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= (j
1
. j
2
. .... j
n
) and an asset allocation (a portfolio for each individual) which
results from independent decisions of investors, each of whom is a price-taker,
such that:
(a) The demand for each asset equals its supply;
(b) Each investors decision is optimal (each investors utility is maximised) given
his/her budget constraint (initial wealth), beliefs (expectations), and prefer-
ences (attitude to risk).
3. Expectations under uncertainty and expected utility theory (EUT).
(a) What is the denition of risk / uncertainty that is adopted in Bailey (2005)? [2]
There is risk when it is known that a number of future states can occur, but
when the identity of the true state (the state which will actually occur) is
unknown.
It is assumed that the full set of possible states is known and that a probability
value can be assigned to measure the likelihood with which each state occurs.
The probabilities are additive (the sum of probabilities across all possible
states is one).
(b) Discuss the implications of uncertainty for EUT, in the context of:
i. Rational expectations (RE). [3]
Under RE, investors have knowledge of the true stochastic model which
determines future economic outcomes.
Moreover, this model is ergodic (stationary) and investors do not make
systematic errors in forecasting.
4
Hence, agents beliefs regarding future outcomes are summarised in well-
dened additive probability distributions.
In this case, the expected utility representation will provide an unbiased
(accurate) representation of preferences under uncertainty, as long as the
EUT axioms are satised.
ii. Expectations which do not conform to the denition of rational
expectations. [3]
If agents do not have RE, then they are unable to form unbiased predic-
tions of the future.
This happens when the set of possible future states is unknown.
At best, agents assign nonadditive probabilities to the incomplete set of
states.
This is not consistent with the EUT representation.
Hint. It is impossible to have rational expectations in a decision-making
environment of true uncertainty, as dened by Davidson (1991).
[8 marks]
4. Risk aversion. Consider an investor with initial wealth = 60 and utility function
n(\) = 200\
1
2
\
2
.
The investor has the option of buying the lottery
1 := ( + 90. 40. :)
at a price of 1
L
= 5.
(a) Provide a complete description of the preferences implied by n. Do these prefer-
ences conform to our expectations of how people make decisions under uncertainty
in the real world? Discuss in detail and, where necessary, provide calculations to
support your answer. [6]
To verify that n provides an accurate representation of preferences, we must
check that n
0
(\) 0 (implying non-satiated consumption demand) and
n
00
(\) < 0 (which means that n is strictly concave and hence that the investor
is strictly risk averse).
Notice that, since n is quadratic, we need to restrict the domain of \ to that
portion where n is an increasing function.
5
Specically,
n
0
(\) = 200 \ 0
if and only if \ < 200.
Clearly, n is strictly concave since
n
00
(\) = 1 < 0
for all \ 0.
Next, we calculate the investors coecients of absolute and relative risk
aversion:
(\) =
n
00
(\)
n
0
(\)
=
1
200 \
=
1
200 \
0 i \ < 200.
1(\) = \ (\) =
\
200 \
0 i \ < 200.
Quadratic utility implies increasing absolute risk aversion (IARA), since
0
(\) = 1 (200 \)
2
(1) =
1
(200 \)
2
0
for all 0 \ < 200.
IARA is not a realistic assumption (discuss why not).
(b) For what value of : would any strictly risk averse investor with initial wealth of
decline to play 1? How do know this? [3]
By denition, any strictly risk averse investor declines to play 1 when 1 is a
fair lottery.
Given that it costs 1
L
to play 1, 1 is fair when 1 (1) 1
L
= .
Hence, we need to nd the value for : that solves
1 (1) 1
L
= : (150) + (1 :) (20) 5 = = 60.
=) : (150 20) = 60 + 5 20 = 45
=) : =
45
130
= 0.35.
(c) Calculate the value for : such that the investor is indierent between buying 1
and not buying 1. [3]
6
We need to solve for : in the following equation:
(60. r. 1) s (60 + 90 5. 60 40 5. :) = (145. 15. :) .
=) n(60) = :n(145) + (1 :) n(15)
=) 200 (60)
1
2
(60)
2
= :
200 (145)
1
2
(145)
2
+ (1 :)
200 (15)
1
2
(15)
2