Page 1 - 20151117_150322.

jpg
Net Present Value
Certainty Case

0
=0

={1)

+1 + 1

= 0
=1

= (1 )
=
1 - = delta
[0,1]

(1 + )

(1 )(1 )
= % tax

=
=

= +

2 increments to compare:
0 = 1,000
1 = 800
2 = 700

(1 + )

(1 + ) 1

0 = 1,000
1 = 600
2 = 600
3 = 700

800
700
+
= 305.78
1.10 (1.10)2
(1.1)2
305.78 (
) = 1,761.90
(1.1)2 1
600
600
700
2 = 1,000 +
+
+
= 567.24
2
1.10 (1.10)
(1.10)3
(1.1)3
567.24 (
) = 2,280.96
(1.1)3 1
1 = 1,000 +

= 10%

Page 2 - 20151117_150841.jpg
Internal Rate of Return
IRR is the rate that makes NPV = 0

= 0 +
+

(1 + )
(1 + )
Example:
10,000 +

=1

5000
6000
6000
+
+
2
(1 + )3
1 + (1 + )

z=10%, NPV=4012
z=20%, NPV=1805
> 20%
31% < z < 32%

31% NPV = 77
32% NPV = 127
1 - 171
Interpolation
127
127/144 = 0.88
30.88%
144 1% move
CERTAINTY total uncertainty never exists
Probabilistic cash flow

0 = 1000
cash flows are stochastic variables
z = 10%
2 parameters: mean and variance
Mean in 2 complex set
Order not complete
() Expected Value
( + ) = () +
( + ) = 2 ()

variance gives dispersion to the mean

if independent, cov = 0
( + ) = () + () + (, )

Page 3 - 20151117_151336.jpg
To calculate the mean
1 ) (
2 )
3 )
(
(
(()) = 0
+
+

1+
(1 + )2 (1 + )3
Variances of the NPV
1
2
3
(1000 +
+
+
1 + (1 + )2 (1 + )3
Variance of -1000 = 0 (number)

() = 2

1 2 3
+
+
1.12
(1.12 )2 (1.12 )3
Investment #1
= 10%
0 = 1000

0.4
0.4
0.2

1
500
600
700

0.5
0.4
0.1

2
400
500
700

0.7
0.3

0.4 500
0.4 600
0.2 700
= 580

0.4(500 580)2
0.4(600 580)2
0.2(700 580)2

= 0.4(80)2
= 0.4(20)2
= 0.2(120)2

= 2560
= 160
= 2880
5600

0.5 400
0.4 500
0.1 700
= 470

0.5(400 470)2
0.4(500 470)2
0.1(700 470)2

= 0.5(70)2
= 0.4(30)2
= 0.1(230)2

= 2450
= 360
= 5290
8100

0.7 500
0.3 600
= 530

0.7(500 530)2
0.3(600 530)2

= 0.7(30)2
= 0.3(70)2

= 630
= 1470
2100

5600 8100 2100

= 11,345 =
1.12 1.212 1.3312
. = 106.5

3
500
600

Page 4
Investment #2
0 = 1000

0.1
0.9

1
100
700

0.2
0.8

2
200
800

0.1
0.4
0.5

0.1 100
0.9 700
= 640

0.1(100 640)2
0.9(700 640)2

= 0.1(540)2
= 0.9(60)2

= 29,160
= 3,240
32,400

0.2 200
0.8 800
= 680

0.2(200 680)2
0.8(800 680)2

= 0.2(480)2
= 0.8(120)2

= 46,080
= 11,520
57,600

0.1 300
0.4 500
0.5 700
= 580

0.1(300 580)2
0.4(500 580)2
0.5(700 580)2

= 0.1(280)2
= 0.4(80)2
= 0.5(120)2

= 7,840
= 2,560
= 7,200
17,600

32,400 57,600 17,600

+
+
= 76,053.2 =
1.12
1.212
1.3312
. = 275
> std. sed. > risk
( 1 ) ( 2 )
( 1 ) ( 2 )

3
300
500
700

Page 5 - 20151117_151351.jpg
Std. Dev
106.5

580 470
530
1 = 1000 +
+
+
= 314
1.1 1.21 1.331
640 600
580
2 = 1000 +
+
+
= 513
1.1 1.21 1.331

275

314 513
1 2
2 1 . . ()

= State of nature
1 1 1
: | |

= 1
=0

> 0

() =
=0

()

() = ( ())2
=0

= [ 2 2() + ()2 ]
= ( 2 ) 2()2 + ()2
= ( 2 ) + 2 ()

2 (())2
=0

Page 6 - 20151117_151400.jpg
Utility Function
happiness function
Hypothesis 1: preferences are asymmetric, meaning cannot have and asymmetric
relationship
If you have then is false
Hypothesis 2: ( )

Note: Problem with symbol for preference; the symbol used in class does not exist in latex. Here is a
pdf about preference:
http://www.oeconomist.com/blogs/daniel/wp-content/uploads/2011/04/pref_symbols.pdf
From here forward I will use a bold < or >
Preferences:
1) Are Not reflexive: > doesnt exist (anti reflexive)
2) The function is transitive if > and > then >
3) Acyclical
1 > 2 > 3 > >
1
~1 cant' return back
Weak preference
-> >
-> ~
Complete preference

or
~

If 1 and 2 are verified then the preference order

is a complete one

(i) Transitive
(ii)Independence if the investor is indifferent but continues A + B then for every outcome C he is
also indifferent between two gambles:
1 = 1
2 = 1
(iii) Certainty equivalence for any gamble there is a certain equivalent value so the investor is
indifferent but the gamble and the CF
(iv) Stochastic dominance

Page 7-20151117_151406.jpg
The Utility Function

Construction

() = ( )
=1

Lottery (a random variable)

() to get x
1
to get y

(, , )

> always

If z exists such that = () + (1 )() we call this z the certain equivalent of the lottery
Hypothesis
1) Strong independence , ,
If ~ and [0,1] then (, , )~(, , )
2) Continuity
> > then ! such that (, , )~
Ex. 1,000 > 500 > 0
(, 1000,0)~500
note: rick adverse > 0.5
3) Monotonicity
>>
(, , )~
>>
(, , )~
1 > 2 then y is preferable to z
Utility function: if > then () > ()
> () > ()
~ () = ()

> 2 > 1

Page 8 - 20151117_151420.jpg

= certain equivalent of the lottery where () + (1 )() = . .

