M339W/389W Financial Mathematics for Actuarial Applications

Spring 2014
University of Texas at Austin
Sample In-Term Exam II - Solutions
Instructor: Milica Čudina

Notes: This is a closed book and closed notes exam.

Time: 75 minutes

2.1. TRUE/FALSE QUESTIONS. Please note your answers on the front page.

Problem 2.1. (2 pts) In the setting of the Black-Scholes stock-price Model, the risk-neutral
probability measure is exactly the one that gives the stock price an expected rate of return equal
to the risk-free interest rate.
Solution: TRUE

Problem 2.2. (2 pts) In the setting of the Black-Scholes stock-price Model, let {S(t), t ≥ 0}
denote the stock price whose drift is α and volatility is σ. Define the new stochastic process
X(t) = ln(S(t)), for every t ≥ 0.
Then,
V ar[X(t + h) − X(t)] = σ 2 h, for every t ≥ 0 and h > 0.
Solution: TRUE
Since {X(t)} is an (arithmetic) Brownian motion, its increment X(t + h) − X(t) is normally
distributed with mean αh and variance σ 2 h.

Problem 2.3. (2 pts) Let {Z(t), t ≥ 0} denote a standard Brownian motion. Then the stochastic
process {U (t), t ≥ 0} defined as
U (t) = (Z(t))2 − t, for every t ≥ 0
has zero drift.
Solution: TRUE
In order to answer the above question, we need to write the process U in differential notation.
Using Ito’s Lemma, we get that
d((Z(t))2 ) = 2Z(t) dZ(t) + dt.
Hence,
dU (t) = 2Z(t) dZ(t).
2

Problem 2.4. (2 pts) For purposes of Black-Scholes option pricing, when the movement of a
stock price follows a geometric Brownian motion, the stock price is said to follow the normal
distribution.
Solution: FALSE

Problem 2.5. (2 pts) Delta as a measurement of option price sensitivity to the changes in the
price of the underlying stock will understate the actual option price changes when the stock price
rises.
Solution: FALSE

Problem 2.6. (2 pts) In the Black-Scholes pricing model, the risk-neutral standard Brownian
motion {Z̃(t)} is the actual/true Brownian motion which “drives” the stock-price process.
Solution: FALSE

Problem 2.7. (2 pts) Let {Z(t), t ≥ 0} be a standard Brownian motion. Then the process
1
M (t) = exp{σZ(t) − σ 2 t}
2
has zero drift.
Solution: TRUE
Define X(t) := Z(t) − 21 σt. Then,
1
dX(t) = dZ(t) − σ dt
2
and
(dX(t))2 = dt.
We can write
M (t) = exp{σX(t)}.
So, by Itô’s Lemma,
1
dM (t) = σ exp{σX(t)} dX(t) + σ 2 exp{σX(t)} (dX(t))2
2
1 2
= σM (t) dX(t) + σ M (t) dt
2
1 1
= σM (t) [dZ(t) − σ dt] + σ 2 M (t) dt
2 2
= σM (t) dZ(t).

Problem 2.8. (2 pts) Let S be a geometric Brownian motion. Define Y (t) = S(t)3 for every t.
Then, the proces Y = {Y (t), t ≥ 0} is a geometric Brownian motion itself.
 3

Solution: TRUE
Done in class for every a 6= 0.

Problem 2.9. (2 pts) The quadratic variation of an Itô process is defined path-by-path.
Solution: TRUE

2.2. FREE-RESPONSE PROBLEMS. Please, explain carefully all your statements and as-
sumptions. Numerical results or single-word answers without an explanation (even if they’re
correct) are worth 0 points.

Problem 2.10. (15 points)Let S(0) = $100, K = $120, σ = 0.3, r = 0.08 and δ = 0.
a. (5 pts) Let VC (0, T ) denote the Black-Scholes European call price for the maturity T . Does
the limit of VC (0, T ) as T → ∞ exist? If it does, what is it?
b. (5 pts) Now, set δ = 0.001 and let VC (0, T, δ) denote the Black-Scholes European call price
for the maturity T . Again, how does VC (0, T, δ) behave as T → ∞?
c. (5 pts) Interpret in a sentence or two the differences, if there are any, between your answers
to questions in a. and b.
Solution:
a. By the Black-Scholes pricing formula, the function C(T ) has the form
VC (0, T ) = S(0)N (d1 ) − Ke−rT N (d2 ),
where N denotes the distribution function of the unit normal distribution and
     
