedging strategy, we find

∂ϕ T −t 1 T −t 2
ξt = (t, St ) = Φ δ+ (x/B) + √ e−(δ+ (x/B)) /2


∂x 2π
1 T −t 2 2r 2
− √ Ke−(T −t)r−(δ− (x/B)) /2 − 2 (B/x)1+2r/σ Φ −δ+ T −t
(B/x)


x 2π σ
1 2 T −t 2
+ √ (B/x)1+2r/σ e−(δ+ (B/x)) /2
2π
K(1 − 2r/σ 2 ) −(T −t)r 2
T −t
e (B/x)2r/σ Φ −δ− (B/x)


−
B
K 2 T −t 2
− √ (B/x)2r/σ e−(T −t)r−(δ− (B/x)) /2
B 2π
T −t

2r 2
T −t
= Φ δ+ (x/B) − 2 (B/x)1+2r/σ Φ −δ+ (B/x)


σ
1
 
T −t 2 B T −t 2
+ √ (1 − K/B) e−(δ+ (x/B)) /2 + e−(T −t)r−(δ− (x/B)) /2
2π x
K 2
T −t
− (1 − 2r/σ 2 )e−(T −t)r (B/x)2r/σ Φ −δ− (B/x) ,


B
since by (12.22) we have
T −t T −t
(B/x))2 /2 2
(x/B))2 /2
e−(δ− = er(T −t) (x/B)2r/σ e−(δ+

and T −t T −t
(x/B))2 /2 2
(B/x))2 /2
e−(δ− = er(T −t) (B/x)2r/σ e−(δ+ .

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0.3
0.25
0.2
0.15
0.1
0.05
0
75
70 100
120
Underlying 65 140
60 160
180
55 200 Time in days
220

Fig. S.49: Delta of the up-and-in long forward contract with K = 60 < B = 80.

b) Up-and-out barrier long forward contract. We have

 
 
 
 
e IE[C | Ft ] = e (ST − K) 1
IE 
−(T −t)r −(T −t)r
 
  Ft 

  
 
 
 max Su < B  
 0≤u≤T
 

= 1  ϕ(t, St ), (S.11.51)

 

max S ≤ B 
 0≤u≤t u
 

where the function

T −t T −t
ϕ(t, x) := xΦ −δ+ (x/B) − Ke−(T −t)r Φ −δ− (x/B)



2
T −t
−B(B/x)2r/σ Φ −δ+ (B/x)


2
T −t
+Ke−(T −t)r (B/x)−1+2r/σ Φ −δ− (B/x)

solves the Black-Scholes PDE with the terminal condition

 2r/σ2  
B K
ϕ(T, x) = (x − K)1[0,B] (x) − B−x 1[B,∞) (x).
x B

Note that only the values of ϕ(t, x) with x ∈ [B, ∞) are used for pricing.

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20

15

10

200
Time in days 150 80
100 70 75
60 65
Underlying

Fig. S.50: Price of the up-and-out long forward contract with K = 60 < B = 80.
As for the hedging strategy, we find
∂ϕ T −t 1 T −t 2
ξt = (t, St ) = Φ −δ+ (x/B) − √ e−(δ+ (x/B)) /2


∂x 2π
1 T −t 2 2r 2
+ √ Ke−(T −t)r−(δ− (x/B)) /2 + 2 (B/x)1+2r/σ Φ −δ+ T −t
(B/x)


x 2π σ
1 2 T −t 2
− √ (B/x)1+2r/σ e−(δ+ (B/x)) /2
2π
K(1 − 2r/σ 2 ) −(T −t)r 2
T −t
+ e (B/x)2r/σ Φ −δ− (B/x)


B
K 2 T −t 2
+ √ (B/x)2r/σ e−(T −t)r−(δ− (B/x)) /2
B 2π
T −t

2r 2
T −t
= Φ −δ+ (x/B) + 2 (B/x)1+2r/σ Φ −δ+ (B/x)


σ
1 T −t 2 1 B −(T −t)r−(δ− T −t
(x/B))2 /2
− √ e−(δ+ (x/B)) /2 − √ e
2π 2π x
K T −t 2 1 K −(T −t)r−(δ− T −t
(x/B))2 /2
+ √ e−(δ+ (x/B)) /2 + √ e
B 2π 2π x
K 2
T −t
+ (1 − 2r/σ 2 )e−(T −t)r (B/x)2r/σ Φ −δ− (B/x)


B
T −t

2r 2
T −t
= Φ −δ+ (x/B) + 2 (B/x)1+2r/σ Φ −δ+ (B/x)


σ
1
 
T −t 2 B T −t 2
− √ (1 − K/B) e−(δ+ (x/B)) /2 + e−(T −t)r−(δ− (x/B)) /2
2π x
 2r/σ2 
2r
   
K B T −t B
+ 1 − 2 e−(T −t)r Φ −δ− ,
B σ x x

by (12.22).

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1
0.95
0.9
0.85
0.8
0.75
0.7
0.65
0.6
0.55
60
65
70
Underlying 75 200
80 100 150
Time in days

Fig. S.51: Delta of the up-and-out long forward contract price with K = 60 < B = 80.

c) Down-and-in barrier long forward contract. We have

 
 
 
 
e IE[C | Ft ] = e (ST − K) 1
IE 
−(T −t)r −(T −t)r
 
  Ft 

  
 
 
 min Su < B  
 0≤u≤T
 

= 1  (St − Ke−(T −t)r ) + 1  ϕ(t, St )


 
 
 

min S < B  min S ≥ B 
 0≤u≤t u
   0≤u≤t u
 

(S.11.52)

where the function

T −t T −t
ϕ(t, x) := xΦ −δ+ (x/B) − Ke−(T −t)r Φ −δ− (x/B)



2
T −t
+B(B/x)2r/σ Φ δ+ (B/x)

−1+2r/σ 2 T −t
−(T −t)r
(B/x) (B/x)


−Ke Φ δ−

solves the Black-Scholes PDE with the terminal condition

 2r/σ2  !
B K
ϕ(T, x) = x − K + B−x 1[0,B] (x).
x B

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18
16
14
12
10
8
6
4
2
0
120 80
140 85
160 90
180 Underlying
200 95
Time in days 220
100

Fig. S.52: Price of the down-and-in long forward contract with K = 60 < B = 80.
As for the hedging strategy, we find
∂ϕ
ξt = (t, St )
∂x
T −t

2r 2
T −t
= Φ −δ+ (x/B) + 2 (B/x)1+2r/σ Φ (B/x)


δ+
σ
1
 
T −t 2 B −(T −t)r−(δ−T −t
(x/B))2 /2
− √ (1 − K/B) e−(δ+ (x/B)) /2 + e
2π x
K 2
T −t
+ (1 − 2r/σ 2 )e−(T −t)r (B/x)2r/σ Φ (B/x) .


δ−
B

0.6
0.5
0.4
0.3
0.2
0.1
0
120 80
140 85
160 90
180 Underlying
200 95
Time in days 220
100

Fig. S.53: Delta of the down-and-in long forward contract with K = 60 < B = 80.

d) Down-and-out barrier long forward contract. We have

 
 
 
 
e IE[C | Ft ] = e (ST − K) 1
IE 
−(T −t)r −(T −t)r
 
  Ft 

  
 
 
 min Su > B  
 0≤u≤T
 

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= 1  ϕ(t, St ) (S.11.53)

 

min S ≥ B 
 0≤u≤t u
 

where the function

  x    x 
T −t T −t
ϕ(t, x) := xΦ δ+ − Ke−(T −t)r Φ δ−
B    B
2r/σ 2 T −t B
−B(B/x) Φ δ+
x
   !
−1+2r/σ 2 T −t B
+Ke −(T −t)r
(B/x) Φ δ−
x

solves the Black-Scholes PDE with the terminal condition

   2r/σ2
K B
ϕ(T, x) = (x − K)1[B,∞) (x) − B − x 1[0,B] (x).
B x

Note that ϕ(t, x) above coincides with the price of (11.11) of the standard
down-and-out barrier call option in the case K < B, cf. Exercise 11.1-(d).

40
35
30
25
20
15
10
5
0 100
220 200 95
180 160 90 Underlying
140 120 85
Time in days 100 80

Fig. S.54: Price of the down-and-out long forward contract with K = 60 < B = 80.
As for the hedging strategy, we find
∂ϕ
ξt = (t, St )
∂x
  x  2r 2
T −t T −t
= Φ δ+ − 2 (B/x)1+2r/σ Φ δ+ (B/x)


B σ
1
  
K T −t 2 B T −t 2
+√ 1− e−(δ+ (x/B)) /2 + e−(T −t)r−(δ− (x/B)) /2
2π B x
 2r/σ2 
2r
   
K B T −t B
− 1 − 2 e−(T −t)r Φ δ− .
B σ x x

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1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2 100
220 200 95
180 160 90 Underlying
140 120 85
Time in days 100 80

Fig. S.55: Delta of the down-and-out long forward contract with K = 60 < B = 80.

e) Up-and-in barrier short forward contract. The price of the up-and-in bar-
rier short forward contract is identical to (S.11.50) with a negative sign.

f) Up-and-out barrier short forward contract. The price of the up-and-out

barrier short forward contract is identical to (S.11.51) with a negative
sign. Note that ϕ(t, x) coincides with the price of (11.8) of the standard
up-and-out barrier put option in the case B < K.

g) Down-and-in barrier short forward contract. The price of the down-and-in

barrier short forward contract is identical to (S.11.52) with a negative sign.

h) Down-and-out barrier short forward contract. The price of the down-and-

out barrier short forward contract is identical to (S.11.53) with a negative
sign.

Exercise 11.4 When B < K, we find

Vegadown-and-out-call
r
T − t −(δ+T −t (St /K))2 /2
= St e
2π
 1−2r/σ2 2 
4r St
 2    2 
B T −t B T −t B St
− 3 Φ δ+ − Ke−(T −t)r Φ δ− log
σ B St KSt KSt B
r  1−2r/σ2
T − t B 2 St T −t 2 2
− e−(δ+ (B /K/St )) /2 .
2π St B

When B > K, we find

Vegadown-and-out-call
! !
T −t
(St /B) √ √
 
St T −t 2 K δ−
= √ e−(δ+ (St /K)) /2 −1 + T −t + T −t
2π B σ

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1−2r/σ2
4r B2
      
St T −t B T −t B St
− Φ δ+ − Ke−(T −t)r Φ δ− log
σ3 B St St St B
! !
T −t
1 B 2 −(δ+T −t (St /B))2 /2 (B/St ) √ √
 
K δ−
−√ e −1 + T −t + T −t .
2π St B σ

The corresponding formulas for the down-and-in qcall option can be obtained
T −t
−t −(δ+ (St /K))2 /2
from the parity relation (11.2) and the value St T2π e of the
Black-Scholes Vega, see Table 6.1.

Exercise 11.5 We have

h i
IE∗ [C] = IE∗ 1{ST ≥K} 1{M0T ≤B}
 
= IE∗ 1 1 T
{S0 eσWbT ≥K} {S0 eσXb0 ≤B}
w∞ w∞
= 1{S0 eσy ≥K} 1{S0 eσx ≤B} dP(Xb0T ≤ x, W cT ≤ y)
−∞ y∨0
w∞ w∞
= 1{S0 eσy ≥K} 1{S0 eσx ≤B} fXbT ,Wb T (x, y)dxdy
−∞ y∨0

1 2 w σ−1 log(B/S0 )
r
=
T πT −∞
w∞
1{S0 eσy ≥K} 1{S0 eσx ≤B} (2x − y)e−µ T /2+µy−(2x−y) /(2T ) dxdy
2 2

y∨0

1 2 w σ−1 log(B/S0 ) w σ−1 log(B/S0 )

r
2 2
= (2x − y)e−µ T /2+µy−(2x−y) /(2T ) dxdy,
T πT σ−1 log(K/S0 ) y∨0
if B ≥ S0 (otherwise the option price is 0), with µ = r/σ − σ/2 and y ∨ 0 =
max(y, 0). Next, letting a = y ∨ 0 and b = σ −1 log(B/S0 ), we have
wb T
(2x − y)e2x(y−x)/T dx = (1 − e2b(y−b)/T ),
a 2
hence, letting c = σ −1 log(K/S0 ), we have
2 1 w b µy−y2 /(2T )
IE∗ [C] = e−µ T /2
√ e (1 − e2b(y−b)/T )dy
2πT c
2 1 wb 2
= e−µ T /2
√ eµy−y /(2T ) dy
2πT c

−µ2 T /2−2b2 /T 1 w b y(µ+2b/T )−y2 /(2T )

−e √ e dy.
2πT c
Using the relation

1 w b γy−y2 /(2T ) −c + γT −b + γT
    
2
√ e dy = eγ T /2 Φ √ −Φ √ ,
2πT c T T

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we find
h i
IE∗ [C] = IE∗ (ST − K) 1{M0T ≤B}
+

−c + µT −b + µT
   
=Φ √ −Φ √
T T
−c + (µ + 2b/T )T −b + (µ + 2b/T )T
    
−µ2 T /2−2b2 /T +(µ+2b/T )2 T /2
−e Φ √ −Φ √
T T
     
S0 S0
= Φ δ− T
− Φ δ− T
K B
   2    
2 2 2 B B
− e−µ T /2−2b T +(µ+2b/T ) T /2 Φ δ− − Φ δ− ,
KS0 S0

0 ≤ x ≤ B. Given the relation

2
µ2 T b2 2b 2r
  
T B
− −2 + µ+ = −1 + log ,
2 T 2 T σ2 S0
we get
h i
e−rT IE∗ [C] = e−rT IE∗ 1{ST ≥K} 1{M0T ≤B}
      
S0 S0
= e−rT Φ δ− T
− Φ δ−T
K B
 1−2r/σ2    2    !
S0 T B T B
− Φ δ− − Φ δ− .
B KS0 S0

Exercise 11.6
a) For x = B and t ∈ [0, T ] we check that
    
T −t B T −t
g(t, B) = B Φ δ+ (1)


− Φ δ+
K
    
T −t B T −t
−(T −t)r
(1)


−e K Φ δ− − Φ δ−
K
    
T −t B T −t
(1)


−B Φ δ+ − Φ δ+
K
    
T −t B T −t
+e−(T −t)r K Φ δ− (1)


− Φ δ−
K
= 0,

and the function g(t, x) is extended to x > B by letting

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g(t, x) = 0, x > B.

b) For x = K and t = T , we find

+∞ if s > 1,






0
δ± (s) = −∞ × 1{s<1} + ∞ × 1{s>1} = 0 if s = 1,



−∞ if s < 1,



hence when x < K < B we have

g(T, x) = x (Φ (−∞) − Φ (−∞))

−K (Φ (−∞) − Φ (−∞))
 2r/σ2
B
−B (Φ (+∞) − Φ (+∞))
x
 2r/σ2
B
+K (Φ (+∞) − Φ (+∞))
K
= 0,

c) when K < x < B, we get

g(T, x) = x (Φ (+∞) − Φ (−∞))

−K (Φ (+∞) − Φ (−∞))
 2r/σ2
B
−B (Φ (+∞) − Φ (+∞))
x
 2r/σ2
B
+K (Φ (+∞) − Φ (+∞))
K
= x − K.

Finally, for x > B we obtain

g(T, K) = x (Φ (+∞) − Φ (+∞))

−K (Φ (+∞) − Φ (+∞))
 2r/σ2
B
−B (Φ (−∞) − Φ (−∞))
x
 2r/σ2
B
+K (Φ (−∞) − Φ (−∞))
K
= 0.

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Exercise 11.7
a) The price at time t ∈ [0, T ] of the European knock-out call option is given
by

EKOCt = e−(T −t)r IE∗ (ST − K)+ 1{ST ≤B} Ft , 0 ≤ t ≤ T.

 

100

90

80

70

60

50

40

30

20

10

0
0 50 100 150 200
K x B

Fig. S.56: Payoff function of the European knock-out call option.

Using the relation

2
ST = St e(T −t)r+(BbT −Bbt )σ−(T −t)σ /2
, 0 ≤ t ≤ T,

we have

e−(T −t)r IE∗ (ST − K)+ 1{ST ≤B} Ft

 


2
= e−(T −t)r IE∗ (xe(T −t)r+ BT −Bt σ−(T −t)σ /2 − K)+
 b b
i
×1 (T −t)r+(Bb −Bb )σ−(T −t)σ2 /2
{xe T t ≤B} x=St

= e−(T −t)r IE∗ (em(x)+X − K)+ 1{em(x)+X ≤B} x=St , 0 ≤ t ≤ T,

 

where
σ2
m(x) := (T − t)r − (T − t) + log x
2
and
X := B bt σ ≃ N (0, (T − t)σ 2 )


bT − B

under P∗ . Next, as in Lemma 7.7 we note that if X is a centered Gaussian

random variable with variance v 2 > 0 and B ≥ K, for any m ∈ R we have

IE (em+X − K)+ 1{em+X ≤B}

 

1 w ∞
(em+x − K)+ 1{em+x ≤B} e−x /(2v ) dx
2 2
= √
2πv 2 −∞
1 w −m+log B m+x 2 2
= √ (e − K)e−x /(2v ) dx
2πv 2 −m+log K

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em w −m+log B 2 K w −m+log B −x2 /(2v2 )

/(2v 2 )
= √ ex−x e
dx − √ dx
2πv 2 −m+log K 2πv 2 −m+log K
2
w
em+v /2 −m+log B −(v2 −x)2 /(2v2 ) K w (−m+log B)/v 2
= √ e dx − √ e−x /2 dx
2πv 2 −m+log K 2π (−m+log K)/v
em+v /2 w −v2 −m+log B −y2 /(2v2 )
2

= √ e dy
2πv 2 −v2 −m+log K
−K Φ((m − log K)/v) − Φ((m − log B)/v)


2
= em+v /2 Φ(v + (m − log K)/v) − Φ(v + (m − log B)/v)

−K Φ((m − log K)/v) − Φ((m − log B)/v) .

Hence, the price of the European knock-out call option is given, if B ≥ K,

by

EKOCt = e−(T −t)r IE∗ (ST − K)+ 1{ST ≤B} Ft

 

m(St ) − log K m(St ) − log K

    
2
= e−(T −t)r em(St )+σ (T −t)/2 Φ v + −Φ v+
v v
m(St ) − log K m(St ) − log B
    
−(T −t)r
− Ke Φ −Φ
v v
(T − t)r + (T − t)σ /2 + log(St /K)
2
 
= St Φ √
σ T −t
(T − t)r + (T − t)σ 2 /2 + log(St /B)
 
− St Φ √
σ T −t
(T t)r − (T − t)σ 2 /2 + log(St /K)
 
−
− Ke−(T −t)r Φ √
σ T −t
(T − t)r − (T − t)σ 2 /2 + log(St /B)
 
+ Ke −(T −t)r
Φ √ ,
σ T −t
0 ≤ t ≤ T , with EKOCt = 0 if B ≤ K.

16
14
12
10
8
6
4
2
0
120
90
80 80
Time to maturity (days) 40 70
60 Underlying
0 50

Fig. S.57: Price map of the European knock-out call option.

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b) By computations similar to part (a) we find that, if B ≤ K,

(T − t)r − (T − t)σ 2 /2 + log(St /B)

 
EKIPt = Ke−(T −t)r Φ − √
σ T −t
(T − t)r + (T − t)σ 2 /2 + log(St /B)
 
−St Φ − √ .
σ T −t

160

140

120

100

80

60

40

20

0
0 50 100 150 200
B x K

Fig. S.58: Payoff function of the European knock-in put option.

When B ≥ K, we find the Black-Scholes put option price

EKIPt = e−(T −t)r IE∗ (K − ST )+ 1{ST ≤B} Ft

 

= e−(T −t)r IE∗ (K − ST )+ Ft

 

(T − t)r − (T − t)σ 2 /2 + log(St /K)

 
= Ke−(T −t)r Φ − √
σ T −t
(T − t)r + (T − t)σ 2 /2 + log(St /K)
 
− St Φ − √ ,
σ T −t
0 ≤ t ≤ T.

35
30
25
20
15
10
5

500
60
70 80 120
Underlying 80 40
90 0 Time to maturity (days)

Fig. S.59: Price map of the European knock-in put option.

c) Using the in-out parity relation

EKOCt + EKICt = e−(T −t)r IE∗ [(ST − K)+ | Ft ]

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(T − t)r + (T − t)σ 2 /2 + log(St /K)

 
= St Φ √
σ T −t
(T t)r − (T − t)σ 2 /2 + log(St /K)
 
−
−Ke−(T −t)r Φ √ ,
σ T −t
which is the price of the European call put option with strike price K,
the price at time t ∈ [0, T ] of the European knock-in call option is given,
if B ≥ K, as

EKICt = e−(T −t)r IE∗ (ST − K)+ 1{ST ≥B} Ft

 

(T − t)r + (T − t)σ 2 /2 + log(St /B)

 
= St Φ √
σ T −t
(T − t)r − (T − t)σ 2 /2 + log(St /B)
 
−(T −t)r
−Ke Φ √ ,
σ T −t
0 ≤ t ≤ T.
160

140

120

100

80

60

40

20

0
0 50 100 150 200
K x B

Fig. S.60: Payoff function of the European knock-in call option.

When B ≤ K, we find the Black-Scholes call option price

EKICt = e−(T −t)r IE∗ (ST − K)+ 1{ST ≥B} Ft

 

= e−(T −t)r IE∗ (ST − K)+ Ft

 

(T − t)r + (T − t)σ 2 /2 + log(St /K)

 
= St Φ √
σ T −t
(T t)r − (T − t)σ 2 /2 + log(St /K)
 
−
−Ke−(T −t)r Φ √ .
σ T −t

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30
25
20
15
10
5 90
0 80
120 70
80 60
Underlying

40
Time to maturity (days)
0 50

Fig. S.61: Price map of the European knock-in call option.

d) Using the in-out parity relation

EKOPt + EKIPt = e−(T −t)r IE∗ [(K − ST )+ | Ft ],

which is the price of the European put option with strike price K, we find
that the price at time t ∈ [0, T ] of the European knock-in put option is
given, if B ≤ K, as

EKOPt = e−(T −t)r IE∗ (K − ST )+ 1{ST ≥B} Ft

 

= e−(T −t)r IE∗ [(K − ST )+ | Ft ] − EKIPt

(T − t)r − (T − t)σ 2 /2 + log(St /K)
 
= Ke−(T −t)r Φ − √
σ T −t
(T − t)r + (T − t)σ 2 /2 + log(St /K)
 
−St Φ − √
σ T −t
(T − t)r + (T − t)σ 2 /2 + log(St /B)
 
+St Φ − √
σ T −t
(T − t)r − (T − t)σ 2 /2 + log(St /B)
 
−(T −t)r
−Ke Φ − √ .
σ T −t

100

90

80

70

60

50

40

30

20

10

0
0 50 100 150 200
B x K

Fig. S.62: Payoff function of the European knock-out put option.

When B ≥ K, we have

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EKIPt = e−(T −t)r IE∗ (K − ST )+ 1{ST ≥B} Ft = 0.

 

14
12
10
8
6
4
90
2
0 80
120 70
Underlying
80 60
40
Time to maturity (days)
0 50

Fig. S.63: Price map of the European knock-out put option.

In addition, by the results of Questions (d) and (c) we can verify the call-put
parity relation

EKICt − EKIPt = e−(T −t)r IE∗ (ST − K)1{ST ≥B} Ft

 

(T − t)r + (T − t)σ /2 + log(St /B)

2
 
= St Φ √
σ T −t
(T − t)r − (T − t)σ 2 /2 + log(St /B)
 
−Ke−(T −t)r Φ √ .
σ T −t

Chapter 12

Exercise 12.1
a) This probability density function is given by

2 −(x−σT /2)2 /(2T )

r  
−x − σT /2
x 7−→ e − σeσx Φ √ , x ≥ 0.
πT T
b) We have
   
2
IE min St = S0 IE min eσBt −σ t/2
t∈[0,T ] t∈[0,T ]
h i
= S0 IE e −σ maxt∈[0,T ] (Bt +σt/2)

w∞ r
2 −(x−σT /2)2 /(2T )

−x − σT /2
!
= S0 e−σx e − σeσx Φ √ dx
0 πT T

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2S0 w ∞ −(x+σT /2)2 /(2T ) w ∞  −x − σT /2 

= √ e dx − S0 σ Φ √ dx
2πT 0 0 T
2S0 w ∞ 2 σS0 w ∞ 2
= √ e−x /(2T ) dx − √ xe−(x+σT /2) /(2T ) dx
2πT σT /2 2πT 0
2S0 w ∞ −x2 /(2T ) σS0 w ∞ 2
= √ e dx − √ (x − σT /2)e−x /(2T ) dx
2πT σT /2 2πT σT /2
√
r
T −σ2 T /8
= 2S0 (1 + σ 2 T /4)Φ(−σ T /2) − S0 σ e . (S.12.54)
2π

0.9

0.8

0.7

0.6
price

0.5

0.4

0.3

0.2

0.1

0
0 10 20 30 40 50
time T

Fig. S.64: Expected minimum of geometric Brownian motion over [0, T ].

c) We have
" + #  
IE K − min St = IE K − min St
t∈[0,T ] t∈[0,T ]
√ ! r !
σ2 T
 
σ T T −σ2 T /8
= K − S0 2 1+ Φ − −σ e .
4 2 2π
2.0

Upper bound
Black−Scholes put price
1.5
Price
1.0 0.5
0.0

1.0 1.2 1.4 1.6 1.8 2.0

K

Fig. S.65: Black-Scholes put price upper bound with S0 = 1.

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The derivative with respect to time is given by

σ2 √ σ2 T
   
∂ σ 2
IE min St = S0 Φ − σ T /2 − 2S0 1 + e−σ T /8


√
∂T t∈[0,T ] 2 4 4 2πT
r
σS0 −σ2 T /8 S0 σ 3 T −σ2 T /8
−√ e + e
8πT 8 2π
√ !
S0 σ 2 3σ 2 T
 
T S0 σ −σ2 T /8
= Φ −σ −√ e 1+ .
2 2 2πT 4

-0.2

-0.4
derivative

-0.6

-0.8

-1
0 5 10 15 20 25 30 35 40 45 50
time T

Fig. S.66: Time derivative of the expected minimum of geometric Brownian motion.

On the other hand, when r > 0 we have

2r/σ2 
σ 2 mt0
     t 
St m0
IE∗ mT0 | Ft = mt0 Φ δ−T −t T −t
 
− St Φ δ −
mt0 2r St St
2
    
σ T −t St
+St e(T −t)r 1 + Φ −δ+ .
2r mt0

When r tends to 0, this minimum tends to

log(St /mt0 ) − σ 2 T /2 log(St /mt0 ) + σ 2 T /2

   
mt0 Φ √ + St Φ − √
σ T σ T
  t 2r/σ2   t !
1
 
T −t St m0 T −t m0
+σ St lim
2
e(T −t)r
Φ −δ+ − Φ δ− ,
r→0 2r mt0 St St

where
  t 2r/σ2   t !
1
 
T −t St m0 T −t m0
lim e(T −t)r Φ −δ+ − Φ δ −
r→0 2r mt0 St St
1 log(St /mt0 ) + σ 2 T /2 + rT
  
= lim (1 + (T − t)r)Φ − √
r→0 2r σ T

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2r mt log(mt0 /St ) − σ 2 T /2 + rT
   
− 1 + 2 log 0 Φ √
σ St σ T
1 2 mt0 log(St /mt0 ) + σ 2 T /2
   
= T − t + 2 log Φ − √
2 σ St σ T
w √
1 −(log(St /mt0 )+σ 2 T /2+rT )/(σ T ) 2
+ lim √ e−y /2 dy
r→0 r 8π −∞
w (− log(St /mt0 )−σ2 T /2+rT )/(σ√T ) 2

− e−y /2 dy
−∞

1 2 mt log(St /mt0 ) + σ 2 T /2
   
= T − t + 2 log 0 Φ − √
2 σ St σ T
√
1 w (− log(St /mt0 )−σ2 T /2+rT )/(σ T ) −y2 /2
− lim √ √ e dy
r→0 r 8π (− log(St /m0 )−σ T /2−rT )/(σ T )
t 2

1 2 t
log(St /m0 ) + σ T /2
t 2
   
m
= T − t + 2 log 0 Φ − √
2 σ St σ T
√
T −((log(St /mt0 )+σ2 T /2)/(σ√T ))2 /2
− √ e ,
σ 2π
hence
log(St /mt0 ) − σ 2 T /2 log(St /mt0 ) + σ 2 T /2
   
IE∗ mT0 | Ft = mt0 Φ + St Φ −
 
√ √
σ T σ T
mt0 log(St /mt0 ) + σ 2 T /2
   
St
+ (T − t)σ + 2 log
2
Φ − √
2 St σ T
r
T −((log(St /mt0 )+σ2 T /2)/(σ√T ))2 /2
−σSt e .
2π
In particular, when T tends to infinity we find that

IE∗ mT0 | Ft
 
lim ∗ = 0, r ≥ 0.
T →∞ IE [ST | Ft ]

When t = 0 we have S0 = m00 , and we recover

√ ! r
σ2 T
 
∗ T T −σ2 T /8
IE m0 = 2 S0 + e
 T
Φ −σ − σS0 .
4 2 2π

Exercise 12.2
a) By (S.12.54), we have
  h i
IE max St = IE eσ maxt∈[0,T ] (Bt −σt/2)
t∈[0,T ]

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h i
= S0 IE e−(−σ) maxt∈[0,T ] (Bt −(−σ)t/2)
√
r
T −σ2 T /8
= 2S0 (1 + σ 2 T /4)Φ(σ T /2) + S0 σ e .
2π

1.9

1.8

1.7

1.6

1.5
price

1.4

1.3

1.2

1.1

1
0 0.1 0.2 0.3 0.4 0.5
time T

Fig. S.67: Expected maximum of geometric Brownian motion over [0, T ].

b) We have
" + #  
σBt −σ 2 t/2 2
IE S0 max e −K = IE S0 max eσBt −σ t/2 − K
t∈[0,T ] t∈[0,T ]
 2
 √ ! r
σ T T T −σ2 T /8
= 2S0 1 + Φ σ + S0 σ e − K.
4 2 2π
2.0

Upper bound
Black−Scholes call price
1.5
Price
1.0 0.5
0.0

0.0 0.2 0.4 0.6 0.8 1.0

K

Fig. S.68: Black-Scholes call price upper bound with S0 = 1.

The derivative with respect to time is given by

√ !
S0 σ 2 3σ 2 T
   
∂ T S0 σ −σ2 T /8
IE max St = Φ σ +√ e 1+ .
∂T t∈[0,T ] 2 2 2πT 4

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10

6
derivative

0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
time T

Fig. S.69: Time derivative of the expected maximum of geometric Brownian motion.

Note that when r > 0 we have

σ2
       
St St
IE∗ M0T | Ft = M0t Φ −δ− T −t
+ St e(T −t)r 1 + T −t
 
Φ δ+
M0t 2r M0t

2r/σ2 
σ 2 M0t
  t 
T −t M 0
−St Φ −δ− .
2r St St

When r tends to 0, this maximum tends to

log(St /M0t ) − σ 2 T /2 log(St /M0t ) + σ 2 T /2

   
M0t Φ − √ + St Φ √
σ T σ T
  t 2r/σ2   t !
1
 
T −t St M T −t M0
+σ 2 St lim e(T −t)r Φ δ+ − 0
Φ −δ − ,
r→0 2r M0t St St

where
  t 2r/σ2   t !
1
 
T −t St M0 T −t M0
lim e(T −t)r Φ δ+ − Φ −δ −
r→0 2r M0t St St
    2

1  log M St
t + σ2 T + rT
= lim (1 + (T − t)r)Φ  0
√
r→0 2r

σ T
2r Mt log(St /M0t ) + σ 2 T /2 − rT
   
− 1 + 2 log 0 Φ √
σ St σ T
1 2 M0t log(St /M0t ) + σ 2 T /2
   
= T − t + 2 log Φ √
2 σ St σ T
w √
1 (log(St /M0t )+σ 2 T /2+rT )/(σ T ) 2
+ lim √ e−y /2 dy
r→0 r 8π −∞
w (log(St /M0t )+σ2 T /2−rT )/(σ√T ) 2

− e−y /2 dy
−∞

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1 2 M0t log(St /M0t ) + σ 2 T /2

   
= log
T −t+ Φ √
2 σ2 St σ T
√
1 w (log(St /M0t )+σ2 T /2+rT )/(σ T ) −y2 /2
+ lim √ √ e dy
r→0 r 8π (log(St /M0 )+σ T /2−rT )/(σ T )
t 2

1 2 t
log(St /M0 ) + σ T /2
t 2
   
M
= T − t + 2 log 0 Φ √
2 σ St σ T
√
T −((log(St /M0t )+σ2 T /2)/(σ√T ))2 /2
+ √ e ,
σ 2π
hence
log(St /M0t ) − σ 2 T /2 log(St /M0t ) + σ 2 T /2
   
IE∗ M0T | Ft = M0t Φ − + St Φ
 
√ √
σ T σ T
M0t log(St /M0t ) + σ 2 T /2
   
St
+ (T − t)σ + 2 log
2
Φ √
2 St σ T
r
T −((log(St /M0t )+σ2 T /2)/(σ√T ))2 /2
+σSt e .
2π
In particular, when T tends to infinity we find that

σ2

IE∗ M0T | Ft
   1 + if r > 0,
lim = 2r
∗
T →∞ IE [ST | Ft ] 
+∞ if r = 0.


