Finance 361

Workshop 1

1
Expectations and Monte Carlo Analysis

• Definition: Monte Carlo analysis is a mathematical technique that generates

random variables for modelling risk or uncertainty of a certain system

• More practically, it’s a method of simulating outcomes under a set of

parameters, namely, a probability distribution, average and variance

• Developed in the 1940’s by a mathematician working on the Manhattan

project, i.e. nuclear bomb research

• Fundamentally it can be applied to any probabilistic problem and, therefore,

has applications across several disciplines

• Its primary purpose in finance is to account for randomness in forecasting

models

2
Monte Carlo and Finance

• Monte Carlo simulations have several applications in the field of finance

• Option pricing: The value of options are driven by the price of the underlying
equity. Simulate thousands of price paths and take a weighted average
present value

• Portfolio valuation: Simulate factors which influence portfolio valuation and

take the average of all your simulations

• Corporate Finance: Can be used in financial modelling to test for the

uncertainty of NPV

3
Workshop 1 Question 1

• An investment opportunity is available. It requires an initial outlay

(investment) of $1mn at the start of the year. The investment has a horizon
of 1 year. The annual return on this investment is normally distributed with
mean 4% and volatility 10%

• So, spend $1mn now and in one year’s time receive $1mn * (1+r)
where r ~ N(4%,10%2)

• Answer the questions below using Monte Carlo analysis with N=1000
random draws

4
Probability Density Function

5
Cumulative Distribution Function

6
Cumulative Distribution Function

7
Workshop 1 Question 1: Monte Carlo Simulation

• Monte Carlo Analysis for each trial:

1. Generate a uniformly distributed random number between 0 and 1. This

represents a probability corresponding to our cumulative distribution function
−In excel:= RAND()

2. Evaluate the random outcome (return) associated with this probability given
our specified distribution, r ~ N (4%,10%2)
−In excel: =NORM.INV(probability, mean, standard_dev)

3. Calculate the payoff with the simulated return

• Repeat for 1,000 trials and take the mean across all trials

8
Workshop 1 Question 1 (a)

a) What is the expected net payoff at the end of the year?

−In theory, expected payoff = mean return*investment
= 4% * $1mn
= $40,000

• The estimated expected payoff using Monte Carlo simulation is close to the
theoretical expected payoff, but very unlikely to be exactly $40,000

• The more trials used in the analysis, the closer it will be to the theoretical
value

9
Workshop 1 Question 1 (b) and (c)

10
Workshop 1 Question 1 (b) and (c)

11
Workshop 1 Question 1 (d)

12
Workshop 1 Question 1 (d)

13
Workshop 1 Question 1 (d)

14
Workshop 1 Question 1 (d)

15
Workshop 1 Question 1 (e)

16
Workshop 1 Question 1 (f), (g), and (h)

17
Workshop 1 Question 2 (2016 S2 Midterm Q2)
Harry is the best kind of trader – the lucky kind. In fact, he is known for executing three profitable trades each day – and
that is before breakfast. On a recent morning, he executed the following three round-trip (buy and sell) trades. He
started with $100 million of capital and each consecutive trade invested all of the capital as it stood at the time. (Harry’s
prime broker is happy to allow trades in fractional units of securities.)

At 7:15am Harry bought the SPY ETF tracker (hereafter SPY), just to “warm up” his trading terminal. At 7:25am Harry
noted the following line on his top left screen “WEATHER ADVISORY [FLORIDA]: Severe overnight frost likely”. Harry
immediately sold SPY and with the proceeds bought concentrated orange juice futures (hereafter Orange). At 7:35am
Harry glanced at a live feed of CNBC on a monitor hanging from the ceiling. The oil ministers of some big oil producing
countries were meeting around a table. They were smiling. Harry immediately sold the orange futures and bought oil
futures (hereafter Oil). At 7:50am Harry needed to go to the bathroom, so he sold his oil futures just as “BREAKING
NEWS: OPEC OIL PRODUCTION TO BE CUT BY 5%” flashed on the CNBC screen

