ACTL 3004 / 5109

Financial Economics for Insurance and Superannuation

Final Exam
S2, 2005

Question 1 (4 marks)
Consider a world in which there are only two risky assets, A and B. There is
also a risk free asset with return rf . The two risky assets are in equal supply in
the market, and hence the market return rM is defined by
rM =

1
(rA + rB ) .
2

2
2
The following information is known: rf = 0.09, A
= 0.04, B
= 0.03, AB =
0.02, E [rM ] = 0.18

Find the CAPM expected return for asset A.

Question 2 (8 marks)
Consider an investor with the following utility function:
2

u (w) = aw b (max (L w, 0))

where a and b are positive constants.

(i) [4 marks] List two behavioural properties implied by this utility function.
(ii) [4 marks] How does this investors investment in risky assets (in dollar
terms) change as his wealth increases?

Question 3 (9 marks)
A guarantee contract pays off according to the gains of the stock index S (t),
with a guaranteed minimum payout and maximum payout. More precisely, it is
a five year contract which pays out 0.8 times the ratio of the terminal and initial
values of the index. Or it pays out 125% if otherwise it would be less, or 175%
if otherwise it would be more. Assume that the Black-Scholes assumptions are
satisfied.
(i) [5 marks] Assume that the index has expected return = 6%, standard
deviation = 20%, dividend yield = 3%, and that the risk free rate is r =
6.5%. How much is this contract worth?
(ii) [4 marks] Find the amount of stock and cash that would be required to
hedge this guarantee (at time 0).

Question 4 (7 marks)
(Yr 2012 comment: This was a topic discussed in the 2005 offering of the course)
Consider two bounded random variables, A and B. The random variable A is
said to be Second Order Stochastic Dominant (SSD) over B if
Z z
Z z
FA (y) dy
FB (y) dy, for all z
a

and

FB (y) dy, for some value of z

FA (y) dy <
a

(where a represents the minimum value of A and B).

It is known that the above statistical relationship can be applied to problems of
investment choice. Derive a relationship between SSD and investment choice,
stating any behavioural assumptions required.

Question 5 (8 marks)
Consider an investment fund whose aim is to track the returns of a target
portfolio (e.g. the stock market index) closely. Specifically, suppose the target portfolio has return rm and suppose that there are n assets available for
investment, with random rates of return r1 , r2 , ..., rn . It is known that these
assets form a subset of the returns contributing to the target portfolio. Letting
w1 , ..., wn denote the proportion invested into asset 1, ..., n, we wish to find a
portfolio whose rate of return
r = w1 r1 + ... + wn rn
has the property that tracking error (defined as variance of the difference between rm and r) is minimised.
(i) [4 marks] Find the set of equations that can be used to solve for w1 , ..., wn .
You are not required to solve these equations.
(ii) [4 marks] An issue with the above approach is that the expected returns
of the portfolio may not match that of the index. Find a set of equations that
can be used to solve for w1 , ..., wn such that both the tracking error is minimised,
and that the expected return of r and rm are matched. You are not required to
solve these equations.

Question 6 (10 marks)

(i) [5 marks] Suppose that there are n assets whose rates of returns are governed
by the single factor model
ri = i + i f
where i and i are constants, i = 1, 2, .., n. f represents the random factor
outcome. Derive the APT expected return for these stocks. You may assume
that E [f ] = 0
(ii) [5 marks] Suppose now that the asset returns are instead given by
ri = i + i f + i
where the i are independent of f , and also independent with every other j ,
i 6= j. Explain the idea of a well diversified portfolio, and hence derive the
corresponding APT expected returns result.

Question 7 (4 marks)
Consider a European option with payoff function
max (0.5ST , ST K)
Let s be the time 0 price of the stock, and C1 , C2 be the prices of calls on this
stock with strike prices K and 2K respectively. Find the price of the option in
terms of s, C1 , C2 .

Question 8 (12 marks)

The Vasicek model assumes that the Q dynamics of the short rate r can be
modelled by
dr = ( r) dt + dW Q
where , , and are constants.
(i) [4 marks] By considering
Z
K (t) =

ds
0

show that the solution to the above SDE is

r (t) = et r (0) + 1 et + et

eau dW Q (u) .

(ii) [4 marks] What is the distribution of r (t)?

(iii) [4 marks] List two advantages and two disadvantages of this model.

Question 9 (13 marks)

As an alternative to the standard GBM model, several researchers have proposed
a model where
dS
S (0)

( S) Sdt + SdW

= s

where , , are constants. Assume also that a bond B (t) is available for
investment with some constant interest rate r > 0.
(i) [3 marks] Assuming no arbitrage, derive the market price of risk for
this model.
(ii) [6 marks] Construct a self-financing replicating strategy for a derivative
with payoff X and maturity T
(iii) [4 marks] Present an applicable formula for the price of a European call
option with strike price K and maturity at time T .
You may find the following mathematical results useful:

1. Girsanov Theorem
Let W (t) be a P - Brownian Motion. If we set the Radon-Nikodym derivative
RT
RT 2
1
dQ
= e 0 (t)dW (t) 2 0 (t)dt
dP
then
Z
t

W Q (t) = W (t) +

(s) ds
0

will be a Q - Brownian motion.

2. Martingale Representation Theorem:
Consider two Q martingales X (t) , Y (t). There exists a previsible process
(t) such that
dX (t) = (t) dY (t) .

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Question 10 (9 marks)
Consider a model where the stock price is modelled by a 2 year trinomial tree.
For example, starting at a current value of $1, in one years time the stock price
can either
rise to a ratio of 1.2 of the current value
stay at the current value
drop to a ratio of 0.85 of the current value.
Assume that a risk free bond is available for trade, with r = 0%, i.e. the value
of the bond is $1 at all times.
The following (European) option prices can be observed in the market:
A call option with strike price of 0.9 and maturity at time 1 is currently
trading at 0.12.
A call option with strike price of 1.3 and maturity at time 2 is currently
trading at 0.0105.
An fixed strike lookback option with payoff



max
max S (t) 1.1, 0
t=0,1,2

and maturity at time 2 is currently trading at 0.0295.

Given the above information, and assuming no arbitrage, find the price of a call
option with a strike price of 1.1 and maturity at time 2.

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Question 11 (10 marks)

Consider the equilibrium asset pricing model
p = E [mx]
where p is the (time 0) market price of an asset, x is the time 1 payoff of the
asset, and m is the equilibrium stochastic discount factor.
Assume the economy is in equilibrium, and the equilibrium stochastic discount
factor m can be represented as
m = a + bRx + cRy
where a, b and c are constants. Rx and Ry represent the (random) returns on
the stock market index and the commodities price index respectively. Assume
that Rx and Ry are independent.
(i) [2 marks] Let rf be the risk free rate. Show that
a=

1
bE [Rx ] cE [Ry ]
1 + rf

(ii) [8 marks] Using the result in (i), solve for b and c, and hence develop
formula for E [Ri ], the expected return on a stock with (random) return Ri .

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Question 12 (6 marks)
Lionel, your friend from high school, is currently looking at different methods
to price options. One day he says to you the following:

I have looked at the derivation and assumptions of the Capital Asset

Pricing Model. It is clear that it is not designed to price options.

Discuss the above statement.

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