Assignment 1 - MAA324

Exercise 1:

What is the relationship between a stock’s continuously compounded rate of return and the
underlying stock prices that can only be observed at finite time intervals?

Solution:

The continuous compound rate of return can be calculated from the formula for continuously
compounded interest, 𝑟:

𝑟𝑁
𝑆𝑁 = 𝑆0𝑒

Where 𝑆𝑁 is the stock price at the end of the period, 𝑆0 is the stock price at the beginning of the

period and 𝑁 is the time length in years.

Solving for 𝑟 we obtain:

𝑟=
1
𝑁 ( )
𝑙𝑛
𝑆𝑁
𝑆0

Hence we obtained a clear relationship between a stock’s continuously compounded rate of return
and the underlying stock prices observed at a finite time interval of length 𝑁.
Exercise 2:

Consider the following definition for the single-period return, 𝑟𝑡, for an investor that buys a long

position in a common stock.

[(𝑃𝑡 − 𝑃𝑡−1)+ 𝑑𝑡 ]
𝑟𝑡 = 𝑃𝑡−1

for a long position.

What is the single-period return, 𝑟𝑡, formula for an investor who sells a stock short?

Solution:

In order to calculate the return of short selling a stock, we need to subtract the proceeds from the
sale from the cost of repurchasing the borrowed shares when closing the position. Additionally,
dividends paid during this period will also be deducted from the short seller's account on the pay
date and delivered to the stock’s owner. Lastly, we divide this value by the initial proceeds from
the sale of the borrowed shares. In mathematical form:

[(𝑃𝑡−1 − 𝑃𝑡 )− 𝑑𝑡 ]
𝑟𝑡 = 𝑃𝑡−1
Exercise 3:

An investor bought one share of stock at 100 SEK and sold it at 120 SEK in one year after
collecting zero-cash dividends.

I. What is the holding period return (HPR)?

II. What is the monthly compounded return?
III. What is the continuously compounded return 𝑟𝑡?

IV. What relationship do you observe between these rates of return and their holding periods?

Solution:

I. The holding period return is calculated as follows:

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 + 𝑆𝑁 − 𝑆0( ) 0 + (120 − 100)

𝐻𝑃𝑅 = 𝑆0
= 100
= 0. 2 = 20%

II. The monthly compounded return can be calculated from the following equation:

(( )
1/𝑚×𝑁
𝑟𝑚 𝑚×𝑁 𝑟𝑚 𝑚×𝑁
𝑆𝑁 = 𝑆0 1 + ( 𝑚 ) ⇒
𝑆𝑁
𝑆0 (
= 1 + 𝑚 ) ⇒ 𝑟𝑚 = 𝑚 ×
𝑆𝑁
𝑆0 ) −1

𝑟𝑚 = 12 × (( 120 1/12×1
100 ) )
− 1 ≈ 0, 1837 = 18. 37%

III. The continuously compounded return can be calculated from:

𝑟=
1
𝑁 ( )
𝑙𝑛
𝑆𝑁
𝑆0
=
1
1
𝑙𝑛 ( ) ≈ 0, 1823 = 18. 23%
120
100

IV. The relationship between holding periods and rates of return is that, for a holding period
of equal length, the returns diminish the more often the rates are compounded.
Exercise 4:

The following table contains the closing prices, 𝑃𝑡, of a common stock at the end of each month

over six months. Assume no dividends are paid. Compute the continuously compounded return
(CCR) and holding period return (HPR) each month. What is the average value of each?

𝑀𝑜𝑛𝑡ℎ (𝑡) 𝑃𝑡

0 100

1 104

2 98

3 95

4 100

5 110

Solution:

The holding period returns (HPR) and continuously compounded returns (CCR) are calculated by

𝐻𝑃𝑅 =
𝑆𝑡 − 𝑆𝑡−1
𝑆𝑡−1
and 𝐶𝐶𝑅 = 𝑙𝑛 ( )
𝑆𝑡−1
𝑆𝑡
respectively. The average value is calculated by taking

the sum of these values and dividing by the number of inputs.

