Problem set 1: Solutions

Damien Klossner∗
damien.klossner@epfl.ch
Extranef 128

March 1, 2015

Problem 1 (10 points)

Asset-liability management is a critical issue for pension funds and life-insurance com-
panies. Consider a Swiss pension fund with assets of CHF 2 billion and liabilities of
CHF 1.5 billion, so the fund currently has a surplus of CHF 500 million. Assume that
the continuously compounded annual return on the assets has a normal distribution
with a mean of 2% and a standard deviation of 6% (and is serially uncorrelated).

(a) If the liabilities of the fund grow at a constant continuously compounded annual rate
of 4%, what is the probability that the fund’s assets will be less than its liabilities
in five years?
(b) Consider instead the situation where the continuously compounded annual growth
rate of liabilities has a normal distribution with a mean of 4% and a standard devi-
ation of 2% (and is serially uncorrelated). What is the probability of being under-
funded in five years? (Assume that the growth rate of the liabilities is uncorrelated
with the rate of return on the fund assets).

Solution

The first step is to derive the distribution of the random variable A5 . Let RtA denote
the simple returns of the assets for the annual period t − 1 to t. After T years, the
∗
This document is partly based on the notes prepared by Ilya Kolpakov for an earlier version of this
course. I would like to thank him for sharing his notes with me.

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assets will grow to
T
Y
1 + RtA


AT = A0
t=1
QT

= A0 elog t=1 (1+RtA )
PT
log (1+RtA )
= A0 e t=1

PT A
= A0 e t=1 rt .
PT
We assume that rtA is ∼ N (µA , σA
2 ). Moreover, since A
t=1 rt , is the sum of (jointly)
normally distributed random variables, it is itself normally distributed with expected
value and variance
" T # T
X X
rtA = E rtA = T µA
 
E
t=1 t=1
" T # T
X X
rtA = V ar rtA = T σA
2
 
V ar .
t=1 t=1

Since the returns are serially uncorrelated, the variance of the sum of returns is simply
the sum of the variances. Now let’s simplify our lives a bit and express the Tt=1 rtA
P

as a function of a standard normal variable. This will enable us to use the standard
normal CDF to calculate the probabilities. Using the fact that
PT
rA − T µA
Z1 = t=1√ t ∼ N (0, 1)
T σA
we write
T
X √
rtA = T µA + T σA Z1
t=1
and finally obtain the distribution of AT
√
AT = A0 eT µA + T σA Z1
(1)

with A0 = 2, µA = 2%, and σA = 6%. Note that the (gross) total return A5 /A0 is
lognormally distributed.1
1
Another way to obtain equation (1) is to make the (slightly stronger) assumption that the instan-
taneous return of the assets follows the SDE

drtA = µA dt + σA dW (t)

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(a) After T years the value of the liabilities will be
T PT L
1 + RtL = L0 e t=1 log (1+Rt )
Y

LT = L0
t=1
PT L
= L0 e t=1 rt = L0 eT µL .

since rtL = µL = 4%, ∀t. Therefore, the probability that the liabilities will outgrow
the fund’s assets in 5 years is
n √ o
P {A5 < L5 } = P A0 /L0 × e5(µA −µL )+ 5σA Z1 < 1
 
log(L0 /A0 ) − 5(µA − µL )
= P Z1 < √
5σA
 
log(L0 /A0 ) − 5(µA − µL )
=Φ √
5σA
= Φ(−1.3989) ≈ 0.0809.

(b) Following the same approach as we used to derive the distribution of the assets
(replacing µA with µL and σA with σL ), we obtain that the value of the liabilities in
T years will be
√
LT = L0 eT µL + T σL Z2

where µL = 4% and σL = 2%. Here Z2 is a standard normal variable which is uncor-

related with Z1 , since by assumption the growth rate of the liabilities is uncorrelated
with the rate of return on the fund’s assets.
where W (t) is a Wiener process. Therefore, the assets will grow in T years to
RT
µA dt+ 0T σA dW (t)
R
AT = A0 e 0 = A0 eT µA +σA W (T )

From the properties of the Wiener process

W (T ) ∼ N (0, T ),
√
so we can write W (T ) = T Z1 (where Z1 is again a standard normal variable) and obtain the same
equation for AT as before
√
AT = A0 eT µA + T σA Z1
.

