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Asset Pricing Solutions

Still missing 16
24th November 2006

Problem 1

This is the most basic of asset pricing questions.


1.1

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 )

and plug in the values given:


0 1(.1)
wb
=
ws
0 .5(.1)
T =2
wb = 2ws

Weights must sum to one, therefore:


wb + ws = 1
2ws + ws = 1
1
ws =
3

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

And the variation of the portfolio:


p2 = var((1 w)b + ws) = (1 w)2 b2 + w2 s2 + 2s,b
= (1 w)2 (.5) + w2 (1) = .5 w + .5w2 + w2 = .5 w + 1.5w2

Now, minimize the variation subject to the above return:


min p2 = 1.5w2 w + .5 s.t. rp = .10
L = 1.5w2 w + .5 + (rp .1)

The FOC with respect to w is:


3w 1 = 0
w=

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

Remember that in general, with two risky assets we have:


rp = (1 ws wb )rf + ws rs + wb rb
p2 = wb2 b2 + ws2 s2 + 2ws wb s,b

In this case we have s2 = b2 = 2 and s,b = 0. So if we know

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

If we have positive cash balances then:


wb
0.4
2
=
=
ws
0.6
3

so: wb = 23 ws and rp = 0.03 +

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:

so: wb = 21 ws and rp = 0.05 +

(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

We want to show that


cov(ki , p) =

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

wj [E(ki kj ) E(ki )E(kj )] =

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

Let the payo to a portfolio be


P =

n
X
1
i=1

xi ,

where xi is the payo to asset i. Therefore


var(P ) = var

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

Let the utility be quadratic, or

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

i (Ci C 2 ) = E(C) E(C 2 )

Since var(C) = E(C 2 ) E(C)2 , we have


E(U ) = E(C) var(C) E(C)2

Notice that

E(U )
= < 0,
var(C)

which implies that an increase in variance reduces utility. Also


E(U )
= 1 2E(C)
E(C)
E(U )
1
If E(C) < 2
, then E(C)
> 0, and the expected utility depends positively on the return. Remember,
the assumption we made when we postulated quadratic utility was that it valid only for a range
where utility was increasing with C , or where

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 =

So the derivative of pB with respect to is:


pB
2 ln 2(2 + 1) 2 (2 ln 2)
=
<0

(2 + 1)2

if = 1 then
pB =

1
2
3
2

1
3

The easiest way to see the eect of raising , is to try = 2,


pB =

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

So the price in utility is:

M C = pe

The gain is  times the marginal utility in period t + 1:


M B = E ect+1 = eE(ct+1 )+ 2 Var(ct+1 ) = e+
1

Setting the marginal benet and cost equal, we have


pe = e+

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

In this problem, we have

1
U
=
C
ct

So if you buy  units, the cost in utility is


MC =

p
ct

The benet is ct+1 units of extra consumption, the value of which is


ct+1
=
E ct+1 U (ct+1 ) = E
ct+1
0

Setting cost and benet equal

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

but there is uncertainty about the second period consumption:


c2 =

1
+ s(1 + r)
2

with probability 1/2, and


c2 = 3/2 + s(1 + r)

with probability 1/2.


The utility maximization is
max E(u) = ln(1 s) +
u

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

Red borrows 1/2 from Green (s1R = 1 3/2 = 1/2).


c1G = 1/2

c2R =

3/2
2

= 3/4
c2G = 1/2(1/2)
= 1/4
13

Problem 11

Identical people, therefore in equilibrium everyone consumes their endowment.


The returns of B and C are uncorrelated; there is just as likely a chance of them both returning
> 0, both returning 0, B returns while C doesn't, and C returns while B doesn't. If they were
perfectly correlated then either both would return > 0 or neither would. If they were perfectly
negatively correlated, then one would return when the other didn't.
This is an uncertainty problem with four dierent states of the world; it's expected utility time.
L = ln c1 +

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)

Identical people => consume endowment:


c1 = y1
=1
A=B=C=1

Plug these values into the FOCs


=1
1
1
1
1
+
+
+
pA = 0
4 4(2) 4(3) 4(4)
pA = 25/48
1
1
+
pB = 0
4(2) 4(4)
pB =

3
16

1
1
+
pc = 0
2(3) 2(4)
pc = 7/24

And as expected pA > pc > pB .


