Cm2 Assignment (Q and A) Setted (23.03.2023)

CM2 ASSIGNMENTS & SOLUTIONS ACTUATORS EDUCATIONAL INSTITUTE
CM2
FINANCIAL ENGINEERING AND
LOSS RESERVING
ASSIGNMENTS & SOLUTIONS
FOR 2023
CA PRAVEEN PATWARI 1 JAI SHREE RAM

INDEX
CHAPTERS PAGE NO
ASSIGNMENT 1 3-20
ASSIGNMENT 2 21-36
ASSIGNMENT 3 37-48
ASSIGNMENT 4 49-64
ASSIGNMENT 5 65-76
SOLUTIONS
ASSIGNMENT 1 77-98
ASSIGNMENT 2 99-111
ASSIGNMENT 3 112-125

ASSIGNMENT 1
CHAPTER
THE EFFICIENT MARKET

HYPOTHESIS
QUESTION 1.
A researcher has analysed the annual returns of equity stocks in a particular country over a 10-year period
and has made the following observations:
(a) Annual market returns in consecutive years have a negative correlation of –0.25.
(b) The closing value of the index of the 100 stocks with the highest market capitalisation has been found
to be 1% higher on average on Fridays than on Mondays.
(c) Announcements of changes in companies' dividend policies typically take three months to become
fully reflected in the quoted share price.
(d) The prices of a particular subset of stocks have been consistently observed to fall immediately fol-
lowing a favourable announcement and to rise immediately following an unfavourable announce-
ment.
Discuss these observations in the light of the EMH.
QUESTION 2.
Discuss the following statement:
The existence of fund managers who sell their services based on their alleged ability to select over-
performing sectors and stocks and so add value to portfolios demonstrates that capital markets are not effi-
cient.

QUESTION 3.
(i) Describe what is meant by an 'efficient market'.
(ii) Describe the three different forms of the Efficient Markets Hypothesis.
(iii) Discuss the implications of the Efficient Markets Hypothesis.
QUESTION 4.
At the quarterly meeting of the Auger Close Investment Club, four members are making proposals for new
equity investment for the club.
Anna wants to buy shares in Armadillo Adventures, claiming that they have performed poorly in recent
weeks and are due an upturn.
Brian wants to invest in Biscuits-R-Us. They have recruited a new head of marketing, who has had success
at other companies. Brian feels that this new appointment will have a positive effect on the firm.
Cathy selects shares at random. This quarter she is recommending the club buy into Cash 4 Kidneys PLC.
Dennis wants the club to buy shares in Diamond Dentists ('DD'). His brother works for a major health in-
surer and has insider information that DD's shares will rise sharply in the near future, when it is announced
that his company has appointed DD as its 'dentist of choice'.
For each club member, describe how their share selection strategy would work in strongly efficient, semi-
strongly efficient, weakly efficient and inefficient markets.
QUESTION 5.
(i) Explain what is meant by an 'excessively volatile' market.
(ii) Describe how you would test if a market is 'excessively volatile'.

(iii) Explain the practical and conceptual difficulties in using a test of an excessively volatile market to
establish whether or not a market is efficient.
QUESTION 6.
(i) Explain the implications of the Efficient Markets Hypothesis for investment trading strategies.
(ii) Explain why investors will still wish to have as much information as possible concerning a company
and its securities before investing in it even if the Efficient Markets Hypothesis applies.

CHAPTER
UTILITY THEORY
QUESTION 7.
Each year, Mr A is offered the opportunity to invest £1,000 in a risk fund. If successful, at the end of the year
he will be given back £2,000. If unsuccessful, he will be given back only £500. There is a 50% chance of ei-
ther outcome. Calculate the expected rate of return per annum on the investment.
QUESTION 8.
(i) Derive an expression for the expectation of Investor X's next-period wealth if he invests a proportion
a of his current wealth w in Equity A (which pays –4% or +8%, with respective probabilities ¼ and ¾)
and the rest in a non-interest-bearing bank account.
(ii) State an expression for the expectation of the next-period utility of Investor X, again assuming that he
invests a proportion a in Equity A and the rest in a non-interest-bearing bank account. He has the util-
ity function U(w) = log(w).
QUESTION 9.
Investor A has an initial wealth of $100, which is currently invested in a non-interest-bearing account, and a
utility function of the form:
U(w) = log(w)
where w is the investor's wealth at any time.
Investment Z offers a return of –18% or +20% with equal probability.
(i) What is Investor A’s expected utility if nothing is invested in Investment Z?
(ii) What is Investor A's expected utility if they're entirely invested in Investment Z?
(iii) What proportion a of wealth should be invested in Investment Z to maximise expected utility? What is
Investor A’s expected utility if they invest this proportion in Investment Z?

QUESTION 10.
Suppose that an investor is asked to choose between various pairs of strategies and responds as follows:
Choose between: Response
B and D B
A and D D
C and D indifferent
B and E B
A and C C
D and E indifferent
Assuming that the investor's preferences satisfy the four axioms discussed above, how does the investor
rank the five investments A to E?
QUESTION 11.
Suppose that an unbiased coin is tossed once. Determine the fairness of a gamble in which you receive $1 if
it lands heads up but lose $1 if it lands tails up.
Suppose that a risk-averse investor with wealth w is faced with the gamble described.
Show that this investor will derive less additional utility from the possible gain than that lost from the poss-
ible loss and hence that risk aversion is consistent with the condition U”(w) < 0.
QUESTION 12.
What is the shape of the utility function of a risk-seeking investor?
QUESTION 13.
What can we say about the marginal utility of wealth of a risk-neutral investor?

QUESTION 14.
Suppose that an unbiased coin is tossed once, and a gamble exists in which an investor receives $1 if it
lands heads up but loses $1 if it lands tails up. Further assume that:
 the investor has initial wealth of $10 and
 a utility function of the form U  w   w .
Determine the investor's certainty equivalent for this gamble.
QUESTION 15.
Draw the quadratic utility function over the range 0  w  1 / 2d and show why it is valid only for
w  1 / 2d , for a non-satiated risk-averse investor.
QUESTION 16.
Suppose Investor A has a power utility function with   1 , whilst Investor B has a power utility function
with   0.5 .
(i) Which investor is more risk-averse (assuming that w > 0)?

(ii) Suppose that Investor B has an initial wealth of 100 and is offered the opportunity to buy Investment
X for 100, which offers an equal chance of a payout of 110 or 92. Will the Investor B choose to buy In-
vestment X?
QUESTION 17.
Consider the following utility function:
U  w   e
 aw
, a 0
Derive expressions for the absolute risk aversion and relative risk aversion measures. What does the latter
indicate about the investor's desire to hold risky assets?
QUESTION 18.
An insurer with initial wealth of £2,000 and a utility of U(x) = log(x) is designing a policy to cover damages
of £500 that occur with probability 0.5.
Calculate the minimum premium that the insurer can charge for the policy.
QUESTION 19.
An investor can invest in two assets, A and B:
A B
expected return 6% 8%
variance 4%% 25%%
The correlation coefficient of the rate of return of the two assets is denoted by p and is assumed to take the
value 0.5.
The investor is assumed to have an expected utility function of the form:
 
E  U   E rp  Var rp  
where  is a positive constant and rp is the rate of return on the assets held by the investor.
(i) Determine, as a function of  , the portfolio that maximises the investor's expected utility.
(ii) Show that, as  increases, the investor selects an increasing proportion of Asset A.
QUESTION 20.
Colin's preferences can be modelled by the utility function such that:
U'  w   3  2w,  w  0
(i) Determine the range of values over which this utility function can be satisfactorily applied.
(ii) Explain how Colin's holdings of risky assets will change as his wealth decreases.
(iii) Which of the following investments will he choose to maximise his expected utility?
Investment A Investment B Investment C
outcome probability outcome probability outcome probability
0.1 0.3 0 0.3 0.2 0.45
0.3 0.4 0.2 0.2 0.3 0.1
0.5 0.3 0.9 0.5 0.4 0.45

QUESTION 21.
Jenny has a quadratic utility function of the form U  w   w  10 w . She has been offered a job with Com-
5 2
pany X, in which her salary would depend upon the success or otherwise of the company. If it is successful,
which will be the case with probability ¾, then her salary will be $40,000, whereas if it is unsuccessful she
will receive $30,000.
(i) Assuming that Jenny has no other wealth, state the salary range over which U(w) is an appropriate
representation of her individual preferences.
(ii) Calculate the expected salary and the expected utility offered by the job.
(iii) Suppose she was also to be offered a fixed salary by Company Z. Determine the minimum level of fixed
salary that she would accept to work for Company Z in preference to Company X.
(iv) Suppose that the owners of Company X are both risk-neutral and very keen that Jenny should join
them and not Company Z. Determine whether the firm should agree to pay her a fixed wage, and, if so,
how much. Comment briefly on your answer.
QUESTION 22.
Jayne's utility function can be described as U  w   w . She faces a potential loss of £100,000 in the event
that her should house burn down, which has a probability of 0.01.
(i) Calculate the maximum premium that Jayne would be prepared to pay to insure herself against the
total loss of her house if her initial level of wealth was £140,000 and comment on your results.
Suppose that UN Life plc has an initial wealth of £100 million and a utility function of the form U(w) = w.
(ii) Calculate the minimum premium UN Life plc would require in order to offer insurance to Jayne and
comment on whether insurance is feasible in this instance.
QUESTION 23.
An insurance company will be required to make a payout of £500 on a particular risk event, which is likely
to occur with a probability of 0.4. The utility for any level of wealth, w, is given by:
U(w) = 4,000 + 0.5w

The insurer's initial level of wealth is £6000. Calculate the minimum premium the insurer will require in
order to take on the risk.
QUESTION 24.
Suppose that Lance and Allan each have a log utility function and an initial wealth of 100 and 200 respec-
tively. Both are offered a gamble such that they will receive a sum equal to 30% of their wealth should they
win, whereas they will lose 10% of their wealth should they lose. The probability of winning is ¼.
(i) State whether or not the gamble is fair.
(ii) Calculate Lance's certainty equivalent for the gamble alone and comment briefly on your answer.
(iii) Repeat part (ii) in respect of Allan and compare your answer with that in part (ii).
(iv) Confirm that your comments in part (iii) apply irrespective of the individual's wealth.

CHAPTER
STOCHASTIC DOMINANCE AND

BEHAVIOURAL FINANCE
QUESTION 25.
Define first-order and second-order stochastic dominance. Illustrate the definitions by sketching cumula-
tive distribution functions of two random variables which represent the returns on two investments, one of
which dominates the other.
QUESTION 26.
Consider the two risky assets, A and B, with cumulative probability distribution functions:
FA  w   w
FB  w   w
1
2
In both cases, 0  w  1 .
(i) Show that A is preferred to B on the basis of first-order stochastic dominance.
(ii) Verify explicitly that A also dominates B on the basis of second-order stochastic dominance.
QUESTION 27.
(i) Within the context of behavioural finance, explain fully what is meant by overconfidence.
The board of directors of an actively managed investment trust are concerned that the decisions of the
trust's investment manager may be subject to overconfidence bias, which could adversely affect the
performance of the trust.
(ii) Discuss possible actions that the board could take in order to try to limit the impact of the investment
manager's overconfidence bias.

CHAPTER
MEASURES OF INVESTMENT RISK

QUESTION 28.
Investment returns (% pa), X, on a particular asset are modelled using a probability distribution with densi-
ty function:

f  x   0.00075 100   x  5 
2
 where  5  x  15
Calculate the mean return and the variance of return.
QUESTION 29.
Investment returns (% pa), X, on a particular asset are modelled using the probability distribution:
X Probability
–7 0.04
5.5 0.96
Calculate the mean return and variance of return.
QUESTION 30.
Define both the skewness and the fourth central moment (called the kurtosis) of a continuous probability
distribution.
QUESTION 31.
ty function:

f  x   0.00075 100   x  5 
2
 where  5  x  15
Calculate the downside semi-variance of return.

QUESTION 32.
X Probability
–7 0.04
5.5 0.96
Calculate the downside semi-variance of return.
QUESTION 33.
ty function:

f  x   0.00075 100   x  5 
2
 where  5  x  15
Calculate the shortfall probability where the benchmark return is 0% pa.
QUESTION 34.
X Probability
–7 0.04
5.5 0.96
Calculate the shortfall probability where the benchmark return is 0% pa.
QUESTION 35.
ty function:

f  x   0.00075 100   x  5 
2
 where  5  x  15
Calculate the VaR over one year with a 95% confidence limit for a portfolio consisting of £100m invested in
the asset.

QUESTION 36.
X Probability
–7 0.04
5.5 0.96
Calculate the 95% VaR over one year with a 95% confidence limit for a portfolio consisting of £100m in-
vested in the asset.
QUESTION 37.
Calculate the 97.5% VaR over one year for a portfolio consisting of £200m invested in shares. Assume that
the return on the portfolio of shares is normally distributed with mean 8% pa and standard deviation 8%
pa.
QUESTION 38.
ty function:

f  x   0.00075 100   x  5 
2
 where  5  x  15
Calculate the 95% TailVaR over one year for a portfolio consisting of £100m invested in the asset
QUESTION 39.
X Probability
–7 0.04
5.5 0.96
Calculate the 95% TailVaR over one year for a portfolio consisting of £100m invested in the asset.

QUESTION 40.
Consider an investment whose returns follow a continuous uniform distribution over the range 0% to 10%
pa.
(i) Write down the probability density function for the investment returns.
(ii) Calculate the mean investment return.
(iii) Calculate the variance and semi-variance measures of investment risk.
(iv) Calculate the shortfall probability and the expected shortfall based on a benchmark level of 3% pa.
QUESTION 41.
Define the following measures of investment risk:
(i) variance of return
(ii) downside semi-variance of return
(iii) shortfall probability
(iv) Value at Risk.
QUESTION 42.
Adam, Barbara and Charlie are all offered the choice of investing their entire portfolio in either a risk-free
asset or a risky asset. The risk-free asset offers a return of 0% pa, whereas the returns on the risky asset are
uniformly distributed over the range –5% to +10% pa. Assuming that each individual makes their invest-
ment choice in order to minimise their expected shortfall, and that they have benchmark returns of –2%,
0% and +2% pa respectively, who will choose which investment? Comment briefly on your answer.
QUESTION 43.
(i) Define 'shortfall probability' for a continuous random variable.
(ii) An investor holds an asset that produces a random rate of return, R , over the course of a year. Calcu-
late the shortfall probability using a benchmark rate of return of 1%, assuming:
R follows a lognormal distribution with   5% and   5% 

2 2
(a)
(b) R follows an exponential distribution with a mean return of 5%.

(iii) Explain with the aid of a simple numerical example the main limitation of the shortfall probability as a
basis for making investment decisions.
QUESTION 44.
Consider a zero-coupon corporate bond that promises to pay a return of 10% next period.
Suppose that there is a 10% chance that the issuing company will default on the bond payment, in which
case there is an equal chance of receiving a return of either 5% or 0%.
(i) Calculate values for the following measures of investment risk:
(a) downside semi-variance
(b) shortfall probability based on the risk-free rate of return of 6%
(c) the expected shortfall below the risk-free return conditional on a shortfall occurring.
(ii) Discuss the usefulness of downside semi-variance as a measure of investment risk for an investor.
QUESTION 45.
An investor is contemplating an investment with a return of £ R, where:
R = 250,000 – 100,000N
and N is a Normal [1, 1] random variable.
Calculate each of the following measures of risk:
(a) variance of return
(b) downside semi-variance of return
(c) shortfall probability, where the shortfall level is £50,000
(d) Value at Risk at the 95% confidence level
(e) Tail Value at Risk at the 95% confidence level, conditional on the VaR being exceeded.
QUESTION 46.
(i) Explain the problem of adverse selection and how it might be dealt with by insurance companies.
(ii) Explain the problem of moral hazard and how it affects the price of insurance.

CHAPTER
STOCHASTIC MODELS OF
INVESTMENT RETURNS
QUESTION 47.
The returns from an investment are assumed to conform to the fixed rate model with the distribution of
rates as specified below:
0.06 with probability 0.2


ik  0.08 with probability 0.7
0.10 with probability 0.1

(i) Calculate the expected accumulated value at the end of 5 years of an initial investment of £5,000.
(ii) Calculate the accumulated value at the mean rate of return.
(iii) Calculate the variance of the accumulated value of the investment
QUESTION 48.
If the yield each year is 0.02, 0.04, or 0.06 and each value is equally likely, the value of S n will be between
1.02 and 1.06 . Each of these extreme values will occur with probability  1 / 3  .
n n n
n 1
Determine the probability that S n will take the value 1.02  1.04 .
QUESTION 49.
Calculate the mean and variance of the accumulated value at the end of 25 years of an initial investment of
£40,000, if the annual rate of return in year k is independent of that in any other year and ik ~ Gamma 16,200
for all k.

QUESTION 50.
A company considers that on average it will earn interest on its funds at the rate of 4% pa. However, the
investment policy is such that in any one year the yield on the company’s funds is equally likely to take any
value between 2% and 6%.
For both single and annual premium accumulations with terms of 5, 10, 15, 20, and 25 years and single (or
annual) investment of £1, find the mean accumulation and the standard deviation of the accumulation at
the maturity date. (Ignore expenses.)
QUESTION 51.
An investor invests 1 unit at time t = 0 and a further 2 units at time t = 2. The expected rate of return in each
year is 10%. Calculate the accumulated value of the fund at time t = 5:
(i) using recursive formulae, and assuming the varying rate model applies
(ii) using the corresponding deterministic model.
Comment on your answers.
QUESTION 52.
An individual now aged exactly 50 has built up a savings fund of £400,000. In order to retire at age 60, they
will require a fund of at least £600,000 at that time. The annual returns on the fund, i, are independent and

identically distributed, with 1  i ~ log N 0.075,0.1
2
.
Calculate the probability that, if no further contributions are made to the fund, they will be able to retire at
age 60.
QUESTION 53.
The annual returns on a fund, i, are independent and identically distributed. Each year, the distribution of 1
2 2
+ i is lognormal with parameters   0.075 and   0.025 .
Calculate the upper and lower quartiles for the accumulated value at the end of 5 years of an initial invest-
ment of £1,000.

QUESTION 54.
A lump sum of $14,000 will be invested at time 0 for 4 years at an annual rate of return, i. The rate of re-
turn, once determined, will be the same in each of the four years. 1+ i has a lognormal distribution with
mean 1.05 and variance 0.007.
Calculate the probability that the investment will accumulate to more than $20,000 in 4 years' time.
QUESTION 55.
A stochastic model of investment returns assumes that the annual rate of return during the next year will
be 7.5% and that the rate of return in subsequent years will be at a fixed but unknown level with probabili-
ties in accordance with the following probability distribution:
5.5% with probability 0.3


i  7.5% with probability 0.5
9.5% with probability 0.2

Calculate the expected accumulated amount at the end of the fifth year of an initial investment of £20,000.
QUESTION 56.
An investment analyst wishes to model the annual rate of growth i of an investment fund using a probabili-
ty distribution of the form:
5% with probability 3k


i  7.5% with probability 1  4k
12.5% with probability k

where k is a suitable constant.
Determine the maximum and minimum values that can be obtained for the mean and standard deviation of
i using this family of distributions.
QUESTION 57.
The annual returns, i, on a fund are independent and identically distributed, with a mean of 6% and a stan-
2
dard deviation of 3%. Each year, the distribution of 1+ i is lognormal with parameters  and  .

2
(i) Calculate the values of  and  .
(ii) Calculate the probability that the accumulation of a single investment of £1 will be greater than 110%
of its expected value after 10 years.
QUESTION 58.
£200 is invested for 12 years. In any year the yield on the investment will be 3% with probability 0.25, 5%
with probability 0.6 and 6% with probability 0.15, and is independent of the yield in any other year.
(i) Calculate the mean accumulation at the end of 12 years.
(ii) Calculate the standard deviation of the accumulation at the end of 12 years.
QUESTION 59.
In any year, the rate of return on funds invested with a particular company has mean value j and standard
deviation s, and is independent of the rates of return in all previous years.
(i) Derive formulae for the mean and the variance of the accumulated value after n years of a single in-
vestment of 1 at time 0.
(ii) Let i t be the rate of return earned in the t th year. Each year the value of 1  it  is lognormally distri-
2
buted, with parameters   0.04 and   0.09 .
(a) Show that n, the number of years that must elapse before the accumulation of a lump sum in-
vested at time 0 has a 75% probability of at least doubling in size, satisfies:
0.04n  0.2024 n  In2  0
(b) Hence calculate the value of n.
QUESTION 60.
The annual rates of return on an investment fund are assumed to be independent and identically distri-
2
buted. Each year the distribution of 1 + i is lognormal with parameters  = 0.07 and  = 0.006, where i is
the annual yield on the fund.
Calculate the amount that should be invested in the fund immediately to ensure an accumulated value of at
least £500,000 in ten years' time with a probability of 0.99.

ASSIGNMENT 2
CHAPTER
PORTFOLIO THEORY
QUESTION 1.
Assuming that there are 350 shares in an equity index (as there are in the FTSE 350), calculate the number
of items of data that need to be specified for an investor to apply MPT.
QUESTION 2.
Consider a portfolio consisting of equal holdings of two securities, Sx and Sy , where:
• the return on S x is equally likely to be 5% or 10% pa
• the return on Sy is equally likely to be 10% or 20% pa.
(i) Calculate the means and variances of returns on each individual security.
(ii) Calculate the mean and variance of the return on the portfolio as a whole, given that the correlation
coefficient of the two securities is:
(a) 1
(b) 0
(c) –1
(d) 0.7
(iii) Comment on your results.

