Self Study Problem Set

1.
Suppose that the average salary offer for graduates at a prestigious business school is $100,000
with a standard deviation of $10,000. Suppose a student receives an offer once a month, and
must decide either to accept it or to turn it down in the hope of receiving a better offer later. She
feels that each month that goes by without a job costs $2000 in terms of search costs, including
any psychic costs of being jobless.
The student would like to determine an optimal strategy for accepting a job offer. In particular,
she would like to set a reservation level, which is the minimum job offer that she will accept. If
she sets a very high reservation level, then she will eventually end up with a high paying job, but
it may take a long time to receive such an offer. She wishes to set an optimal reservation level
that maximizes her payoff net of the search costs.
Set up a spreadsheet model to solve the optimal stopping problem using simulation. Set the
random number seed to 1234 and the number of trials to 1000.

2.
The House Store buys Christmas trees from the wholesalers in the end of November and sells
them at their retail outlet till December 25, the Christmas day. A tree is purchased by House
Store at a price $70 and it is sold at $100 per unit. The store is somewhat far from the residential
area. This adds to the uncertainty in the number of trees sold during the season: This uncertainty
depends on factors such as the pricing by the competitors, the amount of snowfall in that region
etc. Any trees leftover are returned to the wholesalers at $25 a piece.
The wholesaler delivers the trees at one go every year (last week of November). Each year
House Store faces the problem of determining how many trees to purchase from the wholesaler.
If it orders too many, it loses $45 a tree on leftovers. If it orders too few, it foregoes the
opportunity to make profit of $30 a unit, not to mention the customer dissatisfaction.
From past experience, the estimated frequency distribution of demand for trees during the season
is as follows.
Demand
Frequency

100
0.2

150
0.2

1. Suppose the amount ordered is 180 trees.

200
0.35

250
0.2

300
0.05

a. Simulate the tree demand during a season and House Stores total profit for this order
size.
b. In all the experiments use the initial seed 1.
c. The store manager considers the above demand distribution as a very rough
approximation to the actual demand. (Due to lack of specific data, this was a
reasonable guess available to her). She believes that the demand is actually Normally
distributed. The mean and the standard deviation may be estimated by taking them to
equal the mean and standard deviation of the above distribution. Under this
assumption of Normality,
i. Again compute the total profit for order size 180.
ii. Construct a 95% confidence interval for the total profit estimate.
iii. What is the probability that the demand exceeds the order quantity?
2. Determine the optimal order quantity House Store should purchase in order to maximize the
expected profit under the above two different set of distributional assumptions on the
demand.

3.
Consider a simple case of the classical mean variance portfolio theory pioneered by Markowitz
in early 1950s. Consider three securities associated with Reliance, Infosys and Tatas. We want
to divide our wealth in these three securities in the most risk effective manner (short selling of
any of these securities is not allowed).
Future annual return distribution for these stocks has been estimated using the historical data:
Reliance has mean return 30% with the standard deviation 55%, Infosys has mean return 25%
and standard deviation 40% and Tatas have mean return 20% and standard deviation 20%.
Purely for analytical convenience we assume that the returns from these three securities are
independent.
Assignment: Construct an efficient frontier of the portfolio of investments in these three
securities. That is, for any given variance (equivalently, standard deviation) identify the portfolio
with the highest expected return. Assuming variance to be a reasonable measure of risk, the
efficient frontier identifies the best portfolio (the one with the highest expected return) for a
given level of risk.

Procedure outline: Simulation on the spreadsheet allows us to do this in a brute-force manner

through enumeration of all possible portfolios. Let R denote the fraction of the wealth allocated
to Reliance stock, I to Infosys stock and T to Tata stock. Then, we consider portfolios
corresponding to R + I + T =1 where each allocation fraction is non-negative.
We proceed by approximately enumerating all possible portfolios. R is allowed to take values 0,
0.05, 0.1,,0.95 and 1. For each such value of R, I varies from 0, 0.05 up to 1- R. Once R, I
are fixed T is automatically set to 1 - R - I. For each such (R ,I,T) we estimate the mean and
variance of the associated portfolio using Crystal Ball. The returns from the three securities are

generated (we assume that each security return is Normally distributed. Interestingly, the results
are unchanged if we use any other distribution with the same mean and variance). Using these
returns the return on portfolio with allocation (R ,I,T) is determined for each specified
allocation. Crystal Ball is used to generate one thousand return scenarios. These are then used to
estimate the mean and variance of returns from each portfolio. A mean-variance graph is
constructed with variance on the x axis and the mean on the y axis. The upper envelop to the
generated points then approximately captures the efficient frontier. From this rough graph, the
portfolios that contribute to the efficient frontier may be approximately inferred. Mean and
variance may then be estimated for portfolios around these allocations. Plotting these additional
mean-variance points helps in better identification of the efficient frontier.