14

Problem 12

(A)

Uncertainty, RBC, and asset pricing. The triple wammy!


Dene: a = amount of asset held; f = amount of risk free asset held.
She will choose the portfolio that maximizes her expected utility subject to her budget constraints.
1
1
max E(u) = (ln cs + ln ns ) + (ln cr + ln nr )
2
2

subject to

a+f =1
cs = 4(1 ns ) + f
cr = 2(1 nr ) + f + 2a

These three constraints can be combined into 2:


cs = 4(1 ns ) + 1 a
cr = 2(1 nr ) + 1 + a

Plugging the BC back into the E(u):


max E(u) =

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

Plugging this back into the above FOC:

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

Where is some parameter value greater than 1.


These three constraints can be combined into 2:
cs = w(1 ns ) + 1 a
cr = w(1 nr ) + 1 + a

Plugging the BC back into the E(u):


max E(u) =

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

Great, so what does this mean?


We know that regardless of the value of w, this expression will be negative because > 1 by
denition. Therefore, she will hold a negative amount of a, and more than one of f since a+f=1.
This all happens because leisure is more valuable in the sunny state when the asset doesn't pay o.
She'd like to transfer earnings to the sunny state so that she could work less. This transfer occurs
through holding a negative amount of a.
15

Problem 13 - This solution is WRONG. Why?

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

Individuals will consume


c = yx x + y z z

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

is the budget constraint.


We want to maximize
U = E(ec ) = eE(c)+

2
c
2

Therefore, we need to nd the expected value and variance of c.


E(c) = E(yx x + yz z) = xE(yx ) + zE(yz ) = x + z
V ar(c) = V ar(yx x + yz z) = x2 V ar(yx ) + z 2 V ar(yz ) = (x2 + z 2 ) 2

Plugging these in, we have


U = E(ec ) = eE(c)+

2
c
2

= e(x+z)+

(x2 +z 2 ) 2
2

Forming the Lagrangean


L = e(x+z)+

(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

And replacing this in the budget constraint we get ni =


= 1 and so blues are better o.

cBlue
1

17.2

1
2

for both agents and so cRed


=
1

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

And so we get: wiRed nRed


= wiBlue nBlue
, cBlue
= wiBlue nBlue
and cRed
= wiRed nRed
which implies
i
i
i
i
i
i

that:

wiBlue Blue
n
wiRed i

nRed
=
i

cRed
= wiBlue nBlue
i
i

From the budget constraint


wiBlue nBlue
+ wiBlue nBlue
wiRed (1
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

where x1 is her holding of asset 1.


1
E(U )
= 2
x1
x1

1 1
2 p
wx1
p

=0

1
1
w
=
x1 =
x1
w x1
2

From her budget constraint


x2 =

w x1
w
x1
=

=p
p
2p
x2

Now we impose xx12 = 2 (given in problem) to get p = 2, the equilibrium price.


A type A person has no endowment of 1 unit of asset. He will purchase asset 2 at price p to
hold a portfolio in a ratio of 2 to 1, so he will sell half a unit of asset 1 and buy a fourth a unit of
asset 2. His portfolio will thus be x1 = 21 , x2 = 41 . These will alse be his consumption in each state
of the world.
A type B person will sell some of his endowment of asset 2 to buy asset 1 so that he holds a
ratio of 2 to 1. He will sell a half a unit of asset 2 and buy 1 unit of asset 1. His portfolio will thus
be x1 = 1, x2 = 21 . This will also be his consumption in each state of the world. Remember that
there are twice as many type 1 people, so these trades net out to zero.
Type A Type B
So values of consumption are: State 1
0.5
1
State 2
0.25
0.5
Note that average consumption in state 1 is
2
1
2 1 1
2
c1 = cA
+ cB
= + 1=
3 1
2 1
3 2 3
3

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

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