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1. Suppose that there is an asset which pays $80 if it rains in College Park on the Independence Day; pays $20 if it is
1. Suppose that there is an asset which pays $80 if it rains in College Park on the Independence Day; pays $20 if it is cloudy; and pays $5 if it is sunny. a. Assume that there exists a large meteorology data and agents know the probability of each state for sure: PR = 1/8, pc = 1/4, Ps = 5/8 i. What is the agent's expected return from buying this asset at price y? ii. What is the agent's expected return from short selling this asset at price y? iii. Is there a bid-ask spread in this case? b. Now assume the agent does not knows the probabilities and she is ambiguity averse. The agent considers two priors for the weather in College Park on the Independence Day. Her two priors p and p' are described in the table below. Rainy Cloudy Sunny 1/8 1/4 5/8 p' 1/7 4/7 2/7 i. What is the agent's expected return from buying this asset at price y? ii. What is the agent's expected return from short selling this asset at price y? iii. Is there a bid-ask spread in this case? 1. Suppose that there is an asset which pays $80 if it rains in College Park on the Independence Day; pays $20 if it is cloudy; and pays $5 if it is sunny. a. Assume that there exists a large meteorology data and agents know the probability of each state for sure: PR = 1/8, pc = 1/4, Ps = 5/8 i. What is the agent's expected return from buying this asset at price y? ii. What is the agent's expected return from short selling this asset at price y? iii. Is there a bid-ask spread in this case? b. Now assume the agent does not knows the probabilities and she is ambiguity averse. The agent considers two priors for the weather in College Park on the Independence Day. Her two priors p and p' are described in the table below. Rainy Cloudy Sunny 1/8 1/4 5/8 p' 1/7 4/7 2/7 i. What is the agent's expected return from buying this asset at price y? ii. What is the agent's expected return from short selling this asset at price y? iii. Is there a bid-ask spread in this case
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