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QUANTITATIVE METHODS FOR FINANCE

alessandro.sbuelz@unicatt.it
Room 221, 2nd oor, Via Necchi 9
Phone: +39-02-72342345
O ce hours: 14:30-16:30 on Tuesday

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

TEXTBOOK

Lecture notes.

I
A. BATTAUZ - F. ORTU, Arbitrage Theory in Discrete and Continuous
Time (Cod. 8444), Edizioni EGEA, last edition (available at Libreria EGEA, Via
Bocconi, 8).

I
K. SYDSAETER - P. J. HAMMOND, Mathematics for economic analysis,
Prentice-Hall, 1995.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

THE COURSE MATERIAL IS ON BLACKBOARD (BB)

Enroll in a BB course by entering your I-Catt URL (www.i-catt.it).

I
At http://www.unicatt.it/faq/faq.asp?id=146 you'll nd detailed information on how to enroll in BB courses.
I

You enter BB via http://blackboard.unicatt.it.

Your BB username is: surname.IDnumber. Your BB password is: utente.

For any problem, contact supporto.blackboard@unicatt.it.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

COURSE OUTLINE

No-arbitrage pricing of assets replicated by existing traded securities.

No-arbitrage pricing of unreplicable assets.

Constrained optimization with applications to nance/economics.

Equilibrium valuation of assets.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

LINEAR ALGEBRA

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

(REVIEW)

I IS THE NEUTRAL ELEMENT OF THE MULTIPLICATION

I
The n n identity matrix I has 1s down the main diagonal and 0s elsewhere.
The 2 2 identity matrix, for example, is

I =

"

1 0
0 1
2

5 1

"
3

6
7
4 8 3 5

1 0

3 4 0
5 2 2

"

1 0
0 1

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

"

1 0
0 1

"
2

3 4 0
5 2 2

5 1

6
7
4 8 3 5

1 0

TRANSPOSITION AND MULTIPLICATION

I
If you transpose a matrix product you multiply the transposed matrices in
reverse order:
0

A
Bz
}|
{
B
B "
#
B
B
1 2 0
B
B
1 1 1
B
@

bT
}|

5 8 1

z b}|

1T

C
2
3 C
C
5 C
6
7 C
4 8 5 C
C
1 C
A

{ 2

AT
}|

1 1
6
7
4 2 1 5
0 1

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

"

21
14

#T

m
{

21 14

i
7

INVERSE AND INVERTIBLE MATRICES

If it exists, the inverse of an n n matrix C is an n n matrix C 1 satisfying


CC 1 = I

C 1C = I :

and

For example,
z

"

C
}|

1 2
1 3

{ z

C 1
}|

"

3
1

2
1

"

1 0
0 1

1 0
0 1

and
z

An n

"

C 1
}|

3
1

2
1

{ z

"

C
}|

1 2
1 3

"

n matrix C is invertible if its inverse matrix C 1 exists.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

DETERMINANTS OF SQUARE MATRICES

I
C is invertible if and only if (i ) it is non-singular, that is, its determinant
is non-zero.

det

"

1 2
1 3

#!

= 1 ( 1)1+1 det (3) +


|

{z
}
the 1-1 cofactor

1 ( 1)2+1 det (2)


|

{z
}
the 2-1 cofactor

= 1 3 + 1 ( 2)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

1 .

DETERMINANTS OF SQUARE MATRICES

02

31

"
#!
1 2 3
3 2
B6
7C
det @4 2 3 2 5A = 1 ( 1)1+1 det
+
3 2
3 3 2
{z
}
|
the 1-1 cofactor

2 ( 1)2+1 det
|

2 3
3 2

#!

2 3
3 2

#!

{z
the 2-1 cofactor

3 ( 1)3+1 det
|

"

"

{z
the 3-1 cofactor

= 1 (0) + 2 5 + 3 ( 5) =
Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

5
10

CONSTRUCTING THE INVERSE MATRIX

"

1 2
1 3

# 1

=
det
|

"

1
1 2
1 3

{z
=1

#!

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

matrix of cofactors of

"

1 2
1 3

!T

11

CONSTRUCTING THE INVERSE MATRIX

6
6
6
"
#
6
6
1 2
matrix of cofactors of
= 6
6
1 3
6
6
6
4
2
6

= 4

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

( 1)1+1 det (3)

{z
}
the 1-1 cofactor

{z
}
the 1-2 cofactor

{z
}
the 2-1 cofactor

{z
}
the 2-2 cofactor

3
2

1
1

7
7
7
7
7
7
7
7
7
7
5

( 1)1+2 det (1)

( 1)2+1 det (2)

( 1)2+2 det (1)

3
7
5

12

CONSTRUCTING THE INVERSE MATRIX

"

1 2
1 3

# 1

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

1
1

"

"

3
1

3
2

2
1

1
1

#T

13

A FORMULA FOR INVERTING 2

Given ad

2 MATRICES

cb 6= 0, consider the square matrix


"

a b
c d

cb

"

Its inverse is
1
ad

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

d
c

b
a

14

INVERTING A 3

3 MATRIX

Show that

6
6
6
6 2
6
6
4

2
3
3

3 1
3
7
7
7
2 7
7
7
5

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

6
6
1 6
6 2
56
6
4

5
7
3

7
7
7
4 7
7
7
5

15

SYSTEMS OF LINEAR EQUATIONS (REVIEW)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

16

A FIRST EXAMPLE

Consider the following linear system in the unknowns x1, x2, and x3 :
8
>
x 1 + 2 x2 + 3 x3
>
>
>
>
>
<

2 x 1 + 3 x 2 + 2 x3 =
>
>
>
>
>
>
: 3x + 3 x + 2 x =
1
2
3

6
1
0

We can rewrite it as follows:

32

1 2 3
x1
6
6
76
7
6
7
4 2 3 2 5 4 x2 5 = 4 1 5
3 3 2
x3
0
Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

17

A FIRST EXAMPLE

We can also rewrite the system as a `constrained' linear combination:

3
2
1
6
7
6
7
6
7
x1 4 2 5 + x 2 4 3 5 + x 3 4 2 5
2
3
3

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

6
6
7
4 1 5
0

18

A FIRST EXAMPLE

The system admits a solution i the vector

2
6
4

6
7
1 5
0

can be seen as a linear combination of the vectors

6
7
4 2 5

6
7
4 3 5

and

6
7
4 2 5

with proper weights x1, x2, and x3.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

19

A FIRST EXAMPLE

This can happen i (Rouche-Capelli Theorem)

1 2 3

6
7
the number of independent columns of 4 2 3 2 5

3 3 2

equals
2

1 2 3

6
the number of independent columns of 4 2 3 2
|

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

3 3 2

6
7
1 5
0

{z
}
complete matrix

20

A FIRST EXAMPLE

I
has.

The rank of a matrix measures how many indipendent columns the matrix

The rank of a matrix is the highest order of non-singular square submatrices.

1 2 3

1 2 3

6
7
6
4 2 3 2 5 is non-singular so that 4 2 3 2

3 3 2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

3 3 2

6
7
1 5 has maximum rank (3) .
0

{z
}
complete matrix

21

A FIRST EXAMPLE

I
We can work out the solution x1, x2, and x3 by means of the Cramer's
Theorem:
02

B6
x1 = det @4
02

1
B6
x2 = det @4 2
3
02

31

6 2 3
C
1 3 27
5A = ( 5)
0 3 2
31

6 3
C
1 27
5A = ( 5)
0 2

1 2

B6
x3 = det @4 2 3

3 3

31

6
C
17
5A = ( 5)
0

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

5
=1 ;
5

19
=
5

3:8 ;

21
= 4 :2 :
5

22

A FIRST EXAMPLE

I
We can work out x1, x2, and x3 also by means of inversion (given nonsingularity):

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

3 3 2

3 2

x1
1 2 3
7
6
7 6
4 2 3 2 5 4 x2 5
x3
3 3 2

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

3 3 2

6
6
7
4 1 5
0

m
2

3 2

3 1 2
3
1 0 0
x1
1 2 3
6
7
6
7
6
7
6
7 6
4 0 1 0 5 4 x2 5 = 4 2 3 2 5
4 1 5
0 0 1
x3
3 3 2
0

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

23

A FIRST EXAMPLE

x
6 1 7
7
6
7
6
6 x 7
6 2 7
7
6
5
4
x3

6
6
1 6
6 2
56
6
4

5
7
3

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

3 2

7
7
7
4 7
7
7
5

6
6
6
6
6
6
4

7
7
7
1 7
7
7
5

6
6
6
6
6
6
4

7
7
19 7
7
5 7
7
5
21
5

24

A SECOND EXAMPLE

Consider the following linear system in the unknowns x1, x2, x3 and x4 :

