Exercise Solutions

Chapter 1
Exercise 1.1 According to Definition 1.3, we need to check the following five
properties of Brownian motion:
(i) starts at 0 at time 0,
(ii) independence of increments,
(iii) almost sure continuity of trajectories,
(iv ) stationarity of the increments,
(v ) Gaussianity of increments.
Checking conditions (i) to (iv ) does not pose any particular problem since
the time changes t 7→ c + t and t 7→ t/c2 are deterministic and continuous.
a) Let Xt := Bc+t − Bt , t ∈ R+ . For any finite sequence of times t0 < t1 <
· · · < tn , the sequence

(Xt1 − Xt0 , Xt2 − Xt1 , . . . , Xtn − Xtn−1 )

= (Bc+t1 − Bc+t0 , Bc+t2 − Bc+t1 , . . . , Bc+tn − Bc+tn−1 )

is made of independent random variables. Concerning (v ), Xt − Xs =

Bc+t − Bc+s is normally distributed with mean zero and variance t + c −
(c + s) = t − s for any 0 ⩽ s < t.
b) Let Xt := cBt/c2 −, t ∈ R+ . For any finite sequence of times t0 < t1 <
· · · < tn , the sequence

(Xt1 − Xt0 , Xt2 − Xt1 , . . . , Xtn − Xtn−1 )

= (cBt1 /c2 − cBt0 /c2 , cBt2 /c2 − cBt1 /c2 , . . . , cBtn /c2 − cBtn−1/c2 )

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is made of independent random variables. Concerning (v ), Xt − Xs =

cBt/c2 − cBs/c2 is normally distributed with mean zero and variance
c2 (t/c2 − s/c2 ) = t − s for any 0 ⩽ s < t, since

Var [cBt/c2 ] = c2 Var [Bt/c2 ] = c2 t/c2 = t, t ⩾ 0.

Exercise 1.2 The solution to (1.16) is given by

2 /2)t
St = S0 eσBt +(µ−σ , t ⩾ 0,

see the proof of Proposition 1.7 for details. The next code can be used to
generate Figure 1.22.
N=1000; t <- 0:N; dt <- 1.0/N; nsim <- 10; sigma=0.6; mu=0.001
Z <- c(rnorm(n = N, sd = sqrt(dt)));
plot(t*dt, exp(mu*t), xlab = "time", ylab = "Geometric Brownian motion", type = "l", ylim =
c(0, 4), col = 1,lwd=3)
lines(t*dt, exp(sigma*c(0,cumsum(Z))+mu*t-sigma*sigma*t*dt/2),xlab = "time",type = "l",ylim
= c(0, 4), col = 4)

Exercise 1.3
a) Those quantities can be computed from the expression of Stn as a function
of the N (0, t) random variable Bt for n ⩾ 1. Namely, we have
2
E[Stn ] = E S0n enσBt −nσ t/2+nrt
 
2
= S0 e−nσ t/2+nrt E enσBt
 
2 t/2+nrt+n2 σ 2 t/2
= S0 e−nσ
2
= S0n enrt+(n−1)nσ t/2 ,

where we used the Gaussian moment generating function (MGF) formula

(A.41), i.e.
2 2
E enσBt = en σ t/2
 

for the normal random variable Bt ≃ N (0, t), t > 0.

b) By the result of Question (a)), we have E[St ] = S0 ert and
2
E[St2 ] = E S02 e2σBt −σ t+2rt
 
2
= S02 e−σ t+2rt E e2σBt
 
2 t+2rt
= S02 eσ , t ⩾ 0.

Exercise 1.4 From the solution of Exercise 1.3, we have

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 Notes on Financial Risk and Analytics

 (i)  (i)
E St = S0 eµt , t ∈ [0, T ], i = 1, 2,

and
 (i)   ( i )
2   (i) 

Var St = E St − E St
( i )
2 2 ( i )
2
= S0 e2µt+σi t − S0 e2µt
( i )
2 2
= S0 e2µt eσi t − 1 , t ∈ [0, T ], i = 1, 2.

Hence, we have
 (2) (1)   (1)   (2)  (1) (2)

Var St − St = Var St + Var St − 2 Cov St , St

with
 (1) (2)   (1) (2) (1) 2 (2) 2
E St St = E S0 S0 e2µt+σ1 Wt −σ1 t/2+σ2 Wt −σ2 t/2


(1) (2) 2 2 (1) (2) 

= S0 S0 e2µt−σ1 t/2−σ2 t/2 E eσ1 Wt +σ2 Wt


1 
 
(1) (2) 2 2 (1) ( 2 )
2 
= S0 S0 e2µt−σ1 t/2−σ2 t/2 exp E σ1 Wt + σ2 Wt ,
2

with
(1) ( 2 )
2  ( 1 )
2  (1) (2)  ( 2 )
2 
E σ1 Wt + σ2 Wt = E σ1 Wt + 2E σ1 Wt σ2 Wt + E σ2 W t
   

= σ12 t + 2ρσ1 σ2 t + σ22 t,

hence  (1) (2)  (1) (2)

E St St = S0 S0 e2µt+ρσ1 σ2 t ,
and
(1) (2)
 (1) (2)   (1)   (2)  (1) (2)
Cov St , St = E St St − E St E St = S0 S0 e2µt (eρσ1 σ2 t − 1),

and therefore
 (2) (1) 
Var St − St
(1)
2 2µt σ 2 t (2)
2 2µt σ 2 t (1) (2)
= S0 e ( e 1 − 1 ) + S0 e (e 2 − 1) − 2S0 S0 e2µt (eρσ1 σ2 t − 1)
(1) 2 σ 2 t (2) 2 σ 2 t (1) (2) (2) ( 1 )
2

= e2µt S0 e 1 + S0 e 2 − 2S0 S0 eρσ1 σ2 t − S0 − S0 .

Exercise 1.5 We have

2 2 2 2
E S0 eσBt +µt−σ t/2 = S0 eµt−σ t/2 E eσBt = S0 eµt−σ t/2 eσ t/2 = S0 eµt
   

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and
σ2 t σ2 t
 
E[log St ] = E log S0 + σBt + µt − = (log S0 ) + µt − ,
2 2

hence
σ2 t σ2 t
 
Theilt = log E[St ] − E[log St ] = log S0 + µt − (log S0 ) + µt − = .
2 2

5
Geometric Brownian motion

1
0.0 0.2 0.4 0.6 0.8 1.0
Time

Fig. S.1: Twenty sample paths of geometric Brownian motion (St )t∈R+ .

Chapter 2

Exercise 2.1
a) i) By calculation (expected answer). We have

ρ(0) = Cov(Xn , Xn )
= Var[Xn ]
= E[Xn2 ]
= E[(Zn − aZn−1 )2 ]
= E[Zn2 − 2aZn−1 Zn + a2 Zn−1
2
]
= E[Zn2 ] − 2aE[Zn−1 Zn ] + a2 E[Zn−1
2
]
= 1 − 2aE[Zn−1 ]E[Zn ] + a2
= 1 + a2 ,

and

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 Notes on Financial Risk and Analytics

ρ(1) = Cov(Xn , Xn+1 )

= Cov(Zn + aZn−1 , Zn+1 + aZn )
= Cov(Zn , Zn+1 ) + a Cov(Zn−1 , Zn+1 ) + a Cov(Zn−1 , Zn ) + a2 Cov(Zn−1 , Zn )
= Cov(Zn , Zn+1 ) + a Cov(Zn−1 , Zn+1 ) + a Cov(Zn , Zn ) + a2 Cov(Zn−1 , Zn )
= a Var[Zn ]
= a,

and for k ⩾ 2,

ρ(k ) = Cov(Xn , Xn+k )

= Cov(Zn + aZn−1 , Zn+k + aZn+k−1 )
= Cov(Zn , Zn+k ) + a Cov(Zn−1 , Zn+k )
+a Cov(Zn , Zn+k−1 ) + a2 Cov(Zn−1 , Zn+k−1 )
= 0,

since n < n + k − 1. By a similar argument, we obtain ρ(k ) = ρ(−k )

for k ⩽ 0.
ii) Confirmation by simulation with an MA(1) time series constructed
by hand:

library(zoo)
N=10000;Zn<-zoo(rnorm(N,0,1))
Xn<-Zn+2*lag(Zn,-1, na.pad = TRUE);Xn<-Xn[-1]
k=0;cov(Xn[1:(length(Xn)-k)],lag(Xn,k))

or with an MA(1) time series constructed using arima.sim:

n=2000;a=2;
Xn<-arima.sim(model=list(ma=c(a)),n.start=100,n)
x=seq(100,100+n-1)
plot(x,Xn,pch=19, ylab="X", xlab="n", main = 'MA(1) Samples',col='blue')
lines(x,Xn,col='blue')
Xn<-zoo(Xn)
k=1;cov(Xn[1:(length(Xn)-k)],lag(Xn,k))

Using the command ccf to compute the autocovariance empirically,

we find:
ccf(Xn,Xn,lag = 5, type="covariance", plot=T, lwd=2, col='blue', axes=FALSE,
ylim=c(-1-a**2,1+a**2), main="")
axis(side = 1, at = seq(-5,5,1))
axis(side = 2, at = c(-1-a**2,-a,0,a,1+a**2), labels=c(expression(paste("-1-|a|"^"2")),
"a",0,"a", expression(paste("1+|a|"^"2"))))

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b) We note that E[Xn ] = 0, n ∈ Z, and in addition the autocovariance

Cov(Xn , Xn+k ) depends only of |k| and not on n ∈ Z. Therefore, the
time series (Xn )n∈Z is weakly stationary by Definition 2.11. In addition,
by Theorem 2.12 this time series is strictly stationary only if |a| ̸= 1.

Exercise 2.2
a) We rewrite the equation defining (Xn )n⩾1 as

Xn = Zn + LXn = Zn + ϕ(L)Xn , n ⩾ 1.

where L is the lag operator LXn = Xn−1 and ϕ(L) = L. Taking ϕ(z ) := z,
by Theorem 2.12 we need to check whether the solutions of the equation
ϕ(z ) = 1 lie on the complete unit circle. As ϕ(z ) = 1 admits the unique
solution z = 1 which lies on the complete unit circle, we conclude that
the AR(1) time series (Xn )n⩾1 is not weakly stationary.
b) As in part (a)), we rewrite the AR(2) equation for (Yn )n⩾1 as

Yn = Zn + 0.75 × LYn − 0.125 × L2 Yn = Zn + ϕ(L)Yn , n ⩾ 2.

with ϕ(L) = 0.75 × L − 0.125 × L2 . The equation ϕ(z ) = 1 with ϕ(z ) =

0.75z − 0.125z 2 reads z 2 − 6z + 8 = (z − 2)(z − 4) = 0. This equation has
two solutions z = 2, 4 which lie outside the complex unit circle, hence by
Theorem 2.12 the AR(2) time series (Yn )n⩾2 is weakly stationary.

Exercise 2.3
a) We have

E[Xn+1 ] = E Zn+1 + αXn

 

= E[Zn+1 ] + αE Xn
 

= αE Xn , n ⩾ 0,
 

hence by induction we have E[Xn ] = αn E[X0 ] = 0 for all n ⩾ 0.

b) We have

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 Notes on Financial Risk and Analytics

Cov(Xn+k+1 , Xn ) = E[Xn+k+1 Xn ] − E[Xn+k+1 ]E[Xn ]

= E[Xn+k+1 Xn ]
= E[(Zn+k+1 + αXn+k )Xn ]
= E[Zn+k+1 Xn + αXn+k Xn ]
= E[Zn+k+1 Xn ] + E[αXn+k Xn ]
= E[Zn+k+1 ]E[Xn ] + αE[Xn+k Xn ]
= αE[Xn+k Xn ]
= α(E[Xn+k Xn ] − E[Xn+k ]E[Xn ])
= α Cov(Xn+k , Xn ), n ⩾ 0,

hence, since E[Xn ] = 0, n ⩾ 0, we find

Cov(Xn+k , Xn ) = αk Cov(Xn , Xn ) = αk Var[Xn ], k, n ⩾ 0.

c) We have

Var[Xn+1 ] = E[Xn2+1 ]
= E[(Zn+1 + αXn )2 ]
= E[Zn2+1 + 2αZn+1 Xn + α2 Xn2 ]
= E[Zn2+1 ] + 2αE[Zn+1 Xn ] + α2 E[Xn2 ]
= 1 + 2αE[Zn+1 ]E[Xn ] + α2 E[Xn2 ]
= 1 + α2 E[Xn2 ]
= 1 + α2 Var[Xn ].

