STUDENTSSURNAME

OTHERNAMES

STUDENTNUMBER

2015SecondSemester
ClassExamination

Unit:
Date:
TimeAllowed:
No.ofQuestions:
TotalMarks:
Instructions:

Calculators:
Reference
Materials:
Assessment:

ACST307/817QuantitativeAssetandLiabilityModelling2
Monday19thOctober2015
100minutes
3(AnswerALLquestionsinthespacesprovided).
50(Marksareshownattheendofeachquestion)
Thereis1questionbookletwhichcontains3questions.Write
your answers in the separate answer booklet provided.

ShowALLnecessaryworking.

WRITE YOUR NAME AND STUDENT NUMBER ON

QUESTION/ANSWER BOOKLET. YOU MUST DO THIS
BEFOREYOUSTARTTHETEST.

Candidates must cease writing immediately when instructed

to do so by the supervisor at the end of the examination.
FailuretodosowillresultinamarkofZERO.

Youwillbeallowedtotakeacalculatorthatissilentandhas
notextretrievalcapacity.
You will be allowed to take one A4 page into the exam
(handwritten or typed on one or two sides). The standard
normaltableisprovidedonthelastpage.
Thistestcontributesto10%ofyourfinalassessment.

NormalUniversityExaminationrulesapplytotheconductofthistest.

Student Name: ...................................

Student ID: ................................

ACST 307/817: Quantitative Asset-Liability Modelling 2

2015 Mid-Semester Examination

Question 1 [Total 22 marks]
Consider the following firm:
- XYZ mines copper, with fixed cost of $0.5/lb and variable cost of $0.4/lb.
Fixed cost is a cost which must be paid regardless of whether the prospected
copper is mined or not.
The 1-year forward price of copper is $1/lb. The continuously compounded
risk-free interest rate is 6% per annum. One-year option prices for copper are
shown in the table below.
Strike
0.950
0.975
1.000
1.025
1.034
1.050

Call
$0.0649
$0.0500
$0.0376
$0.0274
$0.0243
$0.0194

Put
$0.0178
$0.0265
$0.0376
$0.0509
$0.0563
$0.0665

In your answers, at a minimum consider copper prices in 1 year of $0.70, $0.80,

$0.90, $1.00, $1.10 and $1.20.
(i) If XYZ does nothing to manage copper price risk, what is its profit 1 year from
now, per pound of copper? If on the other hand XYZ sells forward its expected
copper production, what is its estimated profit 1 year from now? Construct
graphs illustrating both unhedged and hedged profit against copper price. [4
marks]
(ii) Suppose the 1-year copper forward price were $0.45 instead of $1. If XYZ
were to sell forward its expected copper production, what is its estimated profit
1 year from now? Should XYZ produce copper? [5 marks]
2

(iii) Compute estimated profit in 1 year if XYZ buys a put option with a strike
of $1.00 . Also draw a graph of profit against copper price for this case. [4
marks]
(iv) Compute estimated profit in 1 year if XYZ sells a call option with a strike
of $1.00 . Also draw a graph of profit against copper price for this case. [4
marks]
(v) Compute estimated profit in 1 year if XYZ buys a collars with the strike
$1.05 for the put and the strike $1.05 for the call (i.e. purchasing the put option
while simultaneously selling the call option). Also draw a graph of profit against
copper price for this case. [5 marks]

Question 2 [Total 10 marks]

(i) Let be the time- price of a nondividend-paying stock. You are given that
- The stock price process is

= 0075 +
where is a standard Brownian motion under the true probability distribution,
and 0 is a constant.
- Let ( ) be the time-t price of a derivative written on , when the time-
stock price is . Then ( ) satisfies

( )
( )
2 ( )
+ 0045
+ 00452
= 0045 ( )

2
Find the market price of risk of the stock.

[5 marks].

(ii) Assume the Black-Scholes framework. You are given:

- is the price of a nondividend-paying stock at time .
- The stock price process is given by

= 005 + 025
where is a standard Brownian motion under the true probability distribution.
- Under the risk-neutral probability distribution, the mean of 05 is 003.
Calculate the continuously compounded risk-free interest rate.

[5 marks].

Question 3 [Total 18 marks]

(i) Let { 0} be a standard Brownian motion and be the time- price
of a stock. It is given that
= 1000035+03
where 0 = 100.
(a) Calculate the mean and variance of 2 [2 marks]
(b) Find Pr(98 2 103).

