Chapter

The

2
Basic

Theory

of

Interest

1. (A nice inheritance) Use the "72 rule". Years = 1994-1776 = 218 years.
(a) i = 3.3%. Years required for inheritance to double = Zf = 8 :'=!21.8. Times
doubled= Hi = 10 times. $1 invested in 1776 is worth 210 :'=!$1,000 today.
(b) i = 6.6%. Years required to double = ~ :'=!10.9. Times doubled = ~
times. $1 invested in 1776 is worth 220 :'=!$1, 000, 000 today.
2. (The 72 rule) Using (1 + r)n = 2 gives nIn (1 +r)
In2 = 0.69. We have nr :'=!0.69 and thus n :'=!~

= 20

= In2. Using In (1 + r) :'=!r and

:'=!PI.

Using instead In(1 + r) :'=!r- !r2 = r(1 -!r)

we have nIn(1 + r) = In2 or
equivalently nr :'=!~.
For r :'=!0.08, we have (1 -r /2)-1 :'=!1.042. Therefore,
n:'=! !(0.069)(1.042)
r

= ~

= ~
t

3. (Effective rates)
(a) 3.04%
(b) 19.56%
(c) 19.25%.
4. (Newton's method) We have
I(")
i
"k
0
1
1
2/3
2
13/21
3 0.618033
4

0.618034

I("k)
= -1 + " + " 2 , I , (,,) = 1 + 2" , "k+1 = "k -f'<Xk>
I("k)

I' ("k)
1
3
1/9
7/3
0.00227 2.23810
-2.2 x 10-6 2.23607
0

2.23608

"k+1
2/3
13/21
0.618033
0.618034
0.618034

5. (A prize)
PV = $4, 682, 460.

CHAPTER
2. mE BASICmEORY OFINTEREST
6. (Sunk cost) The payment stream for apartment A is 1,000, 1,000, 1,000, 1,000
1,000, 1,000 while for B it is 1,900, 900, 900, 900, 900, 900. At any interest rate
PVA <PVB because the initial difference is less than the sum of the subsequent
cash flow differences. Hence, they should not switch. For one year, the sign of
the difference does depend on the interest rate. At 1%per month, the values are
PVA = $11,367.62 and PVB = $11,230.87, so they should switch.
7. (Short cut) The cash flow with waiting is (-l,O,O,x).

We know that PV = -1 +

x/1.13 < -1 + 3/1.12. Hence x/1.1 < 3 which means x < 3.3.
8. (Copy machines) Assume that the maintenance payments occur at the beginning
of each year.
InClemental IRR from A to B: ( Cash flows in $1000)
f(c)

= 0 = -24 + 6c + 6C2 + 6c3 + 6c4 + 10cs,

where
c --.

1
l+r

Using Newton's method, we get c = 0.894112,

r = 0.118 Thus,

IRRA-B = 11.8% > 10%.

Incremental

IRR from B to C: ( Cash flows in $1000)

f(c)

= 0 = -5 + 0.4c + 0.4c2 + 0.4c3 + 0.4c4 + 2cs , c = ~

l+r

Using Newton's method

(co = 1.1), we get c = 1.0862106,

r = -0.079

Thus,
IRRB-c = -7.9%
A move from A to B is justified
9. (An appraisal)

on the basis of IRR.

Consider the PV of the two following

payment

streams:

(a) Change roof now, then every 20 years:

00
1
PVl = $20, 000 x i~ (1.05)20i = $32, 097

(b) Change roof in 5 years and then every 20 years:

PVl
PV2 = "i"i:"OST'
= $25, 149

CHAPTER2. mE BASICmEORY OF INTEREST

Taking the difference

of these two we find the value of roof to be PV1 -PV2

3
=

$6, 948.
10. (Oil depletion

allowance)

Barrels
Gross
Net
Option Option Depletion Taxable After Tax
Yr Produced Revenue Income
1
2
Allowance Income
Income
I
80
$1,600
$1,200
$352
$400
$400
$800
$840
2
70
1,400
1,000
$308
$350
$350
$650
$708
3
50
1,000
500
$220
$250
$250
$250
$388
4
30
600
200
$100
$150
$150
$50
$178
S
10
200
50
$25
$50
$50
$0
$50
Total=
$1,200
PV=
$521.26
All numbersexceptyearsin thousands.
(a) Depletion

= $1, 200, 000 > $1, 000, 000.

(b) PV = $521, 260. IRR = 52.8%.

11. (Conflicting

recommendations)

See the solution

12. (Domination)

NPV1

29.88

NPV2

31.84 > NPV1

IRR1

15.2%

IRR2

12.4% < IRR1

recommend

2.

recommend

1.

for (Crossing) exercise for explanation.

Equations for IRR are

n
Ai = Bi 2: cf i = 1, 2
j=1

where Ci = ~

which gives
1=!!.!.
""1:" c !

"'1=1 t
Hence,
B1/A1 > B2/A2

implies

Ai.
n
n
2: c{ < 2: c~
j=1
j=1

which in turn implies

C1< C2 or equivalently

r1 > r2.

CHAPTER2. mE BASICmEORY OF INTEREST

13. (Crossing)
(a) Let P(c) = Px(c) -Py(c),
P(l)

a continuous

= Px(l)

function

of c. Then

n
n
= L Xi -L
Yi > 0.
i=O
i=O

-Py(l)

likewise
P(O) = Px(O) -Py(O)
By the intermediate

value theorem

= Xo -Yo

< 0.

there is a c such that Px(c) = Py(c).

(b) We solve
-100

+ 30(c + C2 + ...+

C5) = -150 + 42(c + C2 + ...+

C5)

This gives c = 0.946 and r = 5.7%.

14. (Depreciation

choice) Individual

maximizes

the PV of depreciation

(in percentage

terms)
(a) 25%, 38% and 37%.
PV1 = 25 + ~
(b) 331/3%.

100
PV2 = 3

38

37
+ (1 +r)2.

(1 + 1""+r
1

+ (1 + r)2

Then PV1 = PV2 yields TiT = 1 which gives r = 0.

when r > 0, PV2 > PV1 .Hence
15. (An erroneous

always use straight line method.

analysis)
AU. DOLLAR AMOUNTS
Before Tax

Yr

Cost

Revenue

Incame

IN THOUSANDS
Taxable

Deprec.

Incame

After
Tax

Tax

Incame

0 $1Q,(XX)

PV
($10,(XX)

$310

$3;300

$2,(XX)

.\m)

$337

$2,653

$2.'369

$310

$3;300

$2.9:X>

$2,(XX)

.\m)

$337

$2,653

$2,115

$310

$3.'300

$2.9:X)

$2,(XX)

.\m)

$337

$2,653

$1,889

$310

$3;300

$2,(XX)

.\m)

$337

$2,653

$1,686

$310

$2.ID}

$2,(XX)

.\m)

$337

$2,653
Total PV=

$3.'300

$2.9:X)

$2,(XX)

.\m)

$337

$2,653

($10,<XX
$2.'369

$322

$3,432

$3,110

$2,(XX)

$1,110

$377

$2,732

$2,178

$335

$3,sm

$3,234

$2,(XX)

$1,234

$2.814

$2,003

$349

$3,712

$3;3ffi

$2,(XX)

$1;363

$464

$~

$1,843

$E

$3fij1

$3,~

$2,(XX)

$1,~

$500

$1.{;00

$1Q,(XX)
$310

$3;300
NO INFIATlON

496 INHATlON

Total PV=

$l,SOO
($435)

$11)

Chapter

fixed-1

ncome

Secu

rities

1. (Amortization) Use
A = ~
= .07 x 25iOOO = $4,638.83.
I -(I":j:"';jn
I -I:O77
2. (Cycles and annual worth) Let d = 1/(1 + r). Then
P( =P

{ I+dn+1+d2(n+2)+...

Also

} =

P
I -dn+1 .

rP
A = "i-=dn .

Hence
) P(.
A = r(1 I -dn+1
-dn
3. (Uncertain annuity)
(a) To find the life expectancy, we multiply each age of death by its probability.
Thus the life expectancy is
I = 90 x .07 + 91 x .08 + ...101

x .04 = 95.13 years.

(b) To find the present value of an annuity that ends at age 95.13 we calculate
the values for ages 95 and 96. From the standard formula
A {
I
P-1-r
(1 + r)n
with n = 5 and n = 6 we find P95 = $39, 927 and P96 = $46, 228. Then we
find P = .87 x P95+ .13 x P96 = $40, 746.

(c) To find the expected present value of the annuity we calculate the probabilities qi of survival to various ages i. For example, qgo = 1.0, q91 = qgo- .07 =
.93, q92 = q91 -.08 = .85, and so forth. For each year greater than 90 we
evaluate $10, 000 x qi/l.08i-9O. Hence the expected present value is
.93 + "LO82
.85 + ...+ ~ .04
PV = $ 10, 000 LOB
= $3 8, 38 7.

Note that the expected present value of the annuity is less than the present
value evaluated at the expected lifetime. This will always be the case.
5

CHAPTER
3. FIXED-INCOME
SECURI11ES
4. (APR) First find the monthly payment M at the APR of 8.083% using the annuity
formula, as
$203, 150 = $1, 502.41.
M = ~(1+~)360
12 0808331620
(1 + -U)
-1
Next find the initial balance for this monthly payment at the interest rate of 7.875%

12
B = 07875
.(1

1 -.:QZm
+

360} $1, 502 = $207, 209.13.

12 )

The total fees are the difference between the initial balance and the amount of
the loan
Fees = $207, 209.13- $203, 150 = $4, 059.13.
5. (Callable Bond) After five years, the payment the company needs to make if exercising the call provision is
pf = (1 + 0.05) x Face Value = 105.
Exercising the call provision is advantageous, so

100
10
105 < P5 = (1 + .:\)15 + T
1 -(1

+ .:\)15 .

Therefore, the YTM then is lower than 9.366%.

6. (The bi-weekly mortgage)
(a) Monthly payment:
0.1(101
+ -0.1)360
m = 12
3
162 0

(1 + 12 )

x $100,000 = $877.57

-1

Total interest = 360m -$100, 000 = $215, 925.20.

(b) Bi-weekly payment = T = $438.79.
Let n = number of periods. Then
$100, 000 = $438.79 X (1
0.1+ .Q:!)n
26 0.1-1n

26(1+26)
Hence n = 545 or 20.95 years.
Total interest = 545 x $438.79- $100, 000 = $139, 140.55.
Savings in total interest over monthly program = $76,784.65 or 35.6%

CHAPTER
3. FIXED-INCOME
SECURmES

7. (Annual worth)
A Amortize the present value of $22,847 over four years which gives AA = $6,449
per year.
B. Amortize the present value of $37,582 over six years which gives AB = $7,845.
AA < AB
Car A should be selected.
8. (Variable rate mortgage)
(a) A = $100,000 x ~

= $8,882.74

(1.08)25-1= $94, 821.26

(b) Ps = $8882.74 x 0.08(1.080)25
(c) A' = $94, 821.26 x ~

= $9, 653.40

(d) 94, 821.26 = 8882.74 x ~.

This gives n :=::38 years, which means that
the total life of the mortgage is 43 years.
9. (Bond price) Straightforward use of the formula for a bond price (assuming coupons
every six months) gives 91.17.
10. (Duration) Use the formula to obtain 6.84 years.
11. (Annuity duration) Using PV = ~ we have
D

=
=

Hence

-!!.:!:..!:1 ~
PV dr
-r(l +r) .(-~2)
A
r

= ~

D
DM=-=-.
l+r

1
r

pA

885.84

PB =

771.68

Pc

657.52

PD =

869.57

12. (Bond selection)

(a)

CHAPTER3. FIXED-INCOME
SECURrnES
(b)
DA

2.72

DB

2.84

Dc

3.00

DD

1.00

(c) C is most sensitive to a change in yield.

(d)
VA+VB+VC+VD

=PV

DAVA +DBVB +DcVc

+DDVD

= 2PV,

where PV is the present value of the obligation.

(e) Use bond D.
Vc + VD = PV
DcVc + DDVD = 2PV
where
2,000
PV = ~

= $1, 512.29.

Solving Vc = $756.15 and VD = $756.15.

(1) None
13. (Continuous

compounding)
dP
-=
di\

n
-L

e-"tktkCk
k=Q

= -DP

14. (Duration limit) This follows directly from the Macaulay duration formula by setting i\ = my and noting that the second term in the formula goes to zero as n
goes to infinity.
15. (Convexity

value)
c-

We take T = n/m.

-P[I

I
+ (i\/m)

n(n+I)P
m2

Hence
I
C = [I + (i\/m)]2

As m -00

]2

we find C = T2.

T(T + (I/m).

Chapter
The

4
Term

Structure

of

Interest

Rates

1. (Oneforwardrate)
f

2. (Spot update)

1.2

(1 + 52)2
(1+51

Use
/1.k =

-1

(1

= ~
1.063

5k)k

-1

} 11(k-l)

1 + 51
Hence,

= 75%
..

-1.

for example,

1.6

{ (1.061) 6 } 115 -1

= 06

1.05

..

32

All values are

/1.2
5.60

/1.3
5.90

/1.4
6.07

/1.5
6.25

/1,6
6.32

3. (Construction of a zero) Use a combination of the two bonds: let x be the number
of 9%bonds, and y the number of 7%bonds. Select x and y to satisfy
9x + 7y

x +y

1.

The first equation makes the net coupon zero. The second makes the face value
equal to 100. These equations give x = -3.5, and y = 4.5. The price is p =
-3.5 x 101.00 + 4.5 x 93.20 = 65.9.

11

12

CHAPTER4. mE TERMSTRUCTUREOF INTERESTRATES

4. (Spot rate project) All can be done on a spreadsheet

with an optimizer,

as shown

below:
Maturity Coupon
15-Feb-12
6.625
15-Feb-12
9.125
15-Aug-12
7.875
15-Aug-12
8.25
15-Feb-13
8.25
15-Feb-13
8.375
15-Aug-13
8
15-Aug-13
8.75
15-Feb-14
6.875
15-Feb-14
8.875
15-Aug-14
6.875
15-Aug-14
8.625
15-Feb-15
7.75
15-Feb-15
11.25
15-Aug-15
8.5
15-Aug-15
10.5
15-Feb-16
7.875
15-Feb-16
8.875

Buying
Price wl Model
Acc. Int.
Price
$101.48 $101.49
$102.72 $102.71
$102.50 $102.50
$102.87 $102.87
$103.06 $103.06
$103.24 $103.24
$102.60 $102.59
$103.98 $103.99
$99.69
$99.69
$104.26 $104.26
$98.94
$98.94
$103.64 $103.63
$100.88 $100.90
$111.63 $111.64
$103.30 $103.30
$110.18 $110.18
$101.16 $101.17
$104.98 $104.97

Estimation Coefficients
a-O 0.062009143
a-1 0.00627032
a-2 0.001099467
a-3 -0.000593607
a-4
4.95E-05
Maturity
of Zero
Bonds

Time from Estimated

Valuation Spot Interes
(Years)
Rate

15-Feb-12
15-Aug-12
15-Feb-13
15-Aug-13
15-Feb-14
15-Aug-14
15-Feb-15
15-Aug-15
15-Feb-16

0.27950.06383460
0.7781 0.06729211
1.28220.07073894
1.77810.07379215
2.28220.07633260
2.77810.07813531
3.28220.07918981
3.77810.07946645
4.28220.07905432

ValuationDate
5-Nov-11
5. (Instantaneous

rates)

(a) eS(t2)t2 = eS(h)heftl't2(t2-h)

(b) r(t)

fh,t2 = S(t2)t t 2

t (q)q
2- 1
= s(t) + s'(t)t
-S

= lim s(t)t -S(tl)q

= d(s(t)t)
t-h
t -q
dt
(c) We have
d lnx(t) = r(t)dt = s(t)dt + s'(t)tdt

= d(s(t)t).

Hence,
lnx(t)

= lnx(O) + s(t)t.

Finally,
x(t) = x(O)es(t)t.
This is in agreement with the invariance property of expectation dynamics.
Investing continuously gives the same result as investing in a bond that matures at time t.
6. (Discount conversion) The discount factors are found by successive multiplication. For example dO,2= dold1,2 = .950 x .940 = .893. The complete set is .950,
.893, .832, .770, .707, .646.

