IB235 Finance 1 Seminar 2, Autumn Term

_________________________
Solutions Investment under Certainty
Applications

A1.

(a) In the notation of the lecture, Y0 = 80,000 and Y1 = 90,000.

In order to consume £150,000 now, Mrs Spendthrift needs to borrow:

150,000 - 80,000 = 70,000

If she borrows this amount now, then next period she will have to pay back:

70,000 ´ (1 + 0.10) = 77,000

This will leave her with £90,000 - £77,000 = £13,000 to consume next period.

(b) In the notation of the lecture, Y0 = 50,000 and Y1 = 60,000.

As he wishes to consume only £35,000 now, Mr Miserly can lend his surplus income of
£15,000 at the riskless lending rate of 10% per annum. Next period, he will receive:

15,000 ´ (1 + 0.10) = 16,500

This has to be added to his earnings next period of £60,000 to give a total of £76,500.

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IB235 Finance 1 Seminar 2, Autumn Term

A2.
Consumption (£’000s)
next period

C
F B

22 E
G D A Consumption (£’000s)
this period
40 60 75

(a) The slope of the straight line ABC is – (1+R), where R is the rate of riskless lending or
borrowing.

The slope also equals:

EG 0 - 22
= = - 1.1
GD 60 - 40

Hence, R = 0.1 = 10%.

(b) Undertaking the project moves the individual from point E to point B.

His consumption C0 (in £’000s) this period is 40 – I, where I is the initial investment in
the project. His consumption C1 (in £’000’s) next period is 22 + CF1, where CF1 is the
cash flow that the capital project pays out for sure next period.

The equation of the budget line is ABC can be written:

C1
C0 + = 75
1 + 0.1

Substitute C0 = 40 – I and C1 = 22 + CF1:

22 + CF1
(40 - I ) + = 75
1+ 0.1

This can be re-written as:

22 CF1
(40 + ) + (- I + ) = 75
1+ 0.1 1+ 0.1

The NPV (in £’000s) of the project therefore equals:

CF1 22
NPV = - I + = 75 - (40 + ) = 75 - 60 = 15
1+ 0.1 1+ 0.1

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IB235 Finance 1 Seminar 2, Autumn Term

The NPV of the project equals the distance DA = £75,000 - £60,000 = £15,000.

Since this is positive, the individual should invest in the project.

(c) The investor now sits somewhere on the straight line ABC.

The equation of that straight line is:

C1
C0 + = 75
1 + 0.1

where C0, C1 denote the amounts (in £’000s) that the individual consumes now and next
period, respectively.

If C0, C1 are to be equal, then C1 = C0. Substituting in the above equation:

C0
C0 + = 75
1.1
1.1 ´ C 0 + C = 1.1 ´ 75
0
82.5
C0 = = 39.29
2.1

A3.
Consumption (£’000s)
next period

D
90
C
67.5
B
56.25

E A Consumption (£’000s)
O this period
20 30 60 80

(a) The slope of the straight line DA equals – (1+R).

This slope also equals:

DO 0 - 90
= = - 1.125
OA 80 - 0

Hence, R = 0.125 = 12.5%.

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IB235 Finance 1 Seminar 2, Autumn Term

(b) In the absence of lending or borrowing today, investing in the capital project would
leave the individual with £30,000 to consume today. As his income today is £60,000,
the initial investment in the capital project must be £30,000.

(c) The individual consumes £56,250 next period. This consumption is funded entirely by
the cash flow that the capital project pays out next period.

This is because the individual: (i) has no income (e.g. from earnings) next period;
(ii) does not lend any of his initial wealth and therefore earns no interest.

The NPV of the project equals:

56,250
NPV = - 30,000 + = - 30,000 + 50,000 = 20,000
1.125

Note that this equals the distance EA in the diagram.

(d) In fact, the individual wants to consume only £20,000 today, leaving him with a surplus
of £10,000 to lend for one period at the riskless rate of 12.5%. Thus, he consumes
£20,000 today, lends £10,000 for one period and invests £30,000 in the capital project.

