Finance 2: Investors and Markets The plan for Monday May 25, 2009 Remarks Remains of Sharpe’s Ch. 7: Kinked utility and options, finance screw-ups, infering preferences.

On Wednesday June 3 Exam from 8.15 to in Aud. 5. I’ll try to book a class-room (i.e. a room w/ tables). Leture(s) ’till 12. I’ll start on multi-period investment models. (I’ll post literature ”shortly”.) The plan said ”options”, but you’ve really done that in the exercises on Wed. May 27. (And anything else I think of: Hand-In #2)

On Case 16 We found that the wrong probabiilty M’s had higher expected utilities at equilibriumVery strange indeed. The way that orders are executed may be why: If supply does not match demand, the traded quantity (= min. (sum demand, sum suppy) ) is split between the ”excess side” proportionally to order size. So if you happen to be too bullish because of bad probability estimates, it may bring you closer to the true optimum.

Suppose 1unit is offered for sale, and the the ”truely optimal” demand for each of two sellers is 1 unit. If you put in an order of 1, you get ½, but if you order 3, you get 0.75 units. It is – though – just a conjecture I have not investigated further.Think Hand-In #2.

Case 21-23: Kinked preferences Morale of the story: Hockey-stick marginal utilities go well hockey-stick pay-off functions. Many states (24 futures), few assets (bond and stock only for startes).To find out what Karyn really, really wants, we let APSIM do a market completion. (Takes a while.)

With options (out-of-the-money put and ditto call in Case 22) she can achieve much the same profile. (Takes even longer to run.) Exercise: Now what are the welfare gains?

Finance Crashes and Screw-ups The remarks are profectic in hindsigt. Companies sell protection for states that bad but not really bad, and ”pick up pennies in front of a steam train”.’ Names: Peso problem, LTCM collapse, financial crisis