When t = 0 we have S0 = M00 , and we recover

√ ! r
σ2 T
 
∗ T T −σ2 T /8
IE M0 = 2 S0 + + σS0 e
 T
Φ σ .
4 2 2π

Exercise 12.3
a) We have
  wa 2 dx
P min Bt ≤ a =2 e−x /(2T )
√ , a < 0,
t∈[0,T ] −∞ 2πT
i.e. the probability density function φ of sup Bt is given by
t∈[0,T ]

2 −a2 /(2T )
r
φ(a) = e 1(−∞,0] (a), a ∈ R.
πT
b) We have

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IE min St = S0 IE exp σ min Bt
t∈[0,T ] t∈[0,T ]
2S0 w 0 σx−x2 /(2T ) 2S0 w 0 −(x−σT )2 /(2T )+σ2 T /2
= √ e dx = √ e dx
2πT −∞ 2πσ 2 T −∞
√
2S0 σ2 T /2 w −σT −x2 /(2T ) 2S0 2 w −σ T 2
= √ e e dx = √ eσ T /2 e−x /2 dx
2πT −∞ 2π −∞
2 √
√


= 2S0 eσ T /2 Φ − σ T = 2 IE[ST ] 1 − Φ σ T ,

hence
      √ 
IE ST − min St = IE[ST ] − IE min St = IE[ST ] − 2 IE[ST ] 1 − Φ σ T
t∈[0,T ] t∈[0,T ]
 √ 
  2
  √  1
= IE[ST ] 2Φ σ T − 1 = 2S0 eσ T /2 Φ σ T − ,
2
and
2
    √     √ 
e−σ T /2
IE ST − min St = S0 2Φ σ T −1 = S0 1−2Φ −σ T .
t∈[0,T ]

Remark: We note that the price of the lookback option converges to S0

as T goes to infinity.

1
2 (Φ(σT1/2)-1)

0.8

0.6
Price

0.4

0.2

0
0 1 2 3 4 5
Time T

Fig. S.70: Lookback call option price as a function of T with S0 = 1.

Exercise 12.4 We have

IE∗ e−rτ 1{τ ≤T } 1{M0τ −Sτ ≥K}

 
wT w∞w∞
= e−rt f(τ,Sτ ,Mτ ) (t, x, y)dydxdt
1 0 K+x
w T w ∞ w y−K
= e−rt f(τ,Sτ ,Mτ ) (t, x, y)dxdydt
1 K 0

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for T ≥ 1, and IE∗ e−rτ 1{τ ≤T } 1{M0τ −Sτ ≥K} = 0 if T ∈ [0, 1].
 

Exercise 12.5
a) i) The boundary condition (12.3a) is explained by the fact that

f (t, 0, y) = e−(T −t)r IE∗ M0T − ST St = 0, M0t = y

 

= e−(T −t)r IE∗ M0t − ST St = 0, M0t = y

 

= e−(T −t)r IE M0t M0t = y − e−(T −t)r IE∗ [ST | St = 0]

∗
 

= ye−(T −t)r ,

since IE∗ [ST | St = 0] = 0 as St = 0 implies ST = 0 from the relation

2
ST = St eσ(BT −Bt )+(µ−σ /2)(T −t)
, 0 ≤ t ≤ T.

ii) The boundary condition (12.3b), i.e.

∂f
(t, x, y)y=x = 0, 0 ≤ x ≤ y,
∂y
is illustrated in the following Figure S.71, see also Figure 12.3.

80
Lookback put price

60

40

20

0
40 St= 60 80
y=Mt0

Fig. S.71: Graph of the lookback put option price (2D) with St = 60.

iii) Condition (12.3c) follows from the fact that

f (T, x, y) = IE∗ M0T − ST ST = x, M0T = y = y − x.

 

b) i) The boundary condition (12.14a) is explained by the fact that

f (t, x, 0) = e−(T −t)r IE∗ ST − mT0 St = x, mt0 = 0

 

= e−(T −t)r IE∗ ST St = x, mt0 = 0

 

= e−(T −t)r IE∗ [ST | St = x]

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= e−(T −t)r x, x > 0.

ii) Condition (12.14b) follows from the fact that

f (T, x, y) = IE∗ ST − mT0 ST = x, mT0 = y = x − y.

 

We have
f (t, x, x) = xC(T − t),
with

C(τ ) = 1 − e−rτ Φ δ−
τ
(1)

σ2 σ2
 
− 1+ τ
(1) + e−rτ Φ δ−
τ
(1) , τ > 0,



Φ − δ+
2r 2r

hence
∂f
(t, x, x) = C(T − t), 0 ≤ t ≤ T,
∂x
while we also have
∂f
(t, x, y)y=x = 0, 0 ≤ x ≤ y,
∂y
see also Figure 12.8.

Chapter 13

Exercise 13.1 We have

w  w
T T
IE St dt = IE[St ]dt
τ τ
wT 2
= S0 IE[eσBt +rt−σ t/2
]dt
τ
wT
rt−σ 2 t/2
= S0 e IE[e σBt
]dt
τ
wT
= S0 ert dt
τ
e rT
− erτ
= S0 , 0 ≤ τ ≤ T,
r
and
wT w wT
" 2 # 
T
IE St dt = IE St dt Su du
τ τ τ

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w wT 
T
= IE Su St dtdu
τ τ
wT wu
=2 IE[Su St ]dtdu
τ τ
wT wu 2 2
= 2S02 IE[eσBu +ru−σ u/2 eσBt +rt−σ t/2 ]dtdu
τ τ
wT wu 2 2
= 2S02 eru−σ u/2+rt−σ t/2 IE[eσBu +σBt ]dtdu
τ τ
wT 2
wu 2
= 2S02 e(r−σ /2)u e(r−σ /2)t IE[eσBu +σBt ]dtdu
τ τ
wT 2
wu 2
= 2S02 e(r−σ /2)u e(r−σ /2)t IE[e2σBt +σ(Bu −Bt ) ]dtdu
τ τ
wT 2
wu 2
= 2S02 e(r−σ /2)u e(r−σ /2)t IE[e2σBt ] IE[eσ(Bu −Bt ) ]dtdu
τ τ
wT 2
w u 2 2 2
= 2S02 e(r−σ /2)u e(r−σ /2)t e2σ t eσ (u−t)/2 dtdu
τ τ
wT wu 2
= 2S02 eru ert+σ t dtdu
τ τ
2S 2 w T (2r+σ2 )u 2
= 2 0 e − eru e(r+σ )τ du


σ +r τ
2 2 2
re(σ +2r)T − (σ 2 + 2r)erT +(σ +r)τ + (σ 2 + r)e(σ +2r)τ
= 2S02 , 0 ≤ τ ≤ T.
(σ + r)(σ + 2r)r
2 2

Exercise 13.2
rT
a) The integral 0
rs ds has a centered Gaussian distribution with variance

wT w w
" 2 # 
T T
IE rs ds = σ 2 IE Bs Bt dsdt
0 0 0
wT wT
= σ2 IE[Bs Bt ]dsdt
0 0
wT wT
=σ 2
min(s, t)dsdt
0 0
wT wt
= 2σ 2 sdsdt
0 0
wT
=σ 2 2
t dt
0
2
3σ
=T .
3
rT
b) Since the integral 0
rs ds is a random variable with probability density

1 2 3
φ(x) = p e−3x /(2πT ) ,
2πT 3 /3

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we have
wT w∞
" + #
e
−rT
IE ru du − κ = e−rT (x − κ)+ φ(x)dx
0 −∞

e−rT w∞ 2 2 3
= p (x − κ)e−3x /(2σ T ) dx
2πσ 2 T 3 /3 κ
e−rT w ∞ 2
= (x σ 2 T 3 /3 − κ)e−x /2 dx
p
√ √
2π κ/ σ2 T 3 /3
e−rT σ 2 T 3 /3 w ∞ e−rT w ∞
p
2 2
= √ √ 2 3 xe−x /2 dx − κ √ √ e−x /2 dx
2π κ/ σ T /3 2π κ/ σ2 T 3 /3
e−rT σ 2 T 3 /3 h −x2 /2 i∞ e−rT
p
= e √ 2 3 − κ √ (1 − Φ(κ/ σ 2 T 3 /3))
p
− √
2π κ/ σ T /3 2π
e−rT σ 2 T 3 /3 −3κ2 /(2σ2 T 3 ) e−rT
p
= e − κ √ (1 − Φ(κ/ σ 2 T 3 /3))
p
√
2π 2π
r !
e−rT 3
r
σ 2 T 3 −3κ2 /(2σ2 T 3 )
= e−rT
e − κ √ Φ −κ .
6π 2π σ2 T 3

Exercise 13.3 We have

1 wT
" + #  w
1 T

e−(T −t)r IE Su du − κ Ft = e−(T −t)r IE Su du − κ Ft
T 0 T 0
 w
1

T
= e−(T −t)r IE Su du Ft − κe−(T −t)r
T 0
w w
1 1
 
t T
= e−(T −t)r IE Su du Ft + e−(T −t)r IE Su du Ft − κe−(T −t)r
T 0 T t
wt w
−(T −t)r 1 −(T −t)r 1

T
=e Su du + e IE Su du Ft − κe−(T −t)r
T 0 T t
wt wT
−(T −t)r 1 −(T −t)r 1
=e Su du + e IE[Su | Ft ]du − κe−(T −t)r
T 0 T t
1 wt 1 wT
= e−(T −t)r Su du + e−(T −t)r St e(u−t)r du − κe−(T −t)r
T 0 T t
w
1 t w
St T −t ru
= e−(T −t)r Su du + e−(T −t)r e du − κe−(T −t)r
T 0 T 0
w
1 t St (T −t)r
= e−(T −t)r Su du + e−(T −t)r (e − 1) − κe−(T −t)r
T 0 rT
1 wt 1 − e−(T −t)r
= e−(T −t)r Su du + St − κe−(T −t)r ,
T 0 rT
t ∈ [0, T ], cf. Geman and Yor (1993) page 361. We check that the function
f (t, x, y) = e−(T −t)r (y/T − κ) + x(1 − e−(T −t)r )/(rT ) satisfies the PDE

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∂f ∂f ∂f 1 ∂2f
rf (t, x, y) = (t, x, y) + x (t, x, y) + rx (t, x, y) + x2 σ 2 2 (t, x, y),
∂t ∂y ∂x 2 ∂x

t, x > 0, and the boundary conditions f (t, 0, y) = e−(T −t)r (y/T − κ),
0 ≤ t ≤ T , y ∈ R+ , and f (T, x, y) = y/T − κ, x, y ∈ R+ . However, the
condition limy→−∞ f (t, x, y) = 0 is not satisfied because we need to take
y > 0 in the above calculation.

Exercise 13.4
a) We have

1 wT
 
e−(T −t)r IE∗ Su du − K Ft
T 0
 w
1 T

= e−(T −t)r
IE∗ Su du Ft − Ke−(T −t)r
T 0
e−(T −t)r ∗ w t e−(T −t)r ∗ w T
   
= IE Su du Ft + IE Su du Ft − Ke−(T −t)r
T 0 T t

e−(T −t)r w t e−(T −t)r w T ∗

= Su du + IE [Su | Ft ]du − Ke−(T −t)r
T 0 T t
e−(T −t)r w t e−(T −t)r w T (u−t)r
= Su du + e St du − Ke−(T −t)r
T 0 T t
e−(T −t)r tw w
e−rT T ru
= Su du + St e du − Ke−(T −t)r
T 0 T t
e−(T −t)r w t St
= Su du + 1 − e−(T −t)r − Ke−(T −t)r .


T 0 rT
b) Using the relation

(x − K)+ − (K − x)+ = x − K, K, x ∈ R,

we have

1 wT
" + #
∗
C(t, K) − P (t, K) = e IE
−(T −t)r
Su du − K Ft
T 0

1 wT
" + #
−e−(T −t)r IE∗ K− Su du Ft
T 0

1 wT 1 wT
" +  + #
= e−(T −t)r IE∗ Su du − K − K− Su du Ft
T 0 T 0
 w
1

T
= e−(T −t)r IE∗ Su du − K Ft
T 0

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e−(T −t)r w t St
= Su du + 1 − e−(T −t)r − Ke−(T −t)r . (S.13.55)


T 0 rT
c) Any self-financing portfolio strategy (ξt )t∈R+ with price process (Vt )t∈R+
has to satisfy the equation

dVt = ηt dAt + ξt dSt

= rηt At dt + µξt St dt + σξt St dBt
= rVt dt + (µ − r)ξt St dt + σξt St dBt , t ∈ R+ .

On the other hand, by part (a) we have

e−(T −t)r w t
 
St
dVt = d Ss ds + (1 − e−(T −t)r ) − Ke−(T −t)r
T 0 rT
r −(T −t)r w t e−(T −t)r St
= e Ss dsdt + St dt − e−(T −t)r dt
T 0 T T
1 − e−(T −t)r
+ dSt − rKe −(T −t)r
dt
rT
r −(T −t)r tw 1−e −(T −t)r
= e Ss dsdt + dSt − rKe−(T −t)r dt
T 0 rT
1 − e−(T −t)r
= rVt dt + dSt − St (1 − e−(T −t)r )dt
rT
1 − e−(T −t)r
= rVt dt + ((µ − r)St dt + σSt dBt ),
rT
hence
1 − e−(T −t)r
ξt = , t ∈ [0, T ],
rT
which can be recovered by differentiating the pricing function

e−(T −t)r x
y+ 1 − e−(T −t)r − Ke−(T −t)r


T rT
wt
in (S.13.55) with respect to x = St , with y = Su du. We also have
0

e−(T −t)r w t
Vt = Ss ds + ξt St − Ke−(T −t)r , t ∈ [0, T ].
T 0

d) The following code yields $7.906436 for the price of the long forward
contract.
T=1;t=63/252;r=0.0209;K=80;dt=1/252;S=as.numeric(last(futures));
exp(-(T-t)*r)*sum(futures)*dt/T+S*(1-exp(-(T-t)*r))/(r*T)-K*exp(-(T-t)*r)

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Exercise 13.5 The geometric mean price G satisfies

 w  w
1 T 1 t 1 wT
 
G = exp log Su du = exp log Su du + log Su du
T 0 T 0 T t
 w
1 t 1 wT

T −t Su
= exp log Su du + log St + log du
T 0 T T t St
 w
1 t T −t
= exp log Su du + log St
T 0 T
1 wT

+ (r(u − t) + (Bu − Bt )σ − (u − t)σ 2 /2)du
T t
 w
1 t T −t
= exp log Su du + log St
T 0 T
w
1 T −t σ wT

+ (ru − σ 2 u/2)du + (Bu − Bt )du
T 0 T t
 w
1 t (T − t)2 σ wT

= (St )(T −t)/T
exp log Su du + (r − σ 2 /2) + (Bu − Bt )du
T 0 2T T t
wT
where Bu du is centered Gaussian with conditional variance
t

w wT
" 2 # " 2 #
T
IE Bu du Ft = IE (Bu − Bt )du Ft
t t

wT
" 2 #
= IE (Bu − Bt )du
t

w T −t 2 # w
T −t w T −t
"
= IE (Bu − Bt )du = IE [Bs Bu ] dsdu
0 0 0

w T −t w u w T −t (T − t)3
=2 sdsdu = u2 du = .
0 0 0 3
Hence, letting

1 wt T −t (T − t)2 σ wT
m := log Su du + log St + (r − σ 2 /2), X := Bu du,
T 0 T 2T T t
and v 2 = (T − t)σ 2 /3, we find
"  w + #
1 T

e−(T −t)r IE∗ exp log Su du − K Ft
T 0
 w
1 t (T − t)2 σ2

= (St )(T −t)/T e−(T −t)r exp log Su du + (2r − σ 2 ) + (T − t)
T 0 4T 6

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 rt S
(T −t)/T
(T −t)2

(T − t)σ 2 /3 + 1
T 0
log Su du + log t K + 2T (r − σ 2 /2)
×Φ  
σ (T − t)/3
p

 rt S
(T −t)/T
−t)2

−(T −t)r
1
log Su du + log t K + (T2T (r − σ 2 /2)
−Ke Φ T 0 ,
σ (T − t)/3
p

0 ≤ t ≤ T . In case t = 0, we get
"  w + #
1 T

e−rT IE∗ exp log Su du − K
T 0
!
2 log(S0 /K) + T (r + σ 2 /6)/2
= S0 e−T (r+σ /6)/2
Φ p
σ T /3
!
log(S0 /K) + T (r − σ 2 /2)/2
−Ke−rT Φ p .
σ T /3

Exercise 13.6 Under the above condition we have, taking t ∈ [τ, T ],

1 wT
" + #
∗
e−(T −t)r
IE rs ds − K Ft
T −τ τ

1 wT
" + #
= e−(T −t)r IE∗ Λt + rs ds − K Ft
T −τ t
1 wT
 
= e−(T −t)r IE∗ Λt + rs ds − K Ft
T −τ t
e−(T −t)r ∗ w T
 
= e−(T −t)r (Λt − K) + IE rs ds Ft
T −τ t
−(T −t)r w T
e
= e−(T −t)r (Λt − K) + IE∗ [rs | Ft ]ds, t ∈ [τ, T ],
T −τ t

where

IE∗ [rs | Ft ] = vt e−(s−t)λ + m(1 − e−(s−t)λ ), 0 ≤ s ≤ t,

hence

1 wT 1 wT
" + # " + #
∗ ∗
IE rs ds − K Ft = IE Λt + rs ds − K Ft
T −τ τ T −τ t
1 wT ∗
= Λt − K + IE [rs | Ft ]ds
T −τ t
1 w T
= Λt − K + rt e−(s−t)λ + m(1 − e−(s−t)λ ) ds


T −τ t

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1 w T −t e−(T −t)r
= Λt − K + (rt − m) e−λs ds + m(T − t)
T −τ 0 T −τ
1 w T −t −λs T −t
= Λt − K + (rt − m) e ds + m
T −τ 0 T −τ
1−e −(T −t)λ
T −t
= Λt − K + (rt − m) + m .
(T − τ )λ T −τ

Exercise 13.7 This question extends Exercise 7.4 to n ≥ 3. If (St )t∈R+ is a

martingale then for any convex payoff function ϕ we can write
ST1 + · · · + STn ϕ(ST1 ) + · · · + ϕ(STn )
h  i h i
IE∗ ϕ ≤ IE∗ since ϕ is convex,
n n
IE∗ [ϕ(ST1 )] + · · · + IE∗ [ϕ(STn )]
=
n
IE∗ [ϕ(IE∗ [STn | FT1 ])] + · · · + IE∗ [ϕ(IE∗ [STn | FTn ])]
= because (St )t∈R+ is a martingale,
n
IE∗ [IE∗ [ϕ(STn ) | FT1 ]] + · · · + IE∗ [IE∗ [ϕ(STn ) | FTn ]]
≤ by Jensen’s inequality,
n
IE∗ [ϕ(STn )] + · · · + IE∗ [ϕ(STn )]
= by the tower property,
n
= IE∗ [ϕ(STn )].

On the other hand, if (St )t∈R+ is only a submartingale then the above ar-
gument still applies to a convex non-decreasing payoff function ϕ such as
ϕ(x) = (x − K)+ .

Exercise 13.8 Taking t ∈ [τ, T ], under the condition

1 wt
Λt := Ss ds ≥ K,
T −τ τ
we have

1 wT
" + #
e−(T −t)r IE∗ Ss ds − K Ft
T −τ τ

1 wT
" + #
∗
=e −(T −t)r
IE Λt + Ss ds − K Ft
T −τ t
1 wT
 
= e−(T −t)r IE∗ Λt + Ss ds − K Ft
T −τ t
w
e−(T −t)r

T
= e−(T −t)r (Λt − K) + IE∗ Ss ds Ft
T −τ t

e−(T −t)r w T ∗
=e −(T −t)r
(Λt − K) + IE [Ss | Ft ]ds
T −τ t

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e−(T −t)r w T (s−t)r

= e−(T −t)r (Λt − K) + St e ds
T −τ t
−(T −t)r w T −t
e
= e−(T −t)r (Λt − K) + St ers ds
T −τ 0

e−(T −t)r (T −t)r

= e−(T −t)r (Λt − K) + St (e − 1)
(T − τ )r
1 − e−(T −t)r
= e−(T −t)r (Λt − K) + St , t ∈ [τ, T ].
(T − τ )r

Exercise 13.9 The Asian option price can be written as

1 wT
" + #
e−r(T −t) IE∗ Ft = St Ib
E (UT )+ | Ut
 
Su du − K
T 0
= St h(t, Ut ) = St g(t, Zt ),

which shows that

g(t, Zt ) = h(t, Ut ),
and it remains to use the relation
1 − e−(T −t)r
Ut = + e−(T −t)r Zt , t ∈ [0, T ].
rT

Exercise 13.10
i) By change of variable. We note that Zet = e−(T −t)r Zt , where

1 1 wt 1 Λt
   
Zt := Su du − K = −K , 0 ≤ t ≤ T,
St T 0 St T

and the pricing function g(t, Zt ) satisfies the Rogers-Shi PDE

1 1 ∂2g
 
∂g ∂g
(t, z) + − rz (t, z) + σ 2 z 2 2 (t, z) = 0.
∂t T ∂z 2 ∂z

Letting ze := e−(T −t)r z and ge(t, ze) := g t, e(T −t)r ze = g(t, z) = ge t, e−(T −t)r z ,

we note that

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∂g ∂

 (t, z) = ge t, e−(T −t)r z





 ∂t ∂t


∂eg ∂e
g


= t, e−(T −t)r z + re−(T −t)r z t, e−(T −t)r z







 ∂t ∂x



∂eg ∂e
g

= (t, ze) + re
z (t, ze),

 ∂t ∂x



∂g ∂e
g ∂e
g

(t, z) = e−(T −t)r t, e−(T −t)r z = e−(T −t)r (t, ze),







 ∂z ∂e
z ∂e
z



2 2
∂ g ∂ ge ∂ 2 ge

(t, z) = e−2(T −t)r 2 t, e−(T −t)r z = e−2(T −t)r 2 (t, ze),



∂z 2 ∂e
z ∂ez
hence
1 1 ∂2g
 
∂g ∂g
0= (t, z) + − rz (t, z) + σ 2 z 2 2 (t, z)
∂t T ∂z 2 ∂z
1
 
∂e
g ∂e
g −(T −t)r ∂e g
= (t, ze) + re
z (t, ze) + − rz e (t, ze)
∂t ∂x T ∂e
z
1 2
∂ ge
+ σ 2 z 2 e−2(T −t)r 2 (t, ze)
2 ∂e
z
∂e
g 1 ∂e
g 1 ∂ 2 ge
= (t, ze) + e−(T −t)r (t, ze) + σ 2 ze2 2 (t, ze),
∂t T ∂e
z 2 ∂ez
and the (simpler) PDE

∂e
g 1 ∂e
g 1 ∂ 2 ge
(t, ze) + e−(T −t)r (t, ze) + σ 2 ze2 2 (t, ze) = 0.
∂t T ∂e
z 2 ∂ez
ii) Using the Itô formula. Given that

et = d(e−(T −t)r Zt )
dZ
= re−(T −t)r Zt dt + e−(T −t)r dZt
= rZet dt + e−(T −t)r dZt ,

and
dSt = rSt dt + σSt dBt ,
under the risk-neutral probability measure P∗ , an application of Itô’s
formula to the discounted portfolio price leads to

d e−rt St ge t, Z



et
= e−rt − re g t, Zet dt + ge t, Z
et dSt + St de
g t, Zet + dSt • de






g t, Zet
 
= e−rt −rSt ge t, Z et dt + ge t, Zet dSt + St ∂e
g
t, Zet dt + St
∂e
g





t, Zet dZ
et
∂t ∂z

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1 ∂ 2 ge
 
+ e−rt St 2 t, Z et dZet 2 + dSt • de




g t, Zet
2 ∂z

= e−rt −rSt ge t, Z et dt + ge t, Zet dSt + St ∂e g




t, Zet dt
∂t

∂eg ∂eg
+rZet St t, Zet dt + St e−(T −t)r



t, Zet dZt
∂z ∂z
1 −rt ∂ 2 ge
 
+ e et dZet + dSt • de




St 2 t, Z g t, Zet
2 ∂z
 
=e −rt et dt + rSt ge t, Zet dt + σSt ge t, Zet dBt + rZ et St ∂e
g





−rSt ge t, Z t, Z
et dt
∂z

2 ∂e

g
+e −rt
e−(T −t)r
St Zt −r + σ


t, Zet dt
∂z
1

∂eg et dt − σe−(T −t)r St Zt ∂e g
+ e−(T −t)r St



t, Z t, Zet dBt
T ∂z ∂z
1 2 e2 ∂ 2 ge
 
∂eg
+e −rt 2



σ Zt St 2 t, Zet dt − σ St Z et t, Zet dt
2 ∂z ∂z

1 −(T −t)r ∂e
1 2 2 ∂ 2 ge
 
∂eg g
= e St
−rt
t, Zt + e t, Zt + σ Z


e e et t, Z
et dt
∂t T ∂z 2 ∂z 2
 
∂e
g
+St e−rt



σeg t, Z et − σ Zet t, Z
et dBt .
∂z

Since the discounted portfolio price process is a martingale under the

risk-neutral probability measure P∗ , the sum of components in dt should
vanish in the above expression, which yields

et + 1 e−(T −t)r ∂e et + 1 σ 2 Zet2 ∂ ge t, Z

2
∂e
g
g

et = 0,


t, Z t, Z
∂t T ∂z 2 ∂z 2
and the PDE
∂e
g 1 ∂e
g 1 ∂ 2 ge
(t, ze) + e−(T −t)r (t, ze) + σ 2 ze2 2 (t, ze) = 0,
∂t T ∂e
z 2 ∂ez
under the terminal condition ge(T, ze) = ze+ , ze ∈ R.

Exercise 13.11
a) When Λt /T ≥ K we have

1 − e−(T −t)r
 
Λt
f (t, St , Λt ) = e−(T −t)r −K + St ,
T rT

see Exercise 13.8.

b) When Λt /T ≥ K we have

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1 − e−(T −t)r
 
Λt
ξt = and ηt At = e(T −t)r −K , 0 ≤ t ≤ T.
rT T

c) At maturity we have f (T, ST , ΛT ) = (ΛT /T − K)+ , hence ξT = 0 and

+
e−rT
  
ΛT ΛT
ηT AT = AT −K 1{ΛT >KT } = −K .
A0 T T

d) By Proposition 13.12 we have

1 1 Λt
     
Λt ∂g
ξt = f (t, St , Λt ) − −K t, −K
St T ∂z St T

where the function g(t, z) satisfies f (t, x, y) = xg(t, (y/T − K)/x)) and

1 − e−(T −t)r
g(t, z) = ze−(T −t)r + , z > 0,
rT
and solves the PDE
1 1 ∂2g
 
∂g ∂g
(t, z) + − rz (t, z) + σ 2 z 2 2 (t, z) = 0,
∂t T ∂z 2 ∂z

under the terminal condition g(T, z) = z + , hence letting

∂g
h(t, z) := e(T −t)r (t, z),
∂z
we have
1 1 ∂2g
 
∂g ∂g
e(T −t)r (t, z) + e(T −t)r − rz (t, z) + σ 2 z 2 2 (t, z) = 0,
∂t T ∂z 2 ∂z

with h(t, z) = 1, z > 0, hence

∂2g 1
  2
∂g ∂ g
e(T −t)r (t, z) − re(T −t)r (t, z) + e(T −t)r − rz (t, z)
∂t∂z ∂z T ∂z 2
2
∂ g 1 3
∂ g
+σ 2 ze(T −t)r 2 (t, z) + e(T −t)r σ 2 z 2 3 (t, z) = 0,
∂z 2 ∂z
or
1 1 ∂2h
 
∂h ∂h
(t, z) + + (σ 2 − r)z (t, z) + σ 2 z 2 2 (t, z) = 0,
∂t T ∂z 2 ∂z
with the terminal condition h(T, z) = 1{z>0} . On the other hand, we have

1
ηt = (f (t, St , Λt ) − ξt St )
At

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1 1 Λt
    
Λt ∂g
= −K t, −K
At T ∂z St T
e−(T −t)r Λt 1 Λt
    
= − K h t, −K .
At T St T

Exercise 13.12 Asian options with dividends. When reinvesting dividends,

the portfolio self-financing condition reads

dVt = ηt dAt + ξt dSt + δξt St dt

| {z } | {z }
Trading profit and loss Dividend payout
= rηt At dt + ξt ((µ − δ)St dt + σSt dBt ) + δξt St dt
= rηt At dt + ξt (µSt dt + σSt dBt )
= rVt dt + (µ − r)ξt St dt + σξt St dBt , t ∈ R+ .

On the other hand, by Itô’s formula we have

dgδ (t, St , Λt )
∂gδ ∂gδ ∂gδ
= (t, St , Λt )dt + (t, St , Λt )dΛt + (µ − δ)St (t, St , Λt )dt
∂t ∂y ∂x
1 2
∂ gδ ∂gδ
+ σ 2 St2 (t, St , Λt )dt + σSt (t, St , Λt )dBt
2 ∂x2 ∂x
∂gδ ∂gδ ∂gδ
= (t, St , Λt )dt + St (t, St , Λt )dt + (µ − δ)St (t, St , Λt )dt
∂t ∂y ∂x
1 2
∂ gδ ∂gδ
+ σ 2 St2 (t, St , Λt )dt + σSt (t, St , Λt )dBt ,
2 ∂x2 ∂x
hence by identification of the terms in dBt and dt in the expressions of dVt
and dgδ (t, St ), we get
∂gδ
ξt = (t, St , Λt ),
∂x
and we derive the Black-Scholes PDE with dividend
∂gδ ∂gδ
rgδ (t, x, y) = (t, x, y) + y (t, x, y) (S.13.56)
∂t ∂y
∂gδ 1 2
∂ gδ
+(r − δ)x (t, x, y) + σ 2 x2 (t, x, y).
∂x 2 ∂x2
Defining f (t, x, y) := e(T −t)δ gδ (t, x, y) and substituting

gδ (t, x, y) = e(T −t)δ f (t, x, y)

in (S.13.56) yields the equation

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∂f ∂f
rf (t, x, y) = δf (t, x, y) + y
(t, x, y) + (t, x, y)
∂y ∂t
∂f 1 ∂2f
+(r − δ)x (t, x, y) + σ 2 x2 2 (t, x, y),
∂x 2 ∂x
i.e.
∂f ∂f
(r − δ)f (t, x, y) = (t, x, y) + y (t, x, y)
∂t ∂y
∂f 1 ∂2f
+(r − δ)x (t, x, y) + σ 2 x2 2 (t, x, y),
∂x 2 ∂x
whose solution f (t, x, y) is the Asian option pricing function with modified
interest rate r − δ and no dividends, under the terminal condition
y +
f (T, x, y) = gδ (T, x, y) = −K .
T
Therefore the Asian option price gδ (t, St , Λt ) with dividend rate δ can be
recovered from the relation

gδ (t, x, y) = e(T −t)δ f (t, x, y), t ∈ [0, T ], x, y > 0.

Note that we can also define

h(t, x, y) := gδ t, xe−δ(T −t) , y

and substituting
gδ (t, x, y) = h t, xeδ(T −t) , y

in (S.13.56) yields the equation

∂h ∂h
rh(t, x, y) = y (t, x, y) + (t, x, y)
∂y ∂t
∂h 1 ∂2h
+rx (t, x, y) + σ 2 x2 2 (t, x, y),
∂x 2 ∂x
whose solution h(t, x, y) is the Asian option pricing function with interest
rate r and no dividends, under the terminal condition
y +
h(T, x, y) = gδ (T, x, y) = −K .
T
Finally, the Asian option price gδ (t, St , Λt ) with dividend rate δ can be also
recovered from the relation

gδ (t, x, y) = h t, xe−(T −t)δ , y , t ∈ [0, T ], x, y > 0.

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Chapter 14

Exercise 14.1
a) The process ((2 − Bt )+ )t∈R+ is a convex function x 7−→ (2 − x)+ of the
Brownian martingale (Bt )t∈R+ , hence it is a submartingale by Proposi-
tion 14.4-(a).
b) Taking σ := 1 and µ := σ 2 /2 > 0, the process eBt can be written as
2 2
eBt = eσBt −σ t/2+µt
= eµt eσBt −σ t/2
, t ∈ R+ ,

hence it is a submartingale as the driftless geometric Brownian motion

2
eσBt −σ t/2 is a martingale.
c) When t > 0, the question “is ν > t?” cannot be answered at time t
without waiting to know the value of B2t at time 2t > t. Therefore ν is
not a stopping time.
d) For any t ∈ R+ , the question “is τ > t?” can be answered based on the
observation of the paths of (Bs )0≤s≤t and of the (deterministic) curve
(es/2 + αses/2 )0≤s≤t up to the time t. Therefore τ is a stopping time.
e) Since τ is a stopping time and eBt −t/2 t∈R+ is a martingale, the Stopping

Time Theorem 14.7 shows that eBt∧τ −(t∧τ )/2 t∈R+ is also a martingale

and, in particular, its expected value∗

IE eBt∧τ −(t∧τ )/2 = IE eB0∧τ −(0∧τ )/2 = IE eB0 −0/2 = 1

     

is constantly equal to 1 for all t ≥ 0. This shows that

h i
IE eBτ −τ /2 = IE lim eBt∧τ −(t∧τ )/2
 
t→∞

= lim IE eBt∧τ −(t∧τ )/2

 
t→∞
= 1.

