TCH341 - FINANCIAL ECONOMICS

Mid – Term Test

Time Allowed: 75 minutes
Name: Student ID:

This exam has four (04) questions on 7 pages; before you begin, please check to make sure that
your copy has all four questions and all seven pages.
Please circle your final answer to each part of each question after you write it down, so that I
can find it more easily. If you show the steps that led you to your results, I can award partial
credit for the correct approach even if your final answers are slightly off.

Question 1. (2.5 points)

Consider a two period world: periods 0 and 1. Individual A has endowments in period 0 and 1
of 𝑦0 and 𝑦1 . Let these endowments each equal 15,000. Let the initial equilibrium rate of
interest equal 10%. Let 𝜌 be the individual’s subjective rate of time preference and 𝜌 = 12.5%.
Let the utility function be represented by

ln  C1 
1/2

U  C0 , C1   1000  ln  C0  
1/2

1 
where C0 is his current period consumption, C1 is his future period consumption.
i. Ignore production and allowing this individual to borrow and lend at the market rate of
interest, find the optimal consumption path and the saving and/or borrowing for this
individual [1 point]

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ii. Suppose now he discovers an investment opportunity. This is a risk-free project that needs
initial investment of $20,000 and it generates $55,000 in the next period. How would this
change our answer to part (i)? Illustrate the consumer’s consumption path. Discuss the
Fisher Separation Theorem for this individual [1.5 points]

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Question 2. (2.5 points)
Consider a consumer with initial income of 100, who faces a 20% chance of incurring a loss of
75. Suppose the consumer’s preferences are described by an expected utility function

Y 1  1
U Y  
1 
where 𝛾 measures the consumer’s constant coefficient of relative risk aversion.
i. Assume first that the investor’s coefficient of relative risk aversion 𝛾 = 1/2. Find the
maximum amount 𝑥 ∗ that the consumer will pay for an insurance policy that protects him
or her fully against the loss. [1 point]

ii. Now assume that, in addition to the 20 percent chance of a loss of 75, there is also a 20
percent chance of an even bigger loss of 100 (leaving the consumer with no income in
this very bad state). Find the maximum amount that the consumer with γ= 1/2 will be
willing to pay for insurance again all losses now. [1 point]

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iii. Finally, go back to the case from part (i), where there is just a 20 percent chance of a loss
of 75. But suppose that instead of γ= 1/2, the consumer’s coefficient of relative risk
aversion is γ = 2. In this case, will the value of 𝑥 ∗ be larger than, smaller than, or equal
to the value you found in part (i)? Why? [0.5 points] Note: To answer this question, you
don’t need to compute the exact value of 𝑥 ∗ ; all you need to do is say whether it’ s larger
than, smaller than, or equal to the value when γ= 1/2.

Question 3. (2.5 points)

i. Suppose your friend says the following:
Rich people invest in the stock market because they have a lot of money, and don’t need
to worry as much about losing their investments. This explains why rich people have more
money invested in the market than do poor people.
You respond by saying…
Give a thorough response to your friend’s argument [1 points]

4
 ii. Suppose an individual’s utility function depends on her wealth only. We model her
utility function as

1  e  a
  ac
a0
U W  

 c, a0

Does such utility function exhibit reasonable behavioral predictions? Show your answers in
mathematical details. [Hints: Consider what are the reasonable behavioral predictions under
risk – marginal utility, risk aversion, decreasing ARA in W, and constant RRA with respect to
wealth] [1 point]

iii. Suppose two individuals have the following utility functions:

U  W   ln W  and U  W   ln W 
1/2 1/4

Demonstrate which individual has the higher level of risk aversion. Explain briefly.
Are these measures of risk aversion constant, increasing or decreasing. Explain what such
patterns means intuitively [0.7 points]

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Question 4. (2.5 points)
Consider an economy in which there are two periods 𝑡 = 0 (today) and 𝑡 = 1 (next year) and
two states at 𝑡 = 1: a good and bad state that occur with equal probabilities 𝜋 = 1 − 𝜋 =
1/2. Suppose that, in this economy, two assets are traded. A risky stock sells for 𝑃𝑠𝑡𝑜𝑐𝑘 = $1
at 𝑡 = 0 and sells for a high price of $3 in the good state at t = 1, and a smaller price of $1 in
the bad state at t = 1. A risk-free bond sells for 𝑃𝑏𝑜𝑛𝑑 = 0.60 at t = 0 and pays off one dollar for
sure in both the good and bad states at t = 1.
i. What would be the prices of the pure securities? [1 point]

ii. Consider a put option, which gives the holder the right, but not the obligation, to sell a share
of the stock at the strike price 𝐾 = $2 at 𝑡 = 1. In the good state at 𝑡 = 1, it will not be
worthwhile for the option holder to exercise his or her right to sell at the lower strike price
𝐾 = $2. In the bad state, however, the option holder can buy a share of stock for price of
$1 and, by exercising the option,simultaneously sell the share of stock at the higher strike
price 𝐾 = $2, thereby earning a profit of $1. Use this information to find the price at which
the put option should trade at 𝑡 = 0, if there are to be no arbitrage opportunities across the
markets for stocks, bonds, and stock options. [0.5 points]

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iii. Assume an investor with initial income equal to Y = 10, who must choose between the two
assets, the risky stock and the safe bond. Assume that the investor has the following expected
utility:

C1  1
U C  
1 
Suppose that investor’s constant coefficient of relative risk aversion is 𝛾 = 1/2.Which asset
will he or she prefer: the stock or the bond?
If the investor’s constant coefficient of relative risk aversion is 𝛾 = 2. Which asset will he or
she prefer: the stock or the bond? [1 point]