Module Code: MATH254501

Module Title: Financial Mathematics: Market ©UNIVERSITY OF LEEDS

School of Mathematics Semester Two 202223

Calculator instructions:

ˆ You are allowed to use a non-programmable calculator in this examination.

Dictionary instructions:

ˆ You are not allowed to use your own dictionary in this exam. A basic English dictionary
is available to use. Raise your hand and ask an invigilator if you need it.

Exam information:

ˆ There are 7 pages to this examination.

ˆ There will be 2 hours to complete this examination.

ˆ This examination is worth 80% of the module mark.

ˆ This is an Open Book Examination. You are allowed to bring one A4 sheet of notes with
you into the examination. You may write your notes on both sides of the paper. Your
notes may be printed or handwritten.

ˆ The numbers in brackets indicate the marks available for each question.

ˆ You must show all your calculations.

Page 1 of 7 Turn the page over

Module Code: MATH254501

1. State whether the following statements are TRUE or FALSE. You don’t need to explain
your answers.

(a) If a market model is arbitrage free, then all contingent claims have unique risk-
neutral price.
(b) In a general single period market model, the discounted gain process is independent
from the initial capital.
(c) In a complete market model, it is possible to find a contingent claim which does
not have a replicating trading strategy.
(d) In a complete and arbitrage free market model, the prices of a call option and a
put option of the same strike price and maturity are always the same.
(e) A general single period market model is arbitrage free if and only if there exists
a risk-neutral probability measure which is equivalent to the original probability
measure.

Total [10 Marks]

2. Let U (w) denote the utility function for an investor.

(a) If the investor is non-satiated, what property must U (w) have?

(b) If the investor is risk-neutral, what property must U (w) have?
(c) Let X be a fair gamble. Suppose that an investor is risk-seeking. What would the
investor prefer between X and the empty portfolio (i.e. making no investment)?

[3 Marks]

3. Give an example of a utility function which is suitable for a non-satiated, risk-averse

investor with constant absolute risk-aversion, CARA. Your answer must include working
to demonstrate this. [5 marks]

4. A car owner is willing to pay £500 at the start of the year to insure against a loss L (in
£) if the car was stolen. The car owner has initial capital of £15,000 and the probability
1
of the can being stolen is 0.2. If the car owner’s utility function is U (w) = 12 w 2 for
w > 0, calculate L. [8 Marks]

Page 2 of 7 Turn the page over

Module Code: MATH254501

5. An app developer has been offered a contract by a large international bank to design
some software. The developer will receive a basic payment of $1 million, but there is
also the possibility of a bonus payment B.
The bonus payment will only be paid if the developer completes the work within the
term of the contract, T months. The developer is allowed to decide in advance the
number of months, T , the project will take to complete. The bonus, B, is related to T
by
1
B = 5,
T
working in units of $ million. The developer is uncertain how long the project will take to
complete and decides to assume that completion time, C, is a uniform random variable
on the interval [1, 2] (i.e. that the project will take at least one month, but not more
than 2 months to complete).

(a) What is the expected total payment the developer will receive in terms of T ?
[2 Marks]
(b) Even though the developer is uncertain about the completion time, the contract
states a particular time must be chosen before work begins. Assume that the
developer choose a value for T in the interval [1, 2]. What particular value for T
should the developer select to maximise expected total payment?

[4 Marks]

6. A single period market model has two risky assets and a risk-free money market account,
which has interest rate r = 5% compounded continuously. The returns of the risky assets
are R1 , R2 . They have correlation ρ = − 12 and

E[R1 ] = µ1 = 2, E[R2 ] = µ2 = 3, Var(R1 ) = σ12 = 15, Var(R2 ) = σ22 = 60.

An investor is targeting a total expected return of µ = 2.5 on a portfolio. Find such

portfolio with minimum variance. [8 Marks]

7. Suppose that a market has two risky assets with uncorrelated returns and no other
assets. The expected returns are µ1 = 2 and µ2 = 4, respectively and the variance of
returns are σ12 = 1 and σ22 = 2.

