001 2010 4 e

Department of Decision Sciences
Financial Risk Modelling

Only study guide for
DSC3705
University of South Africa
Pretoria
c UNISA 2010
Department of Decision Sciences
University of South-Africa
All rights reserved.
Printed and distributed by the
University of South-Africa
Mucleneuk, Pretoria.
DSC3705/2010
CONTENTS 1 DSC3705
Contents
1 Study unit 1
Introduction 4
2 Study unit 2
Mean-variance portfolio theory 5
2.1 Chapter 6.1: Asset returns . . . . . . . . . . . . . . . . . . . . 5
2.2 Chapters 6.2 to 6.3: Random variables . . . . . . . . . . . . . 7
2.3 Chapter 6.4: Portfolio mean and variance . . . . . . . . . . . . 10
2.4 Chapter 6.5: The feasible set . . . . . . . . . . . . . . . . . . . 18
2.5 Chapter 6.6: The Markowitz model . . . . . . . . . . . . . . . 18
2.6 Chapter 6.7: The two-fund theorem . . . . . . . . . . . . . . . 24
2.7 Chapters 6.8 to 6.9: Inclusion of a risk-free asset . . . . . . . . 26
2.8 Chapter 6.10: Summary . . . . . . . . . . . . . . . . . . . . . 26
3 Study unit 3
The capital asset pricing model 27
3.1 Chapter 7.1: Market equilibrium . . . . . . . . . . . . . . . . . 27
3.2 Chapter 7.2: The capital market line . . . . . . . . . . . . . . 28
3.3 Chapter 7.3: The pricing model . . . . . . . . . . . . . . . . . 30
3.4 Chapter 7.4: The security market line . . . . . . . . . . . . . . 31
3.5 Chapter 7.5: Investment implications . . . . . . . . . . . . . . 35
3.6 Chapter 7.6: Performance evaluation . . . . . . . . . . . . . . 35
CONTENTS 2 DSC3705
3.7 Chapter 7.7: The CAPM as a pricing formula . . . . . . . . . 37
3.8 Chapter 7.9: Summary . . . . . . . . . . . . . . . . . . . . . . 38
4 Study unit 4
Models and data 39
4.1 Chapter 8.2: Factor model . . . . . . . . . . . . . . . . . . . . 39
4.2 Chapter 8.3: The CAPM as a factor model . . . . . . . . . . . 45
4.3 Chapter 8.4: Arbitrage pricing theory . . . . . . . . . . . . . . 47
4.4 Chapter 8.9: Summary . . . . . . . . . . . . . . . . . . . . . . 47
5 Study unit 5
General principles 48
5.1 Chapter 9.2: Utility functions . . . . . . . . . . . . . . . . . . 48
5.2 Chapter 9.3: Risk aversion . . . . . . . . . . . . . . . . . . . . 49
5.3 Chapter 9.4: Specication of utility functions . . . . . . . . . 49
5.4 Chapter 9.5: Utility functions and the mean-variance criterion 49
5.5 Chapter 9.6: Linear pricing . . . . . . . . . . . . . . . . . . . 50
5.6 Chapter 9.7: Portfolio choice . . . . . . . . . . . . . . . . . . . 50
5.7 Chapter 9.9: Finite state models . . . . . . . . . . . . . . . . . 54
5.8 Chapter 9.10: Risk-neutral pricing . . . . . . . . . . . . . . . 57
5.9 Chapter 9.12: Summary . . . . . . . . . . . . . . . . . . . . . 58
6 Appendix
Utility and Risk Preferences 60
CONTENTS 3 DSC3705
6.1 Expected utility . . . . . . . . . . . . . . . . . . . . . . . . . . 61
6.2 The utility function and risk behaviour . . . . . . . . . . . . . 65
6.2.1 Certainty equivalent . . . . . . . . . . . . . . . . . . . 68
6.2.2 Risk prole . . . . . . . . . . . . . . . . . . . . . . . . 70
6.3 Arrow-Pratt . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
6.4 Optimisation . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
7 Solutions: Exercises in study unit 2 82
11 References 106
4 DSC3705
In this module we follow the textbook, Investment Science by David Luen-
berger closely. This study guide indicates the chapters covered in this module
and the exercises in the textbook that you should do. It also includes extra
study notes, study outcomes and study hints to help you. The notes clarify
some of the diculties you may experience in using the textbook.
The references and exercises refer to the textbook and it is indicated with Lu-
enberger. After studying each chapter (including the examples), you should
work through the exercises indicated in the study guide and make sure you
understand the solutions.
You should spend approximately 120 hours on this module (it is the time
spent on problem solving, reading and studying).
1 Study unit 1
Introduction
Luenberger: Chapter 1 and Chapters 2.1, 2.2 and 2.3
Purpose
The rst two chapters revise concepts covered in your rst- and second-
year modules using the textbooks terminology. The rst chapter explains
general investment concepts, while the second chapter explains and denes
basic concepts and principles in the interest rate theory.
Study hints
Read through these chapters and make sure you understand the following
concepts:
cash ows (deterministic/random)
comparison principle
arbitrage
no-arbitrage assumption
5 DSC3705
dynamics of investments
risk aversion
hedging versus pure investments
simple interest
compound interest
continuous compounding interest
present and future values of cash ows
2 Study unit 2
Mean-variance portfolio theory
Luenberger: Chapter 6
Purpose
We apply mean-variance analysis to model uncertainty in nancial decision-
making.
2.1 Chapter 6.1: Asset returns
Study hints
At the end of this section you should be able to do the following:
Distinguish between total return R and the rate of return r.
Explain the process of short selling.
Explain why short selling is considered to be risky.
6 DSC3705
Activity
Work through the calculations of the portfolio weights and the expected rate
of return of the portfolio in Table 6.1(Luenberger, page 141).
Apply the formulas on page 140 with:
w
1
= 0,25, w
2
= 0,50 and w
3
= 0,25
r
1
= 0,17, r
2
= 0,13 and r
3
= 0,23
R
1
= 1,17, R
2
= 1,13 and R
3
= 1,23
X
0
= 16 000
X
01
= w
1
X
0
= ............
X
02
= w
2
X
0
= ............
X
03
= w
3
X
0
= ..........
Then
R =
R
1
(w
1
X
0
) +R
2
(w
2
X
0
) + R
3
(w
3
X
0
)
X
0
= ..................................................
= ..................................................
Also determine R using the formula:
R =
3
i=1
w
i
R
i
= ............................
Determine r =
3
i=1
w
i
r
i
= ...................
7 DSC3705
2.2 Chapters 6.2 to 6.3: Random variables
Revision notes
See Appendix A, page 475 (Luenberger) and the OPS/QMS/OMG202 or
DSC2602 study guide. You may also consult the textbook by Winston used
in the other modules.
Study hints
Explain what a random variable is.
Dene a probability function p(x).
Dene and calculate the expected value, variance and standard devia-
tion of a random variable.
Explain independent random variables.
Dene and calculate the covariance of two random variables.
Derive equation 6.3.
Derive equation 6.4.
Construct a mean-standard deviation diagram (or r diagram).
Study note
Properties of the covariance between random variables are often used in
the module. For revision consult Winston or the QMG/OPS/QMS202 or
DSC2602 study guide.
The denition for covariance is given on page 144.
The textbook uses the notation x
i
to refer to a random variable. However,
it is sometimes useful to indicate a random variable with a tilde and write
x
i
to distinguish it from real numbers.
8 DSC3705
Let x and y and z be real-valued random variables and a and b real numbers.
Suppose E[ x] = x and E[ y] = y. Then the following holds:
cov( x, y) = E[( x x)( y y)] (denition)
cov( x, y) = E( x y) x y
if x and y are independent, then cov( x, y) = 0
cov( x, x) = var( x)
cov( x, y) = cov( y, x)
cov(a x,b y) = ab cov( x, y)
cov(a x + b y, z) = a cov( x, z) + b cov( y, z)
Activity
Suppose the following possible rates of return (in percentage) for two assets
r
1
and r
2
are available.
market condition probability asset 1 asset 2
good p
1
15 1
average p
2
9 10
poor p
3
3 19
Suppose the alternative return on each asset are assumed equally likely (thus
the probability for each market condition is the same). Then p
i
=
1
3
for
i = 1; 2; 3.
Express the % values in decimal form. Determine the mean rate of return
(or expected rate of return) for each asset:
r
1
= E[ r
1
] =
1
3
(0,15) +
1
3
(0,09) +
1
3
(0,03) = 0,09
r
2
= E[ r
2
] = ...............................................
9 DSC3705
var( r
1
) = E[ r
2
1
] ( r
1
)
2
=
1
3
(0,15)
3
+
1
3
(0,09)
2
+
1
3
(0,03)
2
(0,09)
2
= 0,0024
Then the standard deviation
1
=.....................
Determine (in the space below)
2
, the standard deviation of asset 2:
The covariance
12
between asset 1 and asset 2 is:
12
= cov( r
1
, r
2
) = E[( r
1
r
1
)( r
2
r
2
)]
=
1
3
(0,15 0,09)(0,01 0,10) +
1
3
(0,09 0,09)(0,10 0,10)
+
1
3
(0,03 0,09)(0,19 0,10)
= .......................
Calculate (in the space below) the correlation coecient using the formula
12
=

12
2
:
(Did you obtain the answers
1
0,04899,
2
0,073489 and
12
0,9996?)
Calculate cov( r
1
, r
1
) using the denition cov( r
1
, r
1
) = E[( r
1
r
1
)( r
1
r
1
)].
Note that cov( r
1
, r
1
) = var( r
1
) =
11
. The notation
2
1
is also used to indicate
the variance.
10 DSC3705
Please do the following exercise before continuing with the study

material and textbook.
Exercise 2.2.1
1. Derive equation 6.3 (Luenberger p145)
2. Use the data in the previous table. Determine r
1
, r
2
,
1
,
2
,
12
and
12
if p
1
=
1
2
, p
2
=
1
3
and p
3
=
1
6
.
2.3 Chapter 6.4: Portfolio mean and variance

Explanation of the word portfolio from the Merriam-Webster online dictio-
nary:
(http://www.merriam-webster.com/dictionary/)
port fo lio
Function: noun
Inected Form(s): plural portfolios
Etymology: Italian portafoglio, from portare to carry (from Latin)
+ foglio leaf, sheet, from Latin folium
Date: 1722
1: a hinged cover or exible case for carrying loose papers, pic-
tures, or pamphlets
2 [from the use of such a case to carry documents of state] : the
oce and functions of a minister of state or member of a cabinet
3: the securities held by an investor : the commercial paper held
by a nancial house (as a bank)
4: a set of pictures (as drawings or photographs) usually bound
11 DSC3705
in book form or loose in a folder
5: a selection of a students work (as papers and tests) com-
piled over a period of time and used for assessing performance or
progress
In this module a portfolio refers to a collection of investments or nancial
assets held by an investor or a nancial institution. For example an indi-
viduals portfolio may consists of the following assets: an investment in a
savings account; 100 shares in ShopNow; 1 000 shares in AFB Bank and an
investment in RSA-Retail bonds.
Study hints
Calculate the mean return of a portfolio.
Calculate the variance of the rate of return of a portfolio.
Derive the equation
2
P
=
i,j
w
i
w
j
ij
.
Explain the eects of diversication with reference to uncorrelated and
correlated assets (see the diagram at the top of page 152).
Understand and interpret the r- diagram of a portfolio (gure 6.8).
Formulate and apply the portfolio diagram lemma.
12 DSC3705
Study note 1
Suppose a portfolio consists of n assets with random rates of return r
i
. The
textbook uses the notation r
i
without a tilde on pages 150 and 151: however
we want to emphasize that a assets rate of return is uncertain or a random
variable.
The expected rate of return of asset i is E[ r
i
] = r
i
. Suppose we form a
portfolio of these n assets, with weight w
i
for asset
i
. Then the overall rate of
return of the portfolio r is also a random variable with r =
n
i=1
w
i
r
i
. The
expected rate of return or mean of the portfolio is indicated by E[ r] or r.
Then the expected rate of return (or mean) of the portfolio satises:
E[ r] =
n
i=1
w
i
E[ r
i
]
=
n
i=1
w
i
r
i
Remember r and r
i
are constants, and r and r
i
are random variables.
The expected variance of the portfolio return is:
var( r) =
2
=
n
i,j=1
w
i
w
j
ij
Activity
The results of the activity on page 8 are summarised in the next table:
asset 1 asset 2
mean rate of return 0,09 0,10
variance 0,0024 0,0054
The covariance between asset 1 and 2 is equal to 0,0036.
13 DSC3705
Suppose a portfolio is constructed by taking equal parts in the two assets.
Determine the expected rate of return of the portfolio and the variance of
the portfolio return.
Note that:
w
1
=
1
2
; w
2
=
1
2
; r
1
= 0,09; r
2
= 0,10;
11
= 0,0024;
22
= 0,0054 and
12
= 0,0036.
Then:
r
p
= E[ r] = w
1
r
1
+ w
2
r
2
= ...................
2
p
=
2
i,j=1
w
i
w
j
ij
= w
1
w
1
11
+ w
1
w
2
12
+ w
2
w
1
21
+ w
2
w
2
22
= w
2
1
11
+ 2w
1
w
2
12
+ w
2
2
22
= ............................................
= ............................................
Study note 2
Suppose a portfolio is constructed by taking equal portions of the n assets.
Assume the assets are mutually uncorrelated. Suppose that the expected
rate of return (or mean) of each asset is equal to m and the variance of each
asset is equal to
2
.
Then the weights are w
i
=
1
n
, i = 1; . . . ; n and the expected rate of return
(or mean) of the portfolio satises:
14 DSC3705
r = E[ r]
=
1
n
n
i=1
E[ r
i
]
=
1
n
n
i=1
r
i
=
1
n
n
i=1
m
=
1
n
(nm)
= m
The variance of the portfolio satises:
var( r) =
2
=
n
i,j=1
w
i
w
j
ij
=
n
i,j=1
1
n
1
n
ij
=
1
n
2
n
i=1
2
=
1
n
2
(n
2
)
=

2
n
(Remember the assets are uncorrelated, thus
ij
= 0, if i = j. Also:
ii
=
2
for i = 1; . . . ; n. )
Note that the mean value r is independent of n, but the variance decreases
if n increases, and the risk of the portfolio is reduced.
15 DSC3705
Activity
To understand the proof of the portfolio diagram lemma consider a portfolio
with the following two assets:
asset mean return r
i
standard deviation
i
weight w
i
i = 1 0,10 0,20 (1 )
i = 2 0,15 0,25
(a) Plot the coordinates of asset 1 (0,20; 0,10) and asset 2 (0,25; 0,15) on a
r diagram. Note that r is on the y-axis and on the x-axis. Compare
with points 1 and 2 in gure 6.8 (Luenberger).
(b) Calculate the mean return ( r) of the portfolio and the standard deviation
() of the portfolio return. Then
r = w
1
r
1
+ w
2
r
2
= (1 )(0,10) +(0,15) = 0,10 + 0,05
Note that the textbook uses the notation r() to indicate that the expected
return is a function of the weight , hence we may write r() = 0,10+0,05.
=
_
(1 )
2
(0,20)
2
+ 2(1 )
12
+
2
(0,25)
2
.
Case 1: = 1
=