18
Workshop 1 Question 2 (a)

a) Calculate Harry’s paper profit (as a percentage of initial

capital deployed). Paper profit is calculated under the
assumption that all trades are executed at the mid-price
(which is the average of the bid and ask prices)

19
Workshop 1 Question 2 (a)
Harry is the best kind of trader – the lucky kind. In fact, he is known for executing three profitable trades each day – and
that is before breakfast. On a recent morning, he executed the following three round-trip (buy and sell) trades. He
started with $100 million of capital and each consecutive trade invested all of the capital as it stood at the time. (Harry’s
prime broker is happy to allow trades in fractional units of securities.)

At 7:15am Harry bought the SPY ETF tracker (hereafter SPY), just to “warm up” his trading terminal. At 7:25am Harry
noted the following line on his top left screen “WEATHER ADVISORY [FLORIDA]: Severe overnight frost likely”. Harry
immediately sold SPY and with the proceeds bought concentrated orange juice futures (hereafter Orange). At 7:35am
Harry glanced at a live feed of CNBC on a monitor hanging from the ceiling. The oil ministers of some big oil producing
countries were meeting around a table. They were smiling. Harry immediately sold the orange futures and bought oil
futures (hereafter Oil). At 7:50am Harry needed to go to the bathroom, so he sold his oil futures just as “BREAKING
NEWS: OPEC OIL PRODUCTION TO BE CUT BY 5%” flashed on the CNBC screen

(220.45/217.69)

20
Workshop 1 Question 2 (a)
Harry is the best kind of trader – the lucky kind. In fact, he is known for executing three profitable trades each day – and
that is before breakfast. On a recent morning, he executed the following three round-trip (buy and sell) trades. He
started with $100 million of capital and each consecutive trade invested all of the capital as it stood at the time. (Harry’s
prime broker is happy to allow trades in fractional units of securities.)

At 7:15am Harry bought the SPY ETF tracker (hereafter SPY), just to “warm up” his trading terminal. At 7:25am Harry
noted the following line on his top left screen “WEATHER ADVISORY [FLORIDA]: Severe overnight frost likely”. Harry
immediately sold SPY and with the proceeds bought concentrated orange juice futures (hereafter Orange). At 7:35am
Harry glanced at a live feed of CNBC on a monitor hanging from the ceiling. The oil ministers of some big oil producing
countries were meeting around a table. They were smiling. Harry immediately sold the orange futures and bought oil
futures (hereafter Oil). At 7:50am Harry needed to go to the bathroom, so he sold his oil futures just as “BREAKING
NEWS: OPEC OIL PRODUCTION TO BE CUT BY 5%” flashed on the CNBC screen

(220.45/217.69)*(1968.02/1946.49)

21
Workshop 1 Question 2 (a)
Harry is the best kind of trader – the lucky kind. In fact, he is known for executing three profitable trades each day – and
that is before breakfast. On a recent morning, he executed the following three round-trip (buy and sell) trades. He
started with $100 million of capital and each consecutive trade invested all of the capital as it stood at the time. (Harry’s
prime broker is happy to allow trades in fractional units of securities.)

At 7:15am Harry bought the SPY ETF tracker (hereafter SPY), just to “warm up” his trading terminal. At 7:25am Harry
noted the following line on his top left screen “WEATHER ADVISORY [FLORIDA]: Severe overnight frost likely”. Harry
immediately sold SPY and with the proceeds bought concentrated orange juice futures (hereafter Orange). At 7:35am
Harry glanced at a live feed of CNBC on a monitor hanging from the ceiling. The oil ministers of some big oil producing
countries were meeting around a table. They were smiling. Harry immediately sold the orange futures and bought oil
futures (hereafter Oil). At 7:50am Harry needed to go to the bathroom, so he sold his oil futures just as “BREAKING
NEWS: OPEC OIL PRODUCTION TO BE CUT BY 5%” flashed on the CNBC screen

