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# The dynamic of the bond is deterministic given by Bt= (1 +r)t, t∈ {0,1

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(1)

Introduction to mathematical finance

Sheet 2 HS 2014

Hand-in your solutions until 1.10.2014 in Martina Dal Borgo’s mailbox on K floor.

The Binomial Model

The binomial model is a discrete time financial market model, composed of a non-risky asset B (bond), corresponding to an investment into a savings account in a bank and of a risky assetS, which is a stochas- tic process on a probability space (Ω,F,P). The quotes of each asset change at times times 0<1<· · ·< T.

• The dynamic of the bond is deterministic given by

Bt= (1 +r)t, t∈ {0,1, .., T} where r is the risk-free interest rate on [0, T].

• The risky asset (St)t=0,...,T has the following stochastic dynamic: when passing from time t−1 to time t the stock can only increase or decrease its value with constant increase and decrease rates denoted u for “up” andd for “down”:

(S0 ∈R>0

St=St−1ξt, t= 1, . . . , T

where (ξt)t∈{0,1,..,T} are i.i.d. Bernouilli random variables whose distribution is a combination of Dirac’s Deltas: Let p∈(0,1) be the probability that the stock increases. We have:

P[St=uSt−1] =P[ξt=u] =p, P[St=dSt−1] =P[ξt=d] = 1−p.

that is

St=

(uSt−1, with probability p, dSt−1, with probability 1−p.

Hence a trajectory of the stock is a vector such as (T = 4)

(S0, uS0, udS0, u2dS0, u3dS0) which can be identified with the vector

(u, d, u, u)∈ {u, d}4

of the occurrence of the random vector (ξ1, ξ2, ξ3, ξ4).Therefore we can assume that the sample space Ω is the family

{u, d}T ={(e1, . . . , eN)|en=u oren =d },

containing 2N elements and F is the σ-algebra of all subsets of Ω. Moreover we assume that

P[ω]>0, ∀ω∈Ω and we endow this probability space with the filtration F= (Ft)0≤t≤T defined by:

F0 ={∅,Ω}=σ(∅), (1)

Ft=σ(ξ1, .., ξt), t∈ {1, .., T}. (2) The σ-algebra Ft represents the amount of information available in the market at time t. Thanks to exercise 1 and formula (1), one sees that in the model the initial priceS0 of the asset is deterministic. The family of trajectories can be represented on a binomial tree (T = 3)

1

(2)

S0

S0d

S0d2 (1−p)2

(1−p)p (1−p)

S0u

S0ud (1−p)p

S0u2 p2

p

Exercise 1

Prove that if X is a random variable on (Ω,P), measurable with respect to the trivial σ-algebra F ={∅,Ω}, then X is constant.

Exercise 2

Prove that in the binomial model the stock at time t, t= 0,1, . . . , T is St =S0uBdt−B

whereB ∼Binomial (t, p) i.e.

P[B =k] = t

k

pk(1−p)t−k. Exercise 3

Consider a two-period (2 semesters) binomial market model (B, S) consisting of a bond, B, paying an annual risk-free rate r = 4%, and a risky asset with current spot price S0 = 20. The parameters of the model areu= 1.25, d= 0.75.

Verify whether the exercise of a European Call option written onS with strikeK = 18 and with maturity T = 6 months, is more likely than the exercise of a European Call option as the one above but with maturity T0 = 1 year.

Explanation: more likely means which of the two options has the bigger probability of being exercised by the buyer of the option.

Exercise 4

Consider a one-period (annual) financial market model (B, S) consisting of a bond,B, paying an annual risk-free rate r ≥ 0, in one risky asset, S, whose final value depends on some random event (we assume that the event can assume only two possible states{ω1, ω2}, P(ω1) = P(ω1) = 1/2 in which S1 takes the values S11) and S12)). We denote by C a Call option written on the risky asset, with maturity of 1 year and strike K = 100, depending on the same random event:

Time 0 T = 1 (year)

Bond B0 = 1 B1 = (1 +r) Risky asset S0 = 100 S1 =

(120 if ω1 90 if ω2 Call option C0 =? C1 =

((120−100)+ = 20 if ω1 (90−100)+ = 0 if ω2

Notice that in one period, a self-financing strategy is given by a single vector φ = (β, α) that is F0 measurable (hence deterministic). Find a trading strategy φ = (β, α) such that the final value of this strategyV1(φ) satisfies

C1 =V1(φ) =βB1+αS1. 2

(3)

regardless of the outcomeω1 orω2. Compute numerically the initial value of this strategyV0(φ) =αS0+β.

Exercise 5

Consider a one-period (annual) financial market model (B, S) consisting of a bond,B, paying an annual risk-free rater ≥0, in one risky asset,S, whose final value depends on some random event (we assume that the event can assume three possible states{ω1, ω2, ω3}, withP(ω1) = p1, P(ω2) =p2, P(ω3) = 1−p1−p2, in whichS1 takes the values S11) andS12)). We denote by C a Call option written on the risky asset, with maturity of 1 year and strikeK = 100, depending on the same random event:

Time 0 T = 1 (year)

Bond B0 = 1 B1 = (1 +r) Risky asset S0 = 100 S1 =





150 if ω1 110 if ω2 40 if ω3 Call option C0 =? C1 =





(150−100)+ = 50 if ω1 (110−100)+ = 10 if ω2 (40−100)+= 0 if ω3

In the same spirit as the previous exercise, try to find a trading strategy φ = (β, α) such that the final value of this strategyV1(φ) satisfies

C1 =V1(φ) =βB1+αS1.

3

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