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Consider the single-period binomial model. The bank account pays interest r over the period. The stock price at time O is So. At time 1,
Consider the single-period binomial model. The bank account pays interest r over the period. The stock price at time O is So. At time 1, it can move to Soe+u with probability p, and to Sewith probability 1-p. Here, we are considering excess returns, and make the no-arbitrage assumption u,d>. The investor has power utility U with relative risk aversion b and initial capital Wo. (a) Write the risk-neutral probability p using the current notation. (b) For power utility, it is more convenient to invest according to the fraction of wealth rather than the share . Thus, derive the time 1 wealth as a function of -AS/W- the fraction of wealth invested in the risky asset. Here, leave your answer in terms of the risky asset's excess log return XIn(S1/So)-r. (c) Explicitly identify the optimal fraction of wealth policy t
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