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Department of Mathematics MTL 733 (Stochastics of Finance) Tutorial Sheet No. 1

This document contains 24 problems related to stochastic processes and martingales. The problems cover topics like geometric Brownian motion, Wiener processes, martingales, and submartingales. They involve showing certain stochastic processes have independent increments, are jointly normal, or satisfy the definition of a martingale. The problems also involve calculating expectations, variances, and probabilities for stochastic processes.

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125 views2 pages

Department of Mathematics MTL 733 (Stochastics of Finance) Tutorial Sheet No. 1

This document contains 24 problems related to stochastic processes and martingales. The problems cover topics like geometric Brownian motion, Wiener processes, martingales, and submartingales. They involve showing certain stochastic processes have independent increments, are jointly normal, or satisfy the definition of a martingale. The problems also involve calculating expectations, variances, and probabilities for stochastic processes.

Uploaded by

Jayant
Copyright
© © All Rights Reserved
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Department of Mathematics

MTL 733 (Stochastics of Finance)


Tutorial Sheet No. 1
1. Trace the path of the following stochastic processes
(a) {X(t), t ∈ [0, ∞)} where X(t) is the total number of shares held by an investor at any time t.
(b) {Xn , n = 1, 2, . . .} where Xn is the value of one US dollar (USD) in rupees at the end of n-th day.
(c) {X(t), t ∈ [0, ∞)} where X(t) is the stock price of a particular item at any time t.
(d) {Xn , n = 1, 2, . . .} where Xn is the total number of shares held by a particular person at the end of n-th
day.
√ −1
2. Let Xn , for n even take values +1 and −1 each with probability 0.5, and for n odd, take values a, √ a
with
1 a
probability a+1 , a+1 respectively (a > 0, a 6= 1). Further, let Xn ’s be independent, show that {Xn , n =
1, 2, . . .} is covariance/wide sense stationary but not strict stationary.
3. Let {X(t), t ≥ 0} with X(0) = 0 be a stochastic process having independent increments. Show that
V ar{X(s)}, for 0 ≤ s ≤ t;
cov{X(s), X(t)} =
V ar{X[min(s, t)]}, for any s, t (t, s > 0).
4. Let {W (t), t ≥ 0} be a Wiener process. Find the conditional distribution of W (t) given that W (s) = c (where
c is a constant) when s < t.
5. Let {W (t), t ≥ 0} be the Brownian motion. Prove that, E((W (t) − W (s))4 ) = 3(t − s)2 .
6. Let {W (t), t ≥ 0} be the Brownian motion. Prove that (W (t1 ), W (t2 ), . . . , W (tn )) is jointly normal dis-
tributed. Also find the mean and variance for the random variable W (t).
7. Let S(t) be the stock price at any time t. Assume that {S(t), t ≥ 0} follows a geometric Brownian motion.
σ2
)
Prove that E(S(t)) = S(0)et(µ+ 2 where S(0) is the initial price, µ is the drift parameter and σ is the
volatility parameter.
8. Suppose that {S(t), t ≥ 0}, is a geometric Brownian motion with drift parameter µ = 0.01 and volatility
parameter σ = 0.2. If S(0) = 100. Find
(a) E[S(10)].
(b) P [S(10) > 100].
9. The price of a stock follows a geometric Brownian motion with drift µ = 12% per year and variance σ 2 = 9%
per year. If the present price of the stock is Rs.40, what is the probability that a call option having four
months to exercise time and with a strike price K = Rs.42, will be exercised?
10. Let X be a normally distributed random variable with mean µ and variance σ 2 . Let u be a fixed number in
R and define the convex function φ(x) = eux for all x ∈ R. Prove that
2
1
σ2
(a) E(φ(X)) = euµ+ 2 u .
(b) Verify the Jensen’s inequality holds E(φ(X)) ≥ φ(E(X)).
11. Show that for any T > 0, V (t) = W (t + T ) − W (T ) is a Wiener process if {W (t), t ≥ 0} is a Wiener process.
12. Let {W (t), t ≥ 0} be a Brownian motion. Prove that {tW (1/t), t ≥ 0} where tW (1/t) is taken to be zero
when t = 0, is a Brownian motion.
13. Consider the process 
W (t), t<1
Y (t) =
W (t) + Z, t ≥ 1
where {W (t), t ≥ 0} is a Wiener process and Z ∼ N (0, 1) and is independent of W (t). Show that {Y (t), t ≥ 0}
not a Levy process.

