Marking Scheme

STRATHMORE INSTITUTE OF MATHEMATICAL SCIENCES

Bachelor of Business Science Financial Economics
END OF SEMESTER EXAMINATION

BSE 4115: - ECONOMIC ANALYSIS OF ASSET PRICES

DATE: 1st July, 2017 TIME: 2 Hours

INSTRUCTIONS:
(1) This Exam Contains five questions
(2) Answer question one and any other two questions
(3) Question one is compulsory and carries 30 marks
(4) All the other questions carry 20 marks each

QUESTION 1 - COMPULSORY

(a) Outline the Consumption CAPM (CCAPM) and discuss any two problems
of using it in applied work. Hint: The CCAPM is given by:
 0 
u (Ct+1 )
pt = E β 0 X t +1
u (Ct )
1 1− γ
where u(C ) = 1− γ C : ∀γ 6= 0 and Xt+1 is the payoff.
and [4 marks]

(b) Briefly discuss the following propositions. Justify your arguments using
proper workings.

i. The existence of the linear pricing rule such that ρ[ X ( aϕ + bω )] =

aρ( X ϕ ) + bρ( Xω ), where Xω and X ϕ are portfolio payoffs, ρ indicates
price mapping and a and b are constants, is equivalent to the absence

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 of arbitrage opportunities in the economy.
and [4 marks]

ii. To rationally price assets or to ensure market pricing efficiency, we

do not need to assume that all investors are smart. What we need is
a few smart ones who can capitalize on any arbitrage opportunities.
and [4 marks]

Solution:

Linear pricing rule and no arbitrage

• The price mapping is uniquely determined by the payoffs, and it

must be the case that the prices are identical if the payoffs are.
• Linear pricing rule:- The law of one price is valid if and only if the
linear pricing rule is true
• The linear pricing rule implies that the price of a portfolio must be
equal to a portfolio of component prices.
• When the pricing operator is both linear and implying positive state
prices, we refer to this as a positive linear pricing rule. The existence
of such a rule is equivalent to the absence of arbitrage opportunities
in the economy.

Second statement on rational pricing

• Here it suffices to state the Fundamental Theorem of Asset Pricing

and explain the implication of the theorem
• Under The Fundamental Theorem of Asset Pricing, the following are
equivalent:(1) Absence of Arbitrage, (2) Existence of linear pricing
rule,and (3)Existence of an investor with a monotonic preference
whose utility is maximized
• In deriving pricing formulas, many theoretical equilibrium asset
pricing models assume all investors behave rationally and have
identical information sets.
• Hence:To rationally price assets or to ensure market pricing effi-

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 ciency, we do not need to assume that all investors are smart. What
we need is a few smart ones who can capitalize on any arbitrage
opportunities.

(c) Suppose there is a special economy with 3 states and 3 assets, the payoff
matrix X of which is given by:
 
1 3 1
 
X=
 1 1 7 

1 0 0

The associated price vector is p = (1 2 3)0 .

i. Does the equilibrium price measure q exist for this economy? If so

derive this measure. [4 marks]

ii. Is the equilibrium price measure derived in (i) above unique? Explain.
and [2 marks]

iii. In this economy, what is the no-arbitrage price of a derivative security

with payoffs equal to X = (5 10 15) [3 marks]

Solution:

Part (i)

• The existence of the state price vector q is the existence of solution

q to the linear equation given by the state pricing relation.
• In this case the solution exists since rank ( X ) = s
• The solution is given by q = ( XX 0 ) X p. Solving the linear system of
equations gives q = (0.55 0.35 0.10)0

Part (ii)

• The price is unique since the market is complete. Completeness is

given by rank ( X ) = s.
• A complete market not only allows investors to obtain any desired

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 payoff in any state (with a price), but also permits unique asset
pricing.

Part (iii)

• Since the state price vector q = (0.55 0.35 0.10)0 exists, it can be
used to price any contingent asset in the economy.
• The price of the derivative is given by Price = Xq = (5 10 15)(0.55 0.35 0.10
7.75

(d) Conventional wisdom in Finance concerning life cycle portfolio changes

stipulates that young investors hold higher proportions of equities com-
pared to bonds. However, there are no general applicable recommenda-
tions available of how consumption of portfolio should change though
there are three factors relevant in formation of recommendation.
State and explain the three relevant factors mentioned in the statement
above. [9 marks]

Total for Question 1: 30 marks

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QUESTION 2 - OPTIONAL
A few simple rearrangements of the basic pricing equation p = E(mx ) can
give a lot of intuition and introduce some classic issues in finance, including
the determinants of the interest rate and risk adjustments.

