20/9/16

MA4403/MS3019 — Exercise Sheet

1. Suppose you are to receive payments (in thousands of euro) at the end of the next five years,
and that the interest rate is 10%, compounded annually. Which of the following payment
sequences is preferable?

(i) 12, 14, 16, 18, 20 (ii) 16, 16, 15, 15, 15 (iii) 20, 16, 14, 12, 10

What happens if the interest rate is instead 20%? What if it is 30%?

2. The yearly cash flows of an investment are:

−1000, −1200, 800, 900, 800.

Is this a worthwhile investment for someone who can both borrow and save money at the
yearly interest rate of 6%?

3. How much do you need to invest at the beginning of each of the next 60 months in order to
have a value of e100, 000 at the end of 60 months, given that the annual nominal interest
rate will be fixed at 6% and will be compounded monthly?

4. A stock whose current price is e21 may see its price either rise to e23 or fall to e17.
Assuming that the risk free interest rate is zero, find the fair price of a call option on this
stock with strike price e21.

5. When typing a report, a typist makes i errors with probability pi , (i ≥ 0), where p0 = 0.20,
p1 = 0.35, p2 = 0.25 and p3 = 0.15. What is the probability that the typist makes

(i) at least four errors; (ii) at most two errors?

6. Which of the following is more probable:

(i) getting at least one 6 with four throws of a die, or
(ii) getting at least one double 6 with twenty-four throws of two dice?
This is sometimes called ‘de Méré’s paradox’, after the professional gambler Chevalier de
Méré who believed these two events to have equal probability.

7. Two dice are thrown. Find the probability that

(i) one of the dice comes up as 5;
(ii) one of the dice comes up even;
(iii) one of the dice comes up either 3 or 5;
(iv) one of the dice comes up either 3 or even.

8. Suppose that A, B and C are events in a sample space S. Use the formula P (E ∪ F ) =
P (E) + P (F ) − P (E ∩ F ), with E = A ∪ B and F = C, to show that

P (A ∪ B ∪ C) = P (A) + P (B) + P (C) − P (A ∩ B) − P (B ∩ C) − P (A ∩ C) + P (A ∩ B ∩ C)

9. Three dice are thrown. Find the probability that at least one die comes up 3. [Hint: the
result from question 8 can be used.]
Find the probability that at least two dice come up 3.

10. Show that P (A1 ∩ A2 ∩ A3 ) = P (A3 |A1 ∩ A2 )P (A2 |A1 )P (A1 ).

11. An urn contains r red balls and b blue balls. Balls are drawn from the urn without replace-
ment. Find the probability that
 (i) the first ball drawn is red;
(ii) both the first and second balls drawn are red;
(iii) the first, second and third balls drawn are all red;
(iv) the first ball is red and the second is blue;
(v) the first ball is blue and the second is red;
(vi) the second ball is blue.

12. (a) Suppose S is a sample space and that there are events A1 , A2 , . . . , An such that S =
A1 ∪ · · · ∪ An , and Ai ∩ Aj = ∅ whenever i 6= j. That is, each outcome from S belongs to
exactly one of the events Ai . Let B be any other event. Prove Bayes’ Theorem:

P (B|Aj )P (Aj )
P (Aj |B) = Pn
i=1 P (B|Ai )P (Ai )

(b) Declan, Sean and Louise work in a telemarketing centre. The following table shows
the percentage of calls each caller makes and the percentage of persons who are annoyed
and hang up on each caller:
Declan Sean Louise
% of calls 40 25 35
% of hang-ups 20 55 30
Let D denote the event ‘Declan made the call’, S the event ‘Sean made the call’, L the
event ‘Louise made the call’ and H the event ‘the caller hung up’. Find P (D), P (S),
P (L), P (H|D), P (H|S), P (H|L), P (D|H), P (S|H), P (L|H) and P (H).

13. A hand of 5 cards is dealt from a pack of 52. Let X denote the number of Kings in the
hand. Find

(i) P (X = 1) (ii) P (X = 2) (iii) P (X = 3) (iv) P (X = 4) (v) E[X]

14. A gambling book recommends the following strategy for the game of roulette. It recom-
mends that the gambler bet 1 on red. If red appears (which has probability 18/38 of
occurring) then the gambler should take his profit of 1 and quit. If the gambler loses this
bet, he should then make a second bet of size 2 and then quit. Let X denote the gambler’s
winnings. Find P (X > 0), E[X] and Var(X).

15. Four buses carrying 152 students from the same school arrive at a football stadium. The
buses carry (respectively) 39, 33, 46, and 34 students. One of the 152 students is randomly
chosen. Let X denote the number of students who were on the bus of the selected student.
One of the four bus drivers is also randomly chosen. Let Y be the number of students who
were on that driver’s bus.
(i) Which do you think is larger, E[X] or E[Y ]?
(ii) Find E[X] and E[Y ]

16. A fair coin is tossed 10 times. Find the probability that heads comes up exactly five times.
Find the probability that heads comes up at most five times.

17. A coin is tossed 10 times. Find the probability that heads comes up at most four times, if
the probability that on heads on any given toss is 1/4.

18. A coin is tossed repeatedly. At each toss the probability of heads coming up is p. Let Y be
the number of tosses before the first head (so Y = 1 if heads comes up on the first throw,
Y = 2 if tails comes up the first throw and then heads comes up on the second throw, etc.).
Find
 (i) Find P (Y = 1), P (Y = 2) and P (Y = 3).
(ii) Find P (Y = i), for each i.
(iii) Find E[Y ].
(iv) Find Var(Y )

19. A pair of dice is rolled until 7 appears for the first time. What is the expected number of
trials until 7 first appears?
Suppose you play a game by rolling the dice three times. You win if there is at least one
7 and lose otherwise. If you lose, you pay your opponent e3. What should your opponent
pay you if you win to ensure that the game is fair?

