Assignment 1

1. Asset-liability management (10 points). Asset-liability management is a critical issue

(a) If the liabilities of the fund grow at a constant continuously compounded annual rate
of 4%, what is the probability that the fund’s assets will be less than its liabilities in
five years?

(b) Consider instead the situation where the continuously compounded annual growth rate
of liabilities has a normal distribution with a mean of 4% and a standard deviation
of 2% (and is serially uncorrelated). What is the probability of being underfunded in
five years? (Assume that the growth rate of the liabilities is uncorrelated with the
rate of return on the fund assets).

2. Saving for retirement (10 points). Consider a client at a private bank in Geneva.
She has wealth of CHF 1.5 million. She wants to spend some of the money right now,
but she would also like to make a one-time investment today in a retirement account that
will grow to the original CHF 1.5 million by the time she retires in 15 years. Assume
that the continuously compounded annual return on the retirement account has a normal
distribution a mean of 5% and a standard deviation of 10%. Determine how much the
client needs to invest today, in each case, in order to have the probability of reaching her
CHF 1.5 million goal be at least

(a) 25%

(b) 50%

(c) 75%
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Pension funds and life-insurance companies are heavily invested in fixed income securities such as govern-
ment bonds and corporate bonds which currently offer very low returns. In fact Swiss government bonds and
corporate bonds issued by highly-rated corporations such as Nestle currently trade with negative yields.

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3. CRRA utility (5 points). Except for a constant, the utility function

W 1−γ − 1
u(W ) = (1)
1−γ

is identical to the CRRA utility function specified in the lecture slides. The two utility
functions are therefore equivalent in the sense that they generate identical optimal choices.
The advantage of the definition here is that this function has a well-defined limit as γ → 1.
What is this limit?

4. Risk aversion (5 points). Calculate the absolute risk aversion and the relative risk
aversion of the following three utility functions

(a) Logarithmic:
u(W ) = log(W ) (2)

(b) Shifted logarithmic: For some constant W and W > W

u(W ) = log(W − W ) (3)

(c) Shifted power:

5. Risk, return, and diversification in MSCI indices (20 points). The MSCI Global
Equity Indices are widely tracked global equity benchmarks. They cover more that 75
countries and span both developed and emerging markets (EMs). They also serve as the
basis for over 500 exchanged traded funds throughout the world. The Excel file MSCI.xlsx
contains total return indices of seven MSCI indices (sourced from Bloomberg):

• Four developed markets: US, Japan, Switzerland, and Germany

• Three EM regional indices: Asia, Latin America, and Europe & Middle East

The total return indices are in USD and include reinvested dividends.2

(a) For each country/region, compute monthly returns and then the arithmetic mean,
geometric mean, standard deviation, Sharpe Ratio (assuming a monthly interest rate
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The time series for Europe & Middle East exclude reinvested dividends as these are only available from
2000 onwards; hence, the average return is downward biased for this index. MSCI also computes total return
indices in local currency.

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 of 0.3 %), skewness, kurtosis, and 95% VaR. Plot histograms of returns. Compare the
riskiness of emerging market equities with developed market equities.

(b) Compute the correlation matrix for returns in developed markets. Then, compute the
correlation matrix for returns in Switzerland and the EM regions. For a Swiss investor,
which category (developed or EM) offers the best diversification opportunities in the
sense of being least correlated with Swiss index returns on average?

(c) Recompute the two correlation matrices using only data for the crisis period of 2008-
2009 and evaluate the often-stated claim that diversification disappears when you need
it the most.

(d) Consider a Swiss investor diversifying across developed markets. Compute the stan-
dard deviation (for the full sample period) of returns on the following four equally-
weighted portfolios:

• Switzerland
• Switzerland and the US
• Switzerland, the US, and Japan
• Switzerland, the US, Japan, and Germany

Contrast with the standard deviation of returns under the counter-factual assumption
that returns across developed markets are perfectly correlated.

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Figure 1: Total return index for MSCI Switzerland