End-term Exam PHDS (2017-18) IIMN

Pricing & Hedging Derivative Securities

End-term Exam (2017-18)

Name: ____________________________________________ Date: 29/11/2017

Instructions:
1. This is an open-book, open notes and open laptop exam. Use of internet, smart phones, Blue-
tooth or any form of near-field communication is not to be allowed.
2. Please show your workings clearly. If necessary, you may also attach extra sheets.
3. Throughout this paper, W (t) refers to the standard Brownian Motion, and dW (t) represents its
increments. Unless otherwise specified, you may assume that all Black-Scholes assumptions hold.
4. Maximum Time: 3 hours

Question 1

Lets say you are discussing Black-Scholes pricing before a job interview, and your friend argues that
the present value of a call option is nothing but discounted expected profit obtained by exercising the
option. With the risk-free discount rate, and using the risk-neutral probabilities this translates to:
( )
Call option present value = Discounted Expected Revenue Expected Cost
( )
= Discounted ST Q(ST K ) K Q(ST K )
= Discount factor Q(ST K ) (ST K )

He argues that second step above is valid, because the revenue when you exercise the option is the
stock, and the cost that you pay to exercise the option is the strike price, and Q(ST K ) represents
the associated risk-neutral probability. Taken to its logical conclusion, this suggests that if ST K the
present value of option today could actually be zero or negative. What is wrong with your friends
argument? You are not required to derive any result, but point out the hole in the argument.

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End-term Exam PHDS (2017-18) IIMN

Question 2

If W (t) is a Brownian Motion, using Itos lemma for F (W (t)) write the stochastic differential equation
(SDE) for the following functions:
F (W (t)) = W N (t)
F (W (t)) = eW (t)

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End-term Exam PHDS (2017-18) IIMN

Question 3

Given the Brownian Motion W (t), and the GBM for the stock price process S(t):

dS(t) = S(t)dt + S(t)dW (t)

Write the process for a derivative whose value is given by F (S(t)) = 1/(S(t)).

Question 4

Consider the process Z (t) = eW (t) , where W (t) is a standard Brownian motion. Find E[eW (t) ].

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End-term Exam PHDS (2017-18) IIMN

Question 5

For this question you are required to refer to the term sheet titled DAX Ikarus Anleihe, and answer
the following questions:
a) What is the price of the product given that the underlying price was 4720 as on the pricing date,
with an annualized volatility of 20%. You may assume the drift rate (net of convenience yield) to
be 2%. You are also required to report the associated standard error.
b) How do the mean, median and mode of the payoff from the product compare? How do these
change at different levels of volatility? Comment
c) Elaborate on on the business logic and risks of the product both from an investor as well as the
issuer point of view.
From the point of view of pricing you may assume that all assumptions of the Black-Scholes model hold
true. Minimum number of simulations have to be 10000 (ten thousand), with a maximum time-step of
1 week (you are free to increase the number of simulations and work with finer time-steps).
Additional related data for both questions is provided at the end of the two term sheets. You are
required to explicitly state any assumptions made for pricing as well as for providing the business
logic. In the European markets, the term agio refers to a sort of a commission, and you may ignore it
as part of your discussion and pricing.

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End-term Exam PHDS (2017-18) IIMN

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End-term Exam PHDS (2017-18) IIMN

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