ECON3023: ECONOMICS OF FINANCIAL MARKETS

EXAM 2017-18

Solutions

Part A (25%)

Question A.1
See textbooks and articles.

Question A.2
See textbooks.

Part B (75%)

Question B.1
a) What is the banking solution? That is, what portfolio and consumption
levels will the bank choose?
Answer: The banking solution is (c1 = 1, c2 = R) which is obtained invest-
ing in a portfolio (y = 0.5, x = 0.5).
b) Explain why with this solution a bank run is possible.
Answer: If all consumers run to the bank at time 1, the bank will have to
use all its resources xr + y < 1 = c1 . The consumer who did not run, would
lose all his money. Therefore, a bank run is possible.
c) Suppose the government wants to introduce a deposit insurance. What
levels of consumption (c1 , c2 ) should it offer to the consumers to avoid a bank
run?
Answer: As long as it guarantees c2 > 1, no one has an incentive to run to
the bank.
d) Finally, suppose agents’ preferences are represented by u(c) = − 2+3cc . Is
a bank run still possible?
Answer: Note that this utility function is an affine transformation of v(c) =
− 1c since u(c) = 2v(c) + 3. From this one immediately sees that the utility is
CRRA with coefficient of risk aversion equal to 2. This implies that the optimal
contract will be c1 > 1. A bank run can occur for the same reason explained
for point b.

Question B.2
a) What is the feasible consumption set for each agent?
Answer: The set of consumption bundles (c1 , c2 ) that the individual can
achieve by varying the choice of the portfolio (x, y) is given by the following
system of inequalities:
c1 ≤ y + P x,
c2 ≤ ( Py + x)1.5,
x + y ≤ 1.

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 b) Find the equilibrium in this economy, i.e., the price, the portfolio decisions
and the consumption levels. Explain carefully why this is an equilibrium.
Answer: The equilibrium is (P = 1, x = 12 , y = 12 , c1 = 1, c2 = 1.5). The
proof that P = 1 in the textbook. Briefly, this is the only equilibrium price
since for different prices one asset would dominate the other at time 0 and at
time 1 it would be impossible to equate demand and supply. When P = 1, since
preferences are strictly monotonic,
c1 = y + x = 1
c2 = (y + x)1.5 = 1.5
Clearly the consumption level does not depend on the portfolio (x, y). The
two assets are perfect substitute. To clear the market we must have x = 12 , y =
1
2.
The student should explain that the price clears the market, the portfolio is
optimal and expectations are correct.
c) Find out the feasibility constraints in the case of a benevolent social
planner who maximizes the agents’ expected utility. Illustrate such constraints
in a graph. In the same graph, show the equilibrium market allocation.
Answer: The social planner must respect the following feasibility con-
straints:

1
c1 ≤ y
2
1
c2 ≤ 1.5x
2
x+y ≤ 1

The graph should look like in Figure 1.

d) Suppose agents’ relative risk aversion is lower than 1 (for any level of c). Is
consumption at time 1 in the market solution higher or lower than in the efficient
solution? [You need to give a mathematical proof for your answer, without
making further assumptions on the utility function — e.g., do not assume a
CRRA utility function.]
Answer: In the efficient solution, u0 (c1 ) = 1.5u0 (c2 ). In the market solution
c1 = 1 and c2 = 1.5. If we want the efficient solution to coincide with the
market solution we need u0 (1) = 1.5u0 (1.5). Now, relative risk aversion lower
00
than 1 means that − uu0(c)c 0 00
(c) < 1. That is, u (c) + u (c)c > 0. This expression is
the derivative of cu (c). Since it is positive, it implies that cu0 (c) is increasing,
0

and so, in particular, u0 (1) < 1.5u0 (1.5). In conclusion, in the efficient solution,
consumption at time 1 is lower.

Question B.3
a) State the agent’s problem and the first order condition (FOC), assuming
the problem has an interior solution [you only have to write the FOC, not solve
it];

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 Answer: The agent solves the following problem:

   
y
max (0.1) 0.06 ln(y + PH (1 − y)) + 0.94 ln( + (1 − y) 1.2)
y PH
   
y
+ (0.9) 0.04 ln(y + PL (1 − y)) + 0.96 ln( + (1 − y) 1.2)
PL

Assuming an interior solution, the F.O.C. of the problem is

−1
0.96(PL−1 − 1)
   
0.06(1 − PH ) 0.94(PH − 1) 0.04(1 − PL )
0.1 + −1 +0.9 + =0
y + PH (1 − y) yPH + (1 − y) y + PL (1 − y) yPL−1 + (1 − y)

b) Suppose in equilibrium both prices are cash-in-the-market: what is their

expression? and if they are not both cash-in-the-market? [you only need to
write the expressions, not derive the exact prices.]
Answer: Cash in the market prices are given by the following expression

y(1 − λs )
Ps = for s = L, H
(1 − y)λs
If an equilibrium with both prices cash-in-the-market does not exist, then
PL = R = 1.2 and PH is given by the cash-in=the-market price.
If both prices are cash-in-the-market the index of price volatility is

PH (1 − λH )λL
= .
PL λH (1 − λL )
If one price only is c-i-t-m, then

PH y(1 − λH )
= .
PL 1.2(1 − y)λH
c) Explain why cash-in-the-market prices do not reflect the asset fundamen-
tal value and in which sense low liquidity determines high volatility.
Answer: The price in this case reflects the low liquidity in the market. The
price is lower than the fundamental value because many agents want to sell the
asset and there is not enough liquidity.
d) Suppose that the agents are risk neutral. State the agent’s problem.
Explain how to determine the optimal portfolio in equilibrium. [You do not
need to compute the portfolio, just explain the condition to derive it.]
Answer: The agent solves the following problem:

   
y
max (0.1) 0.06(y + PH (1 − y)) + 0.94( + (1 − y) 1.2)
y PH
   
y
+ (0.9) 0.04(y + PL (1 − y)) + 0.96( + (1 − y) 1.2) .
PL

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To determine the portfolio, one has to make sure the agent is indifferent between
the two assets. This is obtained when the derivative of the previous expression
is zero. This can occur for both prices c-i-t-m or for PL = 1.2. One needs to
check which solution is correct (not required for the exam).
e) If agents are risk neutral, do you expect higher or lower volatility compared
to the case of a logarithmic utility function: u(c) = ln c? [You do not need to
compute the price volatility, but give a clear explanation.]
Answer: We expect a lower investment in the short asset and a higher
volatility.