QUANTITATIVE METHODS FOR FINANCE

Mock Exam 1
(Academic Year 2013-14)
[5 exercises; 31 points available; 90 minutes available]

1
[8 points]
Work out the equilibrium price w (X) of the stock that pays out the dividend
2
(X + 4) dt every second(with dX = X dt + X dz). In doing so, make the assumption
4

with

y (8) < 0

y( ) =

1
2

2 2

1
2

r.

[7 points]
Your initial capital is H = 100 Euro. By borrowing 400 Euro and by cashing in 300
5
Euro via the short sale of the stocks that pay out X 3 dt, you invest 800 Euro in the stock that pays
out 5X 3 dt every second(keep the assumption y (8) < 0, which implies y (3) < 0). Work out the total
return H1 dH on your portfolio.

2
[4 points]
Consider the problem of maximizing the expected portfolio return given the
level v > 0 of variance that can be loaded into the portfolio return (assume =
6
1):
max r + w1 ( r1

w1 ; w 2

r ) + w2 ( r2

sub

r)

2 2
1 w1

+ 2

1 2 w1 w2

2 2
2 w2

= v .

The constrained optimal portfolio is characterized by (l is the shadow price):

a)

w1 =

1
2l

r1
2 (1
1

b)

w2 =

1
2l

r2
2 (1
2

c)

w2 =

1
2l

r2
2 (1
2

d)

w1 =

1
2l

r1
2 (1
1

r2

r2 r1
2)
1 2 (1

r1 r
2)
1 2 (1

2)

2)

2)

2)

r1 r
2)
1 2 (1

r2 r
2)
1 2 (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):
4
4
3
3
Y
X ;
y = 1000
Y
X :
7
7
7
7
Given that the production costs are C (x; y) = 20x + 30y + 5xy + 10000 and that the government
sets the production-target constraint (x 180)2 25, the monopolists constrained maximum prot
is:
a)
118939: 063;
b)
122939: 063;
c)
124939: 063;
d)
120939: 063.
x = 1000

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

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

2

6
6
M =6
4

1:0
1
1
1

1: 75
2
3
1

2: 25
2
1
3

2: 6
4
0
4

7
7
7 .
5

e (1) = 3B(1) + Se1 (1)2 + 5Se3 (1) is:

The no-arbitrage price of the payo X
a)
16: 95;
b)
17: 95;
c)
19: 95;
d)
24: 95.

[4 points]

Consider the following

2
1:0
6 1
6
M =6
4 1
1

The set of investment strategies #

characterized by:
4
#3 .
a)
#1 = 10
3
b)
#2 = 10 #3 ;
c)
#0 = 2 14#2 ;
d)
#1 = 4#2 .

one-period market with a zero riskfree rate (r = 0):

3
1: 8
1: 1
1: 5
2
3
1 7
7
7
1
1
2 5
3

such that

V# (0) = V# (1) (! 1 ) = V# (1) (! 3 ) = 2

Alessandro Sbuelz - SBFA, Catholic University of Milan

is

SOLU T ION S

The equilibrium-valuation problem is

1
Et [dw] + X 8 + 8X 4 + 16
dt

= wr + wX X

where

1
1
Et [dW ] = wX + wXX X 2
dt
2

w (0) > 0 (when X is absorbed at 0, the stock keeps paying 16dt every second).

The total per-annum dividend X 8 +8X 4 +16 is made of three distinct pieces: the per-annum dividends
of two dierent power stocks and the constant component 16. Let us formulate the educated three-piece
guess
W (X) = AX 8 + B8X 4 + C

(the boundary condition w (0) > 0 is met by construction if C > 0) ,

where A, B, and C > 0 are constants to be determined (also A and B need to be positive to support a
non-negative stock price). Given

WX X

8AX 8 + 4B8X 4 ,

WXX X 2

8 (8

1) AX 8 + 4 (4

1) B8X 4 ,

the dynamic equilibrium restriction becomes

X8

8X 4

8 + 28

(r + 8
{z

) A + 1

=0

4 +6

( 16
Cr )
|
{z
}

(r + 4
{z
=0

) B + 1

=0

0 .