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The probability that the liabilities will outgrow the assets in 5 years is
n √ o
P {A5 < L5 } = P A0 /L0 × e5(µA −µL )+ 5(σA Z1 −σL Z2 ) < 1
 
log(L0 /A0 ) − 5(µA − µL )
= P σA Z1 − σL Z2 < √ .
5
The random variable (σA Z1 − σL Z2 ) is a linear combination of (jointly) normally
distributed random variables and is itself normal, with exptected value 0 and variance

2
V ar [Z1 ] + σL2 V ar [Z1 ] = σA
2
+ σL2 .


V ar [σA Z1 − σL Z2 ] = σA

Therefore, the normalized random variable

σ Z − σL Z2
qA 1
2 + σ2 )
5(σA L

is standard normal, and we obtain the desired result simply as

 
σ Z − σ Z log (L /A ) − 5(µ − µ )
A 1 L 2 0
P {A5 < L5 } = P q < q 0 A L 
 5(σ 2 + σ 2 ) 2 2
5(σA + σL )
A L
 
log (L 0 /A ) − 5(µ − µ )
= Φ q 0 A L 
2 2
5(σA + σL )

= Φ(−1.3271) ≈ 0.0922.

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Problem 2 (10 points)

Consider a client at a private bank in Geneva. She has wealth of CHF 1.5 million. She
wants to spend some of the money right now, but she would also like to make a one-
time investment today in a retirement account that will grow to the original CHF 1.5
million by the time she retires in 15 years. Assume that the continuously compounded
annual return on the retirement account has a normal distribution a mean of 5% and
a standard deviation of 10%. Determine how much the client needs to invest today, in
each case, in order to have the probability of reaching her CHF 1.5 million goal be at
least

(a) 25%
(b) 50%
(c) 75%.

Solution

We follow the same approach as in Problem 1. If the client invests x in the fund the
value of the investment in T years will grow to
T
Y QT PT
log(1+Rt ) t=1 rt
x (1 + Rt ) = xe t=1 = xe
t=1
PT
where by assumption rt is ∼ N (µ, σ 2 ). Moreover, the random variable t=1 rt , is itself
normally distributed with expected value T µ and variance T σ 2 (using again the fact
that returns are serially uncorrelated). Therefore the normalized random variable
PT
t=1 rt − T µ
√ (2)
Tσ
is a standard normal random variable.
The client would like to invest x million CHF in the fund so that this investment is
worth at least y million with probability p:

PT
P {xe t=1 rt > y} > p.

Using (2) we obtain

(P )
T  
PT rt R − Tµ ln(y/x) − T µ ln(y/x) − T µ
P {xe t=1 rt > y} = P t=1√
> √ = 1−Φ √ >p
Tσ Tσ Tσ

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where Φ(·) is the cdf of a standard normal random variable. Hence
 
ln(y/x) − T µ
Φ √ < 1 − p.
Tσ

Applying Φ−1 (·) (a monotone increasing function) to both sides and solving for x gives
 √ 
x > y exp −T µ − T σΦ−1 (1 − p) .

Plugging in the numbers (T = 15, µ = 0.05, σ = 0.10, y = 1.5) yields

(a) x > 0.546 (million CHF) for p = 25%.

(b) x > 0.709 for p = 50%
(c) x > 0.920 for p = 75%.

Problem 3 (10 points)

Except for a constant, the utility function

W 1−γ − 1
u(W ) = (3)
1−γ

is identical to the CRRA utility function specified in the lecture slides. The two utility
functions are therefore equivalent in the sense that they generate identical optimal
choices. The advantage of the definition here is that this function has a well-defined
limit as γ → 1. What is this limit?