(220.45/217.69)*(1968.02/1946.49)*(46.74/45.91) - 1 = 4.24%

22
Workshop 1 Question 2 (b)

b) Calculate Harry’s realised profit. (Realised profit is

calculated by assuming buying is executed at the Ask price
and selling is executed at the Bid price)

23
Workshop 1 Question 2 (b)
Harry is the best kind of trader – the lucky kind. In fact, he is known for executing three profitable trades each day – and
that is before breakfast. On a recent morning, he executed the following three round-trip (buy and sell) trades. He
started with $100 million of capital and each consecutive trade invested all of the capital as it stood at the time. (Harry’s
prime broker is happy to allow trades in fractional units of securities.)

At 7:15am Harry bought the SPY ETF tracker (hereafter SPY), just to “warm up” his trading terminal. At 7:25am Harry
noted the following line on his top left screen “WEATHER ADVISORY [FLORIDA]: Severe overnight frost likely”. Harry
immediately sold SPY and with the proceeds bought concentrated orange juice futures (hereafter Orange). At 7:35am
Harry glanced at a live feed of CNBC on a monitor hanging from the ceiling. The oil ministers of some big oil producing
countries were meeting around a table. They were smiling. Harry immediately sold the orange futures and bought oil
futures (hereafter Oil). At 7:50am Harry needed to go to the bathroom, so he sold his oil futures just as “BREAKING
NEWS: OPEC OIL PRODUCTION TO BE CUT BY 5%” flashed on the CNBC screen

(220.34/218.45)

24
Workshop 1 Question 2 (b)
Harry is the best kind of trader – the lucky kind. In fact, he is known for executing three profitable trades each day – and
that is before breakfast. On a recent morning, he executed the following three round-trip (buy and sell) trades. He
started with $100 million of capital and each consecutive trade invested all of the capital as it stood at the time. (Harry’s
prime broker is happy to allow trades in fractional units of securities.)

At 7:15am Harry bought the SPY ETF tracker (hereafter SPY), just to “warm up” his trading terminal. At 7:25am Harry
noted the following line on his top left screen “WEATHER ADVISORY [FLORIDA]: Severe overnight frost likely”. Harry
immediately sold SPY and with the proceeds bought concentrated orange juice futures (hereafter Orange). At 7:35am
Harry glanced at a live feed of CNBC on a monitor hanging from the ceiling. The oil ministers of some big oil producing
countries were meeting around a table. They were smiling. Harry immediately sold the orange futures and bought oil
futures (hereafter Oil). At 7:50am Harry needed to go to the bathroom, so he sold his oil futures just as “BREAKING
NEWS: OPEC OIL PRODUCTION TO BE CUT BY 5%” flashed on the CNBC screen

(220.34/218.45)*(1965.06/1951.37)

25
Workshop 1 Question 2 (b)
Harry is the best kind of trader – the lucky kind. In fact, he is known for executing three profitable trades each day – and
that is before breakfast. On a recent morning, he executed the following three round-trip (buy and sell) trades. He
started with $100 million of capital and each consecutive trade invested all of the capital as it stood at the time. (Harry’s
prime broker is happy to allow trades in fractional units of securities.)

At 7:15am Harry bought the SPY ETF tracker (hereafter SPY), just to “warm up” his trading terminal. At 7:25am Harry
noted the following line on his top left screen “WEATHER ADVISORY [FLORIDA]: Severe overnight frost likely”. Harry
immediately sold SPY and with the proceeds bought concentrated orange juice futures (hereafter Orange). At 7:35am
Harry glanced at a live feed of CNBC on a monitor hanging from the ceiling. The oil ministers of some big oil producing
countries were meeting around a table. They were smiling. Harry immediately sold the orange futures and bought oil
futures (hereafter Oil). At 7:50am Harry needed to go to the bathroom, so he sold his oil futures just as “BREAKING
NEWS: OPEC OIL PRODUCTION TO BE CUT BY 5%” flashed on the CNBC screen

(220.34/218.45)*(1965.06/1951.37)*(46.67/46.00) - 1 = 3.05%

26
Workshop 1 Question 3 (2016 S2 Midterm Q1)

Is it possible to test (in the statistical sense) if a

market is inefficient? If you argue that it is
possible, please explain how you would perform
the test. If you argue that it is not possible, please
explain why it is not.