By applying the above relation recursively and using the geometric series
identity (13.51), we obtain

Var[Xn ] = 1 + α2 Var[Xn−1 ]
= 1 + α2 (1 + α2 Var[Xn−2 ])
= 1 + α2 (1 + α2 (1 + α2 Var[Xn−2 ]))
= 1 + α2 + · · · + α2n
Xn
= α2k
k =0
1 − α2n+2

, α ̸= ±1,


1 − α2

=

 n + 1,

α = ±1, n ⩾ 0.

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d) We check that the solution of ϕ(z ) := αz is z = 1/α, hence by Theo-

rem 2.12 there exists an AR(1) solution of (2.28) which is weakly station-
ary when α ̸= ±1. However, the present time series (Xn )n⩾0 started at
X0 = 0 is not weakly stationary because Cov(Xn , Xn ) = E[Xn2 ] is not
constant in n ⩾ 0.

Exercise 2.4
a) We have

Var[Xn ] = Var[Zn−1 − Zn−2 + αZn−3 ]

= Var[Zn−1 ] + Var[−Zn−2 ] + Var[αZn−3 ]
= Var[Zn−1 ] + Var[Zn−2 ] + α2 Var[Zn−3 ]
= 2 + α2 .

Next, since using the linearity relation

Cov(X + Y , Z ) = Cov(X, Z ) + Cov(Y , Z )

and the fact that Cov(X, Z ) = 0 when X and Z are independent random
variables, we have

Cov(Xn+1 , Xn ) = Cov(Zn − Zn−1 + αZn−2 , Zn−1 − Zn−2 + αZn−3 )

= Cov(Zn − Zn−1 + αZn−2 , Zn−1 )
+ Cov(Zn − Zn−1 + αZn−2 , −Zn−2 )
+ Cov(Zn − Zn−1 + αZn−2 , αZn−3 )
= Cov(−Zn−1 , Zn−1 ) + Cov(αZn−2 , −Zn−2 )
= − Cov(Zn−1 , Zn−1 ) − α Cov(Zn−2 , Zn−2 )
= −α − 1,

and

Cov(Xn+2 , Xn ) = Cov(Zn+2 − Zn + αZn−1 , Zn−1 − Zn−2 + αZn−3 )

= Cov(Zn+2 − Zn + αZn−1 , Zn−1 )
+ Cov(Zn+2 − Zn + αZn−1 , −Zn−2 )
+ Cov(Zn+2 − Zn + αZn−1 , αZn−3 )
= Cov(αZn−1 , Zn−1 )
= α Cov(Zn−1 , Zn−1 )
= α,

and

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 Notes on Financial Risk and Analytics

Cov(Xn+k , Xn ) = Cov(Zn+k−1 − Zn+k−2 + αZn+k−3 , Zn−1 − Zn−2 + αZn−3 )

= Cov(Zn+k−1 − Zn+k−2 + αZn+k−3 , Zn−1 )
+ Cov(Zn+k−1 − Zn+k−2 + αZn+k−3 , −Zn−2 )
+ Cov(Zn+k−1 − Zn+k−2 + αZn+k−3 , αZn−3 )
=0

for k ⩾ 3.
b) Since the white noise sequence (Zn )n∈Z is made of independent identically
distributed random variables, we have the identity in distribution
d
Xn = Zn−1 − Zn−2 + αZn−3 ≃ Zn − Zn−1 + αZn−2 , n ⩾ 2,

which shows that (Xn )n⩾3 has the same distribution as an MA(2) time
series the form
Yn = Zn + β1 Zn−1 + β2 Zn−2 ,
with β1 = −1 and β1 = α.

Exercise 2.5
a) We have

∇Xn = Xn − Xn−1
= Zn + α1 Xn−1 − Zn−1 − α1 Xn−2
= Zn − Zn−1 + α1 ∇Xn−1 , n ⩾ 2,

hence (∇Xn )n⩾2 forms an ARMA(1, 1) time series.

b) We have

∇2 Xn = ∇Xn − ∇Xn−1
= Xn − Xn−1 − (Xn−1 − Xn−2 )
= Xn − 2Xn−1 + Xn−2
= Zn + α1 Xn−1 − 2Zn−1 − 2α1 Xn−2 + Zn−2 + α1 Xn−3
= Zn − 2Zn−1 + Zn−2 + α1 ∇2 Xn−1 , n ⩾ 3,

which forms an ARMA(1, 2) time series.

Exercise 2.6
a) We have

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n n
!
∂ X (2) ( 1 )
2
X (2) (1)

rk − a − brk = −2 rk − a − brk
∂a
k =1 k =1
n n
(2) (1)
X X
= 2an − 2 rk + 2b rk ,
k =1 k =1

and
n n
∂ X (2) ( 1 )
2
X (1) (2) (1)

rk − a − brk =2 rk − a + rk − brk
∂b
k =1 k =1
n n
!
X (1) (2) (1) 1 X (2) (1)

=2 rk rk − brk − rl − brl
n
k =1 l =1
n n n n
!
X (1) (2) 2 X (1) (2) X (1) 2 1 X (1) (1)
=2 rk rk − rk rl − 2b (rk ) − rk rl .
n n
k =1 k,l=1 k =1 k,l=1

b) In order to minimize the residual (2.29) over a and b we equate the above
derivatives to zero, which yields the equations
n n n
∂ X (2) ( 1 )
2
X (2)
X (1)
rk − a − brk |a=â, b=b̂
= 2b
an − 2 rk + 2bb rk =0
∂a
k =1 k =1 k =1

and
n
∂ X (2) ( 1 )
2
rk − a − brk |a=â, b=b̂
∂b
k =1
n n n n
!
X (1) (2) 2 X (1) (2)
X (1) 1 X (1) (1)
=2 rk rk − rk rl − 2bb (rk )2 − rk rl
n n
k =1 k,l=1 k =1 k,l=1
= 0.

This leads to estimators b

a, bb of the parameters a and b respectively as the
(1)
empirical mean and covariance of (rk )k=1,2,...,n , i.e.

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 Notes on Financial Risk and Analytics

 n
1 X (2) b (1)

a= rk − brk ,


 b

 n
k =1






 and





n n n n n
1 X (1) (2)
! !
 X (1) (2) X (1) 1 X (1) (2) 1 X (2)

 rk rk − r k r l rk − rl rk − rl
n

 n n
 bb = k=1 k,l=0

k =1 l =0 l =0
.


n n = 2
1 X (1) (1) n n
 !
1 X (1)

(1) 2
 X
( ) − (1)
X
r r r

rk − rk

 k n k l
n


k =1 k,l=0 k =1 k =1

Exercise 2.7 Since the p-value = 0.02377 is lower than the 5% confidence
level, we can reject the nonstationarity (null) hypothesis H0 at that level.

Exercise 2.8
a) We consider the equation

φ(z ) = α1 z + α2 z 2 = 1,

i.e.
α2 z 2 + α1 z − 1 = 0,
with solutions
 1
√
q
−α1 ± α12 + 4α2 −a ± a2 + 8a2 −a ± 3a


2a
z± = = = =
2α2 4a2 4a2 −1,

a
hence by Theorem 2.12 the time series (Xn )n⩾1 is stationary for a ∈
/
{−1, −1/2, 1/2, 1}.
b) We have

E[Xn ] = E[Zn + α1 Xn−1 + α2 Xn−2 ]

= E[Zn ] + α1 E[Xn−1 ] + α2 E[Xn−2 ]
= α1 E[Xn−1 ] + α2 E[Xn−2 ]
= α1 E[Xn ] + α2 E[Xn ],

hence
(1 − α1 − α2 )E[Xn ] = 0,
which implies E[Xn ] = 0, n ∈ Z, since 1 − α1 − α2 ̸= 0.

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c) We have

Cov(Xn , Zn ) = Cov(Zn + α1 Xn−1 + α2 Xn−2 , Zn )

= Cov(Zn , Zn ) + α1 Cov(Zn , Xn−1 ) + α2 Cov(Zn , Xn−2 )
= Cov(Zn , Zn )
= σ2 .

d) We have

Cov(Xn+1 , Xn ) = Cov(Zn+1 + α1 Xn + α2 Xn−1 , Xn )

= Cov(Zn+1 , Xn ) + α1 Cov(Xn , Xn ) + α2 Cov(Xn−1 , Xn ),
= 16α1 + α2 Cov(Xn−1 , Xn )
1
= 4 + Cov(Xn−1 , Xn ),
2
hence
Cov(Xn+1 , Xn ) = 8, n ∈ Z.

Chapter 3
Exercise 3.1
a) Since Z1 + Z2 + · · · + Zn has the centered Gaussian N (0, nσ 2 ) distribution
with variance nσ 2 , we have
N
!
X X
P(Y ⩾ y ) = P Zk ⩾ y N = n P ( N = n )
n⩾1 k =1
n
!!
X X
= 1−P Zk < y N =n P(N = n)
n⩾1 k =1
n
!!
X X
= 1−P Zk ⩽ y N =n P(N = n)
n⩾1 k =1
X 
y

= 1−Φ √ P(N = n)
n⩾1 nσ 2
X λn  y

= e−λ Φ −√ , y > 0.
n! nσ 2
n⩾1

b) Since E[Zk ] = 0 for all k ⩾ 1, we have

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 Notes on Financial Risk and Analytics

N
" #
X X
E[Y ] = E Zk N = n P(N = n)
n⩾1 k =1
n
" #
X X
= E Zk N = n P(N = n)
n⩾1 k =1
X n
X
= P(N = n) E [ Zk | N = n ]
n⩾1 k =1
X X n
= P(N = n) E [ Zk ]
n⩾1 k =1
= 0,

as in (3.12).

Exercise 3.2 By (3.17), we have

λ λwy
Φ′ (y ) = Φ (y ) − Φ(y − z )dF (z )
c c 0
λ λ wy
= Φ (y ) − Φ(y − z )e−z/µ dz
c µc 0
λ w
λ y
= Φ (y ) − Φ(z )e−(y−z )/µ dz,
c µc 0
hence the differential equation
λ ′ λ λ wy
Φ′′ (y ) = Φ (y ) − Φ (y ) + Φ(z )e−(y−z )/µ dz
c µc µ2 c 0
1 λ
 
λ λ
= Φ′ (y ) − Φ (y ) + Φ (y ) − Φ′ (y )
c µc µ c
λ 1
 
= − Φ′ (y ),
c µ

which can be solved as

λµ (λ/c−1/µ)y
Φ (y ) = 1 − e ,
c
given the boundary conditions Φ(∞) = 1 and Φ(0) = 1 − λµ/c, cf. (3.19).
We conclude that
λµ (λ/c−1/µ)y
Ψ (y ) = e , y ⩾ 0,
c

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 N. Privault

provided that c < λµ.

