Investment Science

Chapter 2
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>

2.1
(a) ($1)(1.033)227 = $1, 587.70
(b) ($1)(1.066)227 = $1, 999, 300.00
2.2
We are given that (1+r)n = 2, so that taking the log of both sides, we have n ln (1 + r) = ln 2 0.69.
Using the first suggested approximation, we have that nr n ln (1 + r) 0.69. Since i = 100r, we
must have that ni 69. Thus n 69/i.
If we use the more accurate approximation, we have that nr(1 0.5r) 0.69. Now, if r 0.08,
then (1 0.5r) 0.96 and so we must have 0.96n (100r) = 0.96ni 69 and we have n 72/i.
2.3
Note that the rates calculated below are also commonly refered to as the Annual Percentage
Rates (APRs), for example, on your monthly credit card statement.
(a) (1 + 0.03/12)12 1 = 3.04%
(b) (1 + 0.18/12)12 1 = 19.56%
(c) (1 + 0.18/4)4 1 = 19.25%

2.4
Iteration
0
1
2
3

1
2/3
13/21
78/329

f ()
1
1/9
377/441
...

f 0 ()
3
7/3
47/21
...

2.5
First, denote the present value of the annual payment in the nth year (for n = 0, . . . , 19) by P Vn .
Since the interest rate is 10%, we must have
P Vn (1 + 0.10)n = $500, 000,
so that
P Vn = $500, 000/(1.1)n .
Summing each yearly payment from n = 0 (since payment starts immediately) to n = 19, we arrive
at the net present value of the lottery, denoted by P V and given by
PV =

19
X

P Vn =

n=0

19
X

$500, 000/(1.1)n .

n=0

Recognizing the series on the right as a geometric series, we arrive at

P V = ($500, 000)(11)(1 (1/1.1)20 ) $4, 682, 460.

2.6
First we consider the six month analysis. For simplicity, assume that Plan A is to remain in
the first apartment and that Plan B is to switch to the second apartment. Under Plan A, the
monthly cash flows are given as follows:
(1000, 1000, 1000, 1000, 1000, 1000),
and the present value of these cash flows are given by
P VA = 1000

5
X
n=0

1
.
(1 + 0.12/12)n

Note the fact that we divide the annual interest rate by 12 to arrive at the monthly interest rate.
Then solving the geometric series on the right, we have
P VA = $5, 853.43.
Under Plan B, the monthly cash flows are given as follows:
(1900, 900, 900, 900, 900, 900),
and the present value of these cash flows are given by
P VB = 1000 900

5
X
n=0

1
.
(1 + 0.12/12)n

Note that this implies the following relationship between P VA and P VB :

P VB = 0.9P VA 1000 = $6, 268.09,
so we conclude that the couple should not switch.
Now we consider the one year analysis. The cash flows for Plan A are given by:
(1000, 1000, 1000, 1000, 1000, 1000, 1000, 1000, 1000, 1000, 1000, 1000),
and the cash flows for Plan B are given by
(1900, 900, 900, 900, 900, 900, 900, 900, 900, 900, 900, 900),
so the only thing that changes when calculating P VA is that we sum from n = 0 to n = 11 since
the window of time is now twelve months. Keeping this fact in mind, we arrive at
P VA = 1000

11
X

1/(1 + 0.12/12)n = $11, 367.63,

n=0

and as before,
P VB = 0.9P VA 1000 = $11, 230.87,
so we conclude that the couple should switch.
The break-even point is about eleven months, though you were not expected to determine that.
2.7

In Example 2.4, we determined that the biggest NPV (using a 10% discount rate) was attained
by waiting two years to cut the trees. The cash flow stream for this option was (1, 0, 3). We
know that waiting three years is not better from an NPV perspective, so that N P V (1, 0, 3)
N P V (1, 0, 0, x) for some cash flow x. This means
N P V (1, 0, 3) = 1 + 3/1.12 1 + x/1.13 = N P V (1, 0, 0, x),
so that x $3.3.
2.8
First, we construct the cash flow stream corresponding to the change from Plan A to Plan B.
In the first year we spend $30, 000 to buy the copier (Plan B) instead of spending $6, 000 to
lease. Thus, in first year the incremental charge is $24, 000. For each of the next four years,
we spend only $2, 000 instead of $8, 000 for an incremental benefit of $6, 000. Finally, there
is a resale value of $10, 000 when we buy the copier. Thus, our cash flow stream is given by
(24000, 6000, 6000, 6000, 6000, 10000). The IRR is the rate r that satisfies the following equation:
24 = 6/(1 + r) + 6/(1 + r)2 + 6/(1 + r)3 + 6/(1 + r)4 + 10/(1 + r)5 .
We can solve the above equation using Newtons method to obtain r = 11.84%. Since this is higher
than the prevailing rate (10%), we should buy instead of lease (choose Plan B).
2.9
You have a choice: fix the roof now or wait for five years. The roof must be replaced every 20
years regardless. Clearly, you will save money by waiting. The question is, how much? If you dont
wait, you will pay $20, 000 every 20 years for the rest of eternity. This cash flow stream is given by
(20000, 20000, 20000, ...) where the period is 20 years and the rate is 1.0520 1. The present value
of that stream must be equal to

X

k
20000
1/1.0520 .
k=0

Instead, if we wait five years, we have a cash flow stream that looks exactly the same, but does not
begin for five years. The present value of that stream is
5

20000/1.05

X

k
1/1.0520 .

