Reference no: EM133083021

What do the terms "arbitrage" and "the law of a prize" mean? Discuss and explain how the concepts are connected based on Put-Call Parity. Also explain how the formula itself is connected, that is why you can put equals between the two quantities on each side of the equals sign.

In a market, there are the two risk-bearing assets share A and share B as well as the opportunity to risk-freely invest their money in the bank where both the deposit rate and the lending rate are 2.04%. The expected return and standard deviation for share A, share B, the market portfolio and the minimum variance portfolio are presented in the table below, and the correlation between share A and share B is equal to 0.

Expected return A=15,14

Expected return B=8,48

Expected return The market portfolio =11,01

Expected return Minimum variance portfolio=10,38

Standard deviation A=22,85

Standard deviation B=12,88

Standard deviation=10,29

Standard deviation=9,92

a) Sketch portfolio possibility curve and capital market line for the economy. Mark out the two shares, the risk-free asset, the market portfolio, the effective front and the minimum variance portfolio.

b)You do not trust the bank and therefore want to invest in a portfolio that only contains the two shares and are considering weighting your portfolio so that you have a holding of 15% in share A and 85% in share B. Is it a good or a bad idea to fold the portfolio that way? Justify your answer and illustrate it in a diagram.

c)If the standard deviation for share A was instead 12.88, ie the same as the standard deviation for share B. If only CAPM had an effective portfolio, it would have wanted to invest part of its assets in share B as it has the same standard deviation but lower expected return than share A? Justify your answer and illustrate it in a diagram.

4. The city of Greenville is concerned about rising rent for low-income households. Several policies being considered. Suppose there are a large number of construction companies, each with the identical cost function for building low-cost houses TC = 2500 + 400q +q2 where q is the number of low-cost houses a firm builds. Marginal cost = 400+2q. d. Instead, suppose the government pays each firm $50 per low-cost house built. What will be the long run price of low-cost houses and how many will each firm build? How many low-cost houses will be built in total (assume again demand remains the same)? How many firms will serve the market? What will be the cost to the government of this plan?

e. Finally, suppose that instead of subsidizing houses, the government decides to build 50 house units itself. (Other firms are still free to build low-cost houses, but they are not subsidized.) What will be the long run price of low-cost houses? How many low-cost houses will Greenville have? How many firms will serve the market? What will be the cost to the government (assume its total cost function is the same as a firm)?

1. Using the supply-side L,L,K (productivity) and demand-side gdp=c(i,taxes)+I(i,taxes)+G+(x-m) formulas for the US economy, define the meaning of an output gap and why it would lead to "inflationary pressure." If the recently enacted $1.9 Trillion stimulus program does cause inflation to rise above 2% this year, is it a worthwhile sacrifice to achieve higher GDP growth and lowering the unemployment rate to below 5%? Economists call this type of investigation a cost-benefit analysis.

2. Do the costs (higher inflation) exceed the benefits (lower unemployment)? Please try to explain your personal opinion in detail regarding this cost-benefit analysis.

3. If inflation does begin to rise and stay above 2%, how will the higher interest rates the Fed will enact affect you?