Investment Science Chapter 3

Dr. James A. Tzitzouris <jimt2@ams.jhu.edu>

3.1 Use A= 1− rP
1 (1+r)n

with r = 7/12 = 0.58%, P = $25, 000, and n = 7 × 12 = 84, to obtain A = $377.32. 3.2 Observe that since the net present value of X is P , the cash flow stream arrived at by cycling X is equivalent to one obtained by receiving payment of P every n + 1 periods (since k = 0, . . . , n). Let d = 1/(1 + r). Then

P∞ = P
k=0

(dn+1 )k .

Solving explicitly for the geometric series, we have that P∞ = Denoting the annual worth by A, we must have A= rP , 1 − dn P . 1 − dn+1

so that solving for P as a function of P∞ and substituting the result into the equation for A, we arrive at 1 − dn+1 A=r P∞ . 1 − dn 1

Investment Science Chapter 4 Solutions to Suggested Problems
Dr. James A. Tzitzouris <jimt2@ams.jhu.edu>

4.1 (One forward rate) f1,2 = (1 + s2 )2 1.0692 −1= − 1 = 7.5% (1 + s1 ) 1.063

4.2 (Spot Update) Use f1,k . Hence, for example, f1,k . All values are f1,2 f1,3 f1,4 f1,5 f1,6 5.60 5.90 6.07 6.25 6.32 (1.061)6 = 1.05
1/5

(1 + sk )k = 1 + s1

1/(k−1)

−1

− 1 = 6.32%

1

4.3 (Construction of a zero) Use a combination of the two bonds: let x be the number of 9% bonds, and y teh number of 7% bonds. Select x and y to satisfy 9x + 7y = 0, x + y = 1. The first equation makes the net coupon zero. The second makes the face value equal to 100. These equations give x = −3.5, and y = 4.5, respectively. The price is P = −3.5 × 101.00 + 4.5 × 93.20 = 65.90. 4.5 (Instantaneous rates) (a) es(t2 )t2 = es(t1 )t1 eft1 ,t2 (t2 −t1 ) =⇒ ft1 ,t2 = (b) r(t) = limt→t1 (c) We have d(ln x(t)) = r(t)dt, = s(t)dt + s (t)dt, = d[s(t)t]. Hence, ln x(t) = ln x(0) + s(t)t, and finally that x(t) = x(0)es(t)t . This is in agreement with the invariance property of expectation dynamics. Investing continuously give the same result as investing in a bond that matures at time t. 4.6 (Discount conversion)
s(t)t−s(t1 )t1 t−t1

s(t2 )t2 −s(t1 )t1 t2 −t1

=

d[s(t)t] dt

= s(t) + s (t)

2

The discount factors are found by successive multiplication. For example, d0,2 = d0,1 d1,2 = 0.950 × 0.940 = 0.893. The complete set is 0.950, 0.893, 0.770, 0.707, 0.646. 4.7 (Bond taxes) Let t be the tax rate, xi be the number of bond i purchased, ci be the coupon of bond i, pi be the price of bond i. To create a zero coupon bond, we require, first, that the after tax coupons match. Hence x1 (1 − t)c1 + x2 (1 − t)c2 = 0, which reduces to x1 c1 + x2 c2 = 0. Next, we require that the after tax final cash flows match. Hence p0 = x1 p1 + x2 p2 . Using this last relation in the equationfor final cash flow, we find x1 + x2 = 1. Combining these equations, we find that p0 = c2 p1 − c1 p2 . c2 − c1

After plugging in the given values, we find that p0 = 37.64.

4.8 (Real zeros) We assume that with coupon bonds there is a capital gains tax at maturity. We replicate the zerocoupon bond’s after-tax cash flows using bonds 1 and 2. Let xi be the amount of bond i required 3

4.11 (Running PV examples)

(a)

d0,1 d0,2 d0,3 d0,4 d0,5 d0,6 0.9524 0.9018 0.8492 0.7981 0.7472 0.7010 0 −40 0.9524 9.497 1 10 0.9469 51.970 2 10 0.9416 44.324 34 10 0.9399 36.453

=⇒ N P V = 9.497 6 10 10 9381 19.381 10.000

Year Cash Flow (b) Discount PV(n)

5 10 0.9362 28.144

4.12 (Pure duration)
n n −k

P (λ) = dP (λ) dλ
k=0 n

xk (1 + sk /m) xk
k=0 n

−k

=
k=0

xk (1 + s0 /m)eλ/m k
−k−1

,

= =

−k m −k m

(1 + s0 /m)eλ/m k (1 + sk /m)−k ,

(1 + s0 /m)eλ/m , k

xk

1 dP (λ) P (λ) dλ

=

k=0 n k −k k=0 xk m (1 + sk /m) n −k k=0 xk (1 + sk /m)

≡ D.

This D exactly corresponds to the original definition of duration as a cash flow weighted average of the times of cash payments. No modification factor is needed even though we are working in discrete time. 4.14 (Mortgage division) (a) (1 + r)k−1 − 1 r

P (k) = B − rM (k − 1) = B − r (1 + r)k−1 M (0) − = (1 + r)k−1 (B − rM ), 6

B ,

X1= (X0 – X1) + X0 The total return.Solution of HW3 Problem 6.1 X0 = outlay (in this case it is equal to the deposit. R = X1/X0 = ((X0 – X1) + X0)/X0 Thus.4 Let α equal the percent of investment in stock 1. then the percent in stock 2 is (1-α).97 ⎣ ⎦ ⎣ ⎦ 6 ⎝ ⎠ 2 2 Problem 6.5 = 12. R = 2X0 – X1 X0 Problem 6.4: a) b) c) α = 19 / 23 2 α 2σ 12 + (1 − α ) σ 2 = 2 (19 / 23) ( 0. Now.4 Problem 6.2 Let a and b be the outcomes of two die rolls. Then Z=ab.3 Using the answer of the Problem 6.5 ) ≈ 79.4% r = α r1 + (1 − α ) r2 ≈ 11. problem becomes Minimize σ2 .25 6 ⎝ ⎠ 2 2 2 2 2 var [ Z ] = E ⎡( ab ) ⎤ − ( E [ ab ]) = E ⎡( a ) ( b ) ⎤ − ( E [ a ] E [b ]) = ⎣ ⎦ ⎣ ⎦ 2 2 2 2 4 ⎛ 1 + 4 + 9 + 16 + 25 + 36 ⎞ = E ⎡( a ) ⎤ E ⎡( b ) ⎤ − ( E [ a ] ) ( E [ b ] ) = ⎜ ⎟ − ( 3. Thus. By independence.3) 2 2 2 2 = 13.) X1 = amount received. equal to the returned deposit plus the profit from shorting.15) + (1 − 19 / 23) ( 0. we know: ⎛ 1+ 2 + 3 + 4 + 5 + 6 ⎞ 2 E [ ab ] = E[a ]E[b] = ⎜ ⎟ = 3.

σ2 = i . of units of insurance bought= u a. of units of insurance bought = (1*10^6+ 0.5 Money invested for concert 1 year from now= 1 million Revenue expected unless it rains= 3 million Chances of rain=50% Rain Insurance = $ 0.5*u) . X0 = money invested + no.5 per unit Money obtained from insurance if it rains= $ 1 per unit Let no. j =1 ∑ω ω σ i j 2 ij 2 2 = ω12σ 12 + 2ω1ω 2σ 12 + ω 2 σ 2 2 = α 2σ 12 + 2σ 12 * α * (1 − α ) + σ 2 (1 − α ) 2 2 2 2 = σ 12α 2 + 2σ 12α − 2σ 12α 2 + σ 2 − 2σ 2 α + σ 2 α 2 2 2 dσ 2 / dα = 2σ 12α + 2σ 12 − 4σ 12α − 2σ 2 + 2σ 2 α = 0 2 2 dσ 2 / dα = (2σ 12 − 4σ 12 + 2σ 2 )α + 2σ 12 − 2σ 2 = 0 : take derivatives respect to α ⎛ σ 2 − σ 12 ⎞ α =⎜ 2 2 ⎜ σ − 2σ + σ 2 ⎟ ⎟ 12 2 ⎠ ⎝ 1 ⎛ σ 2 − σ 12 Thus percentage of asset 2 = 1-α = ⎜ 2 1 ⎜ σ − 2σ + σ 2 12 2 ⎝ 1 ⎞ ⎟ ⎟ ⎠ The mean rate of return of this portfolio is r = r1 * α + r2 * (1 − α ) 2 2 2 r = r 1 [(σ 2 − σ 12 ) /(σ 12 − 2σ 12 + σ 2 )] + r2 [(σ 12 − σ 12 ) /(σ 12 − 2σ 12 + σ 2 )] 2 2 = [r 1 (σ 2 − σ 12 ) + r2 (σ 12 − σ 12 )] /(σ 12 − 2σ 12 + σ 2 ) 2 ⎛ r 1σ 2 + r 2σ 12 − (r 1 + r 2 )σ 12 ⎞ ⎟ =⎜ 2 ⎜ ⎟ σ 12 − 2σ 12 + σ 2 ⎝ ⎠ Problem 6.)Now total money invested.

