QUEENS UNIVERSITY BELFAST

Graphical calculators are NOT allowed.

210AMA307

LEVEL 3 EXAMINATION
Applied Mathematics

AMA307

Financial Mathematics

Monday 28 May 2001

Examiners

2.30 pm 5.30 pm

Professor E. A. G. Armour
and the internal examiners

Answer FOUR questions

All questions carry equal marks
Write on both sides of the answer paper

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1. A supermarket chain anticipates that it needs 100,000 bushels of corn in the near
future and wants to agree on a price now for delivery of the corn in 3 months time.
Assume that the spot price for corn is $207 per 100 bushels, the risk-free sterling
interest rate is 8% per annum, the risk-free dollar interest rate is 4% per annum and
the spot exchange rate $/ is 1.50. Suppose that you are a corn trader. Obtain
solutions to (a)-(d) below, showing your working in each case.
(a) Construct an arbitrage argument to determine the arbitrage-free forward price
in dollars per 100 bushels that you should charge the supermarket chain.
(b) Suppose that the supermarket chain wants to pay in pounds instead of dollars.
Derive a new arbitrage argument to determine the forward price of corn in
pounds per 100 bushels, remembering that you need to buy the corn using
dollars.
(c) Assume the storage cost for corn up to 200,000 bushels is $1,000 per month.
This cost must be paid at the beginning of each month. Taking this into
account, derive a new arbitrage-free forward price (in $) for corn in dollars per
100 bushels. What would be the forward price if the supermarket chain only
wanted 50,000 bushels?
(d) In the case of (c), if the forward price is higher than the arbitrage-free price
how would you form a portfolio to get a riskless profit?

/continued. . .

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2. Suppose the current time is only one period t prior to an option expiration. The
strike price of the option is X. We know that the underlying share price can go up
to Su or down to Sd while the spot price of the share is S. The risk-free interest
rate for the period t is r.
(a) Suppose you form a portfolio of numbers of shares and cash amount B in
risk-free bonds. Find and B to replicate the long position of the call with
your portfolio. Do you have to borrow cash or lend cash?
(b) Derive an expression for the risk-neutral probability and justify the probability
you found.
(c) When the variables are X = $21; S = $20; r = 12%; t = 3 months; u =
1.1; d = 0.9, what is the European put option price calculated using the
binomial model? Show your work to answer the question.
(d) For the same variables as in (c), determine the range of an American put
option price which has the same conditions.

/continued. . .

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3. Let S denote the price of a non-dividend-paying asset which undergoes a stochastic

process described by
dS
= dt + dZ
S
where the drift and the volatility are assumed constant and dZ is the standard
Wiener process.
(a) Using Itos lemma, write the stochastic differential equation for a derivative
c(S).
(b) Construct a risk-free portfolio by shorting one derivative and longing underlying assets.
(c) Using an arbitrage-free argument, derive the Black-Scholes equation.
(d) Describe the delta hedging portfolio and outline the difficulties of delta hedging.

/continued. . .

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4. The following is the contract specification for the corn futures

Initial Margin: $ 473 per contract
Maintenance Margin: $ 350 per contract
Contract Size: 5,000 bushels
Let us consider the following transaction.
Day 1 A customer longs two corn futures contract.
Current futures price: $ 2.07 per bushel
Closing futures price of day 1: $2.05 per bushel
Day 2 The price of the corn futures falls to $2.04 per bushel.
(a) What is the excess margin/margin call on the day 2? Show your work to
answer the question.
(b) Suppose the price of the corn futures rises to $2.08 per bushel on the day 3.
Assuming the position is still open, what is the excess margin/margin call on
the day 3? Show your work to answer the question.
(c) Prove that the forward price for a contract with a certain delivery date is the
same as the futures price for a contract with the same delivery date when the
risk-free interest rate is constant and the same for all maturities.

/continued. . .

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5. The Black equation for futures derivatives f is

f
1 2f 2 2
+
F = rf.

2 F 2

where r is the risk-free interest rate, is the time to mature, F is the underlying
futures and is its volatility. In answering the questions, recall that the cumulative
normal probability distribution is
1
N (x) =
2

et

2 /2

dt

(a) Denoting y = ln F and w = er f , show that the Black equation becomes

w 2

2 w w

y 2
y

= 0.

(b) The fundamental solution of the above partial differential equation is

1
er exp
(y, ) =

y 2
2 2

2

Using the fundamental solution of the Black equation, find the price for a
European call option on the futures. Show your work.
(c) Using the fundamental solution of the Black equation, find the price for a
European put option on the futures. Show your work.
(d) Derive the put-call parity for the European futures options.

/continued. . .

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6. (a) At time t = 0, a company sells a forward rate agreement (FRA) to lend for
the period of time T to T (T < T ) at a preset interest rate, RK .
i. The value of the agreement at the initial time t = 0 is zero if the preset
rate is fairly agreed. In this case, show that the preset interest rate, RK , in
the FRA should be the same as the forward rate at the time the contract
is initiated.
ii. Define at time t
rt (rt ): the spot rate applying for T t (T t) years
ft : the forward rate for the period of time between T and T .
Calculate the value of the FRA at time t.
iii. Show that we can value the FRA at time t by calculating the present
value of cash flows on the assumption that the current forward rate, ft , is
realised.
(b) To study the forward rate curve (plotted against the maturity), we need the
instantaneous forward rate. If r is the spot rate of interest applying for T
years and r is the spot rate for T years where T > T , the forward interest
rate for the period of time between T and T is
f=

r T rT
.
T T

Find the instantaneous forward rate. Discuss the forward rate curve plotted
against the maturity with the reference of the bond-yield curve.

/continued. . .

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7. We would like to derive the governing equation for the bond price using the arbitrage
pricing approach. The bond price is assumed to follow the following stochastic
differential equation
dB
= B (r, t)dt + B (r, t)dZ
B
where B (r, t) and B (r, t) are respectively the drift rate and the variance of the
stochastic process and dZ is the standard Wiener process. We also assume that the
bond price depends only on the spot interest rate r, current time t and maturity
time T and the spot rate r(t) follows a continuous Markovian stochastic process
described by
dr = u(r, t)dt + w(r, t)dZ
where u(r, t) and w(r, t)2 are the instantaneous drift and variance of the process
for r(t).
(a) With use of Itos lemma, prove that the drift rate B (r, t) and the variance
B (r, t) can be written as
1
B (r, t) =
B

B
B 1 2 2 B
+u
+ w
t
r
2 r 2

and
B (r, t) =

1 B
w
.
B r

(b) To hedge the risk, take a portfolio which consists of a bond of dollar value V1
with maturity T1 and another bond of dollar value V2 with maturity T2 . With
help of the portfolio find the governing equation for the bond price.
(c) Consider two securities which depend on the spot interest rate. Suppose security A has an expected return of 5% per annum and a volatility of 10%
per annum, while security B has a volatility of 20% per annum. Suppose the
riskless interest rate is 7% per annum. Find the market price of interest rate
risk and the expected return per annum of security B.