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Investment Science AMA532, S2, 2012/13, Solution Outline to Assignment One

1. Let pj , j = 1, , k be the probability distribution. Then by Cauchy-Scharz inequality,


we have
|12| = |E((x1 x1)(x2 x2 ))|

k
X

j=1

|xj1 x1| pj |xj2 x2 | pj

v
v
u
u
k
k
uX
uX
u
u
j
t (x1 x
1)2 pj t (xj2 x2 )2pj
j=1

= 1 2 .

j=1

2. a. The arithmetic mean of stock T is (0.29 + 0.18 0.12 0.15 + 0.21)/5 = 0.082.
The arithmetic mean of stock B is (0.18 0.03 0.15 + 0.12 + 0.09)/5 = 0.042.
By the measure of the mean, stock T is preferred.

b. The standard deviation of stock T is




= [(0.29 0.082)2 + (0.18 0.082)2 + (0.12 0.082)2 + (0.15 0.082)2 +


.5

(0.21 0.082)2 ]/5

= 0.1810

The standard deviation of stock B is




= [(0.18 0.042)2 + (0.03 0.042)2 + (0.15 0.042)2 + (0.12 0.042)2 +


.5

(0.09 0.042)2 ]/5

= 0.1179

By the measure of standard deviation, stock B is preferred.


The coefficients of variation (or shape ratios) are 0.08200.02
= 0.3425 and
0.1810
0.1866. By this measure, stock B is more preferable.

0.0420.02
0.1179

[Note: the solutions with sample mean, that is, when the denominator n = 5 above is
changed to n 1 = 4, are also acceptable.]
3. For 6 months rent: apt A has cash flow (6000, 6000, 6000, 6000, 6000, 6000) and apt B
has cash flow (11000, 5000, 5000, 5000, 5000, 5000, 5000).
PV of apt A =
5
X

6000/(1 + 0.0025)k = 35776.31

k=0

PV of apt B =
6000 +

5
X

5000/(1 + 0.0025)k = 35813.59

k=0

PV of apt A < PV of apt B, they should not switch.


For 12 months rent: apt A has cash flow (6000, 6000, 6000, 6000, 6000, 6000, 6000, 6000,
6000, 6000, 6000, 6000) and apt B has
CFS(11000, 5000, 5000, 5000, 5000, 5000, 5000, 5000, 5000, 5000, 5000, 5000, 5000, 5000).
PV of apt A =
11
X

6000/(1 + 0.0025)k = 71020.63

k=0

PV of apt B =
11000 +

11
X

5000/(1 + 0.0025)k = 65183.86

k=1

PV of apt A > PV of apt B, they should switch.


4. For Project 1, the IRR equation is
0 = 100 +

30
30
30
30
30
+
+
+
+
2
3
4
(1 + r) (1 + r)
(1 + r)
(1 + r)
(1 + r)5

By trial and error method, r 0.15.

[or by Newton method.]

For Project 2, the IRR equation is


0 = 150 +

42
42
42
42
42
+
+
+
+
(1 + r) (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5

By trial and error method, r 0.12.

[or by Newton method.]

By IRR evaluation, the recomendation is project 1.


For Project 1,
PV = 100+

30
30
30
30
30
+
+
+
+
= 29.88.
2
3
4
(1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05)5

For Project 2,
PV = 150+

42
42
42
42
42
+
+
+
+
= 31.84.
2
3
4
(1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05) (1 + 0.05)5

By PV, the recommedation is project 2.

5. It is known that there is no advantage in buying either the stock or the forward contract
if we can borrow to buy a stock today (so both strategies do not require any initial
cash) and if the profit from this strategy is the same as the profit of a long forward
contract. The profit of a long forward contract with a price for delivery of $53 is equal
to: $ ST $53, where ST is the (unknown) value of one share of CLP at expiration
of the forward contract in one year. If we borrow $50 today to buy one share of CLP
stock (that costs $50), we have to repay in one year: $50(1 + r). Our total profit in
one year from borrowing to buy one share of CLP is therefore: $ST $50(1 + r). Now
we can equate the two profit equations and solve for the interest rate r:
$ST $53
$53
$53
1
$50
r

= $ST $50(1 + r)
= $50(1 + r)
= r
= 0.06

Therefore, the 1-year effective interest rate that is consistent with no advantage to
either buying the stock or forward contract is 6 percent.
6. Please note that we have given the continuously compounded rate of interest as 6%.
Therefore, the effective annual interest rate is exp(0.06) 1 = 0.062. In this exercise,
we need to find the future value of the put premium. For the $0.95-strike put, it is:
$0.0178 1.062 = $0.02.
(a) The diagram for the profit of the company is as follows.