k=0

Taking the difference of the two cash flow streams, we have

20000 1 1/1.05

X

1/1.0520

k

= 20000 1 1/1.055

k=0

1
$6, 948.17.
1 1/1.0520

2.10
(a)
Year
1
2
3
4
5

Option 1
352,000
308,000
220,000
100,000
25,000

Option 2
400,000
350,000
250,000
150,000
50,000

Depletion Allowance
400,000
350,000
250,000
150,000
50,000

Taxable Income
800,000
650,000
250,000
50,000
0

Tax
360,000
292,500
112,500
22,500
0

After-Tax Income
840,000
707,500
387,500
177,500
50,000

(b) NPV and IRR using after-tax income:

N P V (0, 840000, 707500, 387500, 177500, 50000)@20% $1, 521, 000
IRR(1000000, 840000, 707500, 387500, 177500, 50000) 52.79%
2.11
Year
0
1
2
3
4
5
IRR
NPV@5%

Project #1
-100
30
30
30
30
30
15.24%
$29.88

Project #2
-150
42
42
42
42
42
12.38%
$31.84

According to the IRRs, Project # 1 is better. However, the opposite is true when considering
NPVs. To explain the difference note the following. Project #2 costs $50 more than Project #1.
Thus, one could borrow $150, invest $100 in Project #1, earn $29.88 plus the original $50 to have
$79.88, which is better than Project #2.
2.12
We must have that
5

A1 = B1

n
X

ck1 ,

k=1

and
A2 = B2

n
X

ck2 .

k=1

Note that by the IRR Theorem, there are unique positive values c1 and c2 that satisfy the two
equations above. Now observe that
A1 /B1 =

n
X

ck1 <

k=1

n
X

ck1 = A2 /B2 .

k=1

Since c1 and c2 are both positive, we must have that c1 < c2 . Therefore, the IRRs, denoted by r1
and r2 , respectively, must satisfy
r1 = 1/c1 1 > 1/c2 1 = r2 .

2.13
(a) We need to prove that there exists a value c > 0 such that Px (c) = Py (c). That is,
n
X

xk ck =

k=0

Rearranging terms, we have

P (c) =

n
X

yk ck .

k=0

n
X

xk ck

k=0

n
X

yk ck = 0.

k=0

Since x0 < y0 , we must have that P (0) = x0 y0 < 0. Furthermore, since

n
X

xk >

k=0

we must have that

P (1) =

n
X

n
X

yk ,

k=0

(xk yk ) > 0.

k=0

Since the continuous function P satisfies the following: P (1) > 0 and P (0) < 0, we must have that
there exists a c (0, 1) such that P (c) = 0. This means that r = 1/c 1 > 0.
(b) We solve
100 + 30

n
X

ck = 150 + 42

k=1

n
X

ck ,

k=1

which yields c = 0.946, so that r = 5.7%.

2.14
Let the amount of the purchase be denoted by A. The ACRS method gives us the following NPV:


N P V1 = A 0.25 + 0.38/(1 + r) + 0.37/(1 + r)2 ,
while the alternate ACRS method give us:


N P V2 = (A/3) 1 + 1/(1 + r) + 1/(1 + r)2 .
Taking the difference, and doing some algebra (left to the reader), we arrive at
N P V2 N P V1 = A (1/12r + 12/100) r/(1 + r)2 ,
which is always positive for r > 0. Thus, the alternate ACRS method (straight-line) is always
better.
2.15
First, without inflation (all dollar amounts in thousands):
Year
0
1
2
3
4
5

Pre-Tax Income
0
3300
3300
3300
3300
3300

Costs
10000
310
310
310
310
310

Depreciation
0
2000
2000
2000
2000
2000

Taxable Income
0
990
990
990
990
990

Now, with 4% inflation (all dollar amounts in thousands):

Tax
0
337
337
337
337
337

After-Tax Income
-10000
2653
2653
2653
2653
2653
NPV@12%=-435

Year
0
1
2
3
4
5

Pre-Tax Income
0
3300
3432
3569
3712
3861

Costs
10000
310
322
335
349
363

Depreciation
0
2000
2000
2000
2000
2000

Taxable Income
0
990
1110
1234
1363
1498

Tax
0
337
377
420
464
509

After-Tax Income
-10000
2653
2732
2814
2900
2989
NPV@12%=89

Investment Science
Chapter 3
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>

3.1
Use
A=

rP
1

1
(1+r)n

with r = 7/12 = 0.58%, P = $25, 000, and n = 7 12 = 84, to obtain A = $377.32.

3.2
Observe that since the net present value of X is P , the cash flow stream arrived at by cycling X is
equivalent to one obtained by receiving payment of P every n + 1 periods (since k = 0, . . . , n). Let
d = 1/(1 + r). Then

X
P = P
(dn+1 )k .
k=0

Solving explicitly for the geometric series, we have that

P =

P
.
1 dn+1

Denoting the annual worth by A, we must have

A=

rP
,
1 dn

so that solving for P as a function of P and substituting the result into the equation for A, we
arrive at


1 dn+1
A=r
P .
1 dn
1

That is, A is directly proportional to P .

