Ivan M.

Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

7.1 Pricing risk using CAPM

In the CAPM setting, it is argued that only a fraction of the total risk of a particular asset
is priced. Use the CML and SML to prove this assertion.
Solution
r r

The CAPM equation for an efficient asset p is rp = rf + mm f p . For an asset j which does
r r
not lie on the efficient frontier, the equation is rj = rf + mm f jm j = rf + (rm rf )j . We
know that the total risk of the asset j is j . The market price of risk is given by the Sharpe
r r
ratio of the market portfolio, mm f . We can see that since jm j j , only a fraction of
total risk of a particular asset is priced.

7.2 CML in Multiple Economies

Consider two fully isolated economies, economy 1 and economy 2. The same assets are
traded in both economies, but the average investor in economy 2 is more risk averse than
the average investor in economy 1. Compare the CMLs in both economies.
Solution
r r

The CML is defined by the following equation, rp = rf + mm f p . As we can see, what

defines the CML are the first two moments of the return distribution of the market portfolio
and the return of the risk-free asset. If all assets are exactly the same in both economies, but
the investors in economy 2 are more risk averse, then the risk free asset would be demanded
more in economy 2 than in economy 1. Therefore, the return to the risk-free asset would be
lower in economy 2 and the CML would be steeper. In addition, the market portfolio would
need to return more in economy 2 so that investors would be willing to hold it. This would
also make the CML steeper.

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

7.6 CAPM
Consider a two-period economy with I agents, J risky assets, and one risk-free asset. You
can write the ith agents wealth as follows:
!
X
X
Yi = Y i
xi (1 + rf ) +
xi (1 + rj )
0

jJ

jJ

where xij is the amount of wealth invested in asset j by the ith investor. The investors
choice problem is then
h  i
max
E
Ui Yi
i
xj

h  
i
(a) Show the FOC is E Ui0 Yi (
rj rf ) = 0
h   i
h  i
rj rf )] = Cov Ui0 Yi , rj .
(b) Show that part (a) can be written as E Ui0 Yi E [(


h  i
h  i
rj rf )] = E Ui00 Yi Cov Yi , rj .
(c) Show that part (b) can be rewritten as E Ui0 Yi E [(
(d) Aggregating on all individuals, show that part (b) can be rewritten as follows
YM 0
rM , rj )
E(
rj rf ) = P
1 Cov(
iI RAi

P
E[U 00 (Yi )]
where RAi = E Ui0 Y and iI Yi = YM 0 (1 + rM ).
[ i ( i )]
(e) Show that part (c) implies E(
rj rf ) =

P YM 0 1

iI RAi

V ar(
rM ).

(f) Derive the traditional CAPM relationship.

Solution
Part (a)
The original choice problem can be rewritten as follows
"
!#
X
max
E Ui Y0i (1 + rf ) +
xij (
rj rf )
i
xj

jJ

The first order condition for asset j is just the derivative of the objective function with
respect to xij , which is
h  
i
E Ui0 Yi (
rj rf ) = 0

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

Part (b)
Let us apply the following identity, E[XY ] = Cov(X, Y ) + E(X)E(Y ) to our FOC:
h  
i
h  
i
h  i
E Ui0 Yi (
rj rf ) = Cov Ui0 Yi , (
rj rf ) + E Ui0 Yi E [(
rj rf )]
h  
i
h  i
0 = Cov Ui0 Yi , (
rj rf ) + E Ui0 Yi E [(
rj rf )]
h  i
h   i
E Ui0 Yi E [(
rj rf )] = Cov Ui0 Yi , rj

Part (c)
We can apply this identity, Cov (g(X), Y ) = E (g(X)) Cov(X, Y ) to the equation we derived
above:
h  i
h  i


E Ui0 Yi E [(
rj rf )] = E Ui00 Yi Cov Yi , rj
Part (d)
Using the above equation, we can see the following
h  i


E Ui00 Yi
E [(
rj rf )] = h  i Cov Yi , rj
E Ui0 Yi


E [(
rj rf )] = RAi Cov Yi , rj


1
E [(
rj rf )]
= Cov Yi , rj
RAi


X 1
X
E [(
rj rf )]
=
Cov Yi , rj
RAi
i
i
!
X 1
X
E [(
rj rf )]
= Cov
Yi , rj
R
Ai
i
i
X 1
E [(
rj rf )]
= Cov (YM 0 (1 + rM ), rj )
RAi
i
X 1
E [(
rj rf )]
= YM 0 Cov (
rM , rj )
RAi
i
YM 0
E(
rj rf ) = P
rM , rj )
1 Cov(
iI RAi

