QUANTITATIVE METHODS FOR FINANCE

Mock Exam 5 (Academic Year 2013-14)

[5 exercises; 31 points available; 90 minutes available]

1
Consider a stock that pays out the dividend (7X + 3m) dt every second (with dX =
X dt + X dz).

[8 points]
Show that the equilibrium price S (X) of the stock has the following dynamics (expressed in total-gain form):
dS +

(7X + 3m) dt

Sr +

7X
r+

dt +

7X

dz .

r+

[7 points]
Your initial capital is H = 100 Euro. By borrowing 50 Euro, you invest 150 Euro in
the stock. Work out the total gain dH on your portfolio.

2
max E
w

where

[4 points]
h

log

f
W

Consider a constrained log-utility investor whose problem is

i
f = 100 ( (1 + r) + w (e
sub
w
300% ,
W
r

r = 1% ;

re =

8
>
< g>
>
:

5%

5%

with probability

r) ) ;

1
2

.
with probability

1
2

If the constrained optimal portfolio is w = 3 and the shadow price is l = 0, the up-state return on the
risky asset is:

a)
b)
c)
d)

g = 10:3 23%;
g = 7:3 23%;
g = 20:3 23%;
g = 15:3 23%.

Alessandro Sbuelz - SBFA, Catholic University of Milan

3
[4 points]
A rm produces two outputs x and y (they can be sold at the xed prices 25
and 35, respectively). An embargo is imposed on the rms average production:
1
1
x+ y
2
2

20 .

Given that the production costs are C (x; y) = 2x2 + 2y 2

is:
a)
801: 571 429;
b)
701: 571 429;
c)
973: 571 429;
d)
773: 571 429.

4
[4 points]
rate (r = 0):

3xy + 30, the constrained maximum prot

Consider the following one-period arbitrage-free market with a zero riskfree

2

6
6
M =6
4

1:0
1
1
1

0:3
3
0
0

1:0
2
0
1

7
7
7 .
5

The no-arbitrage price of a European put option written on the risky security 1 (the strike price is 1:5)
is:
a)
2: 35;
b)
1: 35;
c)
1:75;
d)
0:75.

5
[4 points]
rate (r = 0):

Consider the following one-period arbitrage-free market with a zero riskfree

2

6
6
M =6
4

1
1
1
1

Focus on the payo

X (1) (! 1 )
X (1) (! 2 )
bound of the its no-arbitrage prices is:
a)
2:7;
b)
1:0;
c)
1:15;
d)
1:65.

0:35
0
1
0

7
7
7 .
5

X (1) (! 3 )

Alessandro Sbuelz - SBFA, Catholic University of Milan

The upper

SOLU T ION S

The equilibrium-valuation problem is

1
Et [dS] + 7X + 3m
dt

= Sr + SX X

S (0) 6= 0

1
1
Et [dS] = SX + SXX X 2
dt
2

where

(when X is absorbed at 0, the stock keeps paying 3mdt every second).

Let us formulate the educated guess

S (X) = BX + C ,

where B and C are constants to be determined. Given

SX

B ,

SXX

0 ,

Alessandro Sbuelz - SBFA, Catholic University of Milan

the dynamic equilibrium restriction becomes

BX + 7X + 3m

(BX + C) r + BX

m
3m Cr
| {z }

= 0

(B (r +
|

7)X
}

)
{z

= 0

m
B =
C =

r+
3m
.
r

Hence,
S (X)

7X

r+

3m
.
r

The total gain on the stock is

dS

(7X + 3m) dt

1
SX X + SXX X 2
2

( Sr

Sr

SX X

) dt

7X
r+

Alessandro Sbuelz - SBFA, Catholic University of Milan

7X + 3m

dt

SX X dz

SX X dz .

dt

7X
r+

dz .

The total gain on your portfolio is

dH

150
( dS + (7X + 3m) dt )
S

150

150

Hr

50rdt

dS + (7X + 3m) dt
S

50rdt

7X
S (r +

1050X
S (r +

dt

dt

Alessandro Sbuelz - SBFA, Catholic University of Milan

7X
S (r +

1050X
S (r +

dz

50rdt .

dz .