CHAPTER
4. THETERMSTRUCTURE
OFINTEREST
RATES

13

7. (Bond taxes) Let

t
Xi
Ci
Pi

be the
be the
be the
be the

tax rate
number of bond i bought
coupon of bond i
price of bond i

To create a zero coupon bond, we require, first, that the after tax coupons match.
Hence
x1(1-

t)C1 +x2(1-

t)C2 = 0.

which reduces to
X1C1+ X2C2= 0.
Next, we require that the after tax final cash flow matches. Hence
x1[100-

(100- P1)t] + x2[100 -(100-

P2)t] = [100-

(100-

Po)t].

The price of the zero will be

Po = X1P1 + X2P2.
Using this last relation in the equation for final cash flow, we find
X1 + X2 = 1.
Combining X1 + X2 = 1, C1X1+ C2X2= 0, and Po = X1P1 + X2P2, we find
Po = C2P1-C1P2 .
C2-C1
Plugging in the given values we find Po = 37.64.
B. (Real zeros) We assume that with coupon bonds there is a capital gain tax at
maturity. We replicate the zero-coupon bond after tax flows using bonds 1 and
2. Let Xi = amount of bond i required (for i = 1, 2). We require
(a) 100c1(1- t)X1 + 100c2(1- t)X2 = -(~)t
(b) (100- (100- P1)t + 100c1(1- tX1 + (100- (100- P2)t+ 100c2(1- tX2 =
100- ( !QQ=EQ.
)t
n
(c) P1X1 + P2X2 = Po

CHAPTER 4. nIE TERM STRUCTURE OF INTERFST RATES

=

28.1425.81

(28.14)(1.065)

-10(2i:6~~(.02)

( 24.06-

) = -26.09%

r
Year 5

28.14

Year 6

25.81
-12.5

28.14

15

= 1751%
.
-12.5(.05)

= 24.06

-12.5(.07)

= 20.80

-12.5

(24.06)(1.085)

-10(2i:6~~(.02)

( 20.80
-24.06
24.06- 12.5 ) =

Money left after 6 years = 20.79-

-28 .20%

12.5-

7.5 = .80

If invested in bank = 7.5(1.06)(1.055)(1.045)(1.4)(1.06)

-7.5

= 2.64

11. (Running PV example)

(a)

dO.l
.9524

dO.2
.9018

do.3
.8492

dO.4
.7981

dO.5
.7472

dO.6
.7010

=>

O
-40
.9524

10
.9469

10
.9416

10
.9399

10
.9362

10
.9381

10

(b)

Year
Cash Flow
Discount
PV(n)

9.497

51.970

44.324

36.453

28.144

19.381

10.000

NPV = 9.497

12. (pure duration)

P(A)

dP(A)
~

=
1 dP(A)
--=
P dA

n
n
-k
I Xk (1 + sk/m)-k
= I Xk ( (1 + sZ/m)e;\lm)
.
k=O
k=O
In Xk m
-k ) ( (1 + sZ/m)e;\lm ) -k-l (1 + sZ/m)e;\lm

k=O
n
I Xk ( ---(1
-k )
k=O
m
Lk=oXk ( ~)

+ sk/m)-k .

(1 + sk/m)-k
k
Lk=oXk (1 + Sk/m)-

= D.

This D exactly corresponds to the original definition of duration as a cash flow

weighted average of the times of cash payments. No modification factor is needed
even though we are working in discrete time.

QIAPTER 4. THE TERMSTRUCTUREOF INfEREST RATES

(d) It should be clear that v-+ 0. (Use L'Hopital's
(e) WeknowP(k)
= (l+r)k-I(B-rM).
part (a).) So P(k) is increasing

17

rule if it is not obvious.)

ClearlyB-rM
> 0. (This follows from
in k and I(k) = B -P(k)
must be decreasing

in k. Remember that duration is a weighted sum of the times k, with the

weights being proportional
to to the cash flows at those times. Hence the
duration of the stream determined by P(k), which increases in k, should be
the larger, because more relative weight is given to higher k's.
15. (Short-rate

sensitivity)

In general
Pk-1 (,,) = Ck-1 + 1 Pk <,,) " .
+ rk-1 + I\

Differentiation

at"

= leads to
Sk-I

= -+

Pk
(1 + rk-I)2

Hence, ak = ~

Sk

1 + rk-1

' bk = r+k:;: .This process together with

Pk-1 = Ck-1 +

Pk
1 + rk-1

is initiated with Pn = Cn and Sn = 0; and the two processes are worked backward
to k = 0. So is the final result.

Chapter

Applied

Interest

Rate

Analysis

1. (Capitalbudgeting)
Project Benefit-Cost
Ratio
1
2
2
5/3
3
3/2
4
4/3
5
5/3
So, the approximate method based on cost-benefit ratios implies projects 1, 2,
and 5 would be recommended.
The optimal set of projects is the same. Note: projects 1,2, and 3 provide the
same total net present value and use the entire budget.
2. (The road) The zero-one problem is the same as in Example 5.2 with the following
additional constraint:
(X2 + x4)(I-

(X6 + X7 = 0

Excel's Solver yields an optimal solution with a total benefit of $7,8000,000 for a
cost of $4,700,000 by funding projects 4,6, and 10.
3. (Two-period budget) The problem is to

maximize

150xl + 200x2 + 100x3 + 100x4 + 120xs + 150x6 + 240x7

subject to

90xl + 80x2 + 50x3 + 20x4 + 40xs + 80x6 + 80x7 + y ~ 250

58xl + 80x2 + 100x3 + 64x4 + 50xs + 20x6 + 100x7 ~
250 + (1.1)y
Xi = 0 or 1 for each i
y~o.

Excel's Solver yields a maximal NPV of 610, achieved by funding projects 4,5,6,
and 7, at a cost of 220 in the first year and 234 in the second year. Another plan
19

20

CHAPTER
s. APPLIED
INTEREST
RATEANALYSIS
with NPV of 610 is to fund projects 1,4,5, and 7, at a cost of 230 in the first year
and 272 in the second year. Both plans are under the budget, but the first costs
less.
4. (Bond matrix)

C=

10
10
10
10
10
110

7
7
7
7
7
107

8
8
8
8
8
108

6
6
6
6
106

7
7
7
7
107

y =

5
5
5
105

10
10
110

8
8
108

7
107

100

100
200
800
100
800
1200

(a) pT and XT are identified in Table 5.3

n
= 2:Cij(I+Sn)isochoosingv=
i=l
Sn)l, (1 + Sn)2,..., (1 + Sn)n]T solves the equation CTV = p

(b) Weknowthepriceofbondjispj

[(1+

(c) To meet the obligation of period i exactly, we require

m
2:: CijX j = bi
j=l
or in matrix form Cx = b
(d) The price of the portfolio is pTx = VTCx = vTb which shows that the present
value of the portfolio must equal the present value of the liabilities.
5. (Trinomial lattice) The trinomial lattice spanning three periods (with four time
points) contains 42 = 16 nodes. In general, a trinomial lattice with n time points
contains n2 nodes.
In a full trinomial tree spanning three periods there are 40 nodes. In general, a
n-l
full trinomial tree with n time points contains 2:: 3i = !(3n -1) nodes.
i=O

CHAPTER5. APPUEDINTERESTRATE ANALYSIS

21

6. (A bond project)
C..h

Match! C..h M.tch

: R.lnv..t

G\I.rd for
D .(0)

G\I.rd for
D .(1)

G\I.rd for: G\I.rd for ~ G\I.rd for

D .(2)
i D .(3)
D .(4)

Co.t:
$70,723.31
:, $70,558.12$70,557.61 $70,558.01$70,559.31!$70,559.47$70,580.21
M.t\lrlty Co\lpon , Bo\lght :' Bo\lght , Bo\lght , Bo\lght , Bo\lght :' Bo\lght , Bo\lght
15-Aug-12
15-Aug-12
15-Feb-13
15-Feb-13

7,875
6,25
8.25
8.375

1e5.25!
0i
0:
i

0:
0!
0!
o~

1~-Feb-1~
15-Feb-14
15-Aug-14
15-Aug-14

8.875
8.875
6.875
8.625

0!
0]
0!
0!

0!
0!
i
0!

15-Feb-15
15-Aug-15
15-Aug-15
15-Feb-16

11,25
8.5
10.5
7.875

0:
i
0!
0!

oi
4,14]
0:
144.32:

0
83.62
0

0!
0[
309.81!
0i

0:
0!
249.41!
0!

73.46

198.52
0

0!
l
0:
0!

0:
0!
0!
0:

92.79

0]
0)
0!
134.78!

7. (The fishing problem) The decisions at times after the initial

on d. At time 1 the upper and lower node values are

respectively.

X2

14 + 14d

XI

7+7d

0:

0;
141.98!

0
147.44

time do not depend

Then the initial value is

Xo = max[14d(1

+ d), 7(1 + d + d2)]

The choice depends on d. The critical value of d is

d* = ~

~ .618.
2

For d < d* we choose X2.

For r = 3396 we have d = -75 and for r = 2596 we have d = .8, so solution

is the

same for both.

8. (Complexico

mine)

(a) Since we mine forever, we have KK = KK+I = constant K.

So K = ~

+ dK implies K = 220 every period.

Thus, the initial

(b) The amount

value of the mine, Yo = 220xo = $11 million.

of gold remaining

in the mine in period n,Xn,

Zn-I where Zn equals the amount mined in period

equations from Example 5.5, we find XIO = 2393.

equals Xn-I

n. Using Excel and the

22

CHAPTER
5. APPLIED
INTEREST
RATEANALYSIS
Thus, by part (a), the value of the mine in period 10 is found to be 220x1O =
$526,460 (at that time).
(c) The optimal extraction rate in each period = ~
= 20% so, after 10 years,
5369 ounces of gold remains with a value of $1,181,116 (at that time).
9. (little Bear Oil)
(a) Set up a trinomial lattice with arcs:
"up" = no pumping
"middle" = normal pumping
"down" = enhanced pumping
The reserve values can be entered on each node. (At the final time the maximum reserve is 100,000 and the minimum is 26,214 barrels.)
(b) Work backward to find PV = $366,740. The optimal strategy is: enhanced
pumping for the first two years, followed by normal pumping in the last year.

10. (Multiperiod harmony theorem) We can write

Vo

Xo + -1

max

max [ XO

Xo
achieved

by x6.

+ 51
1

VI

XI

X2

X3

' + (1 + 52
' ) 2 + ...+
+ 51

<XO)

+ 51
Clearly,
~T

(Vl(x6)
*)

yoXo

* = 1 + 51.
-xo

Suppose Xo gives
VI (xo)
~T(- ) ->

1 + 51.

yo Xo -xo

Then Vo -Xo > 0 and thus

~T
yo < -Vl(XO)
Xo +
1

+51

which contradicts the definition of Vo.

11. (Growing annuity) Using the hint we have
S= ~
l+r
implying
S [ l-

+ S(l + g)
(l+r)

(~

)]

l+r

~
l+r

or
1
S

--.

r-g

Xn
(1

'
+ 5n-l
) n -1

}]

CHAPTER5. APPUEDINI'ERESTRATE ANALYSIS

12. (Two-stage growth)
(a) This part follows

easily from (b)

(b) Let R = 1 + r. then

NPV

Dl [ (i)

+Dl

Dl

o + (i)l

[( g

[~

l-(G)k

) k+l

+ ...+

( Rg ) k+2

+ ~1=<"IT

].

(i)k]

+...

23

Chapter

Mean-Variance

Portfolio

Theory

1. (Shorting with margin) The money invested is Xo. The money received at the end
of a year is Xo -XI + Xo. Hence,
R = 2Xo -XI

Xo

2. (Dice product) Let a and b be the outcomes of two die rolls. Then Z = ab. By
independence, we know
E[ab]

E[a]E[b]

and var[Z]

E[a2]E[b2] -(E[a]E[b])2

79.97

3. (Two correlated assets) For solution method, see solution to problem called Two
stocks (below).
(a) a equals 19/23.
(b) The mjnimum standard deviation is approximately 13.7%.
(c) The expected return of this portfolio is approximately 11.4%.
4. (Two stocks) Let a, {3 equal the percent of investment in stock 1 and stock 2,
respectively. The problem is
mina2ul
IX.IJ

+ {32ui + 2a{3uI2

subject to a + {3 = 1.
Setting up the Lagrangian, L, we have:
L = a2ul + {32ui + 2a{3uI2 -i\(a
The first order necessary conditions are:
or = 2aul + 2{3UI2-i\
o = aa
25

+ {3-1)

26

CHAPTER 6. MEAN-VARIANCE PORTFOUO lHEORY

oL
0 = a:ti = 2/,'O"i + 2lXO"12 -"

l=lX+/,'
which

imply

0"2 -0"12
+ O"i -20"12

lX-0"[

The mean rate of return is just lXm1 + /,'m2.

5. (Rain insurance)
(a) The expected rate of return equals (.5) .;~612~5: .2 .u
(b) By inspection, it can be seen that buying 3 million units of insurance eliminates all uncertainty regarding the return. So, 3 million units of insurance
results in a variance of 0 and a corresponding
3

to --1
2.5

expected rate of return

equal

= 20% .

6. (Wild cats)
(a) The three assets are on a single horizontal line. The efficient set is a single
point on the same line, but to the left of the left-most of the three original
points.
(b) Let Wi be the percentage of the total investment invested in asset i. Then,
since the assets are uncorrelated, we have
n
var (total investment) = L wlO"i2
i=l
where Lf:1 Wi = 1. Setting up the Lagrangian,
L = i~wlO"i2 -"

(~Wi

the first-order necessary conditions imply

2

WiO"i =2

"

t=

1,...,n

;\
or Wj = 2""(;."!.
j
Since

Lf:1 Wi = 1, we have ~" ( Lj=l

u7 ) = 1

-I )

CHAPTER6. MEAN-VARIANCEPORTFOUOrnEORY
which implies

-2
Wj = ~
0-.J

27

j = 1,2,...,n

where
""(7'2
=

(I ~ )
i=I 0-1

The minimum variance is

n 2 2
n
Varmin = 2: Wi o-i = 2:
. I
. I
1=
1=

-I.

(0- )2
-2

2 -2
o-i = 0- .

U.1

7. (Markowitz fun)
(a) First solve for the Vi'S from
2VI
VI

+
+

V2
2V2 +
V2 +

=
V3 =
V3 =

1
1
1

This yields VI = .5, V2 = 0, and V3 = .5. This solution happens to be normalized, so also WI = .5, w2 = 0, and W3 = .5.
(b) In this case we solve
2VI
VI

+
+

V2
2V2 +
V2 +

V3
V3

=
=
=

.4
.8
.8

This leads to VI = .1, v2 = .2, andv3 = .3. This solution must be normalized
to get the final result WI = 1/3, W2 = 1/6, and W3 = 1/2.
(c) We find the Vi'S by the formula Vi = vr -rfvf,
where vf is the solution
from part (a) and vr is the solution from part (b). Thus
VI =
V2 =
V3 =

.1 -.2 x .5
.2 -
.3 -.2 x .5

=
=
=

.2
.2

When normalized the solution is WI = 0, W2 = .5, and W3 = .5.

8. (Tracking)
(a)
var(r -rM)

var(r) -2 cov(r, rM) + var(rM )

n
n
2: /Xi/Xjo-ij -2 2: /Xio-iM+ o-k
i,j=I
i=I

28

CHAPTER
6. MEAN-VARIANCE
PORTFOliOrnEORY
SO,to minimize var( r -rM)

subject to

2:~1 (Xi = I set up the Lagrangian

n
n
n
L = ~ (Xi(Xj(]"ij-2 ~ (Xi(]"iM+ (]"It + ,,( ~ (Xi -I)
i,j=l
i=l
i=l
The first order necessary conditions imply
n
2 ~ (Xj(]"ij -2(]"im + "

0 for all i

j=l
n
~ (Xi =
i=l

n
(b) Similar to (a) with the added constraint ~ (Xiri = m.
i=l
So the first order necessary conditions imply
n
2 ~ (Xj(]"ij -2(]"im + " + /.lri = 0 for all i
j=l
n
n
~ (Xi = I
~ (Xiri = m
i=l
i=l
9. (Betting wheel) For every segment the payoff for a bet Bi = I/Ai

will equal $1.

