Asset Pricing I

Problem Set

João Pedro Ruas

2025
 Contents

1 Choice and Risk 1

2 Portfolio choice 12

i
 Chapter 1

Choice and Risk

1
CHAPTER 1. CHOICE AND RISK 2

Exercise 1.1. Which of the following utility functions has Increasing Relative Risk Aversion?

(a) u(Y ) = ln(Y )

√
(b) u(Y ) = Y

(c) u(Y ) = −100 − exp(−aY )

Answer:

c)
CHAPTER 1. CHOICE AND RISK 3

Exercise 1.2. Investor 1 has higher ARA than Investor 2. They have the same wealth and face the same
portfolio choice between the same risk-free and risky asset.

(a) Investor 1 will invest more in the risky asset than Investor 2.

(b) Investor 1 will invest more in the risk-free asset than Investor 2.

Answer:

b).
CHAPTER 1. CHOICE AND RISK 4

Y 1−γ
Exercise 1.3. Two investors have an utility function u(Y ) = 1−γ , but investor 1 has a smaller gamma,
ie, γ1 < γ2 . They have the same initial wealth. Which of the following is true?

(a) Both investors will invest the same amount of money in the risk-free asset.

(b) Both investors will invest the same fraction of wealth in the risk-free asset.

(c) Investor 1 will invest a smaller fraction of his wealth in the risk-free asset.

(d) Investor 1 will invest a larger fraction of his wealth in the risk-free asset.

Answer:

c)
CHAPTER 1. CHOICE AND RISK 5

Exercise 1.4. Consider an economy with two possible states of the world (ω1 , ω2 ) and the three lotteries
Li (ω), i = 1, 2, 3 in the table below.

State ω1 ω2

Probability 0.5 0.5

L1 (ω) 100 120
L2 (ω) 91 131
L3 (ω) 80 140

√
Consider an investor with the utility function u(x) = x. Under the expected utility theory, which
lottery the investor chooses?

Answer:
√
For u(x) = x we compute the expected utility of each lottery:
1 1 1√ 1√
E[u(L1 )] = u(100) + u(120) = 100 + 120 = 10.48
2 2 2 2

1 1 1√ 1√
E[u(L2 )] = u(91) + u(131) = 91 + 131 = 10.49
2 2 2 2

1 1 1√ 1√
E[u(L3 )] = u(80) + u(140) = 80 + 140 = 10.39
2 2 2 2

√
Then, and investor with utility function u(x) = x, will choose lottery L2 .
CHAPTER 1. CHOICE AND RISK 6

Exercise 1.5. Consider an investor with a linear utility function u(Y ) = a + bY . What does it imply in
terms of risk-taking behavior?

Answer:

For this investor, ARA = 0 and RRA = 0. This type of investor is called "risk-neutral".

Risk-neutral investors are indifferent to fair games.

CHAPTER 1. CHOICE AND RISK 7

Exercise 1.6. An investor has log utility function u(Y ) = ln(Y ) and initial wealth Y0 = 1, 000.
Consider the gamble L = (30, −30, 0.4). Compute the CE. Comment the result.

Answer:

E [u (Y + L)] = u (Y + CE)

=⇒ 0.4 ∗ ln(1, 030) + 0.6 ∗ ln(970) = ln(1, 000 + CE)

=⇒ CE = −6.43
CHAPTER 1. CHOICE AND RISK 8

Exercise 1.7. An investor with initial wealth Y0 = 100 is faced with the following lottery: L =
(20, 0, 0.5). Consider the utility function: u(Y ) = 200Y − 21 Y 2 . What is the Certainty Equivalent of
this lottery?

Answer:

CE = 190.55 ∨ CE = 9.45.

Since the CE has to be less than the expected value of the gamble (10), we have that CE = 9.45.

Note that CE = 190.55 is on the nonsense decreasing part of the utility function:

u′ (190.55) = −90.55 < 0.

CHAPTER 1. CHOICE AND RISK 9

Exercise 1.8. Let π = π (Y, h) be the probability of the favorable outcome at which the investor with
wealth Y is indifferent between accepting or rejecting the gamble x̃ = (+h, −h, π).

