Question
You are an investor with log utility and subjective discount factor equal to = 0:98. Your current wealth (i.e., consumption) is $100, but its future
You are an investor with log utility and subjective discount factor equal to = 0:98. Your current wealth (i.e., consumption) is $100, but its future level (at t = 1) is uncertain and depends on the state of the economy. There is a 50% chance (i.e. actual probability) that your wealth (i.e., consumption) will fall to $90. Otherwise, it will increase to $110. You want to determine the price of securities. 2 (A) Calculate the stochastic discount factor (SDF) for the two states of the economy at t = 1, denoted by m(U) and m(D) for the up and down states, respectively. (B) If markets are complete, calculate the corresponding state (Arrow-Debreu) prices, denoted by q(U) and q(D), and the level of the (effective) risk-free rate. (C) Determine the risk-neutral probability of the up state, given by (U). (D) Consider a stock that is negatively correlated with your consumption. In one year, the stock will either sell for 20 or 30. Compute the price of this stock today. (E) Determine the equity risk premium on the stock (hint: first compute the expected return). Explain the sign. (F) Compute the price of a call option on the stock with strike price K = 25.
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