1.

(20 points)
a. Write the Fundamental Theorem of Asset Pricing.

b. What is admissible strategy?

c. Explain two differences between a call option and a long forward position.

d. What is dominant portfolio?

2
2. (25 points) Let A(0) = 100, A(1) = 110, A(2) = 121 and suppose that stock prices
can follow four possible scenarios:
Scenario S(0) S(1) S(2)
w1 90 100 113
w2 90 100 105
w3 90 80 90
w4 90 80 80
a. Draw the tree of the stock prices.

b. Find a risk-neutral probability, if possible.

3
c. Apply the Fundamental Theorem of Asset Pricing to find the time 0 and 1 prices of a
European call option with strike price $86 maturing after two steps.

4
3. (15 points) Suppose that you took a mortgage of $120, 000 on a house tobe paid
back in full by 12 equal annual instalments, each consisting of the interest due on the
outstanding balance plus a repayment of a part of the amount borrowed. if you decided
to clear the mortgage after eight years, how much money would you need to pay on top
of the 8th instalment, assuming that a constant annual compounding rate of 7% applies
throughout the period of the mortgage?

5
4. (20 points) Prove the following proposition:
Given that the stock price S(n) has become known at time n, the risk-neutral conditional
expectation of S(n + 1) will be

E (S(n + 1)|S(n)) = S(n)(1 + r).

6
5. (20 points) Prove the following proposition by using the method of Lagrange multi-
pliers:
The weights of any portfolio belonging to the efficient frontier (except for the minimum
variance portfolio) satisfy the condition C = m u for some real numbers > 0 and
where C is n n covariance matrix of returns, u is a one-row matrix with all n entries
equal to 1, and m is a one-row matrix with entries of expected returns i = E(Ki ) for
i = 1, ..., n.