QUANTITATIVE METHODS FOR FINANCE

Mock Exam 3
(Academic Year 2013-14)
[5 exercises; 31 points available; 90 minutes available]

1
k (X

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

[8 points]
Use the educated guess qX 2 + uX + v (q, u, and v are constants to be determined) to
work out the equilibrium stock price S (X).

[7 points]
Your initial capital is H = 2000 Euro. You retrieve an additional sum of 500 Euro by
selling short the stock and invest 2500 Euro in the riskless asset. Work out the total gain dH on your
portfolio.

2
max E
w

where

[4 points]
h

log

f
W

Consider a constrained log-utility investor whose problem is

i
f = 100 ( (1 + r) + w (e
sub
w
250% ,
W
r

r = 0% ;

re =

8
>
< g>
>
:

3%

3%

with probability

1
2

with probability

1
2

r) ) ;

If the constrained optimal portfolio is w = 2:5 and the shadow price is l = 0, the up-state return on
the risky asset is:

a)
b)
c)
d)

3
g = 85
;
5
g = 85 ;
6
g = 85
;
8
g = 85 .

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 30
and 40, respectively). An embargo is imposed on the rms average production:
1
1
x+ y
2
2
Given that the production costs are
prot is:
a)
1048: 75;
b)
1248: 75;
c)
1848: 75;
d)
1448: 75.

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

30 .

C (x; y) = 12 x2 + 12 y 2

1
xy
3

+ 70,

the constrained maximum

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

2

6
6
M =6
4

1:0
1
1
1

3: 2
3
5
2

4: 8
5
7
3

7
7
7 .
5

The no-arbitrage price of a European call option written on the risky security 2 (the strike price is 3)
is:
a)
2: 70;
b)
1: 25;
c)
1:80;
d)
0:80.

[4 points]

Consider the following one-period market with a zero riskfree rate (r = 0):
2
3
1:0
1:45
1:10
6 1
1
1 7
6
7
M =6
7 .
4 1
1
0 5
1
2
2

The nal proceed prevailing in the state ! 2 of the strategy # that costs 10 cents (V# (0) =
and pays o nothing in the states ! 1 and ! 3 (V# (1) (! 1 ) = V# (1) (! 3 ) = 0) is:
a)
V# (1) (! 2 ) = 72 .
b)
V# (1) (! 2 ) = 27 ;
c)
V# (1) (! 2 ) = 47 ;
d)
V# (1) (! 2 ) = 73 .
Alessandro Sbuelz - SBFA, Catholic University of Milan

10
)
100

SOLU T ION S

The equilibrium-valuation problem is

1
Et [dS] + 2X 2 + 12X + 18 = Sr + SX X
dt

with

1
Et [dS]
dt

1
m)) + SXX X 2
2

SX ( k (X

The educated guess

S (X) = qX 2 + uX + v
has derivatives
SX = 2qX + u

and

SXX = 2q

and must meet the equilibrium equation

(2qX + u) ( k (X

1
m)) + 2qX 2
2

+ 2X 2 + 12X + 18

qX 2 + uX + v r

(2qX + u) X

= 0
m

X2

2qk + q

+2
{z

qr

2q

=0

+ X(2qkm + 12
|

uk
{z

ur

) + (ukm + 18
} |
{z

=0

=0

vr) = 0 .
}

Hence
q =
u =

v =

2
2k + r
(2k + r
km
r

+2
2

4km
+2
) (k + r +

(2k + r

4km
2+2
) (k + r +

Alessandro Sbuelz - SBFA, Catholic University of Milan

12
k+r+

12
k+r+

18
.
r

The total gain on your portfolio is

dH

500
S

500

500

Hr

SX X
(elasticity)
S

dS + 2 (X + 3)2 dt

dS + 2 (X + 3)2 dt
S

500

SX X
S

+ 2500rdt

dt

SX X
S

dt

SX X
S

500

SX X
dz .
S

dz

+ 2500rdt

2qX 2 + uX
S

2k+r

4X 2
2 +2

(2k+r

4kmX
)(k+r+

2 +2

12X
k+r+

S +
=

+ 2500rdt

2k+r

2X 2
2 +2

km
r

4km
(2k+r

2 +2

)(k+r+

12
k+r+

18
r

S + qX 2
S

Alessandro Sbuelz - SBFA, Catholic University of Milan

SOLU T ION S

The correct answer is a).

The investors expected utility is

h
i
f
E
log W
= 0:5 ln (100 + w (100g

0)) + 0:5 ln (100

3w)

and the Lagrangian function is

L (w; l)

f
W

log

The Kuhn-Tucker First Order Conditions are:

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

l (w

2:5 ) .

0
0
0
0 .

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

Lw (w; l)jl=0

=
=
=

Ll (w; l)jl=0

1
100g
1
3
+
2 (100 + 100gw) 2 (100 3w)
1
100g + 6gw + 3
2 (100 3w) (1 + gw)
0 ,
(w

2:5)

0 ,

so that
Lw (w; l)j l=0; w=2:5

= 0 ()

100g + 15g + 3 = 0 = 0 () g =

Alessandro Sbuelz - SBFA, Catholic University of Milan

3
= 3: 529 411 76% .
85

The graphical analysis (not required) follows, with

8
300
>
< 100 + w 85 0 > 0
() w 2
>
:
100 + w ( 3 0) > 0

expected utility

85 100
;
3 3

-30

-25

-20

-15

-10

-5

10

15

20

25

30

35

allocation w

-1

Alessandro Sbuelz - SBFA, Catholic University of Milan

SOLU T ION S

The correct answer is d).

