quiz222...its complete solve kindly

Question: 1. A corporate treasurer is designing a hedging program involving foreign currency options. What are the pros and cons of using (a) NASDAQ OMX and (b) the over-the-counter market for trading?

2. Suppose that a European call option to buy a share for $100.00 costs $5.00 and is held until maturity. Under what circumstances will the holder of the option make a profit? Under what circumstances will the option be exercised? Draw a diagram illustrating how the profit from a long position in the option depends on the stock price at maturity of the option.

3. Suppose that a European put option to sell a share for $60 costs $8 and is held until maturity. Under what circumstances will the seller of the option (the party with the short position) make a profit? Under what circumstances will the option be exercised? Draw a diagram illustrating how the profit from a short position in the option depends on the stock price at maturity of the option.

4. Describe the terminal value of the following portfolio: a newly entered-into long forward contract on an asset and a long position in a European put option on the asset with the same maturity as the forward contract and a strike price that is equal to the forward price of the asset at the time the portfolio is set up. Show that the European put option has the same value as a European call option with the same strike price and maturity.

5. A trader buys a call option with a strike price of $45 and a put option with a strike price of $40. Both options have the same maturity. The call costs $3 and the put costs $4. Draw a diagram showing the variation of the trader's profit with the asset price.

6. Explain why an American option is always worth at least as much as a European option on the same asset with the same strike price and exercise date.

7. Explain why an American option is always worth at least as much as its intrinsic value.

8. Explain carefully the difference between writing a put option and buying a call option.

9. The treasurer of a corporation is trying to choose between options and forward contracts to hedge the corporation's foreign exchange risk. Discuss the advantages and disadvantages of each.

10. Consider an exchange-traded call option contract to buy 500 shares with a strike price of $40 and maturity in 4 months. Explain how the terms of the option contract change when there is: (a) a 10% stock dividend; (b) a 10% cash dividend; and (c) a 4-for-1 stock split.

Q2. As you know, Contingent Valuation is a method of environmental valuation based on asking individuals how much they would be willing to pay (WTP) for a specific environmental service (for example, improved water quality); or, alternatively, the amount of compensation that they would be willing to accept (WTA) to give up an environmental service. Keeping in mind the underlying assumptions otical examples to demonstrate your points. a. If individual preferences are not exogenous b. If individual preferences are not complete c. If individual preferences do not have substitutability d. Inow, Contingent Valuation is a method of environmental valuation based on asking individuals how much they would be willing to pay (WTP) for a specific environmental service (for example, improved water quality); or, alternatively, the amount of compensation that they would be willing to accept (WTA) to give up an environmental service. a. If individual preferences are not exogenous b. If individual preferences are not complete c. If individual preferences do not have substitutability d. If individual action is responsive to framing (recall the findings of behavioral economics)

General Equilibrium (32 points) Consider the case of pure exchange with two consumers. Both consumers have Cobb-Douglas preferences, but with different parameters. Consumer 1 has utility function u(x1 1, x1 2)=(x1 1)(x1 2)1. Consumer 2 has utility function u(x2 1, x2 2)=(x2 1)(x2 2)1. The endowment of good j owned by consumer i is i j . The price of good 1 is p1, while the price of good 2 is normalized to 1 without loss of generality. 1. Only for point 1, assume 1 1 = 1, 2 1 = 3, 1 2 = 3, 2 2 = 1. (that is, total endowment of each good is 4). Assume further = 1/2, = 1/2. Draw the Pareto set and the contract curve for this economy in an Edgeworth box. (you do not need to give the exact solutions, only a graphical representation) What is the set of points that could be the outcome under barter in this economy? (5 points) 2. For each consumer, compute the utility maximization problem. Solve for xi j for j = 1, 2 and i = 1, 2 as a function of the price p1 and of the endowments. What happens to the consumption of good 1 and good 2 as the price p1 increases? Plot also the offer curve of consumer 2. Graphically, find the intersection, the general equilibrium point. (7 points) 4. We now solve analytically for the general equilibrium. Require that the total sum of the demands for good 1 equals the total sum of the endowments, that is, that x1 1 +x2 1 = 1 1 +2 1. Solve for the general equilibrium price p 1. (6 points) 5. What is the comparative statics of p 1 with respect to the endowment of good 1, that is, with respect to i 1 for i = 1, 2? What about with respect to the endowment of the other good? Does this make sense? What is the comparative statics of p 1 with respect to the taste for good 1, that is, with respect to and ? Does this make sense? (4 points) 6. Now require the same general equilibrium condition in market 2. Solve for p 1 again, and check that this solution is the same as the one you found in the point above. In other words, you found a property that is called Walras'Law.In an economy with n markets, if n 1 markets are in equilibrium, the nth market will be in equilibrium as well. (5 points)

Problem 3. Moral Hazard (46 points, due to Botond Koszegi). We analyze here a principal-agent problem with hidden action (moral hazard). The principal is hiring an agent. The agent can put high effort eH or low effort eL. If the agent puts high effort eH, the output is yH = 18 with probability 3/4 and yL = 1 with probability 1/4. If the agent puts low effort eL, the output is yH = 18 with probability 1/4 and yL = 1 In this case, the wage will be w if the agent chooses eH and 0 otherwise. Solve the problem max w 3 4 18 + 1 4 1 w s.t.w c (eH) .1 Argue that the constraint is satisfied with equality and solve for w. Compute the expected profit in this case EH. (5 points) 2. We are still in the case of no hidden action. Assume that the principal wants to implement low effort eL. Similarly to above, set up the maximization problem and solve for w. Compute the expected profit in this case EL and compare with EH. Which profit level is higher? The higher one is the contract chosen by the principal and hence the action implemented. (5 points) 3. Now consider the case with hidden action. The wages can only be a function of the outcomes: wH when y = yH and wL when y = yL. We study this case in two steps. Assume first that the principle wants to implement eH. We study the optimal behavior of the agent after signing the contract. Write the inequality that indicates under what condition the agent prefers action eH to action eL. (This is a function of wH and wL and goes under the name of incentive compatibility constraint). (5 points) 4. Now consider the condition under which the agent prefers the contract offered to the reservation utility .1. (This is the individual rationality constraint) (4 points) 5. Argue that the two inequalities you just derived will be satisfied with equality. Solve the two equations to derive w L and w H. Compute the profits for the principal from implementing the high action under hidden action: EHA H . (5 points) 6. Now, assume that the principal wants the agent to take the low action eL. In this case, you do not need to worry that the agent will deviate to the high action, since that will take more effort. The principal will pay a flat wage w. Write the individual rationality constraint for the agent if he takes the action eL and the pay is w. Set this constraint to equality (Why?) and derive w. Compute the implied profits for the principal from implementing the low action under hidden action: EHA L .(5 points) 7.