Contents Chapter 1 Expected Utility and Risk Aversion Chapter 2Mean-Variance Analysis Chapter 3CAPM, Arbitrage, and Linear Factor Model: Chapter 4 Consumption-Savings Decisions and State Pricin Chapter 5 A Multiperiod Discrete-Time Model of Consumption and Portfolio Choice. Chapter 6 Multiperiod Market Equilibrium Chapter 7 Basics of Derivative Pricing Chapter 8 Essentials of Diffusion Processes and Itd's Lemma. Chapter 9 Dynamic Hedging and PDE Valuatio Chapter 10 Arbitrage, Martingales, and Pricing Kemel: Chapter 11 Mixing Diffusion and Jump Processes. Chapter 12 Continuous-Time Consumption and Portfolio Choic: Chapter 13 Equilibrium Asset Returns. Chapter 14 Time-Inseparable Utility. Chapter 15 Behavioral Finance and Asset Pricing.. Chapter 16 Asset Pricing with Differential Information. Chapter 17Models of the ‘Term Structure of Interest Rates... Chapter 18 Models of Default Risk..Answers to Chapter 1 Exercises 1. Suppose there are two lotteries P ={1,....0,) and ®°=(p).....p{). Let Vig... )=E 00 be an individual's expected utility function defined over these lotteries. Let 5! (1,....p,)= EPO, where 0,=a-+bU, and 2 and b are constants, If 2° f 2, so that V( D> VQ. Bs must it be the ease that W (p)...., 52) 8 (R.---+P,)? In other words, is @ also valid expected utility function for the individual? Are there any restrictions needed on and ib for this to be the case? Answer: IV (r},...5p))>V(r..-..0,) then this implies 3 p70, > Ep . I b is a positive constant, then we ean multiply both sides of the inequality without changing thes Ypby,> Eby . Sinee Fp1 ‘we can then add the constant = to each site ote icq tobian $90 )>Y ofa). Bas simpy W (gj. PAW (H,...5P,)- Hence for i to be a valid expected utility function for the individual, a can be a constant of any sign but bmust be positive. 2. (Allais paradox) Asset A pays $1,500 with certainty, while asset B pays $2,000 with probability 0.8, or $100 with probability 0.2. If offered the choice between asset A or B, a particular individual would choose asset A. Suppose, instead, that the individual is offered the choice between asset C and asset D. Asset C pays $1,500 with probability 0.25 or $100 with probability 0.75, while asset D pays {$2,000 with probability 0.2 or $100 swith probability 0.8. If asset D is chosen, shovw that the individual’s preferences violate the independence axiom. Answer: Using the notation in our text, let the set of outcomes be x= (100, 1500, 2000). ‘Then P* ={0,1,0}, &* =(0.2,0,0.8}, P° =[0.75, 0.25, 0},andP* = (0.80, 0, 0.20). Define asset Fas 2" =(1,0,0}.Then if 2* f P°,the independence axiom states that Abe +(L-A)B" f AB +(1- A) 0.252" 40.752" £ 0.25P° +0.75P. pet ‘Thus, if the individual chooses asset D over asset C, independence is violated.George Pennacehi + Theory ofaetPritng Verify that the HARA utility function in equation (1.33) becomes the constant absolute-risk-aversion Answer: For f=1, 0 (@ ) +1)'. This can be waitten as 7 ican be re-ritlen as Letting +1) As 720, x —>-+2. Thus, the limiting value ofthe first term in the above expression s ing value of the second expression is Ue" , while the limiting value of the third expression is 1. Hence, lim U (Wi )=-=". Consider the individual’s portfolio choice problem given in equation (1.42). Assume 1 (@ )=In(W ) and the rate of return on the risky asset equals £é| [+s sibetitty Solve for the individual's smn aan proportion of initial wealth invested in the risky a AW ‘Answer: From the first order condition EUW Be x= 0 we have Was psa, Solving for *Vii,,we obtain V/s An expected-utility-maximizing individual has constant relative-risk-aversion utiity,U (W ) = 7. with relative risk-aversion coefficient of y=—1. ‘The individual currently owns a product that has a probability pof failing, an event that would result in loss of wealth that has a present value equal to L. With probability I~ x, the product will not fail and no loss will result. The individual is considering whether to purchase an extended warranty on this product. The warranty costs Cand would insure the individual against loss if the product fails. Assuming that the cost of the warranty exceeds the expected loss from the product's failure, determine the individual's level of wealth at which she would be just indifferent between purchasing or not purchasing the warranty. Answer: The level of wealth for which the individual would be ifferent satisfies BUOY ~L)+ (1-5) (W)Answers fo Chapter 1 Exercises 3 6. or w-E NWN W-c which implies . w?-Lw =W?+cL(l-p)-w (c+Ld-p) . Forlevels of wealth above *, the individual would refuse the warranty (self-insure) while forlevels of wealth below ‘i °, the individual would take the warranty. The intuition is as follows. Recall that the Pratt risk premium is 7 =!7R( ). In addition, an individual who thas constant relative risk aversion has absolute risk aversion, (i ), that declines with wealth, Hence, the warranty cost that this individual is willing to pay,c, which is, analogous to the premium, declines with wealth, In the context of the portfolio choice problem in equation (1.42), show that an individual with increasing relative risk aversion invests proportionally less in the risky asset as her initial wealth, increases. Answer: Let x denote a realization of such that it exceeds x,,and let w "be the comesponding level of i. Then fora > 0, we have w °>0iy(+ 1). If relative tisk aversion, &_(W WRU), ng in wealth, this implies RG "2H 9+ JRO L+H)) 6.1) Multiplying both sides of (6.1) by 0 '( °)(2’ ~2,), whieh is a negative quantity, the inequality sign changes: WAU YC) 5-0 I~ 2) + ZR + =) (6.2) Next, let denote a realization of fsuch that itis lower than rand let w "be the conesponding level of i”. Then for & > 0, we have Wi '~1,), which is positive, so that the sign of (6.3) remains the same, we obtain WOW Me 4) SO" NEE WwW +E ROLE) (64) Notice that inequalities (6.2) and (6.4) are of the same form. The inequality holds whether the realization is fe 2° or fer. Therefore, if we take expectations over all realizations, where £ can be either higher than or lower than ,,we obtain EDU OT (Be) <-ELU GV (Ger) (1+ ROW (1+ x) (6.5) ‘Since the frst term on the right-hand-side is just the first order condition, inequality (6.5) reduces to ELTON Mee n)S0 (6.6) ‘Thus, we see that an individual with increasing relative risk aversion has [UW )( fer ge SU ee 67) =AB LOW VE HP] ‘and invests proportionally less in the risky asset as wealth increases. 7. Consider the following four assets whose payoffs are as follows: _| X with probability p, Asset B =| Sith probabil ty p, ~ 0 with probability 1 p, ~|0 with probability 1~ p, X with probability ap, AwaD'= |¥ with probability ap, 0 with probability 1 ap, 0 with probability 1p, Asset A Asset C= where 0 0, The individual’s wealth is normally distributed as (W ,o} ). What is this individual's certainty equivalntlevel of wealth? Answer: Note that from the properties of a normally distributed random variableAnswers to Chapter 2 Exercises 1, Prove that the indifference curves graphed in Figure 2.1 are convex if the ut suppose there are two portfolios, porte function is concave, 1 and 2, that lie on the same indifference curve, tions of retums on portfolios I and 2 be c, 0 Consider a third portfolio located in (.,,.¢,) space that happens to be on a straight line between portfolios 1 and 2, tha i a portfolio having mean and standard deviation satisfying 2,,= xR), +(L-29%,, and 0, = x0, +(x, where 0< x<1, Prove that the Indifference curve is convex by showing that the expected uiility of portfolio 3 exceeds 1. Do this by showing that the utility of portfolio 3 exeeeds the convex combination of utilities for portfolios 1 and 2 for each standardized normal realization, Then integrate over all realizations to show this Inequality holds for expected utilities. Answer: We want to show that 2(U (8, )1> welu (8, )1+0-w)Bl0 (8, )1= 0 +0) or J0 Ry, +20, )nodax> wf" UR, + 27,,)nladcie+ (1 w) [0 Ga, +49, Index a U Ra, + 4.) $0 (Ry, + 2, OWN Ry, + 2D) > WO (Ry, + 20) + w)0 (Ret 28,) because U()) is a concave function. Thus, mutiplying each side of the inequality by n(x), which is always positive, preserves the direction of the inequality. Integrating over all realizations of x gives the desired result in * ‘Show that the covariance between the retum on the minimum variance portfolio and the retum on any ‘other portfolio equals the variance of the return on the minimum variance portfolio. in“: write down the variance of a portfolio that consists of a proportion x invested in the minimum variance portfolio and a proportion (1~ x) invested in any other portfolio. Then minimize the variance of this composite portfolio with respect to.»Answers fo Chapter? Exercises 7 Answer: Let o be the variance of the retum on an arbitrary portfolio and let or, be the covariance of this portfolio’s return with that of the minimum variance portfolio. Then the variance of the composite portfolio consisting of proportions »< and (1— >) in the mi imum variance and arbitrary portfolios, respectively, is x02, +(L- 98a? +291 2)9, If-we minimize this composite portfolio’s variance with respect to », we obtain the first onder condition 2ug?, == so? + 2-290, =0 ‘Now since the minimum variance portfolio has, by definition, the smallest variance of all portfolios, it must be the case that = 1 is the solution to this first order condition. Making this substitution, one obtains 3. Show how to derive the solution for the optimal portfolio weights for a frontier portfolio When thee exists atskless asset, that is, equation (2.42) given by «= 2B —R,9) a ;+ The derivation is similar to the case with no riskless asset. Answer: Since the objective Funetion is R,+w'(R-R.o Awiva+ ate, ‘The first order conditions with respect fo w and Z are Ww -AR= RS) @ [R,+0(R-2,9)] oy Re-arranging (a) gives AN MR-R,2) © and re-arranging (b) gives (BR, @ Pre-multiplying equation (e) by (2 —R,2)' gives a =AR-ROV'UR-R ©8 George Pennacehi + TheosrofhamcP rich ‘and equating the left-hand side of (d) to the right-hand side of (e), we have [® R-RaVMR-R9 ROR 'R-2R,Rv tet Riv te] =Alg-2aR, +01 RR, =2aR, +5R? 4. Show that when 2, =, the optimal portfolio involves 2a" =0. Answer: When &,=,,= 4, the optimal portfolio weights are .* "(R=42). Pre-multiplying by ¢,we obtain AVUR-R, Consider the mean-variance analysis covered in this chapter where there are n_risky assets whose returns are jointly normally distributed. Assume that investors differ with regard to their (concave) utility functions and their initial wealths. Also assume that investors can lend at the risk-free rate, R, Re. ‘Suppose there are 1. risky assets whose returns are mulfi-variate normally distributed. Denote their x1 vector of expected retums as and their nxn covariance matrix as Vv. Let there also be a riskless asset with retum &.. Let portfolio a be on the mean-variance efficient frontier and have an expected retum and standard deviation of 3. and c_, respectively. Let portfolio > be any other (not necessarily efficient) portfolio having expected retum and standard deviation &» and cs respectively. Show that the conelation between portfolios and lb equals portfolio i>°s Sharpe ratio divided by portfolio as Sharpe ratio, where portfolio i's Sharpe ratio equals (R.— 8). (Hin write the correlation as cov(,, R,)/(o.c7,). and derive this covariance using the properties of portfolio efficiency.) Answer: Note that for an efficient portfolio, «SAV MRR.) a and ee @ E=8VE-R) and Ser Ba @ @-R.9V'E-R10 George Pemacehi + Theory ext ‘Thus, the conelation between portfolios 2 and bis cOv(R,sR,)_ #' Vee, “oo, oe, @-Ravw @ ‘Therefore, o 7. _A-com grower has utility of wealth given by (6! )=—="° where 2 > 0. This farmer's wealth ‘depends on the total revenue from the sale of com at harvest time, Total revenue is a random. variable Se Gf where is the number of bushels of com harvested and {is the spot price, net of harvesting costs, of a bushel of com at harvest time, The farmer ean enter into a com futures contract having a current price of § and a random price at harvest time of If k is the number of short positions in this futures contract taken by the farmer; then the farmer's wealth at harvest time is given by Wi = Se k( £@ §). If $21(3,02), N(Z,02), and cov( 4 F= pc,c7,, then solve for the optimal umber of futures contract short positions, K, that the farmer should take. Answer: We showed that an individual having normally distributed wealth and negative exponential utility maximizes the function max E[W"]-4avarfi’ ]=maxS—-k(E- §)-42]o? + eo! -2kpa.0, ‘This leads to the first order condition “E §)- ako? + apo.e.