1 S(0) 1 2
d1 = √ ln + r+ σ T ,
σ T K 2
√
d2 = d1 − σ T .
As T → ∞, we have that
d1 → ∞ ⇒ N (d1 ) → 1,
e−rT N (d2 ) ≤ e−rT → 0.
Hence,
VC (0, T ) → S(0), as T → ∞.
b. In this case, the price of the call option reads as
VC (0, T, δ) = S(0)e−δT N (d1 ) − Ke−rT N (d2 ),
with
     
1 S(0) 1 2
d1 = √ ln + r−δ+ σ T ,
σ T K 2
√
d2 = d1 − σ T .
Since the function N is bounded between 0 and 1, we see that as T → ∞, VC (0, T, δ) → 0.
4

c. When the stock is paying the dividend, the benefit of owning the stock and opposed to
owning the option on that stock lies precisely in the value of the issued dividend. As we
can see from above, even a very small dividend yield is going to render the call options for
very long maturities worthless.

Problem 2.11. (10 points)

√ Use Ito’s Lemma to express df (S(t)) in differential form for f : R+ →
R+ given as f (x) = x, where the stochastic process {S(t)} satisfies the stochastic differential
equation
dS(t) = S(t)(α dt + σ dZ(t))
with α and σ constant and {Z(t), t ≥ 0} a standard Brownian motion.
Solution: Let us start by finding the relevant derivatives of f .
1 1
f 0 (x) = x− 2 ,
2
1 3
f 00 (x) = − x− 2 .
4
By Ito’s Lemma for Ito processes:
 
1 − 12 1 1 − 32
df (S(t)) = S(t) dS(t) + · − S(t) (dS(t))2 .
2 2 4
From the “multiplication table” from class, we conclude that (dS(t))2 = (S(t))2 σ 2 dt. So,
 
1 1 − 1 1 1 − 3
d(S(t) 2 ) = S(t) 2 × S(t)(α dt + σ dZ(t)) + · − S(t) 2 · S(t)2 σ 2 dt
2 2 4
1 1 1 1 1
= S(t) 2 (α − σ 2 ) + S(t) 2 σ dZ(t).
2 4 2
p
Note that { S(t)} has the form of a geometric Brownian motion, but with a different drift and
volatility.

Problem 2.12. (8 points) Consider a non-dividend-paying asset S which satisfies the stochastic
differential equation
dS(t) = S(t)(µS dt + σS dZ(t))
where Z denotes a standard Brownian motion.
Let the stochastic process Y be defined as Y (t) = et S(t)2 . You are given that Y satisfies the
following SDE
dY (t) = Y (t)(1.5 dt + 0.6 dZ(t)).
Calculate the values of µS and σS .
Solution: We will use Itô’s lemma to tie the SDE for S with the SDE for Y . Let F (t, x) = et x2 .
Then,
Ft (t, x) = et x2 = F (t, x), Fx (t, x) = 2et x, Fxx (t, x) = 2et .
 5

So,
1
dY (t) = dF (t, S(t)) = Ft (t, S(t)) dt + Fx (t, S(t)) dS(t) + Fxx (t, S(t)) (dS(t))2
2
1
= F (t, S(t)) dt + 2et S(t) dS(t) + × 2et (dS(t))2
2
1
= F (t, S(t)) dt + 2et S(t)[S(t)(µS dt + σS dZ(t))] + × 2et (S(t))2 σS2 dt
2
2
= Y (t) dt + 2Y (t)(µS dt + σS dZ(t)) + Y (t)σS dt
= Y (t)((2µs + 1 + σS2 ) dt + 2σS dZ(t)).
Comparing the obtained coefficients with the ones provided in the problem statement, we get
σS = 0.3 and µS = 21 (1.5 − 0.09 − 1) = 0.205.

Problem 2.13. (6 points) Let Z = {Z(t); ≥ 0} be a standard Brownian motion.

Define the stochastic process X as X(t) = Z(t)3 + ctZ(t), t ≥ 0 for some constant c.
Find the value of the constant c such that the stochastic process X has zero drift.
Solution: Define F (x, t) = x3 + ctx for x ∈ R, t ∈ (0, ∞). Then,
Ft = cx, Fx = 3x2 + ct, and Fxx = 6x.
By Itô’s Lemma, we have that
1
dX(t) = dF (Z(t), t) = cZ(t) dt + (3Z(t)2 + ct) dZ(t) + (6Z(t)) dt
2
2
= (c + 3)Z(t) dt + (3Z(t) + ct) dZ(t).
The drift is equal to 0 if c = −3.

