University of Toronto,, ECO 204 2011 Summer: Scores Total Points Score 1 2 3 Total Points 100

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University of Toronto, Department of Economics, ECO 204 2011 Summer Ajaz Hussain
TEST 3
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TIME: 1 HOUR AND 50 MINUTES

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MIDDLE NAME (AS IT APPEARS ON ROSI)

STUDENT ID # (AS IT APPEARS ON ROSI)

SIGNATURE: __________________________________________________________________________

SCORES
Question Total Points Score
1 40
2 25
3 35
Total Points = 100

ONLY AID ALLOWED: A CALCULATOR
FOR YOUR CONVENIENCE THERE IS A WORKSHEET AT THE END OF THE TEST
GOOD LUCK!

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QUESTION 1 [40 POINTS]
Consider an economy in which all agents live for two periods: (agents are young in and
old in ). There is a single good in the economy (say corn), the base period is , and the
real interest rate is .

Consider an individual who is endowed with income
in respectively (income is in
units of corn) and her preferences over consumption (in units of corn) in are represented by
the utility function:

Here
and
are consumption (in units of corn) in respectively, and are

parameters. The consumption set is *(
+.

(1.1) [5 POINTS] Does this individual have monotone preferences over consumption in and ?

Show all calculations and state any assumptions.

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(1.2) [5 POINTS] Suggest a positive monotonic transformation of this individuals utility function and use it
throughout this question. Show all calculations and state any assumptions.

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(1.3) [5 POINTS] Write down the inter-temporal budget constraint and interpret the and intercepts
(let
be the -axis variable). Show all calculations and state any assumptions.

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(1.4) [10 POINTS] Solve this individuals inter-temporal Utility Maximization Problem and express all
solutions to the UMP in terms of both Present Value Income and Future Value Income (for example,
express

in terms of PV income, as well as FV income). You are expected to use the appropriate
inequality/equality constrained optimization method. Show all calculations and state any assumptions.

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(1.5) [5 POINTS] True or false: regardless of the real interest rate , the marginal utility of Future Value
Income is always positive. Show all calculations and state any assumptions.

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(1.6) [5 POINTS] Under what conditions will higher real interest rates make this individual happier?
Show all calculations and state any assumptions.

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(1.7) [5 POINTS] Suppose that

; i.e. the individual has the same endowment income in
each period. Given that the individual has the same income in each period, does this mean shell
consume the same amount of corn in each period? Show all calculations and state any assumptions.

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Ajax Inc. wants to raise capital by issuing stocks through an IPO (initial public offering). The board of
governors must decide whether to issue stock either at a price of $100 per share or at $50 per share.
There is uncertainty about the number of shares that will be sold at each price. Suppose the board of
directors believes that:

If the stock is issued at $100 per share then the market will buy either 2m shares with
probability or 1m shares with probability ( )
If the stock is issued at $50 per share then the market will buy either 3m shares with probability
or 2.5m shares with probability ( )

(2.1) [5 POINTS] Graph the decision tree for this decision making under uncertainty problem.

ECO 204, 2011 Summer, Test 3
This test is copyright material and may not be used for commercial purposes without prior permission
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(2.2) [5 POINTS] Suppose
. If Ajax is to issue shares at a price of $100 a share, what must the

probability of selling 2m shares be? Assume Ajax is risk neutral. Show all calculations and state any
assumptions.

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. If Ajax is to issue shares at a price of $100 a share, what must the

probability of selling 2m shares be? Assume Ajax is risk averse and has the utility function
(where is millions of dollars). Show all calculations and state any assumptions.

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and = # calculated in part (2.3). Assuming Ajax is risk averse and has the
utility function (where is millions of dollars) what is the certainty equivalence to the
uncertainty of issuing stocks at a price of $100 per share? Show all calculations and state any
assumptions.

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and = # calculated in part (2.3). Assuming Ajax is risk averse and has the
utility function (where is millions of dollars) what is the certainty equivalence to the
uncertainty of issuing stocks at a price of $50 per share? Show all calculations and state any
assumptions.

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You own a house currently valued at 1m. You have a habit of throwing wild parties by inviting
econ faculty who may cause damage (loss) to your house. You estimate the potential damage (the

loss) to your house at . Let the probability of your house being damaged = .

(3.1) [5 POINTS] Suppose you dont purchase insurance. What is the value of your house in each state of
uncertainty (damage, no damage), as well as the expected value of your house? Show all calculations
and state all assumptions.

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(3.2) [5 POINTS] What is actuarially fair insurance? Provide one proof for actuarially fair insurance.
Show all calculations and state all assumptions.

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(3.3) [5 POINTS] Suppose you purchase an actuarially fair insurance policy in the amount of (i.e. if the

house is damaged, the insurance company will pay you ). What is the value of your house in each state
of uncertainty (damage, no damage), as well as the expected value of your house? Show all calculations
and state all assumptions. Do not assume that you have purchased a full insurance policy.

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(3.4) [5 POINTS] Suppose you purchase an actuarially fair full insurance policy for (i.e. if the house is

damaged, the insurance company will pay you ). What is the value of your house in each state of
uncertainty (damage, no damage), as well as the expected value of your house? Show all calculations
and state all assumptions.

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(3.5) [5 POINTS] Compare the value of your house in each state of uncertainty (damage, no damage), and
the expected value of the house from parts (3.1) and (3.4). What do you notice? Why would someone
purchase a full insurance policy? Show all calculations and state all assumptions.

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(3.6) [5 POINTS] Suppose the probability that your house is damaged by party animals econ faculty is

What is the insurance premium of a full insurance policy? Show all calculations and state all
assumptions.

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(3.7) [5 POINTS] Suppose the probability that your house is damaged by party animal econ faculty is
What is the maximum insurance premium youre willing to pay to insure against damage to

your house? Show all calculations and state all assumptions. Assume where is millions of
dollars.

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Page 1 of 22

are consumption (in units of corn) in respectively, and are

. If Ajax is to issue shares at a price of $100 a share, what must the

. If Ajax is to issue shares at a price of $100 a share, what must the

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