Derive the stochastic differential equation for a derivative dependent on the prices of two securities by...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
Derive the stochastic differential equation for a derivative dependent on the prices of two securities by forming a riskless portfolio consisting of the derivative and the two traded securities. Assume that the securities are non-dividend-paying. You can assume that the price, f, of the derivative depends on the prices, S and S2, of two traded securities. The prices of these securities are given by dS = Sidt+Sdz and dS2 = H2S 2dt+02S2dz2, where 1, 1, 2 and 2 are constants and dz and dz2 are Wiener processes with correlation p. Suggestions: 1) use It's lemma to write down a stochastic differential equation for f; 2) construct your portfolio II; 3) impose the risk-free condition (denote the risk-free interest rate by the letter r); this will lead to the desired stochastic differential equation. The stochastic discount factor (SDF) in a consumption asset pricing model can be written as: Mt+1 = B u' (C++1) u'(ct) Where u (c) is a utility function and u'(c) is its first derivative with respect to c. Suppose the utility function is of the form: 1-Y Ct u(c) = 1-Y If consumption today is 0.5, consumption tomorrow is 0.4, is equal to 0.98 and y is equal to 2, the value of the SDF is: A. 1.531 B. 0.627 C. 1.562 D. 1.225 generated by the process Sn 2. Let Mr be the symmetric random walk defined in the previous example. Define Io = 0 and n-1 In = EM,(Mj+-M), n=1,2,... j=0 a) Show that In = M. b) Show that {In, n 0} is a Markov process, i.e. En f(In+1)] = g(In). 3. Suppose (Mn, n 0} is a martingale, and let An, n 0 be an adapted process. Define the discrete-time stochastic integral (sometimes called a martingale transform) by Io = 0 and = n-1 In A(Mj+1M;). Show that In, n > 0} is a martingale. j=0 4. (Divident-paying stock) Consider a binomial asset model such that, after each movement in the in stock price, a dividend is paid and the stock price is reduced accordingly. Define Ju, Yn+1 (W1, ..., Wn, wn+1)= d, if wn+1 = H if wn+1 = T Derive the stochastic differential equation for a derivative dependent on the prices of two securities by forming a riskless portfolio consisting of the derivative and the two traded securities. Assume that the securities are non-dividend-paying. You can assume that the price, f, of the derivative depends on the prices, S and S2, of two traded securities. The prices of these securities are given by dS = Sidt+Sdz and dS2 = H2S 2dt+02S2dz2, where 1, 1, 2 and 2 are constants and dz and dz2 are Wiener processes with correlation p. Suggestions: 1) use It's lemma to write down a stochastic differential equation for f; 2) construct your portfolio II; 3) impose the risk-free condition (denote the risk-free interest rate by the letter r); this will lead to the desired stochastic differential equation. The stochastic discount factor (SDF) in a consumption asset pricing model can be written as: Mt+1 = B u' (C++1) u'(ct) Where u (c) is a utility function and u'(c) is its first derivative with respect to c. Suppose the utility function is of the form: 1-Y Ct u(c) = 1-Y If consumption today is 0.5, consumption tomorrow is 0.4, is equal to 0.98 and y is equal to 2, the value of the SDF is: A. 1.531 B. 0.627 C. 1.562 D. 1.225 generated by the process Sn 2. Let Mr be the symmetric random walk defined in the previous example. Define Io = 0 and n-1 In = EM,(Mj+-M), n=1,2,... j=0 a) Show that In = M. b) Show that {In, n 0} is a Markov process, i.e. En f(In+1)] = g(In). 3. Suppose (Mn, n 0} is a martingale, and let An, n 0 be an adapted process. Define the discrete-time stochastic integral (sometimes called a martingale transform) by Io = 0 and = n-1 In A(Mj+1M;). Show that In, n > 0} is a martingale. j=0 4. (Divident-paying stock) Consider a binomial asset model such that, after each movement in the in stock price, a dividend is paid and the stock price is reduced accordingly. Define Ju, Yn+1 (W1, ..., Wn, wn+1)= d, if wn+1 = H if wn+1 = T
Expert Answer:
Posted Date:
Students also viewed these finance questions
-
You have been asked to calculate the cost of capital of Mulligan Ltd, a company which specialises in developing new medical equipment products. The following information is available regarding the...
-
Suppose Jones Corporation in the above problem determined that its annual inventory carrying cost = 18%. The item unit cost was as follows: Item 1 = $25.00 Item 2 = $60.00 Item 3 = $5.00 Item 4 =...
-
Find the potential at the sodium ion, Na +, which is surrounded by two chloride ions, Cl , and a calcium ion, Ca 2+ , in water as shown in the diagram. The effective charge of the positive sodium...
-
How are the cash flows originating from a company's financing activities identified?
-
Papas Fried Chicken bought equipment on January 2, 2013, for $ 39,000. The equipment was expected to remain in service for four years and to perform 11,000 fry jobs. At the end of the equipments...
-
Sheffield Co. has the following data related to an item of inventory: Inventory, March 1 390 units @$2.00 Purchase, March 7 1440 units @$2.10 Purchase, March 16 290 units @$2.15 Inventory, March 31...
-
Tim's gross pay for this month is $8,950. His gross year-to-date pay, prior to this month, totaled $111,500. What is the amount of FICA tax withheld from Tim's pay for this month? (Assume an OASDI...
-
How much is the over/underapplied FOH? Indicate whether over/underapplied. Ex. 123456 Overapplied or 123456 Underapplied A company manufactures plastic products for the home and restaurant market....
-
5 . Obermeyer Corporation issued the following statement of cash flows for 2 0 1 7 . Obermeyer Corporation Statement of Cash Flows Indirect Method For the Year Ended December 3 1 , 2 0 1 7 Cash flows...
-
An activity-based costing system would provide AXE Life with an understanding of the costs to develop, sell, and service their products. How can AXE Life use this information to improve the...
-
Company A has a growth rate of 3% and just paid a dividend of $1.50 per share. What is the cost of equity if the current share price is $10?
-
What is the future value of a 5-year ordinary annuity with annual payments of $ 221 , evaluated at a 7.36 percent interest rate?
-
Frank Sills, the CEO and founder of ENVIRO-WEAR, is facing the first big challenge of his young company. Frank began the company on the principle of environmental consciousness in the manufacture of...
-
To balance the chemical equation SiH3 + O2 SiO2 + HO, you could introduce coefficients a, b, c, d and write aSiH3 + bO2 cSiO + dHO then write linear equations for each element. The equation for Si...
-
In which section of the balance sheet are the three inventory accounts of a manufacturing business listed?
-
How is underapplied overhead accounted for on an income statement?
-
A materials purchases journal, a cash payments journal, and a general journal for Vanyo, Inc., a manufacturer of cardboard boxes, are provided in the Working Papers. Your instructor will guide you...
Study smarter with the SolutionInn App