Solutions Manual: Asset Pricing and Portfolio Choice Theory: Kerry Back

Solutions Manual:
Asset Pricing and Portfolio Choice Theory

Kerry Back
Contents
Part I Single-Period Models
1 Utility Functions and Risk Aversion Coefficients . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2 Portfolio Choice and Stochastic Discount Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3 Equilibrium and Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
4 Arbitrage and Stochastic Discount Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
5 Mean-Variance Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
6 Beta Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
7 Representative Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Part II Dynamic Models
8 Dynamic Securities Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
9 Portfolio Choice by Dynamic Programming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
10 Conditional Beta Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
11 Some Dynamic Equilibrium Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
12 Brownian Motion and Stochastic Calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
13 Continuous-Time Securities Markets and SDF Processes . . . . . . . . . . . . . . . . . . . . . 111

4 Contents
14 Continuous-Time Portfolio Choice and Beta Pricing . . . . . . . . . . . . . . . . . . . . . . . . . 127
Part III Derivative Securities
15 Option Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
16 Forwards, Futures, and More Option Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
17 Term Structure Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Part IV Topics
18 Heterogeneous Priors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
19 Asymmetric Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
20 Alternative Preferences in Single-Period Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
21 Alternative Preferences in Dynamic Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
22 Production Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225

Part I
Single-Period Models
1
Utility Functions and Risk Aversion Coefficients
1.1. Calculate the risk tolerance of each of the five special utility functions in Section 1.7 to verify
the formulas given in the text.
u0 (w) 1
u(w) = e ↵w
) u0 (w) = ↵e ↵w
, u00 (w) = ↵2 e ↵w
, 00
= .
u (w) ↵
1 1 u0 (w)
u(w) = log w ) u0 (w) = , u00 (w) = , = w.
w w2u00 (w)
1 u0 (w) w
u(w) = w1 ⇢
) u0 (w) = w ⇢ , u00 (w) = ⇢w ⇢ 1 , 00
= .
1 ⇢ u (w) ⇢
1 1 0
u (w)
u(w) = log(w ⇣) ) u0 (w) = , u00 (w) = , =w ⇣.
w ⇣ (w ⇣)2 u00 (w)
✓ ◆1 ⇢ ✓ ◆ ⇢ ✓ ◆ ⇢ 1
⇢ w ⇣ 0 w ⇣ 00 w ⇣
u(w) = ) u (w) = , u (w) = ,
1 ⇢ ⇢ ⇢ ⇢
u0 (w) w ⇣
00
= .
u (w) ⇢
1.2. Let "˜ be a random variable with zero mean and variance equal to 1. Let ⇡( ) be the risk
premium for the gamble "˜ at wealth w, meaning
u(w ⇡( )) = E [u(w + "˜)] .
Assuming ⇡ is a sufficiently di↵erentiable function, we have the Taylor series approximation

1
⇡( ) ⇡ ⇡(0) + ⇡ 0 (0) + ⇡ 00 (0) 2
2
for small . Obviously, ⇡(0) = 0. Assuming di↵erentiation and expectation can be interchanged,
di↵erentiate both sides of (1.13) to show that ⇡ 0 (0) = 0 and ⇡ 00 (0) is the coefficient of absolute risk
aversion.
4 1 Utility Functions and Risk Aversion Coefficients
Taking first derivatives gives
⇥ ⇤
u0 (w ⇡( ))⇡ 0 ( ) = E u0 (w + "˜)˜
" .
At = 0, this implies
u0 (w)⇡ 0 (0) = u0 (w)E[˜
"] = 0 .
Thus, ⇡ 0 (0) = 0. Taking second derivatives gives
⇥ ⇤
u00 (w ⇡( ))[⇡ 0 ( )]2 u0 (w ⇡( ))⇡ 00 ( ) = E u00 (w + "˜)˜
"2 .
At = 0, we obtain
u0 (w)⇡ 00 (0) = u00 (w)E[˜
"2 ] = u00 (w) .
Hence, ⇡ 00 (0) = u00 (w)/u0 (w).
1.3. Consider the five special utility functions in Section 1.7 (the utility functions with linear risk
tolerance). Which of these utility functions, for some parameter values, have decreasing absolute
risk aversion and increasing relative risk aversion? Which of these utility functions are monotone
increasing and bounded on the domain w 0?
Shifted log and shifted power utility functions have absolute risk aversion ⇢/(w ⇣) and relative
risk aversion ⇢w/(w ⇣), with ⇢ = 1 being shifted log. Absolute risk aversion is decreasing in w.
Relative risk aversion is increasing in w if ⇣ < 0. The shifted power utility function is monotone
increasing and bounded on the domain w 0 if ⇣ < 0 and ⇢ > 1.
1.4. Consider a person with constant relative risk aversion ⇢.
(a) Verify that the fraction of wealth he will pay to avoid a gamble that is proportional to wealth
is independent of initial wealth (i.e., show that ⇡ defined in (1.10) is independent of w for
logarithmic and power utility).
(b) Consider a gamble "˜. Assume 1 + "˜ is lognormally distributed; specifically, assume 1 + "˜ = ez̃ ,
where z̃ is normally distributed with variance 2 and mean 2 /2. Note that by the rule for
means of exponentials of normals, E[˜
"] = 0. Show that ⇡ defined in (1.10) equals
⇢ 2 /2
1 e .
1 Utility Functions and Risk Aversion Coefficients 5
Note: This is consistent with the approximation (1.4), because a first-order Taylor series expan-
sion of the exponential function ex around x = 0 shows that ex ⇡ 1 + x when |x| is small.
(a) For log utility, the left-hand side of (1.10) is
log((1 ⇡)w) = log(1 ⇡) + log w ,
and the right-hand side is
E[log((1 + "˜)w)] = E[log(1 + "˜)] + log w ,
so (1.10) is equivalent to
log(1 ⇡) = E[log(1 + "˜)] , ⇡=1 exp (E[log(1 + "˜)]) .
Hence, ⇡ does not depend on w. For power utility, the left-hand side of (1.10) is
1 1
((1 ⇡)w)1 ⇢
= w1 ⇢
(1 ⇡)1 ⇢
,
1 ⇢ 1 ⇢
and the right-hand side is


1 1 ⇥ ⇤
E ((1 + "˜)w)1 ⇢
= w1 ⇢
E (1 + "˜)1 ⇢
,
1 ⇢ 1 ⇢
so (1.10) is equivalent to
⇥ ⇤ ⇥ ⇤ 1
(1 ⇡)1 ⇢
= E (1 + "˜)1 ⇢
, ⇡=1 E (1 + "˜)1 ⇢ 1 ⇢
.
Hence, ⇡ does not depend on w.

(b) We have E[log(1 + "˜)] = E[z̃] = 2 /2, so the proportional risk premium for log utility is
2 /2
⇡=1 e .
For ⇢ 6= 1,
⇥ ⇤ h i 2 /2+(1 ⇢)2 2 /2 2 /2
E (1 + "˜)1 ⇢
= E e(1 ⇢)z̃
=e (1 ⇢)
=e ⇢(1 ⇢)
.
Therefore, the proportional risk premium is
⇢ 2 /2
⇡=1 e .
1.5. Consider a person with constant relative risk aversion ⇢.
(a) Suppose the person has wealth of $100,000 and faces a gamble in which he wins or loses x with
equal probabilities. Calculate the amount he would pay to avoid the gamble, for various values
of ⇢ (say, between 0.5 and 40), and for x = $100, x = $1,000, x = $10,000, and x = $25,000.
For large gambles, do large values of ⇢ seem reasonable? What about small gambles?
(b) Suppose ⇢ > 1 and the person has wealth w. Suppose he is o↵ered a gamble in which he loses
x or wins y with equal probabilities. Show that he will reject the gamble no matter how large
y is if
x log(0.5) + log(1 x/w)
1 0.51/(⇢ 1)
, ⇢ .
w log(1 x/w)
For example, if w is $100,000, then the person would reject a gamble in which he loses $10,000
or wins 1 trillion dollars with equal probabilities when ⇢ satisfies this inequality for x/w = 0.1.
What values of ⇢ (if any) seem reasonable?
(a) Set " = x/100000. From the solution to the previous exercise, the amount the person would pay
is 100000⇡, where, for log utility,
⇡=1 e0.5 log(1+")+0.5 log(1 ")

,
and, for power utility,

⇥ ⇤ 1
⇡=1 0.5(1 + ")1 ⇢
+ 0.5(1 ")1 ⇢ 1 ⇢
.
This implies the following:

⇢ $100 $1,000 $10,000 $25,000
0.5 $0.03 $2.50 $251 $1,588

1 $0.05 $5 $501 $3,175
2 $0.10 $10 $1,000 $6,250
5 $0.25 $25 $2,434 $13,486
10 $0.50 $50 $4,424 $19,086
15 $0.75 $75 $5,826 $21,198
20 $1.00 $99 $6,763 $22,214
30 $1.50 $148 $7,832 $23,186
40 $2.00 $195 $8,387 $23,655
For the largest gamble, ⇢ > 5 (or, perhaps ⇢ > 2) would seem unreasonable. But, for ⇢  5, the
premium for the $100 gamble is $0.25 or less, which may be too small.
(b) Given 1 ⇢ < 0, the person rejects the gamble if
w1 ⇢
< 0.5(w x)1 ⇢
+ 0.5(w + y)1 ⇢
.
This is true for all y > 0 if

1
w1 ⇢
 0.5(w x)1 ⇢
, w 0.5 1 ⇢(w x)
1
h 1
i
, 0.5 1 ⇢ x 0.5 1 ⇢ 1 w
x 1
, 1 0.5 ⇢ 1
w
1 x
, 0.5 ⇢ 1 1
w
1
, log(0.5) log(1 x/w)
⇢ 1
1 log(1 x/w)
, 
⇢ 1 log(0.5)
log(0.5)
, ⇢ 1
log(1 x/w)
log(0.5) + log(1 x/w)
, ⇢
log(1 x/w)
Thus, all gambles involving 1% losses are rejected if ⇢ 70, 2% losses if ⇢ 36, 10% losses if
⇢ 7.6, 25% losses if ⇢ 3.5, and 50% losses if ⇢ 2. Surely, there should be some possible
gain that would compensate someone for a 50% chance of a 10% loss, implying ⇢ < 7.6. One
could obviously argue for even smaller ⇢.
1.6. This exercise is a very simple version of a model of the bid-ask spread presented by Stoll
(1978).
Consider a person with constant absolute risk aversion ↵. Starting from a random wealth w̃,
(a) Compute the maximum amount the person would pay to obtain a random payo↵ x̃; i.e., compute
BID satisfying
E[u(w̃)] = E[u(w̃ + x̃ BID)] .
(b) Compute the minimum amount the person would require to accept the payo↵ x̃; i.e., compute
ASK satisfying
E[u(w̃)] = E[u(w̃ x̃ + ASK)] .
Note that ✓ ◆
1
E[u(w̃)] = exp ↵E[w̃] + ↵2 var(w̃) .
2
(a) We have
✓ ◆
1
E[u(w̃ + x̃ BID)] = exp ↵E[w̃] ↵E[x̃] + ↵BID + ↵2 [var(w̃) + 2 cov(x̃, w̃) + var(x̃)] .
2
Thus, BID satisfies

✓ ◆
1
1 = exp ↵E[x̃] + ↵BID + ↵2 [2 cov(x̃, w̃) + var(x̃)] .
2
This implies
1
BID = E[x̃] ↵ cov(x̃, w̃) ↵ var(x̃) .
2
(b) We have
✓ ◆
1
E[u(w̃ x̃ + ASK)] = exp ↵E[w̃] + ↵E[x̃] ↵ASK + ↵2 [var(w̃) 2 cov(x̃, w̃) + var(x̃)] .
2
Thus, ASK satisfies

✓ ◆
1
1 = exp ↵E[x̃] ↵ASK + ↵2 [ 2 cov(x̃, w̃) + var(x̃)] .
2
This implies
1
ASK = E[x̃] ↵ cov(x̃, w̃) + ↵ var(x̃) .
2
1.7. Show that condition (ii) in the discussion of second-order stochastic dominance in the end-
of-chapter notes implies condition (i); i.e., assume ỹ = x̃ + z̃ + "˜ where z̃ is a nonpositive random
"|x̃ + z̃] = 0 and show that E[u(x̃)]
variable and E[˜ E[u(ỹ)] for every monotone concave function u.
Note: The statement of (ii) is that ỹ has the same distribution as x̃ + z̃ + "˜, which is a weaker
condition than ỹ = x̃ + z̃ + "˜, but if ỹ has the same distribution as x̃ + z̃ + "˜ and ỹ 0 = x̃ + z̃ + "˜,
then E[u(ỹ)] = E[u(ỹ 0 )] so one can without loss of generality take ỹ = x̃ + z̃ + "˜ (though this is not
true for the reverse implication (i) ) (ii)).
ỹ equals x̃ + z̃ plus mean-independent noise, so by concavity and Jensen’s inequality, E[u(x̃ + z̃)]
E[u(ỹ)], as shown in Section 1.8. Because z̃ is nonpositive and u is monotone, E[u(x̃)] E[u(x̃ + z̃)].
Therefore, E[u(x̃)] E[u(ỹ)].
"|ỹ] = 0 then cov(ỹ, "˜) = 0 (thus

1.8. Use the law of iterated expectations to show that if E[˜
mean-independence implies uncorrelated).
By iterated expectations and mean-independence,
"|ỹ]] = 0 .
E[ỹ "˜] = E[ỹE[˜
Furthermore,
E[˜ "|ỹ]] = 0 .
"] = E[E[˜
Therefore,
cov(ỹ, "˜) = E[ỹ "˜] E[ỹ]E[˜
"] = 0 .
1.9. Show that any monotone utility function with linear risk tolerance is a monotone affine
transform of one of the five utility functions: negative exponential, log, power, shifted log, or shifted
power. Hint: Consider first the special cases (i) risk tolerance = A and (ii) risk tolerance = Bw. In
case (i) use the fact that
u00 (w) d log u0 (w)
=
u0 (w) dw
and in case (ii) use the fact that
wu00 (w) d log u0 (w)
=
u0 (w) d log w
to derive formulas for log u0 (w) and hence u0 (w) and hence u(w). For the case A 6= 0 and B 6= 0,
define ✓ ◆
w A
v(w) = u ,
B
show that the risk tolerance of v is Bw, apply the results from case (ii) to v, and then derive the
form of u.
In case (i), set ↵ = 1/A. For any constant y,

Z w
0 0 d log u0 (x)
log u (w) = log u (y) + dx
y dx
Z w
= log u0 (y) + ↵ dx
y
0
= log u (y) ↵(w y) .
Hence,
u0 (w) = u0 (y)e ↵(w y)

= u0 (y)e↵y e ↵w
.
This implies
Z w
u(w) = u(y) + u0 (x) dx
y
Z w
= u(y) + u0 (y)e↵y e ↵x
dx
y
1⇥ ⇤
= u(y) + u0 (y)e↵y e ↵y
e ↵w
.
↵
This is an affine transform of e ↵w . For u to be monotone, it must be a monotone affine transform
of e ↵w .
In case (ii), set ⇢ = 1/B. For any constant y > 0 and any w > 0,
Z w
0 0 d log u0 (x)
log u (w) = log u (y) + d log x
y d log x
Z w
= log u0 (y) ⇢ d log x
y
= log u0 (y) ⇢(log w log y) .
Hence,
u0 (w) = u0 (y)e ⇢(log w log y)
= u0 (y)y ⇢ w ⇢
.
This implies
Z w
u(w) = u(y) + u0 (x) dx
y
Z w
0 ⇢ ⇢
= u(y) + u (y)y x dx .
y
If ⇢ = 1, then
u(w) = u(y) + u0 (y)y(log w log y) ,
which is a monotone affine transform of log w. If ⇢ 6= 1, then
1
u(w) = u(y) + u0 (y)y ⇢ w1 ⇢
y1 ⇢
.
1 ⇢
which is an affine transform of w1 ⇢ /(1 ⇢). For u to be monotone, it must be a monotone affine
transform of w1 ⇢ /(1 ⇢).
For the case A 6= 0 and B 6= 0, set
✓ ◆
x A
v(x) = u
B
for x > 0. This implies

x A
v 0 (x) u0
= B 00 xB A
v 00 (x) u B
 ✓ ◆
x A
=B A+B
B
= Bx .
Therefore, from case (ii), on the region x > 0, either v(x) = log x if B = 1, or v(x) = x1 ⇢ /(1 ⇢)
for ⇢ = 1/B, up to an affine transform. Moreover,
u(w) = v(A + Bw) .
Hence, for w such that A + Bw > 0, either u(w) = log(A + Bw) if B = 1, or u(w) = (A +
Bw)1 ⇢ /(1 ⇢) for ⇢ = 1/B, up to an affine transform. Setting ⇣ = A/B, we have, up to an affine
transform, u(w) = log(w ⇣) on the region w > ⇣ if B = 1, or
✓ ◆
1 w ⇣ 1 ⇢
u(w) = ,
1 ⇢ ⇢
on the region (w ⇣)/⇢ > 0. Monotonicity of u in the case B 6= 1 requires that u be a monotone
affine transform of ✓ ◆1 ⇢
⇢ w ⇣
.
1 ⇢ ⇢
1.10. Suppose a person has log utility: u(w) = log w for each w > 0.
(a) Construct a gamble w̃ such that E[u(w̃)] = 1. Verify that E[w̃] = 1.

(b) Construct a gamble w̃ such that w̃ > 0 in each state of the world and E[u(w̃)] = 1.
(c) Given a constant wealth w, construct a gamble "˜ with w + "˜ > 0 in each state of the world,
E[˜
"] = 0 and E[u(w + "˜)] = 1.
n
(a) Consider flipping a sequence of coins and having wealth e2 if the first heads appears on the
n–th toss. The probability of the first heads appearing on the n–th toss is 2 n, so the expected
utility is
1
X 1
X
n n
2 log e2 = 1 = 1.
n=1 n=1
(b) Consider flipping coins and having wealth e 2n if the first heads appears on the n–th toss. The
expected utility is
1
X 1
X
n 2n
2 log e = 1= 1.
n=1 n=1
(c) Obviously, there are many ways to do this. Here is one. Let 0 < < 1 be such that
1
X
n 2n
w> 2 e .
1+
n=1
Define p = /(1 + ). With probability 1 p, let

1
!
X
n 2n
"˜ = w 2 e .
n=1
On this event, we have

1
X
n 2n
w + "˜ = (1 + )w 2 e > 0.
n=1
For n = 1, 2, . . ., let
2n
"˜ = e w
with probability p2 n.
Then w + "˜ > 0 in each state of the world, and
1
! "1 #
X X
n 2n n
E[˜
"] = (1 p) w 2 e +p 2 n e 2 w
n=1 n=1
1
!
X
n 2n
= [(1 p) p] w 2 e
n=1
= 0.
Moreover,
1
! " 1
#
X X
n 2n n 2n
E[u(w + "˜)] = (1 p) log (1 + )w 2 e +p 2 log e = 1.
n=1 n=1
1.11. Show that risk neutrality [u(w) = w for all w] can be regarded as a limiting case of negative
exponential utility as ↵ ! 0 by showing that there are monotone affine transforms of negative
exponential utility that converges to w as ↵ ! 0. Hint: Take an exact first-order Taylor series
expansion of negative exponential utility, expanding in ↵ around ↵ = 0. Writing the expansion as
c0 + c1 ↵, show that
e ↵w c0
!w
↵
as ↵ ! 0.
Set f (↵) = e ↵w . We have

f (↵) = f (0) + f 0 (ˆ
↵)↵
ˆ < ↵, and f 0 (↵) = we

for some 0 < ↵ ↵w . Thus,
↵w ↵w
ˆ
e = 1 + we ↵.
This implies
e ↵w +1 ↵w
ˆ
= we ! w,
↵
as ↵ ! 0.
1.12. The notation and concepts in this exercise are from Appendix A. Suppose there are three
possible states of the world which are equally likely, so ⌦ = {!1 , !2 , !3 } with P({!1 }) = P({!2 }) =
P({!3 }) = 1/3. Let G be the collection of all subsets of ⌦:
G = {;, {!1 }, {!2 }, {!3 }, {!1 , !2 }, {!1 , !3 }, {!2 , !3 }, ⌦} .
Let x̃ and ỹ be random variables, and set ai = x̃(!i ) for i = 1, 2, 3. Suppose ỹ(!1 ) = b1 and
ỹ(!2 ) = ỹ(!3 ) = b2 6= b1 .
(a) What is prob(x̃ = aj | ỹ = bi ) for i = 1, 2 and j = 1, 2, 3 ?

(b) What is E[x̃ | ỹ = bi ] for i = 1, 2 ?
(c) What is the –field generated by ỹ ?
(a)
prob(x̃ = a1 | ỹ = b1 ) = 1 ,
prob(x̃ = a2 | ỹ = b1 ) = 0 ,
prob(x̃ = a3 | ỹ = b1 ) = 0 ,
prob(x̃ = a1 | ỹ = b2 ) = 0 ,
prob(x̃ = a2 | ỹ = b2 ) = 1/2 ,
prob(x̃ = a3 | ỹ = b2 ) = 1/2 .
(b)
E[x̃ | ỹ = b1 ] = a1 ,
E[x̃ | ỹ = b2 ] = (a2 + a3 )/2 .

(c) The –field generated by ỹ is

{;, {!1 }, {!2 , !3 }, ⌦} .
1.13. Let ỹ = ex̃ , where x̃ is normally distributed with mean µ and variance 2. Show that
stdev(ỹ) p 2
= e 1.
E[ỹ]
2 /2
We have E[ỹ] = eµ+ , and
var(ỹ) = E[ỹ 2 ] E[ỹ]2

⇥ ⇤ 2 /2)
= E e2x̃ e2(µ+
2 2
= e2µ+2 e2µ+
2
⇣ 2
⌘
= e2µ+ e 1
⇣ 2
⌘
= E[ỹ]2 e 1 ,
so
p
2
stdev(ỹ) = E[ỹ] e 1.
2
Portfolio Choice and Stochastic Discount Factors
2.1. Consider the portfolio choice problem of a CARA investor with n risky assets having normally
distributed returns studied in Section 2.5, but suppose there is no risk-free asset, so the budget
constraint is 10 = w0 . Show that the optimal portfolio is
✓ ◆
1 1 ↵w0 10 ⌃ 1 µ 1
= ⌃ µ+ ⌃ 1.
↵ ↵10 ⌃ 1 1
Note: As will be seen in Section 5.1, the two vectors ⌃ 1µ and ⌃ 11 play an important role in
mean-variance analysis even without the CARA/normal assumption.
The expected payo↵ of a portfolio is 0µ

and the variance is 0 ⌃ . The expected utility is
✓ ◆
0 1 2 0
exp ↵ µ+ ↵ ⌃ .
2
Maximizing this is equivalent to maximizing
0 1 0
µ ↵ ⌃ .
2
Let denote the Lagrange multiplier for the constraint 10 = w0 . The Lagrangean is
0 1 0
(µ 1) ↵ ⌃ ,
2
and the first-order condition is

µ 1 ↵⌃ = 0 ,
which is solved by
1 1
= ⌃ (µ 1) .
↵
Imposing the constraint 10 = w0 yields
16 2 Portfolio Choice and Stochastic Discount Factors
1 0
1⌃ 1
µ 10 ⌃ 1
1 = w0 .
↵ ↵
Therefore,
10 ⌃ 1 µ ↵w0
= ,
10 ⌃ 1 1
and ✓ ◆
1 1 ↵w0 10 ⌃ 1 µ 1
= ⌃ µ+ ⌃ 1.
↵ ↵10 ⌃ 1 1
2.2. Suppose there is a risk-free asset and n risky assets. Adopt the notation of Section 2.5, but do
not assume the risky asset returns are normally distributed. Consider an investor with quadratic
utility who seeks to maximize
1 1
⇣E[w̃] E[w̃]2 var(w̃) .
2 2
Show that the optimal portfolio for the investor is
1 1
= (⇣ w0 Rf )⌃ (µ Rf 1) ,
1 + 2
where
2 = (µ Rf 1)0 ⌃ 1
(µ Rf 1) .
It is shown in Chapter 5 that  is the maximum Sharpe ratio of any portfolio. Hint: In the first-order
conditions, define = (µ Rf 1)0 , solve for in terms of , and then compute .
The expected payo↵ of a portfolio of risky assets is w0 Rf + 0 (µ Rf 1), and the variance is 0⌃ .
The expected utility is
0 1 1 0
⇣[w0 Rf + (µ Rf 1)] [w0 Rf + 0 (µ Rf 1)]2 ⌃
2 2
0 1 2 2 1 0 1 0
= ⇣[w0 Rf + (µ Rf 1)] w0 Rf w0 Rf 0 (µ Rf 1) (µ Rf 1)(µ Rf 1)0 ⌃ .
2 2 2
The first-order condition for maximizing this is
⇣(µ Rf 1) w0 Rf (µ Rf 1) (µ Rf 1)(µ Rf 1)0 ⌃ = 0.
Setting = (µ Rf 1)0 , we have
⇣(µ Rf 1) w0 Rf (µ Rf 1) (µ Rf 1) ⌃ = 0,
with solution
2 Portfolio Choice and Stochastic Discount Factors 17
1
= (⇣ w 0 Rf )⌃ (µ Rf 1) .
Thus,
= (⇣ w 0 Rf )(µ Rf 1)0 ⌃ 1
(µ Rf 1)
= (⇣ w 0 Rf )2 ,
implying
2
= (⇣ w 0 Rf ) ,
1 + 2
and
1 1
= (⇣ w0 Rf )⌃ (µ Rf 1) .
1 + 2
2.3. This exercise provides another illustration of the absence of wealth e↵ects for CARA utility.
The investor chooses how much to consume at date 0 and how much to invest, but the investment
amount does not a↵ect the optimal portfolio of risky assets.
Consider the portfolio choice problem in which there is consumption at date 0 and date 1. Suppose
there is a risk-free asset with return Rf and n risky assets the returns of which are joint normally
distributed with mean vector µ and nonsingular covariance matrix ⌃. Consider an investor who
has time-additive utility and CARA utility for date–1 consumption:
↵c
u1 (c) = e .
Show that (2.27) is the investor’s optimal portfolio of risky assets.
The investor chooses date–0 consumption c0 and a portfolio of risky assets to maximize
✓ ◆
0 1 2 0
u(c0 ) exp ↵(w0 c0 )Rf ↵ (µ Rf 1) + ↵ ⌃ .
2
The optimal portfolio is the portfolio that maximizes
0 1 0
(µ Rf 1) ↵ ⌃ ,
2
just as in the problem with only date–1 consumption. Hence, (2.27) is the optimal portfolio.
2.4. This exercise repeats the previous one, but using asset payo↵s and prices instead of returns
and solving for the optimal number of shares to hold of each asset instead of the optimal amount
to invest.
Suppose there is a risk-free asset with return Rf and n risky assets with payo↵s x̃i and prices pi .
Assume the vector x̃ = (x̃1 · · · x̃n )0 is normally distributed with mean µx and nonsingular covariance
matrix ⌃x . Let p = (p1 · · · pn )0 . Suppose there is consumption at date 0 and consider an investor
with initial wealth w0 and CARA utility at date 1:
↵c
u1 (c) = e .
Let ✓i denote the number of shares the investor considers holding of asset i and set ✓ = (✓1 · · · ✓n )0 .
The investor chooses consumption c0 at date 0 and a portfolio ✓, producing wealth (w0 c0
✓0 p)Rf + ✓0 x̃ at date 1. Show that the optimal vector of share holdings is
1
✓= ⌃ 1 (µx Rf p) .
↵ x
The investor chooses date–0 consumption c0 and a portfolio ✓ of risky assets to maximize
✓ ◆
0 0 1 2 0
u(c0 ) exp ↵(w0 c0 ✓ p)Rf ↵✓ µx + ↵ ✓ ⌃x ✓ .
2
The optimal portfolio ✓ is the portfolio that maximizes
1 0
Rf p0 ✓ + µ0x ✓ ↵✓ ⌃x ✓ .
2
The first-order condition is

Rf p + µ x ↵⌃x ✓ = 0 ,
with solution
1
✓= ⌃ 1 (µx Rf p) .
↵ x
2.5. Consider a utility function v(c0 , c1 ). The marginal rate of substitution is defined to be the
negative of the slope of an indi↵erence curve and is equal to
@v(c0 , c1 )/@c0
MRS(c0 , c1 ) = .
@v(c0 , c1 )/@c1
The elasticity of intertemporal substitution is defined as
d log(c1 /c0 )
,
d log MRS(c0 , c1 )
where the marginal rate of substitution is varied holding utility constant. Show that, if
1
v(c0 , c1 ) = c10 ⇢
+ c11 ⇢
,
1 ⇢ 1 ⇢
then the elasticity of intertemporal substitution is 1/⇢.
Holding utility constant implies

c0 ⇢ dc0 + c1 ⇢ , dc1 = 0 ,
so ✓ ◆ ⇢
dc1 1 c0
= .
dc0 c1
This is the marginal rate of substitution. Setting x = c1 /c0 , we have
log MRS = log + ⇢ log x .
Hence,
d log MRS
= ⇢.
d log x
The elasticity of intertemporal substitution is the reciprocal 1/⇢.
2.6. This exercise shows that an improvement in the investment opportunity set leads to higher
saving (the substitution e↵ect dominates) when the elasticity of intertemporal substitution is high
and higher consumption (the wealth e↵ect dominates) when the elasticity of intertemporal substi-
tution is low.
Consider the portfolio choice problem with only a risk-free asset and with consumption at both the
beginning and end of the period. Assume the investor has time-additive power utility, so he solves
1 1 1
max c10 ⇢
+ c11 ⇢
subject to c0 + c1 = w0 .
1 ⇢ 1 ⇢ Rf
Show that the optimal consumption-to-wealth ratio c0 /w0 is a decreasing function of Rf if ⇢ < 1
and an increasing function of Rf if ⇢ > 1.
Substituting the budget constraint, the objective function is
1 1
c10 ⇢
+ Rf1 ⇢
(w0 c0 )1 ⇢
,
1 ⇢ 1 ⇢
and the first-order condition is
c0 ⇢ Rf1 ⇢
(w0 c0 ) ⇢
= 0.
This implies
1/⇢ 1 1/⇢
c0 = Rf (w0 c0 ) ,
so
1/⇢ R1 1/⇢
f
c0 = w0 .
1+ 1/⇢ R1 1/⇢
f
The factor
1/⇢ R1 1/⇢
f
1+ 1/⇢ R1 1/⇢
f
is an increasing function of Rf if 1 1/⇢ > 0 and a decreasing function of Rf if 1 1/⇢ < 0.
2.7. Each part of this exercise illustrates the absence of wealth e↵ects for CARA utility and is
not true for general utility functions. The assumption in Part (c) that ỹ = aRf + bR̃ + "˜ where "˜
has zero mean and is uncorrelated with R̃ is without loss of generality (even without the normality
assumption): define b = cov(ỹ, R̃)/ var(R̃), a = (E[ỹ] bE[R̃])/Rf and "˜ = ỹ aRf bR̃. This is a
special case of an orthogonal projection (linear regression), which is discussed in more generality
in Section 4.5. The optimal portfolio in Part (c) can be interpreted as the optimal portfolio in the
absence of an endowment plus a hedge ( b) for ỹ.
Suppose there is a risk-free asset with return Rf and a risky asset with return R̃. Consider an
investor who maximizes expected end-of-period utility of wealth and who has CARA utility and
invests w0 . Suppose the investor has a random endowment ỹ at the end of the period, so his end-
of-period wealth is f Rf + R̃ + ỹ, where f denotes the investment in the risk-free asset and
the investment in the risky asset.
(a) Suppose ỹ and R̃ have a joint normal distribution. Derive the optimal portfolio. Show that
if ỹ and R̃ are uncorrelated, then the optimal is the same as if there were no end-of-period
endowment.
(b) Show that if ỹ and R̃ are independent, then the optimal is the same as if there were no
end-of-period endowment, regardless of whether ỹ and R̃ are normally distributed. Hint: Use
the law of iterated expectations as in Section 1.8 and the fact that if ṽ and x̃ are independent
random variables then E[ṽ x̃] = E[ṽ]E[x̃].
(c) Suppose ỹ and R̃ have a joint normal distribution and ỹ = aRf +bR̃+ "˜ for constants a and b and
some "˜ that has zero mean and is uncorrelated with R̃. Show that the optimal is ⇤ b, where
⇤ denotes the optimal investment in the risky asset when there is no end-of-period endowment.
(a) The investment in the risk-free asset is f = w0 . The expected end-of-period wealth is
⇣ ⌘
w 0 Rf + E[R̃] Rf + E[ỹ] and the variance of end-of-period wealth is
2 2
var(R̃) + 2 cov(R̃, ỹ) + var(ỹ) = var(R̃) + var(ỹ) .

✓ ⇣ ⇣ ⌘ ⌘ ⌘◆
1 ⇣
exp ↵ w 0 Rf + E[R̃] Rf + E[ỹ] + ↵2 2
var(R̃) + var(ỹ .
2
Maximizing this over is equivalent to maximizing

⇣ ⌘ 1 2
E[R̃] Rf ↵ var(R̃) ,
2
for which the solution is

E[R̃] Rf
= .
↵ var(R̃)
(b) The expected utility is
h ⇣ ⇣ ⌘ ⌘i h i
E exp ↵w0 Rf ↵ R̃ Rf ↵ỹ = E e ↵w0 Rf ↵ (R̃ Rf )
e ↵ỹ
.
By independence, this equals

h i ⇥ ⇤
E e ↵w0 Rf ↵ (R̃ Rf )
E e ↵ỹ
,
and maximizing this over is equivalent to maximizing

h i
E e ↵w0 Rf ↵ (R̃ Rf )
,
which is the same as if ỹ = 0.

(c) The expected end-of-period wealth is
w0 Rf + (E[R̃] Rf + E[ỹ] = (w0 + a )Rf + ( + b)E[R̃] ,
and the variance of end-of-period wealth is
2 2
var(R̃) + 2 cov(R̃, ỹ) + var(ỹ) = ( + 2 b + b2 ) var(R̃) + var(˜
") .

✓ ⇣ ⌘ ⌘◆
1 ⇣
exp ↵ (w0 + a )Rf + ( + b)E[R̃] + ↵2 ( 2 2
+ 2 b + b ) var(R̃) + var(˜
") .
2
Maximizing this over is equivalent to maximizing
1 2
(E[R̃] Rf ) ↵( + 2 b) var(R̃) ,
2
for which the solution is

E[R̃] Rf
= b.
↵ var(R̃)
2.8. This exercise illustrates the concept of “precautionary savings”—the risk imposed by ỹ results
in higher savings w0 c0 .
Consider the portfolio choice problem with only a risk-free asset and with consumption at both
the beginning and end of the period. Suppose the investor has time-additive utility with u0 = u
and u1 = u for a common function u and discount factor . Suppose the investor has a random
endowment ỹ at the end of the period, so he chooses c0 to maximize
u(c0 ) + E[u((w0 c0 )Rf + ỹ)] .
Suppose the investor has convex marginal utility (u000 > 0) and suppose that E[ỹ] = 0. Show that
the optimal c0 is smaller than if ỹ = 0.
The first-order condition is that
u0 (c0 ) = E[u0 ((w0 c0 )Rf + ỹ)] .
By Jensen’s inequality and the convexity of u0 ,
E[u0 ((w0 c0 )Rf + ỹ)] > u0 (E[(w0 c0 )Rf + ỹ]) = u0 ((w0 c0 )Rf ) .
Thus,
u0 (c0 ) > u0 ((w0 c0 )Rf ) .
The first-order condition if ỹ = 0 is for these to be equal. Because the left-hand side is decreasing
in c0 and the right-hand side increasing in c0 , equality requires that c0 be increased. Thus, the
optimal c0 would be larger if ỹ = 0.
2.9. Letting c⇤0 denote optimal consumption in the previous problem, define the “precautionary
premium” ⇡ by
u0 ((w0 ⇡ c⇤0 )Rf ) = E[u0 ((w0 c⇤0 )Rf + ỹ)] .
(a) Show that c⇤0 would be the optimal consumption of the investor if he had no end-of-period
endowment and had initial wealth w0 ⇡.
(b) Assume the investor has CARA utility. Show that the precautionary premium is independent
of initial wealth (again, no wealth e↵ects with CARA utility).
(a) The first-order condition is that
u0 (c⇤0 ) = E[u0 ((w0 c⇤0 )Rf + ỹ)] .
By the definition of the precautionary premium, this implies
u0 (c⇤0 ) = u0 ((w0 ⇡ c⇤0 )Rf ) .
This is the first-order condition for initial wealth w0 ⇡ when ỹ = 0.

(b) With CARA utility e ↵w , the marginal utility is ↵e ↵w . Therefore the precautionary premium
is ⇡ satisfying
h i
↵(w0 ⇡ c⇤0 )Rf ↵((w0 c⇤0 )Rf +ỹ )
↵e = ↵E e .
Multiplying by e↵(w0 c⇤0 )Rf /↵ yields

⇥ ⇤
e↵⇡Rf = E e ↵ỹ
,
with solution
1 ⇥ ↵ỹ
⇤
⇡= log E e .
↵Rf
2.10. The assumption in this exercise is a weak form of market completeness. The conclusion
follows in a complete market from the formulation (2.35) of the portfolio choice problem.
Suppose there is a stochastic discount factor m̃ with the property that for every function g there
exists a portfolio ✓ (depending on g) such that
n
X
✓i x̃i = g(m̃) .
i=1
Consider an investor with no labor income ỹ. Show that his optimal wealth is a function of m̃.
Hint: For any feasible w̃, define w̃⇤ = E[w̃|m̃], and use the result of Section 1.8.
Setting w̃⇤ = E[w̃|m̃] and "˜ = w̃ w̃⇤ , we have that w̃ is w̃⇤ + "˜. Moreover,
" | m̃] = E[w̃ | m̃]

E[˜ E[w̃⇤ | m̃] = w̃⇤ w̃⇤ = 0 .
Also, because w̃⇤ is a function of m̃,
" | w̃⇤ ] = E [E[˜

E[˜ " | m̃] | w̃⇤ ] = 0 .
Thus, "˜ is mean-independent noise. Hence w̃⇤ is preferred to w̃. Because w̃⇤ is a function of m̃,
there exists by assumption a portfolio ✓˜ with payo↵ equal to w̃⇤ . The cost of the portfolio is
E[m̃w̃⇤ ] = E[m̃E[w̃ | m̃]] = E[m̃w̃] ,
by iterated expectations. Hence, the feasibility of w̃ implies the feasibility of w̃⇤ .

