NATIONAL UNIVERSITY OF SINGAPORE

SEMESTER 1 AY 2021/2022

MA3269 - Mathematical Finance I

30 November 2021 17:00 – 19:00

INSTRUCTIONS TO CANDIDATES

1. Get ready a signed copy of the Exam declaration form for this exam.
2. Use A4 size paper and pen (blue or black ink) to write your answers.
3. Write down your student number clearly on the top left of every page of the answers. Do not
write your name.
4. Write on one side of the paper only. Write the question number and page number on the top
right corner of each page (e.g. Q1P1, Q1P2, . . ., Q2P1, . . .).
5. This examination paper contains FIVE (5) questions and comprises SIX (6) pages. Answer
ALL questions.
6. The total mark for this paper is ONE HUNDRED (100).
7. This is an OPEN BOOK examination.
8. You may use any calculator. However, you should lay out systematically the various steps in the
calculations.
9. Join the Zoom conference and turn on the video setting at all time during the exam. Adjust
your camera such that your face and upper body including your hands are captured on Zoom.
10. You may go for a short toilet break (not more than 5 minutes) during the exam.
11. At the end of the exam,
• scan or take pictures of your work (make sure the images can be read clearly) together with
the declaration form;
• merge all your images into one pdf file (arrange them in the order: Declaration form, Q1 to
Q5 in their page sequence);
• name the pdf file by Matric No MA3269 (e.g. A123456B MA3269);
• upload your pdf file into the LumiNUS folder “Exam Submission”.
12. The Exam Submission folder will close at 19:15 hr (including preparing and uploading
answers). After the folder is closed, exam answers that are not submitted will not be accepted,
unless there is a valid reason.

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Question 1. [20 marks] In parts (a) and (b), all options have the same underlying non-dividend-
paying stock and time to maturity. In part (b), C(K) and P (K) denote respectively the price of a
call option with strike price K and the price of a put option with strike price K.

(a) An option trader takes a long position in 2 call options with strike price 60, a short position in
3 put options with strike price 80, and a long position in 4 put options with strike price 100. Draw
the payoff table and sketch the payoff diagram for the trader’s portfolio at maturity.

(b) Suppose K1 , K2 and K3 are positive integers such that K1 < K2 < K3 .

(i) Use the put-call parity to show that

K2 (P (K2 ) − C(K2 )) − K1 (P (K1 ) − C(K1 ))

= (K1 + K2 )e−rT − S0 ,
K 2 − K1
where T is the common time to maturity of the options, r is the continuously compounded
risk-free rate, and S0 is the initial price of the underlying stock.
(ii) If K3 − K2 = 2(K2 − K1 ), then use a no-arbitrage argument to show that

2(P (K2 ) − P (K1 )) ≤ P (K3 ) − P (K2 ).

(c) A non-dividend-paying stock has a current price of $100. Over each of the next two three-month
periods, the stock price is expected to go up by 20% or go down by 15%. The continuously-
compounded risk-free rate is 5% per annum. A six-month European option has payoff function
 
S1 + S2
max − 85, S2 − 80, 0 ,
2
where S1 and S2 are respectively the stock prices at the end of three months and six months. Use a
two-period binomial model to find the price of this option. Give your answer to two decimal places.
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Question 2. [10 marks]

A certain financial market satisfying the Capital Asset Pricing Model (CAPM) consists of n (n > 2)
risky assets, whose return rates have covariance matrix C, and a risk-free asset. Assume the beta
vector is β.

It is desired to find the portfolio that has the smallest variance among all portfolios who have
one-beta, i.e. β T w = 1, and invest 50% of wealth in the risk-free asset, i.e. 1T w = 1/2.

In other words, the desired portfolio, solves the following optimisation problem
1 T
min w Cw
w 2
such that
1
1T w = and β T w = 1.
2

Let a = 1T C −1 1, r = 1T C −1 β, s = β T C −1 β.

Use the method of Lagrange multipliers to find the optimal w∗ in terms of 1, β, C, a, r and s. (You
may assume that as > r2 .) Give your answer in the simplified and exact form.
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Question 3. [30 marks] In this question, all numerical answers must be simplified and in the
exact form of integers or fractions.

