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Still missing 16
24th November 2006
Problem 1
Part A
You can just remember the asset pricing equation from the lecture notes:
b,s (rs rf ) s2 (rb rf )
wb
=
ws
b,s (rb rf ) b2 (rs rf )
Or you can do it the long way if you forgot the formula. Start with the return of the portfolio
rp = (1 w)rb + wrs = (1 w)(.1) + w(.10) = .1
1
3
Which is the same answer that we had from above. Note that the constraint doesn't enter in the
FOC because regardless of the weights the return will always be .10.
1.2
Part B
In order to draw the picture in return-variance space, we must calculate the variance of the optimal
mutual fund.
3
1
3 1
1 1
3
6
9
1
+
=
p2 = w2 w + = ( )2 + =
2
2
2 3
3 2
18 18 18
3
1 1
Therefore, if we invest in 100% of the mutual fund, then we will be at a point (r, 2 ) = ( 10
, 3 ). If
1
2
we invest 100% in the riskless asset, then we will be at a point (r, ) = ( 20 , 0). Draw a straight
line between the two, which represents the return/variance tradeo for combinations of the mutual
fund and the riskless asset. If there is an interior solution, the solution will occur at wherever the
tangency of the line between the two assets and the indierence curve. Otherwise, the optimal
portfolio will be a corner solution of 100% mutual fund, or 100% riskless asset.
Problem 2
wb
ws
= wb = ws then:
p
p2 = (1 + 2 )ws2 2 ws = p
(1 + 2 )
And so:
p
p
(rs rf ) + p
(rb rf )
2
(1 + )
(1 + 2 )
rp = rf + p
2
(1+ 23 )
(0.06) + q
3 p
2
(1+ 32 )
(0.04) = 0.03 +
0.26p
13
If we were to spend all our income in bonds and stocks we would get ws =
p = 513 0.72 and rp 0.082. If we have negative cash balances then:
wb
0.2
1
=
=
ws
0.4
2
3
5
0.03 +
and wb =
2
5
0.072p
.
and so:
(1+ 12 )
2 p
(0.04) + q
(0.02) = 0.05 +
(1+ 12 )
0.1p
0.05 +
0.045p
.
If we were to spend all our income in bonds and stocks we would get ws = 32 and wb = 13 and so:
p = 35 0.74 and rp 0.083.
So what have we found out? Well, the slope of the rp line is larger when you are a lender than
a borrower. Furthermore, when you stop lending at an interest rate lower and with less risk than
when you start borrow (the rst line is tangent to the CAPM ecient frontier at a lower point than
the second line of portfolio, so there must be some points you are on the CAPM ecient frontier).
3
Problem 3
n
X
wj cov(ki , kj )
j=1
where p = nj=1 wj kj , or the whole portfolio; kj indexes assets, and wj are weights corresponding
to the fraction of the portfolio each assets holds.
Notice that
P
cov(ki , p) = cov(ki ,
n
X
wj kj ) = E(ki
n
X
wj ki kj ) E(ki )E(
j=1
n
X
wj kj ) =
j=1
n
X
wj kj ) E(ki )E(
n
X
wj E(ki kj )
j=1
j=1
n
X
wj kj ) =
j=1
j=1
j=1
= E(
n
X
n
X
wj E(ki )E(kj )
j=1
n
X
wj cov(ki , kj )
j=1
Problem 4
n
X
1
i=1
xi ,
n
X
1
i=1
xi
n
X
1
= 2 var
xi
n
i=1
=
4.1
n
n X
n
1 X
1 X
var
(x
)
+
cov(xi , xj ) =
i
n2 i=1
n2 j=1 i6=j
1
n2 n
2
n
+
cov(xi , xj )
n2
n2
Part A
If cov(xi , xj ) = 0, then
var(P ) =
2
lim var(P ) = 0
n
n
4.2
Part B
If cov(xi , xj ) = 2 , then
var(P ) ==
5
5.1
n 2 n2 n 2 n2 2
+
= 2 = 2 lim var(P ) = 2
n
n2
n2
n
Problem 5
U = ln(C)
Case 1:
Portfolio 1
E(U ) =
1
1
1
ln(100) + ln(200) + ln(300) 5.202
3
3
3
Portfolio 2
E(U ) =
1
1
1
ln(85) + ln(248.5) + ln(266.5) 5.181
3
3
3
There is a dierence of 0.405% between the two numbers, with the utility being higher the rst
portfolio.
