Edwina, a commodities broker, has acquired an option tobuy 1,000 oz of gold at $50/oz. If she takes the option and ifCongress relaxes import quotas, she can sell the gold for$80/oz. If she takes the option and Congress does not relaxthe import quotas, however, the company will lose $10/oz. Edwina believes that there is a 50% chance that the governmentwill relax the quota. She also has the option of waiting untilCongress decides whether to relax the import quota. If sheadopts this strategy, however, there is a 70% chance that someother broker will have already taken the option.a If Edwina is risk-neutral, what should she do? b If Edwina’s utility function for a change x in her as-set position is given by u(x) (10,000 x)1/2, what should she do?
Edwina, a commodities broker, has acquired an option to
buy 1,000 oz of gold at $50/oz. If she takes the option and if
Congress relaxes import quotas, she can sell the gold for
$80/oz. If she takes the option and Congress does not relax
the import quotas, however, the company will lose $10/oz.
Edwina believes that there is a 50% chance that the government
will relax the quota. She also has the option of waiting until
Congress decides whether to relax the import quota. If she
adopts this strategy, however, there is a 70% chance that some
other broker will have already taken the option.
a If Edwina is risk-neutral, what should she do?
b If Edwina’s utility function for a change x in her as-
set position is given by u(x) (10,000
x)
1/2, what
should she do?
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