1
( , + , ) =
2
1
1
( ) = ( + ) + ( )
2
2
If you are risk adverse, you will not accept a lower number then average
=
= =
Pay something to not take risk. Eg. Insurance
. =
( ) < ()
( ) = ( ) = () () +
Taylor: ( + ) = () + () +
( ) = ( + )

2
() +
2

1
= () + () + () + ()
2
Expected value of this
Expected value of ( ) = ( ) real number
1
( ) = () + ()( ) + ( 2 ) ()
2
1
( ) = () + ()0 + 0 ()
2
( ) = ()
1
( ) = () () = () + ( 2 ) ()
2
1
)
()
( = ()
= () + 2 ()
2
1 2 ()
= =
2
()
is positive, = wealth

= random variable
1
1

+
2
2
Expected value ( ) = 0

Page 9 - 20151117_151426.jpg
ARA = Absolure Risk Aversion
=

In general, investors with increase absolute risk

aversion i.e. () > 0 will hold less in risky
assets in absolute terms as their wealth increases.
But investors with increasing relative risk aversion
i.e. () > 0 hold proportionality less in risky
assets as their wealth increases.

()
()

Decreases when (rich)

RRA = Relative Risk Aversion
()

= ( () )
Common Utility Functions
1
ln()
=

1
= 2

()

= 2

( )
1

=1

2
=
=

2
(
)
=
=

(
)

=
2

=
=
= 2

(2 )
= =
=
( )

1
1

=
3

1
2
2
4
= =
=
1
1

2
= 3
2

4 2
1
3

1
2
= = 4 =
1

2
2
1

= 1
=
= (2 ) 2

= ( 1)
1
= 2 + 2
( + )2+
=
= 2
+

=
+
*Interpretation: an investor with a logarithmic utility will hold the same proportion of wealth in risky
assets however rich he becomes

Page 10 - 20151117_151442.jpg

= 1

ln()

ln()

( + )2+

1
() =

=
=
1
=
2
= 1
= 2 + 2

+
0

a
a

Concerning the shape of the utility function; usually we assume that more is better. The is, the utility
function is a strictly monotonic increasing function of wealth. Put another way, the marginal utility is
always positive i.e. () > 0 . But (), which determines the curvature of the utility function,
can take either sign.

Page 11 - 20151117_151447.jpg
Utility Function

()
()
()
=
()
=

INADA Conditions
To have a good utility function, you must have
lim () =
0

Everyone has utility function

Must always be increasing > 0
Risk averse; concave < 0
ARA and RRA two other conditions
One common utility function:
() =

()

1
2

To be a good utility function, ARA when w

constant

lim () =

() = ()
]0, +[

positive
negative
1
lim = +
0
1
=0

lim

1
1
2

=
=
1

1
= = 1

* no bankruptcy I nthis model, w = negative or 0 but can have bankruptcy in other models eg.

Page 12 - 20151117_151455.jpg

() = , > 0

()
=
=
= =
()

()
2
=
=
=
()

INADA
lim =

= > 0
= 2

lim = 0

Investment #1:
0
-1000

0.4
0.4
0.2

500
600
700

0.5
0.4
0.1

400
500
700

0.7
0.3

500
600

1 = 0.4500 + 0.4600 + 0.2700 = 6.35~6.4

2 = 0.5400 + 0.4500 + 0.1700 = 6.25~6.3
3 = 0.7500 + 0.3600 = 6.3
=> 6.4 + 6.3 + 6.3 = 19
Investment #2:
0
-1000

0.1
0.9

100
700

0.2
0.8

6.4
* with equation dont need to discount

6.4
1

200
800

0.1
0.4
0.5

6.3

300
500
700

Page 13 - 20151117_151459.jpg
Bonds
Financial flow, amout know before on fixed dates
Maturity date
Contract between two parties
Types
1. Fixed rate bond
Price = 1000 face value, 6 years at 6% p.r. to maturity
1st april 2013 60
1st april 2014 60

1st april 2019 60

2. Variable rate
i.e. Euribor + 1%, Libor + 1%
(interbank rates)
,
3. Convertible bonds
t=0, put bond on market, maturity 5 years
bond 1000 stock 60 can charge for 15 shares of stock
-price higher because of relative advantage

-interest rate less for convertible
Risks
A. Signature risk (Treasury bond = only risk-free bond)
B. Other risk is in rate. Try to sell in market and wont get 1000 if i.e. to 7% from 6%
Paradox allais people not always rational. 2 lotteries
320 K
p=1
150 K
p=0.2
150 K
p=0.8
0 K
p=0.8
0 K

320 K
0 K

(1, 320 , 0) (0.8, 450 , 0)

(0.25, 320 , 0) (0.2, 450 , 0)

p=0.25
p=0.75

Page 14 - 20151117_151508.jpg
Stocks
2 ways companies get money: stocks and bonds (loan and capital)
Flow between company and investor = dividends
1) Indefinitely (contrast to bonds which have a timeline)
2) Proportionally
3) Not known at onset
Why do we need financial markets?
1) Primary markets companies go to primary market for funding (stocks, bonds)
2) Secondary market purely financial
*no interaction between companies and secondary markets
Pricing in the secondary market.
Three Approaches
1) Technical approach (irrelevant) i.e. analysis w/o probability -> wont see here
2) Fundimental Approach three methods
a. Irving Fisher

