QUANTITATIVE METHODS FOR FINANCE

Mock Exam 4 (Academic Year 2013-14)

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

1
k (X

Consider a stock that pays out the dividend (3X + 2m) dt every second (with dX =
m) dt + X dz).

[8 points]
Show that the equilibrium price S (X) of the stock has the following dynamics (expressed in total-gain form):
dS +

[7 points]

(3X + 2m) dt

Show that, if

Sr +

3X
r+

max E
w

where

[4 points]
h

log

f
W

r+

+k

dz .

<

5m
.
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% ;
The risk premium is E [ re ]
a)
b)
c)
d)

3X

> 0, the following statement holds true:

E [ S (X) ]

+k

dt +

5: 659 075 22
8: 659 075 22
3: 659 075 22
1: 659 075 22

+60%
20%

with probability
with probability

p 2 (0; 1)
1 p

r) ) ;

r = 26%. The shadow price l of the portfolio constraint is:

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, 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
400 0:8Y 1:2X
=
.
y
400 1:2Y 0:8X
The production costs are C (x; y) = 2x + 3y + xy + 150. The government imposes the constraint
Y
60 (ys sale price must not exceed 60). The shadow price l associated to the constraint is:
a)
l = 101: 777 778;
b)
l = 107: 777 778;
c)
l = 120: 777 778;
d)
l = 89: 777 778.

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

0:9
3
0
0

1:0
2
0
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)
1:00;
b)
2:00;
c)
1:25;
d)
0:75.

[4 points]

and the payo

strategy #l
a)
b)
c)
d)

Given the one-period market

2
1
6 1:02
6
M =6
4 1:02
1:02

X (1) (! 1 )

3
0:35
1 7
7
7
0 5
0
iT h
= 2
X (1) (! 3 )

X (1) (! 2 )
e (1) is such that:
that super-replicates X
#l0 = 2=1:02;
#l0 = 1=1:02;
#l1 = 1;
#l1 = 2.

Alessandro Sbuelz - SBFA, Catholic University of Milan

iT

, the maximum-inow

SOLU T ION S

The equilibrium-valuation problem is

1
Et [dS] + 3X + 2m
dt

= Sr + SX X

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

where

1
m)) + SXX X 2
2

Let us formulate the educated guess

S (X) = BX + C ,

where B and C are constants to be determined. Given

SX

B ,

SXX

0 ,

the dynamic equilibrium restriction becomes

B ( k (X

m)) + 3X + 2m

(BX + C) r + BX

m
Bkm + 2m
|
{z
= 0

Cr
}

(B (r +
|

+ k)
{z

= 0

3)X
}

m
B =
C =

Alessandro Sbuelz - SBFA, Catholic University of Milan

3
r+

+k

3m
k
2m
+
.
r r+
+k
r

The total gain on the stock is

dS

(3X + 2m) dt

SX ( k (X

( Sr

If

Sr

1
m)) + SXX X 2
2

SX X

) dt
3X

r+

+k

3X + 2m

dt

SX X dz

SX X dz .
dt

3X
r+

+k

dz .

> 0, we have

E [S (X)]

r 3E [X]
rr+
+k

3m
r
r r+
+k

3m
r+k
2m
+
r r+
+k
r

<

5m
.
r

3m
2m
k
+
r r+
+k
r

Alessandro Sbuelz - SBFA, Catholic University of Milan

3m
k
2m
+
r r+
+k
r

SOLU T ION S

The correct answer is a).

The probability mass p implied by the risk premium is 60%:

0:60p

0:20 (1

The investors expected utility is

h
f
E
log W

and the Lagrangian function is

L (w; l)

p)

0:02 = 0:26

=)

p = 60% .

= 0:6 ln (58w + 102) + 0:4 ln (102

log

f
W

The Kuhn-Tucker First Order Conditions are:

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

l (w

22w)

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

= 0:4

58
22
+ 0:6
58w + 102
102 22w

319w + 663
663
= 0 () w =
2
2601 + 918w 319w
319

1:5 (unfeasible) .

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

8
>
< Lw =
>
:

Ll =

319w+663
2601+918w 319w2

l=0

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

Alessandro Sbuelz - SBFA, Catholic University of Milan

()

8
>
< l = 5: 659 075 22
>
:

10

> 0

w = 1:5 .

SOLU T ION S

The correct answer is b).

The inverse demand functions are

"

X = 200 + y
Y = 200 + x

1:5x
1:5y

so that the monopolists problem is

maxP (x; y)
x;y

s.t.