5 = (1.5-1))/ (1*10^6+0.) To get the minimum variance we will have to buy all the 3 million units which will give us a variance of 0.5*u))/ (1*10^6+ 0.000.5*u) b.6 (A) r The efficient set (at minimum-variance point) assets σ (B) .5*3*10^6) = (0.5*10^6+0.(1*10^6+ 0.5*u)/ (1.5)/(1+1. Var(r) = 0 Therefore r = (10^6(1.5*u) = (500.5) = 0.000+0.000.000)/ (1.Revenue obtained X0 = 3*10^6+ 1*u Now since there are 50% chances of rain we have total revenue:X1= (3*10^ 6+u) *0.000+0.2 = 20% Problem 6.5*3.5*10^6+0.000.000+0.5u) E (Total Return) = X1/X0=(0.5u) Now rate of return E(rate of return)= X1/X0-1= = ((1.5u) . We have to Minimize Var(r) Hence u= 3*10^ 6 units.

4 E(r2)= 0.8 .7 Covariance matrix 2 1 0 1 2 1 V= 0 1 2 Expected rates of return E(r1)= 0. Var = ∑ ωi2σ i2 i =1 n ⎛ n ⎞ L = ∑ ωi2σ i2 − µ ⎜ ∑ ωi − 1⎟ i =1 ⎝ i =1 ⎠ ∂L = 2ωiσ i2 − µ = 0 ∂ωi n µ = 2ωiσ i2 µ ωi = 2 2σ i Then. ωi = σ2 σ i2 n n σ4 1 Var = ∑ ω σ = ∑ 2 = σ 4 ∑ 2 i =1 i =1 σ i i =1 σ i 2 i 2 i n Var = σ 2 Problem 6.8 E(r3)= 0.Since assets are uncorrelated. ∑ ω = ∑ 2σ i =1 n i i =1 n n µ 2 i =1 ∑σ i =1 1 2 i = 2 2 µ 1 2 i µ= ∑σ i =1 n = 2σ 2 Therefore.

8 -0.5 0.8 1 0 w3 0 1 2 0.4 0.5 b) λ=1.1 0. v2 .3 0.8 0. w3 } that satisfies the constraint. µ=0 System with 3 variables and 3 equations: v1 2 1 0 v2 1 2 1 v3 0 1 2 = 0.333 .167 0.4 1 1 w2 1 2 1 0. v3 } to the solution {w1 .733 By using calculator: v1 v2 v3 w1 w2 0.2 0.a) Minimum variance portfolio (consider that w1=w3 by symmetry) Markowitz formulation: ∑σ w j =1 n ij n j − λr i − µ = 0 (1. we normalize the obtained solution {v1 .5 0 0.4 -0.6 = 0 0 0 0 1 0 By using calculator: w1 w2 w3 0. w2 . Then.1) ∑w r i =1 n i i =1 i i =r ∑w =1 w =w 1 3 For solving the system of equations (1.8 w3 E(r) 0.1) we omit the last normalizing constraint.8 1 -1 λ -0. System with 6 variables and 6 equations: w1 2 1 0 0.8 0 0 0 λ 0 µ -1 -1 -1 0 0 0 µ 1 E(r) 0 0 0 -1 0 0 E(r) 0.

..2 v1 2 1 0 v1 0 v2 1 2 1 v2 0..10.8 a) Min Var (∑ α i ri − rM ) i =1 n S . we get a system of 3 equations with 3 variables.2 = 0. By using equation 6. there is a single fund of risky assets such that any efficient portfolio can be constructed as a combination of the fund and the risk-free instrument.2 0.2 v3 0 1 2 v3 0. ∑α i n n i =1 j =1 n n i =1 n n i 2 L = ∑∑ α iα jσ ij − 2∑ α iσ iM + σ M + µ (1 − ∑ α i ) i =1 ∂L = 2∑ α jσ ij − 2σ iM − µ = 0 for each i ∂α i j =1 n ∂L = 1 − ∑αi = 0 ∂µ i =1 So.5 Problem 6. n where r f = 0. k = 1. ∑α σ j =1 n j n ij = µ 2 + σ iM for each i ∑α i =1 i =1 .6 w1 0 w2 0.T .5 w3 0.6 0.c) Given that there is a risky-free part. ∑ n i =1 σ ki vi = rk − r f .

Suppose you bet an amount Bi = 1/Ai on segment i for each i. ∑α σ j =1 n j n ij = µ 2 + σ iM + λ r for each i ∑α i =1 n i i =1 ~ ∑α r = r i i Problem 6.9 (Beeting Wheel) Consider a general betting wheel with n segments. Show that the amount you win is independent of the outcome of the wheel. The payoff for a $1 bet on a segment i is Ai.T . ∑α i n i n n n i =1 ~ ∑ αi ri = r 2 L = ∑∑ α iα jσ ij − 2∑ α iσ iM + σ M + µ (1 − ∑ α i ) + λ (r − ∑ α i ri ) i =1 j =1 n i =1 i i n n ~ n ∂L = 2∑ α jσ ij − 2σ iM − µ − λ ri = 0 for each i ∂α i j =1 n ∂L = 1 − ∑αi = 0 ∂µ i =1 ∂L ~ n = r − ∑ α i ri = 0 ∂λ i So.b) Min Var (∑ α i ri − rM ) i =1 n S . What is the risk-free rate of return for the wheel? Apply this to the wheel in Example 6.7 Sol: .

Solution tan θ = ∑ w (r − r i =1 i i n f ) 1/ 2 ⎛ n ⎞ ⎜ ∑ σ ij wi w j ⎟ ⎜ ⎟ ⎝ i . Risk-free rate of return for the wheel: For any outcome of the wheel.10 Derive ∑σ i =1 n ki λwi = rk − rf . X0 = $1 (amount received) 1 The amount invested will be X1= ∑ Ai R= X0 = X1 $1 1 ∑ Ai −1 1 ⎞ ⎛ r = R −1 = ⎜∑ ⎟ −1 ⎝ Ai ⎠ Problem 6.Data: n segments (from segment i =1 to segment n) Amount received from segment i = Ai for each $1 invested Fraction of segment i invested = Bi = 1/Ai (Wi) a) Expected return for segment i. the amount that we will win will be = $1. Ri = Ai / $1 Amount to win if the outcome equal to segment i: Expected return for segment i times the fraction invested in segment i Ri * Wi ⇒ Ri * Bi ⇒ Ai 1 * = $1 1 Ai For any outcome on the wheel the amount we will win will be $1.. j =1 ⎠ .

⎛ n ⎞ ( rk − rf )⎜ ∑ σ ij wi w j ⎟ ⎜ ⎟ ⎝ i . j =1 ⎠ ⎝ i =1 n ⎛ ⎞ ⎜ ∑ wi ( ri − rf ) ⎟ n ⎝ i =1 ⎠ σ w = (r − r ) ∑ kj j k f n ⎛ ⎞ j =1 ⎜ ∑ σ ij wi w j ⎟ ⎜ ⎟ ⎝ i . j =1 ⎠ ⎛ n ⎞ ⎜ ∑ wi ( ri − rf ) ⎟ ⎠ lets denote λ = ⎝ i =1 n ⎛ ⎞ ⎜ ∑ σ ij wi w j ⎟ ⎜ ⎟ ⎝ i . j =1 ∑ σ kj w j ⎛ n ⎞ j =1 − ⎜ ∑ wi ( ri − rf ) ⎟ 1/ 2 ⎝ i =1 ⎠⎛ n ⎞ ⎜ ∑ σ ij wi w j ⎟ ⎜ ⎟ ⎝ i . j =1 ⎠ ∑σ i =1 n ki λwi = rk − rf . j =1 ∑σ n ij wi w j = σ 2 > 0 . n n ∑ σ ij wi w j n Since i . k = 1. j =1 ⎠ ∂ tan θ = ∂wk 1/ 2 i . we have: ⎛ n ⎞ ⎛ n ⎞n ( rk − rf )⎜ ∑ σ ij wi w j ⎟ − ⎜ ∑ wi ( ri − rf ) ⎟∑ σ kj w j = 0 ⎜ ⎟ ⎠ j =1 ⎝ i . j =1 ⎠ = 0 .

07)/0. what is the standard deviation of this position? expected return = 0.64 ii) If you have $1.32 expected rate of return = 0.Problem 7.07+ (0.39 standard deviation position = 0.23) x= -1000 risk free asset -1000 maket portfolio 2000 c) If you invest $300 in the risk-free asset and $700 in the market portfolio.39) = 1390 1390 = x (1+0.Assume that the market portfolio is efficient a) What is the equation of the capital market line? formulation expected rate of return =[ [ risk-free rate + (expected rate of return from market-risk free rate)]/ standard deviation of market ] * standard deviation expected rate of return from market = 0.2 A small world . how much money should you expect to have at the end of the year?           300(1+0.07)+700*(1+0.The standard deviation of the market is 32%.23 risk-free rate = 0.1 Assume that the expected rate of return on the market portfolio is 23% and the rate of return on T-bills(the risk-free rate) is 7%.07) +(1000-x)(1+0.07 standard deviation of market = 0.000 to invest.39 we can get 1000(1+0.5 (standard deviation) b) i) if expected return of 39% is desired.32 *(standard deviation) = 0. how should you allocate it to achieve the above position? Expected return is 0.07+0.23-0.1 7.23)=1182 Problem 7.

