Tests for ’Mathematical methods in finance’,

November 2010
Vassili N. Kolokoltsov
December 8, 2010

1 Test 1 (one hour duration)

Qu 1. (a) Write down the conditions on a pre-order in Rd that ensure the existence of
a utility function. Write down the conditions on a pre-order ≤ on a set ∆(Y ) of simple
lotteries on Y (where Y is either a finite set or a subset of Rd ) that ensure the existence
of a utility function u on Y such that the pre-order ≤ is determined via the expectations
of u, that is λ ≤ µ ⇐⇒ Eλ u ≤ Eµ u.
(b) Define the stochastic dominance relation (strict and non strict) of the first order.
(c) Show that A ≥ B in this sense (A and B are two random variables) if and only if
Eu(A) ≥ Eu(B) for all non-decreasing u.
(6 mark)
Qu 2. An investor is contemplating an investment with a return of $R where R =
10 − X, where X is 10-exponential random variable, that is P(X > x) = exp{−x/10}.
Calculate each of the following four measures of risk:
(i) variance σ 2 , (ii) downside semi-variance DS; (iii) shortfall probability with respect
to shortfall level 0; (iv) VaR V at the level 5%.
(5 mark)
Qu 3. Three uncorrelated assets have variance 1 each and the expected returns 1,
2 and 3 respectively. (a) Find the efficient frontier (as a function of standard deviation
σ expressed in terms of average return r̄). Shorting is allowed. (b) Find the minimum-
variance point. (c) Sketch the feasible set on the σ − r̄ plane.
(9 mark)
Qu 4. Let the expected return and standard deviation of the efficient market portfolio
are r̄M = 30% and σM = 20%, and the risk free rate is rf = 10%.
(a) Write down the equation for the capital market line in terms of expected return r̄
and standard deviation σ.
(b) If an expected return 40% is desired, which is the standard deviation for the
corresponding position on the capital market line? How to allocate $200 in order to
achieve this position?
(c) If an investor has the exponential utility uα (x) = −e−αx , and if rM is normally dis-
tributed, which return r̄ will be chosen? Describe the levels α, for which the corresponding
investors lend money at the risk-free rates.
(10 mark)

1
 Solutions.
Qu 1.
(a) Pre-order is a reflexive transitive binary relation. If it is complete (for any x, y
either x ≥ y or y ≥ x) and continuous (the sets {x : x ≥ y} and {x : x ≤ y} are closed
for any y), then there exists a continuous function U (called utility function for pre-order
≤) such that x ≤ y ⇐⇒ U (x) ≤ U (y).
To any pre-order ≤ there corresponds the relation < such that x < y if x ≤ y but not
y ≤ x. A complete pre-order on ∆(Y ) can be determined via the expectation if it enjoys
the following properties:
(C) continuity: if λ, µ, ν ∈ ∆(Y ) and λ > µ > ν, then there exist α0 , α00 ∈ (0, 1) such
that
α0 λ + (1 − α0 )ν > µ > α00 λ + (1 − α00 )ν;
(I) independence: if λ, µ, ν ∈ ∆(Y ) and λ > µ, then

αλ + (1 − α)ν > αµ + (1 − α)ν

for any α ∈ (0, 1).

bookwork (3 mark)
(b) A r.v. A non-strictly dominates a r.v. B if

FA (x) ≤ FB (x) ∀x ∈ [a, b], (1)

and strictly dominates if additionally there exists x ∈ [a, b] s.t. FA (x) < FB (x).
bookwork (1 mark)
(c) The condition Eu(A) ≥ Eu(B) writes down as
Z b Z b
u(x)dFA (x) ≥ u(x)dFB (x),
a a

which by integration by parts reduces to

Z b
u0 (x)(FA (x) − FB (x)) dx ≤ 0,
a

which for u0 ≥ 0 is equivalent to (1).

