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Economic Decision Making II Lecture 20: Review Asset Dynamics

Homework 9 Review. A major lottery advertises that it pays the winner $10 million. However, this prize money is paid at the rate of $500,000 each year (with the first payment being immediate) for a total of 20 payments. What is the present value of this prize at 10% interest?A young couple has mad

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Economic Decision Making II Lecture 20: Review Asset Dynamics

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    1. Economic Decision Making II Lecture 20: Review & Asset Dynamics Review Homework 9 and 10 Represent asset dynamics using a binomial lattice Calculate the value of a stock option using binomial lattices. Homework 10: Download assignment on web; Due Wednesday, April 16th Draft of report due Wednesday, April 16th

    2. Homework 9 Review A major lottery advertises that it pays the winner $10 million. However, this prize money is paid at the rate of $500,000 each year (with the first payment being immediate) for a total of 20 payments. What is the present value of this prize at 10% interest? A young couple has made a nonrefundable deposit of the first month’s rent (equal to $1000) on a 6-month apartment lease. The next day they find a different apartment that they like just as well, but its monthly rent is only $900. They plan to be in the apartment only 6 months. Should they switch to the new apartment? What if they plan to stay 1 year? Assume an interest rate of 12%.

    3. Homework 9 Review You are considering the purchase of a nice home. It is in every way perfect for you and in excellent condition, except for the roof. The roof has only 5 years of life remaining. A new roof would last 20 years, but would cost $20,000. The house is expected to last forever Assuming that the costs will remain constant and that the interest rate is 5%, what value would you assign to the existing roof (i.e. how much is this roof worth compared to replacing it immediately)?

    4. Homework 10 Review You are considering buying a new house that costs $300,000. With probability 0.2 the roof will have to be replaced immediately. With probability 0.5 it will have to be replaced in 10 years. Otherwise it will last 20 years. A new roof costs $20,000 and will last 20 years. An alternate house costs $310,000, but has just had a new roof put in. You have a discount rate of 10% You are indifferent between the houses, so you want the house with the lowest expected cost If you are risk neutral, what is the value of information on the state of the roof? If you have utility ln(w) and current wealth equal to $500,000, what is the value of information on the state of the roof?

    5. Asset Dynamics True multi-period investments fluctuate in value 2 primary models are used to represent asset dynamics binomial lattices Ito processes We will cover binomial lattices Can be used to solve most problems

    6. Binomial Lattice Choose a period length. Assume the asset has price S At the beginning of the period the asset price will either go up u or down d by a specified amount. the probability of moving up is p, down is 1-p

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