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The University of Western Australia

School of Mathematics and Statistics


STAT33644: PRACTICE EXERCISES 2 (2011)
1. (a) In a single day a certain investment gains 30%, doesnt change, or loses 20%, and
these occur with probabilities 0.3, 0.4 and 0.3, respectively. Is this a good investment? (There
are several possible answers depending on what you assume.)
(b) A particular investment gains 50% or loses 40% per day with equal probability. Daily
changes are independent. The investment is to be held for 2 days and then sold. Let C
n
be its
value after n days and C
0
= 1. Let n = 2.
(i) Find the mass function of C
2
, and decide whether you think this is a good investment? Ex-
plain your answer.
(ii) Calculate Pr(C
2
> 1) and E(C
2
). Does it surprise you that Pr(C
2
> 1) <
1
2
but E(C
2
) > 1?
Explain!
(iii) Under what circumstances could this investment be considered a good one? [Hint: Focus
on the meaning of the nding E(C
2
) > 1.]
(iv) What about the long-term outlook for individual investors?
(c) A security is priced at $1 today, and its future values uctuate randomly from day to
day, increasing by 20% with probability p and decreasing by 25% with probability 1 p.
(i) Suppose a large number of independent purchases are made in a single day. For which values
of p does the average value (over one day) per investment exceed $1?
(ii) Suppose a single security is purchased and held for a long time. For which values of p does
the average value per day exceed $1? (Assume day to day changes are independent.)
(d) This is Siegels paradox, concerning exchange rates. (i) Suppose the euro to US dollar
exchange rate is unity today and for tomorrow it is a random variable R taking the values 1.25 or
0.8, each with probability
1
2
. Evaluate E(R). Think about the law of the dollar to euro exchange
rate tomorrow, R
1
. What is its law and expectation? Find the corresponding geometric mean
E
g
(R).
(ii) Now let A be a generic single period growth factor in the binomial tree model with 0 < d <
1 < u. Find values for p such that E(A) = E(A
1
). Do such values always exist? Under what
circumstances does A
L
= A
1
?
(iii) Formulate and solve the analagous problem when A LN(,
2
).
Answers. (a). Let C denote the value of the investment after one day. Compute E(C) and
the geometric mean E
g
(C) = exp(E(log C)) by tabulating:
Value c 1.3 1 0.8 Means
Probability p(c) 0.3 0.3 0.4 a = E(C) = 1.01
log c 0.2624 0 -0.2231
(log c)p(c) 0.07871 0 -0.08926 E(log C) = 0.010548
1
By denition E
g
(C) = exp(0.010548) = 0.98951. (Note: Work your arithmetic accurately and
dont round-o until the end. Otherwise you may accumulate large rounding errors.) Asking if
this is a good investment requires specifying good for who?. Contrasting answers are collective
good and individual good.
If this investment is independently made by many people then the law of large numbers
implies that the average value of their investment is E(C), and so it is a reasonable investment;
on average they will realize 1% return per day. However, the table shows that only about 30%
of investors will see an increased value. Similarly, many people holding the investment for N
days realize a nett return near a
N
1 > 0. So this investment looks good for the community.
It is not so good as a long-term investment for individuals since the long-term average return
is, by denition, 100 (E
g
(C) 1) = 1.0493%. What can you say to an individual investor
holding for N days? You could compute
N
= g
N
1 where g
N
= [E(C
1/N
)]
N
. Calculations
show that g
2
= 0.9996, suggesting the investment should not be held longer than one day. Em-
phasizing whats above, you could observe that even for one day you have a 30% chance of a
30% increase and a 40% chance of a 20% decrease, and you may or may not be prepared to
accept this gamble, depending on your degree of risk aversion. If you contemplate holding for
N 2 days, then you need to evaluate the pmf of the value C
