04 Jun Question Following problems will not be considered for grading (good practice workouts):
Question
Following problems will not be considered for grading (good practice workouts):
Text (B&B 5th edition)
Problem #
15.14
15.15
15.16
Solutions
15.14. You have a utility function given by U= 10 lnI where Irepresents the monetary payoff from an investment. You are considering making an investment which, if it pays off, will give you a payoff of $100,000, but if it fails, it will give you a payoff of $20,000. Each outcome is equally likely. What is the risk premium for this lottery?
15.15. In the upcoming year, the income from your current job will be $90,000. There is a 0.8 chance that you will keep your job and earn this income. However, there is 0.2 chance that you will be laid off, putting you out of work for a time and forcing you to accept a lower paying job. In this case, your income is $10,000. The expected value of your income is thus $74,000.
a) If your utility function has the formula 100I – 0.0001I2, determine the risk premium associated with this lottery.
b) Provide an interpretation of the risk premium in this particular example.
15.16. Consider a household that possesses $100,000 worth of valuables (computers, stereo equipment, jewelry, and so forth). This household faces a 0.10 probability of a burglary. If a burglary were to occur, the household would have to spend $20,000 to replace the stolen items. Suppose it can buy an insurance policy for $500 that would fully reimburse it for the amount of the loss.
a) Should the household buy this insurance policy?
b) Should it buy the insurance policy if it cost $1,500? $3,000?
c) What is the most the household would be willing to pay for this insurance policy? How does your answer relate to the concept of risk premium discussed in the text?
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