(a) An investor creates a portfolio with proportions w1 and w2 invested in each risky
asset. If µ denotes the desired expected return on the portfolio, determine w1 and
w2 in terms of µ. [2 Marks]
(b) Show that the minimum-variance set is given by the curve
3
σ 2 = µ2 − 4µ + 6
4
in µ − σ 2 -space. [3 Marks]

Page 3 of 7 Turn the page over

Module Code: MATH254501

8. For a particular market we are given the following information for the return Ri , on a
particular risky asset.

µi = E[Ri ] = 0.05, βi,M = 0.95, Cov(Ri , RM ) = 22.25,

where RM denotes the return on the market portfolio. If the return R0 on the risk-free
money market account is 0.01, calculate the expected return and variance of return on
the market portfolio using the captical asset pricing model. [4 Marks]

9. A company owns a portfolio whose daily losses (expressed in thousands of £) are denoted
by L. Suppose that L is uniformly distributed on [−40, 25], namely L ∼ U ([−40, 25]).

(a) Calculate the daily VaR for the investment with a confidence level of 95%.
[3 Marks]
(b) Explain in words the meaning of the value you found in (a). [2 Marks]

10. For the elementary single period model on the state space Ω = {H, T }, we have interest
rate r = 31 and the prices of a risky asset S are S0 = 1, S1 (H) = 3, S1 (T ) = 31 .

(a) Identify the risk-neutral probability measure P̃. [5 Marks]

(b) Find the replicating trading strategy for the European put option with strike price
K = 2 with the underlying risky asset S. [5 Marks]

Page 4 of 7 Turn the page over

Module Code: MATH254501

11. An elementary single period market model has a risky asset with price S0 = 20 at the
beginning and a money market account with interest rate r = 0.4 compounded only
once at the end of the investment period. The price of the risky asset at the end of the
investment period is a random number S1 which has only two outcomes.

(a) Suppose we know that S1 = 15 with 5% probability and S1 = 25 with 95%

probability. Is this market model arbitrage free? If not, construct an arbitrage.
(b) Now suppose we know that S1 = 15 with 5% probability and S1 = 40 with 95%
probability. Is this market model arbitrage free? If not, construct an arbitrage.

Total [5 Marks]

12. Consider a model where Ω = {ω1 , ω2 , ω3 }, r = 91 , S0 = 5 and S1 (ω) is given by the

table:

ω1 ω2 ω3
20 40 30
S1 3 9 9

Compute all risk neutral measures for this model. Is the model arbitrage free?
[8 Marks]

13. For each of the collections of the subsets of Ω = {ω1 , ω2 , ω3 , ω4 } set out below, state
whether it is a σ-algebra. If it is not, explain why.

(a) F1 = P(Ω).
(b) F2 = {∅, Ω}.
(c) F3 = {∅, {ω1 }, {ω2 , ω3 }, {ω4 }, Ω}.
(d) F4 = {∅, {ω1 }, {ω2 , ω3 , ω4 }, Ω}.

[4 Marks]

14. Let Ω = {ω1 , ω2 , ω3 , ω4 }. A random variance X : Ω → R has


 1 in state ω1

X= 3 in state ω3

−2 in states ω2 , ω4


Let F = {∅, {ω1 , ω2 }, {ω3 , ω4 }, Ω}.

(a) Is F is a σ-algebra? Give a brief explanation for your answer.

[3 Marks]
(b) Is X F-measurable? Give a brief explanation for your answer.
[3 Marks]

Page 5 of 7 Turn the page over

Module Code: MATH254501

15. In a two-period market with state space Ω = {ω1 , ω2 , ω3 , ω4 , ω5 } the possible prices of
a risky asset S at times t = 0, t = 1 and t = 2 are shown in the figure below:

S9 2 = 10 ω1

S1B = 8 / S2 = 8 ω2

%
S2 = 5 ω3

S0 = 5

S9 2 = 8 ω4


S1 = 3

%
S2 = 2 ω5

Calculate the filtration generated by the price of S. [5 Marks]

Page 6 of 7 Turn the page over

Module Code: MATH254501

16. Consider a two-period binomial market model and an “up an in” European call option
on an asset S. Such an option gives the owner the right to buy an asset at strike price
K at time T = 2 only if the price of the asset is at least L at some time at or before
T = 2.
Given the following information and assuming no arbitrage, calculate the price of the
option. The effective interest rate per period is 4%, K = 13 and L = 10.

S2 =5 S0 u2 = 14.4
q

S1 =6 S0 u = 12
q 1−q

)
S0 = 10 S2 =5 S0 ud = 9.6
1−q q

(
S1 = S0 d = 8
1−q

)
S2 = S0 d2 = 6.4

[8 Marks]

Page 7 of 7 End.