QF2101 Basic Financial Mathematics

ASSIGNMENT 2
Question Paper

INSTRUCTIONS

1.

This paper contains a total of 4 questions and comprises 3 printed pages

2.

Do NOT hand in this question paper.

NG Wee Seng Email: matnws@nus.edu.sg Tel: 65164673

2 Question 1 [ 10 marks] Let U, V and W be utility functions. Prove the following statements. (Do NOT use the result in part (iii) to answer parts (i) and (ii) ). (i) If U is a positive affine transformation of V, then V is a positive affine transformation of U. (This is known as symmetry) (ii) If U is a positive affine transformation of V and V is a positive affine transformation of W, then U is a positive affine transformation of W. (This is known as transitivity) (iii) UARA = VARA if and only if U is an affine transformation of V.

Question 2 [5 marks] Determine all utility functions U such that UARA(w) =

(1+ ln w) 2 (w > 1) w( 1 + (ln w) 2 )

Question 3 [ 15 marks] Agent A has an initial wealth of $1, and utility function U(w) 1 Agent B has an initial wealth of $2, and utility function V(x) =

1 , w 0. w

w , w > 1. Both 1 w

agents are offered a lottery that pays $ 2 and $ (1- ) with equal probabilities, where 0 < < 2 . Let the certainty equivalent of the lottery for agent A and B be cA and cB respectively. (i) (ii) Find the absolute risk aversion functions, UARA(x) and VARA(x). Show that cB cA = 1, and hence explain why A turns down the lottery if and only if B does. (iii) Find the range of values of for which agent A will not play the lottery. Leave your answer in surd form, where applicable.
NG Wee Seng Email: matnws@nus.edu.sg Tel: 65164673

3 Question 4 [10 marks] An agent has initial wealth $w0 and utility function U(x) 1 e 2x . An investment X has random rate of return R.

(i)

Suppose the agent has to make a decision between the following two options: (Option 1) (Option 2) Invest $x in investment X , where 0 < x < w0. Do not invest at all.

Show that the value of x for which the agent will be indifferent between the two choices does not depend on w0. (ii) Suppose that w0 = 5 and R follows the probability distribution given in the table below. If the agent invests $ 5 ( 0 1) in investment X, use the Newton-Raphson method to find, to 3 significant figures, the value of that maximises the expected utility of the agents final wealth.

Rate of return Probability

-20% 0.2

-10% 0.2

10% 0.1

30% 0.5

Probability Distribution of Investment X for (ii)

END OF PAPER

NG Wee Seng Email: matnws@nus.edu.sg Tel: 65164673