3.3
(a) To find the life expectancy, we multiply each age of death by its probability. Thus the life
expectancy is
L = 90 0.07 + 91 0.08 + + 101 0.04 = 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
1
P =
1
,
r
(1 + r)n
with n = 5 and n = 6, we find that P95 = $39, 927 and P96 = $46, 228. Then, taking P =
0.87 P95 + 0.13 P96 (the average of the two values, weighted by fraction of the interval), we have
P = $40, 746.
(c) To find the expected present value fo the annuity, we calculate the probabilities qi of survival
to various ages i. For example, q90 = 1.0, q91 = q90 0.07 = 0.93, etc. For each year greater than
90, we evaluate $10, 000 qi /1.08i90 . Hence the expected net present value is
N P V = $10, 000

101
X
i=91

qi
= $38, 387.
1.08i90

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.
3.4
First, find the monthly payment M at the APR of 8.083% using the annuity formula, as
M=

0.08083 360
0.08083
12 (1 +
12 )
$203, 150
0.08083 360
(1 + 12 ) 1

= $1, 502.41.

Next, find the intial balance for this monthly payment at the interest rate of 7.875%, given by
!
12
1
$1, 502 = $207, 209.13.
B=
1
360
0.07875
(1 + 0.08083
12 )
2

The total fees are the difference between the initial balance and the amount of the loan: $207, 209.13
$203, 150 = $4, 059.13.
3.5
After five years, the payment the company needs to make if excercising the call provision is
P5C = (1 + 0.05) Face Value = 105.
Exercising the call provision is advantageous, so
100
10
105 < P5 =
+
15
(1 + )

1
1
(1 + )15


.

Therefore, the YTM then is lower than 9.366%.

3.6
(a) Monthly payment:
m=

0.1
0.1 360
12 (1 + 12 )
360 1
(1 + 0.1
12 )

$100, 000 = $877.57

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

(b) Bi-weekly payment m/2 = $438.79. Let n be the number of periods. Then
$100, 000 = $438.79

n
(1 + 0.1
26 ) 1
0.1
0.1 n
26 (1 + 26 )

Hence n = 545 or 20.95 years. Total interest is 545 $438.79 $100, 000 = $139, 140.55. The
savings in total interest over the monthly program is $76, 784.65 or 35.6%.
3.7
First, amortize the present value of $22,487 over four years which gives AA = $9042 per year.
Second, amortize the present value of $37,582 over four years which gives AB = $9914 per year.
Since AA < AB , car A should be purchased.
3.8

(a) A = $100, 000

0.08(1.08)30
1.0830 1

= $8.882.74

(b) P5 = $8882.74

(1.08)25 1
0.08(1.08)25

= $94, 821.26

(c) A0 = $94, 821.26

0.09(1.09)25
1.0925 1

(d) 94, 821.26 = 8882.74

mortgage is 43 years.

= $9, 653.40

(1.09)n 1
0.09(1.09)n

yields n 38 years, which means that the total life of the

3.9
Straightforward use of the formula for a bond price (assuming coupons every six months) gives 91.17.
3.10
Use the formula to obtain 6.84 years.
3.11
Using N P V = A/r, we have
(1 + r) dP V
,
NPV 
dr

r(1 + r)
A2
1+r
=

=
.
A
r
r

D =

Hence,
DM =

1
D
= .
1+r
r

3.12
(a)
PA = 885.84,
PB = 771.68,
PC

= 657.52,

PD = 869.57
4

(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 = N P V,
DA VA + DB VB + DC VC + DD VD = 2N P V,
where N P V is the present value of the obligation.
(e) Use bond D.
VC + VD = N P V,
DC VC + DD VD = 2N P V,
where
NPV =

2, 000
= $1, 512.29.
1.152

Solving VC = $756.15 and VD = $756.15.

(f) None
3.13

dP
d

n
X

etk tk Ck = DP

k=0

3.14

This follows directly from the Macaulay duration formula by setting = my and noting that the
second term in the formula goes to zero as n goes to infinity.
3.15
We begin with
n(n + 1)P
1
,
2
P (1 + (/m))
m2

C =
and define T = n/m to arrive at
C =

1
T (T + (1/m)),
P (1 + (/m))2

so that as m , we find that C T 2 .

3.16
(a) We have that
P () =

ct dt () dt(),

P 00 () =

ct t(t + 1)dt ()d2 () t(t + 1)dt()d2 ().

Therefore,
P 00 (0)(1 + r)2 =

ct t2 dt +

ct tdt t2 dt tdt,

t
2

ct t dt t dt (by the second condition).

Since
X

ct dt dt =

ct dt dt = 0 (for all ),

and
X
t

tct dt tdt =

(t)ct dt (t)dt = 0 (for all ),

it follows that
P 00 (0)(1 + r)2 =

ct (t2 + t + )dt (t2 + t + )dt.

(b) Let = 2t and = t2 + 1. Then t2 + t + = (t t)2 + 1, which has a minimum at t and

has a value of 1 there.
X
ct (t2 + t + )dt (t2 + t + )dt,
P 00 (0)(1 + r)2 =
t

ct dt dt = 0.

Therefore, P 00 (0) 0.