Exercise 3.3
a) We have

E[RT ] = E[R0 + µT − CNT ]

= E[R0 ] + E[µT ] − E[CNT ]
= R0 + µT − CE[NT ]
= R0 + µT − CλT
= R0 + (µ − λC )T ,

and similarly

Var[RT ] = Var[µT − CNT ] = Var[−CNT ] = C 2 Var[NT ] = λC 2 T .

b) We find

P(RT < 0) = P(R0 + µT − CNT < 0)

= P(NT > (R0 + µT )/C )
X
= P ( NT = k )
k>(R0 +µT )/C
X (λT )k
= e−λT .
k!
k>(R0 +µT )/C

Exercise 3.4
a) We have E[S (T )] = λT E[Z ] and Var[S (T )] = λT E[Z 2 ].
b) We have

Var[x + f (T ) − S (T )]
P(x + f (T ) − S (T ) < 0) ⩽
(E[x + f (T ) − S (T )])2
Var[S (T )]
=
(x + f (T ) − E[S (T )])2
λT E[Z12 ]
= .
(x + f (T ) − λT E[Z1 ])2

Chapter 4

Exercise 4.1

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a) Taking (U , V ) = (U , U ), we have

P(U ⩽ u and V ⩽ v ) = P(U ⩽ u and U ⩽ v )

= P(U ⩽ min(u, v ))
= min(u, v )
= CM (u, v ), u, v ∈ [0, 1].

b) Taking (U , V ) = (U , 1 − U ), we have

P(U ⩽ u and V ⩽ v ) = P(U ⩽ u and 1 − U ⩽ v )

= P(U ⩽ u and U ⩾ 1 − v )
= P(1 − v ⩽ U ⩽ u)
= 1{0⩽1−v⩽u⩽1} P(1 − v ⩽ U ⩽ u)
= 1{0⩽u+v−1⩽1} (u − (1 − v ))
= (u + v − 1) + ,

u, v ∈ [0, 1].
c) We have

C (u, v ) = P(U ⩽ u and V ⩽ v ) ⩽ P(U ⩽ u and V ⩾ 1) ⩽ P(U ⩽ u) = u,

u, v ∈ [0, 1], and similarly we find C (u, v ) ⩽ P(U ⩽ v ) = v for all

u, v ∈ [0, 1], which yields (4.8).
d) For fixed v ∈ [0, 1] we have

∂C C (u + ε, v ) − C (u, v )
(u, v ) = lim
∂u ε→0 ε
P(U ⩽ u + ε and V ⩽ v ) − P(U ⩽ u and V ⩽ v )
= lim
ε→0 ε
P(u ⩽ U ⩽ u + ε and V ⩽ v )
= lim
ε→0 P (u ⩽ U ⩽ u + ε)
= lim P(V ⩽ v | u ⩽ U ⩽ u + ε)
ε→0
= P(V ⩽ v | U = u)
⩽ 1,

u, v ∈ [0, 1], hence

∂C
h′ (u) = (u, v ) − 1 = P(V ⩽ v | U = u) − 1 ⩽ 0,
∂u

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u, v ∈ [0, 1], and since h(1) = C (1, v ) − v = P(V ⩽ v ) − v = 0, v ∈ [0, 1]

we conclude that h(u) ⩾ 0, u ∈ [0, 1], which shows (4.9).

Exercise 4.2
a) When ρ = 1, we have

P(X = 1 and Y = 1) = pX pY + pX pY (1 − pX )(1 − pY ),

 p





 P(X = 0 and Y = 1) = (1 − pX )pY − pX pY (1 − pX )(1 − pY ) ⩾ 0,

 p


P(X = 1 and Y = 0) = pX (1 − pY ) − pX pY (1 − pX )(1 − pY ) ⩾ 0,

 p







P(X = 0 and Y = 0) = (1 − pX )(1 − pY ) + pX pY (1 − pX )(1 − pY ),
 p

hence
 (1 − pX )pY ⩾ pX pY (1 − pX )(1 − pY ),
 p

pX (1 − pY ) ⩾ pX pY (1 − pX )(1 − pY ),
 p

hence

(1 − pX )pY ⩾ pX (1 − pY ) and pX (1 − pY ) ⩾ pY (1 − pX ),

showing that (1 − pX )pY = pX (1 − pY ), which implies pX = pY , and

 P(X = 1 and Y = 1) = pX + pX (1 − pX ) = pX = pY ,
 2




 P(X = 0 and Y = 1) = 0,




P(X = 1 and Y = 0) = 0,







P(X = 0 and Y = 0) = 1 − pX = 1 − pY .



b) When ρ = −1, we have

 P(X = 1 and Y = 1) = pX pY − pX pY (1 − pX )(1 − pY ) ⩾ 0,

 p




 P(X = 0 and Y = 1) = (1 − pX )pY + pX pY (1 − pX )(1 − pY ) ⩾ 0,

 p


P(X = 1 and Y = 0) = pX (1 − pY ) + pX pY (1 − pX )(1 − pY ) ⩾ 0,

 p







P(X = 0 and Y = 0) = (1 − pX )(1 − pY ) − pX pY (1 − pX )(1 − pY ) ⩾ 0,
 p

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hence
 pX pY ⩾ pX pY (1 − pX )(1 − pY ),
 p

pX pY (1 − pX )(1 − pY ),
p
pX pY ⩾


hence

pX pY ⩾ (1 − pX )(1 − pY ) and pX pY ⩾ (1 − pX )(1 − pY ),

showing that pX pY = (1 − pX )(1 − pY ), which implies pX = 1 − pY , and

P(X = 1 and Y = 1) = 0,






 P(X = 0 and Y = 1) = 1,




P(X = 1 and Y = 0) = 1,







P(X = 0 and Y = 0) = 0.



Exercise 4.3
a) We have

P(X ⩾ x) = P(X ⩾ x and Y ⩾ 0) = e−(λ+ν )x ,

and
P(Y ⩾ y ) = P(X ⩾ 0 and Y ⩾ y ) := e−(µ+ν )y ,
x, y ⩾ 0, i.e. X and Y are exponentially distributed with respective pa-
rameters λ + ν and µ + ν.
b) We have

P(X ⩽ x and Y ⩽ 0)
= P(X ⩾ x and Y ⩾ 0) − (P(X ⩾ x) − P(X ⩾ x and Y ⩾ 0))
−(P(Y ⩾ x) − P(X ⩾ x and Y ⩾ 0))
= P(X ⩾ x and Y ⩾ 0) − P(X ⩾ x) − P(Y ⩾ x) + P(X ⩾ x and Y ⩾ 0)),

x, y ⩾ 0, i.e. X and Y are exponentially distributed with respective pa-

rameters λ + ν and µ + ν.
c) Since e−(λ+ν )X and e−(µ+ν )Y are uniformly distributed on [0, 1], a copula
function C (u, v ) can be defined by

C (u, v ) := P(e−(λ+ν )X ⩽ u and e−(µ+ν )Y ⩽ v )

= P(X ⩽ −(λ + ν )−1 log u and Y ⩽ −(λ + ν )−1 log v )

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−1 −1 −1 −1
= eλ(λ+ν ) log u+µ(λ+ν ) log v )y−ν Max(−(λ+ν ) log u,−(λ+ν ) log v ))
−1 −1
= uλ/(λ+ν ) v µ/(λ+ν ) e−ν Max(−(λ+ν ) log u,−(λ+ν ) log v ))
(λ+ν )−1 (λ+ν )−1 ))
= uλ/(λ+ν ) v µ/(λ+ν ) eν min(log u ,log v
ν/(λ+ν ) ,v ν/(λ+ν ) ))
= uλ/(λ+ν ) v µ/(λ+ν ) elog min(u
= uλ/(λ+ν ) v µ/(λ+ν ) min(uν/(λ+ν ) , v ν/(λ+ν ) ))
= uλ/(λ+ν ) v µ/(λ+ν ) (min(u, v ))ν/(λ+ν ) , x, y ⩾ 0.

0.8

0.6
1
0.4 0.8
0.2 0.6
0.4 v
0
0 0.2 0.2
0.4 0.6 0.8 0
u 1

Fig. S.2: Exponential copula function u, v 7→ C (u, b) with λ = 1, µ = 2, ν = 4.

Exercise 4.4
a) We have
1
FX (x) = P(X ⩽ x) = P(X ⩽ x and Y ⩽ ∞) =
1 + e−x
and
1
FY (y ) = P(Y ⩽ y ) = P(X ⩽ ∞ and Y ⩽ y ) = , x, y ∈ R.
1 + e−y
The probability densities are given by

′ e−x
fX (x) = fY (x) = FX (x) = FY′ (x) = , x ∈ R.
(1 + e−x )2

b) We have

−1 1−u
FX (u) = FY−1 (u) = − log , u ∈ (0, 1),
u
and the corresponding copula is given by
−1
C (u, v ) = F(X,Y ) (FX (u), FY−1 (v ))
1−u 1−v
 
= F(X,Y ) − log , − log
u v

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 Notes on Financial Risk and Analytics

1
=
1 + (1 − u)/u + (1 − v )/v
1
=
1 + (1 − u)/u + (1 − v )/v
uv
= , u, v ∈ [0, 1],
u + v − uv
which is a particular case of the Ali-Mikhail-Haq copula.

Exercise 4.5
a) We show that (X, Y ) have Gaussian marginals N (0, σ 2 ) and N (0, η 2 ),
according to the following computation:
w∞ 1 w∞
1 2 2 (x, y )e−x /(2σ )−y /(2η ) dy
2 2 2 2
fe(x, y )dy =
−∞ πση −∞ R− ∪R+
1 −x2 /(2σ2 ) w∞
1R + ( x )
2 2
= e e−y /(2η ) dy +
πση 0
1 −x2 /(2σ2 ) w0
1 R− ( x )
2 2
e e−y /(2η ) dy
πση −∞
1 1
= √ e−x /(2σ ) 1R+ (x) + √ e−x /(2σ ) 1R− (x)
2 2 2 2

σ 2π σ 2π
1 2 2
= √ e−x /(2σ ) , x ∈ R.
σ 2π

b) The couple (X, Y ) does not have a joint Gaussian distribution, and its
joint probability density function does not coincide with fΣ (x, y ).
c) When σ = η = 1, the random variable X + Y has the probability density
function
∂ ∂ w ∞ w a−x e
P(X + Y ⩽ a) = f (x, y )dydx
∂a ∂a −∞ −∞
1 ∂ w a w a−x −x2 /2−y2 /2
= e dydx
π ∂a 0 0
1 ∂ w a −(a−z )2 /2 w z −y2 /2
= e e dydz
π ∂a 0 0
1 w a −y2 /2 1 wa 2
wz 2
= e dy − (a − z )e−(a−z ) /2 e−y /2 dydz
π 0 π 0 0
1 w a −y2 /2 1 wa 2
wa 2
= e dy − (a − z )e−(a−z ) /2 dz e−y /2 dy
π 0 π 0 0
w w
1 a −y2 /2 y −(a−z )2 /2
+ e e dzdy
π 0 0

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 N. Privault

1 −a2 /2 w a −y2 /2 1 w a −y2 /2 −(a−y )2 /2 2

= e e dy + e (e − e−a /2 )dy
π 0 π 0
1 −a2 /2 w a −y2 /2−(a−y )2 /2
= e e dy
π 0
w
1 a −(( 2y−a/ 2)2 −a2 /2)/2
√ √
= e dy
π 0
2 /4 w √
e−a √
a 2 −((y−a/ 2)2 )/2
= √ e dy
π 2 0
√ √
e−a /4 w a( 2−1/ 2) −y2 /2
2

= √ √ e dy
π 2 −a/ 2
√
e−a /4 w a/ 2 −y2 /2
2

= √ √ √ e dy
π 2π −a/ 2
1 2 1 √

√ e−a /4 √ 2Φ a/ 2 − 1 , a ⩾ 0,


=
2π π

which vanishes at a = 0.
0.20
0.15
Density
0.10
0.05
0.00

−6 −4 −2 0 2 4 6

Fig. S.3: Density of X + Y .

d) The random variables X and Y are positively correlated, as

w∞ 1 w∞
1 2 2 (x, y )ye−x /(2σ )−y /(2η ) dy
2 2 2 2
yfΣ (x, y )dy =
−∞ πση −∞ R− ∪R+
1 −x2 /(2σ2 ) w∞
1R + ( x )
2 2
= e ye−y /(2η ) dy
πση 0
1 −x2 /(2σ2 ) w0
1 R− ( x )
2 2
+ e ye−y /(2η ) dy
πση −∞
η −x2 /(2σ2 ) η
1R+ (x) − e−x /(2σ ) 1R− (x),
2 2
= e
πσ πσ
hence
w∞ w∞
E[XY ] = xyfΣ (x, y )dydx
−∞ −∞

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 Notes on Financial Risk and Analytics

η w ∞ −x2 /(2σ2 ) η w0 2 2
= xe dx − xe−x /(2σ ) dx
πσ 0 πσ −∞
2ση
= ,
π
and
E[XY ] 2
ρ= = .
ση π
Under a rotation
cos θ − sin θ
 
R= ,
sin θ cos θ
of angle θ ∈ [0, 2π ] we would find

E[(X cos θ − Y sin θ )(X sin θ + Y cos θ )]

= sin θ cos θE X 2 + (cos2 θ − sin2 θ )E[XY ] − sin θ cos θE Y 2
   

2ση
= σ 2 sin θ cos θ + (cos2 θ − sin2 θ ) − η 2 sin θ cos θ
π
σ2 2ση η 2
= sin(2θ ) + cos(2θ ) − sin(2θ ),
2 π 2
and
σ 2 η
ρ= sin(2θ ) + cos(2θ ) − sin(2θ ),
2η π 2σ
i.e. θ = π/4 and σ = η would lead to uncorrelated random variables.

