RMSC4003

Homework 1
Due: September 22, 2010

1. Consider two portfolios A and B. Let the returns of portfolio A, rA be

normally distributed with mean 8% and standard deviation 10% and
let the corresponding returns for portfolio B be normally distributed
with mean 12% and standard deviation 20%.

Table 1:
% of Chance of Less than this Level
Level of Terminal Wealth Portfolio A Portfolio B
0.7 0 2
0.8 0 5
0.9 4 14
1.0 * *
1.1 57 46
1.2 * *
1.3 99 82

Verify the entries of Table 1 for the level 0.8 and fill out the missing
entries in this table represented by ∗.
2. From the web, download the daily stock prices of Hong Kong Stock
Exchange for one year.
(a) Plot out the daily prices, can you detect any trend?
(b) Construct the returns series from these prices and plot the his-
togram of the return series. Does it look like a normal curve?
What does the q − q normal plot on this set of data tell us?
3. Suppose that E(X) = E(Y ) = 1, Var(X) = 2, Var(Y ) = 3 and Cov(X, Y ) =
1.
(a) What are E(0.1X + 0.9Y ) and Var(0.1X + 0.9Y )?
(b) For what value of w is Var(wX + (1 − w)Y ) minimized? Suppose
that X is the return on one asset and Y is the return on a second
asset. Why would it be useful to minimize Var(wX + (1 − w)Y )?
4. Let X1 , X2 , Y1 and Y2 be random variables.
(a) Show that Cov(X1 + X2 , Y1 + Y2 ) = Cov(X1 , Y1 ) + Cov(X1 , Y2 ) +
Cov(X2 , Y1 ) + Cov(X2 , Y2 ).

1
 (b) Show that if X, Y, and Z are independent, then Cov(α1 X +
2 , where VarX = σ 2 .
Y, α2 X + Z) = α1 α2 σX X

5. Let rt be a log return defined by rt = log Pt − log Pt−1 , where Pt

denotes the price of an asset at time t. Suppose that r1 , r2 , . . . , are
i.i.d. N(0.1,0.6).

(a) What is the distribution of rt (3) = rt + rt−1 + rt−2 ?

(b) What is P (r1 (3) < 2)?
(c) What is the covariance between r1 (2) and r2 (2)?
(d) What is the conditional distribution of rt (3) given rt−2 = 0.8?

6. Suppose you are holding a $1 million portfolio and you want to protect
yourself against the market downturns. You purchased 10 contracts
of put options on S&P500 with a strike of 900. Suppose that the
current level of S$P500 is 1,000 and each contract is worth $100, 000 =
$100 × 1, 000. Suppose that after three months, the S&P500 drops to
a level of 880.

(a) Suppose your portfolio drops to $0.88 million in three months

and you decide to close out all of your positions. What would be
the balance?
(b) Suppose your portfolio drops to $0.8 million in three months and
you decide to close out all of your positions. What would be the
balance?
(c) What is the value of the basis risk?
(d) What causes the basis risk in this case?