Exotics - exercises

1. Consider an option which pays a continuous cash-‡ow to the holder at a rate proportional to the square
of the underlying asset’s price, so that during a time interval dt the holder receives S 2 dt: Suppose that
at expiry the value of the option is
V (S; T ) = S 2 :
The underlying evolution follows geometric Brownian motion

dS = Sdt + SdX:

Derive the Black-Scholes partial di¤erential equation for this "power" option and show that it is

@V 1 2 @2V @V
+ S2 2
+ rS rV = S2:
@t 2 @S @S
By assuming a solution of the form
V (S; t) = (t) S 2
show that
1 2
(t) = 2
2
+ r + 1 e( +r )(T t)
1 :
+r
2. Consider separable solutions of the Black–Scholes equation

@V 2 @2V @V
+ 1
2 S2 + (r D) S rV = 0; (2.1)
@t @S 2 @S
of the form
V (S; t) = f (S)g(t);
Show that (2:1) can be expressed as the following …rst order di¤erential equation (2:2a) and Cauchy-
Euler equation (2:2b)
dg
g = 0 (2.2a)
dt
2
1
2 S 2 f 00 + (r D) Sf 0 + ( r) f = 0; (2.2b)

for some (universal) constant ; where the following notation is used

df d2 f
f0 = ; f 00 = :
dS dS 2

You may assume that (2:2b) has a solution of the form f (S) = S : Solve these to obtain the following
solutions for (2:1) :

i for distinct roots of the A.E (2:2b) (A, B - constants)

1 r D
V (S; t) = e t S 2 2
(AS +
+ BS )

ii for a repeated root of the A.E (2:2b) (", - constants)

2 2
V (S; t) = e
r+ 2 (r D 1
2 +2 ) t
S( 2
1 r D
2 ) (" + log S)

where s
2
r D 1 2( r)
d = 2 2
:
2

1
3. Assume that an asset price S evolves according to the SDE
dS
=( D) dt + dX;
S
where and are constants. In particular S pays out a continuous dividend stream equal to DS dt
during the in…nitesimal time interval dt, where D the dividend yield is constant.
Now suppose a European style derivative security is written on this asset with the properties that
at expiry the holder receives the asset and prior to expiry the derivative pays a continuous cash ‡ow
C (S; t) dt during each time interval of length dt:
Show that the option price satis…es the following partial di¤erential equation

@V 1 2 @2V @V
+ S2 + (r D) S rV = C (S; t) :
@t 2 @S 2 @S
Suppose that the cash ‡ow C (S; t) has the form C (S; t) = f (t) S: By writing V = (t) S and assuming
a …nal condition at time T given by
V (S; T ) = S;
show that the delta of the derivative security is
Z T
D(T t) D( t)
(S; t) = e + e f ( )d :
t

4. An asset S follows a Geometric Brownian Motion dS = Sdt + SdW; where and are constants.
We wish to value an option that pays o¤ at expiry T an amount which is a function of the path taken
by the asset between time zero and expiry. Assuming that an option value V depends on S; t and a
quantity Z t
I (t) = f (S; ) d ;
0
where f is a speci…ed function and r the risk free interest rate, the option pricing equation is

@V 1 2 @2V @V @V
+ S2 2
+ f (S; t) + rS rV = 0;
@t 2 @S @I @S
for the function V (S; I; t) :
For an arithmetic strike Asian call option the payo¤ at time T is
Z !
1 T
max S S (t) dt; 0 :
T 0

By writing the value of this option as

V (S; I; t) = SW (R; t) ;

where R = I=S; show that the partial di¤erential equation for W (R; t) is given by

@W 1 2 @2W @W
+ R2 + (1 rR) = 0:
@t 2 @R2 @R