5.2
U = C 0.001C 2
Case 2:
Portfolio 1
E(U ) =
1
1
1
(100 .001(10, 000)) + (200 .001(40, 000)) + (300 .001(90, 000)) =
3
3
3
=
1
1
1
1
(90) + (160) + (210) = 153
3
3
3
3
Portfolio 2
E(U ) =
=
1
1
1
85 .001 852 +
248.5 .001 248.52 +
266.5 .001 266.52 =
3
3
3
1
1
1
(85 7.225) + (248.5 61.752) + (266.5 71.022) = 153.3335
3
3
3
There is a dierence of 0.0001%, with the utility being higher for second portfolio. However,
as we will show in the next problem, the dierence only occurs because of the slight variation in
variance between the two portfolios. If they had the exact same variance, then the agent would gain
the same level of utility from both bundles.
6
Problem 6
U = C C 2
Let there be n posible outcomes of consumption, where outcome Ci occurs with probability i .
Then
n
E(U ) =
X
i=1
Notice that
E(U )
= < 0,
var(C)
U
= 1 2C > 0,
C
1
1
or C < 2
. If E(C) 2
, then at least one outcome of consumption has C
invalid. Therefore, the result holds for all appropriate values of C .
1
2 ,
and therefore is
Problem 7
When ever people are identical, the equilibrium is one in which people just stick with their endowments. If one person wanted to trade, then everyone would want to trade in the same direction, and
there would be no one with whom to trade. Other than that, this is very much like a consumption
question with uncertainty.
This is a one period model, so consumption = endowment - assets purchased + return on assets
People are endowed with one unit of A and one unit of B , so that: e = pA + pB . Individuals'
budget constraint in the good state is: c + pA A + pB B = e + A + B , and in the bad state is
c + p A A + p B B = e + A.
Since A pays one with certainty, we can make it the numeraire with price = 1. In this case the
budget constraint in the good state can be re-written as c = 1 + pB + (1 pB )B and in the bad
state c = 1 + pB pB B
Expected utility is then:
1 (1 + pB + (1 pB )B)1
1 (1 + pB pB B)1
E(u) = [
]+ [
]
2
1
2
1
Maximize WRT B:
1
1
(1 + pB + (1 pB )B) (1 pB ) + (1 + pB pB B) (pB ) = 0
2
2
All people are identical, the price must be set so that everyone demands one unit of B, the one
unit that they are endowed with:
(1 + pB + (1 pB )) (1 pB ) + (1 + pB pB ) (pB ) = 0
2 (1 pB ) pB = 0
(2 + 1)pB = 2
2
2 + 1
pB =
(2 + 1)2
if = 1 then
pB =
1
2
3
2
1
3
1
4
5
4
1
5
Intuition: is a measure of a person's risk aversion. As increases, this person is more risk
averse and would be willing to pay more for a certainty asset, asset A. As a result the amount
that a person can sell their B for must decrease so that they cannot purchase any A. When = 1,
selling 3 B could get your one A. When = 2, you have to sell 5 B to get one A.
8
8.1
Problem 7.5
Part A
Since everyone is identical, no one will trade in the bond and we will have ct+1 = yt+1 . Suppose
that an individual buys units of the asset in period t. The price is p, so she gives up p units of
consumption. The marginal utility of consumption is
U
= ect = e
c
M C = pe
2 2
2
p=e
2 2
2
2 2
2
8.2
Part B
Notice that 2 > 0 p > 1. The reason this occurs is because even though expected consumption
in period t + 1 is the same as in t, the expected marginal utility is higher. To see this:
2 2
E(Ut0 ) = e
0
E(Ut+1
) = E(ect+1 ) = eE(ct )+
2
2
= e+
2
2
> e
This is just like precautionary saving. The bigger is 2 , the more uncertain is ct+1 , and thus higher
expected marginal utility. Higher also raises p because it means more risk aversion and more
sensitivity of U 00 to c.