SOLU T ION S

The correct answer is a).

The investors expected utility is

h
i
f
E
log W
= 0:5 ln (101 + w (100g

1)) + 0:5 ln (101

6w)

and the Lagrangian function is

L (w; l)

log

f
W

The Kuhn-Tucker First Order Conditions are:

8
Lw =
>
>
>
>
>
>
>
>
<
l
>
Ll
>
>
>
>
>
>
>
:
l Ll =

l (w

3) .

0
0
0
0 .

If l = 0 (we assume a painless constraint), the F.O.C.s become

Lw (w; l)jl=0

Ll (w; l)jl=0

1
100g 1
2 (101 + 100gw

5050g + 6w 600gw 353:5

(100gw w + 101) (101 6w)

0 ,

(w

3)

w)

1
6
2 (101 6w)

0 ,

so that
Lw (w; l)j l=0; w=3

= 0 () 5050g + 18

1800g

Alessandro Sbuelz - SBFA, Catholic University of Milan

353:5 = 0 () g = 10:3 23% .

The graphical analysis (not required) follows, with

8
>
< 101 + w (10:3 23 1) 0
() w 2 ( 10: 833 422 7; 16: 833 333 3) .
>
:
101 + w ( 5 1) 0

expected utility

-14

-12

-10

-8

-6

-4

-2

10

12

14

16

18

20

allocation w

-1

Alessandro Sbuelz - SBFA, Catholic University of Milan

SOLU T ION S

The correct answer is d).

The problem is
maxP (x; y)
x;y

1
1
x+ y
2
2

sub

20

with
P (x; y) = 25x + 35y

2x2 + 2y 2

3xy + 30

The First Order Conditions for constrained optimality will be su cient because the constraint function
is linear (the feasible set (x; y) 2 R2 : 12 x + 12 y 20 is convex) and the prot function P (x; y) is
strictly concave:
3 2
3
2
4
3
Pxx
Pxy
7 6
7
6
H = 4
5=4
5 with Pxx = 4 < 0 and det (H) = 7 > 0 :
3
4
Pyx
Pyy
Given the Lagrangian function
L (x; y; l) = P (x; y)

1
1
x+ y
2
2

20

the Kuhn-Tucker First Order Conditions are:

8
8
>
>
3y 4x 21 l + 25 = 0
L
=
0
x
>
>
>
>
>
>
>
>
>
>
3x 12 l 4y + 35 = 0
>
> Ly = 0
>
>
>
>
>
>
>
>
<
<
,
l 0
l 0
>
>
>
>
>
>
Ll 0
20 12 y 21 x 0
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
: l L =0
: l 20 1 y 1 x = 0
l
2
2
For l = 0 (we assume a painless constraint), we have:
8
8
>
>
3y
4x
+
25
=
0
<
< x=
,
>
>
:
:
3x 4y + 35 = 0
y=
Alessandro Sbuelz - SBFA, Catholic University of Milan

205
7

= 29: 285 714 3

.

215
7

= 30: 714 285 7

8

The unconstrained maximum-prot point is such that P

unfeasible as the constraint is violated:
1 205 1 215
+
= 30
2 7
2 7

For l > 0 (we assume a painful constraint), we have:

8
>
3y 4x 12 l + 25 = 0
>
>
>
>
>
<
3x 12 l 4y + 35 = 0
>
>
>
>
>
>
: 45 1 y 1 x = 0 (the constraint is binding)
2

205 215
; 7
7

= 873: 571 429. It turns out to be

20 :

8
>
= 19: 285 714 3
x = 135
>
7
>
>
>
>
<
,
y = 145
= 20: 714 285 7
7
>
>
>
>
>
>
: l = 20

The constrained maximum prot is

P (29; 21) = 773: 571 429 .

Alessandro Sbuelz - SBFA, Catholic University of Milan

SOLU T ION S

The correct answer is b).