8
>
>
>
>
>
>
<
>
>
>
>
>
>
:

x4

= 1

x3 + 2 x4

= 0

x1

x2 + 2 x3

2 x1

x2

x1 + 2 x2 + 2 x3 + x4 = 1

Let's express it as follows:

6
7
6
x1 4 2 5 + x2 4

1
2
1
1
7
6
7
6
7
6
7
1 5 + x3 4 1 5 + x4 4 2 5 = 4 0 5 .
2
2
1
1

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

25

A SECOND EXAMPLE

The rst three vectors are independent:

02

B6
det @4 2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

1
1
2

31

2
7C
1 5A = 9
2

26

A SECOND EXAMPLE

If the fourth vector is brought on the right-hand side,


2

6
6
7
x1 4 2 5 + x2 4

1
2
1
6
7
6
7
7
1 5 + x3 4 1 5 = 4 0 5
1
2
2

6
7
x4 4 2 5

the solution (with one degree of freedom) can be written as

x
1
6 1 7
6
6
7
6
6
7
6
6 x 7=6 2
6 2 7
6
6
7
6
4
5
4
x3

1
1
2

3 1 02
3
2
1
7
B6
7
7
B6
7
7
B6
7
7
B
6
1 7 B6 0 7
7
7
B6
7
5
@4
5

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

31

6
7C
6
7C
6
7C
6
C
x4 6 2 7
7C
6
7C
4
5A

2 1
5x
3 4
6 3
6
6 2
16 x
6
6 9
9 4
6
4
4x + 4
9 4
9

3
7
7
7
7
7
7
5

27

A THIRD EXAMPLE

Consider the following linear system in the unknowns x1, x2, and x3 :
8
>
2 x1 + 7 x2 + x3 =
>
>
>
>
>
>
>
>
>
< 5 x1 + 6 x2 + 8 x3 =

>
>
>
>
>
>
>
>
>
>
:

9 x2

15
3

= 27

7 x1 + 6 x2 + 7 x3 =

Let's state it as follows:


2

15

6 5 7
6 6 7
6 8 7
6 3
6
7
6
7
6
7
6
x1 6 7 + x2 6 7 + x3 6 7 = 6
4 0 5
4 9 5
4 0 5
4 27

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

3
7
7
7
5

28

A THIRD EXAMPLE

The rst three vectors are independent because


02

31

2 7 1
B6
7C
det @4 5 6 8 5A =
0 9 0

The last vector linearly depends on the rst three vectors as


02

B6
B6
det B6
@4

99

2
5
0
7

7
6
9
6

31

1 15
C
8 3 7
7C
7C = 0
0 27 5A
7
3

Hence, the system admits solution.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

29

A THIRD EXAMPLE

I
We can work out x1, x2, and x3 by focusing on the rst three equations
(given non-singularity):
2

15
2
7
1
6
6
7
6
7
6
7
7
x1 4 5 5 + x2 4 6 5 + x3 4 8 5 = 4 3 5
27
0
9
0
m
3 12
3
15
2 7 1
x1
7
6
7
6
7
6
4 3 5
4 x2 5 = 4 5 6 8 5
0 9 0
27
x3
2

3
7
6
4 3 5
0

The last equation is met by construction:


x1 7 + x2 6 + x3 7 =

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

21 + 18 + 0

30

ONE-PERIOD FINANCIAL MARKETS

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

31

TIMING

Investors face two trading dates only, namely t = 0 and t = 1.

At time t = 0, investors choose their investment strategy.

At time t = 1 they receive the liquidation value of their strategy.

I
At time 0, investors can choose among N + 1 securities, for which we use
the index j , with j = 0; : : : ; N .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

32

THE RISKLESS SECURITY

The security with j = 0 represents a riskless security.

B (0)

1 denotes the time-0 price of the riskless security.

B (1)

1 + r denotes its time-1 price.

The quantity r is the risk-free rate, with r > 0.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

33

THE RISKY SECURITIES

For the N securities with j > 0, Sj (0) denotes their time-0 price.

Sej (1) is a random variable that denotes their time-1 price, with j = 1; : : : ; N .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

34

UNCERTAINTY

I
By time 1, the market uncertainty will resolve in one of K possible states
of the world.
I

! k indicates the generic k-th state of the world at time 1.

The ! k 's are relevant economic/ nancial scenarios.

indicates the set of all states of the world, i.e.

= f! 1; : : : ; ! K g.

Sj (1)(! k ) indicates the time-1 price of the j -th security in scenario ! k .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

35

THE PAYOFF MATRIX M

The payo matrix M has K + 1 rows and N + 1 columns.

I
Each column j of M represents the out ows/in ows from buying 1 unit of
the j -th security (j = 0; 1; :::; N ):
2

6
6
6
6 1+r
6
6
6
6
6 1+r
6
6
6
...
6
6
6
4

1+r

S1(0)

S2(0)

S1(1)(! 1)

S2(1)(! 1)

S1(1)(! 2)

S2(1)(! 2)

...

...

S1(1)(! K )

S2(1)(! K )

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

SN (0)

7
7
7
SN (1)(! 1) 7
7
7
7
7
SN (1)(! 2) 7
7
7
7
...
7
7
7
5

SN (1)(! K )

36

EXEMPLIFYING A MARKET WITH 3 SECURITIES AND 3 STATES

Consider a one-period market with N = 2 and K = 3.

Assume that B (1) = 1:05, so that r = 5%.

The time-0 prices of the risky securities are S1(0) = 0:5 and S2(0) = 2:5.

The time-1 prices of the risky securities are


S1(1)(! 1) = 0

S2(1)(! 1) = 0

S1(1)(! 2) = 2

S2(1)(! 2) = 0

S1(1)(! 3) = 0

S2(1)(! 3) = 5

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

37

EXEMPLIFYING A MARKET WITH 3 SECURITIES AND 3 STATES

The payo matrix is then the following 4

6
6
6
6 1:05
6
= 6
6
6 1:05
6
6
4

1:05

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

3 matrix:

0 :5

2 :5

3
7
7
7
7
7
7
7
7
7
7
5

38

INVESTMENT STRATEGIES

#0 is the position in the risk-free security.

#1; #2 are the positions in the two risky securities.

I
The positions represent the units of each security bought, or sold short, at
time 0.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

39

INVESTMENT STRATEGIES

#1 = 3

(buying 3 units of security 1)

initial out ow:

3 ( 0:5) =

nal in ows:

6
7
6
7
6
7
7
36
2
6
7
6
7
4
5

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

1 :5

6
7
6
7
6
7
7
= 6
6
6
7
6
7
4
5

40

INVESTMENT STRATEGIES

#0 = 10

(LENDING)

(buying 10 units of the riskless security)

initial out ow:

10 ( 1)

nal in ows:

1:05

6
6
6
10 6
6 1:05
6
4

1:05

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

10

10:5

7
6
7
6
7
6
7 = 6 10:5
7
6
7
6
5
4

10:5

3
7
7
7
7
7
7
5

41

INVESTMENT STRATEGIES

#2 =

(selling short 2 units of security 2)

initial in ow:

2 ( 2:5) =

nal out ows:

6
7
6
7
6
7
7
26
0
6
7
6
7
4
5

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

6
6
6
= 6
6
6
4

0
0
10

3
7
7
7
7
7
7
5

42

INVESTMENT STRATEGIES

#0 =

(BORROWING)

(selling short 7 units of the riskless security)

initial in ow:

7 ( 1)

nal out ows:

1:05

6
6
6
76
6 1:05
6
4

1:05

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

7
6
7
6
7
6
7 = 6
7
6
7
6
5
4

7: 35

7
7
7
7: 35 7
7
7
5

7: 35

43

INVESTMENT STRATEGIES

The generic investment strategy is a (column) vector # 2 R3:


0

#0
B
C
# = @ #1 A :
#2

Let's look at the following strategy # :


0

buying 4 units of the riskless security

B
C
B
B
C
B
B
C
B
C = B buying 5 units of security 1
= B
5
B
C
B
B
C
B
@
A
@

buying 2 units of security 2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

C
C
C
C:
C
C
A

44

INVESTMENT STRATEGIES

The market is competitive: no one has price impact.

The market is frictionless:

no indivisibilities

(#is are not only integers);

no short-selling constraint

(#is can be negative);

no trading limits

(#is are unbounded);

no margin requirements;

no bid-ask spreads;

no taxation on capital gains.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

45

THE INITIAL COST OF AN INVESTMENT STRATEGY

I
At time 0, the quantity V# (0) is the cost an investor must face to set up
the investment strategy #.