Below are the values for each period calculated using these formulas in MATLAB:

Period (months) HPR CCR

0-1 0.0400 0.0392

1-2 -0.0577 -0.0594

2-3 -0.0306 -0.0311

3-4 0.0526 0.0513

4-5 0.1000 0.0953

The average values are given by:

𝑛
1 1
𝑛
∑ 𝐻𝑃𝑅𝑖 = 5
(0. 0400 − 0. 0577 − 0. 0306 + 0. 0526 + 0. 1000) = 0. 0209
𝑖=1

𝑛
1 1
𝑛
∑ 𝐶𝐶𝑅𝑖 = 5
(0. 0392 − 0. 0594 − 0. 0311 + 0. 0513 + 0. 0953) = 0. 0191
𝑖=1
Exercise 5:

Find the balance after three years if an amount of 100 SEK is deposited in a bank paying:

I. 10% annual interest rate

II. interest rate of 10% per annum (p.a.) with annual compounding
III. interest rate of 10% p.a. with semiannual compounding
IV. interest rate of 10% p.a. with monthly compounding
V. interest rate of 10% p.a. with daily compounding (365 days)
VI. interest rate of 10% p.a. continuously compounding

Solution:

I. We can calculate the balance after three years with 10% annual interest rate using the
simple interest formula:

(
𝑊𝑁 = 𝑊 0 1 + 𝑟 𝑚 × 𝑁 ) = 100(1 + 0. 1 × 3) = 130. 00

II. The balance after three years with 10% interest rate annually compounded is calculated
from the compound interest formula:
𝑟𝑚 𝑚×𝑁
𝑊𝑁 = 𝑊 0 1 + ( 𝑚 ) = 100 1 + ( 0.1 1×3
1) = 133. 10

III. Similarly, the balance after three years with 10% interest rate semi-annually compounded
is calculated as:
0.1 2×3
𝑊𝑁 = 100 1 + ( 2) = 134. 01

IV. The balance after three years with 10% interest rate monthly compounded is calculated as:

0.1 12×3
𝑊𝑁 = 100 1 + ( 12 ) = 134. 82

V. The balance after three years with 10% interest rate daily compounded is calculated as:

0.1 365×3
𝑊𝑁 = 100 1 + ( 365) = 134. 98

VI. Lastly, the balance after three years with 10% interest rate continuously compounded
using the continuously compounded interest formula:

𝑟×𝑁 0.1×3
𝑊𝑁 = 𝑊 0 × 𝑒 = 100 × 𝑒 = 134.96
 Exercise 6:

Compute the expected value and variance of 𝑅1, 𝑅2 and 𝑅3 in each of the following three

investment projects, where the returns 𝑅1, 𝑅2 and 𝑅3 depend on the market scenario.

Scenario Probability Return 𝑅1 Return 𝑅2 Return 𝑅3

ω1 0.25 12% 11% 2%

ω2 0.75 12% 13% 22%

Which of these is the most risky and the least risky project ?

Solution:
𝑛
The expected values are given by 𝐸[𝑅𝑖] = ∑ 𝑝𝑖 × 𝑅𝑖,𝑘 where 𝑅𝑖,𝑘 is the return of investment
𝑖=1

project 𝑘 in market scenario 𝑖, and 𝑝𝑖 is the probability of scenario 𝑖. We then obtain:

𝑛
𝐸[𝑅1] = ∑ 𝑝𝑖 × 𝑅𝑖,1 = 0. 25 × 0. 12 + 0. 75 × 0. 12 = 0. 120 = 12. 0%
𝑖=1

𝑛
𝐸[𝑅2] = ∑ 𝑝𝑖 × 𝑅𝑖,2 = 0. 25 × 0. 11 + 0. 75 × 0. 13 = 0. 125 = 12. 5%
𝑖=1

𝑛
𝐸[𝑅3] = ∑ 𝑝𝑖 × 𝑅𝑖,3 = 0. 25 × 0. 02 + 0. 75 × 0. 22 = 0. 170 = 17. 0%
𝑖=1

2 2
The variances for each scenario are given by 𝑉(𝑅𝑘) = 𝐸[𝑅𝑘] − (𝐸[𝑅𝑘]) , where the first term is
𝑛
2 2
given by 𝐸[𝑅𝑘] = ∑ 𝑝𝑖 × (𝑅𝑖,𝑘) . Therefore, we first obtain:
𝑖=1