QUESTION 3.
As the proportion invested in S A is varied, a curve is traced in E –V space. The minimum variance can easily
be shown to occur when:
VB  C AB
xA 
VA  2C AB  VB
Prove the above result.
QUESTION 4.
EA  4% VA  4%%   A  2% 
EB  8% VB  36%%  B  6% 
(i) Calculate the co-ordinates of the point of minimum variance in Figure in the case when  AB  0 , and
comment on this result.
(ii) Write down the Lagrangian function W in the case where the correlation coefficient is  AB  0.75 .

QUESTION 5.
Show that with two assets the efficient frontier is a straight line in the case where   1 , as shown in Figure
QUESTION 6.
Explain why an investor's indifference curves slope upwards, and what determines their gradient.
QUESTION 7.
Explain why the optimal portfolio on the efficient frontier is at the point where the frontier is at a tangent to
an indifference curve.
QUESTION 8.
An investor can invest in only two risky assets A and B. Asset A has an expected rate of return of 10% and a
standard deviation of return of 20%. Asset B has an expected rate of return of 15% and a standard devia-
tion of return of 30%. The correlation coefficient between the returns of Asset A and the returns of Asset B
is 0.6.
(i) Calculate the expected rate of return if 20% of an investor's wealth is invested in Asset A and the re-
mainder is invested in Asset B.
(ii) Calculate the standard deviation of return on the portfolio if 20% of an investor's wealth is invested in
Asset A and the remainder is invested in Asset B.
(iii) Explain why an investor who invests 20% of his wealth in Asset A and the remainder in Asset B is
risk-averse.
QUESTION 9.
Consider two independent assets, Asset A and Asset B, with expected returns of 6% pa and 11% pa and
standard deviations of returns of 5% pa and 10% pa, respectively. Let x i denote the proportion of the port-
folio invested in Asset i.
(i) If only Assets A and B are available, determine the equation of the efficient frontier in expected re-
turn-standard deviation space.
A third Asset, Asset C, is risk-free and has an expected return of 4% pa. A Lagrangian function is to be used
to calculate the equation of the new efficient frontier.
(ii) Write down, but do not solve, the five simultaneous equations that result from this procedure.
(iii) Use your simultaneous equations to derive the relationship between x A and x B on the new efficient
frontier.
(iv) Hence derive the equation of the new efficient frontier in expected return-standard deviation space.
QUESTION 10.
Consider a world in which there are only 2 securities, 1 and 2, such that:
V1  10% 
2
E1  5%,
E2  10%, V2   20% 
2
Let  denote the correlation coefficient between the returns yielded by the two securities.
(i) Derive the equation of the opportunity set in E–V space.

(ii) Derive expressions for the portfolio expected return E and the portfolio proportion x 1 invested in Se-
curity 1 at the point of global minimum variance and hence comment briefly on how E and x 1 vary
with  .
QUESTION 11.
(i) Describe in detail the assumptions underlying the use of mean-variance portfolio theory.
Consider a two-security world in which the returns yielded by Assets 1 and 2 are perfectly positively corre-
lated, though they have different expected returns.
(ii) Using the method of Lagrangian multipliers or otherwise, derive the equation of the efficient frontier
in expected return-standard deviation space.
(iii) Use your answer to part (ii) to:
(a) determine the gradient of the efficient frontier
(b) show that the efficient frontier is a straight line in expected return-standard deviation space that
passes through the points representing Assets 1 and 2.

CHAPTER
MODELS OF ASSET RETURNS

QUESTION 12.
Consider a two-factor model. If:
 the mean specific return is 1.0%
 the expected values of the two factors are 3.0% and 2.2% and
 the sensitivities of investment returns to each of the factors are 0.8 and –0.3 respectively,
what is the expected return predicted by the model?
QUESTION 13.
A modeller has developed a two-factor model to explain the returns obtained from security i. It has the
form:
R i  2  1.3I1  0.8I2  c i
However, the modeller is concerned that the two indices 1 and 2 may be correlated and so decides to re-
express the model in terms of orthogonal factors. By regressing Index 1 on Index 2, the modeller obtains
the following equation for the line of best fit:
I1  0.8  0.3I2
* *
Use this information to re-express the two-factor model in terms of two orthogonal factors I1 and I2 .
QUESTION 14.
Show that the variance of portfolio returns can be written as:
N
VP   x i Vi  p VM
2 2
i 1

and use this expression to show that:
 the contribution of the specific risk on each security to the total risk of the portfolio becomes very
small as the number of securities increases and
 the contribution of each security to the portfolio's total risk is only the systematic risk of that security,
ie:

P  p M  M  x i j , as N  
i 1
QUESTION 15.
n
A portfolio P consists of n assets, with a proportion x i invested in asset i, i=1,2,…n (so that  xi  1 )
i 1
(i) The annual returns R P on this portfolio can be assumed to conform to the single-index model of asset
returns. Write down an equation defining this model and show that:
var  R P   P var  R M   var   P 

2
where  P denotes the component of the portfolio return that is independent of movements in the
market.
(ii) Explain why the specific risk, var  P  , is sometimes referred to as the 'diversifiable risk' giving an al-
gebraic justification for your answer.
(iii) Discuss the following statement:
'A portfolio with a beta of zero is equivalent to a risk-free asset.'
QUESTION 16.
Show that in the single-index model of asset returns:
E i   i   i EM
2
Vi  i VM  Vei
and Cij  ijVM
where Vei is the variance of e i .
QUESTION 17.
Consider the data in the table below, which relates to Securities 1, 2 and 3
Security
1 2 3
i 0.0 2.0 –2.2
i 1.1 0.6 2.0
V i 2.2 1.3 1.2
You are given that:
 the expected return and standard deviation of the market return are 10 and 5 respectively
 the returns of each security can be modelled using an appropriate single-index model.
(i) Calculate:
(a) the expected return and standard deviation of return for each security
(b) the covariance of returns between each pair of securities.
(ii) Consider a portfolio which consists of Securities 1, 2 and 3 in equal proportions. Calculate:
(a) the variance of the portfolio
(b) the systematic risk of the portfolio
(c) the specific risk of the portfolio.

QUESTION 18.
Consider the single-index model of investment returns in which for any security i:
R i   i  iR m   i
where E  i   0, E  i j   0 for i  j, E  R mi   0 and R m is the return on the market.
(i) Assuming that this model applies, derive expressions for the mean investment return on security i,
and the mean investment return on a portfolio P, containing n securities, with a proportion x i in-
vested in security i.
n
(ii) Show that C iP   x jC ij where CiP and Cij are the covariance of investment returns between security i
j 1
and portfolio P and securities i and j respectively.

2
(iii) State a general expression for the variance  P of portfolio P in terms of the covariances Cij .
(iv) Use your results from (ii) and (iii) to show that:
P 1
iP 
x i P
C iP
where  iP  2
and comment briefly on this result.
P

CHAPTER
ASSET PRICING MODELS

QUESTION 19.
Consider Security A, which has a standard deviation of investment returns of 4%. If:
 the standard deviation of the market return is 5%
 the correlation between A’s return and that of the market is 0.75
 the risk-free rate is 5%
 and the expected return on the market is 10%
then calculate:
(i) the beta of Security A
(ii) Security A's expected return.
QUESTION 20.
An investor has the choice of the following assets that earn rates of return as follows in each of the four
possible states of the world:
State Probability Asset 1 Asset 2 Asset 3
1 0.2 5% 5% 6%
2 0.3 5% 12% 5%
3 0.1 5% 3% 4%
4 0.4 5% 1% 7%
Market capitalisation 10,000 17,546 82,454
Determine the market price of risk assuming CAPM holds

Define all terms used.

QUESTION 21.
(i) State the assumptions of the Capital Asset Pricing Model (CAPM).
(ii) An investment market consisting of a risk-free asset and a very large number of stocks is such that, for
modelling purposes, the market capitalisation of the kth stock can be expressed as:
1
k
where k =1,2,3,…
2
The expected return on the k-th stock (expressed as a percentage) is:
25e
 k 1 

5 1e
 k 1 

Assuming that the CAPM assumptions hold, find the expected return on the portfolio of risky assets
held by each investor.
QUESTION 22.
(i) Within the context of the Capital Asset Pricing Model, explain what is meant by the 'market price of
risk'.
(ii) Show how the security market line relationship can be rearranged to give an expression for the ex-
pected return in terms of the market price of risk  M , and briefly interpret your answer.
QUESTION 23.
(i) (a) State the equation of the security market line and, assuming that the market portfolio offers a
return in excess of the risk-free rate, use it to derive the betas of the market portfolio and the
risk-free asset.
(b) Draw a diagram of the security market line relationship.
(c) What does the security market line indicate about the relationship between risk and return?
(ii) (a) By considering two points on the capital market line, determine its equation and comment briefly
upon its applicability.
(b) Briefly interpret each of the terms in the relationship.

CHAPTER
BROWNIAN MOTION AND

MARTINGALES
QUESTION 24.
2W t 
Assume that the spot rate of interest at time t, S(t), can be modelled by S  t   e where W(t) is a
Brownian motion with drift coefficient  and volatility coefficient 1 such that W(0) = 0.
(i) Write down an expression for W(t) in terms of a standard Brownian motion, B(t).
(ii) Show that S  t  : t  0 is a continuous-time martingale.
QUESTION 25.
Let Bt  t  0 be a standard Brownian motion process starting with B0  0 .
(i) Show that, when s  t, E  BsBt   s .
(ii) Hence find a general formula for the correlation coefficient  Bt ,Bt  1 2
.
QUESTION 26.
(i) Write down a formula for E e   where X ~ N ,   and, by differentiating, or otherwise, derive an
aX 2
expression for E Xe  ax
.
(ii) Show that:
1 2
aBt  a t
X t   Bt  at  e 2
is a martingale, where Bt is a standard Brownian motion, and a is an arbitrary constant.
You may assume that E  X t    .

CHAPTER
STOCHASTIC CALCULUS AND ITO

PROCESSES
QUESTION 27.
(i) Write down Ito's Lemma as it applies to a function f  X t  of a stochastic process X t that satisfies the
stochastic differential equation dX t   t dBt   t dt , where Bt is a standard Brownian motion.
(ii) Hence find the stochastic differential equations for each of the following processes:
(a) Gt  exp  X t 
2
(b) Qt  Xt
1
(c) Vt   1  X t 
(d) L t  100  10X t
(e) J t  InB t
3
(f) K t  5B t  2B t
QUESTION 28.
In the following, Bt denotes a standard Brownian motion.
(i) Write down the general solution of the stochastic differential equation:
dX t  X t dt  dB t
(ii) Hence determine the solution of the stochastic differential equation:
dR t  0.8  4  R t  dt  dBt
where R 0  5 .

(iii) Find the distribution of the process R t at time t and in the long-term.
QUESTION 29.
The Ito process, X t , is defined by the stochastic differential equation:
dX t  0.5X t 1  X t 1  2X t  dt  X t 1  X t  dBt
where Bt , is a standard Brownian motion, and X 0  0.5 .
 1 
By considering the stochastic differential equation for the process Yt  In   1  , find X t in terms of Bt .
 Xt 
QUESTION 30.
The market price of a certain share is being modelled as a geometric Brownian motion. The price S t at time
t  0 satisfies the equation:
St
log e  t  Bt
S0
where Bt , t  0 is a standard Brownian motion and  and  are constants.
(i) Show that the stochastic differential dS t can be written in the form:
dS t
 c1dBt  c2dt
St
where c1 and c2 are constants you should specify.
(ii) Derive expressions for E St  and Var S t  .
(iii) Derive expressions for Cov St ,St  1 2

 and E St |St  where 0  t 1  t 2 .
2 1
(iv) By using your expression for E St |St  , write down a function of S t that is a martingale.
2 1

QUESTION 31.
Let S t be a geometric Brownian motion process defined by the equation St  exp  t  Wt  , where Wt is a
standard Brownian motion and  and  are constants.
(i) Write down the stochastic differential equation satisfied by X t  log e S t .
(ii) By applying Ito’s Lemma, or otherwise, derive the stochastic differential equation satisfied by S t .
(iii) The price of a share follows a geometric Brownian motion with  = 0.06 and  = 0.25 (both expressed
in annual units). Find the probability that, over a given one-year period, the share price will fall.

CHAPTER
STOCHASTIC MODELS OF SECURITY

PRICES
QUESTION 32.
The shares of Abingdon Life can be modelled using a lognormal model in which   0.104 pa and =0.40 pa.
If the current share price is 2.00, derive a 95% confidence interval for the share price in one week's time,
assuming that there are exactly 52 weeks in a year.
QUESTION 33.
An investor has decided to model PPB plc shares using the continuous-time lognormal model. Using histori-
cal data, the investor has estimated the annual drift and volatility parameters to be 6% and 25% respective-
ly. PPB's current share price is $2.
(i) Calculate the mean and variance of PPB's share price in one year's time.
(ii) Calculate the probability that:
(a) PPB's shares fall in value over the next year.
(b) PPB's shares yield a return of greater than 30% over the next year.
Assume that no dividends are to be paid over the next year.

ASSIGNMENT 3
CHAPTER
CHARACTERISTICS OF
DERIVATIVE SECURITIES
QUESTION 1.
Consider an American put option on a non-dividend-paying share.
List the five factors that determine the price of this option and, for each factor, state whether an increase in
its value produces an increase or a decrease in the value of the option.
QUESTION 2.
A three-month forward contract exists on a zero-coupon corporate bond with a current price per £100 no-
minal of £42.60. The yield available on three-month government securities is 6% pa effective.
Calculate the forward price.
QUESTION 3.
A fixed-interest security pays coupons of 8% pa half-yearly in arrear and is redeemable at 110%.
Two months before the next coupon is due, an investor negotiates a forward contract to buy £60,000 no-
minal of the security in six months' time. The current price of the security is £80.40 per £100 nominal and
the risk-free force of interest is 5% pa.
Calculate the forward price.
On the same day, a different investor negotiates a forward contract to purchase £50,000 nominal of the se-
curity in ten months' time.
Calculate the forward price of this contract.

QUESTION 4.
The current price of a share is £200. The share pays dividends continuously to provide a fixed dividend
yield, and the current dividend is £5 pa.
Calculate the forward price of a five-year contract on one share if the risk-free force of interest is 5% pa.
QUESTION 5.
Suppose that the exercise price of a 3-month European call option on Share X is 100 and the continuously
compounded risk-free rate of return is 12% pa.
Calculate the lower bound for the option’s price if the current price of Share X is:
(i) 115
(ii) 125
QUESTION 6.
Calculate the lower bound for a 3-month European put option on Share X if the current share price is 95,
the exercise price is 100 and the continuously compounded risk-free rate is 12%pa.
QUESTION 7.
Explain why the put-call parity relationship above does not hold in the case of:
(i) American options on non-dividend-paying shares.
(ii) European options on dividend-paying shares.
QUESTION 8.
Company X issues 3-month European call options on its own shares with a strike price of 120p. The call op-
tions are currently priced at 30p per share. The current share price is 123p and the current risk-free force
of interest is r = 6%pa.
(i) If dividends are payable continuously at a rate of q = 12% pa, calculate the fair price for put options on
the share with the same strike price.
(ii) Explain the strategy for arbitrage profit if, instead, the price of the put options is 25p.

QUESTION 9.
Identify the profit or loss for the investors in each of the following scenarios:
(a) Investor A purchases a European call option with an exercise price of 480p for a premium of 37p.
The price of the underlying share is 495p at the expiry date.
(b) Investor B purchases a European put option with an exercise price of 180p for a premium of 12p.
The price of the underlying share is 150p at the expiry date.
(c) Investor C issues a European put option with an exercise price of 250p for a premium of 22p. The
price of the underlying share is 272p at the expiry date.
QUESTION 10.
A call option on a stock that does not pay dividends has the following parameter values (in the usual nota-
tion):
S  240, K  250, T  0.5, r  0.06,   0.2
The graphs below show the theoretical price of this option at time t = 0 when each of the parameters S, K, T
and r is varied without changing the values of the other parameters.
Identify which parameter has been plotted along the x-axis of each graph.

QUESTION 11.
A 9-month forward contract is issued on a share that has a current price of £7. Dividends of 50p per share
are expected in 2 months' time and 8 months' time.
Assuming a risk-free effective rate of interest of 6% per annum and no arbitrage, calculate the forward
price.
QUESTION 12.
The table below shows the closing prices (represented by letters) on a particular day for a series of Euro-
pean call options with different strike prices and expiry dates on a particular non-dividend-paying security.
Strike Price
125 150
3 months W Y
6 months X Z
(i) Write down, with reasons, the strictest inequalities that can be deduced for the relative values of W, X,
Y, Z, assuming that the market is arbitrage-free. (Your inequalities should not involve any other quan-
tities.)
(ii) Calculate numerical values for a lower and an upper bound for X, given that the current share price is
120 and the continuously compounded risk-free interest rate is 6% pa.
QUESTION 13.
Let p t be the price of a European put option exercisable at time T with a strike price K on an underlying
non-dividend-paying share with price S t at time t.
(i) By considering a suitably chosen notional portfolio or portfolios (which should be specified carefully),
show that the price p t satisfies the inequality:
 r T  t 
pt  Ke  St
(ii) Explain how you would modify your inequality if you knew that holders of the share on the day before
the option expires are entitled to receive a cash dividend of 0.02ST payable at time T.

QUESTION 14.
Consider an asset with price S t at time t, paying a dividend at a constant dividend yield, D. Dividends are
paid at the end of each year and are immediately reinvested in the asset. The continuously compounded
risk-free rate of interest is r pa.
Derive the forward price, K, of a contract issued at time t, with maturity at time T, to trade one unit of the
asset, where T – t is an integer number of years. State any assumptions you make.
QUESTION 15.
By constructing two portfolios with identical payoffs at the exercise date of the options, derive an expres-
sion for the put-call parity of European options on a share that has a dividend of known amount d payable
prior to the exercise date.

CHAPTER
THE GREEKS
QUESTION 16.
For each of the Greeks  ,  ,  ,  and  , discuss whether its value will be positive or negative in the case of:
 a call option
 a put option.
QUESTION 17.
An investor claims to be able to value an unusual derivative on a non-dividend-paying share using the pric-
ing formula:
2 4S t
Vt  S t e
where S t denotes the price of the share at time t.
(i) Derive formulae for the delta and gamma of the derivative, based on the pricing formula above.
(ii) For each of the following scenarios, calculate the number of shares that must be purchased or sold
along with a short holding in one derivative, in order to achieve a delta-hedged portfolio:
(a) the current share price is 1
(b) the current share price is 3.
(iii) Explain which of the scenarios in (ii) is likely to involve more portfolio management in the near future
if the investor is determined to maintain a delta-hedged portfolio.
QUESTION 18.
(i) Define the delta, gamma and theta of an option.
(ii) Describe, using a numerical example, the concept of delta hedging

QUESTION 19.
Give definitions of the 'Greeks' that could be used as an aid to management in each of the following situa-
tions. State also the desired ranges for their numerical values and define any notation you use.
(a) A hedge fund manager wishes to establish a delta-neutral position that would not need frequent reba-
lancing.
(b) A derivatives trader is concerned that a change in the distribution of the daily price movements of
particular shares might affect the values of the options held on those shares.
(c) The trustee of a pension fund that purchased a large number of options last year as a means of hedg-
ing is concerned about changes in the value of the fund as the options approach their expiry date.
QUESTION 20.
A call option has a price of 2O.15p and a delta of 0.558 at time t. Determine the hedging portfolio of shares
and cash for this option at time t, given that the price of the underlying share, S t  240p .

CHAPTER
THE BINOMIAL MODEL

QUESTION 21.
Consider a binomial lattice model for a 2-month call option with an exercise price of 200. Suppose that the
share price either goes up by 4% or down by 3% each month, the risk-free continuously compounded rate
is ½% per month and the current share price is also 200. Estimate the value of the option.
QUESTION 22.
A non-dividend-paying share has volatility   20% pa. Calculate the values of u and d for the share price
movements over one month.
QUESTION 23.
Let the value of a share at time 0 be S0  100 and let the continuously compounded risk-free rate be 3% per
time period. In one time period's time the share price will either have gone up to 120 or down to 85. The
real-world probability that the share price goes up is 0.6. Calculate the possible values of the state price def-
lator A 1 .
QUESTION 24.
The market price of a security can be modelled by assuming that it will either increase by 12% or decrease
by 15% each month, independently of the price movement in other months. No dividends are payable dur-
ing the next two months. The continuously compounded monthly riskfree rate of interest is 1%. The cur-
rent market price of the security is 127.
(i) Use the binomial model to calculate the value of a two-month European put option on the security
with a strike price of 125.
(ii) Calculate the value of a two-month American put option on the same security with the same strike
price.
(iii) Calculate the value of a two-month American call option on the same security with the same strike
price.

QUESTION 25.
A company share price is to be modelled using a 5-step recombining binomial tree, with each step in the
tree representing one day. Each day, it is assumed that the share price:
 increases by 2%, or
 decreases by 1%.
Assume that the risk-free force of interest is   5.5% pa and that there are 365 days in a year. No dividends
are to be paid over the next five days.
(i) Calculate the risk-neutral probability of an up-step on any given day.
(ii) Calculate the fair price of a 5-day at-the-money call option on £10,000 worth of shares in this company.
A special option is available where the payoff after 5 days is:
 *
max S5  K,0 
*
where S5 is the arithmetic average share price recorded at the end of each of the 5 days and K is the
strike price.
(iii) Calculate the fair price of the special option (strike price K  1.06S0 ) on £10,000 worth of shares in
this company.
(iv) Explain whether an at-the-money special option is likely to have a higher value of vega than a stan-
dard call option.
QUESTION 26.
In a one-step binomial tree model it is assumed that the initial share price of 260 will either increase to 285
or decrease to 250 at the end of one year. Assume that the annual risk-free force of interest is 0.05 and that
no dividends are payable.
(i) Calculate the price of a one-year European call option with a strike price of 275, using each of the fol-
lowing:
(a) a replicating portfolio method
(b) risk-neutral valuation
(c) a risk-free portfolio method.