Show that
1 1
π(Y, h) ∼
= + hARA(Y ).
2 4

Answer:

By definition, π(Y, h) must be such that

π(Y, h) : Y ∼ Y + x̃ ⇐⇒ E [u(Y )] = E [u (Y + x̃)]

which implies
u(Y ) = π (Y, h) u(Y + h) + [1 − π (Y, h)] u(Y − h). (1.1)

Expanding u(Y + h) and u(Y − h) in Taylor series1 around Y , we obtain

1
u(Y + h) = u(Y ) + hu′ (Y ) + h2 u′′ (Y ) + R1 ,
2

1
u(Y − h) = u(Y ) − hu′ (Y ) + h2 u′′ (Y ) + R2 ,
2
where R1 and R2 are the remainder terms. Replacing these quantities into equation (1.1)
 
′ 1 2 ′′
u(Y ) = π (Y, h) u(Y ) + hu (Y ) + h u (Y ) + R1
2
 
1
+ [1 − π (Y, h)] u(Y ) − hu′ (Y ) + h2 u′′ (Y ) + R2 ,
2
and collecting the terms
 
′ 1 2 ′′
u(Y ) = u(Y ) + [2π (Y, h) − 1] hu (Y ) + h u (Y ) + πR1 + [1 − π] R2 .
2 | {z }
R

Solving for π (Y, h)  ′′ 

1 1 u (Y ) R
π (Y, h) = + h − ′ − ,
2 4 u (Y ) 2hu′ (Y )
and acknowledging that R is small
1 1
π (Y, h) ∼
= + hARA(Y ).
2 4

1
Taylor series:f (x) = f (a) + f ′ (a)(x − a) + 21 f ′′ (a)(x − a)2 + · · · + 1 n
n!
f a(x − a)n
CHAPTER 1. CHOICE AND RISK 10

Exercise 1.9. Let the gamble x̃ be such that E[x̃] = 0 and V ar(x̃) = σx2 .

Show that he risk premium, RP , can be approximated as

1
RP ∼
= σx2 ARA(Y ).
2

Answer:

By the definition of RP

E [u (Y + x̃)] = u (Y + E [x̃] − RP ) = u (Y − RP ) .

Taking a Taylor series expansion of u (Y + x̃)

1
u (Y + x̃) = u(Y ) + x̃u′ (Y ) + x̃2 u′′ (Y ) + O(x̃3 )
2
where O(x̃3 ) is the remainder. Assuming this remainder is near zero,
1
E [u (Y + x̃)] ∼
= u(Y ) + u′′ (Y )σx2 , (1.2)
2
since E[x̃] = 0 and E[x̃2 ] = V ar[x̃] = σx2 .

Now, taking a Taylor series expansion of u (Y − RP )

u (Y − RP ) = u(Y ) − RP u′ (Y ) + O(RP 2 ), (1.3)

where O(RP 2 ) is the remainder. Assuming this remainder is near zero, equating equations (1.2) and
(1.3) gives
1
u(Y ) + u′′ (Y )σx2 ∼
= u(Y ) − RP u′ (Y ),
2
and solving for RP
 ′′ 
∼ 1 2 u (Y )
RP = σx − ′
2 u (Y )

∼ 1
= σx2 ARA(Y ).
2
CHAPTER 1. CHOICE AND RISK 11

Exercise 1.10. Consider the investor has exponential utility u(Y ) = − exp(−αY ) and the gamble x̃ is
normally distributed, with mean 0 and variance σ 2 , i.e, x̃ ∼ N (0, σ 2 ). Show that the risk premium is
given by
1
RP ∼
= ασ 2 .
2

Note: You get extra points if you can show that with this utility function and this gamble we actually
have:
1
RP = ασ 2 .
2

Answer:

From the previous exercise, we have

1
RP ∼
= σx2 ARA(Y ).
2

In this case σx2 = σ 2 and ARA(Y ) = α. Then it follows

1
RP = ασ 2 .
2
 Chapter 2

Portfolio choice

12
CHAPTER 2. PORTFOLIO CHOICE 13

Exercise 2.1. An investor with quadratic utility and an initial wealth of 100, 000 decides to allocate
30, 000 to the risky asset. If he had a higher initial wealth, the optimal allocation to the risky asset would

(a) Increase

(b) Remain the same

(c) Decrease

Solution:

c).
CHAPTER 2. PORTFOLIO CHOICE 14

Exercise 2.2. Consider an investor with quadratic utility function u(Y ) = 11Y − 5Y 2 , and initial
wealth Y0 = $1. Let rf = 0, E[r̃] = 0.1 and V ar[r̃] = (0.2)2 . Find the optimal amount invested in the
risky asset. (Recall V ar[x] = E[x2 ] − E[x]2 ).

Solution: The investor chooses his portfolio by maximizing the expected utility of terminal wealth
h i h 2
i
max E u(Y˜1 ) = max E 11Y˜1 − 5Y˜1 ,
a a

where
Y˜1 = Y0 (1 + rf ) + a(r̃ − rf ).

