Exercise Session 10, Nov 24th ; 2006

Mathematics for Economics and Finance

Prof: Norman Schürho¤
TAs: Zhihua (Cissy) Chen, Natalia Guseva

Exercise 1 Assume a one-year Treasury bond o¤ ers a safe annual rate of re-
turn of 10%. You are about to lend $1 million to a risky company. The loan
maturity is one year. (a) What is your expected rate of return if you decide to
charge 10%, but the company pays $750.000 in case of default (fails to pay all
that it has promised), which happens with probability of 50%, otherwise the com-
pany is solvent (pays back the principal plus interest). (b) What is the interest
rate you need to charge to break even.
Exercise 2 Show that for any random variable X, with mean and …nite vari-
1
ance 2 ; > 0 and any constant k > 0; P (jX j<k ) 1 k2 :

Exercise 3 The monthly return of AMERICATEL a company traded at the

NASDAQ, has been observed for a long period of time and tabulated at the last
day of the month. It is found to have mean 12 and standard deviation of 2.
What is the probability that in the next observation the return is greater than 8
but less than 16 ?
x2
Exercise 4 Consider the pdf de…ned by f (x) = p12 e 2 , x 2 ( 1; 1):Show
(a) It is well de…ned pdf function.
(b) Suppose the stock return you have invested follows the above distribution.
Find the expected value for your stock return.
(c) What is the variance and the skewness of your stock return?
Exercise 5 Assume a random variable X follows exponential distribution with
e x; x 0
pdf: f (x; ) = :
0 x<0
(a) Compute cdf, mean , variance and E(euX ). (b) Show X is memoryless
w.r.t t; which means P (X > s + t j x > t) = P (X > s); for all s; t 0.
Exercise 6 Assume after you graduate from HEC, you …nd a job in UBS as
a trader. Since you have no inside information about the market movement,
you need to update your belief according to the latest buy or sell transaction.
Suppose investors in stock markets can be classi…ed by two di¤ erent group of
people: rational investors and crazy investors with probability 70% and 30%.
The action of crazy investors does not convey any information. Crazy investors
would buy or sell stocks with 50% possibility. Rational investors would buy
stocks only when they receive a good signal. Assume the probability for rational
investors who would buy stocks is 60%. Could you identify the probability of
rational investor based on a buy transaction?
Exercise 7 Exercise Session 9, Q2,Q4.