SRE Chapter 9 General Theory 1, (Certainty equivalent) The possible incomes and their utility levels (found by tak- ing the 1/4-th power) are Income 80 90 100 110 120 130 140 Utility 2.99 3.08 3.16 323 3.31 3.38 344 ‘The total utility is the average of these, which is 3.23. We must find C such that C14 = 3,23, Using an iterative process we find C = $108, 61. 2, (Wealth independence) The investment will be made if: ELU(W —w +x] > EUW], for our case we have: E[-eeterse™] > E[-e-o] or equivalently, erat —w gen] > ea, ‘Dividing the expression by ~e~*™, the investment will be made if: melee] <1 which is independent of W. 3. (Risk aversion invariance) The risk aversion coefficient for a utility function, U(x) is ; ate) = For V(x) = ¢ + bU(x) Vix) = BUG) vr) = BU") so the risk aversion coefficient for V(x) is given by: Wa) TG) 0" 30__ e 40 CHAPTER 9. GENERAL THEORY 44, Relative risk aversion) Given U(x), the relative isk aversion coefficient 1 is de- wa fined as: aes = a Ue) (a) U(x) = logo) uj@ = q ue) = -# q eu) = 1 0 () Ute) = yx" ue) = yar? u"(x) = yaya eutx) = 1-¥ ; ©! Relative risk aversion coefficients, #, are constant for both utility functions. 5. Equivalency) Ireslts are consistent, we have that V(x) = al) * b,and since via) =A and V(B’) = BY we must have Al = aU(a)+b B= aye)+b so solving both equations simultaneously we find parameters & and b: ae a = FAy-0e) @ p = Muay —aue) = Way Te) 6. (HARA) The hyperbolic absolute risk aversion function is given by: 1-¥ uw = ie y (a) Linear: We can write the HARA as: 1 a ay” um = F(axa-n" +ba-»?) choosing y = Land a = 1 and using !Hopital’s rule we can wie: um) = mae HF =x(CHAPTER 9. GENERAL THEORY 41 (b) Quadratic: By choosing y = 2, HARA takes the form ah: ed U(x) = ~3a?x? + abx — 5b Choosing a > 0 and b = 1/a > 0 we have an equivalent form of the re- quired quadratic form. Furthermore, by adding b?/2, which is a legitimate transformation, we get the precise desired form: oye, U(x) = x— Zex?, where ¢ = a? (©) Exponential: By choosing b = 1 and y = ~co and using L'Hopital’s rule we can write yey \T = 1 tim e754) , Ue) = im, 252 (2 +1) (@) Power: If we let b = 0, HARA takes the form: pit Ue) = Pare, which for y < 1 is of the required form U(x) = ext (©) Logarithmic: Let b = 0 and a = 1, then HARA {is given by: ¥ Ue) = (1- yyy, te) = a- yi We can subtract the constant ¢ = (1 ~ y)2-?/y, and obtain an equivalent utility function Ya way a-yhr (22), (x) =(1-y) 7 Now letting y = 0 and using L'Hopital’s rule we get xY-1 U@) = lim (x) 7 yoeux 1 = lim ¥ | gi akaeneP yo TL = Inx. ‘The Arrow Pratt a(x) risk aversion coefficient for HARA is 2 us) eS +h, ia ae) = aa) Ge cy = a ») "Ea which is of the form 1/(cx + @), as required. 7. (The venture capitalist) The expected value ¢ is given by -8p e=pt(l-p)o= so, é padze ‘On the other hand since U(x) = VX: u(c)=Vve = puta) + (1 - puto) = p+3(1-p) 3-27 (P54) c~ (2-2(234))' = Rote? e=4vC-3 which agrees with the values of the table on example 9.3, '8, (Certainty approximation) By definition, the certainty equivalent c is such that F[U(x)] = U(c). Substituting in the given approximations, we have So Solving for e we get: 03) + 4U" (arvar(x) = UR) + URC 2). as req 9. (Quad Now, beWSolving for c yields U(x), cx e+ ‘var (x) Ux) as required. ‘9. (Quadratic mean-variance) in general EU) = Elay-tby2] = aBly] — 3bELy*] = aly] - 2b vary] + ELy}?) If the random payoff of the portfolio of the investor with: ‘unit wealth is R, itwould maximize ELU(R)] = aE{R} - $b(var[R] + E(RI?) Now, if the investor with wealth W purchases the same portfolio, its payoff must ‘be WR and R should maximize: E(U(y2)] = aE[RW] - }bo(var[RW] +ELRW}?) = @WE[R] — fb2(W? var[R] + WE[R]2) = w[ae(R] — Show (varie) + E[R])]. If the second investor has b’ = jp the same R will solve this as the R using unit wealth, 10. (Portfolio optimization) The first-order conditions for portfolio optimization are: ELU'(x*)ai]= AP, for alli Dividing by P; we get FU A+r)) = A for all i or, EU (x")1+E[U'(x*)y4] = A for all i. ‘Taking the difference between