=0Angwers to Chapter? Exercises 1 or Consider the standard Markowitz mean-variance portfolio choice problem where there aren. risky assots and a risk-free asset. The risky assets’ nx vector of returns, f hns a maultivariate normal distribution (3), where Ris the assets’ n> I veetor of expected retums and’ is a non-singular nx neovariance matrix. The risk-free asset's retum is given by R, > 0. As usual, assume no labor Income so that the individual's end-of-period wealth depends only on her portfolio return; that is, W=00,R., where the portfolio retum is R.=R.+n'(8—R,<) where > isan x1 vectorof portfolio weights for the risky assets and ¢ is an x1 vector of 1s. Recall that we solved for the ‘optimal portfolio weights, «°, for the case of an individual with expected utility displaying constant absolute tisk aversion, £[U (17 ) '"], Now, in this problem, consider the different case of an individual with expected utility displaying constant relative risk aversion, E[Uu (i )]= EEL] where 7 <1.What is ~s* for this constant relative-risk-aversion ease? H srt: reeall the efficient frontier and consider the range of the probability distribution of the tangency portfolio. Also consider what would be the individual's marginal utility should end-of-period wealth be nonpositive. This marginal utility will restrict the individual’s optimal portfolio choice. Answer: Note that constant relative risk-aversion (CRRA) utility," y <1,in general is not a defined, real-valued function for Wd <0. In addition, since marginal utility equals GU (Wow fai", as wealth approaches zero it becomes infinite: and absolute tisk aversion, R(7 ) =", also becomes infinite. The implication of this is that an investor with CRRA utility would avoid assets that had a positive probability of ‘making total wealth equal 0 (or negative). To see this, note that if we were to solve the investor's maximization problem. max [0 67] =maxe [0 (0,[2, +08 R91 te Fit order condiions would be of te fon DO a y|=0, aH with 2, being normally distibuted, when w, #0, there is a positive probability that &, =, +w'(R—R,©)<0, no matter what the other elements of . This implies that for those realizations, say where , ), then ="(n, — R,) will be positive or negative infinity, and the average of all realizations can never equal 0. Hence, with 3: being nomnally distributed, the comer solution where the individual puts all wealth in the riskfree asset maximizes expected utility. Note that this is not the case with constant absolute risk aversion, because marginal utility, b=", is positive forboth positive and negative values of wealth,Answers to Chapter 3 Exercises 1, Assume that individual investor chooses between nrisky assets in order to maximize the following utility function: ‘here the mean and variance of investor "s portfolio are Tota, respectively, and where 8, is the expected return on risky asset 5 and cis the covariance between the returns on risky asset iand risky asset j «' is investor k’s portfolio weight invested in risky asset 4, so that 30: = @, isa positive constant and equals investor i's risk woleranca a. Write down the Lagrangian for this problem and show the first-order conditions. Answer. ay ae @ b. Rewrite the first-order condition to show that the expected return on asset is a linear funetion of the covariance between risky asset *s retum and the return on investor \°s optimal portfc fiance of asset iwith investor »°s optimal Answer: From (2), note that > w'c7, isthe cove portfolio, that is, cov(., 2. o. Hence, (2) can be re-written as — 2 ot Ris A, +S eov(8.,85) 3) ae G ‘e.Assume that investor i has initial wealth equal tov? and that there are x =I... 2 total investors, each with different initial wealth and risk tolerance. Show that the equilibrium expected return on asset i is of a similar form to the first-order condition found in part (b), but depends on the wea bh- weighted risk tolemancesof investors and the covariance ofthe ret on asretiw th themarketportibli H int: begin by multiplying the first order condition in (b) by investor ics wealth times tisk tolerance, and then aggregate overall investors.Angwers to Chapter3 Exercises 13 Answer: Multiplying (2) by 17,0, gives WAR 28, Dowie, “) ‘Summing over all investors, we obtain Sw 0.8.-2d 8, Sw'o, = THA, 6) Let 0, = 30,0, be the wealth-weighted risk tolerances of the \ investors. Note also that 2eov(s, fu) ©) aye Leia, = wwe, {is equal to two times the covariance between asset 2s retum and the return on the ‘market portfolio, Thus, (5) can be re-written as 2. Lethe U.S. dollar ($)/Swiss frane (SF) spot exchange rate be $0.68 per SF and the one-year forward exchange rate be $0.70 per SF. The one-year interest rate for borrowing or lending dollars is 6.00 percent. ‘a, What must be the one-year interest rate for borrowing or lending Swiss francs in order for there to be no arbitrage opportunity? b Answer: ‘The covered interest parity relation fora one-year forward rate states that vs s,)-1= 2% 1.0600)-1- 97 percent Fon 070 erent a If the one-year interest rate for borrowing or lending Swiss francs was less than your answer in part (a), describe the arbitrage opportunity. Answer: I 1+ < (1+ j)5 an arbitrage is to Atdate 0: (i borrow ;L- Swiss franes, agreeing to repay I Swiss franc in one year (date 1). Gi) Exchange the Swiss frames for *- US. (it) Take - dollars, and invest these at the interest rate x, along position in a one-year forward exchange contract on the Swiss frane at rate F,,.14 George Pemmacehi + Theory ofhamt xh Atdatel: (i) Pay $£,, and receive one Swiss franc, Gi) Use this Swiss frane to repay your borrowing obligation i) Realize the U.S. dollarinvestment of =1 Swiss franc, ete) ‘The net cash flow at date 0 is zero. At date 1 the net cash flow is ;°(1+ j,)~ £y, U.S. dollars, ‘which is positive based on the assumption that 1+ <= (1+ 54). 3. Suppose that the Arbitrage Pricing Theory holds with given by 2 risk factors, so that asset retums are We a+b, fer by hr se where 3, = 2g +b,4q +544 ,q+ Maintain all of the assumptions made in the notes and, in addition, assume that both 4,, and J, are positive. Thus, the positive risk premia imply that both of the two ‘orthogonal risk factors are “priced” sources of risk. Now define two new risk factors from the risk factors: G9 ah =o fg E ‘Show that there exists ag.c,,c,, and. sueh that is orthogonal to 4% they each have unit variance, and /,, > 0, but that. =0, where /,, and Z,, are the tisk premia associated with Sand respectively. In other words, show that any economy with two priced sourves of risk can also be described by an economy with one priced source of risk. Answer: Definec =|" ‘we can re-define the factor sensitivities Rica ol gh atl, nktc tha Ls a +f bk [f-« +1, 6 [ieAngwers to Chapter3 Exercises 1S where (9% RJ =[, b, Jet This will be true forall assets i=1,...,1. Note, also, that wwe need each asset’s expected rate of retum, as predicted by APT, to be the same after the transformation. This will be the case for all assets if ww of] FAytlb, bE f] @ wit | | =C 21 |.Since we want 2,, >0 and A fest 14] ° so that we need c/o, =—7.q/2.4.Note, also, that we require Séand éto be orthogonal factors, so that £[ 444 = 0, or ENG $5 H(q Ko, HI =ElGs + (a9 +49) faa Ml 4 STAG which implies (Ss) Sine q/c, =~A,/2,, this implies alg = AIA, ) 7) )16 George Pemmacehi + Theory ofhamt xh Note that a natural value of cis c = 17, where is some positive constant. This would censure that Zs positive since then from (8) we would have k(23, + 42,)= 24 >0. This would imply from (7) that c = «2... To find the appropriate value of , note that the Last conditions to be satisfied are that the factors have unit variance, © G+ge o d@+d=l (10) Now ay implies <2) Defining & 7, we obtain (13) (14) 5), and (10) are as) 16)Answers to Chapter 4 Exercises 1. Consider the one-period model of consumption and portfolio choice. Suppose that individuals can invest in a one-period bond that pays a tiskless real retum of &., and ina one-period bond that pays a riskless nominal retum of 8... Derive an expression for R., in terms of Ry Ely} and COVE gs Tale Answer: Note that ELM ud] ‘Therefore the ratio of the two rates are ELM hil _ ELM JEL 1+ covet BLM a] TyT+ 8, .cOv(M yyy) Lay] + R, COV gys Sy an economy with X states of nature and where the following asset pricing formula P=Sanx =E[mXx,] Let an individual in this economy have the utility function In(C,)+=[5In(C,)}, and let c; ‘be her equilibrium consumption at date 0 and C be her equilibrium consumption at date 1 instate 5 5=1,...,k Denote the date 0 price of elementary security 5 asp, and derive an expression fort in terms of the individual’s equilibrium consumption.18 George Pemmacehi + Theory ofhamt xh Answer: Since pean and then p=6r,S é Consider the one-period consumption-portfolio choice problem. The individual’s first-order conditions lead to the general relationship Ly RI where m,, is the stochastie discount factor between dates 0 and 1, and ®, is the one-period stochastic return on any security in which the individual can invest. Let there be a finite number of date I states where 7, is the probal relationship for primitive security s that is, let, be the rate of return on primitive (or elementary) security 3 The individual’s elasticity of intertemporal substitution is defined as R,_ d(C fCy) ci, where C, is the individual’s consumption at date ( and, is the individual’s consumption at date 1 in state s Ifthe individual's expected utility is given by u(c,)+se [0 Ey) ‘where utility displays constant relative tisk aversion, U (C)=C’/y, solve for the elasticity of intertemporal substitution, 2: Answer: Since m), =d0"(C,/U'(Cy)=5(C,/C,)" ', for primitive security 5, the first order condi 1=2.8(CJC,)''R, ‘Totally differentiating this condition gives O=7,6(y- INC JCy)" * RAC JCy) + 7, 0UAngwers to Chapter Exercises 19 Re-ananging, one obtains states of nature, a “good” state and a “had” state.' There are two (05 and a second risky asset that pays cashflows ty 8 ‘The curent price of the tisky asset is 6. a, Solve for the prices of the elementary securities, and, and the risk-neutral probabilities of 4, Consider an economy with assets, a risk-free asset with the fo states. Answer: Let ("| Ps 6 and _fi 10 “is ‘Then mext=[ 1 6] * 2 | tease 07 {a pln PY [ibs oe a] T0247, 0.70881 Hence, the risk-neutral probabilities are # = 58, = 0.26 and = pk, = 0.74. 1b. Suppose that the physical probabilities of the two states are 7, 0.5. What is the stochastic discount factor for the two states? Answer: my = pln, 0495. my = py/z, =1410. 5. Considera one-period economy with two end-of-period states. An option contract pays 3 in state 1 and 0 in state 2 and has a current price of 1. A forward contract pays 3 in state 1 and -2 in state 2. ‘What are the one-petiod risk-free return and the risk-neutral probabilities of the two states? Answer: Let the payoff matrix. x be "Thank Michael! Cliff of Virginia Tech for suggesting this example.20 Geome Penmacchi + Thsony ofRast? hs ‘The prices of the elementary securities of the two states are PePiCle, seh 1 [8 2 on 3 V2, ‘Therefore, the risk-free retum is ten +n -516 R, 6. This question asks you to relate the stochastic discount factor pricing relationship to the CAPM. The CAPM can be expressed as EIRJ=R, +B where [-] is the expectation operator, 8, is the realized retum on asset 5, 5. is the risk-free retum, # Is asset i’s beta, and 7 is a positive market risk premium. Now, consider a stochastic discount factor of the form mathe, ‘where « and b are constants and 8, is the realized retum on the market portfolio, Also, denote the variance of the retum on the market portfolio aso. Derive an expression for y asa function of a ly E[8, J, and 02. (nts You may want to start from the equilibrium expression 0 = =[m(®,-R,)]9)Angwers to Chapter4 Exercises 21 Answer: l(a+be, (R -RJ] =ab[R]~ ak, +bE[R, RJ-bR EIR, ] (8[R]-8,)+HE1R, JBLR,]+ covtR, RI-R.ELR, D =CIRI-R,a+belR D+bcodR, RI og _cbeowR Rd FURI-R 2 seat] cov[R»R,) bo? a+be[R,] bo? a+be[R,] so that a a+be[R,] b. Note that the equation I= E{m8,] holds forall assets, Consider the case of the risk-free asset and the case of the market portfolio, and solve for = and b asa function of R., E[R, and 2 Answer: For the risk-free asset, we have 1 — = Bla the, R L ld or A _pefR,1 For the market portfolio, we have [(a+bR, )R, ]=aE[R, ]+be[R? ] =aR[R,]+b(o2 +218, F) ‘Substituting for a from the risk-free asset equation gives22 Geomge Penmacehi + Thaonyofharct? chs Aveta a et J+b(o? +e1R,7) j =I] tbo?Ms Angwers to Chapter Exercises 23 so of PL JER I- RO Ro Using the formula for and i> in part (b), show that 7 = B[R, |. Answer: + TR I@IRI-8)~ PER HETR I-82) Re a+b, Consider a two-factor economy with multiple risky assets and a risk-free asset whose retum is denoted R.. The economy’s first factors the return on the market portfolio, , , and the second factors the retum on a zero-netinvestment portfolio, &.. In other words, one can interpret the second factor as the retum on a portfolio that is long one asset and short another asset, where the long and short positions are equal in magnitude (e.g, 8, =R,-,) and where 8, and &,, are the retums: ‘on the assets that are long and short, respectively. Itis assumed that cov(®, .,)=0. The expected returns on all assets in the economy satisfy the APT relationship =IR, i+ BA, +B. where 8, is the retum on an arbitrary asset + ,, = cov, 4, are the tisk premiums for factors I and 2, respectively. Now suppose you are given the stochastic discount factor for this economy, m, measured over the same time petiod as the above asset retums. It is given by meathR, +R es) where 2, by and care known constants. Given knowledge of this stochastic discount factorin equation (#*), show how you can solve for, and 2, in equation (*) in terms of =, y o,andc.. Just write down the conditions that would allow you to solve forthe 4, 2,, and 4. You need not derive explicit solutions for the 2.