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we have

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

k

X

j=1

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.

.5

= 0.1810

.5

= 0.1179

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

k=0

PV of apt B =

6000 +

5

X

k=0

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

k=0

PV of apt B =

11000 +

11

X

k=1

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

0 = 150 +

42

42

42

42

42

+

+

+

+

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

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

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.

= copper price 0.90

unhedged...... profit ($)

....

.. ......

...

....

..

....

..

.

...

....

....

....

....

..

...

.

...

.

..

....

....

..

....

...

....

....

.

....

.

...

..

...

...

...

....

....

....

.

..

.

....

....

....

..

.....

...

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

.

...

.

....

...

....

.

...

.

..

...

....

...

....

....

...

...

.

...

.

..

...

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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

($)

.....

......

.. .... ..

....

..

....

....

..

...

....

..

..........

... ......

.....

...

....

...

.....

....

...

.....

...

....

...

.....

....

...

.....

...

....

...

.....

....

...

.....

...

....

...

.....

....

...

.....

...

....

...

.....

...

...

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

...

........

...

...

..

0.95

Strike price

=

=

=

=

=

copper price

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

.....

.. .... ..

....

..

....

..

...

....

.....

....

..

....

.

.

...

.

..

....

.....

..

.....

....

....

....

.

.

..

.

....

...

....

....

.....

..

....

....

.

...

.

...

....

.....

..

....

.....

....

....

.

.

.

..

.

....

...

...

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

...

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

..

........

...

...

....

..

...

...

...

...

....

..

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

...

.. .... ..

...

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

...

...

...

...

...

...

...

.

...

.

..

...

...

...

...

...

....

...

.

..

.

..

...

...

...

...

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

.

.

...

........

.

...

...

...

...

...

.

.

...

..

...

...

...

...

...

...

...

.

.

...

.

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

..

...

....

..

...

.

950

Index price

1107

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,

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 $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

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

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 =

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.

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

$3M $.5u = $.5u $1M.

Thus u = $4M.

14. (Wild cats)

(a)

min

Var =

wi wj ij

i,j

s.t.

X

j

13

wj = 1.

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

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

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 .

(a) The problem is

1

min w> w,

2

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

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

14

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 .

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 =

(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.

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)

n

X

j=1

ij wj

ri = 0,

i = 1, , n.

n

X

ij vj1 1 = 0,

i = 1, , n.

(2)

n

X

ij vj2 ri = 0,

i = 1, , n.

(3)

j=1

j=1

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.

Let = 1, = 0.

Equations are

Solutions are

1v1 + 2v2

= .1

2v1 + 2v2 + v3 = .2

v2 + 2v3 = .3

v12 = .02, v22 = .06, v32 = .12.

16

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 .

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 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

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

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