3
Equilibrium and Efficiency
3.1. Suppose each investor h has a concave utility function, and suppose a feasible allocation
(w̃1 , . . . , w̃m ) of market wealth w̃m satisfies the first-order condition
u0h (w̃h ) = h m̃
for each investor h, where m̃ is a stochastic discount factor and is the same for each investor. Show
that the allocation solves the social planner’s problem (3.2) with weights h = 1/ h. Note: The
first-order condition holds with the stochastic discount factor being the same for each investor in a
competitive equilibrium of a complete market, because there is a unique stochastic discount factor
in a complete market. Recall that h in the first-order condition is the Lagrange multiplier for the
investor’s budget constraint (see Section 2.1) and hence is the marginal value of beginning-of-period
wealth. Thus, the weights in the social planner’s problem can be taken to be the reciprocals of the
marginal values of wealth. Other things equal, investors with high wealth have low marginal values
of wealth and hence have high weights in the social planner’s problem.
By concavity and the first-order conditions, the allocation maximizes

H
X H
X
1
uh (w̃h ) m̃w̃h
h
h=1 h=1
in each state of the world, over all allocations (w̃1 , . . . , w̃H ), feasible or not. If (w̃10 , . . . , w̃H
0 ) is any
other feasible allocation, then

H
X H
X
w̃h0 = w̃m = w̃h ,
h=1 h=1
so
26 3 Equilibrium and Efficiency
H
X H
X H
X H
X
1 1
uh (w̃h ) m̃w̃h uh (w̃h0 ) m̃w̃h0
h h
h=1 h=1 h=1 h=1
XH H
X
1
= uh (w̃h0 ) m̃w̃h .
h
h=1 h=1
Hence,
H
X H
X
1 1
uh (w̃h ) uh (w̃h0 ) .
h h
h=1 h=1
3.2. Suppose there are two investors, the first having constant relative risk aversion ⇢ > 0 and the
second having constant relative risk aversion 2⇢.
(a) Show that the Pareto optimal sharing rules are

p p
w̃1 = w̃m + ⌘ ⌘ 2 + 2⌘ w̃m , and w̃2 = ⌘ 2 + 2⌘ w̃m ⌘,
for ⌘ > 0. Hint: Use the first-order condition and the quadratic formula. Because ⌘ is arbitrary
in (0, 1), there are many equivalent ways to write the sharing rules.
(b) Suppose the market is complete and satisfies the law of one price. Show that the stochastic
discount factor in a competitive equilibrium is
⇣p ⌘ 2⇢
m̃ = ⌘ 2 + 2⌘ w̃m ⌘
for positive constants and ⌘.
(a) The marginal utility of the first investor is w ⇢, and the marginal utility of the second investor
is w 2⇢ . The first-order condition is
⇢ 2⇢ 2⇢
1 w̃1 = 2 w̃2 = 2 (w̃m w̃1 ) .
This implies
w̃1 = (w̃m w̃1 )2 ,
where =( 1/⇢ .
1/ 2) Thus
w̃12 2
(2w̃m + )w̃1 + w̃m = 0.
Applying the quadratic formula yields

3 Equilibrium and Efficiency 27
p
2w̃m + (2w̃m + )2
± 2
4w̃m
w̃1 =
2
p
2
= w̃m + ⌘ ± ⌘ + 2⌘ w̃m ,
where ⌘ = /2. This implies

p
w̃2 = w̃m w̃1 = ⌘± ⌘ 2 + 2⌘ w̃m .
p p
To obtain w̃2 > 0, we must have w̃2 = ⌘+ ⌘ 2 + 2⌘ w̃m and w̃1 = w̃m + ⌘ ⌘ 2 + 2⌘ w̃m .
(b) Pareto optimality of the competitive equilibrium implies
p
w̃2 = ⌘ 2 + 2⌘ w̃m ⌘
for some ⌘ > 0. Thus, the second investor’s marginal utility at a competitive equilibrium equals
⇣p ⌘ 2⇢
⌘ 2 + 2⌘ w̃m ⌘ .
The first-order condition for portfolio choice implies

⇣p ⌘ 2⇢
⌘ 2 + 2⌘ w̃m ⌘
is a stochastic discount factor for some > 0. This is the unique stochastic discount factor in
a complete market.
3.3. Suppose there are n risky assets with payo↵s x̃i and no risk-free asset. Assume there is
consumption only at date 1. Let µ denote the mean and ⌃ the covariance matrix of the vector
X̃ = (x̃1 · · · x̃n )0 of asset payo↵s. Assume X̃ has a normal distribution, and assume ⌃ is nonsingular.
Let ✓¯ = (✓¯1 · · · ✓¯n )0 denote the vector of asset supplies. Assume all investors have CARA utility and
no endowments ỹh . Define ↵ to be the aggregate absolute risk aversion as in Section 1.3. Show that
the vector
p= µ ↵⌃ ✓¯
is an equilibrium price vector for any ¯ explaining

> 0. Interpret the risk adjustment vector ↵⌃ ✓,
in economic terms why a large element of this vector implies an asset has a low price relative to
its expected payo↵. Note: When < 0, this is also an equilibrium price vector, but each investor
has a negative marginal value of wealth. In this model, investors are forced to hold assets because
there is no date–0 consumption. When < 0, they are forced to invest in undesirable assets and
would be better o↵ if they had less wealth. Including consumption at date 0 or changing the budget
constraint to p0 ✓  p0 ✓¯h instead of p0 ✓ = p0 ✓¯h (i.e., allowing free disposal of wealth) eliminates the
equilibria with < 0.
Investor h chooses ✓h to maximize the certainty equivalent
1 0
✓0 µ ↵✓ ⌃✓
2
subject to the budget constraint p0 ✓ = wh0 . The optimum is
1 1
✓h = ⌃ (µ h p)
↵h
where h is the Lagrange multiplier for the budget constraint. Thus,

H H
!
X 1 X h
✓h = ⌃ 1 µ ⌃ 1p .
↵ ↵h
h=1 h=1
To check if markets clear, we need to compute h, which is determined by the budget equation of
investor h:
1 0 h 0
wh0 = p0 ✓h = p⌃ 1
µ p⌃ 1
p.
↵h ↵h
Instead of computing h,
¯
it suffices to sum this over h, noting that aggregate initial wealth is p0 ✓.
This yields !
H
X
1 h
p0 ✓¯ = p0 ⌃ 1
µ p0 ⌃ 1
p,
↵ ↵h
h=1
implying
H
X ✓ ◆
h 1 p0 ⌃ 1µ ↵p0 ✓¯
= .
↵h ↵ p0 ⌃ 1 p
h=1
For p = µ ↵⌃ ✓¯ , the expression in parentheses in the last displayed equation is 1/ . Thus, for
such prices, aggregate demand is
1 1 1 1 ⇥ ⇤
⌃ 1
µ ⌃ 1
p= ⌃ 1
µ ⌃ 1
µ ↵⌃ ✓¯ = ✓¯ .
↵ ↵ ↵ ↵
3.4. Reconsider the previous problem assuming there is a risk-free asset in zero net supply (meaning
investors can borrow from and lend to each other) and assuming there is consumption at date 0.
Both the price vector p of the risky assets and the risk-free return Rf are determined endogenously
in equilibrium. Suppose the utility functions of investor h are
↵h c ↵h c
u0 (c) = e and u1 (c) = he .
PH
Let c̄0 denote the aggregate endowment h=1 yh0 at date 0 and define by
H
X ⌧h
log = log h,
⌧
h=1
PH
where ⌧h = 1/↵h and ⌧ = h=1 ⌧h . Using the result of Exercise 2.4 on the optimal demands for
the risky assets, show that the equilibrium risk-free return and price vector p are given by
✓ ◆
1 1 2 ¯0 ¯
Rf = exp ↵ ✓¯0 µ c̄0 ↵ ✓ ⌃✓ ,
2
1 ¯ .
p= (µ ↵⌃ ✓)
Rf
Explain in economic terms why the risk-free return is higher when ✓¯0 µ is higher and lower when ,
c̄0 , or ✓¯0 ⌃ ✓¯ is higher.
From Exercise 2.4, the optimal portfolio of investor h is
1 1
✓h = ⌃ (µ Rf p) .
↵h
Thus, the aggregate demand for risky assets is

H
!
X 1 1
⌃ 1 (µ Rf p) = ⌃ 1
(µ Rf p) .
↵h ↵
h=1
Market clearing implies
1 1
✓¯ = ⌃ 1
(µ Rf p) ) p= (µ ¯ .
↵⌃ ✓)
↵ Rf
To derive Rf we need to clear the market for date–0 consumption (or the market for the risk-free
asset). Investor h chooses c0 and ✓ to maximize

exp( ↵h c0 ) hE exp ↵h [(wh0 c0 p0 ✓)Rf + ✓0 x̃]

0
= exp( ↵h c0 ) h exp ↵h (wh0 c0 p ✓)Rf E exp ↵h ✓0 x̃ .
Substituting the optimal portfolio ✓ = ✓h yields

 ✓ ◆
0 1
E exp ↵h ✓ x̃ = exp (µ Rf p)0 ⌃ 1
µ + (µ Rf p) ⌃0 1
(µ Rf p) ,
2
and substituting p = 1 ¯ yields

Rf (µ ↵⌃ ✓)
 ✓ ◆
↵2 ¯0
E exp ↵h ✓0 x̃ = exp ↵✓¯0 µ + ✓ ⌃✓ ,
2
Thus, the first-order condition for ch0 is

✓ ◆
↵2 ¯0
↵h exp( ↵h ch0 ) = h ↵ h Rf exp ↵h (wh0 ch0 0
p ✓h )Rf exp ↵✓¯0 µ + ✓ ⌃✓ .
2
Dividing by ↵h , taking logs and rearranging yields
log h log Rf ↵ ¯0 ↵2 ¯0 ¯
ch0 = + (wh0 ch0 p0 ✓h )Rf + ✓µ ✓ ⌃✓ .
↵h ↵h ↵h 2↵h
By the definition of ,
H
X
log log h
= .
↵ ↵h
h=1
Thus, aggregate demand for the consumption good can be expressed as

H
X X H
log log Rf ↵ ¯0 ¯
ch0 = + Rf (wh0 ch0 p0 ✓h ) + ✓¯0 µ ✓ ⌃✓ .
↵ ↵ 2
h=1 h=1
PH PH
By market clearing for the risky assets, h=1 ch0 = c̄ if and only if h=1 wh0 ch0 p0 ✓h = 0.
Thus, each of these is equivalent to
log log Rf ↵ ¯0 ¯
c̄0 = + ✓¯0 µ ✓ ⌃✓ .
↵ ↵ 2
The solution of this is ⇢

1 1 2 ¯0 ¯
Rf = exp ↵ ✓¯0 µ c̄0 ↵ ✓ ⌃✓ .
2
✓¯0 µ is expected aggregate date–1 consumption. Investors prefer to smooth consumption over
time, so when ✓¯0 µ is larger, they wish to borrow to consume more at date 0. The risk-free return
must rise to o↵set this inclination to borrow. The reverse is true when c̄0 is larger. When is
higher, investors do not discount the future as much, and hence wish to save to finance date–1
consumption. The risk-free return must fall to o↵set this inclination to save. ✓¯0 ⌃ ✓¯ is the variance of
aggregate date–1 consumption. When it is larger, there is more risk, and investors expected date–1
utilities are smaller. They wish to transfer wealth from date 0 to date 1 in this circumstance, and
the risk-free return must fall to o↵set that desire.
3.5. Suppose the payo↵ of the market portfolio w̃m has k possible values. Denote these possible
values by a1 < · · · < ak . For convenience, suppose ai ai 1 is the same number for each i.
Suppose there is a risk-free asset with payo↵ equal to 1. Suppose there are k 1 call options on the
market portfolio, with the exercise price of the i–th option being ai . The payo↵ of the i–th option
is max(0, w̃m ai ).
(a) Show for each i = 1, . . . , k 2 that a portfolio that is long one unit of option i and short one
unit of option i + 1 pays if w̃m ai+1 and 0 otherwise. This portfolio of options is a bull
spread.
(b) Consider the following k portfolios. Show that the payo↵ of portfolio i is 1 when w̃m = ai and
0 otherwise. Thus, these are Arrow securities for the events on which w̃m is constant.
(i) i = 1: long one unit of the risk-free asset, short 1/ units of option 1, and long 1/ units
of option 2. This portfolio of options is a short bull spread.
(ii) 1 < i < k: long 1/ units of option i 1, short 2/ units of option i, and long 1/ units
of option i + 1. These portfolios are butterfly spreads.
(iii) i = k 1: long 1/ units of option k 2 and short 2/ units of option k 1.
(iv) i = k: long 1/ units of option k 1.
(c) Given any function f , define z̃ = f (w̃m ). Show that there is a portfolio of the risk-free asset
and the call options with payo↵ equal to z̃.
(a) When w̃m ai+1 , a long position in option i pays w̃m ai , and a short position in option i + 1
has cash flow ai+1 w̃m . The sum of these is ai+1 ai = .
(b) (i) Being long 1/ units of option 2 and short 1/ units of option 1 pays 1 when w̃m a2
and 0 otherwise. Combining this with a payo↵ of 1 yields 1 when w̃m = a1 and 0 otherwise.
(ii) Being long 1/ units of option i 1 and short 1/ units of option i pays 1 when w̃m ai
and 0 otherwise. Being short 1/ units of option i and long 1/ units of option i+1 pays 1
when w̃m ai+1 and 0 otherwise. The sum of these pays 1 when w̃m = ai and 0 otherwise.
(iii) Being long 1/ units of option k 2 produces a payo↵ of 1 when w̃m = ak 1 and 2 when
w̃m = ak . Being short 2/ units of option k 1 produces a payo↵ of 2 when w̃m = ak .
The sum of the two pays 1 when w̃m = ak 1 and 0 otherwise.
(iv) Being long 1/ units of option k 1 produces a payo↵ of 1 when w̃m = ak and 0 otherwise.
(c) Let zi denote the value of z̃ when w̃m = ai . The portfolio consisting of z1 units of the risk-free
asset, (z2 z1 )/ units of option 1, and (zi+1 2zi +zi 1 )/ units of option i for i = 2, . . . , k 1
has payo↵ equal to z̃.
3.6. Suppose all investors have CARA utility. Consider an allocation
w̃h = ah + bh w̃m
PH
where bh = ⌧h /⌧ and h=1 ah = 0. Show that the allocation is Pareto optimal. Hint: Show that it
solves the social planner’s problem with weights h defined as h = ⌧h eah /⌧h .
The first-order condition for the social planner’s problem is
↵h w̃h
(8 h) ↵h he = ⌘˜ .
Setting w̃h = ah + bh w̃m and h = ⌧h eah /⌧h , the left-hand side is e ⌧ w̃m . Thus, the first-order
condition holds for ⌘˜ = e ⌧ w̃m . By concavity, the first-order condition is sufficient for optimality.
3.7. Suppose all investors have shifted CRRA utility with the same coefficient ⇢ > 0. Suppose
w̃m > ⇣. Consider an allocation
w̃h = ⇣h + bh (w̃m ⇣)
PH
where h=1 bh = 1. Show that the allocation is Pareto optimal. Hint: Show that it solves the social
planner’s problem with weights h defined as h = b⇢h .
The first-order condition for the social planner’s problem is
⇢
(8 h) h w̃h = ⌘˜ .
Setting w̃h = ⇣h + bh (w̃m ⇣) and h = b⇢h , the left-hand side is (w̃m ⇣) ⇢. Thus, the first-
order condition holds for ⌘˜ = (w̃m ⇣) ⇢. By concavity, the first-order condition is sufficient for
optimality.
3.8. Show that if each investor has shifted CRRA utility with the same coefficient ⇢ > 0 and shift
⇣h , then, as asserted in Section 3.6, any Pareto optimal allocation involves an affine sharing rule.
Pareto optimality implies the first-order condition
⇢
(8 h) h (w̃h ⇣h ) = ⌘˜
1/⇢
for some weights h and Lagrange multiplier ⌘˜. This implies w̃h ⇣h = h ⌘ ˜ 1/⇢ and adding over
investors yields
H
!
X 1/⇢ 1/⇢
w̃m ⇣= h ⌘˜ ,
h=1
so !⇢
H
X 1/⇢ ⇢
⌘˜ = h (w̃m ⇣) .
h=1
Substituting this into the first-order condition yields

0 1⇢
XH
1/⇢ A
h (w̃h ⇣h ) ⇢ = @ j (w̃m ⇣) ⇢
,
j=1
which implies
1/⇢
h
w̃h ⇣h = P 1/⇢
(w̃m ⇣) .
H
j=1 j
3.9. Consider an economy with date–0 consumption as in Section 3.7. Assume the investors have
time-additive utility and the date–1 allocation solves the social planning problem (3.1). Using the
first-order condition (2.390 ), show that the equilibrium allocation is Pareto optimal. Hint: Using
the first-order condition (3.4) with ⌘˜ = ⌘˜1 , show that
0
(8 h) h uh0 (c̃h0 ) = Rf E[˜
⌘1 ] .
By (2.390 ),
u0h1 (c̃h1 ) ⌘˜1
=
u0h0 (ch0 ) 0
h uh0 (ch0 )
is a stochastic discount factor. Thus


⌘˜1 1
E 0 = .
h uh0 (ch0 ) Rf
This implies
0
h uh0 (c̃h0 ) = ⌘0 ,
defining ⌘0 = Rf E[˜
⌘1 ]. Thus, the first-order conditions for the social planner’s problem are satisfied.
By concavity, this implies Pareto optimality.
4
Arbitrage and Stochastic Discount Factors
4.1. Assume there are two possible states of the world: !1 and !2 . There are two assets, a risk-free
asset returning Rf in each state, and a risky asset with initial price equal to 1 and date–1 payo↵
x̃. Let Rd = x̃(!1 ) and Ru = x̃(!2 ). Assume without loss of generality that Ru > Rd .
(a) What conditions on Rf , Rd and Ru are equivalent to the absence of arbitrage opportunities?
(b) Assuming the conditions from the previous part hold, compute the unique vector of state prices,
and compute the unique risk neutral probabilities of states !1 and !2 .
(c) Suppose another asset is introduced into the market that pays max(x̃ K, 0) for some constant
K. Compute the price at which this asset should trade, assuming the conditions from part (a)
hold.
(a) The payo↵ of a zero-cost portfolio is (R̃ Rf ) for some . For this to be nonnegative in both
states and positive in one state, we must have either (i) > 0 and Ru > Rd Rf or (ii) <0
and Rf Ru > Rd . Thus, a necessary and sufficient condition for the absence of arbitrage
opportunities is that Ru > Rf > Rd .
(b) Let qd denote the state price of state !1 and qu the state price of state !2 . The state prices
satisfy
q d Rf + q u Rf = 1 ,
q d Rd + q u Ru = 1 .
The unique solution to this system of equations is
Ru Rf Rf Rd
qd = , and qu = .
Rf (Ru Rd ) Rf (Ru Rd )
36 4 Arbitrage and Stochastic Discount Factors
The risk neutral probabilities are qd Rf and qu Rf .

(c) The asset should trade at qu max(xu K, 0) + qd max(xd K, 0), where xd denotes the value of
x̃ in state 1 and xu the value of x̃ in state 2.
4.2. Show that, if there is a strictly positive stochastic discount factor, then there are no arbitrage
opportunities.
If x̃ is a nonnegative marketed payo↵, then its price is E[m̃x̃] 0, and E[m̃x̃] = 0 if and only if
x̃ = 0 with probability one. Therefore, there are no arbitrage opportunities.
4.3. Show by example that the law of one price can hold but there can still be arbitrage opportu-
nities.
Suppose there are two possible states of the world, and the market consists of the two Arrow
securities having prices pi . Then the market is complete, and each payo↵ x̃ = (x1 , x2 ) has a unique
cost p1 x1 + p2 x2 . If p1 < 0, then buying the first asset is an arbitrage opportunity.
4.4. Suppose there is no risk-free asset. For what value of ⌫ = E[m̃] does the projection m̃⌫p equal
the projection m̃p ?
In the absence of a risk-free asset, m̃⌫p belongs to the span of the assets if and only if the constant
in (4.9) is zero, i.e., if and only if
⌫ (p0 ⌫E[X̃0 ])0 ⌃x 1 E[X̃0 ] = 0 .
Set µ = E[X̃0 ] and p = p0 . Then,

p0 ⌃ x 1 µ
⌫= .
1 + µ0 ⌃ x 1 µ
Because m̃p is the unique stochastic discount factor in the span of the assets, we must have m̃⌫p =
m̃p .
4.5. Assume there are three possible states of the world: !1 , !2 , and !3 . Assume there are two
assets: a risk-free asset returning Rf in each state, and a risky asset with return R1 in state !1 , R2
in state !2 , and R3 in state !3 . Assume the probabilities are 1/4 for state !1 , 1/2 for state !2 , and
1/4 for state !3 . Assume Rf = 1.0, and R1 = 1.1, R2 = 1.0, and R3 = 0.9.
4 Arbitrage and Stochastic Discount Factors 37
(a) Prove that there are no arbitrage opportunities.

(b) Describe the one-dimensional family of state-price vectors (q1 , q2 , q3 ).
(c) Describe the one-dimensional family of stochastic discount factors
m̃ = (m1 , m2 , m3 ) ,
where mi denotes the value of the stochastic discount factor in state !i . Verify that m1 = 4,
m2 = 2, m3 = 4 is a stochastic discount factor.
(d) Consider the formula
ỹp = E[ỹ] + Cov(X̃, ỹ)0 ⌃x 1 (X̃ E[X̃])
for the projection of a random variable ỹ onto the linear span of a constant and a random vector
X̃. When the vector X̃ has only one component x̃ (is a scalar), the formula simplifies to
ỹp = E[ỹ] + (x̃ E[x̃]) ,
where
cov(x̃, ỹ)
= .
var(x̃)
Apply this formula with ỹ being the stochastic discount factor m1 = 4, m2 = 2, m3 = 4 and
x̃ being the risky asset return R1 = 1.1, R2 = 1.0, R3 = 0.9 to compute the projection of the
stochastic discount factor onto the span of the risk-free and risky assets.
(e) The projection in part (d) is by definition the payo↵ of some portfolio. What is the portfolio?
(a) Let R̃ denote the risky asset return. A zero-cost portfolio has payo↵ (R̃ Rf ) for some . This
equals 0.1 in state 1, 0 in state 2, and 0.1 in state 3. Obviously, there is no such that
(R̃ Rf ) is nonnegative in all states and positive in some state.
(b) State prices must satisfy
q1 + q2 + q3 = 1
1.1q1 + q2 + 0.9q3 = 1 .
Subtracting the top from the bottom shows that q3 = q1 and substituting this into the first
shows that q2 = 1 2q1 . q1 is arbitrary.
(c) Stochastic discount factors are given by
m1 = q1 /(1/4) = 4q1 , m2 = q2 /(1/2) = 2 4q1 , m3 = q3 /(1/4) = 4q1 ,

38 4 Arbitrage and Stochastic Discount Factors
with q1 being arbitrary. Taking q1 = 1 yields m1 = 4, m2 = 2, m3 = 4.

(d) We have E[R̃] = 1 and E[m̃] = 1 and
1 1 1
cov(R̃, ỹ) = (0.1)(3) + (0)( 3) + ( 0.1)(3) = 0 .
4 2 4
Thus, the projection is
m̃p = E[m̃] = 1 .
(e) m̃p is the payo↵ of holding the risk-free asset.
4.6. Suppose there is a risk-free asset and the risky asset returns have a joint normal distribution.
Use the reasoning in Exercise 2.10 and the formula (5.31) for m̃p to show that the optimal portfolio
of risky assets for an investor with zero labor income is ⇡ = ⌃ 1 (µ Rf 1) for some real number
, where ⌃ denotes the covariance matrix of the risky asset returns. Hint: if w̃ and m̃ are joint
normal, then E[w̃|m̃] is the orthogonal projection of w̃ on a constant and m̃—i.e.,
cov(w̃, m̃)
E[w̃|m̃] = E[w̃] + (m̃ E[m̃]) .
var(m̃)
For any feasible w̃, let w̃⇤ = E[w̃ | m̃p ]. Then w̃ equals w̃⇤ plus mean-independent noise, so w̃⇤ is
preferred to w̃. From (5.31),
1
m̃p E[m̃p ] = (µ Rf 1)0 ⌃ 1
(R̃vec µ) .
Rf
Hence, ✓ ◆
⇤ 1 cov(w̃, m̃p )
w̃ = E[w̃] (µ Rf 1)0 ⌃ 1
(R̃vec µ) .
Rf var(m̃p )
This is in the span of the assets and budget feasible, because E[m̃p w̃⇤ ] = E[m̃p w] by iterated
expectations. Thus, w̃⇤ is feasible. The portfolio of risky assets producing w̃⇤ is ⌃ 1 (µ Rf 1) for
✓ ◆ ✓ ◆
1 cov(w̃, m̃p ) 1 cov(w̃⇤ , m̃p )
= = ,
Rf var(m̃p ) Rf var(m̃p )
the second equality following from iterated expectations.
4.7. Assume there is a finite number of assets, and the payo↵ of each asset has a finite variance.
Assume the law of one price holds. Apply facts stated in Section 4.8 to show that there is a unique
stochastic discount factor m̃p in the span of the asset payo↵s. Show that the orthogonal projection
of any other stochastic discount factor onto the span of the asset payo↵s equals m̃p .
4 Arbitrage and Stochastic Discount Factors 39
The span of the assets is a finite-dimensional subspace of L2 . The law of one price states that there
is a unique price C[x̃] for each x̃ in the span of the payo↵s. The function C[·] is linear. Therefore,
it has a Riesz representation C[x̃] = E[x̃m̃p ] for a unique m̃p in the span of the assets. Given any
stochastic discount factor m̃, we have m̃ = m̃⇤ + "˜, where the orthogonal projection m̃⇤ is in the
span of the assets and "˜ is orthogonal to the span of the assets. Hence, C[x̃] = E[m̃x̃] = E[x̃m̃⇤ ] for
all x̃ in the span of the assets. Thus, m̃⇤ is also in the span of the assets and represents the price
function. By the uniqueness of the Riesz representation, it must be that m̃⇤ = m̃p .
5
Mean-Variance Analysis
5.1. Derive the minimum global variance portfolio directly by solving the problem: minimize ⇡ 0 ⌃⇡
subject to 10 ⇡ = 1.
The first-order condition is 2⌃⇡ = 1. Thus, ⇡ = ( /2)⌃ 1 1. Imposing the constraint 10 ⇡ = 1

implies
1 1
⇡= ⌃ 1.
10 ⌃ 1 1
5.2. Assume there is a risk-free asset. Consider an investor with quadratic utility, who seeks to
maximize
1 1
⇣E[w̃] E[w̃]2 var(w̃) .
2 2
(a) Show that the investor will choose a portfolio on the mean-variance frontier.
(b) Assume (5.14) holds, so the tangency portfolio is efficient. Under what circumstances will the
investor choose a mean-variance efficient portfolio? Explain the economics of the condition you
derive. Hint: Compare Exercise 2.2.
(a) From Exercise 2.2, the optimal portfolio is

2 1
= (⇣ w0 Rf )⌃ (µ Rf 1) .
1 + 2
This is proportional to ⌃ 1 (µ Rf 1) and hence is on the mean-variance frontier.
(b) When the tangency portfolio is efficient, it is a positive proportion of ⌃ 1 (µ Rf 1). The sign
of the optimal portfolio’s proportion of ⌃ 1 (µ Rf 1) depends on ⇣ w0 Rf . When ⇣ > w0 Rf ,
the optimal portfolio is on the efficient part of the frontier, and when ⇣ < w0 Rf , the optimal
portfolio is on the inefficient part of the frontier. ⇣ is the bliss level of wealth for the quadratic
42 5 Mean-Variance Analysis
utility function. When ⇣ < w0 Rf , the investor can exceed the bliss level by simply holding the
risk-free asset. To avoid this, he holds an inefficient portfolio of risky assets.
5.3. Suppose that the risk-free return is equal to the expected return of the global minimum
variance portfolio (Rf = B/C). Show that there is no tangency portfolio. Hint: Show there is no
and satisfying
1
⌃ (µ Rf 1) = ⇡µ + (1 )⇡1 .
Recall that we are assuming µ is not proportional to 1.
The mean-variance frontier considering only the risky assets is the set ⇡µ + (1 )⇡1 for some
, and the mean-variance frontier including the risk-free asset is the set ⌃ 1 (µ Rf 1) for some
. For the frontiers to intersect, we must have
1
⌃ (µ Rf 1) = ⇡µ + (1 )⇡1 .
This is equivalent to
✓ ◆ ✓ ◆
1 1 1
⌃ µ= Rf + 0 ⌃ 1,
10 ⌃ 1µ 1⌃ 11
and premultiplying by ⌃ gives

✓ ◆ ✓ ◆
1
µ= Rf + 1.
10 ⌃ 1µ 10 ⌃ 11
Because µ is not proportional to 1, this equation can hold only if
1
= Rf + = 0.
10 ⌃ 1 µ 10 ⌃ 11
This implies
1
Rf + = 0,
10 ⌃ 1 µ 10 ⌃ 11
and substituting Rf = B/C = 10 ⌃ 1 µ/10 ⌃ 1 1 yields
1
= 0,
10 ⌃ 1 1
which is impossible.
5.4. Consider the problem of choosing a portfolio ⇡ of risky assets, a proportion b 0 to borrow
and a proportion ` 0 to lend to maximize the expected return ⇡ 0 µ + ` R` b Rb subject to the
5 Mean-Variance Analysis 43
constraints (1/2)⇡ 0 ⌃⇡  k and 10 ⇡ + ` b = 1. Assume B/C > Rb > R` , where B and C are
defined in (5.6). Define
1 1
⇡b = ⌃ (µ Rb 1) ,
10 ⌃ 1 (µ Rb 1)
1 1
⇡` = ⌃ (µ R` 1) .
10 ⌃ 1 (µ R` 1)
Using the Kuhn-Tucker conditions, show that the solution is either (i) ⇡ = (1 ` )⇡` for 0  `  1,
(ii) ⇡ = ⇡` + (1 )⇡b for 0   1, or (iii) ⇡ = (1 + b )⇡b for b 0.
The Kuhn-Tucker conditions are
µ ⌃⇡ 1 = 0,
R` + ⌘` = 0 ,
Rb + + ⌘b = 0 ,
`, b , ⌘` , ⌘b , 0,
1 0
⇡ ⌃⇡  k ,
2
10 ⇡ + ` b = 1,
✓ ◆
1 0
⌘` ` = ⌘b b = ⇡ ⌃⇡ k = 0 .
2
If ` > 0, then ⌘` = 0, = R` , and
1 1
⇡= ⌃ (µ R` 1) .
Also, = R` implies ⌘b = Rb R` > 0. Hence, b = 0, and 10 ⇡ = 1 `. This implies ⇡ = (1 ` )⇡` .
If b > 0, then ⌘b = 0, = Rb , and

1 1
⇡= ⌃ (µ Rb 1) .
Also, = Rb implies ⌘` = Rb R` > 0, so ` = 0. This implies 10 ⇡ = 1+ b. Hence, ⇡ = (1+ b )⇡b .
If ` = b = 0, then
1 1
⇡= ⌃ (µ 1) ,
where = R` + ⌘ ` R` and = Rb ⌘b  Rb . Thus, = R` + (1 )Rb for some 0   1.

From 10 ⇡ = 1, it follows that ⇡ = ⇡` + (1 )⇡b .
5.5. Establish the properties claimed for the risk-free return proxies:
(a) Show that var(R̃) var(R̃p + bm ẽp ) for every return R̃.
(b) Show that cov(R̃p , R̃p + bz ẽp ) = 0.
(c) Prove (5.18), showing that R̃p + bc ẽp represents the constant bc times the expectation operator
on the space of returns.
(a) By Fact 15, the minimum variance return is R̃p + bẽp for some b. Using Fact 8, we have
var(R̃p + bẽp ) = var(R̃p ) 2bE[R̃p ]E[ẽp ] + var(ẽp ) ,
and by Fact 17, this equals

⇣ ⌘
var(R̃p ) + b2 (1 E[ẽp ]) 2bE[R̃p ] E[ẽp ] .
By Fact 16, E[ẽp ] > 0, so the minimum variance return is found by minimizing (b2 (1 E[ẽp ])
2bE[R̃p ] in b, with solution b = bm .
(b) Using Fact 8, we have cov(R̃p , R̃p + bz ẽp ) = var(R̃p ) bz E[R̃p ]E[ẽp ] = 0.
(c) Using Fact 11 and the definition of bc , we have
bc E[R̃] = bc E[R̃p + bẽp + "˜] = E[R̃p2 ] + bbc E[ẽp ] .
From Facts 2, 8, 11, and 16,
E[R̃(R̃p + bc ẽp )] = E[(R̃p + bẽp + "˜)(R̃p + bc ẽp )]
= E[R̃p2 ] + bbc E[ẽ2p ]
= E[R̃p2 ] + bbc E[ẽp ] .
Thus,
bc E[R̃] = E[R̃(R̃p + bc ẽp )] .
5.6. Show that

1
x̃ = (1 ẽp )
E[R̃p ]
is a stochastic discount factor. Hint: Write any return R̃ as R̃p + (R̃ R̃p ) and use the fact that
1 ẽp is orthogonal to excess returns (because ẽp represents the expectation operator on the space
of excess returns). When there is a risk-free asset, x̃, being spanned by a constant and an excess
return, is in the span of the returns and hence must equal m̃p . Use this fact to demonstrate (5.20).
We have
1 1
E[x̃R̃] = E[(1 ẽp )R̃p ] + E[(1 ẽp )(R̃ R̃p )]
E[R̃p ] E[R̃p ]
1
= E[(1 ẽp )R̃p ]
E[R̃p ]
= 1,
using E[R̃ R̃p ] = E[ẽp (R̃ R̃p ] for the second equality and Fact 8 for the third. Thus, x̃ is a
stochastic discount factor. This implies
1 1 E[ẽp ]
= E[x̃] = .
Rf E[R̃p ]
Moreover, x̃ = m̃p implies
x̃
R̃p = ,
E[x̃2 ]
and
1 1 E[ẽp ] 1
E[x̃2 ] = (1 2E[ẽp ] + E[ẽ2p ]) = = ,
E[R̃p ]2 E[R̃p ] 2 Rf E[R̃p ]
using Fact 16 for the second equality. Thus,
!
1
R̃p = Rf E[R̃p ] (1 ẽp ) = Rf (1 ẽp ) .
E[R̃p ]
5.7. Show that E[R̃2 ] E[R̃p2 ] for every return R̃ (thus, R̃p is the “minimum second-moment
return”). The returns having a given second moment a are the returns satisfying E[R̃2 ] = a, which
is equivalent to
var(R̃) + E[R̃]2 = a ;
thus, they plot on the circle x2 + y 2 = a in (standard deviation, mean) space. Use the fact that R̃p
is the minimum second-moment return to illustrate graphically that R̃p must be on the inefficient
part of the frontier, with and without a risk-free asset (assuming E[R̃p ] > 0 in the absence of a
risk-free asset).
Using Facts 1, 2 and 8,
E[R̃2 ] = E[(R̃p + bẽp + "˜)2 ] = E[R̃p2 ] + b2 E[ẽ2p ] + E[˜

"2 ] E[R̃p2 ] .
With a risk-free asset, the cone intersects the vertical axis at Rf > 0, and the point on the cone
closest to the origin is on the lower part. In the absence of a risk-free asset, the assumption E[R̃p ] > 0
implies that global minimum variance portfolio has a positive expected return (use the definition
of bm and Facts 16 and 17 — which imply 1 E[ẽp ] > 0 — to deduce this). Thus, the point on the
hyperbola closest to the origin must be on the lower part of the hyperbola.
5.8. If all returns are joint normally distributed, then R̃p , ẽp and "˜ are joint normally distributed
in the orthogonal decomposition R̃ = R̃p + bẽp + "˜ of any return R̃ (because R̃p is a return and ẽp
and "˜ are excess returns). Assuming all returns are joint normally distributed, use the orthogonal
decomposition to compute the optimal return for a CARA investor.
When returns are normally distributed, a CARA investor chooses the return R̃ that maximizes
1
E[R̃] ↵w0 var(R̃) .
2
Given R̃ = R̃p + bẽp + "˜ and Facts 11 and 15, the objective function is
1
E[R̃ + bẽp ] ↵w0 [var(R̃p + bẽp ) + var(˜
")] ,
2
so it is optimal to choose "˜ = 0. The investor chooses b to maximize
1
bE[ẽp ] ↵w0 [2b cov(R̃p , ẽp ) + b2 var(ẽp )] ,
2
and the optimum satisfies
E[ẽp ] ↵w0 cov(R̃p , ẽp ) ↵w0 var(ẽp )b = 0 ,
implying
E[ẽp ] cov(R̃p , ẽp )
b= .
↵w0 var(ẽp ) var(ẽp )
Using Facts 8 and 17, we can simplify this further to
1 + ↵w0 E[R̃p ]
b= .
↵w0 (1 E[ẽp ])
5.9. The return R̃p is on the mean-variance frontier. Hence, when there is a risk-free asset, it must
be the return of a weighted average of the tangency portfolio and the risk-free asset. The purpose
of this exercise is to compute the weighted average. When there is a risk-free asset, the projection
m̃p defined in Section 4.4 is the same as the projection m̃⌫p defined in Section 4.5. Furthermore, the
vector of asset payo↵s in the formula (4.10) for m̃⌫p can always be replaced by the vector R̃vec of
returns whenever the asset prices are positive, because the linear span of the returns is the same as
the linear span of the payo↵s. Substituting the returns for the payo↵s and substituting E[m̃] = 1/Rf
and E[m̃R̃vec ] = 1 in (4.10), we have
✓ ◆0
1 1 1
m̃p = + 1 µ ⌃ (R̃vec µ) .
Rf Rf
Using this formula, show that R̃p = ⇡⇤0 R̃vec + (1 )Rf for some (i.e., calculate ).
We have
1 ⇥ ⇤ 1
m̃p = 1 + (µ Rf 1)0 ⌃ 1
µ (µ Rf 1)0 ⌃ 1
R̃vec .
Rf Rf
Hence
2
var(m̃p ) = ,
Rf2
where 2 = (µ Rf 1)0 ⌃ 1 (µ Rf 1) is the squared maximum Sharpe ratio. Because E[m̃p ] = 1/Rf ,
this implies
1 + 2
E[m̃2p ] = .
Rf2
Therefore
Rf ⇥ ⇤ Rf
R̃p = 2
1 + (µ Rf 1)0 ⌃ 1 µ (µ Rf 1)0 ⌃ 1
R̃vec
1+ 1 + 2
Rf (1 + A Rf B) Rf (B Rf C) 0 vec
= ⇡⇤ R̃ ,
1 + 2 1 + 2
in the notation of Section 5.3. Setting
Rf (B Rf C)
= ,
1 + 2
we have
1 + 2 + R f B Rf2 C 1 + A Rf B
1 = = ,
1+ 2 1 + 2
because 2 = A 2Rf B + Rf2 C. Thus,
R̃p = (1 )Rf + ⇡⇤0 R̃vec .
5.10. Assuming there is a risk-free asset, show that in Exercise 5.9 is negative when Rf <
B/C and positive when Rf > B/C. (This verifies that the portfolio generating R̃p is short the
tangency portfolio when the tangency portfolio is efficient and long the tangency portfolio when it
is inefficient.)
Rf (B Rf C)
= <0
1 + 2
when B > Rf C and positive when B < Rf C.
6
Beta Pricing Models
6.1. Suppose there is a risk-free asset. Use the formula (5.9) for frontier portfolios to show that
the beta-pricing model (6.5) implies the return R̃⇤ is on the mean-variance frontier.
Let R̃⇤ = Rf + ⇡ 0 (Rvec Rf 1). Stacking the formula (6.5) for assets 1, . . . , n gives
E[R̃⇤ ] Rf
µ = Rf 1 + ⌃⇡ ,
var(R̃⇤ )
so
1
⇡= ⌃ (µ Rf 1) ,
where
var(R̃⇤ ) ⇡ 0 ⌃⇡
= = 0 .
E[R̃⇤ ] Rf ⇡ (µ Rf 1)
6.2. Suppose there is no risk-free asset. Use the formula (5.1) for frontier portfolios to show that
a beta-pricing model (6.5) is equivalent to the return R̃⇤ being on the mean-variance frontier and
not equal to the global minimum variance return.
Let R̃⇤ = ⇡ 0 Rvec . Stacking the formula (6.5) for assets 1, . . . , n gives
E[R̃⇤ ] ↵
µ = ↵1 + ⌃⇡ ,
var(R̃⇤ )
so
1 1
⇡= ⌃ µ+ ⌃ 1,
where
var(R̃⇤ ) var(R̃⇤ )
= and = ↵ .
E[R̃⇤ ] Rf E[R̃⇤ ] Rf
To have ⇡ = ⇡1 , we must have = 0, which implies = 0 and ⇡ = 0, contradicting 10 ⇡ = 1.
50 6 Beta Pricing Models
6.3. Suppose investors can borrow and lend at di↵erent rates. Let Rb denote the return on borrow-
ing and R` the return on lending. Suppose B/C > Rb > R` , where B and C are defined in (5.6).
Suppose each investor chooses a mean-variance efficient portfolio, as described in Exercise 5.4. Show
that the CAPM holds with R`  Rz  Rb .
From Exercise 5.4, the optimal portfolio of risky assets for each investor h is
h [ h ⇡` + (1 h )⇡b ] ,
where 0  h  1 and h 0 is the fraction of investor h’s wealth that is invested in risky assets. It
follows that the market portfolio of risky assets is ⇡` + (1 )⇡b for some 0   1. The vector
of covariances of the risky asset returns with the market return is therefore
1
Cov(R̃vec , R̃m ) = ⌃[ ⇡` + (1 )⇡b ] = (µ Rb 1) + (µ R` 1) .
B CRb B CR`
Define ✓b = /(B CRb ) and ✓` = (1 )/(B CR` ). Then, we have
1 ✓ b Rb + ✓ ` R`
µ= Cov(R̃vec , R̃m ) + 1.
✓b + ✓` ✓b + ✓`
Thus,
✓ b Rb + ✓ ` R `
Rz = ,
✓b + ✓`
which is a convex combination of Rb and R` .
6.4. Assuming normally distributed returns, no end-of-period endowments, and investors with
CARA utility, derive the CAPM from the portfolio formula (2.27), i.e., from
1 1
h = ⌃ (µ Rf 1) ,
↵h
where ↵h denotes the absolute risk aversion of investor h. Show that the factor risk premium is
↵w0 var(R̃m ), where ↵ is the aggregate absolute risk aversion defined in Section 1.3 and w0 =
P
10 Hh=1 h is the market value of risky assets at date 0.
PH
Setting = h=1 h and adding the optimal portfolios over investors gives
1 1
= ⌃ (µ Rf 1) ,
↵
which in equilibrium is the vector of market values of risky assets at date 0. Thus,
6 Beta Pricing Models 51
µ = Rf 1 + ↵⌃ .
The market portfolio is ⇡ = (1/10 ) . The return on the market portfolio is R̃m = 0 R̃vec / 0 1, and
the vector of betas of the asset returns with respect to the market return is
1
⌃⇡ .
⇡ 0 ⌃⇡
We have
1
µ = Rf 1 + ↵(10 )⌃⇡ = ↵(10 )(⇡ 0 ⌃⇡) ⌃⇡ ,
⇡ 0 ⌃⇡
so the factor risk premium is
↵(10 )(⇡ 0 ⌃⇡) = ↵w0 var(R̃m ) .
6.5. Assume there exists a return R̃⇤ that is on the mean-variance frontier and is an affine function
of a vector F̃ ; i.e., R̃ = a + b0 F̃ . Assume either (i) there is a risk-free asset and R̃⇤ 6= Rf , or (ii)
there is no risk-free asset and R̃⇤ is di↵erent from the global minimum variance return. Show that
there is a beta pricing model with factors F̃ . Note: In the context of a factor model with factors
F̃ , a return R̃ = a + b0 F̃ is called well diversified, because it has no idiosyncratic risk. If there is
a finite number of assets satisfying a factor model, then there is no risky well diversified return,
P P 2
because var( ⇡ "˜i ) = ⇡ var(˜"i ) > 0 if ⇡ 6= 0. However, if there is an infinite number of assets,
then one can take ⇡i = 1/n for i = 1, . . . , n and n ! 1 to obtain a well diversified limit return.
Under either assumption (i) or (ii), there is a beta pricing model with R̃⇤ as the factor. Thus, for
every return R̃,
E[R̃] = ↵ + cov(R̃⇤ , R̃)
= ↵ + b0 Cov(F̃ , R̃)
= ↵ + ˆ 0 ⌃F 1 Cov(F̃ , R̃) ,
where we define
ˆ = ⌃F b .
6.6. Assume the asset returns R̃i for i = 1, . . . , n satisfy
R̃i = E[R̃i ] + Cov(F̃ , R̃i )0 ⌃F 1 (F̃ E[F̃ ]) + "˜i ,

"i |F̃ ] = 0 (note it is not being assumed

where each "˜i is mean-independent of the factors F̃ , i.e., E[˜
that cov(˜
"i , "˜j ) = 0). Assume markets are complete, investors have strictly monotone preferences,
and the market return is well diversified in the sense of having no idiosyncratic risk:
R̃m = E[R̃m ] + Cov(F̃ , R̃m )0 ⌃F 1 (F̃ E[F̃ ]) .
Show that there is a beta pricing model with factors F̃ . Hint: Pareto optimality implies sharing
rules w̃h = fh (w̃m ).
Complete markets and strictly monotone preferences implies Pareto optimality. Given the sharing
rules, the marginal utility of any investor depends only on w̃m and hence depends only on F̃ . Thus,
there is a stochastic discount factor that is proportional to an investor’s marginal utility and equal
to m̃ = g(F̃ ) for some function g. By the strict monotonicity of preferences, m̃ is strictly positive.
Hence, E[m̃] 6= 0. This implies a beta pricing model with m̃ as the factor. This further implies an
APT pricing formula with pricing errors E[m̃˜
"i ]/E[m̃]. The pricing errors are zero, because,
E[m̃˜ "i | F̃ ] = E[g(F̃ )E[˜

"i ] = E[E[g(F̃ )˜ "i | F̃ ] = 0 .
Thus, there is exact APT pricing, i.e., a beta pricing model with F̃ as the factors.
6.7. Suppose two assets satisfy a one-factor model:
R̃1 = E[R̃1 ] + f˜ + "˜1 ,
R̃2 = E[R̃2 ] f˜ + "˜2
where E[f˜] = E["˜1 ] = E[˜

"2 ] = 0, var(f˜) = 1, cov(f˜, "˜1 ) = cov(f˜, "˜2 ) = 0, and cov(˜
"1 , "˜2 ) = 0.
Assume var(˜
"1 ) = var(˜
"2 ) = 2. Define R̃1⇤ = R̃1 and R̃2⇤ = ⇡ R̃1 + (1 ⇡)R̃2 with ⇡ = 1/(2 + 2 ).
(a) Show that R̃1⇤ and R̃2⇤ do not satisfy a one-factor model with factor f˜.
(b) Show that R̃1⇤ and R̃2⇤ satisfy a zero-factor model, i.e.,
R̃1⇤ = E[R̃1⇤ ] + "˜⇤1 ,
R̃2⇤ = E[R̃2⇤ ] + "˜⇤2 ,
where E["˜⇤1 ] = E[˜

"⇤2 ] = 0 and cov(˜
"⇤1 , "˜⇤2 ) = 0.
(c) Assume exact APT pricing with nonzero risk premium for the two assets in the one-factor
model, i.e., E[R̃i ] Rf = cov(R̃i , f˜) for i = 1, 2. Show that there cannot be exact APT pricing
in the zero-factor model for R̃1⇤ and R̃2⇤ .
(a) R̃2⇤ = E[R̃2⇤ ] + (2⇡ 1)f˜ + "˜⇤2 , where "˜⇤2 = ⇡ "˜1 + (1 "2 is uncorrelated with f˜. However,
⇡)˜
"1 , "˜⇤2 ) = ⇡
cov(˜ 2 6= 0.
(b) Define "˜⇤1 = f + "˜1 and "˜⇤2 = (2⇡ 1)f + ⇡ "˜1 + (1 ⇡)˜
"2 . Then
R̃1⇤ = E[R̃1⇤ ] + "˜⇤1 ,
R̃2⇤ = E[R̃2⇤ ] + "˜⇤2 ,
"⇤1 , "˜⇤2 ) = (2⇡

and cov(˜ 1) var(f˜) + ⇡ 2 = 2⇡ 1+⇡ 2 = 0.
(c) Exact APT pricing with zero factors means E[R̃1⇤ ] = E[R̃2⇤ ] = Rf , but E[R̃1⇤ ] = Rf + .
6.8. Assume there are H investors with CARA utility and the same absolute risk aversion ↵.
Assume there is a risk-free asset. Assume there are two risky assets with payo↵s x̃i that are joint
normally distributed with mean vector µ and nonsingular covariance matrix ⌃. Assume HU < H
investors are unaware of the second asset and invest only in the risk-free asset and the first risky
asset. If all investors invested in both assets (HU = 0), then the equilibrium price vector would be
1 ↵
p⇤ = µ ⌃ ✓¯ ,
Rf HRf
where ✓¯ is the vector of supplies of the risky assets (see Exercise 3.4). Assume HU > 0, and set
HI = H HU .
(a) Show that the equilibrium price of the first asset is p1 = p⇤1 , and the equilibrium price of the
second asset is ✓ ◆✓ ◆
↵ HU cov(x̃1 , x̃2 )2
p2 = p⇤2 var(x̃2 ) < p⇤2 .
HRf HI var(x̃1 )
(b) Show that there exist A > 0 and such that
cov(R̃1 , R̃m )
E[R̃1 ] = Rf + ,
var(R̃m )
cov(R̃2 , R̃m )
E[R̃2 ] = A + Rf + ,
var(R̃m )
= E[R̃m ] Rf A⇡2 ,
where ⇡2 = p2 ✓¯2 /(p1 ✓¯1 + p2 ✓¯2 ) is the relative date–0 market capitalization of the second risky
asset. Note that is less than in the CAPM, and the second risky asset has a positive “alpha,”
relative to .
(a) The optimal portfolio of investors who do not invest in the second risky asset is ✓U = (✓U 1 0)0 ,
where
E[x̃1 ] Rf p1
✓U 1 = .
↵ var(x̃1 )
The optimal portfolio of investors who invest in both risky assets satisfies
↵⌃✓I = µ Rf p .
Let ij denote the (i, j)–th element of ⌃. The market clearing condition ✓¯ = HI ✓I + HU ✓U
implies
1 0
HU @ 1 0
↵⌃ ✓¯ = HI ↵⌃✓I + HU ↵⌃✓U = HI (µ Rf p) + ⌃ A (µ Rf p)
11 0 0
0 1
H 0
=@ A (µ Rf p) .
HU 12 / 11 HI
Thus,
0 1 1
H 0
µ Rf p = ↵ @ A ⌃ ✓¯
HU 12 / 11 HI
0 1
1/H 0
= ↵@ A ⌃ ✓¯
HU
HHI 1/HI 12
11
2 0 1 0 13
1 1 0 H U @ 0 0
= ↵4 @ A+ A5 ⌃ ✓¯
H 0 1 HHI 12
1
11
0 1
↵ H U ↵ @0 0
= ⌃ ✓¯ + 2
A ✓¯
H HHI 0 12
22 11
Hence, 0 1
✓ ◆✓ 2
◆
1 ↵ ↵ HU 0
p= µ ⌃ ✓¯ 22
12 @ A.
Rf HRf HRf HI 11 ✓¯2
Note that p2 < p⇤2 because 11 12 > 2
12 .
(b) Set R̃i = x̃i /pi and