9
Problem 7.6
1
U
=
C
ct
p
ct
10
p
=
ct
p = ct
Problem 8
The optimal consumption is provided for us. This consumption satises the FOC. We can use this
fact to solve for the price. People will buy the security when the marginal utility forgone when they
purchase it equals the expected marginal utility gain when they purchase it.
u0 (100)p = .5u0 (50) + .5u0 (150) 2
1004 p = .5(504 ) + (1504 )
p=
=
1004
1004
+
2 504 1504
24 504 24 504
+ 4
2 504
3 504
16
=8+
81
11
Problem 9
Similar to problem 7, people are identical so the equilibrium will be where no one wants to trade,
or in this case not save.
For an individual
c1 = 1 s
1
+ s(1 + r)
2
1
1
1
3
ln( + s(1 + r)) + ln( + s(1 + r))
2
2
2
2
FOC:
(1 + r)
1
(1 + r)
+ 3
=0
+ 1
1 s 2( 2 + s(1 + r)) 2( 2 + s(1 + r))
In equilibrium there is no saving b/c aggregate consumption in one period equals aggregate
output in that period. Therefore,
1 +
(1 + r) 1 + r
+ 3 =0
2( 12 )
2( 2 )
1 + (1 + r) +
1+r
=0
3
4(1 + r)
=1
3
(1 + r) = 3/4
r=
1
4
A negative interest rate. This makes sense as without the constraint that s = 0, people would
want to save. A negative interest rate forces people to pay to save, making it a less attractive
alternative, and forcing s = 0.
12
Problem 10
Both the Red and Green people will optimize their consumption treating the interest rate as another
parameter.
Red:
FOC:
U 0 (ct )
1+r
=
0
U (ct+1 )
1+
c2
=1+r
c1
c2 = c1 (1 + r)
BC:
c1 +
c2
y2
= y1 +
1+r
1+r
1
1+r
2+r
2c1 =
1+r
2+r
c1R =
2(1 + r)
c1 + c1 = 1 +
therefore,
c2R =
2+r
2+r
(1 + r) =
2(1 + r)
2
Green:
FOC:
c2
=1+r
c1
BC:
c1 +
y2
c2
= y1 +
1+r
1+r
c1 + c1 = 1
2c1 = 1
1
c1G =
2
and
1
c2G = (1 + r)
2
Notice that the consumption choice of Greens does not depend on the interest rate. The interest
rate must be set so that Greens can consume 1/2 in the rst period. Because is no storage, the
total consumption in period one must be less than or equal to the total income. This is macro so
we ignore the less than part, and say that total consumption in period one = total income in period
one. Since the populations are equal, the exact sizes are irrelevant.
c1R + c1G = y1R + y1G
2+r
1
+ =1+1
2(1 + r) 2
2+r
=3
1+r
2 + r = 3 + 3r
r = 1/2
This negative interest rate will force Red to borrow from Green, allowing green to consume in
period 2.
c1R =
3/2
2(1/2)
= 3/2
c2R =
3/2
2
= 3/4
c2G = 1/2(1/2)
= 1/4
13
Problem 11
1
1
1
1
ln A + ln(A + B) + ln(A + 2C) + ln(A + B + 2C)
4
4
4
4
(c1 + pA A + pB B + pc C 1 pA pB pC )
{E(u) -(expenditures-income-endowment)}
Where capital letters denote the number of a given asset held.