N
by day N, a trinomial tree
calculation.
1(b). Suppose the current price is $1. On day 2 the investment value is C
2
and its mass
function p
2
(c) = P(C
2
= c) is:
c 1.5
2
= 2.25 1.5 0.6 = 0.9 0.6
2
= 0.36
p
2
(c) 0.25 0.5 0.25
(a) Thus E(C
2
) = 2.25 0.25 + 0.9 0.5 + 0.36 0.25 = 1.1025 = 1.05
2
. So this looks likes
a good deal: If many individuals buy and hold for two days, their nett worth increases by just
over 10%. But the two-day individual investor might compute to nd g
2
2
= 0.9987, i.e. a small
negative return over two days of 0.13%.
(b) Pr(C
2
> 1) = 0.25. This is compatible with the computed value of E(C
2
) since the large
possible value 2.25 occuring with probability 0.25 osets the eects of the two possible values
which are less than 1.
(c) The investment is good on average for many two-day investors. However the individual
investor should realize that this average increase in overall wealth entails some 75% of investors
losing money! Once again, individual degree of risk aversion is an important factor.
Holding for many days looks undesirable since the long-term average return is 5.13% (com-
pute the geometric mean for a single day).
1(c). (a) After one day the average value of C = C
1
is
E(C) = p 1.2 + (1 p) 0.75 = 0.75 + 0.45 p.
Thus E(C) 1 i p (1 0.75)/0.45 = 5/9 = 0.556.
(b) This requires nding p so that the geometric mean E
g
(C) 1. But
E
g
(C) = exp [p log 1.2 + (1 p) log 0.75] ,
2
so E
g
(C) 1 i the exponent 0, i.e.
p
log 0.75
log 1.2 log 0.75
=
0.2877
0.1823 + 0.2877
= 0.6121.
Remark: This calculation shows that p must be larger for protable long-term investment in
this security than for protable collective short-term investment.
1(d) (a) Since 1/0.8 = 1.25 we have R
d
= R
1
and hence E(R
1
) = E(R) =
1
2
(1.25 + 0.8) =
1.025. The paradox is that since E(R) > 1, the mean euro/dollar and dollar/euro rates both
exceed unity. This suggests that a strategy of continued exchanging back and forth between
these currencies will in the long run parlay a modest initial outlay into a large fortune. Such
a long run strategy should be assessed by examining E
g
(R) = exp [
1
2
(log 1.25 + log 0.8)] = 1,
implying that this strategy is neutral in the long run. The nite horizon expectations g
N
exceed
unity and they decrease fairly quickly toward unity: g
2
= 1.013, g
5
= 1.0050, and g
10
= 1.00249.
[Note: Anyone contemplating this strategy would calculate Q
N
:= P(R
N
> 1) where R
N
is a product of
independent copies of R. They would nd that Q
N
= P(U
N
> N/2) where U
N
Bin(N,
1
2
). Symmetry
properties of this binomial law imply that Q
N
=
1
2
if N is odd, and Q
N
<
1
2
if N is even. These give odds
similar to casino games which are never in the gamblers favour. General theory shows that there is no
strategy which can improve this situation, and that eventually the persistent gambler loses everything.
This is inescapable nothing you can do will save you from ultimate ruin.]
( b) You know that E(A) = pu + qd, and in the same way you compute E(A
1
) = p/u + q/d.
These are equal if p =
1
2
and d = u
1
, the situation in (a). More generally, some algebra shows
they are equal if
p =
d
1
d
u u
1
+d
1
d
,
and the restrictions on u and d imply that 0 < p < 1, i.e. given two of the parameters there is a
single value of the third such that A and A
1
have the same expectation. They have the same
distribution if and only if p =
1
2
and d = u
1
.
2. The continuously compounded rate of return on a particular stock has a normal distribu-
tion with mean 10% and standard deviation 20%. The stocks price is currently $50. Find the
probability that in one year the price will be between $55 and $60.
Answer. Let S denote the stock price after one year. The one-year accumulation factor is A =
S/50, and the given information tells us that A LN(0.1, 0.2), i.e., X = log A N(0.1, 0.2
2
).
You want
p := Pr(55 S 60) = Pr(55/50 A 60/50) = Pr(log 1.1 X log 1.2).
Standardizing in the usual way yields
p =
_
log 1.2 0.1
0.2
_