2 2 B   ¡ ¢ B=   £ ¡ ¡       =[ [ + AB]/ ( B( M.) AB £ £ £ Since A and B are in equal amounts in the market     £ £   £ 2 M   = 2 A +2 (1. B Since the market has only two risky assets A and B.10] + .01)+.) + (1.01)/(.)2 2 B ] £   £ £ B   £   = [cov (rB. then the expected rate of return and the variance of the market depend solely on the expected rate of return and the variance of the assets A and B. what are the numerical values of i – rf = i ( M-rf) ¡ ¢ ¡ ¡ ¡   = [ B2 + AB]/ ( A2 + 2 AB + = 2[ B2 + AB]/( A2 + 2 AB +           £         2 B )= 2 B and £ £ £ £ £   £ B ¢ AB B           =[ 2 B + (1.rf) + rf =[ [ + AB]/ ( A2 2 AB + B2)] ( M.rM)]/ 2 M cov(rB.10 = .5) .rM) = cov (rA. M= ½ (A+B).)rB) = A2 + (1.01 2 B = . rA + (1.) AB]/[ 2 A +2 (1.04 AB = .) + (1.rf) + rf 2 2 A 2 AB + B )] ( M.5(. The following information is known: rF = .rf) + rf = [(.02))][.rM) = cov (rB.04+.( =0.)2 2 B ] £   £ £ A   £   = [cov (rA.) AB]/[ 2 A +2 (1.02 M = .) + (1. A.) AB   = [ A2 + AB]/ ( A2 +2 AB + =2 [ A2 + AB]/( A2 +2 AB +           £         2 B )= 2 B £ £ £ £ £ £ A ¢ AB           =[ 2 A + (1.10 2 A = .)2 2 B = 1. rA + (1.04+2(. A and B.rM)]/ 2 M cov(rA. £ ¢ ¢         ¢ ¢ ¡ AB A = A ( M.Consider a world in which there are only two risky assets.18-. and a risk free asset F.18 (a) Find a general expression for M2.rf) + rf ¡       £   2 A ¢ A ¡ ¡ (b)According to CAPM. Te two risky assets are in equal supply in the market.)rB) = B2 + (1. that is.

04 and 0.02))][. .80. Expected rate of return on the market portfolio: £ £ From rM = 0. . (a) Given this information.20.10] + . They are defined by the portfolio weights w = [.20].01)/(. It’s also known that the market portfolio is efficient.5(.3 7.20. -.18-.04+2(. . .16. Two portfolios are known to lie on the minimum-variance set. Does this changer your answers to part (a)? (a) Market portfolio can’t contain negative amount of security. They have expected rates of return of 10%.16 Problem 7. we know 0.1 rM Q Q Q Q   ¡ ¥£ ¡ ¢ ¡ ¤©§¨¦¤¢   5E F  5E F HG5E F R 5E F  5E F TD¥ %£ & @ C B A  5%7 F E  5E F  C B A 3D¥ %£ & @ HI5E F HG5E F ¤D¥ %£ & @ C B A ¥ ¤   ¥¤     ¡ ¤©§¨¦£¤¢  ¢ ¡ ¤¡©§¨¦¤¢   ¡ ¥ ¡   ¥£ ¡ W£ B¥ £ §X¡  ¥ "1£ 53 d E 5¤ d E 53 d E ¤¦¥  " TD¥ %£ C  C 3D¥ %£ ¤D¥ %£ C ¡ 0U B& @ A B& @ A B A & @ 0.3 (Bounds on returns) Consider a universe of just three securities.60. respectively.02+.08+0.01)+. what are the minimum and maximum possible values for the expected rate of return on the market portfolio? (b) Now suppose you are told that w represents the minimum-variance portfolio. and 10%. v = [.10 = . 20%.40].= [(.5 ) F E ¤R HE5¤2&I&HE5E F )  E 5%7 R HE5E R 5E F E F F ) I HE5¤2 R HEF5%7 F E E  5%7 F E )  E 5%7&I&HE5E F E F HI5E F 9  ¡ ¤©¨¥ 1£0  ¤)  ¡§ ¡ 9 7 4 2   ¡§ ¡ 36¤3¢ ¡ ¤©¨¥ 1£0  ) 4 ¥¤      ¥ ¤   ¡ ¤©¨¦£&¢¢¥  %¤"#! ¡§¥ ¡   $£  ¡ ¤¡©¨¥¦¤¢   § £ ¡ Y §X¡ W £ B ¥  c§X¡  ¥ 1£ b& ¥ A& `aX £ "  W   Q5)&Q HS5E ¥   ¤ VU F Q )  5%7 R 5E  5) E P F E F P ) F E 2 F E ¤R 5¤¤ 5%7 HSF5E 5) E P R 5) Q )  5%7&HI5E E P F E F  ¡ ¤©§¨¥10  ¤) 86453¢ ¡ ¤©¨¥ 10  ) ¡ ¡£ 9 7  2 ¡§ ¡£ '  ¡§¥ ¡   $£ ( ¡ ¤©¨¦£&¢¢¥  %¤"#! 2.

(b) If given portfolio1 is the minimum-variance portfolio.16.12. Therefore.12 rM 0.9) both to asset k and to the market itself. rM ) = σ M ] iM ] Substituting in above equations we get: λσ iM = ri − r f _ Q Q .n We apply the above equation both to asset k and to market M. [Hint: Note that   _ n i=n σ ik wi = cov(rk .…. rM ). rM ) = σ iM and 2 2 wi + σ M wM = cov(rM .02=0.9) in Chapter 6.04+0. Solution Equation 6-9 from the textbook n ¡ i=n σ ki λwi = rk − r f _ k = 1.] Apply (6. the expected rate of return of market portfolio became 0.4 (Quick CAPM derivation) Derive the CAPM formula for rk − r f by using Equation (6. Rate of return of portfolio1=0. Problem 7. rate of return of portfolio1 is the minimum rate of return of market portfolio.06+0. So we get λ [σ i2 wi + σ iM wM ] = ri − rf and _ 2 λ [σ iM wi + σ M wM ] = rM − r f _ From the hint: [σ [σ 2 i wi + σ iM wM = cov(ri .2.

6 Problem 7.Standard deviation of return o A: 15% o B: 9% Furthermore. ¡ .Expected rate of return o A: 15% o B: 12% . There is also a risk free asset. whose details are listed below: . and Simpleland satisfies the CAPM exactly.2 λσ M = rM − r f _ Eliminating λ from the above two equations and solving. _ _ σ iM = β i . the correlation coefficient between the returns of stocks A and B is ab=1/3. From the textbook. A and B.6 – Simpleland In Simpleland.Price per share o A: $1. Substituting.5 2 β j = σ jM / σ M   2 σM = n i =1 σ i2 xi2 cov = 0 n   σ jM = x jσ 2 i contributes according to its weight j Therefore β j = x jσ 2 / j i =1 σ i2 xi2 Problem 7. we obtain 2 σM (rM − r f ) β i = ri − rf Which is the required capital asset pricing (CAPM) formula. we get: λ= _ rM − rf 2 σM _ . Therefore. Problem 7.Number of shares outstanding: o A: 100 o B: 150 .50 o B: $2. rM − r f σ _ 2 M σ iM = ri − r f . there are only two risky stocks.00 .

Stock A: 100*1.15-1.Total: 450 We can deduce the respective weights in the market portfolio: .rf) So: rf =(E(ra).296 d.0105/(0.ra)+2/3*Cov(ra.rm)=0.Stock A: 1/3 (=150/450) . Risk Free Asset in Simpleland Relation (7.152+(2/3) 2*0.Stock B: 2/3 So the expected rate of return of the market portfolio is: E(rm)=0.a) rf =(0. 1/3*ra+2/3*rb) Cov(ra.2) gives us: E(ra)-rf = a*(E(rm).12*2/3 E(rm)=13% b.0081 (rm)=0.09 Cov(ra.09 Var(rm)=0.092+2*1/3*2/3*1/3*0.7 ¢ ¢ ¢ .rm)/ ¢ 2 m And we know that: Hence: rm=1/3*ra+2/3*rb Cov(ra. Standard deviation     ¡             Var(rm)= a 2 * a 2 + b 2 * 2 b +2* a* b* ab* a* b Var(rm)=(1/3)2*0.a.15*0.0105 So the Beta of stock A is: a=0. Beta of stock A   a=Cov(ra.15*0.152+2/3*1/3*0.09   c.15*1/3+0. Expected rate of return of the market portfolio Market Capitalization .rm)= Cov(ra.09)2 a =1.296) rf =6.rm)= 1/3* a2+2/3* ab* a* b Cov(ra.rm)= 1/3*0.50=150 .25%     ¡   ¢ ¢ Problem 7.Stock B: 150*2.rb) Cov(ra.296*0.13) / (1-1.rm)= 1/3*Cov(ra.00=300 .a*E(rm)) / (1.