Investment Science
Chapter 4
Solutions to Suggested Problems
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>

4.1
(One forward rate)
f1,2 =

(1 + s2 )2
1.0692
1=
1 = 7.5%
(1 + s1 )
1.063

4.2
(Spot Update)
Use
(1 + sk )k
=
1 + s1


f1,k

1/(k1)
1

.
Hence, for example,
(1.061)6
=
1.05


f1,k

1/5
1 = 6.32%

.
All values are
f1,2 f1,3 f1,4 f1,5 f1,6
5.60 5.90 6.07 6.25 6.32

4.3
(Construction of a zero)
Use a combination of the two bonds: let x be the number of 9% bonds, and y teh number of 7%
bonds. Select x and y to satisfy
9x + 7y = 0,
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, respectively. The price is P = 3.5 101.00 + 4.5 93.20 =
65.90.
4.5
(Instantaneous rates)
(a) es(t2 )t2 = es(t1 )t1 eft1 ,t2 (t2 t1 ) = ft1 ,t2 =
(b) r(t) = limtt1

s(t)ts(t1 )t1
tt1

d[s(t)t]
dt

s(t2 )t2 s(t1 )t1

t2 t1

= s(t) + s0 (t)

(c) We have
d(ln x(t)) = r(t)dt,
= s(t)dt + s0 (t)dt,
= d[s(t)t].
Hence,
ln x(t) = ln x(0) + s(t)t,
and finally that
x(t) = x(0)es(t)t .
This is in agreement with the invariance property of expectation dynamics. Investing continuously
give the same result as investing in a bond that matures at time t.
4.6
(Discount conversion)

The discount factors are found by successive multiplication. For example,

d0,2 = d0,1 d1,2 = 0.950 0.940 = 0.893.
The complete set is 0.950, 0.893, 0.770, 0.707, 0.646.
4.7
(Bond taxes)
Let t be the tax rate, xi be the number of bond i purchased, ci be the coupon of bond i, pi be the
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
x1 c1 + x2 c2 = 0.
Next, we require that the after tax final cash flows match. Hence
p0 = x1 p1 + x2 p2 .
Using this last relation in the equationfor final cash flow, we find
x1 + x2 = 1.
Combining these equations, we find that
p0 =

c2 p1 c1 p2
.
c2 c1

After plugging in the given values, we find that

p0 = 37.64.

4.8
(Real zeros)
We assume that with coupon bonds there is a capital gains tax at maturity. We replicate the zerocoupon bonds after-tax cash flows using bonds 1 and 2. Let xi be the amount of bond i required
3

(for i = 1, 2). We require:



100c1 (1 t)x1 + 100c2 (1 t)x2

(100 (100 p1 )t + 100c1 (1 t))x1 + (100 (100 p2 )t + 100c2 (1 t))x2
p1 x1 + p2 x2


100 p0
=
t,
n


100 p0
= 100
t,
n
= p0 .

Setting
p1 = 92.21,
p2 = 75.84,
t = 30%,
c1 = 0.10,
c2 = 0.07,
n = 10,
we find that x2 = 5.25428 and p0 = 32.767.
4.9
(Flat forwards)
For i < j,
(1 + r)i (1 + fi,j )ji = (1 + r)j .
Hence,
(1 + fi,j )ji = (1 + r)ji ,
which implies that fi,j = r.
4.10
(Orange County blues)
We make the following three assumptions. First, the portfolio is restructured annually to maintain
a duration of 10 years. Second, the value of money borrowed is maintained at $12.5 billion every
year. Finally, Orange County makes interst on deposit at the rate which prevailed at the beginning
of the given year.
4

Year 1 P

= 20(1.085) +

r =
Year 2 P

r =
Year 3 P

r =
Year 4 P

r =
Year 5 P

r =
Year 6 P

r =

10(20)(0.005)
12.5(0.07) = 21.75,
1.085

21.75 20
= 23.33%,
20 12.5
10(21.75)(0.005)
(21.75)(1.08) +
12.5(0.065) = 23.68,
1.08
23.68 21.75
= 20.86%,
21.75 12.5
10(23.68)(0.005)
(23.68)(1.075) +
12.5(0.06) = 25.81,
1.075
25.81 23.68
= 19.02%,
23.68 12.5
10(25.81)(0.005)
(25.81)(1.07) +
12.5(0.055) = 28.14,
1.07
28.14 25.81
= 17.51%,
25.81 12.5
10(28.14)(0.02)
(28.14)(1.065) +
12.5(0.05) = 24.06,
1.065
24.06 28.14
= 26.09%,
28.14 12.5
10(24.06)(0.02)
(24.06)(1.06) +
12.5(0.045) = 20.80,
1.06
20.80 24.06
= 28.20%,
24.06 12.5

Money left after 6 years = 20.7912.57.5 = 0.79. If invested in a bank = 7.5(1.06)(1.055)(1.045)(1.4)(1.06)

7.5 = 2.64.
4.11
(Running PV examples)

(a)

d0,1
d0,2
d0,3
d0,4
d0,5
d0,6
0.9524 0.9018 0.8492 0.7981 0.7472 0.7010

Year
Cash Flow
(b)
Discount
PV(n)

0
40
0.9524
9.497

1
10
0.9469
51.970

2
10
0.9416
44.324

34
10
0.9399
36.453

= N P V = 9.497

5
10
0.9362
28.144

6
10
10
9381
19.381 10.000

4.12
(Pure duration)

P () =

n
X

xk (1 + sk /m)

k=0

dP ()
d

1 dP ()
P () d

n
X


k
xk (1 + s0k /m)e/m
,

k=0

k
m



k
m

xk

k=0

n
X

n
X

xk

(1 + s0k /m)e/m

k1

(1 + s0k /m)e/m ,

(1 + sk /m)k ,

k=0


Pn
k
k
k=0 xk m (1 + sk /m)
Pn
k
k=0 xk (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.
4.14
(Mortgage division)
(a)


k1

P (k) = B rM (k 1) = B r (1 + r)
= (1 + r)k1 (B rM ),
6


M (0)

(1 + r)k1 1
r

 
B ,

We are looking for

V

n
X
P (k)
=
,
(1 + r)k
k=1

n
X
(1 + r)k1 (B rM )

(1 + r)k

k=1

n(B rM )
.
1+r

(b) Plug the expression for B into the result found in part (a) to obtain


n
r(1 + r)n M
V =

rM
,
1 + r (1 + r)n 1


n
rM
=
.
1 + r (1 + r)n 1

(c)

n
X
k=1

I(k)
,
(1 + r)k

n
X
B P (k)
k=1

(1 + r)k

n
X

!
1
= B
V,
(1 + r)k
k=1



r(1 + r)n M
(1 + r)n 1
=
V,
(1 + r)n 1
r(1 + r)n
= M V.