[2 marks]

(c) Find the expression for 2 in terms of 1 , based on which find

[4 marks]

Pr (98 2 103 | 1 = 102) .

(ii) Let be a standard Brownian motion and 0 be a constant. Find for

the following:

2
2 +

= 0

[4 marks]
(iii) Let be a standard Brownian motion. You are given that
- = 2 3 ,

- = .
Suppose that
= ( ) + ( )
Find

(1 2)

(1 2)

[6 marks]

The End

Standard Normal Cumulative Probability Table

Cumulative probabilities for POSITIVE z-values are shown in the following table:
z
0.0
0.1
0.2
0.3
0.4

0.00
0.5000
0.5398
0.5793
0.6179
0.6554

0.01
0.5040
0.5438
0.5832
0.6217
0.6591

0.02
0.5080
0.5478
0.5871
0.6255
0.6628

0.03
0.5120
0.5517
0.5910
0.6293
0.6664

0.04
0.5160
0.5557
0.5948
0.6331
0.6700

0.05
0.5199
0.5596
0.5987
0.6368
0.6736

0.06
0.5239
0.5636
0.6026
0.6406
0.6772

0.07
0.5279
0.5675
0.6064
0.6443
0.6808

0.08
0.5319
0.5714
0.6103
0.6480
0.6844

0.09
0.5359
0.5753
0.6141
0.6517
0.6879

0.5
0.6
0.7
0.8
0.9

0.6915
0.7257
0.7580
0.7881
0.8159

0.6950
0.7291
0.7611
0.7910
0.8186

0.6985
0.7324
0.7642
0.7939
0.8212

0.7019
0.7357
0.7673
0.7967
0.8238

0.7054
0.7389
0.7704
0.7995
0.8264

0.7088
0.7422
0.7734
0.8023
0.8289

0.7123
0.7454
0.7764
0.8051
0.8315

0.7157
0.7486
0.7794
0.8078
0.8340

0.7190
0.7517
0.7823
0.8106
0.8365

0.7224
0.7549
0.7852
0.8133
0.8389

1.0
1.1
1.2
1.3
1.4

0.8413
0.8643
0.8849
0.9032
0.9192

0.8438
0.8665
0.8869
0.9049
0.9207

0.8461
0.8686
0.8888
0.9066
0.9222

0.8485
0.8708
0.8907
0.9082
0.9236

0.8508
0.8729
0.8925
0.9099
0.9251

0.8531
0.8749
0.8944
0.9115
0.9265

0.8554
0.8770
0.8962
0.9131
0.9279

0.8577
0.8790
0.8980
0.9147
0.9292

0.8599
0.8810
0.8997
0.9162
0.9306

0.8621
0.8830
0.9015
0.9177
0.9319

1.5
1.6
1.7
1.8
1.9

0.9332
0.9452
0.9554
0.9641
0.9713

0.9345
0.9463
0.9564
0.9649
0.9719

0.9357
0.9474
0.9573
0.9656
0.9726

0.9370
0.9484
0.9582
0.9664
0.9732

0.9382
0.9495
0.9591
0.9671
0.9738

0.9394
0.9505
0.9599
0.9678
0.9744

0.9406
0.9515
0.9608
0.9686
0.9750

0.9418
0.9525
0.9616
0.9693
0.9756

0.9429
0.9535
0.9625
0.9699
0.9761

0.9441
0.9545
0.9633
0.9706
0.9767

2.0
2.1
2.2
2.3
2.4

0.9772
0.9821
0.9861
0.9893
0.9918

0.9778
0.9826
0.9864
0.9896
0.9920

0.9783
0.9830
0.9868
0.9898
0.9922

0.9788
0.9834
0.9871
0.9901
0.9925

0.9793
0.9838
0.9875
0.9904
0.9927

0.9798
0.9842
0.9878
0.9906
0.9929

0.9803
0.9846
0.9881
0.9909
0.9931

0.9808
0.9850
0.9884
0.9911
0.9932

0.9812
0.9854
0.9887
0.9913
0.9934

0.9817
0.9857
0.9890
0.9916
0.9936

2.5
2.6
2.7
2.8
2.9

0.9938
0.9953
0.9965
0.9974
0.9981

0.9940
0.9955
0.9966
0.9975
0.9982

0.9941
0.9956
0.9967
0.9976
0.9982

0.9943
0.9957
0.9968
0.9977
0.9983

0.9945
0.9959
0.9969
0.9977
0.9984

0.9946
0.9960
0.9970
0.9978
0.9984

0.9948
0.9961
0.9971
0.9979
0.9985

0.9949
0.9962
0.9972
0.9979
0.9985

0.9951
0.9963
0.9973
0.9980
0.9986

0.9952
0.9964
0.9974
0.9981
0.9986

3.0
3.1
3.2
3.3
3.4

0.9987
0.9990
0.9993
0.9995
0.9997

0.9987
0.9991
0.9993
0.9995
0.9997

0.9987
0.9991
0.9994
0.9995
0.9997

0.9988
0.9991
0.9994
0.9996
0.9997

0.9988
0.9992
0.9994
0.9996
0.9997

0.9989
0.9992
0.9994
0.9996
0.9997

0.9989
0.9992
0.9994
0.9996
0.9997