0
1 2 3
1
2

2 0 =
+(
+
+)
2
(1 + )
(1 + )2
1+

0
(1 + )
Price = Dividends in perpetuity

=1

=
Assumes D is the same every year

Page 15 - 20151117_151511.jpg
b. Gordon Shapiro

1+
)
1+
=1
1+
0 = 0

Perpetuity with constant growth rate g < z

c. Molodovski
Not normal that growth is constant
First years more quickly then stabilization
1.03
(1.03)(1.02)
0 = 0
+ 0

(1 + )2
1+
0 = 0 (

Page 17 - 20151117_151520_001.jpg
Mono period markets
Defn: Derivative Product = asset whos output depends on an underlying asset
Ex. Call option on a stock
3 steps in market finance
1) Mono period, have only two time periods: t = 0, t = T (or 1)
2) Binomial model
3) Continuous model (next year)
Mono period market
S = assets
10 , 20 => = 0
0
Can have 0 =
An asset whos value is the same at the moment t=T whatever the state of nature
1 =
(1 ) ( )
( ) > 0
At t = 0 value is known
At t = T value is unknown
Economy matrix (for the price of asset at T = 1)
1
1 |1 (1 ) (1 )
|1 ( ) ( )
|1 ( ) ( )

(1 ) |
( ) |
( )|

Page 18 - 20151117_151532.jpg
00 = ( )
01 = 00 (1 + )
=
0 = = (00 , 10 , 0 , )
= 0

( 0 )

= 0 0

Example

=1

Prices at t=0
1 = 100
1 = 3
31 + 22 + 33 = 0
Construct of portfolio at t=0
2 = 80
2 = 2
3 = 110
3 = 3
= 0: 3(100) + 2(80) + 3(110) = 790
Since the construct of the portfolio will not change between t=0 and t=T, 0 = 1
= 1 () 0 () = ( 0 )
Can be positive or negative
= 1
1
1 1 1 1

= 1
]
[ 1
1
Z is the normal economy matrix

11 1
0
| 1
1
1 1
=
11
1
|
1 1
10

D = the diagonal matrix of prices at t=0

1
=[ 1
1]

1 1
0
1
0
1
1

1
0 |
1

0
1
|

Page 19 - 20151117_151541.jpg
What is the value of Z?

10 = 100
} = 0
20 = 100
1 + 2 + 3 => 3
1 2
.
21 2 = 60
60 180
1
= 1 =
60 ]
2 [140
3 180 100
60
180
100
100
0.6 1.8
1
140
60
|
= = |
100
100 || = |1.4 0.6|
1.8 1.0
180
100
100
100
= 31 + 12 = 3(100) + 1(100) = 400 = 0
Has to be
0.6 1.8 3
0.9 1
4
= |1.4 0.6| | | = |1.2| 2
1
1.8 1.0 4
1.6 3
** but: a market is complete if # assets >= # states of nature in previous example
<
A riskless asset or portfolio is such that the result will be the same in all states of nature
=> = 1 +

= | |

Example:

Page 20 - 20151117_151551_001.jpg
Calculate
0.61 + 1.82 =
0.6 1.8
|1.4 0.6| | 1 | => 1.41 + 0.62 =
2
1.81 + 12 =
1.8 1
1 + 2 = 1 2 = 1 1
Substitute:
0.61 + 1.8(1 1 ) =
1.41 + 0.6(1 1 ) =
1.81 + 1(1 1 ) =
(1) 1.8 1.21 =
(2) 0.6 0.81 =
(3) 1 0.81 =
1.8 1.21 = 0.6 + 0.81
1.2 1.21 = 0.81
1.2 = 21
1 = 0.6
1.8 1.21 =
1.8 1.2(0.6) = 1.08 =
1.8 1.21 =
1 + 0.81 =
1.8 1.21 = 1 + 0.81
0.8 = 21
1 = 0.4
1.8 1.2(0.4) = 1.32
1.08 < < 1.32
What if not?

0.61 + 1.8 1.81 =

1.41 + 0.6 0.61 =
1.81 + 1 11 =

Page 21 - 20151117_151556.jpg
Arbitrage Portfolio
2 arbitrage possibilities:
1.
At t = 0
0 () = 0
() 0
( ()) > 0) > 0
1 = 1 short sale
2 = +1 normal buy
1 ()( ) > 0 0 = 0
will never exist in a good market, but exists in reality
AAO = absence of arbitrage opportunity
T=0

0 () < 0
()( ) 0
if 1.08 < < 1.32 then no arbitrage
3 assets, 3 states of nature => complete market

2.

Given interval (from previous) is between 8% and 32%

Show that can have arbitrage outside of interval
10 = 100
20 = 100
1) Borrow 200 from bank
2) Buy 11 and 12 at t=0 =200 at t=0
1
2
3

60+180-200=40
140+60-200=0
180+100-200=80

= 0%

Page 22 - 20151117_151604.jpg
Assume r = 50% (outside of range)
Invest 200 in a bank at t=0
300 at t=1
200(1.5)=300
Short sell 1 + 2 = 200
1
2
3

60 + 180 = 240
140 + 60 = 200
180 + 100 = 280

Paid
Paid
Paid

Assume r=25% 200(1.25)=250 (within range)

1
60 + 180 = 240
2
140 + 60 = 200
3
180 + 100 = 280

Payoff
300
300
300

+60
+100
+20

All 3 positive
=arbitrage

250
250
250

+60
+100
+20

Not arbitrage

If 2 portfolios, 1 and 2
(1 ) = (2 ) if AAO then to NOT have arbitrage opportunity
(1 ) = (2 )
Sell
Buy
Win $ at beginning

