J2FIN: Problem Sheet 9: DR Jia Shao

Financial Mathematics
J2FIN: Problem Sheet 9

Dr Jia Shao
Financial Mathematics 2024
1. A company specialises in long-term insurance contracts. It holds reserves

in respect of these contracts and it wants to build a model of its future
investment returns.
(a) Identify the similarities and differences between a deterministic and

stochastic model of investment returns.
(b) Explain why the company may prefer to use a stochastic model.
The company has decided to build a stochastic model. It assumes
that the rate of return in each calendar year is Normally distributed
and independent of the rates of return in previous years. The com-
pany plans to review this model once every 2 years.
(c) Set out two possible disadvantages of using this stochastic model.
(d) Suggest how the company may overcome each disadvantage identified
in part (c).
2. A fund earns an annual rate of return i, with the rate of return in any
year being independent of the rate in any other year. The distribution of
log (1 + it ) is normal with parameters µ and σ 2 .
The mean of it is 5% and the standard deviation is 3%.
(a) Calculate µ and σ 2 .

(b) Calculate the probability that the fund return for any year is between
1% and 3%.
(c) Comment on your answer to part (b).
(d) A sum of £10, 000 is invested into the fund. Calculate the probability
that the accumulated value of the fund at the end of 3 years is less
than £11, 000.
3. An insurance company holds a large amount of capital and wishes to

distribute some to policyholders using one of two possible options.
Option A
A sum of £500 will be invested for each policyholder in a fund in which the
expected annual effective rate of return is 3.5% and the standard deviation
of annual returns is 2%. The annual rates of return are independent and
(1 + it ) is log-normally distributed with parameters µ and σ 2 , where it is
the rate of return in year t. The policyholder will receive the accumulated
investment at the end of 15 years.
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Option B
A sum of £500 will be invested for each policyholder for 10 years at a
fixed rate of return of 4% p.a. effective. After 10 years, the accumulated
sum will be invested for a further 5 years at the prevailing 5 -year spot
rate. This spot rate follows the probability density function shown below:
Spot rate
Probability
(% p.a. )
0.5 0.15
1.0 0.25
4.5 0.40
7.0 0.20
The policyholder will receive the accumulated investment at the end of

the 15 years.
(a) Demonstrate that µ = 0.0342 and σ = 0.0193.

(b) Calculate the expected value and standard deviation at the end of
year 15 of:
i. Option A.
ii. Option B.
(c) Determine, for each of Options A and B, the probability that a poli-
cyholder’s accumulated investment at the end of the 15 years will be
less than £775.
(d) Compare the relative risk of the two options.
4. In any year, the effective interest rate per annum has mean value j and
standard deviation s and is independent of the interest rates in all previous
years.
Let Sn be the accumulated amount after n years of a single investment of
one at time t = 0.
You are given that:
E [Sn ] = (1 + j)n
n
Var [Sn ] = 1 + 2j + j 2 + s2 − (1 + j)2n
The interest rate per annum in any year is equally likely to be i1 or

i2 (i1 > i2 ). No other values are possible.
(a) Derive expressions for j and s2 in terms of i1 and i2 .

Consider the accumulated value at time t = 20 of $2 million invested
at time t = 0. This amount has an expected value of $4.5 million
and a standard deviation of $0.75 million.
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(b) Calculate the values of i1 and i2 .
5. Consider the following assets in a world where the Capital Asset Pricing
Model (CAPM) holds. There are three risky assets and one risk-free asset.
No other assets exist in the market.
Total value of
Expected
Asset assets in market Beta
return (% p.a.)
($ m)
Risky asset A 5 10 β
Risky asset B 10 50 1
Risky asset C x 20 2
Risk-free asset 3 40 n/a
(a) Calculate the expected return on the market portfolio.

(b) Calculate x.
(c) Calculate β.
(d) Discuss the limitations of the CAPM.
6. A market that satisfies the assumptions of the Capital Asset Pricing Model
(CAPM) comprises n assets.
Let the random return on asset i be denoted by Ri , the expected return
by ri , and the corresponding returns for the market portfolio by RM and
rM . Let πi be the proportion of asset i in the market portfolio.
(a) i. Define βi algebraically in this market.

ii. Write down the relationship between these expected returns in
this market, including a definition of any additional notation that
you use.
iii. Show that Σπi βi = 1.
(b) Consider a market where n = 4, that is, there are four assets in the
market with the following attributes:
Asset 1 2 3 4 Risk-free Asset

Expected return (per annum) 14% r2 r3 r4 3%
Market capitalisation £4 m £2 m £2 m £2 m
The variance-covariance matrix (in %%) of annual returns on the

four assets is as follows:
Asset 1 2 3 4
1 4 1 1 1
2 1 3 1 1
3 1 1 2 1
4 1 1 1 x2
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for some x2 > 0. The variance of the return on the market portfolio
is 85 %%.
i. Calculate the proportions of each asset in the market portfolio.
ii. Calculate β1 , β2 , β3 and β4 .
iii. Calculate rM , r2 , r3 and r4 .
7. An investor has £100 and is considering investing in two different stocks.

The prices of both stocks are assumed to follow the lognormal model with
the parameters below.
Stock Current price Drift µ Volatility σ

A £5 5% 20%
B £5 8% 30%
(a) Calculate the expected value at time 3 of £100 invested in:

i. stock A
ii. stock B.
(b) Calculate the standard deviation at time 3 of £100 invested in:
i. stock A
ii. stock B.
(c) The investor decides to invest £50 in each stock. Calculate the ex-
pected value of the investor’s portfolio at time 3.
(d) The correlation of the two stocks is 0.3. Calculate the standard
deviation of the value of the investor’s portfolio at time 3.
(e) Comment on the expected return and standard deviation of the port-
folio compared to investing the whole £100 in one stock.
4 PS9,J2FIN2024

J2FIN: Problem Sheet 9: DR Jia Shao

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J2FIN: Problem Sheet 9: DR Jia Shao

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Financial Mathematics

J2FIN: Problem Sheet 9

Financial Mathematics 2024

1. A company specialises in long-term insurance contracts. It holds reserves

(a) Identify the similarities and differences between a deterministic and

(a) Calculate µ and σ 2 .

3. An insurance company holds a large amount of capital and wishes to

The policyholder will receive the accumulated investment at the end of

(a) Demonstrate that µ = 0.0342 and σ = 0.0193.

The interest rate per annum in any year is equally likely to be i1 or

(a) Derive expressions for j and s2 in terms of i1 and i2 .

(b) Calculate the values of i1 and i2 .

(a) Calculate the expected return on the market portfolio.

(a) i. Define βi algebraically in this market.

Asset 1 2 3 4 Risk-free Asset

The variance-covariance matrix (in %%) of annual returns on the

7. An investor has £100 and is considering investing in two different stocks.

Stock Current price Drift µ Volatility σ

(a) Calculate the expected value at time 3 of £100 invested in:

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