27
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Consider a binary call option that has a 90% chance of expiring out of the money
(payoff C = $0) and a 10% chance of expiring in the money (payoff C = $1000). Ignore
the time value of money.

Jake is an expected utility maximising speculator with current total wealth of V =

$10,000 and utility over total final wealth given by U(W) = W^0.5.

Would Jake bid $80 for the call option? Show your workings.

28
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Consider a binary call option that has a 90% chance of expiring out of the money
(payoff C = $0) and a 10% chance of expiring in the money (payoff C = $1000). Ignore
the time value of money.

Jake is an expected utility maximising speculator with current total wealth of V =

$10,000 and utility over total final wealth given by U(W) = W^0.5.

Would Jake bid $80 for the call option? Show your workings.

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State

Bad State

29
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Consider a binary call option that has a 90% chance of expiring out of the money
(payoff C = $0) and a 10% chance of expiring in the money (payoff C = $1000). Ignore
the time value of money.

Jake is an expected utility maximising speculator with current total wealth of V =

$10,000 and utility over total final wealth given by U(W) = W^0.5.

Would Jake bid $80 for the call option? Show your workings.

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State $10,000

Bad State $10,000

30
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Consider a binary call option that has a 90% chance of expiring out of the money
(payoff C = $0) and a 10% chance of expiring in the money (payoff C = $1000). Ignore
the time value of money.

Jake is an expected utility maximising speculator with current total wealth of V =

$10,000 and utility over total final wealth given by U(W) = W^0.5.

Would Jake bid $80 for the call option? Show your workings.

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State $10,000 $80

Bad State $10,000 $80

31
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Consider a binary call option that has a 90% chance of expiring out of the money
(payoff C = $0) and a 10% chance of expiring in the money (payoff C = $1000).
Ignore the time value of money.

Jake is an expected utility maximising speculator with current total wealth of V =

$10,000 and utility over total final wealth given by U(W) = W^0.5.

Would Jake bid $80 for the call option? Show your workings.

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State $10,000 $80 0.10

Bad State $10,000 $80 0.90

32
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Consider a binary call option that has a 90% chance of expiring out of the money
(payoff C = $0) and a 10% chance of expiring in the money (payoff C = $1000).
Ignore the time value of money.

Jake is an expected utility maximising speculator with current total wealth of V =

$10,000 and utility over total final wealth given by U(W) = W^0.5.

Would Jake bid $80 for the call option? Show your workings.

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State $10,000 $80 0.10 $1,000

Bad State $10,000 $80 0.90 $0

33
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Consider a binary call option that has a 90% chance of expiring out of the money
(payoff C = $0) and a 10% chance of expiring in the money (payoff C = $1000). Ignore
the time value of money.

Jake is an expected utility maximising speculator with current total wealth of V =

$10,000 and utility over total final wealth given by U(W) = W^0.5.

Would Jake bid $80 for the call option? Show your workings.

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State $10,000 $80 0.10 $1,000 $10,920

Bad State $10,000 $80 0.90 $0 $9,920

Good State Final Wealth: 10000 – 80 + 1000 = 10920

Bad state Final Wealth: 10000 – 80 + 0 = 9920

34
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Consider a binary call option that has a 90% chance of expiring out of the money
(payoff C = $0) and a 10% chance of expiring in the money (payoff C = $1000). Ignore
the time value of money.

Jake is an expected utility maximising speculator with current total wealth of V =

$10,000 and utility over total final wealth given by U(W) = W^0.5.

Would Jake bid $80 for the call option? Show your workings.

