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Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1

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Problems: Chapter 1

With one dollar, you can buy 500 red hots and no rock candies point A!, or 100 rock candies and no red hots point "!, or any combination o# red hots and rock candies any point alon$ the opportunity set line A"!.

0.' X + 1Y = 100

(hat is, the money spent on candies, )here red hots sell #or 0.' cents a piece and rock candy sells #or 1 cent a piece, cannot e*ceed 100 cents +1.00!. Sol,in$ the abo,e e&uation #or - $i,es:

X = 500 5Y

)hich is the e&uation o# a strai$ht line, )ith an intercept o# 500 and a slope o# 5.

.lton, /ruber, "ro)n and /oet0mann Modern Portfolio Theory and Investment Analysis, 1th .dition Solutions to (e*t Problems: Chapter 1

".

2ndi##erence 3ap

"elo) is one indi##erence map. (he indi##erence cur,es up and to the ri$ht indicate $reater happiness, since these cur,es indicate more consumption #rom both candies. .ach cur,e is ne$ati,ely sloped, indicatin$ a pre#erence o# more to less, and each cur,e is con,e*, indicatin$ that the rate o# e*chan$e o# red hots #or rock candies decreases as more and more rock candies are consumed. 4ote that the e*act slopes o# the indi##erence cur,es in the indi##erence map )ill depend an the indi,idual5s utility #unction and may di##er amon$ students.

(he indi,idual can consume e,erythin$ at time ' and nothin$ at time 1, )hich, assumin$ a riskless lendin$ rate o# 106, $i,es the ma*imum time7' consumption amount: +'0 8 +'0 1 8 0.1! % +9'. 2nstead, the indi,idual can consume e,erythin$ at time 1 and nothin$ at time ', )hich, assumin$ a riskless borro)in$ rate o# 106, $i,es the ma*imum time71 consumption amount: +'0 8 +'0 1 8 0.1! % +:;.1;

.lton, /ruber, "ro)n and /oet0mann Modern Portfolio Theory and Investment Analysis, 1th .dition Solutions to (e*t Problems: Chapter 1

'

(he indi,idual can also choose any consumption pattern alon$ the line A" the opportunity set! belo).

(he opportunity set line can be determined as #ollo)s. Consumption at time ' is e&ual to the amount o# money a,ailable in time ', )hich is the income earned at time ', +'0, plus the amount earned at time ' #rom any money in,ested at time 1, +'0 C1! 1 8 0.1!: C' % +'0 8 +'0 C1! 1.1! or C' % +9' 1.1C1 )hich is the e&uation o# a strai$ht line )ith an intercept o# +9' and a slope o# 1.1.

".

2ndi##erence 3ap We are $i,en that the utility #unction o# the indi,idual is: U C 1, C ' ! = 1 + C 1 + C ' + C 1C ' 50

A particular indi##erence cur,e can be traced by settin$ U C1,C'! e&ual to a constant and then ,aryin$ C1 and C'. "y chan$in$ the constant, )e can trace out other indi##erence cur,es. <or e*ample, by settin$ U C1,C'! e&ual to 50 )e $et: CC 1 + C 1 + C ' + 1 ' = 50 or 50C 1 + 50C ' + C 1C ' = '950 50

.lton, /ruber, "ro)n and /oet0mann Modern Portfolio Theory and Investment Analysis, 1th .dition Solutions to (e*t Problems: Chapter 1

(his indi##erence cur,e appears in the $raph o# the indi##erence map belo) as the cur,e labeled =50> the lo)est cur,e sho)n!. "y settin$ U C1,C'! e&ual to 10, )e $et the cur,e labeled =10,> etc.

C.

Solution

(he optimum solution is )here the opportunity set is tan$ent to the hi$hest possible indi##erence cur,e the point labeled =.> in the #ollo)in$ $raph!.

(his problem is meant to be sol,ed $raphically. "elo), )e sho) an analytical solution: CC U C 1, C ' ! = 1 + C 1 + C ' + 1 ' 50 Substitutin$ the e&uation o# the opportunity set $i,en in part A #or C' in the abo,e e&uation $i,es:

9'C 1 1.1C 1 50

'

(o ma*imi0e the utility #unction, )e take the deri,ati,e o# U )ith respect to C1 and set it e&ual to 0ero: dU 9' '.'C 1 = 1 1.1 + =0 dC 1 50 50 )hich $i,es C1 % +11.;'. Substitutin$ +11.;' #or C1 in the e&uation o# the opportunity set $i,en in part A $i,es C' % +':.50.