Let's assess the initial cost V# (0) for the strategy # :


0

B
C
B
C
B
C
B
= B 5 C
C:
B
C
@
A

The corresponding initial out ow is

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

V# (0) :

46

THE FINAL PROCEEDS OF AN INVESTMENT STRATEGY

I
The nal proceed V# (1) (! k ) is the time-1 cash ow in the state ! k from
liquidating the investment strategy #.

Let's assess the nal proceeds of the strategy # .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

47

THE STRATEGY FOR GIVEN FINAL PROCEEDS

Let's nd the strategy # whose nal proceeds are:


2

V (1) (! 1)
6 #
6
6
6 V (1) (! )
2
6 #
6
4
V# (1) (! 3)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0 :5

7
6
7
6
7
6
7 = 6 0 :5
7
6
7
6
5
4

0 :5

7
7
7
7:
7
7
5

48

BACK-ENGINEERING STRATEGIES

Find the strategy # whose initial cost and nal proceeds are:

V# (0) = 0;
V# (1) (! 2) = 4;
V# (1) (! 3) = 2.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

49

`FREE LUNCHES' ?

They are possible if there are:

violations of the law of one price;

arbitrage opportunities of the rst type;

arbitrage opportunities of the second type.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

50

VIOLATIONS OF THE LAW OF ONE PRICE

Two strategies have di erent costs at time 0


despite
providing the same nal proceeds in any state at time 1.

In our market M there are no such violations.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

51

ARBITRAGE OPPORTUNITIES OF THE FIRST TYPE


There is a strategy with non-positive initial cost
that
never yields negative nal proceeds
while
granting strictly-positive nal proceeds
in
at least one of the states at time 1:

In our market M there are no such opportunities.

I
For example, let's work out the initial cost of a strategy that pays o nothing
but 1 cent in the state ! 3:

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

52

ARBITRAGE OPPORTUNITIES OF THE SECOND TYPE

There is a strategy with strictly-negative initial cost


that
never yields negative nal proceeds.

In our market M there are no such opportunities.

I
For example, let's calculate the nal proceed prevailing in the state ! 3 of a
strategy that costs 10 cents and pays o nothing in the states ! 1 and ! 2.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

53

`FREE LUNCHES' ARE IMPLAUSIBLE

I
Any non-satiated investor (in the sense that she always prefers more wealth
to less) would exploit these situations.

There would be no equilibrium.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

54

THE NO-ARBITRAGE ASSUMPTION

A market satis es the no-arbitrage condition if it does not permit

violations of the law of one price;

arbitrage opportunities of the rst type;

arbitrage opportunities of the second type.

Our market

is arbitrage-free.

6
6
M =6
4

1
1:05
1:05
1:05

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0 :5
0
2
0

2 :5
0
0
5

3
7
7
7
5

55

THE RISK-NEUTRAL PROBABILITY MEASURE Q

I
A risk-neutral probability measure Q is made of K probability masses Q (! k )
such that:

Q (! k ) > 0

for any k = 1; ::::; K .

The masses are strictly-positive .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

56

THE RISK-NEUTRAL PROBABILITY MEASURE Q

2A

Q (! 1) + ::: + Q (! K ) = 1 .

The masses sum to 1 .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

57

THE RISK-NEUTRAL PROBABILITY MEASURE Q

2B

1
E Q [B (1)]
B (0) =
1+r
=

1
[Q (! 1) B (1) + ::: + Q (! K ) B (1)]
1+r

= 1 .

The masses sum to 1 .

I
For the riskless security, the price is the discounted Q-expectation of the
payo .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

58

THE RISK-NEUTRAL PROBABILITY MEASURE Q

i
h
1
Q
Sj (0) =
E Sej (1)
1+r
i
1 h
=
Q (! 1) Sj (1) (! 1) + ::: + Q (! K ) Sj (1) (! K ) ,
1+r

j = 1; :::; N .

Prices are discounted Q-expectations of payo s.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

59

WHY RISK-NEUTRAL?

The statement
h
i
1
Q
E Sej (1) ,
Sj (0) =
1+r

j = 1; :::; N ,

is equivalent to the statement


"

Sej (1) Sj (0)


Q
E
Sj (0)

= r,

j = 1; :::; N .

Q-expected returns equal the risk-free rate.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

60

WHY RISK-NEUTRAL?

I
Under Q, the initial cost of a strategy # equals the discounted Q-expectation
of its nal proceed:

h
i
1
Q
e
V# (0) =
E V# (1)
1+r

The Q-expected return from # equals the risk-free rate.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

61

THE FIRST FUNDAMENTAL THEOREM OF ASSET PRICING

The following statements are equivalent:

the no-arbitrage condition holds;

a risk-neutral probability measure Q exists.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

62

OUR ARBITRAGE-FREE MARKET ADMITS A Q

The risk-neutral probability masses are:

Q (! 1 )
6
6
6
6 Q (! )
2
6
6
4
Q (! 3 )

3
7
7
7
7
7
7
5

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0:212 5

6
6
6
6 0:262 5
6
6
4

0:525

3
7
7
7
7
7
7
5

63

A LONG FORWARD CONTRACT ON SECURITY 2

I
A long forward contract is an agreement to buy the risky security at date 1
at a pre-speci ed price (the delivery price E = 1).

The payo of the contract is


2

f (1) (! 1)
6
6
6
6 f (1) (! )
2
6
6
4
f (1) (! 3)

3
7
7
7
7
7
7
5

S (1) (! 1)
6 2
6
6
6 S (1) (! )
2
6 2
6
4
S2 (1) (! 3)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

7
7
7
E 7
7
7
5

6
6
6
6
6
6
4

7
7
7
1 7
7
7
5

64

NO-ARBITRAGE PRICING OF THE LONG FORWARD

The unique strategy that replicates the long forward payo fe (1) is
#f

2
6
4

0:952 380 95
7
0
5
1

I
The no-arbitrage price of the long forward equals the initial cost of the
replicating strategy #f :
V#f (0)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

1:547 619 1 .

65

NO-ARBITRAGE PRICING OF THE LONG FORWARD

The no-arbitrage price of the long forward is


h
i
1
Q
e
E f (1)
f (0) =
1+r
h
1
Q
E Se2 (1)
=
1+r

1:547 619 1 .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

66

NO-ARBITRAGE PRICING OF A EUROPEAN CALL

I
A European call option on the risky security 2 with strike price E = 1 is the
right to buy the risky security at date 1 at the pre-speci ed strike price.

Find its no-arbitrage price c (0).

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

67

NO-ARBITRAGE PRICING OF A EUROPEAN PUT

I
A European put option on the risky security 2 with strike price E = 1 is the
right to sell the risky security at date 1 at the pre-speci ed strike price.

Find its no-arbitrage price p (0).

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

68

THE PUT-CALL PARITY

c (0)

p (0)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

f (0)

S2 (0)

E
1+r

69

MARKET COMPLETENESS

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

70

COMPLETE MARKETS

f (1) is
A payo X

replicable

if there exists a strategy # such that

V# (1) (! k )

X (1) (! k )

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

for all k = 1; : : : ; K:

71

COMPLETE MARKETS

Our market M is
complete

if every possible payo is replicable,


2

1:05

6
6
6
6 1:05
6
6
4

1:05

for any

0
2
0

that is,

32

#
76 0 7
7
76
7
76
7
6
0 7 6 #1 7
7
7
76
5
54
#2
5

X (1) (! 1), X (1) (! 2), and

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

if there is a # such that


2

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

3
7
7
7
7
7
7
5

X (1) (! 3):

72

COMPLETE MARKETS

M is complete:

1:05
#
6
6 0 7
7
6
6
7
6
6
6 # 7 = 6 1:05
6
6 1 7
7
6
6
5
4
4
#2
1:05

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0
2
0

3 12
0
X (1) (! 1)
7
6
7
6
7
6
7
0 7 6
6 X (1) (! 2)
7
6
5
4
5
X (1) (! 3)

3
7
7
7
7
7
7
5

73

THE SECOND FUNDAMENTAL THEOREM OF ASSET PRICING

The following statements are equivalent:

Both no-arbitrage and market completeness hold;

There exists one, and only one, risk-neutral probability Q.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

74

A UNIQUE Q FOR OUR COMPLETE M

I
There is a unique triplet of strictly-positive masses Q (! 1), Q (! 2), and
Q (! 3) that meets the following constraints:

discounted Q expected nal prices


}|

1:05

6
6
6
1
6 1:05
1+0:05 6
6
4

1:05

0
2
0

3T
0
7
7
7
0 7
7
7
5

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

Q (! 1 )