Let w 0 and w 1 be two portfolios on the the efficient frontier. and consider small variations of the variance of such portfolios near =0.(Zero-beta assets) Let w0 be the portfolio (weights) of risky assets corresponding the minimum-variance point in the feasible region.)w0 + w1. This portfolio can be expressed as wz= (1. that is. a) There is a formula of the form 01= A 0². Find the proper value of . ¡   ¡ ¡ . Let w1 be any other portfolio on the efficient frontier.z=0. Find A.     ¡ ¡ ¡ σ 2 2 = (1 − α ) 2 σ 0 2 + 2α (1 − α )σ 01 + α 2σ 1 2 ∂ (σ 2 ) ∂α α = 0 2 ∂ (σ 2 ) 2 2 = −2(1 − α )σ 0 + (2 − 4α )σ 01 + 2ασ 1 ∂α α = 0 2 ∂ (σ 2 ) 2 2 = −2(1 − 0)σ 0 + (2 − 4(0))σ 01 + 2(0)σ 1 ∂α α = 0 2 ∂ (σ 2 ) 2 = −2σ 0 + 2σ 01 ∂α α = 0 2 σ 0 2 = σ 01 σ 01 = Aσ 0 2 A =1 b) Corresponding to the portfolio w1 there is a portfolio wz on the minimumvariance set that has zero beta with respect to w1. A third portfolio can be constructed based on w 0 and w 1 . Define r0 and r1 to be the corresponding returns.)w0 + w1. 1. [Hint: Consider the portfolios (1.

it can be concluded that : α 1 β =− =1− β 1-α 1− α Since w 0 is the MVP.   σ 02 β= 2 σ1 σ 02 α − = 1 − α σ 12   σ0 2 σ 1 4σ z 2 + σ 1 2σ z 4 = 2 2 (σ z + σ 1 ) 2 σ 0 2 (σ z 2 + σ 1 2 ) 2 = σ 1 2σ z 2 (σ 12 + σ z 2 ) −ασ 1 = (1 − α )σ 0 2 ¡ ¢ ¤ ¡ ¢ ¤ σ0 2 σz 2 ¡ £ ¡ £ σ 12 = σ z 2 + σ 12 ¤¥¦ 2 σ z2 + σ z 2 + σ 12 2 σ 12 ¡ £ ¤¥¦ ¡ £ σ 2 = 1− 2 z 2 σ z + σ1 ¤¥¦ 2 σ z2 + σ z 2 + σ 12 2 σ 12 2 . then : ∂σ 0 2 2 Set : = 0 0 = −2(1 − β )σ z + (2 − 4 β )σ z1 + 2 βσ 1 ∂β Because σ z1 = 0 2     0 = −2(1 − β )σ z + 2 βσ 1 2 2 σ z2 β= 2 σ z + σ 12 ¡ ¢ ¤ ¡ ¢ ¤ σ0   2 σz ¤¥¦ 2 σz   2 σ 0 2σ 1 2 = 2 σ1 − σ 02 σ 0 2σ 1 2 σ 2σ 2 σ 2 −σ 2 1 * = 20 1 2 * 2 2 1 2 0 2 σ 12 − σ 0 2 σ 0 2σ 1 2 σ 1 − σ 0 σ 0 σ 1 + σ 1 (σ 1 − σ 0 2 ) 2 + σ1 σ 12 − σ 0 2   β= α= σ 02 σ 0 2 − σ 12 c) Show the relation of the three portfolios on a diagram that includes the feasible region.Let w 0 be the minimum variance point portfolio. If σ 1z is zero. then the weighted combinatio n of w 0 and σ z 2 = (1 − α ) 2 σ 0 2 + 2α (1 − α )σ 01 + α 2σ 1 2 σ 0 2 = (1 − β ) 2 σ z 2 + 2β (1 − β )σ z1 + β 2σ 1 2 By linear combinatio n of the three portfolios.

5 * 0. r M = 15% r z = 9% σ M = 15% ¦ £¤¥ σ i = 5% ρ iM = 0.05 = 0.00375 (0.5 σ iM = 0.00375 0.r r r r w1 1 0 w0 wz z σ σz σ 0 1 σ d) If there is no risk-free asset.1 = 10% .15 2   ¡ ¢ r i − r z = β iM (r M − r z ) r i = 0. it can be shown that other assets can be priced according to the formula r i − r z = β iM (r M − r z ) where the subscript M denotes the market portfolio and r z is the expected rate of return on the portfolio that has zero beta with the market portfolio. Suppose that a stock i has a correlation coefficient with the market of . Find the expected return of stock i. Suppose that the expected returns on the market and the zero-beta portfolio are 15% and 9% respectively.09 + r i = 0.5. Assume also that the standard deviation of the returns of the market and stock i are 15% and 5% respectively.15 * 0.15 − 0.09) 0.

However. (This uncertainty is uncorrelated with the final price and is also uncorrelated with the market). and it is planning to enter the development stage. and each of these is equally likely.Problem 7.35 c ¨       ¤ £ Hint: E )   £¤¥ − rM =E ¢   ¢ (p − p ) (r ) [( )( )] £¥ (p − p ) (r ) . (a) What is the expected rate of return of this project? (b) What is the beta of this project? [( )( )] 1 E p − p rM − rM c c c) Is this an acceptable project based on a CAPM criterion? In particular what is the excess rate of return (+ or -) above the predicted by the CAPM? Solution: ¦ ©  ¡ ¡ M b) $ # 2 σ rM 1. The cost c of the project will be known shortly after th project is begun.125σ Μ c [( )( )] ! ! c c M $ # E r − r rM − rM = E " − rM =E c M − rM " #% " #% [( )( )] ( p − c ) − ( p − c ) (r  § a) r = p−c p p = − 1 E (r ) = E − 1 . To develop the process. Assume that the risk free rate is rf=9% and the expected return of the market rM = 33% . has a new idea for producing TV sets.125σ M = 1. Due to the fact that p. with expected value p = $24M . this sale price will depend on the market of TV sets at the time.8 Electron Wizards. it is determined that the 2 final sales price p is correlated wth the market return us E p − p rM − rM = $20Mσ Μ .c are independent we c c c 1 have E (r ) = E E ( p ) − 1 = 0. By examining the stick histories of various TV companies. Once the product is developed (which will be at the end of 1 year).05625 * 24 − 1 E (r ) = 0. EWI must invest in a research and development project. the company expects to sell its new process for a price p. The current estimate is that the cost will be either c=$20M or c=$16M. Inc.125 Then: β = 2 = 2 σM σM c) Based on the CAPM the expected return is: ! #$% =E 1 2 E p − p rM − rM = 1.

) rM + 1) – {P(1. for a fund with return rf + (1.9 Formulation: (Gavin’s problem) Prove to Gavin Jones that the results he obtained in egs.125(0. The return for an asset mixture (Q) with above weights is given by (please note that Q or rM with a bar on top is represented as Q or rM i.) *( rM . for an asset combination of two securities with weights and (1.e. 7. ¡ ¡ We have to prove that the formulas. boldface) ¡ ¡ ¢ ¢ Q=P( rf + (1. Nevertheless.rf ) / 2 M }]   £   r − rf = β r M − rf ( ) r = β r M − r f + r f = 1. cov (Q.09 ( ) r = 0. £ ¡ ¡ P = [1/ (1+ rf )] * [ Q. based on the CAPM model.e.) rM + 1) – { (1.) rM + 1)………………………………………………………(1) Also for the covariance we can write.01 therefore the final decision should not be based only on the CAPM criterion. 2 M} = [1/ (1+ rf )]* P [ ( rf + (1.) ¡ ¡ ¡ 2 M )*( rM .) 2 M from certainty equivalent form of the CAPM.) rM + 1).27 Thus we conclude that.) rm show that both CAPM models give the price of $ 100 worth of fund assets as $100.The expected excess rate of return is: r − r f = +0.36 ¡ . the difference is only 0.5 & 7. Specifically.09) + 0.rf ) / Substituting (1) and (2) from above.5 and 7.{cov (Q.rf )}] ¡ ¡ ¡ £ £ P = [1/ (1+ rf )]*[ P ( rf + (1.7 of the book. rM ) = cov ( P ( rf + (1. “certainty equivalent form of the CAPM” & the “CAPM as a pricing formula” both will give the same results for pricing an asset P by appropriately discounting the final return Q.).33 − 0. we have. we have to do this for the case mentioned for Gavin Jones in egs.. 7. rM )*( rM . rM ) …………………………….7 were not accidents. the project is not acceptable since it gives smaller return rate than CAPM. i.…(2) = P(1. Problem 7.

. hence the proof.expanding and canceling out common terms. P = [1/ (1+ rf )]* (1+ rf ) = P.

05)+0.00% 2.30% 1.160*0.12.846 ¢ ¡ σ 2 = b 2 × σ 2 + σ e2 f b= 3 wi × bi σ e2 = 3 i =1 2 wi2 × σ ei .12.50*0.0*(0. we have: B2 = (0.8*(0.05 = 0. solving we have: R1 = 1.160= 10. what is the standard deviation of this rate of return? Market Rate of return 12% Stock Standar deviation 18% Beta Risk free rate Standar deviation of random error term 7.1144 = 11. The risk-free rate is 5%.0.8 1 a) The equation for a single-factor model for stock returns is: ri − rf = β i × (rm − r f ) So.20+0.12.50+0. (a) What is the portfolio’s expected rate of return? (b) Assuming the factor model is accurate.05 = 0.05)+0.1+0.1 (A simple portfolio) Someone who believes that the collection of all stocks satisfies a single-factor model with the market portfolio serving as the factor gives you information on three stocks which makes up a portfolio.0.44% b) Standard Deviations: We know that: i =1 Solving.127*.30*1)^2 = 0.120*0.120 = 12.20*1. In addition.05 = 0. you know that the market portfolio has an expected rate of return of 12% and a standard deviation of 18%.00% 5% Weight in porfolio 20% 50% 30% A B C 1.0.6% R3 =1.0% Since Rportfolio =   rportfolio = n i =1 ri × wi Rportfolio = 0.8+0.Problem 8.05)+0.1 0.127 = 12.30 = 0.7% R2 =0.1*(0.