2.3. MULTIPLE CHOICE QUESTIONS.

Problem 2.14. Assume the Black-Scholes setting.
Assume S(0) = $23.50, σ = 0.24, r = 0.055. The stock pays a 2.5% continuous dividend and the
option expires in 45 days (simplify the number of days in a year to 360).
What is the price of a $25-strike European call?
(a) 0.60
(b) 0.52
(c) 0.41
(d) 0.30
(e) None of the above.
Solution: (d)
In our usual notation, the price is
VC (0) = S(0)e−δ·T N (d1 ) − Ke−r·T N (d2 )
with
d1 = −0.64, d2 = −0.73.
6

So, VC (0) ≈ 0.3.

Problem 2.15. (5 pts) In this problem, use the Black-Scholes pricing model.
Consider a bear spread consisting of a 20−strike put and a 25−strike put. Suppose that σ =
0.30, r = 0.04, δ = 0.02, T = 1 and S(0) = 5.
What is the price of this bear spread?
(a) About 3.7
(b) About 4.1
(c) About 4.8
(d) About 5.2
(e) None of the above
Solution: (c)
Here, you sell a 20−strike put and buy a 25−strike put.
For the 20−put, we have
1 5 1 1
d1 = [ln( ) + (0.04 − 0.02 + · 0.32 ) · 1] = [ln(0.25) + 0.065] = −4.4043;
0.3 · 1 20 2 0.3
d2 = −4.4043 − 0.3 = −4.7043.
For the 25−put, we have
1 5 1 1
d1 = [ln( ) + (0.04 − 0.02 + · 0.32 ) · 1] = [ln(0.2) + 0.065] = −5.1481;
0.3 · 1 25 2 0.3
d2 = −5.1481 − 0.3 = −5.4181.
We conclude that for both options, we have
N (−d1 ) ≈ N (−d2 ) = 1.
We calculate the prices of the two puts:
VP (0, 20) ≈ 20e−0.04 − 5e−0.02 = 14.3148
VP (0, 25) ≈ 25e−0.04 − 5e−0.02 = 19.1187.
So, the price of the bear spread is 4.8039.
Or, simply, the price of the bear spread is
VP (0, 25) − VP (0, 20) = 25e−0.04 − 5e−0.02 − (20e−0.04 − 5e−0.02 ) = 5e−0.04 ≈ 4.8039.

Problem 2.16. (5 pts) Assume the Black-Scholes framework. Let the current price of a non-
dividend-paying stock be equal to S(0) = 95 and let its volatility be equal to 0.35. Consider
a European call on that stock with strike 100 and exercise date in 9 months. Let the risk-free
continuously compounded interest rate be 6% per annum.
Denote the price of the call by VC (0). Then,
(a) VC (0) < $5.20
(b) $5.20 ≤ VC (0) < $7.69
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(c) $7.69 ≤ VC (0) < $9.04

(d) 9.04 ≤ VC (0) < $11.25
(e) None of the above.
Solution: (d)
Using the Black-Scholes formula one gets the price of about 11.06.

Problem 2.17. (5 pts) Assume the Black-Scholes framework. Let the current price of a share of
stock be equal to S(0) = 80, let its volatility be σ = 0.3, and let δ = 0 (in our usual notation).
Consider a gap option with expiration date T = 1 year such that its payoff is S(T ) − 90 if
S(T ) > 100.
You are given that the continuously compounded risk-free interest rate equals r = 0.05 per
annum.
Let VGC (0) denote the price of the above gap option. Then,
(a) VGC (0) < $3.20
(b) $3.20 ≤ VGC (0) < $5.69
(c) $5.69 ≤ VGC (0) < $7.04
(d) 7.04 ≤ VGC (0) < $11.25
(e) None of the above.
Solution: (c)
In our usual notation, the Black-Scholes formula for the price of a gap call option reads as
VGC (0) = S(0)−δT N (d1 ) − K1 e−rT N (d2 )
where
1 1
d1 = √ [ln(S(0)/K2 ) + (r − δ + σ 2 )T ],
σ T 2
√
d2 = d1 − σ T .
In the present problem,
1 0.09
d1 = [ln(80/100) + (0.05 + )] ≈ −0.43,
0.3 2
d2 = −0.73.
So, the price equals
VGC (0) = 80N (−0.43) − 90e−0.05 N (−0.73) = 80 · (1 − 0.6664) − 90e−0.05 · (1 − 0.7673) = 6.7664.

Problem 2.18. (5 pts) Source: MFE Exam, Spring 2007, #15.