Chapter 1: Problem : 2# you consume nothin$ at time 1 and instead in,est all o# your time71 income at a riskless rate o# 106, then at time ' you )ill be able to consume all o# your time7' income plus the proceeds earned #rom your in,estment: +5,000 8 +5,000 1.1! % +10,500. 2# you consume nothin$ at time ' and instead borro) at time 1 the present ,alue o# your time7' income at a riskless rate o# 106, then at time 1 you )ill be able to consume all o# the borro)ed proceeds plus your time71 income: +5,000 8 +5,000 1.1! % +?,595.95 All other possible optimal consumption patterns o# time 1 and time ' consumption appear on a strai$ht line the opportunity set! )ith an intercept o# +10,500 and a slope o# 1.1: C' % +5,000 8 +5,000 C1! 1.1! % +10,500 1.1C1

Chapter 1: Problem 9 2# you consume nothin$ at time 1 and instead in,est all o# your )ealth plus your time71 income at a riskless rate o# 56, then at time ' you )ill be able to consume all o# your time7' income plus the proceeds earned #rom your in,estment: +'0,000 8 +'0,000 8 +50,000! 1.05! % +?:,500.

2# you consume nothin$ at time ' and instead borro) at time 1 the present ,alue o# your time7' income at a riskless rate o# 56, then at time 1 you )ill be able to consume all o# the borro)ed proceeds plus your time71 income and your )ealth: +'0,000 8 +50,000 8 +'0,000 1.05! % +;?,09@.1' All other possible optimal consumption patterns o# time71 and time7' consumption appear on a strai$ht line the opportunity set! )ith an intercept o# +?:,500 and a slope o# 1.05: C' % +'0,000 8 +'0,000 8 +50,000 C1! 1.1! % +?:,500 1.05C1

Chapter 1: Problem 5 With Aob 1 you can consume +:0 8 +50 1.05! % +;'.50 at time ' and nothin$ at time 1, +50 8 +:0 1.05! % +@;.10 at time 1 and nothin$ at time ', or any consumption pattern o# time 1 and time ' consumption sho)n alon$ the line A": C' % +;'.50 1.05C1. With Aob ' you can consume +90 8 +90 1.05! % +;'.00 at time ' and nothin$ at time 1, +90 8 +90 1.05! % +@;.10 at time 1 and nothin$ at time ', or any consumption pattern o# time 1 and time ' consumption sho)n alon$ the line CB: C' % +;'.00 1.05C1.

(he indi,idual should select Aob 1, since the opportunity set associated )ith it line A"! dominates the opportunity set o# Aob ' line CB!.

Chapter 1: Problem 1 With an interest rate o# 106 and income at both time 1 and time ' o# +5,000, the opportunity set is $i,en by the line A": C' % +5,000 8 +5,000 C1! 1.1! % +10,500 1.1C1 With an interest rate o# '06 and income at both time 1 and time ' o# +5,000, the opportunity set is $i,en by the line CB: C' % +5,000 8 +5,000 C1! 1.'! % +11,000 1.'C1

Cines A" and CB intersect at point . )here C' % time7' income % +5,000 and C1 % time7 1 income % +5,000!. Alon$ either line abo,e point ., the indi,idual is lendin$ consumin$ less at time 1 than the income earned at time 1!D alon$ either line belo) point ., the indi,idual is borro)in$ consumin$ more at time 1 than the income earned at time 1!. Since the indi,idual can only lend at 106 and must borro) at '06, the indi,idual5s opportunity set is $i,en by line se$ments A. and .B.

Chapter 1: Problem @ <or P % 50, this is simply a plot o# the #unction C ' =

50 C 1 . 1+ C1 100 C 1 . 1+ C1

Chapter 1: Problem ; (his problem is analo$ous to Problem '. We present the analytical solution belo). (he problem could be sol,ed $raphically, as in Problem '. <rom Problem :, the opportunity set is C' % +10,500 1.1C1. Substitutin$ this e&uation into the pre#erence #unction P % C1 8 C' 8 C1 C' yields: ' P = C 1 + +10,500 1.1 C 1 + +10,500C 1 1.1 C1 dP = 1 1.1 + +10,500 '.'C 1 = 0 dC 1 C1 % +9,@@'.1; C' % +5,'50.05 Chapter 1: Problem ? Cet X % the number o# pi00a slices, and let Y % the number o# hambur$ers. (hen, i# pi00a slices are +' each, hambur$ers are +'.50 each, and you ha,e +10, your opportunity set is $i,en al$ebraically by +'X 8 +'.50Y % +10 Sol,in$ the abo,e e&uation #or X $i,es X % 5 1.'5Y, )hich is the e&uation #or a strai$ht line )ith an intercept o# 5 and a slope o# 1.'5. /raphically, the opportunity set appears as #ollo)s:

Assumin$ you like both pi00a and hambur$ers, your indi##erence cur,es )ill be ne$ati,ely sloped, and you )ill be better o## on an indi##erence cur,e to the ri$ht o# another indi##erence cur,e. Assumin$ diminishin$ mar$inal rate o# substitution bet)een pi00a slices and hambur$ers the lo)er the number o# hambur$ers you ha,e, the more pi00a slices you need to $i,e up one more bur$er )ithout chan$in$ your le,el o# satis#action!, your indi##erence cur,es )ill also be con,e*.