(ii) Repeat your calculations in (i) for a one-year European put option with a strike price of 275.
(iii) Verify numerically that the put-call parity relationship holds in this case.
QUESTION 27.
The market price of a non-dividend-paying security with current market price S is being modelled using a
one-step binomial tree in which the proportionate changes in the security price following an up- and a
down-movement are denoted by u and d .The risk-free force of interest over the period is r.
Show that if an option on this security has a payoff of z u following an up-movement and a payoff of z d fol-
lowing a down-movement, then the option can be replicated exactly using a portfolio consisting of  secur-
z u  zd
ities, where S  , and an amount of cash,  , which you should specify.
ud
QUESTION 28.
The increase in the price of a share over the next year is believed to have a mean of 10% and a standard
deviation of 10%.
(i) Determine the values of u and d for a one-step binomial tree model that are consistent with the mean
and standard deviation of the return on the underlying share, assuming that the share price is twice as
likely to go up than to go down.
(ii) Hence calculate the value of each of the following options, given that the current share price is 250,
the risk-free force of interest is 7½% per annum and dividends can be ignored:
(a) a one-year European call option with a strike price of 275

(b) a one-year European put option with a strike price of 300.
QUESTION 29.
(i) Show that in a one-step binomial tree model of the price of a non-dividend-paying share, the risk-
neutral probability q of an up movement is given by:
rt
e d
q
ud
where d , u, r and t are quantities you should define.

rt
(ii) Explain briefly why it must be assumed that d  e u.

(iii) Write down a formula for  , the expected one-step rate of return on the share based on the real-world
probability p of an up-movement.
(iv) Show that the real-world variance,  , of the one-step rate of return on the share is p 1  p  u  d  .
2 2
rt
(v) Show that p > q if and only if 1    e and interpret this result.
QUESTION 30.
The movement of a share price over the next two months is to be modelled using a two-period recombining
binomial model. Over each month, it is assumed that the share price will either increase or decrease by
10%.
(i) Over each month, the risk-neutral probability of an up-step is q= 0.55. Calculate the monthly risk-free
force of interest r that has been used to arrive at this figure.
(ii) The current share price is 1. The annualised expected force of return on the share is   30% . Calcu-
late the state-price deflators in each of the three possible final states of the share price.
(iii) Calculate the value of each of the following two-month derivatives:
(a) a derivative with payoff profile (1,0,0)
(b) a derivative with payoff profile (0,1,0)
(c) a derivative with payoff profile (0,0,1)
(d) a European call option with a strike price of K= 0.95
(e) a European put option with a strike price of K= 1.05
(f) a derivative whose payoff is 2 |S  0.98| , where S is the share price at the end of the two months.
A payoff profile of (x, y, z) means that the derivative returns x if the share price goes up twice, y if the share
price goes up once and down once, and z if the share price goes down twice.
QUESTION 31.
(i) Explain the difference between a recombining and a non-recombining binomial tree.
(ii) A researcher is using a two-step binomial tree to determine the value of a 6-month
European put option on a non-dividend-paying share. The put option has a strike price of 450.

During the first 3 months it is assumed that the share price of 400 will either increase by 10% or de-
crease by 5% and that the continuously compounded risk-free rate (per 3 months) is 0.01. During the
following 3 months it is assumed that the share price will either increase by 20% or decrease by 10%
and that the continuously compounded risk-free rate is 0.015 (per 3 months).
Calculate the value of the put option.
(iii) The researcher is considering subdividing the option term into months. Explain the advantages and
disadvantages of this modification of the model and suggest an alternative model based on months
that might be more efficient numerically.

ASSIGNMENT 4
CHAPTER
THE BLACK-SCHOLES OPTION

PRICING FORMULA
QUESTION 1.
A forward contract is arranged where an investor agrees to buy a share at time T for an amount K. It is pro-
posed that the fair price for this contract at time t is:
 r T  t 
f  t,St   St  ke
Show that this:

(i) satisfies the boundary condition
(ii) satisfies the Black-Scholes PDE.
QUESTION 2.
A building society issues a one-year bond that entitles the holder to the return on a weighted-average share
index (ABC500) up to a maximum level of 30% growth over the year. The bond has a guaranteed minimum
level of return so that investors will receive at least x% of their initial investment back. Investors cannot
redeem their bonds prior to the end of the year.
(i) Explain how the building society can use a combination of call and put options to prevent making a
loss on these bonds.
(ii) The volatility of the ABC500 index is 30% pa and the continuously compounded risk-free rate of re-
turn is 4% pa. Assuming no dividends, use the Black-Scholes pricing formulae to determine the value
of x (to the nearest 1%) that the building society should choose to make neither a profit nor a loss.
QUESTION 3.
A company's directors have decided to provide senior managers with a performance bonus scheme. The
bonus scheme entitles the managers to a cash payment of £10,000 should the company share price have
increased by more than 20% at the end of the next 6 months. In addition, the managers will be entitled to
5,000 free shares each, should the share price have increased by more than 10% at the end of the next 6
months.
You are given the following data:
Current share price £7.81
Risk-free rate 5% pa (continuously compounded)
Share price volatility 25% pa
No dividends to be paid over the next 6 months.
(i) By considering the terms of the Black-Scholes call option pricing formula, calculate the value of the
bonus scheme to one manager.
(ii) Explain the main disadvantages of this bonus scheme as an incentive for managers to perform.
(iii) Some shareholders are concerned that this scheme might cause an undesirable distortion to the man-
agers’ behaviour. Suggest some modifications to the scheme that will ensure that the managers' aims
coincide with the long-term objectives of the shareholders.
QUESTION 4.
An investor buys, for a premium of 187.06, a call option on a non-dividend-paying stock whose current
price is 5,000. The strike price of the call is 5,250 and the time to expiry is 6 months. The risk-free rate of
return is 5% pa continuously compounded.
The Black-Scholes formula for the price of a call option on a non-dividend-paying share is assumed to hold.
(i) Calculate the price of a put option with the same time to maturity and strike price as the call.
(ii) The investor buys a put option with strike price 4,750 with the same time to maturity. Calculate the
price of the put option if the implied volatility were the same as that in (i).
[You need to estimate the implied volatility to within 1% pa of the correct value.]

QUESTION 5.
The solution to the Black-Scholes equation for the price V (assuming a risk-free force of interest r ) of a Eu-
ropean put option maturing u years from now with strike price K on a stock that pays dividends at force Q
whose current spot price is S is:
  d2   Se    d1 
 ru  qu
V  ke
where d1 ,d2 

log  S / K   r  q   u 1
2
2
 .
 u
V
is given by   e   d1  .
 qu
(i) Show that the hedge ratio  
S
2
 V
(ii) Hence find a formula for   2
.
S
QUESTION 6.
An investment bank has issued a special derivative security which provides a payoff in one year of:
S1  S0  15 if S0  15  S1  S0  5
10 if S 0  5  S1  S 0  5
S0  15  S1 if S0  5  S1  S0  15
0 otherwise
where S t is the price of the underlying share at time t.
An investor purchases one of these special derivatives on a share with initial price £50.
(i) Write down the investor's payoff from this special derivative in one year's time.
(ii) Explain how this payoff can be written in terms of two long and two short call options with different
strike prices.

(iii) Calculate the fair price for this special derivative paid by the investor, using the following basis:
 volatility of the share price,  = 15% pa
 risk-free interest rate, r = 3% pa (continuously compounded)
 no dividends are paid on the underlying share.

CHAPTER
THE 5-STEP METHOD IN

DISCRETE TIME
QUESTION 7.
t
(i) A risky asset has value A t , at time t. A probability measure R is defined so that A t v is an R -
martingale, where v is calculated using the risk-free interest rate. Explain why R can be described as a
risk-neutral probability measure.
(ii) Let X t  v ER C|Ft  , where C is a discrete random variable occurring at time T > t.
T
Prove that X t is an R -martingale.
Hint: if X is a discrete random variable and Y is a vector of random variables, then E E  X | Y   E  X  .
t
(iii) Stating any results that you use, deduce that  t is previsible, where dX t   t dDt and Dt  A t v .
QUESTION 8.
 rt
S t denotes the price of a security at time t. The discounted security process e S t , where r denotes the
continuously compounded risk-free interest rate, is a martingale under the risk-neutral measure Q.
(i) Express mathematically the fact that the discounted security process is a Q-martingale.
Bt denotes the accumulated value at time t of an initial investment of 1 unit of cash.
(ii) (a) Write down an expression for Bt .
(b) Show that the discounted cash process is also a Q -martingale.

(c) Deduce that the discounted value of any self-financing portfolio (where transactions are made
only by switching funds between the security and cash, with no injections or withdrawals of
funds from the portfolio) will also be a Q-martingale.
 r T  t 
Vt is a process defined by Vt  e EQ  X|Ft  , where X is a function of ST , T is a fixed time, and Ft
denotes the filtration representing the history of the security price up to and including time t.
 rt
(iii) Show that the discounted process e Vt is also a Q-martingale.
(iv) Explain the significance of these results in derivative pricing.
QUESTION 9.
The diagram shows a two-step non-recombining binomial tree. The numerical values shown are X i the
possible values of a particular derivative at times i= 0,1,2, based on a probability measure P that attributes
equal probability to the two branches at each step, Fi denotes the filtration of the derivative value process
at time i.
(i) (a) If X 1 = 20, what are the realised values of F0 and F1 ?
(b) What is the value of EP  X2 |F1  in this case?
(c) What is the value of EP  X2 |F1  in the case where X 1  6 ?

(d) Hence calculate EP EP  X 2 |F1  |F0  .
(e) Calculate EP  X2 |F0  and comment on your answer.
(ii) The risk-neutral probability measure Q attributes probabilities of 0.4 and 0.6 to the up-paths and
down-paths at each branch of this tree.
(a) Does your conclusion in (i)(e) still apply when the probability measure Q is used in place of p ?
(b) State briefly why this type of result is useful.
(c) Calculate the value of the derivative at time 0, presenting your calculations in the form of a
tree. Ignore interest.

CHAPTER
THE 5-STEP METHOD IN

CONTINUOUS TIME
QUESTION 10.
What is the replicating strategy for a European call option?
QUESTION 11.
You are trying to replicate a 6-month European call option with strike price 500, which you purchased 4
months ago. If r = 0.05,  = 0.2, and the current share price is 475, what portfolio should you be holding,
assuming that no dividends are expected before the expiry date?
QUESTION 12.
Use Ito's Lemma to show that the SDE for A t is:
dA t  A t  rdt  dZt 
QUESTION 13.
You are given that the fair price to pay at time t for a derivative paying X at time T is
 r T  t 
Vt  e EQ  X|Ft  , where Q is the risk-neutral probability measure and Ft is the filtration with respect
to the underlying process. The price movements of a non-dividend-paying share are governed by the sto-
chastic differential equation dSt  St  rdt  dBt  , where Bt is standard Brownian motion under the risk-
neutral probability measure.
(i) Solve the above stochastic differential equation.
(ii) Determine the probability distribution of S T |S t .

(iii) Hence show that the fair price to pay at time t for a forward on this share, with forward price K and
time to expiry T – t, is:
 r T  t 
Vt  St  Ke
QUESTION 14.
  1
2
2

 t Wt
The process S t is defined by S t  S0e where Wt is standard Brownian motion under a probabili-
2
ty measure P, and  and  are constants.
(i) (a) State the name given to the process S t .
(b) Give a real-world quantity that is commonly modelled using such a process.
(ii) (a) State what is meant by ‘equivalent probability measures'.
(b) State how the Cameron-Martin-Girsanov Theorem could be applied here if we wished to work
r 1
2
2
 
 t W
 is standard Brownian motion and r is the
with a process of the form S t  S0e , where W
t
risk-free rate of interest.

 .
(iii) (a) Determine the stochastic differential equation for dS t in terms of dt and dWt
(b) State the drift of the process in (iii)(a) and comment on your answer.
QUESTION 15.
r 1
2
2

 T Z
 ~ N 0,T  under a probability measure
The random variable ST is defined by ST  S0e , where Z
T
Q. The random variable X is defined by X  max ST  K,0 , where K is a positive constant.
(i) Show that:

EQ  X |F0   S0e  d2   T  K  d2 
rT

where d2 

log  S0 / K   r  1 2  T
2

 T
(ii) Explain carefully the relevance of this result in financial mathematics.

QUESTION 16.
(i) State the general risk-neutral pricing formula for the price of a derivative at time t in terms of the de-
rivative payoff X T at the maturity date T and the constant risk-free force of interest r.
Assume that the price of a share, which pays a constant force of dividend yield q, follows geometric
Brownian motion.
(ii) (a) Derive the formula for the price at time t of Derivative 1, which pays one at time T provided the
share price at that time is less than K.
(b) Derive the formula for the price at time t of Derivative 2, which pays the share price at time T
provided the share price at that time is less than K.
(c) Hence derive the formula for the price of a European put option with strike price K.
Hint for (ii)(a) and (ii)(b): You may wish to use the lognormal integral formulae given on page 18
of the Tables.
(iii) An exotic forward contract provides a payoff equal to the value of the square of the share price at the
maturity date T in return for a payment equal to the square of the forward price. Derive the formula
for the value of this contract at time t.
QUESTION 17.
An exotic forward provides a payoff equal to the square root of the share price at maturity time T less the
square root of the delivery price, K.
(i) (a) Assuming that the Black-Scholes assumptions apply, use risk-neutral pricing to derive a formula
for the price at time t of the forward on a non-dividend-paying share.
(b) Derive the corresponding formula for the vega of the forward.
(ii) (a) Explain why an investor might want to vega hedge their portfolio.
 r T  t 
(b) Use the result that St   d1   Ke   d2   0 , where d1 and d2 are defined as on page 47 in the
Tables, to show that the formula for the vega of a European call option is call  St   d1  T  t .
The current price of the share is $1, which is also the delivery price of the forward. The risk-free force
of interest is 5%, the volatility of the underlying share, which pays no dividends, is 20% and the for-
ward has one year to delivery.
(iii) An investor has a long position in 1,000 exotic forwards. Find the vega-hedged portfolio for this posi-
tion involving standard European call options on the underlying share and also the underlying share
itself.

CHAPTER
THE TERM STRUCTURE OF

INTEREST RATES
QUESTION 18.
Suppose that the current time corresponds to t = 5 and that the force of interest has been a constant 4% pa
over the last 5 years. Suppose also that the force of interest implied by current market prices is a constant
4% pa for the next 2 years and a constant 6% pa thereafter.
If T = 10 and S = 15, write down or calculate each of the four quantities P(t, T), r(t), f(t, T, S) and r(t, T) using
the notation above.
QUESTION 19.
 1  
Show that r  0,T     log P 0,T   r 0,T  
T T  T 
QUESTION 20.
Under one particular term structure model:
f  t,T   0.03e
0.1 T  t 

 0.06 1  e
0.1 T  t 
.
Sketch a graph of f(t,T) as a function of T, and derive expressions for P(t, T) and r(t, T)
QUESTION 21.
Show that the instantaneous forward rate for the Vasicek model can be expressed as:
  
2 2
f  t ,T   r  t  e

   2  1e
 2 


 2 1e
2

e 

 

where   T  t .

QUESTION 22.
Summarise the characteristics of the Vasicek, Cox-Ingersoll-Ross and Hull-White models.
QUESTION 23.
(i) List the desirable characteristics of interest rate models.
(ii) Discuss the limitations of one-factor models of interest rates.
(iii) The short rate of interest is governed by the stochastic differential equation (SDE)
drt  0.6 0.04  rt  dt  0.006dBt
where Bt is a standard Brownian motion.
By considering the function f  rt , t   rt e

0.6t
, or otherwise, solve this SDE.
QUESTION 24.
A bond trader assumes that f  t,T  , the instantaneous forward rate of interest at time T implied by the mar-
ket prices of bonds at the current time t, can be modelled by:
f  t ,T   0.04e
0.2 

 0.06 1  e
0.2 
  0.1 1  e  e
0.2  0.2 
where   T  t .
(i) Sketch a graph of f  t,T  as a function of  .
(ii) Calculate the following quantities using this model:

(a) the instantaneous forward rate of interest in two years’ time
(b) the current price of a 10-year zero-coupon bond
(c) the current 10-year spot rate.
You should express your answers to (a) and (c) as annualised continuously compounded rates.

CHAPTER
CREDIT RISK
QUESTION 25.
To fund an expansion in its operations, a company has just issued 5-year zero-coupon bonds with a total
face value of £10 million, taking its total asset value up to £15 million.
(i) Explain how the value of the bonds can be expressed in terms of a European put option.
(ii) Hence calculate the fair price of a holding of the company bonds with a face value of £100 using the
Black-Scholes model, given that the price of a 5-year zero-coupon government bond is £77.88. Assume
that the annualised volatility of the company's assets over the 5-year period is 25%.
(iii) Explain what is meant by a credit spread and calculate its value for the company bonds.
QUESTION 26.
Company X has just issued some 5-year zero-coupon bonds. A continuous-time two-state model is to be
used to model the status of the company and to calculate the fair price of the bonds. It is believed that the
risk-neutral transition rate for failure of the company is  (t) = 0.002t, where t is the time in years since the
issue of the bonds. The 5-year risk-free spot yield is 5.25% expressed as an annual effective rate.
(i) Calculate the risk-neutral probability that the company will have failed by the end of 5 years.
(ii) In the event of failure of the company, the bonds will make a reduced payment at the maturity date.
The recovery rate for a payment due at time t is:
  t   1  0.05t
Calculate the fair price to pay for £100 nominal of a Company X bond, taking into account the possibil-
ity of company failure.
(iii) An analyst is concerned that the estimate of  (t) may be too simplistic. Explain the possible reasons
for his concern and how the model could be developed to deal with this.

QUESTION 27.
Company X has the following financial structure at time 0:
Debt £3m (current book value)
Equity £6m (issued share capital)
The debt is a zero-coupon bond with face value £5m that is repayable at par at time 10.
There are 400,000 shares in circulation.
(i) Explain how the Merton model could be used to value shares in Company X.
(ii) Assuming that the debt is repaid directly from the company's funds at that time, state the share price
at time 10 if the total value of Company X at that time is:
(a) £15m
(b) £4m
QUESTION 28.
A two-state model is to be used to model the probability that a bond defaults:
2
5  20t  t
where   t   , 0  t  20
500
(i) Calculate the probability that the bond does not default between times 5 and 10.
(ii) Explain how the model may be modified to allow the default intensity  (t) to depend on future unfo-
reseen events such as a sudden downturn in the economy.
QUESTION 29.
A company has just issued 4-year zero-coupon bonds with a nominal value of £4 million. The total value of
the company now stands at £7.5 million. A constant risk-free rate of return of 2% pa continuously-
compounded is available in the market.
(i) Use the Merton model to calculate the theoretical price of £100 nominal of the company's bonds, as-
suming that the annual volatility of the value of the company's assets is 30%.
(ii) Estimate the risk-neutral probability of default on the company's bonds.

QUESTION 30.
An analyst is using a two-state continuous-time model to study the credit risk of zero-coupon bonds issued
by different companies.
The risk-neutral transition intensity function is:
  A  s   0.0148 for Company A, and
 B  s   0.01s for Company B

2

where s measures time in years from now.
The analyst observes that the credit spread on a 3-year zero-coupon bond just issued by Company B is
twice that on a 3-year zero-coupon bond just issued by Company A.
(i) Given that the risk-free force of interest is 5% pa, and that the average recovery rate in the event of
default,  , where 0    1 , is the same for both companies, calculate  .
(ii) Explain how the two-state model for credit risk can be generalised to give the Jarrow- Lando-Turnbull
model.
QUESTION 31.
The credit-worthiness of debt issued by companies is assessed at the end of each year by a credit rating
agency. The ratings are A (the most credit-worthy), B and D (debt defaulted). Historical evidence supports
the view that the credit rating of a debt can be modelled as a Markov chain with the following matrix of
one-year transition probabilities:
 0.92 0.05 0.03 

 
X   0.05 0.85 0.1 
 0 0 1 

(i) Determine the probability that a company rated A will never be rated B in the future.
(ii) (a) Calculate the two-year transition probabilities of the Markov chain.
(b) Hence calculate the expected number of defaults within the next two years from a group of 100
companies, all initially rated A.

The manager of a portfolio investing in company debt follows a "downgrade trigger" strategy.
Under this strategy, any debt in a company whose rating has fallen to B at the end of a year is sold and
replaced with debt in an A-rated company.
(iii) Calculate the expected number of defaults for this investment manager over the next two years, given
that the portfolio initially consists of 100 A-rated bonds.
(iv) Comment on the suggestion that the downgrade trigger strategy will improve the return on the port-
folio.

ASSIGNMENT 5
CHAPTER
RUIN THEORY
QUESTION 1.
If reported claims follow a Poisson process with rate 5 per day (and the insurer has a 24 hour hotline), cal-
culate:
(i) the probability that there will be fewer than 2 claims reported on a given day
(ii) the probability that another claim will be reported during the next hour.
QUESTION 2.
The claims arising during each year from a particular type of annual insurance policy are assumed to follow
a normal distribution with mean 0.7P and standard deviation 2.0P, where P is the annual premium. Claims
are assumed to arise independently. Insurers assess their solvency position at the end of each year.
A small insurer with an initial surplus of £0.1m expects to sell 100 policies at the beginning of the coming
year in respect of identical risks for an annual premium of £5,000. The insurer incurs expenses of 0.2P at
the time of writing each policy. Calculate the probability that the insurer will prove to be insolvent at the
end of the coming year. Ignore interest.
QUESTION 3.
If the insurer expects to sell 200 policies during the second year for the same premium and expects to incur
expenses at the same rate, calculate the probability that the insurer will prove to be insolvent at the end of
the second year.