Thus, the payoff is $1 independent of the wheel.

Since, with this betting strategy, the reward is completely determined, the riskfree rate of return just equals
r =

n I
Li=11/Ai

-1.

Thus, the risk free rate of return in example 6.7 is 0.

10. (Efficient portfolio)

(rk. -rf)

o(tan(J)
0--

-OWk.

~n

i,j=l
-

(]"ijWiWj

1/2 -~

Wiri

i=l

.~
(]"ijWiWj
t,}=l
Using

the hint,

this implies

-rf

) (n
~

i,j=l

(]"ijWiWj

1/2

Chapter
The

7
Capital

Asset

Pricing

Model

1. (Capital market line)

(a) r = .07 + ~O"
(b)

= .07 + .50"

i. 0" = .64
ii. Solvewx.07+(I-w)x.23
= .39givingw = -1. Hence, borrow $1000
at the risk-free rate; invest $2000 in the market

(c) $1182
2. (A small world)
O"'ft =
(a)

2
O"AM
=
2
0"AB

rA

rB

(b)

I
4(0"1
+ 20"A,B+ 0"1)
-2I

0"1 + 0"A,B

(O"A+O"A,B)

hence

!3A=

I
-2 ( 0"1 + 0"A,B )

hence

!3B =

2
20"M
0"1 + 0"A,B

2
20"M

.10+~(.18-.10)=20%
3
.10 + 4(.18- .10) = 16%

3. (Bounds on returns)
(a) Using the two-fund theorem and noting that the market portfolio
contain assets in negative amounts, we have
!w + !v

2w -v

[ "i]

[ :i]

with a rate of return of .1

with a rate of return of .16

31

cannot

32

CHAPTER7. mE CAprr AL ASSEf PRICINGMODEL

so the expected rate of return
.1 ~ rM ~ .16.

of the market

(b) Since rM ~ rminvarportfolio , we have

4. (Quick CAPM derivation)

portfolio

rM is bounded

by:

.12 < rM ~ .16.

From (6.9) we have

n
L UMii\Wi = i\ul:t = rM -rf.
i=l

rm-rf Also,
Hence i\ = ~
O"m
n
L UMii\Wi = i\ COV(rk,rM)
i=l
Combining,

we have

(-

-UkM
rk -rf
5. (Uncorrelated

= rM -rf.

= --y
rM -rf
UM

assets)
{Ji = ~UiM =
nXiUi2 2
UM
)=:j=l XjUj

since the assets are uncorrelated.

6. (Simpleland) The market consists of $150 in shares of A and $300 in shares of B.
Hence, the market return is
150
rM = (450)rA

300
+ (450)rB

1
2
= 3rA + 3rB.

(a) rM = ~ x .15 + ~ x .12 = .13

(b) UM =

[ 9(.15)2
1

+ 9""X3(.15)(.09)

+ 9(.09)2

122 + 3PABUAUB = 3(.15)

122
(c) UAM = 3UA

] 21 =

+ 9(.15)(.09)

.09
= .0105.

UAM = 1.2963
{JA = ~
UM
(d) Since Simpleland satisfies the CAPM exactly, stocks A and B plot on the security market line. Specifically,
r A -rf

= {JA(rM -rf).

Hence,
rf=~=.0625.

CHAPTER 7. mE CAprrAL ASSET PRICING MODEL

7. (Zero-beta

assets)

(a) Let p be a portfolio

2(1-

33

a)auO1

such that p = (1-

+ a2uf

a)wo

.So, since 0 = ~

a)uO1 + au[

(c) The zero-beta portfolio

mum variance point.
(d) p = ~

implies

(using (a, a =

is on the minimum

ri = rz + ~(rM

-rz)

uJ = (1-

, we have 0 = -2u6
(X=O

implies A = 1.
(b) 0 = U1 z = (1.Uo

+ (XW1. Then,

(~

-u1

a)2u6

+ 2UO1which

) < 0.

variance set but below the mini-

= .09 + .5~(.15

-.09)

That is, ri = 10%.

8. (Wizards)
(a)
E(r)

E(~-I)=E(~)E(P)-1

(20
.5
.5 )
+ "16
24-

7
-=
20

9
I = 16024
-1

35%

(b)
uM=E[(rp-rp)(rM-rM)]

E[(y)(rM-rM)]

E(I/c)E(p

Hence

160

20uM

-p)(rM
2

9
82OuM

-rM)]
2

9 2
a-~-~-~ 2 -2
j.JUM
UM
8

(c) rp = rf + fJ(rM -rf)

= .09 + j(.24)

= .36 Thus the rate of return predicted

by the CAPM method exceeds the project rate of return by 1% , so the project
is !1Q1acceptable-but
it is close.
9. (Gavin's problem)
Note: U(XM= cov(arf
Q = p(arf

+ (1-

cov(Q,rM)

= cov(P(arf

+ (1-

a)rM,rM)

= (1-

a)ul:r

a)rM + 1)
+ (1-

a)rM + 1),rM)

= P(1 -a)ul:r.

Chapter
Models

8
and

Data

1. (A simple portfolio)
(a) The beta of the portfolio is a weighted combination of the individual betas:
13= 0.2 x 1.1 + 0.5 x 0.8 + 0.3 x 1 = .92.
Hence, applying the CAPM to the portfolio we find
rp = .05 + .92(.12-

.05) = 11.44%.

(b) Using the single-factor model, we have

O"i =
=
0"2 =
O" =

c
2: wfO"ii = 0.22 x 0.0072 + 0.52 x 0.0232 + 0.32 x .012
i=A
0.00033725
b20"lt + O"i = 0.422 x 0.182 + 0.00033725 = 0.2776
16.7%.

2. (APT Factors) By the APT we have {\0 = rf = 10% and

.15

.10 + 2"1 + {\2

.20

.10 + 3{\1 + 4{\2

This yields {\1 = .02 and {\2 = .01.

3. (Principal components) The estimated covariance matrix of the four stocks is

V=

90.28

50.88

79.00

40.18

50.88
79.00
40.18

107.2
105.4
30.98

105.4
162.2
56.54

30.98
56.54
68.27

The largest eigenvalue is 311.16 with corresponding eigenvector

v = [0.217, 0.263, 0.360, 0.153]
35

36

CHAPTER8. MODELSAND DATA

which has been normalized so that the components sum to one. Therefore, the
first principal component is O.217T1 + O.263T2 + O.360T3 + O.153Tr. This can be
considered as the weighted average of the returns
bles the return of the market portfolio.

of the four stocks, and resem-

The top part of Table 8.2 is reproduced here, showing the time values of the
principle component. Note that its behavior is similar to that of the market.
Principal
Year stock 1 stock2 stock3 stock4 market riskless Component
1 11.91 29.59
23.27 27.24
23.00
6.20
23.07
218.3715.2519.4717.0517.54
6.70
17.74
3
3.64
3.53
-6.58 10.20
2.70
6.40
.92
424.3717.6715.0820.2619.34
5.70
18.60
S 30.42
12.74
16.24
19.84
19.81
5.90
18.97
6
-1.45
-2.56 -15.05
1.51
-4.39
5.20
-6.21
720.1125.4617.8012.2418.90
4.90
19.48
8
9.28
6.92 18.82
16.12
12.78
5.50
13.16
917.63
9.73
3.0522.9313.34
6.10
11.08
10 15.71 25.09
16.94
3.49 15.31
5.80
16.76
aver 15.0014.34
10.9015.0913.83
5.84
13.36
var 90.28107.24162.1968.2772.12
84.93
4. (Variance estimate)

1
E(S2) = E -=-

.
t=

] [

( Ti -r)

-!

1 i=l

[i (

.2:: 1

t=

i(Tj

-r

1-

.!.)(Ti

-r)

-2::

n.]=

2:: (Ti

-r

~
n- 1
0"2.

]..t

{ (1-!)2+~
n

n2

5. (Are more data helpful?)

(a)

A
A
O"n
O"
O"(r) = O"(nr n ) = n- In = n JnJn
Hence O"(:f) is independent

of n.

n.1.

= O".

Tj

]
-!

)]

1 n

Ti-

n j=l

t=

~E

n-1
=

= E -=n

2::(Ti-r)2

[
=

n
1

CHAPTER
8. MODELS
ANDDATA

37

(b) Assuming normality,

a(u2)

= a(na2)

= n

./2u2n

In"-=1

= n

./2
In"-=1

a2
-=
n

./2a2
In"-=1

Part (a) shows that by using smaller periods to get more samples does not improve
the estimate ofr. Part (b) shows that using smaller periods to get more samples
does improve the estimate of a2.
6. (A record) Assuming a normal population,
(a)
A
rm

1 n
-L
Ti = 1%
n. t= 1

Yyr

12Ym = 12%.

(b)
u~

Uyr

-1n-1.

n
L(Ti

-Ym)2

= 0.00072

t= 1

mUm

= 9.29%.

~
a(Tm)

Um
""In = .55%

a(Yyr)

a(12Ym)

~
In"-=1

a(12u~)

(c)

A 2

a am
a(u2yr)

= 12um

= 6.6%

= ./2 X 0.00072 = 0 00021

m
.
= 12a(u~)

= 0.0025.

(d) From the previous exercise we know that the estimate of r will not be improved by having weekly, rather than monthly samples. All that matters is
the total length of the period that is observed. However, the estimate in
a2 can be improved. In fact, letting aweek(uir) denote the standard deviation in uir based on weekly data, we expect that aweek(uir) = ~a(uir)
.47uir = .0012.

7. (Clever, but no cigar) First divide the year into half-month intervals and index
these time points by i. Let Ti be the return over the i-th full month (but some will
start midway through the month). We let r and a2 denote the monthly expected
return and variance of that return.

38

aIAPTER8. MODELS
ANDDATA
Now let Pi be the return over the i-th half-month period. Assume that these
returns are uncorrelated. Then Pi = rm/2 and 0"2(Pi) = 0"2/2. The return over
any monthly period is a sum of two half-month returns; that is, the monthly return
Ti is Ti = Pi + Pi+l. It is easy to see that COV(Ti,Ti+l) = ~0"2 and COV(Ti,Tj) = O
for li-jl

> 1.

Now for Gavin's scheme we form the estimate

-"- I 24
T = 24 ~ Ti.
t=1
We need to evaluate
0"2(:;'0") = -liz

I
w

I
w

~
24 (Ti -r)

t=1
24
.~ COV(Ti,Tj)
t,J=1
24
~ [COV(Ti-l,Ti) + COV(Ti,Ti) + COV(Ti,Ti+l)] .
t=1

Except at the two end periods, each i will give three terms as shown. We will
ignore the slight discrepancy at the ends and assume that every i gives the three
terms as shown in the summation. The terms are ~0"2, 0"2, and ~0"2, respectively.
Hence we have
2~
I
1
12
O" (r) = -x
242 24(-2 + I + -)0"
2
I
-0"2
12
which is identical to the result for twelve nonoverlapping months of data.
=

8. (General tilting)
(a) Let p = pT = 1, Q = 0"2, and Q-l = 1/0"2. Then
r=
(b) Let
P=
ThenpTQ-Ip

[ ]
I
I

.Q=

= 0"2
1 + U2,
2 andPTQ-lp
~
T=

PI

P2

2+2
0"2

p.

O"f

= ~
0"1 + ~.
0"2 Hence

)(

2+2
0"2

O"}

0"1

-1
.

0"2

Chapter
General

9
Theory

1. (Certainty equivalent) The possible incomes and their utility levels (found by taking the 1/4-th power) are
Income
Utility

80
2.99

90
3.08

100
3.16

110
3.23

120
3.31

130
3.38

140
3.44

The total utility is the average of these, which is 3.23. We must find C such that
Cl/4 = 3.23. Using an iterative process we find C = $108, 61.
2. (Wealth independence) The investment will be made if:
E[U(W -w

+ x)] > E[U(W)] ,

for our case we have:

E [ -e-aW e-a(x-w) ] > E [ -e-aw]
or equivalently,
-e-a(W-w)E [e-ax] > -e-aW.
Dividing the expression by -e-aW, the investment will be made if:
eawE [e-ax] < 1
which is independent of W.
3. (Risk aversion invariance) The risk aversion coefficient for a utility function, U (x )
is:
U1'(X)

a(x)

= -~

v' (x)

bU' (x)

V1'(X)

bU1'(X)

For V(x) = c + bU(x)

so the risk aversion coefficient for V (x) is given by:

-~V'1(x) = -~U'1(x) = a(x).

39

40

CHAPTER
9. GENERAL
rnEORY
4. (Relative risk aversion) Given U(x), the relative risk aversion coefficient 11is defined as:
(x)
l1(x) = -U'xU" (x)
(a) U(x) = log(x)

U' (x)
U" (x)
=>l1(x)

=
=
=

~
--IT
x
1

(b) U(x) = )'X)'-l

U' (x)
U" (x)
=>l1(x)

=
=
=

)'2X)'-1
)'2 ()' -1) X)'-2
1 -)'

Relative risk aversion coefficients, 11,are constant for both utility fW1ctions.
5. (Equivalency) If results are consistent, we have that V(x) = aU(x) + b, and since
V(A') = A' and V(B') = B' we must have
A'

aU(A') + b

B'

aU(B') + b

So solving both equations simultaneously we find parameters a and b:

a

A' -B'
U(A')
-U(B')

B'U(A')
U(A') -A'U(B')
-U(B')

6. (HARA) The hyperbolic absolute risk aversion function is given by:

U(x)

y
1-)'

(~+b
ax

)' , b>O.

(a) Linear: We can write the HARA as:

U(x)

y1 ax(1 -)')

l=l.

)' + b(l-

)')y

)'

Choosing)' = 1 and a = 1 and using L'Hopital's rule we can write:

U(x)

=
=

IJ!!-<!=l
limaxeymI=n
)'-1
x

CHAPTER9. GENERALnIEORY
(b) Quadratic:

By choosing

y = 2, HARA takes the form

U(x)

Choosing

41

--a2x2
2

+ abx

--b2

1
2

a > 0 and b = 1/ a > o we have an equivalent

form

of the re-

quired quadratic form. Furthermore, by adding b2/2, which is a legitimate

transformation,
we get the precise desired form:
U(x)

1
2CX2,

= x-

where c = a2
(c) Exponential:

By choosing

b = 1 and y = -00 and using L'Hopital's

can write
U(x)

lim .!..=..r
y--oo
y

-1

(1 -y
~

lim eYIn(R+l)
y--oo
~+1 )I
-lim
e In(
'i/~

y--oo
-e-ax

rule we

)y
+

(d) Power: If we let b = 0, HARA takes the form:

U(x)

= (1-

which for y < 1 is of the required

y)l-YaYxY
y

form

U(x)
(e) Logarithmic:

= cxY

Let b = 0 and a = 1, then HARA is given by:

U(x)

We can subtract
utility

= (1 -y)l-Y

the constant c = (1-

xY
-.
y

y)(l-y)/y,

and obtain an equivalent

function
U(x)

Now letting

= (1 -y)l-Y

y = 0 and using L'Hopital's

U(x)

( -y
XY-l

).

rule we get

lim ~
y-O
y

42

CHAPTER9. GENERALrnEORY

=
=

a(x)

)'
lnx

lim
)'-0
lnx.

=
The Arrow-Pratt

e)'lnx -1

lim
)'-0

risk aversion coefficient

a(x)

U"(x)
-if("XT

e)'lnx

for HARA is

(~

-a2

+ b

= -a

(~

I-)'

(-+bax
I-v

)-1 =

) y-2

) '-1

ax a

-+b
I-)'

-I

b'
r=yx+a

which is of the form l/(cx

+ d), as required.

7. (The venture capitalist) The expected value e is given by

e = p + (1- p)9 = 9- 8p
so,
9-e
p=-

On the other hand since U(x) = .jX:

U(C) = -.JC =

So

C=

(3-2

pU(l)

+ (1- p)U(9)

p + 3(1- p)

3 -2p

3-2

( -S
9-e ))

(-S
9-

2 =16(3+e)2
1

Solving for e we get:

e=4-.JC-3
which agrees with the values of the table on example 9.3
8. (Certainty approximation)
By definition, the certainty equivalent c is such that
E[U(x)]
= U(c). Substituting in the given approximations,
we have
U(x)

+ ~U"(x)var(x)

~ U(x) + U'(x)(c

-x).