] ¡ ¡ ¡ ¡ ¡ ¡ j . The first principle component is the one corresponding to the largest eigenvalue of V.01 Problem 8. the second to the second largest.03% Portfolio's standard deviation = (84.3^2*0.10 ¢ Using the relationship: if Yields: .24% 2 e = 0. is the first principle component extracted from the n returns themselves: that is.324 = 3.5^2*0. What are the values of 0.24%+0.023^2+0. It is known that r-bar1 = 15% and r-bar2 = 20%.2 Two stocks are believed to satisfy the two-factor model r1 = a1 + 2f1 + f2 r2 = a1 + 3f1 + 4f2 In addition there is a risk-free asset with a rate of return on 10%.02 2 = .2. An eigen vector of V is a vector v = (v1.3 Suppose there are n random variables x1. you need an eigenvector calculator as available in most matrix operation packages. Find the first principle component for the data of example 8. x2. A good candidate for the factor in a one-factor model of n asset returns. and so forth.2^2*0. by using the principle eigenvector of the covariance matrix of the return.2 M = 0.10 + 2 .03%)^0. 1.5 = 16.18^2 = 0. and 2 for this model? Since there is a risk-free asset with rate-of-return of 10%: ¢ ¡ ¡ ¡ ¡ 0 = . Does this factor (when normalized) resemble the return on the market portfolio? [Note: For this part.01^2     = 0.07^2+0. … xn and let V be the corresponding covariance matrix. The random variable v1 x1 + v2 x2 + … + vnxn is a principle component.15 = .10 + 3 ¡ ri = ai + bij fj then r-bari = 0 + bij 1 + +4 ¡ 2 1 2 1 = .20 = .66% Problem 8.6%*3. … vn) such that Vv = λv for some λ (called an eigenvalue of V). v2.

25 Covariance matrix From the above matrix we have to calculate the eigen values .02 40.56 25.47 -6.78 1.38 162.24 17.1 5.7 19.18 30.26 65.2 we have the following data Year 1 2 3 4 5 6 7 8 9 10 Average Var Cov Stock 1 11.89 107.31 13.45 20.34 107.25 3.9 5.58 15.09 0.64 24.26 19.7 6. Using the above Covariance values the Covariance matrix is constructed From the excel we get it as 1 2 3 4 1 90.23 73.12 72.00 90.18 2 50.82 34.9 1.59 15.74 -2.54 2.93 3.24 -15.11 9.12 22.95 31.20 100.84 5.09 14. variance and finally the covariance for the above data In the covariance we have to divide the value that is obtained from the excel solver by 9*10 to adjust the bias.51 12.42 -1.99 56.02 105.2 20.37 3.89 79.39 18.82 3.09 68.34 32.05 16.71 15.49 15.4 -6.20 56.2 4.11 21.54 68.8 5.94 10.99 Market 23 17.67 12.54 4 40.37 Stock 4 27.02 0.4 5.83 72.62 1.34 19.9 5.05 10.34 15.28 17.05 17.78 13.99 3 79.54 Stock 2 29.92 9.12 1 0 Riskless 6.08 16.9 12.90 162.38 30.24 16.84 1.99 0.91 18.27 19.25 48.63 15.53 17.23 105.37 30.73 25.2 6.68 3.854 β α e-var From the above first we calculate the averages.8 18.26 50.From the example 8.46 6.5 6.09 Stock 3 23.81 -4.

217r1 + 0.….4 Let ri.To find the eigen values we solve using Excel the following equation: det (V − λ E ) = 0 . This equation has several roots. We get the largest eigen value = 311. Solution. Define the estimates 1 n ˆ= µ ri n i =1   s2 = Show that E (s 2 ) = σ 2 .153r4 Problem 8.263 0.n.263r2 + 0.217 0.16 The corresponding eigen vector is found to be V = [0.153] Since this is the normalized form we have the eigen vector as V = 0. We are interested in the largest eigen value. § ¨   1 n ˆ (ri − µ ) 2 .360r3 + 0. then ¡ ¡ £ ¢ n 1 ˆ E (ri − µ ) 2 n − 1 i =1 n 1 ˆ ˆ = E (ri 2 − 2ri µ + µ 2 ) n − 1 i =1 n 1 ˆ ˆ = E ri 2 − 2nµ 2 + nµ 2 n − 1 i =1 n 1 ˆ = E (ri 2 ) − nE ( µ 2 ) n − 1 i =1 £ ¢ ¡ £ ¢ §   ¤¥¦ ¤¥¦  ¤¥¦   © (by properties of the expectation) (by the linearity of the expectation) .360 0.2. for i = 1. be independent samples of a return r of mean µ and variance σ 2 . n − 1 i =1 E (s 2 ) = E = 1 n ˆ (ri − µ ) 2 n − 1 i =1 © ¨   Since E (Y 2 ) = V (Y ) + E (Y ) 2 .

.....5 ˆ a) Show that σ (r ) is independent of n rn = 2 σn = r n σ2 n and ˆ ˆ r = nrn 2 σ 2 = nσ n ˆ ˆ ˆ var(r ) = var(nrn ) = n 2 * var(rn ) ………………………...e. var(rn ) = n 2 * σ2 n 2 =σ2 ˆ It shows that σ (r ) is independent of n ˆ b) Show that how σ (σ 2 ) depends on “n” ˆ ˆ2 ˆ2 var(σ 2 ) = var(n * σ n ) = n 2 * var(σ n )...(1) since var(rn ) = 2 σn n ˆ and σ = 2 n σ2 n var(rn ) = σ2 n*n = σ2 n2 From (1).i =1 © © £¤¥ Problem 8......d. ¡ § n   ¦ ©  £¤¥ 2 2 2 © (σ + µ ) − n + µ2 ¦ 1 E (s ) = n −1 n ¢ ¨ σ2 q... ...........   ¡ ¦ § = ¢ ¦ ¨ 1 σ2 n(σ 2 + µ 2 ) − n + µ2 n −1 n 2 =σ ...(2) Assume that the return are normally distributed....

7 18 3.4 21 2.1 17 -1. d) How do you think the answers to © would change is you had 2 years of weekly data instead of monthly data? (See exercise 5.24 -2.1 9 1.1 16.5 16 2.5 7 -3.1 11 -2.) n = number of periods = Period i (month) 1 2 3 4 5 6 7 ri 24 (r − rˆ ) i 2 1.4 12 3.69 -2.25 -3. ˆ σ (σ ) = 2 More data does not help to estimate the mean more precisely but it improves the estimation of the volatility.6 A record of annual percentage rates of return of the stock S is shown in the following table.0 4.5 3 4. Record of Rates of Return: Month Percent rateof return 1 1.81 . b) Estimate the ariithmetic standard deviation of these returns.5 0.7 22 2.9 24 1.7 10 0.9 23 -1.5 6. expressed in percent per year.1 8 4. ˆ var(σ 2 ) = 2σ 4 n −1 2σ 2 (n − 1) Then.93038E-32 0.2 4 -2.7 13.7 5 -2.25 4.5 15 -2.2 10. Problem 8. again as percent per year.2 14 4.7 19 3. c) Estimate the accuracy of the estimates found in parts (a) and (b).2 20 -2.0 6 3.0 9 3.2 var(σ n ) = 4 2σ n 2σ 4 = 2 n − 1 n * (n − 1) Therefore.2 Month Percent rateof return 13 4.1 a) Estimate the arithmetic mean rate of return.0 2 0.

