THE AUSTRALIAN NATIONAL UNIVERSITY

RESEARCH SCHOOL OF FINANCE, ACTUARIAL STUDIES

AND STATISTICS
FINM3003/7003: CONTINUOUS TIME FINANCE
PRACTICE EXAMINATION QUESTIONS 2017

NOTE: The questions here are indicative in length and degree of difficulty
of the sorts of questions that may appear on the final exam, but do not nec-
essarily reflect the scope and coverage of the exam. For extra practise, revise
the questions on the assignments and tutorial sheets.

1. You have the following portfolio of options:

Type Position Delta of option Gamma of option Vega of option

Call -1000 0.50 2.2 1.8
Call -500 0.80 0.6 0.2
Put -2000 -0.40 1.3 0.7
Call -500 0.70 1.8 1.4

A traded option is available with = 0.6, = 1.5, V = 0.8.

(a) What position in the traded option and in the underlying makes the
portfolio both delta and gamma neutral?
(b) What position in the traded option and in the underlying makes the
portfolio both delta and vega neutral?
(c) Suppose a second traded option is available with = 0.1, = 0.5,
V = 0.6. How could the portfolio be made delta, gamma and vega neutral?
(d) A deposit instrument offered by a bank guarantees that you will re-
ceive a return during a 6-month period which is the greater of (a) zero and,
(b) 40% of the return provided by a market index.
(e) Describe the payoff as an option on the index. (NOTE: assumereturn
to mean the simple return over the period.)
(f) Value the product at time 0, assuming: r = 8% p.a., the dividend
yield on the index is 3% p.a., and the volatility of the index is 25% p.a.

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 2. (a) Draw schematic diagrams showing the variation of your profit
or loss with the terminal stock price for a portfolio consisting of:
(i) One share and a short position in one call option;
(ii) Two shares and a short position in one call option;
(iii) One share and a short position in two call options;
(iv) One share and a short position in four call options.
Your diagrams need not be to scale, but you should indicate clearly the
distinguishing features of the graphs, such as intercepts and gradients of lines,
etc.
(b) Define a cashornothing call, having payoff Q at time T , on a
stock whose price St follows geometric Brownian motion with parameters ,
2 . Then show that its value at 0 is
erT QN (d2 ),

where d2 = (ln(S0 /K) + (r (1/2) 2 )T )/ T and N (x) is the value of the
Normal c.d.f. at x.
(c) Define an assetornothing call on a stock whose price St follows
geometric Brownian motion with parameters , 2 . Then show that its value
at 0 is
S0 N (d1 ),

where d1 = d2 + T . (You may assume the Black-Scholes formula for a
European call.)
(d) Write down formulae extending the values in (b) and (c) to time
t < T.
3. (a) Use a one-step Binomial model and a no-arbitrage approach to
find the value at time 0 of a derivative on a stock as the present value of an
expectation with respect to a risk-neutral probability distribution. Express
the parameter of the riskneutral distribution in terms of the parameters in
the underlying model.
(b) Next, using a two-step Binomial model, show how to set up a syn-
thetic European call that is, a portfolio consisting of investments in the
stock and a risk-free asset which exactly replicates the cash flow of a Euro-
pean call on the stock. Verify that this replication in fact occurs, and that
your portfolio is self-financing.
(c) Now repeat (b), but this time set up a replicating portfolio consisting
of futures contracts on the stock and a risk-free asset. Again verify that your

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portfolio is self-financing and exactly replicates the cash flow of the European
call. (d) Briefly discuss the possible applications of each of the procedures
in (b) and (c) in terms of practical (investing) applications.
4. The unit root test is used in econometrics to see if a time series can
be regarded as a random walk. The stochastic d.e.

dxt = xt dt + dZt (1)

arises in one of the papers in this area (Phillips Towards a unified theory
for autoregressions, Biometrika 74 (1987) 535547).
(a) Show that the solution of (1) is
Z t
xt = Z t + e(ty) Zy dy. (2)
0

(b) Apply the Ito calculus to x2t to deduce that

Z t Z t
2 2
xt = t + 2 xy dy + 2 xy dZy . (3)
0 0

(c) What does (3) reduce to for = 0?

(d) Lets examine the procedure in Hull for simulating the price of
a stock which follows geometric Brownian motion. Take an interval [0, t]
divided into n subintervals of length t, and let

Sj = S0 ji=1 (1 + Zi ), j = 1, 2, . . . , n, (1)

where the Zi are i.i.d. with distribution N (t, 2 t), and t is small
(e.g., t = 0.01) while n is large (e.g., n = 100). Then (S1 , S2 , . . . Sn ) is an
approximate realisation of the process
2 )t+Z
St = S0 e((1/2) t
(2)

at the points t, 2t, . . . , nt. Using the Central Limit Theorem and the
Law of large numbers, demonstrate (without being too rigorous) how (2)
follows from (1). [Hint: recall the Taylor expansion for the log function,
ln(1 + x) = x x2 /2 . . ..]