Next, we note that eBτ = (α + βτ )eτ /2 at time τ , hence α + βτ = eBτ −τ /2

and
α + β IE[τ ] = IE[α + βτ ] = IE eBτ −τ /2 = 1,
 

i.e. IE[τ ] = (1 − α)/β.

Remark: This argument also recovers IE[τ ] = 0 when α = 1, however it
fails when (α > 1 and β > 0) and when (α < 1 and β < 0), because τ is
not a.s. finite (P(τ < ∞) < 1) in those cases.

Exercise 14.2 Stopping times.

∗
We let t ∧ τ := min(t, τ ).

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a) When 0 ≤ t < 1 the question “is ν > t?” cannot be answered at time t
without waiting to know the value of B1 at time 1. Therefore ν is not a
stopping time.
b) For any t ∈ R+ , the question “is τ > t?” can be answered based on the
observation of the paths of (Bs )0≤s≤t and of the (deterministic) curve
αe−s/2 0≤s≤t up to the time t. Therefore τ is a stopping time.

Since τ is a stopping time and (Bt )t∈R+ is a martingale, the Stopping

Time Theorem 14.7 shows that eBt∧τ −(t∧τ )/2 t∈R is also a martingale


+
and in particular its expected value

IE eBt∧τ −(t∧τ )/2 = IE eB0∧τ −(0∧τ )/2 = IE eB0 −0/2 = 1

     

is constantly equal to 1 for all t. This shows that

h i
IE eBτ −τ /2 = IE lim eBτ ∧t −(τ ∧t)/2 = lim IE eBτ ∧t −(τ ∧t)/2 = 1.
   
t→∞ t→∞

Next, we note that we have e Bτ

= αe −τ /2
at time τ , hence
1
α IE e−τ = IE eBτ −τ /2 = 1, IE e−τ = ≤ 1.
     
i.e.
α
Remark: This argument fails when α < 1 because in that case τ is not
a.s. finite.
c) For any t ∈ R+ , the question “is τ > t?” can be answered based on the
observation of the paths of (Bs )0≤s≤t and of the (deterministic) curve
(1 + αs)0≤s≤t up to the time t. Therefore τ is a stopping time.

Since τ is a stopping time and (Bt )t∈R+ is a martingale, the Stopping

Time Theorem 14.7 shows that (Bt∧τ 2
− (t ∧ τ ))t∈R+ is also a martingale
and in particular its expected value

IE[Bt∧τ
2
− (t ∧ τ )] = IE[B0∧τ
2
− (0 ∧ τ )] = IE[B02 − 0] = 0

is constantly equal to 0 for all t. This shows that

h i
IE[Bτ2 − τ ] = IE lim (Bt∧τ
2
− (t ∧ τ )) = lim IE (Bt∧τ − (t ∧ τ )) = 0.
 2 
t→∞ t→∞

Next, we note that Bτ2 = 1 + ατ at time τ , hence

1 + α IE[τ ] = IE[1 + ατ ] = IE[Bτ2 ] − IE[τ ] = 0,

i.e.
1
IE[τ ] = .
1−α
Remark: This argument is valid whenever α ≤ 1 and yields IE[τ ] = +∞
when α = 1, however it fails when α > 1 because in that case τ is not a.s.

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finite.

Exercise 14.3
a) By the Stopping Time Theorem 14.7, for all n ≥ 0 we have
h √ i
1 = IE e 2rBτL ∧n −r(τL ∧n)
h √ i h √ i
= IE e 2rBτL ∧n −r(τL ∧n) 1{τL <n} + IE e 2rBτL ∧n −r(τL ∧n) 1{τL ≥n}
h √ i h √ i
= IE e 2rBτL −rτL 1{τL <n} + IE e 2rBn −rn 1{τL ≥n}
√ h √ i
= eL 2r IE e−rτL 1{τL <n} + IE e 2rBn −rn 1{τL ≥n} .
 

The first term above converges to

√ √
eL 2r
IE e−rτL 1{τL <∞} = eL 2r IE e−rτL
   

as n tends to infinity, by dominated or monotone convergence and the fact

that r > 0. The second term can be bounded as
h √ i h √ i √
0 ≤ IE e 2rBn −rn 1{τL ≥n} ≤ e−rn IE eL 2r 1{τL ≥n} ≤ e−rn eL 2r ,

which tends to 0 as n tends to infinity because r > 0. Therefore we have

h √ i √
1 = lim IE e 2rBτL ∧n −r(τL ∧n) = eL 2r IE e−rτL ,
 
n→∞
√
which yields IE e−rτ
 −rτ =  e
−L 2r
for any r ≥ 0. When r < 0 we could in
 
L

fact show that IE e L = +∞.

b) In order to maximize the quantity

IE e−rτL BτL = IE e−rτL BτL 1{τL <∞}

   

= L IE e 1{τL <∞}
 −rτL 

= L IE e−rτL
 
√
= Le−L 2r
,

we differentiate
∂ √ √ √ √
(Le−L 2r ) = e−L 2r − L 2re−L 2r = 0,
∂L
√
which yields the optimal level L∗ = 1/ 2r.

This shows that when the value of r is “large”

√ the better strategy is to
opt for a “small gain” at the level L∗ = 1/ 2r rather than to wait for a

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longer time.

Exercise 14.4 See e.g. Theorem 6.16 page 161 of Klebaner (2005). By the Itô
formula, we have
1 w t ′′
Xt = f (Bt ) − f (Bs )ds
2 0
wt 1 w t ′′ 1 w t ′′
= f (B0 ) + f ′ (Bs )dBs + f (Bs )ds − f (Bs )ds
0 2 0 2 0
wt
= f (B0 ) + f ′ (Bs )dBs ,
0

hence the process (Xt )t∈R+ is a martingale. By the Stopping Time Theo-
rem 14.7 we have

f (x) = IE[X0 | B0 = x]
= IE[Xτ ∧t | B0 = x]
w
1

τ ∧t
= IE[f (Bτ ∧t ) | B0 = x] − IE f ′′ (Bs )ds | B0 = x
2 0

= IE[f (Bτ ∧t ) | B0 = x] + IE[τ ∧ t | B0 = x],

since f ′′ (y) = −2 for all y ∈ R. We note that, by dominated convergence,

h i
IE τ | B0 = x = IE lim (τ ∧ t) | B0 = x
 
t→∞
= lim IE[τ ∧ t | B0 = x]
t→∞
≤ |f (x)| + max |f (y)|
y∈[a,b]
< ∞,

hence IE[τ ] < ∞ and therefore P(τ < ∞) = 1, allowing us to write limt→∞ (τ ∧
t) = τ < ∞ with probability P(τ < ∞) = 1. Next, we have

f (x) = lim IE[f (Bτ ∧t ) | B0 = x] + lim IE[τ ∧ t | B0 = x]

t→∞ t→∞
h i h i
= IE lim f (Bτ ∧t ) | B0 = x + IE lim (τ ∧ t) | B0 = x
t→∞ t→∞
= IE[f (Bτ ) | B0 = x] + IE[τ | B0 = x]
= IE[τ | B0 = x],

since f (x) = −2 and f (a) = f (b) = 0 with Bτ ∈ {a, b}.

′′

Remarks.
i) The above exchanges between limt→∞ and the expectation operator
IE[ · | B0 = x] is justified by the dominated convergence theorem, since

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|f (Bτ ∧t )| ≤ max |f (y)|, t ∈ R+ .

y∈[a,b]

ii) The function f (x) can be determined by searching for a quadratic solu-
tion of the form f (x) = α+βx+γx2 , which shows that f ′′ (x) = 2γ = −2
hence γ = −1, and

f (a) = α + βa − a = 0,
2


f (b) = α + βb − b2 = 0,



hence α = −ab and β = a + b. Therefore, we have

IE[τ | B0 = x] = f (x) = −ab + (a + b)x − x2 = (x − a)(b − x).

Exercise 14.5
We use the Stopping Time Theorem 14.7 and the fact that
2
eσBt −σ t/2 t∈R+ is a martingale for all σ ∈ R. By the stopping time theorem,
for all n ≥ 0 we have
2
1 = IE eσBτ ∧n −σ (τ ∧n)/2
 

= IE eσBτ ∧n −σ (τ ∧n)/2 1{τ <n} + IE eσBτ ∧n −σ (τ ∧n)/2 1{τ ≥n}

 2   2 

1{τ <n} + IE e 1{τ ≥n}

 σBτ −σ2 τ /2  σBn −σ2 n/2
= IE e
 

= eσα IE eσβτ −σ τ /2 1{τ <n} + IE eσBn −σ n/2 1{τ ≥n} .

2 2
(S.14.57)
   

2
Under the condition σ 2 ≥ 2σβ we have 0 ≤ eσβτ −σ τ /2
≤ 1, hence by domi-
nated or monotone convergence we find

lim IE eσβτ −σ τ /2 1{τ <n} = IE eσβτ −σ τ /2 lim 1{τ <n} = IE eσβτ −σ 1{τ <∞} ,
2 2 2
τ /2
     
n→∞ n→∞

and the first term in (S.14.57) converges to

eσα IE e−(σ /2−σβ)τ 1{τ <∞} = eσα IE e−(σ /2−σβ)τ

 2   2 

as n tends to infinity. In what follows we use the solutions σ± = β ± β 2 + 2r

p

of the equation r = σ 2 /2 − σβ with σ+ ≥ 0 and σ− ≤ 0, and we distinguish

two cases.
a) If α ≥ 0, we have Bn ≤ α + βn, n ≤ τ , hence the second term above can
be bounded as

0 ≤ IE eσ+ Bn −nσ+ /2 1{τ ≥n}

 2 

≤ e−nσ+ /2 IE eασ+ +βσ+ n 1{τ ≥n}

2  
2
≤ eασ+ −nσ+ /2+βσ+ n

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Introduction to Stochastic Finance with Market Examples, Second Edition

= eασ+ −rn ,

which tends to 0 as n tends to infinity. Therefore, we have

2 2
1 = lim IE eσ+ Bτ ∧n −σ+ (τ ∧n)/2 = eασ+ IE e−(σ+ /2−βσ+ )τ ,
   
n→∞

which yields
2
IE e−rτ = IE e−(σ+ /2−βσ+ )τ
   

= e−ασ+ √
2
= e−αβ−α √β +2r
β 2 +2r
= e−αβ−|α| ,

with
e−2αβ if β ≥ 0,

P(τ < +∞) = IE[1{τ <∞} ] = lim IE 1{τ <∞} e−rτ = 1
 
r→0 if β ≤ 0.

2 2

α α

0 0

−1 −1

−2 −2
0 0.1 0.2 0.3 τ 0.4 0.5 0.6 0.7 0.8 0.9 1 0 0.1 0.2 τ 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

(a) α = 1, β = 0.5 (b) α = 1, β = −0.5

Fig. S.72: Hitting times of a straight line started at α < 0.

b) If α ≤ 0, we have Bn ≥ α + βn, n ≤ τ , hence the second term above can

be bounded as

0 ≤ IE eσ− Bn −nσ− /2 1{τ ≥n}

 2 

≤ e−nσ− /2 IE eασ− +βnσ− 1{τ ≥n} ≤ eασ− −nσ− /2+βnσ−

2   2

= eασ− −rn ,

which tends to 0 as n tends to infinity. Therefore, we have

2 2
1 = lim IE eσ− Bτ ∧n −σ− (τ ∧n)/2 = eασ− IE e−(σ− /2−βσ− )τ ,
   
n→∞

which yields
2
IE e−rτ = IE e−(σ− /2−βσ− )τ = e−ασ−
   

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√ 2
= e−αβ+α √β +2r
2
= e−αβ−|α| β +2r ,

with
1 if β ≥ 0,

P(τ < +∞) = IE[1{τ <∞} ] = lim IE 1{τ <∞} e−rτ = e−2αβ if β ≤ 0.
 
r→0

2 2

1 1

0 0

α α

−2 −2
0 0.1 τ 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0 0.1 0.2 0.3 τ 0.4 0.5 0.6 0.7 0.8 0.9 1

(a) α = −1, β = 0.5 (b) α = −1, β = −0.5

Fig. S.73: Hitting times of a straight line started at α < 0.

Exercise 14.6
a) Letting A0 := 0,

An+1 := An + IE[Mn+1 − Mn | Fn ], n ≥ 0,

and
Nn := Mn − An , n ∈ N, (S.14.58)
we have
(i) for all n ∈ N,

IE[Nn+1 | Fn ] = IE[Mn+1 − An+1 | Fn ]

= IE[Mn+1 − An − IE[Mn+1 − Mn | Fn ] | Fn ]
= IE[Mn+1 − An | Fn ] − IE[IE[Mn+1 − Mn | Fn ] | Fn ]
= IE[Mn+1 − An | Fn ] − IE[Mn+1 − Mn | Fn ]
= − IE[An | Fn ] + IE[Mn | Fn ]
= M n − An
= Nn ,

hence (Nn )n∈N is a martingale with respect to (Fn )n∈N .

(ii) We have

An+1 − An = IE[Mn+1 − Mn | Fn ]

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= IE[Mn+1 | Fn ] − IE[Mn | Fn ]
= IE[Mn+1 | Fn ] − Mn ≥ 0, n ∈ N,

since (Mn )n∈N is a submartingale.

(iii) By induction we have

An = An−1 + IE[Mn − Mn−1 | Fn−1 ], n ≥ 1,

which is Fn−1 -measurable provided that An is Fn−1 -measurable,

n ≥ 1.
(iv) This property is obtained by construction in (S.14.58).
b) For all bounded stopping times σ and τ such that σ ≤ τ a.s., we have

IE[Mσ ] = IE[Nσ ] + IE[Aσ ]

≤ IE[Nσ ] + IE[Aτ ]
= IE[Nτ ] + IE[Aτ ]
= IE[Mτ ],

by (14.7), since (Mn )n∈N is a martingale and (An )n∈N is non-decreasing.

Chapter 15

Exercise 15.1 The option payoffs at immediate exercise are given as follows:

(K − S2 )+ = 0
3
p
∗ = 2/
(K − S1 ) = 0.05
+

2/3
p =
∗ q∗ =
1/3
(K − S0 ) = 0.3
+
(K − S2 )+ = 0.17
3
q∗ = ∗ = 2/
1/3 p
(K − S1 )+ = 0.35
q∗ =
1/3
(K − S2 )+ = 0.44

On the other hand, the expected payoffs are given by:

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(K − S2 )+ = 0

IE∗ [(K − S2 )+ | S1 = 1.2] = 0.17/3

(K − S2 )+ = 0.17

IE∗ [(K − S2 )+ | S1 = 0.9] = 0.26

(K − S2 )+ = 0.44

Consequently, at time t = 1 we would exercise immediately if S1 = 0.9, and

wait if S1 = 1.2. At time t = 0 with S0 = 1 the initial value of the option is
(0.34/3 + 0.35)/3 = 1.39/9 ≃ 0.154 < 0.25 so we would exercise immediately
as well.

Exercise 15.2
2
a) Taking f (x) := Cx−2r/σ , we have

1 2r2 2r
 
2 2
rxf ′ (x) + σ 2 x2 f ′′ (x) = −C 2 x−2r/σ + Cr 1 + 2 x−2r/σ
2 σ σ
2
= Crx−2r/σ
= rf (x),

and the condition limx→∞ f (x) = 0 is satisfied since r > 0.

b) The conditions f (L∗ ) = K − L∗ and f ′ (L∗ ) = −1 read
∗ −2r/σ 2
 C(L ) = K − L∗ ,



 − 2r C(L∗ )−1−2r/σ2 = −1,


σ2
i.e.
∗ −2r/σ 2
 C(L ) = K − L∗



 2r (K − L∗ ) = L∗ ,

σ2
hence
2rK

 L∗ =
2r + σ 2




2r/σ2 1+2r/σ2
Kσ 2 2rK σ2 2rK
  
C = =

.


2r + σ 2 2r + σ 2 2r 2r + σ 2

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Introduction to Stochastic Finance with Market Examples, Second Edition

Exercise 15.3
a) This an American put option with strike price considered at S0 ≥ L∗ ,
hence by Propositions 15.2 and 15.4 the price of this option is
 −2r/σ2
S0
(K − L∗ ) IE∗ e−τL∗ = (K − L∗ )
 
.
L∗

b) This an American put option with strike price K and immediately exer-
cised at S0 ≤ L∗ , hence by Propositions 15.2 and 15.4 the price of this
option is K − S0 .
c) This is an American call option with strike price 2K
b − K exercised at the
optimal level L∗ = K,
b hence by Equation (15.23) the price of this option
is

b − K)) IE∗ e−τL∗ = (K

(L∗ − (2K b S0 .
b − K)) IE∗ e−τL∗ = (K − K)
b − (2K
   
K
b

In conclusion, the pricing function is obtained by pasting together the

pricing functions of American call and put options.

60
Price function
50
Payoff function
40
30
20
10
0
0 ^-K
2K ^
K L* K 200

Fig. S.74: American butterfly payoff and price functions.

Exercise 15.4
a) Given the value
∂
BSp (x, T ) = −Φ(−d+ (x, T ))
∂x
of the Delta of the Black-Scholes put option, see Proposition 6.7, the
smooth fit condition states that at x = S ∗ , the left derivative of (15.31),
which is
2
∂ ∂ 2 (S ∗ )2r/σ
BSp (x, T ) + α (x/S ∗ )−2r/σ = −Φ(−d+ (x, T )) + α 1+2r/σ2 ,
∂x ∂x x
x > S ∗ , should match the right derivative of (15.32), which is −1, hence
2rα ∗ −1
−1 = −Φ(−d+ (S ∗ , T )) − (S ) ,
σ2

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which yields

σ2 S ∗ σ2 S ∗
α∗ = (1 − Φ(−d+ (S ∗ , T ))) = Φ(d+ (S ∗ , T )),
2r 2r
and
 2
σ 2 (S ∗ )1+2r/σ
 BSp (x, T ) + Φ(d+ (S ∗ , T )), x > S∗,


f (x, T ) ≃ 2rx 2r/σ 2


x ≤ S∗.

K − x,


Note that at maturity (T = 0 here) we have d+ (S ∗ , 0) = −∞ since S ∗ <

K, hence Φ(d+ (S ∗ , 0)) = 0 and f (x, 0) = K − x as expected.
b) Equating (15.31) to (15.32) at x = S ∗ yields the equation

K − S ∗ = BSp (x, T ) + α∗ ,

i.e.
S∗ σ2
 
1 = e−rT Φ(−d− (S ∗ , T )) + 1+ Φ(d+ (S ∗ , T )),
K 2r
which can be used to determine the value of S ∗ , and then the correspond-
ing value of α. The proposed strategy is to exercise the put option as soon
as the underlying asset price reaches the critical level S ∗ .

16
S*=87.8
L*=85.71
14
(K-x)+

12

10
Option price

0
85 90 95 100 105
L* = 85.7 S* = 87.3
Underlying x

Fig. S.75: Perpetual vs finite expiration American put option price.

The plot in Figure S.75 yields a finite expiration critical price S ∗ = 87.3
which is expectedly higher than the perpetual critical price L∗ = 85.71,
with K = 100, σ = 10%, and r = 3%. The perpetual price, however,
appears higher than the finite expiration price.

In Figure S.76 we plot the graph of a Barone-Adesi and Whaley (1987)

approximation, together with the European put option price, using the
fOptions package. Note that this approximation is valid only for certain
parameter ranges.

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r=0.1;sig=0.15;T=0.5;K=100;library(ragtop)
library(fOptions);payoff <- function(x){return(max(K-x,0))};vpayoff <- Vectorize(payoff)
par(new=TRUE)
curve(vpayoff, from=85, to=120, xlab="", lwd = 3, ylim=c(0,10),ylab="",col="red")
par(new=TRUE)
curve(blackscholes(callput=-1, x, K, r, T, sig, 0)$Price, from=85, to=120, xlab="", lwd = 3,
ylim=c(0,10),ylab="",col="orange")
par(new=TRUE)
curve(BAWAmericanApproxOption("p",x,K,T,r,b=0,sig,title = NULL, description =
NULL)@price, from=85, to=120 , xlab="Underlying asset price", lwd =
3,ylim=c(0,10),ylab="",col="blue")
grid (lty = 5);legend(105,9.5,legend=c("Approximation","European payoff","Black-Scholes
put"),col=c("blue","red","orange"),lty=1:1, cex=1.)
10

Approximation
European payoff
8

Black−Scholes
put
6
4
2
0

85 90 95 100 105 110 115 120

Underlying asset price

Fig. S.76: American put price approximation.

Exercise 15.5
a) We have
if Z = 1,

ϵ
τϵ =
+∞ if Z = 0.


b) First, we note that

if t = 0,

 {∅, Ω}
Ft =
{∅, Ω, {Z = 0}, {Z = 1}} if t > 0.


Next, we have
{τϵ > 0} = {Z = 0},
hence
{τϵ > 0} ∈
/ F0 = {∅, Ω},
and therefore τ0 is not an (Ft )t∈R+ -stopping time.

c) i) For t = 0 we have {τϵ > 0} = {Z = 0} ∪ {Z = 1} = Ω, hence

{τϵ > 0} ∈ F0 = {∅, Ω}.

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ii) For 0 < t < ϵ we have {τϵ > t} = Ω, hence

{τϵ > t} ∈ Ft = {∅, Ω, {Z = 0}, {Z = 1}}.

iii) For t > ϵ we have {τϵ > t} = {Z = 0}, hence

{τϵ > t} ∈ Ft = {∅, Ω, {Z = 0}, {Z = 1}}.

Therefore τϵ is an (Ft )t∈R+ -stopping time when ϵ > 0.

Note that here the filtration (Ft )t∈R+ is not right-continuous, as

\
{∅, Ω} = F0 ̸= F0+ := Ft = {∅, Ω, {Z = 0}, {Z = 1}}.
t>0

Exercise 15.6
a) This intrinsic payoff is κ − S0 .
b) We note that the process (Zt )t∈R+ defined as
 λ
St 2
t/2−λ2 σ 2 t/2
Zt := e−(r−δ)λt+λσ
S0
2
t/2 λ −(r−δ)λt+λσ 2 t/2−λ2 σ 2 t/2
= e(r−δ)t+σBbt −σ e

2 2
= eλσBbt −λ σ t/2 , t ≥ 0,

is a geometric Brownian motion without drift, hence a martingale, under

the risk-neutral probability measure P∗ .
c) The parameter λ should satisfy the equation

σ2
r = (r − δ)λ − λ(1 − λ),
2
i.e.
λ2 σ 2 /2 + λ(r − δ − σ 2 /2) − r = 0.
This equation admits two solutions

−(r − δ − σ 2 /2) ± (r − δ − σ 2 /2)2 + 4rσ 2 /2

p
λ± = ,
σ2
d) We have
 λ−
(λ− ) St
0 ≤ Zt = e−rt
S0
 λ−
St
≤
S0

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Introduction to Stochastic Finance with Market Examples, Second Edition

 λ−
L
≤ , 0 ≤ t < τL ,
S0

since λ− < 0 and St > L for t ∈ [0, τL ).

e) By the Stopping Time Theorem 14.7 we have

IE∗ [ZτL ] = IE∗ [Z0 ] = 1,

which rewrites as
" λ #
SτL 2
/2+λ2 σ 2 /2)τL
IE∗ e−((r−δ)λ−λσ = 1,
S0

or, given the relation SτL = L,

 λ
L h 2 2 2
i
IE∗ e−((r−δ)λ−λσ /2+λ σ /2)τL = 1,
S0
i.e.  λ
S0
IE∗ e−rτL =
 
,
L
provided that we choose λ such that

−((r − δ)λ − λσ 2 /2 + λ2 σ 2 /2) = −r, (S.15.59)

i.e.
(r − δ − σ 2 /2)2 + 4rσ 2 /2
p
−(r − δ − σ 2 /2) ±
λ= ,
σ2
and we choose the negative solution

−(r − δ − σ 2 /2) − (r − δ − σ 2 /2)2 + 4rσ 2 /2

p
λ :=
σ2
since S0 /L = x/L > 1 and the expectation IE∗ e−rτL < 1 is lower than
 

1 as r ≥ 0.
f) This follows from (15.9) and the fact that r > 0. Using the fact that
SτL = L < K when τL < ∞, we find
h i h i
IE∗ e−rτL (K − SτL )+ S0 = x = IE∗ e−rτL (K − SτL )+ 1{τL <x} S0 = x
h i
= IE∗ e−rτL (K − L)1{τL <x} S0 = x
h i
= (K − L) IE∗ e−rτL 1{τL <x} S0 = x
h i
= (K − L) IE∗ e−rτL S0 = x .

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Next, noting that τL = 0 if S0 ≤ L, for all L ∈ (0, K) we have

IE∗ e−rτL (K − SτL )+ S0 = x

 

0 < x ≤ L,

 K − x,
=
IE e (K − L)+ S0 = x , x ≥ L.
  −rτL 

0 < x ≤ L,

 K − x,
=
(K − L) IE e−rτL S0 = x , x ≥ L.
  

0 < x ≤ L,

 K − x,


= √
  −(r−a−σ2 /2)− (r−a−σ 2 /2)2 +4rσ 2 /2

 (K − L) x σ2

, x ≥ L.

L
g) In order to compute L∗ we observe that, geometrically, the slope of x 7−→
fL (x) = (K − L)(x/L)λ− at x = L∗ is equal to −1, i.e.

(L∗ )λ− −1
fL′ ∗ (L∗ ) = λ− (K − L∗ ) = −1,
(L∗ )λ−

hence
λ−
λ− (K − L∗ ) = L∗ , or L∗ = K < K.
λ− − 1
Equivalently we may recover the value of L∗ from the optimality condition

∂fL (x)  x λ −  x λ− +1

=− − λ− x(K − L) = 0,
∂L L L
at L = L∗ , hence
 x λ −
− − λ− (K − L)xλ− L−λ− −1 = 0,
L
hence
λ− 1
L∗ = K= K,
1 − λ− 1 − 1/λ−
and
1−λ−
1

K
sup IE∗ e−rτL (K − SτL )+ S0 = x = − xλ− .
 
L∈(0,K) λ− 1 − 1/λ−

h) For x ≥ L we have
 x λ−
fL∗ (x) = (K − L∗ )
L∗

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Introduction to Stochastic Finance with Market Examples, Second Edition

  !λ−
λ− x
= K− K
λ− − 1 λ−
λ− −1 K
λ
x(λ− − 1) −
 
K
= −
λ− − 1 λ− K
λ−  λ
λ− − 1 −
 
K x
= −
λ− − 1 −λ− −K
λ−  λ −1
λ− − 1 −

x
=
−λ− −K
 x λ−  λ − 1 λ− K
−
= . (S.15.60)
K λ− 1 − λ−

i) Let us check that the relation

fL∗ (x) ≥ (K − x)+ (S.15.61)

holds. For all x ≤ K we have

 x λ−  λ − 1 λ− K
−
fL∗ (x) − (K − x) = +x−K
K λ− 1 − λ−
!
 x λ − λ − 1 λ −
 
1 x
−
=K + −1 .
K λ− 1 − λ− K

Hence it suffices to take K = 1 and to show that for all

λ−
L∗ = ≤x≤1
λ− − 1

we have
λ−
xλ− λ− − 1

fL∗ (x) − (1 − x) = + x − 1 ≥ 0.
1 − λ− λ−

Equality to 0 holds for x = λ− /(λ− − 1). By differentiation of this relation

we get
λ
λ− − 1 − 1

fL′ ∗ (x) − (1 − x)′ = λ− xλ− −1 +1
λ− 1 − λ−
λ− −1
λ− − 1

= xλ− −1 +1
λ−
≥ 0,

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hence the function fL∗ (x) − (1 − x) is non-decreasing and the inequality

holds throughout the interval [λ− /(λ− − 1), K].

On the other hand, using (S.15.59) it can be checked by hand that fL∗
given by (S.15.60) satisfies the equality
1
(r − δ)xfL′ ∗ (x) + σ 2 x2 fL′′∗ (x) = rfL∗ (x) (S.15.62)
2
λ−
for x ≥ L∗ = K. In case
λ− − 1

λ−
0 ≤ x ≤ L∗ = K < K,
λ− − 1

we have
fL∗ (x) = K − x = (K − x)+ ,
hence the relation
1
 
rfL∗ (x) − (r − δ)xfL′ ∗ (x) − σ 2 x2 fL′′∗ (x) (fL∗ (x) − (K − x)+ ) = 0
2

always holds. On the other hand, in that case we also have

1
(r − δ)xfL′ ∗ (x) + σ 2 x2 fL′′∗ (x) = −(r − δ)x,
2
and to conclude we need to show that
1
(r − δ)xfL′ ∗ (x) + σ 2 x2 fL′′∗ (x) ≤ rfL∗ (x) = r(K − x), (S.15.63)
2
which is true if
δx ≤ rK.
Indeed, by (S.15.59) we have

(r − δ)λ− = r + λ− (λ− − 1)σ 2 /2

≥ r,

hence
λ−
δ ≤ r,
λ− − 1
since λ− < 0, which yields

λ−
δx ≤ δL∗ ≤ δ K ≤ rK.
λ− − 1

j) By Itô’s formula and the relation

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dSt = (r − δ)St dt + σSt dB

bt

we have

d feL∗ (St ) = −re−rt fL∗ (St )dt + e−rt dfL∗ (St )

σ 2 −rt 2 ′′
= −re−rt fL∗ (St )dt + e−rt fL′ ∗ (St )dSt + e St fL∗ (St )
2
σ 2 2 ′′
 
= e−rt −rfL∗ (St ) + (r − δ)St fL′ ∗ (St ) + St fL∗ (St ) dt
2
+e−rt σSt f ′ ∗ (St )dB
L
bt ,

and from Equations (S.15.62) and (S.15.63) we have

1
(r − δ)xfL′ ∗ (x) + σ 2 x2 fL′′∗ (x) ≤ rfL∗ (x),
2
hence
t 7−→ e−rt fL∗ (St )
is a supermartingale.
k) By the supermartingale property of

t 7−→ e−rt fL∗ (St ),

for all stopping times τ we have

fL∗ (S0 ) ≥ IE∗ e−rτ fL∗ (Sτ ) S0 ≥ IE∗ e−rτ (K − Sτ )+

   
S0 ,

by (S.15.61), hence

fL∗ (S0 ) ≥ sup IE∗ e−rτ (K − Sτ )+

 
S0 .
τ stopping time

l) The stopped process

t 7−→ e−rt∧τL∗ fL∗ (St∧τL∗ )

is a martingale since it has vanishing drift up to time τL∗ by (S.15.62), and

it is constant after time τL∗ , hence by the Stopping Time Theorem 14.7
we find
h i
fL∗ (S0 ) = IE∗ e−rτ fL∗ (SτL∗ ) S0
h i
= IE∗ e−rτ fL∗ (L∗ ) S0
h i
= IE∗ e−rτ (K − SτL∗ )+ S0
h i
≤ sup IE∗ e−rτ (K − Sτ )+ S0 .
τ stopping time

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m) By combining the above results and conditioning at time t instead of time

0 we deduce that
h i
fL∗ (St ) = IE∗ e−r(τL∗ −t) (K − SτL∗ )+ St
λ−

 K − St , 0 < St ≤ K,
λ− − 1




=  λ −1  λ
 λ− − 1 − −St − λ−


 , St ≥ K,
−K λ− − 1

λ−

for all t ∈ R+ , where

τL∗ = inf{u ≥ t : Su ≤ L}.

We note that the perpetual put option price does not depend on the value
of t ≥ 0.

Exercise 15.7
a) We have
2 2
(λ) σ 2 t/2
Zt = (St )λ e−t((r−δ)λ−λ(1−λ)σ /2)
= (S0 )λ eλσBbt −λ ,

which is a driftless geometric Brownian motion, and therefore a martingale

under P∗ .
b) The condition is r = (r − δ)λ − λ(1 − λ)σ 2 /2, with solutions

δ − r + σ 2 /2 − (δ − r + σ 2 /2)2 + 2rσ 2
p
λ− = ≤ 0,
σ2

δ − r + σ 2 /2 + (δ − r + σ 2 /2)2 + 2rσ 2
p
λ+ = ≥ 1.
σ2
c) Due to the inequality
(λ+ )
0 ≤ Zt = (St )λ+ e−rt ≤ Lλ+ ,

which holds because λ+ > 0 and St ≤ L, 0 ≤ t < τL , we note that since

(λ )
limt→∞ Zt + = 0, we have
h i h i
1{τL <∞} = IE∗ Zτ(λL+ ) 1{τL <∞}

λ+ −rτL
Lλ+ IE∗ e−rτL = IE∗ SτL e
 
h i
(λ )  (λ ) 
= IE∗ lim ZτL+∧t = lim IE∗ ZτL+∧t
t→∞ t→∞
 (λ ) 
= IE∗ Z0 + = (S0 )λ+ .

