SURNAME: FIRST NAME:

UCSC ID NUMBER:

Mock Exam 2 [8 exercises; 33 points available; 75 minutes available]

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The nal score is given by 9 points + the score obtained in the exercises (3 points for each correct answer).
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1 Given the one-period market (with riskfree rate r = 0)
2 3
1:0 2
6 1+0 1 7
6 7
M =6 7
4 1+0 2 5
1+0 4
h iT h iT
and the payo X (1) (! 1 ) X (1) (! 2 ) X (1) (! 3 ) = 4 1 1 , the minimum-cost strat-
e (1) is such that:
egy #u that super-replicates X
A) #u0 = 5#u1 ; B) #u0 = 5#u1 ;
C) #u0 = 3#u1 ; D) #u0 = 3#u1 ; E) none of the other answers is correct.
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2 Given the one-period market (with riskfree rate r = 0)
2 3
1 0:5 1
6 1+0 4 4 7 1 1 1
06 7
M =6 7 with objective probability masses P (! 1 ) = , P (! 2 ) = and P (! 3 ) = ,
4 1+0 0 4 5 4 4 2
1+0 0 0
2
the no-arbitrage price of the payo Ye (1) = 2B (1) + 2Se1 (1) Se1 (1) Se2 (1) + Se2 (1) is such that:
A) Y (0) = 2; B) Y (0) = 3;
C) Y (0) = 4; D) Y (0) > 4; E) none of the other answers is correct.
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3 Start from the setup of Question 2 and consider the initial wealth
h iW0 = 1. Givenh the
i risk
P e P e
aversion parameter > 0, the strategy # solves the problem max E V# (1) V ar V# (1) . The
#1 ;#2
strategy # has the same wealth variance of a strategy #, with #1 = #2 = 12 , when:
q p
A) = 11 3
; B) = 311 ;
q p
C) = 22 3
; D) = 2211 ; E) none of the other answers is correct.
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4 Start from the setup of Question 2 and consider the initial wealth W0 . Among the strategies
made of risky securities only, the strategy , expressed in terms of portfolio shares, that minimizes the
wealth variance is such that:
A) 1 = 1; B) 2 = 0;
C) 0 = 1; D) 2 = 1; E) none of the other answers is correct.

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 1
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5 Under the objective probability measure P , the underlying stock value dynamics is

dS
= (r q+ ) dt + dz P ;
S
where r is the riskfree rate, q is the dividend yield, is the volatility parameter, is the risk premium
P
( is the market price of risk), and z is a Wiener process under P . S is the positive current stock
value (t is the current date). The European call, the European put, and the futures contract have the same
maturity/delivery date T > t (K is the common strike price of the two options). Their current no-arbitrage
values are c (S; t), p (S; t), and F (S; t), respectively. They are such that:
A) c (S; t) = p (S; t) + er(T t) F (S; t) e r(T t) K;
B) c (S; t) = p (S; t) + e r(T t) F (S; t) e r(T t) K;
C) c (S; t) = p (S; t) er(T t) F (S; t) e r(T t) K;
D) c (S; t) = p (S; t) e r(T t) F (S; t) e r(T t) K;
E) none of the other answers is correct.
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6 Start from the setup of Question 5. The digital option with the terminal payo 1fS Kg (for
t ! T ) has current no-arbitrage value D (S; t), which is such that:
A) dD = + S (r q + ) + 21 S 2 2 dt + Dqdt + S dz P ;
B) dD = + S (r q) + 21 S 2 2 dt + S dz P ;
C) dD = Et [dD] + S dt + S dz P ;
D) dD Et [dD] = ( =D) S dz P ;
E) none of the other answers is correct.
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7 Assume the Vasicek model (the short rate r has dynamics dr = (r r) dt + r dzrP under the
objective probability measure P with > 0). The market price of interest rate risk is r (with r 6= 0) The
zero-coupon bond value B (r; t) with maturity date T > t is such that:
A) Brr = B 1 e ;
1 e
B) Brr = Br ;
e
C) Brr = Br ;
D) Brr = Br 1 e ;
E) none of the other answers is correct.
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8 Start from the setup of Question 7. The zero-coupon bond price B (r; t) with maturity date
T > t is such that:
A) Bt Br (r r) + 12 Brr 2r = Br2 ;
B) Bt Br (r r) + 12 Brr 2r = Br;
C) Bt Br (r r) + 21 Brr r2 2r = Br;
D) Bt + Br (r r) + 12 Brr 2r = Br;
E) none of the other answers is correct.