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 5. The Black-Scholes price at time t T of a European call option on
a stock with price St at time t and volatility , when the strike price is K,
the expiry time is T and the riskfree interest rate is r, is given by

ct = SN (d1 ) Ker(T t) N (d2 ),

where N (x) denotes the cumulative standard normal c.d.f. at x,

ln(S/K) + (r + (1/2) 2 )(T t)

d1 =
T t
and
d2 = d1 T t.

(a) What is meant by the (Theta) of a security or portfolio?

(b) Show that for the above option, the corresponding is given by

= SN 0 (d1 ) rKer(T t) N (d2 ).
2 T t

(c) What does this tell you about the time rate of change of the option
price, when all other parameters are held constant?
(d) What is meant by the (Rho) of a security or portfolio?
(e) Show that for the option in Question 1, the corresponding is given
by
= K(T t)er(T t) N (d2 ).

(f) What does this tell you about the way the option price changes with
changing interest rates, when all other parameters are held constant?
6. (a) Outline a market theory in discrete time whereby a market
consists of a risk-free asset and a risky asset whose values at time t are Bt
and St , t = 1, 2, , T . Your outline should include explanations of the
following concepts:
(i) A Trading Strategy, and when it can be said to be predictable;
(ii) the corresponding Value and Gains processes for the strategy, and
what is meant by an arbitrage opportunity in this setup.
(iii) State the theorem of Harrison and Pliska which gives a criterion for
the market to be arbitrage-free.

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 (iv) State exactly what is meant by saying that the discounted stock price
process St = St /Bt is a martingale. What interpretation(s) can be given to
this?
(b) (i) In the Cox-Ross-Rubinstein model of a discrete time market,
Bt grows at the risk-free rate and St can be constructed from i.i.d. random
variables Zi taking values u and d. What exactly is this construction?
(ii) Use the construction in (i) to show that the Cox-Ross-Rubinstein
model is arbitrage-free if and only if

d < er < u.

Supposing this is so, specify the corresponding equivalent martingale mea-

sure.
(c) Prove that the arbitrage-free price at t of an attainable contingent
claim with payoff fT at T is
1 b (fT |Ft ) ,
E
BT t

where you should specify, briefly, the meanings of E

b and Ft .

7. (a) A three-month European call option on a stock has an exercise price

of $50. The stock price is currently $50, it has a volatility of 40% p.a., and
the risk-free rate with continuous compounding is 10% p.a.
(a) Construct a Cox-Ross-Rubinstein binomial tree with n = 3 equal
time steps for the stock price movements. [3 marks]
(b) What is the risk-neutral probability distribution? [3 marks]
(c) Write at each node the values of the option, calculated using the
risk-neutral probability distribution. [3 marks]
(d) Construct a hedging (replicating) portfolio for the call, and write
at each node of the tree the holdings of stock and bond required. [3 marks]
(e) Verify that this portfolio does in fact replicate the call values.
[3 marks]
(f) Verify that the portfolio is self-financing. [2 marks]
(g) Using tables of the normal distribution, find the value of the call in
Question 1 as given by the Black-Scholes formula. Explain any discrepancy
that you observe. [3 marks]

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8. A stock price St satisfies the stochastic differential equation (sde) (in
the usual notation)
dSt
= dt + dzt , t 0. (1)
St
(a) is called the expected return on the stock. Why? [2 marks]
(b) What is called? Discuss briefly the estimation of in practice.
[3 marks]
(c) What is zt called? List some important properties satisfied by zt .
[3 marks]
(d) Verify that
2
St = S0 e((1/2) )t+zt
satisfies the sde in Equation (1). [6 marks]
NOTE: For (d), it will be helpful to recall Itos Lemma: if dx(t) = adt + bdzt
defines an Ito process and G is a function of x and t, then,

G G 1 2 2 G
 
G
dG(x, t) = a + + b 2
dt + b dzt .
x t 2 x x

(e) Write down the distribution followed by St at a particular time t, being

careful to specify the parameters involved. [6 marks]
9. (a) Define the following kinds of options and where possible write their
payoff functions at time T in a succinct notation; alternatively, give a brief
description of the option:
(i) cash-or-nothing option;
(ii) upandin call;
(iii) compound option (call on a call);
(iv) forward start call;
(v) asyoulikeit option;
(vi) paylater option. [6 marks]
(b) Choose two of the six options in (a) and give a detailed discussion of
their valuation, ending with an explicit formula for the price of the option.
Specify carefully any assumptions you make. [10 marks]
(c) A derivative on a stock St pays off |ST X| (the modulus, or absolute
value, of ST X) at time T . Show that, at time 0, its value is that of 2 calls
plus certain holdings of stock and bonds. [4 marks]