CHAPTER
9. GENERAL
tHEORY

43

Solving for c yields

(x)
c ::::x-U"
+ u;-(-x}var(x)
as required.
9. (Quadratic mean-variance) In general
E[U(y) ]

E[ay-

~by2]

aE[y] -~bE[y2]

aE[y] -~b(var[y]

+ E[y]2)

If the random payoff of the portfolio of the investor with unit wealth is R, it would
maximize
E[U(R)] = aE[R] -~b(var[R]
+ E[R]2)
Now, if the investor with wealth W purchases the same portfolio, its payoff must
be WR and R should maximize:
E[U(y2)]

aE[RW] -~b2(var[RW]

+ E[RW]2)

aWE[R] -~b2(W2 var[R] + W2E[R]2)

W [ aE[R] -~b2W(var[R]

+ E[R]2) ] .

If the second investor has b' = ~, the same R will solve this as the R using unit
wealth.
10. (Portfolio optimization) The first-order conditions for portfolio optimization are:
E[U' (x* )di] = "Pi

for all i.

Dividing by Pi we get
E[U'(x*)(l+ri)]
E[U'(x*)]

+ E[U'(x*)ri]

"

foralli

"

for all i.

or,

Taking the difference between asset i and the risk-free asset yields
E[U'(x*)]

+ E[U'(x*)ri]

-E[U'(x*)]

+ E[U'(x*)rf]

E[U'(x*)ri]-E[U'(x*)rf]
E[U'(x*)(ri

-rf)]

" -"

0.

44

CHAPTER 9. GENERAL nIEORY

11. (Money-back
with

price

guarantee)

0
6

1~

We have the three

1 and the new money-back

1
3

1~

investment

guarantee
1~

1.2
1.2

Residual Rights

states

cated by combining
that the price
no arbitrage

and three

the existing

'securities',

guarantee

9.6

p3,000

Money-Back Guarantee
the new alternative

ones in certain

of the Money-back

example

Risk Free

amounts

security

can be repli-

A, B, and C. It follows

is A + B + C, so that

there

are

opportunities:
6A + 3B + 1.2C

3,000

B + 1.2C

1.2C

A+B+C
Solving

from

1.2

Film Venture

Since we had three

options

alternative:

the

system

gives

us the price

of the Money-back

guarantee

deal:

$1,500
Alternatively
we could have used the state prices from example 9.9 where we had
I/Jl = 1/6, 1/J2 = 1/2 and 1/J3 = 1/6 so that the price of the Money back guarantee
is given by the single

equation:
p=

with

solution

12. (General

results

state prices

in S states.

is characterized
its payoff

result)

Security

by DT x E Es.

appending

vector

N elements

while

of the vector

the (n + 1) -th

element

matrix

are given
value

Now

the negative

A=

The first

Let the NxS

prices

by x E EN. The market

is given

from

p = $1, 500.

positive

N securities

1
1
63,000+2P+6P,

or cost c of a portfolio

consider

matrix

of

x is q .x and

the (S + 1) x N matrix

of the price

vector

--~~--

p given

D be the payoff

by some q E EN and a portfolio

by Ax

is the negative

q as a row

= p correspond

A which

to DT :

to the payoff

of the cost of the portfolio

x.

CHAPTER
9. GENERAL
lHEORY

45

If there is no arbitrage, then we must have no p ~ except p = 0, since otherwise

we could have non-positive cost (c oS0) with a positive probability of yielding
positive payoff or negative cost (c < 0) with zero payoff which is instant money.
Using the stated matrix theory result it follows that there exists a vector y >
such that A Ty = 0. Note that this is the same as:
DIIYl
D21Yl

+
+

D12Y2
D22Y2

+
+

DNIYl

DN2Y2 +

D13Y3
D23Y3

+
+

...+
...+

D1SYS -'llYS+l
D2SYS -'l2YS+l

=
=

0
0

DN3Y3 +

...+

DNSYs -'lNYS+l

Note that by dividing each element of y by YS+l we get positive state prices tfJi =
Yi/Ys+l such that:
D 11tfJl
D21tfJl

+
+

D12tfJ2 +
D22tfJ2 +

D13tfJ3 +
D23tfJ3 +

...+
...+

DlstfJS -'11
D2stfJS -'12

=
=

0
0

DNltfJl

DN2tfJ2 +

DN3tfJ3 +

...+

DNstfJS -'IN

Therefore, if there is no arbitrage, there are positive state prices.

13. (Quadratic pricing) From the earlier exercise we have E[Ut(x*)(ri
U(x) = x -C/2X2 then, Ut (x) = 1- cx, so in this case we have
E[(l-

cWRM)(ri -rf)]

= 0

E[(l-

CWRM)(Ri -R)]

= 0.

cW[E(RMRi) -HMR]

cW[COV(RM,Ri) + HM(Ri -R)].

or equivalently
Written out we have
Hi -R

This implies, Hi -R = )1COV(RM,

Ri) for
)1 = 1 -cwHM.
AppIing this to RM yields
HM -R = )1var(RM)
which shows that
RM-R )
)1 = var(RM

and hence finally

Ri -R = fJi(RM -R).

-rf)]

= 0. If

46

CHAPTER
9, GENERAL
THEORY

14. (At the track) Gavin Jones will choose the fraction (Xof his money m to bet on the
horse so as to maximize his expected utility:
max E[U] = ~~

+ ~~,

(a) The first order necessary condition is:

1
m
---=0
2 .Jm + 4(Xm
which yields:

3
m
4 ..;(1- (X)m

7 = .1346
(X= 52

Gavin's maximizing choice is to bet 13.46% of his money and keep the rest
in his pocket.
(b) We can summarize Gavin's world by the following three alternatives:

1<:
Keepmoneyin pocket

1<:
Betfor NoArbitrage

1<~
BetagainstNoArbitrage

Unear pricing holds if there aren't any arbitrage opportunities. Thus, we

could replicate a four dollar bet against No Arbitrage by 'shorting' the bet
in favor and keeping five dollars in the pocket. Dividing by four we get the
implied payoff for a one dollar bet against No Arbitrage:
y = 45 = 1.25
15. (General risk neutral pricing) From log-optimal pricing we have
p = E (~

Now, using the expectation operation E defined by

~
E(x)
= E ( R*
RX )
where R is the risk free rate, we can multiply the log-optimal pricing formula by
~ = 1 without affecting it. This yields
R.E(;.)
p -R
which is risk neutral pricing.

-R

E(~)

-R

E(d)

Chapter

10

Forwards,

Futures,

and

Swaps

1. (Gold futures) Applying equation 10.2 we have

5
F

=+
=+++

M-I c(k)
L
k=Od(k,M)

d(O,M)
412

2/4

2/4

2/4

d(0,9m)

d(0,9m)

d(3m,9m)

d(6m,9m)

where (with m = "months")

d(0,9m)

d(3m,9m)

d(0,9m)

1
09 = .9354
(1 + 4)3
109 2 = .9565
(1 + 4 )
1 09 = .9780.
(1 + 4 )

Combining these, we find

F = 440.45 + .5345 + .5227 + .5112 = $442.02.
2. (Proportional carrying charges) Suppose at time zero you take out a loan for 5(0),
purchase 1 unit of the commodity, and short (1- q)M units of the commodity at
a forward price of F per unit. The total intial cash outlay of these transactions is
zero. Each period you pay the carrying cost of the commodity by selling a fraction
q of your commodity holdings. Hence the amount of commodity held at the end
of M periods is ( 1- q )M.At the final time you deliver your commodity holdings to
make good on your short, receiving F ( 1- q )M.You also repay your loan by paying
5(0) 1d(O, M). The total profit from these transactions (which clear all accounts)
is F(I- q)M -5(0)/d(0,M).
To avoid arbitrage, this profit must be zero. Hence
F = 5(0)(1 ~ q)-M /d(O,M).
3. (Silver contract) ill general the spot and forward prices are related by:
M-I
5 = Fd(O,M) -L
c(k)d(O, k)
k=O
47

CHAPTER
10. FORWARDS,
FuroRES,ANDSWAPS

49

The transactions yield no net cashflow until the final period where we recieve
S/d(O,M) + Lr=-i c(k)/d(k,M),
from our investments and pay E for the asset, as
required by our forward contract, which in turn we will deliver to Mr. X who lent
us the asset in time 0. Thus if E < S/d(O,M) + ~r=ol c(k)/d(k,M),
we have an
arbitrage profit so the inequality must be false under the no arbitrage condition,
which completes the proof of the forward price formula with canying costs in
section 10.3.
6. (Foreign currency alternative) In Example 10.12 the company hedges by shorting
forward contracts for 500,000 Deutsche marks, assuring dollar receipts in 90
days of $ 500, OOOET,where ET is the forward dollar price for Deutsche marks in
90 days.
Based on the no arbitrage condition we have that:
E-~S
T -1

+ TG 0,

where TUSis the 90 day U.S.risk-free rate, TGis the 90 day interst rate in Germany,
and So is the spot price for Deutsche marks at time 0.
To verify this consider taking a long position on a 90 day Deutsche mark forward,
which has zero cost at time 0 and a value of ST -ET at the maturity time T .
On the other hand consider borrowing ET/ ( 1 +TUS) dollars at time zero for 90 days
and at the same time purchasing 1/ ( 1 +TG) worth of risk free german bonds with a
dollar cost of S0/(l+TG). The total cost of this strategy is S0/(l+TG)-ET/(l+Tus)
with a total net payoff of ST -ET at time T which is equal to the value at time T
of the 90 day forward.
It follows that if there is no arbitrage, the cost of both alternatives must be equal,
therefore we must have So/ ( 1 + TG) -ET / ( 1 + TUS) = 0, which gives us the the
Deutsche mark forward price: ET = So(l + Tus)/(l + TG)
So the dollar value of the receipts at time T for the firm by hedging with forward
contracts is:
1 + Tus
500, 000 1
So dollars
+TG
If instead it borrows 500, 000/(1 + TDM) Deutsche marks (to be repaid with the
receivables at time T) and sells them into dollars, the receipts at time 0 are
500, OOOSo/(l + TG) dollars, which invested for 90 days in U.S. T-bills will pay
1 + TUS
500, 000 1
So dollars.
+TDM
Hence, the two procedures are equivalent.

50

CHAPTER10. FORWARDS.FuroRES, AND SWAPS

7. (A bond forward)
Ft

We solve first for Ft the current

=

S
~ (O 2)

price of the bond:

2 d(O, k)c(k)

+L

,
=

forward

k=1

(O , 2

920( 1.1.035
04 ) 2 -80(1.04)2

)
-80(1.04)2

(1.04)2

$831 ..47

Now we solve for the value of the forward contract:

831.47- 940
it = (Ft -Fo)d(O, 2) =
(1.04)2
= -$100.34.
8. (Simple formula) X / C units of the bond will pay X in coupons plus a final prindpal payment of 100X/C. Hence a stream (X,X,X.. .,X) is worth B(M,C)X/C d(0,M)100X/C.

The result follows immediately.

9. (Equity swap)
(a) The market price at time i -1
Vi-I(Si + Vi) = Si-lo We have
Vi-I(Ti)

for the cash flow Si + di is Si-l.

Vi-I([Si + di -Si-I]/Si-l)

1- Vi-l[l]

1 -d(i

Hence,

-1, i).

(b) We just discount Vi(Ti) back to time 0. Hence Vo(Ti) = d(O, i -1)[1
1, i)] = d(O, i -1) -d(O, i) because d(O, i -l)d(i
-1, i) = d(O, i).

-d(i

(c)
M
L VO(Ti) =
i=1
=

[d(O,O) -d(O, 1)] + [d(O, 1) -d(0,2]

+ ...+

[d(O,M -1) -d(O,M)]

1- d(O,M).

(d) Value = { Lf-1 d(O, i)T -[1-

d(O,M)] } N. The first term can be reduced

using the formula of the previous exerdse.

10. (Forward vanilla) We have
d(0,i+1)=

1
.
(1 +To)(l +TI) ..0 (1 +Ti)

Therefore
d(O, i + l)Ti

=
=
=

Ti
(1 +To)(l +TI) 0. .(1 +Ti)
1 + Ti
-d(O i + 1)
(1 +To)(l +TI) ...(1 +Ti)
,
d(O, i) -d(O, i + 1)

CHAPTER
10. FORWARDS,
FUfURES,
AND SWAPS

51

Then we find

M-I
L [d(O, i) -d(O, i + 1)] = 1- d(O,M),
i=O
which agrees with the text.

11. (Specific vanilla)

(a) The floating side of the swap is worth
VFloat =

[1-d(0,6)]x$10million

[1-

~]

x $10 million

[1- .6029] x $10 million = $3.971 million

(b) The fixed side of the swap is worth

VFixed =
=

M
L d(O, i)r x $10 million
1=0
4.606r x $10 million

where the 4.606 was obtained by SlJmming the discount rates implied by the
term structure.
Setting VFixed= VFloatwe find r = .0864 = 8.64%.
12. (Derivation) We obtain the mean-variance hedge formula by solving:
max E[x + h(ET -Eo)] -r
h

var[x + hET ]

which can be written as:

max E[x] + h(ET -Eo) -r(var[x]
h

+ 2hcov[x,ET ] + h2var[ET ])

Taking the derivative with respect to h we get the first order condition:
ET -Eo -2r

cov[x, ET] -2hrvar[ET]

=0

Solving for h we find the mean-variance hedge formula:

h =

ET -Eo -COV[X,ET ]
2r var[ET ]
var[ET ]

13. (Grapefruit hedge) The mjDimum-variance hedge is

h

UGSG
-{3W = -p--150,000
uoSo

-(.7)

-131,250

$1.50/lb
(~.2 ) ($1.20/lb

orange,

grapefruIt

Ibsorangejuice.

) 150, 000

CHAPTER
10. FORWARDS,
FUfURES,
ANDSWAPS

53

where as before x = 1, 000, 000 x K. Hence,

Uy = .7211 stdev[x].
As expected the standard deviation with the equal and opposite hedge is
greater than with the minimum variance hedge were we had Uy = .6 stdev[x ]
15. (Immunization as hedging) First we calculate the present value of the portfolio.
(We shall use the continuous-time formula for discount factors in this exercise;
however, the discrete-time version would give similar results.)
PV

f I!
partaa-

-'\:"'

c .e -r(ti)ti

Lo-t
i

-(I)d-(1.0S)1

--.

-(2)e-(1.OS3)2

-(l)e-(1.OS6)3

+ 4.253e-(1.OS3)2

Hence the portfolio is balanced in the sense of haVing assets equal to liabilities.
The current spot price of the bond considered for the futures contract is
S = e-(.061)6.
The corresponding forward price is then
F = Se(.OS)l= e-(.061)6e(.OS)1.
A futures contract will not change the PV of the portfolio. One way to express
the present value is to assume that we actually take delivery of the contract. This
means that there will be cash flows at the end of one year (to buy at the contract
price) and at the end of six years (when the bond pays its principal). Hence a
contract to purchase $x par value zero-coupon bonds has present value
PVFutures
= xe-(.061)6 -xe-(.061)6e(.OS)le-(.OS)1= 0.
We now assume that the term structure is of the formf(t)
a parallel shift. In this case
PV

-'\:"'

tf I!
par

0-

c.

Lo-

+ a, where a represents

-(!(ti)+a)ti

i
We will set the derivative
~

da

Ia-O
-=

equal to zero. We have

(1)(I)e-(.OS)l + (2)(2)e-(.OS3)2+ (3)(I)e-(.OS6)e

=

-(2)(4.253)e-(.oS3)2 -6xe-(.061)6
-.566- 3.468x.

+ (1) (x)e-(.061)6e.OSe-.os

SolVing, we find x = -.1632. Hence the fund should short $163,200 worth of the
Treasury futures.

