Stochastic Calculus Final Examination Solutions

June 17, 2005

There are 12 problems and 10 points each.

1. (Property of Brownian Bridge)

Xt
dt + dBt ,
Let Bt0 = {Bt , 0 t 1|B1 = 0} be a Brownian bridge, and define dXt = 1t
with X0 = 0.
a) Show that {Bt0 , 0 t 1} and {Xt , 0 t 1} have the same distribution.

b) Show that Yt = (1 + t)B 0 t is a standard Brownian motion.

1+t
sol:

(a)
(1)Bt0 = Bt tB1 , Bt N (0, t), B1 N (0, 1), tB1 N (0, t2 ) linear combination of
normal distribution is still normal. Compute mean and variance.
EBt0 = 0,
EBs0 Bt0 = s(1 t)ifs < t VarBt0 = t(1 t)

Bt0 N (0, t(1 t)) 0 t 1.

Rt
(2) According to the solution of OU process, Xt = (1 t) 0

1
dBs
1s

Xt is the linear combination of N.D., therefore it is still a N.D. Compute mean and variance
Xt = 0,
Ifs t : EXs Xt
Rs 1
Rt 1
= (1 s)(1 t)E[ 0 1u
dBu 0 1v
dBv ]
Rs 1
Rs 1
Rt 1
= (1 s)(1 t)E[ 0 1u dBu ( 0 1v dBv + s 1v
dBv )]
Rs 1
= (1 s)(1 t)E[( 0 1u dBu )2 ] (independent increment)
Rs 1 2
= (1 s)(1 t)E[ 0 ( 1u
) ds] (Itos isometry)
s
= s(1 t) VarXt = t(1 t)
= (1 s)(1 t) 1s
Xt N (0, t(1 t))

(b)
B

t
1+t

N (0,

t
s
), B 1+s
1+t

t
EXt = E(1 + t)(B 1+t

N (0,

t
B)
1+t 1

s
), B1
1+s

=0
1

N (0, 1) Yt N.D.

t
s
< 1+t
1) :
If 0 s < t 1 (0 1+s
s B t
EXs Xt = (1 + s)(1 + t)[EB 1+s

1+t
VarYt = t

t
s B
EB 1+s
1
1+t

s
t B1
EB 1+t
1+s

s
t
EB12 ]
1+s 1+t

=s

Yt N (0, t)
(1)Y0 = 0
(2)Independent increment
0 = t0 < t1 < ... < tn = 1 : Yt1 Yt0 , Yt2 Yt1 , ..., Ytn Ytn1
Cov(Yti Yti1 , Ytj Ytj1 ) = 0
(3)stationary increment
E(Yt Ys ) = 0

Var(Yt Ys ) = Var(Yt ) + Var(Ys ) 2Cov(Yt , Ys ) = t + s 2s = t s

Yt Ys N (0, t s)
(4)Yt N (0, t)
(5)Bt is continuous in t Yt is also continuous in t
From (1)(5), Yt is a SBM.

2. a) Solve the following stochastic differential equation

dXt = (Xt + )dt + dBt ,

where X0 = x0 and > 0.

b) Verify the solution can be written as

Xt = e

(x0 + (et 1) +

es dBs ).
0

c) Show that Xt converges in distribution, as t , and find the limiting distribution.

d) Find the covariance Cov(Xs , Xt ) for s < t.

sol:
(a)
dXt + Xt dt = dt + dBt
multiply et for both sides
d(et Xt ) = E t dt + et dBt
Rt
Rt
es Xs |t0 = 0 es ds + 0 es dBs
2

 Xt = et (x0 + (et 1) +
(b)
Xt
= Xt +
t

Rt
0

es dBs )

Xt
=
Bt
2
Xt
=
Bt2

By Itos formula:
dXt = (Xt + )dt + dBt
(c)
(1)EXt = x0 et + (1 et ) as t
Rt
2
(2)VarXt = 2 E 0 e2(ts) ds = 2
(1 e2t )
D

2
) as t
N ( , 2
2 (t+s)

Therefore Xt
(d) Cov(Xs , Xt ) = e
R st
= 2 e(t+s) E 0 e2u du
2 (t+s) 2(st)
= 2
e
(e
1)

