Financial Economics - Uncertainty
1. Jen has a concave utility function of U(w)= √ w . Her only major asset is shares in an Internet
start-up company. Tomorrow she will learn her stock’s value. She believes that It is worth $144
with probability of 2/3 and $225 with probability 1/3. Calculate risk premium.
2. Irma has concave utility function U(w) = ln(w). Calculate the arrow-Pratt measure of risk
aversion and find the relation between risk aversion and wealth.
3. Jen’s utility function is U (W)=W0.5, while Ryan’s is U (W) = W0.25.Use the Arrow Pratt measure
to show that Ryan is more risk averse. Next, suppose that each own a home worth 100 (for
simplicity) and is considering painting it orange. If each does so, each house is worth 81 with
50% probability and is worth 121 with 50% probability. Will either person take the gamble?
4. Diversification can eliminate risk if two events are perfectly negatively correlated. Suppose that
two firms are competing for a government contract and have an equal chance of winning.
Because only one firm can win, the other must lose, so the two events are perfectly negatively
correlated. You can buy a share of stock in either firm for $20. The stock of the firm that wins the
contract will worth $40, while the stock of the loser will worth $10.
If you buy two shares of one firm, calculate the expected value and variance of two
shares.
If you buy one share on each firm, calculate the expected value and variance of two
shares.
5. Suppose that two stocks’ value are uncorrelated: whether one firm wins a contract is independent
of whether the other firm gets one. Each of the two firms has a 50% chance of receiving a
government contract. The chance that each firm’s share is worth $40 is ¼, the chance that one is
worth 40 and the other is worth 10 is ½, and the chance that each us worth 10 is ¼. If you buy one
share of each firm, calculate the expected value and the variance of these two shares.
6. Scott is a risk averse person. He wants to insure his home, which is worth 500. The probability
that home will burn next year is 20%. If the fire occurs, the home will worth nothing.
With no insurance calculate the expected value of his home and the risk
Definition of a fair contract is a contract between an insurer and policyholder in which the
expected value of the contract to the policy holder is zero. With fair insurance, for every $1 that
Scott pays the insurance company will pay Scott $5 to cover the damage if the fire occurs.
He wants to fully insure by buying enough insurance to eliminate his risk altogether. That is, he
wants to buy the amount of fair insurance that will leave him equally well-off in both state of
nature.
Calculate the amount of premium.
Show the difference between expected value of home and risk with and without
insurance.
Based on above definition the expected value of a fair contract for policy holder is zero.
Show that expected value of Scott’s insurance is zero.
7. The local government collects a property tax of 20 on Scott’s home. If the tax is collected
whether or not the home burns, how much fair insurance does Scott buy? If the tax is collected
only if the home does not burn, how much fair insurance does Scott buy?
Calculate the expected value of house with and without insurance
8. Investing and attitude towards risk
Chris is a risk neutral person. If Chris does not open a new store, he makes 0. If he opens a new
store, he expect to 200 with 80% probability and to loose 100 with 20% probability. How much is
the expected value? (Develop decision tree)
Ken is a risk averse person. RISK AVERSE INVEST IN A NEW STORE IF HIS EXPECTED
UTILITY FROM INVESTMENT IS GREATER THAN CERTAIN UTILITY FROM NOT
INVESTING. Using a decision tree, compare the decision of Chris and Ken.
U(0)=35
U(200)=40 ….Probability of 80%
U(-100)-0…….Probability of 20%
9. Investing with uncertainty and discounting
Now suppose that the uncertain returns or costs from an investment are spread out over time.
An investment pays if its net present value is positive.
Net present value is calculated by discounting the difference between the return and the cost in
each future period is positive.
Sam is risk neutral. Draw the decision tree. If C=$25 this year. Next year, he receives uncertain
revenues from the investment of $125 with 80% probability or $50 with 20% probability.
Calculate the expected value of revenue next year
With real interest rate of 10%, the calculate expected net present value.
10. We have been assuming that nature dictates the probabilities of various possible events. However,
sometimes we can alter the probabilities at some expense. Gaut, who is risk neutral, is
considering whether to invest in a new store. After investing, he can increase the probability that
demand will be high at new store by advertising at a cost of $50. If he makes the investment but
does not advertise, he has a 40% probability of making 100 and 60% probability of loosing 100.
If he advertises, he has a 80% probability of making 100 and 20% probability of losing 100.
Should he invest in new store?