0.9989
0.9992
0.9995
0.9996
0.9997

0.9990
0.9993
0.9995
0.9996
0.9997

0.9990
0.9993
0.9995
0.9997
0.9998

2015 Class Examination

Model solutions
Question 1 [Total 22 marks]
(i) The following table summarizes the unhedged and hedged profit calculations:
Copper price
in one year
$070
$080
$090
$100
$110
$120

Total cost Unhedged profit Profit on short forward

$090
$090
$090
$090
$090
$090

$020
$010
$000
$010
$020
$030

$030 ($1 $070)

$020 ($1 $080)
$010
$000
$010
$020

[3 marks]
We obtain the following profit diagram:

Net income on
hedged profit
$010 ($1 $090)
$010
$010
$010
$010
$010

[1 mark]
(ii) If the forward price were $0.45 instead of $1, we would get the following table:
Copper price
in one year
$070
$080
$090
$100
$110
$120

Total cost Unhedged profit Profit on short forward

$090
$090
$090
$090
$090
$090

$020
$010
$000
$010
$020
$030

$025 ($045 $070)

$035 ($045 $080)
$045
$055
$055
$075

Net income on
hedged profit
$045 ($045 $090)
$045
$045
$045
$045
$045

[3 marks]
Although the copper forward price of $0.45 is below our total costs of $0.90, it
is higher than the variable cost of $0.40. It still makes sense to produce copper
because even at a price of $0.45 in one year, we will be able to partially cover
our fixed costs. [2 marks]
(iii) In this exercise, we need to find the future value of the put premia. For the
$1-strike put, it is: $00376 006 = 3 992 5 102 $004. The table on the
following page shows the profit calculations for the $1.00-strike put. The figure
below compares the profit diagrams of all other possible hedging strategies.
Copper
price in
one year

Total cost

Unhedged
profit

Profit on long
$1-strike put
option

Put
premium
paid

$070

$090

$020

$030 ($1 $070) $004

$080

$090

$010

$020 ($1 $070) $004

$090

$090

$000

$010

$004

$100

$090

$010

$000

$004

$110

$090

$020

$000

$004

$120

$090

$030

$000

$004

[3 marks]
Profit diagram of the dierent put strategies:
2

Net income
on hedged profit
$006
($1 $090 $004)
$006
($1 $090 $004)
$006
($1 $090 $004)
$006
($1 $090 $004)
$016
($110 $090 $004)
$026
($120 $090 $004)

[1 mark]
(iv) The future value of the $1.00-strike call premium amounts to: $00376
006 = $004.
Copper
price in
one year

Total cost

Unhedged
profit

Profit on short
$1-strike call
option

Call
premium
received

$070

$090

$020

$000

$004

$080

$090

$010

$000

$004

$090

$090

$000

$000

$004

$100

$090

$010

$000

$004

$110

$090

$020

$010 ($1 $110) $004

$120

$090

$030

$020 ($1 $120) $004

3

Net income
on hedged profit
$006
($070 + 004 $090)
$006
($080 + 004 $090)
$004
($090 + 004 $090)
$014
($1 + $004 $090)
$014
($1 + $004 $090)
$014
($1 + $004 $090)

[3 marks]
We obtain the following payo graphs:

[1 mark]
(v) XYZ will buy collars, which means that they buy the put leg and sell the call
leg. We have to compute the net option premium position, and find its future
value, i.e.
($00665 $00194) 006 = 5 001 3 102 $005
[1 mark]

Copper
price in
one year

Total cost

Profit on long
$1.05-strike
put option
$035
($105 $070)
$025
($105 $080)
$015
($105 $090)
$005
($105 $100)