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

Part (e)
Let wj be the proportion of economy wide wealth invested in asset j. Then, for all j,
YM 0
rM , rj )
wj E(
rj rf ) = P
1 wj Cov(
iI RAi

YM 0 X
wj E(
rj rf ) = P
wj Cov(
rM , rj )
1
iI RAi

X
X
YM 0
Cov(
r
,
wj rj )
E(
wj rj rf ) = P
M
1
iI RAi

We know that the weighted average of every risky asset is just the expected return on the
market portfolio, hence,
YM 0
rM , rM )
E(
rM rf ) = P
1 Cov(
iI RAi

YM 0
E(
rM rf ) = P
rM )
1 V ar(
iI RAi

Part (f )
Substituting the equation from part (e) into the equation from part (d), we find
E(
rj rf ) =

Cov(
rM , rj )
E(
rM rf )
V ar(
rM )

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

8.1 Arrow - Debreu Matrix

You are given the following term structure of interest rates for three periods into the future:
r1 = 0.0989
r2 = 0.1027
r3 = 0.1044
(a) Construct the Arrow-Debreu prices for these state-dates
(b) Assume there are three states in each period and the constant Arrow-Debreu statematrix is as follows:

0.28 0.33 0.30

0.27 0.34 0.31
0.24 0.28 0.36
and assume we are in state 1. Are these prices consistent with the term structure just
given?
Solution
Part (a)
We know that qi =

1
,
(1+ri )i

so we find the following

q1 =0.91q2 =

0.8224q3 =0.7424

Part (b)
Summing over the first row of the given Arrow-Debreu matrix, we find the price for the
states 1 year from now are consistent. Squaring the matrix and then summing over the first
row, we find the price of a contingent claim in state 1 is consistent with the term structure.
Cubing the matrix and then summing over the first row, we find these prices consistent with
the term structure given.

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

8.6 Arrow Debreu Equilibrium Model

Think of an economy with two agents with utility functions of the form
U (c) = c0 + E(c ) 2V ar(c ).
Their endowments are given as
InsetT ableHere
. The state probabilities are 1/4 and 3/4.
(a) Intuitively, what condition should a Pareto optimal allocation satisfy in this particular
setup?
(b) Are there several Pareto optima? If so, characterize the set of Pareto optima.
(c) Is the following allocation a Pareto optimum? Why?
(d) Now the agents have a utility function of the form
U (c) = c0 + E [ln(c )]
and the endowments are
InsetT ableHere
. Describe the set of Pareto optima for this utility function and compare it with the
previous utility function
(e) Two Arrow-Debreu securities denoted by Q are introduced. Both are in zero net
supply. Compute the competitive equilibrium allocation. Is it Pareto optimal? Discuss
intuitively its characteristics (the determinants of the prices of the two securities and
the post-trade allocation).
(f) Suppose only one Arrow-Debreu security depending on state 1 is traded. It is in zero
net supply. Compute the competitive equilibrium allocation. Is it Pareto optimal?
Solution
Part (a)
Intuitively, the agents are trying to maximize their utility functions. This will occur when
the term 2V ar(c ) is equal to zero. This will happen when the agents consumption across
the different states are equal.

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

Part (b)
Yes, there are several Pareto optima. To find the set of Pareto optimal consumption bundles,
we have to set the MRS between states equal for each agent. In this problem, it would be
Uc21
Uc11
=
. Using the parameters given to us in the problem, we find the following condition
1
U
U2
c2

c2

0.25 0.75c11 + 0.75c12

0.25 0.75c21 + 0.75c22
=
.
0.75 0.75c11 + 0.75c11
0.75 0.75c21 + 0.75c21
Using the constraints, c11 + c21 = 6 and c12 + c22 = 6, we find c21 = 6 c11 and c22 = 6 c12 , which
we plug back into our condition
0.25 0.75c11 + 0.75c12
0.25 0.75(6 c11 ) + 0.75(6 c12 )
=
0.75 0.75c11 + 0.75c11
0.75 0.75(6 c12 ) + 0.756 c11
= cj1 = cj2 .
We can see that the set of Pareto optima are the set of consumption bundles such that
consumption across both states are equal to each other and less than or equal to the total
endowment in that state.
Part (c)
Yes, the following is a Pareto optimal allocation since it meets our condition derived above
(consumption across states are equal for both agents).
Part (d)
As we saw earlier, to find the set of Pareto optimal consumption bundles, we have to set the
U1
U2
MRS between states equal for each agent, Uc11 = Uc21 . With this utility curve, we have the
c2
c2
following condition
1 c12
1 c22
=
3 c11
3 c21
c12
c22
=
c11
c21
Using the constraints, c11 + c21 = 6 and c12 + c22 = 6, we find c21 = 6 c11 and c22 = 6 c12 ,
which we plug back into our condition
6 c12
c12
=
c11
6 c11
= c11 = c12
This means we have the exact same set of Pareto optima as in the previous utility function.

