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    Problems

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    dandiaconeasa
    This document summarizes four problems related to utility and risk aversion in international investments. The first problem asks about how much an individual with different wealth levels ($5000 and $1,000,000) and utility functions (log and inverse) would pay to avoid a 50% chance of gaining or losing $2000. The second problem asks how much an owner of a store valued at $1,000,000, who faces risks of hurricane damage, would pay for insurance that covers the difference to $1,000,000 if his utility is the log function. The third problem asks whether purchasing both lottery tickets and property insurance represents rational behavior, and if so how it can be explained given the lottery

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    Problems

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    dandiaconeasa
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    This document summarizes four problems related to utility and risk aversion in international investments. The first problem asks about how much an individual with different wealth levels ($5000 and $1,000,000) and utility functions (log and inverse) would pay to avoid a 50% chance of gaining or losing $2000. The second problem asks how much an owner of a store valued at $1,000,000, who faces risks of hurricane damage, would pay for insurance that covers the difference to $1,000,000 if his utility is the log function. The third problem asks whether purchasing both lottery tickets and property insurance represents rational behavior, and if so how it can be explained given the lottery

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    This document summarizes four problems related to utility and risk aversion in international investments. The first problem asks about how much an individual with different wealth levels ($5000 and $1,000,000) and utility functions (log and inverse) would pay to avoid a 50% chance of gaining or losing $2000. The second problem asks how much an owner of a store valued at $1,000,000, who faces risks of hurricane damage, would pay for insurance that covers the difference to $1,000,000 if his utility is the log function. The third problem asks whether purchasing both lottery tickets and property insurance represents rational behavior, and if so how it can be explained given the lottery

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    9 views1 page

    Problems

    Uploaded by

    dandiaconeasa
    This document summarizes four problems related to utility and risk aversion in international investments. The first problem asks about how much an individual with different wealth levels ($5000 and $1,000,000) and utility functions (log and inverse) would pay to avoid a 50% chance of gaining or losing $2000. The second problem asks how much an owner of a store valued at $1,000,000, who faces risks of hurricane damage, would pay for insurance that covers the difference to $1,000,000 if his utility is the log function. The third problem asks whether purchasing both lottery tickets and property insurance represents rational behavior, and if so how it can be explained given the lottery

    Copyright:

    © All Rights Reserved
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    Download as pdf or txt
    of 1

    Seminar 5 International Investments

    Utility and Risk Aversion


    1. Suppose your utility function can be characterized by U(W) = lnW, and you are
    facing a gamble in which you stand either to win or to lose $2000. Each outcome has
    a probability of .5. How much would you be willing to pay to avoid this gamble if
    your initial wealth were $5000? How much would you be willing to pay if your initial
    wealth were $1,000,000? How would your answer dier if your utility function were
    characterized instead by U(W) = 1/W?
    2. A store-owner faces a probability of .02 that a hurricane will reduce the value of his
    store to $1 during the next year. There is also a probability of .03 that a hurricane
    will reduce the stores value to $500,000, and a probability of .95 that no hurricane
    will occur, in which case the store is worth $1,000,000. An insurance company is
    willing to insure the store at its current market value. That is, if a hurricane occurs,
    the insurance company will pay the dierence between $1 million and the stores
    value after the storm. If the store-owners utility function is U(W) = lnW, what is
    the maximum amount he will be willing to pay to buy this insurance?
    3. Many people purchase lottery tickets. This purchase represents an exchange of a
    sure amount of wealth (the cost of the ticket) for an uncertain amount (that is, a
    payo of either zero or the lottery jackpot. Moreover, the expected payo on the
    lottery ticket is less than the cost of the ticket. Many of the same people purchase
    property insurance. This purchase represents an exchange of an uncertain amount of
    wealth (the value of the property uninsured) for a certain amount (the insured value
    of the property). Does this purchase represent rational behavior? If so, how can it
    be explained?
    4. You are interested in buying a store with a value of $1,000,000. You have $1,500,000
    and you decide to place the rest in a bank deposit with an interest rate of 10% per
    year for 6 months. There is a probability of .001 that your store will burn to the
    ground and its value will be reduced to zero. With a power utility (U(W) = 1/W)
    of the wealth 6 months in the future, how much would you be willing to pay for
    insurance (at the beginning)? Assume that if the house does not burn down, its
    end-of-year value still will be $1,000,000.
    Conf. dr. Radu Lupu
    Asist. dr. Sorin Dumitrescu, CFA
    1

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