Companys profit = copper price cost


= copper price 0.90
unhedged...... profit ($)

....
.. ......
...
....
..
....
..
.
...
....
....
....
....
..
...
.
...
.
..
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................................................................................................................................................................................................................................................................................
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... ......
... ....
.....
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..
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...

copper price

0.9

(b)
Purchased put profit = max{0, strike price copper price}
= max{0, 0.95 copper price}

Profit
($)
.....

......
.. .... ..
....
..
....
....
..
...
....
..
..........
... ......
.....
...
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...
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...
...
............................................................................................................................................................................................................................................................................
...
........
...
...
..

Purchased put position

0.95
Strike price

=
=
=
=
=

copper price

(c) Net income


Companys profit + Purchased put profit FV(Put premium)
copper price 0.90 + max{0, 0.95 copper price} 0.0178 e0.06
copper price + max{0, 0.95 copper price} 0.9189
+ max{copper price 0.95, 0} + 0.95 0.9189
+ max{copper price 0.95, 0} + 0.0311

Net income
($)
.
.....

0.0311
0

.....
.. .... ..
....
..
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..
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....................................................................................................................
...
.......................................................................................................................................................................................................................................................................
..
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..
...
...
...
...
....
..

0.95
Strike price

copper price

7. Our initial cash required to put on the collar, i.e. the net option premium, is as follows:
$51.873 + $51.777 = $0.096. Therefore, we receive only 10 cents if we enter into
this collar. The position is very close to a zero-cost collar.
The profit diagram of holding a long index, long 950 put, and short 1107 call looks as
follows:
Profit
.
.......
87.0979

0
69.9021

...
.. .... ..
...
........................................................................
...
...
...
...
...
...
...
.
...
.
..
...
...
...
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.
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..
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.............................................................................................................................................................................................................................................................................
.
.
...
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.
...
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.
.
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..
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...
...
...
...
...
...
.
.
...
.
.............................................................................
..
...
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..
...
.

950

Index price

1107

8. The profit is equal to


2 max{S 950, 0} 3 max{S 1050, 0} 2 120.405 1.02 + 3 71.802 1.02
= 2 max{S 950, 0} 3 max{S 1050, 0} 25.9121

S 950
25.9121,
950 S 1050
= 2S 1925.91,

S + 1224.088, 1050 S,

where S is the strike price.

9. The owner of the stock is entitled to receive dividends. As we will get the stock only
in one year, the value of the prepaid forward contract is todays stock price, less the
present value of the four dividend payments:
P
F0,T
= $50

4
X

$1e0.06 12 i

i=1

= $50 $0.985 $0.970 $0.956 $0.942


= $50 $3.853 = $46.147
b) The forward price is equivalent to the future value of the prepaid forward. With an
interest rate of 6 percent and an expiration of the forward in one year, we thus have:
P
F0,T = F0,T
e0.061 = $46.147 e0.061 = $46.147 1.0618 = $49.00

10

10. a) We plug the continuously compounded interest rate and the time to expiration in
years into the valuation formula and notice that the time to expiration is 9 months, or
0.75 years. We have:
F0,T = S0 erT = $1,100 e0.050.75 = $1,100 1.0382 = $1,142.02
b) We engage in a reverse cash and carry strategy. In particular, we do the following:
Description
Long forward, resulting
from customer purchase
Sell short the index
Lend +S0
TOTAL

Today
0

In 9 months
ST F0,T

+S0
S0
0

ST
S0 erT
S0 erT F0,T

Specifically, with the numbers of the exercise, we have:


Description
Long forward, resulting
from customer purchase
Sell short the index
Lend $ 1,100
TOTAL

Today
0

In 9 months
ST $1,142.02

$1,100
$1,100

ST
$1,100 e0.050.75
= $1,142.02
0

Therefore, the market maker is perfectly hedged. She does not have any risk in the
future, because she has successfully created a synthetic short position in the forward
contract.
c) Now, we will engage in cash and carry arbitrage:
Description
Today
Short forward, resulting 0
from customer purchase
Buy the index
S0
Borrow +S0
+S0
TOTAL
0

In 9 months
F0,T ST
ST
S0 erT
F0,T S0 erT

Specifically, with the numbers of the exercise, we have:

11

Description
Today
Short forward, resulting 0
from customer purchase
Buy the index
$1,100
Borrow $1,100
$1,100
TOTAL