A typical #amily o# indi##erence cur,es appears belo). Althou$h you )ould rather be on an indi##erence cur,e as #ar to the ri$ht as possible, you are constrained by your +10 bud$et to be on an indi##erence cur,e that is on or to the le#t o# the opportunity set. (here#ore, your optimal choice is the combination o# pi00a slices and hambur$ers that is represented by the point )here your indi##erence cur,e is Eust tan$ent to the opportunity set point A belo)!.

Chapter 1: Problem 10 2# you consume C1 at time 1 and in,est lend! the rest o# your time71 income at 56, your time7' consumption C'! )ill be +50 #rom your time7' income plus +50 C1! 1.05! #rom your in,estment. Al$ebraically, the opportunity set is thus C' % 50 8 50 7 C1! 1.05! % 10'.50 7 1.05C1 2# C1 is 0 no time71 consumption!, then #rom the abo,e e&uation C' )ill be +10'.50. 2# C' is 0, then C1 )ill be +?@.1'. /raphically, the opportunity set appears belo), alon$ )ith a typical #amily o# indi##erence cur,es.

Chapter 1: Problem 11 2# you consume C1 at time 1 and in,est lend! the rest o# your time71 income at '06, your time7' consumption C'! )ill be +10,000 #rom your time7' income plus +10,000 #rom your inheritance plus +10,000 7 C1! 1.'0! #rom your in,estment. (he opportunity set is thus C' % +10,000 8 +10,000 8 +10,000 7 C1! 1.'0! % +:',000 7 1.'C1 2# C' is 0 no time7' consumption!, then you can borro) the present ,alue o# your time7' income and your time7' inheritance and spend that amount alon$ )ith your time71 income on time71 consumption. Sol,in$ the abo,e e&uation #or C1 )hen C' is 0 $i,es C1 % +'1,111.1@, )hich is the ma*imum that can be consumed at time 1. Similarly, i# C1 is 0 no time71 consumption!, then you can in,est all o# your time71 income at '06 and spend the #uture ,alue o# your time71 income plus your time7' income and inheritance on time7' consumption. <rom the abo,e e&uation, C' )ill be +:',000 )hen C1 is 0, )hich is the ma*imum that can be consumed at time '. Chapter 1: Problem 1' 2# you consume nothin$ at time ', then you can borro) the present ,alue o# your time7' income #or consumption at time 1. 2# the borro)in$ rate is 106 and your time7' income is +100, then the present ,alue at time 1! o# your time7' income is +100F 1.1! % +?0.?1. Gou can borro) this amount and spend it alon$ )ith your time7 income o# +100 on time71 consumption. So the ma*imum you can consume at time 1 is +?0.?1 8 +100 % +1?0.?1. 2# you consume nothin$ at time 1 and instead in,est all o# your time71 income o# +100 at the lendin$ rate o# 56, the #uture ,alue in period '! o# your period 1 income )ill be +100 1.05! % +105. Gou can then spend that amount alon$ )ith your time ' income o# +100 on time7' consumption. So the ma*imum you can consume at time ' is +105 8 +100 % +'05. With t)o di##erent interest rates, )e ha,e t)o separate e&uations #or opportunity sets: one #or borro)ers and one #or lenders. 2# you only consume some o# your time 1 income at time 1 and in,est the rest at 56, you ha,e the #ollo)in$ opportunity set: C' % 100 8 100 7 C1! 1.05! % '05 7 1.05C1. 2# you only consume some o# your time7' income at time ' and borro) the present ,alue o# the rest at 106 #or consumption at time 1, your opportunity set is: C1 % 100 8 100 7 C'!F 1.1! % 1?0.?1 7 C'F1.1,or, sol,in$ the e&uation #or C', C' % '10 7 1.1C1

10

(he lines intersect at point . )hich represents your income endo)ment #or times 1 and '!. 3o,in$ alon$ the lines abo,e point . represents lendin$ in,estin$ some time71 income!D mo,in$ alon$ the lines belo) point . represents borro)in$ spendin$ more than your time71 income on time71 consumption!. Since you can only lend at 56, line se$ment A. represents your opportunity set i# you choose to lend. Since you must borro) at 106, line se$ment .B represents your opportunity set i# you choose to borro). So your total opportunity set is represented by A.B.

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