Universidad del Pacífico

Departamento Académico de Finanzas

Economía Financiera
2018 – I
Lecturer: Rolando Luna Victoria
Teaching assistants: Luis Ortega – Álvaro Cotera- Carlos Cabrera

Practical Assessment N°2

Comments

1. Regarding statistical distributions, what would be the distribution of asset prices, knowing that
returns distribute normally? Does a consecutive +-1% returns with non-continuous
capitalization yields the same price?

Returns are assumed to distribute normally, meaning that:

𝑟𝑡 ~𝑁(𝜇, 𝜎 2 )

If we define asset prices as the capitalized return of the previous price, we state that

𝑆𝑡 = 𝑆𝑡−1 𝑒 𝑟𝑡

So it can be inferred that prices are distributed Log-normally, as log-normal distributions are
those that yield normal distributions when log is applied.

ln 𝑆𝑡 − ln 𝑆𝑡−1 = 𝑟𝑡

Or
𝑇 𝑇

ln 𝑆𝑇 = ln 𝑆0 + ∑ 𝑟𝑡 , ∑ 𝑟𝑡 ~𝑁(𝜇𝑇, 𝜎 2 𝑇) → ln 𝑆𝑇 ~𝑁(ln 𝑆0 + 𝜇𝑇, 𝜎 2 𝑇)

𝑡=1 𝑡=1

2. Briefly describe the logic of the State Model. Point out the concepts of State, Pure/Complex
assets and Cyclical and Counter-Cyclical assets.

State: Might be understood as a detailed description of the economy, a scenario where different
variables have a given realization. For example, a “good” state would be with high growth, low
inflation, strong terms of exchange, etc., whereas a “bad” state would be its opposite. There are
infinite states.

Pure asset: Asset that pays one positive unit, 1, in a state and 0 in others. Example: AD
Complex asset: Asset that pays something different from 0 in more than 1 state (any real asset)

Cyclical asset: Asset which value is directly related to the performance of the economy. If the
economy does well, the asset’s value moves in that direction.
Counter-cyclical asset: Asset which value is inversely related to the performance of the economy.
If the economy does well, this asset moves in the opposite direction. It is said that these assets
work as “insurance” because if economies do badly, the asset performs well.
Universidad del Pacífico
Departamento Académico de Finanzas
Economía Financiera
2018 – I
Lecturer: Rolando Luna Victoria
Teaching assistants: Luis Ortega – Álvaro Cotera- Carlos Cabrera

3. Define what a risk-free asset is. How does it relate to AD assets?

In the State Model, risk is associated to the range of the payoff. That way, a risk-free asset is that
which pays you the same independently of the state you are in (Range = 0). Regarding the AD
assets, an AD pays 1 in a determined state and 0 in the others. If we sum up all the ADs, we get
an asset that pays 1 in every possible state, so there is no risk associated with it. Then, the
summation of all AD’s defines a risk-free asset’s value (normally related to 1 risk-free bond).
𝐵𝑟𝑓 = ∑𝑆𝑠=1 𝑞𝑠 . From this asset it’s posible to find a risk-free rate.

4. Name the arbitrage characteristics and explain the logic of the no arbitrage principle as well
as its role in equilibrium.

Arbitrage: Is the notion of a riskless profit. Doesn’t require capital at the beginning, has a different
form 0 chance to win something and a 0 chance to lose.

No arbitrage principle: If 2 assets have the same cash flows for tomorrow, they shouldn’t have
different costs today. If not, there would be an arbitrage opportunity. If they have different prices,
I would buy the cheap one, sell the expensive one and get a profit. A minimum requirement for
equilibrium in a competitive market is that prices don’t reflect arbitrage opportunities. If they do,
there is still room for arbitraging and prices to adjust.

5. Prove that the 𝑥 vector in the equation system 𝐴𝑥 = 𝐵 represents the solution to a replicating
portfolio where A and B are the payoff arrays for the n assets and the n+1 asset,
respectively. What happens if 𝐴 = 𝐼? Point out the relevance of not having redundant
assets/states (i.e. that the 𝐴 matrix has full rank) when replicating an asset.