Therefore, we have

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Introduction to Stochastic Finance with Market Examples, Second Edition

IE∗ e−rτL (SτL − K)+ S0 = x = IE∗ (SτL − K)e−rτL 1{τL <∞} S0 = x

   

= (L − K) IE∗ e−rτL 1{τL <∞} S0 = x

 
∗
= (L − K) IE e S0 = x
 −rτL 
 x λ+
= (L − K) ,
L
when S0 = x > L. In order to maximize

sup IE∗ e−rτL (K − SτL )+ S0 = x ,

 
L∈(0,K)

λ+
we differentiate L 7−→ (L − K) (x/L) with respect to L, to find
 x λ+
− λ+ (L − K)xλ+ L−λ+ −1 = 0,
L
hence
λ+ K
L∗δ = K= ,
λ+ − 1 1 − 1/λ+
and
1−λ+
1

K
sup IE∗ e−rτL (K − SτL )+ S0 = x = xλ+ .
 
L∈(0,K) λ+ 1 − 1/λ+

We note that as δ ↘ 0 we have λ+ ↘ 1 and L∗δ ↗ ∞, and since

1−λ+
λ+ − 1
  
K
= exp (λ+ − 1) log → 1,
1 − 1/λ+ λ+ K

we find that the perpetual American call option price without dividend
(δ = 0) is S0 = x.

Exercise 15.8
a) By the definition (15.36) of S1 (t) and S2 (t) we have
α
S1 (t)

Zt = e−rt S2 (t)
S2 (t)
= e−rt S1 (t)α S2 (t)1−α
2
= S1 (0)α S2 (0)1−α e(ασ1 +(1−α)σ2 )Wt −σ2 t/2 ,

which is a martingale when

σ22 = (ασ1 + (1 − α)σ2 )2 ,

i.e.

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ασ1 + (1 − α)σ2 = ±σ2 ,

which yields either α = 0 or
2σ2 σ1 + σ2
α= =1+ > 1,
σ2 − σ1 σ2 − σ1
since 0 ≤ σ1 < σ2 .
b) We have

IE e−rτL (S1 (τL ) − S2 (τL ))+ = IE e−rτL (LS2 (τL ) − S2 (τL ))+
   

= (L − 1) IE e S2 (τL ) . (S.15.64)
+
 −rτL 

c) Since τL ∧ t is a bounded stopping time we can write

α α 
S1 (0) S1 (τL ∧ t)
  
S2 (0) = IE e−r(τL ∧t) S2 (τL ∧ t) (S.15.65)
S2 (0) S2 (τL ∧ t)
α α
S1 (τL ) S (t)
     
= IE e−rτL S2 (τL ) 1{τL <t} + IE e−rt S2 (t) 1 1{τL >t}
S2 (τL ) S2 (t)

We have
α
S1 (t)

e−rt S2 (t) 1{τL >t} ≤ e−rt S2 (t)Lα 1{τL >t} ≤ e−rt S2 (t)Lα ,
S2 (t)

hence by a uniform integrability argument,

α
S1 (t)
  
lim IE e−rt S2 (t) 1 {τL >t} = 0,
t→∞ S2 (t)

and letting t go to infinity in (S.15.65) shows that

α α 
S1 (0) S1 (τL )
  
S2 (0) = IE e−rτL S2 (τL ) = Lα IE e−rτL S2 (τL ) ,
 
S2 (0) S2 (τL )

since S1 (τL )/S2 (τL ) = L/L = 1. The conclusion

α
S1 (0)

IE e−rτL (S1 (τL ) − S2 (τL ))+ = (L − 1)+ L−α S2 (0) (S.15.66)
 
S2 (0)

then follows by an application of (S.15.64).

d) In order to maximize (S.15.66) as a function of L we consider the derivative

L−1 1
 
∂
= α − α(L − 1)L−α−1 = 0,
∂L Lα L

which vanishes for

α
L∗ = ,
α−1

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and we substitute L in (S.15.66) with the value of L∗ .

e) In addition to r = σ22 /2 it is sufficient to let S1 (0) = κ and σ1 = 0 which
yields α = 2, L∗ = 2, and we find
1  κ 2
sup IE e−rτ (κ − S2 (τ ))+ =
 
,
τ stopping time S2 (0) 2

which coincides with the result of Proposition 15.4.

Exercise 15.9
a) It suffices to check the sign of the quantity

(λ − 1)(λ + 2r/σ 2 ), (S.15.67)

in (15.38), which is positive when λ ∈ (−∞, −2r/σ 2 ]∪[1, ∞), and negative
when −2r/σ 2 ≤ λ ≤ 1.
b) The sign of (S.15.67) is positive when λ ∈ (−∞, 1] ∪ [−2r/σ 2 , ∞), and
negative when 1 ≤ λ ≤ −2r/σ 2 .
c) By the Stopping Time Theorem 14.7, for any n ≥ 0 we have
h i
(λ)
xλ = IE∗ e−r(τL ∧n) ZτL ∧n | S0 = x
h i h i
= IE∗ Zτ(λ)
L
1{τL <n} | S0 = x + e−rn IE∗ Zn(λ) 1{τL >n} | S0 = x
≥ IE∗ e−rτL (SτL )λ 1{τL <n} | S0 = x
 

= Lλ IE∗ e−rτL 1{τL <n} | S0 = x .

 

(λ)

By the results of Questions (a)-(b), the process Zt t∈R+ is a martin-
gale when λ ∈ {1, −2rσ 2 /2}. Next, letting n to infinity, by monotone
convergence we find
max(1,−2r/σ 2 )
 
 x

, x ≥ L,
L

 x  λ 
IE∗ e−rτL 1{τL <∞} | S0 = x ≤
 
≤
L 2
  x min(1,−2r/σ )


 , 0 < x ≤ L.
L
d) We note that P∗ (τL < ∞) = 1 by (14.15), hence if −σ 2 /2 ≤ r < 0 we
have

IE∗ e−rτL (K − SτL )+ 1{τL <∞} | S0 = x

 
  x −2r/σ2
 (K − L)
 , x ≥ L,
L

= (K − L) IE∗ e−rτL | S0 = x ≤
 

 (K − L) x ,

0 < x ≤ L.

L

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Similarly, if r ≤ −σ 2 /2 we have

IE∗ e−rτL (K − SτL )+ 1{τL <∞} | S0 = x = (K − L) IE∗ e−rτL | S0 = x

   
x
(K − L) ,

 x ≥ L,

 L
≤ 2
 (K − L) x −2r/σ , 0 < x ≤ L.

  
L
e) This follows by noting that (K − L)(x/L) = (K/L − 1)x increases to ∞
when L tends to zero.
f) If −σ 2 /2 ≤ r < 0 we have

IE∗ e−rτL (SτL − K)+ 1{τL <∞} | S0 = x

 

= (L − K) IE∗ e−rτL 1{τL <∞} | S0 = x

 
  x −2r/σ2
 (L − K) , x ≥ L,


L
≤
 (L − K) x ,

0 < x ≤ L.

L
If r ≤ −σ 2 /2 we have

IE∗ e−rτL (SτL − K)+ 1{τL <∞} | S0 = x

 
∗
= (L − K) IE e 1{τL <∞} | S0 = x
 −rτL 
x
(L − K) ,

 x ≥ L,

 L
≤ 2
 (L − K) x −2r/σ , 0 < x ≤ L.

  
L
g) This follows by noting that for fixed x > 0, the quantity (L − K)x/L =
(1 − K/L)x increases to x when L tends to infinity.

Exercise 15.10 Perpetual American binary options.

a) Similarly, for x ≥ K, immediate exercise is the optimal strategy and
we have CbAm (t, x) = 1. When x < K the optimal exercise level of the
perpetual American binary call option is L∗ = K with the optimal exercise
time τK , and by e.g. (4.4.22) page 135 we have

CbAm (t, x) = sup IE∗ e−(τ −t)r 1{Sτ ≥K} St = x

 
τ ≥t
τ stopping time

= IE∗ e−(τK −t)r St = x

 
x
= , x < K.
K

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1.4

1.2
American binary put price

0.8

0.6

0.4

0.2

0
0 50 100 150 200 250
Underlying x

Fig. S.77: Perpetual American binary put price map with K = 100.

b) For x ≤ K, immediate exercise is the optimal strategy and we have

PbAm (t, x) = 1. When x > K the optimal exercise level of the perpet-
ual American binary put option is L∗ = K with the optimal exercise time
τK , and by e.g. (4.4.11) page 125 we have
PbAm (t, x) = sup IE∗ e−(τ −t)r 1{Sτ ≤K} St = x
 
τ ≥t
τ stopping time

= IE∗ e−(τK −t)r St = x

 
 x −2r/σ2
= , x > K.
K

1.4

1.2
American binary call price

0.8

0.6

0.4

0.2

0
0 50 100 150 200
Underlying x

Fig. S.78: Perpetual American binary call price map with K = 100.

Exercise 15.11 Finite expiration American binary options.

a) The optimal strategy is as follows:
(i) if St ≥ K, then exercise immediately.
(ii) if St < K, then wait.
b) The optimal strategy is as follows:

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(i) if St > K, then wait.

(ii) if St ≤ K, exercise immediately.
c) Based on the answers to Question (a) we set

CdAm (t, T, K) = 1, 0 ≤ t < T,

and
CdAm (T, T, x) = 0, 0 ≤ x < K.
d) Based on the answers to Question (b), we set

PdAm (t, T, K) = 1, 0 ≤ t < T,

and
PdAm (T, T, x) = 0, x > K.
e) Starting from St ≤ K, the maximum possible payoff is clearly reached
as soon as St hits the level K before the expiration date T , hence the
discounted optimal payoff of the option is e−r(τK −t) 1{τK <T } .
f) From Relation (10.13), we find that the first hitting time τa of the level a
by a µ-drifted Brownian motion (Wu + µu)u∈R+ satisfies
   
a − µu −a − µu
P(τa ≤ u) = Φ √ − e2µa Φ √ , u > 0,
u u

and by differentiation with respect to u this yields the probability density

function
∂ a
e−(a−µu) /(2u) 1[0,∞) (u)
2
fτa (u) = P(τa ≤ u) = √
∂u 2πu3
of the first hitting time of level a by Brownian motion with drift µ. Given
the relation
2
Su = St eσWu−t −(u−t)σ /2+(u−t)r
= St e(Wu−t +(u−t)µ)σ , u ≥ t,

with µ = r/σ − σ/2, we find that (Su )u∈[t,∞) hits the level K at a time
τK = t + τa , such that
2
SτK = St eσWτa −σ τa /2+rτa
= St e(Wτa +µτa )σ = K,

i.e.
1 K
a = Wτa + µτa = log .
σ St
Therefore, the probability density function of the first hitting time τK of
level K after time t by (Su )u∈[t,∞) is given by

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Introduction to Stochastic Finance with Market Examples, Second Edition

a 2
s 7−→ p e−(a−(s−t)µ) /(2(s−t))
, s > t,
2π(s − t)3

with
1 σ2 1
 
K
µ := r− and a := log ,
σ 2 σ x
given that St = x. Hence, for x ∈ (0, K) we have

CdAm (t, T, x) = IE e−r(τK −t) 1{τK <T } | St = x

 
wT a 2
= e−(s−t)r p e−(a−(s−t)µ) /(2(s−t)) ds
t 2π(s − t)3
w T −t a 2
= e−rs √ e−(a−µs) /(2s) ds
0 2πs3
w T −t log(K/x) 1
 
σ2

K
2 !
= √ exp −rs − 2 − r− s + log ds
0 σ 2πs3 2σ s 2 x
 (r/σ2 −1/2)±(r/σ2 +1/2)
K
=
x
w T −t log(K/x) 1
 
σ2

K
2 !
× √ exp − 2 ± r+ s + log ds
0 σ 2πs3 2σ s 2 x
 2r/σ2 w
1 x w ∞ −y2 /2 1 K ∞ 2
= √ e dy + √ e−y /2 dy
2π K y− 2π x y +

(r + σ 2 /2)(T − t) + log(x/K)
 
x
= Φ √
K σ T −t
 x −2r/σ2  −(r + σ 2 /2)(T − t) + log(x/K) 
+ Φ √ , 0 < x < K,
K σ T −t
where
1 σ2
   
K
y± = √ ± r+ (T − t) + log ,
σ T −t 2 x
and we used the decomposition

1 σ2 1 σ2
      
K K K
log = r+ s + log + − r+ s + log .
x 2 2 x 2 2 x

We check that
CdAm (T, T, K) = Φ(0) + Φ(0) = 1,
and
 x −2r/σ 2
x
CdAm (T, T, x) = Φ (−∞) + Φ (−∞) = 0, x < K,
K K

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since t = T , which is consistent with the answers to Question (c).

In addition, as T tends to infinity we have

(r + σ 2 /2)(T − t) + log(x/K)
 
x
lim CdAm (t, T, x) = lim Φ √
T →∞ K T →∞ σ T −t
 x −2r/σ2 −(r + σ 2 /2)(T − t) + log(x/K)
 
+ lim Φ √
K T →∞ σ T −t
x
= , 0 < x < K,
K
which is consistent with the answer to Question (a) of Exercise 15.10.

1.4 T=5
T=20

1.2
American binary call price

0.8

0.6

0.4

0.2

0
0 50 100 150 200
Underlying x

Fig. S.79: Finite expiration American binary call price map with K = 100.

g) Starting from St ≥ K, the maximum possible payoff is clearly reached

as soon as St hits the level K before the expiration date T , hence the
discounted optimal payoff of the option is e−r(τK −t) 1{τK <T } .
h) Using the notation and answer to Question (f), for x > K we find

PdAm (t, T, x) = IE e−r(τK −t) 1{τK <T } | St = x

 
w T −t a 2
= e−rs √ e−(a−µs) /2s) ds
0 2πs3
w T −t log(x/K) 1

σ2

x
2 !
= √ exp −rs − 2 r− s + log ds
0 σ 2πs3 2σ s 2 K
 ( r2 − 12 )±( r2 + 12 )
K σ σ
=
x
w T −t log(x/K) 1
 
σ2

x
2 !
× √ exp − 2 ∓ r+ s + log ds
0 σ 2πs3 2σ s 2 K
1 x w ∞ −y2 /2 1  x 2r/σ w ∞ −y2 /2
2

= √ e dy + √ e dy
2π K − y 2π K y+

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Introduction to Stochastic Finance with Market Examples, Second Edition

−(r + σ 2 /2)(T − t) − log(x/K)

 
x
= Φ √
K σ T −t
 x −2r/σ2  (r + σ 2 /2)(T − t) − log(x/K) 
+ Φ √ , x > K,
K σ T −t
with
1 σ2
   
x
y± = √ ∓ r+ (T − t) + log .
σ T −t 2 K
We check that
PdAm (T, T, K) = Φ(0) + Φ(0) = 1,
and
 x −2r/σ 2
x
PdAm (T, T, x) = Φ (−∞) + Φ (−∞) = 0, 0 < x < K,
K K
since t = T , which is consistent with the answers to Question (c).

In addition, as T tends to infinity we have

−(r + σ 2 /2)(T − t) − log(x/K)

 
x
lim PdAm (t, T, x) = lim Φ √
T →∞ K T →∞ σ T −t
 x −2r/σ2 (r + σ 2 /2)(T − t) − log(x/K)
 
+ lim Φ √
K T →∞ σ T −t
 x −2r/σ2
= , x > K,
K
which is consistent with the answer to Question (b) of Exercise 15.10

1.4 T=5
T=20

1.2
American binary put price

0.8

0.6

0.4

0.2

0
0 50 100 150 200 250
Underlying x

Fig. S.80: Finite expiration American binary put price map with K = 100.

i) The call-put parity does not hold for American binary options since for
x ∈ (0, K) we have

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(r + σ 2 /2)(T − t) + log(x/K)
 
x
CdAm (t, T, x) + PdAm (t, T, x) = 1 + Φ √
K σ T −t
 x −2r/σ2  −(r + σ 2 /2)(T − t) + log(x/K) 
+ Φ √ ,
K σ T −t
while for x > K we find
−(r + σ 2 /2)(T − t) − log(x/K)
 
x
CdAm (t, T, x) + PdAm (t, T, x) = 1 + Φ √
K σ T −t
 x −2r/σ2  (r + σ 2 /2)(T − t) − log(x/K) 
+ Φ √ .
K σ T −t

Exercise 15.12 American forward Contracts.

a) For all (bounded) stopping times τ ∈ [t, T ], since the discounted asset
price process Seu u∈[t,∞) := e−(u−t)r Su )u∈[t,∞) is a martingale and the

stopped process Seτ ∧u = e−(τ ∧u−t)r Sτ ∧u )u∈[t,∞) is also a mar-

u∈[t,∞)
tingale by the Stopping Time Theorem 14.7, we have
h i
IE∗ e−r(τ −t) (K − Sτ ) Ft = K IE∗ e−r(τ −t) Ft − IE∗ e−r(τ −t) Sτ Ft
   

= K IE∗ e−r(τ −t) Ft − IE∗ Seτ ∧T Ft

   

= K IE∗ e−r(τ −t) Ft − Seτ ∧t

 

= K IE∗ e−r(τ −t) Ft − Set

 

= K IE∗ e−r(τ −t) Ft − St ,

 

and the above quantity is clearly maximized by taking τ = t. Hence we

have

f (t, St ) = sup IE∗ e−r(τ −t) (K − Sτ ) Ft = K − St ,

 
t≤τ ≤T
τ stopping time

and the optimal strategy is to exercise immediately (or to avoid purchasing

the option) at time t and price K due to the effect of time value of money
when r > 0.
b) Similarly to the above, we have

IE∗ e−r(τ −t) (Sτ − K) Ft = IE∗ e−r(τ −t) Sτ Ft − K IE∗ e−r(τ −t) Ft
     

= St − K IE∗ e−r(τ −t) Ft ,

 

since τ ∈ [t, T ] is bounded and (e−rt St )t∈R+ is a martingale. As the above

quantity is clearly maximized by taking τ = T , we have

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f (t, St ) = sup IE∗ e−r(τ −t) (Sτ − K) Ft = St − e−(T −t)r K,

 
t≤τ ≤T
τ stopping time

and the optimal strategy is to wait until the maturity time T in order to
exercise at price K, due to the effect of time value of money when r > 0.
c) Regarding the perpetual American long forward contract, since the dis-
counted asset price process Seu u∈[t,∞) := e−(u−t)r Su )u∈[t,∞) is a mar-

tingale, by the Stopping Time Theorem 14.7, for all stopping times τ ≥ t
we have∗ ,

IE∗ e−r(τ −t) (Sτ − K) Ft = IE∗ e−r(τ −t) Sτ Ft − K IE∗ e−r(τ −t) Ft
     

= IE∗ Seτ Ft − K IE∗ e−r(τ −t) Ft

   

= Set − K IE∗ e−r(τ −t) Ft

 

= St − K IE∗ e−r(τ −t) Ft

 

≤ St , t ≥ 0.

On the other hand, for all fixed T > 0 we have

IE∗ e−r(T −t) (ST − K) Ft = e−r(T −t) IE∗ [ST | Ft ] − e−r(T −t) IE∗ [K | Ft ]
 

= St − e−r(T −t) K, t ∈ [0, T ],

hence

(St − e−r(T −t) K) ≤ sup IE∗ e−r(τ −t) (Sτ − K) Ft ≤ St ,

 
T ≥ t,
t≥τ
τ stopping time

and letting T → ∞ we get

St = lim (St − e−r(T −t) K)

T →∞

sup IE∗ e−r(τ −t) (Sτ − K) Ft

 
≤
τ ≥t
τ stopping time

≤ St ,

hence we have

f (t, St ) = sup IE∗ e−r(τ −t) (Sτ − K) Ft = St ,

 
τ ≥t
τ stopping time

and the optimal strategy τ ∗ = +∞ is to wait indefinitely.

Regarding the perpetual American short forward contract, we have

∗
Using Fatou’s Lemma.

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f (t, St ) = sup IE∗ e−r(τ −t) (K − Sτ )

 
Ft
τ ≥t
τ stopping time

sup IE∗ e−r(τ −t) (K − Sτ )+

 
≤ Ft
τ ≥t
τ stopping time

= fL∗ (St ), (S.15.68)

with
2r
L∗ = K<K
2r + σ 2
as defined in (15.12). On the other hand, for τ = τL∗ we have

(K − SτL∗ ) = (K − L∗ ) = (K − L∗ )+

since 0 < L∗ = 2Kr/(2r + σ 2 ) < K, hence

fL∗ (St ) = IE∗ e−r(τL∗ −t) (K − SτL∗ )+ Ft

 

= IE∗ e−r(τL∗ −t) (K − SτL∗ ) Ft

 

sup IE∗ e−r(τ −t) (K − Sτ ) Ft

 
≤
τ ≥t
τ stopping time

= f (t, St ),

which, together with (S.15.68), shows that

f (t, St ) = fL∗ (St ),

i.e. the perpetual American short forward contract has same price and
exercise strategy as the perpetual American put option.

Exercise 15.13
a) We have
2
t/2 −2r/σ 2
Yt = e−rt (S0 ert+σBbt −σ )
−2r/σ 2 −rt−2r 2 t/σ 2 +2r B
= S0 e bt /σ+rt
−2r/σ 2 2r B
bt /σ−(2r/σ)2 t/2
= S0 e , t ≥ 0,

and 2
Zt = e−rt St = S0 eσBbt −σ t/2
, t ≥ 0,
which are both martingales under P because they are standard geometric
∗

Brownian motions with respective volatilities σ and 2r/σ.

b) Since (Yt )t∈R+ and (Zt )t∈R+ are both martingales and τL is a stopping
time, we have

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−2r/σ 2
S0 = IE∗ [Y0 ]
= IE∗ [YτL ]
2
= IE∗ e−rτL Sτ−2r/σ

L
2
= IE∗ e−rτL L−2r/σ

2
= L−2r/σ IE∗ e−rτL ,
 

hence
  x −2r/σ2
IE∗ e−rτL =

L
2
if S0 = x ≥ L (note that in this case YτL ∧t remains bounded by L−2r/σ ),
and

S0 = IE∗ [Z0 ] = IE∗ [ZτL ] = IE∗ e−rτL SτL = IE∗ e−rτL L = L IE∗ e−rτL ,
     

hence
x
IE∗ e−rτL =
 
L
if S0 = x ≤ L. Note that in this case ZτL ∧t remains bounded by L.
c) We find

IE e−rτL (K − SτL ) S0 = x = (K − L) IE∗ e−rτL S0 = x

   

K −L

x L ,


 0 < x ≤ L,
= (S.15.69)
  x −2r/σ2
 (K − L)

, x ≥ L.

L
d) We check that when L ≥ x, the maximum value of (S.15.69) is K − x, and
that it is reached at L∗ := x. On the other hand, when L < x, (S.15.69)
can be maximized using L∗ := 2rK/(2r+σ 2 ) as in the perpetual American
put option setting.
e) The stopping strategy τL∗x would be suboptimal in comparison with the
perpetual American put option stopping strategy, see Exercise 15.12-(c).

Exercise 15.14
a) The option payoff equals (κ − St )p if St ≤ L.
b) We have
h i
fL (St ) = IE∗ e−r(τL −t) ((κ − SτL )+ )p Ft
h i
= IE∗ e−r(τL −t) ((κ − L)+ )p Ft
h i
= (κ − L)p IE∗ e−r(τL −t) Ft .

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c) We have
h i
fL (x) = IE∗ e−r(τL −t) (κ − SτL )+ Ft = x
(κ − x)p , 0 < x ≤ L,




=  2r/σ2 (S.15.70)
L
 (κ − L)p

 , x ≥ L.
x

d
d) By the differentiation (κ − x)p = −p(κ − x)p−1 we find
dx
 2r/σ2  2r/σ2
∂fL (x) 2r L L
= 2 (κ − L)p − p(κ − L)p−1 ,
∂L σ L x x

∂fL′ ∗ (x)
hence the condition = 0 reads
∂L |x=L∗
2r 2r
(κ − L∗ ) − p = 0, or L∗ = κ < κ.
σ 2 L∗ 2r + pσ 2

e) By (S.15.70) the price can be computed as

(κ − St )p , 0 < St ≤ L∗ ,




f (t, St ) = fL∗ (St ) =  p  −2r/σ2
pσ 2 κ 2r + pσ 2 St
, St ≥ L∗ ,


2r + pσ 2 2r

κ

using (14.13) as in the proof of Proposition 15.4, since the process

u 7−→ e−ru fL∗ (Su ), u ≥ t,

is a nonnegative supermartingale.

Exercise 15.15
a) The option payoff is κ − (St )p .
b) We have
h i
fL (St ) = E∗ e−r(τL −t) (κ − (SτL )p ) Ft
h i
= E∗ e−r(τL −t) (κ − Lp ) Ft
h i
= (κ − Lp )E∗ e−r(τL −t) Ft .

c) We have

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h i
fL (x) = E∗ e−r(τL −t) (κ − (SτL )p ) St = x

κ − xp , 0 < x ≤ L,



=  x −2r/σ2
 (κ − Lp )

, x ≥ L.
L
d) We have
2
2r (L∗ )−2r/σ −1
fL′ ∗ (L∗ ) = − (κ − (L∗ )p ) = −p(L∗ )p−1 ,
σ 2 (L∗ )−2r/σ2
i.e.
2r
(κ − (L∗ )p ) = p(L∗ )p ,
σ2
or 1/p
2rκ

L∗ = < (κ)1/p . (S.15.71)
2r + pσ 2
Remark: We may also compute L∗ by maximizing L 7−→ fL (x) for all
fixed x. The derivative ∂fL (x)/∂L can be computed as
 2r/σ2 !
∂fL (x) ∂ L
= (κ − L )
p
∂L ∂L x
 2r/σ2  2r/σ2
L 2r L
= −pLp−1 + 2 L−1 (κ − Lp ) ,
x σ x

and equating ∂fL (x)/∂L to 0 at L = L∗ yields

2r ∗ −1
−p(L∗ )p−1 + (L ) (κ − (L∗ )p ) = 0,
σ2
which recovers (S.15.71).
e) We have

κ − (St )p , 0 < St ≤ L∗ ,




fL∗ (St ) = 2
(S )−2r/σ
 (κ − (L∗ )p ) ∗t −2r/σ2 , St ≥ L∗


(L )
κ − (St )p , 0 < St ≤ L∗ ,



= 2
 σ p(S )−2r/σ2 (L∗ )p+2r/σ2 , S ≥ L∗ ,

t t
2r

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κ − (St )p , 0 < St ≤ L∗ ,




= −2r/(pσ2 )
pσ 2 κ 2r + pσ 2 Stp

St ≥ L∗ ,

 < κ,
2r + pσ 2 2r

κ

however we cannot conclude as in Exercise 15.14-(e) since the process

u 7−→ e−ru fL∗ (Su ), u ≥ t,

does not remain nonnegative when p > 1, so that (14.13) cannot be applied
as in the proof of Proposition 15.4.

Chapter 16

Exercise 16.1
a) We have
 
bt = d Xt
dX
Nt
X0  (σ−η)Bt −(σ2 −η2 )t/2 
= d e
N0
X0 2 2
= (σ − η)e(σ−η)Bt −(σ −η )t/2 dBt
N0
X0 2 2
+ (σ − η)2 e(σ−η)Bt −(σ −η )t/2 dt
2N0
X0 2 2 2
− (σ − η 2 )e(σ−η)Bt −(σ −η )t/2 dt
2N0
Xt 2 Xt Xt
= − (σ − η 2 )dt + (σ − η)dBt + (σ − η)2 dt
2Nt Nt 2Nt
Xt Xt
= − η(σ − η)dt + (σ − η)dBt
Nt Nt
Xt
= (σ − η)(dBt − ηdt)
Nt
Xt b
= (σ − η) dB t = (σ − η)Xt dBt ,
b b
Nt

where dBbt = dBt − ηdt is a standard Brownian motion under P.

b
b) By change of numéraire, we have
 
N0
IE[(XT − λNT )+ ] = Ib
E (XT − λNT )+ = N0 Ib
E (XbT − λ)+ .
 
NT

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Next, by the result of Question (a), X

bt is a driftless geometric Brownian
motion with volatility σ − η under P,
b hence we have
√ ! √ !
log(Xb0 /λ) σb T log(Xb0 /λ) σb T
IE[(XT −λ) ] = X0 Φ
b b + b √ + −λΦ √ − ,
σ
b T 2 σ
b T 2

by the Black-Scholes formula with zero interest rate and volatility param-
eter σ
b = σ − η. By multiplication by N0 and the relation X0 = N0 X b0 we
conclude to (16.36), i.e.

IE (XT − λNT )+ = N0 Ib
E (XbT − λ)+
   

= N0 X
b0 Φ(d+ ) − λN0 Φ(d− )
= X0 Φ(d+ ) − λN0 Φ(d− ).

c) We have σ
b = σ − η.

Exercise 16.2
a) By the Girsanov Theorem 16.7, the processes

(1) (1) 1 (1) (1) 1 (2) (1) (1)

dB
bt = dBt − dNt • dBt = dBt − (2) dSt • dBt = dBt −ηρdt,
Nt St

and
(2) (2) 1 (2) (2) 1 (2) (2) (2)
dB
bt = dBt − dNt • dBt = dBt − (2) dSt • dBt = dBt − ηdt
Nt St

are both standard Brownian motions (and martingales) under P

b2 .
b) We have
!
(1)
(1) St
dSbt = d (2)
St
(1)
S0 (1) (2)
−ηBt −(σ 2 −η 2 )t/2
= d eσBt


(2)
S0
(1)
S0 (1) (2) 2 2
= (2)
eσBt −ηBt −(σ −η )t/2
S0
σ2 η2 σ2 − η2
 
(1) (2)
× σdBt + dt − ηdBt + dt − dt − σηρdt
2 2 2
(1) (1) (2)

= St σdBt − ηdBt .
b b b

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(1)
c) We note that the driftless geometric Brownian motion (Sbt )t∈R can be
written as
(1) (1) c
dSbt = σ
bSbt dW t,

where (W
ct )t∈R is a standard Brownian motion under P
b2 . In order to de-
termine σ
b we note that

b2 dt = σ
σ b2 dWct • dW ct
(1) (1)
dSbt dSbt
= (1) • (1)
Sb Sbt
t   
(1) bt(2) · σdBt(1) − ηdB
bt(2)
= σdBt − ηdB
= (σ 2 + η 2 − 2σηρ)dt,

hence σ
b2 = σ 2 + η 2 − 2σηρ. We conclude by applying the change of
numéraire formula
 (1) (2)
+  (2)  b(1)
+ 
e−rT IE∗ ST − λST = S0 Ib
E ST − λ

and the Black-Scholes formula to the the driftless geometric Brownian

(1)
motion (Sbt )t∈R .

Exercise 16.3 We have Nt = P (t, T ) and from (17.25) and the relations
P (t, T ) = F (t, rt ) and P (t, S) = G(t, rt ) we find

dP (t, S)

∂
= rt dt + σ(t, rt ) log G(t, rt )dWt ,


 P (t, S) ∂x



 dNt dP (t, T ) ∂
= = rt dt + σ(t, rt ) log F (t, rt )dWt .



Nt P (t, T ) ∂x


By the Girsanov Theorem (16.12) we also have

ct = dWt − dNt ∂
dW • dW = dW − σ(t, r ) log F (t, rt )dt,
t t t
Nt ∂x
hence
dP (t, S) ∂ ∂ ∂
= rt dt+σ 2 (t, rt ) log F (t, rt ) log G(t, rt )dt+σ(t, rt ) log G(t, rt )dW
ct .
P (t, S) ∂x ∂x ∂x

Using the relation P (t, S) = G(t, rt ) we can also write

∂ ∂ ∂
dP (t, S) = rt P (t, S)dt+σ 2 (t, rt ) log F (t, rt ) G(t, rt )dt+σ(t, rt ) G(t, rt )dW
ct .
∂x ∂x ∂x

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Exercise 16.4 Forward contract. Taking Nt := P (t, T ), t ∈ [0, T ], we have

 w
(P (T, S) − K)
    
T
IE∗ exp − rs ds (P (T, S) − K) Ft = Nt Ib E Ft
t NT
(P (T, S) − K)
 
= P (t, T )IE
b Ft
P (T, T )
= P (t, T )Ib
E[P (T, S) − K | Ft ]
= P (t, T )Ib
E[P (T, S) | Ft ] − KP (t, T )
P (T, S)
 
= P (t, T )IE
b | Ft − KP (t, T )
P (T, T )
P (t, S)
= P (t, T ) − KP (t, T )
P (t, T )
= P (t, S) − KP (t, T ),

since
P (t, T ) P (t, S)
t 7−→ =
Nt P (t, T )
is a martingale under the forward measure P. b The corresponding (static)
hedging strategy is given by buying one bond with maturity S and by short
selling K units of the bond with maturity T .

Remark: The above result can also be obtained by a direct argument using
the tower property of conditional expectations:
  w  
T
IE∗ exp − rs ds (P (T, S) − K) Ft
t
  w    w    
T S
∗
= IE exp − rs ds IE∗ exp − rs ds FT − K Ft
t T
  w    w   
T S
∗ ∗
= IE exp − rs ds IE exp − rs ds − K FT Ft
t T
   w   w   
S T
∗ ∗
= IE IE exp − rs ds − K exp − rs ds FT Ft
t t
  w   w  
S T
∗
= IE exp − rs ds − K exp − rs ds Ft
t t

= P (t, S) − KP (t, T ), t ∈ [0, T ].

