QUANTITATIVE METHODS FOR FINANCE

Mock Exam 2
(Academic Year 2013-14)
[5 exercises; 31 points available; 90 minutes available]

1
[8 points]
Work out the equilibrium price V (X) of the stock that pays out the dividend
3 2
X (7 + X ) dt every second(with dX = X dt + X dz). In doing so, make the assumption
y

13
2

with

<0

y( ) =

1
2

2 2

1
2

r.

[7 points]
Consider a stock that pays out the dividend (8X + 5m) dt every second
(with dX = k (X m) dt + X dz). Show that, for
> 0, the equilibrium price S (X) of the stock
is such that
E [ S (X) ]

2
max E
w

where

[4 points]
h

log

f
W

<

13m
.
r

Consider a constrained log-utility investor whose problem is

i
f = 100 ( (1 + r) + w (e
sub
w
150% ,
W
r
re =

r = 2% ;

+42%
18%

with probability
with probability

2
3
1
3

r) ) ;

The shadow price l of the portfolio constraint is:

a)
b)
c)
d)

4: 201 646 09
9: 201 646 09
1: 201 646 09
7: 201 646 09

10
10
10
10

;
;
2
;
2
.
2

Alessandro Sbuelz - SBFA, Catholic University of Milan

3
[4 points]
A rm produces two outputs x and y (they can be sold at the xed prices 35
and 25, respectively). An embargo is imposed on the rms total production:
x+y
Given that the production costs are
total-production constraint is:
a)
1: 875;
b)
6: 875;
c)
3: 875;
d)
9: 875.

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

25 .

C (x; y) = 2x2 + y 2

xy + 30,

the shadow price l of the

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

2

6
6
M =6
4

1:0
1
1
1

2: 3
2
3
2

1: 3
1
2
1

0:75
0
1
1

7
7
7 .
5

The no-arbitrage price of a European put option written on the risky security 2 (the strike price is 2)
is:
a)
0:70;
b)
1:10;
c)
1:40;
d)
0:55.

[4 points]

Consider the following

2
1:0
6 1
6
M =6
4 1
1

The set of investment strategies #

characterized by:
a)
#1 = 3 2#0 .
b)
#2 = 3#0 3;
c)
#3 = 0;
d)
#3 = #0 3.

one-period market with a zero riskfree rate (r = 0):

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

such that

V# (0) = V# (1) (! 1 ) = V# (1) (! 2 ) = 3

Alessandro Sbuelz - SBFA, Catholic University of Milan

is

SOLU T ION S

The equilibrium-valuation problem is

p
1
Et [dV ] + X (49 + X 6 + 14X 3 )
dt

= V r + VX X

1
1
Et [dV ] = VX + VXX X 2
dt
2

where

V (0) = 0 (when X is absorbed at 0, the stock pays dividends no more).

13

The total per-annum dividend 49X 2 + X 2 + 14X 2 is made of three distinct pieces: the per-annum
dividends of three dierent power stocks. Let us formulate the educated three-piece guess
1

V (X) = A49X 2 + BX

13
2

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

+ C14X 2

where A, B, and C are positive constants. Given

VX X

1
13
7
1
13
7
A49X 2 + BX 2 + C14X 2 ,
2
2
2

VXX X 2

1
2

1
2

1 A49X 2 +

13
2

13
2

1 BX

13
2

7
2

7
2

1 C14X 2 ,

the dynamic equilibrium restriction becomes

49X 2

13
2

0 .

