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ECON0001
ECONOMICS OF FINANCIAL MARKETS
Formative assessment n.1 on the first part of the unit
Section A: investment under risk or uncertainty (30 marks)
1. [Total 9 points] Consider the decision problem of investing an amount of wealth W = $1000000 into a risky asset with return
and into a risk-less asset with risk-free interest rate r = 5%. You are a risk averse investor with a CRRA utility function
where ρ = 0.5, and WT is the amount of wealth at the end of the investment.
(a) Find the optimal allocation in risky and risk-less assets as a function of the probability p and the initial amount of wealth W invested. How does it depend on p? Comment on your result.
(b) Compute the optimal allocation for a probability p = 50% and for p = 51%. What is the optimal allocation for p = 1? Comment.
(c) What is the lower bound of the probability p for investing a positive share into the risky asset? Answer with and without using the utility function, and comment. What is this lower bound of probability for a risk neutral investor? (d) Find the lower bound of the probability p for starting to borrow money at the risk-less interest rate and invest an amount larger than W in the risky asset.
2. [Total 7 points] Consider an asset with a risky rate of return over a time period T expressed by
The investment of an amount of wealth W returns WT at the end of the period T, and investors have utility function U(WT ) = ln(WT ).
(a) Why this asset and this utility imply a positive risk premium?
(b) Find the Certainty Equivalent of the investment for such utility as a function of the probability p of the higher return value and the invested wealth W. How does it depend on p? Comment on your results.
(c) Compute Certainty Equivalent and Risk Premium for a probability p = 50%.
(d) What is the risk premium for p = 0 and for p = 1? Comment on your results.
(e) How does the risk premium depend on the probability p? Proof that the risk premium is anon-monotonic function of the probability p.
3. [Total 8 points] An investor with utility function
faces the decision problem of allocating her wealth x in the following assets: a risky asset that gives a return of 20% or a loss of -5% with equal probability, and a risk-less asset with interest rate equal to 5%.
(a) How does her relative risk aversion depend on wealth x, if σ = 10-6 $-1 ? If her wealth increases from £1 Mln to £10 Mln, how does relative risk aversion changes? And absolute risk aversion?
(b) Find the optimal investment in risky and risk-less asset as a function of σ and as a function of wealth x, and comment.
(c) Study the optimal allocation for σ ! 1 and σ ! 0. What is the condi- tion on σ for investing 100% in the risk-less asset? Justify your answer both conceptually and mathematically.
(d) If she invests a total wealth of £1 Mln, what is the condition on risk aversion σ for the optimal allocation to be 100% invested in the risky asset? Comment on your answer.
(e) Evaluate the marginal effect of σ on the optimal share of investment in the risky asset.