Financial Economics - Group 2

Problem Set 3

1. Consider an agent with two investment alternatives: one risky asset with return r1 and a
risk-free asset with return r0 . Denote with v the initial wealth and A the amount of wealth
invested in the risky asset.
Find the value of A∗ that maximizes the expected utility from the portfolio payoff if
(a) u(x) = ln x and r1 takes two different values, each with probability p and 1 − p.
(b) u(x) = − exp(−cx) and r1 has a normal distribution.
In both cases, how does the investment in the risky asset change with wealth?
2. Consider a market model with one risky asset with initial price s1 = 50 and final prices
S1 = (70 40)> and risk-free asset with return rate 5%.
Consider a financial contract that gives you the right (but not the obligation) to buy the risky
asset at the end of the period at a fixed price K = 55. If you buy it using the contract, you
sell it immediately at the (market model) price.

(a) Calculate the payoffs of this contract

(b) Find the replicating portfolio and calculate the replication price of this contract
(c) Calculate the state price vector
(d) Calculate the risk-neutral probabilities. Show the price of the contract using the risk-
neutral probabilities is the same as the replication price

3. An arbitrage opportunity is a portfolio x such that s · x ≤ 0 and Sx ≥ 0 ∈ Rn with Sx 6= 0.

That is, all the entries of the vector Sx are non-negative with at least one strictly positive.
Prove that
(a) Existence of a strictly positive state price vector implies absence of arbitrage opportunites
(b) Existence of risk neutral probabilities implies absence of arbitrage opportunites
(c) Absence of arbitrage opportunities implies that the LOP holds
4. Prove that the LOP holds iff Sx = 0 ∈ Rn implies s · x = 0
5. Prove that the LOP holds iff there exists a (non-necessarily positive) state price vector π
6. Consider a market model with the following payoff matrix
 
9 0 12
S=
4 8 6

The prices of the first two assets are s1 = 5 and s2 = 4.

(a) Find the price s3 for which the market model is free of arbitrage opportunities.
(b) Find the state-price vector π and the implied risk-free rate r0
(c) Find the risk-neutral probabilities q1 , q2
(d) Calculate the replication strategies of the elementary Arrow-Debreu securities e1 and e2

1
 7. Consider a market model with the following payoff matrix
 
1 1
S=
1 2

The asset prices are s1 = s2 = 1. Prove that LOP holds in this market but there can be
arbitrage opportunities.
8. Consider the following payoff matrix
 
1 0 2
S=
0 1 1

The asset price vector is s = (1 1 2)> . Is this market model free of arbitrage opportunities?
Justify your answer.
9. Consider the following payoff matrix
 
1 4
S= 1 2 
1 0

The asset price vector is s = (1 2)> . Is this market model free of arbitrage opportunities? If
yes, find
(a) Positive state prices π1 , π2 , π3
(b) Risk-neutral probabilities q1 , q2 , q3
(c) Replication strategies of the elementary Arrow-Debreu securities e1 , e2 , e3
(d) Implied risk-free rate r0
10. Consider a market model with two risky assets. Let w := s1 x1 /v denote the proportion of
wealth invested in the first asset, so that 1 − w denotes the proportion of wealth invested in
the second asset.

(a) Prove that the rate of return R of the portfolio satisfies R = wr1 + (1 − w)r2 .
(b) Let σi denote the standard deviation of ri , i = 1, 2, and let ρ denote their correlation.
Calculate V ar[R] in terms of w and find w∗ that minimizes V ar[R].
(c) Let µi denote the expectation of ri , i = 1, 2. Calculate E[R] in terms of w.
(d) Assume the following
Asset µ σ
1 4% 25%
2 5% 32%
and ρ = 0, 2. Find the standard deviations of the portfolios with expected returns 5%, 7%
and 10%.