Seminar 5 International Investments

Utility and Risk Aversion

1. Suppose your utility function can be characterized by U(W) = lnW, and you are
facing a gamble in which you stand either to win or to lose $2000. Each outcome has
a probability of .5. How much would you be willing to pay to avoid this gamble if
your initial wealth were $5000? How much would you be willing to pay if your initial
wealth were $1,000,000? How would your answer dier if your utility function were
characterized instead by U(W) = 1/W?
2. A store-owner faces a probability of .02 that a hurricane will reduce the value of his
store to $1 during the next year. There is also a probability of .03 that a hurricane
will reduce the stores value to $500,000, and a probability of .95 that no hurricane
will occur, in which case the store is worth $1,000,000. An insurance company is
willing to insure the store at its current market value. That is, if a hurricane occurs,
the insurance company will pay the dierence between $1 million and the stores
value after the storm. If the store-owners utility function is U(W) = lnW, what is
the maximum amount he will be willing to pay to buy this insurance?
3. Many people purchase lottery tickets. This purchase represents an exchange of a
sure amount of wealth (the cost of the ticket) for an uncertain amount (that is, a
payo of either zero or the lottery jackpot. Moreover, the expected payo on the
lottery ticket is less than the cost of the ticket. Many of the same people purchase
property insurance. This purchase represents an exchange of an uncertain amount of
wealth (the value of the property uninsured) for a certain amount (the insured value
of the property). Does this purchase represent rational behavior? If so, how can it
be explained?
4. You are interested in buying a store with a value of $1,000,000. You have $1,500,000
and you decide to place the rest in a bank deposit with an interest rate of 10% per
year for 6 months. There is a probability of .001 that your store will burn to the
ground and its value will be reduced to zero. With a power utility (U(W) = 1/W)
of the wealth 6 months in the future, how much would you be willing to pay for
insurance (at the beginning)? Assume that if the house does not burn down, its
end-of-year value still will be $1,000,000.
Conf. dr. Radu Lupu
Asist. dr. Sorin Dumitrescu, CFA
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