Assume that bonds pay a real return of 2%. Stocks pay 22% half the time and -6% half the
time. Suppose you initially have wealth of $100, and let X be your wealth after 1 year. What fraction of
your wealth should you hold in stock under each of the following assumptions? (You can solve this
question by hand)
a) (5 Points) You want to maximize the average value of X.
b) (5 Points) You want to be certain that X is at least $100 (that is, you don't lose any of your initial
wealth). Subject to that constraint, you maximize the average value of X.
Question-8 Using graphs, explain and show how each of the following events affects a country's net
capital outflows, net exports, and equilibrium real exchange rate. (You can solve this question by hand)
a) (5 Points) A rise in foreign interest rates.
b) (5 Points) An announcement that a tax cut will occur in the future.
Question-9 Suppose it takes $1.05 to buy 1 euro, the U.S. price level is 120, and the European price level
is 125. (You can solve this question by hand)
a) (5 Points) Calculate the real exchange rate for the U.S. against the euro.
b) (5 Points) Suppose the U.S. price level rises to 130. Calculate the real exchange rate again and explain
why it has risen or fallen.
Question-10 (5 Points) Suppose that, at a certain real exchange rate, a country's net exports exceed its
net capital outflows. Is the equilibrium exchange rate higher or lower than this level? Explain both in
words and with a graph. (You can solve this question by hand)
Question-11 (5 Points) Suppose you win the lottery. You have the choice between receiving the 25
annual payments of $1 million with the first payment happening immediately or an immediate (up-front
cash) payment of $17 million. Determine the present value difference between the two options given the
interest rate of 5%. (You can solve this question by hand)
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