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    HW6 (1)

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    HW6 (1)

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    7 views2 pages

    HW6 (1)

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    Assignment 6

    Jihwan Do

    *Submit your answers on LearnUs platform by November 7, 14:00.


    Any delay in submission will not be accepted.

    Q1. Consider a decision maker who needs to decide an amount of money


    x ∈ {0, 10, 20} to invest in a risky project. If the project is successful, his
    money will be doubled, yielding 2x of final wealth. If the project fails, the final
    wealth becomes −x. The project is successful with probability λ ∈ (0, 1) . Note
    that if he doesn’t invest (x = 0), his final wealth remains constant at zero.
    (1) Describe the set of possible outcomes C and lotteries available to the
    decision maker.

    (2) Suppose that the decision maker has the expected utility with Bernoulli
    numbers u(x̄) = x̄, where x̄ ∈ C is his final wealth. Derive an optimal
    choice of x for each λ.

    (3) Suppose now that u(x̄) = (100 − x̄)x̄. Derive an optimal choice of x for
    each λ.

    Q2. A decision maker has wealth w > 0 and needs to decide an amount of
    money x > 0 to invest in a risky project. If the project is successful, his money
    will be doubled, yielding w + 2x of final wealth. If the project fails, the final
    wealth becomes w − x. The project is successful with probability λ ∈ (0, 1) .
    The decision maker has an expected utility function with the Bernoulli utility
    function u(·), which is strictly increasing and strictly concave in x.

    (1) Compute the expected value of the final wealth level when he invested
    x > 0 in a risky project.

    (2) Determine whether the decision maker is risk averse.

    (3) Write down the decision maker’s problem and provide the conditions for
    the optimal choice of x (assuming interior solution).

    1
    Q3. We consider a variant of Q2. Other things being the same, suppose now
    that the return following the project’s success follows some continuous distribu-
    tion. More precisely, if the project is successful, the decision maker who invested
    x will obtain αx, where α follows the uniform distribution on [1, 3].
    (1) Derive the (cumulative) distribution function F (α) and its density f (α)
    (be careful about the range of α).

    (2) Write down the decision maker’s problem.

    (3) Let u(x) = (100 − x)x and w = 0. Derive the optimal x∗ for the decision
    maker.

    Q4. Consider a Bernoulli utility function u(x) on money x ≥ 0.


    (1) Provide an example of twice-differentiable and strictly increasing u(·) that
    exhibits strict risk-loving.

    (2) For your u(·), compute the Arrow-Pratt measure of absolute risk aversion.

    (3) Consider a lottery L1 : x becomes 100 or 200 with probability 0.5 each.
    For your u(x), is the certainty equivalence greater or smaller than 150?
    Explain why.

    (4) Consider another lottery L2 : x becomes 100 or 130 or 200 with probability
    0.3, 0.2, and 0.5, respectively. Which of L1 and L2 does the decision maker
    with your u(·) prefer? Explain why.
    √
    (5) Now, suppose u(x) = x and consider the following lottery (gamble): x
    becomes 100 or 400 with probability 0.5 each. Calculate the certainty
    equivalence and risk premium of this lottery.

    Q5. Recall the insurance problem covered in class. Show that if q > π (that
    is, a unit price of the insurance is higher than the probability of loss), then the
    decision maker will not choose full insurance.

    Q6. Check examples 6.C.2 and 6.C.3 on p.188, p.189, and p.192 in M.W.G.

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