12
2
. Thus if = 1 then
12
= (0,20)(0,25).
Complete the following table:
r = =
0
0,5
1,0
The coordinates of (; r) for = 0, =
1
2
and = 1 are (0,20; 0,10),
(0,2250; 0,125), (0,25; 0,15). Plot these coordinates on the diagram in (a).
Notice that these three points are on a straight line in the mean-standard
16 DSC3705
deviation diagram. This line is indicated with = 1 on the diagram in gure
6.8.
Case 2: = 1.
If = 1 then
12
= (0,20)(0,25). Use the equation on page 154 to obtain
()
= |0,20(1 ) + 0,25|. Write down the steps in the space below:

Then 0,20(1 ) 0,25 = 0 implies = 0,44. You may also apply the
formula =

1
1
+
2
to obtain 0,44. Verify the value 0,44 in the space below:
If > 0,44, the values r of the portfolio will be on the straight line
connecting (0; A) = (0;
(0,10)(0,24)+(0,15)(0,20)
0,20+0,25
) = (0; 0,122) and (
2
; r
2
) (or point
2), thus the upper straight line in gure 6.8. If < 0,44, the portfolio mean
and standard deviation will be on the straight line between (0; A) and (
1
; r
1
)
(or point 1), thus the lower line in gure 6.8. Note that the boundaries of
the triangle between A, point 1 and point 2 in gure 6.8 cover all possible
portfolio outcomes if = 1.
Choose any value for and determine the mean and standard deviation of
the portfolio:
Plot the coordinates on the diagram in (a) to verify that this coordinate is
either on the upper straight line or the lower straight line.
Case 3
For other values the portfolios mean and standard deviation will not be
on a straight line. The coordinates will be on a curve connecting points 1
17 DSC3705
and 2 within the boundaries of the triangle.
For example, suppose
12
= 0,01.
Determine the value for :
......................................
Calculate the portfolio mean and standard deviation and complete the fol-
lowing table:
r = =
0
0,25
0,5
0,75
1,0
Then the portfolio values for = 0,0; 0,25; 0,5; 0,75; 1 are (0,20; 0,10), (0,1737; 0,1125),
(0,1750; 0,1250), (0,1737; 0,1375), (0,25; 0,15). If these values are represented
on the diagram in (a) and are connected a curve-shaped graph is obtained.
One of the problems in Assignment 1 is a practical problem to understand
gure 6.8 (the portfolio diagram). Please do this problem and construct the
diagram with two assets. Although this is quite time-consuming you will
benet from the time spent on this problem.
Please do the following exercise before continuing with the study

material and textbook.
Exercise 2.3.1
1. This question refers to the example on p152 (Luenberger).
Suppose that each assets random rate of return r
i
, i = 1; 2; 3 has mean (or
expected value) m and variance
2
. Assume each return pair has a covariance
cov(r
i
,r
j
) = 0,3
2
for i = j. Suppose a portfolio consists of equal portions of
18 DSC3705
the three assets. Show that the variance of the portfolio return satises the
following equation.
var(r) =
0,7
2
3
+ 0,3
2
2.4 Chapter 6.5: The feasible set

Study hints
At the end of this section you should be able to answer the following:
What is a feasible set?
What is a minimum-variance set?
Which portfolio will a risk-averse investor prefer?
Where is the ecient frontier on a r diagram?
Which is the minimum-variance point (MVP)?
2.5 Chapter 6.6: The Markowitz model
Study hints
Formulate the mathematical problem that leads to minimum-variance
portfolios for n assets.
Apply the Lagrangean method to derive the equations that should be
solved to determine the weights of portfolios that lead to minimum-
variance portfolios. Note that dierent weights are obtained for each
specic r. The weights are used to determine the standard deviation
of the portfolio. The coordinates (; r) are points on the minimum-
variance set.
19 DSC3705
Formulate the equations for the ecient set.
Determine the minimum-variance point (MVP) (in special cases).
Study note
The following example will improve your understanding of the basic principles
in this section.
Activity
Work through all the steps in the following example.
Suppose there are two assets with mean rate of return values 0,10 and 0,18.
Suppose
11
= 0,0225,
22
= 0,09 and
12
= 0,0045. Let portions w
1
and w
2
be invested in asset 1 and asset 2.
Formulate the Markowitz model (see page 158 in the text book):
Minimise
z =
1
2
[w
1
w
1
(0,0225) + 2w
1
w
2
(0,0045) +w
2
w
2
(0,09)]
Subject to
0,10w
1
+ 0,18w
2
= r
w
1
+ w
2
= 1
Derive the Lagrangean equations to nd the minimum-variance for a given
r:
L =
1
2
(0,0225)w
2
1
+w
1
w
2
(0,0045)+
1
2
(0,09)w
2
2
(0,10w
1
+0,18(w
2
r)(w
1
+w
2
1)
Hence,
L
w
1
= 0,0225w
1
+ 0,0045w
2
0,10
L
w
2
= 0,0045w
1
+ 0,09w
2
0,18 .
20 DSC3705
Then the set of equations to determine an ecient portfolio with mean rate
of return r is:
0,0225w
1
+ 0,0045w
2
0,10 = 0
0,0045w
1
+ 0,09w
2
0,18 = 0
0,10w
1
+ 0,18w
2
= r
w
1
+ w
2
= 1
For each r, one should solve:
_
_
0,0225 0,0045 0,10 1
0,0045 0,09 0,18 1
0,10 0,18 0 0
1 1 0 0
_
_
_
_
w
1
w
2
_
=
_
_
0
0
r
1
_
_
.
For instance, if r = 0,12, the solution to the previous system of equations is:
_
_
0,75
0,25
0,0984
0,0082
_
_
Activity
Use Maxima/Mupad/Matlab/Derive to verify the solution.
In this special case where n = 2, one need only solve the last two equations
for every r. (This will only be possible if n = 2.)
Thus for r = 0,12 we should solve:
0,10w
1
+ 0,18w
2
= 0,12
w
1
+ w
2
= 1.
21 DSC3705
Activity
Show that the solution to
_
0,10 0,18
1 1
_ _
w
1
w
2
_
=
_
0,12
1
_
is
_
0,75
0,25
_
.
For each r, one determines the weights of a portfolio on the minimum-
variance set. Then the variance, and hence the standard deviation, of the
portfolio are calculated.
The following table is a summary of a few possible portfolios on the minimum-
variance set. Verify some of the values, to make sure you know how to do
the calculations.
r w
1
w
2

0,10 1 0 0,15
0,11 0,875 0,125 0,1401
0,12 0,75 0,25 0,1413
0,13 0,6250 0,3750 0,1513
0,14 0,5 0,5 0,1743
0,15 0,375 0,625 0,2011
0,16 0,25 0,75 0,2318
0,18 0 1 0,30
Activity
Plot the standard deviation and expected return values on a r diagram
to obtain the minimum-variance set.
Note that the minimum-variance point (MVP) will be between r = 0,10 and
r = 0,12. (Compare the values and remember the minimum should be
calculated.) How do we determine the coordinates of the minimum-variance
point? Since this is an example with n = 2, the problem can be reduced to
a single-variable calculus problem.
22 DSC3705
Let w
1
= and w
2
= 1 . We should determine the minimum of
z = 0,0225
2
+ 2(1 )(0,0045) + (1 )
2
(0,09).
Remember that if z
() = 0 and z
() > 0, z has a minimum value z()

(rst-year calculus).
z
() = 2(0,0225)+2(1)(0,0045)+2(1)(0,0045)+2(0,09)(1)(1).
Activity
Solve z
() = 0 to obtain 0,8261.
Verify that z
(0,8261) 0,21 > 0.

Thus z has a minimum value if 0,8261.
Then r
MV P
0,8261(0,10) + (1 0,8261)(0,18) 0,1139.
The minimum-variance is:
2
MV P
(0,8261)
2
(0,0225) + 2(0,8261)(1 0,8261)(0,0045) + (1 0,8261)
2
(0,09)
0,0194
Thus
MV P
0,1392.
Indicate the point, MV P = (0,1392; 0,1139), on the previous r diagram.
Alternative method to nd the minimum-variance point:
See the comment before Example 6.11 on page 163 for another method to
obtain the weights of the minimum-variance set.
Hence, set = 1 and = 0 is the following equations (see equation 6.5a in
23 DSC3705
the textbook) and solve the system of equations.
0,0225w
1
+ 0,0045w
2
0,10 = 0
0,0045w
1
+ 0,09w
2
0,18 = 0
Then the equations are:
.....................................................................
.....................................................................
Solve the above system of system of linear equations:
Then:
w
1
=...............................
w
2
=...............................
Since equation (6.5c) should also be satised, divide each value with
2
i=1
w
i
,
the sum of the two values.
Hence the weights are:
....................................
Compare your solution to the previous solution.
Note: The set of equations in example 6.10 (page 161) could be solved using
quadratic programming techniques and computer packages (Lingo).
24 DSC3705
2.6 Chapter 6.7: The two-fund theorem
Study hints
Formulate and apply the two-fund theorem.
Study note
Verify all the steps in the following example:
Suppose there are two mutual funds w
1
and w
2
available on the minimum-
variance set with:
Fund Weights Expected return Standard deviation
w
1
(w
1
1
; w
1
2
; . . . ; w
1
n
) r
1
1
w
2
(w
2
1
; w
2
2
; . . . ; w
2
n
) r
2
2
NB: Note that the superscripts 1 and 2 in this problem indicate fund 1 and
fund 2, thus r
1
is the expected return of fund 1 and r
2
is the expected return
of fund 2. Then
1
is the standard deviation of fund 1 and
2
is the standard
deviation of fund 2. In this problem
2
does not indicate . See also the
notation on page 162.
Since portfolios 1 and 2 are on the minimum-variance set, both satisfy equa-
tions 6.8a, 6.8b and 6.8c on page 162.
Activity: Write down the equations for the two portfolios:
Then a new portfolio with weights (w
1
1
; w
1
2
; . . . ; w
1
n
)+(1)(w
2
1
; w
2
2
; . . . ; w
2
n
)
is also a minimum-variance portfolio for any R. To prove that the
new portfolio is a minimum-variance portfolio we should show that the new
portfolio satises equations 6.8a to 6.8c.
Suppose the weights of the new portfolio p are w
p
1
; . . . ; w
p
n
.
25 DSC3705
Then w
p
i
= w
1
i
+ (1 )w
2
i
. Hence:
n
i=1
w
p
i
=
n
i=1
[w
1
i
+ (1 )w
2
i
]
=
n
i=1
w
1
i
+ (1 )
n
i=1
w
2
i
= 1 + (1 ) 1
= 1
and equation 6.8c is satised. (
w
1
i
= 1 and
w
2
i
= 1 since portfolios 1
and 2 satisfy equation 6.8c.)
To show that equation 6.8b is satised, remember the n assets have return
r
1
; r
2
; . . . ; r
n
and r
1
=
w
1
i
r
i
and r
2
=
w
2
i
r
i
.
Then:
n
i=1
w
p
i
r
i
=
n
i=1
(w
1
i
+ (1 )w
2
i
) r
i
=
n
i=1
w
1
i
r
i
+ (1 )
n
i=1
w
2
i
r
i
= r
1
+ (1 ) r
2
= r
p
Next we show that the new portfolio satises the minimum-variance condition
(equation 6.8a).
The following holds for each i (i = 1; 2; . . . ; n):
n
j=1
ij
w
p
j
r
p
i
=
n
j=1
ij
[w
1
j
+ (1 )w
2
j
] r
p
i

=
n
j=1
ij
w
1
j
+ (1 )
n
j=1
ij
w
2
j
r
p
i

= [ r
1
i
] + (1 )[ r
2
i
] ( r
1
i
+ (1 ) r
2
i
]
= 0
Conclusion: If the weights of two mutual funds on the minimum-variance set
are available, the portfolio with the weights w
1
i
+ (1 )w
2
i
, i = 1; . . . ; n is
26 DSC3705
also on the minimum-variance set. The return of this new portfolio will then
be r = r
1
+ (1 ) r
2
. Hence, if you want a minimum-variance portfolio
with a value r
, then r
= r
1
+ (1 ) r
2
. Express in terms of r
, r
1
and
r
2
. Hence, choose =
r
r
2
r
1
r
2
and invest this portion in fund 1 and the rest
in fund 2.
One method to nd two funds on a minimum-variance set is to solve equation
6.8a with = 0 and = 1 to calculate the weights of one fund. To determine
the weights of the second fund solve equation 6.8a with = 1 and = 0. In
the rst case, the r constraint (equation 6.8b) is ignored, while in the second
case the weights constraint (equation 6.8c) is ignored.
Note that in the rst case you ignore the r constraint, thus the minimum-
variance value (obtain from the set of weights) is independent of r, and you
obtain the minimum-variance point of the set.
2.7 Chapters 6.8 to 6.9: Inclusion of a risk-free asset
Study hints
At the end of this section you should be able to:
Dene the rate of return of a portfolio with one risk-free asset.
Dene the standard deviation of a portfolio with one risk-free asset.
Formulate the one-fund theorem and illustrate the theorem on a r
diagram.
Apply the one-fund theorem in a simplied case.
2.8 Chapter 6.10: Summary
Read and understand this paragraph. It is an excellent summary of all the
important concepts in the chapter.
27 DSC3705
Do the following exercise before continuing:

Exercise 2.8.1
1. Luenberger p170, 6.3
3 Study unit 3
The capital asset pricing model
Purpose
We discuss the capital asset pricing model (CAPM) and apply it to invest-
ment decision problems. The CAPM describes the relationship between the
expected return of a asset and its risk relative to the market risk. It is used
in the pricing of risky securities.
3.1 Chapter 7.1: Market equilibrium
The concept of a market portfolio is discussed. Remember that a market
portfolio exists in an idealised environment and the concept leads to philo-
sophical debates. In the framework of this chapter we assume a market
portfolio exits.
28 DSC3705
Study hints
Discuss the concept of the market portfolio.
Dene capitalisation weights.
3.2 Chapter 7.2: The capital market line
Study note
The capital market line represents the set of risk-return combinations avail-
able by combining the market portfolio with risk-free borrowing or lending.
It is represented on a r diagram (or a mean-standard deviation diagram.)
The capital market line relates the expected rate of return ( r) for an ecient
portfolio to a given risk of return (measured by the standard deviation ()).
It is based on the idea that an investor demands additional expected return
(called the risk premium) if he/she is asked to accept additional risk. For a
given level of risk, the portfolio located on this line oers the best return. The
capital market line is graphically tangent to the ecient frontier containing
the market portfolio.
The capital market line passes through the risk-free point and the market
portfolio. Hence, to determine the equation of the capital market line, you
should determine the equation of the straight line that passes through (0; r
f
)
and (
M
; r
M
), with r
f
the risk free rate, r
M
the market rate of return and
M
the market standard deviation of return.
Activity
Suppose the All-Shares index for a country is used as a proxy for the market
of the country. Suppose the expected rate of return of the index is 13% and
the standard deviation of the rates of return is 19%. Suppose the current
risk-free rate is 9%.
Determine the equation of the capital market line. Represent the capital
market line graphically.
29 DSC3705
Solution:
Given: r
f
= 0,09; r
M
= 0,13;
M
= 0,19
Equation of the capital market line (see equation 7.1 p 176, Luenberger):
r = r
f
+
_
r
M
r
f
M
_
= ...............................
= ................................
Did you obtain the equation r = 0,09 + 0,2105?
Draw a graph of this straight line with r on the y-axis and on the x-axis (or
use Maxima to plot the function). Note that it is important to indicate the
coordinates (or position) of the risk-free asset and the market on the graph
and to use a proper scale.
Study hints
Derive equation (7.1) of the capital market line.
Represent the capital market line on a r diagram.
Dene, calculate and interpret the price of risk.
30 DSC3705
Understand that the capital maket line relates the expected rate of
return of an ecient portfolio to its standard deviation.
3.3 Chapter 7.3: The pricing model
This section discusses the theory of the capital asset pricing model.
Study hints
Formulate the capital asset pricing model (CAPM).
Prove the capital asset pricing model (CAPM).
Dene and interpret the beta () of an asset.
Apply the CAPM formula.
Determine the beta of a portfolio.
Understand that the expected rate of return of an asset is proportional
to its covariance with the market.
Study notes
Make sure you understand the following:
For an individual asset, is a good indication of risk.
For a portfolio, is a good indication of risk.
r
f
is the risk-free rate of return.
r
i
r
f
is the expected excess rate of return of asset i.
r
M
r
f
is the expected excess return of the market.
The expected excess return of the individual asset i is proportional to
the expected excess return of the market. The value of measures this
proportion.
31 DSC3705
3.4 Chapter 7.4: The security market line
Study hints
Determine the equation of a security market line in terms of the co-
variance of assets and the market (thus cov(r,r
M
) is on the x-axis).
Determine the equation of a security market line in terms of the beta
of assets (thus is on the x-axis).
Represent the security market line on a graph.
Dene systematic risk.
Explain nonsystematic risk.
Explain diversication.
Know that ecient (minimum-variance) assets have systematic risk
only.
Work through the explanation in the following study notes.
Study note 1
The CAPM model can be represented as a security market line. There are
two possible equations to describe this security market line.
Equation 1
The security line can be expressed in terms of the expected asset return r
i
and the covariance of the asset and the market
iM
. The equation is:
r
i
=
_
r
M
r
f
2
M
_
iM
+ r
f
.
Hence, the risk-reward is expressed in terms of the covariance of the return
with the market. To sketch this equation, note that the covariance
iM
is
32 DSC3705
represented on the x-axis and the expected return is represented on the y-
axis. See gure 7.3a (Luenberger). Note that if the asset is the market, then
the expected return is r
M
and
iM
=
MM
=
2
M
. This value is indicated
with an M in gure 7.3a (Luenberger).
Equation 2
The security line can also be expressed as
r
i
= ( r
M
r
f
)
i
+ r
f
.
In this case, the risk-reward is expressed as a linear relationship between the
expected return of asset i and the beta of the asset. Thus the risk of an asset
is a function of its beta. To sketch this equation note that the
i
value is on
the x-axis, and the expected return on the y-axis.
Activity
Suppose the All-Shares index for a country is used as a proxy for the market
of the country. Suppose the expected rate of return of the index is 13% and
the standard deviation of the rates of return is 19%. Suppose the current
risk-free rate is 9%.
1. Determine the equation of the security market market line in terms of the
covariance of asset i and the market M (
iM
). Represent the equation on a
(
iM
; r) -diagram.
Solution
Apply equation 1. The equation of the security market line is:
r
i
= r
f
+

iM
2
M
( r
M
r
f
)
= ..............................
= ..............................
Did you obtain r = 0,09 + 1,1080
iM
?
Draw a graph of this straight line with r on the y-axis and
iM
on the x-axis
33 DSC3705
(or use Maxima to plot the function). Indicate the positions of the risk-free
asset and the market on the graph and use a proper scale.
2. Determine the equation of the security market line in terms of
i
. Repre-
sent the equation of the security market line on a (
i
; r)-diagram.
Solution:
Apply equation 2. The equation of the security market line is:
r
i
= r
f
+
i
( r
M
r
f
)
= .............................
= .............................
Did you obtain r = 0,09 + 0,04
i
?
Draw a graph of this straight line with r on the y-axis and
i
on the x-axis
(or use Maxima to plot the function). Indicate the positions of the risk-free
asset and the market and use a proper scale.
34 DSC3705
Comment: In the mean-variance application and the capital market line
scenarios the risk-reward is expressed in terms of standard deviation and
represented on a r diagram. In the CAPM scenario the risk-reward
is expressed in terms of covariance or beta and is represented on a r
iM
diagram or a r diagram. Make sure you understand the dierence between
all these graphical representations.
Study note 2
This is an additional explanation to help you to understand systematic risk
on page 182.
The following holds for the random rate of return of asset i:
r
i
r
f
=
i
(r
m
r
f
) +
i
E[r
i
] E[r
f
] =
i
(E[r
M
] E[r
f
]) + E[
i
]
r
i
r
f
=
i
( r
m
r
f
) + E[
i
]
E[
i
] = 0
Apply the properties of covariances (see note in previous section). Then:
cov(r
i
,r
M
) = cov(r
f
+
i
(r
M
r
f
) +
i
,r
M
)
= cov(r
f
,r
M
) +
i
cov(r
M
r
f
,r
M
) + cov(
i
,r
M
)
= 0 +
i
cov(r
M
,r
M
) + cov(
i
,r
M
)
=
i
2
M
+ cov(
i
,r
M
)
=
_
cov(r
i
,r
M
)
2
M
_
2
M
+ cov(
i
,r
M
)
cov(
i
,r
M
) = 0
35 DSC3705
Hence,
2
i
= cov(r
i
,r
i
)
= cov(r
f
+
i
(r
M
r
f
) +
i
,r
f
+
i
(r
M
r
f
) +
i
)
= cov(r
f
,r
f
+
i
(r
M
r
f
) +
i
) +
i
cov(r
M
r
f
,r
f
+
i
(r
M
r
f
) +
i
)
+cov(
i
,r
f
+
i
(r
M
r
f
) +
i
)
=
2
i
cov(r
M
,r
M
) + cov(
i
,
i
) (the other cov values are zero)
=
2
i
2
M
+ var(
i
)
= systematic risk + specic/nonsystematic risk
3.5 Chapter 7.5: Investment implications
Read and understand this paragraph. Remember the CAPM is a model that
may be applied in investments. Do you think that all investors apply this
model?
3.6 Chapter 7.6: Performance evaluation
Study hints
Note that

r is the expected return of an asset obtained from a sample.
Dene Jensens index.
Determine and interpret Jensens index.
Dene the Sharpe index.
Determine and interpret the Sharpe index.
Study note: Note that the covariance in table 7.3 has been expressed as a
percentage with cov =
170
(100)(100)
= 0,0107.
36 DSC3705

Exercise 3.6.1
Consider the following assets: Fund AA, Standard&Poor Index (S&P500)
and Treasure bills (T-bills). Suppose the following rates of return percentages
are available:
year AA S&P T-bills
1 17 16,8 6,4
2 34 31,5 8,4
3 5 3,2 7,8
4 32 30,6 5,6
5 10 7,7 3,5
1. Determine the mean and standard deviation of the return data.
2. Determine the beta () of fund AA.
3. Calculate the Jensen index of the fund AA and illustrate the value on a
r diagram.
4. Calculate the Sharpe index of the fund AA and illustrate the value on a
r diagram.
5. Interpret the index values.
Hint: The problem is similar to example 7.4 in the textbook.
Note: We use S&P500 or JSETop40 or ALSI as a proxy for the market
portfolio and T-bills or government RSA bonds as a risk-free asset.
37 DSC3705
3.7 Chapter 7.7: The CAPM as a pricing formula
Study hints
Formulate the pricing form of the CAPM.
Explain the relationship between the linearity of the pricing formula
and arbitrage opportunities.
Apply the pricing formula to verify the value of a share.
Study note
The following are comments on example 7.5(Luenberger):
The beta of the fund is:
=
r r
f
r
M
r
f
=
(0,1)(0,07) + (0,9)(0,15) 0,07
0,15 0,07
= 0,9
The risk premium = ( r
M
r
f
) = 0,9(0,15 0,07) = 0,072.
The risk-adjusted interest rate = 0,07 + 0,072 = 0,142.
38 DSC3705
Activity
If the expected value of the share after one period is R120, what should you
pay at the start of the period?
Answer:
P =
120
1,142
105,08
Read and understand this paragraph. It summarises all the important con-
cepts in the chapter.
Please complete the following exercise:

Exercise 3.8.1
5. Consider an investment market in which the
risk-free rate on Treasury bills is 4% per annum;
expected return on the market is 8% per annum;
standard deviation of the return on the market is 30% per annum;
assumptions of the capital asset pricing model hold.
39 DSC3705
(a) Consider an ecient portfolio ZZ that consists entirely on Treasury bills
and non-dividend paying shares. Suppose there are no other types of invest-
ments. If ZZ yields an expected return of 7%, what is its beta?
(b) Determine the standard deviation of the returns of ZZ.
(c) Split the total standard deviation of ZZ into amounts attributed to sys-
tematic and unsystematic risk.
(d) Calculate the market value (price) of ZZ assuming that all the securities
in ZZ are due to be redeemed for a total sum of 100 dollar in one period from
now.
6. Prove that the beta of the market is always equal to one.
4 Study unit 4
Models and data
Purpose
In this unit models to approximate the parameter values (such as mean values
and covariance values) for stock returns are discussed. The factor model is
explained and the arbitrage pricing theory derived.
Read chapter 8.1.
4.1 Chapter 8.2: Factor model
Study hints
40 DSC3705
Understand the concept of a single-factor model.
Assume a factor model is valid and apply equations 8.2a-8.2d to calcu-
late the standard parameters for mean-variance analysis.
Dene and calculate the return and the variance of any portfolio if the
portfolios assets are described by a single-factor model.
Use the factor model to explain diversiable and nondiversiable risk.
Use historical data to nd the intercept and factor loading values in
the factor model.
Read the paragraph on multifactor models.
List a few factors that may inuence the return of an asset.
Work through all the steps in the following study notes.
Study note 1
A factor model is a model which relates the return on an asset to the assets
sensitivity to the movements of various factors.
We adapt the note of William Sharpe on linear factor models to explain
equation 8.1 (http://www.stanford.edu/wfsharpe/mia/fac/mia fac2.htm).
A linear factor model relates the return of an asset (the asset can be a share,
bond or mutual fund) to the value of one or more factors. Suppose only one
factor is involved (f
1
= f), then the relationship between the return on the
asset and the factor can be described by
r
i
= b
i
f + (a
i
+ e
i
)
where
r
i
= return on asset i
(r
i
is a random variable)
b
i
= change in the return on asset i per unit change in the
return in factor f
(f is a random variable)
f = value of the factor
a
i
+ e
i
= the portion of the return on asset i not related to the
factor
a
i
is a known expected value and e
i
unknown residual
(or error) component.
41 DSC3705
To understand this model it is useful to express the model as follows:
r
i
= a
i
+ b
i

f + e
i
In this expression the tilde indicates that the values of the return r
i
and the
factor f is generally not known in advance ( r
i
and

f are stochastic variables).
We do not know beforehand what the return on a asset will be, since we do
not know with certainty what value the factor f will take on. We assume we
know the sensitivity of the return on an asset to the factor f, thus the factor
loading b
i
is a given value. The a
i
and the b
i
values are parameters in the
model and can be determined from historical data. For example the value
of b
i
is determined from the covariance estimation (based on historical data)
between the return on asset i and f in example 8.1.
The error (or residual) terms e
i
should satisfy the following assumptions:
The mean value of each of the error terms is zero, thus E[ e
i
] = 0.
The error terms are uncorrelated with the factor(s), thus the correlation
between e
i
and

f is zero. Hence E[(

f

f) e
i
] = 0.
The error term for one assets returns is uncorrelated with the error
term of any other asset. Hence E[ e
i
e
j
] = 0.
Note that you do not need to use the notation e
i
since the textbook uses the
notation e
i
. We use the tilde just to emphasize the fact that the variables
are stochastic (or random).
Study note 2
The factors (the f in a single-factor model, or the f
1
and f
2
in a two-factor
model) may be:
Consumer Price Index (CPI)
Gross National Product (GNP)
Unemployment rate
Rate of return on benchmark portfolios
Firm characteristics such as price earnings ratio
42 DSC3705
Rate of return on the market portfolio
Transportation factors
The b
i
(in a single-factor model) or the b
1i
and b
2i
(in a two-factor model)
may be called:
Factor sensitivities
Factor loadings
Factor betas
The e
i
term may be called:
Idiosyncratic return
Security-specic return
Non-factor return
Residual return
Diversiable risk
Error term
Example
Suppose we have one asset with return r and one factor f, and a time period
of one year. Suppose the factor model is r = (a+e) +bf. Suppose the factor
loading is b = 0,5 and the realised mean value of the factor in the year is 7%.
If the total mean return on the asset is 10%, then:
E[ r] = E[a + e] + bE[

f]
r = a + b
f ( since E[ e] = 0)
10,0 = a + (0,5)(7)
a = 6,5
Thus the assets non-factor mean return is 6,5% and the factor-related mean
return is 3,5%.
43 DSC3705
Study note 3
Derive equations 8.2b to 8.2d:
2
i
= cov(r
i
,r
i
)
= cov(a
i
+ b
i
f + e
i
,a
i
+ b
i
f + e
i
)
= b
2
i
cov(f,f) + 2b
i
cov(f,e
i
) +cov(e
i
,e
i
)
= b
2
i
2
f
+
2
e
i
The factor-related value b
2
i
2
f
is also called the nondiversiable risk, whereas
2
e
i
refers to the diversiable risk.
Justication:
Since a
i
is not random cov(a
i
,a
i
) = 0, cov(a
i
,f) = 0 and cov(a
i
,e
i
) = 0.
The assumptions of the factor model imply that the following hold:
cov(f,e
i
) = 0
cov(e
i
,e
j
) = 0 for i = j
The following holds for i = j:
ij
= cov(r
i
,r
j
)
= cov(a
i
+ b
i
f + e
i
,a
j
+ b
j
f + e
j
)
= b
i
b
j
cov(f,f) +cov(e
i
,e
i
) (the other covariances are zero)
= b
i
b
j
2
f
+ 0
= b
i
b
j
2
f
Also:
cov(r
i
,f) = cov(a
i
+ b
i
f + e
i
,f)
= cov(a
i
,f) + b
i
cov(f,f) + cov(e
i
,f)
= 0 + b
i
cov(f,f) + 0
= b
i
2
f
44 DSC3705
Study note 4
This relates to estimating historical factor loadings. Suppose we have known
data return values for a stock (thus not a stochastic model) then we apply
linear regression to determine the factor loading values.
Suppose the returns on a stock for the past n weeks are r
1
; r
2
; . . . ; r
n
. Sup-
pose the factor return values for the n weeks are f
1
; f
2
; . . . ; f
n
. For example
the factor values may be the interest rates, market values or index values.
Thus f
i
may be the interest rate value in week i.
Then the factor loading rate b value, measuring the expected change in r,
given the change in f, can be determined using regression analysis.
Suppose r =
1
n
n
k=1
r
k
and

f =
1
n
n
k=1
f
k
.
The formula for b is:
b =

rf
2
f
=
n
k=1
(r
k
r)(f
k

f)
n
k=1
(f
k

f)
2
Then
a = r b
f
and the equation of the single-factor model is
r = a + b
f.
Compare these formulas with the formulas used in example 8.1 and equations
8.2a to 8.2d. In example 8.1 the subscript i is used to distinguish between
the dierent stocks. The superscript k denotes the kth value of a specic
stock.
Study note 5
The single-factor model is also known as the single-index model in some
references and textbooks.
45 DSC3705

