EconECON

136 - 136
Practice
– FinalFinal
ExamExam

August 2, 2021

Question 1 (10 points)

Consider a model for security price evolution that superimposes random jumps according to a Poisson
process on a geometric Brownian motion (GBM). Specifically, let S(t) denote the price of the security at
time t, and suppose that
N (t)
Y
⇤
S(t) = S (t) Ji ,
i=1

where t 0, S ⇤ (t) is a GBM with volatility parameter and drift parameter µ. Assume that jump sizes
Ji are independent and identically distributed random variables with mean zero. Also, assume that Ji ’s,
the GBM, and the Poisson process N (t) with parameter > 0 are independent from each other in the
QN (t)
sense explained in Section 8.4. ( i=1 Ji is defined to equal 1 when N (t) = 0.) Show that risk-neutral
probabilities for the security’s price evolution will result if the intensity parameter of the Poisson process
is given by = µ+ 2 /2 r, where r is the risk-free rate and is assumed to be constant. Hint: show
that under =µ+ 2 /2 r, we will have E[S(t)] = S(0)ert .

Question 2 (20 points)

Consider a risk-averse investor with an increasing and concave utility function. Suppose that the investor
wants to maximize the expected utility of her end-of-period wealth by investing the amount ! in two
securities with the rate of return R1 and R2 . Assume that the end-of-period wealth

W = ! + ! 1 R1 + ! 2 R2 ,

is a normal random variable. Set !1 0 and !2 0, where ! = !1 + !2 . Suppose that the risk-free
rate is zero. Assume the validity of the Capital Asset Pricing Model (CAPM) as in Section 9.5, i.e.,
R1 = 1 Rm + e 1 and R2 = 2 Rm + e 2 for some constants 1 and 2; also e1 and e2 are independent normal
random variables with mean zero and variance 2
e, they are also independent from the marker rate of return
Rm . Variance of Rm is denoted by 2 Suppose that !1 ⌘ ↵! is invested in security 1 and !2 ⌘ (1
m. ↵)!

1
is invested in security 2; 0  ↵  1. Show that if the expected rate of return of both securities is zero, the
optimal fraction to invest in security 1 will be
2
+ m 2
e 2( 2 1)
↵= .
2 e2 + ( 2 1)
2 2
m

Question 3 (10 points)

What should be the cost of a call option if the strike price is equal to zero?

Question 4 (10 points)

If the of a stock is .80, what is the expected rate of return of that stock if the expected value of the
market’s rate of return is .07, and the risk-free rate is .05? Assume the CAPM.