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Exercises 9

The document contains exercises related to financial mathematics, focusing on concepts such as the Central Limit Theorem for triangular schemes, Black-Scholes pricing, and binomial asset pricing models. It includes tasks for computing option prices, exploring convergence in pricing models, and analyzing the Vega and implied volatility of options. Additionally, it presents a binomial tree for calculating the price of an American power put option and discusses optimal exercise strategies.

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24 views2 pages

Exercises 9

The document contains exercises related to financial mathematics, focusing on concepts such as the Central Limit Theorem for triangular schemes, Black-Scholes pricing, and binomial asset pricing models. It includes tasks for computing option prices, exploring convergence in pricing models, and analyzing the Vega and implied volatility of options. Additionally, it presents a binomial tree for calculating the price of an American power put option and discusses optimal exercise strategies.

Uploaded by

gameom260
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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INTRODUCTION TO FINANCIAL MATHEMATICS

Exercise sheet 9

Exercise 41⋆ Prove the following Central Limit Theorem for triangular schemes: Let n ∈ N and consider a sequence
Ln = (Ln1 , . . . , Lnn ) of r.v.s (“triangular scheme”) with the following properties:
(i) for every n ∈ N the r.v.s (Lni )i=1,...,n are independent and identically distributed;
(ii) there exists a sequence of constants K n → 0, such that

|Lni | ≤ K n ∀i ∈ {1, . . . , n};


Pn
(iii) for Zn = i=1 Lni holds that E[Zn ] → µ and Var(Zn ) → σ 2 .
Then, the r.v. Zn converges in law to the r.v. Z, that follows the normal distribution with mean E[Z] = µ and variance
Var(Z) = σ 2 .

Hint: Use the characteristic function.

Exercise 42⋆ Consider an arbitrage-free financial market where the risk-free interest equals 1%. Let S denote a financial
asset in this market with spot price equal to 95 and volatility equal to 20%. Assume that a European call option with
strike 95 and maturity in one year is traded in this market.
(i) Compute the Black–Scholes price of this derivative.
(ii) Compute the price of this derivative in a sequence of binomial models with decreasing step size n (e.g. n =
10, 20, 40, 60, 80, 100, . . . ) and study its convergence to the Black–Scholes price.
(iii) Provide the code and a plot that shows this convergence (either code and plot embedded in the PDF file or as a
Python notebook).

Exercise 43⋆ Consider


√ the sequence of binomial
√ asset pricing models defined in the lecture, with parameters rn := r∆n ,
an := r∆n − σ ∆n and bn := r∆n + σ ∆n , where σ > 0 and ∆n := T /n.

(i) Consider a power option C with payoff C := (ST )2 . Define C0n to be the arbitrage-free price at time 0 in the n-th
binomial model. Compute the limit limn→∞ C0n .
(ii) Compute the Delta (∆) of the power option.

Exercise 44⋆ Let v BS denote the Black–Scholes formula for the price of a European call option with strike price K and
maturity T in the Black–Scholes model (i.e. in the limit of binomial models).
(i) Show that the Vega V, i.e. the sensitivity of v BS wrt the volatility σ, equals

∂ BS √
V(t, x) := vt (x, K, r, T, σ) = xΦ′ (d1 ) T − t.
∂σ

(ii) Let C0∗ (K, T ) be a traded price for a call option with strike K and maturity T , that lies strictly between the trivial
no-arbitrage bounds, i.e.
(S0 − e−rT K)+ < C0∗ (K, T ) < S0 .
Show that there exists a unique implied volatility σ imp (K, T ) ∈ (0, ∞), such that

C0∗ (K, T ) = v BS (S0 , K, r, T, σ imp (K, T )).

(iii) Compute numerically the implied volatility for the option prices available at FX-data (see “Exercises” in Brightspace).
Provide the code and a matrix that shows the implied volatility for each strike and maturity (either code and matrix
embedded in the PDF file or as a Python notebook).

1
Hints: Use the properties of the Vega in (i) in order to show the uniqueness in (ii). In the numerical example (iii), use
that the “effective” rate r := rdom − rfor , while time is counted in fractions of a year, e.g. 2 months equal 60/365 days.

Exercise 45⋆ Assume that the price of a financial asset is provided by the following binomial tree:

128

96

72 64

54 48

36 32

24

16

Figure 1: Binomial tree.

i.e. we have that b̂ = 1 + b = 43 , â = 1 + a = 32 , while we define r = 19 .


(i) Compute the price of an American power put option with strike price K = 56, i.e.

C am = [(56 − Sτ )+ ]2 .

(ii) Describe the optimal exercise strategy for this power put option.

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