Exercise 16.5
a) We choose Nt := St as numéraire because this allows us to write the
option payoff as (ST (ST −K))+ = NT (ST −K)+ . In this case, the forward
measure Pb satisfies

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dP
b NT ST
= e−rT = e−rT ,
dP N0 S0
or
dP
b|F NT ST
t
= e−(T −t)r = e−(T −t)r , 0 ≤ t ≤ T.
dP|Ft Nt St
b) By the change of numéraire formula of Proposition 16.5, the option price
becomes

e−(T −t)r IE∗ (ST (ST − K))+ Ft = IE∗ e−(T −t)r NT (ST − K)+ Ft
   

= Nt Ib
E (ST − K)+ Ft
 

= St Ib
E (ST − K)+ Ft . (S.16.72)
 

c) In order to compute (S.16.72) it remains to determine the dynamics of

b Since St = S0 eσBt +rt−σ2 t/2 , we have
(St )t∈R+ under P.

dP
b ST 2
= e−rT = eσBT −σ T /2 ,
dP S0

hence by the Girsanov Theorem 7.3, B

bt := Bt −σt is a standard Brownian
motion under P,
b with
2
ST = S0 erT +σBT −σ T /2
2 2
= S e(r+σ )T +σBbT −σ T /2
0
2
= St e(r+σ bT −Bbt )σ−(T −t)σ2 /2
)(T −t)+(B
, 0 ≤ t ≤ T.

d) According to the above, (S.16.72) becomes

+
+
e−(T −t)r IE∗ ST (ST − K) Ft = St Ib E ST − K
   
Ft
b S0 erT +σ2 T +σBbT −σ2 T /2 − K + Ft
= St IE



2 2
+
= St Ib
E St e(r+σ )(T −t)+(BbT −Bbt )σ−(T −t)σ /2 − K
 
Ft
2
= St e(T −t)(r+σ ) Bl(St , K, r + σ 2 , σ, T − t), 0 ≤ t ≤ T,

since the Black-Scholes formula with interest rate r + σ 2 reads

2
b St e(r+σ2 )(T −t)+(BbT −Bbt )σ−(T −t)σ2 /2 − K + Ft
e−(T −t)(r+σ ) IE



= Bl(St , K, r + σ 2 , σ, T − t), 0 ≤ t ≤ T.

Remarks:
i) The option price can be rewritten using other Black-Scholes parametriza-
tions, such as for example

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2
St Bl St e(T −t)(r+σ ) , K, 0, σ, T − t ,

or 2 2
St e(T −t)(r+σ ) Bl St , Ke−(T −t)(r+σ ) , 0, σ, T − t ,

however we prefer to choose the simplest possibility.

ii) Deflated (or forward) processes such as St /N1 = 1 or

e−(T −t)r ∗ 
IE (ST (ST − K))+ Ft = Ib
E (ST − K)+ Ft , 0 ≤ t ≤ T,
  
Nt

are martingales under the forward measure P. b

iii) This option can also be priced via an integral calculation instead of using
change of numéraire, as follows:

e−(T −t)r IE∗ [ST (ST − K)+ | Ft ]

2
= e−(T −t)r IE∗ St e(T −t)r+(BT −Bt )σ−(T −t)σ /2

2
×(St e(T −t)r+(BT −Bt )σ−(T −t)σ /2 − K)+ Ft

2 2
= St e−(T −t)σ /2 IE∗ (St e(T −t)r+2(BT −Bt )σ−(T −t)σ /2 − Ke(BT −Bt )σ )+ Ft
 
2 2
= St e−(T −t)σ /2 IE∗ (xe(T −t)r+2(BT −Bt )σ−(T −t)σ /2 − Ke(BT −Bt )σ )+ x=S
 
t
2
= St e−(T −t)σ /2 IE∗ (em(x)+2X − KeX )+ x=S , 0 ≤ t ≤ T,
 
t

where X ≃ N (0, v ) with v = (T − t)σ and m(x) = (T − t)r − (T −

2 2 2

t)σ 2 /2 + log x. Next, we note that

+  1 w∞
+ 2
/(2v 2 )
IE em+2X − KeX =√ em+2x − Kex e−x

dx
2πv 2 −∞
1 w∞ 2
/(2v 2 )
=√ (em+2x − Kex )e−x dx
2πv 2 −m+log K
em w ∞ 2 K w∞
/(2v 2 ) 2 2
=√ e2x−x ex−x /(2v ) dx
dx − √
2πv 2 −m+log K 2πv 2 −m+log K
em+2v w ∞ Kev /2 w ∞
2 2
2 2 2 2 2 2
= √ e−(2v −x) /(2v ) dx − √ e−(v −x) /(2v ) dx
2πv 2 −m+log K 2π −m+log K
em+2v w ∞ Kev /2 w ∞
2 2
2 2 2 2
= √ e−x /(2v ) dx − √ e−x /(2v ) dx
2πv −2v −m+log K
2 2
2πv 2 −v2 −m+log K
em+2v w ∞ Kev /2 w ∞
2 2
−x2 /2 2
= √ e dx − √ e−x /2 dx
2π (−2v2 −m+log K)/v 2π (−v2 −m+log K)/v
m − log K m − log K
   
2 2
= em+2v Φ 2v + − Kev /2 Φ v + ,
v v

hence

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+
e−(T −t)r IE∗ ST ST − K
 
Ft
2
+ 
= St e−(T −t)σ /2 IE∗ em(x)+2X − KeX

x=St
(T − t)(r + σ 2 ) + (T − t)σ 2 /2 + log(St /K)
 
2 (T −t)(r+σ 2 )
= St e Φ √
σ T −t
(T − t)(r + σ 2 ) − (T − t)σ 2 /2 + log(St /K)
 
−KSt Φ √
σ T −t
2
= St e(T −t)(r+σ ) Bl(St , K, r + σ 2 , σ, T − t), 0 ≤ t ≤ T.

Exercise 16.6
2
a) Knowing that St = S0 eσWt +rt−σ t/2
, we check that the discounted
numéraire process
2
e−rt Nt := Stn e−(n−1)nσ t/2−nrt
2 2
= S0n enσWt +nrt−nσ t/2 e−(n−1)nσ t/2−nrt
2
= S0 enσWt −(nσ) t/2 , 0 ≤ t ≤ T,

is a martingale under P∗ , and

dP
b NT Sn 2 2
= e−rT = Tn e−nσ T −nrT = enσWT −(nσ) T /2 . (S.16.73)
dP∗ N0 S0

b) From Equation (S.16.73) and the Girsanov theorem, the process W

ct :=
Wt − σnt is a standard Brownian motion under P,
b and we have
2
St = S0 ert+σWt −σ t/2
= S ert+σ(Wb t +nσt)−σ2 t/2
0
2
= S0 e(r+nσ b t +σ2 t/2
)t+σ W
, t ≥ 0.

c) We have

e−(T −t)r IE∗ STn 1{ST ≥K} Ft = IE∗ e−(T −t)r STn 1{ST ≥K} Ft
   

= e(n−1)nσ T /2+(n−1)rT IE∗ NT 1{ST ≥K} Ft

2  
2
b 1{S ≥K} Ft
= e(n−1)nσ T /2+(n−1)rT Nt IE
 
T
2
= e(n−1)nσ b T ≥ K | Ft )
T /2+(n−1)rT
Nt P(S
log(St /K) + (r + (n − 1/2)σ 2 )(T − t)
 
(n−1)nσ 2 T /2+(n−1)rT
=e Nt Φ √
σ T −t
log(St /K) + (r + (n − 1/2)σ 2 )(T − t)
 
n (n−1)nσ 2 (T −t)/2+(n−1)r(T −t)
= St e Φ √ ,
σ T −t

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0 ≤ t ≤ T , n ≥ 0.
d) The power call option with payoff (STn − K n )+ is priced at time t ∈ [0, T ]
as

+
e−(T −t)r IE∗ STn − K n
 
Ft
log(St /K) + (r + (n − 1/2)σ 2 )(T − t)
 
2
= Stn e(n−1)nσ (T −t)/2+(n−1)r(T −t) Φ √
σ T −t
log(St /K) + (r − σ 2 /2)(T − t)
 
−K e n −(T −t)r
Φ √ , n ≥ 1.
σ T −t

Exercise 16.7 Bond options.

a) Itô’s formula yields

P (t, S) P (t, S) S
 
= ζ (t) − ζ T (t) (dWt − ζ T (t)dt)


d
P (t, T ) P (t, T )
P (t, S) S
= ζ (t) − ζ T (t) dW (S.16.74)


ct ,
P (t, T )

where (W ct )t∈R is a standard Brownian motion under P

+
b by the Girsanov
Theorem 7.3.
b) From (S.16.74) or (19.7) we have
w wt
P (t, S) P (0, S) cs − 1

t 2
= exp ζ S (s) − ζ T (s) dW ζ S (s) − ζ T (s) ds ,


P (t, T ) P (0, T ) 0 2 0

hence
w wu
P (u, S) P (t, S) cs − 1

u 2
= exp ζ S (s) − ζ T (s) dW ζ S (s) − ζ T (s) ds ,


P (u, T ) P (t, T ) t 2 t

t ∈ [0, u], and for u = T this yields

w wT
P (t, S) cs − 1

T 2
P (T, S) = exp ζ S (s) − ζ T (s) dW ζ S (s) − ζ T (s) ds ,


P (t, T ) t 2 t

since P (T, T ) = 1. Let P

b denote the forward measure associated to the
numéraire
Nt := P (t, T ), 0 ≤ t ≤ T.
c) For all S ≥ T > 0 we have
h rT i
IE e− t rs ds (P (T, S) − K)+ Ft

1wT S
" + #
P (t, S)
 
2
= P (t, T )IE
b exp X − ζ (s) − ζ T (s) ds − K Ft
P (t, T ) 2 t

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+
= P (t, T )Ib
E eX+m(t,T,S) − K
 
Ft ,

where X is a centered Gaussian random variable with variance

wT 2
v 2 (t, T, S) = ζ S (s) − ζ T (s) ds
t

given Ft , and

1 P (t, S)
m(t, T, S) = − v 2 (t, T, S) + log .
2 P (t, T )

Recall that when X is a centered Gaussian random variable with variance

v 2 , the expectation of (em+X − K)+ is given, as in the standard Black-
Scholes formula, by
2
IE[(em+X − K)+ ] = em+v /2
Φ(v + (m − log K)/v) − KΦ((m − log K)/v),

where wz 2 dy
Φ(z) = e−y /2
√ , z ∈ R,
−∞ 2π
denotes the Gaussian cumulative distribution function and for simplicity
of notation we dropped the indices t, T, S in m(t, T, S) and v 2 (t, T, S).

Consequently we have
h rT i
IE e− t rs ds (P (T, S) − K)+ Ft
1 P (t, S) 1 P (t, S)
   
v v
= P (t, S)Φ + log − KP (t, T )Φ − + log .
2 v KP (t, T ) 2 v KP (t, T )

d) The self-financing hedging strategy that hedges the bond option is ob-
tained by holding a (possibly fractional) quantity

1 P (t, S)
 
v
Φ + log
2 v KP (t, T )

of the bond with maturity S, and by shorting a quantity

1 P (t, S)
 
v
KΦ − + log
2 v KP (t, T )

of the bond with maturity T .

Exercise 16.8
a) The process
e−rt S2 (t) = S2 (0)eσ2 Wt +(µ−r)t

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is a martingale if
1 2
r−µ= σ .
2 2
b) We note that
2
e−rt Xt = e−rt e(r−µ)t−σ1 t/2 S1 (t)
−rt (σ22 −σ12 )t/2
=e e S1 (t)
2
= e−µt−σ1 t/2 S1 (t)
2
= S1 (0)eµt−σ1 t/2 eσ1 Wt +µt
2
= S1 (0)eσ1 Wt −σ1 t/2

is a martingale, where
2 2 2
Xt = e(r−µ)t−σ1 t/2 S1 (t) = e(σ2 −σ1 )t/2 S1 (t).

c) By (16.38) we have

Xt
X(t)
b =
Nt
2 2 S1 (t)
= e(σ2 −σ1 )t/2
S2 (t)
S1 (0) (σ22 −σ12 )t/2+(σ1 −σ2 )Wt
= e
S2 (0)
S1 (0) (σ22 −σ12 )t/2+(σ1 −σ2 )W
= e b t +σ2 (σ1 −σ2 )t
S2 (0)
S1 (0) (σ1 −σ2 )W b t +σ2 σ1 t−(σ22 +σ12 )t/2
= e
S2 (0)
S1 (0) (σ1 −σ2 )W b t −(σ1 −σ2 )2 t/2 ,
= e
S2 (0)

where
ct := Wt − σ2 t
W
is a standard Brownian motion under the forward measure P
b defined by

dP
b rT NT
= e− 0 rs ds
dP N0
−rT S2 (T )
=e
S2 (0)
= e−rT eσ2 WT +µT
= eσ2 WT +(µ−r)T
2
= eσ2 WT −σ2 t/2 .

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2 2
d) Given that Xt = e(σ2 −σ1 )t/2 S1 (t) and X(t)
b = Xt /Nt = Xt /S2 (t), we have
2 2
e−rT IE[(S1 (T ) − κS2 (T ))+ ] = e−rT IE[(e−(σ2 −σ1 )T /2 XT − κS2 (T ))+ ]
2 2 2 2
= e−rT e−(σ2 −σ1 )T /2 IE[(XT − κe(σ2 −σ1 )T /2 S2 (T ))+ ]
2 2
= S2 (0)e−(σ2 −σ1 )T /2 Ib bT − κe(σ22 −σ12 )T /2 )+ ]
E[(X
2 2
= S2 (0)e−(σ2 −σ1 )T /2 IE[(
b X b0 e(σ1 −σ2 )Wb T −(σ1 −σ2 )2 T /2 − κe(σ22 −σ12 )T /2 )+ ]
2 2
= S2 (0)e−(σ2 −σ1 )T /2 X b0 Φ0 (T, X b0 ) − κe(σ22 −σ12 )T /2 Φ0 (T, Xb0 )


+ −
2 2
= S2 (0)e−(σ2 −σ1 )T /2 X
b0 Φ0 (T, X
+
b0 )
2 2 2 2
−κS2 (0)e−(σ2 −σ1 )T /2 e(σ2 −σ1 )T /2 Φ0− (T, X
b0 )
2 2
= X0 e−(σ2 −σ1 )T /2 Φ0+ (T, X
b0 ) − κS2 (0)Φ0 (T, X
−
b0 )
−(σ22 −σ12 )T /2
= S1 (0)e Φ0+ (T, X
b0 ) − κS2 (0)Φ0− (T, X
b0 ),

where
log(x/κ) (σ − σ2 )2 − (σ22 − σ12 ) √
 
Φ0+ (T, x) = Φ √ + 1 T
|σ1 − σ2 | T 2|σ1 − σ2 |
 
log(x/κ) √


 Φ √ + σ1 T , σ1 > σ2 ,
|σ1 − σ2 | T



=
log(x/κ) √
  

Φ √ − σ1 T , σ1 < σ2 ,


|σ1 − σ2 | T

and
log(x/κ) (σ − σ2 )2 + (σ22 − σ12 ) √
 
Φ0− (T, x) = Φ √ − 1 T
|σ1 − σ2 | T 2|σ1 − σ2 |
log(x/κ) √
  

 Φ √ + σ2 T , σ1 > σ2 ,
|σ1 − σ2 | T



=
log(x/κ) √
  

Φ √ − σ2 T , σ1 < σ2 ,


|σ1 − σ2 | T

if σ1 ̸= σ2 . In case σ1 = σ2 , we find

e−rT IE[(S1 (T ) − κS2 (T ))+ ] = e−rT IE[S1 (T )(1 − κS2 (0)/S1 (0))+ ]
= (1 − κS2 (0)/S1 (0))+ e−rT IE[S1 (T )]
= (S1 (0) − κS2 (0))1{S1 (0)>κS2 (0)} .

Exercise 16.9 We have

e−(T −t)r IE∗ 1{RT ≥κ} Rt = e−(T −t)r P∗ RT ≥ κ Rt

 

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f
)(T −t)−(T −t)σ 2 /2
= e−(T −t)r P∗ Rt e(WT −Wt )σ+(r−r


≥ κ Rt
f 2
= e−(T −t)r P∗ xe(WT −Wt )σ+(r−r )(T −t)−(T −t)σ /2 ≥ κ x=Rt

(r − rf )(T − t) − (T − t)σ 2 /2 − log(κ/Rt )

 
= e−(T −t)r Φ √ ,
σ T −t
after applying the hint provided, with

η 2 := (T − t)σ 2 and µ := (r − rf )(T − t) − (T − t)σ 2 /2.

Remark: Binary options are often proposed at the money, i.e. κ = Rt , with
a short time to maturity, for example the small value

T − t ≃ 30 seconds = 0.000000951 = 9.51 × 10−7 year−1 ,

in which case we have

r − rf √
  
σ
e−(T −t)r IE∗ 1{RT ≥κ} Rt = e−(T −t)r Φ
 
− T −t
σ 2
≃ Φ(0)
1
= .
2
Taking for example r − rf = 0.02 = 2% and σ = 0.3 = 30%, we have

r − rf σ √ 0.02 0.3 p
   
− T −t= − 9.51 × 10−7 = −0.000081279
σ 2 0.3 2

and

e−(T −t)r IE∗ 1{RT ≥κ} Rt = e−(T −t)r Φ(−0.000081279)

 

= e−r×0.000000951 × 0.499968
= 0.49996801
1
≃ ,
2
with r = 0.02 = 2%.

Exercise 16.10
a) It suffices to check that the definition of (WtN )t∈R+ implies the correlation
identity dWtS • dWtN = ρdt by Itô’s calculus.
b) We let q
bt =
σ (σtS )2 − 2ρσtR σtS + (σtR )2
and

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σtS − ρσtN p σN
dWtX = dWtS − 1 − ρ2 t dWt , t ≥ 0,
σ
bt σ
bt
which defines a standard Brownian motion under P∗ due to the definition
of σ
bt .

Exercise 16.11
a) We have σb = (σ S )2 − 2ρσ R σ S + (σ R )2 .
p

b) Letting Xet = e−rt Xt = e(a−r)t St /Rt , t ≥ 0, we have

" + #
∗ ST h
+ i
IE −κ Ft = e−aT IE∗ XT − eaT κ Ft
RT
 + 
= e−(a−r)T IE∗ X eT − e(a−r)T κ Ft

et Φ (r − a +√σ b2 /2)(T − t) 1
  
St
= e−(a−r)T X + √ log
b T −t
σ b T −t
σ κRt
(r − a − σb2 /2)(T − t) 1
 
St
−κe (a−r)T
Φ √ + √ log
σb T −t b T −t
σ κRt
(r − a + σb2 /2)(T − t) 1
 
St (r−a)(T −t) St
= e Φ √ + √ log
Rt b T −t
σ b T −t
σ κRt
(r − a − σb2 /2)(T − t) 1
 
St
−κΦ √ + √ log ,
b T −t
σ b T −t
σ κRt

hence the price of the quanto option is

" + #
ST
e−(T −t)r IE∗ −κ Ft
RT
(r − a + σb2 /2)(T − t) 1
 
St −a(T −t) St
= e Φ √ + √ log
Rt b T −t
σ b T −t
σ κRt
(r 2
1
 
− a − σ /2)(T − t) St
−κe−r(T −t) Φ √ + √ log
b
.
b T −t
σ b T −t
σ κRt

Chapter 17

Exercise 17.1
a) We have

a
 wt 
drt = r0 de−bt + d 1 − e−bt + σd e−bt ebs dBs


b 0

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wt wt
= −br0 e−bt dt + ae−bt dt + σe−bt d ebs dBs + σ ebs dBs de−bt
0 0
wt
= −br0 e−bt dt + ae−bt dt + σe−bt ebt dBt − σb ebs dBs e−bt dt
0
wt
= −br0 e−bt dt + ae−bt dt + σdBt − σb ebs dBs e−bt dt
 0 a

= −br0 e−bt dt + ae−bt dt + σdBt − b rt − r0 e−bt − 1 − e−bt dt
b
= (a − brt )dt + σdBt ,

which shows that rt solves (17.46).

b) We note that
a wt
rt = r0 e−bt + 1 − e−bt + σ e−(t−u)b dBu


b 0
a
= r0 e−bs e−(t−s)b + e−(t−s)b 1 − e−bs


b
a ws wt
+ 1 − e−(t−s)b + σe−(t−s)b e−(s−u)b dBu + σ e−(t−u)b dBu


b 0 s
a wt
= rs e−(t−s)b + 1 − e−(t−s)b + σ e−(t−u)b dBu , 0 ≤ s ≤ t.


b s

Hence, assuming that rs has the N (a/b, σ 2 /(2b)) distribution, the distri-
bution of rt is Gaussian with mean
a
IE[rt ] = e−(t−s)b IE[rs ] +
1 − e(t−s)b


b
a a
= e−(t−s)b + 1 − e(t−s)b


b b
a
= ,
b
and variance

a wt 
Var[rt ] = Var rs e−(t−s)b + 1 − e(t−s)b + σ e−(t−u)b dBu


b s
 wt 
= Var rs e −(t−s)b
+σ e −(t−u)b
dBu
s
 w 
t
= Var rs e−(t−s)b + Var σ e−(t−u)b dBu
 
s
w 
t
=e −2(t−s)b
Var rs + σ Var
2
e−(t−u)b dBu
 
s

σ2 wt
= e−2(t−s)b + σ2 e−2(t−u)b du
2b s
σ 2 w t−s
= e−2(t−s)b + σ2 e−2bu du
2b 0

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σ2
= , t ≥ 0.
2b

Exercise 17.2
a) The zero-coupon bond price P (t, T ) in the Vasicek model is given by

log P (t, T ) = A(T − t) + rt C(T − t), 0 ≤ t ≤ T,

where
1
C(T − t) := − 1 − e−(T −t)b ,


b
and
4ab − 3σ 2 σ 2 − 2ab
A(T − t) := + (T − t)
4b3 2b2
2
σ − ab −(T −t)b σ2
+ e − 3 e−2(T −t)b 0 ≤ t ≤ T.
(S.17.75)
b3 4b
Since limT →∞ C(T − t)/(T − t) = 0 and

lim A(T − t)/(T − t) = (σ 2 − 2ab)/(2b2 ),

T →∞

we find
log P (t, T ) σ 2 − 2ab a σ2
r∞ = − lim =− = − 2.
T →∞ T −t 2b2 b 2b
b) We have

P (t, T )
log = log P (t, T ) − log P (0, T )
P (0, T )
= A(T − t) − A(T ) + rt C(T − t) − r0 C(T )
σ 2 − 2ab
 2
σ 2 −(T −t)b

σ − ab
= −t − e−(T −t)b
+ e
2b2 b3 4b3
 2 2

σ σ − ab rt
r0
+e−bT 1 − e−(T −t)b + 1 − e−bT ,


− −
4b3 b3 b b

hence
P (t, T ) σ2
 
a rt − r0 rt − r0
lim log = − 2 t− =− + r∞ t,
T →∞ P (0, T ) b 2b b b

and∗
∗
The log function is continuous on (0, ∞).

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P (t, T ) 2 2
lim log = e−(rt −r0 )/b+t(a/b−σ /(2b )) = e−(rt −r0 )/b+r∞ t ,
T →∞ P (0, T )

which shows that the yield of the long-bond return is the asymptotic bond
yield r∞ .

Remark: By Relations (17.32)-(17.34), the Vasicek bond price P (t, T ) can

be rewritten in terms of the asymptotic bond yield r∞ as
2
C 2 (T −t)/(4b)
P (t, T ) = e−(T −t)r∞ +(rt −r∞ )C(T −t)−σ , 0 ≤ t ≤ T,

see e.g. Relation (3.12) in Brody et al. (2018).

Exercise 17.3 An estimator of σ can be obtained from the orthogonality

relation
n−1 n−1
X
2 X
r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ = σ 2 (r̃tl )2γ (Zl )2 − ∆t

l=0 l=0
≃ 0,

which is due to the independence of ttl and Zl , l = 0, . . . , n − 1, and yields

n−1
X
2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl
l=0
b2 =
σ n−1
.
X
∆t (r̃tl )
2γ

l=0

Regarding the estimation of γ, we can combine the above relation with the
second orthogonality relation
n−1
X
2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ r̃tl

l=0
n−1
X
= σ2 (r̃tl )2γ+1 (Zl )2 − ∆t

l=0
≃ 0,

cf. § 2.2 of Faff and Gray (2006). One may also attempt to minimize the
residual
n−1
X 2

2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ
l=0

by equating the following derivatives to zero, as

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n−1 2
∂ X
2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ
∂σ
l=0
n−1
X
2
= −4σ (r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ

l=0
= 0,

hence
n−1 n−1
X
2 X
(r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t (r̃tl )4γ = 0,
l=0 l=0

which yields
n−1
X
2
(r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl
l=0
b2 =
σ n−1
. (S.17.76)
X
∆t (r̃tl )4γ
l=0

We also have
n−1 2
∂ X
2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ
∂γ
l=0
n−1
X
2
= −4σ 2 ∆t (r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl − σ 2 ∆t(r̃tl )2γ log r̃tl

l=0
= 0,

which yields
n−1
X
2
(r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl log r̃tl
l=0
b2 =
σ n−1
, (S.17.77)
X
∆t (r̃tl )4γ log r̃tl
l=0

and shows that γ can be estimated by matching Relations (S.17.76) and

(S.17.77), i.e.

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n−1
X
2
(r̃tl )2γ r̃tl+1 − a∆t − (1 − b∆t)r̃tl
l=0
n−1
X
(r̃tl )4γ
l=0
n−1
X
2
(r̃tl ) 2γ
r̃tl+1 − a∆t − (1 − b∆t)r̃tl log r̃tl
l=0
= n−1
.
X
(r̃tl )
4γ
log r̃tl
l=0

Remarks.
i) Estimators of a and b can be obtained by minimizing the residual
n−1
X
2
r̃tl+1 − a∆t − (1 − b∆t)r̃tl
l=0

as in the Vašíček (1977) model, i.e. from the equations

n−1
X
r̃tl+1 − a∆t − (1 − b∆t)r̃tl = 0

l=0

and
n−1
X
r̃tl+1 − a∆t − (1 − b∆t)r̃tl r̃tl = 0.

l=0

ii) Instead of using the (generalised) method of moments, parameter esti-

mation for stochastic differential equations can be achieved by maximum
likelihood estimation, see e.g. Lindström (2007) and references therein.

Exercise 17.4
a) We have rt = r0 + at + σBt , and

F (t, rt ) = F (t, r0 + at + σBt ),

hence by Proposition 17.2 the PDE satisfied by F (t, x) is

∂F ∂F 1 ∂2F
−xF (t, x) + (t, x) + a (t, x) + σ 2 2 (t, x) = 0, (S.17.78)
∂t ∂x 2 ∂x
with terminal condition F (T, x) = 1.
b) Using the relation rt = r0 + at + σBt and the fact that the stochastic
wT
integral (T − s)dBs is independent of Ft , we have
t

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  w  
T
F (t, rt ) = IE∗ exp − rs ds Ft
t
  wT wT  
∗
= IE exp −r0 (T − t) − a sds − σ Bs ds Ft
t t
  wT  
∗ −r0 (T −t)−a(T 2 −t2 )/2
= IE e exp −(T − t)σBt − σ (T − s)dBs Ft
t
  wT  
−r0 (T −t)−a(T 2 −t2 )/2−(T −t)σBt ∗
=e IE exp −σ (T − s)dBs Ft
t
  wT 
= e−r0 (T −t)−a(T −t)(T +t)/2−(T −t)σBt IE∗ exp −σ (T − s)dBs
t

σ2 w T
 
= exp −(T − t)rt − a(T − t) /2 + 2
(T − s) ds
2
2 t
= exp −(T − t)rt − a(T − t)2 /2 + (T − t)3 σ 2 /6 ,

hence F (t, x) = exp −(T − t)x − a(T − t)2 /2 + (T − t)3 σ 2 /6 .

Note that the PDE (S.17.78) can also be solved by looking for a solution of
the form F (t, x) = eA(T −t)+xC(T −t) , in which case one would find A(s) =
−as2 /2 + σ 2 s3 /6 and C(s) = −s.
c) We check that the function F (t, x) of Question (b) satisfies the PDE
(S.17.78) of Question (a), since F (T, x) = 1 and

σ2
 
−xF (t, x) + x + a(T − t) − (T − t)2 F (t, x) − a(T − t)F (t, x)
2
σ2
+ (T − t)2 F (t, x) = 0.
2

Exercise 17.5
wt
a) We check from (17.51) and the differentiation rule d f (u)du = f (t)dt
0
that
 w
t 1

drt = αβd St du + r0 dSt
0 Su
wt 1 wt 1
= αβSt d du + αβ dudSt + r0 dSt
0 Su 0 Su
St wt S dS
t t
= αβ dt + αβ du + r0 dSt
St 0 Su St
dSt
= αβdt + (rt − r0 St ) + r0 dSt
St
dSt
= αβdt + rt
St
= αβdt + rt (−βdt + σdBt )

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= β(α − rt )dt + σdBt , t ≥ 0.

b) Taking µ(t, x) := β(α − x) and σ(t, x) = σx, by Itô’s formula we have

 rt  rt rt
d e− 0 rs ds P (t, T ) = −rt e− 0 rs ds P (t, T )dt + e− 0 rs ds dP (t, T )
rt rt
= −rt e− 0
rs ds
F (t, rt )dt + e− dF (t, rt )
0
rs ds

rt ∂Frt
= −rt e− 0 rs ds F (t, rt )dt + e− 0 rs ds (t, rt )(µ(t, rt )dt + σ(t, rt )dBt )
∂x
rt 1 2 2
 
∂ F ∂F
+ e− 0 rs ds σ (t, rt ) 2 (t, rt ) + (t, rt ) dt
2 ∂x ∂t
r ∂F
− 0t rs ds
=e σ(t, rt ) (t, rt )dBt
∂x
rt 1 ∂2F
 
∂F ∂F
+ e− 0 rs ds −rt F (t, rt ) + µ(t, rt ) (t, rt ) + σ 2 (t, rt ) 2 (t, rt ) + (t, rt ) dt.
∂x 2 ∂x ∂t
(S.17.79)
rt
Given that t 7−→ e− 0 rs ds P (t, T ) is a martingale, the above expression
(S.17.79) should only contain terms in dBt and all terms in dt should
vanish inside (S.17.79). This leads us to the identities

rt F (t, rt )


1

∂F ∂2F ∂F


 = µ(t, rt ) (t, rt ) + σ 2 (t, rt ) 2 (t, rt ) + (t, rt ) (S.17.80a)


∂x 2 ∂x ∂t



  rt rt
d e− 0 rs ds P (t, T ) = e− 0 rs ds σ(t, rt ) ∂F (t, rt )dBt ,
 
(S.17.80b)


∂x
and in particular to the bond pricing PDE

∂F 1 ∂2F ∂F
xF (t, x) = β(α − x) (t, x) + σ 2 x2 2 (t, x) + (t, x).
∂x 2 ∂x ∂t

Exercise 17.6
a) Applying the Itô formula
1
df (rt ) = f ′ (rt )drt + f ′′ (rt )(drt )2
2
to the function f (x) = x2−γ with

f ′ (x) = (2 − γ)x1−γ and f ′′ (x) = (2 − γ)(1 − γ)x−γ ,

we have

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dRt = drt2−γ
= df (rt )
1
= f ′ (rt )drt + f ′′ (rt )(drt )2
2
γ/2
= f ′ (rt ) (βrtγ−1 + αrt )dt + σrt dBt drt +

1 ′′ γ/2
2
f (rt ) (βrtγ−1 + αrt )dt + σrt dBt
2
γ/2 σ 2 ′′
= f ′ (rt ) (βrtγ−1 + αrt )dt + σrt dBt drt + f (rt )rtγ dt


2
γ/2
σ2
= (2 − γ)rt1−γ (βrtγ−1 + αrt )dt + σrt dBt + (2 − γ)(1 − γ)rtγ rt−γ dt
2
σ2 1−γ/2
= (2 − γ)(β + αrt2−γ )dt + (2 − γ)(1 − γ)dt + σ(2 − γ)rt dBt
2
2
 σ  p
= (2 − γ) β + (1 − γ) + αRt dt + (2 − γ)σ Rt dBt .
2

We conclude that the process Rt = rt2−γ follows the CIR equation

p
dRt = b(a − Rt )dt + η Rt dBt

with initial condition R0 = r02−γ and coefficients

1 σ2
 
b = (2 − γ)α, a = β + (1 − γ) , and η = (2 − γ)σ.
α 2

b) By Itô’s formula and the relation P (t, T ) = F (t, rt ), t ∈ [0, T ], we have

 rt  rt rt
d e− 0 rs ds P (t, T ) = −rt e− 0 rs ds P (t, T )dt + e− 0 rs ds dP (t, T )
rt rt
= −rt e− 0
rs ds
F (t, rt )dt + e− 0
rs ds
dF (t, rt )
rt rt rt
rs ds ∂F rs ds ∂F
= −rt e − 0
rs ds
F (t, rt )dt + e − 0 (t, rt )dt + e− 0 (t, rt )drt
∂t ∂x
rs ds 1
rt 2
∂ F
+ e− 0 (t, rt )(drt )2
2 ∂x2
rt rt ∂F −(1−γ) γ/2
= −rt e− 0 F (t, rt )dt + e− 0 rs ds
rs ds
(t, rt )((βrt + αrt )dt + σrt dBt )
∂x
rt 1 ∂2F
 
∂F
+ e− 0 rs ds (t, rt ) + σ 2 rtγ 2 (t, rt ) dt
∂t 2 ∂x
r
− 0t rs ds γ/2 ∂F
=e σrt (t, rt )dBt
rt
 ∂x
−(1−γ) ∂F
+ e− 0 rs ds −rt F (t, rt ) + (βrt + αrt ) (t, rt )
∂x

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1 2 γ ∂2F

∂F
+ σ rt (t, rt ) + (t, rt ) dt. (S.17.81)
2 ∂x2 ∂t
rt
Given that t 7−→ e− 0 rs ds P (t, T ) is a martingale, the above expression
(S.17.81) should only contain terms in dBt and all terms in dt should
vanish inside (S.17.81). This leads to the identities

 r F (t, r ) = (βr−(1−γ) + αr ) ∂F (t, r ) + 1 σ 2 rγ ∂ F (t, r ) + ∂F (t, r )
 2
t t t t t t
t
2 t

∂x ∂x2 ∂t



  rt
  rt ∂F
 d e− 0 rs ds P (t, T ) = σe− 0 rs ds rtγ/2

(t, rt )dBt ,


∂x
and to the PDE
∂F ∂F σ2 γ ∂ 2 F
xF (t, x) = (t, x) + (βx−(1−γ) + αx) (t, x) + x (t, x).
∂t ∂x 2 ∂x2

Exercise 17.7
rt
a) The discounted bond prices process e− 0 rs ds F (t, rt ) is a martingale, and
we have
 rt 
d e− 0 rs ds F (t, rt )
rt σ2 ∂ 2 F
 
∂F ∂F
= e− 0 rs ds −rt F (t, rt )dt + (t, rt )dt + (t, rt )drt + (t, rt )(drt )2
∂t ∂x 2 ∂x 2

r
 
− 0t rs ds ∂F ∂F √
=e −rt F (t, rt )dt + (t, rt )dt + (t, rt )(−art dt + σ rt dBt )
∂t ∂x
rt 2 2
σ ∂ F
+rt e− 0 rs ds (t, rt )dt,
2 ∂x2
hence F (t, x) satisfies the affine PDE

∂F ∂F σ2 ∂ 2 F
−xF (t, x) + (t, x) − ax (t, x) + x (t, x) = 0. (S.17.83)
∂t ∂x 2 ∂x2
b) Plugging F (t, x) = eA(T −t)+xC(T −t) into the PDE (S.17.83) shows that
2
 
σ x 2
eA(T −t)+xC(T −t) −x − A′ (T − t) − xC ′ (T − t) − axC(T − t) + C (T − t)
2
= 0.