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

Part (e)
Sed ut perspiciatis unde omnis iste natus error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore veritatis et quasi architecto
beatae vitae dicta sunt explicabo. Nemo enim ipsam voluptatem quia voluptas sit aspernatur
aut odit aut fugit, sed quia consequuntur magni dolores eos qui ratione voluptatem sequi
nesciunt. Neque porro quisquam est, qui dolorem ipsum quia dolor sit amet, consectetur,
adipisci velit, sed quia non numquam eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat voluptatem. Ut enim ad minima veniam, quis nostrum exercitationem
ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi consequatur? Quis autem
vel eum iure reprehenderit qui in ea voluptate velit esse quam nihil molestiae consequatur,
vel illum qui dolorem eum fugiat quo voluptas nulla pariatur?Sed ut perspiciatis unde
omnis iste natus error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore veritatis et quasi architecto beatae vitae dicta sunt
explicabo. Nemo enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed
quia consequuntur magni dolores eos qui ratione voluptatem sequi nesciunt. Neque porro
quisquam est, qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia
non numquam eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat
voluptatem. Ut enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi consequatur? Quis autem vel eum iure
reprehenderit qui in ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui
dolorem eum fugiat quo voluptas nulla pariatur?Sed ut perspiciatis unde omnis iste natus
error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa
quae ab illo inventore veritatis et quasi architecto beatae vitae dicta sunt explicabo. Nemo
enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui ratione voluptatem sequi nesciunt. Neque porro quisquam est,
qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia non numquam
eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat voluptatem. Ut
enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam,
nisi ut aliquid ex ea commodi consequatur? Quis autem vel eum iure reprehenderit qui in
ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui dolorem eum fugiat
quo voluptas nulla pariatur?Sed ut perspiciatis unde omnis iste natus error sit voluptatem
accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore
veritatis et quasi architecto beatae vitae dicta sunt explicabo. Nemo enim ipsam voluptatem
quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui
ratione voluptatem sequi nesciunt. Neque porro quisquam est, qui dolorem ipsum quia dolor
sit amet, consectetur, adipisci velit, sed quia non numquam eius modi tempora incidunt ut
labore et dolore magnam aliquam quaerat voluptatem. Ut enim ad minima veniam, quis
nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi
consequatur? Quis autem vel eum iure reprehenderit qui in ea voluptate velit esse quam nihil
molestiae consequatur, vel illum qui dolorem eum fugiat quo voluptas nulla pariatur?Sed
ut perspiciatis unde omnis iste natus error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore veritatis et quasi architecto
beatae vitae dicta sunt explicabo. Nemo enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui ratione voluptatem
8