✓¯1 x̃1 + ✓¯2 x̃2
R̃m = ¯ .
✓1 p1 + ✓¯2 p2
We have
pi ¯ + ¯
cov(R̃i , R̃m ) = ¯ ( i1 ✓1 i2 ✓2 ) .
✓1 p1 + ✓¯2 p2
The formula for p in the previous part implies

0 1
✓ ◆✓ 2 2
◆
↵ ↵ HU 11 2 0
µ = Rf p + ⌃ ✓¯ + 12 @ A.
H H HI 11 ✓¯2
Thus,
↵ ¯
E[R̃1 ] = Rf + (✓1 p1 + ✓¯2 p2 ) cov(R̃1 , R̃m )
H
cov(R̃1 , R̃m )
= Rf + ,
var(R̃m )
where
↵ ¯
= (✓1 p1 + ✓¯2 p2 ) var(R̃m ) .
H
Also,
✓ ◆✓ 2 2
◆
↵ ¯ ¯ ↵ HU 11 2
E[R̃2 ] = Rf + (✓1 p1 + ✓2 p2 ) cov(R̃2 , R̃m ) + 12
✓¯2
H Hp2 HI 11
✓ ◆ !
cov(R̃2 , R̃m ) ↵ HU var(R̃1 ) var(R̃2 ) cov(R̃1 , R̃2 )2 ¯
= Rf + + ✓ 2 p2
var(R̃m ) H HI var(R̃1 )
cov(R̃2 , R̃m )
= Rf + + A,
var(R̃m )
where ✓ ◆ !
↵ HU var(R̃1 ) var(R̃2 ) cov(R̃1 , R̃2 )2
A= ✓¯2 p2 > 0 .
H HI var(R̃1 )
It follows that
E[R̃m ] = ⇡1 E[R̃1 ] + ⇡2 E[R̃2 ] = Rf + + ⇡2 A .
Hence,
= E[R̃m ] Rf ⇡2 A < E[R̃m ] Rf .
6.9. Suppose there is no risk-free asset and the minimum-variance return is di↵erent from the
constant-mimicking return, i.e., bm 6= bc . From Section 6.2, we know there is a beta pricing model
with the constant-mimicking return as the factor:
E[R̃] = ↵ + cov(R̃, R̃p + bc ẽp )
for every return R̃. From Section 6.6, we can conclude there is a stochastic discount factor that is an
affine function of the constant-mimicking return unless ↵ = 0. However, the existence of a stochastic
discount factor that is an affine function of the constant-mimicking return would contradict the
result of Section 5.11. So, it must be that ↵ = 0 in (6.25). Calculate ↵ to demonstrate this.
We have
cov(R̃, R̃p + bc ẽp ) = E[R̃(R̃p + bc ẽp )] E[R̃]E[R̃p + bc ẽp ]
= bc E[R̃] E[R̃]E[R̃p + bc ẽp ] .
Thus,
E[R̃] = ↵ + cov(R̃, R̃p + bc ẽp )
implies
E[R̃]{1 bc + E[R̃p + bc ẽp ]} = ↵ .
This can be true for all R̃ only if
1 bc + E[R̃p + bc ẽp ] = 0 and ↵ = 0.
Note that this implies

1
= .
bc E[R̃p + bc ẽp ]
The denominator of this expression is nonzero because bc 6= bm .
6.10. Suppose there is no risk-free asset and the minimum-variance return is di↵erent from the
constant-mimicking return, i.e., bm 6= bc . From Section 5.11, we know that there is a stochastic
discount factor that is an affine function of the minimum-variance return:
m̃ = + (R̃p + bm ẽp )
for some and . From Section 6.6, we can conclude there is a beta pricing model with the
minimum-variance return as the factor unless E[m̃] = 0. However, this would contradict the result
of Section 6.2. So it must be that E[m̃] = 0 for the stochastic discount factor m̃ in (6.26). Calculate
E[m̃] to demonstrate this.
We have
E[m̃] = + E[R̃p ] + bm E[ẽp ]

E[R̃p ]E[ẽp ]
= + E[R̃p ] +
1 E[ẽp ]
(1 E[ẽp ]) + E[R̃p ]
= .
1 E[ẽp ]
Because m̃ is a stochastic discount factor and ẽp is an excess return,
0 = E[m̃ẽp ]
= E[ẽp ] + E[R̃p ẽp ] + bm E[ẽ2p ]
= E[ẽp ] + bm E[ẽp ]
E[R̃p ]E[ẽp ]
= E[ẽp ] +
1 E[ẽp ]
(1 E[ẽp ]) + E[R̃p ]
= E[ẽp ]
1 E[ẽp ]
= E[ẽp ]E[m̃] ,
using Facts 8 and 16 for the third equality. Because E[ẽp ] 6= 0 (by Fact 17), this implies E[m̃] = 0.
7
Representative Investors
7.1. Show that if uh0 and uh1 are concave for each h, then the social planner’s utility functions û0
and û1 are concave.
Consider û0 . The argument is identical for û1 . For convenience, drop the subscript 0 from û0 and
uh0 . Consider two aggregate consumption levels c1 and c2 . Let {ch1 | h = 1, . . . , H} and {ch2 | h =
P PH
1, . . . , H} satisfy Hh=1 ch1 = c1 and h=1 ch2 = c2 . Let 0 < < 1. We have
H
X
û( c1 + (1 )c2 ) h uh ( ch1 + (1 )ch2 )
h=1
XH H
X
h uh (ch1 ) + (1 ) h uh (ch1 ) ,
h=1 h=1
PH
using the definition of û — and the fact that h=1 ch1 + (1 )ch2 = c1 + (1 )c2 — for the first
inequality and concavity of the uh for the second. Because this is true for every {ch1 | h = 1, . . . , H}
P PH
satisfying H h=1 ch1 = c1 and for every and {ch2 | h = 1, . . . , H} satisfying h=1 ch2 = c2 , we have
û( c1 + (1 )c2 ) û(c1 ) + (1 )û(c2 ) .
7.2. Use the results on affine sharing rules in Section 3.6 to establish (b0 ) in Section 7.2.
The solution of the social planner’s problem in each period is
ch = ⇣h + bh (c ⇣) ,
where
1/⇢
bh = P h 1/⇢
.
H
j=1 j
60 7 Representative Investors
For shifted log utility, we have

H
X
û(c) = h log(bh (c ⇣))
h=1
H H
!
X X
= h log bh + h log(c ⇣) .
h=1 h=1
PH
Thus, ignoring the constants h=1 h bh , the representative investor’s utility for consumption at
dates 0 and 1 is ! !
H
X H
X
h log(c0 ⇣) + h log(c1 ⇣) ,
h=1 h=1
which is an affine transform of

log(c0 ⇣) + log(c1 ⇣) .
For shifted power utility, we have

H
X 1
û(c) = h (bh (c ⇣))1 ⇢
1 ⇢
h=1
H
!
X 1 ⇢ 1
= h bh (c ⇣)1 ⇢
.
1 ⇢
h=1
Thus, the representative investor’s utility for consumption at dates 0 and 1 is, up to an affine
transform,
1
(c0 ⇣)1 ⇢
+ (c1 ⇣)1 ⇢
.
1 ⇢ 1 ⇢
7.3. Suppose there is a representative investor with quadratic utility u(w) = (⇣ w)2 . Assume
E[w̃m ] 6= ⇣. Show that in the CAPM (6.12) equals
var(w̃m )
,
E[⌧ (w̃m )]
where ⌧ (w) denotes the coefficient of risk tolerance of the representative investor at wealth level w.
Thus, the risk premium is higher when market wealth is riskier or when the representative investor
is more risk averse.
We have u0 (w) = 2(⇣ w), u00 (w) = 2, and ⌧ (w) = u0 (w)/u00 (w) = ⇣ w. There is a stochastic
discount factor m̃ = u0 (w̃m ) = 2 (⇣ w̃m ) for some , and E[m̃] 6= 0 by virtue of the assumption
E[w̃m ] 6= ⇣. Thus,
7 Representative Investors 61
1 1
E[R̃] = cov(m̃, R̃)
E[m̃] E[m̃]
for each return R̃. We have E[m̃] = 2 E[⌧ (w̃m )] and cov(m̃, R̃) = 2 cov(w̃m , R̃). Therefore,
1 1
E[R̃] = + cov(m̃, R̃)
2 E[⌧ (w̃m )] E[⌧ (w̃m )]
1 var(w̃m ) cov(m̃, R̃)
= + .
2 E[⌧ (w̃m )] E[⌧ (w̃m )] var(w̃m )
Therefore, = var(w̃m )/E[⌧ (w̃m )].
7.4. Suppose returns and end-of-period endowments are joint normally distributed and there is a
representative investor with constant absolute risk aversion ↵. Show that in the CAPM (6.12)
equals ↵ var(w̃m ). Thus, the risk premium is higher when market wealth is riskier or when the
representative investor is more risk averse.
We have
1 1
E[R̃] = cov(m̃, R̃) ,
E[m̃] E[m̃]
where m̃ = ↵e ↵w̃m for some . By Stein’s Lemma,
↵w̃m
cov( ↵e , R̃) = ↵2 E[e ↵w̃m
] cov(w̃m , R̃) .
Thus,
1
E[R̃] = ↵w̃m ]
+ ↵ cov(w̃m , R̃)
↵E[e
1 cov(w̃m , R̃)
= ↵w̃m ]
+ ↵ var(w̃m ) .
↵E[e var(w̃m )
This implies = ↵ var(w̃m ).
7.5. Assume in (7.11) that log R̃ and log(c̃1 /c0 ) are joint normally distributed. Specifically, let
R̃ = eỹ and c̃1 /c0 = ez̃ with E[ỹ] = µ, var(ỹ) = 2, E[z̃] = µc , var(z̃) = 2
c, and corr(ỹ, z̃) = .
(a) Show that

1 2 2 1 2
µ= log + ⇢ c + ⇢µc ⇢ c .
2 2
(b) Let r = log Rf denote the continuously compounded risk-free rate. Show that
1 2 2
r= log + ⇢µc ⇢ c ,
2
1 2
µ=r+⇢ c .
2
Note that c is the covariance of the continuously compounded return y with the continuously
compounded consumption growth rate z, so (7.21b) has the usual form
Expected Return = Risk-Free Return + ✓ ⇥ Covariance ,
with ✓ = ⇢, except for the extra term 2 /2. The extra term, which involves the total and hence
idiosyncratic risk of the return, is usually called a Jensen’s inequality term, because it arises from
2 /2
the fact that E[eỹ ] = eµ+ > eµ .
(a) (7.11) states that

c0 ⇢ 1 ⇣ ⌘
E[R̃] = h i h i cov R̃, c̃1 ⇢ .
E c̃1 ⇢ E c̃1 ⇢
h i
. Also, c1 ⇢ = c0 ⇢ e ⇢z̃ , so E c̃1 ⇢ = c0 ⇢ e
2 /2 ⇢µc +⇢2 2
We have E[R̃] = eµ+ c /2 . Hence,
2 /2 1 1 ⇣ ⌘
⇢2 2
i cov R̃, c̃1 ⇢ .
eµ+ = e⇢µc c /2 h
E c̃1 ⇢
⇣ ⌘ h i h i h i
Substituting cov R̃, c̃1 ⇢ = E R̃c̃1 ⇢ E R̃ E c̃1 ⇢ yields
h i
2 /2 1 E R̃c̃1 ⇢
⇢2 2 2 /2
eµ+ = e⇢µc c /2 h i + eµ+ .
E c̃1 ⇢
Also,
h i
⇥ ⇤
E R̃c̃1 ⇢ E eỹ ⇢z̃
h i = ⇢z̃ ]
E c̃1 ⇢ E [e
exp µ ⇢µc + 12 ( 2 2⇢ c + ⇢2 2
c)
=
exp ⇢µc + 12 ⇢2 2
c
2 /2
= eµ ⇢ c+
.
Thus,
2 /2 1 ⇢2 2
eµ ⇢ c+
= e⇢µc c /2 ,
which implies
1 2 2 1 2
µ= log + ⇢ c + ⇢µc ⇢ c .
2 2
(b) From
1 c0 ⇢
Rf = = h i,
E[m̃] E c̃1 ⇢
h i
and E c̃1 ⇢ = c0 ⇢ e ⇢µc +⇢2 2 ⇢2 2
c /2 , we obtain Rf = e⇢µc c /2 / . Hence, r = log +⇢µc ⇢2 2
c /2.
Substituting r in the formula for µ obtained in Part (a) yields µ = r + ⇢ 2 /2.

c
7.6. Suppose there is a risk-free asset and a representative investor with power utility, so (7.10)
is a stochastic discount factor. Let z̃ = log(c˜1 /c0 ) and assume z̃ is normally distributed with mean
µc and variance 2
c. Let  denote the maximum Sharpe ratio of all portfolios. Use the Hansen-
Jagannathan bound (4.13) to show that
p
log(1 + 2 )
⇢ .
c
Hint: Apply the result of Exercise 1.15. Note that (7.22) implies risk aversion must be larger if
consumption volatility is smaller or the maximum Sharpe ratio is larger. Also, using the approxi-
mation log(1 + x) ⇡ x (a first-order Taylor series approximation of log(1 + x) around x = 0), the
lower bound on ⇢ in (7.22) is approximately / c .
We have
stdev(m̃) stdev e ⇢z̃ p
= ⇢z̃
= e ⇢2 2
c 1,
E[m̃] E [e ]
using the result of Exercise 1.15. Thus, the Hansen-Jagannathan bound (4.13) implies
p
e ⇢2 2
c 1 ,
which implies
2 2
e⇢ c 1 + 2 ,
and p
log(1 + 2 )
⇢ .
c
7.7. Suppose there is a risk-free asset in zero net supply and the risky asset returns have a factor
structure
R̃i = ai + b0i F̃ + "˜i ,
where the "˜i have zero means and are independent of each other and of F̃ . Assume there are no
end-of-period endowments and there is a representative investor with CARA utility. Let ↵ denote
the risk aversion of the representative investor. Let ⇡ ⇤ denote the vector of market weights. Denote
initial market wealth by w0 and end-of-period market wealth by w̃m = w0 R̃m . Let i denote the
APT pricing error defined in Section 6.7. Assume "˜i with probability one, for some constant .
Via the following steps, show that
↵w0 ⇡i⇤ exp(↵ w0 ⇡i⇤ ) var(˜

"i )
| i|  .
Rf
(a) Show that

E [exp( ↵w̃m )˜
"i ]
i = .
Rf E [exp( ↵w̃m )]
(b) Show that
E [exp( ↵w0 ⇡i⇤ "˜i )˜
"i ]
i = ⇤ .
Rf E [exp( ↵w0 ⇡i "˜i )]
Hint: Use independence and the fact that end-of-period market wealth is
X
w̃m = w0 ⇡j⇤ R̃j + w0 ⇡i⇤ R̃i
j6=i
X
= w0 ⇡j⇤ R̃j + w0 ⇡i⇤ ai + w0 ⇡i⇤ b0i F̃ + w0 ⇡i⇤ "˜i .
j6=i
(c) Show that

E [exp( ↵w0 ⇡i⇤ "˜i )] 1.
Hint: Use Jensen’s inequality.

(d) Show that
|E [exp( ↵w0 ⇡i⇤ "˜i )˜
"i ]|  ↵w0 ⇡i⇤ exp(↵ w0 ⇡i⇤ ) var(˜
"i ) .
Hint: Use an exact first-order Taylor series expansion of the exponential function.
(a) There is a stochastic discount factor m̃ = ⌘↵e ↵w̃m for some ⌘. Because E[m̃] = 1/Rf ,
1
⌘↵ = ↵w̃m ]
,
Rf E[e
so
e ↵w̃m
m̃ = .
Rf E[e ↵w̃m ]
This implies
E[e ↵w̃m "˜i ]
i = .
Rf E[e ↵w̃m ]
(b) Using the fact that

X
w̃m = w0 ⇡j⇤ R̃j + w0 ⇡i⇤ ai + w0 ⇡i⇤ b0i F̃ + w0 ⇡i⇤ "˜i
j6=i
and the independence of "˜i from F̃ and from R̃j for j 6= i, we obtain
P
↵w̃m ↵(w0 ⇡j⇤ R̃j +w0 ⇡i⇤ ai +w0 ⇡i⇤ b0i F̃ ) ↵w0 ⇡i⇤ "˜i
E[e "˜i ] = E[e j6=i ]E[e "˜i ] ,
P
↵w̃m ↵(w0 ⇡j⇤ R̃j +w0 ⇡i⇤ ai +w0 ⇡i⇤ b0i F̃ ) ↵w0 ⇡i⇤ "˜i
E[e ] = E[e j6=i ]E[e ].
Thus,
E [exp( ↵w0 ⇡i⇤ "˜i )˜
"i ]
i = ⇤ .
Rf E [exp( ↵w0 ⇡i "˜i )]
(c) The random variable ↵w0 ⇡i⇤ "˜i has mean zero and the exponential function is convex, so
Jensen’s inequality implies
↵w0 ⇡i⇤ "˜i
E[e ] e0 = 1 .
(d) The exact first-order series expansion of ex around x = 0 is
ex = 1 + e y x
for some y between x and 0. Applying this with x = ↵w0 ⇡i⇤ "˜i gives
↵w0 ⇡i⇤ "˜i ↵w0 ⇡i⇤ ˜

e =1 ↵w0 ⇡i⇤ "˜i e
for some ˜ between "˜i and 0. Using this and E[˜

"i ] = 0, we obtain
↵w0 ⇡i⇤ ˜ 2
E [exp( ↵w0 ⇡i⇤ "˜i )˜
"i ] = ↵w0 ⇡i⇤ E[e "˜i ] .
Because of the assumption "˜i , we have ˜ and therefore
↵w0 ⇡i⇤ ˜ ⇤
e  e↵w0 ⇡i
Hence,
⇤
|E [exp( ↵w0 ⇡i⇤ "˜i )˜
"i ]|  ↵w0 ⇡i⇤ e↵w0 ⇡i var(˜
"i ) .
Part II
Dynamic Models
8
Dynamic Securities Markets
8.1. Suppose there is a risk-free asset with constant return Rf each period. Suppose there is a
single risky asset with dividends given by
8
>
< h Dt with probability 1/2 ,
Dt+1 =
>
: D
` t with probability 1/2 ,
where h > ` are constants, and D0 > 0 is given. Suppose the price of the risky asset satisfies
Pt = kDt for a constant k. Suppose the information in the economy consists of the history of
dividends, so the information structure can be represented by a tree as in Figure ?? with two
branches emanating from each node (corresponding to the outcomes h and `). For each date t > 0
⌫t t ⌫t
and each path, let ⌫t denote the number of dates s  t such that Ds = h Ds 1 , so Dt = D0 h ` .
Recall that, for 0  n  t, the probability that ⌫t = n is the binomial probability
t t!
2 .
n!(t n)!
(a) State a condition implying that there are no arbitrage opportunities for each finite horizon T .
(b) Assuming the condition in part (a) holds, show that there is a unique one-period stochastic
discount factor from each date t to t + 1, given by
8
>
<zh if Dt+1 /Dt = h,
Zt+1 =
>
:z if D /D =
` t+1 t `,
for some constants zh and z` . Calculate zh and z` in terms of Rf , k, h and `.
(c) Assuming the condition in part (a) holds, show that there is a unique SDF process M , and
show that Mt depends on ⌫t and the parameters Rf , k, h and `.
70 8 Dynamic Securities Markets
(d) Assuming the condition in part (a) holds, show that there is a unique risk neutral probability
measure for any given horizon T < 1, and show that the risk neutral probability of any path
depends on ⌫t and the parameters Rf , k, h and `.
(e) Consider T < 1 and the random variable

8
>
<1 if Dt+1 = h Dt for each t < T ,
x=
>
:0 if D
t+1 = ` Dt for any t < T .
Calculate the self-financing wealth process that satisfies WT = x.

(f) Suppose there is a representative investor with time additive utility, constant relative risk aver-
sion ⇢ and discount factor . Assume the risk free asset is in zero net supply. Calculate Rf and
k in terms of h, `, ⇢ and .
(g) Given the formula for k in the previous part, what restriction on the parameters h, `, ⇢ and
is needed to obtain k > 0? Show that this restriction is equivalent to
"1 #
X
t 1 ⇢
E Dt < 1.
t=1
(a) This is a dynamic version of Exercise 4.1. The return on the risky asset when Dt+1 = h Dt is
Pt+1 + Dt+1 (k + 1)Dt+1 k+1
= = h.
Pt kDt k
Likewise, the return when Dt+1 = ` Dt is (k + 1) ` /k. Define
k+1 k+1
Rh = h, R` = `.
k k
The necessary and sufficient condition for absence of arbitrage opportunities is
R h > Rf > R` .
(b) As in Exercise 4.1, the unique one-period conditional state prices are
Rf R` Rh Rf
qh = , q` = .
Rf (Rh R` ) Rf (Rh R` )
The unique one-period stochastic discount factor is obtained by dividing the state prices by the
probabilities, so zh = 2qh , and z` = 2q` .
(c) The SDF process is obtained by compounding the one-period stochastic discount factors. This
produces
Mt = 2t qh⌫t q`t ⌫t
.
8 Dynamic Securities Markets 71
(d) There are 2T distinct events (paths) that can be distinguished at date T, each of which has
probability 2 T. The risk neutral probability of any path is
RfT MT /2T = RfT qh⌫T q`T ⌫T

.
(e) By (8.16), the self-financing wealth process satisfies


MT x
W t = Et .
Mt
If x = 1, then MT = 2T qhT and Mt = 2t qht . The conditional probability that x = 1 is 1/2T t if

Ds /Ds 1 = h for all s  t and is zero otherwise. Therefore,
8 ⇣ T T⌘
 >
< 2 qh
MT x
1
2T t t
2t q h
= qhT t if Ds /Ds 1 = h for all s  t ,
Et =
Mt >
:0 otherwise .
(f) Setting Ct = Dt , (8.35) implies

✓ ◆ ⌫t /⇢ ✓ ◆ (t ⌫t )/⇢
1/⇢ 1/⇢ 2qh 2q`
Dt = D0 t/⇢
Mt = D0 t/⇢
2t qh⌫t q`t ⌫t = D0 .
⌫t t ⌫t
Given that Dt = D0 h ` , this holds for all values of ⌫t if and only if
✓ ◆ 1/⇢ ✓ ◆ 1/⇢
2qh 2q`
h = , ` = ,
so
⇢ ⇢
qh = h , q` = ` .
2 2
This implies !
1 2 1
Rf = = ⇢ ⇢ .
qh + q` h + `
Also,
1 = q h Rh + q ` R`
✓ ◆ ✓ ◆
k+1 1 ⇢ k+1 1 ⇢
= h + ` ,
2 k 2 k
This implies ⇣ ⌘
1 ⇢ 1 ⇢
h + `
k= ⇣ ⌘.
1 ⇢ 1 ⇢
2 h + `
(g) The condition k > 0 is equivalent to
1 ⇢ 1 ⇢ 2
h + ` < ,
which can be rewritten as < 1, where we define

" ✓ ◆ #
Dt 1 ⇢
=E .
Dt 1
Note that ✓ ◆1 ✓ ◆1
⇢ ⇢
D1 Dt
t
Dt1 ⇢ = D01 ⇢ ··· ,
D0 Dt 1
and, by independence,
h i
E t
Dt1 ⇢
= D01 ⇢ t
.
Thus, " #
1
X 1
X
E t
Dt1 ⇢ = D01 ⇢ t
<1 , < 1.
t=1 t=1
8.2. This exercise verifies the assertion in Section 8.10 regarding marketed consumption processes.
Consider any T < 1, and suppose Ct is a marketed date–t payo↵, for t = 0, . . . , T . Show that there
exists a wealth process W and portfolio process ⇡ such that C, W and ⇡ satisfy
Wt+1 = (Wt Ct )⇡t0 Rt+1 . (8.1)
for t = 0, . . . , T 1, and CT = WT . Hint: Add up the wealth processes and take a weighted average
of the portfolio processes associated with the individual payo↵s.
For each t  T , let Wt,s denote the self-financing wealth process for s 2 {0, . . . , t} such that
Wt,t = Ct . Let ⇡t,s for s 2 {0, . . . , t} denote the corresponding portfolio process, so
0
Wt,s+1 = Wt,s ⇡t,s Rs+1
for s < t. Define !

T
X T
X
1
Ws = Wt,s , ⇡s = PT Wt,s ⇡t,s .
t=s t=s+1 Wt,s t=s+1
Then, for all s,

! T
1 X
(Ws Cs )⇡s0 Rs+1 = (Ws Cs ) PT
0
Wt,s ⇡t,s Rs+1
t=s+1 Wt,s t=s+1
T
X
= Wt,s+1
t=s+1
= Ws+1 .
8.3. This exercise shows a sense in which the log-optimal portfolio is asymptotically superior to
any other portfolio.
Suppose the return vectors R1 , R2 , . . . are independent and identically distributed. Let w be a
positive constant. Assume max⇡ E[log(⇡ 0 Rt )] > 1 and let ⇡ ⇤ be a solution to
max E[log(⇡ 0 Rt )] .
⇡
Let W ⇤ be the wealth process defined by the intertemporal budget constraint (8.1) with ⇡t = ⇡ ⇤
and Yt = Ct = 0 for each t and W0⇤ = w. Consider any other portfolio ⇡ for which
E[log(⇡ 0 Rt ))] < max E[log(⇡ 0 Rt )] .

⇡
Let W be the wealth process defined by the intertemporal budget constraint (8.1) with ⇡t = ⇡ and
Yt = Ct = 0 for each t and W0 = w. Show that, with probability one, there exists T (depending on
the state of the world) such that
Wt⇤ > Wt
for all t T . Hint: Apply the Strong Law of Large Numbers to (1/T ) log WT⇤ and to (1/T ) log WT .
From the intertemporal budget constraint, we have
⇤
log Wt+1 = log Wt⇤ + log (⇡ ⇤ )0 Rt+1 ,
for all t, so
T 1
1 ⇤ log w 1 X
log WT = + log (⇡ ⇤ )0 Rt+1 .
T T T
t=0
Likewise,
T 1
1 log w 1 X
log WT = + log ⇡ 0 Rt+1 .
T T T
t=0
By the Strong Law of Large Numbers,
T 1
1 X
log (⇡ ⇤ )0 Rt+1 ! E[log((⇡ ⇤ )0 Rt )]
T
t=1
with probability one as T ! 1, and

T 1
1 X
log ⇡ 0 Rt+1 ! E[log(⇡ 0 Rt )]
T
t=1
with probability one as T ! 1. Therefore, with probability one, there exists T such that
1 1
log Wt⇤ > log Wt , Wt⇤ > Wt
t t
for all t T.
8.4. This exercise shows that a probability Q consistent with risk-neutral pricing on an infinite
horizon is generally not equivalent to P.
In the setting of Exercise 8.1, let P denote the probability measure under which the random variables
Dt /Dt 1 are independent and identically distributed and equal to h or ` with probability 1/2
each. Assume 
Pt+1 + Dt+1
E 6= Rf .
Pt
Suppose there is an infinite horizon. Show that there is no probability measure Q on the space of
infinite paths that is (a) equivalent to P, and (b) satisfies

⇤ Pt+1 + Dt+1
Et = Rf
Pt
for each t. Hint: Apply the Strong Law of Large Numbers to show that any Q satisfying (b) cannot
be equivalent to P.
The condition 
Pt+1 + Dt+1
E⇤t = Rf
Pt
implies that the date–t conditional probability of the event Dt+1 /Dt = h is Rf qh , and the date–t
conditional probability of the event Dt+1 /Dt = ` is Rf q` , where qh and q` are the conditional state
prices calculated in Exercise 8.1. This implies that the random variables Dt /Dt 1 are i.i.d. under
Q. By the Strong Law of Large Numbers,
T 
1 X Dt Dt
!E
T Dt 1 Dt 1
t=1
with P–probability one as T ! 1, and

T 
1X ⇤ Dt
Dt ! E
T Dt 1
t=1
with Q–probability one as T ! 1. The assumption


Pt+1 + Dt+1
E 6= Rf
Pt
and (b) imply  

Dt ⇤ Dt
E 6= E .
Dt 1 Dt 1
Thus, the event
T 
1 X Dt Dt
!E
T Dt 1 Dt 1
t=1
has probability one under P but probability zero under Q.

9
Portfolio Choice by Dynamic Programming
9.1. Consider the problem of maximizing the expected utility of terminal wealth with i.i.d. returns
studied in Section 9.4. Suppose the investor has log utility. Let U = max⇡ E[log ⇡ 0 Rt+1 ]. Assume U
is finite.
(a) Show that

Vt (w) = (T t)U + log w .
(b) Show that the optimal portfolio at each date t is the one that maximizes
E[log ⇡ 0 Rt+1 ] .
(a) The proof is by induction. It is true for t = T . Suppose it is true at t = s + 1. Then
Vs (w) = max E[Vs+1 (w⇡ 0 Rs+1 )]

⇡
= max E[(T s 1)U + log(w⇡ 0 Rs+1 )]

⇡
= (T s 1)U + log w + max E[log(⇡ 0 Rs+1 )]

⇡
= (T s)U + log w .
(b) This follows from
argmax⇡ E[Vs+1 (w⇡ 0 Rs+1 )] = argmax⇡ {(T s 1)U + log w + E[log(⇡ 0 Rs+1 )]} .
9.2. Consider the finite horizon problem with intermediate consumption and i.i.d. returns studied
in Section 9.5. Suppose the investor has log utility. Assume max⇡ E[log(⇡ 0 Rt+1 )] is finite. Define
1
⇠t = T +1 t
.
1
78 9 Portfolio Choice by Dynamic Programming
(a) Show that

1
Jt (w) = log w + Jt (1) .
⇠t
E[log ⇡ 0 Rt+1 ] .
(c) Show that the optimal consumption at each date t is
C t = ⇠t Wt .
(a) Note that

1 1 + T +1 t
= =1+ ,
⇠t 1 ⇠t+1
so
⇠t+1
⇠t = .
⇠t+1 +
The proof is by induction. We have JT (w) = log w, which implies JT (1) = 0. Also, ⇠T = 1.
Therefore,
1
JT (w) = log w + JT (1) .
⇠T
Suppose the claim is true for t = s + 1. We have
⇢
⇥ ⇤
Js (w) = max log c + Es Js+1 ((w c)⇡ 0 Rs+1 )
c,⇡
⇢ 
= max log c + Es log((w c)⇡ 0 Rs+1 ) + Js+1 (1)
c,⇡ ⇠s+1
⇢
⇥ ⇤
= max log c + log(w c) + Es log(⇡ 0 Rs+1 ) + Js+1 (1)
c,⇡ ⇠s+1 ⇠s+1
⇢
= max log c + log(w c) + max E[log(⇡ 0 Rt+1 )] + Js+1 (1) .
c ⇠s+1 ⇠s+1 ⇡
Solving the first-order condition for maximizing over c yields
⇠s+1
c= w = ⇠s w .
+ ⇠s+1
Substituting this produces
1
log c + log(w c) = log ⇠s + log w + log(1 ⇠s ) .
⇠s+1 ⇠s ⇠s+1
Substituting this yields
1
Js (w) Js (1) = log w .
⇠s
9 Portfolio Choice by Dynamic Programming 79
(b) This follows from the calculation for part (a).

(c) This follows from the calculation for part (a).
9.3. Consider a finite horizon problem with intermediate consumption, state variables Xt , log
utility, and no endowments Yt . Assume max⇡ Et [log(⇡ 0 Rt+1 )] is finite for each t with probability
one. The value function at date T is
JT (x, w) = log w .
Define
1
⇠t = T +1 t
.
1
(a) Show that
1
Jt (x, w) = log w + Jt (x, 1) .
⇠t
Et [log ⇡ 0 Rt+1 ] .
(c) Show that the optimal consumption at each date t is
C t = ⇠t Wt .
The solution is the same as for the previous exercise.
(a) The proof is by induction. We have JT (x, w) = log w, which implies JT (x, 1) = 0. Also, ⇠T = 1.
Therefore,
1
JT (x, w) = log w + JT (x, 1) .
⇠T
Suppose the claim is true for t = s + 1. We have
⇢
⇥ ⇤
Js (x, w) = max log c + Es Js+1 (Xs+1 , (w c)⇡ 0 Rs+1 )
c,⇡
⇢ 
= max log c + Es log((w c)⇡ 0 Rs+1 ) + Es [Js+1 (Xs+1 , 1)]
c,⇡ ⇠s+1
⇢
⇥ ⇤
= max log c + log(w c) + Es log(⇡ 0 Rs+1 ) + Es [Js+1 (Xs+1 , 1)]
c,⇡ ⇠s+1 ⇠s+1
⇢
⇥ ⇤
= max log c + log(w c) + max Es log(⇡ 0 Rs+1 ) + Es [Js+1 (Xs+1 , 1)] .
c ⇠s+1 ⇠s+1 ⇡
Solving the first-order condition for maximizing over c yields
⇠s+1
c= w = ⇠s w .
+ ⇠s+1
Substituting this produces
1
log c + log(w c) = log ⇠s + log w + log(1 ⇠s ) .
⇠s+1 ⇠s ⇠s+1
Substituting this yields

1
Js (x, w) Js (x, 1) = log w .
⇠s
(b) This follows from the calculation for part (a).
(c) This follows from the calculation for part (a).
9.4. Consider the infinite horizon problem with i.i.d. returns studied in Section 9.6. Suppose the
investor has log utility. Assume max⇡ E[log ⇡ 0 Rt+1 ] is finite.
(a) Show that the stationary value function satisfies
log w
J(w) = +A
1
for a constant A. Hint: First show that

t 1
Y
C t = ⇠t W0 (1 ⇠s )⇡s0 Rs+1 ,
s=0
for each t, where ⇠t = Ct /Wt .

(b) Show that there is a unique solution Jˆ of the Bellman equation satisfying
ˆ log w
J(w) = +A
1
for a constant A. Thus, this solution of the Bellman equation is the value function J.
(c) Show that the portfolio attaining the maximum in the Bellman equation, when Jˆ = J, is the
one that maximizes
E[log ⇡ 0 Rt+1 ] .
(d) Show that the consumption attaining the maximum in the Bellman equation is
c = (1 )w .
(e) Show that the transversality condition
lim T
E[J(WT⇤ )] = 0
T !1
holds.
(a) We have C0 = ⇠0 W0 . Suppose

t 1
Y
C t = ⇠t W0 (1 ⇠s )⇡s0 Rs+1 .
s=0
Then
Ct+1 = ⇠t+1 (Wt Ct )⇡t0 Rt+1

Ct
= ⇠t+1 (1 ⇠t )⇡t0 Rt+1
⇠t
Yt
= ⇠t+1 W0 (1 ⇠s )⇡s0 Rs+1 .
s=0
Thus, this holds for each t, implying

"1 # "1 t 1
!#
X X Y
E t
log Ct = E t
log ⇠t W0 (1 ⇠s )⇡s0 Rs+1
t=0 t=0 s=0
1
! " 1 t 1
!#
X X Y
= t
log W0 + E t
log ⇠t (1 ⇠s )⇡s0 Rs+1
t=0 t=0 s=0
" 1 t 1
!#
log W0 X Y
= +E t
log ⇠t (1 ⇠s )⇡s0 Rs+1 .
1
t=0 s=0
Thus,
log w
J(w) = + A,
1
where we define
" 1 t 1
!#
X Y
A= max E t
log ⇠t (1 ⇠s )⇡s0 Rs+1 .
(⇠t ,⇡t )t=0,1,...
t=0 s=0
Note: This optimization problem can easily be solved directly, without using dynamic program-
ming, to compute the optimal ⇠t and ⇡t .
(b) The Bellman equation is
⇢ h i
ˆ
J(w) = max ˆ
log c + E J((w c)⇡ 0 Rt+1 ) .
c,⇡
ˆ
Substituting J(w) = A + (log w)/(1 ) yields
⇢ 
log w log ((w c)⇡ 0 Rt+1 )
+ A = max log c + E +A
1 c,⇡ 1
⇢
log(w c) ⇥ ⇤
= A + max log c + + max E log ⇡ 0 Rt+1
c 1 1 ⇡
log log w U
= A + log(1 )+ + + ,
1 1 1
where we use the fact that the maximum in c occurs at c = (1 )w, and where we set
⇥ ⇤
U = max E log ⇡ 0 Rt+1 .
⇡
Thus,
log U
A = A + log(1 )+ + .
1 1
This has the unique solution
(1 ) log(1 ) + log + U
A= .
(1 )2
(c) This follows from the calculation in part (b).

(d) This follows from the calculation in part (b).
(e) Using Ct⇤ = (1 )Wt⇤ for each t, we have
WT⇤ = (WT⇤ 1 CT⇤ 0

1 )⇡T RT
= WT⇤ 0
1 ⇡T 1 RT
= ...
TY1
= W0 T
⇡t0 Rt+1 .
t=0
This implies
T
X1
log WT⇤ = log W0 + T log + log ⇡t0 Rt+1 .
t=0
Using the result from part (c) gives
E[log WT⇤ ] = log W0 + T log + T U .
Now we have
E[JT (WT⇤ )] = E[J0 (WT⇤ )]

T
✓ ◆
T E[log WT⇤ ]
= A+
1
✓ ◆
T log W0 + (T ) log + T U
= A+
1
!0
as T ! 1.
9.5. This exercise computes the value function and optimal portfolio for an investor with finite
horizon and CARA utility for intermediate consumption, assuming i.i.d. returns.
Consider the finite horizon problem with intermediate consumption and i.i.d. returns studied in
Section 9.5. Suppose one of the assets is risk-free with return Rf . Let R denote the vector of risky
asset returns, let µ denote the expected value of R, and let ⌃ denote the covariance matrix of R.
Assume ⌃ is nonsingular.
(a) For constants ↵, , 0 and define 0,

⇢
⇥ 0
⇤
J1 (w) = max e ↵c + E J0 ((w c)Rf + (R Rf 1)) ,
c,
where
0w
J0 (w) = 0 e .
Show that
1w
J1 (w) = 1 e
for constants 1 and 1.
(b) Using dynamic programming, deduce from the result of part (a) that the value function Jt of
an investor with CARA utility and horizon T t has constant absolute risk aversion. How does
the risk aversion depend on the remaining time T t until the horizon?
(c) If the investor has an infinite horizon, then the value function is independent of t. A good guess
would therefore be J(w) = 0 e 0w where 0 and are such that 1 = 0 and = in
0 1 0
part (a); i.e., (0 , 0) is a fixed point of the map (0 , 0) 7! (1 , 1) calculated in part (a). Show
that this implies ✓ ◆
Rf 1
0 = ↵.
Rf
(a) We have
⇢ h i
↵c 0 (R
0 (w c)Rf Rf 1)
J1 (w) = max e 0 E e 0
c,
⇢ h i
↵c 0 (R
0 (w c)Rf Rf 1)
= max e 0 e min E e 0
c
⇢
↵c 0 (w c)Rf
= max e 0 U 0 e ,
c
where we define
h 0 (R
i
Rf 1)
U0 = min E e 0
.
Maximizing in c yields
✓ ◆
0 Rf 1 0 0 R f U 0
c= w log
↵+ 0 Rf ↵+ 0 Rf ↵
and
2 3
✓ ◆ ↵ ✓ ◆ 0 Rf
↵ 0 Rf
4 0 0 R f U 0 ↵+ 0 Rf 0 0 R f U 0 ↵+ 0 Rf
5e ↵+ 0 Rf
w
J1 (w) = + 0 U 0 .
↵ ↵
Thus
↵ 0 Rf
1 = ,
↵ + 0 Rf
✓ ◆ ↵ ✓ ◆ 0 Rf
0 0 Rf U0 ↵+ 0 Rf 0 0 R f U 0 ↵+ 0 Rf
1 = + 0 U 0
↵ ↵
✓ ◆✓ ◆ 0 Rf
↵ + 0 Rf 0 0 Rf U0 ↵+ 0 Rf
= 0 U0 .
↵ ↵
(b) We have
↵w
JT (w) = e
and ⇢
↵c
⇥ 0
⇤
Jt (w) = max E + E Jt+1 ((w c)Rf + (R Rf 1)) .
c,
Thus, applying the result of the previous part successively shows that Jt is CARA utility for
all t. Let ↵⌧ denote the absolute risk aversion of the value function JT ⌧, so ↵0 = ↵. We can
show that
↵
↵ ⌧ = P⌧ s ,
s=0 Rf
which is decreasing in ⌧ and converges to

✓ ◆
Rf 1
↵
Rf
as ⌧ ! 1. The proof of this is by induction. It is true for ⌧ = 0. Suppose it is true for arbitrary
⌧ . Then we have
↵↵⌧ Rf
↵⌧ +1 =
↵ + ↵ ⌧ Rf
P
↵2 Rf / ⌧s=0 Rf s
= P
↵ + ↵Rf / ⌧s=0 Rf s
↵Rf
= P⌧ s
s=0 Rf + Rf
↵
= P⌧ +1 s
.
s=0 Rf
(c) 1 = 0 implies
↵ 0 Rf
0 = ,
↵ + 0 Rf
of which the solution is ✓ ◆
Rf 1
0 = ↵.
Rf
9.6. This exercise demonstrates that there can be multiple solutions Jˆ of the Bellman equation
in an infinite-horizon positive dynamic programming problem and that attaining the maximum in
the Bellman equation may not produce the optimum.
Suppose there is a single asset that is risk-free with return Rf > 1. Consider an investor with an
infinite horizon, utility function u(c) = c, and discount factor = 1/Rf . Suppose he is constrained
to consume 0  Ct  Wt .
(a) Show that the value function for this problem is J(w) = w.
(b) Show that the value function solves the Bellman equation.
ˆ
(c) Show that J(w) = 2w also solves the Bellman equation.
ˆ
(d) Show that, using the true value function J(w) = w in the Bellman equation, the suboptimal
policy Ct = 0 for every t achieves the maximum for every value of w.
(a) This is a complete market, and the investor can choose at each date t any consumption sequence
(Ct , Ct+1 , . . .) satisfying the budget constraint
1
X
Rft u
C u = Wt
u=t
and the constraint 0  Cu  Wu for u t. The last constraint implies finiteness of the sums in
the following.
1
X 1
X
u u t
Vt (w) = max Cu subject to Cu = w
u=t u=t
1
X 1
X
t u t u t
= max Cu subject to Cu = w
u=t u=t
t
= w.
(b) We have
max {c + J((w c)Rf )} = max {c + (w c)Rf )}

0cw 0cw
=w
= J(w) .
(c) We have
ˆ
max {c + J((w c)Rf )} = max {c + 2 (w c)Rf )}
0cw 0cw
= 2w
ˆ
= J(w) .
(d) We have
max {c + J((w c)Rf )} = max {c + (w c)Rf }

0cw 0cw
= max w ,
0cw
which is independent of c and hence maximized by any 0  c  w.
9.7. This exercise illustrates the fact that the transversality condition (9.25) holds in bounded and
negative dynamic programming.
Consider the infinite horizon problem with i.i.d. returns studied in Section 9.6. Denote the investor’s
utility function by u(c).
(a) Case B: Assume there is a constant K such that K  u(c)  K for each c. Show that the
transversality condition (9.25) holds.
(b) Case N: Assume u(c)  0 for each c and J(w) > 1 for each w. Show that the transversality
condition (9.25) holds. Hint: Use (9.28) and the definition of a value function to deduce that
the limit in (9.25) is nonnegative.
(a) If u is bounded in absolute value by K, then

1
X
VT +1 (WT⇤ +1 ) = max t
u(Ct )
t=T +1
is bounded in absolute value by

1
X T +1
t K
K = !0
1
t=T +1
as T ! 1.
(b) By the definition of a value function,
" 1
#
X
V0 (w) E u(Ct⇤ ) ,
t=0
so (9.28) implies
lim E[VT +1 (WT⇤ +1 )] 0.
T !1
On the other hand, u  0 implies V  0, so we must actually have
lim E[VT +1 (WT⇤ +1 )] = 0 .

