QUANTITATIVE METHODS FOR FINANCE

January-2014 Exam
[5 exercises; 31 points available; 90 minutes available]

[8 points]
Assume dX = k (X m) dt + X dz with k > 0 and m > 0. Given m < 5
and = 0, show that the equilibrium price S (X) of the stock that pays out 3 (X + 5) dt every second
is such that
6m
.
E [ S (X) ]
>
r
1

[7 points]
Your initial capital is H = 100 Euro. Assume dX = X dt + X dz (the associated
1 2
parabola is y ( ) = 21 2 2 +
r ). By borrowing 500 Euro and by cashing in 400
2
1
Euro via the short sale of the stocks that pay out X 2 dt, you invest 1000 Euro in the stock that pays
1
out 3X 5 dt every second (assume y 21 < 0, which implies y 51 < 0). Work out the total return
1
dH on your portfolio.
H

2
[4 points]
Consider the problem of maximizing the risk-adjusted expected return on
a portfolio with constrained exposure to the second risky security (assume A > 0, r2 > r1 > r,
1 < < 0):
2 > 1 > 0, and
max r + w1 ( r1

w1 ; w 2

r ) + w2 ( r2

A
2

r)

2 2
1 w1

+ 2

1 2 w1 w2

2 2
2 w2

sub

w2 =

1
.
2

The shadow price l of the constraint is:

a)

l = (r1

r)

2
1

(r2

r)

A
2

2
2

(1

b)

l = (r2

r)

(r1

r)

A
2

2
1

(1

c)

l = (r2

r) +

2
1

(r1

r)

A
2

2
2

d)

l = (r2

r)

2
1

(r1

r)

A
2

2
2

(1

);

);

1);

).

Alessandro Sbuelz - SBFA, Catholic University of Milan

3
[4 points]
A rm produces two outputs x and y, whose sale prices are X and Y , respectively. The rm is monopolist in both markets and faces the following demand functions (x and y are
complementary goods):
2
Y
3

x = 1000

4
X ;
3

4
Y
3

y = 1000

2
X :
3

Given that the production costs are C (x; y) = 15x + 10y + xy + 5000 and that the government sets
the production-target constraint (y 300)2 100, the shadow price l of the constraint is:
9
a)
l = 11
;
9
b)
l = 14
;
9
c)
l = 8;
d)
l = 92 .

[4 points]
4
rate (r = 0):

Consider the following one-period arbitrage-free market with a zero riskfree

2

6
6
M =6
4

1:0
1+0
1+0
1+0

3: 1
2
3
4

3: 7
7
4
1

1: 9
3
2
1

1: 1
1
0
2

e (1) = 7B(1) + 3Se3 (1)2 is:

The no-arbitrage price of the payo X
a)
21: 9;
b)
19: 9;
c)
15: 9;
d)
17: 9.

[4 points]

and the payo

strategy #l
a)
b)
c)
d)

Given the one-period market

2
1
6 1+0
6
M =6
4 1+0
1+0

7
7
7 .
5

(with riskfree rate r = 0)

3
1:5
2 7
7
7
0 5
4

X (1) (! 1 )

X (1) (! 2 )
X (1) (! 3 )
e (1) is such that:
that super-replicates X
#l1 = 1=2;
#l1 = 1=2;
#l1 = 1=4;
#l1 = 1=4.

Alessandro Sbuelz - SBFA, Catholic University of Milan

iT

iT

, the maximum-inow

SOLU T ION S

Given

= 0, the equilibrium-valuation problem is

1
Et [dS] + 3X + 15
dt

= Sr ,

where

1
Et [dS] = SX ( k (X
dt

1
m)) + SXX X 2
2

Let us formulate the educated guess

S (X) = BX + C ,

where B and C are constants to be determined. Given

SX

B ,

SXX

0 ,

the dynamic equilibrium restriction becomes

B ( k (X

m)) + 3X + 15

(BX + C) r

m
Bkm + 15
|
{z
= 0

Cr
}

(B (r + k)
|
{z
= 0

3)X
}

m
B =

3
,
r+k

C =

3m k
15
+
.
r r+k
r

Alessandro Sbuelz - SBFA, Catholic University of Milan

Then, we have

E [S (X)]

r 3E [X]
3m k
15
+
+
r r+k
r r+k
r

3m r
r r+k

3m r + k
r r+k

3m k
15
+
r r+k
r

15
r
|{z}

>

>

3m
r

3m
3m
+
.
r
r

The equilibrium value of the stock that pays out X 2 dt every secondis

G (X) =
( it solves the problem

X2
r+

1
2

1
1
Et [dG] + X 2 = Gr + GX X
dt

1
2

1
8

with G (0) = 0 ) :

The equilibrium value of the stock that pays out 3X 5 dt every secondis

Alessandro Sbuelz - SBFA, Catholic University of Milan

3X 5

F (X) =
( it solves the problem

r+

1
5

1
5

2
25

1
1
Et [dF ] + 3X 5 = F r + FX X
dt

with F (0) = 0 ) :

The total gain on your portfolio is

dH

1000
F

1000

1000

( Hr

400
G

dF + 3X 5 dt

dF + 3X 5 dt
F

r +

1
5

400

dt +

1
dz
5

0 dz .