60

200 + x 1:5y
{z
}
|

0 ,

ys sale price as a function of outputs

with
P (x; y) = x (200 + y

1:5x) + y (200

1:5y + x)

(2x + 3y + xy + 150) :

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 : 200 + x 1:5y 60g is convex) and the prot function P (x; y)
is strictly concave:
3
3 2
2
3
1
Pxx
Pxy
7
7 6
6
H = 4
5 with Pxx = 3 < 0 and det (H) = 8 > 0 :
5=4
1
3
Pyx
Pyy

The corresponding Lagrangian function is

L (x; y; l) = P (x; y)

l (200

1:5y + x

60)

and the Kuhn-Tucker First Order Conditions are are:

8
8
>
>
L
=
0
y 3x l + 198 = 0
x
>
>
>
>
>
>
>
>
>
>
Ly = 0
1: 5l + x 3y + 197 = 0
>
>
>
>
>
>
>
>
>
>
<
<
,
l 0
l 0
>
>
>
>
>
>
Ll 0
(200 1:5y + x 60) 0
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
: l L =0
: l (200 1:5y + x 60) = 0 .
l
Alessandro Sbuelz - SBFA, Catholic University of Milan

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

8
>
< Lx (x; y; 0) = Px = 0
>
:

Ly (x; y; 0) = Py = 0

8
>
< x = 98: 875
>
:

y = 98: 625

Such a solution corresponds to the unconstrained maximum-prot point (P (98: 875; 98: 625) = 19353:
187 5). The constraint is violated:
Y (98: 875; 98: 625) = 150: 937 5

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

8
>
Lx = 0
>
>
>
>
>
<
,
Ly = 0
>
>
>
>
>
>
: L = 0 (the constraint is binding)
l

60 :

8
>
x = 78: 666 666 7
>
>
>
>
>
<
y = 145: 777 778
>
>
>
>
>
>
: l = 107: 777 778

The constrained maximum prot is

P (x ; y ) = 14452: 666 6 .

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

2
3
3T 2
3
1:0
1+0 3 2
Q (! 1 )
1 6
6
7
7 6
7
4 0:9 5 =
4 1 + 0 0 0 5 4 Q (! 2 ) 5 .
1+0
1:0
1+0 0 1
Q (! 3 )
Since

02

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

the unique measure Q is:

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

02

3 ,

31
1:0
7C
B
6
@(1 + 0) 4 0:9 5A
1:0
0

3
0:3
6
7
4 0:3 5
0:4

with
02

3T 1
1 3 2
B6
C
B4 1 0 0 7
5 C
@
A
1 0 1

02

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

Alessandro Sbuelz - SBFA, Catholic University of Milan

0
1 6
4 1
3
0
|

3
1
3
{z

3
0
7
2 5
3

matrix of cofactors

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

max ( 2
6
4 max ( 2
max ( 2

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

Its no-arbitrage price is

2

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

1 .

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

and
V#X (0)

3
0
6 7
4 2 5
1
2

0
1 6
4 3
3
0

3T
2
6
7
4 0 5
1

3
1:0
6
7
4 0:9 5
1:0

Alessandro Sbuelz - SBFA, Catholic University of Milan

1
1
2
{z

3T
0
7
3 5
3

matrix of cofactors

3
0
6 7
4 2 5
1
2

3
2
7
6
4 0 5
1
2

1:0 .

SOLU T ION S

The correct answer is d).

The market is obviously incomplete (2

replicable:
02
1:02
B6
det @4 1:02
1:02

securities and 3 states of the world). The payo is not

31
1 2
7C
0 0 5A
0 1

1: 02 .

The candidate super-replicating strategies # = [#0 ; #1 ]T solve the system

2

3
1:02 1
6
7
4 1:02 0 5 #
1:02 0

3
2
6 7
4 0 5
1

()

8
>
< 1:02 #0 + 1 #1
1:02 #0 + 0 #1
>
:
1:02 #0 + 0 #1

theta_1

2
0
1

(not below the green line)

(to the right of the yellow line)
(to the right of the blue line)

2
1

-3

-2

g
tin
a
ic
pl
e
r
er
p
su

-1

-1
-2

)
(1
X
-2

theta_0

-3
-4
-5

We determine the maximum-inow strategy among all those that super-replicate

the initial-inow function
f# (0) =

#0 1

#1 0:35

e (1) by studying
X

V# (0) ).

The level curve f of such a function is identied by the straight line of equation
#0

#1 0:35 = f

() #1 =

f
0:35

#0

Alessandro Sbuelz - SBFA, Catholic University of Milan

1
(see the red solid lines below).
0:35
10

theta_1

2
1

-3

-2

-1

1
-1

p
su

-2

er

p
-re

lic

in
at

-X

(1

g2

)
3

theta_0

-3
-4

f = 0.7

f=0

-5

The maximum-inow strategy is given by the couple [#l0 ; #l1 ]T represented by the intersection between
the green line and the yellow line. Hence, we must solve the system
(

1:02 #l0 + 1 #l1 = 2

1:02 #l0 + 0 #l1 = 0

"

#l0
#l1

to obtain the seeked strategy

#

"

0
2

Alessandro Sbuelz - SBFA, Catholic University of Milan

11