Exercise 4.6
a) We have

P(τi ∧ τ ⩾ s) = P(τi ⩾ s and τ ⩾ s)

= P(τi ⩾ s)P(τ ⩾ s)
= e−λi s e−λs
= e−(λi +λ)s , s ⩾ 0,

hence τi ∧ τ is an exponentially distributed random variable with param-

eter λi + λ, i = 1, 2.
b) Next, we have

P(τ1 ∧ τ > s and τ2 ∧ τ > t) = P(τ1 > s and τ > s and τ2 > t and τ > t)
= P(τ1 > s and τ2 > t and τ > Max(s, t))
= P(τ1 > s)P(τ2 > t)P(τ > Max(s, t))
= e−λ1 s e−λ2 t e−λ Max(s,t)

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= e−λ1 s−λ2 t−λ Max(s,t)

= e−(λ1 +λ)s−(λ2 +λ)t+λ min(s,t)
= (1 − FX (s))(1 − FY (t)) min(eλs , eλt ),

s, t ⩾ 0.
c) We have

FX,Y (s, t) = P(τ1 ∧ τ ⩽ s and τ2 ∧ τ ⩽ t)

= P(τ1 ∧ τ ⩽ s) − P(τ1 ∧ τ ⩽ s and τ2 ∧ τ > t)
= P(τ1 ∧ τ ⩽ s) − P(τ2 ∧ τ > t) − P(τ1 ∧ τ > s and τ2 ∧ τ > t)

= P(τ1 ∧ τ ⩽ s) + P(τ2 ∧ τ ⩽ t) + P(τ1 ∧ τ > s and τ2 ∧ τ > t) − 1

= FX (s) + FY (t) + (1 − FX (s))(1 − FY (t)) min(eλs , eλt ) − 1.

d) We find
−1
C (u, v ) = FX,Y (FX (u), FY−1 (v ))
−1 −1
= FX (FX (u)) + FY (FX (v ))
−1 −1
−1 −1 (u) (v )

+(1 − FX (FX (u)))(1 − FY (FX (v ))) min eλFX , eλFX −1
−1
(u) λFY−1 (v )
= u + v − 1 + (1 − u)(1 − v ) min e λFX
,e

= u + v − 1 + (1 − u)(1 − v ) min e−λ log(1−u)/(λ1 +λ) , e−λ log(1−v )/(λ2 +λ)

= u + v − 1 + min (1 − v )(1 − u)1−λ/(λ1 +λ) , (1 − u)(1 − v )1−λ/(λ2 +λ)

= u + v − 1 + min (1 − v )(1 − u)1−θ1 , (1 − u)(1 − v )1−θ2 , u, v ∈ [0, 1],

with
λ λ
θ1 = and θ2 = .
λ1 + λ λ2 + λ

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 Notes on Financial Risk and Analytics

1
0.9
0.8
0.7
0.6
0.5
0.4
0.3 1
0.2 0.8
0.1 0.6
0.4 u
0 0 0.2
0.2 0.4 0.6 0.8 0
v 1

Fig. S.4: Survival copula graph with θ1 = 0.3 and θ2 = 0.7.

e) We have

C (u, v ) = u + v − 1 + (1 − u)(1 − v )1−θ2 1{(1−u)θ1 <(1−v )θ2 }

+(1 − v )(1 − u)1−θ1 1{(1−u)θ1 >(1−v )θ2 } , u, v ∈ [0, 1],

hence
∂C
(u, v ) = −(1 − v )1−θ2 1{(1−u)θ1 <(1−v )θ2 }
∂u
−(1 − θ1 )(1 − v )(1 − u)−θ1 1{(1−u)θ1 >(1−v )θ2 }

and the survival copula density is given by

∂2C
(u, v ) = (1 − θ2 )(1 − v )−θ2 1{(1−u)θ1 <(1−v )θ2 }
∂u∂v
+(1 − θ1 )(1 − u)−θ1 1{(1−u)θ1 >(1−v )θ2 } , u, v ∈ [0, 1],

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3.5
3
2.5
2
1.5 1
1 0.8
0.6
0.5 0.4 u
0.2
0 0 0.2 0.4 0
0.6 0.8 1
v

Fig. S.5: Survival copula density graph with θ1 = 0.3 and θ2 = 0.7.

Remark: When λ = 0 we have θ1 = θ2 = 0 and τ = +∞ a.s., therefore

we have
min(τ1 , τ ) = τ1 and min(τ2 , τ ) = τ2 ,
hence the copula C (u, v ) is given by

C (u, v ) = u + v − 1 + (1 − v )(1 − u) = uv, u, v ∈ [0, 1],

which coincides with the copula of independence.

Chapter 5

Exercise 5.1 The payoff C is that of a put option with strike price K = $3.

Exercise 5.2 Each of the two possible scenarios yields one equation:

 5ξ + η = 0
 
 ξ = −2
with solution
2ξ + η = 6, η = +10.
 

The hedging strategy at t = 0 is to shortsell −ξ = +2 units of the asset

S priced S0 = 4, and to put η = $10 on the savings account. The price
V0 = ξS0 + η of the initial portfolio at time t = 0 is

V0 = ξS0 + η = −2 × 4 + 10 = $2,

which yields the price of the claim at time t = 0. In order to hedge then
option, one should:
i) At time t = 0,

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a. Charge the $2 option price.

b. Shortsell −ξ = +2 units of the stock priced S0 = 4, which yields $8.
c. Put η = $8 + $2 = $10 on the savings account.
ii) At time t = 1,
a. If S1 = $5, spend $10 from savings to buy back −ξ = +2 stocks.
b. If S1 = $2, spend $4 from savings to buy back −ξ = +2 stocks, and
deliver a $10 - $4 = $6 payoff.
Pricing the option by the expected value E∗ [C ] yields the equality

$2 = E∗ [C ]
= 0 × P∗ (C = 0) + 6 × P∗ (C = 6)
= 0 × P∗ (S1 = 2) + 6 × P∗ (S1 = 5)
= 6 × q∗ ,

hence the risk-neutral probability measure P∗ is given by

2 1
p∗ = P∗ (S1 = 5) = and q ∗ = P∗ (S1 = 2) = .
3 3

Exercise 5.3
a) Each of the stated conditions yields one equation, i.e.

 4ξ + η = 1 ξ = 2
 

with solution
5ξ + η = 3, η = −7.
 

Therefore, the portfolio allocation at t = 0 consists to purchase ξ = 2 unit

of the asset S priced S0 = 4, and to borrow −η = $7 in cash.

We can check that the price V0 = ξS0 + η of the initial portfolio at time
t = 0 is
V0 = ξS0 + η = 2 × 4 − 7 = $1.
b) This loss is expressed as

ξ × $2 + η = 2 × 2 − 7 = −$3.

Note that the $1 received when selling the option is not counted here be-
cause it has already been fully invested into the portfolio.

Exercise 5.4

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a) i) Does this model allow for arbitrage? Yes | ✓ No |

ii) If this model allows for arbitrage opportunities, how can they be real-
ized? By shortselling | By borrowing on savings | ✓ N.A. |

b) i) Does this model allow for arbitrage? Yes | No | ✓

ii) If this model allows for arbitrage opportunities, how can they be real-
ized? By shortselling | By borrowing on savings | N.A. | ✓

c) i) Does this model allow for arbitrage? Yes | ✓ No |

ii) If this model allows for arbitrage opportunities, how can they be real-
ized? By shortselling | ✓ By borrowing on savings | N.A. |

Exercise 5.5 Hedging a claim with possible payoff values Ca , Cb , Cc would

require to solve
(1) (0)




(1 + a)ξS0 + (1 + r )ηS0 = Ca



(1) (0)

(1 + b)ξS0 + (1 + r )ηS0 = Cb



(1) (0)

(1 + c)ξS0 + (1 + r )ηS0 = Cc ,


for ξ and η, which is not possible in general due to the existence of three
conditions with only two unknowns.

Exercise 5.6
a) Each of two possible scenarios yields one equation:

S1 − K

 
 α=
 αS 1 + β = S 1 − K S1 − S1



with solution
αS 1 + β = 0, S −K
 
 β = −S 1 1

.


S1 − S1

b) We have
S1 − K
0⩽α= ⩽1
S1 − S1
since K ∈ [S 1 , S 1 ].

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 Notes on Financial Risk and Analytics

c) We find

SRMC = αS0 + β
= α(S0 − S 1 )
S1 − K
= (S0 − S 1 ) .
S1 − S1

We note that when S0 < S 1 the value of SRMC is negative because in

this case, investing in the zero-cost portfolio (α, −αS0 ) that would yield a
payoff at least equal to α(S 1 − S0 ) = −α(S 0 − S1 ) > 0, which represents
an arbitrage opportunity.

Exercise 5.7
a) The payoff of the long box spread option is given in terms of K1 and K2
as

(x − K1 )+ − (K1 − x)+ − (x − K2 )+ + (K2 − x)+ = x − K1 − (x − K2 )

= K2 − K1 .

b) From Table 5.1 we check that the strike prices suitable for a long box
spread option on the Hang Seng Index (HSI) are K1 = 25, 000 and K2 =
25, 200.
c) Based on the data provided, we note that the long box spread can be
realized in two ways.
i) Using the put option issued by BI (BOCI Asia Ltd.) at 0.044.
In this case, the box spread option represents a short position priced

0.540
| {z } ×7, 500 −0.064 ×8, 000 −0.370 ×11, 000 +0.044 ×10, 000 = −92
| {z } | {z } | {z }
Long call Short put Short call Long put

index points, or −92 × $50 = −$4, 600.

Note that option prices are quoted in index points (to be multiplied
by the relevant option/warrant entitlement ratio), and every index
point is worth $50.
ii) Using the put option issued by HT (Haitong Securities) at 0.061.
In this case, the box spread option represents a long position priced

| {z } ×7, 500 −0.044

0.540 ×8, 000 −0.370 ×11, 000 +0.061 ×10, 000 = +78
| {z } | {z } | {z }
Long call Short put Short call Long put

index points, or 78 × $50 = $3, 900.

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d) As the option built in i)) represents a short position paying $4, 600 today
with an additional $50 × (K2 − K1 ) = 200 = $10, 000 payoff at maturity
on March 28, I would definitely enter this position.
As for the option built in ii)), it is less profitable because it costs $3, 900,
however it is still profitable taking into account the $10, 000 payoff at
maturity on March 28.

Chapter 6
Exercise 6.1
a) We have

FX ( x ) = P ( X ⩽ x )
wx
= fX (y )dy
0
wx 1
= γθγ dy
0 (θ + y )γ +1
  γ x
θ
= −
θ+y
 γ 0
θ
= 1− , x ∈ R+ .
θ+x

b) Since the distribution of X admits a probability density function, the

cumulative distribution function x 7−→ FX (x) is continuous in x and we
have P(X = x) = 0 for all x > 0. Hence the Value at Risk VXp at the level
p is given by the relation FX (VXp ) = p, i.e.
 γ
θ
= 1 − p,
θ + VXp

which gives
1
 
VXp = θ − 1 .
(1 − p)1/γ
In particular, with p = 99%, θ = 40 and γ = 2, we find
√
VXp = ((1 − p)−1/γ − 1)θ = 40 100 − 1 = $360.

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1 0.05

p=0.9

0.8 0.04

0.6 0.03
FX(x)

fX(x)
0.4 0.02

0.2 0.01

Vxp
0 0
0 100 200 300 400 500 0 Vxp 100 200 300 400 500
x x

Fig. S.6: Pareto CDF x 7→ FX (x) and PDF x 7→ fX (x) with 99%
VX = $86.49.

Exercise 6.2
a) We have P(X = 100) = 0.02.
b) We have VXq = 100 for all q ∈ [0.97, 0.99].
c) The value at risk VXq at the level q ∈ [0.99, 1] satisfies

FX (VXq ) = P(X ⩽ VXq ) = 0.99 + 0.01 × (VXq − 100)/50 = q,

hence

VXq = 100 + 50(100q − 99) = 5000q − 4850, q ∈ [0.99, 1].

Exercise 6.3 We find VX99% = 100 according to the following cumulative

distribution function:

FX (x)
1.00
0.99
0.98
0.97
0.96
0.95
0.94
0.93
0.92
0.91
0.90
0.89
0.88
0.87

0 x
−20 −10 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160

Fig. S.7: Cumulative distribution function of X and Y .

Exercise 6.4
a) We have
1 1
VXp := inf x ∈ R : P(X ⩽ x) ⩾ p = − log(1 − p) = E[X ] log .