_
log 1.1 0.1
0.2
_
= (0.4116)(0.02345) = 0.65970.4906 = 0.1691.
I used a statistical package to get the nal normal distribution probabilities, but using tables
will give almost the same answer.
3
3. The per period return X on a certain security is modelled as
X =
_
+ with probability
1
2
,
with probability
1
2
,
where and > 0 are constants. Let A = 1 +X be the corresponding per period accumulation
factor (or price relative; so X is not a log-return).
(a) Show that the mean and variance of A are 1 + and
2
, respectively.
(b) Assuming < 1 + (why??), show that the geometric mean of A is
E
g
(A) =
_
1 + 2 +
2

2
.
(c) In nancial situations and typically are near zero. Use the expansion

1 +z 1 +
1
2
z
1
8
z
2
+ ,
valid for z 0, to derive the approximation
E
g
(A) 1 +
1
2

2
= E(A)
1
2
V ar(A).
Compare the exact and approximate values for the following parameter values: (i)
1
= 13.0%
and = 20.2%, and (ii)
2
= 6.0% and = 8.7%. Express the results in percentage terms.
This approximation appears in texts on investments, and it is discussed at some length by J.D.
McBeth, Whats the long-term expected return to your portfolio, Financial Analysts Journal,
51(5) (1995), 68. It is in fact a rather poor approximation; see O. de La Grandville, The
long-term expected rate of return: setting it right, Financial Analysts Journal, 54(5) (1998),
7580.
Answer. (a) Clearly E(X) =
1
2
( + ) +
1
2
( ) = , and hence E(A) = 1 + . Similarly
E(X
2
) =
1
2
( + )
2
+
1
2
( )
2
=
2
+
2
. Hence V ar(X) =
2
(or, just observe that
(X )
2
=
2
) and V ar(A) = V ar(1 +X) =
2
.
(b) Compute
E(log A) =
1
2
log(1 + +) +
1
2
log(1 + ) =
1
2
log[(1 +)
2

2
] = log
_
1 + 2 +
2

2
.
The restriction < 1 + is needed to ensure that the argument of the second logarithm term
is positive. This isnt a real restriction in nancial situations. From its denition the geometric
expectation is
E
g
(A) = e
E(log A)
=
_
1 + 2 +
2

2
.
(c) Let z = 2 +
2

2
in the square-root approximation given in the question. Then using
all the terms displayed on the RHS,
E
g
(A) 1+
1
2
(2+
2

2
)
1
8
(2+
2

2
)
2
= 1+
1
2

1
8
(
4
+
4
+4
3
4
2
2
2

2
) 1+
1
2

2
.
Here I have neglected all terms of higher than second order on the basis that they contribute
very little in comparison to the terms retained. This is reasonable since and are rarely more
than 0.2.
1
Estimated from S&P 500 Stock Composite Index (1926-2000).
2
Estimated from Salomon Brothers long-term, high-grade corporate bond total return index (1926-2000).
4
Asset type % % E
g
(Y )% Approx.
Common Stocks 12.98 20.17 11.16 10.94
Small Company Stocks 17.3 33.4 12.44 11.72
Long-term Corp. Bonds 6.0 8.7 5.64 5.62
Long-term Govt. Bonds 5.7 9.4 5.28 5.26
4. Let A
n
denote the accumulation factor for period n and assume these factors are iid. For
0, let M() = E(A

n
) denote the moment function, assuming it is nite. The horizon-N
mean per-period accumulation g
N
can be expressed in terms of M() as g
N
= [M(1/N)]
N
.
Recall for the binomial tree model that g
N
= (pu
1/N
+qd
1/N
)
N
.
Show for large N that g
N
(1 + N
1
(p log u + q log d))
N
and hence that lim
N
g
N
=
g

