Department of Economics Prof. G.

Jump
ECO 2503H1 F
Final Examination
Dec. 14, 2009

Duration: 2 hours
Aids Permitted: Hand-held electronic calculators; Formula Sheet (provided).
Instructions: Answer all questions and record your answers in an examination booklet.
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1. (20 marks)
A digital put option is written on an underlying share of stock. This option can be
exercised only at the time of maturity (not prior). The exercise price of the option is
X = $27.50 and the maturity (expiry) date is T = 0.5 (1/2 year in the future). The price of
the underlying stock at date T is denoted ST. If S T ≤ X , the owner of the option will
exercise it and receive a lump sum amount of $100 to be paid by the person who wrote
and sold the option. (Note that this is a digital put option so that the payment received is
$100 no matter how far below X is the value of ST). If S T > X , the option will not be
exercised and will be worth nothing.
The price of the stock is expected to evolve over time in accordance with the standard
model shown as "actual" on the Formula Sheet. The following are the values of the
parameters of this model.

S0 = $25 σ = 0.20 r = 0.04 µ = 0.12

Your task is to determine the current price of this option using either one of the following
methods. (The choice is yours).

(i) The Binomial Option Pricing Model with the number of sub-periods n = 3.

(ii) An appropriate modification of the Black-Scholes formula for determining the price
of a European call option.

2. (28 marks)
Consider a CCAPM world in which the representative household has the following
lifetime (expected) utility function;
∞
E[U ] = ln(c0 ) + E ∑ (0.9) t ln(ct ).
t =1
Suppose that this is a Lucas (fruit tree) type world. In equilibrium each household owns
1 unit of an (infinitely-lived) asset that pays a "dividend" in amount yt at each date t.
Suppose, further, that the dividend payments are independent from one date to the next
and that the probability distribution is that ln(yt) is normally distributed with a mean
µy =1 and a standard deviation σy= 0.1.

1
(Recall that for the log normal distribution E[ y t ] = exp( µ y + 1 / 2σ y2 ) ).

We know that in equilibrium ct = yt for all values of t.

(a) Let Pt denote the equilibrium price of the asset at date t and show that Pt is
∞
β
proportional to ct. (Recall that ∑β
t =1
t
=
1− β
).

(b) Let (1 + r ) denote the gross rate of return on the asset between dates 0 and 1. Show
that the value of this gross rate of return is proportional to the rate of growth in
consumption between dates 0 and 1.

(c) Now suppose that y0 = 2.5 Compute the value of the risk premium associated with
the asset. That is, compute the value of (r − r f ) .

(d) Find the probability that P1 will be greater than 27.

3. (12 marks)
It is currently date 0. The value of the assets owned by a particular corporation is V0.
The market values of outstanding debt and equity of this corporation are given by D0 and
Q0, respectively: D0 + Q0 = V0 . Suppose that the debt is in the form of zero coupon
bonds, all of which mature at future date T with a total face value of DT.
Let c0 and p0 denote current prices of a European call option and a European put option,
respectively, each written on the value of V with an expiry date T and an exercise price
DT . Let r denote the continuously-compounded risk-free rate of interest.

Show that the following relationships must be satisfied:

Q0 = c0 .
D0 = e − rt DT − p0 .

(Hint: The firm is bankrupt at date T if VT < DT , in which case QT = 0).

4. (10 marks)
Consider the following CAPM setting with 2 risky securities and no risk-free security.

Security Expected Return Standard Deviation

Security A 0.15 0.25

Security B 0.10 0.15
cov(rA , rB ) = 0
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2
Suppose that Investor 1 thinks the market portfolio consists of a share 60% invested in
Security A and a share 40% invested in Security B. Investor 2 thinks the market portfolio
consists on 50% invested in each security.

What value of beta will each investor calculate for Security A? For Security B ?

5. (20 marks)
The following table describes the prices and payoffs (in terms of real consumption) of a
risky Security M and a risk-free bond in a simple 2-period, 2-state A-D economy. There
is no profitable arbitrage opportunity here and the security market is complete. Both of
these securities are traded and, since Security M is the only risky security that is traded, it
must also be the market portfolio. Also shown in table are the payoffs of an arbitrary
security labeled Security X.

________________________________________________________________________

Price at Date 0 ________Payoffs at Date 1________

State 1 State 2
Prob. = 0.4 Prob. = 0.6

Security M PM = 2 1 4

1
Risk-free Bond = 0.8333...
PB = 1 1
1.2
(rf = 0.2)
………………………………………………………………………………………………

Security X Px = ? 5 2
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(a) Compute the gross rate of return (1+ rM) for each state for the market portfolio; then
compute rM .
(b) Determine the value of Px,; then use this to compute the gross rate of return (1+ rx) for
each state and also the value of rx .
(c) Now compute the value for CAPM β x .
(To assist with this computation, σ M2 = 0.54 and the correlation between rM and rx = -1.)

(d) Finally, use your results from Parts (a) – (c) to determine whether the CAPM
relationship (rx − r f ) = β x (rM − r f ) is satisfied here.

6. (10 marks)
In a CAPM world is it possible to have rM < 0 while rf > 0? Explain.