MSc in Finance coursework (60%) Max word count 2000

Question 1 (50 marks)

SupposethatEmma’sutilityfunctionisgivenby𝑈(𝐼)=√10𝐼,where𝐼representsherannualincome in thousands ofEuros.

• Is Emma risk loving, risk neutral, or riskaverse?Explain. (10 marks)

• SupposeEmmaiscurrentlyearninganincomeof€40,000(𝐼=40).Thisistheonlysourceof She can earn the same amount next year with certainty. She has the chance to take a newjobthatoffersa0.6probabilityofearning€44,000(𝐼=44)anda0.4probabilityofearning

€33,000(𝐼=33).Basedontheexpectedvalueandexpectedutility,shouldshetakethenewjob?

(10marks)

• Giventhenewjobin(b),wouldEmmabewillingtobuyinsurancetoprotectagainstthevariable income associated with the new job? If so, how much would she be willing to pay for that insurance? (10marks)

• Accordingtothearticle“RiskandUncertainty”,byK.FrancisParkandZurShapira¹,thetheoryof expectedutilityfallsshortinaccuratelydepictingpeople’sdecisionmakinginmanycases.Choose one case or situation in which expected utility is not suitable to represent people’s decision making.Explain. (20marks)

Question 2 (50 marks)

Consider the IS-LM model to represent the economy in the short run.

• Suppose households attempt to save more, so that consumer confidence falls. Use the IS-LM diagram to show the effect of the fall in consumer confidence on output and the interestrate.

(15 marks)

• Discuss the effects of the fall in consumer confidence on consumption, investment, and private saving. Will the attempt to save more necessarily lead to moresaving?Explain. (15marks)

• Go to the Bureau of Economic Analysis (US Department of Commerce) websitehttps://www.bea.gov/. Find the data on personal saving rate and the gross domestic product (GDP) from 2000 to2016.

2016. Create a graph (e.g. using Excel) showing the personal saving rate and the year-over-year growthrateofGDPforthatperiod.Comparetheaveragesavingrateforthreetimeperiods: from 2000 to 2007; from 2009 to 2011; and from 2009to2016. (10marks)

1. Discuss how the data in (c) i. is related to the explanation in (b). [Hint: “Paradox of Saving” or “ParadoxofThrift”.] (10marks)

¹ Risk and Uncertainty, The Palgrave Encyclopedia of Strategic Management, 2017. DOI: https://doi.org/10.1057/978-1-349-94848-2_250-1