QUANTITATIVE METHODS FOR FINANCE

Mock Exam 6 (Academic Year 2013-14)

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

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

[8 points]

Show that, under the condition

with

y (3) < 0

y( ) =

1
2

2 2

1
2

r,

the equilibrium price F (X) of the stock has the following dynamics (expressed in total-return form):
dF

+ X 3 dt
F

(r + 3

) dt + 3 dz .

[7 points]
Your initial capital is H = 100 Euro. You invest 50 Euro in the stock and 50 Euro in
the riskfree asset. Work out the per-annum expected total return dt1 H1 Et [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
100% ,
W
r

r = 1% ;

re =

+40%
20%

with probability
with probability

1
2
1
2

r) ) ;

The shadow price l of the portfolio constraint is:

a)
b)
c)
d)

4: 035 714 29 10 3 ;
8: 035 714 29 10 3 ;
12: 035 714 29 10 3 ;
1: 035 714 29 10 3 .

Alessandro Sbuelz - SBFA, Catholic University of Milan

3
[4 points]
A rm produces two outputs x and y, whose sale prices are X and Y , respectively. The rm is monopolist in both markets and faces the following demand functions (x and y are
complementary goods):
x = 150

1
Y
3

2
X ;
3

y = 150

2
Y
3

1
X :
3

Given that the production costs are C (x; y) = x + 2y + 2xy + 300, the rms maximum prot is:
a)
6218: 25;
b)
4255: 125;
c)
5775: 25;
d)
5213: 125.

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

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

2

6
6
M =6
4

1:0
1
1
1

0:5
0
1
0

0:75
0
1
1

7
7
7 .
5

e (1) = 2B(1) + Se2 (1)2 + 5Se1 (1)2

The no-arbitrage price of the payo X
a)
8: 25;
b)
7: 50;
c)
5: 25;
d)
9: 15.

[4 points]

The following
a)
b)
c)
d)

is:

Consider the following one-period market with a zero riskfree rate (r = 0):
3
2
3
5
1:0
8
8
6
7
6 1
0
0 7
6
7
M =6
1
1 7
6 1
7 .
6
7
0
1 5
4 1
1
2
0

holds true:
the market is not arbitrage-free;
5
Q (! 2 ) = 58 2q with q 2 81 ; 16
;
5
1 5
Q (! 3 ) = 8 q with q 2 8 ; 16 ;
Q (! 1 ) = 58 .

Alessandro Sbuelz - SBFA, Catholic University of Milan

SOLU T ION S

1
We are dealing with a powerstock that pays out X 3 dt every second(with dX = X dt +
X dz). The equilibrium-valuation problem is
1
Et [dF ] + X 3
dt

and

= F r + FX X

F (0) = 0 ,

where

1
1
Et [dF ] = FX X + FXX X 2
dt
2

Let us formulate the educated guess

F (X) = AX 3

(the boundary condition F (0) = 0 is met by construction) ,

where A is a constant to be determined (we want it positive to support a non-negative stock price).
Given

FX

3AX 2 ,

FXX

6AX ,

the dynamic equilibrium restriction becomes

1
3AX 3 + 6AX 3
2

+ X3

AX 3 r + 3AX 3

m
3A + 3A

+1

Ar + 3A

m
A

1 =

Alessandro Sbuelz - SBFA, Catholic University of Milan

r+3

3 +3

Under the condition

y (3)

r+3

3 +3

with

< 0

y( ) =

1
2

2 2

1
2

r,

the non-negativity of the equilibrium stock price is granted.

Since
dF

X 3 dt

1
FX X + FXX X 2
2

X3

) dt

FX X dz ,

dt

FX X dz

m
dF

X 3 dt

( F r + FX X

the total return on the powerstock is

dF + X 3 dt
=
F

r+

FX
X
F

dt +

FX
X dz ,
F

with the elasticity being

FX
X
F

3 .

The per-annum expected total gain is

1
Et [dH]
dt

50
F

1
Et [dF ] + X 3
dt

50 (r + 3

+ 50r

+ 50r .

Hence, the per-annum expected total return is

1 1
Et [dH]
dt H

= r +

Alessandro Sbuelz - SBFA, Catholic University of Milan

150
100

SOLU T ION S

The correct answer is b).

The investors expected utility is

h
f
E
log W

and the Lagrangian function is

L (w; l)

= 0:5 ln (39w + 101) + 0:5 ln (101

= E

log

f
W

The Kuhn-Tucker First Order Conditions are:

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

l (w

21w)

1) .

0
0
0
0 .

