MATH4512 Fundamental of Mathematical Finance

2021-2022 Spring Semester

Suggested Solution of Assignment 4

Bonus Problem 1 (Optional, 30 marks)

You are given the following two investment plans:
Investment plan A Investment plan B
Payoff Probability Payoff Probability
4 𝑝 4 0.4 − 2𝑝
9 0.6 − 𝑝 9 0.6 + 𝑝
16 0.4 16 𝑝
where 0 ≤ 𝑝 ≤ 0.2.
(a) Suppose that the utility function of an investor is 𝑢(𝑤) = ln 𝑤 for 𝑤 > 0, find the
range of 𝑝 such that the investor strictly prefers investment plan A.
(b) We take 𝑝 = 0.15.
Another investor chooses the investment plan based on the 5 properties
mentioned in the lecture note and suppose that this investor is indifference
between (i) receiving $9 for sure and (ii) receiving a random payoff $𝑋 where
$4 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑞
𝑋={ .
$16 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 1 − 𝑞
Find the range of 𝑞 such that the investor strictly prefers investment plan A.
Provide full justification to your answer (*Note: You need to demonstrate clearly
how to use those properties to get the final answer.)
😊Solution
(a) Using maximum expected utility criterion, the investor prefers investment plan
A to investment plan B if and only if
𝑝𝑢(4) + (0.6 − 𝑝)𝑢(9) + 0.4𝑢(16)
> (0.4 − 2𝑝)𝑢(4) + (0.6 + 𝑝)𝑢(9) + 𝑝𝑢(16)
⇔ 𝑝 ln 4 + (0.6 − 𝑝) ln 9 + 0.4 ln 16
> (0.4 − 2𝑝) ln 4 + (0.6 + 𝑝) ln 9 + 𝑝 ln 16.
⇔ 0 ≤ 𝑝 < 0.184338.
(b) Using interchangeability (since 9~𝑋), the two investment plans are equivalent
to
Investment plan A Investment plan B
Payoff Probability Payoff Probability
4 𝑝 4 0.4 − 2𝑝
𝑋 0.6 − 𝑝 𝑋 0.6 + 𝑝
16 0.4 16 𝑝
Using decomposability, the two investment plans can be expressed as
Investment plan A Investment plan B
Payoff Probability Payoff Probability
4 𝑝 + 𝑞(0.6 − 𝑝) 4 0.4 − 2𝑝 + 𝑞(0.6 + 𝑝)
16 0.4 + (1 − 𝑞)(0.6 − 𝑝) 16 𝑝 + (1 − 𝑞)(0.6 + 𝑝)
 Using monotonicity, the investor prefers investment plan A if and only if the
chance of getting $16 (higher payoff) is higher than that of investment plan B.
That is,
0.4 + (1 − 𝑞)(0.6 − 𝑝) > 𝑝 + (1 − 𝑞)(0.6 + 𝑝)
𝑝=0.15
⏞ 0.4 + (1 − 𝑞)(0.45) > 0.15 + (1 − 𝑞)(0.75)
⇒
⇒ 𝑞 > 0.166667.
Bonus Problem 2 (Optional, 20 marks)
An investor is facing two investment plans (Plan X and Plan Y) as follows:
Plan X Plan Y
Payoff Probability Payoff Probability
𝐴1 0.5 𝐴1 0.45
𝐴2 0.1 𝐴2 0.3
𝐴3 0.3 𝐴3 0.1
𝐴4 0.1 𝐴4 0.15
You are given that
• The investor has strict preference on these outcomes: For any 𝐴𝑖 and 𝐴𝑗 ,
we have either 𝐴𝑖 ≻ 𝐴𝑗 or 𝐴𝑖 ≺ 𝐴𝑗 .
• 𝐴1 is the best outcome and 𝐴4 is the worst outcome.
Question: Suppose that the investor prefers Plan Y to Plan X, what can you say about the
investor’s preference between the outcomes 𝐴2 and 𝐴3 ? Choose the best answer below
and provide full justification to your answer.
(A) The investor prefers 𝐴2 to 𝐴3
(B) The investor prefers 𝐴3 to 𝐴2
(C) The given information cannot indicate the investor’s preference between 𝐴2
and 𝐴3 .
(*Note: If your answer is (C), you need to give an example which the investor prefers 𝐴2 to
𝐴3 and another example which the investor prefers 𝐴3 to 𝐴2 .)
(😊Hint: You can consider either 5 axioms or maximum expected utility criterions)
😊Solution
We first derive a criterion of choosing the optimal investment plan based on those 5
axioms:
Using continuity axiom, there exists probabilities 𝑝, 𝑞 (where 0 < 𝑝, 𝑞 < 1) such that
𝐴 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑝
𝐴2 ~𝐿2 = { 1
𝐴4 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 1 − 𝑝
and
𝐴 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑞
𝐴3 ~𝐿3 = { 1
𝐴4 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 1 − 𝑞
By the interchangeability axiom, the two plans are equivalent to
Plan X Plan Y
Payoff Probability Payoff Probability
𝐴1 0.5 𝐴1 0.45
𝐴2 𝐿2 0.1 𝐿2 0.3
 𝐴3 𝐿3 0.3 𝐿3 0.1
𝐴4 0.1 𝐴4 0.15

