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    Additional Exercises - Risk and Risk Aversion

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    exercises on risk and risk aversion. the subject is financial economics. University of johannesburg honours level

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    Additional Exercises - Risk and Risk Aversion

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    shalommothapo
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    exercises on risk and risk aversion. the subject is financial economics. University of johannesburg honours level

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    exercises on risk and risk aversion. the subject is financial economics. University of johannesburg honours level

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    © All Rights Reserved
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    Download as pdf or txt
    240 views2 pages

    Additional Exercises - Risk and Risk Aversion

    Uploaded by

    shalommothapo
    exercises on risk and risk aversion. the subject is financial economics. University of johannesburg honours level

    Copyright:

    © All Rights Reserved
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    Additional Exercises

    Risk and Risk Aversion


    Honours IMF / Advanced Micro
    Compiled by Andrew Duncan
    1. Suppose that you are exposed to a 50/50 probability of gaining or losing R1; 000. An insurance contract
    that removes your risk costs R500. Assume that your utility function is u(W) =
    1
    W
    . At what level
    of wealth will you be indierent between taking the gamble or paying the insurance?
    2. Assume that your utility function is u(W) = lnW and that you are faced with a 50/50 probability of
    winning or losing R100.
    (a) How much will you pay to avoid this risk if your current level of wealth is R1; 000? (Hint: if
    lnc
    L
    = x, then c
    L
    = e
    ln c
    L
    = e
    x
    ; where e is the exponential function)
    (b) Without recalculating the risk premium, comment on how you would expect the amount calculated
    in part (a) to change if your preferences were given by v (W) =
    p
    W. Motivate your answer.
    (c) How much would you pay if your utility is given by u and if your current level of wealth is
    R10; 000?
    (d) Did you expect that the premium you were willing to pay would increase, decrease or stay the
    same in part (b)? Why?
    3. Suppose that an investor has preferences described by the utility function
    u(W) =
    W

    ; (*)
    where W denotes wealth and > 0 is some constant.
    (a) What is the dening property of a strictly risk averse investor (your denition must be expressed
    in terms of lotteries)?
    (b) Discuss in detail the nature of the preferences that are implied by equation (*). Show appropriate
    calculations to support your answer.
    (c) Assume that the investor has initial wealth A = 500. Let = 0:5. Consider the lottery
    L := (A+ 50; A100; 0:6) .
    1. Is L a fair lottery? Why?
    2. Calculate u(Y ).
    3. Calculate the expected utility of L.
    4. What can we conclude from the above calculations if the investor has the option of playing
    L for free?
    5. Showing all calculations, calculate the investors certainty equivalent c
    L
    for L.
    6. Calculate the investors risk premium rp
    L
    for L.
    7. Interpret the values that you calculated for rp
    L
    and c
    L
    .
    (d) Suppose that we change the investors utility function to
    u
    0
    (W) = lnW:
    Assume that A, , and L are unchanged from part (c). Let rp
    0
    L
    denote the risk premium implied
    by u
    0
    . Without calculating rp
    0
    L
    , comment on its size relative to rp
    L
    . Motivate your answer.
    4. (Modied question from Danthine and Donaldson 2005) An agent with utility function
    u(W) =
    p
    W
    is confronted by the lottery
    L = (16; 4; ) .
    1
    (a) Assume that =
    1
    2
    . What is the agents certainty equivalent c
    L
    for L?
    (b) Let =
    1
    2
    . Assume that there is an insurance policy which guarantees that the agent will receive
    E (L). Suppose that the premium on the insurance policy is 2.
    1. Describe the cash-ows that are associated with the insurance policy from the perspective of
    the agent and from the perspective of the insurance company.
    2. Is it optimal for the agent to insure? Motivate your answer.
    (c) Answer part (b.2.) again, this time assuming that the agents utility function is given by
    v (W) =
    1
    W
    :
    (d) Explain the dierence (if any) between your answers to parts (b.2.) and (c).
    (e) Calculate the value for such that rp
    L
    = 0. Assume that the agents preferences are captured
    by utility function u.
    (f) Repeat parts (a) to (e) for the lottery
    L
    0
    = (36; 16; ) .
    Explain what is going on, and why?
    Solutions to Selected Questions
    It is important that you attempt to solve the problems in this worksheet independently. I will provide
    selected answers on Edulink by Tuesday 19 March.
    2

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