λ 1−p

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When p = 95% this yields

VXp ≃ 2.996E[X ].

b) We find that the required capital CX satisfies

1
CX = VXp − E[X ] = E[X ] log − E[X ],
1−p
i.e.
CX = VX95% − E[X ] ≃ 1.996E[X ],
which means doubling the estimated amount of liabilities.

Exercise 6.5 By Proposition 6.2 and the geometric series identity (13.53), we
have
1
E[X | X ⩾ a] = E X 1{X ⩾a}
 
P(X ⩾ a)
1 X
= kP(X = k )
P(X ⩾ a)
k ⩾a
1 X
= X k (1 − p)k
(1 − p) k
k⩾a
k⩾a
(1 − p)a X
= X (k + a)(1 − p)k
(1 − p) a
(1 − p) k⩾0
k

k⩾0
1 X
= a+ X k (1 − p)k
(1 − p) k
k ⩾0
k⩾0
X
= a+p k (1 − p)k
k ⩾0
1
= a+
p
= a + E[X ].

This can be recovered numerically for example with a = 11 using the code
below.

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 Notes on Financial Risk and Analytics

geo_samples <- rgeom(100000, prob = 1/4)

mean(geo_samples)
mean(geo_samples[geo_samples>=10])

Exercise 6.6
a) As in the proof of the Markov inequality, for every x > 0 and r > 0 we
have

xr P(X ⩾ x) = xr E 1{X ⩾x}

 

⩽ E X r 1{X ⩾x}
 

⩽ E [|X|r ] ,

hence
1
P(X ⩽ x) ⩾ 1 − E[|X|r ], x > 0. (A.1)
xr
From the inequality (A.1), it follows that

VXp = inf x ∈ R : P(X ⩽ x) ⩾ p



1
⩽ inf x ∈ R : 1 − r E[|X|r ] ⩾ p

x
1
 
= inf x ∈ R : xr ⩾ E[|X|r ]
1−p
E[|X|r ] 1/r
 
=
1−p
∥X∥Lr (Ω)
= .
(1 − p)1/r

b) Taking p = 95% and r = 1 we get

1
VX95% ⩽ E[|X|] = 20E[|X|].
1−p
To summarize, a smaller Lr -norm of X tends to make the value at risk
VX smaller.

Exercise 6.7

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See the attached code∗ for a solution using R.

a) i) VaR95
Ac-H = 5.
ii) VaR80
Ac-H = 4.
iii) VaR95
Pr-H = −3.
iv) VaR80
Pr-H = −2.
b) By Proposition 6.16, we have:
i) VaR95
Ac-G = 1.15+3.048× qnorm(0.95)=6.164,
ii) VaR80
Ac-G = 1.15+3.048× qnorm(0.80)=3.71551,
iii) VaR95
Pr-G = 1.15-3.048× qnorm(0.95)=-3.864.
iv) VaR80
Pr-G = 1.15-3.048× qnorm(0.80)=-1.41551,

Remark. The “Practitioner” Values at Risk can be better visualized after ap-
plying top-down and left-right symmetries (or a 180o rotation) to the original
CDF, as in the next figure.

∗


Right-click to save as attachment (may not work on .

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 Notes on Financial Risk and Analytics

Chapter 7

Exercise 7.1
p
a) Noting that p = 1 − e−λVaRX and using integration by parts on VaRpX , ∞


with u(x) = x and v ′ (x) = e−λx , we have

1 w∞
E[X | X > VaRpX ] = xfX (x)dx
P(X > VaRpX ) VaRpX
λ w ∞
= xe−λx dx
1 − p VaRpX
λ w∞
= u(x)v ′ (x)dx
1 − p VaRpX
λ

∞ w∞ 
′

= u(x)v (x) VaRp − u ( x ) v ( x ) dx
1−p X VaRpX
1 w∞
h 
λ x −λx i∞ −λx
= − e + p e dx
1−p λ VaRXp
λ VaRX
VaRpX −λVaRp 1 −λVaRp
 
λ
= e X + e X
1−p λ λ2

VaRpX 1−p
 
λ
= (1 − p) + 2
1−p λ λ
p 1
= VaRX +
λ
1 log(1 − p)
= − .
λ λ
b) We have
1 w1 q
TVpX = V dq
1−p p X
1 w1
= − log(1 − q )dq
λ(1 − p) p
1 w 1−p
= − (log q )dq
λ(1 − p) 0
1
1 − p + (1 − p) log
1−p
=
λ(1 − p)
1 1 1
= + log
λ λ 1−p
1
 
= E[X ] 1 + log
1−p

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= E[X ] + VXp .

Exercise 7.2
a) If P(X > z ) > 0 we have E (X − z )1{X>z} > 0, hence
 

E X 1{X>z} > E z 1{X>z} = zP(X > z ),

   

and
E X 1{X>z}
 
E[X | X > z ] = > z. (A.2)
P(X > z )
Recall that E[X | X > z ] is not defined if P(X > z ) = 0.
b) We have

E[X ] = E X 1{X ⩽z} + E X 1{X>z}

   

⩽ zE 1{X ⩽z} + E X 1{X>z}

   

= zP(X ⩽ z ) + E X 1{X>z}
 

⩽ E[X | X > z ]P(X ⩽ z ) + E[X | X > z ]P(X > z )

= E[X | X > z ].

Note that E[X ] = E[X | X > z ] when P(X ⩽ z ) = 0, i.e. P(X > z ) = 1.
c) When P(X ⩽ z ) > 0, from (A.2) we find

E[X ] ⩽ zP(X ⩽ z ) + E X 1{X>z}

 

< E[X | X > z ]P(X ⩽ z ) + E[X | X > z ]P(X > z )

= E[X | X > z ].

d) By (6.7) we have P X ⩽ VXp ⩾ p > 0, hence by (c)) above we find

p p
CTEX = E X X > VX > E[X ].


Exercise 7.3
a) We have VaR0.9
X = 4 and CTEX = 6.
0.9

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 Notes on Financial Risk and Analytics

b) We have VaR0.8
X = 2 and

3+2×4+6 17
CTE0.8
X = = = 4.25.
4 4

Equivalently, we have
0.05 × 3 + 0.1 × 4 + 0.05 × 6
CTE0.8
X =
0.05 + 0.1 + 0.05
0.05 × 3 + 0.1 × 4 + 0.05 × 6
=
0.2
0.85
= = 4.25.
0.2

Exercise 7.4
a) VaR90%
X = 4.
5+6 11
b) E X 1{X>V 90% } = = .
 
X 23 23
2
c) P X > VX90% = .


23

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E X 1{X>V 90% }
 
5+6 11
d) CTE90% = E X | X > VX 90%
= 5.50.
  X
=
= =
X
P X > VX90% 2 2
4+5+6 15
e) E X 1{X ⩾V 90% } = = .
 
X 23 23
3
f) P X ⩾ VX90% = .


23
1
g) ES90% E X 1{X ⩾V 90% } + VX90% 1 − p − P X ⩾ VX90% = 10 ×
 



=
X 1−p X
4+5+6 3 150 2.3 − 3 150 − 40 × 0.7
 
+ 10 × 4 0.1 − = + 40 × = =
23 23 23 23 23
122
= 5.304.
23
1 w1 q
w w 22/23 w1
1

21/23 q q q
h) TV90% = V dq = V dq + V dq + V dq
w1 − p p 1−p
X X p X 21/23 X 22/23 X
1 21/23 w 22/23 w1 
= 4dq + 5dq + 6dq
1 − p  p  21/23  22/23
1 21 5 6 84 − 92p + 5 + 6 122
= 4 −p + + = = = 5.304.
1−p 23 23 23 23(1 − p) 23
We note that ES90%
X = TV90%
X according to Proposition 7.12. The attached
code computes the above risk measures, as illustrated in Figure S.8.

> source("var-cte_quiz.R")
VaR90= 4, Threshold= 0.9130435
CTE90= 5.5
ES90= 5.304348

Fig. S.8: Value at Risk and Expected Shortfall for small data.

Exercise 7.5

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 Notes on Financial Risk and Analytics

a) The value at risk is VX98% = 100.

FX (x)

1.00
0.99
p= 0.98

0.97
0.96

x
−20 −10 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160

Fig. S.9: Cumulative distribution function of X.

b) Taking p = 0.98, we have

1 w1 q
TV98% = V dq
X 1−p p X
1
= ((0.99 − 0.98) × 100 + (1 − 0.99) × 150) = 125.
0.02
c) We have
1 h i
CTE98% = E X 1{X>V p }
X
P(X > VXp ) X

1
= × 150 × 0.01 = 150.
0.01
d) We have

1 h i Vp
ES98% = E X 1{X ⩾V p } + X (1 − p − P(X ⩾ VX ))
X 1−p X 1−p
1 100
= (100 × 0.03 + 150 × 0.01) + (0.02 − (0.03 + 0.01))
0.02 0.02
4.5 100
= + (0.02 − (0.03 + 0.01)) = 125.
0.02 0.02
Note that we also have
1 h i Vp
ES98% = E X 1{X>V p } + X (1 − p − P(X > VX ))
X 1−p X 1−p
1 100
= ( 150 × 0.01 )+ (0.02 − 0.01)
0.02 0.02
= 125,

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hence the Expected Shortfall ES98%

X does coincide with the tail value at
risk T VX98% .

Exercise 7.6
a) The cumulative distribution function of X is given by the following graph:

FX (x)
1.02
1.00
0.98
0.96
0.94
0.92
0.90
0.88
0 x
−20 −10 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 180 190 200 210

Fig. S.10: Cumulative distribution function of X.

b) The distribution of X + Y is given by

P(X + Y = 0) = 81%, P(X + Y = 100) = 18%, P(X + Y = 200) = 1%.

The cumulative distribution function of X + Y is given by the following

graph:

FX+Y (x)
1.00
0.98
0.96
0.94
0.92
0.90
0.88
0.86
0.84
0.82
0.80
0 x
−20 −10 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 180 190 200 210

Fig. S.11: Cumulative distribution function of X + Y .

c) We have VX99%
+Y = VX +Y = VX +Y = 100.
95% 90%

Note that we have VX99%

+Y = 100 because

VX99% = inf{x ∈ R : P(X ⩽ x) ⩾ 0.99} = 100.

d) We have
1 w1 1 − 0.9
TV90% = V q dq = 100 × = 100.
X 1 − 0.9 0.9 X 1 − 0.9
e) We have

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 Notes on Financial Risk and Analytics

1 w1
TV99%
X +Y = V q dq
1 − 0.9 0.9 X +Y
w w1
1

0.99
= 100dq + 200dq
0.1 0.9 0.99
1
= (100 × 0.09 + 200 × 0.01)
0.1
= 110,

and
1 w1
TV80%
X +Y = V q dq
1 − 0.8 0.9 X +Y
1 w 0.81 w 0.99 w1
 
= 0dq + 100dq + 200dq
0.2 0.8 0.81 0.99
1
= (100 × 0.18 + 200 × 0.01) = 100.
0.2

Exercise 7.7 (Exercise 6.2 continued).

a) For all p ∈ [0.99, 1] we have
1 w1 q
TVpX = V dq
1−p p X
1 w 1
= (5000q − 4850)dq
1−p p
1 (1 − p2 )
 
= 5000 − (1 − p)4850
1−p 2
= 2500p − 2350.

In particular,

TV99%
X = 2500 × 0.99 − 2350 = 125 ⩾ VX99% = 100.

b) We have VX98% = 100 and

CTE98% = E X | X > VX98%

 
X
1 h i
=
E X 1{X>V 98% }
P X > VX98% X

1 w∞
= xfX (x)dx
0.01 100
1 w ∞ dFX (x)
= x dx
0.01 100 dx

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1 0.01 w 150
= xdx
0.01 50 100
150 − 100
2 2
=
2 × 50
= 125.

Note that
0.01 1 (1 − 0.992 )
 
TV98% = × 100 + 5000 − 0.01 × 4850
X 0.02 0.02 2
= 112.50
⩾ VX98% = 100,

which differs from CTE98%

X = 125 since

P X = VX98% = P(X = 100) = 0.02 > 0.

Exercise 7.8
a) We have
p
VXp := inf x ∈ R : P(X ⩽ x) ⩾ p = log .