If you have 𝑛 assets that pay 𝑎𝑖𝑗 for the 𝑖 = 1,2,3 … . 𝑛 state and for the 𝑗 = 1,2,3 … 𝑛 asset, you
can group payoffs into the 𝐴 matrix:
𝑎11 𝑎12 𝑎13
𝐴 = [ 21 𝑎22 𝑎23 ]
𝑎
𝑎31 𝑎32 𝑎33
For the 𝑖 = 𝑗 = 3 case.
Then, to replicate a 4th asset with payoffs:

𝑏1
𝐵 = [𝑏2 ]
𝑏3

A linear combination of payoffs is required in the form

𝑎11 𝑥1 + 𝑎12 𝑥2 + 𝑎13 𝑥3 = 𝑏1

𝑎21 𝑥1 + 𝑎22 𝑥2 + 𝑎23 𝑥3 = 𝑏2
𝑎31 𝑥1 + 𝑎32 𝑥2 + 𝑎33 𝑥3 = 𝑏3
Universidad del Pacífico
Departamento Académico de Finanzas
Economía Financiera
2018 – I
Lecturer: Rolando Luna Victoria
Teaching assistants: Luis Ortega – Álvaro Cotera- Carlos Cabrera

In order to replicate the cash flows of the 4th asset, where 𝑥𝑖 is the weight of each asset 𝑖 = 1,2,3
in the replicating portfolio. Then it’s straightforward that:

𝐴𝑥 = 𝐵

And 𝑥 contains the solution to the replicating portfolio. If 𝐴 = 𝐼 then it is understood that all assets
are AD assets, and
𝑥=𝐵

The weights of the replicating AD portfolio are exactly the payoffs of the replicated asset.

The solution to the lineal system can be written in matrix terms:

𝐴𝑥 = 𝐵 → 𝑥 = 𝐴−1 𝐵

For the 𝐴−1 matrix to exist, it’s necessary that its determinant is different from 0, and so we need
linearly independent rows and columns (full rank), which is the same as stating that assets (and
states) should not be redundant.

Exercises

1. In the Excel Spreadsheet you have the historical time series of the S&P 500 index and the
price of a UST10Y (United States Sovereign 10Y Bond). Find the annual returns of these
assets, as well as the statistical moments of such returns. Discuss your results. Do these
returns resemble a normal distribution? Calculate the statistical moments for a 3-year holding
period. What can you conclude from the data?

2. An arbitrageur is looking for a riskless profit opportunity. He realizes that there are 2 possible
scenarios: (i) slow growth, (ii) recession. Furthermore, in his evaluation he perceives that
Amazon Inc. that costs USD 60 pays USD 90 and USD 50 in each scenario, respectively. For
its part, Apple which it’s quoted at USD 360 would cost USD 420 in the optimistic scenario and
USD 300 in the pessimist one. With this it’s asked, if Google will cost USD 600 in an expansion
and USD 400 in a recession, how much should it cost? If it costs USD 500, is arbitrage
possible? What would be your strategy? How much would you profit?

3. We have the following market assets in a 2-state economy:

I. Gold: its price is USD 40 and moves to USD 15 in the positive state and USD 70 in the
negative state.
II. Silver: its price is USD 60 and moves to USD 68 in the positive state and USD 40 in
the negative state.
III. Copper: its price is USD 70 and moves to USD 115 in the positive state and USD 45 in
the negative state.
Universidad del Pacífico
Departamento Académico de Finanzas
Economía Financiera
2018 – I
Lecturer: Rolando Luna Victoria
Teaching assistants: Luis Ortega – Álvaro Cotera- Carlos Cabrera

a) What is the value of the AD1 asset in this economy?

a. 0.63
b. 0.06
c. 0.42
d. None of the above
b) Is arbitrage possible in this economy?
a. Yes, sell the overvalued asset and buy the replicating portfolio
b. Yes, buy the undervalued asset and sell the replicating portfolio
c. There are no arbitrage possibilities
d. It can’t be determined
c) In a no-arbitrage world, if you assume the same probability of occurrence for each state,
the Risk Premium of Silver is:
a. 2%
b. -20.9%
c. It can’t be determined
d. None of the above

4. Consider the following assets in a 3-state economy:

I. Alpha: Is quoted at S/88, it’s worth S/200 in the Good state, S/120 in the Normal state
and S/65 in the Bad state.
II. Beta: Is quoted at S/55, it’s worth S/100 in the Good state, S/50 in the Normal state and
S/45 in the Bad state.
III. Delta: Is quoted at S/96, it’s worth S/186 in the Good state, S/101 in the Normal state
and S/77 in the Bad state.

You are asked to find the AD assets value and the risk-free rate. Indicate an arbitrage strategy for
Gamma if its price is S/50, costs S/145 in the Good state, S/120 in the Normal state and S/45 in
the Bad state.