The problem is
maxP (x; y)
x;y

1
1
x+ y
2
2

sub

30

with
1 2 1 2
x + y
2
2

P (x; y) = 30x + 40y

1
xy + 70
3

The First Order Conditions for constrained optimality will be su cient because the constraint
function is linear (the feasible set (x; y) 2 R2 : 12 x + 21 y 30 is convex) and the prot function P (x; y)
is strictly concave:
3 2
2
3
1
1
Pxx
Pxy
3
8
7 6
6
7
=
H = 4
5 4
5 with Pxx = 1 < 0 and det (H) = > 0 :
9
1
Pyx
Pyy
1
3
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

1
1
x+ y
2
2

30

8
1
>
y x 21 l + 30 = 0
>
3
>
>
1
>
>
x 12 l y + 40 = 0
>
3
>
>
>
>
<
l 0
>
>
>
30 21 y 12 x 0
>
>
>
>
>
>
>
>
: l 30 1 y 1 x = 0 .
2
2

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

8
8
1
195
>
>
y
x
+
30
=
0
< 3
< x = 4 = 48: 75
,
>
>
: 1
:
x
y
+
40
=
0
y = 225
= 56: 25 .
3
4
Alessandro Sbuelz - SBFA, Catholic University of Milan

The unconstrained maximum-prot point is such that P

unfeasible as the constraint is violated:

195 225
; 4
4

1
1
48: 75 + 56: 25 = 52: 5
2
2

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

8
1
>
y x 21 l + 30 = 0
>
3
>
>
>
>
<
1
x 12 l y + 40 = 0
3
>
>
>
>
>
>
: 30 1 y 1 x = 0 (the constraint is binding)
2

7145
4

= 1786: 25. It turns out to be

30 :

8
>
= 26: 25
x = 105
>
4
>
>
>
>
<
,
y = 135
= 33: 75
4
>
>
>
>
>
>
:
l = 30 .

The constrained maximum prot is

P

105 135
;
4
4

5795
= 1448: 75 .
4

Alessandro Sbuelz - SBFA, Catholic University of Milan

SOLU T ION S

The correct answer is c).

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 5
Q (! 1 )
1 6
6
7
7 6
7
4 3: 2 5 =
4 1 + 0 5 7 5 4 Q (! 2 ) 5 .
1+0
4: 8
1+0 2 3
Q (! 3 )
Since

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

the unique measure Q is:

02
3T 1
1 3 5
Q (! 1 )
B6
7 C
7
6
B
4 Q (! 2 ) 5 = @4 1 5 7 5 C
A
1 2 3
Q (! 3 )
2

2 ,

31
1:0
B
6
7C
@(1 + 0) 4 3: 2 5A
4: 8

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

with
02

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

02

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

Alessandro Sbuelz - SBFA, Catholic University of Milan

1
1 6
4 4
2
3
|

1
2
1
{z

3
4
7
2 5
2

matrix of cofactors

The payo to be priced is

e (1)
X

max

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

Se2 (1)

max ( 5
6
4 max ( 7
max ( 3

3; 0

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

Its no-arbitrage price is

2

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

1: 8 .

An alternative would be the calculation of the initial cost of the unique replicating strategy #X :

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

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

3
2
6 7
4 4 5
0
2

and
V#X (0)

3T
3
6
7
4 0 5
1

1
1 6
4 1
2
4
|

{z

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

matrix of cofactors

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

Alessandro Sbuelz - SBFA, Catholic University of Milan

4
2
2

3
3
7
6
4 0 5
1
2

1: 8 .

10

SOLU T ION S

The correct answer is a).

8
>
< #0 +
>
:

+ 11
# = 0:10
10 2
#0 + #1 + #2 = 0
#0 + 2#1 + 2#2 = 0

29
#
20 1

Since

()

02

1
B6
det @4 1
1

we have
2

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

1
6
4 1
1

145
100

11
10

145
100

1
2

31

10
100

6
4

0
0

3 2
#0
7 6
76
1 5 4 #1 5 = 4
#2
2

11
10

32

10
100

0
0

7
5 .

7
,
20

7C
1 5A =
2

1
2

7
1 5
2

1
2

11
10

145
100

3
7
5

2
6
4

0
2
7
2
7

7
5 ,

where
2

1
6
4 1
1

145
100

1
2

11
10

7
1 5
2

0
1 6
1
7 4
20
1

Hence,
V# (1) (! 2 )

7
10
9
10
11
20

7
20
1
10
9
20

3
7
5

3
#
0
h
i
6
7
1 1 0 4 #1 5
#2

Alessandro Sbuelz - SBFA, Catholic University of Milan

2
6
4

20
7
20
7

18
7
11
7

2
7
9
7

7
5 .

2
.
7

11