1
14. Let {W (t), t ≥ 0} be a brownian motion. Find the conditional expectation of Ws given Wt = x for 0 < s < t.
15. Let X1 , X2 , . . . be a sequence of iid random variables each takes 0 or 2 with equal probabilities. Let Yn =
X1 X2 . . . Xn , (n = 1, 2, . . .). Prove that, {Yn , n = 1, 2, . . .} is a martingale.
16. Let
Pn Xi , i = 1, 2, . . . be a sequence of iid random variables with common distribution N (0, 1). Define Sn =
n 2
i=1 X i . For what values of α, exp{αS n − 2 α } is a Fn martingale.
17. For every n = 0, 1, . . . , N , let an and bn be the number of stocks and bonds respectively bought at time n
and held over the period [n, n + 1). The bond price is modelled according to B0 = 1, Bn = (1 + r), n =
1, 2, . . . N where r > −1 is the constant rate of return for the bond. The stock price is modelled according
to S0 = s, Sn = (1 + Rn )Sn−1 , n = 1, 2, . . . , N where s > 0 and {Rn , n = 1, 2, . . . , N } is a sequence of iid
random variables. Let {Vn , n = 0, 1, . . . , N } be the portfolios consisting of the bond and the stock. Let
Vn = an Sn + bn Bn
be the value of the portfolio over [n, n + 1). Let {Fn , n = 1, 2, . . . , N } be the filtration given by Fn =
σ(R1 , R2 , . . . , Rn ), n = 1, 2, . . . , N . Show that Vn /Rn is martingale with respect to the filtration {Fn , n =
1, 2, . . . , N } if E(Rn+1 | Fn ) = r.
18. Let {Xn , n = 0, 1, 2, . . .}, {Yn , n = 0, 1, 2, . . .} be stochastic processes. We say {Xn } is a martingale with
respect to {Yn } iff
(a) E[|Xn |] < ∞ and (b) E[Xn+1 /Y0 , Y1 , Y2 , . . . , Yn ] = Xn .
Prove that {Xn } is a martingale with respect to {Yn } where Xn = Y1 + Y2 + . . . + Yn , n ≥ 1, Y0 = 0,
{Yi , i = 1, 2, . . .} are independent random variable with E(Yn ) = 0.
19. Let Xn be a symmetric random walk and Fn be a filtration. Show that Yn = (−1)n cos(πXn ) is a martingale
with respect to Fn .
20. Let Xn be a sequence of square integrable random variables. Show that if Xn is a martingale with respect
to a filtration Fn , then Xn2 is a sub martingale with respect to the same filtration. (Hint: Use Jensen’s
inequality with convex function φ(x) = x2 )
21. Show that X(t) = [W (t)]2 − t is a martingale, where {W (t), t ≥ 0} is a brownian motion. But Y (t) = [W (t)]2
is not a martingale. Further, let Z(t) = [W (t)]3 . Check if Z(t) is a martingale.
22. Let {X(t), t ≥ 0} be a Poission process with rate 1. Which of the following are martingales.
(a) {X(t) − t, t ≥ 0}
(b) {X(t)2 − t, t ≥ 0}
(c) {(X(t) − t)2 − t, t ≥ 0}
Justify your answer.
23. Let S be the stochastic process defined by
S(t) = exp(σW (t) + α + βt)
For which choice of parameters α, β and σ is S a martingale? Justify your answer.
24. Consider the binomial tree model. Let Sn be the stock price at time n (risky asset).

uSn with probability p
Sn+1 = n = 0, 1, . . .
dSn with probability 1 − p

Find the value of p such that discounted process {S0 , e−r S1 , e−2r S2 , . . .} is a martingale where r is the interest
rate. Justify your answer.

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