Question 3 (32%)

Jerome has engaged in high-risk trading. Based on book value he has accumulated a loss of 10,000 so far. He knows his account will be closed tomorrow but he reckons he can do one last bet on a market index which would earn him 10,000 with a probability of 50%, offsetting all his losses, but with residual 50% chance he would lose another 10,000 on top of the 10,000 he already accumulated.

1. 1. Write down the two alternative prospects Jerome is facing NO TRADE vs. TRADE and their expected values? (4%)?
2. What would he choose if he was risk averse, what if he was risk seeking? Why? (Ignore the case of risk neutrality). (12%)
3. Based on Prospect Theory, is he more likely to be risk averse or risk seeking? Justify your answer using a diagram. (16%)

Jerome has engaged in high-risk trading. Based on book value he has accumulated a loss of 10,000 so far. He knows his account will be closed tomorrow but he reckons he can do one last bet on a market index which would earn him 10,000 with a probability of 50%, offsetting all his losses, but with residual 50% chance he would lose another 10,000 on top of the 10,000 he already accumulated. a. Write down the two alternative prospects Jerome is facing - NO TRADE vs. TRADE - and their expected values? (4\%)? b. What would he choose if he was risk averse, what if he was risk seeking? Why? (Ignore the case of risk neutrality). (12\%) c. Based on Prospect Theory, is he more likely to be risk averse or risk seeking? Justify your answer using a diagram. (16%) Jerome has engaged in high-risk trading. Based on book value he has accumulated a loss of 10,000 so far. He knows his account will be closed tomorrow but he reckons he can do one last bet on a market index which would earn him 10,000 with a probability of 50%, offsetting all his losses, but with residual 50% chance he would lose another 10,000 on top of the 10,000 he already accumulated. a. Write down the two alternative prospects Jerome is facing - NO TRADE vs. TRADE - and their expected values? (4\%)? b. What would he choose if he was risk averse, what if he was risk seeking? Why? (Ignore the case of risk neutrality). (12\%) c. Based on Prospect Theory, is he more likely to be risk averse or risk seeking? Justify your answer using a diagram. (16%)