Problem
Assume there are two "states of the world"; in the good state, a risky asset yields a high return; in the bad state, it yields a loss. The safe asset yields a zero return in both. Let c denote consumption in the good state, a in the bad. Draw a figure with consumption in the good state on the vertical axis and consumption in the bad on the horizontal axis. Draw a 45° line. In the figure, let S represent the individual's consumption in the two states if she invests only in the safe asset (consumption in the two states is the same), while R represents her consumption in the two states if she invests only in the risky asset (a higher consumption in the good state, a lower one in the bad). Explain why the line SR shows her consumption possibilities-her consumption in the two states depending on the proportion of her assets that she invests in the safe or risky asset. Now draw an indifference curve showing the bundles of consumption in the two states among which she is indifferent. Mark the point of tangency between, the indifference curve tangent and the consumption possibilities curve with the letter E.
a. If E is halfway between S and R what does this imply for how the individual allocates her portfolio?
b. Now assume a 50 percent tax is imposed, with full loss offset. What happens to point .9 to point TO Draw the new consumption possibilities locus, and describe what happens to E, and to the portfolio allocation.
c. Assume now that losses are not deductible. What happens to point g> Draw the new consumption possibilities locus, and explain what happens to the portfolio allocation.
d. Assume now that there are no taxes, but the safe asset yields a positive return. Show what happens to point S Now assume that there are taxes. What is the new point S? Use the diagram to analyze the impact of taxes on portfolio allocation with and without loss offsets.
The response should include a reference list. Double-space, using Times New Roman 12 pnt font, one-inch margins, and APA style of writing and citations.