T !1
9.8. This exercise illustrates the fact that (9.29) is a sufficient condition for any solution Jˆ of the
Bellman equation to be the true value function and a sufficient condition for the argmax in the
Bellman equation to be the optimum.
Consider the infinite horizon problem with i.i.d. returns studied in Section 9.6. Denote the investor’s
utility function by u(c). Let Jˆ be a function that solves the Bellman equation. Assume (9.29) holds.
ˆ t )] are finite for each t. Suppose (C ⇤ , ⇡ ⇤ )
For arbitrary decisions (Ct , ⇡t ), assume E[u(Ct )] and E[J(W t t
attain the maximum in the Bellman equation. Show that Jˆ is the value function and (Ct⇤ , ⇡t⇤ ) are
optimal.
For arbitrary decisions, we have
ˆ t)
J(W ˆ t+1 )]
E[u(Ct ) + J(W
for each t. Thus,
ˆ 0)
J(W ˆ 1 )]
E[u(C0 ) + J(W
E[u(c0 ) + u(C1 ) + 2 ˆ 2 )]
E[J(W
···
"T 1 #
X
E t
u(Ct ) + T ˆ T )]
E[J(W
t=0
for any T . Applying (9.29a) and (9.29b) yields

"1 #
X
ˆ 0) E
J(W t
u(Ct ) + lim sup T ˆ T )]
E[J(W
t=0 T !1
" 1
#
X
t
E u(Ct ) .
t=0
For the decisions that attain the maximum in the Bellman equation, the first inequality is an
equality, and the transversality condition (9.29b) implies that the last inequality is an equality
also, so Jˆ is the value function, and the decisions are optimal.
10
Conditional Beta Pricing Models
10.1. Suppose all investors have constant absolute risk aversion, with possibly di↵erent risk aversion
coefficients Ah . Assume there are no endowments Yht , the return vectors Rt are i.i.d. over time, and
there is a risk-free asset with return Rf each period. Assume all investors have infinite horizons,
and assume the value functions are as described in Exercise 9.5.
(a) Making the approximation (10.13d), what is ↵t in the approximate CCAPM?

(b) Making the approximation (10.28d), what is ↵t in the approximate CAPM?
(a) The approximation (10.13d) is

H
X 1
1
⇡ ,
↵t Ah
h=1
so ↵t is approximately the aggregate absolute risk aversion of the utility functions.

(b) Under the given assumptions, the value function of each investor has constant absolute risk
aversion (Rf 1)↵h /Rf , so the approximation (10.28d) is
H H
!
1 X Rf Rf X 1
⇡ = .
↵t (Rf 1)Ah Rf 1 Ah
h=1 h=1
Therefore, ↵t is approximately (Rf 1)/Rf times the aggregate absolute risk aversion of the
utility functions.
11
Some Dynamic Equilibrium Models
11.1. Consider a generalization of the model studied in Sects. 11.2–11.5 in which, at each date t,
log Dt+1 = log Dt + µt + "t+1 ,
with µ being a Markov process (observed by the representative investor at each date) and indepen-
dent of "1 , "2 , . . .. This implies that the distribution of µt+1 , µt+2 , . . . at any date t, conditional on
the information at that date, depends only on the value of µt . Adopting the other assumptions in
Section 11.2, show that the market price-dividend ratio at date t depends on µt as follows:
1
" ( s 1
) #
Pt X X
= s t E exp (1 ⇢) µ` µt ,
Dt
s=t+1 `=t
where ✓ ◆
1 2 2
 = exp (1 ⇢) .
2
Note: the model analyzed by Mehra and Prescott (1985) is of this form, with µt following a “finite-
state Markov chain.”
We have, for s > t, !

s 1
X s
X
Ds = Dt exp µ` + "` .
`=t `=t+1
Hence,
92 11 Some Dynamic Equilibrium Models
" 1 ✓ ◆1 #
Pt X Ds ⇢
s t
= Et
Dt Dt
s=t+1
1
" s 1
! s
!#
X X X
s t
= Et exp (1 ⇢) µ` exp (1 ⇢) "`
s=t+1 `=t `=t+1
1
" s 1
!#
X X
s t 2 2
= exp (1 ⇢) (s t) Et exp (1 ⇢) µ`
s=t+1 `=t
1
" s 1
!#
X X
= s t Et exp (1 ⇢) µ` .
s=t+1 `=t
11.2. In the model of Sects. 11.2–11.5, the return on the market portfolio is given by (11.5), which
implies log Rmt = log ⌫ + µ + "t , where the "t are i.i.d. standard normals. Using the parameter
values µ = 0.017, = 0.00125, = 0.99 and ⇢ = 10, calculate the standard deviation of the market
return. Note: you will find it is much smaller than the sample standard deviation of 16.54% in the
data studied by Mehra and Prescott (1985). This is a very simple version of the excess volatility
puzzle.
p
The parameter values imply ⌫ = 0.8937. Thus, log Rmt = 0.129 + 0.00125 "t . From the calculation
in the previous exercise, this implies
p
stdev(Rmt ) = e2⇥0.129+2⇥0.0125 e2⇥0.129+0.0125 = 0.040 = 4.0% .
11.3. The model studied in Sections 11.2–11.5 has the properties assumed in Exercise 7.6; hence,
(7.22), derived from the Hansen-Jagannathan bound, must hold. In our current notation, (7.22) is
p
log(1 + 2 )
⇢ ,
where  denotes the maximum Sharpe ratio of all portfolios. In particular, the inequality (11.37)
must hold for  equal to the market Sharpe ratio. Combining the estimate of the standard deviation
of the market return of 16.54% from Mehra and Prescott (1985) with the historical equity premium
cited in Section 11.4 and the estimate = 0.035, derive a numerical lower bound on ⇢ from (11.37).
Note: you will find this bound is more reasonable than the estimate of 47.6 presented in the text.
This is because of two o↵setting factors: both the risk premium of the market and the volatility
of the market are higher in the data than the model would predict, given reasonable values of
and ⇢.
11 Some Dynamic Equilibrium Models 93
An equity premium of 6.18% and a standard deviation of 16.54% imply a Sharpe ratio of 0.374.
Using = 0.035, we have p
log(1 + 0.3742 )
⇢ = 16.098 .
0.035
11.4. This exercise shows that the condition ⌫ < 1 is necessary for the Bellman equation of a
representative investor to have a solution, in the model of Sections 11.2–11.5.
Consider the infinite-horizon portfolio choice model studied in Section 9.6. Suppose there is a risk-
free asset and a single risky asset with return
1 µ+ "t
Rt = e
⌫
for a sequence of independent standard normals "t , where ⌫ is defined in (11.2). Suppose B 1 ⇢ <1
as in Section 9.6 and that it is optimal for the investor to always hold a zero position in the risk-free
asset. Show that ⌫ < 1.
Let ⇡ denote the weight on the risky asset. It is shown in Section 9.6 that the optimal portfolio is
given by ⇡ solving 
1
max E ((1 ⇡)Rf + ⇡R)1 ⇢
.
⇡ 1 ⇢
If the optimum is ⇡ = 1, then

1 1 ⇢ 1
B ⌘ max E ((1 ⇡)Rf + ⇡R)1 ⇢
1 ⇢ ⇡ 1 ⇢
✓ ◆1 ⇢
1 1 ⇢)µ+(1 ⇢)2 2 /2
= e(1
1 ⇢ ⌫
✓ ◆1 ⇢⇣
1 1 ⌫⌘
= .
1 ⇢ ⌫
Thus, B 1 ⇢ = ⌫ ⇢ , and B 1 ⇢ < 1 implies ⌫ < 1.

12
Brownian Motion and Stochastic Calculus
12.1. Simulate the path of a Brownian motion over a year (using your favorite programming
language or Excel) by simulating N standard normal random variables zi and calculating Bti =
p
B t i 1 + zi t for i = 1, . . . , N , where t = 1/N and B0 = 0. To simulate a standard normal
random variable in a cell of an Excel worksheet, use the formula = NORMSINV(RAND()).
(a) Plot the path—the set of points (ti , Bti ).

(b) Calculate the sum of the ( Bti )2 . Confirm that for large N the sum is approximately equal to
one.
(c) Calculate the sum of | Bti |. Confirm that this sum increases as N increases. Note: the sum
converges to 1 as N ! 1 (because a Brownian motion has infinite total variation) but this
may be difficult to see.
(d) Use the simulated Brownian motion to simulate a path of a geometric Brownian motion via the
formula (12.22). Plot the path.
12.2. Derive the following from Itô’s formula.

Ru
(a) Suppose Xt = 0 rs ds for some stochastic process r, so dX = r dt. Define Rt = eXt and show
that dR/R = r dt.
(b) Suppose dX = ↵ dt + ✓ dB for a Brownian motion B and stochastic processes ↵ and ✓. Define
Yt = eXt . Show that
dY 1
= dX + (dX)2 .
Y 2
(c) Suppose dS/S = µ dt + dB for a Brownian motion B and stochastic processes µ and . Define
Yt = log St . Show that
96 12 Brownian Motion and Stochastic Calculus
✓ ◆2
dS 1 dS
dY = .
S 2 S
(d) Suppose Xi is a strictly positive process with dXi /Xi = ↵i dt+✓i dBi for i = 1, 2, and Brownian
motions Bi . Define Yt = X1t X2t . Show that
✓ ◆✓ ◆
dY dX1 dX2 dX1 dX2
= + + .
Y X1 X2 X1 X2
(e) Suppose Xi is a strictly positive process with dXi /Xi = ↵i dt+✓i dBi for i = 1, 2, and Brownian
motions Bi . Define Yt = X1t /X2t . Show that
✓ ◆ ✓ ◆✓ ◆
dY dX1 dX2 dX2 2 dX1 dX2
= + .
Y X1 X2 X2 X1 X2
(a) For f (x) = ex , we have f 0 (x) = ex and f 00 (x) = ex , so
1
dR = f 0 (X) dX + f 00 (X)(dX)2
2
1
= eX r dt + eX (r dt)2
2
= eX r dt .
Hence, dR/R = r dt.

(b) For f (x) = ex , we have f 0 (x) = ex and f 00 (x) = ex , so
1
dY = eX dX + eX (dX)2 .
2
Hence, dY /Y = dX + (1/2)(dX)2 .
(c) For f (x) = log x, we have f 0 (x) = 1/x and f 00 (x) = 1/x2 , so
1
dY = f 0 (S) dS + f 00 (S)(dS)2
2
dS 1 (dS)2
=
S 2 S2
✓ ◆
dS 1 dS 2
= .
S 2 S
(d) For f (x1 , x2 ) = x1 x2 , we have
@f @f @2f @2f
= x2 , = x1 , = 1, = 0.
@x1 @x2 @x1 @x2 @x2i
Hence,
dY = X2 dX1 + X1 dX2 + (dX1 )(dX2 ) .
12 Brownian Motion and Stochastic Calculus 97
This implies ✓ ◆✓ ◆
dY dX1 dX2 dX1 dX2
= + + .
Y X1 X2 X1 X2
(e) For f (x1 , x2 ) = x1 /x2 , we have
@f 1 @f x1 @2f 1 @2f @2f x1

= , = , = , = 0, =2 3.
@x1 x2 @x2 x22 @x1 @x2 x22 @x21 @x22 x2
Hence,
1 X1 1 X1
dY = dX1 dX2 (dX1 )(dX2 ) + 3 (dX2 )2 .
X2 X22 X22 X2
This implies
✓ ◆✓ ◆ ✓ ◆2
dY X2 dX1 dX2 dX1 dX2 dX2
= dY = + .
Y X1 X1 X2 X1 X2 X2
12.3. Assume S is a geometric Brownian motion:
dS
= µ dt + dB
S
for constants µ and and a Brownian motion B.
(a) Show that ✓ ◆

St+1 ⇣ 2
⌘
vart = e2µ e 1 .
St
Hint: Compare Exercise 1.15.
(b) Assume the statistics for the U.S. market return reported by Mehra and Prescott (1985):
 ✓ ◆
St+1 St+1
Et = 1.0698 and stdevt = 0.1654 .
St St
Show that µ = 0.0675 and = 0.1537.

(c) Assume C is a geometric Brownian motion:
dC
= ↵ dt + ✓ dB
C
for constants ↵ and ✓ and a Brownian motion B. Assume the statistics for aggregate U.S.
consumption reported by Mehra and Prescott (1985):
 ✓ ◆
Ct+1 Ct+1
Et = 1.018 and stdevt = 0.036 .
Ct Ct
Show that ↵ = 0.0178 and ✓ = 0.035.

(a) We have
Z t+1 ✓ ◆ Z t+1
1 2
log St+1 = log St + µ ds + dBs
t 2 t
1 2
= log St + µ + (Bu Bt ) .
2
Hence, log St+1 log St is normally distributed with mean µ 2 /2 and variance 2. Thus,
St+1 /St is the exponential of a normally distributed variable with mean µ 2 /2 and variance
2. This is the same assumption as in Exercise 1.15 (with µ in that exercise being µ 2 /2
here). Thus,
✓ ◆  2⇣ ⌘
St+1 St+1 2
vart = Et e 1
St St
⇣ 2 ⌘
= e2µ e 1 .
(b) From eµ = 1.0698, we obtain µ = 0.0675. From

p
eµ e 2
1 = 0.1654 ,
we obtain = 0.1537.
(c) From e↵ = 1.018, we obtain ↵ = 0.0178. From
p
e↵ e✓ 2 1 = 0.036 ,
we obtain ✓ = 0.035.
12.4. Consider the equation

dS
= µ dt + dB
S
for a Brownian motion B, where µ and are stochastic processes. Show that this equation is
satisfied by ✓Z t ✓ ◆ ◆
Z t
1 2
St = S0 exp µs s ds + s dBs .
0 2 0
What technical conditions are needed to ensure that St is well defined for t 2 [0, T ]?
Define
Z t✓ ◆ Z t
1 2
Xt = log S0 + µs s ds + s dBs .
0 2 0
Then,
✓ ◆
1 2
dX = µ dt + dB .
2
Define St = eXt . From part (b) of the preceding exercise, we have
dS
= dX + (1/2)(dX)2
S ✓ ◆
1 2 1
= µ dt + dB + ( dB)2
2 2
= µ dt + dB .
We need to assume that the ordinary integral

Z t✓ ◆
1 2
µs s ds
0 2
is well defined and finite for each t, with probability one and that
Z t
2
s <1
0
for each t, with probability one.
12.5. Assume
Z t
t (t s)
Xt = ✓ e (✓ X0 ) + e dBs
0
for a Brownian motion B and constants ✓ and . Show that
dX = (✓ X) dt + dB .
Note: The process X is called an Ornstein-Uhlenbeck process. Assuming  > 0, ✓ is called the long-
run or unconditional mean, and  is the rate of mean reversion. This is the interest rate process in
the Vasicek model (Section 16.8).
Define
Z t
Zt = es dBs
0
and
t
f (t, z) = ✓ e (✓ X0 z) .
Then, Xt = f (t, Zt ) and dZt = et dBt . We have
@f t @f t @2f
= e (✓ X0 z) , =e , = 0.
@t @z @z 2
Hence,
t t
dXt = e (✓ X0 Zt ) dt + e dZt
= (✓ Xt ) dt + dBt .
12.6. Let X be an Ornstein-Uhlenbeck process with a long-run mean of zero; i.e.,
dX = X dt + dB
for constants  and . Set Y = X 2 . Show that

p
dY = ̂(✓ˆ Y ) dt + ˆ Y dB
for constants ̂, ✓ˆ and ˆ . Note: The squared Ornstein-Uhlenbeck process Y is a special case of
the interest rate process in the Cox-Ingersoll-Ross model (Section 17.2) and a special case of the
variance process in the Heston model (Section 16.8) — special because ̂✓ˆ = ˆ 2 /4.
For f (x) = x2 , we have f 0 (x) = 2x and f 00 (x) = 2, so
dY = 2X dX + (dX)2
= 2X 2 dt + 2 X dB + 2 dt
p
= ( 2 2Y ) dt + 2 Y dB
✓ 2 ◆
p
= 2 Y dt + 2 Y dB
2
p
= ̂(✓ˆ Y ) dt + ˆ Y dB ,
where we define
2
̂ = 2 , ✓ˆ = , ˆ=2 .
2
12.7. Suppose dS/S = µ dt + dB for constants µ and and a Brownian motion B. Let r be a
constant. Consider a wealth process W as defined in Section 12.6:
dW dS
= (1 ⇡)r dt + ⇡ ,
W S
where ⇡ is a constant.
(a) By observing that W is a geometric Brownian motion, derive an explicit formula for Wt .
(b) For a constant ⇢ and dates s < t, calculate Es [Wt1 ⇢

]. Hint: write Wt1 ⇢
= e(1 ⇢) log Wt .
(c) Consider an investor who chooses a portfolio process to maximize


1
E w1 ⇢ .
1 ⇢ T
Show that if a constant portfolio ⇡t = ⇡ is optimal, then the optimal portfolio is
µ r
⇡= .
⇢ 2
(a) We have
dW
= [r + ⇡(µ r)] dt + ⇡ dB .
W
Thus, ✓✓ ◆ ◆
1 2 2
Wt = W0 exp r + ⇡(µ r) ⇡ t + ⇡ Bt .
2
(b) For any s < t, we have
✓ ◆
1 2 2
log Wt = log Ws + r + ⇡(µ r) ⇡ (t s) + ⇡ (Bt Bs ) .
2
Hence,
Wt1 ⇢
= e(1 ⇢) log Wt
✓ ✓ ◆ ◆
1 2
= Ws1 ⇢ exp (1 ⇢) r + ⇡(µ r) ⇡ 2
(t s) + (1 ⇢)⇡ (Bt Bs ) .
2
By the usual rule for means of exponentials of normals and the fact that Bt Bs is normally
distributed with mean zero and variance t s, this implies
h i ✓ ✓ ◆ ◆
1 ⇢ 1 ⇢ 1 2 2 1
Es W t = Ws exp (1 ⇢) r + ⇡(µ r) ⇡ (t s) + (1 ⇢)2 ⇡ 2 2 (t s)
2 2
✓ ✓ ◆ ◆
1 ⇢ 1 2 2 1 2 2
= Ws exp (1 ⇢) r + ⇡(µ r) ⇡ + (1 ⇢)⇡ (t s)
2 2
✓ ✓ ◆ ◆
1 ⇢ 1 2 2
= Ws exp (1 ⇢) r + ⇡(µ r) ⇢⇡ (t s) .
2
(c) The objective is to maximize
✓ ✓ ◆◆
1 1 2 2
exp T (1 ⇢) r + ⇡(µ r) ⇢⇡ .
1 ⇢ 2
The first-order condition is
✓ ✓ ◆◆
1 1 2 2 2
exp T (1 ⇢) r + ⇡(µ r) ⇢⇡ T (1 ⇢) µ r ⇢ ⇡ = 0.
1 ⇢ 2
Equivalently, µ r ⇢ 2⇡ = 0, which implies ⇡ = (µ r)/⇢ 2.
12.8. This exercise shows how to create correlated Brownian motions from independent Brownian
motions.
Let B1 and B2 be independent Brownian motions. Define a stochastic process B̂2 by B̂20 = 0 and
p
dB̂2 = ⇢ dB1 + 1 ⇢2 dB2 for any ⇢ 2 [ 1, 1].
(a) Use Levy’s theorem to show that B̂2 is a Brownian motion.

(b) Show that ⇢ is the correlation process of the two Brownian motions B1 and B̂2 .
(a) B̂2 is a continuous local martingale with

p
(dB̂2 )2 = ⇢2 (dB1 )2 + (1 ⇢2 )(dB2 )2 + 2⇢ 1 ⇢2 (dB1 )(dB2 ) = ⇢2 dt + (1 ⇢2 ) dt = dt .
Thus, B̂2 is a Brownian motion.

(b) We have
p
(dB1 )(dB̂2 ) = (dB1 )(⇢ dB1 + 1 ⇢2 dB2 ) = ⇢ dt .
12.9. This exercise shows how to project imperfectly correlated Brownian motions onto each other,
leaving a residual that is a stochastic integral with respect to an independent Brownian motion.
Equation (12.27) identifies ⇢ dB1 as the orthogonal projection of dB2 on dB1 in the sense that
p
dB2 = ⇢ dB1 + 1 ⇢2 dZ2
with Z2 being independent of B1 . The construction of Z1 and Z2 can be continued for n > 2. This
process is Gram-Schmidt orthogonalization.
Let B1 and B2 be imperfectly correlated Brownian motions with correlation process ⇢. Define
Z1 = B1 . Define Z20 = 0 and
1
dZ2 = p (dB2 ⇢ dZ1 ) .
1 ⇢2
Show that Z1 and Z2 are independent Brownian motions.
The following shows that Z2 is a Brownian motion:

1 ⇥ ⇤
(dZ2 )2 = (dB2 )2 2⇢(dB2 )(dZ1 ) + ⇢2 (dZ1 )2
1 ⇢2
1 ⇥ ⇤
= dt 2⇢2 dt + ⇢2 dt
1 ⇢2
= dt .
The following shows that Z1 and Z2 are independent:

1
(dZ1 )(dZ2 ) = p (dZ1 )(dB2 ⇢ dZ1 )
1 ⇢2
1
=p (⇢ dt ⇢ dt
1 ⇢2
= 0.
12.10. This exercise illustrates the implementation of Gram-Schmidt orthogonalization via the
Cholesky decomposition discussed in Sections 4.9 and 12.13.
Let B1 and B2 be independent Brownian motions. Suppose
dYi = ↵i dt + i1 dB1 + i2 dB2
for i = 1, 2.
(a) What are the elements of the matrix A such that

0 1
dY1 ⇣ ⌘
@ A dY1 dY2 = A dt ?
dY2
(b) Let 0 1
a 0
L=@ A.
b c
Calculate a, b and c with a > 0 and c > 0 such that LL0 = A.
(c) Define Z = (Z1 Z2 )0 by Zi0 = 0 and
0 10 1
11 12 dB1
L dZ = @ A@ A,
21 22 dB2
so dY = ↵ dt + L dZ. Show that Z1 and Z2 are independent Brownian motions.

(d) Define correlated Brownian motions
1
dB̂i = q ( i1 dB1 + i2 dB2 ) ,
2 + 2
i1 i2
as in (12.26). Show that Z1 = B̂1 and

1
dZ2 = p (dB̂2 ⇢ dZ1 ) ,
1 ⇢2
as in Exercise 12.9, where ⇢ is the correlation process of B̂1 and B̂2 .
(a) We have
(dY1 )2 = ( 2
11 + 2
12 ) dt , (dY1 )(dY2 ) = ( 11 21 + 12 22 ) dt , (dY2 )2 = ( 2
21 + 2
22 ) dt .
Hence, 0 1
2 + 2 +
11 12 11 21 12 22
A=@ A.
+ 2 + 2
11 21 12 22 21 22
(b) We want to solve

0 10 1 0 1
a 0 a b 2 + 2
11 12 11 21 + 12 22
@ A@ A=@ A.
b c 0 c + 2 + 2
11 21 12 22 21 22
Hence,
a2 = 2
11 + 2
12 ,
ab = 11 21 + 12 22 ,
b2 + c 2 = 2
21 + 2
22 .
This implies
q
a= 2 2 ,
+ 12
11
11 21 + 12 22
b= p ,
2 + 2
11 12
s
( 2
2 2 11 21 + 12 22 )
c= 21 + 22 2 2
11 + 12
| 11 22 12 21 |
= p .
2 + 2
11 12
(c) We want to compute (dZ1 dZ2 )0 such that

0 10 1 0 1
a 0 dZ1 11 dB1 + 12 dB2
@ A@ A=@ A.
b c dZ2 21 dB1 + 22 dB2
Thus,
a dZ1 = 11 dB1 + 12 dB2 ,
b dZ1 + c dZ2 = 21 dB1 + 22 dB2 .
This implies
1
dZ1 = ( 11 dB1 + 12 dB2 ) ,
a
1
dZ2 = ( 21 dB1 + 22 dB2 b dZ1 ) .
c
One can calculate directly that (dZ1 )2 = (dZ2 )2 = dt and (dZ1 )(dZ2 ) = 0, but it also follows
from Exercise 12.9 and Part (d) of this exercise.
(d) Substituting for a from the previous part shows that Z1 = B̂1 . The correlation process of B̂1
and B̂2 is ⇢ given by
11 21 + 12 22
⇢ dt = (dB̂1 )(dB̂2 ) = p 2 2 2 2
dt
( 11 + 12 )( 21 + 22 )
Simple algebra shows that
1 1
( 21 dB1 + 22 dB2 ) =p dB̂2
c 1 ⇢2
and
b ⇢
dZ1 = p dZ1 .
c 1 ⇢2
Thus,
1
dZ2 = p (dB̂2 ⇢ dZ1 ) .
1 ⇢2
12.11. This exercise is to express the conditional variance formula (12.25b) and conditional co-
variance formula (12.25d) in terms of processes being martingales. A more general fact, which does
not require the finite variance assumption, and which can be used as the definition of (dMi )2 and
Rt
(dMi )(dMj ), is that 0 (dMis )2 is the finite-variation process such that (12.28a) is a local martingale,
Rt
and 0 (dM1s ) (dM2s ) is the finite-variation process such that (12.28b) is a local martingale.
Suppose dMi = ✓ dBi for i = 1, 2, where Bi is a Brownian motion and ✓i satisfies (12.5), so Mi is
a finite-variance martingale.
(a) Show that (12.25b) is equivalent to

Z t
Mit2 (dMis )2
0
being a martingale.
(b) Show that (12.25d) is equivalent
Z t
M1t M2t (dM1s ) (dM2s )
0
being a martingale.
(a) Drop the i subscript. For u > s, we have
⇥ ⇤
vars (Mu Ms ) = Es (Mu Ms )2 Es [Mu Ms ] 2
⇥ ⇤
= Es (Mu Ms )2
⇥ ⇤
= Es Mu2 2Ms Mu + Ms2
= Es [Mu2 ] 2Ms Es [Mu ] + Ms2
= Es [Mu2 ] Ms2 ,
using the martingale property Es [Mu ] = Ms . For

Z t
Mit2 (dMis )2
0
to be a martingale means that, for u > s,

 Z u Z s
Es Mu2 (dMt )2 = Ms2 (dMt )2 .
0 0
By the calculation above, this is equivalent to

Z u
vars (Mu Ms ) = E s (dMt )2 ,
s
which is (12.25b).
(b) We have, for u > s,
covs (M1u M1s , M2u M2s ) = Es [(M1u M1s )(M2u M2s )] Es [M1u M1s ]Es [M2u M2s ]
= Es [(M1u M1s )(M2u M2s )]
= Es [M1u M2u M1u M2s M1s M2u + M1s M2s ]
= Es [M1u M2u ] M2s Es [M1u ] M1s Es [M2u ] + M1s M2s
= Es [M1u M2u ] M1s M2s ,
using the martingale property Es [Miu ] = Mis . For

Z t
0
to be a martingale means that, for u > s,

 Z u Z s
Es M1u M2u (dM1t )(dM2t ) = M1s M2s (dM1t )(dM2t ) .
0 0
By the calculation above, this is equivalent to

Z u
covs (M1u M1s , M2u M2s ) = Es (dM1t )(dM2t ) ,
s
which is (12.25d).
12.12. Let B be a Brownian motion. Define Yt = Bt2 t.
(a) Use the fact that a Brownian motion has independent zero-mean increments with variance equal
to the length of the time interval to show that Y is a martingale.
(b) Apply Itô’s formula to calculate dY and verify condition (12.5) to show that Y is a martingale.
Hint: To verify (12.5) use the fact that
Z T Z T
E Bt2 dt = E[Bt2 ] dt .
0 0
(c) Let dM = ✓ dB for a Brownian motion B. Use Itô’s formula to show that
Z t
2
Mt (dMs )2
0
is a local martingale.
(d) Let dMi = ✓i dBi for i = 1, 2, and Brownian motions B1 and B2 . Use Itô’s formula to show that
Z t
0
is a local martingale.
(a) We want to show that Es [Bt2 t] = Bs2 s. Equivalently, Es [Bt2 ] Bs2 = t s. By the calculation
in Part (a) of the preceding exercise,
Es [Bt2 ] Bs2 = vars (Bt Bs ) ,
and, because B is a Brownian motion, vars (Bt Bs ) = t s.

(b) For f (t, x) = x2 t, we have
@f @f @2f
= 1, = 2x , = 2.
@t @x @x2
Thus,
dYt = df (t, Bt ) = dt + 2Bt dBt + (dB)2 = 2Bt dBt .
To verify that Y is a martingale on [0, T ], we need to show that

Z T
E (2Bt )2 dt < 1 .
0
We have
Z T Z T Z T
2
E (2Bt ) dt = 4 E[Bt2 ] dt =4 t dt = 2T 2 < 1 .
0 0 0
(c) Set Zt = Mt2 and

Z t
Yt = Zt (dMs )2 .
0
Then,
dYt = dZt (dMt )2 .
As in the preceding part, applying Itô’s formula to Zt = f (Mt ) = Mt2 gives
dZt = 2Mt dMt + (dMt )2 .
Thus, dYt = 2Mt dMt , which inherits the local martingale property of M .
(d) Set Zt = M1t M2t and
Z t
Yt = Zt (dM1s ) (dM2s ) .
0
Then
dYt = dZt (dM1t ) (dM2t ) .
Applying Itô’s formula to Zt as in Exercise 12.2 gives
dZt = M1t dM2t + M2t dM1t + (dM1t ) (dM2t ) .
Thus,
dYt = M1t dM2t + M2t dM1t ,
implying Y is a local martingale.
12.13. Let dMi = ✓i dBi for i = 1, 2 and Brownian motions B1 and B2 . Suppose ✓1 and ✓2
satisfy condition (12.5), so M1 and M2 are finite-variance martingales. Consider discrete dates
s = t0 < t1 < · · · < tN = u for some s < u. Show that
2 3
N
X
covs (M1u M1s , M2u M2s ) = Es 4 (M1tj M1tj 1 )(M2tj M2tj 1 )5 .
j=1
Hint: This is true of discrete-time finite-variance martingales, and the assumption that the Mi are
stochastic integrals is neither necessary nor helpful in this exercise. However, it is interesting to
compare this to (12.25d).
As calculated in Exercise 12.11,
covs (M1u M1s , M2u M2s ) = Es [M1u M2u ] M1s M2s .
Also, the calculation in Exercise 12.11 shows that
Etj 1 [(M1tj M1tj 1 )(M2tj M2tj 1 )] = Etj 1 [M1tj M2tj ] M1tj 1 M2tj 1 .
Therefore, by iterated expectations,

2 3
N
X N
X
Es 4 (M1tj M1tj 1 )(M2tj M2tj 1 )5 = Es [Etj 1 [(M1tj M1tj 1 )(M2tj M2tj 1 )]]
j=1 j=1
N
X
= Es [Etj 1 [M1tj M2tj ]] Es [M1tj 1 M2tj 1 ]
j=1
N
X
= Es [M1tj M2tj ] Es [M1tj 1 M2tj 1 ]
j=1
= Es [M1tN M2tN ] Es [M1t0 M2t0 ]
= Es [M1u M2u ] M1s M2s .

13
Continuous-Time Securities Markets and SDF Processes
13.1. Let rd denote the instantaneously risk-free rate in the domestic currency, and let Rd denote
the domestic currency price of the domestic money market account:
✓Z t ◆
d d
Rt = exp rs ds .
0
As in Section 13.12, let X denote the price of a unit of a foreign currency in units of the domestic
currency. Let rf denote the instantaneously risk-free rate in the foreign currency, and let Rf denote
the foreign currency price of the foreign money market account:
✓Z t ◆
f f
Rt = exp rs ds .
0
Suppose M d is an SDF process for the domestic currency, so M f ⌘ M d X/X0 is an SDF process
for the foreign currency. Assume
dX
= µx dt + x dBx
X
for a Brownian motion Bx .
(a) Show that

dM f
= rf dt + dZ
Mf
for some local martingale Z.
(b) Deduce from the previous result and Itô’s formula that
✓ ◆✓ ◆
dX dM d
µx dt = (rd rf ) dt .
X Md
(c) Suppose M d Rd is a martingale under the physical probability and define the risk neutral proba-
bility corresponding to M d . Assume M d XRf is also a martingale under the physical probability.
Show that
112 13 Continuous-Time Securities Markets and SDF Processes
dX ⇤
= (rd rf ) dt + x dBx ,
X
where Bx⇤ is a Brownian motion under the risk neutral probability.
Note: The result of Part (c) is called uncovered interest parity under the risk neutral probability.
Suppose for example that r⇤ < r. Then it may appear profitable to borrow in the foreign currency
and invest in the domestic currency money market. The result states that, under the risk neutral
probability, the cost of the foreign currency is expected to increase so as to exactly o↵set the interest
rate di↵erential.
(a) Set Y = M f Rf . Then Y is a local martingale, and
dY dM f
= + rf dt ,
Y Mf
so
dM f
= rf dt + dZ ,
Mf
where Z is a local martingale defined by dZ = dY /Y .
(b) From the previous part, the formula M f = M d X/X0 , and the formula (13.16a) for the SDF
process M d , we have
dM f
rf dt + dZ =
Mf
✓ ◆✓ ◆
dM d dX dX dM d
= + +
Md X X Md
✓ ◆✓ ◆
d 0 dX dM d
= r dt dB + µx dt + x dBx + .
X Md
For this to be true, the dt terms on each side must match, implying
✓ ◆✓ ◆
d f dX dM d
µx dt = (r r ) dt .
X Md
(c) If M d XRf is a martingale under the physical probability, then XRf /Rd is a martingale under
the risk neutral probability. Setting Y = XRf /Rd , we have
dY dX
= (rf rd ) dt + .
Y X
This process has zero drift under the risk neutral probability, so the drift of dX/X under the
risk neutral probability is (rd rf ) dt. Because volatilities do not change when we make an
equivalent change of measures, we know that
13 Continuous-Time Securities Markets and SDF Processes 113
dX ⇤
= (rd rf ) dt + x dBx
X
for some Brownian motion Bx⇤ under the risk neutral probability. If fact, defining Bx⇤ by
✓ ◆
⇤ 1 dX d f µx r d + r f
dBx = (r r ) dt = dt + dBx ,
x X x
the facts that Bx⇤ has no drift under the risk neutral probability and (dBx⇤ )2 = (dBx )2 = dt
implies Bx⇤ is a Brownian motion under the risk neutral probability, by Levy’s theorem.
13.2. Generalizing from the discrete-time model in Section 8.7, assume an investor’s optimal
consumption satisfies the first-order condition
e t u0 (C
t)
= Mt
u0 (C 0)
for a constant discount factor and stochastic discount factor process M . Assume
1
u(c) = c1 ⇢
.
1 ⇢
(a) Assume (or prove) that the optimal consumption process is an Itô process:
dC
= ↵ dt + ✓ dZ
C
for a Brownian motion Z. Use the fact that the drift of dM/M must be r to show that
1
r = + ⇢↵ ⇢(1 + ⇢)✓2 .
2
(b) Interpreting the investor as a representative investor, give an economic explanation for why
the equilibrium interest rate r should be higher when (i) the discount rate is higher, (ii) the
expected growth rate ↵ of consumption is higher, or (iii) the variance ✓2 of consumption growth
is smaller.
(c) Assume there is a constant risk-free rate and a single risky asset. Assume the dividend-reinvested
price of the risky asset is a geometric Brownian motion:
dS
= µ dt + dB .
S
Assume the Brownian motion B is the only source of uncertainty in the economy. Show that
µ r
✓= .
⇢
(d) Assume the risk-free rate is consistent with the statistics reported by Mehra and Prescott (1985);
i.e., r = log 1.008. Use the numbers for ↵, ✓, µ and calculated in Exercise 12.3. Show that
they imply ⇢ > 10 and < 0.
(a) We can prove C is an Itô process by applying Itô’s formula to

t 1
⇢
Ct = C0 e ⇢ Mt
and using Levy’s theorem to construct the Brownian motion Z. However, to derive the formula
for r, it is convenient to use
Mt = C0⇢ e t
Ct ⇢
.
Setting f (t, c) = C0⇢ e tc ⇢, we have @f /@t = f , @f /@c = ⇢f /c and @ 2 f /@c2 = ⇢(1+⇢)f /c2 .
Hence,
✓ ◆
dM dC 1 dC 2
= dt ⇢ + ⇢(1 + ⇢)
M C 2 C
✓ ◆
1
= + ⇢↵ ⇢(1 + ⇢)✓2 dt ⇢✓ dZ .
2
Equating the drift to r dt yields the result.

(b) A higher means greater impatience, implying the representative investor would want to borrow
against future consumption, unless the risk-free rate rises. Likewise, a higher expected growth
rate of consumption or less risk in the growth rate of consumption would induce borrowing,
unless the risk-free rate rises.
(c) The unique SDF process M satisfies
dM µ r
= r dt dB .
M
Matching coefficients to the formula in the solution to part (a), we obtain
µ r µ r
= ⇢✓ , ✓= .
⇢
(d) Given µ = 0.0675, = 0.1537, ↵ = 0.0178, ✓ = 0.035, and r = log 1.008, from (µ r)/ = ⇢✓,
we obtain ⇢ = 11.07. Given this value of ⇢, the formula
1
r = + ⇢↵ ⇢(1 + ⇢)✓2
2
implies = 0.107.
13.3. Assume there is a representative investor with utility u(c) = log c and suppose that his
optimal consumption satisfies the first-order condition (13.48). Assume WT = 0, so the wealth of
the investor at any date t is the value of receiving the market dividend from date t to T . Assume
(13.34) is a martingale. Show that the market price-dividend ratio Wt /Ct is given by
Z T
(s t)
e ds .
t
Conclude that if the horizon T is infinite, then Wt /Ct = 1/ .
We have, for s t,
Ms e (s t) C
t
=
Mt Cs
and Z T Z T
Ms (s t)
W t = Et Cs ds = Ct e .
t Mt t
For T = 1, this implies

Ct
Wt = .
13.4. Adopt the same assumptions as in the previous problem, but suppose that (13.49) is the
representative investor’s utility function. Assume that the market dividend is a geometric Brownian
motion:
dC
= ↵ dt + ✓ dZ
C
for constants ↵ and ✓ and a Brownian motion Z. Define
1
⌫= (1 ⇢)↵ + ⇢(1 ⇢)✓2 .
2
Show that the market price-dividend ratio Wt /Ct is given by

Z T
⌫(s t)
e ds .
t
Conclude that if the horizon is infinite and ⌫ > 0, then Wt /Ct = 1/⌫.
We have, for s t,
Ms e (s t) C ⇢
t
=
Mt Cs ⇢
and
Z T ✓ ◆
Wt Ms Cs
= Et ds
Ct Mt Ct
"Zt ✓ ◆1 #
T ⇢
(s t) Cs
= Et e ds .
t Ct
From
dC
= ↵ dt + ✓ dZ ,
C
it follows that ✓✓ ◆ ◆
1 2
Cs = Ct exp ↵ ✓ (s t) + ✓(Zs Zt ) ,
2
so ✓ ◆1 ✓ ✓ ◆ ◆
⇢
Cs 1 2
= exp (1 ⇢) ↵ ✓ (s t) + (1 ⇢)✓(Zs Zt ) .
Ct 2
Given date–t information, this is the exponential of a normally distributed random variable with
mean ✓ ◆
1 2
(1 ⇢) ↵ ✓ (s t)
2
and variance
(1 ⇢)2 ✓2 (s t) .
Therefore,
"Z ✓ ◆1 # Z "✓ ◆1 #
T ⇢ T ⇢
(s t) Cs (s t) Cs
Et e ds = e Et ds
t Ct t Ct
Z T
(s t) ((1 ⇢)↵(s t) (1 ⇢)✓ 2 (s t)/2+(1 ⇢)2 ✓ 2 (s t)/2
= e e ds
t
Z T
⌫(s t)
= e ds
t
1⇣ ⌫(T t)
⌘
= 1 e .
⌫
For ⌫ > 0 and T = 1, this implies Wt /Ct = 1/⌫.
13.5. Consider an investor with initial wealth W0 > 0 who seeks to maximize E[log WT ]. Assume
the investor must choose among portfolio processes ⇡ satisfying (13.13a) and the following stronger
version of (13.13b):
Z T
E ⇡t0 ⌃t ⇡t dt < 1 .
0
Recall that this condition implies

Z T
E ⇡t0 t dBt = 0.
0
Using the formula (13.12) for Wt show that the optimal portfolio process is
⇡t = ⌃t 1 (µt rt 1) .
Hint: the objective function obtained by substituting the formula (13.12) for Wt can be maximized
in ⇡ separately at each date and in each state of the world.
From (13.12), the realized utility is

Z T✓ ◆ Z T
1 0
log W0 + rt + ⇡t0 (µt rt 1) ⇡ ⌃ t ⇡t dt + ⇡t0 t dBt .
0 2 t 0
Thus, ignoring the constant log W0 , the expected utility is

Z T ✓ ◆
0 1 0
E rt + ⇡t (µt rt 1) ⇡ ⌃t ⇡t dt .
0 2 t
The optimal portfolio process maximizes
1 0
⇡t0 (µt rt 1) ⇡ ⌃t ⇡t
2 t
for each t and in each state of the world, implying
⇡t = ⌃t 1 (µt rt 1) .
13.6. This exercise establishes the market completeness result asserted in Section 13.10. It uses
martingale representation under the physical probability measure.
Adopt the assumptions of Section 13.10. Let M = Mp . Define WT = x and

Z T
Ms MT
W t = Et Cs ds + WT
t Mt Mt
for t < T .
(a) Apply the result of Section 12.7 to deduce that there is a stochastic process such that, for all
t  T,
Z t Z t
0
Ms Cs ds + Mt Wt = W0 + dB .
0 0
(b) Take the di↵erential of the formula in Part (a) to show that
✓ ◆0 ✓ ◆
1 dM
dW = C dt + rW dt + W p + dB (dW ) .
M M
Use this formula to compute ✓ ◆

dM
(dW )
M
and show that
✓ ◆0 ✓ ◆0
1 1
dW = C dt + rW dt + W p+ p dt + W p+ dB .
M M
(c) Define
1 1 1 0
= W⌃ (µ r1) + ( ) .
M
Show that (W, C, ) satisfies the intertemporal budget constraint (13.33).
(a) We have
Z t Z t Z T
Ms Cs ds + Mt Wt = Ms Cs ds + Et Ms Cs ds + MT WT
0 0 t
Z T
= Et Ms Cs ds + MT WT ,
0
which is a martingale adapted to the vector B. Hence, the martingale representation theorem
implies
Z t Z t
0
Ms Cs ds + Mt Wt = W0 + dB
0 0
for some process .