Alessandro Sbuelz - SBFA, Catholic University of Milan

Notice that C =

16
r

y (8)

r+8

> 0. Under the condition

8 + 28

with

< 0

y( ) =

1
2

2 2

1
2

r,

the non-negativity of the equilibrium stock price is granted:

A =

B =

r+8

1
> 0;
(8 + 28 2 )

1
r+4

(4 + 6 2 )

> 0:

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

G (X) =
( it solves the problem

X3
r+

5
3

5
3

5
1
Et [dG] + X 3 = Gr + GX X
dt

5
9

with G (0) = 0 ) :

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

F (X) =
( it solves the problem

r+3

5X 3
(3 + 3 2 )

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

Alessandro Sbuelz - SBFA, Catholic University of Milan

with F (0) = 0 ) :

The total gain on your portfolio is

dH

800
F

300
G

dF + 5X 3 dt

dF + 5X 3 dt
F

800

800 (( r + 3

( Hr

1900

dG + X 3 dt

dG + X 3 dt
G

300

) dt

) dt

3 dz)

300

400rdt

r +

400rdt

5
3

dt

5
dz
3

400rdt

1900 dz .

The total return on your portfolio is

1
dH
H

(r

19

Alessandro Sbuelz - SBFA, Catholic University of Milan

) dt

19 dz .

SOLU T ION S

The correct answer is c).

For this equality-constrained problem, the Lagrangian function is

L (w1 ; w2 ; l)

r + w1 (r1

r) + w2 (r2

l w12

r)

2
1

+ w22

2
2

+2

1 2 w1 w2

and the First Order Conditions (FOCs) are su cient. The objective function is strictly increasing and
concave in w1 and w2 . The constraint function is a variance, which is always strictly convex in w1 and
w2 for 6= 1. The FOCs are:
8
>
L w1
>
>
>
>
>
<
L w2
>
>
>
>
>
>
: L

8
>
>
>
>
>
>
<

The rst two equations can be rewritten as

2l

"

2
1

1 2
2
2

1 2

#"

w1
w2

"

r
r

>
>
>
>
>
>
:

r1
r2

2lw1

2
1

2lw2

2 1

r + r1 = 0

2lw2

2
2

2lw1

1 2

r + r2 = 0

2 w1 w2

1 2

w2 2

w12

2
1

with det

"

2
1
1 2

2
2

+v =0 .

1 2
2
2

#!

2 2
1 2

r1 r
2 (1

2)

>0.

Hence,
"

w1
w2

1
2l

2
1

1
2
2 (1

2)

"

2
2

1 2
2
1

1 2

# "

r
r

r1
r2

that is,

w1 =

1
2l

r1
2
1 (1

r
2)

r2 r
2 (1

2)

and

Alessandro Sbuelz - SBFA, Catholic University of Milan

w2 =

1
2l

r2
2
2 (1

r
2)

SOLU T ION S

The correct answer is d).

The inverse demand functions are

"

X = 1000 + 3y 4x
Y = 1000 4y + 3x

so that the monopolists problem is

maxP (x; y)
x;y

s.t.

(x

180)2

25

with
P (x; y) = x (1000 + 3y

4x) + y (1000

4y + 3x)

(20x + 30y + 5xy + 10000) :

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

(x; y) 2 R2 : (x

180)2

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

3 2
3
2
8
1
Pxx
Pxy
7 6
7
6
H = 4
5=4
5 with Pxx =
1
8
Pyx
Pyy

25

8 < 0 and

det (H) = 63 > 0 :

Given the Lagrangian function

L (x; y; l) = P (x; y)
the Kuhn-Tucker First Order Conditions
8
>
Lx = 0
>
>
>
>
>
Ly = 0
>
>
>
>
>
<
,
l 0
>
>
>
Ll 0
>
>
>
>
>
>
>
>
: l L =0
l

l (x

180)2

25

are:
8
>
y 8x l (2x 360) + 980 = 0
>
>
>
>
>
x 8y + 970 = 0
>
>
>
>
>
<
l 0
>
>
>
25 (x 180)2 0
>
>
>
>
>
>
>
>
: l 25 (x 180)2 = 0

Alessandro Sbuelz - SBFA, Catholic University of Milan

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

82
8
>
>
y
8x
+
980
=
0
=
0
< x=
<
6
,
4
>
>
:
:
x 8y + 970 = 0
y=

8810
63

= 139: 841 270

8740
63

= 138: 730 159

The unconstrained maximum-prot point is such that P

unfeasible as the constraint is violated:

8810 8740
; 63
63

180)2

25 :

(139: 841 270

7
5 .