By decomposability axiom, the two plans are equivalent to

Plan X Plan Y
Payoff Probability Payoff Probability
𝐴1 0.5 + 0.1𝑝 𝐴1 0.45 + 0.3𝑝
+ 0.3𝑞 + 0.1𝑞
𝐴4 0.1 𝐴4 0.15
+ 0.1(1 − 𝑝) + 0.3(1 − 𝑝)
+ 0.3(1 − 𝑞) + 0.1(1 − 𝑞)
Since 𝐴1 is the best outcome, it follows from monotonicity property that the investor
prefers Plan Y if and only if the chance of getting 𝐴1 in plan Y is higher than that in plan
𝑋, i.e.
0.45 + 0.3𝑝 + 0.1𝑞 > 0.5 + 0.1𝑝 + 0.3𝑞
⇒ 𝑝 > 𝑞 + 0.25 > 𝑞.
As mentioned in class, the values of the probabilities 𝑝 and 𝑞 (deduced from continuity
axiom) reflects the investor’s satisfaction to the outcomes 𝐴2 and 𝐴3 , it follows that
𝐴2 ≻ 𝐴3 since 𝑝 > 𝑞. (Alternatively, one can verify this by applying monotonicity
properties on 𝐿2 and 𝐿3 ). The answer is (A).

Bonus Problem 3 (Optional, 30 marks)

We consider the following two investment plans:
Investment plan A Investment plan B
Payoff Probability Payoff Probability
𝐴1 𝑝1 𝐴1 𝑞1
𝐴2 𝑝2 𝐴2 𝑞2
𝐴3 𝑝3 𝐴3 𝑞3
⋮ ⋮ ⋮ ⋮
𝐴𝑛 𝑝𝑛 𝐴𝑛 𝑞𝑛
where 𝐴1 < 𝐴2 < 𝐴3 < ⋯ < 𝐴𝑛 . It is also given that
𝑝1 + 𝑝2 + ⋯ + 𝑝𝑘 < 𝑞1 + 𝑞2 + ⋯ + 𝑞𝑘
for all 𝑘 = 1,2, … , 𝑛 − 1.

Question
An investor is asked to choose one of the above investment plans. It is given that the
investor makes the decision based on the 5 axioms presented in the lecture. Show that
the investor will prefer investment plan 𝐴. Provide full justification to your answer.
(😊Hint: We let 𝑃𝑘 = 𝑝1 + 𝑝2 + ⋯ + 𝑝𝑘 and 𝑄𝑘 = 𝑞1 + 𝑞2 + ⋯ + 𝑞𝑘 , then the given
condition can be rewritten as 𝑃𝑘 < 𝑄𝑘 for all 𝑘 = 1,2, … , 𝑛 − 1. Since 𝑝1 + ⋯ + 𝑝𝑛 = 1,
you can argue that 𝑝𝑛 > 𝑞𝑛 (please include the argument in your solution). It will be
useful in comparing two plans in last step.)
😊Solution
By continuity property, we get for any 𝑖 = 2,3, … , 𝑛 − 1, there exists a probability 𝛼𝑖 ∈
(0,1) such that
𝐴 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 1 − 𝛼𝑖
𝐴𝑖 ~𝐿1 = { 1 .
𝐴𝑛 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝛼𝑖
Furthermore, it follows from monotonicity property that
𝐴1 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 1 − 𝛼𝑖 𝐴1 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 1 − 𝛼𝑗
𝐴
⏟𝑖 < 𝐴𝑗 ⇔ 𝐴𝑖 ~ {𝐴 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝛼 ≺{
𝑛 𝑖 𝐴𝑛 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝛼𝑗
𝑤ℎ𝑒𝑛 𝑖<𝑗
= 𝐴𝑗 ⇔ 𝛼𝑖 < 𝛼𝑗 .
(*Recall that the investor should prefer the plan which has higher probability of getting
the better outcome (i.e. 𝐴𝑛 in our case).
So we have 𝛼2 < 𝛼3 < ⋯ < 𝛼𝑛−1 (As 𝐴1 < 𝐴2 < ⋯ < 𝐴𝑛−1 < 𝐴𝑛 )

By interchangeability, two investment plans are equivalent to

Investment plan A Investment plan B
Payoff Probability Payoff Probability
𝐴1 𝑝1 𝐴1 𝑞1
𝐿2 𝑝2 𝐿2 𝑞2
𝐿3 𝑝3 𝐿3 𝑞3
⋮ ⋮ ⋮ ⋮
𝐴𝑛 𝑝𝑛 𝐴𝑛 𝑞𝑛
By decomposability, two investment plans can be “simplified” into
Investment plan A Investment plan B
Payoff Probability Payoff Probability
𝑛−1 𝑛−1
𝐴1 𝐴1
𝑝1 + ∑(1 − 𝛼𝑘 )𝑝𝑘 𝑞1 + ∑(1 − 𝛼𝑘 )𝑞𝑘
𝑘=2 𝑘=2
𝑛−1 𝑛−1
𝐴𝑛 𝐴𝑛
𝑝𝑛 + ∑ 𝛼𝑘 𝑝𝑘 𝑞𝑛 + ∑ 𝛼𝑘 𝑞𝑘
𝑘=2 𝑘=2
Recall from monotonicity property that the investor will choose the plan which has
larger likelihood of earning 𝐴𝑛 (since 𝐴𝑛 > 𝐴1 ), we consider the difference
𝑛−1 𝑛−1