Page 23 - 20151117_151607.jpg
recall

0.6 1.8
= |1.4 0.6|
1.8 1

(normal economy matrix from previous example)

*this was incomplete because 3 states of nature and 2 assets

*saw that with 1.08 < R < 1.32 AAO
Price Vector of the State of Nature

= (1 )

= ( )
=1

1
*1 is the price of a vector so that it will pay 1 on 1 and 0 otherwise, i.e: ( )
0
0
etc.
0
( )

(0 )
Note: example, base in 4

4
3
And |5| = 41 + 32 + 53 + 44
4
=
To Calculate:
= 1

0.6 1.4 1.8 1

1
|
| | 2| = | |
1.8 0.6 1
1
3

0.6 1.8
= |1.4 0.6|
1.8 1

0.61 + 1.42 + 1.83 = 1

1.81 + 0.62 + 1.03 = 1

Incomplete market
2 equations, 3 variables (in solution there will be 1 variable)

1
0
|0
0

0
1
0
0

0
0
1
0

0
0
0|
1

0.6 1.4 1.8

= |
|
1.8 0.6 1

Page 24 - 20151117_151614.jpg
Definitions:

AAO if B > 0 and < 1

i.e. 0 < < 1

Solution
0.61 + 1.42 + 1.83 = 1
1.81 + 0.62 + 1.03 = 1
1) Multiply both by 10 (simplification)
61 + 142 + 183 = 10
181 + 62 + 103 = 10
2) Multiply first by -3 and second by 1
181 422 543 = 30
181 + 62 + 103 = 10
362 + 443 = 20
left with 2 variables
2 =

20 443
36

3 0 < 3 < 10/22

2044
Since 2 = 36 3

By definition 0 < B < 1 to 20-443 >0

10
5
3 <
=
22 11
20

If 3 = 0 then 2 = 36 = 9
If 3 = 1 then
10
61 = 10 14
18
10
1 =
27
10
10
3 = 0, 2 = 18,3 = 27 not acceptable because b has to be > 0
If 3 is 0<3 <1, say 1/3
Calculate 1 and 2
1
61 + 142 = 4
61 + 142 + 10 ( ) = 10
13
10
20
181 + 62 +
= 10
181 + 62 =
3
3
1 = 26/81
2 = 4/27
3 = 1/3

Page 25 - 20151117_151617.jpg

will find an R s.t. 1.08 < R < 1.32 (from previous example)
ZQ from previous analysis
0.6 1.4 1.8 1
1
(1.8 0.6 1 ) (2 ) = (1)
3

1
1
26 4 1 1
1 + 2 + 3 =
+
+ =

81 27 3
81
26 + 12 + 27 1 65
=
= 1.25( 1.08 < < 1.32)
= =
65
81
81
Value of 00 = 3=1 00
00 = (1 + 2 + 3 )
1
If 1 = (1 + 2 + 3 ) then = 1 + 2 + 3

1 = 1 , 2 = 2 , +3 = 3

All are > 0

And sum =1 (probabilities)

=risk neutral probability (martingale probability)

=
0
= 1 ( )
= "risk neutral probability" martingale
*mono period so no
=1
1
R = 1+r
0 = (1 )
Net present value of expected value

Eq = expected value
1
actualized

Page 26 - 20151117_151622.jpg
Exercise
Mono period market
= 10%
0 = 12
1 (1 ) = 12
1 (2 ) = 18
(1) Economy Matrix
1
1
Y
1.1
1 12
=
1.1
2 18
1
=(
3/2

(1) Economy matrix Z

(2) Price vector of the market

1
12/12
18/12

Z= 1
2

11/10
)
11/10

= (

1
3/2
)
11/10 11/10

3
1 + 2 = 1
2
11
11
1 + 2 = 1
10
10

(2)

3
1
2 ) (1 ) = (1)
= (
11 11 2
1
10 10
2 eq, 2 unknown (TI-89)

1 =

(3) Price an asset which gives 2 in 1 and 2/3 in 2

Price at t=0

= 1 ( )
=1
2

R
11/10
11/10

52

=21 + 3 2 = (2 11) + (3 11) = 33 = 1.6

if value 0 < 2/3 or > 2 not In a correct price

*i.e., wont pay less than 2/3 or more than 2

8
2
, 2 =
11
11

Page 27 - 20151117_151627.jpg

1 = 2 = 100 at t=0
1 1 120
2 1 140
1 2 110
2 2 120
1 3 80
2 3 30
1. Is this a complete market? No- 2 assets/three states of nature
2. If not find the interval of R where ok
3. Find
Solution
120 140
12/10 14/10

= [110 120]
= [11/10 12/10] ( 1 ) =

2
80
30
8/10
3/10
Interval of R
12
14
1 + 2 = 1
1 + 2 =
10
10
11
12
so
1 + 2 =
10
10
8
3
2 = 1 1
1 + 2 =
10
10
2 assets
At t=1

(1)
(2)
(3)

121 + 14(1 1 ) = 10
111 + 12(1 1 ) = 10
81 + 3(1 1 ) = 10

21 + 14 = 10
1 + 12 = 10
51 + 3 = 10

=>
=>
=>

Simplify (2) =>

1 = 10 + 12

(1)(2)

21 + 14 = 10
2(10 + 12) + 14 = 10
=1

(2)(3)

5(101 + 12) + 3 = 10
501 + 63 = 10
63
=
= 1.05
60

Simplify (3) =>

(2)(3)

1 = 2

3 equations, 2
unknown, cant solve
directly

3
5

3
(2 ) + 12 = 10
5
3
2 + 12 = 10
5
= 1.04

1.05 < 12 < 1.09

Page 28 - 20151117_151633.jpg
3. Find Betas

1.2 1.4 1.01

= (1.1 1.2 1.01)
0.8 0.3 1.01
= 1
1
1.2 1.1 0.8
1
( 1.4 1.2 0.3 ) (2 ) = (1)
1.01 1.01 1.01 3
1