Typically correlations play an important role in determining the portfolios in the efficient
frontier, so assuming independence (and hence zero correlations) between securities can give
misleading results. Fortunately, in the above analysis, the independence assumption is not
critical. From historical data on returns the correlations between different securities are easily
estimated. Some additional effort then is needed to generate return samples so that they are
correlated and Normally distributed. Once that is achieved, the remaining procedure to
determine the efficient frontier is unchanged.

4.
(Q2.3 in B&F)
Suppose that there are 100 MBA students in the first-year class. Of these students, 20 of them
have two years of work experience, 30 have three years of work experience, 15 have 4 years of
work experience, and 35 have five or more years of work experience. Suppose that a first-year
MBA student is selected at random.
(a) What is the probability that this student has at least four years of work experience?
(b) Suppose that you are told that this student has at least three years of work experience.
What is the conditional probability that this student has at least four years of work
experience?

5.
(Q2.17 in B&F)
In a particular town there are two automobile rental agencies that offer different prices for a
weekend out-of-state automobile rental. An automobile rental at Express Car Rentals (ECR)
costs $195 and includes free unlimited mileage. An automobile rental at Discount Rentals
Agency (DRA) costs $130 plus a mileage charge; the first 300 miles are free and each additional
mile costs $0.20 per mile. A market survey indicates that the miles driven by rent-a-car
customers for weekend rentals obeys the probability distribution shown in the table below.
Miles driven
200
300

Probability
0.07
0.19

400
500
600
700
800
900

0.23
0.14
0.07
0.13
0.09
0.08
a. Last weekend, Ann rented a car from ECR and Bill rented a car from DRA. They were
charged the same amount for their rentals. How many miles did Bill drive?
b. What is the probability that a randomly selected rent-a-car customer will find a better
price at ECR?
c. Carol handles reservations at DRA. A customer calls and says that he would like to rent a
car for the weekend. He also says that according to his estimate of the distance he is
going to travel, it will be less expensive for him to rent a car from DRA. What is the
expected cost that Carol will charge this customer?

6.
Suppose an urn contains seven black balls and five white balls. We draw two balls from the urn
without replacement. Assuming that each ball is equally likely to be drawn, what is the
probability that both drawn balls are black?

7.
(Q 3.5 in B&F)
Helen has an early class tomorrow morning. She knows that she needs to get to bed by 10:00pm
in order to be sufficiently rested to concentrate and participate in class. However, before she goes
to bed, she must start and then complete a homework assignment which is due tomorrow
morning. According to her experience, the time it takes her to complete a homework assignment
for this class is normally distributed with mean = 3.5hrs and standard deviation = 1.2 hrs. Helen
looks at her watch and sees that it is now 6:00pm. What is the probability that she will be able to
get to bed in time to be sufficiently rested for the next days class?

8.
(Q 3.17 in B&F)
Andre is a fearless circus performer who gets shot from a special cannon during the grand finale
of the show. After being shot from the cannon, Andre is supposed to land on a safety net at the
other side of the arena. The distance he travels varies, but is normally distributed with a mean of
150 ft and a standard deviation of 10ft. The landing net is 30 ft. long.
a. To maximize Andres probability of landing on the net, how far away from the cannon
should he position the nearest edge of the net?
b. Given the net position in part(a), what is the probability that Andre will land on the safety
net and so be able to return for tomorrow nights show?

9.
(Q1.2 in B&F)

The Newtowne Art Gallery has a valuable painting it wishes to sell at auction. There will be
three bidders for the painting. The first bidder will bid on Monday, the second will bid on
Tuesday and the third will bid on Wednesday. Each bid must be accepted or rejected that same
day. If all three bids are rejected, the painting will be sold for a standing offer of $900,000.
Newtownes chief auctioneer estimates for the bid probabilities are given in the table below. For
example, the auctioneer has estimated that the likelihood the second bidder will bid $2,000,000
is p=0.9.
a. Formulate the problem of deciding which bid to accept as a decision tree.
b. Solve for the optimal decision strategy.
Amount of bid
Bidder 1(Monday)
Bidder 2 (Tuesday)
$1,000,000
0.0
0.0
$2,000,000
0.5
0.9
$3,000,000
0.5
0.0
$4,000,000
0.0
0.1
Table: Estimates of the probabilities of bids by the three bidders

Bidder 3 (Wednesday)
0.7
0.0
0.0
0.3