°s since the conditions are nonlinear and may be tedious to manipulate.4 Geonge Pemacehi + Theory ofharet ch Answer: We know from APT that 4, =, 2 sfa=a18,-2) ‘Therefore, we can determine these three parameters if we can derive conditions for R,,2[R.,}, and 2[8,] in terms of the other parameters, Fist, we know that Elm] =EfatbR, +R] a =atbe[R,]+ IR] ‘Second, we can use the condition 1=E[mR,] =Bf(a+bR, +R RT =a8(R,]+be(R?]+ 18.8.1 =ak[R,]+b(o? +E[R,F)+cE1R,JELR,] Q Lastly, we know that for the difference between to risky asset returns, = 21m] =s[(+bR, +8 )R,1 aB[R,]+bE[R,R,]+ cE [R? aB[R,]+ DER TLR, 1+ (0? +218,F] 8) Equations (1), (2), and (3) are three equations in the three unknowns &.., 20%,.1, and £[8,] They can be solved in terms of 2, by 6 sand c,, Then, acconding to APT, these solutions ;, &[R, Tyand E[R,T determine 4, =", 4, = £18, 7 =i, and 2,=E(8,T.Answers to Chapter 5 Exercises 1. Consider the following consumption and portfolio choice problem. Assume that (I (© S'[eC,—bC], BOT,.7)=0, and y, 0, where 5 = 1, and p> 0 is the individuals sul of time preference, Further, assume that n=0 so that there are no risky assets but there is a single- period riskless asset yielding a retum of 2, =1/5 that is constant each period (equivalently, the risk- free interest rate x, = 2), Note that in this problem labor income is stochastic and there is only one (riskless) asset for the individual consumer-investor to hold, Hence, the individual has no portfolio choice decision but must decide only what to consume each period. In solving this problem, assume that the individual's optimal level of consumption remains below the “bliss point” of the quadratic utility funetion, thatis, C? 0 is the (continuously compounded) rate of time preference, Assume there is no wage income (y, = V 5) and a constant risk-free retum equal to R.. = R,- Also, assume that 1=1 and the retum of the single risky asset, _, has an identical and independent normal distribution of ‘(R,o*) each period. Denote the proportion of wealth invested in the risky asset at date sasAngwers to Chapter S Exercises 29 a. Derive the optimal portfolio weight at date’ -1, «o'_,. H intsit might be easiest to evaluate ‘expectations in the objective function prior to taking the first-order condition, Answer: ‘The individual's problem at date °-1 is R= R, +aX(R,-R.) max — 5° te HE, eM] Bmax 5TH oB,[S eMC ETH Olte HN max —STtertes ge Meer Conf eten TE RH ce abot Maximizing this with respect to c._, is the same as maximizing ma, —C, IR, +0, (R-RI-F HW, 4-C, ae ‘Taking the derivative with respect to 7, we have BWW, y—C.,MR-RJ-bMR, -C, Ye, 40" or b. Solve for the optimal level of consumption at date 7 —1,C7 ,..C? , will be a function Of Wb Re By and o% Answer: ‘Taking the derivative of this expression with respect to C, , gives O=5™ Des SHR $a, (RR II-B, ,-C, Je? 07) xe substituting in for co, and simplifying leads to (R-R,)» Geonge Pemacehi + Theory ofharet ch ‘This implies or -C,3)R, =-p+Ing, -D(W Solving for c,_,,we obtain +E TR where Ht =| ping, +FR-R)o7 b+ Re c Solve for the indirect ufility function of wealth at date 71, J(W, ,.7 =). Answer: aSe tts gig (04 -s'e angie a-oge T ext where G |e +6712" | ts independent of L_ Derive the optimal portfolio weight at date T-2, of _,. Answer max 0°76" B.S tg max —5te%1 pg, ,[orige Be tealten bart f fa oe & cya etAnswers to Chapler Exereises 31 Maximizing this with respect to, , is the same as maximizing bR, max Iw. ,-C. 4) Re+ mag, (Hes Cre] Ree 1+R, ww or Ryd 8) Cg )BR oF w Solve for the optimal level of consumption at date T—2, C5. Answer: cmax 5 Fe ‘Taking the derivative of this expression with respect to C,_, and simplifying gives32__Geome Penmacchi + Thsony ofasct? chs 4, Am individual faces the following consumption and portfolio choice problem: max £, 5/3" Infc.]+5° Inf ,] ‘where each petiod the individual can choose between a risk-free asses paying a time-varing retum of over the period from t to t+1 and a single risky asset. The individual receives no wage income. The risky asset's retum over the period from t to +1 is given by Jol 0)8,. with probability £ © [G+ aR, with probability £ where u>0 and -1< <0. Let @, be the individual’s proportion of wealth invested in the risky asset at date ©, Solve for the individual's optimal portfolio weight «7 fo T-1. Answer: With log utility, the individual’s portfolio choice is myopic. Itis the same fora multi- period problem as it would be for a one-period problem. As shown in Chapter 5, the first onder conditions fordate + are or R, R,+@dR, a Riltoul Riedl ‘Therefore 2eanty +a) Tr ont+og) Atala +a) tard, 2ay(u, +a) +2074 Dota, +ola+a) o(ysa) fata) “Answers to Chapter 6 Exercises 2. ‘Two individuals agree at date 0 to a forward contract that matures at dafe 2, ‘The contract is written ‘onan underlying asset that pays a dividend at date 1 equal to D,. Let be the date 2 random payoff (profit) to the individual who is the long party in the forward contract. Also let mg, be the stochastic discount factor over the period from dates 0 to i where i=1,2, andllet #4[-] be the expectations operator at date 0, What is the value of {mq £1? Explain your answer. Answer: Let 5, be the price of the underlying asset at date and let D,, be the date 0 present value of dividends that it pays between dates 0 and 1. Pricing using a stochastic discount factor implies 5 = By%9,0,]+ Byltaa53] =Dy + Bylmy,S,] where D, is the date () present value of dividends, If we let £,, be the forward price, then we know that the payoff to the Jong party is =, -F,,. This long forward position represents ownership in a share of the underlying asset, a short position (selling) the underlying asset's dividends, and borrowing an amount such that the repayment at date 2 equals §,,. Using the stochastic discount factor approach to pricing, we know that E4[y, §1= EqLi (5; ~Fy.)1= Elias .]— Elmy,8yg} Now note that S, = By[0™D,]+ Bgly,S] = 04 + BylimyoS,] Where D, is the date 0 present value of dividends. Also note that E[g,F,]= lig Fy = we have E,lm,, Ly] Elm: Fye] Fa = 8 -Dy However, we know that the absence of arbitrage implies that the forward price satisfies Fyy = RUS —Dy) Which implies that EqLmq, f]=0. Assume that there is an economy populated by infinitely lived representative individuals who ‘maximize the lifetime utility function deer] where ¢ is consumption at date © and a>0, 0<0'<1. The economy is a Lucas endowment economy (Lucas 1978) having multiple risky assets paying date « dividends that total c. per capita, ‘Write down an expression for the equilibrium per capita price of the market portfolio in terms of the assets” future dividends.3M __ Geomye Pemmacehi + Theory ofharct? ch Answer: A result of the Lucas (1978) model is that the price of a risky asset, ,, satisfies Uc) aU al In this problem U (<0) ‘endowment economy with one share per individual, we have < [Sareos a(S] 3. For the Lucas model with labor income, show that assumptions (6.25) and (6.26) lead to the pricing relationship (6.27) and (6.28). =o, 80 that U(G,9=ad'e". Also, because thi - Thus, Answer: " wean] Sof) Ca] So wemeseonma ye Now So thatAngwers to Chapter Exercises 35 Se Rady 5e where = 0 P)u, + HO-/Po? +a31-A-pa.a, 4. Consider a special case of the model of rational speculative bubbles discussed in this chapter. Assume ‘that infinitely lived investors are risk-neutral and that there is an asset paying a constant, one-period risk-free retum of R, = 5°" > 1, There is also an infinitely lived risky asset with price p, at date ‘The tisky asset is assumed to pay a dividend of 0 . Mme lad) ith <0 © For limited liability assets, such as oil, we cannot have a bubble path with a price becoming negative, so we need to consider only bubbles with b> 0. In this case, we see from the above equation (*) that fora bubble solution to exist, the bubble component must be expected to increase infinitely. But this cannot be a rational expectation if there is an upper bound on the price of oil, as would be the case if there ‘was a perfect substitute in perfectly elastic supply. Thus, since p_ cannot rise above Bowe} cannot — pi. Thus, a bubble path where , must be expected to increase to infinity cannot possibly occur. 1 abOVE Page ‘Suppose p, is the price of a bond that matures at date T X,>%, and X,—X, =, —X, All options are written on the same asset and have the same maturity. Show that (q+q) «consider a portfolio that is Long the option having a strike price of X,, long the option having the strike price of X,, and short two opfions having the strike price of %,.3 4 George Penmacehi + Theory ofhamt hs Answer: The portfolio mentioned in the hint has the following payoffs: Stock Price Portfolio Value 5.8% 0 X0 X,<8,8X, $US. -X,)= % <8, §,-X,- 2S, -X,)+5, -% ‘This portfolio has either a zero or positive payoff at expiration. Therefore, it must have a non-negative value, implying + -24 >0, or g=HG ta). Consider the binomial (Cox-Ross-Rubinstein) option pricing model. The underlying stock pays no dividends and has the characteristic that u=2 and ci=1/2, In other words, if the stock increases (Gecreass9 over a period, its value doubles (ha:ve9). Also, assume that one plus the risk-free interest rate satisfies R, = 5/4. Let there be two periods and three dates: 0, 1, and 2. At the initial date 0, the stock price is §,=4. The following option is a type of Asian option referred fo as an average price call. The option matures at date 2 and has a terminal value equal to on = s0| where S; and S; are the prices of the stock at dates 1 and 2, respectively. Solve for the no-arbitrage value of this call option at date 0, Answer: The stock price tree is Date 0 Date 1 Date Date Date 2 16 we 3% 1 - 1 s 4% 4 1 z z s 2 ] 2 1 d's 1 [po, += phol= $HOSe, +0.80,1= 24, +c,]-Using this and the terminal payoff specified inthe question, the tree for the call option is Date 0 Date 1 Date 2 wz 7Angwers to Chapter Exercises 39 5. Caleulate the price of a three-month American put option on a non-dividend-paying stock when the stock price is $60, the strike price is $60, the anmualized, risk-free return is R, =<", and the annual standard deviation of the stock’s nile of return is c= 45, so that v= Wci= eo" = oY, Use a binomial tree with a time interval of one month, Answer: u= 08 rice tree 1387, so that /.