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ECON0001
ECONOMICS OF FINANCIAL MARKETS
1. Consider a one-factor pricing model where the dependent variable is the spread between a 5y Credit Default Swaps index and the 5y Treasury Note, while the factor is a stock market index. Assume that you estimate a negative coefficient for the factor. If one day you observe the spread located more than two standard deviations above the regression line, what portfolio do you build with positions on the CDS index, the Treasury Note and the stock market index?
2. Consider this situation of choice under uncertainty: an urn contains 120 balls. 40 balls are green, while the remaining balls are either white or black. Which gamble would you choose between (1) and (2)?
(1) If the ball is green you get £5000.
(2) If the ball is white you get £5000.
Which gamble would you choose between (3) and (4)?
(3) If the ball is black or green you get £5000.
(4) If the ball is black or white you get £5000.
Experimental evidence shows people tend to prefer gamble (1) over gamble (2), and gamble (4) over gamble (3). Explain the rational behind such choices, and why they are not consistent with expected utility theory.
3. What does a convex utility function for losses means in terms of risk premium? What are the possible implications for trading behaviour of a trader facing relatively large losses?
4. Think of contrarian trading strategies. What are the implications of a contrarian strategy that is systematically successful for market efficiency? And what do you think is the effect of contrarian strategies on market stability?
5. Consider the following scenario: US and China reach a definitive and comprehensive trade agreement, which puts an end to the so-called tariffs war. Reflect on this event and its implications for markets efficiency or inefficiency, in light of the model of prices dynamics based on a geometric random walk.