FOCs:
WRT c1
1
=0
c1
WRT A:
1
1
1
1
+
+
+
pA = 0
4A 4(A + B) 4(A + 2C) 4(A + B + 2C)
WRT B:
1
1
+
pB = 0
4(A + B) 4(A + B + 2C)
WRT C:
2
2
+
pc = 0
4(A + 2C) 4(A + B + 2C)
3
16
1
1
+
pc = 0
2(3) 2(4)
pc = 7/24
Problem 12
(A)
subject to
a+f =1
cs = 4(1 ns ) + f
cr = 2(1 nr ) + f + 2a
ns ,nr ,a
1
1
1
1
ln[4(1 ns ) + 1 a] + ln ns + ln[2(1 nr ) + 1 + a] + ln nr
2
2
2
2
FOCs:
WRT ns :
1
4
+
=0
2(4(1 ns ) + 1 a) 2ns
1
2
=
4 4ns + 1 a
2ns
4ns = 4 4ns + 1 a
5a
ns =
8
WRT nr :
2
1
+
=0
2[2(1 nr ) + 1 + a] 2nr
1
1
=
2 2nr + 1 + a
2nr
2nr = 3 2nr + a
3+a
nr =
4
WRT a:
1
1
+
=0
2[4(1 ns ) + 1 a] 2[2(1 nr ) + 1 + a]
1
1
=
4 4ns + 1 a
2 2nr + 1 + a
2 2nr + 1 + a = 4 4ns + 1 a
3
(3 + a)
(5 a)
+a=5
a
2
2
a=1
ns = 4/8 = 1/2
nr = 4/4 = 1
f =0
(B)
This part of the question was only worth ve points, and the calc-algebra gets a bit tedious, so
it might just be an intuition question, but let's math it up anyway.
Still uncertainty, still expected utility:
max E(u) =
1
1
ln cs + ln ns + ln cr + ln nr
2
2
2
2
subject to
a+f =1
cs = w(1 ns ) + f
cr = w(1 nr ) + f + 2a
ns ,nr ,a
1
1
ln[w(1 ns ) + 1 a] + ln ns + ln[w(1 nr ) + 1 + a] + ln nr
2
2
2
2
FOCs:
WRT ns :
w
+
=0
2(w(1 ns ) + 1 a) 2ns
wns = w wns + a
(w + w)ns = w + a
ns =
w + a
w( + 1)
WRT nr :
w
1
+
=0
2(w(1 nr ) + 1 + a) 2nr
nr =
w+1+a
2w
WRT a:
1
1
+
=0
2(w(1 ns ) + 1 a) 2(w(1 nr ) + 1 + a)
w wns + 1 a = w wnr + 1 + a
wns wnr + 2a = 0
w + a w 1 a
+
+ 2a = 0
+1
2
(2
(
1
w 1 w
)a = + +
+1 2
2
2
+1
w + 1 (w + 1)
3 + 3 2
)a =
2( + 1)
2
+1
+3
+ 1 2
)a = (w + 1)(
)
2( + 1)
2( + 1)
a=
(w + 1)(1 )
+3
Each individual must choose n1 , c1 , and s before 2 is revealed based on E(u) maximization. Keep
in mind that once 2 is revealed people can choose c2 and n2 as they want.
E(u) = ln[w(1 n1 ) s] + ln n1 + ln[w(1 n2 ) + s(1 + r)] +
1
1
ln n2 + (2) ln n2
2
2
FOCs:
WRT n1 :
w
1
+
=0
w(1 n1 ) s n1
These people are identical, therefore people must consume their endowments. s = 0
1
1
=
1 n1
n1
n1 =
WRT n2 :
1
2
w
1
1
+
=0
+
w(1 n2 ) + s(1 + r) 2n2 n2
s=0
1
3
=
1 n2
2n2
2n2 = 3 3n2
n2 = 3/5
WRT s:
1
1+r
+
=0
w(1 n1 ) s w(1 n2 ) + s(1 + r)
s = 0, n1 = 1/2, n2 = 3/5
1
1+r
=
w(1/2)
w(2/5)
r = 1/4
With an interest rate = 0 people would want to save so that they can work less in the future if
they like tomorrow lots (2 = 2). Therefore, a negative interest rate makes sense as it makes savings
less attractive.
NOTE: if the individuals observe 2 before choosing eort and consumption in period 2, then
there is no reason why the consumption and leisure choices should be the same in both states of
nature, i.e.independent of 2 . The above solution is only true if the individual rst chooses c2 and
n2 , and after that observes 2 . (Svetla ).