In 9 months
$1, 142.02 ST
ST
$1,100 e0.050.75
= $1,142.02
0

Again, the market maker is perfectly hedged. He does not have any index price risk in
the future, because he has successfully created a synthetic long position in the forward
contract that perfectly offsets his obligation from the sold forward contract.
11. Suppose that the amount deposited in the bank is X0 and the value of the stock after
1
one year is X1 . Then R = X
. The total return of the investment is thus equal to
X0
1.3X0+X1
= 0.65 + 0.5R.
2X0
12. = 0.3, A = 0.15, B = 0.05.
(a) The minimum variance problem is
min 2 A2 + 2(1 )AB + (1 )2 B2 := f().
So

df()
= 2A2 + (2 4)AB 2(1 )B2 = 0.
d

Thus
2AB + 2B2
2A2 4AB + 2B2
AB + B2
=
A2 2AB + B2
= 0.0122,
1 = 0.9878.
=

(b) Minimum SD =

2 A2 + 2(1 )AB + (1 )2 B2 = 0.05.

(c) Expected return is =


rA + (1 )
rB = 0.0203.

13. (Rain insurance) Let u be the # of units of insurance bought. So the possible outcomes
of return are (.4, u) and (.6, 4 106 ).
(a) The expected rate of return is

.4u+.64106 (106+.5u)
.
106 +.5u

(b) Let X be his return. His mean return is E(X) = (.4u + .6 4 106 ).

The variance of his return is V ar(u) = E(X 2 ) E(X)2 = .4u2 + .6(4 106 )2 (.4u +
.6 4 106 )2.
12

dV ar(u)
= .8u 2(.4u + .6 4 106 ) .4 = .48u 1.92 106 = 0.
du
Then u = 4 106 . So V ar(u) = 0.

When u = 4 106 , the expected rate of return =


33%.

4106
106 +2106

1=

4
3

1 = 31 . That is,

or
Rate of return

Prob.

$3M $.5u
$1M +$.5u

.6

$.5u$1M
$1M +$.5u

.4

Variance is minimized (=0) when the rate of return is unchanged, i.e.,


$3M $.5u = $.5u $1M.
Thus u = $4M.
14. (Wild cats)
(a)

(b) The problem is


min

Var =

wi wj ij

i,j

s.t.

X
j

13

wj = 1.

Since ij = 0, i 6= j, Var =

wj2 j2. Let

L(w, ) =

X
j

Then

wj =
=

X
w 2 2 wj
j

1 .

L(w, )
= 2i2wi = 0
wj

.
2j2

So

1
j 22
j

j 22
j

1

= 1. We have

. So wj =

1
j2


P

1
j 2
j

1

, and Var =

1
12

The portfolio for the minimum variance point is


while the minimum variance point is


P

1
j 2
j

1

1
j 4
j

1
j 2
j

1
j 2
j

1

2

j2 =

,,

1
2
n


P

1
j 2
j

1
j 2
j

1

1 !

, r .

15. (Markowitz fun)


(a) The problem is

1
min w> w,
2

Let L(w, ) = 12 w> w (

s.t.

wj = 1.

wj 1). Thus

w1 + w2
w1 + 2w2 + w3
w2 + 2w3
w1 + w2 + w3

=
=
=
=

0
0
0
1.

Eliminating , we have
w2 w3 = 0
w1 2w3 = 0
w1 + w2 + w3 = 1.
Thus
w2 3w3 = 1,

2w3 = 1

We have w3 = 0.5 and w2 = 0.5. So w1 = 1. The minimum variance solution is


w1 = 1, w2 = 0.5 and w3 = 0.5. Here = 0.5.

14

(b) Solve the following system of equations


w1 + w2 .4
w1 + 2w2 + w3 .8
w2 + 2w3 .8
0.4w1 + 0.8w2 + 0.8w3
w1 + w2 + w3

=
=
=
=
=

0
0
0
0.7
1.

From the second and third equations, we have w1 + w2 w3 = 0. Thus together with
w1 + w2 + w3 = 1, we have 2w3 = 1, so w3 = 12 .
Multiplying w1 + w2 w3 = 0 by 4 and adding it to 4w1 + 8w2 + 8w3 = 7, we have
4w2 + 12w3 = 7. So w2 = 14 (7 12 12 ) = 14 . Finally we have w1 = 1 41 12 = 14 .
The optimal portfolio solution is w1 = 41 , w2 = 14 , w3 = 12 .