54

CHAPTER
10. FORWARDS,
furoRES, ANDSWAPS

16. (Symmetric probability) Given the future wealth W = a + hx + CX2, the investor's
problem can be written as
max E[U(a + hx + CX2)] where U is strictly concave.
h
(a) The first order necessary condition for the problem is
E[U' (a + hx + CX2)X] = 0
Let f(x) be the probability density function of x, such that f(x)
Then the first order condition takes the form
['"' U'(a + hx + cx2)xf(x)

= f( -x).

dx = 0

or equivalently,
r,", U'(a + hx + cx2)xf(x)
Io'"'-U'(a

-hx

+ cx2)xf(-x)

dx + Io'"'U'(a + hx + cx2)xf(x)

dx

dx + I:

dx

U'(a + hx + cx2)xf(x)

However, since f (x) is symmetric, f (x) = f ( -x) , so we can writte the above
condition as
-Io'"' u' (a -hx

+ CX2)X f(x)

dx + Io'"'u' (a + hx + CX2)X f(x)

dx = 0.

Rearranging by moving the first term to the right hand side of the equation
we get
Io'"'U'(a + hx + cx2)xf(x)

dx = Io'"'U'(a -hx

+ cx2)xf(x)

dx

Clearly, this condition holds if h = 0. Furthermore, since U is strictly concave h = 0 is the only solution.
(b) The farmer's revenue is given by
C2 + CC
R = 10C -1600
1OOOh
where c = 3, 000.
If C has a symmetric distribution, then the distribution of x = C -C is such
that f(x) = f( -x), and we can write the farmer's revenue as
R

(x + 3000)2
x
10(x + 3, 000) -1000
-16OOh

21,000

(4-

LOOO
h

) x-

LOOO
X2

CHAPTER10. FORWARDS,FUTURES,AND SWAPS

From part (a) we know that for an investor with strictly
optimal solution is:
h
4 -IOOO
= 0.

concave utility

55
the

Hence, h * = 4,000.

17. (Double symmetric

var(R)

probability)

var(Axy

A2var(xy)

We have
+ Ex -hy)
+ E2var(x)

+2ABcov(xy,x)
Setting the derivative

-2Ahcov(xy,y)

-2Ehcov(x,Y).

of the above (with respect to h) to zero we have

2hvar(y)
Hence

+ h2var(y)

-2A

cov(xy,y)

h* = E cov(x,y)

-2E

cov(x,y)

+ A cov(xy,Y)

= 0.

var(y)
Now we show that cov(xy,Y)
cov(xy,y)
because E(y)

Let s = -x,

= E(xy2)

h*=~.

-E(xy)E(y)

= E(xy2),

= 0 by symmetry.

ds = -dx,

E(xy2)

= J J xy2 f(x,y)dxdy.

t = -y,

dt = -dy.

E(xy2)

Since E(xy2)

= 0.

= -E(xy2)

Then

f f ( -S)t2 f( -s, -t)ds

-f

-E(xy2).

it follows

dt

f st2 f(s, t)ds dt

that E(xy2)

= 0. Thus cov(xy,y)

Uy

18. (A general farm problem)

In general the farmer's

R = PC + h(P -Po)

substituting

for P in terms of D we now find

revenue will be

= 0 and

56

OIAPTER 10. FORWARDS,FUTURES,AND SWAPS

R=

(10 -100,000
D
) C + wo:oooh
tJ-D

after some algebraic manipulation we can write the equation as

R = -100,
000-tJ) + 10C -100, tJ000
(C- (:)(D

) (C-

C- ) -100, h000 + 100,(:000

) (D-D)-

then, substituiting values for (: and tJ we get

(C-(:)(D-tJ)
R = -100,000

+ 7(C -C) -100,000

h

+ 100

) (D -D),-

which is of the formR = Axy+Bx-hy

and where the distributions ofx = C -(:
and y = D -tJ are symmetric about (0,0) as required in Exercise 13. Thus, we can
find the minimum variance position by applying the result h = Baxy/a; which
gives us
h
3 = ~7aCD
100,000
+ 100
Solving for h we find

3 + ~7acD
h = 100, 000 -100

as required.
(a) For the case where D = 100C we know that PCD = aCD/aCaD = 1 so then
~
-~
-ac
--1afj -aD -100ac
-100
Thus, the minimum variance hedging position is
h

100,000 ( -~

+ ~)

= 4, 000
(b) If the crop size is not correlatedwith the total demand,Iiamely aCD= 0, the
minimum variancehedgeis given by
h

100,000 ( -~)

-3, 000

Varianceis minimized by taking an opposite position to the expected crop

size.

Chapter
Models

11
of

Asset

Dynamics

1. (Stock lattice) If we consider that ~t is small, then by the formulas

u

eu,;M = 1.105
1

-=
u

0.905

~ + ~ ( ~ ) .fM = 0.65

149.1

(11.1), we set

1S1.834

.1

21

11

16

.9

55

11

16

.1

61

0.01S

0.016

Figure 11.1 The binomial lattice. The numbers above the nodes are the stock prices. The
numbers below the final nodes are the probabilities of achieving those nodes.
The binomial lattice for the stock is shown in the left in Figure 11.1. If we do
not consider that ~t is small, then by the formulas (11.25), we get p = 0.64367,
u = 1.11005, and d = 0.90086. For comparison, this binomial lattice is shown to
the right of the first one.
57

58

CHAPTER
11. MODElSOFASSET
DYNAMICS
The probabilities of the various final nodes are shown in the above figure under
the nodes. For example, the probability of the top node is p4 = .644 = .179.
2. (Time scaling) Each movement in k corresponds to a month, and each movement
in K corresponds to a year. Let kK denote the first month of year K. Then
11
W(K) = 2: W(kK-l + i)
i=O
So,

11
E[W(K)] = E[ 2: w(kK-l + i)] = 12v
i=O
11
Var[W(K)] = E [ 2: w(kK-l + i)]2 = 120"2
i=O

3. (Arithmetic and geometric mean)

(a) Proof: For n = 2,
(VI -V2)2 ~ 0 ==>
vf + 2VlV2 + v~ ~ 4VlV2.
That is:

1
2
4(Vl + V2) ~ VIV2

So,
VA ~ vG
(b)

rl = 50%, r2 = -20%
Arithmetic mean is

I
2(r1
+ r2) = 15%.

Geometric mean is
[(I +rl)(1

1
+r2)]2 -I

= 9.54%

(c) The arithmetic mean rate of return essentially assigns a return based on
simple interest, while the geometric mean rate of return is a measure of
compound interest. Usually, the geometric mean rate of return is the most
appropriate for measurement of investment performance.

CHAPTER11. MODELSOF ASSI' DYNAMICS

4. (Complete
w -(w

the square)

-W)2
2a2

-~[
2a2
1

--w-

-2a2w
[

+ W2 -2ww

( -2
w+a

)]

+ w2 + 2a2w

-2a2w

+ a4 -a4]

-a2
+w+-

2a2

So,
-1
u

f +OO w
=

e
~

e'W+T2

-u2
ew+T

-00
1

- (w-'W ) 2 / 2u2

dw

f +OO
e-[w-('W+u2)]2/2u2 dw

-00

5. (Log variance) Suppose that u = ew, where w is distributed

E(U2)

E(e2W)

as N(w,

f +OOe2we-(W-'W)2/2U2dw.

~
Following

59

-00

the method in exercise (4), we have

2w -~

= -2k[W

-(w+

2a2)]2 + 2a2 + 2w.

Then
E(U2) = e2u2+2'W
So,
var(u)
6. (Expectations)

= E(U2) -U2

= e2'W+u2(eU2 -1)

We have
1
v = J.l -2a2

= 0.2 -2

x 0.16 = 0.12

So,
E[lnS(l)]
Stdev[lnS(l)]
E[S(l)]
Stdev[S(l)]

= 0.12
= 0.40

= eO.2= 1.22

= eO.2(eO.16-1)~

= 0.51

a2)

60

CHAPTER
11. MODELS
OFASSETDYNAMICS
7. (Application of Ito'slemma) We have G(t) = F(s,t) = st(t),
and o2F/oS2 = -ls-t.

Therefore according to Ito's lemma

dG(t)

(ts-taS

-ls-~b2S2)dt

(ta -lb2)Gdt

8. (Reverse check) We have a = 11-to"2,

dS

then oF/aS = ts-t,

+ tbGdz

b = O",S = F(Q) = eQ. Thus

(aQa+at+2~b

(S(11-to"2)

I1Sdt + O"Sdz.

oF

+ tS-tbSdz

oF

1 02 F

) dt+aQbdz
oF

+ tS0"2) dt + SO"dz

9. (Two simulations) Using eX = 1 + x + tx2 + ...,

expressed as
1
S(tk+l) = [1 + (v + 20"2f2(tk~t

the equation in (11.20) can be

+ O"f(tk).Jt;i]S(tk)

Obviously, it is different from the expression in (11.19). But the expected values
of the two expressions are identical to the first order:
E[S(tk+l)] = [1 + (v + to"2)~t]S(tk)

= [1 + l1~t]S(tk)

So, over the long run the two methods should produce similar results.
10. (A simulation experiment)
(a) A simulation shows that convergence is achieved only after a few thousand
years. (SeeFig. 11.2 for an example.)
We know that 1nS(t) has a normal distribution with mean vt = .10- .302/2 =
0.055t and variance 0"2t = .09. Hence tlnS(t) has mean v and standard
deviation '5t. As t goes to infinity, it is clear that the standard deviation goes
to zero and
1
tlnS(t) -+ v.
(b) We have O"= .30. We would like the standard deviation of the simulation to
be .005. Hence we must have .30/ .jf = .005. In other words, t ~ 3, 600 years;
or equivalently, about 43,000 months. This is consistent with the simulation
experiment.
(c) This does not converge. The expected value is 0"2 = .302 but the simulation moves around that value. [For those who have studied statistics: The
distribution of the quantity approaches a chi-squared distribution.]

Chapter
Basic

12
Options

Theory

1. (Bull spread) The initial cost of the spread is nonnegative since C(Kl) ~ C(K2)
for Kl < K2 (see Exercise 4).

Figure 12.1 Bull spread. This is the combination of a call and a put.
2. (Put-call parity) Use the same portfolio as in the text: buy one call, sell one put,
and lend an amount dK. This will reproduce the payment of the stock, except
that it will be short by an amount with present value D. Hence
C -p + dK = 5 -D.
3. (Parity formula)

max[O,5 -K]

(5 -K)

0- (K -5)

-max[O,K

-O + K = 5
+K =5

Therefore, Q = 5.

63

-5]

if 5 ~ K
if 5 ~ K.

+K

64

CHAPTER
12. BASICOPnONSTHEORY
4. (Call strikes)
(a) Assume K2 > KI, and suppose to the contrary that C(K2) > C(KI). Buy
option 1 and short option 2. Use option 1 to cover the obligations of option 2,
since max[O, 5-KI] ;:: max[O, 5-K2] for all5. Keep profit of C(K2) -C(KI).
(b) Assume K2 > KI and suppose to the contrary that K2 -KI < C(KI) -C(K2).
Buy option 2 and short option 1 to obtain K2 -KI + E profit (where E > 0).
Use option 2 and profits K2 -KI to cover option 1 since
max[0,5 -K2]

+ (K2 -KI)

= max[K2 -KI,5

-KI]

;:: max[[0,5 -KI].

Hence you still keep E profit. This arbitrage opportunity

assumed inequality cannot hold.
(c) Assume K3 > K2 > KI and suppose to the contrary that
C(K2) >

( K;""=K;:
K3-K2
) C(KI)

Buy (~
) of option 1 and (~
2. the profit is some E > 0.
Notice that

shows that the

( K3
K2-KI-K1 ) C(K3).

) of option 3 and short one unit of option

( K:i=K4
K3-Kl) C (K I ) + ( ~K3-Kl ) C (K 3)
;:: (~)(5-Kl)+
=

(~

5 -K2.

(~)(5-K3)

) {(5-

K2) + (K2 -KI

+ (~

) {(5-

K2) + (K2 -K3

Also
(~)C(KI)

+ (~)C(K3)

> 0.

Therefore it is possible to cover option 2 and make a profit of E > 0. This is

an arbitrage opportunity, so the original inequality cannot hold.
5. (Fixed dividend) The intitial present value of the dividend is 3e-(.IO)(3.S)/I2) =
2.9138. Hence we set 5*(0) = 50- 2.9138 = 47.086. We assume (and this is an
approximation) that 5* has the same volatility as 5. Hence we assume that 5*
follows a binomial process with u = eO".[&f= e.2/.J[2= 1.0594 and d = .9439. The
monthly return is R = 1 + 0.1/12 = 1.0083. We find the risk-neutral probability
q = ~ = 0.5577. The process for 5* is shown in the upper part of Fig. 12.2. The
stock price itself is expressed as 5(t) = 5*(t) + 3e-(.10)(3.S-t)/I2)for t < 3.5 and
5(t) = 5* (t) for t ;:: 3.5. Hence we find the lattice for 5 by adding the appropriate
amount to each node in the 5* lattice. The result is shown in the figure. The call
option value is found by the normal backward process on the stock lattice. We
find $2.83 and $2.51 for American and European options, respectively. See Fig.
12.2.

CHAPTER

47.09

Random

12.

BASIC

OPTIONS

49.88

52.85

55.99

59.32

62.84

66.58

44.44

47.09

49.88

52.85

55.99

59.32

41.95

44.44

47.09

49.66

52.85

39.60

41.95

44.44

47.09

37.38

39.60

41.95

35.28

37.36

Component

of

Stock

Price

(S.)

rnEORY

65

33.30

50.00

Stock

Price

52.82

55.81

58.98

59.32

62.84

66.58

47.38

50.05

52.87

52.85

55.99

59.32

44.91

47.43

47.09

49.88

52.65

42.59

41.95

44.44

47.09

37.38

39.60

41.95

35.28

37.38

(S)

33.30

2.83

American

4.23

6.23

6.98

10.14

13.26

16.58

1.11

1.80

2.87

4.23

6.40

9.32

0.27

0.48

0.87

1.58

2.85

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

Call

Option

0.00

2.51

European

3.70

5.32

7.47

10.14

13.26

16.58

1.07

1.72

2.72

4.23

6.40

9.32

0.27

0.48

0.87

1.58

2.85

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

0.00

Call

Option

0.00

Figure

6.

(Call
to

inequality)
the

price

7.

of

off

(A)
the

max[O,S

-KB(T)].

(Perpetual
we

price

(A

of

be

From

call

(A)

stock

than
call

is

must

stock

to

C(S,

T)
~
C

always

greater

and
of

than

sell
(B).

or

equal

oS

S.

or

C
to

zero.

Hence,

-KB(T)
in

the

the

-KB(T).
Thus

B(T)

limit

equal

Hence

SincelimT-~

max[O,

I T)

than
bonds.

Thus

max[O,S-KB(T)].

limT-~
(S

is

that

greater

C(S)

satisfy

call

of

equal

always

dividend.

one
share

or

6,
T)

with

purchase
one

Exercise
C(S,

option

on

purchase
greater

of

limT-~
a

of

(B)

value

call)
have

Call

payoff

of

must

However

0,

8.

The

payoff

12.2

S.
C

Clearly
=

=
the

surprise)

(a)

PV(r)

(b)

The

will

value

changing
that
are

ofr.

increase

of

r
predicted
increased;

if

the

in

is

Simplico

the
by
whereas

decreased.

mine

with

spreadsheet.
part

Hence

(a).
the

The
value

it

reason
of

4%

is
the

is

$22.2

million,

moves

in

that

when

gold

income

the

obtained

opposite
r

is
is

reduced,
largely

by

just

direction
the
independent

as
costs

66

CHAPTER
12. BASICOPTIONS
rnEORY
9. (My coin) This is like the example in the text. Draw a lattice with three stages.
The payoffs of the four final nodes are 27, 27, 0, 0. Roll back one stage. The
three nodes there have implied values 27, 9, 0. Roll back one more stage. The
implied values there are 15, 3 which can be written as 12+3, 0+3. Hence the
implied value of initial node is 4+3=7. The result can also be found by direct riskneutral valuation (without rolling back) using q = 1/3 and R = 1. The risk-neutral
probability of the two nodes with 27 are 1/27 and 6/27. Hence the total value is
7.

10. (The happy call) The payoff is

max[.5S,S -K]

= .5S + max[O, .5S -K]

= .5S + .5max[0,S -2K].

