Problem Set 2

Foundations of Asset Pricing

Asset Pricing Theory I

Hamilton Galindo

This Problem Set is based on Huang-Litzenberger’s book - Ch.3 and class notes. I
strongly recommend reading these carefully. The due date is Tuesday, May 25. If you
have any questions, please let me know. You can email me anytime:
hamilton.galindo@asu.edu.

Q1. (3 points) Assuming that the utility function has a negative exponential form:

u(W̃ ) = −e−bW̃

a) Make the assumption that you consider necessary to link the expected utility
theory with Markowitz’s approach.
b) Using that assumption, show step by step that we can transform the Max utility
function to Min the portfolio’s variance.

Q2. (2 points) Let there be two securities with rates of returns ri and rj . Suppose that
these two securities have identical expected rates of return and identical variances.
The correlation coefficient between ri and rj is ρ. Show that the equally weighted
portfolio achieves the minimum variance independently of ρ.

Q3. (4 points) Prove:

a) The entire “portfolio frontier” can be generated by any two different frontier
portfolios.
b) Any linear combination of frontier portfolios is on the frontier.
c) Any convex combination of efficient portfolios will be an efficient portfolio.
d ) The set of efficient portfolios is a convex set.

Q4. (8 points) Suppose an economy with two risky assets. The var-cov matrix is defined
as follows:
 
0.01 0.05
V =
0.05 0.02

V suggests that both assets are correlated where 0.01 is the variance of the return
of the first asset, and the covariance between both assets is 0.05. Moreover, this

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 Asset Pricing

economy faces two states of nature: state 1 and state 2. The probability of the state
1 is 0.5. The value of the interest rate of the first asset in the first state is 2 % and
in the second state is 8 %. For the second asset, the value of the interest rate is 30 %
and 10 % for state 1 and state 2 respectively.

a) (2 points) Find the coefficients of Markowitz optimization: A, B, C, and D

b) (2 points) The investor wants to get a portfolio with an expected return equals
to 8 %. What is the optimal portfolio? Explain the investment strategy.
c) (1 points) What is the variance of the return of the optimal portfolio?
d ) (1 points) What is the portfolio with zero expected return: w0 ? Explain the
investment strategy.
e) (1 points) What is the portfolio with one expected return: w1 ? Explain the
investment strategy.
f ) (1 points) What is the expected return and variance of the global minimum
variance portfolio?

Q5. (3 points) Define absolute risk tolerance to be the inverse of the Arrow-Pratt measure
of absolute risk aversion. Show that solutions of the Cass-Stiglitz’s condition to get
two fund monetary separation exhibit linear absolute risk tolerance.