University of Warwick 2018/2019

Department of Statistics Dr M Herdegen

ST 339 Introduction to Mathematical Finance

Exercise Sheet 3
Please submit your solutions by 3pm on Wednesday 14th November to the undergraduate support
office.

Exercise 3-1

Let S = (St0 , St1 , St2 , St3 )t∈{0,1} be an arbitrage-free non-redundant market on a probability space
(Ω, F, P ) with S01 = 50, S02 = 100 and S03 = 200. Assume that S has finite second moments.
Denote by µ and Σ the mean vector and covariance matrix of the return vector R of the risky
assets. Assume that r = 0.01 and that µ and Σ have been estimated as
   
0.04 0.2 0.1 0.1
µ = 0.04 and Σ = 0.1 0.2 0.1 .
0.05 0.1 0.1 0.2

Suppose that the total market capitalisation of the market is 1,000,000 and that a mean-variance
equilibrium exists.
(a) Compute the Markowitz tangency portfolio πtan .
(b) Compute the shares outstanding η i for each risky asset i ∈ {1, 2, 3}.
(c) A portfolio manager who trades in the above market offers a portfolio π ∈ H 3 which is
advertised to “outperform the market portfolio by 1%”. Comment on the validity of this
advertisement.

Exercise 3-2

Let S = (St0 , St )t∈{0,1} be an arbitrage-free non-redundant market on a probability space (Ω, F, P )

with S00 = 1, S01 = 50, S02 = 100 and S03 = 250. Assume that S has finite second moments.
Denote by µ and Σ the mean vector and covariance matrix of the return vector R of the risky
assets. Set A = 1> Σ−1 1, B = 1> Σ−1 µ, and C = µ> Σ−1 µ. Let r be the interest rate and assume
that r < B 1
A . Moreover, assume that µ and 1 are not collinear. For a portfolio π ∈ H
1+d−1 with

σπ2 > 0, the Sharpe ratio λπ is defined by

µπ − r
λπ =
σπ
µπ −r
Similarly, for a risk-only portfolio π ∈ H d−1 , the Sharpe ratio λπ is defined by λπ = σπ .

(a) Find the (unique) risk-only portfolio with

√ maximal Sharpe ratio. Moreover show that the
corresponding Sharpe ratio is given by Ar2 − 2Br + C.
Hints: First argue, why it suffices to maximise over all risk-only efficient portfolios. Mo-
roever, use that maximising over λπ is equivalent to maximising over (λπ )2 . Finally, use
B 2
that σπ2µ = A1 + AC−B
A


2 µ0 − A .
0

1
This assumption is not really needed and only made to simplify part (a).
 (b) Find all general portfolios (with nonvanishing variance) with maximal Sharpe ratio and
calculate the corresponding Sharpe ratio.
(c) Comment on the relationship between the solution in (a) and (b). Can you give an alter-
native interpretation to the portfolio found in (a)?

Exercise 3-3

Let S = (St0 , St )t∈{0,1} be a financial market on a probability space (Ω, F, P ), and let r > −1
denote the interest rate. Suppose that the return Ri of asset i is given by the exact2 multi-factor
model
XK
i i
R =α + βki Yk ,
k=1

where Y1 , . . . , YK , K ≤ d, are random variables denoting economic factors and αi , βki ∈ R are
constants, i ∈ {1, . . . , d}, k ∈ {1, . . . , K}. Setting
 1  1 1

α β1 . . . βK Y1
 
 ..  d  .. . . .
. d×K ..  ∈ RK ,
α :=  .  ∈ R , B :=  . . . ∈R , and Y :=
  .
α d d d
β1 . . . β K YK

this can be written compactly as

R = α + BY.
We may assume without loss of generality that the rank of B is K.3
(a) Show that if S satisfies NA, there exists numbers y1 , . . . , yK ∈ R such that
K
X
αi + βki yk = r, i ∈ {1, . . . , d}.
k=1

Hint: Use the FTAP, fix an EMM Q and set yk = E Q [Yk ], k ∈ {1, . . . , K}.

(b) Deduce that if S satisfies NA, then each Ri can be written as

K
X
i
R =r+ βki Yek , (∗)
k=1

for random variables Ye1 , . . . , YeK .

(c) Suppose each Ri satisfies a representation as in (∗). Show that S satisfies NA if and only
if there exists a measure Q ≈ P on F such that Ye1 , . . . , YeK are Q-integrable and have
Q-expectation 0.

2
Here, exact refers to the fact that there are no idiosyncratic noise terms εi .
0 0
3
If rk(B) = K 0 < K, we can write B = B 0 A0 for some matrices B 0 ∈ Rd×K and A ∈ RK ×K , and define the
0
random variables Y10 , . . . , YK0 0 by Y 0 = A0 Y . Then B 0 Y 0 = B 0 A0 Y = BY , so that R = α + B 0 Y 0 , where Y 0 ∈ RK
0 0
and rk(B ) = K .
Exercise 3-4

Let M be a nonempty convex subset of all probability measures on (R, B). Let U : R → R be a
measurable function such that U is integrable with respect to any ν ∈ M. Define the relation 
on M by Z Z
ν1  ν2 :⇔ U (x) ν1 (dx) ≥ U (x) ν2 (dx).

(a) Show that  is a preference order.

(b) Show that  satisfies the independence axiom.
(c) Show that  satisfies the continuity axiom.
(This is the converse of Theorem 4.10 in the lecture notes.)

Exercise 3-5

Let M be the (convex)

R set of all probability measures on (R, B) with finite second moment, i.e.,
ν ∈ M if and only if x2 ν(dx)
R < ∞. Moreover, denote by M0 ⊂ M the (convex) subset of all
ν ∈ M with mean zero, i.e., x ν(dx) = 0 for ν ∈ M0 . Define the preference order  on M and
on M0 by
ν1  ν2 if and only if µν1 − σν21 ≥ µν2 − σν22 ,
where µν = x ν(dx), and σν2 = (x − µν )2 ν(dx) for ν ∈ M.
R R

(a) Show that if ν1 , ν2 ∈ M and α ∈ [0, 1], then

µαν1 +(1−α)ν2 = αµν1 + (1 − α)ν2 ,

2
σαν1 +(1−α)ν2
= ασν21 + (1 − α)σ22 + α(1 − α)(µν1 − µν2 )2 .

Hint: First show that σν2 = x2 ν(dx) − (µν )2 for ν ∈ M.

R

(b) Show that  satisfies the continuity axiom on M and on M0 .

Hint: Use (a) and the intermediate value theorem.
(c) Show that  fails the independence axiom on M by constructing a counterexample.
Hint: In the construction of the counterexample, you can choose ν1 and ν2 to be Dirac
distributions. Moreover, you can choose ν3 = ν2 .
(d) Show that  satisfies the independence axiom on M0 . Moreover, show that is has a
von Neumann-Morgenstern representation on M0 by finding an appropriate measurable
function U : R → R that is integrable with respect to any ν ∈ M0 such that
Z Z
ν1  ν2 if and only if U (x) ν1 ( dx) ≥ U (x) ν2 ( dx).