Hence, by linear pricing, we add the prices of the individual pieces to obtain
CH = .5P + .5C2. Thus x= .5, 13= 0, )' = .5.
11. (You are a president) Notice that a $1 increase in the S&Pindex index corresponds
to a rate of return of 4Ii74 in the index. Hence, for each dollar invested in the
spedal offer, the payoff is $1 plus ~ x 4Ii74 of a call option on the S&P 100 index
with strike price $414.74 and expiration in November.
The price of the $1 portion of the payoff is its present value. Assuming 3.5 months
until maturity, this value is
PI =

1 3.5 = .991010707.
1 + .031112"

The value of one call with strike price 414.74 is found by interpolation to be
C = 13 -(13-

i~)4.74

= 10.393.

The value of the fractional call that is offered is therefore

1
P2 = 41 x 4"l4J4
x 10.393 = .0662647.
Hence the total value of the offer (per dollar invested) is
V = PI + P2 = .991010707 + .0662647 = $.9972754.
We conclude that, from the data we have, the offer is low by about 0.3%-which is
not bad.
12. (Simplico invariance) Note that changing u or d amounts to changing the standard
deviation of gold price and therefore would have an influence on the lease value
of the Simplico gold mine. However, the initial gold price $400 is relatively very

68

CHAPTER12. BASICOPnONS nIEORY

0
1
2
3
305.78 371.05 450.07 545.93
256.62 310.56 375.08
212.01 255.59
171.11
K-Value

4
5
6
7
8
9
662.68 805.98 984.441212.451516.031940.64
451.97 543.14 650.54 775.99 921.25 1091.61
306.83 366.28 433.65 506.54 576.57 614.03
204.76 243.00 284.76 326.57 358.26 345.39
133.83 157.87 183.13 206.32 218.80 194.28
100.36115.23127.64131.29109.28
71.05 77.47 77.62 61.47
46.26 45.34 34.58
26.24 19.45
10.94

10
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00

Figure 12.4 Average value Complexico. The overall value does not change much, but the
computation is slightly more complicated than the original version.

14. (Average value Complexico) The Complexico gold mine of Example 12.8 is modified to reflect the average value of gold price in adjacent periods and the discounting of revenue received at the end of each period. As before V i (xi) = KiXi
for all i with KlO = 0 .However, the following adjustments are made

(~!i.t.l.
..
Ki=

)2

2R -R
2,000+R

~
Ki+l

.
1=1,2...,9.

Gold prices follow a process described by u = 1.2, d = 0.9, and q = 0.6667 the
K-values, shown in Fig. 12.4, are calculated by working back from period 9.
The value of the lease is 50, 000 x 305.78 = $15, 288, 786. the value in the original
version was $16,220,000.
15. ("As you like it" option) We use the solutions for the call and the put in the examples in the text. At the end of the third year, we know that the value will be
the maximum of the call or the put value. Hence, we just copy those values from
the examples and then work backward with the standard risk-neutral discounted
valuation process. The table below shows the details. The value is A = $6.73,
which is greater than either the put or the call value.
6.73

8.34
4.83

11.18
4.92
4.81

14.71
6.96
2.45
7.86

CHAPTER12. BASICOPTIONS11IEORY

69

16. (Tree harvesting)

Grcmth

1.6
1.6

1.5
2.4

6
4.5

7.2
5.4
4.05

Lumber Price

1.4
3.36

1.3
4.368

1.2
5.242

1.15
6.028

1.1
6.631

1.05
6.962

1.02
7.101

1.01
7.172

8.64 10.37
12.44
14.93
6.48 7.776 9.331
11.2
4.86 5.832 6.998
8.398
3.6454.3745.2496.2997.558
3.281
3.937 4.724
2.952
3.543
2.657

17.92
13.44
10.08

21.5
25.8
16.12
19.35
12.09
14.51
9.0710.88
6.802
8.163
5.102 6.122
3.826
4.592
2.87 3.444
2.152
2.583
1.937

30.96
23.22
17.41
13.06
9.796
7.347
5.51
4.132
3.099
2.325

5.669
4.252
3.189
2.391

1.743
23.1331.1340.6451.9565.41
81.45
100.6123.4150.7
20.68
28.06
36.81
47.2 59.55
74.23
91.7
18.7325.5733.6743.2654.6568.1684.19103.1124.9
17.27 23.64
31.17 40.07
50.62
16.32 22.28
29.32
37.59
Optimal Value
15.88 21.49 28.19
Bold=cut
16.02 21.14
15.86

112.5
63.15
47.36
35.52
26.64
19.98
14.98

183.2
137.4

222
166.5

77.29 93.68
57.97
70.26
43.48
52.69
32.61
39.52
24.46
29.64
18.34 22.23
13.7616.67
12.5

The first two rows show the growth rate and the cumulative growth by year. The
first lattice shows the price of lumber using an up factor of u = 1.2 and a down
factor of d = .9. The bottom lattice shows the optimal value as a function of
position in the lattice. The risk-neutral probability of an up move is q = ~
(1.1- 0.9)/(1.20.9) = .6667. The value at a typical node is the maximum

=
of

either (1) the market value of the trees or (2) the risk-neutral discounted value of
continuing to the next time. For example, the value at the top node of the second
to last column (in millions) is
max[25.8

x 7.101, (q222 + (1-

q)166.5)IR

-2]

= 183.2.

In this case the maximum was obtained in the first portion of the maximization,
meaning that the trees should be harvested. The value is entered in bold face to
indicate that.

Chapter

1 3

Additional

Option

Topics

1. (Numerical evaluation of normal distribution) The equation is best implemented

on a calculator, spreadsheet, or other computing device. The answer for the call
stated in the exercise is C = $2.57.
2. (Perpetual put)
(a) For the expression P(S) = aIS + a2S-Y we have
p' (S)

aI -)'a2S-Y-I

p" (S)

)'()' + l)a2S-Y-2.

Substituting in the Black-Scholes equation

!0"2)'()' + l)a2S-Y + raIS -r)'a2S-Y

-aIrS

-a2rS-Y

= 0.

Canceling terms we find

!0"2)'()' + 1) -r)'

-r

= 0.

Hence, )' = 2r /0"2 satisfies the equation. Since a I and a2 are arbitrary,
this represents two independent solutions to the second-order differential
equation; and hence is the general solution.
(b) P(oo) = implies aI = 0.
P(G) = K- G implies a2G-Y = K -G leading to a2 = (KP(S) = (K- G) (S /G)-Y .

G)/G-Y. Hence

(c) It makes sense to maximize P(S) since the maximization is independent of S.

We maximize (K- G) GY.Differentiation with respect to G gives the condition
-G-Y + )'(K -G)GY-I

= 0.

Thus G = )'K/()' + 1) and

P(S) = K

(1 -21+)'

71

)(

~
)'K

-y

72

CHAPTER
13. ADDmONALOPnONTOPICS
3. (Sigma estimation) Using the spreadsheet implementation of the previous exerdse, we adjust O"by trial and error to obtain the give call premium. The result is
O"= .251.
4. (Black-Scholes approximation) For S = Ke-rT we find
dl

=
--2

d2

In(e-rT) + (r + 0"2/2)T
O".jf
O".jf
.

-~.O".jf

Hence
C

~
=

S [ ! + u..j'f ] -SerT
2~
SO".jf ~ .4SO"vT.
I;;;
~

e-rT

[!

-u..j'f

2"272"7r ]

For delta we have

6 = N(dl)

~ ~+ ~

~ ~ + .20".jf.

For the call of the example

Ke-rT = 60e-.5/l2 = 57.55.
The value at that value of S is (by the above approximation) .4x.2x 57.55x.J57U =
2.972. The value of 6 at the base point is
6 ~ .5 + .2 x .2..rsTf2 = .5258.
The difference in S is 62- 57.55 = 4.44. Hence the final value is
C ~ 2.97 + 4.44 x .5258 = $5.30.
5. (Delta) Using the options calculator the price of the call at $63 is $6.557. Hence,
6 ~ 6.557- 5.798 = .759.
Changing T to T = 5/12 + .1 we obtain a call price of $6.490. Hence e ~ (6.490 5.798) /0.1 = 6.02.
6. (A spedal identity) This is just the Black-Scholes equation.

CHAPTER
13. ADDmONALOP11ON
TOPICS

73

7. (Gamma and theta)

02C
06
aS2=-as

oS
N'(dl)
-su:!f .

=N'(dl)~
oS

For theta, use Exercise6 to write

e

rC -rS6

rSN(dl)

-~

-~u2s2r
-rKe-rTN(d2)

-rSN(dl)

-~uSN'(dl)/JT

-rKe-rTN(d2).

8. (Great Western CD) It is possible to set up a lattice of possible S&Preturns in the

standard way; however the payoff of the CD depends on the path through this
lattice. Hence it is necessary to use a full tree representation. We use two-month
periods so that the tree will not be too large. In the tree a move across corresponds
to an up move; a move down to the nearest nonzero entry corresponds to a down
move.
The parameters are u = e.2.Ji76 = 1.085, d = l/u.
shown in Fig. 13.1.

The tree of S&P returns is

The tree can be expressed in a filled in form as shown in Fig. 13.2. In this version,
each row represents a distinct path trough the tree. This version simplifies the
computation of the average value along a path (formed from the cells beginning
in the second column).
The risk-neutral valuation is shown in Fig. 13.3. The final column is the total
return of the CD, defined as the average of the S&P returns of the path, or 1,
whichever is larger. The risk-free rate is set arbitrarily at first. It is adjusted (with
a solving program or by trial and error) until the original value is 1.0. Note that
the risk-neutral probabilities will vary as the risk-free rate is adjusted. The final
equivalent interest rate is 7.63%.

74

CHAPTER

13.

ADDmONAL

sig=

0.2

u=
d=

TOPICS

0.55741874

0.44258128

0.92159478

RR.

1.01272205
0.99999999
8.491

Rete=

(Two-month

risk-free

(Risk-neutrel
E-09

(RR

1.08507580

return)

result

(Dillerence

7.63%

1.00000000

q=

1.0850758

Vel=
Error=
Yeerly

ornoN

of

from

Vel

converted

from

to

1.17738905

yeerly

finel
1.

sheet.)

Drive

to

zero.)

rete.)

1.27755812

1.38824497

1.50418059

1.83214985
1.38824497

1.27755812

1.38824497
1.17738905

1.17738905

1.27755612

1.38824497
1.17738905

1.08507560

1.17738905
1.00000000

1.08507580

1.17738905

1.27755812

1.38824497
1.17738905

1.08507580

1.17738905
1.00000000

1.00000000

1.08507580

1.17738905
1.00000000

0.92159478

1.00000000
0.84933893

1.00000000

1.08507580

1.17738905

1.27755812

1.38824497
1.17738905

1.08507580

1.17738905
1.00000000

1.00000000

1.08507580

1.17738905
1.00000000

0.92159478

1.00000000
0.84933693

0.92159478

1.00000000

1.08507580

1.17738905
1.00000000

0.92159478

1.00000000
0.84933893

0.84933893

0.92159478

1.00000000
0.84933693

0.78274448

0.84933693
0.72137322

0.92159478

1.00000000

1.08507580

1.17738905

1.27755812

1.38624497
1.17738905

1.08507580

1.17738905
1.00000000

1.00000000

1.08507580

1.17738905
1.00000000

0.92159478

1.00000000
0.84933893

0.92159478

1.00000000

1.08507560

1.17738905
1.00000000

0.92159478

1.00000000
0.84933893

0.849338930.92159478

1.00000000
0.84933693
0.78274448

0.84933693
0.72137322

0.849338930.92159478

1.00000000

1.08507580

1.17738905
1.00000000

0.92159478

1.00000000
0.84933693

0.849338930.92159478

1.00000000
0.84933693
0.78274448

0.84933893
0.72137322

0.78274448

0.849338930.92159478

1.00000000
0.84933693
0.78274448

0.84933693
0.72137322

0.721373220.78274448

0.84933893
0.72137322
0.68481379

0.72137322
0.61288892

Figure

parameters

13.1

Great

and

Western

the

solution

CD.

This

are

is

shown

the

at

tree

the

of

top.

possible

returns

on

the

S&P

500.

The

CHAPTER

C"PV 01pr.viciu. .h..t but with dupllcel8dnumbers.

13.

ADDmONAL

OPTION

1 i 1.0860768! 1.17738906 1.27766812! 1.38824497! 1.27766812! 1.38824497

1 1.0860768! 1.17739906i 1.27766812! 1.38824497 1.27766812! 1.17738906

;
,

1!

1.0860768;

;
!,

l'
1

1.0860758'
1.17738906
1.0850758! c 1.17738905i

1,1.0850758;

;
!

1; 1.0860768; 1.17738905
1.0850768'
1!1.0850758!1.177389051.0850768:

L:l
j
;

::~::~~::11,1773890~
1 ~ 1.0850768!+
l' 1.0850768'

1
1:

::~::~~::11.1ii3890~
~::~~:::~:1~::::~=::~
1.0850768;" 1.1ii38905i 0.921594i8i1.1i738905
r
1.0850768; 1.17738905' 1.0850768' 1.17738905

!
j,

1
1

1
1

1.0850758!
1.0850758!

1.17738906

1.27766812!

1.17738905:

1.0860758!
1.0850768; c

1.17738906

1.0850768;
1.0850768i

1.17738905
1.17738905

1.0860768'

1.27765812;
, 1.27766812!

1.0860758! 1.17738905

1.38824497
, 1.17738906

1.0850758!1:17i38905

1 1.0860768;
10.92159478!

1
1

"

1.0850768i
1.0850758i

1.17738905
1

1 1.0860758;
)J.),~~~~!~~L
1: 1.0850758;

1 1.0860768;
!.r!:~~~~
10.92159478'

j
;"
;
.,
!

1
1;~
1;
1!

1 i 0.92169478!
1: 0.92159478j
1
1 c 0.92159478!"
1c 0.92159478; , 0.84933893
1 , 0.92159478; 0.84933893! 0.92159478!
1
1 0.92159478i 0,84933893! 0.92159478i 0.84933893

!
j
!
!
!

1i 1.0850758i
1! 0.92169478!
1!0.92159478!
I:Q,92159~78!
1!0.92159478!

10.92169478iO,84933893;0.78274448!0.i2137322
1 1.0850758! 1.17738906i 1.27755812! 1.38824497
1 1.0850758!1.177389061.27755812!1.17738905
11,08507$8(r,)7738905!
1.0860758! 1.17738905
1 1.0860758;1.17738905i
1.0850i58i
1

!
!

1! 0.92159478;
1 0.92159478!

l' 1.0860758;
1 i 1.0860758!

!
!
!
.,

1! 0.92159478!
1! 0.92159478;
1! 0.92159478!

1! 0.92159478i
1 0.92159478i
1 i 0.92159478i

!
!

r,Q,9?169478l
1! 0.92159478!

1 0,92r~9478jO.~~93~~93,Q,782744~8!
Q,84933893
1 0.92159478! 0.84933893; 0.78274448!0.72137322

,
!

1! 0.92159478; 0.84933893 0.92159478'

1: 0.92159478! 0.84933893i 0.92159478!

!
;
!
:
!

1 i 0.92159478! 0.84933893 0.92159478! 0.84933893i

1! 0.92169478! 0.84933893 0.78274448; 0.84933893;
1 i 0.92159478! 0.84933893! 0.78274448! 0.84933893
1; 0:92169478: 0.84933893 0.78274448: 0.84933893'
1 i 0:92159478!0:84933893!0.i82i4448jo:84933893
i

!
!
:

1 0.92159478! 0.84933893 0.78274448! 0.72137322: 0.78274448io:7213i322

1; 0.92159478! 0.84933893 0.78274448! 0.72137322i 0.88481379! 0.72137322
1 i 0.92159478! 0.84933893' 0.78274448! 0.72137322 0.88481379! 0.81258892

'+

0.92169478'

Figure

13.2

shown

in duplicated

Great

Western
form.

1,0.92159478;

1
1

;
:
;

1.0850758i
1.0850768! ,
1.0860758!
1.0850758!

75

!
!

TOPICS

1! 1.0860758;1.17738905

1 i 0.92159478!
1
1! 0.92159478! 0.84933593

0.92169478!

l'

"

0.84933893i
0.84933893

0.92159478'

1 0.92169478;
0.92159478!
0.92169478!
c

0.84933893
1
0.84933893

l' 0.92159478'
1
1 0.92159478! 0.84933893

CD.