6
6
6
6 Q (! )
2
6
6
4
Q (! 3 )

3
7
7
7
7
7
7
5

initial prices
}|
{
z

6
6
6
6 0 :5
6
6
4

2: 5

3
7
7
7
7
7
7
5

75

A UNIQUE Q FOR OUR COMPLETE M

The unique triplet is


2

Q (! 1 )
6
6
6
6 Q (! )
2
6
6
4
Q (! 3 )

02

3
7
7
7
7
7
7
5

B6 1:05
B6
B6
B
1:05 B6
1:05
B6
B6
@4

0
2

1:05

0:212 5

6
6
6
6 0:262 5
6
6
4

0:525

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

3T 1 1 2
1
0
6
7 C
6
7 C
6
7 C
C
7
0 7 C 6
6 0:5
C
6
7 C
4
5 A

2: 5

3
7
7
7
7
7
7
5

3
7
7
7
7
7
7
5

76

AN INCOMPLETE MARKET

The market
2

6
6
6
6 1:02
6
M0 = 6
6
6 1:02
6
6
4

1:02

0:5
0
2
0:10

7
7
7
7
7
7 ,
7
7
7
7
5

N + 1 = 2,

K = 3,

is incomplete.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

77

AN INCOMPLETE MARKET

Indeed, the payo


2

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

6
7
6
7
6
7
7 = 6 1 :5
6
7
6
7
4
5

3
7
7
7
7
7
7
5

cannot be replicated:
02

1:02

B6
B6
B6
6
det B
B6 1:02
B6
@4

1:02

0
2
0:10

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

31

7C
7C
7C
C
1:5 7
7C =
7C
5A

1: 989 .

78

OUR INCOMPLETE M 0 IS ARBITRAGE-FREE

M 0 supports many risk-neutral probability measures:

discounted Q-expected nal prices


}|

6
1
1+0:02 4

1: 02

1: 02

3 6 Q (! 1 ) 7
7
1: 02 6
7
6
76
5 6 Q (! 2 ) 7
7
7
6
0 :1
5
4
Q (! 3 )

intial prices
z }| {

2
6
4

0 :5

3
7
5

m
2
6
4

1: 02
0

7
6
5 Q (! 1 ) + 4

1: 02
2

7
6
5 Q (! 2 ) + 4

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

1: 02
0:10

7
5 Q (! 3 )

2
6

1:02 4

1
0 :5

3
7
5
79

OUR INCOMPLETE M 0 IS ARBITRAGE-FREE

2
6
4

1: 02
0

7
6
5 Q (! 1 ) + 4

1: 02
2

7
5 Q (! 2 )

2
6

1:02 4

1
0 :5

6
4

7
5

1: 02
0:10

q
z
}|
{
7
5 Q (! 3 )

m
2
6
4

1: 02
0

1: 02
2

32
76
54

Q (! 1 )
Q (! 2 )

3
7
5

2
6
4

1: 02

1:02q

0:51

0:10q

3
7
5

m
2
6
4

Q (! 1 )
Q (! 2 )

3
7
5

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

2
6
4

1: 02
0

3 12
1: 02
1: 02
7
6
5
4

0:51

1:02q
0:10q

80

3
7
5

OUR INCOMPLETE M 0 IS ARBITRAGE-FREE

We have

6
4

Q (! 1 )
Q (! 2 )

7
5

1
1:02
6
6
4

32

1
2 76
74
5
1
2

1: 02
0:51

1:02q
0:10q

3
7
5

2
6
4

0:745

0:95q

0:255

0:05q

3
7
5

with the strict-positivity constraints


8
>
Q (! 1) = 0:745
>
>
>
>
>
<

Q (! 2) = 0:255
>
>
>
>
>
>
: Q (! ) = q > 0
3

0:95q > 0
0:05q > 0

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

q 2 (0; 0:784 210 53) .

()

81

NO-ARBITRAGE PRICING OF AN UNREPLICABLE PAYOFF

The no-arbitrage prices of the unreplicable payo


2

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

6
7
6
7
6
7
7 = 6 1 :5
6
7
6
7
4
5

3
7
7
7
7
7
7
5

are
2

1 (0:745

6
6
h
i
6
1
1
Q
f
6 1:5 (0:255
E X (1) =
1+r
1:02 6
6
4

0:95q ) +
0:05q )

2 q

7
7
7
+ 7
7
7
5

= 0:95588235q + 1:1053922 .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

82

NO-ARBITRAGE PRICING OF AN UNREPLICABLE PAYOFF

The no-arbitrage prices range from

i
h
1
Q
f
inf
E X (1) =
inf
[0:955 882 35q + 1:1053922] = 1:1053922
Q 1+r
q2(0;0:784 210 53)

to

h
i
1
Q
f
sup
E X (1) =
sup
[0:955 882 35q + 1:1053922] = 1:8550052 .
Q 1+r
q2(0;0:784 210 53)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

83

WHERE DOES THE UPPER BOUND COME FROM?

h
i
1
Q
f
1: 855 005 2 = sup
E X (1)
Q 1+r

V#u (0)

where
#u = arg minV# (0) subject to V# (1) (! k )
#

X (1) (! k ) in each state k:

#u denotes a minimum-cost super-replicating strategy.

V#u (0) is

f (1)
the minimum cost of super-replicating X

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

84

f (1)
MINIMUM-COST SUPER-REPLICATION OF X

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

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

1:02 #0 + 2 #1 1:5
>
>
>
>
>
>
: 1:02 # + 0:10 #
2
0
1

the solution of which can be found graphically.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

85

f (1)
MINIMUM-COST SUPER-REPLICATION OF X
8
>
r1
>
>
>
>
>
<

r2
>
>
>
>
>
>
: r
3

1:02 #0 + 0 #1 = 1

1:02 #0 + 2 #1 = 1:5

1:02 #0 + 0:10 #1 = 2

theta_1
14
12
10
8
6

r_2

4
2

-5

-4

-3

-2

-1

10

theta_0

-2
-4

r_1

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

r_3

86

f (1)
MINIMUM-COST SUPER-REPLICATION OF X

theta_1
14

12

10

(1.5 , 8)

g
tin
a
ic
pl
e
-r
er
p
su

r_2

)
(1
X

-5

-4

-3

-2

-1

10

theta_0

-2

-4

The strategy

r_1

r_3

[#0; #1]T = [1:5; 8]T

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

f (1) .
super-replicates X
87

f (1)
MINIMUM-COST SUPER-REPLICATION OF X

The initial-cost function of any strategy # is

V#(0) = #0 + #1 0:5 .

#0
0:5 :

c
Its level curve c is the straight line #1 = 0:5

theta_1

c=0

8
7
6

g
tin
a
ic
pl
e
-r
er
p
su

r_2

4
3
2

)
(1
X

1
-5

-4

-3

-2

-1

-1

theta_0

-2
-3
-4
-5

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

r_1

r_3
c = 1.855

88

f (1)
MINIMUM-COST SUPER-REPLICATION OF X

u ]T is the point of inI


The minimum-cost super-replicating strategy [#u
;
#
0 1
tersection between r2 and r3:

Hence, we must solve the system


8
u
u
>
< 1:02 #0 + 2 #1 = 1:5

>
: 1:02 #u + 0:10 #u = 2
0
1

to obtain
2

3
u
#
6 0 7
4
5
#u
1

6
= 4

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

1: 986 58
0:263 158

3
7
5

89

WHERE DOES THE LOWER BOUND COME FROM?


h
i
1
Q
f
1: 105 392 2 = inf
E X (1)
Q 1+r

V#l (0)

where
#l = arg max
#

V# (0) subject to V# (1) (! k )

X (1) (! k ) in each state k:

#l denotes a maximum-in ow strategy that generates a liability lighter than


f (1).
X
V#l (0) is

the maximum in ow from super-replicating

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

f (1)
X

90

MAXIMUM-INFLOW SUPER-REPLICATION OF
8
>
h1 : 1:02 #0 + 0 #1 =
>
>
>
>
>
<

f (1)
X

h2 : 1:02 #0 + 2 #1 = 1:5
>
>
>
>
>
>
: h : 1:02 # + 0:10 # = 2
3
0
1
theta_1

h_3

5
4
3
2

-3.0

-2.5

-2.0

-1.5

-1.0

su

-r
er

lic

ati

ng

-X

(1

ep1

-0.5

0.5

1.0

-1

1.5

2.0

2.5

3.0

theta_0

-2

h_2

-3

h_1

-4
-5

The strategy

[#0; #1]T = [ 0:25;

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0:5]T

super-replicates

f (1) .
X

91

f (1)
X

MAXIMUM-INFLOW SUPER-REPLICATION OF

The initial-in ow function of any strategy # is


f#(0) =

#0

#1 0 : 5

Its level curve f is the straight line

theta_1

V#(0)
#0
0:5 :

f
0:5

#1 =

).