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State $10,000 $80 0.10 $1,000 $10,920 104.50

Bad State $10,000 $80 0.90 $0 $9,920 99.60

Good State Utility: 109201/2 = 104.50

Bad state Final Wealth: 99201/2 = 99.60

35
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Would Jake bid $80 for the call option? Show your workings.
• This is a question of whether his utility is higher when invested or not
invested
• I.e. whether E[U(W)] > U[E(W)]

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State $10,000 $80 0.10 $1,000 $10,920 104.50

Bad State $10,000 $80 0.90 $0 $9,920 99.60

36
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Would Jake bid $80 for the call option? Show your workings.
• This is a question of whether his utility is higher when invested or not
invested
• I.e. whether E[U(W)] > U[E(W)]

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State $10,000 $80 0.10 $1,000 $10,920 104.50

Bad State $10,000 $80 0.90 $0 $9,920 99.60

Invest: E[U(W)] = (0.1*104.50) + (0.9*99.60) = 100.09

37
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Would Jake bid $80 for the call option? Show your workings.
• This is a question of whether his utility is higher when invested or not
invested
• I.e. whether E[U(W)] > U[E(W)]

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State $10,000 $80 0.10 $1,000 $10,920 104.50

Bad State $10,000 $80 0.90 $0 $9,920 99.60

Invest: E[U(W)] = (0.1*104.50) + (0.9*99.60) = 100.09

Don’t Invest: U[E(W)] = 100001/2 = 100

38
Workshop 1 Question 4 (2015 S2 Midterm Q3)
Would Jake bid $80 for the call option? Show your workings.
• This is a question of whether his utility is higher when invested or not
invested
• I.e. whether E[U(W)] > U[E(W)]

Current Investment Final

Wealth
Probability Payoff Utility
Cost Wealth

Good State $10,000 $80 0.10 $1,000 $10,920 104.50

Bad State $10,000 $80 0.90 $0 $9,920 99.60

Invest: E[U(W)] = (0.1*104.50) + (0.9*99.60) = 100.09

Don’t Invest: U[E(W)] = 100001/2 = 100

E[U(W)] > U[E(W)], therefore, he should invest!

39
Workshop 1 Question 5 (2016 S1 Final Q1)
Moore Semiconductor Corporation (MSC) and Silicon Valley Silicon (SVS) are two IT firms that
own 50% of the shares of Cross Dot Tech (CDT). Unfortunately, CDT is being sued for patent
infringement. The plaintiff has offered to drop the case if CDT pays it $100mn to settle the
case. Alternatively, CDT can contest the lawsuit in court. The probability of the suit being
dismissed is 80%, while there is a 20% chance that the suit is upheld, in which case CDT will
have to pay damages of $300mn. Once the case is settled between the parties or resolved by
the courts, the Cross Dot patent will be worth $1 billion. Company law requires that MSC and
SVS vote on whether to settle the case. For a vote to settle the case to be binding, it must have
the support of a majority of shareholders (that is more than 50%). Ignore the time value of
money.
a) Calculate the value of CDT in each of the three scenarios. [3 Marks]

40
Workshop 1 Question 5 (2016 S1 Final Q1)
Moore Semiconductor Corporation (MSC) and Silicon Valley Silicon (SVS) are two IT firms that
own 50% of the shares of Cross Dot Tech (CDT). Unfortunately, CDT is being sued for patent
infringement. The plaintiff has offered to drop the case if CDT pays it $100mn to settle the
case. Alternatively, CDT can contest the lawsuit in court. The probability of the suit being
dismissed is 80%, while there is a 20% chance that the suit is upheld, in which case CDT will
have to pay damages of $300mn. Once the case is settled between the parties or resolved by
the courts, the Cross Dot patent will be worth $1 billion. Company law requires that MSC and
SVS vote on whether to settle the case. For a vote to settle the case to be binding, it must have
the support of a majority of shareholders (that is more than 50%). Ignore the time value of
money.
a) Calculate the value of CDT in each of the three scenarios. [3 Marks]