1−p

b) We have
1 w∞
E[X | X > VaRpX ] = xfX (x)dx
P(X > VaRpX ) VaRpX
1 w∞
= xe−λx dx
1 − p VaRpX
1 w∞ xe−x
= dx
1 − p VaRpX (1 + e−x )2
p
1 p VaRpX eVaRX
= log(1 + eVaRX ) − p
1−p 1 + eVaRX
1 1 1
 
p p p
= log 1 + − p log
1−p 1−p 1 − p 1 − p 1 + 1−p 1−p
1 1 p p
= log − log
1−p 1−p 1−p 1−p
p
=− log p − log(1 − p).
1−p

c) We have

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 Notes on Financial Risk and Analytics

1 w1 q
TVpX = V dq
1−p p X
1 w1 q
= log dq
1−p p 1−q
1 w1 1 w1
= log qdq − log(1 − q )dq
1−p p 1−p p
1 w1 1 w 1−p
= log qdq − log qdq
1−p p 1−p 0
1 w 1 1
w
1 w1 
= log qdq − log qdq − log qdq
1−p p 1−p 0 1−p
p − 1 − p log p −1 + p + (1 − p) log(1 − p)
= −
1−p 1−p
p
= − log p − log(1 − p).
1−p

Exercise 7.9
a) We have
 w∞
qP(Z ⩾ q ) = E q 1{Z ⩾q} ⩽ E Z 1{Z ⩾q} = q ⩾ 0.
  
xfZ (x)dx,
q

b) We have
w∞ w∞
xfZ (x)dx = xϕ(x)dx
q q
1 w ∞ −x2 /2
= √ xe dx
2π q
1 h −x2 /2 i∞
= −√ e
2π q
1 −q2 /2
= √ e
2π
= ϕ(q ), q ⩾ 0,

and 1 − p = P(Z ⩾ q ), hence

w∞
(1 − p)q ⩽ xfZ (x)dx = ϕ(q ), q ⩾ 0.
q

p p
c) Taking q := qZ with 1 − p = P(Z ⩾ qZ ), we recover
σX
VXp = µX + σX qZ
p
⩽ µX + p
ϕ ( qZ ) = CTEpX ,
1−p

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see Proposition 7.5.

Chapter 8
Exercise 8.1
a) We have
w∞ 1
E [ X | G ] = λG xe−λG x dx =
0 λG
and w∞ 1
E[X | B ] = λB xe−λB x dx = .
0 λB
b) We find

fX (x | B )P(B )
P(B | X = x) =
fX (x | G)P(G) + fX (x | B )P(B )
λB e−λB x P(B )
=
λG e−λG x P(G) + λB e−λB x P(B )
1
=
λG P(G) (λB −λG )x
1+ e
λB P ( B )
1
= ,
P(G)
1 + λ(x)
P(B )

where λ(x) is the likelihood ratio

fX (x | G) λ
λ(x) = = G e(λB −λG )x , x > 0.
fX (x | B ) λB

c) The condition
DP(B | X = x) ⩽ LP(G | X = x)
rewrites as
DP(B | X = x) ⩽ L(1 − P(B | X = x)),
i.e.
(L + D )P(B | X = x) ⩽ L
or
L+D
⩽ L,
P(G)
1 + λ(x)
P(B )

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or
λG (λB −λG )x D P(B )
λ(x) = e ⩾ .
λB L P(G)
This condition holds if and only if

1 D λB P(B )
 
x⩾ log ,
λB − λG L λG P(G)

provided that λB > λG . Therefore we have

D P(B )
 
A = x ∈ R : λ(x) ⩾
L P(G)
1 D λB P(B )
   
= log ,∞ ,
λB − λG L λG P(G)

under the condition

1 1
E[X | B ] = < = E[X | G].
λB λG

Exercise 8.2
a) We find

fX (x | B )P(B )
P(B | X = x) =
fX (x | G)P(G) + fX (x | B )P(B )
P(B )/λB
= 1[0,λB ] (x)
P(G)/λG + P(B )/λB
1
= 1[0,λB ] (x) .
λB P(G)
1+
λG P ( B )

b) We have
w∞ 1 w λG λG
E[X | G] = yfX (y | G)dy = ydy = ,
−∞ λG 0 2
and similarly
w∞ 1 w λB λB
E[X | B ] = yfX (y | B )dy = ydy = .
−∞ λB 0 2

c) The condition
DP(B | X = x) ⩽ LP(G | X = x)

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rewrites as
DP(B | X = x) ⩽ L(1 − P(B | X = x)),
i.e.
(L + D )P(B | X = x) ⩽ L
or
λB P ( G )
D1[0,λB ] (x) ⩽ L1(λB ,∞) (x) + L .
λG P ( B )
This condition holds if and only if

λB D P(B )
⩾ .
λG L P(G)

when x ∈ [0, λB ], and is always satisfied when x ∈ (λB , ∞). Therefore,

we have A = R if
λB D P(B )
⩾ ,
λG L P(G)
and A = (λB , ∞) if
λB D P(B )
< ,
λG L P(G)
under the condition

E[X | B ] = λB < λG = E[X | G].

Exercise 8.3
a) We have

F G (x) = e−λG x and F B (x) = e−λB x , x ⩾ 0,

hence
−1 log y
F B (y ) = − , y ∈ (0, 1],
λB
and
log y
 
−1

F G F B (y ) = F G −
λB
= eλG (log y )/λB
= y λG /λB , y ∈ [0, 1].

We check that, according to Proposition 8.7,

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d −1
d λG /λB
F G F B (y ) = y
dy dy
d λG (log y )/λB
= e
dy
λ
= G eλG (log y )/λB
yλB
λ
= G e(λG −λB )(log y )/λB
λB
λ −1
= G e(λB −λG )F B (y )
λB
−1
= λ F B (y ) , x ∈ [0, 1].

Figure S.12 presents three samples of exponential ROC curves, with suc-
cessively (λB , λG ) = (10, 1), (λB , λG ) = (2, 1), and (λB , λG ) = (1, 1).

1
True Positive Rate (TPR)

0.8

0.6

0.4

λB=10,λG=1
0.2
λB=2,λG=1
λB=1,λG=1
0
0 0.2 0.4 0.6 0.8 1

False Positive Rate (FPR)

Fig. S.12: Exponential ROC curves.

b) We have
x
F G (x) : = 1 − , x ∈ [0, λG ],
λG
and
x
F B (x) : = 1 − , x ∈ [0, λB ],
λB
hence
F −1
B ( y ) : = λB ( 1 − y ) , y ∈ [0, 1],
hence
−1 λB λ − λB λ
F G F B (x) = 1 − (1 − y ) = G + B y, y ∈ [0, 1].


λG λG λG

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 N. Privault

Figure S.13 presents three samples of uniform ROC curves, with succes-
sively (λB , λG ) = (1, 8), (λB , λG ) = (1, 2), and (λB , λG ) = (1, 1).

1
True Positive Rate (TPR)

0.8

0.6

0.4

λB=1,λG=8
0.2
λB=1,λG=2
λB=1,λG=1
0
0 0.2 0.4 0.6 0.8 1

False Positive Rate (FPR)

Fig. S.13: Uniform ROC curves.

Exercise 8.4
a) We have

P ( B ) fX ( x | B )
P(B | X = x) =
P ( G ) fX ( x | G ) + P ( B ) fX ( x | B )
2 2
P(B )e−(x−µB ) /(2σ )
=
P(G)e−(x−µG ) /(2σ ) + P(B )e−(x−µB ) /(2σ )
2 2 2 2

1
= , x ∈ R,
1 + eα+βx
with
µG − µB
β := >0
σ2
and
µG + µB P(G)
 
α := −β + log .
2 P(B )
b) We have

fX ( x | G )
λ(x) =
fX ( x | B )
2 2 2 2
= e−(x−µG ) /(2σ )+(x−µB ) /(2σ )
2 2 2
= e−(µG −µB −2x(µG −µB ))/(2σ )
βx−(µ2G −µ2B )/(2σ 2 )
=e , x ∈ R.

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c) The condition

2 2 2) D (x) P(B )
λ(x) = eβx−(µG −µB )/(2σ ⩾
L(x) P(G)

is equivalent to

µ2G − µ2B D (x) P(B )

 
βx ⩾ + log
2σ 2 L(x) P(G)
µ2G − µ2B P(B ) D (x)
⩾ + log + log
2σ 2 P(G) L(x)
µ2G − µ2B P(B )
⩾ + log + x(a + b),
2σ 2 P(G)

hence
µ2G − µ2B 1 P(B )
x⩾ + log ,
2σ (β − a − b)
2 β−a−b P(G)

provided that
µG − µB
β := > a + b.
σ2
In this case, we have

µ2G − µ2B 1 P(B )

 
A ∗ = [ x∗ , ∞ ) = + log , ∞ ,
2σ 2 (β − a − b) β − a − b P(G)

where
µ2G − µ2B 1 P(B )
x∗ := + log .
2σ 2 (β − a − b) β − a − b P(G)

Chapter 9

Exercise 9.1 By differentiation of (9.2), i.e.

P(τ < T | Ft ) := P(ST < K | Ft )

(µ − σ 2 /2)(T − t) + log(St /K ))
 
= Φ − √ , T ⩾ t,
σ T −t
with respect to T , we find

σ2 log(St /K )
 
dT
dP(τ ⩽ T | Ft ) = −µ+
2σ 2π (T − t) 2
p
T −t

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2 !
(µ − σ 2 /2))(T − t) + log(St /K ))
× exp − ,
2(T − t)σ 2

provided that µ < σ 2 /2.

Exercise 9.2 Consider the first hitting time

τK := inf{u ⩾ t : Su ⩽ K}

of the level K > 0 starting from St > K. By Lemma 15.1 in Privault (2022),
we have  2r/σ2
K
E∗ e−(τK −t)r Ft = ,
 
St
provided that St ⩾ K.

Exercise 9.3
a) We have
 q q 
E[Xk Xl ] = E (ak M + 1 − a2k Zk )(al M + 1 − a2l Zl )
 q q q q 
= E ak al M 2 + ak M 1 − a2l Zl + al M 1 − a2k Zk + 1 − a2k 1 − a2l Zk Zl
q q
= ak al E M 2 + ak 1 − a2l E[Zl M ] + al 1 − a2k E[Zk M ]
 
q q
+ 1 − a2k 1 − a2l E[Zk Zl ]
q q
= ak al E M 2 + ak 1 − a2l E[Zl ]E[M ] + al 1 − a2k E[Zk ]E[M ]
 
q q
+ 1 − a2k 1 − a2l 1{k=l}
= ak al + (1 − a2k )1{k=l}
= 1{k=l} + ak al 1{k̸=l} , k, l = 1, 2, . . . , n,

b) We check that the vector (X1 , . . . , Xn ), with covariance matrix (9.12) has
the probability density function

φ ( x1 , . . . , xn )
2
n w (x −a m) (x −a m)2 −m2 /2
1 Y
2 −1/2 ∞
− 1 12 − n n2 e
= ( 1 − ak ) e 2(1−a )
1 · · · e 2(1−an ) √ dm
(2π )n/2 k=1 −∞ 2π

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which is jointly Gaussian, with marginals given by

w∞ w∞
xk 7−→ ··· φ(x1 , . . . , xn )dx1 · · · dxk−1 dxk+1 · · · dxn
−∞ −∞
(xk −ak m)2
1 w∞ − 2
e−m /2
2(1−a2 )
= q e k √ dm
2π (1 − a2k ) −∞ 2π
(xk −ak m)2
1 w∞ − −m2 /2
2(1−a2 )
= q e k dm
−∞
2π 1 − a2k
x2 −2ak xk m+m2
1 w∞ − k
2(1−a2 )
= q e k dm
−∞
2π 1 − a2k
(m−ak xk ) 2
e−xk /2 w ∞ − 2(1−a2 )
2

= q e k dm
2π 1 − a2k −∞
1 2
= √ e−xk /2 , xk ∈ R.
2π
c) We have
n 2
w ∞ − (x1 −a1 m ) (x −an m)2 −m2 /2
1 Y
2(1−a2 )
− n e
φ(x1 , . . . , xn ) = (1 − a2k )−1/2 e 1 ···e 2(1−a2
n) √ dm
(2π )n/2 −∞ 2π
k =1
 
n x2 +a2 m2 −2x1 a1 m x2 +a2 m2 −2xn an m
1 w∞ 1
−2 1 1 +···+ n n + m2 dm
1−a2 1−a2
Y
= (1 − a2k )−1/2 e 1 n √
(2π )n/2 −∞ 2π
k =1
 