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

d h
E log
dw

f
W

= 0:5

39
21
+ 0:5
39w + 101
101 21w

819w 909
909
= 0 () w =
(39w + 101) (21w 101)
819

1 (unfeasible) .

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

8
>
< Lw =
>
:

Ll =

819w 909
(39w+101)(21w 101)

l=0

w + 1 = 0 (the constraint is binding)

()

Alessandro Sbuelz - SBFA, Catholic University of Milan

8
>
< l = 8: 035 714 29
>
:

10

> 0

w =1 .

SOLU T ION S

The correct answer is d).

The inverse demand functions are

"

X = 150 + y 2x
Y = 150 2y + x

so that the monopolists problem is

maxP (x; y)
x;y

with
P (x; y) = x (150 + y

2x) + y (150

2y + x)

(x + 2y + 2xy + 300) :

The First Order Conditions are:

8
>
< Px =
>
:

Py =

4x + 149 = 0
,

4y + 148 = 0

8
>
< x = 37:25
>
:

y = 37

The prot function P (x; y) is strictly concave, as the Hessian matrix is negative denite everywhere:
3
3 2
2
4
0
Pxx
Pxy
7
7 6
6
H = 4
5 with Pxx = 4 < 0 and det (H) = 16 > 0 :
5=4
0
4
Pyx
Pyy
Hence, the maximum prot is
P (37:25; 37)

Alessandro Sbuelz - SBFA, Catholic University of Milan

5213: 125 .

SOLU T ION S

The correct answer is c).

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 0 0
Q (! 1 )
1 6
6
7
7 6
7
4 0:5 5 =
4 1 + 0 1 1 5 4 Q (! 2 ) 5 .
1+0
0:75
1+0 0 1
Q (! 3 )
Since

31
1 0 0
7C
B6
det @4 1 1 1 5A
1 0 1
02

the unique measure Q is:

02
3
3T 1
Q (! 1 )
1 0 0
B6
6
7
7 C
1
1
1
4 Q (! 2 ) 5 = B
4
5 C
@
A
Q (! 3 )
1 0 1
2

= 1 ,

31
1:0
7C
6
B
@(1 + 0) 4 0:5 5A
0:75
0

3
0:25
7
6
4 0:5 5
0:25
2

with
02

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

02

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

1 0
1 6
4 0 1
1
1 0
|

{z

3
0
7
1 5
1

matrix of cofactors

Alessandro Sbuelz - SBFA, Catholic University of Milan

The payo to be priced is

e (1)
X
2

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

=
m

2B(1) + Se2 (1)2

+ 5Se1 (1)2

3
2
3
2
3
2 3
2
02
5 02
2
6 7
6 2 7
6
7
6 7
2
4 2 5 + 4 1 5 + 4 5 1 5 = 4 8 5 .
2
12
5 02
3

Its no-arbitrage price is

2

3T 2
3
2
0:25
1 6 7 6
7
X (0) =
4 8 5 4 0:5 5
1+0
3
0:25

5: 25 .

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

3
2
6 7
4 8 5
3
2

1
1 6
4 0
1
0

0
1
1

{z

3
1:0
6
7
4 0:5 5
0:75

3T
1
7
0 5
1
}

3
2
6 7
4 8 5
3
2

3
2
6 7
4 5 5
1
2

matrix of cofactors

and
V#X (0)

3T
2
6 7
4 5 5
1

Alessandro Sbuelz - SBFA, Catholic University of Milan

5: 25 .

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
6
4

1:0
5
8
3
8

Lets x Q (! 4 ) = q. Since

1 6
6
6
1+04

7
5 =

1+0
1+0
1+0
1+0

0
1
0
2

3T 2

0
1
1
0

31
1 0 0
7C
B6
det @4 1 1 1 5A
1 0 1
02

7
7
7
5

6
6
6
4

Q (! 1 )
Q (! 2 )
Q (! 3 )
Q (! 4 )

7
7
7 .
5

= 1 ,

the candidate measure Q must be such that:

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

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

02

0
1
1

3
q
7
2q 5 .

6
4

2q

6
B
@(1 + 0) 4

3 2
1
1
7 6 5
0 5 4 8
1

1
6
4 0
0
5
8
5
8

3
8

1:0
5
8
3
8

3
7
5

31
1
6 7C
q 4 2 5A .
0
2

3
q
7
2q 5

1
4

Alessandro Sbuelz - SBFA, Catholic University of Milan

By imposing the positivity of the probability masses, we have

8
>
>
>
<

5
8

q>0
5
2q > 0
8
>
2q 41 > 0
>
>
:
q>0

()

q2

1 5
;
8 16

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

Alessandro Sbuelz - SBFA, Catholic University of Milan

10