University College London

Department of Economics
BSc in Economics 2018/2019
Economics of Financial Markets

Antonio Guarino
Problem Set 1

Answers are due by Thursday, 17th January (12:00pm).

1) Consider a three period economy with a short and long asset. Suppose
there is only one agent in the economy. At time 0, the agent has to decide the
fraction of his endowment to invest in the short asset. If his preferences are
represented by a log utility function, we proved in class that the interior solution
must satisfy the following condition
R
=
(R 1)

where is the probability of being an early consumer and R > 1 is the return
of the long asset at time 2.
Find out if there are conditions (i.e., values of and R) such that there is
a corner solution = 0. If such a condition does not exist, explain why. If it
does exist, give an economic interpretation. Similarly, solve the same problem
for the corner solution = 1.

2) Consider the same economy as in exercise 1. In particular, assume

that = 0:5 and R = 1:2.The agent’s utility function has the following form:
Case a) u(ct ) = log ct
Case b) u(ct ) = ct 1
1
Case c) u(ct ) = 2ct2
1
Case d) u(ct ) = ct2 + 3
For each case, compute the optimal portfolio of short and long assets, and
the value of the expected utility. Give an economic intuition for your results.

3) In a 3-period economy like that we studied in class:

a) agents sometimes choose to be early consumers and sometimes to be late
consumers, depending on their preferences for liquidity;
b) agents choose the probability with which to be early consumers;
c) each agent has a given probability of being an early consumer;

1
 d) some agents know they will be early consumers and some know they will
be late consumers.
For each of these statements, say whether they are true or false and explain.

4) In the same economy as in exercise 1, suppose R < 1. Find the

optimal portfolio at time 0. Suppose there is a market for the long asset at time
1. Find the equilibrium price for the long asset.

5) De…ne the concept of allocative (Pareto) e¢ ciency. Illustrate reasons

a market may not be Pareto e¢ cient.

Read Allen and Gale, Comparing Financial Systems, Chapter 2.