(b) By taking the di↵erential of the formula from the previous part, we obtain
0
M C dt + M dW + W dM + (dW )(dM ) = dB .
Dividing by M and rearranging produces

✓ ◆
dM 1 dM 0
dW = C dt W
(dW ) + dB
M M M
✓ ◆0 ✓ ◆
1 dM
= C dt + rW dt + W p + dB (dW ) .
M M
From this, we can compute the covariation as

✓ ◆ ✓ ◆0
dM 1
(dW ) = W p+ p dt ,
M M
so ✓ ◆0 ✓ ◆0
1 1
dW = C dt + rW dt + W p + p dt + W p + dB .
M M
(c) From the definition of and the definition of p,
0 1
(µ r1) = W (µ r1)0 ⌃ 1
(µ r1) + 0 1
(µ r1)
M
0 1 0
=W p p + p,
M
0 1
= W (µ r1)0 ⌃ 1
+ 0 1
M
0 1 0
=W p + .
M
Therefore, the intertemporal budget constraint (13.34) holds.
13.7. This exercise establishes the market completeness result asserted in Section 13.10, using
martingale representation under the risk neutral probability.
Adopt the assumptions of Section 13.10. Let M denote the unique stochastic discount factor process.
Assume M R is a martingale. Consider T < 1, and define the probability QT in terms of ⇠T =
MT RT by (13.38). Define B ⇤ by (13.41). Let x be a random variable that depends only on the
path of the vector process B ⇤ up to time T and let C be a process adapted to B ⇤ . Assume
Z T
⇤ Cs x
E ds + < 1.
0 Rs RT
For t  T , define Z T
Cs x
Wt⇤ = E⇤t ds + .
t Rs RT
Observe that Z
Z t T
Cs Cs x
ds + Wt⇤ = E⇤t ds + ,
0 Rs 0 Rs RT
which is a QT –martingale.
(a) Apply the result of Section 12.7 to deduce that there is a stochastic process ⌘ such that, for all
t  T,
Z t Z t Z t
Cs
ds + Wt⇤ = W0⇤ + 0
⌘ (µ r1) ds + ⌘ 0 dB .
0 Rs 0 0
(b) Set W = RW ⇤ (so, in particular, WT = x) and = R⌘. Apply Itô’s formula and use the result
of the previous part to deduce that W , C and satisfy the intertemporal budget constraint
(13.33).
(a) Recall that

dB ⇤ = dt + dB = 1
(µ r1) dt + dB .
By the martingale representation theorem, applied under the risk neutral probability, there
exists such that
Z t Z t
Cs
ds + Wt⇤ = W0⇤ + 0
dB ⇤
0 Rs 0
Z t Z t
= W0⇤ + 0 1
(µ r1) dt + 0
dB .
0 0
Setting ⌘ = 1 0 , we have
Z t Z t Z t
Cs
ds + Wt⇤ = W0⇤ + ⌘ (µ0
r1) dt + ⌘ 0 dB .
0 Rs 0 0
(b) From the previous part,
C
dt + dW ⇤ = ⌘ 0 (µ r1) dt + ⌘ 0 dB .
R
Setting W = RW ⇤ yields
1 W
dW ⇤ = dW dR ,
R R2
so
1 W C
dW dR = dt + ⌘ 0 (µ r1) dt + ⌘ 0 dB
R R2 R
C 1 0 1 0
= dt + (µ r1) dt + dB .
R R R
Multiplying by R and using dR/R = r dt produces
0 0
dW = W r dt C dt + (µ r1) dt + dB .
13.8. This exercise verifies that, as asserted in Section 13.9, condition (13.43) is sufficient for M W
to be a martingale.
Let M be an SDF process such that M R is a martingale. Define B ⇤ by (13.41). Let W be a positive
self-financing wealth process. Define W ⇤ = W/R.
(a) Use Itô’s formula, (13.8), (13.16b) and (13.41) to show that
1
dW ⇤ = 0
dB ⇤ .
R
(b) Explain why the condition Z T

⇤ 1 0
E ⌃ dt < 1
0 R2
implies that W ⇤ is a martingale on [0, T ] under the risk neutral probability defined from M ,
where E⇤ denotes expectation with respect to the risk neutral probability.
(c) Deduce from the previous part that (13.43) implies M W is a martingale on [0, T ] under the
physical probability.
(a) We have
dW ⇤ dW dR
⇤
=
W W R
= ⇡ 0 (µ r1) dt + ⇡ 0 dB
= ⇡0 dt + ⇡ 0 dB
= ⇡ 0 dB ⇤ ,
using Itô’s formula, (13.8), (13.16b) and (13.41) successively. This implies
dW ⇤ = W ⇤ ⇡ 0 dB ⇤
W 0
= ⇡ dB ⇤
R
1 0
= dB ⇤ ,
R
where = W ⇡.
p 0
(b) Define ⌘ = ⌃ , Z0 = 0 and
1 0
dZ = dB ⇤ .
⌘
By Levy’s theorem, Z is a Brownian motion under the risk neutral probability. We have
⌘
dW ⇤ = dZ .
R
The sufficient condition (12.5) for W ⇤ to be a martingale under the risk neutral probability is
that Z T
⌘2
E⇤ dt < 1 .
0 R2
This is equivalent to Z T
⇤ 1 0
E ⌃ dt < 1 .
0 R2
(c) We have
Z T Z T 
⇤ 1 0 ⇤ 1 0
E ⌃ dt = E t ⌃t t dt
0 R2 0 Rt2
Z T 
MT R T 0
= E t ⌃t t dt
0 Rt2
Z T 
Mt 0
= E t ⌃t t dt ,
0 Rt
using iterated expectations and Et [MT RT ] = Mt Rt for the last equality. Thus, (13.43) is a
sufficient condition for W ⇤ = W/R to be a martingale on [0, T ] under the risk neutral probability,
hence a sufficient condition for M W to be a martingale under the physical probability.
13.9. This exercise verifies that Novikov’s condition can be expressed as (13.32), as asserted in
Section 13.7.
For a local martingale Y satisfying dY /Y = ✓0 dB for some stochastic process ✓, Novikov’s condition
is that  ⇢ Z T
1
E exp ✓0 ✓ dt < 1.
2 0
Under this condition, Y is a martingale on [0, T ]. Consider Y = M W , where M is an SDF process
and W is a self-financing wealth process.
(a) Show that dY /Y = ✓0 dB, where ✓ = 0⇡

p ⇣ and ⇣ = 0.
(b) Deduce that Novikov’s condition is equivalent to (13.32).
(a) For Y = M W , we have

✓ ◆✓ ◆
dY dM dW dM dW
= + +
Y M W M W
0
= r dt dB + r dt + ⇡ 0 (µ r1) dt + ⇡ 0 dB ⇡0 dt
= ( 0⇡ )0 dB
= ( 0⇡ p ⇣)0 dB ,
using =µ r1 and = p + ⇣.
(b) Setting ✓ = 0⇡ ⇣, we have
p
✓0 ✓ = ⇡ 0 ⌃⇡ + 0
p p + ⇣ 0⇣ 2⇡ 0 p 2⇡ 0 ⇣ + 2 0
p⇣ .
Substituting p =µ r1, ⇣ = 0 and
0
p⇣ = (µ r1)0 ⌃ 1
⇣ = 0,
we obtain
✓0 ✓ = ⇡ 0 ⌃⇡ + 0
p p + ⇣ 0⇣ 2⇡ 0 (µ r1) .
13.10. By specializing (13.32), state sufficient conditions for M Si to be a martingale for i =

1, . . . , n.
To apply (13.32) to W = Si , take the portfolio process ⇡ to be the i–th basis vector ei . Condition
(13.32) in this case is
 ⇢ Z T
1 0
E exp p p + ⇣ 0 ⇣ + e0i ⌃ei 2(µi r) dt < 1.
2 0
Note that e0i ⌃ei is the squared volatility of the asset return, i.e., the i–th diagonal element of ⌃.
13.11. This exercise verifies that if M W is a martingale, where W is a “consumption-reinvested”

wealth process (in particular, self-financing), then the valuation formula (13.350 ) for the consump-
tion process is valid, as asserted in Section 13.8.
Suppose W > 0, C and ⇡ satisfy the intertemporal budget constraint (13.33). Define the
consumption-reinvested wealth process W † by (13.36).
(a) Show that W † satisfies the intertemporal budget constraint (13.37).

(b) Show that
Z t
Cs
Wt† Wt = Wt† ds
0 Ws†
for each t. Hint: Define Y = W/W † and use Itô’s formula to show that
C
dY = dt .
W†
Conclude that
Z t
Wt Cs
=1 ds
Wt† 0 Ws†
for all t.
(c) Let M be an SDF process and assume M W † is a martingale. Use this assumption and iterated
expectations to show that, for any t < T ,
 Z T Z t Z T
† Cs † Cs
E t MT W T †
ds = Mt Wt †
ds + Et Ms Cs ds .
0 Ws 0 Ws t
(d) Let M be an SDF process and assume M W † is a martingale. Use the results of the previous
two parts to show that (13.34) is a martingale.
(a) From (13.36) and (13.33), we have

dW † dW C
= + dt
W† W W
= r dt + ⇡ 0 (µ r1) dt + ⇡ 0 dB .
(b) Setting Y = W/W † yields

✓ ◆✓ ◆ ✓ ◆2
dY dW dW † dW dW † dW †
= +
Y W W† W W† W†
C
= dt ⇡ 0 ⌃⇡ dt + ⇡ 0 ⌃⇡ dt
W
C
= dt ,
W
so
CY C
dY = dt = dt .
W W†
This implies
Wt
= Yt
Wt†
Z t
C
= Y0 †
ds
0 W
Z t
C
=1 †
ds ,
0 W
using W0† = W0 , which follows from (13.36). Multiplying by Wt† yields

Z t
C
Wt = Wt† Wt† †
ds .
0 W
(c) For t < s < T , iterated expectations and the fact that Es [MT WT† ] = Ms Ws† imply
  h i
† Cs Cs †
Et MT W T † = Et E s M T W T
Ws Ws†
= Et [Ms Cs ] .
Therefore,
 Z T Z t h i  Z T
Cs Cs Cs
Et MT WT† ds = ds ⇥ Et MT WT† + Et MT WT† ds
0 Ws† †
0 Ws t Ws†
Z t Z T 
Cs Cs
= Mt Wt† †
ds + Et MT WT† ds
0 Ws t Ws†
Z t Z T
Cs
= Mt Wt† †
ds + Et [Ms Cs ] ds
0 Ws t
Z t Z T
Cs
= Mt Wt† †
ds + Et Ms Cs ds .
0 Ws t
(d) Let  Z T
Cs
X t = Etds . MT WT†
Ws† 0
This is a martingale. Using Parts (c) and (b) successively, we have
Z t Z T
† Cs
X t = Mt W t †
ds + Et Ms Cs ds
0 Ws t
Z T
†
= Mt (Wt Wt ) + Et Ms Cs ds .
t
From the assumption that MW† is a martingale, it follows that

Z T
Mt W t E t Ms Cs ds
t
is a martingale. The second term in this expression is zero at t = T . Therefore,

Z T
Mt W t E t Ms Cs ds = Et [MT WT ] .
t
This implies
Z t Z t Z T
Mt W t + Ms Cs ds = Ms Cs ds + Et Ms Cs ds + Et [MT WT ]
0 0 t
 Z T
= E t MT W T + Ms Cs ds .
0
13.12. This exercise provides an alternate proof that requiring M W to be a martingale for self-
financing wealth processes W validates the valuation formula (13.350 ) for consumption processes.
It considers reinvesting consumption in the money market account rather than in the portfolio
generating the wealth process.
Suppose W , C and ⇡ satisfy the intertemporal budget constraint (13.33). Define

Z t
Cs
Wt† = Wt + Rt ds .
0 R s
(a) Show that W † satisfies the intertemporal budget constraint (13.80 ).

(b) Let M be an SDF process. Assume M R is a martingale and M W † is a martingale. Deduce that
(13.34) is a martingale.
(a) We have
✓Z t ◆
† Cs
dW = dW + C dt + ds dR
0 Rs
dR
= dW + C dt + (W † W)
R
0 0
= rW dt + (µ r1) dt + dB + (W † W )r dt
= rW † dt + 0
(µ r1) dt + 0
dB .
(b) From the definition of W † , we have

Z t Z t Z t
Cs
Ms Cs ds + Mt Wt = Ms Cs ds + Mt Wt† Mt R t ds .
0 0 0 Rs
Given the assumption that M W † is a martingale, it suffices to show that

Z t Z t
Cs
Ms Cs ds Mt R t ds
0 0 Rs
is a martingale. By iterated expectations and the assumption that M R is a martingale, we

obtain, using the same reasoning as in the previous exercise,
 Z T Z t  Z T
Cs Cs Cs
E t MT R T ds = ds ⇥ Et [MT RT ] + Et MT RT ds
0 Rs 0 Rs t Rs
Z t Z T
Cs
= Mt R t ds + Et Ms Cs ds .
0 Rs t
Thus,
Z T Z T Z T Z t Z T
Cs Cs
Et Ms Cs ds MT R T ds = Et Ms Cs ds Mt R t ds Et Ms Cs ds
0 0 Rs 0 0 Rs t
Z t Z t
Cs
= Ms Cs ds Mt Rt ds
0 0 Rs
14
Continuous-Time Portfolio Choice and Beta Pricing
14.1. Assume the continuous-time CAPM holds:

✓ ◆✓ ◆
dSi dWm
(µi r) dt = ⇢
Si Wm
for each asset i, where Wm denotes the value of the market portfolio, ⇢ = ↵Wm , and ↵ denotes the
p
aggregate absolute risk aversion. Define i = e0i ⌃ei to be the volatility of asset i, as described in
Section 13.2, so we have
dSi
= µi dt + i dZi
Si
for a Brownian motion Zi . Likewise, the return on the market portfolio is
dWm
= µm dt + m dZm
Wm
for some µm , m and Brownian motion Zm . Let im denote the correlation process of the Brownian
motions Zi and Zm .
(a) Using the fact that the market return must also satisfy the continuous-time CAPM relation,
show that the continuous-time CAPM can be written as
i m im
µi r= 2
(µm r) .
m
(b) Suppose r, µi , µm , i, m and ⇢i are constant over a time interval t, so both Si and Wm
are geometric Brownian motions over the time interval. Define the annualized continuously
compounded rates of return over the time interval:
log Si log Wm
ri = and rm = .
t t
128 14 Continuous-Time Portfolio Choice and Beta Pricing
Let r̄i and r̄m denote the expected values of ri and rm . Show that the continuous-time CAPM
implies
cov(ri , rm ) 1
r̄i r= (r̄m r) + [cov(ri , rm ) var(ri )] t.
var(rm ) 2
(a) We have
✓ ◆2
dWm 2
(µm r) dt = ⇢ =⇢ m dt ,
Wm
so ⇢ = (µm r)/ 2
m. Therefore
✓ ◆✓ ◆
µm r dSi dWm
(µi r) dt = 2
m Si Wm
µm r
= 2
( i m im ) dt .
m
(b) We have E[ log Si ] = (µi 2 t and E[ 2

i /2) log Sm ] = (µm m /2) t, so
1 2 1 2
r̄i = µi i , and r̄m = µm m.
2 2
From Part (a),
1 2
r̄i r = µi r i
2
i m im 1 2
= 2
(µm r) i
m 2
✓ ◆
i m im 1 2 1 2
= 2
r̄m + m r i
m 2 2
i m im 1 1 2
= 2
(r̄m r) + i m im i .
m 2 2
Also,
2
i
var(ri ) = ,
t
2
m
var(rm ) = ,
t
i m im
cov(ri , rm ) = .
t
Making these substitutions yields the result.
14.2. This exercise derives the ICAPM from the portfolio choice formula (14.24).
For each investor h = 1, . . . , H, let ⇡h denote the optimal portfolio presented in (14.24). Using the
notation of Section 14.7, (14.24) implies
14 Continuous-Time Portfolio Choice and Beta Pricing 129
X̀
W h ⇡h = ⌧ h ⌃ 1
(µ r1) ⌧h ⌘hj ⌃ 1
⌫ 0 ej .
j=1
(a) Deduce that

X̀
µ r1 = ↵W ⌃⇡ + ⌘j ⌫ 0 e j ,
j=1
where ⇡ denotes the market portfolio:

H
X Wh
⇡= ⇡h .
W
h=1
(b) Explain why (14.42) is the same as (14.29a).
(a) We have
X̀
⌧h (µ r1) = Wh ⌃⇡h + ⌧h ⌘hj ⌫ 0 ej .
j=1
Summing over h yields

H H
!
X X̀ X
⌧ (µ r1) = ⌃ W h ⇡h + ⌧h ⌘hj ⌫ 0 ej ,
h=1 j=1 h=1
which implies !
H
X̀ X ⌧h ⌘hj
µ r1 = ↵W ⌃⇡ + ⌫ 0 ej .
⌧
j=1 h=1
The result follows from the definition

H
X ⌧h ⌘hj
⌘j = .
⌧
h=1
(b) Stacking the equations (14.29a) for i = 1, . . . , n yields

✓ ◆ X̀
dW
(µ r1) dt = ↵W ( dB) + ⌘j ( dB)(dXj )
W
j=1
X̀
= ↵W ( dB)(dB 0 ) 0 ⇡ + ⌘j ( dB)(dB 0 )⌫ 0 ej
j=1
X̀
= ↵W ⌃⇡ dt + ⌘j ⌫ 0 ej dt .
j=1
14.3. Consider an investor with log utility and an infinite horizon. Assume the capital market line
is constant, so we can write J(w) instead of J(w, x) for the stationary value function defined in
Section 14.10.
(a) Show that

log w
J(w) = K +
solves the HJB equation (14.31), where
log r + 2 /2
K= + 2
.
Show that c = w and ⇡ = ⌃ 1 (µ r) achieve the maximum in the HJB equation.

(b) Show that the transversality condition
h i
lim E e t
J(WT⇤ ) = 0
T !1
holds, where W ⇤ denotes the wealth process generated by the consumption and portfolio pro-
cesses in part (a).
(a) Substituting J = K + log w/ , Jw = 1/( w) and Jww = 1/( w2 ), the HJB equation (14.31) is
⇢
1h ci 1 0
0 = max log c K log w + r + ⇡ 0 (µ r1) ⇡ ⌃⇡ .
c,⇡ w 2
The maximum is achieved at c = w and ⇡ = ⌃ 1 (µ r1). Substituting these into the HJB
equation, it reduces to the formula given for K.
(b) We have
✓ ◆
dW ⇤ 0 C⇤
= r + ⇡ (µ r) dt + ⇡ 0 dB
W⇤ W⇤
= (r + 2 ) dt + (µ r)0 ⌃ 1
dB .
Hence, ✓ ◆
⇤ 1
d log W = r + 2 dt + (µ r)0 ⌃ 1
dB .
2
This implies that
h i ✓ ◆
t T T 1 2
E e log WT = e log W0 + e r +  T !0
2
as T ! 1.
14.4. Consider an investor with power utility and an infinite horizon. Assume the capital market
line is constant, so we can write J(w) instead of J(w, x) for the stationary value function defined
in Section 14.10.
(a) Define
(1 ⇢)r (1 ⇢)2
⇠= .
⇢ 2⇢2
Assume (14.32) holds, so ⇠ > 0. Show that
✓ ◆
⇢ 1 1 ⇢
J(w) = ⇠ w
1 ⇢
solves the HJB equation (14.31). Show that c = ⇠w and ⇡ = (1/⇢)⌃ 1 (µ r1) achieve the
maximum in the HJB equation.
(b) Show that, under the assumption ⇠ > 0, the transversality condition
h i
lim E e t
J(WT⇤ ) = 0
T !1
holds, where W ⇤ denotes the wealth process generated by the consumption and portfolio pro-
cesses in part (a).
(a) Substituting J = ⇠ ⇢ w 1 ⇢ /(1 ⇢), wJw = ⇠ ⇢ w1 ⇢ and w2 Jww = ⇢⇠ ⇢ w1 ⇢ , the HJB equation
(14.31) is
⇢ h
1 ci 1
0 = max c1 ⇢
⇠ ⇢
w1 ⇢
+ r + ⇡ 0 (µ r1) ⇠ ⇢
w1 ⇢
⇢⇠ ⇢
w1 ⇢ 0
⇡ ⌃⇡ .
c,⇡ 1 ⇢ 1 ⇢ w 2
The maximum is achieved at c = ⇠w and ⇡ = (1/⇢)⌃ 1 (µ r1). Substituting these into the
HJB equation, it reduces to the formula given for ⇠.
(b) We have
✓ ◆
dW ⇤ C⇤ 0
= r + ⇡ (µ r) dt + ⇡ 0 dB
W⇤ W⇤
✓ ◆
2 1
= r+ ⇠ dt + (µ r)0 ⌃ 1 dB .
⇢ ⇢
Hence, ✓✓ ◆ ◆
Z T
2 2 1
WT⇤ = W0 exp r ⇠+ T+ (µ r) ⌃ 0 1
dBt .
⇢ 2⇢2 ⇢ 0
This implies
✓ ✓ ◆ Z T ◆
2 2 1 ⇢
(WT⇤ )1 ⇢ = W01 ⇢ exp (1 ⇢) r ⇠+ T+ (µ r) ⌃ 0 1
dBt .
⇢ 2⇢2 ⇢ 0
Thus,
h i ✓⇢ ✓ ◆ ◆
2 2 (1 ⇢)2 2
E e T
(WT⇤ )1 ⇢
= W01 ⇢
exp + (1 ⇢) r ⇠+ + T
⇢ 2⇢2 2⇢2
✓⇢ ◆
(1 ⇢)2
= W01 ⇢ exp + (1 ⇢)(r ⇠) + T .
2⇢
The transversality condition holds if and only if
(1 ⇢)2
+ (1 ⇢)(r ⇠) + < 0.
2⇢
Substituting the formula for ⇠ into this and rearranging shows that it is equivalent to
(1 ⇢)r (1 ⇢)2
> 0.
⇢ 2⇢2
14.5. Consider an investor who seeks to maximize E[log WT ]. Assume

Z T Z T
E |rt | dt < 1 and E 2t dt < 1 ,
0 0
where  denotes the maximum Sharpe ratio. Assume portfolio processes are constrained to satisfy
Z T
E ⇡t0 ⌃t ⇡t dt < 1 .
0
Maximizing at each date and in each state of the world as in Exercise 13.5, show that V (t, w, x) =
log w + f (t, x), where Z ✓ ◆
T
1
f (t, x) = E rs + 2s ds Xt = x .
t 2
From (13.12), the realized utility is

Z T✓ ◆ Z T
1 0
log Wt + rs + ⇡s0 (µs rs 1) ⇡ ⌃s ⇡s ds + ⇡s0 s dBs .
t 2 s t
The assumption Z T
E ⇡s0 ⌃s ⇡s ds < 1 ,
0
implies
Z t
⇡s0 s dBs
0
is a martingale. Thus, the expected utility is

Z T ✓ ◆
1 0
log Wt + Et rs + ⇡s0 (µs rs 1) ⇡ ⌃s ⇡s ds .
t 2 s
This is maximized by maximizing
1 0
⇡s0 (µs rs 1) ⇡ ⌃ s ⇡s
2 s
for each s, implying

⇡s = ⌃s 1 (µs rs 1) .
Making this substitution, the expected utility is

Z T ✓ ◆ Z T ✓ ◆
1 0 1 1 2
log Wt + Et r + (µ r1) ⌃ (µ r1) ds = log Wt + Et r+  ds .
t 2 t 2
Hence, V (t, w, x) = log w + f (t, x), where

Z T ✓ ◆
1
f (t, x) = E r + 2 ds Xt = x .
t 2
14.6. This exercise completes the proof in Section 14.3 that the tangency portfolio is optimal when
the capital market line is constant.
Assume the capital market line is constant and the horizon is finite. Define Z by (14.9), W ⇤ by
(14.12), by (14.13), and by (14.14).
(a) Take the di↵erential of (14.13) to show that

✓ ◆ ✓ ◆
dMp
dW = rW dt C dt (dW ) + W+  dZ .
Mp Mp
(b) Use the result of the previous part and the formula dMp /Mp = r dt  dZ to calculate
✓ ◆
dMp
(dW ) ,
Mp
and use the definition (14.14) of to show that W , C and satisfy the intertemporal budget
constraint (13.33).
(a) (14.13) implies

Mp C dt + W dMp + Mp dW + (dW )(dMp ) = dZ .
Dividing by Mp and rearranging yields

✓ ◆
dMp
dW = rW dt + W  dZ (dW ) C dt + dZ .
Mp Mp
(b) From the previous part, we have

✓ ◆ ✓ ◆
dMp
(dW ) = W+ 2 dt .
Mp Mp
Therefore, ✓ ◆ ✓ ◆
2
dW = rW dt C dt + W +  dt + W +  dZ .
Mp Mp
From (14.14), we obtain
✓ ◆
0
(µ r1) = W+ (µ r1)0 ⌃ 1
(µ r1)
Mp
✓ ◆
= W+ 2 ,
Mp
✓ ◆
0
dB = W+ (µ r1)0 ⌃ 1
dB
Mp
✓ ◆
0
= W+ p dB
Mp
✓ ◆
= W+  dZ .
Mp
Therefore, the intertemporal budget constraint (13.33) holds.
14.7. Consider a power-utility investor with a finite horizon (case (d) in Section 14.10). Assume the
capital market line is constant and the investor is constrained to always have nonnegative wealth.
Let M = Mp . Calculate the optimal portfolio as follows.
(a) Using (14.10), show that, for s > t,

h i
1 1/⇢ ↵(s t)
Et Ms1 1/⇢
= Mt e ,
for a constant ↵.
(b) Define Ct and WT from the first-order conditions and set
Z T
Ms MT
W t = Et Cs ds + WT .
t Mt Mt
Show that
1/⇢
Wt = g(t)Mt
for some deterministic function g (which you could calculate).

(c) By applying Itô’s formula to W in Part (b), show that the optimal portfolio is
1 1
⌃ (µ r1) .
⇢
(a) For s t, we have

✓ ◆
1 2
Ms = Mt exp r(s t)  (s t) (Zs Zt ) .
2
Therefore,
✓ ◆
1 1/⇢ 1 2
Ms1 1/⇢ = Mt exp r(s t)(⇢ 1)/⇢  (s t)(⇢ 1)/⇢ (Zs Zt )(⇢ 1)/⇢ .
2
The exponential is of a normally distributed variable, so
h i
1 1/⇢ ↵(s t)
Et Ms1 1/⇢
= Mt e ,
where
1 2 1
↵= r(⇢ 1)/⇢  (⇢ 1)/⇢ + 2 (⇢ 1)2 /⇢2 .
2 2
(b) The first order conditions are
⇣ ⌘ 1/⇢
t ⇢ t
e Ct = Mt ) Ct = e Mt ,
WT ⇢ = MT ) WT = ( MT / ) 1/⇢
.
Thus,
Z T
1
Wt = Et Ms Cs ds + MT WT
Mt t
Z T ⇣ ⌘ 1/⇢
1 1 1/⇢
= Et es Ms1 1/⇢
ds + ( / ) 1/⇢
MT
Mt t
Z T⇣ ⌘ 1/⇢ h i h i
1 1 1 1/⇢
= es Et Ms1 1/⇢
ds + ( / ) 1/⇢
E t MT
Mt t Mt
Z T⇣ ⌘ 1/⇢
1/⇢ 1/⇢ ↵(T t)
= Mt es e↵(s t)
ds + ( / ) 1/⇢
Mt e .
t
Hence,
1/⇢
W t = Mt g(t) ,
where
Z T ⇣ ⌘ 1/⇢
s
g(t) = e e↵(s t)
ds + ( / ) 1/⇢ ↵(T t)
e .
t
(c) From Itô’s formula,
dW dg dM 1/⇢
= +
W g M 1/⇢
g0 (1/⇢)M 1 1/⇢ dM + (1/2)(1/⇢)(1 + 1/⇢)M 2 1/⇢ (dM )2
= dt + .
g M 1/⇢
The stochastic part of this comes from
(1/⇢)M 1 1/⇢ dM 1 dM r 1 0
1/⇢
= = dt + p dB .
M ⇢ M ⇢ ⇢
Hence the stochastic part of the portfolio return must be
1 0
p dB ,
⇢
implying
1 1
⇡0 = 0
p = (µ r1)0 ⌃ 1
.
⇢ ⇢
Postmultiplying by 0⌃ 1 shows that this has the unique solution
1
⇡0 = (µ r1)0 ⌃ 1
.
⇢
14.8. This exercise derives a linear partial di↵erential equation (PDE) for the optimal wealth of
a power utility investor in complete markets. This specific example is due to Wachter (2002). In
general this approach leads to a PDE for a function of M and the state variables that influence M ,
but only the state variable appears here due to homotheticity (power utility).
Suppose the risk-free rate r is constant. Suppose there is a single risky asset. Suppose the asset
does not pay dividends prior to T and its price S satisfies
dSt
= µt dt + t dBt
St
for a Brownian motion B. Define

µt r
t = .
t
Assume is an Ornstein-Uhlenbeck process
d t = (✓ t ) dt + dB
for constants , ✓ and , where B is the same Brownian motion that appears in dS/S. Define Ct
and WT by the first-order conditions (14.6), and set
Z T
Ms MT
W t = Et Cs ds + WT
t Mt Mt
for t < T .
(a) Show that

"Z ✓ ◆1 ✓ ◆1 #
T 1/⇢ 1/⇢
1/⇢ 1/⇢ s/⇢ Ms 1/⇢ MT
Wt = Mt Et e ds + .
t Mt Mt
Explain why "Z #

T ✓ ◆1 1/⇢ ✓ ◆1 1/⇢
1/⇢ s/⇢ Ms 1/⇢ MT
Et e ds +
t Mt Mt
is some function f (t, t ).
1/⇢
(b) Using the formula Wt = Mt f (t, t ), show that
✓ ◆
dW f
= something dt + + dB .
W f ⇢
(c) Using the fact that the drift of the martingale

Z t
Ms Cs ds + Mt Wt ,
0
must be zero, derive a PDE that must be satisfied by f and its partial derivatives ft , f and
f .
(d) Define the portfolio weight on the risky asset by
✓ ◆
1 f
⇡= + .
f ⇢
Show that (C, W, ⇡) satisfies the intertemporal budget constraint. Hint: Follow the steps in
Rt
Exercise 14.6, using the fact that the drift of 0 Ms Cs ds + Mt Wt is zero, i.e., f satisfies the
PDE.
(a) The first order conditions are

⇣ ⌘ 1/⇢
t ⇢ t
e Ct = Mt ) Ct = e Mt ,
WT ⇢ = MT ) WT = ( MT / ) 1/⇢
.
Thus,
Z T
1
Wt = Et Ms Cs ds + MT WT
Mt t
Z T
1/⇢ 1 1 1/⇢
= Et e s/⇢ Ms1 1/⇢ ds + 1/⇢ MT
Mt t
"Z ✓ ◆ ✓ ◆1 #
1/⇢ 1/⇢
T
Ms 1 1/⇢ MT 1/⇢
= Mt Et e s/⇢ ds + 1/⇢
.
t Mt Mt
We have
dM
= r dt dB ,
M
so, for s > t, ✓ ◆
Z s Z s
Ms 1 2
= exp r(s t) u du u dBu .
Mt 2 t t
Conditional on date–t information, the distribution of

Z s Z s
2
u du and u dBu
t t
depend only on t.
(b) Writing M 1/⇢ = eX , where X = log M/⇢ and using deX /eX = dX + (dX)2 /2, we have
1/⇢
✓ ◆ 2
dM 1 1 2
1/⇢
= r dt dt dB + 2 dt
M ⇢ 2 2⇢
2⇢r + (1 + ⇢) 2
= dt + dB .
2⇢2 ⇢
Also,
1
df = ft dt + f d + f (d )2
2
1 2
= ft dt + f [(✓ ) dt + dB] + f dt
 2
1 2
= ft + (✓ )f + f dt + f dB .
2
Hence,
!✓ ◆
dW dM 1/⇢ df dM 1/⇢ df
= 1/⇢
+ + 1/⇢
W M f M f
1 2 ✓ ◆
2⇢r + (1 + ⇢) 2 ft + (✓ )f + 2 f f f
= 2
dt + dt + + dB + dt .
2⇢ f ⇢ f ⇢f
Rt
(c) The di↵erential of 0 Ms Cs ds + Mt Wt is
✓ ✓ ◆✓ ◆◆
C dW dM dW dM
M C dt + M dW + W dM + (dW )(dM ) = M W + + +
W W M W M
t 1/⇢ ✓ ◆ !
e M dW f
= MW 1/⇢ f
+ r dt dB + dt .
M W ⇢ f
Using the previous formula for dW/W and equating the drift to zero yields
t 1/⇢ 2 1 2 ✓ ◆
e 2⇢r + (1 + ⇢) ft + (✓ )f + 2 f f f
+ + + r + = 0.
f 2⇢2 f ⇢f ⇢ f
Multiplying by 2⇢2 f and simplifying yields

⇣ ⌘ 1/⇢
2⇢2 e t
+ (1 ⇢)(2⇢r + 2
)]f + 2⇢2 ft + 2⇢[⇢(✓ ) + (1 ⇢) ]f + ⇢2 2
f = 0.
Rt
(d) Given that f satisfies the PDE from Part (c), the di↵erential of 0 Ms Cs ds + Mt Wt is
✓ ✓ ◆✓ ◆◆ ✓ ◆
C dW dM dW dM f
MW + + + = MW + dB dB
W W M W M ⇢ f
= M W (⇡ ) dB .
Thus,
✓ ◆✓ ◆
dW C dM dW dM
= (⇡ ) dB dt
W W M W M
✓ ◆✓ ◆
C dW dM
= dt + r dt + ⇡ dB
W W M
C
= dt + r dt + ⇡ dt + ⇡ dB
W
C
= dt + r dt + ⇡(µ r) dt + ⇡ dB .
W
14.9. This exercise demonstrates the equivalence between the intertemporal and static budget
constraints in the presence of non-portfolio income when the investor can borrow against the income,
as asserted in Section 14.2.
Let M be an SDF process and Y a non-portfolio income process. Assume

Z T
E Mt |Yt | dt < 1
0
for each finite T . The intertemporal budget constraint is
0 0
dW = rW dt + (µ r1) dt + Y dt C dt + dB .
(a) Suppose that (C, W, ) satisfies the intertemporal budget constraint (14.43), C 0, and the
nonnegativity constraint (14.7) holds.
(i) Suppose the horizon is finite. Show that (C, W ) satisfies the static budget constraint
Z T Z T
W0 + E Mt Yt dt E Mt Ct dt + MT WT
0 0
by showing that
Z t
Ms (Cs Ys ) ds + Mt Wt
0
is a supermartingale. Hint: Show that it is a local martingale and at least as large as the
martingale Xt , where Z T
X t = Et Ms Ys ds .
0
This implies the supermartingale property (Appendix A.13.)
(ii) Suppose the horizon is infinite and limT !1 E[MT WT ] 0. Assume Y 0. Show that the
static budget constraint
Z 1 Z 1
W0 + E Mt Yt dt E Mt Ct dt
0 0
holds.
(b) Suppose the horizon is finite, markets are complete, C 0, and (C, W ) satisfies the static
budget constraint (14.44) as an equality. Show that there exists such that (C, W, ) satisfies
the intertemporal budget constraint (14.43).
(a) (i) The di↵erential of

Z t
0
is
M (C Y ) dt + M dW + W dM + (dM )(dW )
= rM W dt + M 0 (µ r1) dt + M 0
dB rM W dt MW 0
dB M 0
dt
0 0
=M dB MW dB .
Thus, it is a local martingale. By the nonnegative wealth constraint (14.7) and the nonneg-
ativity of C, Z
Z t T
Ms Cs ds + Mt Wt + Et Ms Ys ds 0.
0 t
This implies Z
Z t T
Ms (Cs Ys ) ds + Mt Wt Et Ms Ys ds .
0 0
Hence,
Z t
0
is a supermartingale, which implies
Z T
W0 E Ms (Cs Ys ) ds + MT WT .
0
Rearranging produces the static budget constraint.

(ii) Taking the limit of the finite-horizon static budget constraint as T ! 1, using the nonneg-
ativity of C, Y and M and the Monotone Convergence Theorem yields
Z 1 Z 1 Z 1
W0 + E Mt Yt dt E Mt Ct dt + lim E[MT WT ] E Mt Ct dt .
0 0 T !1 0
(b) The proof is the same as in Exercise 13.6, replacing C in that exercise by C Y . Specifically,
defining Z T
Ms MT
W t = Et (Cs Ys ) ds + WT ,
t Mt Mt
it follows that
Z t
0
is a martingale. Therefore,
Z t Z t
0
Ms (Cs Ys ) ds + Mt Wt = W0 + s dBs
0 0
for some stochastic process . Setting
1 1 1 0
= W⌃ (µ r1) + ( ) ,
M
it follows that (C, W, ) satisfies the intertemporal budget constraint.

Part III
Derivative Securities
15
Option Pricing
15.1. The fundamental PDE (15.23) can be written as

1 2 2
⇥ + rS + S = rV .
2
For the Black-Scholes call option formula, calculate the theta and gamma and verify the funda-
mental PDE.
The delta, gamma and theta can be calculated as

@ ⇥ rT
⇤
= SN (d1 ) e K N(d2 )
@S
@d1 @d2
= N(d1 ) + S n(d1 ) e rT K n(d2 )
@S
✓ ◆ @S
@d1 @d2
= N(d1 ) + S n(d1 )
@S @S
= N(d1 ) ,
@
=
@S
@d1
= n(d1 )
@S
1
= n(d1 ) p ,
S T
@ ⇥ ⇤
⇥= SN (d1 ) e rT K N(d2 )
@T
@d1 @d2
= S n(d1 ) + e rT K n(d2 ) re rT K N(d2 )
✓ @T ◆ @T
@d2 @d1
= S n(d1 ) re rT K N(d2 )
@T @T
rT
= S n(d1 ) p re K N(d2 ) .
2 T
Thus, we want to confirm that
146 15 Option Pricing

rT 1 2 2 1 ⇥ rT
⇤
S n(d1 ) p re K N(d2 ) + rS N(d1 ) + S n(d1 ) p = r SN (d1 ) e K N(d2 ) .
2 T 2 S T
p
It suffices to note that the two terms on the left-hand side involving the reciprocal of T cancel.
15.2. Use put-call parity to show that a European put and a European call with the same strike
and time to maturity have the same gamma.
Letting C denote the call price and P the put price, put-call parity at date 0 is P = C + e rT K S.
Therefore,
@P @C
= 1,
@S @S
and
@2P @2C
= .
@S 2 @S 2
15.3. Consider an asset with a constant dividend yield q. Assume the price S of the asset satisfies
dS
= (µ q) dt + dB ,
S
where B is a Brownian motion under the physical measure, and µ and are constants. Consider a
European call and a European put with strike K on the asset. Assume the risk-free rate is constant,
and adopt the assumptions of Section 15.3.
(a) Let A denote the event ST > K. Show that E[ST 1A ] = e(µ q)T S ⇤
0 N(d1 ), where
1 2
log(S0 /K) + µ q + T
d⇤1 = p 2
.
T
Hint: This can be computed directly under the physical measure or by changing measures using
e(q µ)T S
T /S0 as the Radon-Nikodym derivative.
p
(b) Show that E[K1A ] = K N(d⇤2 ), where d⇤2 = d⇤1 T.
(c) It follows from the previous parts that the expected return of the European call under the
physical measure, if held to maturity, is
e(µ q)T S ⇤ K N(d⇤2 )

0 N(d1 )
qT S
,
e 0 N(d1 ) e rT K N(d2 )
where d1 and d2 are defined in (15.29). Assuming T = 1, µ = 0.12, r = 0.04, q = 0.02, and
= 0.20, show that the expected rate of return of a European call that is 20% out of the money
(S0 /K = 0.8) is 118%.
15 Option Pricing 147
(d) Show that the expected return of the European put under the physical measure, if held to
maturity, is
K N( d⇤2 ) e(µ q)T S0 N( d⇤1 )
.
e rT K N( d2 ) e qT S0 N( d1 )
Assuming T = 1, µ = 0.12, r = 0.04, q = 0.02, and = 0.20, show that the expected rate of
return of a European put that is 20% out of the money (S0 /K = 1.2) is 54%.
(a) Using the physical measure, recall that

✓ ◆
1 2
p
log ST = log S0 + µ q T+ T x̃ ,
2
p
where x̃ ⌘ BT / T is a standard normal under the physical measure. The event A is the event
that log ST > log K, which is equivalent to x̃ > d⇤2 . Thus,
Z 1 p
1 2 /2)T + x2 /2
E[ST 1A ] = p S0 e(µ q Tx
e dx
2⇡ d⇤2
Z 1 p
(µ q)T 1 (x T )2 /2
=e S0 p e dx
2⇡ d⇤2
Z 1
1 y 2 /2
= e(µ q)T
S0 p e dy
2⇡ d⇤1
= e(µ q)T
S0 [1 N( d⇤1 )]
= e(µ q)T
S0 N(d⇤1 ) ,
p
changing variables as y = x T to obtain the third equality. To compute E[ST 1A ] via the
change of measure, note that
" #
e(q µ)T S
T
E[ST 1A ] = e (µ q)T
S0 E 1A = e(µ q)T
S0 E⇤ [1A ] = e(µ q)T
S0 prob⇤ (A) ,
S0
where the asterisks denote the measure defined by the Radon-Nikodym derivative e(q µ)T S
T /S0 .
Set ⇠t = e(q µ)t S

t /S0 . Then
d⇠
= dB ,
⇠
so ⇠ is a martingale under the physical measure. Girsanov’s theorem implies that
✓ ◆
⇤ d⇠
dB = dB (dB) = dB dt
⇠
defines a Brownian motion under prob⇤ . Thus,

dS
= (µ q+ 2
) dt + dB ⇤ ,
S
and A is the event that

✓ ◆
1
log S0 + µ q+ 2
T + BT⇤ > log K .
2
B⇤
pT < d⇤1 .
T
Therefore, prob⇤ (A) = N(d⇤1 ), and E[ST 1A ] = e(µ q)T S ⇤
0 N(d1 ).
(b) We have E[K1A ] = K prob(A). As shown in the solution to Part (a), A is the event that x̃ > d⇤2 ,
where x̃ is a standard normal under the physical measure. Thus, prob(A) = 1 N( d⇤2 ) = N(d⇤2 ),
and E[K1A ] = K N(d⇤2 ).
(c) The expected payo↵ of the call under the physical measure is 0.0305K, and its Black-Scholes
price is 0.0140K. Thus, the expected rate of return is 0.0305/0.0140 1 = 118%.
(d) Denote the complement of A by Ac . The expected payo↵ of the put under the physical measure
is
E[K1Ac ] E[ST 1Ac ] = K prob(Ac ) e(µ q)T

S0 prob⇤ (A)
= K[1 N(d⇤2 )] e(µ q)T

S0 [1 N(d⇤1 )]
= K N( d⇤2 ) e(µ q)T

S0 N( d⇤1 ) .
Thus, the expected return is as claimed. For the parameters given, the expected payo↵ of
the put is 0.0080K, and its Black-Scholes price is 0.0173K, so the expected rate of return is
0.0080/0.0173 1= 54%.
15.4. Adopt the Black-Scholes assumptions. Consider an American put and exercise boundary f
with associated exercise time
8
>
<min{t | St  f (t)} if St  f (t) for some t 2 [0, T ] ,
⌧=
>
:T otherwise .
Show that there is a trading strategy with value max(0, K S⌧ ) at date ⌧ and value (15.26) at
date 0. Hint: Consider replicating the date–T payo↵ X = er(T ⌧ ) max(0, K S⌧ ).
From the market completeness result, there exists a self-financing wealth process W such that
WT = X and Wt = e r(T t) ER [X] for each t 2 [0, T ]. Taking t = 0 yields
t
h i ⇥ ⇤
rT
W0 = e ER er(T ⌧)
max(0, K S⌧ ) = E R e r⌧
max(0, K S⌧ ) .
Taking t = ⌧ yields
h i
r(T ⌧ ) R
W⌧ = e E⌧ er(T ⌧)
max(0, K S⌧ ) = E R
⌧ [max(0, K S⌧ )] = max(0, K S⌧ ) .
Note that this calculation for t = ⌧ depends on the stopping theorem.
15.5. Consider a perpetual American call on an asset with price S given by (15.1) and with a
constant dividend yield q > 0. Assume the risk free rate r is constant. Let V (St ) denote the value
of the call (exercised optimally). Assume V is twice continuously di↵erentiable.
(a) Using the fact that M V is a local martingale, derive an ordinary di↵erential equation (ODE)
that V must satisfy in the continuation region.
(b) Show that AS satisfies the ODE for constants A and if and only if is a root of the quadratic
equation ✓ ◆
1 2 2 1 2
+ r q r = 0.
2 2
Show that the positive root of this equation satisfies > 1.
(c) The general solution of the ODE is A1 S 1 + A2 S 2 , where the i are the roots of the quadratic
equation (15.32). Use the fact that limS#0 f (S) = 0 to show that f (S) = AS for some constant
A, where is the positive root of the quadratic equation.
(d) Use the value matching and smooth pasting conditions to show that the optimal exercise point
is S ⇤ = K/( 1), where is the positive root of the quadratic equation, and to derive A.
(e) Show that, if S0  S ⇤ , the value of the call is
✓ ◆✓ ◆ ✓ ◆
K 1 S0
.
1 K
(a) We have
1
dV = V 0 (S) dS + V 00 (S) (dS)2
2
1 2 2 00
= SV 0 (S)[µ dt + dB] + S V (S) dt .
2
Also,
dM µ+q r d"
= r dt db + .
M "
Therefore
✓ ◆✓ ◆
d (M V ) dM dV dM dV
= + +
MV M V M V
µ+q r d" SV 0 1 2 2V
00 SV 0
= r dt dB + + [µ dt + dB] + S dt (µ + q r) dt .
" V 2 V V
For this to be a local martingale, we must have
1
rV (S) + (r q)SV 0 (S) + S V 00 (S) = 0 .
2 2
2
(b) If V (S) = AS , then SV 0 (S) = AS , and S 2 V 00 (S) = ( 1)AS . Hence, the ODE is
1 2
rAS + (r q)AS + ( 1) AS = 0 .
2
This is satisfied by and A 6= 0 if and only if is a root of the quadratic equation (15.32).
(c) If < 0, we have limS#0 S = 1, so the coefficient Ai corresponding to the negative root of the
quadratic equation must be zero.
(d) The value matching condition is A(S ⇤ ) = S ⇤ K. The smooth pasting condition is A(S ⇤ ) 1 =
1. Multiplying the latter equation by S ⇤ and substituting from the former gives (S ⇤ K) = S ⇤ .
Thus, S ⇤ = K/( 1). This implies
✓ ◆
K K
A = (S ⇤ K)(S ⇤ ) = .
1 1
(e) Substituting the values of A and S ⇤ from the previous part, we have
✓ ◆ ✓ ◆ ✓ ◆
K K K 1 S0
V (S0 ) = AS0 = S0 = .
1 1 1 K
15.6. Consider a perpetual American put under the assumptions of Exercise 15.5. Consider the
exercise time ⌧ = min{t | St  S ⇤ } for a constant S ⇤ . Let V (St ) denote the value of the put
(exercised optimally). Assume V is twice continuously di↵erentiable and limS!1 V (S) = 0. Show
that the optimal exercise point is
K
S⇤ = ,
1
where is the negative root of the quadratic equation (15.32). Show that the value of the put is,
for S0 S⇤,
✓ ◆ ✓ ◆
K K
.
1 1 S0
The same calculations as in the previous exercise show that
V (S) = A1 S + A2 S ,
for constants Ai , where and are the roots of the quadratic equation (15.32). The fact that
limS!1 V (S) = 0 implies that the coefficient Ai corresponding to the positive root must be zero.
Thus, V (S) = AS , where is the negative root. The value matching and smooth pasting conditions
give A(S ⇤ ) = K S ⇤ and A(S ⇤ ) 1 = 1. Multiplying the latter equation by S ⇤ and substituting
from the former gives (K S⇤) = S ⇤ . Thus, S ⇤ = K/(1 ). This implies
✓ ◆
K
A = (K S ⇤ )(S ⇤ ) = K .
1 1
Thus, ✓ ◆ ✓ ◆
⇤ ⇤ K K
V (S0 ) = AS0 = (K S )(S ) = .
1 1 S0
15.7. Consider perpetual American calls and puts under the assumptions of Exercise 15.5. Let ER
denote expectation under the infinite-horizon risk neutral probability. Let ⌧ = min{t | St = S ⇤ } for
a constant S ⇤ . For any stochastic process X,
ER [X⌧ 1{⌧ <1} ] = E[M⌧ R⌧ X⌧ 1{⌧ <1} ] .
This follows from Revuz and Yor (1991, Proposition VIII.1.3). Thus, setting Xt = 1/Rt = e rt ,
M1 = 0 and e 1 = 0, we have
ER [e r⌧
] = E[M⌧ ] .
Moreover, because the expected rate of change of S is r q under the risk neutral probability,
8
>
< S0⇤
S if S ⇤ S0
R r⌧
E [e ] = ⇣ ⌘
> S⇤
:
S0 if S ⇤  S0 ,
where is the positive root and the negative root of the quadratic equation (15.32). See Borodin
and Salminen (2000, p. 622). Use these facts to derive the values of perpetual American calls and
puts.
The value of a call option exercised at S ⇤ S0 is

✓ ◆
⇤ R r⌧ ⇤ S0
(S K)E [e ] = (S K) .
S⇤
Maximizing this in S ⇤ gives

K
S⇤ = .
1
Hence the value of a call, when S0  S ⇤ , is
✓ ◆✓ ◆ ✓ ◆✓ ✓ ◆
K ( 1)S0 K 1 S0
K = .
1 K 1 K
The value of a put option exercised at S ⇤  S0 is

✓ ◆
S⇤
(K S ⇤ )ER [e r⌧
] = (K S⇤) .
S0
Maximizing this in S ⇤ gives

K
S⇤ = .
1
Hence, the value of a put, when S0 S ⇤ , is
✓ ◆ ✓ ◆
K K
.
1 1 S0
15.8. Consider a second risky non-dividend-paying asset with price Z. Assume
dZ
= µz dt + z dBz ,
Z
where Bz is a Brownian motion under the physical measure. Let ⇢ denote the correlation process
of Bz and B.
(a) Define ⇠t = Mt St = Et [MT ST ]. Show that
d⇠ dM
= r dt + dB + .
⇠ M
(b) Prove that ✓ ◆ ✓ ◆

d⇠ µz r
(dBz ) = ⇢ dt .
⇠ z
(c) Use Girsanov’s theorem to show that
dZ
= (r + ⇢ z ) dt + z dBz⇤ ,
Z
where Bz⇤ is a Brownian motion under probS .