25 1.5 2.61 0.2 4.1 1.89 3.4 2.4472=0. Since we are quaring the standard deviation with units as percent.41 0.021206% 25.1 9.5687% where n = 2 since we are dealing with yearly standard deviations Accuracy of the variance estimator stdev( s ) monthly = 2 2 2 stdev( s ) yearly = 12 * stdev( s ) monthly = where n = 24 and σ is the monthly σ.21 7.81 11.1206= 0.01 ¡ ˆ 1 r= n n i =1 ri = 1.5 -2.25 12.29 7.191304 sy = 9.289545% σ rˆ = σ n = 2σ 2 n −1 = 2.4 3.2 4.9 -1.29 4.7 2.84 10.1 -1.56 4.2 -2.49 0.61 8.24 12.1 -2.84 11.8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 a)   4.0% c) The accuracy of the estimators is determined by taking the following standard deviations: Accuracy of the mean estimator 6. then we need to multiply by 100 to get the answer as a percent and not percent squared ¢ s2 = 1 n = 24 ˆ ( ri − r ) 2 = n − 1 i =1 7.7 3.9 1.254472% .7 0.4 = n = 24 i =1 ˆ ( ri − r ) 2 ˆ ˆ ry = 12r = b) 12.0 165.7 3.56 2.

ri +! ) = E (ri ri +1 ) − E (ri ) E (ri +1 ) = E[( ρ i + ρ i +1 )( ρ i +1 + ρ i + 2 )] − r * r = E[ ρ i ρ i +1 ] + E[ ρ i ρ i + 2 ] + E[ ρ i +1 ]2 + E[( ρ i +1 )( ρ i + 2 )] − r * r E ( ρ i ) = V ( ρ1 ) + E ( ρ i ) 2 = 1 / 2σ 2 + (r / 2) 2 From the formula above 2 ¡ From the hint: ρi are uncorrelated-   independent.7 Gavin Jones figured out a clever way to get 24 samples of monthly returns in just over one year instead of only samples. How does the variance of his estimate compare with that of the usual method of using 12 nonoverlapping monthly returns? Solution 1 n ri ) = r n i =1 Monthly rate of return=r Half monthly rate of return =r/2 E (ri ) = r = 1 / 12ry E ( Head r ) = E ( E ( ρ i ) = r / 2 = 1 / 24ry 2 V (ri ) = σ 2 = 1 / 12σ y 2 V ( ρ i ) = 1 / 2σ 2 = 1 / 24σ y From the hint: ri = ρ i + ρ i +1 Cov (ri . Analyze Gavin’s idea. the first sample covers Jan. 1 to Feb. is dependent on the number of periods. The accuracy would increase with more periods to estimate the standard deviation. the mean monthly return. 1 and the second sample covers Jan. n.d) Exercise 8-5 proves that the accuracy of the mean estimator is independent of the number of periods. . he takes overlapping samples. Problem 8. and so forth. He figures that error in his estimate of r . 15 to Feb. The accuracy of the standard deviation estimator however. 15. will be reduces by this method. that is. the accuracy of the mean estimator would not change by using 2 years of weekly data instead of 2 years of monthly data. As a result.

+ V (r 24) + 2 cov(r1. Thus r’=inv(Pinv(Q)P)Pinv(Q)p=Qinv(Q)p=p.= E[ ρ i ]E[ ρ i +1 ] + E[ ρ i ]E[ ρ i + 2 ] + E[ ρ i +1 ]2 + E[ ρ i +1 ]E[ ρ i + 2 ] − r 2 = r / 2 * r / 2 + r / 2 * r / 2 + σ 2 / 2 + ( r / 2) 2 + r / 2 * r / 2 − r 2 = 3* r 2 / 4 + r2 / 4 + σ 2 / 2 − r2 =σ2 /2 From the page 215 and the hint: 24 1 24 1 V ( Head r ) = V ( ri ) = 2 V ( ri ) 24 i =1 24 i =1 1 = 2 [V (r1) + V (r 2) + . The error vector has covariance matrix Q.. Solution: Suppose that p=r+e. + 2 cov(r 23 + r 24)] 24 1 = 2 [24σ 2 + 2 * 24(σ 2 / 2)] T 24 1 = σ2 12 he result is equal to page 215 (8. r 2) + 2 cov(r 2 + r 3) + ...8 We use the general model with p=Pr+e where P is an mxn matrix.. The vector p is a set of observation values and e is a vector of errors having mean 0. Then the estimate r’ of r is r’=inv(tr(P)inv(Q)P)tr(P)inv(Q)p where inv is the inverse of a matrix and tr is the transpose of a matrix.. and P and e are m-dimensional vectors. . we must show that r’=p.11)     Problem 8. a) If there is a single asset an just one measurement of the form p=r+e. r is an n-dimensional vector. then P and Q are scalars with tr(P)=P=1.

inv(Q).fM)=0.25 i^2. Solution: First we note that the inverse of a 2x2 matrix A is given with entries A11=a. find the best estimates of the ri’s. A22=d.b) Suppose we have two uncorrelated measurements with values p1 and p2 having variances 1 and 2 respectively. A12=b. Assuming the i’s are known exactly. Q22= 2^2 with the inverse of Q. Inv(A)=[1/(ad-bc)]M   ¡ ¡ ¡ ¡ ¡         . given by the entries inv(Q)11=1/ 1^2 inv(Q)12=0 inv(Q)21=0 inv(Q)22=1/ 2^2 Putting these into the above formula we get         r’=[1/(1/ 1^2 +1/ 2^2)](p1/ 1^2 + p2/ 2^2). Solution: Here we have P=tr(1 1) p=tr(p1 p2) r=(r) and Q is the matrix with entries Q11= 1^2. Q21=0. Q12=0. There are measurements of the form r1=p1+e1 r2=p2+e2 r3=p3+e3 r4=p4+e4 r1=rf+ 1*fM r2=rf+ 2*fM r3=rf+ 3*fM r4=rf+ 4*fM where the ei’s are uncorrelated and where cov(ei. c) We consider example 8.5. We need to show that             r’=[1/(1/ 1^2 +1/ 2^2)](p1/ 1^2 + p2/ 2^2). A21=c.

We also use the formula r_ei=r_f + i(r_M-r_f) where r_ei and r_M are the expected values of the return for security i (using the equilibrium model) and the market respectively.12%.05) and Q is the matrix with entries Q11=3. r_f is the risk free rate.02 and we also compute p=tr(14.5. and Q22=2. M21=-c. Note that the first entry for Q is /( 10) For stock 2 we have r_h=14. Inserting these into the above formula we get r’=14. We have as well that cov(e_i.02 _M/( 10). M12=-b.275^2.25(3. f_M)=0.34% and r_e=13.74^2 where     ¡       2.42^2.00)^2.99) and Q is the matrix with entries Q11=3. Q12=Q21=0.05 as computed in example 8. For stock 1 we have r_h=15. and M22=a.25 _i^2 where the errors e_i (for the measurements r_h) are uncorrelated.74=1. So p=tr(15. Q12=Q21=0. and Q22=2.Where M is the matrix with entries M11=d.00^2.275)^2.99% using 2=1. and _ei= i _M/( 10)       ¡ ¡ for the variance of the error in the measurement of r_ei. . Inserting these into the above formula we get r’=13.72%. For part (c) we use the above formula stated at the beginning with P=tr(1 1).25(3.00 and r_e=13.34 13.00 13.

Q12=Q21=0.25%.826^2 where     ¡ 1.09 11.027^2.03% using 3=1. and Q22=3.76^2 where     3.For stock 3 we have r_h=10.40 _M/( 10).90% and r_e=17.27) and Q is the matrix with entries Q11=2.40 and we also compute p=tr(10. and Q22=1. For stock 4 we have r_h=15.90 17. Inserting these into the above formula we get r’=14.03) and Q is the matrix with entries Q11=4.68 and we also compute p=tr(15.826=0.613)^2.027)^2.25(2. Inserting these into the above formula we get r’=12.68 _M/( 10).27% using 3=0. Q12=Q21=0.76=1. ¡ .19%.09% and r_e=11.613^2.25(4.

.000. $50. $30.82 + $17.000.000.000 p of each = 1/7 Find the certainty equivalent Salary = $80.000.61 + $18.000. each with equal probability.000. $120. $60.000. $140.000.Problem 1 An investor has a utility function U(x) = x^1/4 for salary. $50. What is the certainty equivalent of this job offer? Certainty Equivalent U(x) = x^1/4 Salary = $80.34) E(U(x)) = 1/7($127. $20.15 Cx^1/4 = $18. $20.78 + $18. $40.000.000. $40.000. The bonus will be $0.077) E(U(x)) = $18.000 with bonus Bonus = $0.04 The value C above is the Certainty Equivalent. $30.000 with a bonus.610. $10. or $60.000. $100.99 + $19.154 Need to find A value C such that U(C) = $18.000.15 C = $18.000 E(U(x)) = 1/7 ($16.15^4 C = $108. $90. He has a new job offer which pays $80.000.000.000. $110. $10.21 + $18. $130.000.32 + $17.

only the investment w and the payoff x are. [ ] [ ] ( ) ] > E[− e ] E [− e e E [− e ]⋅ E [e ( ) ] > E [− e ] E [e ( ) ] < 1 E − e − a (W − w+ x ) > E − e −aW − aW − aW −a x−w −a x − w − aW − aW −a x−w E[U (W − w + x)] > E[U (W )] The initial wealth. Show that his evaluation of this incremental investment is independent of W. The investor is faced with an opportunity to invest an amount w W and obtain a random payoff x. To evaluate the incremental investment. we will compare the investment versus not making the investment. is no longer part of the equation. W. and E [U (W )] is the expected value of the utility function of wealth if the investment is not made. . E [U (W − w + x )] is the expected value of the utility function if the investment is made.Problem 2   Suppose an investor has exponential utility function U(x) = -e-ax and an initial wealth level of W. This shows that the evaluation is independent of W.

Problem 3 3) Suppose U(x) is utility function with Arrow-Pratt risk aversion coefficient a(x) Let V(x) = C + bU(x). What is the risk aversion coefficient of V? a(x) = -U”(x)/U’(x) V’(x) = bU’(x) V”(x) = bU”(x) a(V) = bU”(x)/bU’(x) a(V) = U”(x)/U’(x) Therefore the risk aversion coefficient = -a(x) .

