ECOS2040 Intermediate Financial Economics
Intermediate Financial Economics
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ECOS2040 Intermediate Financial Economics
Answers to Problem Set 1
1. (a) PV = 60, 600 + 42, 900/1.3 = 93, 600; FV = (60, 600× 1.3) + 42, 900 = 121, 680.
(b) PV budget constraint: c1 + c2/1.3 = 93, 600. Tangency condition: c2/c1 = 1.3. Solve
simultaneously to find c1 = 46, 800 and c2 = 60, 840.
(c) Saves m1 − c1 = 13, 800. Will thus be repaid 13, 800× 1.3 = 17, 940.
(d) At r = 0.1, PV = 60, 600 + 42, 900/1.1 = 99, 600. Solve c1 + c2/1.1 = 99, 600 and
c2/c1 = 1.1 simultaneously to find c1 = 49, 800 and c2 = 54, 780.
(e) At r = 0.1, the PV of the bundle found in (b) is 46, 800 + 60, 840/1.1 = 102, 109.
Since this is greater than 99, 600, it lies outside the budget at r = 0.1.
(f) Solve c1 + c2/1.1 = 102, 109 and c2/c1 = 1.1 simultaneously to find c1 = 51, 055 and
c2 = 56, 160.
(g) The substitution effect increases c1 (46,800 to 51,055). The income effect decreases c1
(51,055 to 49,800). The substitution and income effects both decrease c2.
2. At r = 0.3, the PV of the new endowments is 32, 000 + 77, 220/1.3 = 91, 400. Since
this is less than the PV of the original endowments in Q1(a), he should not take up
the opportunity. At r = 0.1, the PV of the new endowments is 32, 000 + 77, 220/1.1 =
102, 200. Since this is greater than the PV of the original endowments in Q1(e), he should
take up the opportunity.