1.2 1.1 0.8

= ( 1.4 1.2 0.3 )
1.01 1.01 1.01
1.21 + 1.12 + 0.83 = 1
1.41 + 1.22 + 0.33 = 1
1.011 + 1.012 + 1.013 = 1
1 = 0.79
2 = 1.75
3 = 0.33

Page 29 - 20151117_151638.jpg
Derivatives
Product where payout is a function of another asset f(x) where x is the underlying asset
2 examples call/put
CALL a contract which gives the right (but not the obligation) to buy an asset at time T for price K
T=maturity date
K=strike
Example: t=0, value = 100, strike (K) = 105
payout
100
15
1 = 120
5
2 = 110
0
<= right but not obligation (otherwise would be -25)
3 = 80
PUT a contract which gives the right (but not the obligation) to sell an asset at time T for price K
Example from above: Put and call in 1 for K=100
call
put
20
0
Strike = 100
1 = 120
10
0
2 = 110
0
20
3 = 80
Pricing (Using example from yesterday)
Assume R = 1.06 (1.05 < R < 1.09),1 = 0.189, 2 = 0.189, 3 = 0.566
1
= 1
1.2 1.1 0.8
1
( 1.4 1.2 0.3 ) (2 ) = (1)
1.01 1.01 1.01 3
1
3

0 = ( )
1=1

1
2
3

call
20
10
0

put
0
0
20

Price at t=0
CALL = 1 (1 ) + 2 (2 ) + 2 (2 )
= 1.89(20) + 0.566(10) + 0
= 9.44
PUT

= 1 0 + 2 0 + 0.189(20)
=3.78

Page 30 - 20151117_151644.jpg

is a hedging portfolio () = ( )
Using Previous Example:
= 0
0
1 1
0 + 1001 + 1002
2 2
120 140 1.06
= |110 120 1.06|
80 30 1.06

1.20 1.4 1.06

= |1.10 1.2 1.06|
0.8 0.3 1.06

1 120 + 2 140 + 3 1.06 = 20

1 110 + 2 120 + 3 1.06 = 10
1 80 + 2 30 + 3 1.06 = 0
3 equations, 3 unknowns (CALL)
1 :
2.33 100 =
2 :
0.6667 100 =
0 :
157.23 1 =

1.2 1.1 0.8

= | 1.4 1.2 0.3 |
1.06 1.06 1.06
1 = 120
2 = 110
3 = 80

233.33
-66.67
-157.23
9.44

Value of option because AAO

PUT
1
2
3

120
110
80

payout
0
0
20

1 120 + 2 140 + 3 1.06 = 0

1 110 + 2 120 + 3 1.06 = 0
1 80 + 2 30 + 3 1.06 = 20
62.93 + 1.333(100) 0.6667(100) = 3.767

call
20
10
0

Page 31 - 20151117_151647.jpg
Put-Call Parity

+
= 0 +
1+
Proof: at t=0 have 2 portfolios

1 = +
1+
2 = +
3 possibilities at t=T
1) >
2) =
3) <

9.44 +

100
= 100 +
1.06

0 + = 0 + 0
Action
Buy Call
Buy bond w/ payoff x at T
Write a put
Short one share stock
Total

Today
0

0
0

0
+ 0 + 0

At t=T
<
0
x
( )

x
0

Page 33 - 20151117_151654.jpg
1) Find interval of P
2) Hedging portfolio of P
1
0 = 02 = 100 with 4 states of nature
Put an asset S with K=110
1) Interval of P
Payout on 1 Put=110 | |
1
2
90 180
1
|110 90| = 20
80
40
2
|110 80| = 30
3 130 95
|110 130| = 0
4 150 80
|110 150| = 0
Payout P => (0 < P < 30)
(1)
901 + 1802
(2)
801 + 402
(3)
1301 + 952
(4)
1501 + 802

=
=
=
=

20
30
0
0

(1) And (2)

901 + 1802 = 20

=>

801 + 402 = 30

=>

23
1 =
= 0.4259 100
54
11
2 =
= 0.1019 100
108
Reject > 30

(1) And (3)

901 + 1802 = 20

=>

1301 + 952 = 0

=>

38
297
52
2 =
297

=>

1501 + 802 = 0

=>

8
1 =
99
5
2 =
33

(2) And (3)

801 + 402 = 30

=>

1301 + 952 = 0

=>

(3) And (4)

801 + 402 = 30
1501 + 802 = 0

10.18
32.4

1 =

(1) And (4)

901 + 1802 = 20

42.59

19
= 1.1875 100
16
13
2 =
= 1.625 100
8
Reject =>

2 =

Note:
Ie.

4.72

-0.0808
.1515
7.07
118.75
-168.50
-43.75

12 = 01 = 100
1 + 2 = 1001 + 1002
100(0.0805) + 100(0.1515) = 7.07

Conclusion: 4.72 < P < 7.07

Page 34 - 20151117_151702_001.jpg

Call 100 for 2 will have another interval of C

With 4.72 < p < 7.07
1 = 2 = 100
Say P = 6, find R
Assumptions from above:
1
2 Payout 1 ( = 110)
90 180 100-90=20
1
80
40 110-80=30
2
3 130 95 110-130=0
4 150 80 110-180=0
90/100 180/100 20/6
0.9 1.8 10/3
80/100
40/100 30/6
5 )
==(
) = (0.8 0.4
130/100 95/100
0/6
1.3 0.95
0
1.5 0.8
0
150/100 80/100
0/6
0.9 1.8 10/3

1
5 ) ( ) = ( )
= (0.8 0.4
2
1.3 0.95
0
3

1.5 0.8
0
10
(1) 0.91 + 1.82 + 3 =
1 + 2 + 3 = 1
3
So
(2) 0.81 + 0.42 + 53
=
(3) 1.91 + 0.952
=
1 = 1 2 3
(4) 1.51 + 0.82
=
Simplified:
100
(1) 91 + 182 +
= 10

