Please read the instructions below before you start the exam.
April/May 2020 EC349 2019/20 A 800
EC349 2018/19 A 800
Only Casio FX-83GTPLUS or FX-85TGPLUS or FX-83GTx or FX-
85GTx calculators are permitted
UNIVERSITY OF READING
FINANCIAL ECONOMICS (EC349)
Three hours
Section A: Answer BOTH Q1 and Q2 and Answer EITHER Q3 OR Q4
(50 marks); and
Section B: Answer BOTH Q5 and Q6 and Answer EITHER Q7 OR Q8
(50 marks)
This examination requires the use of a combination of discursive material,
diagrams, and/or mathematical expressions.
You must type your solutions in Word adding hand-written diagrams or
equations by photographing and embedding such material in your
document. Diagrams may be placed at the end of the document, but must
be properly labelled and clearly referenced in the text. Word documents
can then be saved in pdf format for submission if preferred.
Only one document may be submitted. This can be in Word or pdf format.
You are advised that your final script should not exceed 3000 words in
length. It is expected to be shorter than this allowing for other types of
material (diagrams, equations). In writing your answers, bear in mind you
can provide a good answer by being succinct and using fewer words. Long
answers are unlikely to be good answers in this context.
You should take no longer than three (3) hours to complete this exam.
You must complete only the number of questions required. Additional
answers must be removed or crossed out. Only those presented first will be
marked
Section A (answer both Q1 and Q2; answer either Q3 or Q4) 50 marks
Q1. An investor’s utility function is ( ) = . > .
a) Find the investor’s Arrow-Pratt coefficient of Absolute Risk Aversion (ARA) (3 marks)
b) Find the investor’s Arrow-Pratt coefficient of Relative Risk Aversion (RRA) (3 marks)
c) What happens to investor’s degree of ARA and RRA as investor’s wealth increases (4 marks)
Q2. In 2018 the rate of return on short-term government securities (per-ceived to be risk-free) was about
5%. Suppose the expected rate of return required by the market for a portfolio with a beta measure of 1 is
12%. According to the capital asset pricing model (security market line):
a) What is the expected rate of return on the market portfolio (3 marks)
b) What would be the expected rate of return on a stock with β= 0 (3 marks)
c) The CAPM predicts that investors demand higher expected rates of return from stocks that have a
high (positive) sensitivity to fluctuations in the stock market. (True or false) (2 marks)
d) Diversiflcation means that the equally weighted portfolio is optimal. (True or false). (2 marks)
Q3 A consumer earns income of ￡80,000 at the present and none in the future ( $ = ￡80,000, % = 0).
Market interest rate on b
orrowing and lending is 10%. Consumer utility function is represented by
( $, %) = $
&.'( %
&.(&. Where $ is the pound amount of present consumption and % is the pound amount
of future consumption.
a) Determine the values of the utility maximizing present and future consumption levels. (20 marks)
b) What is the optimal saving (5 marks)
c) Show that )!)” = ( ( ))
(5 marks)
Q4 Your money utility function defined over wealth ( ) = &.( > 0
a) Show that you always prefer more wealth to less (5 marks)
b) Prove that you are always risk averse (5 marks)
c) Suppose your current wealth is ￡100. Find your expected utility for your current wealth.
(5 marks)
d) Suppose you face a gamble with 50-50 chance of winning or losing ￡50. What is the expected
utility with gamble (5 marks)
Section B (answer both Q5 and Q6; answer either Q7 or Q8) 50 marks
Q5 Are the following statements true or false Briefly discuss the validity or otherwise of each.
a) Financial liberalization is the process of creating new financial products, services, or processes.
(2 marks)
b) Stocks are the most important source of external financing for businesses. (2 marks)
c) Financial intermediaries are the most important source of external funds used to finance businesses.
(2 marks)
d) Collateral is a prevalent feature of debt contracts for both households and businesses.
(2 marks)
e) Financial innovation is the elimination of restrictions on financial markets and institutions.
(2 marks)
Q6 Explain the following terms:
a) Financial crisis (2 marks)
b) Adverse selection (2 marks)
c) Moral hazard (2 marks)
d) Bank panic (2 marks)
e) Debt deflator (2 marks)
Q7
a) Banks make profits through the process of asset transformation, discuss. (10 marks)
b) Off-balance-sheet activities consist of trading financial instruments and generating income from
fees and loan sales, all of which affect bank profits but are not visible on bank balance sheets.
Why (10 marks)
c) Why is the financial crisis that started in 1929 until 1930s was considered “The Mother of All
financial Crises” and termed “The Great Depression” (10 marks)
Q8
a) The presence of asymmetric information in financial markets leads to adverse selection and moral
hazard problems that interfere with the efficient functioning of those markets. Explain tools that can
be used to solve these problems. (10 marks)
b) The global investment in FinTech firms has grown over the past decade, what are the key drivers of
this growth (10 marks)
c) Fintechs are businesses which use technology to transform or enable business and operating models
in the financial services sector. What are the contributions of FinTechs to the global financial system
(10 marks)