Financial Calculus
Financial Calculus
Instructions to Candidates
1. This paper consists of FOUR Questions. Answer ALL the Questions in this
paper.
3. In addition to this paper you are provided with the 2002 edition of the Formulae
Table.
1ZT
( St dt − K)+ ,
T 0
at maturity time T. Here, K > 0 denotes the strike price. Let Y denote the
stochastic process given by:
Z t
Yt = Su du, t ≥ 0,
0
and assume that (t, s, y) → v(t, s, y) is C 1,2,1 and satisfies the partial differential
equation:
y
v(T, s, y) = ( − K)+ , s ≥ 0, y ≥ 0.
T
1
Prove that the price of this Asian Option at time t is given by:
Pt = v(t, St , Yt ), f or t ∈ [0, T ],
and
πtB = v(t, St , Yt ) − St vs (t, St , Yt ), f or t ∈ [0, T ].
2. Consider a two-period binomial model, for an asset with initial price S0 = 120.
The continuously compounded risk free rate per annum r = 5%. Assuming
that the share price movements occur every 6 months with factors u = 1.2 and
d = 0.8:
(a) Calculate the price of a one year European call option with strike price
K = 120. (2 marks)
(b) Calculate the price of a one year European put option with strike price
K = 120. (1 mark)
(c) Calculate the price of an American put option with strike K = 120. (3
marks)
(d) Calculate the price of a European knock-in put option with strike K = 120
and a barrier B = 130. (2 marks)
(e) Calculate the price of a European knock-out put option with strike K = 120
and a barrier B = 130. (2 marks)
3. Consider a date t0 between 0 and T , and consider a chooser option, which gives
the right at time t0 to choose to own either a T-call with strike K or a T-put
with strike K. Show that the value of the chooser option a time 0 is the sum
of the value of a T-call with strike K and the value of a T-put with strike
e−r(T −t0 ) K. (5 marks)
4. Draw the payoff diagram of each of the following options trading strategies: