Solution sketches and hints for selected problems

Peter Cziraki, University of Toronto

I. The Time Value of Money

1. For monthly payments, we simply need to obtain the monthly interest rate, which can be calculated
from the yearly rate. In cases where the first payment occurs immediately, we can simply add it to the
rest of the annuity/perpetuity. We do not need to discount it since we are paid the money immediately.
2. Hint: rearrange the perpetuity formula to isolate the P/E ratio on one side of the equation. The
interpretation follows from this rearranged equation.

3. (a) Hint: As a reality check: do we ever observe this in real life? Can you think of some examples?
What type of firms might exhibit this property?
(b) Hint: think about where such a firm would obtain funding from. What would happen to all ‘other’
firms in the economy?

4. We are looking for t that satisfies

2C = C × (1 + r)t ⇔ 2 = 1 × (1 + r)t .

Take logs and simplify

ln 2
t × ln(1 + r) = ln 2 ⇔ t = .
ln(1 + r)
Assuming the usual returns on long-term portfolios, i.e. between 6-8% (take a look at assumptions
pension funds make), the investment will take 9-12 years to double.

5. Similarly to problem (1), we can redefine the unit of time to be 5 years. Then, all we need to do is
calculate the 5-year interest rate (assuming yearly compounding), and substitute into the perpetuity
formula.
6. As a first (incorrect) approach (which does build intuition, however) we could just add up the cash
flows in each year, counting how many times $25,000 equals $200,000 – the answer is 8. The reason
this would be incorrect is because the $25,000 received 10 years after retirement is worth much less
than the $200,000 paid exactly at retirement. (Corollary: the correct answer has to be larger than 8.)
To correct for the time value of money we can write the pension payments as an annuity, and solve
 
25, 000 1
200, 000 = 1− .
0.05 (1 + 0.05)t

Rearrange and take logs. The correct answer is the first integer t higher than the number calculated
from the equation. In this particular case, it would take 11 years – which is considerably longer than
the 8 years that the ‘naive’ approach wiithout discounting would suggest.

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II. Preferences and Risk
1. The key to both (1) and (2) is graph the distributions. What do the probabilty density functions of
these distributions look like? From the probability density functions you can derive the cumulative
distribution functions, and use the definitions to make your comparisons.
2. Idem
3. For the VaR, think through the definition of the measure. What happens in the left tail of the
distribution? Where is the ‘leftmost’ 5% of the return distribution? The GLPM measure follows from
the definition (use Excel to simplify computations).
4. Hint: In general, what is the variance of the sum of two random variables?

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IV. Mean-Variance Analysis
1. It is suficient if the investor is risk-neutral, or (for professional investors) has an external benchmark
that is linked to the expected return only.
2. Because B may have a negative correlation with the rest of their portfolio so that adding B to the
portfolio decreases the overall variance of the portfolio – i.e. the additional covariance effect dominates
the effect additional variance.

3. 3.1. Set the portfolio standard deviation to zero and rearrange.

3.2. Go back to the original formulation on p.36. and substitute the newly calculated α into the first
(i.e. the expected return) equation.
3.3. Since this portfolio of assets 1 and 2 is risk free, the expected return of the portfolio must also
equal the risk-free rate in the economy, otherwise there is a profitable arbitrage opportunity.
3.4. Suppose wlog that asset 1 has the higher expected return of the two assets. The upper line
segment is the hypotenuse of a right-angled triangle in which the adjacent is σ1 and the opposing
is µ1 − µp where µp is the expected return calculated in 3.2. As a result, the slope of the line
µ −µ
segment is 1σ1 p
4. Write down the portfolio return in general (for the random return), and then take expectations.
5. Take the expected return for the GMV portfolio from slide 46, substitute it into the portfolio variance
formula in slide 45, and rearrange.
6. 6.1. 20.1607%
6.3. 24.8574%, 17.7719%, 3.7134%
6.4. wM = 0.6491, E[rp ] = 10.4561%

7. 7.1. A = 0.9134, B = 7.1571, C = 62.3847.

wGM V = [0.3076, 0.2344, 0.4580]
7.2. See slide 46 for the formulae
7.3. 11%
7.4. wp = [0.5608, 0.0811, 0.3581]
7.5. See slide 60 for the formula
7.6. See slide 66 for the formula
8. Write down the definition of covariance, and substitute the risk-free asset as one of the two assets

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V. The CAPM
1. 1.1. 11%
1.2. Substitute the β values into the security market line to obtain the expected returns
1.3. From slide 16, we know that the portfolio β is the weighted average of the individual asset βs
2. Download daily closing prices from Yahoo finance or Google finance. You can treat the NYSE Amex
Composite as the market portfolio. For the interpretation, recall that the CAPM is a model of expected
returns (not realized returns).

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VI. Arbitrage Pricing Theory
1. First, write down the relation between expected returns µ, factor loadings β and factor premia λ. We
know that
0.09 = rf + 2λ
and
0.16 = rf + 4λ

Solving this, we see that the risk-free rate is 1% and the factor premium is 4%. Writing down the
equation for Ford,
0.14 > 0.01 + 3 × 0.04
Ford is underpriced, because taking an exposure of 3 to the factor (GDP growth) should be associated
(≈rewarded) with an expected return of 13%, whereas Ford’s expected return is 14%. Once the
arbitrageurs notice this (according to the APT, this happens instantaneously), they will start buying
Ford, which increases prices today, leading to a decrease in expected returns, until the pricing equation
is satisfied.

2. 2.1. Working in terms of factor premia, we have

E[ri ] = rf + βi,mkt × (rmkt − rf ) + βi,size × λsize

2.2. [1.04; 1] for Badger, and [0.09; 0] for Loblaws. The latter is not exactly true in the FF sense of
the size factor (SMB), but would be appropriate for the information given (treating firm size as
binary so that only small and large firms exist).
2.3. Putting 2.1.and 2.2. together, you can calculate the expected returns with the information on
slide 2.
3. Collecting the information, we have  
1 1 1
B :=  2 4 7 
1 5 6

and
 
0.09
µ =  0.17 
0.21

3.1. We need to solve (f) from slide 29. The weight vector is [1.1; 0.5; -0.6].
3.2. Using the weights above, or the direct approach from slide 38, rf = 5.8%.
3.3. We need to solve (1) and (2) from slide 29. The weight vectors are [1.2; 0; -0.2] for the GDP
factor portfolio, and [0.8; 1; -0.8] for the inflation factor portfolio.
3.4. Using the weights above, or the direct approach from slide 38, E[rF 1 ] = 6.6% and E[rF 2 ] = 7.4%.
3.5. Given the answers to the previous questions, we have

E[ri ] = 0.058 + βi,1 × 0.008 + βi,2 × 0.016

3.6. Writing down the equation for BMW,

0.15 < 0.058 + 1 × 0.008 + 8 × 0.016

BMW is overpriced.

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3.7. We can use a replicating portfolio of Second Cup, Boeing, and Tiffany to obtain an asset with the
same factor loadings [1; 8], but a higher expected return. The resulting portfolio weights are [-1.2;
4; -1.8]. Then our arbitrage strategy is to go long in this replicating portfolio and short in BMW.
The portfolio has no risk because the factor exposures were chosen so that the long and the shrot
positions offset. Taking an exposure of 1 to the first factor (unexpected GDP growth) and an
exposure of 8 to the second factor (unexpected inflation) should be associated (≈rewarded) with
an expected return of 19.4%, whereas BMW’s expected return is 15%. The arbitrage portfolio
will therefore generate a risk-free return of 4.4%.
3.8. No. Once the arbitrageurs notice the opportunity outlined in (3.7.) (according to the APT,
this happens instantaneously), they will start short selling BMW, which decreases prices today,
leading to an increase in expected returns, until the pricing equation is satisfied. Also, they will
buy a replicating portfolio of Second Cup, Boeing, and Tiffany (to offset their risk exposure in the
long-short strategy), so the prices of those assets will rise, leading to a decrease in their expected
returns. The two effects remain until the pricing equation is once again satisfied.

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 VII. Law of One Price, Arbitrage, Stochastic Discount Factors
1. 1.1. 4 securities – one for each factor (3) and one for the condition that weights must sum to 1. See
e.g. lecture 6, slide 25.
1.2. 50 securities whose payoffs are linearly independent: we need as many securities (N) as states (S).
See lecture 7, slide 42
2. 2.1. We need to solve Xθ1 = [1; 0]0 and Xθ2 = [0; 1]0 . The weight vectors are [0.4; -0.2] for the AD
security of state 1 and [-0.3; 0.2] for the AD security of state 2.
2.2. Using the formula from slide 36, we have ψ 0 = [0.56; 0.43]
2.3. As discussed in class, the state price for state 1 is higher. This means that investors are willing to
pay a higher amount today for an additional unit of payoff in that state, hence that state is more
“scarce”. Note that this result hinges critically not only on the payoffs, but also on the relative
prices of the assets today. You can verify that if the stock were trading at 18 dollars today (not
17), then state 2 would be the “scarce” state.
3. See slide 38.
4. 4.1. Yes, because we can find an unique vector of state prices, ψ – and, given the probabilities, an
unique sdf, m.
• Intuitively: there is no combination of assets 1 and 2 that would yield asset 3.
• More formally: we can solve (there is an unique solution to) the system of equations
16 = 13ψ1 + 18ψ2 + 21ψ3
10 = 10.1ψ1 + 10.1ψ2 + 10.1ψ3
23 = 20ψ1 + 26ψ2 + 27ψ3
which, of course, is p = Xψ from slide 36.
• More formally, using Excel: We can solve above problem directly, applying ψ = X −1 p. We
can verify in Excel that the inverse X −1 exists, and therefore we have an unique ψ.
4.2. Yes, because ψ  0, the vector of state prices is strictly positive. (Given that probabilities are
also strictly positive, this also means that m  0.)
4.3. For example, θ40 = [0; 0.6; 1] will have payoffs [26.06; 32.06; 33.06], and θ50 = [1; 1.3; 0] will have
payoffs [26.13; 31.13; 34.13]. Many other solutions are also possible
5. Use the conditions from slide 42. The following market, for example, is incomplete:

Asset Price s=1 s=2 s=3 s=4

1 16 13 18 21 32
2 10 10.1 10.1 10.1 10.1
3 23 20 26 27 40

6. Use the definition from slide 24. The LooP does not hold in this market:
Asset Price s=1 s=2 s=3
1 16 13 18 21
2 10 10.1 10.1 10.1
3 18 13 18 21
Probability 0.2 0.3 0.5

Notice that 1 and 3 have the same payoffs, but different prices. We cannot find the state prices.
6.1. Security 1 is underpriced and security 3 is overpriced. This cannot be an equilibrium, because
no investor would hold asset 3. Investors would short asset 3 and go long in asset 1 until prices
converge.
7–9. The proofs can be found in Cochrane pp. 62-72.

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VIII. Consumption-Based Asset Pricing
1. 1.1. See lecture 8, slide 6.
1.3. We can find the individual’s willingness to pay for the asset by applying p = E[mx].
0
First, in the consumption-based model, we know that the sdf is equal to m := β uu(c t+1 )
0 (c ) . Supposing
t
now that the investor consumes all his endowment in the first period, as stated in (1.2.), we can
pin down the denominator u0 (ct ). The only variation in the sdf will come from the expected utility
across states tomorrow.
We obtain m0 = [0.96; 0.768]. Therefore p = E[mx] = 16.896.
1.4. We calculated the sdf in the previous step.
Applying the definition of the sdf from lecture 7, slide 39, we obtain ψ 0 = [0.576; 0.3072]
1.5. Applying the definition of risk-neutral probabilities from lecture 7, slide 43, we obtain
ψ̂ 0 = [0.6521; 0.3478]
Like the true (‘physical’) probabilities, risk-neutral probabilities are strictly positive and sum to
one. However, from slide 18 of lecture 8, we know that the risk-neutral probabilities overweight
bad states, and underweight good states, relative to the true probabilities. In this particular case,
the bad state (c1 = 16) is overweighted, the risk-neutral probability rises from 60% to 65.21%,
and the good state is underweighted.
1.6. From lecture 7, slide 39, we know the relation between state prices and the risk-free rate. The
price of a risk-free bond is 0.8832 per unit of face value. Therefore, the risk-free rate is 13.22%

2. 2.1. We need 2 assets whose payoffs are linearly independent.

2.2. We need 4 assets whose payoffs are linearly independent.
2.3. In that case, we would need 2 assets (whose payoffs are linearly independent) because that would
allow us to construct the factor portfolios.

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IX. Efficient Financial Markets
1. See lecture 9, slide 19. The price is weighted sum of future dividends. As a result, we typically think
that as dividends move, prices should move less. Another way of stating the problem is that to justify
the observed volatility of stock prices, we would need to believe that investors frequently and drastically
change their views on future dividends. This also holds for the aggregate stock market, i.e. is unlikely
to be driven by idiosyncractic (firm-specific) effects.
2. Joint hypothesis problem: we cannot jointly test the hypotheses that markets are efficient and the
asset pricing mode we are using is correct. We can only test whether markets are efficient assuming
that our asset pricing model is correct. Similarly, we can only test whether our asset pricing model is
correct assuming that markets are efficient.
The second question does not have a single correct answer. Focus on the quality of your argumentation.
3. Hint: would professional investors be able to earn superior returns in a financial market that is strong-
form efficient?
Structure your answer based on the empirical evidence discussed in class and the relevant chapters in
EGBG.