Sei sulla pagina 1di 7

University of Johannesburg

Department of Economics and Econometrics


B.Com Honours in Economics
International Money and Finance: Semester Test 1
Assessor: Dr AS Duncan Internal Moderator: Dr J Muteba Mwamba
Date: 20 March 2013 Time: 17:30-20:00
Instructions to the candidates:
1. The test consists of 3 pages (including this page) and 43 marks. There are 3 bonus
marks. Thus, your test result will be computed as a percentage of 40 marks (with a
maximum percentage of 100).
2. Read each question carefully and understand what is being asked before you write
down your answer.
3. Answer all 6 questions.
4. Write in full sentences. Make sure that your answers are detailed, unambiguous, and
convincing!
5. Pay attention to mark allocation. One fact will earn at most one mark.
6. Use bullet points to structure your answers.
7. Write neatly.
8. Show all workings.
9. Give calculated answers correct to two decimal places.
10. The use of non-programmable calculators is permitted.
11. Label all diagrams.
12. Good luck!
2
1. Functions of the nancial system. Financial assets give investors the ability to
transfer income across time and between dierent states of the world.
(a) What is a nancial asset? [1]
A nancial asset is a legally binding claim to a stream of expected future
cash-ows or payos.
(b) What does it mean for a nancial asset to be risky? Provide an example in which
you clearly distinguish between a risky asset and a risk-free asset (the correct
answer is NOT that government bonds are risk-free and stocks are risky!). [2]
A nancial asset is risky when at least two of its state-contingent future
payos are unequal.
Over short time-horizons, the future payos of a risk-free asset are known ex
ante (i.e. at the time of choice), and do not vary across dierent states of the
world.
Example: Suppose that there is one future time period and two possible
states. Asset has a payo of 3 in both states, and thus it is risk-free. Asset
1 has a payo of 2 in state 1 and a payo of 4 in state 2, and so it is risky.
(c) Explain the dierent ways in which nancial assets are used to achieve the above-
mentioned functions. [3]
Financial assets allow agents with funding decits to borrow money from
agents with funding surpluses at market determined interest rates. Usually,
this is achieved via a nancial intermediary (e.g. a bank). In so doing, agents
can smooth income, and hence consumption, over time.
By forming portfolios, agents are able to invest in combinations of dissimilar
assets (dissimilar in the sense that their returns are not perfectly positively
correlated). In so doing, investors can minimise their risk (portfolio variance)
given a desired level of expected return. This is known as diversication.
Diversication helps to stabilise income across dierent states of the world.
Finally, nancial markets establish fair prices for risky assets. At these prices,
risk can be transferred from one investor to another. The result is that risk
bearing assets are held by those investors who are most willing to be exposed
to risk.
(d) Clearly explain why (or under what assumptions) these functions are useful to
investors. [2]
Experimental and empirical evidence suggests that investors are risk averse.
3
This means that they prefer stable streams of consumption to variable ones,
in both the time and the state dimension.
When investors have concave utility functions, the ability to transfer income
over time or states, or to trade risky assets, are utility enhancing features of
nancial markets.
[8 marks]
2. Equilibrium. USING YOUR OWN WORDS, explain what it means for the economy
to be in a competitive general asset market equilibrium.
[4 marks]
Competitive general asset market equilibrium is dened as an asset price vector
1

= (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

=) 10200 = 18487.5: + 2887.5(1 :)


=) 15600: = 10200 2887.5 = 7312.5
=) : = 0.47.
[12 marks]
5. Ecient market hypothesis (EMH).
(a) If the market is weak-form ecient, must it also be semi-strong-form ecient?
Motivate your answer. [2]
No, it is possible for the market to be weakly ecient, but not semi-strong
ecient.
To be weak-form ecient the current market price must reect all information
contained in past prices.
To be semi-strong form ecient this must also be true; however, in addition,
prices must reect all other publicly available information.
Hence, semi-strong version of the EMH is a stronger criterion for market
eciency than is the weak-form version.
(b) Discuss the Grossman-Stiglitz paradox and its implications for the EMH. [3]
Strong-form eciency implies the absence of information asymmetry between
investors.
What is the incentive to collect information if (i) collecting information is
costly and (ii) current prices already reect all information (the market is
strong-form ecient)?
If there is no incentive to collect information, how does information become
embedded in prices in the rst place?
This is the Grossman-Stiglitz paradox.
The implication of the paradox is that it is impossible for markets to be
strong-form ecient.
7
(c) What is the "January eect"? Explain the implications of this eect for the
EMH. [2]
[7 marks]
The shares of many small companies (those with a smaller-than-average mar-
ket capitalization) tend to experience above average returns in January, es-
pecially in the rst half of the month.
The January eect represents a predictable change in returns which is seem-
ingly unrelated to fundamentals.
Hence, this eect casts some doubt on market eciency.
6. Bonus question. Discuss what it means for the market price of a security to be
"rational". Write down an expression for the current rational market price of some
risky security. To do this, you will need to introduce appropriate mathematical notation
(you must dene all the symbols that you use).
[4 marks]
The market price of an asset is rational if it reects the fundamental value of that
asset.
This is true when price equals the discounted present value of the expected future
cash-ows associated with the asset.
Cash-ow discounting takes into account the time-value of money, as well as fair (equi-
librium) compensation for risk-bearing.
Assume that there are 1 time periods (where 1 is large and possibly innite).
Denote the expected cash ows for some risky asset by 1(
t
) for t = 1. 2. .... 1.
Let :
f
denote the risk-free rate and :j = j :
f
the risk premium on the asset.
Then, we have the following formula for the current rational price of the asset:
1
0
=
T
X
t=1
1 (
t
)
(1 +:
f
+:j)
t
.

Potrebbero piacerti anche