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A31021 Any Calculator
Department of Economics Economics of Financial Markets Time Allowed: 1 Hour plus 30 minutes for uploading of answers
Answer TWO questions
Page 1 Turn Over Any Calculator A31021 Page 2 Turn Over Answer Two Questions. Each question has 25 marks allocated. The marks awarded for each section of a question are shown in bracket. In order to gain full marks you must explain fully the steps you take in solving the problems. Since this is an online exam, if you use formulae from the lectures or class exercises, you will not get credit for stating these formulae without an explanation of what the formulae mean and why you are using them to answer the question.
1. You observe that a consumer with a power utility function in consumption U=400C0.5 and a subjective discount factor of value 5/6, chooses to consume 400 today and a distribution of consumption next period such that the expected value of marginal utility is 12 and a standard deviation of marginal utility is 0.1. There is a single financial asset with an expected net return of x and this asset has a standard deviation of return of y and a correlation of -0.8 with the individual’s marginal utility of future consumption.
What is the relationship between x and y if the individual is maximising utility? (10 marks)
Explain how the Consumption-based CAPM provides an understanding of the risk of an asset and discuss how this is illustrated in terms of the relationship between x and y (15 marks)
2. The consumer has a utility function given by U(C)=ln(C-H) where H is the habit level of consumption. Her subjective discount factor is given by 0.8. There are two states of the world next period. Given contingent claim prices the individual chooses a level of consumption 15 today and 16 in state 1 and 17 in state 2. State 1 occurs with probability 0.6.
Use this information to calculate the value of the two contingent claim prices (7 marks).
Discuss how incorporating Habit in the utility function delivers time-varying risk aversion (8 marks)
Discuss, briefly, how time-varying risk aversion provides an explanation for the predictability of stock returns. (10 marks)
3. An individual with current wealth of 10 at time t, investing over a single period, has a utility function U=100Wt+1-0.5Wt+12 where Wt+1 is wealth at t+1. She can hold either cash which pays zero interest or a share which has a Any Calculator A31021 Page 3 Turn Over
price today of P and will have a price next period of 90 in state 1 with probability 0.5 and 120 in state 2 with probability 0.5 (the price includes any dividend owing). What is the optimal portfolio for this individual to hold? (15 marks) Use you solution in the problem above to explain the optimal portfolio selection when an individual’s labour income varies across the two states of the world in the second period (10 marks)
4. (a) Consider the share of a new company that is expected to pay no dividend for n periods and then a dividend D* which grows at rate g after that. The expected return on the asset is R*. Show that the price (P) of such an asset is P=D* (1+g) (1+R*) n (R*-g)
(10 marks)
(b) Use the analysis above to consider how the share price of a company displaying this dividend behaviour could develop a bubble. (7 marks)
(c) examine how the price equation above could be used to explain the impact of the covid-19 pandemic on share prices (8 marks)