) dt

dG + X 2 dt

500rdt

dG + X 2 dt
G

400

r +

500rdt

1
2

dt +

1
dz
2

500rdt

The total return on your portfolio is

1
dH
H

r dt

Alessandro Sbuelz - SBFA, Catholic University of Milan

SOLU T ION S

The correct answer is d).

For this equality-constrained problem, the Lagrangian function is

L (w1 ; w2 ; l)

r + w1 (r1

r) + w2 (r2

A
2

r)

w12

2
1

+ w22

2
2

+2

1 2 w1 w2

1
2

w2

and the First Order Conditions (FOCs) are su cient. The objective function is strictly concave in w1
and w2 . The constraint function is convex as it is linear in w2 . The FOCs are:
8
>
L w1
>
>
>
>
>
<
L w2
>
>
>
>
>
>
: L

8
>
>
>
>
>
>
<
>
>
>
>
>
>
:

Aw1

2
1

Aw2

2 1

Aw2

2
2

Aw1

1 2

1
2

w2

+ (r1

r) = 0

l + (r2

r) = 0

=0

Given the explicit form of the third equation (w2 = 12 ), the rst two equations can be rewritten as
"

A
A

2
1
1 2

0
1

#"

w1
l

"

(r1
(r2

r) + 12 A
r) + 21 A

1 2
2
2

with det

"

A
A

2
1

0
1

1 2

#!

= A

2
1

>0.

Hence,
"

w1
l

1
A 21

"

0
A 21

# "

l = (r2

r)

1
A

1 2

(r1
(r2

r)
r)

1
A 1 2
2
1
A 22
2

that is,

w1 =

r1 r
A 21

and

Alessandro Sbuelz - SBFA, Catholic University of Milan

2
1

(r1

r)

A
2

2
2

SOLU T ION S

The correct answer is d).

The inverse demand functions are

"

X = 21 y
Y = 12 x

x + 500
y + 500

so that the monopolists problem is

maxP (x; y)
x;y

s.t.

(x

300)2

100

with
P (x; y) = x

1
y
2

x + 500 + y

1
x
2

y + 500

(15x + 10y + xy + 5000) :

The First Order Conditions for constrained optimality will be su cient because the feasible set

(x; y) 2 R2 : (x

300)2

100

(x; y) 2 R2 : 290

is convex and the prot function P (x; y) is strictly concave:

3
3 2
2
2
0
Pxx
Pxy
7
7 6
6
H = 4
5 with Pxx =
5=4
0
2
Pyx
Pyy

2 < 0 and

310

det (H) = 4 > 0 :

Given the Lagrangian function

L (x; y; l) = P (x; y)

l (y

300)2

100

the Kuhn-Tucker First Order Conditions are:

8
8
>
>
L
=
0
485 2x = 0
x
>
>
>
>
>
>
>
>
>
>
Ly = 0
600l 2y 2ly + 490 = 0
>
>
>
>
>
>
>
>
>
>
<
<
,
l 0
l 0
>
>
>
>
2
>
>
Ll 0
(y 300)
100
0
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
: l L =0
: l (y 300)2 100 = 0
l
Alessandro Sbuelz - SBFA, Catholic University of Milan

For l = 0 (we assume a painless constraint), we have:

8
>
<
>
:

485

2x = 0
,

2y + 490 = 0

8
>
< x=
>
:

The unconstrained maximum-prot point is such that P

unfeasible as the constraint is violated:
(245

300)2

485
2

y = 245

8810 8740
; 63
63

= 113831: 25. It turns out to be

100 :

For l > 0 (we assume a painful constraint), we have:

8
>
485 2x = 0
>
>
>
>
>
<
600l 2y 2ly + 490 = 0
>
>
>
>
>
>
: (y 300)2 100 = 0 (the constr. is binding)

8
>
x = 485
>
2
>
>
>
>
>
>
>
< l = y 245
y 300
,
>
>
(
>
>
>
>
290
>
>
>
: x = 310

8
>
x = 485
>
2
>
>
>
>
<
,
l = 92 > 0
>
>
>
>
>
>
: y = 290 .
with l > 0

The constrained maximum prot is

P

485
; 290
2

= 111806: 25 .

Alessandro Sbuelz - SBFA, Catholic University of Milan

SOLU T ION S

The correct answer is b).

