Aps502h1 20209 6316201532472020

APS 502 Financial Engineering Dec.
15, 2020
Take-Home Final Exam
Instructions: You may only use the material from class (course slides,
course text, and homeworks and any material from quercus for APS 502). You
must not in any circumstance consult with anyone about the exam or use the
Internet outside of using quercus. A simple non-programmable calculator is
permitted.
IMPORTANT: Interpretation of the exam questions is part of the
exam and so NO questions will be taken DURING the exam that
ask for clari…cation of the questions. SHOW ALL WORK AND BE
VERY NEAT AND LEGIBLE as this aids in determing maximal
partial credit! Please be sure to send you exam solutions to me by
12:30PM Toronto time on Dec. 15. Late papers will be penalized.
See quercus Announcement for the details of how you should submit
your exam.
Problem 1 (12 points)

You have the following data on government bonds and the quality of the
bonds are AAA e.g. you can assume they are US bonds (or Canadian). Assume
coupon payments are annual and that the …rst coupon payment occurs a year
from now.
Bond Year of Maturity Coupon amount ($) Face Value ($) Price
A 1 25 100 100.00
B 2 50 500 422.61
C 3 20 300 232.28
D 10 0 1000 192.31
(a) (8 points) Calculate the forward rates f0;1 ; f1;2 ; f2;3 ; and f3;10 .
(b) (4 points) Is it a good investment if it costs $21 million dollars now for
an investment that generates the following cash ‡ow? Assume cash ‡ows will
be paid with 100% certainty.
year 1 2 3
cash ‡ow (in million dollars) 9 10 11
For example, after one year you receive 9 million dollars, after two years you
receive 10 million dollars, etc...
Consider the …shing problem from lecture (see Dynamic Programming slides).
Now consider a four period verison of the problem where you have the choice to
…sh or not …sh at the start of four consecutive periods. Also, when deciding not
to …sh at the start of a period suppose that the population of the …sh grows by
a factor of 1.5 by the start of the next period e.g. if 10 …sh were in the pond at
1
the start of a period and you did not …sh then there would be 15 …sh in the pond
by start of the next period. Keeping all other aspects of the …shing problem
the same as in the slides determine the optimal …shing strategy and the value
of this strategy. Show your work (include a tree diagram in your work).
Consider three risky assets with the following covariance matrix and ex-
pected return vector
2 3 2 3
0:03 0:04 0:02 0:10
Q = 4 0:04 0:08 0:04 5 and = 4 0:15 5
0:02 0:04 0:04 0:075
For example, asset 3 has a standard deviation of 3 = 0:20 = 20% and an

expected return of 3 = 0:075 = 7:5%:
Consider the following two portfolios of the three assets
2 3 2 3
0:4357 0:4286
P 1 = 4 0:3400 5 and P 2 = 4 0:3571 5
0:2243 0:2143
Determine whether or not each portfolio above could be a minimum variance

portfolio of the three assets. Show all work. Use at least 4 digits to the right of
the decimal point.
(a) (9 points) Consider the following 6 portfolios and a risk-free asset. The
risk-free rate of return is 1.5% and the expected returns and standard deviations
of the 6 portfolios are in the following table
Portfolio A B C D E F
Expected return 3.2% 8.1% 9.8% 5.1% 10.7% 4.8%
Standard deviation 2.7% 9.9% 13.7% 6.2% 17% 6.1%
Note: the entries are in % e.g. 3.2% = 0.032.
Rank the portfolios from best to worst. Show all work.

(b) (9 points, 3 points for each Case) For each of the following cases deter-
mine whether it is consistent or inconsistent with CAPM. BRIEFLY explain
(justify) your answers. Let A and B denote arbitrary risky securities while F
and M represent the risk-free asset and the market portfolio, respectively. For
example, in Case 1, is it possible for the securities to have the expected return
values and beta values as given and not violate CAPM?
security E[ ] (expected return) (beta)

(i) Case 1: A 25% 0.8
B 15% 1.2
2
security E[ ] (expected return) (standard deviation)
(ii) Case 2: A 25% 30%
M 15% 30%
security E[ ] (expected return) (standard deviation)

A 25% 55%
(iii) Case 3:
F 5% 0%
M 15% 30%
We derived the Capital Asset Pricing Model from several assumptions about
…nancial markets and investor behavior. In other words, CAPM is a consequence
of these assumptions. In particular, it was important that all investors use
Markowitz optimization when constructing portfolios and that everyone has the
same estimates of the expected returns and covariance/variance quantities.
Suppose that you don’t think that all of these assumptions hold and so
CAPM is not valid mathematically, but you still wish to use Markowitz opti-
mization for constructing portfolios. Could the results of CAPM still be useful
when constructing portfolios in this case? If so, how? If not, why not? Your
response should be precise and use relevant quantitative reasoning.

Consider two securities with expected returns 1 and 2 and standard de-
viations 1 and 2 with correlation of 0. Let w and 1 w be the investment
weights in the two securities 1 and 2, respectively with the portfolio of the two
securities represented as
w
p= .
1 w
2
(w)
Now let f (w) = p (w) where 2p (w) is the variance of portfolio p when w is
p
the weight of the …rst security and p (w) is the expected return of portfolio p
when w is the weight of the …rst security.
Now suppose that you wish to …nd a portfolio p that minimizes f (w) where
you allow short selling.
(a) (3 points) Explain BRIEFLY why it makes sense to minimize f (w).
(b) (7 points) What conditions do optimal portfolios have to satisfy?
(c) (5 points) Under what conditions will the optimal portfolio p that mini-
mizes f (w) be a minimum variance portfolio?
3
(a) (8 points, 4 points each) Draw a payo¤ diagram showing the pro…t and
loss with the stock price at maturity for a portfolio consisting of:
(i) Buy one share of stock and a short position in one call option.
(ii) Buy two shares of stock and a short position in one call option.
Your diagrams should take into account the cost from purchashing the stock
and revenue from selling the calls. You can ignore discounting when combining
costs and revenues with the payo¤ of a portfolio at maturity. Suppose the
current stock price is equal to the strike price K of the call option. Let the
current call price be denoted by c ; and the stock price at maturity ST : Assume
all options are European.
(b) (8 points) Consider an exotic European option on an underlying stock
whose payo¤ depends on the average price of the stock on a path of prices that
realizes from now to maturity. In addition, if the average price on a realized path
exceeds 57 then the option will expire worthless else the payo¤ is the average
price on the realized path of prices. Consider a binomial model of the stock
price whose current price is 50 and that will either go up in value by a factor of
1.5 or go down by a factor of 0.5 next period. Suppose the per period risk free
rate is 10%.
Use a three period binomial model of stock prices and …nd the price of this
exotic option. Show all work. (note: as an illustration of a realized path of
prices for the three period model consider that one possible path is (50, 25,
37.5, 56.25) and the average price on this path is 42.1875).

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APS 502 Financial Engineering Dec.

Problem 1 (12 points)

For example, asset 3 has a standard deviation of 3 = 0:20 = 20% and an

Determine whether or not each portfolio above could be a minimum variance

Rank the portfolios from best to worst. Show all work.

security E[ ] (expected return) (beta)

security E[ ] (expected return) (standard deviation)

Problem 6 (15 points)

Problem 7 (16 points)

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