(d) It should be clear that V 0. (Use LHopitals rule if it is not obvious.)

(e) We know P (k) = (1 + r)k1 (B rM ). Clearly B rM > 0. (This follows from part (a).) So
P (k) is increasing in k and I(k) = B P (k) must be decreasing in k. Remember that duration is a
7

weighted sum of the times k, with the weights being proportional 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 values of k.
4.15
(Short-rate sensitivity)
In general,
Pk1 () = ck1 +

Pk ()
.
1 + rk1 +

Differentiation at = 0 leads to
Sk1 =

Pk
Sk
+
.
2
(1 + rk1 )
1 + rk1

Hence,
ak =
bk =

1
,
(1 + rk1 )2
1
,
1 + rk1

and this process, together with

Pk1 = ck1 +

Pk
,
1 + rk1

is initiated with Pn = cn and Sn = 0; and the two processes are worked backward to k = 0. S0 is
the final result.

Investment Science
Chapter 6
Solutions to Suggested Problems
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>

6.1
The money invested is X0 . The money received at the end of a year is X0 X1 + X0 . Hence,
R =

2X0 X1
.
X0

6.3
For solution method, see solution to Problem 6.4 in this solution set.
(a) = 19/23
(b) The minimum standard deviation is approximately 13.7%.
(c) The expected return of this portfolio is approximately 11.4%.
6.4
Let and equal the percent of investment in stock 1 and stock 2, respectively. The problem is:
min, 2 12 + 212 + 2 22
s.t. + = 1.

Setting up the Lagrangian, L, we have:

L = 2 12 + 212 + 2 22 ( + 1).
The first order necessary conditions are:
L
= 212 + 212 ,

L
= 222 + 212 ,
0=

1 = + ,
0=

which imply
=

22 12
.
12 + 22 212

The mean rate of return is simply m1 + m2 .

6.5
(a) The expected rate of return equals
(0.5)(3)(106 ) + (0.5)u
.
106 + 0.5u

(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
expected rate of return equal to
3
1 = 20%.
2.5

6.6
(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. The since the assets are
uncorrelated, we have
n
X
var(total investment) =
wi2 i2 ,
i=1

where the weights sum to 1. Setting up the Lagrangian, we have

!
n
n
X
X
2 2
L =
wi i
wi 1 ,
i=1

i=1

so that the first-order necessary conditions imply

, i = 1, . . . , n,
2

wi i2 =
or wj =

.
2j2

Since the weights sum to 1, we have

=

2
Pn

1
i=1 i2

which implies
wj

2
, j = 1, . . . , n,
j2

where

2 =

1
Pn

1
i=1 i2

The minimum variance is

2
min
=

n
X

wi2 i2 =
2.

i=1

6.7
(a) First solve for the vi s from
2v1 + v2
= 1,
v1 + 2v2 + v3 = 1,
+ v2 + v3 = 1.
3

This yields v1 = 0.5, v2 = 0, and v3 = 0.5. This solution happens to be normalized, so also
w1 = 0.5, w2 = 0, and w3 = 0.5.
(b) In this case, we solve
2v1 + v2
= 0.4,
v1 + 2v2 + v3 = 0.8,
+ v2 + v3 = 0.8.
This yields v1 = 0.1, v2 = 0.2, and v3 = 0.3. This solution must be normalized, to arrive at
w1 = 1/3, w2 = 1/6, and w3 = 1/2.
(c) We find the vi s by the formula vi = vib rf via where the vib s and the via s are the solutions from
parts (b) and (a) above, respectively. Thus, v1 = 0, v2 = 0.2, and v3 = 0.2. This solution must be
normalized, to arrive at w1 = 0, w2 = 1/2, and w3 = 1/2.
6.8
(a)
var(r rM ) = var(r) 2cov(r, rM ) + var(rM ),
n
n
X
X
2
=
i j ij 2
i iM + M
.
i,j=1

So, to minimize var(r rM ) subject to

i=1

n
X

i = 1,

i=1

set up the Lagrangian

L=

n
X

i j ij 2

n
X

i,j=1

i iM +

2
M

i=1

n
X

!
i 1 .

i=1

The first order necessary conditions imply

n
X

j ij 2iM + = 0, i = 1, . . . , n,

j=1
n
X

i = 1.

i=1

(b) Similar to (a) with the added constraint that

n
X

i ri = m.

i=1

So, the first order necessary conditions imply

n
X

j ij 2iM + + ri = 0, i = 1, . . . , n,

j=1
n
X

i ri = m,

i=1
n
X

i = 1.

i=1

Investment Science
Chapter 7
Solutions to Suggested Problems
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>

7.1
(a) r = 0.07 +

0.230.07

0.32

= 0.07 +

(b) i. = 0.64, ii. Solve 0.07w + 0.23(1 w) = 0.39, yielding w = 1. Hence, borrow $1000 at the
risk-free rate; invest $2000 in the market.
(c) $1182
7.2
(a)
2
M