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

sequi nesciunt. Neque porro quisquam est, qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia non numquam eius modi tempora incidunt ut labore et dolore
magnam aliquam quaerat voluptatem. Ut enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi consequatur? Quis
autem vel eum iure reprehenderit qui in ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui dolorem eum fugiat quo voluptas nulla pariatur?Sed ut perspiciatis
unde omnis iste natus error sit voluptatem accusantium doloremque laudantium, totam rem
aperiam, eaque ipsa quae ab illo inventore veritatis et quasi architecto beatae vitae dicta sunt
explicabo. Nemo enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed
quia consequuntur magni dolores eos qui ratione voluptatem sequi nesciunt. Neque porro
quisquam est, qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia
non numquam eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat
voluptatem. Ut enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi consequatur? Quis autem vel eum iure
reprehenderit qui in ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui
dolorem eum fugiat quo voluptas nulla pariatur?Sed ut perspiciatis unde omnis iste natus
error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa
quae ab illo inventore veritatis et quasi architecto beatae vitae dicta sunt explicabo. Nemo
enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui ratione voluptatem sequi nesciunt. Neque porro quisquam est,
qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia non numquam
eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat voluptatem. Ut
enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam,
nisi ut aliquid ex ea commodi consequatur? Quis autem vel eum iure reprehenderit qui in
ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui dolorem eum fugiat
quo voluptas nulla pariatur?Sed ut perspiciatis unde omnis iste natus error sit voluptatem
accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore
veritatis et quasi architecto beatae vitae dicta sunt explicabo. Nemo enim ipsam voluptatem
quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui
ratione voluptatem sequi nesciunt. Neque porro quisquam est, qui dolorem ipsum quia dolor
sit amet, consectetur, adipisci velit, sed quia non numquam eius modi tempora incidunt ut
labore et dolore magnam aliquam quaerat voluptatem. Ut enim ad minima veniam, quis
nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi
consequatur? Quis autem vel eum iure reprehenderit qui in ea voluptate velit esse quam nihil
molestiae consequatur, vel illum qui dolorem eum fugiat quo voluptas nulla pariatur?Sed
ut perspiciatis unde omnis iste natus error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore veritatis et quasi architecto
beatae vitae dicta sunt explicabo. Nemo enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui ratione voluptatem
sequi nesciunt. Neque porro quisquam est, qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia non numquam eius modi tempora incidunt ut labore et dolore
magnam aliquam quaerat voluptatem. Ut enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi consequatur? Quis
autem vel eum iure reprehenderit qui in ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui dolorem eum fugiat quo voluptas nulla pariatur?Sed ut perspiciatis
9

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

unde omnis iste natus error sit voluptatem accusantium doloremque laudantium, totam rem
aperiam, eaque ipsa quae ab illo inventore veritatis et quasi architecto beatae vitae dicta sunt
explicabo. Nemo enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed
quia consequuntur magni dolores eos qui ratione voluptatem sequi nesciunt. Neque porro
quisquam est, qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia
non numquam eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat
voluptatem. Ut enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi consequatur? Quis autem vel eum iure
reprehenderit qui in ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui
dolorem eum fugiat quo voluptas nulla pariatur?Sed ut perspiciatis unde omnis iste natus
error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa
quae ab illo inventore veritatis et quasi architecto beatae vitae dicta sunt explicabo. Nemo
enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui ratione voluptatem sequi nesciunt. Neque porro quisquam est,
qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia non numquam
eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat voluptatem. Ut
enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam,
nisi ut aliquid ex ea commodi consequatur? Quis autem vel eum iure reprehenderit qui in
ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui dolorem eum fugiat
quo voluptas nulla pariatur?Sed ut perspiciatis unde omnis iste natus error sit voluptatem
accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore
veritatis et quasi architecto beatae vitae dicta sunt explicabo. Nemo enim ipsam voluptatem
quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui
ratione voluptatem sequi nesciunt. Neque porro quisquam est, qui dolorem ipsum quia dolor
sit amet, consectetur, adipisci velit, sed quia non numquam eius modi tempora incidunt ut
labore et dolore magnam aliquam quaerat voluptatem. Ut enim ad minima veniam, quis
nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi
consequatur? Quis autem vel eum iure reprehenderit qui in ea voluptate velit esse quam nihil
molestiae consequatur, vel illum qui dolorem eum fugiat quo voluptas nulla pariatur?Sed
ut perspiciatis unde omnis iste natus error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore veritatis et quasi architecto
beatae vitae dicta sunt explicabo. Nemo enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui ratione voluptatem
sequi nesciunt. Neque porro quisquam est, qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia non numquam eius modi tempora incidunt ut labore et dolore
magnam aliquam quaerat voluptatem. Ut enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi consequatur? Quis
autem vel eum iure reprehenderit qui in ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui dolorem eum fugiat quo voluptas nulla pariatur?Sed ut perspiciatis
unde omnis iste natus error sit voluptatem accusantium doloremque laudantium, totam rem
aperiam, eaque ipsa quae ab illo inventore veritatis et quasi architecto beatae vitae dicta sunt
explicabo. Nemo enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed
quia consequuntur magni dolores eos qui ratione voluptatem sequi nesciunt. Neque porro
quisquam est, qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia
non numquam eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat
10