(x)1 = x * (-1 / x2) / (1 / x) = -(1 / x) / (1 / x) = -1 = constant U’(x)2 = 2 * x( -1) U”(x)2 = ( 3 – 2) * x( -2) = 2 ( -1)* x( -2) So. (x)2 = -1= constant ¢ ¡ ¡ ¢ ¢ ¡ ¡ ¡ ¡     ¢ ¡   .Problem 4 The Arrow-Pratt relative risk aversion coefficient is (x) = x * U”(x) / U’(x) Show that the risk aversion coefficients are constant for U(x)1 = ln x and U(x)2 = * x U’(x)1 = 1 / x U”(x)1 = -1 / x2 So.

V(x)=aU(x)+b for some a>0 and b. that is. To check her result. The result is a utility function V(x).4 to deduce her utility function U(x) over the range A<=x<=B. Find A and B. where A<A’<B’<B. Given: U(A)=A. U(B)=B. If the results are consistent. U and V should be equivalent.Problem 5 A young woman uses the first procedure described in Section 9. U(B)=B from A to B V(A’)=A’. she repeats the whole procedure over the range A’<=x<=B’. with V(A’)=A’. She uses the normalization U(A)=A. U(B’)=B’ from A’ to B’ V(x)=aU(x)+b a>0 Find: a and b Solution: V ( A ' ) = A ' = aU ( A ' ) + b V ( B ' ) = B ' = aU ( B ' ) + b a= B' = A '− b U ( A' ) A '− b A ' U ( B ' ) bU ( B ' ) − +b U (B') + b = U ( A' ) U ( A' ) U ( A' ) A 'U ( B ' ) 1 − U (B') U ( A' ) − U ( B ' ) =b =b B '− U ( A' ) U ( A' ) U ( A' ) B 'U ( A ' ) U ( A ' ) A 'U ( B ' ) − b= U ( A ' ) − U ( B ' ) U ( A ' ) (U ( A ' ) − U ( B ' ) ) B 'U ( A ' ) − A 'U ( B ' ) b= U ( A' ) − U ( B ' ) V ( A' ) = A' = aU ( A' ) + b V ( B' ) = B' = aU ( B' ) + b b = B'− aU ( B' ) A' = aU ( A' ) + B'− aU ( B' ) a= A'− B' U ( A' ) − U ( B' ) A'− B' = a(U ( A' ) − U ( B' ) ) . V(B’)=B’.

b = 0 γ (1 − γ ) 1−γ ∂U ( x) (1 − γ ) = γx γ −1 = (1 − γ )1−γ x γ −1 γ thenU ( x) = ln x * (ax + b(1 − γ ))λ The Arrow-Pratt risk aversion coefficient is. b=0.5ax^2+0. γ 1−γ Show how the parameters γ . b>0. 1 (b) Quadratic: U ( x ) = x − cx 2 2 Let λ =2 so we will have 0.5b^2+abx/(1-b) So a=b=1     ¡ £¤¥ £ (c) Exponential: U ( x ) = −e − ax λ =. a and b can b chosen to obtain the following special cases (or an equivalent from). (a) Linear or risk neutral: U(x) =x Let λ =1 so we have ax=x then a=1.Problem 6 The HARA ( for hyperbolic absolute risk aversion) class of utility functions is defined by ax U ( x) = + b .     U ( x) = ax +b 1−γ  1− γ     U ( x) = ax +b 1−γ  1− γ γ γ = = (1 − γ ) 1−γ (ax + b(1 − γ )) γ = ¦ ¦ © ©  ax (lim + b) = (lim1 + x) x x →∞ 1 − γ x →∞ then b=1 a=1 ax +b 1− γ ¨ ¢ 1− γ γ 1 1−γ γ =x (1 − γ ) x γ γ .∞ § γ (d) Power: U ( x) = cx γ  γ U ( x) = cx γ then a=1 b=1 γ = γ (e) Logarithmic: U ( x ) = ln x  γ 1 γ 1−γ ∂x γ γ = 0. a = 1.

  ¡ £ a   ax +b 1− γ £¤¥ ¢ a( x ) = − ¡ U ′′( x) = U ′( x) γ −1   £ 2   ax a +b 1− γ £¤¥ ¢   ¡ £ 2   ax U ′′( x) = − a +b 1− γ £¤¥ ¢     ¡ ax U ′( x) = a +b 1− γ £¤¥ £ γ −1 ¢ γ −2 γ −2 = a a x+b 1− γ = 1 1 b x+ 1− γ a .

6 1. the table and equations would not agree.76 5.1 0. and for e as a function of C. Do the values in Table 9. From this.84 4 3.24 2.6 0. If they were not true. Finally. we simply solve the equation from the first part for expected values to get expected value as a function of certainty equivalent. Substituting probabilities as a function of expected values into the certainty equivalent equation yields the desired certainty equivalent as a function of expected values.4 6. we can calculate the expected values in terms of probability and vice versa.2 0. Find an analytical expression for C as a function of e. e=9-8*p e-9=-8*p   .56 1.4 2. U(C)=Sqrt(C)=e=E[U(x)] For an undetermined probability value for the $1M lottery outcome. U(C)=p*U(1)+(1p)*U(9) From the table e=p*1+(1-p)*9 e=p+9-9*p=9-8*p Since we are looking for an expression for C as a function of e.2 3. To find the second part of the problem.6 5. E[U(x)]=$5M.3. Since we know the probabilities in the table. C=$4M U(C)=e p e C 0 0.9 1 9 8. we can solve U(C) for C.5. Certainty equivalent.8 1 9 7.7 0.8 0.Problem 7 (The venture capitalist) A venture capitalist with a utility function U(x)=Sqrt(x) carried out the procedure of Example 9.8 5 4. we can solve the last equation for p and substitute this into the equation for C to find the answer.2 7.1 of the example agree with these expressions? Venture capitalist U(x)=Sqrt(x) Lottery outcomes. either $1M or $9M p(receiving $1M) varies For p(either two outcomes)=0.4 0.44 1 Analytical expression for C as a function of e is found: For this problem. we compare these two equations to the table by substituting in values from the table for C and e to determine that the equations remain true statements. variable probability p.76 4.3 0.5 0. we will have an equation with an unknown.84 6.96 1.

1 in Example 9.3 agree with these expressions? Substituting values from table into these equations C(6. C(e)=[(e+3)^2]/16 Analytical expression for e as a function of C is found: U(C)=Sqrt(C)=e=E[U(x)] U(C)=p*U(1)+(1-p)*U(9)=Sqrt(C) U(1)=Sqrt(1)=1 U(9)=Sqrt(9)=3 p=(9-e)/8 U(C)=Sqrt(C)=(9-e)/8+[1-(9-e)/8]*3=(9-e)/8+3-[3*(9-e)]/8 =(9-e)/8+3-(27/8)+3*e/8=(9-e+24-27+3*e)/8 =(2*e+6)/8=(e+3)/4 Sqrt(C)=(e+3)/4 4*Sqrt(C)-3=e So.76)-3=6.p=(9-e)/8 an equation for C U(C)=p*U(1)+(1-p)*U(9)=Sqrt(C) C=[p*U(1)+(1-p)*U(9)]^2 U(1)=Sqrt(1)=1 U(9)=Sqrt(9)=3 C=[p*1+(1-p)*3]^2=[p+3*(1-p)]^2=(p+3-3*p)^2=(3-2*p)^2=4*p^2-12*p+9 Substituting for p C=4*[(9-e)/8]^2-12*[(9-e)/8]+9 =4*[(9-e)^2]/64-12*(9-e)/8+9 =(4/64)*[e^2-18*e+81]-(108+12*e)/8+9 =(1/16)*(e^2-18*e+81)-(216/16)+(24*e)/16+(144/16) =(1/16)*e^2-(18/16)*e+(81/16)-(216/16)+(24*e)/16+(144/16) =(1/16)*e^2+(6/16)*e+(9/16)=(1/16)*(e^2+6*e+9)=(1/16)*(e+3)^2 So. the values in the table agree with these equations.6+3)^2]/16=5.6. e(C)=4*Sqrt(C)-3 Do the values of Table 9. the same value as the table e(5.6)=[(6.76. the same value as the table From these observations.76)=4*Sqrt(5.       .

if we let c donate the certainty equivalent and assume it is close to x . we can use the first-order expansion U (C ) = U ( X ) + U ' ( X )(C − X ) _ _ _ Using these approximations.Problem 8 There is a useful approximation to certainty equivalent that is easy to derive. show that C = X+ _ U (C ) − U ( X ) _ _ U '( X ) As the definition U (C ) = E[U ( X )] _ _ 1 U (C ) ≈ U ( X ) + U " ( X )Var ( X ) 2 _ _ _ 1 [U ( X ) + U " ( X )Var ( X )] − U ( X ) _ 2 C = X+     _ U '( X ) _ 1 U " ( X )Var ( X ) C = X+ _ 2 U '( X ) _ . A second_ order expansion near x =E(x) gives _ _ _ _ _ 1 U ( x ) ≈ U ( x) + U ' ( x)( x − X ) + U ' ' ( x)( x − X ) 2 2 _ _ 1 E[U ( x )] ≈ U ( x) + U ' ' ( x )Var ( x ) 2 _ On the other hand.

changing b to b’ does yield the same result. if the investor with wealth W purchases the same portfolio.Problem 9 An investor with unit wealth maximizes the expected value of the utility function U(x) = ax – bx2/2 and obtains a mean-variance efficient portfolio. the payoff will be WR and R should maximize: E[U(x2)] = aE[RW] – 1/2b2(var[RW] + E[RW]2) = aWE[R] – 1/2b2(W2var[R] + W2E[R]2) = W[aE[R] – 1/2b2W(var[R] + E[R]2)] If b2 = b’= b/W is substituted in the final equation for the second investor. the same R will solve the expected value of the utility function as the R using unit wealth. it would maximize: E[U(R)] = aE[R] – 1/2b(var[R] + E[R]2) Similarly. but gets a different portfolio return. What is the value of b’? In general. However. E[U(x)] = E[ax – 1/2bx2] = aE[x] –1/2bE[x2] = aE[x] – 1/2b(var[x] + E[x]2) In this situation. if the random payoff of the portfolio of the investor with unit wealth is R. A friend of his with wealth W and the same utility function does the same calculation. .