bookwork (2 mark)
Qu 2. (i) σ 2 (10 − X) = σ 2 (X) = 100,
Z ∞
2 1 x
(ii) E(10 − X) = 0; DS = E(10 − X) 110−X≤0 = (x − 10)2 exp{− } dx
10 10 10
Z ∞
1 y
= e−1 y2 exp{− } dy = 100e−1 = 36.8;
0 10 10
(iii) P(10 − X ≤ 0) = P(X ≥ 10) = e−1 = 0.368;
10 + V
(iv) P(10 − X ≤ −V ) = 0.05 ⇐⇒ exp{− } = 0.05 ⇐⇒ V = 10(log 20 − 1).
10
(5 mark)

2
 Qu 3.
(a) Basic equations for weights x:

xk − kλ − µ = 0, k = 1, 2, 3,

x1 + 2x2 + 3x3 = r̄, x1 + x2 + x3 = 1.

Solving first three and substituting into the bottom two:

14λ + 6µ = r̄, 6λ + 3µ = 1.
Hence
λ = −1 + r̄/2, µ = −r̄ + 7/3,
4 1 1 1 2
x1 = − r̄, x2 = , x3 = r̄ − .
3 2 3 2 3
µ ¶1/2
7 1
σ = (x21 + x22 + x23 )1/2 = − 2r̄ + r̄2 .
3 2
(6 mark) √
(b) The min-variance point is r̄ = 2, σ = 3/3 = 0.58.
(2 mark)
(c) Graph
(1 mark)
Qu 4.
0.30 − 0.10
(a) r̄ = 0.10 + σ = 0.10 + σ.
0.20
(1 mark)

(b) 40% = 10% + σ =⇒ σ = 30%.

Let x denote the weight of the market portfolio.
r̄ − rf
xr̄M + (1 − x)rf = r̄ =⇒ x = .
r̄M − rf

Hence x = 3/2, 1 − x = −1/2. Hence borrow $100 and invest $300 in the market.
(3 mark)
(c) Return of the portfolio r = xrM + (1 − x)rf with the mean r̄ has variance x2 σM
2

and becomes normal µ ¶2

r̄ − rf
N (r̄, σM ).
r̄M − rf
Since MGF (moment generating function) for normals N (µ, σ 2 ) is

M (t) = EetY = exp{tµ + t2 σ 2 /2},

we have

−αr −αrf α 2 σM
2
Euα (r) = −Ee = −e exp{−α(r̄ − rf ) + (r̄ − rf )/2}.
(r̄M − rf )2

3
Since the minimum of the function exp{−αy + β 2 y 2 /2} on {y ≥ 0} is attained on y ∗ =
α/β 2 , it follows that the maximum of Euα (r) is attained at
1
r ∗ = rf + 2
(r̄M − rf )2 = 0.10 + α−1 .
ασM

Finally, lending occurs when

2
∗ −1 σM
r − rf ≤ r̄M − rf ⇔ α ≤ = 0.20 ⇔ α ≥ 5.
r̄M − rf

(6 mark)

4
2 Test 2 (one hour duration)
Qu 1. A derivative has initial price S = 100 and monthly standard deviation of the log
share price 10%. Its expected return is 2% per month. A bank account earns 5% per
month, continuously compounded.
(a) Set up a binomial model (with period one month) and calculate risk neutral prob-
abilities, real world probabilities and the state price deflators (or density) for two months.
(b) Define the prices of the stock for all possible scenarios in two months (organize
them into a lattice or a diagram) and then calculate the price of an option that after two
months pays F (S) = log(S − 90) if S > 90 or nothing otherwise.
(12 mark)
Qu 2. Let risk free interest rate is 4% p.a. (equiv. to 0.016% per trading day)
continuously compounded, volatility σ = 20% p.a. Assume there are 250 trading days
per year. A stock has an initial price of 100p.
(a) Set up a binomial model (with period one day) and calculate the price at time 0
of a European put with strike price 101 p that expires in 2 days.
(b) Consider an American put and an American call, both with exercise prices of 101
p and maturity 2 days (they can be exercised either at the end of day 1 or at the end
of day 2). At the end of day 1, before the investor is allowed to exercise, the company
announces unexpectedly that a dividend of 3p per share will be paid at the end of day
2 immediately prior to the expiry of the options. Construct the binomial lattice of share
prices allowing for the dividend payment. Explain the conditions under which the holders
of the put or call options will exercise at the end of day 1 after the announcement of the
dividend.
(12 mark)
Qu 3. (a) Give the formula for the put-call parity. Explain briefly its derivation.
(b) Times 1 ≤ m ≤ N − 1 given, a chooser option confers the right to receive either
call or put at time m, both having maturity N and strike price K. Explain how this
option can be replicated by a combination of two appropriate put and call options and
deduce a formula for the price of this option in terms of the risk-neutral probabilities.
(6 mark)