QUESTION 4.
The number of claims from a portfolio of policies has a Poisson distribution with parameter 30 per year.
2
The individual claim amount distribution is lognormal with parameters   3 and   1.1 . The rate of pre-
mium income from the portfolio is 1,200 per year.
If the insurer has an initial surplus of 1,000, estimate the probability that the insurer's surplus at time 2 will
be negative, by assuming that the aggregate claims distribution is approximately normal.
QUESTION 5.
An insurer knows from past experience that the number of claims received per month has a Poisson distri-
bution with mean 15, and that claim amounts have an exponential distribution with mean 500. The insurer
uses a security loading of 30%. Calculate the insurer's adjustment coefficient and give an upper bound for
the insurer's probability of ruin, if the insurer sets aside an initial surplus of 1,000.
QUESTION 6.
Write down the equation for the adjustment coefficient for personal accident claims if 90% of claims are for
£10,000 and 10% of claims are for £25,000, assuming a proportional security loading of 20%.
Show that this equation has a solution in the range 0.00002599 < R <0.00002601.
Find an upper limit for the adjustment coefficient and comment on your answer.
QUESTION 7.
Consider Question 4. The number of claims has a Poisson distribution with parameter 30 per year. The in-
2
dividual claim amount distribution is lognormal with parameters   3 and   1.1 .The rate of premium
income from the portfolio is 1,200 per year. The insurer has an initial surplus of 1,000
This insurer is investigating the possibility of using proportional reinsurance. It has approached a reinsur-
er, who uses a security loading of 50% to calculate its reinsurance premiums. If the insurer decides to rein-
sure 20% of each risk in the portfolio, estimate the effect the reinsurance will have on its probability of ruin
at Time 2. Again you can assume that the aggregate claim distribution is approximately normal.
Comment on the usefulness of reinsurance in this context.

QUESTION 8.
Calculate E[Y] if X has an exponential distribution with parameter 0.01, and the insurer has an excess of
loss reinsurance arrangement with retention limit M .
QUESTION 9.
Calculate Var(Z) (in terms of M) if X ~U(0,100), where the insurer has an excess of loss reinsurance ar-
rangement with retention limit M, 0<M<100.
QUESTION 10.
What will be the general equation for R, the direct insurer's adjustment coefficient, when there is reinsur-
ance?
QUESTION 11.
A general insurance company is planning to set up a new class of travel insurance. It plans to start the busi-
ness with £2 million and expects claims to occur according to a Poisson process with parameter 50. Indi-
vidual claims are thought to have a gamma distribution with parameters   150 and   1 4 . A premium
loading factor of 30% is applied.
Explain how each the following changes to the company's model will affect the probability of ultimate ruin:
(i) A 28% premium loading factor is applied instead.
(ii) Individual claims are found to have a gamma distribution with parameters   150 and   1 2 .
(iii) The Poisson parameter is now believed to be 60.
QUESTION 12.
S  t t 0 and S*  t t 0 are compound Poisson processes representing the aggregate claims up to time t
from two risks. Individual claim amounts have the same distribution for the two risks and premiums are cal-
culated using the same premium loading factor for the two risks. The Poisson parameters for the two risks are
*
 and  , respectively. The probability of ruin in finite time and in infinite time for these two risks, given ini-
tial surplus U, are   U, t  and   U, t  and   U  and   U  , respectively. You are given that    2 .
* * *

Which of the following equations is/are true:
  U   2 U
*
I.
 U   U
*
II.
  U, t     U,2t 
*
III.
  U, t     U, t 
*
IV.
QUESTION 13.
An insurance company has a portfolio of policies, for which claims occur as a Poisson process at a rate of 25
claims per year. The claim amounts in pounds follow a generalised (three parameter) Pareto distribution
with parameters k = 3,   500 and   4 . The insurer includes a premium loading of 15% in its premiums
for this portfolio. You may assume that the aggregate claim amount for a year is approximately normally
distributed.
(i) Find u, the initial capital required in order to ensure that the probability of ruin at the end of the first
year is 2%.
(ii) If the insurer takes out proportional reinsurance, reinsuring 30% of the loss with a reinsurer which
loads its premiums by 45%, find the new level of initial capital required, and compare your answer
with that in part (i).
QUESTION 14.
Aggregate annual claims from a portfolio of general insurance policies have a compound Poisson distribu-
tion with Poisson parameter  . Individual claim amounts have an exponential distribution with mean 1.
The premium loading factor used to calculate the premium for these policies is 0.30. Given an initial surplus
of 2, calculate the probability of ruin at the first claim.
QUESTION 15.
The aggregate claims produced by a risk have a compound Poisson distribution with Poisson parameter
100 and individual claim size density, f(x), where:
0.2 x 5
f  x   0.2e x 5

The premium charged by the insurer to insure the risk is calculated using a premium loading factor of 0.15.
The insurer is considering excess of loss reinsurance for this risk. The reinsurer's premium would be calcu-
lated using a premium loading factor of 0.30. The table below shows, for various values of the retention lim-
it M, the insurer's expected profit in one year net of reinsurance, with some missing values indicated by as-
terisks.
Retention limit M Expected annual profit Adjustment coefficient
7.5 59 0.0227
10 * 0.0252
15 * 0.0240
* 147 0.0220
 * 0.0213
(i) Calculate the missing values of M and of the insurer's expected profit in one year and set out the com-
plete table.
(ii) Using the values in the completed table comment on the effect on the insurer of the choice of different
values for M .
QUESTION 16.
(i) The random variable W has a compound negative binomial distribution, so that W can be written in
the form:
N
W   Yi
i 1
where Yi  for i = 1, 2,..., is a sequence of independent and identically distributed random variables,
2
each with mean m and variance s , and N is independent of that sequence and has the following
probability function:
 k  x 1 k
P N  x     p 1  p  x  0,1,...
x
 x 
for some parameters k (k > 0) and p (0 < p < 1).
Show that:
(a) E(W) = k(l – p)m/p
(b) 
var  W   k(1  p) m  ps
2 2
/p 2
(ii) An insurer plans to issue 5,000 one-year policies at the start of a year. For each policy the annual
aggregate claims have a compound negative binomial distribution; the negative binomial parame-
ters are k = 0.5 and p = 0.5, and individual claim amounts, in pounds, have a lognormal distribution
with parameters   5.04 and   1.15 .
The premium for each policy is £160 and is payable at the start of the year. Claims are assumed to be
paid at the mid-point of the year. Calculate the minimum annual rate of interest the insurer must earn
throughout the year if the accumulation to the end of the year of premiums minus claims is to exceed
£52,500 with probability 90%. You may assume that the distribution of total aggregate claims in the
year may be approximated by a normal distribution.
QUESTION 17.
A Poisson claims process has security loading   2/5 and claim size density function:
3 3x 7 7x
f x  e  e , x  0
2 2
(i) Derive the moment generating function (MGF) for the claim size distribution, and state the values
of t for which it is valid.
(ii) Calculate the value of the adjustment coefficient.
QUESTION 18.
(i) Show that the adjustment coefficient for a compound Poisson claims process satisfies the inequality:
2 c /   E  X  
r 
E X  
2
and define what each of the symbols represents.

(ii) An insurer considers that claims of a certain type occur in accordance with a compound Poisson
process. The claim frequency for the whole portfolio is 100 per annum and individual claims have
an exponential distribution with a mean of £8,000.
(a) Calculate the adjustment coefficient if the total premium rate for the portfolio is £1,000,000
per annum.
(b) Verify that the value calculated in (ii)(a) satisfies the inequality in (i).
(c) The insurer decides to take out excess of loss reinsurance for this portfolio. The reinsurer
has agreed to pay the excess of any individual claim above £20,000 in return for an annual
premium of £80,000. Calculate the adjustment coefficient for the direct insurer when the
reinsurance is in operation.
(d) Estimate the direct insurer's probability of ultimate ruin with and without the reinsurance
arrangement, assuming that the initial surplus is £20,000 and that future premiums remain
at the same level.
(e) Comment briefly on the effect of the reinsurance on the probability of ruin.
QUESTION 19.
Claims occur on a portfolio of insurance policies according to a Poisson process with Poisson parameter  .
Claim amounts, X 1 , X 2 ,... , are assumed to be identically distributed with moment generating function
Mx  t  . The insurer calculates premiums using a loading factor    0 . The insurer's adjustment coefficient,
R, is defined to be the smallest positive root of the equation:
  cr  M X  r 
where c is the insurer's premium income rate.
(i) Using the above equation for R, or otherwise, show that, provided R is small, an approximation to R is
R̂ , where:
2c /    
R̂  2 2
 
where   E X i  and   var  X i  .

2

(ii) Describe how the adjustment coefficient can be used to assess reinsurance arrangements on the
basis of security.
(iii) The Poisson parameter,  , for this portfolio is 20 and all individual claims are for a fixed amount of
£5,000. The insurer's premium loading factor,  , is 0.15 and proportional reinsurance can be pur-
chased from a reinsurer who calculates premiums using a loading factor of 0.25.
Calculate the maximum proportion of each claim that could be reinsured so that the insurer's security,
measured by R̂ , is greater than the insurer’s security without reinsurance.

CHAPTER
RUN-OFF TRIANGLES
QUESTION 20.
The table below shows the numbers of household insurance claims reported in each development year for
accident years from 2009 to 2012. Use the basic chain ladder method to estimate the total ultimate number
of claims arising from accidents occurring between 1 January 2009 and 31 December 2012.
Development Year
Number of claims reported
0 1 2 3
2009 17,500 5,000 2,250 750
2010 21,000 6,200 2,750

Accident Year
2011 18,800 5,500
2012 21,300
Apply chain-ladder technique to the data and comment on any unusually large error figures.
QUESTION 21.
The cumulative claims paid each year under a certain cohort of insurance policies are recorded in the table
below, for accident years 2010, 2011, 2012 and 2013.
Development Year
Accident Year 0 1 2 3
2010 2,457 4,196 4,969 5,010
2011 2,648 4,715 5,561

2012 3,084 5,315
2013 3,341
(i) Calculate the development factors under the basic chain ladder technique and state the assumptions
underlying the use of this method.
(ii) The rate of claims inflation over these years, measured over the 12 months to the middle of each
year, is given in the table below.
2011 2.1%
2012 10.5%
2013 3.2%
Calculate the development factors under the inflation-adjusted chain ladder technique and state the
assumptions underlying the use of this method.
(iii) Based on the development factors calculated in parts (i) and (ii), calculate the fitted values under
these two models and comment on how these compare with the actual values.
QUESTION 22.
The tables below show the cumulative cost of incurred claims and the number of claims reported each year
for a certain cohort of insurance policies. The claims are assumed to be fully run-off at the end of Develop-
ment Year 2.
Cumulative cost of incurred claims:
Development Year
Accident Year 0 1 2
0 288 634 893
1 465 980
2 773

The numbers of claims reported in each year are:
Development Year
Accident Year 0 1 2
0 110 85 55
1 167 113
2 285
Given that the total amount paid in claims to date, relating to accident years 0, 1 and 2, is £2,750, calculate
the outstanding claims reserve using the average cost per claim method.
QUESTION 23.
An insurance company has paid the following claim amounts (in £000s):
Development Year
1 2 3 4 5
1 2,800 1,400 987 322 57
2 3,260 2,004 1,017 421

Accident
3 3,854 1,978 857
Year
4 3,722 2,114
5 4,627
The earned premium in each year is 6,727 for Accident Year 1, 8,289 for Accident Year 2, 9,627 for Accident
Year 3, 9,928 for Accident Year 4 and 10,004 for Accident Year 5.
Apply the Bornhuetter-Ferguson method to estimate the amount of claims yet to be paid, stating any as-
sumptions that you make.

QUESTION 24.
The table below shows the cumulative costs of incurred claims. The claims are assumed to be fully run-off
by the end of Development Year 2.
£000s Development Year
Accident Year 0 1 2
2011 2,670 3,290 4,310
2012 2,850 3,420
2013 3,030
Annual premiums written were:
Year Premiums (£000s)
2011 5,390
2012 5,600
2013 6,030
The ultimate loss ratio has been estimated at 80% and the total amount of claims paid to date is £5,720,000.
Calculate the outstanding claims reserve using the Bornhuetter-Ferguson method.

ASSIGNMENT 1
SOLUTIONS
THE EFFICIENT MARKET HYPOTHESIS
ANSWER 1.
(a) Annual market returns are negatively correlated
This observation suggests that, over annual time periods, the market tends to systematically overreact
to new information and hence that the market may not be semi-strong form efficient.
In addition, trading rules could be developed based on this information that could generate excess,
risk-adjusted returns, which suggests that this observation is inconsistent with the weak form of the
EMH.
(b) The index is higher on Fridays than on Mondays
The observation suggests that there is a consistent tendency for prices on Fridays to be 'inflated',
while prices on Mondays are 'depressed', ie there is a systematic bias present in the prices.
Trading rules could be developed based on this information (eg buy on Monday, sell on Friday) that
could generate excess, risk-adjusted returns, which suggests that this observation is inconsistent with
the weak form of the EMH.
(c) Announcements take three months to be reflected
If the semi-strong form of the EMH holds, public dividend announcements should have an immediate
effect on the share prices as the market should respond quickly and accurately to new information.
This observation suggests that the market is not semi-strong form efficient.
(d) Prices fall following a favourable announcement
The prices are reacting when information is made public. This suggests that the prices have previous-
ly been distorted by insider information.
Therefore, this observation contradicts the strong form of the EMH.

Note that, once a particular form of the EMH is contradicted, this also contradicts any of the stronger
forms.
ANSWER 2.
The Efficient Markets Hypothesis (EMH) suggests that it is not possible to achieve excess risk adjusted in-
vestment returns using investment strategies based only on certain subsets of information. The existence of
fund managers who sell their services based on their alleged ability to select over-performing sectors and
stocks does not demonstrate that capital markets are inefficient.
In particular, the semi-strong form of the EMH suggests that excess risk-adjusted investment returns can-
not be obtained using only publicly available information.
In certain investment markets, it may therefore be possible (and legal) to achieve excess returns using pri-
vileged or inside information, which would not contradict the semi-strong form of the EMH.
More generally, the EMH does not preclude managers achieving higher investment returns by adopting
'riskier' investment strategies and receiving due reward for the risks taken.
It says precisely that it is not possible to develop investment strategies that yield excess risk- adjusted re-
turns - though it is difficult to determine exactly how risk should be interpreted in this context.
Some fund managers must necessarily achieve higher than average returns over a given short time period -
eg several years. The point of the EMH is that managers cannot consistently achieve above excess returns.
Moreover, they cannot guarantee to achieve excess returns over any particular time period.
Finally, rather than reflecting any market inefficiency in contradiction of the EMH, the existence of such
managers may instead reflect the following facts:
 Individual investors may be unaware of the EMH or choose not believe it and hence may be inclined to
believe the claims of such managers and so place money with them.
 Certain individual investors may choose to believe the claims of such managers, reflecting the fact that
investment decisions are often made on the basis of subjective and emotional factors, in addition to,
or instead of, on the basis of financial theory.
For the above reasons, the existence of such fund managers does not therefore demonstrate that capital
markets are inefficient.

ANSWER 3.
(i) Definition of efficient market
An efficient market is one in which every security's price equals its investment value at all times.
In an efficient market information is fully reflected in the price.
This means that share prices adjust instantaneously and without bias to new information.
(ii) Three forms of Efficient Markets Hypothesis
The strong form requires that prices reflect all information that is currently known - whether or not it
is publicly available.
The semi-strong form requires that prices reflect all information that is publicly available.
The weak form requires that prices fully reflect all information contained in the past history of prices.
(iii) Implications of the Efficient Markets Hypothesis
The past history of prices is a subset of publicly available information, so a market must be weak form
efficient if it is semi-strong form efficient. Similarly, if it is strong form efficient it must also be semi-
strong and weak form efficient.
The Efficient Markets Hypothesis does not imply that beating the market is impossible, since investors
could out-perform the market by chance, or by accepting above average levels of risk.
However, it does imply that it is not possible consistently to achieve superior risk-adjusted invest-
ment performance net of costs without access to superior information.
Weak form efficiency implies that it is impossible to achieve excess risk-adjusted investment returns
purely by using trading rules based upon the past history of prices and trading volumes. It therefore
suggests that technical analysis cannot be justified.
If only weak form efficiency applies, excess risk-adjusted returns are still possible by good fundamen-
tal analysis of public information.
The semi-strong form means that prices adjust instantaneously and without bias to newly published
information. This implies that it is not possible to trade profitably on information gained from public
sources. So neither fundamental analysis (without insider information) nor technical analysis will
yield excess risk-adjusted returns.

Fundamental analysis may still, however, aid investors in selecting the investments that are most
suitable for meeting their investment needs and objectives.
If the strong form is correct then the market reflects all known knowledge about the company and
consequently excess risk-adjusted returns are possible only by chance. This implies that insiders can-
not profit from dealing on inside information, ie insider trading is not profitable.
ANSWER 4.
Anna
Anna makes her recommendation based on the past price history of the investment. If weak form EMH
holds, then the current share price already reflects the information contained in the past price history, so
there would be no advantage in using this approach.
Similarly, if the semi-strong or strong form of EMH holds, there is no advantage in using this approach.
If the market was inefficient, Anna's strategy may be beneficial.
Brian
Brian makes his recommendation based on company information that is in the public domain. If semi-
strong form EMH holds, then the current share price already reflects relevant public information, so there
would be no advantage in using this approach.
Similarly, if the strong form of EMH holds, there is no advantage in using this approach.
If the market is inefficient or only weak form efficient, Brian's strategy may be beneficial.
Cathy
The approach of choosing stocks at random provides no advantage, whatever the level of market efficiency.
If strong form EMH holds, this strategy is no worse than any other.
Dennis
Dennis makes his recommendation based on insider information. If strong form EMH holds, then the cur-
rent share price already reflects all relevant information, so there would be no advantage in using this ap-
proach.
If the market is inefficient or weak or semi-strong form efficient, Dennis's strategy may be beneficial
(though it could be questionable on ethical grounds).

ANSWER 5.
(i) Excessively volatile markets
An excessively volatile market is one in which the changes in the market values of stocks (the ob-
served volatility) are greater than can be justified by the news arriving. This is claimed to be evidence
of market over-reaction, which is not compatible with efficiency.
(ii) Testing if a market is excessively volatile
To test if a market is excessively volatile you need a long history of prices and cashflows for one of the
securities in question - eg for the market in a particular equity, you would need many months or years
of share prices and dividend payments.
A discounted cashflow model based on the actual dividends that were paid and some terminal value
for the share could then be used to calculate a perfect foresight price for the equity. This would
represent the 'correct’ equity price if market participants had been able to predict future dividends
correctly.
The difference between the perfect foresight price and the actual price arises from the forecast errors
of future dividends. If market participants are rational, there should be no systematic forecast errors.
Also if markets are efficient, then broad movements in the perfect foresight price should be correlated
with moves in the actual price as both are reacting to the same news and hence the same changes in
the anticipated future cashflows.
If instead the actual price changes are greater, then this would suggest that the market in the particu-
lar equity is excessively volatile.
This was the approach adopted by Shiller.
(iii) Practical and conceptual difficulties
These include:
 the difficulty of choosing an appropriate terminal value for the share price
 the difficulty of choosing an appropriate discount rate at which to discount future cashflows —
in particular, should it be constant?
 possible biases in the estimates of the variances because of autocorrelation in the time series da-
ta used

 possible non-stationarity of the time series data used, ie it may have stochastic trends which in-
validate the measurements obtained for the variance of the stock price
 the distributional assumptions underlying the statistical tests used might not be satisfied
 the distributional characteristics of the share prices and dividends are unlikely to remain con-
stant over a long period of time.
ANSWER 6.
(i) Implications of the Efficient Markets Hypothesis
The Efficient Markets Hypothesis implies that it is impossible, except by chance, to make abnormal
profits using trading strategies that are based on only past share prices (weak form), publicly availa-
ble information (semi-strong form) or any information (strong form).
In practice, however, the definition has sometimes been refined to preclude the possibility of syste-
matically higher returns after allowing for transaction costs.
Market efficiency also implies that active investment management (which aims to enhance returns by
identifying under- or over-priced securities) cannot be justified and consequently provides a rationale
for passive investment management strategies, such as index tracking.
(ii) Information
Even if markets are efficient, investors will still wish to have as much information as possible concern-
ing a company and its securities in order to identify the characteristics of the shares, eg the volatility
of returns, risk, income and capital growth etc. An appreciation of these will enable investors to make
an informed decision whether or not to hold the security as part of a portfolio designed to meet their
investment objectives.
UTILITY THEORY
ANSWER 7.
25%
ANSWER 8.
(i) E(w) = (1+0.05a)w

(ii) E[U(w)] = 0.25 {log((1 – 0.04a)w)} + 0.75{log((1 + 0.08a)w)}
ANSWER 9.
(i) 4.605
(ii) 4.597
(iii) a = 0.2777, Expected utility = 4.6066
ANSWER 10.
B>C=D=E>A
ANSWER 11.
The gamble is fair because your expected gain from accepting the gamble is zero and your expected wealth
remains unchanged (though your actual wealth will of course change by $1)
The investor's certain utility if the gamble is rejected is U(w). The investor's expected utility obtained by
accepting the gamble is given by:
E(U) = ½U(w – 1) + ½U(w + l)
The gamble is therefore rejected if:
½U(w – 1) + ½U(w + l) < U(w)
 U(w – 1) + U(w +1) < 2U(w)

 U(w+1) – U(w) < U(w) – U(w –1)
ie if the additional utility from winning the gamble is less than the loss of utility from losing the gamble.
This will be the case if U  w   0 , which is by definition the case for a risk-averse investor.
''

ANSWER 12.
A risk-seeking investor has a convex utility function, because U  w   0 . The utility function looks as fol-
''
lows:
ANSWER 13.
For a risk-neutral investor, U  w   0 . Thus, U'(w) is constant and so the marginal utility of wealth must
*
itself be constant (and positive assuming non-satiation), so that each additional $1 leads to the same change
in utility, regardless of wealth.
ANSWER 14.
–0.0251
ANSWER 15.
For non-satiation we require:
U’(w) > 0, ie 1 + 2dw > 0
 2dw > –1
 dw > –½
 w < –1/2d, as d < 0 for risk-averse investor.