By the First Fundamental Theorem of Asset Pricing, any arbitrage opportunity is ruled out if the
market M supports a risk-neutral probability measure Q (recall that the riskfree rate is r = 0):
2

2
3
3T 2
3
1:0
1+0 3 2
Q (! 1 )
1 6
6
7
7 6
7
4 0:3 5 =
4 1 + 0 0 0 5 4 Q (! 2 ) 5 .
1+0
1:0
1+0 0 1
Q (! 3 )
Since

02

31
1 3 2
B6
7C
det @4 1 0 0 5A
1 0 1

the unique measure Q is:

3T 1
1 3 2
Q (! 1 )
B6
7 C
7
6
B
4 Q (! 2 ) 5 = @4 1 0 0 5 C
A
1 0 1
Q (! 3 )
2

02

3 ,

31
1:0
7C
B
6
@(1 + 0) 4 0:3 5A
1:0
0

3
0:1
6
7
4 0:1 5
0:8

with
02

3T 1
1 3 2
B6
C
B4 1 0 0 7
5 C
@
A
1 0 1

02

31
1 1 1
B6
7C
@4 3 0 0 5A
2 0 1

Alessandro Sbuelz - SBFA, Catholic University of Milan

0
1 6
4 1
3
0
|

3
1
3
{z

3
0
7
2 5
3

matrix of cofactors

10

The payo to be priced is

e (1)
X
2

3
X (1) (! 1 )
6
7
4 X (1) (! 2 ) 5
X (1) (! 3 )

max

Se1 (1) ; 0

1:5

m
2

3
2
3
3; 0)
0
7
6
7
0 ; 0 ) 5 = 4 1:5 5 .
0; 0)
1:5

max ( 1:5
6
4 max ( 1:5
max ( 1:5

Its no-arbitrage price is

2

3T 2
3
0
0:1
1 6
7 6
7
X (0) =
4 1:5 5 4 0:1 5
1+0
1:5
0:8

1: 35 .

An alternative would be the calculation of the intial cost of the unique replicating strategy #X :
2

3
#X
0
6 X 7
4 #1 5
#X
2

3
1 3 2
7
6
4 1 0 0 5
1 0 1
2

and
V#X (0)

3
0
7
6
4 1:5 5
1:5
2

0
1 6
4 3
3
0

3T
1: 5
6
7
4 0:5 5
0

{z

3
3T 2
0
0
7
7
6
3 5
4 1:5 5
1:5
3

matrix of cofactors

3
1:0
6
7
4 0:3 5
1:0

Alessandro Sbuelz - SBFA, Catholic University of Milan

1
1
2

3
1: 5
7
6
4 0:5 5
0
2

1: 35 .

11

SOLU T ION S

The correct answer is d).

By the First Fundamental Theorem of Asset Pricing, any arbitrage opportunity is ruled out if the
market M supports a risk-neutral probability measure Q:

"

1:0
0:35

3
3T 2
1+0 0
Q (! 1 )
1 6
7 6
7
=
4 1 + 0 1 5 4 Q (! 2 ) 5 .
1+0
1+0 0
Q (! 3 )
2

Lets x Q (! 3 ) = q. Since
det

"

#!

1+0 0
1+0 1

= 1 ,

the candidate measures Q must be such that:

"

Q (! 1 )
Q (! 2 )

0"
@

1+0 0
1+0 1

"

1
0

"

0:65 q
0:35

1
1

#T 1
A

# "
#

(1 + 0)

1 q
0:35

"

1
0:35

"

1+0
0

#!

By imposing the positivity of the probability masses, we have

8
>
<

0:65 q > 0
0:35 > 0 (true)
>
:
q>0

()

Alessandro Sbuelz - SBFA, Catholic University of Milan

q 2 (0; 0:65) .

12

Hence, the market M is arbitrage-free and, by the Second Fundamental Theorem of Asset Pricing,
Qs multiplicity implies M s incompleteness.

The upper bound of the no-arbitrage prices of the payo

2

3
X (1) (! 1 )
6
7
4 X (1) (! 2 ) 5
X (1) (! 3 )

3
0
6 7
4 1 5
2

is

sup
Q

1
(0 Q (! 1 ) + 1 Q (! 2 ) + 2 Q (! 3 ))
1+0

Alessandro Sbuelz - SBFA, Catholic University of Milan

sup
q2(0;0:65 )

1
(1 0:35 + 2 q)
1+0

1
(1 0:35 + 2 0:65)
1+0

1:65 .

13