5
4
3

g
tin
a
ic
p1l
e
-r
er
p
su

)
(1
-X

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.5

1.0

1.5

2.0

2.5

3.0

theta_0

-1

h_3

-2
-3

h_1

-4

h_2
f = 1.10539
f=0

-5

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

92

MAXIMUM-INFLOW SUPER-REPLICATION OF

f (1)
X

I
The liability-type strategy [#l0; #l1]T is the point of intersection between h1
and h2:
I

Hence, we must solve the system


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

1:02 #l0 + 2 #l1 =

1
1 :5

to obtain
2

3
l
#
6 0 7
4
5
#l1

6
= 4

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0:980 392
0:25

3
7
5

93

REPLICABLE PAYOFFS ADMIT A UNIQUE NO-ARBITRAGE PRICE

Consider the following replicable payo :


2

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

2: 04

7
6
7
6
7
6
7 = 6 4: 04
7
6
7
6
5
4

2: 14

3
7
7
7
7
7
7
5

Its no-arbitrage price does not depend on q :

h
i
1
Q
f
E X (1)
1+r

0:745

6
6
1 6
6 0:255
1:02 6
6
4

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

3T
0:95q
7
7
7
0:05q 7
7
7
5

2: 04

6
6
6
6 4: 04
6
6
4

2: 14

3
7
7
7
7
7
7
5

2: 5 .

94

OPTIMIZATION:

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

AN

INTRODUCTION

95

WEALTH ALLOCATION AND FINAL WEALTH

I
An investor allocates her initial wealth of 100 between a riskless security
( its net return is r ) and a risky security ( its net return is re ).
I

The proportion of initial wealth allocated to the risky security is w

The nal wealth achieved with the allocation w is

f
W

100 ( 1

w ) (1 + r)

100 ( (1 + r)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

w (re

100 w (1 + re)
r) ) .

96

PORTFOLIO RETURNS AND BORROWING

The portfolio based on the allocation w yields a net return of

f
W

100
=
100

r + w (re

r) .

I
If the investor invests more than her initial wealth in the risky security
(w > 1), she needs to borrow:

| 1 {z w }

<

0 .

proportion allocated to the riskless security

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

97

THE RETURN ON THE RISKLESS SECURITY

Assume for now that

0% .

Hence, a purely riskless allocation (w = 0) implies

f
W

100

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

with

probability

1.

98

THE RETURN ON THE RISKY SECURITY

re

If

8
>
< g = 30%
>
: b

10%

0:25 ,

with probability mass

the expectation is

E [ re ]

with probability mass

0% .

Hence, a purely risky allocation (w = 1) implies

f
W

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

100 .

99

THE INVESTOR IS RISK AVERSE

I
If the investor were to pursue a purely riskless allocation (w = 0), she would
f = 100 (with probability 1)
get the following utility out of the nal wealth W

U ( 100 )

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

log ( 100 ) .

100

THE INVESTOR IS RISK AVERSE

I
If the investor were to pursue a purely risky allocation (w = 1), she would
f = 100 ( 1 + re ):
get the following expected utility out of the nal wealth W
E [ log ( 100 (1 + re) ) ]

0:25

<

log ( 0:25

log ( 100 ) .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

log ( 130 )

130

0:75

0:75

log ( 90 )

90 )

101

THE INVESTOR IS RISK AVERSE

(expected) utility

p=1

4.86
4.84

4.82

(W

4.80

(W

4.76

)]

lo
g

4.78

4.74

[l
og

4.72

4.70
4.68
4.66
4.64

log ( 100 )

4.62
4.60

p = 0.25

4.58
4.56
4.54
4.52

p=0

4.50
70

75

80

85

90

95

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

100

105

110

115

120

125

130

135

140

145

150

wealth W

102

THE RETURN ON THE RISKLESS SECURITY

Assume

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

2% .

103

A POSITIVE RISK PREMIUM ON THE RISKY SECURITY

Consider

10%

0 :5

so that the risk premium is

E [ re ]

2%

8% .

The standard deviation of the risky return is

std [ re ]
Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

20% .

104

OPTIMAL ALLOCATION WITHOUT PORTFOLIO CONSTRAINTS

Recall that the nal wealth is

f
W

100 ( ( 1 + r )

The optimal allocation is

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

+ w ( re

arg max E
w

r) ) .

log

f
W

105

OPTIMAL ALLOCATION WITHOUT PORTFOLIO CONSTRAINTS

242:86%

()

h
8
d
>
>
>
dw E
>
>
>
>
>
>
>
>
>
>
>
>
>
>
h
<
d E
dw
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
h
>
>
d
:
dw E

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

log

f
W

log

f
W

log

f
W

i
i
i

>0

w=w

<0

for w < w

=0

(stationarity)

for w > w

106

OPTIMAL ALLOCATION WITHOUT PORTFOLIO CONSTRAINTS

Recall that

f is always strictly positive:


w must be such that the nal wealth W

log x

8
>
100 ( (1 + r) + w (g
>
>
<
>
>
>
:

100 ( (1 + r) + w (b

is a real number only if

x>0 .

r) ) = 102 + w28 > 0


()
r ) ) = 102

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

w2

51 17
;
14 2

w12 > 0

107

OPTIMAL ALLOCATION WITHOUT PORTFOLIO CONSTRAINTS

h
d
E
log
dw

f
W

1
2

1
28
102 + w28

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

1
2

1
102

w12

12 )

108

OPTIMAL ALLOCATION WITHOUT PORTFOLIO CONSTRAINTS

1
2

1
28
102 + w28

1
2

1
102

w12

12 )

14 ( 102
w 12 )
( 102 + w 28) ( 102

6 ( 102 + w 28)
w 12 )

816
336 w
( 102 + w 28) ( 102
Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

w 12 )

0
109

OPTIMAL ALLOCATION WITHOUT PORTFOLIO CONSTRAINTS

816
( 102 + w28 )

336w
( 102 w12 )

The denominator is striclty positive for

The numerator is non-negative for


17
7

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

w2

w2(

51 ; 17
14 2

1; 17
7 ]

with

242:86% :

110

OPTIMAL ALLOCATION WITHOUT PORTFOLIO CONSTRAINTS

expected utility

5.0

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

-5

-4

-3

-2

-1

1
-0.5

w*

10

allocation w

-1.0

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

111

WITH A PORTFOLIO CONSTRAINT ( w

1)

The investor cannot borrow to allocate more than 100 into the risky security:
= 1

expected utility

-5

-4

-3

-2

-1

10

allocation w

-1

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

112

WITH A PORTFOLIO CONSTRAINT ( w

1)

The portfolio constraint is binding at the optimum:

8
>
>
>
>
>
>
>
<
>
>
>
>
>
>
>
:

d E
dw

f
W

log

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

w=w

>

113

WITH A PORTFOLIO CONSTRAINT ( w

Let's introduce the Lagrangian function

L (w; l)

1)

log

f
W

l (w

1) .

l is the Lagrange multiplier with

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0 .

114

WITH A PORTFOLIO CONSTRAINT ( w

1)

Let's use the Lagrangian function to re-express the optimality conditions:

8
@ L
>
>
>
@w
>
w=w ; l=l
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
l
0
>
>
>
>
>
<

>
>
>
>
>
>
@ L
>
>
0
>
@l
>
w
=
w
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
@ L
>
: l
= 0
@l
w=w

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

=)

8
h
i
d
f
>
>
E
log
W
>
dw
>
w=w
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
l = 0:041026 > 0
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
:

(w

= 0

1) = 0

(w

1) ) = 0
115

WITH A PORTFOLIO CONSTRAINT ( w

I
If the constraint is relaxed ( say to w
utility goes up by

h
d
E
log
dw

f
W

1)

1:01 ), the optimized expected

0:01

0:01 .

w=w

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

116

WITH A PORTFOLIO CONSTRAINT ( w

1)

expected utility 4.6850

4.6845

4.6840

about 0.00041

4.6835

4.6830

4.6825

4.6820
0.960

0.965

0.970

0.975

0.980

0.985

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0.990

0.995

1.000

1.005

1.010

1.015

1.020

1.025

1.030

1.035

1.040

allocation w

117

WITH A PORTFOLIO CONSTRAINT ( w

The Lagrange multiplier

( optimized-expected-utility gain

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

is

1)

shadow price

0:041026 .

per

unit of constraint relaxation )

118

UNCONSTRAINED OPTIMIZATION

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

119

A PROFIT FUNCTION

I
A rm produces two outputs x and y (they can be sold at the xed prices
20 and 30, respectively).