This

is

the

tree

Each

row

of

the

sheet

0.i8274448:ij:i2137322
0.92159478;
1
0.92159478i 0.84933893
0.78274448: 0.84933893
0.782i4448: 0.72137322

of

possible

represents

returns

on

a path

through

the

S&P
the

500,
tree.

but

76

CHAPTER

13.

ADDmONAL

Ri.k.Neutrel

ere

0.99999999

ornoN

Valuetion.

averege

of

1.05651643

Celi.

p.th

from

in

finel

previou.

TOPICS

column

.heef.

1.12874264

or

1,

1.19883352

which

ever

1.25972483

i.

maximum.

1.30897438

1.343766

1.30278188

1.23390736

1.26501114

1.23020182

1.15860322

1.199535321.23020182

1.1953925

1.13577814

1.18331241

1.13374757

1.072910971.12532407

1.187858231.19812173

1.16331241

1.104101051.13123232

1.10166748

1.03773908

1.07490761

1.10166748

1.07210264

1.020756281.04485584

1.01974532

0.99591923

1.03741115

1.08222685

1.11273766

1.18855689

1.07442068

1.07490761

1.10186748

1.07210264

1.01078778

1.045714171.07210264

1.0425378

0.99585418

1.01529099

0.972289120.99230094

1.01880965

1.04495564

1.01529099

0.98743777

0.97503335

0.98743777

0.98743777

0.957564230.98487685

1.02256418

1.08993082

1.11176028

1.14131009

1.10850077

1.04800309

1.07442068

1.04465584

0.99230094

1.01880965

1.04485584

1.01529099

0.98743777

0.96572111

0.96036815

0.99713007

1.01760903

0.98743777

0.97503335

0.98743777

0.98743777

0.95069003

0.962784750.97503335

0.98743777

0.98743777

0.97503335

0.98743777

0.98743777

0.962784750.97503335

0.98743777

0.98743777

0.97503335

0.98743777

0.98743777

Figure

adjusted

13.3

Great

until

Western

the

value

CD.

at

the

This

originating

is

the

risk-neutral

node

valuation.

is

1.0

The

interest

rate

used

is

CHAPTER
13. ADDmONALOrnON TOPICS

77

9. (The control variate method) We have

x = Xavg+ a(yavg -y).
Let 0-2 denote the variance of x. Then
0-2 = var(xavg) + 2acov(xavg,Yavg) + a2var(yavg).
Minimization leads immediately to
COv(Xavg,
Yavg)
a---var(yavg)
.
The average values of x and y each contain factors of l/n (where n is the number
of samples). These factors cancel out, giving
cov(x,y)
a-- -var(y)

10. (Control variate application) The simulation can be carried out by moving through
the lattice, selecting the subsequent nodes according to the risk-neutral probabllities. As the simulation is carried out, the sample averages of the unknown x
and the control variate y are calculated The covariance between x and y and the
variance of y are estimated from the samples as well. For instance the estimate
of var(Y) is ~ If:l (Yi -y)2, where n is the number of samples. We use these
estimates to select the parameter a (which may change with n, but in practice
tends to be quite stable).
The results of such a simulation using the standard call option as control variate
are shown in Fig. 13.4. The column headed x is the average of the call price
itself, formed without using the control variate. The column headed by y is the
corresponding estimate of the control variate. The column headed by x estimate
is the estimate of x corrected for the control variate. The final two columns give
the standard deviation (as computed from the formula using sample covariances
and variances) of the two estimates. Notice that using the control variate reduces
the standard deviation by about half.
The same experiment was repeated using the normalized average price as a control variate. Specifically, we used the form
1
Y= {6(SO+SI+S2+S3+S4+SS)-K

} /R s.

The expected value of the one period return is qu + (1 -q)d = R. Hence the
expected value of Y is E(y) = {(1 +R +R2 +R3 +Rs +R6)62 -60}/Rs = 3.171732.
The results are shown in Fig. 13.5.

80

CHAPTER
13. ADDmONALornoN TOPICS

11. (Pay-later options)

(a) We set up a standard price lattice using the parameters u = eu..jKf = e.2Ji7I2 =
1.06. This lattice is shown at the top of Fig. 13.6.
!
:"""
!)

10.7! 11.3! 12.0 12.7 13.5! 14.3 15.1 16.0! 17.0

!
:

!
[StockPrIce

!
:

9.5! 10.1
! 9.0

! 0.25 0.38! 0.57 0.85! 1.23 1.75! 2.40! 3.20 4.09! 5.04!

!
!

! -0.05

-0.06! -0.06! -0.04! 0.04

-0.04! -0.07! -0.10! -0.14

10.7! 11.3!
9.5! 10.1

0.23! 0.59
-0.19! -0.22

0'

12.0
10.7

12.7!
11.3!

1.19
-0.17

2.07!
0.11!

13.5
12.0!

3.00!
0.93

Figure 13.6 Pay-Iateroption. The pay-Iater premium is set so that the original value is zero.
Next we calculate R = 1 + 0.10/12. This gives q = 0.44 as the risk-neutral
probability for an up move. The standard lattice using discounted riskneutral valuation is shown as the second lattice in the figure. The resulting
price of the option is $0.53.
(b) The paylater option lattice is set up exactly the same way except that the final
values are S -K -C, for those cells where S -K is positive, and zero otherwise.
The value C is unknown. We use a solving routine in the spreadsheet (or trial
and error) to adjust the value of C so that the initial price is zero. In this
case that value is $2.04. The corresponding lattice with that value is shown
as the third lattice in the figure.
(c) Obviously the pay-later option premium is higher than that of a standard
option: The premium is not paid until later (meaning there is interest rate
advantage, and more importantly, no premium is paid if the option does not
end up in the money.

CHAPTER

!,

!,
!
!

13.

ADDmONAL

OPnON

TOPICS

81

69.8! 83.5 100! , 120! , 143! , 172, 205 246! , 294! 353, , 422
505
605! , 724
,
:;
: 58.3 69.8!
; 83.5: 100!
" 120:
" 143 172!, 205!; 246: 294 353 422!, 505
!HousePrta
:
48.7! 58.3,69.8!83.5! 100 120! 143, 172! 205 246 294! 353
!
:
! 40.7 48.7! 58.3 69.8 83.5, 100 120: 143, 172 205' 246

, 28.4: 34 40.7!48.7 58.3,69.8 83.5 100, 120

Figure 13.7 California housing put. The put value is remarkably small.

12. (California

housing put)

The calculation is shown on the spreadsheet in Fig. 13.7. The up and down
factors for housing prices are u = eO", d = e-O", using the small6t approximation
(although it is not fully justified

here). This produces the house price lattice.

The mortgage interest rate of 1096defines an amount A that is the yearly payment
per dollar of loan. This is A = .13. This defines the yearly balance which is initially
recorded in the first full row of the spreadsheet.
The value of the put is calculated in the usual backward style using the appropriate risk-neutral
probabilities
(q = .73) and the risk-free rate of 1096. As an
example, the last entry in the third to last column is max[20.7
0 + (1- q)2.38)/1.1]
= 10.5.
The put value is .72 for a loan of $90; which is quite small.

-9.63(1.05),

(q x

82

CHAPTER
13. ADDmONALOPnONTOPICS
We then assume that the bank would like to charge for the put. Hence the new
loan is for $90.72. At 10% the payments of this loan are $11.9 per year. These
payments spread over fifteen years is equivalent to an interest rate of 10.1%. (See
the example on APR in Chapter 3.)
This new rate will change the balance structure of the first row. In fact, the values
shown in the spreadsheet correspond to this 10.1% rate. In theory, these new
balances will change the put value and the whole process must be iterated until
convergerice. However, only this single step is required in this example, because
the put value is so small, and the value does not change except in far out decimal
places. (We have also not accounted for the fact that the full $.72 may not be
recovered if the put option is exercised. The value of this "put on put" is likely
to be extremely small, however, and can safely be ignored.)

13. {Forest value) This solution is identical to that of Exercise 16 in Chapter 12, except
that the risk-neutral probability is q = ~
= (1.1- .9 + .05)/(1.2- .9) = .833.
The value obtained from the modified spreadsheet is $42.42 millions.
14. (Mr. Smith's put) This is straightforward. It turns out that it is never optimal to
exercise the put early. The appropriate lattices are shown in Fig. 13.8.
,

;!
0;!
1i
2;i'
: 0.625:
0.644:
0.664:
:
: 0.607:
0.625:
:
:
: 0.589:
:
:
:
:

15tockPriCe

: 0.017: 0.007
:
: 0.023
:
:
:
:

0.002:
0.01:
0.031:

i PutOption

3;
0.684:
0.644:
0.607:
0.571:

4;
0.7051
0.664:
0.625:
0.589:

5,

0.726:
0.684:
0.644:
0.607:

I 0.5541 g:~~~1 g:~i~1

0:
0:
0:
0.003:
0:
0:
0.015: 0.004:
0:
: 0.041: 0.023: 0.007:

6 ;;
0.748:
0.705:
0.664:
0.625:

0:
0:
0:
0:

I 0.053\ g:g~~i g:g~i

Figure 13.8 Mr. Smith's put. The lattice calculations are standard.

Chapter

14

Interest-Rate

Derivatives

1. (A callable bond)
The calculation of the bond value in part (a) is straightforward The calculation is
shown in the two upper lattices of the spreadsheet in Fig. 1. The value is 91.72.

0.21

0.19,

0.17

I
,

I
!

I
0.1Si

0.18;
0.13;

0.16
0.12

0.1S!
0.11i

0.13,
0.l0

0.00!

0.00

O.OS,

0.04,

0.04

0.03,

0.03,

71.SSl
81.91

72.68
81.99
90.22

84J9
91fJ)l
9722:

Short rate lattice!

,
r
,

,Bond v..u.tionJ

!
,

!
,

!
!

,
!

0.07

O.OS

,
:

91.n!

!
:

84.9S!

,
1
n.77'

l
!

91.76!

97.6S

10237!

",.

10S.77!

90.98
103.47

97.24!
10823!

102.S4! 100.69
1ll.84!
1!4.26

100.581 11!.l8!
l!S.46!
l!S.50!

90.71

84.90!
96.ni

91.~!
97.44
101.S4: 104.78

101.93:
100.00i

Figure

Callable

107.78

108.43:

107.79

100.00

1ll.52
1!4.46

1!0.70!
1!2.4S!

108.81:
100.59

106.00
106.00

100.00, 100.00:
100.00! 100.00,

100.00
100.00

104.88! 100.00
100.00 100.00

L.~~I..!~:!.L.!~,~i!91:~L.!91:~

14.1

83

%.28
106.00
99.7S 100.00
102.S4 100.00

bond.

84

CHAPTER
14. INTEREST-RATE
DERIVAnVES
To find the value with the call feature, we construct a third lattice in a similar way,
except that at each step we compare the discounted risk-neutral value of the next
period with the option of calling the bond, which gives 106. The value is 90.95.
2. (General adjustable formula) First find the payment require, form Chapter 3,
p

ks

= (rks + p)(l + rks + p)100

(l+rks+p)n-k-l
.

After one period the remaining principal will be loaned again. This amount is
Lks = 100[1 + rks + pJ -Pks.
Then the recursion for the value is found by discounted risk-neutral valuation as

Vks =

[ LkS ( 1 + iio

[.5V(k+l).S + .5V(k+l),(s+1)J) + Pks

1 + rks

-100.

3. (Bond futures option) You could set up a futures price lattice as shown in Example
14.4. Then use this as the underlying price lattice and carry out a standard option
backward evaluation.
4. (Adjustable-rate CAP) The same spreadsheet as in the example can be used. It
is only necessary to change the formula for the interest rate used to determine
the loan payments, so that it is capped at 11%. The formulas in the evaluation
lattice do not change, since the bank should still discount by the actual rate. The
resulting two lattices are shown in Fig. 14.2. The answer is $4.20.

!
,

i!,
i

!
,

58.39

Ill!

100;

,
": 40.92 58.39 1Iii " 100!
c
i 32.23i 40.35 57.13 108.6i 100i

!-6.073!-2.496!

-2.635:
,
, 0.033
, 1.294!
: 1.76857 2.7~i 2.634, 1.876!

0
0

Figure 14.2 Auto loan with a CAP of 11%.

5. (Forward construction) The elementary price lattice is constructed using the equations in the text. The value of a zero-coupon bond is found by summing the
elementary prices corresponding to the maturity date. The spot rate is then determined from the value of the zero. The results are shown in Fig. 14.3

alAPTER

!
!
i!
i!,
i

!
!
,
0.060i

DERIVA11VES

0.104
,
O.078i
0.0S8i

0J1)3!
,
omoi
0.052i,

0.084

0.076

0.068

0.063
0.047

0.OS7
0.043

0.051
0.038~

0.061!
!
O.046i
O.034i
,

0.055

0.086
0.06S

0.041
0.031

!
!
i
i,

0.054i

0.049

0.044~

0.039i

0.03S

0.032

0.029

O.026i

0.023

0.020

0.OS7

0J})4

0.118i

0.127

0.122

O,I~
0.223

0.151
0.212

0,167
0,l77!

O.lror
0.136!

0.138
0.(1)8

O,lll
0.068i

i!

i
0.101!

9.046r
0,l90 !

of

forward

I
!

Figure

INTEREST.RATE

!
,
i
0.072i!

I,
!

14.

14.3

Construction

prices

and

determination

of

spot

rates.

85

86

CHAPTER

!a's,

14.

.1.!i1

INTEREST.RATEDERIVAnVES

1I.lIlY!

Y:IW,

,
!

10,
9!

i
:
;
!
i

7!
6:
5,
4!
3!

i
:
,
!
!

1!

8.92!

!
!,

8!
7!
6'

Equations!
:;

4!

!
i

2!
ti

i'

;
ShortRate

ll.~!

,
,

10.77

11.'IJ!

!
!

:
:
,
!
! to.99
9.90!

!
!

1:L./~

1~.U:I! i~.:l/'

,
!

i
i 14.52

i~.:1i

i~.:ll!

l~.!i/,

1~:I:l

14.93
14.78

15.00!
14.85!

15.11
14.96

15.16
15.01

,
!

!
f
;
11.76!
11.64!

!
!
fl~,~:
12.54, 12.96
12.42! 12.83
12.29! 12.70

13.66
13,5Z
13.39
13.25
13.12

13.99!
13.85[
13.72;
13.58 i
13.44!

14.23
14.09
13.95;
13.81
13.67!

14.49
14.34
14.20
14.06
13.92

14.56!
.4.41:
14.27;
14.13!
13.99:

14.66
14.52
14.37
14.23 !
14.09

14.71
14.57
14.42
14.28
14.13

:
:
;
,
!

11.41!

12.05!

12.86

13.18!

13.40!

13.64

13.71!

13.81

13.85

0.002!

0.007 0.015
0.027
0063" 0.039
0069

0.024!
0.047!
0067

0.031
0.05
00
c9

0.035
0.047
0048

0.036!
0.041!
0037 "

12.45

!
!'

!,

0.004 0.014!'
ivvi' , 00270048
; o.\1\17
..;

...;

'

."

..!

0.044! 0.098! 0.131! 0.136 0.12! 0.095! 0.07 0.048! 0.032: 0.02 0.012!

14.4 Term match using

volatility)

From node

( k -1,

or ak + bk(S + 1). The variance

var

i:L~~,

! 0.213' 0.291 0.263! 0.196! 0.131 0.082 0.048! 0.027 0.015 0.008! 0.004! 0.002 0.001
0.464! 0.427: 0.291 0.175: 0.098! 0.053 0.027 0.014! 0.007 0.003 0.002! 8E-04;4E-04 2E-O4!

Figure

6. (Ho-Lee

iU.bb

!(ak
lb2
2

+ bkS)2 + !(ak
-lb2

the Black-Derman-

s) the short

Toy model.

rate next period

is either

ak + bkS

is
+ bk(S + 12-

~[ak

+ bk(S + 1) + ak + bkS]2

1b2

4 k.
Hence the standard deviation is bk/2.