For a six-month European put option on a stock, you are given:
(i) The strike price is $50.00.
(ii) The current stock price is $50.00.
(iii) The only dividend during this time period is $1.50 to be paid in four months.
(iv) σ = 0.30
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(v) The continuously compounded risk-free interest rate is 5%. Under the Black-Scholes framework,
calculate the price of the put option.
(a) $3.50
(b) $3.95
(c) $4.19
(d) $4.73
(e) $4.93
Solution: (c)
See http://www.soa.org/files/pdf/edu-exam-mfe-0507-sol.pdf

Problem 2.19. (5 pts) Source: MFE Exam, Spring 2007, #3.

You are asked to determine the price of a European put option on a stock. Assuming the Black-
Scholes framework holds, you are given:
(i) The stock price is $100.
(ii) The put option will expire in 6 months.
(iii) The strike price is $98.
(iv) The continuously compounded risk-free interest rate is r = 0.055.
(v) δ = 0.01
(vi) σ = 0.50
Calculate the price of this put option.

(a) $3.50
(b) $8.60
(c) $11.90
(d) $16.00
(e) $20.40
Solution: (c)
See http://www.soa.org/files/pdf/edu-exam-mfe-0507-sol.pdf

Problem 2.20. Assume the Black-Scholes setting.

Mary wagers to pay one share of stock to Matt if the price at expiration in 1 year is above $75.00.
Assume S(0) = 60.00, σ = 0.15, r = 0.04, and the dividend rate of 0.01. What is the value of
Marys bet?
(a) 6.72
(b) 7.52
(c) 8.72
(d) 9.51
(e) None of the above.
Solution: (a)
This is the Black-Scholes price of an asset call, i.e.,
VAC (0) = S(0)e−0.01 N (d1 )
 9

with
 
1 60 1
d1 = ln( ) + 0.04 − 0.01 + 0.152 = −1.21.
0.15 75 2
So,
VAC (0) = 60e−0.01 N (−1.21) = 60e−0.01 (1 − 0.8869) ≈ 6.72.

Problem 2.21. Assume the Black-Scholes setting.

Assume S(0) = $63.75, σ = 0.20, r = 0.055. The stock pays no dividend and the option expires in
50 days (simplify the number of days in a year to 360).
What is the price of a $60-strike European put?
(a) 0.66
(b) 0.55
(c) 0.44
(d) 0.37
(e) None of the above.
Solution: (d)
In our usual notation, the price is
VP (0) = Ke−r·T N (−d2 ) − S(0)N (−d1 )
with
    
1 63.75 1 2 5
d1 = p ln + (0.055 + 0.2 ) = 0.95,
0.2 5/36 60 2 36
√
d2 = d1 − 0.25 0.125 = 0.88.
So,
5
VP (0) = 60e−0.055· 36 (1 − 0.8106) − 63.75 · (1 − 0.8289) = 0.37.

Problem 2.22. Assume the Black-Scholes setting.

Assume S(0) = $28.50, σ = 0.32, r = 0.04. The stock pays a 1.0% continuous dividend and the
option expires in 110 days (simplify the number of days in a year to 360).
What is the price of a $30-strike put?
(a) 2.75
(b) 2.10
(c) 1.80
(d) 1.20
(e) None of the above.
Solution: (a)
In our usual notation, the price is
VP (0) = Ke−r·T N (−d2 ) − S(0)e−δ·T N (−d1 )
10

with
d1 = −0.15, d2 = −0.33.
So, VP (0) = 2.75.

Problem 2.23. Assume the Black-Scholes setting.

Let S(0) = $38.50, σ = 0.25, r = 0.06. The stock pays no dividend and the option expires in 45
days (simplify the number of days in a year to 360). What is the price of a $35-strike European
call?
(a) 3.50
(b) 3.65
(c) 3.80
(d) 3.95
(e) None of the above.
Solution: (d)
In our usual notation, the price is
VC (0) = S(0)N (d1 ) − Ke−0.06·0.125 N (d2 )
with
   
1 38.50 1 2
d1 = √ ln + (0.06 + 0.25 )(0.125) = 1.21,
0.25 0.125 35 2
√
d2 = d1 − 0.25 0.125 = 1.12.
So, VC (0) = 38.50 · 0.8869 − 35e−0.06·0.125 · 0.8686 = 3.97.