2
2

as t

Rt
Rs
Cov( 0 eu dBu , 0 eu dBu )

3. a) Give a precise description of the simplest Girsanov theorem.

b) Let L be the line given by the equation y = a + bt with a > 0. Define
L = inf{t : Bt = a + bt}.
Use the simplest Girsanov theorem (Brownian motion with drift) to derive the probability
density function fL (t) of L .
sol:
(a)
If the process {Bt } is a P-BM and Q is the measure on C[0, T ] induced by the process

Xt = Bt + t, then every bounded Borel measurable function W on the space C[0, T ]

satisfies
EQ (W ) = EP (W MT ),
where Mt is the P-mtgle defined by Mt = exp(Bt

(b)

2 t
)
2

L = inf{t : Bt = a + bt}, a = inf{t : Xt = a}, whereXt = Bt bt

P (L t) = Q(a t) = EQ (1(a t)) = EP (1(a t)MT )(simplest Girsanov theorem)
2
whereMt = exp{bBT b2 T }

= EP (1(a t)Mta ) ({a t} is Fta measurable)

2
= EP (1(a t) exp(ab b2 a ))
Rt
2
= 0 exp(ab b2 s) a3 ( as )ds
s2

a
) for t 0.
( a+bt
fa (t) = t
P (L t) = t3/2
t
4. a) State the Martingale representation theorem.

b) State the Feynman-Kac representation theorem for Brownian motion.

Sol:
(a) Xt is an {Ft }-martingale, where {Ft } is the standard Brownian filtration,
if a and T , such that E(XT2 ) < ,
2

and ! (s, ) H [0, T ], such that Xt =

t
0

(s, )dBs, 0 t T .

(b) Suppose that the function q : R R is bounded. Consider



ut (t, x) = 21 uxx (t, x) + q(x)u(t, x)

u(0, x) = f (x)

where f : R R is also bounded.

If u(t, x) is the unique bounded solution of the function, then
u(t, x) = E[f (x + Bt )exp(

Rt
0

q(x + Bs )ds)]

5. The Black-Scholes model is assumed to be

dSt = St dt + St dBt ,
dt = rt dt.
a) By using arbitrage theory to show the procedure of deriving the Black-Scholes PDE for
European call option.
4

b) Show how to transform this PDE into a heat equation.

6. (continued)
c) Use Fourier transform technique to derive the solution of the above heat equation.
d) Derive Black-Scholes formula for European call option via Feynman-Kac representation.
Sol:
(a) Hedging price Yt = t Bt + t St .
Itos formula:
2

dY = ( Y
+ S Y
+ 21 2 S 2 SY2 )dt + S Y
dWt
t
S
S
And
dY

= t dBt + t dSt
= (rt Bt + t St )dt + t St dWt

Matching coefficient:

Yt =

1 Y
(
rBt t

t =
t =

+ 21 2 S 2 SY2 )Bt +

Y
S
1 Y
(
rBt t

+ 21 2 S 2 SY2 )

Y
S
S t

(T, St ) + 12 2 (T, St )ST2 SY2 (T, St ) = 0

Y (T, S) = f (T, S) = (S K)+
Y
t

(b) Let

= 2 (T t)

2
)(T
2

z = ln S + (r

= 12 zu2
u(0, z) = f (z) = (ez K)+

t)

Set u(, z) = er(T t)Y (t,St ) , then

(c) Take Fourier transform:



= 12 (iw)2 u
(w, ) = 21 u(w, )
u
(0, w) = f(w)

u
(w, )
t

1 2
u
(, w) = f(w)e 2 w
Inverse Fourier transform:

u(, z) =

1
2

z2

1 2
f(w)e 2 w eiwz dw

By transform of Gaussian, we have F (e 2 )(w) =

2
z2

= F ( 1 e
e
Therefore,

2
z2

e 2 w

)(w) F (g (z))(w)

u(, z) = f gR (z)

= 12 f (y)g (z y)dy
R
(zy)2
= 12 f (y) 1 e 2 dy
R
(zy)2
1
= 2
f (y)e 2 dy

R y
(zy)2
1
+ 2
dy
= 2
(e

K)
e

(d) y = Wtheta + z dy = dW , where {W } is the standard Brownian motion.