Taking successively x = 0 and x = 1 in the above relation then yields the

two equations

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A (T − t) = 0,
 ′


2
 −1 − C ′ (T − t) − aC(T − t) + σ C 2 (T − t) = 0.

2
Remark: The initial condition A(0) = 0 shows that A(s) = 1, and it can
be shown from the condition C(0) = 0 that

2(1 − eγ(T −t) )

C(T − t) = , t ∈ [0, T ],
2γ + (a + γ)(eγ(T −t) − 1)
√
with γ = a2 + 2σ 2 , see e.g. Eq. (3.25) page 66 of Brigo and Mercurio
(2006).

Exercise 17.8
a) The payoff of the convertible bond is given by max(αSτ , P (τ, T )).
b) We have

max(αSτ , P (τ, T )) = P (τ, T )1{αSτ ≤P (τ,T ))} + αSτ 1{αSτ >P (τ,T ))}
= P (τ, T ) + (αSτ − P (τ, T ))1{αSτ >P (τ,T ))}
= P (τ, T ) + (αSτ − P (τ, T ))+
= P (τ, T ) + α(Sτ − P (τ, T )/α)+ ,

where the latter European call option payoff has the strike price K :=
P (τ, T )/α.
c) From the Markov property applied at time t ∈ [0, τ ], we will write the
corporate bond price as a function C(t, St , rt ) of the underlying asset
price and interest rate, hence we have
h rτ i
C(t, St , rt ) = IE∗ e− t rs ds max(αSτ , P (τ, T )) Ft .

The martingale property follows from the equalities

rt rt h rτ i
e− 0 rs ds C(t, St , rt ) = e− 0 rs ds IE∗ e− t rs ds max(αSτ , P (τ, T )) Ft
h rτ i
= IE∗ e− 0 rs ds max(αSτ , P (τ, T )) Ft .

d) We have
 rt 
d e− 0 rs ds C(t, St , rt )
rt rt
rs ds ∂C
= −rt e− 0
rs ds
C(t, St , rt )dt + e− 0 (t, St , rt )dt
∂t
rt
rs ds ∂C (1)
+e− 0 (t, St , rt )(rSt dt + σSt dBt )
∂x

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rt
rs ds ∂C (2)
+e− 0 (t, St , rt )(γ(t, rt )dt + η(t, St )dBt )
∂y
rt σ 2
∂2C rt 1 ∂2C
+e− 0 rs ds St2 2 (t, St , rt )dt + e− 0 rs ds η 2 (t, rt ) (t, St , rt )dt
2 ∂x 2 ∂y 2
rt ∂2C
+ρσSt η(t, rt )e− 0 rs ds (t, St , rt )dt. (S.17.84)
∂x∂y
rt
The martingale property of e− 0 rs ds C(t, St , rt ) t∈R+ shows that the sum

of terms in factor of dt vanishes in the above Relation (S.17.84), which

yields the PDE
∂C ∂C ∂C
0 = − yC(t, x, y) + (t, x, y)dt + ry (t, x, y) + γ(t, y) (t, x, y)
∂t ∂x ∂y
2
σ 2∂ C2
1∂ C
2
∂2C
+ x (t, x, y) + η 2 (t, y) (t, x, y) + ρσxη(t, y) (t, x, y),
2 ∂x2 2 ∂y 2 ∂x∂y
with the terminal condition

C(τ, x, y) = max(αx, F (τ, y)), where F (τ, rτ ) = P (τ, T )

is the bond pricing function.

e) The convertible bond can be priced as
h rτ i
IE∗ e− t rs ds max(αSτ , P (τ, T )) Ft
h rτ i h rτ i
= IE∗ e− t rs ds P (τ, T ) Ft + α IE∗ e− t rs ds (Sτ − P (τ, T )/α)+ Ft

= P (t, T ) + αP (t, T )Ib

E (Sτ /P (τ, T ) − 1/α)+ Ft . (S.17.85)
 

f) By Proposition 16.8 we find

dZt = (σ − σB (t))Zt dW
ct ,

where (W
ct )t∈R is a standard Brownian motion under the forward measure
+

P.
b
g) By modeling (Zt )t∈R+ as the geometric Brownian motion

dZt = σ(t)Zt dW
ct ,

Relation (S.17.85) shows that the convertible bond is priced as

P (t, T ) + αSt Φ(d+ ) − P (t, T )Φ(d− ),

where

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1 v 2 (t, τ )
 
St
d+ = log + ,
v(t, T ) P (t, T ) 2

1 v 2 (t, τ )
 
St
d− = log − ,
v(t, T ) P (t, T ) 2
rT
and v 2 (t, T ) = t
σ 2 (s, T )ds, 0 < t < T .

Exercise 17.9 We have

1 1
  
∂ ∂ c
Pc (0, n) = + 1 −
∂r ∂r (1 + r)n r (1 + r)n
1
 
n c nc
=− − 2 1− + ,
(1 + r) n+1 r (1 + r)n r(1 + r)n+1

hence
1+r ∂
Dc (0, n) = − Pc (0, n)
Pc (0, n) ∂r
(1 + r)c 1
 
n nc
− − 1 − +
(1 + r)n r2 (1 + r)n r(1 + r)n
= −
1 1
 
c
+ 1−
(1 + r) n r (1 + r) n

1+r
−nr − (c((1 + r)n − 1)) + nc
= − r
r + c ((1 + r)n − 1)
1+r
1 + r − nr − (r + c((1 + r)n − 1)) + nc
= − r
r + c ((1 + r)n − 1)
1+r 1 + r + n(c − r)
= −
r r + c ((1 + r)n − 1)
(1 − c/r)n 1+r c ((1 + r)n − 1)
 
= + ,
1 + c ((1 + r) − 1) /r
n r r + c ((1 + r) − 1)
n

with D0 (0, n) = n. We note that

1+r 1 + r + n(c − r) 1
 
lim Dc (0, n) = lim − =1+ .
n→∞ n→∞ r r + c ((1 + r) − 1)
n r

When n becomes large, the duration (or relative sensitivity) of the bond price
converges to 1+1/r whenever the (nonnegative) coupon amount c is nonzero,
otherwise the bond duration of Pc (0, n) is n. In particular, the presence of a
nonzero coupon makes the duration (or relative sensitivity) of the bond price
bounded as n increases, whereas the duration n of P0 (0, n) goes to infinity

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as n increases.

As a consequence, the presence of the coupon tends to put an upper limit

the risk and sensitivity of bond prices with respect to the market interest
rate r as n becomes large, which can be used for bond immunization. Note
that the duration Dc (0, n) can also be written as the relative average
n
!
1 n X k
Dc (0, n) = +c
Pc (0, n) (1 + r)n (1 + r)k
k=1

of zero coupon bond durations, weighted by their respective zero-coupon

prices.

Exercise 17.10
a) We have
w wt 1wt T 2

t
P (t, T ) = P (s, T ) exp ru du + σuT dBu − |σu | du ,
s s 2 s

0 ≤ s ≤ t ≤ T.
b) We have  rt  rt
d e− 0
rs ds
P (t, T ) = e− 0 rs ds σtT P (t, T )dBt ,

which gives a martingale after integration, from the properties of the Itô
integral.
c) By the martingale property of the previous question we have
h rT i h rT i
IE e− 0 rs ds Ft = IE P (T, T )e− 0 rs ds Ft
rt
= P (t, T )e− 0
rs ds
, 0 ≤ t ≤ T.

d) By the previous question we have

rt h rT i
P (t, T ) = e 0 IE e− 0 rs ds Ft
rs ds

h rt rT i
= IE e 0 rs ds e− 0 rs ds Ft
h rT i
= IE e− t rs ds Ft , 0 ≤ t ≤ T,
rt
since e− 0 rs ds is an Ft -measurable random variable.
e) We have
w
P (t, S) P (s, S) 1wt S 2

t
= exp (σuS − σuT )dBu − (|σu | − |σuT |2 )du
P (t, T ) P (s, T ) s 2 s

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w
P (s, S) 1wt S

t
= exp (σuS − σuT )dBuT − (σu − σuT )2 du ,
P (s, T ) s 2 s

0 ≤ t ≤ T , hence letting s = t and t = T in the above expression, we find

w
P (t, S) 1wT S

T
2
P (T, S) = exp σsS − σsT dBsT − σs − σsT ds .


P (t, T ) t 2 t

f) We have

P (t, T )IE
b (P (T, S) − κ)+
 
" + #
P (t, S) r T (σsS −σsT )dBsT −r T (σsS −σsT )2 ds/2
= P (t, T )IE b et t −κ
P (t, T )
∗

+
= P (t, T ) IE e −κ
 X 
Ft
1
 
2 v(t)
= P (t, T )em(t)+v (t)/2 Φ + (m(t) + v 2 (t)/2 − log κ)
2 v(t)
1
 
v(t)
−κP (t, T )Φ − + (m(t) + v 2 (t)/2 − log κ) ,
2 v(t)

where
P (t, S) 1 w T S
2
m(t) := log − σs − σsT ds,
P (t, T ) 2 t
and X is a centered Gaussian random variable with variance
wT
2
v 2 (t) := σsS − σsT ds,
t

given Ft . This yields

P (t, T )IE
b (P (T, S) − κ)+
 

1 P (t, S) 1 P (t, S)
   
v(t) v(t)
= P (t, S)Φ + log − κP (t, T )Φ − + log .
2 v(t) κP (t, T ) 2 v(t) κP (t, T )

Exercise 17.11 (Exercise 4.18 continued). From Proposition 17.2, the bond
pricing PDE is

∂F ∂F 1 ∂2F

 (t, x) = xF (t, x) − (α − βx) (t, x) − σ 2 x2 2 (t, x)
2

∂t ∂x ∂x

F (T, x) = 1.


We search for a solution of the form

F (t, x) = eA(T −t)−xB(T −t) ,

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with A(0) = B(0) = 0, which implies

 A (s) = 0
 ′


 B ′ (s) + βB(s) + 1 σ 2 B 2 (s) = 1,


2
hence in particular A(s) = 0, s ∈ R, and B(s) solves a Riccati equation,
whose solution can be checked to be
2(eγs − 1)
B(s) = ,
2γ + (β + γ)(eγs − 1)

with γ = β 2 + 2σ 2 .
p

Exercise 17.12
a) We have
1

 y0,1 = − T log P (0, T1 ) = 9.53%,


 1
1


y0,2 = − log P (0, T2 ) = 9.1%,
T2
1 P (0, T2 )


 y1,2 = − log = 8.6%,



T2 − T1 P (T1 , T2 )
with T1 = 1 and T2 = 2.
b) We have

Pc (1, 2) = ($1 + $0.1) × P0 (1, 2) = ($1 + $0.1) × e−(T2 −T2 )y1,2 = $1.00914,

and

Pc (0, 2) = ($1 + $0.1) × P0 (0, 2) + $0.1 × P0 (0, 1)

= ($1 + $0.1) × e−(T2 −T2 )y0,2 + $0.1 × e−(T2 −T2 )y0,1
= $1.00831.

Exercise 17.13
√
a) The discretization rtk+1 := rtk + (a − brtk )∆t ± σ ∆t does not lead to a
binomial tree because rt2 can be obtained in four different ways from rt0 ,
as
√
rt2 = rt1 (1 − b∆t) + a∆t ± σ ∆t

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 √ √


 (rt0 (1 − b∆t) + a∆t + σ ∆t)(1 − b∆t) + a∆t + σ ∆t

√ √


 (rt0 (1 − b∆t) + a∆t + σ ∆t)(1 − b∆t) + a∆t − σ ∆t



= √ √
(r (1 − b∆t) + a∆t − σ ∆t)(1 − b∆t) + a∆t + σ ∆t


 t0



√ √


(rt0 (1 − b∆t) + a∆t − σ ∆t)(1 − b∆t) + a∆t − σ ∆t.



b) By the Girsanov Theorem, the process (rt /σ)t∈[0,T ] with

drt a − brt
= dt + dBt
σ σ
is a standard Brownian motion under the probability measure Q with
Radon-Nikodym density

dQ 1 wT 1 wT
 
= exp − (a − brt )dBt − 2 (a − brt )2 dt
dP σ 0 2σ 0
1 wT 1 wT
 
≃ exp − 2 (a − brt )(drt − (a − brt )dt) − 2 (a − brt )2 dt
σ 0 2σ 0
1 wT 1 wT
 
= exp − 2 (a − brt )drt + 2 (a − brt )2 dt .
σ 0 2σ 0

In other words, if we generate (rt /σ)t∈[0,T ] and the increments σ −1 drt ≃

√
± ∆t as a standard Brownian motion under Q, then, under the proba-
bility measure P such that
 w
dP 1 T 1 wT

= exp (a − br t )drt − (a − brt ) 2
dt ,
dQ σ2 0 2σ 2 0

the process
drt a − brt
dBt =− dt
σ σ
will be a standard Brownian motion under P, and the samples

drt = (a − brt )dt + σdBt

of (rt )t∈[0,T ] will be distributed as a Vasicek process under P.

c) Approximating
√ the standard Brownian increment σ −1 drt under Q by
± ∆t, we have
Y  1 a − brt √  Y  a − brt √

2T /∆T ± ∆t = 1± ∆t
2 2σ σ
0<t<T 0<t<T
!
a − brt √
Y  
= exp log 1± ∆t
σ
0<t<T

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!
a − brt √
X 
= exp log 1 ± ∆t
σ
0<t<T
!
X a − brt √
1 X (a − brt )2
≃ exp ± ∆t − ∆t
σ 2 σ2
0<t<T 0<t<T
 w
1 T 1 wT

≃ exp (a − brt )drt − 2 (a − brt )2 dt
2
σ 0 2σ 0
dP
= .
dQ

d) We check that

IE[∆rt1 | rt0 ] = (a − brt0 )∆t

√ √
= p(rt0 )σ ∆t − (1 − p(rt0 ))σ ∆t
√ √
= σp(rt0 ) ∆t − σq(rt0 ) ∆t,

with
1 a − brt0 √ 1 a − brt0 √
p(rt0 ) = + ∆t and q(rt0 ) = − ∆t.
2 2σ 2 2σ
Similarly, we have

IE[∆rt2 | rt1 ] = (a − brt1 )∆t

√ √
= p(rt1 )σ ∆t − (1 − p(rt1 ))σ ∆t
√ √
= σp(rt1 ) ∆t − σq(rt1 ) ∆t,

with
1 a − brt1 √ 1 a − brt1 √
p(rt1 ) = + ∆t, q(rt1 ) = − ∆t.
2 2σ 2 2σ

Exercise 17.14
a) We have

100 100 100

 
P (1, 2) = IE∗ = + .
1 + r1 2(1 + r1u ) 2(1 + r1d )

b) We have
100 100
P (0, 2) = + .
2(1 + r0 )(1 + r1u ) 2(1 + r0 )(1 + r1d )

c) We have P (0, 1) = 91.74 = 100/(1 + r0 ), hence

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100 − P (0, 1)
r0 = = 100/91.74 − 1 = 0.090037061 ≃ 9%.
P (0, 1)

d) We have
P (0, 1) P (0, 1)
83.40 = P (0, 2) = +
2(1 + r1u ) 2(1 + r1d )
√
and r1u /r1d = e2σ ∆t
, hence

P (0, 1) P (0, 1)
83.40 = P (0, 2) = √ +
2(1 + r1d e2σ ∆t ) 2(1 + r1d )
or
√ √ √
P (0, 1) P (0, 1)
 
e2σ ∆t
(r1d )2 + 2r1d eσ ∆t
cosh σ ∆t 1 − +1− = 0,
2P (0, 2) P (0, 2)

and
√ √
P (0, 1)
  
r1d = e−σ ∆t cosh σ ∆t −1
2P (0, 2)
s 
2
P (0, 1) √ P (0, 1)
− 1 cosh2 σ ∆t + − 1


±
2P (0, 2) P (0, 2)

= 0.078684844 ≃ 7.87%,

and
√
r1u = r1d e2σ ∆t

√ √
P (0, 1)
  
= eσ ∆t cosh σ ∆t −1
2P (0, 2)
s 
2
P (0, 1) √
P (0, 1)
± − 1 cosh σ ∆t +
2
− 1
2P (0, 2) P (0, 2)

= 0.122174525 ≃ 12.22%.

We also find
1 √ rd 1 √ ru
   
µ= σ ∆t + log 1 = −σ ∆t + log 1 = 0.085229181 ≃ 8.52%.
∆t r0 ∆t r0

Exercise 17.15
a) When n = 1 the relation (17.55) shows that fe(t, t, T1 ) = f (t, t, T1 ) with
F (t, x) = c1 e−(T1 −1)x and P (t, T1 ) = c1 ef (t,t,T1 ) , hence

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1 ∂F
D(t, T1 ) := − (t, f (t, t, T1 )) = T1 − t, 0 ≤ t ≤ T1 .
P (t, T1 ) ∂x

b) In general, we have

1 ∂F
D(t, Tn ) = − t, fe(t, t, Tn )


P (t, Tn ) ∂x
n
1 X ˜
= (Tk − t)ck e−(Tk −t)f (t,t,Tn )
P (t, Tn )
k=1
n
X
= (Tk − t)wk ,
k=1

where
ck ˜
wk := e−(Tk −t)f (t,t,Tn )
P (t, Tn )
˜
ck e−(Tk −t)f (t,t,Tn )
= n
X
cl e−(Tl −t)f (t,t,Tl )
l=1
˜
ck e−(Tk −t)f (t,t,Tn )
= n , k = 1, 2, . . . , n,
˜
X
cl e−(Tl −t)f (t,t,Tn )
l=1

and the weights w1 , w2 , . . . , wn satisfy

n
X
wk = 1.
k=1

c) We have

1 ∂2F
C(t, Tn ) = t, fe(t, t, Tn )


P (t, Tn ) ∂x2
n
X
= (Tk − t)2 wk
k=1
Xn n
X
= (Tk − t − D(t, Tn ))2 wk + 2D(t, Tn ) (Tk − t)wk − (D(t, Tn ))2
k=1 k=1
n
X
= (D(t, Tn ))2 + (Tk − t − D(t, Tn ))2 wk
k=1
= (D(t, Tn ))2 + (S(t, Tn ))2 ,

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where
n
X
(S(t, Tn ))2 := (Tk − t − D(t, Tn ))2 wk .
k=1

d) We have
n
1 X
D(t, Tn ) = ck B(Tk − t)eA(Tk −t)+B(Tk −t)fα (t,t,Tn )
P (t, Tn )
k=1
n
1 X
= ck B(Tk − t)eA(Tk −t)+B(Tk −t)fα (t,t,Tn )
eA(Tn −t)+B(Tn −t)fα (t,t,Tn ) k=1
n
X
= ck B(Tk − t)eA(Tk −t)−A(Tn −t)+(B(Tk −t)−B(Tn −t))fα (t,t,Tn ) .
k=1

e) We have
n
1X


e−(Tn −t)b −e−(Tk −t)b fα (t,t,Tn )/b
D(t, Tn ) = 1 − e−(Tk −t)b ck eA(Tk −t)−A(Tn −t)+


b
k=1
n
1X (e−(Tn −t)b −e−(Tk −t)b )
= 1 − e−(Tk −t)b ck eA(Tk −t)−A(Tn −t) (P (t, t + α(Tn − t))


(Tn −t)αb .
b
k=1

Chapter 18

Exercise 18.1
a) By partial differentiation with respect to T under the expectation Ib
E, we
have
∂P ∂ h rT i
(t, T ) = IE∗ e− t rs ds Ft
∂T ∂T h
rT i
= IE∗ − rT e− t rs ds Ft

= −P (t, T )IE[r
b T | Ft ].

b) As a consequence of Question (a), we find

1 ∂P
f (t, T ) = − (t, T ) = Ib
E[rT | Ft ], 0 ≤ t ≤ T, (S.18.86)
P (t, T ) ∂T

see Relation (22) page 10 of Mamon (2004).

c) The martingale property of (f (t, T ))t∈[0,T ] under the forward measure
Ib
E follows from Relation (S.18.86) and the tower property of conditional
expectations as in e.g. (7.1) or (7.42).

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Remark. In the Vasicek model, by (17.2) and (19.9) we have

a wT
rT = r0 e−bT + (1 − e−bT ) + σ e−(T −s)b dWs
b 0
a wT
= r0 e−bT + (1 − e−bT ) + σ e−(T −s)b dW
cs
b 0
σ 2 w T −(T −s)b
− e (1 − e−(T −s)b )ds
b 0
a wT
= r0 e−bT + (1 − e−bT ) + σ e−(T −s)b dW
cs
b 0
w
σ 2 T −(T −s)b w
σ 2 T −2(T −s)b
− e ds + e ds,
b 0 b 0
hence
a wt
Ib
E[rT | Ft ] = r0 e−bT + 1 − e−bT + σ e−(T −s)b dW


cs
b 0
σ 2 w T −(T −s)b σ 2 w T −2(T −s)b
− e ds + e ds
b 0 b 0
a wt
= r0 e−bT + 1 − e−bT + σ e−(T −s)b dWs


b 0
σ 2 w t −(T −s)b
+ e 1−e −(T −s)b


ds
b 0
σ 2 w T −(T −s)b σ 2 w T −2(T −s)b
− e ds + e ds
b 0 b 0
a  a

= r0 e−bT
+ 1−e −bT
+e −(T −t)b
rt − r0 e−bt − 1 − e−bt


b b
σ 2 w t −(T −s)b σ 2 w t −2(T −s)b
+ e ds − e ds
b 0 b 0
2 wT 2 wT
σ σ
− e−(T −s)b ds + e−2(T −s)b ds
b 0 b 0
a  a  σ 2 w T −(T −s)b σ 2 w T −2(T −s)b
= + e−(T −t)b rt − − e ds + e ds
b b b t b t
2 w T −t 2 w T −t
a  a  σ σ
= + e−(T −t)b rt − − e−bs ds + e−2bs ds
b b b 0 b 0
a  a  σ2
σ2
= + e−(T −t)b rt − − 2 1 − e−(T −t)b + 2 1 − e−2(T −t)b


b b b b
σ2 a σ2 σ2

a
= − 2 + e−(T −t)b rt − + 2 − 2 e−2(T −t)b ,
b 2b b b b

which recovers (18.31).

Exercise 18.2 We have

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 w 
T2
P (0, T2 ) = exp − f (t, s)ds = e−r1 T1 −r2 (T2 −T1 ) , t ∈ [0, T2 ],
0

and
 w 
T2
P (T1 , T2 ) = exp − f (t, s)ds = e−r2 (T2 −T1 ) , t ∈ [0, T2 ],
T1

from which we deduce

1
r2 = − log P (T1 , T2 ),
T2 − T1
and
T2 − T1 1
r1 = −r2 − log P (0, T2 )
T1 T1
1 1
= log P (T1 , T2 ) − log P (0, T2 )
T1 T1
1 P (0, T2 )
= − log .
T1 P (T1 , T2 )

Exercise 18.3 (Exercise 4.15 continued).

T
a) We check that P (T, T ) = eXT = 1.
b) We have
1
f (t, T, S) = − XtS − XtT − µ(S − T )


S−T
1
 wt 1 wt 1 
= µ−σ (S − t) dBs − (T − t) dBs
S−T 0 S−s 0 T −s

1 wt S−t
 
T −t
= µ−σ − dBs
S−T 0 S−s T −s
1 w t (T − s)(S − t) − (T − t)(S − s)
= µ−σ dBs
S−T 0 (S − s)(T − s)
σ w t (s − t)(S − T )
= µ+ dBs .
S − T 0 (S − s)(T − s)

c) We have
wt t−s
f (t, T ) = µ − σ dBs .
0 (T − s)2

d) We note that
wt 1
lim f (t, T ) = µ − σ dBs
T ↘t 0 t−s

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does not exist in L2 (Ω).

e) By Itô’s calculus we have

dP (t, T ) 1 XtT
= σdBt + σ 2 dt + µdt − dt
P (t, T ) 2 T −t
1 log P (t, T )
= σdBt + σ 2 dt − dt, t ∈ [0, T ].
2 T −t
f) Letting

1 XtT
rtT := µ + σ 2 −
2 T −t
1 w t dB
s
= µ + σ2 − σ ,
2 0 T −s

by Question (e) we find that

dP (t, T )
= σdBt + rtT dt, 0 ≤ t ≤ T.
P (t, T )

g) The equation of Question (f) can be solved as

σ2 t w t T
 
P (t, T ) = P (0, T ) exp σBt − + rs ds , 0 ≤ t ≤ T,
2 0

hence the process

 w
σ2
  
t
P (t, T ) exp − rsT ds = P (0, T ) exp σBt − t , 0 ≤ t ≤ T,
0 2

is a martingale under P∗ , with the relation

 w    w  
t T
P (t, T ) exp − rsT ds = IE∗ P (T, T ) exp − rsT ds Ft
0 0
  w  
T
∗
= IE exp − T
rs ds Ft , 0 ≤ t ≤ T,
0

showing that
w    w  
t T
P (t, T ) = exp rsT ds IE∗ exp − rsT ds Ft
0 0
 w   w  
t T
∗
= IE exp rs ds exp −
T
rsT ds Ft
0 0
  w  
T
= IE∗ exp − rsT ds Ft , 0 ≤ t ≤ T.
t

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h) By Question (g) we have

P (t, T ) − r t rsT ds
 
dPT 2
IE Ft = e 0 = eσBt −σ t/2 , 0 ≤ t ≤ T.
dP P (0, T )

i) By the Girsanov Theorem, the process B

bt := Bt − σt is a standard Brow-
nian motion under PT .
j) We have
wT S−T
log P (T, S) = −µ(S − T ) + σ dBs
0 S−s
wt S−T wT S−T
= −µ(S − T ) + σ dBs + σ dBs
0 S−s t S−s
S−T w T S−T
= log P (t, S) + σ dBs
S−t t S−s
S−T w T S−T b wT S−T
= log P (t, S) + σ dBs + σ 2 ds
S−t t S−s t S−s
S−T w T S−T b S−t
= log P (t, S) + σ dBs + (S − T )σ 2 log ,
S−t t S−s S−T
0 < T < S.
k) We have

P (t, T ) IET (P (T, S) − K)+ Ft

 

+
= P (t, T ) IE e − K | Ft
 X 

1
 
2 vt
= P (t, T )emt +vt /2 Φ + (mt + vt2 /2 − log κ)
2 vt
1
 
vt
−κP (t, T )Φ − + (mt + vt2 /2 − log κ)
2 vt
1 1
   
mt +vt2 /2
= P (t, T )e Φ vt + (mt − log κ) − κP (t, T )Φ (mt − log κ) ,
vt vt

with
S−T S−t
mt = log P (t, S) + (S − T )σ 2 log
S−t S−T
and
w T (S − T )2
vt2 = σ 2 ds
t (S − s)2

1 1
 
= (S − T )2 σ 2 −
S−T S−t
(T − t)
= (S − T )σ 2 ,
(S − t)

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hence

P (t, T ) IET (P (T, S) − K)+ Ft

 
 (S−T )σ2
S−t 2
= P (t, T )(P (t, S))(S−T )(S−t) evt /2
S−T
(S−T )σ2 !!
1 (P (t, S))(S−T )(S−t) S − t

×Φ vt + log
vt κ S−T
(S−T )σ2 !!
1 (P (t, S)) (S−T )(S−t)

S−t
−κP (t, T )Φ log .
vt κ S−T

Exercise 18.4
a) In the Vašíček (1977) model, by (17.32) we have
  w 
T
P (t, T ) = IE exp − rs ds
t
  w wT 
T
= IE exp − h(s)ds − Xs ds
t t
 w    w 
T T
= exp − h(s)ds IE exp − Xs ds
t t
 w 
T
= exp − h(s)ds + A(T − t) + Xt C(T − t) , 0 ≤ t ≤ T,
t

 w 
T
hence, since X0 = 0 we find P (0, T ) = exp − h(s)ds + A(T ) .
0
b) By the identification
 w 
T
P (t, T ) = exp − h(s)ds + A(T − t) + Xt C(T − t)
t
 w 
T
= exp − f (t, s)ds ,
t

we find
wT wT
h(s)ds = f (t, s)ds + A(T − t) + Xt C(T − t),
t t

and by differentiation with respect ot T this yields

h(T ) = f (t, T ) + A′ (T − t) + Xt C ′ (T − t), 0 ≤ t ≤ T,

where

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4ab − 3σ 2 σ 2 − 2ab σ 2 − ab −b(T −t) σ 2 −2b(T −t)

A(T −t) = + (T −t)+ e − 3e .
4b3 2b2 b3 4b
Given an initial market data curve f M (0, T ), the matching f M (0, T ) =
f (0, T ) can be achieved at time t = 0 by letting

σ 2 − 2ab σ 2 − ab −bT σ 2 −2bT

h(T ) := f M (0, T )+A′ (T ) = f M (0, T )+ − e + 2e ,
2b2 b2 2b
T > 0. Note however that in general, at time t ∈ (0, T ] we will have

h(T ) = f (t, T ) + A′ (T − t) + Xt C ′ (T − t) = f M (0, T ) + A′ (T ),

and the relation

f (t, T ) = f M (0, T ) + A′ (T ) − A′ (T − t) − Xt C ′ (T − t), t ∈ [0, T ],

will allow us to match market data at time t = 0 only, i.e. for the initial
curve. In any case, model calibration is to be done at time t = 0.

Exercise 18.5 (Exercise 4.12 continued,

p see also Proposition 4.1 in Carmona
and Durrleman (2003)). Letting σ := σ12 − 2ρσ1 σ2 + σ22 , we have

dSt = rSt dt + σdWt ,

where (Wt )t∈[0,T ] , is a standard Brownian motions under P∗ , hence

wt
St = S0 ert + σ e(t−s)r dWs , t ≥ 0,
0

The spread ST has a Gaussian distribution with mean α := IE∗ [ST ] = S0 erT
and variance

η 2 := Var∗ [ST ]
 w 
T
= Var σ e(T −s)r dBs
0
wT
2
= σ 2
e(T −s)r ds
0
σ 2 2rT
= e −1 ,


2r
and probability density function

2 !
S0 erT − x
p
r/π
φ(x) = √ exp − , x ∈ R.
σ e2rT − 1 σ 2 e2rT − 1 /r

Hence, we have

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e−rt w ∞ 2 2
e−rt IE∗ [(ST − K)+ ] = p (x − K)+ e−(x−α) /(2η ) dx
2πη 2 −∞
e−rt w ∞ 2 2
= p (x − K)e−(x−α) /(2η ) dx
2πη 2 K
e−rt w ∞ −(x−α)2 /(2η2 ) Ke−rt w ∞ −(x−α)2 /(2η2 )
= p xe dx − p e dx
2πη 2 K 2πη 2 K
−rt w ∞ −rt w
ηe 2 Ke ∞ 2
= √ (x + α)e−x /2 dx − √ e−x /2 dx
2π (K−α)/η 2π (K−α)/η
ηe−rt h −x2 /2 i∞
 
K −α
=−√ e − (K − α)e−rt Φ −
2π (K−α)/η η
ηe−rt −(K−α)2 /(2η2 )
 
K − α
= √ e − (K − α)e−rt Φ − .
2π η

Exercise 18.6 From the definition

1 1
 
L(t, t, T ) = −1 ,
T −t P (t, T )

we have
1
P (t, T ) = ,
1 + (T − t)L(t, t, T )
and similarly
1
P (t, S) = .
1 + (S − t)L(t, t, S)
Hence we get

1 P (t, T )
 
L(t, T, S) = −1
S − T P (t, S)
1 1 + (S − t)L(t, t, S)
 
= −1
S − T 1 + (T − t)L(t, t, T )
1 (S − t)L(t, t, S) − (T − t)L(t, t, T )
 
= .
S−T 1 + (T − t)L(t, t, T )

When T = one year and L(0, 0, T ) = 2%, L(0, 0, 2T ) = 2.5% we find

1 2T L(0, 0, 2T ) − T L(0, 0, T ) 2 × 0.025 − 0.02

 
L(t, T, S) = = = 2.94%,
T 1 + T L(0, 0, T ) 1 + 0.02

so that we would prefer a spot rate at L(T, T, 2T ) = 2% over a forward con-

tract with rate L(0, T, 2T ) = 2.94%.

