TCH341 - FINANCIAL ECONOMICS

Mid – Term Test

Time Allowed: 60 minutes
Name: Student ID:

1. Suppose that Jean’s utility function for inter-temporal consumption is

U  C0 , C1   ln  C0    ln  C1 

where C0 is his current period consumption, C1 is his future period consumption and  is a time
preference factor that specifies how the consumer trades off utility in period 1 against utility in
period 2. Let  be 0.95. Jean is endowed with $100 this period and $100 in the next period, and
suppose the risk-free interest rate is 10%.
i. Draw the capital market line that Jean is facing. States the precise X-Intercept and Y-
Intercept. What does the value of X-Intercept mean? [10 points]

ii. Using the Lagrange equation, show his optimal consumption path (i.e., the optimal level
of current and future consumption) if he can only allocate wealth through lending and
borrowing [15 points]

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iii. Suppose now he discovers an investment opportunity. This is a risk-free project that needs
initial investment of $80 and it generates $100 in the next period. What is his optimal
consumption path now? Why would some people invest huge amount this period and
simultaneously borrow money from the bank to spend? [15 points]

2. Suppose Louis’s utility function is 𝑈(𝑊) = 𝑙𝑛(𝑊). His current wealth is $5,000, but he is
faced with 40% of the chance of losing 20% of his wealth.
i. What is the maximum amount of insurance premium he is willing to pay to avoid such
risk? [10 points]

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ii. From the insurance company’s perspective, what is the fair price that it should charge
Louis? [5 points]

iii. How do you interpret the difference between the answer in (i) and (ii)? [5 points]

3. In Financial Economics, we assume everyone is risk-averse. This is like a building block for
many theories. How can you convince your mom that risk-aversion is a reasonable assumption?
Feel free to use any example, and you should first define risk-aversion. [10 points]

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

W 1
 ,   0,   1
U  W  1 
 ln W ,  1

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] [10 points]

4. Which asset is preferred?

Investment X Investment Y
Payoff Probability Payoff Probability
1 0.25 3 0.33
7 0.50 5 0.33
10 0.25 8 0.34
Check that neither investment dominates the other on the basis of
i. The Mean-Variance criterion [5 points]

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ii. First Order and Second Order Stochastic Dominance [10 points]

Payoff Prob(A) Prob(B) F(A) G(B) F-G ∑(𝐹 − 𝐺)

1
2
3
4
5
6
7
8
9
10

How could you rank these investments? [5 points]