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 2
 SOLUTIONS
1 The correct answer is B.

The market is obviously incomplete (2 securities and 3 states of the world). The payo is not replicable:
02 31
1+0 1 4
B6 7C
det @4 1 + 0 2 1 5A = 6 .
1+0 4 1

The candidate super-replicating strategies # = [#0 ; #1 ]T solve the system

2 3 2 3 8
1+0 1 4 >
< 1 #0 + 1 #1 4 (not below the green line)
6 7 6 7
4 1 + 0 2 5# 4 1 5 () 1 #0 + 2 #1 1 (not below the yellow line) :
>
:
1+0 4 1 1 #0 + 4 #1 1 (not below the grey line)

theta_1 10

)
(1
X
g
t in
5 li ca
p
-re
p er
su

-4 -2 2 4 6 8 10
theta_0

-5

e (1) by studying the

We determine the minimum-cost strategy among all those that super-replicate X
initial-cost function
c# (0) = #0 1 + #1 2 ( = V# (0) ).
The level curve c of such a function is identi ed by the straight line of equation
c 1
#0 1 + #1 2 = c () #1 = #0 (see the red solid lines below).
2 2

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 3
 theta_1 10

)
(1
X
g
t in
5 li ca
c=3 p
-re
p er
su

-4 -2 2 4 6 8 10
theta_0

-5

The minimum-cost strategy is given by the couple [#u0 ; #u1 ]T represented by the intersection between the
green line and the grey line. Hence, we must solve the system

(
1 #0 + 1 #1 = 4
1 #0 + 4 #1 = 1

to obtain the seeked strategy

" #
5
[] =
1

and the associated minimum cost

V#u (0) = (5) 1 + ( 1) 2 = 3 .

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 4
 2 The correct answer is D.

By the First and Second Fundamental Theorems of Asset Pricing, the market M 0 is arbitrage-free and
complete as it supports a unique risk-neutral probability measure Q (recall that the riskfree rate is r = 0):

2 3 2 3T 2 3 2 3 2 3
1
1:0 1+0 4 4 Q (! 1 ) Q (! 1 ) 8
6 7 1 6 7 6 7 6 7 6 1 7
4 0:5 5 = 4 1 + 0 0 4 5 4 Q (! 2 ) 5 , 4 Q (! 2 ) 5 = 4 8 5 .
1+0 3
1:0 1+0 0 0 Q (! 3 ) Q (! 3 ) 4

The payo realizations are

2 3 2 3 2 3 2 3 2 3 2 3
Y (1) (! 1 ) 1+0 4 4 4 42 10
6 7 6 7 6 7 6 7 6 7 6 7
4 Y (1) (! 2 ) 5 = 2 4 1 + 0 5 + 2 4 0 5 4 0 4 5 + 4 42 5 = 4 18 5
Y (1) (! 3 ) 1+0 0 0 0 02 2

and the no-arbitrage price is

2 3T 2 3
1
h i 10 8
1 1 6 7 6 7
Y (0) = E Q Ye (1) = 4 18 5 4 1
8 5 = 5 .
1+r 1+0 3
2 4

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 5
 3 The correct answer is D.