1
8

1
r+
2
{z

=0

13
143
+
2
8

13
r+
2
{z

A + 1

B + 1

7
35
+
2
8

7
r+
2
{z
=0

Alessandro Sbuelz - SBFA, Catholic University of Milan

+
}

=0

14X 2

1
2

C + 1

Under the condition

13
2

y( )

r+
1
2

2 2

13
2

13
143
+
2
8
1
2

< 0

with

r ,

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

A =

B =

C =

1
r+

1
2

1
2

r+

13
2

1
8

143
8

> 0;

1
13
2

1
r+

7
2

7
2

35
8

> 0;

> 0:

The equilibrium-valuation problem is

1
Et [dS] + 8X + 5m
dt

= Sr + SX X

where

1
Et [dS] = SX ( k (X
dt

1
m)) + SXX X 2
2

Let us formulate the educated guess

S (X) = BX + C ,

Alessandro Sbuelz - SBFA, Catholic University of Milan

where B and C are constants to be determined. Given

SX

B ,

SXX

0 ,

the dynamic equilibrium restriction becomes

B ( k (X

m)) + 8X + 5m

(BX + C) r + BX

m
Bkm + 5m
{z
|
= 0

Cr
}

(B (r +
|

+ k)
{z

= 0

8)X
}

m
B =
C =

Alessandro Sbuelz - SBFA, Catholic University of Milan

8
r+

+k

k
5m
8m
+
.
r r+
+k
r

If

> 0, we have

E [S (X)]

r 8E [X]
rr+
+k

8m
k
5m
+
r r+
+k
r

r
8m
r r+
+k

8m
r+k
5m
+
r r+
+k
r

<

13m
.
r

Alessandro Sbuelz - SBFA, Catholic University of Milan

8m
k
5m
+
r r+
+k
r

SOLU T ION S

The correct answer is d).

The investors expected utility is

h
f
E
log W

and the Lagrangian function is

L (w; l)

= E

i
h

1
2
ln (40w + 102) + ln (102
3
3

log

f
W

The Kuhn-Tucker First Order Conditions are:

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

l (w

20w)

1:5 ) .

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

2
40
1
20
+
3 40w + 102 3 102 20w

800w + 2040
51
= 0 () w =
= 2: 55
(40w + 102) (102 20w)
20

1:5 (unfeasible) .

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

8
>
< Lw =
>
:

Ll =

800w+2040
(40w+102)(102 20w)

l=0

w + 1:5 = 0 (the constraint is binding)

Alessandro Sbuelz - SBFA, Catholic University of Milan

()

8
>
< l = 7: 201 646 09
>
:

10

> 0

w = 1:5 .

SOLU T ION S

The correct answer is b).

The problem is
sub

maxP (x; y)
x;y

x+y

25

with
2x2 + y 2

P (x; y) = 35x + 25y

xy + 30

The First Order Conditions for constrained optimality will be su cient because the constraint function
is linear (the feasible set f(x; y) 2 R2 : x + y 25g is convex) and the prot function P (x; y) is strictly
concave:
3
2
3 2
4
1
Pxx
Pxy
7
6
7 6
H = 4
5 with Pxx = 4 < 0 and det (H) = 7 > 0 :
5=4
1
2
Pyx
Pyy
Given the Lagrangian function
L (x; y; l) = P (x; y)
the Kuhn-Tucker First Order Conditions are:
8
>
Lx = 0
>
>
>
>
>
Ly = 0
>
>
>
>
>
<
,
l 0
>
>
>
Ll 0
>
>
>
>
>
>
>
>
: l L =0
l

l (x + y

25) ,

8
>
y 4x l + 35 = 0
>
>
>
>
>
x l 2y + 25 = 0
>
>
>
>
>
<
l 0
>
>
>
25 y x 0
>
>
>
>
>
>
>
>
: l (25 y x) = 0

For l = 0 (we assume a painless constraint), we have:

8
>
< y
>
:

4x + 35 = 0
2y + 25 = 0

8
>
< x=
>
:

y=

Alessandro Sbuelz - SBFA, Catholic University of Milan

95
7

= 13: 571 428 6

.

135
7

= 19: 285 714 3

8

The unconstrained maximum-prot point is such that P

unfeasible as the constraint is violated:

95 135
; 7
7

95 135
+
= 32: 857 142 9
7
7

= 448: 571 429. It turns out to be

25 :

For l > 0 (we assume a painful constraint), we have:

8
>
y 4x l + 35 = 0
>
>
>
>
>
<
x l 2y + 25 = 0
>
>
>
>
>
>
: 25 y x = 0 (the constraint is binding)

8
>
x = 85
= 10: 625
>
8
>
>
>
>
<
,
= 14: 375
y = 115
8
>
>
>
>
>
>
: l = 55 = 6: 875
8

The constrained maximum prot is

P

85 115
;
8 8

= 421: 562 5 .