(c) Let = 1 and = 0. The system of linear equations is


v1 + v2 = 0.4
v1 + 2v2 + v3 = 0.8
v2 + 2v3 = 0.8
From the first two equations, we have v2 v3 = 0.4. This together with the third
equation gives v3 = 0.4 and v2 = 0. From the first equation again, we have v1 = 0.4.
The normalized solution is w1 = 0.5, w2 = 0 and w3 = 0.5 with the expected rate of
return being equal to 0.6. The other optimal portfolio w1 = 1, w2 = 0.5 and w3 = 0.5
has the expected rate of return 0.4.
By the two-fund theorem, we have
10 4
= 3.
64
The optimal portfolio for the expected rate of return being equal to 0.7 is
0.4(1 ) + 0.6 = 1, thus =

(1 3)(1, 0.5, 0.5) + 3(0.5, 0, 0.5) = (0.5, 1, 0.5).


(d) Let rf = 0.1. The solution is found by the system of equations:

or by the formula:

v1 + v2 = 0.4 0.1
v1 + 2v2 + v3 = 0.8 0.1
v2 + 2v3 = 0.8 0.1.
v1 = 0.4 0.1 2 = 0.2
v2 = 0 0.1 1 = 0.1
v3 = 0.4 0.1 1 = 0.3.

The normalized solution is w1 =

0.2
0.2+0.1+0.3

15

= 13 , w2 =

1
6

and w3 = 12 .

16. We know that the efficient portfolio required in One-Fund Theorem satisfies
n
X
i=1

ki vi = rk rf ,

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

(1)

Indeed, from the equations for the efficient set, we have


n
X

j=1

ij wj
ri = 0,

i = 1, , n.

Thus, by the definition of v 1 with ( = 1, = 0) and v 2 with ( = 0, = 1),


n
X

ij vj1 1 = 0,

i = 1, , n.

(2)

n
X

ij vj2 ri = 0,

i = 1, , n.

(3)

j=1

j=1

It is clear that (1) can be obtained from (3) rf (2).


17.

(i) Let = 0, = 1.
Equations are

Solutions are

1v1 + 2v2
= 1
2v1 + 2v2 + v3 = 1

v2 + 2v3 = 1
v11 = .2, v21 = .6, v31 = .2.

Normalized solutions are w1 = 31 , w2 = 1, w3 = 31 .


Let = 1, = 0.
Equations are

Solutions are

1v1 + 2v2
= .1
2v1 + 2v2 + v3 = .2

v2 + 2v3 = .3
v12 = .02, v22 = .06, v32 = .12.

Normalized solutions are w1 = .125, w2 = .375, w3 = .75.


16

(ii) Let rf = 0.1. The solution is found by solving


v1 = v12 rf v11 = 0
v2 = v22 rf v21 = 0
v3 = v32 rf v31 = .1
Normalized solutions are w1 = 0, w2 = 0, w3 = 1.
18. (Without shorting) The Lagrangian is
L(w, , , ) =

1 2
[w + 2w22 + 2w32 + 2w1 w2 ]
2 1
(3w1 + w2 + w3 2) (w1 + w2 + w3 1) 1 w1 2 w2 3 w3 .

The KKT condition is

w1 + w2 3 1 = 0
2w2 + w1 2 = 0
2w3 3 = 0
3w1 + w2 + w3 2 = 0
w1 + w2 + w3 1 = 0
1 w1 = 0, 1 0, w1 0,
2 w2 = 0, 2 0, w2 0,
3 w3 = 0, 3 0, w3 0.

Case 1. Let 1 > 0, w1 = 0. As r2 = r3 = 1, this case cannot find the solution.


Case 2. Let 2 > 0, w2 = 0. Then
3w1 + w3 2 = 0, w1 + w3 1 = 0,
1
1
= w1 = , w3 = ,
2
2
= 1 = 0, 3 = 0,
1
1
3 + = , + + 2 = , + = 1
2
2
1
= = , = 2, 2 = 1 < 0, (impossible)
2
Case 3. Let 3 > 0, w3 = 0. Then w1 = 12 , w2 = 12 . So 1 = 0, 2 = 0. Thus
3
3 + = 1, + = , + + 3 = 0
2
1
5
= = , = , 3 = 2 < 0, (impossible)
4
2
17

Case 4. Let 1 = 2 = 3 = 0, w1 > 0, w2 > 0, w3 > 0. Then = w22 , = w1 + 25 w2.


So
w1 2w2 + 2w3 = 0, 3w1 + w2 + w3 = 2, w1 + w2 + w3 = 1
= 7w1 4w2 = 4, 2w1 = 1,
7
1
3
1
13
1
= w1 = , w2 = ( + 4)/4 = , w3 = , = , = .
2
2
8
8
16
16
The optimal portfolio for r = 2 is ( 21 , 18 , 38 ).
19. N/A

18