16
Problem 14
where yi is the return on asset i. Since each individual is endowed with one unit of x, and two units
of z, and x is numaraire,
1 + 2p = x + pz
2
c
2
2
c
2
= e(x+z)+
(x2 +z 2 ) 2
2
(x2 +z 2 ) 2
2
(x + pz 1 2p)
FOC
(x 2 1)e(x+z)+
(z 2 1)e(x+z)+
(x2 +z 2 ) 2
2
(x2 +z 2 ) 2
2
=
= p
x 2 1
1
=
2
z 1
p
Since everyone is identical, the demand for z and x should equal the endowment of x and z :
2 1
1
2 2 1
2 + 2 1
2
=
p
=
=
=
1
2 2 1
p
2 1
2 1
1 2
17
Problem 15
17.1
Part A
In this case each individual can only maximize their utility in each state, can cannot insure against
uncertainty. So the problem is:
max ln ni + ln ci
ni ,ci
s.t ci = wi (1 ni )
The FOC are:
L
1
= =0
ci
ci
L
1
=
wi = 0
ni
ni
L
= ci wi (1 ni ) = 0
So:
ci = wi ni
cBlue
1
17.2
1
2
Part B
Now by their agreement agents can insure against uncertainty. the problem is to
max
cRed
,nRed
,cBlue
,nBlue
i
i
i
i
1
1
[ln cBlues
+ ln nBlue
] + [ln cRed
+ ln nRed
]
i
i
i
i
2
2
s.t. cRed
+ cBlue
= wiRed (1 nRed
) + wiBlue (1 nBlue
)
i
i
i
i
The FOC are:
1
2
and
L
1
= Red = 0
Red
ci
ci
1
L
= Red wiRed = 0
Red
ni
ni
L
1
= Blue = 0
Blue
ci
ci
L
1
= Blue wiBlue = 0
Blue
ni
ni
L
= cRed
+ cBlue
wiRed (1 nRed
) wiBlue (1 nBlue
)=0
i
i
i
i
that:
wiBlue Blue
n
wiRed i
nRed
=
i
cRed
= wiBlue nBlue
i
i
wiBlue Blue
n
) wiBlue (1 nBlue
)=0
i
wiRed i
4wiBlue nBlue
= wiRed + wiBlue
i
nBlue
=
i
wiRed + wiBlue
4wiBlue
nRed
=
i
wiRed + wiBlue
4wiRed
And so:
cRed
= cBlue
=
i
i
So in state 1:
cRed
=
1
wiRed + wiBlue
4
6
= cBlue
1
8
3
8
6
=
8
nBlue
=
1
nRed
1
17.3
Part C
In state 1 Red people are better o, while Blue people are worse o. To see this compare total
utility with and without the agreement. For Red people: ln 12 + ln 12 < ln 68 + ln 68; and for Blue
people: ln 1 + ln 12 > ln 38 + ln 68.
17.4
Part D
A simple problem of hedging. Red people will hold 2/8 of asset 1 while Blue people will sell 2/8 of
this same asset. Red people will sell 2/8 of asset 2 and Blue will buy 2/8 of asset 2.
18
Problem 15.5
Since type A and type B people have the same preferences, we know that they will hold the two
assets in the same ratio as each other. Further, since there is twice and much of asset 1 as there is
asset 2, we know that the ratio will be two units of asset 1 for each unit of asset 2. Finally since
everyone is holdingt more than half of their portfolio in asset 1, we expect that the price of asset 2
in terms of asset 1 will be greater than 1 (to induce them to hold this portfolio).
We can solve for the price that will induce someone to hold a portfolio in this ratio, then once
we know it we can solve for the actual portfolios. Let p be the price of asset 2 in terms of asset 1.
Consider a person allocating a portfolio of value w among the two assets. She maximizes
E(U ) =
1
1
1
ln(x1 ) + ln( (w x1 ))
2
2
p
1 1
2 p
wx1
p
=0
1
1
w
=
x1 =
x1
w x1
2
w x1
w
x1
=
=p
p
2p
x2
which is equal to avergae output from asset 1 (i.e. 23 of people are endowed with asset 1).
Note: You can also solve this problem by nding the demand for asset 2 by each type of person
as a function of price, then setting excess demand to zero to nd the equilibrium. But you have to
be careful to account for the fact that there are twice as many type 1 people.
19
Problem 16