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EC3013 Financial Economics (2021/2022)

Resit Set Exercises 2

Question 1 [30 marks]

Suppose that Sam has vNM utility function u, which is known at two points: u(100) = 1

and u(200) = 2. When facing a lottery L1 =

(

£100, w.p. 0.6

£200, w.p. 0.4

, Sam tells the max

amount he is willing to pay for this lottery is £120.

(a) What is Sam’s expected utility for the lottery L2 =

(

£100, w.p. 0.6

£120, w.p. 0.4

? [15

marks]

(b) What is Sam’s risk preferences? [15 marks]

Assignment?

Question 2 [50 marks]

A put option on a stock that currently sells for £100, but may rise to £110 or fall to

£80 after 1 year. The risk free rate of return is 20%, and the exercise price is £90.

(a) Calculate the value of the put option using the risk-neutral valuation relationship

(RNVR). Explain the reasoning behind your calculations. [10 marks]

(b) Calculate the value of the put option by using the first principles. Explain the

reasoning behind your calculations. [10 marks]

(c) What is the price of a call option on the same stock with the same exercise price

and expiration date? Explain the reasoning behind your calculations. [10 marks]

(d) Is there an arbitrage opportunity in this market? Explain. [10 marks]

(e) You a big jump in stock prices in the near future. Using the call and put options

from (a)-(c), construct an option portfolio to make some profit. Sketch the Profit

and Loss graph for your portfolio and briefly explain. [10 marks]

Question 3 [20 marks]

Briefly explain the Equity Premium Puzzle. [20 marks]

Criteria:

You are asked to answer all exercises. Please type all your step-by-step calculations and

the relevant explanation.

Plagiarism:

Please be advised that this coursework reflects an individual work of each student, and

any form of plagiarism is strictly prohibited – it is considered a very serious matter and

severe penalties can apply.