Given market M 0 , the joint distributions of the terminal prices of the risky assets are such that:

h
i h i
e P P e
E S1 (1) = 1; E S2 (1) = 2
h i h i
V arP Se1 (1) = 3; V arP Se2 (1) = 4
h i
Cov P Se1 (1) ; Se2 (1) = 2

The expectation and variance of terminal wealth are:

h i
E P
Ve# (1) = (W0 #1 0:5 #2 1) + #1 1 + #2 2 = W0 + #1 (1 0:5) + #2 (2 1)
h i
V arP Ve# (1) = #21 3 + #22 4 + 2#1 #2 2

h i
Given the risk aversion parameter > 0, the strategy # that solves the problem max E P
Ve# (1)
#1 ;#2
h i
P e
V ar V# (1) is obtained imposing the following F.O.C.:

8 h i h i
>
>
<
@
@#1
E P
Ve# (1) V ar P
Ve# (1) = 0

>
> h i h i
: @
E P Ve# (1) V arP Ve# (1) = 0;
@#2

which take the speci c form

8
>
< (1 0:5) (2#1 3 + 2#2 2) = 0

>
:
(2 1) (2#2 4 + 2#1 2) = 0:

1
The solution is #1 = 0; #2 = 8
. The corresponding wealth variance is

h i
V ar P
Ve# (1) = (#1 )2 3 + (#2 )2 4 + 2#1 #2 2
2
2 1 1
= (0) 3+ 4 + 2 (0) 2
8 8
1
= 2
16

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 6
 The wealth variance of # is

h i 2 2
V arP Ve# (1) = #1 3 + #2 4 + 2#1 #2 2
2 2
1 1 1 1
= 3+ 4+2 2
2 2 2 2
11
=
4

h i h i
The terminal wealth variance of # , V arP Ve# (1) , and the terminal wealth variance of #, V arP Ve# (1) ,
are equal when

1 11
2
=
16 4

p
11
Which is veri ed when = 22
.

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 7
 4 The correct answer is D.

The strategy made only of risky assets, #, that minimizes the wealth variance is the solution of the
following problem

h i
min V ar P
Ve# (1) s.t. #1 S1 (0) + #2 S2 (0) = W0
#1 ;#2

W0 #1 0:5
As the budget constraint imposes that #2 = 1
, the wealth variance is

h i
V ar P
Ve# (1) = #21 3 + #22 4 + 2#1 #2 2
= #21 3 + (W0 #1 0:5)2 4 + 2#1 (W0 #1 0:5) 2

h i
The minimum is obtained by imposing d
V ar P e
V# (1) = 0
d#1

d h i
V arP Ve# (1) = 2#1 3 2 0:5 (W0 #1 0:5) 4 + 2W0 2 4#1 0:5 2 = 4#1 = 0
d#1

The solution is #1 = 0 and #2 = W0 #1 0:5 = W0 . The strategy can be expressed in terms of portfolio
shares:

#1 S1 (0) 0 0:5
1 = = =0
W0 W0
#2 S2 (0) W0 1
2 = = =1
W0 W0
0 = 1 1 2 = 0

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 8
 5 The correct answer is B.

The put-call parity states that

q(T t) r(T t)
c (S; t) p (S; t) = |e {z S } e K .
= e r(T t) F (S;t)

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 9
 6 The correct answer is E.

The digital option provides no payouts. By Ito's Lemma, we have:

1 2 2
dD = + S (r q+ )+ S dt + S dz P .
2

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 10
 7 The correct answer is D.

Since

1 e
B (r; t) = e( a( ) b( ) r )
with =T t and b ( ) = > 0 ,

we have

Br = B b( )

1 e
= B

and

Brr = B b2 ( )

1 e 1 e
= B

1 e
= Br .

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 11
 8 The correct answer is E.

For the no-arbitrage bond value B (r; t), the pricing restriction is

1
Et [dB] = Br + Br r r ,
dt

1 2
Bt Br (r r) + Brr r = Br + Br r r (recall the assumption r 6= 0).
2

Alessandro Sbuelz, Andrea Tarelli - SBFA, UCSC - QUANTITATIVE METHODS FOR FINANCE 12