The production costs are quadratic:

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

2xy + 20 .

The pro t function remains quadratic:

P (x; y ) = 20x + 30y

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

x2 + 2 y 2

2xy + 20

120

P 'S LEVEL CURVES

I
The level curve p = 300
pro t P (x; y ) equals 300.

is the set of output pairs (x; y ) such that the

y 70
60

50

40

30

20

10

0
0

10

20

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

30

40

50

60

70

121

P 'S LEVEL CURVES

The level curve

p = 600

is in black

y 70
60

50

40

30

20

10

0
0

10

20

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

30

40

50

60

70

122

P 'S LEVEL CURVES

I
The level curve p = 705
is the singleton (x = 35; y = 25), which is
the maximum-pro t production in the absence of constrains.

y 70
60

50

40

30

20

10

0
0

10

20

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

30

40

50

60

70

123

FIRST PARTIAL DERIVATIVE WITH RESPECT TO x

P (35 + h; 25)
Px (35; 25) = lim
h!0
h

P (35; 25)

= 0

It is the slope of P 's graph in (x = 35; y = 25) along the direction (x; y = 25)

700
650
600

profit level z

550
20

28

22

30
32

24

output y

34
26

36
38

28

40
30

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

output x

42

124

FIRST PARTIAL DERIVATIVE WITH RESPECT TO x

Px (35; 25)

@
20x + 30y
@x

(20

x2

2y 2 + 2xy

20
( x=35; y=25 )

2x + 2y )j ( x=35; y=25 )

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

125

FIRST PARTIAL DERIVATIVE WITH RESPECT TO y

P (35; 25 + k)
Py (35; 25) = lim
k!0
k

P (35; 25)

= 0

It is the slope of P 's graph in (x = 35; y = 25) along the direction (x = 35; y )

700
650
600

profit level z

550
20

28

22

30
32

24

output y

34
26

36
38

28
30

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

output x

40
42

126

FIRST PARTIAL DERIVATIVE WITH RESPECT TO y

Py (35; 25)

@
20x + 30y
@y

(30

x2

2y 2 + 2xy

20
( x=35; y=25 )

4y + 2x)j ( x=35; y=25 )

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

127

THE (NECESSARY) FIRST-ORDER CONDITIONS FOR OPTIMALITY

I
P : X
(x ; y ) 2 X .

R2

! R admits

rst partial derivatives at the interior point

I
If P has a local/global maximum at the interior point (x ; y ), then (x ; y )
is a stationary point for P :

Px ( x ; y )

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

Py ( x ; y )

0 .

128

THE HESSIAN MATRIX

I
If P : X
R2 ! R admits second partial derivatives at the interior
point (x0; y0) 2 X , then P 's Hessian matrix at (x0; y0) is
2
6
4

Pxx (x0; y0)


Pyx (x0; y0)

Schwartz's Theorem:

In our case, the Hessian is

Pxy (x0; y0)


Pyy (x0; y0)

3
7
5

Pxy (x0; y0) = Pyx (x0; y0) .

2
6
4

2
2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

2
4

3
7
5

129

TAYLOR'S FORMULA STOPPED AT THE SECOND ORDER

I
Given any point (x0; y0), our quadratic pro t function can be re-expressed
as follows:

P (x; y )

P ( x0 ; y 0 )

Px (x0; y0)

(x

x
1 6
4
2
y

x0 )

Py (x0; y0)

3T 2
x0
Pxx (x0; y0)
7
6
5
4
y0
Pyx (x0; y0)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

(y

Pxy (x0; y0)


Pyy (x0; y0)

y0 )
3
7
5

2
6
4

x
y

x0
y0

3
7
5

130

P 'S HESSIAN AT THE MAX. POINT (x = 35; y = 25)

P (x; y )

705

0 (x

35)

1
2

6
4

<0

for

x
y

any

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0 (y

3T 2
35
7
6
5
4

25

x 6= 35

25)

2
2
or

( stationarity )

2
{z

3
7
5

y 6= 25

2
6
4

x
y

35
25

3
7
5

(negative de nite)

131

P 'S HESSIAN AT THE MAX. POINT (x = 35; y = 25)

Pxx (x ; y )

02
B6

det @4

Pxx (x ; y )
Pyx (x ; y )

Pxy (x ; y )
Pyy (x ; y )

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

31
7C
5A

<

02
B6

det @4

2
2

2
4

31

7C
5A = 4 > 0

132

THE (SUFFICIENT) SECOND-ORDER CONDITIONS FOR A LOCAL


MAXIMUM

I
P :X
R2 ! R admits continuous rst and second partial derivatives
in an open ball of the interior point (x ; y ) 2 X .

If (x ; y ) is a stationary point for P and if

P 's Hessian matrix at (x ; y ) is negative de nite,

equivalently, Pxx (x ; y ) < 0 and


02

B6
det @4

Pxx (x ; y )

Pxy (x ; y )

Pyx (x ; y )

Pyy (x ; y )

31

7C
5A > 0

then (x ; y ) is a local maximum point for P .


Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

133

CONVEX SETS

I
X R2 is convex when the segment that connects two arbitrary points of
the set does not lie outside the set.

R2 is strictly convex (the connecting segment lies strictly inside R2).

( x; y ) 2 R

: x

0 ^ y
y

is convex:

here

-2

-1

-1

-2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

134

P 'S STRICT CONCAVITY

I
P : X R2 ! R is strictly concave in its strictly convex domain X when
the segment that connects two arbitrary points of P 's graph lies strictly below the
graph.

600
400

profit level z

200

20
0
0

40

10
20
30

output y

60

output x

40
50
60 80

20x + 30y

x2 + 2 y 2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

2xy + 20

is strictly concave.

135

P 'S STRICT CONCAVITY

I
P : X
R2 ! R is strictly concave in its strictly convex domain X
if and only if the non-empty sets f (x; y ) 2 X : P (x; y )
a g are strictly
convex .

y 50

level 300

40

level 600

30

level 700

20

10

0
0

20x + 30y

10

20

x2 + 2 y 2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

30

40

2xy + 20

50

60

70

is strictly concave.
136

P 'S STRICT CONCAVITY

I
Assume that P : X
R2 ! R is twice derivable in all the points of its
open and strictly convex domain X .
I
P is strictly concave in X if and only if the Hessian matrix is negative
de nite in any point of X .

20x + 30y

x2 + 2 y 2

its Hessian 4

2
2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

2
4

7
5

2xy + 20

is strictly concave:

is always negative de nite.

137

STRICT CONCAVITY

P :X

AND

THE UNIQUE GLOBAL MAXIMUM

R2 ! R is strictly concave in its strictly convex domain X .

I
If a local maximum point exists for P , it is also of global maximum and
unique.

600
400

profit level z

200

20
0
0

40

10
20
30

output y

60

output x

40
50
60 80

(35; 25) is the unique global maximum point.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

138

C 'S STRICT CONVEXITY

I
C : X R2 ! R is strictly convex in its strictly convex domain X when
the segment that connects two arbitrary points of C 's graph lies strictly above the
graph.

100
80
60

cost level z

40
20
0
10

15

8
10

6
4

output y

5
2
0

The cost function

C (x; y )

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

output x

x2 + 2 y 2

2xy + 20

is strictly convex.
139

C 'S STRICT CONVEXITY

I
C : X
R2 ! R is strictly convex in its strictly convex domain X if
and only if
C is strictly concave there.

0
-20
-40

-60
-80
-100
10

15

8
10

6
4

5
2
0

x2 + 2 y 2

2xy + 20

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

is strictly concave.
140

C 'S STRICT CONVEXITY

I
C : X R2 ! R is strictly convex in its strictly convex domain X if and
only if the non-empty sets f (x; y ) 2 X : C (x; y )
a g are strictly convex .

y 10

level 120

level 80

8
7
6

level 40

5
4
3
2
1
0
0

x2 + 2 y 2

2xy + 20

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

10

11

12

13

14

15

is strictly convex.

141

MAXIMIZATION WITH EQUALITY CONSTRAINTS

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

142

RECALLING THE COST FUNCTION

I
A rm produces two outputs x and y (they can be sold at the xed prices
20 and 30, respectively) and its cost function is:

C (x; y )

x 2 + 2y 2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

2xy + 20 .