𝐷 = (𝑝𝑛 + ∑ 𝛼𝑘 𝑝𝑘 ) − (𝑞𝑛 + ∑ 𝛼𝑘 𝑞𝑘 )
⏟ 𝑘=2 ⏟ 𝑘=2
𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑒𝑎𝑟𝑛𝑖𝑛𝑔
𝐴𝑛 (𝑝𝑙𝑎𝑛 𝐴) 𝐴𝑛 (𝑝𝑙𝑎𝑛 𝐵)
(𝑝1 + 𝑝2 + ⋯ + 𝑝𝑚 ) − ⏟
By writing 𝑝𝑚 = ⏟ (𝑝1 + 𝑝2 + ⋯ + 𝑝𝑚−1 ) and 𝑞𝑚 =
𝑃𝑚 𝑃𝑚−1
(𝑞1 + 𝑞2 + ⋯ + 𝑞𝑚 ) − ⏟
⏟ (𝑞1 + 𝑞2 + ⋯ + 𝑞𝑚−1 ), we get
𝑄𝑚 𝑄𝑚−1
𝑛−1 𝑛−1

𝐷 = 𝑃𝑛 − 𝑃𝑛−1 + ∑ 𝛼𝑘 (𝑃𝑘 − 𝑃𝑘−1 ) − (𝑄𝑛 − 𝑄𝑛−1 ) − ∑ 𝛼𝑘 (𝑄𝑘 − 𝑄𝑘−1 )

𝑘=2 𝑘=2
= 𝑃𝑛 − (1 − 𝛼𝑛−1 )𝑃𝑛−1 − (𝛼𝑛−1 − 𝛼𝑛−2 )𝑃𝑛−2 − ⋯ − (𝛼3 − 𝛼2 )𝑃2 − 𝛼2 𝑃1
 −𝑄𝑛 + (1 − 𝛼𝑛−1 )𝑄𝑛−1 − (𝛼𝑛−1 − 𝛼𝑛−2 )𝑄𝑛−2 − ⋯ − (𝛼3 − 𝛼2 )𝑄2 − 𝛼2 𝑄1
= (𝑃𝑛 − 𝑄𝑛 ) + (1 − 𝛼𝑛−1 )(𝑄𝑛−1 − 𝑃𝑛−1 ) + (𝛼𝑛−1 − 𝛼𝑛−2 )(𝑄𝑛−2 − 𝑃𝑛−2 ) + ⋯
+ (𝛼3 − 𝛼2 )(𝑄2 − 𝑃2 ) + 𝛼2 (𝑄1 − 𝑃1 ) … (∗)
Since 𝑃𝑛 = 𝑝1 + 𝑝2 + ⋯ + 𝑝𝑛 = 1, 𝑄𝑛 = 𝑞1 + ⋯ + 𝑞𝑛 = 1 and
𝑝1 + 𝑝2 + ⋯ + 𝑝𝑘 < ⏟
⏟ 𝑞1 + 𝑞2 + ⋯ + 𝑞𝑘 𝑓𝑜𝑟 𝑘 = 1,2, … , 𝑛 − 1.
𝑃𝑘 𝑄𝑘
Together with the fact that 𝛼2 < 𝛼3 < ⋯ < 𝛼𝑛 , we deduce from (∗) that
𝐷=⏟ (𝑃𝑛 − 𝑄𝑛 ) + ⏟(1 − 𝛼𝑛−1 ) ⏟
(𝑄𝑛−1 − 𝑃𝑛−1 ) + ⏟
(𝛼𝑛−1 − 𝛼𝑛−2 ) ⏟
(𝑄𝑛−2 − 𝑃𝑛−2 ) + ⋯
=0 >0 >0 >0 >0
(𝛼3 − 𝛼2 ) ⏟
+⏟ (𝑄2 − 𝑃2 ) + 𝛼 (𝑄1 − 𝑃1 ) > 0
⏟2 ⏟
>0 >0 >0 >0
Hence
𝑛−1 𝑛−1

(𝑝𝑛 + ∑ 𝛼𝑘 𝑝𝑘 ) > (𝑞𝑛 + ∑ 𝛼𝑘 𝑞𝑘 ) .

⏟ 𝑘=2 ⏟ 𝑘=2
𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑒𝑎𝑟𝑛𝑖𝑛𝑔
𝐴𝑛 (𝑝𝑙𝑎𝑛 𝐴) 𝐴𝑛 (𝑝𝑙𝑎𝑛 𝐵)
So we conclude that the investor should choose the investment plan A.