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MTH5210 PRACTICE Exam.
You can use 1 double-sided A4 sheet of hand written notes. There are five questions, 20 marks each. In the following, Bt, t ≥ 0, denotes the standard Brownian motion process started at zero. 1. Let Vt = e ∫ t 0 µ(s)ds+ ∫ t 0 σ(s)dBs , where µ(t) and σ(t), 0 ≤ t ≤ T , are deterministic continuous functions. (a) Show that Xt = log Vt is a Gaussian process with independent increments. (b) Find the quadratic variation of Vt. [5 marks] (c) Give the necessary and sufficient condition on the functions µ(t) and σ(t), so that the process Vt is a martingale. Justify your answer. [5 marks] (d) It is given that for any u ∈ R the process eu log Vt−u24 t3 is a martingale. Find µ(t) and σ2(t). [5 marks] 2. Consider the following market model. Let St = Bt+ t 2 be the price process of an asset and let βt = 1, be a savings account, 0 ≤ t ≤ T . (a) Find the change of measure dQ/dP = Λ so that St is a martingale under Q. You should show that EΛ = 1. [10 marks] (b) Give the formula for the price at time t < T of the contract that pays Y = eST at time T . [5 marks] (c) Give the self-financing replicating portfolio for the contract in (b). [5 marks] 3. Let Mt = B 2 t −Bt − t, 0 ≤ t ≤ T . (a) Show that Mt is a martingale. [5 marks] (b) State what is meant by the Predictable Representation Property of Brow- nian motion process Bt. Specify this result for the martingale Mt in this question. [5 marks] (c) Find a random time change τt so that the process Vt =M(τt) is a Brownian motion. Justify this by using the theorem of Levy on characterisation of Brownian motion. [5 marks] (d) Write Vt in terms of Brownian motion Bt. Show that the process Xt = V ([M,M ]t) is in fact Mt. [5 marks] 34. Solve the following partial differential equations for the function f(x, t) by using the probability method. Specify the diffusion process and give its gener- ator. You may exchange expectation and integration without justification, and use that the fourth moment ofN(µ, σ2) distribution is given by µ4+6µ2σ2+3σ4. (a) t∂ 2f ∂x2 (x, t) + ∂f ∂t (x, t) = 0, for 0 ≤ t ≤ T , and f(x, T ) = x4. [10 marks]. (b) t∂ 2f ∂x2 (x, t) + ∂f ∂t (x, t) = −x4, for 0 ≤ t ≤ T , and f(x, T ) = 0. [10 marks]. 5. Explain briefly (in one or two sentences and referring to mathematical theo- rems if possible) the following concepts. (a) A market model and a claim or option. [5 marks] (b) Self-financing portfolios and their use in pricing theory. [5 marks] (c) Arbitrage, and how to check if it exists. [5 marks] (d) Equivalent martingale measure and its role in pricing options. [5 marks]