ANSWER 16.
(i) Investor B is more risk-averse because they have a lower risk aversion coefficient  . We can show
this by deriving the absolute risk aversion and relative risk aversion measures for each investor.
For Investor A:
A(w) = R(w) = 0
ie Investor A is risk-neutral.
For Investor B:
1 1
A w    0, R  w    0
2w 2
Hence, Investor B is strictly risk-averse for all w > 0.
(ii) If Investor B buys X, then they will enjoy an expected utility of:
0.5 2
   
110  1  2 
92  1   18.08

If, however, they do not buy X, then their expected (and certain) utility is:
2  
100  1  18
Thus, as buying X yields a higher expected utility, the investor ought to buy it.

ANSWER 17.
The utility function U  w   e

 aw
is such that:
U'  w   ae and U"  w   a e

 aw 2  aw
Thus:
U"  w 
A w    a  0 and A '  w   0
U'  w 
and:
 wU"  w 
R w    aw  0 and R '  w   a  0
U'  w 
Hence, as the absolute risk aversion is constant and independent of wealth the investor must hold the same
absolute amount of wealth in risky assets as wealth increases. Both this, and the fact that the relative risk
aversion increases with wealth, are consistent with a decreasing proportion of wealth being held in risky
assets as wealth increases.
ANSWER 18.
E [U(2,000 + Q – Y)] = U(2,000)
and with U(x)= log(x) the expectation becomes:
E  U  2,000  Q  Y    0.5log  2,000  Q  500   0.5log 2,000  Q 

 log (1,500  Q)   log (2,000  Q) 
0.5 0.5
 log (1,500  Q)   2,000  Q  

0.5 0.5
 log   1,500  Q    2,000  Q  
Equating this with U(2,000) = log(2,000) yields:
log  1,500  Q   2,000  Q    log 2,000 

 1,500  Q    2,000  Q   2,0002

2
 Q  3,500Q  1,000,000  0
Resulting in:
2
3,500  3,500  4  1,000,000
Q  1,750  2,015.56
2
Taking the positive root gives a minimum premium of £265.56.
ANSWER 19.
20 100
(i) xA  
19 19
(ii) Differentiating the formula for the optimal value of x A in terms of  gives:
dx A 100
 0
d 19 2
This confirms that as  increases, so x A , the proportion of wealth held in Asset A, increases too
ANSWER 20.
(i) Assuming non-satiation, which requires that U'(w) > 0, Colin's preferences can be modelled by this
utility function provided that 0  w  32 .
(ii) Differentiating the expression given in the question yields U  w   2 .

''
Thus, over the relevant range of w:
2 4
A w    0, A '  w   0
3  2w 
2
3  2w
2w 6
and R w    0, R '  w   0
3  2w 
2
3  2w

Hence, as Colin's wealth decreases the:
 absolute amount of his investment in risky assets will increase (as his absolute risk aversion de-
creases as his wealth decreases)
 proportion of his wealth that is invested in risky assets will increase (as his relative risk aversion
decreases as his wealth decreases).
(iii) Colin will choose investment B to maximise his expected utility.
ANSWER 21.
(i) w < $50,000
(ii) Expected salary = $37,500, Expected utility = 23,250
(iii) $36,771
(iv) Yes - if they are risk-neutral, then they should offer Jenny a fixed salary in preference to a variable one.
Jenny is risk-averse and therefore derives additional utility from the certainty offered by a fixed salary.
Therefore, Company X will be able to entice Jenny to work for them in return for a salary of just (or
strictly speaking slightly above) $36,771, instead of the expected salary of $37,500 in (i).
ANSWER 22.
(i) P = £1,300
The maximum premium of £1,300 exceeds the expected loss of £1,000. This is because Jayne is risk-
averse.
(ii) Q = 1,000
So, the minimum premium required by UN Life is less than the maximum premium Jayne is prepared
to pay, which means that the insurance contract is feasible.
ANSWER 23.
Q = 200
ANSWER 24.
(i) The gamble is fair

(ii) –1.3340. This is negative because he is risk - averse.
(iii) –2.668. Comparing the two answers, we can see that the two certainty equivalents are equal to the
same proportion of each individuals initial wealth. This is because the log utility function is consistent
with preferences that exhibit constant relative risk aversion.
(iv) The constancy of relative risk aversion with a log utility function can be confirmed by differentiating
it, ie:
If: U(w) = log(w)
1 1
U'  w   and U  w    2
''
then:
w w
U w 
''
Thus: R  w   w  1 and R '  w   0
U'  w 
So, the log utility function exhibits constant relative risk aversion irrespective of w - though the log utility
function is of course defined only for w >0.
STOCHASTIC DOMINANCE AND BEHAVIOURAL FINANCE
ANSWER 25.
Assuming an investor prefers more to less, a distribution of investment returns A is said to exhibit first-
order stochastic dominance over a distribution of investment returns B if:
FA  x   FB  x  for all x, and
FA  x   FB  x  for some value of x .
In other words, the probability of B producing a return below a certain value is never less than the probability
of A producing a return below the same value and exceeds it for at least some value of x.

Here FA  x  must never be above FB  x  . Note, however, that the lowest possible value of x may be non zero
and even negative.
Assuming an investor prefers more to less and is risk averse, a distribution of investment returns A is said
to exhibit second-order stochastic dominance over a distribution of investment returns B if:
x x
a FA  y  dy  a FB  y  dy
for all x, with the strict inequality holding for some value of x, where a is the lowest return that the portfo-
lios can possibly provide.
Here the area under FB  x  must never be less than the area under FA  x  for any value of x.

ANSWER 26.
(i) A is preferred to B on the basis of first-order stochastic dominance if:
FA  w   FB  w  , for all 0  w  1 , and
FA  w   FB  w  for some value of w in this range.
This is the case if:

1
ww 2
1
 w w 0 2
 w
1
2
w 1
2
1  0 
This clearly holds for all 0  w  1 , the equality being strict for 0 < w < 1. Hence A first-order domi-
nates B.
(ii) A second-order dominates B if G A  w   GB  w  for all 0  w  1 , with the strict inequality holding for
w
some value of w, where G  w    F  y  dy .
0
This is the case if:
w w
 y dy   y dy
1
2
0 0
w w
 1 y2    2 y 
3
 2
 2  0  3  0
3
1 2 2
 2
w  3w 0 2
 
3 1
2 3
 3
w2 4
w2 1  0
This is true for all 0  w  1 and strictly true for 0  w  1 . Hence A does second-order dominate B.

ANSWER 27.
(i) Overconfidence occurs when people systematically overestimate their own capabilities, judgment and
abilities.
Moreover, studies show that the discrepancy between accuracy and overconfidence increases (in all
but the simplest tasks) as the respondent is more knowledgeable. (Accuracy increases to a modest de-
gree but confidence increases to a much larger degree.)
This may be a result of:
 Hindsight bias– events that happen will be thought of as having been predictable prior to the
event; events that did not happen will be thought of as having been unlikely ever to happen.
 Confirmation bias– people will tend to look for evidence that confirms their point of view (and
will tend to dismiss evidence that does not justify it).
(ii) The board could require that all investment decisions made by the investment manager are reviewed
by a second investment manager before being implemented.
Alternatively, the management of the investment trust could be split equally between two investment
managers.
Either of these should reduce the impact of overconfidence bias, although the views of the second in-
vestment manager could be subject to similar overconfidence biases as those of the first manager.
The investment manager could be sent on a training course about behavioural finance. This would
make the manager aware of the possibility of overconfidence bias.
However, providing training may have the opposite effect to that intended, making the investment
manager feel more knowledgeable and aware of the issues and so even more confident.
The board could place tighter constraints on the investment decisions taken by the investment man-
ager, eg limits could be placed on the size of any transactions and/or on the size of holdings in indi-
vidual companies or sectors.
Limiting the manager's actions should limit the scope for biases in investment decisions but will also
reduce the manager's scope for active investment management and possibly the returns achieved.

MEASURES OF INVESTMENT RISK

ANSWER 28.
Mean return = 5% pa, Variance of return = 20%% pa
ANSWER 29.
Mean return = 5% pa, Variance of return = 6%% pa
ANSWER 30.
The skewness of a continuous probability distribution is defined as the third central moment.
It is a measure of the extent to which a distribution is asymmetric about its mean. For example, the normal
distribution is symmetric about its mean and therefore has zero skewness, whereas the lognormal distribu-
tion is positively skewed.
The kurtosis of a continuous probability distribution is defined as the fourth central moment.
It is a measure of how likely extreme values are to appear (ie those in the tails of the distribution)
ANSWER 31. ANSWER 36.

10%% pa £5.5m
5.76%% pa £15.36m
0.15625 £46,200

£0.5m
0.04
ANSWER 35.
£2.293m

ANSWER 40.
f  x   10 for 0  x  10 and 0 otherwise

1
(i)
(ii) 5% pa
(iii) 8.33%% pa, 4.17%% pa
(iv) 0.3, 0.45%
ANSWER 41.
In the following we assume the investment return is given by a continuous random variable X with density
function f(x). This is the return over a chosen time period.
could be given for discrete or mixed cases.

  x    f  x  dx
2
(i)

where   E  X  is the mean return for the chosen period.
(ii) The downside semi-variance only takes into account returns below the mean return:
  x    f  x  dx
2

(iii) A shortfall probability measures the probability of returns falling below a certain chosen benchmark
level L:
L
PX  L   f  x  dx

(iv) Value at Risk represents the maximum potential loss in value on a portfolio over a given future time
period with a given degree of confidence.
Alternatively, for a given confidence limit (1-p):
VaR(X) = –t where P(X < t) = p

ANSWER 42.
Adam chooses the risk-free asset.
Barbara chooses the risk-free asset.
Charlie chooses the risky asset.
The expected shortfall increases with the benchmark return.
ANSWER 43.
(i) The shortfall probability for a continuous random variable, X, is:
L
PX  L   f  x  dx

where L is the chosen benchmark level.

(ii) (a) 0.15866 (b) 0.18127
(iii) The main limitation of the shortfall probability is that it ignores the extent of the shortfall below the
benchmark L.
Thus, if L = 0, then the investor will prefer a gamble that offers +$1 with probability 0.51 and –
$1,000,000 with probability 0.49 to one that that offers either $1,000,000 or –$2, each with probabili-
ty of ½. This is somewhat unrealistic.
ANSWER 44.
(i) (a) 5.18%% pa
(b) The probability of receiving less than 6% is equal to the sum of the probabilities of receiving 5%
and 0%, ie 0.10.
(c) 3.5%
(ii)
 It gives more weight to downside risk, ie variability of investment returns below the mean,
which is likely to be of greater concern to an investor than upside risk.
 In fact, it completely ignores risk above the mean.
 This is consistent with the investor being risk-neutral above the mean, which is unlikely to be
the case in practice.
 The mean is an arbitrary benchmark, which might not be appropriate for the particular investor.
 If investment returns are symmetrically distributed about the mean (as they would be, for ex-
ample, with a normal distribution) then it will give equivalent results to the variance.
 However, it is less mathematically tractable than the variance.
ANSWER 45.
10
(a) 10
9
(b) 5  10
(c) 0.15866
(d) £14,490
(e) £56,260
ANSWER 46.
(i) Adverse selection refers to the fact that people who know that they are particularly bad risks are more
inclined to take out insurance than those who know that they are good risks.
To try to reduce the problems of adverse selection, insurance companies try to find out information
about potential policyholders. Policyholders can then be put into small, reasonably homogeneous
groups and charged appropriate premiums.
(ii) Moral hazard describes the fact that a policyholder may, because they have insurance, act in a way
which makes the insured event more likely to occur.
Moral hazard makes insurance more expensive. It may even push the price of insurance above the
maximum premium that a person is prepared to pay.
STOCHASTIC MODELS OF INVESTMENT RETURNS

ANSWER 47.
(i) £7,286
(ii) £7,279
 £363 
2
(iii)

ANSWER 48.
n
n
3
ANSWER 49.
£273,939,  £25,417 
2
ANSWER 50.
Single investment £1 Annual investment £1
Term (years) Mean Standard Mean Standard

Accumulation (£) deviation (£) accumulation (£) deviation (£)
5 1.21665 0.03021 5.63298 0.09443
10 1.48024 0.05198 12.48635 0.28353
15 1.80094 0.07748 20.82453 0.57899
20 2.19112 0.10886 30.96920 1.00476
25 2.66584 0.14810 43.31174 1.59392
ANSWER 51.
(i) 4.27251
(ii) 4.27251
The corresponding deterministic model gives the same answer.

0.862 0.2922

£1,511, £1,401 £28,529

ANSWER 56.
Mean: Minimum value = 6.875%, Maximum value = 7.5%
SD: Minimum value = 0%, Maximum value = 3.25%
ANSWER 57.
(i) 0.057869, 0.00080068
(ii) 0.1335
ANSWER 58.
(i) £345.06
(ii) £11.58
ANSWER 59.
ESn   E 1  i1 1  i2  ... 1  in   E1  i1 E1  i2 ...E1  in   1  j

n
(i)
n
Var  Sn   1  j  s   1  j
2 2 2n
 
(ii) (a) Proof

(b) 54.8 years
ANSWER 60.
£438,971

ASSIGNMENT 2
SOLUTIONS
PORTFOLIO THEORY
ANSWER 1.
61,775
ANSWER 2.
(i)  
E Sx   7.5%, E Sy  15%
V  S x    2.5%  , V  S Y   5% 
2 2
(ii)  
E R p  11.25%
(a)  
V R p  3.75%
2
(b)  
V R p   2.795% 
2
(c)  
V R p  1.25%
2
(d)
 
V R p  3.491% 
2
(iii) The more closely correlated the investments in the portfolio, the larger the variance. The highest re-
sult was obtained when the securities were assumed to be perfectly correlated (ie the correlation
coefficient was +1) and the lowest result when the securities were assumed to be perfectly negatively
correlated (ie the correlation coefficient was 1). This is to be expected. For example, with negative
correlation, the potential deviations from the expected return of each security separately will tend to
cancel each other out, giving a smaller overall portfolio deviation from the overall expected return of
the portfolio.
ANSWER 3.
Proof

ANSWER 4.
(i) x A  0.9, x B  0.1, P  1.9%
This is less than both of the individual security standard deviations of 2%and 6%, illustrating the ben-
efits of diversification.
W  4x A  36x B  18x A x B    4x A  8x B  EP     x A  x B  1 
2 2
(ii)
ANSWER 5.
A straight line in  Ep , p  space.
ANSWER 6.
An investor's indifference curves slope upwards because we are assuming that the investor is risk-averse
and prefers more to less. Consequently, additional expected return yields extra utility, whereas additional
risk reduces utility. Thus, any increase (decrease) in risk/standard deviation must be offset by an increase
(decrease) in expected return in order to maintain a constant level of expected utility.
The gradient of the indifference curves is determined by the degree of the investor's risk aversion. The
more risk-averse the investor, the steeper the indifference curves - as the investor will require a greater
increase in expected return in order to offset any extra risk.
ANSWER 7.
The optimal portfolio occurs at the point where the indifference curve is tangential to the efficient frontier
for the following two reasons:
1. The indifference curves that correspond to a higher level of expected utility are unattainable as they
lie strictly above the efficient frontier.
2. Conversely, lower indifference curves that cut the efficient frontier are attainable, but correspond to a
lower level of expected utility.
The highest attainable indifference curve, and corresponding highest level of expected utility, is therefore
the one that is tangential to the efficient frontier. The optimal portfolio occurs at the tangency point, which
is in fact the only attainable point on this indifference curve, which is why it is optimal.

ANSWER 8.
(i) 14%
(ii) 26.6%
(iii) In mean-variance portfolio theory, risk is measured by standard deviation of returns.
An investor who invests 20% of his wealth in Asset A rather than investing 100% in Asset B is demon-
strating risk aversion, because they are choosing to reduce the level of risk at the cost of attaining a
lower expected return.
ANSWER 9.
2
(i)   5E  70E  265, E  7%
V
(ii)  50x A  6    0
x A
V
 200x B  11    0
x B
V
 4    0
xC
V
 E  6x A  11x B  4x C  0

V
 1  x A  xB  xC  0

7
(iii) x B  x A
8
(iv) 4  0.806
ANSWER 10.
V   20  16  E  240 1    E  800 1   

2
(i)

30 1    4  2
(ii) E x1 
5  4 5  4
ANSWER 11.
(i)
 All expected returns, variances and covariances of pairs of assets are known.
 Investors make their decisions purely on the basis of expected return and variance.
 Investors are non-satiated.
 Investors are risk-averse.
 There is a fixed single-step time period.
 There are no taxes or transaction costs.
 Assets may be held in any amounts, ie short-selling is possible, we can have infinitely divisible
holdings, there are no maximum investment limits.
1  2  E  1E2
(ii) p  aEp  b where a  and b  2 1
E1  E2 E1  E2
E1  E2
(iii) (a) (b) Proof
1  2
MODELS OF ASSET RETURNS

ANSWER 12.
2.74%
ANSWER 13.
* *
R i  3.04  1.3I1  1.19I2  ci
ANSWER 14.
Proof

ANSWER 15.
(i) R P   P  P R M   P
(ii) As n   , the variance var( P ) will tend to zero. So this component of the variance of returns can be
reduced to a very small level by selecting a sufficiently diversified portfolio. It is therefore often called
the ‘diversifiable risk’.
(iii) The statement is not correct.
A zero beta indicates no systematic risk.
A portfolio will only be totally risk-free if it has zero variance, ie if var  R P   0 .
From the equation var  R P   P var  R M   var   P  , we see that, even if P  0 , the overall variance
2
will only be zero if var  P   0 , as well.
But, any (non-trivial) portfolio of risky assets will have a non zero specific risk, ie var  P   0 .
However, it is theoretically true that a well-diversified portfolio with a beta of zero will be approx-
imately risk-free.
ANSWER 16.
Proof
ANSWER 17.
(i) (a) E1  11, E2  8, E3  17.8, 1  5.70, 2  3.21, 3  10.06
(b) C1,2  16.5, C1,3  55.0, C2,3  30.0
(ii) (a) 38.55
(b) 38.028
(c) 0.522
ANSWER 18.
(i) Ep  p  pEm

n
(ii)  x jCij
j 1
n n
(iii)  P    x i x jC ij
2
i  1 j 1
C iP cov  R i ,R P 
(iv)  iP  2

P VP
ASSET PRICING MODELS

ANSWER 19.
(i) 0.6
(ii) 8%
ANSWER 20.
1.179
ANSWER 21.
(i)
 Investors make their decisions purely on the basis of expected return and variance. So all ex-
pected returns, variances and covariances of assets must be known.
 Investors are non-satiated.
 Investors are risk-averse.
 There are no taxes or transaction costs.
 Assets may be held in any amounts.
 All investors have the same fixed one-step time horizon.
 All investors make the same assumptions about the expected returns, variances and covariances
of assets.

 All investors measure returns consistently (eg in the same currency or in the same real/nominal
terms).
 The market is perfect and in equilibrium.
 All investors may lend or borrow any amounts of a risk-free asset at the same risk-free rate r.
(ii) 17.25%
ANSWER 22.
(i) Within the context of the Capital Asset Pricing Model, the market price of risk is defined as:
EM  r
M
where:
 EM = the expected return on market portfolio
 r = the risk-free rate of return

  M = the standard deviation of market portfolio returns.
It is the additional expected return that the market requires in order to accept an additional unit of
risk, as measured by the portfolio standard deviation of return.
It is equal to the gradient of the capital market line in E  space.
(ii) the security market line relationship Ei  r  i  EM  r  and also that the beta of a security is defined
as:
cov  R i ,R M 
i  2
M
If we define iM  cov  R i ,R M  , then the security market line can written as:
 iM  iM  EM  r   iM
Ei  r  2
 EM  r   r   r M
M M  M  M
iM iM i M
As   iMi is a measure of the risk of portfolio i, the security market line states that the
M M
expected return on any portfolio can be expressed as the sum of the risk-free rate and the amount of
risk multiplied by the market price of risk, ie:
expected return = risk-free rate + (market price of risk) × (amount of risk)
ANSWER 23.
(i) (a) The security market line for any portfolio P is:
EP  r   EM  r  P
where:
 EP is the expected return on portfolio P
 r is the risk-free rate of return

 EM is the expected return on the market portfolio
 P is the beta of the portfolio with respect to the market portfolio
The security market line holds for all securities and portfolios. Thus, applying it to the market portfo-
lio gives:
EM  r   EM  r  M  EM 1 M   r 1 M 
Given that EM  r , it must be the case that M  1 .
Similarly, applying the security market line relationship to the risk-free asset (with a beta of  r )
gives:
r  r   EM  r  r
ie 0   EM  r  r
Given that EM  r , then it must be the case that  r = 0, ie the risk-free asset has a beta of zero – which
must be the case as it involves zero risk-systematic or otherwise
(i) (b)

(i) (c) The security market line relationship is of interest because:
 it enables us to determine the expected return on any asset or portfolio. This can be done if we
can estimate the risk-free rate, the expected return on the market portfolio and the beta of the
individual asset or portfolio.
 it tells us that the expected return on any asset is equal to the risk-free rate plus a risk pre-
mium, which is a linear function of the systematic risk of the asset as measured by the beta fac-
tor.
 it tells us that expected return does not depend on any other factors and in particular it is inde-
pendent of the specific risk of an asset, which can be eliminated by diversification.
The above results do of course depend upon the appropriateness or otherwise of the Capital Asset
Pricing Model.
(ii) (a) The capital market line is the equation of the efficient frontier in  E,  space, which is a straight
line.
It passes through the risk-free asset with coordinates (0, r) and the market portfolio, which has
coordinates  M ,EM 
Thus, the gradient of the capital market line is equal to:
EM  r EM  r

M  0 M
It has an intercept on the vertical axis at the risk-free rate r and consequently, for any efficient
portfolio P, its equation must be:
E r 
EP  r   M  P
 M 
The capital market line relationship only holds for efficient portfolios - those for which there is no
other portfolio that offers either a higher expected return for a given risk or a lower risk for a giv-
en expected return - assuming that the Capital Asset Pricing Model itself applies. Efficient portfo-
lios are always combinations of the risk-free asset and the market portfolio.