= 0.8782, This allows us fo calculate the stock. DateO Date1 Date2 Dale3 DateO Datel Date2 Date ws 88.59 ws i 7780 iT 3 68.33 us% us 68.337 1 La, 7 s ; = 60 7 6 ¢ 3 52.69 z 52.69 asf 46.277 a's 40.64 Since R* = 0.4998, working backwards from date 3 using P,=maslX — SR (EP HU DP, Jh one obtains DateO Date1 Date2 Date3 Date Datel Date2 Date 3 Pus 0.00 Ps i 0.00% Past 1307 0.00 Zz z = 5467 Zz P BR = 516 3.63 1 , 1 arey 1 P r Post soit 731 P, i 13.73 ? Post 19.36 6. Let the current date be ¢ and let 7 > ¢ be a future date, where + is the number of periods in the interval. Let (2) and 2(;) be the date « prices of single shares of assets A and B, respectively. Asset A pays no dividends but asset B does pay dividends, and the present (date ) value of asset IB’s known dividends per share paid over the interval from t fo T equals D. The per-period risk-free retum is assumed to be constant and equal to R,.40 George Penaceht + Tasary choretP ich a. Consider a type of forward contract that has the following features. At date tan agreement is, made to exchange at date T one share of asset A for? shares of asset B. No payments between the parties are exchanged at date t Note that F is negotiated at date cand can be considered a forward price. Give an expression for the equilibrium value of this forward price and explain your reasoning. Answer: "The payoff of the contract af dale Tis. A(T) —F2(7). This can be replicated by buying one share of asset 8, investing °D dollars atthe risk-free rate, and short-selling shares of asset B. Note that we need to invest FD at the risk-free rate because the dividends on the F shares sold short need to be paid during the time of the short sale. Since this portfolio replicates the forward contract that has zero value, it must be that A(Q+ED -FB()= _ MO P= 5@-D “ra type of European call option that gives the holder the right to buy one share of asset A. in exchange for paying X shares of asset B at date T. Give the no-arbitrage lower bound for the date tvalue of this call option, (2). Answer: Consider the value of a long forward contract in part (a) that has a forward price of X shares of asset B. Ils date tvalue is 109 = A( + XD - XB(O) Hence, the call option has a value that is at least as great as this forward contract. {> max[ A()+ x0 = 500, 0] ‘¢.Derive a put-call parity relation for European options of the type described in part (b). Answer: Let portfolio A include one call option, x shares of asset B, and borrowing of xD dollars at the risk-free rate, Its value at date Tis max A(T) = XB O]+ XB() + XDRE ~ XO Ri = mafA(T),XB(2)] Let portfolio B include one put option and one share of asset A. Its date T value is max[XB(T) —A(T),0]+A(2) = max XB(T),A(T)] nce the portfolios have the same date T value, the absence of arbitrage implies that their date Cvalues must be equal 9+ XB(D- XD = PFAAnswers to Chapter 8 Exercises 1, A variable, =(9, follows the process das ptt ode where 1 and cr are constants, Find the process followed by y(:) =~" Answer: Using Ité’s lemma, we have san putes Latotae follows geometric Brownian motion, 2. Let be a price index, such as the Consumer Price Index (CP1). Lett! equal the nominal supply (stock) of money in the economy. Forexample, 1 might be designated as the amount of bank deposits and currency in circulation. Assume P and each follow geometric Brownian motion processes e S = p,ct+ a,c, > a a yacto, a: Hinde da, Derive the with dz,dz, = pct: Monetary economists define real money balances, m, to be = stochastic process for m.42 George Pemmacehi + Theory other? xen Answer: Applying Ito's lemma for the case of two state variables: 2 ay + oe 4 Sa +m on (eas \(ce) 12m 10a Seat +528 (oy + 28 on * atar Hee +04 Lotta pa,20, 0 e Ph en thn Ben fdt—m, dn ® ¢motct-mpe.o, ct ‘Therefore, Fay, ceto,d2, ~n,c0~0,02, +(08 ~ pao, )ot = (4, -4, +08 90,0, Jatt o, de, - 0,0, which can be written as Fc aat+ode where a= j1,—,+02~po,0,, 020, dz, -0,d2, and a? =? +02—2p¢,0,,. Thus we see that m also follows a geometic Brownian motion process. 3. The value (price) of a portfolio of stocks, (1), follows a geometric Brownian motion process: as/S=a,dctodz, while the dividend yield for this portfolio, (1), follows the process ay= mys ylact 0, Ha, where cada, = pct and x, ysando-are positive constants, Solve for the process followed by the portfolio’s dividends paid per unit time, D (1) = ys. Answer: Applying It’s lemma +2 ays 2 ay asby = WS + Say+-0,80, = Wa, Sct+ yor,Sda, + Sx(7S— y)dtt @, Syd, + 0,S0,¥# pct Jat+ yo, S02, +0,55 Lye, +xyS— Y+0.0, a,Angwers to Chapter Fxereises 43 4 ‘The Omstein-Uhlenbeck process can be useful for modeling a time series whose value changes stochastically but which tends to revert to a long-run value (its unconditional or steady state mean). ‘This continuous-time process is given by ad=[a- Byatt ood ‘The process is sometimes referred to as an elastic xancom walks s(t varies stochastically around ‘unconditional mean of «//, and f is a measure of the strength of the variable’s reversion to this mean, Find the distribution of («) given y( ), where t> %- In particular find Ef (0) vt) and var{ (2) (J. Sntsmake the change in variables: x0-[10 glen » B and apply 1t6"s lemma to find the stochastic process for >). The distribution and first two moments of 2) should be obvious. From this, derive the distribution and moments of (=). Answer: Consider the stochastic process followed by 242). Applying 1t0’s lemma, we have ae aldy -a)e ix x a +oly 3 = MOM — fy)aies PM Marcat (By arrrat =P Vode ‘Thus we can write x= ay) +f oo" dads) ‘This implies that (+) is normally distributed with ELA Ola) = 6) Varl (0) )]= “amen S(t) Converting +() back into (:), we have exponen 42 HO = SAW HE and a I= AGES Wade ay, B4 Geonge Pemacehi + Theory other hg In other words, if we know »4i,), then we also know \(;,) and vice-versa. Henee, ELMO! Wa )= =) a ae 4 Ayn) pike sem MELE aye aehondg +S B ( Finally, we also know that varl OL yy) =e 2 vad C9 La IT d-etew “gs Also note that (1) is a linear function of +(1). Therefore, since +(1) has a normal distribution, 80 does (2.Answers to Chapter 9 Exercises 1. Suppose that the pri where, /f, and y are constants, The risk-free interest rate equals a constant, r. Denote 1(5(8,2) as the current price of a European put option on this stock having an exercise price of x and a ‘maturity date of T. Derive the equilibrium partial differential equation and boundary condition for the price of this put option using the Black-Scholes hedging argument, Answer: ‘The derivation is very similar to the standard Black-Scholes derivation: Jemma says Now consider forming a portfolio of 1 put option (sell the put option), units of the stock, and invest 5(:) = p(:) - (2) in the risk-free asset. Let 11 (2) be the value of this portfolio at time & which initially has a zero value. Then the change in value of this portfolio over the next instant is coto+{ 19-2 ote et as. Note that the retum on this portfolio is instantaneously riskless. Thus, to avoid arbitrage, ‘the rate of retum on this “hedge” portfolio must equal the risk-free rate of retum, But since the intial value of the portfolio is zero, its future value must also be zero, Therefore, this which is the equilibrium PDE for the option price. It is solved subject to the boundary condition p(s(T),t)=max[0, x ~ s(t)].46 Geonye Pemmacehi + Theory other xen 2. Define P(x{9.r) as the date ¢ price of a pure discount bond that pays $1 in r periods. ‘The bond price depends on the instantaneous maturity yield, 2(:), which follows the process cxf) = af E- x(a ord, where a, 7,and care positive constants, If the process followed by the price of a bond having periods until maturity is (ery (50) = a(n )dt—0,, (4,7) and the market price of bond risk is, mas) —29) oan) then write down the equilibrium partial differential equation and boundary condition that this bond rice satisfies. Answer: It’s lemma implies OP 44 12P a 2 oe een=Lact (ay =[paG-o+e,+2e, orx]ace povedz = ular yer (aePlairIee where (50) =[ ace-9+e,+4e, a*x| /e(g2). and o,(22)= 2 ove (x7). ‘The market price of risk condition can be re-written as. wet) =49+ AN 20, (51) Subsituting in for (1,7) and o,(x,r) and simplifying, we have 1 ea-2+2,+42,0%= 2 - low, ‘This can be re-written as fore, +lat+(io-ae, - 2 and solved subject to the boundary condition (1,7 =0)=1Angwers to Chapter9 Exercises 47 3. The date tprice of stock A, (2), follows the process CWA=y,dt+o,dz and the date tprice of stock B, 5 (9 , follows the process Ba = p,dt+07,04 where o, and c7, are constants and t. Assuming a ‘constant interest rate equal to x use a Black-Scholes hedging argument to derive the equilibrium partial differential equation that this option’s price, (1), must satisfy Answer: Ito's lemma impliesAngwers fo Chapter9 Exercises 49 Now consider forming a portfolio that includes —1 unit of the option and a position in the underlying stock and the risk-free asset. We restrict this portfolio to require zero net investment, that is, after selling one unit of the call option and taking a hedge position in the underlying stock, the remaining surplus or deficit of funds is made up by borrowing or lending at the risk-free rate. Moreover, we require that the portfolio be self-financing in the sense that any surplus or deficit of funds from the option and stock positions are made up by investing or acquiting funds at the risk-free rate. Hence, if we let w(t) be the number of shares invested in the stock, then this zero net investment, self-financing restriction, implies that the amount invested in the risk-free asset for all dates tmmust be 2()= (2)— 9(98(). Therefore, denoting the value of this hedge portfolio as H (:) implies that its instantaneous return satisfies i (D = —delt) + w(N( ASL + FH(YAY + [9 ~ w(QS(Oeat Substituting in for cic(:) and cs(), we obtain + w(D(uSat+ oSde) +L) w(QS(Dhise Now consider selecting the number of shares invested in the stock to equal w (2) = +2 ‘This implies as. tantaneously tiskless, so to avoid arbitrage it must equal the competitive risk-free rate of return, x. But since we restricted the hedge portfolio to require zero-net investment at the initial date, say t=0, then + (0)=0 and GH (0) = ahi (O)at= 20 =0 =0 eso that ait (9 Vo This no-arbitrageAnswers to Chapter 10 Exercises In this problem, you are asked to derive the equivalent martingale measure and the pricing kemel for the case to two sources of risk. Let S, and 5, be the values of two risky assets that follow the processes dit o62,4=12 where both 1. and , may be funetions of 5, ,, andj and clz, and cz, are two independent Brownian motion processes, implying dz,ciz, =0. Let i(5,,5,,0) denote the value of a contingent claim whose payoff depends solely on 5,5, and & Also let 2(t) be the instantaneous, risk-free interest rate. From It6’s lemma, we know that the derivative’s value satisfies df= y,8t+o, 8% +0, 2, 0,5, f+ 0g 0,5, and where the and where 41, £= $445, $ +15 $+ 2075 + subscripts on £ denote the partial derivatives with respect to its three anguments, POR Sy By forming a rskless portfolio composed ofthe contingent claim an the to risky assets, show that in the absence of arbitrage an expression for jc. can be derived in terms of and Answer: Form a portfolio of —1 units of the contingent claim, § units of the risky asset 1, and. & units of risky asset 2. Let H_ be the value of this portfolio. Then H=-£4 §5+ £3, w ‘The change in value of this portfolio over the next instant is =-dE+ fag, + =p, Bt- 04 £4 0 Be, 2) + RMS OH FO, 03 + SHSct+ 40,5,0%, L4H + aS ~H Ale Since the portfolio is riskless, the absence of arbitrage implies that it must eam the risk-free rate, Denoting the (possibly stochastic) instantaneous risk-free rate as. 2(°), we have oH =[§uq9, + 5448, —m, flac= at= £4 $5, + E5,]at @Answers to Chapler 10 Exercises SL which implies mS + $4.5, -u, fo rl-£+ $5, + £5] “ “ into (4) and re-arrange, one obtains ont | 6 It we substitute § = “and 6) =14804+005 Define the risk-neutral processes <2, and c®, in terms of the original Brownian motion processes, and then give the risk-neutral process for c= in terms of 2 and cz. Answer: Let 43,= cg +8,(at and cB = az, +0,(at Then the process for a is: OER (240 4 +404) Sto 4 Hy +0, fi (C+ Gog $4.0.) B40, £5, +0, 88, Aor, fit Ao, Bit uy rit og £8 +04 Let B(2) be the value of a “money market fund’ that invests in the instantaneous maturity, risk- five asset. Show that F(:)= £(:)/B(t) is a martingale under the risk-neutral probability measure. Answer: Applying 1t0’s lemma, one obtains wort Fo +0. @) 8 +0,,Fdh Let (0) be the state price deflatorsuch that (0% (1) is a martingale under the physical probability measure, If OM = 4,040,404 + 6,20 what must be the values of 7,4 7,,»and oF, that preclude arbitrage? Show how you solve for these values. Answer: Define £ = #4 and apply It's lemma: am = aM +Mde+(aN(at) 1M, HMM fH6 4 t.y +, fr, Jt 0 +1f0,,+M oy dg +1 fo, +M ory Hey,52 George Penmacehi + Theory oft Pics If © is a martingale, then its drift must be zero, implying My FaGa FF, 7 10) Hane 7 (10) Now consider the case in which £ is the instantaneously tiskless asset, that is, £()=B() is the money market investment. This implies that c-, and (9. Using (10), requires 9) ay In other words, the expected rate of change of the pricing kemel must equal minus the instantaneous tisk-free interest rate. Next, consider the general ease where the asset £ is risky, so that o-, #0 and c-, 20. Using (10) and (11) together, we obtain Fe FF ana 4. =29- (12) =19 ‘Comparing (12) to (6), we see that 13) 2. The Cox, Ingersoll, and Ross (Cox, Ingersoll, and Ross 1985b) model of the term structure of interest rates assumes that the process followed by the instantaneous maturity, risk-free interest rate is dre aly —ddt+ ov edz where @.’, and o are constants. Let P(t,r) be the date ¢ price of a zero-coupon bond paying $1 at date t+ 1. Itis assumed that 2(2) is the only sourve of uncertainty affecting P(r). Also, let 41,60) and o,(%.7) be the instantaneous mean and standard deviation of the rate of retum on this bond and assume MEDD gp on) where # is a constant.Answers to Chapler 10 Exercises $3 a, Waite down the stochastic process followed by the pricing kemel (state price deflator), (0, for this problem, that is, the process x), where A(S(Z)> X) is the risk-neutral probability that S(T) >. From the standard Black-Scholes call option price c= SN (c,)— Ke" N (ql), ones sees that. HS(Z)> X)=N(4,), since only when S(T) > X (the call option is in the money), ddoes one “pay” the exervise price, x. Hence, we have cnc, = ©" PN(o)- 1b, Consider the value of an assetornothing call, anc: If (7) is the stock’s price at the option’s ‘maturity date of 7, the payoff of this optio - s(t) Hf s(r)>x 0 if simysxAnswers to Chapler 10 Exercises SS Derive the value of this option when its time until maturity is + and the current stock price is. Explain your reasoning. Answer: Using risk-neutral valuation, ang =¢"E[anc. ]. But this equals a standard call option plus a cash-or-nothing call paying an amount equal to the exercise price (F =X). Hence, the value of an asset-orsnothing call is SW (<,) ~ Xe" (a) + XEN (A) = SN (q). 