Exercise 18.7 (Exercise 17.4 continued).

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a) By Definition 18.1, we have

1
f (t, T, S) = (log P (t, T ) − log P (t, S))
S−T
1 σ2 σ2
   
= −(T − t)rt + (T − t)3 − −(S − t)rt + (S − t)3
S−T 6 6
1 σ2
= rt + (T − t) − (S − t) .
3 3


S−T 6
b) We have

f (t, T ) = lim f (t, T, S)

S↘T
∂
=− log P (t, T )
∂T 
σ2

∂
=− −(T − t)rt + (T − t)3
∂T 6
σ2
= rt − (T − t) .2
2
c) We have
dt f (t, T ) = (T − t)σ 2 dt + σdBt .
d) The HJM condition (18.28) is satisfied since the drift of dt f (t, T ) equals
rT
σ t σds.

Exercise 18.8
a) We have
wt
Xt = X0 e−bt + σ e−(t−s)b dBs(1)
0
and wt
Yt = Y0 e−bt + σ e−(t−s)b dBs(2) , t ∈ R+ ,
0

see (17.2).
b) We have

σ2
Var[Xt ] = Var[Yt ] = (1 − e−2bt ), t ∈ R+ ,
2b
see page 478, and therefore
 wt wt 
Cov(Xt , Yt ) = Cov X0 e−bt + σ e−(t−s)b dBs(1) , Y0 e−bt + σ e−(t−s)b dBs(2)
0 0
w wt 
t
= σ Cov
2
e−(t−s)b
dBs , e
(1) −(t−s)b (2)
dBs
0 0

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w wt 
t
= σ 2 IE e−(t−s)b dBs(1) e−(t−s)b dBs(2)
0 0
wt
= ρσ 2
e−2(t−s)b
ds
0
2
σ
=ρ 1 − e−2bt ,


t ∈ R+ .
2b
c) We have

Cov(log P (t, T1 ), log P (t, T2 ))

= Cov log F1 (t, Xt , T1 )F2 (t, Yt , T2 )eρU (t,T1 ) , log F1 (t, Xt , T1 )F2 (t, Yt , T2 )eρU (t,T2 )

= Cov C1T1 + Xt AT1 1 + C2T1 + Yt AT2 1 , C1T2 + Xt AT1 2 + C2T2 + Yt AT2 2

= Cov Xt AT1 1 + Yt AT2 1 , Xt AT1 2 + Yt AT2 2

= AT1 1 AT1 2 Var[Xt ] + AT2 1 AT2 2 Var[Yt ] + AT1 1 AT2 2 + AT1 2 AT2 1 Cov(Xt , Yt )

= AT1 1 AT1 2 + AT2 1 AT2 2 + ρ AT1 1 AT2 2 + AT1 2 AT2 1 Var[Xt ].

When Cov(Xt , Yt ) = ρ Var[Xt ] = ρ Var[Yt ], we find the correlation

Cov(log P (t, T1 ), log P (t, T2 ))

Cov(log P (t, T1 ), log P (t, T2 )) = p
Var[log P (t, T1 )] Var[log P (t, T2 )]
AT1 AT2 + AT2 1 AT2 2 + ρ AT1 1 AT2 2 + AT1 2 AT2 1


= q1 1

2
2
AT1 1 + AT2 1 + ρ AT1 1 AT2 1 + AT1 1 AT2 1

1
×q
2
2
.
AT1 2 + AT2 2 + ρ AT1 2 AT2 2 + AT1 2 AT2 2

When ρ = 1, we find

Cov(log P (t, T1 ), log P (t, T2 ))

AT1 1 AT1 2 + AT2 1 AT2 2 + AT1 1 AT2 2 + AT1 2 AT2 1
= q q
T1 2 T1 2

2
2
+ A2 + AT1 1 AT2 1 + AT1 1 AT2 1 AT1 2 + AT2 2 + AT1 2 AT2 2 + AT1 2 AT2 2



A1
AT1 1 + AT2 1 + AT2 2

T2

A1
=
AT1 1 + AT2 1 AT1 2 + AT2 2
= ±1.

For example, if AT1 1 = 4, AT1 2 = 1, AT2 1 = 1 and AT2 2 = 4, we find

8 + 17ρ
Cov(log P (t, T1 ), log P (t, T2 )) = .
17 + 8ρ

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0.5
Correlation

-0.5

-1
-1 -0.5 0 0.5 1
ρ

Fig. S.81: Log bond prices correlation graph in the two-factor model.

Exercise 18.9
a) We have
wt wt
f (t, x) = f (0, x) + α s2 ds + σ ds B(s, x) = r + αtx2 + σB(t, x).
0 0

b) We have
rt = f (t, 0) = r + B(t, 0) = r.
c) We have
 w 
T
P (t, T ) = exp − f (t, s)ds
t
 w T −t w T −t 
= exp −(T − t)r − αt s2 ds − σ B(t, x)dx
0 0

α w T −t 
= exp −(T − t)r − t(T − t) − σ 3
B(t, x)dx , t ∈ [0, T ].
3 0

d) Using (18.43), we have

w T −t 2 # w
T −t w T −t
"
IE B(t, x)dx = IE[B(t, x)B(t, y)]dxdy
0 0 0
w T −t w T −t
=t min(x, y)dxdy
0 0
w T −t w y 1
= 2t xdxdy = t(T − t)3 .
0 0 3
e) By Question (d) we have
 
α w T −t 
IE[P (t, T )] = IE exp −(T − t)r − t(T − t)3 − σ B(t, x)dx
3 0

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 α    w T −t 
= exp −(T − t)r − t(T − t)3 IE exp −σ B(t, x)dx
3 0
 2 w 
 α  σ T −t
= exp −(T − t)r − t(T − t)3 exp Var B(t, x)dx
3 2 0

σ2
 
α
= exp −(T − t)r − t(T − t) +
3 3
t(T − t) , 0 ≤ t ≤ T.
3 6

f) By Question (e) we check that the required relation is satisfied if

α σ2
− t(T − t)3 + t(T − t)3 = 0,
3 6
i.e. α = σ 2 /2.

Remark: In order to derive an analog of the HJM absence of arbitrage con-

dition in this stochastic string model, one would have to check whether the
discounted bond price e−rt P (t, T ) can be a martingale by doing stochastic
calculus with respect to the Brownian sheet B(t, x).
g) We have
  w  
T
IE exp − rs ds (P (T, S) − K)+
0
w S−T
"   + #
α
= e−rT IE exp −(S − T )r − T (S − T )3 + σ B(T, x)dx − K
3 0

= e−rT IE (xem+X − K)+ ,

 

where x = e−(S−T )r , m = −αT (S − T )3 /3, and

w S−T
X=σ B(T, x)dx ≃ N (0, σ 2 t(T − t)3 /3).
0

Given the relation α = σ 2 /2, this yields

  w  
T
IE exp − rs ds (P (T, S) − K)+
0
!
log(e−(S−T )r /K)
= e−rS Φ σ T (S − T )3 /12 + p
p
σ T (S − T )3 /3
!
log(e−(S−T )r /K)
T (S − T )3 /12 + p
p
−Ke−rT Φ −σ
σ T (S − T )3 /3
!
log(e−(S−T )r /K)
= P (0, S)Φ σ T (S − T ) /12 + p
p
3
σ T (S − T )3 /3

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!
log(e−(S−T )r /K)
−KP (0, T )Φ −σ T (S − T )3 /12 +
p
.
σ T (S − T )3 /3
p

Chapter 19

Exercise 19.1
a) We price the floorlet at t = 0, with T1 = 9 months, T2 = 1 year, κ = 4.5%.
The LIBOR rate (L(t, T1 , T2 ))t∈[0,T1 ] is modeled as a driftless geometric
Brownian motion with volatility coefficient σ b = σ1,2 (t) = 0.1 under the
forward measure P2 . The discount factors are given by

P (0, T1 ) = e−9r/12 ≃ 0.970809519

and
P (0, T2 ) = e−r ≃ 0.961269954,
with r = 3.95%.
b) By (19.21), the price of the floorlet is
h r T2 i
IE∗ e− 0 rs ds (κ − L(T1 , T1 , T2 ))+
= P (0, T2 ) κΦ − d− (T1 ) − L(0, T1 , T2 )Φ − d+ (T1 ) , (S.19.87)

where
log(L(0, T1 , T2 )/κ) + σ 2 T1 /2
d+ (T1 ) = √ ,
σ1 T1
and
log(L(0, T1 , T2 )/κ) − σ 2 T1 /2
d− (T1 ) = √ ,
σ T1
are given in Proposition 19.5, and the LIBOR rate L(0, T1 , T2 ) is given by

P (0, T1 ) − P (0, T2 )
L(0, T1 , T2 ) =
(T2 − T1 )P (0, T2 )
e−3r/4 − e−r
=
0.25e−r
= 4(er/4 − 1)
≃ 3.9695675%.

Hence, we have

log(0.039695675/0.045) + (0.1)2 × 0.75/2

d+ (T1 ) = √ ≃ −1.404927033,
0.1 × 0.75

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and
log(0.039695675/0.045) − (0.1)2 × 0.75/2
d− (T1 ) = √ ≃ −1.491529573,
0.1 × 0.75
hence
h r T2 i
IE∗ e− 0 rs ds (κ − L(T1 , T1 , T2 ))+
= 0.961269954 × (κΦ(1.491529573) − L(0, T1 , T2 ) × Φ(1.404927033))
= 0.961269954 × (0.045 × 0.932089 − 0.039695675 × 0.919979)
≃ 0.52147141%.

Finally, we need to multiply (S.19.87) by the notional principal amount of

$1 million per interest rate percentage point, i.e. $10, 000 per percentage
point or $100 per basis point, which yields $5214.71.

Exercise 19.2
a) We price the swaption at t = 0, with T1 = 4 years, T2 = 5 years, T3 = 6
years, T4 = 7 years, κ = 5%, and the swap rate (S(t, T1 , T4 ))t∈[0,T1 ] is
modeled as a driftless geometric Brownian motion with volatility coeffi-
cient σ
b = σ1,4 (t) = 0.2 under the forward swap measure P1.4 . The discount
factors are given by P (0, T1 ) = e−4r , P (0, T2 ) = e−5r , P (0, T3 ) = e−6r ,
P (0, T4 ) = e−7r , where r = 5%.
b) By Proposition 19.17 the price of the swaption is

(P (0, T1 ) − P (0, T4 ))Φ(d+ (T1 − t))

−κΦ(d− (T1 ))(P (0, T2 ) + P (0, T3 ) + P (0, T4 )),

where d+ (T1 ) and d− (T1 ) are given in Proposition 19.17, and the LIBOR
swap rate S(0, T1 , T4 ) is given by

P (0, T1 ) − P (0, T4 )
S(0, T1 , T4 ) =
P (0, T1 , T4 )
P (0, T1 ) − P (0, T4 )
=
P (0, T2 ) + P (0, T3 ) + P (0, T4 )
e−4r − e−7r
=
e−5r + e−6r + e−7r
e3r − 1
=
e2r + er + 1
e0.15 − 1
=
e0.1 + e0.05 + 1
= 0.051271096.

By Proposition 19.17 we also have

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log(0.051271096/0.05) + (0.2)2 × 4/2

d+ (T1 ) = √ = 0.526161682,
0.2 4
and
log(0.051271096/0.05) − (0.2)2 2 × 4/2
d− (T1 ) = √ = 0.005214714,
0.2 4
Hence, the price of the swaption is given by

(e−4r − e−7r )Φ(0.526161682) (S.19.88)

−κΦ(0.005214714)(e−5r + e−6r + e−7r )
= (0.818730753 − 0.70468809) × 0.700612
−0.05 × 0.50208 × (0.818730753 + 0.740818221 + 0.70468809)
= 2.3058251%.

Finally, we need to multiply (S.19.88) by the notional principal amount of

$10 million, i.e. $100, 000 by interest percentage point, or $1, 000 by basis
point, which yields $230, 582.51.

Exercise 19.3 Taking t = 0, we have T1 = 3, T2 = 4 and T3 = 5. The LIBOR

swap rate S(t, T1 , T3 ) is modeled as a driftless geometric Brownian motion
with volatility σ = 0.1 under the forward swap measure P bi,j . The receiver
swaption is priced using the Black-Scholes formula as
h r T1 i
+
IE∗ e− t rs ds P (T1 , T1 , T3 ) (κ − S(T1 , T1 , T3 )) Ft
2
X
= κΦ(−d− (T1 − t)) (Tk+1 − Tk )P (t, Tk+1 )
k=1
−(P (t, T1 ) − P (t, T3 ))Φ(−d+ (T1 − t)),

where κ = 5%, r = 2% and P (t, T1 ) = e−3r = 0.9417, P (t, T2 ) = e−4r =

0.9231, P (t, T3 ) = e−5r = 0.9048. Hence,

P (t, T1 , T3 ) = P (t, T2 ) + P (t, T3 ) = 0.92311 + 0.90483 = 1.82794

and
P (t, T1 ) − P (t, T3 ) 0.9417 − 0.9048
S(t, T1 , T3 ) = = = 0.02018.
P (t, T1 , T3 ) 1.82794

We also have
log(S(t, T1 , T3 )/κ) + σ 2 (T1 − t)/2
d+ (T1 − t) = √
σ T1 − t

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log(2.018/5) + 0.12 × 3/2

= √ = −5.1518
0.1 3
and p
d− (T1 − t) = d+ (T1 − t) − σ T1 − t = −5.3250,
hence
h r T1 i
+
IE∗ e− t rs ds P (T1 , T1 , T3 ) (κ − S(T1 , T1 , T3 )) Ft
= 0.05 × 1.82794 × Φ(5.3250) − (0.9417 − 0.9048) × Φ(5.1518)
= 0.05 × 1.82794 × 0.9999999 − (0.9417 − 0.9048) × 0.9999999
= 0.054496
= 5.4496%
= 544.96 bp,

which yields $54, 496 after multiplication by the $10, 000 notional principal.

Exercise 19.4
a) We have

P (t, T2 ) dP (t, T2 ) 1 1
     
d = + P (t, T2 )d + dP (t, T2 ) • d
P (t, T1 ) P (t, T1 ) P (t, T1 ) P (t, T1 )
dP (t, T2 ) dP (t, T1 ) dP (t, T1 ) • dP (t, T1 )
 
= + P (t, T2 ) − +
P (t, T1 ) (P (t, T1 ))2 (P (t, T1 ))3
dP (t, T1 ) • dP (t, T2 )
−
(P (t, T1 ))2
1
= rt P (t, T2 )dt + ζ2 (t)P (t, T2 )dWt


P (t, T1 )
P (t, T2 )
rt P (t, T1 )dt + ζ1 (t)P (t, T1 )dWt


−
(P (t, T1 ))2
P (t, T2 )
+ (rt P (t, T1 )dt + ζ1 (t)P (t, T1 )dWt )2


(P (t, T1 ))3
1
(rt P (t, T1 )dt + ζ1 (t)P (t, T1 )dWt ) • (rt P (t, T2 )dt + ζ2 (t)P (t, T2 )dWt )


−
(P (t, T1 ))2
P (t, T2 ) P (t, T2 )
= ζ2 (t) dWt − ζ1 (t) dWt
P (t, T1 ) P (t, T1 )
P (t, T2 ) P (t, T2 )
+ (ζ1 (t))2 dt − ζ1 (t)ζ2 (t) dt
P (t, T1 ) P (t, T1 )
P (t, T2 ) P (t, T2 )
=− ζ1 (t)(ζ2 (t) − ζ1 (t))dt + (ζ2 (t) − ζ1 (t))dWt
P (t, T1 ) P (t, T1 )

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P (t, T2 )
= (ζ2 (t) − ζ1 (t))(dWt − ζ1 (t)dt)
P (t, T1 )
P (t, T2 ) c P (t, T2 ) c
= (ζ2 (t) − ζ1 (t)) dWt = (ζ2 (t) − ζ1 (t)) dWt ,
P (t, T1 ) P (t, T1 )

where dW ct = dWt − ζ1 (t)dt is a standard Brownian motion under the

T1 -forward measure P.
b
b) From Question (a) or (19.7) we have

P (T1 , T2 )
P (T1 , T2 ) =
P (T1 , T1 )
w w T1
P (t, T2 ) cs − 1

T1
= exp (ζ2 (s) − ζ1 (s))dW (ζ2 (s) − ζ1 (s))2 ds
P (t, T1 ) t 2 t
P (t, T2 ) X−v2 /2
= e ,
P (t, T1 )

where X is a centered Gaussian random variable with variance v 2 =

w T1
(ζ2 (s) − ζ1 (s))2 ds, independent of Ft under P. b Hence by the hint
t
(19.43) with x := P (t, T2 )/P (t, T1 ) and κ := K/x, we find
h r T1 i
IE∗ e− 0 rs ds (K − P (T1 , T2 ))+ Ft = P (t, T1 )Ib E (K − P (T1 , T2 ))+ | Ft
 

1 P (t, T2 ) 1
    
v K v K
= P (t, T1 ) KΦ + log − Φ − + log
2 v x P (t, T1 ) 2 v x
1 1
   
v K v K
= KP (t, T1 )Φ + log − P (t, T2 )Φ − + log .
2 v x 2 v x

Exercise 19.5
a) The forward measure P
bS is defined from the numéraire Nt := P (t, S) and
this gives
Ft = P (t, S)Ib
E[(κ − L(T, T, S))+ | Ft ].
b) The LIBOR rate L(t, T, S) is a driftless geometric Brownian motion with
volatility σ under the forward measure P bS . Indeed, the LIBOR rate
L(t, T, S) can be written as the forward price L(t, T, S) = X bt = Xt /Nt
where Xt = (P (t, T ) − Pr (t, S))/(S − T ) and rNt = P (t, S). Since both dis-
t t
counted bond prices e− 0 rs ds P (t, T ) and e− 0 rs ds P (t, S) are martingales
under P , the same is true of Xt . Hence L(t, T, S) = Xt /Nt becomes a
∗

martingale under the forward measure P bS by Proposition 16.4, and com-

puting its dynamics under P bS amounts to removing any “dt” term in
(19.44) after rewriting the equation in terms of the standard Brownian
motion (W ct )t∈R under P
+
bS , i.e. we have

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dL(t, T, S) = σL(t, T, S)dW

ct ,

2
which is solved as L(t, T, S) = L(0, T, S)eσW
b t −σ t/2
, 0 ≤ t ≤ T.
c) We find

Ft = P (t, S)Ib
E[(κ − L(T, T, S))+ | Ft ]
2
= P (t, S)IE[(κ
b − L(t, T, S)e−(T −t)σ /2+(W b t )σ )+ | F ]
b T −W
t

= P (t, S)(κΦ(−d− (T − t)) − X bt Φ(−d+ (T − t)))

= κP (t, S)Φ(−d− (T − t)) − P (t, S)L(t, T, S)Φ(−d+ (T − t))
= κP (t, S)Φ(−d− (T − t)) − (P (t, T ) − P (t, S))Φ(−d+ (T − t))/(S − T ),
2
where em = L(t, T, S)e−(T −t)σ , v 2 = (T − t)σ 2 , and
/2

√
log(L(t, T, S)/κ) σ T − t
d+ (T − t) = √ + ,
σ T −t 2

and √
log(L(t, T, S)/κ) σ T − t
d− (T − t) = √ − ,
σ T −t 2
because L(t, T, S) is a driftless geometric Brownian motion with volatility
σ under the forward measure P bS .

Exercise 19.6
a) We have
j−1
X
P (Ti , Ti , Tj ) = cl+1 P (Ti , Tl+1 ).
l=i

b) It suffices to let c̃l = 1, l = i + 1, . . . , j − 1. and c̃j = cj + 1/κ.

c) The swaption can be priced as
h r Ti
+ i
IE∗ e− t rs ds P (Ti , Ti ) − P (Ti , Tj ) − κP (Ti , Ti , Tj ) Ft

j−1
!+ 
r Ti X
= IE∗ e− t rs ds 1 − κ c̃l+1 P (Ti , Tl+1 ) Ft 
l=i

j−1 j−1
!+ 
r Ti X X
∗
= κ IE e − t rs ds
c̃l+1 Fl+1 (Ti , γκ ) − c̃l+1 Fl+1 (Ti , rTi ) Ft 
l=i l=i

j−1
!+ 
r Ti X
∗
= κ IE e− t rs ds
c̃l+1 (Fl+1 (Ti , γκ ) − Fl+1 (Ti , rTi )) Ft 
l=i

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j−1
" #
r Ti
1{rTi ≤γκ }
X
∗
= κ IE e
− t rs ds
c̃l+1 (Fl+1 (Ti , γκ ) − Fl+1 (Ti , rTi )) Ft
l=i
j−1
" #
r Ti X +
= κ IE∗ e− t rs ds
c̃l+1 (Fl+1 (Ti , γκ ) − Fl+1 (Ti , rTi )) Ft
l=i
j−1
X h r Ti i
+
=κ c̃l+1 IE∗ e− t rs ds (Fl+1 (Ti , γκ ) − P (Ti , Tl+1 )) Ft
l=i
j−1
X
=κ c̃l+1 P (t, Ti )Ib
Ei (Fl+1 (Ti , γκ ) − P (Ti , Tl+1 ))+ Ft ,
 

l=i

which is a weighted sum of bond put option prices with strike prices
Fl+1 (Ti , γκ ), l = i, i + 1, . . . , j − 1.

Exercise 19.7
a) We have
dP (t, Ti )
= rt dt + ζ (i) (t)dBt , i = 1, 2,
P (t, Ti )
and
w wT 1 w T (i)

T
P (T, Ti ) = P (t, Ti ) exp rs ds + ζ (i) (s)dBs − |ζ (s)|2 ds ,
t t 2 t

0 ≤ t ≤ T ≤ Ti , i = 1, 2, hence
wT wT 1 w T (i)
log P (T, Ti ) = log P (t, Ti ) + rs ds + ζ (i) (s)dBs − |ζ (s)|2 ds,
t t 2 t
0 ≤ t ≤ T ≤ Ti , i = 1, 2, and
1
d log P (t, Ti ) = rt dt + ζ (i) (t)dBt − |ζ (i) (t)|2 dt, i = 1, 2.
2
In the present model, we have

drt = σdBt ,

where (Bt )t∈R+ is a standard Brownian motion under P, by the solution

of Exercise 17.4 and (17.25) we have

ζ (i) (t) = −(Ti − t)σ, 0 ≤ t ≤ Ti , i = 1, 2.

Letting
(i)
dBt = dBt − ζ (i) (t)dt,
defines a standard Brownian motion under Pi , i = 1, 2, and we have

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w
P (T, T1 ) P (t, T1 ) 1 w T (1)

T
= exp (ζ (1) (s) − ζ (2) (s))dBs − (|ζ (s)|2 − |ζ (2) (s)|2 )ds
P (T, T2 ) P (t, T2 ) t 2 t
w
P (t, T1 ) 1 w T (1)

T
= exp (ζ (1) (s) − ζ (2) (s))dBs(2) − (ζ (s) − ζ (2) (s))2 ds ,
P (t, T2 ) t 2 t

which is an Ft -martingale under P2 and under P1,2 , and

 w
P (T, T2 ) P (t, T2 ) 1 w T (1)

T
= exp − (ζ (1) (s) − ζ (2) (s))dBs(1) − (ζ (s) − ζ (2) (s))2 ds ,
P (T, T1 ) P (t, T1 ) t 2 t

which is an Ft -martingale under P1 .

b) We have
1
f (t, T1 , T2 ) = − (log P (t, T2 ) − log P (t, T1 ))
T2 − T1
1 σ2
= rt + ((T1 − t)3 − (T2 − t)3 ).
T2 − T1 6

c) We have

1 P (t, T2 )
df (t, T1 , T2 ) = − d log
T2 − T1 P (t, T1 )
1 1
 
=− (ζ (2) (t) − ζ (1) (t))dBt − (|ζ (2) (t)|2 − |ζ (1) (t)|2 )dt
T2 − T1 2
1 1
 
(2)
=− (ζ (t) − ζ (t))(dBt + ζ (2) (t)dt) − (|ζ (2) (t)|2 − |ζ (1) (t)|2 )dt
(2) (1)
T2 − T1 2
1 1 (2)
 
(2)
=− (ζ (t) − ζ (t))dBt − (ζ (t) − ζ (t))2 dt .
(2) (1) (1)
T2 − T1 2

d) We have

1 P (T, T2 )
f (T, T1 , T2 ) = − log
T2 − T1 P (T, T1 )
w
1 1

T
= f (t, T1 , T2 ) − (ζ (2) (s) − ζ (1) (s))dBs − (|ζ (2) (s)|2 − |ζ (1) (s)|2 )ds
T2 − T1 t 2
w
1 1 w T (2)

T
= f (t, T1 , T2 ) − (ζ (s) − ζ (s))dBs −
(2) (1) (2)
(ζ (s) − ζ (1) (s))2 ds
T2 − T1 t 2 t
w
1 1 w T (2)

T
= f (t, T1 , T2 ) − (ζ (2) (s) − ζ (1) (s))dBs(1) + (ζ (s) − ζ (1) (s))2 ds .
T2 − T1 t 2 t

Hence f (T, T1 , T2 ) has a Gaussian distribution given Ft with conditional

mean
1 w T (2)
m1 := f (t, T1 , T2 ) − (ζ (s) − ζ (1) (s))2 ds
2 t

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under P1 , resp.
1 w T (2)
m2 := f (t, T1 , T2 ) + (ζ (s) − ζ (1) (s))2 ds
2 t
under P2 , and variance
1 wT
v2 = (ζ (2) (s) − ζ (1) (s))2 ds.
(T2 − T1 )2 t

Hence, we have
h r T2 i
(T2 − T1 ) IE∗ e− t rs ds (f (T1 , T1 , T2 ) − κ)+ Ft
= (T2 − T1 )P (t, T2 ) IE2 (f (T1 , T1 , T2 ) − κ)+ Ft
 

= (T2 − T1 )P (t, T2 ) IE2 (m2 + X − κ)+ Ft

 
 
v 2 2
= (T2 − T1 )P (t, T2 ) √ e−(κ−m2 ) /(2v ) + (m2 − κ)Φ((m2 − κ)/v) .
2π

e) We have

L(T, T1 , T2 ) = S(T, T1 , T2 )
1 P (T, T1 )
 
= −1
T2 − T1 P (T, T2 )
1
=
T2 − T1
w
P (t, T1 ) 1 w T (1)
  
T
× exp (ζ (1) (s) − ζ (2) (s))dBs − (|ζ (s)|2 − |ζ (2) (s)|2 )ds − 1
P (t, T2 ) t 2 t
1
=
T2 − T1
w
P (t, T1 ) 1 w T (1)
  
T
× exp (ζ (1) (s) − ζ (2) (s))dBs(2) − (ζ (s) − ζ (2) (s))2 ds − 1
P (t, T2 ) t 2 t
1
=
T2 − T1
w
P (t, T1 ) 1 w T (1)
  
T
× exp (ζ (1) (s) − ζ (2) (s))dBs(1) + (ζ (s) − ζ (2) (s))2 ds − 1 ,
P (t, T2 ) t 2 t

and, by Itô calculus,

1 P (t, T1 )
 
dS(t, T1 , T2 ) = d
T2 − T1 P (t, T2 )
1 P (t, T1 ) 1

= (ζ (t) − ζ (2) (t))dBt + (ζ (1) (t) − ζ (2) (t))2 dt
(1)
T2 − T1 P (t, T2 ) 2
1

− (|ζ (1) (t)|2 − |ζ (2) (t)|2 )dt
2

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1
  
= + S(t, T1 , T2 ) (ζ (1) (t) − ζ (2) (t))dBt + ζ (2) (t)(ζ (2) (t) − ζ (1) (t))dt)dt
T2 − T1
1
  
(1)
= + S(t, T1 , T2 ) (ζ (1) (t) − ζ (2) (t))dBt + (|ζ (2) (t)|2 − |ζ (1) (t)|2 )dt
T2 − T1
1
 
(2)
= + S(t, T1 , T2 ) (ζ (1) (t) − ζ (2) (t))dBt , t ∈ [0, T1 ],
T2 − T1

hence t 7→ 1
T2 −T1 + S(t, T1 , T2 ) is a geometric Brownian motion, with

1
+ S(T, T1 , T2 )
T2 − T1
1
 
= + S(t, T1 , T2 )
T2 − T1
w
1 w T (1)

T
× exp (ζ (1) (s) − ζ (2) (s))dBs(2) − (ζ (s) − ζ (2) (s))2 ds ,
t 2 t

0 ≤ t ≤ T ≤ T1 .
f) We have
h r T2 i
(T2 − T1 ) IE∗ e− t rs ds (L(T1 , T1 , T2 ) − κ)+ Ft
h r T1 i
= (T2 − T1 ) IE∗ e− t rs ds P (T1 , T2 )(L(T1 , T1 , T2 ) − κ)+ Ft
= P (t, T1 , T2 ) IE1,2 (S(T1 , T1 , T2 ) − κ)+ Ft .
 

The forward measure P2 is defined by

P (t, T2 ) − r t rs ds
 
dP2
IE∗ Ft = e 0 , 0 ≤ t ≤ T2 ,
dP P (0, T2 )

and the forward swap measure is defined by

P (t, T2 ) − r t rs ds
 
dP1,2
IE∗ Ft = e 0 , 0 ≤ t ≤ T1 ,
dP P (0, T2 )
(2)

hence P2 and P1,2 coincide up to time T1 and Bt t∈[0,T1 ] is a standard
Brownian motion until time T1 under P2 and under P1,2 , consequently
under P1,2 we have

L(T, T1 , T2 ) = S(T, T1 , T2 )
1 1
  r r
T (1) (2) (2) 1 T (1) (2) 2
=− + + S(t, T1 , T2 ) e t (ζ (s)−ζ (s))dBs − 2 t (ζ (s)−ζ (s)) ds ,
T2 − T1 T2 − T1

has same distribution as

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 Solutions Manual

1 P (t, T1 ) X−Var[X]/2
 
e −1 ,
T2 − T1 P (t, T2 )

where X is a centered Gaussian random variable with variance

w T1
(ζ (1) (s) − ζ (2) (s))2 ds
t

given Ft . Hence, we have

h r T2 i
(T2 − T1 ) IE∗ e− t rs ds (L(T1 , T1 , T2 ) − κ)+ Ft
= P (t, T1 , T2 )
r T1 (1)
1 (ζ (s) − ζ (2) (s))2 ds 1
 
×Bl + S(t, T1 , T2 ), t ,κ + , T1 − t .
T2 − T1 T1 − t T2 − T1

Exercise 19.8
a) The LIBOR rate L(t, T, S) is a driftless geometric Brownian motion with
deterministic volatility function σ(t) under the forward measure P
bS .

