ACTL 3004/5109

Final Examination, November 2003

Sample solutions
Question 1
(i)
Need to solve

1
1
1
= p
(1 p)
w0
w1
w2

so
w0 =

w1 w2
pw2 + (1 p) w1

(ii)
Dierentiating:
(1 p) w1
w0
=
2 >0
w2
(pw2 + (1 p) w1 )

so the level of initial wealth to be indierent increases. Intuitively this is because

as w2 increases towards w1 the gamble becomes more and more like a riskless
investment paying w1 .

Question 2
(i)
Using APT
E [rA ] = 4% + 0.5 (6%) + 1.5 (4%) = 13%
E [rB ] = 4% 0.25 (8%) + 0.75 (6%) + 0.75 (4%) = 9.5%
(ii)
For the expected return
E [rp ] = 0.6E [rA ] + 0.4E [rB ]
= 11.6%
The sensitivities to the factors are

0.4 (0.25)
0.1
p = 0.6 (0.5) + 0.4 (0.75) = 0.6
0.6 (1.5) + 0.4 (0.75)
1.2

Also check by

E [rp ] = 4% 0.1 (8%) + 0.6 (6%) + 1.2 (4%) = 11.6%.

(iii)
It does not matter. The APT assumes the availability of well diversified
portfolios. In particular consider a portfolio with 0 sensitivity to all the factors.
This acts as 0 .

Question 3
(i)(not directly in Yr 2004 oering)
From the question we have
Z

1
1 eaT (r (0) b)
a
Z T

+
1 ea(T t) dWtQ .
a 0

r (t) dt = T b +

and since

1
1 eaT (r (0) b)
a
and

1 ea(T t)
a
are deterministic. the random variable is of the form
Z T
Z T
r (t) dt = m (T ) +
g (t) dWtQ
Tb +

RT
which is distributed as N m (T ) , 0 g 2 (t) dt . Hence the mean is
m (T ) = T b +

and variance

1
1 eaT (r (0) b)
a

2
1 2aT
2 aT
+ e
v (T ) = 2 T e
.
a
a
2a
2

(ii)
The bond price is

but since

RT
0

h RT
i
EQ e 0 r(t)dt

r (t) dt is normal we can use the MGF of a normal to find that

1

P (r (0) , T ) = em(T )+ 2 v

(T )

and simple manipulations show that this is the same as the required form in
the question. (Students are required to do this to get full marks. Partial marks
given otherwise).
(iii)
Looking at the price of a 1 yr ZCB gives
1
1
=
1.05
1 + a (0)

and looking at the price of a 2 yr ZCB gives

1
1
1
1
1
1
=
+
1.0552
1 + a (0) 2 1 + a (1)
2 1 + a (1) + b (1)
with b (1) = 4%.
Notice that students were not required to solve these equations.
(iv)
Tree is
5% 8.04%
4.04%
and so the option values at time 1 are
1
+
1
? 100 1.06
1.0804
= 1.78
1
+
1
100 1.06 1.0404
=0

and using backwards recursion (recall that q = 0.5, and that you need to discount at 5%) gives the value of the option to be 0.85.

Quesiton 4
The value of the option can be represented as

ST
EQ erT
1K1 ST K2
K1
where
dSt = rSt dt + St dW Q
and so one can use completing the square techniques to find the price.
Alternatively, a short-cut is to notice that the payo can be represented as

1
EQ erT ST 1ST K2 EQ erT ST 1ST K1
K1

and in particular one can infur from the Black-Scholes formula (put option)

2
EQ erT ST 1ST K2 = S0 N dK
1

and so the price of the option is

S0 K2
1
N d1
N dK
1
K1
where
2
dK
1 =

ln

S0
K2

+ r + 12 2 (T )

ln

S0
K1

+ r + 12 2 (T )

and
1
dK
1

with T = 1.

Question 5
The stock tree is
12

14.4
10.2

10
8.5

10.2
7.225

The payo is
?
?

14.4 13 (10 + 12 + 14.4)

12 13 (10 + 12 + 10.2)

? 10.2 13 (10 + 8.5 + 10.2)

10 13 (10 + 8.5 + 7.225)
Note in particular that this option is path dependent and so one cannot use a
recombining tree.
To get the replicating portfolio setup the equation
i Si+1,up + i Bi+1
i Si+1,down + i Bi+1

= optioni+1,up
= optioni+1,down

and
optioni = i Si + i Bi
Using the above equations and backwards recursion, this provide the values
(i , i , option)of the units of stock, bond and option value as.
(0.238, 1.073, 1.741)

(0.225, 0.918, 1.329)

(0.266, 3.09, 0.954)

(ii)
Using with

er d
= 0.54517364
ud
and backwards recursion we find that the value of the option is

e8% q 2 (2.267) + q (1 q) (1.267 = 0.633) + (1 q)2 (1.425)

q=

= 1.329

Question 6
(i)
The initial stock investment is
S0 = 100 x
and the payment at the end of the year is
max (S1 , 95)
= max (S1 95, 0) + 95
which is the payo of a call and cash.
Hence for every $100 premium the investor buys a portfolio of call and cash:
100 = BS (100 x, 95) + 95e0.04
where BS (100 x, 95) represents the Black-Scholes formula with initial S0 =
100 x and strike 95, with parameters r = 4%, = 0.30, T = 1. This is an
equation that can be solved numerically.
(Key is to interprete the problem - partial marks given for sensible but
incorrect interpretation)
(ii)
Three possibilities are
(Static) Buy stock and put
(Static) Buy cash and call
Dynamic Hedge using stock and bond
And the student is expected to provide brief comments on what is involved.
Marks are also given for alternative strategies.

Question 7
(i)
Consider the special case of a market factor model:
ri = i + i rM + i
where the APT gives
E [ri ] = rf + i (E [rM ] rf )
which is the CAPM security market line.
(ii)
Bookwork. See lecture notes.

Question 8
(i)
Let rY be the (random) annual return and ri be the subperiod returns.
Assuming iid and the approximation
X
ri = rY

we have

V ar (rY ) = 2Y
by assumption, but also from the iid property we have
X
V ar (rY ) = V ar
ri
X
=
V ar (ri )
= n2n

and hence
Y =

n n .

(ii)
For the estimate of the mean using n subperiods:
Stdev (c
n )
Y ) = Stdev (nc
= n Stdev (c
n )
n
= n
n
= Y
which does NOT decrease when n increases.
For the estimate of the variance using n subperiods:


Stdev s2Y
= n Stdev s2n
2
2
= n n
n1
2
2 Y
=
n1
which does decrease when n increases.
Hence it is useful for the estimate of the variance but not useful for the mean.
(iii)
Bookwork. Problems include
May need long history
Long dataset may have structural changes
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 Company dividends, new stocks

Code changes
(Other sensible answers also accepted)
(iv)
Using a factor model may reduce the number of parameters. Related to this
are the use of APT and CAPM.

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