= E[U (x*)] R => = E[U (x*)] (1+ rf ) 2. = E[U (x*) Ri] => = E[U (x*)(1+ ri )] => = E[U (x*)(1+ ri )] = E[U (x*)] (1+ rf ) E[U (x*)(1+ ri)] .rf)]=0     ¡ ¡           ¡ ¡           ¡ ¡   . Suppose that the optimal portfolio for this investor has random) payoff x*. If there is a risk-free asset with rate of return R. Thus. n. 2. and one risk-free asset with rate of return rf.E[U (x*)(1+ rf)] = 0 E[U (x*)(1+ ri )-U (x*)(1+ rf)]=0 E[U (x*)( ri .4) p. Thus. then di = R and Pi = 1. then di = Ri and Pi = 1. There are n risky assets with rate of return ri=1. 243 we know that E[U (x*)di ]= Pi. If there is a asset i with total return Ri. The investor has initial wealth W0. …. 1. 2. n. From (9. …. Show that E[U (x*)(ri-rf)]=0 for i = 1.Problem 10 Suppose an investor has utility function U.

2θ 2 + θ 4 θ1 + θ 2 + θ 3 + θ 4 = W 1 W 1.36 + + =λ 3θ1 + 1.2θ 2 + 6θ 3 + 3000 θ1 + 1.2θ 2 + θ 4 1.2θ 2 + θ 4 1.2θ 2 + θ 4 θ1 + θ 2 + θ 3 + θ 4 = W thus θ1 = 0.9 0.2W − 250 θ 4 = 0.2θ 2 + 6θ 3 + 3000 θ1 + 1.6W = 1.8 =λ 3θ1 + 1.2W θ 2 = −1250 θ 3 = 0.500 .2θ 2 + θ 4 0.8W = 3θ 1 + 1.36 0.Problem 11 0.2θ 2 + 6θ 3 + 3000 0.2θ 2 + θ 4 1.4 0.8W = θ 1 + 1.2θ 2 + θ 4 0.6W + 1500 The price of money back guaranteed investment P = $1.48 0.3 + =λ θ1 + 1.4 + =λ 3θ1 + 1.2θ 2 + 6θ 3 + 3000 λ= 0.

.... dS2 − p2 d13 d 23 dS3 − p3 .. d 12      ........... ... d SN   ¡     Let construct a matrix A = ....  d1 N  d 2N d SN y S +1   − pN ... ..     .Problem 12 Formulation: The following is a general result from matrix theory: Let A be mxn matrix... Here d ij is .. Then there is a vector y > 0 with AT y = 0 ........ . − p N dividend of the security j in the state i . d1 N D1 ¨  θ1 d 23 d 2N θ 2 ..... D3 ¦ ¦ © © ¦ ¦ © © ¦ d11 © © d 12 d 13 .. d S1 £ ........ there are positive state prices........ dS2  − p2 y2    d 11   d 21 .... Suppose that the equation Ax = p can achieve no p ≥ 0 except p = 0 . ... ... d S1    − p1 y1 =0 §   §   § − p1  − p2 − p3 .......t.... ¦ ¦ © © ¦ ¦ © © ¦ Aθ = ....    AT y = y3   d 22 . [Hint: If there are S states and N securities... Dk > 0 .......... d1 N   d 21 £ £ £ d2N .........θ N ) as vector of weights of the securities in the portfolio.... d SN ...... In order to avoid the arbitrage we need to conclude that if PN ≤ 0 then for all i Di = 0 ... .... let A be an appropriate (S + 1)xN matrix] Solution:   d11 £ £ d12 d 22 .9........... prove the positive state price theorem in Section 9.... In this case we have arbitrage because with 0 or negative price there is a possibility to get dividend in one of the states.... ............ .... that is.......... .... − p N θN − PN ¦ © ¦ © ¦ d S1 © dS2 d S3 ...t....... It means that system (*) can achieve with T = 0 . ........ . Now lets assume that PN = 0 or PN < 0 and there is some k s... Let take vector θ = (θ 1θ 2θ 3 ..... Use this result to show that if there is no arbitrage. θ 3 = ¨  ¦ ¦ ¨ =T   ¢ ¤ ¥   (**) ..... ¦ © ¦ © ¦ − p1 d 21 © © © d 22 D2 (*) Here Di is dividend in state i and PN is price of the portfolio. According to the algebra we have that ∃y i > 0 s.

. d1 N d 2 N ... .... .......... ......... pi = ¥ £ £ £ £ £ £ ¤           ¢ ¡ ¥ £ £ £ £ £ ¤ S j =1 d jiψ j which means that for S j =1 d jiψ j ....... Expression (**) will looks like: d 11 d 21 ........ ..... .Because y S +1 ≠ 0 we can divide all y i by y S +1 and define them as state price... d S 2 − p 2 A Tψ = ψ 3 = 0 where ψ i > 0 .t... ....... d SN − p N 1 ¦       ¢ ¦       ¡ ψ1 By solving this we have for each state that pi = each state we constructed a positive state price ψ i s.. d S1 − p1 ψ2 d 12 d 22 ........

the problem is solved. Ri ) . Ri ) RM − R = γCov (RM . equivalently E [(1 − cWR M )(Ri − R )] = 0 . In the4 quadratic case. RM ) = γVar ( RM ) . We denote by the RM the return of the portfolio. and using the fact that initial capital is W we get (rk − r )E [U ' (WRM )] = 0 . and equivalently Ri − R = γCov (R M . . so Ri − R = ( RM − R ) = β i (RM − R ) . we have (rk − r )E U ' (x * ) = 0 . we have U’(x)=1-cx. Ri )] . Var ( RM ) and so. Problem 13 [ ] Ri − R − cWR M ( Ri − R ) = cW [cov(R M . so Ri − R = cW [E (R M Ri ) − R M R ] = cW [cov(RM . where γ = 1 − CWRM . so. If we apply this relation to the portfolio. Ri ) + R M ( Ri − R )]. where r is the risk free rate. we obtain Cov (RM .From the above exercise.

he receives $5 if the horse wins and nothing if it loses. J. (a) What fraction of his money should Gavin bet on No Arbitrage? (b) What is the implied winning payoff of a $1 bet against No Arbitrage? Solution: (a) If we denote by α fraction of his money m G. dE 1 m 3 m = − =0 dα 2 m + 4α m 8 (1 − α )m 7 Solving this equation we obtain α = = 0.14.Problem 9. should bet we need 1 3 m + 4α m + (1 − α )m 4 4 So we need the 1st derivative to be equal to zero.1346 52 max E[U ] = (b) Implied wining payoff of a $1 bet against No Arbitrage is 5 = 1.) He can either bet on this horse or keep money in his pocket Gavin decides that he has a square-root utility for money. (For every dollar Gavin bets. (At the track) At the horse race one Saturday afternoon Gavin Jones studies the racing form and concludes that the horse No Arbitrage has a 25% chance to win and is posted at 4 to 1 odds. that is.25 4 .

R R* E (ax + by ) = aE ( x ) + bE ( y ) . R ¥ This is risk neutral pricing. We can then define a new expectation operation E by E( x ) = E( Rx ). show that the price of any security d is P= E (d ) . P = E( d ) By (3) R* d R* R ) = E( d ) = E( R* R 1 = * E (d ) By (1) R   By (2) ¢ Rx ) . assume R* (2) d ) R* (3) ♦ . then E ( x ) = x . £ £ Using this new expectation operation. This is because E ( £ b) For any random variables x and y. there holds E ( x ) ≥ 0 . Note that the usual rules of expectation hold. R*   ¡ This can be regarded as the expectation of an artificial probability. with the implied artificial probabilities. we know 1 d * E (d ) = E ( ) (1) R R ¨ § ¦ ¦ According to the definition of the operation E . there holds c) For any nonnegative random variable x. From the rules b). ¤ 1 1 )= .Problem 15 (General risk-neutral pricing) We can transform the log-optimal pricing formula into a risk-neutral pricing equation. From the log-optimal pricing equation we have P = E( d ) R* Where R* is the return on the log-optimal portfolio. for any variable x. we can get d R* d R ) = E( d ) E( ) = E( * R R R* © From the log-optimal pricing equation we have: P = E ( So. Namely: a) If x is certain. E ( x ) = E ( d/R as a variable.

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