Problem 4: Risk

a)Explain what is meant by risk aversion. Be as precise as possible (use examples if necessary).

b)[2 points] Tim has a job offer as a summer intern at Teradata. The internship pays $5,000 over two months. Just as the time limit for accepting the offer is about to end, Tim gets a call for an interview for an internship at Verizon. This internship would pay $10,000 over two months. Tim assesses that there is a 60% chance that he will get this internship. Since it is late in the spring semester, it is certain that another internship offer will not materialize.

Suppose Tim is risk-neutral. Would he decline the Teradata internship and take the chance with the Verizon internship? Why?

Suppose Tim is risk-averse, and his utility function is . Would he decline the Teradata internship and take the chance with the Verizon internship? Why?

c)Suppose instead that the internship at Verizon pays $12,000 but the chance of getting the internship is only 50%. Continue to assume Tim is risk-averse with utility function is .

How does this prospect compare with the offer in (b) - i.e. is this better or worse than getting $10,000 with 60% probability?

d)Compute the EMV and standard deviation of the Verizon lotteries in (b) and (c) above. On the basis of these numbers, explain (in words) the rationale for the choices a risk-averse Tim would make.