= 125806: 349. It turns out to be

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

8
>
y 8x l (2x 360) + 980 = 0
>
>
>
>
>
<
x 8y + 970 = 0
>
>
>
>
>
>
: 25 (x 180)2 = 0 (the constr. is binding)

8
8
x = 2880l+8810
>
16l+63
>
>
>
x = 175
>
>
>
>
>
>
>
>
>
>
< y = 2300l+8740
<
16l+63
,
,
y = 143: 125
>
>
>
>
(
>
>
>
>
>
>
>
>
175
>
: l = 27: 687 5 > 0 .
>
x
=
with
l
>
0
:
185

The constrained maximum prot is

P (175; 143:125) = 120939: 063 .

Alessandro Sbuelz - SBFA, Catholic University of Milan

SOLU T ION S

The correct answer is c).

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
4

1:0
1: 75
2: 25
2: 6

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

Since

31
2 2 4
7C
B6
det @4 3 1 0 5A = 16 ,
1 3 4
02

we can focus on the three risky securities to work out the unique measure Q:
02
3T 1
3
2 2 4
Q (! 1 )
B6
7 C
7
6
3
1
0
5 C
4
4 Q (! 2 ) 5 = B
A
@
1 3 4
Q (! 3 )
2

31
1: 75
7C
6
B
@(1 + 0) 4 2: 25 5A
2: 6
0

3
0:05
7
6
4 0:35 5 .
0:6
2

The riskless security is also properly priced:

3T 2
3
1
0:05
1 6 7 6
7
4 1 5 4 0:35 5 .
1+0
1
0:6

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

3B(1) + Se1 (1)2 + 5Se3 (1)

2

3 2
3
2 3
1
22
4
6 7 6 2 7
6 7
34 1 5 + 4 3 5 + 54 0 5
1
12
4

3T 2
3
27
0:05
1 6
7 6
7
X (0) =
4 12 5 4 0:35 5
1+0
24
0:6

3
27
6
7
4 12 5 .
24

19: 95 .

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

3
#X
1
6 X 7
4 #2 5
#X
3

and

V#X (0)

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

2
6
6
6
4

0
15
4
3
4
9
2

3T
7
7
7
5

2
6
6
6
4

3
27
7
6
4 12 5
24
2

1:0
1: 75
2: 25
2: 6

Alessandro Sbuelz - SBFA, Catholic University of Milan

3
7
7
7
5

2
6
4

15
4
3
4
9
2

3
7
5

19: 95 .

10

SOLU T ION S

The correct answer is c).

8
>
< 1:0#0 + 1: 8#1 + 1: 1#2 + 1: 5#3 = 2
#0 + 2#1 + 3#2 + #3 = 2
>
:
#0 + 3#1 + #3 = 2

1:0 1: 8 1: 1 1: 5 6
6
76
2
3
1 56
4 1
4
1
3
0
1

()

#0
#1
#2
#3

2 3
2
7
7 6 7
7=4 2 5 .
5
2

Since
31
1:0 1: 8 1: 1
7C
B6
det @4 1
2
3 5A =
1
3
0
02

2: 5 ,

we have
3
2
3
1:0 1: 8 1: 1
#0
7
6
6
7
2
3 5
4 #1 5 = 4 1
1
3
0
#2
2

3
2:0 2:8#3
6
7
= 4
0:6#3
5
0:2#3

3
2
B6 7
@4 2 5
2
02

=)

31
1: 5
7C
6
#3 4 1 5A
1
2

#0 = 2

5
2:8 #2 ,
1

where
2

3
1:0 1: 8 1: 1
6
7
2
3 5
4 1
1
3
0

9
1 6
4 3: 3
2:5
3: 2

3
1: 1
1: 9

Alessandro Sbuelz - SBFA, Catholic University of Milan

3T
1
7
1: 2 5
0:2

3: 6
6
4 1: 2
0:4

1: 32
0:44
0:48

3
1: 28
7
0:76 5 .
0:08
11