Next period, the individual wishes to consume £67,500. This figure will include the
return of the one-period loan with interest:

10,000 ´ (1 + 0.125) = 11,250

The cash flow generated by the capital project next period provides the balance:

67,500 - 11,250 = 56,250

Hence, the NPV of the project equals:

56,250
NPV = - 30,000 + = - 30,000 + 50,000 = 20,000
1.125

This is the same answer as we obtained in part (b).

This is to be expected since we are in a world of certainty and lending and borrowing
are possible at the same risk-free rate. Therefore, the Fisher Separation principle holds.
So two individuals with different inte-rtemporal consumption preferences will agree on
capital investment decisions.

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IB235 Finance 1 Seminar 2, Autumn Term

_________________________
Solutions Risk Aversion and Expected Utility
Theory

T1.

(a) Use the Chain Rule to differentiate U(W) twice:

U ¢(W ) = - e - aW × (-a ) = a × e - aW
U ¢¢(W ) = a × e -aW × (-a ) = - a 2 × e -aW

(b) The graph of U(W) is:

(i) monotonically increasing since U´(W) > 0.

(ii) concave, since U´´(W) < 0.

These in turn imply that the investor is rational (in the sense that he will always prefer
more wealth to less wealth) and risk-averse.

The graph of U(W) looks like:

U(W)

-1

(c) The coefficient of absolute risk aversion ARA equals:

U ¢¢(W) (-a 2 ) × e - aW
ARA = - = - = a
U ¢(W) a×e - aW

Thus, this investor exhibits constant absolute risk aversion. When faced with the
choice of investing in a well-diversified portfolio of risky assets or in the riskless asset,
the investor will choose to invest the same absolute amount of his wealth in the
portfolio of risky assets, regardless of how wealthy he is.

T2.

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IB235 Finance 1 Seminar 2, Autumn Term

(a) Use the Chain Rule to differentiate U(W) twice:

(1 - γ) × W - γ
U ¢(W ) = = W-γ
1- γ
U ¢¢(W ) = - γ × W - γ - 1

(b) The graph of U(W) is:

(i) monotonically increasing since U´(W) > 0.

(ii) concave, since U´´(W) < 0.

These in turn imply that the investor is (i) rational (in the sense that he will always
prefer more wealth to less wealth) and (ii) risk-averse.

The graph of U(W) looks like:

U(W)

0<g<1

W
g>1

(c) The coefficient of relative risk aversion RRA equals:

U ¢¢(W ) (- γ) × W - γ - 1
RRA = - W × = -W × = γ
U ¢(W ) W -γ

Thus, this investor exhibits constant relative risk aversion. When faced with the choice
of investing in a well-diversified portfolio of risky assets or in the riskless asset, the
investor will choose to invest the same relative amount (i.e. proportion) of his wealth in
the portfolio of risky assets, regardless of how wealthy he is.

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IB235 Finance 1 Seminar 2, Autumn Term

Applications

A1. The individual has utility-of-wealth function U(W ) = W and can exchange his current
wealth W0 = £100 for the following simple lottery:

1/4 75
1/2
105
1/4 115

(a) Expected wealth:

1 1 1
E[W ] = ´ 75 + ´ 105 + ´ 115 = 100
4 2 4

(b) Expected utility of wealth:

1 1 1
E[U(W )] = ´ U(75) + ´ U(105) + ´ U(115)
4 2 4
1 1 1
= ´ 75 + ´ 105 + ´ 115
4 2 4
= 9.9695

(c) Certainty equivalent CE satisfies:

U(CE) = E[U(W )]
CE = 9.9695
CE = (9.9695) 2 = 99.39

First and second derivatives of U(W):

U(W ) = W = W1 2
1 1
U ¢(W ) = × W -1 2 , U ¢¢(W ) = - × W -3 2
2 4

1
(- ) × W -3/2
U ¢¢(W ) 1 -1 1
- = - 4 = W =
U ¢(W ) 1 2 2 ×W
× W -1/2
2

(d) Coefficient of absolute risk aversion:

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IB235 Finance 1 Seminar 2, Autumn Term

U¢¢(W ) 1 1
ARA = - = = = 0.005
U¢(W ) W = E[W ] 2 × W W = 100 200

(e) Coefficient of relative risk aversion:

é U¢¢(W ) ù 1 1
RRA = W × ê - ú = W× =
ë U¢(W ) û W =E[W ] 2W W = 100 2

(f) Markowitz risk premium πM is the difference between individual’s expected wealth
E[W] and his certainty equivalent wealth CE:

πM = E[W ] - CE = 100 - 99.39 = 0.61

(g) Variance of payoffs to lottery:

1 1 1
σ2 = × (75 - 100) 2 + × (105 - 100) 2 + × (115 - 100) 2 = 225
4 2 4

The Pratt-Arrow approximation to the risk premium, pPA, is defined as:

1 é U ¢¢(W ) ù 1 1 1
π = × - × σ2 = × ARA × σ 2 = ´ ´ 225 = 0.5625
PA 2 êë U ¢(W ) úû 2 2 200
W = E[W ]

A2. The possible payoffs next period to the gamble are:

1/4 500
1/2
200
1/4 -200

These have to be added to the individual’s initial wealth W0 = 1,000.

The possible values for the individual’s final wealth next period are therefore:

1500
1/4
1/2
1200
1/4
800

His expected wealth next period equals:

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IB235 Finance 1 Seminar 2, Autumn Term

1 1 1
E[W ] = ´ 1,500 + ´ 1,200 + ´ 800 = 1,175
4 2 4

His expected utility of wealth depends on the precise form of his utility function.

(a) Suppose that the investor has utility-of-wealth function:

1-γ
W
U(W ) = , g >0
1- γ

For a given value of γ, the individual’s expected utility of final wealth equals:

1 1 1
E[U(W )] = ´ U(1,500) + ´ U(1,200) + ´ U(800)
4 2 4
1 (1500)1 - γ 1 (1200)1 - γ 1 (800)1 - γ
= ´ + ´ + ´
4 1- γ 2 1- γ 4 1- γ

The individual’s certainty equivalent wealth CE is then obtained by solving:

U(CE) = E[U(W )]

(CE)1 - γ 1 (1500)1 - γ 1 (1200)1 - γ 1 (800)1 - γ

i.e. = ´ + ´ + ´
1- γ 4 1- γ 2 1- γ 4 1- γ

for each value of γ.

The results are as follows:

γ E[U(W)] CE
2.0 – 0.0009 1116.28
1.5 – 0.0595 1131.57
1.1 – 4.9451 1143.57
1.01 – 93.1981 1146.24
1.001 – 992.9803 1146.50

Although the values of expected utility are very different, the values of the certainty
equivalent appear to be converging steadily towards a particular value.

(b) Now repeat the calculations assuming that the investor has utility-of-wealth function:

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IB235 Finance 1 Seminar 2, Autumn Term

U(W ) = ln W

The individual’s expected utility of final wealth equals:

1 1 1
E[U(W )] = ´ U(1,500) + ´ U(1,200) + ´ U(800)
4 2 4
1 1 1
= ´ ln(1500) + ´ ln(1200) + ´ ln(800)
4 2 4
= 7.0445

The individual’s certainty equivalent wealth CE is then obtained by solving:

U(CE) = E[U(W )]
i.e. ln(CE ) = 7.044
CE = 1146.53

It can be shown mathematically that:

W 1- γ - 1
® lnW as γ ® 1
1- γ

Thus, U(W) = lnW represents the limiting case as γ→1 of the power-law utility
functions, and CE = 1146.53 is the limit to which the values of the certainty equivalent
are converging, in part (a). Note that the constant term -1/(1-g) has no impact on the
value of CE as it does not affect either the first or second derivatives of U(W), and
therefore does not affect how risk averse the investor is.

This numerical example illustrates a general result. The values of a given utility
function can only be used to rank different lotteries for a given investor, and not across
investors with different utility functions. On the other hand, the certainty equivalent
can be compared across investors with differing degrees of risk aversion, as it is the
amount of money that the investor would be willing to pay to take the gamble.

Note also that the certainty equivalent CE increases with decreasing risk aversion (γ).
This makes sense: the less risk averse the individual, the more that he will value a risky
gamble (as he is tempted by the expected payoff, but worries less about the risk).

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