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
(b) What is Sam’s risk preferences? [15 marks]
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]
You are asked to answer all exercises. Please type all your step-by-step calculations and
the relevant explanation.
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.