Problem Set 1: Uncertainty

1. You are considering betting on Portsmouth to beat Leicester at odds of to . You will receive twice your stake if Portsmouth win. If it is a draw or Leicester win you will lose your stake. a) You have of wealth. Draw your budget constraint.

b) At the moment, the bet only allows to be better off if Portsmouth win. Explain how the gamble could be altered to allow you to be richer if Leicester win. This will mean the budget constraint continues across the whole diagram with the same slope. c) You think the probability of Portsmouth winning is shop is offering fair odds on the original gamble? ( ). Do you think that the betting

( ) d) You maximise the Von Neumann-Morgenstern utility function where is consumption if Portsmouth win and is consumption if they do not win. How much will you bet on Portsmouth?

2. William is getting married and wishes to insure himself against the possibility that his new wife Kate will leave him. If William and Kate stay together then William will keep his fortune of his fortune will be reduced to . The probability that Kate will divorce William is per insured, with . ) where is consumption when divorced if Kate leaves him

. William can buy insurance at a cost of

pounds

( Williams expected utility function is and is his consumption if he stays married.

Write down Williams expected contingent consumption in a world where he has bought units of insurance. is the amount the insurance company pays him if he divorces. He pays a premium of . Write down the equation for the budget line that William faces. (It will depend on ). What is its slope? What is the MRS? For what value of will William perfectly insure?

Use diagrams to discuss Williams insurance decision assuming he is risk averse but abstracting from the precise form of his utility function, both in the perfect insurance case, and in the cases when the value of is higher than the one you found in (d). As a preview to topics to be considered later in the course, think about why William may not be able to buy insurance against divorce.

3) Suppose

) and

). What is [

( )]?

( ). A risky asset gives a normally distributed return with mean 4) My utility is: ( ) and standard deviation , and costs . A safe asset costs and gives a guaranteed return of . Suppose I have 100 to spend on the two assets. How much do I spend on each? 5) Buying a 1 share in a firm selling raincoats gives 1.50 when it rains, and nothing when its sunny. Buying a 1 share in a firm selling parasols gives 5 when its sunny, and nothing otherwise. The probability of sun is 25%. Suppose that you have 200 to spend on the two types of shares (you ( ) . cannot just keep the cash), and that your utility is given by ( ) ) on the parasols, what is the a) If you spend on the raincoat firms shares, and ( expected amount of income you get? What would your utility of getting this income with certainty be? b) If you spend expected utility? on the raincoat firms shares, and ( ) on the parasols, what is your

c) By maximising the expression you found in (b) with respect to , find the optimal number of the raincoat firms shares to purchase.