𝑛
2 2 2 2
𝐸[𝑅1] = ∑ 𝑝𝑖 × (𝑅𝑖,1) = 0. 25 × (0. 12) + 0. 75 × (0. 12) = 0. 0144
𝑖=1

𝑛
2 2 2 2
𝐸[𝑅2] = ∑ 𝑝𝑖 × (𝑅𝑖,2) = 0. 25 × (0. 11) + 0. 75 × (0. 13) = 0. 0157
𝑖=1

𝑛
2 2 2 2
𝐸[𝑅3] = ∑ 𝑝𝑖 × (𝑅𝑖,3) = 0. 25 × (0. 02) + 0. 75 × (0. 22) = 0. 0364
𝑖=1
And now we calculate the variances as follows:

2 2 2
𝑉(𝑅1) = 𝐸[𝑅1] − (𝐸[𝑅1]) = 0. 0144 − (0. 120) = 0. 0144 − 0. 0144 = 0
2 2 2
𝑉(𝑅2) = 𝐸[𝑅2] − (𝐸[𝑅2]) = 0. 0157 − (0. 125) = 0. 0157 − 0. 015625 = 0. 000075
2 2 2
𝑉(𝑅3) = 𝐸[𝑅3] − (𝐸[𝑅3]) = 0. 0364 − (0. 170) = 0. 0364 − 0. 0289 = 0. 0075

To measure the risk of every project we need to check the standard deviations, where the
relationship between the variance and standard deviation is given by:

2
𝑉𝑖 = σ 𝑖 ⇒ σ 𝑖 = 𝑉𝑖

We then obtain the following:

σ1 = 𝑉1 = 0 = 0 = 0%

σ2 = 𝑉2 = 0. 000075 ≈ 0. 00866 ≈ 0. 87%

σ3 = 𝑉3 = 0. 0075 ≈ 0. 0866 = 8. 66%

As such, the most risky project is project number 3, and the least risky project is project number 1.
Exercise 7:

Suppose that the prices of 2 kinds of stocks are 𝑆1(0) = 30 𝑆𝐸𝐾 and 𝑆2(0) = 40 𝑆𝐸𝐾. We

prepare a portfolio worth 𝑊(0) = 1000 𝑆𝐸𝐾 by purchasing 𝑥1 = 20 shares of stock 𝑆1 and

𝑥2 = 10 shares of stock 𝑆2.

● What is the allocation (weights) of funds between the two securities?

● If the stock prices change to 𝑆1(1) = 35 𝑆𝐸𝐾 and 𝑆2(1) = 39 𝑆𝐸𝐾, how is the portfolio

split between the two securities?

Solution:

𝑥𝑖×𝑆𝑖(0)
The weights for the portfolio at time 𝑡 = 0 are given by ω𝑖 = 𝑊(0)
, so:

𝑥1×𝑆1(0) 20×30
ω1 = 𝑊(0)
= 1000
= 0. 6 = 60%
𝑥2×𝑆2(0) 10×40
ω2 = 𝑊(0)
= 1000
= 0. 4 = 40%

At time 𝑡 = 1, 𝑆1(1) = 35 𝑆𝐸𝐾 and 𝑆2(1) = 39 𝑆𝐸𝐾, so we calculate 𝑊(1) as follows:

𝑊(1) = 𝑥1 × 𝑆1(1) + 𝑥2 × 𝑆2(1) = 20 × 35 + 10 × 39 = 1090

So the weights are:

𝑥1×𝑆1(1) 20×35
ω1 = 𝑊(1)
= 1090
≈ 0. 6422 = 64. 22%
𝑥2×𝑆2(1) 10×39
ω2 = 𝑊(1)
= 1090
≈ 0. 3578 = 35. 78%
Exercise 8:

Compute the value 𝑊(1) of a portfolio worth initially 𝑊(0) = 1000 𝑆𝐸𝐾 that consists of two
securities with weights ω1 = 25% and ω2 = 75%, given that the security prices are

𝑆1(0) = 450 𝑆𝐸𝐾 and 𝑆2(0) = 330 𝑆𝐸𝐾 initially, changing to 𝑆1(1) = 480 𝑆𝐸𝐾 and

𝑆2(1) = 320 𝑆𝐸𝐾.