Exercise 4.1.1
1. The record of the rates of return (in percentages) for two stocks and an
index of industrial prices are given in the following table.
year Stock 1 Stock 2 Index (factor)
k r
k
1
r
k
2
f
k
1 23,27 27,24 12,3
2 19,47 17,05 5,5
3 6,58 10,20 4,3
4 15,08 20,26 6,7
5 16,24 19,84 9,7
(a) Determine the equation of the factor model for each stock.
(b) For each stock plot the values (f
k
; r
k
i
) on a graph and draw the equation
of the factor model for the stock on the same graph. (Thus you should have
two graphs similar to gure 8.1, p199 Luenberger).
(Hint: The problem is similar to example 8.1. You may use a spreadsheet
package (Excel) if you prefer.)
4.2 Chapter 8.3: The CAPM as a factor model

Study hints
Adapt the factor model to model the relationship between the variable
(r
i
r
f
) and factor (r
M
r
f
).
46 DSC3705
Determine the equation 8.5 of the characteristic line and illustrate the
line graphically.
State which assumptions e
i
satises.
Distinguish between the characteristic line and the CAPM model. (Read
and understand the paragraph before example 8.2 on page 206).
Study note
Note that the single-factor model makes no assumptions about eciency.
Make sure you understand the dierence between the CAPM model and the
single-factor model. The least-squares line (regression line) tted through
data points (r
M
r
f
; r
i
r
f
) for a specic stock in such a way that E[e
i
] = 0,
is called a characteristic line. If
i
= 0, this characteristic line gives the
CAPM model.
The following exercise will help you to understand the concept of a charac-
teristic line.
Exercise 4.2.1
1. Apply equation 8.5 to determine the equation of the characteristic line for
the return (in percentages) of the following stock.
Year Stock (r
k
i
) Market (r
k
M
) Riskless (r
k
f
)
1 27,24 23,0 7,1
2 17,05 15,3 6,9
3 10,2 11,5 6,8
4 20,26 18,5 7
5 19,84 18,1 6,8
Determine r
f
=
1
5
5
k=1
r
k
f
. Determine the equation of the characteristic line.
Represent the values (r
M
r
f
; r
i
r
f
) and the equation of the characteristic
line on the same diagram.
47 DSC3705
4.3 Chapter 8.4: Arbitrage pricing theory
Study hints
Discuss the assumptions of the APT model.
Explain the APT model in the one-factor model environment.
Give the conditions under which the APT model and the CAPM model
are identical.
Suppose there are n assets governed by two factors. Formulate the
APT model for the two factors. Thus, apply the APT theorem with
m = 2.
Explain the relation between the APT model and CAPM model in the
two-factor case (see page 211 at the bottom).
Read and understand this section.

Exercise 4.4.1
48 DSC3705
5 Study unit 5
General principles
Purpose
In this unit, investment decision-making in the utility framework is discussed.
The utility criterion and the mean-variance criterion are compared. Linear
pricing, one of the fundamental properties in security pricing, is explained.
Appendix 6 (in this study guide) contains extra notes on utility decision-
making to enhance the understanding of chapters 9.1 to 9.5.
5.1 Chapter 9.2: Utility functions
Study hints
What is a utility function?
Dene and calculate the expected utility of a random variable.
Apply the expected maximum utility criterion (see appendix 6 in this
guide).
Sketch a utility function.
49 DSC3705
5.2 Chapter 9.3: Risk aversion
Study hints
Dene and calculate the certainty equivalent of a random variable or
lottery.
Dene and apply risk aversion.
Dene and apply the Arrow-Pratt absolute risk aversion coecient.
Distinguish between risk-averse, risk-neutral and risk-seeking investor
behaviour.
5.3 Chapter 9.4: Specication of utility functions
Study hints
Read through this section. It explains methods to determine an in-
vestors utility function.
5.4 Chapter 9.5: Utility functions and the mean-variance
criterion
Study hints
Dene a quadratic utility function.
Compare the mean-variance criterion with the expected utility crite-
rion.
50 DSC3705
Note that the mean-variance criterion may be applied if the returns are
normal random variables (thus the normal distribution holds).
Activity
Make sure you have worked through appendix 6 (in this study
guide).
5.5 Chapter 9.6: Linear pricing
Study hints
Explain type A arbitrage.
Explain type B arbitrage.
Describe the concepts of linear pricing.
Determine the price of a portfolio based on the linear pricing principle.
5.6 Chapter 9.7: Portfolio choice
Study hints
State the portfolio choice problem (9.3a-9.3d).
Formulate the portfolio choice theorem.
Use a utility function to construct a portfolio that gives maximum
satisfaction (utility) for a given wealth level.
Apply Lagrangean multipliers to solve equations 9.3a to 9.3d.
51 DSC3705
Determine the optimal portfolio.
Formulate the portfolio pricing equation.
Formulate the set of equations to determine the amounts to be invested
for an optimal portfolio. Solve the equations in special cases. Note
that this set of equations should normally be solved using a numerical
algorithm.
Study note
Activity Work through all the steps in the following explanation.
Example 9.5 (Luenberger)
Suppose

d
1
represents the random outcome of investing in the lm. The
tilde indicates the outcome is uncertain. Then the expected return of the
lm venture is
E[

d
1
] = 0,3(3) + 0,4(1) + 0,3(0) = 1,3
Since E[
d
1
] > 0, the lm venture is favourable. Note that if E[
d
1
] = 0, the
venture will be fair and if E[
d
1
] < 0 a risk-averse investor should not invest
at all.
If state s
1
(high success) occurs, the lm outcome is

d
1
(s
1
) = 3.
If state s
2
(medium success) occurs, the lm outcome is

d
1
(s
2
) = 1.
If state s
3
(failure) occurs, the lm outcome is

d
1
(s
3
) = 0.
Suppose

d
2
represent the outcome of investing in the risk-free opportunity.
Since the outcome is deteministic,

d
2
(s
1
) =

d
2
(s
2
) =

d
2
(s
3
) = 1,2 and we
may indicate the outcome as d
2
= 1,2.
Assume the lm venture and the risk-free opportunity each has a unit price
of 1. Suppose the amount
1
is invested in the risky lm venture. Suppose
the amount
2
is invested in the risk-free opportunity. A total amount of W
is available to be invested. Then
1
+
2
= W, since the price per unit is
P
i
= 1, i = 1; 2 and
1
P
1
+
2
P
2
= W.
If state s
1
(high success) occurs, the nal outcome is 3
1
+ 1,2
2
.
52 DSC3705
If state s
2
(medium success) occurs, the nal outcome is 1
1
+ 1,2
2
.
If state s
3
(failure) occurs, the outcome is 0 + 1,2
2
.
Formulation of the portfolio problem:
Maximise E[u(
2
i=1
i

d
i
)] = max E[u(
1

d
1
+
2
d
2
)]
= max [0,3 ln(3
1
+ 1,2
2
) + 0,4 ln(
1
+ 1,2
2
) + 0,3 ln(1,2
2
)]
subject to
1
+
2
= W
Apply the Lagrangean multiplier method:
L = 0,3 ln(3
1
+ 1,2
2
) + 0,4 ln(
1
+ 1,2
2
) + 0,3 ln(1,2
2
) (
1
+
2
w)
L
1
= 0,3
_
3
3
1
+ 1,2
2
_
+ 0,4
_
1
1
+ 2
2
_
2
= 0,3
_
1,2
3
1
+ 1,2
2
_
+ 0,4
_
1,2
1
+ 2
2
_
+ 0,3
_
1,2
1,2
2
_
Hence, the following set of nonlinear equations should be solved for xed W:
0,9
3
1
+ 1,2
2
+
0,4
1
+ 1,2
2
=
0,36
3
1
+ 1,2
2
+
0,48
1
+ 1,2
2
+
0,36
1,2
2
=
1
+
2
= W
Using the rst two equations we obtain:
0,54
3
1
+ 1,2
2
0,08
1
+ 1,2
2
0,36
1,2
2
= 0
53 DSC3705
In this example, since we have only two unknowns, we could apply the fol-
lowing trick to solve the system of equations.
Suppose one unit of wealth is invested, thus W = 1 and
1
+
2
= 1. Then:
0,54
3(1
2
) + 1,2
2
0,08
(1
2
) + 1,2
2
0,36
1,2
2
= 0
0,54
3 1,8
2
0,08
1 + 0,2
2
0,36
1,2
2
= 0 (II)
Solve this equation using MUPAD/Maxima or any other computer package
with a suitable function to nd the root of a nonlinear function. You may also
apply a numerical technique such as the secant method or Newton-method to
approximate the zero (or root). Your pocket calculator may also be used if it
has a suitable function (see the reference manual of your pocket calculator).
The solution is
2
0,911 (the other zero of the equation is a negative value).
Then
1
0,089.
Thus for any value W,
1
0,089W and
2
0,911W and =
1
W
.
Suppose

x
2
i=1
d
i
is the optimal solution. Assume W = 1 unit, then
the expected return of the optimal portfolio is:
E[

x
] = E[0,089
d
1
+ 0,911d
2
]
= 0,3(0,089 3 + 0,911 1,2) + 0,4(0,089 1 + 0,911 1,2) + 0,3(0 + 0,911 1,2)
Would you advice the investor to invest in the lm venture?
Alternative solution:
Since this portfolio problem has only two unknowns the problem could be
solved by expressing the original portfolio problem in one variable.
Since
1
= W
2
, the portfolio problem is equivalent to:
Maximise V (
2
) = 0,3 ln(3(W
2
) + 1,2
2
) + 0,4 ln((W
2
) + 1,2
2
) + 0,3 ln(1,2
2
)
= 0,3 ln(3W 1,8
2
) + 0,4 ln(W + 0,2
2
) + 0,3 ln(1,2
2
)
54 DSC3705
Dierentiate V to
2
and solve V
(
2
) = 0.
Then: V
(
2
) =
0,3(0,18)
3W 1,8
2
+
0,4(0,2)
W + 0,2
2
+
0,3(1,2)
1,2
2
= 0. (Compare this
equation to equation II on the previous page).
Use Maxima to determine
2
.
Chapter 9.8 Log-optimal pricing
This paragraph is not for examination.
5.7 Chapter 9.9: Finite state models
Study hints
Explain states (sometimes called states-of-nature).
Dene elementary state securities.
Express the price of a security in terms of the elementary state security
prices.
Formulate the positive state price theorem.
Determine the state prices if no arbitrage opportunities exist.
Study note
In the following note, an arbitrage portfolio and state prices are discussed
using the examples and terminology used in the textbook Mathematics for
Economics and Finance by Martin Anthony and Norman Biggs. This text-
book is prescribed for the Mathematical modelling II module.
Suppose an investor can choose between a number of dierent assets. After a
specied time period, the assets in the portfolio will have a new value. This
55 DSC3705
future value of the portfolio will depend on a number of factors that may
change in the time period. This uncertainty is modelled by assuming that
there are a number of possible states. If the future portfolio has the same
value at the end of the time period, whichever state has occurred, it is called
a riskless portfolio. A portfolio that costs nothing, cannot lose money and
yields a prot in at least one state is called an arbitrage portfolio.
We illustrate an arbitrage portfolio with an example.
Suppose the citizens of an island can invest in three assets namely land,
bonds (which yield a xed return) and stocks (which yield an uncertain
return). A general election is due. After the election, one of two parties,
the conservative party (CP) or the liberal party (LP), will be in power. The
winning partys economic decisions will inuence the value of the assets. An
economist predicts the following possible total returns of each asset in the
two states.
CP LP
Land 1,25 0,95
Bonds 1,05 1,05
Stocks 0,90 1,15
Then R =
1,25 0,95
1,05 1,05
0,90 1,15
is the matrix of total returns.
If an investor decides to invest $5 000 in land, $1 000 in bonds and $4 000 in
stocks, the row vector
Y = [5 000 1 000 4 000]
represents the portfolio.
Suppose the CP wins the election, then the value of the portfolio at the end
of the time-period is 5 000(1,25) + 1 000(1,05) + 4 000(0,90) = 10 900.
Then the product Y R is the vector [10 900 10 400], where the 10 900 is the
nal value of the portfolio if CP wins and 10 400 is the nal value if LP wins.
If the portfolio of the investor is Y = [5 000 10 000 5 000] the investor
borrows $10 000 from the bank and uses the money to buy land and stocks.
At the end of the year he/she owes the amount 10 000 1,05 dollars, but the
56 DSC3705
value of the land or stocks may be more. Calculate Y R, then
Y R = [250 0].
This means if CP wins the portfolio has nal value $250 and if LP wins the
portfolio value is zero.
This is an example of an arbitrage portfolio. It initially costs nothing and
yields a positive return in one state, and in the other state the investor is no
worse o.
Arbitrage portfolios and state prices
If there are m assets and n states, the m n return matrix R, where R
ij
indicates the return from investing one unit of asset i, if state j occurs.
Suppose the initial portfolio is Y = [y
1
y
2
. . . y
m
] with y
i
the number
of units of asset i. Y R is a (1 n) matrix containing the nal values of the
portfolio in the n states.
Then Y is an arbitrage portfolio if y
1
+ y
2
+ . . . + y
m
= 0 and Y R has
no negative values and at least one positive entry. Checking Y R for every
possible Y to see if there are arbitrage opportunities is not practical. The
state price method is easier.
The
i
values in = [
1

2
. . .
n
] are called state prices for R if
R = u
with
=
_
2
.
.
.
n
_
_
and u =
_
_
1
1
.
.
.
1
_
_
where u is a (m1) matrix and represents the nal price of 1 unit for each
asset.
To determine state prices the system R = u should be solved.
If R = u is inconsistent (i.e. the system has no solution), state prices do
not exist and there must be an arbitrage portfolio. Also if the system has a
57 DSC3705
solution, with one of the
i
values negative or zero, i.e.
i
0 for at least
one i, there must be an arbitrage portfolio.
If the system R = u has more than one solution or has a unique solution
(i.e. the system is consistent) and
i
> 0 for all i, then positive state prices
do exist and arbitrage is not possible.
In example 9.9 (Luenberger), there are three states and three assets and the
system of equations R = u has a unique solution. In this example
R =
_
_
3 1 0
1,2 1,2 1,2
6 0 0
_
_
.
Thus we should solve:
_
_
3 1 0
1,2 1,2 1,2
6 0 0
_
_
_
_
3
_
_
=
_
_
1
1
1
_
_
Activity
Verify that the solution to this system is
1
=
1
6
,
2
=
1
2
and =
1
6
. Because
i
> 0, for i = 1; 2; 3, we can say there is no arbitrage.
5.8 Chapter 9.10: Risk-neutral pricing
Study hints
Derive the risk-neutral pricing formula (equation 9.15).
How do you determine the risk-neutral probabilities in the risk-neutral
pricing formula?
Chapter 9.11: Pricing alternatives
Read this section.
58 DSC3705
This is an excellent summary giving an overview on all the important aspects
of chapter 9.
Please do the following exercise.