Alessandro Sbuelz - SBFA, Catholic University of Milan

SOLU T ION S

The correct answer is a).

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
6
6
4
Since

1:0
2: 3
1: 3
0:75

3T 2
3
1
+
0
2
1
0
Q
(!
)
1
7
1 6
7
7 6
7
1
+
0
3
2
1
Q
(!
7 =
4
5 4
2) 5 .
1+0
5
1+0 2 1 1
Q (! 3 )

31
1+0 2 1
7C
B6
det @4 1 + 0 3 2 5A = 0
1+0 2 1
02

but

02

31
2 1 0
B6
7C
det @4 3 2 1 5A = 1 ,
2 1 1

we can focus on the three risky securities to work out the unique measure Q:
02
3T 1
3
2 1 0
Q (! 1 )
B6
7 C
7
6
3
2
1
5 C
4
4 Q (! 2 ) 5 = B
A
@
2 1 1
Q (! 3 )
2

31
2: 3
7C
6
B
@(1 + 0) 4 1: 3 5A
0:75
0

3
0:25
7
6
= 4 0:30 5 .
0:45
2

The riskless security is also properly priced:

3T 2
3
1
0:25
1 6 7 6
7
4 1 5 4 0:30 5 .
1+0
1
0:45

Alessandro Sbuelz - SBFA, Catholic University of Milan

10

The payo to be priced is

e (1)
X
2

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

max

Se2 (1) ; 0

m
2

3
2 3
1; 0)
1
7
6 7
2; 0) 5 = 4 0 5 .
1; 0)
1

max ( 2
6
4 max ( 2
max ( 2

Its no-arbitrage price is

2

3T 2
3
1
0:25
1 6 7 6
7
X (0) =
4 0 5 4 0:30 5
1+0
1
0:45

0:7 .

An alternative would be the calculation of the intial cost of the replicating strategy #X that involves
only the three risky securities (#X
0 = 0):
2

3
#X
1
6 X 7
4 #2 5
#X
3

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

and

V#X (0)

2
6
6
6
4

0
2
3
0

3T
7
7
7
5

3
1
6 7
4 0 5
1

2
6
6
6
4

1:0
2: 3
1: 3
0:75

Alessandro Sbuelz - SBFA, Catholic University of Milan

3
7
7
7
5

3
2
6
7
4 3 5
0

0:7 .

11

SOLU T ION S

The correct answer is c).

8
>
< 1:0#0 + 2: 4#1 + 1: 4#2 + 0:8#3 = 3
#0 + 2#1 + #2 = 3
>
:
#0 + 3#1 + 2#2 + #3 = 3
Since

we have

31
1:0 2: 4 1: 4
7C
B6
det @4 1
2
1 5A = 0
1
3
2

but

3
3
2
2: 4 1: 4 0:8
#1
6
7
7
6
1
0 5
4 #2 5 = 4 2
#3
3
2
1

1:0 2: 4 1: 4 0:8 6
6
76
2
1
0 56
4 1
4
1
3
2
1

()

02

#0
#1
#2
#3

3
3
7
7 6 7
7=4 3 5 .
5
3

31
2: 4 1: 4 0:8
7C
B6
det @4 2
1
0 5A = 0:4 ,
3
2
1
02

3
3
B6 7
@4 3 5
3

31
1
6 7C
#0 4 1 5A
1

02

3
3 #0
6
7
= 4 #0 3 5 ,
0

where
2

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

1
2
1 6
0
4 0:2
0:4
0:8 1: 6

Alessandro Sbuelz - SBFA, Catholic University of Milan

3T
1
7
0:6 5
0:4

2: 5
6
4 5:0
2: 5

0:5
0
1: 5

3
2:0
7
4:0 5 .
1:0
12