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WI4675 Exercise 2

The document contains exercises related to financial mathematics, focusing on forward contracts, derivatives, and arbitrage opportunities in financial markets. It includes tasks such as deriving the forward price formula, constructing portfolios with specific payoffs, and analyzing conditions for arbitrage-free markets. Additionally, it discusses pricing European options and the implications of different stock price scenarios in a one-period model.

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15 views1 page

WI4675 Exercise 2

The document contains exercises related to financial mathematics, focusing on forward contracts, derivatives, and arbitrage opportunities in financial markets. It includes tasks such as deriving the forward price formula, constructing portfolios with specific payoffs, and analyzing conditions for arbitrage-free markets. Additionally, it discusses pricing European options and the implications of different stock price scenarios in a one-period model.

Uploaded by

gameom260
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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INTRODUCTION TO FINANCIAL MATHEMATICS

Exercise sheet 2

Exercise 6 Consider an investor who, at time t ≥ 0, agrees to a forward contract on a basic good S, which pays no
dividend or interest (e.g. a resource like oil), with maturity date T > t and strike price K > 0. The investor has the
obligation to buy oil at the future time-point T for the price K. Let πt (K) denote the price of this contract at time t.
Generally, the strike price is determined, such that the price to undertake this obligation at time t is free for the investor.
This strike price is called the forward price of S at time t and is denoted by Ft . In other words, πt (Ft ) = 0 holds.
Show using the replication and no-arbitrage principles from the lecture that
St
Ft = for all 0 ≤ t ≤ T
B(t, T )
must hold, where B(t, T ) denotes the price of a risk free asset at time t, that pays one euro at time T .

Exercise 7 Consider a financial market that consists of a stock and the risk-less bond. An investor wishes to buy from
you a derivative on the stock with maturity in 6 months and the payoff shown in Figure 1. The price of the stock today

100

8 13

Figure 1: Target payoff.

is €12 and the price of the bond that pays off €100 in 6 months is €97.5 today. In the financial market one can find the
following European options on the stock:
Type Maturity Strike (€) Price (€)
Call 6 13 0.2
Call 6 8 4.30
Put 6 8 0.10
Put 6 13 0.875
(i) Construct a portfolio that consists of traded assets and has the same payoff as the derivative in Figure 1.
(ii) You have just sold the derivative constructed in (i) for the price of €17. Design a strategy to take advantage of the
arbitrage opportunity and find the profit that stems from such an agreement.

Exercise 8 Consider the financial market of Exercise 3, assuming it is free of arbitrage. Find a formula for the price of
a European basket call option, i.e. a derivative with payoff
+
S11 + S12 − K .

Exercise 9 Consider a one-period financial market model consisting of one stock and a bank account with S 0 ≡ 1.
Assume that the stock price at time 0 is S0 = 1, and at time 1 can take any of the three values d, m and u, each with
strictly positive probability, where we assume that 0 < d < m < u. Under which conditions is this model free of
arbitrage?

Exercise 10 Consider a one-period financial market model with r = 0 and a risky asset S. Let S0 = 100 and

120 with probability 2 ,
 1

S1 = 100 with probability 14 ,


with probability 14 .

80

Let Ct (T, K) for t ∈ {0, 1} be the price of a European call option with strike price K = 100 and maturity T = 1 on
the asset S. Show that more than one price C0 (T, K) exists, which is consistent with the no-arbitrage principle.

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