Suppose You Own a Stock Portfolio Composed of Shares in Firms

question 18

Essay

Suppose you own a stock portfolio composed of shares in firms that are part of the financial services industry.You don't work - all you do is plan your consumption now and when you retire, and the only asset you have is your stock portfolio.In this problem, model your decisions in a graph with "consumption now" on the horizontal axis and "consumption at retirement" on the vertical.Throughout, assume that the long run rate of return of investment is r over the period from now to retirement.
a.Graph your initial budget constraint - and indicate where in your graph your endowment point lies as well as what the slope of the budget constraint is.
b.This morning, you woke up to find that the current financial crisis has wiped out some of the firms in your stock portfolio.As a result, your portfolio is only worth half of what it was yesterday.Assuming that the long run rate of return r remains unchanged, what has just happened to your budget constraint?
c.Assuming that consumption now and in the future is always a normal good, will you cut down on your consumption plans now?
d.Now suppose I offer you a deal: I will give you enough cash to raise your current (financial) wealth back to what it was yesterday, but in exchange you agree to give me half of any return in your investments when you retire.You carefully analyze the deal and calculate that, under this deal, you could in fact just afford to consume the same bundle (but not strictly more) as you would without the deal.Will you accept the deal?
e.Does your answer to (d) depend on our assumption that consumption is always a normal good?
f.Can you tell whether, if you accept the deal, you will consume more than you otherwise would have? What does your answer depend on?
g.Can you tell whether, if you accept the deal, you consume more now than you had planned yesterday before the financial crisis wiped out half your wealth? What does your answer depend on?

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Definitions:

Negative Externality

A situation where a third party suffers from a transaction or activity they are not directly involved in, often leading to market failure if not corrected by government intervention.

Compensation

The total amount of the monetary and non-monetary pay provided to an employee by an employer in return for work performed.

Licenses

Official permissions or permits to do, use, or own something.

Pollution

The introduction of harmful substances or products into the environment, causing adverse effects on living organisms and ecosystems.