5. Outline a derivation of the form of the multivariate state price deflator given in equations (10.33) and (10.34). Answer: Let s: process 5, ...8,)/ be an nd. vector of asset prices. They are assumed to follow the oS =a(S)at+ 4s)az. a where @(S) is an rxd vector of expected retums and asset prices and (5) is an con ‘matrix of volatility terms multiplying the nd vector of Wiener processes. Note that the elements of (5) and (5) may be functions of each of the asset prices as well as calendar time, % (5) is assumed to be of full rank, which is equivalent to assuming that the retums ‘on any one asset eannot be perfectly hedged by the retums on a portfolio of the other assets. In this sense, none of the assets are assumed to be redundant. Now if the contingent claim is a function of these asset prices and calendar time, that is, (5,0), then 1t6’s lemma gives its process to be of the form: wots, @ where fals)+o +} ote.) @ Oy and where ,) isan rod vector of fist devivatives and c, isan ron mattix of second derivatives whose + }* element is c... tf ] is the trace of matrix x, that i, the sum of its diagonal elements, Ifa hedge portfolio composed of —1 unit of the contingent claim and c_ units of asset 5 i=1,...,» is formed, its value is He-ctds 6) a CO}56 George Penmacehi + Theory ofhamt rng ‘This implies da(s)~4.c=-xe+ ris ao or poem t= L(a(s)~ 18) @) Now consider forming n portfolios from the n underlying securities. The goal is to make these n portfolios be “primitive” securities that each depend of a single =(P, ...P,)' be the rod veetor of prices for the » primitive portfolios, they will equal 's 0 (0) where 1, = (it...) = v'a(S) and 1 is the rus identity matrix. Using (9) and (10), wwe can re-write (8) as won res Mu, 2B) ap ‘Now from the definition that © = (6, ...0.)' is the nx<1 vector of market prices of risks associated with each of the Brownian motions, © = ju, ~ 1°. Using this and equation (4), ‘equation (11) can be re-written as ae “a = (2) or 4.-t=2.0 (13) ‘To deduce the form of the pricing kemel, if aM =p, ctto! az as) ©...) ism sd. veetor, then define 2 and apply It6"s lemma: de =oM +M dot (cc(aM ) 4 «sy Lou, +M pct ¥,o0, Jatt for’, + ME claAnswers to Chapler 10 Exercises $7 If * = satisfies 1 is a known positive constant, a Define P(x.) as the price of a default-free discount bond that pays $1 in r periods. Using It’s Jemma for the case of jump-diffusion processes, write down the process followed by (xr). Answer: P(ist)=| (0-28, -F, +4078, t+ oP c2+ [POY ~PCar) se b, Assume that the market price of jump risk is zero, but that the market price of Brownian motion (c2) tisk is given by 4,0 that ¢ =[a,, — (Vcr, where (1,7) is the expected rate of return on the bond and cr_(r) is the standard deviation of the bond’s rate of return from Brownian motion risk (not including the risk from jumps). Derive the equilibrium partial differential equation that the value P(1,r) must satisfy. Answer: From Ito’s lemma, the expected rate of retum on the bond is —yp,-p,+tote,|+4 2) P(r! s(@—np_-2,+dote, +4 1p(e¥,2)- PG] (50) P and its standard deviation from Brownian motion risk is o(e)=-0 Thus, if ¢=[a, - Vo, or P. 10+60,=40-40% =1)x(9- np, -2, +Lorp, + 2[P(ey,7)- Pl, =p |KO JP, 77P, plPGy.t) Post)Answers to Chapler 11 Exercises 61 then 9-60 =U e(o-p,-2, + Lov, + tet.) Peo) 508 [x(0-2)+ gop, -w -P, + 4[P(ex,7)-P]=0 ‘Suppose that a security’s price follows a jump-diffusion process and yields a continuous dividend at a constant rate of dit: For example, its price, :(2, follows the process S/S =[ulS.0)- Ak dat ofS, daz (Fea, where o(*) is a Poisson counting process and (= (%- 1), Also let = 2[%-1]5 let, the probability of a jump be 2ci3and denote (S,0) as the asset's total expected mate of retum, Consider a forwand contract written on this security that is negotiated at date © and matures at date? where >0. Let 1{1;£) be the date t continuously compounded, risk-free interest rae for borrowing or lending between dates tand7. Assuming that one can trade continuously in the security, derive the equilibrium date “forward price using an argument that rules out arbitrage. i n=: some information in this problem is extraneous. The solution is relatively simple. Answer: Consider the two portfolios created at date t: Atdatet: Portfolio A: a long forward position in the security that matures at date 7 and has forward price F. Portfolio B: a purchase of =* shares of the security, worth Se", and risk-free borrowing of Fer, Inbetween dates tand Portfolio B: as the security pays dividends at rate Sit, reinvest them in the security at the current price. Atdate: Portfolio A: S, ~£ Portfolio B: one share of the security, worth S., and borrowing of F. Since Portfolios A and B have the same date value, their values at date tmust be the same. Since the long position in the forward contract has a date “value of zero, this implies 0=se% ~FeAnswers to Chapter 12 Exercises 1, Consider the following consumption and portfolio choice problem. An individual must choose between two different assets, a stock and a short (instantaneous) maturity, default-free bond. In addition, the individual faces a stochastic rate of inflation, that is, uncertain changes in the price level (e.g,, the Consumer Price Index). The price level (currency price of the consumption good) follows the process ob /2, = mate Sag ‘The nominal (currency value) of the stock is given by S. This nominal stock price satisfies a ‘The nominal (currency value) of the bond is given by ©, It pays an instantaneous nominal rate of retum equal to + Hence, its nominal price satisfies B/B, = et Note that cl” and are standard Wiener processes with cZcio= pat Also assume 2, 5, 44,0; ‘and { are all constants, ‘a What processes do the real (consumption good value) rates of retum on the stock and the bond satisfy? Answer: Denote the real value of the stock as = = SP, and the real value of the bond as hb, = B/P, Then using It0’s lemma, we have that the real processes for the stock and bond are dg/g =(u~ 2 +5? ~odjp)cr+ oda 8 ab ina +08 )dt- dag b. Let C, be the individual's date treal rate of consumption and « be the proportion of real wealth, W , that is invested in the stock. Give the process followed by real wealth, ov. Answer: ah =((w (ux +5* - ofp) +U- oi 2 +52) —C) ct +o (ode~ Seay ~U- ey 5H ag [0 (4-080 +6 A454 —C]act ow oae—5W AgAnswers to Chapler12 Exercises 63 ¢. Assume that the individual solves the following problem: max, | U(C, dct subject to the real wealth dynamic budget constraint given in part (b). Assuming U (C,.9 is a ‘concave utility function, solve for the individual’s optimal choice of c in terms of the indirect utility-of-wealth function, Answer: ‘The Bellman equation is O= max (C (99+ 0.4 4, Loy ap — I +E-a +57) —C] 1 +15), “Lota? +5 -2upad] ‘The first order conditions are =u, -3, IH (U- 08p -9 + J, 58 (wo* - pod) =0 or How does « vary with p? What is the economic intuition for this comparative static result? Answer: If the difference between the expected real rates of return of the stock and the bond is constant, that is, (17 ~ cp ~ i) is constant, then 3 0 op ‘and we see that the greater the correlation between the stock’s return and the price level, the greater the demand for the stock as a hedge against price level changes. If (2—a8p — 9) is not constant when p changes, then op ol and the sign depends on —3, /{i J... > 0, which is the reciprocal of the individual’s relative risk aversion. The more tisk averse the individual, the smalleris the magnitude of J, GJ. )<0, 80 that more risk-averse individuals still have Gco/d>0, that is, ‘they demand more of the stock as a hedge against price level changes.“4 George Penmacehi + Ta=2:y ent? cha Consider the individual’s intertemporal consumption and portfolio choice problem for the case of a single risky asset and an instantaneously risk-free asset. The individual maximizes expected lifetime utility of the form 5 ie era, det] “The price of the risky’ asset, 5 is assumed to follow the geometuie Brownian motion process ags= pdt ode where and care constants, The instantaneously risk-free asset pays an instantancous rate of retum of ;. Thus, an investment that takes the form of continually reinvesting a this risk-free rate has a value (price), 5, hat follows the process dB/B = dt ‘where « is assumed to change over time, following the Vasicek mean-reverting process (Vasicek 1977) dy =afb- r]dt+ aif where dat = p: a. Write down the intertemporal budget constraint for this problem. Answer: Let « be the proportion of wealth invested in the risky asset. Then the intertemporal budget constraint is oh = o[ uri ct+ [aT —c set ow ace b. What are the two state variables for this consumption-portfolio choice problem? Write down the stochastic, continuous-time Bellman equation for this problem. Answer: The two state variables are wealth, 1, and the instantaneous maturity risk-free interest rate, x. Therefore, the Bellman equation is, O=max forse )+5,4lo(u- yi +80 —Cly, +b teal stew "etd, +490, +aii pos, } ‘c. Take the first-order conditions for the optimal choices of consumption and the demand for the risky asset. Answer. (4-9, +0 F023, +19 post, =0Answers to Chapler12 Exercises 65 @._ Show how the demand for the risky asset can be written as two terms: one term that would be present even if rwere constant and another term that exists due to changes in (investment opportunities). Answer: Solving fore, we have ue ps Tet o ‘The second term reflects the influence of changes in the risk-free interest rate on the ‘optimal proportion of wealth held in the risky asset. 3. Consider the following resource allocation-pottfolio choice problem faced by a university. The university obtains “utility” (e.g., an enhanced reputation for its students, faculty, and alumni) from. ‘carrying out research and teaching in two different areas: the “arts” and the “Sciences.” LetC., be the ‘number of units of arts activities “consumed” at the university and let. be the number of science activities consumed at the university. At date 0, the university is assumed to maximize an expected utility fumetion of the form ©.) is assumed to be increasing and strictly concave with respect to the consumption levels. Itis assumed that the cost (or price) of consuming a unit of arts activity is fixed af one. In other words, in what follows we express all values in terms of units of the arts activity, making units of the arts activity the numeraire. Thus, consuming units of the arts activity always costs C .. The cost (or price) of consuming one unit of science activity at date + is given by S(9),implying that the university’s expenditure on ©. units of science activities costs SC. (1) is assumed to follow the process a [ferate 2,0 dsls=a,ct+ ode where a, and may be functions of is assumed to fund its consumption of arts and sciences activities from its endowment. its endowment is denoted 1. It can be invested in eithera risk-free asset ora risky asset. The tisk-five asset pays a constant rate of retum equal to x. The ptice of the risky asset is denoted > and is assumed to follow the process OPP = pot ode where 4. and are constants and cixig’= pct Let « denote the proportion of the university’s endowment invested in the risky asset, and thus (I~ 0) is the proportion invested in the risk-free asset. The university’s problem is then to maximize its expected utility by optimally selecting C,, and 0.66 e. For the speci George Penace antPriing Write down the university’s intertemporal budget constraint, that is, the dynamics for its endowment, Answer: aN =e (de/P)+(L- ew wit-(C, + 55a Sle (u— 2m tat —C,— SC Jatt on ode b. What are the two state variables for this problem? Define a “derived utility of endowment” (wealth) function and write down the stochastic, continuous-time Bellman equation for this problem. Answer: The two state variables are W, and ,, Note that P, is not since 1 and care constants, that is, there is a constant investment opportunity set. The Bellman equation is O= max eFC, C)+ 9, tala +H = tow tord,, +}o%s0, +opo0R 83, Write