We can take the following steps to solve the problem:

• Find Y˜1 : Since Y0 = 1 and rf = 0 =⇒ Y˜1 = Y0 (1 + rf ) + a(r̃ − rf ) = Y0 + ar̃ = 1 + ar̃

du(.) dY˜1
• Find dY˜1 da
:
du(.) dY˜1
= (11 − 10Y1 )r̃
dY˜1 da
h i
du(.) dY˜1
• Find E dY˜1 da
:
" #
du(.) dY˜1 h i h i h i h i
E = E (11 − 10Y1 )r̃ = E 11r̃ − 10Y1 r̃ = E 11r̃ − 10(1 + ar̃)r̃ = E r̃ − 10ar̃2
dY˜1 da

= E [r̃] − 10aE r̃2 = 0.1 − 10a 0.22 + 0.12 = 0.1 − 0.5a

 

h i
du(.) dY˜1
• FOC: E dY˜1 da
=0
" #
du(.) dY˜1
E = 0 ⇐⇒ 0.1 − 0.5a = 0 ⇐⇒ a = $0.2.
dY˜1 da
CHAPTER 2. PORTFOLIO CHOICE 15

Exercise 2.3. Consider an investor with a utility function u(Y ) = ln(Y ), and initial wealth Y0 . Let rf
be the risk-free return and assume the risky return is the simple gamble r̃ = (r2 , r1 , π). Further assume
r2 > rf > r1 and E[r̃] = πr2 + (1 − π)r1 > rf . Find the optimal fraction of wealth (a/Y0 ) invested
in the risky asset. Comment the result.

Solution: The investor chooses his portfolio by maximizing the expected utility of terminal wealth
h i h i
max E u(Y˜1 ) = max E ln(Y˜1 ) ,
a a

where
Y˜1 = Y0 (1 + rf ) + a(r̃ − rf ).

We can take the following steps to solve the problem:

du(.) dY˜1
• Find dY˜1 da
:

du(.) dY1 1 1
= · (r̃ − rf ) = · (r̃ − rf )
dY1 da Y1 Y0 (1 + rf ) + a(r̃ − rf )
h i
du(.) dY˜1
• Find E dY˜1 da
:
" #
du(.) dY˜1
 
(r̃ − rf )
E =E
dY˜1 da Y0 (1 + rf ) + a(r̃ − rf )

(r2 − rf ) (r1 − rf )
=π + (1 − π)
Y0 (1 + rf ) + a(r2 − rf ) Y0 (1 + rf ) + a(r1 − rf )
h i
du(.) dY˜1
• FOC: E dY˜1 da
=0

(r2 − rf ) (r1 − rf )
π + (1 − π) = 0,
Y0 (1 + rf ) + a(r2 − rf ) Y0 (1 + rf ) + a(r1 − rf )

which after some algebra gives

 
a (1 + rf ) π(r2 − rf ) + (1 − π)(r2 − rf ) (1 + rf )(E[r̃] − rf )
= = .
Y0 −(r2 − rf )(r1 − rf ) −(r1 − rf )(r2 − rf )
CHAPTER 2. PORTFOLIO CHOICE 16

• The sign of the rhs depends on the sign of E[r̃] − rf . If E[r̃] − rf > 0 =⇒ a/Y0 > 0;

• (a/Y0 ) increases with the return premium (E[r̃] − rf );

• (a/Y0 ) decreases with the return "dispersion" around rf , (r2 − rf )(r1 − rf );

Numeric example:

rf r2 r1 π E[r̃] a/Y0
0.05 0.40 −0.2 0.5 0.100 0.600
0.05 0.45 −0.2 0.5 0.125 0.7875
0.05 0.45 −0.25 0.5 0.100 0.4375

The fraction of initial wealth allocated to the risky asset rises when the risky asset becomes less risky or
pay higher expected returns.
CHAPTER 2. PORTFOLIO CHOICE 17

Exercise 2.4. Consider an investor with utility function u(Y ) = ln(Y ), and initial wealth Y0 . Let rf be
the risk-free return and assume the risky return is the simple gamble r̃ = (r2 , r1 , π). Further assume
r2 > rf > r1 and E[r̃] = πr2 + (1 − π)r1 > rf .

Define w ≡ a/Y0 , the fraction of wealth invested in the risky asset. Show the optimal fraction does not
change with wealth.

Solution: The investor chooses his portfolio by maximizing the expected utility of terminal wealth
h i h i
max E u(Y˜1 ) = max E ln(Y˜1 ) ,
a a

where
Y˜1 = Y0 (1 + rf ) + a(r̃ − rf ).