A financial market consisting of n (n > 2) risky assets and a risk-free asset satisfies the Capital Asset
Pricing Model (CAPM). In the above diagram which shows the frontier curve for risky assets and
the capital market line (CML), G is the point representing the global minimum-variance portfolio
(GMVP), M is the point representing the market (tangency) portfolio, A is the point representing a
portfolio on CML, B is a point representing a portfolio on the efficient frontier for risky assets, and
C is a point representing a zero-mean portfolio on the inefficient frontier for risky assets.

The portfolios A and G have the same variance. The portfolios B and C have the same variance.
The portfolios A and B have the same mean. The equation of the frontier curve for risky assets is

σ 2 = 12µ2 − 8µ + 4.

Assuming the mean of GMVP is higher than the risk-free rate, find

(i) the equation of the asymptote to the efficient frontier curve for risky assets;
(ii) the variance of the portfolio C;
(iii) the mean and variance of the portfolio G (i.e. the GMVP);
(iv) the mean of the portfolio A;
(v) the covariance of the rates of return of the portfolios G and C;
(vi) the covariance of the rates of return of the portfolios B and C;
(vii) the mean and variance of the portfolio M (i.e. the market portfolio);
(viii) the equation of CML;
(ix) the risk-free rate;
(x) the beta of the portfolio B;
(xi) the covariance of the rates of return of the portfolios A and G;
(xii) the covariance of the rates of return of the portfolios A and C.
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Question 4. [20 marks]

(a) An agent with an initial wealth of $1 and utility function U (w) = − exp(−αw), w > 0, α > 1,
is offered an investment X whose rate of return, R follows the probability distribution given below.

r −0.2 0 0.5
P(R = r) 0.2 0.5 0.3

(i) If α = 2, find the certainty equivalent of investment X. Give your answer to four significant
figures.
(ii) Let RU denote the Arrow-Pratt absolute risk aversion function associated with U . Find all
utility functions V whose associated Arrow-Pratt absolute risk aversion function is RV =
1 + RU
. Give your answer in terms of α.
w
(iii) An investor with an initial wealth of $1 and a utility function V , which is obtained in (ii),
wants to maximize his expected utility by investing $x in investment X and keeping the
remaining $(1 − x) in cash that earns zero interest, where 0 ≤ x ≤ 1. Assuming the optimal
x satisfies 0 < x < 1, find the optimal x in terms of α, and determine the range of α.

(b) Let U1 and U2 be strictly concave utility functions, whose domain and range are both (0, ∞).
Let U be defined by
U (w) = U1 ◦ U2−1 (w) + w, w ∈ (0, ∞),

where U2−1 is the inverse function of U2 . Suppose the investor with the utility function U1 is globally
more risk averse than the investor with the utility function U2 .

(i) Prove that U is increasing.

(ii) Prove that the investor with the utility function U is risk averse.
(iii) Let R1 , R2 and R denote the Arrow-Pratt absolute risk aversion functions associated with U1 ,
U2 and U respectively. Prove that
(R1 − R2 ) ◦ U2−1
 

2 1 1
= U20 ◦ U2−1 · + .
R U10 ◦ U2−1 U20 ◦ U2−1
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Question 5. [20 marks] In this question, ra , µa , σa denote respectively the rate of return, mean
and standard deviation of a portfolio labeled a.

A financial market consists of n (n > 2) risky assets. Suppose x is a portfolio on the efficient
frontier for risky assets, not necessarily the market (tangency) portfolio. Assume x is not the global
minimum-variance portfolio (GMVP). Let y be a portfolio, whose representing point Y on the σ − µ
plane is obtained in the following way:

• draw the tangency line to the efficient frontier for risky assets at the point X, which represents
the portfolio x;
• find the intercept point Z of this tangency line with the vertical axes (i.e. the µ-axis);
• finally, draw a horizontal line parallel to the horizontal axis (i.e. the σ-axis) starting from Z,
and find the intercept point Y of this horizontal line with the frontier for risky assets.

Prove

(i) Cov(rx , ry ) = 0;
(ii) for any portfolio p investing in n risky assets,
Cov(rp , rx )
µp − µy = (µx − µy ) .
σx2

– END OF PAPER –