(ii)(b) Interpret the relationship
r is the risk-free rate of return, ie the rate of return on a security that has a zero standard devia-
tion of return. This is sometimes interpreted as the return on a Treasury bill.
EM  r
The quantity is the market price of risk.
M
It can be interpreted as the extra expected return that can be gained by increasing the level of risk
of an efficient portfolio by one unit. In this context, risk strictly means the standard deviation of
investment returns.
E r 
The second term in the relationship,  M   P , is known as the risk premium. It represents the
 M 
additional return over and above the risk-free rate that can be obtained on a portfolio P by ac-
cepting risk, ie a non-zero portfolio standard deviation.
BROWNIAN MOTION AND MARTINGALES

ANSWER 24.
(i) W  t   t  B  t 
(ii) Proof
ANSWER 25.
(i) Proof
min  t 1 , t 2 
(ii) 
 Bt ,Bt1 2
 max  t 1 , t 2 
ANSWER 26.
1 2 2
 
a   a
2 2
(i)  a e
(ii) Proof

STOCHASTIC CALCULUS AND ITO PROCESSES

ANSWER 27.
(i) Ito's Lemma states that f  X t  satisfies the SDE:
df  X t    t f '  X t  dBt   t f '  X t   2  t f  X t   dt

1 2 *

(ii) (a) dG t   t G t dBt   t  12  t  G t dt

2
 
dQ t  2 t Q t dBt  2 t Q t   t  dt
1 2 1
(b) 2 2
 
dVt   t Vt dBt    t Vt   t Vt  dt
2 2 2 3
(c)
 
(d) dLt  10t dBt  10t  0 dt  10  t dBt   t dt 
1 1 2
(e) dJt  Bt dBt  2 Bt dt
(f)  2
dJ t  15Bt  2 dBt  15Bt dt 
ANSWER 28.
(i) The process X t is an Ornstein-Uhlenbeck process so that:
t
t   t s 
X t  X 0e   e dBs
0
(ii) The process R t  4 is an Ornstein-Uhlenbeck process so that:
t
  t s 
R t  4  R0  4 e
t
  e dBs
0
which in this case becomes:

t
0.8t 0.8 t s 
Rt  4  e  e dBs
0

(iii) Since dBs ~ N 0,ds  , and these increments are independent, it follows that:
 t   1.6t 
0.8t 1.6 t s  0.8t 1  e
Rt ~ N 4  e ,e ds   N  4  e , 
   1.6 
 0   
In the long-term lim R t ~ N  4,0.625 .

t 
ANSWER 29.
1
Xt  Bt
1e
ANSWER 30.
1 2
(i) c1   and c2    2 
ESt   S0e
t  1 2  t
(ii)
e 
2 2
Var  St   S0e
2 2t 2 t t
e
   S02e t  t   e  t e
3 2 1 2 1 2
 t1  t2
(iii) Cov S t ,S t 1 2 2 1
e 2

2
1 2

 t t1  1   t 2 t1 
2
 1 
2
 t t 
E St |St   St e
2
 St e
2 1
e
2 2
2 1 1 1
(iv) We can rearrange the last result in the form:
   1
2
2
 t2     1
2
2
 t1 
E e S t |S t   e St
 
2 1 1
 2

  1 2  t 1
which shows that, subject to the convergence criterion, the process e S t is a martingale with
respect to St  .
ANSWER 31.
(i) dX t  dt  dWt

(ii) 
 
dSt  St    1 2  dt  dWt 
2

(iii) 0.405
STOCHASTIC MODELS OF SECURITY PRICES

ANSWER 32.
(1.80,2.23)
ANSWER 33.
(i) 2.1911, 0.30963
(ii) (a) 0.40517 (b) 0.20913

ASSIGNMENT 3
SOLUTIONS
CHARACTERISTICS OF DERIVATIVE SECURITIES
ANSWER 1.
The five factors and the effect of an increase in each of them on an American put option are:
Factor Value of American put option will...

share price decrease
exercise price increase
time to expiry increase
volatility of share price increase
risk-free rate of interest decrease
ANSWER 2. ANSWER 5.
£43.23 (i) 17.96
(ii) 27.96
ANSWER 3.
£47,021, £37,826 ANSWER 6.
2.04
ANSWER 4.
£226.63
ANSWER 7.
(i) This is because it can be worthwhile to exercise an American put early - in which case the cash will not
have accumulated fully and so the payoffs do not work out to be the same. This means that Portfolio B
is worth more than Portfolio A.
(ii) Dividends will be received on Portfolio B, but not on Portfolio A. Again we see that Portfolio B is then
worth more than Portfolio A.
ANSWER 8.
(i) 28.8p
(ii) If the put options are only 25p, then they are cheap. If things are cheap, then we should buy them in
order to generate arbitrage profits. So, looking at the put-call parity relationship, we 'buy the cheap
side and sell the expensive side', ie we buy put options and shares and sell call options and cash.
For example:
• sell 1 call option 30p
• buy 1 put option (25p)
• buy 1 share (123p)
• sell (borrow) cash 118p
This is a zero-cost portfolio and, because put-call parity does not hold, we know it will make an arbi-
trage profit, which we can check as follows.
In 3 months' time, repaying the cash will cost us:

0.060.25
118e  119.78
We will also have received dividends to totalling d, say, on the share.
1. If the share price is above 120 in 3 months' time, then the other party will exercise their call op-
tion and we will have to sell them the share. They will pay 120 for it and our profit is:
120 –119.78 + d = 0.22 + d
(In this case, the put option will expire worthless.)
2. If the share price is below 120 in 3 months’ time, then we will exercise our put option and sell the
share for 120. Our profit is:
120 – 119.78 + d = 0.22 + d
(In this case, the call option will expire worthless.)
So we see that in either case, this zero-cost portfolio generates positive future profits.

ANSWER 9.
(a) Profit = –37 + (495 – 480) = –22, ie a loss of 22p.
(b) Profit = –12 + (180 –150) = +18, ie a profit of 18p
(c) Profit = +22 + 0 = +22, ie a profit of 22p.
ANSWER 10.
ANSWER 11.
£6.29
ANSWER 12.
(i) 0  Y   W, Z   X

(ii) The lower bound for a European call option is given by the inequality:
 r T  t 
ct  St  Ke
The upper bound for a call option is given by the inequality:
c t  S t ie c t  120
ANSWER 13.
 r T  t   r T  t 
(i) pt  St  Ke ie pt  Ke  St
1  r T  t   r T  t  1
(ii) pt  S t  Ke ie pt  Ke  St
1.02 1.02
ANSWER 14.
Consider the following two portfolios, set up at time t:
Portfolio A: A forward contract to buy one unit of the asset at time T for forward price K; simultaneously
 r T  t 
invest an amount Ke in the risk-free investment.
 T  t 
Portfolio B: Buy 1  D units of the asset, reinvesting the dividend income in the asset immediately
as it is received.
At time T, the risk-free investment in Portfolio A has grown to amount K, which is used to buy one unit of
the asset using the forward contract.
At time T, the amount of the asset in Portfolio B has grown with the reinvested dividend income to one unit.
So, the outcome of both of these portfolios is that one unit of the underlying asset is held at time T. [1]
Assuming no arbitrage, the value of these portfolios must therefore also be equal at time t.
 r T  t 
The cost of setting up Portfolio A is Ke .
 T  t 
The cost of setting up Portfolio B is St 1  D
Equating these:
 r T  t   T  t  r T  t   T  t 
Ke  S t 1  D   K  St e 1  D 

ANSWER 15.
Suppose that the dividend d is payable at some date t  t 1  T . Consider two portfolios at time t as follows:
1. Portfolio A - which consists of one European call option plus cash equal in amount to the discounted
value of the strike price plus the present value of the dividends to be paid at time t 1 -iea cash amount
 r t 1  t   r T  t 
of de  Ke .
2. Portfolio B - which consists of one European put plus one dividend-paying share.
Then the value of portfolio A at the exercise date T is given by:
r T  t 1  r T  t 1 
ST  K  d e  K  ST  d e if ST  K
(ie the call option is exercised leaving the investor with the share plus the accumulated value of the
dividend received), and:
r T  t 1  r T  t 1 
0  de  K  de K if S T  K
(ie the call expires worthless and the investor is left with cash equal to the exercise price plus the ac-
cumulated value of the dividend).
Similarly, the value of portfolio B is:
r T  t 1  r T t 1 
0  ST  d e  S T  de if ST  K
(ie the put expires worthless and the investor is left with the share plus the accumulated value of the
dividend received), and:
r T  t 1  r T  t 1 
K  ST  S T  de  K  de if ST  K
(ie the put option is exercised and the investor is left with cash equal to the exercise price plus the accumu-
lated value of the dividend).
Thus, the payoffs at expiry are the same for both portfolios regardless of the share price at that time. Since
they have the same value at expiry and since the options cannot be exercised before then, in an arbitrage-
free market they should have the same value at any time t < T.
Therefore:
 r t 1  t   r T  t 
ct  d e  Ke  Pt  St

THE GREEKS
ANSWER 16.
Delta
An increase in the share price would either push a call option that is currently out-of-the-money towards
being in-the-money or push one that is already in-the-money further into-the-money. Therefore delta is
positive for a call option.
A decrease in the share price would either push a put option that is currently out-of-the-money towards
being in-the-money or push one that is already in-the-money further into-the-money. Therefore delta is
negative for a put option.
Vega
If the underlying security becomes more volatile then there is a greater chance of the price moving in fa-
vour of the option holder. Although there is also an increased chance of it moving against the holder, the
downside loss is capped. Therefore vega should be positive for both a call option and a put option.
Theta
The intuitive argument is very similar to before. The greater the time to expiry, the more chance that the
share price will move in the holder's favour, with the downside loss again being capped. Thus, because time
t works in the opposite direction to time to expiry T– t, theta is usually negative for both a call and a put op-
tion.
There are circumstances where theta may be positive but these are considered beyond the scope of this
subject.
Rho
We can think of holding a call option as having cash in the bank waiting to buy the share. If interest rates
rise then the holder of a call option will benefit in the meantime. The holder of a put option may already
own a share and is waiting to sell it for cash. So if interest rates rise then the holder of the put will lose out
on that interest in the meantime. So rho is positive for a call option and negative for a put option.

Lambda
Again, we can think of holding a call option as having cash in the bank waiting to buy the share. If the divi-
dend rate rises then the holder of a call option will lose out in the meantime. The holder of a put option may
already own a share and is waiting to sell it for cash. So if dividend rates rise then the holder of the put will
benefit from the extra dividends in the meantime. So lambda is negative for a call option and positive for a
put option.
ANSWER 17.
(i)   2S t e
4S t
1  2S t  ,   2e
4S t
1  8S t
2
 8S t 
(ii) (a) Selling 0.03663 shares
(b) selling 0.0001843 shares
(iii) In the first scenario, we have a higher value of gamma and so the delta of the portfolio is more sensi-
tive to changesin the share price. This means it is more likely to involve more rebalancing of the port-
folio in the near future if the investor is to maintain a delta-hedged position.
ANSWER 18.
(i)  measures the sensitivity of the price f of a derivative to changes in the price S t of the underlying
asset:
f

St
 measures the sensitivity of the  of a derivative to changes in the price S t of the underlying asset:
2
  f
 
St S2t
 measures the sensitivity of the price f of a derivative to changes in time:
f

t

(ii) Delta hedging involves creating a portfolio consisting of a holding of a derivative and the underlying
asset, so that the delta for the portfolio is zero.
This means that the value of the portfolio will not change if the price of the underlying changes by a
small amount (all other factors remaining unchanged).
The delta of a portfolio can be calculated as a weighted sum of the deltas of the constituents of the
portfolio.
Suppose, for example, that an institution has sold 1,000,000 call options on a share, each with a delta
of 0.5. The delta for this portfolio would be –0.5 × 1,000,000 = – 500,000, and so this portfolio is not
delta-hedged.
If, however, the institution also purchased 500,000 shares, the portfolio would now be delta-hedged,
because the shares themselves have a delta of 1, so that the delta for the portfolio would be 1,000,000
× (–0.5) + 500,000 × 1 = 0. A small change in the value of the shares would now make no difference to
the value of the portfolio as a whole.
ANSWER 19.
Let f denote the value of the part of the portfolio containing the relevant shares and derivatives on those
shares.
Let S t denote the share price.
Let  denote the market volatility of the share price.
Let t denote calendar time.
(a) Hedge fund manager
For a delta-neutral position, the hedge fund manager will want to have an overall delta of zero:
f
 0
St
To minimise the need for rebalancing to maintain a delta-neutral position, the manager will also want
to have a low gamma:
2
 f
 2
0
S t

(b) Derivatives trader
The derivatives trader will be primarily concerned about the volatility. In order for changes in the vo-
latility not to affect the value of the options, the trader will want to have a vega close to zero:
f
 0

(c) Pension fund trustee
The pension fund trustee will be primarily concerned about the effect of calendar time on the value of
the options. To avoid the fund value falling, the trustee will prefer to have a non-negative theta:
f
 0
t
ANSWER 20.
So the hedging portfolio consists of 0.558 shares and cash of –113.77p .
THE BINOMIAL MODEL

ANSWER 21.
4.914
ANSWER 22.
u = 1.0594, d = 0.9439
ANSWER 23.
0.8339 if S1  120
A1  
1.1752 if S1  85
ANSWER 24.
(i) 7.342
(ii) 7.843
(iii) 11.817

ANSWER 25.
(i) 0.338357
(ii) £135.05
(iii) £0.07
(iv) Vega is the rate of change of an option value f with respect to the volatility  of the underlying asset,
ie the shares in the company:
f


The special option's payoff is dependent on the average share price, which is a much smoother
process than the current share price. So, because the special option's final payoff is less dependent on
the current share price, its value will vary less with changes in the volatility of the share price.
So, the special option will have a lower value of vega.
ANSWER 26.
(i) 6.34 ; We obtain the same value of the call option, whichever approach we take.
(ii) 7.93 ; We obtain the same value of the put option, whichever approach we take.
(iii) Put – call parity holds
ANSWER 27.
Suppose the portfolio consists of  securities and an initial amount of cash  .
If the security price moves up, the value of the portfolio will be:
r r z u  zd
e  Su   e  u
ud
We want this to equal the payoff following an upward movement in the security price:
r z u  zd
ie e  u  zu
ud
r  z  z   r  uz  dzu 
So:   e  zu  u d u   e  d 
 ud   ud 

If the security price moves down, the value of the portfolio will be:
r r z u  zd  uz  dzu  z u  zd
e  Sd  e  d d  d  zd
ud  ud  ud
 r  uz  dz u 
So, with an initial cash holding of   e  d  , the portfolio replicates the derivative payoff, irres-
 ud 
pective of the actual price movement.
ANSWER 28.
(i) u = 1.17071 and d = 0.95858
(ii) (a) 9.224
(b) 28.323
ANSWER 29.
(i) Let u and d be the assumed proportionate changes in the price of the underlying share if it goes up
and down respectively, and let r be the risk-free interest rate (continuously compounded).
t is the length of the one-step time period.
Let S be the current price of the share.
If q and 1-q are the risk-neutral probabilities for the tree, the expected final value of the share should
be the same as if it had been invested in risk-free cash.
So we need:
qSu  1  q  Sd  Se
rt
Cancelling the S's gives:
qu  1  q  d  e
rt
Rearranging gives:
rt
e d
q u  d  d  e
rt
 q
ud
rt
(ii) The condition d  e  u is needed to ensure that the market is arbitrage-free. Otherwise we could
make a guaranteed profit.

rt
For example, if d  u  e , the cash investment would outperform the share in all circumstances. So
we could make a guaranteed profit by selling the share at the start and investing the proceeds in cash.
When we buy back the share at the end, we would have a positive profit of either
rt rt
Se  Su or Se  Sd .
(iii) Let R be the one-step return on the share. Then
u with probability p
1R  
d with probability 1  p
So:
E 1  R   pu  1  p  d    E  R   pu  1  p  d  1
(iv) Similarly, the variance of the rate of return is:
  var  R 
2
 var 1  R 
 E  1  R     E 1  R  
2 2
 
2
 pu   1  p  d   pu  1  p  d 
2 2
If we collect the p's together, expand and simplify, we get:
2
  p u d  2 2
 d 2
  p  u  d   d 
2
 p u d  2 2
  p u  d
2 2
 2pd  u  d 
 p(u  d)[(u  d)  p  u  d   2d]
 p  u  d [ u  d   p  u  d ]
 p  u  d  [1  p]
2
 p  1  p  u  d 
2

(v) Since u > d by definition, the inequality p > q is equivalent to:
pu  d  d  q u  d  d
rt
e d
ie 1   u  d   d  ert  d  d  ert
ud
In words, this says that the real-world probability of an up movement is greater than the risk-neutral
probability whenever the expected increase in the value of the underlying security exceeds the risk-
free interest rate, ie whenever the underlying security is risky.
ANSWER 30.
(i) 0.995%
(ii) A2 1  0.75535, A2 2  1.03695, A2 3  1.42356
(iii) (a) 0.2965
(b) 0.4852
(c) 0.1985
(d) 0.0965
(e) 0.0768
(f) 0.2136
ANSWER 31.
(i) In a recombining binomial tree u and d, the proportionate increase and decrease in the underlying
security price at each step, are assumed constant throughout the tree. As a result, the security price af-
ter a specified number of up- and down- movements is the same, irrespective of the order in which the
movements occurred.
In a non-recombining binomial tree the values of u and d can change at each stage. As a result, each node
in the tree will in general generate two new nodes, making the tree much larger than a recombining tree.
n
Consequently, an n -period tree will have 2 , rather than just n +1, possible states at time n.
(ii) 51.922
(iii) The researcher is proposing using a 6-step non-recombining tree.

This would result in a model that was much less crude than the two-step tree and should be capable of
producing a more accurate valuation.
However, there would be a lot more parameter values to specify (although some of these may be as-
sumed to be equal). Appropriate values of u and d would be required for each branch of the tree and
values of r for each month.
6
The new tree would be big, having 2  64 nodes in the expiry column. This would make the calcula-
tions prohibitive to do manually and would require more programming and calculation time on a
computer.
An alternative model that might be more efficient numerically would be a 6-step recombining tree
(lattice), which would have only 7 nodes in the final column.

ASSIGNMENT 4
SOLUTIONS
THE BLACK-SCHOLES OPTION PRICING FORMULA
ANSWER 1.
(i) At expiry:
f  T,ST   ST  K
which is what we would expect. The investor will pay K and receive a share worth ST
(ii) We first differentiate f  t,St  with respect to S t and t to find the Greeks:
f  f  r T  t 
 1  0   rKe
St St t
Using these Greeks we see that:

1 2 2
  rS t   S t
2
 r T  t 
  rKe  1  rS t  0

 r S t  Ke
 r T  t 

 rf  S t ,t 
and so the PDE is satisfied.
ANSWER 2.
(i) If an investor buys a bond the building society can invest the money in the ABC500 so that it is not ex-
posed to movements in the ABC500 index. However, the building society is guaranteeing that inves-
tors will receive at least x% of their initial investment back. The building society can hedge this loss by
buying a put option on the index with a strike price of x% of the current share price. This put option
will cost money lets say p.

The building society is also limiting the investors return to 130% of their initial investment. They can
do this by selling call options with a strike price of 130% of the current share price. This call option
will be priced at c, say. If c  p then the building society will not make a loss.
(ii) 86%
ANSWER 3.
(i) £16,400
(ii) Both the £10,000 cash bonus and the share options do not give managers any incentive to help the
company share price once the 6-month period is over.
Managers may be able to sell their free shares, add the proceeds to the £10,000 and may have little in-
terest in how the company subsequently performs.
In addition, because the managers do not receive any bonus at all whether the share price increases
by 9%, or decreases by 50%, say, they may be tempted to undertake a riskier business/investment
strategy that is not in the best interests of the shareholders.
Any increase above 20% is not further rewarded.
(iii) The share options will provide managers more of a long-term incentive if they are restricted from sell-
ing the shares for a fixed time period after they are awarded, 3 years say.
In addition, a condition maybe imposed that the shares will only be awarded provided the Manager
continues to work for the company for a fixed time period, 3 years say.
These will ensure the managers have an interest in how the company performs after the 6-month pe-
riod is over.
Instead of a cash bonus, the managers could be given the equivalent amount in more bonus shares,
again with the restrictions mentioned above.
The number of free shares issued could be made to depend more gradually on the company’s share
price performance, eg 100 free shares for each percentage point performance above a specified
benchmark level.
This may stop any manager being tempted to employ an all-or-nothing approach in their busi-
ness/investment strategy.
It may be possible to pay the managers salaries almost entirely in shares so that their interests are the
same as that of the shareholders.

