MATH 423 May 28, 2021

Midterm Exam

This is a remote exam. Books, calculators and notes are allowed.

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Instructions:
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- Start is 12:00pm. End is 1:40pm. Upload your work until 1:50pm.

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- Answer the questions on a piece of paper (or electronically).

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- Write down your full name and unique name.

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- There is no need to print the question sheet.

- There is no need to copy the questions.

- Label your answers with the same labels as the questions are labelled.

- Produce a pdf file of your work (e.g. take a picture and use an app like “Genius Scan”).

- Change the name of the file to “LastnameFirstname”.pdf.

- Go to Canvas → Math423 → Assignments → Midterm Exam → Submit Assignment.

Good luck!
Sheet 1 of 5
Problem 1 Answer the following questions:

a) Why is short selling riskier than borrowing

cash?
b) What is larger an annual rate of 8% or a
quarterly rate of 2%? Explain.
c) Let σij be a covariance of ith and j th returns
of some assets. Is σ12 ≠ σ21 possible (if so give
an example)? Explain.
d) In the mean-variance graph, draw the effi-
cient frontier of a bond and the market portfo-
lio and point out a non-feasible portfolio. La-
bel the axis.
e) Write down the Lagrangian of
minw wCwT /µwT subject to a weight
vector w = (w1 , . . . , w7 ) fulfilling w1 + w4 = 0

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and wCwT = 1.

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f) Why do we assume that there are no arbi-

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trage opportunities in the market? ve lo rin
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g) What are the advantages of futures con-

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tracts over forward contracts?

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h) How much do you pay at most for stock

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S at maturity T if you hold (a) a call with

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strike K and (b) a forward with continuously

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compounded interest rate r?

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i) How much do you pay to enter a new for-

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ward contract which expires after 1 year? For

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how much you expect to sell it after 6 months?

(Continuously compounded interest rate can
be assumed.)
j) How much do you pay at most for stock S
at maturity T if you hold (a) a call with strike
K and (b) a forward with continuously com-
pounded interest rate r?
k) Consider a call option for stock S with strike
K and maturity T . Explain why providing the
stock S is the same as providing the payoff
(S(T ) − K)+ at maturity T .
l) What is special about an American call op-
tion?

Sheet 2 of 5
Problem 2 Consider a market with only two stocks: S1 and S2 . The data on the returns of the
stocks (Ki = (Si (1) − Si (0))/Si (0)) after one year is given below.

Scenario Probability K1 K2
A1 1/2 0.12 -0.02
A2 1/3 -0.06 0.24
A3 1/6 0.24 0

(a) Find the expected return vector µ and the covariance matrix C. Write down the formulas
you used.

(b) Find a portfolio that has the minimum variance among all portfolios with expected return
x.

(d) Find the minimal variance portfolio. Either set up and solve the corresponding Lagrangian
optimization problem or use part (b).

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(d) Can a portfolio with mean 0.06 be attained using only S1 and S2 without short selling? If

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yes, find the representation. If not, explain why not.

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(e) Assume that the (annual) interest rate is 4% (recall that we deal with a one year period in
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the question, and there is no compounding). Find the best portfolio (in both risky and risk
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free assets) you would invest in with mean 6% (best in terms of the mean-variance theory).
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Sheet 3 of 5
Problem 3 Consider a market in which CAPM assumptions hold.

(a) Write the expressions for the Capital Market Line and Security Market Line. Explain
each term and how to derive these equations.

You are given the following graphs of mean annual return v.s. standard deviation and beta,
for all possible portfolios of assets in the market. Assume that the intercepts are at or in
the middle of the bars according to the way it looks. That is, on the graph to the left the µ
and σ intercepts are 0.025 and 0.05, and on the graph to the right, the intercept is 0.025.

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(b) What is the risk-free rate? What is the mean and the standard deviation of the market
portfolio? Explain your answers. ve lo rin
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(c) A hedge fund that is operating in this market, i.e. it only uses the assets in the market,
is offering a portfolio with the average annual return of 10%. What level of standard
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deviation for the portfolio is acceptable? What is the correlation coefficient between
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the portfolio and the market portfolio? Show your calculations.

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Sheet 4 of 5
Problem 4 Suppose that S(0) = $100 and that the annual rate of interest r = 5% is continuously-
compounded. We also know that two dividends of $5 each will be paid at times t = 1 and t = 2
(time units are in years). Consider a long Forward position at time t = 0 for delivery at time T = 3
years.

(a) What is the Forward price at time 0.

(b) Find an arbitrage opportunity if the Forward price is set to be F(0,3)=110.

(c) Suppose the stock price at time t = 1.5 is $110. Compute the value at time t = 1.5 of the
long Forward position that was signed at time t = 0.

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Sheet 5 of 5