asset i and the risk-free asset yields ELU'(x*)] + BLU" (x*)r] - E[U'(x"*)] + ELU'(xe*)ry] = LU" (xe*)r4] ~ BLU" (x")rp] ELU(x*)(—ry)] = A ie, 0 0.44 CHAPTER 9. GENERAL THEORY 11. (Money-back guarantee) We have the three investment options from example 9.6 with price 1 and the new money-back guarantee alternative: 6 3 1.2, 3,000 Ss Ss Gs re i ° 2 P Residual Rights Film Venture Risk Free Money-Back Guarantee ‘Since we had three states and three ‘securities’, the new alternative can be repli- ‘cated by combining the existing ones in certain amounts A, B, and C. It follows that the price of the Money-back guarantee security is A+B +C, so that there are no arbitrage opportunities: GA+3B+12C = 3,000 B+12C = P 120 =P AtB+C = P Solving the system gives us the price of the Money-back guarantee deal: P = $1,500 ‘Alternatively we could have used the state prices from example 9.9 where we had Wr = 1/6, Y2 = 1/2 and Ws = 1/6 50 that the price of the Money back guarantee is given by the single equation: 1 Lot P= 73,0004 5P + GP. with solution P = $1,500. 12. (General positive state prices result) Let the NxS matrix D be the payoff matrix of N securities in $ states. Security prices are given by some q € EN and a portfolio js characterized by x € EN. The market value or cost c of a portfolio xis q-x and its payoff is given by D’x € ES, Now consider the ($ + 1) x N matrix A which results from appending the negative of the price vector q as a row to DT: ‘The first N elements of the vector p given by Ax = p correspond to the payoff ‘vector while the (n+ 1) ~ th element is the negative of the cost of the portfolio x. 13. D Note vily (Qua ies ore13. (CHAPTER 9. GENERAL THEORY, 45 If there is no arbitrage, then we must have no p > 0 except p = O, since otherwise we could have non-positive cost (c < 0) with a positive probability of yielding Positive payoff or negative cost (c < 0) with zero payoff which is instant money. Using the stated matrix theory result it follows that there exists a vector y > 0 such that A7y = 0. Note that this is the same as: Durr + Diaz + Diys + + Duys - ai¥sn = 0 Davi + Daye + Dasys + + Dass - gays = 0 Diy + Dyay2 + Dyays + +++ + Dys¥s - anys = 0 Note that by dividing each element of y by y’s41 we get positive state prices yj = il Yeo Such that: Dut + Dawe + Divs + + Diss - a = 0 Dat + Dee + Deas + + Das - g = 0 Det + DyaW2 + Dyas + ++» + Duss - qn = 0 ‘Therefore, if there is no arbitrage, there are positive state prices. (Quadratic pricing) From the earlier exercise we have E{U’(x*)(r; - r7)] = 0. If U(x) = x ~c/2x? then, U'(x) = 1 —cx, so in this case we have EL ~cWRw)(r4-7p)] =0 or equivalently E[(1 ~ cWRy)(Ri—R)] = 0. Written out we have Ri-R = cWIE(RwRt) — RR] = cW[cov(Ry,Ri) + Ru(Ri ~ R)]- This implies, Ry ~ R = ycov(Ry, Ri) for y=1-cWRw. Appling this to Ry yields Rw - R= yvartRw) which shows that ae Ry-R Y vartRw) and hence finally Ri~R = Bi(Ry —R).46 CHAPTER 9, GENERAL THEORY 14, (At the track) Gavin Jones will choose the fraction cr of his money m to bet on the ‘horse so as to maximize his expected utility: max E(U) = tvm+dam + 3V- com, Chapt (a) The first order necessary condition is: Forw i 2 Vm dom which yields: iL icae Gavin's maximizing choice is to bet 13.46% of his money and keep the rest in his pocket. (b) We can summarize Gavin’s world by the following three alternatives: Keep money in pocket Bet for No Arbitrage Ravens Angee Linear pricing holds if there aren't any arbitrage opportunities. Thus, we could replicate a four dollar bet against No Arbitrage by ‘shorting’ the bet {n favor and keeping five dollars in the pocket. Dividing by four we get the i. implied payoff for a one dollar bet against No Arbitrage: | yazr tas 15, (General risk neutral pricing) From log-optimal pricing we have 2 @rot ure | p=e(4) afor zer0 Now, using the expectation operation £ defined by got a of fx) = (2) mak Where & is the risk free rate, we can multiply the log-optimal pricing formula by Re 1 without affecting it. This yields Pa ‘which Is risk neutral pricing.