EC907 ECONOMICS OF FINANCIAL MARKETS

EC907  ECONOMICS OF FINANCIAL MARKETS

You are reminded to read the university regulations about plagiarism.  Any material copied must be placed in quotation marks and full references (including page numbers) must be given.  A bibliography must be included at the end of the paper.

(1)   “It is not so much that people hate uncertainty but rather they hate losing”, (Amos Tversky, 1975).

Explain how loss aversion differs from risk aversion and describe how the portfolio investment trading behaviour of loss averse agents can result in discontinuous stock market movements.   

(2)   Market risk premium is one of the most important numbers in Finance.   Unfortunately, estimating and understanding its values has proven difficult ….  Empirical research has failed to document a significant positive relationship between expected returns and the level of market volatility”, (Scott Mayfield,2004).

Discuss the above in light of the mean variance framework of portfolio choice that greater expected return is required to compensate for higher variance of returns which proxies for market volatility.  Use evidence from regime switching models of stock returns to throw light on this. 

(3)   “Synthetic securitization marks the pinnacle of financial engineering that brought the financial system to its knees.”  Discuss how poor financial product design and perverse incentives from Basel II worked to destroy the financial system.