3 3
(2) 81 + 42 + 503
= 10
(3) 191 + 952
= 10
(4) 151 + 82
= 10
Take value = 6 for put, want to find interval of call
Assets
90 80 130 150
901 + 1802 + 203 = 80
1
180 40 95 80
801 + 402 + 303 = 0
2
20 30 0
0

1301 + 952 = 0
80 0
0
0

1501 + 802 = 0

Page 35 - 20151117_151718.jpg
10

3 3
0.81 + 0.42 + 53
1.91 + 0.952
1.51 + 0.82
0.91 + 1.82 +

1 + 2 + 3 = 1

=
=
=

So
1 = 1 2 3

(1)

2.41 1.52 =

(2)
(3)
(4)

4.21 4.62 = 5
1.31 + 0.952 = 0
1.51 + 0.82 = 0

10
3

(1)(2)(3)

R=1.16

(1)(2)(4)
(1)(3)(4)
(2)(3)(4)

R=1.25
R=1.215
R=0.99

At R=1.3 => Arbitrage opportunity

Find (Test R = 1.1)
= 1
0.9 1.8 3.3 1.1
0.8 0.4
5 1.1
1.3 0.95 0 1.1
1.5 0.8
0 1.1
0.9
1.8
3.3
1.1

0.8
0.4
5
1.1

With 1.17
0.2496
0.0352
0.538
0.0318

1.3
0.95
0
1.1

1.5
0.8
0
1.1

With 1.22
0.3077
-0.0031
0.2352
0.2798

1
2
3
4
With 1.3
0.3914
-0.0583
-0.2004
0.637

1
1
1
1

0.9
1.8
3.3
1.1

0.8
0.4
5
1.1

With 1.1 *
1 = 0.1584
2 = 0.948
3 = 1.008
4 = 0.3533

So 1.16 < R < 1.215

1.3
0.95
0
1.1

1.5
0.8
0
1.1

Page 36 - 20151117_151725_001.jpg
Price of a Call

+
= +
1+
110
+
= 6 + 100
1.2
110
= 6 + 100
= 14.33
1.2
Hedging Portfolio
0.9
0.8
1.3
1.5

Z=

1
2
3
4

=
=
=
=

1.8
0.4
0.95
0.8

3.3
5
0
0

1.2
1.2
1.2
1.2

Payout
0
0
=
20
40

1
2
3
4

100.1
0.1723
6.032
-91.94
14.53

= 1
will have one riskless asset

1
1

)
( 2 ) = (1)
3
1
1 + 2 + 3 = 1
1
=

0 < < 1 <= Important

Page 37 - 20151117_151729.jpg
Imagine a call 1 + 2 , = 210
What is payout ?
Total
1
2
90
+ 180 =
270
80
+
40
=
120
130 +
95
=
225
150 +
80
=
230
90
80
130
150

Call Payout
180
20 1.2
40
30 1.2
95
0
1.2
80
0
1.2

1
2
3
4

K
210
210
210
210

=
=
=
=

60
0
15
20

60(0.285) + 15(0.3533) + 20(0.183) = 26.07

1 = 0.6143 100 = 61.43
2 = 0.4857 100 = 48.57
= 8.484
3 = 1.414 6
= -92.5
4 = 92.5
25.95 ~ 26 OK
Can put 0 0 20 40 in 3rd column
In that case multiply by 14.33 (not 6)
0.6143 100
0.8 100
0.4857 100
0.4857 100
1.414
1.414 14.33
92.5
37.14
25.97

Payout
60
0
15
20

Page 38 - 20151117_151731.jpg
Mean Variance Portfolio and Markowitz
If you have 2 portfolios 1 and 2
If (1 ) (2 ) and (1 ) (2 ) then 1 2
An efficient portfolio is one that is not dominated by another
Function (() , ())

>0

Partial derivative more function

>0

Problem is to find the geometrical set of efficient portfolios

Hypothesis
- AAO
- Historical probabilities of subjective probabilities (but not risk neutral probabilities)
- In the market, everyone assumes the same probabilities
- You can borrow or lend at the same risk free rate r
- No cost to buy or sell
- Can buy a portion of stocks (ie. 0.4)
= (1 ) states of nature
= (1 ) probability set (historical or subjective)
< 0 always; means that is a q has p=0 then dont have to consider it
is a vector (N,1) => N rows, 1 column

1 = 1

(N,1)

=1

=
=1

mean by definition

Page 39 - 20151117_151745.jpg

1 = 1
=1

=
(N,1)

=
(N,K)(K,1)(N,Z)

=
=1

To find the geometric solution of an efficient portfolio, 2 solutions

1. Take the value for variance and maximize E
Var = constant
Max Exp. Value
2. Take E as a constant and minimize the variance
What is of

= ( ) =
=1

=1

=> =

1st constraint : =
2nd constraint : 1 = 1
Because = 1 because Z is a standard economy matrix

Page 40 - 20151117_151750.jpg

Have a portfolio of 2 assets 1 and 2 and 1 and 2

Portfolio = 1 1 + 2 2
Calculate the variance of P
2
2
= 1 (1 ) + 2 (2 ) + 21 2 (1 , 2 )
= 2 = variance of portfolio
What is ? It is the matrix of variance and covariance
Def. positive and symmetric matrix
12 1,2
=(
)
2,1 12
(1

2 ) (

12
2,1

1,2 1
)( )
12
2

With constraints from before, have to minimize

Page 41 - 20151117_151754.jpg
Minimize
1
Min
2

Something becomes a positive number and objective function and objective function
Constraints:
=
1 = 1 1 1 = 0
Lagrange
When you have an objective function (what your min or max)
When you have linear constraints
1
= 1 (1 1) 2 ( )
2
Derivatives:

(1)
=0

(2)
=0
1

(3)
=0
2

1 1 2

= 1 (1 1 2 )

1 1 = 0

1 1 (1 1 2 ) = 1

= 0

1 (1 1 2 ) = 1

not one equation but n equations.