1 x2 x2 n
−2 1 +···+ n
1 1−a2 1−a2
Y
= √ e 1 n (1 − a2k )−1/2
(2π )n/2 2π
k =1
   
2 a2 a2 x 1 a1
w∞ − m2 1+ 1 +···+ n +2m +···+ xn an2
1−a2 1−a2 2(1−a2 ) 2(1−an )
e 1 n 1 dm
−∞
 
x2 x2
2 
 
−1 1 +···+ n2 1 x1 a1 xn an
2 1−a2 1−an
1−a2
+···+ 1−a2
e 1 2 1 n
= p exp 

a2 a2
(2π )n (1 − a21 ) · · · (1 − a2n )

1+ 1
1−a2
+···+ n
1−a2
1 n
 −1/2
a21 a2n
× 1+ +···+
1 − a21 1 − a2n
 
x2 x2
−1 1 +···+ n 2 !
2 1−a2 1−a2

e 1 n 1 x1 a1 xn an
= p exp +···+
(2π )n α2 (1 − a21 ) · · · (1 − a2n ) 2α2 1 − a21 1 − a2n

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1 x2 x2
−2 1 +···+ n 2 !
1−a2 1−a2

e 1 n 1 x1 a1 xn an
= p exp +···+
(2π )n α2 (1 − a21 ) · · · (1 − a2n ) 2α2 1 − a21 1 − a2n
    
x2 a2 x2 a2
−1 1 1− 1 +···+ n 1− n !
2 1−a2 α2 (1−a2 ) 1−a2 α2 (1−a2
n)
e 1 1 n 1 X xp xl ap al
= exp
2α2 (1 − a2p )(1 − a2l )
p
(2π )n α2 (1 − a21 ) · · · (1 − a2n ) 1⩽p̸=l⩽n
1 1 ⟨x,Σ−1 x⟩
−2
= p e ,
(2π )n det Σ

where
a21 a2n
α2 : = 1 + +···+ ,
1 − a12 1 − a2n
and
α2 (1−a21 )−a21
 
−a1 a2 −a1 an
(1−a21 )2 (1−a21 )(1−a22 )
··· (1−a21 )(1−a2n )

..


α2 (1−a22 )−a22 .. 
 −a2 a1 . .

 (1−a22 )(1−a21 ) (1−a22 )2 
1  .. .. .. ..
 
Σ−1 . . .

= 2 . .
α  ..

 .. α2 (1−a2n−1 )−a2n−1 −an−1 an

 . . 
 (1−a4n−1 ) 2 2
(1−an−1 )(1−an ) 
..
 
−an an−1 α2 (1−a2 )−a2
−an a1 .
 
n n
(1−a2n )(1−a21 ) (1−a2n )(1−a2n−1 ) (1−a2n )2

Exercise 9.4 We have

1 a1 a2
 
Σ= ,
a2 a1 1
and letting

a21 a22
α2 : = 1 + +
1 − a12 1 − a22
(1 − a21 )(1 − a22 ) + a21 (1 − a22 ) + a22 (1 − a21 )
=
(1 − a21 )(1 − a22 )
1 − a22 a21
= ,
(1 − a21 )(1 − a22 )

we find

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 α2 (1−a2 )−a2 
1 
1
(1−a21 )2
1
− (1−aa21)(a1−a2
2)
−1
Σ = 2 1
α2 (1−a22 )−a22
2 
α − (1−aa22)(a1−a
1
2) ( 1−a 2 )2
2 1 2
(1−a22 )a21
 2   
α
1  1−a1 2 1 − 2
1−a2 a12 − (1−aa21)(a1−a
2
2)
= 2  1 2
(1−a2 )a2

α α2
− (1−aa22)(a1−a
1
2) 1−a22
1 − 1−a12 a22
2 1 2 1
α2
 
1  1−a22 a21
− (1−aa21)(a1−a2
2)
= 2 1
α2
2 
α − (1−aa22)(a1−a
1
2) 1−a22 a21
2 1
α2
 
(1 − a21 )(1 − a22 )  1−a22 a21
− (1−aa21)(a1−a
2
2)
= 1
α2
2 
1 − a22 a21 − (1−aa22)(a1−a
1
2)
2 1 1−a22 a21
α2
 
1  1−a22 a21
− (1−aa21)(a1−a2
2)
= 2 1
α2
2 
α − (1−aa22)(a1−a
1
2) 1−a 2 a2
 2 1
 2 1
1 1 −a1 a2
= .
1 − a22 a21 −a1 a2 1

In particular, the case n = 2 is able to recover all two-dimensional copulas

by setting the correlation coefficient ρ = a1 a2 . In the general case, Σ is
parametrized by n numbers, which offers less degrees of freedom compared
with the joint Gaussian copula correlation method which relies on n(n − 1)/2
coefficients, see also Exercise 9.3.

Chapter 10

Exercise 10.1 By absence of arbitrage we have (1 − α)erd T = erT , hence

α = 1 − e(r−rd )T .

Exercise 10.2
a) The bond payoff 1{τ >T −t} is discounted according to the risk-free rate,
before taking
 expectation.
b) We have E 1{τ >T −t} = e−λ(T −t) , hence Pd (t, T ) = e−(λ+r )(T −t) .


c) We have PM (t, T ) = e−(λ+r )(T −t) , hence λ = −r − T 1−t log PM (t, T ).

Exercise 10.3
a) We have
wt
(1)
rt = −a rs ds + σBt , t ⩾ 0,
0

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hence
wt 1 (1)

rs ds = σB − rt
0 a t
σ wt 
(1) (1)
= Bt − e−(t−s)a dBs
a 0
σ wt −(t−s)a (1)
= (1 − e )dBs ,
a 0
and
wT wT wt
rs ds = rs ds − rs ds
t 0 0
σ wT −(T −s)a (1) σ wt (1)
= (1 − e )dBs − (1 − e−(t−s)a )dBs
a 0 a 0
σ w t −(T −s)a wT 
(1) (1)
= − (e − e−(t−s)a )dBs + (e−(T −s)a − 1)dBs
a 0 t
σ −(T −t)a wt σ w T −(T −s)a
−(t−s)a (1) (1)
= − (e − 1) e dBs − (e − 1)dBs
a 0 a t
1 w
σ T −(T −s)a (1)
= − (e−(T −t)a − 1)rt − (e − 1)dBs .
a a t
The answer for λt is similar.
b) As a consequence of the answer to the previous question, we have
w wT 
T
E rs ds + λs ds Ft = C (a, t, T )rt + C (b, t, T )λt ,
t t

and
w wT 
T
Var rs ds +
λs ds Ft
t t
w  w 
T T
= Var rs ds Ft + Var λs ds Ft
t t
w wT 
T
+2 Cov Xs ds, Ys ds Ft
t t

σ2 wT
= (e−(T −s)a − 1)2 ds
a2 t
ση w T −(T −s)a
+2ρ (e − 1)(e−(T −s)b − 1)ds
ab t
w
η 2 T −(T −s)b
+ 2 (e − 1)2 ds
b t
wT wT
= σ2 C 2 (a, s, T )ds + 2ρση C (a, s, T )C (b, s, T )ds
t t

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wT
+η 2 C 2 (b, sT )ds,
t

from the Itô isometry.

Exercise 10.4 (Exercise 10.3 continued).

a) We use the fact that (rt , λt )t∈[0,T ] is a Markov process.
b) We use the tower property (A.33) of the conditional expectation given Ft .

c) Writing F (t, rt , λt ) = P (t, T ), we have

 rt 
d e− 0 (rs +λs )ds P (t, T )
rt rt
(rs +λs )ds (rs +λs )ds
= −(rt + λt )e− 0 P (t, T )dt + e− 0 dP (t, T )
rt rt
− (r +λs )ds − (r +λs )ds
= −(rt + λt )e 0 s P (t, T )dt + e 0 s dF (t, rt , λt )
rt rt
− (r +λs )ds − (r +λs )ds ∂F
= −(rt + λt )e 0 s P (t, T )dt + e 0 s (t, rt , λt )drt
∂x
rt 1 rt ∂2F
(rs +λs )ds ∂F
+ e− 0 (t, rt , λt )dλt + e− 0 (rs +λs )ds 2 (t, rt , λt )σ12 (t, rt )dt
∂y 2 ∂x
1 − r t (rs +λs )ds ∂ 2 F
+ e 0 (t, rt , λt )σ22 (t, λt )dt
2 ∂y 2
rt ∂2F rt ∂F
+ e− 0 (rs +λs )ds ρ (t, rt , λt )σ1 (t, rt )σ2 (t, λt )dt + e− 0 (rs +λs )ds (t, rt , λt )dt
∂x∂y ∂t
rt ∂F r t ∂F
(1) (2)
= e− 0 (rs +λs )ds (t, rt , λt )σ1 (t, rt )dBt + e− 0 (rs +λs )ds (t, rt , λt )σ2 (t, λt )dBt
∂x ∂y
rt 
∂F
+ e− 0 (rs +λs )ds −(rt + λt )P (t, T ) + (t, rt , λt )µ1 (t, rt )
∂x
∂F 1 ∂2F 1 ∂2F
+ (t, rt , λt )µ2 (t, λt ) + (t, rt , λt )σ12 (t, rt ) + (t, rt , λt )σ22 (t, λt )
∂y 2 ∂x2 2 ∂y 2
∂2F

∂F
+ρ (t, rt , λt )σ1 (t, rt )σ2 (t, λt ) + (t, rt , λt ) dt,
∂x∂y ∂t

hence the bond pricing PDE is

∂F
− (x + y )F (t, x, y ) + µ1 (t, x) (t, x, y )
∂x
∂F 1 ∂2F
+ µ2 (t, y ) (t, x, y ) + σ12 (t, x) 2 (t, x, y )
∂y 2 ∂x
1 2 ∂2F ∂2F ∂F
+ σ2 (t, y ) 2 (t, x, y ) + ρσ1 (t, x)σ2 (t, y ) (t, x, y ) + (t, rt , λt ) = 0.
2 ∂y ∂x∂y ∂t

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d) We have
  w wT  
T
P (t, T ) = 1{τ >t} E exp − rs ds − λs ds Ft
t t
 w  w 
T T
= 1{τ >t} exp −E rs ds Ft − E λs ds Ft
t t
w wT
1
 
T
× exp Var rs ds + λs ds Ft
2 t t
= 1{τ >t} exp (−C (a, t, T )rt − C (b, t, T )λt )
 2w
η2 w T 2

σ T 2
× exp C (a, s, T )ds + C (b, s, T )e−(T −s)b ds
2 t 2 t
 wT 
× exp ρση C (a, s, T )C (b, s, T )ds .
t

e) This is a direct consequence of the answers to Questions (c)) and (d)).

f) The above analysis shows that
  w  
T
P(τ > T | Gt ) = 1{τ >t} E exp − λs ds Ft
t

η2 w T 2
 
= 1{τ >t} exp −C (b, t, T )λt + C (b, s, T )ds ,
2 t

for a = 0 and
 w
σ2 w T 2
    
T
E exp − rs ds Ft = exp −C (a, t, T )rt + C (a, s, T )ds ,
t 2 t

for b = 0, and this implies

 wT 
Uρ (t, T ) = exp ρση C (a, s, T )C (b, s, T )ds
t
 ση 
= exp ρ (T − t − C (a, t, T ) − C (b, t, T ) + C (a + b, t, T )) .
ab
g) We have

∂
f (t, T ) = −1{τ >t} log P (t, T )
∂T
σ2 η2
 
= 1{τ >t} rt e−(T −t)a − C 2 (a, t, T ) + λt e−(T −t)b − C 2 (b, t, T )
2 2
−1{τ >t} ρσηC (a, t, T )C (b, t, T ).

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h) We use the relation

  w  
T
P(τ > T | Gt ) = 1{τ >t} E exp − λs ds Ft
t

η2 w T 2
 
= 1{τ >t} exp −C (b, t, T )λt + C (b, s, T )ds
2 t
rT
= 1{τ >t} e− t
f2 (t,u)du
,

where f2 (t, T ) is the Vasicek forward rate corresponding to λt , i.e.

η2 2
f2 (t, u) = λt e−(u−t)b − C (b, t, u).
2
i) In this case we have ρ = 0 and
  w  
T
P (t, T ) = P(τ > T | Gt )E exp − rs ds Ft ,
t

since Uρ (t, T ) = 0.

