Module Code: MATH254001

Module Title: Financial Mathematics 3 c UNIVERSITY OF LEEDS

School of Mathematics Semester Two 201819

Calculator instructions:

• You are allowed to use a calculator which has had an approval sticker issued by the
School of Mathematics.

Dictionaries:

• You are not allowed to use your own dictionary in this exam. A basic English dictionary
is available to use: raise your hand and ask an invigilator, if you need it.

Exam information:

• There are 5 pages to this exam.

• There will be 2 hours to complete this exam.
• Answer all questions.
• You must show all your calculations.
• The numbers in brackets indicate the marks available for each question.

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Module Code: MATH254001

1. (a) (i) State the expected utility theorem. [2 marks]

(ii) For the following utility functions,
1 1
U1 (w) = w2 and U2 (w) = w2 −
2 2
show that for any two portfolios W and W̃ these utility functions always result
in the same preferences. [3 marks]
(b) Assuming that an investor is non-satiated and risk-averse, in what subset of [0, 2π]
must w be in so that U (w) = sin(w) is an appropriate utility function? [4 marks]
1
(c) For an investor with utility function, U (w) = 12 w 4 where w > 0, calculate the
coefficient of absolute risk aversion and the coefficient of relative risk
aversion. [4 marks]
(d) Alice believes that her car would cost $12,500 to replace if it was stolen or damaged.
Based on crime statistics for the area she lives in, she believes that the probability
of her car being stolen or damaged is 0.15.
(i) Alice’s utility function is given by U (w) = ln(w) for w > 0 and she has
$35,000 in the bank. Calculate how much Alice would be prepared to pay (in
a single payment) to insure her car against theft or damage. [4 marks]
(ii) Repeat the calculation in (d)(i) but now assume that Alice has $500,000 in
the bank. Give a very short explanation of your answer. [3 marks]

Total [20 marks]

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Module Code: MATH254001

2. (a) For a market with two risky assets which have returns R1 and R2 respectively, we
have the following information

E[R1 ] = µ1 = 2, E[R2 ] = µ2 = 3, V ar(R1 ) = σ12 = 15, V ar(R2 ) = σ22 = 20.

Moreover, we are given that the covariance of R1 and R2 is − 21 . There are no

other assets in the market.
(i) State the minimum variance problem for the market described above. [4 marks]
(ii) For the global minimum variance portfolio, find the proportion of wealth to
invest in each asset, the expected return and the variance of return. [8 marks]
(iii) Without further calculation, explain how you would expect the variance of
return calculated in (a)(ii) to change if the two risky assets were
independent. [2 marks]
(b) Now suppose that a money market account (i.e. a risk-free asset) is added to the
market model described in part (a).
(i) State the equation of the Capital Market Line, being careful to explain all of
the notation you use. [4 marks]
(ii) Describe the market portfolio and how it features in portfolios on the Capital
Market Line. [2 marks]
(c) Consider a particular risky asset with return Rα . Let RM denote the return on the
market portfolio.
(i) State the definition of βα,M , the “beta” of the risky asset. [2 marks]
(ii) If the beta of the risky asset, βα,M , is greater than 1, how does V ar(Rα )
compare with V ar(RM ) and what can we say about the correlation coefficient
of returns on the market portfolio and the risky asset? [3 marks]

Total [25 marks]

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Module Code: MATH254001

3. (a) State two disadvantages of using the standard deviation of returns as a risk
measure. [2 marks]
(b) (i) Suppose that the daily return, R, on a portfolio is normally distributed with
expected value E[R] = 0 and standard deviation σ = 10. Calculate V aR0.99
showing all of your working. You are given that for a standard normal random
variable, Z, P (Z ≤ −2.33) = 0.01. [4 marks]
(ii) State the definition of the expected shortfall for a continuous loss distribution
explaining any notation you use. [3 marks]
(iii) State one advantage the expected shortfall has over the value at risk. [1 mark]
(c) In the elementary one period market model we have state space Ω = {H, T }, one
risky asset S and a money market account with effective interest rate r = 3%.

A European call option on the risky asset has strike price K = 13. You are
given that S1 (H) = 15, S1 (T ) = 8 and S0 = 10.
(i) Assuming no arbitrage, derive from first principles the option price. [6 marks]
(ii) The payoff, X, on a digital European put option is given by

1, if K > S1
X=
0, otherwise.

Without further calculation, state the price of the digital call option and briefly
justify your answer. [3 marks]
(d) In the general single period market model with Ω = {ω1 , ω2 , ω3 }, one risky asset,
S, and a money market account we have S0 = 4 for the risky asset. Moreover, the
effective rate of interest on the money market account is 0% and at time t = 1 we
have:
ω1 ω2 ω3
S1 6 4 3
(i) Calculate all risk-neutral probability measures for this model. [7 marks]
(ii) State if the model is arbitrage-free. [2 marks]
(iii) A large bank has designed an investment product with payoff X at time t = 1.
Given,
ω1 ω2 ω3
X 0 1 1.5
show that X is an attainable contingent claim. [4 marks]

Total [30 marks]

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Module Code: MATH254001

4. (a) State whether the following are TRUE or FALSE in the context of the general
single period market model.
1. If the trading strategy (x, φ) is an arbitrage in some market model with finite
state space Ω, we have
E[Ĝ(x, φ)] > 0
where Ĝ(x, φ) is the discounted gains process.
2. If a market model is arbitrage-free, then all contingent claims have unique
risk-neutral price.
3. In complete market models, it is possible to find a contingent claim which does
not have a replicating trading strategy.
4. In an arbitrage-free and complete market model, there exists only one possible
risk-neutral probability measure.
[4 marks]
(b) Suppose a multi-period market model has a finite state space, Ω = {ω1 , ω2 , . . . , ωk }.
(i) State the definition of a σ-algebra on Ω. [3 marks]
Now suppose that we have a state space Ω = {ω1 , ω2 , ω3 , ω4 }.
(ii) For each of the collections of subsets of Ω = {ω1 , ω2 , ω3 , ω4 } set out below,
state whether it is a σ-algebra or not. If it is not, explain why.

F1 = {∅, {ω1 }, {ω2 , ω3 , ω4 }, Ω}

F2 = {∅, {ω1 }, {ω1 , ω2 }, {ω3 , ω4 }, Ω}

[3 marks]
(iii) Let X : Ω → R be a contingent claim such that

3 if ω = ω1
X(ω) =
7 if ω = ω2 , ω3 , ω4

State whether or not X is F1 -measurable? Justify your answer. [2 marks]

(c) (i) Let F and G be σ-algebras on a set Ω. State what F ⊂ G means.
(ii) What is a filtration (Ft ) of σ-algebras on a set Ω.
(iii) Provide an explanation of what filtrations are used to represent in multi-period
market models.
[5 marks]
(d) A two-period market has a single risky asset and Ω = {ω1 , ω2 , ω3 }. The risky asset
prices are as follows
ω1 ω2 ω3
S0 10 10 10
S1 10 20 20
S2 10 20 30
Calculate the filtration generated by the asset prices. [7 marks]
Total [25 marks]

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