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Mathematical Finance End Sem

This document is the end semester exam for a mathematical finance course. It contains 10 questions in Part A worth 2 marks each and 4 questions in Part B worth 5 marks each. The exam covers topics like arbitrage, geometric Brownian motion, option pricing models, and estimating volatility. Standard normal distribution tables are provided to help with calculations.

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0% found this document useful (0 votes)
187 views4 pages

Mathematical Finance End Sem

This document is the end semester exam for a mathematical finance course. It contains 10 questions in Part A worth 2 marks each and 4 questions in Part B worth 5 marks each. The exam covers topics like arbitrage, geometric Brownian motion, option pricing models, and estimating volatility. Standard normal distribution tables are provided to help with calculations.

Uploaded by

makesh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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DEPARTMENT OF MATHEMATICS, IIT MADRAS

MA 5950-Mathematical Finance
End Semester Exam (for Graduating Students)
08/06/2020
Time: Two Hours Maximum: 40 Marks
This question paper has 10 questions in Part-A and 4 questions in Part-B.
The Standard Normal Distribution table is attached at the end.

PART-A
(Each question carries two marks)

1. What is arbitrage? Explain it with an example.

2. The share price of a stock S(t), t ≥ 0 increases by 4% or decreases by


2% with equal probability at random time points of a Poisson Process
N (t), t ≥ 0 with parameter λ = 5. The increase or decrease at different
time points are independent events. If S(0) = 100, what is E(S(t))?
What is the continuously compounded interest rate, if the probability
distribution of S(t) is risk-neutral ?

3. Let S(t), t ≥ 0 be a geometric Brownian motion with drift parameter µ


and volatility σ; and S(0) = s. If ∆ is a small increment of time, what
are the values taken on by S(∆) and the corresponding probabilities,
in the Binomial approximation model?

4. Show that (1 + r/n)n is an increasing function of n = 1, 2, 3, ... for a


fixed r.

5. State the put-call option formula. Prove the put-call option formula
using law of one price.

6. If there are three different


 wagers with returns given by the return
−8 3 5
matrix R =  2 −7 5 ,
−2 −3 α

(a) what must be α such that there is no arbitrage?


(b) Give a value of α such that there is an arbitrage. Give an arbitrage
strategy for the α so chosen.

1
7. Let C be the cost of a call option to purchase a security at time t for
the price K. Let S be the current price of the security, and let r be the
continuously compounded interest rate. State and prove an inequality
involving the quantities C, S, and Ke−rt .
8. In the no-arbitrage probability distribution which is a geometric Brow-
nian motion with drift parameter µ and volatility σ, show that µ =
rt − σ 2 t/2 where r is the continuously compounded interest rate.
9. Show that the no-arbitrage put option cost P (s, t, K, σ, r) of the risk-
neutral geometric Brownian motion , is decreasing and convex in s.
10. Find the no-arbitrage cost of a European (K, t) call option on a security
that at times tdi , i = 1, 2 pays f (S(tdi )) as dividends,
where td1 < td2 < t.
PART-B
(Each question carries five marks)
1. Let C(K, t) and P (K, t) be the costs of European call and put options
respectively, on a specified security that has strike price K and expira-
tion time t. For fixed expiration time t,
(a) show that C(K, t) is a convex and non-increasing function of K.
(b) prove that P (K, t) is convex in K, or explain why it is not neces-
sarily true.
2. The initial price of a stock is 100 and the price after one period is
assumed to be either 200,110 or 50. At a cost of C per share, we can
purchase at time 0 the option to buy the stock at time 1 for the price
of 150. The normal interest rate per period is r = 10%.
(a) Write down the return matrix R corresponding to investments in
one share of the stock and one call option.
(b) Find an interval for which there is no arbitrage if C lies in that
interval.
(c) Find an arbitrage strategy x such that xT R > 0 for a C not in
the no-arbitrage interval.
3. The prices of a certain security follow a geometric Brownian motion
with parameters µ = .10 and σ = .25. If the securitys price is presently
40, what is the probability that a call option, having four months until
its expiration time and with a strike price of K = 42, will be exercised?
If the interest rate is 8%, what is the risk-neutral valuation of the call
option ?

2
4. (a) Let Xi , i = 1, 2, ..., n be independent random variables, all having
the same distribution with expected value µ and variance σ 2 . Let X =
(Σn1 Xi )/n. Show that E(S 2 ) = σ 2 where S 2 = (Σn1 (Xi − X)2 )/(n − 1)
(b) Explain any one method of estimating the volatility σ of a stock
price.

***

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