Question: i) Suppose that Marys utility function is U(W) = W 1 /3 where W is wealth. Is she risk averse? Suppose that Mary has initial

i) Suppose that Marys utility function is U(W) = W 1 /3 where W is wealth. Is she risk averse? Suppose that Mary has initial wealth of $125,000. What is her certainty equivalent for the lottery that offers a 50% probability of raising her wealth by $35,000 and a 50% probability of lowering her wealth by $35,000? What is the risk-premium of that lottery?

ii) Suppose, a businessman has a utility function of u(w) = w, and an initial holding of $10,000. Consider a risky project (buying a mortgage pool). When successful, this project reaps a great outcome (a net gain of $6900 in 20% of cases when a bunch of mortgage loans are repaid with interest) and otherwise results in a net loss (a net loss of $1500 in 80% of cases, when multiple home- owner defaults happen on the mortgaged loans). Show that the businessman would not undertake this project, but would be willing to buy a 1/100th share of the project at a price of $1.

Step by Step Solution

There are 3 Steps involved in it

1 Expert Approved Answer

Step: 1 Unlock blur-text-image

Question Has Been Solved by an Expert!

Get step-by-step solutions from verified subject matter experts

Step: 2 Unlock

Step: 3 Unlock

Students Have Also Explored These Related General Management Questions!

Ann purchases insurance against damage to her phone wires at 45 cent a month, even though the probability that she incurs a repair cost of $60 is only 0.4%. Is such behavior consistent with the...

Ann purchases insurance against damage to her phone wires at 45 cent a month, even though the probability that she incurs a repair cost of $60 is only 0.4%. Is such behaviour consistent with the...

Consider a person with a current wealth W0 = 100 , 000 who faces the prospect of p = . 25 chance of losing 20 , 000 through car theft during the next year. Suppose that his utility function is U ( W...

Consumer A has a utility function of U (w) in dollar. And she has a current wealth of $80,000. Consumer B has a utility function of U(w) = ,1-0.6 (106) w where w is her wealth = (1-10.4) w1-0.4 with...

please show formulas and explanations 3. Consider the following portfolio allocation problem. An investor has initial wealth w0=100. The investor allocates the amount x to a stock portfolio, which...

Exercise 2 (15 points) Let us assume that an indiiidnal has a property initially valued at 500.0006. With a probability lt'lO. he can lose 90% of the initial value. He nds the situation not...

1. 2.8 Marys utility function is U(W) = W0.33, where W is wealth. Is she risk averse? Mary has an initial wealth of $27,000. How much of a risk premium would she require to participate in a gamble...

Suppose you have initial wealth (W 0) of $120, and part of this wealth is invested in an asset that is worth $100. However, there is a 25% probability that this asset will be completely destroyed by...

Felix has a utility function U = W 1 2 U = W 1 2 , where W W is his wealth in millions of dollars and U U is the utility he obtains from that wealth. In the final stage of a game show, the host...

Carol Cagle has a repetitive manufacturing plant producing trailer hitches in Arlington, Texas. The plant has an average inventory turnover of only 12 times per year. She has therefore deter-mined...

Limo Ltd is a small family owned company that has been suffering from the credit crunch and has very limited borrowing power. The company gets it finance mainly from bank overdraft which has been...

Question 5 0 Investors are able to reduce risks by diversifing an ineaternmether would be greater if not for volatile exchange rates associated with the curet formpacter it it the different kinds of...

As the manager of Smith Construction, you need to make a decision on the number of homes to build in a new residential area where you are the only builder. Unfortunately, you must build the homes...