2
AM

2
AB
=

A =
B =

1 2
2
( + 2AB + B
),
4 A
1 2
( + AB ),
2 A
1
2
(AB + B
),
2
2 +
A
AB
,
2
M
2 +
B
AB
.
2
M

(b)
5
rA = 0.1 + (0.18 0.1) = 20%,
4
3
rB = 0.1 + (0.18 0.1) = 16%.
4

7.3
(a) Using the two-fund theorem and noting that the market portfolio cannot contain assets in
negative amounts, we have
1
1
w+ v =
2
2
2w v =

0.7 0 0.3

T

with a return of 0.1,

0.4 0.6 0

T

with a return of 0.16,

so the expected rate of return of the market portfolio rM is bounded as follows: 0.1 rM 0.16.
(b) Since rM rmin var portfolio , we have 0.12 < rM 0.16.
7.4
From (6.9) we have
n
X

2
M i wi = M
= rM rf .

i=1

Hence,
=

rM rf
.
2
M

Furthermore,
n
X

ki wi = kM = rk rf .

i=1

Substituting the expression for into the above equation, we arrive at our objective.

7.5
We have
i =

xi i2
iM
P
=
n
2
2
M
j=1 xj j

for all i = 1, . . . , n, since the assets are uncorrelated.

7.6
The market consists of $150 in shares of A and $300 in shares of B. Hence, the market return is
1
2
rM = (150/450)rA + (300/450)rB = rA + rB .
3
3

(a) 0.13
(b) 0.09
2 + 2
(c) AM = 31 A
3 AB A B = 0.0105, A = 1.2963

(d) Since Simpleland satisfies the CAPM exactly, stocks A and B plot on the security market line.
Specifically, rA rf = A (
rM rf ). Hence, rf = 0.0625.
7.7
(a) Let p be a portfolio such that p = (1)w0 +w1 . Then, p2 = (1)2 02 +2(1)01 +2 12 .

d 2 
, we have 0 = 202 + 201 which implies that A = 1.
So, since 0 = dp 
=0
 2 
0
(b) 0 = 1z = (1 )01 + 12 implies (using (a)), = 2
< 0.
2
0

(c) The zero-beta portfolio is on the minimum variance set but below the minimum variance point.
(d) =

iM
i M

= ri = rz +

i
rM
M (

rz ) = 0.09 + (0.5)(0.5/0.15)(0.15 0.09) That is, ri = 10%.

Investment Science
Chapter 10
Solutions to Suggested Problems
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>
10.1
We are given that S = $412, M = 3 (quarters), and r = 9% (compounded quarterly). The
storage cost is $2 per ounce per year, so ck = $0.50 for each quarter k = 0, 1, and 2 (at the
beginning of the quarter). We use the formula:
F=

M 1
ck
S

d 0,3 k =0 d k , M

along with the following intermediate results:

d 0,3 =

d 1,3 =

d 2,3 =

to arrive at

0.09
1
4

0.09
1
4

0.09
1
4

= 0.9354

= 0.9565

= 0.9780

F = $ 440.45$ 0.5345$ 0.5227$ 0.5112 = $ 442.02

10.2
There is a typo in the text. The exponent M should be -M in the formula.
Suppose at time zero you:
1.
2.
3.
4.

borrow S(0)
buy 1 unit of the asset for S(0)
take a short position of (1-q)M units at a forward price of F per unit
at the beginning of each period, sell q units of the asset to pay the cost of carry

Note that the total cash outlay for these actions is zero.

10.2 (continued)
At the time of delivery, you have (1-q)M units of the asset remaining. Then you do the
following:
1. make delivery and receive F(1-q)M as payment
2. repay your loan with S(0)/d(0,M)
Your total profit is F(1-q)M S(0)/d(0,M). If this amount is anything but zero (negative
or positive), then you have made a profit (or received a loss) without making any
investment (i.e., without taking any risk). Thus, consistent with our assumption that
arbitrage opportunities do not exist, the profit must be zero. Here, we have glossed over
the case where the profit is negative. Technically speaking, a negative profit is possible
in this example, however if you were to reverse each position in above analysis, you
would have a new investment strategy that has a positive arbitrage return. Thus, the
profit must be exactly zero and we arrive at the answer.
F=

S 0
d 0, M 1qM

10.3
In general, the spot and forward prices are related by:
M 1

S = Fd 0, M c k d 0, k
k =0

If the yield curve is flat, and with forward contracts being settled at the end of the month,
this formula can be written for any maturity date M as:

S=

M 1

r
12

k =0

ck

r
12

So, taking any two maturities, we can solve for the spot price and the interest rate. In
particular, by taking the forward prices for April and July we have the equations:
S=

406.50 20

12
r
1
12

409.3

20
S=

4
12
r
1
12

M 1

k=0

r
12

Solving the equations simultaneously we obtain:

S =403.15, r=0.05
Other contract dates give the same results.
10.4
There is a typo in the text. The exponent r-q should be r+q in the formula.
In order to solve this problem, we assume that the interval of time from 0 to T is divided
into n discreet time intervals of length T/n. Next we proceed as in Exercise 2.
Suppose at time zero you:
1.
2.
3.
4.

borrow S(0)
buy 1 unit of the asset for S(0)
take a short position of e-qT units at a forward price of F per unit
at the beginning of each period, sell qT/n units of the asset to pay the cost of carry