down the first-order conditions for the optimal choices of © Answer ena =o ac ot Bogs = B-s3, -0 (u-DWo, +en17075,, +0855, =0 4. Show how the demand for the risky asset can be written as two terms, a standard (single-period) portfolio demand term and a hedging term. Answer: Re-writing the first order condition for «2, one obtains pos o solve for the university’s ‘optimal level of arts activity in terms of the level and price of the science activity. Answer: Using the first order conditions for Cand, one ean show which impliesAnswers to Chapler12 Fyereises 67 ‘Consider an individual’s intertemporal consumption, labor, and portfolio choice problem for the case of a risk-free asset and a single risky asset. The individual maximizes expected lifetime utility of ‘the form Ien 5: By if etC Ltt BW,)) where ©. is the individual’s consumption at date ¢ and |. is the amount of labor effort that the individual exerts at date t. u(C,, L,) is assumed to be an increasing concave function of C. but a decreasing concave function of L,,. The risk-free asset pays a constant rate of retum equal to r per: unit time, and the price of the risky asset, 5, satisfies the process os! (det ode where sc and care constants. For each unit of labor effort exerted at date + the individual eams an instantaneous flow of labor income of 1. y. Oand s, <0. ‘& Solve for the equilibrium risk-free interest rate, 1, and the process it follows, cits What Parametric assumptions are needed for the unconditional mean of rto be positive? Answer: We can write the technologies’ nx vector of expected rates of return as j= J. This implies that the equilibrium interest rate equals SQ" pe-1 eQe nxt an £2") 'e> O and a, =O 'e< 0 are both constants. Since ce and 4) jy the process for the risk free rate can be written 2s dr= aya + a Xat+ aya aay + a (2 er dct gly = (ayy — 440 + d+ ahyag (0- Hock oad where x=—a, > 0,0 = (039 ~ A)! = “ey ay/ ay + ory andd = cyl. AML of these newly defined parameters are constants. 0 will be positive when cy, > 20%y condition that is necessary for the unconditional mean of the interest rate to be positive.Answers to Chapler 13 Fyereises 75 1b. Derive the optimal (market) portfolio weights for this economy, o”. How does «* vary with +? Answer: For this problem, we have =O" 5) ~{erinsecreney yy cour % ‘Therefore, we see that the vector of optimal risky-asset portfolio proportions ‘constant, independent of 1, Derive the partial differential equation for P(x,t,7), the date tprice of a defuult-free discount bond that matures at date . Does this equation look familiar? Answer: Note that © is constant, as is «’. Therefore, let Y= 0"4, where ¢, is the n > 1 veetor whose # element equals oop, =a,)\0.p,. Hence, T isa scalar constant. Therefore, based on equation (13.42), the partial differential equation (PDE) for 2(x,t,) takes the form on }p,o8 4p +P {x0-2)-11-9 ‘This equation is the same form as the one derived in Chapter 9, equation (9.26). Thus, ‘we have provided an equilibrium justification for the Vasicek model that we derived ‘earlier based on a no-arbitrage argument. Hence, the solution to this PDE form (9.28). of the der the intertemporal consumption-portfolio choice model and the Intertemporal Capital Asset nium specification by Cox, Ingersoll, and Ross. a, What assumptions are needed for the single-petiod Sharpe-Treyner-Linter- Mossin CAPM results to hold in this multiperiod environment where consumption and portfolio choices are made continuously? Answer: For the single-period CAPM results to obtain, one needs to assume constant investment ‘opportunities so that risky asset rates of return have constant means, variances, and covariances and the risk-free interest rate is constant. This implies that risky asset prices follow geometric Brownian motion and are lognormally distributed over discrete intervals. Alternatively, if all individuals have log utility, the CAPM results hold instantaneously, though asset prices’ means and covariance matrix ean be changing over time,76 _Geome Penmacchi + Thsony ofhamt? resi b. Briefly discuss the portfolio choice implications of a situation in which the instantaneous real interest rate, x(:), is stochastic, following a mean-reverting process such as the square root process of Cox, Ingersoll, and Ross or the Omstein-Uhlenbeck process of Vasieek. Specifically, suppose that individuals can hold the instantaneous-maturity risk-free asset, a long-maturity default-free bond, and equities (stocks) and that arise in 2(=) raises all assets’ expected rates of return, How would the results differ from the single-period Markowitz portfolio demands? In explaining your answer, discuss how the results are sensitive to utility displaying greater or lesser tisk aversion compared to log utility. Answer: ‘The instantancous-maturity interest rate can be interpreted as a state variable that changes investment opportunities. Suppose that risk-aversion is greater than log uti so that the wealth effect exceeds the substitution effect. In this case a rise in 22) leads to an increase in optimal consumption (6/0 0) and a fall in x(*) leads to a decline in optimal consumption (2c /0r> 0). To hedge against unfavorable shifts in investment opportunities, there will be an additional hedging demand for assets that have a positive retum when (2) declines. An example of such an asset is a long-term bond, so that there should be a demand for long term bonds that exceed what would be predicted by the single-period Markowitz results. Conversely, suppose that tisk- aversion is less than log utility, so that the substitution effect is greater than the wealth effect. In this ease a rise in 2(+) leads to a decline in optimal consumption (GC /Or<0) and a fall in x(2) leads to a rise in optimal consumption (2c /Or>0). To hedge against unfavorable shifts in investment opportunities, there will be an additional hedging demand for assets that have a negative retum when x(:) declines. In this case, individuals might want to short a long-term bond to hedge against a rise in (=), that is, there will be a hedging demand for long-term borrowing (e.g., via a mortgage) so that there should be a net demand for long term bonds that is less than what would be predicted by the single-period Markowitz results. Instantaneous portfolio demands ‘would be the same as predicted by the single-period Markowitz model for the case of log utility Consider a continuous-time version of a Lucas endowment economy. Let C, be the aggregate dividends paid at date c, which equals aggregate consumption at date ©. Its assumed to follow the lognonmal process uct 07.62, a where «and o_are constants. The economy is populated with representative individuals whose lifetime utility is of the form QAnswers to Chapler 13 Exercises 77 a Solve for the process followed by the continuous-time pricing kemel, 1 . In particular, relate the ‘equilibrium instantaneous risk-free interest nate and the market price of risk to the parameters in ‘equation (1) and utility function (2) above. Answer: Note that process for i BU (C.8/8C, CEA, Hence, applying It’s lemma we have thatthe dere co +P DG Deer dc) perc? tat =[o-01,+h-niy -202 -p Joven tat--paerertax or =o. cz [ Hence, we see that r= p+ (1-y)ye,~3 0-2-7) and O=(1=7)o.4 Anu -F0-2-e +P] Suppose that a particular risky asset’s price follows the process © asls Matt o,c2, where dc, =p,,ct, Derive a value for using the pricing kemel process. Answer: Because 61 .=£,[5,\_],we know that (0 ) must follow a martingale (zero drift) process, Using It's lemma we have (su )=Mds+ sa +dsat ‘S(dS/S) + M Sle ME) M S(deA ) (y1,-=0,p,.)it+ 002, ~ 802, SH Setting the drift equal to zero, we have we From the previous results, show that Merton’s Intertemporal Capital Asset Pricing Model (ICAPM) and Breeden’s Consumption Capital Asset Pricing Model (CCAPM) hold between this particular tisky asset and the market portfolio of all risky assets. Answer: We note that aggregate consumption is the dividends paid by the market portfolio. Hence, the return on the market and aggregate consumption must be perfectly corvelated. This implies78 Geonge Pemmacehi + Theory other hg Now Breeden’s CCAPM says which is implied by our previous derivation in 3.b. Hence, the CCAPM holds and this result also shows that the ICAPM (and single-period CAPM) relationship also holds.Answers to Chapter 14 Exercises 1. _In the Constantinides habit persistence model, suppose that there are three, rather than to, technologies. Assume that there are the risk-free technology and two risky technologies: oB/B = rt 55, = matt 0,35, ass, Jc Also assume thatthe parameters are such that there isan interior solution for dhe portfolio weights (all portfolio weights are positive). What would be the optimal consumption and portfolio weights for this case? pci oc Answer: Let «, and «0, be the proportions of wealth held in risky technology one and two, respectively. Then the dynamics for wealth are now GH = (14-04 + (4, — Dey + EM — COO} att OjenhT cg, + oO da, ‘The Bellman equation then becomes = ma (0 C.4.94 IN =m, ey MC, ~bay +67, (U4 DO, +(e DO, + OW CL] shor, [ato votes -2¢oyoimo,]W* 16°96 -ax)-p0"9}. ‘Taking the first order conditions with respect to C., «2, and, one obtains (c,-by"'=4, -3,0r bet, - 30", (iy DW, +(0,07 +,fo,0;)a (as 3 9, + (03 + 0790,0,)8 *, = 080 Geomge Pemmacehi + Theory otha xen Solving the above two linear equations in the two unknowns, ©, and c,, one obtains "Note that for this constant investment opportunity set case, the ratio 0/0; is always constant. Thus, the proportion of each risky asset to the total of the both risky assets, 5, = —"\; and, = —%— are constant. Hence, the solution to the consumption- portfolio choice problem is identical to the problem solved hy Constantinides for the case ‘of one risky asset where the mean and variance of the single asset's rate of retum are =H 8+ yd, a? = dio] + 5}q} +280, o,0, 2. Consideran endowment economy where a representative agent maximizes utility of the form max Do where x. is a level of extemal habit and equals x, = at date +1. 1,Where C-fs aggreamte consumption ‘a. Write down an expression for the one-period, risk-free interest rate at date + R.. Answer: The pricing kemal for this problem is FUCK oC.“ K) which in equalibrium equalsAnswers to Chapler 14 Exercises 81 1b. If consumption growth, .,/°, follows an independent and identical distribution, is the one- period riskless interest rate, R.., constant over time? Answer: Note that the risk-free rate ean be written as 0-06.69" Ru" Fee 88 CWO] It c_,/C follows an independent and identical distribution, the expectation in the denominator of the above expression will be constant. However, the numerator in the ‘expression will be changing as the realizations of Cx-+ and C, change, Hence, & will not be constant, but time varying. ‘The following problem is based on the work of Menzly, Santos, and Veronesi (Menzly, Santos, and ‘Veronesi 2001). Consider a continuous-time endowment economy where agents maximize utility that displays extemal habit persistence. Utility is of the form allie Inc ~x pat] and aggregate consumption (dividend output) follows the lognormal process dC UC, = pect ode Define ¥, as the inverse surplus consumption ratio, that is, ¥, satisfy the mean-reverting process Ton? This assumed to ay =k — Jat or(¥. = A)az where ¥ > 4 > Lis the long-run mean of the inverse surplus, i: > 0 reflects the speed of mean reversion, a > 0, The parameter 2 sets a lower bound for ¥ ,and the positivity of c-(v, ~ 2) implies that a shock to the aggregate output (dividend-consumption) process decreases the inverse surplus consumption ratio (and increases the surplus consumption ratio). LetP, be the price of the market portfolio. Derive a closed-form expression for the price-dividend ratio of the market portfolio, &/¢.. How does P,/C, vary with an increase in the surplus consumption ratio? Answer: Denote the representative individual's stochastic discount factor between dates tand >t asm... Then since we have82___Geonye Pemmacehi + Theory ofhamt xh Let P, be the date © value of the market portfolio of all assets. Specifically, itis the claim to the dividend stream equal to aggregate consumption from dates t: to... Thus etal] [Perr ee yer olf eooy ayy Tek] =eile LY +(x, -Ye"" Jar cong ‘Therefore P./C, declines with an increase in the inverse surplus consumption ratio, so that it increases with an increase in the surplus consumption ratio. 