Explanation: The LIBOR rate L(t, T, S) can be written as the forward

price L(t, T, S) = X bt = Xt /Nt where Xt = (P (t, T ) − P (t, S))/(S − T )
rt
andr Nt = P (t, S). Since both discounted bond prices e− 0 rs ds P (t, T ) and
t
e− 0 rs ds P (t, S) are martingales under P∗ , the same is true of Xt . Hence
L(t, T, S) = Xt /Nt becomes a martingale under the forward measure P bS
by Proposition 16.4, and computing its dynamics under P bS amounts to
removing any “dt” term in the original SDE defining L(t, T, S), i.e. we
find
dL(t, T, S) = σ(t)L(t, T, S)dW
ct , 0 ≤ t ≤ T,
hence
w wt 
t
L(t, T, S) = L(0, T, S) exp cs −
σ(s)dW σ 2 (s)ds/2 ,
0 0

where (W
ct )t∈R is a standard Brownian motion under P
+
bS .
b) Choosing the annuity numéraire Nt = P (t, S), we have
h rS i h rS i
IE∗ e− t rs ds ϕ(L(T, T, S)) Ft = IE∗ e− t rs ds NS ϕ(L(T, T, S)) Ft

= Nt Ib
E ϕ(L(T, T, S)) Ft
 

= P (t, S)IE[ϕ(L(T,
b T, S)) | Ft ].

c) Given the solution

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Introduction to Stochastic Finance with Market Examples, Second Edition

w wT 
T
L(T, T, S) = L(0, T, S) exp cs −
σ(s)dW σ 2 (s)ds/2
0 0
w wT 
T
= L(t, T, S) exp cs −
σ(s)dW σ 2 (s)ds/2 ,
t t

we find

P (t, S)IE
b [ϕ(L(T, T, S)) | Ft ]
h  rT r  i
= P (t, S)IbE ϕ L(t, T, S)e t σ(s)dWb s − tT σ2 (s)ds/2 F
t
w∞ 2 2 2 dx
= P (t, S) ϕ L(t, T, S)ex−η /2 e−x /(2η ) p


,
−∞ 2πη 2
wT
because σ(s)dWcs is a centered Gaussian variable with variance η 2 :=
wT t

σ 2 (s)ds, independent of Ft under the forward measure P.

b
t

Chapter 20

Exercise 20.1 For any x ∈ [0, T ], we have

P(T − TNT > x and NT ≥ 1)

P(T − TNT > x | NT ≥ 1) =
P(NT ≥ 1)
P(NT − NT −x = 0 and NT ≥ 1)
=
P(NT ≥ 1)
P(NT − NT −x = 0 and NT −x ≥ 1)
=
P(NT ≥ 1)
P(NT − NT −x = 0)P(NT −x ≥ 1)
=
P(NT ≥ 1)
e−(T −(T −x))λ (1 − e−(T −x)λ )
=
1 − e−λT
e−(T −(T −x))λ
− e−λT
=
1 − e−λT
e−λx − e−λT
= , 0 ≤ t ≤ T.
1 − e−λT

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Nt

0
T1 T2 T3 T4 T5 TNT T −x T t

We note that

P(T − TNT > 0 | NT ≥ 1) = 1 and P(T − TNT > T | NT ≥ 1) = 0.

Exercise 20.2
a) When t ∈ [0, T1 ), the equation reads

dSt = −ηλSt- dt = −ηλSt dt,

which is solved as St = S0 e−ηλt , 0 ≤ t < T1 . Next, at the first jump time

t = T1 we have

∆St := St − St- = ηSt- dNt = ηSt- ,

which yields St = (1 + η)St- , hence ST1 = (1 + η)ST1- = S0 (1 + η)e−ηλT1 .

Repeating this procedure over the Nt jump times contained in the interval
[0, t] we get
St = S0 (1 + η)Nt e−ληt , t ≥ 0.
b) When t ∈ [0, T1 ) the equation reads

dSt = −ηλSt- dt = −ηλSt dt,

which is solved as St = S0 e−ηλt , 0 ≤ t < T1 . Next, at the first jump time

t = T1 we have
dSt = St − St- = dNt = 1,
which yields St = 1 + St- , hence ST1 = 1 + ST1- = 1 + S0 e−ηλT1 , and for
t ∈ [T1 , T2 ) we will find

St = (1 + S0 e−ηλT1 )e−(t−T1 )ηλ , T1 ≤ t < T2 .

More generally, the equation can be solved by letting Yt := eηλt St and

noting that (Yt )t∈R+ satisfies dYt = eληt dNt , which has the solution
wt
Yt = Y0 + eηλs dNs , t ≥ 0,
0

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hence in general we have

wt
St = e−ηλt S0 + e−(t−s)ηλ dNs , t ≥ 0,
0

Exercise 20.3
a) Taking expectations on both sides of (20.40), we have

u(t) = IE[St ]
 wt wt wt 
= IE S0 + µ Ss ds + σ Ss dBs + η Ss- dYs
0 0 0
 w   w   w 
t t t
= IE[S0 ] + IE µ Ss ds + IE σ Ss dBs + IE η Ss- dYs
0 0 0
wt wt
= S0 + µ IE[Ss ]ds + 0 + ηλ IE[Z] IE[Ss- ]ds
0 0
wt wt
= S0 + µ u(s)ds + ηλ IE[Z] u(s)ds, , t ≥ 0.
0 0

b) The above equation can be rewritten in differential form as

u′ (t) = µu(t) + ηλ IE[Z]u(t)

with u(0) = S0 , which admits the solution

IE[St ] = u(t) = u(0)e(µ+ηλ IE[Z])t = S0 e(µ+ηλ IE[Z])t , t ≥ 0.

Exercise 20.4
a) We have

 X0 e , 0 ≤ t < T1 ,
 αt




X0 eαT1 + σ e(t−T1 )α = X0 eαt + σe(t−T1 )α , T1 ≤ t < T2 ,




Xt =
  
X0 eαT1 + σ e(T2 −T1 )α + σ e(t−T2 )α







= X0 eαt + σe(t−T1 )α + σe(t−T2 )α , T2 ≤ t < T3 ,


and more generally the solution (Xt )t∈R+ can be written as

Nt
X wt
Xt = X0 eαt + σ e(t−Tk )α = X0 eαt + σ e(t−s)α dNs , t ≥ 0.
0
k=1
(S.20.89)
b) Letting f (t) := IE[Xt ] and taking expectation on both sides of the stochas-
tic differential equation dXt = αXt dt + σdNt we find

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df (t) = αf (t)dt + σλdt,

or
f ′ (t) = αf (t) + σλ.
Letting g(t) = f (t)e −αt
, we check that

g ′ (t) = σλe−αt ,

hence
wt wt λ
g(t) = g(0) + g ′ (s)ds = g(0) + σλ e−αs ds = f (0) + σ (1 − e−αt ),
0 0 α
and

f (t) = IE[Xt ]
= g(t)eαt
λ
= f (0)eαt + σ (eαt − 1)
α
λ
= X0 eαt + σ (eαt − 1), t ≥ 0.
α
We could also take the expectation on both sides of (S.20.89) and directly
find
wt λ
f (t) = IE[Xt ] = X0 eαt +σλ e(t−s)α ds = X0 eαt +σ (eαt −1), t ≥ 0.
0 α
Exercise 20.5
Nt
Y
a) We have Xt = X0 (1 + σ) = X0 (1 + σ)Nt = (1 + σ)Nt , t ∈ R+ .
k=1
b) By stochastic calculus and using the relation dXt = σXt- dNt , we have
 wt   w
t

dSt = d S0 Xt + rXt Xs−1 ds = S0 dXt + rd Xt Xs−1 ds
0 0
w  w  w 
t t t
= S0 dXt + rXt d Xs ds + r
−1
Xs ds dXt + rdXt • d
−1
Xs−1 ds
0 0 0
w 
t
= S0 dXt + rXt Xt−1 dt + r Xs−1 ds dXt + rdXt • (Xt−1 dt)
0
w   wt 
t
= S0 dXt + rdt + r Xs−1 ds dXt = rdt + S0 + r Xs−1 ds dXt
0 0
 wt 
= rdt + σ S0 Xt- + rXt- Xs−1 ds dNt = rdt + σSt- dNt .
0

c) We have

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IE[Xt /Xs ] = IE[(1 + σ)Nt −Ns ]

X
= (1 + σ)k P(Nt − Ns = k)
k≥0
X ((t − s)λ)k X ((t − s)(1 + σ)λ)k
= e−(t−s)λ (1 + σ)k = e−(t−s)λ
k! k!
k≥0 k≥0

= e−(t−s)λ e(t−s)(1+σ)λ = e(t−s)λσ , 0 ≤ s ≤ t.

Remarks: We could also let f (t) = IE[Xt ] and take expectation in the
equation dXt = σXt- dNt to get f ′ (t) = σλf (t)dt and f (t) = IE[Xt ] =
f (0)eλσt = eλσt . Note that the relation IE[Xt /Xs ] = IE[Xt ]/ IE[Xs ], which
happens to be true here, is wrong in general.
d) We have
 wt  wt
IE[St ] = IE S0 Xt + rXt Xs−1 ds = S0 IE[Xt ] + r IE[Xt /Xs ]ds
0 0
wt wt
= S0 eλσt + r e(t−s)λσ ds = S0 eλσt + r eλσs ds
0 0
(eλσt − 1)r
= S0 eλσt + , t ≥ 0.
λσ

Exercise 20.6
a) Since IE[Nt ] = λt, the expectation IE[Nt − 2λt] = −λt is a decreasing
function of t ∈ R+ , and (Nt − 2λt)t∈R+ is a supermartingale.
b) We have
St = S0 ert−λσt (1 + σ)Nt , t ≥ 0.
c) The stochastic differential equation

dSt = rSt dt + σSt- (dNt − λdt)

contains a martingale component (dNt − λdt) and a positive drift rSt dt,
therefore (St )t∈R+ is a submartingale.
d) Given that σ > 0 we have ((1 + σ)k − 1)+ = (1 + σ)k − 1, hence

e−rT IE∗ [(ST − K)+ ] = e−rT IE∗ [(S0 e(r−σλ)T (1 + σ)NT − K)+ ]
= e−rT IE∗ [(S0 e(r−σλ)T (1 + σ)NT − S0 e(r−λσ)T )+ ]
= S0 e−σλT IE∗ [((1 + σ)NT − 1)+ ]
X
= S0 e−σλT ((1 + σ)k − 1)+ P(NT = k)
k≥0
X
= S0 e −σλT
((1 + σ)k − 1)P(NT = k)
k≥0

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X X
= S0 e−σλT (1 + σ)k P(NT = k) − S0 e−σλT P(NT = k)
k≥0 k≥0
X (T (1 + σ)λ)k
= S0 e−σλT −λT − S0 e−σλT
k!
k≥0

= S0 (1 − e−σλT ),

where we applied the exponential identity

X xk
ex =
k!
k≥0

to x := T (1 + σ)λ.

Exercise 20.7
a) For all k = 1, 2, . . . , Nt we have

XTk − XTk- = a + σXTk- ,

hence
XTk = a + (1 + σ)XTk- ,
and continuing by induction, we obtain

XTk = a + (1 + σ)a + · · · + (1 + σ)k−1 a + X0 (1 + σ)k

(1 + σ)k − 1
=a + X0 (1 + σ)k ,
σ
which shows that

Xt = XTNt
(1 + σ)Nt − 1
= X0 (1 + σ)Nt + a
σ
 a a
= (1 + σ)Nt X0 + − , t ≥ 0.
σ σ
This result can also be obtained by noting that
a  a
XTk + = (1 + σ) XTk- + , k = 1, 2, . . . , Nt .
σ σ
b) We have
X (λt)k
IE[(1 + σ)Nt ] = e−λt (1 + σ)k = eσλt , t ≥ 0,
k!
n≥0

hence

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eλσt − 1  a a
IE[Xt ] = X0 eλσt + a = eλσt X0 + − , t ≥ 0.
σ σ σ

Nt
Y
Exercise 20.8 We have St = S0 ert (1 + ηZk ), t ∈ R+ .
k=1

Exercise 20.9 We have


NT
!2 
X
Var[YT ] = E  Zk − E[YT ] 
k=1

NT
!2 
X X
= E Zk − λtE[Z] NT = k  P(NT = k)
n≥0 k=1
 !2 
X λ n tn Xn
=e −λt
E Zk − λtE[Z] 
n!
n≥0 k=1
 !2 
X λn tn Xn n
X
=e−λt
E  Zk − 2λtE[Z] Zk + λ t (E[Z])
2 2 2
n!
n≥0 k=1 k=1
X λn tn
=e −λt
n!
n≥0
 
X n
X n
X
×E 2
 Zk Zl + |Zk | − 2λtE[Z]
2
Zk + λ t (E[Z])
2 2 2

1≤k<l≤n k=1 k=1

X λn tn
=e −λt
n!
n≥0

×(n(n − 1)(E[Z])2 + nE |Z|2 − 2nλt(E[Z])2 + λ2 t2 (E[Z])2 )

 
X λn tn  X λn tn
= e−λt (E[Z])2 + e−λt E |Z|2

(n − 2)! (n − 1)!
n≥2 n≥1
X λn tn
−λt
−2e λt(E[Z]) 2
+ λ2 t2 (E[Z])2 )
(n − 1)!
n≥1

= λtE |Z|2 ,
 

or, using the moment generating function of Proposition 20.6,

Var[YT ] = E |YT |2 − (E[YT ])2

 

∂2
= E[eαYT ]|α=0 − λ2 t2 (E[Z])2
∂αw2
∞
= λt |y|2 µ(dy) = λtE |Z|2 .
 
−∞

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Exercise 20.10
a) Applying the Itô formula (20.24) to the function f (x) = ex and to the
process Xt = µt + σWt + Yt , we find

1
 
dSt = µ + σ 2 St dt + σSt dWt + (St − St- )dNt
2
1 2
 
= µ + σ St dt + σSt dWt + (S0 eµt+σWt +Yt − S0 eµt+σWt +Yt− )dNt
2
1 2
 
= µ + σ St dt + σSt dWt + (S0 eµt+σWt +Yt- +ZNt − eµt+σWt +Yt− )dNt
2
1
 
= µ + σ 2 St dt + σSt dWt + St- (eZNt − 1)dNt ,
2

hence the jumps of St are given by the sequence (eZk − 1)k≥1 .

b) The discounted process e−rt St satisfies

1
 
d(e−rt St ) = e−rt µ − r + σ 2 St dt+σe−rt St dWt +e−rt St- (eZNt −1)dNt .
2

Hence by the Girsanov Theorem 20.20, choosing u, λ̃, ν̃ such that

1
µ − r + σ 2 = σu − λ̃ IEν̃ [eZ − 1],
2
shows that

d(e−rt St ) = σe−rt St (dWt +udt)+e−rt St- eZNt −1 dNt − λ̃ IEν̃ eZ −1 dt

 

is a martingale under (Pu,λ̃,ν̃ ).

Exercise 20.11
a) We have
Nt Nt
!
Y X
St = S0 e µt
(1 + Zk ) = S0 exp µt + Xk , t ≥ 0.
k=1 k=1

b) We have the discounted asset price process

Nt
!
X
Set := e−rt St = S0 exp (µ − r)t + Xk , t ≥ 0,
k=1

satisfies the stochastic differential equation

dSet = (µ − r)Set dt + XNt Set- dNt

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= (µ − r + λ IE[Z])Set dt + XNt − λ IE[Z] Set- dNt t ≥ 0,

hence it is a martingale if
2
0 = µ − r + λ IE[Z] = µ − r + λ IE[eXk − 1] = µ − r + (eσ /2
− 1)λ.

c) We have

e−(T −t)r IE[(ST − κ)+ | St ]


NT
! !+ 
X
=e −(T −t)r
IE  S0 exp µT + Xk −κ St 
k=1

NT
! !+ 
X
= e−(T −t)r IE  St exp (T − t)µ + Xk −κ St 
k=Nt +1

NT
! !+ 
X
=e −(T −t)r
IE  x exp (T − t)µ + Xk −κ 
k=Nt +1
x=St

NT −Nt
! !+ 
X
= e−(T −t)r IE  x exp (T − t)µ + Xk −κ 
k=1
x=St
 Pn + 
(T −t)µ+
X Xk
=e −(T −t)r
IE xe k=1 −κ P(NT − Nt = n)
n≥0 x=St

((T − t)λ)n
 Pn + 
xe(T −t)µ+ k=1 Xk − κ
X
= e−(r+λ)(T −t) IE
x=St n!
n≥0
X ((T − t)λ)n 2
= e−(T −t)λ Bl(St e(µ−r)(T −t)+nσ /2 , r, nσ 2 /(T − t), κ, T − t)
n!
n≥0
X 2
 ((T − t)λ)n
=e −(T −t)λ
St e(µ−r)(T −t)+nσ /2 Φ(d+ ) − κe−(T −t)r Φ(d− ) ,
n!
n≥0

with
2
log(St e(µ−r)(T −t)+nσ
/2
/κ) + (T − t)r + nσ 2 /2
d+ = √
σ n
log(St /κ) + (T − t)µ + nσ 2
= √ ,
σ n

2
log(St e(µ−r)(T −t)+nσ /κ) + (T − t)r − nσ 2 /2
/2
d− = √
σ n

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log(St /κ) + (T − t)µ

= √ ,
σ n
2
and µ = r + (1 − eσ /2
)λ.

Exercise 20.12
a) We have
d(eαt St ) = σeαt (dNt − βdt),
hence wt
eαt St = S0 + σ eαs (dNs − βd),
0
and
wt
St = S0 e−αt + σ e−(t−s)α (dNs − βds), t ≥ 0. (S.20.90)
0

b) We have

f (t) = IE[St ]
w  wt
t
= S0 e−αt + σ IE e−(t−s)α dNs − βσ e−(t−s)α ds
0 0
wt wt
= S0 e−αt + λσ e−(t−s)α ds − βσ e−(t−s)α ds
0 0
1−e −αt
= S0 e−αt + (λ − β)σ
 α 
λ−β β − λ −αt
=σ + S0 + σ e , t ≥ 0.
α α

c) By rewriting (S.20.90) as
wt wt
St = S0 − αS0 e−(t−s)α ds + σ e−(t−s)α (dNs − βds)
0 0
wt
= S0 + σ e−(t−s)α (dNs − (β + αS0 /σ)ds)
0
wt wt
= S0 + σ e−(t−s)α (λ − β − αS0 /σ)ds) + σ e−(t−s)α (dNs − λds),
0 0

t ∈ R+ , we check that the process (St )t∈R+ is a submartingale, provided

that λ − β − αS0 /σ ≥ 0, i.e. S0 + (β − λ)σ/α ≤ 0. We also check that this
condition makes the expectation f (t) = IE[St ] decreasing in Question (b).
d) Since, given that NT = n the jump times (T1 , T2 , . . . , Tn ) of the Poisson
process (Nt )t∈R+ are independent uniformly distributed random variables
over [0, T ], hence we can write
  wT 
IE[ϕ(ST )] = IE ϕ S0 e−αT + σ e−(T −s)α (dNs − βds),
0

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X
= P(NT = n)
n≥0
  wT  
× IE ϕ S0 e−αT + σ e−(T −s)α (dNs − βds) NT = n
0
X (λT )n
=e −λT
n!
n≥0
wT
" n
! #
X
× IE ϕ S0 e−αT + σ e−(T −Tk )α − σβ e−(T −s)α ds NT = n
0
k=1
X λn
= e−λT
n!
n≥0
wT wT n
!
X 1 − e−αT
× ··· ϕ S0 e
−αT
+σ e
−(T −sk )α
− σβ ds1 · · · dsn ,
0 0 α
k=1

T ≥ 0.

Exercise 20.13
a) From the decomposition Yt − λt(t + IE[Z]) = Yt − λ IE[Z]t − λt2 as the
sum of a martingale and a decreasing function, we conclude that t 7→
Yt − λt(t + IE[Z]) is a supermartingale.
b) Writing

dSt = µSt dt + σSt- dYt

 
r−µ
= rSt dt + σSt- dYt − dt
σ
= rSt dt + σSt- dYt − λ̃ IE[Z]dt , 0 ≤ t ≤ T,

we conclude that (St )t∈[0,T ] is a martingale under Pλ̃ provided that

µ−r
= −λ̃ IE[Z]dt,
σ
i.e.
r−µ
λ̃ = .
σ IE[Z]
We note that λ̃ < 0 if µ < r, hence in this case there is no risk-neutral
probability measure and the market admits arbitrage opportunities as the
risky asset always overperforms the risk-free interest rate r.
c) We have

e−(T −t)r IEλ̃ [ST − κ | Ft ] = ert IEλ̃ [e−rT ST | Ft ] − Ke−(T −t)r

= St − Ke−(T −t)r ,

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since (St )t∈[0,T ] is a martingale under Pλ̃ .

Exercise 20.14
a) We have
Nt
Y
St = S0 eµt (1 + Zk ), t ≥ 0.
k=1

b) Letting Xk = log(1 + Zk ), k ≥ 1, we find that

Nt
!
X
e−rt St = S0 exp (µ − r)t + Xk , t ≥ 0,
k=1

and (20.43) can be rewritten for the discounted price process

Set := e−rt St , t ≥ 0,

as
dSet = (µ − r + λ IE[Z])Set dt + Set- (dYt + λ IE[Z]),
which becomes a martingale if
w∞
0 = µ − r + λ IE[Z] = µ − r + λ zν(dz).
−∞

c) We have

e−(T −t)r IE[(ST − κ)+ | St ]


NT
!+ 
Y
= e−(T −t)r IE  S0 eµT Zk − κ St 
k=1

NT
!+ 
X Y
=e −(T −t)r
IE  St e (T −t)µ
Zk − κ St  P(NT − Nt = n)
n≥0 k=Nt +1

NT
!+ 
X Y ((T − t)λ)n
=e −(r+λ)(T −t)
IE  St e(T −t)µ Zk − κ St 
n!
n≥0 k=Nt +1
X ((T − t)λ)n
= e−(r+λ)(T −t)
n!
n≥0
!+
w∞ w∞ n
Y
× ··· St e
(T −t)µ
zk − κ ν(dz1 ) · · · ν(dzn ).
−∞ −∞
k=1

Exercise 20.15

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a) The discounted price process (e−rt St )t∈[0,T ] is a martingale, hence it is

both a submartingale and a supermartingale.
b) The discounted price process (e−rt St )t∈[0,T ] is a supermartingale.
c) The discounted price process (e−rt St )t∈[0,T ] is a submartingale.
d) Under the probability measure P e , the discounted price process (e−rt St )t∈[0,T ]
λ̃
is a martingale, hence it is both a submartingale and a supermartingale.

Chapter 21

Exercise 21.1
a) We have IE[Nt − αt] = IE[Nt ] − αt = λt − αt, hence Nt − αt is a martingale
if and only if α = λ. Given that

d(e−rt St ) = ηe−rt St- (dNt − αdt),

we conclude that the discounted price process e−rt St is a martingale if

and only if α = λ.
b) Since we are pricing under the risk-neutral probability measure we take
α = λ. Next, we note that

ST = S0 e(r−ηλ)T (1 + η)NT = St e(r−ηλ)(T −t) (1 + η)NT −Nt , 0 ≤ t ≤ T,

hence the price at time t of the option is

e−(T −t)r IE[|ST |2 | Ft ]

= e−(T −t)r IE[|St |2 e2(r−ηλ)(T −t) (1 + η)2(NT −Nt ) | Ft ]
= |St |2 e(r−2ηλ)(T −t) IE[(1 + η)2(NT −Nt ) | Ft ]
= |St |2 e(r−2ηλ)(T −t) IE[(1 + η)2(NT −Nt ) ]
X
= |St |2 e(r−2ηλ)(T −t) (1 + η)2n P(NT − Nt = n)
n≥0
X (λ(T − t))n
= |St |2 e(r−2ηλ−λ)(T −t) (1 + η)2n
n!
n≥0
2
= |St |2 e(r−2ηλ−λ)(T −t)+(1+η) λ(T −t)

2 (r+η 2 λ)(T −t)

= |St | e , 0 ≤ t ≤ T.

Exercise 21.2
a) Regardless of the choice of a particular risk-neutral probability measure
Pu,λ̃,ν̃ , we have

e−(T −t)r IEu,λ̃,ν̃ [ST − K | Ft ] = ert IEu,λ̃,ν̃ [e−rT ST | Ft ] − Ke−(T −t)r

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= ert e−rt St − Ke−(T −t)r

= St − Ke−(T −t)r
= f (t, St ),

for
f (t, x) = x − Ke−(T −t)r , t, x > 0.
b) Clearly, holding one unit of the risky asset and shorting a (possibly frac-
tional) quantity Ke−rT of the riskless asset will hedge the payoff ST − K,
and this (static) hedging strategy is self-financing because it is constant
in time.
∂f
c) Since (t, x) = 1 we have
∂x

∂f aλ
e
σ2 (t, St- ) + (f (t, St- (1 + a)) − f (t, St- ))
∂x St-
ξt =
σ 2 + a2 λe
aλe
σ2 + (St- (1 + a) − St- )
St-
=
σ 2 + a2 λ
e
= 1, 0 ≤ t ≤ T,

which coincides with the result of Question (b).

Exercise 21.3
a) We have
1
 
St = S0 exp µt + σBt − σ 2 t (1 + η)Nt .
2
b) We have

1
 
Set = S0 exp (µ − r)t + σBt − σ 2 t (1 + η)Nt ,
2

and
dSet = (µ − r + λη)Set dt + η Set- (dNt − λdt) + σ Set dWt ,
hence we need to take
µ − r + λη = 0,
since the compensated Poisson process (Nt − λt)t∈R+ is a martingale.
c) We have

e−r(T −t) IE∗ [(ST − κ)+ | St ]

" + #
1
 
= e−r(T −t) IE∗ S0 exp µT + σBT − σ 2 T (1 + η)NT − κ St
2

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Introduction to Stochastic Finance with Market Examples, Second Edition

 + 
2
= e−r(T −t) IE∗ St eµ(T −t)+(BT −Bt )σ−(T −t)σ /2 (1 + η)NT −Nt − κ St
X
= e−r(T −t) P(NT − Nt = n)
n≥0
 + 
2
∗
× IE St eµ(T −t)+(BT −Bt )σ−(T −t)σ /2
(1 + η)n − κ St
X (λ(T − t))n
= e−(r+λ)(T −t)
n!
n≥0
 + 
∗ (r−λη)(T −t)+(BT −Bt )σ−(T −t)σ 2 /2
× IE St e (1 + η)n − κ St
X (λ(T − t))n
= e−λ(T −t) Bl(St e−λη(T −t) (1 + η)n , r, σ 2 , T − t, κ)
n!
n≥0
X   (λ(T − t))n
= e−λ(T −t) St e−λη(T −t) (1 + η)n Φ(d+ ) − κe−r(T −t) Φ(d− ) ,
n!
n≥0

with
log(St e−λη(T −t) (1 + η)n /κ) + (r + σ 2 /2)(T − t)
d+ = √
σ T −t
log(St (1 + η) /κ) + (r − λη + σ 2 /2)(T − t)
n
= √ ,
σ T −t
and
log(St e−λη(T −t) (1 + η)n /κ) + (r − σ 2 /2)(T − t)
d− = √
σ T −t
log(St (1 + η) /κ) + (r − λη − σ 2 /2)(T − t)
n
= √ .
σ T −t

Exercise 21.4
a) The discounted process Set = e−rt St satisfies the equation

dSet = YNt Set- dNt , ,

and it is a martingale since the compound Poisson process YNt dNt is

centered with independent increments as IE[Y1 ] = 0.
b) We have
NT
Y
ST = S0 erT (1 + Yk ),
k=1

hence

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 Solutions Manual


NT
!+ 
Y
e
−rT
IE (ST − κ) = e
+ −rT
IE  S0 erT
(1 + Yk ) − κ 
 

k=1

NT
!+ 
X Y
=e −rT
IE  S0 erT (1 + Yk ) − κ NT = n P(NT = n)
n≥0 k=1
 !+ 
n
 (λT )
X Y n
=e −rT −λT
IE  S0 erT (1 + Yk ) − κ
n!
k≥0 k=1
!+
X (λT )n w 1 w1 n
Y
= e−rT −λT ··· S0 erT (1 + yk ) − κ dy1 · · · dyn .
2n n! −1 −1
k≥0 k=1

Exercise 21.5
a) We find α = λ where λ is the intensity of the Poisson process (Nt )t∈R+ .
b) We have

e−(T −t)r IE[ST − κ | Ft ] = ert IE[e−rT ST | Ft ] − e−(T −t)r IE[κ | Ft ]

= ert IE[e−rt St | Ft ] − e−(T −t)r κ
= St − e−(T −t)r κ,

since the process (e−rt St )t∈R+ is a martingale.

Exercise 21.6
a) We have
St = S0 e(r−λα)t (1 + α)Nt , t ≥ 0.
b) We have
  
ST
e−(T −t)r IE∗ [ϕ(ST ) | Ft ] = e−(T −t)r IE∗ ϕ x
St |x=St

= e−(T −t)r IE∗ ϕ(xe(r−λα)(T −t) (1 + α)NT −Nt ) |x=St

 

∞
X ((T − t)λ)k
= e−(r+λ)(T −t) ϕ St e(r−λα)(T −t) (1 + α)k , 0 ≤ t ≤ T.


k!
k=0

c) We have

dVt = rηt ert dt + ξt dSt

= rηt ert dt + ξt (rSt dt + αSt- (dNt − λdt))
= rVt dt + αξt St- (dNt − λdt)
= rf (t, St )dt + αξt St- (dNt − λdt). (S.21.91)

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Introduction to Stochastic Finance with Market Examples, Second Edition

d) By the Itô formula with jumps we have

d(e−rt f (t, St )) = −re−rt f (t, St )dt + e−rt df (t, St )

= −re−rt f (t, St )dt

∂f ∂f ∂f
+e−rt (t, St )dt + rSt (t, St )dt − λSt (t, St )dt
∂t ∂x ∂x

+ f (t, (1 + α)St- ) − f (t, St- ) dNt

= −re−rt f (t, St )dt


∂f ∂f ∂f
+e−rt (t, St ) + rSt (t, St ) − λSt (t, St )
∂t ∂x ∂x

+λe−rt (f (t, (1 + α)St ) − f (t, St )) dt

+e−rt f (t, (1 + α)St- ) − f (t, St- ) dNt

−λe−rt IE[f (t, (1 + α)x) − f (t, x)]|x=St- dt.

Since the discounted price process (e−rt f (t, St ))t∈R+ is a martingale under
the risk-neutral measure, d(e−rt f (t, St )) must reduce to its martingale
component, i.e. the sum of “dt” terms vanishes, and we get

d(e−rt f (t, St ))
= e−rt f (t, (1 + α)St- ) − f (t, St- ) dNt − λe−rt IE[f (t, (1 + α)x) − f (t, x)]|x=St- dt

= e−rt f (t, (1 + α)St- ) − f (t, St- ) dNt − λe−rt f (t, (1 + α)St- ) − f (t, St- ) dt,

or equivalently

df (t, St ) = rf (t, St )dt+ f (t, (1+α)St- )−f (t, St- ) (dNt −λ)dt. (S.21.92)

Finally, by identification of the terms in the above formula (S.21.92) with

those appearing in (S.21.91), we obtain

αξt St- (dNt − λdt) = f (t, (1 + α)St- ) − f (t, St- ) (dNt − λdt),

which yields the hedging strategy

1
ξt = f (t, (1 + α)St- ) − f (t, St- ) , 0 < t ≤ T.


αSt-

Exercise 21.7
a) We have

IE[Nt | Fs ] = eθYs −sm(θ) IE e(Yt −Ys )θ−(t−s)m(θ) Fs

 

= eθYs −sm(θ) IE e(Yt −Ys )θ−(t−s)m(θ) = Ns , 0 ≤ s ≤ t.

 

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 Solutions Manual

b) We have
 
NT
IEθ e−rt St | Fs = IE eYt
 
Fs
Ns
 
Y t Nt
= IE e Fs
Ns
= eYs IE eYt −Ys e(Yt −Ys )θ−(t−s)m(θ) | Fs
 

= eYs e−(t−s)m(θ) IE e(1+θ)(Yt −Ys )

 

= eYs e−(t−s)m(θ) e(t−s)m(θ+1) ,

hence we should have m(θ) = m(θ + 1). For example, when (Yt )t∈R+ =
(Nt − t)t∈R+ is a compensated Poisson process we have m(θ) = eθ − θ − 1
and the condition reads eθ + 1 = eθ+1 , i.e. θ = − log(e − 1).
c) We have
 
NT
e−(T −t)r IEθ [(ST − K)+ | Ft ] = e−(T −t)r IE (ST − K)+ Ft
Nt
"  θ #
ST
= e−(T −t)((1+r)θ+m(θ)) IE (ST − K)+ Ft .
St

Chapter 22

Exercise 22.1 For all j = 1, 2, . . . , M − 1 we have

Bj,j−1 + Bj,j + Bj,j+1 = 1 + r∆t,

hence when the terminal condition is a constant ϕ(T, x) = c > 0 we get

 −(N −i)
T
ϕ(ti , x) = c(1 + r∆t)−(N −i) = c 1 + r , i = 0, . . . , N.
N

In particular, when the number N of discretization steps tends to infinity,

denoting by [x] the integer part of x ∈ R we find

ϕ(s, x) = lim ϕ t[N s/T ] , x

N →∞
 −(N −[N s/T ])
T
= c lim 1 + r
N →∞ N
 −[N (T −s)/T ]
T
= c lim 1 + r
N →∞ N

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Introduction to Stochastic Finance with Market Examples, Second Edition

 −(T −s)/T
T
= c lim 1+r
N →∞ N
= ce−r(T −s) ,

for all s ∈ [0, T ], as expected.

Exercise 22.2
a) We have

btN = X
X btN + rX
btN (tk+1 − tk ) + σ X
btN (Wt − Wtk ),
k+1 k k k k+1

which yields
k
Y
btN = X
btN 1 + r(ti − ti−1 ) + (Wti − Wti−1 )σ , k = 0, 1, . . . , N.


X k 0
i=1

b) We have

btN = X
X btN + (r − σ 2 /2)X
btN (tk+1 − tk ) + σ X
btN (Wt − Wtk )
k+1 k k k k+1

1 2 bN
+ σ Xtk (Wtk+1 − Wtk ) , 2
2
which yields
k 
1
Y 
bN = X
X bN 1 + (r − σ 2 /2)(ti − ti−1 ) + (Wti − Wti−1 )σ + (Wti − Wti−1 )2 σ 2 .
tk t0
i=1
2

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