143

A COST CONSTRAINT THAT DEFINES AN IMPLICIT FUNCTION

I
The output pair (x = 10; y = 10) commands a cost of 120. In a neighborhood of x = 10, the cost constraint

C (x; y ) = 120

implies the existence of a unique function

y =

( x)

such that

10 =

(10)

and

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

d
dx

C x ( x; (x) )

( x) =

.
C y ( x; (x) )

144

A COST CONSTRAINT THAT DEFINES AN IMPLICIT FUNCTION

output y
14

( 10 , 10 )

12
10
8
6
4
2

-5

-4

-3

-2

-1

10

11

12

13

14

15

16

17

18

-2

(10)

20

( level curve ) cost = 120

-4

10 =

19

output x

and

d
dx

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

C x ( 10; 10 )

( x)

x = 10

= 0
C y ( 10; 10 )

145

PROFIT MAXIMIZATION WITH A COST CONSTRAINT

The rm's pro t is

P (x; y )

20x + 30y

C (x; y )

The optimization problem is

max P (x; y )
x; y

subject to

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

C (x; y ) = a

146

PROFIT MAXIMIZATION WITH A COST CONSTRAINT

From the constraint equation

C (x; y )

we can work out y from x via the implicit function

By plugging y =

( x) :

(x) into P , the problem becomes:

max P ( x;
x

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

( x) ) .

147

PROFIT MAXIMIZATION WITH A COST CONSTRAINT

I
If P ( x; (x) )
must be stationary:

exhibits an interior extremum point, then such a point

dP
d
= Px + Py
=0
dx
dx
m
Px
=
Py

d
dx

m
Px
=
Py

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

Cx
Cy

148

PROFIT MAXIMIZATION WITH A COST CONSTRAINT

The necessary condition for optimality

Px = Py

Cx = C y

holds if and only if there exists a real number


such that

Px

l Cx

Py

l Cy

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

(the

Lagrange multiplier )

149

PROFIT MAXIMIZATION WITH A COST CONSTRAINT

By introducing the Lagrangian function

L (x; y; l; a)

P (x; y )

l (C (x; y )

a) ;

the necessary condition for optimality and the constraint can be expressed as
follows (stationarity for L):

8
>
Lx =
>
>
>
>
>
<

Ly
>
>
>
>
>
>
: L
l

=
=

Px

lCx

= 0

Py

lCy

= 0

(C

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

a) = 0

(constraint)
150

PROFIT MAXIMIZATION WITH A COST CONSTRAINT

8
>
Lx = 0
>
>
<
>
>
>
:

Ly = 0

x 2 + 2y 2
|

20

2x + 2 y

l (2x

2y ) = 0
,

30

4y + 2 x

2x y + 20
{z

Ll = 0

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

l (4y

=0
}

2 x) = 0

8
>
x
>
>
>
<
>
>
>
>
: y

8
>
725
>
>
l
=
+
>
a 20
>
>
<
>
>
>
>
>
>
: l =

1
2

35
= l+1

25
= l+1

(select)

(discard)

725 2
a 20

151

PROFIT MAXIMIZATION WITH A COST CONSTRAINT

725
a 20

35
l +1

25
l +1

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

1
2

35

25

20
725

20
725

1
2

1
2

152

PROFIT MAXIMIZATION WITH A COST CONSTRAINT

L (x ; y ; l ; a )

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

P (x ; y )

l (C (x ; y )
|

{z

= 0

a)

P (x ; y )

1
(725) 2

(a

1
20) 2

a .

153

THE LAGRANGE MULTIPLIER l

d P
da

( x ; y

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

IS A

d
da

SHADOW PRICE

725
a 20

1
(725) 2

1
2

(a

1
20) 2

154

THE LAGRANGE MULTIPLIER l

IS A

SHADOW PRICE

If we x the cost constraint at a = 120 , then the shadow price is

1:6926 .

I
The rm is willing to surrender up to 1:6926 cents of pro ts to obtain a
1-cent relaxation of the cost constraint ( da = 0:01 ):

d
P( x ; y
da

0:01

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0:01

'

1:6926 cents .

155

GRAPHICAL ANALYSIS WITH

a = 120

I
The optimal production is x = 12:9987 and y = 9:2848. The constrainedmaximum pro t is P (x ; y ) = 418: 5165:

( level curve ) profit = 418.52

output y
14

12

10

-5

-4

-3

-2

-1

10

11

12

13

14

15

16

17

18

19

20

output x

-2

-4

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

( constraint ) cost = 120

156

GRAPHICAL ANALYSIS WITH

a = 120

I
At the point (x ; y ) there is tangency
level curve and the maximum-pro t level curve:
P x (x ; y ) = P y (x ; y )

between the constrained-cost

C x (x ; y ) = C y (x ; y )
( level curve ) profit = 418.52

output y
14

12

10

-5

-4

-3

-2

-1

10

11

12

13

14

15

16

17

18

19

20

output x

-2

-4

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

( constraint ) cost = 120

157

OPTIMIZATION WITH INEQUALITY CONSTRAINTS

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

158

THE PORTFOLIO RETURN

The portfolio return is


rep

w1 re1 + w2 re2 + (1

w1

wj

fraction of initial wealth in the risky asset

rej

net return on the the risky asset

net return on the riskless asset .

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

w2 ) r

( j = 1; 2 ) ,

( j = 1; 2 ) ,

159

THE EXPECTED RETURN ON A PORTFOLIO

The expectation

E [ rep ]

is

T (w 1 ; w 2 )

r + w1 ( r1

rj

E rej

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

r ) + w2 ( r2

r) ,

( j = 1; 2 ) .

160

T 'S LEVEL CURVES

The allocation pairs (w1; w2) such that T (w1; w2) = 8%

are in black.

w_2
1.4
1.2
1.0
0.8
0.6
0.4
0.2
-1.4

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.2

0.4

0.6

-0.2

0.8

1.0

1.2

1.4

w_1

-0.4
-0.6
-0.8
-1.0
-1.2
-1.4

r1 = 12%; r2 = 8%; r = 2%:

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

161

T 'S LEVEL CURVES

The allocation pairs (w1; w2) such that T (w1; w2) = 10%

are in black.

w_2
1.4
1.2
1.0
0.8
0.6
0.4
0.2
-1.4

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

0.2

0.4

0.6

-0.2

0.8

1.0

1.2

1.4

w_1

-0.4
-0.6
-0.8
-1.0
-1.2
-1.4

r1 = 12%; r2 = 8%; r = 2%:

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

162

VARIANCES

AND

V ar rej

Cov [ re1 , re2 ] = (

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

CORRELATION

2
j

( j = 1; 2 )

163

THE VARIANCE OF A PORTFOLIO RETURN

The variance V ar (rep) is

V (w 1 ; w 2 )

3T
w1
6
7
4
5

w2

2w2
1 1

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

2
6
4

+ 2

2
1

1 2

1 2

2
2

1 2 w1 w2

3
7
5

2
6
4

w1
w2

3
7
5

2w2
2 2

for any portfolio choice (w1; w2) .

164

V 'S LEVEL CURVES

I
The allocation pairs (w1; w2) such that
black.

V (w1; w2) = (20%)2

are in

w_2
1

-1

w_1

-1

= 30%,

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

= 20%,

0 :5

165

V 'S LEVEL CURVES

I
The allocation pairs (w1; w2) such that
black.

V (w1; w2) = (10%)2

are in

w_2
1

-1

w_1

-1

= 30%,

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

= 20%,

0 :5

166

V 'S LEVEL CURVES

The allocation pair (w1; w2) such that


w1 = 0 ; w 2 = 0 .

