Beruflich Dokumente
Kultur Dokumente
Final Exam
Problem 1.
Suppose that the risk free rate is 5% and that the expected return of a portfolio with a beta of 1 is 10%.
According to the CAPM:
1. What is the expected return on the market portfolio?
2. What is the expected return on a portfolio with a beta of 1.5?
You consider buying a share of stock A currently priced at NOK 50. The stock is expected to pay no
dividends next year and you expect it to then sell at NOK 55.
3. According to the CAPM, what is the stock's beta?
You nd another stock B that you expect to be able to sell for NOK 55 next year. B trades at 45 but
you nd that stocks A and B have the same estimated betas.
4. Is this data consistent with the CAPM? If not, show how you would trade to exploit any deviations
from the CAPM.
Another stock, C, is perfectly correlated with the market.
5. Show that C has zero non-systematic risk.
Problem 2.
There are two periods: period zero (today) and period 1 (next period). In the next period there are
three possible states of the world: recession (with probability 0.3), normal growth (with probability 0.4)
and expansion (with probability 0.3). There are two stocks (stock A and stock B) in the economy. The
stocks will yield payos next period according to the following table:
Stock
A
B
Recession
6
15
Normal Growth
12
5
Expansion
14
10
1. Can you rank the stocks by the criterion of rst order stochastic dominance? If you can rank them,
which stock rst order stochastically dominates the other? You may use a graph to answer this
question if you choose to.
2. Can you rank the stocks by the criterion of second order stochastic dominance? If you can rank
them, which stock second order stochastically dominates the other? You may use a graph to answer
this question if you choose to.
Consider an investor with the following utility function:
u(w) =
w.
The investor has a current wealth of $10. This investor is today given one unit of stock A as a present
from his uncle. If the investor sells the stock the proceeds from selling the stock are guaranteed and will
be delivered next period. Also assume that the investor cannot invest in stock B.
3. What is the minimum price the investor would be willing to sell the stock for?
Problem 3.
A gambler has a utility function based on the logarithm of wealth, i.e. u(W ) = ln(W ). The gambler's
current wealth is W0 . The gambler is oered a bet on a proposition that has probability p of returning
double his bet and (1 p) of returning nothing.
1. What fraction of W0 should he bet on this proposition?
2. Discuss how the optimal bet varies with the possible values of p.
Problem 4.
Consider a one-period economy with two dates, 0 and 1. At date 1 the economy has three possible states,
u, n and d. A stock has the following state contingent payos:
State u n d
Payo 100 80 50
The current price of the stock is 65. At date 1 a risk free bond with a face value of 1000 matures. This
bond is currently trading at a price of 800.
1. With only this information, is it possible to price a call option on the stock with an exercise price
of 100?
2. With only this information, is it possible to price a call option on the stock with an exercise price
of 80?
Suppose the current price of a call option on the stock with exercise price of 70 is 11.
3. What is the current price of a put option on the stock with an exercise price of 70?
Problem 5.
State price
probability
q
0.2
0.3
0.4
0.1
State
Price
0.16
0.24
0.32
0.08
Cashow
650
200
110
80
Problem 6.
A consumer has state independent preferences dened by the utility function u(W ). The consumer can
invest his initial wealth W0 in two assets. The rst is riskless and pays return, per dollar, of Rf . The
second is risky with a return of R per dollar.
> Rf .
1. Show that the fraction of wealth invested in the risky asset is never zero, as long as E(R)
Why is this behavior referred to as `local risk neutrality'?
Problem 7.
Consider a two-date economy and an agent with utility function over consumption
U (C) =
1
C 1
1
1. Show that the agent will always prefer a smooth consumption stream to a more variable one with
the same mean, that is
+ U (C)
> U (C1 ) + U (C2 )
U (C)
where C =
C1 +C2
2
and C1 6= C2 .
Financial Theory
Solutions
Problem 1.
1.
E[rp ] = rf + p (E[rm ] rf )
0.1 = 0.05 + (E[rm ] rf )
E[rm ] = 10%
2.
3.
E[rA ] =
55
1 = 10
50
A = 1
4.
E[rB ] =
55
1 = 22%
45
which seem to indicate a return of 10%. Stock B is underpriced, buy it and nance this by selling
A.
Cash ow Cash ow Beta
Strategy at date 0 at date 1 risk
buy B
45
55
1
sell A
50
55
1
net
5
0
0
5.
corr(rc , rm ) =
cov(rc , rm )
2
m
cov(rc , rm )
c m
=1
c
= cm
m
2
2
c2 = cm
m
+ 2c = c2 + 2c
2c = 0
Problem 2.
If the investor does sell the stock he will get for sure 10 + p. To see the minimum price, solve
4.55 =
10 + p
p = 16.67
The the investor sells the stock for 16.67 he will be as well o as he would be by keeping the stock.
If the sale price is larger than 16.67 the investor would be more than happy to sell it.
4
Problem 3.
W0 + wW0 = W0 (1 + w)
W0 wW0 = W0 (1 w)
with probability p
with probability 1 p
1
1
+ (1 p)
(1) = 0
W0 (1 + w)
W0 (1 w)
1
1
+ (1 p)
(1) = 0
1+w
1w
1
1
= (1 p)
1+w
1w
p(1 w) = (1 p)(1 + w)
Solution
w = (2p 1)
Problem 4.
K
(1 + r)
p=cS+
K
70
= 11 65 +
=2
(1 + r)
1 + 0.0.25
Where the risk free rate is found from the bond price:
>> r=1000/800-1
r = 0.25000
Alternatively it is possible to back out the state prices, or alternatively, the state price probabilites.
Three states, three securities gives a cash ow matrix
> X
X =
1000
100
30
1000 1000
80
50
10
0
>> P
P =
800
65
11
Solve for state prices or state price probabilities q . Note that the state price probabilities sum
to one.
>> phihat=inv(X)*P'
phihat =
0.20000
0.50000
0.10000
>> qhat=phihat*(1+r)
qhat =
0.25000
0.62500
0.12500
>> qhat'*ones(3,1)
ans = 1.0000
Find the cash ows from the put and price those:
>> S
S =
100
80 50
>> P=max(0,K-S)
P =
0
0 20
>> q=P*qhat/(1+r)
q = 2.0000
>> q=P*phihat
q = 2.0000
Problem 5.
1. Risk free rate can be had from the relationship betwen state price probabilities and state prices
>> r=0.2/0.16-1
r = 0.25000
X =
650
200
110
80
>> q=[0.2 0.3 0.4 0.1 ]
q =
0.20000 0.30000 0.40000 0.10000
>> phi=q/(1+r)
phi =
0.160000 0.240000 0.320000 0.080000
>> q*X/(1+r)
ans = 193.60
>> phi*X
ans = 193.60
F
F
117.60 =
110
80
F
200
117.60 =
110
80
Solving the last one for F, nd that F = 175, which contradicts that F > 200.
>> F=(117.60-phi(2:4)*X(2:4))/phi(1)
F = 175
Want to show the fraction invested in the risk free asset is not zero.
The consumers problem is to maximize expected utility as a function of . The objective function
is
max f ()
If the consumer is risk averse, the second derivative is negative, f 0 () = 0 denes a maximum.
We want to show that 6= 0. Evaluate rst order condition at = 0:
f 0 (0)
Rf )]
= E[U 0 (W0 Rf )W0 (R
Rf )
= U 0 (W0 Rf )W0 (E[R]
> Rf
> 0 if E[R]