7. (Term match) This can be solved by a simple modification of the spreadsheet in

the Ho-Lee example. We merely change the formula for the short rate to ake'OlS.
The new values of the ak'S are found by optimization as in the earlier example.
The resulting spreadsheet is shown in Fig. 14.4
8. (Swaps) Fig. 14.5 shows three binomial lattices. The first is the short-rate lattice.
The second is the lattice ofvalues for the floating rate payment stream (in hundred
thousands of dollars). Each node value is equal to the amount of interest to be
paid at the end of the year plus the risk-neutral sum of the values in the next two

CHAPTER
14. INTEREST-RATE
DERIVAnVES

87

nodes-all of this discounted by the risk-free rate. For example, the value at the
top of the last column is 100 x .260/1.260 = 20.629; and the value at the top of
the second to last column is [100x.20+ .5 x 20.629+ .5 x 15.250]/1.20 = 31.612.
The final value is $3.979 million.
,,
,
~Q~!'~~~c~~~~~
!

,;
,
1:

0.154

T...
,, 0.260
0.138: 0.125

1
: 0.091
0,071 0.063

9
0.082!
0.057!

0.074
0.051

0.066:
0,046l

I
,
!
Floatingratevalue!
37.308
!,
39.874!
, 28.214
! 40,474 30,240: 20.838

25.751!

21.002

0.060
0.041

; ZO.629
31.612! 15.250
23.72)l 11.077
17.421:
i 7.939
12,586! 5,634

15.019[

7.954

32.558
28.012:
22.330
15.654:
39.790!
": 35.313
29.785:
, 23.338
16.124! 8.153
8.297

Figure 14.5 Determination of swap interest rate.

The third lattice is constructed with a given fixed interest rate A. The values are
the present values of the fixed-rate payments. For example the value at the top
of the second to last column is [100A + .5 x 6.857 + .5 x 7.322] /1.2. The value of
A is adjusted until the initial value of this lattice is equal to that of the one above.
This value is A = 8.64%.
9. (Swaption) To find the value of the swaption, we merely put the minimum of the
two value lattices (from the previous exercise) in the third column. (The case
where this minimum indicates exercise of the swaption is shown in bold in Fig.
14.6.) We then value the lattice backward in the usual way. The value of the
,!

ic 25.751

1 32,581

28,0)2

1.628

jSwaptionValue

Figure 14.6 Evaluation of a swaption

CHAPTER
14. INTEREST-RATE
DERIVAnVES

89

12. (Continuous zero) Since the cash flow is all at time T we have
V(O) = F.[ exp (I:

-r(s)

ds )]

First find that r(s) = ro + uz(s). Hence r(s) is a normal random variable. Next
we need J~ -r(s) ds = -roT- u Jl z(s) ds = -roT- u Z(T). The variable Z(T)
is basically a sum of normal random variables, so it is normal. It has zero mean,
since each z(s) has zero mean. We need the variance of Z(T).
Let S(t) = var Z(t). Then
S(t) = F.[I: z(s) ds ]2.
Hence
~

= 2F.[ z(t) I: z(s) ds ]

And

dZ rt
d2S(t) = 2F.[z(t)2] + 2F. dt
~
Jo z(s) ds .

Since changes in z(t) are independent of z(s) for s < t the second term on the
right of the above is zero. Hence
~ dt2

2var

z(t)

2t

And we find S(t) = t3/3 + at + b. Since S(O) = 0 and S'(O) = 0 it follows that
a = b = 0. Hence S(T) = T2/3.
Since -Z(T)

is normal, with mean zero and variance T3/3 we have

F.[exp(-uZ(T]

= exp[u2T3/6].

Hence
V(O) = exp [ -roT + u2T3/6 ]
which agrees with the Ho-Lee example.

Chapter

1 5

Optimal

Portfolio

Growth

1. (Simple wheel strategy) At each turn, your money will either be multiplied by
3)' + (1- )') = I + 2)' or by 1- )', each with probability one-half. Hence over the
long run, the factor is (1 +2)')n/2(1-)')n/2.
We wish to maximize (1 +2)')(1- )') =
I + )' -2)'2. This is easily found to give)' = 1/4.
2. (How to play the state lottery)
(a) Suppose Victor buys one ticket. His expected logarithm is then
EIn

10-6 In[107 + (105 -1)]

+ (1-10-6)In[105

10-6In107 + (1- 10-6) [In 105- 10-5]

10-6 In 107 + In 105- 10-6 In 105- 10-5

In 105 + [7In10 -5In10

<

In 105.

-1]

-10]10-6

Hence, Victor should not buy a lottery"ticket (even at the 10 to I odds in his
favor!).
(b) Let IXbe the fraction of tickets purchased. The optimal solution maximizes
10-6 In[ 107IX+ 105 -IX] + (1 -10-6) In[105 -IX]
This implies
10-6(107107IX

Approximately,

1)

+ 105 -IX

I -10-6

+=0

105 -IX

10
-- I
107IX+ 105 -105

which has solution IX = 11/100. Victor should invest only 11 cents of his
$100,000 wealth, despite the tempting odds.
3. (Easy policy) The expected logarithm is
~In(2IX + (I-IX)
91

+ ~In(I

+ (I-IX).

92

CHAPTERIS. OYrIMAL PORTFOUOGROwrn

Differentiation

and setting to zero gives

1

!
1-= IX

1+(X

1--

0.

This has solution (X= !.

4. (A general betting wheel)
(a) If sector j occurs on the wheel, the total return is rj(Xj+l~f:l (Xi. where 1Lf=1 (Xi is the fraction of wealth not invested. So, maximizing the expected
log of returns for all sectors gives the problem
n
max 2: pjln(rj(Xj
al,...lXn
..
1=1

n
+ 1- 2: (XJ.
t=I

(b) These are the first-order conditions of differentiating

spect to (X.

the objective with re-

(c) Setting (Xi = Pi in the equation from (b) implies

n
Pkrk
-,
n
-L.
rkPk + 1- Li=1 Pi j=1 rjpj

Pj
,\:,n
.
+ 1- L.i=1 Pj

But since ~f=1 Pi = 1, this requirement reduces to

n
~=2:J!L
Pkrk

j=1 rjpj

which holds if, as assumed, Lj=1 ~ = 1.

J
(d) Since rl = 1, r2 = 2, r3 = 6, we have L;=I ~ = 1. Thus by part (c) an optimal
strategy is (Xi = Pi; that is, (XI = ~' (X2= ~ 1 (X3= ! .So the optimal growth
rate is em = 1.06991; (see Example 15.5).
5. (More on the wheel) From the previous problem, the first-order conditions imply
n
,

Pkrk

Pj

=L.
f or k =1,2,...n-l
rk(Xk + (Xo j=1 rj(Xj + (Xo
where (Xo = 1- ~f=1 (Xi. Dividing both sides by rk and summing over k = 1, 2, ..., n1 we have

n-l
2:

Pk

k=1 rk(Xk + (Xo

( )(
n-l
2:

..!.

i=1 rk

2:
n

Pj

j=1 rj(Xj + (Xo

CHAPTERIS. OPTIMALPORTFOUOGROWTH
(a) Using the fact that Lk-::;t :k = 1-

!; and lXn = 0, we can simplify

93

to get

n
L rklXkPk+ lXO.
~Pnrn = k=l
Thus, we have
Pkrk
= ~
rk lXk + lXO
lXO
which implies

lXk =

-J:.-

Pnrn
Finally,

since

Lk=llXk

= 1 -lXO we find

lXk = Pk --orPnrn
rk

rk

lXO.

lXO = Pnrn

and

k = 1, 2, ..., n -1.

(b) For the specific wheel

lXl

pumping)

lX2

lX3

---=

Since Vi = Jli -!Ui2

v

n
L WiJli -!
i=l

.23-

3.3

6. (Volatility

---=

18

3.6

18

for each stock, we have Jli = .23. Thus,

L~j WiUijWj

-2 12 [ Ui~j(n2 -n)

+ nu ii] .

n
Since Ui~j = .08 and Uii = Ui2 = .16, we have v = .19- ~.
7. (Dow Jones Average puzzle) Keeping the certificates in his drawer is equivalent to
following a "buy and hold" strategy. The Dow Jones Average, on the other hand,
"sells" some portion of stocks when they get high (and split) and the proceeds
of the "sale" are used to buy other stocks in the Average. This is a weak form of
pumping, and so we expect that the DowJones Average will out-perform the buy
and hold strategy (and it does).
8. (power utility)
(a) We know that returns combine according to weight in the portfolio. Hence,
letting B(t) be the value of a bond at time t, we have
~X(t)

-~
-w

S(t)

+ (1- w )~B(t)

(r + w(Jl-

r) dt + wudz.

94

CHAPTER15. OPTIMAL PORlFOUO GROWfH

It follows that X(t) is lognormal with mean Tt + w(J1 -T)t
standard deviation WO"Jf. In other words,
X(t)
(b) We have immediately
U(X(t

-!W20"2t

and

= X(0)ert+w(IJ-r)t-~w2u2t+wnu..ff.
that

= !X(y'
)1

= ~e>'[rt+w(IJ-r)t-~w2u2t+wnu..ff].
)1

Hence the expected value is

E [U(X(t)]

= !E[X(y']
)1

(C) The first-order

conditions

= ~e>'[rt+w(IJ-r)t-~w2u2t]+~>'2w2u2t.
)1
are
dE [U(X(t)
dw

] =

0.

Or equivalently
0 = E [U(X(t)

) ] [)1t(J1 -T)

-W0"2yt

+ W0"2)12t].

Hence
)1t(J1- T) = wyt0"2(1

-y)

which yields
w=

J1-T
0"2(1- y)

as stated.
9. (Discrete-time

log-optimal

(a) The log-optimal

pricing

portfolio

formula)

is defined by the problem

n
max E[ In (1 + 2:: TiXi -(1i=l
The first-order

conditions

Ti

are
-T

E T+roThis is equivalent

]=0

for t. = 1,2,...,n.

to
E[TiPO] -TfE[Po]

Using the relation

n
2:: Xj)Tf ) ].
j=l

= 0.

E[TiPO] = COV(Ti,PO) + riE[Po],

as
-COV(Ti,PO)
T.t -Tf = which is the stated result.

E[Po ]

the above can be written

CHAPTER15. OPTIMALPORTFOUOGROWfH

95

(b) We have
( .-r
Jlt

)At = -COV(nim,
1/(1 + JloAt + nom))
E[I/(I+JloAt+nom)]

Using, in the numerator, the approximation

that the denominator approaches 1, we find
(Jli -rf)At

= O"i,oAt.

Hence,
II.
,..t

-r

1/(1 + x) ~ 1-

= (T.
t, o.

.
x, and noting

Chapter

16

General

1. (A state

Investment

Analysis

tree)

Security

1.2

1.0

0.8

1.2

1.3

1.4

To find the short-term riskless asset, we note that for any portfolio with weights
(XI, (X2with (XI + (X2= 1, the payoff factor for state 1 is 1.2. Hence if there is a
riskless return it must be 1.2. We therefore solve the equations
(XI + 1.3(X2 =

1.2

.8(XI + 1.4(X2 =

1.2

This has solution (XI = 1/3, (X2 = 2/3. Since (XI + (X2 = 1 it is a portfolio, and
hence defines a riskless asset.
Yes, there is an arbitrage: buy security 2 and subtract the same amount of security
1.
2. (Node separation)
1.21

1.21
1.1

1.0

1.1
A tree must be used to represent the growth of $1 because the middle node
separates.

97

98

QIAPTER16. GENERAL
INVESTMENT
ANALYSIS
3. (Bond valuation)
(a) The appropriate lattice is

100,{

The value at the top node at time 1 is VII = (.5 + .5)/1.1 = .9091. The value
at the lower node is VIO = (.5 + .5)/1 = 1.0. Finally, the value at the initial
node is
Voo = .5 x .5(.9091 + 1.0)/1.1 = $0.8678.
(b)
I $1 + 4L2l
I $1 + 4U
I $1 + 4U
I $1 = $0.8678.
voo = 4L2l
4. (Optimal option valuation) In each period we have the the following maximization
problem
m:x { PI ~(Xu + (1- (X)Ro+ P2~(X+ (1- (X)Ro+ P3~(Xd + (1- (X)Ro} .
The solution is (X = 1.01. The corresponding risk-neutral probabilities are qI =
.218, q2 = .635, and q3 = .148. The option lattice is almost identical to that of
the example in the text. The value of the call is found to be $5.8070.
5. (Gold correlation) We wish to find the qij'S. The gold fluctuation is modeled as
a binomial lattice with u = 1.2, d = .9. The interest rate has u = 1.1 and d = .9
with risk-neutral probabilities of .5. The initial interest rate is 4%. The risk-neutral
probability for gold is
qUg = l+r-d d = .46667.

uTo find the risk-neutral probabilities for each of the four successornodes, we
need a total of four equations,but we only have three equations so far (the two
individual risk-neutral probabilities and the fact that the sum of all four probabilities is 1.) Wemust first find the real probabilities and then use the invariance
theorem to get the final equation.

CHAYI'ER16. GENERALINVESTMENTANALYSIS
Let S' and r' denote the S(k + 1) f S(k) and r(k + 1) fr(k),

respectively.

99

Then we

calculate
(InS']

.6In(I.3)

+ .4 In(0.9)

= .067

(Inr']

.7In(I.I)

+ .3 In(.09)

= .035

var(InS']

.6(Inl.2)2

var(Inr']

.7(Inl.l)2

cov(InS',Inr')

-(InS']2

= .02

+ .3(InO.9)2 -(r']2
= .008
1
p(var(InS')var(Inr')}2
= -.005

We can now solve for the Pij'S (letting

correspond

+ .4(InO.9)2

i = gold, j = interest

rate).

We let "1 "

to an "up" move.
Pll + P12

.6

Pll + P21

.7

P21 + P22

.4

Pll(Inl.2)(Inl.l)
+P22(InO.9)2

P12(Inl.2)(InO.9)

cov(InS',Inr')

+ P21(InO.9)(Inl.l)
+(InS')((Inr')

This yields Pll = .33 P12 = .27 P21 = .37 P22 = .03
We now have the following

set of equations for the qij'S

qll + q12

qua = .46667

qll + q21

qur = .5

qll + q12 + q21 + q22

PIIP22

qllq22
q12q21
The solution

is qll

P12P21

= .1 q12 = .36 q21 = .4 q22 = .14.

6. (Complexico mine) This problem can be solved by combining the methods for
solving example 16.4 and example 12.8. A set of spreadsheets is required. The
answer is $14.898 (in millions).
7. (Simultaneous solution) We use a numerical Black-Scholes calculator and find S
and u so that the prices of the two options match the given data. Using a time to
maturity of T = .25 and interest rate of 7% we find S = $16.81 and u = 20.6%. It
would be more appropriate
the standard

to use a formula

for options

on futures,

rather than

option formula.

8. (Default risk) We may treat the default risk as risk-neutral risk because it is independent of the interest-rate process and because we seek the zero-level price.

100

CHAPTER16. GENERALINVESTMENTANALYSIS
(a)
10

10

10

10

110

~~~~~

In this case
p = 100 X

( .::i!:.- )
1.1

+ L

k=l

(~

1.1

= $65.17.

(b) Evaluation can be done recursively using

Vt,s = Ct,s+

1 -21 (.9Vt+l,s + .9Vt+l,S+1).

+ rt,s

This produces vo,o = $63.25.

9. (Automobile choice) We set ao = 111000. Hence ak = ao(1.05)-5 = 11(1000.
(1.05)k). We know from the CE formula that for uncertain cash flows at time j,
the CE at time j -1 is equal to the discounted CE at time j .
For car B:
CEB= -35, 000- ~

In (.5e-~12,OOO
+ .5e-~8,OOO)= -$27, 761.78.

For car A: We must use two stages. The certainty equivalent of the second car, as
evaluated when that car is purchased is
CEA2= -20,000-

~In(.5e-~lO,OOO

+ .5e-~5,OOO)= -$14,718.54.

The total certainty equivalent at year 2 is therefore either-$14, 177.19+$10, 000 =

$4,177.19 or -$14, 177.19 + $5, 000 = $9,177.19 each with probability .5.
Hence the overall certainty equivalent of car A is
CEA = -20, 000- -a!w In ( e-a210,OOO+CEA2
+ .5e-a25,OOO+CEA2
) = $28, 132.52.
Hence car B is preferred and the difference in certainty equivalence is $370.74.
10. (Continuco mine simulation) The results of one simulation are shown below. The
corresponding (average) value is $22.5 million.