PS 2 Fall2022

PROBLEM SET 2
Expected Utility
Question 1
Suppose an investor is endowed with a log-utility function over wealth. That

is, u(w) = ln(w).
(a) Show that u′ > 0 and u′′ < 0.
(b) Consider the following gamble: a 50% chance of winning $100 and 50%
chance of winning $200. What is the certainty equivalent of this gamble?
(c) Suppose instead that u(w) = 5 + 10w. What is the certainty equiva-
lent of the gamble in this case? If your answer is dierent than your answer
to part (b), explain why this is so.
Question 2
Suppose a consumer has log-utility over wealth, dened by u(W ) = ln(W ).

Suppose this consumer has $100, and is considering taking a gamble in which
the consumer ips a coin, and gets $20 she ips heads and $0 if she ips tails.
What is the most amount of money the consumer would be willing to pay to
play take this gamble? What if the consumer has $1, 000 dollars of wealth?
Question 3
Suppose a farmer is considering insuring his corn crop from rain damage. The
farmer believes there is a 10% chance it will rain. If it rains, his crop is only
worth $10, 000, if it does not rain his crop is worth $50, 000. The farmer can
choose to purchase $x worth of insurance, so that if the crop is ruined by rain,
the insurance company pays the farmer $x. The cost of insurance is equal to
1
$0.10 per dollar of insurance the farmer purchases, this is known as the pre-
mium .
Suppose the farmer has constant relative risk aversion (CRRA) utility, given
W −2
by u(W ) = .
−2
(a) Show that u′ > 0 and u′′ < 0
(b) How much insurance should the farmer purchase?
Question 4
Suppose Allison sells snowcones on the sidewalk. If it is a rainy day, she will
only make $10 selling snowcones, if it is sunny, she will make $30. Also sup-
pose the local casino will sell fair gambles on whether or not it rains. For ev-
ery dollar Allison bets that it will rain, she will get paid $2 if it rains, and $0
√
otherwise. Suppose Allison has utility over wealth given by u(W ) = W .
2
How much should Allison bet on rain if the probability that it rains is ?
3
Question 5
Show that the optimal allocation to a single risky asset P (given a riskfree
rate rf ) is: increasing in RP , and decreasing in rf , A and σP2 . A is risk aver-
sion.
Question 6
(a) Suppose there are three assets, X,Y, and Z. The covariances of their re-
turns are σx,y , σy,z , σx,z and their variances are σx2 , σy2 , σz2 . Show that if you in-
vest ωx in asset X, ωy in Y, and ωZ in asset Z that the variance of the port-
folio return is ω ′ Σω . That is, write out all of the terms of the variance, and
show that ω ′ Σω is identical.
2
(b) Now suppose we have the same three assets X,Y,Z. If we add a risk-free
asset F with return rf , show that the expected portfolio return can be writ-
ten as: rf + ω ′ (R̄ − rf ι), where R̄ is the vector of expected returns for X,Y,Z
and ω is the vector of weights in X,Y,Z, and that this is equivalent to writing
the expected return as rf + ωp (E[rp ] − rf ).
Question 8
Suppose that there are many stocks in the security market and that the char-
acteristics of stocks A and B are as follows: the expected return on A is 10%
and it has a standard deviation of 5%, while the expected return on B is 15%
and it has a standard deviation of 10%. The return correlation between stocks
A and B is −1. Suppose that it is possible to borrow at the risk-free rate;
what must be the value of the risk free rate?
Question 9
Suppose that you have $1 million and the following two opportunities from
which to construct a portfolio: a risk-free asset earning 12% per year, and a
risky asset with expected return of 30% per year with a standard deviation of
40%. If you construct a portfolio with a 30% standard deviation, what is its
expected rate of return?
Question 10
A pension fund manager is considering three mutual funds. The rst is a stock
fund, the second is a long-term government and corporate bond fund, and the
third is a risk-free T-bill money market fund that yields a rate of %8. The
correlation between the stock and bond funds is 0.10. The probability distri-
butions of the risky funds is as follows:
(A) What are the investment proportions in the minimum-variance portfolio,
and what is it's standard deviation and expected rate of return?
3
Table 1: Question 10
Expected Return Standard Deviation
Stock Fund (S) 20% 30%
Bond Fund (B) 12% 15%
(B) Draw the investment opportunity set of the two risky funds. Use invest-
ment proportions for the stock fund from 0 to 100% in increments of 5%.
(C) What is the expected return and standard deviation of the optimal risky
portfolio?
(D) What is the Sharpe ratio of the best feasible CAL?
(E) You require that your portfolio yield an expected return of 14%. What is
the standard deviation of your portfolio? What are the proportions invested
in the T-bill, stock, and bond funds?
(F) If you were to use only the two risky funds, and still require an expected
return of 14%, what would the investment proportions in your portfolio be?
Compare this standard deviation to what you found in part (E).

PS 2 Fall2022

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PS 2 Fall2022

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PROBLEM SET 2

Suppose an investor is endowed with a log-utility function over wealth. That

Suppose a consumer has log-utility over wealth, dened by u(W ) = ln(W ).

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PS 2 Fall2022

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Copyright:

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PS 2 Fall2022

Uploaded by

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Original Description:

Original Title

Copyright

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PS 2 Fall2022

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PROBLEM SET 2

Suppose an investor is endowed with a log-utility function over wealth. That

Suppose a consumer has log-utility over wealth, dened by u(W ) = ln(W ).

You might also like

Suppose a consumer has log-utility over wealth, dened by u(W ) = ln(W ).