(a) We have
✓ ◆✓ ◆
d⇠ dM dS dM dS
= + +
⇠ M S M S
dM
= + µ dt + dB (µ r) dt
M
dM
= r dt + dB + .
M
(b) We have
✓ ◆ ✓ ◆
d⇠ dM
(dBz ) = (dBz )(dB) + (dBz )
⇠ M
µz r
= ⇢ dt dt ,
z
using the fact that ✓ ◆✓ ◆

dZ dM
= (µz r) dt .
Z M
(c) Define Bz⇤ to be zero at date 0, and define
✓ ◆ ✓ ◆
⇤ d⇠ µz r
dBz = dBz (dBz ) = dBz ⇢ dt .
⇠ z
By Girsanov’s theorem, Bz⇤ is a Brownian motion under probs . We have
dZ
= µz dt + dBz z
Z  ✓ ◆
⇤ µz r
= µz dt + z dBz + ⇢ dt
z
= (r + ⇢ z ) dt + z dBz⇤ .
15.9. This exercise verifies the assertion (15.6) regarding the dynamics of an SDF process.
Suppose the information in the economy is given by independent Brownian motions B1 , . . . , Bn .

Consider a non-dividend-paying asset with price satisfying
X n
dS
= µ dt + i dBi
S
i=1
for stochastic processes µ and i.
(a) Define a stochastic process and Brownian motion B s such that
dS
= µ dt + dB s .
S
(b) Consider an SDF process M . We have

n
X
dM
= r dt i dBi
M
i=1
for some stochastic processes i. Define a stochastic process and Brownian motion B m such
that
dM
= r dt dB m .
M
(c) Let ⇢ denote the correlation process of B s and B m . Show that ⇢ = (µ r)/ .
(d) Show that there is a local martingale Z such that
dM µ r
= r dt dB s + dZ ,
M
and (dB s )(dZ) = 0.
(a) Define B0s = 0, v

u n
uX
=t 2
i ,
i=1
n
1X
dB s = i dBi .
i=1
By Levy’s theorem, B s is a Brownian motion, and we have
dS
= µ dt + dB s .
S
(b) Define B0m = 0, v
u n
uX
=t 2,
i
i=1
n
1X
dB m = i dBi .
i=1
By Levy’s theorem, B m is a Brownian motion, and we have
dM
= r dt dB m .
M
(c) We have
✓ ◆✓ ◆
dS dM
(µ r) dt =
S M
= (dB s )(dB m )
= ⇢ dt ,
so ⇢ = (µ r)/ .
(d) We want
dM µ r
= r dt dB s + dZ ,
M
which is equivalent to
dM µ r
dZ = + r dt + dB s
M
µ r
= dB m + dB s .
This defines a local martingale Z, and
µ r µ r
(dB s )(dZ) = (dB s )(dB m ) + dt = ⇢ dt + dt = 0 .
15.10. A compound option is an option on an option. Suppose there is a constant risk-free rate,
and the underlying asset price has a constant volatility. Consider a European call option with strike
K 0 maturing at T 0 . Assume the underlying asset does not pay dividends during [0, T 0 ]. Consider a
European option maturing at T < T 0 to purchase the first call option at price K. The purpose of
this exercise is to value the “call on a call.” The value at T of the underlying call is given by the
Black-Scholes formula with T 0 T being the time to maturity. Denote this value by V (T, ST ). The
value at T of the call on a call is
max(0, V (T, ST ) K) .
Let S ⇤ denote the value of the underlying asset price such that V (T, S ⇤ ) = K. The call on a call is
in the money at its maturity T if ST > S ⇤ , and it is out of the money otherwise. Let A denote the
set of states of the world such that ST > S ⇤ , and let 1A denote the random variable that equals 1
when ST > S ⇤ and 0 otherwise. The value at its maturity T of the call on a call is
V (T, ST )1A K1A .
(a) What is the value at date 0 of receiving the payo↵ K1A at date T ?
(b) To value receiving V (T, ST )1A at date T , let C denote the set of states of the world such
that ST 0 > K 0 , and let 1C denote the random variable that equals 1 when ST 0 > K 0 and 0
otherwise. Recall that V (T, ST ) is the value at T of receiving ST 0 1C K 0 1C at date T 0 . Hence,
the value at date 0 of receiving V (T, ST )1A at date T must be the value at date 0 of receiving
(ST 0 1C K 0 1C )1A at date T 0 . Via the following steps, show that this date–0 value is
p rT 0
p
M(d1 , d01 , T /T 0 ) e K 0 M(d2 , d02 , T /T 0 ) ,
where M(a, b, ⇢) denotes the probability that ⇠1 < a and ⇠2 < b, where ⇠1 and ⇠2 are standard
normals with correlation ⇢.
(i) Show that the value at date 0 of receiving V (T, ST )1A at date T is
rT 0
S0 probS (D) e K 0 probR (D) ,
where D = A \ C.
(ii) Show that probS (D) is the probability that
B⇤ B⇤ 0
p T < d1 and pT < d01 ,
T T0
where
log(S0 /S ⇤ ) + r + 12 2 T
d1 = p ,
T
log(S0 /K ) + r + 12
0 2 T0
d01 = p ,
T0
and where B ⇤ denotes a Brownian motion under probS . Note that the random variables in
p
(15.35) are standard normals under probS with a correlation equal to T /T 0 .
(iii) Show that probR (D) is the probability that
B⇤ B⇤ 0
p T < d2 and pT < d02 ,
T T0
where
p
d2 = d1 T,
p
d02 = d01 T0 ,
and where B ⇤ now denotes a Brownian motion under probR .
(a) This is a digital option. Its value is e rT K probR (A). The calculation of probR (A) is the same
calculation made in Section 15.6, replacing K with S ⇤ . Therefore, the value is e rT K N(d2 ).
(b) (i) The random variable (ST 0 1C K 0 1C )1A equals
ST 0 1C 1A K 0 1C 1A = ST 0 1D K 0 1D .
The random variable ST 0 1D is the payo↵ of a share digital paying on the event D. Following
the same calculation as in Section 15.6, the value at date 0 of this share digital is S0 probS (D).
The random variable K 0 1D is the payo↵ of a digital paying on the event D. Following the
same calculation as in Section 15.6, the value at date 0 of this digital is e rT 0 K 0 probR (D).
(ii) We have ✓ ◆
1
d log S = r+ 2
dt + dB ⇤
2
where B ⇤ is a Brownian motion under probS . The event D occurs if and only if log ST >
log S ⇤ and log ST 0 > log K. This is equivalent to
✓ ◆
1 2
log S0 + r + T + BT⇤ > log S ⇤ ,
2
✓ ◆
1 2
log S0 + r + T 0 + BT⇤ 0 > log K .
2
Rearranging shows that D is the event (15.35).
(iii) We have ✓ ◆
1
d log S = r 2
dt + dB ⇤
2
where B ⇤ is a Brownian motion under probR . The event D occurs if and only if log ST >
log S ⇤ and log ST 0 > log K. This is equivalent to
✓ ◆
1 2
log S0 + r T + BT⇤ > log S ⇤ ,
2
✓ ◆
1 2
log S0 + r T 0 + BT⇤ 0 > log K .
2
Rearranging shows that D is the event (15.36).
15.11. Calculate the value of a call on a put assuming a constant risk-free rate and a constant
volatility for the underlying asset price. Assume the underlying asset does not pay dividends during
[0, T 0 ], where T 0 is the time to maturity of the put. Assume
r(T 0 T )
K<e K0 ,
where K is the exercise price of the call on the put, K 0 is the exercise price of the put, and T is the
time to maturity of the call on the put. This assumption ensures there is some S ⇤ > 0 such that
the Black-Scholes value of the put at time T equals K when ST = S ⇤ .
The call on the put will be in the money at T if ST < S ⇤ . Let A denote the event ST < S ⇤ . The
put will be in the money at T 0 if ST 0 < K. Let C denote this event, and set D = A \ C. The value
at date 0 of the call on the put is the value at date 0 of receiving the cash flows K1A at date
T and K 0 1D ST 0 1D at date T 0 . Following the same calculations as in the previous exercise, the
value at date 0 of the call on the put is
rT 0
e rT
K probR (A) + e K 0 probR (D) S0 probS (D) .
We have ✓ ◆
1
d log S = r 2
dt + dB ⇤
2
where B ⇤ is a Brownian motion under probR . The event A is the event
✓ ◆
1 2
log S0 + r T + BT⇤ < log S ⇤ .
2
B⇤
pT < d2 .
T
Thus, probR (A) = N( d2 ). The event D is the event
✓ ◆
1 2
log S0 + r T + BT⇤ < log S ⇤ ,
2
✓ ◆
1 2
log S0 + r T 0 + BT⇤ 0 < log K .
2
B⇤
pT < d2 ,
T
⇤
B 0
pT < d02 .
T0
Let M(a, b, ⇢) denote the probability that two standard normals with correlation ⇢ are less than a
p
and b respectively. Then probR (D) = M( d2 , d02 , T /T 0 ). We also have
✓ ◆
1 2
d log S = r + dt + dB ⇤
2
where B ⇤ is a Brownian motion under probS . The same calculation shows that probS (D) =
p
M( d1 , d01 , T /T 0 ). Thus, the value at date 0 of the call on the put is
rT 0
p p
e rT
K N(d2 ) + e K 0 M( d2 , d02 , T /T 0 ) S0 M( d1 , d01 , T /T 0 ) .
16
Forwards, Futures, and More Option Pricing
16.1. Under the assumption that S1 and S2 have volatilities i and correlation ⇢, show that
q
d(S1 /S2 ) 2 2
= something dt + 2 + 2 2⇢ 1 2 dB
S1 /S2
for a Brownian motion B. Hint: Use Levy’s theorem.
Set Y = S1 /S2 . We have

✓ ◆✓ ◆ ✓ ◆2
dY dS1 dS2 dS1 dS2 dS2
= +
Y S1 S2 S1 S2 S2
2
= µ1 dt + 1 dB1 µ2 dt 2 dB2 ⇢ 1 2 dt + 2 dt
2
= (µ1 µ2 ⇢ 1 2 + 2 ) dt + 1 dB1 2 dB2 .
Define
q
= 2 2⇢ + 2
1 1 2 2,
B0 = 0, and
1
dB = ( 1 dB1 2 dB2 ) .
Then B is a Brownian motion by Levy’s theorem, and
dY 2
= (µ1 µ2 ⇢ 1 2 + 2 ) dt + dB .
Y
16.2. This exercise implements Merton’s formula when the discount bond price is given by the
Vasicek model (Section 17.1).  is the rate of mean reversion of the short rate process, and is the
(absolute) volatility of the short rate process.
160 16 Forwards, Futures, and More Option Pricing
Suppose the price of a non-dividend-paying stock has a constant volatility . Assume the volatility
at date t of a discount bond maturing at T > t is
⇣ ⌘
(T t)
1 e

for constants  > 0 and > 0. Assume the discount bond and stock have a constant correlation ⇢.
(a) Using the result of the previous exercise, write the volatility of S/P (T ) as a function (t).
(b) Define s
Z T
1
avg = (t)2 dt .
T 0
Show that
 ✓ T
◆ ✓ ◆
2 2 1 2 2 1 e 2 1 e 2T
avg = + 2 2⇢ (2 2⇢ ) + .
 T 2T
(c) Use l’Hôpital’s rule to show that for small T , avg ⇡ .
(d) Show that avg > for large T if ⇢ is sufficiently small.
(a) Taking S1 = S and S2 = P in the previous exercise, it follows that the volatility of S/P is
r
2 2⇢
2
(t) = 2+
2
1 e (T t) 1 e (T t) .
 
(b) We have
Z Z ⇣ Z T⇣ ⌘ ⌘
1 T 2 T
2⇢
(t)2 dt = 2
+ 1 2e (T t)
+e 2(T t)
1 e (T t) dt
dt
T 0 2 T T 0
2
0 
2 2 T 1 2T 2⇢ 1
= S + T 1 e + 1 e T 1 e T
2 T  2 T 
 ✓ ◆ ✓ ◆
2 1 2 2 1 e T 2 1 e 2T
= + 2 2⇢ (2 2⇢ ) +
 T 2T
(c) By l’Hôpital’s rule,
1 e T 1 e 2T
lim = lim = 1.
T !0 T T !0 2T
Therefore,
Z T
1
lim (t)2 dt = 2
.
T !0 T 0
(d) We have
Z T 2
1 2⇢
lim (t)2 dt = 2
+ .
T !1 T 0 2
This is larger than 2 if and only if
2⇢ > 0 , ⇢< .

2
16 Forwards, Futures, and More Option Pricing 161
16.3. Consider a forward contract on an asset that pays a single known discrete dividend at a
known date T < u, where u is the date the forward matures. Suppose there are traded discount
bonds maturing at T and u. Prove the following spot-forward parity formula for t < T :
St Pt (T )
Ft (u) = .
Pt (u)
To create a synthetic long forward, buy the asset at date t by shorting units of the discount bond
maturing at T and
St Pt (T )
Pt (u)
units of the discount bond maturing at u. The short sales produce revenue at t equal to
Pt (T ) + St Pt (T ) = St ,
which is sufficient to buy a unit of the asset. Use the dividend paid at T to cover the short position
in the date–T bond. At date u, one will own the asset and owe
St Pt (T )
.
Pt (u)
Thus, this must be the forward price.
16.4. Consider a European call option on an asset that pays a single known discrete dividend at
a known date T < u, where u is the date the option expires. Assume the asset price S drops by
when it goes ex-dividend at date T (i.e., ST = limt"T St ) and otherwise is an Itô process. Suppose
there are traded discount bonds maturing at T and u. Assume the volatility of the following process
8
>
<(St Pt (T ))/Pt (u) if t < T ,
Zt =
>
:S /P (u)
t t if T  t  u ,
is a constant during [0, u]. Show that the value at date 0 of the call option is
yu
(S0 P0 (T )) N(d1 ) e K N(d2 ) ,
where y is the yield at date 0 of the discount bond maturing at u and

1 2
log((S0 P0 (T ))/K) + y + 2 u
d1 = p ,
u
p
d2 = d1 u.
The process Z is the forward price of the asset, for a forward contract maturing at u. A call maturing
at u on a forward maturing at u is equivalent to a call maturing at u on the underlying asset. So,
Black’s formula gives the date–0 value of the call. Substituting u for the time to maturity of the
option, P0 (u) = e yu , and
S0 P0 (T )
F0 (u) =
P0 (u)
in Black’s formula yields the result.
16.5. The purpose of this exercise is to explain why exchange options can be priced by arbitrage
without assuming the existence of a money market account or traded discount bonds. The steps
are similar to those in the market completeness proof in Section 15.5.
Suppose the prices of two non-dividend-paying assets are given by

dSi
= µi dt + i dBi ,
Si
where the Bi are Brownian motions under the physical measure with correlation ⇢. The µi , i
and ⇢ can be stochastic processes. However, assume the volatility of S1 /S2 is a constant (this
assumption can be relaxed somewhat). Assume there is an SDF process such that M S1 and M S2
are martingales. Let XT = S2T f (S1T /S2T ) for some nonnegative function f , for example, f (a) =
max(0, a 1) as in (16.8). Assume E[MT XT ] < 1. Define Z = S1 /S2 .
(a) Show that

dZ
= dB ⇤ ,
Z
where B ⇤ is a Brownian motion under the probability measure probS2 and satisfies
dB ⇤ = (µ1 µ2 ⇢ 2 2 + 2
2 ) dt + 1 dB1 2 dB2 .
(b) Show that

Z t
ESt 2 [f (ZT )] S2
= E [f (ZT )] + ⇤
s dBs
0
for some stochastic process and all 0  t  T .
(c) Define Wt = S2t ESt 2 [f (ZT )]. Note that WT = XT . Show that W is a self-financing wealth process
generated by the portfolio process in which the fraction
S2
⇡=
W
of wealth is invested in asset 1 and 1 ⇡ is invested in asset 2.
(a) Itô’s formula implies

✓ ◆✓ ◆ ✓ ◆2
dZ dS1 dS2 dS1 dS2 dS2
= +
Z S1 S2 S1 S2 S2
2
= (µ1 µ2 ⇢ 1 2 + 2 ) dt + 1 dB1 2 dB2 .
On the other hand, Z is a martingale under probS2 with the same volatility as under the physical
measure. Hence,
dZ
= dB ⇤ ,
Z
for a Brownian motion B ⇤ under probS2 , where
q
= 2 + 2 2⇢
1 2 1 2.
(b) We have
2 T /2+ BT⇤
ZT = Z0 e .
This implies that the distribution under probS2 of f (ZT ) conditional on date–t information
depends only on Bt⇤ . Thus, ESt 2 [f (ZT )] is a martingale adapted to B ⇤ . The claim follows from
the martingale representation theorem.
(c) Writing ✓ ◆
W
W = S2
S2
and applying Itô’s formula gives
✓ ◆ ✓ ◆✓ ◆
dW dS2 S2 W S2 dS2 W
= + d + d .
W S2 W S2 W S2 S2
Given that W/S2 = ESt 2 [f (ZT )], we have
W
d = dB ⇤ = (µ1 µ2 ⇢ 1 2 + 2
2 ) dt + ( 1 dB1 2 dB2 ) .
S2
Making this substitution produces
dW S2 2 S2
= µ2 dt + 2 dB2 + (µ1 µ2 ⇢ 1 2 + 2 ) dt + ( 1 dB1 2 dB2 )
W W W
S2
+ ( 2 dB2 )( 1 dB1 2 dB2 )
✓ W
◆ ✓ ◆
S2 dS1 S2 dS2
= + 1 .
W S1 W S2
16.6. This exercise derives Margrabe’s formula without relying on the Black-Scholes formula. The
steps are similar to those in the proof of the Black-Scholes formula in Chapter 15.
Adopt the assumptions of Exercise 16.5. Let A denote the event S1T > S2T .
(a) Show that, for i = 1, 2,

E[MT SiT 1A ] = Si0 probSi (A) .
Conclude that the value at date 0 of an option to exchange asset 2 for asset 1 at date T is
S10 probS1 (A) S20 probS2 (A) .
(b) Define Y = S2 /S1 . Show that
1
d log Y = 2
dt + dB ⇤ ,
2
where B ⇤ is a Brownian motion under the probability measure probS1 . Use this fact and the
fact that A is the event log YT < 0 to show that probS1 (A) = N(d1 ), where
1 2
log(S10 /S20 ) + 2 T
d1 = p .
T
(c) Define Z = S1 /S2 . Show that
1
d log Z = 2
dt + dB ⇤ ,
2
where B ⇤ is a Brownian motion under the probability measure probS2 . Use this fact and the
fact that A is the event log ZT > 0 to show that probS2 (A) = N(d2 ), where
p
d2 = d1 T.
(a) We have 
MT SiT
E[MT SiT 1A ] = Si0 E 1A = Si0 ESi [1A ] = Si0 probSi (A) .
Si0
The payo↵ of the exchange option is S1T 1A S2T 1A , and its value at date 0 is
E[MT S1T 1A ] E[MT S2T 1A ] = S10 probS1 (A) S20 probS2 (A) .
(b) Y is a martingale under probS1 with the same volatility under probS1 as under the physical
measure. Thus,
dY
= dB ⇤ ,
Y
p
where B ⇤ is a Brownian motion under probS1 and = 2
1 + 2
2 2⇢ 1 2. This implies
1
d log Y = 2
dt + dB ⇤ .
2
Thus,
1
log YT = log Y0 2
T + BT⇤ .
2
The event A is the event log YT < 0, which is equivalent to
1 2
B⇤ log Y0 + T
pT < p 2
= d1 .
T T
Thus, probS1 (A) = N(d1 ).
(c) The same reasoning as in the previous part yields
1
log ZT = log Z0 2
T + BT⇤ ,
2
where B ⇤ is a Brownian motion under probS2 . The event A is the event log ZT > 0, which is
equivalent to
B⇤ log Z0 12 2T
pT < p = d2 .
T T
Thus, probS2 (A) = N(d2 ).
16.7. This exercise follows the steps in the derivation of the PDE’s for the Heston (1993) option
pricing model, using a di↵erent volatility process.
Set Vt = log t, where t is the volatility of a non-dividend-paying asset with price S. Assume
dSt
= µt dt + t dB1t ,
St
h p i
dVt = (✓ Vt ) dt + ⇢ dB1t + 1 ⇢2 dB2t ,
where µ, , ✓, and ⇢ are constants, and B1 and B2 are independent Brownian motions under the
physical probability measure. Assume there is a constant risk-free rate.
(a) Show that any SDF process must satisfy
dMt µt r d"t
= r dt dB1t t dB2t + ,
Mt t "t
for some stochastic process , where " is a local martingale uncorrelated with B1 and B2 .
(b) Assume that in the previous part is a constant. Show that
dSt ⇤
= r dt + t dB1t ,
St
⇢(µt r) h p i
dVt = ⇤ (✓⇤ Vt ) dt dt + ⇤
⇢ dB1t + 1 ⇤
⇢2 dB2t ,
t
for some constants ⇤ and ✓⇤ , where B1⇤ and B2⇤ are independent Brownian motions under the
risk neutral probability corresponding to M .
(c) Let W (t, St , Vt ) denote the conditional probability probR
t (ST > K) for a constant K. Show that
W must satisfy the PDE

⇥ ⇤ 1 1
Wt + rSWS + ⇤ ✓⇤ ⇤ V ⇢(µ r)e V
WV + e2V S 2 WSS + 2
WV V + ⇢eV SWSV = 0 .
2 2
(a) As shown in the previous chapter,
dM µ r d
= r dt dB1 + ,
M
where is a local martingale uncorrelated with B1 . Define by

✓ ◆
d
dt = (dB2 ) ,
and set
d" d
= + dB2 .
"
Then, we have
dM µ r d"
= r dt dB1 dB2 + ,
M "
and
✓ ◆ ✓ ◆
d" d
(dB1 ) = (dB1 ) + (dB2 )(dB1 ) = 0 ,
"
✓ ◆ ✓ ◆
d" d
(dB2 ) = (dB2 ) + (dB2 )2
"
= dt + dt = 0 .
(b) By Girsanov’s theorem,
µ r
dB1⇤ = dB1 + dt and dB2⇤ = dB2 + dt
define Brownian motions under the risk neutral probability. Substituting yields
dS
= r dt + dB1⇤ ,
S
⇢(µ r) p p
dV = (✓ V ) dt dt 1 ⇢2 dt + [⇢ dB1⇤ + 1 ⇢2 dB2⇤ ]
⇢(µ r) p
= (✓⇤ V ) dt dt + [⇢ dB1⇤ + 1 ⇢2 dB2⇤ ] ,
where p
⇤ 1 ⇢2
✓ =✓ .

(c) From Itô’s formula, the drift of dW is

⇢(µ r) 1 1
Wt + rSWS + (✓⇤ V ) WV + 2 2
S WSS + 2
WV V + ⇢SWSV .
2 2
Setting this to zero yields the PDE.
16.8. This problem is adapted from Hull and White (1987).
Assume
dSt
= µt dt + t dB1t ,
St
d t = ( t ) dt + ( t ) dB2t ,
for some functions (·) and (·), where B1 and B2 are independent Brownian motions under the
physical probability measure and µ may be a stochastic process. Assume t in (16.26) equals
( t ) for some function (·). Assume there is a constant risk-free rate and the asset does not pay
dividends.
(a) Show that
dSt ⇤
= r dt + t dB1t ,
St
⇤ ⇤
d t = ( t ) dt + ( t ) dB2t ,
for some function ⇤ (·), where B1⇤ and B2⇤ are independent Brownian motions under the risk
neutral probability.
(b) Use iterated expectations to show that the date–0 value of a call option equals
⇥ ⇤
ER S0 N(d1 ) e rT
K N(d2 ) ,
where
1 2
log(S0 /K) + r + 2 avg T
d1 = p ,
avg T
p
d2 = d1 avg T ,
and the risk-neutral expectation in (16.27) is taken over the random “average” volatility
s
Z
1 T 2
avg = dt
T 0 t
on which d1 and d2 depend. This average volatility is explained in a nonrandom context in
Section 15.12.
(c) Implement the Black-Scholes formula numerically. Plot the value of an at-the-money (S0 = K)
call option as a function of the volatility . Observe that the option value is approximately an
affine (linear plus constant) function of .
(d) Explain why the value of an at-the-money call option on an asset with random volatility is
approximately given by the Black-Scholes formula with
2s 3
Z T
1
ER 4 2 dt5
T 0 t
input as the volatility.

(e) From Part (c), one should observe that the Black-Scholes value is not exactly linear in the
volatility. Neither is it uniformly concave nor uniformly convex; instead, it has di↵erent shapes
in di↵erent regions. Explain why if it were concave (convex) over the relevant region, then the
Black-Scholes formula with 2s 3
Z T
1
ER 4 2
t dt
5
T 0
input as the volatility would overstate (understate) the value of the option.
(a) Setting
µ r
dB1⇤ = dB1 + dt and dB2⇤ = dB2 + dt
yields
dS
= r dt + dB1⇤ ,
S
d = ( ) dt + ( )[dB2⇤ ( ) dt]
⇤
= ( ) dt + ( ) dB2⇤ ,
where
⇤
( )= ( ) ( ) ( ).
(b) Conditioning on avg , log ST is normally distributed under probR with mean
✓ ◆
1 2
log S0 + r T
2 avg
and variance 2T . We know that, given this distribution, the mean of e rT max(0, ST K) is
S0 N(d1 ) e rT K N(d2 ). By iterated expectations,
⇥ ⇤
ER [e rT
max(0, ST K)] = ER ER [e rT
max(0, ST K) | avg ]
= ER [S0 N(d1 ) e rT
K N(d2 )] .
(d) If f is an affine function and x̃ is a random variable, then E[f (x̃] = f (E[x̃]). Because the function
rT
avg 7! S0 N(d1 ( avg )) e K N(d2 ( avg ))
is approximately affine, we have
ER [S0 N(d1 ( avg )) e rT

K N(d2 ( avg ))] ⇡ S0 N(d1 (ER [ avg ])) e rT
K N(d2 (ER [ avg ])) .
(e) If f is a concave function, then Jensen’s inequality states that E[f (x̃]  f (E[x̃]). Thus, if the
function
rT
avg 7! S0 N(d1 ( avg )) e K N(d2 ( avg ))
were concave, we would have
ER [S0 N(d1 ( avg )) e rT

K N(d2 ( avg ))]  S0 N(d1 (ER [ avg ])) e rT
K N(d2 (ER [ avg ])) .
16.9. This exercise generalizes the price of risk specification in the Heston model. Under the
condition in Part (d), it is a member of the extended affine family defined by Cheridito, Filipović,
and Kimmel (2007), and M R is a martingale. Part (a) transforms the vector process (log S, V ) into
a “standard form.” See Section 16.9 for discussion, including the significance of the condition in
Part (d). The usefulness of generalizing the price of risk process is that it permits more flexible
dynamics under the physical measure (and hence more flexible expected returns) while preserving
the pricing formulas (that depend on dynamics under the risk neutral probability).
In the Heston model (16.17), define Y1 = V / 2 and Y2 = log S ⇢V / .

(a) Derive the constants ai , bij and such that

0 1 0 1 0 10 1 0p 10 1
dY1 a1 b11 b12 Y1 Y1 0 dB1
@ A = @ A dt + @ A @ A dt + @ A@ A.
p
dY2 a2 b21 b22 Y2 0 Y1 dB2
(b) Consider a price of risk specification
10 + 11 Y1t
1t = p ,
Y1t
20 + 21 Y1t
2t = p ,
Y1t
for constants ij . The specification in Section 16.8 is the special case 10 = 0. Derive 20 and
21 as functions of 10 and 11 from the fact that (16.19) must hold for all V .
(c) Assume that M defined in terms of 10 and 11 is such that M R is a martingale. Derive
constants a⇤i and b⇤ij in terms of 10 and 11 such that
0 1 0 1 0 10 1 0p 10 1
dY1 a⇤1 b⇤11 b⇤12 Y1 Y1 0 dB1⇤
@ A = @ A dt + @ A @ A dt + @ A@ A,
p
dY2 a⇤2 b⇤21 b⇤22 Y2 0 Y1 dB2⇤
where the Bi⇤ are independent Brownian motions under the risk-neutral probability.
(d) Assume ✓/ 2 1/2. Under what condition on 10 is a⇤1 1/2?
(a) We have
1
dY1 = 2
dV
p
 V
= 2
(✓ V ) dt + dB1
✓ p
= 2
dt Y1 dt + Y1 dB1 ,
⇢
dY2 = d log S dV
✓ ◆ p
1 ⇢ p p
= µ V dt (✓ V ) dt + V [⇢ dB1 + 1 ⇢2 dB2 ] ⇢ V dB1
2
✓ ◆ 2 p p
⇢✓
= µ dt Y1 dt + ⇢ Y1 dt + 1 ⇢2 Y1 dB2 .
2
Thus, 0 1 0 1 0 1 0 1
a1 ✓/ 2 b11 b12  0
@ A=@ A, @ A=@ A,
a2 µ ⇢✓/ b21 b22 2 /2 + ⇢ 0
and = 2 (1 ⇢2 ).
(b) Given
1/2 1/2 20 1/2 21 1/2

1 = 10 Y1 + 11 Y1 , and 2 = p Y1 + p Y1 ,
1 ⇢2 1 ⇢2
the condition (16.19) is equivalent to

✓ ◆ ✓ ◆ ✓ ◆
20 1/2 21 1/2 µ r 1/2
⇢ 10 + Y1 + ⇢ 11 + Y1 = Y1 .
1/2
Multiplying by Y1 and noting that this must hold for all values of Y1 , we obtain
20 µ r
⇢ 10 + = ,
21
⇢ 11 + = 0.
Thus,
20 =µ r ⇢ 10 ,
21 = ⇢ 11 .
(c) By Girsanov’s theorem,
dB1⇤ = dB1 + 1 dt ,
dB2⇤ = dB2 + 2 dt
are Brownian motions under the risk-neutral probability. Making these substitutions yields
0p 10 1 0p 10 1 0 1
Y1 0 dB1 Y1 0 dB1⇤ + Y
@ A@ A=@ A@ A @ 10 11 1
A dt .
p p ⇤
0 Y1 dB2 0 Y1 dB2 20 + Y
21 1
Thus, 0 1 0 1 0 1
a⇤ a ✓/ 2
@ 1A = @ 1 10
A=@ 10
A,
a⇤2 a2 20 r ⇢✓/ + ⇢ 10
and 0 1 0 1 0 1
b⇤11 b⇤12 b11 11 b12  11 0
@ A=@ A=@ A.
b⇤21 b⇤22 b21 21 b22 2 /2 + ⇢ + ⇢ 11 0
(d) a⇤1 1/2 if and only if ✓/ 2 1/2 10 .

16.10. This exercise values an American call on an asset paying a known discrete dividend at a
known date. Part (c) is similar to the valuation of a compound option in Exercise 15.10.
Consider an American call option with strike K on an asset that pays a single known discrete
dividend at a known date T < u, where u is the date the option expires. Assume the asset price
S drops by when it goes ex-dividend at date T (i.e., ST = limt"T St ) and otherwise is an Itô
process. Assume there is a constant risk-free rate.
(a) Show that if < 1 e r(u T ) K, then the call should not be exercised early.
For the remainder of this exercise, assume > 1 e r(u T ) K. Assume the volatility of the
following process 8
>
< St r(T t)
e if t < T ,
Zt =
>
:S
t if T  t  u ,
is constant over [0, u]. Note that Z is the value of the following non-dividend-paying portfolio:
borrow e r(T t) at any date t < T to partially finance the purchase of the asset and use its
dividend to repay the debt. Let V (t, St ) denote the value of a European call on the asset with strike
K maturing at u. Let S ⇤ denote the value of the stock price just before T such that the holder of
the American option would be indi↵erent about exercising just before the stock goes ex-dividend.
This value is given by S ⇤ K = V (T, S ⇤ ). Exercise is optimal just before T if limt"T St > S ⇤ ;
equivalently, ST > S ⇤ . Let A denote the event ST > S ⇤ and let C denote the set of states
of the world such that ST  S ⇤ and Su > K. The cash flows to a holder of the option who
exercises optimally are (ST + K)1A at (or, rather, “just before”) date T and (Su K)1C at
date u.
(b) Show that the value at date 0 of receiving (ST + K)1A at date T is
rT rT
S0 e N(d1 ) e (K ) N(d2 ) ,
where
1 2
log(S0 e rT ) log(S ⇤ )+ r+ 2 T
d1 = p ,
T
p
d2 = d1 T.
(c) Show that the value at date 0 of receiving (Su K)1C at date u is
p p
S0 e rT
M( d1 , d01 , T /u) e ru
K M( d2 , d02 , T /u) ,
where M(a, b, ⇢) denotes the probability that ⇠1 < a and ⇠2 < b when ⇠1 and ⇠2 are standard
normal random variables with correlation ⇢, and where
rT 1 2
log(S0 e ) log K + r + u
d01 = p 2
,
u
p
d02 = d01 u.
(a) Exercise is optimal just before T if and only if ST + K exceeds the value of the call at T .
The value of the call at T is bounded below by ST e r(u T ) K. Thus, a necessary condition
for exercise to be optimal is that
r(u T ) r(u T )
ST + K > ST e K , > (1 e )K .
(b) The cash flow ST 1A = ZT 1A is a share digital paying in the event A = {ZT > S ⇤ }. Its value
at date 0 is
Z0 probZ (A) = (S0 e rT
) N(d1 ) ,
where
⇣ ⌘
Z0 1 2
log S⇤ + r+ 2 T log(S0 e rT ) log(S ⇤ )+ r+ 1 2
T
p p 2
d1 = = .
T T
The cash flow ( K)1A is a share digital paying in the event A = {ZT > S ⇤ }. Its value at
date 0 is
rT
e ( K) probR (A) = e rT
( K) N(d2 ) .
(c) The cash flow Su 1C = Zu 1C is a share digital paying in the event C = {ZT  S ⇤ , Zu > K}.
Its value at date 0 is
Z0 probZ (C) = (S0 e rT
) probZ (C) .
To calculate probZ (C), recall that

✓ ◆
1
d log Z = r+ 2
dt + dB ⇤ ,
2
where B ⇤ is a Brownian motion under probZ . Thus, the event C is equivalent to
✓ ◆
1 2
log Z0 + r + T + BT⇤  log(S ⇤ ),
2
✓ ◆
1 2
log Z0 + r + u + Bu⇤ > log K .
2
1 2
B⇤ log(S ⇤ ) log Z0 r+ 2 T
pT  p = d1 ,
T T
1 2
B⇤ log Z0 log K + r + u
pu < p 2
= d01 .
u u
(d) The cash flow K1C = Zu 1C is a digital paying in the event C = {ZT  S ⇤ , Zu > K}. Its
value at date 0 is e ru K probR (C). To calculate probR (C), recall that
✓ ◆
1 2
d log Z = r dt + dB ⇤ ,
2
where B ⇤ is a Brownian motion under probR . Thus, the event C is equivalent to

✓ ◆
1 2
log Z0 + r T + BT⇤  log(S ⇤ ),
2
✓ ◆
1 2
log Z0 + r u + Bu⇤ > log K .
2
1 2
B⇤ log(S ⇤ ) log Z0 r 2 T
pT  p = d2 ,
T T
1 2
Bu⇤ log Z0 log K + r u
p < p 2
= d02 .
u u
17
Term Structure Models
17.1. In the Vasicek model, set f (t, r) = exp( ↵(T t) (T t)r).
(a) Show that f satisfies the fundamental PDE and the boundary condition f (T, r) = 1 if and only
if
0
+  = 1,
1
↵0 ✓ + 2 2
= 0,
2
and ↵(0) = (0) = 0.

(b) Verify that the formula (17.6) for yields with (⌧ ) = ⌧ b(⌧ ) and ↵(⌧ ) = ⌧ a(⌧ ) satisfies these
conditions.
(a) The fundamental PDE for the Vasicek model is
1 2
ft + (✓ r)fr + frr = rf .
2
Taking f (t, r) = exp( ↵(T t) (T t)r) implies
ft = (↵0 + 0
r)f ,
fr = f,
2
frr = f.
Substituting these into the fundamental PDE yields
1
↵0 + 0
r (✓ r) + 2 2
= r.
2
For this to hold for all values of r, we must have

176 17 Term Structure Models
1
↵0 ✓ + 2 2
= 0,
2
0
+  = 1.
Also, f (T, r) = 1 implies ↵(0) + (0)r = 0. For this to hold for all values of r, we must have
↵(0) = (0) = 0.
(b) From (17.6c), we have
1 e ⌧
(⌧ ) = ,

0 ⌧
(⌧ ) = e ,
0 ⌧ ⌧
(⌧ ) +  (⌧ ) = e +1 e = 1,
(0) = 0 .
Also, (17.6c) implies

✓ 2
◆ ✓ 2
◆
✓2 ⌧
2
2⌧
↵(⌧ ) = ✓ ⌧+ 1 e 1 e ,
22 3 43
2
✓ 2 ◆ 2
↵0 (⌧ ) = ✓ + ✓ e ⌧ e 2⌧
,
22 2 22
2
✓ 2
◆ 2
1
↵0 (⌧ ) ✓ (⌧ ) + 2 2
(⌧ ) = ✓ + ✓ e ⌧ e 2⌧
2 22 2 22
2
⌧ ⌧ 2⌧
✓ 1 e + 1 2e +e
22
= 0,
↵(0) = 0 .
17.2. Consider a single-factor affine model as defined in (17.15).
(a) Show that

p
dr = dt r dt + ↵ + r dB ⇤
for constants , , ↵ and .