Exercise 5.9.1
Refer to the appendix (in this study guide) to help with problems 5 and 6.
5. Colins preferences can be modelled by a utility function such that
u
(w) = 3 2w, with w > 0 representing the wealth of Colin.

(a) Over what domain can this utility function be satisfactorily applied?
(b) How will Colins holdings of risky assets change if his wealth increases?
(c) Which of the following investments will he choose?
A B C
rate of return probability rate of return probability rate of return probability
0,1 0,3 0 0,3 0,2 0,45
0,3 0,4 0,2 0,2 0,3 0,1
0,5 0,3 0,6 0,5 0,4 0,45
6. Thobela has a utility function u(x) = ln(x). Suppose she has initial wealth
w and is oered a gamble. If she bets x her nal wealth will be w + x with
59 DSC3705
probability p (0 < p < 1), otherwise her nal wealth will be wx. Determine
the value x as a function of p if she is an expected utility maximiser.
60 DSC3705
6 Appendix
Utility and Risk Preferences
This section supplements chapter 9 of the textbook.
The strategy to maximise the expected prot does not make provision for a
decision-makers willingness to take risks. Utility theory takes into account
a decision-makers attitude towards risks. In this section we discuss the
concepts of expected utility, risk preferences and risk prole.
If the consequence or outcome of an action or a decision is uncertain we
indicate the outcome by x, where indicates uncertainty. (We read x-
tilde.) Then x is considered to be a random variable or a function, and the
value of the random variable in a specic instance is sometimes indicated
by x, without the tilde to emphasise that we refer to a specic value of the
outcome and not to the random variable in its entirety.
In the context of investment and economic problems, we assume that the out-
comes are dened on the real line since the outcomes are in general amounts
of money. The outcomes represent the possible levels of nal wealth. For ex-
ample, x may represent the uncertainty of the monetary outcome of a lottery
ticket, or some shares of stock whose future value is uncertain.
A utility function u is a way of assigning a number to every outcome such
that the more preferred outcome get assigned a larger number than the less
preferred outcome. If x
1
and x
2
are two outcomes, x
1
is more preferred
than x
2
if u(x
1
) u(x
2
). If we have to choose between two lotteries or
investments the problem is to nd the best choice. One criterion is the
expected maximum utility criterion. It can be proved that if a a decision-
makers choice over lotteries satises a set of axioms, then the decision-maker
should choose the lottery with the maximum expected utility.
(http://homepage.newschool.edu/het/essays/uncert/vnmaxioms.htm)
61 DSC3705
6.1 Expected utility
Denition 6.1.1 Let x be a random variable with outcomes x
1
; x
2
; . . . ; x
n
and corresponding probabilities p
1
; . . . ; p
n
. Then the expected value of x is:
E[ x] =
n
i=1
p
i
x
i
If u(x) is the utility function, the expected utility of the x is given by:
E[u( x)] =
n
i=1
p
i
u(x
i
)
If P is a lottery with outcomes x
1
; x
2
; . . . ; x
n
and corresponding probabilities
p
1
; p
2
; . . . ; p
n
, then we may denote the uncertain outcomes of the lottery with
x and the expected value of the lottery is:
E[P] = E[ x] =
n
i=1
p
i
x
i
In the same way the expected utility of the lottery P is given by:
E[u(P)] = E[u( x)] =
n
i=1
p
i
u(x
i
)
In the context of this section you may model uncertain decisions either with
monetary outcomes in terms of lotteries or with random variables.
Let the collection of possible outcomes be given in: Z = {0; 10; 20; 30; 40; 50}.
A decision-maker must choose between lotteries P and Q. Apply the ex-
pected maximum utility criterion.
s
P
e
e
e
e
e
0,5
0,3
0,2
s
50
s
20
s
0
s
Q
e
e
e
e
e
0,3
0,4
0,3
s
40
s
30
s
0
62 DSC3705
The utility function is given in the rst two columns of the following table:
Outcome utility prob. lottery P p(z)u(z) prob. lottery Q q(z)u(z)
z
i
u(z
i
) p(z
i
) q(z
i
)
0 3,2 0,2 0,64 0,3 0,96
10 4,5 0,0 0,0 0 0
20 5,5 0,3 1,65 0 0
30 6,3 0 0 0,4 2,52
40 7,1 0 0 0,3 2,13
50 7,7 0,5 3,85 0 0
sum 1,0 6,14 1,0 5,61
The expected outcome of lottery P is then
E[u(P)] =
zZ
p(z)u(z) = 0,2u(0) + 0,3u(20) + 0,5u(50) 6,14.
The expected outcome of lottery Q is then
E[u(Q)] =
zZ
q(z)u(z) = 0,3u(0) + 0,4u(30) + 0,3u(40) 5,61.
The expected utility of P is larger than the expected utility of Q. If the
decision-maker applies the expected maximum utility criterion she/he should
prefer P to Q.
Example 6.1.1
In the previous example the utility function was given in tabular form. The
utility function can also be dened as a real function. Let u(z) =
z. If we
calculate the expected utility for the lottery P (see the previous example),
63 DSC3705
we have:
E[u(P)] =
zZ
p(z)u(z)
= 0,2u(0) + 0,3u(20) + 0,5u(50)
= 0,2
0 + 0,3
20 + 0,5
50
4,88
Valuing investment by expected utility

The value of an investment can be measured by the expected value of the
utility of its consequence. The investment with the largest expected utility
is most preferable. The consequences of an investment correspond to the
investor receiving a certain amount of money. If the risk-prole of an investor
can be presented with a utility function u, u(x) is the utility the investor
receives from an amount x. Assume an investor must choose between two
investments. If investment 1 returns an amount of x
1
and investment 2
returns an amount of x
2
, the investor should choose the rst investment if
E[u(x
1
)] > E[u(x
2
)].
The decision-maker is an expected utility maximiser if he/she prefers the
investment or lottery with the largest expected utility.
Example 6.1.2
Suppose John is considering a new business. To participate, John must
invest R5 000. There is a 25% chance that the investment will give a return
on R5 000; leaving him just as well o as if he had not made the investment.
But there is a 45% chance that he will lose all his money, and a 30% chance
that the investment will return the original R5 000 plus an additional R10 000.
Assume that Johns preferences can be modelled with utility function
u(x) = ln x, where x is the total wealth. Suppose John has initial wealth
R10 000. Should he make the investment?
Answer:
We represent the problem in the following diagram:
64 DSC3705
s
d
d
d
d
d
Y es No
s s
x
s
d
d
d
d
d
0,30
0,25
0,45
s
x + 10 000
s
x
s
x 5 000
We calculate the expected utility of the investment and compare it with the
expected utility of no investment.
The expected utility of no investment:
u(10 000) = ln(10,000) 9,2
Expected utility of the investment:
EU = 0,3u(10 000 + 10 000) + 0,25u(10 000) + 0,45u(10 000 5 000) 9,106
The expected utility of no investment is more than the expected utility of an
investment, thus no investment should be made.
Activity
If John has an initial wealth of R70 000 rather than R10 000, should he invest?
[Answer: yes. u(70 000) = 11,15 and EU = 11,16]
65 DSC3705
6.2 The utility function and risk behaviour
John Von Neumann and Oscar Morgenstern showed in 1944 that any con-
sistent, rational decision-maker should choose between lotteries or gambles
according to the rules of utility theory. Since then, decision analysts have
developed methods to assess the utility function of an individual. The rela-
tive attractiveness of dierent outcomes is measured and is then captured in
a utility function over a range of possible consequences. Initially the concept
of utility functions was developed to apply in economic decisions. Between
1960 and 1970 the mathematical properties of utility functions describing at-
titude towards money and risk were worked out in detail. It was recognized
that there are families of utility functions that represent dierent attitudes
towards risk. Nowadays social sciences and behaviour sciences also apply the
utility concept.
Why should we apply risk preferences when choosing between lotteries? Con-
sider the following lotteries for example:
s
P
e
e
e
e
e
0,5 0,5
s
30
s
1
s
Q
e
e
e
e
e
0,5 0,5
s
2 000
s
1 900
The expected value (or payo) of lottery P is:
E[P] = 0,5(30) + 0,5(1) = 14,50
The expected value of lottery Q is:
E[Q] = 0,5(2 000) + 0,5(1 900) = 50
66 DSC3705
If you were to make decisions on the basis of expected value, you would
choose lottery Q. However, which lottery is riskier? If we play each lottery
10 times, the worst we could do in lottery P is to lose R10. If we play lottery
Q ten times, the worst that can happen is to lose R19 000! We could say
that lottery Q is more risky. A risk-averse person will prefer lottery P, while
a risk-seeking person might enjoy lottery Q! Expected payo should not be
the only criteria used to choose between lotteries.
Assume you are obliged to play lottery Q, but you do not want to lose R1 900.
Your optimistic friend is interested in taking your place and is willing to pay
R30 for the opportunity. If you are prepared to accept the R30, but not
less, for the lottery to avoid playing, your certainty equivalent for the lottery
would be R30. We write CE[Q] = 30. The certainty equivalent is the least
you would accept to avoid playing the lottery. You will receive R30 for sure,
whether your friend wins or loses.
The utility function of a decision-maker gives information on his/her attitude
towards risk. In the textbook methods to determine a decisionmakers utility
function are described.
The rst restriction placed on a utility function is that it should be consistent
with more being preferred to less. The utility of (x+1) rand should be greater
than the utility of x rand. Thus an utility function is an increasing function
with a positive rst derivative. Whether a utility function is concave or
convex is the second important property of a utility function. This property
describes a decision-makers attitude towards risk.
In the denitions in this section X is a subset of the real line.
Denition 6.2.1 A function u : X R is strictly increasing whenever
u(x
1
) < u(x
2
) if x
1
< x
2
and x
1
; x
2
X.
Note that if the function u is strictly increasing and it is dierentiable then
u
(x) > 0 for all x X. If u
(x) 0, then u is increasing on the domain.

A function u(x) is said to be strictly concave if every pair of two distinct
points on the curve can be joined with a straight line entirely below the
curve. A concave function opens downward. The following criteria may be
used to determine whether a function is concave.
67 DSC3705
Denition 6.2.2 A twice dierentiable function u : X R is strictly con-
cave if and only if u
(x) < 0 for all x X.

Note that if u
(x) < 0 for all x X, then u(x) is strictly concave.

If u
(x) 0, u is concave.
Example of a concave function:
u(x)
y
x .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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. . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. .. . . . . .
. . . . . . . . . .
. . . . . . . . . . . . .
. . . . . . . . . . . . . . . . .
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. . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . .
. . . . . . . . . . . . .
. . . . . . . . . .
. . . . . .. .
. . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
straight line below u

A function u(x) is strictly convex if any two points on the curve y = u(x) can
be joined by a straight line above the curve. A convex curve opens upward.
Denition 6.2.3 A twice dierentiable function u : X R is strictly con-
vex if and only if u
(x) > 0 for all x X

68 DSC3705
The following sketch is an example of a convex function.
0 1 2 3 4 5 6 7 8 9 10
0
10
20
30
40
50
60
70
80
90
100
x
u
(
x
)
Convex function
6.2.1 Certainty equivalent
Denition 6.2.4 A certainty equivalent of a lottery P is an amount CE[P],
such that the decision-maker is indierent between the lottery P and receiving
the amount CE[P] for certain.
Note: The decision-maker would be neutral between playing the lottery and
receiving a xed amount (the certainty equivalent) in exchange for the lottery
ticket.
If the utility function is known, the certainty equivalent CE of a lottery P
is the value x that solves the equation
u(x) = E[u(P)]
Hence for a lottery P we have u(CE) = E[u(P]), in other words, the utility
of the certainty equivalent should be equal to the expected utility of the
lottery.
We could also dene the certainty equivalent in term of a random variable
x. Then u(CE) = E[u( x)]. Then CE = u
1
{E[u( x)]}.
69 DSC3705
Example 6.2.1
Determine the expected value, the expected utility and the certainty equiv-
alent of the following lottery, if the utility function is u(x) = 4x x
2
, where
0 x 2.
s
P
e
e
e
e
e
0,5 0,5
s
2
s
0
Ex
T
y
.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
u(x)
EU=2 . . . . ..
.
.
.
.
.
.
.
.
.
.
CE=?
*
EV=1
The expected value EV = E[ x] = 0,5(0) + 0,5(2) = 1.
The expected utility EU = E[u( x)] = 0,5u(0)+0,5u(2) = 0,5(0)+0,5(4) = 2.
To determine the certainty equivalent we solve the equation: u(x) = EU,
70 DSC3705
with EU = 2.
4x x
2
= 2
x
2
+ 4x 2 = 0
x =
4
_
(4)
2
4(1)(2)
2(1)
x 3,414 or x 0,585
Hence x 0,585 [ because 3,414 is not in the domain.]
The certainty equivalent is CE 0,585.
Note that the function u is monotone increasing and concave on the interval
[0 ; 2]. To verify this, determine u
(x) and u
(x).
Denition 6.2.5 The risk premium RP of a lottery P is the dierence be-

tween the expected value and the certainty equivalent.
RP[P] = EV [P] CE[P]
Example 6.2.2
Maria has a utility function u(x) =

x. What would she be willing to pay
for a lottery that pays R 1 000 000 with a probability of 0,0015 and zero
otherwise?
Solution:
Determine the expected utility EU = E[u( x)] of the lottery. Solve
x = EU.
The certainty equivalent of the lottery is R2,25.
6.2.2 Risk prole

