Mathematics of Finance

1.
S  1.15USD / Euro;
rEuro  2.5%; rUSD  4.5%;
1.15e10.045  Fe10.025
One-Year forward exchange rate: 1.15e0.045
F  1.1732
e0.025

2.
Assume the Call option price with K=90 is C 1, Call option price with K=100 is C 2.
The payoff table shows below:
ST=105
Short call with K=90 (C1) -(105-90)+C1
Long 2 calls with K=100(-2C2) 2*(105-100-C2)
Total payoffs C1 -5-2C2

3.
Straddle: Long (or Short) the same amount of calls and puts at the same strike price
Straggle: Long (or Short) the same amount of calls and puts at the different strike
price.
Straddle Strangle
Long Short Long Short
Long/Short same units of calls Long/Short same units of calls and puts with
and puts with the same strike different strike (Kc,Kp)
Cost/Premium Cost=C+P Premium=C+P Cost=C+P Premium=C+P
Break-Even K  (C  P ) K  (C  P ) K c  C  P; K P  C  P K c  C  P; K P  C  P
point

4.
The parameters affecting European currency option price and its direction toward
option price are:
European currency options
Call Put
 Spot FX + —
K — +
σ + +
T-t + +
rL(Local rate) + —
rF (Foreign rate) — +

5.
1
rf  f t  (r  rf ) X t f X   2 X 2 f XX
2

6.
The Black-Sholes option price for currencies is:
 rf T
C  St e N (d1 )  Ke  rT N (d 2 )
 rf T
P  Ke  rt N ( d 2 )  St e N ( d1 )

St: the exchange rate at time t; K: strike exchange rate; r: domestic rate; r f: foreign
rate; σ: volatility of exchange rate; T-t: time to maturity.
St 2
ln  (r  rf  )(T  t )
K 2
where d1 
 T t
d 2  d1   T  t

7.
(i) It is possible that two investments have same VaR but different CVaR. Since the
CVaR is the conditional expectation of losses exceeding VaR, we can find 2
different portfolios with the same VaR under 95% confident level but different
conditional expectation loss beyond VaR if one of them has extreme loss in
some cases while the other doesn’t have.
(ii) It is possible that two investments have same CVaR but different VaR. The
same, we can find 2 portfolios with the same conditional expectation of losses
beyond critical level but different at that critical point.

8.
 dX t  0.15 X t dt  0.35 X t dWt
X 0  100
Since the stock price follows geometric Brownian motion,
1
(0.15 0.352 ) t  0.35 t  t
X t  100e 2
,  t ~ N (0,1)
Xt 1 0.352
ln( )  (0.15  0.35 )t  0.35t  t ~ N ((0.15 
2
)t , 0.352 t )
100 2 2
2
0.35
ln X t ~ N (ln100  (0.15  )t , 0.352 t )
2
2
Xt follows Log-Normal distribution with mean ln100  (0.15  0.35 )t and variance
2
2 .
0.35 t

9.
The PDF for the stock price in 1 year is:
1
[ln x  (ln100  (0.15  0.352 )1]2
2
1 1 
p ( x,1)  e 20.352 1
,x 0
x 2  0.352

The PDF for the stock price in 2 years is:

0.352
[ln x  (ln100  (0.15  )2)]2
2
1 1 
p ( x, 2)  e 20.352 2
,x 0
x 2  0.352  2

10.
The PDF of Normal distribution with mean=1, standard deviation=0.5 is
( x 1) 2

1 2(0.5) 2
f ( x)  e
2 (0.5) 2

The Probability that variable is positive:

Prob(x>0)= P ( x  1  0  1)  P( Z  2)  0.9772.

0.5 0.5

11.
r=0, S=100, K=100, σ=0.2, t=1
 C  SN (d1 )  Ke  rt N (d 2 )
100 0.22
ln( )  (0  )1
0.04
d1  100 2   0.1;
0.2 1 0.4
d 2  0.1  0.2 1  0.1
C  100 N (0.1)  100e 0 N (0,1)
 100 N (0.1)  100(1  N (0.1))
 100(2 N (0.1)  1)
 100(2  0.539828  1)
8

12.
The probability for a boy being born p=0.51, for a girl q=1-p=0.49, n=3
Prob(3 children are all grils)=
C03 (0.51)0 (0.49)3  0.1176  11.76%

13.
The put-call parity index:
( Se  q  De  r )  P  C  Ke  rT where S: spot price; K: strike price; C: call price;
P=put price; T: time to maturity; q: dividend yield; r: risk-free interest rate; D: cash
dividend; τ: time to next dividend paid.

When we consider index option, the problem will be the dividend. Of course if all
the component stocks in this index never pay dividend, the index is just like an
individual stock, the put-call parity holds.

Unfortunately most stocks pay dividends, especially blue chips. If an individual

stock goes ex-right, it won’t affect the weight of the stock on index; however, if the
stock pays cash, the index won’t reflect it and adjust to the same level. In this case,
the put-call parity fails.

14.
When a call is deeply out-of-the-money, which means the stock price is far lower
than the strike price, there almost doesn’t need any hedge position, the Delta is near
to zero.
An example: suppose S=10, K=100, r=0.02, t=1, σ=0.3, the delta is near zero:
 X 10
K 100
sigma 30.00%
r 2%
t 1
q 0.00%
Call 0.0000
Delta 0.000

However, if the volatility of the stock return or there is still long time before
maturity, the delta may not be zero:
X 10
K 100
sigma 80.00%
r 2%
t 1
q 0.00%
Call 0.0149
Delta 0.0071

X 10
K 100
sigma 30.00%
r 2%
t 10
q 0.00%
Call 0.1156
Delta 0.0408

15.
 r  3%;0 r4  4%;
0 2

e 40 r4  e 20 r2 e 22 r4

 e0.16  e0.06 e 22 r4
 e0.1  e 22 r4
 2 r4  5%