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Asset Pricing: Assignment #1 Due Date, March 18, 2020: The Asset's Return Is Thus Log-Normally Distributed

The document outlines an assignment on asset pricing that includes 5 problems: 1) Deriving pricing formulas for a CARA investor buying a normally distributed asset. 2) Showing stochastic dominance between random variables with different means. 3) Deriving an expected utility maximizing consumption formula for a CRRA investor. 4) Deriving an expression for the minimum-variance portfolio without a risk-free asset. 5) Analyzing an investor's optimal portfolio and Sharpe ratio in a multi-asset market.

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jeremy Antonin
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51 views

Asset Pricing: Assignment #1 Due Date, March 18, 2020: The Asset's Return Is Thus Log-Normally Distributed

The document outlines an assignment on asset pricing that includes 5 problems: 1) Deriving pricing formulas for a CARA investor buying a normally distributed asset. 2) Showing stochastic dominance between random variables with different means. 3) Deriving an expected utility maximizing consumption formula for a CRRA investor. 4) Deriving an expression for the minimum-variance portfolio without a risk-free asset. 5) Analyzing an investor's optimal portfolio and Sharpe ratio in a multi-asset market.

Uploaded by

jeremy Antonin
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Asset Pricing: Assignment #1

Due date, March 18, 2020

1. Decision theory: Using univariate analysis, it can be shown that


Z ∞
1 (x−µ)2 γ 2
√ e− 2σ2 −γx d x = e−γ (µ− 2 σ ) ,
2πσ 2 −∞
γ 2
which in turn implies that E[e−γX ] = e−γ (µ− 2 σ ) , for a normally distributed random variable
X ∼ N (µ, σ 2 ).

Consider a CARA investor with risk aversion coefficient γ, who considers buying an asset
that promises payoffs X̃ ∼ N (µ, σ 2 ).

(a) Derive a formula for the price, P , that makes the investor indifferent between buying
the asset or not.

(b) Assume that the (gross) risk-free rate is Rf = 1 + rf , which means that the investor
can instead deposit P in the bank and then receive P (1 + rf ), as opposed to buying the
asset for P and receive X̃. Derive a formula for the price, P , that makes the investor
indifferent between buying the asset and depositing the money in the bank.

2. Stochastic dominance: Let X̃ be a random variable with E[X̃] = 0, V ar(X̃) > 0, and define
the random variables Ỹa = aX̃, a > 0, with associated cumulative distribution functions Fa .
Show that Fa second order stochastically Dominates Fb if and only if a ≤ b.

3. Multi-period decisions: Consider a two-date economy, as discussed a in class, in which an


investor with time-separable expected utility, U = u(c0 ) + δE[u(c1 )], 0 < δ < 1, and wealth
W = 1, determines how much to consume at date 0 and how much to invest in a risky asset
with returns R̃ = ex̃ , where x̃ is normally distributed, x̃ ∼ N (µ, σ 2 ), σ > 0.1 Assume that
the investor has CRRA preferences with relative risk aversion coefficient γ.

Derive a formula for how much the expected utility maximizing investor will consume at time
0, c0 , as a function of the parameters, γ, δ, µ, and σ.

4. Modern Portfolio Theory I : Derive an expression for the minimum-variance portfolio in a


market without risk-free asset, as discussed in class.

5. Modern Portfolio Theory II : Consider an investor with mean-variance preferences, U =


E[Rp ] − γ2 V ar(Rp ), and initial wealth W . The market consists of N risky assets, with returns
1
The asset’s return is thus log-normally distributed.

1
Rn , E[Rn ] = µn , V ar(Rn ) = σn2 = σnn , and Cov(Rn , Rm ) = σnm , 1 ≤ n, m ≤ N . There is
also a risk-free asset, offering return Rf > 1.

Consider the case for which σnn = a > 0, for all n, and that σnm = b, 0 < b < a for all n and
m 6= n.

(a) Assume that µn = c > Rf for all n. Derive a formula for the portfolio weights, wN ,
the investor will choose, as well as the total amount, V he/she will invest. The formula
should be general, (allowing dependence on a, b, c, γ, W , and N ).

(b) Derive a formula for the Sharpe ratio of the investor’s portfolio in question 5(a).

(c) What is the limit of the formula in 5(b), as N → ∞? Verify the derived limit by plotting
the Sharpe ratio as a function of N , using parameters: a = 0.1, b = 0.01, c = 0.1, γ = 2,
W = 1?

(d) Now, consider the case when µn = c > Rf for n = 1, . . . , N/2, and µn = c + ,  > 0, for
n = N/2 + 1, . . . , N (where N is even). Repeat the analysis in 5(a-c), using  = 0.01 in
the plot.

(e) Finally, consider a situation where the expected returns, the µs, were estimated from
observed data, and therefore contained some estimation errors. What inferences can one
draw about the portfolio choice problem in this situation, from your analysis in 5(a-d)?
Explain!

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