i. Pays the ransom: 900M

41
Workshop 1 Question 5 (2016 S1 Final Q1)
Moore Semiconductor Corporation (MSC) and Silicon Valley Silicon (SVS) are two IT firms that
own 50% of the shares of Cross Dot Tech (CDT). Unfortunately, CDT is being sued for patent
infringement. The plaintiff has offered to drop the case if CDT pays it $100mn to settle the
case. Alternatively, CDT can contest the lawsuit in court. The probability of the suit being
dismissed is 80%, while there is a 20% chance that the suit is upheld, in which case CDT will
have to pay damages of $300mn. Once the case is settled between the parties or resolved by
the courts, the Cross Dot patent will be worth $1 billion. Company law requires that MSC and
SVS vote on whether to settle the case. For a vote to settle the case to be binding, it must have
the support of a majority of shareholders (that is more than 50%). Ignore the time value of
money.
a) Calculate the value of CDT in each of the three scenarios. [3 Marks]

i. Pays the ransom: 900M

ii. Wins the case: 1B

42
Workshop 1 Question 5 (2016 S1 Final Q1)
Moore Semiconductor Corporation (MSC) and Silicon Valley Silicon (SVS) are two IT firms that
own 50% of the shares of Cross Dot Tech (CDT). Unfortunately, CDT is being sued for patent
infringement. The plaintiff has offered to drop the case if CDT pays it $100mn to settle the
case. Alternatively, CDT can contest the lawsuit in court. The probability of the suit being
dismissed is 80%, while there is a 20% chance that the suit is upheld, in which case CDT will
have to pay damages of $300mn. Once the case is settled between the parties or resolved by
the courts, the Cross Dot patent will be worth $1 billion. Company law requires that MSC and
SVS vote on whether to settle the case. For a vote to settle the case to be binding, it must have
the support of a majority of shareholders (that is more than 50%). Ignore the time value of
money.
a) Calculate the value of CDT in each of the three scenarios. [3 Marks]

i. Pays the ransom: 900M

ii. Wins the case: 1B

i. Loses the cases: 700M

43
Workshop 1 Question 5 (2016 S1 Final Q1)
b) Both MSC and SVS are expected utility maximisers. MSC is risk neutral. SVS is risk
averse and has a logarithmic utility function. Use the theory of expected utility
maximisation to explain how MSC and SVS will vote. [6 Marks]

44
Workshop 1 Question 5 (2016 S1 Final Q1)
b) Both MSC and SVS are expected utility maximisers. MSC is risk neutral. SVS is risk
averse and has a logarithmic utility function. Use the theory of expected utility
maximisation to explain how MSC and SVS will vote. [6 Marks]
Wealth Outcomes:
i. Pays the ransom: 900M

ii. Wins the case: 1B

i. Loses the cases: 700M

MSCMSC
Probability Final Wealth Utility
Pay Ransom 1 $450M 450M

Lose Suit 0.2 $350M 350M

Win Suit 0.8 $500M 500M

45
Workshop 1 Question 5 (2016 S1 Final Q1)
b) Both MSC and SVS are expected utility maximisers. MSC is risk neutral. SVS is risk
averse and has a logarithmic utility function. Use the theory of expected utility
maximisation to explain how MSC and SVS will vote. [6 Marks]
Wealth Outcomes:
i. Pays the ransom: 900M

ii. Wins the case: 1B

i. Loses the cases: 700M

MSCMSC
Probability Final Wealth Utility
Pay Ransom 1 $450M 450M

Lose Suit 0.2 $350M 350M

Win Suit 0.8 $500M 500M

Utility from paying ransom: U[E(W)] = 450M

Utility from going to court: E[U(W)] = (0.2*350M) + (0.8*500M) = 470M

46
Workshop 1 Question 5 (2016 S1 Final Q1)
b) Both MSC and SVS are expected utility maximisers. MSC is risk neutral. SVS is risk
averse and has a logarithmic utility function. Use the theory of expected utility
maximisation to explain how MSC and SVS will vote. [6 Marks]
Wealth Outcomes:
i. Pays the ransom: 900M

