Question 1. Price movements (20 points). We have discussed the Gordon-growth model during class. We said that, when cash flows are expected to grow at a constant rate 1+g, an asset's price can be approximately written as Pv=rgCFt. - la (10 points). Suppose there is a better-than-expected eamings announcement. In this case, does the price move up or move down? Explain carefully why the price movement happens. - 1b (10 points). Suppose for some reason, market participants become more risk averse. In this case, does the price move up or move down? Explain carefully why the price movement happens. Question 2. Asset allocation (30 points). We have discussed a simple asset allocation problem during class - we considered allocating money between a risk-free asset (a one-year T-bill) and a risky asset (the stock market). In this question, we just go over the same kind of question, with slightly different numbers. We like to make sure you know how to actually do this problem! Suppose you consider asset allocation between a one-year T-bill and the stock market. The T-bill offers an interest rate of 3%. The stock market, currently priced at 1,200 , may go up to 1,500 in one year with probability 0.5, may go up to 1,300 in one year with probability 0.3, and may go down to 900 in one year with probability 0.2. - 2a (10 points). What is the expected net return of the stock market? What is the standard deviation of the stock market return? Hint: You should follow the procedure given to you on page 4 of lecture note 3 to compute Esse and Ssep.. - 2b (10 points). Suppose you have a utility function U(E,S)=E2S2, where E is the expected net return of your portfolio, and S is the standard deviation of your portfolio return. What is the 1 utility level you receive if you choose to invest all your wealth in the T-bill? What is the utility level you receive if you choose to invest all your wealth in the stock market? If you only have two options - investing all your wealth in the T-bill or in the stock market-which option will you choose? - 2c (10 points). Suppose you now have a utility function U(E,S)=ES2, where E is again the expected net return of your portfolio, and S is the standard deviation of your portfolio return. What is the utility level you receive if you choose to invest all your wealth in the T-bill? What is the utility level you receive if you choose to invest all your wealth in the stock market? If you only have two options - investing all your wealth in the T-bill or in the stock market-which option will you choose? Question 1. Price movements (20 points). We have discussed the Gordon-growth model during class. We said that, when cash flows are expected to grow at a constant rate 1+g, an asset's price can be approximately written as Pv=rgCFt. - la (10 points). Suppose there is a better-than-expected eamings announcement. In this case, does the price move up or move down? Explain carefully why the price movement happens. - 1b (10 points). Suppose for some reason, market participants become more risk averse. In this case, does the price move up or move down? Explain carefully why the price movement happens. Question 2. Asset allocation (30 points). We have discussed a simple asset allocation problem during class - we considered allocating money between a risk-free asset (a one-year T-bill) and a risky asset (the stock market). In this question, we just go over the same kind of question, with slightly different numbers. We like to make sure you know how to actually do this problem! Suppose you consider asset allocation between a one-year T-bill and the stock market. The T-bill offers an interest rate of 3%. The stock market, currently priced at 1,200 , may go up to 1,500 in one year with probability 0.5, may go up to 1,300 in one year with probability 0.3, and may go down to 900 in one year with probability 0.2. - 2a (10 points). What is the expected net return of the stock market? What is the standard deviation of the stock market return? Hint: You should follow the procedure given to you on page 4 of lecture note 3 to compute Esse and Ssep.. - 2b (10 points). Suppose you have a utility function U(E,S)=E2S2, where E is the expected net return of your portfolio, and S is the standard deviation of your portfolio return. What is the 1 utility level you receive if you choose to invest all your wealth in the T-bill? What is the utility level you receive if you choose to invest all your wealth in the stock market? If you only have two options - investing all your wealth in the T-bill or in the stock market-which option will you choose? - 2c (10 points). Suppose you now have a utility function U(E,S)=ES2, where E is again the expected net return of your portfolio, and S is the standard deviation of your portfolio return. What is the utility level you receive if you choose to invest all your wealth in the T-bill? What is the utility level you receive if you choose to invest all your wealth in the stock market? If you only have two options - investing all your wealth in the T-bill or in the stock market-which option will you choose
