University of Geneva - HEC

Advanced Finance
Fall 2014
Problem Set 2

Instructions:

• Please hand in your answers at the beginning of lecture on Thursday, November 20th , 2014. No late
submissions will be accepted.

• Please hand in one solution set for each group.

• Please write legibly, in capital letters, the surnames and first names of each member in the group,
at the upper left corner of the first page of your answer sheet.

• Your answers need to be succinct and to the point; you might get penalized for long-winded answers.
Your handwriting also needs to be clearly legible.

• Please justify all your answers, even in multiple-choice questions. I will give no credit for answers
without an explanation.

• The problem set will be graded out of 100. The number of points that each problem is worth is
written in brackets.

1
1 Prospect Theory [10 points]

Which one of the following is a key idea of Prospect Theory?

a. People frame their decisions in gains and losses rather than simply considering their potential final
wealth.

b. People do not know probabilities exactly, and hence overestimate small probabilities. This can be
modeled by a probability weighting function.

c. People like to avoid losses.

d. All of the above.

e. None of the above.

2 Utility Theories [10 points]

Consider an investor who faces a choice between lottery A that offers him a certain payoff of 100 and
lottery B that pays 95 with probability 1 − p and 100 + 5 1−p
p with probability p. If the investor chooses

lottery A when p is close to 0.5 and lottery B when p is close to 0, then the investor’s behavior could be
explained by

a. Expected Utility Theory with a concave utility function.

b. Mean-Variance Theory.

c. Prospect Theory.

3 Utility Theories [10 points]

Which of the following statements is correct?

a. Expected Utility Theory and Mean-Variance Theory coincide when all asset payoffs have two possible
outcomes.

b. Mean-Variance theory describes “rational” decisions.

c. Prospect Theory explains why the same person might buy insurance and gamble, by proposing that
people have a value function that is concave in gains and convex in losses.

d. All of the above.

e. None of the above.

2
4 Calibration Theorem [20 points]

Consider the following table:

g
L $101 $105 $110

$400 $400 $420 $550

$4, 000 $5, 750 $635, 670 $60, 528, 930
$8, 000 $19, 290 $3, 058, 540 $510, 000, 000

With the help of this table, explain Rabin’s calibration theorem. What is the intuition behind the theorem,
and what is its message?

5 Market Completeness [20 points]

Consider the market with basis assets whose payoff matrix is

 
1 1 2
 
A = 2 5 2 ,
 
 
3 4 37

where the i-th column of matrix A contains the payoffs of the i-th asset. Is the market complete?

6 Market Completeness [10 points]

When there are more assets than states of the world, then:

a. Some securities are redundant.

b. Markets are complete.

c. Markets are incomplete.

d. None of the above.

3
7 Hedging Portfolio [20 points]

1. Consider the market with basis assets whose payoff matrix is

 
2 −1 0
 
A = −1 2 −1 .
 
 
0 −1 2

 
0
 
Find the hedging portfolio of an asset with payoff b = 1 .
 
 
4

2. Consider the market with basis assets whose payoff matrix is

 
1 3
 
A = 0 2 .
 
 
1 1

 
5
 
Find the hedging portfolio of an asset with payoff b = 4 .
 
 
1