Solution

When γ approaches 1 both the denominator and the nominator go to 0 so the limit is
unclear. Rewrite the u(W ) as

e(1−γ) ln W − 1
u(γ) = .
1−γ
a(γ) a0 (γ)
Now we use the l’Hopital’s rule limγ→1 b(γ) = limγ→1 b0 (γ) to obtain

0
e(1−γ) ln W − 1 γ − ln W e(1−γ) ln W
lim u(γ) = lim = lim = ln W.
γ→1 γ→1 (1 − γ)0γ γ→1 −1

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Problem 4 (10 points)

Calculate the absolute risk aversion and the relative risk aversion of the following three
utility functions.

Solution

(a) Logarithmic:
u(w) = log(w).

We have u0 (w) = w−1 and u00 (w) = −w−2 so that

ARA(w) = w−1 and RRA(w) = 1.

(b) Shifted logarithmic: For some constant w and w > w

u(w) = log(w − w).

We have u0 (w) = (w − w)−1 and u00 (w) = −(w − w)−2 so that

ARA(w) = (w − w)−1 and RRA(w) = w/(w − w).

(c) Shifted power:

w − w 1−γ
 
γ
u(W ) = .
1−γ γ
 −γ  −γ−1
We have u0 (w) = w−w
γ and u00 (w) = − w−w
γ so that

γ γw
ARA(w) = and RRA(w) = .
w−w w−w

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Problem 5 (20 points)

The MSCI Global Equity Indices are widely tracked global equity benchmarks. They
cover more that 75 countries and span both developed and emerging markets (EMs).
They also serve as the basis for over 500 exchanged traded funds throughout the world.
The Excel file MSCI.xlsx contains total return indices of seven MSCI indices (sourced
from Bloomberg):

• Four developed markets: US, Japan, Switzerland, and Germany

• Three EM regional indices: Asia, Latin America, and Europe & Middle East

The total return indices are in USD and include reinvested dividends.2

(a) For each country/region, compute monthly returns and then the arithmetic mean,
geometric mean, standard deviation, Sharpe Ratio (assuming a monthly interest rate
of 0.3 %), skewness, kurtosis, and 95% VaR. Plot histograms of returns. Compare
the riskiness of emerging market equities with developed market equities.
(b) Compute the correlation matrix for returns in developed markets. Then, compute
the correlation matrix for returns in Switzerland and the EM regions. For a Swiss
investor, which category (developed or EM) offers the best diversification opportu-
nities in the sense of being least correlated with Swiss index returns on average?
(c) Recompute the two correlation matrices using only data for the crisis period of 2008-
2009 and evaluate the often-stated claim that diversification disappears when you
need it the most.
(d) Consider a Swiss investor diversifying across developed markets. Compute the stan-
dard deviation (for the full sample period) of returns on the following four equally-
weighted portfolios:

• Switzerland

• Switzerland and the US

2
The time series for Europe & Middle East exclude reinvested dividends as these are only available
from 2000 onwards; hence, the average return is downward biased for this index. MSCI also computes
total return indices in local currency.

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 • Switzerland, the US, and Japan

• Switzerland, the US, Japan, and Germany

Contrast with the standard deviation of returns under the counter-factual assump-
tion that returns across developed markets are perfectly correlated.