= 1 1 1
(1,N)(N,N)(N,1) so A is a constant
= 1 1
also a constant
= 1
2 Cauchy Shwartz inequality

Page 42 - 20151117_151801.jpg
From (1)
From (2)

1 2 = 1
1 2 =

Find 1 and 2 , A, B and are known

Multiply (1) by (-B)
Multiply (2) by (A)
Take the sum of the results:
2 2 + 2 =
2 =

1 =

2 <
= 2
Know that > 0

=1
2
2)
1 ( + ( ) = 2
1 ( 2 ) =

1 =
2
1 2

Try to calculate the variance

2 =


2 = (
1+
)
2

2


=
1 +

2
2
2 =

+
2

2

+ ( )
= + 2
2 + 2
=

2 2 +
=

=geometrical set of efficient portfolios

Page 43 - 20151117_151805.jpg
2
=0

2 2 +
=0
2
2 2 = 0

**Asymtotes
2 =

Top slope = +

Bottom Slope = =
2 2 +
2
2

() 2 ( ) +
=
2
2

22
2 22 +
2 +
2 +
=

+ =
=
=

2 2
2 2 ( 2 )
1
1

2 = , =
= + lim

2
=

** lim
=

gives the slope

2 =

We know that =
=

22

2 = 22

2 2 +

Known: mean () and variance ()

Unknown: the portfolio
To calculate the portfolio


= 1 (
1+
)
2
2
To calculate the portfolio of minimum variance

= 1 (
1+
)
2

2
1
= 1 1

(NN)(N1) gives | |

1
1 1 1 =
Verify

Page 44-20151117_151811.jpg
(1) Find variance
(2) Minimum variance portfolio
(3) Variance on minimum variance portfolio
1
3
24 10 25
= |10 75 32| = variance covariance matrix
25
32 12
1 = 2 = 3 =

(1) Variance = 205/9

1 1 1
(
)
3 3 3

24 10 25
(10 75 32)
25
32 12

1/3
(1/3)
1/3
c

= (13 97/3 23)

= 205/9
(2) Minimum variance portfolio
1
= 1 1

= 1 1 1
0.0018 0.0137 0.0327
1 = |0.0137
0.005
0.0152 |
0.0327
0.0152 0.0254

Page 45 - 20151117_151816.jpg
=

1 1
1

24 10 25
= |10 75 32|
25
32 12
1 =

det

det = 11 (22 33 23 32 ) 12 (21 33 23 31 ) + 13 (21 32 22 31 )

= 24(75 12 32 32) + 10(10 12 32 25) + 25(10 32 75 25)
= 67.051

det 2 2 = |

| =

Adjugate (3 * 3)
22 33 23 32
23 31 21 32
21 32 22 31

13 32 12 32
11 33 13 31
12 31 11 32

12 23 13 22
13 12 11 23
11 22 12 21

0.0018 0.0137 0.0327

1
= (1 1 1) (0.0137
0.005
0.0152 ) (1) = 0.0499
0.0327
0.0152 0.0254 1
1
1
=
= 20.03
0.0499
= 20.03 = 4.476
2 =

Page 46 - 20151117_151824.jpg
=

1 1
1

1
= 20.03

0.0018 0.0137 0.0327 1

0.0209
0.4177
20.03 |0.0137
0.005
0.0152 | |1| = 20.03 |0.0065| = |0.1299|
0.0327
0.0152 0.0254 1
0.0226
0.4517
To find variance

%
%)(/ ) (%)
%
% = % weighting of portfolio
(%

To find the min variance = 1 1

(1) Take inverse of matrix

1
(2) = (1 1 1)(1 ) (1)
1
1
(3) Use A in equation = 2
1
1
(4) Apply ( ) (1 ) (1)

Page 47 - 20151117_151831_001.jpg
( , ) =
1
= 1 1 = minimum variance portfolio

= variance / covariance matrix

Proof:
1
1
1
( , ) = = 1 ( 1 ) = 1 1 = 1
= 1
1 = 1 =>
=

Theorem of Separation
For all (which is the portfolio of efficient frontier)

=
+ (1 )

Know
and , have to find a

1
= 1 1 + 2 1 = 1 + 2 =
To prove it is true, need to prove
1 + 2 = 1
1
= 1 1
1
= 1

With 1 =
2 , 2 =

+
=1
2

2
Find , 2 if = 0 1 = 0

= 0, =
2

2 2 +
2
2

() 2 () +
=
2
2

2
2 2 ( 2) +

=
2
2 22 + 2
=
2 ( 2 )

= 2

2 =

Page 48 - 20151117_151839.jpg

Covariances => examples 1,2,3,

28 1.2
1.25
1.25
(1) (1.25 0.25) (
)(
) = (35.3 14.2) (
)
1.2 50.8 0.25
0.25
28 1.2 1
1
(2) (1 0) (
)( )
= (28 1.2) ( )
1.2 50.8 0
0
28
1.2
.
75
. 75
(2) (. 75 . 25) (
)( )
= (20.7 11.8) ( )
1.2 50.8 . 25
. 25
(1) 47.68 = 6.9
(2) 28 = 5.3
(3) 18.48 = 4.3

= 47.68
= 28
= 18.48

Page 49 - 20151117_151843.jpg
Exercise
2 portfolios x and y
5 states of nature (each prob 0.2)
x
y
18
0
1
5
-3
2
12 15
3
4
12
4
6
1
5

(1) Mean of two assets (expected value)

