Consider Richard has the following value function under prospect theory v(w) w when w 0 2( w) when w 0 Richard is deciding whether to buy a state lottery ticket Each ticket costs $1, and the probability of the following winning payoffs is given as follows Probability 0 50 0 25 0 20 0 05 Return $0 00 $1 00 $2 00 $7 50 7 1 Is this individual loss averse Explain What is the difference between loss aversion and risk aversion (4 points) 7 2 Would Richard buy the ticket (6 points) 8 Question worth 10 points An investor is confronted with the following investment possibilities today 1 year 2 years Bond rises 1 04 1 02 rises falls rises falls 0 98 Bond rises 1 04 1 02 rises falls rises falls 0 98 falls 0 96 rises 1 21 1 1 rises Shares falls rises 1 03 falls 0 94 falls 0 88 the probabilities for rises and falls are identical ( 0 5) Mike is a Prospect Theory investor with a value function as proposed by Kahneman and Tversky and his reference point is his initial wealth (The interest rate factor is assumed to be 1 1 1) His utility function is u(x) A B( x) if x0 if x 0 where 0 88 Please use the interest rate factors provided above for the calculation of the x (e g 1 1 02 1 04) Which investment (bonds or shares) would Mike prefer if he had a one year investment horizon Which investment would he prefer if he had a two year horizon Assume 2 Explain the results (10 points)

Question: Consider Richard has the following value function under prospect theory: v(w) w when w>0 =-2(-w) when w <0 Richard is deciding whether to buy

Consider Richard has the following value function under prospect theory: v(w) w when w>0 =-2(-w) when w

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71 To determine if Richard is lossaverse we need to compare how he values gains and losses According to the prospect theory value function provided Ri... View full answer

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