ii. Wins the case: 1B

i. Loses the cases: 700M

MSCMSC
Probability Final Wealth Utility
Pay Ransom 1 $450M 450M

Lose Suit 0.2 $350M 350M

Win Suit 0.8 $500M 500M

Utility from paying ransom: U[E(W)] = 450M

Utility from going to court: E[U(W)] = (0.2*350M) + (0.8*500M) = 470M

U[E(W)] < E[U(W)], therefore, MSC will litigate

47
Workshop 1 Question 5 (2016 S1 Final Q1)
b) Both MSC and SVS are expected utility maximisers. MSC is risk neutral. SVS is risk
averse and has a logarithmic utility function. Use the theory of expected utility
maximisation to explain how MSC and SVS will vote. [6 Marks]
Wealth Outcomes:
i. Pays the ransom: 900M

ii. Wins the case: 1B

i. Loses the cases: 700M

SVSMSC
Probability Final Wealth Utility
Pay Ransom 1 $450M 6.11

Lose Suit 0.2 $350M 5.86

Win Suit 0.8 $500M 6.21

48
Workshop 1 Question 5 (2016 S1 Final Q1)
b) Both MSC and SVS are expected utility maximisers. MSC is risk neutral. SVS is risk
averse and has a logarithmic utility function. Use the theory of expected utility
maximisation to explain how MSC and SVS will vote. [6 Marks]
Wealth Outcomes:
i. Pays the ransom: 900M

ii. Wins the case: 1B

i. Loses the cases: 700M

SVSMSC
Probability Final Wealth Utility
Pay Ransom 1 $450M 6.11

Lose Suit 0.2 $350M 5.86

Win Suit 0.8 $500M 6.21

Utility from paying ransom: U[E(W)] = 6.11

Utility from going to court: E[U(W)] = (0.2*5.86) + (0.8*6.21) = 6.14

49
Workshop 1 Question 5 (2016 S1 Final Q1)
b) Both MSC and SVS are expected utility maximisers. MSC is risk neutral. SVS is risk
averse and has a logarithmic utility function. Use the theory of expected utility
maximisation to explain how MSC and SVS will vote. [6 Marks]
Wealth Outcomes:
i. Pays the ransom: 900M

ii. Wins the case: 1B

i. Loses the cases: 700M

SVSMSC
Probability Final Wealth Utility
Pay Ransom 1 $450M 6.11

Lose Suit 0.2 $350M 5.86

Win Suit 0.8 $500M 6.21

Utility from paying ransom: U[E(W)] = 6.11

Utility from going to court: E[U(W)] = (0.2*5.86) + (0.8*6.21) = 6.14

U[E(W)] < E[U(W)], therefore, SVS will litigate

50
Workshop 1 Question 5 (2016 S1 Final Q1)
b) Both MSC and SVS are expected utility maximisers. MSC is risk neutral. SVS is risk
averse and has a logarithmic utility function. Use the theory of expected utility
maximisation to explain how MSC and SVS will vote. [6 Marks]

E[U(W1)] If settle E[U(W1)] if litigates Outcome

MSC 450 470 Litigates

SVS 6.11 6.14 Litigates

c) Based on the voting outcomes in b) above, will CDT settle the case or proceed to
court? [1 Mark]

51
Workshop 1 Question 5 (2016 S1 Final Q1)
b) Both MSC and SVS are expected utility maximisers. MSC is risk neutral. SVS is risk
averse and has a logarithmic utility function. Use the theory of expected utility
maximisation to explain how MSC and SVS will vote. [6 Marks]

E[U(W1)] If settle E[U(W1)] if litigates Outcome

MSC 450 470 Litigates

SVS 6.11 6.14 Litigates

c) Based on the voting outcomes in b) above, will CDT settle the case or proceed to
court? [1 Mark]

They’ll proceed to court as 100% of shareholders are voting to do so

52