Notice that the cost of carry at the beginning of the kth period is qT/n, not q. This is
because here (unlike in Exercise 2), q is defined as the cost of carry per unit time. This is
a subtle but significant difference. If xk denotes the number of units of the asset held at
time tk=Tk/n, then taking limits as n becomes increasingly large, we must have
T
x= x k x k 1 , t = ,
n
x k = x k 1qx k 1

x
T
dx
qT

=qx
=qx x T =e
n
dt
t

Note that the total cash outlay for these actions is zero.
At the time of delivery, you have e-qT units of the asset remaining. Then you do the
following:
1. make delivery and receive Fe-qT as payment
2. repay your loan with S(0)erT
Your total profit is Fe-qT S(0)erT. If this amount is anything but zero (negative or
positive), then you have made a profit (or received a loss) without making any investment
(i.e., without taking any risk). Thus, consistent with our assumption that arbitrage
opportunities do not exist, the profit must be zero. Here, we have glossed over the case
where the profit is negative. Technically speaking, a negative profit is possible in this
example, however if you were to reverse each position in above analysis, you would have
a new investment strategy that has a positive arbitrage return. Thus, the profit must be
exactly zero and we arrive at the answer.
F =S 0erqT

10.7
We solve first for Ft, the current forward price of the bond:
2
d 0, k c k
S
Ft =

= $ 831.47
d 0,2 k =1 d 0,2

Now we solve for the value of the forward contract:

f t = F t F 0 d 0,2=$ 100.34

10.12
We obtain the mean-variance hedge formula by maximizing:
E [ xh F T F 0 ]r var [ xhF T ]

which is the same as maximizing

E [ x ]h F T F 0 r var [ x ]2 hcov [ x , F T ]h 2 var [ F T ]
Taking the derivative with respect to h we obtain the first order condition that:
FT F 02 r cov [ x , F T ]2 hr var [ F T ]=0

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

h=

FT F 0
2 r var [ F T ]

cov [ x , F T ]
var [ F T ]

10.13
The minimum variance hedge is
h= w=

G S G
150,000=131,250
O S O

Hence the farmer should short 131,250 pounds of orange juice. To check how effective
this hedge is, we note that
new = 1 old = 0.714 old
2

10.14
We have the future cashflow y = ST W + (FT F0) h.
(a) The equal and opposite hedge h is given by an opposite equivalent dollar value of the
hedging instrument. Therefore h = -kW where k is the price ratio between the asset and
the hedging instrument. By taking this hedge position, the cashflow received at the future
date can be written as
y=W S T k F 0 F T
where its variance is given by
2y = W 2 var [ S T kF T kF 0 ] = W 2 2S 2 k ST k 2 2F
Hence

y = W S 12 k

ST
2S

k 2

2F
2S

(b) In example 10.12, we have k = K/M = 0.262, thus the equal and opposite hedge for
the receivable W = 1,000,000 Danish Krone is h = -262,000 Deutsche Marks and the
standard deviation of the future cashflow y is given by

y = W K 12 k

KM
2K

2M
2K

K
K
= 12 M
M K
M
2
x

2M
2K

so that
y = 0.7211 x
As expected, the standard deviation with the equal and opposite hedge is greater than with
the minimum variance hedge for which we determined
y = 0.6 x

Investment Science
Chapter 11
Solutions to Suggested Problems
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>
11.1
We are given that
S 0=$ 100,
=0.12,
=0.20,
t=0.25,

so that

u=e t =1.105,
1
d = =0.905,
u
1 1
p=
t=0.65,
2 2

and the binomial lattice is given by

149.10
Probability = 17.9%
134.90
122.10
122.10
110.50
Probability = 38.4%
110.50
100
100
100
90.50
Probability = 31.1%
90.50
81.90
81.90
74.10
Probability = 11.1%
67.10
Probability = 1.5%

11.2
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 = w k K 1i
i=0

So
E [ W K ]= E

[
11

i=0

w k K 1i =12 ,

[
11

Var

i=0

]
2

w k K 1i

=12

11.3
(a) Proof: For n = 2,
2

12 0,

which implies

122 1 2224 1 2.
That is,
2
1
12 1 2,

so

AG.
(b) Since r1=50% and r2=-20%, the arithmetic mean is
1
r r =0.15
2 1 2
and the geometric mean is
1
2

[ 1r 1 1r 2 ] 1=0.0954
(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.
11.4
w

w w

1
[2 2 ww 22 w w w 22 2 w 2 2 w 4 4 ]
2 2
2
2
1
2
= 2 [ w w
] w

2
2
=

So
u

=
=
=

e
e

2
w

2
2

e w e ww / 2 dw
2
2

2
2
[ w w
] /2

e
2

dw

11.5
Suppose that u = ew, where w is distributed as
2

Nw
,

then
E [ u2 ]

E [ e2 w ]

e2 w e ww / 2 dw
2
2

and following the method in exercise 11.4, we have

2 w

w w

2 2

2
1
2
2
w
w
2

2 w

[
]

2
2
2

so that
E[u

2 22 w

and
var [ u ]

E [ u ] u
2

2 2 w

e 1
2

11.6
We have

1
2
2

1
0.2 0.16
2

0.12

so
E [ ln S 1 ]
E [ S 1 ]

=
=

Stdev [ ln S 1 ]
Stdev [ S 1 ]

0.12,
1.22,

=
=

0.40
0.51

11.7
We have G(t) = F(s, t) = S1/2(t), then
F
S

2S

F
S2

1
4 S3

and therefore according to Ito's Lemma, we must have that

dG t =
=

2 S

a S

1
8S

b 2 S 2 dt

1
1
1
a b 2 G dt bG dz
2
8
2

1
2S

b S dz

Investment Science
Chapter 12
Solutions to Suggested Problems
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>
12.1
The initial cost of the spread is nonnegative since C(K1) C(K2) for K1 < K2 (see 12.4).
12.2
Use the same portfolio as in the text:
1. buy one call
2. sell one put
3. lend an amount d K
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 = S D.
12.3
Q

=
=

max {0, S K }max {0, K S }K ,

S K 0 K , if S K
0 K S K , if S K

= S.