1
K)+
E(eW +z K)+ = E(ez e W

= E(ez+ 2 e W1 2 K)+

K)
) Kez+ 2 ( zln
= ez+ 2 ( zlnK+

= S0 (

ln( K0 )+(r+ 2 )(T t)

)
T t

KerT (

ln( K0 )+(r 2 )(T t)

)
T t

7. Derive the pricing formula for European put option by using the technique of change of
numeraire and Girsanov theorem.
payoff X = (K S(T ))+
rT (K S(T ))+ ]
p = E[e
rT (K S(T ))I(k S(T )]
= E[e

= erT K P (K S(T )) erT E[S(T

)I(K S(T ))]
= (1) (2)
6

2
2

)T + T Z

2
)T ]
2

z 1 T [ln( SK0 ) + (r
2
1

[ln( SK0 ) + (r 2 )T ]
T
(1) = KerT P (z d2 ) = KerT (d2 )
rT S(T ) I(K S(T ))]
(2) = S0 E[e

K S0 e(r
where d2 =

(Let

dP
dP

S(0)
rT S(T )
e
S(0)

= e WT

d2 ,

2
T
2

t = W
t t
Let W

2
2

k S0 e(r 2 )T + T Z = S0 e(r+ 2 )T +WT

z d1 )
= S0 P (z d1 ) = S0 (d1 ) Therefore, p = KerT (d2 ) S0 (d1 )
8. Barrier option pricing:
Find the arbitrage price of a contingent claim that pays M if the stock price gets to a level
K or higher during the time period [0, T ] and that pays zero otherwise. In other words,
find a formula for the arbitrage price of the claim
X = M I{
sol:
sup St > K sup Bt + 1 (r
t[0,T ]

t[0,T ]

2
)t
2

sup St >K} .
t[0,T ]

ln SK0

Let a = 1 ln SK0 , b = 1 (r 2 )t
= inf{Bt = a + bt}
(a+bt)2
a
2t
f = 2t
e
3
rT
u0 = e E[M 1( sup St > K)] = erT M P ( sup St > K)
t[0,T ]

t[0,T ]

= e M P ( T ) (Law( + Bt , t T |PT ) = Law(r + Bt , t T |PT ))

= erT M P (L T )
rT

= erT M [1 (

2
ln K
(r 2 )T
S0

)+

ln
K 22 (r 2 )
(
e
S0

2
K
(r 2 )T
S0

)]

9. a) State the Poisson process martingale property theorem.

b) Let N (t) be a Poisson process with intensity . Show that
exp{ln(1 u)N (t) + ut}, 0 < u < 1,
7

is a martingale.
Sol:
(a) Let N (t) be a Poisson process with intensity . Then M (t) = N (t)t is a martingale.
(b)
E[exp{ln(1 u)N (t + s)}|Ft ] = E[exp{ln(1 u)N (t) + ln(1 u)(N (t + s) N (t))}|Ft ]
= exp{ln(1 u)N (t)}E[exp{ln(1 u)(N (t + s) N (t))}|Ft ]
= exp{ln(1 u)N (t)}E[exp{ln(1 u)(N (t + s) N (t))}]
= exp{ln(1 u)N (t)} exp{us}
Therefore, E[exp{ln(1 u)N (t + s) + u(t + s)}|Ft ] = exp{ln(1 u)N (t) + ut}
10. Consider the stock and bond model given by
dSt = (t, St )dt + (t, St )dBt

and dt = r(t, St )t dt,

where all of the model coefficients (t, St ), (t, St ), and r(t, St ) are given by explicit functions of the current time and the current stock price. Use the coefficient matching method
to show that arbitrage price at time t of a European option with terminal time T and payout h(ST ) is given by f (t, St ), where f (t, St ) is the solution of the terminal value problem
1
ft (t, St ) = 2 (t, x)fxx (t, x) r(t, x)xfx (t, x) + r(t, x)f (t, x),
2
f (T, x) = h(x).
Sol:
(a) For European call option, the payout is h(St ) = (ST K)+ .
Consider the replicating portfolio at time t, Vt
Let at : the number of units of stock.
bt : the number of units of the bond.
Total value of the portfolio at time t is
V t = a t S t + b t t
We require that the restructuing of the portfolio be self-financing.
So, the requirement is
dVt = at dSt + bt dt
8