Consider the choice between a prospect that oers an 80% chance of winning
R1000 and a 20% chance of winning nothing, and the alternative of receiving
71 DSC3705
R700 for sure. Many people prefer the certain amount over the gamble,
although the gamble has a higher expected value (R800). This preference for
a sure amount instead of taking part in the gamble is called risk-aversion. If
an individual prefers taking part in this lottery over taking the sure amount,
his/her behaviour is called risk-seeking. Dierent people have dierent risk
attitudes and are willing to accept dierent levels of risk. A utility function
is used to represent a decision-makers attitude towards risk. Dierent utility
functions represent dierent qualitative attitudes towards risk.
Decision-makers may have one of three risk proles.
risk-averse
risk-neutral
risk-seeking
Intuitively, we think of a risk-averse person as one who prefers to behave
conservatively. Say a decision-maker must choose between the 50-50 lottery
P with outcomes 0 and 2, so the expected value EV [P] = 1. If the decision-
maker prefers the expected value of the lottery for certain, and does not want
to participate in the lottery, the decision-maker is risk-averse. The risk-
averse decision-maker would rather prefer receiving the R1 and will avoid
taking part in the lottery.
Denition 6.2.6 A decision-maker is risk-averse if she/he prefers the ex-
pected value of the lottery to the lottery.
For a risk-averse decision-maker the utility of the expected value of the lottery
must be greater than the expected utility of the lottery. Suppose the lottery
is represented by a random variable x with EU the expected utility of the
lottery and EV the expected value of the lottery. Then:
u(EV ) > EU
hence u(E[ x]) > E[u( x)]
72 DSC3705
Example 6.2.3
In the previous example, with u(x) = 4x x
2
where 0 x < 2, and P the
50-50 lottery with outcomes 0 and 2, we have:
Utility of the expected value:
u(EV ) = u(E[ x]) = u(1) = 3
Expected utility of the lottery:
EU = E[u( x)] = 2
Hence: u(E[ x]) > E[u( x)] or u(EV ) > EU.
The risk premium of the lottery is:
RP = EV CE 1 0,586 = 0,414
Note the risk premium is positive. If a decision-maker is risk-averse, the

expected value of the lottery should be larger than the certainty equivalent
of the lottery (thus the risk premium should be positive).
The following theorem can be proved:
Theorem 6.2.1 A decision-maker is risk-averse if his or her utility function
is concave.
A risk-averse decision-maker has a (strictly) concave utility function if u
(x) >
0 and u
(x) < 0 for all x. The utility function of a risk-neutral decision-maker

is a straight line, and a risk-seeking decision-maker has a convex utility func-
tion.
73 DSC3705
For a risk-neutral decision-maker the expected utility of a lottery is equal
to the utility of the expected value of the lottery and the utility function
is a straight line. A risk-neutral decision-maker is willing to base his/her
decisions purely on the criterion of maximising the expected value of his/her
income. A risk-seeking decision-maker prefers taking part in a lottery and
the expected utility of the lottery is larger than the utility of the expected
value of the lottery.
We may use the sign and the magnitude of the risk premium to classify a
decision-makers attitude towards risk. If the risk premium is negative, the
decision-maker is willing to take the risk and is a risk-seeker. If the risk-
premium is positive the decision-maker would avoid risks and is risk-averse.
If the risk premium is zero, the decision-maker is risk-neutral.
The characteristics of the risk prole of a decision-maker are summarised in
the next table.
Decision-maker Utility function Risk premium
Risk-averse concave positive
u
(x) < 0 RP > 0

Risk-neutral straight line zero
u
(x) = 0 RP = 0
Risk-seeking convex negative
u
(x) > 0 RP < 0

If a function u(x) represents the attitude of a decision-maker towards risk,
then so does any other function of the form au(x) + b, where a is a positive
constant and b is an arbitrary constant.
Example 6.2.4
A coin is tossed. If it comes up heads, you receive R30. If it comes up tails,
you lose R1.
S = is the set of states = {head; tail}
X = is the set of outcomes = {x
1
; x
2
} = {30; 1}.
74 DSC3705
We can represent the lottery by a function x : S R with p(x
1
) = 0,5 and
p(x
2
) = 0,5. The tree representation is:
s
e
e
e
e
e
0,5 0,5
s
30
s
1
The expected value of the lottery is:
EV = E[ x] = 0,5(30) + 0,5(1) = 14,5
Assume you are a risk-averse decision-maker with utility function
u(x) = 1 e
x/35
.
u
(x) =
_
1
35
e
x/35
_
=
1
35
e
x/35
Then u
(x) > 0 for all x, thus u is an increasing function.

The function is concave because:
u
(x) =
1
35

1
35
e
x/35
< 0 for all x.
Remember: an exponential function is always positive for any x value, thus
e
x/35
is also positive for all x .
The utility of the expected value is:
u(E[ x]) = u(14,5)
= 1 e
14,5/35
0,3392
75 DSC3705
The expected value of the utility is:
EU = E[u( x)] = p
1
u(x
1
) + p
2
u(x
2
)
= 0,5u(30) + 0,5u(1)
= 0,5(1 e
30/35
) + 0,5(1 e
(1)/35
)
0,5(0,5756) + 0,5(0,0289)
0,2733
Note that u(E[ x ]) > E[u( x)], thus the utility of the expected value is greater
that the expected value of the utility.
Determine the certainty equivalent of the lottery. The method is:
Determine the expected utility EU = E[u( x)].
Determine the certainty equivalent CE. CE is the x value with the
same utility as the EU value.
To nd CE solve the equation u(x) = EU.
Apply the method to the given problem.
EU = E[u( x)] = 0,2733. Solve the equation u(x) = EU.
1 e
x/35
= 0,2733
e
x/35
= 0,2733 1
e
x/35
= 0,7267
ln e
x/35
= ln(0,7267)
x
35
0,3192
x 11,17
The certainty equivalent is then CE 11,17.
Determine the risk premium of the lottery.
RP = EV CE
14,5 11,17
= 3,33
76 DSC3705
Note that the risk premium is positive. This conrms that the decision-maker
is risk-averse.
Activity
The following exercise will help you to understand the previous example.
1. Determine u(x) = 1 e
x/35
for x = 0; 5; 10; 15; 20; 25; 30 accurate
to 2 decimal places.
2. Sketch the function u(x) and indicate on the x axis the values CE,
EV , RP.
3. Indicate the value EU (the expected utility) on the y axis. Note that
u(CE) = EU.
4. Indicate the value of u(EV ) (thus the utility of the expected value) on
the y-axis. Note that u(EV ) > EU.
Example 6.2.5
You are a risk-averse decision-maker with an utility function
u(x) = 1 e
x/35
.
Which of the following lotteries would you prefer?
s
P
e
e
e
e
e
0,5 0,5
s
30
s
1
s
Q
e
e
e
e
e
0,6 0,4
s
23,5
s
1
77 DSC3705
Note the expected value of the lotteries is the same:
EV [P] = 0,5(1) + 0,5(30) = 14,5
EV [Q] = 0,4(1) + 0,6(23,5) = 14,5
Determine the expected utility of each lottery:
EU[P] = 0,5u(1) + 0,5u(30) 0,2733
EU[Q] = 0,5u(1) + 0,6u(23,5) 0,2588
You would prefer lottery P since the expected utility of lottery P is larger
than the expected utility of lottery Q.
6.3 Arrow-Pratt
For a given baseline wealth w and a random variable x, an interesting ques-
tion is what happens to the risk premium if the wealth w increases? For
greater amounts of w, is the risk premium of the decision-maker larger or
smaller?
Let us consider the risk premium of a risk-averse person with a given utility
function u. Let
u
be the risk premium function, depending on the initial
wealth w and the random variable x, and we write
u
(w, x). The function
u
will be positive for all values of w. It seems to be empirically true for
many people that, as their assets (wealth) increase, they are willing to pay a
smaller risk premium for a given risk. The reasoning is that if they become
richer, they can better aord to take a specic risk. (An example: a stu-
dent with pocket money of R500 per month can aord a loss of R10 better
than a student with pocket money of R100.) We say the decision-maker is
decreasingly risk-averse.
Denition 6.3.1 A decision-maker is said to be decreasingly risk-averse if
she/he is risk-averse and his risk-premium
u
(w, x) for any lottery x, is de-
creasing as the wealth amount w increases.
Remember: The derivative of a (strictly) increasing dierentiable function
is always positive and the derivative of a (strictly) decreasing function is
78 DSC3705
negative.
Denition 6.3.2 The Arrow-Pratt measure of absolute risk-aversion for a
utility function u(x), is dened by
R
A
(x) =
u
(x)
u
(x)
The next theorem can be proved:
1
Theorem 6.3.1 A decision-maker is decreasingly risk-averse if and only if
R
A
(x) is a decreasing function.
Example 6.3.1
Suppose a decision-makers utility function is u(x) = ln x. Then u
(x) =
1
x
and u
(x) =
1
x
2
. The function u
(x) < 0 for all x, thus the decision-maker

is risk-averse. The Arrow-Pratt measure becomes
R
A
(x) =
1
x
2
1
x
=
1
x
Note:
1
x
is a decreasing function for all x > 0, hence the decision-maker has
decreasing risk-aversion.
Decreasing risk-aversion is a reasonable assumption. It seems reasonable that

you should become less risk averse as your wealth level increases. A person
who can aord larger losses, may be prepared to undertake greater risks.
Denition 6.3.3 A decision-maker is constantly risk-averse if she/he is
risk-averse and the risk premium
u
for any lottery x and wealth w is a
constant positive value.
1
Decisions with Multiple Objectives: Preferences and Value Tradeos by Keeney and
Raia, 1976
79 DSC3705
Theorem 6.3.2 A decision-maker has constant risk-aversion if and only if
R
A
(x) is a positive constant number.
Example 6.3.2
Suppose the decision-makers utility function is u(x) = e
0,2x
. Then u
(x) =
0,2e
0,2x
and u
(x) = (0,2)(0,2)e
0,2x
. We have u
(x) < 0 for all x, thus

the decision-maker is risk-averse. The Arrow-Pratt measure becomes:
R
A
(x) =
_
0,04e
0,2x
0,2e
0,2x
_
= 0,2 > 0
The decision-maker has constant risk aversion and is prepared to pay a xed
premium, irrespective of his/her wealth. This means that if your utility
function is exponential, you would not change your portfolio even if, through
good luck, you suddenly become very wealthy.
Denition 6.3.4 A decision-maker is increasingly risk-averse if she/he is

risk-averse and the risk premium
u
(w, x), for any lottery x, is increasing as
the wealth w increases.
Theorem 6.3.3 A decision-maker has increasing risk aversion if and only
if R
A
(x) is an increasing function of x.
Example 6.3.3
Suppose the decision-makers utility function is u(x) = 4x x
2
and 0
x < 2. Then u
(x) = 4 2x and u
(x) = 2, thus
R
A
(x) =
_
2
4 2x
_
0 x < 2
R
A
(x) is an increasing function (sketch the function R
A
(x) on the interval
[0;2)) and the decision-maker has increasing risk aversion. The wealthier the
decision-maker becomes, the larger the risk premium he/she requires.
If the wealth of the decision-maker increases, she/he becomes more risk-

averse and is less likely to take risks. Do you know a decision-maker who
displays such behaviour? What about wealthy older people?
80 DSC3705
6.4 Optimisation
In a problem involving uncertainty we sometimes have to nd the optimal
solution of a function V that depends on the uncertainty x and a parameter .
From calculus one knows that if V is a continuous and dierentiable function
with V
(x
) = 0 and V
(x
) < 0 then the function V has a local maximum

in the point x = x
. In the following example we apply this optimisation

technique to an example involving expected utility.
Example 6.4.1
A speculator considers taking part in a gamble with uncertain outcomes. If
an amount y is invested, the amount can either be doubled or lost. If p is the
probability that the amount will be doubled, the gamble can be presented
as:
s
P
e
e
e
e
e
1 p p
s
0
s
2y
The speculator with initial capital x can invest only an amount between 0
and x. Suppose the amount x, 0 1, is invested. The speculators
nal wealth will either be (xx)+2x = x+x if the gamble is successful,
or (xx) if the gamble is lost. We represent the nal wealth in the following
tree diagram:
s
P
e
e
e
e
e
1 p p
s
x x
s
x + x
Assume the utility function of the speculator is given by u(x) = ln(x). Hence,
the expected utility of his nal wealth will be:
81 DSC3705
V () = E[u( x)] = pu(x + x) + (1 p)u(x x)]
= p ln(x + x) + (1 p) ln(x x)
To nd the optimal value of V , we dierentiate V with respect to to get:
V
() = p
x
x + x
+ (1 p)
x
x x
Solve V
() = 0. Then
px
x + x
=
(1 p)x
x x
px(x x) = (x px)(x + x)
simplify then:
(2p 1)x
2
= x
2
since x = 0 we have
= 2p 1
Thus the speculator should invest (2p 1)100% of his initial wealth. Note
that, if p
1
2
, then < 0 and the optimal amount to be invested is 0.
Suppose the probability to double the amount is 0,6. The speculator should
invest (20,61)(100) = 20% of his initial wealth. Thus, if the investor has
an initial wealth of R1 000, she/he should consider investing R200. You may
verify that, if she/he invests 20% of his initial wealth, the expected utility of
the investment will be 7,04. If she/he invests any other amount the expected
utility will be less.
Note that you can dierentiate V
() to prove that V
() is indeed negative
for all possible values. Thus V () will have a maximum value if = 2p1.
You should obtain:
V
() =
px
2
(x + x)
2

(1 p)x
2
(x x)
2
0 if [0; 1]
82 DSC3705
7 Solutions: Exercises in study unit 2
EXERCISE 2.2.1
Question 1
Derive equation 6.3
Solution
cov(x
1
,x
2
) = E[(x
1
x
1
)(x
2
x
2
)]
= E[x
1
x
2
x
1
x
2
x
1
x
2
+ x
1
x
2
]
= E[x
1
x
2
] x
1
E[x
2
] E[x
1
] x
2
+ x
1
x
2
= E[x
1
x
2
] x
1
x
2
x
1
x
2
+ x
1
x
2
= E[x
1
x
2
] x
1
x
2
EXERCISE 2.3.1
Question 1
This question refers to the example on page 152.
Suppose each asset i = 1; 2; 3 has a rate of return with mean m and variance
2
. Assume each return pair has a covariance 0,3
2
for i = j. Suppose a
portfolio consists of equal portions of the three assets. Show that the variance
of the rate of return of portfolio satises the following equation.
var(r) =
0,7
2
3
+ 0,3
2
83 DSC3705
Solution
var(r) =
n
i,j=1
w
i
w
j
ij
= w
1
w
1
11
+ w
1
w
2
12
+ w
1
w
3
13
+ w
2
w
1
21
+ w
2
w
2
22
+ w
2
w
3
23
+
+w
3
w
1
31
+ w
3
w
2
32
+ w
3
w
3
33
= (
1
3
)(
1
3
)
_
2
+ 0,3
2
+ 0,3
2
+ 0,3
2
+
2
+ 0,3
2
+ 0,3
2
+ 0,3
2
+
2
_
=
1
9
(3
2
) +
1
9
(6 0,3
2
)
=
1
3
2
+ 0,3(
2
3
)
2
=
1
3
2
+ 0,3
2
(1
1
3
)
=
1 0,3
3

2
+ 0,3
2
=
0,7
3

2
+ 0,3
2
Compare this last equation with the results for the general case (n assets)
on page 152.
EXERCISE 2.8.1
Question 1
Luenberger p170, 6.3
Solution
=

