Solutions to Mid-term Examination 1, winter 2009

FNCE 3P96: Financial Theory

Instructor: Unyong Pyo

Problem 1:(25 marks)

a. Graphically demonstrate the Fisher separation theorem for the case where an individual ends
up lending in the financial markets. Label the following points on the graph: initial wealth W0;
optimal production/investment (P0,P1); optimal consumption (C0*,C1*); present value of final
wealth, W0*.

Assume the individual is initially endowed, at point A, with current income of y0 and end-of-
period income of y1. Using the market rate, the present value of his endowment is his current
y1
wealth, W0: W0 y0
1 rf
The individual will take on investment up to the point where the marginal rate of return on
investment equals the market rate of interest at point B. This determines the optimal investment
in production (P0, P1). Finally, in order to achieve his maximum utility (on indifference curve U1)
the individual will lend (i.e., consume less than P0) along the capital market line until he reaches
point C. At this point his optimal consumption is C0 , C1 which has a present value of
C1
W0 C0
1 rf

C1

W*1
W1 C
C*1 U1
B
P1

y1
A

C0
C*0 P0 y0 W0 W*0

0
b. Show graphically what is the impact of an exogenous fall in the market interest rate on (i) the
wealth (ii) production levels and (iii) the utility of the individual as in part a. Is he always better
off?

(a) An exogenous decrease in the interest rate shifts the capital market line from the line through
AW0 to the line through AW0. Borrowers originally chose levels of current consumption to
the right of A. After the decrease in interest rate, their utility has increased unambiguously
from UB to UB . The case for those who were originally lenders is ambiguous. Some
individuals who were lenders become borrowers under the new, lower, rate, and experience
an increase in utility from U L 1 to U B 1 . The remaining lenders experience a decrease in
utility, from U L to U L .
2 2

(b) Becauseborrowersandlendersfacethesameinvestmentopportunitysetandchoosethesameoptimal
investment(atAbeforetheinterestratedecreasesandatAafterward),currentwealthistheintercept
ofthecapitalmarketlinewiththeC0axis.OriginallyitisatW0;thenitincreases
to W0 .
(c) The amount of investment increases from I to I.

c. Assume now that technological innovation made it possible to produce more using the same
level of inputs. Show graphically what is the impact of the technological innovation (i) the
wealth production levels and (iii) the utility of the individual as in part a. Is he always better off?
C1* '
W ' C 0 '
* *
. Yes, he is always better off with the increased production given inputs.
1 rf

C1
W*1
W*1
W1 C
C*1 B
P1 *
C1 U1
C
P1 U1
B

y1 A
P0
C0
C*0 C*0 P0 y0 W0 W*0 W*0

1
Problem 2:(20 marks)

You bought a regular house which current value is 500,000. If the value of the house grows
1

according to the formula V 500,000 t 1

1 2
where t is a time variable equal to zero now
2
and to one a year later. Assume that the interest rate is 4% per year with monthly compounding.
12
0.04
a. When is the optimal time to sell the house? r 1 1 0.0474154
12
d
1
dV0 1 2
500,000 t 1 1.0474154 t
dt dt
2
1 1
500,000 1 2
1 1 2
t 1 1.0474154 t 500,000 t 1 1.00474154 t 1 ln 1.0474154
2 2 2 2
1
500,000 1 2 1
1

t 1 1.0474154 t t 1 4 ln 1.0474154 0
4 2 2
1 1
1 1 1 1
t 1 4 ln 1.0474154 0 t 1 4 ln 1.0474154 t 1
2 2 2 4 ln 1.0474154
1
t 2 1 8.7931 years
4 ln 1. 0474154

b. Compute both (i) the optimal selling price of the house and (ii) its present value at time zero.
1 1
1 2 1 2
V 500,000 t 1 500,000 8.7931 1 1,161,529.17
2 2
8.7931
V0 1,161,529.17 1.0474154 772,897.92

Now assume that you are the manager of Tucal Inc. and that you are evaluating the following
three projects, where Project A and Project B are mutually exclusive and Project C is
independent of the other two.

Year Project A Project B Project C

0 $1,000 $1,000 $1,200
1 0 $2,250 $4,300
2 $5,500 0 0

Assume that the cost of capital is 12% per year.

a. Compute the NPV of the three projects.

5500
NPV A 1000 $3,384.57
1.12 2
2250
NPVB 1000 $1,008.93
1.12
4300
NPVC 1200 $2,639.29
1.12
b. Assuming that projects are replicable both in time and space, which combination of projects is
optimal to choose?
4300 1200 5500 4300
NPV A C 2200 $8,380.40 every two years
1.12 1.12 2
4300 2250 2200 4300 2250
NPV B C 2200 $6.905.50 every two years
1.12 1.12 2
Choose the combination of projects A and C.