Hence put (1) and (2) into (4)

dVt = dt + (t, St )dBt
= [at u(t, St ) + bt r(t, St )t ]dt + at (t, St )dBt
Vt = f (t, St ) and Ito formula for geometric Brownian Motion.
dVt = ft (t, St )dt + (1/2)fxx (t, St )dSt dSt + fx (t, St )dSt
= [ft (t, St ) + (1/2)fxx (t, St 2 )(t, St ) + fx (t, St (t, St ))]dt + fx (t, St )(t, St )dBt
Compare (1) and (2)
at = fx (t, St )
bt = r(t,S1t )t (ft (t, St ) + 1/2fxx (t, St ) 2 (t, St ))
Vt = f (t, St )
= a t S t + b t t
= fx (t, St )St + r(t,S1t )t (ft (t, St ) + 1/2fxx (t, St ) 2 (t, St ))
The arbitrage price at time t of European option with terminal time T is f (t, x) which is
the solution of the terminal value problem.


ft (t, x) = 12 2 (t, x)fxx (t, x) r(t, x)xfx (t, x) + r(t, x)f (t, x)
f (T, x) = h(x)

(b)from (a)
at = fx (t, St )
bt = r(t,S1t )t (ft (t, St ) + 1/2fxx (t, St ) 2 (t, St ))
Vt = f (t, St ) = at St + bt t
Hence they replicate h(ST ).

11. The price of a security U is defined as the product of two asset prices R and S, i.e.,
Ut = Rt St . Suppose R and S are Ito processes given by
dRt = 2(100 Rt )dt + St dBt ,
dSt = Rt St dt + St dBt .
9

Show that {tUt , t 0} is also an Ito process, and find its expected instantaneous rate of
return at time 0 if R0 = 0.15 and S0 = 35. Sol:
(a).
dUt = UR dR + US dS + URS dRdS
= St (2(100 Rt )dt + St dBt ) + Rt (Rt St dt + St dBt ) + St2 dt
= (200St 2St Rt + Rt2 St + St2 )dt + (St2 + Rt St )dBt

Let f = tUt , by Ito formula

dtUt = ft dt + fU dU + 12 fU U (dU )2
= Ut dt + tdUt
= Ut dt + (200tSt 2tUt + tUt Rt + tSt2 )dt + (tSt2 + tRt St )dBt
(b).
t
E( dtU
) =
dt
=
=
=
=

Ut dt + 200tSt 2tUt + tUt Rt + tSt2

U0 + 0 (t )
R 0 S0
0.1535
5.25

12. Assume that X follows a geometric Brownian motion with drift and volatility . The
economy is risk-neutral, and the risk-free rate of interest is r. A machine prints a certificate
worth X(t) at random time t generated by a Poisson arrival process with intensity .
What is the value of the machine? Hint: By how much should the asset value change at
the time the certificate is printed? Assume that V is linear in X.
sol:
dX = Xdt + XdW To find the value V of the machine, which pays a cash flow of X(t)
determined by the Poisson process:
V = V (X)
By Itos lemma:
dV = VX dX + 21 VXX (dX)2
= [XVX + 12 2 X 2 VXX ]dt + XVX dW
Expected cash gain (ECG) = E[dV ] = [XVX 12 2 X 2 VXX ]dt
Expected cash flow (ECF) = Xdt (a cash flow paid with probability dt)
Total Revenue (TR)=ECG+ECF=[XVX + 21 2 X 2 VXX + X]dt
Arbitrage theory:
[XVX + 21 2 X 2 VXX + X]dt = rV dt
10

 XVX + 12 2 X 2 VXX + X = rV
Let V = AX + B, VX = A, VXX = 0
r(AX + B) = XA + 0 + X
rA = A + rB = 0

A = r
,B = 0
Hence, V =

X
r

11