By the First Fundamental Theorem of Asset Pricing, any arbitrage opportunity is ruled out if the
market M supports a risk-neutral probability measure Q (recall that the riskfree rate is r = 0):
2
6
6
6
6
6
6
4

1:0
3: 1
3: 7
1: 9
1: 1

2
3T 2
3
7
7
1+0 2 7 3 1
Q (! 1 )
7
1 6
7 6
7
7 =
4 1 + 0 3 4 2 0 5 4 Q (! 2 ) 5 .
7
1+0
7
1+0 4 1 1 2
Q (! 3 )
5

Since

31
1+0 3 1
7C
B6
det @4 1 + 0 2 0 5A =
1+0 1 2
02

3 ,

we can focus on the riskless security and on the two last risky securities to work out the unique measure
Q:
3T 1
1+0 3 1
Q (! 1 )
B6
7 C
7
6
B
4 Q (! 2 ) 5 = @4 1 + 0 2 0 5 C
A
1+0 1 2
Q (! 3 )
2

02

31
1:0
7C
6
B
@(1 + 0) 4 1: 9 5A
1: 1
0

3
0:3
7
6
4 0:3 5 .
0:4
2

The other two risky securities are also properly priced:

3: 1

3: 7

3T 2
3
2
0:3
1 6 7 6
7
4 3 5 4 0:3 5 ,
1+0
4
0:4
2

3T 2
3
0:3
7
1 6 7 6
7
4 4 5 4 0:3 5 ,
1+0
1
0:4

Alessandro Sbuelz - SBFA, Catholic University of Milan

The payo to be priced is

e (1)
X

=
m

3
X (1) (! 1 )
6
7
4 X (1) (! 2 ) 5
X (1) (! 3 )

Its no-arbitrage price is

7B(1) + 3Se3 (1)2

2

3
2
3
1
32
6 7
6
7
7 4 1 5 + 3 4 22 5
1
12

3T 2
3
34
0:3
1 6
7 6
7
X (0) =
4 19 5 4 0:3 5 =
1+0
10
0:4

3
34
6
7
4 19 5 .
10

19: 9 .

An alternative would be the calculation of the intial cost of the replicating strategy #X that involves
X
only the three mentioned securities (#X
1 = #2 = 0):
2

3
#X
0
6 X 7
4 #3 5
#X
4

3
1+0 3 1
7
6
4 1+0 2 0 5
1+0 1 2
2

and

2
V#X (0)

6
6
6
6
6
6
4

7
0
0
13
2

3T
7
7
7
7
7
7
5

2
6
6
6
6
6
6
4

3
34
7
6
4 19 5
10
2

1:0
3: 1
3: 7
1: 9
1: 1

Alessandro Sbuelz - SBFA, Catholic University of Milan

3
7
7
6
4 13 5
2
2

3
7
7
7
7
7
7
5

19: 9 .

10

SOLU T ION S

The correct answer is b).

The market is obviously incomplete (2 securities and 3 states of the world). The payo is not
replicable:
02
31
1+0 2 0
B6
7C
det @4 1 + 0 0 1 5A =
5 .
1+0 4 2
The candidate super-replicating strategies # = [#0 ; #1 ]T solve the system
2

3
1+0 2
6
7
4 1 + 0 0 5#
1+0 4

3
0
6 7
4 1 5
2

()

8
>
< 1 #0 + 2 #1
1 #0 + 0 #1
>
:
1 #0 + 4 #1

theta_1

-2

(not below the green line)

(not to the left of the yellow line)
(not below the blue line)

-3

0
1
2

g
tin
a
ic
pl
e
-r
er
p
su

-1

)
(1
-X

theta_0

-1

-2

We determine the maximum-inow strategy among all those that super-replicate

the initial-inow function
f# (0) =

#0 1

#1 1:5

Alessandro Sbuelz - SBFA, Catholic University of Milan

f = 0.7

e (1) by studying
X

V# (0) ).
11

f=0

The level curve f of such a function is identied by the straight line of equation
#0 1

#1 1:5 = f

f
1:5

() #1 =

1
(see the red solid lines below).
1:5

#0

theta_1

g
tin
a
ic
pl
e
r
er
p
su
-2

-1

)
(1
X
-

f = 0.25

-1

theta_0

f=0

The maximum-inow strategy is given by the couple [#l0 ; #l1 ]T represented by the intersection between
the green line and the yellow line. Hence, we must solve the system
(

1 #l0 + 2 #l1 = 0
1 #l0 + 0 #l1 = 1

to obtain the seeked strategy

"

#l0
#l1

"

1
1
2

and the associated maximum inow

V#l (0)

( 1) 1

Alessandro Sbuelz - SBFA, Catholic University of Milan

1
2

1:5 = 0:25 .

12