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

voluptatem. Ut enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi consequatur? Quis autem vel eum iure
reprehenderit qui in ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui
dolorem eum fugiat quo voluptas nulla pariatur?Sed ut perspiciatis unde omnis iste natus
error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa
quae ab illo inventore veritatis et quasi architecto beatae vitae dicta sunt explicabo. Nemo
enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui ratione voluptatem sequi nesciunt. Neque porro quisquam est,
qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia non numquam
eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat voluptatem. Ut
enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam,
nisi ut aliquid ex ea commodi consequatur? Quis autem vel eum iure reprehenderit qui in
ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui dolorem eum fugiat
quo voluptas nulla pariatur?Sed ut perspiciatis unde omnis iste natus error sit voluptatem
accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore
veritatis et quasi architecto beatae vitae dicta sunt explicabo. Nemo enim ipsam voluptatem
quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui
ratione voluptatem sequi nesciunt. Neque porro quisquam est, qui dolorem ipsum quia dolor
sit amet, consectetur, adipisci velit, sed quia non numquam eius modi tempora incidunt ut
labore et dolore magnam aliquam quaerat voluptatem. Ut enim ad minima veniam, quis
nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi
consequatur? Quis autem vel eum iure reprehenderit qui in ea voluptate velit esse quam nihil
molestiae consequatur, vel illum qui dolorem eum fugiat quo voluptas nulla pariatur?Sed
ut perspiciatis unde omnis iste natus error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore veritatis et quasi architecto
beatae vitae dicta sunt explicabo. Nemo enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui ratione voluptatem
sequi nesciunt. Neque porro quisquam est, qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia non numquam eius modi tempora incidunt ut labore et dolore
magnam aliquam quaerat voluptatem. Ut enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi consequatur? Quis
autem vel eum iure reprehenderit qui in ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui dolorem eum fugiat quo voluptas nulla pariatur?Sed ut perspiciatis
unde omnis iste natus error sit voluptatem accusantium doloremque laudantium, totam rem
aperiam, eaque ipsa quae ab illo inventore veritatis et quasi architecto beatae vitae dicta sunt
explicabo. Nemo enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed
quia consequuntur magni dolores eos qui ratione voluptatem sequi nesciunt. Neque porro
quisquam est, qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia
non numquam eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat
voluptatem. Ut enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi consequatur? Quis autem vel eum iure
reprehenderit qui in ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui
dolorem eum fugiat quo voluptas nulla pariatur?Sed ut perspiciatis unde omnis iste natus
error sit voluptatem accusantium doloremque laudantium, totam rem aperiam, eaque ipsa
quae ab illo inventore veritatis et quasi architecto beatae vitae dicta sunt explicabo. Nemo
11

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

enim ipsam voluptatem quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui ratione voluptatem sequi nesciunt. Neque porro quisquam est,
qui dolorem ipsum quia dolor sit amet, consectetur, adipisci velit, sed quia non numquam
eius modi tempora incidunt ut labore et dolore magnam aliquam quaerat voluptatem. Ut
enim ad minima veniam, quis nostrum exercitationem ullam corporis suscipit laboriosam,
nisi ut aliquid ex ea commodi consequatur? Quis autem vel eum iure reprehenderit qui in
ea voluptate velit esse quam nihil molestiae consequatur, vel illum qui dolorem eum fugiat
quo voluptas nulla pariatur?Sed ut perspiciatis unde omnis iste natus error sit voluptatem
accusantium doloremque laudantium, totam rem aperiam, eaque ipsa quae ab illo inventore
veritatis et quasi architecto beatae vitae dicta sunt explicabo. Nemo enim ipsam voluptatem
quia voluptas sit aspernatur aut odit aut fugit, sed quia consequuntur magni dolores eos qui
ratione voluptatem sequi nesciunt. Neque porro quisquam est, qui dolorem ipsum quia dolor
sit amet, consectetur, adipisci velit, sed quia non numquam eius modi tempora incidunt ut
labore et dolore magnam aliquam quaerat voluptatem. Ut enim ad minima veniam, quis
nostrum exercitationem ullam corporis suscipit laboriosam, nisi ut aliquid ex ea commodi
consequatur? Quis autem vel eum iure reprehenderit qui in ea voluptate velit esse quam
nihil molestiae consequatur, vel illum qui dolorem eum fugiat quo voluptas nulla pariatur?
Part (f )

12

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

8.7 Risk Sharing and Trade

Think of a simple exchange economy with two agents that have the following utility functions

U1 () = 0.25c0 + 0.5E [ln(c )]