2
Problem 3:(20 marks)

W2
Chris measures his utility with a quadratic utility function given by: U W W .
100,000
Chris has an initial wealth of $10,000 and faces a gamble such that he may gain or lose $500
with equal probabilities.

a. Under what condition does Chris has a positive marginal utility?

dU W d W2 2W 2W
W 1 0 1 W $50,000
dW dW 100000 100000 100000

b. Compute the certainty equivalent amount to taking the gamble. (Hints: use your answer from
part a, solutions for a quadratic equation ax2 + bx + c = 0, a > 0 are given by
b b 2 4ac
x .
2a

E U W 0.5 10000 500
10000 500 2
0.5 10000 500
10000 500 2
8,997.5
100,000 100,000

U W * W *
W
* 2
8997.5 W * 100000W * 8997.5 100000 0
2

100000
100000 100000 2 4 1 899750000
W*
2
50,000 500 6401 9,996.875122 or 90,003.12488
Since W * 50,000 from part (a), certainty Equivalent Amount : W * $9,996.88

c. Determine the risk premium associated to the gamble from your answer to part a. should Chris
take the gamble?
E[W] = 0.5 (10000 500) + 0.5 (10000 + 500) = $10,000
Risk Premium = E[W] W* = 10,000 9,996.88 = $3.12.
No, Chris should not take the gamble because the risk premium is positive.

d. Find Chris ARA as a function of his wealth. Determine whether the ARA is increasing,
decreasing, or constant in W.

2W W 1
U ' W 1 1 ; U ' ' W
100000 50000 50000
U ' ' W 1 / 50000 1
ARA
U ' W 1 W / 50000 50000 W
d 1 1
ARA 0
dW 50000 W 2
50000 W 2
ARA is increasing in his wealth.
-------------------------------------------------

*** continued from Problem 4.g ***

Although no calculation is required, you can confirm the same MRP with calculations.
14000 15000
E U W exp 0.4 exp 0.6 0.2325168817
10000 10000
W*

U W * 0.2325168817 exp 0.2325168817
W*
ln 0.2325168817
10000 10000
W * 10000 ln 0.2325168817 10000 - 1. 458792447 $14,587.92
Markowitz Risk Premium = E[W] W* = 14,600 14,587.92 = $12.08.

3
Problem 4:(30 marks)
Assume your current wealth is $15,000. You are exposed to a gamble with 40% chances of
losing $600 and 60% of gaining $400. You have a negative exponential utility function
W
U W exp .
10,000
a. Show whether you are risk averse, risk neutral or risk lover. Explain your answer.
dU W 1 W 1 W
U ' W exp exp 0,
dW 10000 10000 10000 10000
d dU W d 1 W 1 1 W
U ' ' W exp exp ,
dW dW dW 10000 10000 10000 10000 10000
2
1 W
exp 0 risk averse.
10000 10000
b. Compute the expected payoff from the gamble and determine your expected wealth if you take
the gamble.
E[G] = 0.4 (600) + 0.6 400 = 0
E[W] = 0.4 (15,000 600) + 0.6 (15,000 + 400) = $15,000
c. Define the certainty equivalent. Compute the certainty equivalent wealth to taking the gamble.
Certainty Equivalent Wealth is the wealth that one accepts with certainty if the gamble is
removed.
14400 15400
E U W exp 0.4 exp 0.6 0.22339976
10000 10000
W*

U W * 0.22339976 exp 0.22339976
W*
ln 0.22339976
10000 10000
W * 10000 ln 0.22339976 10000 1.498792467 $14,987.92

d. From part c, determine your Markowitz risk premium (MRP). What is the interpretation of the
computed MRP?
Markowitz Risk Premium = E[W] W* = 15,000 14,987.92 = $12.08.
Interpretation: You are willing to pay $12.08 to avoid the gamble.

e. Can you compute the Arrow-Pratt risk premium (APRP)? Why? If your answer is positive,
then determine the APRP and compare it to the MRP from part d.
W2 Var W 0.4 14400 15000 0.6 15400 15000 240,000
2 2

2
1 15000
exp
1 U ' ' W 1 10000 10000 240,000
APRP : W2 240,000 $12.
2 U ' W 2 1 15000 2 10,000
exp
10000 10000
ARRP ($12) is close to MRP ($12.08) because the gamble is actuarially neutral and its risk
is small.
f. Determine your Absolute Risk Aversion (ARA). Comment on your risk aversion as a function
of wealth.
2
1 W
exp
U ' ' W 10000 10000 1
ARA ,
U ' W 1 W 10000
exp
10000 10000
d
ARA d 1 0.
dW dW 10000
ARA is constant in W, implying that your level of risk-aversion does not change
regardless of your wealth.

g. Assume that you played the gamble and lost $400 so that your wealth becomes $14,600. You
are offered the same gamble after this loss. Use your answer to part f to determine the new MRP.
Explain your answer (no calculations are required for this question)
Since ARA is constant in W, MRP stays the same at $12.08 with the lower wealth.
Check the details of calculations for confirmation at the end of page 4.