(b) Assume > 0 in (17.35). Show that r is a translation of a square-root process — i.e., there
exists ⌘ and Y such that
rt = ⌘ + Y t ,
p
dY = ˆ dt ̂Y dt + ˆ Y dB ⇤ .
ˆ and ˆ .
for constants ̂, ✓,
17 Term Structure Models 177
(c) The condition ˆ > 0 is necessary and sufficient for Yt 0 for all t in (17.36b) and hence for the
square root to exist. Assuming > 0, what are the corresponding conditions on the coefficients
in (17.35) that guarantee ↵ + rt 0 for all t?
(a) Assume
r= 0 + 1X ,
p
dX = ⌘ dt + kX dt + a + bX dB ⇤ ,
with 1 6= 0. Then
p
dr = 1 ⌘ dt + 1 kX dt + 1 a + bX dB ⇤
✓ ◆ s ✓ ◆
r 0 r 0
= 1 ⌘ dt + 1k dt + 1 a + b dB ⇤
1 1
q
= ( 1⌘ k 0 ) dt + kr dt + a 12 b 0 1 + b 1 r, dB ⇤
p
= dt r dt + ↵ + r dB ⇤ ,
where = 2
1⌘ k 0,  = k, ↵ = a 1 b 0 1, and = b 1.
(b) Define ⌘ = ↵/ and Y = r ⌘. Then
p
dY = dr = dt r dt + ↵ + r dB ⇤ ,
p
= dt (⌘ + Y ) dt + ↵ + (⌘ + Y ) dB ⇤ ,
p
= ˆ dt ̂Y dt + ˆ Y dB ⇤ ,
p
where ˆ = ⌘, ̂ = , and ˆ = .
(c) We have
↵ + r = ↵ + (⌘ + Y ) = Y .
Thus, Y 0 , ↵+ r 0. Because ˆ = ⌘ = + ↵/ , the condition ˆ > 0 is equivalent

to + ↵ > 0.
17.3. Consider a two-factor affine model with Gaussian factors — i.e., (Xt ) in (17.15) is a constant
matrix. Show that the two factors can be taken to be the short rate and its drift in the sense that
⇤
drt = Yt dt + dZ1t ,
⇤ ⇤
dYt = (a + brt + cYt ) dt + ⇣1 dZ1t + ⇣2 dZ2t
for constants , a, b, c, ⇣1 and ⇣2 and independent Brownian motions Zi⇤ under the risk neutral
probability.
Assume
r= 0 + 1 X1 + 2 X2 ,
and 0 1 0 1 0 10 1 0 10 1
X1 ✓1 k11 k12 X1 dB ⇤
11 12
d @ A = @ A dt + @ A @ A dt + @ A @ 1A .
X2 ✓2 k21 k22 X2 21 22 dB2⇤
Define 0 1 0 10 1
⇣ ⌘ ✓ ⇣ ⌘ k11 k12 X
Y = 1 2
@ 1A + 1 2
@ A @ 1A .
✓2 k21 k22 X2
Then
0 10 1
⇣ ⌘ 11 12 dB1⇤
dr = Y dt + 1 2
@ A@ A
21 22 dB2⇤
⇤ ⇤
= Y dt + 1 dB1 + 2 dB2
for constants 1 and 2. Also,

0 10 1 0 10 10 1
⇣ ⌘ k11 k12 ✓ ⇣ ⌘ k11 k12 k11 k12 X
dY = 1 2
@ A @ 1 A dt + 1 2
@ A@ A @ 1 A dt
k21 k22 ✓2 k21 k22 k21 k22 X2
0 10 10 1
⇣ ⌘ k11 k12 dB ⇤
+ 1 2 @ A @ 11 12
A @ 1A .
k21 k22 21 22 dB2⇤
Furthermore, 0 1 0 1
r 0 X1
@ A = L@ A,
P2
Y i=1 i ✓i X2
where 0 1
1 2
L = @P P2
A.
2
i=1 i ki1 i=1 i ki2
If L is singular, then 0 1
2
X ⇣ ⌘ X1
Y i ✓i = 1 2
@ A = (r 0)
i=1 X2
for some , which implies
0 10 1
⇣ ⌘ 11 12 dB1⇤
dY = dr = Y dt + 1 2
@ A@ A.
dB2⇤
21 22
If L is nonsingular, then we have

0 1 0 1
X2 r 0
@ A=L 1@ A.
P2
X2 Y i=1 i ✓i
Hence,
0 10 1 0 10 1 0 1
⇣ ⌘ k11 k12 ✓ ⇣ ⌘ k11 k12 k k r
dY = @ A @ 1 A dt + @ A @ 11 12 A L 1 @ 0
A dt
1 2 1 2 P2
k21 k22 ✓2 k21 k22 k21 k22 Y i=1 i ✓i
0 10 10 1
⇣ ⌘ k11 k12 11 12 dB1⇤
+ 1 2 @ A@ A@ A.
k21 k22 dB2⇤
21 22
In either case,
dY = (a + br + cY ) dt + ⌘1 dB1⇤ + ⌘2 dB2⇤
for constants a, b, c, ⌘1 and ⌘2 .

p
Define = 2 2
1 + 2 and
1
dZ1⇤ = ( ⇤
1 dB1 + ⇤
2 dB2 ) .
Then Z1⇤ is a Brownian motion under the risk neutral probability, and
dr = Y dt + dZ1⇤ .
Let ⇠ be a vector of unit length that is orthogonal to ( 0, )0 . Define

1 2) e.g., ⇠ = ( 2 / 1/
dZ2⇤ = ⇠1 dB1⇤ + ⇠2 dB2⇤ .
Then, under the risk neutral probability, Z2⇤ is a Brownian motion that is independent of Z1⇤ .
Defining
0 1 0 1 10 1
⇣ / ⇠1 ⌘1
@ 1A = @ 1 A @ A,
⇣2 2/ ⇠2 ⌘2
we have
0 1
⇣
dB1⇤ ⌘
dY = (a + br + cY ) dt + ⌘1 ⌘2 @ A
dB2 ⇤
0 10 1
⇣ ⌘ 1/ 2/ dB1⇤
= (a + br + cY ) dt + ⇣1 ⇣2 @ A@ A
⇠1 ⇠2 dB2⇤
0 1
⇣ ⌘ dZ ⇤
1A
= (a + br + cY ) dt + ⇣1 ⇣2 @ .
dZ2⇤
17.4. This exercise shows that the factors in a two-factor CIR model can be taken to be the short
rate and its volatility. This idea is developed by Longsta↵ and Schwartz (1992).
Suppose r is the sum of two independent square-root processes X1 and X2 as in Section 17.3. Define
Yt = 2 2
1 X1t + 2 X2t . Note that the instantaneous variance of r = X1 + X2 is
⇣ p p ⌘2
⇤ ⇤
1 X1t dB1t + 2 X2t dB2t = Yt dt .
Assume 1 6= 2. Show that

0 1 0 1
dr r
@ A= dt + K @ A dt + ⌃S(r, Y ) dB ⇤ ,
dY Y
for a constant vector , and constant matrices K and ⌃, where S(r, Y ) is a diagonal matrix the
squared elements of which are affine functions of (r, Y ).
It is without loss of generality to take 1 > 0 and 2 > 0 (because Bi⇤ can be used as the Brownian
motion if necessary). It is also with loss of generality to take 1 > 2 (because X1 and X2 can be
reordered if necessary). From r = X1 + X2 and Y = 2 2
1 X1 + 2 X2 , we obtain
Y 2 2
2r 1r Y
X1 = 2 2 , and X2 = 2 2 .
1 2 1 2
We have
0 1 0 10 1 0 10 1 0 p 10 1
X1 1 0 ✓1 1 0 X1 1 X1 0 dB1⇤
d@ A = @ A @ A dt @ A @ A dt + @ p A @ ⇤A
X2 0 2 ✓2 0 2 X2 0 2 X2 dB2
0 10 1 0 10 1
1 0 ✓ 2 1 r
A @ 1 A dt + 1 @ 2
=@ 2 2
A @ A dt
0 2 ✓2 2
1 2 1 1 Y
0 p 10 1
Y 2r 0 dB ⇤
1 @ 1 2 A @ 1A .
+p 2 2 p
1 2 0 2
2
1r Y dB2⇤
Thus,
0 1 0 10 1
r 1 1 dX1
d@ A = @ A@ A
Y 2 2 dX
1 2 2
0 10 10 1 0 10 10 1
1 1 1 0 ✓ 1 1 2 1r
A @ 1 A dt + 1 2
=@ A@
2 2
@ A@ A @ A dt
2 2 0 2 ✓2 2 2 2
1 2 1 2 1 2 1 1 Y
0 10 p 10 1
1 1 1 Y 2
2r 0 dB1⇤
+p 2 @ A@ 1 p A @ A.
2 2 2 2r ⇤
1 2 1 2 0 2 1 Y dB 2
17.5. This exercise develops the completely affine version of the Vasicek model.
Assume the short rate is an Ornstein-Uhlenbeck process under the physical measure; i.e.,
dr = ̂(✓ˆ r) dt + dB ,
for constants ̂, ✓ˆ and , where B is a Brownian motion under the physical measure. Assume there
is an SDF process M with
dM d"
= r dt dB + ,
M "
where is a constant and " is a local martingale uncorrelated with B.
(a) Show that the short rate is an Ornstein-Uhlenbeck process under the risk neutral probability
corresponding to M (i.e., the Vasicek model holds).
(b) Show that the risk premium of a discount bond depends only on its time to maturity and is
independent of the short rate.
(a) Girsanov’s theorem states that B ⇤ is a Brownian motion under the risk neutral probability,
where dB ⇤ = dB + dt. We have
dr = ̂(✓ˆ r) dt + (dB ⇤ dt)
= (✓ r) dt + dB ⇤ ,
where  = ̂ and ✓ = ✓ˆ /.

(b) The price at t of a discount bond maturing at T is
↵(⌧ ) (⌧ )rt
e ,
where ⌧ = T t, ↵(⌧ ) = ⌧ a(⌧ ), (⌧ ) = ⌧ b(⌧ ), and a(·) and b(·) are the functions given in (17.6).
Setting Xt = ↵(T t) (T t)rt , Itô’s formula implies that the return of a discount bond is
1 1
dX + (dX)2 = ↵0 (⌧ ) dt + 0
(⌧ )r dt (⌧ ) dr + 2
(⌧ )(dr)2
2 2
1
= ↵0 (⌧ ) dt + 0
(⌧ )r dt (⌧ )(✓ˆ r) dt (⌧ ) dB + 2
(⌧ ) 2
dt .
2
Therefore, the risk premium of a discount bond is

✓ ◆✓ ◆
dM dP
= ( dB)( (⌧ ) dB) = (⌧ ) dt .
M P
An alternative calculation of the risk premium uses the the fundamental PDE (Exercise 17.1).
The fundamental PDE is
1
↵0 (⌧ ) ✓ (⌧ ) + 2 2
(⌧ ) = 0 ,
2
0
(⌧ ) +  (⌧ ) = 1 .
The first equation is equivalent to
1
↵0 ✓ˆ (⌧ ) + (⌧ ) + 2 2
= 0.
2
Substituting these, the return of a discount bond is
1
↵0 (⌧ ) dt + 0
(⌧ )r dt (⌧ )(✓ˆ r) dt (⌧ ) dB + 2
(⌧ ) 2
dt = r dt (⌧ ) dt (⌧ ) dB .
2
Thus, the risk premium is (⌧ ).
17.6. This exercise develops the completely affine version of the multi-factor CIR model.
Assume r = X1 + X2 where the Xi are independent square-root processes under the physical
measure; i.e.,
p
dXi = ̂i (✓î Xi ) dt + i Xi dBi ,
for constants ̂i , ✓î and i, where the Bi are independent Brownian motions under the physical
measure. Assume there is an SDF process M with
dM p p d"
= r dt 1 X1 dB1 2 X2 dB2 + ,
M "
where 1 and 2 are constants and " is a local martingale uncorrelated with B.
(a) Show that the Xi are independent square-root processes under the risk neutral probability
corresponding to M .
(b) Show that the risk premium of a discount bond is a linear function of the factors X1 and X2 ,
with coefficients depending on the time to maturity.
p
(a) By Girsanov’s theorem, setting dBi⇤ = dBi + i X i dt produces independent Brownian motions
Bi⇤ under the risk neutral probability. We have
p p
dXi = ̂i (✓î Xi ) dt + Xi (dBi⇤
i i X i dt)
p
= i (✓i Xi ) dt + i Xi dBi⇤ ,
where i = ̂i + i i and ✓= ̂i ✓î /i .

(b) The price at t of a discount bond maturing at T is
Pt (T ) = eYt ,
where
2
X
Yt = [↵i (⌧ ) + i (⌧ )Xit ]
i=1
with ⌧ = T t and ↵i (·) and i (·) being defined in (17.14). By Itô’s formula,
dP 1
= dY + (dY )2
P 2
X2 
1
= ↵i0 (⌧ ) dt + 0
i (⌧ )Xi dt i (⌧ ) dXi + 2
i (⌧ )(dXi )
2
2
i=1
X2  p
ˆ 1
= ↵i0 (⌧ ) dt + 0
i (⌧ )Xi dt i (⌧ )̂i (✓i Xi ) dt i (⌧ ) i X i dBi + 2 2
i (⌧ ) i Xi dt .
2
i=1
Therefore, the risk premium of a discount bond is

✓ ◆✓ ◆ 2
X
dM dP
= i i i (⌧ )Xi dt .
M P
i=1
17.7. Assume there is an SDF process with
dM ⇥ 1
⇤0 d"
= r dt S(Xt ) + S(Xt ) ⇤Xt dB + ,
M "
where B is a vector of independent Brownian motions under the physical measure, " is a local
martingale uncorrelated with B, S(X) is a diagonal matrix the squared elements of which are
affine functions of X, S(X) 1 denotes the inverse of S(X), is a constant vector, and ⇤ is a
constant matrix. Assume M R is a martingale, so there is a risk neutral probability corresponding
to M . [Warning: This assumption is not valid in general. See the end-of-chapter notes.]
(a) Assume r = 0X and dX = ( + KX) dt + S(X) dB ⇤ , where B ⇤ is a vector of independent

0+
Brownian motions under the risk neutral probability, 0 is a constant, and are constant
vectors, and K and are constant matrices. Show that
dX = ( ˆ + K̂X) dt + S(X) dB
for a constant vector ˆ and constant matrix K̂.

(b) Using the fact that bond prices are exponential-affine, calculate
✓ ◆✓ ◆
dP dM
P M
to show that the risk premium of a discount bond is affine in X.

(c) Consider the Vasicek model with the price of risk specification (17.38). Show that, in contrast
to the completely affine model considered in Exercise 17.5, the risk premium of a discount bond
can depend on the short rate.
(a) By Girsanov’s theorem,
⇥ ⇤
dB ⇤ = dB + S(X) + S(X) 1
⇤X dt .
Thus,
dX = ( + KX) dt + S(X) dB ⇤
⇥ 1
⇤
= ( + KX) dt + S(X) dB + S(X) + S(X) ⇤X dt
= [ + KX + S(X)S(X) + ⇤X] dt + S(X) dB .
The vector S(X)S(X) is an affine function of X, say A + CX for a vector A and matrix C.
Set ˆ = + A and K̂ = K + C + ⇤.
(b) Let k denote the dimension of X. The price at t of a discount bond maturing at T is Pt = eYt ,
where
k
X ⌧
X
Yt = ↵i (⌧ ) i (⌧ )Xi ,
i=1 i=1
for some functions ↵i (·) and i (·) and where ⌧ = T t. By Itô’s formula,
dP 1
= dY + (dY )2
P 2
Xk k k
1 XX
= [↵i0 (⌧ ) dt + 0
i (⌧ )Xi dt
i (⌧ ) dXi ] + i (⌧ ) j (⌧ )(dXi )(dXj ) .
2
i=1 i=1 j=1
P
The stochastic part of dP/P comes from i dXi and hence is
(⌧ )> S(X) dB ,
where (⌧ )> denotes the row vector ( 1 (⌧ ) · · · k (⌧ )). Thus,

✓ ◆✓ ◆
dP dM ⇥ ⇤
= (⌧ )> S(X) (dB)(dB)0 S(X) + S(X) 1
⇤X
P M
= (⌧ )> S(X)S(X) dt (⌧ )> ⇤X dt ,
which is an affine function of X.

(c) In the Vasicek model, we can take X = r and S(X) = 1. Hence,
✓ ◆✓ ◆
dP dM
= (⌧ )> S(X)S(X) dt (⌧ )> ⇤X dt
P M
= (⌧ ) dt (⌧ ) ⇤r dt .
17.8. This example is from Du↵ee (2002). The model in (b) is an essentially affine model.
Assume 0 1 0 1 0 10 10 1
dr (✓ r) 0 1 0 dB1⇤
@ A=@ A dt + @ A@ p A@ A
dY ( Y) 0 ⌘ 0 Y dB2⇤
for constants , ✓, , , and ⌘, where the Bi⇤ are independent Brownian motions under a risk
neutral probability.
(a) Given the completely affine price of risk specification (17.21), where X = (r Y )0 and
0 1
1 0
S(X) = @ p A ,
0 Yt
show that
dr = (✓ˆ r) dt + dB1 ,
ˆ where B1 is a Brownian motion under the physical measure. Show that the
for some constant ✓,
risk premium of a discount bond depends only on its time to maturity and does not depend on
r or Y .
(b) Consider the price of risk specification (17.38), replacing S(X) 1 by

0 1
1 0
@ A.
0 0
Show that the risk premium of a discount bond can depend on r and Y .
(a) By Girsanov’s theorem, B ⇤ is related to a vector B of independent Brownian motions under

the physical measure as
dB ⇤ = dB + S(X) dt
0 10 1
1 0 1
= dB + @ p A @ A dt
0 Y 2
0 1
1
= dB + @ p A dt .
2 Y
Thus,
dr = (✓ r) dt + dB1⇤
= (✓ r) dt + (dB1 + 1 dt)
= (✓ˆ r) dt + dB1 ,
where ✓ˆ = ✓+ 1 /. Note that r satisfies the Vasicek model (under the risk neutral probability).
Thus, the price at t of a discount bond maturing at T is Pt = eZt , where
Zt = ↵(⌧ ) (⌧ )rt ,
for functions ↵(·) and (·), where ⌧ = T t. It follows that
dP 1
= dZ + (dZ)2
P 2
1
= ↵0 (⌧ ) dt + 0
(⌧ )r dt (⌧ )[(✓ˆ r) dt + dB1 ] + 2 2
(⌧ ) dt
2 0 1
 ⇣ ⌘
1 dB1
= ↵0 (⌧ ) + 0
(⌧ )r (⌧ )(✓ˆ r) + 2 2
(⌧ ) dt + (⌧ ) 0 @ A.
2 dB2
Hence,
0 1
✓ ◆✓ ◆
dM dP 0
(⌧ )
= S(X)0 (dB)(dB)0 @ A
M P 0
0 10 1
⇣ ⌘ 1 0 (⌧ )
= 1 2
@ p A@ A dt
0 Yt 0
= 1 (⌧ ) dt .
(b) By Girsanov’s theorem, B ⇤ is related to a vector B of independent Brownian motions under

the physical measure as
0 1
1 0
dB ⇤ = dB + S(X) dt + @ A ⇤X dt
0 0
0 10 1 0 10 10 1
1 0 1 1 0 ⇤ ⇤ r
= dB + @ p A @ A dt + @ A @ 11 12 A @ A dt
0 Y 2 0 0 ⇤21 ⇤22 Y
0 1 0 1
1 ⇤11 r + ⇤21 Y
= dB + @ p A dt + @ A dt .
2 Y 0
Thus,
dr = (✓ r) dt + dB1⇤
= (✓ r) dt + (dB1 + 1 dt + ⇤11 r + ⇤21 Y dt)
= ̂(✓ˆ r) dt + ⇤21 Y dt + dB1 ,
where ̂ =  ⇤11 and ✓ˆ = (✓ + 1 )/̂.
Note that r satisfies the Vasicek model (under the risk neutral probability). Thus, the price at t of
a discount bond maturing at T is Pt = eZt , where
Zt = ↵(⌧ ) (⌧ )rt ,
for functions ↵(·) and (·), where ⌧ = T t. It follows that

dP 1
= dZ + (dZ)2
P 2
1
= ↵0 (⌧ ) dt + 0
(⌧ )r dt (⌧ )[̂(✓ˆ r) dt + ⇤21 Y dt + dB1 ] + 2 2
(⌧ ) dt
2 0 1
 ⇣ ⌘
1 dB1
= ↵0 (⌧ ) + 0
(⌧ )r (⌧ )̂(✓ˆ r) + ⇤21 Y dt + 2 2
(⌧ ) dt + (⌧ ) 0 @ A.
2 dB2
Hence,
2 0 1 30 0 1
✓ ◆✓ ◆
dM dP 1 0 (⌧ )
= 4S(X) + @ A ⇤X 5 (dB)(dB)0 @ A
M P 0 0 0
2 0 1 0 10 13 0 1
⇣ ⌘ 1 0 ⇣ ⌘ ⇤11 ⇤21 1 0 (⌧ )
=4 1 2 @ p A+ r Y @ A@ A5 @ A dt
0 Yt ⇤12 ⇤22 0 0 0
0 1
⇣ p ⌘ (⌧ )
= 1 + ⇤11 r + ⇤12 Y 2 Y
@ A dt
0
= (⌧ )[ 1 + ⇤11 r + ⇤12 Y ] dt .
17.9. This exercise verifies that the two-factor version of the model of Constantinides (1992) is a
quadratic model.
Assume Mt = exp(X1t + (X2t a)2 ) is an SDF process, where
dX1 = µ dt + dB1t ,
dX2 = X2t dt + dB2t ,
with µ, ,  and being constants and with B1 and B2 being independent Brownian motions under
the physical measure.
(a) Derive dM/M , and deduce that r is a quadratic function of X1 and X2 and the market prices
of risk are affine functions of X1 and X2 .
(b) Given the prices of risk calculated in the previous part, find Brownian motions B1⇤ and B2⇤ under
the risk neutral probability and show that the dX satisfy (17.24b).
(a) We have M = eY , where Y = X1 + (X2 a)2 . Itô’s formula implies
dY = dX1 + 2(X2 a) dX2 + (dX2 )2

2
= µ dt + dB1 + 2(X2 a)[ X2 dt + dB2 ] + dt
2
= [µ + 2(X2 a)X2 ] dt + dB1 + 2 (X2 a) dB2 ,
and
dM 1
= dY + (dY )2
M 2
2 1 2 2
= [µ + 2(X2 a)X2 ] dt + dB1 + 2 (X2 a) dB2 + dt + 2 (X2 a)2 dt
 2
2 1 2 2
= µ+ + 2(X2 a)X2 + 2 (X2 a)2 dt + dB1 + 2 (X2 a) dB2 .
2
Because the drift of dM/M is minus the short rate, we have
2 1 2 2
r= µ + 2(X2 a)X2 2 (X2 a)2 .
2
Also,
dM
= r dt 1 dB1 2 dB2 ,
M
where
1 = ,
2 = 2 (X2 a) .
(b) By Girsanov’s theorem, B ⇤ is a vector of independent Brownian motions under the risk neutral
probability associated to M , where
dB1⇤ = dB1 dt ,
dB2⇤ = dB2 2 (X2 a) dt .
We have
dX1 = µ dt + (dB1⇤ + dt)
= (µ + ) dt + dB1⇤ ,
dX2 = X2 dt + [dB2⇤ + 2 (X2 a) dt]
= 2a 2
dt + (2 2
)X2 dt + dB2⇤ .
This is a special case of (17.24b).
17.10. This exercise develops the Vasicek model with time-dependent parameters studied by Hull
and White (1990).
Consider the Vasicek model with time-dependent parameters:

drt = (t) ✓(t) rt dt + (t) dBt⇤ ,
where B ⇤ is a Brownian motion under a risk neutral probability. Define

✓ Z t ◆ Z t ✓ Z t ◆
r̂t = exp (s) ds r0 + exp (s) ds (u) dBu⇤ ,
0 0 u
Z t ✓ Z t ◆
g(t) = exp (s) ds (u)✓(u) du .
0 u
(a) Show that r̂ defined in (17.41a) satisfies
dr̂t = (t)r̂t dt + (t) dBt⇤ .
(b) Define rt = r̂t + g(t). Show that r satisfies (17.40).

(c) Given any functions (·) and (·), explain how to choose ✓(·) to fit the current yield curve.
(a) By Leibniz’s rule,

✓ Z t ◆ Z t ✓ Z t ◆
dr̂ = (t) exp (s) ds r0 dt + (t) dBt⇤ (t) exp (s) ds (u) dBu⇤ dt
0 0 u
= (t)r̂t dt + (t) dBt⇤ .
(b) By Leibniz’s rule again,

Z t ✓ Z t ◆
g 0 (t) = (t)✓(t) (t) exp (s) ds (u)✓(u) du
0 u
= (t)[✓(t) g(t)] .
Thus,
drt = dr̂t + g 0 (t) dt
= (t)r̂t dt + (t) dBt⇤ + (t)[✓(t) g(t)] dt
= (t)[✓(t) rt ] dt + (t) dBt⇤ .
(c) The price at t of a discount bond maturing at T is

 ✓ Z T ◆ ✓ Z T ◆  ✓ Z T ◆
ER
t exp r u du = exp g(u) du E R
t exp r̂u du .
t t t
Note that the conditional expectation

 ✓ Z T ◆
ER
t exp r̂u du
t
does not involve the function ✓(·). Thus, one can match the market price Qt (T ) by setting
✓ Z T ◆
Q (T )
exp g(u) du = h ⇣t R ⌘i .
T
t ER
t exp t r̂ u du
Equivalently, taking logs,

Z T  ✓ Z T ◆
g(u) du = log Qt (T ) log ER
t exp r̂u du .
t t
We want to hold for each T > t. Di↵erentiating in T gives

 ✓ Z T ◆
d d R
g(T ) = log Qt (T ) + log Et exp r̂u du .
dT dT t
Taking another derivative in T and using the previous formula for g 0 yields
 ✓ Z T ◆
d2 d2 R
(T )[✓(T ) g(T )] = log Qt (T ) + log Et exp r̂u du .
dT 2 dT 2 t
Thus, to fit the yield curve at t, one should choose ✓(T ) for T > t by
 ✓ Z T ◆
1 d2 1 d2 R
✓(T ) = g(T ) log Qt (T ) + log Et exp r̂u du .
(T ) dT 2 (T ) dT 2 t
17.11. This exercise asks for the Hull-White model to be written in the Heath-Jarrow-Morton
form. Assume the short rate is rt = r̂t + g(t), where
dr̂ = r̂ dt + dB ⇤ ,
for constants  and and g(·) is chosen to fit the current yield curve.
(a) Calculate the forward rates fs (u) using the Vasicek bond pricing formula.
(b) Calculate ↵s (u) and s (u) such that, as s changes,
⇤
dfs (u) = ↵s (u) ds + s (u) dBs .
(c) Prove that

Z u
↵s (u) = s (u) s (t) dt .
s
(a) The price Ps (u) at s of a discount bond maturing at u is

 ✓ Z u ◆ ✓ Z u ◆  ✓ Z u ◆
R R
Es exp rt dt = exp g(t) dt Es exp r̂t dt
s
✓ Zs u ◆ s
= exp g(t) dt eYs ,

s
where
Ys = ↵(⌧ ) (⌧ )r̂s
with ⌧ = u s, ↵(⌧ ) = ⌧ a(⌧ ), (⌧ ) = ⌧ b(⌧ ) and a(·) and b(·) being defined in (17.6), taking
✓ = 0. Thus,
2 2 2
⌧ 2⌧
↵(⌧ ) = 2
⌧+ 1 e 1 e ,
2 3 43
1 ⌧
(⌧ ) = 1 e .

It follows that the forward rate fs (u) is
d log Ps (u)
= g(u) + ↵0 (⌧ ) + 0
(⌧ )r̂s
du
2 2 2
⌧ 2⌧ ⌧
= g(u) + e e +e r̂s .
22  2 22
(b) Fixing u, the forward rate evolves for s < u as

2 2
⌧ 2⌧ ⌧ ⌧
dfs (u) = e ds e ds + e r̂s ds + e dr̂s
 2 2

= e ⌧
e 2⌧
+ e ⌧
r̂s ds e ⌧
r̂s ds + e ⌧
dBs⇤
 
2
= e ⌧
e 2⌧
ds + e ⌧
dBs⇤ .

Thus, the drift is

2 ⇣ ⌘
(u s) 2(u s)
↵s (u) = e e ,

and the volatility is
(u s)
s (u) = e .
(c) We have
Z u Z u
(u s) (t s)
s (u) s (t) dt = e e dt
s s
2 ⇣ ⌘
(u s) (u s)
= e 1 e

= ↵s (u) .
17.12. This exercise derives an option pricing formula for discount bonds in the Vasicek/Hull-
White model.
Assume the short rate is rt = r̂t + g(t), where
dr̂ = r̂ dt + dB ⇤ ,
and g(·) is chosen to fit the current yield curve.
(a) Consider a forward contract maturing at T on a discount bond maturing at u > T . Let Ft
denote the forward price for t  T . What is the volatility of dFt /Ft ?
(b) What is the average volatility between 0 and T of dFt /Ft in the sense of (16.15)?
(c) Consider a call option maturing at T on a discount bond maturing at u > T . Derive a formula
for the value of the call option at date 0.
(a) The forward price is Ft = Pt (u)/Pt (T ). The volatility of dF/F is the volatility of d log F , so it
is the volatility of d log Pt (u) d log Pt (T ). From the previous exercise, the price Pt (x) at t of
a discount bond maturing at x is
✓ Z x ◆
exp g(s) ds eYt (x) ,
t
where
Yt (x) = ↵(x t) (x t)r̂t
with
2 2 2
⌧ 2⌧
↵(⌧ ) = 2
⌧+ 1 e 1 e ,
2 3 43
1 ⌧
(⌧ ) = 1 e .

The volatility of d log Pt (u) d log Pt (T ) is the volatility of dYt (u) dYt (T ), which is the volatility
of
[ (u t) (T t)]dr̂t .
Hence, the volatility is

⇣ ⌘
(T t) (u t) T u
e e = e e et .
 
(b) The average volatility in the sense of (16.15) is
s
Z T
T u 1
avg = e e e2t dt
 T 0
r
T u e2T 1
= e e
 2T
(c) Because the risk-free rate is stochastic, we need to use Merton’s (equivalently, Black’s) formula.
The value at date 0 is
yT
P0 (u) N(d1 ) e K N(d2 ) ,
where
1 2
log(P0 (u)/K) + y + 2 avg T
d1 = p ,
avg T
p
d2 = d1 avg T ,
and y = log P0 (T )/T .

Part IV
Topics
18
Heterogeneous Priors
18.1. Suppose each investor h has CARA utility with absolute risk aversion ↵h . Assume the infor-
mation in the economy is generated by w̃m . Assume investor h believes w̃m is normally distributed
with mean µh and variance 2, where is the same for all investors.
(a) Show that the Radon-Nikodym derivative of investor h’s probability Ph with respect to the
average probability P is ⇣ ⌘
(w̃m µh )2
exp 2 2
z̃h = PH ⇣ ⌘.
1 (w̃m µj )2
H j=1 exp 2 2
(b) Show that the sharing rule (18.4) is equivalent to

" ✓ # 0 1
H
X ◆ 2 2 XJ
⌧j h ↵h µj µh ⌧h ⌧j (µh µj ) A
w̃h = ⌧h log + + w̃ m + ⌧ h
@ w̃m .
⌧ 2 2
j=1 j ↵j 2 ⌧ ⌧
j=1
(c) Show that if investors also disagree about the variance of w̃m , then the sharing rule (18.4) is
quadratic in w̃m .
(a) We have z̃h = gh (w̃m ) for some function gh . Consider a random variable x̃ = f (w̃m ) for some
function f . By the normal distribution assumption and the definition of a Radon-Nikodym
derivative,
Z 1 ✓ ◆
1 (w µh )2
p f (w) exp dw = Eh [x̃]
2⇡ 1 2 2
= E[x̃z̃h ]
H Z ✓ ◆
1 X 1 1
(w µj )2
= p f (w)gh (w) exp dw .
H 2⇡ 1 2 2
j=1
Because this is true for each function f , we must have

198 18 Heterogeneous Priors
✓ ◆ H ✓ ◆
(w µh )2 1 X (w µj )2
exp = gh (w) exp ,
2 2 H 2 2
j=1
implying ⇣ ⌘
(w µh )2
exp 2 2
gh (w) = PH ⇣ ⌘.
1 (w µj )2
H j=1 exp 2 2
(b) Notice that

✓ ◆ ✓ ◆
z̃h gh (w̃m ) (w̃m µj )2 (w̃m µh ) 2 µ2j µ2h + 2(µh µj )w̃m
log = log = = .
z̃j gj (w̃m ) 2 2 2 2
Also, the ⌧j /⌧ sum to one, so

H
X H
X
⌧j ⌧j
log( h ↵h z̃h ) log( j ↵j z̃j ) = [log( h ↵h z̃h ) log( j ↵j z̃j )]
⌧ ⌧
j=1 j=1
H 
X ✓ ◆ ✓ ◆
⌧j h ↵h ⌧j z̃h
= log + log
⌧ j ↵j ⌧ z̃j
j=1
H ✓ ◆ H
!
X ⌧j h ↵h
X ⌧j µ2j µ2h + 2(µh µj )w̃m
= log + .
⌧ j ↵j ⌧ 2 2
j=1 j=1
Substituting this into (18.4) produces the result.

(c) Following the reasoning in Part (a) produces
⇣ ⌘
1 (w̃m µh )2
h
exp 2
2 h
z̃h = gh (w̃m ) = ✓ ◆.
1 PH 1 (w̃m µj )2
H j=1 j
exp 2 j2
Hence, ✓ ◆
z̃h j (w̃m µj )2 (w̃m µh )2
log = log + .
z̃j h 2 j2 2 h2
Now, one can follow the reasoning in Part (b), producing a sharing rule that includes terms
2 /
involving the w̃m 2
j.
18.2. Assume all investors have constant relative risk aversion ⇢ and the same discount factor .
Solve the social planning problem in a finite-horizon discrete-time model to show that the social
planner’s utility is " #
T
X
t C1 ⇢
E Zt t
1 ⇢
t=0
18 Heterogeneous Priors 199
for some stochastic process Z. Show that Z is a supermartingale relative to the average beliefs if
⇢ > 1. Hint: For the last statement, use a conditional version of the Minkowski inequality. The
Minkowski inequality states that for random variables x̃h and any ⇢ > 1,
" H
!⇢ #1/⇢ H
X X ⇥ ⇤1/⇢
E x̃h  Et x̃⇢h .
h=1 h=1
The social planning problem is

H X
T
" # H
X 1 ⇢ X
t Cht
max h E Zht subject to (8 t) Cht = Ct .
1 ⇢
h=1 t=0 h=1
This is equivalent to maximizing

H
X 1 ⇢ H
X
Cht
h Zht subject to Cht = Ct
1 ⇢
h=1 h=1
for each t and in each state of the world. Following the calculations in Exercise 3.9 yields
( h Zht )1/⇢
Cht = PH Ct .
1/⇢
j=1 ( j Zjt )
Thus,
( 1/⇢
1 ⇢ h Zht ) 1 ⇢
ht Zht Cht = ⇣P ⌘1 ⇢ Ct ,
H 1/⇢
j=1 ( j Zjt )
and the social planner’s utility is

2 3
T PH ! T
" !#
X ( h Zht )1/⇢ Ct1 ⇢ 7 X t Ct1 ⇢
t 6
E 4 ⇣P h=1 ⌘1 ⇢ 5= E Zt ,
H 1/⇢ 1 ⇢ 1 ⇢
t=0 j=1 ( j Zjt ) t=0
where !⇢
H
X
1/⇢
Zt = ( h Zht ) .
h=1
Set x̃h = ( 1/⇢ .

h Zh,t+1 ) If ⇢ > 1, then the Minkowski inequality yields
200 18 Heterogeneous Priors
" H
!⇢ #1/⇢
X
Et [Zt+1 ]1/⇢ = Et x̃h
h=1
H
X ⇥ ⇤1/⇢
 Et x̃⇢h
h=1
XH
1/⇢
= Et [ h Zh,t+1 ]
h=1
H
X
1/⇢
= ( h Zht )
h=1
1/⇢
= Zt .
Thus, Et [Zt+1 ]  Zt when ⇢ > 1.
18.3. Consider an infinite-horizon version of the model in Section 18.5 in which both investors
agree the dividend process is a two-state Markov chain, with states D = 0 and D = 1. Suppose the
investors’ beliefs Ph satisfy, for all t 0,
P1 (Dt+1 = 0|Dt = 0) = 1/2 , P1 (Dt+1 = 1|Dt = 0) = 1/2 ,

P1 (Dt+1 = 0|Dt = 1) = 2/3 , P1 (Dt+1 = 1|Dt = 1) = 1/3 ,
P2 (Dt+1 = 0|Dt = 0) = 2/3 , P2 (Dt+1 = 1|Dt = 0) = 1/3 ,

P2 (Dt+1 = 0|Dt = 1) = 1/4 , P2 (Dt+1 = 1|Dt = 1) = 3/4 .
Assume the discount factor of each investor is = 3/4. For s = 0 and s = 1, set
"1 #
X
t
Vh (s) = Eh Dt | D0 = s .
t=1
For each h, use the pair of equations
Vh (s)
= Ph (Dt+1 = 0 | Dt = s)Vh (0) + Ph (Dt+1 = 1 | Dt = s)[1 + Vh (1)]
to calculate Vh (0) and Vh (1). Show that investor 2 has the highest fundamental value in both states
[V2 (0) > V1 (0) and V2 (1) > V1 (1)] but investor 1 is the most optimistic in state D = 0 about
investor 2’s future valuation, in the sense that
P1 (Dt+1 = 0 | Dt = 0)V2 (0) + P1 (Dt+1 = 1 | Dt = 0)[1 + V2 (1)]
> P2 (Dt+1 = 0 | Dt = 0)V2 (0) + P2 (Dt+1 = 1 | Dt = 0)[1 + V2 (1)] .

