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Question 1 (4 marks)
Consider a world in which there are only two risky assets, A and B. There is
also a risk free asset with return rf . The two risky assets are in equal supply in
the market, and hence the market return rM is defined by
rM =
1
(rA + rB ) .
2
2
2
The following information is known: rf = 0.09, A
= 0.04, B
= 0.03, AB =
0.02, E [rM ] = 0.18
Question 2 (8 marks)
Consider an investor with the following utility function:
2
(i) [4 marks] List two behavioural properties implied by this utility function.
(ii) [4 marks] How does this investors investment in risky assets (in dollar
terms) change as his wealth increases?
Question 3 (9 marks)
A guarantee contract pays off according to the gains of the stock index S (t),
with a guaranteed minimum payout and maximum payout. More precisely, it is
a five year contract which pays out 0.8 times the ratio of the terminal and initial
values of the index. Or it pays out 125% if otherwise it would be less, or 175%
if otherwise it would be more. Assume that the Black-Scholes assumptions are
satisfied.
(i) [5 marks] Assume that the index has expected return = 6%, standard
deviation = 20%, dividend yield = 3%, and that the risk free rate is r =
6.5%. How much is this contract worth?
(ii) [4 marks] Find the amount of stock and cash that would be required to
hedge this guarantee (at time 0).
Question 4 (7 marks)
(Yr 2012 comment: This was a topic discussed in the 2005 offering of the course)
Consider two bounded random variables, A and B. The random variable A is
said to be Second Order Stochastic Dominant (SSD) over B if
Z z
Z z
FA (y) dy
FB (y) dy, for all z
a
and
FA (y) dy <
a
Question 5 (8 marks)
Consider an investment fund whose aim is to track the returns of a target
portfolio (e.g. the stock market index) closely. Specifically, suppose the target portfolio has return rm and suppose that there are n assets available for
investment, with random rates of return r1 , r2 , ..., rn . It is known that these
assets form a subset of the returns contributing to the target portfolio. Letting
w1 , ..., wn denote the proportion invested into asset 1, ..., n, we wish to find a
portfolio whose rate of return
r = w1 r1 + ... + wn rn
has the property that tracking error (defined as variance of the difference between rm and r) is minimised.
(i) [4 marks] Find the set of equations that can be used to solve for w1 , ..., wn .
You are not required to solve these equations.
(ii) [4 marks] An issue with the above approach is that the expected returns
of the portfolio may not match that of the index. Find a set of equations that
can be used to solve for w1 , ..., wn such that both the tracking error is minimised,
and that the expected return of r and rm are matched. You are not required to
solve these equations.
Question 7 (4 marks)
Consider a European option with payoff function
max (0.5ST , ST K)
Let s be the time 0 price of the stock, and C1 , C2 be the prices of calls on this
stock with strike prices K and 2K respectively. Find the price of the option in
terms of s, C1 , C2 .
ds
0
eau dW Q (u) .
( S) Sdt + SdW
= s
where , , are constants. Assume also that a bond B (t) is available for
investment with some constant interest rate r > 0.
(i) [3 marks] Assuming no arbitrage, derive the market price of risk for
this model.
(ii) [6 marks] Construct a self-financing replicating strategy for a derivative
with payoff X and maturity T
(iii) [4 marks] Present an applicable formula for the price of a European call
option with strike price K and maturity at time T .
You may find the following mathematical results useful:
1. Girsanov Theorem
Let W (t) be a P - Brownian Motion. If we set the Radon-Nikodym derivative
RT
RT 2
1
dQ
= e 0 (t)dW (t) 2 0 (t)dt
dP
then
Z
t
W Q (t) = W (t) +
(s) ds
0
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Question 10 (9 marks)
Consider a model where the stock price is modelled by a 2 year trinomial tree.
For example, starting at a current value of $1, in one years time the stock price
can either
rise to a ratio of 1.2 of the current value
stay at the current value
drop to a ratio of 0.85 of the current value.
Assume that a risk free bond is available for trade, with r = 0%, i.e. the value
of the bond is $1 at all times.
The following (European) option prices can be observed in the market:
A call option with strike price of 0.9 and maturity at time 1 is currently
trading at 0.12.
A call option with strike price of 1.3 and maturity at time 2 is currently
trading at 0.0105.
An fixed strike lookback option with payoff
max
max S (t) 1.1, 0
t=0,1,2
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1
bE [Rx ] cE [Ry ]
1 + rf
(ii) [8 marks] Using the result in (i), solve for b and c, and hence develop
formula for E [Ri ], the expected return on a stock with (random) return Ri .
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Question 12 (6 marks)
Lionel, your friend from high school, is currently looking at different methods
to price options. One day he says to you the following:
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