U2 () = c0 + E [ln(c )]
The endowments are.
(a) Describe the Pareto optimum or the set of Pareto optima. Is it unique? Is perfect
risk sharing achieved? Why or why not? Answer the same question if the state 2
endowments were 5 for agent 1 and 3 for agent 2.
(b) Agents can trade with two Arrow-Debreu securities denoted by Q (with payoffs (1, 0))
and R (with payoffs (0, 1)). Calculate the competitive equilibrium allocation. Is it
Pareto optimal? Discuss intuitively its characteristics (the determinants of the prices
of the two securities and the post-trade allocation).
(c) Suppose that both securities can be traded at the beginning and there are no shortselling constraints. A firm has zero cost of introducing one unit of either security, and
it wants to maximize its profits. Which security should it introduce? For which agent
is this introduction more valuable? Is the outcome Pareto optimal? Why or why not?
Solution
Part (a)
Part (b)
Part (c)

13

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

9.2 Option Pricing

Consider an endowment economy identical to the one considered in the discussion of the
consumption CAPM. Consider an option that entitles the owner to exercise the right to buy
one unit of the asset one period in the future at a fixed price p . The price p is known at
period t, whereas the option to buy is exercised at period t + 1. Suppose the representative
agents utility function is U (c) = ln(c). You are asked to price the option. Follow these steps:
(a) Write the value of the option at expiration as a function of the price of the underlying
asset.
(b) Write the price of the asset at the later date as a function of the state at that date, ,
the total quantity of good available.
(c) Given the chosen utility function, write q(, c), the Arrow-Debreu price.
(d) Use Arrow-Debreu pricing to price the option.
Solution
Part (a)
The value of the option would be max(0, St+1 () p )
Part (b)
The price of the option would be
St+1 () =

=1

1/ct+1+
ct+1
1/ct+1 ()

ct+1 ()
1

Part (c)
The Arrow-Debreu price would be qt+1 () = p() ct+1ct() .
Part (d)
Using Arrow-Debreu, the price (for states where the option values is positive, denoted 0 ,
would be
X
Ct =
qt+1 (0 )(S(0 p ).
0

14

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

9.4 CCAPM
Consider the usual representative agent economy. Suppose that the representative agent
has log utility, U (c) = ln(c). Define the wealth portfolio as a claim to all future dividends
available for consumption in this economy.
(a) Show that the price of this wealth portfolio is proportional to consumption itself.
(b) Show that the return on this portfolio is proportional to consumption growth. Hint:
Think about the definition of the return on an asset to write down the return on the
wealth portfolio.
(c) Finally, express the price of a cash flow paying off $100 at each date for the next two
periods in terms of the return on the wealth portfolio.
Solution
Part (a)
t

After maximization, the discount factor from 0 to t is mt = 0 cc0t . The price of the wealth
P
portfolio is P0 = E0 Tt=0 mt et . We know that at equilibrium, et = ct . This means that
P
P
1
E Tt=0 mt et = E Tt=0 mt ct . With our log utility, we can also see that P0 = 1
c0 .
Part (b)
The return on the wealth portfolio is defined as r1 = P1 +eP10P0 . If we insert the price of the
wealth portfolio we found in part (a), we see that the return can be written as
r1 =
=
=

1
c
1 1

+ c1

1
c
1 0

1
c
1 0
1
(c
1 1

c0 ) + c1

1
c
1 0

c1 c0
c0

Part (c)
P0 = 100E0 (m1 + m2 )
c0
c0
= 100E0 ( + )
c1
c2
(c2 c1 )c0 + (1 + )c1 c0
= 100E0 (
)
c1 c2
c0
= 100E0 ((
r2 + (1 + )) )
c2

15

Ivan M. Rodriguez

FIN 7855 - Assignment 3

November 12, 2014

9.5 Pricing Kernel

Begin with the fundamental equation E[mRi ] = 1 where Ri is the gross return on asset i,
and m is the pricing kernel. Noting that this fundamental equation should hold for the gross
returns on the riskless asset and on the market portfolio (RM ) as well, obtain a CAPM-like
expression. Define a functional relation between m and RM so that you will obtain precisely
the CAPM expression.
Solution
We know the following
Pi =

qs dis

1=

qs

qs Ris

ms s Ris

dis
Pi

= E(mRi )
= E(m)E(Ri ) + Cov(m, Ri )
E(Ri )
+ Cov(m, Ri )
=
1 + rf
Rf = E(Ri ) + Cov(m, Ri )Rf
Rf = E(RM ) + Cov(m, RM )Rf
Setting these last two equations equal to each other, we have the following equation
E(Ri ) Rf
Cov(m, Ri )
=
E(RM ) Rf
Cov(m, RM )
Cov(m, Ri )
E(Ri ) Rf =
(E(RM ) Rf )
Cov(m, RM )

16