20. Suppose that in each period of length T the cost of a security either goes up by a factor of
2 or down by a factor of 1/2, (that is, u = 2, d = 1/2). If the initial price of the security is
e100, determine the no-arbitrage cost of a call option to purchase the security at the end
of 2 periods for a price of e150, if the interest rate r is such that erT = 7/6.

21. Consider a two-period stock model over a period of 6 months, with interest rate 4%. The
initial price of the stock is e4, while in each period the stock may either increase by a factor
of 2 or decrease by a factor of 1/2.
(i) What are the risk neutral probabilities for this stock?
(ii) Find the arbitrage free price of a call option on this stock with strike price e6.
(iii) A lookback call option with strike price eK pays out nothing if the stock price never
exceeded K over the lifetime of the option and pays out the difference between the
maximum stock price and K if it did. Find the arbitrage free price of a lookback
call option on this stock with strike price e6.

22. Repeat Question 21, but this time with three periods.

23. Consider a two-period binomial model with the associated risk-neutral probability of an
upward movement p = (ert/2 − d)/(u − d). Show by direct computation that
E e−rt S(2) = S(0)
 

for the stock price S(0) at time 0 and the stock price S(2) after two periods.

24. For a standard normal random variable Z, find

(i) P (Z < − 0.66); (ii) P (|Z| < 1.64); (iii) P (|Z| > 2.20).

25. A person is chosen at random from a population whose height is normally distributed with
mean 1.7 m and standard deviation 5 cm. Find the following probabilities
(i) that the person chosen at random is taller than 1.73 m;
(ii) that the height of the person chosen at random is between 1.6 m and 1.8 m.

26. Rework Questions 16 and 17, using the normal approximation to the Binomial distribution.

27. A model for the movement of a stock supposes that, if the present price of the stock is
S, then — after one time period — it will either be Su with probability p or Sd with
probability 1 − p. Assuming that successive movements are independent, approximate the
probability that the stock’s price will be up at least 30% after the next 1, 000 time periods
if u = 1.012, d = 0.990, and p = 0.52.

28. In each time period, a certain stock either goes down 1 with probability 0.39, remains the
same with probability 0.20, or goes up 1 with probability 0.41. Assuming that the changes
in successive time periods are independent, approximate the probability that, after 700 time
periods, the stock will be up more than 10 from where it started.
29. Suppose that S(y), y ≥ 0, is a geometric Brownian motion with drift parameter µ = 0.01
and volatility parameter σ = 0.2. This means that
h  S(t) i h  S(t) i
E log = µt, Var log = σ 2 t.
S(0) S(0)

If S(0) = 100, find (i) E[S(10)]; (ii) P (S(10) > 100); (iii) P (S(10) < 100).

30. An investor estimates that the price of a certain stock in one month’s time will have a
lognormal distribution with parameters µ = 1 and σ = 0.2. Determine the investor’s
estimate of the likelihood that the stock price will exceed e3.40 in one month’s time.
Determine the investor’s estimate of the likelihood that the stock price will be below e3.00
in one month’s time.

31. (a) Consider a random variable X with a binomial distribution with parameters 4 and
8/11. What are the possible values of X and with what probabilities does each occur?
Verify that the expected value of X is 32/11, or approximately 2.91, and that the variance
of X is 0.79 to two decimal places.
(b) Suppose that in each period, the cost of a security either goes up by a factor of u = 6/5
or down by a factor of d = 5/6. The risk free interest rate over the period of length T
satisfies erT = 1.1. If the initial price of the security is e60, determine the no-arbitrage
cost of a call option to purchase the security at the end of 4 periods for a price of e70.
(c) For the stock in (b), find the price of the corresponding put option, again with strike
price e70. Verify the put-call parity formula in this case.

32. The price of a certain security follows a geometric Brownian motion with parameters µ =
0.12 and σ = 0.24. If the security’s price is presently e40, what is the probability that a
call option, having 4 months to exercise time and with a strike price of K = e42, will be
exercised? (A security whose price at the time of expiration of a call option is above the
strike price is said to finish in the money.)
What is the risk-neutral valuation of this option?

33. Calculate the price of a 3-month European call option on a non-dividend-paying stock with
a strike price of e50 when the current stock price is e50, the risk-free interest rate is 10%
per annum, and the volatility is 30% per annum.

34. A stock price is currently e50. Assuming that the expected rate of return from the stock
is 18% and its volatility is 30%, what is the probability distribution for the stock price in
two years? Calculate the mean and standard deviation of the distribution.

35. What is the price of a European call option on a non-dividend-paying stock when the stock
price is e52, the strike price is e50, the risk-free interest rate is 12% per annum, the
volatility is 30% per annum, and the time to maturity is six months?

36. (a) Estimate the stock volatility of the stock whose observed price (in euro) at the end of
each of 15 consecutive days are as follows:

32.875, 33.500, 31.125, 32.000, 33.500, 33.500, 30.625, 30.375,

33.750, 33.000, 30.125, 33.000, 30.250, 30.250, 33.250.

(b) Estimate the stock volatility of the stock whose observed price (in euro) at the end of
each of 12 consecutive days are as follows:

76.324, 75.418, 78.548, 80.267, 82.172, 74.165,

77.414, 77.481, 78.712, 79.385, 80.539, 81.482