AB
B
= 1, thus
AB
= 0,0045.
Then
2
p
=
2
(0,15)
2
+ 2()(1 )(0,0045) + (1 )
2
(0,30)
2
.
Solve
d
d
(
2
p
) = 0.
0,8261.
MV P
0,1392.
84 DSC3705
r
p
0,1139.
Question 2
Solution
Final wealth (prot of loss) without insurance:
state probability outcome
rain 0,5 10
6
no rain 0,5 (3 1)10
6
Suppose he buys u units of insurance. He pays 0,50u. Note that if it rains
he receives u units. Then he invests 10
6
+0,5u at the start of the year. Final
netto wealth at the end of the year:
state probability outcome
rain 0,5 u 10
6
1
2
u
no rain 0,5 (3 1)10
6
1
2
u
Rate of return=
netto value at the end of the year
initial investment
.
If he buys insurance then
expected rate of return =
1
2
_
0,5u 10
6
0,5u + 10
6
_
+
1
2
_
2(10
6
) 0,5u
0,5u + 10
6
_
=
0,5(10
6
)
0,5u + 10
6
.
To minimise the risk he should buy full insurance, thus he should buy 3
million units of insurance with a initial payment of
3
2
million rand. He will
then have
1
2
million rand at the end of the event, whether it rains or not.
The expected rate of return in this case is
0,5(10
6
)
10
6
+
3
2
(10
6
)
.
85 DSC3705
Question 3
Solution
(a) To determine the minimum-variance portfolio you may apply one of the
following methods.
Solution method 1
Solve
3
j=1
ij
w
j
r
i
= 0 for i = 1; 2; 3.
Let = 0 and = 1.
Solve:
_
_
2 1 0
1 2 1
0 1 2
_
_
_
_
w
1
w
2
w
3
_
_
=
_
_
1
1
1
_
_
.
Solution: w
1
=
1
2
, w
2
= 0 and w
3
=
1
2
.
Solution method 2
Let Z =
2
p
=
3
i,j=1
w
i
w
j
ij
.
Substitute the sigma (
ij
) values (from the covariance matrix), remember
w
i
w
j
= w
j
w
i
and simplify the expression.
Then Z = 2w
2
1
+ 2w
1
w
2
+ 2w
2
w
3
+ 2w
2
2
+ 2w
2
3
.
Let w
1
= w
3
(see hint) then w
2
= 1 w
1
w
3
= 1 2w
1
.
Then Z = 2(2w
2
1
2w
1
+ 1).
Dierentiate to w
1
, then Z
(w
1
) = 2(4w
1
2).
Solve Z
(w
1
) = 0. Then Z
(w
1
) = 0 if w
1
=
1
2
. Z
(
1
2
) > 0, thus Z has a
minimum if w
1
=
1
2
.
Hence,
2
p
has a minimum if w
1
=
1
2
, w
2
= 0 and w
3
=
1
2
.
86 DSC3705
(b) To construct the second ecient portfolio let = 1 and = 0.
Solve:
_
_
2 1 0
1 2 1
0 1 2
_
_
_
_
w
1
w
2
w
3
_
_
=
_
_
0,4
0,8
0,8
_
_
.
Then w
1
= 0,1, w
2
= 0,2 and w
3
= 0,3.
Normalise the weights, thus divide each w
i
value with
3
i=1
w
i
= 0,6.
Then
_
_
w
1
w
2
w
3
_
_
=
_
_
1
6
2
6
3
6
_
_
.
(c) Apply the one-fund theorem (apply equation 6.10).
Solve
3
i=1
ki
v
i
= r
k
r
f
for k = 1; 2; 3.
Then:
_
_
2 1 0
1 2 1
0 1 2
_
_
_
_
v
1
v
2
v
3
_
_
=
_
_
0,4 0,2
0,8 0,2
0,8 0,2
_
_
=
_
_
0,2
0,6
0,6
_
_
.
The solution is v
1
= 0, v
2
= 0,2 and v
3
= 0,2.
Normalise the weights (
3
i=1
v
i
= 0,4).
Then
_
_
v
1
v
2
v
3
_
_
=
_
_
0
1
2
1
2
_
_
.
87 DSC3705
EXERCISE 3.6.1
Question
The following problem is similar to example 7.4 in the textbook.
Suppose the following rates of return percentages are available:
year AA S+P T-bills
1 17 16,8 6,4
2 34 31,5 8,4
3 5 3,2 7,8
4 32 30,6 5,6
5 10 7,7 3,5
Determine the mean and standard deviation of the return data.
Determine the beta () of fund AA.
Calculate the Jensen index of the fund AA and illustrate the value on a (; r)
diagram.
Calculate the Sharpe index of the fund AA and illustrate the value on a (; r)
diagram.
Interpret the index values.
Solution
Remember in this problem the data is a sample. Use sample functions to
estimate parameters. Hence calculate the standard deviation using n1 = 4.
See page 184, Luenberger.
AA S&P T-bills
Rates of return 17,6 16,68 6,34
Standard deviation 16,165 14,91 1,94
Then: r
f
= 6,34, r
M
= 16,68, r
AA
= 17,6, S
M
= 16,68,
AA

240,24
233,317
1,08,
88 DSC3705
J
AA
0,093 and S
AA
0,6966.
The Jensens index is used to determine the excess return of an asset or
portfolio over the securitys required rate of return as determined by the
CAPM model. Thus fund AA performs slightly better than the market.
The Sharpe ratio is a measure of risk-adjusted performance of an asset. It is
used to characterise how well the return of an asset compensated the investor
for the risk taken. When comparing two funds, the fund with a higher Sharpe
index indicate more return for the same risk. In the case, the Sharpe index
of the market is 0,6935 (justication:
r
M
r
f
M
=
16,686,34
14,91
). The Sharpe index
for fund AA is very close to the Sharpe index for the market. According to
the Sharpe index the AA fund performs slightly better than the market.
EXERCISE 3.8.1
Question 1
Solution
(a) r = 0,07 +
0,230,07
0,32
= 0,07 + 0,5.
(b i) Let r = 0,39 and solve the previous equation to obtain = 0,64.
(b ii) Solve 0,39 = (0,07) + (1 )(0,23). Then = 1, and (1 ) = 2.
Thus, borrow 1000 from the bank, and invest 2000 in the market. Do you
think this is a good option?
(c) Solution method 1
Expected money at the end of the year = (1,07)(300) + (1,23)(700) = 1182.
Then the expected rate return is r
p
=
1182
1000
1 = 0,182.
Solution method 2
=
300
1000
and (1 ) =
700
1000
r
p
= 0,3(0,07) + (0,7)(0,23) = 0,182
Expected money at the end of the year = (1 + 0,182)(1000) = 1182.
Question 2
89 DSC3705
Solution
2
M
=
2
i,j=1
w
i
w
j
ij
= (
1
2
)(
1
2
)
2
A
+ (
1
2
)(
1
2
)
AB
+ (
1
2
)(
1
2
)
AB
+ (
1
2
)(
1
2
)
2
B
= 0,02
cov(A,M) = cov(A,
1
2
(A + B))
= cov(A,
1
2
A) + cov(A,
1
2
B)
=
1
2
cov(A,A) +
1
2
cov(A,B)
=
1
2
2
A
+
1
2
AB
= 0,025
A
=
cov(A,M)
2
M
=
0,025
0,02
= 1,25
Verify that cov(B,M) = 0,015. Hence,
B
=
0,015
0,02
= 0,75.
r
A
= 0,10 + 1,25(0,18 0,10) = 0,20
r
B
= 0,10 + 0,76(0,18 0,10) = 0,16
Question 3
Solution
r
W
= (0,6)(0,10) + 0,2(0,2) + (0,2)(0,10) = 0,12
90 DSC3705
r
V
= (0,8)(0,10) + (0,2)(0,20) + (0,4)(0,10) = 0,08
r
M
= r
W
+ (1 ) r
V
= (0,12) + (1 )(0,08)
= 0,08 + 0,04
The weights of market portfolio are
(w
M
1
; w
M
2
; w
M
3
) = (0,6; 0,20; 0,20) + (1 )(0,80; 0,20; 0,40)
= (0,8 0,2; 0,4 0,2; 0,20 + 0,40)
The market portfolio has positive weights for all three assets.
Hence,
0,8 0,2 0 4;
0,4 0,2 0
1
2
;
0,20 + 0,40 0 2.
Thus
1
2
2.
Minimum rate of return if =
1
2
, then r
min
= 0,08 + 0,04(
1
2
) = 0,10
Maximum rate of return if = 2, thus r
max
= 0,16.
Question 4
Solution
(a) Weight of asset A=
150
450
=
1
3
.
Weight of asset B =
300
450
=
2
3
.
r
M
=
1
3
(0,15) +
2
3
(0,12) = 0,13.
(b)
2
M
= (
1
3
)
2
(0,15)
2
+ 2(
1
3
)(
2
3
)(
1
3
)(0,04)(0,09) + (
2
3
)
2
(0,09)
2
= 0,0081.
91 DSC3705
(c) cov(r
A
,r
M
) = 0,0105 and
A
=
0,0105
0,0081
= 1,296
(cov(r
A
,r
M
) = cov(r
A
,
1
3
r
a
+
2
3
r
B
) =
1
3
cov(r
A
,r
A
) +
2
3
cov(r
A
,r
B
)
Thus cov(r
A
,r
M
) =
1
3
(0,15)
2
+
2
3

1
3
0,15 0,09)
(d) Solve 0,15 r
f
= 1,296(0,13 r
f
) to determine r
f
.
Question 5
Consider an investment market in which the
risk-free rate on treasury bills is 4%;
expected rate of return on the market is 8%;
standard deviation of the rate of return on the market is 30%;
assumptions of the capital asset pricing model hold.
(a) Consider an ecient portfolio ZZ that consists entirely of treasury bills
and non-dividend paying shares. Suppose there are no other types of invest-
ments. If ZZ yields an expected return of 7%, what is its beta?
(b) Determine the ZZs standard deviation of the returns.
(c) Split the total standard deviation of ZZ into amounts attributed to sys-
tematic and unsystematic risk.
(d) Calculate the market value (price) of ZZ assuming that all the securities
in ZZ are due to be redeemed for a total sum of 100 rand in one period from
now.
Solution
(a) Let r
m
= 0,08, r
f
= 0,04 and r
ZZ
= 0,07.
Use the equation r
z
r
f
=
ZZ
( r
m
r
f
) to determine
ZZ
= 0,75.
(b) Use the equation
ZZ
=
ZZ
M
to determine
ZZ
, since ZZ is on the
capital market line (ecient portfolio). (See comment in last paragraph on
page 182.)
92 DSC3705
Then
ZZ
= (0,30)(0,75) = 0,225.
(c)
2
ZZ
=
2
ZZ
2
M
+ var(
i
)
(0,225)
2
= = (0,75)
2
(0,30)
2
+ var(
i
)
Then var(
i
) = 0, since ZZ is on the market line (ecient portfolio). Thus
ZZ has only systematic risk
ZZ
= (0,225).
(d)
P =
100
(1 + 0,04) + 0,75(0,08 0,04)
= 93,5
Question 6
Prove that the beta of the market is always equal to one.
Solution
i
=

iM
2
M
Let i = M, then
M
=

MM
2
M
=

2
M
2
M
= 1.
The following solutions refer to the exercises in the study guide.
EXERCISE 4.1.1
Question 1
The following problem is similar to example 8.1.
93 DSC3705
The records of the rates of return (in percentages) for two stocks and an
index of industrial prices are given in the following table.
year k Stock 1 (r
k
1
) Stock 2 (r
k
2
) Index (f
k
)
1 23,27 27,24 12,3
2 19,47 17,05 5,5
3 6,58 10,20 4,3
4 15,08 20,26 6,7
5 16,24 19,84 9,7
(a) Determine the equation of the factor model for each stock.
(b) For each stock i plot the values (f
k
; r
k
i
) k = 1; . . . ; 5 on a graph. Draw
the equation r
i
= a + b
f on the same graph.

You may use a spreadsheet package (Excel) if you prefer. Remember when
applying the covariance function of Excel you should multiply the answer by
n
n1
(n is the number of data values in the sample).
Solution
Apply the following formulas for stock i, i = 1; 2.
r
i
=
1
5
5
k=1
r
k
i
f =
1
5
5
k=1
f
k
var(r
i
) = cov(r
i
,r
i
) =
2
r
i
=
1
4
5
k=1
(r
k
i
r
i
)
2
var(f) = cov(f,f) =
2
f
=
1
4
5
k=1
(f
k