ANSWER 4.
(i) 307.44
(ii) 92.11
ANSWER 5.
  d1 
 qu
(i)   e
2 2
 1 2 d1  1 2 d1  qu
 qu e 1 e
(ii) e 
2 S u S 2u
ANSWER 6.
(i) If S0  50 , then the payoff is
S1  35 if 35  S1  45
10 if 45  S1  55
65  S1 if 55  S1  65
0 otherwise
(ii) The payoff from the special derivative can be replicated with the following combination of call op-
tions:
 a long call option with strike price £35 [1]
 a short call option with strike price £45 [1]
 a short call option with strike price £55 [1]
 a long call option with strike price £65 [1]

[Total 4]
With this combination of options the overall payoff is:
max S1  35,0  max S1  45,0  max S1  55,0  max S1  65,0

We can check that this combination of options does indeed give the same payoff as the special deriva-
tive, by considering the payoff for different ranges of the share price.
If S1  35 , no option is exercised, so the payoff is 0.
If 35  S1  45 , only the call option with strike price £35 is exercised, so the payoff is:
S1  35
If 45  S1  55 , the call options with strike prices £35 and £45 will be exercised, giving a payoff of:
S1  35  S1  45  10
If 55  S1  65 , the call options with strike prices £35, £45 and £55 will be exercised, giving a payoff of
:
S1  35  S1  45  S1  55  65  S1
If S1  65 , all call options will be exercised, giving a payoff of:
S1  35  S1  45  S1  55  S1  65  0
So, in all cases, this combination of call options gives the same payoff as the special derivative.
(iii) £7.54
THE 5-STEP METHOD IN DISCRETE TIME

ANSWER 7.
t
(i) If A t v is an R-martingale then we have:
ER  A t v Fs   A s v
t s
 
t s
 A s 1  i 
st
 ER  A t Fs   As v
So, using R as our probability measure we see that, statistically speaking, we expect A t to 'act like
cash', ie to increase at the risk-free rate. The riskiness within it has been 'neutralised' and therefore R
is the risk-neutral probability measure.
(ii) For a martingale we need:
ER  X t |Fs   X s
The LHS is:
ER  X t |Fs   ER  v ER C|Ft  Fs 
T
 
By analogy with the hint in the question, we have:
ER ER C|Ft  Fs   ER C|Fs 
ie the tower law. So, we can simplify the RHS of the previous equation to give:
v ER ER C|Ft  Fs   v ER C|Fs   X s

T T
(iii) We make use of the martingale representation theorem in the following form:
Let D t and X t be R -martingales. Then there exists a unique process  t such that dX t   t dDt . Fur-
thermore,  t is previsible.
Since  t satisfies this equation and the conditions for the theorem to apply, we conclude that  t is
previsible.
ANSWER 8.
(i) The martingale property tells us that, whenever t < T:
 rT  rt
EQ e ST |Ft   e St
 
(ii) (a) Bt is the accumulated value at time t of an initial investment of 1 unit of cash.
rt
So: B t  e
(b) The discounted cash process is therefore:

 rt  rt rt
e Bt  e e 1
which trivially satisfies the martingale equation EQ e BT Ft   e

 rT  rt
Bt .
 

(c) We have established that the discounted values of both of the components (the shares and the
cash) of such a portfolio are martingales. So any multiple of these will also be a martingale.
Also, if we 'rebalance' the portfolio by making switches from cash to shares or vice versa, this will
not affect the martingale property.
A good intuitive way to think of martingales here is that, on average, they don't drift up or down.
So, if our (discounted) cash and shares are not drifting up or down, neither will any combination
of them.
 rt
(iii) To show that the process e Vt is a martingale, we need to prove that, if t 1  t 2 then:
 rt 2  rt
EQ e Vt Ft   e Vt 1
(1)
 2  1 1
We've used t 1 and t 2 here, rather than t and T, to avoid confusion, because there's already a T in the
definition of Vt .
Substituting the definition of Vt into the left-hand side (LHS) of (1), we have:
2
LHS  EQ e

 rt 2  r  T  t 2 
e EQ X |Ft 2
 Ft 1


e
 rT
EQ EQ X |Ft
  2
 Ft  1
We can simplify this nested expectation using the tower law to get;
LHS  e
 rT
EQ X|Ft 1

From the definition of Vt , the right-hand side {RHS} of (1) equals:
1
RHS  e
 rt 1  r  T  t 1 
e EQ X |Ft  1
  erTEQ  X |Ft  1
So: LHS = RHS

 rt
This shows that e Vt is also a Q-martingale.
(iv) We have shown that, if we have a self-financing portfolio consisting of shares and cash, its discounted
value will be a Q-martingale, ie it will have no drift.

If it is possible to rebalance such a portfolio so that it will always replicate over the next instant the
value of a derivative based on the share, then the discounted value of the derivative must equal the
discounted value of this portfolio.
It turns out that such a replicating strategy is possible. The Martingale Representation Theorem guar-
antees this.
 rt
But the discounted process e Vt behaves in precisely this way, and gives the correct payoff x when t
= T.
So Vt must equal the value of the derivative.
 r T  t 
This gives us the derivative pricing formula Vt  e EQ  X|Ft  .
ANSWER 9.
(i) (a) The filtration Fi is just the set of values representing the path followed up to time i. So, in this
case (where we are told what has happened up to time 1), we have:
F0  13 and F1  13,20
(b) If F1  13,20 , there are two possible values for X 2 , namely 25 and 15, which we are assuming
are equally likely.
1 1
So: EP  X 2 |F1    25   15  20
2 2
This figure has already been written in on the tree in the question at time 1.
(c) If X 1  6 , then F1  13,6 .
1 1
Here: EP  X 2 |F1    12   0  6
2 2
Again, this matches the figure shown in the tree at time 1.
(d) We have established that, if we start at the '13' node (corresponding to the only possible value of
F0 ), the conditional expectation EP  X2 |F1  can take two possible values, and these are equally
likely under the probability measure P .

1 1
So: EP EP  X 2 |F1  F0    20   6  13
2 2
This matches the figure shown in the tree at time 0.

(e) If we start at the '13' node, X 2 can take four possible values (25,15,12 or 0), each with probabili-
1 1 1
ty  
2 2 4
.
So:  1
 1 1 1
E X |F   25   15   12   0  13
P 2 0 4 4 4 4
This expectation is the same as the expectation in (i)(d), ie EP Ep  X2 |F1  F0   EP  X2 |F0  . This
is an example of the 'tower property' of conditional expectations.
(ii) (a) Yes. The tower property applies equally well in this case, ie it is also true that:
EQ EQ  X2 |F1  F0   EQ  X2 |F0 
(b) Equalities of the form EQ  X n |F11   EQ EQ  X n |Fi  Fi1  are useful because they enable us to
work backwards through a binomial tree, calculating the value of the derivative at time i –1 from
the values at time i.
(c) We need to calculate EQ  X2 |F0  . Calculating the values of the conditional expectations by work-
ing backwards using the risk-neutral probability measure Q, leads to the following tree:
So the value of the derivate at time 0 is 10.48

THE 5-STEP METHOD IN CONTINUOUS TIME

ANSWER 10.
Hold:
V
 t     d1  shares and
S
  t  E t   t Dt  e
 rt
 Vt  t St  units of the cash bond (ie an actual cash amount of Vt   t S t ).
ANSWER 11.
6 4
Here T  ,t , r  0.05,   0.2, K  500 and S t  475. So you need:
12 12

 t    d1    

 In  475 / 500   0.05  0.22 2   6  4  12 
 
  0.314 shares
 0.2  6  4  12 
 
and: Vt  t S t  475  d1   500e

0.052/12
 
 d1  0.2 2/12  0.314  475
= – 142 cash
ANSWER 12.
We have that:
 rt 
Zt  r  1 2  t
2

At  e t  e
 2

If we let X t  Zt  r  1 2  t , so that dX t  dZ t  r  1 2  dt ,then:  2

Xt
At  e
We can then apply Ito's Lemma to get:
  2 X

dA t    r  1 2  e  1 2  e  dt  e dZt
2 X

X
t t t
  rA t dt  A t dZ t
  A t  rdt  dZ t 

 rt
This shows that A t is just a 'randomised' version of the ordinary discount factor e , for which
    e  rdt .
d e
 rt  rt
ANSWER 13.
(i) Solving the SDE
The process is geometric Brownian motion. To solve it we consider the function f St   logSt .
Applying the Taylor's series formula to the above function, we get:
1 1 1 
df  S t   d  log S t   dS t    2   dS t 
2
St  
2  St 
1 1
 rS t dt  S t dBt   2  rS t dt  S t dBt 
2

St 2S t
1 2
 r dt   dBt   dt
2
 1 2
  r    dt  dB t
 2 
Changing the t's to s’s and integrating this equation between limits of s = 0 and s = t, we get:
t t
1 2
log Ss s0   r 
st
2  0
  ds    dBs
 0
 1 2
 logSt  logS0   r    t  Bt
 2 
r 1
2

 t Bt

2
S t  S0 e
(ii) Probability distribution
From part (i), we know that, under the risk-neutral probability measure Q,
 1 2
logSt  logS0   r    t  Bt
 2 

Since Bt ~ N 0,t  then:
logSt  logS0 ~ N r  1 2  t,  t  2
 2

Replacing 0 and t with t and T-t we get:
log ST  log S t ~ N r  1 2   2
 T  t  ,  T  t 
2
 
logST |St ~ N logS t  r  1 2   2
 T  t  ,  T  t 
2
 
ST |St ~ log N logSt  r  1 2   2
 T  t  ,  T  t 
2
(iii) Fair price for a forward
We are given that the fair price to pay at time t for a derivative paying X at time T is
 r T  t 
Vt  e EQ  X|Ft  , where Q is the risk-neutral probability measure.
The random variable payoff of a forward on a non-dividend-paying share is:
X  ST  K
Substituting this into the fair price formula, we get:

 r T  t  r T t 
Vt  e EQ  X|Ft   e EQ ST  K|Ft 
 r T  t 
e  EQ ST |Ft   K 
Now EQ ST |Ft  is the conditional mean of the random variable ST , and from part (ii), we know that

ST |St ~ log N logSt  r  1 2   2
 T  t  ,  T  t  . 2
Using the formula for the expectation of the lognormal distribution on page 14 of the Tables:
EQ ST |Ft   e
logS  r    Tt 
t
1
2
2
1
2  Tt 
2

r T  t 
 St e

So:
 r T  t   r T  t 
Vt  e EQ  X |Ft   e EQ ST |Ft   K 
 r T  t 
 St  Ke
ANSWER 14.
(i) (a) This process is geometric Brownian motion (also known as the continuous-time log normal model).
(b) This process is commonly used to model share prices (with or without dividends). [1]
[Total 2]
(ii) (a) In words, two probability measures are equivalent if they are defined on the same sample space
and have the same null sets (ie sets that have probability zero).
Mathematically, P and Q are equivalent if P  A   0  Q  A   0 , where P  A  denotes the probability

under measure P and Q(A) denotes the probability under measure Q. [1]
This is sometimes expressed as 'Equivalent measures agree on what is possible’.
(b) The CMG Theorem tells us that, for any  there is a probability measure Q (equivalent to p) such
  W  t is standard Brownian motion under Q.
that Wt t
So we could change probability measures and work with Q.

  t , under the measure Q, the formula for S , in terms of W
Since Wt  W  becomes:
t t t
  1
2
2

 t  W
 t    1
2
2
 
 t W
S t  S0 e  S0 e
t t
r 1
2
2

 t W r
If we want this to equal S0e , we need to set     r, ie   . [2]
t
[Total 3]
r 1
2
2

 t W 
(iii) (a) We can write the equation S t  S0e in the form:
t
St  f  X t 
  and f  x   S e
where X t  r  1 2  t  Wt 0
2
 x

 2
 and f '  x   f ''  x   S e
So: dX t  r  1 2  dt  dWt 0
x
Using a Taylor Series expansion, we can write:
1
dS t  df  X t   f '  X t  dX t  f ''  X t dX t 
2
 S0 e
Xt
dX  t
1
2
 dX t 
2


 S t dX t  2  dX t 
1 2

Substituting the SDE for X t gives:

    
 
2
   1  r  1 2 dt  dW
dS t  S t   r  1 2  dt  dW
2
 t
 2  2 t
  
Simplifying using the 2 × 2 multiplication grid, we get:




     1 2dt 
dS t  S t   r  1 2  dt  dW
2
t
 2


 S t  rdt  dW
 
t
(b) The drift in this equation is rS t , or just r, if we're thinking in units of S t .
 has mean zero. This means that the

 is standard Brownian motion, the increment dW
Since Wt t
expected value of dS t under the measure Q is rS t dt , ie the share price is drifting upwards at the
risk-free rate. This means that Q is the risk-neutral probability measure for the process S t .
ANSWER 15.
(i) If we take logs of the equation given, we get:

log S T  log S0  r  1 2 
2
 T  Z T
 ~ N 0,T  , we see that the distribution of S given F under the probability measure Q is:
Since ZT T 0

2 2

ST |F0 ~ log N logS0  r  1 2  T,  T 
 
The expectation we require is:
EQ  X|F0   EQ max ST  K,0 F0 


K
 x  K  f  x  dx
 
  x f  x  dx  K  f  x  dx
K K
where f(x) is the density function of the above lognormal distribution.
We can evaluate these integrals using the formula on page 18 of the Tables, with L = K and U   , and
2
with  and  replaced with log S0  r  1 2  T and  T .  2
 2
If we put k =1, we get:
  2
 2
logS0  r  1 2  T  1 2  T

  
 0 2 
 log K  log S  r  1 2 T 
 

K xf  x  dx  e       
 T
  T 
  
  
rT


 log K   log S  r  1 2 T 

 S0e 1   
 0 2  


  T 

   T 
  
We can simplify this using the identity 1    x     x  to get:

  log K  log S  r  1 2 T

xf  x  dx  S0e  
rT 0 2

  
K  T
 T
 
 
 log  S / K   r  1 2 T

rT
 S0 e  
0 2 

 T

  T 
 
rT

 S0 e  d 2   T 
where d2 is as defined in the question.

Similarly, if we put k = 0, we get:


K f  x  dx    d2 
So the expectation is:

EQ  X |F0   S0e  d2   T  K  d2 
rT

(ii) If ST denotes the value of a share at time T ,and Q denotes the risk-neutral measure for this share, this
formula allows us to work out the fair price of a European call option on the share with strike price K
and time to expiry T .
This price would be calculated as the discounted value of the expectation in part (i), namely:
e
 rT
EQ  X |F0   e
 rT
 0  2 
S erT  d   T  K  d  
2 
 S0   d1   Ke   d2 
 rT
where d1  d2   T .
This matches the Black-Scholes formula for valuing a call option on a non-dividend-paying share.
ANSWER 16.
 r T  t 
(i) Vt  e EQ  X T Ft 
where:
r = constant risk-free force of interest
T = maturity date of the derivative
t = today's date
XT = derivative payoff at maturity date T
Q = risk-neutral probability measure
Ft = filtration at time t

(ii) (a) Derive the formula for the price of Derivative 1
The payoff function of this non-standard derivative is:
1 S T  K
X 1T  
0 S T  K
To derive the pricing formula of the derivative, we substitute the payoff function into the general
risk-neutral pricing formula in part (i), ie:
 r T  t 
V1t  e EQ  X1T |Ft 
which, as the derivative pays 1 provided the share price is between 0 and the strike price K , is
equal to:
K
 r T  t 
V1t  e  1f ST |St  dST (1)
0
where f  ST |St  is the probability density function of the share price at the maturity date, ST ,
given the current share price, S t .
Note that as the share price is assumed to follow geometric Brownian motion, the independence of
increments means we do not have to condition on the full past history of the share price - only the
current share price, S t .
The distribution of ST given S t is:
ST St ~ log N InSt  r  q  1 2 
  2
 T  t  ,  T  t 
2
We can simply state this result or obtain it using the following reasoning:
Under the risk-neutral probability measure, Q, the tradeable asset is expected to grow at the risk-
free force of interest, r. Here, the tradeable asset is the share plus the dividends earned. Assuming
the dividends are immediately reinvested in the asset, they will give a rate of growth of the tradea-
ble asset of q. So this means the share price alone must grow at a rate r–q.
Therefore, if S t denotes the share price at time t, then it has SDE:
dS t  S t   r  q  dt  dZ t 

where Z t denotes standard Brownian motion. This has solution:

ST  St exp r  q  1 2 
2
  T  t    Z T  Zt  
giving the distribution:
 
InS T |S t ~ N In S t  r  q  1 2 
2
  T  t  ,   T  t 
2
 S T |S t ~ log N In S t  r  q  1 2 
  2
  T  t  ,   T  t 
2
To work out the Integral (1) above, we need to use the formula for evaluating the truncated mo-
ments of a lognormal distribution, which appears on page 18 of the Tables.
We have 1   S T  and so k =0 in the formula on page 18 of the Tables.

0
Thus, (1) above is equal to:

 r T  t 
V1t  e  e0     U     L   (2)
  0 0 
where:
U0 

InK  In S t  r  q  1 2   2
  T  t   0
 Tt
 
t 2 
 In  S / K   r  q  1 2  T  t  
 
  Tt 
 
  d2
L0 
 
In0  InS t  r  q  1 2 
2
  T  t   0  
 Tt
So, (2) above becomes:
 r T  t 
V1t  e   d2       
 r T  t 
e   d2   0
 r T  t 
e   d2 

(b) The payoff function of this non-standard derivative is:
S ST  K
X 2T   T
0 ST  K
To derive the pricing formula of this derivative, we substitute the payoff function into the risk-
neutral pricing formula in part (i), ie:
 r T  t 
V2t  e EQ  X2T |Ft 
Substituting in for X 2T gives:
K
 r T  t 
V2t  e  ST f ST |St  dST (3)
0
To evaluate this, we again use the formula for evaluating the truncated moments of a lognormal
distribution on page 18 of the Tables, where:
ST |St ~ log N InSt  r  q  1 2 

  2
 T  t  ,  T  t 
2
In this instance, S T   S T  , so k = 1 in the formula on page 18 of the Tables. Thus, (3) above is
1
equal to:
 r T  t   InS 
 r q  1 2 
2
 T  t   1  Tt  
2
    U1     L1  
2
V2t  e
t
e (4)
 
where:
U1 

In K  InS t  r  q  1 2   2
 T  t    Tt
 Tt


In K  InS t  r  q  1 2 
2
 T  t    T  t  2
 Tt


In K  InS t  r  q  1 2 
2
T  t 
 Tt

 
t 2 
 In  S / K   r  q  1 2  T  t  
 
  Tt 
 
 d1
L1 

In0  InS t  r  q  1 2   2
  T  t    T  t  
 Tt
2
So, after some cancelling of terms involving r and  , (4) above becomes:
 q T  t 
V2t  S t e    d1       
 q T  t 
 St e    d1   0 
 q T  t 
 St e    d1 
(c) Derive the pricing formula for a European put option
The payoff function for a European put option can be written as:
K  S T ST  K
X PT  
0 ST  K
This payoff function can be replicated using a combination of +K of the derivatives in part (ii)(a)
and –1 of the derivatives in part (ii)(b).
Consequently, and assuming that markets are arbitrage-free, the price of a European put option
must be given by:
p t  K  V1t  V2t
 r T  t   q T  t 
 Ke   d 2   S t e    d1 
(iii) Price of exotic forward contract
Here the payoff function is equal to:
2 2
X T  ST  K

So, once again substituting this into the general risk-neutral pricing formula in part (i) gives:
 r T  t 
EQ S T  K |Ft 
2 2
Vt  e
 
e
 r T  t 
E Q
S2 |F   K 2
 T t 
where:
ST |St ~ log N InSt  r  q  1 2 

  2
 T  t  ,  T  t 
2
As this derivative contract provides a non-zero payoff regardless of the share price at maturity, we can
evaluate EQ ST |Ft  using the formula for the moments of a non-truncated lognormal distribution on
2
 
page 14 of the Tables, ie:
 r T  t   2 InS t 
 r q  1 2 
2
 T  t    1
2 4   T  t 
2
2
Vt  e e K 
 
2  r 2q   T  t 
2
2  r T  t 
 St e K e
ANSWER 17.
(i) (a) The general risk-neutral formula for pricing a derivative at time t <T is:
 r T  t 
Vt  e EQ  X T |Ft 
In this Instance, the payoff function of the derivative is:

1 1
X T  ST  K 2 2
So, the price will be given by:

 r T  t 
EQ ST  K |Ft 
1 1
Vt  e 2 2
 
Black-Scholes assumes that under the risk-neutral measure Q, the underlying share price follows
geometric Brownian motion with drift r and volatility  and so:
logST |St ~ N logSt  r  12 

  2
 T  t  ,  T  t 
2

Hence, using the formula for the moments of a lognormal distribution from page 14 in the
Tables, with r  1 2 , the price will be given by:
Vt  e
 r T  t   1
2  logS  r    T t 
t
1
2
2
1
2 1 2   T  t 
2 2
1
K 
e
2
 
Note that the formula in the Tables also works for non-integer values of r.
This simplifies to:
1  1
 1 2 r  4
2
 T  t  1 r Tt 
Vt  S t e 2
K e 2
(b) The vega of a derivative with price f based on an underlying share with volatility  is defined as:
f


So, here:
 12 r 1 
2
 T  t 
   1 4   T  t  St e
1 4
2
(ii) (a) A vega-hedged portfolio is one whose overall vega, which is equal to the sum of the vegas of the
constituent securities, is close to zero.
Consequently, the value of such a portfolio will be relatively insensitive to changes in the volatili-
ty of the underlying share.
An investor might therefore wish to vega hedge in order to:
 protect the value of a portfolio against (small) changes in the volatility of the underlying
share.
 compensate for the fact that the volatility of the share is unknown, as it cannot be observed
directly. It is less important to have an accurate estimate of the volatility if vega is low and
hence has little effect on the portfolio's value.
(b) Differentiating the Black-Scholes formula for a European call option with respect to  using the
product and chain rules for differentiation gives:
d1  r T  t  d
 call  S t   d1   Ke   d2  2
 

where   x  
1
2
exp  2 x  1 2
 is the probability density function of the standard normal distri-
bution (from page 11 of the Tables).
Now:
d2  d1   T  t
Thus:
d2 d1
  Tt
 