(a) Show that all asset returns lie inside a mean variance frontier and assets
on the frontier are perfectly correlated with each other and the discount
factor such that returns on the frontier can be generated as portfolios of
any two frontier returns among others. [10 marks]

Solution:

• Part (a) of the question tests the linkage of the SDF to MVO

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(b) Show that idiosyncratic risk does not affect asset prices. [10 marks]

Solution:

• Part (b) is testing risk adjustments. The solution is as shown below:

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(B) Risk corrections
Using the definition of covariance 𝑐𝑜𝑣(𝑚, 𝑥) = 𝐸(𝑚𝑥) − 𝐸(𝑚)𝐸(𝑥), we can write the basic
pricing equation as

𝑝 = 𝑐𝑜𝑣(𝑚, 𝑥) + 𝐸(𝑚)𝐸(𝑥).

Substituting the risk-free equation, we obtain

𝐸(𝑥)
𝑝= + 𝑐𝑜𝑣(𝑚, 𝑥).
𝑅𝑓

The first term is the standard discounted present value formula, the asset’s price in a risk neutral
world. The second term is a risk adjustment. An asset whose payoff covaries positively with the
discount factor has its price raised and vice-versa.

To understand the risk adjustment, substitute back for 𝑚 in terms of consumption, to obtain

𝐸(𝑥) 𝑐𝑜𝑣[𝛽𝑢′ (𝑐𝑡+1 ), 𝑥𝑡+1 ]

𝑝= + .
𝑅𝑓 𝑢′ (𝑐𝑡 )

Marginal utility 𝑢′ (𝑐𝑡 ) declines as 𝑐 rises. Thus an asset’s price is lowered if its payoff covaries
positively with consumption, and vice-versa.

Why?

 Investors do not like uncertainty about consumption. If you buy an asset whose payoff
covaries positively with consumption, one that pays off well when you are already feeling
wealthy, and pays off badly when you are already feeling poor, that asset will make your
consumption stream more volatile. You require a low price to induce you to buy such an
asset.

If you buy an asset whose payoff covaries negatively with consumption, it helps to smooth
consumption and so is more valuable than its expected payoff might indicate, e.g. insurance.

Total for Question 2: 20 marks

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QUESTION 3 - OPTIONAL

(a) Consider a two-period (t, t + 1), two-state economy satisfying the follow-
ing pricing relationship between asset prices, P, consumption C, and any
dividends the assets may pay D:
 0 
u (Ct+1 )
Pt = Et β 0 ( Pt+1 + Dt+1 )
u (Ct )
1
Where β = 1.05 and utility is given by:

u(C ) = C − 0.1C2

In equilibrium consumption equals dividends. At time t, Pt = (2 1.5)0

and at time t + 1, Pt+1 = (2 1)0 and dividends can either grow to:
( (
4 2
D1,t+1 = OR to : D2,t+1 =
2 2

1
Both states have the same probability, i.e. π (st+1 ) = 2

i. Is the market in this case complete? Explain. [2 marks]

Solution:

The market is complete. There are two periods and two states.

ii. Consider a one-period discount bond with certain payoff Bt+1 = 1.

Calculate the price of this bond, Bt , at time t. [5 marks]

Solution:

To price the bond we need the risk free asset. From the information
provided price at time t is given by Pt = (2.1 1.5). The combined
payoff for the price and dividend is given as X1,t+1 = (6 3) and
X2,t+1 = (4 3). From this information a risk free asset pays off 3
regardless of the state. The price for this asset is given as 1.5. Hence

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 the risk free rate can be obtained as 3/1.5 − 1 = 200%. The price of
the bond is 1/(1 + r ) = 1/3.

iii. Next, compute the risk-neutral price under Q of a one-period call

option written on the first asset with an exercise price,K = 2
and [4 marks]

Solution:
1
Price = 1 + r EQ [ v j ] where v j are the payoffs. First we obtain the
risk neutral probabilities from the state prices q = ( XX 0 )−1 X p =
(0.05 0.45)0 and the state probabilities are q1 = 0.05/0.5 = 0.1 and
q2 = 0.45/0.5 = 0.9. Hence the risk neutral price p = 1/3 × (0.1 ×
4 + 0.9 × 2) = 0.73333

iv. How would the result in (iii) above compare with the price under real
probabilities, P? Hence, what does this mean for the Fundamental
Theorem of Asset Pricing?
and [9 marks]

Solution:

The result under the real probabilities will be the same as that
under risk neutral probabilities. Proof by calculating π j × m j ×
v j = 1/2(0.1/0.5 × 4 + 0.9/0.5 × 2) = 0.7333. It follows that The
Fundamental Theorem of Asset Pricing, which provides (1) Absence
of Arbitrage (2) Existence of linear pricing rule and (3) Existence of
an investor with a monotonic preference whose utility is maximized
is equivalent to the statements statements: (1) A market admits no
arbitrage, if and only if, the market has a martingale measure and
(2) The Martingale Measure is unique if and only if every contingent
claim can be hedged [Market Completeness]

Total for Question 3: 20 marks

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QUESTION 4 - OPTIONAL

(a) Consider investment choice in the presence of a risk-free asset and a

single risky asset with return R̃i > R f , and no end of period endowment
ỹ = 0. The investor chooses an amount φ to invest in the risky asset,
leaving ω0 − φ to invest in the risk free asset. Show that if the investor is
risk averse the investment in the risky asset increases with the level of
initial wealth. [8 marks]

Solution:

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Page 11 of 15
(b) Outline the key tenets of the following behavioral models of optimal
investment choice

i. Prospect theory [3 marks]

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ii. Disappointment Aversion Theory [3 marks]

iii. Regret Theory [6 marks]

Solution:

Prospect theory

• Reference point

• Loss aversion

• Risk loving in the region of losses

• Subjective weighted probabilities rather than "objective" probabili-

ties (people behave as if they regard extremely improbable events
as impossible and extremely probable events as certain).

Disappointment theory

• Extend the expected utility framework by discriminating good and

bad outcomes, i.e. outcomes above or below the certainty equiva-
lent;

• Bad outcomes are more heavily weighted than good outcomes.

• As a result, agents are more sensitive to bad outcomes and less to

good ones, hence the name disappointment aversion" .

• Disappointment Theory is similar in spirit to loss aversion theory

(first order risk aversion). But the reference point is endogeneous
(certainty equivalent) rather than arbitrary.

• Loss aversion models the shape of the utility function, while disap-
pointment models the probabilities.

Regret theory

• Adds a new psychological dimension to investment choices.

• Regret is defined as a cognitively-mediated emotion of pain and

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 anger when, with hindsight, we observe that we took a bad decision
in the past and could have taken one with better outcome.

• Regret theory assumes that agents are rational but base their deci-
sions not only on expected value of payoffs but also on expected
regret. They maximize their (modified) expected utility.

• So they care about the portfolio expected return and volatility (as
in mean variance) but also about expected regret.

U ( x, y) = v( x ) + f (v( x ) − v(y))

• Where U ( x, y) is the modified utility of achieving x, knowing that

y could have been achieved. v( x ) is the traditional utility function,
also called value function or choiceless utility.

• It is the "value" or utility that an investor would derive from out-

come x if he experienced it without having to choose.

• This value function is assumed to be monotonically increasing and

concave (risk aversion) as in traditional finance.

• The difference v( x ) − v(y) is the value loss/gain of having chosen

x rather than the best foregone choice y. The regret function f (.) is
monotonically increasing and decreasingly concave, with f (0) = 0.

• Regret introduces introduces two dimensions of risk.

• Loosely speaking, the first one is traditional volatility, linked to

deviations of the chosen portfolio return from its expected value.

• The second one is regret risk, linked to deviations of the chosen

portfolio returns from the return of the best forgone alternative.

• Investor exhibit traditional risk aversion, but also regret aversion.

Total for Question 4: 20 marks

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QUESTION 5 - OPTIONAL
Assume that in an economy risk-free borrowing or lending is possible at a
fixed rate, r = 10%. (Interest is paid once per time period, with no compound-
ing.)

(a) One period from the present, investors know (with certainty) that each
unit of an asset will pay a dividend of KES 24 and will have a market
value of KES 130. Explain how to obtain the market price of the asset
today in the absence of arbitrage opportunities. [2 marks]

(b) Generalize your answer in (i) above to obtain today’s price, pt for an asset
that pays a dividend of dt+1 at date t + 1, when its market value will equal
pt+1 . Hence, extend your analysis to obtain a Net Present Value (NPV)
relationship for a finite number, N, periods into the future, allowing for
dividends that may differ at each date though they are known (with
certainty) today. [4 marks]

(c) Suppose now that investors are uncertain about the asset’s future divi-
dend stream and that the dividend stream will be paid into perpetuity,
with a constant growth rate g. construct the pricing formula for the price
today of the asset. [4 marks]

(d) What are the implications of this uncertainty for the construction and
interpretation of the NPV relationship? [5 marks]

(e) What does the NPV relationship suggest for those assets with dividend
streams that co-vary negatively with the marginal utility and positively
with consumption? [5 marks]

Solution:

Total for Question 5: 20 marks

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