f)
2
cov(r
i
,f) =
1
4
5
i=1
(r
k
i
r
i
)(f
k

f)
b
i
=
cov(r
i
,f)
var(f)
a
i
= r
i
b
i

f
e var = var(r
i
) b
2
i
var(f)
94 DSC3705
Answers:
f = 7,7, cov(f,f) 10,64

i = 1 i = 2
i
r 13,496 18,918
var(r
i
) 136,07 37,85
cov(r
i
,f) 25,995 18,133
b
i
2,44 1,7
a
i
5,3 5,8
e var 72,57 6,95
EXERCISE 4.2.1
Question 1
Apply equation 8.5 to determine the equation of the characteristic line for
the return (in percentages) of the following stock.
year (k) stock (r
k
i
) market (r
k
M
) riskless (r
k
f
)
1 27,24 23,0 7,1
2 17,05 15,3 6,9
3 10,2 11,5 6,8
4 20,26 18,5 7
5 19,84 18,1 6,8
Determine r
f
=
1
5
5
k=1
r
k
f
.
Let (r
i
r
f
) be represented on the y-axis and (r
M
r
f
) on the x-axis. Repre-
sent the coordinates (r
k
M
r
f
; r
k
i
r
f
) and the equation of the characteristic
line on the same diagram.
Solution
Note that in this example i = 1, since we have only one stock. (Compare
with table 8.2, with 4 stocks.)
Let r
f
=
1
5
5
k=1
r
k
f
. Then r
f
6,92.
Calculate r
k
i
r
f
and r
k
M
r
f
for k = 1; . . . ; 5. Note the value r
f
is the
95 DSC3705
expected riskless value for the given period and is kept constant in the cal-
culation of the other values.
The mean values r
i
r
f
and r
M
r
f
are 11,998 and 10,36 respectively.
Then:
var
i
=
1
4
5
k=1
((r
k
i
r
f
) r
i
r
f
)
2
37,84992
var
M
=
1
4
5
k=1
((r
k
M
r
f
) r
i
r
f
)
2
18,052
with
r
f
6,92.
cov(i,M) =
1
4
4
k=1
((r
k
i
r
f
) r
i
r
f
)((r
k
M
r
f
) r
i
r
f
) 26,02095
=
cov(i,M)
var
M
=
26,02095
18,052
1,441
= (11,998) 1,441(10,36) 2,935
The equation of the characteristic line is:
r
i
r
f
= 2,94 + 1,44(r
M
r
f
)
Note:
You could also apply the following formulas:
r
M
=
1
5
5
k=1
r
k
M
r
i
=
1
5
5
k=1
r
k
i
96 DSC3705
var
M
=
2
M
=
1
4
5
k=1
(r
k
M
r
M
)
2
cov(i,M) =
i,M
=
1
4
5
k=1
(r
k
i
r
i
)(r
k
M
r
M
)
You would obtain the same results since the subtraction of a constant
value r
f
does not inuence the covariances.
Use Excel to t a regression line through the values (r
k
M
r
f
; r
k
i
r
f
).
Enter the values r
M
r
f
(the x-axis values) and r
i
r
f
(the y-axis val-
ues) in two columns on a spreadsheet. Choose the option [Tools] on the
task bar, then choose [Data Analysis] and [Regression]. Complete
the pop-up menu. The regression line you obtain should be similar to
the equation of the characteristic line.
EXERCISE 4.4.1
Question 1
Solution
r
M
= 0,12
M
= 0,18 r
f
= 0,05
Then r
p
= 0,2 r
A
+0,5 r
B
+0,3 r
C
, with r
A
the expected rate of return of stock
A; r
B
the expected rate of return on stock B and r
C
the expected rate of
return on stock C.
If CAPM conditions are satised the
i
values should be zero. One of the
criticisms against the CAPM model is that it assumes all investors hold the
same portfolio (i.e. market portfolio). In practice some of the assumptions
are often violated. Remember the CAPM model and the factor model are
both merely models trying to explain market behaviour.
Use the formula
r r
f
= ( r
M
r
f
)
to obtain
r
A
= 0,05 + 1,10(0,12 0,05) 0,127
97 DSC3705
r
B
= 0,05 + 0,08(0,12 0,05) 0,106
r
C
= 0,05 + 1,0(0,12 0,05) 0,120
Then
r
p
0,1144.
Apply equation 7.4 to determine the beta (
p
) of the portfolio.
p
= 0,2(1,1) + 0,5(0,80) + 0,3(1,00) 0,92
2
M
= (0,18)
2
2
e
=
3
i=1
w
2
i
2
e
i
= 0,2
2
(0,07)
2
+ 0,5
2
(0,023)
2
+ 0,3
2
(0,01)
2
0,00034
Then
2
p
= (0,92)
2
(0,18)
2
+ 0,00034 0,02776.
Thus
p
16,67%.
Question 2
Solution
Apply the theorem on page 209, then r
f
= 0,10, r
1
= 0,15, r
2
= 0,20 with
0
,
1
,
2
the APT factors. Then
0
= r
f
= 0,10 and
r
i
= 0,10 + b
i1
1
+ b
i2
2
.
Thus
0,15 = 0,10 + 2
1
+ 1
2
0,20 = 0,10 + 3
1
+ 4
2
.
Solve the set of equations. Then
1
= 0,02,
2
= 0,10.
Example:
The equation r = 0,10+0,02b
1
+0,02b
2
describes a plane in the three dimen-
sional space (with b
1
on the x-axis, b
2
on the y-axis and r on the z-axis)and
98 DSC3705
describes all assets (and portfolios consisting of the assets) which are inu-
enced by factors f
1
and f
2
. Thus all assets governed by factors f
1
and f
2
must lie on this plane. Each asset has its own b
1
and b
2
values. The price of
risk associated with factors f
1
and f
2
are indicated by
1
and
2
. When an
asset does not satisfy the equation it is not on the plane and it is mispriced.
For example, suppose P is a portfolio with r = 0,15, b
1
= 0,8 and b
2
= 1,2.
Thus the expected rate of return of the portfolio according to the market is
0,15. But according to the APT theorem the expected rate of return should
be
r
p
= 0,10 + 0,02(0,8) + 0,01(1,2) 0,128.
Since the the observed expected rate of return in the market is 0,15 arbitrage
is possible. Find the asset on the plane with the same b
1
and b
2
values as
the portfolio P (thus satisfying the equation of the plane). Short this asset
which has expected rate of return of 0,128. You receive an amount per unit
and invest this amount in portfolio P which has expected rate of return of
0,15. At the end of the investment period you must replace the shorted asset
at its then value.
Let us assume you receive an amount A from shorting the asset and you
invest this amount A in portfolio P. At the end of one time period the
expected amount you should receive is A(1+0,15) = 1,15A. The asset which
you should replace, has expected value A(1 + 0,128) = 1,128A.
The expected risk-free prot is 1,28A1,15A > 0. More investors will follow
the same strategy of buying P and the rate of return of P will decrease since
the price will increase because of the demand of P.
According to Wikipedia( http://en.wikipedia.org/wiki/Arbitragepricingtheorem):
The APT describes the mechanism of arbitrage whereby in-
vestors will bring an asset which is mispriced, according to the
APT model, back into line with its expected price. Note that
under true arbitrage, the investor locks-in a guaranteed payo,
whereas under APT arbitrage as described below, the investor
locks-in a positive expected payo. The APT thus assumes ar-
bitrage in expectations - i.e. that arbitrage by investors will
bring asset prices back into line with the returns expected by
the model.
99 DSC3705
EXERCISE 5.9.1
Question 1
Solution
Solve u(x) = E[u(x)] to determine the certainty equivalent.
E[u(x)] =
1
7
(80 000)
1
4
+
1
7
(90 000)
1
4
+
1
7
(100 000)
1
4
+
1
7
(110 000)
1
4
+
1
7
(120 000)
1
4
+
1
7
(130 000)
1
4
+
1
7
(140 000)
1
4
18,1534
Hence (CE)
1
4
= 18,1534
CE = 108 600,52
Question 2
Solution
Apply the Arrow-Pratt measure.
R
A
=
u
(x)
u
(x)
=
_
a
2
e
ax
ae
ax
_
= a
Constant risk-averse, thus investment decision is independent of wealth.
100 DSC3705
Question 3
Solution
The Arrow-Pratt coecient of u(x) is a
1
(x) =
u
(x)
u
(x)
.
The Arrow-Pratt coecient of v(x) is a
2
(x) =
v
(x)
v
(x)
=
bu
(x)
bu
(x)
=
u
(x)
u
(x)
.
Hence a
1
(x) = a
2
(x).
Question 4
Luenberger p 256, 9.4
Solution
Arrow-Pratt relative risk aversion coecient if u(x) = ln x is:
=
x (x
2
)
x
1
= 1.
Arrow-Pratt relative risk aversion coecient if u(x) = x
is:
=
x (
2
( 1)x
2
)
2
x
1
= ( 1)
Both coecients are constant values (independent of x).
Question 5
Colins preferences can be modelled by a utility function such that
u
(w) = 3 2w, with w > 0, the wealth of Colin.

(a) Over what ranges can this utility function be satisfactorily applied?
(b) How will Colins holdings of risky assets change if his wealth increases?
(c) Which of the following investments will he choose?
101 DSC3705
A B C
outcome probability outcome probability outcome probability
0,1 0,3 0 0,3 0,2 0,45
0,3 0,4 0,2 0,2 0,3 0,1
0,5 0,3 0,9 0,5 0,4 0,45
Solution
(a) The utility function is a parabola. The utility function increases if u
> 0
u
(w) = 3 2w > 0 if 0 < w <

3
2
.
(b) Arrow-Pratt:
a(w) =
2
3 2w
The function a(w) is an increasing function on the interval (0;
3
2
). Thus
increasing absolute risk aversion. If Colins wealth increases, his investment
in risky assets will decrease.
(c)
u(x) =
_
u
(w) dw =
_
3 2wdw = 3w w
2
+ k
Note that it is sucient to use u(x) = 3w w
2
, since the addition of a
constant does not aect the functions rankings.
E[u
A
] = 0,3u(0,1) + 0,4u(0,3) + 0,3u(0,5) 0,786
E[u
B
] = 0,3u(0) + 0,2u(0,2) + 0,5u(0,6)
E[u
C
] = 0,45u(0,2) + 0,1u(0,3) + 0,45u(0,4) 0,80
If Colin is an expected utility maximiser he would choose investment with
the largest utility.
Question 6
Thobela has a utility function u(x) = ln(x). Suppose she has initial wealth
w and is oered a gamble. If she bets x her nal wealth will be w + x with
probability p (0 < p < 1), otherwise her nal wealth will be wx. Determine
the optimal value x as a function of p if she is an expected utility maximiser.
102 DSC3705
Solution
V (x) = E[u( x)] = pu(w + x) + (1 p)u(w x)
= p ln(w + x) + (1 p) ln(w x)
Hence V
(x) = p
1
w + x
+ (1 p)
1
w x
Solve V
(x) = 0, then x = w(2p 1).

Note V
(x) = p(w + x)
2
(1 p)(w x)
2
< 0 for all x, thus V has a
maximum if x = w(2p 1).
If p
1
2
she should not bet any money at all. (Why?)
If (2p 1) > 0, (thus p >
1
2
) she should bet w(2p 1).
Question 7
Solution
Suppose the investors optimal value is x
1
with total return
R
1
=
x
1
1
.
Suppose the friend with initial wealth w, has optimal value x
2
, with total
return
R
2
=
x
2
w
.
Assume R
1
= R
2
(same return), then x
2
= R
2
w = R
1
w = x
1
w.
Apply equation (9.4) E[u
(x
)d
i
] =
i
P
i
and remember u(x) = ax b
x
2
2

u
(x) = a bx.
Investor:
E[(a bx
1
)d
1
] =
i
P
i
103 DSC3705
Friend:
E[(a b
2
)d
i
] =
i
P
i
thus E[(a b
1
w)d
i
] =
i
P
i
then b = b
w
b
=
b
w
Question 8
Solution
The random optimal payo x
satises
E[u
(x
)d
i
] = P
i
Suppose there is a risk-free asset with total return R then d
i
= R and P
i
= 1.
Then
= E[u
(x)]R
and
E[u
(x
)d
i
] = (E[u
(x
)]R)P
i
.
Assume R = 1+r
f
, with r
f
xed. P
i
is the current known price. Note that d
i
(the payo) and r
i
are random variables, with r
i
=
d
i
P
i
P
i
, thus d
i
= P
i
(1+r
i
).
Then for each i:
E[u
(x
)d
i
] E[u
(x
)]RP
i
= 0
E[u
(x
)d
i
] (1 + r
f
)P
i
E[u
(x
)] = 0
E[u
(x
)(d
i
P
i
(1 + r
f
))] = 0
E[u
(x
)(P
i
(1 +r
i
) P
i
(1 + r
f
))] = 0
E[u
(x
)(P
i
(r
i
r
f
) = 0
P
i
E[u
(x
)(r
i
r
f
) = 0
E[u
(x
)(r
i
r
f
)] = 0
104 DSC3705
Question 9
Luenberger p 257, 9.11
Hint: Use the state prices (
1
;
2
;
3
) in example 9.9 and apply equation
9.15.
Solution
State prices are
1
=
1
6
, =
1
2
and
3
=
1
6
. Suppose the initial price is P, if
state 1 (high success) occurs then outcome d
1
= 3 000, if state 2 (moderate
success) occurs then outcome d
2
= P, if state 3 (failure) occurs then outcome
d
3
= P.
payo = (d
1
; d
2
; d
3
) = (3 000; P; P)
0
=
1
+
2
+
3
=
1
6
+
3
6
+
1
6
=
5
6
q
1
=
1
6
5
6
= 0,2; q
2
=
3
6
5
6
= 0,6; q
3
=
1
6
5
6
= 0,2
E(d) = 0,2(3000) + 0,6P + 0,2P

Apply formula 9.15:
Assume
0
= price of security with payo (1; 1; 1). The risk-free return
(risk-free bond) is R = 1,2.
Then
P =
1
R
E(d) =
1
1,2
(0,2(3000) + 0,6P + 0,2P)
and
P = 1 500.
Question 10
105 DSC3705
Solution
For each $1 the probability is
1
4
to get $5, and the probability is
3
4
to receive
zero dollar. Suppose Gavins initial wealth is w. Suppose w is bet on the
horse. If the horse wins, Gavin receives 5w or else he receives nothing.
Thus the nal wealth of Gavin is:
state probability wealth
wins
1
4
w + 5w w = w + 4w
loses
3
4
w w
E[u(x)] =
1
4
_
w(1 + 4) +
3
4
_
w(1 )
Then V () =
1
4
1 + 4 +
3
4
1 .
V
() =
1
4
w
1
2
(1 + 4)
1
2
+
3
4
w
1
2
(1 )
1
2
(1)
Solve V
() = 0, then 0,1346.
106 DSC3705
11 References
The following source provides an explanation of the lexicon of decision-
making. Look for the menu Lexicon.
http://faculty.fuqua.duke.edu/daweb/
You could also use a search engine to nd the lexicon. Then you should search
for Lexicon of decision-making. Please try to read through this explanation.
The author, Tom Spradlin, provides a short narrative that should clarify
some of the concepts we use in this module.
In the development of this tutorial letter I used the following references. Most
of these books are available in the library.
Prof B Swart, Lecture notes
Anthony M and Norman Biggs. 2000. Mathematics for Economics and
Finance. Cambridge University Press
Aliprantis, CD and Chakrabarti, SK. 2000. Games and Decision Making.
Oxford University Press.
Clemen, RT and Reilly, T. 2001. Making Hard Decisions. Pacic Grove,
Calif: Duxberry.
Elton, EJ and Gruber MJ. 1995. Modern Portfolio Theory and Investment
Analysis. John Wiley and Sons, Inc.
Keeney, R and Raia, H. 1976. Decisions with Multiple Objectives: Prefer-
ences and Value Tradeos New York: Wiley.
Luenberger, DG. 1998. Investment Science Oxford University Press
Ross, SM. 2003. An Elementary introduction to Mathematical Finance New
York: Cambridge University Press.
Tapiero, CS. 2004. Risk and Financial Management John Wiley and Sons,
Ltd.
Van Zandt, T. 2003. Introduction to the Economics of Uncertainty and In-
formation. (This book has not been published yet, however the author gave
us permission to use the book.)
Varian, HR. 1990. Intermediate Microeconomics:A Modern Approach. New
York: WW Norton.
Winston, WL. 1993. Operations Research Applications and Algorithms Bel-
mont, Calif: Duxberry Press.
http://www.stanford.edu/wfsharpe/mia/fac/mia fac2.htm
http://homepage.newschool.edu/het/essays/uncert/vnmaxioms.htm

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Department of Decision Sciences

Financial Risk Modelling

Please do the following exercise before continuing with the study

2.3 Chapter 6.4: Portfolio mean and variance

= |0,20(1 ) + 0,25|. Write down the steps in the space below:

Please do the following exercise before continuing with the study

2.4 Chapter 6.5: The feasible set

() > 0, z has a minimum value z()

(0,8261) 0,21 > 0.

Do the following exercise before continuing:

Do the following exercise before continuing:

Please complete the following exercise:

Do the following exercise before continuing:

4.2 Chapter 8.3: The CAPM as a factor model

Do the following exercise before continuing:

Please do the following exercise.

(w) = 3 2w, with w > 0 representing the wealth of Colin.

Valuing investment by expected utility

(x) > 0 for all x X. If u

(x) 0, then u is increasing on the domain.

(x) < 0 for all x X.

(x) < 0 for all x X, then u(x) is strictly concave.

straight line below u

(x) > 0 for all x X

Denition 6.2.5 The risk premium RP of a lottery P is the dierence be-

6.2.2 Risk prole

Note the risk premium is positive. If a decision-maker is risk-averse, the

(x) < 0 for all x. The utility function of a risk-neutral decision-maker

(x) < 0 RP > 0

(x) > 0 RP < 0

(x) > 0 for all x, thus u is an increasing function.

(x) < 0 for all x, thus the decision-maker

Decreasing risk-aversion is a reasonable assumption. It seems reasonable that

(x) < 0 for all x, thus

Denition 6.3.4 A decision-maker is increasingly risk-averse if she/he is

If the wealth of the decision-maker increases, she/he becomes more risk-

) < 0 then the function V has a local maximum

. In the following example we apply this optimisation

f on the same graph.

f = 7,7, cov(f,f) 10,64

(w) = 3 2w, with w > 0, the wealth of Colin.

(w) = 3 2w > 0 if 0 < w <

(x) = 0, then x = w(2p 1).

E(d) = 0,2(3000) + 0,6P + 0,2P

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