1) Explain the shapes of a typical value function and a typical probability weighting function in the cumulative prospect theory.

2) a)Explain how a stop-loss hedging scheme can be implemented for the

writer of an out-of-the-money call option with a strike price of $200. Why does it provide a relatively poor hedge?

b) What is portfolio insurance? Does it work when the market crashes? Explain.

3) Assume that all options are European. Show that a box spread is worth the present value of the difference between the strike prices.