V (w 1 ; w 2 ) = 0

is the point

w_2
1

-1

w_1

-1

= 30%,

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

= 20%,

0 :5

167

MAXIMIZING THE RISK-ADJUSTED EXPECTED RETURN

The investor's risk aversion is measured by the parameter

The risk-adjusted expected return on the portfolio is

J (w 1 ; w 2 )

1
A > 0

A
V (w 1 ; w 2 ) .
2

T (w 1 ; w 2 )

The problem is

max J (w1; w2)

w1 ; w 2

sub

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

( total risk exposure must not exceed q )


z
}|
{

w1

w2

168

MAXIMIZING THE RISK-ADJUSTED EXPECTED RETURN

I
If q = 3 , the constraint is painless and not binding with w1 = 107:4%
and w2 = 155:6% (the shadow price of the constraint is l = 0).
w_2

J's level curves

he

-1.0

-0.5

w_
1

re

0.5

+w

_2
=

1.0

1.5

2.0

2.5

3
3.0

w_1

-1

A=2 ;

= 30%;

= 20%;

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0:5; r1 = 12%; r2 = 8%; r = 2%:

169

MAXIMIZING THE RISK-ADJUSTED EXPECTED RETURN

I
Given L (w1; w2; l) = J (w1; w2)
l (w1 + w2 q ) , the rst-order
conditions for constrained optimality can be written a la Kuhn-Tucker :
8
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
<

>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
l
>
>
>
:

L w1

w1 ; w 2 ; l

= 0

L w2

w1 ; w 2 ; l

= 0
q=3

Ll

w1 ; w 2 ; l

0
0

Ll

w1 ; w 2 ; l

= 0

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

=)

8
>
>
>
>
>
>
J w1
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
J w2
>
>
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
:

w1 ; w 2 ;

= l

w1 ; w 2 ;

= l

w1 + w2

l = 0
3 < 0

170

MAXIMIZING THE RISK-ADJUSTED EXPECTED RETURN

The

8
>
>
<
>
>
:

The

feasibility

conditions are:

l
Ll

w1 ; w 2 ; l

( w1 + w2

complementary slackness

Ll

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0 )

condition is:

w1 ; w 2 ; l

171

MAXIMIZING THE RISK-ADJUSTED EXPECTED RETURN

I
If q = 1 , the constraint is painful and binding with w1 = 47:4% and
w2 = 52:6% (the shadow price of the constraint is l = 4:63%).
w_2

w_
1+

J's level curves


w_
2=

[ 1.074 , 1.556 ]

1
1

he
-1.0

-0.5

re

0.5

1.0

1.5

2.0

2.5

3.0

w_1

-1

A=2 ;

= 30%;

= 20%;

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

0:5; r1 = 12%; r2 = 8%; r = 2%:


172

MAXIMIZING THE RISK-ADJUSTED EXPECTED RETURN

I
Given L (w1; w2; l) = J (w1; w2)
l (w1 + w2 q ) , the rst-order
conditions for constrained optimality can be written a la Kuhn-Tucker :
8
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
<

>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
l
>
>
>
:

L w1

w1 ; w 2 ; l

= 0

L w2

w1 ; w 2 ; l

= 0
q=1

Ll

w1 ; w 2 ; l

0
0

Ll

w1 ; w 2 ; l

= 0

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

=)

8
>
>
>
>
>
>
J w1
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
J w2
>
>
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
:

w1 ; w 2

= l

w1 ; w 2

= l

w1 + w2

> 0

1 = 0

173

STOCK PRICING

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

174

THE DIVIDEND PROCESS

I The current date is t


I The stock pays out the dividend Xdt every `second' (a period of length dt)

I The dynamics of the dividend process is

dX =

a (X; t) dt
|

{z

b (X; t) dz
|

expected change Et [dX ]


where dz is Gaussian with Et [dz ] = 0 and Et

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

{z

unexpected change
h

dz 2

= dt

175

A FUNCTION OF THE DIVIDEND X AND ITS DYNAMICS

I S (X ) is a function of X

I Given the notation


d
SX =
S
dX

d2
SXX =
S ,
2
dX

and

we have
1
dS = SX dX + SXX b2dt
2

1
SX a + SXX b2
2 {z
|

dt
}

expected change Et [dS ]

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

S
b dz
| X {z }

unexpected change

176

EQUILIBRIUM STOCK PRICING

I The stock price is S (X )


I The per-annum expected total gain on the stock is
1
Et [dS ]
dt

+ X

expected capital gain + income gain

I In equilibrium, the following restriction holds true:


1 E [dS ]
dt t

+ X

Sr + SX b

I Sr is the cost of borrowing expressed in Euro (r is the riskfree rate)


I SX b

is the risk premium expressed in Euro

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

177

EQUILIBRIUM STOCK PRICING

I SX b

is the equity risk expressed in Euro

is the premium per unit of systematic risk

is the fraction of equity risk that is systematic.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

178

TRENDING DIVIDENDS

I X 's dynamics is
dX = X

dt + X

dz

I X is expected to grow at the rate

IX=0

is an absorbing boundary

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

179

STOCK PRICING WITH TRENDING DIVIDENDS

I The equilibrium restriction is


1
SX X + SXX X 2 2 + X
2{z
|
}

Sr + SX X

1 E [dS ]
= dt
t

I If X = 0, the stock is worthless (it is unable to generate dividends):


S (0)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

(boundary condition)

180

STOCK PRICING WITH TRENDING DIVIDENDS

I The solution is
S (X ) =

(non-negative and meaningful i

r+

r+

> 0)

I Given the parabola


y( )

1 2 2
+
2

1 2
2

we impose

y (1)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

(r +

<

181

STOCK PRICING WITH TRENDING DIVIDENDS

I The elasticity of S (X ) with respect to X is


SX
X = 1
S

0
@

1
dS
S A
dX
X

I A 1% change in the dividend implies a 1% change in the stock price

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

182

STOCK PRICING WITH TRENDING DIVIDENDS

I The total return on the stock is

dS

+
S

Xdt

r +
|

SX X
S

{z
expected total return

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

dt
}

SX X
S

dz

|
{z
}
unexpected total return

183

STOCK PRICING WITH TRENDING DIVIDENDS

I The per-annum expected total return on the stock is

1 1
Et [dS ]
dt S

X
S

r +

r +

| {z }
per-annum dividend yield

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

SX
X
S

184

THE EXPECTED TOTAL RETURN ON A PORTFOLIO

I Our initial capital is H = 100 Euro. We invest 60 Euro in the stock and
40 Euro in the riskfree asset

I The per-annum expected total gain is


1
Et [dH ]
dt

60 1
Et [dS ] + X
S dt

60 (r +

+ 40r

+ 40r

I The per-annum expected total return is


1 1
Et [dH ]
dt H

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

r +

60
100

185

RATIONAL BUBBLES

I Another solution to
1
SX X + SXX X 2 2 + X
2

Sr + SX X

with

S (0) = 0

is given by
S (X )

r+
|

{z
}
fundamental value

c X

{z
}
bubble

positive constant

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

1
+
2

"

1
2

+2 2

#1
2

>

186

RATIONAL BUBBLES

I The elasticity of S (X ) with respect to X is `excessive':

SX
X
S

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

( 1
S

1) cX

>

187

THE COEFFICIENT

I Given the parabola


y (1)

y ( ) = 12 2 2 +

(r +

<

1 2
2

and

y ( 1)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

_1
ma
gam

- ( r + sigma*lambda*rho - mu ) < 0

we have

gamma

188

`POWER' STOCK PRICING

I The stock that pays out X 2dt every `second' has the following equilibrium price:

P (X ) =

X2
r+2

2 + 2

I Given the parabola


y( )

1 2 2
+
2

1 2
2

we impose

y (2)

r+2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

2 + 2

<

189

`POWER' STOCK PRICING

I The total return on the stock is

dP

+ X 2dt
P

r +
|

PX X
P

dt

{z
expected total return

(r + 2

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

) dt

PX X
P

dz

|
{z
}
unexpected total return

2 dz

190

MEAN-REVERTING DIVIDENDS

I X 's dynamics is
dX =

k (X

m) dt + X

dz

I The long-run mean is E [X ] = m > 0


I k > 0 is the speed of mean reversion
I If k ! +1, X remains xed at the level m

I X = 0 is a re ecting boundary

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

191

STOCK PRICING WITH MEAN-REVERTING DIVIDENDS

I The per-annum expected capital gain is


1
Et [dS ]
dt

SX ( k (X

1
m)) + SXX X 2 2
2

I The equilibrium stock price solves


1
Et [dS ] + X
dt

Sr + SX X

and is
S (X ) =

m
k
X
+
r r+
+k r+
+k

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

192

STOCK PRICING WITH MEAN-REVERTING DIVIDENDS

I The absence of mean reversion brings us back to the trending-dividends case


(without growth):
X
lim S (X ) =
k!0
r+

I A massive mean reversion brings us back to the riskless case (without growth):
lim S (X ) =

k!+1

I Systematic risk and risk aversion (


E [ S (X ) ]

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

m
r

> 0) do have a long-run impact:


m
k+r
r r+
+k

<

m
r
193

APPENDIX

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

194

THE CAPITAL ASSET PRICING MODEL

I The stock market portfolio is worth M with dynamics


dM + XM dt

M (r +

) dt

I The premium for systematic risk (expressed in Euro) is M

M dzM

I The CAPM states


1
Et [dM ] + XM
dt

Mr

+
|

covt [dM; dM ]
vart [dM ]
{z

`beta' equal to 1

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

195

THE CAPITAL ASSET PRICING MODEL

I For the single stock, the CAPM states


1
Et [dS ] + X =
dt

Sr

+
|

covt [dS; dM ]
vart [dM ]
{z

M
}

X b
`beta' equal to SM

Sr

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

SX b

196