Solution

(a) Return statistics and histograms are shown in Table 1 and Figure 1 below. As
the VaR measure I computed historical 95%-VaR which is simply the fifth per-
centile of historical returns (in MATLAB one can compute it using the command
prctile(R,5) where R is the vector or matrix of historical returns). Note that
emerging market returns tend to have higher standard deviations. Their minimums
and maximums are also more extreme compared to developed markets.
(b) Correlations of Swiss index returns with developed and emerging markets over the
whole sample are shown in Tables 2 and 3. Emerging markets returns are less cor-
related with Swiss returns compared to developed markets. As a category, emerging
markets are more beneficial to a Swiss-based investor from the diversification per-
spective.
(c) The correlation computed for the crisis period of 2008–2009 are shown in Tables 4
and 5. Clearly those correlations are much higher and both emerging and developed
markets’ returns become highly correlated with Swiss returns.
Since in 2008-2009 the markets were more volatile than usual the proper diversifi-
cation would be highly beneficial. Unfortunately, the increased correlation between
the markets made the diversification impossible. Hence we find support for the claim
that diversification disappears when it is the most valuable.
(d) Standard deviations of returns on equally-weighted portfolios invested in developed
markets are reported in Table 6. Interestingly, more diversified portfolios do not
become less volatile for returns computed using actual returns (first row). The
reason is that we are diversifying into more volatile markets. Assuming all the
four developed markets are perfectly correlated increases the standard deviations of
returns by roughly 20% ≈ 1/0.8.

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 US Jap SZ Ger Asia LatAm MidEast

Mean (A) 0.0093 0.0024 0.0103 0.0095 0.0090 0.0167 0.0062

Mean (G) 0.0084 0.0006 0.0091 0.0073 0.0065 0.0127 0.0028
Std. Dev. 0.0418 0.0603 0.0495 0.0664 0.0705 0.0885 0.0827
Sharpe 0.5212 -0.0350 0.5117 0.3390 0.2974 0.5367 0.1355
Skew. -0.5954 0.2332 -0.2552 -0.4427 -0.2376 -0.5279 -0.0014
Kurt. 4.1950 3.9670 3.8178 4.5611 3.9259 4.5759 5.4593
Min. -0.1710 -0.1938 -0.1563 -0.2435 -0.2405 -0.3469 -0.3205
Max. 0.1143 0.2426 0.1668 0.2369 0.2212 0.2850 0.4142
95% VaR -0.0664 -0.0912 -0.0901 -0.1046 -0.1179 -0.1333 -0.1363

Table 1: Monthly returns summary statistics

SZ US Japan Germany

SZ 1.00 0.63 0.50 0.71

US 0.63 1.00 0.42 0.70
Japan 0.50 0.42 1.00 0.40
Germany 0.71 0.70 0.40 1.00

Table 2: Correlations between developed markets (whole sample)

SZ Asia LatAm MidEast

SZ 1.00 0.48 0.39 0.49

Asia 0.48 1.00 0.58 0.56
LatAm 0.39 0.58 1.00 0.56
MidEast 0.49 0.56 0.56 1.00

Table 3: Correlations of Switzerland and emerging markets (whole sample)

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 SZ US Japan Germany

SZ 1.00 0.89 0.85 0.95

US 0.89 1.00 0.84 0.93
Japan 0.85 0.84 1.00 0.88
Germany 0.95 0.93 0.88 1.00

Table 4: Correlations between developed markets (2008–2009)

SZ Asia LatAm MidEast

SZ 1.00 0.86 0.77 0.84

Asia 0.86 1.00 0.89 0.89
LatAm 0.77 0.89 1.00 0.95
MidEast 0.84 0.89 0.95 1.00

Table 5: Correlations of Switzerland and emerging markets (2008–2009)

SZ SZ-US SZ-US-JN SZ-US-JN-GR

Hist. Corr. 0.049 0.041 0.042 0.044

Perfect Corr. 0.042 0.046 0.051 0.054
Ratio 1.000 0.902 0.822 0.817

Table 6: Standard deviations of returns of equally-weighed portfolios

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 US Japan Switzerland Germany
15 15 15 15

10 10 10 10

5 5 5 5

0 0 0 0
−0.2 0 0.2 0.4 −0.2 0 0.2 0.4 −0.2 0 0.2 0.4 −0.2 0 0.2 0.4

Asia LatAm MidEast

15 15 15

10 10 10

5 5 5

0 0 0
−0.2 0 0.2 0.4 −0.2 0 0.2 0.4 −0.2 0 0.2 0.4

Figure 1: Histograms of returns. Realized returns below 95% VaR are in red.

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