5
 Solutions.
Qu 1. (a)
√
u = eσ ∆t
= e0.1 = 1.10517, d = 1/u = 0.904837, 1 + r = e0.05 ;

e0.05 − d
p̃ == 0.731.
u−d
Since E(S1 /S0 ) = 1.02 = pu + (1 − p)d (where p is real world prob.), it follows
1.02 − d
p= = 0.575.
u−d
Deflators for two months are (note that e−2×0.05 = e−0.1 )

p̃2 p̃(1 − p̃) (1 − p̃)2

e−0.1 = 1.4624, e−0.1 = 0.72809, e−0.1 = 0.36249.
p2 p(1 − p) (1 − p)2
(7 mark)
(b) The values of stocks are

100 110.52 112.14

90.48 100
81.87

The value of the option is

e−0.1 × 0.7312 log(32.14) + 2e−0.1 × 0.731 × (1 − 0.731) log(10) = 2.4972.

(5 mark) √
Qu 2. (a) u = e0.2/ 250 = 1.01273, d = 1/u, 1 + r = e0.00016 . The risk neutral prob.

e0.00016 − d
p̃ = = 0.50316.
u−d
The value of the put is
£ ¤
e−2×0.016 2p̃(1 − p̃)(101 − 100) + (1 − p̃)2 (101 − 97.502) = 1.3635.

(5 mark)
(b) The values of stocks are (reduced by 3 after the payment)

100 101.273 99.562

98.743 97
94.502

Call will be worthless at expiration. If the stock has risen in the first day, exercising
the call would yield a profit.
If share price is 101.273, exercising put yields nothing, but holding it to the expiration
yields a profit. If share price is 98.743, exercising it yields 101 − 98.743 = 2.257, and
leaving it to expiration has the value

e−0.016 [p̃(101 − 97) + (1 − p̃)(101 − 94.502)] > 2.257.

6
Thus it is better not to exercise put earlier.
(7 mark)
Qu 3. (a) Portfolio A: European Call + cash K/(1 + r)N ;
Portfolio B: European put + one share. Both are worth

max(SN , K) = (SN − K)+ + K = (K − SN )+ + SN

at expiration. Hence their prices today coincide:

K
CN + = PN + S0 .
(1 + r)N

Alternative interpretation:
CN = PN + FN ,
where FN = S0 − K(1 + r)−N is the (risk-neutral) price of the forward contract to buy
one share of stock at time N for K.
bookwork (3 mark)
(b) From the put-call parity (risk-neutral expectations are assumed)

(SN − K)+ (K − SN )+ K
Em N −m
= E m N −m
+ Sm − ,
(1 + r) (1 + r) (1 + r)N −m

and hence
µ ¶ µ ¶+
(SN − K)+ (K − SN )+ (K − SN )+ K
max Em , Em = Em + Sm − .
(1 + r)N −m (1 + r)N −m (1 + r)N −m (1 + r)N −m

Consequently (by taking expectations at time zero), the price equals the sum of the time-
zero price of a put with maturity N and trike K, and a call with maturity m and strike
price K(1 + r)−(N −m) .
bookwork (3 mark)