Hence:
d1  r T  t   d 
call  St   d1   Ke   d2   1  T  t 
   
d1   r T  t   r T  t 
 S t   d1   Ke   d2    Ke   d2  T  t
  
So, using the result that:

 r T  t 
St   d1   Ke   d2   0
we have:
d1  r T  t 
 call   0  Ke   d2  T  t

 r T  t 
 Ke   d2  T  t
Or equally, given that:

 r T  t 
St   d1   Ke   d2 
this can be written as:
call  St   d1  T  t
(iii) Using the information given in the question, together with the formulae found earlier in the question,
the price and vega of the forward are:
1 
 12 r  4
1
2
 T  t  1 r Tt 
Vt  S t e 2
K e 2


 1 2 0.05 40.2 1
1
2
 0.051
 1 e  1 e
 0.019216
 r  1 2  T  t
1  4  
   1 4   T  t  St e  
1 2
2
 2
 1 2 0.05 40.2 1
1
 1 4  0.2  1  1x e
Using the Black-Scholes formula on page 47 in the Tables:
d1 

log 1   0.05  1 2  0.2  1
2
  0.35
0.2  1
d2  0.35  0.2  1  0.15
So, the price of the European call option is:
c t  1    0.35  1  e   0.15 
0.051
= 0.63683 – 0.951229 × 0.55962
= 0.104503
and its vega is equal to:
call  St   d1  T  t
1  1 20.35 1
2
 1 e
2
= 0.375240
Finally, the vega of a share is equal to zero.
So, to vega hedge the long position in 1,000 forwards, we need to find the number of European calls x
and shares y such that:
1,000 × 0.019216 = 0.104503x + 1 × y [½]
–1,000 × 0.048522 = 0.375240x + 0 × y [½]

Solving these equations gives:
x = –129.31
y = 32.729
ie we need to short sell 129.31 calls and buy 32.729 shares.
This portfolio will respond in a similar way to the exotic forward to (small) changes in the volatility of
the underlying share. Strictly speaking, in order to vega hedge the exotic forward we need to take the
opposite positions to those found above, ie buy 129.31 calls and short sell 32.729 shares.
THE TERM STRUCTURE OF INTEREST RATES

ANSWER 18.
20.0430.06 
P 5,10  e
0.26
 e  0.771
 r 5  0.04
 f 5,10,15  0.06
1
 r 5,10   2  0.04  3  0.06   0.052
5
ANSWER 19.
1
By applying the product rule to the equation r  0,T    log P  0,T  , we have:
T
   1 
r  0,T     log P 0,T  
T T  T 

1    1

T T
 log P  0,T    log P  0,T    
T  T 
1   1 

T T
 log P  0,T    log P  0,T   2 
T 
1  
  log P  0,T    r  0,T 
T  T 
ANSWER 20.
0.1 T  t 
The factor e equals 1 when T = t, but then decreases exponentially to zero as T   . So f(t,T)is a
weighted average of 0.03 and 0.06, and its graph will increase from 0.03 (ie a force of interest of 3%) to 0.06.
We can find P  t,T  from the relationship P  t ,T   exp    f  t ,u  du 

T
 t 
P  t ,T   exp    f  t ,u  du 
T
 t 
 T
 exp    0.03e
 t 
0.1 u  t 
 0.06 1  e 
0.1 u  t  
du 



 exp    0.06  0.03e
 t
T 0.1 u  t 
du 
 0.1 u  t   
T
 exp   0.06u  0.3e 
  t 
 

 exp 0.06  T  t   0.3e
0.1 T  t 
 0.3 
1
We can find r  t,T  from the relationship r  t ,T   log P  t ,T 
Tt
1
r  t ,T   log P  t ,T 
Tt

1
Tt 
0.06  T  t   0.3e
0.1 T  t 
 0.3 
 1  e 0.1 T  t  
 0.06  0.3  
 Tt 
ANSWER 21.
We have a formula for P  t,T  under this model. So the instantaneous forward rate can be derived from this

using the relationship: f  t ,T    log P  t ,T 
T

By use of the chain rule, and noting that  1 , this gives:
T

f  t ,T    a     b    r  t  
T 
 
 a     b    r  t  
 T 
 
 a     b    r  t    a '     b'    r  t 
 T 
From the definitions of b    and a    , we find that:

d 1e  
b'      e
d   

and:
d      
2 2
a '     b       2  

b 
2
d 
  2  4 

   
2 2
  b'     1     2    2b    b'   
 2  4
 
 
    1e  
2 2
 e 

1   2   2 
 2  2  
e

 
   
2 2
  1e 
   2  
 2  2
1e


e

Substituting these expressions into the general formula for f(t,T) gives the required answer.
ANSWER 22.
The following table summarises the characteristics of the Vasicek, Cox-Ingersoll-Ross (CIR) and Hull-White
models.
Vasicek CIR Hull-White
Arbitrage-free Yes Yes Yes
Positive interest rates No Yes No
Mean-reverting interest rates Yes Yes Yes
Easy to price bonds and derivatives Yes 1 Yes

Yes
Realistic dynamics  2  2  2
No No No
Adequate fit to historical data No No Yes
Easy to calibrate to current data No No  3

Yes
Can price a wide range of derivatives  4  4  4

No No No
Notes:
(1) Although the CIR model is harder to use than the other two models, it is more tractable than models with
two or more factors.
(2) All three models produce perfectly correlated changes in bond prices, which is inconsistent with the em-
pirical evidence, and fail to model periods of high and low interest rates and high and low volatility.
(3) Whilst one-factor models are generally difficult to calibrate, the Hull-White model is easier than the oth-
er two because its time-varying mean-reversion function aids fitting.
(4) All three models can be used to price short-term, straightforward derivatives, but not complex deriva-
tives.
ANSWER 23.
(i) The model should be arbitrage-free.
Interest rates should ideally be positive.
Interest rates should be mean-reverting over the long term.
Bonds and derivative contracts should be easy to price.
The model should produce realistic interest rate dynamics.
It should fit historical interest rate data adequately.
It should be easy to calibrate to current market data.
It should be flexible enough to cope with a range of derivatives.
(ii) Limitations of one factor models
A result of one-factor models is that yields on bonds of different durations are perfectly correlated.
This is not realistic.
In fact, they need not even be positively correlated. Sometimes we see, for example, that short-dated
bonds fall in price while long-dated bonds increase in price.
If we look at the long run of historical data we find that there have been sustained periods of both high
and low interest rates with periods of both high and low volatility. These are features that are difficult
to capture in one-factor models.
This issue is especially important for two types of problem in insurance:
 the pricing and hedging of long dated insurance contracts with interest rate guarantees
 asset-liability modelling and long-term risk management.

One-factor models struggle to cope with valuing derivative contracts. We need more complex models
to deal effectively with these. For example, any contract that makes reference to more than one inter-
est rate should allow these rates to be less than perfectly correlated.
(iii) Using a Taylor Series expansion for the given function we get:

d rt e
0.6t
  df  r , t 
t
2
f 1 f f
 drt   dt
2
 drt  2
rt 2 rt t
1
 0.6  0.04  rt  dt  0.006dB t    0   drt   0.6rt e dt
0.6t 2 0.6t
e
2
0.6t 0.6t 0.6t 0.6t
 0.024e dt  0.006e dB t  0.6rt e dt  0.6rt e dt
0.6t 0.6t
 0.024e dt  0.006e dB t
Alternatively, you can use the general form of Ito’s Lemma, the product rule or an integrating factor to
derive this equation.
Substituting s for t and integrating between 0 and t we get:
t t t
 d  rse    0.024e
0.6s 0.6s 0.6s
ds   0.006e dBs
0 0 0
t t t
r e0.6s   0.04 e0.6s   0.006 e0.6sdB

s 0  0  s
0
t
 rt e
0.6t
 r0  0.04 e  0.6t

 1  0.006  e
0
0.6s
dBs
We can then rearrange to get the required solution:
t
 rt  r0e
0.6t
 0.04 1  e  0.6t
  0.006 e 0
0.6 t s 
dBs

ANSWER 24.
0.2
(i) The factor e reduces from 1 to zero as the term  increases from zero to infinity. So the first two
terms represent a weighted average of 0.04 (the short rate) and 0.06 (the long rate).
The final term is zero when   0 or    , but positive in between. So this adds a 'hump' to the graph.
0.2
In fact, if you differentiate the function given, you will find that the maximum occurs when e  0.4 ,
which corresponds to the point where  = 4.58 and f = 7.6%.
The graph looks like this:
(ii) (a) 6.87%
(b) £49.64
(c) 7.00%
CREDIT RISK
ANSWER 25.
(i) This is the Merton model. After the bond issue the total current value of the company will be F(0) = 15
(working in £ million). In 5 years' time the company will have an unknown value of F(5).
The bondholders have first call on the company’s assets at that time. So they will receive 10 if F 5  10
and F(5) if F(5)<10.

So the redemption payment from the bonds is min(F(5),10], which can be written as 10–max[10–
F(5),0]. The function max[10–F(5),0] is the payoff for a European put option on F(t) maturing at time
5 with strike price 10.
(ii) The fair price is £74.39 per £100 face value.
(iii) Credit spread
The price of the company bonds (£74.39) is less than the price of the government bonds (£77.88) be-
cause of the risk of default, ie the company may not make the redemption payment in full on the due
date.
As a result, the yield rB (assuming full payment) will be slightly higher. It can be found from the equa-
tion:
5rB
100e  74.39  r  0.0592
The difference between the bond yield of 5.92% and the default-free rate of 5% is called the credit
spread. So here the credit spread is 0.92% (per annum, continuously compounded).
ANSWER 26.
(i) 0.02469
(ii) £76.95
(iii) Stochastic transition rates
The analyst may be concerned because the fair price of the bond is critically dependent on an accurate
assessment of the default transition intensity. If this assessment is incorrect then the bond could be
mispriced.
An alternative approach would be to assume that the transition intensity   t  is stochastic and de-
pendent on a separate state variable process, X(t) say.
By using a stochastic approach,   t  can be allowed to vary with company fortunes and other eco-
nomic factors.
For example, a rise in interest rates may make default more likely and so X(t) could include appropri-
ate allowance for changes in interest rates. This approach can be used to develop models for credit
risk that combine the structural modelling and intensity-based approaches.

ANSWER 27.
(i) The Merton model values shares as call options on the company's assets with a strike price equal to
the face value of Company X's debt.
The equity value at time 10 will be:
max F 10   5,0
where F(10) = total value of Company X at time 10.

Company X will default on payment of the debt if the total value of its assets at time 10 is less than the
promised debt repayment at that time.
There are 400,000 shares, so the (theoretical) share price at time 10 in £m will be:
max F 10   5,0

400,000
An appropriate option pricing formula can then be used to value this 'call option' at time 0.
(ii) The share price at time 10 will be:
max 15  5,0 £10m
(a)   £25 per share
400,000 400,000
(b) Here the share price at time 10 will be 0 because the value of the outstanding debt exceeds the
total value of the company.
ANSWER 28.
(i) 0.3803
(ii) Unforeseen events can be considered as random and so a stochastic approach would be needed
By using a stochastic approach,   t  can be allowed to vary with company fortunes and other eco-
nomic factors.
This is done by introducing an additional stochastic process X(t), which models a suitable economic
indicator, such as interest rates.
For example, a downturn in the economy may make default more likely and so   t  could include ap-
propriate allowance for this possibility.

ANSWER 29.
(i) £87.85
(ii) 0.18916
ANSWER 30.
(i) 0.5818
(ii) Instead of the simple default / no default two-state model, a more general model has been developed
by Jarrow, Lando and Turnbull, in which there are n states. The n states relate to n – 1 possible credit
ratings for a non-defaulted company, and one default state.
Transitions are possible between all states, except for the default state, which is absorbing (ie once a
company has entered the default state, it cannot leave it).
ANSWER 31.
(i) 0.375
(ii) (a) The two-year transition probabilities are given by:
 0.92 0.05 0.03  0.92 0.05 0.03  0.8489 0.0885 0.0626 

2    
X   0.05 0.85 0.1  0.05 0.85 0.1  0.0885 0.7250 0.1865 
 0 0 1  1  1 
  0 0  0 0
(b) The probability that a company rated A at time zero is in State D at time 2 is 0.0626. So the ex-
pected number of companies in this state out of 100 is 6.26.
(iii) 5.91
(iv) The downgrade trigger strategy will reduce the expected number of defaults, as we have seen. How-
ever, the return on the portfolio will also be a function of the yields on the debt. Companies rated B
are likely to have bonds with a higher yield (because of the higher risk), so excluding these may in fact
reduce the yield on the portfolio.
Also, the actual number of defaults may not match the expected number. The return depends on the
actual progress of the portfolio, rather than the expected outcome.

ASSIGNMENT 5
SOLUTIONS
RUIN THEORY
ANSWER 1. ANSWER 4.
(i) 0.04043 0.25%
(ii) 0.1881
ANSWER 5.
ANSWER 2. 0.630
0.067
ANSWER 3.
0.074
ANSWER 6.
10,000R 25,000R
1  13,800R  0.9e  0.1e
Upper limit = 0.0000302
This is a reasonable initial estimate, compared with the correct value of approximately 0.000026.
ANSWER 7.
0.0016
The reinsurance has reduced the probability of ruin to some extent, ie from about 0.25% to about 0.16%.
However, this result is probably quite sensitive to the assumptions made (we are near the tail of the normal
distribution), and slightly different assumptions might give us very different results.
We will also want to look at the effect of reinsurance on profitability. As we are paying a reinsurance pre-
mium, it is likely that the overall effect on profitability is negative (although the effect on security is posi-
tive, as we have seen). There is likely to be a trade-off between security and profitability here.

ANSWER 8.

100 1  e
0.01M

ANSWER 9.
100  M 
2
100  M 
4

300 40,000
ANSWER 10.
1   1    E  X   1    E Z   r  M Y  r 
In the case of proportional reinsurance this is:
1   1    E  X   1   1    E  X  r  M Y  r 
ANSWER 11.
(i) Since there is a smaller loading factor, the premiums will be reduced even though claims remain the
same. Hence, the probability of ultimate ruin will increase.
(ii) The mean of the distribution has decreased from 600 to 300, and the variance has decreased from
2,400 to 600. Therefore the claims are smaller on average and less uncertain. Both of these factors will
decrease the probability of ultimate ruin.
(iii) The Poisson parameter has increased so claims occur more often (but their size is unchanged). How-
ever, the premium received will also increase proportionally (as c  1    m1 ). Hence, the timing at
which ruin may occur will be earlier, but not the probability of it occurring in the first place. There-
fore, the probability of ultimate ruin will be unchanged.
ANSWER 12.
Equations II and III are true.
*
Doubling  means claims occur in half the time, but premium income comes in at double the rate. So
graph of U(t) is squashed compared to U  t  :

*

No change to   u  , but increases   u,t  .
ANSWER 13.
(i) £5,386
(ii) £4,895
The initial capital required has decreased. With the reinsurer taking on more of the risks the variance of the
claim amounts paid by the insurer will have reduced and hence the amount of capital the insurer needs to
write the business has decreased. This may make it worthwhile for the insurer to take out reinsurance (al-
though the effect on profits and cashflows will also need to be considered).
ANSWER 14.
0.05884
ANSWER 15.
(i)
Retention limit M Expected annual profit Adjustment coefficient
7.5 59 0.0227
10 94.8 0.0252
15 129.7 0.0240
24.56 147 0.0220
 150 0.0213

(ii) The adjustment coefficient is a measure of security (ie a higher adjustment coefficient implies a re-
duced probability of ruin). We can see that decreasing the retention limit (ie passing on more of the
claims to a reinsurer) at first increases the adjustment coefficient and then decreases it. So decreasing
the retention limit will at first reduce the probability of ruin and then eventually increase it.
A higher retention limit implies that the insurer is holding more of the claims (and more of the pre-
mium). However, by holding more of the claims they also shoulder more of the risk of claims not being
as expected.
A lower retention limit means more of the claim is passed onto the reinsurer which reduces the risk
and should reduce the probability of ruin. However in the extreme case of a retention limit of 7.5 so
much of the claim is passed onto the reinsurer that their larger premium (due to the larger premium
loading factor) eats into the surplus of the insurer and results in a greater probability of ruin.
ANSWER 16.
mk 1  p 
(i) (a) EW  
p
k 1  p 
(b) Var  W  
p
2 m 2
 ps
2

(ii) 10.23% per annum
ANSWER 17.
3 7
(i)  where t  3
2  3  t  2 7  t 
(ii) 1
ANSWER 18.
2 c /   E  X  
(i) r 
E X  
2
(ii) (a) 0.000025
(b) r < 0.00003125

(c) 0.000034
(d) 0.51
(e ) So the reinsurance reduces the probability of ultimate ruin.
ANSWER 19.
2  c    2c /    
(i) R 
 2
  
2
 2
 
2
(ii) The adjustment coefficient can be used to assess the effectiveness of different reinsurance arrange-
ments, using Lundberg’s inequality to find an upper bound for the probability of ruin for the insurer
under different reinsurance arrangements. An arrangement that produces a lower upper bound for
the probability of ruin is in some sense more secure for the insurer than an arrangement that has a
higher upper bound for the probability of ruin.
Note however that the adjustment coefficient cannot tell us anything about the relative profitability of
different reinsurance arrangements. This will need to be assessed using other means.
1
(iii) 33 3 %
RUN-OFF TRIANGLES
ANSWER 20.
Projected ultimate number of claims = 115,106
Development Year
0 1 2 3
Actual 17,500 5,000 2,250 750
2009 Expected 17,500 5,100 2,274 754
Error 0 –100 –24 –4

Actual 21,000 6,200 2,750
2010 Expected 21,000 6,119 2,728
Error 0 81 22
Actual 18,800 5,500
2011 Expected 18,800 5,478
Error 0 22
Actual 21,300
2012 Expected 21,300
Error 0
The fit looks pretty good.
ANSWER 21.
(i) d1  1.737208 ; d2  1.181686 ; d3  1.008251
(ii) d1  1.700340 ; d2  1.164429 ; d3  1.007268
(iii) The fitted incremental payments are:
Development Year
Accident Year 0 1 2 3
2010 2,457 1,811 776 42
2011 2,648 1,952 836
2012 3,084 2,274
2013 3,341

The inflation adjusted method appears to fit the original data better, given that the residuals are smaller in
this case. However, there are not many categories of data, and it is not clear whether either method will
provide satisfactory results in the future.
ANSWER 22.
1,868
ANSWER 23.
£6,508,000
ANSWER 24.
£7,895,000

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CM2 ASSIGNMENTS & SOLUTIONS ACTUATORS EDUCATIONAL INSTITUTE

CA PRAVEEN PATWARI 1 JAI SHREE RAM

CA PRAVEEN PATWARI 2 JAI SHREE RAM

THE EFFICIENT MARKET

CA PRAVEEN PATWARI 3 JAI SHREE RAM

(iii) Discuss the implications of the Efficient Markets Hypothesis.

(ii) Describe how you would test if a market is 'excessively volatile'.

CA PRAVEEN PATWARI 4 JAI SHREE RAM

where w is the investor's wealth at any time.

Investment Z offers a return of –18% or +20% with equal probability.

(i) What is Investor A’s expected utility if nothing is invested in Investment Z?

CA PRAVEEN PATWARI 5 JAI SHREE RAM

Choose between: Response

What is the shape of the utility function of a risk-seeking investor?

CA PRAVEEN PATWARI 6 JAI SHREE RAM

 the investor has initial wealth of $10 and

 a utility function of the form U  w   w .

Determine the investor's certainty equivalent for this gamble.

(i) Which investor is more risk-averse (assuming that w > 0)?

variance 4%% 25%%

Investment A Investment B Investment C

outcome probability outcome probability outcome probability

0.1 0.3 0 0.3 0.2 0.45

0.3 0.4 0.2 0.2 0.3 0.1

0.5 0.3 0.9 0.5 0.4 0.45

CA PRAVEEN PATWARI 8 JAI SHREE RAM

U(w) = 4,000 + 0.5w

CA PRAVEEN PATWARI 9 JAI SHREE RAM

CA PRAVEEN PATWARI 10 JAI SHREE RAM

STOCHASTIC DOMINANCE AND

(i) Show that A is preferred to B on the basis of first-order stochastic dominance.

CA PRAVEEN PATWARI 11 JAI SHREE RAM

MEASURES OF INVESTMENT RISK

Calculate the mean return and the variance of return.

Calculate the mean return and variance of return.

Calculate the downside semi-variance of return.

CA PRAVEEN PATWARI 12 JAI SHREE RAM

Calculate the downside semi-variance of return.

Calculate the shortfall probability where the benchmark return is 0% pa.

Calculate the shortfall probability where the benchmark return is 0% pa.

CA PRAVEEN PATWARI 13 JAI SHREE RAM

CA PRAVEEN PATWARI 14 JAI SHREE RAM

R follows a lognormal distribution with   5% and   5% 

(b) R follows an exponential distribution with a mean return of 5%.

CA PRAVEEN PATWARI 15 JAI SHREE RAM

(i) Calculate values for the following measures of investment risk:

(a) downside semi-variance

(b) shortfall probability based on the risk-free rate of return of 6%

CA PRAVEEN PATWARI 16 JAI SHREE RAM

0.06 with probability 0.2

(ii) Calculate the accumulated value at the mean rate of return.

(iii) Calculate the variance of the accumulated value of the investment

CA PRAVEEN PATWARI 17 JAI SHREE RAM

(ii) using the corresponding deterministic model.

Comment on your answers.

CA PRAVEEN PATWARI 18 JAI SHREE RAM

5.5% with probability 0.3

5% with probability 3k

where k is a suitable constant.