4, Consider an individual’s consumption and portfolio choice problem when her preferences display habit persistence. The individual's lifetime utility satisfies af! erwcaxyes] o here C, is date s consumption and. , is the individual's date s level of habit. The individual can ‘choose among a tisk-frve asset that pays a constant rate of retum equal to x and n tisky assets. The instantaneous rate of retum on risky asset + satisfies BJP. = ott o.dg, i=1,....n @) where cizdz,=o,deand 1, o.,and c7,are constants, Thus, the individual's level of wealth, W , follows the process eu. ate (an —C Jatt Yo oz 8Answers to Chapler 14 Exercises 83 where «is the proportion of wealth invested in risky asset i The habit level, x ,is assumed to follow the process dx= AC 64a (4) ‘where Cis the date cconsumption that determines the individual's habit, a. Let J(0 , 1) be the individual’s derived utility-of-wealth function. Write down the continuous ime Bellman equation that J( , 1 satisfies. Answer: O= max [PC x)+ Holl eo = or nse .x y+ Fel SF oxtn,-o0 +001 0) | ms cco [You on +8 2 LY So ponte. 5,2) +L Dewey mat 26.92] b. Derive the firstorder conditions with respect to the portfolio weights, «...Does the optimal portfolio proportion of risky asset ito risky asset 3 «»/c» , depend on the individual’s preferences? Why or why not? Answer: The first order conditions are 0=5, (4-2 +4, where [v.,] =, Thus, the proportion of wealth in risky asset i to risky asset i is a constant, that is, >. (ua Yen) ‘This means that the individual splits his portfolio between the risk-free asset, paying retum 2; and a portfolio of the risky assets that holds the 1. risky assets in constant proportions. This is due to the “constant investment opportunity set” assumption, that is, that ., ,ando. are constants. Hence, two “mutual funds,” one holding only the risk-free asset and the other holding a risky asset portfolio with the above weights would satisfy all investors. Only the investor's preferences, current level of wealth, ., and the investor’s time horizon determine how much is putin the first fund and how ‘uch is allocated to the second.4 George Penmacehi + Theos amt cng © Assume that the consumption, ©. in equation (4) is such that the individuals preferences display an internal habit, similar to the Constantinides model (Constantinides 1990). Derive the first-order condition with respect to the individual’s date coptimal consumption, .. Answer: In this case, ©. =C., the individual’s consumption. Hence the first order condition is as , 2.4%) ag aw * ac. x era (Cx) = Assume that the consumption, G.,in equation (4) is such that the individual’s preferences display ‘an external habit, similar to the Campbell-Cochrane model (Campbell and Cochrane 1999), Derive the first-order condition with respect to the individual’s date “optimal consumption, C,. Answer: In this case,C.=C?s where C,'is per capita aggregate consumption. The individual fakes this as given, so thatthe first order condition is simply era, x)-2Answers to Chapter 15 Exercises 1. In the Barberis, Huang, and Santos model, verify that the first-order conditions (15.16) and (15.17) lead to the envelope condition (15.18). Answer: ‘The detived utility of wealth function in (15.15) ean be written as FO) 42) =< + BSE WAR 9 2) + TIM ys 2)] where C! and sare the optimal consumption and portfolio weights that satisfy the fist order conditions (15.16) and (15.17). Totally differentiating with respect to i one obtains! SEAR 92) ea AR a, * os, a. wos Substituting (15.16) gives I, (53, +, [a Oia) all and substituting (15.17) gives TW oV=E[S, Wy] Using (15.16) once again, we see that the above equation equals J, (5 2)=C/ 2. Inthe Barberis, Huang, and Santos model, solve for the price-dividend ratio, P/D,, for Economy I ‘when utility is standard constant relative tisk aversion, that is, "Recall that W ., = 0", + B+ (Ry Re36 Geonge Pemacehi + Theory other hg Answer: As shown in Chapter 6, the price of the market portfolio equals Now Inc, (OJ= $a +0. Ms InD,, DJ= $9, +0, Le, so that B/D == gee Ean poeek, ned Sault eh Eatr tne so lente eB m-ri2.9.01 Se Hterieeso aera In the Kogan, Ross, Wang, and Westerfield model, verity that 2 W ©" satisfies the equality Answer: Equating 1, 0 ,gleads 10 z i +08) al[leusy ] > orsince the denominators are equal oorfieee?]] [ore y wae")Answers to Chapler 1S Exercises 87 Now if A=” and Also note that ‘Thus, substituting these expressions into the above equal like deterministic terms we obtain of expectations and canceli fe [te rabelowe *y] Now consider a change in probability measure, cal it thei measure, by defining ly ca —yordewith wy @,80 thal w. —2, = 2 ~@ ~yorT. From Chapter 10, we know that this change in measure implies that for some random variable, »,24[1= Ef b¢¢_] where cP, foi, =¢, = ol” "9s the Radon-Nikodym derivative? Viewing x as the anguments ofthe above expectaions and making the substitution of, — or, == — 2, ~yoT, wwe obtain JPe termine Ta. y] all hatin Chapter 10 we shoved that under the measure (2) = £,| 1°" er) while under the P measure ceay~ fe ceyne oar =e.[2F 1°") ems came where 2/6 = ata te Ralon-Nikodym derivative is the ratio LF tesand are constants this implies 32, So, of the arguments under the expectations operators, that is, 30 cai lel38 George Penmacehi + Theory ofhamt rng Where > y, > the discount bond maturing at date. or x [[eeuso*] pas[s [Now note that [Now this condition can be written as «fer It can be verified that this is the derivative at x= 0 of the function nop=29y [(* som (y*)"] that i, it equals 0° ( sa ett 08 (x= 0)0 )o%. By making a final change “it cam be shown that (+) measure to, say, the Q, measure (2), which implies In the Kogan, Ross, Wang, and Westerfield model, suppose that both representative individuals are rational but have different levels of risk aversion. The first type of representative individual maximizes utility of the form sea and the second type of representative individual maximizes utility of the form 2] Ssumingw ,, =,» solve for the equilibrium price of the risky asset deflated byAnswers to Chapler 1S Exercises 89 Answer: The two different types of rational individuals have optimization problems that lead to ch =AM ‘Substituting out forts _ implies where 2 = 4//,, This implies D We have cht =A, -C,, et cit =a, -c,.¥" Tet C2, (0,42) and C3, (0,42) be the solutions to the above. Also, note that the present value of terminal consumption must equal the individuals’ initial wealths (discounted by the value of a T-period discount bond), so that EglC cM MM gl _ EglC nM] TEM) BLT B[c.cHa] Becta] ety ELM 1 et J (0.2) eM) gl] Because it was assumed thatt ., =W ., we have E,[¢”, J=48,[¢2 ] AEM, ~C,.)")» Geonge Pemacehi + Theory other hg or E(ICl, (05,4) -A(D, -C 2 (0544) ‘This condition is only a function of the terminal distribution of D -. Itcan be solved numerically to determine the value of Z as a function of the model parameters 7, 7 and c. Once we have this value, say 2°, then we can write C!-(D,52")=C!(D,)- ‘Then the price of the risky asset is B(D,M M4] _ {D4 1 EDM) [4] _EID,C1,0,YVAI_ ELD,C1, (0 © Ber. 0,7, E{c;.( which can be computed numerically, say by Monte Carto simulation of the expectations.Answers to Chapter 16 Exercises 1. Show that the maxi problem in (16.4). on problem in objective function (16.6) is equivalent to the ma Answer: ‘The expression in equation (16.4) ean be re-written as ‘The term E[ “1 r] is i the form of the moment generating function for the random variable 2% Since fpwas assumed to be normally distributed, it has a well-known moment ‘generating function. Substituting in this function, one obtains all ebbe ale Because the exponential function is monotonic, the above maximization problem is equivalent to imax ( (9451-82) x? va 1] 2. Show that the results in (16.8) cam be detived from Bayes rule and the assumption that # and. Gare nomnally distributed. Answer: By assumption, the marginal distribution for 274s ae Since $e- Her £4 ‘and £2: Ni (0,02) and is assumed to be independent of 2% we have that the marginal distribution for 94s N(m,o? +o?). The covariance of and equals (4m) (Ge m)] = BL mH Bo m)1= BLE)? + AI = HA ol I= 0%, Thus, the correlation between Hand equals p,= 07! oo? + Rule relates conditional and marginal probabilities. For the normal, if we have two random varlables, say sand = whose joint and marginal probability density functions are f(x 2), £(9,and £(2) respectively, then Bayes Rule says that the conditional probability den ies satisfy Ax) _ ex ce92 Geomge Penmacehi + Thaonyofharct rciy Let the joint bivariate normal density for and Gebe n(P,.y.p,) and denote the marginal nonnal densities of if and Eby r(P,) and Cy). Give the assumed means variances and covariances, we have HAF. ¥9h a(R, Now n(&,,¥,2,) can be re-arranged to take the form [-ln(t-oe) ey | 1(P, ¥P= Oy) J ‘Thus, Bayes Rule states that the conditional density of , given y, is bya Pe YP) 48, |y) = 1 ai Im p2)+y, ofl-p V2 ey Notice that 1n(2, | y,) is of the same form as a univariate normal density function for the variable 5, having a mean of [m(1~?)+ y.] and a variance of (I~ p?). Thus, from this observation we can see that [| y;]=m(1- p?)+ y.and var{2,| y]=o7(.- p?). 3. Consider a special case of the Grossman model. Traders can choose between holding a risk-free asset, ‘which pays an end-of-period return of, and a risky asset that has a beginning-of-period price of, per share and an end-of-period payoff (price) of : per share. The unconditional distribution ‘of P1is assumed to be N (m0). The tisky asset is assumed to be a derivative security, such as a futures contract, so that its net sopply squat zm, ‘There are two different traders who maximize expected utility over end-of-period wealth, iT 1, 4=1,2. The form of the th trader’s utility function is TGF,Answers to Chapler 16 Exercises 93 At the beginning of the period, the th trader observes y,, whicl value of the risky asset a noisy signal of the end-of-period y Bit? where ¢, : 11(0,72) and is independent of same, Also assume FL2,¢, Note that the varianees of the traders’ signals are the a, Suppose each trader does not attempt to infer the other trader’s information from the equilibrium price, %,. Solve for each of the traders” demands for the risky asset and the ‘equilibrium price, °,. Answer: Maximiring investor *s ufility with respect to the amount invested in the risky asset, x, leads to x _EIPALI-R 2 ~~ aya where if 1 just equals 7, then £[i% ]=m + p(y —m) and var [&% o? (1—p*), where p’ jubstituting these conditional moments into the above equation gives ntoy-m)-R,Py aod py Since the asset is in zero net supply, x, + X; = 0,80 that aut ata Ip? tp? b. Now suppose each trader does attempt to infer the other's signal from the equilibrium price, >. ‘What will be the rational expectations equilibrium price in this situation? What will be each of the traders’ equilibrium demands for the risky asset? Answer: The result of the Grossman model is that the price is fully revealing. The equilibrium price is the same as it would be if both signals were public information. This implies that the equilibrium price is ond Fy + vai?94 George Penmacehi + Theory ofhamt rng where =p: Trader i's equilibrium demand, x , is given by using BEB: | Z]=m0—p')+4p"(y + yy) and varl 8, | 1]=o7 1p"), thatis, ndl-p +1 py +4)-ReB x,=——___2 os * aal-p) Substituting the equilibrium price in the above equation proves that + X,=0. However, we have even a stronger result. Note that since the numerators of X., i=1,2are the same, it must be the case that X, =X, =0,80 that inthis fully revealing case each individual takes a zero position in the risky asset even though their risk aversions differ. In the Kyle model (Kyle 1985), replace the original assumption Better-Informed Traders with the following new one: ‘The single risk-neutral insti=ris assumed to have etter information than the other agents. He observes a signal of the asset's end-of-period value equal to Gf where &: (0.0%), 0< 0? 