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You are on page 1of 9

1. You are invested in two hedge funds. The probability that hedge fund Alpha gen-

erates positive returns in any given year is 60%. The probability that hedge fund

Omega generates positive returns in any given year is 70%. Assume the returns are

independent. What is the probability that both funds generate positive returns in a

given year? What is the probability that both funds lose money?

Solution: Probability that both generate positive returns = 60% 70% = 42%.

Probability that both funds lose money = (160%)(170%) = 40%30% = 12%.

2. Corporation ABC issues $100 million of bonds. The bonds are rated BBB. The

probability that the rating on the bonds is upgraded within the year us 8%. The

probability of a downgrade is 4%. What is the probability that the rating remains

unchanged?

Solution: The sum of all three events upgrade, downgrade, and no change, must

sum to one. There is no other possible outcome. 88% + 8% + 4% = 100%.

c(100 x2 ) for 10 x 10

f (x) =

0 otherwise

Solution: Given the density function, we can find c by noting that the sum of

probabilities must be equal to one:

Z Z 10 10

2 1 3

f (x)dx = c(100 x )dx = c 100x x =1

10 3 10

3

c=

4, 000

4. Given the probability density function, F (x), for 0 x 10:

x

F (x) = (20 x)

100

Check that this is a valid CDF; that is, show that F (0) = 0 and F (10) = 1. Calculate

the probability density function, f (x).

Solution:

Calculate the value of the CDF for minimum and maximum values of x:

F (0) = 0

F (10) = 1

Seminar 4 / June 3, 2015 Valuation of International Financial Assets

d 20 2x 1

f (x) = F (x) = = (10 x)

dx 100 100 50

c

f (x) =

x

where 1 x e. Calculate the cumulative distribution function, F (x), and solve

for the constant c.

Solution: Calculate the CDF by integrating the PDF:

Z x Z x

c

F (x) = f (t)dt = dt = c[ln(t)]x1 = cln(x)

1 1 t

The CDF is expressed as:

F (x) = ln(x)

6. You own two bonds. Both bonds have a 30% probability of defaulting. Their default

probabilities are statistically independent. What is the probability that both bonds

default? What is the probability that only one bond defaults? What is the probability

that neither bond defaults?

Solution:

P[both bonds default] = 30% 30% = 9%

P[one defaults] = 2 30% (1-30%) = 42%

P[neither defaults] = (1-30%)(1-30%) = 49%

7. Your firm forecasts that there is a 50% probability that the market will be up signif-

icantly next year, a 20% probability that the market will be down significantly next

year, and a 30% probability that the market will be flat, neither up or down signif-

icantly. You are asked to evaluate the prospects of a new portfolio manager. The

manager has a long bias and is likely to perform better in an up market. Based on

past data, you believe that the probability that the manager will be up if the market

is up significantly is 80%, and that the probability that the manager will be up if

the market is down is only 10%. If the market is flat, the manager is just as likely

to be up as to be down. What is the unconditional probability that the manager is

up next year?

Solution:

Seminar 4 / June 3, 2015 Valuation of International Financial Assets

Using M to represent the market and X to represent the portfolio manager, we are

given the following information:

P [Mup ] = 50%

P [Mdn ] = 20%

P [Mf lat ] = 30%

P [Xup |Mup ] = 80%

P [Xup |Mdn ] = 10%

P [Xup |Mf lat ] = 50%

+ P [Xup |Mf lat ] P [Mf lat ]

P [Xup ] = 40% + 2% + 15% = 57%

8. At the start of the year, a bond portfolio consists of two bonds, each worth $100. At

the end of the year, if a bond defaults, it will be worth $20. If it does not default,

the bond will be worth $100. The probability that both bonds default is 20%. The

probability that neither bond defaults is 45%. What are the mean, median, and

mode of the year-end portfolio?

Solution: We are given the probability of two outcomes:

P [V = $40] = 20%

P [V = $200] = 45%

At the year-end, the value of the portfolio, V, can have only one of three values,

and the sum of all probabilities must be 1. This allows us to calculate the final

probability:

P [V = $120] = 100% 20% 45% = 35%

The mean of V is then $140:

The mode of the distribution is $200; this is the most likely single outcome. The

median of the distribution is $120; half of the outcomes are less than or equal to

$120.

x

f (x) = s.t. 0 x 10

50

what are the mean, median, and mode of x?

Seminar 4 / June 3, 2015 Valuation of International Financial Assets

the PDF. So, the mode is equal to 10. To calculate the median, we need to find m,

such that the integral of f (x) from the lower bound of f (x), zero, to m is equal to

0.50. That is, we need to find:

Z m

x

dx = 0.50

0 50

Solve the left-hand side of the equation

Z m Z m m

m2

x 1 1 1 2 1 2

dx = xdx = x = (m 0) =

0 50 50 0 50 2 0 100 100

Set this result equal to 0.50:

m2

= 0.50

100

Which gives m = 7.07 The mean is:

Z 10 Z 10 10

x 1 2 1 1 3 1, 000

= x dx = x dx = x = = 6.67

0 50 50 0 50 3 0 150

y = (x + 5)3 + x2 + 10x

what is the expected value of y? Assume the following:

E[x] = 4

E[x2 ] = 9

E[x3 ] = 12

Solution: E[x2 ] and E[x3 ] cannot be derived from knowledge of E[x]. In this prob-

lem, E[x2 ] 6= E[x]2 and E[x3 ] 6= E[x]3 . Find the expected value of y:

E[y] = E[(x + 5)3 + x2 + 10x] = E[x3 + 16x2 + 85x + 125]

E[y] = E[x3 ] + E[16x2 ] + E[85x] + E[125]

= E[x3 ] + 16E[x2 ] + 85E[x] + 125

E[y] = 12 + 16 9 + 85 4 + 125 = 621

11. Assume that a random variable Y has a mean of zero and a standard deviation of

one. Given two constants, and , calculate the expected value of X1 and X2 , where

X1 and X2 are defined as:

X1 = Y +

X2 = (Y + )

Seminar 4 / June 3, 2015 Valuation of International Financial Assets

Solution:

The expected value of X1 is :

= E[Y ] + = 0 + =

Multiplying a standard normal variable by a constant and then adding another con-

stant produces a different result than if we first add and then multiply.

