Financial Economics: Tutorials second half 1

Financial Economics
Problem Set 2

Problem 1: Insurance: how much to buy

This is similar to what I have done in the lecture but now not with somebody choosing the
level of insurance instead of the excess again.

• An agent can decide how much insurance to purchase.

• The agent chooses p ∈ [0, D], which is the amount of insurance the agent wants to buy.

• D is the damage that occurs with probability π.

• p = 0 means no insurance bought, while p = D is full-insurance.

• Also suppose that for each Dollar insured, the insurer charges a premium of r.

• The wealth of the agent is denote c̃.

• Denote consumption in the loss state as cl and consumption in the no-loss state as cnl .

(a) Write down the expression for the consumption in the two states of the world, i.e. cnl and
cl as a function of how much insurance the agent buys.

(b) Find the combinations of cnl and cl the agent can feasibly choose by choosing p. Hint: I am
looking for the budget line cl as a function of cnl .

(c) Interpret the slope of the budget line. Draw the budget line in a cl -cnl diagram and comment
on how the price of insurance r impacts the slope.

(d) Suppose we have a risk-averse agent. Describe how we can graphically represent such
preferences and how the graphic representation incorporates π and the degree of the agent’s
risk aversion.

(e) Add some indifference curves of a risk-averse agent and show the optimal allocation. (As-
sume that π < r for your graph.) How can you read off your graph how much insurance
the agent is going to buy?

(f) Discuss the conditions for full insurance and buying no insurance at all to be optimal.
Financial Economics: Tutorials second half 2

Problem 2: Complete Markets for State-Contingent Claims

1. Explain what Complete Markets for State-Contingent Claims means.

2. What are the requirements for a complete market of contingent claims to exist? Is this
likely to be true in reality?

3. Sketch the condition that has to hold for consumption in any two states to be optimal for
an agent and interpret it.

4. Draw the optimal choice for n = 2 with an arbitrary initial allocation c̃ and explain
indffernce curves and the budget constraint.
Financial Economics: Tutorials second half 3

Problem 3: Some violations of Expected Utility Theory

1. What are the underlying assumptions for optimal individual choices to look like if som-
body maximised expected utility?

2. People’s choices often depend on irrelevant alternatives (like in the decoy effect). Explain
how this violates the assumptions underlying EUT.

3. Provide some evidence from introspection and the lectures for people typically being
motivated by changes in wealth or consumption rather than by wealth or consumption
levels.

4. Explain why the often observed behaviour of the same person buying insurance and lot-
tery tickets at the same time (and for all wealth levels) is not consistent with expected
utility theory.

5. What is probability weighting, and how can it explain the lottery-insurance paradox.
Financial Economics: Tutorials second half 4

Problem 4: Discounting Utility

1. Suppose you have an income of $1000 per month and you are given the choice between
and additional
√ $225 today and $y in one year’s time. Your utility function over money
is u (x) = x. Supposing you are an exponential discounter with a discount factor δ
between years of 5/6, find the amount y that would make you indifferent between taking
the money now or in a year’s time.

2. Suppose instead the choice is between an additional $225 today and $3900 in t years’
time. Find the lowest value of t such that you would prefer to take the $225 today.

3. Without calculating, discuss how the magnitude of the discount factor δ influences your
answer to the two questions above.

4. Again without calculating anything, comment on how your answers to (1) and (2) would
change if your base income increased.(Tricky!)
Financial Economics: Tutorials second half 5

Problem 5: Time Consistency and Going to The Gym

Imaging the following situation. Suppose you have got the once-off chance to book a world-
famous personal trainer. For this you will have to pay some money today (t = 0). Then next
month (t = 1), if you have booked her, you can either train with her or not. Training will incur
an effort cost. Then the month after (t = 3) you will enjoy a health benefit if you booked the
trainer and trained the period before. Period utilities are:

time action 1 action 2

t = 0 u0 (book) = −1 u0 (notbook) = 0
t = 1 u1 (train) = −1 u1 (nottrain) = 0
t = 2 u2 (trained) = 3 u2 (nottrained) = 0

1. Denote the discount factor by δ and write down the intertemporal utilities U 0 for the three
possible course of action (book and train, book and not train, not book and not train)
p
2. For which value of δ will you plan to buy and to train. Recall that x = −b/2 ± b2 /4 − c
gives the solutions to x2 + bx + c = 0

3. In period 0, for which δ’s do you plan to work out in t = 1 in case you book the trainer.
Compare this to the critical delta required once you arrive in t = 1 to actually work out.
Comment.

4. for which ranges of δ will you follow the three course of action: (a) not book and not
work out even if you had booked, (b) not book but work out if you had booked, (c) book
and work out, (d) book but do not work out.
Financial Economics: Tutorials second half 6

Problem 6: What to do with a lottery win?

Suppose there are two periods t = 1 representing now and t = 2 is later. Your income is c̃
Dollars every period. Your mum gave you a lottery ticket for your birthday and you won 50, 000
Dollars. Now you have to decide how much of the win you are spending right now and how
much (denoted by x) to put in a term deposit that pays interest r and matures in period t = 2.
You have a concave period utility function u(c) and discount future utility with discount factor
δ.

1. Describe the factors that impact the optimal amount you will save. Comment on the
direction the factors will impact your saving decision.

2. Show the optimal saving decision in a graph with consumption in t = 1 on the x and
consumption in t = 2 on the y-axis. Label all points.

3. What is the slope of an indifference curve? What is the slope of the budget line. What do
the slopes actually tell you.

4. Assume u(c) = ln c, δ = 0.8 and r = 0.25. Calculate the optimal saving amount x∗ .

5. Now suppose that instead r = 0.1. Recalculate x∗ and comment.

6. Finally, assume that the bank pays a massive interest rate of r = 0.4. Recalculate x∗ and
comment again.

7. Give an intuition for why the impact of wealth on saving depends on the the sign of
(1 + r) − 1/δ.

8. Draw a graph showing indifference curves budget lines and optimal allocations for the
the cases above.
Financial Economics: Tutorials second half 7

Problem 7: Saving and Borrowing in Imperfect markets

Suppose, we have a complete but imperfect market for shifting consumption between two
periods denoted by t = 1 and t = 2. The interest rates an agent faces differ for borrowing and
saving, with the interest rate for borrowing rb exceeding that for saving rs .

1. Draw the budget constraint for an agent with arbitrary endowment ĉ and explain where
saving and where borrowing occurs and what the corresponding slopes are.

2. Add indifference curves for three different people with endowment ĉ leading to one per-
son saving, one borrowing and one doing neither. Comment on what determines if some-
body borrows, saves or stays put.

3. Now suppose competition increases in the intermediary sector, and banks are now forced
to increase interest rates on deposits and decrease interest rates on loans. Further suppose
that they now apply one interest rate r to all transactions which is between rs and rb .
What happens to the three agents with respect to their behaviour and with respect to their
welfare.

4. Draw a graph showing, where the three individuals end up.

5. What are the policy implications following from this analysis?

6. A banker tells you that interest rates on loans are higher because there is a higher risk that
the borrower defaults than that his bank defaults on deposits. Therefore, the interest rate
spread between loans and deposits is actually not because of lack of competition. Does
this argument have merit? Discuss.