The solution is given by

(1 + rf )(E[r̃] − rf )
â = · Y0 .
−(r1 − rf )(r2 − rf )

Defining ŵ = (â/Y0 ), it follows

dŵ
= 0.
dY0
CHAPTER 2. PORTFOLIO CHOICE 18

Exercise 2.5. Consider an investor with a utility function u(Y ) = Y 1−γ /(1 − γ), and initial wealth Y0 .
Let rf be the risk-free rate and the risky return is the simple gamble r̃ = (r2 , r1 , π). Further assume
r2 > rf > r1 and E[r̃] = πr2 + (1 − π)r1 > rf . Find the optimal fraction of wealth (a/Y0 ) invested
in the risky asset.

Solution: The investor chooses his portfolio by maximizing the expected utility of terminal wealth
" 1−γ #
h i Y˜1
max E u(Y˜1 ) = max E ,
a a (1 − γ)

where
Y˜1 = Y0 (1 + rf ) + a(r̃ − rf ).

···

···

···

n o
a (1 + rf ) [(1 − π) (rf − r1 )]1/γ − [π (r2 − rf )]1/γ
=
Y0 (r1 − rf ) [π (r2 − rf )]1/γ − (r2 − rf ) [(1 − π) (rf − r1 )]1/γ
CHAPTER 2. PORTFOLIO CHOICE 19

Exercise 2.6. Consider an investor with a utility function u(Y ) = − exp(−αY ) and initial wealth Y0 .
Let rf be the risk-free return and assume the return on the risky asset r̃ ∼ N (µ, σ 2 ).

Show that the expression for the optimal amount a to invest in the risky asset is given by
µ − rf
a= .
ασ 2

Solution: The investor chooses his portfolio by maximizing the expected utility
h i h i
max E u(Y˜1 ) = max E − exp(−αY˜1 ) ,
a a

where
Y˜1 = Y0 (1 + rf ) + a(r̃ − rf ).

Since r̃ ∼ N (µ, σ 2 ), then

 
Y˜1 ∼ N Y0 (1 + rf ) + a(µ − rf ), a2 σ 2

Using the moment generating function for the normal distribution1 :

h i  
E − exp(−αY˜1 ) = − exp − α Y0 (1 + rf ) + a (µ − rf ) + 1/2α2 a2 σ 2 .

FOC:

− −α (µ − rf ) + aα2 σ 2 exp(·) = 0

=⇒ − α (µ − rf ) + aα2 σ 2 = 0

µ − rf
=⇒ a =
ασ 2

1
Moment generating function for the normal distribution:
 
h i 1
If X ∼ N m, s2 , then E exp (γX) = exp γm + γ 2 s2 , for any γ


2
CHAPTER 2. PORTFOLIO CHOICE 20

Exercise 2.7. Consider the standard portfolio choice problem:

• one risk-free asset with return: rf = 2%

• one risky asset with expected return: E[r̃] = 10%

• initial wealth: Y0 = 1, 000

• terminal wealth: Y˜1

• amount to invest in the risky asset: a

Also consider that

• The investor is risk-neutral

• The investor cannot borrow

Find the optimal amount to invest in the risky asset.

Solution:

Since the investor is risk-neutral, he maximizes the expected return of the portfolio. Therefore

a = 1, 000.
CHAPTER 2. PORTFOLIO CHOICE 21

Exercise 2.8. There is one risk-free asset with rf = 0.04 and one risk asset with return r =
(0.2, −0.1, 0.6). The utility function is y(Y ) = ln(Y ) and the initial wealth is Y0 = 1, 000. Com-
pute the optimal amount of money to lend or borrow at the risk-free rate.

Solution:

Solving for a:
a = 1, 857.1.

Which means we need to borrow 857.1 at the risk-free rate.

CHAPTER 2. PORTFOLIO CHOICE 22

Exercise 2.9. Consider the standard portfolio choice problem for an investor with constant absolute
risk aversion equal to 0.1. The risk-free rate is 0.02. The return on the risky asset follows a normal
distribution with an expected value of 0.10 and standard-deviation of 0.20. The investor has 100 to
invest.

Compute the optimal amount of money to invest in the risk-free asset.

Solution:

CARA =⇒ exponential utility function.

Solving for a:
µ − rf
a=
ασ 2

And it follows:
µ − rf 0.1 − 0.02
Y0 − a = Y0 − 2
= 100 − = 80.
ασ 0.10.22