18 Heterogeneous Priors 201
Consider investor 1. Set x = V1 (0) and y = V1 (1). We want to solve
4 1 1
x= x+ (1 + y) ,
3 2 2
4 2 1
y= x+ (1 + y) .
3 3 3
The solution is V1 (0) = x = 4/3 = 1.33 and V1 (1) = y = 11/9 = 1.22. Now for investor 2, set
x = V2 (0) and y = V2 (1). We want to solve
4 2 1
x= x+ (1 + y) ,
3 3 3
4 1 3
y= x+ (1 + y) .
3 4 4
The solution is V2 (0) = x = 16/11 = 1.45 and V2 (1) = y = 21/11 = 1.91 Hence, investor 2 has the
highest fundamental value in both states. The last claim is equivalent to
 
1 16 1 21 2 16 1 21
· + · 1+ > · + · 1+ .
2 11 2 11 3 11 3 11
Multiplying by 11, this is equivalent to

48 64
> ,
2 3
which is true.
19
Asymmetric Information
19.1. In the economy of Section 19.4, assume the uninformed investors are risk neutral. Find a
fully revealing equilibrium, partially revealing equilibria in which the price reveals s̃ + bz̃ for any
b, and a completely unrevealing equilibrium (an equilibrium in which the price is constant rather
than depending on s̃ and/or z̃).
The equilibrium condition is that

E[x̃ | p(s̃, z̃)]
p(s̃, z̃) = .
Rf
If p(s̃, z̃) = µ(s̃)/Rf , then
E[x̃ | p(s̃, z̃)] E[x̃ | µ(s̃)] µ(s̃)
= = = p(s̃, z̃) ,
Rf Rf Rf
so there is a fully revealing equilibrium. On the other hand, if p(s̃, z̃) = x̄/Rf , then
E[x̃ | p(s̃, z̃)] E[x̃]
= = p(s̃, z̃) ,
Rf Rf
so there is a completely unrevealing equilibrium. For the partially revealing equilibria, suppose
p(s̃, z̃) = a0 + a1 (s̃ + bz̃) with a1 6= 0. Then

E[x̃ | p(s̃, z̃)] E[x̃ | s̃ + bz̃] 1 cov(x̃, s̃)
= = x̄ + (s̃ s̄ + bz̃ bz̄) .
Rf Rf Rf var(s̃) + b2 var(z̃)
This equals p(s̃, z̃) if and only if

1 cov(x̃, s̃)
a0 = x̄ (s̄ + bz̄) ,
Rf var(s̃) + b2 var(z̃)

1 cov(x̃, s̃)
a1 = ,

b cov(x̃, s̃)
a1 b = ) .
204 19 Asymmetric Information
For any b, we can define a0 and a1 by the first two equations and the third equation will hold. Thus,
there is an equilibrium revealing s̃ + bz̃ for any b. This includes b = 0, which is the fully revealing
equilibrium.
19.2. Consider the model of Section 19.5, but assume there is a continuum of investors indexed by
h 2 [0, 1] with possibly di↵ering risk aversion coefficients ↵h and possibly di↵ering error variances
var(˜
"h ). Suppose, for some b, that each investor observes x̃ + bỹ in addition to his private signal s̃h .
The market-clearing condition is
Z 1
✓h (x̃ + bỹ, s̃h ) dh = ỹ ,
0
where ✓h is the number of shares demanded by investor h. Let 2 denote the variance of x̃ conditional
h
on x̃ + bỹ and s̃h . Set = 1/ 2

h h.
Define
Z 1 Z 1
1
⌧= ⌧h dh and = ⌧h h dh ,
0 ⌧ 0
where ⌧h is the risk tolerance of investor h.
(a) Show that the equilibrium price is a discounted weighted average of the conditional expectations
of x̃ minus a risk premium term, where the weight on investor h is ⌧h h /(⌧ ).
(b) Define
var(x̃) (1 ) var(x̃)
= and h = .
var(x̃) + b2 var(ỹ) (1 ) var(x̃) + var(˜
"h )
Show that
1
⌧h h h = .
↵h var(˜
"h )
(c) Assume the strong law of large numbers holds in the sense that
Z 1
⌧h h h "˜h dh = 0 .
0
Define
Z 1
1
= ⌧h h h dh .
⌧ 0
Show that the equilibrium price equals a0 + a1 (x̃ + bỹ) if and only if
(1 )[(1 )x̄ bȳ]
a0 = ,
Rf
(1 ) + 
a1 = ,
Rf
Z 1
1
b= 1 dh .
0 ↵h var(˜
"h )
19 Asymmetric Information 205
(a) The number of shares of the risky asset demanded by investor h is
⌧h h E[x̃ | x̃ + bỹ, s̃h ] Rf p(x̃, ỹ) ,
so the market-clearing condition is

Z 1
⌧h h E[x̃ | x̃ + bỹ, s̃h ] Rf p(x̃, ỹ) dh = ỹ ,
0
which we can rearrange as

Z 1 Z 1
Rf p(x̃, ỹ) ⌧h h dh = ⌧h h E[x̃ | x̃ + bỹ, s̃h ] dh ỹ .
0 0
Z 1 ✓ ◆
⌧h h E[x̃ | x̃ + bỹ, s̃h ] ỹ
p(x̃, ỹ) = dh .
0 ⌧ Rf ⌧ Rf
(b) From (19.4c), the conditional variance is
2
h = (1 h )(1 ) var(x̃) .
This implies
1 1 h var(˜"h )
= (1 ) var(x̃) = (1 ) var(x̃) = var(˜
"h ) .

h h h (1 ) var(x̃)
Thus,
h h 1
⌧h h h = = .
↵h ↵h var(˜
"h )
(c) From (19.4a),
E[x̃ | x̃ + bỹ, s̃h ] = E[x̃ | x̃ + bỹ] + h s̃h E[s̃ | x̃ + bỹ]
= E[x̃ | x̃ + bỹ] h E[x̃ | x̃ + bỹ] + h s̃h
Thus,
Z 1 ✓ ◆
⌧h h E[x̃ | x̃ + bỹ, s̃h ] ỹ
p(x̃, ỹ) = dh
0 ⌧ Rf ⌧ Rf
Z 1 Z 1
1 1
= ⌧h h E[x̃ | x̃ + bỹ] dh ⌧h h h E[x̃ | x̃ + bỹ] dh
⌧ Rf 0 ⌧ Rf 0
Z 1
1 ỹ
+ ⌧h h h s̃h dh
⌧ Rf 0 ⌧ Rf
E[x̃ | x̃ + bỹ] E[x̃ | x̃ + bỹ] x̃ ỹ
= + .
Rf Rf Rf ⌧ Rf
From (19.2a),
E[x̃ | x̃ + bỹ] = x̄ + (x̃ x̄ + bỹ bȳ) .
Therefore,
(1 )[x̄ + (x̃ x̄ + bỹ bȳ)] x̃ ỹ
p(x̃, ỹ) = + .
Rf Rf ⌧ Rf
This is equal to a0 + a1 (x̃ + bỹ) if and only if
(1 )x̄)[(1
bȳ]
a0 = ,
Rf
(1 ) + 
a1 = ,
Rf
(1 ) b 1
a1 b = .
Rf ⌧ Rf
The last two equations imply

b 1
= ,
Rf ⌧ Rf
so
Z 1 Z 1
1 1
b= = 1 ⌧h h h dh = 1 dh .
⌧  0 0 ↵h var(˜
"h )
19.3. In the single-period Kyle model, assume the informed investor has CARA utility. There is
a linear equilibrium. Derive an expression for as a root of a fifth-order polynomial, assuming
the informed investor observes s̃ = x̃ + "˜, where "˜ is normally distributed with zero mean and is
independent of x̃.
Let ṽ = E[x̃ | s̃], and set

✓ ◆
2 var(x̃)
= var(x̃ | s̃) = 1 var(x̃) .
var(x̃) + var(˜
")
A strategy for the informed trader is affine in the signal s̃ if and only if it is affine in ṽ, so we are
looking for an equilibrium in which the informed trader plays ✓(v) = ↵ + v for some ↵ and .
With ỹ = ↵ + ṽ + z̃, the normal-normal updating rule implies E[x̃ | ỹ] = E[ṽ | ỹ] = + ỹ, where
✓ 2 var(ṽ)
◆
= 1 2 var(ṽ) + var(z̃)
v̄ , (19.1a)
var(ṽ)
= 2 . (19.1b)
var(ṽ) + var(z̃)
The informed trader maximizes the certainty equivalent

19 Asymmetric Information 207
↵ ↵ 2 2 2
E[✓(x̃ (✓ + z̃)) | s̃] var(✓(x̃ (✓ + z̃)) | s̃) = ✓(ṽ ✓) ✓ [ + var(z̃)] .
2 2
The optimum is attained at
ṽ
✓= 2 2 var(z̃)
.
2 +↵ +↵
Thus,
↵= 2 2 var(z̃)
, (19.1c)
2 +↵
+↵
1
= . (19.1d)
2 +↵ 2+↵ 2 var(z̃)
Substituting (19.1d) into (19.1b) yields

"✓ ◆2 #
1 var(ṽ)
var(ṽ) + var(z̃) = ,
2 + ↵ 2 + ↵ 2 var(z̃) 2 + ↵ 2 + ↵ 2 var(z̃)
which can be rearranged as

⇥ 2 2
⇤2 ⇥ 2 2
⇤
var(ṽ) + 2 +↵ +↵ var(z̃) var(z̃) = 2 + ↵ +↵ var(z̃) var(ṽ) .
Thus, is a root of a fifth-order polynomial.
19.4. In the continuous-time Kyle model, assume log ṽ is normally distributed instead of ṽ being
normally distributed. Denote the mean of log ṽ by µ and the variance of log ṽ by 2. Set = v/ z.
Show that the strategies

1 2
P0 = eµ+ 2 v
dPt = Pt dYt
(log ṽ µ)/ Yt
d✓t = dt
1 t
form an equilibrium by showing the following:
(a) Define Wt = Yt / z. Show that, conditional on ṽ, W is a Brownian bridge on [0, 1] with terminal
value (log ṽ µ)/ v. Use this fact to show that P satisfies P1 = ṽ and is a martingale relative
to the market makers’ information.
(b) For v > 0 and p > 0, define
p v + v(log v log p) 1
J(t, p) = + v z (1 t)v .
2
In the definition of the class of allowed strategies in Section 19.7, modify condition (ii) to (ii0 )
hR i
1
E 0 Pt2 dt < 1. Prove the verification theorem.
(a) We have
1 (log ṽ µ)/ v W
dW = (d✓ + z dB) = dt + dB .
z 1 t
Hence, W is a Brownian bridge on [0, 1] with terminal value (log ṽ µ)/ v. Moreover,
dP
= dY = v dW ,
P
so P is a geometric Brownian motion relative to the market makers’ information. We also have
1 2 1 2 1 2
v W1
P1 = P0 e 2 v = eµ+ 2 v elog ṽ µ 2 v = elog ṽ = ṽ ,
so Pt is the conditional expectation of ṽ given the market makers’ information, for each t.
Furthermore, P being a geometric Brownian motion implies that ✓ satisfies condition (ii0 ).
(b) We have
v zv
Jt = ,
2
1 v
Jp = ,
p
v
Jpp = ,
p2
(dP )2 = 2 2
v P dt .
Hence,
Z 1
1
J(1, P1 ) = J(0, P0 ) + Jt dt + Jp dP + Jpp (dP )2
0 2
Z 1✓ ◆ 2
v zv 1 v 1v v
= J(0, P0 ) + dP +
2 0 P 2
Z 1
P v dP
= J(0, P0 ) +
0 P
Z 1
= J(0, P0 ) + (P v)(d✓ + z dB) .
0
Rearranging gives
Z 1 Z 1
(v P ) d✓ = J(0, P0 ) J(1, P1 ) + (P v) z dB .
0 0
Taking expectations throughout, using the assumption (ii0 ), yields

Z 1
E (ṽ P ) d✓ = J(0, P0 ) J(1, P1 )  J(0, P0 ) ,
0
the inequality following from J(1, p) 0, which can be deduced from the fact that J(1, p) is
convex in p and hence has a unique minimum at p = v. Thus, any strategy that implies P1 = ṽ
is optimal.
20
Alternative Preferences in Single-Period Models
20.1. Consider the following pairs of gambles:

8
>
<80% chance of $4,000
A : 100% chance of $3,000 versus B:
>
:20% chance of $0
8 8
>
<25% chance of $3,000 >
<20% chance of $4,000
C: versus D : .
>
:75% chance of $0 >
:80% chance of $0
(a) Show that an expected utility maximizer who prefers A to B must also prefer C to D.
(b) Show that the preferences A B and D C violate the independence axiom by showing that
C = ↵A + (1 ↵)Q and D = ↵B + (1 ↵)Q for some 0 < ↵ < 1 and some gamble Q.
(c) Plot the gambles A, B, C, and D in the probability simplex of Figure ??, taking p1 to be the
probability of $0 and p3 to be the probability of $4,000. Show that the line connecting A with
B and the line connecting C with D are parallel.
Note: the preferences A B and D C are common. This example is also due to Allais (1953)
and is a special case of the common ratio e↵ect. See, e.g., Starmer (2000).
(a) Preference for C over D is equivalent to
0.25u(x2 ) > 0.2u(x3 ) , u(x2 ) > 0.8u(x3 ) , A B.
(b) Let Q be the gamble that pays 0 for sure, and set ↵ = 0.25.
(c) In the probability simplex, A = (0, 0), B = (0.2, 0.8), C = (0.75, 0) and D = (0.8, 0.2). The
slope of the line connecting A and B is 0.8/0.2 = 4, and the slope of the line connecting C and
D is 0.2/0.05 = 4.
210 20 Alternative Preferences in Single-Period Models
20.2. Consider the following pairs of gambles:

8 8
>
<90% chance of $3,000 >
<45% chance of $6,000
A: versus B :
>
:10% chance of $0 >
:55% chance of $0
8 8
>
<0.2% chance of $3000 >
<0.1% chance of $6,000
C: versus D : .
>
:99.8% chance of $0 >
:99.9% chance of $0
Show that an expected utility maximizer who prefers A to B must also prefer C to D. Note: the
preferences A B and D C are common. This example is due to Kahneman and Tversky (1979).
We have
A B , 0.002u(x2 ) + 0.998u(x1 ) > 0.001u(x3 ) + 0.999u(x1 )
, 0.002u(x2 ) > 0.001u(x3 ) + 0.001u(x1 )
, u(x2 ) > 0.5u(x3 ) + 0.5u(x1 ) ,
and
C D , 0.9u(x2 ) + 0.1u(x1 ) > 0.45u(x3 ) + 0.55u(x1 )
, 0.9u(x2 ) > 0.45u(x3 ) + 0.45u(x1 )
, u(x2 ) > 0.5u(x3 ) + 0.5u(x1 ) .
20.3. Consider weighted utility. Let "˜ have zero mean and unit variance. For a constant , denote
the certainty equivalent of w + "˜ by w ⇡( ). Assume ⇡(·) is twice continuously di↵erentiable.
By di↵erentiating
v(w ⇡( ))E[ (w + "˜)] = E[ (w + "˜)v(w + "˜)] ,
assuming di↵erentiation and expectation can be interchanged, show successively that ⇡ 0 (0) = 0 and
v 00 (w) 2 0 (w)
⇡ 00 (0) = .
v 0 (w) (w)
Note: This implies that for CRRA weighted utility and small , ⇡( )/w ⇡ (⇢ 2 ) var( "˜/w)/2.
We have
v 0 (w ⇡( ))E[ (w + "˜)]⇡ 0 ( ) + v(w ⇡( ))E[ 0 (w + "˜)˜

"]
= E[ (w + "˜)v 0 (w + "˜)˜
"] + E[ 0 (w + "˜)v(w + "˜)˜
"] .
20 Alternative Preferences in Single-Period Models 211
At "] = 0, we obtain ⇡ 0 (0) = 0. Taking second derivatives and substituting ⇡(0) = 0,

= 0, using E[˜
⇡ 0 (0) = 0, E[˜ "2 ] = 1 yields
"] = 0, and E[˜
v 0 (w) (w)⇡ 00 (0) + v(w) 00

(w) = v(w) 00
(w) + 2 0 (w)v 0 (w) + (w)v 00 (w) ,
which implies
v 00 (w) 2 0 (w)
⇡ 00 (0) = .
v 0 (w) (w)
20.4. Consider CRRA weighted utility.
(a) Show that g in (20.11) is strictly monotone in y > 0 — so the preferences are monotone with
regard to stochastic dominance — if and only if  0 and ⇢  + 1 with at least one of these
being a strict inequality.
(b) Show that g in (20.11) is strictly monotone and concave if and only if  0 and ⇢ +1
with either < 0 or ⇢ < + 1.
(c) Consider a lognormal gamble: w̃ = w(1+˜
") where log(1+˜
") is normally distributed with variance
2 and mean 2 /2 (implying E[˜
"] = 0). Show that the certainty equivalent is w(1 ⇡) where
(⇢ 2 ) 2 /2
⇡=1 e .
Note: This implies that ⇡ ⇡ (⇢ 2 ) 2 /2 for small . Compare Exercise 1.4.
(a) We have g(y) = y +1 ⇢ y , so
g 0 (y) = ( + 1 ⇢)y ⇢
y 1
⇥ ⇤
=y 1 ( +1 ⇢)y 1 ⇢
.
This is positive for all y > 0 if and only if  0 and +1 ⇢ 0 with at least one of these
being a strict equality.
(b) We have
g 00 (y) = ( + 1 ⇢)( ⇢)y ⇢ 1

( 1)y 2
⇥ ⇤
=y 2 ( +1 ⇢)( ⇢)y 1 ⇢
( 1) .
Assuming  0 and +1 ⇢ 0, g 00 (y)  0 for all y > 0 if and only if ⇢  0.

(c) Let z̃ = log(1 + "˜), and let P denote the distribution of wez̃ . We are assuming
h ⇣ ⌘ i
z̃ 1 1 ⇢
1 E we 1 ⇢ wez̃
[w(1 ⇡)]1 ⇢ = v(w(1 ⇡)) = v(U (P )) = .
1 ⇢ E [(wez̃ ) ]
Equivalently,
⇥ ⇤
1 ⇢ E e[ +(1 ⇢)]z̃
(1 ⇡) =
E [e z̃ ]
[ +(1 ⇢)] 2 /2+[ +(1 ⇢)]2 2 /2
e
= 2 /2+ 2 2 /2
e
(⇢ 2 )(1 ⇢) 2 /2
=e .
Hence,
(⇢ 2 ) 2 /2
1 ⇡=e .
20.5. Consider CRRA disappointment-averse utility and a random wealth w̃ = ez̃ , where z̃ is
normally distributed with mean µ and variance 2. Let ⇠ denote the certainty equivalent of w̃, and
set ✓ = log ⇠.
(a) Show that ✓ satisfies the equation

2 ⇣ 2
⌘3
✓ µ (1 ⇢)
1 1 1+ N
✓ = µ + (1 ⇢) 2
+ log 4 ⇣ ⌘ 5,
2 1 ⇢ 1+ N ✓ µ
where N denotes the standard normal distribution function. Hint: See the calculation of
⇥ ⇤
E ebz̃ 1{z̃<a} for a normal random variable z̃ in Section 7.4.
(b) Let µ = 2 /2 + log w for a constant w. [ Defining the standard normal x̃ = (z̃ µ)/ , we then
2 /2+ x̃
have w̃ = w(1 + "˜), where "˜ ⌘ e 1 has mean zero.] Define ⇡ = (w ⇠)/w. [ Then
w(1 ⇡) is the certainty equivalent of w(1+ "˜).] Show numerically that ⇡/ 2 appears to increase
without bound and ⇡/ appears to converge to a positive constant as # 0.
(a) The certainty equivalent ⇠ is defined by

h i
1 1 ⇢ E 1{w̃<⇠} (1 + ) 1 1 ⇢ w̃1 ⇢ + 1{w̃ ⇠} 1
1
⇢ w̃
1 ⇢
⇠ = ⇥ ⇤ .
1 ⇢ E 1{w̃<⇠} (1 + ) + 1{w̃ ⇠}
This is equivalent to ⇥ ⇤ ⇥ ⇤
E w̃1 ⇢ + E 1{w̃<⇠} w̃1 ⇢
⇠1 ⇢
= . (⇤)
1 + P (w̃ < ⇠)
20 Alternative Preferences in Single-Period Models 213
The denominator on the right-hand side of (⇤) is

✓ ◆
✓ µ
1 + P (z̃ < ✓) = 1 + N .
To evaluate the numerator, define the standard normal x̃ = (z̃ µ)/ . We have
w̃1 ⇢
= e(1 ⇢)µ+(1 ⇢) x̃
,
and
✓ µ
w̃ < ⇠ , x̃ < .
Therefore,
⇥ ⇤ h i
E 1{w̃<⇠} w̃1 ⇢
= e(1 ⇢)µ
E 1{x̃<(✓ µ)/ } e
(1 ⇢) x̃
Z (✓ µ)/
1 1 2
= e(1 ⇢)µ
p e(1 ⇢) x 2 x dx
1 2⇡
Z (✓ µ)/
⇢)µ+ 12 (1 ⇢)2 2 1 1
(1 ⇢) ]2
= e(1 p e 2 [x dx
1 2⇡
✓ ◆
⇢)µ+ 12 (1 ⇢)2 2 ✓ µ
= e(1 prob ỹ < ,
where ỹ is normally distributed with mean (1 ⇢) and variance equal to 1. This is

✓ ◆
⇢)µ+ 12 (1 ⇢)2 2 ✓ µ (1 ⇢) 2
e(1 N .
By the usual rule for means of exponentials of normals,

⇥ ⇤ ⇢)µ+ 12 (1 ⇢)2 2
E w̃1 ⇢
= e(1 .
Therefore the numerator on the right-hand side of (⇤) equals

 ✓ 2
◆
(1 ⇢)µ+ 12 (1 ⇢)2 2 ✓ µ (1 ⇢)
e 1+ N ,
and we have 2 ⇣ 2
⌘3
✓ µ (1 ⇢)
1+ N
⇢)µ+ 12 (1 ⇢)2 2
4 5.
⇠1 ⇢
= e(1 ⇣ ⌘
✓ µ
1+ N
Taking logs and dividing by 1 ⇢ yields
2 ⇣ 2
⌘3
✓ µ (1 ⇢)
1 1 1+ N
✓ = µ + (1 ⇢) 2
+ log 4 ⇣ ⌘ 5.
2 1 ⇢ 1+ N ✓ µ
(b) For example, with ⇢ = 2, = 1, w = 1,
= 0.3 ) ⇡/ = 0.53 ,
= 0.1 ) ⇡/ = 0.37 ,
= 0.01 ) ⇡/ = 0.286 ,
= 0.001 ) ⇡/ = 0.277 ,
= 0.0001 ) ⇡/ = 0.276 .
21
Alternative Preferences in Dynamic Models
21.1. Consider consumption processes (ii) and (iii) in the introduction to this chapter. Take T = 2.
Suppose consumption C0 is known at date 0 (before any coins are tossed). Assume the power
certainty equivalent and the CES aggregator.
(a) Assume two coins are tossed at date 0 determining C1 and C2 . Calculate the utility U0 of the
person before the coins are tossed.
(b) Assume a coin is tossed at date 1 determining C1 , and a coin is tossed at date 2 determining
C2 . Calculate the utility U0 .
(c) Show numerically that the utility is higher in part (a) than in part (b) — i.e., early resolution
of uncertainty is preferred — if ⇢ > ↵. Show that late resolution is preferred if ⇢ < ↵, and show
that the person is indi↵erent about the timing of resolution of uncertainty if ⇢ = ↵.
(a) Because C2 is known at date 1, we have ⇠1 = C2 . Therefore,

1
U1 = V (C1 , C2 ) = C11 ↵
+ C21 ↵ 1 ↵
.
This implies
1 X X 1 ⇢
⇠01 ⇢
= E[U11 ⇢
]= x1 ↵
+ y1 ↵ 1 ↵
.
4
x2{a,b} y2{a,b}
It follows that
8 2 31 ↵
9 1
1 ↵
>
< 1 ⇢ >
=
1 X X 1 ⇢
U0 = V (C0 , ⇠0 ) = C01 ↵
+ 4 x1 ↵
+ y1 ↵ 1 ↵ 5 .
>
: 4 >
;
x2{a,b} y2{a,b}
(b) We have
216 21 Alternative Preferences in Dynamic Models
1 X 1
⇠11 ⇢
= E1 [U21 ⇢
]= y ⇢
.
2
y2{a,b}
Therefore,
2 0 11 ↵ 3 1 1↵
1 ⇢
6 1 X 7
U1 = V (C1 , ⇠1 ) = 4C11 ↵
+ @ y1 ⇢A
5 .
2
y2{a,b}
Hence,
2 0 11 ↵ 3 11 ⇢
↵
1 ⇢
1 X 6 1 1 X 7
⇠01 ⇢
= E[U11 ⇢
]= 4x
↵
+ @ y1 ⇢A
5 .
2 2
x2{a,b} y2{a,b}
It follows that
0 1 1
8 2 3 11 ⇢ 9 11 ↵ 1 ↵
> 0 1 1 ↵ ↵ > ⇢
B >
< 1 ⇢ >
= C
B 1 1 X 6 1 1 X 1 7 C
U0 = V (C0 , ⇠0 ) = B
BC0
↵
+ 4x
↵
+ @ y ⇢A
5 C
C .
@ >
> 2 2 >
> A
: x2{a,b} y2{a,b} ;
(c) For example, take a = 100, b = 200, C0 = 150, = 0.9, and ↵ = 4. The utility in part (a) is
⇢ = 2 ) U0 = 95.95 , ⇢ = 4 ) U0 = 92.63 , ⇢ = 6 ) U0 = 90.37 .
The utility in part (b) is
⇢ = 2 ) U0 = 97.48 , ⇢ = 4 ) U0 = 92.63 , ⇢ = 6 ) U0 = 89.48 .
21.2. Derive (21.12a)–(21.12f) in the order given. To compute B, use (21.8), (21.9) and the fact
that ✓ ◆
Wt+1 1 Ct+1
Rm,t+1 = = .
Wt C t 1 ✓ Ct
(a) From (21.8),

◆ ✓
1
Ct+1
Rm,t+1 =
1 ✓ Ct
✓ ◆
1 Ct+1
= B1 ↵ ↵ .
Ct
Thus, (21.9) implies

21 Alternative Preferences in Dynamic Models 217
h i
1 ⇢
B1 ⇢
= E Rm,t+1
"✓ ◆ #
1 ↵
1 ⇢ Ct+1 1 ⇢
= B ↵
E
Ct
✓ ◆
1 ↵
1 ⇢ 1 2 2
= B ↵
exp (1 ⇢)µ + (1 ⇢) .
2
The solution of this is ✓ ◆

1 1 2
B= exp ↵µ + ↵(1 ⇢) .
2
(b) We have ✓ ◆
1 ↵
1 Ct+1
Rm,t+1 = B ↵
.
Ct
Substituting the formula for B produces the result.
(c) This follows from  ✓ ◆
Ct+1 1 2
E = exp µ + .
Ct 2
(d) Substituting the formulas for B and Rm,t+1 into (21.11) produces the result.
(e) This follows from 1/Rf = Et [Mt+1 /Mt ].
(f) We have
1
Wt Ct 1 ✓ B1 ↵ ↵
= = 1 .
Ct ✓ 1 ( B1 ↵) ↵
Substituting the formula for B shows that

1
B1 ↵ ↵
=⌫
defined in (21.12f).
21.3. Consider the continuous-time portfolio choice problem with linear habit (21.15). Assume
(21.16) holds with strict inequality. Repeating the argument at the end of Section 21.5 shows that,
for any date t,
Z T Z T Z T
(a b)(u t)
Et Mu Cu du = Et M̂u Ĉu du + Xt Et Mu e du .
t t t
1
(Section 21.5 considers t = 0.) Assume power utility: u(c x) = 1 ⇢ (c x)1 ⇢. Assume the
information in the economy is generated by a single Brownian motion B, there is a constant risk-
free rate r, and there is a single risky asset with constant expected rate of return µ and constant
volatility .
(a) Show that the optimal Ĉ is

1
( /⇢)t ⇢
Ĉt = Ke M̂t ,
for a constant K.
(b) Define
1 h i
(r+a b)(T t)
t = 1 e .
r+a b
Show that
Z T
Xt (a b)(u t)
Et Mu e du = t Xt ,
Mt t
M̂t = (1 + b t )Mt ,
Z T 1
1 ⇢
Et M̂u Ĉu du = t Mt ,
Mt t
for a non-random function .

(c) Define
Z T
1
Wt = Et Mu Cu du .
Mt t
Show that
1
✓ ◆
⇢ µ r
dWt = t Mt dBt + something dt
⇢
✓ ◆
µ r
= (Wt t Xt ) dBt + something dt .
⇢
(d) Show that the optimal portfolio is

✓ ◆
t Xt µ r
⇡t = 1 .
Wt ⇢ 2
(a) This follows from the first-order condition
⇢
Ĉt = M̂t .
(b) We have Et [Mu /Mt ] = Pt (u) = e r(u t) . Calculating the integral

Z T
(r+a b)(u t)
e du
t
yields the first two formulas. For the third, note that
1 1
( /⇢)u 1 ⇢ ( /⇢)u 1 1 1 ⇢
M̂u Ĉu = Ke M̂u = Ke (1 + b u) ⇢ Mu .
Therefore,
Z Z "✓ ◆1 1 #
T 1 T
1 ⇢ ( /⇢)u 1 1 Mu ⇢
Et M̂u Ĉu du = KMt e (1 + b u) ⇢ Et du .
Mt t t Mt
Also, from
dM µ r
= r dt dB ,
M
we obtain
"✓ ◆1 1 # ✓ ◆ ✓ ◆2 ✓ ◆ !
Mu ⇢ ⇢ 1 1 µ r ⇢ 1
Et = exp r (u t) (u t) .
Mt ⇢ 2 ⇢2
Therefore, the integral is a non-random function.

(c) We have
1
⇢
Wt = t Xt + t Mt .
Because X has no stochastic part, Itô’s formula gives

1
1 ⇢ dM
dW = something dt M
t t
⇢ M
1
µ r
= something0 dt + M
t t
⇢
dB .
⇢
1 1
⇢ ⇢
Substituting for t Mt from Wt = t Xt + t Mt gives the result.
(d) The optimal portfolio is computed by setting
✓ ◆
µ r
W ⇡ dB = (W X) dB .
⇢
21.4. Consider the model with a single risky asset described in Section 21.4. Assume the investor
is a representative investor, there is a single unit of the risky asset, and the risk-free asset is in zero
net supply. Assume Bayesian updating of the set of priors, and assume the representative investor
is risk neutral (but ambiguity averse). Let Pt denote the price of the risky asset at date t, with
P2 = x̃. Take Rf = 1. The intertemporal budget equation is
Wt+1 = Wt + ✓t (Pt+1 Pt ) ,
where ✓t denote the number of shares of the risky asset chosen at date t. The distribution of x̃
conditional on s̃ is normal with mean µ + (s̃ µ) and variance (1 ) 2, and the marginal
distribution of s̃ is normal with mean µ and variance 2/ , for  
a b. Take the backward
induction (dynamic programming) approach.
(a) Suppose s̃ < µ. Show that ✓1 = 1 maximizes
min E [W2 | s̃]
if and only if
P1 = µ + b (s̃ µ) .
(b) Suppose s̃ > µ. Show that ✓1 = 1 maximizes
min E [W2 | s̃]
if and only if
P1 = µ + a (s̃ µ) .
(c) Suppose that P1 depends on s̃ as described in the previous parts. Show that ✓0 = 1 maximizes
min E [W1 ]
if and only if
( b a)
P0 = µ p .
2⇡ a
Hint: The function P1 is concave in s̃. Hence, E [P1 (s̃)] < P1 (µ), and the di↵erence P1 (µ)
E [P1 (s̃)] is maximized at the maximum variance for s̃.
(d) Now take the forward planning approach. Let P0 and P1 (s) be as described in the previous
parts. The investor chooses ✓0 and a plan s 7! ✓1 (s) at date 0 to maximize
min E [W2 ] = min E [W0 + ✓0 {P1 (s̃) P0 } + ✓1 (s){x̃ P1 (s̃)}] .
Show that the investor can achieve unbounded worst-case expected wealth. In particular, choos-
ing ✓0 = 1 and ✓s (1) = 1 for all s is not optimal.
(a) For each , E [x̃ | s̃] = µ + (s̃ µ). Thus,
E [W2 | s̃] = W1 + ✓1 (µ P1 ) + ✓1 (s̃ µ) .
If ✓1 < 0, then ✓1 (s̃ µ) > 0, and
min E [W2 | s̃] = W1 + ✓1 (µ P1 ) + a ✓1 (s̃ µ)
= W1 + ✓1 [µ + a (s̃ µ) P1 ] .
We can make this arbitrarily large by taking ✓1 ! 1 unless
µ+ a (s̃ µ) P1 0.
If ✓1 > 0, then ✓1 (s̃ µ) < 0, and
min E [W2 | s̃] = W1 + ✓1 (µ P1 ) + b ✓1 (s̃ µ)
= W1 + ✓1 [µ + b (s̃ µ) P1 ] .
µ+ b (s̃ µ) P1  0 .
Thus, the existence of an optimum implies
µ+ b (s̃ µ)  P1  µ + a (s̃ µ) .
If the first inequality is an equality, then any long position is optimal. If the second is an
equality, then any short position is optimal. If both are strict inequalities, then ✓1 = 0 is the
unique optimum. Thus, ✓1 = 1 is optimal if and only if
P1 = µ + b (s̃ µ) .
(b) If ✓1 < 0, then ✓1 (s̃ µ) < 0, and
min E [W2 | s̃] = W1 + ✓1 (µ P1 ) + b ✓1 (s̃ µ)
= W1 + ✓1 [µ + b (s̃ µ) P1 ] .
µ+ b (s̃ µ) P1 0.
If ✓1 > 0, then ✓1 (s̃ µ) > 0, and
min E [W2 | s̃] = W1 + ✓1 (µ P1 ) + a ✓1 (s̃ µ)
= W1 + ✓1 [µ + a (s̃ µ) P1 ] .

µ+ a (s̃ µ) P1  0 .
Thus, the existence of an optimum implies
µ+ a (s̃ µ)  P1  µ + b (s̃ µ) .
P1 = µ + a (s̃ µ) .
(c) We have
E [W1 ] = W0 ✓0 P0 + ✓0 E [P1 (s̃)] .
If ✓0 < 0, then E [W1 ] is minimized by maximizing E [P1 (s̃)], which is equivalent to minimizing
the variance of s̃; i.e., taking = b. Thus, for ✓0 < 0,
⇣ ⌘
min E [W1 ] = W0 + ✓0 E b [P1 (s̃)] P0 .
E b [P1 (s̃)] P0 0.
If ✓0 > 0, then E [W1 ] is minimized by minimizing E [P1 (s̃)], which is equivalent to maximizing
the variance of s̃; i.e., taking = a. Thus, for ✓0 > 0,
⇣ ⌘
min E [W1 ] = W0 + ✓0 E a [P1 (s̃)] P0 .
E a [P1 (s̃)] P0  0 .
Hence, the existence of an optimum implies
E a [P1 (s̃)]  P0  E b [P1 (s̃)] .
P0 = E a [P1 (s̃)] .
It remains to calculate this. We have
P1 (s̃) = µ + b (s̃ µ)1{s̃<µ} + a (s̃ µ)1{s̃>µ}
=µ+ b (s̃ µ) ( b a )(s̃ µ)1{s̃>µ} .
Thus,
⇥ ⇤
E a [P1 (s̃)] = µ ( b a )E
a
(s̃ µ)1{s̃>µ}
Z 1 ✓ ◆
x x2
=µ ( b a) p exp dx .
0 2⇡ 2/ 2 2/
To evaluate the integral, use the fact that

✓ ◆
x x2
p exp dx = 2
n0 (x)
2⇡ 2 2 2
where n denotes the normal density with mean zero and variance 2. We have
Z 1
1
n0 (x) dx = n(1) n(0) = n(0) = p .
0 2⇡ 2
Thus, ✓ ◆
Z 1
x x2
p exp dx = p ,
0 2⇡ 2 2 2 2⇡
which yields the result.
(d) For any positive number n, consider ✓0 = n and ✓1 (s) = n for all s. Then, for each ,
⇣ ⌘
E [W2 ] = W0 + n E [x̃] P0 = W0 + n(µ P0 ) ! 1
as n ! 1.
22
Production Models
22.1. Assume there is costless adjustment of capital, i.e. Kt+1 = Kt + It for any It .
(a) Show that a capital stock process is optimal if and only if Kt solves

Mt
max Et 1 [⇡(K, Xt ) + K] K
K Mt 1
for each t.
(b) Show that the first-order condition for the maximization problem in the previous part is a
special case of (22.4a).
(a) Substituting It = Kt+1 Kt in (22.2), the firm’s value is

"1 #
X
E Mt [⇡(Xt , Kt ) Kt+1 + Kt ] .
t=0
This equals
" 1
#
X
M0 [⇡(X0 , K0 ) + K0 ] + E Mt ⇡(Xt , Kt ) Mt 1 Kt + M t Kt ] .
t=1
In this infinite sum, Kt appears in only in the single term
E[Mt ⇡(Xt , Kt ) Mt 1 Kt + M t Kt ] .
Because Kt is chosen at time t 1, maximizing this expectation is equivalent to maximizing the

conditional expectation given time t 1 information in each state of the world. The conditional
expectation is 
Mt
Mt 1 Et 1 [⇡(Xt , Kt ) + Kt ] Mt 1 Kt ,
Mt 1
226 22 Production Models
and maximizing this is equivalent to maximizing


Mt
Et 1 [⇡(Xt , Kt ) + Kt ] Kt .
Mt 1
(b) The first-order condition is


Mt
Et 1 [⇡K (Xt , Kt ) + ] = 1 ,
Mt 1
and ⇡K (Xt , Kt ) + equals Rt defined in (22.4b0 ).
22.2. Assume a firm combines labor L with capital K to produce output Qt = Kt↵ Lt , where ↵
and are constants with ↵ +  1. The firm’s operating cash flow is Pt Qt Wt Lt , optimized over
Lt 0, where P and W are regarded as exogenous stochastic processes. Show that operating cash
flow equals Xt Kt for some exogenous stochastic process X and constant  1, and show that
= 1 if ↵ + = 1.
The first-order condition for maximizing P K ↵ L W L is P K ↵ L 1 = W , which implies
W L = P K ↵L ,
so operating cash flow is

(1 )P K ↵ L .
Furthermore, the first-order condition implies

✓ ◆1/( 1) ✓ ◆1/(1 )
W P K↵
L= = .
P K↵ W
Therefore, operating cash flow is

✓ ◆ /(1 ) ✓ ◆ /(1 )
↵ P K↵ P
(1 )P K = (1 )P K ↵/(1 )
.
W W
This is of the form claimed with = ↵/(1 ). We have  1 because ↵  1 , and = 1 if

↵=1 .
22.3. Assume a firm can produce any output Qt up to a maximum capacity Zt Kt , where Z is
1/
a positive stochastic process. Assume the output price is Pt = Yt Qt for a positive stochastic
process Y and constant > 1. Assume operating cash flow equals revenue Pt Qt .
22 Production Models 227
(a) Show that it is optimal to produce at full capacity Qt = Zt Kt , and operating cash flow is
1 1/
X t Kt , where X = Y Z 1 1/ .
(b) Assume investment is irreversible and there is no depreciation. Assume the risk-free rate r is
constant, the market price of risk is constant, and X is a geometric Brownian motion with drift
µ and volatility . Assume the correlation of X and M is a constant ⇢, and assume µ ⇢ < r.
Show that the value (22.22) of the asset paying marginal cash flow is
✓ ◆
1 1
k 1/ Xt ,
r µ+ ⇢
and the dividend-price ratio is r µ+ ⇢.

(c) Show that the return on the asset, including the dividend, is
(r + ⇢) dt + dB ,
where B is the Brownian motion driving X.

(d) Use the result of Exercise 15.5 to show that the optimal exercise time for the option is
min{t | St (k) /( 1)}, where is the positive root of the quadratic equation (22.27).
Show that this implies Pt Zt  ⇤
for all t and the firm invests only when Pt Zt = ⇤, where
✓ ◆✓ ◆
⇤ 1
= (r µ + ⇢) .
1
Note that Pt Zt is the output price per unit of capital.

(e) The value of each growth option is given by (15.33), where the strike price is 1 and
✓ ◆
1 1
S0 = k 1/ X0 .
r µ+ ⇢
Integrate the values of the growth options over k 2 [K0 , 1) to compute the value of the firm.
What condition on and is needed for the value of the firm to be finite?
(a) The firm chooses Q  ZK to maximize P Q = Y Q1 1/ . Because 1 1/ > 0, the optimum is

Q = ZK. Hence, P Q = Y Z 1 1/ K1 1/ = XK 1 1/ .
(b) Marginal operating cash flow is ⇡K (X, K) = (1 1/ )XK 1/ . The value of the asset paying
marginal cash flow is
✓ ◆ Z 1 ✓ ◆ Z 1 
1 Mu 1 Mu X u
k 1/ Et Xu du = k 1/
Xt Et du .
t Mt t Mt X t
M X is a geometric Brownian motion with drift (r µ+ ⇢). Therefore,


Mu X u (r µ+ ⇢)(u t)
Et =e .
Mt X t
It follows that the value of the asset paying marginal cash flow is
✓ ◆✓ ◆
1 Xt
k 1/ .
r µ + ⇢)
The dividend on the asset is the marginal cash flow, which is

✓ ◆
1
Xt k 1/ .
Therefore, the dividend yield is r µ+ ⇢.

(c) From the previous part,
dS(k) dX
= = µ dt + dB .
S(k) X
Therefore the return on the asset is
(r µ+ ⇢) dt + µ dt + dB = (r + ⇢) dt + dB .
(d) Observing that the strike of the option is 1, Exercise 15.5 shows that the optimal exercise time
is /( 1), where is the positive root of the quadratic equation (15.32). In that equation,
q denotes the dividend yield, which here is r µ+ ⇢. Substituting this value of q, (15.32) is
the same as (22.27). The condition St (k) = /( 1) is equivalent to
✓ ◆✓ ◆
1/
k Xt = (r µ+ ⇢) ,
1 1
and
1/ 1/ 1 1/ 1/
Kt X t = Kt Yt Zt = Qt Y t Z t = Pt Z t .
Thus, the firm invests when

✓ ◆✓ ◆
Pt Zt = (r µ+ ⇢) .
1 1
Via this investment, it ensures St (Kt )  /( 1) for all t, which is equivalent to

✓ ◆✓ ◆
Pt Zt  (r µ+ ⇢) .
1 1
for all t.
(e) From (15.33), the values of the growth options are

✓ ◆✓ ◆  ✓ ◆
1 1 1 1 1/
k X0
1 r µ+ ⇢
✓ ◆ ✓ ◆✓ ◆✓ ◆
1 1 1 X0 /
= k .
1 r µ+ ⇢
The integral of k / over [K0 , 1) is finite if and only if > . Assuming > ,
Z 1
/ ( )/
k dk = K0 ,
K0
and the aggregate value of growth options is

✓ ◆✓ ◆ ✓ ◆✓ ◆✓ ◆
1 1 1 X0 ( )/
K0 .
1 r µ+ ⇢
The value of assets in place is

Z 1 Z 1
1 1/
E Mt ⇡(Xt , K0 ) dt = K0 E Mt Xt dt
0 0
Z 1
1 1/ (r µ+ ⇢)t
= K0 X0 e dt
0
X0 1 1/
= K0 .
r µ+ ⇢
22.4. Under the assumptions of Section 22.8, marginal q (22.23) is a function of Xt . Denote this
function by f . The purpose of this exercise is to derive the formula (22.26) for f .
(a) Show that

Z t
Mu Xu du + Mt f (Xt )
0
is a martingale.
(b) Using Itô’s formula and the result of the previous part, show that f satisfies the di↵erential
equation
1
x + (µ ⇢)xf 0 (x) + 2 2 00
x f (x) = rf (x)
2
for 0 < x < x⇤ .
(c) Show that the function
x
r µ+ ⇢
satisfies the di↵erential equation.
(d) Show that the homogeneous equation
1
(µ ⇢)xf 0 (x) + 2 2 00
x f (x) = rf (x)
2
is satisfied by Ax for constants A and if and only if is a root of the quadratic equation
(22.27).
(e) The general solution of the di↵erential equation in Part (b) is
x
+ A1 x 1
+ A2 x 2
r µ+ ⇢
for constants Ai , where the i are the roots of the quadratic equation. From the definition of f ,
it follows that limx#0 f (x) = 0. Use this fact to show that
x
f (x) = + Ax ,
r µ+ ⇢
where is the positive root of the quadratic equation and A is a constant.

b part. Thus,
(f) Because the process in Part (a) is a martingale, its di↵erential cannot have a dK
b t in df (Xt ) calculated from Itô’s formula must be zero when Xt = x⇤ . Use
the coefficient of dK
this fact to compute the constant A and derive (22.26).
(a) We have
Z t Z t Z 1
Mu
Mu Xu du + Mt f (Xt ) = Mu X u + Mt E t Xu du
0 0 u Mt
Z 1
= Et Mu Xu du .
0
(b) The di↵erential is

 ✓ ◆
dM dM
M X dt + M df + f dM + (df )(dM ) = M X dt + df + f + (df ) .
M M
Also,
1
df = f 0 (X) dX + f 00 (X) (dX)2
2
✓ ◆
0 dX 1 2 00 dX 2
= Xf (X) + X f (X) ,
X 2 X
and
dX dW 1 dKb
= .
X W b
K
Hence, ✓ ◆2 ✓ ◆2
dX dW 2
= = dt ,
X W
and
✓ ◆ ✓ ◆✓ ◆ ✓ ◆✓ ◆
dM 0 dX dM 0 dW dM
(df ) = Xf (X) = Xf (X) = ⇢Xf 0 (X) dt .
M X M W M
Therefore, the coefficient of dt in the di↵erential is

1 2 2 00
M X + µXf 0 (X) + X f (X) rf ⇢Xf 0 (X) .
2
Equating this to zero yields the di↵erential equation.
(c) For this function f ,
1 (µ ⇢)x rx
x + (µ ⇢)xf 0 (x) + 2 2 00
x f (x) = x + = = rf (x) .
2 r µ+ ⇢ r µ+ ⇢
(d) Given f (x) = Ax , we have
1 1
(µ ⇢)xf 0 (x) + 2 2 00
x f (x) rf (x) = (µ ⇢)Ax + ( 1) 2
Ax rAx .
2 2
This is equal to zero for all x 6= 0 if and only if
1 2
(µ ⇢) + ( 1) r = 0,
2
which is the quadratic equation (22.27).
(e) If 2 < 0, then f (x) ! 1 as x ! 0, unless A2 = 0.
(f) The term involving dK̂ in the calculation in Part (b) comes from M df and is equal to
1 dKb
M Xf 0 (X)
Kb
This is equal to zero when Xt = x⇤ if and only if f 0 (x⇤ ) = 0. We have
1
f 0 (x) = + Ax 1
.
r µ+ ⇢
Setting this equal to zero at x = x⇤ yields
✓ ◆
1 1
A= (x⇤ )1 .
r µ+ ⇢
Hence,
✓ ◆
1 1
f (x) = x (x⇤ )1 x
r µ+ ⇢
✓ ◆
x 1⇣x⌘ 1
= 1 .
r µ+ ⇢ x⇤

Solutions Manual: Asset Pricing and Portfolio Choice Theory: Kerry Back

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Solutions Manual:

Asset Pricing and Portfolio Choice Theory

Part I Single-Period Models

1 Utility Functions and Risk Aversion Coefficients . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2 Portfolio Choice and Stochastic Discount Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

3 Equilibrium and Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

4 Arbitrage and Stochastic Discount Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

6 Beta Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

Part II Dynamic Models

8 Dynamic Securities Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

9 Portfolio Choice by Dynamic Programming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

10 Conditional Beta Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

11 Some Dynamic Equilibrium Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

12 Brownian Motion and Stochastic Calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

13 Continuous-Time Securities Markets and SDF Processes . . . . . . . . . . . . . . . . . . . . . 111

14 Continuous-Time Portfolio Choice and Beta Pricing . . . . . . . . . . . . . . . . . . . . . . . . . 127

Part III Derivative Securities

15 Option Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

16 Forwards, Futures, and More Option Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

17 Term Structure Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

18 Heterogeneous Priors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197

19 Asymmetric Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

20 Alternative Preferences in Single-Period Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

21 Alternative Preferences in Dynamic Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

22 Production Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225

Utility Functions and Risk Aversion Coefficients

u(w ⇡( )) = E [u(w + "˜)] .

Assuming ⇡ is a sufficiently di↵erentiable function, we have the Taylor series approximation

Taking first derivatives gives

Thus, ⇡ 0 (0) = 0. Taking second derivatives gives

Hence, ⇡ 00 (0) = u00 (w)/u0 (w).

1.4. Consider a person with constant relative risk aversion ⇢.

(a) For log utility, the left-hand side of (1.10) is

log((1 ⇡)w) = log(1 ⇡) + log w ,

and the right-hand side is

E[log((1 + "˜)w)] = E[log(1 + "˜)] + log w ,

log(1 ⇡) = E[log(1 + "˜)] , ⇡=1 exp (E[log(1 + "˜)]) .

and the right-hand side is

Hence, ⇡ does not depend on w.

Therefore, the proportional risk premium is

1.5. Consider a person with constant relative risk aversion ⇢.

⇡=1 e0.5 log(1+")+0.5 log(1 ")

and, for power utility,

This implies the following:

0.5 $0.03 $2.50 $251 $1,588

This is true for all y > 0 if

Thus, BID satisfies

Thus, ASK satisfies

"|ỹ] = 0 then cov(ỹ, "˜) = 0 (thus

By iterated expectations and mean-independence,

In case (i), set ↵ = 1/A. For any constant y,

u0 (w) = u0 (y)e ↵(w y)

= log u0 (y) ⇢(log w log y) .

which is a monotone affine transform of log w. If ⇢ 6= 1, then

for x > 0. This implies

u(w) = v(A + Bw) .

(a) Construct a gamble w̃ such that E[u(w̃)] = 1. Verify that E[w̃] = 1.

Define p = /(1 + ). With probability 1 p, let

On this event, we have

Set f (↵) = e ↵w . We have

ˆ < ↵, and f 0 (↵) = we

G = {;, {!1 }, {!2 }, {!3 }, {!1 , !2 }, {!1 , !3 }, {!2 , !3 }, ⌦} .