5 Edwina, a commodities broker, has acquired an option to buy 1,000 oz of gold a

Question

5 Edwina, a commodities broker, has acquired an option to buy 1,000 oz of gold at $50/oz. If she takes the option and if Congress relaxes import quotas, she can sell the gold for S80/oz. If she takes the option and Congress does not relax the import quotas, however, the company will lose $10/oz. Edwina believes that there is a 50% chance that the government will relax the quota. She also has the option of waiting until Congress decides whether to relax the import quota. If she adopts this strategy, however, there is a 70% chance that some other broker will have already taken the option a If Edwina is risk-neutral, what should she do? b If Edwina's utility function for a change x in her as- set position is given by u(x) = (10,000 + x)12, what should she do?

Explanation / Answer

a) Expected value of taking the option now = 0.5*(-10)+0.5*(30)=10 dollars

Expected value of taking the option later = 0.7*0+0.3*30= 9

She should take the option now

b) Utility in first = 0.5*(10000-10000)^1/2 +0.5 *( 10000+30000)^1/2 = 100

Utiity in second = 0.7*sqrt(10000)+03*(sqrt(40000)) = 70+0.3*200=130

She should wait.

Related Questions

Navigate

• Browse (All)
• Browse 5
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.