= u
p
d
q
, where the second equality is shown in lectures by direct calculation. [Hint: Write
u
1/N
= exp(N
1
log u) and approximate.]
Answer. You are told that
g
N
=
_
pu
1/N
+qd
1/N
_
N
= exp
_
N log(pu
1/N
+qd
1/N
)
_
.
Now pu
1/N
+qd
1/N
1 as N , so you need an estimate of the dierence D
N
= p(u
1/N

1) +q(d
1/N
1). Use
x
1/N
1 = exp
_
N
1
log x
_
1 = 1 +N
1
log x +O(N
2
) 1,
so D
N
= N
1
(p log u +q log d) +O(N
2
), giving
log
_
pu
1/N
+qd
1/N
_
= log(1 +D
N
) = D
N
+O(D
2
N
) = N
1
(pu
1/N
+qd
1/N
) +O(N
2
).
It follows from this that
lim
N
N log
_
pu
1/N
+qd
1/N
_
= p log u +q log d,
i.e. g
N
exp(p log u +q log d) = u
p
d
q
= g

.
5. Suppose that the accumulation factors A
n
have the gamma law with pdf
f
A
(x) =

x
1
e
x
/(), (x > 0),
where () =
_

0
v
1
e
v
dv is the gamma function. You can see almost by inspection (a minds
eye integration by parts) that (n + 1) = n!, i.e. the gamma function smoothly interpolates
factorials. (In fact it is the unique log-convex function to do so, the Bohr-Mollerup theorem.)
Gamma functions can be evaluated using the factorial button on some calculators, () =
( 1)!.
(a) Show that the moment function
M() := E(A

) =

( +)
()
.
5
Hence show that a = /, s
2
= /
2
, and that
g
N
=
1
_
( + 1/N)
()
_
N
.
The logarithmic derivative of the gamma function is called the psi-function:
() =
d
d
log () =

()
()
, ( > 0).
[Numerical values of the gamma and psi functions can be calculated using the Maple package
with the commands
evalf(GAMMA(x)); and evalf(Psi(x));
where x represents a specic numerical value. To execute the command, use the enter button
and not return. Other packages can be used too.]
(b) Use a MacLaurin expansion to show for large N that
g
N

1
(1 +()/N)
N
,
Hence show that g

=
1
exp(()).
Answer. (a). Compute the moment function
M() := E(A

) =
_
x

f(x)dx = (

/())
_

0
x
+1
e
x
dx
= (

/())
_

0
(x)
+1
e
x
d(x) =

( +)/().
This gives a = M(1) = /, a
2
= M(2) = ( + 1)/
2
= /
2
+a
2
, whence s
2
= /
2
.
(b) Since M() =

( +)/(), it follows from the denition that


g
N
= [M(1/N)]
N
=
1
_
( + 1/N)
()
_
N
.
A Maclaurin (or Taylor) expansion gives ( + 1/N) () +N
1

(), whence
g
N

1
_
1 +N
1

()
()
_
N
=
1
_
1 +
()
N
_
N
.
Let N to get g

=
1
exp(()), using lim
N
(1 +z/N)
N
= e
z
.
6. Recall the lecture note stu in 3.3,6 about the mean, variance and geometric mean
for the binomial tree model, and read 3.7 about parameter estimation. There are three free
parameters, p, u > 1 and d < 1, which must be estimated using observed data. Often this
problem is simplied by setting d = u
1
.
(a) Assume this holds, and write down expressions for a and a
2
in terms of p and u. By
eliminating p, show that u solves the quadratic equation au
2
(1 +a
2
)u +a = 0. [This can be
obtained in a few lines. You should not need pages of algebra.]
6
Substituting the sample mean a of observed one-period accumulations for a, and the corre-
sponding sample second-order moment a
2
for a
2
, and solving the resulting quadratic equation
gives a number u called the method of moments estimate of u.
(b) Use the S&P values from the example in printed notes 3.7 to compute u and a correspond-
ing estimate p from a. Hence estimate the 75 year mean return
75
and