= 0.2(18 + 5 + 12 + 4 + 6) = 9
= 0.2(0 + 3 + 15 + 12 + 1) = 5
(2) Matrix of variance/covariance
12 1,2
28 1.2
|
|=|
|
1.2 50.8
2,1 12

= 2 = 0.2((18 9)2 + (5 9)2 + (12 9)2 + (4 9)2 + (6 9)2 ) = 28

= 2 = 0.2((0 5)2 + (3 5)2 + (15 5)2 + (12 5)2 + (1 5)2 ) = 50.8
= 0.2 [( ())( ())]
= 0.2[(18 9)(0 5) + (5 9)(3 5) + (12 9)(15 5) + (4 9)(12 5) + (6 9)(1 + 5)]
= 1.2
(3) Find the mean and covariance
1
2
3
4
%x
125
100
75
50
%y
-25
0
25
50
10
9
8
7

cov
6.9
5.3
4.3 4.37
Covariance:
%(()) + (%(())
1
1.25(9) 0.25(5) = 10
2
1.00(9) + 0(5) = 9
3
0.75(9) + 0.25(5) = 8
4
0.50(9) + 0.50(5) = 7
5
0.25(9) + 0.75(5) = 6
6
0.00(9) + 1.00(5) = 5
7
0.25(9) + 1.25(5) = 4

5
25
75
6
5.47

6
0
100
5
7.12

7
-25
125
4
9.05

} Given
} Find

Page 50 - 20151117_151853.jpg

Portfolio: 1 = + (1 )
And to find a to get % split of portfolio
= 2 = 2 2 + (1 )2 2 + 2(1 )
= 2 28 + (1 )2 50.8 + 2(1 ) 1.2
= 282 + 50.8(2 2 + 1) 2.4 + 2.42
= 282 + 50.82 101.6 + 50.8 2.4 + 2.42
= 81.22 104 + 50.8
162.4 104 = 0
162.4 = 104
= 0.64
1 = 0.36

So efficient portfolio %s
= 0.64, = 0.36
(4) Calculate the expected value ( )\s

0.64 9 = 5.76
0.36 5 = 1.8
/ = 7.56

Covariance 2

28 1.2 0.64
= (0.64 0.36) (
)(
)
1.2 50.8 0.36
= 17.5
Variance
= 4.183
1
=

= 282 + 50.82 101.6 + 50.8 2.4 + 2.42

= 81.22 104 + 50.8
This also works:
2
= 2
+ 2 2( )
50.8 (1.2)
=
28 + 50.8 2(1.2)
= 0.64039

Page 51-20151117_151857.jpg
This page was crossed out?

Page 52 - 20151117_151907.jpg
Efficient Frontier
Plot is on risk and return
Efficient frontier = it is not possible to adjust allocation to gain higher expected return on the
same level risk or less risk with the same level of return
If we take two portfolios that lie on the efficiency frontier, the curvature of the efficient frontier
between them will depend on the correlation but the portfolios returns. If perfectly correlated,
then the efficient frontier is just a straight line. The boundary becomes more convex as their
correlation decreases (this is because the ability to reduce risk through portfolio diversification
increases, even when no short sales are allowed).
Any portfolio on the eff. Front is a linear combination of any two other portfolios along the eff
front.
Any portfolio along is likely to contain all the assets in the opportunity set with either + or
weight (unless != 0 ie str.)
If short sales are allowed, there is no upper limit to the risk, One can take and the opp. set tends to
infinity as return is assoc. with portfolio std deviation
If no short sales constraints, the opp set cannot extend indfinitely far alonf the dir of risk. In
this case, the eff front is the envelope of all portfolios lying bet. the global min port and the max
exp return port.
Short Sale = sale of securities not owned by the seller (who hopes to buy them back later at a lower
price) or any sales that is complete by the delivery of a security borrowed by the seller. Short sellers
assume that they will be able to buy the stock at a lower price than the price of which they sold short.
Short sales make money if stock goes down in price.

Page 53 - 20151117_151911_001.jpg
Before there was no riskless asset in our model

Add a riskless asset N+1 assets, we know that

=0 = 1
1 = 1
= 1 +
Before =
Not = +
is what you put into the bank at time = 0
1 = 1 = 1 1
= +

+ = 0
+ ( 1 1) = 0
( 1) = 0
Same type of problem we have seen in the first case (no )
1

Problem is to minimize 2 with * as a constraint.

Derivate 2 so

Page 54 - 20151117_151923.jpg
1
( ( 1) )
2

(a) = ( 1) = 0
=

(b)

= ( 1) = 0

Find geometric set of efficient portfolio. How with a riskless asset?

(a) = 1 1 1
(b) ( 1) ( 1 1 1)
( 1 1 1 1 1 + 2 1 1 1)
( + 2 )
( 2 + 2 )
=

2 + 2

Calculate 2 en unction de
2 = by definition
= ( 1)
= + 0
= + (1 1)
1
( 1)

2 =
2 =
So
1 =
2 =

( 1)
2 + 2

( )2
2 + 2
( )
2 + 2

2 + 2

> always

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= 2 + 2 + equation of a line
= +
Plot the line

0 + (1 + 0 )
+ (1 )
0<<1
<0
<

Minimum variance portfolio => ( , )

Want to find the coordinates of T
All portfolios in the line will have the equation
= 0 + (1 0 )
When at the point T, 0 = 0
Know that 1 = 1
= [ 1 1 1]
=
1

2 + 2

[ 1 1 1] = 1
2 + 2

[ ] = 1
2 + 2
( )( ) = 2 + 2
( ) + 2 = 2 + 2
( ) = 2 + 2 + 2
( ) = 2 +

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=
=
=
=
=

2+2

2+2

()

2+2
2+2 )

2+2

2+2 )

2+2

1
2+2

=
=

If = 0 we are at R


=

T tangency portfolio is the market portfolio

N assets (stocks)
n companies

= =
=1