MATH4210 Financial Mathematics (2011-12)

Assignment 4
Due date is Nov 8, 2011 . Please put your assignment in the assignment box opposite to the General Oce of the Department of Mathematics (Room 220, LSB) before 5pm. Note: Answers should be given within 2 decimal places whenever necessary. The interest rate is compounded continuously.

Answer All Questions

1. Suppose Xt is the standard Wiener process. Show that (a) 1 Ut = Xct , c Vt = tX1/t are also standard Wiener processes. They are known as the Brownian scaling and time inversion of the standard Wiener process. 2. Let Xt be the standard Wiener process. (a) Solve the stochastic dierential equation: dYt = adt + bdXt , Y0 = c, where a, b and c are constants. (b) Take a = 0.2, b = 0.3 and c = 20. Compute the probability of Y5 lying between 19.9 and 20.2. 3. Consider a stock with an initial price S(t) = 60 on current day t, an expected return of = 0.18, and a volatility = 0.25. Assume that there are 252 trading days in a calendar year. Find the expectation, standard deviation, and the 95% condence interval of the stock price S(t + t) at the end of the next day t + t using (a) S(t + t) S(t) N (t, 2 t) (Chapter 6); S(t) (b) ln S(t + t) S(t) N 2 2 t, 2 t (Chapter 7).

c>0

(b)

4. The underlying stock St at time t follows the geometric Brownian motion dSt = St dt + St dXt , where is the drift parameter, is the volatility, and Xt is the standard Wiener process.
MATH4210 Financial Mathematics 1

(a) Use Its lemma to compute d ln o

1 St

(b) Suppose that the current stock price is S0 > 0. Compute E 1 , St t > 0.

5. (Its lemma in high dimensions) Consider two It processes: o o dYi,t = ai (Y1,t , Y2,t , t)dt + bi (Y1,t , Y2,t , t)dXi,t , i = 1, 2,

where ai (Y1,t , Y2,t , t) and bi (Y1,t , Y2,t , t), i = 1, 2 are suciently smooth functions. Furthermore X1,t and X2,t are standard Wiener processes related by dXi,t dXj,t = ij dt, i, j = 1, 2,

where 1 ij 1 for i, j = 1, 2 and ii = 1 for i = 1, 2. Suppose f (Y1,t , Y2,t , t) is a suciently smooth function of Y1,t , Y2,t and t. (a) Write down the Taylor series expansion of df to the second order in terms of Y1,t , Y2,t and t. (b) Show that f (Y1,t , Y2,t , t) is also an It process satisfying o 2 2 f 2f 1 f ai df = ij bi bj + + dt + Yi,t 2 Yi,t Yj,t t
i=1 i,j=1

bi
i=1

f dXi,t , Yi,t

where ai and bi are the simplied notations for ai (Y1,t , Y2,t , t) and bi (Y1,t , Y2,t , t), i = 1, 2 respectively. (Hint: mimic the proof in Chapter 7 for the original Its lemma.) o 6. Suppose Xt is the standard Wiener process, and Yt and Zt are two It processes. o (a) Verify the following Its product rule and quotient rule: o d(Yt Zt ) = Zt dYt + Yt dZt + dYt dZt and d(Yt /Zt ) = dYt Yt dZt dYt dZt Yt (dZt )2 + . 2 2 3 Zt Zt Zt Zt

(b) Suppose the two Its processes are given by o dYt = Y Yt dt + Y Yt dXt , and dZt = Z Zt dt + Z Zt dXt . Show that d(Yt Zt ) = (Y + Z + Y Z )dt + (Y + Z )dXt Y t Zt d(Yt /Zt ) 2 = (Y Z Y Z + Z )dt + (Y Z )dXt . Yt /Zt

and

MATH4210 Financial Mathematics