12. X is a random variable. X has an equal probability of being -1, 0, or +1. What is

the correlation between X and Y if Y = X 2 .

Solution:

We have:

1

P [X = 1] = P [X = 0] = P [X = 1] =

3

Y = X2

1 1 1

E[X] = (1) + (0) + (1) = 0

3 3 3

1 1 1 1 1 2

E[Y ] = (12 ) + (02 ) + (12 ) = (1) + (1) =

3 3 3 3 3 3

The covariance can be found as:

1 2 1 2

Cov[X, Y ] = (1 0) 1 + (0 0) 0

3 3 3 3

1 2

+ (1 0) 1 =0

3 3

Because the covariance is 0, the correlation is also zero. There is no need to calculate

the variances and standard deviations.

E[(X )3 ] = E[X 3 ] 3 2 3

Solution:

Seminar 4 / June 3, 2015 Valuation of International Financial Assets

E[(X )3 ] = E[X 3 3X 2 + 32 X 3 ]

Next, we separate the terms inside the expectation operator and move any constants,

namely , outside the operator: 1

E[X] is simply the mean, . For E[X 2 ], we reorganize our equation for variance, as

follows:

2 = E[X 2 ] 2

E[X 2 ] = 2 + 2

Substituting these results into our equation and collecting terms, we arrive at the

final equation:

E[(X )3 ] = E[X 3 ] 3( 2 + 2 ) + 32 3

= E[X 3 ] 3 2 3

14. Given two random variables, XA and XB , with corresponding means A and B and

standard deviations A and B , prove that the variance of XA plus XB is:

V ar[XA + XB ] = A2 + B2 + 2AB A B

Solution:

First we note that the expected value of XA plus XB is just the sum of the means.

= E[((XA A ) + (XB B ))2 ]

= E[(XA A )2 ] + E[(XB B )2 ] + 2E[(XA A )(XB B )]

= A2 + B2 + 2Cov[XA , XB ]

= A2 + B2 + 2AB A B

1

Pn n

(x + y)n = k=0 k xnk y k

Seminar 4 / June 3, 2015 Valuation of International Financial Assets

15. Assume we have four bonds, each with a 10% probability of defaulting over the next

year. The event of default for any given bond is independent of the other bonds

defaulting. What is the probability that zero, one, two, three, or all of the bonds

default? What is the mean number of defaults? The standard deviation?

Solution:

We can calculate the probability of each possible outcome as follows:

n

# of defaults2 k

pk (1 p)k Probability

0 1 65.61% 61.61%

1 4 7.29% 29.16%

2 6 0.81% 4.86%

3 4 0.09% 0.36%

4 1 0.01% 0.01%

100.00%

We can calculate the mean number of default two ways. The first is to use the formula

for the mean:

= np = 4 10% = 0.40

On average there are 0.40 defaults. The other way we could arrive at this result is

to use the probabilities from the table:

4

X

= pi xi = 0.40

i=0

Solution (cont.): To calculate the standard deviation, we also have two choices:

= 0.60

As with the mean, we could also use the probabilities from the table:

4

X

2

= pi (xi )2 = 0.60

i=0

16. For a uniform distribution with a lower bound x1 and an upper bound x2 , prove that

the formulas for calculating the mean and variance are:

1

= (x2 + x1 )

2

1

2 = (x2 x1 )2

12

Seminar 4 / June 3, 2015 Valuation of International Financial Assets

Solution:

For the mean:

Z x2 Z x2 x 2

1 1

= cxdx = c xdx = c x2 = c (x22 x21 )

x1 x1 2 x1 2

1

= (x2 + x1 )

2

For the variance:

Z x2 Z x2 x2

2 2 1

= c(x ) dx = c (x 2x + )dx = c x3 x2 + 2 x

2 2

x1 x1 3 x1

1

2 = (x2 x1 )2

12

17. Prove that the normal distribution is a proper probability distribution. That is, show

that: Z

1 (x)2

e 22 dx = 1

2 2

Use: Z

2

ex dx =

x

y=

2

dx = 2dy

Z

1 (x)2 1 2 1

e 22 dx = ey dy = =1

2

18. Prove that the mean of the normal distribution is . That is, show that:

Z

1 (x)2

x e 22 dx =

2 2

3

R x2

x1

cdx = [cx]xx21 = c(x2 x1 ) = 1

Seminar 4 / June 3, 2015 Valuation of International Financial Assets

x

y=

2

dx = 2dy

Z Z

1

(x) 2

1 2

x e 2 2

dx = ( 2y + )ey dy

2

Z

2 y2

Z

2

= ye dy + ey dy

2 1 2

= [ yey ] + =

2

19. Prove that the variance of a normal distribution is 2 . You may find the following

result useful: Z

2 1

x2 ex dx =

2

Solution:

x

y=

2

dx = 2dy

Z

2 2 2 y2

Z

2 1

(x)2

V ar[x] = (x ) e 2 dx =

2

y e dy

2

We know that:

1

Z

2

x2 ex dx =

2

Using this result:

2 2 1

V ar[x] = = 2

2

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