Problem 2.24. (5 points) Let {Z(t), t ≥ 0} be a standard Brownian motion. For some two times
s, t such that s ≤ t, set b = E[Z(t) − t | Z(s)]. Then,
(a) b = 0
(b) b = Z(s)
(c) b = s
(d) b = Z(s) − t
(e) None of the above.
Solution: (d)

Problem 2.25. (5 points) Consider two stocks with the following system of SDE:
dS1 (t)
= (x + r) dt + 0.12 dZ(t),
S1 (t)
dS2 (t)
= (2x + r) dt + σ2 dZ(t).
S2 (t)
Find σ2 .
 11

(a) 0.06
(b) 0.12
(c) 0.24
(d) 0.3
(e) None of the above.
Solution: (c)
The two stocks share a common source of uncertainty – the standard Brownian motions Z. So,
they must have the same Sharpe ratio, i.e.,
x+r−r 2x + r − r
= ⇒ σ2 = 0.24.
0.12 σ2

Problem 2.26. (5 pts) Assume that the current exchange rate is $1.25/e. The risk-free con-
tinuously compounded interest rate on the dollar is r§ = 0.06 and the risk-free continuously
compounded interest rate on the euro is re = 0.035.
Under the Black-Scholes setting, the volatility of the euro/dollar exchange rate is given to be
equal to σ = 0.11.
Find the price C of bundle of 100 European call options with 6 months to expiry and the strike
price of $1.30.
(a) $2.59
(b) $2.93
(c) $3.54
(d) $3.75
(e) None of the above.
Solution: (a)
The price of a single call is
x(0)e−re N (d1 ) − Ke−r$ N (d2 )
with
1 1
d1 = √ [ln(x(0)/K) + (r$ − re + σ 2 )T ] = · · · = −0.3046 ≈ −0.30,
σ T 2
√
d2 = d1 − σ T = −0.3824 ≈ −0.38.
So,
VC (0) = 100[1.25e−0.035 N (−0.30) − 1.3e−0.05 N (−0.38)] ≈ 2.59.

Problem 2.27. (5 pts) The current price of a share of stock is given to be S(0) = 45. The stock
is assumed to follow a geometric Brownian motion. Let σ = 0.4. The stock is projected to pay a
single $5.00 dividend in 1 month.
Assume that r = 0.08.
Consider an at-the-money call on that stock with expiry in 3 months. Find the price VC (0) of
this call.
(a) 0.2337
12

(b) 0.2559
(c) 0.2774
(d) 0.3013
(e) None of the above.
Solution: (e)
The prepaid forward price on this stock is
0.08
P
F0,T (S) = S(0) − De−rTD = 45 − 5e− 12 = 40.0332. ≈
P
VC (0) = F0,T (S)N (d1 ) − Ke−rT N (d2 )
with
1 P 1
d1 = √ [ln(F0,T (S)/K) + (r + σ 2 )T ] = · · · = −0.38,
σ T 2
√
d2 = d1 − σ T = −0.58.
We get that the price is

VC (0) = 40.0332N (−0.38) − 45e−0.08/4 N (−0.58) = 40.0332(1 − 0.6480) − 45e−0.02 (1 − 0.719) = 1.697.

Problem 2.28. (5 points) The current price of corn futures with delivery in two years is $6
per bushel. Assume that the corn-futures prices follow a geometric Brownian motion with the
volatility parameter of 0.25
Let the continuously compounded interest rate equal 0.08.
Consider a an at-the-money European call option on the two-year corn futures contract with
expiry in 1 year.
Find the price VC (0) of this call option.
(a) $4.509
(b) $4.930
(c) $5.054
(d) $5.727
(e) None of the above.
Solution: (d)
As usual, we will need the values of d1 and d2 , first. With Td denoting the delivery date, we have
1 1 1 √ 1 √
d1 = √ [ln(F0,Td (S)/K) + σ 2 T ] = σ T = · 0.25 · 1 = 0.125,
σ T 2 2 2
√
d2 = d1 − σ T = 0.125 − 0.25 = −0.125.
The price VC (0) is, then,
VC (0) = 60e−0.08 (2N (0.13) − 1) = 60e−0.08 (2 · 0.5517 − 1) ≈ 5.727.
 13

Problem 2.29. (5 points) Assume the Black-Scholes framework. Let the current stock price be
equal to S(0) = $40. The stock’s volatility is given to be 0.25 and it is projected to pay out a
continuous dividend proportional to its price at the rate 0.03. Under some probability measure
the rate of return on the stock is given to be 0.08.
Consider a European call option on this stock with expiry in one year and with the strike price
of $27.
The continuously compounded interest rate is 0.04.
Find the Sharpe ratio of the call option.
(a) 0.02
(b) 0.04
(c) 0.08
(d) 0.16
(e) None of the above.
Solution: (d)
There is a common source of uncertainty in the call and the stock price. So, they have to have
the same Sharpe ratio. The answer is
α−r 0.08 − 0.04
= = 0.16.
σ 0.25