1, does the insider trade more orless when > 0 compared to the case of = 0? What is the intuition for this result? How ‘might a positive value for p be interpreted as some of the liquidity traders being better-informed. ‘traders? What insights might this result have for a market with multiple insiders (informed traders)? Answer: Note that if v> p, and > 0, the insider trades less. A positive value for > can be interpreted as some of the liquidity traders being better informed traders such that they ‘end to move their trading in the direction of «: The result that the insider trades less ‘when he faces a market with other insiders is a general result that each insider realize that there is less noise trading to camouflage trades. Competition to trade o information lowers the profits of each insider.Answers to Chapter 17 Exercises 1. Consider the following example of a two-factor term structure model (Jegadeesh and Pennacchi 1996; Balduzzi, Das, and Foresi 1998). The instantaneous-maturity interest rate is assumed to follow the physical process gide+o.z, and the physical process for the interest rate’s stochastic ‘central tendency,” (:), satisfies 4 AT -/(olde+ 0,63, where cad, = pat and a>0, 0.4 5>0, 7 >0, 0,, and p ave constants. In addition, define the constant market prices of risk associated with cz and dz, to be , and 6,. Rewrite this model the affine model notation used in this chapter and solve for the equilibrium price of a zero-coupon bond, (7). Answer: Following the notation in the text, et the state variable process be ox =alx)dt+ bd w where x(1) = G70), ay @ @ and dz =(cz, dz,)' is a vector of independent Brownian motion processes so that ciqaz, =O. Note tha the covariance mat in (3) results in the same variances and covariances as in the case of the correlated Brownian motions cz, and cig, To find ©=(4, 6,)', which is the vector of market prices of risk associated with the independent Brownian motions, note from (3) we can take ci 80 that 6, = 0. To find 4,, note from (3) that cz, = pda, +/1— p7 cz, Since 2, = dz, + 0,0 and we want of, = pat, += pot, this implies that az, +4, cit= plo + 6,c1)+4/1= p? (az, +A,ct). By equating the coefficients of the ct terms we have 0, = 0, +,/1- "0, or 0, =10, - p0,Wfi=Pp*.98 George Penmacehi + Theory ofhamt rng ‘Now equation (17.14) in the text becomes alx)—bO = « (Fx) -o0 | (-a a \e en (a) 67-0,8,, \ 0 -8) * ‘Thus from (4) we see that ® and -98, \_(a(y »)) = (6) oF - 0,8, ( oy « so that (7-0,015-cOa) 7 : 0 \ 7-2,8/8 ‘Further, equation (17.15) in the text becomes b=ZVs08) e, o @) — =EVs%) op oNi-P Which implies that we can take = and lets be the identity matrix wheres ‘Lastly, from 1x) = @ + /i'x, we have that @=0 and f'=(1 0). ‘To derive the formula for a zero-coupon bond’s price, P(t, T,x) = TS, where Y(ST.x)r = Al) +B(o)'x and r=7 1, we need to find A(r) and B(r) from the ordinary 4(0)% Assume ‘1, % cand y are positive constants and that c — 4 °/y > 0, where / also is a constant. Solve for the equilibrium price of a zero-coupon bond, °(/5"). Answer: For this one-factor specification, we have (ST, 2) = exP-Ale)— Be) {9 —C (7) 249) ao ‘The ondinary differential equations (17.28), (17.29), and (17.30) become BO) a+ n3(0)-LB(pFo? +c(No? ® or Se f—2(z)—2C @)B(Z)0? +20 (KE @) ZO) 4 aqc(r)-2(00? @ orAnswers fo Chapter 17 Exercises 101 ‘subject to the boundary conditions A(0) = 5(0) = c (0) =0. The solutions to these first-order ordinary differential equations can be found in Anh, Dong-Hyun, Robert F. Dittmar, and A, Ronald Gallant 2002 “Quadratic Term Structure Models: Theory and Evidence,” Review of Financial Studies 15, 243-288 and Singleton, Kenneth and Qiang Dai 2003 “Fixed Income Pricing,” in Handbook of Economies and Finance, Chapter 20, C. Constantinides, M. Hanis, and R. Stulz, eds., North Holland. Define ‘Then the solution to the non-linear, first-order ordinary differential equation (4) -_ we -D (4PM eF 420 ‘This value forc (z) can be substituted into (3) to obtain a first-order, linear differential ‘equation for £(r) whose solution is 2n(z+8) worcio) 8) ce) 6 z o Finally, substituting (5) and (6) into (2), the right-hand side of (2) is entirely a function of . This can be integrated directly to find the value of &(c) with the integrating constant determined by A(0)= 0. This complicated function for A(r) is not reproduced here, but Anh, Dittmar, and Gallant (2002) give its formula for the case of ff = 0 and 7 =1, conditions which they show are needed to empirically identify the other parameters. 3. Show that for the extended Vasicek model wher = LaE00, then 2(0,1)=Hexp(-f x(s)a9)]=exp(—}, £0,909). Net 109+ 2-2?" Va"), Answer: Starting from (17.52): ar=af2()- xQ)aet oc w and substituting in £(2) O,Met+ 10, +021—2%*)/(2a), then (17,52) and (17.51) show that the integral equation of (1) can be written as, rae) [oe ay) ertte [fee aeogiquy 2 =e" P+ [ioe iu)102 George Pennacchi + Theonyofaet Pens We can use (2) to substitute in for x() in the bond price equation to obtain P= wl evo(-f, 0«3}| “fo (-,[ 20.085 (de + foo" weteo fo \ rade eo C =e -f/ 0.9 Zooey ce} exo(-f, Zd-e ~)sia)] =en{-f 90.9+ where the last line of (3) is obtained by switching the order of integration. Now note that the risk-neutral Brownian motion process <(s) are mean zero, normally distributed independent increments, so that exp (-[; (1-=*)<%(3)) is lognormally distributed. ‘Thus, the expectation of this variable equals the exponential of one-half of its variance. ‘This allows us to waite (op | o i 0,1) =exp| -[° 10,9+ 250-0" Zadl-e F0,2) ml J) 09+ Fa seo getcey'as] o =en(-[, 10,5)a) 4. Determine the value of an o-payment interest rate floor using the LIBOR market model. Answer: Let 1(1,1) be the date tprice of a flooret whose date T +r payoff equals rmax[X ~L(1,7,7),0]. Note that it can be shown to be a call option on a bond since 20.0) = PC, + )max[?x —20(7,7,2).0] =8G.5-+ ma (saclay 1)0| =max[+rx)eC,7 +)-10] =rmay| Lex - (eos 1] ‘The last line in (1) shows that the floonlet is a call option on a bond having a payoff of 1+7X atts maturity date of 7 +r. To value this floortet using the LIBOR market model, we compute expectations under the forward rate measure generated by A6T) &) A typleal floormay have dates 7, tet .eeT, ste r(n-D.Answers to Chapter 18 Exercises 1. Consider the example given in the “Structural approach” to modeling default risk. Maintain the assumptions made in the chapter but now suppose that a third party guarantees the firm's debtholders that if the firm defaults, the debtholders will receive their promised payment of 3 . In other words, this third-party guarantor will make a payment to the debtholders equal to the difference between the promised payment and the firm’s assets if default occurs. (Banks often provide such a guarantee in the form of a letter of credit. Insurance companies often provide such a guarantee in the form of bond insurance.) ‘What would be the fair value of this bond insurance at the initial date, :? In other words, what is the competitive bond insurance premium charged at date =? Answer: Let 1(2) be the date ¢ value of the insurance for the bond that matures at date T. ‘Then a2) = max{0,8 - A(2)] ‘We see that the insurance has a payoff that resembles that of a European put option written ‘on the firm’s assets having an exereise price of 5. Therefore, the present value of the insurance is HQ=P(GTIBN (6 AN(-) where b, = [nfo A/( (2 7)8)1+ *1'y by = — 4 and (2) is given in 9.61), 2. Consider Merton-type “Structural” model of credit risk (Merton 1974). A firm is assumed to have shareholders’ equity and two zero-coupon bonds that both mature at date T. The first bond is “Senior” debt and promises to pay 2, at matuity date 7, while the second bond is “junior” (or subordinated) debt and promises to pay 5, at maturity date 7. Let A(9, D,(2, and D,(2) be the date + values of the fimr’s assets, senior debt, and junior debt, respectively. Then the maturity values ‘of the bonds are ifa(t)>B, +2, =B, 1B, +B, >AT)2B, otherwiseAnswers fo Chapter 18 Exercises 105 ‘The firm is assumed to pay no dividends to its shareholders, and the value of shareholders’ equity at date 1, £ (7), is assumed to be eqya[A- +B) HAT2 8 +8, lo otherwise Assume that the value of the firm's assets follows the process AMA = jidtt ode where j1 denotes the instantaneous expected rate of return on the firm's assets and cis the constant standard deviation of return on firm assets. In addition, the continuously compounded, risk-free interest rate is assumed to be the constant x. Let the current date be +, and define the time until the debt matures as a. Give a formula for the current, date +, value of shareholders? equity, (1). Answer: Shareholders” equity is analogous to a call option written on the firms assets with exercise price 5, +5. Therefore, (9 = ACB) +B, )PGTIN(D,) where by =|INA(Q/[P(STVE, + B+} | hy = ~ vy and 7) is given in (9.61). 1b. Give afornmila for the current, date +; value of the senior debt, © (1). Answer: The senior debt’s payoff is analogous to a risk-free payoff of 5,, less the value of a put option on the firm's assets having exercise price 5, . Hence, we have (57)B, -P(GT)BN (Hy) + (ON (A) = POSTYBAN() + AON) where % = INA(QP(GTIBL+ 44M k ly -y and uz) is given in (9.61). c. Using the results from parts (a) and (b), give a formula for the current, date t, value of the junior debt, 0,(2. Answer: Since the value of the firm's assets must equal the sum of the Values of the claimss on those assets, A(9=2(0)+D,(9+0, (9. Therefore, DAD=AM-E)-D9 =A(D- ACON (A) +(B, +B, )PCETIN CD) —P(ST)BN (i) — AGN (-K) = A(OIN (HA) —N (H+ PCT ICE, + BIN (H,) BN)106 _Geome Pennacchi + TheomyofAamt? ves Consider portfolio of = different defaultable bonds (orloans), where the 2 bond has a default intensity of 2,(¢.x) where x is a vector of state variables that follows the multivariate diffusion process in (18.7). Assume that the only source of comtelation between the bonds’ defaults is through their default intensities. Suppose that the maturity dates for the bonds all exceed date T >t. Write down the expression for the probability that none of the bonds in the portfolio defaults over the period from date ¢ to date Answer: As given in equation (18.5), the physical probability of the * bond surviving over the interval from the current date © to date 7 is 2 [exo(-[ AGaxC ya) ‘The doubly stochastic modeling of default implies that, given none of the bonds las yet defaulted, the default intensity for the zt default among the m bonds is given by the sum of the default intensities D",1(t,x(9). Similarty, the probability of joint survivorship (that ‘none of the bonds will default) before date 7 is given by »fer(-[ D1,z0sxen24)] 4. Consider the standard “plain vanilla” swap contract described in Chapter 17. In equation (17.74) it ‘was shown that under the assumption that each party’s payments were default free, the equil ‘swap rate agreed to at the initiation of the contract, date 1, equals ‘Where for this contract, fixed-interest-rate coupon payments are exchanged for floating- interest-rate ‘coupon payments at the dates T,, ++, Where T.,, ='7, +7 and ris the maturity of the LIBOR of the Nloating-rate coupon payments. This swap rate formula is valid when neither of the parties have ‘eredit isk. Suppose, instead, that they both have the same credit risk, and itis equivalent to the eredit risk reflected in LIBOR interest rates. (Recall that LIBOR refleets the level of default isk for a lange international bank.) Moreover, assume a reduced-form model of default with recovery proportional to rmuarket value, so that the value of a LIBOR discount bond promising $1 at maturity date 7, is given by (18.22): D(tyyt)= Ba 2! where the default-adjusted instantaneous discount rate R((,x) = 1(1,x) + A(‘,x)E(t,») is assumed to be the same for both parties. Assume that if default occurs at some date r <7, ,, the counterparty whose position is in the money (whose position has positive value) suffers a proportional Toss of L(r,x) in ‘that position. Show that under these assumptions, the equilibrium swap rate isAnswers fo Chapter 18 Exercises 107 Answer: This problem is based on Section I of Duffie, Darrell, and Kenneth J. Singleton 1997 “An Econometric Model of the Term Structure of Interest-Rate Swap Yields,” Journalof F nance 52, 1287-1321, See that article fora more complete explanation of the solution, ‘The swap can be viewed as an agreement to exchange n +I stochastic cashflows. It & is the swap’s fixed anmualized coupon rate, then conditional on no default by date 7 , the floating-rate payer's net cashflow (fixed-rate payer's net payment) at date 7 is rf —L,.(7,,.7)], where L,..(7,,.7) is the annualized z -maturity LIBOR at date T_, = 1,—r. (Note that the notation used in Chapter 17 for this spot LIBOR was L(T.,,7,,.1). Here we use a slightly different notation to avoid confusion with ‘the proportional loss rate L(73%).) ‘When recovery is proportional to market value, a similar argument to that made in the text can be used to compute the present value of the payment at date 2 lel sie Lr ~]} (a) where R(x) =2(5x)+ A(¢x)E(x). Expression (1) is analogous to equation (18.22) for the case of a defanltable bond with a fixed promised payment. Thus, the present value ofall of the swap's +1 payments is Snfelorme| ~ LAT, wl} Q) At the inception of the swap, which is assumed to be date the expression (2) must equal eto foritto be fairly priced. Thus, at date T, we have 5, (7,)=K, so that Sm [oh EL gla) —DaoalT vol|-6 @ ‘Rearanging this expression, we obtain Thy eno] “ Now note that, by the assumption that LIBOR interest rates reflect credit risk equivalent to the parties of the swap, we have lerh,, " 6)108 George Pennacchi + Theonyofaet Piers After substituting in (5), the right-hand side of (4) ean be written as ah o =) ,,7,)-20G,.7) (Ty oT) ‘where in the last line of (6) we make use of the fact that D (Ty.1, the right-hand side of (4), we obtain 1. Substituting (6) for £54) Dy, T)=1~D (yey) o o 8)