12.4
1. Assume K2 > K1, and suppose to the contrary that C(K2) > C(K1). Buy option 1 and
sell option 2. Use option 1 to cover the obligations of option 2, since we have that
max{0, S- K1} max{0, S- K2} for all S. Keep profit of C(K2) C(K1).
2. Assume K2 > K1, and suppose to the contrary that K2 K1 < C(K1) C(K2). Buy
option 2 and short option 1 to obtain K2 K1 + profit (where >0). Use option 2 and
profits K2 K1 to cover option 1 since we may conclude that
max {0, S K 2 } K 2 K 1 = max { K 2 K 1, S K 1 } max {0, S K 1 }.

3. Assume K3 > K2 > K1 and suppose to the contrary that

C K 2

K 3K 2
K 2 K 1
C K 1
C K 3 .
K 3 K 1
K 3 K 1

Buy (K3 K2)/(K3 K1) of option 1 and (K2 K1)/(K3 K1) of option 3 and short one
unit of option 2. The profit is some >0. Notice that

K 3K 2
K K 1
C K 1 2
C K 3
K 3K 1
K 3K 1

and that

K 3K 2
K K 1
S K 1 2

K 3K 1
K 3K 1

S K 2

S K 3

K 3K 2
K K 1
C K 1 2
C K 3 0
K 3 K 1
K 3K 1

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

arbitrage opportunity, so the original inequality cannot hold.
12.6
The payoff of (A) purchase one call is always greater than or equal to the payoff of (B)
purchase one share of stock and sell K bonds. Hence, the price of (A) must be greater
than or equal to the price of (B). Thus, C S KB(T). However, the value of a call is
always greater than or equal to zero. Thus, C max{0, S KB(T)}.
12.7
From Exercise 6, C max{0, S KB(T)}. Since the limit of B(T) is zero as T approaches
infinity, the limit of C(S, T) is the greater than or equal to that of max{0, S KB(T)} as T
approaches infinity, which is S. Clearly, the price of a call option must be less than or
equal to that of the underlying. Thus, in the limit, C = S.
12.9
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, and 0. Roll back one stage. The three nodes there have
implied values 27, 9, and 0. Roll back one more stage. The implied values there are 15
and 3, which can be written as 12+3 and 0 + 3. Hence, the implied value of the initial
node is 4 + 3 = 7. The result can also be found by direct risk-neutral valuation (without
rolling back the lattice) 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.

Investment Science
Chapter 13
Solutions to Suggested Problems
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>
13.1
The equation is best implemented on a computer. The answer for the call stated in the
exercise is C = $2.57.
13.2
(a) For the expression P(S) = a1S + a2S- we have
1

P ' S

a 1 a 2 S

P ' ' S

1 a 2 S

Substituting in the Black-Scholes equation and canceling terms we find that

1 2
1 r r=0
2

Hence, = 2r/^2 satisfies the equation. Since a1 and a2 are arbitrary, this represents two
independent solutions to the second-order differential equation; and hence is the general
solution.
(b) P() = 0 implies a1 = 0.
P(G) = K G implies a2G- = K G leading to a2 = (K G)/G-.
Hence, P(S) = (K G)(S/G)-
(c) It makes sense to maximize P(S) since the maximization is independent of S. We
maximize (K-G)G-. Differentiation with respect to G gives the condition
G K G G 1 = 0.
Thus, G = K/(+1) and

P S =K 1
1

1 S
K

13.3
Using the spreadsheet implementation of the previous exercise, we adjust by trial and
error to obtain the given call premium. The result is = 0.251.

13.4
For
rT

S =K e

we find

rT

d1

ln e

T
2

d2

r / 2 T

T
2

Hence
C

T
1 T
rT rT 1

S e e

2 2 2
2 2 2

S T
0.4 S t
2

For delta, we have

= N d 1

1 t
1

0.2 t
2 2 2
2

For the call of the example, we have

rT

Ke

0.5/12

= 60 e

= 57.55

The value at that value of S is (by the above approximation) C = 2.972. The value of at
the base point is 0.5258. The difference in S is 62 57.55 = 4.44. Hence, the final value
is 2.972 + 4.44 * 0.5258 = 5.30.
13.5
We calculate the price of the call at $63 to be $6.557; hence, 6.557 5.798 = 0.759.
Setting the expiration time T as follows, T = 5/12 + 0.1, we obtain a call price of $6.490.
Hence, (6.490 5.798)/0.1 = 6.02.
13.6
This is just the Black-Scholes equation.

13.7

=
=
=

2 C
2
S
N d 1
S
N ' d 1

=
=

S
d1
N ' d 1
S

S T

For theta, use Exercise 6 to write

1
rC rS 2 S 2
2

1
rSN d 1 rK erT N d 2 rSN d 1 S N ' d 1 / T
2
SN ' d 1
=
rK erT N d 2
2 T
=