Solution:

To find the amount of shares per security we can solve for 𝑥𝑖 in the weights equation, so:
𝑥𝑖×𝑆𝑖(0) ω𝑖×𝑊(0)
ω𝑖 = 𝑊(0)
⇒ 𝑥𝑖 = 𝑆𝑖(0)

Solving for 𝑖 = 1, 2 we obtain:

ω1×𝑊(0) 0.25×1000
𝑥1 = 𝑆1(0)
= 450
≈ 0. 556

ω2×𝑊(0) 0.75×1000
𝑥2 = 𝑆2(0)
= 330
≈ 2. 273

So the current value 𝑊(1) of the portfolio is:

𝑊(1) = 𝑥1 × 𝑆1(1) + 𝑥2 × 𝑆2(1) ≈ 0. 556 × 480 + 2. 273 × 320 = 994. 24

Exercise 9:

Jerome has a five-stock portfolio with the following values and returns.

Determine this portfolio’s (value-weighted) expected return.

Solution:

The expected value of the portfolio’s return can be calculated by:

𝑛
𝐸[𝑟𝑝] = ∑ ω𝑖 × 𝐸[𝑟𝑖], where ω𝑖 is the weight of asset 𝑖
𝑖=1

We then obtain:

40,000 50,000 20,000 100,000 30,000

𝐸[𝑟𝑝] = 240,000
× 0. 08 + 240,000
× 0. 2 + 240,000
× 0. 15 + 240,000
× 0. 09 + 240,000
× 0. 1

𝐸[𝑟𝑝] = 0. 01333 + 0. 04167 + 0. 01250 + 0. 03750 × 0. 09 + 0. 01250

𝐸[𝑟𝑝] = 0. 11750 = 11. 75%

Exercise 10:

A two-asset portfolio earns a weighted average rate of return during time period 𝑡 of

𝑟𝑝𝑡 = 𝑥1 × 𝑟1𝑡 + 𝑥2 × 𝑟2𝑡

and the weights sum to one: 𝑥1 + 𝑥2 = 1. This portfolio’s expected return is:

𝐸(𝑟𝑝) = 𝑥1 × 𝐸(𝑟1) + 𝑥2 × 𝐸(𝑟2)

Derive the portfolio’s risk formula in terms of the variances of the two assets and their covariances.
Show all the steps of your derivation for full credit.

Solution:

2
From the definition of variance we have 𝑉(𝑟𝑖) = 𝐸[𝑟𝑖 − 𝐸(𝑟𝑖)] , for 𝑟𝑝 we then have that:

2 2
𝑉(𝑟𝑝) = 𝐸[𝑟𝑝 − 𝐸(𝑟𝑝)] = 𝐸[𝑥1 · 𝑟1𝑡 + 𝑥2 · 𝑟2𝑡 − 𝑥1 · 𝐸(𝑟1) + 𝑥2 · 𝐸(𝑟2)]

2
𝑉(𝑟𝑝) = 𝐸[𝑥1 · (𝑟1𝑡 − 𝐸(𝑟1)) + 𝑥2 · (𝑟2𝑡 − 𝐸(𝑟2))]

2 2 2 2
𝑉(𝑟𝑝) = 𝐸[𝑥1 · (𝑟1𝑡 − 𝐸(𝑟1)) + 𝑥2 · (𝑟2𝑡 − 𝐸(𝑟2)) + 2 · 𝑥2 · 𝑥2 · (𝑟1𝑡 − 𝐸(𝑟1) · (𝑟2𝑡 − 𝐸(𝑟2)]

2 2
And since σ𝑖 = (𝑟𝑖𝑡 − 𝐸(𝑟𝑖)) , we obtain:

2 2 2 2
𝑉(𝑟𝑝) = 𝐸[𝑥1 · σ1 + 𝑥2 · σ2 + 2 · 𝑥2 · 𝑥2 · σ12]

Where σ12 is the covariance factor between both assets.