Problem set 1 - Theory of Finance A.Y.

2014-15 - LUISS
The problem set is a group work. Problem set must be typed and submitted by email by the group
representative at acagnazzo@luiss.it by the due date below. Submit also any script, or excel file,
you have used.
Available online: February 26 - 9AM - Deadline: March 2 - 9AM
Problem 1
In the Excel file treasury.xls you can find interest rate series for the 10-year Treasury constant
maturity bonds (both standard, and inflation-indexed or TIPS) at monthly frequency for the period
1/2006-3/2014. For the nominal bonds, report the average, the standard deviation and the first
order auto-correlation of the nominal and effective real monthly returns. Compute effective real
returns using monthly CPI inflation data also available in the Excel file. Data is from the FRED
database. Is there any difference between the real rates of nominal Treasury bonds and those on
TIPS? If so, can you think of any explanation for it? How does the Fisher equation perform in the
data?
Problem 2
Consider a consumer that wants to maximize her utility that depends on the consumption of
two goods: apples X and peaches Y . The price of apples is PX and the price of peaches is PY .
The consumer has a disposable income equal to W and cannot save. Suppose the utility function
is equal to U(X, Y ) = X Y 1 . Find the demand curves of X and Y . Compute the derivative of
each demand curve with respect to PX , PY , and W and comment your results.
Problem 3
Assume that R is lognormally distributed, with mean and variance 2 . Therefore, r = log R
is normally distributed, with mean and variance 2 . Assume further that = 0. Prove that:
2

E(R) = e 1/2 and that 2 (R) = e

2 (r )

[e

2 (r )

1].

Problem 4
Use data on the total return index for Apple, Home Depot e General Electric that you can find
here (Excel sheet total return). A total return index can be used to back out holding period
returns that account for dividends. First, compute the mean and the variance for the monthly
returns for each stock in the sample and plot the series in the same graph. Second, use the
Fama-French factors available here to estimate the following OLS regressions (for each stock i ):
1

i
Rt+1
RFt = i + i (Mktt+1 RFt ) + t+1

(1)

i
Rt+1
RFt = i + i,1 (Rti RFt1 ) + i,2 (Mktt+1 RFt ) + t+1

(2)

i
RFt = i + i,1 (Mktt+1 RFt ) + t+1 + i,2 SMBt+1 + i,3 HMLt+1
Rt+1

(3)

where Ri denote the holding period return for Apple, Home Depot and General Eletric, RF the
risk-free rate and Mkt the equity market return, SMB the small-minus-big risk factor and HML the
high-minus-low risk factor (for the time being, take these last two variables as statistical risk factors;
in the next classes we will understand better what they represent). For each regression, report the
values of the estimated coefficients, the t-tests and corresponding p-values and the R2. Also, plot
a figure with actual and predicted values. Comment briefly your results and the significance of the
estimated coefficients.
Problem 5
Use the data you find here to replicate all the figures from the first set of slides (Introduction).
The excel file contains data for the period 12/31/1998 - today of the following time series: 1) large
European equity index; 2) Germany small stocks equity index; 3) European corporate bond index;
Italian 10Y, 30Y and 3-month sovereign bond indices; and Italian CPI index. For all the financial
time series, you will find values for the total return indices (they include dividends and coupons).
Problem 6
Consider these long-term investment data:
1. The price of a 10-year $100 par zero coupon inflation-indexed bond is $84.49.
2. A real-estate property is expected to yield 2% per quarter (nominal) with a SD of the (effective) quarterly rate of 10%.
3. The constant annual risk-free rate is 3.55%.
(a) Compute the annual rate on the real bond.
(b) Compute the continuously compounded (CC) annual risk premium in the real-estate
investment.
(c) Use Excel solver or any other computer package to find the SD of the CC annual excess
return on the real-estate investment, assuming that the CC return is normally distributed.
(d) What is the probability of loss or shortfall after 10 years?