INTRODUCTION TO FINANCIAL MATHEMATICS

Exercise sheet 5

Exercise 21⋆ Suppose you are an asset trader and in the market one asset is traded, that now costs €100 and tomorrow
it will be worth either €120 or €80. The risk-free rate is r = 0. The Oracle of Delphi tells you that the asset will increase
with probability 55% and will decrease with probability 45% . You receive an offer to buy a put option on the asset with
strike €100 expiring tomorrow at the price of €8. Should you buy the put? Could it be possible to earn money without
risk? If yes, design a strategy to do so.

Exercise 22⋆ Consider a one-period financial market model with three traded assets S̄ = (S 0 , S 1 , S 2 ). The first one is
the risk-less asset with current value S00 = 0.8. The other two are risky assets with current value S01 = 8 and S02 = 4.8
respectively. Assume that at the terminal time the market will be in one of the following four states:
       
1 1 1 1
S̄1 (ω1 ) = 10 , S̄1 (ω2 ) = 12 , S̄1 (ω3 ) = 10 , S̄1 (ω4 ) = 6 . (1)
8 8 4 4

(i) Is the market complete?

(ii) Which derivatives can be (exactly) replicated?
(iii) Calculate the price of the derivative with payoff 3, 5, 7, and 3 at the states ω1 , ω2 , ω3 and ω4 respectively.
(iv) What is the minimum and the maximum price, which is compatible with the no arbitrage principle, for a call option
on S 1 with exercise price 9?
(v) We extend the market by adding the option of the previous question to the list of available products, with price
1.2. Show that this extended market is complete and find the initial price of a derivative with payoff 0, 2, 0 and 2
at the states ω1 , ω2 , ω3 and ω4 respectively.

Exercise 23⋆ Consider an arbitrage-free one-period financial market model (S 0 , S), that consists of the risk-free asset
S 0 and a risky asset S, on an underlying probability space (Ω, F, P). The risk-free rate is r = 0, i.e. it holds S00 = S10 = 1.
Moreover, let S0 = 50 and assume that S1 is uniformly distributed on the interval (0, 100) under the probability measure
P. In particular, it holds for every continuous function f : R → R, that
Z ∞
f (x)
EP [f (S1 )] = 1(0,100) (x) dx.
−∞ 100

For m ∈ N, define ϕm : R → R by
2m + 1
ϕm (x) := (x − 50)2m ,
502m
and Zm : Ω → R by Zm (ω) := ϕm (S1 (ω)).
(i) Show that Zm > 0 P-almost surely and EP [Zm ] = 1. Deduce that every Zm is the Radon–Nikodym density
Zm = dQ dP of the probability measure Qm , which is equivalent to P. Show furthermore that EQ [S1 ] = S0 and
m 1 1

deduce that Qm is an equivalent martingale measure for the market (S , S).

0

(ii) Consider the claim C = |S1 − S0 |, and let π(C) denote the price of this claim. Show, with help from (i), that
π(C) = 50.

Exercise 24⋆ Consider the financial market of Exercise 3.14, where r ∈ (b, h). We extend the financial market (S 0 , S 1 )
on Ω = {b, 0, h}, using another risky asset, denoted S 2 . This asset is actually a European put option on S 1 with maturity
T = 1 and strike price K0 ∈ (s0 (1 + b), s0 ). Let us denote by p0 > 0 the price of this asset at time t = 0. Therefore,
the following hold:
S02 := p0 and S12 := (K0 − S11 )+ .
Finally, let us denote by C : Ω → R+ another claim with payoff profile

C(b) := kb , C(0) := k0 , C(h) := kh , kb , k0 , kh ∈ R+ . (2)

1
 (i) Show that in the extended financial market (S 0 , S 1 , S 2 ) every claim of the form (2) is replicable and provide the
replicating strategy (ξ 0 , ξ 1 , ξ 2 ).
(ii) Show that the price π(C) of a claim of the form (2) is given by the formula
1 
π(C) = qb kb + q0 k0 + qh kh
1+r
and describe qb , q0 , qh as functions of s0 , h, b, r, p0 and K0 .

(iii) Show that the condition qb + q0 + qh = 1 is satisfied and show that qb , q0 , qh > 0 holds if and only if

(K0 − s0 (1 + b))(h − r)
p0 < . (3)
(1 + r)(h − b)

Provide an example of an arbitrage strategy in the extended financial market (S 0 , S 1 , S 2 ), in case condition (3) is
not satisfied. Describe qb , q0 , qh in that case, and explain what does this mean for the extended financial market.
(iv) Compute the price of another European put option on S 1 with maturity T = 1 and strike price K ∈ (s0 (1+b), s0 )
as a function of p0 . Which prices of p0 maximize the latter price? Compare these results with the outcome of
question (iv) in Exercise 3.14.

Exercise 25⋆ Consider a one-period financial market model (Ω, F, P, S 0 , S), where the space of events Ω has a finite
number of elements, while the σ-algebra F := 2Ω . Let S 0 denote the risk-free asset with S00 = 1 at time t = 0 and
interest rate r > −1 (i.e. S10 = 1 + r), and let S denote the risky asset with initial price S0 > 0 at time t = 0, whose
price S1 at time t = 1 is a random variable.

(i) Assume that the space of events contains only two elements, i.e. Ω = {ω1 , ω2 }, where

S1 (ω1 ) := S01 (1 + a) and S1 (ω2 ) = S01 (1 + b)

with a, b ∈ R. Further, let P[{ω1 }] = p = 1 − P[{ω2 }] for p ∈ (0, 1). What conditions should a, b, r satisfy such
that there exists an equivalent martingale measure? Describe the set of equivalent martingale measures.

(ii) Assume that the space of events Ω contains a finite number of elements (i.e. |Ω| = n for 2 < n < ∞) and that it
holds P[{ω}] > 0 for every ω ∈ Ω. Set

α := min S11 (ω) and β := max S11 (ω)

ω∈Ω ω∈Ω

and assume that it holds 0 < α < β. Show that the market is free of arbitrage if and only if it holds

α < S01 (1 + r) < β.