Chapter 11

Exercise 11.1 It suffices to check that as λ tends to ∞, the ratio

j−1 k k
!
STi,ji
X X X
δk exp − δp rp − λ δp
k =i p=i p=i
j−1 k k
!
X X X
(1 − ξ ) 1 − e−λδk exp


− δp rp − λ δp
k =i p=i p=i

converges to 0, while it tends to +∞ as λ goes to 0. Therefore, the equation

(11.4) admits a numerical solution.

Exercise 11.2 Equation (11.4) reads

j−1 k k
!
STi,ji
X X X
δk exp − δp rp − λ δp
k =i p=i p=i
j−1 k k
!
X X X
= (1 − ξ ) eλδk − 1 exp δp ,


− δp rp − λ
k =i p=i p=i

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or
j−1 k
!
STi,ji
X X
δk P (0, Tk+1 ) exp −λ δp
k =i p=i
j−1 k
!
X X
= (1 − ξ ) eλδk − 1 P (0, Tk+1 ) exp δp ,


−λ
k =i p=i

since  
k
X
P (0, Tk+1 ) = exp − δp rp  , k = 0, 1, 2.
p=i

From the terminal data of Figure 11.6 we infer with

 i = 0,


j = 3,





0 = 03/20/2015,



 T
1 = 06/22/2015,




 T
 t = 04/12/2015,




 T2 = 09/21/2015,
 T3 = 12/21/2015,




δ1 = δ2 = δ3 = 0.25,





ξ = 0.4,





 1,3
ST1 = 0.1079.


Hence, from the data of Figure S.14, Equation (11.4) rewrites as

0.1079 × 0.25
 
× 0.99952277 × e−λ×0.25 + 0.99827639 × e−λ×0.5 + 0.99607821 × e−λ×0.75
= (1 − 0.4) × eλ×0.25 − 1


 
× 0.99952277 × e−λ×0.25 + 0.99827639 × e−λ×0.5 + 0.99607821 × e−λ×0.75 ,

with solution λ = 0.0017987468. The default probability is given by p =

1 − e−λ×0.75 = 0.001348151.
Next, from the discount factors of Figure S.14 we solve the Equation (11.4)
numerically in Table S.1 below to find the default rate λ1 = 0.0017987468
and default probability 0.0012460256, which is consistent with the value of
0.0013 in Figure 11.6, see also Castellacci (2008).

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 Notes on Financial Risk and Analytics

Date Delta Discount Factor Premium Leg Protection Leg

Jun 22, 2015 0.2611111 0.99952277 0.0002814722 0.0002814708
Sep 21, 2015 0.2527778 0.99827639 0.0002721533 0.000272154
Dec 21, 2015 0.2527778 0.99607821 0.0002715541 0.0002715548
Sum 0.0008251796 0.0008251796

Table S.1: CDS Market data.

Fig. S.14: CDS Price data.

Exercise 11.3
a) We have
j−1   w  
Tk + 1
1(Tk ,Tk+1 ] (τ )(1 − ξk+1 ) exp −
X
E r (s)ds Gt
t
k =i
j−1   w  
Tk + 1
E (1{Tk <τ } − 1{Tk+1 <τ } )(1 − ξk+1 ) exp −
X
= r (s)ds Gt
t
k =i
j−1   r r Tk+1  rT 
Tk k +1
= 1{τ >t} r (s)ds
X
E (1 − ξk+1 ) e− t λs ds − e− t λs ds
e− t Ft
k =i

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j−1 r Tk+1  r r Tk+1 

Tk
= 1{τ >t} (1 − ξ ) r (s)ds
X
e− t E e− t λs ds − e− t λs ds
Ft
k =i
j−1
= 1{τ >t} (1 − ξ )
X
P (t, Tk+1 ) (Q(t, Tk ) − Q(t, Tk+1 )) .
k =i

b) We have
j−1   w  
Tk + 1
V p (t, T ) = Sti,j 1{τ >Tk+1 } exp −
X
δk E r (s)ds Gt
t
k =i
j−1   w  
Tk + 1
= Sti,j δk E 1{Tk+1 <τ } exp −
X
r (s)ds Gt
t
k =i
j−1   w   w  
Tk+1 Tk + 1
= 1{τ >t} Sti,j
X
δk E exp − λs ds exp − r (s)ds Ft
t t
k =i
j−1  w    w  
Tk + 1 Tk + 1
= Sti,j 1{τ >t}
X
δk exp − r (s)ds E exp − λs ds Ft
t t
k =i
j−1
= 1{τ >t} Sti,j
X
δk P (t, Tk+1 )Q(t, Tk+1 ).
k =i

c) By equating the protection and premium legs, we find

j−1
X
(1 − ξ ) P (t, Tk+1 ) (Q(t, Tk ) − Q(t, Tk+1 ))
k =i
j−1
= Sti,j
X
δk P (t, Tk+1 )Q(t, Tk+1 ).
k =i

For j = i + 1, this yields

(1 − ξ )P (t, Ti+1 ) (Q(t, Ti ) − Q(t, Ti+1 )) = Sti,i+1 δi P (t, Ti+1 )Q(t, Ti+1 ),

hence
1−ξ
Q(t, Ti+1 ) = ,
Sti,i+1 δi + 1 − ξ
with Q(t, Ti ) = 1, and the recurrence relation

(1 − ξ )P (t, Tj +1 ) (Q(t, Tj ) − Q(t, Tj +1 ))

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j−1
X
+ (1 − ξ ) P (t, Tk+1 ) (Q(t, Tk ) − Q(t, Tk+1 ))
k =i
j−1
= Sti,j δj P (t, Tj +1 )Q(t, Tj +1 ) + Sti,j
X
δk P (t, Tk+1 )Q(t, Tk+1 ),
k =i

i.e.
(1 − ξ )Q(t, Tj )
Q(t, Tj +1 ) =
1 − ξ + Sti,j δj
j−1
P (t, Tk+1 ) (1 − ξ )Q(t, Tk ) − Q(t, Tk+1 ) (1 − ξ ) + δk Sti,j



X
+ .
k =i P (t, Tj +1 )(1 − ξ + Sti,j δj )

Exercise 11.4 (Exercise 11.3 continued). From the terminal data of Fig-
ure 11.7, we find the following spread data and survival probabilities:

k Maturity Tk St1,k (bp) Q(t, Tk )

1 6M 0.5 10.97 0.999087
2 1Y 1 12.25 0.997961
3 2Y 2 14.32 0.995235
4 3Y 3 19.91 0.990037
5 4Y 4 26.48 0.982293
6 5Y 5 33.29 0.972122
7 7Y 7 52.91 0.937632
8 10Y 10 71.91 0.880602

Table S.2: Spread and survival probabilities.

Background on Probability Theory

Exercise A.1
a) We have
X X λk
E[X ] = kP(X = k ) = e−λ k
k!
k⩾0 k⩾0
X λk X λk
= e−λ = λe−λ = λ.
(k − 1) ! k!
k⩾1 k⩾0

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 N. Privault

b) We have
X
E[X 2 ] = k 2 P(X = k )
k⩾0
X λk
= e−λ k2
k!
k ⩾1

−λ
X λk
=e k
(k − 1) !
k ⩾1

−λ
X λk X λk
=e + e−λ
(k − 2) ! (k − 1) !
k ⩾2 k⩾1
X λk X λk
= λ2 e−λ + λe−λ
k! k!
k⩾0 k⩾0
2
= λ + λ,

and
Var[X ] = E[X 2 ] − (E[X ])2 = λ = E[X ].

Exercise A.2 We have

w∞ 2 / (2η 2 ) dy
P(eX > c) = P(X > log c) = e−y
2πη 2
p
log c
w∞ 2 /2 dy
= e−y √ = 1 − Φ((log c)/η ) = Φ(−(log c)/η ).
(log c)/η 2π

Exercise A.3
a) Using the change of variable z = (x − µ)/σ, we have
w∞ 1 w∞ 2 / (2σ 2 )
φ(x)dx = √ e−(x−µ) dx
−∞ 2πσ 2 −∞
1 2
w∞
2
= √ e−y /(2σ ) dy
2πσ 2 −∞
1 w ∞ −z 2 /2
= √ e dz.
2π −∞

Next, using the polar change of coordinates dxdy = rdrdθ, we find†

†
“In a discussion with Grothendieck, Messing mentioned the formula expressing the
2
integral of e−x in terms of π, which is proved in every calculus course. Not only did

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1 w ∞ −z 2 /2 1 w ∞ −y2 /2 w ∞ −z 2 /2
 2
√ e dz = e dy e dz
2π −∞ 2π −∞ −∞
w w
1 ∞ ∞ −(y2 +z 2 )/2
= e dydz
2π −∞ −∞
1 w 2π w ∞ −r2 /2
= re drdθ
w2π 0 0 ∞ 2
= re−r /2 dr
0
wR 2
= lim re−r /2 dy
R→+∞ 0
h 2 iR
= − lim e−r /2
R→+∞ 0
−R2 /2
= lim (1 − e )
R→+∞
= 1,

or w∞ √
2 /2
e−z dz = 2π.
−∞

b) We have
w∞
E[X ] = xφ(x)dx
−∞
1 w∞ 2 2
= √ xe−(x−µ) /(2σ ) dx
2πσ 2 −∞
1 w∞ 2 2
= √ (µ + y )e−y /(2σ ) dx
2πσw2 −∞
µ ∞ −y 2 /2 σ w∞ 2
= √ e dy + √ ye−y /2 dy
2π −∞ 2π −∞
µ w ∞ −y2 /2 σ wA 2
= √ e dy + √ lim ye−y /2 dy
2π −∞ 2π A→+∞ −A
µ w ∞ −y2 /2
= √ e dy
2π −∞
w∞
= µ φ(y )dy
−∞
= µP(X ∈ R)
= µ,
2
by symmetry of the function y 7−→ ye−y /2 on R.
c) Similarly, by integration by parts twice on R, we find

Grothendieck not know the formula, but he thought that he had never seen it in his
life”. Milne (2005).

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w∞
E[(X − E[X ])2 ] = (x − µ)2 φ(x)dx
−∞
1 w∞ 2 2
= √ y 2 e−(y−µ) /(2σ ) dy
2πσ −∞2

σ2 w ∞ 2
= √ y × ye−y /2 dy
2π −∞
σ 2 w ∞ −y2 /2
= √ e dy
2π −∞
= σ2 .

d) By a completion of squares argument, we have

w∞
E[eX ] = ex φ(x)dx
−∞
1 w∞ 2 2
= √ ex−(x−µ) /(2σ ) dx
2πσ −∞
2
eµ w ∞ y−y2 /(2σ2 )
= √ e dy
2πσ 2 −∞
eµ w ∞ σ2 /2+(y−σ2 )2 /(2σ2 )
= √ e dy
2πσ 2 −∞
µ 2 w
e + σ /2 ∞ x2 /(2σ2 )
= √ e dy
2πσ 2 −∞

σ2
= eµ + .
2

Exercise A.4
a) We have
1 w∞ 2 2
E[X + ] = √ x+ e−x /(2/σ ) dx
2πσw2 −∞
σ ∞ 2
= √ xe−x /2 dx
2π 0
σ h −x2 /2 ix=∞
= √ −e
2π x=0
σ
= √ .
2π
b) We have
1 w∞ 2 / (2σ 2 )
E[(X − K )+ ] = √ (x − K )+ e−x dx
2πσ 2 −∞

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1 w∞ 2 / (2σ 2 )
= √ (x − K )e−x dx
2πσ 2 K
1 w∞ 2 / (2σ 2 ) K w∞ 2 / (2σ 2 )
= √ xe−x dx − √ e−x dx
2πσ 2 K 2πσ 2 K
σ h −x2 /(2σ2 ) i∞ K w −K/σ −x2 /2
= √ −e −√ e dx
2π x=K 2π −∞
 
σ 2 2 K
= √ e−K /(2σ ) − KΦ − .
2π σ

c) Similarly, we have
1 w∞ 2 / (2σ 2 )
E[(K − X )+ ] = √ (K − x)+ e−x dx
2πσ 2 −∞
1 wK 2 / (2σ 2 )
= √ (K − x)e−x dx
2πσ 2 −∞
K wK 2 / (2σ 2 ) 1 wK 2 2
= √ e−x xe−x /(2σ ) dx
dx − √
2πσ 2 −∞ 2πσ 2 −∞
K w K/σ −x2 /2 σ h −x2 /(2σ2 ) ix=K
= √ e dx − √ −e
2π −∞ 2π −∞
 
σ −K 2 /(2σ )2 K
= √ e + KΦ .
2π σ

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