. Compare
75
with
the empirical and the lognormal estimates in Table 3, 3.7.
Answer. Lecture calculations have shown you that a = pu + qd and a
2
= pu
2
+ qd
2
(*).
Multiply the rst equation by u and by d to obtain the two equations au = pu
2
+ q and
ad = p+qd
2
. Add these equations and compare the result with (*) to get au+ad = pu
2
+qd
2
+
ud = a
2
+ud. Taking d = 1/u gives the quadratic equation
au
2
(1 +a
2
)u +a = 0.
This derivation involves a bit of algebraic trickery to avoid cubic and quartic terms.
Alternatively, solving the rst equation for p and using d = 1/u leads to
p =
a d
u d
=
au 1
u
2
1
. (1)
This gives
q = 1 p =
u
2
au
u
2
1
so qd
2
=
u a
u(u
2
1)
.
Substituting these into the identity for a
2
and putting the right-hand side over the common
denominator u(u
2
1) (do it!) leads to
a
2
u =
u
3
(au 1) +u a
u
2
1
=
a(u
4
1) u(u
2
1)
u
2
1
= a(u
2
+ 1) u,
as above.
The solution is
u =
1
2a
_
1 +a
2

_
(a
2
+ 1)
2
4a
2
_
.
The rst line of Table 3 (for the S & P 500 composite index) in Chapter 3 gives r = 12.98%,
i.e. a = 1.1298. Similarly s = 0.2017, so a
2
= s
2
+ a
2
= 1.317131. Substituting these sample
estimates into the quadratic solution gives a method-of-moments estimate of u. One solution for
u exceeds unity, and the other < 1. Use the larger: u = 1.252550. Next, (1) yields p = 0.72973.
(If you round to u = 1.2525 then p = 0.7298, and if u = 1.2526 then p = 0.7297.)
Use these values to compute (hats omitted) E(A
1/75
) = pu
1/75
+qu
1/75
= 1.001384, giving
g
75
= [E(A
1/75
)]
75
= 1.109300, i.e.
75
= 10.93%. Also, the assumption about d implies that
g

= u
2p1
= 1.109004, i.e.

= 10.90%. See Q.4 for the comparisons.


Rounding too early in your calculations can lead to arithmetic errors. For example, rounding
to give u = 1.25 and p = .73 leads to
75
= 10.84%. An error like this could lose you business if
a competitor quotes the higher more accurate predicted return.
7. (a) Here CR wins or loses one unit for each dollar bet. So p = 19/37 = 0.51351,
= (19 18)/37 = 0.02703 > 0, so the game is favourable for the casino. The optimal growth
7
factor is 2p
p
q
q
= 1.000365. You may be surprised by how close this is to unity, but the theory
shows that its the best possible rate.
(b) Now the expected payo is = E(X
n
) = p q, so the game is favourable if and only
if this is positive.
(c) CRs fortune multiplies each game by a factor 1+X
n
. This factor has a geometric mean
exp(g()) where
g() = (p log(1 +) +q log(1 ).
Maximizing g() with respect to gives you the critical value
c
= p q/, and hence
(d) the optimal geometric expected growth factor is
g
c
= exp[g(
c
)] = exp[p log(1 +
c
) +q log(1
c
)]
= exp[p log(p(1 +)) +q log(q(1 + 1/))] = (1 +)(q/)
q
p
p
.
(e) Since CR per dollar bet losses are $35 and they are the unit of currency, it follows that
= 1/35. A careful computation shows the optimal growth rate is g
c
= 1.00001053.
3
3
Remark. You can work in natural currency units, i.e., CR wins $1 with probability p and loses with
probability q. The expected geometric growth factor then becomes exp[p log(1 + ) + q log(1 )]. This only
makes sense if < 1. The mean payo per play is p q, which must be positive. Maximizing gives the critical
value c = (p/) q. You nd that 1 c = q(1 + ) > 0, i.e., c < 1. The optimal expected growth rate is
(1 +)(p/)
p
q
q
. Setting = 1/ will give you the rate determined in (d). So the two formulations are equivalent.
An even more general formulation allows an arbitrary win and loss .
8