$070

$090

$080

$090

$090

$090

$100

$090

$110

$090

$000

$120

$090

$000

Profit on short
$1.05-strike
call option

Net
premium

$000

$005

$000

$005

$000

$005

$000

$005

$005
($105 $110)
$015
($105 $120)

$005
$005

Hedged profit

$01
($105 090 $005)
$01
($105 090 $005)
$01
($105 090 $005)
$01
($105 090 $005)
$01
($105 090 $005)
$01
($105 090 $005)

We see that we are completely and perfectly hedged. Buying a collar where the
put and call leg have equal strike prices perfectly osets the copper price risk.
[3 marks]
Profit diagram:

[1 mark]
5

Question 2 [Total 10 marks]

(i) Comparing
( )
2 ( )
( )
= 0045 ( )
+ 0045
+ 00452

2
with the Black-Scholes partial dierential equation (PDE), i.e.
2 2 2

=
+
+

2
2
we have

= 0045 and

2
= 0045
2

which gives = 03 [3 marks]

Moreover, from
= 0075 +
we know that

= 0075
[1 mark]
Hence the market price of risk of the stock is

0075 0045
=
= 01

03
[1 mark]
(ii) From
= 005 + 025
the market price of risk of the stock is given by

005
=
= 4 (005 )

025

[1 mark]
It is known that

and =

i.e. under world, is normally distributed with mean and variance

, i.e.
( ) under Q world.
[3 marks]
Proof (See 2008 mid-session test Q3)
Using the given Radon-Nikodym derivative,

we have

1 2

= 2

n
o
2
1 2
1 2
1

= 2 () = 2 2 ()

= + 2

where since (0 ) under world we have

n
o
1 2

= () = 2

==================================================
Hence we have

= 05 = 4 (005 ) 05 = 003
05

and = 0035 [1 mark]

Question 3 [Total 18 marks]

(i) (a)

(2 ) = 10000352+032 = 10000352 032

1

= 100 00352 2 2(03) = 1173511

where
1

() = ( ) = 2

[1 mark]

(22 )

n
o

00352+032 2
= 1002 2(00352+032 ) = 1002 200352 062
= 100
1

= 1002 200352 2 2(06) = 16487

so

(2 ) = (22 ) {(2 )}2 = 16487 (1173511)2

2
2 2
1
1
= 1002 200352 2 2(06) 100 00352 2 2(03)
= 27159351

[1 mark]
(b)
ln 2 = ln 100 + 0035 2 + 032
So we have

(ln 2 ) = ln 100 + 0035 2 = 467517

and
(ln 2 ) = (03)2 2 = 018
Hence

ln 2 (467517 018) .
8

[1 mark]
Now

Pr (98 2 103) = Pr (ln 98 ln 2 ln 103)

ln 98 467517
ln 103 467517

= Pr

018
018
= Pr (02126 00953)
= (1 05398) (1 05832)
= 00434
[1 mark]
(c) We have
2
10000352+032
=
= 0035+03(2 1 )
00351+03
1
1
100
which imples
2 = 1 0035+03(2 1 )
By independent increments, the increment 2 1 does not depend on the
given condition 1 = 103. Hence
2 1 | 1 = 103 (0 1)
[2 marks]
Now

=
=
=
=
=

Pr (98 2 103 | 1 = 102)

Pr 98 1 0035+03(2 1 ) 103 | 1 = 102

Pr 98 1020035+03(2 1 ) 103

1
98
103
1
Pr
ln
0035 2 1
ln
0035
03
102
03
102
Pr (02500 00841)
05987 05319 = 00668.

[2 marks]
(ii) Since
9

2
2 +

= ( ) = 0

from Its Lemma, we have

1
( ) = = + + ( )2

2 2

2
2
2 22 +
2 +
2 +

= 0
+ 0
+ 0
( )2
2
2

2
2 +

= 0

2
2 +

+ 0

Hence

= +
[4 marks]
(iii) We have
= ( ) = 05
Using Its Lemma
1
= + + ( )2
2
!

( )2
= 05 +
+

3
05
2
2
4 2

Hence with ( )2 = 92 2 ,

p
92 2

+

2 3 +
3
2
82
p

p
p
3
9 2 p
=
+

8
2

9
=
+ 2

8
2

10

[4 marks]
So we have
( )
=
( )

1
+ 98 2
+ 1 98 2

3
32

Hence
1 + 1 98 2
(1 2)
162 9
=

=
3 1
(1 2)
12

2
= 33485
[2 marks]

11